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Capital One Financial 10-Q 2012 Table of Contents
UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q
For the quarterly period ended March 31, 2012 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 April 30, 2012, there were 580,342,796 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 (“MD&A”) This 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 2011 Annual Report on Form 10-K (“2011 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 2011 Form 10-K in “Part I—Item 1A. Risk Factors.”
SUMMARY OF SELECTED FINANCIAL DATA
Below we provide selected consolidated financial data from our results of operations for the three months ended March 31, 2012 and 2011, and selected comparative consolidated balance sheet data as of March 31, 2012, and December 31, 2011. We also provide selected key metrics we use in evaluating our performance. On February 17, 2012, we completed the previously announced acquisition (the “ING Direct acquisition”) of substantially all of the ING Direct business in the United States (“ING Direct”) from ING Groep N.V., ING Bank N.V., ING Direct N.V. and ING Direct Bancorp, which resulted in the addition of loans of $40.4 billion, other assets of $53.9 billion and deposits of $84.4 billion at acquisition. The ING Direct acquisition had a significant impact on our results and selected metrics for the three months ended and as of March 31, 2012. We use the term “acquired loans” to refer to the substantial majority of loans acquired in the ING Direct and Chevy Chase Bank business combinations, which were recorded at fair value at acquisition and subsequently accounted for based on expected cash flows to be collected. Because this accounting methodology takes into consideration estimated credit losses expected to be realized over the remaining estimated lives of the loans, including these acquired loans in our credit quality metrics may have a material impact. We therefore present certain credit quality metrics with and without these acquired loans. Table 1: Consolidated Financial Highlights (Unaudited)
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INTRODUCTION
We are 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 Capital One Bank (USA), National Association (“COBNA”), Capital One, National Association (“CONA”) and ING Bank, fsb. The Company and its subsidiaries are hereafter collectively referred to as “we,” “us” or “our.” CONA and COBNA are hereafter collectively referred to as the “Banks.” We continue to deliver on our strategy of combining the power of national scale lending and local scale banking. The closing of the ING Direct acquisition in the first quarter of 2012 resulted in the addition of loans of $40.4 billion and other assets of $53.9 billion at acquisition. The ING Direct acquisition strengthens our customer franchise and brand and adds over seven million customers and approximately $84.4 billion in deposits to our Consumer Banking business segment. With the ING Direct acquisition, we have grown to become the sixth largest depository institution and the largest direct banking institution in the United States. We had $173.8 billion in total loans outstanding and $216.5 billion in deposits as of March 31, 2012, compared with $135.9 billion in total loans outstanding and $128.2 billion in deposits as of December 31, 2011. 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, such as fee-based services provided to customers, merchant interchange fees with respect to certain credit card transactions, gains and losses and fees associated with the sale and servicing of loans. Our expenses primarily consist of the cost of funding our assets, our provision for credit 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 primary business segments, which are defined primarily 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.
In the first quarter of 2012, we re-aligned the reporting of our Commercial Banking business to reflect the operations on a product basis rather than by customer type. Table 2 summarizes our business segment results, which we report based on income from continuing operations, net of tax, for the three months ended March 31, 2012 and 2011. We provide additional information on the realignment of our Commercial Banking business segment below under “Business Segment Results” and in “Note 14—Business Segments” of this Report. We also provide a reconciliation of our total business segment results to our consolidated U.S. GAAP results in “Note 14—Business Segments.”
