10-K 1 d283628d10k.htm FORM 10-K Form 10-K
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-K

 

 

(Mark One)

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

For the fiscal year ended December 31, 2011

or

 

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

For the transition period from             to             .

Commission File Number 1-11921

 

 

E*TRADE Financial Corporation

(Exact Name of Registrant as Specified in its Charter)

 

 

 

Delaware   94-2844166

(State or other jurisdiction

of incorporation or organization)

 

(I.R.S. Employer

Identification Number)

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)

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

 

Title of Each Class   Name of Each Exchange on Which Registered
Common Stock, par value $0.01 per share  

The NASDAQ Stock Market LLC

NASDAQ Global Select Market

Securities Registered Pursuant to Section 12(g) of the Act: None

 

 

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

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

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, 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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendments to this Form 10-K.    x

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

 

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

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

At June 30, 2011, the aggregate market value of voting stock held by non-affiliates of the registrant was approximately $3.0 billion (based upon the closing price per share of the registrant’s common stock as reported by the NASDAQ Global Select Market on that date). Shares of common stock held by each officer, director and holder of 5% or more of the outstanding common stock have been excluded in that such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes.

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

As of February 17, 2012, there were 285,676,649 shares of common stock outstanding.

 

 

DOCUMENTS INCORPORATED BY REFERENCE

Certain portions of the definitive Proxy Statement related to the Company’s 2012 Annual Meeting of Shareholders, to be filed hereafter (incorporated into Part III hereof).

 

 

 


Table of Contents

E*TRADE FINANCIAL CORPORATION

FORM 10-K ANNUAL REPORT

For the Year Ended December 31, 2011

TABLE OF CONTENTS

 

PART I

    
Forward-Looking Statements      1   

Item 1.

  Business      1   
 

Overview

     1   
 

Strategy

     1   
 

Products and Services

     2   
 

Sales and Customer Service

     4   
 

Technology

     4   
 

Competition

     5   
 

Regulation

     5   
 

Available Information

     7   

Item 1A.

 

Risk Factors

     8   

Item 1B.

 

Unresolved Staff Comments

     19   

Item 2.

 

Properties

     20   

Item 3.

 

Legal Proceedings

     20   

PART II

    

Item 5.

  Market for Registrant’s Common Equity, Related Shareholder Matters and Issuer Purchases of Equity Securities      25   

Item 6.

  Selected Consolidated Financial Data      27   

Item 7.

  Management’s Discussion and Analysis of Financial Condition and Results of Operations      29   
 

Overview

     29   
 

Earnings Overview

     33   
 

Segment Results Review

     46   
 

Balance Sheet Overview

     51   
 

Liquidity and Capital Resources

     55   
 

Risk Management

     60   
 

Concentrations of Credit Risk

     63   
 

Summary of Critical Accounting Policies and Estimates

     72   
 

Statistical Disclosure by Bank Holding Companies

     80   
 

Glossary of Terms

     85   

Item 7A.

  Quantitative and Qualitative Disclosures about Market Risk      90   

Item 8.

  Financial Statements and Supplementary Data      92   
 

Management Report on Internal Control Over Financial Reporting

     92   
 

Reports of Independent Registered Public Accounting Firm

     93   
 

Consolidated Statement of Income (Loss)

     95   
 

Consolidated Balance Sheet

     96   
 

Consolidated Statement of Comprehensive Income (Loss)

     97   
 

Consolidated Statement of Shareholders’ Equity

     98   
 

Consolidated Statement of Cash Flows

     100   
 

Notes to Consolidated Financial Statements

     102   
 

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

     102   
 

Note 2—Facility Restructuring and Other Exit Activities

     111   
 

Note 3—Operating Interest Income and Operating Interest Expense

     112   
 

Note 4—Fair Value Disclosures

     113   
 

Note 5—Available-for-Sale and Held-to-Maturity Securities

     121   
 

Note 6—Loans Receivable, Net

     125   

 

i


Table of Contents
 

Note 7—Accounting for Derivative Instruments and Hedging Activities

     133   
 

Note 8—Property and Equipment, Net

     136   
 

Note 9—Goodwill and Other Intangibles, Net

     137   
 

Note 10—Other Assets

     138   
 

Note 11—Deposits

     138   
 

Note 12—Securities Sold Under Agreements to Repurchase and FHLB Advances and Other Borrowings

     140   
 

Note 13—Corporate Debt

     142   
 

Note 14—Other Liabilities

     144   
 

Note 15—Income Taxes

     145   
 

Note 16—Shareholders’ Equity

     149   
 

Note 17—Earnings (Loss) per Share

     151   
 

Note 18—Employee Share-Based Payments and Other Benefits

     151   
 

Note 19—Regulatory Requirements

     154   
 

Note 20—Lease Arrangements

     155   
 

Note 21—Commitments, Contingencies and Other Regulatory Matters

     155   
 

Note 22—Segment Information

     161   
 

Note 23—Condensed Financial Information (Parent Company Only)

     163   
 

Note 24—Quarterly Data (Unaudited)

     166   

Item 9.

  Changes in and Disagreements with Accountants on Accounting and Financial Disclosure      166   

Item 9A.

  Controls and Procedures      166   

Item 9B.

  Other Information      167   

PART III

  

PART IV

  

Item 15.

  Exhibits and Financial Statement Schedules      168   

Signatures

     171   

 

 

Unless otherwise indicated, references to “the Company,” “we,” “us,” “our” and “E*TRADE” mean E*TRADE Financial Corporation and 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.

 

ii


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. 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.

 

ITEM 1. BUSINESS

OVERVIEW

E*TRADE Financial Corporation is a financial services company that provides online brokerage and related products and services primarily to individual retail investors under the brand “E*TRADE Financial.” Our primary focus is to profitably grow our online brokerage business, which includes our self-directed trading and investing customers. We also provide investor-focused banking products, primarily sweep deposits and savings products, to retail investors. Our competitive strategy is to attract and retain customers by emphasizing value beyond price, ease of use and innovation, with delivery of our products and services primarily through online and technology-intensive channels.

Our corporate offices are located at 1271 Avenue of the Americas, 14th Floor, New York, New York 10020. We were incorporated in California in 1982 and reincorporated in Delaware in July 1996. We have approximately 3,200 employees. We operate directly and through numerous subsidiaries many of which are overseen by governmental and self-regulatory organizations. Our most significant subsidiaries are described below:

 

   

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

 

   

E*TRADE Securities LLC is a registered broker-dealer and is a wholly-owned operating subsidiary of E*TRADE Bank. It is the primary provider of brokerage products and services to our customers;

 

   

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

 

   

E*TRADE Capital Markets, LLC is a registered broker-dealer and market maker.

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

We provide services to customers in the U.S. through our website at www.etrade.com. In addition to our website, we also provide services through our network of customer service representatives, investment professionals and investment advisors. We also provide these services over the phone or in person through our 28 E*TRADE branches. Information on our website is not a part of this report.

STRATEGY

Our core business is our trading and investing customer franchise. Building on the strengths of this franchise, our growth strategy is focused on:

 

   

Strengthening our overall financial and franchise position. We are focused on strengthening our overall capital structure and continuing to mitigate credit losses in our loan portfolio. We are also focused on positioning the Company for future growth and maintaining disciplined expense management.

 

1


Table of Contents
   

Improving our market position in our retail brokerage business. We plan to grow our customer base by continuing to increase our sales force, focus on long-term investing and develop innovative products and services.

 

   

Accelerating the growth of our corporate services and market making businesses. Our corporate services and market making businesses enhance our strategy by allowing us to realize additional economic benefit from our retail brokerage business.

 

   

Enhancing our position with long-term investors. We believe growing our investing and retirement products and services is key to our long term success. Our primary focus is to expand the reach of our brand along with the awareness of our products to this key customer segment.

 

   

Optimizing the value of our bank franchise. 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.

PRODUCTS AND SERVICES

We assess the performance of our business based on our segments, trading and investing and balance sheet management. We consider multiple factors, including the competitiveness of our pricing compared to similar products and services in the market, the overall profitability of our businesses and customer relationships when pricing our various products and services. We manage the performance of our business using various customer activity and financial metrics, including daily average revenue trades (“DARTs”), average commission per trade, margin receivables, end of period brokerage accounts, net new brokerage accounts, customer assets, net new brokerage assets, brokerage related cash, corporate cash, E*TRADE Financial Tier I leverage and common ratios, E*TRADE Bank Tier I capital ratio, special mention loan delinquencies, allowance for loan losses, enterprise net interest spread and average enterprise interest-earning assets. Costs associated with certain functions that are centrally-managed are separately reported in a corporate/other category.

Trading and Investing

Our trading and investing segment offers a full suite of financial products and services to individual retail investors. The most significant of these products and services are described below:

Trading Products and Services

 

   

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

 

   

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

 

   

access to E*TRADE Mobile, which allows customers to securely trade stocks and options, monitor real-time investment, market and account information and transfer funds between accounts via iPhone®, iPad®, AndroidTM or BlackBerry® smartphone;

 

   

use of Power E*TRADE Pro, our desktop trading software for qualified active traders, which provides customers with customization capabilities, an expanded feature set and more news and information, plus live streaming news via CNBC TV;

 

   

an open applications programming interface (“Open API”) for third-party and independent software developers, which allows customers to have access to technical information and documentation, reference guides, and other resources to help network external applications and programs with our active trader platform;

 

   

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

 

2


Table of Contents
   

margin accounts allowing customers to borrow against their securities;

 

   

cross-border trading, which allows customers residing outside of the U.S. to trade in U.S. securities;

 

   

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

 

   

research and trading idea generation tools that assist customers with identifying investment opportunities including Analyst and Technical research, Consensus Ratings, and market commentary from Morningstar, Dreyfus and BondDesk Group.

Long-Term Investing Products and Services

 

   

use of the Investor Resource Center, which provides an aggregated view of our investing tools, market insights, independent research, education and other investing resources;

 

   

flexible advisory services through Online Advisor, our investment advice tool designed to provide investors with actionable investment guidance, including recommended asset allocations ranging from fully self-directed investing to 100 percent discretionary portfolio management from an affiliated registered investment advisor;

 

   

fixed income tools in our Bond Resource Center aimed at helping customers identify, evaluate and implement fixed income investment strategies;

 

   

retirement planning resources including Retirement QuickPlan, an easy-to-use, four-step calculator that provides a customized action plan to help customers get on track with personal retirement savings goals, and access to Chartered Retirement Planning CounselorsSM who can provide customers with one-on-one portfolio recommendations and personalized plans;

 

   

managed investment portfolio advisory services with an investment of $25,000 or more from an affiliated registered investment advisor, which provides one-on-one professional portfolio management;

 

   

unified managed account advisory services with an investment of $250,000 or more from an affiliated registered investment advisor, which provides customers the opportunity to work with a dedicated investment professional to obtain a comprehensive, integrated approach to asset allocation, investments, portfolio rebalancing and tax management;

 

   

no fee and no minimum individual retirement accounts; plus, Rollover Specialists to guide customers through the rollover process;

 

   

access to more than 1,000 non-proprietary exchange-traded funds and over 8,000 non-proprietary mutual funds;

 

   

investing and trading educational services via online videos, web seminars and web tutorials; and

 

   

FDIC insured deposit accounts, including checking, savings and money market accounts.

Corporate Services

We offer software and services for managing equity compensation plans for corporate customers. Our Equity Edge platform facilitates the management of employee option plans, employee stock purchase plans and restricted stock plans, including necessary accounting and reporting functions. This is a product of the trading and investing segment since it serves as an introduction to E*TRADE for many employees of our corporate customers who conduct equity option and restricted stock transactions, with our goal being that these individuals will also use our other products and services. Our corporate services business received top ratings in overall satisfaction and loyalty among broker plan administrators by Group Five, an independent consulting and research firm, in its 2011 Stock Plan Administration Benchmarking Study.

 

3


Table of Contents

Market Making

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

Balance Sheet Management

The balance sheet management segment consists of the management of our balance sheet, focusing on asset allocation and managing credit, liquidity and interest rate risks. The balance sheet management segment manages loans previously originated or purchased from third parties as well as our customer cash and deposits, which originate in the trading and investing segment.

For additional statistical information regarding products and customers, see Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) beginning on page 29. Three years of segment financial performance and data can be found in the MD&A beginning on page 46 and in Note 22—Segment Information of Item 8. Financial Statements and Supplementary Data beginning on page 161.

SALES AND CUSTOMER SERVICE

We believe providing superior sales and customer service is fundamental to our business. Growing our sales force with a focus on long-term investing is one of the key factors in our growth strategy. We also strive to maintain a high standard of customer service by staffing the customer support team with appropriately trained personnel who are equipped to handle customer inquiries in a prompt yet thorough manner. Our customer service representatives utilize our proprietary web-based platform to provide customers with answers to their inquiries. We also have specialized customer service programs that are tailored to the needs of each customer group.

We provide sales and customer support through the following channels of our registered broker-dealer and investment advisory subsidiaries:

 

   

Branches—we have 28 branches located in the U.S. where retail investors can go to service any of their needs while receiving face to face customer support. Financial consultants are also available on-site to help customers assess their current asset allocation.

 

   

Online—we have an Online Advisor tool available that provides asset allocation and a range of investment solutions that can be managed online or through a dedicated investment professional. We also have an online service center where customers can request services on their accounts and obtain answers to frequently asked questions. The online service center also provides customers with the ability to send a secure message to one of our customer service representatives.

 

   

Telephonic—we have a toll free number that connects customers to an automated phone system which will help ensure that they are directed to the appropriate department where a financial consultant or licensed customer service representative can assist with their inquiry.

TECHNOLOGY

We believe our focus on being a technological leader in the financial services industry enhances our competitive position. This focus allows us to deploy a secure, scalable technology and back office platform that promotes innovative product development and delivery. We continued to increase our investments in these critical platforms in 2011, helping to drive significant efficiencies as well as enhancing our service and operational support capabilities. Our technology platform also enabled us to deliver trading and investing functionality with the introduction of Open API, mobile offerings across new devices and the Equity Edge Online platform.

 

4


Table of Contents

COMPETITION

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

The financial services industry has become more concentrated as companies involved in a broad range of financial services have been acquired, merged or have declared bankruptcy. During the past four years, this trend accelerated considerably as a significant number of U.S. financial institutions consolidated, were forced to merge, or received substantial government assistance. We believe we can continue to attract customers by appealing to retail investors by providing them with easy to use and innovative financial products and services.

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

REGULATION

Our business is subject to regulation by U.S. federal and state regulatory and self-regulatory agencies and securities exchanges and by various non-U.S. governmental agencies or regulatory or self-regulatory bodies, securities exchanges and central banks, each of which has been charged with the protection of the financial markets and the protection of the interests of those participating in those markets.

Our regulators, rulemaking agencies and primary securities exchanges in the U.S. include, among others, the Securities and Exchange Commission (“SEC”), the Financial Industry Regulatory Authority (“FINRA”), the New York Stock Exchange (“NYSE”), the National Association of Securities Dealers Automated Quotations (“NASDAQ”), the FDIC, the Federal Reserve, the Municipal Securities Rulemaking Board, the Office of the Comptroller of the Currency (“OCC”) and the Consumer Financial Protection Bureau (“CFPB”).

Both our brokerage and banking entities are subject to the Bank Secrecy Act, as amended by the USA PATRIOT ACT of 2001 (“BSA/USA PATRIOT Act”), which contains anti-money laundering and financial transparency laws. In order to comply with the BSA/USA PATRIOT Act, we have established an Anti-Money Laundering (“AML”) unit which is responsible for developing and implementing enterprise-wide programs for compliance with the various anti-money laundering and counter-terrorist financing laws and regulations.

For customer privacy and information security, under the rules of the Gramm-Leach-Bliley Act of 1999, our brokerage and banking entities are required to disclose their privacy policies and practices related to sharing customer information with affiliates and non-affiliates. The rules also give customers the ability to “optout” of having non-public information disclosed to third parties or receiving marketing solicitations from affiliates and non-affiliates based on non-public information received from our brokerage and banking entities.

Brokerage Regulation

Our broker-dealers are registered with the SEC and are subject to regulation by the SEC and by self-regulatory organizations, such as FINRA and the securities exchanges of which each is a member, as well as various state regulators. Such regulation covers all aspects of the brokerage business, including, but not limited to, client protection, net capital requirements, required books and records, safekeeping of funds and securities, trading,

 

5


Table of Contents

prohibited transactions, public offerings, margin lending, customer qualifications for margin and options transactions, registration of personnel and transactions with affiliates. Our international broker-dealers are regulated by their respective local regulators such as the United Kingdom Financial Services Authority (“FSA”) and Hong Kong Securities & Futures Commission.

Banking Regulation

Our banking entities are subject to regulation, supervision and examination for safety and soundness by the OCC, the Federal Reserve, the FDIC and by the CFPB for compliance with federal consumer finance laws. Such regulation covers all aspects of the banking business, including lending practices, safeguarding deposits, customer privacy and information security, capital structure, transactions with affiliates and conduct and qualifications of personnel.

Each of our banking entities has deposits insured by the FDIC and pays quarterly assessments to the Deposit Insurance Fund (“DIF”), maintained by the FDIC, to pay for this insurance coverage. As of April 1, 2011, the assessment base for insured depository institutions was changed from domestic deposits, with some adjustments, to average consolidated total assets minus average tangible equity. The FDIC also changed its methodology for calculating the assessment rate for E*TRADE Bank and other large and highly complex depository institutions. The new risk-based assessment utilizes a scorecard method for calculating a large depository institution’s assessment rate based on a number of factors, including the institution’s CAMELS ratings, asset quality and brokered deposits. The FDIC will continue to assess the changes to the assessment rates at least annually.

