UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

þ 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

 

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from (not applicable)

 

Commission file number 1-6880

 

U.S. BANCORP

(Exact name of registrant as specified in its charter)

 

 

800 Nicollet Mall

Minneapolis, Minnesota 55402

(Address of principal executive offices, including zip code)

 

651-466-3000

(Registrant’s telephone number, including area code)

 

(not applicable)

(Former name, former address and former fiscal year, if changed since last report)

 

 

     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, and (2) has been subject to such filing requirements for the past 90 days.

 

YES þ  NO o

 

     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 the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

 

     Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

 

YES o  NO þ

 

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

 

 

 

Table of Contents and Form 10-Q Cross Reference Index

 

 

 

“Safe Harbor” Statement under the Private Securities Litigation Reform Act of 1995.

This Quarterly Report on Form 10-Q contains forward-looking statements. Statements that are not historical or current facts, including statements about beliefs and expectations, are forward-looking statements. These statements often include the words “may,” “could,” “would,” “should,” “believes,” “expects,” “anticipates,” “estimates,” “intends,” “plans,” “targets,” “potentially,” “probably,” “projects,” “outlook” or similar expressions. These forward-looking statements cover, among other things, anticipated future revenue and expenses and the future plans and prospects of U.S. Bancorp. Forward-looking statements involve inherent risks and uncertainties, and important factors could cause actual results to differ materially from those anticipated, including changes in general business and economic conditions, changes in interest rates, deterioration in the credit quality of our loan portfolios or in the value of the collateral securing those loans, deterioration in the value of securities held in our investment securities portfolio, legal and regulatory developments, increased competition from both banks and non-banks, changes in customer behavior and preferences, effects of mergers and acquisitions and related integration, effects of critical accounting policies and judgments, and management’s ability to effectively manage credit risk, market risk, operational risk, legal risk and regulatory and compliance risk. For discussion of these and other risks that may cause actual results to differ from expectations, refer to our Annual Report on Form 10-K for the year ended December 31, 2007, on file with the Securities and Exchange Commission, including the sections entitled “Risk Factors” and “Corporate Risk Profile.” Forward-looking statements speak only as of the date they are made, and U.S. Bancorp undertakes no obligation to update them in light of new information or future events.

 

 

 

Table 1    Selected Financial Data

 

 

Management’s Discussion and Analysis

 

 

Earnings Summary U.S. Bancorp and its subsidiaries (the “Company”) reported net income of $1,090 million for the first quarter of 2008 or $.62 per diluted common share, compared with $1,130 million, or $.63 per diluted common share for the first quarter of 2007. Return on average assets and return on average common equity were 1.85 percent and 21.3 percent, respectively, for the first quarter of 2008, compared with returns of 2.09 percent and 22.4 percent, respectively, for the first quarter of 2007. Several significant items were reflected in the Company’s first quarter 2008 results, including a $492 million gain related to the Visa Inc. initial public offering that occurred in March 2008 (“Visa Gain”) and $253 million of impairment charges on structured investment securities. The Company’s results also included a provision for credit losses which exceeded net charge-offs by $192 million, reflecting continuing stress in the residential real estate markets and related industries, in addition to the continued growth of the consumer loan portfolios. The first quarter of 2008 also included a $62 million reduction to pretax income related to the adoption of a new accounting standard, a $25 million contribution to the U.S. Bancorp Foundation and a $22 million accrual for certain litigation matters. These items taken together had an approximate impact of ($.02) per diluted common share.

Total net revenue, on a taxable-equivalent basis, for the first quarter of 2008, was $485 million (14.3 percent) higher than the first quarter of 2007, reflecting a 9.8 percent increase in net interest income and an 18.6 percent increase in noninterest income. The increase in net interest income from a year ago was driven by growth in earning assets and improving net interest margins. The growth in noninterest income included organic growth in operating fee revenues of 7.3 percent and the net favorable impact of the Visa Gain, offset by the structured investment securities impairment and the impact of the adoption of a new accounting standard in the first quarter of 2008.

