E TRADE FINANCIAL CORP 10-K 2006
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Commission file number 1-11921
E*TRADE Financial Corporation
(Exact name of registrant as specified in its charter)
135 East 57th Street, New York, New York 10022
(Address of principal executive offices and zip code)
(Registrants telephone number, including area code)
Securities Registered Pursuant to Section 12(b) of the Act:
Title of each class
Common Stock$0.01 par value
Mandatory Convertible Notes
Securities Registered Pursuant to Section 12(g) of the Act:
Indicate by check mark if the registrant is a well-known seasonal issuer, as defined in Rule 405 of the Securities Act. Yes x No ¨
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Securities Act. Yes ¨ No x
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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer 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
At June 30, 2005, the aggregate market value of voting stock, comprised of the registrants common stock and shares exchangeable into common stock, held by nonaffiliates of the registrant was approximately $4.8 billion (based upon the closing price for shares of the registrants common stock as reported by the New York Stock Exchange on that date.) Shares of common stock held by each officer, director and holder of 5% or more of the outstanding common stock have been excluded in that such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes.
Number of shares outstanding of the registrants common stock as of February 21, 2006: 417,911,092
We are filing this Amendment No. 1 on Form 10-K/A solely to correct a typographical error in the independent registered public accountants report on our internal control over financial reporting. The typographical error was an inadvertent omission of a paragraph in the Reports of Independent Registered Public Accounting Firm contained in Item 8. Financial Statements and Supplementary Data of our original Annual Report on Form 10-K filed on March 3, 2006 (Original Report). There are no changes to the financial or supplemental information contained in Item 8. This Amendment relates solely to the Reports of Independent Registered Public Accounting Firm.
In order to comply with certain technical requirements of the SECs rules in connection with the filing of this amendment on Form 10-K/A, we are including in this amendment the complete text of Item 8. We are also including in this amendment updated certifications of our principal executive and principal financial officers and an updated Consent of Independent Registered Public Accounting Firm.
This Amendment No. 1 to our Annual Report on Form 10-K as originally filed on March 3, 2006 continues to speak as of the date of our Original Report, and we have not updated the disclosures contained in this Amendment No. 1 to reflect any events that occurred at a date subsequent to the filing of the Original Report.
Item 8. Financial Statements and Supplementary Data
MANAGEMENT REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
The management of E*TRADE Financial Corporation is responsible for establishing and maintaining adequate internal control over financial reporting. E*TRADE Financial Corporations internal control system was designed to provide reasonable assurance to the companys management and board of directors regarding the preparation and fair presentation of published financial statements. Internal control over financial reporting is defined in Rule 13a-15(f) or 15d-15(f) promulgated under the Securities Exchange Act of 1934 as a process designed by, or under the supervision of, the companys principal executive and principal financial officers and effected by the companys board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles and includes those policies and procedures that:
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
E*TRADE Financial Corporations management assessed the effectiveness of its internal control over financial reporting as of December 31, 2005. In making this assessment, it used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission in Internal ControlIntegrated Framework. Based on our assessment we believe that, as of December 31, 2005, E*TRADE Financial Corporations internal control over financial reporting is effective based on those criteria.
E*TRADE Financial Corporations audited consolidated financial statements include the results of the following entities, but managements assessment does not include an assessment of the internal control over financial reporting of these entities because they were acquired during the fourth quarter of 2005. This approach is consistent with published SEC guidance on the permissible scope of managements internal control report.
These entities represented 13% of total assets at December 31, 2005 and 3% of revenues for year ended December 31, 2005.
E*TRADE Financial Corporations Independent Registered Public Accounting Firm, Deloitte & Touche LLP, has issued an audit report on our assessment of the E*TRADE Financial Corporations internal control over financial reporting. The report of Deloitte & Touche LLP appears on the next page.
REPORTS OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of
E*TRADE Financial Corporation
We have audited managements assessment, included in the accompanying Management Report on Internal Control Over Financial Reporting, that E*TRADE Financial Corporation and subsidiaries (the Company) maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. As described in the report on Internal Control Over Financial Reporting, management excluded from their assessment the internal control over financial reporting at Harrisdirect, LLC and BrownCo, which were acquired on October 6, 2005 and November 30, 2005, respectively, and whose financial statements represented 13% of total assets at December 31, 2005 and 3% of revenues for 2005. Accordingly, our audit did not include the internal control over financial reporting at Harrisdirect, LLC and BrownCo. The Companys management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on managements assessment and an opinion on the effectiveness of the Companys internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating managements assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.
A companys internal control over financial reporting is a process designed by, or under the supervision of, the companys principal executive and principal financial officers, or persons performing similar functions, and effected by the companys board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A companys internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the companys assets that could have a material effect on the financial statements.
Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, managements assessment that the Company maintained effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on the criteria established in Internal ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Also in our opinion, the Company maintained, in all material respects, effective
internal control over financial reporting as of December 31, 2005, based on the criteria established in Internal ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements as of and for the year ended December 31, 2005 of the Company and our report dated March 1, 2006 expressed an unqualified opinion on those financial statements.
/s/ Deloitte & Touche LLP
March 1, 2006
To the Board of Directors and Stockholders of
E*TRADE Financial Corporation
We have audited the accompanying consolidated balance sheets of E*TRADE Financial Corporation and subsidiaries (the Company) as of December 31, 2005 and 2004, and the related consolidated statements of income, comprehensive income, shareholders equity, and cash flows for each of the three years in the period ended December 31, 2005. These consolidated financial statements are the responsibility of the Companys management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of E*TRADE Financial Corporation and subsidiaries as of December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2005, in conformity with accounting principles generally accepted in the United States of America.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Companys internal control over financial reporting as of December 31, 2005, based on the criteria established in Internal ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 1, 2006 expressed an unqualified opinion on managements assessment of the effectiveness of the Companys internal control over financial reporting and an unqualified opinion on the effectiveness of the Companys internal control over financial reporting.
/s/ Deloitte & Touche LLP
March 1, 2006
CONSOLIDATED BALANCE SHEETS
(in thousands, except share amounts)
See accompanying notes to consolidated financial statements
CONSOLIDATED STATEMENTS OF INCOME
(in thousands, except per share amounts)
See accompanying notes to consolidated financial statements
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
See accompanying notes to consolidated financial statements.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS EQUITY
See accompanying notes to consolidated financial statements
E*TRADE FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS EQUITY(Continued)
See accompanying notes to consolidated financial statements
CONSOLIDATED STATEMENTS OF CASH FLOWS
See accompanying notes to consolidated financial statements
E*TRADE FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS(Continued)
See accompanying notes to consolidated financial statements
E*TRADE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTE 1SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
OrganizationE*TRADE Financial Corporation (together with its subsidiaries, E*TRADE or the Company) is a global company offering a wide range of financial services to the consumer under the brand E*TRADE FINANCIAL. The Company offers investing, trading, cash management and lending products and services to its retail and institutional customers.
