Form 10-Q
Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

 

(Mark One)

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

For the Quarterly Period Ended June 30, 2011

or

 

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

Commission File Number 1-11921

 

 

E*TRADE Financial Corporation

(Exact Name of Registrant as Specified in its Charter)

 

Delaware   94-2844166

(State or Other Jurisdiction

of Incorporation or Organization)

 

(I.R.S. Employer

Identification Number)

1271 Avenue of the Americas, 14th Floor, New York, New York 10020

(Address of Principal Executive Offices and Zip Code)

(646) 521-4300

(Registrant’s Telephone Number, including Area Code)

 

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨

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

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

As of August 1, 2011, there were 285,213,819 shares of common stock outstanding.


Table of Contents

E*TRADE FINANCIAL CORPORATION

FORM 10-Q QUARTERLY REPORT

For the Quarter Ended June 30, 2011

TABLE OF CONTENTS

 

PART I—FINANCIAL INFORMATION

  

Item 1. Consolidated Financial Statements (Unaudited)

     3   

Consolidated Statement of Income (Loss)

     44   

Consolidated Balance Sheet

     45   

Consolidated Statement of Comprehensive Income

     46   

Consolidated Statement of Shareholders’ Equity

     47   

Consolidated Statement of Cash Flows

     48   

Notes to Consolidated Financial Statements (Unaudited)

     50   

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

     50   

Note 2—Operating Interest Income and Operating Interest Expense

     53   

Note 3—Fair Value Disclosures

     53   

Note 4—Available-for-Sale and Held-to-Maturity Securities

     62   

Note 5—Loans, Net

     66   

Note 6—Accounting for Derivative Instruments and Hedging Activities

     72   

Note 7—Deposits

     75   

Note 8—Securities Sold Under Agreements to Repurchase and FHLB Advances and Other Borrowings

     75   

Note 9—Corporate Debt

     76   

Note 10—Shareholders’ Equity

     77   

Note 11—Earnings (Loss) per Share

     78   

Note 12—Regulatory Requirements

     78   

Note 13—Commitments, Contingencies and Other Regulatory Matters

     80   

Note 14—Segment Information

     85   

Note 15—Subsequent Event

     87   

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

     3   

Overview

     3   

Earnings Overview

     7   

Segment Results Review

     14   

Balance Sheet Overview

     18   

Liquidity and Capital Resources

     22   

Risk Management

     26   

Concentrations of Credit Risk

     27   

Summary of Critical Accounting Policies and Estimates

     36   

Glossary of Terms

     37   

Item 3.    Quantitative and Qualitative Disclosures about Market Risk

     42   

Item 4.    Controls and Procedures

     87   

PART II—OTHER INFORMATION

        

Item 1.    Legal Proceedings

     87   

Item 1A. Risk Factors

     91   

Item 2.    Unregistered Sales of Equity Securities and Use of Proceeds

     91   

Item 3.    Defaults Upon Senior Securities

     91   

Item 5.    Other Information

     91   

Item 6.    Exhibits

     92   

Signatures

     93   

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, Equity Edge, OptionsLink and the Converging Arrows logo are registered trademarks of E*TRADE Financial Corporation in the United States and in other countries.

 

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Table of Contents

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 and in our Annual Report on Form 10-K for the year ended December 31, 2010 filed with the Securities and Exchange Commission (“SEC”). The cautionary statements made in this report should be read as being applicable to all forward-looking statements wherever they appear in this report. We further caution that there may be risks associated with owning our securities other than those discussed in such filings. Important factors that may cause actual results to differ materially from any forward-looking statements are set forth in Item 1A. Risk Factors in the Annual Report on Form 10-K for the year ended December 31, 2010, and as updated in this report.

ITEM 1.    CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

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

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

GLOSSARY OF TERMS

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

OVERVIEW

Strategy

Our core business is our trading and investing customer franchise. Building on the strengths of this franchise, our growth strategy is focused on four areas: retail brokerage, corporate services and market making, wealth management, and banking.

 

   

Our retail brokerage business is our foundation. We believe a focus on these key factors will position us for future growth in this business: growing our sales force with a focus on long-term investing, optimizing our marketing spend, continuing to develop innovative products and services and minimizing account attrition.

 

   

Our corporate services and market making businesses enhance our strategy by allowing us to realize additional economic benefit from our retail brokerage business. Our corporate services business is a leading provider of software and services for managing equity compensation plans and is an important source of new retail brokerage accounts. Our market making business allows us to increase the economic benefit on the order flow from the retail brokerage business as well as generate additional revenues through external order flow.

 

   

We also plan to expand our wealth management offerings. Our vision is to provide wealth management services that are enabled by innovative technology and supported by guidance from professionals when needed.

 

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Our retail brokerage business generates a significant amount of customer cash and we plan to continue to utilize our bank to optimize the value of these customer deposits.

Our strategy also includes an intense focus on mitigating the credit losses in our legacy loan portfolio and maintaining disciplined expense management. We remain focused on strengthening our overall capital structure and positioning the Company for future growth.

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;

 

   

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

 

   

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;

 

   

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

 

   

our ability to obtain regulatory approval to move capital from our bank to our parent company; and

 

   

changes to the rules and regulations governing the financial services industry.

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 trading customers;

 

   

our ability to generate meaningful growth in the long-term investing customer group;

 

   

our ability to assess and manage credit risk;

 

   

our ability to generate capital sufficient to meet our operating needs, particularly a level sufficient to offset loan losses;

 

   

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           As of or For the        
     Three Months Ended
June 30,
    Variance     Six Months Ended June 30,     Variance  
     2011     2010     2011 vs. 2010     2011     2010     2011 vs. 2010  

Customer Activity Metrics:

           

Daily average revenue trades (“DARTs”)

    147,908        170,283        (13 )%      162,476        162,916        (0 )% 

Average commission per trade

  $ 11.14      $ 11.05        1   $ 11.24      $ 11.21        0

Margin receivables (dollars in billions)

  $ 5.7      $ 4.8        19   $ 5.7      $ 4.8        19

End of period brokerage accounts

    2,759,773        2,649,500        4     2,759,773        2,649,500        4

Net new brokerage accounts

    24,950        17,523        *        75,462        19,421        *   

Customer assets (dollars in billions)

  $ 185.6      $ 143.8        29   $ 185.6      $ 143.8        29

Net new brokerage assets (dollars in billions)

  $ 1.5      $ 2.1        *      $ 5.4      $ 4.3        *   

Brokerage related cash (dollars in billions)

  $ 26.3      $ 20.7        27   $ 26.3      $ 20.7        27

Company Financial Metrics:

           

Corporate cash (dollars in millions)

  $ 423.7      $ 481.1        (12 )%    $ 423.7      $ 481.1        (12 )% 

E*TRADE Bank excess risk-based capital (dollars in millions)

  $ 1,390.0      $ 1,008.4        38   $ 1,390.0      $     1,008.4        38

Special mention loan delinquencies (dollars in millions)

  $ 461.3      $ 660.3        (30 )%    $ 461.3      $ 660.3        (30 )% 

Allowance for loan losses (dollars in millions)

  $ 878.6      $ 1,102.9        (20 )%    $ 878.6      $ 1,102.9        (20 )% 

Enterprise net interest spread

    2.89     2.89     0.00     2.87     2.93     (0.06 )% 

Enterprise interest-earning assets (average in billions)

  $ 42.9      $ 41.0        5   $ 42.8      $ 41.7        3

 

*   

Percentage not meaningful.

Customer Activity Metrics

 

   

DARTs are the predominant driver of commissions revenue from our customers.

 

   

Average commission per trade is an indicator of changes in our customer mix, product mix and/or product pricing.

 

   

Margin receivables represent credit extended to customers and non-customers to finance their purchases of securities by borrowing against securities they currently own. Margin receivables are a key driver of net operating interest income.

 

   

End of period brokerage accounts and net new brokerage accounts are indicators of our ability to attract and retain brokerage customers.

 

   

Changes in customer assets are an indicator of the value of our relationship with the customer. An increase in 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.

 

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

 

   

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

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 capital that E*TRADE Bank has in excess of the regulatory minimum to be considered well-capitalized and is an indicator of E*TRADE Bank’s ability to absorb future losses. It is also a potential source of additional corporate cash, as this capital, if requested by us and approved by our regulators, could be sent as a dividend or otherwise distributed to the parent company.

 

   

Special mention loan delinquencies are loans 30-89 days past due and are an indicator of the expected trend for charge-offs in future periods as these loans have a greater propensity to migrate into nonaccrual status and ultimately charge-off.

 

   

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 management’s forecast of loan losses over the next twelve months as well as the estimated losses, including economic concessions to borrowers, over the estimated remaining life of loans modified in troubled debt restructurings. The general allowance for loan losses also includes a specific qualitative component to account for a variety of economic and operational factors that are not directly considered in the quantitative loss model, including the current level of unemployment and the limited historical charge-off and loss experience on modified loans, but are factors we believe may impact our level of credit losses.

 

   

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 the Second Quarter of 2011

Enhancements to Our Trading and Investing Products and Services

 

   

We continued to grow our sales force in the second quarter, increasing our financial consultant team by 30% in the first half of the year, as we continued to focus on engagement with long-term and retirement investors, as well as corporate clients;

 

   

We introduced weekly options, expanded fixed income news and research offerings in the Bond Resource Center, and expanded the availability of personalization tools;

 

   

We provided E*TRADE Securities’ customers with access to the AIG public offering, advocating for retail investors to have access to initial public offerings and other offerings typically limited to institutional investors; and

 

   

We expanded our corporate services client base with more than 30 new client contracts and continued to execute our strategy to service both private and public companies as a foundation for future retail brokerage account growth.

Issuance and Extinguishment of Senior Notes

 

   

During the quarter, we issued an aggregate principal amount of $435 million in senior notes due May 2016 (“6 3/4% Notes”), and used the proceeds to redeem all of the outstanding 7 3/8% Notes due September 2013, approximately $415 million in aggregate principal amount, including paying the associated redemption premium, accrued interest and related fees and expenses.

 

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Conversions of Convertible Debentures

 

   

On April 29, 2011, Citadel sold 27.5 million shares of the Company’s common stock through a secondary offering. As part of and following the offering, Citadel converted $314.1 million in convertible debentures into 30.4 million shares of common stock. A total of $325.1 million in convertible debentures were converted into 31.4 million shares of common stock during the quarter.

EARNINGS OVERVIEW

We generated net income of $47.1 million and $92.4 million, or $0.16 and $0.32 per share for the three and six months ended June 30, 2011, respectively. We reported total net revenue of $517.6 million and $1.1 billion for the three and six months ended June 30, 2011, respectively and provision for loan losses declined 38% and 49% to $103.1 million and $219.2 million, for the three and six months ended June 30, 2011, respectively, compared to the same periods in 2010.