Financial Regulatory Reform Legislation and Basel III Accords

The Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) was signed into law on July 21, 2010 and includes comprehensive changes to the financial services industry. Under the Dodd-Frank Act, our primary federal bank regulator, the Office of Thrift Supervision (“OTS”), was abolished in July 2011. The OTS’ regulatory oversight responsibilities for the thrifts and parent company were transferred to the OCC and Federal Reserve, respectively. In addition, the CFPB will oversee compliance by the Company with federal consumer finance laws. Although the Dodd-Frank Act maintains the federal thrift charter, and retains the previous lending and investment limitations for thrifts, it eliminates certain benefits of the charter. The Dodd-Frank Act also requires all companies, including savings and loan holding companies, that directly or indirectly control an insured depository institution to serve as a source of strength for the institution.

The Dodd-Frank Act requires various federal agencies to adopt a broad range of new rules and regulations, the details, substance and impact of which may not be known for months or years. However, the implementation of holding company capital requirements will impact us as the parent company was not previously subject to capital requirements. We believe the requirements are an important measure of our capital strength and we are monitoring these requirements internally, using the current capital ratios that apply to bank holding companies, as the requirements are expected to become effective by July 2015. We are currently in compliance with the current capital requirements that apply to bank holding companies, and we have no plans to raise additional capital as a result of this new law.

The current risk-based capital guidelines that apply to E*TRADE Bank are based upon the 1988 capital accords of the International Basel Committee on Banking Supervision (“BCBS”), a committee of central banks and bank supervisors, as implemented by the U.S. federal banking agencies, including the OCC, commonly known as Basel I. In September, 2010, the Group of Governors and Heads of Supervision, the oversight body of the BCBS, announced agreement on the calibration and phase-in arrangements for a strengthened set of capital and liquidity requirements, known as the Basel III Accords. The final Basel III Accords were released in December, 2010 and are subject to individual adoption by member nations, including the U.S., beginning January 1, 2013. The Basel III Accords are intended to strengthen the prudential standards for large and internationally active banks; however, they may impact how the U.S. regulators implement the Dodd-Frank Act

 

6


Table of Contents

for other banking institutions, including the possibility of higher capital and liquidity requirements. The full impact of the Basel III Accords on the regulatory requirements to which we will be subject is currently unclear, and will remain unknown for at least some time until implementing capital regulations are proposed and adopted. It is currently anticipated that U.S. banking regulators will propose regulations to implement the Basel III Accords in the first quarter of 2012. 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.

For additional regulatory information on our brokerage and banking regulations, see Note 19—Regulatory Requirements of Item 8. Financial Statements and Supplementary Data beginning on page 154.

AVAILABLE INFORMATION

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

The public may read and copy any materials we file with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Washington, DC 20549. The public may obtain information of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains a website that contains the materials we file with the SEC at www.sec.gov.

 

7


Table of Contents
ITEM 1A.     RISK FACTORS

The following factors which could materially affect our business, financial condition and results of operations should be carefully considered in addition to the other information set forth in this report. Although the risks described below are those that management believes are the most significant, these are not the only risks facing our company. Additional risks and uncertainties not currently known to us or that we currently do not deem to be material may also materially affect our business, financial condition and results of operations.

Risks Relating to the Nature and Operation of Our Business

We have incurred significant losses in recent years and cannot assure that we will be profitable in the future.

We incurred net losses of $28.5 million and $1.3 billion for the years ended December 31, 2010 and 2009, respectively. These losses were due primarily to the credit losses in our loan portfolio and, in 2009, the loss on the Debt Exchange in which $1.7 billion aggregate principal amount of interest-bearing debt was exchanged for an equal principal amount of non-interest-bearing convertible debentures. Although we have taken a significant number of steps to reduce our credit exposure and reported net income of $156.7 million for the year ended December 31, 2011, we likely will continue to suffer credit losses in 2012. In late 2007, we experienced a substantial diminution of customer assets and accounts as a result of customer concerns regarding our credit related exposures. While we were able to stabilize our retail franchise during the ensuing period, it could take additional time to fully mitigate the credit issues in our loan portfolio, which could result in a return to a net loss position.

We will continue to experience losses in our mortgage loan portfolio.

At December 31, 2011, the principal balance of our home equity loan portfolio was $5.3 billion and the allowance for loan losses for this portfolio was $463.3 million. At December 31, 2011, the principal balance of our one- to four-family loan portfolio was $6.6 billion and the allowance for loan losses for this portfolio was $314.2 million. Although the provision for loan losses has improved in recent periods, performance is subject to variability in any given quarter and we cannot state with certainty that the declining loan loss trend will continue. In particular, a significant portion of our mortgage loan portfolio is secured by properties worth less than the outstanding balance of loans secured by such properties. There can be no assurance that our allowance for loan losses will be adequate if the residential real estate and credit markets deteriorate beyond our expectations. In addition, as the OCC conducts its first cycle of examinations since succeeding to the OTS as our bank’s primary federal banking supervisor, its views of our loan-related programs and practices that were designed in accordance with guidance from the OTS may differ from the views previously taken by the OTS and may result in our making changes to such programs and practices. We may be required under such circumstances to further increase our allowance for loan losses, which could have an adverse effect on our regulatory capital position and our results of operations in future periods.

The carrying value of our home equity and one- to four-family loan portfolios was $4.9 billion and $6.3 billion, respectively, at December 31, 2011. Our home equity and one- to four-family loan portfolios are held on the consolidated balance sheet at carrying value because they are classified as held for investment, which indicates that we have the intent and ability to hold them for the foreseeable future or until maturity. The fair value of our home equity and one- to four-family loan portfolios was estimated to be $4.3 billion and $5.7 billion, respectively, at December 31, 2011, in accordance with the fair value measurements accounting guidance, as disclosed in Note 4—Fair Value Disclosures of Item 8. Financial Statements and Supplementary Data on page 113. The fair value of our home equity and one- to four-family loan portfolios was estimated using a modeling technique that discounted future cash flows based on estimated principal and interest payments over the life of the loans, including expected losses and prepayments. There was limited or no observable market data for our home equity and one- to four-family loan portfolios. Given the limited market data, the fair value measurements cannot be determined with precision and the amount that would be realized in a forced liquidation,

 

8


Table of Contents

an actual sale or immediate settlement could be significantly lower than both the carrying value and the estimated fair value of the portfolio. In addition, changes in the underlying assumptions used, including discount rates and estimates of future cash flows, could significantly affect the results of current or future fair value estimates.

Certain characteristics of our mortgage loan portfolio indicate an increased risk of loss. For example, at December 31, 2011:

 

   

approximately 50% and 60% of the one- to four-family and home equity loan portfolios, respectively, had a current LTV/CLTV of greater than 100%;

 

   

approximately 57% and 49% of the one- to four-family and home equity loan portfolios, respectively, were originated with low or no documentation;

 

   

borrowers with current FICO scores less than 700 consisted of approximately 37% and 38% of the one- to four-family and home equity loan portfolios, respectively; and

 

   

approximately 82% and 88% of the one- to four-family and home equity loan portfolios, respectively, were purchased from a third party.

The foregoing factors are among the key items we track to predict and monitor credit risk in our mortgage portfolio, together with loan type, housing prices, loan vintage and geographic location of the underlying property. We believe the relative importance of these factors varies, depending upon economic conditions.

Home equity loans have certain characteristics that result in higher risk than first lien, amortizing one- to four-family loans.

Approximately 85% of the home equity loan portfolio consists of second lien loans on residential real estate properties. The average estimated current CLTV on our home equity loan portfolio was 112% as of December 31, 2011. We hold both the first and second lien positions in less than 1% of the home equity loan portfolio, exposing us to risk associated with the actions and inactions of the first lien lender. We do not directly service any of our loans and as a result, we rely on third party vendors and servicers to provide information on our loan portfolio. We monitor our borrowers by refreshing FICO scores and CLTV information on a quarterly basis. We do not receive complete data on the first lien positions of second lien home equity loans. In addition, we rely on third party servicers to provide payment information on home equity loans, including which borrowers are paying only the minimum amount due. We have incomplete information regarding the number of borrowers paying only the minimum amounts, which impacts our ability to accurately report on whether borrowers are repaying any principal during the draw period across the aggregate portfolio.

Home equity lines of credit convert to amortizing loans at the end of the draw period, which ranges from 60 months to 120 months. At December 31, 2011, the vast majority of the home equity line of credit portfolio had not converted from the interest-only draw period to an amortizing loan. In addition, approximately 79% of the home equity line of credit portfolio will not begin amortizing until after 2014. As a result, we do not yet have sufficient data relating to loan default and delinquency of amortizing home equity lines of credit to determine if the performance is different than the trends observed for home equity lines of credit in an interest-only draw period.

We could experience significant losses on other securities held on the balance sheet.

At December 31, 2011, we held $422.6 million in amortized cost of non-agency collateralized mortgage obligations (“CMO”) on our consolidated balance sheet. We incurred net impairment charges of $14.9 million during 2011, which was a result of the deterioration in the expected credit performance of the underlying loans in the securities. If the credit quality of these securities further deteriorates, we may incur additional impairment charges which would have an adverse effect on our regulatory capital position and our results of operations in future periods.

 

9


Table of Contents

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

During November 2007, well-publicized concerns about E*TRADE Bank’s holdings of asset-backed securities led to widespread concerns about our continued viability. From the beginning of this crisis through December 31, 2007, when the situation stabilized, customers withdrew approximately $5.6 billion of net cash and approximately $12.2 billion of net assets from our bank and brokerage businesses. Many of the accounts that were closed belonged to sophisticated and active customers with large cash and securities balances. While we were able to stabilize our retail franchise, concerns about our viability may recur, which could lead to destabilization and asset and customer attrition. If such destabilization should occur, there can be no assurance that we will be able to successfully rebuild our franchise by reclaiming customers and growing assets. If we are unable to sustain or, if necessary, rebuild our franchise, in future periods our revenues will be lower and our losses will be greater than we have experienced.

We have a large amount of debt.

We have issued a substantial amount of high-yield debt, with restrictive financial and other covenants and our expected annual interest cash outlay is approximately $165 million. Our ratio of debt (our corporate debt) to equity (expressed as a percentage) was 30% at December 31, 2011. The degree to which we are leveraged could have important consequences, including: 1) a substantial portion of our cash flow from operations is dedicated to the payment of principal and interest on our indebtedness, thereby reducing the funds available for other purposes; 2) our ability to obtain additional financing for working capital, capital expenditures, acquisitions and other corporate needs is significantly limited; and 3) our substantial leverage may place us at a competitive disadvantage, hinder our ability to adjust rapidly to changing market conditions and make us more vulnerable in the event of a further downturn in general economic conditions or our business. In addition, a significant reduction in revenues could have a material adverse effect on our ability to meet our debt obligations.

In June 2011, we granted a security interest to the holders of the 2017 Notes and the 2019 Notes pursuant to the terms of the applicable indentures. Under the applicable indentures, the security interest is limited to $300 million of property and assets owned by certain unregulated subsidiaries. The security interest granted was secured by collateral significantly less in value than $300 million. Also in June 2011, certain of our subsidiaries issued guarantees on each outstanding series of senior notes and 2019 Notes. E*TRADE Bank and E*TRADE Securities LLC, among others, did not issue such guarantees.

We conduct all of our operations through subsidiaries and have no revenue sources other than dividends from our subsidiaries, which are subject to advance regulatory approval in the case of our most significant subsidiaries.

We depend on dividends, distributions and other payments from our subsidiaries to fund payments on our obligations, including our debt obligations. Regulatory and other legal restrictions limit our ability to transfer funds to or from our subsidiaries. In addition, many of our subsidiaries are subject to laws and regulations that authorize regulatory bodies to block or reduce the flow of funds to us, or that prohibit such transfers altogether in certain circumstances. These laws and regulations may hinder our ability to access funds that we may need to make payments on our obligations, including our debt obligations. The majority of our capital is invested in our banking subsidiary E*TRADE Bank, which may not pay dividends to us without approval from the OCC and the Federal Reserve. Our primary brokerage subsidiaries, E*TRADE Securities LLC and E*TRADE Clearing LLC, are both subsidiaries of E*TRADE Bank; therefore, the OCC, together with the Federal Reserve, controls our ability to receive dividend payments from our brokerage business as well. Furthermore, even if we receive the approval of the OCC and the Federal Reserve to receive dividend payments from our brokerage business, in the event of our bankruptcy or liquidation or E*TRADE Bank’s receivership, we would not be entitled to receive any cash or other property or assets from our subsidiaries (including E*TRADE Bank, E*TRADE Clearing LLC and E*TRADE Securities LLC) until those subsidiaries pay in full their respective creditors, including customers of those subsidiaries and, as applicable, the FDIC and the Securities Investor Protection Corporation.

 

10


Table of Contents

From late 2009 through mid-2011, we requested and received the approval of the OTS, our then primary bank regulator to permit E*TRADE Bank to pay quarterly dividends to the Company. The dividends approved by the OTS had been equal to the profits from the previous quarter of E*TRADE Securities LLC. We believe our former regulator, the OTS, viewed these dividend requests as distinct from a more comprehensive request to release a portion of E*TRADE Bank’s excess capital. During the third quarter of 2011, we transitioned regulators from the OTS to the OCC and the Federal Reserve. We believe our new regulators would subject all dividend requests to an equal level of scrutiny; therefore rather than request a dividend from E*TRADE Bank in an amount equal to the profits of E*TRADE Securities LLC in the prior quarter, we believe the best path for our shareholders is to work on a comprehensive dividend plan that efficiently distributes capital among our regulated entities and parent company. We are in dialogue with our regulators regarding our ability to implement a comprehensive dividend plan and we expect to complete that dialogue by the end of 2012. Following the completion of that dialogue, we expect to have a better understanding of the timing of any future dividends; however, we cannot predict the likelihood or the timing of regulatory approval for any such dividends.

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

In 2007, we recognized an increased provision expense totaling $640 million and asset losses and impairments of $2.45 billion, including the sale of our asset-backed securities portfolio to Citadel. As a result, various plaintiffs filed class actions and derivative lawsuits, which were subsequently consolidated into one class action and one derivative lawsuit, alleging disclosure violations regarding our home equity, mortgage and securities portfolios during 2007. In addition, the SEC initiated an informal inquiry into matters related to our loan and securities portfolios. While we have entered into a memorandum of understanding to settle the consolidated class action lawsuit, the settlement is subject to Court approval and has not yet been finalized. The continued defense of these matters and the finalization of the terms of the settlement with the plaintiffs in the consolidated class action have entailed and will continue to entail considerable cost and may be time consuming for our management. Unfavorable outcomes in any of these matters, including the consolidated class action if the settlement is not finalized on the terms anticipated or does not obtain the requisite approval of the Court, could have a material adverse effect on our business, financial condition, results of operations and cash flows.

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

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

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

Online investing services to the retail customer, including trading and margin lending, account for a significant portion of our revenues. Turmoil in the global financial markets could lead to changes in volume and price levels of securities and futures transactions which may, in turn, result in lower trading volumes and margin lending. In particular, a decrease in trading activity within our lower activity accounts could impact revenues and

 

11


Table of Contents

increase dependence on more active trading customers who receive more favorable pricing based on their trade volume. A decrease in trading activity or securities prices would also typically be expected to result in a decrease in margin borrowing, which would reduce the revenue that we generate from interest charged on margin borrowing.

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

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

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

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

We rely on third party service providers to perform certain functions.

We rely on third party service providers for certain technology, processing, servicing and support functions. These third party service providers are also subject to operational and technology vulnerabilities, which may impact our business. An interruption in or the cessation of service by any third party service provider and our inability to make alternative arrangements in a timely manner could have a material impact on our business and financial performance.

Downturns in the securities markets increase the credit risk associated with margin lending or securities loaned transactions.

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

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

Net operating interest income is an important source of our revenue. Our results of operations depend, in part, on our level of net operating interest income and our effective management of the impact of changing interest rates and varying asset and liability maturities. Our ability to manage interest rate risk could impact our financial condition. We use derivatives to help manage interest rate risk. However, the derivatives we utilize may not be completely effective at managing this risk and changes in market interest rates and the yield curve could

 

12


Table of Contents

reduce the value of our financial assets and reduce net operating interest income. The lower interest rate environment in recent years has compressed our net interest spread, and given the continued challenges of the current interest rate environment, our net interest spread could average less than 2.50% for the year ending December 31, 2012. Among other items, we periodically enter into repurchase agreements to support the funding and liquidity requirements of E*TRADE Bank. If we are unsuccessful in maintaining our relationships with counterparties, we could recognize substantial losses on the derivatives we utilized to hedge repurchase agreements.

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

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

Although we are currently constrained by the terms of our corporate debt and the memoranda of understanding we and E*TRADE Bank entered into with our primary banking regulators, we may seek to acquire businesses in the future. The assets of these businesses are primarily customer accounts. Our retention of customers’ assets may be impacted by our ability to successfully continue to integrate the acquired operations, products (including pricing) and personnel. Diversion of management attention from other business concerns could have a negative impact. If we are not successful in our integration efforts, we may experience significant attrition in the acquired accounts or experience other issues that would prevent us from achieving the level of revenue enhancements and cost savings that we expect with respect to an acquisition.

Risks associated with principal trading transactions could result in trading losses.

A majority of our market making revenues are derived from trading as a principal. We may incur trading losses relating to the purchase, sale or short sale of securities. We carry equity security positions on a daily basis and from time to time, we may carry large positions in securities of a single issuer or issuers engaged in a specific industry. Sudden changes in the value of these positions could impact our financial results.

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

Technological advances, competition and regulatory changes in the marketplace may continue to tighten securities spreads. Tighter spreads could reduce revenue capture per share by our market maker, thus reducing revenues for this line of business.

Advisory services subject us to additional risks.

