10-Q 1 d531747d10q.htm FORM 10-Q Form 10-Q
Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

(Mark One)

x

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

For the Quarterly Period Ended March 31, 2013

or

 

¨

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

Commission File Number 1-11921

 

 

E*TRADE Financial Corporation

(Exact Name of Registrant as Specified in its Charter)

 

Delaware   94-2844166

(State or Other Jurisdiction

of Incorporation or Organization)

 

(I.R.S. Employer

Identification Number)

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

(Address of Principal Executive Offices and Zip Code)

(646) 521-4300

(Registrant’s Telephone Number, including Area Code)

 

 

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

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

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

 

Large accelerated filer

 

x

  

Accelerated filer

 

¨

Non-accelerated filer

 

¨  (Do not check if a smaller reporting company)

  

Smaller reporting company

 

¨

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

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

As of May 3, 2013, there were 286,834,552 shares of common stock outstanding.


Table of Contents

E*TRADE FINANCIAL CORPORATION

FORM 10-Q QUARTERLY REPORT

For the Quarter Ended March 31, 2013

TABLE OF CONTENTS

 

PART I—FINANCIAL INFORMATION

  

Item 1. Consolidated Financial Statements (Unaudited)

     41   

Consolidated Statement of Income

     41   

Consolidated Statement of Comprehensive Income

     42   

Consolidated Balance Sheet

     43   

Consolidated Statement of Shareholders’ Equity

     44   

Consolidated Statement of Cash Flows

     45   

Notes to Consolidated Financial Statements (Unaudited)

     47   

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

     47   

Note 2—Operating Interest Income and Operating Interest Expense

     50   

Note 3—Fair Value Disclosures

     51   

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

     60   

Note 5—Loans Receivable, Net

     65   

Note 6—Accounting for Derivative Instruments and Hedging Activities

     72   

Note 7—Deposits

     75   

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

     76   

Note 9—Corporate Debt

     76   

Note 10—Shareholders’ Equity

     77   

Note 11—Earnings per Share

     78   

Note 12—Regulatory Requirements

     78   

Note 13—Commitments, Contingencies and Other Regulatory Matters

     80   

Note 14—Segment Information

     84   

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

     3   

Overview

     3   

Earnings Overview

     6   

Segment Results Review

     11   

Balance Sheet Overview

     15   

Liquidity and Capital Resources

     19   

Risk Management

     23   

Concentrations of Credit Risk

     25   

Summary of Critical Accounting Policies and Estimates

     33   

Glossary of Terms

     34   

Item 3. Quantitative and Qualitative Disclosures about Market Risk

     38   

Item 4. Controls and Procedures

     85   

PART II—OTHER INFORMATION

  

Item 1.     Legal Proceedings

     86   

Item 1A.  Risk Factors

     88   

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

     89   

Item 3.     Defaults Upon Senior Securities

     89   

Item 4.     Mine Safety Disclosures

     89   

Item 5.     Other Information

     89   

Item 6.     Exhibits

     89   

Signatures

     90   

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.

 

2


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 our filings. Important factors that may cause actual results to differ materially from any forward-looking statements are set forth in Item 1A. Risk Factors in the Annual Report on Form 10-K for the year ended December 31, 2012.

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

The following discussion should be read in conjunction with the consolidated financial statements and the related notes that appear elsewhere in this document and with the Annual Report on Form 10-K for the year ended December 31, 2012.

GLOSSARY OF TERMS

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

OVERVIEW

Strategy

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

 

   

Strengthening our overall financial and franchise position. We are focused on achieving a more efficient distribution of capital between our regulated entities, improving capital ratios by reducing risk, deleveraging the balance sheet and reducing costs, and enhancing our enterprise-wide risk management culture and capabilities.

 

   

Improving our market position in our retail brokerage business. We plan to accelerate the growth in our customer franchise and to continue enhancing the customer experience.

 

   

Capitalizing on the value of our complementary brokerage 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 in retirement and investing. We believe growing our retirement and investing 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.

 

   

Continuing to manage and de-risk the Bank. We are focused on optimizing the value of customer deposits, while continuing to mitigate credit losses in our loan portfolio, and improving the Bank’s risk profile. In addition, we do not plan to offer new banking products to customers, including mortgages.

 

3


Table of Contents

Key Factors Affecting Financial Performance

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

 

   

customer demand for financial products and services;

 

   

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

 

   

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

 

   

customer perception of the financial strength of our franchise;

 

   

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

 

   

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

 

   

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

 

   

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

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

 

   

have continued success in the acquisition, growth and retention of brokerage customers;

 

   

generate meaningful growth in the retirement and investing customer group;

 

   

strengthen our risk management capabilities;

 

   

reduce credit costs;

 

   

achieve the capital ratios stated in our strategic plan, with a particular focus on the Tier 1 leverage ratio at E*TRADE Bank;

 

   

generate capital sufficient to meet our operating needs at both our bank and our parent company;

 

   

assess and manage interest rate risk; and

 

   

have 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
Three Months Ended
March 31,
    Variance  
     2013     2012     2013 vs. 2012  

Customer Activity Metrics:

      

Daily average revenue trades (“DARTs”)

     148,538       156,988       (5 )% 

Average commission per trade

   $ 11.30     $ 11.04       2

Margin receivables (dollars in billions)

   $ 5.7     $ 5.3       8

End of period brokerage accounts

     2,933,225       2,829,006       4

Net new brokerage accounts

     30,034       45,994       (35 )% 

Annualized brokerage account attrition rate

     8.5     8.7     *   

Customer assets (dollars in billions)

   $ 218.7     $ 201.9       8

Net new brokerage assets (dollars in billions)

   $ 3.1     $ 4.0       (23 )% 

Brokerage related cash (dollars in billions)

   $ 34.7     $ 31.0       12

Company Financial Metrics:

      

Corporate cash (dollars in millions)

   $ 351.6     $ 483.8       (27 )% 

E*TRADE Financial Tier 1 leverage ratio

     6.0     5.5     0.5

E*TRADE Financial Tier 1 common ratio

     11.2     9.4     1.8

E*TRADE Bank Tier 1 leverage ratio

     9.3     7.3     2.0

Special mention loan delinquencies (dollars in millions)

   $ 312.1     $ 374.9       (17 )% 

Allowance for loan losses (dollars in millions)

   $ 455.0     $ 579.2       (21 )% 

Enterprise net interest spread

     2.30     2.49     (0.19 )% 

Enterprise interest-earning assets (average dollars in billions)

   $ 40.9     $ 44.9       (9 )% 

 

*   

Percentage not meaningful.

 

4


Table of Contents

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, net new brokerage accounts and brokerage account attrition rate are indicators of our ability to attract and retain brokerage customers. The brokerage account attrition rate is calculated by dividing attriting brokerage accounts, which are gross new brokerage accounts less net new brokerage accounts, by total brokerage accounts at the previous period end. This rate is presented on an annualized basis.

 

   

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.

 

   

Brokerage related cash is an indicator of the level of engagement with our brokerage customers and is 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 1 leverage ratio is Tier 1 capital divided by average total assets for leverage capital purposes for the parent company. E*TRADE Financial Tier 1 common ratio is Tier 1 capital less elements of Tier 1 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 1 leverage and Tier 1 common ratios are non-GAAP measures as the parent company is not yet held to these regulatory capital requirements and are indications of E*TRADE Financial’s capital adequacy. See Liquidity and Capital Resources for a reconciliation of these non-GAAP measures to the comparable GAAP measures.

 

   

E*TRADE Bank Tier 1 leverage ratio is Tier 1 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”).

 

   

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

 

5


Table of Contents

Significant Events in the First Quarter of 2013

Enhancements to Our Trading and Investing Products and Services

 

   

We launched a revamped tablet experience, and enhanced our iPhone and Android platforms adding useful tools such as mobile bill pay, and access to index futures, giving customers better insight into the markets outside of traditional trading hours;

 

   

We upgraded our E*TRADE Pro platform by enhancing its capabilities with the integration of futures trading, allowing us to provide customers with a much more streamlined futures trading experience; and

 

   

We hosted our second annual National Retirement Education Day in New York and at all our branches to provide customers with perspectives on how to better prepare for and manage their retirement assets.

EARNINGS OVERVIEW

We generated net income of $35.1 million, or $0.12 per diluted share, on total net revenue of $419.9 million for the three months ended March 31, 2013. Net operating interest income decreased 15% to $241.3 million for the three months ended March 31, 2013 compared to the same period in 2012, which was driven primarily by decreases in enterprise interest-earning assets and enterprise interest-bearing liabilities as a result of our deleveraging initiatives, in addition to a decrease in enterprise net interest spread. Commissions, fees and service charges, principal transactions and other revenue decreased 5% to $164.1 million for the three months ended March 31, 2013, compared to the same period in 2012, which was driven primarily by lower trading activity during 2013. In addition, gains on loans and securities, net decreased 55% to $15.7 million for the three months ended March 31, 2013 compared to the same period in 2012.

Provision for loan losses declined 41% to $42.7 million for the three months ended March 31, 2013 compared to the same period in 2012. The decline was driven primarily by improving credit trends and loan portfolio run-off, as well as a $12.5 million benefit from a settlement with a third party mortgage originator. Total operating expenses decreased 3% to $295.5 million for the three months ended March 31, 2013 compared to the same period in 2012. This decrease was driven primarily by decreases in advertising and market development and other operating expenses, partially offset by an increase in facility restructuring and other exit activities expense for the three months ended March 31, 2013.

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.

Revenue

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

 

     Three Months
Ended March 31,
    Variance  
       2013 vs. 2012  
     2013     2012     Amount     %  

Net operating interest income

   $ 241.3     $ 284.9     $ (43.6     (15 )% 

Commissions

     100.7       107.4       (6.7     (6 )% 

Fees and service charges

     32.5       32.0       0.5       2

Principal transactions

     21.8       24.1       (2.3     (10 )% 

Gains on loans and securities, net

     15.7       34.9       (19.2     (55 )% 

Net impairment

     (1.2     (3.5     2.3       *   

Other revenues

     9.1       9.6       (0.5     (6 )% 
  

 

 

   

 

 

   

 

 

   

Total non-interest income

     178.6       204.5       (25.9     (13 )% 
  

 

 

   

 

 

   

 

 

   

Total net revenue

   $ 419.9     $ 489.4     $ (69.5     (14 )% 
  

 

 

   

 

 

   

 

 

   

 

*  

Percentage not meaningful.

 

6


Table of Contents

Net Operating Interest Income

Net operating interest income decreased 15% to $241.3 million for the three months ended March 31, 2013 compared to the same period in 2012. Net operating interest income is earned primarily through investing customer cash and deposits in enterprise interest-earning assets, which include: real estate loans, margin receivables, 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 have been prepared on the basis required by the SEC’s Industry Guide 3, “Statistical Disclosure by Bank Holding Companies” (dollars in millions):

 

    Three Months Ended March 31,  
    2013     2012  
    Average
Balance
    Operating
Interest
Inc./Exp.
    Average
Yield/
Cost
    Average
Balance
    Operating
Interest
Inc./Exp.
    Average
Yield/
Cost
 

Enterprise interest-earning assets:

  

Loans(1)

  $ 10,398.1     $ 106.7       4.10   $ 12,972.7     $ 139.5       4.30

Available-for-sale securities

    12,987.0       64.2       1.98     16,054.9       105.9       2.64

Held-to-maturity securities

    9,500.4       58.1       2.44     6,917.6       53.4       3.09

Margin receivables

    5,666.7       54.4       3.90     4,857.3       48.0       3.97

Cash and equivalents

    1,593.4       0.8       0.21     1,604.6       0.8       0.21

Segregated cash

    158.2       0.1       0.11     1,830.0       0.4       0.08

Securities borrowed and other

    592.4       12.8       8.76     653.1       12.7       7.80
 

 

 

   

 

 

     

 

 

   

 

 

   

Total enterprise interest-earning assets

    40,896.2       297.1       2.91     44,890.2       360.7       3.22
   

 

 

       

 

 

   

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

    5,096.2           4,441.2      
 

 

 

       

 

 

     

Total assets

  $ 45,992.4         $ 49,331.4      
 

 

 

       

 

 

     

Enterprise interest-bearing liabilities:

  

Deposits

  $ 26,950.1       3.2       0.05   $ 27,927.9       8.3       0.12

Customer payables

    5,059.0       1.9       0.15     5,965.7       2.7       0.18

Securities sold under agreements to repurchase

    4,453.6       36.7       3.30     4,989.2       40.7       3.23

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

    1,261.1       16.9       5.37     2,732.2       25.4       3.68

Securities loaned and other

    749.0       —         0.01     588.5       0.2       0.12
 

 

 

   

 

 

     

 

 

   

 

 

   

Total enterprise interest-bearing liabilities

    38,472.8       58.7       0.61     42,203.5       77.3       0.73
   

 

 

       

 

 

   

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

    2,600.5           2,153.3      
 

 

 

       

 

 

     

Total liabilities

    41,073.3           44,356.8      

Total shareholders’ equity

    4,919.1           4,974.6      
 

 

 

       

 

 

     

Total liabilities and shareholders’ equity

  $ 45,992.4         $ 49,331.4      
 

 

 

       

 

 

     

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

  $ 2,423.4     $ 238.4       2.30   $ 2,686.7     $ 283.4       2.49
 

 

 

   

 

 

     

 

 

   

 

 

   

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

  

    2.33         2.53

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

  

    106.30         106.37

Return on average:

  

       

Total assets

        0.31         0.51

Total shareholders’ equity

        2.86         5.03

Average equity to average total assets

        10.70         10.08

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

 

     Three Months Ended
March 31,
 
     2013     2012  

Enterprise net interest income

   $ 238.4     $ 283.4  

Taxable equivalent interest adjustment

     (0.2     (0.3

Customer cash held by third parties and other(4)

     3.1       1.8  
  

 

 

   

 

 

 

Net operating interest income

   $ 241.3      $ 284.9   
  

 

 

   

 

 

 

 

(1)   

Nonaccrual loans are included in the average loan balances. Interest payments received on nonaccrual loans are recognized on a cash basis in operating interest income until it is doubtful that full payment will be collected, at which point payments are applied to principal.

(2)   

Non-operating interest-earning and non-interest earning assets consist of certain segregated cash balances, 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 revenue earned on average customer assets of $9.5 billion and $4.0 billion for the three months ended March 31, 2013 and 2012, respectively, held by third parties outside the Company, including money market funds and sweep deposit accounts at unaffiliated financial institutions.

 

7


Table of Contents

The fluctuation in enterprise interest-earning assets is driven primarily by changes in enterprise interest-bearing liabilities, specifically customer cash and deposits. Average enterprise interest-earning assets decreased 9% to $40.9 billion for the three months ended March 31, 2013 compared to the same period in 2012. This was primarily a result of decreases in average loans, average available-for-sale securities and average segregated cash, partially offset by an increase in average held-to-maturity securities.

Average enterprise interest-bearing liabilities decreased 9% to $38.5 billion for the three months ended March 31, 2013 compared to the same period in 2012. The decrease in average enterprise interest-bearing liabilities was due primarily to our deleveraging strategy which drove a decrease in average FHLB advances and other borrowings.

Enterprise net interest spread decreased by 19 basis points to 2.30% for the three months ended March 31, 2013 compared to the same period in 2012, due primarily to lower yields on loans and reinvestment at lower rates in the current interest rate environment, which remains challenging. We expect enterprise net interest spread will continue to average approximately 10 basis points below the average from 2012; however, enterprise net interest spread may further fluctuate based on the size and mix of the balance sheet, as well as the impact from the level of interest rates.

Commissions

Commissions revenue decreased 6% to $100.7 million for the three months ended March 31, 2013 compared to the same period in 2012. 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 customer mix and the different commission rates on various trade types (e.g. equities, options, futures, fixed income, stock plan, exchange-traded funds, mutual funds, forex and cross border). Accordingly, changes in the mix of trade types will impact average commission per trade.

DART volume decreased 5% to 148,538 for the three months ended March 31, 2013 compared to the same period in 2012. Option-related DARTs as a percentage of total DARTs represented 24% of trading volume for the three months ended March 31, 2013 compared to 23% in the same period in 2012. Exchange-traded funds-related DARTs as a percentage of total DARTs represented 7% of trading volume for the three months ended March 31, 2013 compared to 8% in the same period in 2012.

Average commission per trade increased 2% to $11.30 for the three months ended March 31, 2013 compared to the same period in 2012. The increase was driven by a favorable change in customer and product mix, when compared to the same period in 2012.

Fees and Service Charges

Fees and service charges increased 2% to $32.5 million for the three months ended March 31, 2013 compared to the same period in 2012. The table below shows the components of fees and service charges and the resulting variances (dollars in millions):

 

    

Three Months Ended

March 31,

     Variance  
        2013 vs. 2012  
     2013      2012      Amount     %  

Order flow revenue

   $ 15.4      $ 15.5      $ (0.1     (1 )% 

Mutual fund service fees

     4.4        3.8        0.6       16

Foreign exchange revenue

     3.4        3.5        (0.1     (3 )% 

Advisor management fees

     2.5        1.2        1.3       108

Reorganization fees

     1.2        1.7        (0.5     (29 )% 

Other fees and service charges

     5.6        6.3        (0.7     (11 )% 
  

 

 

    

 

 

    

 

 

   

Total fees and service charges

   $ 32.5      $ 32.0      $ 0.5       2
  

 

 

    

 

 

    

 

 

   

 

8


Table of Contents

The increase in fees and services charges for the three months ended March 31, 2013 was driven primarily by increases in advisor management fees and mutual fund service fees.

Principal Transactions

Principal transactions decreased 10% to $21.8 million for the three months ended March 31, 2013 compared to the same period in 2012. Principal transactions are derived from our market making business in which we act as a market-maker for our brokerage customers’ orders as well as orders from third party customers. The decrease in principal transactions revenue was driven primarily by lower levels of market volatility when compared to the same period in 2012.

Gains on Loans and Securities, Net

Gains on loans and securities, net decreased 55% to $15.7 million for the three months ended March 31, 2013 compared to the same period in 2012. The table below shows the activity and resulting variances (dollars in millions):

 

    

Three Months Ended

March 31,

     Variance  
        2013 vs. 2012  
     2013     2012      Amount     %  

Gains on available-for-sale securities, net

   $ 15.8     $ 34.9      $ (19.1     (55 )% 

Hedge ineffectiveness

     (0.1     —          (0.1     *   
  

 

 

   

 

 

    

 

 

   

Gains on loans and securities, net

   $ 15.7     $ 34.9      $ (19.2     (55 )% 
  

 

 

   

 

 

    

 

 

   

 

*  

Percentage not meaningful.

Net Impairment

We recognized $1.2 million and $3.5 million of net impairment during the three months ended March 31, 2013 and 2012, respectively, on certain securities in our non-agency CMO portfolio due to continued deterioration in the expected credit performance of the underlying loans in those specific securities. The gross other-than-temporary impairment (“OTTI”) and the noncredit portion of OTTI, which was or had been previously recorded through other comprehensive income, are shown in the table below (dollars in millions):

 

     Three Months Ended
March 31,
 
     2013     2012  

Other-than-temporary impairment (“OTTI”)

   $ (0.6   $ (12.6

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

     (0.6     9.1  
  

 

 

   

 

 

 

Net impairment

   $ (1.2   $ (3.5
  

 

 

   

 

 

 

Provision for Loan Losses

Provision for loan losses decreased 41% to $42.7 million for the three months ended March 31, 2013 compared to the same period in 2012. The decrease in provision for loan losses was driven primarily by improving credit trends, as evidenced by the lower levels of delinquent loans in the one- to four-family and home equity loan portfolios, and loan portfolio run-off, as well as a $12.5 million benefit recorded from a settlement with a third party mortgage originator for the three months ended March 31, 2013. The provision for loan losses has declined 92% from its peak of $517.8 million in the third quarter of 2008. We expect provision for loan losses to continue to decline over the long term, although it is subject to variability in any given quarter.

 

9


Table of Contents

Operating Expense

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

 

    

Three Months Ended

March 31,

    Variance  
       2013 vs. 2012  
     2013      2012     Amount      %  

Compensation and benefits

   $ 95.7      $ 92.3     $ 3.4        4

Advertising and market development

     36.6        47.6       (11.0      (23 )% 

Clearing and servicing

     31.6        34.6       (3.0      (8 )% 

FDIC insurance premiums

     29.3        28.4       0.9        3

Professional services

     17.3        20.3       (3.0      (15 )% 

Occupancy and equipment

     17.5        17.8       (0.3      (2 )% 

Communications

     18.5        19.1       (0.6      (3 )% 

Depreciation and amortization

     23.0        22.2       0.8        4

Amortization of other intangibles

     6.1        6.3       (0.2      (4 )% 

Facility restructuring and other exit activities

     7.6        (0.4     8.0        *   

Other operating expenses

     12.3        18.0       (5.7      (32 )% 
  

 

 

    

 

 

   

 

 

    

Total operating expense

   $ 295.5      $ 306.2     $ (10.7      (3 )% 
  

 

 

    

 

 

   

 

 

    

 

*  

Percentage not meaningful

Compensation and Benefits

Compensation and benefits increased 4% to $95.7 million for the three months ended March 31, 2013 compared to the same period in 2012. The increase resulted primarily from $4.5 million in severance associated with the executive terminations that was recorded during the three months ended March 31, 2013.

Advertising and Market Development

Advertising and market development decreased 23% to $36.6 million for the three months ended March 31, 2013 compared to the same period in 2012. This fluctuation is due largely to the planned decrease in advertising expenditures as part of our expense reduction initiatives.

Clearing and Servicing

Clearing and servicing decreased 8% to $31.6 million for the three months ended March 31, 2013 compared to the same period in 2012. This decrease resulted primarily from lower trading volumes and lower loan balances compared to 2012.

Professional Services

Professional services decreased 15% to $17.3 million for the three months ended March 31, 2013 compared to the same period in 2012. The decrease was due primarily to lower consulting fees when compared to 2012.

Facility Restructuring and Other Exit Activities

Facility restructuring and other exit activities were $7.6 million for the three months ended March 31, 2013. These costs were driven primarily by severance costs incurred as part of our expense reduction initiatives.

Other Operating Expenses

Other operating expenses decreased 32% to $12.3 million for the three months ended March 31, 2013 compared to the same period in 2012. The decrease was driven primarily by reduced expenses related to real estate owned (“REO”) compared to the same period in 2012 and a $2.4 million benefit from sales tax refunds that was recorded during the three months ended March 31, 2013.

 

10


Table of Contents

Other Income (Expense)

Other income (expense) decreased 46% to $24.3 million for the three months ended March 31, 2013 compared to the same period in 2012 as shown in the following table (dollars in millions):

 

    

Three Months Ended

March 31,

    Variance  
       2013 vs. 2012  
     2013     2012     Amount      %  

Corporate interest expense

   $ (28.6   $ (45.1   $ 16.5        (37 )% 

Equity in income (loss) of investments and other

     4.3       (0.1     4.4        *   
  

 

 

   

 

 

   

 

 

    

Total other income (expense)

   $ (24.3   $ (45.2   $ 20.9        (46 )% 
  

 

 

   

 

 

   

 

 

    

 

*  

Percentage not meaningful.

Total other income (expense) included corporate interest expense on interest-bearing corporate debt for the three months ended March 31, 2013 and 2012. Corporate interest expense decreased 37% to $28.6 million for the three months ended March 31, 2013 compared to the same period in 2012 as a result of the refinance of $1.3 billion of higher yielding corporate debt during the fourth quarter of 2012. During the three months ended March 31, 2013, corporate interest expense was partially offset by a gain of $4.8 million included in equity in income (loss) of investments and other related to an investment in a venture fund.

Income Tax Expense

Income tax expense was $22.2 million and $3.4 million for the three months ended March 31, 2013 and 2012, respectively. The effective tax rate was 38.8% for the three months ended March 31, 2013 compared to 5.2% for the same period in 2012.

During the first quarter of 2012, we recorded an income tax benefit of $26.3 million related to certain losses on the 2009 Debt Exchange that were previously considered non-deductible. Through additional research completed in the first quarter of 2012, we identified that a portion of those losses were incorrectly treated as non-deductible in 2009 and were deductible for tax purposes. The $26.3 million tax benefit resulted in a corresponding increase to the net deferred tax asset.

Valuation Allowance

We are required to establish a valuation allowance for deferred tax assets and record a charge to income if we determine, based on available evidence at the time the determination is made, that it is more likely than not that some portion or all of the deferred tax assets will not be realized. If we did conclude that a valuation allowance was required, the resulting loss could have a material adverse effect on our financial condition and results of operations.

We did not establish any valuation allowance against federal deferred tax assets as of March 31, 2013 as we believe that it is more likely than not that all of these assets will be realized. We continue to maintain a valuation allowance for certain of our state, foreign country and charitable contribution deferred tax assets as it is more likely than not that they will not be realized.

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; loans previously originated by the Company or purchased from third parties; customer cash and deposits; and credit,

 

11


Table of Contents

liquidity and interest rate risk for the Company as described in the Risk Management section. Costs associated with certain functions that are centrally-managed are separately reported in a corporate/other category.

Trading and Investing

The following table summarizes trading and investing financial information and key metrics as of and for the three months ended March 31, 2013 and 2012 (dollars in millions, except for key metrics):

 

     Three Months  Ended
March 31,
    Variance  
       2013 vs. 2012  
     2013     2012     Amount     %  

Net operating interest income

   $ 134.1     $ 170.4     $ (36.3     (21 )% 

Commissions

     100.7       107.4       (6.7     (6 )% 

Fees and service charges

     32.0       31.0       1.0       4

Principal transactions

     21.8       24.1       (2.3     (10 )% 

Other revenues

     8.1       7.9       0.2       1
  

 

 

   

 

 

   

 

 

   

Total net revenue

     296.7       340.8       (44.1     (13 )% 

Total operating expense

     198.2       211.5       (13.3     (6 )% 
  

 

 

   

 

 

   

 

 

   

Trading and investing income

   $ 98.5     $ 129.3     $ (30.8     (24 )% 
  

 

 

   

 

 

   

 

 

   

Key Metrics:

        

DARTs

     148,538       156,988       (8,450     (5 )% 

Average commission per trade

   $ 11.30     $ 11.04     $ 0.26       2

Margin receivables (dollars in billions)

   $ 5.7     $ 5.3     $ 0.4       8

End of period brokerage accounts

     2,933,225       2,829,006       104,219       4

Net new brokerage accounts

     30,034       45,994       (15,960     (35 )% 

Annualized brokerage account attrition rate

     8.5     8.7     (0.2 )%      *   

Customer assets (dollars in billions)

   $ 218.7     $ 201.9     $ 16.8       8

Net new brokerage assets (dollars in billions)

   $ 3.1     $ 4.0     $ (0.9     (23 )% 

Brokerage related cash (dollars in billions)

   $ 34.7     $ 31.0     $ 3.7       12

 

*  

Percentage not meaningful.

The trading and investing segment offers products and services to individual retail investors, generating revenue from these brokerage and banking relationships 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. Net operating interest income is generated primarily from margin receivables and from a deposit transfer pricing arrangement with the balance sheet management segment. The balance sheet management segment utilizes the vast majority of customer cash and deposits and compensates the trading and investing segment via a market-based transfer pricing arrangement. This compensation is reflected in segment results as operating interest income for the trading and investing segment and operating interest expense for the balance sheet management segment and is eliminated in consolidation. Customer cash and deposits utilized by the balance sheet management segment include retail deposits and customer payables. 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.

Trading and investing income decreased 24% to $98.5 million for the three months ended March 31, 2013 compared to the same period in 2012. We continued to generate net new brokerage accounts, ending the first quarter of 2013 with 2.9 million accounts. Brokerage related cash, which is one of our most profitable sources of funding, increased by $3.7 billion when compared to the same period in 2012.

 

12


Table of Contents

Trading and investing commissions decreased 6% to $100.7 million for the three months ended March 31, 2013 compared to the same period in 2012. This decrease in commissions was primarily the result of a decrease in DARTs of 5% to 148,538 for the three months ended March 31, 2013 compared to the same period in 2012.

