10-Q 1 d10q.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, 2008

or

 

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

Commission File Number 1-11921

 

 

E*TRADE Financial Corporation

(Exact Name of Registrant as Specified in its Charter)

 

 

 

Delaware   94-2844166

(State or Other Jurisdiction

of Incorporation or Organization)

 

(I.R.S. Employer

Identification Number)

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

(Address of Principal Executive Offices and Zip Code)

(646) 521-4300

(Registrant’s Telephone Number, including Area Code)

 

 

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, 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 5, 2008, there were 473,062,126 shares of common stock outstanding.

 

 

 


Table of Contents

E*TRADE FINANCIAL CORPORATION

FORM 10-Q QUARTERLY REPORT

For the Quarter Ended March 31, 2008

TABLE OF CONTENTS

 

 

PART I—FINANCIAL INFORMATION

    

Item 1. Consolidated Financial Statements (Unaudited)

   3

Consolidated Statement of Income (Loss)

   43

Consolidated Balance Sheet

   44

Consolidated Statement of Comprehensive Income (Loss)

   45

Consolidated Statement of Shareholders’ Equity

   46

Consolidated Statement of Cash Flows

   47

Notes to Consolidated Financial Statements (Unaudited)

   49

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

   49

Note 2—Facility Restructuring and Other Exit Activities

   52

Note 3—Operating Interest Income and Operating Interest Expense

   53

Note 4—Available-for-Sale Mortgage-Backed and Investment Securities

   54

Note 5—Loans, Net

   57

Note 6—Accounting for Derivative Financial Instruments and Hedging Activities

   57

Note 7—Deposits

   61

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

   61

Note 9—Corporate Debt

   62

Note 10—Shareholders’ Equity

   63

Note 11—Earnings (Loss) per Share

   63

Note 12—Employee Share-Based Payments

   63

Note 13—Regulatory Requirements

   65

Note 14—Commitments, Contingencies and Other Regulatory Matters

   66

Note 15—Fair Value Disclosures

   70

Note 16—Segment Information

   75

Note 17—Subsequent Events

   78

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

   3

Overview

   3

Earnings Overview

   7

Segment Results Review

   15

Balance Sheet Overview

   18

Liquidity and Capital Resources

   22

Risk Management

   24

Summary of Critical Accounting Policies and Estimates

   33

Glossary of Terms

   37

Item 3.   Quantitative and Qualitative Disclosures about Market Risk

   41

Item 4.   Controls and Procedures

   78

PART II —OTHER INFORMATION

    

Item 1.    Legal Proceedings

   79

Item 1A. Risk Factors

   80

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

   81

Item 3.   Defaults Upon Senior Securities

   81

Item 4.   Submission of Matters to a Vote of Security Holders

   81

Item 5.   Other Information

   81

Item 6.   Exhibits

   81

Signatures

   82

 

 

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

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

 

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Table of Contents

ITEM 1.    CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

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

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

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. Important factors that may cause actual results to differ materially from any forward-looking statements are set forth in our 2007 Form 10-K filed with the Securities and Exchange Commission (“SEC”) under the heading “Risk Factors.”

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

GLOSSARY OF TERMS

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

OVERVIEW

Strategy

Our strategy centers on growing our global customer base and mitigating the risks associated with our balance sheet. We plan to grow our global customer base by appealing to retail investors, specifically those who are customers of large established financial institutions, by providing them with innovative, easy, low-cost financial solutions and service. Our financial solutions include a suite of trading, investing and banking products.

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

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

 

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Key Factors Affecting Financial Performance

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

 

   

customer demand for financial products and services;

 

   

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

 

   

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;

 

   

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

 

   

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

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

 

   

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

 

   

deepening customer acceptance of our products and services;

 

   

our ability to assess and manage credit risk; and

 

   

disciplined expense control and improved operational efficiency.

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

 

     As of or For the
Three Months Ended
March 31,
       
     Variance  
     2008     2007     2008 vs. 2007  

Customer Activity Metrics:

      

Retail customer assets (dollars in billions)

   $ 168.4     $ 200.5     (16) %

Customer cash and deposits (dollars in billions)

   $ 34.9     $ 36.0     (3) %

U.S. daily average revenue trades

     155,706       141,238     10 %

International daily average revenue trades

     35,018       28,798     22 %
                  

Total daily average revenue trades

     190,724       170,036     12 %

Average commission per trade

   $ 11.04     $ 11.89     (7) %

End of period total accounts

     4,778,238       4,546,544     5 %

Company Financial Metrics:

      

Net revenue growth(1)

     (51) %     8 %   (59) %

Enterprise net interest spread (basis points)

     250       274     (9) %

Enterprise interest-earning assets (average in billions)

   $ 49.9     $ 52.9     (6) %

Nonperforming loans receivable as a % of gross loans receivable

     2.02 %     0.39 %   1.63 %

Allowance for loan losses (dollars in millions)

   $ 565.9     $ 68.0     732 %

Allowance for loan losses as a % of nonperforming loans

     96.84 %     58.68 %   38.16 %

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

   $ 695.3     $ 161.9     329 %

 

(1)

 

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

 

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Customer Activity Metrics

 

   

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

 

   

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

 

   

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

 

   

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

 

   

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

Company Financial Metrics

 

   

Net revenue growth is an indicator of our overall financial well-being and our ability to execute on our strategy. The negative revenue growth during the comparable periods was due to lower revenue in our institutional segment, which was related to an increase in provision for loan losses.

 

   

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

 

   

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

 

   

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

 

   

Allowance for loan losses is an estimate of the losses inherent in our loan portfolio as of the balance sheet date.

 

   

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

 

   

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

Significant Events in the First Quarter of 2008

Turnaround Plan Progress

On January 24, 2008, we announced a turnaround plan focused on resolving the risks in our balance sheet and returning our primary focus to the retail investor. We made the following progress on this plan during the first quarter of 2008:

Retail Investor

 

   

Opened 305,000 gross new accounts;

 

   

Produced 62,000 net new accounts;

 

   

Ended the quarter with a record 4.8 million total customer accounts;

 

   

Increased customer cash and deposit balances in March 2008 for the fourth consecutive month; and

 

   

Stabilized retail customer asset flows and generated net inflows of approximately $300 million(1).

 

(1)   Excludes the effects of market movements in the value of customer assets.

 

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Balance Sheet Risk

 

   

Increased excess E*TRADE Bank risk-based capital (excess to the regulatory minimum well-capitalized threshold) to approximately $695 million, an increase of $260 million compared to December 31, 2007;

 

   

Improved E*TRADE Bank tier-1 and risk-based capital ratios to 6.78% and 12.36%, respectively;

 

   

Ended the quarter with $10.7 billion in excess Federal Home Loan Bank (“FHLB”) borrowing capacity;

 

   

Completed $69 million in non-core asset sales; and

 

   

Reduced holding company debt by $60 million(1), including $25 million in debt-for-equity swaps.

Citadel Investment

In January 2008, the Company issued an additional $150.0 million of springing lien notes in accordance with the terms of the agreement with Citadel Limited Partnership (“Citadel”). This was the final note issuance under the agreement with Citadel and brings the total springing lien notes outstanding to $1.9 billion in principal. In connection with this issuance, the Company received $150.0 million in cash. Additionally, the Company received all required regulatory approvals in order to issue to Citadel the remaining 46.7 million shares of common stock required to be issued under the agreement; however as of March 31, 2008 the shares had not yet been issued.

Enhanced Research Tools for the Retail Investor

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

Retirement Planning Tool

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

Summary Financial Results

Income Statement Highlights for the Three Months Ended March 31, 2008 (dollars in millions, except per share amounts)

 

       Three Months Ended
March 31,
    Variance  
       2008      2007     2008 vs. 2007  

Total net revenue

     $ 316.2      $ 645.0     (51) %

Net operating interest income

     $ 332.8      $ 390.6     (15) %

Provision for loan losses

     $ (233.9 )    $ (21.2 )   1004 %

Net operating interest income after provision for loan losses

     $ 98.9      $ 369.4     (73) %

Commission revenue

     $ 129.8      $ 159.0     (18) %

Fees and service charges revenue

     $ 62.6      $ 59.5     5 %

Operating margin

     $ (56.4 )    $ 270.6     (121) %

Net income (loss)

     $ (91.2 )    $ 169.4     (154) %

Diluted net earnings (loss) per share

     $ (0.20 )    $ 0.39     (151) %

 

(1)   The $60 million reduction in holding company debt occurred subsequent to the $150 million debt issuance to Citadel in January 2008.

 

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The operating environment during the first quarter of 2008 remained challenging as the deterioration in the residential real estate and credit markets continued to impact our financial performance. The losses in our institutional segment caused by this deterioration more than offset our retail segment income. Our retail customer base showed positive growth trends during the first quarter of 2008, including the addition of over 60,000 net new customers and net inflows of customer assets of approximately $300 million(1). We believe these are indications that our retail segment has stabilized and has returned to modest growth.

Total net revenue for the three months ended March 31, 2008 decreased 51% compared to the same period in 2007 due primarily to an increase in our provision for loan losses of $212.7 million to $233.9 million. As a result of the decrease in net revenue, net income declined by 154% from the same period in prior year to a loss of $91.2 million for the three months ended March 31, 2008.

Balance Sheet Highlights (dollars in billions)

 

     March 31,
2008
    December 31,
2007
    Variance  
         2008 vs. 2007  

Total assets

   $ 53.2     $ 56.8     (6) %

Total enterprise interest-earning assets

   $ 47.5     $ 52.3     (9) %

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

     75 %     71 %   4 %

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

     68 %     61 %   7 %

The decrease in total assets was attributable primarily to a decrease of $1.6 billion in loans receivable, net and a decrease of $2.9 billion in available-for-sale mortgage-backed and investment securities. For the foreseeable future, we plan to allow our loans, particularly our home equity loans, to pay down, resulting in an overall decline in the balance of the loan portfolio. During this period, we plan to increase our excess regulatory capital levels at E*TRADE Bank as we focus on mitigating the credit risk inherent in our loan portfolios. During the three months ended March 31, 2008, we increased our excess risk-based capital at E*TRADE Bank by 60% to $695 million. In connection with this strategy and the Citadel Investment, we have updated our secondary market purchase policies to prohibit the acquisition of asset-backed securities, collaterized debt obligations (“CDO”) and certain other instruments with a high level of credit risk through January 1, 2010.

EARNINGS OVERVIEW

Net income (loss) decreased 154% to a loss of $91.2 million for the three months ended March 31, 2008 compared to the same period in 2007. The decrease in net income for the three months ended March 31, 2008 was due principally to an increase in our provision for loan losses of $212.7 million to $233.9 million. The losses in our institutional segment more than offset our retail segment income, which was $125.5 million for the three months ended March 31, 2008.

We report corporate interest income and corporate interest expense separately from operating interest income and operating interest expense. We believe reporting these two items separately provides a clearer picture of the financial performance of our operations than would a presentation that combined these two items. Our operating interest income and operating interest expense is generated from the operations of the Company and is a broad indicator of our success in our banking and balance sheet management business. Our corporate debt, which is the primary source of our corporate interest expense, has been issued primarily in connection with the Citadel Investment and past acquisitions, such as Harrisdirect and BrownCo.

 

(1)   Growth in customer assets as compared to December 31, 2007 and excludes the effects of market movements in the value of customer assets.

 

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

The following sections describe in detail the changes in key operating factors and other changes and events that have affected our consolidated net revenue, expense excluding interest, other income (expense) and income tax expense (benefit).

Revenue

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

 

     Three Months Ended
March 31,
    Variance  
     2008 vs. 2007  
     2008     2007     Amount     %  

Revenue:

        

Operating interest income

   $ 710,737     $ 829,795     $ (119,058 )   (14 )%

Operating interest expense

     (377,966 )     (439,209 )     61,243     (14 )%
                          

Net operating interest income

     332,771       390,586       (57,815 )   (15 )%

Provision for loan losses

     (233,871 )     (21,186 )     (212,685 )   1004 %
                          

Net operating interest income after provision for loan losses

     98,900       369,400       (270,500 )   (73 )%
                          

Commission

     129,764       158,993       (29,229 )   (18 )%

Fees and service charges

     62,612       59,498       3,114     5 %

Principal transactions

     20,495       30,082       (9,587 )   (32 )%

Gain (loss) on sales of loans and securities, net

     (9,145 )     17,375       (26,520 )   *  

Other revenue

     13,610       9,650       3,960     41 %
                          

Total non-interest income

     217,336       275,598       (58,262 )   (21 )%
                          

Total net revenue

   $ 316,236     $ 644,998     $ (328,762 )   (51 )%
                          

 

*   Percentage not meaningful

Total net revenue declined by 51% to $316.2 million for the three months ended March 31, 2008 compared to the same period in 2007. This decline was driven by an increase in the provision for loan losses of $212.7 million to $233.9 million for the three months ended March 31, 2008 compared to the same period in 2007.

Net Operating Interest Income

Net operating interest income decreased 15% to $332.8 million for the three months ended March 31, 2008 compared to the same period in 2007. Net operating interest income is earned primarily through holding credit balances, which include margin, real estate and consumer loans, and by holding customer cash and deposits, which are a low cost source of funding. The decrease in net operating interest income was due primarily to the decrease in enterprise interest-earning assets.

 

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

 

    Three Months Ended March 31,  
    2008     2007  
    Average
Balance
    Operating
Interest
Inc./Exp.
    Average
Yield/
Cost
    Average
Balance
  Operating
Interest
Inc./Exp.
  Average
Yield/
Cost
 

Enterprise interest-earning assets:

           

Loans, net(1)

  $ 29,925,013     $ 451,574     6.04 %   $ 28,093,409   $ 451,399   6.43 %

Margin receivables

    6,936,549       94,913     5.50 %     6,787,828     123,986   7.41 %

Mortgage-backed and related available-for-sale securities

    9,281,381       110,072     4.74 %     12,040,109     157,967   5.25 %

Available-for-sale investment securities

    176,360       2,902     6.58 %     3,651,560     59,860   6.56 %

Trading securities

    572,817       10,708     7.48 %     119,779     3,269   10.92 %

Cash and cash equivalents(2)

    2,210,282       20,798     3.78 %     1,358,120     15,930   4.76 %

Stock borrow and other

    808,330       15,712     7.78 %     820,679     13,687   6.67 %
                               

Total enterprise interest-earning assets(3)

    49,910,732       706,679     5.67 %     52,871,484     826,098   6.27 %
                     

Non-operating interest-earning assets(4)

    4,797,002           4,422,167    
                     

Total assets

  $ 54,707,734         $ 57,293,651    
                     

Enterprise interest-bearing liabilities:

           

Retail deposits

  $ 25,383,594       171,535     2.72 %   $ 24,696,611     177,329   2.91 %

Brokered certificates of deposit

    1,229,811       15,169     4.96 %     466,559     5,659   4.92 %

Customer payables

    5,261,612       14,635     1.12 %     6,380,411     20,479   1.30 %

Repurchase agreements and other borrowings

    7,980,130       94,934     4.71 %     12,137,872     159,031   5.24 %

FHLB advances

    5,974,084       70,802     4.69 %     4,996,389     62,852   5.03 %

Stock loan and other

    1,679,887       10,656     2.51 %     1,349,305     12,515   3.76 %
                               

Total enterprise interest-bearing liabilities

    47,509,118       377,731     3.17 %     50,027,147     437,865   3.53 %
                     

Non-operating interest-bearing liabilities(5)

    4,357,534           3,016,712    
                     

Total liabilities

    51,866,652           53,043,859    

Total shareholders’ equity

    2,841,082           4,249,792    
                     

Total liabilities and shareholders’ equity

  $ 54,707,734         $ 57,293,651    
                     

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

  $ 2,401,614     $ 328,948     2.50 %   $ 2,844,337   $ 388,233   2.74 %
                               

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

      2.64 %       2.94 %

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

      105.06 %       105.69 %

Return on average:

           

Total assets

      (0.67 )%       1.18 %

Total shareholders’ equity

      (12.84 )%       15.95 %

Average equity to average total assets

      5.19 %       7.42 %
Reconciliation from enterprise net interest income to net operating interest income (dollars in thousands):  
    Three Months Ended March 31,                      
            2008                     2007                              
           

Enterprise net interest income(6)

  $ 328,948     $ 388,233          

Taxable equivalent interest adjustment

    (3,698 )     (7,320 )        

Customer cash held by third parties and other(7)

    7,521       9,673          
                       

Net operating interest income

  $ 332,771     $ 390,586          
                       

 

(1)

 

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

(2)

 

Includes segregated cash balances.

