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 June 30, 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, developments in the residential and commercial real estate markets, 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 $950 million for the second quarter of 2008 or $.53 per diluted common share, compared with $1,156 million, or $.65 per diluted common share for the second quarter of 2007. Return on average assets and return on average common equity were 1.58 percent and 17.9 percent, respectively, for the second quarter of 2008, compared with returns of 2.09 percent and 23.0 percent, respectively, for the second quarter of 2007. Significant items included in the second quarter of 2008 results were net securities losses of $63 million, which primarily reflected impairment charges on structured investment securities, and an incremental provision for credit losses, which exceeded net charge-offs by $200 million. Together these items reduced earnings per diluted common share by approximately $.11.

Total net revenue, on a taxable-equivalent basis, for the second quarter of 2008, was $265 million (7.5 percent) higher than the second quarter of 2007, reflecting a 15.6 percent increase in net interest income and a modest increase in noninterest income. The increase in net interest income from a year ago was driven by growth in earning assets and an improvement in the net interest margin. Noninterest income from a year ago was relatively flat as strong growth in the majority of revenue categories was muted by impairment charges primarily related to certain structured investment securities and higher retail lease residual losses.

Total noninterest expense in the second quarter of 2008 was $165 million (9.9 percent) higher than in the second 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 Wealth Management and Payment Services businesses. The increase in operating expense also included higher credit collection costs and incremental costs associated with investments in tax-advantaged projects.

The provision for credit losses for the second quarter of 2008 increased $405 million over the second quarter of 2007. This reflected an increase to the allowance for credit losses of $200 million in the second quarter of 2008. The increases in the provision and allowance 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 most geographic regions. It also reflected the current economic conditions and the corresponding impact on the commercial and consumer loan portfolios. Net charge-offs in the second quarter of 2008 were $396 million, compared with $191 million in the second 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.

The Company reported net income of $2,040 million for the first six months of 2008, or $1.14 per diluted common share, compared with $2,286 million, or $1.27 per diluted common share for the first six months of 2007. Return on average assets and return on average common equity were 1.71 percent and 19.6 percent, respectively, for the first six months of 2008, compared with returns of 2.09 percent and 22.7 percent, respectively, for the first six months of 2007. Several significant items were reflected in the Company’s results for the first six months of 2008, including a $492 million gain related to the Visa Inc. initial public offering that occurred in March 2008 (“Visa Gain”), an unfavorable change in net securities gains (losses) of $318 million, which primarily reflected impairment charges on structured investment securities, and an incremental provision for credit losses, which exceeded net charge-offs by $392 million. The first six months of 2008 also included a $62 million reduction in 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.

Total net revenue, on a taxable-equivalent basis, for the first six months of 2008, was $750 million (10.8 percent) higher than the first six months of 2007, reflecting a 12.7 percent increase in net interest income and a 9.1 percent increase in noninterest income. The increase in net interest income from a year ago was driven by growth in earning assets and an improved net interest margin. Noninterest income growth was driven by organic business growth and the Visa Gain, partially offset by impairment charges on structured investment securities, higher retail lease residual losses and the adoption of a new accounting standard during the first six months of 2008.

 

 

Total noninterest expense in the first six months of 2008 was $389 million (12.0 percent) higher than in the first six months of 2007, primarily due to investments in business initiatives, higher credit collection costs and incremental expenses associated with investments in tax-advantaged projects.

The provision for credit losses for the first six months of 2008 increased $713 million over the same period of 2007. This reflected an increase to the allowance for credit losses of $392 million in the first six months of 2008. The increases in the provision and allowance 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 most geographic regions. It also reflected the current economic conditions and the corresponding impact on the commercial and consumer loan portfolios. Net charge-offs in the first six months of 2008 were $689 million, compared with $368 million in the first six months 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.

 

