Annual Reports

  • 10-K (Feb 25, 2014)
  • 10-K (Feb 26, 2013)
  • 10-K (Feb 22, 2011)
  • 10-K (Feb 24, 2010)
  • 10-K (Feb 26, 2009)
  • 10-K (Feb 28, 2008)

 
Quarterly Reports

 
8-K

 
Other

E TRADE FINANCIAL CORP 10-K 2011
Form 10K
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-K

 

(Mark One)

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2010

or

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from              to             .

Commission File Number 1-11921

 

E*TRADE Financial Corporation

(Exact Name of Registrant as Specified in its Charter)

 

 

 

Delaware   94-2844166

(State or other jurisdiction

of incorporation or organization)

 

(I.R.S. Employer

Identification Number)

1271 Avenue of the Americas, 14th Floor, New York, New York 10020

(Address of principal executive offices and Zip Code)

(646) 521-4300

(Registrant’s telephone number, including area code)

 

Indicate by check mark if the registrant is a well-known seasoned 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 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 whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T 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 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 registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendments to this Form 10-K.  x

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 definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer  x

  Accelerated filer                        ¨

Non-accelerated filer    ¨ (Do not check if a smaller reporting company)

  Smaller reporting company     ¨

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, 2010, the aggregate market value of voting stock held by non-affiliates of the registrant was approximately $2.3 billion (based upon the closing price per share of the registrant’s common stock as reported by the NASDAQ Global Select Market 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.

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:

As of February 17, 2011, there were 221,247,848 shares of common stock outstanding.

 

 

DOCUMENTS INCORPORATED BY REFERENCE

Certain portions of the definitive Proxy Statement related to the Company’s 2011 Annual Meeting of Shareholders, to be filed hereafter (incorporated into Part III hereof).

 

 

 


Table of Contents

E*TRADE FINANCIAL CORPORATION

FORM 10-K ANNUAL REPORT

For the Year Ended December 31, 2010

TABLE OF CONTENTS

 

PART I

    

Reverse Stock Split

     1   
Forward-Looking Statements      1   

Item 1.

  Business      1   
 

Overview

     1   
 

Strategy

     2   
 

Products and Services

     2   
 

Sales and Customer Service

     4   
 

Technology

     5   
 

Competition

     5   
 

Regulation

     5   

Item 1A.

 

Risk Factors

     8   

Item 1B.

 

Unresolved Staff Comments

     19   

Item 2.

 

Properties

     19   

Item 3.

 

Legal Proceedings

     19   

PART II

    

Item 5.

  Market for Registrant’s Common Equity, Related Shareholder Matters and Issuer Purchases of Equity Securities      24   

Item 6.

  Selected Consolidated Financial Data      26   

Item 7.

  Management’s Discussion and Analysis of Financial Condition and Results of Operations      28   
 

Overview

     28   
 

Earnings Overview

     31   
 

Segment Results Review

     44   
 

Balance Sheet Overview

     50   
 

Liquidity and Capital Resources

     54   
 

Risk Management

     59   
 

Concentrations of Credit Risk

     61   
 

Summary of Critical Accounting Policies and Estimates

     71   
 

Statistical Disclosure by Bank Holding Companies

     79   
 

Glossary of Terms

     85   

Item 7A.

  Quantitative and Qualitative Disclosures about Market Risk      90   

Item 8.

  Financial Statements and Supplementary Data      92   
 

Management Report on Internal Control Over Financial Reporting

     92   
 

Reports of Independent Registered Public Accounting Firm

     93   
 

Consolidated Statement of Loss

     95   
 

Consolidated Balance Sheet

     96   
 

Consolidated Statement of Comprehensive Loss

     97   
 

Consolidated Statement of Shareholders’ Equity

     98   
 

Consolidated Statement of Cash Flows

     100   
 

Notes to Consolidated Financial Statements

     102   
 

Note 1—Organization, Basis of Presentation and Summary of Significant Accounting Policies

     102   
 

Note 2—Discontinued Operations

     110   
 

Note 3—Facility Restructuring and Other Exit Activities

     111   

 

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Note 4—Operating Interest Income and Operating Interest Expense

     113   
 

Note 5—Fair Value Disclosures

     113   
 

Note 6—Available-for-Sale and Held-to-Maturity Securities

     123   
 

Note 7—Loans, Net

     127   
 

Note 8—Accounting for Derivative Instruments and Hedging Activities

     133   
 

Note 9—Property and Equipment, Net

     138   
 

Note 10—Goodwill and Other Intangibles, Net

     139   
 

Note 11—Other Assets

     140   
 

Note 12—Deposits

     141   
 

Note 13—Securities Sold Under Agreements to Repurchase and FHLB Advances and Other Borrowings

     142   
 

Note 14—Corporate Debt

     144   
 

Note 15—Other Liabilities

     147   
 

Note 16—Income Taxes

     147   
 

Note 17—Shareholders’ Equity

     153   
 

Note 18—Loss per Share

     155   
 

Note 19—Employee Share-Based Payments and Other Benefits

     155   
 

Note 20—Regulatory Requirements

     158   
 

Note 21—Lease Arrangements

     159   
 

Note 22—Commitments, Contingencies and Other Regulatory Matters

     160   
 

Note 23—Segment and Geographic Information

     165   
 

Note 24—Condensed Financial Information (Parent Company Only)

     170   
 

Note 25—Quarterly Data (Unaudited)

     173   

Item 9.

  Changes in and Disagreements with Accountants on Accounting and Financial Disclosure      173   

Item 9A.

  Controls and Procedures      174   

Item 9B.

  Other Information      174   

PART III

  

PART IV

  

Item 15.

  Exhibits and Financial Statement Schedules      175   

Signatures

     179   

 

 

Unless otherwise indicated, references to “the Company,” “we,” “us,” “our” and “E*TRADE” mean E*TRADE Financial Corporation and its subsidiaries.

E*TRADE, E*TRADE Financial, E*TRADE Bank, Equity Edge, OptionsLink and the Converging Arrows logo are registered trademarks of E*TRADE Financial Corporation in the United States and in other countries.

 

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REVERSE STOCK SPLIT

In June 2010, we completed a 1-for-10 reverse stock split and a corresponding decrease to our authorized shares of common stock to a total of 400 million shares. All prior periods presented have been adjusted to reflect the impact of this reverse stock split, including the impact on basic and diluted weighted-average shares and shares issued and outstanding.

FORWARD-LOOKING STATEMENTS

This report contains forward-looking statements involving risks and uncertainties. These statements relate to our future plans, objectives, expectations and intentions. These statements may be identified by the use of words such as “expect,” “may,” “anticipate,” “intend,” “plan” and similar expressions. Our actual results could differ materially from those discussed in these forward-looking statements, and we caution that we do not undertake to update these statements. Factors that could contribute to our actual results differing from any forward-looking statements include those discussed under Risk Factors, Management’s Discussion and Analysis of Financial Condition and Results of Operations and elsewhere in this report. The cautionary statements made in this report should be read as being applicable to all forward-looking statements wherever they appear in this report. We further caution that there may be risks associated with owning our securities other than those discussed in such filings.

 

ITEM 1. BUSINESS

OVERVIEW

E*TRADE Financial Corporation is a financial services company that provides online brokerage and related products and services primarily to individual retail investors, under the brand “E*TRADE Financial.” Our primary focus is to profitably grow our online brokerage business, which includes our active trader and long-term investing customers. We also provide investor-focused banking products, primarily sweep deposits and savings products, to retail investors. Our competitive strategy is to attract and retain customers by emphasizing low-cost, ease of use and innovation, with delivery of our products and services primarily through online and technology-intensive channels.

Our corporate offices are located at 1271 Avenue of the Americas, 14th Floor, New York, New York 10020. We were incorporated in California in 1982 and reincorporated in Delaware in July 1996. We have approximately 3,000 employees. We operate directly and through numerous subsidiaries many of which are overseen by governmental and self-regulatory organizations. Our most significant subsidiaries are described below:

 

   

E*TRADE Bank is a federally chartered savings bank that provides investor-focused banking products to retail customers nationwide and deposit accounts insured by the Federal Deposit Insurance Corporation (“FDIC”);

 

   

E*TRADE Capital Markets, LLC is a registered broker-dealer and market maker;

 

   

E*TRADE Clearing LLC is the clearing firm for our brokerage subsidiaries and is a wholly-owned operating subsidiary of E*TRADE Bank. Its main purpose is to transfer securities from one party to another; and

 

   

E*TRADE Securities LLC is a registered broker-dealer and is a wholly-owned operating subsidiary of E*TRADE Bank. It is the primary provider of brokerage products and services to our customers.