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

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

We had net deferred tax assets of $1.6 billion as of December 31, 2011. We did not establish a valuation allowance against our federal net deferred tax assets as of December 31, 2011 as we believe that it is more likely

 

13


Table of Contents

than not that all of these assets will be realized. In evaluating the need for a valuation allowance, we estimated future taxable income based on management approved forecasts. This process required significant judgment by management about matters that are by nature uncertain. If future events differ significantly from our current forecasts, a valuation allowance may need to be established, which could have a material adverse effect on our results of operations and our financial condition.

As a result of the Public Equity Offering, the Debt Exchange and related transactions in 2009, we believe that we experienced an “ownership change” for tax purposes that could cause us to permanently lose a significant portion of our U.S. federal and state deferred tax assets.

As a result of the Public Equity Offering, the Debt Exchange and related transactions in 2009, we believe that we experienced an “ownership change” as defined under Section 382 of the Internal Revenue Code of 1986, as amended (“Section 382”)(which is generally a greater than 50 percentage point increase by certain “5% shareholders” over a rolling three year period). Section 382 imposes an annual limitation on the utilization of deferred tax assets, such as net operating loss carry forwards and other tax attributes, once an ownership change has occurred. Depending on the size of the annual limitation (which is in part a function of our market capitalization at the time of the ownership change) and the remaining carry forward period of the tax assets (U.S. federal net operating losses generally may be carried forward for a period of 20 years), we could realize a permanent loss of a portion of our U.S. federal and state deferred tax assets and certain built-in losses that have not been recognized for tax purposes. We believe the tax ownership change will extend the period of time it will take to fully utilize our pre-ownership change net operating losses (“NOLs”), but will not limit the total amount of pre-ownership change NOLs we can utilize. This is a complex analysis and requires the Company to make certain judgments in determining the annual limitation. As a result, it is possible that we could ultimately lose a significant portion of our deferred tax assets, which could have a material adverse effect on our results of operations and financial condition.

Risks Relating to the Regulation of Our Business

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

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

Similarly, E*TRADE Financial Corporation and ETB Holdings, Inc., as savings and loan holding companies, and E*TRADE Bank, E*TRADE Savings Bank and E*TRADE United Bank, as federally chartered savings banks, are subject to extensive regulation, supervision and examination by the OCC and the Federal Reserve (including pursuant to the terms of the memoranda of understanding that E*TRADE Financial Corporation, E*TRADE Bank, E*TRADE Savings Bank and E*TRADE United Bank entered into with our former primary banking regulator) and, in the case of the savings banks, also the FDIC. Such regulation covers all banking business, including lending practices, safeguarding deposits, capital structure, recordkeeping, transactions with affiliates and conduct and qualifications of personnel.

Recently enacted regulatory reform legislation may have a material impact on our operations. In addition, if we are unable to meet these new requirements, we could face negative regulatory consequences, which would have a material negative effect on our business.

On July 21, 2010, the President signed into law the Dodd-Frank Act. This law contains various provisions designed to enhance financial stability and to reduce the likelihood of another financial crisis and significantly

 

14


Table of Contents

changed the bank regulatory structure for our Company and its thrift subsidiaries. Portions of the Dodd-Frank Act were effective immediately, but many provisions will only be effective after the adoption of implementing regulations, which have been delayed in numerous cases. The key effects of the Dodd-Frank Act, when fully implemented, on our business are:

 

   

changes to the thrift supervisory structure;

 

   

changes to regulatory capital requirements;

 

   

changes to the assessment base used by depository institutions to calculate their FDIC insurance premiums, increases in the minimum reserve ratio for the FDIC’s deposit insurance fund to 1.35%, and imposition of the additional costs of this increase on depository institutions with assets of $10 billion or more; and

 

   

establishment of the CFPB with broad authority to implement new consumer protection regulations and, for banks and thrifts with $10 billion or more in assets, to examine and enforce compliance with federal consumer laws.

Under the legislation, the OTS was abolished in July 2011 and its functions and personnel were distributed among the OCC, the FDIC and the Federal Reserve. Primary jurisdiction for the supervision and regulation of savings and loan holding companies, including the Company, was transferred to the Federal Reserve; supervision and regulation of federal savings associations, such as the Company’s three thrift subsidiaries, was transferred to the OCC. Although the Dodd-Frank Act maintains the federal thrift charter, it eliminates certain preemption, branching and other benefits of the charter and imposes new penalties for failure to comply with the qualified thrift lender test. The Dodd-Frank Act also requires all companies, including savings and loan holding companies that directly or indirectly control an insured depository institution, to serve as a source of strength for the institution, including committing necessary capital and liquidity support.

We are required to file periodic reports with the Federal Reserve and are subject to examination and supervision by them. The Federal Reserve also has certain types of enforcement powers over us, ETB Holdings, Inc., and our non-depository institution subsidiaries, including the ability to issue cease-and-desist orders, force divestiture of our thrift subsidiaries and impose civil and monetary penalties for violations of federal banking laws and regulations or for unsafe or unsound banking practices. Our thrift subsidiaries are subject to similar reporting, examination, supervision and enforcement oversight by the OCC. In concurrence with the transfer of parent company supervisory authority from the OTS to the Federal Reserve, the Federal Reserve has issued guidance aligning the supervisory and regulatory standards of savings and loan holding companies more closely with the standards applicable to bank holding companies. The Federal Reserve had also indicated that its supervision of savings and loan holding companies may entail a more rigorous level of review than previously applied by the OTS.

The Dodd-Frank Act also creates a new independent regulatory body, the CFPB, which has been given broad rulemaking authority to implement the consumer protection laws that apply to banks and thrifts and to prohibit “unfair, deceptive or abusive” acts and practices. For all banks and thrifts with total consolidated assets over $10 billion, including E*TRADE Bank, the CFPB has exclusive rulemaking and examination, and primary enforcement authority, under federal consumer financial laws and regulations. In addition, the Dodd-Frank Act permits states to adopt consumer protection laws and regulations that are stricter than those regulations promulgated by the CFPB.

For us, one of the most significant changes under the new law is that savings and loan holding companies such as our Company for the first time will become subject to the same capital and activity requirements as those applicable to bank holding companies. In addition, we will be subject to the same capital requirements as those applied to banks, which requirements exclude, on a phase-out basis, all trust preferred securities from Tier I capital. The Dodd-Frank Act provides for a five year phase-in period for these new capital requirements. We fully expect to meet the capital requirements applicable to thrift holding companies as they are phased in.

 

15


Table of Contents

However, it is possible that our regulators may impose more stringent capital and other prudential standards on us prior to the end of the five year phase-in period. For example, both the Federal Reserve and the OCC have proposed rules that would ultimately require the parent company and E*TRADE Bank, respectively, to conduct capital adequacy stress tests on their operations.

The Dodd-Frank Act requires various federal agencies to adopt a broad range of new rules and regulations, the details, substance, and impact of which may not be known for months or years. It is difficult to predict at this time what specific impacts the Dodd-Frank Act and the yet-to-be-written rules and regulations may have on us. However, given that the legislation is likely to materially change the regulatory environment for the financial services industry in which we operate, we expect at a minimum that our compliance costs will increase.

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

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

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

The SEC, FINRA, the OCC, the Federal Reserve and various other regulatory agencies have stringent rules with respect to the maintenance of specific levels of regulatory capital by banks and net capital by securities broker-dealers. E*TRADE Bank is subject to various regulatory capital requirements administered by the OCC, and E*TRADE Financial Corporation will, for the first time, become subject to specific capital requirements administered by the Federal Reserve. Failure to meet minimum capital requirements can trigger certain mandatory, and possibly additional discretionary actions by regulators that, if undertaken, could harm E*TRADE Bank’s and E*TRADE Financial Corporation’s operations and financial statements.

E*TRADE Bank must meet specific capital guidelines that involve quantitative measures of E*TRADE Bank’s assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. Quantitative measures established by regulation to ensure capital adequacy require E*TRADE Bank to maintain minimum amounts and ratios of total and Tier I capital to risk-weighted assets and of Tier I capital to adjusted total assets. To satisfy the capital requirements for a “well capitalized” financial institution, E*TRADE Bank must maintain higher total and Tier I capital to risk-weighted assets and Tier I capital to adjusted total assets ratios. E*TRADE Bank’s capital amounts and classification are subject to qualitative judgments by the regulators about the strength of components of its capital, risk weightings of assets, off-balance sheet transactions and other factors. Any significant reduction in E*TRADE Bank’s regulatory capital could result in E*TRADE Bank being less than “well capitalized” or “adequately capitalized” under applicable capital rules. A failure of E*TRADE Bank to be “adequately capitalized” which is not cured within time periods specified in the indentures governing our debt securities would constitute a default under our debt securities and likely result in the debt securities becoming immediately due and payable at their full face value.

The regulators may request we raise equity to increase the regulatory capital of E*TRADE Bank or to further reduce debt. If we were unable to raise equity, we could face negative regulatory consequences, such as restrictions on our activities, requirements that we divest ourselves of certain businesses and requirements that we dispose of certain assets and liabilities within a prescribed period. Any such actions could have a material negative effect on our business.

 

16


Table of Contents

Similarly, failure to maintain the required net capital by our securities broker-dealers could result in suspension or revocation of registration by the SEC and suspension or expulsion by FINRA, and could ultimately lead to the firm’s liquidation. If such net capital rules are changed or expanded, or if there is an unusually large charge against net capital, operations that require an intensive use of capital could be limited. Such operations may include investing activities, marketing and the financing of customer account balances. Also, our ability to withdraw capital from brokerage subsidiaries could be restricted.

As a non-grandfathered savings and loan holding company, we are subject to activity limitations and requirements that could restrict our ability to engage in certain activities and take advantage of business opportunities.

Under the Gramm-Leach-Bliley Act of 1999, our activities are restricted to those that are financial in nature and certain real estate-related activities. We believe all of our existing activities and investments are permissible under the Gramm-Leach-Bliley Act of 1999. At the same time, we are unable to pursue future activities that are not financial in nature or otherwise real-estate related. We are also limited in our ability to invest in other savings and loan holding companies. The Dodd-Frank Act also requires savings and loan holding companies like ours, as well as all of our thrift subsidiaries, to be both “well capitalized” and “well managed” in order for us to conduct certain financial activities, such as market making and securities underwriting. We believe that we will be able to continue to engage in all of our current financial activities. However, if we and our thrift subsidiaries are unable to satisfy the above “well capitalized” and “well managed” requirements, we could be subject to activity restrictions that could prevent us from engaging in market making and securities underwriting, as well as other negative regulatory actions.

In addition, E*TRADE Bank is subject to extensive regulation of its activities and investments, capitalization, community reinvestment, risk management policies and procedures and relationships with affiliated companies. Acquisitions of and mergers with other financial institutions, purchases of deposits and loan portfolios, the establishment of new depository institution subsidiaries and the commencement of new activities by bank subsidiaries require the prior approval of the OCC and the Federal Reserve, and in some cases the FDIC, which may deny approval or limit the scope of our planned activity. Our compliance with these regulations and conditions could place us at a competitive disadvantage in an environment in which consolidation within the financial services industry is prevalent. Also, these regulations and conditions could affect our ability to realize synergies from future acquisitions, could negatively affect us following an acquisition and could also delay or prevent the development, introduction and marketing of new products and services. In addition, E*TRADE Clearing LLC and E*TRADE Securities LLC, as operating subsidiaries of E*TRADE Bank, are subject to increased regulatory oversight and the same activity restrictions that are applicable to E*TRADE Bank.

Risks Relating to Owning Our Stock

We are substantially restricted by the terms of our corporate debt.

The indentures governing our corporate debt contain various covenants and restrictions that limit our ability and certain of our subsidiaries’ ability to, among other things:

 

   

incur additional indebtedness;

 

   

create liens;

 

   

pay dividends or make other distributions;

 

   

repurchase or redeem capital stock;

 

   

make investments or other restricted payments;

 

   

enter into transactions with our shareholders or affiliates;

 

17


Table of Contents
   

sell assets or shares of capital stock of our subsidiaries;

 

   

receive dividend or other payments from our subsidiaries; and

 

   

merge, consolidate or transfer substantially all of our assets.

As a result of the covenants and restrictions contained in the indentures, we are limited in how we conduct our business and we may be unable to raise additional debt or equity financing to compete effectively or to take advantage of new business opportunities. Each of these series of our corporate debt contains a limitation, subject to important exceptions, on our ability to incur additional debt if our Consolidated Fixed Charge Coverage Ratio (as defined in the relevant indentures) is less than or equal to 2.5 to 1.0. As of December 31, 2011, our Consolidated Fixed Charge Coverage Ratio was 1.6 to 1.0. The terms of any future indebtedness could include more restrictive covenants.

Although these covenants provide substantial flexibility, for example the ability to incur “refinancing indebtedness” and to incur up to $300 million of secured debt under a credit facility, the covenants, among other things, generally limit our ability to incur additional debt even if we were to substantially reduce our existing debt through debt exchange transactions. We could be forced to repay immediately all our outstanding debt securities at their full principal amount if we were to breach these covenants and did not cure the breach within the cure periods (if any) specified in the respective indentures. Further, if we experience a change of control, as defined in the indentures, we could be required to offer to purchase our debt securities at 101% of their principal amount. Under our debt securities a “change of control” would occur if, among other things, a person became the beneficial owner of more than 50% of the total voting power of our voting stock which, with respect to the 2015 Notes and 2016 Notes, would need to be coupled with a ratings downgrade before we would be required to offer to purchase those securities.

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

The value of our common stock may be diluted if we need additional funds in the future or engage in debt-for-equity exchanges in the future.

In the future, we may need to raise additional funds via debt and/or equity instruments, which may not be available on favorable terms, if available at all. If adequate funds are not available on acceptable terms, we may be unable to fund our capital needs and our plans for the growth of our business. In addition, if funds are available, the issuance of equity securities could significantly dilute the value of our shares of our common stock and cause the market price of our common stock to fall. We have the ability to issue a significant number of shares of stock in future transactions, which would substantially dilute existing shareholders, without seeking further shareholder approval.

In recent periods, the global financial markets were in turmoil and the equity and credit markets experienced extreme volatility, which caused already weak economic conditions to worsen. Continued turmoil in the global financial markets could further restrict our access to the equity and debt markets.

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

From January 1, 2009 through December 31, 2011, the price per share of our common stock ranged from a low of $5.90 to a high of $29.00. The market price of our common stock has been, and is likely to continue to be, highly volatile and subject to wide fluctuations. In the past, volatility in the market price of a company’s securities has often led to securities class action litigation. Such litigation could result in substantial costs to us and divert our attention and resources, which could harm our business. As discussed in Note 21—Commitments, Contingencies and Other Regulatory Matters of Item 8. Financial Statements and Supplementary Data, we are currently a party to litigation related to the decline in the market price of our stock, and such

 

18


Table of Contents

litigation could occur again in the future. Declines in the market price of our common stock or failure of the market price to increase could also harm our ability to retain key employees, reduce our access to capital, impact our ability to utilize deferred tax assets in the event of another ownership change and otherwise harm our business.

We have various mechanisms in place that may discourage takeover attempts.

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

 

   

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

 

   

the prohibition of cumulative voting in the election of directors;

 

   

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

 

   

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

 

   

the prohibition of shareholder action by written consent; and

 

   

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

In addition, certain provisions of our stock incentive plans, management retention and employment agreements (including severance payments and stock option acceleration), certain provisions of Delaware law and the requirements under our debt securities to offer to purchase such securities at 101% of their principal amount may also discourage, delay or prevent someone from acquiring or merging with us.

We may not be able to generate sufficient cash to service all of our indebtedness and may be forced to take other actions to satisfy our obligations under our indebtedness, which may not be successful.

Our ability to make scheduled payments on or to refinance our debt obligations depends on our financial condition, operating performance, and our ability to receive dividend payments from our subsidiaries which is subject to prevailing economic and competitive conditions and to certain financial, business and other factors beyond our control. We may not be able to maintain a level of cash flows from operating activities sufficient to permit us to pay the principal and interest on our indebtedness.

If our cash flows and capital resources are insufficient to fund our debt service obligations, we may be forced to reduce or delay investments and capital expenditures, or to sell assets, seek additional capital or restructure or refinance our indebtedness. These alternative measures may not be successful and may not permit us to meet our scheduled debt service obligations. In addition, the terms of existing or future debt instruments may restrict us from adopting some of these alternatives.

Our ability to restructure or refinance our debt will depend on the condition of the capital markets and our financial condition at such time. Any refinancing of our debt could be at higher interest rates and may require us to comply with more onerous covenants, which could further restrict our business operations. In addition, any failure to make payments of interest and principal on our outstanding indebtedness on a timely basis would likely result in a reduction of our credit rating, which could harm our ability to incur additional indebtedness. If our cash flows and available cash are insufficient to meet our debt service obligations, we could face substantial liquidity problems and might be required to dispose of material assets or operations to meet our debt service and other obligations. We may not be able to consummate those dispositions or to obtain the proceeds that we could realize from them, and these proceeds may not be adequate to meet any debt service obligations then due.

 

ITEM 1B.    UNRESOLVED STAFF COMMENTS

None.

 

19


Table of Contents
ITEM 2.    PROPERTIES

A summary of our significant locations at December 31, 2011 is shown in the following table. All facilities are leased, except for 165,000 square feet of our office in Alpharetta, Georgia. Square footage amounts are net of space that has been sublet or part of a facility restructuring.

 

Location

   Approximate Square Footage  

Alpharetta, Georgia

     260,000  

Arlington, Virginia

     119,000  

Jersey City, New Jersey

     107,000  

Menlo Park, California

     91,000  

Sandy, Utah

     66,000  

New York, New York

     39,000  

Chicago, Illinois

     25,000  

All of our facilities are used by either our trading and investing or balance sheet management segments, in addition to the corporate/other category. All other leased facilities with space of less than 25,000 square feet are not listed by location. In addition to the significant facilities above, we also lease all 28 E*TRADE branches, ranging in space from approximately 2,500 to 7,000 square feet. We believe our facilities space is adequate to meet our needs in 2012.

