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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 September 30, 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 October 31, 2012, there were 581,684,101 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 “Part II—Item 1A. Risk Factors” in this Report and in “Part I—Item 1A. Risk Factors” in our 2011 Form 10-K.
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, 2012 and 2011, and selected comparative consolidated balance sheet data as of September 30, 2012, and December 31, 2011. We also provide selected key metrics we use in evaluating our performance. On February 17, 2012, we completed the 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 “(the “ING Direct acquisition”). The ING Direct acquisition resulted in the addition of loans of $40.4 billion, other assets of $53.9 billion and deposits of $84.4 billion as of the acquisition date. On May 1, 2012, pursuant to the agreement with HSBC Finance Corporation, HSBC USA Inc. and HSBC Technology and Services (USA) Inc. (collectively, “HSBC”), we closed the acquisition of substantially all of the assets and assumed liabilities of HSBC’s credit card and private-label credit card business in the United States (other than the HSBC Bank USA, National Association consumer credit card program and certain other retained assets and liabilities) (the “HSBC U.S. card acquisition”). The HSBC U.S. card acquisition included (i) the acquisition of HSBC’s U.S. credit card portfolio, (ii) its on-going private label and co-branded partnerships, and (iii) other assets, including infrastructure and capabilities. At closing, we acquired approximately 27 million new active accounts, approximately $27.8 billion in outstanding credit card receivables designated as held for investment and approximately $327 million in other net assets. The ING Direct and HSBC U.S. card acquisitions had a significant impact on our results and selected metrics for the three and nine months ended September 30, 2012 and our financial condition as of September 30, 2012. We use the term “acquired loans” to refer to a limited portion of the credit card loans acquired in the HSBC U.S. card acquisition and the substantial majority of consumer and commercial loans acquired in the ING Direct and Chevy Chase Bank (“CCB”) acquisitions, which were recorded at fair value at acquisition and subsequently accounted for based on expected cash flows to be collected (under the accounting standard formerly known as “Statement of Position 03-3, Accounting for Certain Loans or Debt Securities Acquired in a Transfer,” commonly referred to as “SOP 03-3”). HSBC U.S. card loans accounted for based on expected cash flows consisted of loans with a fair value at acquisition of approximately $651 million that were deemed to be credit impaired because they were delinquent and revolving cardholder privileges had been revoked. The difference between the fair value and initial expected cash flows represents the accretable yield, which is recognized into interest income over the life of the loans. The difference between the contractual payments on the loans and the expected cash flows represents the nonaccretable difference or the amount not considered collectible, which approximates what we refer to as the “credit mark.” The credit mark established under the accounting for these loans takes into consideration future expected credit losses over the life of the loans. Accordingly, there are no charge-offs or an allowance associated with these loans unless the estimated cash flows expected to be collected decrease subsequent to acquisition. In addition, these loans are not classified as delinquent or nonperforming
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Table of Contentseven though the customer may be contractually past due because we expect that we will fully collect the carrying value of these loans. The accounting and classification of these loans may significantly alter some of our reported credit quality metrics. We therefore supplement certain reported credit quality metrics with metrics adjusted to exclude the impact of these acquired loans. Of the $27.8 billion in outstanding HSBC U.S. card loans that we acquired that were designated as held for investment, $26.2 billion had existing revolving privileges at acquisition and were therefore excluded from the acquired loan accounting guidance applied to the loans described above. These loans were recorded at fair value of $26.9 billion at acquisition, which resulted in a net premium of $705 million that is being amortized against interest income over the remaining life of the loans. In the second quarter of 2012, we recorded provision expense of $1.2 billion to establish an allowance related to these loans. We recorded additional provision expense related to HSBC U.S. card loans of $107 million in the third quarter of 2012. The total provision expense related to HSBC U.S. card loans of $1.3 billion is included in the provision for credit losses of $3.3 billion recorded in the first nine months of 2012. For additional information, see “Credit Risk Profile” and “Note 5—Loans—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 included Capital One Bank (USA), National Association (“COBNA”), Capital One, National Association (“CONA”), and ING Bank, fsb as of September 30, 2012. On November 1, 2012, we merged ING Bank, fsb into CONA, with CONA surviving the merger. 