A complete list of our subsidiaries can be found in Exhibit 21.1.

 

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We provide services to customers in the U.S. through our website at www.etrade.com. In addition to our website, we also provide services through our network of customer service representatives, relationship managers and investment advisors. We also provide these services over the phone or in person through our 28 E*TRADE Branches. Information on our website is not a part of this report.

STRATEGY

Our core business is our trading and investing customer franchise. Building on the strengths of this franchise, our growth strategy is focused on four areas: retail brokerage, corporate services and market making, wealth management, and banking.

 

   

Our retail brokerage business is our foundation. We believe a focus on these key factors will position us for future growth in this business: growing our sales force with a focus on long-term investing, optimizing our marketing spend, continuing to develop innovative products and services and minimizing account attrition.

 

   

Our corporate services and market making businesses enhance our strategy by allowing us to realize additional economic benefit from our retail brokerage business. Our corporate services business is a leading provider of software and services for managing equity compensation plans and is an important source of new retail brokerage accounts. Our market making business allows us to increase the economic benefit on the order flow from the retail brokerage business as well as generate additional revenues through external order flow.

 

   

We also plan to expand our wealth management offerings. Our vision is to provide wealth management services that are enabled by innovative technology and supported by guidance from professionals when needed.

 

   

Our retail brokerage business generates a significant amount of customer cash and we plan to continue to utilize our bank to optimize the value of these customer deposits.

Our strategy also includes an intense focus on mitigating the credit losses in our legacy loan portfolio and maintaining disciplined expense management. We remain focused on strengthening our overall capital structure and positioning the Company for future growth.

PRODUCTS AND SERVICES

We assess the performance of our business based on our segments, trading and investing and balance sheet management. We consider multiple factors, including the competitiveness of our pricing compared to similar products and services in the market, the overall profitability of our businesses and customer relationships when pricing our various products and services. We manage the performance of our business using various customer activity and financial metrics, including daily average revenue trades (“DARTs”), average commission per trade, margin receivables, end of period brokerage accounts, net new brokerage accounts, customer assets, net new brokerage assets, brokerage related cash, corporate cash, E*TRADE Bank excess risk-based capital, special mention loan delinquencies, allowance for loan losses, enterprise net interest spread and average enterprise interest-earning assets. Costs associated with certain functions that are centrally managed are separately reported in a “Corporate/Other” category.

Trading and Investing

Our trading and investing segment offers a full suite of financial products and services to individual retail investors. The most significant of these products and services are described below:

Trading Products and Services

 

   

automated order placement and execution of U.S. equities, futures, options, exchange-traded funds and bond orders;

 

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FDIC insured sweep deposit accounts that automatically transfer funds to and from customer brokerage accounts;

 

   

access to E*TRADE Mobile Pro, which allows customers to trade stocks and transfer funds between accounts via a Blackberry®, the Apple iPhoneTM, the Apple iPod® Touch, the Apple iPadTM or the AndroidTM device as well as the ability to monitor real-time investment, market and account information;

 

   

use of Power E*TRADE Pro, our desktop trading software for qualified active traders, which includes CNBC Plus, providing customers with customization capabilities, an expanded feature set and more news and information;

 

   

an open applications programming interface (“Open API”) for third-party and independent software developers, which allows customers to have access to technical information and documentation, reference guides, and other resources to help network external applications and programs with our active trader platform;

 

   

two-second execution guarantee on all qualified market orders for Standard & Poor’s (“S&P”) 500 stocks and exchange-traded funds;

 

   

margin accounts allowing customers to borrow against their securities;

 

   

cross-border trading, which allows customers residing outside of the U.S. to trade in U.S. securities;

 

   

access to international equities in Canada, France, Germany, Hong Kong, Japan and the United Kingdom and foreign currencies, including the Canadian dollar, Euro, Hong Kong dollar, Yen and Sterling; and

 

   

research and trade idea generation tools that assist customers with identifying investment opportunities to make informed decisions; these tools include market commentary from Dreyfus and Minyanville’s Buzz & Banter, a business and finance site.

Long-Term Investing Products and Services

 

   

use of the Investor Resource Center, which provides an aggregated view of our investing tools, market insights, independent research, education and other investing resources;

 

   

flexible advisory services through Online Advisor, our investment advice tool designed to provide investors with actionable investment guidance, including recommended asset allocations ranging from fully self-directed investing to 100 percent discretionary portfolio management from an affiliated registered investment advisor;

 

   

fixed income tools in our Bond Resource Center aimed at helping customers identify, evaluate and implement fixed income investment strategies;

 

   

access to Retirement QuickPlan, which is an easy-to-use, four-step retirement planning tool that provides a quick assessment of an individual’s or a family’s retirement savings and investing plan as well as tips to help get on track with personal retirement savings goals;

 

   

managed investment portfolio advisory services with an investment of $25,000 or more from an affiliated registered investment advisor, which provides one-on-one professional portfolio management;

 

   

unified managed account advisory services with an investment of $250,000 or more from an affiliated registered investment advisor, which provides customers the opportunity to work with a dedicated investment professional to obtain a comprehensive, integrated approach to asset allocation, investments, portfolio rebalancing and tax management;

 

   

no fee and no minimum individual retirement accounts;

 

   

access to more than 1,000 non-proprietary exchange-traded funds and over 8,000 non-proprietary mutual funds;

 

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investing and trading educational services via online videos, web seminars and web tutorials; and

 

   

FDIC insured deposit accounts, including checking, savings and money market accounts.

Corporate Services

We offer software and services for managing equity compensation plans for corporate customers. Our Equity Edge platform facilitates the management of employee option plans, employee stock purchase plans and restricted stock plans, including necessary accounting and reporting functions. This is a product of the trading and investing segment since it serves as an introduction to E*TRADE for many employees of our corporate customers who conduct equity option and restricted stock transactions, with our goal being that these individuals will also use our other products and services. Our corporate services business rated highest in overall satisfaction and loyalty among broker plan administrators for full and partial outsourced stock plan administration by GROUP FIVE, an independent consulting and research firm, in their 2010 Stock Plan Administration Benchmarking Study.

Market Making

Our trading and investing segment also includes market making activities which match buyers and sellers of securities from our retail brokerage business and unrelated third parties. As a market maker, we take positions in securities and function as a wholesale trader by combining trading lots to match buyers and sellers of securities. Trading gains and losses result from these activities. Our revenues are influenced by overall trading volumes, the number of stocks for which we act as a market maker and the trading volumes and volatility of those specific stocks.

Balance Sheet Management

The balance sheet management segment consists of the management of our balance sheet, focusing on asset allocation and managing credit, liquidity and interest rate risks. The balance sheet management segment manages loans previously originated or purchased from third parties as well as our customer cash and deposits, which originate in the trading and investing segment.

For additional statistical information regarding products and customers, see Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) beginning on page 28. Three years of segment financial performance and data can be found in the MD&A beginning on page 45 and in Note 23—Segment and Geographic Information of Item 8. Financial Statements and Supplementary Data beginning on page 160.

SALES AND CUSTOMER SERVICE

We believe providing superior sales and customer service is fundamental to our business. Growing our sales force with a focus on long-term investing is one of the key factors in our growth strategy. We also strive to maintain a high standard of customer service by staffing the customer support team with appropriately trained personnel who are equipped to handle customer inquiries in a prompt yet thorough manner. Our customer service representatives utilize our proprietary web-based platform to provide customers with answers to their inquiries. We also have specialized customer service programs that are tailored to the needs of each customer group.

We provide sales and customer support through the following channels of our registered broker-dealer and investment advisory subsidiaries:

 

   

Branches—we have 28 branches located in the U.S. where retail investors can go to service any of their needs while receiving face to face customer support. Financial consultants are also available on-site to help customers assess their current asset allocation.

 

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Online—we have an Online Advisor tool available that provides asset allocation and a range of investment solutions that can be managed online or through a dedicated investment professional. We also have an online service center where customers can request services on their accounts and obtain answers to frequently asked questions. The online service center also provides customers with the ability to send a secure message to one of our customer service representatives.

 

   

Telephonic—we have a toll free number that connects customers to an automated phone system which will help ensure that they are directed to the appropriate department where a financial consultant or licensed customer service representative can assist with their inquiry.