Trading and investing fees and service charges increased 4% to $32.0 million for the three months ended March 31, 2013 compared to the same period in 2012. This increase for the three months ended March 31, 2013 was primarily driven by increases in advisor management fees and mutual fund service fees.

Trading and investing principal transactions decreased 10% to $21.8 million for the three months ended March 31, 2013 compared to the same period in 2012. The decrease in principal transactions revenue was driven primarily by lower levels of market volatility when compared to the same period in 2012.

Trading and investing operating expense decreased 6% to $198.2 million for the three months ended March 31, 2013 compared to the same period in 2012. The decrease for the three months ended March 31, 2013 resulted primarily from the planned decrease in advertising expenditures as part of our expense reduction initiatives.

As of March 31, 2013, we had approximately 2.9 million brokerage accounts, 1.2 million stock plan accounts and 0.4 million banking accounts. For the three months ended March 31, 2013 and 2012, our brokerage products contributed 77% and 70%, respectively, and our banking products contributed 23% and 30%, 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 three months ended March 31, 2013 and 2012 (dollars in millions):

 

    

Three Months Ended

March 31,

    Variance  
       2013 vs. 2012  
     2013     2012     Amount     %  

Net operating interest income

   $ 107.2     $ 114.4     $ (7.2     (6 )% 

Fees and service charges

     0.5       1.0       (0.5     (56 )% 

Gains on loans and securities, net

     15.7       35.0       (19.3     (55 )% 

Net impairment

     (1.2     (3.5     2.3       (67 )% 

Other revenues

     1.0       1.6       (0.6     (40 )% 
  

 

 

   

 

 

   

 

 

   

Total net revenue

     123.2       148.5       (25.3     (17 )% 

Provision for loan losses

     42.7       71.9       (29.2     (41 )% 

Total operating expense

     50.1       58.6       (8.5     (15 )% 
  

 

 

   

 

 

   

 

 

   

Balance sheet management income

   $ 30.4     $ 18.0     $ 12.4       69
  

 

 

   

 

 

   

 

 

   

Key Metrics:

        

Special mention loan delinquencies

   $ 312.1     $ 374.9     $ (62.8     (17 )% 

Allowance for loan losses

   $ 455.0     $ 579.2     $ (124.2     (21 )% 

The balance sheet management segment generates revenue from managing loans previously originated by the Company or purchased from third parties, as well as utilizing customer cash and deposits to generate additional net operating interest income. The balance sheet management segment utilizes customer cash and deposits from the trading and investing segment, wholesale borrowings and proceeds from loan pay-downs to invest in available-for-sale and held-to-maturity securities. Net operating interest income is generated from interest earned on available-for-sale and held-to-maturity securities and loans receivable, net of interest paid on wholesale borrowings and on a deposit transfer pricing arrangement with the trading and investing segment. The balance sheet management segment utilizes the vast majority of customer cash and deposits and compensates the

 

13


Table of Contents

trading and investing segment via a market-based transfer pricing arrangement. This compensation is reflected in segment results as operating interest income for the trading and investing segment and operating interest expense for the balance sheet management segment and is eliminated in consolidation. Customer cash and deposits utilized by the balance sheet management segment include retail deposits and customer payables.

Balance sheet management income increased 69% to $30.4 million for the three months ended March 31, 2013 when compared to the same period, due primarily to a decrease in provision for loan losses of 41% to $42.7 million for the three months ended March 31, 2013.

Gains on loans and securities, net were $15.7 million for the three months ended March 31, 2013 compared to $35.0 million for the same period in 2012.

We recognized $1.2 million and $3.5 million of net impairment during the three months ended March 31, 2013 and 2012, respectively, on certain securities in the non-agency CMO portfolio due to continued deterioration in the expected credit performance of the underlying loans in those specific securities.

Provision for loan losses decreased 41% to $42.7 million for the three months ended March 31, 2013 compared to the same period in 2012. The decrease in provision for loan losses was driven primarily by improving credit trends and loan portfolio run-off, as well as a $12.5 million benefit from a settlement with a third party mortgage originator for the three months ended March 31, 2013.

Total balance sheet management operating expense decreased 15% to $50.1 million for the three months ended March 31, 2013 compared to the same period in 2012. The decrease in operating expense for the three months ended March 31, 2013 resulted primarily from reduced servicing expenses due to lower loan balances, reduced expenses related to REO and lower consulting fees when compared to the same period in 2012.

Corporate/Other

The following table summarizes corporate/other financial information for the three months ended March 31, 2013 and 2012 (dollars in millions):

 

    

Three Months Ended

March 31,

    Variance  
       2013 vs. 2012  
     2013     2012     Amount     %  

Total net revenue

   $ —       $ —       $ —         *   
  

 

 

   

 

 

   

 

 

   

Compensation and benefits

     20.5       18.3       2.2       12

Professional services

     8.4       7.3       1.1       15

Occupancy and equipment

     1.1       0.9       0.2       21

Communications

     0.3       0.4       (0.1     (11 )% 

Depreciation and amortization

     4.0       4.3       (0.3     (7 )% 

Facility restructuring and other exit activities

     7.6       (0.4     8.0       *   

Other operating expenses

     5.3       5.3       —         0
  

 

 

   

 

 

   

 

 

   

Total operating expense

     47.2       36.1       11.1       31
  

 

 

   

 

 

   

 

 

   

Operating loss

     (47.2     (36.1     (11.1     31

Total other income (expense)

     (24.3     (45.2     20.9       (46 )% 
  

 

 

   

 

 

   

 

 

   

Corporate/other loss

   $ (71.5   $ (81.3   $ 9.8       (12 )% 
  

 

 

   

 

 

   

 

 

   

 

*  

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.

 

14


Table of Contents

The corporate/other loss before income taxes was $71.5 million for the three months ended March 31, 2013, compared to $81.3 million for the same period in 2012.

The operating loss increased 31% to $47.2 million for the three months ended March 31, 2013 when compared to the same period in 2012, due primarily to an increase in facility restructuring and other exit activities expense as a result of severance costs incurred as part of our expense reduction initiatives.

Total other income (expense) included corporate interest expense on interest-bearing corporate debt for the three months ended March 31, 2013 and 2012. Corporate interest expense decreased 37% to $28.6 million for the three months ended March 31, 2013 compared to the same period in 2012 as a result of the refinance of $1.3 billion of higher yielding corporate debt during the fourth quarter of 2012. During the three months ended March 31, 2013, corporate interest expense was partially offset by a gain of $4.8 million included in equity in income (loss) of investments and other related to an investment in a venture fund.

BALANCE SHEET OVERVIEW

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

 

                   Variance  
     March  31,
2013
     December  31,
2012
     2013 vs. 2012  
           Amount     %  

Assets:

          

Cash and equivalents

   $ 1,507.7      $ 2,761.5      $ (1,253.8     (45 )% 

Segregated cash

     318.8        376.9        (58.1     (15 )% 

Securities(1)

     22,633.4        23,084.2        (450.8     (2 )% 

Margin receivables

     5,748.6        5,804.0        (55.4     (1 )% 

Loans receivable, net

     9,585.3        10,098.7        (513.4     (5 )% 

Investment in FHLB stock

     61.4        67.4        (6.0     (9 )% 

Other(2)

     5,111.1        5,194.0        (82.9     (2 )% 
  

 

 

    

 

 

    

 

 

   

Total assets

   $ 44,966.3      $ 47,386.7      $ (2,420.4     (5 )% 
  

 

 

    

 

 

    

 

 

   

Liabilities and shareholders’ equity:

          

Deposits

   $ 25,877.8      $ 28,392.5      $ (2,514.7     (9 )% 

Wholesale borrowings(3)

     5,724.9        5,715.6        9.3       0

Customer payables

     5,084.3        4,964.9        119.4       2

Corporate debt

     1,765.9        1,765.0        0.9       0

Other liabilities

     1,561.6        1,644.2        (82.6     (5 )% 
  

 

 

    

 

 

    

 

 

   

Total liabilities

     40,014.5        42,482.2        (2,467.7     (6 )% 

Shareholders’ equity

     4,951.8        4,904.5        47.3       1
  

 

 

    

 

 

    

 

 

   

Total liabilities and shareholders’ equity

   $ 44,966.3      $ 47,386.7      $ (2,420.4     (5 )% 
  

 

 

    

 

 

    

 

 

   

 

(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.

Segregated Cash

Segregated cash decreased by $58.1 million to $318.8 million during the three months ended March 31, 2013. The level of cash required to be segregated under federal or other regulations, or segregated cash, is driven largely by customer cash and securities lending balances we hold as a liability in excess of the amount of margin receivables and securities borrowed balances we hold as an asset. The excess represents customer cash that we are required by our regulators to segregate for the exclusive benefit of our brokerage customers.

 

15


Table of Contents

Securities

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

 

                   Variance  
     March  31,
2013
     December  31,
2012
     2013 vs. 2012  
           Amount     %  

Trading securities

   $ 100.5      $ 101.3      $ (0.8     (1 )% 
  

 

 

    

 

 

    

 

 

   

Available-for-sale securities:

          

Residential mortgage-backed securities:

          

Agency mortgage-backed securities and CMOs

   $ 11,429.2      $ 12,097.2      $ (668.0     (6 )% 

Non-agency CMOs

     14.1        235.2        (221.1     (94 )% 
  

 

 

    

 

 

    

 

 

   

Total residential mortgage-backed securities

     11,443.3        12,332.4        (889.1     (7 )% 

Investment securities

     1,233.1        1,110.6        122.5       11
  

 

 

    

 

 

    

 

 

   

Total available-for-sale securities

   $ 12,676.4      $ 13,443.0      $ (766.6     (6 )% 
  

 

 

    

 

 

    

 

 

   

Held-to-maturity securities:

          

Residential mortgage-backed securities:

          

Agency mortgage-backed securities and CMOs

   $ 8,106.2      $ 7,887.5      $ 218.7       3

Investment securities

     1,750.3        1,652.4        97.9       6
  

 

 

    

 

 

    

 

 

   

Total held-to-maturity securities

   $ 9,856.5      $ 9,539.9      $ 316.6       3
  

 

 

    

 

 

    

 

 

   

Total securities

   $ 22,633.4      $ 23,084.2      $ (450.8     (2 )% 
  

 

 

    

 

 

    

 

 

   

Securities represented 50% and 49% of total assets at March 31, 2013 and December 31, 2012, respectively. The decline in available-for-sale securities during the three months ended March 31, 2013 was due primarily to a decrease of $668.0 million in agency mortgage-backed securities and CMOs. In addition, we sold $230.5 million in amortized cost of available-for-sale non-agency CMOs during the first quarter of 2013 as part of our focus to reduce risk and deleverage the balance sheet.

Loans Receivable, Net

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

 

                 Variance  
     March  31,
2013
    December  31,
2012
    2013 vs. 2012  
         Amount     %  

One- to four-family

   $ 5,217.1     $ 5,442.2     $ (225.1     (4 )% 

Home equity

     4,021.1       4,223.4       (202.3     (5 )% 

Consumer and other

     739.8       844.9       (105.1     (12 )% 

Unamortized premiums, net

     62.3       68.9       (6.6     (10 )% 

Allowance for loan losses

     (455.0     (480.7     25.7       (5 )% 
  

 

 

   

 

 

   

 

 

   

Total loans receivable, net

   $ 9,585.3     $ 10,098.7     $ (513.4     (5 )% 
  

 

 

   

 

 

   

 

 

   

Loans receivable, net decreased 5% to $9.6 billion at March 31, 2013 from $10.1 billion at December 31, 2012. 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.

 

16


Table of Contents

Deposits

Deposits are summarized as follows (dollars in millions):

 

                   Variance  
     March  31,
2013
     December  31,
2012
     2013 vs. 2012  
           Amount     %  

Sweep deposits

   $ 18,923.1      $ 21,253.6      $ (2,330.5     (11 )% 

Complete savings deposits

     4,827.4        4,981.6        (154.2     (3 )% 

Checking deposits

     1,061.7        1,055.4        6.3       1

Other money market and savings deposits

     974.9        995.2        (20.3     (2 )% 

Time deposits

     90.7        106.7        (16.0     (15 )% 
  

 

 

    

 

 

    

 

 

   

Total deposits

   $ 25,877.8      $ 28,392.5      $ (2,514.7     (9 )% 
  

 

 

    

 

 

    

 

 

   

Deposits represented 65% and 67% of total liabilities at March 31, 2013 and December 31, 2012, respectively. At March 31, 2013, 92% of our customer deposits were covered by FDIC insurance. Deposits provide the benefit of lower interest costs compared with wholesale funding alternatives. Deposits decreased 9% to $25.9 billion at March 31, 2013 from $28.4 billion at December 31, 2012. The decrease was driven primarily by $2.3 billion in sweep deposits that were transferred off of the balance sheet to third parties during the first quarter of 2013 as part of our deleveraging initiatives.

The deposits balance is a component of the total customer cash and deposits balance reported as a customer activity metric of $41.7 billion and $41.0 billion at March 31, 2013 and December 31, 2012, respectively. The total customer cash and deposits balance is summarized as follows (dollars in millions):

 

                 Variance  
     March  31,
2013
    December  31,
2012
    2013 vs. 2012  
         Amount     %  

Deposits

   $ 25,877.8     $ 28,392.5     $ (2,514.7     (9 )% 

Less: brokered certificates of deposit

     (2.0     (11.2     9.2       (82 )% 
  

 

 

   

 

 

   

 

 

   

Retail deposits

     25,875.8       28,381.3       (2,505.5     (9 )% 

Customer payables

     5,084.3       4,964.9       119.4       2

Customer cash balances held by third parties and other

     10,699.3       7,644.2       3,055.1       40
  

 

 

   

 

 

   

 

 

   

Total customer cash and deposits

   $ 41,659.4     $ 40,990.4     $ 669.0       2
  

 

 

   

 

 

   

 

 

   

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  
     March  31,
2013
     December  31,
2012
     2013 vs. 2012  
           Amount     %  

Securities sold under agreements to repurchase

   $ 4,459.4      $ 4,454.7      $ 4.7       0
  

 

 

    

 

 

    

 

 

   

FHLB advances

   $ 836.4      $ 831.7      $ 4.7       1

Subordinated debentures

     427.7        427.7        —         0

Other

     1.4        1.5        (0.1     (7 )% 
  

 

 

    

 

 

    

 

 

   

Total FHLB advances and other borrowings

   $ 1,265.5      $ 1,260.9      $ 4.6       0
  

 

 

    

 

 

    

 

 

   

Total wholesale borrowings

   $ 5,724.9      $ 5,715.6      $ 9.3       0
  

 

 

    

 

 

    

 

 

   

 

17


Table of Contents

Wholesale borrowings represented 14% and 13% of total liabilities at March 31, 2013 and December 31, 2012, 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-earnings assets fluctuate.

Corporate Debt

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

 

     Face Value      Discount     Net  

March 31, 2013

                   

Interest-bearing notes:

       

6  3/4% Notes, due 2016

   $ 435.0      $ (5.3   $ 429.7  

6% Notes, due 2017

     505.0        (4.4     500.6  

6  3/8% Notes, due 2019

     800.0        (7.1     792.9  
  

 

 

    

 

 

   

 

 

 

Total interest-bearing notes

     1,740.0        (16.8     1,723.2  

Non-interest-bearing debt:

       

0% Convertible debentures, due 2019

     42.7        —         42.7  
  

 

 

    

 

 

   

 

 

 

Total corporate debt

   $ 1,782.7      $ (16.8   $ 1,765.9  
  

 

 

    

 

 

   

 

 

 

 

     Face Value      Discount     Net  

December 31, 2012

                   

Interest-bearing notes:

       

6  3/4% Notes, due 2016

   $ 435.0      $ (5.8   $ 429.2  

6% Notes, due 2017

     505.0        (4.6     500.4  

6  3/8% Notes, due 2019

     800.0        (7.3     792.7  
  

 

 

    

 

 

   

 

 

 

Total interest-bearing notes

     1,740.0        (17.7     1,722.3  

Non-interest-bearing debt:

       

0% Convertible debentures, due 2019

     42.7        —         42.7  
  

 

 

    

 

 

   

 

 

 

Total corporate debt

   $ 1,782.7      $ (17.7   $ 1,765.0  
  

 

 

    

 

 

   

 

 

 

Shareholders’ Equity

The activity in shareholders’ equity during the three months ended March 31, 2013 is summarized as follows (dollars in millions):

 

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

Beginning balance, December 31, 2012

   $ 7,322.1      $ (2,417.6   $ 4,904.5  

Net income

     —          35.1       35.1  

Net change from available-for-sale securities

     —          (15.1     (15.1

Net change from cash flow hedging instruments

     —          26.1       26.1  

Other(1)

     1.2        —         1.2  
  

 

 

    

 

 

   

 

 

 

Ending balance, March 31, 2013

   $ 7,323.3      $ (2,371.5   $ 4,951.8  
  

 

 

    

 

 

   

 

 

 

 

(1)   

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

 

18


Table of Contents

LIQUIDITY AND CAPITAL RESOURCES

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

Capital is generated primarily through the business operations of the trading and investing and balance sheet management segments, which are primarily contained within E*TRADE Bank; therefore, we believe a key indicator of the capital generated or used in our business operations is the level of regulatory capital in E*TRADE Bank. As of March 31, 2013, E*TRADE Bank’s Tier 1 leverage ratio was 9.3%, an increase from 8.7% at December 31, 2012. We have been focused on improving the Tier 1 leverage ratio at E*TRADE Bank through deleveraging the balance sheet by a reduction in wholesale borrowings, retail deposits and customer payables, the majority of which has been completed. We are now focused on continuing to generate capital through earnings.

We submitted an initial long-term strategic and capital plan to the OCC and Federal Reserve during the second quarter of 2012. The plan included: our five-year business strategy; forecasts of our business results and capital ratios; capital distribution plans in current and adverse operating conditions; and internally developed stress tests. During the third quarter of 2012, we received initial feedback from our regulators on this plan and we believe that key elements of this plan, specifically reducing risk, deleveraging the balance sheet and the development of an enterprise risk management function, are critical. We submitted an updated long-term strategic and capital plan to the OCC and Federal Reserve in February 2013, which included the key elements outlined in the initial plan as well as the progress made during 2012 on those key elements. We believe that our targets for capital levels at E*TRADE Bank and corresponding distributions of capital from E*TRADE Bank and its subsidiaries to the parent company will be achievable over time. We plan to continue an active and ongoing dialogue with our regulators to ensure our execution of the plan is consistent with their expectations.

Consolidated Cash and Equivalents

The consolidated cash and equivalents balance decreased by $1.3 billion to $1.5 billion at March 31, 2013 when compared to December 31, 2012. The majority of this balance is cash held in regulated subsidiaries, primarily the Bank, outlined as follows (dollars in millions):

 

     March  31,
2013
     December  31,
2012
     Variance  
           2013 vs. 2012  

Corporate cash

   $ 351.6      $ 407.6      $ (56.0

Bank cash

     1,126.2        2,319.6        (1,193.4

International brokerage and other cash

     29.9        34.3        (4.4
  

 

 

    

 

 

    

 

 

 

Total consolidated cash and equivalents

   $ 1,507.7      $ 2,761.5      $ (1,253.8
  

 

 

    

 

 

    

 

 

 

 

19


Table of Contents

Corporate cash is the primary source of liquidity at the parent company. We define corporate cash as cash held at the parent company as well as cash held in certain subsidiaries that can distribute cash to the parent company without any regulatory approval. We believe corporate cash is a useful measure of the parent company’s liquidity as it is the primary source of capital above and beyond the capital deployed in our regulated subsidiaries. Corporate cash can fluctuate in any given quarter and is impacted primarily by tax settlements, approval and timing of subsidiary dividends, debt service costs and other overhead cost sharing arrangements. We target corporate cash to be at least two times our annual debt service, or approximately $220 million. From the level of corporate cash at March 31, 2013, we expect that it will decline generally in line with our corporate interest expense. However, the parent company has approximately $400 million in net deferred tax assets, which will ultimately become sources of corporate cash as the parent’s subsidiaries reimburse the parent for the use of its deferred tax assets.

Liquidity Available from Subsidiaries

Liquidity available to the Company from its subsidiaries is limited by regulatory requirements. In addition, neither E*TRADE Bank nor its subsidiaries may pay dividends to the parent company without approval from its regulators. Loans by E*TRADE Bank to the parent company and its other non-bank subsidiaries are subject to various quantitative, arm’s length, collateralization and other requirements.

E*TRADE Bank is subject to capital requirements determined by its primary regulators. At March 31, 2013 and December 31, 2012, E*TRADE Bank had $1.8 billion and $1.6 billion, respectively, of Tier 1 leverage capital in excess of the regulatory minimum level required to be considered “well capitalized.”

The Company’s broker-dealer subsidiaries are subject to capital requirements determined by their respective regulators. At March 31, 2013 and December 31, 2012, all of our brokerage subsidiaries met their minimum net capital requirements. Our broker-dealer subsidiaries had excess net capital of $670.8 million at March 31, 2013, an increase of $15.7 million from $655.1 million at December 31, 2012. The excess net capital of the broker-dealer subsidiaries at March 31, 2013 included $526.0 million and $96.8 million of excess net capital at E*TRADE Clearing LLC and E*TRADE Securities LLC, respectively, which are subsidiaries of E*TRADE Bank and are also included in the excess capital of E*TRADE Bank.

 

20


Table of Contents

Financial Regulatory Reform Legislation and Basel III Framework

The Dodd-Frank Act 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 implementation of holding company capital requirements will impact us as the parent company was not previously subject to regulatory capital requirements. These holding company capital requirements are expected to become effective in 2015. We believe these capital ratios are an important measure of capital strength and accordingly manage our capital against the current capital ratios that apply to bank holding companies. The Tier 1 leverage, Tier 1 risk-based capital and total risk-based capital ratios are non-GAAP measures as the parent company is not yet held to these regulatory capital requirements and are calculated as follows (dollars in millions):

 

     March 31,
2013
    December 31,
2012
    March 31,
2012
 

Shareholders’ equity

   $ 4,951.8     $ 4,904.5     $ 5,035.9  

Deduct:

      

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

     (304.4     (315.4     (345.3

Good will and other intangible assets, net of deferred tax liabilities

     1,883.1       1,899.4       1,930.6  

Add:

      

Qualifying restricted core capital elements (TRUPs)(1)

     433.0       433.0       433.0  
  

 

 

   

 

 

   

 

 

 

Subtotal

     3,806.1       3,753.5       3,883.6  

Deduct:

      

Disallowed servicing assets and deferred tax assets

     1,265.2       1,278.9       1,353.2  
  

 

 

   

 

 

   

 

 

 

Tier 1 capital

     2,540.9       2,474.6       2,530.4  
  

 

 

   

 

 

   

 

 

 

Add:

      

Allowable allowance for loan losses

     237.6       251.8       282.5  
  

 

 

   

 

 

   

 

 

 

Total capital

   $ 2,778.5     $ 2,726.4     $ 2,812.9  
  

 

 

   

 

 

   

 

 

 

Total average assets

   $ 45,679.4     $ 48,152.7     $ 49,331.4  

Deduct:

      

Goodwill and other intangible assets, net of deferred tax liabilities

     1,883.1       1,899.4       1,930.6  
  

 

 

   

 

 

   

 

 

 

Subtotal

     43,796.3       46,253.3       47,400.8  

Deduct:

      

Disallowed servicing assets and deferred tax assets

     1,265.2       1,278.9       1,353.2  
  

 

 

   

 

 

   

 

 

 

Average total assets for leverage capital purposes

   $ 42,531.1     $ 44,974.4     $ 46,047.6  
  

 

 

   

 

 

   

 

 

 

Total risk-weighted assets(2)

   $ 18,741.8     $ 19,849.9     $ 22,244.0  

Tier 1 leverage ratio (Tier 1 capital / Average total assets for leverage capital purposes)

     6.0     5.5     5.5

Tier 1 capital / Total risk-weighted assets

     13.6     12.5     11.4

Total capital / Total risk-weighted assets

     14.8     13.7     12.6

 

(1)   

The Company included 100% of its trust preferred securities (“TRUPs”) in E*TRADE Financial’s Tier 1 capital due to the delay in the implementation of the TRUPs phase-out by regulatory agencies. If the TRUPs phase-out had been implemented, E*TRADE Financial’s Tier 1 leverage ratio would have been 5.7% at March 31, 2013.

(2)   

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

As of March 31, 2013, the parent company Tier 1 leverage ratio was approximately 6.0% compared to the minimum ratio required to be “well capitalized” of 5%, the Tier 1 risk-based capital ratio was approximately 13.6% compared to the minimum ratio required to be “well capitalized” of 6%, and the total risk-based capital ratio was approximately 14.8% compared to the minimum ratio required to be “well capitalized” of 10%.

 

21


Table of Contents

Our Tier 1 common ratio, which is a non-GAAP measure and currently has no mandated minimum or “well capitalized” standard, was 11.2% as of March 31, 2013. We believe this ratio is an important measure of our capital strength. The Tier 1 common ratio is defined as Tier 1 capital less elements of Tier 1 capital that are not in the form of common equity, such as trust preferred securities, divided by total risk-weighted assets. The following table shows the calculation of the Tier 1 common ratio (dollars in millions):

 

     March 31,
2013
    December 31,
2012
    March 31,
2012
 

Shareholders’ equity

   $ 4,951.8     $ 4,904.5     $ 5,035.9  

Deduct:

      

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

     (304.4     (315.4     (345.3

Goodwill and other intangible assets, net of deferred tax liabilities

     1,883.1       1,899.4       1,930.6  
  

 

 

   

 

 

   

 

 

 

Subtotal

     3,373.1       3,320.5       3,450.6  

Deduct:

      

Disallowed servicing assets and deferred tax assets

     1,265.2       1,278.9       1,353.2  
  

 

 

   

 

 

   

 

 

 

Tier 1 common

   $ 2,107.9     $ 2,041.6     $ 2,097.4  
  

 

 

   

 

 

   

 

 

 

Total risk-weighted assets

   $ 18,741.8     $ 19,849.9     $ 22,244.0  

Tier 1 common ratio (Tier 1 common / Total risk-weighted assets)

     11.2     10.3     9.4

In June 2012, the U.S. Federal banking agencies published notices of proposed rulemaking for comment related to the implementation of the Basel III framework for the calculation and components of a banking organization’s regulatory capital and a U.S. version of the international standardized approach for calculating a banking organization’s risk-weighted assets. In November 2012, the banking agencies announced a delay in the implementation of Basel III in the U.S. and have not yet issued final Basel III rules. We believe the most relevant elements of the proposal to us relate to the proposed risk-weighting of mortgage loans and margin receivables in addition to the inclusion in the calculation of Common Tier 1 capital of unrealized gains (losses) on all available-for-sale debt securities. Under the current proposal, we do not believe the incorporation of these elements have a significant impact on our current capital ratios; however, the final impact of the Basel III capital standards on regulatory requirements will remain uncertain until the final rules implementing Basel III are adopted for U.S. institutions. We will continue to monitor the ongoing rule-making and comment process to assess both the timing and the impact of the Dodd-Frank Act and Basel III capital standards on our business.

On October 9, 2012, the Federal Reserve adopted final regulations implementing the requirement for certain Federal Reserve-regulated savings and loan holding companies, including the Company, to conduct company-run stress tests on an annual basis. Under the Federal Reserve’s stress test regulations, we will be required to utilize stress-testing methodologies providing for results under at least three different sets of conditions, including baseline, adverse, and severely adverse conditions. The final regulations will apply to the Company in the fall of the calendar year after it becomes subject to minimum capital requirements, a period which has not yet been specified. We conducted a company-run stress test for the Company, which we believe is consistent with the Federal Reserve’s methodologies, and provided the results to the Federal Reserve with the submission of the long-term strategic and capital plan in February 2013.

Also on October 9, 2012, the OCC adopted final regulations implementing the requirement for national banks or federal savings associations with over $10 billion in average total consolidated assets, including E*TRADE Bank, to conduct company-run stress tests on an annual basis. Under the OCC’s stress test regulations, E*TRADE Bank also will be required to utilize stress-testing methodologies providing for results under at least three different sets of conditions, including baseline, adverse and severely adverse scenarios. The final regulations require E*TRADE Bank to conduct its first stress test using financial statement data as of

 

22


Table of Contents

September 30, 2013, and it will be required to report results to the OCC on or before March 31, 2014. We conducted a company-run stress test for E*TRADE Bank, which we believe is consistent with the OCC’s methodologies, and provided the results to the OCC with submission of the long-term strategic and capital plan in February 2013.