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, which added over seven million customers and approximately $84.4 billion in deposits to our Consumer Banking business segment as of the acquisition date, strengthens our customer franchise. 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. The closing of the HSBC U.S. card acquisition in the second quarter of 2012 added approximately 27 million new active accounts and approximately $27.8 billion in outstanding credit card receivables as of the acquisition date that we designated as held for investment. Period-end loans held for investment increased to $203.1 billion and deposits increased to $213.3 billion as of September 30, 2012, up from period-end loans of $135.9 billion and deposits of $128.2 billion 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, and gains and losses, as well as 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. The acquired HSBC U.S. card business is reflected in our Credit Card business, while the acquired ING Direct business is primarily reflected in our Consumer Banking business. 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 and nine months ended September 30, 2012 and 2011. We provide additional information on the realignment of our Commercial
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Table of ContentsBanking 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.” Table 2: Business Segment Results
EXECUTIVE SUMMARY AND BUSINESS OUTLOOK
In the third quarter of 2012, we experienced continued momentum and strong earnings performance across all three of our business segments, including strong contributions from our acquired ING Direct and HSBC U.S. card businesses. Third quarter results, together with the issuance of $853 million in perpetual preferred securities, further bolstered our regulatory capital position. The third quarter was the first to include a full-quarter impact of the operations of both the ING Direct and HSBC U.S. card acquisitions. Our results for the quarter reflected some continuing impact from the accounting for these acquisitions and merger-related expenses. The impact, however, was considerably smaller than in the first two quarters of 2012. We are continuing to devote significant effort to integrating the operations of these acquired businesses. The combination of ING Direct and HSBC’s U.S. card business with Capital One has shifted the mix of our interest-earning assets and driven substantial growth in our total net revenues, putting us in a position that we believe will sustain strong returns and capital generation, even in an environment with low industry growth and prolonged low interest rates. Financial Highlights We reported net income of $1.2 billion ($2.01 per diluted share) on total net revenue of $5.8 billion in the third quarter of 2012, with each of our three business segments contributing to our earnings. In comparison, we
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Table of Contentsreported net income of $92 million ($0.16 per diluted share) on total net revenue of $5.1 billion in the second quarter of 2012, and net income of $813 million ($1.77 per diluted share) on total net revenue of $4.2 billion in the third quarter of 2011. Net income was $2.7 billion ($4.75 per diluted share) on total net revenue of $15.8 billion for the first nine months of 2012, compared with net income of $2.7 billion ($5.95 per diluted share) on total net revenue of $12.2 billion for the first nine months of 2011. Our regulatory capital ratios, which declined in the second quarter of 2012 due to the significant increase in risk-weighted assets from the HSBC U.S. card acquisition and related purchase accounting adjustments, increased in the third quarter. Our Tier 1 risk-based capital ratio under Basel I was 12.7% as of September 30, 2012, up from 11.6% as of June 30, 2012, while our Tier 1 common ratio increased to 10.7% as of September 30, 2012, from 9.9% as of June 30, 2012. The increases in our capital ratios reflected strong internal capital generation, as well as the issuance of $853 million in fixed-rate, non-cumulative perpetual preferred stock, which qualifies as Tier 1 capital. We provide additional information on recent capital issuances in “Capital Management—Recent Equity and Debt Offerings and Transactions.” Below are additional highlights of our performance for the third quarter and first nine months of 2012. These highlights generally are based on a comparison to the same prior year periods, except as otherwise noted. The changes in our financial condition and credit performance are generally based on our financial condition and credit performance as of September 30, 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