(3)

 

Amount includes a taxable equivalent increase in operating interest income of $3.7 million and $7.3 million for the three months ended March 31, 2008 and 2007, respectively.

(4)

 

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

(5)

 

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

(6)

 

Enterprise net interest income is taxable equivalent basis net operating interest income excluding corporate interest income and corporate interest expense, stock conduit interest income and expense and interest earned on customer cash held by third parties. Management believes this non-GAAP measure is useful to analysts and investors as it is a measure of the net operating interest income generated by our operations.

(7)

 

Includes interest earned on average customer assets of $3.3 billion and $3.9 billion for the three months ended March 31, 2008 and 2007, respectively, held by parties outside E*TRADE Financial, including third party money market funds and sweep deposit accounts at unaffiliated financial institutions. Other consists of net operating interest earned on average stock conduit assets of $0.01 million and $2.7 million for the three months ended March 31, 2008 and 2007, respectively.

 

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Average enterprise interest-earning assets decreased 6% to $49.9 billion for the three months ended March 31, 2008 compared to the same period in 2007, primarily the result of a decrease in our available-for-sale portfolio. Average available-for-sale mortgage-backed and investment securities decreased 40% to $9.5 billion for the three months ended March 31, 2008 compared to the same period in 2007. This decrease was primarily due to the sale of certain mortgage-backed securities in the first quarter of 2008 and the sale of our asset-backed securities portfolio towards the end of the fourth quarter of 2007. This decrease was slightly offset by an increase in average loans, net. Average loans, net grew 7% to $29.9 billion for the three months ended March 31, 2008 compared to the same period in 2007. Average loans, net grew as a result of our focus on growing real estate loan products in the first and second quarters of 2007. Beginning in the second half of 2007, we altered our strategy and halted the focus on growing the balance sheet. For the foreseeable future, we plan to allow our loans, particularly our home equity loans, to pay down, resulting in an overall decline in the balance of the loan portfolio.

Average enterprise interest-bearing liabilities decreased 5% to $47.5 billion for the three months ended March 31, 2008 compared to the same period in 2007. The decrease in average enterprise interest-bearing liabilities was primarily due to a decrease in repurchase agreements. Average repurchase agreements and other borrowings decreased 34% to $8.0 billion for the three months ended March 31, 2008 compared to the same period in 2007. This decrease was slightly offset by an increase in average retail deposits. Average retail deposits increased 3% to $25.4 billion for the three months ended March 31, 2008 compared to the same period in 2007. Increases in average retail deposits were driven by growth in the Complete Savings Account.

Enterprise net interest spread decreased by 24 basis points to 2.50% for the three months ended March 31, 2008 compared to the same period in 2007. This decrease was primarily the result of a challenging interest rate environment throughout the past 12 months as well as growth in our Complete Savings Account, which pays a higher interest rate than the majority of our other deposit products.

Provision for Loan Losses

Provision for loan losses increased $212.7 million to $233.9 million for the three months ended March 31, 2008 compared to the same period in 2007. The increase in the provision for loan losses was related primarily to deterioration in the performance of our home equity loan portfolio, which began in the second half of 2007. During the first quarter of 2008, we also observed deterioration in the performance of our one- to four-family loan portfolio. We believe the deterioration in both of these portfolios was caused by several factors, including: home price depreciation in key markets; growing inventories of unsold homes; rising foreclosure rates; significant contraction in the availability of credit; and a general decline in economic growth. In addition, the combined impact of home price depreciation and the reduction of available credit made it increasingly difficult for borrowers to refinance existing loans. We believe these factors will cause the provision for loan losses to continue at historically high levels in future periods.

Commission

Commission revenue decreased 18% to $129.8 million for the three months ended March 31, 2008, compared to the same period in 2007, which was driven primarily by a decrease of $34.3 million, or 96%, in institutional commission revenue as a result of our exit of our institutional brokerage operations. This was partially offset by an increase of $5.1 million, or 4%, in our retail commission revenue. The primary factors that affect our retail commission revenue are DARTs and average commission per trade, which is impacted by both trade types and the mix between our domestic and international businesses. Each business has a different pricing structure, unique to its customer base and local market practices, and as a result, a change in the relative number of executed trades in these businesses impacts average commission per trade. Each business also has different trade types (e.g. equities, options, fixed income, exchange-traded funds, contract for difference and mutual funds) that can have different commission rates. As a result, changes in the mix of trade types within either of these businesses may impact average commission per trade.

 

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DARTs increased 12% to 190,724 for the three months ended March 31, 2008 compared to the same period in 2007. Our U.S. DART volume increased 10% for the three months ended March 31, 2008 compared to the same period in 2007. Our international DARTs grew by 22% for the three months ended March 31, 2008 compared to the same period in 2007, driven entirely by organic growth. Our international operations continue to be a strong growth contributor within our retail trading business, and we believe that over time they will become a significant component of our entire business. In addition, option-related DARTs further increased as a percentage of our total U.S. DARTs and now represent 17% of U.S. trading volume versus 14% a year ago.

Average commission per trade decreased 7% to $11.04 for the three months ended March 31, 2008 compared to the same period in 2007. The decrease was primarily a function of the mix of customers. Main Street Investors, who generally have a higher commission per trade, traded less during the period compared to Active Traders and Mass Affluent customers, who generally have a lower commission per trade. Customer appreciation and win-back campaigns also contributed to the decrease in average commission per trade.

Fees and Service Charges

Fees and service charges increased 5% to $62.6 million for the three months ended March 31, 2008 compared to the same period in 2007. This increase was due to an increase in foreign currency margin revenue, fixed income product revenue and mutual fund fees, partially offset by a decrease in CDO management fee revenue.

Principal Transactions

Principal transactions decreased 32% to $20.5 million for the three months ended March 31, 2008 compared to the same period in 2007. The decrease in principal transactions resulted from lower institutional trading volumes. Our principal transactions revenue is influenced by overall trading volumes, the number of stocks for which we act as a market maker, the trading volumes of those specific stocks and the performance of our proprietary trading activities.

Gain (Loss) on Loans and Securities, Net

Gain (loss) on loans and securities, net was a loss of $9.1 million for the three months ended March 31, 2008, as shown in the following table (dollars in thousands):

 

     Three Months Ended
March 31,
    Variance  
     2008 vs. 2007  
     2008     2007     Amount     %  

Gain on sales of originated loans

   $ 730     $ 1,915     $ (1,185 )   (62 )%

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

     (157 )     (1,662 )     1,505     (91 )%
                          

Gain on sales of loans, net

     573       253       320     126 %

Gain on securities and other investments

     13,263       8,517       4,746     56 %

Loss on impairment

     (26,602 )     (249 )     (26,353 )   *  

Gain on trading securities

     3,621       8,854       (5,233 )   (59 )%
                          

Gain (loss) on securities, net

     (9,718 )     17,122       (26,840 )   *  
                          

Gain (loss) on loans and securities, net

   $ (9,145 )   $ 17,375     $ (26,520 )   *  
                          

 

*   Percentage not meaningful

 

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The decrease in the total gain (loss) on loans and securities, net during the three months ended March 31, 2008 was due primarily to the $26.6 million impairment that was recorded on certain AAA-rated and AA-rated collateralized mortgage obligations (“CMO”) in the first quarter of 2008. Further declines in the performance of our CMO portfolio could result in additional impairments in future periods.

Other Revenue

Other revenue increased 41% to $13.6 million for the three months ended March 31, 2008 compared to the same period in 2007. The increase in other revenue was due to an increase in the cash surrender value of Bank-Owned Life Insurance (BOLI), an increase in fees earned in connection with distribution of shares during initial public offerings and software consulting fees from our Corporate Services business.

Expense Excluding Interest

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

 

     Three Months Ended
March 31,
   Variance  
        2008 vs. 2007  
     2008    2007    Amount     %  

Compensation and benefits

   $ 128,777    $ 123,782    $ 4,995         4  %

Clearing and servicing

     48,579      67,252      (18,673 )   (28) %

Advertising and marketing development

     60,472      45,592      14,880     33  %

Communications

     27,439      26,156      1,283     %

Professional services

     24,347      24,985      (638 )   (3) %

Depreciation and amortization

     22,071      19,383      2,688     14  %

Occupancy and equipment

     22,003      23,579      (1,576 )   (7) %

Amortization of other intangibles

     10,910      10,268      642     %

Facility restructuring and other exit activities

     10,492      733      9,759     *  

Other

     17,523      32,675      (15,152 )   (46) %
                        

Total expense excluding interest

   $ 372,613    $ 374,405    $ (1,792 )   (0) %
                        

 

*   Percentage not meaningful

Expense excluding interest declined slightly to $372.6 million for the three months ended March 31, 2008 compared to the same period in 2007.

Compensation and Benefits

Compensation and benefits increased 4% to $128.8 million for the three months ended March 31, 2008 compared to the same period in 2007. This increase resulted primarily from increased severance compensation of $12.0 million during the first quarter of 2008.

Clearing and Servicing

Clearing and servicing expense decreased 28% to $48.6 million for the three months ended March 31, 2008 compared to the same period in 2007. This decrease is related primarily to the exit of our institutional brokerage operations, which resulted in lower clearing expenses.

Advertising and Market Development

Advertising and market development expense increased 33% to $60.5 million for the three months ended March 31, 2008 compared to the same period in 2007. This planned increase was aimed at restoring customer confidence as well as expanded efforts to promote our products and services to retail investors.

 

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Facility Restructuring and Other Exit Activities

Facility restructuring and other exit activities expense increased to $10.5 million for the three months ended March 31, 2008 compared to the same period in 2007. The increase is due primarily to the exit of our institutional brokerage operations during the three months ended March 31, 2008.

Other

Other expense decreased 46% to $17.5 million for the three months ended March 31, 2008 compared to the same period in 2007. The decrease is due primarily to the sale of our corporate aircraft related assets, which resulted in a $23.7 million gain on sale during the three months ended March 31, 2008. This decrease was slightly offset by an increase in our regulatory services and fees as well as an increase in bad debt and trade errors.

Other Income (Expense)

Other income (expense) increased from an expense of $8.2 million to an expense of $90.5 million for the three months ended March 31, 2008 compared to the same period in 2007, as shown in the following table (dollars in thousands):

 

     Three Months Ended
March 31,
    Variance  
     2008 vs. 2007  
     2008     2007     Amount     %  

Other income (expense):

        

  Corporate interest income

   $ 2,426     $ 1,705     $ 721     42  %

  Corporate interest expense

     (95,241 )     (37,791 )     (57,450 )   152  %

  Gain on sales of investments, net

     502       19,756       (19,254 )   (97 )%

  Loss on early extinguishment of debt

     (2,851 )     —         (2,851 )   *  

  Equity in income of investments and venture funds

     4,699       8,095       (3,396 )   (42 )%
                          

Total other income (expense)

   $ (90,465 )   $ (8,235 )   $ (82,230 )   *  
                          

 

*   Percentage not meaningful

Total other income (expense) for the three months ended March 31, 2008 primarily consisted of corporate interest expense resulting from our corporate debt, which includes the springing lien notes, senior notes and mandatory convertible notes. Corporate interest expense increased 152% to $95.2 million for the three months ended March 31, 2008, which was primarily due to the interest expense on the springing lien notes that were issued in the fourth quarter of 2007 and first quarter of 2008.

The loss on early extinguishment of debt of $2.9 million for the three months ended March 31, 2008 is primarily due to a loss of $10.8 million related to the early extinguishment of FHLB advances and a loss of $0.6 million on the prepayment of debt related to the sale of the corporate aircraft. These losses were partially offset by an $8.5 million gain recognized on the exchange of the $25.0 million of our senior notes for 4.5 million shares of our common stock.

Income Tax Expense (Benefit)

Income tax benefit from continuing operations was $55.6 million during the three months ended March 31, 2008 compared to an income tax expense of $92.9 million for the same period in 2007. The recording of a net tax benefit in the current period compared to a net tax expense for the same period in 2007 relates primarily to $146.8 million in loss before income taxes for the three months ended March 31, 2008 compared to $262.4 million in income before income taxes for the same period in 2007. Our effective tax rates for the three months ended March 31, 2008 and 2007 were (37.9)% and 35.4%, respectively.

 

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The $55.6 million income tax benefit for the three months ended March 31, 2008 includes a $4.3 million tax benefit related to the favorable resolution and settlement of a Hong Kong tax examination. In addition, the net income tax benefit includes a $1.7 million tax expense recognized in establishing deferred taxes as a result of our determination that undistributed earnings from certain of our profitable foreign operations are no longer permanently reinvested outside the U.S.

We expect our 2008 tax expense to be based on a pro-forma tax rate in the range of 37% to 38% before taking into account the two items listed above and before consideration of $11.5 million of projected 2008 incremental tax expense, which is summarized in the following table (dollars in millions):

 

     Tax

Incremental tax benefits

  

Tax exempt income

   $ 14.0

Low income housing tax credits

     2.4
      

Total tax benefits

     16.4

Incremental tax expenses

  

Non-deductible officer’s compensation

     3.4

Tax rate differential of international operations

     6.7

Non-deductible portion of interest expense on springing lien notes

     17.8
      

Total tax expense

     27.9
      

Projected incremental tax items

   $ 11.5
      

A proportionate amount of these incremental tax items were included in the $55.6 million income tax benefit for the three months ended March 31, 2008.

During the three months ended March 31, 2008, we did not provide for additional valuation allowance against our federal deferred tax assets, including those related to our operating loss and credit carryforwards, since we continue to believe that it is not more likely than not that the net deferred federal tax assets will not be recognized. The ability to recognize these deferred tax assets is generally based on our ability to generate future profits and can be subject to other limitations in the event of a substantial change in ownership in the Company. Thus, while we currently believe it is more likely than not the deferred tax assets will be recognized, such recognition cannot be assured, nor can there be any assurance that our judgment regarding the need for a valuation allowance will not change at some point in the future.

