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Capital One Financial 10-Q 2011 Table of Contents
UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
FORM 10-Q
For the quarterly period ended June 30, 2011 OR
For the transition period from to Commission File No. 1-13300
CAPITAL ONE FINANCIAL CORPORATION (Exact name of registrant as specified in its charter)
Registrant’s telephone number, including area code: (703) 720-1000 (Former name, former address and former fiscal year, if changed since last report) (Not applicable)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨ Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act) Yes ¨ No x As of July 31, 2011, there were 459,374,369 shares of the registrant’s Common Stock, par value $.01 per share, outstanding.
Table of ContentsTABLE OF CONTENTS
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Table of ContentsINDEX OF MD&A TABLES AND SUPPLEMENTAL TABLES
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Table of ContentsItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations This Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) should be read in conjunction with our unaudited condensed consolidated financial statements and related notes in this Report and the more detailed information contained in our 2010 Annual Report on Form 10-K (“2010 Form 10-K”). This discussion contains forward-looking statements that are based upon management’s current expectations and are subject to significant uncertainties and changes in circumstances. Please review “Forward-Looking Statements” for more information on the forward-looking statements in this Report. Our actual results may differ materially from those included in these forward-looking statements due to a variety of factors including, but not limited to, those described in this Report in “Part II—Item 1A. Risk Factors,” in our 2010 Form 10-K in “Part I—Item 1A. Risk Factors” and in Exhibit 99.5 to our Current Report on Form 8-K filed on July 13, 2011.
SUMMARY OF SELECTED FINANCIAL DATA
Below we provide selected consolidated financial data from our results of operations for the three and six months ended June 30, 2011 and 2010, and selected comparative consolidated balance sheet data as of June 30, 2011, and December 31, 2010. We also provide selected key metrics we use in evaluating our performance. Table 1: Consolidated Financial Highlights (Unaudited)
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INTRODUCTION
Capital One Financial Corporation (the “Company”) is a diversified financial services holding company with banking and non-banking subsidiaries that offer a broad array of financial products and services to consumers, small businesses and commercial clients through branches, the internet and other distribution channels. Our principal subsidiaries include:
The Company and its subsidiaries are collectively referred to as “we,” “us” or “our” in this Report. CONA and COBNA are collectively referred to as the “Banks” in this Report. Our revenues are primarily driven by lending to consumers and commercial customers and by deposit-taking activities, which generate net interest income, and by activities that generate non-interest income, including the sale and servicing of loans and providing fee-based services to customers. Customer usage and payment patterns, credit quality, levels of marketing expense and operating efficiency all affect our profitability. Our expenses primarily consist of the cost of funding our assets, our provision for loan and lease losses, operating expenses (including associate salaries and benefits, infrastructure maintenance and enhancements and branch operations and expansion costs), marketing expenses and income taxes. We had $129.0 billion in total loans outstanding and $126.1 billion in deposits as of June 30, 2011, compared with $125.9 billion in total loans outstanding and $122.2 billion in deposits as of December 31, 2010. Our principal operations are currently organized, for management reporting purposes, into three major business segments, which are defined based on the products and services provided or the type of customer served: Credit Card, Consumer Banking and Commercial Banking. The operations of acquired businesses have been integrated into our existing business segments.
Certain activities that are not part of a segment are included in our “Other” category. Table 2 summarizes our business segment results, which we report based on income from continuing operations, net of tax, for the three and six months ended June 30, 2011 and 2010. We provide a reconciliation of our total business segment results to our consolidated U.S. GAAP results in “Note 14—Business Segments” of this Report.