Basis of PresentationThe consolidated financial statements include the accounts of the Company and its majority-owned subsidiaries. Entities in which the Company holds at least a 20% ownership or in which there are other indicators of significant influence are generally accounted for by the equity method. Entities in which the Company holds less than 20% ownership and does not have the ability to exercise significant influence are generally carried at cost. Intercompany accounts and transactions are eliminated in consolidation. The Company evaluates investments including joint ventures, low income housing tax credit partnerships and other limited partnerships to determine if the Company is required to consolidate the entities under the guidance of FASB Interpretation No. 46, Consolidation of Variable Interest Entities-an interpretation of ARB No. 51 (FIN 46R.)
Certain prior period items in these consolidated financial statements have been reclassified to conform to the current period presentation. As discussed in Note 3, the operations of certain businesses have been accounted for as discontinued operations in accordance with Statement of Financial Accounting Standards (SFAS) No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. Accordingly, results of operations from prior periods have been reclassified to discontinued operations. Unless noted, discussions herein pertain to the Companys continuing operations.
Use of EstimatesThe consolidated financial statements were prepared in accordance with accounting principles generally accepted in the United States of America, which require management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and related notes for the periods presented. Actual results could differ from managements estimates. Material estimates in which management believes near-term changes could reasonably occur include: allowances for loan losses and uncollectible margin loans; classification and valuation of certain investments; valuation and accounting for financial derivatives; estimates of effective tax rates, deferred taxes and valuation allowances; valuation of goodwill and other intangibles and valuation and expensing of share-based payments.
Financial Statement Descriptions and Related Accounting PoliciesBelow are descriptions and accounting policies for the Companys financial statement categories.
Cash and EquivalentsFor the purpose of reporting cash flows, the Company considers all highly liquid investments with original or remaining maturities of three months or less at the time of purchase that are not required to be segregated under Federal or other regulations to be cash equivalents. Cash and equivalents are composed of interest-bearing and non-interest-bearing deposits, certificates of deposit, commercial paper, funds due from banks and Federal funds. Cash and equivalents included $7.1 million and $23.7 million at December 31, 2005 and 2004, respectively, of overnight cash deposits that the Company is required to maintain with the Federal Reserve Bank.
Cash and Investments Required to be Segregated Under Federal or Other RegulationsCash and investments required to be segregated under Federal or other regulations consist primarily of interest-bearing cash accounts. Certain cash balances, related to collateralized financing transactions by our brokerage subsidiaries, are required to be segregated for the exclusive benefit of our brokerage customers.
Brokerage Receivables, net and PayablesBrokerage receivables represent credit extended to customers to finance their purchases of securities by borrowing against securities they currently own, as well as commission
receivables from customers upon settlement of their trades. Receivable from non-customers represent credit extended to principal officers and directors of the Company to finance their purchase of securities by borrowing against securities owned by them. Brokerage receivables are recorded net of allowance for doubtful accounts. Securities owned by customers and non-customers are held as collateral for amounts due on brokerage receivables, the value of which is not reflected in the consolidated balance sheets. In many cases, the Company is permitted to sell or repledge these securities held as collateral and use the securities to enter into securities lending transactions, to collateralize borrowings or for delivery to counterparties to cover customer short positions. Receivables from brokers, dealers and clearing organizations result from the Companys stock borrowing activities.
Brokerage payables include payables from customers, non-customers, brokers, dealers and clearing organizations. Brokerage payables to customers and non-customers represent credit balances in customer accounts arising from deposits of funds and sales of securities, also referred to as free credit balances, and other funds pending completion of securities transactions. The Company pays interest on certain free credit balances. Payables from brokers, dealers and clearing organizations also result from the Companys stock lending activities.
Deposits paid for securities borrowed and deposits received for securities loaned are recorded at the amount of cash collateral advanced or received, which are included in brokerage receivables, net and brokerage payables, respectively, on the consolidated balance sheets. Deposits paid for securities borrowed transactions require the Company to deposit cash with the counterparty. This cash is included in cash and investments required to be segregated under federal or other regulations. With respect to deposits received for securities loaned, the Company receives collateral in the form of cash in an amount generally in excess of the market value of the securities loaned. Interest income and interest expense are recorded on an accrual basis. The Company monitors the market value of the securities borrowed and loaned on a daily basis, with additional collateral obtained or refunded, as necessary.
Trading SecuritiesCertain trading securities and financial derivative instruments, that are not designated for hedge accounting, are bought and held principally for the purpose of selling them in the near term and are carried at estimated fair value based on quoted market prices. Realized and unrealized gains and losses on securities classified as trading held by the Bank are included in gain on sales of loans and securities, net and are derived using the specific identification cost method. Realized and unrealized gains and losses on trading securities held by broker-dealers are recorded in principal transactions and are also derived by the specific identification method.
Available-for-Sale Mortgage-Backed and Investment SecuritiesThe Company classified its debt, mortgage-backed securities and marketable equity securities as either trading or available-for-sale. None of the Companys mortgage-backed or investment securities were classified as held-to-maturity at December 31, 2005 or 2004.
Available-for-sale securities consist of mortgage-backed securities, asset-backed securities, corporate bonds, municipal bonds, publicly traded equity securities, retained interests from securitizations and other debt securities. Securities classified as available-for-sale are carried at fair value, with the unrealized gains and losses reflected as a component of accumulated other comprehensive income (AOCI), net of tax. Fair value is based on quoted market prices, when available. For illiquid securities, fair value is estimated by obtaining market price quotes on similar liquid securities and adjusting the price to reflect differences between the two securities, such as credit risk, liquidity, term, coupon, payment characteristics and other information. Realized and unrealized gains or losses on available-for-sale securities, except for publicly traded equity securities, are computed using the specific identification cost method. Amortization or accretion of premiums and discounts are recognized in interest income using the interest method over the expected life of the security. Realized and unrealized gains or losses on publicly traded equity securities are computed using the average cost method. Realized gains and losses and declines in fair value judged to be other-than-temporary are included in gain on sales of loans and securities,
net for the Companys banking operations; other amounts relating to corporate investments are included in gain on sale and impairment of investments. Interest earned is included in interest income for banking operations or corporate interest income for corporate investments.
The Company regularly analyzes certain available-for-sale investments for other-than-temporary impairment when the fair value of the investment is lower than its book value. The Companys methodology for determining impairment involves projecting cash flows relating to each investment and using assumptions as to future prepayment speeds, losses and loss severities over the life of the underlying collateral pool. Assumptions about future performance are derived from the actual performance to date and the Companys view on how the collateral will perform in the future. In projecting future performance, the Company incorporates the views of industry analysts, rating agencies and the management of the issuer, along with its own independent analysis of the issuer of the securities, the servicer, the economy and the relevant sector as a whole. If the Company determines impairment is other-than-temporary, it reduces the recorded book value of the investment by the amount of the impairment and recognizes a realized loss on the investment. The Company does not, however, adjust the recorded book value for declines in fair value that it believes are temporary. Management continues to monitor and evaluate these securities closely for impairment that is other-than-temporary.