 

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SEGMENT RESULTS REVIEW

Retail

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

 

     Three Months Ended
March 31,
   Variance  
        2008 vs. 2007  
     2008    2007    Amount     %  

Retail segment income:

          

Net operating interest income

   $ 212,987    $ 227,481    $ (14,494 )   (6) %

Commission

     128,388      123,305      5,083     %

Fees and service charges

     59,213      54,203      5,010     %

Gain on loans and securities, net

     1,069      4,911      (3,842 )   (78) %

Other revenue

     9,683      9,751      (68 )   (1) %
                        

Net segment revenue

     411,340      419,651      (8,311 )   (2) %

Total segment expense

     285,846      248,193      37,653     15  %
                        

Total retail segment income

   $ 125,494    $ 171,458    $ (45,964 )   (27) %
                        

Key Metrics:

          

Retail customer assets (dollars in billions)

   $ 168.4    $ 200.5    $ (32.1 )   (16) %

Customer cash and deposits (dollars in billions)

   $ 34.9    $ 36.0    $ (1.1 )   (3) %

U.S. DARTs

     155,706      141,238      14,468     10  %

International DARTs

     35,018      28,798      6,220     22  %
                        

DARTs

     190,724      170,036      20,688     12  %

Average commission per trade

   $ 11.04    $ 11.89    $ (0.85 )   (7) %

Average margin debt (dollars in billions)

   $ 7.0    $ 6.9    $ 0.1     %

End of period total accounts

     4,778,238      4,546,544      231,694     %

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

During the fourth quarter of 2007, we experienced a disruption in our customer base which caused a decline in the core drivers of our retail segment, including: net new accounts, customer cash and deposits, DARTs, margin debt and retail client assets. We believe this disruption was due to the uncertainty surrounding the Company in connection with the credit related losses in our institutional segment. While we continue to anticipate credit related losses, primarily in our home equity loan portfolio, we believe our retail customer base has stabilized. During the first quarter of 2008, our retail customer base showed positive growth trends, including adding over 60,000 net new customers and net growth in customer assets of approximately $300 million(1). We believe these are indications that our retail segment has not only stabilized but has returned to modest growth.

Retail segment income decreased 27% to $125.5 million for the three months ended March 31, 2008 compared to the same period in 2007. This was due primarily to a decrease in net operating interest income and an increase in total segment expense.

 

(1)   Growth in customer assets as compared to December 31, 2007 and excludes the effects of market movements in the value of customer assets.

 

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Retail net operating interest income decreased 6% to $213.0 million for the three months ended March 31, 2008 compared to the same period in 2007. This decrease was driven primarily by a decrease in customer cash and deposits during the comparable periods.

Retail commission revenue increased 4% to $128.4 million for the three months ended March 31, 2008 compared to the same period in 2007. The increase in commission revenue was primarily the result of increased trading volumes in the overall domestic equity market and in our international commissions where DARTs increased 22% from 28,798 to 35,018 for the three months ended March 31, 2008 compared to the same period in 2007.

Retail segment expense increased 15% to $285.8 million for three months ended March 31, 2008 compared to the same period in 2007. This increase related primarily to our planned growth in marketing spend as we expanded efforts to promote our products and services to retail investors.

As of March 31, 2008, we had approximately 3.6 million active trading and investing accounts and 1.1 million active deposit and lending accounts. For the three months ended March 31, 2008 and 2007, our retail trading and investing products contributed 71% and 70%, respectively, and our deposit products contributed 24% and 23%, respectively, of total retail net revenue. All other products contributed less than 10% of total retail net revenue for the three months ended March 31, 2008 and 2007.

Institutional

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

 

     Three Months Ended
March 31,
    Variance  
       2008 vs. 2007  
     2008     2007     Amount     %  

Institutional segment income (loss):

        

Net operating interest income

   $ 119,784     $ 163,105     $ (43,321 )   (27) %

Provision for loan losses

     (233,871 )     (21,186 )     (212,685 )   1004  %
                          

Net operating interest income (expense) after provision for loan losses

     (114,087 )     141,919       (256,006 )   (180) %

Commission

     1,376       35,688       (34,312 )   (96) %

Fees and service charges

     5,324       7,475       (2,151 )   (29) %

Principal transactions

     20,495       30,082       (9,587 )   (32) %

Gain (loss) on loans and securities, net

     (10,214 )     12,464       (22,678 )   (182) %

Other revenue

     3,943       41       3,902     *  
                          

Net segment revenue

     (93,163 )     227,669       (320,832 )   (141) %

Total segment expense

     88,708       128,534       (39,826 )   (31) %
                          

Total institutional segment income (loss)

   $ (181,871 )   $ 99,135     $ (281,006 )   (283) %
                          

Key Metrics:

        

Nonperforming loans receivable as a percentage of gross loans receivable

     2.02  %     0.39  %     *     1.63  %

Allowance for loan losses (dollars in millions)

   $ 565.9     $ 68.0     $ 497.9     732  %

Allowance for loan losses as a % of nonperforming loans

     96.84  %     58.68  %     *     38.16  %

Average revenue capture per 1,000 equity shares

   $ 0.566     $ 0.576     $ (0.010 )   (2) %

 

*   Percentage not meaningful

 

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Our institutional segment generates revenue from balance sheet management and market-making activities. Balance sheet management activities include managing loans previously purchased from the retail segment as well as third parties, and leveraging these loans and retail customer cash and deposit relationships to generate additional net operating interest income.

As a result of our exposure to the credit crisis in the residential real estate and credit markets, our institutional segment incurred a loss of $181.9 million for the three months ended March 31, 2008. The loss was driven primarily by an increase in the provision for loan losses for our loan portfolio of $212.7 million for the three months ended March 31, 2008 compared to the same period in 2007. We believe the provision for loan losses will continue at historically high levels in future periods as the crisis in the residential real estate and credit markets continues to impact the performance of our loan portfolio.

Net operating interest income decreased 27% to $119.8 million for the three months ended March 31, 2008 compared to the same period in 2007. The decrease in net operating interest income was due primarily to the decrease in average interest-earning assets of 6% to $49.9 million for the quarter ended March 31, 2008 compared to the same period in 2007.

Provision for loan losses increased $212.7 million to $233.9 million for the three months ended March 31, 2008 compared to the same period in 2007. The increase in the provision for loan losses was related primarily to deterioration in the performance of our home equity loan portfolio, which began in the second half of 2007. During the first quarter of 2008, we also observed deterioration in the performance of our one- to four-family loan portfolio. We believe the deterioration in both of these portfolios was caused by several factors, including: home price depreciation in key markets; growing inventories of unsold homes; rising foreclosure rates; significant contraction in the availability of credit; and a general decline in economic growth. In addition, the combined impact of home price depreciation and the reduction of available credit made it increasingly difficult for borrowers to refinance existing loans. We believe these factors will cause the provision for loan losses to continue at historically high levels in future periods.

Institutional commission revenue decreased 96% to $1.4 million for three months ended March 31, 2008 compared to the same period in 2007. The decrease was a result of our exit of our institutional brokerage operations.

Fees and service charges revenue decreased 29% to $5.3 million for the three months ended March 31, 2008 compared to the same period in 2007. The decrease for the three months ended March 31, 2008, is primarily the result of a decrease in CDO management fees, which are no longer a revenue stream due to the sale of our collateral management agreements during the first quarter of 2008.

Gain (loss) on loans and securities, net decreased to a loss of $10.2 million for the three months ended March 31, 2008. This decline was due primarily to the $26.6 million impairment that was recorded on certain AAA-rated and AA-rated CMOs in the first quarter of 2008. This loss was partially offset by an increase in the gain on securities and other investments due to the sales of certain of our mortgage-backed securities.

Total institutional segment expense decreased 31% to $88.7 million for the three months ended March 31, 2008 compared to the same period in 2007 and was due primarily to a decline in our clearing expense related to the exit of our institutional brokerage operations, as well as a reduction in corporate overhead expenses, the majority of which are allocated to the institutional segment.

 

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BALANCE SHEET OVERVIEW

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

 

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

Assets:

          

Cash and equivalents(1)

   $ 3,489,905    $ 2,113,075    $ 1,376,830     65  %

Trading securities

     422,941      130,018      292,923     225  %

Available-for-sale mortgage-backed and investment securities

     8,402,077      11,255,048      (2,852,971 )   (25) %

Margin receivables

     6,655,659      7,179,175      (523,516 )   (7) %

Loans, net

     28,444,165      30,139,382      (1,695,217 )   (6) %

Investment in FHLB stock

     241,392      338,585      (97,193 )   (29) %

Other assets(2)

     5,540,811      5,690,654      (149,843 )   (3) %
                        

Total assets

   $ 53,196,950    $ 56,845,937    $ (3,648,987 )   (6) %
                        

Liabilities and shareholders’ equity:

          

Deposits

   $ 27,467,227    $ 25,884,755    $ 1,582,472     %

Wholesale borrowings(3)

     12,352,637      16,379,197      (4,026,560 )   (25) %

Customer payables

     5,413,283      5,514,675      (101,392 )   (2) %

Corporate debt

     3,156,699      3,022,698      134,001     %

Accounts payable, accrued and other liabilities

     2,091,765      3,215,547      (1,123,782 )   (35) %
                        

Total liabilities

     50,481,611      54,016,872      (3,535,261 )   (7) %

Shareholders’ equity

     2,715,339      2,829,065      (113,726 )   (4) %
                        

Total liabilities and shareholders’ equity

   $ 53,196,950    $ 56,845,937    $ (3,648,987 )   (6) %
                        

 

(1)

 

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

(2)

 

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

(3)

 

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

The decrease in total assets was attributable primarily to a decrease of $2.9 billion in available-for-sale mortgage-backed and investment securities and a decrease of $1.7 billion in loans, net. The decrease in available-for-sale mortgage-backed and investment securities was primarily due to a $2.2 billion decrease in our mortgage-backed securities. The decrease in loans, net is due to our strategy of reducing balance sheet risk and halting our previous focus on growing the balance sheet. For the foreseeable future, we plan to allow our loans, particularly our home equity loans, to pay down, resulting in an overall decline in the balance of the loan portfolio. During this period, we plan to continue increasing our excess regulatory capital levels at E*TRADE Bank as we focus on strengthening our capital position.

The decrease in total liabilities was attributable primarily to the decrease in wholesale borrowings which was partially offset by an increase in deposits. The decrease in wholesale borrowings was a result of paying down our FHLB advances and securities sold under agreements to repurchase in the first quarter of 2008. The $1.6 billion increase in deposits was due primarily to the growth in money market and savings accounts.

 

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Loans, Net

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

 

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

Loans held-for-sale

   $ 19,327     $ 100,539     $ (81,212 )   (81)%

One- to four-family

     14,639,145       15,506,529       (867,384 )   (6)%

Home equity

     11,385,998       11,901,324       (515,326 )   (4)%

Consumer and other loans:

        

Recreational vehicle

     1,811,794       1,910,454       (98,660 )   (5)%

Marine

     497,693       526,580       (28,887 )   (5)%

Commercial

     264,909       272,156       (7,247 )   (3)%

Credit card

     85,547       90,764       (5,217 )   (6)%

Other

     15,925       23,334       (7,409 )   (32)%

Unamortized premiums, net

     289,735       315,866       (26,131 )   (8)%

Allowance for loan losses

     (565,908 )     (508,164 )     (57,744 )   11 %
                          

Total loans, net

   $ 28,444,165     $ 30,139,382     $ (1,695,217 )   (6)%
                          

Loans, net decreased 6% to $28.4 billion at March 31, 2008 from $30.1 billion at December 31, 2007. This decline was due primarily to our strategy on reducing balance sheet risk and halting our previous focus on growing the balance sheet. We do not expect to grow our loan portfolio for the foreseeable future. In addition, we intend to allow our home equity and consumer loan portfolios to fully decline over time.

As a general matter, we do not originate or purchase sub-prime(1) loans to hold on our balance sheet; however, in the normal course of purchasing large pools of real estate loans in prior periods, we invariably ended up acquiring a de minimis amount of these loans. As of March 31, 2008, sub-prime real estate loans represented less than one-fifth of one percent of our total real estate loan portfolio.

We have a credit default swap (“CDS”) on $4.0 billion of our first-lien residential real estate loan portfolio through a synthetic securitization structure. A CDS provides, for a fee, an assumption by a third party of a portion of the credit risk related to the underlying loans. The CDS we entered into provides protection for losses in excess of 10 basis points, but not to exceed approximately 75 basis points. In addition, our regulatory risk-weighted assets were reduced as a result of this transaction because we transferred a portion of our credit risk to an unaffiliated third party.

 

(1)   Defined as borrowers with Fair Isaac Credit Organization (“FICO”) scores less than 620 at time of origination.

 

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Available-for-Sale Mortgage-Backed and Investment Securities

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

 

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

Mortgage-backed securities:

          

Backed by U.S. government sponsored and Federal agencies

   $ 7,314,317    $ 9,330,129    $ (2,015,812 )   (22)%

CMOs and other

     970,660      1,123,255      (152,595 )   (14)%
                        

Total mortgage-backed securities

     8,284,977      10,453,384      (2,168,407 )   (21)%
                        

Investment securities:

          

Municipal bonds

     95,696      314,348      (218,652 )   (70)%

Publicly traded equity securities:

          

Preferred stock(1)

     —        371,404      (371,404 )   (100)%

Corporate investments

     1,014      1,271      (257 )   (20)%

Other

     20,390      114,641      (94,251 )   (82)%
                        

Total investment securities

     117,100      801,664      (684,564 )   (85)%
                        

Total available-for-sale securities

   $ 8,402,077    $ 11,255,048    $ (2,852,971 )   (25)%
                        

 

(1)

 

On January 1, 2008, the Company elected the fair value option for preferred stock in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 159, The Fair Value Option for Financial Assets and Financial Liabilities-Including an Amendment of FASB Statement No. 115 (“SFAS No. 159”). As a result of this election, preferred stock is classified on the balance sheet as trading securities as of March 31, 2008.

Available-for-sale securities represented 16% and 20% of total assets at March 31, 2008 and December 31, 2007, respectively. Available-for-sale securities decreased 25% to $8.4 billion at March 31, 2008 compared to December 31, 2007, due primarily to the sale of certain mortgage-backed securities in the first quarter of 2008. Substantially all mortgage-backed securities backed by U.S. Government sponsored and Federal agencies are AAA-rated.

Margin Receivables

The margin receivables balance is a component of the margin debt balance, which is reported as a key retail metric of $6.7 billion and $7.3 billion at March 31, 2008 and December 31, 2007, respectively. The total margin debt balance is summarized as follows (dollars in thousands):

 

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

Margin receivables

   $ 6,655,659    $ 7,179,175    $ (523,516 )   (7)%

Margin held by third parties and other

     48,462      81,669      (33,207 )   (41)%
                        

Margin debt

   $ 6,704,121    $ 7,260,844    $ (556,723 )   (8)%
                        

 

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Deposits

Deposits are summarized as follows (dollars in thousands):

 

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

Money market and savings accounts

   $ 11,978,286    $ 10,028,115    $ 1,950,171     19%

Sweep deposit accounts

     10,001,293      10,112,123      (110,830 )   (1)%

Certificates of deposit (1)

     3,719,406      4,156,674      (437,268 )   (11)%

Brokered certificates of deposit (2)

     1,219,370      1,092,225      127,145     12 %

Checking accounts

     548,872      495,618      53,254     11 %
                        

Total deposits

   $ 27,467,227    $ 25,884,755    $ 1,582,472     6 %
                        

 

(1)

 

Includes retail brokered certificates of deposit.