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Table of ContentsTable 2: Business Segment Results
EXECUTIVE SUMMARY AND BUSINESS OUTLOOK
Despite ongoing challenges and uncertainties, including high oil and gas prices and global economic concerns, the U.S. economy showed positive trends during the first quarter of 2012. Our results for the first quarter of 2012 reflected the impact of growth in consumer and business spending, coupled with traction from our geographic expansion and strategy to deepen our customer relationships, and credit performance improvement. The completion of our previously announced ING Direct acquisition also had a significant impact on our results during the first quarter. We believe that cyclical and seasonal improvement trends, as well as actions we took in underwriting and managing our business through the recession, including focusing on our most resilient businesses, have continued to drive our strong credit performance. Financial Highlights We reported net income of $1.4 billion, or $2.72 per diluted share, for the first quarter of 2012 on revenues of $4.9 billion, with each of our three business segments contributing to our earnings. Current-quarter results include an approximate half-quarter impact from the operations of ING Direct and a benefit from the recognition of a bargain purchase gain of $594 million in the ING Direct acquisition. The bargain purchase gain represents the excess of the fair value of the net assets acquired in the ING Direct acquisition as of the acquisition date over the consideration transferred. This gain was driven largely by a substantial decline in long-term interest rates between the period of our announcement of the ING Direct acquisition and its closing, which resulted in an increase in the fair value of the acquired assets. Net income excluding the impact of the bargain purchase gain was $809 million, or $1.56 per diluted share, for the first quarter of 2012. In comparison, we reported net income of $1.0 billion, or $2.21 per diluted share, for the first quarter of 2011 on revenues of $4.1 billion. Our capital levels strengthened during the quarter, driven by strong earnings growth and capital actions related to the financing of the ING Direct acquisition and the acquisition of HSBC’s U.S. credit card business. On March 20, 2012, we closed a public offering of 24,442,706 shares of our common stock, which we sold to the underwriters at a per share price of $51.14 for net proceeds of approximately $1.24 billion. On February 16, 2012, we issued 40 million shares of our common stock at settlement of the forward sale agreements that we entered into with certain counterparties acting as forward purchasers in connection with a public offering of shares of our common stock on July 19, 2011 for net proceeds of $1.9 billion. In addition, on February 17, 2012, we issued 54,028,086 shares of our common stock to the ING Sellers with a fair value of $2.6 billion. Our recent equity issuances contributed to a significant increase in our regulatory capital ratios, with the Tier 1 common
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Table of Contentsratio increasing by 220 basis points during the quarter to 11.9% as of March 31, 2012. The Tier 1 risk-based capital ratio increased to 13.9% as of March 31, 2012, from 12.0% as of December 31, 2011. In addition, we issued $1.25 billion of our senior notes due 2015 in a public offering, that closed on March 23, 2012. Below are additional highlights of our performance for the first quarter of 2012. These highlights generally are based on a comparison to the same prior year period. The changes in our financial condition and credit performance are generally based on our financial condition and credit performance as of March 31, 2012, compared with our financial condition and credit performance as of December 31, 2011. 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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Significant Recent Developments Acquisition-Related Developments HSBC Acquisition—U.S. Credit Card Business We completed the transaction in which we acquired substantially all of the assets and assumed liabilities of HSBC’s credit card and private-label credit card business in the United States (the “HSBC Transaction”) for a purchase price of $31.3 billion on May 1, 2012. In the HSBC Transaction, the Company acquired $28.2 billion of credit card receivables and $0.6 billion in other net assets. We used the net proceeds from the equity and debt offerings described above, along with cash sourced from current liquidity, to fund the cash consideration payable in connection with the acquisition of HSBC’s U.S credit card business. 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 Quarterly Report on Form 10-Q. 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
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Table of Contentseconomic 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 2011 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, except for the forward-looking statements specifically discussing the acquisition of ING Direct or of HSBC’s U.S. credit card business, 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 Quarterly Report on Form 10-Q for more information on the forward-looking statements in this report and “Item 1A. Risk Factors” in our 2011 Form 10-K for factors that could materially influence our results. Total Company Expectations 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, 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 attract and retain credit card and auto finance customers and further strengthen our brand. We believe our actions have created a well-positioned balance sheet and capital and liquidity levels which have provided us with investment flexibility to take advantage of attractive organic growth opportunities and adjust, where we believe appropriate, to changing market conditions. The addition of ING Direct and of the HSBC’s U.S. credit card business has