Total noninterest expense in the first quarter of 2008 was $224 million (14.2 percent) higher than in the first quarter of 2007, principally due to higher costs associated with business initiatives designed to expand the Company’s geographical presence and strengthen customer relationships, including investments in relationship managers, branch initiatives and payment services businesses. The increase in operating expenses also included higher credit collection costs, the impact of a new accounting standard, litigation costs, a charitable contribution and incremental expenses associated with tax-advantaged projects.

The provision for credit losses for the first quarter of 2008 increased $308 million over the first quarter of 2007. The increase in the provision for credit losses from a year ago reflected continuing stress in the residential real estate markets, including homebuilding and related supplier industries, driven by declining home prices in several geographic regions. It also reflected the continued growth of the consumer loan portfolios. Net charge-offs in the first quarter of 2008 were $293 million, compared with net charge-offs of $177 million in the first quarter of 2007. Refer to “Corporate Risk Profile” for further information on the provision for credit losses, net charge-offs, nonperforming assets and factors considered by the Company in assessing the credit quality of the loan portfolio and establishing the allowance for credit losses.

 

RECENT ACCOUNTING CHANGES

 

Effective January 1, 2008, the Company adopted Statement of Financial Accounting Standards No. 157 (“SFAS 157”), “Fair Value Measurements”, Statement of Financial Accounting Standards No. 159 (“SFAS 159”), “The Fair Value Option for Financial Assets and Financial Liabilities” and Securities and Exchange Commission (“SEC”) Staff Accounting Bulletin No. 109 (“SAB 109”), “Written Loan Commitments Recorded at Fair Value Through Earnings”. Notes 2 and 10 of the Notes to Consolidated Financial Statements discuss accounting standards adopted by the Company in the first quarter of 2008, as well as accounting standards recently issued but not yet required to be adopted, including the expected impact of these changes in accounting standards on the Company’s financial statements. To the extent the adoption of new accounting standards affects the Company’s financial condition, results of operations or liquidity, the impacts are discussed in the applicable section(s) of Management’s Discussion and Analysis and the Notes to Consolidated Financial Statements.

 

 

Net Interest Income Net interest income, on a taxable-equivalent basis, was $1,830 million in the first quarter of 2008, compared with $1,666 million in the first

 

 

quarter of 2007. The $164 million (9.8 percent) increase was due to strong growth in average earning assets, as well as an improving net interest margin from a year ago. Average earning assets increased $15.9 billion (8.3 percent) in the first quarter of 2008, compared with the first quarter of 2007, primarily driven by an increase in average loans of $10.5 billion (7.3 percent) and average investment securities of $3.0 billion (7.4 percent). During the first quarter of 2008, the net interest margin increased to 3.55 percent, compared with 3.51 percent in the first quarter of 2007. The improvement in the net interest margin was due to several factors, including growth in higher spread assets, the benefit of the Company’s current asset/liability position in a declining interest rate environment and related asset/liability re-pricing dynamics. Short-term funding rates were marginally lower due to market volatility and changing liquidity in the overnight fed fund markets given current market conditions. In addition, the Company’s net interest margin benefited from an increase in yield-related loan fees. The Company expects the net interest margin to remain relatively stable throughout the remainder of the year, given the current rate environment and yield curve. Refer to the “Consolidated Daily Average Balance Sheet and Related Yields and Rates” table for further information on net interest income.

Average loans for the first quarter of 2008 were $10.5 billion (7.3 percent) higher than the first quarter of 2007, driven by growth in a majority of the loan categories. This included growth in average commercial loans of $4.7 billion (10.0 percent), retail loans of $3.5 billion (7.4 percent), residential mortgages of $1.4 billion (6.5 percent) and commercial real estate loans of $.9 billion (3.2 percent). The increase in commercial loans was primarily driven by growth in corporate and commercial banking balances as business customers utilized bank credit facilities, rather than the capital markets, to fund business growth and liquidity requirements. Retail loans experienced strong growth in credit card balances, installment products and home equity lines, offset somewhat by lower retail leasing balances. The increase in residential mortgages reflected higher balances in the consumer finance division. The growth in commercial real estate loans reflected higher demand for bank financing as changing market conditions have limited borrower access to the capital markets.