(2)

 

Includes institutional brokered certificates of deposit.

Deposits represented 54% and 48% of total liabilities at March 31, 2008 and December 31, 2007, respectively. Deposits increased $1.6 billion to $27.5 billion at March 31, 2008 compared to December 31, 2007, driven by a $2.0 billion increase in money market and savings accounts. Deposits generally provide us the benefit of lower interest costs, compared with wholesale funding alternatives.

The deposits balance is a component of the total customer cash and deposits balance reported as a customer activity metric of $34.9 billion and $33.6 billion at March 31, 2008 and December 31, 2007, respectively. The total customer cash and deposits balance is summarized as follows (dollars in thousands):

 

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

Deposits

   $ 27,467,227     $ 25,884,755     $ 1,582,472     6 %

Less: brokered certificates of deposit

     (1,219,370 )     (1,092,225 )     127,145     12 %
                          

Deposits excluding brokered certificates of deposit

     26,247,857       24,792,530       1,455,327     6 %

Customer payables

     5,413,283       5,514,675       (101,392 )   (2)%

Customer cash balances held by third parties and other

     3,235,217       3,286,212       (50,995 )   (2)%
                          

Total customer cash and deposits

   $ 34,896,357     $ 33,593,417     $ 1,302,940     4 %
                          

Wholesale Borrowings

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

 

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

Securities sold under agreements to repurchase

   $ 7,109,716    $ 8,932,693    $ (1,822,977 )   (20)%

FHLB advances

     4,803,600      6,967,406      (2,163,806 )   (31)%

Subordinated debentures

     435,830      435,830      —       —  %

Other

     3,491      43,268      (39,777 )   (92)%
                        

Total other borrowings

     5,242,921      7,446,504      (2,203,583 )   (30)%
                        

Total wholesale borrowings

   $ 12,352,637    $ 16,379,197    $ (4,026,560 )   (25)%
                        

 

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Wholesale borrowings represented 24% and 30% of total liabilities at March 31, 2008 and December 31, 2007, respectively. The decrease in other borrowings of $4.0 billion during for the three months ended March 31, 2008 was due primarily to a decrease in FHLB advances. Securities sold under agreements to repurchase coupled with FHLB advances are the primary wholesale funding sources of the Bank. As a result, we expect these balances to fluctuate over time as our deposits and our interest-earning assets fluctuate.

Corporate Debt

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

 

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

Senior notes

   $ 1,251,814    $ 1,272,742    $ (20,928 )   (2)%

Springing lien notes

     1,461,094      1,304,391      156,703     12 %

Mandatory convertible notes

     443,791      445,565      (1,774 )   *
                        

Total corporate debt

   $ 3,156,699    $ 3,022,698    $ 134,001     4 %
                        

 

*   Percentage not meaningful.

Corporate debt increased to $3.2 billion at March 31, 2008 compared to $3.0 billion at December 31, 2007. The increase is related to the additional $150.0 million of 12 1 /2% springing lien notes issued to Citadel in the first quarter of 2008, offset by a decline in senior notes of $25 million in principal related to a debt for equity exchange. We expect the outstanding principal of our senior notes to decline in future periods as the mandatory convertible notes are converted to equity and as we continue to pursue debt for equity exchanges.

LIQUIDITY AND CAPITAL RESOURCES

We have established liquidity and capital policies. The objectives of these policies are to support the successful execution of our business strategies while ensuring ongoing and sufficient liquidity through the business cycle and during periods of financial distress. During the fourth quarter of 2007, we experienced a disruption in our customer base, which caused a significant decline in customer deposits. We believe this disruption was due to the uncertainty surrounding the Company in connection with the credit related losses in our institutional segment. Deposits are the primary source of liquidity for E*TRADE Bank, so this sudden and rapid decline created a substantial amount of liquidity risk. We followed our existing liquidity policies and contingency plans and successfully met our liquidity needs during this extraordinary period. We believe that our ability to meet liquidity needs during this time validates the effectiveness of the liquidity policies and contingency plans. While the liquidity risk associated with our customer deposits remains at historically high levels, we believe the progress made to date on our turnaround plan has substantially reduced this risk when compared to the fourth quarter of 2007.

Capital is generated primarily through our business operations and our capital market activities. During the second half of 2007, our institutional segment incurred a significant amount of losses as a result of its exposure to the crisis in the residential real estate and credit markets. Consequently, this segment required a significant capital infusion during the fourth quarter. The Company raised $2.5 billion in cash from Citadel, the majority of which was used to provide capital to the institutional segment. While this segment continues to have exposure to the crisis in the residential real estate and credit markets, we believe that the proceeds from the Citadel Investment as well as capital generated in our retail segment will be sufficient to meet our capital needs for at least the next twelve months. In addition, we plan to raise additional capital in 2008 by issuing shares of common stock in exchange for existing corporate debt, primarily our senior notes. We completed one of these transactions in the first quarter of 2008, which resulted in a retirement of $25 million of existing corporate debt.

 

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Changes in Cash and Equivalents

In the first quarter of 2008, the consolidated cash and equivalents balance increased to $3.1 billion for the period ended March 31, 2008. Cash and equivalents at E*TRADE Financial Corporation, on a standalone holding company basis, decreased $16.8 million to $234.9 million.

Corporate Debt

Our current senior debt ratings are Ba3 by Moody’s Investor Service, B (watch neg) by Standard & Poor’s and BB by Dominion Bond Rating Service (“DBRS”). The Company’s long-term deposit ratings are Ba2 by Moody’s Investor Service, BB- (watch neg) by Standard & Poor’s and BB (high) by DBRS. A significant change in these ratings may impact the rate and availability of future borrowings.

Liquidity Available from Subsidiaries

Liquidity available to the Company from its subsidiaries, other than Converging Arrows, Inc. (“Converging Arrows”) is limited by regulatory requirements. At March 31, 2008, Converging Arrows had $61.0 million of cash and investment securities available as a source of liquidity for the parent company. Converging Arrows is not restricted in its dealings with the parent company and may transfer funds to the parent company without regulatory approval. In addition to Converging Arrows, brokerage and banking subsidiaries may provide liquidity to the parent; however, they are restricted by regulatory guidelines.

Any loans by E*TRADE Bank to the parent company and its other non-bank subsidiaries are subject to various quantitative, arm’s length, collateralization and other requirements. At March 31, 2008, E*TRADE Bank had approximately $695.3 million of capital above the “well capitalized” level. In the current credit environment, we plan to increase the excess capital at E*TRADE Bank in order to increase our ability to absorb credit losses while still maintaining “well capitalized” status. Therefore, we do not expect to dividend this excess capital to the parent during the foreseeable future. E*TRADE Bank is also required by Office of Thrift Supervision (“OTS”) regulations to maintain tangible capital of at least 1.50% of tangible assets. E*TRADE Bank satisfied this requirement at March 31, 2008 and December 31, 2007. 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.

Brokerage subsidiaries are required to maintain net capital equal to the greater of $250,000 or 2% of aggregate debit balances arising from customer transactions. At March 31, 2008 and December 31, 2007, all of our significant brokerage subsidiaries met their minimum net capital requirements. The Company’s broker-dealer subsidiaries had excess net capital of $768.2 million at March 31, 2008, of which $565.8 million is available for dividend while still maintaining a capital level above regulatory “early warning” guidelines.

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.

Other Sources of Liquidity

In addition to the liquidity available from subsidiaries, the parent company held $234.9 million in cash available as a resource. We also maintain $451.0 million in uncommitted financing to meet margin lending

 

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Table of Contents

needs. There were no outstanding balances, and the full $451.0 million was available at both March 31, 2008 and December 31, 2007.

We rely on borrowed funds, such as FHLB advances and securities sold under agreements to repurchase, to provide liquidity for the Bank. Our ability to borrow these funds is dependent upon the continued availability of funding in the wholesale borrowings market. At March 31, 2007, the Bank had approximately $10.7 billion in additional borrowing capacity with the FHLB.

We have the option to make the interest payments of approximately $605 million on our springing lien notes in the form of either cash or additional springing lien notes through May 2010.

RISK MANAGEMENT

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

We manage risk through a governance structure involving the various boards, senior management and several risk committees. We use management level risk committees to help ensure that business decisions are executed within our desired risk profile.

The Corporate Risk Committee, consisting of senior management executives, monitors the risk process and significant risks throughout the Company. In addition to this committee, various enterprise risk committees and departments throughout the Company aid in the identification and management of risks. These departments include internal audit, compliance, finance, legal, treasury, credit and enterprise risk management.

Interest Rate Risk Management

Interest rate risk is the risk of loss from adverse changes in interest rates. Interest rate risks are monitored and managed by the E*TRADE Bank’s Asset Liability Committee (“ALCO”). The ALCO reviews balance sheet trends, market interest rate and sensitivity analyses. The analysis of interest sensitivity to changes in market interest rates under various scenarios is reviewed by ALCO. The scenarios assume both parallel and non-parallel shifts in the yield curve. See Item 3. Quantitative and Qualitative Disclosures about Market Risk for additional information about our interest rate risks.

Credit Risk Management

Credit risk is the risk of loss resulting from adverse changes in a borrower’s or counterparty’s ability or willingness to meet its financial obligations under agreed-upon terms. Our primary sources of credit risk are our loan and securities portfolios, where it results from extending credit to customers and purchasing securities, respectively. The degree of credit risk associated with our loans and securities varies based on many factors including the size of the transaction, the credit characteristics of the borrower, features of the loan product or security, the contractual terms of the related documents and the availability and quality of collateral. Credit risk is one of the most common risks in financial services and is one of our most significant risks.

Credit risk is monitored by our Credit Risk Committee. The Credit Risk Committee’s duties include monitoring asset quality trends, evaluating market conditions including those in residential real estate markets, determining the adequacy of our allowance for loan losses, establishing underwriting standards, approving large credit exposures, approving large portfolio purchases and delegating credit approval authority. The Credit Risk

 

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Table of Contents

Committee uses detailed tracking and analysis to measure credit performance and reviews and modifies credit policies as appropriate.

Housing Market Conditions

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

Loss Mitigation

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

This team’s primary focus is reducing our exposure to open home equity lines. As of December 31, 2007, we had $6.3 billion of unused lines of credit available under home equity lines of credit. Through a variety of strategies, including voluntary line closures, automatically freezing lines on all delinquent accounts, and freezing lines on loans with materially reduced home equity, we have reduced this amount to $5.6 billion as of March 31, 2008. We expect this exposure to continue to decline as we implement additional actions in future periods.

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

In addition, we continue to review our purchased home equity loan portfolio in order to identify loans to be repurchased by the originator. More specifically, home equity loans that become 30 days delinquent are reviewed for early payment defaults, violations of transaction representations and warranties, or material misrepresentation on the part of the seller. Any loans identified with these deficiencies are submitted to the original seller for repurchase. During the first quarter of 2008, approximately $23.7 million of home equity repurchases were completed by the original sellers.

Underwriting Standards—Originated Loans

During the second half of 2007, we exited our wholesale mortgage origination channel and no longer originate loans through brokers. In April 2008, we decided to exit our retail mortgage origination business, which represented our last remaining loan origination channel. After we complete the exit of this business, we expect to partner with a third party company to provide access to real estate loans for our customers.

During the three months ended March 31, 2008, we originated approximately $116 million in one- to four-family loans through our retail mortgage origination business. These loans were predominately prime credit quality first-lien mortgage loans secured by a single-family residence.

We priced our loans primarily based on the risk elements inherent in the loan. We evaluated criteria such as, but not limited to: borrower credit score, loan-to-value ratio (“LTV”), documentation type, occupancy type and other risk elements. In the first quarter of 2008, we further adjusted our loan origination practices and pricing to

 

25


Table of Contents

significantly curtail originations of higher risk loans, particularly home equity loans with FICO scores below 700 or a combined loan-to-value ratio (“CLTV”) greater than 80%.

Our underwriting guidelines were established with a focus on both the credit quality of the borrower as well as the adequacy of the collateral securing the loan. We designed our underwriting guidelines so that our one- to four-family loans were salable in the secondary market. These guidelines included limitations on loan amount, loan-to-value ratio, debt-to-income ratio, documentation type and occupancy type. We also required borrowers to obtain mortgage insurance on higher loan-to-value first lien mortgage loans. Our past underwriting standards for originating loans are more fully described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K for the year ended December 31, 2007.

Underwriting Standards—Purchased Loans

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

Loan Portfolio

We track and review many factors to predict and monitor credit risk in our loan portfolios, which are primarily made up of loans secured by residential real estate. These factors include, but are not limited to: borrowers’ debt-to income ratio when loans are made, borrowers’ credit scores when loans are made, loan-to-value ratios, housing prices, documentation type, occupancy type, and loan type. In economic conditions in which housing prices generally appreciate, we believe that loan type, loan-to-value ratios and credit scores are the key factors in determining future loan performance. In the current housing market with declining home prices and less credit available for refinance, we believe the loan-to-value ratio becomes a more important factor in predicting and monitoring credit risk.

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

As noted above, we believe loan type, loan-to-value ratios and borrowers’ credit scores are key determinates of future loan performance. Our home equity loan portfolio is primarily second lien loans(1) on residential real estate properties, which have a higher level of credit risk than first lien mortgage loans. We believe home equity loans with a CLTV of 90% or higher or a FICO score below 700 are the loans with the highest levels of credit risk in our portfolios.

 

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

 

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Table of Contents

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

 

     One- to
Four-Family
   Home Equity

LTV/CLTV

at Origination

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

<=70%

   $ 6,300,710     $ 6,666,212    $ 3,443,039     $ 3,628,619

70% - 80%

     7,977,419       8,450,977      1,989,506       2,086,277

80% - 90%

     181,370       202,133      3,778,084       3,871,249

>90%

     179,646       187,207      2,175,369       2,315,179
                             

Total

   $ 14,639,145     $ 15,506,529    $ 11,385,998     $ 11,901,324
                             

Average LTV/CLTV at loan origination(1)

     70.0 %        79.5 %  
                     

Average estimated current LTV/CLTV(1)

     83.0 %        87.9 %  
                     

 

     One- to
Four-Family
   Home Equity

FICO at Origination

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

>=720

   $ 9,785,868    $ 10,373,807    $ 6,700,307    $ 6,992,793

719 - 700

     1,973,535      2,089,014      1,828,691      1,898,924

699 - 680

     1,508,166      1,585,613      1,597,468      1,668,427

679 - 660

     884,149      943,538      717,894      757,016

659 - 620

     476,958      503,573      527,494      566,030

<620

     10,469      10,984      14,144      18,134
                           

Total

   $ 14,639,145    $ 15,506,529    $ 11,385,998    $ 11,901,324
                           

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

 

     One- to
Four-Family
   Home Equity

Acquisition Channel

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

Purchased from a third party

   $ 12,090,866    $ 12,904,759    $ 10,162,056    $ 10,638,021

Originated by the Company

     2,548,279      2,601,770      1,223,942      1,263,303
                           

Total real estate loans

   $ 14,639,145    $ 15,506,529    $ 11,385,998    $ 11,901,324
                           

 

     One- to
Four-Family
   Home Equity

Vintage Year

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

2003 and prior

   $ 733,786    $ 844,670    $ 841,586    $ 901,240

2004

     1,497,954      1,669,492      1,092,652      1,156,867

2005

     2,954,011      3,084,336      2,665,662      2,790,423

2006

     5,534,511      5,829,146      5,502,027      5,760,906

2007

     3,887,761      4,078,885      1,276,399      1,291,888

2008

     31,122      —        7,672      —  
                           

Total real estate loans

   $ 14,639,145    $ 15,506,529    $ 11,385,998    $ 11,901,324
                           

 

(1)

 

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

 

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Allowance for Loan Losses

The allowance for loan losses is management’s estimate of credit losses inherent in our loan portfolio as of the balance sheet date. The estimate of the allowance for loan losses is based on a variety of factors, including the composition and quality of the portfolio; delinquency levels and trends; probable expected losses for the next twelve months; current and historical charge-off and loss experience; current industry charge-off and loss experience; the condition of the real estate market and geographic concentrations within the loan portfolio; the interest rate climate; the overall availability of housing credit; and general economic conditions. Determining the adequacy of the allowance is complex and requires judgment by management about the effect of matters that are inherently uncertain. Subsequent evaluations of the loan portfolio, in light of the factors then prevailing, may result in significant changes in the allowance for loan losses in future periods. We believe our allowance for loan losses at March 31, 2008 is representative of probable losses inherent in the loan portfolio at the balance sheet date.