TECHNOLOGY

We believe our focus on being a technological leader in the financial services industry enhances our competitive position. This focus allows us to deploy a secure, scalable technology and back office platform that promotes innovative product development and delivery. We continued to increase our investments in these critical platforms in 2010, helping to drive significant efficiencies as well as enhancing our service and operational support capabilities. Our technology platform also enabled us to deliver trading and investing functionality with the introduction of Open API, mobile offerings across new devices and the Equity Edge Online platform.

COMPETITION

The online financial services market continues to evolve rapidly and we expect it to remain highly competitive. Our trading and investing segment competes with full commission brokerage firms, discount brokerage firms, online brokerage firms, Internet banks, traditional “brick & mortar” retail banks and thrifts and market making firms. Some of these competitors provide Internet trading and banking services, investment advisor services, touchtone telephone and voice response banking services, electronic bill payment services and a host of other financial products. Our balance sheet management segment competes with investment banking firms and other users of market liquidity, in addition to the competitors above, in its quest for the least expensive source of funding.

The financial services industry has become more concentrated as companies involved in a broad range of financial services have been acquired, merged or have declared bankruptcy. During the past three years, this trend accelerated considerably as a significant number of U.S. financial institutions consolidated, were forced to merge, or received substantial government assistance. We believe we can continue to attract customers by appealing to retail investors within large established financial institutions by providing them with easy to use and innovative financial products and services.

We also face competition in attracting and retaining qualified employees. Our ability to compete effectively in financial services will depend upon our ability to attract new employees and retain and motivate our existing employees while efficiently managing compensation related costs.

REGULATION

Our business is subject to regulation by U.S. federal and state regulatory and self-regulatory agencies and securities exchanges and by various non-U.S. governmental agencies or regulatory or self-regulatory bodies, securities exchanges and central banks, each of which has been charged with the protection of the financial markets and the protection of the interests of those participating in those markets.

Our regulators, rulemaking agencies and primary securities exchanges in the U.S. include, among others, the Securities and Exchange Commission (“SEC”), the Financial Industry Regulatory Authority (“FINRA”), the New York Stock Exchange (“NYSE”), the National Association of Securities Dealers Automated Quotations (“NASDAQ”), the FDIC, the Federal Reserve, the Municipal Securities Rulemaking Board and the Office of Thrift Supervision (“OTS”).

 

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Both our brokerage and banking entities are subject to the Bank Secrecy Act, as amended by the USA PATRIOT ACT of 2001 (“BSA/USA PATRIOT Act”), which contains anti-money laundering and financial transparency laws. In order to comply with the BSA/USA PATRIOT Act, we have established an Anti-Money Laundering (“AML”) unit which is responsible for developing and implementing enterprise-wide programs for compliance with the various anti-money laundering and counter-terrorist financing laws and regulations.

Brokerage Regulation

Our broker-dealers are registered with the SEC and are subject to regulation by the SEC and by self-regulatory organizations, such as FINRA and the securities exchanges of which each is a member, as well as various state regulators. Such regulation covers all aspects of the brokerage business, including, but not limited to, client protection, net capital requirements, required books and records, safekeeping of funds and securities, trading, prohibited transactions, public offerings, margin lending, customer qualifications for margin and options transactions, registration of personnel and transactions with affiliates. Our international broker-dealers are regulated by their respective local regulators such as the United Kingdom Financial Services Authority (“FSA”) and Hong Kong Securities & Futures Commission.

Banking Regulation

Our banking entities are subject to regulation, supervision and examination by the OTS, the Federal Reserve and the FDIC. Such regulation covers all aspects of the banking business, including lending practices, safeguarding deposits, customer privacy and information security, capital structure, transactions with affiliates and conduct and qualifications of personnel.

Under safeguarding deposits, each of our banking entities, as an insured depository institution, is a member of the Deposit Insurance Fund (“DIF”), maintained by the FDIC. All members of the DIF are required to pay assessed premiums, based on their institutional risk category and the amount of insured deposits held, to fund the DIF. On December 31, 2009 the FDIC required all insured depository institutions to prepay deposit insurance premiums for the fourth quarter of 2009 and for 2010, 2011, and 2012.

For customer privacy and information security, under the rules of the Gramm-Leach-Bliley Act, our banking entities are required to disclose their privacy policies and practices related to sharing customer information with affiliates and non-affiliates. The rules also give customers the ability to “opt-out” of having non-public information disclosed to third parties or receiving marketing solicitations from affiliates and non-affiliates based on non-public information received from our banking entities.

Financial Regulatory Reform Legislation and Basel III Accords

The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) was signed into law on July 21, 2010 and includes comprehensive changes to the financial services industry. Under the Dodd-Frank Act, our primary regulator, the OTS, will be abolished and its functions and personnel distributed among the Office of the Comptroller of the Currency (the “OCC”), FDIC and the Federal Reserve. Although the Dodd-Frank Act maintains the federal thrift charter, it eliminates certain benefits of the charter and imposes new penalties for failure to comply with the qualified thrift lender test. The Dodd-Frank Act also requires all companies, including savings and loan holding companies, that directly or indirectly control an insured depository institution to serve as a source of strength for the institution.

We believe the majority of the changes in the Dodd-Frank Act will have no material impact on our business. We believe, however, that the implementation of holding company capital requirements is relevant to us as the parent company is not currently subject to capital requirements. We fully expect that our holding company capital ratios will exceed the “well capitalized” minimums well in advance of the effective date and we have no plans to raise additional capital as a result of this new law. Our confidence in our ability to meet these requirements is reinforced by: our trajectory toward sustainable profitability; anticipated additional conversions of our convertible debt; and the utilization of our deferred tax asset as we deliver profitable results.

 

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The current risk-based capital guidelines that apply to E*TRADE Bank are based upon the 1988 capital accord of the International Basel Committee on Banking Supervision (“BCBS”), a committee of central banks and bank supervisors, as implemented by the U.S. federal banking agencies, including the OTS. On September 12, 2010, the Group of Governors and Heads of Supervision (“GHOS”), the oversight body of the BCBS, announced agreement on the calibration and phase-in arrangements for a strengthened set of capital requirements, known as the Basel III Accords. The final Basel III Accords were released on December 16, 2010 and are subject to individual adoption by member nations, including the U.S. beginning January 1, 2013. The GHOS agreement is intended to strengthen the prudential standards for large and internationally active banks and is not directly applicable to us; however, it may impact how the U.S. regulators implement the Dodd-Frank Act for other banking institutions, including the possibility of higher capital requirements. The full impact of the GHOS agreement on the regulatory requirements to which we will be subject is unclear, and will remain unknown for at least some time until implementing capital regulations are proposed and adopted. We will continue to monitor the ongoing rule-making process to assess both the timing and the impact of the Dodd-Frank Act and Basel III Accords on our business.

For additional regulatory information on our brokerage and banking regulations, see Note 20—Regulatory Requirements of Item 8. Financial Statements and Supplementary Data beginning on page 154.

AVAILABLE INFORMATION

We make our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports, available free of charge at our website as soon as reasonably practicable after they have been filed with the SEC. Our website address is www.etrade.com.

The public may read and copy any materials we file with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Washington, DC 20549. The public may obtain information of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains a website that contains the materials we file with the SEC at www.sec.gov.

 

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ITEM 1A. RISK FACTORS

The following factors which could materially affect our business, financial condition and results of operations should be carefully considered in addition to the other information set forth in this report. Although the risks described below are those that management believes are the most significant, these are not the only risks facing our company. Additional risks and uncertainties not currently known to us or that we currently do not deem to be material may also materially affect our business, financial condition and results of operations.

Risks Relating to the Nature and Operation of Our Business

We have incurred significant losses in recent years and cannot assure that we will be profitable in the future.

We incurred a net loss of $28.5 million, or $0.13 loss per share, for the year ended December 31, 2010 and net losses of $1.3 billion and $512 million for the years ended December 31, 2009 and 2008, respectively. These losses were due primarily to the credit losses in our loan portfolio and, in 2009, the loss on the Debt Exchange in which $1.7 billion aggregate principal amount of interest-bearing debt was exchanged for an equal principal amount of non-interest-bearing convertible debentures. Although we have taken a significant number of steps to reduce our credit exposure, we likely will continue to suffer credit losses in 2011. In late 2007, we experienced a substantial diminution of customer assets and accounts as a result of customer concerns regarding our credit related exposures. While we were able to stabilize our retail franchise during 2008, 2009 and 2010, it could take additional time to fully mitigate the credit issues in our loan portfolio and return to profitability.