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Business Segments
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Recent Developments Hurricane Sandy On October 29, 2012, Hurricane Sandy made landfall on the New Jersey coast. The Federal Emergency Management Agency (“FEMA”) has given a Major Disaster Declaration to coastal counties in Connecticut, New Jersey and New York. Other counties in those states and in other states in the Northeast and Mid-Atlantic also experienced varying, although lesser, damage and disruption from the storm. We have significant consumer and commercial loan exposure in Connecticut, New Jersey and New York, the states with the most severe FEMA disaster declarations. Note that some of these exposures are not in the counties that received the most damage. See “Note 16—Subsequent Events” for more information. The storm and its aftermath expose these loans to an elevated risk of loss. Due to the recency of events, we have not completed our evaluation of the impact of the storm and do not know the extent of disruption to the individuals, businesses, or properties that support these loans. Consequently, it is too early to estimate the potential financial impact on our future earnings. Historically, insurance proceeds and government support that follow natural disasters have significantly mitigated our losses. However, we cannot give assurance that those historical patterns will apply in this case, particularly given our concentration of Commercial Real Estate exposure in the hardest hit areas. ING Bank, fsb Merger On November 1, 2012, we effected the merger of ING Bank, fsb with CONA, with CONA surviving the merger. See “Supervision and Regulation” for more information.
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Table of ContentsSenior Notes Offering We closed a public offering of two different series of our senior notes on November 6, 2012, for total proceeds of approximately $1.0 billion. The offering of senior notes included $250 million aggregate principal amount of our Floating Rate Senior Notes due 2015 and $750 million aggregate principal amount of our 1.000% Senior Notes due 2015. 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 economic trends and analysis of our business as discussed in “Part I—Item 1. Business” and “Part I—Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our 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 acquisitions of ING Direct and 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 and sustain strong returns and capital generation through the acquisition and retention of franchise-enhancing customer relationships across our businesses. We believe that franchise-enhancing customer relationships create and sustain significant long-term value through low credit costs, long and loyal customer relationships 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 scalable infrastructure and operating platforms that are appropriate for a bank of our size and business mix so that we can meet the rising regulatory and compliance requirements facing all banks and deliver a “brand-defining” customer experience that builds and sustains a valuable, long-term customer franchise. The acquisitions of ING Direct and HSBC’s U.S. credit card business strengthened and expanded our customer base, and, over time, we expect to expand and deepen our customer relationships with new products and services. We expect our average loans for the full-year 2013 to decline modestly from third quarter 2012 average loan balances, as significant run-off of mortgage and card loans we acquired is partially offset by growth in our businesses. We expect run-off of approximately $11 billion in ending loan balances in 2013, primarily comprised of approximately $9 billion in mortgage loans acquired from ING Direct and Chevy Chase Bank, and approximately $2 billion in credit card loans acquired from HSBC. We expect this run-off to be partially offset by growth in certain of our businesses, including parts of Domestic Card, Auto and Commercial Banking. However, we expect continued weak consumer demand across our Credit Card and auto lending businesses, as well as intensifying competition in several businesses, particularly auto and commercial and industrial lending.
