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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
September 30, 2011 For the quarterly period ended September 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 October 31, 2011, there were 459,677,105 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 ContentsPART I—FINANCIAL INFORMATION Item 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 nine months ended September 30, 2011 and 2010, and selected comparative consolidated balance sheet data as of September 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. We had $130.0 billion in total loans outstanding and $128.3 billion in deposits as of September 30, 2011, compared with $125.9 billion in total loans outstanding and $122.2 billion in deposits as of December 31, 2010. 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. 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 nine months ended September 30, 2011 and 2010. We provide a reconciliation of our total business segment results to our consolidated results using generally accepted accounting principles in the U.S. (“U.S. GAAP”) 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 $813 million ($1.77 per diluted share) in the third quarter of 2011, with each of our three business segments contributing to our earnings. In comparison, we reported net income of $911 million ($1.97 per diluted share) in the second quarter of 2011 and net income of $803 million ($1.76 per diluted share) in the third quarter of 2010. Net income totaled $2.7 billion ($5.95 per diluted share) for the first nine months of 2011, compared with net income of $2.0 billion ($4.49 per diluted share) for the first nine months of 2010. Our capital levels continued to increase during the third quarter of 2011, with total stockholders’ equity up $2.8 billion from year-end 2010. Our Tier 1 risk-based capital ratio under Basel I was 12.4% and our Tier 1 common equity ratio, a non-GAAP measure, was 10.0% as of September 30, 2011, both up 60 basis points from the end of the second quarter of 2011, reflecting strong internal capital generation as well as the continued decline in the amount of disallowed deferred tax assets. Based on our current understanding of the Basel III framework, which has not been implemented by the U.S. banking agencies and is subject to change, we estimate that our Tier 1 common equity ratio was 10.1% as of September 30, 2011. Our stockholders’ equity and capital ratios do not reflect any impact from the equity forward sale agreements executed in July 2011 referenced below, as they have not been settled in whole or in part as of the date of this Report. We present the calculation of our regulatory capital ratios and a reconciliation of our supplemental non-GAAP capital measures below under “Supplemental Tables.” 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 rewards 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. As previously announced, 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 (“ING Direct”), in exchange for $6.2 billion in cash and approximately 55.9 million shares of our common stock, subject to certain adjustments. We continue to expect the ING Direct acquisition to close in late 2011 or early 2012, subject to customary closing conditions, including certain governmental clearances and approvals. In the third quarter of 2011, we closed a public underwritten offering of our senior notes, from which we received total proceeds of approximately $3.0 billion, and a public underwritten offering of 40 million shares of our common stock at a price per share of $50.00, subject to forward sale agreements. After underwriter’s discounts and commissions, the net proceeds to us from the equity offering will be at an initial forward sale price per share of $48.50. The forward sale price is subject to adjustment under the forward sale agreements. We have not received any proceeds from this public offering of our shares of common stock yet. 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 approximately $1.9 billion based on the initial forward price. 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. We expect to
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Table of Contentsuse the net proceeds from the debt and equity offerings, along with cash sourced from our current liquidity, to fund the $6.2 billion in cash consideration payable in connection with the ING Direct acquisition. In addition to the pending ING Direct acquisition, we announced in August 2011 that we had entered into a purchase agreement with HSBC Finance Corporation, HSBC USA Inc. and HSBC Technology and Services (USA) Inc. (collectively, “HSBC”), to acquire substantially all of the assets and assume liabilities of HSBC’s credit card and private-label credit card business in the United States for a premium estimated at $2.6 billion as of June 30, 2011. We currently expect the HSBC acquisition to close in the second quarter of 2012, subject to customary closing conditions, including certain governmental clearances and approvals. We took several actions during the quarter to manage the anticipated impact of the pending ING Direct acquisition on our market risk exposure and regulatory capital requirements. Since the date we entered into the agreement to acquire ING Direct, interest rates have declined substantially, and our current estimate of the fair value of the ING Direct net assets and liabilities has increased correspondingly. In order to capture some of the anticipated benefits to regulatory capital on the closing date attributable to this decline in interest rates, in August 2011, we entered into various pay-fixed/receive-floating interest-rate swap transactions with a total notional principal amount of approximately $23.8 billion. These swap transactions are designed to mitigate the effect of a rise in interest rates on the fair values of a significant portion of the ING Direct assets and liabilities during the period from when we entered into the swap transactions to the anticipated closing date of the ING Direct acquisition in late 2011 or early 2012. Although the interest-rate swaps represent economic hedges, they are not