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Loans and Allowance for Credit Losses

6 Months Ended

Jun. 30, 2020

We segregate our loans into two segments: commercial and financial loans and commercial real estate loans. We further classify commercial and financial loans as fund finance loans, leveraged loans, overdrafts and other. These classifications reflect their risk characteristics, their initial measurement attributes and the methods we use to monitor and assess credit risk. For additional information on our loans, including our internal risk-rating system used to assess our risk of credit loss for each loan, refer to pages 141 to 143 in Note 4 to the consolidated financial statements included under Item 8, Financial Statements and Supplementary Data, in our 2019 Form 10-K.

The following table presents our recorded investment in loans, by segment, as of the dates indicated:



(In millions)	June 30, 2020			December 31, 2019
Domestic⁽¹⁾:
Commercial and financial:
Fund Finance ⁽²⁾	$	9,696		$	10,270
Leveraged loans	3,071			3,342
Overdrafts	2,292			1,739
Other⁽³⁾	2,450			3,411
Commercial real estate	1,944			1,766
Total domestic	19,453			20,528
Foreign⁽¹⁾:
Commercial and financial:
Fund Finance⁽²⁾	3,986			3,145
Leveraged loans	1,230			1,119
Overdrafts	2,163			1,517
Other⁽³⁾	28			—
Total foreign	7,407			5,781
Total loans	26,860			26,309
Allowance for loan losses	(141		)	(74		)
Loans, net of allowance	$	26,719		$	26,235

⁽¹⁾ Domestic and foreign categorization is based on the borrower’s country of domicile.

⁽²⁾Fund finance loans include primarily $5,026 million loans to real money funds, $7,272 million private equity capital call finance loans and $820 million loans to business development companies as of June 30, 2020, compared to $6,040 million loans to real money funds, $6,076 million private equity capital call finance loans and $932 million loans to business development companies as of December 31, 2019.

⁽³⁾Includes $1,448 million securities finance loans, $933 million loans to municipalities and $97 million other loans as of June 30, 2020 and $2,537 million securities finance loans, $848 million loans to municipalities and $26 million other loans as of December 31, 2019.

The commercial and financial segment is composed primarily of fund finance loans, leveraged loans, overdrafts and other loans. Fund finance loans are composed of revolving credit lines providing liquidity and leverage to mutual fund and private equity fund clients.

Certain loans are pledged as collateral for access to the Federal Reserve's discount window. As of June 30, 2020 and December 31, 2019, the loans pledged as collateral totaled $7.51 billion and $6.75 billion, respectively.

As of June 30, 2020 and December 31, 2019, we had no loans on non-accrual status and no loans 30 days or more contractually past due.

We sold $127 million leveraged loans in the second quarter of 2020, of which $23 million remain unsettled and held for sale as of June 30, 2020.

In certain circumstances, we restructure troubled loans by granting concessions to borrowers experiencing financial difficulty. Once restructured, the loans are generally considered impaired until their maturity, regardless of whether the borrowers perform under the modified terms of the loans. There were no loans modified in troubled debt restructurings as of both June 30, 2020 and December 31, 2019.

We recognize an allowance for credit losses in accordance with ASC 326 for financial assets held at amortized cost and off-balance sheet commitments. Further discussion of our adoption of ASC 326 on January 1, 2020, including the impact on our consolidated financial statements, is provided in Note 1. For additional discussion on the allowance for credit loss for debt securities, please refer to Note 3.

When the allowance is recorded, a provision for credit losses expense is recognized in net income. The allowance for credit losses for financial assets represents the portion of the amortized cost basis, including accrued interest for financial assets held at amortized cost, which management does not expect to recover due to expected credit losses and is presented on the statement of condition as an offset to the amortized cost basis. The accrued interest balance is presented separately on the statement of condition within accrued interest and fees receivable. The allowance for off-balance sheet commitments is presented within other liabilities.

The allowance for credit losses may be determined using various methods, including discounted cash flow methods, loss-rate methods, probability-of-default methods, or other methods as determined by us. The method used to estimate expected credit losses may vary depending on the type of financial asset, our ability to predict the timing of cash flows, and the information available to us.