Net Interest Income Net interest income, on a taxable-equivalent basis, was $1,908 million in the second quarter of 2008, compared with $1,650 million in the second quarter of 2007. Net interest income, on a taxable-equivalent basis, was $3,738 million in the first six months of 2008, compared with $3,316 million in the first six months of 2007. The increases were due to strong growth in average earning assets, as well as an improving net interest margin from a year ago. Average earning assets increased $19.8 billion (10.3 percent) and $17.8 billion (9.3 percent) in the second quarter and first six months of 2008, respectively, compared with the same periods of 2007, primarily driven by increases in average loans and investment securities. The net interest margin in the second quarter and first six months of 2008 was 3.61 percent and 3.58 percent, respectively, compared with 3.44 percent and 3.47 percent, respectively, for the same periods 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 repricing dynamics. Also, short-term funding rates were 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. Given the current rate environment, asset repricing dynamics and yield curve, the Company expects the net interest margin to remain relatively stable or decline slightly during the remainder of 2008. 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 second quarter and first six months of 2008 were $17.4 billion (12.0 percent) and $14.0 billion (9.6 percent) higher, respectively, than the same periods of 2007, driven by growth in all major loan categories. The increase in commercial loans was primarily driven by growth in corporate and commercial banking balances, reflective of new customer growth, along with business customers utilizing bank credit facilities to fund business growth and liquidity requirements, rather than relying upon the capital markets. Retail loans experienced strong growth in installment products, home equity lines and credit card balances, offset somewhat by lower retail leasing balances. In addition, retail loan growth in the second quarter and first six months of 2008 included increases of $2.9 billion and $1.4 billion, respectively, in average federally guaranteed student loan balances due to both the transfer of balances from loans held for sale and a portfolio purchase. The increase in residential mortgages reflected higher balances in the consumer finance division. The growth in commercial real estate loans reflected changing market conditions that have limited borrower access to the capital markets and the impact of an acquisition.

Average investment securities in the second quarter and first six months of 2008 were $2.3 billion (5.6 percent) and $2.7 billion (6.5 percent) higher, respectively, than the same periods of 2007. The increases were 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 second quarter and first six months of 2008 decreased $.1 billion (.5 percent) and $.3 billion (1.2 percent), respectively, compared with the same periods of 2007, reflecting a decline in personal and business demand deposits, partially offset by higher trust and other demand deposits. The decline in personal demand deposit balances occurred in Consumer Banking. 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 $8.4 billion (15.0 percent) in the second quarter and $6.6 billion (11.8 percent) in the first six months of 2008, compared with the same periods of 2007, due to an increase in interest checking balances driven by higher balances from broker-dealer, government and institutional trust customers, and an increase in money market savings balances driven by higher broker-dealer balances. The increases in interest checking and money market savings balances were partially offset by a modest decline in average savings accounts, primarily within Consumer Banking.

Average time certificates of deposit less than $100,000 were lower in the second quarter and first six months of 2008 by $2.1 billion (14.1 percent) and $1.6 billion (11.0 percent), respectively, compared with the same periods of 2007. 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. Average time deposits greater than $100,000 increased by $10.7 billion (52.3 percent) and $8.8 billion (41.7 percent) in the second quarter and first six months of 2008, respectively, compared with the same periods of 2007, as a result of both the Company’s wholesale funding decisions and its ability to attract larger customer deposits, given the current market conditions.

 

Provision for Credit Losses The provision for credit losses for the second quarter and first six months of 2008 increased $405 million and $713 million, respectively, compared with the same periods of 2007. This reflected increases to the allowance for credit losses of $200 million in the second quarter and $392 million in the first six months of 2008. The increases in the provision and allowance 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 many geographic regions, including Florida and the Southwest. It also reflected the current economic conditions and the corresponding impact on the commercial and consumer loan portfolios. Net charge-offs were $396 million in the second quarter and $689 million in the first six months of 2008, compared with $191 million in the second quarter and $368 million in the first six months of 2007. Given current economic conditions and the continuing decline in home and other collateral values, the Company expects net charge-offs to increase in the third quarter of 2008. 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.

 

Noninterest Income Noninterest income in the second quarter and first six months of 2008 was $1,892 million and $3,936 million, respectively, compared with $1,885 million and $3,608 million in the same periods of 2007. The $7 million (.4 percent) increase during the second quarter and $328 million (9.1 percent) increase during the first six months of 2008, compared with the same periods in 2007, were driven by strong fee-based revenue growth in several categories, partially offset by impairment charges on certain structured investment securities and higher retail lease residual losses from a year ago. In addition, noninterest income for the first six months of 2008 was impacted by the recognition of the $492 million Visa Gain in the first quarter of 2008 and the adoption of Statement of Financial Accounting

 

Table 2    Noninterest Income

 

*    Not meaningful.

 

 

Standards No. 157 (“SFAS 157”), “Fair Value Measurements”, effective January 1, 2008. Upon adoption of SFAS 157, trading revenue decreased $62 million, as primary market and nonperformance risk is now required to be considered when determining the fair value of derivative positions. In addition, under SFAS 157 mortgage production gains included in mortgage banking revenue increased, because the deferral of costs related to the origination of mortgage loans held for sale (“MLHFS”) is not permitted.

