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 September 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 continued deterioration in general business and economic conditions and in the financial 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 the other information in this report, including the section entitled “Risk Factors,” and 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 $576 million for the third quarter of 2008 or $.32 per diluted common share, compared with $1,096 million, or $.62 per diluted common share for the third quarter of 2007. Return on average assets and return on average common equity were .94 percent and 10.8 percent, respectively, for the third quarter of 2008, compared with returns of 1.95 percent and 21.7 percent, respectively, for the third quarter of 2007. The Company’s fundamental business performance continues to be strong despite the challenging financial markets, which impacted the third quarter of 2008 results. Included in the third quarter of 2008 results were $411 million of securities losses, which included valuation impairment charges on structured investment securities, perpetual preferred stock (including the stock of government sponsored enterprises (“GSEs”)) and certain non-agency mortgage-backed securities. In addition, the Company recorded other market valuation losses related to the bankruptcy of an investment banking firm and continued to build the allowance for credit losses by recording $250 million of provision for credit losses expense in excess of net charge-offs. These items reduced earnings per diluted common share by approximately $.28. Results for the third quarter of 2007 were impacted by a $115 million charge for the Company’s proportionate share of a litigation settlement between Visa U.S.A. Inc. and American Express (“Visa Charge”).

Total net revenue, on a taxable-equivalent basis, for the third quarter of 2008, was $183 million (5.1 percent) lower than the third quarter of 2007, reflecting a 16.7 percent increase in net interest income, offset by a 24.8 percent decrease 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 declined from a year ago as strong growth in the majority of revenue categories was offset by securities impairments, other market valuation losses and higher retail lease residual losses.

Total noninterest expense in the third quarter of 2008 was $47 million (2.6 percent) higher than in the third 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 acquisitions and investments in relationship managers, branch initiatives and Payment Services’ businesses. The increase also included higher credit collection costs and incremental costs associated with investments in tax-advantaged projects. The increase from a year ago was partially reduced by the Visa Charge recognized in the third quarter of 2007.

The provision for credit losses for the third quarter of 2008 increased $549 million over the third quarter of 2007. This reflected an increase to the allowance for credit losses of $250 million in the third 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 changes in economic conditions and the corresponding impact on the commercial and consumer loan portfolios. Net charge-offs in the third quarter of 2008 were $498 million, compared with $199 million in the third 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 $2,616 million for the first nine months of 2008, or $1.46 per diluted common share, compared with $3,382 million, or $1.89 per diluted common share for the first nine months of 2007. Return on average assets and return on average common equity were 1.45 percent and 16.6 percent, respectively, for the first nine months of 2008, compared with returns of 2.04 percent and 22.4 percent, respectively, for the first nine months of 2007. The Company’s results for the first nine months of 2008 declined from the same period of 2007, as strong growth in net interest income and the majority of noninterest income categories was more than offset by securities impairment charges, growth in operating expenses and higher credit costs. Included in the first nine months of 2008 was 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 $736 million, which primarily reflected valuation impairment charges on various investment securities, and an incremental provision for credit losses, which has exceeded net charge-offs by $642 million. The first nine 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. Included in the Company’s results for the first nine months of 2007 was the $115 million Visa Charge.

Total net revenue, on a taxable-equivalent basis, for the first nine months of 2008, was $567 million (5.4 percent) higher than the first nine months of 2007, reflecting a 14.1 percent increase in net interest income, partially offset by a 2.5 percent decrease 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. The decrease in noninterest income included fundamentally strong organic business growth and the Visa Gain, more than offset by valuation impairment charges on investment securities, other valuation losses, higher retail lease residual losses and the adoption of a new accounting standard during the first nine months of 2008.

Total noninterest expense in the first nine months of 2008 was $436 million (8.7 percent) higher than in the first nine months of 2007, primarily due to investments in business initiatives, higher credit collection costs and incremental expenses associated with investments in tax-advantaged projects, partially offset by the Visa Charge recognized in the first nine months of 2007.