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Table of ContentsTable 2: Business Segment Results
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EXECUTIVE SUMMARY AND BUSINESS OUTLOOK
Financial Highlights We reported net income of $911 million ($1.97 per diluted share) in the second quarter of 2011. In comparison, we reported net income of $1.0 billion ($2.21 per diluted share) in the first quarter of 2011 and net income of $608 million ($1.33 per diluted share) in the second quarter of 2010. Net income totaled $1.9 billion ($4.18 per diluted share) for the first six months of 2011, compared with net income of $1.2 billion ($2.73 per diluted share) for the first six months of 2010. Our earnings in the second quarter of 2011 further bolstered our Tier 1 risk-based capital ratio under Basel I to 11.8% as of June 30, 2011, up 90 basis points from 10.9% as of March 31, 2011, and comfortably above the current minimum regulatory requirement of 4.0%. Our Tier 1 common equity ratio, a non-GAAP measure, rose to 9.4% as of June 30, 2011, up 100 basis points from 8.4% as of March 31, 2011. See “Supplemental Tables” below for a calculation of our regulatory capital ratios and a reconciliation of our supplemental non-GAAP capital measures. We grew loans and deposits in the second quarter of 2011. Our strategies and actions are designed to deliver profitable long-term growth through the acquisition and retention of franchise-enhancing customer relationships across our businesses. We believe that franchise-enhancing customer relationships produce strong long-term economics through low credit costs, low customer attrition and a gradual build in loan balances and revenues over time. Examples of franchise-enhancing customer relationships include transactor customers and new partnerships in our Credit Card business, long-term retail deposit customers in our Consumer Banking business and primary banking relationships with commercial customers in our Commercial Banking business. We intend to grow these customer relationships by continuing to invest in our bank infrastructure to allow us to provide more convenient and flexible customer banking options, including a broader range of fee-based and credit products and services, by leveraging our direct bank customer franchise with national reach and by continued marketing investments to further strengthen our brand. We believe our actions have created a well-positioned balance sheet and strong capital and liquidity levels which have provided us with investment flexibility to take advantage of attractive opportunities and adjust, where we believe appropriate, to changing market conditions. Our recent investments and partnership alliances include our September 2010 acquisition of the $807 million Sony Card legacy portfolio associated with our partnership alliance with Sony Corporation of America (“Sony”) and our January 2011 acquisition of the existing $1.4 billion credit card loan portfolio of Hudson’s Bay Company (“HBC”), one of the largest retailers in Canada. In April 2011, we acquired the existing $3.7 billion private-label credit card loan portfolio of Kohl’s Department Stores (“Kohl’s”) from JPMorgan Chase & Co, which consists of more than 20 million Kohl’s customer accounts. In June 2011, we entered into a definitive agreement with ING Groep N.V., ING Bank N.V., ING Direct N.V., ING Direct Bancorp, collectively, the Sellers, under which we will acquire substantially all of the Sellers’ ING Direct business in the United States, for an estimated price of $9.0 billion at announcement. We expect the ING Direct transaction to close in late 2011 or early 2012, subject to customary closing conditions, including certain governmental clearances and approvals. In conjunction with the announcement of the ING Direct acquisition, we announced that we expected to finance a portion of the cash consideration through a public equity raise prior to the close of the transaction. On July 19, 2011, we closed a public underwritten offering of 40 million shares of our common stock, subject to forward sale agreements. We also closed a public offering of our senior notes for total proceeds of approximately $3.0 billion. Each of these offerings is described in more detail below under “Recent Acquisitions and Related Developments—Equity and Debt Offerings.” In addition to these public offerings, we may seek to rebalance our investment portfolio prior to the close of the ING Direct acquisition. Our financial strength and flexibility and our experience in the credit card and direct banking businesses are key factors that we believe have enabled us to take advantage of our recent investment opportunities. We believe these factors will help us deliver attractive financial results as well as compelling value creation over time.
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Table of ContentsBelow are additional highlights of our performance for the second quarter and first six months of 2011. These highlights generally are based on a comparison to the same prior year periods. The changes in our financial condition and credit performance are generally based on our financial condition and credit performance as of June 30, 2011, compared with our financial condition and credit performance as of December 31, 2010. We provide a more detailed discussion of our financial performance in the sections following this “Executive Summary and Business Outlook.” Total Company
Business Segments
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Business Environment and Recent Developments Recent Business and Regulatory Developments During the second quarter, the operating environment continued to be challenging and uncertain given global macroeconomic concerns and fragile U.S. economic conditions. The banking industry continues to face a difficult and increasingly complex environment in which economic uncertainty, regulation and changes in customer and competitor behavior impact how we allocate resources and manage operations, as well as how we position ourselves for future earnings growth. Despite these challenges, our recent partnerships and acquisitions have contributed to new account originations and an increase in purchase volumes. We are continuing to assess the potential impact of proposed rules promulgated by the agencies charged with implementing the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), including rules relating to resolution plans and credit exposure reports, the FDIC’s orderly liquidation authority, derivatives, risk retention and other securitization matters. These rules may result in modifications to our business models and organizational structure and may subject us to escalating costs associated with any such changes. Recent Acquisitions and Related Developments During the past several years, we have explored opportunities to acquire financial services companies and financial assets and enter into strategic partnerships as part of our growth strategy. In the first six months of 2011, we acquired the existing credit card loan portfolios of HBC and Kohl’s and announced our planned acquisition of ING Direct. We continue to evaluate and anticipate engaging in additional strategic partnerships and selected acquisitions of financial institutions and other financial assets, including credit card and other loan portfolios. We may issue common stock or debt in connection with future acquisitions, including in public offerings, to fund such acquisitions. Hudson’s Bay Company On January 7, 2011, we acquired the existing $1.4 billion credit card loan portfolio of HBC, one of the largest retailers in Canada, from GE Capital Retail Finance. The acquisition and partnership with HBC significantly expand our credit card customer base in Canada, tripling the number of customer accounts, and provide an additional distribution channel. The acquisition included a transfer of approximately 400 employees directly involved in managing HBC’s loan portfolio.