designated for hedge accounting. Accordingly, changes in the fair value are recorded in earnings. Our results for the third quarter of 2011 include a mark-to-market loss of $266 million related to these interest-rate swaps, which was attributable to a decline in interest rates as of the end of the quarter. Changes in the fair value of these interest-rate swaps will continue to be recorded in earnings until the swaps are terminated. We also sold approximately $6.4 billion of investment securities, consisting predominantly of agency mortgage-backed securities (“MBS”). We recorded a gain of $239 million on the sale of these securities, which largely offsets the mark-to-market loss recognized on the interest-rate swaps. We will continue to evaluate market conditions and may take additional balance sheet management actions, such as entering into similar swap transactions or selling additional investment securities, to manage the anticipated impact of the pending ING Direct and HSBC acquisitions on our market risk exposure and regulatory capital requirements. For additional detail, see “Market Risk Management” section of this Report and “Note 10—Derivative Instruments and Hedging Activities.” Below are additional highlights of our performance for the third quarter and first nine 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 September 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
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Business Segments
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Business Environment and Recent Developments Recent Business and Regulatory Developments The challenging economic environment intensified during the third quarter of 2011, due to concerns about the U.S. debt ceiling and subsequent downgrade of the U.S. debt, the continued elevated U.S. unemployment rate and the European debt crisis. These concerns resulted in increased economic uncertainty and market volatility. We have continued to monitor our portfolio credit performance for signs that these difficult market conditions are causing deterioration in our credit results. Our credit metrics are stabilizing with normal seasonality re-emerging after a long period of cyclical improvement. We believe actions we made in underwriting and managing our business through the recession, including focusing on our most resilient businesses, have continued to drive our strong credit performance. In addition, our recent partnerships and acquisitions have contributed to new account originations and a continued increase in purchase volumes in our Credit Card business. 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. 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, including the acquisition of HBC’s existing credit card loan portfolio in the first quarter of 2011, the acquisition of Kohl’s existing credit card loan portfolio in the second quarter of 2011 and our pending acquisitions of ING Direct and HSBC’s U.S. credit card business. 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. 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
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Table of Contentsanalysis 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 the risk factors set forth in 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 Our third quarter results continue to demonstrate the impact of our strategy to deliver profitable long-term growth through the acquisition and retention of franchise-enhancing customer relationships across our businesses. We believe we remain well-positioned to win in the marketplace and deliver shareholder value. We expect that the combined acquisitions of ING Direct and the HSBC U.S. credit card business will deliver attractive financial results in the near-term and put us in an even stronger position to enhance and sustain the value we can deliver to our customers, our communities and our shareholders over the long-term. We believe strong earnings will enable us to maintain strong capital levels and trajectory and that deep access to deposits will bolster our already-strong liquidity. Based on recent trends, including modest loan growth, and our targeted initiatives to attract new business and develop franchise-enhancing customer relationships, we believe the period of shrinking loans during the recession has come to an end. We expect modest year-over-year growth in ending loan balances in 2011. Although we expect an increase in period- end loans, we expect that average loan balances for 2011 will be comparable to average loan balances for 2010 given the lower loan balance starting point in 2011. Following the completion of the planned acquisitions of ING Direct and the HSBC U.S. credit card business, we expect our loan growth rate trajectory will be muted by the larger base of loans and the expected run-off of several of our legacy and acquired business loan portfolios. Business Segments Expectations Credit Card Business We believe that our Domestic Card loan balances reached a low point in the first quarter of 2011. We expect seasonal loan growth in the fourth quarter of 2011. We believe we remain well positioned to gain market share in the new level playing field resulting from the CARD Act. We believe the credit results in our Domestic Card business are stabilizing and exhibiting expected seasonal patterns. Consumer Banking Business In our Consumer Banking business, we expect that auto originations and returns will remain strong and drive growth in auto loans for 2011. We expect that the continuing run-off of the legacy home loan portfolio will largely offset the growth in auto loans. We believe we have reached a cyclical low point for auto finance charge-offs. We expect that the auto finance charge-off rate will increase in the fourth quarter of 2011, driven by seasonal patterns. Over the long run, competitive factors and moderation in auction prices for used vehicles is likely to create higher charge-off rates. 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 credit performance trajectory. However, we continue to expect some quarterly uncertainty and variability 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 the fourth quarter of 2011.