We will continue to experience losses in our mortgage loan portfolio.

At December 31, 2010, the principal balance of our home equity loan portfolio was $6.4 billion and the allowance for loan losses for this portfolio was $576.1 million. At December 31, 2010, the principal balance of our one- to four-family loan portfolio was $8.2 billion and the allowance for loan losses for this portfolio was $389.6 million. Although the provision for loan losses has improved in recent periods, performance is subject to variability in any given quarter and we cannot state with certainty that the declining loan loss trend will continue. In particular, a significant portion of our mortgage loan portfolio is collateralized by properties in which the value is now estimated to be less than the outstanding balance of the loan. There can be no assurance that our allowance for loan losses will be adequate if the residential real estate and credit markets deteriorate beyond our expectations. We may be required under such circumstances to further increase our allowance for loan losses, which could have an adverse effect on our regulatory capital position and our results of operations in future periods.

The carrying value of our home equity and one- to four-family loan portfolios was $5.9 billion and $7.8 billion, respectively, at December 31, 2010. Our home equity and one- to four-family loan portfolios are held on the consolidated balance sheet at carrying value because they are classified as held for investment, which indicates that we have the intent and ability to hold them for the foreseeable future or until maturity. The fair value of our home equity and one- to four-family loan portfolios was estimated to be $4.7 billion and $7.3 billion, respectively, at December 31, 2010, in accordance with the fair value measurements accounting guidance, as disclosed in Note 5—Fair Value Disclosures of Item 8. Financial Statements and Supplementary Data on page 110. The fair value of our home equity and one- to four-family loan portfolios was estimated using a modeling technique that discounted future cash flows based on estimated principal and interest payments over the life of the loans, including expected losses and prepayments. There was limited or no observable market data for our home equity and one- to four-family loan portfolios, which indicates that the market for these types of loans is considered to be inactive. Given the limited market data, the fair value measurements cannot be determined with precision and the amount that would be realized in a forced liquidation, an actual sale or immediate settlement could be significantly lower than both the carrying value and the estimated fair value of the portfolio. In addition, changes in the underlying assumptions used, including discount rates and estimates of future cash flows, could significantly affect the results of current or future fair value estimates.

 

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We could experience significant losses on other securities held on the balance sheet.

At December 31, 2010, we held $490.3 million in amortized cost of non-agency collateralized mortgage obligations (“CMO”) on our consolidated balance sheet. We incurred net impairment charges of $37.7 million during 2010, which was a result of the deterioration in the expected credit performance of the underlying loans in the securities. If the credit quality of these securities further deteriorates, we may incur additional impairment charges which would have an adverse effect on our regulatory capital position and our results of operations in future periods.

Loss of customers and assets could destabilize the Company or result in lower revenues in future periods.

During November 2007, well-publicized concerns about E*TRADE Bank’s holdings of asset-backed securities led to widespread concerns about our continued viability. From the beginning of this crisis through December 31, 2007, when the situation stabilized, customers withdrew approximately $5.6 billion of net cash and approximately $12.2 billion of net assets from our bank and brokerage businesses. Many of the accounts that were closed belonged to sophisticated and active customers with large cash and securities balances. While we were able to stabilize our retail franchise in 2008, 2009 and 2010, concerns about our viability may recur, which could lead to destabilization and asset and customer attrition. If such destabilization should occur, there can be no assurance that we will be able to successfully rebuild our franchise by reclaiming customers and growing assets. If we are unable to sustain or, if necessary, rebuild our franchise, in future periods our revenues will be lower and our losses will be greater than we have experienced.

We have a large amount of debt.

We have issued a substantial amount of high-yield debt, with restrictive financial and other covenants. Following the completion of the Debt Exchange in 2009, in which $1.7 billion aggregate principal amount of interest-bearing corporate debt was exchanged for an equal principal amount of non-interest-bearing convertible debentures, our expected annual interest cash outlay decreased to approximately $166 million. Our ratio of debt (our corporate debt) to equity (expressed as a percentage) was 53% at December 31, 2010. The degree to which we are leveraged could have important consequences, including: 1) a substantial portion of our cash flow from operations is dedicated to the payment of principal and interest on our indebtedness, thereby reducing the funds available for other purposes; 2) our ability to obtain additional financing for working capital, capital expenditures, acquisitions and other corporate needs is significantly limited; and 3) our substantial leverage may place us at a competitive disadvantage, hinder our ability to adjust rapidly to changing market conditions and make us more vulnerable in the event of a further downturn in general economic conditions or our business. In addition, a significant reduction in revenues could have a material adverse effect on our ability to meet our obligations under our debt securities.

We depend on payments from our subsidiaries.

We depend on dividends, distributions and other payments from our subsidiaries to fund payments on our obligations, including our debt obligations. Regulatory and other legal restrictions limit our ability to transfer funds to or from our subsidiaries. In addition, many of our subsidiaries are subject to laws and regulations that authorize regulatory bodies to block or reduce the flow of funds to us, or that prohibit such transfers altogether in certain circumstances. These laws and regulations may hinder our ability to access funds that we may need to make payments on our obligations. The majority of our capital is invested in our banking subsidiary E*TRADE Bank, which may not pay dividends to us without approval from the OTS. Our primary brokerage subsidiaries, E*TRADE Securities LLC and E*TRADE Clearing LLC, are both subsidiaries of E*TRADE Bank; therefore, as our primary banking regulator and as a result of the memoranda of understanding with the OTS under which we continue to operate, the OTS controls our ability to receive dividend payments from our brokerage business as well. Furthermore, even if we receive the approval of the OTS to receive dividend payments from our brokerage business, in the event of our bankruptcy or liquidation or E*TRADE Bank’s receivership, we would not be entitled to receive any cash or other property or assets from our subsidiaries (including E*TRADE Bank,

 

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E*TRADE Clearing LLC and E*TRADE Securities LLC) until those subsidiaries pay in full their respective creditors, including customers of those subsidiaries and, as applicable, the FDIC and the Securities Investor Protection Corporation.

We are subject to investigations and lawsuits as a result of our losses from mortgage loans and asset-backed securities.

In 2007, we recognized an increased provision expense totaling $640 million and asset losses and impairments of $2.45 billion, including the sale of our asset-backed securities portfolio to Citadel. As a result, various plaintiffs filed class actions and derivative lawsuits, which have subsequently been consolidated into one class action and one derivative lawsuit, alleging disclosure violations regarding our home equity, mortgage and securities portfolios during 2007. In addition, the SEC initiated an informal inquiry into matters related to our loan and securities portfolios. The defense of these matters has and will continue to entail considerable cost and will be time-consuming for our management. Unfavorable outcomes in any of these matters could have a material adverse effect on our business, financial condition, results of operations and cash flows.

Many of our competitors have greater financial, technical, marketing and other resources.

The financial services industry is highly competitive, with multiple industry participants competing for the same customers. Many of our competitors have longer operating histories and greater resources than we have and offer a wider range of financial products and services. Other of our competitors offer a more narrow range of financial products and services and have not been as susceptible to the disruptions in the credit markets that have impacted our Company, and therefore have not suffered the losses we have. The impact of competitors with superior name recognition, greater market acceptance, larger customer bases or stronger capital positions could adversely affect our revenue growth and customer retention. Our competitors may also be able to respond more quickly to new or changing opportunities and demands and withstand changing market conditions better than we can. Competitors may conduct extensive promotional activities, offering better terms, lower prices and/or different products and services or combination of products and services that could attract current E*TRADE customers and potentially result in price wars within the industry. Some of our competitors may also benefit from established relationships among themselves or with third parties enhancing their products and services.

Turmoil in the global financial markets could reduce trade volumes and margin borrowing and increase our dependence on our more active customers who receive lower pricing.

Online investing services to the retail customer, including trading and margin lending, account for a significant portion of our revenues. Turmoil in the global financial markets could lead to changes in volume and price levels of securities and futures transactions which may, in turn, result in lower trading volumes and margin lending. For example, in the months following the abnormal intraday volatility (or so-called “flash crash”) of May 6, 2010, retail trading levels declined significantly; our DARTs for the third quarter of 2010 declined by 26% over the preceding quarter and 30% over the same quarter in the prior year. In particular, a decrease in trading activity within our lower activity accounts could impact revenues and increase dependence on more active trading customers who receive more favorable pricing based on their trade volume. A decrease in trading activity or securities prices would also typically be expected to result in a decrease in margin borrowing, which would reduce the revenue that we generate from interest charged on margin borrowing. More broadly, any reduction in overall transaction volumes would likely result in lower revenues and may harm our operating results because many of our overhead costs are fixed.