Other Sources of Liquidity

We also maintain uncommitted lines of credit with unaffiliated banks to finance margin lending, with available balances subject to approval when utilized. At March 31, 2013, there were no outstanding balances.

We rely on borrowed funds, from sources such as securities sold under agreements to repurchase and FHLB advances, to provide liquidity for E*TRADE Bank. Our ability to borrow these funds is dependent upon the continued availability of funding in the wholesale borrowings market. In addition, we can borrow from the Federal Reserve Bank’s discount window to meet short-term liquidity requirements, although it is not viewed as a primary source of funding. At March 31, 2013, E*TRADE Bank had approximately $3.7 billion and $1.0 billion in additional collateralized borrowing capacity with the FHLB and the Federal Reserve Bank, respectively. We also have the ability to generate liquidity in the form of additional deposits by raising the yield on our customer deposit account products.

Off-Balance Sheet Arrangements

We enter into various off-balance-sheet arrangements in the ordinary course of business, primarily to meet the needs of our customers and to reduce our own exposure to interest rate risk. These arrangements include firm commitments to extend credit and letters of credit. Additionally, we enter into guarantees and other similar arrangements as part of transactions in the ordinary course of business. For additional information on each of these arrangements, see Item 1. Consolidated Financial Statements (unaudited).

RISK MANAGEMENT

As a financial services company, our business exposes us to certain risks. The identification, mitigation and management of existing and potential risks are key to effective enterprise risk management. There are certain risks that are inherent to our business (e.g. execution of transactions) whereas other risks will present themselves through the conduct of that business. We seek to monitor and manage our significant risk exposures through a set of board-approved limits as well as Key Risk Indicators (“KRIs”) or metrics. We have in place a governance framework that regularly reports metrics, major risks and exposures to senior management and the Board of Directors. During 2013, we will continue to enhance our risk management culture and capabilities while complying with evolving regulatory guidelines and expectations.

We developed a Board-approved Risk Appetite Statement (“RAS”) which was disseminated to all employees and specifies the significant risks we are exposed to and our tolerance of those risks. As described in the RAS, our business exposes us to the following eight major categories of risk:

 

   

Credit Risk—the risk of loss arising from the inability or failure of a borrower or counterparty to meet its credit obligations.

 

   

Interest Rate Risk—the risk of loss of income or value of future income due to changes in interest rates arising from the Company’s balance sheet position. This includes convexity risk, which arises from optionality in the balance sheet, related to deposit flows or to prepayments in mortgage assets.

 

   

Liquidity Risk—the potential inability to meet contractual and contingent financial obligations either on- or off-balance sheet, as they come due.

 

   

Market Risk—the risk that asset values or income streams will be adversely affected by changes in market prices.

 

 

23


Table of Contents
   

Operational Risk—the risk of loss due to failure of people, processes and systems, or damage to physical assets caused by unexpected events.

 

   

Strategic Risk—sometimes called business risk, is the risk of loss of market size, market share or margin in any business.

 

   

Reputational Risk—the potential that negative perceptions regarding our conduct or business practices will adversely affect valuation, profitability, operations or customer base or require costly litigation or other measures.

 

   

Legal, Regulatory and Compliance Risk—the current and prospective risk to earnings or capital arising from violations of, or non-conformance with, laws, rules, regulations, prescribed practices, internal policies, and procedures, or ethical standards.

For additional information about our interest rate risk, see Item 3. Quantitative and Qualitative Disclosures about Market Risk. For additional information on liquidity risk, see Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources. Market risk, operational risk, strategic risk, reputational risk and legal, regulatory and compliance risk and the management of risk are more fully described in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the year ended December 31, 2012. We are also subject to other risks that could impact our business, financial condition, results of operations or cash flows in future periods. See Item 1A. Risk Factors in the Annual Report on Form 10-K for the year ended December 31, 2012.

Credit Risk Management

Credit risk is the risk of loss arising from the inability or failure of a borrower or counterparty to meet its credit obligations. We are exposed to credit risk in the following areas:

 

   

We hold credit risk exposure in our loan portfolio. We are not currently originating or purchasing loans for investment. Even though the portfolio is running off, losses are likely to remain significant.

 

   

We extend margin loans to our brokerage customers which exposes us to the risk of credit losses in the event we cannot liquidate collateral during significant market movements.

 

   

We engage in financial transactions with counterparties which expose us to credit losses in the event a counterparty cannot meet its obligations. These financial transactions include our invested cash, securities lending, repurchase and reverse repurchase agreements and derivatives contracts, as well as the settlement of trades.

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

Loss Mitigation on the Loan Portfolio

We have a credit risk operations team that focuses on the mitigation of potential losses in the loan portfolio. Through a variety of strategies, including voluntary line closures, automatically freezing lines on all delinquent accounts, and freezing lines on loans with materially reduced home equity, we have reduced our exposure to open home equity lines from a high of over $7 billion in 2007 to $0.3 billion as of March 31, 2013.

 

24


Table of Contents

We have an initiative to assess our servicing relationships and, where appropriate, transfer certain mortgage loans to servicers that specialize in managing troubled assets. We believe this initiative has improved and will continue to improve the credit performance of the loans transferred in future periods when compared to the expected credit performance of these same loans if they had not been transferred. A total of $2.7 billion of our mortgage loans were held at servicers that specialize in managing troubled assets as of March 31, 2013.

We have a loan modification program that focuses on the mitigation of potential losses in the loan portfolio. We consider modifications in which we make an economic concession to a borrower experiencing financial difficulty a TDR. During the three months ended March 31, 2013, we modified $31.5 million and $2.8 million of one- to four-family and home equity loans, respectively, in which the modification was considered a TDR.

We also processed minor modifications on a number of loans through traditional collections actions taken in the normal course of servicing delinquent accounts. These actions typically result in an insignificant delay in the timing of payments; therefore, we do not consider such activities to be economic concessions to the borrowers. As of March 31, 2013 and December 31, 2012, we had $33.0 million and $33.4 million of mortgage loans, respectively, in which the modification was not considered a TDR due to the insignificant delay in the timing of payments. Approximately 4% and 8% of these loans were classified as nonperforming as of March 31, 2013 and December 31, 2012, respectively.

We continue to review the mortgage loan portfolio in order to identify loans to be repurchased by the originator. Our review is primarily focused on identifying loans with violations of transaction representations and warranties or material misrepresentation on the part of the seller. Any loans identified with these deficiencies are submitted to the original seller for repurchase. During the first quarter of 2013, we agreed to a settlement with a third party mortgage originator specific to loans sold to us by this originator. A one-time payment of $12.5 million was agreed upon to satisfy in full all pending and future repurchase requests with this specific originator. We applied the full amount in the first quarter of 2013 to the allowance for loan losses, resulting in a corresponding reduction to net charge-offs as well as provision for loan losses. Approximately $14.5 million of loans were repurchased by or settled with the original sellers for the three months ended March 31, 2013. A total of $421.0 million of loans have been repurchased by the original sellers, including global settlements, since we actively started reviewing our purchased loan portfolio beginning in 2008.

CONCENTRATIONS OF CREDIT RISK

Loans

We track and review factors to predict and monitor credit risk in the mortgage loan portfolio on an ongoing basis. These factors include: loan type, estimated current loan-to-value (“LTV”)/combined loan-to-value (“CLTV”) ratios, delinquency history, documentation type, borrowers’ current credit scores, housing prices, loan vintage and geographic location of the property. In economic conditions in which housing prices generally appreciate, we believe that loan type, LTV/CLTV ratios, documentation type and credit scores are the key factors in determining future loan performance. In a housing market with declining home prices and less credit available for refinance, we believe the LTV/CLTV ratio becomes a more important factor in predicting and monitoring credit risk. These factors are updated on at least a quarterly basis. We track and review delinquency status to predict and monitor credit risk in the consumer and other loan portfolio on at least a quarterly basis.

The home equity loan portfolio is primarily second lien loans on residential real estate properties, which have a higher level of credit risk than first lien mortgage loans. Approximately 15% of the home equity loan portfolio was in the first lien position as of March 31, 2013. We hold both the first and second lien positions in less than 1% of the home equity loan portfolio. The home equity loan portfolio consists of approximately 21% of home equity installment loans and approximately 79% of home equity lines of credit.

Home equity installment loans are primarily fixed rate and fixed term, fully amortizing loans that do not offer the option of an interest-only payment. The majority of home equity lines of credit convert to amortizing

 

25


Table of Contents

loans at the end of the draw period, which typically ranges from five to ten years. At March 31, 2013, the 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 80% of the home equity line of credit portfolio will not begin amortizing until after 2014. However, during the year ended December 31, 2012, approximately 40% of our borrowers made voluntary annual principal payments of at least $500 on their home equity lines of credit and approximately half of those borrowers reduced their principal balance by at least $2,500 during the year ended December 31, 2012. The following table outlines when home equity lines of credit convert to amortizing for the home equity line of credit portfolio as of March 31, 2013:

 

Period of Conversion to Amortizing Loan

   % of Home Equity Line
of Credit Portfolio

Already amortizing

   9%

Through December 31, 2013

   4%

Year ending December 31, 2014

   7%

Year ending December 31, 2015

   26%

Year ending December 31, 2016

   41%

Year ending December 31, 2017

   13%

Additionally, in the current and anticipated interest rate environment, we do not expect interest rate resets to be a material driver of credit costs in the near future. As of March 31, 2013, a total of $2.5 billion of one- to four-family loans had already reset for the first time and another $2.2 billion were expected to reset for the first time in the next five years. We expect approximately $1.9 billion in one- to four-family loans that have already reset to experience another interest rate reset in the remainder of 2013. We estimate that less than 1% of all one- to four-family loans expected to reset in the remainder of 2013 will experience a payment increase of more than 10% and nearly 80% are expected to reset to a lower payment in the remainder of 2013. The following table outlines the percentage of one- to four-family loans that have reset and are expected to reset for the first time as of March 31, 2013:

 

Period of First Interest Rate Reset

   % of Total One- to Four-Family
First Resets

Already reset

   54%

Through December 31, 2013

   2%

Year ending December 31, 2014

   5%

Year ending December 31, 2015

   5%

Year ending December 31, 2016

   15%

Year ending December 31, 2017

   19%

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

 

     One- to Four-Family     Home Equity  

Current LTV/CLTV (1)

   March 31,
2013
    December 31,
2012
    March 31,
2013
    December 31,
2012
 

<=80%

   $ 1,419.4     $ 1,324.2     $ 954.8     $ 927.5  

80%-100%

     1,434.9       1,404.4       800.0       776.2  

100%-120%

     1,141.0       1,231.5       899.7       932.0  

>120%

     1,221.8       1,482.1       1,366.6       1,587.7  
  

 

 

   

 

 

   

 

 

   

 

 

 

Total mortgage loans receivable

   $ 5,217.1     $ 5,442.2     $ 4,021.1     $ 4,223.4  
  

 

 

   

 

 

   

 

 

   

 

 

 

Average estimated current LTV/CLTV (2)

     104.7     108.1     111.0     113.8

Average LTV/CLTV at loan origination (3)

     71.3     71.2     79.4     79.4

 

(1)   

Current CLTV calculations for home equity loans are based on the maximum available line for home equity lines of credit and outstanding principal balance for home equity installment loans. Current property values are updated on a quarterly basis using the most recent property value data available to us. For properties in which we did not have an updated valuation, we utilized home price indices to estimate the current property value.

(2)   

The average estimated current LTV/CLTV ratio reflects the outstanding balance at the balance sheet date and the maximum available line for home equity lines of credit, divided by the estimated current value of the underlying property.

(3)   

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

 

26


Table of Contents
     One- to Four-Family      Home Equity  

Documentation Type

   March 31,
2013
     December 31,
2012
     March 31,
2013
     December 31,
2012
 

Full documentation

   $ 2,211.1      $ 2,317.9      $ 2,057.0      $ 2,166.5  

Low/no documentation

     3,006.0        3,124.3        1,964.1        2,056.9  
  

 

 

    

 

 

    

 

 

    

 

 

 

Total mortgage loans receivable

   $ 5,217.1      $ 5,442.2      $ 4,021.1      $ 4,223.4  
  

 

 

    

 

 

    

 

 

    

 

 

 

 

     One- to Four-Family      Home Equity  

Current FICO (1)

   March 31,
2013
     December 31,
2012
     March 31,
2013
     December 31,
2012
 

>=720

   $ 2,658.5      $ 2,819.5      $ 2,105.4      $ 2,238.3  

719 - 700

     487.3        498.1        410.1        417.9  

699 - 680

     416.8        425.5        333.7        345.8  

679 - 660

     320.8        347.2        268.8        279.7  

659 - 620

     442.7        494.0        355.5        370.3  

<620

     891.0        857.9        547.6        571.4  
  

 

 

    

 

 

    

 

 

    

 

 

 

Total mortgage loans receivable

   $ 5,217.1      $ 5,442.2      $ 4,021.1      $ 4,223.4  
  

 

 

    

 

 

    

 

 

    

 

 

 

 

(1)   

FICO scores are updated on a quarterly basis; however, as of March 31, 2013 and December 31, 2012, there were some loans for which the updated FICO scores were not available. The current FICO distribution as of March 31, 2013 included original FICO scores for approximately $115 million and $12 million of one- to four-family and home equity loans, respectively. The current FICO distribution as of December 31, 2012 included original FICO scores for approximately $121 million and $20 million of one- to four-family and home equity loans, respectively.

 

     One- to Four-Family      Home Equity  

Vintage Year

   March 31,
2013
     December 31,
2012
     March 31,
2013
     December 31,
2012
 

2003 and prior

   $ 179.9      $ 190.4      $ 201.1      $ 218.2  

2004

     491.8        514.3        337.1        359.7  

2005

     1,043.3        1,095.1        1,078.3        1,131.3  

2006

     2,041.9        2,123.4        1,876.8        1,962.9  

2007

     1,456.2        1,515.0        519.0        542.2  

2008

     4.0        4.0        8.8        9.1  
  

 

 

    

 

 

    

 

 

    

 

 

 

Total mortgage loans receivable

   $ 5,217.1      $ 5,442.2      $ 4,021.1      $ 4,223.4  
  

 

 

    

 

 

    

 

 

    

 

 

 

Average age of mortgage loans receivable (years)

     6.9        6.7        7.2        6.9  
     One- to Four-Family      Home Equity  

Geographic Location

   March 31,
2013
     December 31,
2012
     March 31,
2013
     December 31,
2012
 

California

   $ 2,465.3      $ 2,568.7      $ 1,271.6      $ 1,333.3  

New York

     369.5        386.4        298.2        313.1  

Florida

     349.4        368.3        284.2        298.9  

Virginia

     229.1        235.0        182.5        192.1  

Other states

     1,803.8        1,883.8        1,984.6        2,086.0  
  

 

 

    

 

 

    

 

 

    

 

 

 

Total mortgage loans receivable

   $ 5,217.1      $ 5,442.2      $ 4,021.1      $ 4,223.4  
  

 

 

    

 

 

    

 

 

    

 

 

 

Approximately 40% of the Company’s real estate loans were concentrated in California at both March 31, 2013 and December 31, 2012. No other state had concentrations of real estate loans that represented 10% or more of the Company’s real estate portfolio.

 

27


Table of Contents

Allowance for Loan Losses

The allowance for loan losses is management’s estimate of probable losses inherent in the loan portfolio as of the balance sheet date. The estimate of the allowance for loan losses is based on a variety of quantitative and qualitative factors, including the composition and quality of the portfolio; delinquency levels and trends; current and historical charge-off and loss experience; our historical loss mitigation experience; the condition of the real estate market and geographic concentrations within the loan portfolio; the interest rate climate; the overall availability of housing credit; and general economic conditions. The allowance for loan losses is typically equal to management’s forecast of loan losses in the twelve months following the balance sheet date as well as the forecasted losses, including economic concessions to borrowers, over the estimated remaining life of loans modified as TDRs. The general allowance for loan losses also included a qualitative component to account for a variety of factors that are not directly considered in the quantitative loss model but are factors we believe may impact the level of credit losses. The qualitative component was $60 million and $44 million at March 31, 2013 and December 31, 2012, respectively.

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

 

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

March 31, 2013

  $ 161.0       3.07   $ 263.1       6.49   $ 30.9       4.13   $ 455.0       4.53

December 31, 2012

  $ 183.9       3.37   $ 257.3       6.04   $ 39.5       4.62   $ 480.7       4.54

 

(1)   

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

During the three months ended March 31, 2013, the allowance for loan losses decreased by $25.7 million from the level at December 31, 2012, primarily driven by improving credit trends and loan portfolio run-off. The following table shows the trend of the ratio of the general allowance for loan losses, excluding the qualitative component, to loans that are 90+ days delinquent excluding modified TDRs (dollars in millions):

 

     Total 90+ Days Delinquent
Loans, Excluding
Modified TDRs
     General Allowance for
Loan Losses Before
Qualitative
Component
     Coverage
Ratio
 

March 31, 2013

   $     310.0      $     247.3        80

December 31, 2012

   $ 348.7      $ 265.2        76

September 30, 2012

   $ 383.3      $ 276.5        72

June 30, 2012

   $ 432.6      $ 290.4        67

March 31, 2012

   $ 520.9      $ 326.6        63

Troubled Debt Restructurings

TDRs include loan modifications completed under our programs that involve granting an economic concession to a borrower experiencing financial difficulty, as well as loans that have been charged-off based on the estimated current value of the underlying property less estimated selling costs due to bankruptcy notification. As of March 31, 2013, we had $206.7 million net investment of TDRs that had been charged-off due to bankruptcy notification, $108.1 million of which were classified as performing.

 

28


Table of Contents

The following table shows the TDRs by delinquency category as of March 31, 2013 and December 31, 2012 (dollars in millions):

 

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

TDRs
 

March 31, 2013

              

One- to four-family

   $ 915.9      $ 115.5      $ 60.1      $ 125.0      $ 1,216.5  

Home equity

     228.3        17.5        9.7        19.5        275.0  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 1,144.2      $ 133.0      $ 69.8      $ 144.5      $ 1,491.5  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

December 31, 2012

              

One- to four-family

   $ 927.6      $ 118.8      $ 48.6      $ 134.1      $ 1,229.1  

Home equity

     231.9        17.6        7.9        19.6        277.0  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 1,159.5      $ 136.4      $ 56.5      $ 153.7      $ 1,506.1  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

TDRs on accrual status, which are current and have made six or more consecutive payments, were $942.4 million and $981.4 million at March 31, 2013 and December 31, 2012, respectively.

Troubled Debt Restructurings—Loan Modifications

The following table shows TDR loan modifications by delinquency category as of March 31, 2013 and December 31, 2012 (dollars in millions):

 

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

March 31, 2013

              

One- to four-family

   $ 830.6      $ 105.0      $ 54.1      $ 80.2      $ 1,069.9  

Home equity

     187.2        14.0        6.8        6.9        214.9  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 1,017.8      $ 119.0      $ 60.9      $ 87.1      $ 1,284.8  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

December 31, 2012

              

One- to four-family

   $ 838.0      $ 105.2      $ 43.9      $ 79.1      $ 1,066.2  

Home equity

     195.0        15.1        6.2        7.1        223.4  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 1,033.0      $ 120.3      $ 50.1      $ 86.2      $ 1,289.6  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Included in allowance for loan losses was a specific valuation allowance of $148.1 million and $171.4 million that was established for modifications at March 31, 2013 and December 31, 2012, respectively. The specific valuation allowance for these individually impaired loans represents the forecasted losses over the

 

29


Table of Contents

remaining life of the loan, including the economic concession to the borrower. The following table shows TDR loan modifications and the specific valuation allowance by loan portfolio as well as the percentage of total expected losses as of March 31, 2013 and December 31, 2012 (dollars in millions):

 

    Recorded
Investment in
Modifications
before
Charge-offs
    Charge-offs     Recorded
Investment in
Modifications
    Specific
Valuation
Allowance
    Net
Investment in
Modifications
    Specific Valuation
Allowance as a %
of Modifications
    Total
Expected
Losses
 

March 31, 2013

             

One- to four-family

  $ 1,391.1     $ (321.1   $ 1,070.0     $ (81.7   $ 988.3       8     29

Home equity

    370.8       (156.0     214.8       (66.4     148.4       31     60
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

     

Total

  $ 1,761.9     $ (477.1   $ 1,284.8     $ (148.1   $ 1,136.7       12     35
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

     

December 31, 2012

             

One- to four-family

  $ 1,383.3     $ (317.1   $ 1,066.2     $ (89.7   $ 976.5       8     29

Home equity

    382.6       (159.2     223.4       (81.7     141.7       37     63
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

     

Total

  $ 1,765.9     $ (476.3   $ 1,289.6     $ (171.4   $ 1,118.2       13     37
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

     

The recorded investment in TDR loan modifications includes the charge-offs related to certain loans that were written down to the estimated current value of the underlying property less estimated costs to sell. These charge-offs were recorded on modified loans that were delinquent in excess of 180 days or in bankruptcy and on TDRs when certain characteristics of the loan, including CLTV, borrower’s credit and type of modification, cast substantial doubt on the borrower’s ability to repay the loan. The total expected loss on TDR loan modifications includes both the previously recorded charge-offs and the specific valuation allowance. Total expected losses on TDR loan modifications decreased slightly from 37% at December 31, 2012 to 35% at March 31, 2013.

Net Charge-offs

The following table provides an analysis of the allowance for loan losses and net charge-offs for the three months ended March 31, 2013 and 2012 (dollars in millions):

 

     Charge-offs     Recoveries(1)      Net
Charge-offs
    % of Average
Loans
(Annualized)
 

Three Months Ended March 31, 2013

                         

One- to four-family

   $ (18.8   $ 12.5      $ (6.3     0.47

Home equity

     (57.4     7.9        (49.5     4.65

Consumer and other

     (16.2     3.6        (12.6     6.10
  

 

 

   

 

 

    

 

 

   

Total

   $ (92.4   $ 24.0      $ (68.4     2.63
  

 

 

   

 

 

    

 

 

   

Three Months Ended March 31, 2012

                         

One- to four-family

   $ (90.5   $ —        $ (90.5     5.61

Home equity

     (225.0     9.8        (215.2     15.90

Consumer and other

     (12.9     3.0        (9.9     3.64
  

 

 

   

 

 

    

 

 

   

Total

   $ (328.4   $ 12.8      $ (315.6     9.74
  

 

 

   

 

 

    

 

 

   

 

(1)   

Recoveries include the impact of mortgage originator settlements.

Loan losses are recognized when it is probable that a loss has been incurred. The charge-off policy for both one- to four-family and home equity loans is to assess the value of the property when the loan has been delinquent for 180 days or is in bankruptcy, regardless of whether or not the property is in foreclosure, and

 

30


Table of Contents

charge-off the amount of the loan balance in excess of the estimated current value of the underlying property less estimated costs to sell. TDRs are charged-off when they are identified as collateral dependent based on the terms of the modification, which includes assigning a higher level of risk to loans in which the LTV or CLTV is greater than 110%, a borrower’s credit score is less than 600 and certain types of modifications, such as interest-only payments and terms longer than 30 years. Consumer loans are charged-off when the loan has been 120 days delinquent or when it is determined that collection is not probable.

Net charge-offs for the three months ended March 31, 2013 compared to the same period in 2012 decreased by $247.2 million. During the first quarter of 2012, we completed an evaluation of certain programs and practices that were designed in accordance with guidance from our former regulator, the OTS, which resulted in loan modification policies and procedures being aligned with the guidance from the OCC and a significant increase in charge-offs during the first quarter of 2012. Net charge-offs for the three months ended March 31, 2013 included a $12.5 million benefit recorded from a settlement with a third party mortgage originator during the first quarter of 2013. The timing and magnitude of charge-offs are affected by many factors and we anticipate variability from quarter to quarter while continuing to see a downward trend over the long term.

Nonperforming Assets

We classify loans as nonperforming when they are no longer accruing interest, which includes loans that are 90 days and greater past due, TDRs that are on nonaccrual status for all classes of loans and certain junior liens that have a delinquent senior lien. The following table shows the comparative data for nonperforming loans and assets (dollars in millions):

 

     March 31,
2013
    December 31,
2012
 

One- to four-family

   $ 644.4     $ 639.1  

Home equity

     223.9       247.5  

Consumer and other

     2.0       6.4  
  

 

 

   

 

 

 

Total nonperforming loans

     870.3       893.0  

REO and other repossessed assets, net

     58.1       71.2  
  

 

 

   

 

 

 

Total nonperforming assets, net

   $ 928.4     $ 964.2  
  

 

 

   

 

 

 

Nonperforming loans receivable as a percentage of gross loans receivable

     8.67     8.44

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

     24.98     28.77

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

     117.51     103.96

Consumer and other allowance for loan losses as a percentage of consumer and other nonperforming loans

     1545.00     617.19

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

     52.28     53.83

During the three months ended March 31, 2013, nonperforming assets, net decreased $35.8 million to $928.4 million when compared to December 31, 2012. This was attributed primarily to a decrease in home equity nonperforming loans driven by improving credit trends.

Delinquent Loans

We believe the distinction between loans delinquent 90 to 179 days and loans delinquent 180 days and greater is important as loans delinquent 180 days and greater have been written down to their expected recovery value, whereas loans delinquent 90 to 179 days have not (unless they are in process of bankruptcy or are modifications that have substantial doubt as to the borrower’s ability to repay the loan). We believe loans delinquent 90 to 179 days are an important measure because these loans are expected to drive the vast majority of

 

31


Table of Contents

future charge-offs. Additional charge-offs on loans delinquent 180 days and greater are possible if home prices decline beyond current expectations, but we do not anticipate these charge-offs to be significant, particularly when compared to the expected charge-offs on loans delinquent 90 to 179 days. We expect the balances of one- to four-family loans delinquent 180 days and greater to decline over time; however, we expect the balances to remain at high levels in the near term due to the extensive amount of time it takes to foreclose on a property in the current real estate market. The following table shows the comparative data for loans delinquent 90 to 179 days (dollars in millions):

 

     March 31,
2013
    December 31,
2012
 

One- to four-family

   $ 99.9     $ 94.7  

Home equity

     52.5       64.2  

Consumer and other loans

     2.0       6.2  
  

 

 

   

 

 

 

Total loans delinquent 90-179 days

   $ 154.4     $ 165.1  
  

 

 

   

 

 

 

Loans delinquent 90-179 days as a percentage of gross loans receivable

     1.54     1.56

In addition to nonperforming assets, we monitor loans in which a borrower’s current credit history casts doubt on their ability to repay a loan. We classify loans as special mention when they are between 30 and 89 days past due. The following table shows the comparative data for special mention loans (dollars in millions):

 

     March 31,
2013
    December 31,
2012
 

One- to four-family

   $ 220.2     $ 233.8  

Home equity

     76.1       89.3  

Consumer and other loans

     15.8       19.1  
  

 

 

   

 

 

 

Total special mention loans

   $ 312.1     $ 342.2  
  

 

 

   

 

 

 

Special mention loans receivable as a percentage of gross loans receivable

     3.11     3.23

The trend in special mention loan balances is generally indicative 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. One- to four-family loans are generally secured in a first lien position by real estate assets, reducing the potential loss when compared to an unsecured loan. Home equity loans are generally secured by real estate assets; however, the majority of these loans are secured in a second lien position, which substantially increases the potential loss when compared to a first lien position. The loss severity of our second lien home equity loans is approximately 95%.

During the three months ended March 31, 2013, special mention loans decreased by $30.1 million to $312.1 million and are down 69% from their peak of $1.0 billion as of December 31, 2008. This decrease was largely due to a decrease in both one- to four-family and home equity special mention loans. While the level of special mention loans can fluctuate significantly in any given period, we believe the continued decrease is an encouraging sign regarding the future credit performance of the mortgage loan portfolio.