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Table of ContentsWe expect average quarterly non-interest expense, excluding marketing costs, through 2013 to be approximately equal to non-interest expense, excluding marketing costs, for the third quarter of 2012. We also expect our marketing expense for 2013 to be approximately $1.5 billion. We believe our actions have created a well-positioned balance sheet with strong capital and liquidity levels, and a strong capital generation trajectory. We expect to exceed an assumed Basel III Tier 1 common ratio internal target of 8 percent in 2013. Our estimated Basel III capital trajectory includes the estimated impact of implementing the Basel II Advanced Approaches to calculate regulatory capital, which we expect will apply to us in 2016 or later. The assumed 8 percent Basel III Tier 1 common ratio target assumes a buffer of 50 basis points for a systemically important financial institution (SIFI) under applicable rules and regulations and a further buffer of 50 basis points. It is estimated based on our current interpretation, expectations and understanding of the Basel III capital rules and other capital regulations proposed by U.S. regulators and the application of such rules to our businesses as currently conducted. Basel III calculations are necessarily subject to change based on, among other things, the scope and terms of the final rules and regulations, model calibration and other implementation guidance, changes in our businesses and certain actions of management, including those affecting the composition of our balance sheet. The actual target will depend on regulatory expectations and business judgments. We believe this ratio provides useful information to investors and others by measuring our progress against expected future regulatory capital standards. Business Segment Expectations Credit Card Business As noted above, in Domestic Card, the closing of the HSBC U.S. card acquisition has impacted and will continue to affect quarterly trends in loan growth, revenue margin and credit metrics. We anticipate that the run-off of parts of the portfolios acquired in the HSBC U.S. card acquisition as well as anticipated run-off of in our installment loan portfolio will more than offset the underlying growth trajectory in other parts of our Domestic Card business resulting in a modest decline in full-year average loan balances in 2013 from average loan balances in the third quarter of 2012. The credit mark on the non-revolving credit card loans acquired in the HSBC U.S. card acquisition has already absorbed a significant portion of the credit losses on those loans. We expect that virtually all future net charge-offs on the accounts acquired in the HSBC U.S. card acquisition will be covered by the allowance for loan and lease losses, and the Domestic Card charge-off rate will increase accordingly in the fourth quarter of 2012. Thereafter, we expect charge-off levels to remain relatively stable with normal seasonal patterns. As we have disclosed in the past, we are taking actions that we believe will enhance our franchise, such as aligning HSBC customer practices with our own, and ending the sale of products like payment protection. By the fourth quarter of 2013, we expect that these moves will result in a 50 basis point reduction from the third quarter 2012 revenue margin, adjusted for seasonality and the impact of post-acquisition HSBC U.S. card purchase accounting adjustments. And, in 2014, the run-off of another year of payment protection products is expected to reduce revenue margin by another 10 basis points from 2013. We also expect the run-off of higher-margin, higher-loss HSBC U.S. card loans will change the mix of loans in our Domestic Card business, driving another 15 basis points of reduction from third quarter revenue margin by the fourth quarter of 2013. Other factors which we are unable to accurately predict will also affect revenue margin. These factors, which include market and pricing dynamics, credit trends, and competitive intensity, could have positive or negative impacts on the Domestic Card revenue margin. Consumer Banking Business In our Consumer Banking business, we expect the ING Direct acquisition to continue to have a significant impact on Consumer Banking loan volumes as we anticipate that run-off in the acquired Home Loans portfolio will more than offset growth in auto loans.
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Table of ContentsCommercial 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 and into 2013.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The preparation of financial statements in accordance with U.S. Generally Accepted Accounting Principles (“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 have 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.
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, 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.
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Table of ContentsTable 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 three and nine months ended September 30, 2012 and 2011. Table 3: Average Balances, Net Interest Income and Net Interest Yield
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Table of ContentsTable 4 presents the variances between our net interest income for the three and nine months ended September 30, 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 $4.6 billion for the third quarter of 2012 increased by $1.4 billion, or 42%, from the third quarter of 2011, driven by a 50% increase in average interest-earning assets, which was partially offset by a 6% decline in our net interest margin to 6.97%. Net interest income of $12.1 billion for the first nine months of 2012 increased by $2.5 billion, or 26%, from the first nine months of 2011, driven by a 41% increase in average interest-earning assets, which was partially offset by an 11% decline in our net interest margin to 6.50%.