 

ITEM 3.    LEGAL PROCEEDINGS

On October 27, 2000, Ajaxo, Inc. (“Ajaxo”) filed a complaint in the Superior Court for the State of California, County of Santa Clara. Ajaxo sought damages and certain non-monetary relief for the Company’s alleged breach of a non-disclosure agreement with Ajaxo pertaining to certain wireless technology that Ajaxo offered the Company as well as damages and other relief against the Company for their alleged misappropriation of Ajaxo’s trade secrets. Following a jury trial, a judgment was entered in 2003 in favor of Ajaxo against the Company for $1.3 million for breach of the Ajaxo non-disclosure agreement. Although the jury found in favor of Ajaxo on its claim against the Company for misappropriation of trade secrets, the trial court subsequently denied Ajaxo’s requests for additional damages and relief. On December 21, 2005, the California Court of Appeal affirmed the above-described award against the Company for breach of the nondisclosure agreement but remanded the case to the trial court for the limited purpose of determining what, if any, additional damages Ajaxo may be entitled to as a result of the jury’s previous finding in favor of Ajaxo on its claim against the Company for misappropriation of trade secrets. Although the Company paid Ajaxo the full amount due on the above-described judgment, the case was remanded back to the trial court, and on May 30, 2008, a jury returned a verdict in favor of the Company denying all claims raised and demands for damages against the Company. Following the trial court’s filing of entry of judgment in favor of the Company on September 5, 2008, Ajaxo filed post-trial motions for vacating this entry of judgment and requesting a new trial. By order dated November 4, 2008, the trial court denied these motions. On December 2, 2008, Ajaxo filed a notice of appeal with the Court of Appeal of the State of California for the Sixth District. Oral argument on the appeal was heard on July 15, 2010. On August 30, 2010, the Court of Appeal affirmed the trial court’s verdict in part and reversed the verdict in part, remanding the case. E*TRADE petitioned the Supreme Court of California for review of the Court of Appeal decision. On December 16, 2010, the California Supreme Court denied the Company’s petition for review and remanded for further proceedings to the trial court. On September 20, 2011, the trial court granted limited discovery at a conference on November 4, 2011, and set a motion schedule and trial date. The trial will continue on May 14, 2012. The Company will continue to defend itself vigorously.

On October 2, 2007, a class action complaint alleging violations of the federal securities laws was filed in the United States District Court for the Southern District of New York against the Company and its then

 

20


Table of Contents

Chief Executive Officer and Chief Financial Officer, Mitchell H. Caplan and Robert J. Simmons, respectively, by Larry Freudenberg on his own behalf and on behalf of others similarly situated (the “Freudenberg Action”). On July 17, 2008, the trial court consolidated this action with four other purported class actions, all of which were filed in the United States District Court for the Southern District of New York and which were based on the same facts and circumstances. On January 16, 2009, plaintiffs served their consolidated amended class action complaint in which they also named Dennis Webb, the Company’s former Capital Markets Division President, as a defendant. Plaintiffs contend, among other things, that the value of the Company’s stock between April 19, 2006 and November 9, 2007 was artificially inflated because the defendants issued materially false and misleading statements and failed to disclose that the Company was experiencing a rise in delinquency rates in its mortgage and home equity portfolios; failed to timely record an impairment on its mortgage and home equity portfolios; materially overvalued its securities portfolio, which included assets backed by mortgages; and based on the foregoing, lacked a reasonable basis for the positive statements made about the Company’s earnings and prospects. Plaintiffs seek to recover damages in an amount to be proven at trial, including interest and attorneys’ fees and costs. The parties entered into a Memorandum of Understanding (“MOU”) on December 17, 2011 to settle these consolidated actions. Under the terms of the MOU, the Company and its insurance carriers will pay $79 million in return for full releases. Approximately $10.8 million of the total settlement figure will be paid by the Company, and was recorded in the other operating expense line item of the consolidated statement of income (loss) for the year ended December 31, 2011. This settlement is subject to Court approval and it has not yet been finalized. The defendants continue to deny that they committed any violations of law or breached any fiduciary duty to shareholders.

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

On August 15, 2008, Ronald M. Tate as trustee of the Ronald M. Tate Trust Dtd 4/13/88, and George Avakian filed an action in the United States District Court for the Southern District of New York against the Company, Mitchell H. Caplan and Robert J. Simmons based on the same facts and circumstances, and containing the same claims, as the Freudenberg consolidated actions discussed above. By agreement of the parties and approval of the court, the Tate action was consolidated with the Freudenberg consolidated actions for the purpose of pre-trial discovery. Plaintiffs seek to recover damages in an amount to be proven at trial, including interest, attorneys’ and expert fees and costs. The plaintiffs in this action will be part of the anticipated settlement class for the consolidated actions described above.

Based upon the same facts and circumstances alleged in the Freudenberg consolidated actions discussed above, a verified shareholder derivative complaint was filed in the United States District Court for the Southern District of New York on October 4, 2007 by Catherine Rubery, against the Company and its then Chief Executive Officer, President/Chief Operating Officer, Chief Financial Officer and individual members of its board of directors. The Rubery complaint was consolidated with another shareholder derivative complaint brought by shareholder Marilyn Clark in the same court and against the same named defendants. On July 26, 2010, Plaintiffs served their consolidated amended complaint, in which they also named Dennis Webb, the Company’s former Capital Markets Division President, as a defendant. Plaintiffs allege, among other things, causes of action for breach of fiduciary duty, waste of corporate assets, unjust enrichment, and violation of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. The complaint seeks, among other things, unspecified monetary damages in favor of the Company, changes to corporate governance procedures and various forms of injunctive relief.

On April 2, 2008, a class action complaint alleging violations of the federal securities laws was filed by John W. Oughtred on his own behalf and on behalf of all others similarly situated in the United States District Court for the Southern District of New York against the Company. Plaintiff contends, among other things, that the Company committed various sales practice violations in the sale of certain auction rate securities to investors between April 2, 2003, and February 13, 2008 by allegedly misrepresenting that these securities were highly

 

21


Table of Contents

liquid and safe investments for short term investing. On December 18, 2008, plaintiffs filed their first amended class action complaint. Defendants filed their pending motion to dismiss plaintiffs’ amended complaint on February 5, 2009, and briefing on defendants’ motion to dismiss was completed on April 15, 2009. Plaintiffs seek to recover damages in an amount to be proven at trial, or, in the alternative, rescission of auction rate securities purchases, plus interest and attorney’s fees and costs. On March 18, 2010, the District Court dismissed the complaint without prejudice. On April 22, 2010, Plaintiffs amended their complaint. The Company has moved to dismiss the amended complaint. By an Order dated March 31, 2011, the Court granted E*TRADE’s motion and dismissed the action with prejudice. On May 2, 2011, Plaintiffs filed a Notice of Appeal to the U.S. Court of Appeals for the Second Circuit. Plaintiffs filed their brief on August 12, 2011. The Company’s response brief was filed October 26, 2011. Plaintiffs’ reply brief was filed on November 21, 2011. Oral argument has not yet been scheduled.

Beginning in approximately August 2008, representatives of various states attorneys general and FINRA initiated inquiries regarding the purchase of auction rate securities by E*TRADE Securities LLC’s customers. On February 9, 2011, E*TRADE Securities LLC received a “Wells Notice” from FINRA Staff stating that they have made a preliminary determination to recommend that disciplinary action be brought against E*TRADE Securities LLC for alleged violations of certain FINRA rules in connection with the purchases of auction rate securities by customers of E*TRADE Securities LLC. E*TRADE Securities LLC is cooperating with these inquiries and has submitted a Wells response to FINRA setting forth the bases for E*TRADE Securities’ belief that disciplinary action is not warranted.

On January 19, 2010, the North Carolina Securities Division filed an administrative petition before the North Carolina Secretary of State against E*TRADE Securities LLC seeking to revoke the North Carolina securities dealer registration of E*TRADE Securities LLC or, alternatively, to suspend that registration until all North Carolina residents are made whole for their investments in auction rate securities purchased through E*TRADE Securities LLC. On March 8, 2011, E*TRADE Securities LLC, without admitting or denying the underlying allegations, findings or conclusions, resolved the North Carolina administrative action by entering into a consent order (“North Carolina Order”) pursuant to which E*TRADE Securities LLC agreed to pay a $25,000 civil penalty and to reimburse the North Carolina Securities Division’s investigative costs of $400,000. E*TRADE Securities LLC also agreed to various undertakings set forth in the North Carolina Order, including additional internal training on fixed income products and the retention of an independent consultant to review E*TRADE Securities LLC’s policies and procedures related to the approval and sale of fixed income products. As of December 31, 2011, no existing North Carolina customers held any auction rate securities.

On February 3, 2010, a class action complaint was filed in the United States District Court for the Northern District of California against E*TRADE Securities LLC by Joseph Roling on his own behalf and on behalf of all others similarly situated. The lead plaintiff alleges that E*TRADE Securities LLC unlawfully charged and collected certain account activity fees from its customers. Claimant, on behalf of himself and the putative class, asserts breach of contract, unjust enrichment and violation of California Civil Code Section 1671 and seeks equitable and injunctive relief for alleged illegal, unfair and fraudulent practices under California’s Unfair Competition Law, California Business and Professional Code Section 17200 et seq. The plaintiff seeks, among other things, certification of the class action on behalf of alleged similarly situated plaintiffs, unspecified damages and restitution of amounts allegedly wrongfully collected by E*TRADE Securities LLC, attorneys’ fees and expenses and injunctive relief. The Company moved to transfer venue on the case to the Southern District of New York; that motion was denied. The Court granted E*TRADE’s motion to dismiss in part and denied the motion to dismiss in part. The Court bifurcated discovery to permit initial discovery on individual claims and class certification. Following preliminary discovery, Plaintiffs moved to amend their verified complaint for a second time, to assert new allegations and to add a new plaintiff. The Company filed its opposition to this motion on December 27, 2011. The Company intends to vigorously defend itself against the claims raised in this action.

On July 21, 2010, the Colorado Division of Securities filed an administrative complaint in the Colorado Office of Administrative Courts against E*TRADE Securities LLC based upon purchases of auction rate

 

22


Table of Contents

securities through E*TRADE Securities LLC by Colorado residents. On October 19, 2011, E*TRADE Securities LLC and the Colorado Division of Securities reached an agreement in principle to settle the Colorado proceeding whereby E*TRADE Securities LLC will offer to purchase auction rate securities held by Colorado customers who found themselves unable to sell their securities after those securities had been frozen in the broader auction rate securities market. The agreement in principle also included an agreement with the North American Securities Administrators Association (“NASAA”) whereby E*TRADE Securities LLC will offer to purchase auction rate securities purchased through E*TRADE Securities LLC on a nationwide basis and pay a $5 million penalty to be allocated among 48 states and the District of Columbia, Puerto Rico and the Virgin Islands but exclusive of North Carolina and South Carolina with whom E*TRADE Securities previously had reached separate settlements. Under the agreement in principle each state will receive its allocated share of the $5 million penalty pursuant to administrative consent cease and desist orders to be entered into by each state. A Consent Order memorializing the agreement in principle as it related to Colorado customers was entered by the Colorado Securities Commissioner on November 16, 2011, and amended on November 23, 2011, whereby E*TRADE Securities LLC, without admitting or denying the underlying allegations, agreed to pay an administrative penalty to Colorado of $84,202, which amount constituted Colorado’s share of the total NASAA state settlement amount of $5 million, and to reimburse the Colorado Division of Securities’ costs associated with the administrative action in the amount of $596,580. Under the terms of the Consent Order, E*TRADE Securities LLC will offer to purchase (or offer to arrange a third party to purchase), at par plus accrued and unpaid dividends and interest, from eligible investors nationwide their auction rate securities purchased through E*TRADE Securities LLC, or through an entity acquired by the Company on or before February 13, 2008, if such auction rate securities have failed at auction at least once since February 13, 2008 (“the Purchase Offer”). E*TRADE Securities LLC also agreed to identify eligible investors who purchased auction rate securities through E*TRADE Securities LLC on or before February 13, 2008, and sold those securities below par between February 13, 2008, and November 16, 2011, and to reimburse those sellers the difference between par value and the actual sales price plus reasonable interest. E*TRADE Securities LLC agreed to hold open the Purchase Offer until May 15, 2012, and to various other undertakings set forth in the Consent Order, including the establishment of a dedicated toll-free telephone assistance line and website to provide information and to respond to questions regarding the Consent Order. As of December 31, 2011, the total amount of auction rate securities held by Colorado customers was approximately $1.2 million and the total amount of auction rate securities held by E*TRADE Securities LLC customers nationwide (including Colorado customers) was $61.3 million. The Company recorded a reserve of $48 million in the other operating expense line item of the consolidated statement of income (loss). The reserve represented the Company’s estimate of the current fair value relative to par value of auction rate securities held by E*TRADE Securities LLC customers, as well as former customers who purchased auction rate securities through E*TRADE Securities LLC and are covered by the Consent Order. The agreement includes the resolution of all material individual auction rate securities arbitrations and litigations. The reserve also includes penalties and other estimated settlement costs.

On August 24, 2010, the South Carolina Securities Division filed an administrative complaint before the Securities Commissioner of South Carolina against E*TRADE Securities LLC based upon purchases of auction rate securities through E*TRADE Securities LLC by South Carolina residents. The complaint sought to suspend the South Carolina broker-dealer license of E*TRADE Securities LLC until South Carolina customers who purchased auction rate securities through E*TRADE Securities LLC and who wished to liquidate those positions were able to do so, and sought a fine not to exceed $10,000 for each potential violation of South Carolina statutes or rules. On March 25, 2011, E*TRADE Securities LLC, without admitting or denying the underlying allegations, findings or conclusions, resolved the South Carolina administrative action by entering into a consent order, pursuant to which E*TRADE Securities LLC agreed to pay a $10,000 civil penalty and to reimburse the South Carolina Securities Division’s investigative costs of $2,500. As of December 31, 2011, no existing South Carolina customers held any auction rate securities.

On May 16, 2011, Droplets Inc., the holder of two patents pertaining to user interface servers, filed a complaint in the U.S. District Court for the Eastern District of Texas against E*TRADE Financial Corporation, E*TRADE Securities LLC, E*TRADE Bank N.A. and multiple other unaffiliated financial services firms.

 

23


Table of Contents

Plaintiff contends that the defendants engaged in patent infringement under federal law. Plaintiff seeks unspecified damages and an injunction against future infringements, plus royalties, costs, interest and attorneys’ fees. On September 30, 2011, the Company and several co-defendants filed a motion to transfer the case to the Southern District of New York. Venue discovery occurred throughout December 2011. On January 1, 2012, a new judge was assigned to the case. The Company will defend itself vigorously in this matter.

Several cases have been filed nationwide involving the April 2007 leveraged buyout (“LBO”) of the Tribune Company (“Tribune”) by Sam Zell, and the subsequent bankruptcy of Tribune. In William Niese et al. v. A.G. Edwards et al., in Superior Court of Delaware, New Castle County, former Tribune employees and retirees claimed that Tribune was actually insolvent at the time of the LBO and that the LBO constituted a fraudulent transaction that depleted the plaintiffs’ retirement plans, rendering them worthless. E*TRADE Clearing LLC, along with numerous other financial institutions, is a named defendant, but has not been served with process. One of the defendants removed the action to federal district court in Delaware on July 1, 2011. In Deutsche Bank Trust Company Americas et al. v. Adaly Opportunity Fund et al., filed in the Supreme Court of New York, New York County on June 3, 2011, the Trustees of certain notes issued by Tribune allege wrongdoing in connection with the LBO. In particular the Trustees claim that the LBO constituted a constructive fraudulent transfer under various state laws. E*TRADE Capital Markets, LLC, along with numerous other financial institutions, is a named defendant. In Deutsche Bank et al. v. Ohlson et al., filed in the U.S. District Court for the Northern District of Illinois, noteholders of Tribune asserted claims of constructive fraud. E*TRADE Capital Markets LLC is a named defendant. In EGI-TRB LLC et al. v. ABN-AMRO et al, filed in the Circuit Court of Cook County Illinois, creditors of Tribune assert fraudulent conveyance claims against multiple shareholder defendants. E*TRADE Clearing LLC is a named defendant. There have been several motions filed by various parties to transfer venue and to consolidate these actions. The Company’s time to answer or otherwise respond to the complaint has been stayed pending further orders of Court. The Company will defend itself vigorously in these matters.

In addition to the matters described above, the Company is subject to various legal proceedings and claims that arise in the normal course of business. In each pending matter, the Company contests liability or the amount of claimed damages. In view of the inherent difficulty of predicting the outcome of such matters, particularly in cases where claimants seek substantial or indeterminate damages, or where investigation or discovery have yet to be completed, the Company is unable to reasonably estimate a range of possible losses on its remaining outstanding legal proceedings; however, the Company believes any losses would not be reasonably likely to have a material adverse effect on the consolidated financial condition or results of operations of the Company.

An unfavorable outcome in any matter could have a material adverse effect on the Company’s business, financial condition, results of operations or cash flows. In addition, even if the ultimate outcomes are resolved in the Company’s favor, the defense of such litigation could entail considerable cost or the diversion of the efforts of management, either of which could have a material adverse effect on the Company’s business, financial condition, results of operations or cash flows.

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

 

24


Table of Contents

PART II

 

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

Price Range of Common Stock

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

 

     High      Low  

2011:

     

First Quarter

   $ 18.13      $ 14.60  

Second Quarter

   $ 16.83      $ 13.23  

Third Quarter

   $ 16.66      $ 9.07  

Fourth Quarter

   $ 11.69      $ 7.42  

2010:

     

First Quarter

   $ 18.50      $ 14.10  

Second Quarter

   $ 19.90      $ 11.73  

Third Quarter

   $ 15.60      $ 11.15  

Fourth Quarter

   $ 16.24      $ 13.73  

The closing sale price of our common stock as reported on the NASDAQ on February 17, 2012 was $9.35 per share. At that date, there were 1,648 holders of record of our common stock.