Commissions, fees and service charges, principal transactions and other revenue decreased 11% to $174.1 million and 4% to $374.8 million for the three and six months ended June 30, 2011, respectively, compared to the same periods in 2010, which was driven primarily by a decline in trading activity during the comparable periods.

Total operating expenses increased 6% to $290.9 million and 3% to $588.9 million for the three and six months ended June 30, 2011, respectively, when compared to the same periods in 2010. This increase was driven primarily by an increase in advertising and market development expense and FDIC insurance premiums during the three and six months ended June 30, 2011.

The following sections describe in detail the changes in key operating factors and other changes and events that have affected net revenue, provision for loan losses, operating expense, other income (expense) and income tax expense (benefit).

Revenue

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

 

     Three Months  Ended
June 30,
    Variance     Six Months Ended
June 30,
    Variance  
       2011 vs. 2010       2011 vs. 2010  
         2011             2010         Amount     %     2011     2010     Amount      %  

Net operating interest income

   $ 315.4      $ 302.0      $ 13.4        4   $ 625.1      $ 622.4      $ 2.7         0

Commissions

     103.8        119.6        (15.8     (13 )%      228.3        232.8        (4.5      (2 )% 

Fees and service charges

     36.6        35.2        1.4        4     73.9        77.4        (3.5      (5 )% 

Principal transactions

     23.8        28.7        (4.9     (17 )%      53.3        54.9        (1.6      (3 )% 

Gains on loans and securities, net

     31.0        48.9        (17.9     (37 )%      63.3        78.0        (14.7      (19 )% 

Net impairment

     (2.9     (12.2     9.3        (76 )%      (8.9     (20.8     11.9         (57 )% 

Other revenues

     9.9        11.8        (1.9     (16 )%      19.3        25.8        (6.5      (25 )% 
  

 

 

   

 

 

   

 

 

     

 

 

   

 

 

   

 

 

    

Total non-interest income

     202.2        232.0        (29.8     (13 )%      429.2        448.1        (18.9      (4 )% 
  

 

 

   

 

 

   

 

 

     

 

 

   

 

 

   

 

 

    

Total net revenue

   $ 517.6      $ 534.0      $ (16.4     (3 )%    $ 1,054.3      $ 1,070.5      $ (16.2      (2 )% 
  

 

 

   

 

 

   

 

 

     

 

 

   

 

 

   

 

 

    

Total net revenue decreased 3% to $517.6 million and 2% to $1.1 billion for the three and six months ended June 30, 2011, respectively, compared to the same periods in 2010. This was driven primarily by lower gains on loans and securities, net and commissions, which were partially offset by an increase in net operating interest income and a decrease in net impairment.

Net Operating Interest Income

Net operating interest income increased 4% to $315.4 million and increased slightly to $625.1 million for the three and six months ended June 30, 2011, respectively, compared to the same periods in 2010. Net operating interest income is earned primarily through investing customer cash and deposits in interest-earning assets, which include: margin receivables, real estate loans, available-for-sale securities and held-to-maturity securities.

 

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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 millions):

 

      Three Months Ended June 30,  
     2011     2010  
     Average
Balance
     Operating
Interest
Inc./Exp.
     Average
Yield/
Cost
    Average
Balance
     Operating
Interest
Inc./Exp.
     Average
Yield/
Cost
 

Enterprise interest-earning assets:

                

Loans(1)

   $ 15,030.0       $ 181.0         4.82   $ 18,844.0       $ 225.3         4.78

Margin receivables

     5,732.5         58.7         4.11     4,479.4         50.0         4.47

Available-for-sale securities

     15,428.2         107.0         2.78     12,551.7         94.2         3.00

Held-to-maturity securities

     3,950.3         32.9         3.34     135.1         1.3         3.74

Cash and equivalents

     1,489.2         0.8         0.20     3,390.4         1.9         0.23

Segregated cash and investments

     638.6         0.2         0.09     927.3         0.6         0.24

Securities borrowed and other

     639.2         12.5         7.84     662.4         6.6         4.00
  

 

 

    

 

 

      

 

 

    

 

 

    

Total enterprise interest-earning assets

     42,908.0         393.1         3.67     40,990.3         379.9         3.71
     

 

 

         

 

 

    

Non-operating interest-earning and non-interest earning assets(2)

     4,290.5              4,273.5         
  

 

 

         

 

 

       

Total assets

   $ 47,198.5            $ 45,263.8         
  

 

 

         

 

 

       

Enterprise interest-bearing liabilities:

                

Retail deposits

   $ 26,042.5         11.1         0.17   $ 24,118.0         14.7         0.24

Brokered certificates of deposit

     49.0         0.7         5.64     116.1         1.5         5.18

Customer payables

     5,489.3         2.1         0.16     4,660.2         1.7         0.14

Securities sold under agreements to repurchase

     5,369.1         38.0         2.80     6,332.6         30.7         1.92

Federal Home Loan Bank (“FHLB”) advances and other borrowings

     2,745.2         26.9         3.89     2,747.2         30.8         4.43

Securities loaned and other

     655.2         0.4         0.24     599.5         0.4         0.28
  

 

 

    

 

 

      

 

 

    

 

 

    

Total enterprise interest-bearing liabilities

     40,350.3         79.2         0.78     38,573.6         79.8         0.82
     

 

 

         

 

 

    

Non-operating interest-bearing and non-interest bearing liabilities(3)

     2,208.5              2,704.2         
  

 

 

         

 

 

       

Total liabilities

     42,558.8              41,277.8         

Total shareholders’ equity

     4,639.7              3,986.0         
  

 

 

         

 

 

       

Total liabilities and shareholders’ equity

   $ 47,198.5            $ 45,263.8         
  

 

 

         

 

 

       

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

   $ 2,557.7       $ 313.9         2.89   $ 2,416.7       $ 300.1         2.89
  

 

 

    

 

 

      

 

 

    

 

 

    

Enterprise net interest margin (net yield on enterprise interest-earning assets)

           2.93           2.93

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

           106.34           106.27

Return on average:

                

Total assets

           0.40           0.31

Total shareholders’ equity

           4.06           3.52

Average equity to average total assets

           9.83           8.81

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

 

     Three Months Ended
June 30,
 
         2011           2010    

Enterprise net interest income

   $ 313.9      $ 300.1   

Taxable equivalent interest adjustment

     (0.3     (0.3

Customer cash held by third parties and other(4)

     1.8        2.2   
  

 

 

   

 

 

 

Net operating interest income

   $ 315.4      $ 302.0   
  

 

 

   

 

 

 

 

(1)   

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

(2)   

Non-operating interest-earning and non-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.

(3)   

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

(4)   

Includes interest earned on average customer assets of $3.7 billion and $3.1 billion for the three months ended June 30, 2011 and 2010, respectively, held by parties outside the Company, including third party money market funds and sweep deposit accounts at unaffiliated financial institutions.

 

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     Six Months Ended June 30,  
     2011     2010  
     Average
Balance
     Operating
Interest
Inc./Exp.
     Average
Yield/
Cost
    Average
Balance
     Operating
Interest
Inc./Exp.
     Average
Yield/
Cost
 

Enterprise interest-earning assets:

                

Loans(1)

   $ 15,425.2       $ 367.3         4.76   $ 19,383.3       $ 466.9         4.82

Margin receivables

     5,588.7         115.0         4.15     4,247.9         94.7         4.49

Available-for-sale securities

     15,589.6         218.2         2.80     13,132.9         203.8         3.10

Held-to-maturity securities

     3,238.4         53.7         3.32     67.9         1.3         3.71

Cash and equivalents

     1,659.7         1.7         0.20     2,913.5         3.3         0.23

Segregated cash and investments

     682.7         0.4         0.11     1,254.6         1.5         0.24

Securities borrowed and other

     641.5         22.3         7.00     674.2         13.7         4.09
  

 

 

    

 

 

      

 

 

    

 

 

    

Total enterprise interest-earning assets

     42,825.8         778.6         3.64     41,674.3         785.2         3.77
     

 

 

         

 

 

    

Non-operating interest-earning and non-interest earning assets(2)

     4,381.0              4,260.7         
  

 

 

         

 

 

       

Total assets

   $ 47,206.8            $ 45,935.0         
  

 

 

         

 

 

       

Enterprise interest-bearing liabilities:

                

Retail deposits

   $ 25,805.1         22.4         0.17   $ 24,467.8         33.1         0.27

Brokered certificates of deposit

     59.6         1.6         5.45     118.0         3.0         5.11

Customer payables

     5,404.6         4.0         0.15     4,917.3         3.6         0.15

Securities sold under agreements to repurchase

     5,625.6         76.0         2.69     6,352.2         65.5         2.05

Federal Home Loan Bank (“FHLB”) advances and other borrowings

     2,748.7         52.2         3.78     2,754.2         60.2         4.35

Securities loaned and other

     670.0         0.7         0.22     609.4         0.9         0.30
  

 

 

    

 

 

      

 

 

    

 

 

    

Total enterprise interest-bearing liabilities

     40,313.6         156.9         0.77     39,218.9         166.3         0.84
     

 

 

         

 

 

    

Non-operating interest-bearing and non-interest bearing liabilities(3)

     2,497.3              2,819.3         
  

 

 

         

 

 

       

Total liabilities

     42,810.9              42,038.2         

Total shareholders’ equity

     4,395.9              3,896.8         
  

 

 

         

 

 

       

Total liabilities and shareholders’ equity

   $ 47,206.8            $ 45,935.0         
  

 

 

         

 

 

       

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

   $ 2,512.2       $ 621.7         2.87   $ 2,455.4       $ 618.9         2.93
  

 

 

    

 

 

      

 

 

    

 

 

    

Enterprise net interest margin (net yield on enterprise interest-earning assets)

           2.90           2.97

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

           106.23           106.26

Return on average:

                

Total assets

           0.39           (0.06 )% 

Total shareholders’ equity

           4.20           (0.65 )% 

Average equity to average total assets

           9.31           8.48

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

 

      Six Months Ended
June 30,
 
         2011           2010    

Enterprise net interest income

   $ 621.7      $ 618.9   

Taxable equivalent interest adjustment

     (0.6     (0.6

Customer cash held by third parties and other(4)

     4.0        4.1   
  

 

 

   

 

 

 

Net operating interest income

   $ 625.1      $ 622.4   
  

 

 

   

 

 

 

 

(1)   

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

(2)   

Non-operating interest-earning and non-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.

(3)   

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

(4)   

Includes interest earned on average customer assets of $3.7 billion and $3.1 billion for the six months ended June 30, 2011 and 2010, respectively, held by parties outside the Company, including third party money market funds and sweep deposit accounts at unaffiliated financial institutions.

 

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Average enterprise interest-earning assets increased 5% to $42.9 billion and 3% to $42.8 billion for the three and six months ended June 30, 2011, respectively, compared to the same periods in 2010. This was primarily a result of the increases in average margin receivables and average available-for-sale and held-to-maturity securities, offset by decreases in average loans and average cash and equivalents.