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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. We also discuss below refinements we made in the third quarter of 2011 in determining the estimated amount of uncollectible finance charges and fees for credit card loans. Management has discussed our critical accounting policies and estimates with the Audit and Risk Committee of the Board of Directors. Fair 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.
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Table of ContentsWe 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 20% of our total assets of $200.1 billion as of September 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 September 30, 2011, and approximately 2% of these financial instruments (less than 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.” Key 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 functions, 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. Revenue Recognition We recognize finance charges and fees on credit card loans when the amounts are billed to the customer and include these amounts in the loan balance, net of the estimated uncollectible amount of finance charges and fees. Our process for estimating the uncollectible amount of billed finance charges and fees is consistent with the process we use to estimate the allowance for incurred principal losses on our credit card loan receivables. We determine the adequacy of the uncollectible finance charge and fee reserve on a quarterly basis, primarily based on the use of a roll-rate methodology. We refine our estimation process and key assumptions used in
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Table of Contentsdetermining our loss reserves as additional information becomes available. In the third quarter of 2011, we revised the manner in which we estimate expected recoveries of finance charge and fee amounts previously considered to be uncollectible. Our revised recovery assumptions better reflect the post-recession pattern of relatively low delinquency roll-rates combined with increased recoveries of finance charges and fees previously considered uncollectible. This reduced the uncollectible finance charge and fee reserves by approximately $83 million as of September 30, 2011, and resulted in a corresponding increase in revenues of $83 million in the third quarter of 2011. We also applied these revised assumptions to the estimated recovery of principal charge-offs in determining our allowance for loan and lease losses. The revision, however, had an insignificant impact on the overall determination of our allowance for lease and loan losses as of September 30, 2011. 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 nine months ended September 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 nine months ended September 30, 2011 and 2010.
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Table 4 presents the variance between our net interest income for the three months ended September 30, 2011 and 2010, and for the nine months ended September 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)
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Table of ContentsOur net interest income of $3.3 billion for the third quarter of 2011 increased by $174 million, or 6%, from the third quarter of 2010, driven by a 2% (18 basis points) expansion in our net interest margin to 7.39% and a 3% increase in average interest-earning assets.
Our net interest income of $9.6 billion for the first nine months of 2011 increased by $125 million, or 1%, from the first nine months of 2010, driven by a 2% (15 basis points) expansion in our net interest margin to 7.28%, which was partially offset by a 1% decrease in average interest-earning assets.