We measure expected credit losses of financial assets on a collective (pool) basis when similar risk characteristic exist. Each reporting period, we assess whether the assets in the pool continue to display similar risk characteristics.

Prior to the implementation of ASC 326, we reviewed loans for indicators of impairment. Loans where indicators existed were evaluated individually for impairment at least quarterly. For those loans where no such indicators were identified, the loans were collectively evaluated for impairment. As of December 31, 2019, we had one loan for $25 million in the

commercial and financial segment that was individually evaluated for impairment and deemed to be impaired. We recorded a specific reserve of $1 million for this loan.

For a financial asset that does not share risk characteristics with other assets, expected credit losses are measured based on net realizable value, that is, the difference between the discounted value of the expected future cash flows, utilizing the effective interest rate, and the amortized cost basis of the asset. As of June 30, 2020, we had one loan for $25 million in the commercial and financial segment that no longer met the similar risk characteristics of their collective pool.

When the asset is collateral dependent, which means when the borrower is experiencing financial difficulty and repayment is expected to be provided substantially through the operation or sale of the collateral, expected credit losses are measured as the difference between the amortized cost basis of the asset and the fair value of the collateral, adjusted for the estimated costs to sell.

Determining the appropriateness of the allowance is complex and requires judgment by management about the effect of matters that are inherently uncertain. In future periods, factors and forecasts then prevailing may result in significant changes in the allowance for credit losses in those future periods.

We estimate credit losses over the contractual life of the financial asset while factoring in prepayment activity where supported by data over a three year reasonable and supportable forecast period. We utilize a baseline, upside and downside scenario which are applied based on a probability weighting, in order to better reflect management’s expectation of expected credit losses given existing market conditions and the changes in the economic environment. The multiple scenarios are based on a three year horizon (or less depending on contractual maturity) and then revert linearly over a two year period to a ten-year historical average thereafter. The contractual term excludes expected extensions, renewals and modifications, but includes prepayment assumptions where applicable.

Credit Quality

Credit quality for financial assets held at amortized cost are continuously monitored by management and is reflected within the allowance for credit losses. The allowance for credit losses as reported in our consolidated statement of condition is adjusted by provision for credit losses, which is reported in earnings, and reduced by the charge-off of principal amounts, net of recoveries.

We use an internal risk-rating system to assess our risk of credit loss for each financial asset. The risk-rating process incorporates the use of risk-rating tools in conjunction with management judgment. Qualitative and quantitative inputs are captured in a systematic

manner and following a formal review and approval process, an internal credit rating based on our credit scale is assigned.

When computing allowance levels, credit loss assumptions are estimated using a model that categorizes asset pools based on loss history, delinquency status and other credit trends and risk characteristics, including current conditions and reasonable and supportable forecasts about the future. Determining the appropriateness of the allowance is complex and requires judgment by management about the effect of matters that are inherently uncertain. In future periods evaluations of the overall asset portfolio, in light of the factors and forecasts then prevailing, may result in significant changes in the allowance and credit loss expense in those future periods.

Credit quality is assessed and monitored at least annually, by evaluating various attributes in order to enable the earliest possible detection of any concerns with the customer’s credit rating. The results of those evaluations are utilized in underwriting new loans and transactions with counterparties and in our process for estimation of expected credit losses.

In assessing the risk rating assigned to each financial asset held at amortized cost, among the factors considered are the borrower’s debt capacity, collateral coverage, payment history and delinquency experience, financial flexibility and earnings strength, the expected amounts and source of repayment, the level and nature of contingencies, if any, and the industry and geography in which the borrower operates. These factors are based on an evaluation of historical and current information, and involve subjective assessment and interpretation. Credit counterparties are evaluated and risk-rated on an individual basis at least annually.

Management regularly reviews financial assets in the portfolio to assess credit quality indicators and to determine appropriate loans classification and grading in accordance with applicable bank regulations. Our internal risk rating methodology assigns risk ratings ranging from Investment Grade, Speculative, Special Mention, Substandard, Doubtful and Loss.

•

Investment Grade. Assets consisting of counterparties with strong credit quality and low expected credit risk and probability of default. Ratings apply to counterparties with a strong capacity to support the timely repayment of any financial commitment. Approximately 79% of our loans were rated as investment grade as of June 30, 2020 with external credit ratings, or equivalent, of "BBB-" or better.