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

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

 

    One- to Four-Family     Home Equity     Consumer and Other     Total  
    Allowance   Allowance
as a %

of Loans
Receivable(1)
    Allowance   Allowance
as a %

of Loans
Receivable(1)
    Allowance   Allowance
as a %

of Loans
Receivable(1)
    Allowance   Allowance
as a %

of Loans
Receivable(1)
 

March 31, 2008

  $ 41,403   0.28 %   $ 490,831   4.23 %   $ 33,674   1.24 %   $ 565,908   1.95 %

December 31, 2007

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

 

(1)

 

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

During the three months ended March 31, 2008, the allowance for loan losses increased by $57.7 million from the level at December 31, 2007. This increase was driven primarily by the increase in the allowance allocated to the home equity loan portfolio, which began to deteriorate during the second half of 2007. During the first quarter of 2008, we also observed deterioration in the performance of our one- to four-family loan portfolio. We believe the deterioration in both of these portfolios was caused by several factors, including: home price depreciation in key markets; growing inventories of unsold homes; rising foreclosure rates; significant contraction in the availability of credit; and a general decline in economic growth. In addition, the combined impact of home price depreciation and the reduction of available credit made it increasingly difficult for borrowers to refinance existing loans. We believe these factors will cause the provision for loan losses to continue at historically high levels in future periods.

 

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The following table provides an analysis of the net charge-offs for the three months ended March 31, 2008 and 2007 (dollars in thousands):

 

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

Three months ended March 31, 2008

 

      

One- to four-family

   $ (15,058 )   $ 455    $ (14,603 )   0.38  %

Home equity

     (150,128 )     762      (149,366 )   5.02  %

Recreational vehicle

     (11,470 )     3,266      (8,204 )   1.73  %

Marine

     (3,085 )     1,335      (1,750 )   1.35  %

Credit card

     (2,511 )     195      (2,316 )   10.58  %

Other

     (160 )     272      112     (0.16 )%
                         

Total

   $ (182,412 )   $ 6,285    $ (176,127 )   2.36  %
                         

Three months ended March 31, 2007

         

One- to four-family

   $ (674 )   $ —      $ (674 )   0.02  %

Home equity

     (11,941 )     422      (11,519 )   0.37  %

Recreational vehicle

     (7,487 )     3,373      (4,114 )   0.72  %

Marine

     (2,612 )     1,238      (1,374 )   0.85  %

Credit card

     (3,569 )     194      (3,375 )   11.21  %

Other

     (355 )     586      231     (0.31 )%
                         

Total

   $ (26,638 )   $ 5,813    $ (20,825 )   0.30  %
                         

Loan losses are recognized when it is probable that a loss will be incurred. Our policy is to charge-off closed-end consumer loans when the loan is 120 days delinquent or when we determine that collection is not probable. For credit cards, our policy is to charge-off loans when collection is not probable or the loan has been delinquent for 180 days. Our policy for one- to four-family loan charge-offs prior to January 1, 2008 was to recognize a charge-off when we foreclosed on the property. For home equity loans, our policy prior to January 1, 2008 was to charge-off loans when we foreclosed on the property or when the loan had been delinquent for 180 days. As of January 1, 2008, we adjusted our charge-off policy mainly for loans in the process of foreclosure. Our updated policy for both one- to four-family and home equity loans is to assess the value of the property when the loan has been delinquent for 180 days, regardless of whether or not the property is in foreclosure, and charge-off the amount of the loan balance in excess of the estimated current property value. As a result of this change, we recorded additional charge-offs of $8.3 million on one- to four-family loans and $21.7 million on home equity loans during the first quarter of 2008.

 

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Net charge-offs for the three months ended March 31, 2008 compared to the same period in 2007 increased by $155.3 million. The overall increase was primarily due to higher net charge-offs on home equity loans, which was driven mainly by the same factors as described above. The continued pressure in the residential real estate market, specifically home price depreciation combined with tighter mortgage lending guidelines, will likely lead to a higher level of charge-offs in future periods. The following graph illustrates the net charge-offs by quarter:

LOGO

Nonperforming Assets

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

 

     March 31,
2008
    December 31,
2007
 

One- to four-family(1)

   $ 292,165     $ 181,315  

Home equity

     285,074       229,523  

Consumer and other loans

     7,141       7,604  
                

Total nonperforming loans

     584,380       418,442  

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

     60,852       45,895  
                

Total nonperforming assets, net

   $ 694,232     $ 464,337  
                

Nonperforming loans receivable as a percentage of gross loans receivable

     2.02 %     1.37 %

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

     14.17 %     10.39 %

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

     172.18 %     200.05 %

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

     471.56 %     396.71 %

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

     96.84 %     121.44 %

 

(1)

 

One- to four-family excludes held-for-sale loans of $0.3 million and $0.1 million at March 31, 2008 and December 31, 2007, respectively. Loans held-for-sale are accounted for at lower of cost or market value with adjustments recorded in the gain (loss) on loans and securities, net line item and are not considered in the allowance for loan losses.

 

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During the three months ended March 31, 2008, our nonperforming assets, net increased $229.9 million from $464.3 million at December 31, 2007. The increase was attributed primarily to an increase in nonperforming one- to four-family loans of $110.9 million and home equity loans of $55.6 million for the three months ended March 31, 2008 when compared to December 31, 2007. We expect nonperforming loan levels to increase over time due to the weak conditions in the residential real estate and credit markets.

The following graph illustrates the nonperforming loans by quarter:

LOGO

The allowance as a percentage of total nonperforming loans receivable, net decreased from 121% at December 31, 2007 to 97% at March 31, 2008. This decrease was driven primarily by an increase in one- to four-family non-performing loans, which have a significantly lower level of expected loss when compared to home equity loans.

In addition to nonperforming assets in the table above, we monitor loans where a borrower’s past credit history casts doubt on their ability to repay a loan (“Special Mention” loans). 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 thousands):

 

     March 31,
2008
    December 31,
2007
 

One- to four-family(1)

   $ 363,389     $ 296,764  

Home equity

     276,790       291,675  

Consumer and other loans

     22,912       23,800  
                

Total Special Mention loans

   $ 663,091     $ 612,239  
                

Special Mention loans receivable as a percentage of gross loans receivable

     2.29 %     2.00 %

 

(1)

 

One- to four-family excludes held-for-sale loans of $0.1 million and $0.4 million at March 31, 2008 and December 31, 2007, respectively. Loans held-for-sale are accounted for at lower of cost or market value with adjustments recorded in the gain (loss) on loans and securities, net line item and are not considered in the allowance for loan losses.

 

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The trend in Special Mention loan balances are 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. Our 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.

While our total Special Mention loans increased during the period, our home equity Special Mention loans, which we believe represent our most significant exposure to future credit losses, declined by $14.9 million to $276.8 million.

The following graph illustrates the Special Mention loans by quarter:

LOGO

Securities

We focus primarily on security type and credit rating to monitor credit risk in our securities portfolios. We believe our asset-backed securities portfolio, which we sold in the fourth quarter of 2007, represented our highest concentration of credit risk within the securities portfolio. Subsequent to the sale of that portfolio, we believe our highest concentration of remaining credit risk, while dramatically lower than the credit risk inherent in asset-backed securities, is our CMO portfolio. The table below details the amortized cost by average credit ratings and type of asset as of March 31, 2008 and December 31, 2007 (dollars in thousands):

 

March 31, 2008

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

Mortgage-backed securities backed by U.S. Government sponsored and Federal agencies

   $ 7,553,314    $ —      $ —      $ —      $ —      $ 7,553,314

CMOs and other

     1,003,619      126,188      413      —        —        1,130,220

Municipal bonds, corporate bonds, preferred stock and FHLB stock

     311,232      396,977      14,311      —        —        722,520
                                         

Total

   $ 8,868,165    $ 523,165    $ 14,724    $ —      $ —      $ 9,406,054
                                         

 

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December 31, 2007

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

Mortgage-backed securities backed by U.S. Government sponsored and Federal agencies

   $ 9,697,723    $ —      $ —      $ —      $ —      $ 9,697,723

CMOs and other

     1,066,290      132,330      469      —        —        1,199,089

Asset-backed securities

     —        —        —        —        122      122

Municipal bonds, corporate bonds, preferred stock and FHLB stock

     675,058      596,047      8,342      —        —        1,279,447
                                         

Total

   $ 11,439,071    $ 728,377    $ 8,811    $ —      $ 122    $ 12,176,381
                                         

While the vast majority of this portfolio is AAA-rated, we continue to monitor these securities for impairment. During the three months ended March 31, 2008, we identified approximately $183 million of CMOs that showed a possibility of future loss. As a result, $95 million of these securities were written down to their estimated fair market value by recording a $26.6 million impairment during the first quarter of 2008. Further declines in the performance of our CMO portfolio could result in additional impairments in future periods.

During the three months ended March 31, 2008, we sold certain of our mortgage-backed securities, which is the primary reason for the decline in our securities balance compared to the balance as of December 31, 2007.

SUMMARY OF CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The preparation of our financial condition and results of operations requires us to make judgments and estimates that may have a significant impact upon the financial results of the Company. We believe that of our significant accounting policies, the following require estimates and assumptions that require complex, subjective judgments by management, which can materially impact reported results: allowance for loan losses and uncollectible margin loans; classification and valuation of certain investments; valuation and accounting for financial derivatives; estimates of effective tax rate; deferred taxes and valuation allowances; and valuation of goodwill and other intangibles. These are more fully described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K for the year ended December 31, 2007.

Classification and Valuation of Certain Investments

Effective January 1, 2008, the Company adopted SFAS No. 157, Fair Value Measurements (“SFAS No. 157”), which defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. The Company determines the fair values of its financial instruments and for nonfinancial assets and nonfinancial liabilities that are recognized or disclosed at fair value in the financial statements on a recurring basis in accordance with SFAS No. 157. The Company will not adopt this statement until January 1, 2009 for nonfinancial assets and nonfinancial liabilities that are not recognized or disclosed at fair value in the financial statements on a recurring basis. Examples of nonfinancial assets and nonfinancial liabilities for which the Company has not applied the provisions of SFAS No. 157 include reporting units, nonfinancial assets and nonfinancial liabilities and indefinite-lived intangible assets measured at fair value in impairment tests under SFAS No. 142, Goodwill and Other Intangible Assets (“SFAS No. 142”), nonfinancial long-lived assets measured at fair value for an impairment assessment under SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (“SFAS No. 144”) as well as nonfinancial liabilities for exit or disposal activities initially measured at fair value under SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities (“SFAS No. 146”).

 

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In determining fair value, the Company uses various valuation approaches, including market, income and/or cost approaches. The fair value hierarchy established in SFAS No. 157 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. As such, 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 standard describes three levels of inputs that may be used to measure fair value and are as follows:

 

   

Level 1—Quoted prices in active markets for identical assets or liabilities. Examples of assets and liabilities utilizing Level 1 inputs include actively traded equity securities.

 

   

Level 2—Quoted prices in markets that are not active or for which all significant inputs are observable, either directly or indirectly. Examples of assets and liabilities utilizing Level 2 inputs include mortgage-backed securities backed by U.S. Government sponsored and Federal agencies, certain CMOs, most investment securities and most over-the-counter (“OTC”) derivatives.

 

   

Level 3—Unobservable inputs that are significant to the fair value of the assets or liabilities. Level 3 assets and liabilities include financial 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. Examples of assets and liabilities utilizing significant Level 3 inputs or those that require significant management judgment include most CMOs, servicing rights, retained interest in securitizations, certain other mortgage-backed securities, and certain OTC derivatives. In certain securities, including a portion of the CMO portfolio, where there has been limited activity or less transparency around inputs to the valuation, securities are classified as Level 3 even though the Company believes that Level 2 inputs could likely be obtainable in a more active market.

The availability of observable inputs can vary from instrument to instrument and in certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, an instrument’s 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 the fair value measurement of an instrument requires judgment and consideration of factors specific to the instrument.

Fair Value Option

Effective January 1, 2008, the Company elected to carry investments in Federal National Mortgage Association (“FNMA”) and Federal Home Loan Mortgage Corporation (“FHLMC”) preferred stock at fair value through earnings under SFAS No. 159. The Company elected to carry the investment in preferred stock at fair value through earnings to allow the Company to economically hedge the portfolio without the burden of complying with SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities (“SFAS No. 133”), as amended. The impact of this adoption was an after-tax decrease to opening retained earnings as of January 1, 2008 of approximately $86.9 million. As of December 31, 2007, the Company’s investment in preferred stock was reported in the balance sheet line item available-for-sale mortgage-backed and investment securities. In accordance with SFAS No. 159, as a result of the fair value election the investment in preferred stock is reported in the balance sheet line item trading securities as of March 31, 2008. Realized and unrealized gains and losses on securities classified as trading are included in the gain (loss) on loans and securities, net line item. During the first quarter of 2008, the Company used equity put options and credit default swaps as economic hedges against potential declines in the value of the preferred stock. Derivatives used as economic hedges but not designated in a hedging relationship for accounting purposes are included in derivative assets or derivative liabilities. The mark on the net hedged position is recognized in gain (loss) on loans and securities, net.

Valuation Techniques

The fair value for certain financial instruments is derived using pricing models and other valuation techniques that in involve significant management judgment. The price transparency of financial instruments is a

 

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key determinant of the degree of judgment involved in determining the fair value of the Company’s financial instruments. Financial instruments for which actively quoted prices or pricing parameters are available will generally have a higher degree of price transparency than financial instruments that are thinly traded or not quoted.

SFAS No. 157 states that the fair value measurement of a liability must reflect the nonperformance risk of the entity. The Company manages credit risk by following an established credit approval process, which includes monitoring credit limits based on counterparty credit rating, as well as by enforcing collateral requirements through credit support agreements which reduce risk by permitting the netting of transactions with the same counterparty upon occurrence of certain events. During the three months ended March 31, 2008, the consideration of credit risk did not result in a material adjustment to the valuation of OTC derivative contracts.