Non-Interest Income Non-interest income consists of servicing and securitizations income, service charges and other customer-related fees, interchange income (net of rewards expense) and other 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 non-interest income. We also record the provision for mortgage repurchase losses related to continuing operations in non-interest income. The “other” component of non-interest income includes gains and losses on derivatives not accounted for in hedge accounting relationships
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Table of Contentsand gains and losses from the sale of investment securities, which we generally do not allocate to our business segments because they relate to centralized asset/liability and market risk management activities undertaken by our Corporate Treasury group. Table 5 displays the components of non-interest income for the three and nine months ended September 30, 2011 and 2010. Table 5: Non-Interest Income
Non-interest income of $871 million for the third quarter of 2011 decreased by $36 million, or 4%, from non-interest income of $907 million for the third quarter of 2010. The decrease in non-interest income for the third quarter of 2011 reflects the net impact of two significant items recorded during the quarter resulting from actions taken to reposition our balance sheet and manage the anticipated impact of the pending ING Direct acquisition on our market risk exposure and regulatory capital requirements. First, in August 2011, we entered into various pay-fixed/receive-floating interest-rate swap transactions with a total notional principal amount of approximately $23.8 billion. Since the date we entered into the agreement to acquire ING Direct, interest rates have declined substantially, and our current estimate of the fair value of the ING Direct net assets and liabilities has increased correspondingly. These swap transactions are intended to capture some of the anticipated benefits to regulatory capital on the closing date attributable to this decline in interest rates and designed to mitigate the effect of a rise in interest rates on the fair values of a significant portion of the ING Direct assets and liabilities during the period from when we entered into the swap transactions to the anticipated closing date of the ING Direct acquisition in late 2011 or early 2012. Although the interest-rate swaps represent economic hedges, they are not designated for hedge accounting. Accordingly, changes in the fair value are recorded in earnings. We recognized a mark-to-market loss of $266 million on these interest-rate swaps in the third quarter of 2011, which was attributable to the decline in interest rates as of the end of the quarter. Changes in the fair value of these interest-rate swaps will continue to be recorded in earnings until the swaps are terminated. Second, we sold approximately $6.4 billion of investment securities, consisting predominantly of agency MBS, during the third quarter of 2011. We recorded a gain of $239 million on the sale of these securities. The combined impact of the mark-to-market derivative loss and the gain on the sale of investment securities accounted for $27 million of the reduction in non-interest income in the third quarter of 2011.
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Table of ContentsNon-interest income of $2.7 billion for the first nine months of 2011 decreased by $105 million, or 4%, from non-interest income of $2.8 billion for the first nine months of 2010. This decrease was primarily due to the absence of a one-time pre-tax gain of $128 million recorded in the first quarter of 2010 and net gains on the sale of securities in 2010. We provide additional information on the reserve for representation and warranty claims below in “Consolidated Balance Sheet Analysis and Credit Performance—Potential Mortgage Representation and Warranty Liabilities.” 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 declined by $245 million to $622 million in the third quarter of 2011 and by $1.6 billion in the first nine months of 2011 to $ 1.5 billion, relative to 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, reflecting the improvement in the credit performance of our loan portfolio. The net charge-off rate was 2.52% and 3.02% for the third quarter and first nine months of 2011, respectively, compared with 4.82% and 5.41% for the third quarter and first nine months of 2010, respectively. As charge-offs declined, we recorded an allowance release of $208 million and $1.3 billion in the third quarter and first nine months of 2011, respectively. Our allowance releases have been significantly lower in 2011 relative to 2010, reflecting a stabilization of the improvement in credit trends. 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 nine months ended September 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 nine months ended September 30, 2011 and 2010. Table 6: Non-Interest Expense
Non-interest expense of $2.3 billion for the third quarter of 2011 was up $301 million, or 15%, from the third quarter of 2010. Non-interest expense of $6.7 billion for the first nine months of 2011 was up $871 million, or 15%, from the first nine months of 2010. The increase reflects the recognition of expense of $60 million and $90 million in the third quarter and first nine months of 2011, respectively, for contingent payments related to