Mortgage- and asset-backed securities that both have an unrealized loss and are rated below AA by at least half of the agencies that rate the securities, as well as interest-only securities that have unrealized losses, are evaluated for impairment in accordance with Emerging Issues Task Force 99-20 (EITF 99-20), Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets. Accordingly, when the present value of a securitys anticipated cash flows declines below the last periodic estimate, the Company recognizes an impairment charge in gain on sales of loans and securities, net in the consolidated statements of income.
Asset Securitization and Retained InterestsAn asset securitization involves the transfer of financial assets to another entity in exchange for cash and/or beneficial interests in the assets transferred. Asset transfers in which the Company surrenders control over the financial assets are accounted for as sales to the extent that consideration, other than beneficial interests in the transferred assets, is received in the exchange in accordance with SFAS No. 140 Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. The carrying amount of the assets transferred is allocated between the assets sold in these transactions and the retained beneficial interests, based on their relative fair values at the date of the transfer. The Company records gains or losses for the difference between the allocated carrying amount of the assets sold and the net cash proceeds received. These gains or losses are recorded in gain on sales of loans and securities, net. Fair value is determined based on quoted market prices, if available. Generally, quoted market prices are not available for beneficial interests; therefore, the Company estimates the fair value based on the present value of the associated expected future cash flows. In determining the present value of the associated expected future cash flows, management is required to make estimates and assumptions. Key estimates and assumptions include future default rates, credit losses, discount rates, prepayment speeds and collateral repayment rates. Retained beneficial interests are accounted for in accordance with SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities and EITF 99-20 and are included in available-for-sale investment securities in the consolidated balance sheets.
Loans Receivable, netLoans receivable, net consists of real estate and consumer loans that management has the intent and ability to hold for the foreseeable future or until maturity. These loans are carried at amortized cost adjusted for charge-offs, net allowance for loan losses, deferred fees or costs on originated loans and unamortized premiums or discounts on purchased loans. Loan fees and certain direct loan origination costs are deferred and the net fee or cost is recognized in interest income using the interest method over the contractual life of the loans. Premiums and discounts on purchased loans are amortized or accreted into income using the interest method over the remaining period to contractual maturity and adjusted for anticipated prepayments. The Company classifies loans as nonperforming when full and timely collection of interest or principal becomes uncertain or when they are 90 days past due. Interest previously accrued, but not collected, is reversed against
current income when a loan is placed on nonaccrual status and is considered nonperforming. Accretion of deferred fees is discontinued for nonperforming loans. Payments received on nonperforming loans are recognized as interest income when the loan is considered collectible and applied to principal when it is doubtful that full payment will be collected. Real estate loans are generally charged off to the extent that the carrying value of the loan exceeds the estimated net realizable value of the underlying collateral at the time of repossession. HELOCs are charged-off when the loan becomes 180 days past due. Consumer loans are charged off to the extent that the carrying value of the loan exceeds the estimated net realizable value of the underlying collateral when the loan becomes 120 days past due.
Allowance for Loan LossesThe allowance for loan losses is managements estimate of credit losses inherent in the Companys loan portfolio as of the balance sheet date. The estimate of the allowance is based on a variety of factors, including the composition and quality of the portfolio, delinquency levels and trends, expected losses for the next twelve months, current and historical charge-off and loss experience, current industry charge-off and loss experience, the condition of the real estate market and geographic concentrations within the loan portfolio, the interest rate climate as it affects adjustable-rate loans and general economic conditions. Determining the adequacy of the allowance is complex and requires judgment by management about the effect of matters that are inherently uncertain. Subsequent evaluations of the loan portfolio, in light of the factors then prevailing, may result in significant changes in the allowance for loan losses in future periods. In general, the allowance for loan losses should be at least equal to twelve months of projected losses for all loan types. Management believes this level is representative of probable losses inherent in the loan portfolio at the balance sheet date. Loan losses are charged and recoveries are credited to the allowance for loan losses.
Loans Held-for-Sale, netLoans held-for-sale, net consists of mortgages acquired and loans originated by the Company that are intended for sale in the secondary market. These loans are carried at the lower of cost or estimated fair value, as determined on an aggregate basis, based on quoted market price for loans with similar characteristics. Net unrealized losses are recognized in a valuation allowance by charges to income. Premiums and discounts on loans held-for-sale are deferred and recognized as part of gain (loss) on sales of loans held-for-sale, net and are not accreted or amortized.
Property and Equipment, netProperty and equipment are carried at cost and depreciated on a straight-line basis over their estimated useful lives, generally three to ten years. Leasehold improvements are amortized over the lesser of their estimated useful lives or lease terms. Buildings are depreciated over forty years. Land is carried at cost. Technology development costs are charged to operations as incurred. Technology development costs include costs incurred in the development and enhancement of software used in connection with services provided by the Company that do not otherwise qualify for capitalization treatment as internally developed software costs in accordance with Statement of Position (SOP) 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use.
In accordance with SOP 98-1, the cost of internally developed software is capitalized and included in property and equipment at the point at which the conceptual formulation, design and testing of possible software project alternatives are complete and management authorizes and commits to funding the project. The Company does not capitalize pilot projects and projects where it believes that future economic benefits are less than probable. Internally developed software costs include the cost of software tools and licenses used in the development of the Companys systems, as well as payroll and consulting costs.
Investment in Federal Home Loan Bank (FHLB) StockInvestment in FHLB stock is carried at its amortized cost, which approximates fair value.
Goodwill and Other Intangibles, netGoodwill and other intangibles, net represents the excess of the purchase price over the fair value of net tangible assets acquired through the Companys business combinations. The Company tests goodwill and intangible assets with indefinite lives for impairment on at least an annual basis or when certain events occur. The Company evaluates the remaining useful lives of other intangible assets each
reporting period to determine whether events and circumstances warrant a revision to the remaining period of amortization.
Servicing RightsServicing assets are recognized when the Company sells a loan and retains the related servicing rights. The servicing rights are initially recorded at their allocated cost basis based on the relative fair value of the loan sold and the servicing rights are retained at the date of the sale in accordance with SFAS No. 140. The fair value of the servicing retained is estimated based on market quotes for similar servicing assets. Servicing assets are amortized in proportion to and over the period of estimated net servicing income. The Company measures impairment by stratifying the servicing assets, based on the characteristics of the underlying loans and by interest rates. Impairment is recognized through a valuation allowance for each stratum. The valuation allowance is adjusted to reflect the excess of the servicing assets cost basis for a given stratum over its fair value. Any fair value in excess of the cost basis of servicing assets for a given stratum is not recognized. The Company estimates the fair value of each stratum based on an industry standard present value of cash flows model. The Company recognizes both amortization of servicing rights and impairment charges in service charges and fees in the consolidated statements of income. Servicing assets are included in other assets in the consolidated balance sheets.