Average investment securities in the first quarter of 2008 were $3.0 billion (7.4 percent) higher than the first quarter of 2007. The increase was driven by the purchase in the fourth quarter of 2007 of structured investment securities from certain money market funds managed by an affiliate and an increase in tax-exempt municipal securities, partially offset by a reduction in mortgage-backed securities.

Average noninterest-bearing deposits for the first quarter of 2008 decreased $.6 billion (2.0 percent) compared with the first quarter of 2007, reflecting a decline in personal and business demand deposits, partially offset by higher trust deposits. The decline in personal demand deposit balances occurred in the Consumer business line. The decline in business demand deposits occurred within most business lines as business customers utilized deposit balances to fund business growth and meet other liquidity requirements.

Average total savings deposits increased year-over-year by $4.8 billion (8.6 percent) due to a $5.2 billion (20.8 percent) increase in interest checking balances driven by higher balances from broker-dealer, government and institutional trust customers. This increase was partially offset by a decline of $.3 billion (4.9 percent) in average savings accounts and $.1 billion (.5 percent) in average money market savings, primarily within Consumer Banking.

Average time certificates of deposit less than $100,000 were lower in the first quarter of 2008 than in the first quarter of 2007 by $1.2 billion (7.9 percent), while average time deposits greater than $100,000 increased by $7.0 billion (31.8 percent) over the same period. The decline in time certificates of deposit less than $100,000 was due to the Company’s funding and pricing decisions and competition for these deposits by other financial institutions that have more limited access to wholesale funding sources given the current market environment.

 

Provision for Credit Losses The provision for credit losses for the first quarter of 2008 increased $308 million over the first quarter of 2007. The increase in the provision for credit losses from a year ago reflected continuing stress in the residential real estate markets, including homebuilding and related supplier industries, driven by declining home prices in several geographic regions. It also reflected the continued growth of the consumer loan portfolios. Net charge-offs in the first quarter of 2008 were $293 million, compared with net charge-offs of $177 million in the first quarter of 2007. Refer to “Corporate Risk Profile” for further information on the provision for credit losses, net charge-offs, nonperforming assets and factors considered by the Company in assessing the credit quality of the loan portfolio and establishing the allowance for credit losses.

 

 

 

Table 2     Noninterest Income

 

*    Not meaningful.

 

Noninterest Income Noninterest income in the first quarter of 2008 was $2,044 million, compared with $1,723 million in the first quarter of 2007. The $321 million (18.6 percent) increase in the first quarter of 2008 over the first quarter of 2007, was driven by strong organic fee-based revenue growth of 7.3 percent and the Visa Gain in the first quarter of 2008. The Visa Gain represented $339 million of cash proceeds received for Class B shares redeemed in March 2008 and $153 million related to the Company’s proportionate share of stock redeemed to fund an escrow account for the settlement of Visa Inc. litigation matters. In addition, noninterest income was impacted by the adoption of SFAS 157 in the first quarter of 2008. Trading revenue decreased $62 million, as, under SFAS 157, primary market and nonperformance risk is now required to be considered when determining the fair value of customer derivatives. Mortgage banking revenue grew by $19 million, as mortgage production gains increased because the deferral of costs related to the origination of mortgage loans held for sale (“MLHFS”) is not permitted under SFAS 157.

The strong growth in credit and debit card revenue was primarily driven by an increase in customer accounts and higher customer transaction volumes over a year ago. Corporate payment products revenue growth reflected organic growth in sales volumes and card usage. ATM processing services increased primarily due to new sales of ATM and debit processing services. Merchant processing services revenue growth primarily reflected an increase in the number of merchants and business expansion. Trust and investment management fees increased year-over-year due to core account growth, partially offs et by unfavorable equity market conditions. Deposit service charges growth was driven by increased transaction-related fees and the impact of continued growth in net new checking accounts. This growth rate was muted somewhat as deposit account-related revenue, traditionally reflected in this fee category, continued to migrate to yield-related loan fees as customers utilized new consumer products. Treasury management fees increased due to higher sales activity and the favorable impact of declining rates on customer compensating balances. Commercial products revenue increased year-over-year due to higher foreign exchange, commercial leasing and other commercial lending fee revenue. Mortgage banking revenue increased due to an increase in mortgage servicing income and production gains, including $19 million from the adoption of SFAS 157. These favorable impacts to mortgage banking revenue were partially offset by the unfavorable net change in the valuation of mortgage servicing rights (“MSRs”) and related economic hedging activities. Other income was higher year-over-year due to the Visa Gain, partially offset by lower retail lease revenue due to higher end-of-term losses and the $62 million unfavorable impact to trading income upon adoption of a new accounting standard. Securities gains (losses) were lower year-over-year due to an impairment of certain structured investment securities recognized in the first quarter of 2008.