Dividends

We have never declared or paid cash dividends on our common stock. The terms of our corporate debt currently prohibit the payment of dividends and will continue to prohibit the payment of dividends for the foreseeable future. E*TRADE Bank may not pay dividends to the parent company without approval from its regulators. This dividend restriction includes E*TRADE Securities LLC and E*TRADE Clearing LLC as they are subsidiaries of E*TRADE Bank.

Equity Compensation Plan Information

Refer to Note 18—Employee Shared-Based Payments and Other Benefits of Item 8. Financial Statements and Supplementary Data for equity compensation plan information.

 

25


Table of Contents

Performance Graph

The following performance graph shows the cumulative total return to a holder of the Company’s common stock, assuming dividend reinvestment, compared with the cumulative total return, assuming dividend reinvestment, of the S&P 500 and the S&P Super Cap Diversified Financials during the period from December 31, 2006 through December 31, 2011.

 

LOGO

 

     12/06      12/07      12/08      12/09      12/10      12/11  

E*TRADE Financial Corporation

     100.00        15.83        5.13        7.85        7.14        3.55  

S&P 500

     100.00        105.49        66.46        84.05        96.71        98.75  

S&P Composite 1500 Diversified Financials

     100.00        85.64        39.44        52.71        55.88        40.04  

 

26


Table of Contents
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA

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

 

     Year Ended December 31,      Variance  
     2011       2010      2009      2008      2007      2011 vs. 2010  

Results of Operations:(1)

             

Net operating interest income

   $ 1,220.0      $ 1,226.3     $ 1,260.6     $ 1,268.0     $ 1,583.6       (1 )% 

Total net revenue

   $ 2,036.6      $ 2,077.9     $ 2,217.0     $ 1,925.6     $ 161.7       (2 )% 

Provision for loan losses

   $ 440.6      $ 779.4     $ 1,498.1     $ 1,583.7     $ 640.1       (43 )% 

Income (loss) from continuing operations

   $ 156.7      $ (28.5   $ (1,297.8   $ (809.4   $ (1,442.3     *   

Net income (loss)

   $ 156.7      $ (28.5   $ (1,297.8   $ (511.8   $ (1,441.8     *   

Basic earnings (loss) per share from continuing operations

   $ 0.59      $ (0.13   $ (11.85   $ (15.88   $ (33.98     *   

Diluted earnings (loss) per share from continuing operations

   $ 0.54      $ (0.13   $ (11.85   $ (15.88   $ (33.98     *   

Basic net earnings (loss) per share

   $ 0.59      $ (0.13   $ (11.85   $ (10.04   $ (33.97     *   

Diluted net earnings (loss) per share

   $ 0.54      $ (0.13   $ (11.85   $ (10.04   $ (33.97     *   

Weighted average shares—basic

     267,291        211,302       109,544       50,986       42,444       26

Weighted average shares—diluted

     289,822        211,302       109,544       50,986       42,444       37

 

* Percentage not meaningful.
(1) 

In 2008, the Company sold its Canadian brokerage business and exited its direct retail lending business.

(Dollars in millions):

 

     December 31,      Variance  
     2011      2010      2009      2008      2007      2011 vs. 2010  

Financial Condition:

                 

Available-for-sale securities

   $ 15,651.5      $ 14,805.7      $ 13,319.7      $ 10,806.1      $ 11,255.0        6

Held-to-maturity securities

   $ 6,079.5      $ 2,462.7      $ —         $ —         $ —           147

Margin receivables

   $ 4,826.3      $ 5,120.6      $ 3,827.2      $ 2,791.2      $ 7,179.2        (6 )% 

Loans receivable, net

   $ 12,332.8      $ 15,121.9      $ 19,167.1      $ 24,451.8      $ 30,038.8        (18 )% 

Total assets

   $ 47,940.5      $ 46,373.0      $ 47,366.5      $ 48,538.2      $ 56,845.9        3

Deposits

   $ 26,460.0      $ 25,240.3      $ 25,597.7      $ 26,136.2      $ 25,884.8        5

Corporate debt

                 

Interest-bearing

   $ 1,450.5      $ 1,441.9      $ 1,437.8      $ 2,750.5      $ 3,022.7        1

Non-interest-bearing

   $ 43.0      $ 704.0      $ 1,020.9      $ —         $ —           (94 )% 

Shareholders’ equity

   $ 4,928.0      $ 4,052.4      $ 3,749.6      $ 2,591.5      $ 2,829.1        22

 

27


Table of Contents

 

    As of or For the Year Ended December 31,     Variance  
    2011     2010     2009     2008     2007     2011 vs. 2010  

Customer Activity Metrics:(1)

           

DARTs

    157,475       150,532       179,183       169,075       161,119       5

Average commission per trade

  $ 11.01     $ 11.21     $ 11.33     $ 10.98     $ 11.57       (2 )% 

Margin receivables (dollars in billions)

  $ 4.8     $ 5.1     $ 3.7     $ 2.7     $ 6.6       (6 )% 

End of period brokerage accounts

    2,783,012       2,684,311       2,630,079       2,515,806       2,373,265       4

Net new brokerage accounts

    98,701       54,232       114,273       142,541       4,688       *   

Customer assets (dollars in billions)

  $ 172.4     $ 176.2     $ 150.5     $ 110.1     $ 181.3       (2 )% 

Net new brokerage assets (dollars in billions)

  $ 9.7     $ 8.1     $ 7.2     $ 3.9     $ (13.3     *   

Brokerage related cash (dollars in billions)

  $ 27.7     $ 24.5     $ 20.4     $ 15.8     $ 17.5       13

Company Metrics:

           

Corporate cash (dollars in millions)

  $ 484.4     $ 470.5     $ 393.2     $ 434.9     $ 312.4       3

E*TRADE Financial Tier I leverage ratio

    5.7     3.6     N/A        N/A        N/A        2.1

E*TRADE Financial Tier I common ratio

    9.4     4.8     N/A        N/A        N/A        4.6

E*TRADE Bank Tier I capital ratio

    7.8     7.3     6.7     6.3     6.2     0.5

Special mention loan delinquencies (dollars in millions)

  $ 467.1     $ 589.4     $ 804.5     $ 1,035.1     $ 612.2       (21 )% 

Allowance for loan losses (dollars in millions)

  $ 822.8     $ 1,031.2     $ 1,182.7     $ 1,080.6     $ 508.2       (20 )% 

Enterprise net interest spread

    2.79     2.91     2.72     2.52     2.64     (0.12 )% 

Enterprise interest-earning assets (average dollars in billions)

  $ 42.7     $ 41.1     $ 44.5     $ 46.9     $ 56.1       4

Total employees (period end)

    3,240       2,962       3,084       3,249       3,757       9

 

* Percentage not meaningful.
(1) 

Metrics have been represented to exclude activity from discontinued operations for the years ended December 31, 2008 and 2007, and international local market trading for the years ended December 31, 2009, 2008 and 2007.

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

 

28


Table of Contents
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

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

GLOSSARY OF TERMS

In analyzing and discussing our business, we utilize certain metrics, ratios and other terms that are defined in the Glossary of Terms, which is located at the end of Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

OVERVIEW

Strategy

Our core business is our trading and investing customer franchise. Building on the strengths of this franchise, our growth strategy is focused on:

 

   

Strengthening our overall financial and franchise position. We are focused on strengthening our overall capital structure and continuing to mitigate credit losses in our loan portfolio. We are also focused on positioning the Company for future growth and maintaining disciplined expense management.

 

   

Improving our market position in our retail brokerage business. We plan to grow our customer base by continuing to increase our sales force, focus on long-term investing and develop innovative products and services.

 

   

Accelerating the growth of our corporate services and market making businesses. Our corporate services and market making businesses enhance our strategy by allowing us to realize additional economic benefit from our retail brokerage business.

 

   

Enhancing our position with long-term investors. We believe growing our investing and retirement products and services is key to our long term success. Our primary focus is to expand the reach of our brand along with the awareness of our products to this key customer segment.

 

   

Optimizing the value of our bank franchise. 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.

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.

 

29


Table of Contents

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 at both our bank and our parent company;

 

   

our ability to assess and manage interest rate risk; and

 

   

disciplined expense control and improved operational efficiency.

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

 

      As of or For the
Year Ended December 31,
    Variance  
     2011     2010     2009     2011 vs. 2010  

Customer Activity Metrics:(1)

        

DARTs

     157,475       150,532       179,183       5

Average commission per trade

   $ 11.01     $ 11.21     $ 11.33       (2 )% 

Margin receivables (dollars in billions)

   $ 4.8     $ 5.1     $ 3.7       (6 )% 

End of period brokerage accounts

     2,783,012       2,684,311       2,630,079       4

Net new brokerage accounts

     98,701       54,232       114,273       *   

Customer assets (dollars in billions)

   $ 172.4     $ 176.2     $ 150.5       (2 )% 

Net new brokerage assets (dollars in billions)

   $ 9.7     $ 8.1     $ 7.2       *   

Brokerage related cash (dollars in billions)

   $ 27.7     $ 24.5     $ 20.4       13

Company Financial Metrics:

        

Corporate cash (dollars in millions)

   $ 484.4     $ 470.5     $ 393.2       3

E*TRADE Financial Tier I leverage ratio

     5.7     3.6     N/A        2.1

E*TRADE Financial Tier I common ratio

     9.4     4.8     N/A        4.6

E*TRADE Bank Tier I capital ratio

     7.8     7.3     6.7     0.5

Special mention loan delinquencies (dollars in millions)

   $ 467.1     $ 589.4     $ 804.5       (21 )% 

Allowance for loan losses (dollars in millions)

   $ 822.8     $ 1,031.2     $ 1,182.7       (20 )% 

Enterprise net interest spread

     2.79     2.91     2.72     (0.12 )% 

Enterprise interest-earning assets (average dollars in billions)

   $ 42.7     $ 41.1     $ 44.5       4

 

* Percentage not meaningful.
(1) 

The year ended December 31, 2009 presented has been updated to exclude international local market trading.

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 to finance their purchases of securities by borrowing against securities they 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.

 

30


Table of Contents
   

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.

 

   

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 Financial Tier I leverage ratio is Tier I capital divided by average total assets for the holding company for leverage capital purposes. E*TRADE Financial Tier I common ratio is 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 for the holding company. The Tier I leverage and Tier I common ratios are non-GAAP measures as the holding company is not yet held to these capital requirements. See Liquidity and Capital Resources for a reconciliation of these non-GAAP measures to the comparable GAAP measures.

 

   

E*TRADE Bank Tier I capital ratio is Tier I capital divided by adjusted total assets for E*TRADE Bank and is an indication of E*TRADE Bank’s capital adequacy.

 

   

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 probable losses inherent in the loan portfolio as of the balance sheet date and is typically equal to management’s forecast of loan losses in the twelve months following the balance sheet date as well as the forecasted losses, including economic concessions to borrowers, over the estimated remaining life of loans modified as troubled debt restructurings (“TDR”). See Summary of Critical Accounting Policies and Estimates for a discussion of the estimates and assumptions used in the allowance for loan 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 2011

Enhancements to Our Trading and Investing Products and Services

 

   

We continued to grow our sales force, increasing our financial consultant team by 42% in 2011, as we continued to focus on engagement with long-term and retirement investors, as well as corporate clients;

 

   

We developed E*TRADE 360, a fully dynamic and customizable online investing dashboard now available to all customers.

 

   

We developed a newly redesigned public website featuring simplified navigation, personalization based on objectives and experience levels, and enhanced content.

 

31


Table of Contents
   

We launched the E*TRADE Community, which utilizes social media to offer customers a platform to interact with one another and share ideas and strategies with other E*TRADE customers;

 

   

We added several new features to our E*TRADE Pro platform, including new options strategies (multi-legged orders), expanded CNBC content and logarithmic charts;

 

   

We introduced a suite of sophisticated Options Tools designed to help traders quickly and easily identify and analyze potential investment opportunities;

 

   

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;

 

   

We launched a number of enhancements for Mobile Pro, including mobile check deposit capability for Apple iPhone® and AndroidTM;

 

   

We introduced weekly options on select stocks, indexes and ETFs;

 

   

We expanded tools, education and research offerings in the Bond Resource Center;

 

   

We continued to expand our free investor education offerings across a number of channels including online videos, live and on-demand web seminars, and live events;

 

   

We strengthened our retirement offering with Rollover Specialists as well as Certified Retirement Planning Counselors added in nearly every branch, and expanded educational resources with additional videos and seminars, commentary, planning checklists, Rollover Quiz, IRA selection tools and upgraded Tax Center;

 

   

We enhanced our customer service offering with 24/7 online chat capabilities, an e-mail platform available to prospects, and an enhanced online service center;

 

   

We launched portfolio margin accounts, which provide sophisticated traders with additional tools to manage risk and leverage capital;

 

   

We introduced unified managed account advisory services to long-term investors seeking professional money management services with an investment of $250,000 or more; and

 

   

We expanded our corporate services client base by bringing on 46 new clients and continued to execute our strategy to service both private and public companies as a foundation for future retail brokerage account growth.

Market Recognition

 

   

Our corporate services business received top ratings in overall satisfaction and loyalty among broker plan administrators by Group Five, an independent consulting and research firm, in its 2011 Stock Plan Administration Benchmarking Study; and

 

   

Our customer service team was awarded the 2011 International Service Excellence Award in the Contact Center category, based on a proven display of excellence, professionalism and outstanding service achievement.

Issuance and Extinguishment of Senior Notes

 

   

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

Conversions of Convertible Debentures

 

   

During the year, a total of $660.9 million in convertible debentures were converted into 63.9 million shares of common stock, increasing shareholders’ equity by $661 million.

 

32


Table of Contents

Legal Settlements for the Auction Rate Securities and Freudenberg Matters

 

   

We reached a settlement with the Colorado Division of Securities and the NASAA whereby E*TRADE Securities LLC offered to purchase auction rate securities from eligible investors who purchased those securities through E*TRADE Securities LLC. We recorded a reserve of $48 million in connection with this settlement. We also entered into a memorandum of understanding to settle the Freudenberg Action, which resulted in the recording of a net reserve of $10.8 million as of December  31, 2011.

EARNINGS OVERVIEW

2011 Compared to 2010

We generated net income of $156.7 million, or $0.54 per diluted share, on total net revenue of $2.0 billion for the year ended December 31, 2011. Commissions, fees and service charges, principal transactions and other revenue decreased 2% to $711.3 million for the year ended December 31, 2011 compared to 2010, which was driven primarily by the elimination of all account activity fees, which took effect in the second quarter of 2010. In addition, gains on loans and securities, net and net impairment decreased 18% to $105.3 million for the year ended December 31, 2011 compared to 2010.

Provision for loan losses declined 43% to $440.6 million for the year ended December 31, 2011 compared to 2010, driven by improving credit trends and loan portfolio run-off. Total operating expenses increased 8% to $1.2 billion for the year ended December 31, 2011 compared to 2010. This increase was driven primarily by increases in advertising and market development expense, FDIC insurance premiums and other operating expenses during the year ended December 31, 2011.

The following sections describe in detail the changes in key operating factors and other changes and events that 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):

 

                 Variance  
     Year Ended December 31,     2011 vs. 2010  
             2011                 2010         Amount     %  

Net operating interest income

   $ 1,220.0     $ 1,226.3     $ (6.3     (1 )% 

Commissions

     436.2       431.0       5.2       1

Fees and service charges

     130.4       142.4       (12.0     (8 )% 

Principal transactions

     105.4       103.4       2.0       2

Gains on loans and securities, net

     120.2       166.2       (46.0     (28 )% 

Net impairment

     (14.9     (37.7     22.8       (60 )% 

Other revenues

     39.3       46.3       (7.0     (15 )% 
  

 

 

   

 

 

   

 

 

   

Total non-interest income

     816.6       851.6       (35.0     (4 )% 
  

 

 

   

 

 

   

 

 

   

Total net revenue

   $       2,036.6     $ 2,077.9     $ (41.3     (2 )% 
  

 

 

   

 

 

   

 

 

   

Net Operating Interest Income

Net operating interest income decreased 1% to $1.2 billion for the year ended December 31, 2011 compared to 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.