Real Estate Owned and Repossessed AssetsIncluded in other assets in the consolidated balance sheets is real estate acquired through foreclosure and repossessed consumer assets. Real estate properties acquired through foreclosures, commonly referred to as real estate owned (REO) and repossessed assets, are recorded at fair value, less estimated selling costs at acquisition.
Income TaxesThe Company accounts for income taxes in accordance with SFAS No. 109, Accounting for Income Taxes, which prescribes the use of the asset and liability method whereby deferred tax asset or liability account balances are calculated at the balance sheet date using current tax laws and rates in effect. Valuation allowances are established, when necessary, to reduce deferred tax assets when it is more likely than not that a portion or all of a given deferred tax assets will not be realized. In accordance with SFAS No. 109, income tax expense includes (i) deferred tax expense, which generally represents the net change in the deferred tax asset or liability balance during the year plus any change in valuation allowances and (ii) current tax expense, which represents the amount of tax currently payable to or receivable from a taxing authority plus amounts accrued for expected tax deficiencies (including both tax and interest.) Accruals for expected tax deficiencies are recorded in accordance with SFAS No. 5, Accounting for Contingencies, when management determines that a tax deficiency is both probable and reasonably estimable.
Securities Sold Under Agreements to RepurchaseSecurities under agreements to repurchase similar securities (Repurchase Agreements) are collateralized by fixed- and variable-rate mortgage-backed securities or investment grade securities. Repurchase Agreements are treated as financings for financial statement purposes and the obligations to repurchase securities sold are reflected as borrowings in the consolidated balance sheets.
Mandatory Convertible DebtThe Company accounts for its mandatory convertible debt by allocating the proceeds using the relative fair value of the stock purchase contracts and the debt securities on the date of issuance. The issue costs are deferred and allocated to the debt securities and the stock purchase contracts based on their relative fair values at issuance date. The portion of issuance costs allocated to the debt is amortized over the life of the debt using the interest method.
The value of the stock purchase contracts is included in equity based on the requirements of SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity, and EITF Issue No. 00-19, Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Companys Own Stock. The Company evaluated the mandatory convertible debt under SFAS No. 150 and EITF No. 00-19. In order for the stock purchase contracts to be included in equity, the following statements must be met.
Based on our review of the above criterion and other relevant technical requirements, the stock purchase contracts are included in equity.
Foreign Currency TranslationAssets and liabilities of consolidated subsidiaries outside of the United States are translated into U.S. dollars using the exchange rate in effect at each period end. Revenues and expenses are translated at the average exchange rate during the period. The effects of foreign currency translation adjustments arising from differences in exchange rates from period to period are deferred and included in AOCI as the functional currency of our subsidiaries is their local currency. Currency transaction gains or losses, derived on monetary assets and liabilities stated in a currency other than the functional currency, are recognized in current operations and have not been significant to the Companys operating results in any period.
Advertising and Market DevelopmentAdvertising production costs are expensed when the initial advertisement is run. Costs of print advertising are expensed as the services are received.
Share-Based PaymentsEffective July 1, 2005, the Company early adopted SFAS No. 123(R), Share-Based Payment and Staff Accounting Bulletin No. 107, Share-Based Payment, using the modified prospective application method to account for its share-based compensation plans. Upon adoption, the Company began expensing options as compensation and benefits with a one-time pre-tax credit of $2.8 million in cumulative effect of accounting change related to estimated forfeiture on restricted stock for its adoption in 2005 related to restricted stock awards. Results for prior periods have not been restated. Prior to July 1, 2005, the Company accounted for its employee stock option and awards under Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations, and accordingly, did not record compensation costs for option grants to employees if the exercise price equaled the fair market value on the grant date. Additionally, for restricted stock awards, compensation was recorded on a straight-line basis over the vesting period of the awards with forfeitures recorded as they occurred.
Under this transition method, compensation cost in 2005 includes the portion of options and awards vesting in the period for (1) all share-based payments granted prior to, but not vested as of July 1, 2005, based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123, Accounting for Stock-Based Compensation and (2) all share-based payments granted subsequent to July 1, 2005, based on the grant date fair value estimated in accordance with the provisions of SFAS No. 123(R.) Compensation cost for options granted prior to July 1, 2005 is recognized on an accelerated amortization method over the vesting period of the options using an estimated forfeiture rate. Compensation cost for options granted on or after July 1, 2005 is recognized on a straight-line basis over the vesting period using an estimated forfeiture rate. Also under SFAS No. 123(R), the Company has reflected the tax benefit from tax deduction in excess of compensation recognized as a financing activity in the consolidated statements of cash flows.
The following table illustrates the effect on the Companys reported net income and net income per share if the Company had applied the fair value recognition provisions of SFAS No. 123, to stock-based employee compensation in periods prior to July 1, 2005 (in thousands, except per share amounts):
The underlying assumptions to these fair value calculations are discussed in Note 21.
Comprehensive IncomeThe Companys comprehensive income is comprised of net income, foreign currency cumulative translation adjustments, unrealized gains (losses) on available-for-sale mortgage-backed and investment securities and the effective portion of the unrealized gains (losses) on financial derivatives in cash flow hedge relationships, net of reclassification adjustments and related taxes.
Earnings Per ShareBasic earnings per share (EPS) is computed by dividing net income by the weighted-average common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock. The Units will be reflected in diluted earnings per share calculations using the treasury stock method as defined by SFAS No. 128, Earning per Share. Under this method, the number of shares of common stock used in calculating diluted earnings per share (based on the settlement formula applied at the end of the reporting period) is deemed to be increased by the excess, if any, of the number of shares that would be issued upon settlement of the purchase contracts less the number of shares that could be purchased by the Company in the market at the average market price during the period using the proceeds to be received upon settlement.
Financial Derivative Instruments and Hedging ActivitiesThe Company enters into derivative transactions to protect against the risk of market price or interest rate movements on the value of certain assets, liabilities and future cash flows. The Company must also recognize certain contracts and commitments as derivatives when the characteristics of those contracts and commitments meet the definition of a derivative promulgated by SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended.
Each derivative is recorded on the balance sheet at fair value as a freestanding asset or liability. Financial derivative instruments in hedging relationships that mitigate exposure to changes in the fair value of assets or liabilities are considered fair value hedges under SFAS No. 133. Financial derivative instruments designated in hedging relationships that mitigate the exposure to the variability in expected future cash flows or other forecasted transactions are considered cash flow hedges. The Company formally documents all relationships between hedging instruments and hedged items and the risk management objective and strategy for each hedge transaction.