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 growth in sales volumes, card usage and business expansion. ATM processing services increased primarily due to growth in transaction volumes. Merchant processing services revenue growth reflected higher core transaction volume and business expansion. Trust and investment management fees increased year-over-year due to core account growth, partially offset by unfavorable equity market conditions. Deposit service charges remained relatively flat and increased modestly in the second quarter and first six months of 2008, respectively, compared with the same periods of the prior year. Higher transaction-related fees and the impact of continued growth in net new checking accounts were muted as deposit account-related revenue continued to migrate to yield-related loan fees, as customers utilized new consumer products. Treasury management fees increased due primarily to the favorable impact of declining rates on customer compensating balances. Commercial products revenue increased year-over-year due to higher commercial lending-related fees, foreign exchange and commercial leasing revenue. Mortgage banking revenue increased due to an increase in mortgage servicing income and production revenue, including the impact of SFAS 157, partially offset by the unfavorable net change in the value of mortgage servicing rights (“MSRs”) and related economic hedges. Securities gains (losses) were lower year-over-year due primarily to the impact of the impairment charges on structured investment securities recognized in the first and second quarters of 2008. Other income in the second quarter of 2008 declined year-over-year due primarily to the $42 million adverse impact of higher retail lease residual losses compared with the second quarter of 2007. Other income for the first six months of 2008 was higher than the same period of the prior year due to the Visa Gain recognized in the first quarter of 2008, partially offset by lower retail lease revenue and the $62 million unfavorable impact to trading income upon adoption of SFAS 157.

 

Noninterest Expense Noninterest expense was $1,835 million in the second quarter and $3,631 million in the first six months of 2008, reflecting increases of $165 million (9.9 percent) and $389 million (12.0 percent), respectively, from the same periods of 2007. Compensation expense was higher due to growth in ongoing bank operations, acquired businesses and other bank initiatives and the adoption of SFAS 157 in the first quarter of 2008. Under this new accounting standard, compensation expense is no longer deferred for the origination of MLHFS. Employee benefits expense increased year-over-year as higher payroll taxes and medical costs were partially offset by lower pension costs. Net occupancy and equipment expense increased over the prior year primarily due to acquisitions and branch-based and other business expansion initiatives. Technology and communications expense increased primarily due to higher processing volumes and business expansion. Other expense increased year-over-year due

 

Table 3    Noninterest Expense

 

 

 

 

primarily to credit-related costs for other real estate owned and loan collection activities, investments in tax-advantaged projects, and higher litigation and fraud costs. In addition, marketing and business development expense for the first six months of 2008, increased over the same period of the prior year primarily due to $25 million recognized in the first quarter of 2008 for a charitable contribution to the Company’s foundation. These increases were partially offset by a decrease in other intangibles expense.

 

Income Tax Expense The provision for income taxes was $386 million (an effective rate of 28.9 percent) for the second quarter and $862 million (an effective rate of 29.7 percent) for the first six months of 2008, compared with $500 million (an effective rate of 30.2 percent) and $993 million (an effective rate of 30.3 percent) for the same periods of 2007. The decreases in the effective rates for the second quarter and first six months of 2008, compared with the same periods of the prior year, primarily reflected higher tax-exempt income from investment securities and insurance products as well as incremental tax credits from affordable housing and other tax-advantaged investments. For further information on income taxes, refer to Note 8 of the Notes to Consolidated Financial Statements.

 

Loans The Company’s total loan portfolio was $165.9 billion at June 30, 2008, compared with $153.8 billion at December 31, 2007, an increase of $12.1 billion (7.8 percent). The increase was driven by growth in all major loan categories. The $4.1 billion (8.0 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 $2.0 billion (7.0 percent) at June 30, 2008, compared with December 31, 2007, reflecting changing market conditions that have limited borrower access to the capital markets and the impact of an acquisition.

Residential mortgages held in the loan portfolio increased $.5 billion (2.3 percent) at June 30, 2008, compared with December 31, 2007, reflecting an increase in mortgage banking activity and higher consumer finance originations.

Total retail loans outstanding, which include credit card, retail leasing, student loans, home equity and second mortgages and other retail loans, increased $5.4 billion (10.7 percent) at June 30, 2008, compared with December 31, 2007. The increase reflected higher student loans due to the purchase of a portfolio during the first six months of 2008 and the reclassification of certain student loans held for sale into the student loan portfolio in response to a change in business strategy. The increase also reflected growth in home equity, credit card and installment loans. These increases were partially offset by a decrease in retail leasing balances.

 

Loans Held for Sale At June 30, 2008, loans held for sale, consisting primarily of residential mortgages and student loans to be sold in the secondary market, were $3.8 billion, compared with $4.8 billion at December 31, 2007. The decrease in loans held for sale was principally due to a change in business strategy to discontinue selling federally guaranteed student loans in the secondary market and, instead, hold them in the loan portfolio.