The provision for credit losses for the first nine months of 2008 increased $1,262 million over the same period of 2007. This reflected an increase to the allowance for credit losses of $638 million in the first nine 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 changing economic conditions and the corresponding impact on the commercial and consumer loan portfolios. Net charge-offs in the first nine months of 2008 were $1,187 million, compared with $567 million in the first nine 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 $1,967 million in the third quarter of 2008, compared with $1,685 million in the third quarter of 2007. Net interest income, on a taxable-equivalent basis, was $5,705 million in the first nine months of 2008, compared with $5,001 million in the first nine months of 2007. The increases were due to strong growth in average earning assets, as well as an improved net interest margin from a year ago. Average earning assets increased $20.1 billion (10.3 percent) and $18.6 billion (9.6 percent) in the third quarter and first nine 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 third quarter and first nine months of 2008 was 3.65 percent and 3.60 percent, respectively, compared with 3.44 percent and 3.46 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, given current market conditions, short-term funding rates were lower due to volatility and changing liquidity in the overnight federal funds markets. In addition, the Company’s net interest margin benefited from an increase in yield-related loan fees. 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 third quarter and first nine months of 2008 were $19.0 billion (12.9 percent) and $15.7 billion (10.7 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 as business customers utilize bank credit facilities, rather than the capital markets, to fund business growth and liquidity requirements. 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 third quarter and first nine months of 2008 included increases of $3.4 billion and $2.1 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 during the first nine months of 2008. The growth in commercial real estate loans reflected strong new business growth driven by capital market conditions and the impact of an acquisition late in the second quarter of 2008. The increase in residential mortgages reflected an increase in mortgage banking activity and higher consumer finance originations.

Average investment securities in the third quarter and first nine months of 2008 were $1.4 billion

 

 

(3.5 percent) and $2.2 billion (5.5 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 maturities of mortgage-backed and government agency securities, as well as realized and unrealized losses on certain investment securities recorded in the first nine months of 2008.

Average noninterest-bearing deposits for the third quarter and first nine months of 2008 increased $1.4 billion (5.1 percent) and $.2 billion (.9 percent), respectively, compared with the same periods of 2007. The increases reflected higher balances within Wealth Management & Securities Services and Corporate Banking and the impact of an acquisition near the end of the second quarter of 2008.

Average total savings deposits increased $7.6 billion (13.6 percent) in the third quarter and $7.0 billion (12.4 percent) in the first nine months of 2008, compared with the same periods of 2007, due primarily to an increase in interest checking balances driven by higher broker-dealer and institutional trust balances, and an increase in money market savings balances driven by higher broker-dealer and Consumer Banking balances and an acquisition near the end of the second quarter of 2008.

Average time certificates of deposit less than $100,000 were lower in the third quarter and first nine months of 2008 by $1.9 billion (13.2 percent) and $1.7 billion (11.7 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 $7.3 billion (34.3 percent) and $8.3 billion (39.2 percent) in the third quarter and first nine months of 2008, respectively, compared with the same periods of 2007, as a result of both the Company’s wholesale funding decisions and the business lines’ ability to attract larger customer deposits, given current market conditions.

 