We rely heavily on technology, and technology can be subject to interruption and instability.

We rely on technology, particularly the Internet, to conduct much of our activity. Our technology operations are vulnerable to disruptions from human error, natural disasters, power loss, computer viruses, spam attacks, unauthorized access and other similar events. Disruptions to or instability of our technology or external technology that allows our customers to use our products and services could harm our business and our reputation. In addition, technology systems, whether they be our own proprietary systems or the systems of third

 

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parties on whom we rely to conduct portions of our operations, are potentially vulnerable to security breaches and unauthorized usage. An actual or perceived breach of the security of our technology could harm our business and our reputation.

Vulnerability of our customers’ computers and mobile devices could lead to significant losses related to identity theft or other fraud and harm our reputation and financial performance.

Because our business model relies heavily on our customers’ use of their own personal computers, mobile devices and the Internet, our business and reputation could be harmed by security breaches of our customers and third parties. Computer viruses and other attacks on our customers’ personal computer systems and mobile devices could create losses for our customers even without any breach in the security of our systems, and could thereby harm our business and our reputation. As part of our E*TRADE Complete Protection Guarantee, we reimburse our customers for losses caused by a breach of security of the customers’ own personal systems. Such reimbursements could have a material impact on our financial performance.

We rely on third party service providers to perform certain functions.

We rely on third party service providers for certain technology, processing, servicing and support functions. These third party service providers are also subject to operational and technology vulnerabilities, which may impact our business. An interruption in or the cessation of service by any third party service provider and our inability to make alternative arrangements in a timely manner could have a material impact on our business and financial performance.

Downturns in the securities markets increase the credit risk associated with margin lending or securities loaned transactions.

We permit customers to purchase securities on margin. A downturn in securities markets may impact the value of collateral held in connection with margin receivables and may reduce its value below the amount borrowed, potentially creating collections issues with our margin receivables. In addition, we frequently borrow securities from and lend securities to other broker-dealers. Under regulatory guidelines, when we borrow or lend securities, we must simultaneously disburse or receive cash deposits. A sharp change in security market values may result in losses if counterparties to the borrowing and lending transactions fail to honor their commitments.

We may be unsuccessful in managing the effects of changes in interest rates and the enterprise interest-earning assets in our portfolio.

Net operating interest income is an important source of our revenue. Our results of operations depend, in part, on our level of net operating interest income and our effective management of the impact of changing interest rates and varying asset and liability maturities. Our ability to manage interest rate risk could impact our financial condition. We use derivatives to help manage interest rate risk. However, the derivatives we utilize may not be completely effective at managing this risk and changes in market interest rates and the yield curve could reduce the value of our financial assets and reduce net operating interest income. Among other items, we periodically enter into repurchase agreements to support the funding and liquidity requirements of E*TRADE Bank. If we are unsuccessful in maintaining our relationships with counterparties, we could recognize substantial losses on the derivatives we utilized to hedge repurchase agreements.

If we do not successfully manage consolidation opportunities, we could be at a competitive disadvantage.

There has recently been significant consolidation in the financial services industry and this consolidation is likely to continue in the future. Should we be excluded from or fail to take advantage of viable consolidation opportunities, our competitors may be able to capitalize on those opportunities and create greater scale and cost efficiencies to our detriment.

 

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We have acquired a number of businesses and, although we are currently constrained by the terms of our corporate debt and the memoranda of understanding we and E*TRADE Bank entered into with the OTS, may continue to acquire businesses in the future. The primary assets of these businesses are their customer accounts. Our retention of these assets and the customers of businesses we acquire may be impacted by our ability to successfully continue to integrate the acquired operations, products (including pricing) and personnel. Diversion of management attention from other business concerns could have a negative impact. If we are not successful in our integration efforts, we may experience significant attrition in the acquired accounts or experience other issues that would prevent us from achieving the level of revenue enhancements and cost savings that we expect with respect to an acquisition.

Risks associated with principal trading transactions could result in trading losses.

A majority of our market making revenues are derived from trading as a principal. We may incur trading losses relating to the purchase, sale or short sale of securities for our own account, as well as trading losses in our market maker stocks. We carry equity security positions on a daily basis and from time to time, we may carry large positions in securities of a single issuer or issuers engaged in a specific industry. Sudden changes in the value of these positions could impact our financial results.

Reduced spreads in securities pricing, levels of trading activity and trading through market makers could harm our market maker business.

Technological advances, competition and regulatory changes in the marketplace may continue to tighten securities spreads. Tighter spreads could reduce revenue capture per share by our market maker, thus reducing revenues for this line of business.

Advisory services subject us to additional risks.

We provide advisory services to investors to aid them in their decision making and also provide full service portfolio management. Investment decisions and suggestions are based on publicly available documents and communications with investors regarding investment preferences and risk tolerances. Publicly available documents may be inaccurate and misleading, resulting in recommendations or transactions that are inconsistent with the investors’ intended results. In addition, advisors may not understand investor needs or risk tolerances, failures that may result in the recommendation or purchase of a portfolio of assets that may not be suitable for the investor. To the extent that we fail to know our customers or improperly advise them, we could be found liable for losses suffered by such customers, which could harm our reputation and business.

Our international operations subject us to additional risks and regulation, which could impair our business growth.

We conduct business in a number of international locations. Action or inaction in any of these operations, including the failure to follow proper practices with respect to regulatory compliance and/or corporate governance, could harm our operations and/or our reputation.

We have a significant deferred tax asset and cannot assure it will be fully realized.

We had net deferred tax assets of $1.5 billion as of December 31, 2010. We did not establish a valuation allowance against our federal net deferred tax assets as of December 31, 2010 as we believe that it is more likely than not that all of these assets will be realized. In evaluating the need for a valuation allowance, we estimated future taxable income based on management approved forecasts. This process required significant judgment by management about matters that are by nature uncertain. If future events differ significantly from our current forecasts, a valuation allowance may need to be established, which would have a material adverse effect on our results of operations and our financial condition.

 

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As a result of the Public Equity Offering, the Debt Exchange and related transactions in 2009, we believe that we experienced an “ownership change” for tax purposes that could cause us to permanently lose a significant portion of our U.S. federal and state deferred tax assets.

As a result of the Public Equity Offering, the Debt Exchange and related transactions in 2009, we believe that we experienced an “ownership change” as defined under Section 382 of the Internal Revenue Code of 1986, as amended (“Section 382”) (which is generally a greater than 50 percentage point increase by certain “5% shareholders” over a rolling three year period). Section 382 imposes an annual limitation on the utilization of deferred tax assets, such as net operating loss carryforwards and other tax attributes, once an ownership change has occurred. Depending on the size of the annual limitation (which is in part a function of our market capitalization at the time of the ownership change) and the remaining carryforward period of the tax assets (U.S. federal net operating losses generally may be carried forward for a period of 20 years), we could realize a permanent loss of a portion of our U.S. federal and state deferred tax assets and certain built-in losses that have not been recognized for tax purposes. We believe the tax ownership change will extend the period of time it will take to fully utilize our pre-ownership change net operating losses (“NOLs”), but will not limit the total amount of pre-ownership change NOLs we can utilize. This is a complex analysis and requires the Company to make certain judgments in determining the annual limitation. As a result, it is possible that we could ultimately lose a significant portion of our deferred tax assets, which could have a material adverse effect on our results of operations and financial condition.

Risks Relating to the Regulation of Our Business

We are subject to extensive government regulation, including banking and securities rules and regulations, which could restrict our business practices.

The securities and banking industries are subject to extensive regulation. All of our broker-dealer subsidiaries have to comply with many laws and rules, including rules relating to sales practices and the suitability of recommendations to customers, possession and control of customer funds and securities, margin lending, execution and settlement of transactions and anti money-laundering. We are also subject to additional laws and rules as a result of our market maker operations.