 

32


Table of Contents

Securities

We focus primarily on security type and credit rating to monitor credit risk in our securities portfolios. The table below details the amortized cost of municipal bonds, corporate bonds and non-agency debt securities by average credit ratings and type of asset as of March 31, 2013 and December 31, 2012 (dollars in millions):

 

March 31, 2013

   AAA      AA      A      BBB      Below
Investment
Grade and
Non-Rated
     Total  

Municipal bonds and corporate bonds

   $ 10.3      $ 19.9      $ —        $ 5.5      $ —        $ 35.7  

Non-agency CMOs

     —          —          —          —          21.1        21.1  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 10.3      $ 19.9      $ —        $ 5.5      $ 21.1      $ 56.8  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

December 31, 2012

   AAA      AA      A      BBB      Below
Investment
Grade and
Non-Rated
     Total  

Municipal bonds and corporate bonds

   $ 10.3      $ 19.9      $ —        $ 5.5      $ —        $ 35.7  

Non-agency CMOs

     3.9        3.0        7.4        8.2        237.6        260.1  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 14.2      $ 22.9      $ 7.4      $ 13.7      $ 237.6      $ 295.8  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

We also held $22.3 billion and $22.5 billion of agency mortgage-backed securities and CMOs, agency debentures and agency debt securities at March 31, 2013 and December 31, 2012, respectively. We consider securities backed by the U.S. government or its agencies to have low credit risk as the long-term debt rating of the U.S. government is AA+ by S&P and AAA by Moody’s and Fitch.

Certain non-agency CMOs were other-than-temporarily impaired as a result of the deterioration in the expected credit performance of the underlying loans in those specific securities. As of March 31, 2013, we held approximately $21.1 million in amortized cost of non-agency CMOs that had been other-than-temporarily impaired. We recorded $1.2 million and $3.5 million of net impairment for the three months ended March 31, 2013 and 2012, respectively, related to other-than-temporarily impaired non-agency CMOs. During the three months ended March 31, 2013, we sold $230.5 million amortized cost of available-for-sale non-agency CMOs as part of our focus to reduce risk and deleverage the balance sheet. Further declines in the performance of our remaining non-agency CMO portfolio could result in additional impairments in future periods.

SUMMARY OF CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Our discussion and analysis of our financial condition and results of operations are based on our consolidated financial statements, which have been prepared in conformity with GAAP. Note 1–Organization, Basis of Presentation and Summary of Significant Accounting Policies of Item 8. Financial Statements and Supplementary Data in the Company’s Annual Report on Form 10-K for the year ended December 31, 2012 contains a summary of our significant accounting policies, many of which require the use of estimates and assumptions that affect the amounts reported in the consolidated financial statements and related notes for the periods presented. We believe that of our significant accounting policies, the following are noteworthy because they are based on estimates and assumptions that require complex and subjective judgments by management: allowance for loan losses; valuation of goodwill and other intangible assets; estimates of effective tax rates, deferred taxes and valuation allowance; classification and valuation of certain investments; accounting for derivative instruments; and fair value measurements. Changes in these estimates or assumptions could materially impact our financial condition and results of operations and actual results could differ from our estimates. These policies are more fully described in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the year ended December 31, 2012.

 

33


Table of Contents

GLOSSARY OF TERMS

2009 Debt Exchange—In the third quarter of 2009, we exchanged $1.7 billion aggregate principal amount of our corporate debt, including $1.3 billion principal amount of the 12  1/2% springing lien notes due November 2017 and $0.4 billion principal amount of the 8% senior notes due June 2011, for an equal principal amount of newly-issued non-interest-bearing convertible debentures due 2019.

Active accounts—Accounts with a balance of $25 or more or a trade in the last six months.

Active customers—Customers that have an account with a balance of $25 or more or a trade in the last six months.

Active Trader—The customer group that includes those who execute 30 or more trades per quarter.

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

Agency—U.S. Government sponsored and federal agencies, such as Federal National Mortgage Association, Federal Home Loan Mortgage Corporation, Government National Mortgage Association, the Small Business Administration and the Federal Home Loan Bank.

ALCO—Asset Liability Committee.

AML—Anti-Money Laundering.

APIC—Additional paid-in capital.

Average commission per trade—Total trading and investing segment commissions revenue divided by total number of trades.

Average equity to average total assets—Average total shareholders’ equity divided by average total assets.

Bank—ETB Holdings, Inc. (“ETBH”), the entity that is our bank holding company and parent to E*TRADE Bank.

Basis point—One one-hundredth of a percentage point.

BCBS—International Basel Committee on Banking Supervision.

BOLI—Bank-Owned Life Insurance.

Brokerage account attrition rate—Attriting brokerage accounts, which are gross new brokerage accounts less net new brokerage accounts, divided by total brokerage accounts at the previous period end.

CAMELS rating—A U.S. supervisory rating of a bank’s overall condition. The components of the rating consist of Capital adequacy, Asset quality, Management, Earnings, Liquidity and Sensitivity to market risk.

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

CFPB—Consumer Financial Protection Bureau.

 

34


Table of Contents

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

CLTV—Combined loan-to-value.

CMOs—Collateralized mortgage obligations.

Corporate cash—Cash held at the parent company as well as cash held in certain subsidiaries that can distribute cash to the parent company without any regulatory approval.

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

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

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

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

DIF—Depositors Insurance Fund.

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

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

Enterprise interest-earning assets—Consists of the primary interest-earning assets of the Company and includes: loans, available-for-sale securities, held-to-maturity securities, margin receivables, trading securities, securities borrowed balances and cash and investments required to be segregated under regulatory guidelines that earn interest for the Company.

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

Enterprise net interest margin—The enterprise net operating interest income divided by total enterprise interest-earning assets.

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

Exchange-traded funds (“ETFs”)—A fund that invests in a group of securities and trades like an individual stock on an exchange.

 

35


Table of Contents

Fair value—The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

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

Fannie Mae—Federal National Mortgage Association.

FASB—Financial Accounting Standards Board.

FCA—United Kingdom Financial Conduct Authority.

FDIC—Federal Deposit Insurance Corporation.

Federal Reserve—Board of Governors of the Federal Reserve System.

FHLB—Federal Home Loan Bank.

FICO—Fair Isaac Credit Organization.

FINRA—Financial Industry Regulatory Authority.

Fixed charge coverage ratio—Net income before taxes, depreciation and amortization and corporate interest expense divided by corporate interest expense. This ratio indicates the Company’s ability to satisfy fixed financing expenses.

Forex—A type of trade that involves buying one currency while simultaneously selling another. Currencies are traded in pairs consisting of a “base currency” and a “quote currency.”

Freddie Mac—Federal Home Loan Mortgage Corporation.

Generally Accepted Accounting Principles (“GAAP”)—Accounting principles generally accepted in the United States of America.

Ginnie Mae—Government National Mortgage Association.

Gross loans receivable—Includes unpaid principal balances and premiums (discounts).

IFRS—International Financial Reporting Standards.

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

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

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

 

36


Table of Contents

LIBOR—London Interbank Offered Rate. LIBOR is the interest rate at which banks borrow funds from other banks in the London wholesale money market (or interbank market).

Long-term investor—The customer group that includes those who invest for the long term.

LTV—Loan-to-value.

NASDAQ—National Association of Securities Dealers Automated Quotations.

Net new customer asset flows—The total inflows to all new and existing customer accounts less total outflows from all closed and existing customer accounts, excluding the effects of market movements in the value of customer assets.

NOLs—Net operating losses.

Nonperforming assets—Assets that do not earn income, including those originally acquired to earn income (nonperforming loans) and those not intended to earn income (REO). Loans are classified as nonperforming when they are no longer accruing interest, which includes loans that are 90 days and greater past due, TDRs that are on nonaccrual status for all classes of loans and certain junior liens that have a delinquent senior lien.

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

NYSE—New York Stock Exchange.

OCC—Office of the Comptroller of the Currency.

Operating margin—Income before other income (expense), income tax expense and discontinued operations, if applicable.

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

OTTI—Other-than-temporary impairment.

OTS—Office of Thrift Supervision.

Real estate owned (“REO”) and other repossessed assets—Ownership or physical possession of real property by the Company, generally acquired as a result of foreclosure or repossession.

Recovery—Cash proceeds received on a loan that had been previously charged off.

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

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

Return on average total assets—Annualized net income divided by average assets.

Return on average total shareholders’ equity—Annualized net income divided by average shareholders’ equity.

 

37


Table of Contents

Risk-weighted assets—Primarily computed by the assignment of specific risk-weightings assigned by the regulators to assets and off-balance sheet instruments for capital adequacy calculations.

S&P—Standard & Poor’s.

SEC—U.S. Securities and Exchange Commission.

Special mention loans—Loans where a borrower’s current credit history casts doubt on their ability to repay a loan. Loans are classified as special mention when loans are between 30 and 89 days past due.

Stock plan trades—Trades that originate from our corporate services business, which provides software and services to assist corporate customers in managing their equity compensation plans. The trades typically occur when an employee of a corporate customer exercises a stock option or sells restricted stock.

Sweep deposit accounts—Accounts with the functionality to transfer brokerage cash balances to and from a FDIC insured account at the banking subsidiaries.

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

Tier 1 capital—Adjusted equity capital used in the calculation of capital adequacy ratios. Tier 1 capital equals: total shareholders’ equity, plus/(less) unrealized losses (gains) on available-for-sale securities and cash flow hedges and qualifying restricted core capital elements, less disallowed servicing and deferred tax assets, goodwill and certain other intangible assets.

Troubled Debt Restructuring (“TDR”)—A loan modification that involves granting an economic concession to a borrower who is experiencing financial difficulty, and loans that have been charged-off due to bankruptcy notification.

Wholesale borrowings—Borrowings that consist of securities sold under agreements to repurchase and FHLB advances and other borrowings.

ITEM 3.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The following discussion about market risk disclosure includes forward-looking statements. Actual results could differ materially from those projected in the forward-looking statements as a result of certain factors, including, but not limited to, those set forth in Item 1A. Risk Factors in the Annual Report on Form 10-K for the year ended December 31, 2012.

Interest Rate Risk

Our exposure to interest rate risk is related primarily to interest-earning assets and interest-bearing liabilities, the vast majority of which are held for non-trading purposes. The management of interest rate risk is essential to profitability. The primary objective of the management of interest rate risk is to control exposure to interest rates within the Board-approved limits, as outlined in the scenario analysis below, and with limited exposure to earnings volatility resulting from interest rate fluctuations. Our general strategies to manage interest rate risk include balancing variable-rate and fixed-rate assets and liabilities and utilizing derivatives in a way that

 

38


Table of Contents

reduces overall exposure to changes in interest rates. Exposure to interest rate risk requires management to make complex assumptions regarding maturities, market interest rates and customer behavior. Changes in interest rates, including the following, could impact interest income and expense:

 

   

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

 

   

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

 

   

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

Exposure to interest rate risk is dependent upon the distribution and composition of interest-earning assets, interest-bearing liabilities and derivatives. The differing risk characteristics of each product are managed to mitigate our exposure to interest rate fluctuations. At March 31, 2013, 90% of our total assets were enterprise interest-earning assets.

At March 31, 2013, approximately 64% of total assets were residential real estate loans and available-for-sale and held-to-maturity mortgage-backed securities. The values of these assets are sensitive to changes in interest rates, as well as expected prepayment levels. As interest rates increase, fixed rate residential mortgages and mortgage-backed securities tend to exhibit lower prepayments. The inverse is true in a falling rate environment.

When real estate loans prepay, unamortized premiums are written off. Depending on the timing of the prepayment, the write-offs of unamortized premiums may result in lower than anticipated yields. The Asset Liability Committee (“ALCO”) reviews estimates of the impact of changing market rates on prepayments. This information is incorporated into our interest rate risk management strategy.

Our liability structure consists of two central sources of funding: deposits and wholesale borrowings. Cash provided to us through deposits is the primary source of funding. Key deposit products include sweep accounts, complete savings accounts and other money market and savings accounts. Wholesale borrowings include securities sold under agreements to repurchase and FHLB advances. Other sources of funding include customer payables, which is customer cash contained within our broker-dealers, and corporate debt issued by the parent company.

Deposit accounts and customer payables tend to be less rate-sensitive than wholesale borrowings. Agreements to repurchase securities and the majority of FHLB advances re-price as agreements reset. Sweep accounts, complete savings accounts and other money market and savings accounts re-price at management’s discretion. Corporate debt has fixed rates.

Derivative Instruments

We use derivative instruments to help manage interest rate risk. Interest rate swaps involve the exchange of fixed-rate and variable-rate interest payments between two parties based on a contractual underlying notional amount, but do not involve the exchange of the underlying notional amounts. Option products are utilized primarily to decrease the market value changes resulting from the prepayment dynamics of the mortgage portfolio, as well as to protect against increases in funding costs. The types of options employed include Cap Options (“Caps”), Floor Options (“Floors”), “Payor Swaptions” and “Receiver Swaptions”. Caps mitigate the market risk associated with increases in interest rates while Floors mitigate the risk associated with decreases in market interest rates. Similarly, Payor and Receiver Swaptions mitigate the market risk associated with the respective increases and decreases in interest rates. See derivative instruments discussion in Note 6—Accounting for Derivative Instruments and Hedging Activities in Item 1. Consolidated Financial Statements (Unaudited).

 

39


Table of Contents

Scenario Analysis

Scenario analysis is an advanced approach to estimating interest rate risk exposure. Under the Economic Value of Equity (“EVE”) approach, the present value of all existing interest-earning assets, interest-bearing liabilities, derivatives and forward commitments are estimated and then combined to produce an EVE figure. The approach values only the current balance sheet in which the most significant assumptions are the prepayment rates of the loan portfolio and mortgage-backed securities and the repricing of deposits. This approach does not incorporate assumptions related to business growth, or liquidation and re-investment of instruments. This approach provides an indicator of future earnings and capital levels because changes in EVE indicate the anticipated change in the value of future cash flows. The sensitivity of this value to changes in interest rates is then determined by applying alternative interest rate scenarios, which include, but are not limited to, instantaneous parallel shifts up 100, 200 and 300 basis points and down 100 basis points. The change in EVE amounts fluctuate based on the parallel shifts in interest rates primarily due to the change in timing of cash flows in the Company’s residential loan and mortgage-backed securities portfolios. Expected prepayment rates on residential mortgage loans and mortgage-backed securities increase as interest rates decline. In a rising interest rate environment, expected prepayment rates decrease.

The EVE method is used at the E*TRADE Bank level and not for the Company. The ALCO monitors E*TRADE Bank’s interest rate risk position. E*TRADE Bank had nearly 100% of enterprise interest-earning assets at both March 31, 2013 and December 31, 2012, respectively, and held 99% of enterprise interest-bearing liabilities at both March 31, 2013 and December 31, 2012, respectively. The sensitivity of EVE at March 31, 2013 and December 31, 2012 and the limits established by E*TRADE Bank’s Board of Directors are listed below (dollars in millions):

 

Parallel Change in
Interest Rates (basis points)(1)

  Change in EVE        
  March 31, 2013     December 31, 2012        
  Amount     Percentage(2)     Amount     Percentage(2)     Board Limit  
+300   $ (618.8     (14.7 )%    $ (446.3     (11.1 )%      (25 )% 
+200   $ (313.0     (7.4 )%    $ (168.5     (4.2 )%      (15 )% 
+100   $ (68.3     (1.6 )%    $ 23.6       0.6     (10 )% 
-100   $ (155.8     (3.7 )%    $ (175.6     (4.4 )%      (10 )% 

 

(1)   

On March 31, 2013 and December 31, 2012, the yield for the three-month treasury bill was 0.07% and 0.05%, respectively. As a result, the requirements of the EVE model were temporarily modified, resulting in the removal of the minus 200 and 300 basis points scenarios for the periods ended March 31, 2013 and December 31, 2012.

(2)   

The percentage change represents the amount of change in EVE divided by the base EVE as calculated in the current interest rate environment.

We actively manage interest rate risk positions. As interest rates change, we will re-adjust our strategy and mix of assets, liabilities and derivatives to optimize our position. For example, a 100 basis points increase in rates may not result in a change in value as indicated above. The Company compares the parallel shift in interest rate changes in EVE to the established board limits in order to assess the Company’s interest rate risk on a monthly basis. In the event that the percentage change in EVE exceeds the board limits, E*TRADE Bank’s Chief Risk Officer, Chief Financial Officer and Treasurer must all be promptly notified in writing and decide upon a plan of remediation. In addition, E*TRADE Bank’s Board of Directors must be promptly notified of the exception and the planned resolution.

 

40


Table of Contents

PART I-FINANCIAL INFORMATION

ITEM 1.    CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

E*TRADE FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF INCOME

(In thousands, except per share amounts)

(Unaudited)

 

     Three Months Ended
March 31,
 
     2013     2012  

Revenue:

    

Operating interest income

   $ 300,060     $ 362,261  

Operating interest expense

     (58,731     (77,409
  

 

 

   

 

 

 

Net operating interest income

     241,329       284,852  
  

 

 

   

 

 

 

Commissions

     100,732       107,431  

Fees and service charges

     32,510       31,998  

Principal transactions

     21,746       24,146  

Gains on loans and securities, net

     15,680       34,906  

Other-than-temporary impairment (“OTTI”)

     (568     (12,634

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

     (597     9,102  
  

 

 

   

 

 

 

Net impairment

     (1,165     (3,532

Other revenues

     9,033       9,596  
  

 

 

   

 

 

 

Total non-interest income

     178,536       204,545  
  

 

 

   

 

 

 

Total net revenue

     419,865       489,397  
  

 

 

   

 

 

 

Provision for loan losses

     42,650       71,947  

Operating expense:

    

Compensation and benefits

     95,651       92,278  

Advertising and market development

     36,584       47,588  

Clearing and servicing

     31,644       34,555  

FDIC insurance premiums

     29,291       28,362  

Professional services

     17,302       20,335  

Occupancy and equipment

     17,516       17,854  

Communications

     18,514       19,120  

Depreciation and amortization

     23,048       22,239  

Amortization of other intangibles

     6,067       6,296  

Facility restructuring and other exit activities

     7,569       (424

Other operating expenses

     12,349       18,036  
  

 

 

   

 

 

 

Total operating expense

     295,535       306,239  
  

 

 

   

 

 

 

Income before other income (expense) and income tax expense

     81,680       111,211  

Other income (expense):

    

Corporate interest income

     13       14  

Corporate interest expense

     (28,620     (45,125

Equity in income (loss) of investments and other

     4,294       (106
  

 

 

   

 

 

 

Total other income (expense)

     (24,313     (45,217
  

 

 

   

 

 

 

Income before income tax expense

     57,367       65,994  

Income tax expense

     22,243       3,403  
  

 

 

   

 

 

 

Net income

   $ 35,124     $ 62,591  
  

 

 

   

 

 

 

Basic earnings per share

   $ 0.12     $ 0.22  

Diluted earnings per share

   $ 0.12     $ 0.22  

Shares used in computation of per share data:

    

Basic

     286,626       285,478  

Diluted

     291,696       290,017  

See accompanying notes to consolidated financial statements

 

41


Table of Contents

E*TRADE FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME

(In thousands)

(Unaudited)

 

     Three Months Ended
March 31,
 
     2013     2012  

Net income

   $ 35,124     $ 62,591  

Other comprehensive income

    

Available-for-sale securities:

    

OTTI, net(1)

     352       7,889  

Noncredit portion of OTTI reclassification (into) out of other comprehensive income, net(2)

     371       (5,684

Unrealized gains (losses), net(3)

     (6,037     36,175  

Reclassification into earnings, net(4)

     (9,791     (21,816
  

 

 

   

 

 

 

Net change from available-for-sale securities

     (15,105     16,564  
  

 

 

   

 

 

 

Cash flow hedging instruments:

    

Unrealized gains, net(5)

     5,975       8,396  

Reclassification into earnings, net(6)

     20,128       19,327  
  

 

 

   

 

 

 

Net change from cash flow hedging instruments

     26,103       27,723  
  

 

 

   

 

 

 

Foreign currency translation gains (losses), net

     (6     725  
  

 

 

   

 

 

 

Other comprehensive income

     10,992       45,012  
  

 

 

   

 

 

 

Comprehensive income

   $ 46,116     $ 107,603  
  

 

 

   

 

 

 

 

(1)   

Amounts are net of benefit from income taxes of $0.2 million and $4.7 million for the three months ended March 31, 2013 and 2012, respectively.

(2)   

Amounts are net of provision for income taxes of $0.2 million and benefit from income taxes of $3.4 million for the three months ended March 31, 2013 and 2012, respectively.

(3)   

Amounts are net of benefit from income taxes of $3.7 million and provision for income taxes of $21.8 million for the three months ended March 31, 2013 and 2012, respectively.

(4)   

Amounts are net of provision for income taxes of $6.0 million and $13.1 million for the three months ended March 31, 2013 and 2012, respectively.

(5)   

Amounts are net of provision for income taxes of $3.8 million and $5.2 million for the three months ended March 31, 2013 and 2012, respectively.

(6)   

Amounts are net of benefit from income taxes of $12.8 million and $11.9 million for the three months ended March 31, 2013 and 2012, respectively.

See accompanying notes to the consolidated financial statements

 

42


Table of Contents

E*TRADE FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEET

(In thousands, except share data)

(Unaudited)

 

     March 31,     December 31,  
     2013     2012  
ASSETS     

Cash and equivalents

   $ 1,507,722     $ 2,761,494  

Cash required to be segregated under federal or other regulations

     318,817       376,898  

Trading securities

     100,538       101,270  

Available-for-sale securities

     12,676,378       13,443,020  

Held-to-maturity securities (fair value of $10,173,470 at March 31, 2013 and $9,910,496 at December 31, 2012)

     9,856,513       9,539,948  

Margin receivables

     5,748,626       5,804,041  

Loans receivable, net (net of allowance for loan losses of $455,032 at March 31, 2013 and $480,751 at December 31, 2012)

     9,585,286       10,098,723  

Investment in FHLB stock

     61,400       67,400  

Property and equipment, net

     278,266       288,170  

Goodwill

     1,934,232       1,934,232  

Other intangibles, net

     254,555       260,622  

Other assets

     2,643,981       2,710,921  
  

 

 

   

 

 

 

Total assets

   $ 44,966,314     $ 47,386,739  
  

 

 

   

 

 

 

LIABILITIES AND SHAREHOLDERS’ EQUITY

    

Liabilities:

    

Deposits

   $ 25,877,748     $ 28,392,552  

Securities sold under agreements to repurchase

     4,459,421       4,454,661  

Customer payables

     5,084,337       4,964,922  

FHLB advances and other borrowings

     1,265,489       1,260,916  

Corporate debt

     1,765,905       1,764,982  

Other liabilities

     1,561,587       1,644,236  
  

 

 

   

 

 

 

Total liabilities

     40,014,487       42,482,269  
  

 

 

   

 

 

 

Commitments and contingencies (see Note 13)

    

Shareholders’ equity:

    

Common stock, $0.01 par value, shares authorized: 400,000,000 at March 31, 2013 and December 31, 2012, shares issued and outstanding: 286,776,149 at March 31, 2013 and 286,114,334 at December 31, 2012

     2,868       2,861  

Additional paid-in-capital (“APIC”)

     7,320,491       7,319,257  

Accumulated deficit

     (2,072,596     (2,107,720

Accumulated other comprehensive loss

     (298,936     (309,928
  

 

 

   

 

 

 

Total shareholders’ equity

     4,951,827       4,904,470  
  

 

 

   

 

 

 

Total liabilities and shareholders’ equity

   $ 44,966,314     $ 47,386,739  
  

 

 

   

 

 

 

See accompanying notes to the consolidated financial statements

 

43


Table of Contents

E*TRADE FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY

(In thousands)

(Unaudited)

 

     Common Stock      Additional
Paid-in Capital
    Accumulated
Deficit
    Accumulated
Other
Comprehensive
Loss
    Total
Shareholders’
Equity
 
   Shares      Amount           

Balance, December 31, 2012

     286,114      $ 2,861      $ 7,319,257     $ (2,107,720   $ (309,928   $ 4,904,470  

Net income

     —          —          —         35,124       —          35,124  

Other comprehensive income

     —          —          —         —         10,992       10,992  

Exercise of stock options and related tax effects

     12        —          (3,624     —         —         (3,624

Issuance of restricted stock, net of forfeitures and retirements to pay taxes

     650        7        (4,458     —         —         (4,451

Share-based compensation

     —          —          9,316       —         —         9,316  
  

 

 

    

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

Balance, March 31, 2013

     286,776      $ 2,868      $ 7,320,491     $ (2,072,596   $ (298,936   $ 4,951,827  
  

 

 

    

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 
     Common Stock      Additional
Paid-in Capital
    Accumulated
Deficit
    Accumulated
Other
Comprehensive
Loss
    Total
Shareholders’
Equity
 
   Shares      Amount           

Balance, December 31, 2011

     285,368      $ 2,854      $ 7,306,862     $ (1,995,137   $ (386,629   $ 4,927,950  

Net income

     —          —          —         62,591       —         62,591  

Other comprehensive income

     —          —          —         —         45,012       45,012  

Exercise of stock options and related tax effects

     2        —          (3,078     —         —         (3,078

Issuance of restricted stock, net of forfeitures and retirements to pay taxes

     306        3        (1,457     —         —         (1,454

Share-based compensation

     —          —          4,873       —         —         4,873  

Other

     —          —          7       —         —         7  
  

 

 

    

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

Balance, March 31, 2012

     285,676      $ 2,857      $ 7,307,207     $ (1,932,546   $ (341,617   $ 5,035,901  
  

 

 

    

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

See accompanying notes to the consolidated financial statements

 

44


Table of Contents

E*TRADE FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF CASH FLOWS

(In thousands)

(Unaudited)

 

     Three Months Ended
March 31,
 
     2013     2012  
Cash flows from operating activities:     

Net income

   $ 35,124     $ 62,591  

Adjustments to reconcile net income to net cash provided by (used in) operating activities:

    

Provision for loan losses

     42,650       71,947  

Depreciation and amortization (including discount amortization and accretion)

     113,472       92,738  

Net impairment and gains on loans and securities, net

     (14,515     (31,374

Equity in (income) loss of investments and other

     (4,294     106  

Share-based compensation

     9,316       4,873  

Deferred taxes

     17,683       (66,569

Other

     481       1,188  

Net effect of changes in assets and liabilities:

    

Decrease (increase) in cash required to be segregated under federal or other regulations

     58,081       (136,091

Decrease (increase) in margin receivables

     55,415       (459,535

Increase in customer payables

     119,415       115,355  

Proceeds from sales of loans held-for-sale

     2,010       93,071  

Originations of loans held-for-sale

     —         (95,348

Net decrease (increase) in trading securities

     732       (4,372

Decrease in other assets

     101,486       126,049  

(Decrease) increase in other liabilities

     (77,590     36,269  
  

 

 

   

 

 

 

Net cash provided by (used in) operating activities

     459,466       (189,102
  

 

 

   

 

 

 

Cash flows from investing activities:

    

Purchases of available-for-sale securities

     (1,976,909     (3,928,003

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

     2,681,770       2,076,018  

Purchases of held-to-maturity securities

     (928,807     (1,729,615

Proceeds from maturities of and principal payments on held-to-maturity securities

     593,911       162,227  

Net decrease in loans receivable

     414,304       445,434  

Capital expenditures for property and equipment

     (15,087     (22,887

Proceeds from sale of REO and repossessed assets

     22,372       29,820  

Net cash flow from derivatives hedging assets

     3,747       (38,784

Other

     6,000       (2,147
  

 

 

   

 

 

 

Net cash provided by (used in) investing activities

   $ 801,301     $ (3,007,937
  

 

 

   

 

 

 

 

See accompanying notes to the consolidated financial statements

 

45


Table of Contents

E*TRADE FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF CASH FLOWS-(Continued)

(In thousands)

(Unaudited)

 

     Three Months Ended
March 31,
 
     2013     2012  

Cash flows from financing activities:

    

Net (decrease) increase in deposits

   $ (2,514,805   $ 3,121,381  

Net increase in securities sold under agreements to repurchase

     4,760       6,754  

Advances from FHLB

     170,000       820,000  

Payments on advances from FHLB

     (170,000     (820,000

Net cash flow from derivatives hedging liabilities

     (4,475     (9,210

Other

     (19     (3,287
  

 

 

   

 

 

 

Net cash (used in) provided by financing activities

     (2,514,539     3,115,638  
  

 

 

   

 

 

 

Decrease in cash and equivalents

     (1,253,772     (81,401

Cash and equivalents, beginning of period

     2,761,494       2,099,839  
  

 

 

   

 

 

 

Cash and equivalents, end of period

   $ 1,507,722     $ 2,018,438  
  

 

 

   

 

 

 

Supplemental disclosures:

    

Cash paid for interest

   $ 39,034     $ 61,888  

Cash paid for income taxes

   $ 944     $ 3,608  

Non-cash investing and financing activities:

    

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

   $ 41,102     $ —    

Transfers from loans to other real estate owned and repossessed assets

   $ 19,252     $ 24,915  

 

See accompanying notes to the consolidated financial statements

 

46


Table of Contents

E*TRADE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

Organization—E*TRADE Financial Corporation 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.” The Company also provides investor-focused banking products, primarily sweep deposits and savings products, to retail investors.