Fair value hedges are accounted for by recording the fair value of the financial derivative instrument and the change in fair value of the asset or liability being hedged on the consolidated balance sheets with the net difference, or hedge ineffectiveness, reported as fair value adjustments of financial derivatives in the consolidated statements of income. Cash payments or receipts and related accruals during the reporting period on derivatives included in fair value hedge relationships are recorded as an adjustment to interest income on the hedged asset or liability. If a financial derivative in a fair value hedging relationship is no longer effective, de-designated from its hedging relationship or terminated, the Company discontinues fair value hedge accounting for the derivative and the hedged item. Changes in the fair value of these derivative instruments no longer designated in an accounting hedge relationship are recorded in gain on sales of loans and securities, net, in the consolidated statements of income. The accumulated adjustment of the carrying amount of the hedged interest-earning asset or liability is recognized in earnings as an adjustment to interest income over the expected remaining life of the asset using the effective interest method.
Cash flow hedges are accounted for by recording the fair value of the financial derivative instrument as either a freestanding asset or a freestanding liability in the consolidated balance sheets, with the effective portion of the change in fair value of the financial derivative recorded in AOCI, net of tax in the consolidated balance sheets. Amounts are then included in interest expense as a yield adjustment in the same period the hedged forecasted transaction affects earnings. The ineffective portion of the change in fair value of the financial derivative is reported as fair value adjustments of financial derivatives in the consolidated statements of income. If it becomes probable that a hedged forecasted transaction will not occur, amounts included in AOCI related to the specific hedging instruments are reported as gain on sales of loans and securities, net in the consolidated statements of income. Derivative gains and losses that are not held as accounting hedges are recognized as gain on sales of loans and securities, net in the consolidated statements of income as these derivatives do not qualify for hedge accounting under SFAS No. 133. If a financial derivative ceases to be highly effective as a hedge, hedge accounting is discontinued prospectively and the financial derivative instrument continues to be recorded at fair value with changes in fair value being reported as gain on sales of loans and securities, net in the consolidated statements of income.
CommissionsThe Company derives commissions revenue from its retail and institutional customers. Commissions revenue from securities transactions are recognized on a trade date basis. The Company receives commissions for providing certain institutional customers with market research and other information, which is a common industry practice. These commissions revenue contributed less than 10% of the Companys net revenues for all periods presented. Direct costs from these arrangements are expensed as the commissions are received, in proportion to the cost of the total arrangement. As a result, payments for independent research are deferred or accrued to properly match expenses at the time commission revenue is earned. For these arrangements, payments for independent research of $6.0 million were deferred and costs of $19.4 million were accrued at December 31, 2005 and payments of $6.3 million were deferred and costs of $18.6 million were accrued at December 31, 2004.
Principal TransactionsPrincipal transactions consist primarily of revenue from market-making activities. Market-making activities are the matching of buyers and sellers of securities and include transactions where the Company will purchase securities for its balance sheet with the intention of resale to transact the customers buy or sell order.
Gain on Sales of Loans and Securities, netGain on sales of originated loans are recognized at the date of settlement and are based on the difference between the cash received and the carrying value of the related loans sold, less related transaction costs. In cases where the Company retains the servicing rights associated with loans sold, the gain recognized is the difference between cash received and the allocated basis of the loans sold, less the related transaction costs. In accordance with SFAS No. 140, the allocated basis of the loans, which is determined at the sale date, is the result of the allocation of basis between the loans sold and the associated servicing right, based on the relative fair values of the loans at the date of transfer.
Gain on sales of loans and securities, net includes gains or losses resulting from sales of loans purchased for resale; the sale or impairment of available-for-sale mortgage-backed and investment securities; and gains or losses on financial derivatives that are not accounted for as hedging instruments under SFAS No. 133. Gains or losses resulting from the sale of loans are recognized at the date of settlement and are based on the difference between the cash received and the carrying value of the related loans, less related transaction costs. Nonrefundable fees and direct costs associated with the origination of mortgage loans are deferred and recognized when the related loans are sold. Gains or losses resulting from the sale of available-for-sale securities are recognized at the trade date, based on the difference between the anticipated proceeds and the amortized cost of the specific securities sold.
Service Charges and FeesService charges and fees consist of account maintenance fees, servicing fee income and other customer service fees. Account maintenance fees are charged to the customer either quarterly or annually and accrued as earned.
Other RevenuesOther revenues consists of stock plan administration services, payments for order flow from third party market makers and foreign exchange margin revenue. Stock plan administration services are recognized in accordance with applicable accounting guidance, including SOP 97-2, Software Revenue Recognition. Payments for order flow revenues are accrued in the same period in which the related securities transactions are completed or related services are rendered.
Interest IncomeInterest income is recognized as earned on interest-earning assets, customer margin loan balances, stock borrow balances, cash required to be segregated under regulatory guidelines and fees on customer assets invested in money market funds. Interest income includes the effect of hedges on interest-earning assets.
Interest ExpenseInterest expense is recognized as incurred on interest-bearing liabilities, customer credit balances, interest paid to banks and interest paid to other broker-dealers through a subsidiarys stock loan program. Interest expense includes the effect of hedges on interest-bearing liabilities.
New Accounting StandardsBelow are the new accounting pronouncements that relate to activities the Company is engaged.
FSP 123(R) -4Classification of Options and Similar Instruments Issued as Employee Compensation That Allow for Cash Settlement upon the Occurrence of a Contingent Event
On February 3, 2006, the Financial Accounting Standards Board (FASB) issued FASB Staff Position (FSP) No. 123(R)-4, Classification of Options and Similar Instruments Issued as Employee Compensation That Allow for Cash Settlement upon the Occurrence of a Contingent Event. FSP 123(R)-4 addresses the classification of options and similar instruments issued as employee compensation that allow for cash settlement upon the occurrence of a contingent event. An entity must recognize a share-based liability equal to the portion of the award attributed to past service, multiplied by the awards fair value on that date for an option or similar instrument that is classified as equity, but subsequently becomes a liability because the contingent cash settlement event is probable of occurring. FSP 123(R)-4 is effective for the Company in the first quarter of 2006, with early adoption permitted. Upon adoption, the Company must retroactively restate prior periods for the change. The Company has not issued any options or similar instruments as employee compensation that allow for cash settlement upon the occurrence of a contingent event that would require a change under the FSP. Therefore, the Company does not believe this FSP will have an impact on its results of operations or financial condition.
EITF 03-01The Meaning of Other-Than-Temporary Impairment and its Application to Certain Issues
In March 2004, the EITF amended and ratified previous consensus reached on EITF 03-01, The Meaning of Other-Than-Temporary Impairment. This amendment, which was originally effective for financial periods beginning after June 15, 2004, introduced qualitative and quantitative guidance for determining whether securities are other-than-temporarily impaired. In September 2004, the FASBs staff issued a number of FSPs
that focused primarily upon the application of EITF 03-01 to debt securities that are impaired solely due to interest rates and/or sector spreads. In November 2005, the FASB issued FSP 115-1/124-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments, which nullified and replaced the qualitative and quantitative guidance for determining whether securities are other-than-temporarily impaired. The new guidance is consistent with the Companys current practice which is primarily found within SFAS No. 115 and EITF 99-20, as to the measurement and recognition of other-than-temporary impairments of its debt and equity securities.