Average enterprise interest-bearing liabilities increased 5% to $40.4 billion and 3% to $40.3 billion for the three and six months ended June 30, 2011, respectively, compared to the same periods in 2010. The increase in average enterprise interest-bearing liabilities was primarily due to increases in average retail deposits and average customer payables, offset by a decrease in average securities sold under agreements to repurchase.

Enterprise net interest spread was consistent at 2.89% and decreased by six basis points to 2.87% for the three and six months ended June 30, 2011, respectively, compared to the same periods in 2010. In the current interest rate environment with historically low levels of interest rates, we expect moderate pressure on the enterprise net interest spread.

Commissions

Commissions revenue decreased 13% to $103.8 million and 2% to $228.3 million for the three and six months ended June 30, 2011, respectively, compared to the same periods in 2010. The main factors that affect commissions are DARTs, average commission per trade and the number of trading days during the period. Average commission per trade is impacted by different trade types (e.g. equities, options, fixed income, stock plan, exchange-traded funds, mutual funds and cross border) that can have different commission rates. Accordingly, changes in the mix of trade types will impact average commission per trade.

DART volume decreased 13% to 147,908 and decreased slightly to 162,476 for the three and six months ended June 30, 2011, respectively, compared to the same periods in 2010. Option-related DARTs as a percentage of total DARTs represented 20% and 19% of trading volume for the three and six months ended June 30, 2011, respectively, compared to 16% for the comparable periods in 2010. Exchange-traded funds-related DARTs as a percentage of total DARTs represented 10% and 9% of trading volume for the three and six months ended June 30, 2011, respectively, compared to 10% for the comparable periods in 2010.

Average commission per trade increased 1% to $11.14 and increased slightly to $11.24 for the three and six months ended June 30, 2011, respectively, compared to the same periods in 2010. The slight increase was due to an improvement in the product and customer mix when compared to the same periods in 2010.

Fees and Service Charges

Fees and service charges increased 4% to $36.6 million and decreased 5% to $73.9 million for the three and six months ended June 30, 2011, respectively, compared to the same periods in 2010. The increase for the three months ended June 30, 2011 was driven by an increase in reorganization fees revenue when compared to the same period in 2010. The decrease for the six months ended June 30, 2011 was primarily due to the elimination of all account activity fees, which took effect in the second quarter of 2010.

Principal Transactions

Principal transactions decreased 17% to $23.8 million and 3% to $53.3 million for the three and six months ended June 30, 2011, respectively, compared to the same periods in 2010. Principal transactions are derived from our market making business in which we act as a market-maker for our brokerage customers’ orders as well as orders from third party customers. The decrease in principal transactions revenue was driven by a decrease in trading volumes when compared to the same periods in 2010.

 

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Gains on Loans and Securities, Net

Gains on loans and securities, net were $31.0 million and $63.3 million for the three and six months ended June 30, 2011, respectively, as shown in the following table (dollars in millions):

 

    Three Months  Ended
June 30,
    Variance     Six Months  Ended
June 30,
    Variance  
      2011 vs. 2010       2011 vs. 2010  
        2011             2010         Amount     %         2011             2010         Amount     %  

Gains on loans, net

  $ 0.1      $ 7.0      $ (6.9     *      $ 0.1      $ 6.2      $ (6.1     *   
 

 

 

   

 

 

   

 

 

     

 

 

   

 

 

   

 

 

   

Gains on available-for-sale securities, net

    25.3        42.9        (17.6     (41 )%      61.1        72.3        (11.2     (15 )% 

Gains (losses) on trading securities, net

    0.3        (0.4     0.7        *        0.9        0.3        0.6        *   

Hedge ineffectiveness

    5.3        (0.6     5.9        *        1.2        (0.8     2.0        *   
 

 

 

   

 

 

   

 

 

     

 

 

   

 

 

   

 

 

   

Gains on securities, net

    30.9        41.9        (11.0     (26 )%      63.2        71.8        (8.6     (12 )% 
 

 

 

   

 

 

   

 

 

     

 

 

   

 

 

   

 

 

   

Gains on loans and securities, net

  $ 31.0      $ 48.9      $ (17.9     (37 )%    $ 63.3      $ 78.0      $ (14.7     (19 )% 
 

 

 

   

 

 

   

 

 

     

 

 

   

 

 

   

 

 

   

 

*   Percentage not meaningful.

Net Impairment

We recognized $2.9 million and $8.9 million of net impairment during the three and six months ended June 30, 2011, respectively, on certain securities in our non-agency CMO portfolio due to continued deterioration in the expected credit performance of the underlying loans in those specific securities. The gross other-than-temporary impairment (“OTTI”) and the noncredit portion of OTTI, which was or had been previously recorded through other comprehensive income, are shown in the table below (dollars in millions):

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
       2011         2010         2011         2010    

Other-than-temporary impairment (“OTTI”)

   $ (2.0   $ (15.1   $ (6.9   $ (29.6

Less: noncredit portion of OTTI recognized into (out of) other comprehensive income (before tax)

     (0.9     2.9        (2.0     8.8   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net impairment

   $ (2.9   $ (12.2   $ (8.9   $ (20.8
  

 

 

   

 

 

   

 

 

   

 

 

 

Other Revenues

Other revenues decreased 16% to $9.9 million and 25% to $19.3 million for the three and six months ended June 30, 2011, respectively, compared to the same periods in 2010. The decrease for the six months ended June 30, 2011, was due to a decline in the income from the cash surrender value of bank-owned life insurance when compared to the same period in 2010. Additionally, the decrease during the six months ended June 30, 2011 was primarily due to the gain on sale of approximately $1 billion in savings accounts to Discover Financial Services in the first quarter of 2010, which increased other revenues during the six months ended June 30, 2010.

Provision for Loan Losses

Provision for loan losses decreased 38% to $103.1 million and 49% to $219.2 million for the three and six months ended June 30, 2011, respectively, compared to the same periods in 2010. The decrease in provision for loan losses was driven by improving credit trends, as evidenced by the lower levels of at-risk (30-179 days delinquent) loans in the one- to four-family and home equity loan portfolios. The provision for loan losses has declined 80% from its peak of $517.8 million in the third quarter of 2008 and we expect it to continue to decline in 2011 when compared to 2010, although performance is subject to variability from quarter to quarter.

 

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Operating Expense

The components of operating expense and the resulting variances are as follows (dollars in millions):

 

     Three Months  Ended
June 30,
    Variance     Six Months Ended
June 30,
     Variance  
       2011 vs. 2010        2011 vs. 2010  
         2011              2010         Amount     %         2011              2010          Amount     %  

Compensation and benefits

   $ 80.5       $ 80.9      $ (0.4     (1 )%    $ 164.5       $ 168.2       $ (3.7     (2 )% 

Clearing and servicing

     39.2         38.2        1.0        3     78.3         77.3         1.0        1

Advertising and market development

     37.0         29.8        7.2        24     81.4         67.9         13.5        20

Professional services

     21.5         19.5        2.0        10     44.9         39.8         5.1        13

FDIC insurance premiums

     24.0         19.3        4.7        25     44.6         38.6         6.0        16

Communications

     17.2         18.4        (1.2     (6 )%      32.8         38.9         (6.1     (16 )% 

Occupancy and equipment

     17.2         17.6        (0.4     (3 )%      34.0         35.8         (1.8     (5 )% 

Depreciation and amortization

     22.7         22.0        0.7        3     44.8         42.6         2.2        5

Amortization of other intangibles

     6.5         7.1        (0.6     (8 )%      13.1         14.3         (1.2     (8 )% 

Facility restructuring and other exit activities

     2.1         (1.8     3.9        *        5.6         1.5         4.1        *   

Other operating expenses

     23.0         24.7        (1.7     (7 )%      44.9         46.1         (1.2     (3 )% 
  

 

 

    

 

 

   

 

 

     

 

 

    

 

 

    

 

 

   

Total operating expense

   $ 290.9       $ 275.7      $ 15.2        6   $ 588.9       $ 571.0       $ 17.9        3
  

 

 

    

 

 

   

 

 

     

 

 

    

 

 

    

 

 

   

 

*   Percentage not meaningful.

Operating expense increased 6% to $290.9 million and 3% to $588.9 million for the three and six months ended June 30, 2011, respectively, compared to the same periods in 2010. The fluctuation was driven primarily by increases in advertising and market development expense and FDIC insurance premiums, which were partially offset by decreases in communications expense, compared to the same periods in 2010.

Compensation and Benefits

Compensation and benefits decreased 1% to $80.5 million and 2% to $164.5 million for the three and six months ended June 30, 2011, respectively, compared to the same periods in 2010. These decreases resulted primarily from lower incentive compensation expense when compared to the same periods in 2010.

Advertising and Market Development

Advertising and market development expense increased 24% to $37.0 million and 20% to $81.4 million for the three and six months ended June 30, 2011, respectively, compared to the same periods in 2010. These fluctuations were due largely to the planned increase in advertising expenditures in our continuing effort to attract new accounts and customer assets during the three and six months ended June 30, 2011.

FDIC Insurance Premiums

FDIC insurance premiums increased 25% to $24.0 million and 16% to $44.6 million for the three and six months ended June 30, 2011, respectively, compared to the same periods in 2010. The increase was due primarily to an industry wide change in the FDIC insurance premium assessment calculation.

Communications

Communications expense decreased 6% to $17.2 million and 16% to $32.8 million for the three and six months ended June 30, 2011, respectively, compared to the same periods in 2010. The decrease was driven primarily by a decline in vendor services fees when compared to the same periods in 2010.

 

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Other Income (Expense)

Other income (expense) increased 1% to $41.0 million and 6% to $84.6 million for the three and six months ended June 30, 2011, respectively, when compared to the same periods in 2010, as shown in the following table (dollars in millions):

 

     Three Months  Ended
June 30,
    Variance     Six Months  Ended
June 30,
    Variance  
       2011 vs. 2010       2011 vs. 2010  
         2011             2010         Amount     %         2011             2010         Amount      %  

Corporate interest income

   $ 0.1      $ 0.1      $ —          *      $ 0.7      $ 0.1      $ 0.6         *   

Corporate interest expense

     (44.8     (41.2     (3.6     9     (88.1     (82.2     (5.9      7

Gains on sales of investments, net

     —          —          —          *        —          0.1        (0.1      *   

Gains on early extinguishment of debt

     3.1        —          3.1        *        3.1        —          3.1         *   

Equity in income (loss) of investments and venture funds

     0.6        0.7        (0.1           (0.3     2.5        (2.8      *   
  

 

 

   

 

 

   

 

 

     

 

 

   

 

 

   

 

 

    

Total other income (expense)

   $ (41.0   $ (40.4   $ (0.6     1   $ (84.6   $ (79.5   $ (5.1      6
  

 

 

   

 

 

   

 

 

     

 

 

   

 

 

   

 

 

    

 

*   Percentage not meaningful.