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Table of ContentsKohl’s On April 1, 2011, we acquired Kohl’s existing $3.7 billion private-label credit card loan portfolio from JPMorgan Chase & Co., which consists of more than 20 million Kohl’s customer accounts. Under the related partnership agreement with Kohl’s, we share a fixed percentage of revenues, consisting of finance charges and late fees, with Kohl’s, and Kohl’s is responsible for reimbursing us for a fixed percentage of credit losses incurred. The revenue-sharing arrangement with Kohl’s has the effect of reducing our overall revenue margins for our Domestic Card business, while the loss-sharing arrangement has the effect of reducing the net charge-off rate. However, because we replaced lower yielding cash and other investments with the Kohl’s receivables, we do not expect that the addition of the Kohl’s portfolio will have a material impact on our total company revenue margin or net interest margin. Interest income was reduced by $215 million in the second quarter and first six months of 2011 for amounts earned by Kohl’s. Loss sharing amounts attributable to Kohl’s reduced charge-offs by $42 million in the second quarter and first six months of 2011. In addition, the expected reimbursement from Kohl’s netted in our allowance for loan and lease losses was approximately $170 million as of June 30, 2011. The reduction in the provision for loan and lease losses attributable to Kohl’s for the second quarter and first six months of 2011 was $212 million. ING Direct On June 16, 2011, we entered into a purchase and sale agreement with ING Groep N.V., ING Bank N.V., ING Direct N.V., ING Direct Bancorp, collectively, the Sellers, under which we will acquire substantially all of the Sellers’ ING Direct business in the United States in exchange for $6.2 billion in cash and approximately 55.9 million shares of our common stock, subject to certain adjustments described in the purchase and sale agreement. We will effect the transaction through (i) the acquisition of the equity interests of ING Bank, fsb, (ii) the acquisition of the equity interests of each of WS Realty, LLC and ING Direct Community Development LLC and (iii) the acquisition of certain assets and the assumption of certain liabilities of ING Direct Bancorp. We expect the ING Direct transaction to close in late 2011 or early 2012, subject to customary closing conditions, including certain governmental clearances and approvals. Equity and Debt Offerings On July 19, 2011, we closed a public offering of shares of our common stock, subject to forward sale agreements that we entered into with certain counterparties acting as forward purchasers. The forward purchasers agreed to borrow and sell to the public, through the underwriters, 40 million shares of our common stock at a price per share of $50.00. After underwriter’s discounts and commissions, the net proceeds to the company will be at an initial forward sale price per share of $48.50. We did not receive any proceeds from this public offering of our shares of common stock. Under the terms of the forward sale agreements, we must settle the forward sale agreements on or before February 15, 2012. We expect to settle the forward sale agreements entirely by physical delivery of shares of common stock in exchange for cash proceeds from the forward purchasers of $1.9 billion based on the initial forward price. The forward sale price is subject to adjustment under the forward sale agreements. However, we may, subject to certain conditions, elect cash or net share settlement of all or a portion of our obligation to deliver shares of common stock. In addition, we granted the underwriters a 30-day option to purchase an additional 6 million shares of our common stock to cover any over-allotments, which shares are not subject to the forward sale agreements. We also closed a public offering of four different series of our senior notes on July 19, 2011, for total proceeds of approximately $3.0 billion. The offering of senior notes included $250 million aggregate principal amount of our Floating Rate Senior Notes due 2014, $750 million aggregate principal amount of our 2.125% Senior Notes due 2014, $750 million aggregate principal amount of our 3.150% Senior Notes due 2016 and $1.25 billion aggregate principal amount of our 4.750% Senior Notes due 2021.