grown our loan balances. Although we anticipate strong underlying growth in our Auto Finance, Commercial Banking and Domestic Card segments, we expect modest overall loan growth because of significant run-off portfolios that we acquired in the ING Direct Acquisition and HSBC Transaction. The timing and pace of this modest loan growth will depend on broader economic trends that impact overall consumer and commercial demand. As noted above, we closed the HSBC Transaction in the second quarter of 2012. We expect that the closing of the HSBC Transaction will have a significant impact on our financial results in the second quarter. While we expect the acquisition to enhance our earnings trajectory and capital generation in the long-term, we anticipate that it will have a substantial negative effect on earnings and capital in the short-term. We anticipate that the largest impact on our earnings for the second quarter of 2012 from the HSBC Transaction, will result from an increase in our provision for credit losses due to an expected significant build in the allowance for loan and lease losses associated with loans acquired in the transaction. Over the next several years, we expect expenses and earnings to be affected by the amortization of intangibles as well as transaction and merger-related expenses. Business Segment Expectations Credit Card Business In Domestic Card, the closing of the HSBC Transaction has added significant new customer relationships and loan portfolios and will affect quarterly trends in loan growth, revenue margin, non-interest expense, charge-off rates and earnings. We anticipate that the run-off of parts of the portfolios acquired in the HSBC Transaction will offset the underlying growth trajectory, resulting in modest loan growth for the segment. We expect to take a credit mark to cover expected losses on delinquent loans in the HSBC portfolio that no longer carry revolving privileges. We
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Table of Contentsanticipate the credit mark would absorb most of the HSBC credit losses for the next several quarters, lowering the overall charge-off rate of the Domestic Card segment during that time. When we announced the HSBC Transaction, we planned to take certain actions to bring HSBC customer practices into alignment with our customer practices. We expect that these planned actions will put downward pressure on Domestic Card revenue margin as we implement them over the next several quarters. The overall trends and level of Domestic Card revenue margin will depend upon the competitive environment, the pace and nature of Domestic Card loan growth, and other market forces in addition to the expected impact from our planned customer actions. Consumer Banking Business In our Consumer Banking business, we added significant new customer relationships, loans and deposits with the acquisition of ING Direct, and the acquisition will have a significant impact on Consumer Banking loan and deposit growth trajectories. The addition of the ING Direct loan portfolio caused loan yields to decrease. We expect loan yields will decrease again in the second quarter after which we expect them to remain relatively stable because we anticipate loan yield increases from the expected mortgage run-off to be offset by loan yield decreases from a higher mix of prime loans in our Auto Finance business in 2012. We expect that the growth in auto loans will be more than offset by a sizeable run-off of the ING Direct home loan portfolio and the continuing run-off of certain loans in our legacy Home Loan portfolio, which will drive a declining trend in Consumer Banking loan volumes. We expect that seasonal patterns will drive quarterly credit trends throughout the rest of 2012. Commercial Banking Business Our Commercial Banking business continues to grow loans, deposits, and revenues as we attract new customers and deepen relationships with existing customers. Although we anticipate some quarterly fluctuations in nonperforming loan and charge-off rates, we expect our Commercial Banking business to continue strong and relatively steady performance trends throughout 2012.
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 2011 Form 10-K. In the “MD&A—Critical Accounting Policies and Estimates” section of our 2011 Form 10-K, we 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.
We evaluate our critical accounting estimates and judgments on an ongoing basis and update them as necessary based on changing conditions. Management has reviewed and approved these critical accounting policies and has discussed our judgments and assumptions with the Audit and Risk Committee of the Board of Directors. There has been no material changes in the methods used to formulate these critical accounting estimates from those discussed in the “MD&A—Critical Accounting Policies and Estimates” section of our 2011 Form 10-K.
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CONSOLIDATED RESULTS OF OPERATIONS
The section below provides a comparative discussion of our consolidated financial performance for the three months ended March 31, 2012 and 2011. 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 average yield or cost for the first quarter of 2012 and 2011.
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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 variances between our net interest income for the first quarter of 2012 and 2011, 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)
Net interest income of $3.4 billion for the first quarter of 2012 increased by $274 million, or 9%, from the first quarter of 2011, driven by a 27% increase in average interest-earning assets, which was partially offset by a 14% decline in our net interest margin to 6.20%. The addition of the ING Direct loan portfolio of $40.4 billion, which primarily consisted of consumer loans, and investment security portfolio of $30.2 billion, accounted for approximately $136 million of the $274 million increase in net interest income.