Total other income (expense) for the three and six months ended June 30, 2011 primarily consisted of corporate interest expense on interest-bearing corporate debt. Offsetting interest expense for the three and six months ended June 30, 2011 was a $3.1 million gain on early extinguishment of debt related to the call of the 7 3/8% Notes in the second quarter of 2011.

Income Tax Expense (Benefit)

Income tax expense was $35.5 million and $69.2 million for the three and six months ended June 30, 2011, respectively compared to income tax expense of $17.2 million and income tax benefit of $0.9 million for the same periods in 2010. The effective tax rates were 43.0% and 32.9% for the three months ended June 30, 2011 and 2010, respectively and 42.8% and (6.6)% for the for the six months ended June 30, 2011 and 2010, respectively.

Valuation Allowance

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 could have a material adverse effect on our results of operations and financial condition.

We did not maintain a valuation allowance against federal deferred tax assets as of June 30, 2011 as we believe that it is more likely than not that all of these assets will be realized. We continue to maintain a valuation allowance for certain state and foreign deferred tax assets as it is more likely than not that they will not be realized.

Tax Ownership Change

During the third quarter of 2009, we exchanged $1.7 billion principal amount of interest-bearing debt for an equal principal amount of non-interest-bearing convertible debentures. Subsequent to the Debt Exchange, $592.3 million and $128.7 million debentures were converted into 57.2 million and 12.5 million shares of common stock during the third and fourth quarters of 2009, respectively. As a result of these conversions, we believe we experienced a tax ownership change during the third quarter of 2009.

 

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As of the date of the 2009 ownership change, we had federal NOLs available to carryforward of approximately $1.4 billion. Section 382 imposes an annual limitation on the amount of post-ownership change taxable income a corporation may offset with pre-ownership change NOLs. We believe the tax ownership change will extend the period of time it will take to fully utilize pre-ownership change NOLs, but will not limit the total amount of pre-ownership change NOLs we can utilize. Our estimate is that we will be subject to an overall annual limitation on the use of pre-ownership change NOLs of approximately $194 million. Our overall pre-ownership change NOLs have a statutory carryforward period of 20 years (the majority of which expire in 17 years). As a result, we believe we will be able to fully utilize these NOLs in future periods.

SEGMENT RESULTS REVIEW

We report operating results in two segments: 1) trading and investing; and 2) balance sheet management. Trading and investing includes retail brokerage products and services; investor-focused banking products; market making; and corporate services. Balance sheet management includes the management of asset allocation and credit, liquidity and interest rate risk; loans previously originated or purchased from third parties; and customer cash and deposits. Costs associated with certain functions that are centrally-managed are separately reported in a corporate/other category.

Trading and Investing

The following table summarizes trading and investing financial information and key metrics as of and for the three and six months ended June 30, 2011 and 2010 (dollars in millions, except for key metrics):

 

    Three Months Ended
June 30,
    Variance     Six Months Ended
June 30,
    Variance  
      2011 vs. 2010       2011 vs. 2010  
    2011     2010     Amount     %     2011     2010     Amount     %  

Net operating interest income

  $ 191.8      $ 192.4      $ (0.6     (0 )%    $ 380.6      $ 386.1      $ (5.5     (1 )% 

Commissions

    103.8        119.6        (15.8     (13 )%      228.3        232.8        (4.5     (2 )% 

Fees and service charges

    35.8        35.4        0.4        1     71.9        76.7        (4.8     (6 )% 

Principal transactions

    23.8        28.7        (4.9     (17 )%      53.3        54.9        (1.6     (3 )% 

Other revenues

    7.7        9.7        (2.0     (20 )%      15.8        21.1        (5.3     (25 )% 
 

 

 

   

 

 

   

 

 

     

 

 

   

 

 

   

 

 

   

Total net revenue

    362.9        385.8        (22.9     (6 )%      749.9        771.6        (21.7     (3 )% 

Total operating expense

    192.6        182.5        10.1        6     395.2        382.5        12.7        3
 

 

 

   

 

 

   

 

 

     

 

 

   

 

 

   

 

 

   

Trading and investing income before income taxes

  $ 170.3      $ 203.3      $ (33.0     (16 )%    $ 354.7      $ 389.1      $ (34.4     (9 )% 
 

 

 

   

 

 

   

 

 

     

 

 

   

 

 

   

 

 

   

Key Metrics:

               

DARTs

    147,908        170,283        (22,375     (13 )%      162,476        162,916        (440     (0 )% 

Average commission per trade

  $ 11.14      $ 11.05      $ 0.09        1   $ 11.24      $ 11.21      $ 0.03        0

Margin receivables (dollars in billions)

  $ 5.7      $ 4.8      $ 0.9        19   $ 5.7      $ 4.8      $ 0.9        19

End of period brokerage accounts

    2,759,773        2,649,500        110,273        4     2,759,773        2,649,500        110,273        4

Net new brokerage accounts

    24,950        17,523        7,427        *        75,462        19,421        56,041        *   

Customer assets (dollars in billions)

  $ 185.6      $ 143.8      $ 41.8        29   $ 185.6      $ 143.8      $ 41.8        29

Net new brokerage assets (dollars in billions)

  $ 1.5      $ 2.1      $ (0.6     *      $ 5.4      $ 4.3      $ 1.1        *   

Brokerage related cash (dollars in billions)

  $ 26.3      $ 20.7      $ 5.6        27   $ 26.3      $ 20.7      $ 5.6        27

 

*  

Percentage not meaningful.

 

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Our trading and investing segment generates revenue from brokerage and banking relationships with investors and from market making and corporate services activities. This segment generates five main sources of revenue: net operating interest income; commissions; fees and service charges; principal transactions; and other revenues. Other revenues include results from providing software and services for managing equity compensation plans from our corporate customers, as we ultimately service retail investors through these corporate relationships.

Trading and investing income before income taxes decreased 16% to $170.3 million and 9% to $354.7 million for the three and six months ended June 30, 2011, respectively, compared to the same periods in 2010. We continued to generate net new brokerage accounts, ending the quarter with 2.8 million accounts. Our brokerage related cash, which is one of our most profitable sources of funding, increased by $5.6 billion when compared to the same period in 2010.

Trading and investing commissions decreased 13% to $103.8 million and 2% to $228.3 million for the three and six months ended June 30, 2011, respectively, compared to the same periods in 2010. These decreases in commissions were primarily the result of a decrease in DARTs of 13% to 147,908 and a slight decrease to 162,476 for the three and six months ended June 30, 2011, respectively, compared to the same periods in 2010.

Trading and investing fees and service charges increased 1% to $35.8 million and decreased 6% to $71.9 million for the three and six months ended June 30, 2011, respectively, compared to the same periods in 2010. This decrease for the six months ended June 30, 2011 was driven primarily by our elimination of all account activity fees in the second quarter of 2010.

Trading and investing principal transactions decreased 17% to $23.8 million and 3% to $53.3 million for the three and six months ended June 30, 2011, respectively, compared to the same periods in 2010. The decrease in principal transactions revenue was driven by a decrease in trading volumes when compared to the same periods in 2010.

Trading and investing operating expense increased 6% to $192.6 million and 3% to $395.2 million for the three and six months ended June 30, 2011, respectively, compared to the same periods in 2010. The increase for the three and six months ended June 30, 2011 related primarily to an increase in advertising and market development expense.

As of June 30, 2011, we had approximately 2.8 million brokerage accounts, 1.0 million stock plan accounts and 0.5 million banking accounts. For the three months ended June 30, 2011 and 2010, our brokerage products contributed 68% for both periods and our banking products, which include sweep products, contributed 32% for both periods, of total trading and investing net revenue. For the six months ended June 30, 2011 and 2010, our brokerage products contributed 70% and 68%, respectively, and our banking products contributed 30% and 32%, respectively, of total trading and investing net revenue.

 

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Balance Sheet Management

The following table summarizes balance sheet management financial information and key metrics as of and for the three and six months ended June 30, 2011 and 2010 (dollars in millions):

 

    Three Months  Ended
June 30,
    Variance     Six Months Ended
June 30,
    Variance  
      2011 vs. 2010       2011 vs. 2010  
        2011             2010         Amount     %         2011             2010         Amount     %  

Net operating interest income

  $ 123.7      $ 109.6      $ 14.1        13   $ 244.5      $ 236.3      $ 8.2        3

Fees and service charges

    0.8        (0.2     1.0        *        1.9        0.8        1.1        144

Gains on loans and securities, net

    31.4        48.9        (17.5     (36 )%      63.6        78.0        (14.4     (18 )% 

Net impairment

    (2.9     (12.2     9.3        (76 )%      (8.9     (20.8     11.9        (57 )% 

Other revenues

    1.8        2.1        (0.3     (13 )%      3.3        4.7        (1.4     (29 )% 
 

 

 

   

 

 

   

 

 

     

 

 

   

 

 

   

 

 

   

Total net revenue

    154.8        148.2        6.6        4     304.4        299.0        5.4        2

Provision for loan losses

    103.1        165.7        (62.6     (38 )%      219.2        433.6        (214.4     (49 )% 

Total operating expense

    58.3        53.2        5.1        9     111.7        105.0        6.7        6
 

 

 

   

 

 

   

 

 

     

 

 

   

 

 

   

 

 

   

Balance sheet management loss before income taxes

  $ (6.6   $ (70.7   $ 64.1        (91 )%    $ (26.5   $ (239.6   $ 213.1        (89 )% 
 

 

 

   

 

 

   

 

 

     

 

 

   

 

 

   

 

 

   

Key Metrics:

               

Special mention loan delinquencies

  $ 461.3      $ 660.3      $ (199.0     (30 )%    $ 461.3      $ 660.3      $ (199.0     (30 )% 

Allowance for loan losses

  $ 878.6      $ 1,102.9      $ (224.3     (20 )%    $ 878.6      $ 1,102.9      $ (224.3     (20 )% 

Allowance for loan losses as a % of gross loans receivable

    6.04     6.09     *        (0.05 )%      6.04     6.09     *        (0.05 )% 

 

*   Percentage not meaningful.

Our balance sheet management segment generates revenue from managing loans previously originated or purchased from third parties as well as our customer cash and deposit relationships to generate additional net operating interest income.

The balance sheet management segment reported a loss of $6.6 million and $26.5 million for the three and six months ended June 30, 2011, respectively. The losses in the segment are due primarily to the provision for loan losses of $103.1 million and $219.2 million for the three and six months ended June 30, 2011, respectively.

Gains on loans and securities, net were $31.4 million and $63.6 million for the three and six months ended June 30, 2011, respectively, compared to $48.9 million and $78.0 million for the same periods in 2010. The gains on loans and securities, net were due primarily to gains on the sale of certain agency mortgage-backed securities and agency debentures during the three and six months ended June 30, 2011.