Basis of PresentationThe consolidated financial statements include the accounts of the Company and its majority-owned subsidiaries as determined under the voting interest model. Entities in which the Company holds at least a 20% ownership interest or in which there are other indicators of significant influence are generally accounted for by the equity method. Entities in which the Company holds less than a 20% ownership interest and does not have the ability to exercise significant influence are generally carried at cost. Intercompany accounts and transactions are eliminated in consolidation. The Company also evaluates its continuing involvement with certain entities to determine if the Company is required to consolidate the entities under the variable interest entity model. This evaluation is based on a qualitative assessment of whether the Company has both: 1) the power to direct matters that most significantly impact the activities of the variable interest entity; and 2) the obligation to absorb losses or the right to receive benefits of the variable interest entity that could potentially be significant to the variable interest entity.

Certain prior period items in these consolidated financial statements have been reclassified to conform to the current period presentation. These consolidated financial statements reflect all adjustments, which are all normal and recurring in nature, necessary to present fairly the financial position, results of operations and cash flows for the periods presented. All prior periods have been adjusted to present gains on sales of investments, net and equity in income (loss) of investments and venture funds on a single line item, equity in income (loss) of investments and other, on the consolidated statement of income. These two line items were previously presented as separate line items on the consolidated statement of income.

The Company reports corporate interest income and corporate interest expense separately from operating interest income and operating interest expense. The Company believes reporting these two items separately provides a clearer picture of the financial performance of the Company’s operations than would a presentation that combined these two items. Operating interest income and operating interest expense is generated from the operations of the Company. Corporate debt, which is the primary source of corporate interest expense, has been issued primarily in connection with recapitalization transactions and past acquisitions.

Similarly, the Company reports gains on sales of investments, net separately from gains on loans and securities, net. The Company believes reporting these two items separately provides a clearer picture of the financial performance of its operations than would a presentation that combined these two items. Gains on loans and securities, net are the result of activities in the Company’s operations, namely its balance sheet management segment. Gains on sales of investments, net relate to investments of the Company at the corporate level and are not related to the ongoing business of the Company’s operating subsidiaries. Gains on sales of investments, net is reported in the equity in income (loss) of investments and other line item on the consolidated statement of income.

These consolidated financial statements should be read in conjunction with the Annual Report on Form 10-K for the year ended December 31, 2012.

Related PartiesKenneth Griffin, President and CEO of Citadel, joined the Board of Directors on June 8, 2009 pursuant to a director nomination right granted to Citadel in 2007. During the periods presented, the Company routed a portion of its customer equity orders in exchange-listed options and Regulation NMS

 

47


Table of Contents

Securities to an affiliate of Citadel for order handling and execution at current market rates. Payments for these customer equity orders represented approximately 1% of the Company’s total net revenue for both the three months ended March 31, 2013 and 2012, respectively.

Joseph M. Velli, Chairman and CEO of ConvergEx Group, joined the Board of Directors in January 2010. During the periods presented, the Company used ConvergEx Group for clearing and transfer agent services. Payments for these services represented less than 1% of the Company’s total operating expenses for the three months ended March 31, 2013 and 2012.

Use of Estimates—The consolidated financial statements were prepared in accordance with GAAP, which requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and related notes for the periods presented. Actual results could differ from management’s estimates. Certain significant accounting policies are noteworthy because they are based on estimates and assumptions that require complex and subjective judgments by management. Changes in these estimates or assumptions could materially impact the Company’s financial condition and results of operations. Material estimates in which management believes changes could reasonably occur include: allowance for loan losses; valuation of goodwill and other intangible assets; estimates of effective tax rates, deferred taxes and valuation allowance; classification and valuation of certain investments; accounting for derivative instruments; and fair value measurements.

Financial Statement Descriptions and Related Accounting Policies

Margin Receivables—The fair value of securities that the Company received as collateral in connection with margin receivables and securities borrowing activities, where the Company is permitted to sell or re-pledge the securities, was approximately $8.2 billion as of both March 31, 2013 and December 31, 2012. Of this amount, $1.6 billion and $1.5 billion had been pledged or sold in connection with securities loans, bank borrowings and deposits with clearing organizations as of March 31, 2013 and December 31, 2012, respectively.

Offsetting Assets and Liabilities—Effective January 1, 2013, the Company adopted the amended disclosure guidance about offsetting certain assets and liabilities, which required additional information about derivative instruments, repurchase agreements and securities borrowing and securities lending transactions that are offset or subject to an enforceable master netting arrangement or similar agreement. For financial statement purposes, the Company does not offset derivative instruments, repurchase agreements or securities borrowing and securities lending transactions. The Company’s derivative instruments, repurchase agreements and securities borrowing and securities lending transactions are transacted under master agreements that are widely used by counterparties and that may allow for net settlements of payments in the normal course as well as offsetting of all contracts with a given counterparty in the event of bankruptcy or default of one of the two parties to the transaction; therefore, all of these transactions are presented in the amended disclosures. The following table presents information about

 

48


Table of Contents

these transactions to enable the users of the Company’s financial statements to evaluate the potential effect of rights of setoff between these recognized assets and recognized liabilities as of March 31, 2013 and December 31, 2012 (dollars in thousands):

 

                      Gross Amounts Not Offset in
the Consolidated Balance Sheet
       
    Gross Amounts
of Recognized
Assets and
Liabilities
    Gross
Amounts
Offset in the
Consolidated
Balance
Sheet
    Net Amounts
Presented in the
Consolidated
Balance Sheet
    Financial
Instruments
    Collateral
Received or
Pledged
(Including Cash)
    Net Amount  

March 31, 2013

           

Assets:

           

Deposits paid for securities borrowed(1)(5)

  $ 464,160     $ —       $ 464,160     $ (214,344   $ (241,039   $ 8,777  

Derivative assets(1)(3)

    16,307       —         16,307       (15,122     —         1,185  
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total

  $ 480,467     $ —       $ 480,467     $ (229,466   $ (241,039   $ 9,962  
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Liabilities:

           

Repurchase agreements(4)

  $ 4,459,421     $ —       $ 4,459,421     $ —       $ (4,458,797   $ 624  

Deposits received for securities loaned(2)(6)

    786,014       —         786,014       (214,344     (521,386     50,284  

Derivative liabilities(2)(3)(4)

    289,285       —         289,285       (15,122     (274,163     —    
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total

  $ 5,534,720     $ —       $ 5,534,720     $ (229,466   $ (5,254,346   $ 50,908  
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

December 31, 2012

           

Assets:

           

Deposits paid for securities borrowed(1)(5)

  $ 407,331     $ —       $ 407,331     $ (142,410   $ (259,490   $ 5,431  

Derivative assets(1)(3)

    14,734       —         14,734       (5,176     (8,427     1,131  
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total

  $ 422,065     $ —       $ 422,065     $ (147,586   $ (267,917   $ 6,562  
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Liabilities:

           

Repurchase agreements(4)

  $ 4,454,661     $ —       $ 4,454,661     $ —       $ (4,454,659   $ 2  

Deposits received for securities loaned(2)(6)

    735,720       —         735,720       (142,410     (554,400     38,910  

Derivative liabilities(2)(3)(4)

    328,464       —         328,464       (5,176     (323,288     —    
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total

  $ 5,518,845     $ —       $ 5,518,845     $ (147,586   $ (5,332,347   $ 38,912  
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

(1)   

Net amounts presented in the consolidated balance sheet are reflected in the other assets line item.

(2)   

Net amounts presented in the consolidated balance sheet are reflected in the other liabilities line item.

(3)   

Excludes net accrued interest payable of $18.7 million and $14.1 million as of March 31, 2013 and December 31, 2012, respectively.

(4)   

The Company pledges available-for-sale and held-to-maturity securities as collateral for amounts due on repurchase agreements and derivative liabilities. The collateral pledged included available-for-sale securities at fair value and held-to-maturity securities at amortized cost for both March 31, 2013 and December 31, 2012.

(5)   

Included in the gross amounts of deposits paid for securities borrowed is $182.3 million and $93.9 million as of March 31, 2013 and December 31, 2012, respectively, transacted through a program with a clearing organization, which guarantees the return of cash to the Company. For presentation purposes, these amounts presented are based on the original counterparties to the Company’s master securities loan agreements.

(6)   

Included in the gross amounts of deposits received for securities loaned is $475.0 million and $419.6 million as of March 31, 2013 and December 31, 2012, respectively, transacted through a program with a clearing organization, which guarantees the return of securities to the Company. For presentation purposes, these amounts presented are based on the original counterparties to the Company’s master securities loan agreements.

New Accounting and Disclosure Guidance—Below is the new accounting and disclosure guidance that relates to activities in which the Company is engaged.

 

49


Table of Contents

Disclosures about Offsetting Assets and Liabilities

In December 2011, the FASB amended the disclosure guidance about offsetting assets and liabilities. The amended disclosure guidance will enable users of the Company’s financial statements to evaluate the effect or potential effect of netting arrangements on the Company’s financial position. This includes the effect or potential effect of rights of setoff between recognized assets and recognized liabilities within the scope of amended disclosure guidance, such as derivative instruments, repurchase agreements and reverse repurchase agreements, and securities borrowing and securities lending transactions. The amended disclosure guidance became effective for annual and interim periods beginning on January 1, 2013 for the Company and was applied retrospectively for all comparative periods presented. The Company’s disclosures reflect the adoption of the amended disclosure guidance in Financial Statement Descriptions and Related Accounting Policies section in Note 1—Organization, Basis of Presentation and Summary of Significant Accounting Policies.

Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income

In February 2013, the FASB amended the presentation guidance on the reporting of amounts reclassified out of accumulated other comprehensive income. The amended guidance does not change the current requirements for reporting net income or other comprehensive income in financial statements. However, the guidance amends the presentation of the amounts reclassified out of accumulated other comprehensive income by component. In addition, the amended guidance requires the presentation, either on the face of the statement where net income is presented or in the notes, of significant amounts reclassified out of accumulated other comprehensive income by the respective line items of net income. The amended guidance became effective for annual and interim periods beginning on January 1, 2013 for the Company and was applied prospectively. The Company’s disclosures reflect the adoption of the amended presentation guidance in Note 10—Shareholders’ Equity.

NOTE 2—OPERATING INTEREST INCOME AND OPERATING INTEREST EXPENSE

The following table shows the components of operating interest income and operating interest expense (dollars in thousands):

 

     Three Months Ended
March 31,
 
     2013     2012  

Operating interest income:

    

Loans

   $ 106,669     $ 139,501  

Available-for-sale securities

     64,005       105,661  

Held-to-maturity securities

     58,069       53,406  

Margin receivables

     54,447       47,990  

Securities borrowed and other

     16,870       15,703  
  

 

 

   

 

 

 

Total operating interest income

     300,060       362,261  
  

 

 

   

 

 

 

Operating interest expense:

    

Securities sold under agreements to repurchase

     (36,703     (40,764

FHLB advances and other borrowings

     (16,930     (25,422

Deposits

     (3,153     (8,342

Customer payables and other

     (1,945     (2,881
  

 

 

   

 

 

 

Total operating interest expense

     (58,731     (77,409
  

 

 

   

 

 

 

Net operating interest income

   $ 241,329     $ 284,852  
  

 

 

   

 

 

 

 

50


Table of Contents

NOTE 3—FAIR VALUE DISCLOSURES

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. In determining fair value, the Company may use various valuation approaches, including market, income and/or cost approaches. The fair value hierarchy requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. Fair value is a market-based measure considered from the perspective of a market participant. Accordingly, even when market assumptions are not readily available, the Company’s own assumptions reflect those that market participants would use in pricing the asset or liability at the measurement date. The fair value measurement accounting guidance describes the following three levels used to classify fair value measurements:

 

   

Level 1—Unadjusted quoted prices in active markets for identical assets or liabilities that are accessible by the Company.

 

   

Level 2—Quoted prices in markets that are not active or for which all significant inputs are observable, either directly or indirectly.

 

   

Level 3—Unobservable inputs that are significant to the fair value of the assets or liabilities.

The availability of observable inputs can vary and in certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, the level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement. The Company’s assessment of the significance of a particular input to a fair value measurement requires judgment and consideration of factors specific to the asset or liability.

Recurring Fair Value Measurement Techniques

U.S. Treasury Securities and Agency Debentures

The fair value measurements of U.S. Treasury securities were classified as Level 1 of the fair value hierarchy as they were based on quoted market prices in active markets. The fair value measurements of agency debentures were classified as Level 2 of the fair value hierarchy as they were based on quoted market prices observable in the marketplace.

Residential Mortgage-backed Securities

The Company’s residential mortgage-backed securities portfolio was comprised of agency mortgage-backed securities and CMOs, which represented the majority of the portfolio, and non-agency CMOs. Agency mortgage-backed securities and CMOs are guaranteed by U.S. government sponsored and federal agencies. All of the Company’s non-agency CMOs were backed by first lien mortgages and were below investment grade or non-rated as of March 31, 2013. The weighted average coupon rates for the residential mortgage-backed securities as of March 31, 2013 are shown in the following table:

 

     Weighted Average
Coupon Rate
 

Agency mortgage-backed securities

     3.16

Agency CMOs

     3.47

Non-agency CMOs

     3.43

The fair value of agency mortgage-backed securities was determined using a market approach with quoted market prices, recent market transactions and spread data for similar instruments. The fair value of agency CMOs was determined using market and income approaches with the Company’s own trading activities for identical or similar instruments. Agency mortgage-backed securities and CMOs were categorized in Level 2 of the fair value hierarchy.

 

51


Table of Contents

Non-agency CMOs were valued using market and income approaches with market observable data, including recent market transactions when available. The valuations of non-agency CMOs reflect the Company’s best estimate of what market participants would consider in pricing the financial instruments. The Company considers the price transparency for non-agency CMOs to be a key determinant of the degree of judgment involved in determining the fair value. As of March 31, 2013, the Company’s non-agency CMOs were categorized in Level 3 of the fair value hierarchy. The Company’s portfolio management group determines the fair value measurements using a discounted cash flow methodology for non-agency CMOs on a monthly basis with market observable data to the extent available. The fair value measurements, valuation techniques and level classification methodology are reviewed and compared to prior periods on a quarterly basis by management from the finance, credit, enterprise risk management and compliance departments.

The significant inputs used in the fair value measurement of non-agency CMOs are yield, default rate, loss severity and prepayment rate. Significant changes in any of those inputs in isolation would result in a significant change in the fair value. Generally, an increase in the yield, default rate or loss severity in isolation would result in a decrease in the fair value, and an increase in the prepayment rate would result in an increase in the fair value. In addition, an increase in the assumption used for the prepayment rate generally will result in an increase in yield.

The following table presents additional information about the underlying loans and significant inputs used in discounted cash flow methodologies for the valuation of non-agency CMOs that were categorized in Level 3 of the fair value hierarchy as of March 31, 2013:

 

     Weighted
Average
    Range

Underlying loans:

    

Coupon rate

     3.07   2.86% - 6.42%

Maturity (years)

     21     20 - 25

Significant inputs:

    

Yield

     4   3% - 10%

Default rate(1)

     19   4% - 53%

Loss severity

     38   16% - 66%

Prepayment rate

     8   3% - 24%

 

(1)   

The default rate reflects the implied rate necessary to equate market price to the book yield given the market credit assumption.

Other Debt Securities

The fair value measurements of agency debt securities were determined using market and income approaches along with the Company’s own trading activities for identical or similar instruments and were categorized in Level 2 of the fair value hierarchy.

The Company’s municipal bonds are revenue bonds issued by state and other local government agencies. The valuation of corporate bonds is impacted by the credit worthiness of the corporate issuer. The majority of the Company’s municipal bonds and corporate bonds were rated investment grade as of March 31, 2013. These securities were valued using a market approach with pricing service valuations corroborated by recent market transactions for identical or similar bonds. Municipal bonds and corporate bonds were categorized in Level 2 of the fair value hierarchy.

Derivative Instruments

Interest rate swap and option contracts were valued with an income approach using pricing models that are commonly used by the financial services industry. The market observable inputs used in the pricing models include the swap curve, the volatility surface, and prime or overnight indexed swap basis from a financial data provider. The Company does not consider these models to involve significant judgment on the part of

 

52


Table of Contents

management, and the Company corroborated the fair value measurements with counterparty valuations. The Company’s derivative instruments were categorized in Level 2 of the fair value hierarchy. The consideration of credit risk, the Company’s or the counterparty’s, did not result in an adjustment to the valuation of its derivative instruments in the periods presented.

Securities Owned and Securities Sold, Not Yet Purchased

Securities transactions entered into by broker-dealer subsidiaries are included in trading securities and securities sold, not yet purchased in the Company’s fair value disclosures. For equity securities, the Company’s definition of actively traded is based on average daily volume and other market trading statistics. The fair value of securities owned and securities sold, not yet purchased was determined using listed or quoted market prices and the majority were categorized in Level 1 of the fair value hierarchy.

Nonrecurring Fair Value Measurement Techniques

Loans Receivable and REO

The Company records certain other assets at fair value on a nonrecurring basis: 1) one- to four-family and home equity loans in which the amount of the loan balance in excess of the estimated current value of the underlying property less estimated costs to sell has been charged-off; and 2) real estate acquired through physical possession of property or upon foreclosure that is carried at the lower of the property’s carrying value or fair value, less estimated selling costs.

Loans that have been delinquent for 180 days or in bankruptcy are charged-off based on the estimated current value of the underlying property less estimated selling costs and are classified as nonperforming loans. These loans continue to be reported as nonperforming unless they subsequently meet the requirements for being reported as performing loans. TDRs that are charged-off based on the estimated current value of the underlying property less estimated selling costs are classified as nonperforming loans at the time of modification and return to accrual status after six consecutive payments are made in accordance with the modified terms. Property valuations for these one- to four-family and home equity loans are based on the most recent “as is” property valuation data available, which may include appraisals, broker price opinions, prices for similar properties, automated valuation models or home price indices. Subsequent to the recording of an initial fair value measurement, these loans continue to be measured at fair value on a nonrecurring basis, utilizing the estimated value of the underlying property less estimated selling costs. These property valuations are updated on a monthly, quarterly or semi-annual basis depending on the type of valuation initially used. If the value of the underlying property has declined, an additional charge-off is recorded. If the value of the underlying property has increased, previously charged-off amounts are not reversed. If the valuation data obtained is significantly different from the valuation previously received, the Company orders additional property valuation data to corroborate or update the valuation.

Property valuations for real estate acquired through physical possession of property or upon foreclosure are based on the lowest value of the most recent property valuation data available, which may include appraisals, listing prices or approved offer prices. Nonrecurring fair value measurements on one- to four-family and home equity loans and real estate owned were classified as Level 3 of the fair value hierarchy as the majority of the valuations included Level 3 inputs that were significant to the estimate of fair value.

Real estate owned and loans receivable that have been subject to fair value measurement requirements are evaluated and reviewed on a quarterly basis in accordance with policies and procedures that were designed to be in compliance with guidance from the Company’s regulators. These policies and procedures govern the frequency of the review, the use of acceptable valuation methods, and the consideration of estimated selling costs.

 

53


Table of Contents

The following table presents additional information about significant unobservable inputs used in the valuation of assets measured at fair value on a nonrecurring basis that were categorized in Level 3 of the fair value hierarchy as of March 31, 2013 (dollars in thousands):

 

     Unobservable Inputs      Average      Range  

One- to four-family

     Appraised value       $ 367      $ 25 — $2,150  

Home equity

     Appraised value       $ 264      $ 8 — $1,475  

Real estate owned

     Appraised value       $ 273      $ 13 — $1,000  

Recurring and Nonrecurring Fair Value Measurements

Assets and liabilities measured at fair value at March 31, 2013 and December 31, 2012 are summarized in the following tables (dollars in thousands):

 

     Level 1      Level 2      Level 3      Total Fair Value  

March 31, 2013:

           

Recurring fair value measurements:

           

Assets

           

Trading securities

   $ 99,576      $ 962      $ —        $ 100,538  

Available-for-sale securities:

           

Residential mortgage-backed securities:

           

Agency mortgage-backed securities and CMOs

     —          11,429,270        —          11,429,270  

Non-agency CMOs

     —          —          14,054        14,054  
  

 

 

    

 

 

    

 

 

    

 

 

 

Total residential mortgage-backed securities

     —          11,429,270        14,054        11,443,324  
  

 

 

    

 

 

    

 

 

    

 

 

 

Investment securities:

           

Agency debentures

     —          604,484        —          604,484  

Agency debt securities

     —          592,717        —          592,717  

Municipal bonds

     —          31,453        —          31,453  

Corporate bonds

     —          4,400        —          4,400  
  

 

 

    

 

 

    

 

 

    

 

 

 

Total investment securities

     —          1,233,054        —          1,233,054  
  

 

 

    

 

 

    

 

 

    

 

 

 

Total available-for-sale securities

     —          12,662,324        14,054        12,676,378  
  

 

 

    

 

 

    

 

 

    

 

 

 

Other assets:

           

Derivative assets(1)

     —          16,307        —          16,307  

Deposits with clearing organizations(2)

     30,999        —          —          30,999  
  

 

 

    

 

 

    

 

 

    

 

 

 

Total other assets measured at fair value on a recurring basis

     30,999        16,307        —          47,306  
  

 

 

    

 

 

    

 

 

    

 

 

 

Total assets measured at fair value on a recurring basis(3)

   $ 130,575      $ 12,679,593      $ 14,054      $ 12,824,222  
  

 

 

    

 

 

    

 

 

    

 

 

 

Liabilities

           

Derivative liabilities(1)

   $ —        $ 289,285      $ —        $ 289,285  

Securities sold, not yet purchased

     96,604        249        —          96,853  
  

 

 

    

 

 

    

 

 

    

 

 

 

Total liabilities measured at fair value on a recurring basis(3)

   $ 96,604      $ 289,534      $ —        $ 386,138  
  

 

 

    

 

 

    

 

 

    

 

 

 

Nonrecurring fair value measurements:(4)

           

Loans receivable:

           

One- to four-family

   $ —        $ —        $ 113,355      $ 113,355  

Home equity

     —          —          26,708        26,708  
  

 

 

    

 

 

    

 

 

    

 

 

 

Total loans receivable

     —          —          140,063        140,063  

REO

     —          —          29,522        29,522  
  

 

 

    

 

 

    

 

 

    

 

 

 

Total assets measured at fair value on a nonrecurring basis

   $ —        $ —        $ 169,585      $ 169,585  
  

 

 

    

 

 

    

 

 

    

 

 

 

 

(1)   

All derivative assets and liabilities are interest rate contracts. Information related to derivative instruments is detailed in Note 6—Accounting for Derivative Instruments and Hedging Activities.

(2)   

Represents U.S. Treasury securities held by a broker-dealer subsidiary.

(3)   

Assets and liabilities measured at fair value on a recurring basis represented 29% and 1% of the Company’s total assets and total liabilities, respectively.

(4)   

Represents the fair value of assets prior to deducting estimated selling costs that were carried on the consolidated balance sheet as of March 31, 2013, and for which a fair value measurement was recorded during the period.

 

54


Table of Contents
     Level 1      Level 2      Level 3      Total Fair Value  

December 31, 2012:

           

Recurring fair value measurements:

           

Assets

           

Trading securities

   $ 100,259      $ 1,011      $ —        $ 101,270  

Available-for-sale securities:

           

Residential mortgage-backed securities:

           

Agency mortgage-backed securities and CMOs

     —          12,097,298        —          12,097,298  

Non-agency CMOs

     —          185,668        49,495        235,163  
  

 

 

    

 

 

    

 

 

    

 

 

 

Total residential mortgage-backed securities

     —          12,282,966        49,495        12,332,461  
  

 

 

    

 

 

    

 

 

    

 

 

 

Investment securities:

           

Agency debentures

     —          527,996        —          527,996  

Agency debt securities

     —          546,762        —          546,762  

Municipal bonds

     —          31,346        —          31,346  

Corporate bonds

     —          4,455        —          4,455  
  

 

 

    

 

 

    

 

 

    

 

 

 

Total investment securities

     —          1,110,559        —          1,110,559  
  

 

 

    

 

 

    

 

 

    

 

 

 

Total available-for-sale securities

     —          13,393,525        49,495        13,443,020  
  

 

 

    

 

 

    

 

 

    

 

 

 

Other assets:

           

Derivative assets(1)

     —          14,890        —          14,890  

Deposits with clearing organizations(2)

     32,000        —          —          32,000  
  

 

 

    

 

 

    

 

 

    

 

 

 

Total other assets measured at fair value on a recurring basis

     32,000        14,890        —          46,890  
  

 

 

    

 

 

    

 

 

    

 

 

 

Total assets measured at fair value on a recurring basis(3)

   $ 132,259      $ 13,409,426      $ 49,495      $ 13,591,180  
  

 

 

    

 

 

    

 

 

    

 

 

 

Liabilities

           

Derivative liabilities(1)

   $ —        $ 328,504      $ —        $ 328,504  

Securities sold, not yet purchased

     87,088        489        —          87,577  
  

 

 

    

 

 

    

 

 

    

 

 

 

Total liabilities measured at fair value on a recurring basis(3)

   $ 87,088      $ 328,993      $ —        $ 416,081  
  

 

 

    

 

 

    

 

 

    

 

 

 

Nonrecurring fair value measurements:(4)

           

Loans receivable:

           

One- to four-family

   $ —        $ —        $ 752,008      $ 752,008  

Home equity

     —          —          90,663        90,663  
  

 

 

    

 

 

    

 

 

    

 

 

 

Total loans receivable

     —          —          842,671        842,671  

REO

     —          —          75,885        75,885  
  

 

 

    

 

 

    

 

 

    

 

 

 

Total assets measured at fair value on a nonrecurring basis

   $ —        $ —        $ 918,556      $ 918,556  
  

 

 

    

 

 

    

 

 

    

 

 

 

 

(1)   

The majority of derivative assets and liabilities are interest rate contracts. Information related to derivative instruments is detailed in Note 6—Accounting for Derivative Instruments and Hedging Activities.

(2)   

Represents U.S. Treasury securities held by a broker-dealer subsidiary.

(3)   

Assets and liabilities measured at fair value on a recurring basis represented 29% and 1% of the Company’s total assets and total liabilities, respectively.

(4)   

Represents the fair value of assets prior to deducting estimated selling costs that were carried on the consolidated balance sheet as of December 31, 2012, and for which a fair value measurement was recorded during the period.

 

55


Table of Contents

The following table presents the losses associated with the assets measured at fair value on a nonrecurring basis during the three months ended March 31, 2013 and 2012 (dollars in thousands):

 

     Three Months Ended
March 31,
 
     2013      2012  

One- to four-family

   $ 15,875      $ 100,347  

Home equity

     18,852        151,825  
  

 

 

    

 

 

 

Total losses on loans receivable measured at fair value

   $ 34,727      $ 252,172  
  

 

 

    

 

 

 

Losses on REO measured at fair value

   $ 896      $ 4,296  

Transfers Between Levels 1 and 2

For assets and liabilities measured at fair value on a recurring basis, the Company’s transfers between levels of the fair value hierarchy are deemed to have occurred at the beginning of the reporting period on a quarterly basis. The Company’s transfers of securities owned and securities sold, not yet purchased between Level 1 and 2 are generally driven by trading activities of those securities during the period. The Company had no material transfers between Level 1 and 2 during the three months ended March 31, 2013 and 2012.