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Non-Interest Income Non-interest income primarily consists of 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 and 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 first quarter of 2012 and 2011. Table 5: Non-Interest Income
Non-interest income of $1.5 billion for the first quarter of 2012 increased by $579 million, or 61%, from non-interest income of $942 million for the first quarter of 2011. This increase was attributable to the recognition of a bargain purchase gain of $594 million at acquisition of ING direct and income of $162 million related to the sale of Visa stock shares in the first quarter of 2012. The bargain purchase gain represents the excess of the fair value of the net assets acquired in the ING Direct acquisition as of the acquisition date over the consideration transferred. This gain was driven largely by a substantial decline in long-term interest rates between the period shortly after our announcement of the ING Direct acquisition and the closing of the acquisition, which resulted in an increase in the fair value of the acquired assets. We provide additional information on the allocation of the ING Direct purchase price to the fair values of assets acquired and liabilities assumed and the bargain purchase gain in “Note 2—Acquisitions.”
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Table of ContentsThese income amounts were partially offset by the recognition of expense of $75 million in the first quarter of 2012 to establish a reserve for expected customer refunds attributable to issues associated with cross-selling certain other products to credit card customers and a mark-to-market loss of $78 million recorded in the first quarter of 2012 for interest-rate swaps we entered into in 2011 to partially hedge the interest rate risk of the net assets associated with the ING Direct acquisition. The cumulative mark-to-market loss on these interest-rate swaps, which we terminated in the first quarter of 2012, from inception to termination totaled $355 million. See the “Market Risk Profile” section below and “Note 10—Derivative Instruments and Hedging Activities” for additional information on the ING Direct acquisition related hedges. We also recorded higher other-than-temporary impairment losses of $14 million in the first quarter of 2012, compared with $3 million in the first quarter of 2011. The impairment losses stemmed from deterioration in the credit quality of certain non-agency mortgage-backed securities due to the continued weakness in the housing market. We provide additional information on other-than-temporary impairment recognized on our available-for-sale securities in “Note 4—Investment Securities.” Provision for Credit Losses We build our allowance for loan and lease losses and unfunded lending commitment reserves through the provision for credit losses. Our provision for credit 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. We recorded a provision for credit losses of $573 million in the first quarter of 2012, compared with $534 million in the first quarter of 2011. The increase in the provision was driven primarily by the year-over-year increase in legacy loan balances and smaller allowance releases as a result of the stabilization of the improvement in credit trends. The net charge-off rate steadily declined, falling to 2.04% in the first quarter of 2012, from 2.69% in the fourth quarter of 2011 and 3.66% in the first quarter of 2011. The net charge-off rate excluding acquired loans was 2.40% in the first quarter of 2012, compared with 2.79% in the fourth quarter of 2011 and 3.82% in the first quarter of 2011. We provide additional information on the provision for credit losses and changes in the allowance for loan and lease losses under the “Credit Risk Profile—Summary of Allowance for Loan and Lease Losses” section below. 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 and occupancy costs, and miscellaneous expenses. Marketing expenses are also included in non-interest expense. Table 6 displays the components of non-interest expense for the first quarter of 2012 and 2011.