Mortgage-backed Securities Backed by U.S. Government Sponsored and Federal Agencies

Mortgage-backed securities backed by U.S. government sponsored and federal agencies include to be announced (“TBA”) securities and mortgage pass-through certificates. The fair value of TBA securities is determined using quoted market prices. The fair value of mortgage pass-through certificates is determined using quoted market prices, price activity and spread data for similar instruments. Mortgage-backed securities backed by U.S. government sponsored and federal agencies are generally categorized in Level 2 of the fair value hierarchy.

Collateralized Mortgage Obligations

CMOs, generally non-agency mortgage-backed securities, are typically valued using external price activity and spread data for similar instruments. The valuations of 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 these financial instruments to be a key determinant of the degree of judgment involved in determining the fair value. Due to the limited activity and low level of transparency around inputs to the valuation, a portion of these securities are classified as Level 3 even though the Company believes that Level 2 inputs could likely be obtainable in a more active market.

Investment Securities

Investment securities includes preferred stock, municipal bonds and corporate bonds. The fair value of preferred stock is typically estimated using market price quotations and the investment is generally categorized in Level 2 of the fair value hierarchy. The fair value of municipal bonds is estimated using pricing information based on bond characteristics, such as credit quality, maturity, coupon as well as where bonds with similar characteristics have traded. Municipal bonds are generally categorized in Level 2 of the fair value hierarchy. The fair value of corporate bonds is estimated using market price quotes corroborated by recently executed transactions observable in the market. Corporate bonds are generally categorized in Level 2 of the fair value hierarchy.

Derivative Financial Instruments

Derivative financial instruments include OTC swaps and option contracts related to interest rates, credit standing of reference entities or equity prices. The majority of the Company’s derivative financial instruments, interest rate swap and option contracts, are valued with pricing models commonly used by the financial services industry using market observable pricing inputs. The Company does not consider these models to involve significant judgment on the part of management. The majority of the Company’s derivative financial instruments are categorized in Level 2 of the fair value hierarchy.

Securities Owned and Securities Sold, Not Yet Purchased

Proprietary securities transactions entered into by broker-dealer subsidiaries for trading or investment purposes are included in “Securities owned” and “Securities sold, not yet purchased” in the Company’s SFAS

 

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No. 157 disclosures. The fair value of securities owned and securities sold, not yet purchased is determined using observable market price quotes from recently executed transactions and are generally categorized in Level 1 or Level 2 of the fair value hierarchy.

Servicing Rights

On January 1, 2008, the Company elected to account for servicing rights under the fair value measurement method in accordance with SFAS No. 156, Accounting for Servicing Financial Assets, an Amendment of SFAS No. 140 (“SFAS. No. 156”). The fair value of the servicing rights is determined using models that include observable inputs, if available. To the extent observable inputs are not available, the Company estimates fair value based on the present value of expected future cash flows using its best estimate of the key assumptions, including anticipated loan prepayments and discount rates. Servicing rights are categorized as Level 3 in the fair value hierarchy when unobservable inputs are significant to the fair value measurements.

Retained Interests in Securitization

The fair value of the retained interests in securitizations is determined using models that include observable inputs, if available. To the extent observable inputs are not available, the Company estimates fair value based on the present value of expected future cash flows using its best estimate of the key assumptions, including forecasted credit losses, prepayments rates and discount rates. Retained interests in securitizations are categorized as Level 3 in the fair value hierarchy when unobservable inputs are significant to the fair value measurements.

 

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GLOSSARY OF TERMS

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

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

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

Average equity to 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.

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

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

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

Contract for difference (“CFDs”)—A derivative based on an underlying stock or index that covers the difference between the nominal value at the opening of a trade and at the close of a trade. A CFD is researched and traded in the same manner as a stock.

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

Customer cash and deposits—Deposits (excluding brokered certificates of deposit), 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.

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

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

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

 

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

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

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

Fair value—The exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date.

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

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

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.

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

Margin debt—The extension of credit to brokerage customers of the Company, on and off balance sheet, where the loan is secured with securities owned by the customer.

Mass Affluent—The customer segment that includes those who hold $50,000 or more in assets in combined retail accounts.

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

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

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

 

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Operating expenses—Total expense excluding interest, as shown on the Company’s consolidated statement of income (loss).

Operating margin—Income (loss) before other income (expense) and income taxes.

Operating margin (%)—Percentage of net revenue that goes to income (loss) before other income (expense) and income taxes. It is calculated by dividing our income (loss) before other income (expense) and income taxes, by our total net revenue.

Option adjustable-rate mortgage (“ARM”) loan—An adjustable-rate mortgage loan that provides the borrower with the option to make a fully-amortizing, interest-only, or minimum payment each month. The minimum payment on an Option ARM loan is usually based on the interest rate charged during the introductory period. This introductory rate is usually significantly below the fully-indexed rate for loans with short duration introductory periods.

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

Organic—Business related to new and existing customers as opposed to acquisitions.

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

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

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

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

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

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

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

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

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

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

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

 

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Taxable equivalent interest adjustment—The operating interest income earned on certain assets is completely or partially exempt from federal and/or state income tax. As such, these tax-exempt instruments typically yield lower returns than a taxable investment. To provide more meaningful comparison of yields and margins for all interest-earning assets, the interest income earned on tax exempt assets 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 (loss), as that is not permitted under GAAP.

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

 

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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The following discussion about our market risk disclosure includes forward-looking statements. Actual results could differ materially from those projected in the forward-looking statements as a result of certain factors, including, but not limited to, those set forth in Item 1A. “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2007 and as updated in this report. Market risk is our exposure to changes in interest rates, foreign exchange rates and equity and commodity prices. Our exposure to interest rate risk is related primarily to interest-earning assets and interest-bearing liabilities.

Interest Rate Risk

The management of interest rate risk is essential to profitability. Interest rate risk is our exposure to changes in interest rates. In general, we manage our interest rate risk by balancing variable-rate and fixed-rate assets and liabilities and we utilize derivatives in a way that reduces our overall exposure to changes in interest rates. In recent years, we have managed our interest rate risk to achieve a minimum to moderate risk profile with limited exposure to earnings volatility resulting from interest rate fluctuations. 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 flatten or change shape affecting the spread between short- and long-term rates. Widening or narrowing spreads could impact net interest income.

 

   

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

Exposure to market risk is dependent upon the distribution and composition of interest-earning assets, interest-bearing liabilities and derivatives. The differing risk characteristics of each product are managed to mitigate our exposure to interest rate fluctuations. At March 31, 2008, 89% of our total assets were enterprise interest-earning assets.

At March 31, 2008, approximately 65% of our total assets were residential real estate loans and available-for-sale 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 ALCO reviews estimates of the impact of changing market rates on loan production volumes and prepayments. This information is incorporated into our interest rate risk management strategy.

Our liability structure consists of transactional deposit relationships, such as money market and savings accounts; certificates of deposit; securities sold under agreements to repurchase; customer payables; other borrowings; and corporate debt. Our transactional deposit accounts and customer payables tend to be less rate-sensitive than wholesale borrowings. Agreements to repurchase securities re-price as interest rates change. Money market and savings accounts re-price at management’s discretion. Certificates of deposit re-price over time depending on maturities. FHLB advances and corporate debt generally have fixed rates.

Derivative Financial Instruments

We use derivative financial instruments to help manage our interest rate risk. Interest rate swaps involve the exchange of fixed-rate and variable-rate interest payments between two parties based on a contractual underlying notional amount, but do not involve the exchange of the underlying notional amounts. Option products are

 

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utilized primarily to decrease the market value changes resulting from the prepayment dynamics of the mortgage portfolio, as well as to protect against increases in funding costs. The types of options employed include Cap Options (“Caps”) and Floor Options (“Floors”), “Payor Swaptions” and “Receiver Swaptions.” Caps mitigate the market risk associated with increases in interest rates while Floors mitigate the risk associated with decreases in market interest rates. Similarly, Payor and Receiver Swaptions mitigate the market risk associated with the respective increases and decreases in interest rates. See derivative financial instruments discussion at Note 6—Accounting for Derivative Financial Instruments and Hedging Activities in Item 1. Consolidated Financial Statements.

Scenario Analysis

Scenario analysis is an advanced approach to estimating interest rate risk exposure. Under the Net Present Value of Equity (“NPVE”) approach, the present value of all existing assets, liabilities, derivatives and forward commitments are estimated and then combined to produce a NPVE figure. The sensitivity of this value to changes in interest rates is then determined by applying alternative interest rate scenarios, which include, but are not limited to, instantaneous parallel shifts up 100, 200 and 300 basis points and down 100 and 200 basis points. The NPVE method is used at the E*TRADE Bank level and not for the Company.

E*TRADE Bank has 95% and 96% of our enterprise interest-earning assets at March 31, 2008 and December 31, 2007, respectively, and holds 96% and 96% of our enterprise interest-bearing liabilities at March 31, 2008 and December 31, 2007, respectively. The sensitivity of NPVE at March 31, 2008 and December 31, 2007 and the limits established by E*TRADE Bank’s Board of Directors are listed below (dollars in thousands):

 

    Change in NPVE         Board Limit      
    March 31, 2008   December 31, 2007  
Parallel Change in
Interest Rates (basis points)
        Amount                 Percentage               Amount                 Percentage        
+300   $ (398,125 )   (17)%   $ (434,303 )   (17)%   (55)%
+200   $ (355,206 )   (15)%   $ (323,193 )   (12)%   (30)%
+100   $ (211,769 )   (9)%   $ (174,280 )   (7)%   (20)%
-100   $ 217,930     9%   $ 99,245     4%   (20)%
-200(1)   $ —       —  %   $ (63,785 )   (2)%   (30)%

 

(1)

 

On March 31, 2008, the yield on the three-month Treasury bill was 1.38%. As a result, the OTS temporarily modified the requirements of the NPV Model, resulting in removal of the minus 200 basis points scenario for the quarter ended March 31, 2008.

Under criteria published by the OTS, E*TRADE Bank’s overall interest rate risk exposure at March 31, 2008 was characterized as “minimum.” We actively manage our interest rate risk positions. As interest rates change, we will re-adjust our strategy and mix of assets, liabilities and derivatives to optimize our position. For example, a 100 basis points increase in rates may not result in a change in value as indicated above. The ALCO monitors E*TRADE Bank’s interest rate risk position.

Other Market Risk

Equity Security Risk

Equity securities risk is the risk of potential loss from investing in public and private equity securities including foreign currency exchange risk. We hold equity securities for corporate investment purposes and in trading securities for market-making purposes. The foreign currency exchange risk associated with these investments is not material to the Company. For corporate investment purposes, we currently hold publicly traded equity securities, in which we had an estimated fair value of $1.3 million as of March 31, 2008. See the corporate investments line item in the publicly traded equity securities discussion at Note 4—Available-for-Sale Mortgage-Backed and Investment Securities in Item 1. Consolidated Financial Statements.

 

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PART I—FINANCIAL INFORMATION

 

ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

E*TRADE FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF INCOME (LOSS)

(In thousands, except per share amounts)

(Unaudited)

 

     Three Months Ended March 31,  
         2008             2007      

Revenue:

    

Operating interest income

   $ 710,737     $ 829,795  

Operating interest expense

     (377,966 )     (439,209 )
                

Net operating interest income

     332,771       390,586  

Provision for loan losses

     (233,871 )     (21,186 )
                

Net operating interest income after provision for loan losses

     98,900       369,400  
                

Commission

     129,764       158,993  

Fees and service charges

     62,612       59,498  

Principal transactions

     20,495       30,082  

Gain (loss) on loans and securities, net

     (9,145 )     17,375  

Other revenue

     13,610       9,650  
                

Total non-interest income

     217,336       275,598  
                

Total net revenue

     316,236       644,998  
                

Expense excluding interest:

    

Compensation and benefits

     128,777       123,782  

Clearing and servicing

     48,579       67,252  

Advertising and market development

     60,472       45,592  

Communications

     27,439       26,156  

Professional services

     24,347       24,985  

Depreciation and amortization

     22,071       19,383  

Occupancy and equipment

     22,003       23,579  

Amortization of other intangibles

     10,910       10,268  

Facility restructuring and other exit activities

     10,492       733  

Other

     17,523       32,675  
                

Total expense excluding interest

     372,613       374,405  
                

Income (loss) before other income (expense) and income taxes

     (56,377 )     270,593  

Other income (expense):

    

Corporate interest income

     2,426       1,705  

Corporate interest expense

     (95,241 )     (37,791 )

Gain on sales of investments, net

     502       19,756  

Loss on early extinguishment of debt

     (2,851 )     —    

Equity in income of investments and venture funds

     4,699       8,095  
                

Total other income (expense)

     (90,465 )     (8,235 )
                

Income (loss) before income taxes

     (146,842 )     262,358  

Income tax expense (benefit)

     (55,649 )     92,948  
                

Net income (loss)

   $ (91,193 )   $ 169,410  
                

Basic earnings (loss) per share

   $ (0.20 )   $ 0.40  

Diluted earnings (loss) per share

   $ (0.20 )   $ 0.39  

Shares used in computation of per share data:

    

Basic

     460,857       423,786  

Diluted

     460,857       437,535  

See accompanying notes to consolidated financial statements

 

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E*TRADE FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEET

(In thousands, except share amounts)

(Unaudited)

 

     March 31,
2008
    December 31,
2007
 
ASSETS     

Cash and equivalents

   $ 3,061,987     $ 1,778,244  

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

     427,918       334,831  

Trading securities

     422,941       130,018  

Available-for-sale mortgage-backed and investment securities (includes securities pledged to creditors with the right to sell or repledge of $8,032,306 at March 31, 2008 and $10,074,082 at December 31, 2007)

     8,402,077       11,255,048  

Margin receivables

     6,655,659       7,179,175  

Loans, net (net of allowance for loan losses of $565,908 at March 31, 2008 and $508,164 and December 31, 2007)

     28,444,165       30,139,382  

Investment in FHLB stock

     241,392       338,585  

Property and equipment, net

     324,940       355,433  

Goodwill

     1,950,682       1,933,368  

Other intangibles, net

     419,105       430,007  

Other assets

     2,846,084       2,971,846  
                

Total assets

   $ 53,196,950     $ 56,845,937  
                
LIABILITIES AND SHAREHOLDERS’ EQUITY     

Liabilities:

    

Deposits

   $ 27,467,227     $ 25,884,755  

Securities sold under agreements to repurchase

     7,109,716       8,932,693  

Customer payables

     5,413,283       5,514,675  

Other borrowings

     5,242,921       7,446,504  

Corporate debt

     3,156,699       3,022,698  

Accounts payable, accrued and other liabilities

     2,091,765       3,215,547  
                

Total liabilities

     50,481,611       54,016,872  
                

Shareholders’ equity:

    

Common stock, $0.01 par value, shares authorized: 600,000,000; shares issued and outstanding: 468,335,796 at March 31, 2008 and 460,897,875 at December 31, 2007

     4,683       4,609  

Additional paid-in capital (“APIC”)

     3,507,223       3,463,220  

Accumulated deficit

     (425,170 )     (247,368 )

Accumulated other comprehensive loss

     (371,397 )     (391,396 )
                

Total shareholders’ equity

     2,715,339       2,829,065  
                

Total liabilities and shareholders’ equity

   $ 53,196,950     $ 56,845,937  
                

See accompanying notes to consolidated financial statements

 

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E*TRADE FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME (LOSS)

(In thousands)

(Unaudited)

 