Similarly, E*TRADE Financial Corporation and ETB Holdings, Inc., as savings and loan holding companies, and E*TRADE Bank, E*TRADE Savings Bank and E*TRADE United Bank, as federally chartered savings banks, are subject to extensive regulation, supervision and examination by the OTS (including pursuant to the terms of the memoranda of understanding that E*TRADE Financial Corporation and E*TRADE Bank entered into with the OTS) and, in the case of the savings banks, also the FDIC. Such regulation covers all banking business, including lending practices, safeguarding deposits, capital structure, recordkeeping, transactions with affiliates and conduct and qualifications of personnel.

Recently enacted regulatory reform legislation may have a material impact on our operations. In addition, if we are unable to meet the new requirements, we could face negative regulatory consequences. Any such actions could have a material negative effect on our business.

On July 21, 2010, the President signed into law the Dodd-Frank Act. This new law contains various provisions designed to enhance financial stability and to reduce the likelihood of another financial crisis and will significantly change the current bank regulatory structure for our Company and its thrift subsidiaries. The key effects of the Dodd-Frank Act on our business are:

 

   

changes to the thrift supervisory structure;

 

   

changes to regulatory capital requirements;

 

   

increases in the FDIC assessment for depository institutions with assets of $10 billion or more;

 

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establishment of a Consumer Financial Protection Bureau with broad authority to implement new consumer protection regulations and, for banks and thrifts with $10 billion or more in assets, to examine and enforce compliance with federal consumer laws; and

 

   

increases in the minimum reserve ratio for the FDIC’s deposit insurance fund to 1.35%.

Under the legislation, the OTS will be abolished by April 2012 and its functions and personnel distributed among the OCC, FDIC and the Federal Reserve. Primary jurisdiction for the supervision and regulation of federal thrifts, such as the Company’s three thrift subsidiaries, will be transferred to the OCC; supervision and regulation of savings and loan holding companies, including the Company, will be transferred to the Federal Reserve. Although the Dodd-Frank Act maintains the federal thrift charter, it eliminates certain benefits of the charter and imposes new penalties for failure to comply with the qualified thrift lender test. The Dodd-Frank Act also requires all companies, including savings and loan holding companies that directly or indirectly control an insured depository institution to serve as a source of strength for the institution.

The Dodd-Frank Act also creates a new independent regulatory body, the Consumer Financial Protection Bureau, which has been given broad rulemaking authority to implement the consumer protection laws that apply to banks and thrifts and to prohibit “unfair, deceptive or abusive” acts and practices. For all banks and thrifts with total consolidated assets over $10 billion, including E*TRADE Bank, the Consumer Financial Protection Bureau has exclusive rulemaking and examination, and primary enforcement authority, under federal consumer financial laws and regulations. In addition, the Dodd-Frank Act permits states to adopt consumer protection laws and regulations that are stricter than those regulations promulgated by the Consumer Financial Protection Bureau.

For us, one of the most significant changes under the new law is that savings and loan holding companies such as our Company for the first time will become subject to the same capital and activity requirements as those applicable to bank holding companies. In addition, we will be subject to the same capital requirements as those applied to banks which requirements exclude, on a phase-out basis, all trust preferred securities from Tier 1 capital. While the Dodd-Frank Act provides for a five year phase-in period for these new capital requirements, it requires holding companies like ours, as well as all of our thrift subsidiaries, to be both “well capitalized” and “well managed” in order to be able to engage in certain financial activities such as market making and securities underwriting as soon as the OTS is abolished. We fully expect to meet these capital requirements and to have our Company and its thrift subsidiaries qualify as both “well capitalized” and “well managed” within the applicable phase in periods. However, if we are unable to satisfy these requirements, we could be subject to activity restrictions and other negative regulatory actions. In addition, it is possible that our regulators may impose more stringent capital and other prudential standards on us prior to the end of the five year phase-in period.

The Dodd-Frank Act requires various federal agencies to adopt a broad range of new rules and regulations, the details, substance, and impact of which may not be known for months or years. It is difficult to predict at this time what other specific impacts the Dodd-Frank Act and the yet-to-be-written rules and regulations may have on us. However, given that the legislation is likely to materially change the regulatory environment for the financial services industry in which we operate, we expect at a minimum that our compliance costs will increase.

The OTS may request that we raise additional equity to support E*TRADE Bank or to further reduce debt. If we are unable to do so, we could face negative regulatory actions. Any such actions could have a material negative effect on our business.

In early 2009, the OTS advised us, and we agreed, that we needed to raise additional equity capital for E*TRADE Bank and reduce substantially the amount of our outstanding debt in order to withstand any further deterioration in current credit and market conditions. In furtherance of these objectives, we completed the Debt Exchange, the Public Equity Offering and the At the Market Common Stock Offering in 2009. Pursuant to memoranda of understanding that we and E*TRADE Bank entered into with the OTS, we and E*TRADE Bank are required to submit to the OTS and implement both capital and de-leveraging plans to continue to monitor and address these matters.

 

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If we are unable to comply with the terms of our capital plan in the ordinary course of business or are unable to raise any additional cash equity to be contributed as capital to E*TRADE Bank or to further reduce our debt, in each case, as may in the future be required by the OTS, we could face negative regulatory consequences.

If we fail to comply with applicable securities and banking laws, rules and regulations, either domestically or internationally, we could be subject to disciplinary actions, damages, penalties or restrictions that could significantly harm our business.

The SEC, FINRA and other self-regulatory organizations and state securities commissions, among other things, can censure, fine, issue cease-and-desist orders or suspend or expel a broker-dealer or any of its officers or employees. The OTS may take similar action with respect to our banking activities. Similarly, the attorneys general of each state could bring legal action on behalf of the citizens of the various states to ensure compliance with local laws. Regulatory agencies in countries outside of the U.S. have similar authority. The ability to comply with applicable laws and rules is dependent in part on the establishment and maintenance of a reasonable compliance system. The failure to establish and enforce reasonable compliance procedures, even if unintentional, could subject us to significant losses or disciplinary or other actions.

If we do not maintain the capital levels required by regulators, we may be fined or even forced out of business.

The SEC, FINRA, OTS and various other regulatory agencies have stringent rules with respect to the maintenance of specific levels of regulatory capital by banks and net capital by securities broker-dealers. E*TRADE Bank is subject to various regulatory capital requirements administered by the OTS, which will soon be administered by the OCC, and E*TRADE Financial Corporation will, for the first time, become subject to specific capital requirements administered by the Federal Reserve. Failure to meet minimum capital requirements can trigger certain mandatory, and possibly additional discretionary actions by regulators that, if undertaken, could harm E*TRADE Bank’s and E*TRADE Financial Corporation’s operations and financial statements.

The Bank must meet specific capital guidelines that involve quantitative measures of E*TRADE Bank’s assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. Quantitative measures established by regulation to ensure capital adequacy require E*TRADE Bank to maintain minimum amounts and ratios of total and Tier 1 capital to risk-weighted assets and of Tier 1 capital to adjusted total assets. To satisfy the capital requirements for a “well capitalized” financial institution, E*TRADE Bank must maintain higher total and Tier 1 capital to risk-weighted assets and Tier 1 capital to adjusted total assets ratios. E*TRADE Bank’s capital amounts and classification are subject to qualitative judgments by the regulators about the strength of components of its capital, risk weightings of assets, off-balance sheet transactions and other factors. Any significant reduction in E*TRADE Bank’s regulatory capital could result in E*TRADE Bank being less than “well capitalized” or “adequately capitalized” under applicable capital rules. A failure of E*TRADE Bank to be “adequately capitalized” which is not cured within time periods specified in the indentures governing our debt securities would constitute a default under our debt securities and likely result in the debt securities becoming immediately due and payable at their full face value.

Similarly, failure to maintain the required net capital by our securities broker-dealers could result in suspension or revocation of registration by the SEC and suspension or expulsion by FINRA, and could ultimately lead to the firm’s liquidation. Net capital is the net worth of a broker or dealer (assets minus liabilities), less deductions for certain types of assets. If such net capital rules are changed or expanded, or if there is an unusually large charge against net capital, operations that require an intensive use of capital could be limited. Such operations may include investing activities, marketing and the financing of customer account balances. Also, our ability to withdraw capital from brokerage subsidiaries could be restricted, which in turn could limit our ability to repay debt and redeem or purchase shares of our outstanding stock.

 

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As a non-grandfathered savings and loan holding company, we are subject to regulations that could restrict our ability to take advantage of certain business opportunities.