 

Noninterest Expense Noninterest expense was $1,796 million in the first quarter of 2008, an increase of $224 million (14.2 percent) over the first quarter of 2007. Compensation expense was higher due to growth in ongoing bank operations, acquired businesses and other bank initiatives and the impact from the adoption of a new accounting standard in the first quarter of 2008. Employee benefits expense increased year-over-year as higher medical costs were partially offset by

 

 

 

Table 3     Noninterest Expense

 

lower pension costs. Net occupancy and equipment expense increased over the first quarter of 2007 primarily due to rental cost escalation, acquisitions and branch-based business initiatives. Marketing and business development expense increased year-over-year primarily due to $25 million recognized in the first quarter of 2008 for a charitable contribution to the Company’s foundation intended to support community-based programs within the Company’s geographical markets. Other intangibles expense decreased primarily reflecting the timing and relative size of recent acquisitions. Other expense increased year-over-year due primarily to investments in tax-advantaged projects, higher litigation costs and credit-related costs for other real estate owned and loan collection activities.

 

Income Tax Expense The provision for income taxes was $476 million (an effective rate of 30.4 percent) for the first quarter of 2008, compared with $493 million (an effective rate of 30.4 percent) for the first quarter of 2007. For further information on income taxes, refer to Note 9 of the Notes to Consolidated Financial Statements.

 

Loans The Company’s total loan portfolio was $158.3 billion at March 31, 2008, compared with $153.8 billion at December 31, 2007, an increase of $4.5 billion (2.9 percent). The increase was driven by growth in all major loan categories. The $1.7 billion (3.3 percent) increase in commercial loans was primarily driven by new and existing business customers utilizing bank credit facilities, rather than the capital markets, to fund business growth and liquidity requirements, as well as growth in corporate payment card balances.

Commercial real estate loans increased $.8 billion (2.6 percent) at March 31, 2008, compared with December 31, 2007, as developers sought bank financing as changing market conditions have limited borrower access to the capital markets.

Residential mortgages held in the loan portfolio increased $.4 billion (1.9 percent) at March 31, 2008, compared with December 31, 2007, reflecting an increase in consumer finance and traditional branch originations.

Total retail loans outstanding, which include credit card, retail leasing, home equity and second mortgages and other retail loans, increased $1.6 billion (3.2 percent) at March 31, 2008, compared with December 31, 2007. The increase was primarily driven by higher student loans due to the purchase of a portfolio late in the first quarter of 2008, and growth in installment, credit card and home equity loans. These increases were partially offset by a decrease in retail leasing balances.

 

Loans Held for Sale At March 31, 2008, loans held for sale, consisting primarily of residential mortgages and student loans to be sold in the secondary market, were $5.2 billion, compared with $4.8 billion at December 31, 2007. The increase in loans held for sale was principally due to seasonal loan originations and the timing of sales during the first quarter of 2008.

 

Investment Securities Investment securities, both available-for-sale and held-to-maturity, totaled $41.7 billion at March 31, 2008, compared with $43.1 billion at December 31, 2007, reflecting purchases of $1.1 billion of securities, more than offset by sales, maturities and prepayments. As of March 31, 2008, approximately 37 percent of the investment securities portfolio represented adjustable-rate financial instruments, compared with 39 percent at December 31, 2007. Adjustable-rate financial instruments include variable-rate collateralized mortgage obligations, mortgage-backed securities, agency securities, adjustable-rate money market accounts, asset-backed securities,

 

 

corporate debt securities and floating-rate preferred stock.