We recognized $2.9 million and $8.9 million of net impairment during the three and six months ended June 30, 2011, respectively, on certain securities in the non-agency CMO portfolio due to continued deterioration in the expected credit performance of the underlying loans in those specific securities. The net impairment included gross OTTI of $2.0 million and $6.9 million for the three and six months ended June 30, 2011. The amount that had been previously recorded through other comprehensive income and was reclassified into earnings during the three and six months ended June 30, 2011 was $0.9 million and $2.0 million, respectively.

Provision for loan losses decreased 38% to $103.1 million and 49% to $219.2 million for the three and six months ended June 30, 2011, respectively, compared to the same periods in 2010. The decrease in provision for loan losses was driven by improving credit trends, as evidenced by the lower levels of at-risk (30-179 days delinquent) loans in the one- to four- family and home equity loan portfolios.

Total balance sheet management operating expense increased 9% to $58.3 million and 6% to $111.7 million for the three and six months ended June 30, 2011, respectively, compared to the same periods in 2010. The

 

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increase in operating expense for the three and six months ended June 30, 2011 was due primarily to increased FDIC insurance premiums as a result of an industry wide change in the FDIC insurance premium assessment calculation.

Corporate/Other

The following table summarizes corporate/other financial information for the three and six months ended June 30, 2011 and 2010 (dollars in millions):

 

    Three Months  Ended
June 30,
    Variance     Six Months Ended
June 30,
    Variance  
      2011 vs. 2010       2011 vs. 2010  
        2011             2010         Amount     %     2011     2010     Amount     %  

Total net revenue

  $ (0.0   $ (0.0   $ —          *      $ (0.0   $ (0.0   $ —          *   
 

 

 

   

 

 

   

 

 

     

 

 

   

 

 

   

 

 

   

Compensation and benefits

    17.3        19.9        (2.6     (13 )%      35.0        41.0        (6.0     (15 )% 

Professional services

    8.0        7.0        1.0        13     17.5        15.4        2.1        14

Communications

    0.4        0.5        (0.1     (15 )%      0.7        0.9        (0.2     (26 )% 

Occupancy and equipment

    0.8        0.7        0.1        9     1.8        1.4        0.4        30

Depreciation and amortization

    4.7        6.4        (1.7     (27 )%      9.4        11.3        (1.9     (16 )% 

Facility restructuring and other exit activities

    2.1        (1.8     3.9        *        5.6        1.5        4.1        *   

Other operating expenses

    6.8        7.3        (0.5     (6 )%      12.0        12.1        (0.1     (1 )% 
 

 

 

   

 

 

   

 

 

     

 

 

   

 

 

   

 

 

   

Total operating expense

    40.1        40.0        0.1        0     82.0        83.6        (1.6     (2 )% 
 

 

 

   

 

 

   

 

 

     

 

 

   

 

 

   

 

 

   

Operating loss

    (40.1     (40.0     (0.1     0     (82.0     (83.6     1.6        (2 )% 

Total other income (expense)

    (41.0     (40.4     (0.6     1     (84.6     (79.5     (5.1     6
 

 

 

   

 

 

   

 

 

     

 

 

   

 

 

   

 

 

   

Corporate/other loss before income taxes

  $ (81.1   $ (80.4   $ (0.7     1   $ (166.6   $ (163.1   $ (3.5     2
 

 

 

   

 

 

   

 

 

     

 

 

   

 

 

   

 

 

   

 

*   Percentage not meaningful.

Our corporate/other category includes costs that are centrally-managed, technology related costs incurred to support centrally-managed functions, restructuring and other exit activities, corporate debt and corporate investments.

Our corporate/other loss before income taxes was $81.1 million and $166.6 million for the three and six months ended June 30, 2011, compared to $80.4 million and $163.1 million, respectively, for the same periods in 2010. Total other income (expense) consisted primarily of $44.8 million and $88.1 million in corporate interest expense for the three and six months ended June 30, 2011, respectively, on interest-bearing corporate debt. Offsetting interest expense for the three and six months ended June 30, 2011 was a $3.1 million gain on early extinguishment of debt related to the call of the 7 3/8% Notes in the second quarter of 2011.

 

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BALANCE SHEET OVERVIEW

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

 

                   Variance  
     June  30,
2011
     December  31,
2010
     2011 vs. 2010  
           Amount     %  

Assets:

          

Cash and equivalents

   $ 1,369.7       $ 2,374.3       $ (1,004.6     (42 )% 

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

     668.0         609.5         58.5        10

Securities(1)

     19,947.0         17,330.6         2,616.4        15

Margin receivables

     5,661.0         5,120.6         540.4        11

Loans, net

     13,679.7         15,127.4         (1,447.7     (10 )% 

Investment in FHLB stock

     152.8         164.4         (11.6     (7 )% 

Other(2)

     5,506.1         5,646.2         (140.1     (2 )% 
  

 

 

    

 

 

    

 

 

   

Total assets

   $ 46,984.3       $ 46,373.0       $ 611.3        1
  

 

 

    

 

 

    

 

 

   

Liabilities and shareholders’ equity:

          

Deposits

   $ 25,998.1       $ 25,240.3       $ 757.8        3

Wholesale borrowings(3)

     7,915.0         8,620.0         (705.0     (8 )% 

Customer payables

     5,341.7         5,020.1         321.6        6

Corporate debt

     1,543.4         2,145.9         (602.5     (28 )% 

Other liabilities

     1,373.8         1,294.3         79.5        6
  

 

 

    

 

 

    

 

 

   

Total liabilities

     42,172.0         42,320.6         (148.6     (0 )% 

Shareholders’ equity

     4,812.3         4,052.4         759.9        19
  

 

 

    

 

 

    

 

 

   

Total liabilities and shareholders’ equity

   $ 46,984.3       $ 46,373.0       $ 611.3        1
  

 

 

    

 

 

    

 

 

   

 

(1)   

Includes balance sheet line items trading, available-for-sale and held-to-maturity securities.

(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 FHLB advances and other borrowings.

Securities

Trading, available-for-sale and held-to-maturity securities are summarized as follows (dollars in millions):

 

                   Variance  
     June 30,
2011
     December 31,
2010
     2011 vs. 2010  
           Amount     %  

Trading securities

   $ 79.9       $ 62.2       $ 17.7        28
  

 

 

    

 

 

    

 

 

   

Available-for-sale securities:

          

Residential mortgage-backed securities:

          

Agency mortgage-backed securities and CMOs

   $ 13,578.4       $ 12,898.1       $ 680.3        5

Non-agency CMOs

     375.7         395.4         (19.7     (5 )% 
  

 

 

    

 

 

    

 

 

   

Total residential mortgage-backed securities

     13,954.1         13,293.5         660.6        5

Investment securities

     1,078.5         1,512.2         (433.7     (29 )% 
  

 

 

    

 

 

    

 

 

   

Total available-for-sale securities

   $ 15,032.6       $ 14,805.7       $ 226.9        2
  

 

 

    

 

 

    

 

 

   

Held-to-maturity securities:

          

Agency mortgage-backed securities and CMOs

   $ 4,076.2       $ 1,928.6       $ 2,147.6        111

Investment securities

     758.3         534.1         224.2        42
  

 

 

    

 

 

    

 

 

   

Total held-to-maturity securities

   $ 4,834.5       $ 2,462.7       $ 2,371.8        96
  

 

 

    

 

 

    

 

 

   

Total securities

   $ 19,947.0       $ 17,330.6       $ 2,616.4        15
  

 

 

    

 

 

    

 

 

   

 

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Securities represented 42% and 37% of total assets at June 30, 2011 and December 31, 2010, respectively. The increase in available-for-sale securities was due primarily to an increase of $0.7 billion in agency mortgage-backed securities and CMOs, partially offset by the sale or call of agency debentures. The increase in held-to-maturity securities was due primarily to the purchase of $2.1 billion in agency mortgage-backed securities and CMOs.

Loans, Net

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

 

                 Variance  
     June 30,
2011
    December 31,
2010
    2011 vs. 2010  
         Amount     %  

Loans held-for-sale

   $ 4.7      $ 5.5      $ (0.8     (15 )% 

One- to four-family

     7,347.2        8,170.3        (823.1     (10 )% 

Home equity

     5,833.6        6,410.3        (576.7     (9 )% 

Consumer and other

     1,262.0        1,443.4        (181.4     (13 )% 

Unamortized premiums, net

     110.8        129.1        (18.3     (14 )% 

Allowance for loan losses

     (878.6     (1,031.2     152.6        (15 )% 
  

 

 

   

 

 

   

 

 

   

Total loans, net

   $ 13,679.7      $ 15,127.4      $ (1,447.7     (10 )% 
  

 

 

   

 

 

   

 

 

   

Loans, net decreased 10% to $13.7 billion at June 30, 2011 from $15.1 billion at December 31, 2010. This decline was due primarily to the strategy of reducing balance sheet risk by allowing the loan portfolio to pay down, which we plan to do for the foreseeable future.

Deposits

Deposits are summarized as follows (dollars in millions):

 

                   Variance  
     June 30,
2011
     December 31,
2010
     2011 vs. 2010  
           Amount     %  

Sweep deposits

   $ 17,582.7       $ 16,139.6       $ 1,443.1        9

Complete savings deposits

     6,227.7         6,683.6         (455.9     (7 )% 

Other money market and savings deposits

     1,083.9         1,092.9         (9.0     (1 )% 

Checking deposits

     794.6         825.6         (31.0     (4 )% 

Certificates of deposit

     265.5         407.1         (141.6     (35 )% 

Brokered certificates of deposit

     43.7         91.5         (47.8     (52 )% 
  

 

 

    

 

 

    

 

 

   

Total deposits

   $ 25,998.1       $ 25,240.3       $ 757.8        3
  

 

 

    

 

 

    

 

 

   

Deposits represented 62% and 60% of total liabilities at June 30, 2011 and December 31, 2010, respectively. At June 30, 2011, 93% of our customer deposits were covered by FDIC insurance. Deposits generally provide the benefit of lower interest costs compared with wholesale funding alternatives. The increase in deposits of $0.8 billion during the six months ended June 30, 2011 was driven primarily by an increase of $1.4 billion in sweep deposits, partially offset by decreases of $0.5 billion and $0.1 billion in complete savings deposits and certificates of deposit, respectively.