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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 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 three and nine months ended September 30, 2012 and 2011. Table 5: Non-Interest Income
Non-interest income of $1.1 billion for the third quarter of 2012 increased by $265 million, or 30%, from non-interest income of $871 million for the third quarter of 2011. The increase was largely attributable to
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Table of Contentsincreased fees resulting from continued growth and market share from new account originations and the acquisition of ING Direct in the first quarter of 2012 and the HSBC U.S. card acquisition in the second quarter of 2012. In addition, we recognized mark-to-market gains on retained interests in interest-only strips and negative amortization mortgage securities of $75 million in the third quarter of 2012, attributable to lower market interest rates. Non-interest income of $3.7 billion for the first nine months of 2012 increased by $1.0 billion, or 39%, from non-interest income of $2.7 billion for the first nine months of 2011. This increase reflected the combined impact of the bargain purchase gain of $594 million recognized in the first quarter of 2012 at acquisition of ING Direct, income of $162 million recorded in the first quarter of 2012 from the sale of Visa stock shares, the increased fees resulting from continued growth and market share from new account originations, due in part to the acquisitions of ING Direct and the HSBC U.S. card portfolio and the mark-to-market gains of $75 million recognized on retained interests in mortgage-related securities in the third quarter of 2012. The favorable impact of these items was partially offset by cross-sell activities related to expected customer refunds of approximately $114 million recorded in the first nine months of 2012, a mark-to-market derivative loss of $78 million recognized in the first quarter of 2012 related to the settlement of 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 and an increase in the provision for repurchase losses. We also recorded higher other-than-temporary impairment losses of $13 million and $40 million in the third quarter and first nine months of 2012, respectively, compared with $6 million and $15 million in the third quarter and first nine months of 2011, respectively. The impairment losses stemmed from deterioration in the credit quality of certain non-agency mortgage-backed securities due to the persistent 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 $1.0 billion and $3.3 billion in the third quarter and first nine months of 2012, respectively, compared with $622 million and $1.5 billion in the third quarter and first nine months of 2011, respectively. The significant increase in our provision for credit losses was primarily related to the addition of the $26.2 billion in outstanding HSBC U.S. card loans designated as held for investment that had existing revolving privileges at acquisition. These loans were recorded at a fair value of $26.9 billion, resulting in a net premium of $705 million at acquisition. Fair value was determined by discounting all expected cash flows (contractual principal, interest, finance charges and fees of $33.3 billion less those amounts not expected to be collected of $3.0 billion) at a market discount rate. Under applicable accounting guidance, we are required to amortize the net premium of $705 million over the contractual principal amount as an adjustment to interest income over the remaining life of the loans. Given the guidance applicable to revolving loans, it is necessary to record an allowance through provision for credit losses to properly recognize an estimate of incurred losses on the existing principal balances, which represents a portion of the total amounts not expected to be collected described above. In the second quarter of 2012, we recorded provision for credit losses of $1.2 billion to establish an allowance primarily related to these loans. We recorded an additional allowance and provision for credit losses for these loans of $107 million in the third quarter of 2012. The allowance was calculated using the same methodology utilized for determining the allowance for our existing credit card loan portfolio. The provision for credit losses of $107 million and $1.3 billion for the third
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Table of Contentsquarter and first nine months of 2012, respectively, is included in the total provision for credit losses recorded for each period. The provision for credit losses, excluding the allowance build related to acquired HSBC U.S. card loans, was $907 million and $2.0 billion for the third quarter and the first nine months of 2012, respectively. The increase in the provision for credit losses excluding the impact of the allowance build for acquired HSBC U.S. card loans was largely attributable to the growth in auto loan originations, coupled with the absence of the allowance for loan losses release for our credit card business in 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” and “Note 6—Allowance for Loan and Lease Losses.” For information on the allowance methodology for our credit card loan portfolio, see “Note 1—Summary of Significant Accounting Policies” in our 2011 Form 10-K. 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 are also included in non-interest expense. Table 6 displays the components of non-interest expense for the three and nine months ended September 30, 2012 and 2011. Table 6: Non-Interest Expense