The Company conducts a regular assessment of its investment portfolios to determine whether any securities are other-than-temporarily impaired. At March 31, 2008, the available-for-sale securities portfolio included a $1.6 billion net unrealized loss, compared with a net unrealized loss of $1.1 billion at December 31, 2007. The substantial portion of securities with unrealized losses were either government securities, issued by government-backed agencies or privately issued securities with high investment grade credit ratings and limited credit exposure. Some securities classified within obligations of state and political subdivisions are supported by mono-line insurers. While mono-line insurers have experienced credit rating downgrades, management believes the underlying credit quality of the issuers and the support of the mono-line insurers alleviate any impairment concerns. The majority of investment securities classified as asset-backed securities at March 31, 2008, represented interests in structured investments. The valuation of these securities is determined through estimates of expected cash flows, discount rates and management’s assessment of various market factors, which are judgmental in nature. During the first quarter of 2008, the Company completed its valuation of these structured investments and, as a result, recorded $253 million of impairment charges primarily as a result of widening credit spreads during the quarter. The Company expects that approximately $65 million of principal and interest payments will not be received for certain structured investment securities, which was incorporated in determining the impairment charges recorded during the quarter ended March 31, 2008. On March 31, 2008, the Company exchanged its interest in certain structured investment securities and received its share of the underlying investment securities collateral as an in-kind distribution as permitted under the applicable restructuring agreements. Refer to Note 3 in the Notes to Consolidated Financial Statements for further information on investment securities.

 

Deposits Total deposits were $138.3 billion at March 31, 2008, compared with $131.4 billion at December 31, 2007, an increase of $6.9 billion (5.2 percent). The increase in total deposits was primarily the result of increases in interest checking accounts, money market savings accounts and time deposits greater than $100,000, partially offset by decreases in noninterest-bearing deposits and time certificates of deposit less than $100,000. The $3.1 billion (10.8 percent) increase in interest checking account balances was due primarily to higher broker-dealer balances. The $2.2 billion (8.9 percent) increase in money market savings account b alances was due to higher broker-dealer and branch-based balances. Time deposits greater than $100,000 increased $2.9 billion (11.1 percent) at March 31, 2008, compared with December 31, 2007. Time deposits greater than $100,000 are largely viewed as purchased funds and are managed to levels deemed appropriate given alternative funding sources. The $.5 billion (1.4 percent) decrease in noninterest-bearing deposits was primarily due to the seasonal decline of business demand balances. Time certificates of deposit less than $100,000 decreased $1.2 billion (8.3 percent) at March 31, 2008, compared with December 31, 2007, primarily within consumer banking, reflecting the Company’s funding and pricing decisions and competition for these deposits by other financial institutions that have more limited access to wholesale funding sources given the current market environment.

 

Borrowings The Company utilizes both short-term and long-term borrowings to fund growth of assets in excess of deposit growth. Short-term borrowings, which include federal funds purchased, commercial paper, repurchase agreements, borrowings secured by high-grade assets and other short-term borrowings, were $36.4 billion at March 31, 2008, compared with $32.4 billion at December 31, 2007. Short-term funding is managed within approved liquidity policies. The increase of $4.0 billion (12.4 percent) in short-term borrowings reflected wholesale funding associated with the Company’s asset growth and asset/liability management activities. Long-term debt was $36.2 billion at March 31, 2008, compared with $43.4 billion at December 31, 2007, primarily reflecting the repayment of $2.9 billion of convertible senior debentures and $5.2 billion of medium-term note maturities in the first quarter of 2008. The $7.2 billion (16.6 percent) decrease in long-term debt reflected asset/liability management decisions to fund balance sheet growth with other funding sources. Refer to the “Liquidity Risk Management” section for discussion of liquidity management of the Company.

 

Overview Managing risks is an essential part of successfully operating a financial services company. The most prominent risk exposures are credit, residual value, operational, interest rate, market and liquidity risk. Credit risk is the risk of not collecting the interest and/or the principal balance of a loan or investment when it is due. Residual value risk is the potential reduction in the end-of-term value of leased assets or the residual cash flows related to asset securitization and other off-balance sheet structures. Operational risk includes risks related to fraud, legal and compliance risk, processing

 

 

errors, technology, breaches of internal controls and business continuation and disaster recovery risk. Interest rate risk is the potential reduction of net interest income as a result of changes in interest rates, which can affect the repricing of assets and liabilities differently, as well as their market value. Market risk arises from fluctuations in interest rates, foreign exchange rates, and security prices that may result in changes in the values of financial instruments, such as trading and available-for-sale securities that are accounted for on a mark-to-market basis. Liquidity risk is the possible inability to fund obligations to depositors, investors or borrowers. In addition, corporate strategic decisions, as well as the risks described above, could give rise to reputation risk. Reputation risk is the risk that negative publicity or press, whether true or not, could result in costly litigation or cause a decline in the Company’s stock value, customer base, funding sources or revenue.