 

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Table of Contents

The deposits balance is a component of the total customer cash and deposits balance reported as a customer activity metric of $34.7 billion and $33.5 billion at June 30, 2011 and December 31, 2010, respectively. The total customer cash and deposits balance is summarized as follows (dollars in millions):

 

                 Variance  
     June 30,
2011
    December 31,
2010
    2011 vs. 2010  
         Amount      %  

Deposits

   $ 25,998.1      $ 25,240.3      $ 757.8         3

Less: brokered certificates of deposit

     (43.7     (91.5     47.8         (52 )% 
  

 

 

   

 

 

   

 

 

    

Retail deposits

     25,954.4        25,148.8        805.6         3

Customer payables

     5,341.7        5,020.1        321.6         6

Customer cash balances held by third parties and other

     3,428.2        3,363.8        64.4         2
  

 

 

   

 

 

   

 

 

    

Total customer cash and deposits

   $ 34,724.3      $ 33,532.7      $ 1,191.6         4
  

 

 

   

 

 

   

 

 

    

Wholesale Borrowings

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

 

                   Variance  
     June 30,
2011
     December 31,
2010
     2011 vs. 2010  
           Amount     %  

Securities sold under agreements to repurchase

   $ 5,184.2       $ 5,888.3       $ (704.1     (12 )% 
  

 

 

    

 

 

    

 

 

   

FHLB advances

   $ 2,299.7       $ 2,284.1       $ 15.6        1

Subordinated debentures

     427.5         427.5         —          0

Other

     3.6         20.1         (16.5     (82 )% 
  

 

 

    

 

 

    

 

 

   

Total FHLB advances and other borrowings

   $ 2,730.8       $ 2,731.7       $ (0.9     (0 )% 
  

 

 

    

 

 

    

 

 

   

Total wholesale borrowings

   $ 7,915.0       $ 8,620.0       $ (705.0     (8 )% 
  

 

 

    

 

 

    

 

 

   

Wholesale borrowings represented 19% and 20% of total liabilities at June 30, 2011 and December 31, 2010, respectively. Securities sold under agreements to repurchase and FHLB advances are the primary wholesale funding sources of the Bank. As a result, we expect these balances to fluctuate over time as deposits and interest-earning assets fluctuate. The decrease in securities sold under agreements to repurchase of $0.7 billion during the six months ended June 30, 2011 was due to a planned decrease in the forecasted issuance of debt. We do not anticipate another significant decrease in securities sold under agreements to repurchase in the near term.

 

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Table of Contents

Corporate Debt

Corporate debt by type is shown as follows (dollars in millions):

 

     Face Value      Discount     Fair Value
Hedge
Adjustment
     Net  

June 30, 2011

                          

Interest-bearing notes:

          

Senior notes:

          

7 7/8% Notes, due 2015

   $ 243.2       $ (1.3   $ 8.3       $ 250.2   

6 3/4% Notes, due 2016

     435.0         (8.3     —           426.7   
  

 

 

    

 

 

   

 

 

    

 

 

 

Total senior notes

     678.2         (9.6     8.3         676.9   

12 1/2% Springing lien notes, due 2017

     930.2         (170.5     6.8         766.5   
  

 

 

    

 

 

   

 

 

    

 

 

 

Total interest-bearing notes

     1,608.4         (180.1     15.1         1,443.4   

Non-interest-bearing debt:

          

0% Convertible debentures, due 2019

     100.0         —          —           100.0   
  

 

 

    

 

 

   

 

 

    

 

 

 

Total corporate debt

   $ 1,708.4       $ (180.1   $ 15.1       $ 1,543.4   
  

 

 

    

 

 

   

 

 

    

 

 

 
     Face Value      Discount     Fair Value
Hedge
Adjustment
     Net  

December 31, 2010

                          

Interest-bearing notes:

          

Senior notes:

          

8% Notes, due 2011

   $ 3.6       $ —        $ —         $ 3.6   

7 3/8% Notes, due 2013

     414.7         (2.5     15.1         427.3   

7 7/8% Notes, due 2015

     243.2         (1.5     9.3         251.0   
  

 

 

    

 

 

   

 

 

    

 

 

 

Total senior notes

     661.5         (4.0     24.4         681.9   

12 1/2% Springing lien notes, due 2017

     930.2         (177.5     7.3         760.0   
  

 

 

    

 

 

   

 

 

    

 

 

 

Total interest-bearing notes

     1,591.7         (181.5     31.7         1,441.9   

Non-interest-bearing debt:

          

0% Convertible debentures, due 2019

     704.0         —          —           704.0   
  

 

 

    

 

 

   

 

 

    

 

 

 

Total corporate debt

   $ 2,295.7       $ (181.5   $ 31.7       $ 2,145.9   
  

 

 

    

 

 

   

 

 

    

 

 

 

Corporate debt decreased 28% to $1.5 billion at June 30, 2011 from $2.1 billion at December 31, 2010. The decline was due to the conversion of approximately $604 million in convertible debentures into 58.4 million shares of common stock during the six months ended June 30, 2011. The remaining face value of the convertible debentures as of June 30, 2011 was $100.0 million.

During the second of quarter of 2011, we issued an aggregate principal amount of $435 million in 6 3/4% Notes, and used the proceeds to redeem all of the outstanding 7 3/8% Notes due September 2013, approximately $415 million aggregate principal amount, including paying the associated redemption premium, accrued interest and related fees and expenses.

 

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Table of Contents

Shareholders’ Equity

The activity in shareholders’ equity during the six months ended June 30, 2011 is summarized as follows (dollars in millions):

 

      Common Stock/
Additional Paid-In
Capital
     Accumulated
Deficit/Other
Comprehensive Loss
    Total  

Beginning balance, December 31, 2010

   $ 6,642.9       $ (2,590.5   $ 4,052.4   

Net income

     —           92.4        92.4   

Conversions of convertible debentures

     603.9         —          603.9   

Net change from available-for-sale securities

     —           79.7        79.7   

Net change from cash flow hedging instruments

     —           (23.4     (23.4

Other(1)

     3.8         3.5        7.3   
  

 

 

    

 

 

   

 

 

 

Ending balance, June 30, 2011

   $ 7,250.6       $ (2,438.3   $ 4,812.3   
  

 

 

    

 

 

   

 

 

 

 

(1)   

Other includes employee share-based compensation accounting and changes in accumulated other comprehensive loss from foreign currency translation.

Shareholders’ equity increased 19% to $4.8 billion at June 30, 2011 from $4.1 billion at December 31, 2010. This increase was due primarily to the conversion of $603.9 million in convertible debentures into 58.4 million shares of common stock during the six months ended June 30, 2011.

LIQUIDITY AND CAPITAL RESOURCES

We have established liquidity and capital policies 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 could continue for some time.

We believe liquidity is of critical importance to the Company and especially important within E*TRADE Bank. The objective of our policies is to ensure that we can meet our corporate and banking liquidity needs under both normal operating conditions and under periods of stress in the financial markets. Our corporate liquidity needs are primarily driven by the amount of principal and interest due on our corporate debt as well as any capital needs at E*TRADE Bank. Our banking liquidity needs are driven primarily by the level and volatility of our customer deposits. Management maintains an extensive set of liquidity sources and monitors certain business trends and market metrics closely in an effort to ensure we have sufficient liquidity and to avoid dependence on other more expensive sources of funding. Management believes the following sources of liquidity are of critical importance in maintaining ample funding for liquidity needs: Corporate cash, Bank cash, deposits and unused FHLB borrowing capacity. Management believes that within deposits, sweep deposits are of particular importance as they are the most stable source of liquidity for E*TRADE Bank when compared to non-sweep deposits. Overall, management believes that these liquidity sources, which we expect to fluctuate in any given period, are more than sufficient to meet our needs for the foreseeable future.

Capital is generated primarily through our business operations and our capital market activities. The trading and investing segment has been profitable and a generator of capital for the past seven years and we expect that trend to continue. The balance sheet management segment has generated cumulative losses in prior periods, driven primarily by the provision for loan losses; we believe the provision for loan losses will decline in 2011 as compared to 2010 but is subject to variability from quarter to quarter. The primary business operations of both the trading and investing and balance sheet management segments are contained within E*TRADE Bank; therefore, we believe a key indicator of the capital generated or used in our business operations is the level of regulatory capital in E*TRADE Bank. During the six months ended June 30, 2011, E*TRADE Bank generated

 

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an additional $284 million of risk-based capital in excess of the level our regulators define as well-capitalized. The continued generation of additional risk-based capital is a positive indicator that the regulatory capital in E*TRADE Bank is sufficient to meet its operating needs.

Consolidated Cash and Equivalents

The consolidated cash and equivalents balance decreased by $1.0 billion to $1.4 billion for the six months ended June 30, 2011. The majority of this balance is cash held in regulated subsidiaries, primarily the Bank, outlined as follows (dollars in millions):

 

     June 30,
2011
     December 31,
2010
     Variance  
            2011 vs. 2010  

Corporate cash

   $ 423.7       $ 470.5       $ (46.8

Bank cash

     883.7         1,812.1         (928.4

International brokerage and other cash

     62.3         91.7         (29.4
  

 

 

    

 

 

    

 

 

 

Total consolidated cash

   $ 1,369.7       $ 2,374.3       $ (1,004.6
  

 

 

    

 

 

    

 

 

 

Corporate cash is the primary source of liquidity at the parent company. 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. We believe corporate cash is a useful measure of the parent company’s liquidity as it is the primary source of capital above and beyond the capital deployed in our regulated subsidiaries. Corporate cash can fluctuate in any given quarter and is impacted primarily by tax settlements, approval and timing of subsidiary dividends, debt service costs and other unallocated overhead costs.

Liquidity Available from Subsidiaries

Liquidity available to the Company from its subsidiaries is limited by regulatory requirements. In addition, E*TRADE Bank may not pay dividends to the parent company without approval from its regulator. 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.

We maintain capital in excess of regulatory minimums at our regulated subsidiaries, the most significant of which is E*TRADE Bank. As of June 30, 2011, we held $1.4 billion of risk-based total capital at E*TRADE Bank in excess of the regulatory minimum level required to be considered “well capitalized.” In the current credit environment, we plan to maintain excess risk-based total 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 June 30, 2011 and December 31, 2010, all of our brokerage subsidiaries met their minimum net capital requirements. Our broker-dealer subsidiaries had excess net capital of $720.7 million1 at June 30, 2011, an increase of $71.5 million from December 31, 2010. While we cannot assure that we would obtain regulatory approval in the future to withdraw any of this excess net capital, $539.0 million is available for dividend while still maintaining a capital level above regulatory “early warning” guidelines.

 

1    The excess net capital of the broker-dealer subsidiaries at June 30, 2011 included $460.9 million and $188.8 million of excess net capital at E*TRADE Clearing LLC and E*TRADE Securities LLC, respectively, which are subsidiaries of E*TRADE Bank and are also included in the excess risk-based capital of E*TRADE Bank.