Level 3 Rollforward for Recurring Fair Value Measurements

Level 3 assets and liabilities include instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation. While the Company’s fair value estimates of Level 3 instruments utilized observable inputs where available, the valuation included significant management judgment in determining the relevance and reliability of market information considered.

The following tables present additional information about Level 3 assets and liabilities measured at fair value on a recurring basis for the three months ended March 31, 2013 and 2012 (dollars in thousands):

 

     Available-for-sale
Securities
 
     Non-agency
CMOs
 

Opening balance, January 1, 2013

   $ 49,495  

Losses recognized in earnings(1)

     (1,165

Net gains recognized in other comprehensive income(2)

     1,716  

Sales

     (34,949

Settlements

     (1,043
  

 

 

 

Closing balance, March 31, 2013

   $ 14,054  
  

 

 

 

 

(1)   

Losses recognized in earnings were related to instruments held at March 31, 2013 and are reported in the net impairment line item.

(2)   

Net gains recognized in other comprehensive income are reported in the net change from available-for-sale securities line item.

 

56


Table of Contents
     Available-for-sale
Securities
 
     Non-agency
CMOs
 

Opening balance, January 1, 2012

   $ 97,106  

Losses recognized in earnings(1)

     (2,753

Net gains recognized in other comprehensive income(2)

     31  

Settlements

     (4,182

Transfer in to Level 3(3)(4)

     53,639  

Transfer out of Level 3(3)(5)

     (61,572
  

 

 

 

Closing balance, March 31, 2012

   $ 82,269  
  

 

 

 

 

(1)   

Losses recognized in earnings were related to instruments held at March 31, 2012 and are reported in the net impairment line item.

(2)   

Net gains recognized in other comprehensive income are reported in the net change from available-for-sale securities line item.

(3)   

The Company’s transfers in and out of Level 3 are as of the beginning of the reporting period on a quarterly basis.

(4)   

Non-agency CMOs transferred in to Level 3 due to a lack of observable market data, resulting from a decrease in market activity for the securities.

(5)   

Non-agency CMOs transferred out of Level 3 because observable market data became available for those securities.

The Company’s transfers of certain non-agency CMOs in and out of Level 3 are generally driven by changes in price transparency for the securities. Financial instruments for which actively quoted prices or pricing parameters are available will have a higher degree of price transparency than financial instruments that are thinly traded or not quoted. As of March 31, 2013, less than 1% of the Company’s total assets and none of its total liabilities represented instruments measured at fair value on a recurring basis categorized as Level 3.

 

57


Table of Contents

Fair Value of Financial Instruments Not Carried at Fair Value

The following table summarizes the carrying values, fair values and fair value hierarchy level classification of financial instruments that are not carried at fair value on the consolidated balance sheet at March 31, 2013 and December 31, 2012 (dollars in thousands):

 

     March 31, 2013  
     Carrying Value      Level 1      Level 2      Level 3      Total Fair Value  

Assets

              

Cash and equivalents

   $ 1,507,722      $ 1,507,722      $ —        $ —        $ 1,507,722  

Cash required to be segregated under federal or other regulations

   $ 318,817      $ 318,817      $ —        $ —        $ 318,817  

Held-to-maturity securities:

  

Agency mortgage-backed securities and CMOs

   $ 8,106,185      $ —        $ 8,356,974      $ —        $ 8,356,974  

Agency debentures

     163,439        —          169,602        —          169,602  

Agency debt securities

     1,586,889        —          1,646,894        —          1,646,894  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total held-to-maturity securities

   $ 9,856,513      $ —        $ 10,173,470      $ —        $ 10,173,470  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Margin receivables

   $ 5,748,626      $ —        $ 5,748,626      $ —        $ 5,748,626  

Loans receivable, net:

              

One- to four-family

   $ 5,078,187      $ —        $ —        $ 4,499,149      $ 4,499,149  

Home equity

     3,789,974        —          —          3,484,719        3,484,719  

Consumer and other

     717,125        —          —          738,760        738,760  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total loans receivable, net(1)

   $ 9,585,286      $ —        $ —        $ 8,722,628      $ 8,722,628  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Investment in FHLB stock

   $ 61,400      $ —        $         $ 61,400      $ 61,400  

Liabilities

              

Deposits

   $ 25,877,748      $ —        $ 25,878,474      $ —        $ 25,878,474  

Securities sold under agreement to repurchase

   $ 4,459,421      $ —        $ 4,497,790      $ —        $ 4,497,790  

Customer payables

   $ 5,084,337      $ —        $ 5,084,337      $ —        $ 5,084,337  

FHLB advances and other borrowings

   $ 1,265,489      $ —        $ 926,244      $ 206,600      $ 1,132,844  

Corporate debt

   $ 1,765,905      $ —        $ 1,889,139      $ —        $ 1,889,139  

 

(1)   

The carrying value of loans receivable, net includes the allowance for loan losses of $455.0 million and loans that are valued at fair value on a nonrecurring basis as of March 31, 2013.

 

58


Table of Contents
     December 31, 2012  
     Carrying Value      Level 1      Level 2      Level 3      Total Fair Value  

Assets

              

Cash and equivalents

   $ 2,761,494      $ 2,761,494      $ —        $ —        $ 2,761,494  

Cash required to be segregated under federal or other regulations

   $ 376,898      $ 376,898      $ —        $ —        $ 376,898  

Held-to-maturity securities:

  

Agency mortgage-backed securities and CMOs

   $ 7,887,555      $ —        $ 8,182,064      $ —        $ 8,182,064  

Agency debentures

     163,434        —          169,769        —          169,769  

Agency debt securities

     1,488,959        —          1,558,663        —          1,558,663  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total held-to-maturity securities

   $ 9,539,948      $ —        $ 9,910,496      $ —        $ 9,910,496  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Margin receivables

   $ 5,804,041      $ —        $ 5,804,041      $ —        $ 5,804,041  

Loans receivable, net:

              

One- to four-family

   $ 5,281,702      $ —        $ —        $ 4,561,821      $ 4,561,821  

Home equity

     4,002,486        —          —          3,551,357        3,551,357  

Consumer and other

     814,535        —          —          838,721        838,721  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total loans receivable, net(1)

   $ 10,098,723      $ —        $ —        $ 8,951,899      $ 8,951,899  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Investment in FHLB stock

   $ 67,400      $ —        $ —        $ 67,400      $ 67,400  

Liabilities

              

Deposits

   $ 28,392,552      $ —        $ 28,394,400      $ —        $ 28,394,400  

Securities sold under agreement to repurchase

   $ 4,454,661      $ —        $ 4,493,463      $ —        $ 4,493,463  

Customer payables

   $ 4,964,922      $ —        $ 4,964,922      $ —        $ 4,964,922  

FHLB advances and other borrowings

   $ 1,260,916      $ —        $ 926,750      $ 196,765      $ 1,123,515  

Corporate debt

   $ 1,764,982      $ —        $ 1,837,736      $ —        $ 1,837,736  

 

(1)   

The carrying value of loans receivable, net includes the allowance for loan loss of $480.7 million and loans that are valued at fair value on a nonrecurring basis as of December 31, 2012.

The fair value measurement techniques for financial instruments not carried at fair value on the consolidated balance sheet at March 31, 2013 and December 31, 2012 are summarized as follows:

Cash and equivalents, cash required to be segregated under federal or other regulations, margin receivables and customer payables—Fair value is estimated to be carrying value.

Held-to-maturity securities—The held-to-maturity securities portfolio included agency mortgage-backed securities and CMOs, agency debentures, and agency debt securities. The fair value of agency mortgage-backed securities is determined using market and income approaches with quoted market prices, recent market transactions and spread data for similar instruments. The fair value of agency CMOs and agency debt securities is determined using market and income approaches with the Company’s own trading activities for identical or similar instruments. The fair value of agency debentures is based on quoted market prices that were derived from assumptions observable in the marketplace.

Loans receivable, net—Fair value is estimated using a discounted cash flow model. Loans are differentiated based on their individual portfolio characteristics, such as product classification, loan category, pricing features and remaining maturity. Assumptions for expected losses, prepayments and discount rates are adjusted to reflect the individual characteristics of the loans, such as credit risk, coupon, term, and payment characteristics, as well as the secondary market conditions for these types of loans. There was limited or no observable market data for the home equity and one- to four-family loan portfolios, which indicates that the market for these types of loans is considered to be inactive. Given the limited market data, these fair value measurements cannot be determined with precision and changes in the underlying assumptions used, including discount rates, could significantly affect the results of current or future fair value estimates. In addition, the amount that would be realized in a forced liquidation, an actual sale or immediate settlement could be significantly lower than both the carrying value and the estimated fair value of the portfolio.

 

59


Table of Contents

Investment in FHLB stock—FHLB stock is carried at cost, which is considered to be a reasonable estimate of fair value.

Deposits—Fair value is the amount payable on demand at the reporting date for sweep deposits, complete savings deposits, other money market and savings deposits and checking deposits. For certificates of deposit and brokered certificates of deposit, fair value is estimated by discounting future cash flows using discount factors derived from current observable rates implied for other similar instruments with similar remaining maturities.

Securities sold under agreements to repurchase—Fair value is determined by discounting future cash flows using discount factors derived from current observable rates implied for other similar instruments with similar remaining maturities.

FHLB advances and other borrowings—Fair value for FHLB advances is estimated by discounting future cash flows using discount factors derived from current observable rates implied for similar instruments with similar remaining maturities. For subordinated debentures, fair value is estimated by discounting future cash flows at the rate implied by dealer pricing quotes. For margin collateral, overnight and other short-term borrowings, fair value approximates carrying value.

Corporate debt—Fair value is estimated using dealer pricing quotes. The fair value of the non-interest-bearing convertible debentures is directly correlated to the intrinsic value of the Company’s underlying stock. As the price of the Company’s stock increases relative to the conversion price, the fair value of the convertible debentures increases.

NOTE 4—AVAILABLE-FOR-SALE AND HELD-TO-MATURITY SECURITIES

The amortized cost basis and fair value of available-for-sale and held-to-maturity securities at March 31, 2013 and December 31, 2012 are shown in the following tables (dollars in thousands):

 

     Amortized
Cost
     Gross
Unrealized /
Unrecognized
Gains
     Gross
Unrealized /
Unrecognized
Losses
    Fair Value  

March 31, 2013:

          

Available-for-sale securities:

          

Residential mortgage-backed securities:

          

Agency mortgage-backed securities and CMOs

   $ 11,252,894      $ 212,231      $ (35,855   $ 11,429,270  

Non-agency CMOs

     21,062        1,473        (8,481     14,054  
  

 

 

    

 

 

    

 

 

   

 

 

 

Total residential mortgage-backed securities

     11,273,956        213,704        (44,336     11,443,324  
  

 

 

    

 

 

    

 

 

   

 

 

 

Investment securities:

          

Agency debentures

     596,692        8,047        (255     604,484  

Agency debt securities

     580,264        13,389        (936     592,717  

Municipal bonds

     30,235        1,218        —         31,453  

Corporate bonds

     5,478        —          (1,078     4,400  
  

 

 

    

 

 

    

 

 

   

 

 

 

Total investment securities

     1,212,669        22,654        (2,269     1,233,054  
  

 

 

    

 

 

    

 

 

   

 

 

 

Total available-for-sale securities

   $ 12,486,625      $ 236,358      $ (46,605   $ 12,676,378  
  

 

 

    

 

 

    

 

 

   

 

 

 

Held-to-maturity securities:

          

Residential mortgage-backed securities:

          

Agency mortgage-backed securities and CMOs

   $ 8,106,185      $ 261,782      $ (10,993   $ 8,356,974  

Investment securities:

          

Agency debentures

     163,439        6,163        —         169,602  

Agency debt securities

     1,586,889        62,338        (2,333     1,646,894  
  

 

 

    

 

 

    

 

 

   

 

 

 

Total investment securities

     1,750,328        68,501        (2,333     1,816,496  
  

 

 

    

 

 

    

 

 

   

 

 

 

Total held-to-maturity securities

   $ 9,856,513      $ 330,283      $ (13,326   $ 10,173,470  
  

 

 

    

 

 

    

 

 

   

 

 

 

 

60


Table of Contents
     Amortized
Cost
     Gross
Unrealized /
Unrecognized
Gains
     Gross
Unrealized /
Unrecognized
Losses
    Fair Value  

December 31, 2012:

          

Available-for-sale securities:

          

Residential mortgage-backed securities:

          

Agency mortgage-backed securities and CMOs

   $ 11,881,185      $ 232,905      $ (16,792   $ 12,097,298  

Non-agency CMOs

     260,064        4,362        (29,263     235,163  
  

 

 

    

 

 

    

 

 

   

 

 

 

Total residential mortgage-backed securities

     12,141,249        237,267        (46,055     12,332,461  
  

 

 

    

 

 

    

 

 

   

 

 

 

Investment securities:

          

Agency debentures

     515,990        12,434        (428     527,996  

Agency debt securities

     525,408        21,354        —         546,762  

Municipal bonds

     30,235        1,111        —         31,346  

Corporate bonds

     5,478        —          (1,023     4,455  
  

 

 

    

 

 

    

 

 

   

 

 

 

Total investment securities

     1,077,111        34,899        (1,451     1,110,559  
  

 

 

    

 

 

    

 

 

   

 

 

 

Total available-for-sale securities

   $ 13,218,360      $ 272,166      $ (47,506   $ 13,443,020  
  

 

 

    

 

 

    

 

 

   

 

 

 

Held-to-maturity securities:

          

Residential mortgage-backed securities:

          

Agency mortgage-backed securities and CMOs

   $ 7,887,555      $ 301,686      $ (7,177   $ 8,182,064  

Investment securities:

          

Agency debentures

     163,434        6,335        —         169,769  

Agency debt securities

     1,488,959        69,705        (1     1,558,663  
  

 

 

    

 

 

    

 

 

   

 

 

 

Total investment securities

     1,652,393        76,040        (1     1,728,432  
  

 

 

    

 

 

    

 

 

   

 

 

 

Total held-to-maturity securities

   $ 9,539,948      $ 377,726      $ (7,178   $ 9,910,496  
  

 

 

    

 

 

    

 

 

   

 

 

 

Contractual Maturities

The contractual maturities of all available-for-sale and held-to-maturity debt securities at March 31, 2013 are shown below (dollars in thousands):

 

     Amortized Cost      Fair Value  

Available-for-sale securities:

     

Due within one to five years

   $ 62,094      $ 63,915  

Due within five to ten years

     1,266,374        1,281,083  

Due after ten years

     11,158,157        11,331,380  
  

 

 

    

 

 

 

Total available-for-sale securities

   $ 12,486,625      $ 12,676,378  
  

 

 

    

 

 

 

Held-to-maturity securities:

     

Due within one year

   $ 84      $ 83  

Due within one to five years

     488,161        513,562  

Due within five to ten years

     2,821,346        2,972,697  

Due after ten years

     6,546,922        6,687,128  
  

 

 

    

 

 

 

Total held-to-maturity securities

   $ 9,856,513      $ 10,173,470  
  

 

 

    

 

 

 

The Company pledged $2.6 billion and $2.8 billion at March 31, 2013 and December 31, 2012, respectively, of available-for-sale securities and $3.0 billion and $2.9 billion at March 31, 2013 and December 31, 2012, respectively, of held-to-maturity securities as collateral for repurchase agreements, derivatives and other purposes.

 

61


Table of Contents

Investments with Unrecognized or Unrealized Losses

The following tables show the fair value and unrealized or unrecognized losses on available-for-sale and held-to-maturity securities, aggregated by investment category, and the length of time that individual securities have been in a continuous unrealized or unrecognized loss position at March 31, 2013 and December 31, 2012 (dollars in thousands):

 

     Less than 12 Months     12 Months or More     Total  
     Fair Value      Unrealized /
Unrecognized
Losses
    Fair Value      Unrealized /
Unrecognized
Losses
    Fair Value      Unrealized /
Unrecognized
Losses
 

March 31, 2013:

               

Available-for-sale securities:

               

Residential mortgage-backed securities:

               

Agency mortgage-backed securities and CMOs

   $ 2,914,594      $ (30,738   $ 541,537      $ (5,117   $ 3,456,131      $ (35,855

Non-agency CMOs

     —          —         11,317        (8,481     11,317        (8,481

Investment securities:

               

Agency debentures

     108,117        (255     —          —         108,117        (255

Agency debt securities

     199,065        (936     —          —         199,065        (936

Corporate bonds

     —          —         4,400        (1,078     4,400        (1,078
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Total temporarily impaired available-for-sale securities

   $ 3,221,776      $ (31,929   $ 557,254      $ (14,676   $ 3,779,030      $ (46,605
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Held-to-maturity securities:

               

Residential mortgage-backed securities:

               

Agency mortgage-backed securities and CMOs

   $ 1,868,969      $ (10,929   $ 65,687      $ (64   $ 1,934,656      $ (10,993

Agency debt securities

     322,701        (2,333     —          —         322,701        (2,333
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Total temporarily impaired held-to-maturity securities

   $ 2,191,670      $ (13,262   $ 65,687      $ (64   $ 2,257,357      $ (13,326
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

December 31, 2012:

               

Available-for-sale securities:

               

Residential mortgage-backed securities:

               

Agency mortgage-backed securities and CMOs

   $ 2,588,947      $ (16,680   $ 16,337      $ (112   $ 2,605,284      $ (16,792

Non-agency CMOs

     —          —         198,635        (29,263     198,635        (29,263

Investment securities:

               

Agency debentures

     62,786        (428     —          —         62,786        (428

Corporate bonds

     —          —         4,455        (1,023     4,455        (1,023
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Total temporarily impaired available-for-sale securities

   $ 2,651,733      $ (17,108   $ 219,427      $ (30,398   $ 2,871,160      $ (47,506
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Held-to-maturity securities:

               

Residential mortgage-backed securities:

               

Agency mortgage-backed securities and CMOs

   $ 1,240,008      $ (6,937   $ 2,427      $ (240   $ 1,242,435      $ (7,177

Agency debt securities

     84        (1     —          —         84        (1
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Total temporarily impaired held-to-maturity securities

   $ 1,240,092      $ (6,938   $ 2,427      $ (240   $ 1,242,519      $ (7,178
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

 

62


Table of Contents

The Company does not believe that any individual unrealized loss in the available-for-sale or unrecognized loss in the held-to-maturity portfolio as of March 31, 2013 represents a credit loss. The credit loss component is the difference between the security’s amortized cost basis and the present value of its expected future cash flows, and is recognized in earnings. The noncredit loss component is the difference between the present value of its expected future cash flows and the fair value and is recognized through other comprehensive income. The Company assessed whether it intends to sell, or whether it is more likely than not that the Company will be required to sell a security before recovery of its amortized cost basis. For debt securities that are considered other-than-temporarily impaired and that the Company does not intend to sell as of the balance sheet date and will not be required to sell prior to recovery of its amortized cost basis, the Company determines the amount of the impairment that is related to credit and the amount due to all other factors.

The majority of the unrealized or unrecognized losses on mortgage-backed securities are attributable to changes in interest rates and a re-pricing of risk in the market. Agency mortgage-backed securities and CMOs, agency debentures and agency debt securities are guaranteed by U.S. government sponsored and federal agencies. Municipal bonds and corporate bonds are evaluated by reviewing the credit-worthiness of the issuer and general market conditions. The Company does not intend to sell the securities in an unrealized or unrecognized loss position as of the balance sheet date and it is not more likely than not that the Company will be required to sell the debt securities before the anticipated recovery of its remaining amortized cost of the securities in an unrealized or unrecognized loss position at March 31, 2013.

The majority of the Company’s available-for-sale and held-to-maturity portfolio consists of residential mortgage-backed securities. For residential mortgage-backed securities, the Company calculates the credit portion of OTTI by comparing the present value of the expected future cash flows with the amortized cost basis of the security. The expected future cash flows are determined using the remaining contractual cash flows adjusted for future credit losses. The estimate of expected future credit losses includes the following assumptions: 1) expected default rates based on current delinquency trends, foreclosure statistics of the underlying mortgages and loan documentation type; 2) expected loss severity based on the underlying loan characteristics, including loan-to-value, origination vintage and geography; and 3) expected loan prepayments and principal reduction based on current experience and existing market conditions that may impact the future rate of prepayments. The expected cash flows of the security are then discounted at the interest rate used to recognize interest income on the security to arrive at the present value amount. The following table presents a summary of the significant inputs considered for securities that were other-than-temporarily impaired as of March 31, 2013:

 

     March 31, 2013
     Weighted
Average
    Range

Default rate(1)

     7   4% - 25%

Loss severity

     51   45% - 70%

Prepayment rate

     6   2% - 8%

 

(1)   

Represents the expected default rate for the next twelve months.

 

63


Table of Contents

The following table presents a roll forward for the three months ended March 31, 2013 and 2012 of the credit loss component on debt securities held by the Company that had a noncredit loss recognized in other comprehensive income and had a credit loss recognized in earnings (dollars in thousands):

 

     Three Months Ended
March 31,
 
     2013     2012  

Credit loss balance, beginning of period

   $ 186,722     $ 202,945  

Additions:

    

Subsequent credit impairment

     1,165       3,532  

Securities sold

     (23,393     —    
  

 

 

   

 

 

 

Credit loss balance, end of period(1)

   $ 164,494     $ 206,477  
  

 

 

   

 

 

 

 

(1)   

The credit loss balance at March 31, 2013 included $113.7 million of credit losses associated with debt securities that have been factored to zero, but the Company still holds legal title to these securities until maturity or until they are sold.

Within the securities portfolio, the highest concentration of credit risk is the non-agency CMO portfolio. As of March 31, 2013, the Company held approximately $21.1 million in amortized cost of non-agency CMO securities that had been other-than-temporarily impaired as a result of deterioration in the expected credit performance of the underlying loans in the securities. The following table shows the components of net impairment for the three months ended March 31, 2013 and 2012 (dollars in thousands):

 

     Three Months Ended
March 31,
 
     2013     2012  

Other-than-temporary impairment (“OTTI”)

   $ (568   $ (12,634

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

     (597     9,102  
  

 

 

   

 

 

 

Net impairment

   $ (1,165   $ (3,532
  

 

 

   

 

 

 

Gains on Loans and Securities, Net

The detailed components of the gains on loans and securities, net line item on the consolidated statement of income for the three months ended March 31, 2013 and 2012 are as follows (dollars in thousands):

 

     Three Months Ended
March 31,
 
     2013     2012  

Gains (losses) on loans, net

   $ 2     $ (7

Gains on securities, net

    

Gains on available-for-sale securities and other investments

     24,192       34,937  

Losses on available-for-sale securities and other investments

     (8,401     —    

Gains on trading securities, net

     —         1  

Hedge ineffectiveness

     (113     (25
  

 

 

   

 

 

 

Gains on securities, net

     15,678       34,913  
  

 

 

   

 

 

 

Gains on loans and securities, net

   $ 15,680     $ 34,906  
  

 

 

   

 

 

 

During the first quarter of 2013, the Company sold $230.5 million in amortized cost of its available-for-sale non-agency CMOs for proceeds of approximately $227 million, which resulted in a pre-tax net loss of $3.8 million.

 

64


Table of Contents

NOTE 5—LOANS RECEIVABLE, NET

Loans receivable, net at March 31, 2013 and December 31, 2012 are summarized as follows (dollars in thousands):

 

     March 31,     December 31,  
     2013     2012  

One- to four-family

   $ 5,217,118     $ 5,442,174  

Home equity

     4,021,046       4,223,461  

Consumer and other

     739,820       844,942  
  

 

 

   

 

 

 

Total loans receivable

     9,977,984       10,510,577  

Unamortized premiums, net

     62,334       68,897  

Allowance for loan losses

     (455,032     (480,751
  

 

 

   

 

 

 

Total loans receivable, net

   $ 9,585,286     $ 10,098,723  
  

 

 

   

 

 

 

At March 31, 2013, we pledged $7.8 billion and $0.7 billion of loans as collateral to the FHLB and Federal Reserve Bank, respectively. At December 31, 2012, we pledged $8.2 billion and $0.8 billion of loans as collateral to the FHLB and Federal Reserve Bank, respectively. Additionally, the Company’s entire loans receivable portfolio was serviced by other companies at March 31, 2013 and December 31, 2012.

The following table represents the breakdown of the total recorded investment in loans receivable and allowance for loan losses by loans that have been collectively evaluated for impairment and those that have been individually evaluated for impairment at March 31, 2013 and December 31, 2012 (dollars in thousands):

 

     Recorded Investment      Allowance for Loan Losses  
     March 31,
2013
     December 31,
2012
     March 31,
2013
     December 31,
2012
 

Loans collectively evaluated for impairment

   $ 8,548,789      $ 9,073,326      $ 306,926      $ 309,377  

Loans individually evaluated for impairment (TDRs)

     1,491,529        1,506,148        148,106        171,374  
  

 

 

    

 

 

    

 

 

    

 

 

 

Total loans evaluated for impairment

   $ 10,040,318      $ 10,579,474      $ 455,032      $ 480,751  
  

 

 

    

 

 

    

 

 

    

 

 

 

Credit Quality

The Company tracks and reviews factors to predict and monitor credit risk in its mortgage loan portfolio on an ongoing basis. These factors include: loan type, estimated current LTV/CLTV ratios, delinquency history, documentation type, borrowers’ current credit scores, housing prices, loan vintage and geographic location of the property. In economic conditions in which housing prices generally appreciate, the Company believes that loan type, LTV/CLTV ratios, documentation type and credit scores are the key factors in determining future loan performance. In a housing market with declining home prices and less credit available for refinance, the Company believes the LTV/CLTV ratio becomes a more important factor in predicting and monitoring credit risk. The factors are updated on at least a quarterly basis. The Company tracks and reviews delinquency status to predict and monitor credit risk in the consumer and other loan portfolio on at least a quarterly basis.

The home equity loan portfolio is primarily second lien loans on residential real estate properties, which have a higher level of credit risk than first lien mortgage loans. Approximately 15% of the home equity portfolio was in the first lien position as of March 31, 2013. The Company holds both the first and second lien positions in less than 1% of the home equity loan portfolio. The home equity loan portfolio consists of approximately 21% of home equity installment loans and approximately 79% of home equity lines of credit.

 

65


Table of Contents

Home equity installment loans are primarily fixed rate and fixed term, fully amortizing loans that do not offer the option of an interest-only payment. The majority of home equity lines of credit convert to amortizing loans at the end of the draw period, which typically ranges from five to ten years. At March 31, 2013, the 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 80% of the home equity line of credit portfolio will not begin amortizing until after 2014. The following table outlines when home equity lines of credit convert to amortizing for the home equity line of credit portfolio as of March 31, 2013:

 

Period of Conversion to Amortizing Loan

   % of Home Equity Line of Credit
Portfolio
 

Already amortizing

     9

Through December 31, 2013

     4

Year ending December 31, 2014

     7

Year ending December 31, 2015

     26

Year ending December 31, 2016

     41

Year ending December 31, 2017

     13

The following tables show the distribution of the Company’s mortgage loan portfolios by credit quality indicator at March 31, 2013 and December 31, 2012 (dollars in thousands):

 

     One- to Four-Family     Home Equity  

Current LTV/CLTV (1)

   March 31,
2013
    December 31,
2012
    March 31,
2013
    December 31,
2012
 

<=80%

   $ 1,419,410     $ 1,324,167     $ 954,727     $ 927,559  

80%-100%

     1,434,958       1,404,415       800,021       776,199  

100%-120%

     1,140,987       1,231,448       899,677       932,033  

>120%

     1,221,763       1,482,144       1,366,621       1,587,670  
  

 

 

   

 

 

   

 

 

   

 

 

 

Total mortgage loans receivable

   $ 5,217,118     $ 5,442,174     $ 4,021,046     $ 4,223,461  
  

 

 

   

 

 

   

 

 

   

 

 

 

Average estimated current LTV/CLTV (2)

     104.7     108.1     111.0     113.8

Average LTV/CLTV at loan origination (3)

     71.3     71.2     79.4     79.4

 

(1)   

Current CLTV calculations for home equity loans are based on the maximum available line for home equity lines of credit and outstanding principal balance for home equity installment loans. Current property values are updated on a quarterly basis using the most recent property value data available to the Company. For properties in which the Company did not have an updated valuation, it utilized home price indices to estimate the current property value.