     Three Months Ended
March 31,
 
     2008     2007  

Net income (loss)

   $ (91,193 )   $ 169,410  

Other comprehensive loss

    

Available-for-sale securities:

    

Unrealized gains, net

     1,761       6,889  

Reclassification into earnings, net

     8,058       (11,168 )
                

Net change from available-for-sale securities

     9,819       (4,279 )
                

Cash flow hedging instruments:

    

Unrealized losses, net

     (78,157 )     (1,124 )

Reclassification into earnings, net

     2,393       188  
                

Net change from cash flow hedging instruments

     (75,764 )     (936 )
                

Foreign currency translation losses

     (950 )     (2,863 )
                

Other comprehensive loss

     (66,895 )     (8,078 )
                

Comprehensive income (loss)

   $ (158,088 )   $ 161,332  
                

 

See accompanying notes to consolidated financial statements

 

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E*TRADE FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY

(In thousands)

(Unaudited)

 

    Common Stock     Additional
Paid-in

Capital
    Accumulated
Deficit
    Accumulated
Other
Comprehensive

Loss
    Total
Shareholders’

Equity
 
    Shares     Amount          

Balance, December 31, 2007

  460,898     $ 4,609     $ 3,463,220     $ (247,368 )   $ (391,396 )   $ 2,829,065  

Cumulative effect of adoption of SFAS No. 156

  —         —         —         285       —         285  

Cumulative effect of adoption of SFAS No. 159

  —         —         —         (86,894 )     86,894       —    
                                             

Adjusted balance

  460,898       4,609       3,463,220       (333,977 )     (304,502 )     2,829,350  

Net loss

  —         —         —         (91,193 )     —         (91,193 )

Other comprehensive loss

  —         —         —         —         (66,895 )     (66,895 )

Exchange of debt for common stock

  4,500       45       17,640       —         —         17,685  

Exercise of stock options and purchase plans, including tax benefit

  272       3       (1,306 )     —         —         (1,303 )

Issuance of restricted stock

  8       —         —         —         —         —    

Cancellation of restricted stock

  (14 )     —         —         —         —         —    

Retirement of restricted stock to pay taxes

  (77 )     (1 )     (415 )     —         —         (416 )

Amortization of deferred share-based compensation to APIC under SFAS No. 123(R)

  —         —         13,989       —         —         13,989  

Additional purchase consideration(1)

  2,749       27       9,405       —         —         9,432  

Other

  —         —         4,690       —         —         4,690  
                                             

Balance, March 31, 2008

  468,336     $ 4,683     $ 3,507,223     $ (425,170 )   $ (371,397 )   $ 2,715,339  
                                             
    Common Stock     Additional
Paid-in
Capital
    Retained
Earnings
    Accumulated
Other
Comprehensive
Loss
    Total
Shareholders’
Equity
 
    Shares     Amount          

Balance, December 31, 2006

  426,304     $ 4,263     $ 3,184,290     $ 1,209,289     $ (201,472 )   $ 4,196,370  

Cumulative effect of adoption of FIN 48

  —         —         —         (14,903 )     —         (14,903 )
                                             

Adjusted balance

  426,304       4,263       3,184,290       1,194,386       (201,472 )     4,181,467  

Net income

  —         —         —         169,410       —         169,410  

Other comprehensive loss

  —         —         —         —         (8,078 )     (8,078 )

Exercise of stock options and purchase plans, including tax benefit

  1,240       12       18,975       —         —         18,987  

Repurchases of common stock

  (1,030 )     (10 )     (23,012 )     —         —         (23,022 )

Issuance of restricted stock

  615       6       (6 )     —         —         —    

Retirement of restricted stock to pay taxes

  (64 )     (1 )     (1,518 )     —         —         (1,519 )

Amortization of deferred share-based compensation to APIC under SFAS No. 123(R)

  —         —         11,567       —         —         11,567  

Other

  97       2       2,212       —         —         2,214  
                                             

Balance, March 31, 2007

  427,162     $ 4,272     $ 3,192,508     $ 1,363,796     $ (209,550 )   $ 4,351,026  
                                             

See accompanying notes to consolidated financial statements

 

(1)   Amounts represent additional contingent consideration paid in connection with prior acquisitions.

 

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E*TRADE FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF CASH FLOWS

(In thousands)

(Unaudited)

 

     Three Months Ended
March 31,
 
     2008     2007  

Cash flows from operating activities:

    

Net income (loss)

   $ (91,193 )   $ 169,410  

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

    

Provision for loan losses

     233,871       21,186  

Depreciation and amortization (including discount amortization and accretion)

     77,649       70,018  

(Gain) loss on loans and securities, net and (gain) loss on sales of investments, net

     8,643       (37,131 )

Equity in income of investments and venture funds

     (4,699 )     (8,095 )

Gain on sale of corporate aircraft related assets

     (23,715 )     —    

Loss on early extinguishment of debt

     2,851       —    

Non-cash facility restructuring costs and other exit activities

     3,041       (850 )

Share-based compensation

     13,989       11,567  

Tax benefit from tax deductions in excess of compensation expense

     2,582       (8,432 )

Other

     (4,349 )     674  

Net effect of changes in assets and liabilities:

    

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

     (101,419 )     (128,944 )

Decrease (increase) in margin receivables

     534,831       (125,168 )

(Decrease) increase in customer payables

     (68,725 )     130,480  

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

     165,529       451,037  

Purchases and originations of loans held-for-sale

     (85,754 )     (368,552 )

Proceeds from sales, repayments and maturities of trading securities

     695,676       343,993  

Purchases of trading securities

     (621,058 )     (306,961 )

Decrease (increase) in other assets

     199,526       (400,590 )

Increase (decrease) in accounts payable, accrued and other liabilities

     (1,234,456 )     371,573  

Facility restructuring liabilities

     (3,894 )     (2,943 )
                

Net cash (used in) provided by operating activities

     (301,074 )     182,272  
                

Cash flows from investing activities:

    

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

     (1,070,770 )     (7,324,763 )

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

     3,994,007       4,823,918  

Net decrease (increase) in loans receivable

     1,029,897       (3,347,604 )

Purchases of property and equipment

     (25,226 )     (43,427 )

Proceeds from sale of corporate aircraft related assets

     69,250       —    

Cash used in business acquisitions, net

     (7,883 )     (2,688 )

Net cash flow from derivatives hedging assets

     (37,116 )     4,473  

Other

     (14,348 )     (25,778 )
                

Net cash provided by (used in) investing activities

   $ 3,937,811     $ (5,915,869 )
                

See accompanying notes to consolidated financial statements

 

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E*TRADE FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF CASH FLOWS—(Continued)

(In thousands)

(Unaudited)

 

     Three Months Ended
March 31,
 
     2008     2007  

Cash flows from financing activities:

    

Net increase in deposits

   $ 1,579,545     $ 2,183,771  

Net increase (decrease) in securities sold under agreements to repurchase

     (1,803,041 )     2,332,036  

Net increase (decrease) in other borrowed funds

     (4,400 )     39,627  

Advances from other long-term borrowings

     600,000       3,386,000  

Payments on advances from other long-term borrowings

     (2,810,694 )     (2,229,934 )

Proceeds from issuance of springing lien notes

     150,000       —    

Proceeds from issuance of subordinated debentures and trust preferred securities

     —         40,000  

Proceeds from issuance of common stock from employee stock transactions

     1,279       10,555  

Tax benefit from tax deductions in excess of compensation expense recognition

     (2,582 )     8,432  

Repurchases of common stock

     —         (23,022 )

Net cash flow from derivatives hedging liabilities

     (57,834 )     (30,419 )

Other

     4,458       —    
                

Net cash (used in) provided by financing activities

     (2,343,269 )     5,717,046  
                

Effect of exchange rates on cash

     (9,725 )     (702 )
                

Increase (decrease) in cash and equivalents

     1,283,743       (17,253 )

Cash and equivalents, beginning of period

     1,778,244       1,212,234  
                

Cash and equivalents, end of period

   $ 3,061,987     $ 1,194,981  
                

Supplemental disclosures:

    

Cash paid for interest

   $ 432,698     $ 569,847  

Cash paid for income taxes

   $ 9,574     $ 10,789  

Non-cash investing and financing activities:

    

Transfers from loans to other real estate owned and repossessed assets

   $ 58,735     $ 22,095  

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

   $ 1,630     $ 8,973  

Issuance of common stock to retire debentures

   $ 17,685     $ —    

 

See accompanying notes to consolidated financial statements

 

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E*TRADE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

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

Basis of Presentation—The consolidated financial statements include the accounts of the Company and its majority-owned subsidiaries. Entities in which the Company holds at least a 20% ownership 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 20% ownership 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 evaluates investments including joint ventures, low income housing tax credit partnerships and other limited partnerships to determine if the Company is required to consolidate the entities under the guidance of Financial Accounting Standards Board (“FASB”) Interpretation No. 46, Consolidation of Variable Interest Entities-an interpretation of ARB No. 51 (“FIN 46R”).

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, and should be read in conjunction with the consolidated financial statements of E*TRADE Financial Corporation included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2007.

The Company reports corporate interest income and expense separately from operating interest income and 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 expense is generated from the operations of the Company and is a broad indicator of the Company’s success in its banking and balance sheet management business. Corporate debt, which is the primary source of the corporate interest expense has been issued primarily in connection with the Citadel Investment and acquisitions, such as Harrisdirect and BrownCo.

Similarly, the Company reports gain on sales of investments, net separately from gain (loss) 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. Gain (loss) on loans and securities, net are the result of activities in the Company’s operations, namely its balance sheet management businesses, including impairment on our available-for-sale mortgage-backed and investment securities portfolio. Gain on sales of investments, net relates to historical equity investments of the Company at the corporate level and are not related to the ongoing business of the Company’s operating subsidiaries.

Use of Estimates—The consolidated financial statements were prepared in accordance with GAAP, which require 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. Material estimates in which management believes near-term changes could reasonably occur include allowance for loan losses and uncollectible margin receivables; classification and valuation of certain investments; valuation of certain debt instruments; valuation and accounting for financial derivatives; estimates of effective tax rates; deferred taxes and valuation allowances; valuation of goodwill and other intangibles; and valuation and expensing of share-based payments.

 

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Financial Statement Descriptions and Related Accounting Policies

Margin Receivables—At March 31, 2008, the fair value of securities that the Company received as collateral in connection with margin receivables and stock borrowing activities, where the Company is permitted to sell or re-pledge the securities, was approximately $8.8 billion. Of this amount, $2.2 billion had been pledged or sold at March 31, 2008 in connection with securities loans, bank borrowings and deposits with clearing organizations.

Loans Receivable, Net—Loans receivable, net consists of real estate and consumer loans that management has the intent and ability to hold for the foreseeable future or until maturity. These loans are carried at amortized cost adjusted for charge-offs, net, allowance for loan losses, deferred fees or costs on originated loans and unamortized premiums or discounts on purchased loans. Loan fees and certain direct loan origination costs are deferred and the net fee or cost is recognized in interest income using the interest method over the contractual life of the loans. Premiums and discounts on purchased loans are amortized or accreted into income using the interest method over the remaining period to contractual maturity and adjusted for actual prepayments. The Company classifies loans as nonperforming when full and timely collection of interest or principal becomes uncertain or when they are 90 days past due. Interest previously accrued, but not collected, is reversed against current income when a loan is placed on nonaccrual status and is considered nonperforming. Accretion of deferred fees is discontinued for nonperforming loans. Payments received on nonperforming loans are recognized as interest income when the loan is considered collectible and applied to principal when it is doubtful that full payment will be collected. One- to four-family and home equity loans are charged off to the extent that the carrying value of the loan exceeds the estimated value of the underlying collateral when the loan has been delinquent for 180 days, regardless of whether or not the property is in foreclosure. Credit cards are charged-off when the loan has been delinquent for 180 days. Consumer loans are charged-off when the loan has been delinquent for 120 days.

Fair Value—Effective January 1, 2008, the Company adopted SFAS No. 157, which defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. The Company determines the fair values of its financial instruments and for nonfinancial assets and nonfinancial liabilities that are recognized or disclosed at fair value in the financial statements on a recurring basis in accordance with SFAS No. 157. The Company will not adopt this statement until January 1, 2009 for nonfinancial assets and nonfinancial liabilities that are not recognized or disclosed at fair value in the financial statements on a recurring basis. Examples of nonfinancial assets and nonfinancial liabilities for which the Company has not applied the provisions of SFAS No. 157 include reporting units, nonfinancial assets and nonfinancial liabilities and indefinite-lived intangible assets measured at fair value in impairment tests under SFAS No. 142, nonfinancial long-lived assets measured at fair value for an impairment assessment under SFAS No. 144 as well as nonfinancial liabilities for exit or disposal activities initially measured at fair value under SFAS No. 146.

In determining fair value, the Company uses various valuation approaches, including market, income and/or cost approaches. The fair value hierarchy established in SFAS No. 157 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. As such, 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 standard describes three levels of inputs that may be used to measure fair value and are as follows:

 

   

Level 1—Quoted prices in active markets for identical assets or liabilities. Examples of assets and liabilities utilizing Level 1 inputs include actively traded equity securities.

 

   

Level 2—Quoted prices in markets that are not active or for which all significant inputs are observable, either directly or indirectly. Examples of assets and liabilities utilizing Level 2 inputs include mortgage- backed securities backed by U.S. Government sponsored and Federal agencies, certain CMOs, most investment securities and most OTC derivatives.

 

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Level 3—Unobservable inputs that are significant to the fair value of the assets or liabilities. Level 3 assets and liabilities include financial 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. Examples of assets and liabilities utilizing significant Level 3 inputs or those that require significant management judgment include most CMOs, servicing rights, retained interest in securitizations, certain other mortgage-backed securities and certain OTC derivatives. In certain securities, including a portion of the CMO portfolio, where there has been limited activity or less transparency around inputs to the valuation, securities are classified as Level 3 even though the Company believes that Level 2 inputs could likely be obtainable in a more active market.

The availability of observable inputs can vary from instrument to instrument and in certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, an instrument’s 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 the fair value measurement of an instrument requires judgment and consideration of factors specific to the instrument.

Fair Value Option—Effective January 1, 2008, the Company elected to carry investments in FNMA and FHLMC preferred stock at fair value through earnings under SFAS No. 159. The Company elected to carry the investment in preferred stock at fair value through earnings to allow the Company to economically hedge the portfolio without the burden of complying with SFAS No. 133, as amended. The impact of this adoption was an after-tax decrease to opening retained earnings as of January 1, 2008 of approximately $86.9 million. As of December 31, 2007, the Company’s investment in preferred stock was reported in the balance sheet line item available-for-sale mortgage-backed and investment securities. In accordance with SFAS No. 159, as a result of the fair value election the investment in preferred stock is reported in the balance sheet line item trading securities as of March 31, 2008. Realized and unrealized gains and losses on securities classified as trading are included in the gain (loss) on loans and securities, net line item.

For additional information regarding the adoption of SFAS No. 157 and SFAS No. 159, see Note 15—Fair Value Disclosures.

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

SFAS No. 156—Accounting for Servicing Financial Assets, an Amendment of SFAS No. 140

In March 2006, the FASB issued SFAS No. 156. This statement establishes, among other things, the accounting for all separately recognized servicing assets and liabilities. The Company adopted this statement on January 1, 2007. As of January 1, 2008, the Company elected to account for servicing rights under the fair value measurement method. The transition adjustment to opening retained earnings as of January 1, 2008 related to the fair value measurement election was $0.3 million.