We are required to file periodic reports with the OTS and are subject to examination by the OTS. The OTS also has certain types of enforcement powers over us, ETB Holdings, Inc. and certain of its subsidiaries, including the ability to issue cease-and-desist orders, force divestiture of E*TRADE Bank and impose civil and monetary penalties for violations of federal banking laws and regulations or for unsafe or unsound banking practices. In addition, under the Gramm-Leach-Bliley Act, our activities are restricted to those that are financial in nature and certain real estate-related activities. We may make merchant banking investments in companies whose activities are not financial in nature if those investments are made for the purpose of appreciation and ultimate resale of the investment and we do not manage or operate the company. Such merchant banking investments may be subject to maximum holding periods and special recordkeeping and risk management requirements. In recent periods, the Company moved its subsidiaries, E*TRADE Clearing LLC and E*TRADE Securities LLC, respectively, to become operating subsidiaries of E*TRADE Bank, resulting in increased regulatory oversight and restrictions on the activities of E*TRADE Clearing LLC and E*TRADE Securities LLC.

We believe all of our existing activities and investments are permissible under the Gramm-Leach-Bliley Act. Even if our existing activities and investments are permissible, we are unable to pursue future activities that are not financial in nature. We are also limited in our ability to invest in other savings and loan holding companies.

In addition, E*TRADE Bank is subject to extensive regulation of its activities and investments, capitalization, community reinvestment, risk management policies and procedures and relationships with affiliated companies. Acquisitions of and mergers with other financial institutions, purchases of deposits and loan portfolios, the establishment of new bank subsidiaries and the commencement of new activities by bank subsidiaries require the prior approval of the OTS, and in some cases the FDIC, which may deny approval or limit the scope of our planned activity. These regulations and conditions could place us at a competitive disadvantage in an environment in which consolidation within the financial services industry is prevalent. Also, these regulations and conditions could affect our ability to realize synergies from future acquisitions, could negatively affect us following the acquisition and could also delay or prevent the development, introduction and marketing of new products and services.

Risks Relating to Owning Our Stock

We are substantially restricted by the terms of our corporate debt.

The indentures governing our corporate debt contain various covenants and restrictions that limit our ability and certain of our subsidiaries’ ability to, among other things:

 

   

incur additional indebtedness;

 

   

create liens;

 

   

pay dividends or make other distributions;

 

   

repurchase or redeem capital stock;

 

   

make investments or other restricted payments;

 

   

enter into transactions with our shareholders or affiliates;

 

   

sell assets or shares of capital stock of our subsidiaries;

 

   

receive dividend or other payments from our subsidiaries; and

 

   

merge, consolidate or transfer substantially all of our assets.

 

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As a result of the covenants and restrictions contained in the indentures, we are limited in how we conduct our business and we may be unable to raise additional debt or equity financing to compete effectively or to take advantage of new business opportunities. Each of these series of our corporate debt contains a limitation, subject to important exceptions, on our ability to incur additional debt if our Consolidated Fixed Charge Coverage Ratio (as defined in the relevant indentures) is less than or equal to 2.50 to 1.0. As of December 31, 2010, our Consolidated Fixed Charge Coverage Ratio was 0.95 to 1.0. The terms of any future indebtedness could include more restrictive covenants.

Although these covenants provide substantial flexibility, for example the ability to incur “refinancing indebtedness” and to incur up to $300 million of secured debt under a credit facility, the covenants, among other things, generally limit our ability to incur additional debt even if we were to substantially reduce our existing debt through debt exchange transactions. We could be forced to repay immediately all our outstanding debt securities at their full principal amount if we were to breach these covenants and did not cure the breach within the cure periods (if any) specified in the respective indentures. Further, if we experience a change of control, as defined in the indentures, we could be required to offer to purchase our debt securities at 101% of their principal amount. Under our debt securities a “change of control” would occur if, among other things, a person became the beneficial owner of more than 50% of the total voting power of our voting stock which, with respect to the 2011 Notes, 2013 Notes and 2015 Notes, would need to be coupled with a ratings downgrade before we would be required to offer to purchase those securities.

We cannot assure that we will be able to remain in compliance with these covenants in the future and, if we fail to do so, that we will be able to obtain waivers from the appropriate parties and/or amend the covenants.

The value of our common stock may be diluted if we need additional funds in the future or engage in debt-for-equity exchanges in the future.

In the future, we may need to raise additional funds via debt and/or equity instruments, which may not be available on favorable terms, if available at all. If adequate funds are not available on acceptable terms, we may be unable to fund our capital needs and our plans for the growth of our business. In addition, if funds are available, the issuance of equity securities could significantly dilute the value of our shares of our common stock and cause the market price of our common stock to fall. We have the ability to issue a significant number of shares of stock in future transactions, which would substantially dilute existing shareholders, without seeking further shareholder approval.

In recent periods, the global financial markets were in turmoil and the equity and credit markets experienced extreme volatility, which caused already weak economic conditions to worsen. Continued turmoil in the global financial markets could further restrict our access to the equity and debt markets.

Citadel is our largest shareholder and debtholder, with approximately 9.9% of our common stock or approximately 27% of our common stock assuming conversion of convertible debentures held by Citadel. Accordingly, Citadel’s interests may conflict with the interests of other shareholders.

Citadel is the largest holder of our common stock, and based upon our review of publicly available information, we believe Citadel owns approximately 9.9% of our outstanding common stock or approximately 27% of our common stock assuming conversion of convertible debentures held by Citadel. Although Citadel is not required to disclose to us the amount of our outstanding debt securities it owns, we believe it owns in the aggregate approximately $590 million of the non-interest-bearing convertible debentures. In addition, Kenneth Griffin, President and CEO of Citadel, joined the Board of Directors on June 8, 2009 pursuant to a director nomination right granted to Citadel in 2007.

Citadel is an independent entity with its own investors and is entitled to act in its own economic interest with respect to its equity and debt investments in E*TRADE. As discussed below, our debt securities contain restrictive covenants. In pursuing its economic interests, Citadel may make decisions with respect to fundamental corporate transactions which may be different than the decisions of investors who own only common shares.

 

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Citadel is a substantial holder of our common stock and has not entered into any contractual arrangements to protect the interests of other shareholders.

Based upon our review of publicly available information, we believe Citadel owns approximately 9.9% of our outstanding common stock or approximately 27% of our common stock assuming conversion of convertible debentures held by Citadel. Under the law of Delaware, where the Company is incorporated, this would most likely be sufficient to permit Citadel to influence or cause the election of a substantial number of directors and significantly impact, corporate policy, including decisions to enter into mergers or other extraordinary transactions. The Company and Citadel have not entered into a shareholders agreement or similar contract to restrict these actions, but Citadel will be unable to accomplish these matters for so long as it is subject to certain rules of the OTS regarding rebuttals of control over thrifts and thrift holding companies. If these rules change, or if Citadel receives a waiver or is no longer subject to its rebuttal of control agreement with the OTS or decides to become a thrift holding company, it will be in a position to influence or cause the election of a substantial number of directors and to substantially impact, corporate policy. Further, if Citadel acquires securities representing more than 50% of the total voting power, holders of our debt securities would have the right to require the Company to repurchase all such securities for cash at 101% of their face amount.

The market price of our common stock may continue to be volatile.

From January 1, 2008 through December 31, 2010, the price per share of our common stock ranged from a low of $5.90 to a high of $54.80. The market price of our common stock has been, and is likely to continue to be, highly volatile and subject to wide fluctuations. In the past, volatility in the market price of a company’s securities has often led to securities class action litigation. Such litigation could result in substantial costs to us and divert our attention and resources, which could harm our business. As discussed in Note 22—Commitments, Contingencies and Other Regulatory Matters of Item 8. Financial Statements and Supplementary Data, we are currently a party to litigation related to the decline in the market price of our stock, and such litigation could occur again in the future. Declines in the market price of our common stock or failure of the market price to increase could also harm our ability to retain key employees, reduce our access to capital, impact our ability to utilize deferred tax assets in the event of another ownership change and otherwise harm our business.

We have various mechanisms in place that may discourage takeover attempts.

Certain provisions of our certificate of incorporation and bylaws may discourage, delay or prevent a third party from acquiring control of us in a merger, acquisition or similar transaction that a shareholder may consider favorable. Such provisions include:

 

   

authorization for the issuance of “blank check” preferred stock;

 

   

provision for a classified Board of Directors with staggered, three-year terms;

 

   

the prohibition of cumulative voting in the election of directors;

 

   

a super-majority voting requirement to effect business combinations and certain amendments to our certificate of incorporation and bylaws;

 

   

limits on the persons who may call special meetings of shareholders;

 

   

the prohibition of shareholder action by written consent; and

 

   

advance notice requirements for nominations to the Board or for proposing matters that can be acted on by shareholders at shareholder meetings.