(2)   

The average estimated current LTV/CLTV ratio reflects the outstanding balance at the balance sheet date and the maximum available line for home equity lines of credit, divided by the estimated current value of the underlying property.

(3)   

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

 

     One- to Four-Family      Home Equity  
     March 31,      December 31,      March 31,      December 31,  

Documentation Type

   2013      2012      2013      2012  

Full documentation

   $ 2,211,060      $ 2,317,933      $ 2,056,966      $ 2,166,554  

Low/no documentation

     3,006,058        3,124,241        1,964,080        2,056,907  
  

 

 

    

 

 

    

 

 

    

 

 

 

Total mortgage loans receivable

   $ 5,217,118      $ 5,442,174      $ 4,021,046      $ 4,223,461  
  

 

 

    

 

 

    

 

 

    

 

 

 

 

66


Table of Contents
     One- to Four-Family      Home Equity  
     March 31,      December 31,      March 31,      December 31,  

Current FICO (1)

   2013      2012      2013      2012  

>=720

   $ 2,658,498      $ 2,819,541      $ 2,105,361      $ 2,238,296  

719 - 700

     487,307        498,057        410,098        417,926  

699 - 680

     416,784        425,474        333,653        345,771  

679 - 660

     320,761        347,219        268,817        279,765  

659 - 620

     442,735        494,021        355,500        370,282  

<620

     891,033        857,862        547,617        571,421  
  

 

 

    

 

 

    

 

 

    

 

 

 

Total mortgage loans receivable

   $ 5,217,118      $ 5,442,174      $ 4,021,046      $ 4,223,461  
  

 

 

    

 

 

    

 

 

    

 

 

 

 

(1)   

FICO scores are updated on a quarterly basis; however, as of March 31, 2013 and December 31, 2012, there were some loans for which the updated FICO scores were not available. The current FICO distribution as of March 31, 2013 included original FICO scores for approximately $115 million and $12 million of one- to four-family and home equity loans, respectively. The current FICO distribution as of December 31, 2012 included original FICO scores for approximately $121 million and $20 million of one- to four-family and home equity loans, respectively.

 

     One- to Four-Family      Home Equity  
     March 31,      December 31,      March 31,      December 31,  

Vintage Year

   2013      2012      2013      2012  

2003 and prior

   $ 179,896      $ 190,407      $ 201,091      $ 218,182  

2004

     491,801        514,283        337,089        359,737  

2005

     1,043,288        1,095,047        1,078,272        1,131,341  

2006

     2,041,936        2,123,395        1,876,813        1,962,946  

2007

     1,456,194        1,515,020        519,019        542,203  

2008

     4,003        4,022        8,762        9,052  
  

 

 

    

 

 

    

 

 

    

 

 

 

Total mortgage loans receivable

   $ 5,217,118      $ 5,442,174      $ 4,021,046      $ 4,223,461  
  

 

 

    

 

 

    

 

 

    

 

 

 

Average age of mortgage loans receivable (years)

     6.9        6.7        7.2        6.9  
     One- to Four-Family      Home Equity  
     March 31,      December 31,      March 31,      December 31,  

Geographic Location

   2013      2012      2013      2012  

California

   $ 2,465,272      $ 2,568,709      $ 1,271,641      $ 1,333,317  

New York

     369,465        386,380        298,165        313,148  

Florida

     349,397        368,319        284,149        298,860  

Virginia

     229,137        235,019        182,488        192,143  

Other states

     1,803,847        1,883,747        1,984,603        2,085,993  
  

 

 

    

 

 

    

 

 

    

 

 

 

Total mortgage loans receivable

   $ 5,217,118      $ 5,442,174      $ 4,021,046      $ 4,223,461  
  

 

 

    

 

 

    

 

 

    

 

 

 

 

67


Table of Contents

Delinquent Loans

The following table shows total loans receivable by delinquency category as of March 31, 2013 and December 31, 2012 (dollars in thousands):

 

     Current      30-89 Days
Delinquent
     90-179 Days
Delinquent
     180+ Days
Delinquent
     Total  

March 31, 2013

              

One- to four-family

   $ 4,635,019      $ 220,208      $ 99,893      $ 261,998      $ 5,217,118  

Home equity

     3,850,935        76,101        52,535        41,475        4,021,046  

Consumer and other

     722,017        15,796        2,007        —          739,820  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total loans receivable

   $ 9,207,971      $ 312,105      $ 154,435      $ 303,473      $ 9,977,984  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

December 31, 2012

              

One- to four-family

   $ 4,834,915      $ 233,796      $ 94,652      $ 278,811      $ 5,442,174  

Home equity

     4,028,936        89,347        64,239        40,939        4,223,461  

Consumer and other

     819,468        19,101        6,178        195        844,942  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total loans receivable

   $ 9,683,319      $ 342,244      $ 165,069      $ 319,945      $ 10,510,577  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Nonperforming Loans

The Company classifies loans as nonperforming when they are no longer accruing interest. Nonaccrual loans include loans that are 90 days and greater past due, TDRs that are on nonaccrual status for all classes of loans and certain junior liens that have a delinquent senior lien. As of March 31, 2013, the Company had nonaccrual loans of $644.4 million, $223.9 million and $2.0 million for one- to four-family, home equity and consumer and other loans, respectively. As of December 31, 2012, the Company had nonaccrual loans of $639.1 million, $247.5 million and $6.4 million for one- to four-family, home equity and consumer and other loans, respectively.

Allowance for Loan Losses

The following table provides a roll forward by loan portfolio of the allowance for loan losses for the three months ended March 31, 2013 and 2012 (dollars in thousands):

 

     Three Months Ended March 31, 2013  
     One- to
Four-Family
    Home Equity     Consumer
and Other
    Total  

Allowance for loan losses, beginning of period

   $ 183,937     $ 257,333     $ 39,481     $ 480,751  

Provision for loan losses

     (16,616     55,248       4,018       42,650  

Charge-offs

     (18,786     (57,409     (16,241     (92,436

Recoveries

     12,500       7,954       3,613       24,067  
  

 

 

   

 

 

   

 

 

   

 

 

 

Charge-offs, net

     (6,286     (49,455     (12,628     (68,369
  

 

 

   

 

 

   

 

 

   

 

 

 

Allowance for loan losses, end of period

   $ 161,035     $ 263,126     $ 30,871     $ 455,032  
  

 

 

   

 

 

   

 

 

   

 

 

 

 

68


Table of Contents
     Three Months Ended March 31, 2012  
     One- to
Four- Family
    Home Equity     Consumer
and Other
    Total  

Allowance for loan losses, beginning of period

   $ 314,187     $ 463,288     $ 45,341     $ 822,816  

Provision for loan losses

     15,867       42,977       13,103       71,947  

Charge-offs

     (90,452     (225,075     (12,881     (328,408

Recoveries

     —         9,825       2,995       12,820  
  

 

 

   

 

 

   

 

 

   

 

 

 

Charge-offs, net

     (90,452     (215,250     (9,886     (315,588
  

 

 

   

 

 

   

 

 

   

 

 

 

Allowance for loan losses, end of period

   $ 239,602     $ 291,015     $ 48,558     $ 579,175  
  

 

 

   

 

 

   

 

 

   

 

 

 

During the three months ended March 31, 2013, the allowance for loan losses decreased by $25.7 million from $480.7 million at December 31, 2012. The general allowance for loan losses also included a qualitative component to account for a variety of factors that are not directly considered in the quantitative loss model but are factors the Company believes may impact the level of credit losses. The qualitative component was $60 million and $44 million at March 31, 2013 and December 31, 2012, respectively.

During the first quarter of 2013, the Company agreed to a settlement with a third party mortgage originator specific to loans sold to the Company by this originator. A one-time payment of $12.5 million was agreed upon to satisfy in full all pending and future repurchase requests with this specific originator. The full amount of the settlement was applied as recoveries to the allowance for loan losses in the first quarter of 2013, resulting in a corresponding reduction to net charge-offs as well as provision for loan losses.

Impaired Loans—Troubled Debt Restructurings

TDRs include loan modifications completed under the Company’s programs that involve granting an economic concession to a borrower experiencing financial difficulty, as well as loans that have been charged off based on the estimated current value of the underlying property less estimated selling costs due to bankruptcy notification. Upon being classified as a TDR, such loan is categorized as an impaired loan and is considered impaired until maturity regardless of whether the borrower performs under the terms of the loan. Impairment on TDRs is measured on an individual basis.

TDR loan modifications are accounted for as nonaccrual loans at the time of modification and return to accrual status after six consecutive payments are made in accordance with the modified terms. TDRs are classified as nonperforming until six consecutive payments have been made.

The unpaid principal balance in one- to four-family TDRs was $1.2 billion at both March 31, 2013 and December 31, 2012. For home equity loans, the recorded investment in TDRs represents the unpaid principal balance. As of March 31, 2013 the Company had $206.7 million recorded investment of TDRs that had been charged-off due to bankruptcy notification, $108.1 million of which were classified as performing. As of December 31, 2012 the Company had $216.6 million recorded investment of TDRs that had been charged-off due to bankruptcy notification, $119.2 million of which were classified as performing.

 

69


Table of Contents

The following table shows a summary of the Company’s recorded investment in TDRs that were on accrual and nonaccrual status, in addition to the recorded investment of TDRs as of March 31, 2013 and December 31, 2012 (dollars in thousands):

 

            Nonaccrual TDRs         
     Accrual  TDRs(1)      Current(2)      30-89 Days
Delinquent
     90+ Days
Delinquent
     Recorded
Investment
in TDRs
 

March 31, 2013

              

One- to four-family

   $ 748,986      $ 166,945      $ 115,571      $ 185,065      $ 1,216,567  

Home equity

     193,369        34,939        17,467        29,187        274,962  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 942,355      $ 201,884      $ 133,038      $ 214,252      $ 1,491,529  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

December 31, 2012

              

One- to four-family

   $ 785,199      $ 142,373      $ 118,834      $ 182,719      $ 1,229,125  

Home equity

     196,199        35,750        17,634        27,440        277,023  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 981,398      $ 178,123      $ 136,468      $ 210,159      $ 1,506,148  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

(1)   

Represents TDRs that are current and have made six or more consecutive payments.

(2)   

Represents TDRs that are current but have not yet made six consecutive payments and certain junior lien TDRs that have a delinquent senior lien.

The following table shows the average recorded investment and interest income recognized both on a cash and accrual basis for the Company’s TDRs during the three months ended March 31, 2013 and 2012 (dollars in thousands):

 

     Average Recorded
Investment
     Interest Income
Recognized
 
     Three Months Ended
March 31,
     Three Months Ended
March 31,
 
     2013      2012      2013      2012  

One- to four-family

   $ 1,220,664      $ 990,961      $ 8,445      $ 8,093  

Home equity

     281,362        387,038        5,043        2,685  
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 1,502,026      $ 1,377,999      $ 13,488      $ 10,778  
  

 

 

    

 

 

    

 

 

    

 

 

 

Included in the allowance for loan losses was a specific valuation allowance of $148.1 million and $171.4 million that was established for TDRs at March 31, 2013 and December 31, 2012, respectively. The specific allowance for these individually impaired loans represents the forecasted losses over the estimated remaining life of the loan, including the economic concession to the borrower. The following table shows detailed information related to the Company’s loans that were modified in a TDR as of March 31, 2013 and December 31, 2012 (dollars in thousands):

 

     March 31, 2013      December 31, 2012  
     Recorded
Investment
in TDRs
     Specific
Valuation
Allowance
     Net
Investment
in TDRs
     Recorded
Investment
in TDRs
     Specific
Valuation
Allowance
     Net
Investment
in TDRs
 

With a recorded allowance:

                 

One- to four-family

   $ 480,141      $ 81,685      $ 398,456      $ 503,557      $ 89,684      $ 413,873  

Home equity

   $ 165,524      $ 66,421      $ 99,103      $ 185,133      $ 81,690      $ 103,443  

Without a recorded allowance:(1)

                 

One- to four-family

   $ 736,426      $ —        $ 736,426      $ 725,568      $ —        $ 725,568  

Home equity

   $ 109,438      $ —        $ 109,438      $ 91,890      $ —        $ 91,890  

Total:

                 

One- to four-family

   $ 1,216,567      $ 81,685      $ 1,134,882      $ 1,229,125      $ 89,684      $ 1,139,441  

Home equity

   $ 274,962      $ 66,421      $ 208,541      $ 277,023      $ 81,690      $ 195,333  

 

(1)   

Represents loans where the discounted cash flow analysis or collateral value is equal to or exceeds the recorded investment in the loan.

 

70


Table of Contents

Troubled Debt Restructurings—Loan Modifications

The Company has loan modification programs that focus on the mitigation of potential losses in the one- to four-family and home equity mortgage loan portfolio. The Company currently does not have an active loan modification program for consumer and other loans. The various types of economic concessions that may be granted typically consist of interest rate reductions, maturity date extensions, principal forgiveness or a combination of these concessions. Trial modifications are classified immediately as TDRs and continue to be reported as delinquent until the successful completion of the trial period, which is typically 90 days. The loan then becomes a permanent modification reported as current but remains on nonaccrual status until six consecutive payments have been made.

The vast majority of the Company’s TDR loan modifications include an interest rate reduction in combination with another type of concession. The Company prioritizes the interest rate reduction modifications in combination with the following modification categories: principal forgiven, principal deferred and re-age/extension/capitalization of accrued interest. Each class is mutually exclusive in that if a modification had an interest rate reduction with principal forgiven and an extension, the modification would only show up in the principal forgiven column in the table below. The following tables provide the number of loans, post-modification balances immediately after being modified by major class, and the financial impact of modifications during the three months ended March 31, 2013 and 2012 (dollars in thousands):

 

     Three Months Ended March 31, 2013  
            Interest Rate Reduction                
     Number of
Loans
     Principal
Forgiven
     Principal
Deferred
     Re-age/
Extension/
Interest
Capitalization
     Other with
Interest Rate
Reduction
     Other      Total  

One- to four-family

     93      $ 8,074      $ 2,301      $ 19,782      $ 831      $ 4,792      $ 35,780  

Home equity

     66        —          —          1,362        2,353        1,067        4,782  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

     159      $ 8,074      $ 2,301      $ 21,144      $ 3,184      $ 5,859      $ 40,562  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 
     Three Months Ended March 31, 2012  
            Interest Rate Reduction                
     Number of
Loans
     Principal
Forgiven
     Principal
Deferred
     Re-age/
Extension/
Interest
Capitalization
     Other with
Interest Rate
Reduction
     Other      Total  

One- to four-family

     179      $ 9,839      $ 9,393      $ 49,423      $ 3,808      $ 8,303      $ 80,766  

Home equity

     319        —          —          2,286        26,292        1,354        29,932  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

     498      $ 9,839      $ 9,393      $ 51,709      $ 30,100      $ 9,657      $ 110,698  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

     Three Months Ended March 31, 2013  
     Financial Impact  
     Principal
Forgiven
     Pre-Modification Weighted
Average Interest Rate
    Post-Modification Weighted
Average Interest Rate
 

One- to four-family

   $ 2,989        5.2     2.3

Home equity

     —          4.5     1.3
  

 

 

      

Total

   $ 2,989       
  

 

 

      

 

71


Table of Contents
     Three Months Ended March 31, 2012  
     Financial Impact  
     Principal
Forgiven
     Pre-Modification Weighted
Average Interest Rate
    Post-Modification Weighted
Average Interest Rate
 

One- to four-family

   $ 2,842        6.0     2.5

Home equity

     8        4.2     1.5
  

 

 

      

Total

   $ 2,850       
  

 

 

      

The Company considers modifications that become 30 days past due to have experienced a payment default. The following table shows the recorded investment of modifications at March 31, 2013 and 2012 that experienced a payment default within 12 months after the modification for the three months ended March 31, 2013 and 2012 (dollars in thousands):

 

     Three Months Ended
March 31, 2013
     Three Months Ended
March 31, 2012
 
     Number of
Loans
     Recorded
Investment
     Number of
Loans
     Recorded
Investment
 

One- to four-family(1)

     54      $ 19,088        84      $ 35,182  

Home equity(2)

     24        1,117        118        7,189  
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

     78      $ 20,205        202      $ 42,371  
  

 

 

    

 

 

    

 

 

    

 

 

 

 

(1)   

As of the three months ended March 31, 2013 and 2012, $3.0 million and $5.7 million, respectively, of the recorded investment in one- to four-family loans that had a payment default in the trailing 12 months were classified as current.

(2)   

As of the three months ended March 31, 2013 and 2012, $0.2 million and $1.3 million, respectively, of the recorded investment in home equity loans that had a payment default in the trailing 12 months were classified as current.

The delinquency status is the primary measure the Company uses to evaluate the performance of TDR loan modifications. The following table shows the TDR loan modifications by delinquency category as of March 31, 2013 and December 31, 2012 (dollars in thousands):

 

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

March 31, 2013

              

One- to four-family

   $ 830,585      $ 105,032      $ 54,076      $ 80,234      $ 1,069,927  

Home equity

     187,208        14,023        6,772        6,856        214,859  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 1,017,793      $ 119,055      $ 60,848      $ 87,090      $ 1,284,786  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

December 31, 2012

              

One- to four-family

   $ 838,020      $ 105,142      $ 43,905      $ 79,102      $ 1,066,169  

Home equity

     195,021        15,107        6,173        7,118        223,419  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 1,033,041      $ 120,249      $ 50,078      $ 86,220      $ 1,289,588  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

NOTE 6—ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES

The Company enters into derivative transactions primarily to protect against interest rate risk on the value of certain assets, liabilities and future cash flows. Cash flow hedges, which include a combination of interest rate swaps, forward-starting swaps and purchased options, including caps and floors, are used primarily to reduce the variability of future cash flows associated with existing variable-rate assets and liabilities and forecasted issuances of liabilities. Fair value hedges, which include interest rate swaps and swaptions, are used to offset exposure to changes in value of certain fixed-rate assets and liabilities. The Company also recognizes certain

 

72


Table of Contents

contracts and commitments as derivatives when the characteristics of those contracts and commitments meet the definition of a derivative. Each derivative is recorded on the consolidated balance sheet at fair value as a freestanding asset or liability. The following table summarizes the fair value amounts of derivatives designated as hedging instruments reported in the consolidated balance sheet at March 31, 2013 and December 31, 2012 (dollars in thousands):

 

            Fair Value  
     Notional      Asset(1)      Liability(2)     Net(3)  

March 31, 2013

          

Interest rate contracts:

          

Cash flow hedges:

          

Pay-fixed rate swaps

   $ 2,430,000      $ —        $ (284,222   $ (284,222

Purchased options

     1,630,000        8,669        —         8,669  
  

 

 

    

 

 

    

 

 

   

 

 

 

Total cash flow hedges

     4,060,000        8,669        (284,222     (275,553
  

 

 

    

 

 

    

 

 

   

 

 

 

Fair value hedges:

          

Pay-fixed rate swaps

     609,211        7,638        (5,063     2,575  
  

 

 

    

 

 

    

 

 

   

 

 

 

Total derivatives designated as hedging instruments(4)

   $ 4,669,211      $ 16,307      $ (289,285   $ (272,978
  

 

 

    

 

 

    

 

 

   

 

 

 

December 31, 2012

          

Interest rate contracts:

          

Cash flow hedges:

          

Pay-fixed rate swaps

   $ 2,205,000      $ —        $ (310,079   $ (310,079

Purchased options

     2,325,000        13,391        —         13,391  
  

 

 

    

 

 

    

 

 

   

 

 

 

Total cash flow hedges

     4,530,000        13,391        (310,079     (296,688
  

 

 

    

 

 

    

 

 

   

 

 

 

Fair value hedges:

          

Pay-fixed rate swaps

     514,180        1,343        (18,385     (17,042
  

 

 

    

 

 

    

 

 

   

 

 

 

Total derivatives designated as hedging instruments(4)

   $ 5,044,180      $ 14,734      $ (328,464   $ (313,730
  

 

 

    

 

 

    

 

 

   

 

 

 

 

(1)   

Reflected in the other assets line item on the consolidated balance sheet.

(2)   

Reflected in the other liabilities line item on the consolidated balance sheet.

(3)   

Represents derivative assets net of derivative liabilities for disclosure purposes only.

(4)   

All derivatives were designated as hedging instruments as of March 31, 2013 and December 31, 2012.

Cash Flow Hedges

The effective portion of changes in fair value of the derivative instruments that hedge cash flows is reported as a component of accumulated other comprehensive loss, net of tax in the consolidated balance sheet, for both active and discontinued hedges. Amounts are included in net operating interest income as a yield adjustment in the same period the hedged forecasted transaction affects earnings. The ineffective portion of changes in fair value of the derivative instrument, which is equal to the excess of the cumulative change in the fair value of the actual derivative over the cumulative change in the fair value of a hypothetical derivative which is created to match the exact terms of the underlying instruments being hedged, is reported in the gains on loans and securities, net line item in the consolidated statement of income.

If it becomes probable that a hedged forecasted transaction will not occur, amounts included in accumulated other comprehensive loss related to the specific hedging instruments would be immediately reclassified into the gains on loans and securities, net line item in the consolidated statement of income. If hedge accounting is discontinued because a derivative instrument is sold, terminated or otherwise de-designated, amounts included in accumulated other comprehensive loss related to the specific hedging instrument continue to be reported in accumulated other comprehensive loss until the forecasted transaction affects earnings.

 

73


Table of Contents

The future issuances of liabilities, including repurchase agreements, are largely dependent on the market demand and liquidity in the wholesale borrowings market. As of March 31, 2013, the Company believes the forecasted issuance of all debt in cash flow hedge relationships is probable. However, unexpected changes in market conditions in future periods could impact the ability to issue this debt. The Company believes the forecasted issuance of debt in the form of repurchase agreements is most susceptible to an unexpected change in market conditions.

The following table summarizes the effect of interest rate contracts designated and qualifying as hedging instruments in cash flow hedges on accumulated other comprehensive loss and on the consolidated statement of income for the three months ended March 31, 2013 and 2012 (dollars in thousands):

 

     For the Three Months
Ended March 31,
 
           2013                 2012        

Gains on derivatives recognized in OCI (effective portion), net of tax

   $ 5,975     $ 8,396  

Losses reclassified from AOCI into earnings (effective portion), net of tax

   $ (20,128   $ (19,327

Cash flow hedge ineffectiveness gains (losses) (1)

   $ (145   $ 311  

 

(1) The cash flow hedge ineffectiveness is reflected in the gains on loans and securities, net line item on the statement of consolidated income.

During the upcoming twelve months, the Company expects to include a pre-tax amount of approximately $134.1 million of net unrealized losses that are currently reflected in accumulated other comprehensive loss in net operating interest income as a yield adjustment in the same periods in which the related hedged items affect earnings. The maximum length of time over which transactions are hedged is 10 years.

The following table shows the balance in accumulated other comprehensive loss attributable to active and discontinued cash flow hedges at March 31, 2013 and December 31, 2012 (dollars in thousands):

 

     March 31,
2013
    December 31,
2012
 

Accumulated other comprehensive loss balance (net of tax) related to:

       

Discontinued cash flow hedges

   $ (233,933      $ (247,983

Active cash flow hedges

     (192,305        (204,358
  

 

 

      

 

 

 

Total cash flow hedges

   $ (426,238      $ (452,341
  

 

 

      

 

 

 

The following table shows the balance in accumulated other comprehensive loss attributable to cash flow hedges by type of hedged item at March 31, 2013 and December 31, 2012 (dollars in thousands):

 

     March 31,
2013
    December 31,
2012
 

Repurchase agreements

   $ (544,246   $ (579,763

FHLB advances

     (137,010     (146,253

Home equity lines of credit

     5,474       7,854  

Other

     393       116  
  

 

 

   

 

 

 

Total balance of cash flow hedges, before tax

     (675,389     (718,046

Tax benefit

     249,151       265,705  
  

 

 

   

 

 

 

Total balance of cash flow hedges, net of tax

   $ (426,238   $ (452,341
  

 

 

   

 

 

 

Fair Value Hedges

Fair value hedges are accounted for by recording the fair value of the derivative instrument and the fair value of the asset or liability being hedged on the consolidated balance sheet. Changes in the fair value of both

 

74


Table of Contents

the derivatives and the underlying assets or liabilities are recognized in the gains on loans and securities, net line item in the consolidated statement of income. To the extent that the hedge is ineffective, the changes in the fair values will not offset and the difference, or hedge ineffectiveness, is reflected in the gains on loans and securities, net line item in the consolidated statement of income.

Hedge accounting is discontinued for fair value hedges if a derivative instrument is sold, terminated or otherwise de-designated. If fair value hedge accounting is discontinued, the previously hedged item is no longer adjusted for changes in fair value through the consolidated statement of income and the cumulative net gain or loss on the hedged asset or liability at the time of de-designation is amortized to interest income or interest expense using the effective interest method over the expected remaining life of the hedged item. Changes in the fair value of the derivative instruments after de-designation of fair value hedge accounting are recorded in the gains on loans and securities, net line item in the consolidated statement of income.

The following table summarizes the effect of interest rate contracts designated and qualifying as hedging instruments in fair value hedges and related hedged items on the consolidated statement of income for the three months ended March 31, 2013, and 2012 (dollars in thousands):

 

     Three Months Ended March 31,  
     2013     2012  
     Hedging
Instrument
    Hedged
Item
    Hedge
Ineffectiveness(1)
    Hedging
Instrument
    Hedged
Item
    Hedge
Ineffectiveness(1)
 

Agency debentures

   $ 15,988     $ (15,903   $ 85     $ 31,848     $ (30,117   $ 1,731  

Agency mortgage-backed securities

     (104     51       (53     4,331       (4,331     —    

FHLB advances

     —         —         —         (1,276     (791     (2,067
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total gains (losses) included in earnings

   $ 15,884     $ (15,852   $ 32     $ 34,903     $ (35,239   $ (336
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

(1)   

Reflected in the gains on loans and securities, net line item on the consolidated statement of income.

NOTE 7—DEPOSITS

Deposits are summarized as follows (dollars in thousands):

 

     Amount      Weighted-Average Rate  
     March 31,
2013
     December 31,
2012
     March 31,
2013
    December 31,
2012
 

Sweep deposits(1)

   $ 18,923,113      $ 21,253,611        0.06     0.05

Complete savings deposits

     4,827,371        4,981,615        0.01     0.01

Checking deposits

     1,061,751        1,055,422        0.03     0.03

Other money market and savings deposits

     974,854        995,188        0.01     0.01

Time deposits(2)

     90,659        106,716        1.42     1.75
  

 

 

    

 

 

      

Total deposits(3)

   $ 25,877,748      $ 28,392,552        0.05     0.05
  

 

 

    

 

 

      

 

(1)   

A sweep product transfers brokerage customer balances to banking subsidiaries, which hold these funds as customer deposits in FDIC insured demand deposit and money market deposit accounts.

(2)   

Time deposits represent certificates of deposit and brokered certificates of deposit.

(3)   

As of March 31, 2013 and December 31, 2012, the Company had $119.3 million and $113.1 million in non-interest bearing deposits, respectively.

 

75


Table of Contents

NOTE 8—SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE AND FHLB ADVANCES AND OTHER BORROWINGS

Securities sold under agreements to repurchase, FHLB advances and other borrowings at March 31, 2013 and December 31, 2012 are shown in the following table (dollars in thousands):

 

     Repurchase
Agreements(1)
     FHLB Advances and
Other Borrowings
     Total     Weighted
Average
Interest
Rate
 
        FHLB
Advances
    Other       

Due within one year

   $ 3,509,421      $ 170,000     $ 1,170      $ 3,680,591       0.41

Due between one and two years

     100,000        100,000       180        200,180       1.04

Due between two and three years

     350,000        —         —          350,000       0.86

Due between three and four years

     500,000        250,000       —          750,000       1.44

Due between four and five years

     —          400,000       —          400,000       0.46

Thereafter

     —          —         427,747        427,747       2.97
  

 

 

    

 

 

   

 

 

    

 

 

   

Subtotal

     4,459,421        920,000       429,097        5,808,518       0.78

Fair value hedge adjustments

     —          35,134       —          35,134    

Deferred costs

     —          (118,742     —          (118,742  
  

 

 

    

 

 

   

 

 

    

 

 

   

Total other borrowings at March 31, 2013

   $ 4,459,421      $ 836,392     $ 429,097      $ 5,724,910       0.78
  

 

 

    

 

 

   

 

 

    

 

 

   

Total other borrowings at December 31, 2012

   $ 4,454,661      $ 831,749     $ 429,167      $ 5,715,577       0.83
  

 

 

    

 

 

   

 

 

    

 

 

   

 

(1)   

The maximum amount at any month end for repurchase agreements was $4.5 billion for the three months ended March 31, 2013 and $5.0 billion and for the year ended December 31, 2012.