 

Investment Securities Investment securities, both available-for-sale and held-to-maturity, totaled $41.1 billion at June 30, 2008, compared with $43.1 billion at December 31, 2007, reflecting purchases of $3.1 billion of securities, more than offset by sales, maturities and prepayments. As of June 30, 2008, approximately 38 percent of the investment securities portfolio represented adjustable-rate financial instruments, compared with 39 percent at December 31, 2007. Adjustable-rate financial instruments include collateralized mortgage obligations, mortgage-backed securities, agency securities, money market accounts, asset-backed securities, corporate debt securities and preferred stock.

The Company conducts a regular assessment of its investment portfolios to determine whether any securities are other-than-temporarily impaired. At June 30, 2008, the available-for-sale securities portfolio included a $2.0 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. As mono-line insurers have experienced credit rating downgrades, management continuously monitors the underlying credit quality of the issuers and the support of the mono-line insurers. The Company held interests in structured investment securities at June 30, 2008. 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. The Company

 

 

periodically completes a valuation of these structured investment securities and, as a result, recorded $66 million and $319 million of impairment charges during the second quarter and first six months of 2008, respectively, primarily as a result of wider market spreads for these types of securities caused by the continuing decline in housing prices and an increase in foreclosure activity. Further adverse changes in market conditions may result in additional impairment charges in future periods. The Company expects that approximately $131 million of principal payments will not be received for certain structured investment securities. During the first six months of 2008, the Company exchanged its interest in certain structured investment securities and received its pro rata share of the underlying investment securities as an in-kind distribution according to the applicable restructuring agreements. In addition, during the second quarter and first six months of 2008, the Company recorded $11 million of other-than-temporary impairment charges on non-structured investment securities. Refer to Note 3 in the Notes to Consolidated Financial Statements for further information on investment securities.

 

Deposits Total deposits were $135.1 billion at June 30, 2008, compared with $131.4 billion at December 31, 2007, an increase of $3.7 billion (2.8 percent). The increase in total deposits was primarily the result of increases in interest checking accounts, money market savings accounts and noninterest-bearing deposits, partially offset by decreases in time certificates of deposit less than $100,000 and time deposits greater than $100,000. The $2.7 billion (9.2 percent) increase in interest checking account balances was due primarily to higher broker-dealer balances. The $2.2 billion (9.2 percent) increase in money market savings account balances reflected higher broker-dealer and branch-based balances and the impact of an acquisition. Noninterest-bearing deposits increased $.6 billion (1.9 percent) at June 30, 2008, compared with December 31, 2007, reflecting an acquisition and higher other demand deposits, partially offset by lower business demand balances. Time certificates of deposit less than $100,000 decreased $1.5 billion (10.6 percent) at June 30, 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. Time deposits greater than $100,000 decreased $.8 billion (3.1 percent) at June 30, 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.

 

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 $41.1 billion at June 30, 2008, compared with $32.4 billion at December 31, 2007. Short-term funding is managed within approved liquidity policies. The increase of $8.7 billion (27.0 percent) in short-term borrowings reflected wholesale funding associated with the Company’s asset growth and asset/liability management activities. Long-term debt was $39.9 billion at June 30, 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, partially offset by the issuance of $4.7 billion of medium-term notes, in the first six months of 2008. The $3.5 billion (8.1 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 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 and for home equity and second mortgages, credit risk is also diversified by geography and monitoring loan-to-values during the underwriting process.

 

The following tables provide summary information of the loan-to-values of residential mortgages and home equity and second mortgages by distribution channel and type at June 30, 2008:

 

 

 

 

 

Within the consumer finance division, approximately $3.1 billion of residential mortgages were to customers that may be defined as sub-prime borrowers, compared with $3.3 billion 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 June 30, 2008, compared with $.9 billion at December 31, 2007. The following table provides further information on home equity and second mortgages for the consumer finance division:

 

 

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

 

 

 

 

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 1.6 percent of the Company’s total assets at June 30, 2008, compared with 1.7 percent 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 $687 million at June 30, 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 .41 percent at June 30, 2008, compared with .38 percent at December 31, 2007.

 

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 June 30, 2008, approximately $296 million and $88 million of these delinquent and nonperforming residential mortgages and 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 delinquencies to continue to increase due to general economic conditions and continuing stress in the residential mortgage portfolio and residential construction industry.

 

Nonperforming Assets The level of nonperforming assets represents another indicator of the potential for future credit losses. At June 30, 2008, total nonperforming assets were $1,135 million, compared with $690 million at December 31, 2007. The ratio of total nonperforming assets to total loans and other real estate was .68 percent at June 30, 2008, compared with .45 percent at December 31, 2007. The increase in nonperforming assets was driven primarily by the residential construction portfolio and related industries, an increase in foreclosed residential properties and the impact of the economic slowdown on other commercial customers.

 

 

 

Table 5      Nonperforming Assets (a)

 

Changes in Nonperforming Assets