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Table of ContentsTable 6: Non-Interest Expense
Non-interest expense of $2.5 billion for the first quarter of 2012 increased by $342 million, or 16%, from the first quarter of 2011. The increase was primarily due to higher operating expenses related to our recent acquisitions, including an estimated $150 million of half-quarter operating expenses attributable to ING Direct, increased marketing expenditures, primarily related to reward products in our Credit Card business and higher infrastructure costs from our continued investments in our home loan business and growth in auto originations. Income Taxes We recorded an income tax provision based on income from continuing operations of $353 million (19.0% effective income tax rate) in the first quarter of 2012, compared with an income tax provision of $354 million (25.5% effective income tax rate) in the first quarter of 2011. The decrease in our effective tax rate in the first quarter of 2012 from the first quarter of 2011 was primarily due to the ING Direct bargain purchase gain of $594 million, which was non-taxable. In addition, we recorded tax benefits of $6 million and $42 million in the first quarter of 2012 and 2011, respectively, related to the resolution of certain discrete tax issues and audits. Our effective income tax rate, excluding both the impact of the non-taxable bargain purchase gain and the benefit from these discrete tax issues and audits, was 28.4% and 28.6% in the first quarter of 2012 and 2011, respectively. We provide additional information on items affecting our income taxes and effective tax rate in our 2011 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 pre-tax provision for mortgage repurchase losses of $169 million in the first quarter of 2012, of which $153 million ($97 million, net of tax) was included in discontinued operations. In comparison, we recorded a pre-tax provision for mortgage repurchase losses of $44 million in the first quarter of 2011, of which $39 million ($29 million, net of tax) was included in discontinued operations. The increase in the provision for
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Table of Contentsrepurchase losses was primarily due to a GSE settlement to resolve present and future representation and warranty claims. We had already established an estimated reserve related to the GSE claims; however, we increased this reserve by $95 million in the first quarter of 2012 based on the final settlement amount, which we paid subsequent to the end of the first quarter of 2012. We provide additional information on the provision for mortgage repurchase losses and the related reserve for potential representation and warranty claims in “Consolidated Balance Sheet Analysis—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. 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. 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. See “Note 20—Business Segments” of our 2011 Form 10-K for information on the allocation methodologies used to derive our business segment results. 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. In the first quarter of 2012, we re-aligned the reporting of our Commercial Banking business to reflect the operations on a product basis rather than by customer type. As a result of this re-alignment, we now report three product categories: commercial and multifamily real estate, commercial and industrial loans and small-ticket commercial real estate, which is a run-off portfolio. We previously reported four categories within our Commercial Banking business: commercial and multifamily real estate, middle market, specialty lending and small-ticket commercial real estate. Middle market and specialty lending related products are included in commercial and industrial loans. All tax-related commercial real estate investments, some of which were previously included in the “Other” segment, are now included in the commercial and multifamily real estate category of our Commercial Banking business. Prior period amounts have been recast to conform to the current period presentation. We summarize our business segment results for the three months ended March 31, 2012 and 2011 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 March 31, 2012, compared with December 31, 2011. See “Note 14—Business Segments” of this Report for a reconciliation of our business segment results to our consolidated 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 $566 million in the first quarter of 2012, compared with $643 million in the first quarter of 2011. The primary sources of revenue for our Credit Card business are net interest income and non-interest income from customers and interchange fees. Expenses primarily consist of ongoing operating costs, such as salaries and associate benefits, communications and other technology expenses, supplies and equipment, occupancy costs, as well as marketing expenses.
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Table of ContentsTable 7 summarizes the financial results of our Credit Card business, which is comprised of Domestic Card, including installment loans, and International Card operations, and displays selected key metrics for the periods indicated. Table 7: Credit Card Business Results
Key factors affecting the results of our Credit Card business for the first quarter of 2012, compared with first quarter of 2011 included the following:
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Domestic Card Business Domestic Card generated net income from continuing operations of $515 million in the first quarter of 2012, compared with net income from continuing operations of $654 million in the first quarter of 2011. Since 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. The decrease in Domestic Card net income from continuing operations in the first quarter of 2012 compared with first quarter of 2011 was driven by: (1) an increase in the provision for credit losses due to a lower allowance release of $170 million in the first quarter of 2012 compared to a $574 million allowance release in the first quarter of 2011 which was partially offset by lower net charge-offs of $531 million in the first quarter of 2012 compared to $804 million in the first quarter of 2011, (2) an increase in non-interest expense primarily due to increased marketing expenses as we continue to experience growth opportunities in certain customer segments and (3) a decrease in non-interest income primarily as a result of a $75 million reserve build in cross-sell for anticipated customer refunds associated with past cross-selling activities.