SFAS No. 157—Fair Value Measurements

In September 2006, the FASB issued SFAS No. 157, which establishes, among other things, a framework for measuring fair value and expands disclosure requirements as they relate to fair value measurements. The Company adopted this statement on January 1, 2008 for financial assets and financial liabilities and for nonfinancial assets and nonfinancial liabilities that are recognized or disclosed at fair value in the consolidated financial statements on a recurring basis, the effects of which were not material to the financial condition, results of operations or cash flows. The Company will not adopt this statement until January 1, 2009 for nonfinancial assets and nonfinancial liabilities that are not recognized or disclosed at fair value in the consolidated financial

 

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statements on a recurring basis, for which the Company does not expect the adoption of this statement to have a material impact on the Company’s financial condition, results of operations or cash flows in future periods. For additional information regarding the adoption of SFAS No. 157 and SFAS No. 159, see Note 15—Fair Value Disclosures.

SFAS No. 159—The Fair Value Option for Financial Assets and Financial Liabilities

In February 2007, the FASB issued SFAS No. 159 which provides an option under which a company may irrevocably elect fair value as the initial and subsequent measurement attribute for certain financial assets and financial liabilities. This fair value option will be available on a contract-by-contract basis with changes in fair value recognized in earnings as those changes occur. The Company adopted this statement on January 1, 2008 and elected the fair value option for FNMA and FHLMC preferred stock. The impact of this adoption was an after-tax decrease to opening retained earnings as of January 1, 2008 of approximately $86.9 million. For additional information regarding the adoption of SFAS No. 157 and SFAS No. 159, see Note 15—Fair Value Disclosures.

SFAS No. 161—Disclosures About Derivative Instruments and Hedging Activities

In March 2008, the FASB issued SFAS No. 161, Disclosures About Derivative Instruments and Hedging Activities. This statement establishes, among other things, the disclosure requirements for derivative instruments and for hedging activities. This statement is effective at the beginning of an entities first interim period beginning after November 15, 2008 or January 1, 2009 for the Company. The Company is currently evaluating the impact this guidance will have on its financial condition, results of operations or cash flows.

Staff Accounting Bulletin (“SAB”) No. 109—Written Loan Commitments Recorded at Fair Value Through Earnings

In November 2007, the SEC issued Staff Accounting Bulletin No. 109, Written Loan Commitments Recorded at Fair Value Through Earnings (“SAB No. 109”), which becomes effective for the Company January 1, 2008. SAB No. 109 supersedes SAB No. 105, Application of Accounting Principles to Loan Commitments (“SAB No. 105”), and states, consistent with the guidance in SFAS No. 156 and SFAS No. 159, that the expected net future cash flows related to the associated servicing of the loan should be included in the measurement of all written loan commitments that are accounted for at fair value through earnings. SAB No. 109 retains the view expressed in SAB No. 105 that internally developed intangible assets (such as customer relationship intangible assets) should not be recorded as part of the fair value of a derivative loan commitment and broadens its application to all written loan commitments that are accounted for at fair value through earnings. The Company adopted this statement on January 1, 2008 and the impact of adoption was not material to the Company’s financial condition, results of operations or cash flows.

NOTE 2—FACILITY RESTRUCTURING AND OTHER EXIT ACTIVITIES

Restructuring liabilities are included in accounts payable, accrued and other liabilities in the consolidated balance sheet. The following table summarizes the expense recognized by the Company as facility restructuring and other exit activities for the periods presented (dollars in thousands):

 

     Three Months Ended March 31,
         2008            2007    

Restructuring of institutional brokerage operations

   $ 9,991    $ —  

Other exit activities

     501      733
             

Total facility restructuring and other exit activities

   $ 10,492    $ 733
             

 

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Exit of Non-Core Operations

Institutional Brokerage Operations

Toward the end of the third quarter in 2007, the Company announced a plan to simplify and streamline the business by exiting and/or restructuring certain non-core operations. The Company has taken steps to restructure the institutional equity business to focus on areas that complement order flow generated by retail customers. In the first quarter of 2008, the Company announced the decision to exit the institutional trading operations that do not align with the core retail business. As a result of these exits, the Company incurred costs of $5.8 million for facilities consolidation and asset write-off costs, $2.9 million in severance costs and $1.3 million of other costs related to these exits for the three months ended March 31, 2008. The total charge for both of these exit activities is expected to be between $25.0 million and $30.0 million, all of which will be recorded to the institutional segment.

Other Exit Activities

In the first quarter of 2008, the Company has continued the consolidation and relocation of certain facilities. The Company incurred $0.5 million related to facilities consolidation and relocation primarily related to the exit of certain operating leases. In the first quarter of 2007, the Company incurred cost of $1.2 million to exit certain facilities in California and recognized $(0.5) million of adjustments to restructuring activities from prior periods.

NOTE 3—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,
 
     2008     2007  

Operating interest income:

    

Loans, net

   $ 451,574     $ 451,399  

Mortgage-backed and investment securities

     109,276       210,507  

Margin receivables

     94,913       123,986  

Other

     54,974       43,903  
                

Total operating interest income

     710,737       829,795  
                

Operating interest expense:

    

Deposits

     (186,704 )     (182,988 )

Repurchase agreements and other borrowings

     (94,934 )     (159,031 )

FHLB advances

     (70,802 )     (62,852 )

Other

     (25,526 )     (34,338 )
                

Total operating interest expense

     (377,966 )     (439,209 )
                

Net operating interest income

   $ 332,771     $ 390,586  
                

 

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NOTE 4—AVAILABLE-FOR-SALE MORTGAGE-BACKED AND INVESTMENT SECURITIES

The amortized cost basis and estimated fair values of available-for-sale mortgage-backed and investment securities are shown in the following tables (dollars in thousands):

 

     Amortized
Cost
   Gross
Unrealized Gains
   Gross
Unrealized Losses
    Estimated
Fair Values

March 31, 2008:

          

Mortgage-backed securities:

          

Backed by U.S. Government sponsored and Federal agencies

   $ 7,526,011    $ 12,797    $ (224,491 )   $ 7,314,317

CMOs and other

     1,108,723      143      (138,206 )     970,660
                            

Total mortgage-backed securities

     8,634,734      12,940      (362,697 )     8,284,977
                            

Investment securities:

          

Debt securities:

          

Municipal bonds

     105,866      —        (10,170 )     95,696

Corporate bonds

     25,548      —        (6,908 )     18,640
                            

Total debt securities

     131,414      —        (17,078 )     114,336

Publicly traded equity securities:

          

Corporate investments

     1,256      —        (242 )     1,014

Retained interests from securitizations

     964      786      —         1,750
                            

Total investment securities

     133,634      786      (17,320 )     117,100
                            

Total available-for-sale securities

   $ 8,768,368    $ 13,726    $ (380,017 )   $ 8,402,077
                            

December 31, 2007:

          

Mortgage-backed securities:

          

Backed by U.S. Government sponsored and Federal agencies

   $ 9,638,676    $ 86    $ (308,633 )   $ 9,330,129

CMOs and other

     1,170,360      2      (47,107 )     1,123,255
                            

Total mortgage-backed securities

     10,809,036      88      (355,740 )     10,453,384
                            

Investment securities:

          

Debt securities:

          

Municipal bonds

     320,521      58      (6,231 )     314,348

Corporate bonds

     36,557      2,134      (3,412 )     35,279

Other debt securities

     78,836      1      (1,546 )     77,291
                            

Total debt securities

     435,914      2,193      (11,189 )     426,918

Publicly traded equity securities:

          

Preferred stock

     505,498      —        (134,094 )     371,404

Corporate investments

     1,460      —        (189 )     1,271

Retained interests from securitizations

     980      1,091      —         2,071
                            

Total investment securities

     943,852      3,284      (145,472 )     801,664
                            

Total available-for-sale securities

   $ 11,752,888    $ 3,372    $ (501,212 )   $ 11,255,048
                            

 

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Other-Than-Temporary Impairment of Investments

The following tables show the fair values and unrealized losses on investments, aggregated by investment category, and the length of time that individual securities have been in a continuous unrealized loss position (dollars in thousands):

 

     Less than 12 Months     12 Months or More     Total  
     Fair
Values
   Unrealized
Losses
    Fair
Values
   Unrealized
Losses
    Fair
Values
   Unrealized
Losses
 

March 31, 2008:

               

Mortgage-backed securities:

               

Backed by U.S. Government sponsored and Federal agencies

   $ 329,538    $ (4,147 )   $ 5,803,092    $ (220,344 )   $ 6,132,630    $ (224,491 )

CMOs and other

     317,808      (59,847 )     578,593      (78,359 )     896,401      (138,206 )

Debt securities:

               

Municipal bonds

     71,824      (6,991 )     23,872      (3,179 )     95,696      (10,170 )

Corporate bonds

     —        —         18,439      (6,908 )     18,439      (6,908 )

Publicly traded equity securities:

               

Corporate investments

     —        —         120      (242 )     120      (242 )
                                             

Total temporarily impaired securities

   $ 719,170    $ (70,985 )   $ 6,424,116    $ (309,032 )   $ 7,143,286    $ (380,017 )
                                             

December 31, 2007:

               

Mortgage-backed securities:

               

Backed by U.S. Government sponsored and Federal agencies

   $ 1,394,002    $ (6,802 )   $ 7,849,331    $ (301,831 )   $ 9,243,333    $ (308,633 )

CMOs and other

     537,522      (25,415 )     585,629      (21,692 )     1,123,151      (47,107 )

Debt securities:

               

Municipal bonds

     272,698      (4,898 )     29,052      (1,333 )     301,750      (6,231 )

Corporate bonds

     —        —         21,935      (3,412 )     21,935      (3,412 )

Other debt securities

     —        —         76,433      (1,546 )     76,433      (1,546 )

Publicly traded equity securities:

               

Preferred stock

     355,942      (134,094 )     —        —         355,942      (134,094 )

Corporate investments

     —        —         173      (189 )     173      (189 )
                                             

Total temporarily impaired securities

   $ 2,560,164    $ (171,209 )   $ 8,562,553    $ (330,003 )   $ 11,122,717    $ (501,212 )
                                             

The Company does not believe that any individual unrealized loss as of March 31, 2008 represents an other-than-temporary impairment. The majority of the unrealized losses on mortgage-backed securities are attributable to changes in interest rates and a re-pricing of risk in the market. Substantially all mortgage-backed securities backed by U.S. Government sponsored and Federal agencies are AAA-rated. The Company has the intent and ability to hold the securities in an unrealized loss position at March 31, 2008 until the market value recovers or the securities mature. Municipal bonds and corporate bonds are evaluated by reviewing the credit-worthiness of the issuer and general market conditions.

Within the securities portfolio, the asset-backed securities portfolio, which was sold in the fourth quarter of 2007, represented the highest concentration of credit risk. Subsequent to the sale of that portfolio, the highest concentration of remaining credit risk, while dramatically lower than the credit risk inherent in asset-backed

 

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securities, is the CMO portfolio. While the vast majority of this portfolio is AAA-rated, the Company identified approximately $183 million of CMO securities with a possibility of future loss. As a result, $95 million of these securities were written down to their estimated fair market value by recording a $26.6 million impairment during the first quarter of 2008. The Company recorded other-than-temporary impairment charges of $0.2 million for asset-backed securities in the first quarter of 2007.

The Company elected the fair value option for its preferred stock under SFAS No. 159 as of January 1, 2008. Subsequent to the adoption, preferred stock was classified as trading securities.

The detailed components of the gain (loss) on loans and securities, net and gain on sales of investments, net line items on the consolidated statement of income (loss) are shown below.

Gain (Loss) on Loans and Securities, Net

Gain (loss) on loans and securities, net are as follows (dollars in thousands):

 

     Three Months Ended
March 31,
 
         2008             2007      

Gain on sales of originated loans

   $ 730     $ 1,915  

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

     (157 )     (1,662 )

Gain (loss) on securities, net

    

Gain on securities and other investments

     13,263       8,517  

Loss on impairment

     (26,602 )     (249 )

Gain on trading securities

     3,621       8,854  
                

Gain (loss) on securities, net

     (9,718 )     17,122  
                

Gain (loss) on loans and securities, net

   $ (9,145 )   $ 17,375  
                

Gain on Sales of Investments, Net

Gain on sales of investments, net are as follows (dollars in thousands):

 

     Three Months Ended
March 31,
         2008            2007    

Realized gains on sales of publicly traded equity securities

   $ 254    $ 19,717

Other

     248      39
             

Gain on sales of investments, net

   $ 502    $ 19,756
             

 

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NOTE 5—LOANS, NET

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

 

     March 31,
2008
    December 31,
2007
 

Loans held-for-sale

   $ 19,327     $ 100,539  
                

Loans receivable, net:

    

One- to four-family

     14,639,145       15,506,529  

Home equity

     11,385,998       11,901,324  

Consumer and other loans:

    

Recreational vehicle

     1,811,794       1,910,454  

Marine

     497,693       526,580  

Commercial

     264,909       272,156  

Credit card

     85,547       90,764  

Other

     15,925       23,334  
                

Total consumer and other loans

     2,675,868       2,823,288  
                

Total loans receivable

     28,701,011       30,231,141  

Unamortized premiums, net

     289,735       315,866  

Allowance for loan losses

     (565,908 )     (508,164 )
                

Total loans receivable, net

     28,424,838       30,038,843  
                

Total loans, net

   $ 28,444,165     $ 30,139,382  
                

The following table provides an analysis of the allowance for loan losses for the three months ended March 31, 2008 and 2007 (dollars in thousands):

 

     Three Months Ended
March 31,
 
     2008     2007  

Allowance for loan losses, beginning of period

   $ 508,164     $ 67,628  

Provision for loan losses

     233,871       21,186  

Charge-offs

     (182,412 )     (26,444 )

Recoveries

     6,285       5,619  
                

Net charge-offs

     (176,127 )     (20,825 )
                

Allowance for loan losses, end of period

   $ 565,908     $ 67,989  
                

The Company has a CDS on $4.0 billion of its first-lien residential real estate loan portfolio through a synthetic securitization structure. A CDS provides, for a fee, an assumption by a third party of a portion of the credit risk related to the underlying loans. The CDS the Company entered into provides protection for losses in excess of 10 basis points, but not to exceed approximately 75 basis points. In addition, the Company’s regulatory risk-weighted assets were reduced as a result of this transaction because it transferred a portion of the Company’s credit risk to an unaffiliated third party.

NOTE 6—ACCOUNTING FOR DERIVATIVE FINANCIAL INSTRUMENTS AND HEDGING ACTIVITIES

The Company enters into derivative transactions to protect against the risk of market price or interest rate movements on the value of certain assets, liabilities and future cash flows. The Company is also required to recognize certain contracts and commitments as derivatives when the characteristics of those contracts and commitments meet the definition of a derivative as promulgated by SFAS No. 133, as amended.

 

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Fair Value Hedges

Overview of Fair Value Hedges

The Company uses a combination of interest rate swaps, forward-starting swaps and purchased options on swaps to offset its exposure to changes in value of certain fixed-rate assets and liabilities. Changes in the fair value of the derivatives are recognized currently in earnings. 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 othe