Credit Risk Management The Company’s strategy for credit risk management includes well-defined, centralized credit policies, uniform underwriting criteria, and ongoing risk monitoring and review processes for all commercial and consumer credit exposures. In evaluating its credit risk, the Company considers changes, if any, in underwriting activities, the loan portfolio composition (including product mix and geographic, industry or customer-specific concentrations), trends in loan performance, the level of allowance coverage relative to similar banking institutions and macroeconomic factors. Refer to “Management’s Discussion and Analysis — Credit Risk Management” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2007, for a more detailed discussion on credit risk management processes.

The Company manages its credit risk, in part through diversification of its loan portfolio. As part of its normal business activities, the Company offers a broad array of commercial and retail lending products. The Company’s retail lending business utilizes several distinct business processes and channels to originate retail credit, including traditional branch lending, indirect lending, portfolio acquisitions and a consumer finance division. Generally, loans managed by the Company’s consumer finance division exhibit higher credit risk characteristics, but are priced commensurate with the differing risk profile. With respect to residential mortgages originated through these channels, the Company may either retain the loans on its balance sheet or sell its interest in the balances into the secondary market while retaining the servicing rights and customer relationships. For residential mortgages that are retained in the Company’s portfolio, credit risk is also diversified by geography and monitoring loan-to-values during the underwriting process.

 

The following table provides summary information of the loan-to-values of residential mortgages by distribution channel and type at March 31, 2008:

 

Note:  loan-to-values determined as of the date of origination and consider mortgage insurance, as applicable.

 

Within the consumer finance division approximately $3.2 billion, or 32.1 percent of that division, represents residential mortgages to customers that may be defined as sub-prime borrowers, compared with $3.3 billion, or 33.5 percent, at December 31, 2007. The following table provides further information on residential mortgages for the consumer finance division:

 

 

In addition to residential mortgages, the consumer finance division had $.8 billion of home equity and second mortgage loans to customers that may be defined as sub-prime borrowers at March 31, 2008, compared with $.9 billion at December 31, 2007. Including residential mortgages, and home equity and second mortgage loans, the total amount of loans to customers that may be defined as sub-prime borrowers represented only 1.7 percent of total assets at March 31, 2008, and at December 31, 2007. The Company does not have any residential mortgages whose payment schedule would cause balances to increase over time.

 

Loan Delinquencies Trends in delinquency ratios represent an indicator, among other considerations, of credit risk within the Company’s loan portfolios. The Company measures delinquencies, both including and excluding nonperforming loans, to enable comparability with other companies. Accruing loans 90 days or more past due totaled $676 million at March 31, 2008, compared with $584 million at December 31, 2007. Consistent with banking industry practices, these loans are not included in nonperforming assets and continue to accrue interest because they are adequately secured by collateral, and/or are in the process of collection and are reasonably expected to result in repayment or restoration to current status. The ratio of accruing loans 90 days or more past due to total loans was .43 percent at March 31, 2008, compared with .38 percent at December 31, 2007.

 

Table 4     Delinquent Loan Ratios as a Percent of Ending Loan Balances

 

 

 

 

To monitor credit risk associated with retail loans, the Company monitors delinquency ratios in the various stages of collection, including nonperforming status. The following table provides summary delinquency information for residential mortgages and retail loans:

 

 

Within these product categories, the following table provides information on delinquent and nonperforming loans as a percent of ending loan balances, by channel:

 

 

Within the consumer finance division at March 31, 2008, approximately $240 million and $86 million of these delinquent and nonperforming residential mortgages and other retail loans, respectively, were with customers that may be defined as sub-prime borrowers, compared with $227 million and $89 million, respectively, at December 31, 2007.