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Table of ContentsTable 7.1 summarizes the financial results for Domestic Card and displays selected key metrics for the periods indicated. Table 7.1: Domestic Card Business Results
International Card Business Our International Card business generated net income from continuing operations of $51 million in the first quarter of 2012, compared with a net loss from continuing operations of $11 million in the first quarter of 2011. The increase in International Card net income in the first quarter of 2012 was driven primarily by: (1) a decrease in provision for loan losses as a result of an allowance release of $6 million in the first quarter of 2012 compared to an allowance build of $109 million in first quarter of 2011 due to the addition of the Hudson’s Bay Company (“HBC”) loan portfolio, and lower net charge-offs of $115 million in the first quarter of 2012 compared to $125 million in the first quarter of 2011 attributable to the improvement in credit environment in Canada and the U.K. and (2) partially offset by an increase in non-interest expense of $28 million from higher operating expenses in both the U.K. and Canada.
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Table of ContentsTable 7.2 summarizes the financial results for International Card and displays selected key metrics for the periods indicated. Table 7.2: International Card Business Results
Consumer Banking Business Our Consumer Banking business generated net income from continuing operations of $224 million in the first quarter of 2012, compared with net income from continuing operations of $215 million in the first quarter of 2011. The primary sources of revenue for our Consumer Banking business are net interest income from loans and deposits and non-interest income from customer fees. Expenses primarily consist of ongoing operating costs, such as salaries and associated benefits, communications and other technology expenses, supplies and equipment and occupancy costs.
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Table of ContentsOn February 17, 2012, we acquired ING Direct, and the substantial majority of the lending and retail deposit businesses acquired are reported in the Consumer Banking segment. The acquisition resulted in the addition of loans with carrying value of $40.4 billion and deposits of $84.4 billion at acquisition. Table 8 summarizes the financial results of our Consumer Banking business and displays selected key metrics for the periods indicated. Table 8: Consumer Banking Business Results
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Net income generated by our Consumer Banking business of $224 million for the first quarter of 2012 represented an increase of $9 million over the first quarter of 2011. Key factors contributing to the increase in the results of our Consumer Banking business for the first quarter of 2012, compared with the first quarter of 2011 included the following:
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Commercial Banking Business Our Commercial Banking business generated net income from continuing operations of $210 million in the first quarter of 2012, compared with net income from continuing operations of $162 million in first quarter of 2011. The primary sources of revenue for our Commercial Banking business are net interest income from loans and deposits and non-interest income from customer fees. Expenses primarily consist of ongoing operating costs, such as salaries and associated benefits, communications and other technology expenses, supplies and equipment and occupancy costs. Because we have some tax-related commercial investments that generate tax-exempt income or tax credits, we make certain reclassifications to our Commercial Banking business results to present revenues on a taxable-equivalent basis.
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Table of ContentsTable 9 summarizes the financial results of our Commercial Banking business and displays selected key metrics for the periods indicated. Table 9: Commercial Banking Business Results
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Key factors affecting the results of our Commercial Banking business for the first quarter of 2012, compared with the first quarter of 2011 included the following:
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CONSOLIDATED BALANCE SHEET ANALYSIS AND CREDIT PERFORMANCE
Total assets of $294.5 billion as of March 31, 2012 increased by $88.5 billion, or 43%, from $206.0 billion as of December 31, 2011. Total liabilities of $257.5 billion as of March 31, 2012, increased by $81.1 billion, or 46%, from $176.4 billion as of December 31, 2011. Stockholders’ equity increased by $7.3 billion during the first three months of 2012, to $37.0 billion as of March 31, 2012 from $29.7 billion as of December 31, 2011. The increase in stockholders’ equity was primarily attributable to our net income of $1.4 billion in the first quarter of 2012 and the $5.8 billion in equity issuances in the first quarter of 2012. Following is a discussion of material changes in the major components of our assets and liabilities during the first three months of 2012. Investment Securities Our investment securities portfolio, which had a fair value of $60.8 billion and $38.8 billion, as