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Table of ContentsWe expect to use the net proceeds of these offerings, along with cash sourced from current liquidity, to fund the $6.2 billion in cash consideration payable in connection with the ING Direct acquisition. Business Outlook We discuss below our current expectations regarding our total company performance and the performance of each of our business segments over the near-term based on market conditions, the regulatory environment and our business strategies as of the time we filed this Report. The statements contained in this section are based on our current expectations regarding our outlook for our financial results and business strategies. Our expectations take into account, and should be read in conjunction with, our expectations regarding economic trends and analysis of our business as discussed in “Part I—Item 1. Business” and “Part I—Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our 2010 Form 10-K. Certain statements are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Actual results could differ materially from those in our forward-looking statements. Forward-looking statements do not reflect (i) any change in current dividend or repurchase strategies, (ii) the effect of any acquisitions, divestitures or similar transactions or (iii) any changes in laws, regulations or regulatory interpretations, in each case after the date as of which such statements are made. See “Forward-Looking Statements” in this Report “Item 1A. Risk Factors” in our 2010 Form 10-K and Exhibit 99.5 to our Current Report on Form 8-K filed on July 13, 2011, for factors that could materially influence our results. Total Company Expectations We continue to gain traction across all of our businesses as a result of our focus on franchise-enhancing customer relationships. We believe the recently announced ING Direct acquisition will deliver strong financial results in the near-term as well as compelling long-term value creation. As a result, we believe we are in a strong position to deliver attractive and sustainable results over the long-term, including moderate growth and attractive risk-adjusted returns on assets in our Credit Card and Auto Finance businesses, moderate growth in low-risk loans in our Commercial Banking business and strong growth in low-cost deposits and high-quality commercial and retail customer relationships. Based on recent trends and our targeted initiatives to attract new business and develop customer relationships, we expect modest year-over-year growth in ending loan balances in 2011. Although we expect growth in our period-end loan balances in 2011, we expect that our average loan balances for 2011 will be comparable to our average loan balances for 2010 given the lower starting point for our loan balances in 2011. Business Segments Expectations Credit Card Business Based on the traction we are gaining in our Domestic Card business, we believe that our Domestic Card loan balances reached a low point in the first quarter of 2011. We expect modest loan growth in the second half of 2011, as the headwinds of elevated charge-offs and the run-off of the installment loan portfolio continue to diminish. We believe we are well positioned to gain market share in the new level playing field resulting from the CARD Act. We believe the credit performance improvement in our Credit Card business will continue despite elevated unemployment. Consumer Banking Business In our Consumer Banking business, we expect that auto originations and returns will remain strong and drive growth in auto loans in 2011. We expect that the continuing run-off of the mortgage portfolio will largely offset the growth in auto loans. While we expect that our Auto Finance business will continue to deliver strong credit performance and economic results, we believe that we have likely experienced the low point for the Auto Finance charge-off rate. We expect the Auto Finance charge-off rate will increase in the second half of 2011, driven by seasonal patterns, competitive factors and expected changes in auction prices for used vehicles. We
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Table of Contentsbelieve loan pricing in some loan portfolio categories is approaching historic highs and is likely to moderate or decline over time. Commercial Banking Business In our Commercial Banking business, we believe that the worst of the commercial credit downturn is behind us and there is positive trajectory. However, we continue to expect some quarterly uncertainty and volatility in commercial charge-offs and nonperforming loans. We have been growing commercial loans with lower credit risk and expect further modest growth to continue in 2011. Growth in treasury management and capital market services is driving higher fee revenues and deepening relationships with our commercial customers.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The preparation of financial statements in accordance with U.S. GAAP requires management to make a number of judgments, estimates and assumptions that affect the reported amount of assets, liabilities, income and expenses in the consolidated financial statements. Understanding our accounting policies and the extent to which we use management judgment and estimates in applying these policies is integral to understanding our financial statements. We provide a summary of our significant accounting policies in “Note 1—Summary of Significant Accounting Policies” of our 2010 Form 10-K. We have identified the following accounting policies as critical because they require significant judgments and assumptions about highly complex and inherently uncertain matters and the use of reasonably different estimates and assumptions could have a material impact on our reported results of operations or financial condition. These critical accounting policies govern:
We evaluate our critical accounting estimates and judgments on an ongoing basis and update them as necessary based on changing conditions. The use of fair value to measure our financial instruments is fundamental to the preparation of our consolidated financial statements because we account for and record a significant portion of our assets and liabilities at fair value. Accordingly, we provide information below on financial instruments recorded at fair value in our consolidated balance sheets. Management has discussed our critical accounting policies and estimates with the Audit and Risk Committee of the Board of Directors.