•

Speculative. Assets consisting of counterparties that face ongoing uncertainties or exposure to business, financial or economic downturns. However, these counterparties may have financial flexibility or access to financial alternatives, which allow for financial commitments to be met. Assets rated as speculative, which is approximately 21% of our loans as of June 30, 2020, primarily comprises our leveraged loans. Approximately 83% of those leveraged loans have an external credit rating, or equivalent, of "BB" or "B" as of June 30, 2020.


•	Special Mention. Assets consisting of counterparties with potential weaknesses that, if uncorrected, may result in deterioration of repayment prospects.


•	Substandard. Assets consisting of counterparties with well-defined weakness that jeopardizes repayment with the possibility we will sustain some loss.


•	Doubtful. Assets consisting of counterparties with well-defined weakness which make collection or liquidation in full highly questionable and improbable.


•	Loss. Assets which are uncollectible or have little value.

The following tables present our recorded investment in each class of loans by credit quality indicator as of the dates indicated:



June 30, 2020	Commercial and Financial		Commercial Real Estate		Total Loans
(In millions)	Commercial and Financial		Commercial Real Estate		Total Loans
Investment grade	$	19,413	$	1,777	$	21,190
Speculative	5,449		167		5,616
Special mention	54		—		54
Total⁽¹⁾	$	24,916	$	1,944	$	26,860



December 31, 2019	Commercial and Financial		Commercial Real Estate		Total Loans
(In millions)	Commercial and Financial		Commercial Real Estate		Total Loans
Investment grade	$	19,501	$	1,766	$	21,267
Speculative	5,008		—		5,008
Special mention	25		—		25
Substandard	9		—		9
Total⁽¹⁾	$	24,543	$	1,766	$	26,309

⁽¹⁾ Loans Include $4,455 million and $3,256 million of overdrafts as of June 30, 2020 and December 31, 2019, respectively. Overdrafts are short-term in nature and do not present a significant credit risk to us.

Financial assets held at amortized cost that are not loans are disaggregated based on product type. We assess credit risk based on the entire balance within fees receivable.

Securities purchased under a resale agreement and securities-financing within our principal business utilized the collateral maintenance provisions included within ASC 326. An allowance for credit losses is recognized for any remaining exposure based on counterparty type.

The allowance for credit losses for off-balance sheet credit exposures, recorded in accrued expenses and other liabilities in our consolidated statement of condition, represents management’s’ estimate of credit losses primarily in outstanding letters and lines of credit and other credit-enhancement facilities provided to our clients and outstanding as of the balance sheet date. The allowance is evaluated quarterly by management. Factors considered in evaluating the appropriate level of this allowance are similar to those considered with respect to the allowance for credit losses on financial assets held at amortized cost. Provisions to maintain the allowance at a level considered by us to be appropriate to absorb estimated credit losses in outstanding facilities are recorded in the provision for credit losses in our consolidated statement of income.

The following table presents the amortized cost basis, by year of origination and credit quality indicator as of June 30, 2020. For origination years before the fifth annual period, we present the aggregate amortized cost basis of loans. For purchased loans, the date of issuance is used to determine the year of origination, not the date of acquisition. For modified, extended or renewed lending arrangements, we evaluate whether a credit event has occurred which would consider the loan to be a new arrangement.



(In millions)	2020		2019		2018		2017		2016		2015		Prior		Revolving Loans		Total⁽¹⁾⁽²⁾
Domestic loans:
Commercial and financial:
Risk Rating:
Investment grade	$	2,478	$	438	$	5	$	120	$	—	$	—	$	—	$	10,465	$	13,506
Speculative	322		999		944		741		108		—		—		835		3,949
Special mention	—		—		29		25		—		—		—		—		54
Total commercial and financing	$	2,800	$	1,437	$	978	$	886	$	108	$	—	$	—	$	11,300	$	17,509

Commercial real estate:
Risk Rating:
Investment grade	$	178	$	440	$	654	$	279	$	197	$	29	$	—	$	—	$	1,777
Speculative	—		110		57		—		—		—		—		—		167
Total commercial real estate	$	178	$	550	$	711	$	279	$	197	$	29	$	—	$	—	$	1,944