of March 31, 2012 and December 31, 2011, respectively, consists of the following: U.S. Treasury and U.S. agency debt obligations; agency and non-agency mortgage-backed securities; other asset-backed securities collateralized primarily by credit card loans, auto loans, student loans, auto dealer floor plan inventory loans, equipment loans and home equity lines of credit; municipal securities; foreign government/agency bonds; covered bonds; and limited Community Reinvestment Act (“CRA”) equity securities. Our investment securities portfolio continues to be heavily concentrated in securities that generally have lower credit risk and high credit ratings, such as securities issued and guaranteed by the U.S. Treasury and government sponsored enterprises or agencies. Our investments in U.S. Treasury and agency securities, based on fair value, represented 72% of our total investment securities portfolio as of March 31, 2012, compared with 69% as of December 31, 2011. All of our investment securities were classified as available for sale as of March 31, 2012 and reported in our consolidated balance sheet at fair value. Table 10 presents the amortized cost and fair value for the major categories of our investment securities as of March 31, 2012 and December 31, 2011. Table 10: Investment Securities
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Investment securities increased by $22.1 billion, or 57%, in the first quarter of 2012 to $60.8 billion as of March 31, 2012, from $38.8 billion as of December 31, 2011. The increase was primarily attributable to the acquisition of ING Direct which included investment securities of $30.2 billion at acquisition. We sold approximately $7.3 billion of investment securities, consisting predominantly of agency MBS and FDIC notes in the first quarter of 2012. We recorded a net gain of $11 million on the sale of these securities. We provide additional information in “Market Risk Profile.” Unrealized gains and losses on our available-for-sale securities are recorded net of tax as a component of accumulated other comprehensive income (“AOCI”). We had gross unrealized gains of $721 million and gross unrealized losses of $228 million on available-for sale securities as of March 31, 2012, compared with gross unrealized gains of $683 million and gross unrealized losses of $227 million on available-for sale securities as of December 31, 2011. The substantial majority of the gross unrealized losses as of March 31, 2012 related to non-agency residential MBS. Of the $228 million gross unrealized losses as of March 31, 2012, $125 million related to securities that had been in a loss position for more than 12 months. We recognized net OTTI on debt securities of $14 million in the first quarter of 2012. In comparison, we recognized net OTTI on investment securities of $3 million in the first quarter of 2011, which was due in part to the deterioration in the credit performance and outlook of certain non-agency securities as a result of continued weaknesses in the housing market.
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Table of ContentsWe provide additional information on our available-for-sale securities in “Note 4—Investment Securities.” Credit Ratings Our investment securities portfolio continues to be heavily concentrated in securities that generally have lower credit risk and high credit ratings, such as securities issued and guaranteed by the U.S. Treasury and government sponsored enterprises or agencies. Approximately 91% of our total investment securities portfolio was rated AA+ or its equivalent, or better as of both March 31, 2012 and December 31, 2011, while approximately 6% and 4% were below investment grade as of March 31, 2012 and December 31, 2011, respectively. We categorize the credit ratings of our investment securities based on the lowest credit rating as issued by the rating agencies S&P, Moody’s Investors Service (“Moody’s”) and Fitch Ratings (“Fitch”). Table 11 provides information on the credit ratings of our non-agency residential MBS, non-agency commercial MBS and asset-backed securities, which accounted for the substantial majority of the unrealized losses related to our investment securities portfolio as of March 31, 2012 and December 31, 2011. Table 11: Non-Agency Investment Securities Credit Ratings
Total Loans Table 12 summarizes loans held for investment, net of the allowance for loan and lease losses, as of March 31, 2012 and December 31, 2011. Table 12: Net Loans Held for Investment
Total loans held for investment increased by $37.9 billion, or 28%, in the first quarter of 2012 to $173.8 billion as of March 31, 2012, from $135.9 billion as of December 31, 2011. The increase was primarily attributable to the acquisition of ING Direct which included loans of $40.4 billion. Partially offsetting the increase in loans was the continued expected run-off of loans in businesses we exited or repositioned early in the economic recession, other loan pay downs and charge-offs. The run-off portfolios include installment loans in our Credit Card business, home loans in our Consumer Banking business and small-ticket commercial real estate loans in our Commercial Banking business. We provide additional information on the composition of our loan portfolio and credit quality below in “Credit Risk Profile.”