Provision for Credit Losses The provision for credit losses for the third quarter and first nine months of 2008 increased $549 million and $1,262 million, respectively, compared with the same periods of 2007. This reflected increases to the allowance for credit losses of $250 million in the third quarter and $638 million during the first nine months of 2008. The increases in the provision and allowance for credit losses from a year ago reflected continuing stress in the residential re al estate markets, including homebuilding and related supplier industries, driven by declining home prices in most geographic regions. It also reflected changing economic conditions and the corresponding impact on the commercial and consumer loan portfolios. Net charge-offs were $498 million in the third quarter and $1,187 million in the first nine months of 2008, compared with $199 million in the third quarter and $567 million in the first nine 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 fourth 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 third quarter and first nine months of 2008 was $1,412 million and $5,348 million, respectively, compared with $1,877 million and $5,485 million in the same periods of 2007. The $465 million (24.8 percent) decrease during the third quarter and $137 million (2.5 percent) decrease during the first nine months of 2008, compared with the same periods in 2007, were driven by strong fee-based revenue growth in a majority of revenue categories, offset by impairment charges related to structured investment securities, perpetual preferred stock (including the stock of GSEs), and certain non-agency mortgage-backed securities. In addition, retail lease residual losses increased from a year ago. Noninterest income for the first nine months of 2008 was also impacted by the recognition of the $492 million Visa Gain in the first quarter of 2008 and the adoption of Statement of Financial Accounting 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 customer derivatives. In addition, under SFAS 157 mortgage production gains increased, because the deferral of costs related to the origination of mortgage loans held for sale (“MLHFS”) is not permitted under the new accounting standard.

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 and business expansion. ATM processing services increased primarily due to growth in transaction volumes. Merchant

 

 

 

Table 2     Noninterest Income

 

*    Not meaningful

processing services revenue growth reflected higher transaction volume and business expansion. Deposit service charges increased year-over-year primarily due to account growth and higher transaction-related fees. Higher transaction-related fees and the impact of continued growth in net new checking accounts were muted somewhat 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, as well as core business growth. Commercial products revenue increased year-over-year due to higher customer syndication fees, letters of credit, capital markets and other commercial loan fees. Mortgage banking revenue for the third quarter of 2008 decreased from the same period of the prior year, due to an unfavorable net change in the valuation of mortgage servicing rights (“MSRs”) and related economic hedging activities, partially offset by increases in mortgage servicing income and production revenue. Mortgage banking revenue for the first nine months of 2008 increased from the same period of the prior year, due to an increase in mortgage servicing income and production revenue, partially offset by the unfavorable net change in the valuation of MSRs and related economic hedging activities. Securities gains (losses) were lower year-over-year due primarily to the impact of the impairment charges on various investment securities recognized in the third quarter and during the first nine months of 2008. Other income for the third quarter of 2008 declined from the third quarter of 2007, due to the adverse impact of higher retail lease residual losses, lower equity investment revenue and market valuation losses related to the bankruptcy of an investment banking firm. Other income for the first nine months of 2008 was higher than the same period of the prior year due to the $492 million Visa Gain recognized in the first quarter of 2008, partially offset by higher retail lease residual losses, lower equity investment revenue, market valuation losses and the $62 million unfavorable impact to trading income upon adoption of SFAS 157.

 

Noninterest Expense Noninterest expense was $1,823 million in the third quarter and $5,454 million in the first nine months of 2008, reflecting increases of $47 million (2.6 percent) and $436 million (8.7 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. Professional services expense increased over the prior year due to increased litigation-related costs. Marketing and business development expense increased year-over-year due to costs incurred in the third quarter of 2008 for a national advertising campaign. In addition, marketing and business development expense further increased for the first nine months of 2008, due to $25 million recognized in the first quarter of 2008 for a charitable contribution to the Company’s foundation. Technology and communications expense increased primarily due to higher processing volumes and business expansion. Other expense decreased in the third quarter

 

 

 

Table 3     Noninterest Expense

 

 

of 2008, compared with the same period in the prior year, due primarily to the $115 million Visa Charge recognized in the third quarter of 2007. Other expense was higher in the first nine months of 2008, compared with the same period of the prior year, as increases in credit-related costs for other real estate owned and loan collection activities, investments in tax-advantaged projects, and litigation and fraud costs, were partially offset by the $115 million Visa Charge recognized in the prior year.