Non-U.S. loans:
Commercial and financial:
Risk Rating:
Investment grade	$	2,001	$	—	$	—	$	—	$	—	$	—	$	—	$	3,906	$	5,907
Speculative	336		412		348		208		25		—		63		108		1,500
Total commercial and financing	$	2,337	$	412	$	348	$	208	$	25	$	—	$	63	$	4,014	$	7,407

Total loans	$	5,315	$	2,399	$	2,037	$	1,373	$	330	$	29	$	63	$	15,314	$	26,860

Off-balance sheet commitments and guarantees:
Unfunded credit facilities	$	—	$	—	$	—	$	—	$	—	$	—	$	—	$	33,126	$	33,126
Indemnified securities financing	367,214		—		—		—		—		—		—		—		367,214
Standby letters of credit	—		—		—		—		—		—		—		3,246		3,246
Total off-balance sheet commitments and guarantees	$	367,214	$	—	$	—	$	—	$	—	$	—	$	—	$	36,372	$	403,586

Total financing receivables and off-balance sheet commitments and guarantees	$	372,529	$	2,399	$	2,037	$	1,373	$	330	$	29	$	63	$	51,686	$	430,446

⁽¹⁾Any reserve associated with accrued interest is not material.

⁽²⁾As of June 30, 2020, accrued interest receivable of $63 million included in the amortized cost basis of loans has been excluded from the amortized cost basis within this table.

The following table presents the activity in the allowance for credit losses by portfolio and class for the periods indicated:



	Three Months Ended June 30, 2020
	Commercial and Financial
(In millions)	Leveraged Loans			Other Loans		Commercial Real Estate		Off-Balance Sheet Commitments			All Other ⁽²⁾			Total Credit Reserve
Allowance for credit losses:
Beginning balance	$	83		$	10	$	4	$	22		$	5		$	124
Charge-offs⁽¹⁾	(14		)	—		—		—			—			(14		)
Provision	43			10		4		(4		)	(1		)	52
FX translation	1			—		—		—			—			1
Ending balance	$	113		$	20	$	8	$	18		$	4		$	163

⁽¹⁾ Related to the sale of leveraged loans in the second quarter of 2020.

⁽²⁾ Includes the reserves on HTM investment securities.



	Six Months Ended June 30, 2020
	Commercial and Financial
(In millions)	Leveraged Loans			Other Loans		Commercial Real Estate		Off-Balance Sheet Commitments			All Other⁽²⁾		Total Credit Reserve
Allowance for credit losses:
Beginning balance	$	61		$	10	$	2	$	19		$	1	$	93
Charge-offs⁽¹⁾	(19		)	—		—		—			—		(19		)
Provision	70			10		6		(1		)	3		88
FX translation	1			—		—		—			—		1
Ending balance	$	113		$	20	$	8	$	18		$	4	$	163

⁽¹⁾Primarily related to the sale of leveraged loans in the second quarter of 2020.

⁽²⁾ Includes the reserves on HTM investment securities.

Allowance for Loan Losses under Incurred Loss Methodology for the period ended June 30, 2019

The following table presents activity in the allowance for loan losses as of June 30, 2019 under the incurred loss methodology:



(In millions)	Three months ended June 30, 2019
Allowance for loan losses:
Beginning balance	$	70
Provision for credit losses⁽¹⁾	1
Other⁽²⁾	1
Ending balance	$	72

(In millions)	Six months ended June 30, 2019
Allowance for loan losses:
Beginning balance	$	67
Provision for credit losses⁽¹⁾	5
Ending balance	$	72

⁽¹⁾ The provisions for credit losses were primarily attributable to exposure to purchased leveraged loans to non-investment grade loans.

⁽²⁾Consists primarily of FX translation.

Loans are reviewed on a regular basis, and any provisions for loan losses that are recorded reflect management's estimate of the amount necessary to maintain the allowance for loan losses at a level considered appropriate to absorb estimated incurred losses in the loan and lease portfolio. The $52 million provision for credit losses recognized for the three months ended June 30, 2020 was primarily due to portfolio credit migration within our loan portfolio, as well as a downward revision in management’s economic outlook.