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Table of ContentsFair Value Fair value is defined as the price that would be received for an asset or paid to transfer a liability in an orderly transaction between market participants on the measurement date (also referred to as an exit price). The fair value accounting guidance provides a three-level fair value hierarchy for classifying financial instruments. This hierarchy is based on whether the inputs to the valuation techniques used to measure fair value are observable or unobservable. Fair value measurement of a financial asset or liability is assigned to a level based on the lowest level of any input that is significant to the fair value measurement in its entirety. The three levels of the fair value hierarchy are described below:
The degree of management judgment involved in determining the fair value of a financial instrument is dependent upon the availability of quoted prices in active markets or observable market parameters. When quoted prices and observable data in active markets are not fully available, management judgment is necessary to estimate fair value. Changes in market conditions, such as reduced liquidity in the capital markets or changes in secondary market activities, may reduce the availability and reliability of quoted prices or observable data used to determine fair value. We have developed policies and procedures to determine when markets for our financial assets and liabilities are inactive if the level and volume of activity has declined significantly relative to normal conditions. If markets are determined to be inactive, it may be appropriate to adjust price quotes received. When significant adjustments are required to price quotes or inputs, it may be appropriate to utilize an estimate based primarily on unobservable inputs. Significant judgment may be required to determine whether certain financial instruments measured at fair value are included in Level 2 or Level 3. In making this determination, we consider all available information that market participants use to measure the fair value of the financial instrument, including observable market data, indications of market liquidity and orderliness, and our understanding of the valuation techniques and significant inputs used. Based upon the specific facts and circumstances of each instrument or instrument category, judgments are made regarding the significance of the Level 3 inputs to the instruments’ fair value measurement in its entirety. If Level 3 inputs are considered significant, the instrument is classified as Level 3. The process for determining fair value using unobservable inputs is generally more subjective and involves a high degree of management judgment and assumptions. Our financial instruments recorded at fair value on a recurring basis represented approximately 21% of our total assets of $199.8 billion as of June 30, 2011, compared with 22% of our total assets of $197.5 billion as of December 31, 2010. Financial assets for which the fair value was determined using significant Level 3 inputs represented approximately 2% of these financial instruments (less than 1% of total assets) as of June 30, 2011, and approximately 2% of these financial instruments (1% of total assets) as of December 31, 2010. We discuss changes in the valuation inputs and assumptions used in determining the fair value of our financial instruments, including the extent to which we have relied on significant unobservable inputs to estimate fair value and our process for corroborating these inputs, in “Note 13—Fair Value of Financial Instruments.”
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Table of ContentsKey Controls Over Fair Value Measurement We have a governance framework and a number of key controls that are intended to ensure that our fair value measurements are appropriate and reliable. Our governance framework provides for independent oversight and segregation of duties. Our control processes include review and approval of new transaction types, price verification and review of valuation judgments, methods, models, process controls and results. Groups independent from our trading and investing function, including our Valuations Group and Valuations Advisory Committee, participate in the review and validation process. The Valuation Advisory Committee includes senior representation from business areas, our Enterprise Risk Oversight division and our Finance division. Our Valuations Group performs monthly independent verification of fair value measurements by comparing the methodology driven price to other market source data (to the extent available), and uses independent analytics to determine if assigned fair values are reasonable. The Valuations Advisory Committee regularly reviews and approves our valuation methodologies to ensure that our methodologies and practices are consistent with industry standards and adhere to regulatory and accounting guidance. For additional information on our critical accounting policies and estimates, see “Part II—Item 7. MD&A—Critical Accounting Policies and Estimates” of our 2010 Form 10-K.
CONSOLIDATED RESULTS OF OPERATIONS
The section below provides a comparative discussion of our consolidated financial performance for the three and six months ended June 30, 2011 and 2010. Following this section, we provide a discussion of our business segment results. You should read this section together with our “Executive Summary and Business Outlook” where we discuss trends and other factors that we expect will affect our future results of operations. Net Interest Income Net interest income represents the difference between the interest income and applicable fees earned on our interest-earning assets, which include loans held for investment and investment securities, and the interest expense on our interest-bearing liabilities, which include interest-bearing deposits, senior and subordinated notes, securitized debt and other borrowings. We include in interest income any past due fees on loans that we deem are collectible. Our net interest margin represents the difference between the yield on our interest-earning assets and the cost of our interest-bearing liabilities, including the impact of non-interest bearing funding. We expect net interest income and our net interest margin to fluctuate based on changes in interest rates and changes in the amount and composition of our interest-earning assets and interest-bearing liabilities. Table 3 below presents, for each major category of our interest-earning assets and interest-bearing liabilities, the average outstanding balances, interest income earned or interest expense incurred, and the average yield or cost for the three and six months ended June 30, 2011 and 2010.
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Table of ContentsTable 3: Average Balances, Net Interest Income and Net Interest Yield
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Table 4 presents the variance between our net interest income for the three months ended June 30, 2011 and 2010, and for the six months ended June 30, 2011 and 2010, and the extent to which the variance was attributable to: (i) changes in the volume of our interest-earning assets and interest-bearing liabilities or (ii) changes in the interest rates of these assets and liabilities. Table 4: Rate/Volume Analysis of Net Interest Income(1)
Our net interest income of $3.1 billion for the second quarter of 2011 increased slightly from the second quarter of 2010, driven by an 11 basis points expansion of our net interest margin to 7.20%, which was partially offset by a modest decline in average interest-earning assets. Our net interest income of $6.3 billion for the first six months of 2011 decreased slightly from the first six months of 2010, driven by a 2% decrease in average interest-earning assets, which was offset by a 13 basis points expansion of our net interest margin to 7.22%.