The Company expects the accelerating trends in delinquencies to continue during the remainder of 2008 as residential home valuations are expected to continue to decline and economic factors adversely affect the consumer sector.

 

Nonperforming Assets The level of nonperforming assets represents another indicator of the potential for future credit losses. At March 31, 2008, total nonperforming assets were $845 million, compared with $690 million at December 31, 2007. The ratio of total nonperforming assets to total loans and other real estate was .53 percent at March 31, 2008, compared with .45 percent at December 31, 2007. The increase in nonperforming assets was driven primarily by an increase in foreclosed residential properties and the impact of the economic downturn on commercial customers, including real estate developers.

 

 

Table 5    Nonperforming Assets (a)

 

Changes in Nonperforming Assets

 

 

Included in nonperforming loans were restructured loans of $30 million at March 31, 2008, compared with $17 million at December 31, 2007. At March 31, 2008, and December 31, 2007, the Company had no commitments to lend additional funds under restructured loans.

Other real estate included in nonperforming assets was $141 million at March 31, 2008, compared with $111 million at December 31, 2007, and was primarily related to properties that the Company has taken ownership of that once secured residential mortgages and home equity and second mortgage loan balances. The increase in other real estate assets was due to higher residential mortgage loan foreclosures as customers experienced financial difficulties given inflationary factors, changing interest rates and other current economic conditions.

 

The following table provides an analysis of other real estate owned (“OREO”) as a percent of their related loan balances, including further detail for residential mortgages and home equity and second mortgage loan balances by geographical location:

 

 

Within other real estate in the table above, approximately $66 million at March 31, 2008, and $61 million at December 31, 2007, were from portfolios that may be defined as sub-prime.

The Company expects nonperforming assets to increase moderately over the next several quarters due to general economic conditions and continued stress in the residential mortgage portfolio and residential construction industry.

 

Restructured Loans Accruing Interest On a case-by-case basis, management determines whether an account that experiences financial difficulties should be modified as to its interest rate or repayment terms to maximize the Company’s collection of its balance. Loans restructured at a rate equal to or greater than that of a new loan with comparable risk at the time the contract is modified are excluded from restructured loans once repayment performance, in accordance with the modified agreement, has been demonstrated over several payment cycles. Loans that have interest rates reduced below comparable market rates remain classified as restructured loans; however, interest income is accrued at the reduced rate as long as the customer complies with the revised terms and conditions.

In late 2007, the Company began implementing a mortgage loan restructuring program for certain qualifying borrowers. In general, borrowers with sub-prime credit quality, that are current in their repayment status, will be allowed to retain the lower of their existing interest rate or the market interest rate as of their interest reset date.

 

The following table provides a summary of restructured loans that continue to accrue interest:

 

Restructured loans that continue to accrue interest were higher at March 31, 2008, compared with December 31, 2007, reflecting the impact of restructurings for certain residential mortgage customers in light of current economic conditions. The Company expects this trend to continue during 2008 as residential home valuations are expected to continue to decline and certain borrowers take advantage of the Company’s mortgage loan restructuring programs.

 

Analysis of Loan Net Charge-Offs Total loan net charge-offs were $293 million for the first quarter of 2008, compared with net charge-offs of $177 million for the first quarter of 2007. The ratio of total loan net charge-offs to average loans outstanding on an annualized basis for the first quarter of 2008 was .76 percent, compared with .50 percent, for the first quarter of 2007. The year-over-year increase in total net charge-offs was due primarily to continued stress in the residential housing market, homebuilding and related industry sectors, in addition to the growth of the credit card and other consumer loan portfolios.

 

 

 

Table 6    Net Charge-offs as a Percent of Average Loans Outstanding

 

 

Commercial and commercial real estate loan net charge-offs for the first quarter of 2008 increased to $67 million (.33 percent of average loans outstanding on an annualized basis), compared with $36 million (.19 percent of average loans outstanding on an annualized basis) for the first quarter of 2007. The year-over-year increase in net charge-offs reflected anticipated increases in nonperforming loans and delinquencies within the portfolios, especially residential homebuilding and related industry sectors. Given the continuing stress in the homebuilding and related industries, as well as the potential impact of the economic downturn on other commercial customers, the Company expects commercial and commercial real estate net charge-offs to continue to increase moderately over the next several quarters.