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):

 

33


Table of Contents
    Year Ended December 31,  
    2011      2010      2009   
    Average
Balance
    Operating
Interest
Inc./Exp.
    Average
Yield/

Cost
    Average
Balance
    Operating
Interest
Inc./Exp.
    Average
Yield/

Cost
    Average
Balance
    Operating
Interest
Inc./Exp.
    Average
Yield/

Cost
 

Enterprise interest-earning assets:

                 

Loans(1)

  $ 14,689.8     $ 692.1       4.71   $ 18,302.2     $ 879.0       4.80   $ 23,113.6     $ 1,138.1       4.92

Margin receivables

    5,374.8       221.7       4.13     4,532.5       200.3       4.42     3,103.5       138.5       4.46

Available-for-sale securities

    15,326.5       422.5       2.76     13,275.9       387.5       2.92     11,593.3       473.1       4.08

Held-to-maturity securities

    4,177.1       136.9       3.28     1,085.8       35.9       3.31     —         —         —    

Cash and equivalents

    1,618.9       3.2       0.20     2,414.3       5.4       0.22     4,215.7       14.8       0.35

Segregated cash and investments

    915.6       0.9       0.10     857.1       1.9       0.22     1,785.7       4.2       0.23

Securities borrowed and other

    620.9       48.8       7.85     662.9       29.4       4.43     690.4       50.4       7.30
 

 

 

   

 

 

     

 

 

   

 

 

     

 

 

   

 

 

   

Total enterprise interest-earning assets

    42,723.6       1,526.1       3.57     41,130.7       1,539.4       3.74     44,502.2       1,819.1       4.09
   

 

 

       

 

 

       

 

 

   

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

    4,339.5           4,395.1           3,873.3      
 

 

 

       

 

 

       

 

 

     

Total assets

  $ 47,063.1         $ 45,525.8         $ 48,375.5      
 

 

 

       

 

 

       

 

 

     

Enterprise interest-bearing liabilities:

                 

Retail deposits:

                 

Sweep deposits

  $ 17,513.1       13.4       0.08   $ 14,014.4       10.1       0.07   $ 11,022.3       7.6       0.07

Complete savings deposits

    6,174.4       16.1       0.26     7,577.0       28.6       0.38     11,539.9       140.1       1.21

Other money market and savings deposits

    1,071.5       2.5       0.23     1,114.6       2.8       0.25     1,243.7       5.9       0.47

Checking deposits

    783.2       0.8       0.10     761.9       0.9       0.11     797.5       3.0       0.37

Certificates of deposit

    270.7       7.3       2.70     795.3       14.5       1.82     1,750.4       45.2       2.58

Brokered certificates of deposit

    48.8       2.7       5.58     115.3       5.9       5.14     193.8       10.0       5.17

Customer payables

    5,456.3       8.6       0.16     4,713.2       7.0       0.15     4,662.9       8.8       0.19

Securities sold under agreements to repurchase

    5,417.2       153.1       2.83     6,154.3       129.6       2.11     6,725.4       200.1       2.98

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

    2,741.1       106.2       3.87     2,754.3       119.3       4.33     3,392.0       148.8       4.38

Securities loaned and other

    634.8       1.5       0.23     622.4       1.6       0.26     513.0       2.4       0.46
 

 

 

   

 

 

     

 

 

   

 

 

     

 

 

   

 

 

   

Total enterprise interest-bearing liabilities

    40,111.1       312.2       0.78     38,622.7       320.3       0.83     41,840.9       571.9       1.37
   

 

 

       

 

 

       

 

 

   

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

    2,285.9           2,876.4           3,558.5      
 

 

 

       

 

 

       

 

 

     

Total liabilities

    42,397.0           41,499.1           45,399.4      

Total shareholders’ equity

    4,666.1           4,026.7           2,976.1      
 

 

 

       

 

 

       

 

 

     

Total liabilities and shareholders’ equity

  $ 47,063.1         $ 45,525.8         $ 48,375.5      
 

 

 

       

 

 

       

 

 

     

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

  $ 2,612.5     $ 1,213.9       2.79   $ 2,508.0     $ 1,219.1       2.91   $ 2,661.3     $ 1,247.2       2.72
 

 

 

   

 

 

     

 

 

   

 

 

     

 

 

   

 

 

   

 

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

 

     Year Ended December 31,  
     2011     2010     2009  

Enterprise net interest income

   $ 1,213.9     $ 1,219.1     $ 1,247.2  

Taxable equivalent interest adjustment

     (1.2     (1.2     (2.1

Customer cash held by third parties and other(4)

     7.3       8.4       15.5  
  

 

 

   

 

 

   

 

 

 

Net operating interest income

   $ 1,220.0     $ 1,226.3     $ 1,260.6  
  

 

 

   

 

 

   

 

 

 

 

(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, $3.1 billion and $2.9 billion for the years ended December 31, 2011, 2010 and 2009, respectively, held by parties outside the Company, including third party money market funds and sweep deposit accounts at unaffiliated financial institutions.

 

34


Table of Contents

 

     Year Ended December 31,  
     2011     2010     2009  

Enterprise net interest:

      

Spread

     2.79     2.91     2.72

Margin (net yield on interest-earning assets)

     2.84     2.96     2.80

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

     106.51     106.49     106.36

Return on average:

      

Total assets

     0.33     (0.06 )%      (2.68 )% 

Total shareholders’ equity

     3.36     (0.71 )%      (43.61 )% 

Average equity to average total assets

     9.91     8.84     6.15

The fluctuation in enterprise interest-earning assets is driven primarily by changes in enterprise interest-earning liabilities, specifically customer cash and deposits. Average enterprise interest-earning assets increased 4% to $42.7 billion for the year ended December 31, 2011 compared to 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 4% to $40.1 billion for the year ended December 31, 2011 compared to 2010. The increase in average enterprise interest-bearing liabilities was primarily due to increases in average sweep deposits and average customer payables, offset by a decrease in average securities sold under agreements to repurchase.

Enterprise net interest spread decreased by 12 basis points to 2.79% for the year ended December 31, 2011 compared to 2010, reflecting yields on average enterprise interest-earning assets and the current interest rate environment. We expect enterprise net interest spread to continue to compress and, given the continued challenges of the current interest rate environment, our enterprise net interest spread could average less than 2.50% for the year ending December 31, 2012.

Commissions

Commissions revenue increased 1% to $436.2 million for the year ended December 31, 2011 compared to 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.

 

35


Table of Contents

DART volume increased 5% to 157,475 for the year ended December 31, 2011 compared to 2010. Option-related DARTs as a percentage of total DARTs represented 21% of trading volume for the year ended December 31, 2011 compared to 17% in 2010. Exchange-traded funds-related DARTs as a percentage of total DARTs represented 11% of trading volume for the year ended December 31, 2011 compared to 10% in 2010.

Average commission per trade decreased 2% to $11.01 for the year ended December 31, 2011 compared to 2010. The decrease was driven by a change in the customer mix; specifically customers who have a higher commission per trade traded less during the year compared to our active trader customers, who generally have lower commission per trade, when compared to 2010.

Fees and Service Charges

Fees and service charges decreased 8% to $130.4 million for the year ended December 31, 2011 compared to 2010. The decrease for the year ended December 31, 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 increased 2% to $105.4 million for the year ended December 31, 2011 compared to 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 increase in principal transactions revenue was driven by a favorable mix of trading volume and revenue earned per share, as well as a continued focus on expanding our external customer base, when compared to 2010.

Gains on Loans and Securities, Net

Gains on loans and securities, net were $120.2 million for the year ended December 31, 2011 compared to $166.2 million in 2010, as shown in the following table (dollars in millions):

 

     Year Ended     Variance  
     December 31,     2011 vs. 2010  
         2011             2010         Amount     %  

Gains on loans, net

   $ 0.1     $ 6.3     $ (6.2     *   
  

 

 

   

 

 

   

 

 

   

Gains on available-for-sale securities, net

     124.4       160.7       (36.3     (23 )% 

Gains (losses) on trading securities, net

     (1.9     0.2       (2.1     *   

Hedge ineffectiveness

     (2.4     (1.0     (1.4     *   
  

 

 

   

 

 

   

 

 

   

Gains on securities, net

     120.1       159.9       (39.8     (25 )% 
  

 

 

   

 

 

   

 

 

   

Gains on loans and securities, net

   $ 120.2     $ 166.2     $ (46.0     (28 )% 
  

 

 

   

 

 

   

 

 

   

 

* Percentage not meaningful.

The decrease of 28% to $120.2 million in gains on loans and securities, net for the year ended December 31, 2011 compared to 2010, was primarily due to more trading volatility in 2010 when compared to 2011.

 

36


Table of Contents

Net Impairment

We recognized $14.9 million of net impairment during the year ended December 31, 2011, 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):

 

     Year Ended
December 31,
 
    
         2011             2010      

Other-than-temporary impairment (“OTTI”)

   $ (9.2   $ (41.5

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

     (5.7     3.8  
  

 

 

   

 

 

 

Net impairment

   $ (14.9)      $ (37.7
  

 

 

   

 

 

 

Other Revenues

Other revenues decreased 15% to $39.3 million for the year ended December 31, 2011 compared to 2010. The decrease was due primarily 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 year ended December 31, 2010.

Provision for Loan Losses

Provision for loan losses decreased 43% to $440.6 million for the year ended December 31, 2011 compared to 2010. The decrease in provision for loan losses was driven by improving credit trends and loan portfolio run-off, as evidenced by the lower levels of delinquent loans in the one- to four-family and home equity loan portfolios. The provision for loan losses has declined for three consecutive years, down 72% from its peak of $1.6 billion for the year ended December 31, 2008. We expect provision for loan losses to continue to decline in 2012 compared to 2011, although it is subject to variability from quarter to quarter.

As we transition from the OTS to the OCC, we are evaluating programs and practices that were designed in accordance with guidance from the OTS. We are working to align certain policies and procedures to the guidance from the OCC and have suspended certain loan modification programs that will require changes. We increased the qualitative reserve in 2011 to reflect additional estimated losses during the period of reduced activity in our modification programs, as well as uncertainty around certain loans modified under our previous programs. Once the evaluation of the existing programs and practices is complete and any necessary changes have been implemented, we will re-assess the overall qualitative reserve.

 

37


Table of Contents

Operating Expense

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

 

     Year Ended      Variance  
     December 31,      2011 vs. 2010  
          2011                2010           Amount     %  

Compensation and benefits

   $ 333.6      $ 325.0      $ 8.6       3

Clearing and servicing

     147.1        147.5        (0.4     (0 )% 

Advertising and market development

     145.2        132.2        13.0       10

FDIC insurance premiums

     105.4        77.7        27.7       36

Professional services

     89.7        81.2        8.5       10

Occupancy and equipment

     68.8        70.9        (2.1     (3 )% 

Communications

     67.3        73.3        (6.0     (8 )% 

Depreciation and amortization

     89.6        87.9        1.7       2

Amortization of other intangibles

     26.2        28.5        (2.3     (8 )% 

Facility restructuring and other exit activities

     7.7        14.4        (6.7     *   

Other operating expenses

     154.3        104.0        50.3       48
  

 

 

    

 

 

    

 

 

   

Total operating expense

   $ 1,234.9      $ 1,142.6      $ 92.3       8
  

 

 

    

 

 

    

 

 

   

 

* Percentage not meaningful.

Compensation and Benefits

Compensation and benefits increased 3% to $333.6 million for the year ended December 31, 2011 compared to 2010. The increase resulted primarily from higher compensation expense as a result of increasing our financial consultants by 42%, partially offset by a decrease in incentive compensation.

Advertising and Market Development

Advertising and market development expense increased 10% to $145.2 million for the year ended December 31, 2011 compared to 2010. This fluctuation was due largely to the planned increase in advertising expenditures in our continuing effort to attract new accounts and customer assets during the year ended December 31, 2011.

FDIC Insurance Premiums

FDIC insurance premiums increased 36% to $105.4 million for the year ended December 31, 2011 compared to 2010. The increase was due primarily to an industry wide change in the FDIC insurance premium assessment calculation, effective in the second quarter of 2011.

Professional Services

Professional services increased 10% to $89.7 million for the year ended December 31, 2011 compared to 2010. The increase was due primarily to a $6.0 million credit in connection with a legal settlement in the third quarter of 2010, which decreased professional services for the year ended December 31, 2010. There were no similar settlements made during the year ended December 31, 2011.

Communications

Communications expense decreased 8% to $67.3 million for the year ended December 31, 2011 compared to 2010. The decrease was driven primarily by a decline in vendor services fees compared to 2010.

 

38


Table of Contents

Other Operating Expenses

Other operating expenses increased 48% to $154.3 million for the year ended December 31, 2011 compared to 2010. The increase was driven by a reserve of $48 million related to an offer to purchase auction rate securities held by customers of E*TRADE Securities LLC, as well as former customers who purchased auction rate securities through E*TRADE Securities LLC. This reserve relates primarily to our estimate of the securities’ current fair value relative to their par value and includes penalties and other estimated settlement costs. We also entered into a memorandum of understanding to settle the Freudenberg Action, which resulted in the recording of a net reserve of $10.8 million for the year ended December 31, 2011.

Other Income (Expense)

Other income (expense) increased 11% to $175.8 million for the year ended December 31, 2011 compared to 2010 as shown in the following table (dollars in millions):

 

     Year Ended     Variance  
     December 31,     2011 vs. 2010  
         2011             2010         Amount     %  

Corporate interest income

   $ 0.7     $ 6.2     $ (5.5     (89 )% 

Corporate interest expense

     (177.8     (167.1     (10.7     6

Gains on sales of investments, net

     —          2.7       (2.7     *   

Gains on early extinguishment of debt

     3.1       —          3.1       *   

Equity in loss of investments and venture funds

     (1.8     (0.8     (1.0     *   
  

 

 

   

 

 

   

 

 

   

Total other income (expense)

   $ (175.8   $ (159.0   $ (16.8     11
  

 

 

   

 

 

   

 

 

   

 

* Percentage not meaningful.

Total other income (expense) primarily consisted of corporate interest expense on interest-bearing corporate debt for the year ended December 31, 2011. Corporate interest expense increased 6% to $177.8 million for the year ended December 31, 2011 compared to 2010. In addition to the stated interest on corporate debt, the corporate interest expense line item included the benefit of discontinued fair value hedges on corporate debt, which decreased $7.8 million for the year ended December 31, 2011 compared to 2010. Offsetting interest expense for the year ended December 31, 2011 was a $3.1 million gain on early extinguishment of debt related to the call of the 2013 Notes in the second quarter of 2011. Offsetting corporate interest expense for the year ended December 31, 2010 was a benefit of $6.0 million related to a legal settlement.

Income Tax Expense (Benefit)

Income tax expense was $28.6 million for the year ended December 31, 2011 compared to $25.3 million in 2010. The effective tax rate was 15.4% for the year ended December 31, 2011 compared to 806.3% in 2010. During the third quarter of 2011, we recorded an income tax benefit of $61.7 million related to the taxable liquidation of a European subsidiary. The subsidiary was liquidated for U.S. tax purposes in connection with our international restructuring activities. This liquidation resulted in the taxable recognition of certain losses, including historical acquisition premiums that we incurred internationally. This tax benefit resulted in a corresponding increase to the deferred tax assets, which were $1.6 billion as of December 31, 2011. For the year ended December 31, 2010, our reported pre-tax loss was relatively close to breakeven, which resulted in an unusually high effective tax rate.

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

 

39


Table of Contents

allowance was required, the resulting loss could have a material adverse effect on our financial condition and results of operations. Our analysis of the need for a valuation allowance recognizes that we are in a cumulative book loss position as of the three-year period ended December 31, 2011, which is considered significant and objective evidence that we may not be able to realize some portion of the deferred tax assets in the future. However, we did not establish a valuation allowance against federal deferred tax assets as of December 31, 2011 as we believe that it is more likely than not that all of these assets will be realized. Approximately two-thirds of existing federal deferred tax assets are not related to net operating losses and therefore, have no expiration date. We expect to utilize the vast majority of the existing federal deferred tax assets over the next seven years, with a small balance remaining as a result of the current limitation caused by the ownership change (which is expected to be fully utilized in advance of the statutory carry forward period).

Our evaluation of the need for a valuation allowance focused on identifying significant, objective evidence that we will be able to realize the deferred tax assets in the future. We determined that our expectations regarding future earnings are objectively verifiable due to various factors. One factor is the consistent profitability of the core business, the trading and investing segment, which has generated substantial income for each of the last eight years, including through uncertain economic and regulatory environments. The core business is driven by brokerage customer activity and includes trading, brokerage cash, margin lending, long-term investing and other brokerage related activities. These activities drive variable expenses that correlate to the volume of customer activity, which has resulted in stable, ongoing profitability in this business.

Another factor is the mitigation of losses in the balance sheet management segment, which generated a large net operating loss in 2007 caused by the crisis in the residential real estate and credit markets. Much of this loss came from the sale of the asset-backed securities portfolio and credit losses from the mortgage loan portfolio. We no longer hold any of those asset-backed securities and shut down mortgage loan acquisition activities in 2007. In effect, the key business activities that led to the generation of the deferred tax assets were shut down over four years ago. As a result, the losses in the balance sheet management segment have continued to decline significantly. In addition, we continue to realize the benefit of various credit loss mitigation activities for the mortgage loans purchased in 2007 and prior, most notably, actively reducing or closing unused home equity lines of credit and aggressively exercising put-back clauses to sell back improperly documented loans to the originators. As a result of these loss containment measures, provision for loan losses has declined for three consecutive years, down 72% from its peak of $1.6 billion for the year ended December 31, 2008.

We maintain a valuation allowance for certain of our state deferred tax assets as it is more likely than not that they will not be realized. At December 31, 2011, we had state deferred tax assets of approximately $102.1 million that related to our state net operating loss carry forwards and temporary differences with a valuation allowance of $28.7 million against such deferred tax assets.

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.

As of the date of the ownership change, we had federal NOLs available to carry forward of approximately $1.4 billion. Section 382 imposes restrictions on the use of a corporation’s NOLs, certain recognized built-in losses and other carryovers after an “ownership change” occurs. Section 382 rules governing when a change in ownership occurs are complex and subject to interpretation; however, an ownership change generally occurs when there has been a cumulative change in the stock ownership of a corporation by certain “5% shareholders” of more than 50 percentage points over a rolling three-year period.

 

40


Table of Contents

Section 382 imposes an annual limitation on the amount of post-ownership change taxable income a corporation may offset with pre-ownership change NOLs. In general, the annual limitation is determined by multiplying the value of the corporation’s stock immediately before the ownership change (subject to certain adjustments) by the applicable long-term tax-exempt rate. Any unused portion of the annual limitation is available for use in future years until such NOLs are scheduled to expire (in general, NOLs may be carried forward 20 years). In addition, the limitation may, under certain circumstances, be increased or decreased by built-in gains or losses, respectively, which may be present with respect to assets held at the time of the ownership change that are recognized in the five-year period (one-year for loans) after the ownership change. The use of NOLs arising after the date of an ownership change would not be affected unless a corporation experienced an additional ownership change in a future period.

We believe the tax ownership change will extend the period of time it will take to fully utilize our pre-ownership change NOLs, but will not limit the total amount of pre-ownership change NOLs we can utilize. Our updated estimate is that we will be subject to an overall annual limitation on the use of our pre-ownership change NOLs of approximately $194 million. The overall pre-ownership change NOLs, which were approximately $1.4 billion, have a statutory carry forward period of 20 years (the majority of which expire in 16 years). As a result, we believe we will be able to fully utilize these NOLs in future periods.