 

Income Tax Expense The provision for income taxes was $198 million (an effective rate of 25.6 percent) for the third quarter and $1,060 million (an effective rate of 28.8 percent) for the first nine months of 2008, compared with $473 million (an effective rate of 30.1 percent) and $1,466 million (an effective rate of 30.2 percent) for the same periods of 2007. The decreases in the effective rates for the third quarter and first nine months of 2008, compared with the same periods of the prior year, reflected the marginal impact of lower pre-tax income, higher tax-exempt income from investment securities and insurance products, and 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 $169.9 billion at September 30, 2008, compared with $153.8 billion at December 31, 2007, an increase of $16.1 billion (10.4 percent). The increase was driven by growth in all major loan categories. The $5.4 billion (10.5 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 $3.0 billion (10.2 percent) at September 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 late in the second quarter of 2008.

Residential mortgages held in the loan portfolio increased $.6 billion (2.5 percent) at September 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, home equity and second mortgages and other retail loans, increased $7.1 billion (14.0 percent) at September 30, 2008, compared with December 31, 2007. The increase reflected higher student loans due to the purchase of a portfolio during the first nine 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 September 30, 2008, loans held for sale, consisting primarily of residential mortgages and student loans to be sold in the secondary market, were $3.1 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 $39.3 billion at September 30, 2008, compared with $43.1 billion at December 31, 2007, reflecting purchases of $3.5 billion of securities, more than offset by sales, maturities, prepayments, securities impairments realized by the Company and unrealized losses on the available-for-sale portfolio due to changes in interest rates and liquidity premiums given current market conditions. As of September 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 September 30, 2008, the available-for-sale securities portfolio included a $2.5 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. As of September 30, 2008, approximately 8 percent of the available-for-sale securities portfolio represented perpetual preferred securities and trust preferred securities, primarily issued by the financial services sector, or structured investment securities. The unrealized losses for these securities were approximately $827 million at the end of the third quarter of 2008.

During the third quarter and first nine months of 2008, the Company’s assessment of the investment securities portfolio has resulted in the realization of other-than-temporary impairments for several classes of investment securities.

In the third quarter and first nine months of 2008, the Company recorded $196 million and $207 million, respectively, of other-than-temporarily impaired charges on certain investment securities, including certain non-agency mortgage-backed securities and perpetual preferred stock, representing the stock of GSEs and certain failed institutions.

With respect to structured investment securities held by the Company, there is no active market for these securities so their valuation is determined through discounted cash flows using estimates of expected cash flows, discount rates and management’s assessment of various market factors, which are judgmental in nature. The lack of an active market for these structured investment securities is reflected in the rate used to discount the expected cash flows. As a result of the valuation of these securities and impairment assessment, the Company has recorded $215 million and $534 million of impairment charges during the third quarter and first nine months of 2008, respectively. These impairment charges were a result of wider market spreads for these types of securities due to market illiquidity, as well as changes in expected cash flows resulting from 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 $439 million of principal payments will not be received for certain structured investment and non-agency mortgage-backed securities. During the first nine 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.

Refer to Note 3 in the Notes to Consolidated Financial Statements for further information on investment securities.

 

Deposits Total deposits were $139.5 billion at September 30, 2008, compared with $131.4 billion at December 31, 2007, an increase of $8.1 billion (6.1 percent). The increase in total deposits was primarily the result of increases in interest checking accounts, non-interest-bearing deposits, money market savings accounts and time deposits greater than $100,000, partially offset by a decrease in time certificates of deposit less than $100,000. The $2.5 billion (8.5 percent) increase in interest checking account balances was due primarily to higher broker-dealer balances. Noninterest-bearing deposits increased $2.1 billion (6.4 percent), primarily reflecting higher trust demand deposit balances. The $2.1 billion (8.8 percent) increase in money market savings account balances reflected higher broker-dealer and branch-based balances and the impact of an acquisition. Time deposits greater than $100,000 increased $1.7 billion (6.5 percent) at September 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. Time certificates of deposit less than $100,000 decreased $1.3 billion (9.2 percent) at September 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.