Retail loan net charge-offs for the first quarter of 2008 were $200 million (1.58 percent of average loans outstanding on an annualized basis), compared with $129 million (1.10 percent of average loans outstanding on an annualized basis) for the first quarter of 2007. The increase in retail loan net charge-offs in the first quarter of 2008, compared with the same period of 2007, reflected continued stress in the residential housing market and growth in the credit card and other consumer loan portfolios. It also reflected higher retail loan delinquency ratios, compared with the prior year. The Company anticipates higher delinquency levels in the retail portfolios and that retail net charge-offs will continue to increase, but remain manageable during 2008.

 

The following table provides an analysis of net charge-offs as a percent of average loans outstanding managed by the consumer finance division, compared with other retail related loans:

 

 

 

 

Within the consumer finance division, the Company originates loans to customers that may be defined as sub-prime borrowers. The following table provides further information on net charge-offs as a percent of average loans outstanding for this division:

 

 

Analysis and Determination of the Allowance for Credit Losses The allowance for loan losses provides coverage for probable and estimable losses inherent in the Company’s loan and lease portfolio. Management evaluates the allowance each quarter to determine that it is adequate to cover these inherent losses. Several factors were taken into consideration in evaluating the allowance for credit losses at March 31, 2008, including the risk profile of the portfolios, loan net charge-offs during the period, the level of nonperforming assets, accruing loans 90 days or more past due, delinquency ratios and changes in restructured loan balances compared with December 31, 2007. Management also considered the uncertainty related to certain industry sectors, and the extent of credit exposure to specific borrowers within the portfolio. In addition, concentration risks associated with commercial real estate and the mix of loans, including credit cards, loans originated through the consumer finance division and residential mortgage balances, and their relative credit risks, were evaluated. Finally, the Company considered current economic conditions that might impact the portfolio.

At March 31, 2008, the allowance for credit losses was $2,435 million (1.54 percent of loans), compared with an allowance of $2,260 million (1.47 percent of loans) at December 31, 2007. The ratio of the allowance for credit losses to nonperforming loans was 358 percent at March 31, 2008, compared with 406 percent at December 31, 2007. The ratio of the allowance for credit losses to annualized loan net charge-offs was 207 percent at March 31, 2008, compared with 285 percent at December 31, 2007.

 

Residual Value Risk Management The Company manages its risk to changes in the residual value of leased assets through disciplined residual valuation setting at the inception of a lease, diversification of its leased assets, regular residual asset valuation reviews and monitoring of residual value gains or losses upon the disposition of assets. As of March 31, 2008, no significant change in the amount of residuals or concentration of the portfolios has occurred since December 31, 2007. Refer to “Management’s Discussion and Analysis — Residual Value Risk Management” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2007, for further discussion on residual value risk management.

 

Operational Risk Management The Company manages operational risk through a risk management framework and its internal control processes. Within this framework, the Corporate Risk Committee (“Risk Committee”) provides oversight and assesses the most significant operational risks facing the Company within its business lines. Under the guidance of the Risk Committee, enterprise risk management personnel establish policies and interact with business lines to monitor significant operating risks on a regular basis. Business lines have direct and primary responsibility and accountability for identifying, controlling, and monitoring operational risks embedded in their business activities. Refer to “Management’s Discussion and Analysis — Operational Risk Management” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2007, for further discussion on operational risk management.

 

Interest Rate Risk Management In the banking industry, changes in interest rates are a significant risk that can impact earnings, market valuations and safety and soundness of an entity. To minimize the volatility of net interest income and the market value of assets and liabilities, the Company manages its exposure to changes in interest rates through asset and liability management activities within guidelines established by its Asset Liability Policy Committee (“ALPC”) and approved by the Board of Directors. ALPC has the responsibility for approving and ensuring compliance with ALPC management policies, including interest rate risk exposure. The Company uses Net Interest Income Simulation Analysis and Market Value of Equity Modeling for measuring and analyzing consolidated interest rate risk.

 

 

 

Table 7    Summary of Allowance for Credit Losses