SFAS No. 154Accounting Changes and Error Corrections
In June 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections. This statement supersedes APB Opinion No. 20, Accounting Changes and SFAS No. 3, Reporting Accounting Changes in Interim Financial Statements. The statement applies to all voluntary changes in accounting principle and changes the requirements for accounting and reporting of a change in accounting principle. SFAS No. 154 requires retrospective application to prior periods financial statements of a voluntary change in accounting principle unless it is impracticable. The statement requires that a change in method of depreciation, amortization, or depletion for long-lived, nonfinancial assets be accounted for as a change in accounting estimate that is effected by a change in accounting principle. SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The statement does not change the transition provisions of any existing accounting pronouncements, including those that are in a transition phase as of the effective date of this statement. The Company will adopt SFAS No. 154, as applicable, beginning in 2006.
SOP No. 03-3Accounting for Certain Loans or Debt Securities Acquired in a Transfer
In December 2003, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants issued SOP No. 03-3, Accounting for Certain Loans or Debt Securities Acquired in a Transfer to address accounting for differences between the contractual cash flows of certain loans and debt securities and the cash flows expected to be collected when loans or debt securities are acquired in a transfer and those cash flow differences are attributable, at least in part, to credit quality. As such, SOP No. 03-3 applies to loans and debt securities purchased or acquired in purchase business combinations and does not apply to originated loans. SOP No. 03-3 requires that the excess of contractual cash flows over cash flows expected to be collected (nonaccretable difference) not be recognized as an adjustment of yield or valuation allowance, such as the allowance for credit losses. Subsequent to the initial investment, increases in expected cash flows generally should be recognized prospectively through adjustment of the yield on the loan or debt security over its remaining life. Decreases in expected cash flows should be recognized as impairment. SOP No. 03-3 is effective for loans and debt securities acquired in fiscal years beginning after December 15, 2004, with early application encouraged. In 2005, the Company adopted this new pronouncement, which effect was not material to the Companys financial condition, result of operations or cash flows.
NOTE 2BUSINESS COMBINATIONS
Over the past two years, the Company completed several business combinations and asset acquisitions which were all accounted for under the purchase method of accounting. The purchase prices have been allocated to the net assets acquired and the liabilities assumed based on their estimated fair values at the date of acquisition. For certain acquisitions, the consolidated financial statements reflect preliminary allocations of purchase price, as appraisals of the net assets acquired have not been finalized. The Company does not expect changes in the preliminary allocations from the finalization of these appraisals to be material to its consolidated statements of income. The results of operations of each are included in the Companys consolidated statements of income from the date of each acquisition.
On November 30, 2005, the Company completed its acquisition of J.P. Morgan Invest, LLC (BrownCo), an online discount brokerage business with approximately 186,000 customer accounts, from JP Morgan Chase &
Co. for an aggregate purchase price of approximately $1.6 billion in cash. The purchase price included approximately $306.6 million in net assets acquired, $269.7 million in customer list and noncompete intangibles, $9.0 million in contracts and employee termination liabilities, with the remaining $1,062.4 million recorded as goodwill. Regulatory capital of $294.5 million was included in the purchase price. The intangible assets will be amortized over approximately 22 years on an accelerated basis.
On October 6, 2005, the Company completed its acquisition of Harrisdirect LLC (Harrisdirect), a U.S.-based online discount brokerage business with approximately 425,000 customer accounts, from BMO Financial Group for an aggregate purchase price of approximately $709.0 million in cash. The purchase price included approximately $22.4 million in net assets acquired, $156.4 million in customer list and noncompete intangibles, $11.1 million in contract and employee termination liabilities, with the remaining $541.4 million recorded as goodwill. Regulatory capital of $16.0 million was included in the purchase price. The intangible assets will be amortized over approximately 19 years on an accelerated basis.
Wealth Management Advisors
The Company acquired Kobren Insight Management on November 2, 2005 and Howard Capital Management, Inc. on January 1, 2005. Both companies are registered investment advisory firms. The companies combined have over $1.5 billion in assets under management. The Company recorded $24.6 million of intangible assets and $7.6 million of goodwill related to the acquisitions. The intangible assets will be amortized over approximately 20 years on an accelerated basis. In accordance with the terms of the acquisitions, the Company may pay additional cash and stock if certain milestones are met. These milestones are for certain revenues and earnings targets, which if met, will cause the Company to pay up to an additional $34.6 million.
In October 2004, the Company acquired certain active accounts from a brokerage company. The Company paid $17.0 million in cash and recorded an intangible asset of $17.0 million which will be amortized over 10 years.
In 2005, the Company sold its Consumer Finance Corporation, exited the institutional proprietary trading business conducted by E*TRADE Professional Securities, LLC and announced its intention to sell its professional agency business which conducts its activities as E*TRADE Professional Trading, LLC. In 2004, the Companys retail segment completed the sale of substantially all of the assets and liabilities of E*TRADE Access, the company that previously owned its ATM network. All of these transactions and intended transactions, except the Consumer Finance Corporations servicing operations, were accounted for as discontinued operations as of December 31, 2005, 2004 and 2003.
Below is a table summarizing the gains (losses), net of taxes, resulting from the sale and closure of discontinued operations (in thousands):
Consumer Finance Corporation
On October 31, 2005, the Company completed the sale of the origination and servicing business of Consumer Finance Corporation to GE Capital. The servicing business exited did not qualify as a discontinued operation; however, the origination business is accounted for as a discontinued operation. The sale resulted in a pre-tax gain of $46.1 million upon close, $35.5 million relating to the servicing business and $10.6 million ($6.4 million, net of tax), relating to the origination business.
The Company will not have significant continuing involvement in the operations of the servicing business but will continue to have significant cost-generating activities in the form of a servicing agreement. As such, the servicing business did not qualify as a discontinued operation. The Company will not have significant continuing involvement in the operations of the origination business and will not continue any significant revenue-producing or cost-generating activities of the origination business. Therefore, the results of operations, net of income taxes, of this origination business are presented as discontinued operations on the Companys consolidated statements of income for all periods presented.
The following table summarizes the results of discontinued operations for the origination business (in thousands):
On May 9, 2005, the Company closed E*TRADE Professional Securities, LLC (ETPS), a unit that conducted proprietary trading operations. In June 2005, the Company filed to withdraw its broker-dealer license for ETPS, with an effective date of May 31, 2005. ETPS was a Philadelphia Stock Exchange (PHLX) member and a standalone entity which employed less than 200 traders. This closure resulted in a $2.4 million, net of tax, loss on disposal of discontinued operations, which included employee terminations, facility closure and impairment of goodwill and intangibles.
In December 2005, the Company decided to sell its professional agency business, E*TRADE Professional Trading, LLC (ETPT.) This business includes a broker-dealer registered with the SEC and a member of the NASD Inc. (NASD) who currently executes and clears its customer security transactions through an affiliate, E*TRADE Clearing LLC, on a fully disclosed basis under an introducing broker-dealer relationship. The Company executed a sale agreement on February 17, 2006. Under the terms of the sale agreement, the Company continues to retain the obligation for contingent liabilities that existed prior to the sale, which contingent liabilities would not, in the Companys estimation individually or collectively, be material to the Companys financial results.