Our ability to utilize the pre-ownership change NOLs is dependent on our ability to generate sufficient taxable income over the duration of the carry forward periods and will not be impacted by our ability or inability to generate taxable income in an individual year.

2010 Compared to 2009

We incurred a net loss of $28.5 million, or $(0.13) per diluted share, on total revenue of $2.1 billion for the year ended December 31, 2010. Commissions, fees and service charges, principal transactions and other revenue decreased 17% to $723.1 million for the year ended December 31, 2010 compared to 2009, which was driven by a decrease in commissions.

Provision for loan losses declined 48% to $779.4 million for the year ended December 31, 2010 compared to 2009, driven by improving credit trends and loan portfolio run-off. Total operating expense decreased 8% to $1.1 billion for the year ended December 31, 2010 compared to 2009. This decrease was driven primarily by decreases in majority of the operating expense categories, offset by a planned increase in advertising and market development expense.

 

41


Table of Contents

The following sections describe in detail the changes in key operating factors and other changes and events that 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):

 

                 Variance  
     Year Ended December 31,     2010 vs. 2009  
             2010             2009     Amount     %  

Net operating interest income

   $ 1,226.3     $ 1,260.6     $ (34.3     (3 )% 

Commissions

     431.0       548.0       (117.0     (21 )% 

Fees and service charges

     142.4       192.5       (50.1     (26 )% 

Principal transactions

     103.4       88.1       15.3       17

Gains on loans and securities, net

     166.2       169.1       (2.9     (2 )% 

Net impairment

     (37.7     (89.1     *        *   

Other revenues

     46.3       47.8       (1.5     (3 )% 
  

 

 

   

 

 

   

 

 

   

Total non-interest income

     851.6       956.4       (104.8     (11 )% 
  

 

 

   

 

 

   

 

 

   

Total net revenue

   $ 2,077.9     $ 2,217.0     $ (139.1     (6 )% 
  

 

 

   

 

 

   

 

 

   
        

 

* Percentage not meaningful.

Net Operating Interest Income

Net operating interest income decreased 3% to $1.2 billion for the year ended December 31, 2010 compared to 2009. The slight decrease in net operating interest income was due primarily to a decrease in our average interest earning assets of $3.4 billion during the year ended December 31, 2010, which was offset by an increase in our net operating interest spread during the same period.

Average enterprise interest-earning assets decreased 8% to $41.1 billion for the year ended December 31, 2010 compared to 2009. This decrease was primarily a result of the decrease in our average loans portfolio, average available-for-sale mortgage-backed securities and average cash and equivalents, partially offset by an increase in average margin receivables, average available-for-sale and held-to-maturity securities.

Average enterprise interest-bearing liabilities decreased 8% to $38.6 billion for the year ended December 31, 2010 compared to 2009. The decrease in average enterprise interest-bearing liabilities was primarily due to decreases in average complete savings deposits and average certificates of deposit offset by an increase in average sweep deposits.

Enterprise net interest spread increased by 19 basis points to 2.91% for the year ended December 31, 2010 compared to 2009. This increase was largely driven by a decrease in the yields paid on our deposits and lower wholesale borrowing costs, partially offset by a decrease in higher yielding enterprise interest-earning assets.

Commissions

Commissions decreased 21% to $431.0 million for the year ended December 31, 2010 compared to 2009. Our DART volume decreased 16% to 150,532 for the year ended December 31, 2010 compared 2009. Option-related DARTs as a percentage of our total DARTs represented 17% of trading volume for the year ended December 31, 2010 compared to 13% in 2009. Exchange-traded funds-related DARTs as a percentage of total DARTs represented 10% of trading volume for the year ended December 31, 2010 compared to 14% in 2009.

 

42


Table of Contents

Average commission per trade decreased 1% to $11.21 for the year ended December 31, 2010 compared to 2009. The slight decrease in the average commission per trade was due primarily to the elimination of the $12.99 commission tier and the per share commission applied to market trades larger than 2,000 shares, which became effective in the second quarter of 2010, partially offset by an improvement in the product and customer mix when compared to 2009.

Fees and Service Charges

Fees and service charges decreased 26% to $142.4 million for the year ended December 31, 2010 compared to 2009. The decrease was primarily due to the elimination of all account activity fees, which became effective in the second quarter of 2010, and lower order flow revenue.

Principal Transactions

Principal transactions increased 17% to $103.4 million for the year ended December 31, 2010 compared to 2009. The increase in principal transactions was driven by an increase in the volume of orders from our third party customers which was partially offset by a decrease in our average revenue earned per share traded when compared to 2009.

Gains on Loans and Securities, Net

Gains on loans and securities, net were $166.2 million and $169.1 million for years ended December 31, 2010 and 2009, respectively, as shown in the following table (dollars in millions):

 

           Variance  
     Year Ended December 31,     2010 vs. 2009  
           2010                 2009           Amount     %  

Gains (losses) on loans, net

   $ 6.3     $ (12.5   $ 18.8       *   
  

 

 

   

 

 

   

 

 

   

Gains on available-for-sale securities, net

     160.7       173.2       (12.5     (7 )% 

Gains on trading securities, net

     0.2       7.8       (7.6     (98 )% 

Hedge ineffectiveness

     (1.0     0.6       (1.6     *   
  

 

 

   

 

 

   

 

 

   

Gains on securities, net

     159.9       181.6       (21.7     (12 )% 
  

 

 

   

 

 

   

 

 

   

Gains on loans and securities, net

   $ 166.2     $ 169.1     $ (2.9     (2 )% 
  

 

 

   

 

 

   

 

 

   

 

* Percentage not meaningful.

Net Impairment

We recognized $37.7 million and $89.1 million of net impairment during the years ended December 31, 2010 and 2009, respectively, on certain securities in our non-agency CMO portfolio due to continued deterioration in the expected credit performance of the underlying loans in the securities. The gross OTTI and the noncredit portion of OTTI, which was or had been previously recorded through other comprehensive income (loss), are shown in the table below (dollars in millions):

 

     Year Ended December 31,  
         2010             2009      

Other-than-temporary impairment (“OTTI”)

   $ (41.5   $ (232.1

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

     3.8       143.0  
  

 

 

   

 

 

 

Net impairment

   $ (37.7   $ (89.1
  

 

 

   

 

 

 

 

43


Table of Contents

Other Revenues

Other revenues decreased 3% to $46.3 million for the year ended December 31, 2010 compared to 2009. The decrease was due to a decline in the income from the cash surrender value of our bank-owned life insurance, partially offset by the gain on the sale of approximately $1 billion in savings accounts to Discover Financial Services in the first quarter of 2010.

Provision for Loan Losses

Provision for loan losses decreased 48% to $779.4 million for the year ended December 31, 2010 compared 2009. The decrease in the provision for loan losses was driven by lower levels of delinquent loans in our one- to four-family and home equity loan portfolios.

Operating Expense

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

 

            Variance  
     Year Ended December 31,      2010 vs. 2009  
          2010                2009           Amount     %  

Compensation and benefits

   $ 325.0      $ 366.2      $ (41.2     (11 )% 

Clearing and servicing

     147.5        170.7        (23.2     (14 )% 

Advertising and market development

     132.2        114.4        17.8       16

FDIC insurance premiums

     77.7        94.3        (16.6     (18 )% 

Professional services

     81.2         78.7         2.5        3

Occupancy and equipment

     70.9        78.4        (7.5     (10 )% 

Communications

     73.3         84.4         (11.1     (13 )% 

Depreciation and amortization

     87.9        83.3        4.6       6

Amortization of other intangibles

     28.5        29.7        (1.2     (4 )% 

Facility restructuring and other exit activities

     14.4        20.7        (6.3     *   

Other operating expenses

     104.0        122.5        (18.5     (15 )% 
  

 

 

    

 

 

    

 

 

   

Total operating expense

   $ 1,142.6      $ 1,243.3      $ (100.7     (8 )% 
  

 

 

    

 

 

    

 

 

   

 

* Percentage not meaningful.

Compensation and Benefits

Compensation and benefits decreased 11% to $325.0 million for the year ended December 31, 2010 compared to 2009. This decrease resulted from lower incentive compensation expense and lower salary expense due to a reduction in our employee base compared to 2009.

Clearing and Servicing

Clearing and servicing expense decreased 14% to $147.5 million for the year ended December 31, 2010 compared to 2009. This decrease resulted primarily from lower trading volumes and lower loan balances compared to 2009.

Advertising and Market Development

Advertising and market development expense increased 16% to $132.2 million for the year ended December 31, 2010 compared to 2009. This fluctuation was due largely to a planned increase in advertising expense to attract new accounts and customer assets during the year ended December 31, 2010.

FDIC Insurance Premiums

FDIC insurance premiums decreased 18% to $77.7 million for the year ended December 31, 2010 compared to 2009. The decrease was due primarily to an industry wide special assessment that resulted in an additional

 

44


Table of Contents

$21.6 million of expense in the second quarter of 2009. There were no similar assessments made during the year ended December 31, 2010.

Other Operating Expenses

Other operating expenses decreased 15% to $104.0 million for the year ended December 31, 2010 compared to 2009. The decrease was driven primarily by a decline in bad debt expense, real-estate owned and legal reserves compared to 2009.

Other Income (Expense)

Other income (expense) was an expense of $159.0 million and $1.3 billion for the years ended December 31, 2010 and 2009, respectively, as shown in the following table (dollars in millions):

 

                 Variance  
     Year Ended December 31,     2010 vs. 2009  
         2010             2009         Amount      Variance  

Corporate interest income

   $ 6.2     $ 0.9     $ 5.3        620

Corporate interest expense

     (167.1     (282.7     115.6        (41 )% 

Gains (losses) on sales of investments, net

     2.7       (1.7     4.4        *   

Losses on early extinguishment of debt

     —          (1,018.9     1,018.9        *   

Equity in loss of investments and venture funds

     (0.8     (8.6     7.8        (91 )% 
  

 

 

   

 

 

   

 

 

    

Total other income (expense)

   $ (159.0   $ (1,311.0   $ 1,152.0        (88 )% 
  

 

 

   

 

 

   

 

 

    

 

* Percentage not meaningful.

Total other income (expense) for the year ended December 31, 2010 primarily consisted of corporate interest expense resulting from our interest-bearing corporate debt. Corporate interest expense decreased 41% to $167.1 million for the year ended December 31, 2010 compared to 2009. This was due to the reduction in interest-bearing debt in connection with our Debt Exchange in 2009. The losses on early extinguishment of debt of $1.0 billion for the year ended December 31, 2009 were related primarily to the Debt Exchange. The loss on the Debt Exchange resulted from de-recognition of the debt that was exchanged and the corresponding recognition of the newly-issued non-interest-bearing convertible debentures at fair value. Corporate interest income increased to $6.2 million for the year ended December 31, 2010 when compared to 2009 due to a benefit of $6.0 million in connection with a legal settlement.

Income Tax Expense (Benefit)

Income tax expense was $25.3 million for the year ended December 31, 2010 compared to a benefit of $537.7 million in 2009. Our effective tax rate was 806.3% for the year ended December 31, 2010 compared to (29.3)% in 2009. The effective tax rate for the year ended December 31, 2010 was higher than in 2009 for two reasons: 1) our pre-tax loss included items not deductible for tax purposes, predominantly about one-third of the interest expense on the 2017 Notes; and 2) our reported pre-tax loss is relatively close to breakeven for the year ended December 31, 2010. As a result, our income subject to taxation was higher, resulting in an unusually high effective tax rate for the year ended December 31, 2010.

Valuation Allowance

During the year ended December 31, 2010, we did not maintain a valuation allowance against federal deferred tax assets as we believed that it was more likely than not that all of these assets will be realized. Our evaluation focused on identifying significant, objective evidence that we would be able to realize our deferred tax assets in the future. Our analysis of the need for a valuation allowance recognized that we were in a cumulative book loss position as of the three-year period ended December 31, 2010, which is considered significant and objective evidence that we may not be able to realize some portion of our deferred tax assets in the future. However, we believed we were able to rely on our forecasts of future taxable income and overcome the uncertainty created by the cumulative loss position.

 

45


Table of Contents

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. For more information on our segments, see Note 22—Segment Information in Item 8. Financial Statements and Supplementary Data beginning on page 161.

Trading and Investing

The following table summarizes trading and investing financial information and key metrics as of and for the years ended December 31, 2011, 2010 and 2009 (dollars in millions, except for key metrics):

 

             Variance  
     Year Ended December 31,      2011 vs. 2010  
     2011      2010      2009      Amount     %  
             

Net operating interest income

   $ 746.1      $ 763.0      $ 699.6      $ (16.9     (2 )% 

Commissions

     436.2        431.0        548.0        5.2       1

Fees and service charges

     128.0        139.1        185.6        (11.1     (8 )% 

Principal transactions

     105.4        103.4        88.1        2.0       2

Other revenues

     31.2        37.9        35.5        (6.7     (18 )% 
  

 

 

    

 

 

    

 

 

    

 

 

   

Total net revenue

     1,446.9        1,474.4        1,556.8        (27.5     (2 )% 

Total operating expense

     825.9        752.6        796.6        73.3       10
  

 

 

    

 

 

    

 

 

    

 

 

   

Trading and investing income

   $ 621.0      $ 721.8      $ 760.2      $ (100.8     (14 )% 
  

 

 

    

 

 

    

 

 

    

 

 

   
             

Key Metrics:

             

DARTs

     157,475        150,532        179,183        6,943       5

Average commission per trade

   $ 11.01      $ 11.21      $ 11.33      $ (0.20     (2 )% 

Margin receivables (dollars in billions)

   $ 4.8      $ 5.1      $ 3.7      $ (0.3     (6 )% 

End of period brokerage accounts

     2,783,012        2,684,311        2,630,079        98,701       4

Net new brokerage accounts

     98,701        54,232        114,273        44,469       *   

Customer assets (dollars in billions)

   $ 172.4      $ 176.2      $ 150.5      $ (3.8     (2 )% 

Net new brokerage assets (dollars in billions)

   $ 9.7      $ 8.1      $ 7.2      $ 1.6       *   

Brokerage related cash (dollars in billions)

   $ 27.7      $ 24.5      $ 20.4      $ 3.2       13

 

* Percentage not meaningful.

The 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 corporate customers, as we ultimately service retail investors through these corporate relationships.

2011 Compared to 2010

Trading and investing income decreased 14% to $621.0 million for the year ended December 31, 2011 compared to 2010. We continued to generate net new brokerage accounts, ending the year with 2.8 million accounts. Our brokerage related cash, which is one of our most profitable sources of funding, increased by $3.2 billion when compared to 2010.

 

46


Table of Contents

Trading and investing commissions increased 1% to $436.2 million for the year ended December 31, 2011 compared to 2010. This increase in commissions was primarily the result of an increase in DARTs of 5% to 157,475 for the year ended December 31, 2011 compared to 2010.

Trading and investing fees and service charges decreased 8% to $128.0 million for the year ended December 31, 2011 compared to 2010. This decrease for the year ended December 31, 2011 was driven primarily by the elimination of all account activity fees, which took effect in the second quarter of 2010.

Trading and investing principal transactions increased 2% to $105.4 million for the year ended December 31, 2011 compared to 2010. The increase in principal transactions revenue was driven by a favorable mix of trading volume and revenue earned per share, as well as a continued focus on expanding our external customer base, when compared to 2010.

Trading and investing operating expense increased 10% to $825.9 million for the year ended December 31, 2011 compared to 2010. The increase for the year ended December 31, 2011 was driven primarily by a reserve of $48 million related to an offer to purchase auction rate securities held by customers of E*TRADE Securities LLC, as well as former customers who purchased auction rate securities through E*TRADE Securities LLC. This reserve relates primarily to our estimate of the securities’ current fair value relative to their par value and includes penalties and other estimated settlement costs. In addition, compensation and benefits expense increased 8% to $245.8 million as a result of increasing our financial consultants by 42%.

As of December 31, 2011, we had approximately 2.8 million brokerage accounts, 1.1 million stock plan accounts and 0.5 million banking accounts. For the years ended December 31, 2011 and 2010, our brokerage products contributed 69% and 67%, respectively, and our banking products contributed 31% and 33%, respectively, of total trading and investing net revenue.

2010 Compared to 2009

Trading and investing segment income decreased 5% to $721.8 million for the year ended December 31, 2010 compared to 2009. We generated new brokerage accounts, ending the year with 2.7 million accounts. Our brokerage related cash increased by $4.1 billion when compared to 2009.

Trading and investing net operating interest income increased 9% to $763.0 million for the year ended December 31, 2010 compared to 2009. This increase was driven primarily by a decrease in yields paid on customer deposits and an increase in the average balance of margin receivables during the period.

Trading and investing commissions decreased 21% to $431.0 million for the year ended December 31, 2010 compared to 2009. The decrease in commissions was primarily the result of a decrease in DARTs of 16% to 150,532 and a decrease in the average commission per trade of 1% to $11.21 for the year ended December 31, 2010 compared to 2009. The slight decrease in the average commission per trade was due primarily to the elimination of the $12.99 commission tier and the per share commission applied to market trades larger than 2,000 shares, which became effective in the second quarter of 2010, partially offset by an improvement in the product and customer mix when compared to the same period in 2009.

Trading and investing fees and service charges decreased 25% to $139.1 million for the year ended December 31, 2010 compared to 2009. The decreases were primarily due to lower order flow revenue and the elimination of all account activity fees, which became effective in the second quarter of 2010.

Trading and investing principal transactions increased 17% to $103.4 million for the year ended December 31, 2010 compared to 2009. The increase in principal transactions was driven by an increase in the volume of equity shares that were traded, which was partially offset by a decrease in our average revenue earned per share traded for the year ended December 31, 2010.