 

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Financial Regulatory Reform Legislation and Basel III Accords

We believe the majority of the changes in the Dodd-Frank Act will have no material impact on our business. We believe, however, that the implementation of holding company capital requirements is relevant to us as the parent company is not currently subject to capital requirements. These requirements are expected to become effective within the next four years. We believe the requirements are an important measure of our capital strength and we have begun to track these ratios internally, using the current capital ratios that apply to bank holding companies, as we plan for this future requirement. The Tier I leverage, Tier I risk-based capital and total risk-based capital ratios are non-GAAP measures as the holding company is not yet held to these capital requirements and are calculated as follows (dollars in millions):

 

                 Variance  
     June 30,
2011
    December 31,
2010
    2011 vs. 2010  
         Amount     %  

Shareholders’ equity

   $ 4,812.3      $ 4,052.4      $ 759.9        19

Deduct:

        

Losses in other comprehensive income on available-for-sale debt securities and cash flow hedges, net of tax

     (383.6     (439.9     56.3        (13 )% 

Goodwill and other intangible assets, net of deferred tax liabilities

     1,992.8        2,046.4        (53.6     (3 )% 

Add:

        

Qualifying restricted core capital elements

     433.0        433.0        —          0
  

 

 

   

 

 

   

 

 

   

Subtotal

     3,636.1        2,878.9        757.2        26

Deduct:

        

Disallowed servicing assets and deferred tax assets

     1,248.4        1,351.3        (102.9     (8 )% 
  

 

 

   

 

 

   

 

 

   

Tier I capital

     2,387.7        1,527.6        860.1        56
  

 

 

   

 

 

   

 

 

   

Add:

        

Allowable allowance for loan losses

     296.7        295.6        1.1        0
  

 

 

   

 

 

   

 

 

   

Total capital

     2,684.4        1,823.2        861.2        47
  

 

 

   

 

 

   

 

 

   

Total average assets

     47,198.5        46,043.4        1,155.1        3

Deduct:

        

Goodwill and other intangible assets, net of deferred tax liabilities

     1,992.8        2,046.4        (53.6     (3 )% 
  

 

 

   

 

 

   

 

 

   

Subtotal

     45,205.7        43,997.0        1,208.7        3

Deduct:

        

Disallowed servicing assets and deferred tax assets

     1,248.4        1,351.3        (102.9     (8 )% 
  

 

 

   

 

 

   

 

 

   

Average total assets for leverage capital purposes

   $ 43,957.3      $ 42,645.7        1,311.6        3
  

 

 

   

 

 

   

 

 

   

Total risk-weighted assets(1)

     23,154.7        22,915.8        238.9        1

Tier I capital/Average total assets for leverage capital purposes

     5.4     3.6     *        1.8

Tier I capital/Total risk-weighted assets

     10.3     6.7     *        3.6

Total capital/Total risk-weighted assets

     11.6     8.0     *        3.6

 

*   Percentage not meaningful.
(1)   

Under the regulatory guidelines for risk-based capital, on-balance sheet assets and credit equivalent amounts of derivatives and off-balance sheet items are assigned to one of several broad risk categories according to the obligor or, if relevant, the guarantor or the nature of any collateral. The aggregate dollar amount in each risk category is then multiplied by the risk weight associated with that category. The resulting weighted values from each of the risk categories are aggregated for determining total risk-weighted assets.

 

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During the first half of 2011, $603.9 million in convertible debentures were converted into 58.4 million shares of common stock, which improved our holding company ratios. The increase to capital as a result of these additional conversions raised our estimated holding company capital ratios to exceed the “well capitalized” minimums under current bank holding company guidelines. As of June 30, 2011, the parent company Tier I leverage ratio was approximately 5.4% compared to the minimum ratio required to be “well capitalized” of 5%, the Tier I risk-based capital ratio was approximately 10.3% compared to the minimum ratio required to be “well capitalized” of 6%, and the total risk-based capital ratio was approximately 11.6% compared to the minimum ratio required to be “well capitalized” of 10%.

We have also begun to track our Tier I common ratio internally, which is a non-GAAP measure and currently has no mandated minimum or “well capitalized” standard. We believe this ratio is an important measure of our capital strength. The Tier I common ratio is defined as the Tier I capital less elements of Tier I capital that are not in the form of common equity, such as trust preferred securities, divided by total risk-weighted assets. As of June 30, 2011, the parent company Tier I common ratio was approximately 8.4%. The following table shows the calculation of Tier I common ratio (dollars in millions):

 

                 Variance  
     June 30,
2011
    December 31,
2010
    2011 vs. 2010  
         Amount     %  

Shareholders’ equity

   $ 4,812.3      $ 4,052.4      $ 759.9        19

Deduct:

        

Losses in other comprehensive income on available-for-sale debt securities and cash flow hedges, net of tax

     (383.6     (439.9     56.3        (13 )% 

Goodwill and other intangible assets, net of deferred tax liabilities

     1,992.8        2,046.4        (53.6     (3 )% 
  

 

 

   

 

 

   

 

 

   

Subtotal

     3,203.1        2,445.9        757.2        31

Deduct:

        

Disallowed servicing assets and deferred tax assets

     1,248.4        1,351.3        (102.9     (8 )% 
  

 

 

   

 

 

   

 

 

   

Tier I common

     1,954.7        1,094.6        860.1        79
  

 

 

   

 

 

   

 

 

   

Total risk-weighted assets

     23,154.7        22,915.8        238.9        1

Tier I common/Total risk-weighted assets

     8.4     4.8     *        3.6

 

*   Percentage not meaningful.

The Federal Reserve Bank announced that it expects to issue a notice of proposed rule-making in 2011 that will outline how the Basel III Accords will be implemented for U.S. institutions. We will continue to monitor the ongoing rule-making process to assess both the timing and the impact of the Dodd-Frank Act and Basel III Accords on our business.

Other Sources of Liquidity

We also maintain $350 million in uncommitted financing to meet margin lending needs. At June 30, 2011, there were no outstanding balances and the full $350 million was available.

We rely on borrowed funds, from sources such as securities sold under agreements to repurchase and FHLB advances, to provide liquidity for E*TRADE Bank. Our ability to borrow these funds is dependent upon the continued availability of funding in the wholesale borrowings market. At June 30, 2011, E*TRADE Bank had approximately $3.1 billion in additional collateralized borrowing capacity with the FHLB. We also have the ability to generate liquidity in the form of additional deposits by raising the yield on our customer deposit accounts.

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

 

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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  1. Consolidated Financial Statements (Unaudited).

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

 

   

Interest Rate Risk—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—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.

For additional information on liquidity risk, see Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources. For additional information about our interest rate risk, see Item 3. Quantitative and Qualitative Disclosures about Market Risk. Operational risk and the management of risk are more fully described in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the year ended December 31, 2010. We are also subject to other risks that could impact our business, financial condition, results of operations or cash flows in future periods. See Item 1A. Risk Factors in the Annual Report on Form 10-K for the year ended December 31, 2010, and as updated in this report.

Credit Risk Management

Our primary sources of credit risk are our loan and securities portfolios, where risk 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, whose objective is to monitor current and expected market conditions and the associated probable impact on the Company’s credit risk. The Credit Risk Committee establishes credit risk guidelines in accordance with the Company’s strategic objectives and existing policies. The Credit Risk Committee reviews investment and lending activities involving credit risk to ensure consistency with those established guidelines. These reviews involve an analysis of portfolio balances, delinquencies, losses, recoveries, default management and collateral liquidation performance, as well as, any credit risk mitigation efforts relating to the portfolios. In addition, the Credit Risk Committee reviews and approves credit related counterparties engaged in financial transactions with the Company.

 

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Loss Mitigation

We have a credit management team that focuses on the mitigation of potential losses in the loan portfolio. 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 our exposure to open home equity lines from a high of over $7 billion in 2007 to $0.5 billion as of June 30, 2011.

We also have an active loan modification program that focuses on the mitigation of potential losses in the loan portfolio. We consider modifications in which we made an economic concession to a borrower experiencing financial difficulty a troubled debt restructuring (“TDR”). During the six months ended June 30, 2011, we modified $274.4 million and $62.3 million of one- to four-family and home equity loans, respectively, in which the modification was considered a TDR.

We also processed minor modifications on a number of loans through traditional collections actions taken in the normal course of servicing delinquent accounts. These actions typically result in an insignificant delay in the timing of payments; therefore, we do not consider such activities to be economic concessions to the borrowers. As of June 30, 2011 and December 31, 2010, we had $45.6 million and $49.9 million of mortgage loans, respectively, in which the modification was not considered a TDR due to the insignificant delay in the timing of payments. Approximately 9% and 8% of these loans were classified as nonperforming as of June 30, 2011 and December 31, 2010, respectively.

We continue to review the mortgage loan portfolio in order to identify loans to be repurchased by the originator. Our review is primarily focused on identifying loans with 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. Approximately $12.6 million and $25.8 million of loans were repurchased by the original sellers for the three and six months ended June 30, 2011, respectively. A total of $247.5 million of loans were repurchased by the original sellers since we actively started reviewing our purchased loan portfolio beginning in 2008.

We also have an initiative to assess our servicing relationships and where appropriate transfer certain mortgage loans to higher quality servicers, including servicers who specialize in handling troubled loans. We believe this initiative will improve the credit performance of the loans transferred in future periods when compared to the expected credit performance of these same loans if they had not been transferred. As of June 30, 2011, $1.1 billion of mortgage loans were at these higher quality servicers. We also completed a transfer of an additional $1.4 billion of mortgage loans in early July 2011, which resulted in a total of $2.5 billion, or approximately 20%, of our mortgage loan portfolio at higher quality servicers as of July 2011.

Underwriting Standards—Originated Loans

We provide access to real estate loans for our customers through a third party company. This product is offered as a convenience to our customers and is not one of our primary product offerings. We structured this arrangement to minimize our assumption of any of the typical risks commonly associated with mortgage lending. The third party company providing this product performs all processing and underwriting of these loans. Shortly after closing, the third party company purchases the loans from us and is responsible for the credit risk associated with these loans. We originated $28.2 million and $56.0 million in loans during the three and six months ended June 30, 2011, respectively, and we had commitments to originate mortgage loans of $19.2 million at June 30, 2011.

CONCENTRATIONS OF CREDIT RISK

Loans

We track and review factors to predict and monitor credit risk in the mortgage loan portfolio on an ongoing basis. These factors include: loan type, estimated current loan-to-value (“LTV”)/combined loan-to-value (“CLTV”) ratios, documentation type, borrowers’ current credit scores, housing prices, acquisition channel, loan vintage and geographic location of the property. In economic conditions in which housing prices generally appreciate, we believe that loan type, LTV/CLTV ratios, documentation type and credit scores are the key factors

 

27


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in determining future loan performance. In a housing market with declining home prices and less credit available for refinance, we believe the LTV/CLTV ratio becomes a more important factor in predicting and monitoring credit risk. The factors are updated on at least a quarterly basis. We track and review delinquency status to predict and monitor credit risk in the consumer and other loan portfolio on an ongoing basis.

The home equity loan portfolio is primarily second lien loans on residential real estate properties, which have a higher level of credit risk than first lien mortgage loans. Approximately 14% of the home equity portfolio was in the first lien position as of June 30, 2011. We hold both the first and second lien positions in less than 1% of the home equity loan portfolio. We believe home equity loans with a CLTV of 90% or higher or a Fair Isaac Credit Organization (“FICO”) score below 700 are the loans with the highest levels of credit risk in our portfolios.