The Company will not have significant continuing involvement in the operations of either its proprietary trading or its professional agency businesses and will not continue any significant revenue-producing or cost-generating activities of these businesses. Therefore, the Companys results of operations, net of income taxes, include these businesses as discontinued operations on the Companys consolidated statements of income for all periods presented.
The following table summarizes the results of discontinued operations for the proprietary and agency trading businesses (in thousands):
In 2004, the Company completed the sale of substantially all of the assets and liabilities of E*TRADE Access to Cardtronics, LP and Cardtronics, Inc. Although the Company believes that an ATM network is an important distribution channel for its customers, it determined that its continued ownership and direct operation of the ATM network was not essential to providing this customer benefit and that the capital it had invested in this endeavor could be better applied to other operations.
The sale resulted in a $57.5 million pre-tax gain ($31.4 million after taxes.) As part of the sales agreement, Cardtronics assumed substantially all of the liabilities of E*TRADE Access. The Company has reflected E*TRADE Access results of operations, financial position and cash flows as discontinued operations in the consolidated financial statements for all periods reported herein.
The following table summarizes the results of discontinued operations of our ATM business for the periods presented (in thousands):
NOTE 4FACILITY RESTRUCTURING AND OTHER EXIT ACTIVITIES
The following table summarizes the amount recognized by the Company as facility restructuring and other exit activities for the periods presented (in thousands):
Exit of Consumer Finance Business
On October 31, 2005, the Company completed the sale of the servicing and origination businesses of Consumer Finance Corporation to GE Capital resulting in a pre-tax gain of $46.1 million. The pre-tax gain from the servicing business of $35.5 million is reflected in other exit activity as the servicing business was not deemed to be a discontinued operation. (See Note 3 for additional information.)
Israel Exit Activity
The Company terminated the trademark and technology license of an Israeli-based company in 2002 due to failure to perform obligations and commenced arbitration proceedings. The Israeli company counterclaimed for wrongful termination. An arbitration tribunal in London decided against the Company and as a result, the Company recognized $14.5 million and $1.4 million in exit activities for 2004 and 2003.
2003 Restructuring Plan
In April 2003, the Company announced a restructuring plan (2003 Restructuring Plan) exiting and consolidating leased facilities and exiting and disposing of certain unprofitable product offerings and initiatives. The original 2003 facility consolidation charge primarily related to charges to exit the E*TRADE FINANCIAL Center in New York and consolidation of excess facilities located in Menlo Park and Rancho Cordova, California. The E*TRADE FINANCIAL Center in New York, encompassing approximately 31,000 square feet, was used by customers to access the Companys products and services and served as an introduction point for new customers to the Companys products and services. The Company exited this center as it was not cost effective to engage in these activities within a facility of its size, and subsequently, opened an approximately 2,000 square foot new center in New York that was more cost effective. The leased California facilities were used for corporate and administrative functions and were exited as the Company consolidated employees into nearby offices and moved certain functions to its offices in Virginia.
The other charges related to the exit of or write-off of unprofitable product lines and the early termination of certain contracts, such as the revenue sharing agreements associated with 43 E*TRADE Zones located in Target stores. These unprofitable product lines consisted of our Stock Basket product offered to customers and our online advisory service, eAdvisor, a joint initiative with Enlight Holdings, LLC. The Company terminated its revenue sharing agreements associated with its Zones in Target stores to focus on other methods of reaching its current and potential customers.
In 2004, the Company completed its exit of the Enlight Holdings, LLC product offering resulting in adjustments to estimated costs associated with its exit. In 2005, the Company made additional adjustment to previously estimated costs associated with the consolidation of facilities in California. The rollforward of the 2003 Restructuring Plan reserve is presented below (in thousands):
2001 Restructuring Plan
In August 2001, the Company announced a restructuring plan (2001 Restructuring Plan) aimed at streamlining operations primarily by consolidating facilities in the United States and Europe. The restructuring was designed to consolidate certain facilities, bring together key decision-makers and streamline operations. The original 2001 restructuring charge related to facility consolidation represents the undiscounted value of ongoing lease commitments, offset by anticipated third-party sublease revenues, the write-off of capitalized software, hardware and other fixed assets and other costs. Subsequent to 2001, the Company recognized additional facility consolidation adjustments, as a result of updated estimates of sublease income and sublease start dates, driven by economic circumstances. The rollforward of the 2001 Restructuring Plan reserve is presented below (in thousands):
Facility Consolidation Obligations
The components of the facility consolidation restructuring liabilities for the 2003 and 2001 Restructuring Plans at December 31, 2005, and their timing are as follows (in thousands):
Other Exit Activities
Other exit activities in 2005 are primarily related to the liquidation of proprietary money market funds and the outsourcing of certain brokerage activities. These costs primarily relate to customer notification, reimbursement of losses taken on sale of securities and severance. Other exit charges in 2003 were primarily related to the gain on sale of the Companys German subsidiary, partially offset by the charges relating to the exit of the Companys proprietary institutional research business located in Europe.
NOTE 5BROKERAGE RECEIVABLES, NET AND BROKERAGE PAYABLES
Brokerage receivables, net and brokerage payables consist of the following (in thousands):
Receivables from customers and non-customers are brokerage receivables whereby credit is extended to customers to finance their purchases of securities by borrowing against securities they currently own (also known as margin balances). At December 31, 2005, the fair value of securities that the Company received as collateral, where the Company is permitted to sell or repledge the securities, is approximately $8.8 billion. Of this amount, $2.4 billion has been pledged or sold at December 31, 2005 in connection with securities lending, bank borrowings and deposits with clearing organizations.
NOTE 6AVAILABLE-FOR-SALE MORTGAGE-BACKED AND INVESTMENT SECURITIES
The amortized cost basis and estimated fair values of available-for-sale mortgage-backed and investment securities are shown in the following table (in thousands):
Other-Than-Temporary Impairment of Investments
The following tables show the fair value and unrealized losses on investments, aggregated by investment category and the length of time that individual securities have been in a continuous unrealized loss position (in thousands):
The Company does not believe any individual loss as of December 31, 2005 represents an other-than-temporary impairment. The majority of the unrealized losses on mortgage- and asset-backed securities are attributable to changes in interest rates and not reflective of deterioration in the credit quality of the issuer and/or securitization. Substantially all mortgage-backed securities backed by Federal agencies are AAA rated and have unrealized losses due to changes in market interest rates. As market interest rates increase, the fair value of fixed-rate securities will decrease. During 2005, increasing market interest rates caused higher unrealized losses on our fixed-rate securities including mortgage- and asset-backed securities. The Company has the ability and intent to hold these securities until the market value recovers or the securities mature. Asset-backed securities, corporate bonds and other debt securities are evaluated by reviewing the credit worthiness of the lender and based on market conditions. As of December 31, 2005, unrealized losses on mortgage- and asset-backed securities were primarily attributed to rising interest rates and not underlying credit impairment. Based on its evaluation, the Company recorded other-than-temporary charges of $38.3 million, $14.0 million and $2.2 million for 2005, 2004 and 2003, respectively, for its asset- and mortgage-backed securities and interest-only securities. Additionally, the Company recognized $2.0 million and $4.4 million of other-than-temporary impairments for 2005 and 2004, respectively, from retained beneficial interests in securitized receivables held by a subsidiary, ETCF Asset Funding Corporation.