Non-interest expense of $3.0 billion for the third quarter of 2012 increased by $748 million, or 33%, from the third quarter of 2011. The increase was primarily due to higher operating expenses and merger-related costs related to our recent acquisitions, higher infrastructure costs from our continued investments in our home loan business and growth in auto originations, and increased amortization of intangibles resulting from the ING Direct and HSBC U.S. card acquisitions. We recorded intangible amortization expense related to purchased credit card relationships (“PCCR”) from the HSBC U.S. card acquisition of $127 million in the third quarter of 2012. We recorded other asset and intangible amortization expense related to the ING Direct and HSBC U.S. card acquisitions of $42 million in the third quarter of 2012. Non-interest expense of $8.7 billion for the first nine months of 2012 increased by $2.0 billion, or 29%, from the first nine months of 2011. The increase was primarily due to higher operating expenses and merger-related costs related to our recent acquisitions, increased marketing expenditures, higher infrastructure costs from our
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Table of Contentscontinued investments in our home loan business and growth in auto originations, and increased amortization on intangibles. We recorded PCCR intangible amortization expense related to the HSBC U.S. card acquisition of $212 million in the first nine months of 2012. We recorded other asset and intangible amortization expense related to the ING Direct and HSBC U.S. card acquisitions of $99 million in the first nine months of 2012. Our results for the first nine months of 2012 also reflect the unfavorable impact of civil penalties of $60 million related to cross-sell activities and net legal costs of $98 million related to interchange and other litigation developments. Income Taxes Our effective tax rate on income from continuing operations varies between periods due, in part, to fluctuations in our pre-tax earnings, which affect the relative impact tax benefits from tax-exempt income, tax credits and other tax items. We recorded an income tax provision based on income from continuing operations of $535 million (31.1% effective income tax rate) in the third quarter of 2012, compared with an income tax provision of $370 million (30.0% effective income tax rate) in the third quarter of 2011. The increase in the effective tax rate in the third quarter of 2012 compared to the third quarter of 2011 was attributable to the release of a valuation allowance against certain state deferred tax assets, which was recorded in the third quarter of 2011 and contributed to a reduction in the effective tax rate for the period. We recorded an income tax provision based on income from continuing operations of $931 million (24.4% effective income tax rate) for the first nine months of 2012, compared with an income tax provision of $1.2 billion (29.2% effective income tax rate) for the first nine months of 2011. Our effective income tax rate for the first nine months of 2012 reflects the impact of discrete tax benefits of $213 million primarily related to the non-taxable ING Direct bargain purchase gain of $594 million, recognition of a deferred tax benefit due to changes in our state tax position as a result of the acquisition of the HSBC U.S. card business and the resolution of certain tax issues and audits. Our effective tax rate for the first nine months of 2011 reflects the impact of tax benefits of $98 million 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. Our effective income tax rate, excluding the benefit from these discrete tax items, was 30.0% and 31.7% for the first nine months of 2012 and 2011, respectively. The decrease in our effective income tax rate, excluding the impact of discrete items, for the first nine months of 2012 relative to the same period in the prior year was primarily due to an increase in affordable housing and other business tax credits. 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 that we closed in 2007. We did not record a provision for repurchase losses in the third quarter of 2012. We recorded a pre-tax provision for repurchase losses of $349 million in the first nine months of 2012, of which $307 million ($194 million, net of tax) was included in discontinued operations. In comparison, we recorded a pre-tax provision for repurchase losses of $72 million in the third quarter of 2011, of which $75 million ($53 million, net of tax) was included in discontinued operations, and a pre-tax provision of $153 million in the first nine months of 2011, of which $147 million ($104 million, net of tax) was included in discontinued operations. The increase in the provision for repurchase losses in the first nine months of 2012 was primarily driven by updated estimates in the first and second quarters of anticipated outcomes from various litigation and threatened
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Table of Contentslitigation in the insured securitization segment based on relevant factual and legal developments and an increased reserve associated with a first quarter settlement between a subsidiary and a GSE to resolve present and future claims. We provide additional information on the provision for repurchase losses and the related reserve for potential representation and warranty claims in “Consolidated Balance Sheet Analysis—Potential Mortgage Representation and Warranty Liabilities” and “Note 15—Commitments, Contingencies and Guarantees.”