NOTE 9—CORPORATE DEBT

Corporate debt at March 31, 2013 and December 31, 2012 is outlined in the following table (dollars in thousands):

 

     Face Value      Discount     Net  

March 31, 2013

                   

Interest-bearing notes:

       

6  3/4% Notes, due 2016

   $ 435,000      $ (5,319   $ 429,681  

6% Notes, due 2017

     505,000        (4,364     500,636  

6  3/8% Notes, due 2019

     800,000        (7,069     792,931  
  

 

 

    

 

 

   

 

 

 

Total interest-bearing notes

     1,740,000        (16,752     1,723,248  

Non-interest-bearing debt:

       

0% Convertible debentures, due 2019

     42,657        —         42,657  
  

 

 

    

 

 

   

 

 

 

Total corporate debt

   $ 1,782,657      $ (16,752   $ 1,765,905  
  

 

 

    

 

 

   

 

 

 
     Face Value      Discount     Net  

December 31, 2012

                   

Interest-bearing notes:

       

6  3/4% Notes, due 2016

   $ 435,000      $ (5,738   $ 429,262  

6% Notes, due 2017

     505,000        (4,601     500,399  

6  3/8% Notes, due 2019

     800,000        (7,336     792,664  
  

 

 

    

 

 

   

 

 

 

Total interest-bearing notes

     1,740,000        (17,675     1,722,325  

Non-interest-bearing debt:

       

0% Convertible debentures, due 2019

     42,657        —         42,657  
  

 

 

    

 

 

   

 

 

 

Total corporate debt

   $ 1,782,657      $ (17,675   $ 1,764,982  
  

 

 

    

 

 

   

 

 

 

 

76


Table of Contents

NOTE 10—SHAREHOLDERS’ EQUITY

The activity in shareholders’ equity during the three months ended March 31, 2013 is summarized in the following table (dollars in thousands):

 

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

Beginning balance, December 31, 2012

   $ 7,322,118      $ (2,417,648   $ 4,904,470  

Net income

     —          35,124       35,124  

Net change from available-for-sale securities

     —          (15,105     (15,105

Net change from cash flow hedging instruments

     —          26,103       26,103  

Other(1)

     1,241        (6     1,235  
  

 

 

    

 

 

   

 

 

 

Ending balance, March 31, 2013

   $ 7,323,359      $ (2,371,532   $ 4,951,827  
  

 

 

    

 

 

   

 

 

 

 

(1)   

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

Accumulated Other Comprehensive Loss

The following tables present after-tax changes in each component of accumulated other comprehensive loss (dollars in thousands):

 

     Available-
for-sale
Securities
    Cash Flow
Hedging
Instruments
    Foreign
Currency
Translation
    Total  

Beginning balance, December 31, 2012

   $ 136,972     $ (452,341   $ 5,441     $ (309,928

Other comprehensive income (loss) before reclassifications

     (5,314     5,975       (6     655  

Amounts reclassified from accumulated other comprehensive loss

     (9,791     20,128       —         10,337  
  

 

 

   

 

 

   

 

 

   

 

 

 

Net change

     (15,105     26,103       (6     10,992  
  

 

 

   

 

 

   

 

 

   

 

 

 

Ending balance, March 31, 2013

   $ 121,867     $ (426,238   $ 5,435     $ (298,936
  

 

 

   

 

 

   

 

 

   

 

 

 
     Available-
for-sale
Securities
    Cash Flow
Hedging
Instruments
    Foreign
Currency
Translation
    Total  

Beginning balance, December 31, 2011

   $ 68,330     $ (457,953   $ 2,994     $ (386,629

Other comprehensive income before reclassifications

     38,380       8,396       725       47,501  

Amounts reclassified from accumulated other comprehensive loss

     (21,816     19,327       —         (2,489
  

 

 

   

 

 

   

 

 

   

 

 

 

Net change

     16,564       27,723       725       45,012  
  

 

 

   

 

 

   

 

 

   

 

 

 

Ending balance, March 31, 2012

   $ 84,894     $ (430,230   $ 3,719     $ (341,617
  

 

 

   

 

 

   

 

 

   

 

 

 

 

77


Table of Contents

The following table presents the income statement line items impacted by reclassifications out of accumulated other comprehensive loss during the three months ended March 31, 2013 (dollars in thousands):

 

Accumulated Other Comprehensive Loss
Components

   Amount Reclassified from
Accumulated Other
Comprehensive Loss
   

Affected Line Items in the Income Statement

Available-for-sale securities:

    
   $ 15,765     Gains on loans and securities, net
     (5,974   Tax expense
  

 

 

   
   $ 9,791     Reclassification into earnings, net
  

 

 

   

Cash flow hedging instruments:

    
   $ 2,377     Operating interest income
     (35,269   Operating interest expense
  

 

 

   
     (32,892   Reclassification into earnings, before tax
     12,764     Tax benefit
  

 

 

   
   $ (20,128   Reclassification into earnings, net
  

 

 

   

NOTE 11—EARNINGS PER SHARE

The following table is a reconciliation of basic and diluted earnings per share (in thousands, except per share amounts):

 

     Three Months Ended
March 31,
 
     2013      2012  

Basic:

     

Net income

   $ 35,124      $ 62,591  
  

 

 

    

 

 

 

Basic weighted-average shares outstanding

     286,626        285,478  
  

 

 

    

 

 

 

Basic earnings per share

   $ 0.12      $ 0.22  
  

 

 

    

 

 

 

Diluted:

     

Net income

   $ 35,124      $ 62,591  
  

 

 

    

 

 

 

Basic weighted-average shares outstanding

     286,626        285,478  

Effect of dilutive securities:

     

Weighted-average convertible debentures

     4,125        4,159  

Weighted-average options and restricted stock issued to employees

     945        380  
  

 

 

    

 

 

 

Diluted weighted-average shares outstanding

     291,696        290,017  
  

 

 

    

 

 

 

Diluted earnings per share

   $ 0.12      $ 0.22  
  

 

 

    

 

 

 

As of March 31, 2013 and 2012, the Company excluded 2.7 million and 2.9 million shares, respectively, of stock options and restricted stock awards and units from the calculations of diluted earnings per share as the effect would have been anti-dilutive.

NOTE 12—REGULATORY REQUIREMENTS

Registered Broker-Dealers

The Company’s largest U.S. broker-dealer subsidiaries are subject to the Uniform Net Capital Rule (the “Rule”) under the Securities Exchange Act of 1934 administered by the SEC and FINRA, which requires the

 

78


Table of Contents

maintenance of minimum net capital. The minimum net capital requirements can be met under either the Aggregate Indebtedness method or the Alternative method. Under the Aggregate Indebtedness method, a broker-dealer is required to maintain minimum net capital of the greater of 6  2/3% of its aggregate indebtedness, as defined, or a minimum dollar amount. Under the Alternative method, a broker-dealer is required to maintain net capital equal to the greater of $250,000 or 2% of aggregate debit balances arising from customer transactions. The method used depends on the individual U.S. broker-dealer subsidiary. The Company’s other broker-dealers, including its international broker-dealer subsidiaries located in Europe and Asia, are subject to capital requirements determined by their respective regulators.

As of March 31, 2013 and December 31, 2012, all of the Company’s broker-dealer subsidiaries met minimum net capital requirements. Total required net capital was $0.1 billion at both March 31, 2013 and December 31, 2012. In addition, the Company’s broker-dealer subsidiaries had excess net capital of $0.7 billion at both March 31, 2013 and December 31, 2012. The tables below summarize the minimum excess capital requirements for the Company’s broker-dealer subsidiaries at March 31, 2013 and December 31, 2012 (dollars in thousands):

 

     Required
Net
Capital
     Net
Capital
     Excess Net
Capital
 

March 31, 2013:

        

E*TRADE Clearing LLC(1)

   $ 128,110      $ 654,097      $ 525,987  

E*TRADE Securities LLC(1)

     250        97,026        96,776  

G1 Execution Services, LLC(2)

     1,000        20,091        19,091  

Other broker-dealers

     4,888        33,879        28,991  
  

 

 

    

 

 

    

 

 

 

Total

   $ 134,248      $ 805,093      $ 670,845  
  

 

 

    

 

 

    

 

 

 

December 31, 2012:

        

E*TRADE Clearing LLC(1)

   $ 123,656      $ 658,968      $ 535,312  

E*TRADE Securities LLC(1)

     250        79,318        79,068  

G1 Execution Services, LLC(2)

     1,283        10,598        9,315  

Other broker-dealers

     4,639        36,070        31,431  
  

 

 

    

 

 

    

 

 

 

Total

   $ 129,828      $ 784,954      $ 655,126  
  

 

 

    

 

 

    

 

 

 

 

(1)   

Elected to use the Alternative method to compute net capital.

(2)   

Elected to use the Aggregate Indebtedness method to compute net capital.

Banking

E*TRADE Bank is subject to various regulatory capital requirements administered by federal banking agencies. Failure to meet minimum capital requirements can trigger certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on E*TRADE Bank’s financial condition and results of operations. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, 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. In addition, E*TRADE Bank may not pay dividends to the parent company without approval from its regulators and any loans by E*TRADE Bank to the parent company and its other non-bank subsidiaries are subject to various quantitative, arm’s length, collateralization and other requirements. E*TRADE Bank’s capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.

Quantitative measures established by regulation to ensure capital adequacy require E*TRADE Bank to meet minimum total capital, Tier 1 capital and Tier 1 leverage ratios. As shown in the table below, at both March 31,

 

79


Table of Contents

2013 and December 31, 2012, E*TRADE Bank was categorized as “well capitalized” under the regulatory framework for prompt corrective action. However, events beyond management’s control, such as a continued deterioration in residential real estate and credit markets, could adversely affect future earnings and E*TRADE Bank’s ability to meet its future capital requirements. E*TRADE Bank’s actual and required capital amounts and ratios at March 31, 2013 and December 31, 2012 are presented in the table below (dollars in thousands):

 

     Actual     Minimum Required to be
Well Capitalized Under
Prompt Corrective
Action Provisions
    Excess
Capital
 
     Amount      Ratio     Amount      Ratio    

March 31, 2013:

            

Total capital

   $ 4,043,765        21.93   >$ 1,844,237        >10.00   $ 2,199,528  

Tier 1 capital

   $ 3,809,682        20.66   >$ 1,106,542        >6.00   $ 2,703,140  

Tier 1 leverage

   $ 3,809,682        9.26   >$ 2,057,339        >5.00   $ 1,752,343  

December 31, 2012:

            

Total capital

   $ 4,009,540        20.61   >$ 1,945,669        >10.00   $ 2,063,871  

Tier 1 capital

   $ 3,762,242        19.34   >$ 1,167,401        >6.00   $ 2,594,841  

Tier 1 leverage

   $ 3,762,242        8.68   >$ 2,167,136        >5.00   $ 1,595,106  

NOTE 13—COMMITMENTS, CONTINGENCIES AND OTHER REGULATORY MATTERS

Legal Matters

Litigation Matters

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. The Company 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. The testimonial phase of the third trial in this matter commenced on February 21 and 22, 2012 and concluded on June 12, 2012. The parties await decision on whether there will be a second phase of this bench trial. 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 Chief Executive Officer and Chief Financial Officer by Larry Freudenberg on his own behalf and on behalf of others

 

80


Table of Contents

similarly situated (the “Freudenberg Action”). On July 17, 2008, the trial court consolidated this action with four other purported class actions. Plaintiffs contended, 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. The parties entered into a Stipulation of Settlement on May 17, 2012, which was submitted to the Court for approval. The settlement was approved by the Court and the class was certified by a final judgment and order of dismissal dated October 22, 2012. Under the terms of the settlement, the Company and its insurance carriers paid $79.0 million in return for full releases. Approximately $11.0 million of the total settlement figure was paid by the Company, which was expensed in the year ended December 31, 2011. As of January 14, 2013, all appeals and requests for attorneys’ fees have been resolved and the settlement is final.

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 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 certain corporate governance procedures and various forms of injunctive relief. The parties agreed to settle this action and a Stipulation of Settlement was signed on October 2, 2012, which included an agreement to implement or maintain certain corporate governance procedures. The parties did not reach an agreement on the issue of plaintiffs’ attorneys’ fees, however. The Court preliminarily approved the Stipulation of Settlement on April 2, 2013 and set a final hearing date for September 13, 2013. The unresolved issue of plaintiffs’ attorneys’ fees will be addressed at the final hearing.

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 and its then Chief Executive Officer and Chief Financial Officer 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 moved for exclusion from the settlement class in Freudenberg. The Court granted that relief on October 11, 2012. Tate and Avakian filed an amended complaint on January 23, 2013, adding an additional claim under California law. The Company answered the amended complaint on March 13, 2013. The Company will continue to defend itself vigorously in this matter.

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 and multiple other unaffiliated financial services firms. 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. On March 28, 2012, a change of venue was granted and the case has been transferred to the United States District Court for the Southern District of New York. The Company filed its answer and

 

81


Table of Contents

counterclaim on June 13, 2012 and plaintiff has moved to dismiss the counterclaim. The Company filed a motion for summary judgment. Plaintiffs sought to change venue back to the Eastern District of Texas on the theory that this case is one of several matters that should be consolidated in a single multi-district litigation. On December 12, 2012, the Multidistrict Litigation Panel denied the transfer of this action to Texas. By opinion dated April 4, 2013, the Court denied defendants’ motion for summary judgement and plaintiff’s motion to dismiss the counterclaims. The Company will continue to 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 in this case, 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. G1 Execution Services, LLC (formerly known as E*TRADE Capital Markets, LLC), along with numerous other financial institutions, is a named defendant in this case. 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 and G1 Execution Services, LLC is a named defendant in this case. 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 and E*TRADE Clearing LLC is a named defendant in this case. 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 complaints has been stayed pending further orders of the Court. The Court has set a motion schedule for omnibus motions to dismiss in 2013. Discovery remains stayed until the pending motions are resolved. A hearing on the motion to dismiss is set for May 24, 2013. 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.

Regulatory Matters

The securities and banking industries are subject to extensive regulation under federal, state and applicable international laws. From time to time, the Company has been threatened with or named as a defendant in lawsuits, arbitrations and administrative claims involving securities, banking and other matters. The Company is also subject to periodic regulatory audits and inspections. Compliance and trading problems that are reported to regulators, such as the SEC, FINRA or OCC by dissatisfied customers or others are investigated by such regulators, and may, if pursued, result in formal claims being filed against the Company by customers or

 

82


Table of Contents

disciplinary action being taken against the Company or its employees by regulators. Any such claims or disciplinary actions that are decided against the Company could have a material impact on the financial results of the Company or any of its subsidiaries.

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.

During 2012, the Company completed a review of order handling practices and pricing for order flow between E*TRADE Securities LLC and G1 Execution Services, LLC. The Company is in the process of implementing changes to its practices and procedures recommended during that review and expects to complete them in the near future. Banking regulators and federal securities regulators were regularly updated during the course of the review and may initiate investigations into the Company’s historical practices which could subject it to monetary penalties and cease-and-desist orders, which could also prompt claims by customers of E*TRADE Securities LLC. Any of these actions could materially and adversely affect the Company’s market making and trade execution businesses.

Insurance

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.

Estimated Liabilities

For all legal matters, an estimated liability is established in accordance with the loss contingencies accounting guidance. Once established, the estimated liability is adjusted based on available information when an event occurs requiring an adjustment.

Commitments

In the normal course of business, the Company makes various commitments to extend credit and incur contingent liabilities that are not reflected in the consolidated balance sheet. Significant changes in the economy or interest rates may influence the impact that these commitments and contingencies have on the Company in the future.

Other Investments

The Company has investments in low-income housing tax credit partnerships and other limited partnerships. The Company had $4.4 million in commitments to fund low income housing tax credit partnerships and other limited partnerships as of March 31, 2013.

Securities, Unused Lines of Credit and Certificates of Deposit

At March 31, 2013, the Company had commitments to purchase $0.1 billion in securities and commitments to sell $0.1 billion in securities. In addition, the Company had approximately $0.1 billion of certificates of deposit scheduled to mature in less than one year and $0.6 billion of unfunded commitments to extend credit.

 

83


Table of Contents

Guarantees

In prior periods when the Company sold loans, the Company provided guarantees to investors purchasing mortgage loans, which are considered standard representations and warranties within the mortgage industry. The primary guarantees are that: the mortgage and the mortgage note have been duly executed and each is the legal, valid and binding obligation of the Company, enforceable in accordance with its terms; the mortgage has been duly acknowledged and recorded and is valid; and the mortgage and the mortgage note are not subject to any right of rescission, set-off, counterclaim or defense, including, without limitation, the defense of usury, and no such right of rescission, set-off, counterclaim or defense has been asserted with respect thereto. The Company is responsible for the guarantees on loans sold. If these claims prove to be untrue, the investor can require the Company to repurchase the loan and return all loan purchase and servicing release premiums. Management does not believe the potential liability exposure will have a material impact on the Company’s results of operations, cash flows or financial condition due to the nature of the standard representations and warranties, which have resulted in a minimal amount of loan repurchases.

Prior to 2008, ETBH raised capital through the formation of trusts, which sold trust preferred securities in the capital markets. The capital securities must be redeemed in whole at the due date, which is generally 30 years after issuance. Each trust issued trust preferred securities at par, with a liquidation amount of $1,000 per capital security. The trusts used the proceeds from the sale of issuances to purchase subordinated debentures issued by ETBH.

During the 30-year period prior to the redemption of the trust preferred securities, ETBH guarantees the accrued and unpaid distributions on these securities, as well as the redemption price of the securities and certain costs that may be incurred in liquidating, terminating or dissolving the trusts (all of which would otherwise be payable by the trusts). At March 31, 2013, management estimated that the maximum potential liability under this arrangement, including the current carrying value of the trusts, was equal to approximately $436.6 million or the total face value of these securities plus dividends, which may be unpaid at the termination of the trust arrangement.

NOTE 14—SEGMENT INFORMATION

The Company reports its operating results in two segments, based on the manner in which its chief operating decision maker evaluates financial performance and makes resource allocation decisions: 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; loans previously originated by the Company or purchased from third parties; customer cash and deposits; and credit, liquidity and interest rate risk. The balance sheet management segment utilizes the vast majority of customer cash and deposits and compensates the trading and investing segment via a market-based transfer pricing arrangement, which is eliminated in consolidation. Customer cash and deposits utilized by the balance sheet management segment include retail deposits and customer payables.

The Company does not allocate costs associated with certain functions that are centrally-managed to its operating segments. These costs are separately reported in a corporate/other category, along with technology related costs incurred to support centrally-managed functions; restructuring and other exit activities; and corporate debt and corporate investments.

 

84


Table of Contents

The Company evaluates the performance of its segments based on the segment’s income (loss) before income taxes. Financial information for the Company’s reportable segments is presented in the following tables (dollars in thousands):

 

     Three Months Ended March 31, 2013  
     Trading and
Investing
     Balance Sheet
Management
     Corporate/
Other
    Total  

Net operating interest income

   $ 134,115      $ 107,214      $ —       $ 241,329  

Total non-interest income

     162,565        15,971        —         178,536  
  

 

 

    

 

 

    

 

 

   

 

 

 

Total net revenue

     296,680        123,185        —         419,865  

Provision for loan losses

     —          42,650        —         42,650  

Total operating expense

     198,240        50,087        47,208       295,535  
  

 

 

    

 

 

    

 

 

   

 

 

 

Income (loss) before other income (expense) and income taxes

     98,440        30,448        (47,208     81,680  

Total other income (expense)

     —          —          (24,313     (24,313
  

 

 

    

 

 

    

 

 

   

 

 

 

Income (loss) before income taxes

   $ 98,440      $ 30,448      $ (71,521     57,367  
  

 

 

    

 

 

    

 

 

   

Income tax expense

             22,243  
          

 

 

 

Net income

           $ 35,124  
          

 

 

 

 

     Three Months Ended March 31, 2012  
     Trading and
Investing
     Balance Sheet
Management
     Corporate/
Other
    Total  

Net operating interest income

   $ 170,448      $ 114,403      $ 1     $ 284,852  

Total non-interest income

     170,389        34,169        (13     204,545  
  

 

 

    

 

 

    

 

 

   

 

 

 

Total net revenue

     340,837        148,572        (12     489,397  

Provision for loan losses

     —          71,947        —         71,947  

Total operating expense

     211,541        58,595        36,103       306,239  
  

 

 

    

 

 

    

 

 

   

 

 

 

Income (loss) before other income (expense) and income taxes

     129,296        18,030        (36,115     111,211  

Total other income (expense)

     —          —          (45,217     (45,217
  

 

 

    

 

 

    

 

 

   

 

 

 

Income (loss) before income taxes

   $ 129,296      $ 18,030      $ (81,332     65,994  
  

 

 

    

 

 

    

 

 

   

Income tax expense

             3,403  
          

 

 

 

Net income

           $ 62,591  
          

 

 

 

Segment Assets

 

     Trading and
Investing
     Balance Sheet
Management
     Corporate/
Other
     Total  

As of March 31, 2013

   $ 9,440,818      $ 34,806,263      $ 719,233      $ 44,966,314  

As of December 31, 2012

   $ 9,505,280      $ 37,305,600      $ 575,859      $ 47,386,739  

ITEM 4.     CONTROLS AND PROCEDURES

 

  (a)  

Our Chief Executive Officer and our Chief Financial Officer, after evaluating the effectiveness of the Company’s “disclosure controls and procedures” (as defined in the Securities Exchange Act of 1934 (“Exchange Act”) Rules 13a-15(e) and 15d-15(e)) as of the end of the period covered by this quarterly report, have concluded that our disclosure controls and procedures are effective based on their evaluation of these controls and procedures required by paragraph (b) of Exchange Act Rules 13a-15 or 15d-15.

 

85


Table of Contents
  (b)  

Our Chief Executive Officer and our Chief Financial Officer have evaluated the changes to the Company’s internal control over financial reporting that occurred during our last fiscal quarter ended March 31, 2013, as required by paragraph (d) of Exchange Act Rules 13a-15 and 15d-15, and have concluded that there were no such changes that materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II—OTHER INFORMATION

 

ITEM 1.    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. The Company 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. The testimonial phase of the third trial in this matter commenced on February 21 and 22, 2012 and concluded on June 12, 2012. The parties await decision on whether there will be a second phase of this bench trial. 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 Chief Executive Officer and Chief Financial Officer 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. Plaintiffs contended, 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. The parties entered into a Stipulation of Settlement on May 17, 2012, which was submitted to the Court for approval. The settlement was approved by the Court and the class was certified by a final judgment and order of dismissal dated October 22, 2012. Under the terms of the settlement, the Company and its insurance carriers paid $79.0 million in return for full releases. Approximately $11.0 million of the total settlement figure was paid by the Company, which was expensed in the year ended December 31, 2011. As of January 14, 2013, all appeals and requests for attorneys’ fees have been resolved and the settlement is final.

 

86


Table of Contents

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.

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 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 certain corporate governance procedures and various forms of injunctive relief. The parties agreed to settle this action and a Stipulation of Settlement was signed on October 2, 2012, which included an agreement to implement or maintain certain corporate governance procedures. The parties did not reach an agreement on the issue of plaintiffs’ attorneys’ fees, however. The Court preliminarily approved the Stipulation of Settlement on April 2, 2013 and set a final hearing date for September 13, 2013. The unresolved issue of plaintiffs’ attorneys’ fees will be addressed at the final hearing.

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 and its then Chief Executive Officer and Chief Financial Officer 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 moved for exclusion from the settlement class in Freudenberg. The Court granted that relief on October 11, 2012. Tate and Avakian filed an amended complaint on January 23, 2013, adding an additional claim under California law. The Company answered the amended complaint on March 13, 2013. The Company will continue to defend itself vigorously in this matter.

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 and multiple other unaffiliated financial services firms. 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. On March 28, 2012, a change of venue was granted and the case has been transferred to the United States District Court for the Southern District of New York. The Company filed its answer and counterclaim on June 13, 2012 and plaintiff has moved to dismiss the counterclaim. The Company filed a motion for summary judgment. Plaintiffs sought to change venue back to the Eastern District of Texas on the theory that this case is one of several matters that should be consolidated in a single multi-district litigation. On December 12, 2012, the Multidistrict Litigation Panel denied the transfer of this action to Texas. By opinion dated April 4, 2013, the Court denied defendants’ motion for summary judgement and plaintiff’s motion to dismiss the counterclaims. The Company will continue to 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

 

87


Table of Contents

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 in this case, 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. G1 Execution Services, LLC (formerly known as E*TRADE Capital Markets, LLC), along with numerous other financial institutions, is a named defendant in this case. 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 and G1 Execution Services, LLC is a named defendant in this case. 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 and E*TRADE Clearing LLC is a named defendant in this case. 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 complaints has been stayed pending further orders of the Court. The Court has set a motion schedule for omnibus motions to dismiss in 2013. Discovery remains stayed until the pending motions are resolved. A hearing on the motion to dismiss is set for May 24, 2013. The Company will defend itself vigorously in these matters.

During 2012, the Company completed a review of order handling practices and pricing for order flow between E*TRADE Securities LLC and G1 Execution Services, LLC. The Company is in the process of implementing changes to its practices and procedures recommended during that review and expects to complete them in the near future. Banking regulators and federal securities regulators were regularly updated during the course of the review and may initiate investigations into the Company’s historical practices which could subject it to monetary penalties and cease-and-desist orders, which could also prompt claims by customers of E*TRADE Securities LLC. Any of these actions could materially and adversely affect the Company’s market making and trade execution businesses.

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.

 

ITEM 1A.     RISK FACTORS

There have been no material changes in the Company’s risk factors from those disclosed in its Annual Report on Form 10-K for the year ended December 31, 2012.

 

88


Table of Contents
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

None.

 

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None.

 

ITEM 4. MINE SAFETY DISCLOSURES

Not applicable.

 

ITEM 5. OTHER INFORMATION

None.

 

ITEM 6. EXHIBITS

 

10.1   

Employment Agreement dated January 17, 2013 by and between E*TRADE Financial Corporation and Paul T. Idzik. (Incorporated by reference to Exhibit 10.15 of the Company’s Form 10-K filed on February 26, 2013.)

*10.2   

Employment Agreement dated May 1, 2013 by and between E*TRADE Financial Corporation and Navtej S. Nandra.

*31.1   

Certification—Section 302 of the Sarbanes-Oxley Act of 2002

*31.2   

Certification—Section 302 of the Sarbanes-Oxley Act of 2002

*32.1   

Certification—Section 906 of the Sarbanes-Oxley Act of 2002

*101.INS   

XBRL Instance Document

*101.SCH   

XBRL Taxonomy Extension Schema Document

*101.CAL   

XBRL Taxonomy Extension Calculation Linkbase Document

*101.DEF   

XBRL Taxonomy Extension Definition Linkbase Document

*101.LAB   

XBRL Taxonomy Extension Label Linkbase Document

*101.PRE   

XBRL Taxonomy Extension Presentation Linkbase Document

 

* Filed herein.

 

89


Table of Contents

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

Dated: May 7, 2013

 

E*TRADE Financial Corporation

(Registrant)

By

 

/S/     PAUL T. IDZIK        

 

 

Paul T. Idzik

Chief Executive Officer

(Principal Executive Officer)

 

By

 

/S/     MATTHEW J. AUDETTE        

 

 

Matthew J. Audette

Chief Financial Officer

(Principal Financial and Accounting Officer)

 

90