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Table of ContentsThe decrease in average interest-earning assets in the second quarter and first six months of 2011 reflected the continued run-off of businesses that we exited or repositioned, including our installment, home loan and small-ticket commercial real estate loan portfolios, which more than offset the impact of modest revolving credit card loan growth and the addition of the existing HBC credit card loan portfolio of $1.4 billion in the first quarter of 2011 and the addition of the existing Kohl’s private-label credit card loan portfolio of $3.7 billion in the second quarter of 2011. The increase in our net interest margin in the second quarter of 2011 and first six months of 2011 was primarily attributable to an improvement in our cost of funds, which was partially offset by a decline in the yield on our interest-earning assets. Our cost of funds continued to benefit from the shift in the mix of our funding to lower cost consumer and commercial banking deposits from higher cost wholesale sources. In addition, the overall interest rate environment, combined with our disciplined pricing, contributed to the decrease in our average deposit interest rates. The decrease in yield on interest-earning assets was attributable to a reduction in late payment fees resulting from the Federal Reserve guidelines regarding reasonable fees that went info effect in the third quarter of 2010 and the addition of the Kohl’s portfolio. Under our partnership agreement with Kohl’s, we share a fixed percentage of revenues, consisting of finance charges and late fees. We report revenues related to Kohl’s credit card loans on a net basis in our consolidated financial statements, which has the effect of reducing the yield on our average interest-earning assets. The impact of these factors was partially offset by the run-off of lower margin installment loans, a reduced level of new accounts with low introductory promotional rates and an increase in the recognition of billed finance charges and fees due to the improvement in credit performance. Non-Interest Income Non-interest income consists of servicing and securitizations income, service charges and other customer-related fees, interchange income and other non-interest income. We also record the provision for mortgage repurchase losses related to continuing operations in non-interest income. The servicing fees, finance charges, other fees, net of charge-offs and interest paid to third party investors related to our consolidated securitization trusts are reported as a component of net interest income. Table 5 displays the components of non-interest income for the three and six months ended June 30, 2011 and 2010. Table 5: Non-Interest Income
Non-interest income of $857 million for the second quarter of 2011 increased by $50 million, or 6%, from non-interest income of $807 million for the second quarter of 2010. This increase was primarily due to a
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Table of Contentsreduction in the provision for mortgage repurchase losses and a decline in other-than-temporary impairment, which was partially offset by a decrease in service charges and other customer-related fees due to the reduction in penalty fees as a result of the CARD Act. In the second quarter of 2010, we significantly increased our reserve for mortgage representation and warranty claims for legacy mortgage loans sold by our subsidiaries to various parties. The increase was primarily attributable to a refinement we made in estimating our reserve for representation and warranty claims to extend the timeframe, in most instances, over which we estimated our repurchase liability to the full life of the mortgage loans sold by our subsidiaries. We provide additional information on our reserve for representation and warranty claims in “Consolidated Balance Sheet Analysis and Credit Performance—Potential Mortgage Representation and Warranty Liabilities.” The other-than-temporary losses recorded in the second quarter of 2010 were attributable to certain non-agency mortgage-backed securities that had deteriorated in credit quality due to the continued weakness in the housing market and elevated unemployment. Non-interest income of $1.8 billion for the first six months of 2011 decreased by $69 million, or 4%, from non-interest income of $1.9 billion from the first six months of 2010. This decrease reflected the impact of a one-time pre-tax gain of $128 million recorded in the first quarter of 2010 as result of the deconsolidation of certain option-adjustable rate mortgage trusts and the reduction in penalty fees as a result of the CARD Act. The impact of these factors was partially offset by the decreases in the provision for mortgage repurchase losses and other-than-temporary impairment losses. Provision for Loan and Lease Losses We build our allowance for loan and lease losses through the provision for loan and lease losses. Our provision for loan and lease losses in each period is driven by charge-offs and the level of allowance for loan and lease losses that we determine is necessary to provide for probable credit losses inherent in our loan portfolio as of each balance sheet date. Our provision for loan and lease losses fell by $380 million to $343 million in the second quarter of 2011 and by $1.3 billion in the first six months of 2011 to $877 million, compared with the same prior year periods. The decrease in the provision was largely driven by a substantial decline in net charge-offs across all of our business segments, as underlying credit trends and credit performance continued to improve. The net charge-off rate was 2.91% and 3.28% for the second quarter and first six months of 2011, respectively, compared with 5.36% and 5.69% for the second quarter and first six months of 2010, respectively. As charge-offs declined, we recorded an allowance release of $579 million and $1.1 billion in the second quarter and first six months of 2011, respectively. See “Consolidated Balance Sheet Analysis and Credit Performance—Allowance for Loan and Lease Losses” for a discussion of changes in our allowance for loan and lease losses and details of our provision for loan and lease losses and charge-offs by loan category for the three and six months ended June 30, 2011 and 2010. Non-Interest Expense Non-interest expense consists of ongoing operating costs, such as salaries and associated employee benefits, communications and other technology expenses, supplies and equipment, occupancy costs and miscellaneous expenses. Marketing expenses also are included in non-interest expense. Table 6 displays the components of non-interest expense for the three and six months ended June 30, 2011 and 2010.