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Table of ContentsDeposits Our deposits have become our largest source of funding for our operations and asset growth. Total deposits increased by $88.3 billion, or 69%, in the first quarter of 2012, to $216.5 billion as of March 31, 2012, from $128.2 billion as of December 31, 2011. The increase in deposits reflects the addition of $84.4 billion in deposits from the ING Direct acquisition and increased retail marketing efforts to attract new business and continued strategy to leverage our bank outlets to attract lower cost deposit funding. We provide additional information on the composition of our deposits, average outstanding balances, interest expense and yield below in “Liquidity Risk Profile.” Senior and Subordinated Notes and Other Borrowings Senior and subordinated notes and other borrowings decreased to $17.4 billion as of March 31, 2012, from $23.0 billion as of December 31, 2011. The $5.6 billion decrease in our debt, which excludes securitized debt obligations, was primarily attributable to an approximately $5.8 billion decrease in short-term FHLB advances offset by an increase of $1.0 billion in unsecured senior debt. We provide additional information on our borrowings in “Note 9—Deposits and Borrowings.” Securitized Debt Obligations Borrowings owed to securitization investors decreased by $1.0 billion to $15.5 billion as of March 31, 2012, from $16.5 billion as of December 31, 2011. This decrease was attributable to pay downs of the loans underlying the consolidated non-credit card securitization trusts and the scheduled maturities of the debt within our credit card securitization trusts. Potential Mortgage Representation & Warranty Liabilities In recent years, we acquired three subsidiaries that originated residential mortgage loans and sold them to various purchasers, including purchasers who created securitization trusts. These subsidiaries are Capital One Home Loans, which was acquired in February 2005; GreenPoint Mortgage Funding, Inc. (“GreenPoint”), which was acquired in December 2006 as part of the North Fork acquisition; and Chevy Chase Bank, which was acquired in February 2009 and subsequently merged into CONA. In connection with their sales of mortgage loans, the subsidiaries entered into agreements containing varying representations and warranties about, among other things, the ownership of the loan, the validity of the lien securing the loan, the loan’s compliance with any applicable loan criteria established by the purchaser, including underwriting guidelines and the ongoing existence of mortgage insurance, and the loan’s compliance with applicable federal, state and local laws. The representations and warranties do not address the credit performance of the mortgage loans, but mortgage loan performance often influences whether a claim for breach of representation and warranty will be asserted and has an effect on the amount of any loss in the event of a breach of a representation or warranty. Each of these subsidiaries may be required to repurchase mortgage loans in the event of certain breaches of these representations and warranties. In the event of a repurchase, the subsidiary is typically required to pay the then unpaid principal balance of the loan together with interest and certain expenses (including, in certain cases, legal costs incurred by the purchaser and/or others). The subsidiary then recovers the loan or, if the loan has been foreclosed, the underlying collateral. The subsidiary is exposed to any losses on the repurchased loans after giving effect to any recoveries on the collateral. In some instances, rather than repurchase the loans, a subsidiary may agree to make a cash payment to make an investor whole on losses or to settle repurchase claims. In addition, our subsidiaries may be required to indemnify certain purchasers and others against losses they incur as a result of certain breaches of representations and warranties. In some cases, the amount of such losses could exceed the repurchase amount of the related loans.
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Table of ContentsThese subsidiaries, in total, originated and sold to non-affiliates approximately $111 billion original principal balance of mortgage loans between 2005 and 2008, which are the years (or “vintages”) with respect to which our subsidiaries have received the vast majority of the repurchase requests and other related claims. Table 13 presents the original principal balance of mortgage loan originations, by vintage for 2005 through 2008, for the three general categories of purchasers of mortgage loans and the outstanding principal balance as of March 31, 2012 and December 31, 2011: Table 13: Unpaid Principal Balance of Mortgage Loans Originated and Sold to Third Parties Based on Category of Purchaser
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