 

47


Table of Contents

Trading and investing operating expense decreased 6% to $752.6 million for the year ended December 31, 2010 compared to 2009. The decrease related primarily to decreases in compensation and benefits, clearing and servicing, and communications expenses, which were partially offset by increases in advertising and market development expense and professional services.

As of December 31, 2010, we had approximately 2.7 million brokerage accounts, 1.0 million stock plan accounts and 0.5 million banking accounts. For the years ended December 31, 2010 and 2009, our brokerage products contributed 67% and 77%, respectively, and our banking products, which include sweep products, contributed 33% and 23%, respectively, of total trading and investing net revenue.

Balance Sheet Management

The following table summarizes balance sheet management financial information and key metrics as of and for the years ended December 31, 2011, 2010 and 2009 (dollars in millions):

 

                       Variance  
     Year Ended December 31,     2011 vs. 2010  
     2011     2010     2009     Amount     %  

Net operating interest income

   $ 473.9     $ 463.3     $ 560.9     $ 10.6       2

Fees and service charges

     2.4       3.2       6.9       (0.8     (24 )% 

Gains on loans and securities, net

     121.2       166.3       169.2       (45.1     (27 )% 

Net impairment

     (14.9     (37.7     (89.1     22.8       (60 )% 

Other revenues

     7.2       8.4       12.3       (1.2     (14 )% 
  

 

 

   

 

 

   

 

 

   

 

 

   

Total net revenue

     589.8       603.5       660.2       (13.7     (2 )% 

Provision for loan losses

     440.6       779.4       1,498.1       (338.8     (43 )% 

Total operating expense

     238.4       215.5       244.1       22.9       11

Losses from early extinguishment of debt

     —          —          (50.6     —          *   
  

 

 

   

 

 

   

 

 

   

 

 

   

Balance sheet management loss

   $ (89.2   $ (391.4   $ (1,132.6   $ 302.2       (77 )% 
  

 

 

   

 

 

   

 

 

   

 

 

   

Key Metrics:

          

Special mention loan delinquencies

   $ 467.1     $ 589.4     $ 804.5     $ (122.3     (21 )% 

Allowance for loan losses

   $ 822.8     $ 1,031.2     $ 1,182.7     $ (208.4     (20 )% 

Allowance for loan losses as a % of gross loans receivable

     6.25     6.38     5.81     *        (0.13 )% 
          

 

* Percentage not meaningful.

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

2011 Compared to 2010

The balance sheet management segment reported a loss of $89.2 million for the year ended December 31, 2011. The losses in the segment are due primarily to the provision for loan losses of $440.6 million for the year ended December 31, 2011.

Gains on loans and securities, net were $121.2 million for the year ended December 31, 2011 compared to $166.3 million in 2010. The decrease in gains on loans and securities, net was primarily due to more trading volatility in the markets in 2010 when compared to 2011.

 

48


Table of Contents

We recognized $14.9 million of net impairment during the year ended December 31, 2011 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 $9.2 million for the year ended December 31, 2011. The amount that had been previously recorded through other comprehensive income and was reclassified into earnings during the year ended December 31, 2011 was $5.7 million.

Provision for loan losses decreased 43% to $440.6 million for the year ended December 31, 2011 compared to 2010. The decrease in provision for loan losses was driven by improving credit trends and loan portfolio run-off, as evidenced by the lower levels of delinquent loans in the one- to four- family and home equity loan portfolios.

Total balance sheet management operating expense increased 11% to $238.4 million for the year ended December 31, 2011 compared to 2010. The increase in operating expense for the year ended December 31, 2011 was due primarily to increased FDIC insurance premiums as a result of an industry wide change in the FDIC insurance premium assessment calculation, effective in the second quarter of 2011.

2010 Compared to 2009

The balance sheet management segment reported a loss of $391.4 million for the year ended December 31, 2010. The losses in this segment were due primarily to the provision for loan losses of $779.4 million for the year ended December 31, 2010.

Gains on loans and securities, net were gains of $166.3 million and $169.2 million for the years ended December 31, 2010 and 2009, respectively. The gains on loans and securities, net for the year ended December 31, 2010 were due primarily to gains on the sale of certain agency mortgage-backed securities and agency debentures.

We recognized $37.7 million and $89.1 million of net impairment during the years ended December 31, 2010 and 2009, respectively, on certain securities in our non-agency CMO portfolio due to continued deterioration in the expected credit performance of the underlying loans in the securities. The net impairment included gross OTTI of $41.5 million and $232.1 million for the years ended December 31, 2010 and 2009, respectively. Of the gross OTTI for the years ended December 31, 2010 and 2009, $3.8 million and $143.0 million related to the noncredit portion of OTTI, which was recorded through other comprehensive income (loss).

Provision for loan losses decreased 48% to $779.4 million for the year ended December 31, 2010 compared to 2009. The decrease in the provision for loan losses was driven by lower levels of delinquent loans in our one- to four- family and home equity loan portfolios.

Total balance sheet management operating expense decreased 12% to $215.5 million for the year ended December 31, 2010 compared to 2009. The decrease for the year ended December 31, 2010 was due to decreases in clearing and servicing expense, FDIC insurance premiums and other expense. The decrease in the FDIC insurance premiums for the year ended December 31, 2010 was a result of an industry wide assessment that resulted in an additional $21.6 million of expense in the second quarter of 2009. There were no similar assessments made during the year ended December 31, 2010.

 

49


Table of Contents

Corporate/Other

The following table summarizes corporate/other financial information for the years ended December 31, 2011, 2010 and 2009 (dollars in millions):

 

                       Variance  
     Year Ended December 31,     2011 vs. 2010  
     2011     2010     2009     Amount     %  

Total net revenue

   $ (0.1   $ (0.0   $ —        $ (0.1     *   
  

 

 

   

 

 

   

 

 

   

 

 

   

Compensation and benefits

     70.3       80.2       93.7       (9.9     (12 )% 

Professional services

     35.4       28.9       42.7       6.5       23

Occupancy and equipment

     2.7       2.6       3.4       0.1       4

Communications

     1.5       1.7       1.9       (0.2     (11 )% 

Depreciation and amortization

     18.4       21.0       19.1       (2.6     (12 )% 

Facility restructuring and

          

other exit activities

     7.7       14.3       20.7       (6.6     *   

Other operating expenses

     34.5       25.8       21.2       8.7       34
  

 

 

   

 

 

   

 

 

   

 

 

   

Total operating expense

     170.5       174.5       202.7       (4.0     (2 )% 
  

 

 

   

 

 

   

 

 

   

 

 

   

Operating loss

     (170.6     (174.5     (202.7     3.9       (2 )% 

Total other income (expense)

     (175.8     (159.0     (1,260.4     (16.8     11
  

 

 

   

 

 

   

 

 

   

 

 

   

Corporate/other loss

   $ (346.4   $ (333.5   $ (1,463.1   $ (12.9     4
  

 

 

   

 

 

   

 

 

   

 

 

   

 

* Percentage not meaningful.

The 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.

2011 Compared to 2010

The corporate/other loss before income taxes was $346.4 million for the year ended December 31, 2011, compared to $333.5 million in 2010. Compensation and benefits decreased 12% to $70.3 million due primarily to a decrease in incentive compensation during the year ended December 31, 2011 compared to 2010. The increase in professional services was due primarily to a $6.0 million credit in connection with a legal settlement in the third quarter of 2010, which decreased professional services for the year ended December 31, 2010. Other operating expenses increased 34% to $34.5 million primarily due to the recording of a net reserve of $10.8 million related a memorandum of understanding that was entered into to settle the Freudenberg Action during the year ended December 31, 2011.

Total other income (expense) consisted primarily of $177.8 million in corporate interest expense for the year ended December 31, 2011 on interest-bearing corporate debt. In addition to the stated interest on corporate debt, the corporate interest expense line item included the benefit of discontinued fair value hedges on corporate debt, which decreased $7.8 million for the year ended December 31, 2011 compared to 2010. Offsetting interest expense for the year ended December 31, 2011 was a $3.1 million gain on early extinguishment of debt related to the call of the 2013 Notes in the second quarter of 2011.

2010 Compared to 2009

The corporate/other loss was $333.5 million for the year ended December 31, 2010, compared to $1.5 billion for the same period in 2009. The loss for the year ended December 31, 2010 was due to total operating expenses of $174.5 million and other expense of $159.0 million. Total other income (expense) primarily

 

50


Table of Contents

consisted of corporate interest expense of $167.1 million resulting from our interest-bearing corporate debt. Corporate interest expense decreased 41% to $167.1 million for the year ended December 31, 2010 due to the reduction in interest-bearing debt in connection with our Debt Exchange in the third quarter of 2009. The loss for the year ended December 31, 2009 was due primarily to the $968.3 million pre-tax non-cash loss on extinguishment of debt related to the Debt Exchange, which is reported in the total other income (expense) line item.

BALANCE SHEET OVERVIEW

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

 

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

Assets:

          

Cash and equivalents

   $ 2,099.8      $ 2,374.3      $ (274.5     (12 )% 

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

     1,275.6        609.5        666.1       109

Securities(1)

     21,785.4        17,330.6        4,454.8       26

Margin receivables

     4,826.3        5,120.6        (294.3     (6 )% 

Loans receivable, net

     12,332.8        15,121.9        (2,789.1     (18 )% 

Investment in FHLB stock

     140.2        164.4        (24.2     (15 )% 

Other(2)

     5,480.4        5,651.7        (171.3     (3 )% 
  

 

 

    

 

 

    

 

 

   

Total assets

   $ 47,940.5      $ 46,373.0      $ 1,567.5       3
  

 

 

    

 

 

    

 

 

   

Liabilities and shareholders’ equity:

          

Deposits

   $ 26,460.0      $ 25,240.3      $ 1,219.7       5

Wholesale borrowings(3)

     7,752.4        8,620.0        (867.6     (10 )% 

Customer payables

     5,590.9        5,020.1        570.8       11

Corporate debt

     1,493.5        2,145.9        (652.4     (30 )% 

Other liabilities

     1,715.7        1,294.3        421.4       33
  

 

 

    

 

 

    

 

 

   

Total liabilities

     43,012.5        42,320.6        691.9       2

Shareholders’ equity

     4,928.0        4,052.4        875.6       22
  

 

 

    

 

 

    

 

 

   

Total liabilities and shareholders’ equity

   $ 47,940.5      $ 46,373.0      $ 1,567.5       3
  

 

 

    

 

 

    

 

 

   

 

(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.

Cash and Investments Required to be Segregated under Federal or Other Regulations

The level of cash and investments required to be segregated under federal or other regulations, or segregated cash and investments, is driven largely by the amount of customer payables we hold as a liability in excess of the amount of margin receivables we hold as an asset. This difference represents excess customer cash that we are required by our regulators to segregate in a cash account for the exclusive benefit of our brokerage customers. Segregated cash and investments increased by $0.7 billion during the year ended December 31, 2011. This increase was driven primarily by an increase in customer payables of $0.6 billion during the year ended December 31, 2011.

 

51


Table of Contents

Securities

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

 

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

Trading securities

   $ 54.4      $ 62.2      $ (7.8     (13 )% 
  

 

 

    

 

 

    

 

 

   

Available-for-sale securities:

          

Residential mortgage-backed securities:

          

Agency mortgage-backed securities and CMOs

   $ 13,965.7      $ 12,898.1      $ 1,067.6       8

Non-agency CMOs

     341.6        395.4        (53.8     (14 )% 
  

 

 

    

 

 

    

 

 

   

Total residential mortgage-backed securities

     14,307.3        13,293.5        1,013.8       8

Investment securities

     1,344.2        1,512.2        (168.0     (11 )% 
  

 

 

    

 

 

    

 

 

   

Total available-for-sale securities

   $ 15,651.5      $ 14,805.7      $ 845.8       6
  

 

 

    

 

 

    

 

 

   

Held-to-maturity securities:

          

Residential mortgage-backed securities:

          

Agency mortgage-backed securities and CMOs

   $ 5,296.5      $ 1,928.6      $ 3,367.9       175

Investment securities

     783.0        534.1        248.9       47
  

 

 

    

 

 

    

 

 

   

Total held-to-maturity securities

   $ 6,079.5      $ 2,462.7      $ 3,616.8       147
  

 

 

    

 

 

    

 

 

   

Total securities

   $ 21,785.4      $ 17,330.6      $ 4,454.8       26
  

 

 

    

 

 

    

 

 

   

Securities represented 45% and 37% of total assets at December 31, 2011 and 2010, respectively. The increase in available-for-sale securities was due primarily to an increase of $1.1 billion in agency mortgage-backed securities and CMOs, partially offset by the sale or call of agency debentures.

Loans Receivable, Net

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

 

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

One- to four-family

   $ 6,615.8     $ 8,170.3     $ (1,554.5     (19 )% 

Home equity

     5,328.7       6,410.3       (1,081.6     (17 )% 

Consumer and other

     1,113.2       1,443.4       (330.2     (23 )% 

Unamortized premiums, net

     97.9       129.1       (31.2     (24 )% 

Allowance for loan losses

     (822.8     (1,031.2     208.4       (20 )% 
  

 

 

   

 

 

   

 

 

   

Total loans receivable, net

   $ 12,332.8     $ 15,121.9     $ (2,789.1     (18 )% 
  

 

 

   

 

 

   

 

 

   

Loans receivable, net decreased 18% to $12.3 billion at December 31, 2011 from $15.1 billion at December 31, 2010. This decline was due primarily to our strategy of reducing balance sheet risk by allowing the loan portfolio to pay down, which we plan to do for the foreseeable future.

 

52


Table of Contents

Deposits

Deposits are summarized as follows (dollars in millions):

 

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

Sweep deposits

  $ 18,619.0     $ 16,139.6     $ 2,479.4       15

Complete savings deposits

    5,720.8       6,683.6       (962.8     (14 )% 

Other money market and savings deposits

    1,033.2       1,092.9       (59.7     (5 )% 

Checking deposits

    863.3       825.6       37.7       5

Certificates of deposit

    190.5       407.1       (216.6     (53 )% 

Brokered certificates of deposit

    33.2       91.5       (58.3     (64 )% 
 

 

 

   

 

 

   

 

 

   

Total deposits

  $ 26,460.0     $ 25,240.3     $ 1,219.7       5
 

 

 

   

 

 

   

 

 

   

Deposits represented 62% and 60% of total liabilities at December 31, 2011 and 2010, respectively. At December 31, 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. Deposits increased 5% to $26.5 billion at December 31, 2011 from $25.2 billion at December 31, 2010. The increase was due primarily to an increase of $2.5 billion in sweep deposits, partially offset by a decrease of $1.0 billion in complete savings deposits.

The deposits balance is a component of the total customer cash and deposits balance reported as a customer activity metric of $35.5 billion and $33.5 billion at December 31, 2011 and 2010, respectively. The total customer cash and deposits balance is summarized as follows (dollars in millions):

 

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

Deposits

  $ 26,460.0     $ 25,240.3     $ 1,219.7       5

Less: brokered certificates of deposit

    (33.2     (91.5     58.3       (64 )% 
 

 

 

   

 

 

   

 

 

   

Retail deposits

    26,426.8       25,148.8       1,278.0       5

Customer payables

    5,590.9       5,020.1       570.8       11

Customer cash balances held by third parties and other

    3,520.1       3,363.8       156.3       5
 

 

 

   

 

 

   

 

 

   

Total customer cash and deposits

  $ 35,537.8     $ 33,532.7     $ 2,005.1       6
 

 

 

   

 

 

   

 

 

   

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  
     December 31,      2011 vs. 2010  
     2011      2010      Amount     %  

Securities sold under agreements to repurchase

   $ 5,015.5      $ 5,888.3      $ (872.8     (15 )% 
  

 

 

    

 

 

    

 

 

   

FHLB advances

   $ 2,302.7      $ 2,284.1      $ 18.6       1

Subordinated debentures

     427.6        427.5        0.1       0

Other

     6.6        20.1        (13.5     (67 )% 
  

 

 

    

 

 

    

 

 

   

Total FHLB advances and other borrowings

   $ 2,736.9      $ 2,731.7      $ 5.2       0
  

 

 

    

 

 

    

 

 

   

Total wholesale borrowings

   $ 7,752.4      $ 8,620.0      $ (867.6     (10 )% 
  

 

 

    

 

 

    

 

 

   

Wholesale borrowings represented 18% and 20% of total liabilities at December 31, 2011 and 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-

 

53


Table of Contents

earning assets fluctuate. The decrease in securities sold under agreements to repurchase of $0.9 billion during the year ended December 31, 2011 was due to a planned decrease in the forecasted issuance of debt. We anticipate further decreases in securities sold under agreements to repurchase of approximately $300 million during the second quarter of 2012 and $150 million during the fourth quarter of 2012.

Corporate Debt

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

 

    Face Value     Discount     Fair Value Hedge
Adjustment
    Net  

December 31, 2011

       

Interest-bearing notes:

       

7  7/8% Notes, due 2015

  $ 243.2     $ (1.2   $ 7.4     $ 249.4  

6  3/4% Notes, due 2016

    435.0       (7.4     —          427.6  

12  1/2% Springing lien notes, due 2017

    930.2       (162.9     6.2       773.5  
 

 

 

   

 

 

   

 

 

   

 

 

 

Total interest-bearing notes

    1,608.4       (171.5     13.6       1,450.5  

Non-interest-bearing debt:

       

0% Convertible debentures, due 2019

    43.0       —          —          43.0  
 

 

 

   

 

 

   

 

 

   

 

 

 

Total corporate debt

  $ 1,651.4     $ (171.5   $ 13.6     $ 1,493.5  
 

 

 

   

 

 

   

 

 

   

 

 

 
    Face Value     Discount     Fair Value Hedge
Adjustment
    Net  

December 31, 2010

       

Interest-bearing 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  

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