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Table of ContentsTable 6: Non-Interest Expense
Non-interest expense of $2.3 billion for the second quarter of 2011 was up $255 million, or 13%, from the second quarter of 2010. Non-interest expense of $4.4 billion for the first six months of 2011 was up $570 million, or 15%, from the first six months of 2010. The increase was attributable to higher operating costs associated with increased purchase volumes and with the recent acquisitions of the Sony, HBC and Kohl’s loan portfolios, higher legal fees and increased marketing costs. We have expanded our marketing efforts to attract and support targeted customers and new business volume through a variety of channels. Income Taxes Our effective tax rate may vary between periods due, in part, to fluctuations in our pre-tax earnings, which affects the relative tax benefit of tax-exempt income, tax credits and permanent tax items. We recorded an income tax provision based on income from continuing operations of $450 million (32.3% effective income tax rate) in the second quarter of 2011, compared with an income tax provision of $369 million (31.2% effective income tax rate) in the second quarter of 2010, and $804 million (28.9% effective income tax rate) for the first six months of 2011 compared with $613 million (28.6% effective income tax rate) for the first six months of 2010. We recorded tax benefits of $45 million and $50 million for the first six months of 2011 and 2010, respectively, related to the resolution of certain tax issues and audits, which lowered our effective income tax rate for those periods. Our effective income tax rate excluding the benefit from these discrete tax items was 30.5% and 30.9% for the first six months of 2011 and 2010, respectively. We provide additional information on items affecting our income taxes and effective tax rate in our 2010 Form 10-K under “Note 18—Income Taxes.” Loss from Discontinued Operations, Net of Tax Loss from discontinued operations reflects ongoing costs, which primarily consist of mortgage loan repurchase representation and warranty charges, related to the mortgage origination operations of GreenPoint’s wholesale mortgage banking unit, which we closed in 2007. We recorded a loss from discontinued operations, net of tax, of $34 million and $50 million in the second quarter and first six months of 2011, respectively. In comparison, we recorded a loss from discontinued operations, net of tax, of $204 million and $288 million in the second quarter and first six months of 2010, respectively.
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Table of ContentsThe decrease in the loss from discontinued operations in the second quarter and first six months of 2011 was attributable to a significant reduction in the provision for mortgage repurchase losses. We recorded a pre-tax provision for mortgage repurchase losses of $37 million in the second quarter of 2011, of which $33 million ($22 million, net of tax) was included in discontinued operations, and a pre-tax provision of $81 million in the first six months of 2011, of which $72 million ($51 million, net of tax) was included in discontinued operations. In comparison, we recorded a pre-tax provision for mortgage repurchase losses of $404 million in the second quarter of 2010, of which $309 million ($212 million, net of tax) was included in discontinued operations, and a pre-tax provision of $628 million in the first six months of 2010, of which $433 million ($309 million, net of tax) was included in discontinued operations. In the second quarter of 2010, we significantly increased our reserve for mortgage representation and warranty claims for legacy mortgage loans sold by our subsidiaries to various parties. The increase was primarily attributable to a refinement we made in estimating our reserve for representation and warranty claims to extend the timeframe, in most instances, over which we estimated our repurchase liability to the full life of the mortgage loans sold by our subsidiaries. We provide additional information on our reserve for representation and warranty claims in “Consolidated Balance Sheet Analysis and Credit Performance—Potential Mortgage Representation and Warranty Liabilities.”
BUSINESS SEGMENT FINANCIAL PERFORMANCE
Our principal operations are currently organized into three major business segments, which are defined based on the products and services provided or the type of customer served: Credit Card, Consumer Banking and Commercial Banking. The operations of acquired businesses have been integrated into our existing business segments. The results of our individual businesses, which we report on a continuing operations basis, reflect the manner in which management evaluates performance and makes decisions about funding our operations and allocating resources. Our business segment results are intended to reflect each segment as if it were a stand-alone business. We use an internal management and reporting process to derive our business segment results. Our internal management and reporting process employs various allocation methodologies, including funds transfer pricing, to assign certain balance sheet assets, deposits and other liabilities and their related revenue and expenses directly or indirectly attributable to each business segment. We may periodically change our business segments or reclassify business segment results based on modifications to our management reporting methodologies and changes in organizational alignment. See “Note 20—Business Segments” of our 2010 Form 10-K for information on the allocation methodologies used to derive our business segment results. We summarize our business segment results for the three and six months ended June 30, 2011 and 2010 in the tables below and provide a comparative discussion of these results. We also discuss changes in our financial condition and credit performance statistics as of June 30, 2011, compared with December 31, 2010. See “Note 14—Business Segments” of this Report for a reconciliation of our business segment results to our consolidated U.S. GAAP results. Information on the outlook for each of our business segments is presented above under “Executive Summary and Business Outlook.”