The following tables show the distribution of the mortgage loan portfolios by credit quality indicator (dollars in millions):

      One- to Four-Family     Home Equity  

Current LTV/CLTV(1)

   June 30,
2011
    December 31,
2010
    June 30,
2011
    December 31,
2010
 

<=70%

   $ 1,157.5      $ 1,380.3      $ 975.7      $ 1,084.9   

70% - 80%

     715.0        852.9        345.7        400.0   

80% - 90%

     916.0        1,168.3        475.6        575.9   

90% - 100%

     1,030.1        1,161.2        611.0        727.0   

>100%

     3,528.6        3,607.6        3,425.6        3,622.5   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total mortgage loans receivable

   $ 7,347.2      $ 8,170.3      $ 5,833.6      $ 6,410.3   
  

 

 

   

 

 

   

 

 

   

 

 

 

Average estimated current LTV/CLTV(2)

     105.1     100.8     110.6     107.7

Average LTV/CLTV at loan origination(3)

     70.8     70.6     79.2     79.3

 

(1)   

Current CLTV calculations for home equity loans are based on the maximum available line for home equity lines of credit and outstanding principal balance for home equity installment loans. Current property values are updated on a quarterly basis 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.

(2)   

The average estimated current LTV/CLTV ratio reflects the outstanding balance at the balance sheet date, divided by the estimated current property value.

(3)   

Average LTV/CLTV at loan origination calculations are based on LTV/CLTV at time of purchase for one- to four-family purchased loans and undrawn balances for home equity loans.

     One- to Four-Family      Home Equity  
     June 30,      December 31,      June 30,      December 31,  

Documentation Type

   2011      2010      2011      2010  

Full documentation

   $ 3,158.2       $ 3,556.5       $ 2,938.0       $ 3,201.4   

Low/no documentation

     4,189.0         4,613.8         2,895.6         3,208.9   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total mortgage loans receivable

   $ 7,347.2       $ 8,170.3       $ 5,833.6       $ 6,410.3   
  

 

 

    

 

 

    

 

 

    

 

 

 
     One- to Four-Family      Home Equity  

Current FICO(1)

   June 30,
2011
     December 31,
2010
     June 30,
2011
     December 31,
2010
 

>=720

   $ 4,009.3       $ 4,438.4       $ 3,072.8       $ 3,101.8   

719 - 700

     603.1         709.6         531.2         665.7   

699 - 680

     529.9         566.3         428.9         550.8   

679 - 660

     400.0         434.8         352.2         411.7   

659 - 620

     589.9         634.0         480.8         512.5   

<620

     1,215.0         1,387.2         967.7         1,167.8   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total mortgage loans receivable

   $ 7,347.2       $ 8,170.3       $ 5,833.6       $ 6,410.3   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

(1)   

FICO scores are updated on a quarterly basis; however, as of June 30, 2011 and December 31, 2010, there were some loans for which the updated FICO scores were not available. The current FICO distribution as of June 30, 2011 included original FICO scores for approximately $178 million and $63 million of one- to four-family and home equity loans, respectively. The current FICO distribution as of December 31, 2010 included original FICO scores for approximately $218 million and $168 million of one- to four-family and home equity loans, respectively.

 

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     One- to Four-Family      Home Equity  

Acquisition Channel

   June 30,
2011
     December 31,
2010
     June 30,
2011
     December 31,
2010
 

Purchased from a third party

   $ 6,021.6       $ 6,687.7       $ 5,102.6       $ 5,607.2   

Originated by the Company

     1,325.6         1,482.6         731.0         803.1   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total mortgage loans receivable

   $ 7,347.2       $ 8,170.3       $ 5,833.6       $ 6,410.3   
  

 

 

    

 

 

    

 

 

    

 

 

 
     One- to Four-Family      Home Equity  

Vintage Year

   June 30,
2011
     December 31,
2010
     June 30,
2011
     December 31,
2010
 

2003 and prior

   $ 272.1       $ 297.6       $ 345.2       $ 392.1   

2004

     685.1         759.3         529.9         585.7   

2005

     1,528.1         1,713.4         1,496.2         1,615.8   

2006

     2,800.1         3,108.3         2,716.9         2,999.1   

2007

     2,050.3         2,276.6         733.9         805.0   

2008

     11.5         15.1         11.5         12.6   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total mortgage loans receivable

   $ 7,347.2       $ 8,170.3       $ 5,833.6       $ 6,410.3   
  

 

 

    

 

 

    

 

 

    

 

 

 
     One- to Four-Family      Home Equity  

Geographic Location

   June 30,
2011
     December 31,
2010
     June 30,
2011
     December 31,
2010
 

California

   $ 3,407.2       $ 3,773.6       $ 1,705.7       $ 2,038.3   

New York

     546.9         613.0         416.4         459.0   

Florida

     515.0         563.4         412.9         456.0   

Virginia

     313.6         338.1         256.9         278.0   

Other states

     2,564.5         2,882.2         3,041.7         3,179.0   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total mortgage loans receivable

   $ 7,347.2       $ 8,170.3       $ 5,833.6       $ 6,410.3   
  

 

 

    

 

 

    

 

 

    

 

 

 

Approximately 39% and 40% of the Company’s real estate loans were concentrated in California at June 30, 2011 and December 31, 2010, respectively. No other state had concentrations of real estate loans that represented 10% or more of the Company’s real estate portfolio.

Allowance for Loan Losses

The allowance for loan losses is management’s estimate of credit losses inherent in the loan portfolio as of the balance sheet date. The estimate of the allowance for loan losses is based on a variety of quantitative and qualitative factors, including the composition and quality of the portfolio; delinquency levels and trends; current and historical charge-off and loss experience; historical loss mitigation 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. The allowance for loan losses is typically equal to management’s forecast of loan losses in the twelve months following the balance sheet date as well as the estimated losses, including economic concessions to borrowers, over the estimated remaining life of loans modified in TDRs.

The general allowance for loan losses also included a specific qualitative component to account for a variety of economic and operational factors that are not directly considered in the quantitative loss model but are factors we believe may impact the level of credit losses. Examples of these economic and operational factors are the current level of unemployment and the limited historical charge-off and loss experience on modified loans. As of June 30, 2011, this qualitative component was 15% of the general allowance for loan losses and was applied by loan portfolio segment.

 

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In determining the general 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 general allowance is available to absorb credit losses inherent in the total loan portfolio as of the balance sheet date.

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 the allowance for loan losses at June 30, 2011 is representative of probable losses inherent in the loan portfolio at the balance sheet date.

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

 

     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)
 

June 30, 2011

  $ 326.6        4.43   $ 493.5        8.36   $ 58.5        4.58   $ 878.6        6.04

December 31, 2010

  $ 389.6        4.75   $ 576.1        8.87   $ 65.5        4.48   $ 1,031.2        6.38

 

(1)   

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

During the six months ended June 30, 2011, the allowance for loan losses decreased by $152.6 million from the level at December 31, 2010. The decrease was driven by improving credit trends, as evidenced by the lower levels of at-risk (30-179 days delinquent) loans in the one- to four-family and home equity loan portfolios. The provision for loan losses has declined 80% from its peak of $517.8 million in the third quarter of 2008 and we expect it to continue to decline in 2011 when compared to 2010, although performance is subject to variability from quarter to quarter.

Troubled Debt Restructurings

Included in allowance for loan losses was a specific allowance of $329.2 million and $357.0 million that was established for TDRs at June 30, 2011 and December 31, 2010, respectively. The specific allowance for these individually impaired loans represents the expected loss over the remaining life of the loan, including the economic concession to the borrower. The following table shows loans that have been modified in a TDR and the specific valuation allowance by loan portfolio as well as the percentage of total expected losses as of June 30, 2011 and December 31, 2010 (dollars in millions):

 

     Recorded
Investment
in TDRs
    Specific
Valuation
Allowance
    Net
Investment
in TDRs
    Specific Valuation
Allowance as a %
of TDR Loans
    Total Expected
Losses
 

June 30, 2011

                             

One- to four-family

  $ 756.6      $ 96.1      $ 660.5        13     27

Home equity

    452.8        233.1        219.7        51     55
 

 

 

   

 

 

   

 

 

     

Total

  $ 1,209.4      $ 329.2      $ 880.2        27     37
 

 

 

   

 

 

   

 

 

     

December 31, 2010

                             

One- to four-family

  $ 548.6      $ 84.5      $ 464.1        15     28

Home equity

    488.3        272.5        215.8        56     59
 

 

 

   

 

 

   

 

 

     

Total

  $ 1,036.9      $ 357.0      $ 679.9        34     42
 

 

 

   

 

 

   

 

 

     

 

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The recorded investment in TDRs includes the charge-offs related to certain loans that were written down to the estimated current property value less costs to sell. These charge-offs were recorded on loans that were delinquent in excess of 180 days or in bankruptcy prior to the loan modification. The total expected loss on TDRs includes both the previously recorded charge-offs and the specific valuation allowance.

The following table shows the TDRs by delinquency category as of June 30, 2011 and December 31, 2010 (dollars in millions):

 

     TDRs Current      TDRs 30-89 Days
Delinquent
     TDRs 90-179 Days
Delinquent
     TDRs 180+ Days
Delinquent
     Total Recorded
Investment in
TDRs
 

June 30, 2011

                                  

One- to four-family

   $ 631.3       $ 58.0       $ 19.7       $ 47.6       $ 756.6   

Home equity

     370.6         47.6         30.7         3.9         452.8   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 1,001.9       $ 105.6       $ 50.4       $ 51.5       $ 1,209.4   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

December 31, 2010

                                  

One- to four-family

   $ 420.2       $ 55.5       $ 21.6       $ 51.3       $ 548.6   

Home equity

     388.7         56.7         39.8         3.1         488.3   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 808.9       $ 112.2       $ 61.4       $ 54.4       $ 1,036.9   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

The average twelve month re-delinquency rates on loans that have been modified in a TDR were 31% and 43% for one- to four- family loans and home equity loans, respectively, as of June 30, 2011.

Net Charge-offs

The following table provides an analysis of the allowance for loan losses and net charge-offs for the three and six months ended June 30, 2011 and 2010 (dollars in millions):

 

     Charge-offs     Recoveries      Net
Charge-offs
    % of
Average Loans
(Annualized)
 

Three Months Ended June 30, 2011

                         

One- to four-family

   $ (59.6   $ —         $ (59.6     3.18

Home equity

     (119.3     9.0         (110.3     7.12

Consumer and other

     (12.7     4.5         (8.2     2.49
  

 

 

   

 

 

    

 

 

   

Total

   $ (191.6   $ 13.5       $ (178.1     4.74
  

 

 

   

 

 

    

 

 

   

Three Months Ended June 30, 2010

                         

One- to four-family

   $ (69.6   $ —         $ (69.6     2.95

Home equity