 

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 $37.4 billion at September 30, 2008, compared with $32.4 billion at December 31, 2007. Short-term funding is managed within approved liquidity policies. The increase of $5.0 billion (15.6 percent) in short-term borrowings reflected wholesale funding associated with the Company’s asset growth and asset/liability management activities. Long-term debt was $40.1 billion at September 30, 2008, compared with $43.4 billion at December 31, 2007, primarily reflecting repayments of $3.3 billion of convertible senior debentures and maturities of $6.2 billion of medium-term notes and $.3 billion of subordinated debt, partially offset by the issuance of $7.0 billion of medium-term notes, in the first nine months of 2008. The $3.3 billion (7.7 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.

 

CORPORATE RISK PROFILE

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 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 September 30, 2008:

 

 

 

Within the consumer finance division approximately $3.0 billion of residential mortgages were to customers that may be defined as sub-prime borrowers at September 30, 2008, 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 September 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:

 

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 1.5 percent of total assets at September 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.

 

 

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

 

 

 

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 $787 million at September 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 .46 percent at September 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 September 30, 2008, approximately $381 million and $102 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 deteriorating economic conditions and continuing stress in the residential mortgage portfolio and residential construction industry.

 

Restructured Loans Accruing Interest In certain circumstances, management may modify the terms of a loan to maximize the collection of the loan balance. In most cases, the modification is either a reduction in interest rate, extension of the maturity date or a reduction in the principal balance. Generally, the borrower is experiencing financial difficulties or is expected to experience difficulties in the near-term so concessionary modification is granted to the borrower that would otherwise not be considered. Restructured loans, except those where the principal balance has been reduced, accrue interest as long as the borrower complies with the revised terms and conditions and has demonstrated repayment performance at a level commensurate with the modified terms over several payment cycles. Loans restructured at a rate equal to or greater than a market rate for a new loan with comparable risk at the time the contract is modified, are classified as restructured loans in the calendar year the restructuring occurs, but are excluded from restructured loans in subsequent years once repayment performance, in accordance with the modified agreement, has been demonstrated. Loans that have interest rates reduced below market rates for borrowers with comparable risk remain classified as restructured loans for the remaining life of the loan.

 

The majority of the Company’s loan restructurings occur on a case-by-case basis in connection with ongoing loan collection processes. However, in late 2007, the Company began implementing a mortgage loan restructuring program for certain qualifying borrowers. In general, certain borrowers in the consumer finance division facing an interest rate reset that are current in their repayment status, are 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 are performing, and therefore, continue to accrue interest:

 

Restructured loans that continue to accrue interest were $629 million higher at September 30, 2008, compared with December 31, 2007, reflecting the impact of restructurings for certain commercial real estate, residential mortgage and credit card customers in light of current economic conditions. The Company expects this trend to continue in the near term as residential home valuations continue to decline and certain borrowers take advantage of the Company’s mortgage loan restructuring programs.

 

Nonperforming Assets The level of nonperforming assets represents another indicator of the potential for future credit losses. At September 30, 2008, total nonperforming assets were $1,492 million, compared with $690 million at December 31, 2007. The ratio of total nonperforming assets to total loans and other real estate was .88 percent at September 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, as well as the residential mortgage portfolio, an increase in foreclosed residential properties and the impact of the economic slowdown on other commercial customers.

Included in nonperforming loans were restructured loans that are not accruing interest of $100 million at September 30, 2008, compared with $17 million at December 31, 2007. At September 30, 2008, the Company had $4 million of commitments to lend additional funds under restructured loans, compared with no commitments at December 31, 2007.

Other real estate included in nonperforming assets was $164 million at September 30, 2008, compared with $111 million at December 31, 2007, and was primarily related to properties that the Company has taken ownership of which previously secured residential mortgages and home equity and second mortgage loan

 

 

 

Table 5     Nonperforming Assets (a)

 

Changes in Nonperforming Assets