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Table of ContentsCredit Card Business Our Credit Card business generated net income from continuing operations of $618 million and $1.3 billion in the second quarter and first six months of 2011, respectively, compared with net income from continuing operations of $568 million and $1.1 billion in the second quarter and first six months of 2010, respectively. The primary sources of revenue for our Credit Card business are net interest income and non-interest income from customer and interchange fees. Expenses primarily consist of ongoing operating costs, such as salaries and associated benefits, communications and other technology expenses, supplies and equipment, occupancy costs and marketing expenses. Table 7 summarizes the financial results of our Credit Card business, which is comprised of the Domestic Card and International Card operations, and displays selected key metrics for the periods indicated. Our Credit Card business results for 2011 reflect the impact of the acquisitions of the existing portfolio credit card loan portfolios of Kohl’s and HBC. The results related to the Kohl’s loan portfolio, which totaled approximately $3.7 billion at acquisition on April 1, 2011, are included in our Domestic Card business. The results related to the HBC loan portfolio, which totaled approximately $1.4 billion at acquisition on January 7, 2011, are included in our International Card business. Under the terms of the partnership agreement with Kohl’s, we share a fixed percentage of revenues, consisting of finance charges and late fees, with Kohl’s, and Kohl’s is required to reimburse us for fixed percentage of credit losses incurred. Revenues and losses related to the Kohl’s credit card program are reported on a net basis in our consolidated financial statements. The revenue sharing amounts earned by Kohl’s are reflected as an offset against our revenues in our consolidated statements of income, which has the effect of reducing our net interest income and revenue margins. The loss sharing amounts from Kohl’s are reflected as a reduction in our provision for loan and lease losses in our consolidated statements of income. We also report the related allowance for loan and lease losses attributable to the Kohl’s portfolio in our consolidated balance sheets net of the loss sharing amount due from Kohl’s. Interest income was reduced by $215 million in the second quarter and first six months of 2011 for amounts earned by Kohl’s. Loss sharing amounts attributable to Kohl’s reduced charge-offs by $42 million in the second quarter and first six months of 2011. In addition, the expected reimbursement from Kohl’s netted in our allowance for loan and lease losses was approximately $170 million as of June 30, 2011. The reduction in the provision for loan and lease losses attributable to Kohl’s was $212 million for the second quarter and first six months of 2011. We provide additional information on the acquisition of the existing credit card loan portfolios of Kohl’s and HBC in “Note 2—Acquisitions.”
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Table of ContentsTable 7: Credit Card Business Results
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Table of ContentsKey factors affecting the results of our Credit Card Banking business for the second quarter and first six months of 2011, compared with the second quarter and first six months of 2010 included the following.
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Table of ContentsDomestic Credit Card Business Table 7.1 summarizes the financial results for Domestic Card and displays selected key metrics for the periods indicated. Domestic Card accounted for 87% of total revenues for our Credit Card business in the second quarter of 2011 and 86% in the first six months of 2011, compared with 87% in both the second quarter and first six months of 2010. Because our Domestic Card business currently accounts for the substantial majority of our Credit Card business, the key factors driving the results for this division are similar to the key factors affecting our total Credit Card business. Table 7.1: Domestic Card Business Results
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Table of Contents
Our Domestic Card division generated net income from continuing operations of $642 million and $1.3 billion in the second quarter and first six months of 2011, respectively, compared with net income from continuing operations of $483 million and $855 million in the second quarter and first six months of 2010, respectively. The primary factors affecting Domestic Card results for the second quarter and the first six months of 2011, compared with the second quarter and the first six months of 2010 include: (1) a decline in total revenue attributable to a decrease in average loan yields as a result of reduced fees and the impact of the addition of the Kohl’s loan portfolio and lower average loan balances; (2) a significant reduction in the provision for loan and lease losses due to the continued improvement in credit performance metrics, including decreases in delinquency and charge-off rates; and (3) an increase in non-interest expense attributable to increased operating costs associated with higher purchase volumes and with the acquisitions of the Sony and Kohl’s loan portfolios, higher legal expenses and increased marketing expenditures. International Credit Card Business Table 7.2 summarizes the financial results for International Card and displays selected key metrics for the periods indicated. International Card accounted for 13% of total revenues for our Credit Card business in the second quarter of 2011 and 14% in the first six months of 2011, compared with 13% in both the second quarter and first six months of 2010. Table 7.2: International Card Business Results
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