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. Total interest income and net fees are directly attributable to the segment in which they are reported. The net interest income of each segment reflects the results of our funds transfer pricing process, which is primarily based on a matched maturity method that takes into consideration market rates. Our funds transfer pricing process provides a funds credit for sources of funds, such as deposits generated by our Consumer Banking and Commercial Banking businesses, and a funds charge for the use of funds by each segment. The allocation process is unique to each business segment and acquired businesses. 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 affordable housing tax-related 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 and nine months ended September 30, 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 September 30, 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.”
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Table of ContentsCredit Card Business Our Credit Card business generated net income from continuing operations of $741 million and $1.0 billion in the third quarter and first nine months of 2012, respectively, compared with net income from continuing operations of $663 million and $1.9 billion in the third quarter and first nine months of 2011, respectively. The primary sources of revenue for our Credit Card business are 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. Table 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. The closing on May 1, 2012 of the HSBC U.S. card acquisition, which added approximately $27.8 billion in outstanding credit card receivables designated as held for investment to our Credit Card business, had a significant impact on the results of our Credit Card business for the third quarter and first nine months of 2012. 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 2012, compared with the third quarter and first nine months of 2011 included the following:
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Domestic Card Business Domestic Card generated net income from continuing operations of $673 million and $924 million in the third quarter and first nine months of 2012, respectively, compared with net income from continuing operations of $637 million and $1.9 billion in the third quarter and first nine months of 2011, respectively. 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. The increase of $36 million in Domestic Card net income from continuing operations in the third quarter of 2012 from the same prior year period was driven by an increase in total net revenue largely due to the addition of the HSBC U.S. card portfolio. The increase in total net revenue was partially offset by a higher provision for credit losses, largely attributable to the allowance build for the HSBC U.S. card loan portfolio, an increase in non-interest expense due to higher operating expenses resulting from the acquisition of the HSBC U.S. card business and the amortization of intangibles and other assets associated with the HSBC U.S. card acquisition, including intangible amortization expense related to purchased credit card relationships of $127 million in the third quarter of 2012. The decrease of $1.0 billion in Domestic Card net income from continuing operations in the first nine months of 2012 from the same prior year period was driven by an increase in total net revenue largely due to the addition of the HSBC U.S. card portfolio, which was more than offset by the unfavorable impact of several items related to the HSBC U.S. card acquisition. These items included a significant increase in the provision for credit losses resulting from an allowance build of $1.3 billion for the HSBC U.S. card loan portfolio and an increase in non-interest expense due to higher operating expenses resulting from the acquisition of the HSBC U.S. card business and the amortization of intangibles and other assets associated with the HSBC U.S. card acquisition, including intangible amortization expense related to purchased credit card relationships of $212 million in the first nine months of 2012. The regulatory fine related to cross-sell activities of $60 million and litigation expenses to cover interchange and other settlements recorded in the second quarter of 2012 also contributed to the increase in non-interest expense in the first nine months of 2012.
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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 $68 million and $86 million in the third quarter and first nine months of 2012, respectively, compared with net income from continuing operations of $26 million in the third quarter of 2011 and a net loss of $9 million in the first nine months of 2011.
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Table of ContentsThe primary driver of the improvement in results in the third quarter and first nine months of 2012 was a decrease in the provision for credit losses, attributable to lower net-charge offs resulting from an improvement in the credit environment in Canada and the U.K. and the absence of an allowance build for the Hudson’s Bay Company loan portfolio of approximately $105 million that we acquired in January 2011. Table 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
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