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Table of Contentsacquisitions and partnership agreements. In addition, our operating costs have increased due in part to the integration of the recent acquisitions of the Sony, HBC and Kohl’s loan portfolios, as well as higher marketing costs. We have expanded our marketing efforts to attract and support targeted customers and new business volume through a variety of channels. We provide additional information on contingent payment arrangements in “Note 15—Commitments, Contingencies and Guarantees.” Income Taxes We recorded an income tax provision based on income from continuing operations of $370 million (30.0% effective income tax rate) in the third quarter of 2011, compared with an income tax provision of $335 million (29.1 % effective income tax rate) in the third quarter of 2010, and $1.2 billion (29.2% effective income tax rate) for the first nine months of 2011, compared with $948 million (28.8% effective income tax rate) for the first nine months of 2010. We recorded tax benefits of $98 million in the first nine months of 2011, which were related to the release of a valuation allowance against certain state deferred tax assets and net operating loss carryforwards and the resolution of certain tax issues and audits. We monitor the status of our deferred tax assets on a regular basis. The release of the deferred tax valuation allowance reflects our projected ability to utilize the deferred tax assets to offset future taxable income based on our achieving sustained profitability in certain tax jurisdictions. We recorded tax benefits of $71 million in the first nine months of 2010, which were related to adjustments for the resolution of certain tax issues and audits. Our effective income tax rate excluding the benefit from these discrete tax benefit items was 31.7% and 30.9% for the first nine months of 2011 and 2010, respectively. The higher effective income tax rate for the first nine months of 2011 was primarily attributable to the recognition of expense for non-deductible contingent payments related to certain acquisitions. 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 $52 million and $102 million in the third quarter and first nine months of 2011, respectively. In comparison, we recorded a loss from discontinued operations, net of tax, of $15 million and $303 million in the third quarter and first nine months of 2010, respectively. The increase in the loss from discontinued operations in the third quarter of 2011 was attributable to the recognition of an additional provision for mortgage repurchase losses due to an increase in repurchase activity with respect to certain uninsured investors. The decrease in the loss from discontinued operations in the first nine months of 2011 was attributable to a significant reduction in the provision for mortgage repurchase losses. We provide 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.
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Table of ContentsThe 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. Certain activities that are not part of a segment, such as management of our corporate investment portfolio and asset/liability management by our centralized Corporate Treasury group are included in the “Other” category. 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 nine months ended September 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 September 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.” Credit Card Business Our Credit Card business generated net income from continuing operations of $663 million and $1.9 billion in the third quarter and first nine months of 2011, respectively, compared with net income from continuing operations of $631 million and $1.7 billion in the third quarter and first nine 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 a 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 $206 million and $421 million in the third quarter and first nine months of 2011, respectively, for amounts earned by Kohl’s. Loss sharing amounts attributable to Kohl’s reduced charge-offs by $39 million and $80 million in the third quarter and first nine months of 2011, respectively. In addition, the
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Table of Contentsexpected reimbursement from Kohl’s netted in our allowance for loan and lease losses was approximately $156 million as of September 30, 2011. The reduction in the provision for loan and lease losses attributable to Kohl’s was $236 million for the first nine 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.” Table 7: Credit Card Business Results
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Key factors affecting the results of our Credit Card business for the third quarter and first nine months of 2011, compared with the third quarter and first nine months of 2010 included the following:
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Domestic 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 86% of total revenues for our Credit Card business in both the third quarter and first nine months of 2011, compared with 87% in both the third quarter and first nine 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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Domestic Card generated net income from continuing operations of $637 million and $1.9 billion in the third quarter and first nine months of 2011, respectively, compared with net income from continuing operations of $544 million and $1.4 billion in the third quarter and first nine months of 2010, respectively. The increase in Domestic Card net income from continuing operations in the third quarter of 2011, compared with the third quarter of 2010 was driven by: (1) an increase in total revenue attributable to a benefit of approximately $78 million in the third quarter of 2011 from the revision we made in the way we estimate recoveries in determining the uncollectible amount of finance charges and fees; (2) a significant reduction in the provision for loan and lease losses due to the improvement in credit performance metrics, including decreases in delinquency and charge-off rates; and (3) an increase in non-interest expense attributable to higher operating and integration costs related to the acquisitions of the credit card loan portfolios of Sony and Kohl’s, coupled with increased marketing expenditures. The increase in Domestic Card net income from continuing operations in the first nine months of 2011, compared with the first nine months of 2010 was driven by: (1) a decline in total revenue attributable to lower average loan balances and a decrease in average loan yields as a result of reduced fees and the impact of the addition of the Kohl’s loan portfolio; (2) a significant reduction in the provision for loan and lease losses due to the 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 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 14% of total revenues for our Credit Card business in the third quarter and first nine months of 2011, compared with 13% in both the third quarter and first nine months of 2010.
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Table of ContentsTable 7.2: International Card Business Results
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