Publicly Traded Equity Securities
For the years ended December 31, 2005, 2004 and 2003, the Company recognized gains on sales of its publicly traded equity securities of $82.7 million, $130.6 million and $151.7 million, respectively. In 2005, these gains included sales of the Companys holdings in Softbank Investment Corporation (SBI), all of its holdings in Archipelago Holdings Incorporated, Ameritrade Holding Corporation and holdings in International Stock Exchange of $59.7 million, $9.8 million, $8.4 million and $4.8 million, respectively. In 2004 and 2003, these gains primarily included sales of the Companys holdings in SBI.
The contractual maturities of available-for-sale debt securities, including mortgage-backed securities, at December 31, 2005 are shown below (in thousands):
The Company pledged $11.8 billion at December 31, 2005 and $10.1 billion at December 31, 2004 of mortgage-backed securities as collateral for repurchase agreements, short-term borrowings, derivative instruments and FHLB advances.
Realized Gains (Losses)
Realized gains and losses from the sales and other-than-temporary impairment of available-for-sale investment securities, including mortgage-backed securities, are as follows (in thousands):
During 2005, 2004 and 2003, the Company realized gains from the sales of trading securities of $108.8 million, $101.3 million and $81.3 million, respectively. In addition, the Company had unrealized trading asset appreciation of $0.6 million, $2.5 million and $4.8 million in 2005, 2004 and 2003, respectively.
NOTE 7LOANS, NET
Loans, net are summarized as follows (in thousands):
In addition to these loans, net, the Company had commitments to originate, buy and sell loans at December 31, 2005 (see Note 24.)
Approximately 32% and 45% of the Companys real estate loans were concentrated in California at December 31, 2005 and 2004, respectively. No other state had concentrations of real estate loans that represented 10% or more of the Companys real estate portfolio.
The following table shows the percentage of adjustable and fixed-rate loans in the Companys portfolio (dollars in thousands):
The weighted-average remaining maturity of mortgage loans secured by one- to four-family residences was 341 and 340 months at December 31, 2005 and 2004, respectively. Additionally, all mortgage loans outstanding at December 31, 2005 and 2004 in the held-for-investment portfolio were serviced by other companies.
The Company actively sells its originated loans and loans originated by correspondents. The Company may sell loans that it originally purchased from others. A summary of these activities is presented below (in thousands):
Activity in the allowance for loan losses is summarized as follows (in thousands):
During 2005, the allowance for loan losses increased by $15.6 million. Approximately $12.9 million of this increase is due to higher real estate loans outstanding which increased by $8.1 billion during 2005. The remaining increase in the allowance was due to slightly higher expected losses on RV and credit card loans offset by lower automobile loan related losses.
The $8.6 million increase in net charge-offs in 2005 was primarily due to higher net charge-offs on credit cards of $6.7 million, marine and RV of $4.7 million and real estate loan portfolios of $2.8 million, offset partially by lower net charge-offs on automobile loans of $5.8 million. Higher credit card charge-offs are the
result of increased bankruptcy filings as customers declared bankruptcy ahead of the new bankruptcy laws in October 2005. We do not anticipate that the 2005 level of credit card charge-offs will continue. The increase in net charge-offs was also due to growth in loans receivable and specific events affecting customer behavior during the period and not indicative of a decline in credit quality.
We classify loans as nonperforming when full and timely collection of interest or principal becomes uncertain or when they are 90 days past due. The following is the relative breakout of nonperforming loans (in thousands):
If the Companys nonperforming loans at December 31, 2005, had been performing in accordance with their terms, the Company would have recorded additional interest income of approximately $0.8 million, $1.0 million and $1.1 million in 2005, 2004 and 2003, respectively. During 2005, we recognized $1.0 million in interest on loans that were in nonperforming status at December 31, 2005. At December 31, 2005 and 2004, there were no commitments to lend additional funds to any of these borrowers.
Collateralized Debt Obligations
On December 1, 2005, the Company and an unrelated financial advisor transferred asset-backed securities to E*TRADE ABS CDO IV, Ltd. (CDO IV.) The Company utilized a warehouse line to purchase the asset-backed securities that were sold to CDO IV. As of December 31, 2005, 92% of the pool of underlying securities had been transferred into CDO IV. Additional purchases of asset-backed securities were made in open market transactions and transferred to CDO IV in January and February 2006. In prior years, the Company transferred asset-backed securities to E*TRADE ABS CDO III, Ltd. (CDO III), E*TRADE ABS CDO II, Ltd. (CDO II) and E*TRADE ABS CDO I, Ltd. (CDO I.) Asset-backed securities were also transferred to CDO III by an unrelated financial advisor. Concurrent with these transfers, the respective CDOs sold beneficial interests to independent investors in the form of senior and subordinated notes and preference shares, collateralized by the asset-backed securities. Neither the CDOs themselves nor the investors in the beneficial interests sold by the CDOs have recourse to the Company. CDO I, II and III are qualifying special purpose entities as defined in SFAS No. 140, and, as such, are not required to be consolidated in the Companys consolidated financial statements.
CDO IV is not a qualified special purpose entity but rather a special purpose entity, as the Company has been appointed by the CDO to actively manage the collateral of the CDO. The transaction was accounted for as a sale in accordance with SFAS No. 140. The CDO IV transaction differs from the previous three CDO transactions in that it is a managed deal whereby the portfolio manager (E*TRADE Global Asset Management (ETGAM)) is appointed to actively manage the collateral of the CDO as opposed to a static deal where the collateral is fixed throughout the life of the CDO. Because CDO IV is a managed deal, it is a special purpose entity and not a qualified special purpose entity.
The Company reviewed CDO IV to determine if consolidation was necessary under the requirements of FIN 46R. The calculation of the CDOs beneficial interests indicated that ETGAM was not the recipient of the
majority of the potential benefits or losses of the deal and therefore, not the primary beneficiary of the transaction and not required to consolidate the CDO.
The Company purchased preference shares in each of the CDOs. Retained interests are subordinate to the notes sold by each CDO and on an equal standing with the preference shares purchased by other preference share investors in each CDO. The Company also purchased $1 million of the BBB subordinated notes in the CDO IV transaction.
The following table summarizes the asset-backed securities transferred to each CDO, the amount of the cash proceeds, the preference shares purchased by the Company and the current rating for those preference shares (dollars in millions):