In addition, certain provisions of our stock incentive plans, management retention and employment agreements (including severance payments and stock option acceleration), certain provisions of Delaware law and the requirements under our debt securities to offer to purchase such securities at 101% of their principal amount may also discourage, delay or prevent someone from acquiring or merging with us.

 

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We may not be able to generate sufficient cash to service all of our indebtedness and may be forced to take other actions to satisfy our obligations under our indebtedness, which may not be successful.

Our ability to make scheduled payments on or to refinance our debt obligations depends on our financial condition and operating performance, which is subject to prevailing economic and competitive conditions and to certain financial, business and other factors beyond our control. We may not be able to maintain a level of cash flows from operating activities sufficient to permit us to pay the principal and interest on our indebtedness.

If our cash flows and capital resources are insufficient to fund our debt service obligations, we may be forced to reduce or delay investments and capital expenditures, or to sell assets, seek additional capital or restructure or refinance our indebtedness. These alternative measures may not be successful and may not permit us to meet our scheduled debt service obligations. In addition, the terms of existing or future debt instruments may restrict us from adopting some of these alternatives.

Our ability to restructure or refinance our debt will depend on the condition of the capital markets and our financial condition at such time. Any refinancing of our debt could be at higher interest rates and may require us to comply with more onerous covenants, which could further restrict our business operations. In addition, any failure to make payments of interest and principal on our outstanding indebtedness on a timely basis would likely result in a reduction of our credit rating, which could harm our ability to incur additional indebtedness. If our cash flows and available cash are insufficient to meet our debt service obligations, we could face substantial liquidity problems and might be required to dispose of material assets or operations to meet our debt service and other obligations. We may not be able to consummate those dispositions or to obtain the proceeds that we could realize from them, and these proceeds may not be adequate to meet any debt service obligations then due.

 

ITEM 1B. UNRESOLVED STAFF COMMENTS

None.

 

ITEM 2. PROPERTIES

A summary of our significant locations at December 31, 2010 is shown in the following table. All facilities are leased, except for 165,000 square feet of our office in Alpharetta, Georgia. Square footage amounts are net of space that has been sublet or part of a facility restructuring.

 

Location

   Approximate Square Footage  

Alpharetta, Georgia

     260,000  

Arlington, Virginia

     140,000  

Jersey City, New Jersey

     107,000  

Sandy, Utah

     77,000  

Menlo Park, California

     76,000  

New York, New York

     39,000  

Chicago, Illinois

     25,000  

All of our facilities are used by either our trading and investing or balance sheet segments. All other leased facilities with space of less than 25,000 square feet are not listed by location. In addition to the significant facilities above, we also lease all of our 28 E*TRADE Branches, ranging in space from approximately 2,500 to 7,000 square feet. We believe our facilities space is adequate to meet our needs in 2011.

 

ITEM 3. LEGAL PROCEEDINGS

On October 27, 2000, Ajaxo, Inc. (“Ajaxo”) filed a complaint in the Superior Court for the State of California, County of Santa Clara. Ajaxo sought damages and certain non-monetary relief for the Company’s alleged breach of a non-disclosure agreement with Ajaxo pertaining to certain wireless technology that Ajaxo

 

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offered the Company as well as damages and other relief against the Company for their alleged misappropriation of Ajaxo’s trade secrets. Following a jury trial, a judgment was entered in 2003 in favor of Ajaxo against the Company for $1.3 million for breach of the Ajaxo non-disclosure agreement. Although the jury found in favor of Ajaxo on its claim against the Company for misappropriation of trade secrets, the trial court subsequently denied Ajaxo’s requests for additional damages and relief. On December 21, 2005, the California Court of Appeal affirmed the above-described award against the Company for breach of the nondisclosure agreement but remanded the case to the trial court for the limited purpose of determining what, if any, additional damages Ajaxo may be entitled to as a result of the jury’s previous finding in favor of Ajaxo on its claim against the Company for misappropriation of trade secrets. Although the Company paid Ajaxo the full amount due on the above-described judgment, the case was remanded back to the trial court, and on May 30, 2008, a jury returned a verdict in favor of the Company denying all claims raised and demands for damages against the Company. Following the trial court’s filing of entry of judgment in favor of the Company on September 5, 2008, Ajaxo filed post-trial motions for vacating this entry of judgment and requesting a new trial. By order dated November 4, 2008, the trial court denied these motions. On December 2, 2008, Ajaxo filed a notice of appeal with the Court of Appeal of the State of California for the Sixth District. Oral argument on the appeal was heard on July 15, 2010. On August 30, 2010, the Court of Appeal affirmed the trial court’s verdict in part and reversed the verdict in part, remanding the case. E*TRADE petitioned the Supreme Court of California for review of the Court of Appeal decision. On December 16, 2010, the California Supreme Court denied the Company’s petition for review and remanded for further proceedings to the trial court. The Company will continue to defend itself vigorously.

On October 11, 2006, a state class action was filed by Nikki Greenberg on her own behalf and on behalf of all those similarly situated plaintiffs, in the Superior Court for the State of California, County of Los Angeles on behalf of all customers or consumers who allegedly made or received telephone calls from the Company that were recorded without their knowledge or consent. On February 7, 2008, class certification was granted and the class defined to consist of (1) all persons in California who received telephone calls from the Company and whose calls were recorded without their consent within three years of October 11, 2006, and (2) all persons who made calls from California to the Beverly Hills branch of the Company on August 8, 2006. Plaintiffs sought to recover unspecified monetary damages plus injunctive relief, including punitive and exemplary damages, interest, attorneys’ fees and costs. On October 16, 2009, the court granted final approval of the parties’ proposed settlement agreement. Objectors to the court’s order granting final approval of the parties’ settlement agreement filed notices of appeal which were subsequently dismissed on January 26, 2010. The Company paid the settlement amount to the Claims Administrator on March 5, 2010. Administration of the settlement was completed in August 2010 for an amount that had no material impact on the Company and the action is now concluded.

On October 2, 2007, a class action complaint alleging violations of the federal securities laws was filed in the United States District Court for the Southern District of New York against the Company and its then Chief Executive Officer and Chief Financial Officer, Mitchell H. Caplan and Robert J. Simmons, by Larry Freudenberg on his own behalf and on behalf of others similarly situated (the “Freudenberg Action”). On July 17, 2008, the trial court consolidated this action with four other purported class actions, all of which were filed in the United States District Court for the Southern District of New York and which were based on the same facts and circumstances. On January 16, 2009, plaintiffs served their consolidated amended class action complaint in which they also named Dennis Webb, the Company’s former Capital Markets Division President, as a defendant. Plaintiffs contend, among other things, that the value of the Company’s stock between April 19, 2006 and November 9, 2007 was artificially inflated because the defendants issued materially false and misleading statements and failed to disclose that the Company was experiencing a rise in delinquency rates in its mortgage and home equity portfolios; failed to timely record an impairment on its mortgage and home equity portfolios; materially overvalued its securities portfolio, which included assets backed by mortgages; and based on the foregoing, lacked a reasonable basis for the positive statements made about the Company’s earnings and prospects. Plaintiffs seek to recover damages in an amount to be proven at trial, including interest and attorneys’ fees and costs. Defendants filed their motion to dismiss on April 2, 2009, and briefing on defendants’ motion to dismiss was completed on August 31, 2009. On May 11, 2010, the Court issued an order denying defendants’

 

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motion to dismiss. The Company filed an Answer to the Complaint on June 25, 2010. Fact discovery and expert discovery are expected to conclude on May 15, 2012. The Company intends to vigorously defend itself against these claims.

On October 17, 2007, the SEC initiated an informal inquiry into matters related to the Company’s mortgage loan and mortgage-related securities investment portfolios. The Company is cooperating fully with the SEC in this matter.

On August 15, 2008, Ronald M. Tate as trustee of the Ronald M. Tate Trust Dtd 4/13/88, and George Avakian filed an action in the United States District Court for the Southern District of New York against the Company, Mitchell H. Caplan and Robert J. Simmons based on the same facts and circumstances, and containing the same claims, as the Freudenberg consolidated actions discussed above. By agreement of the parties and approval of the court, the Tate action has been consolidated with the Freudenberg consolidated actions for the purpose of pre-trial discovery. Plaintiffs seek to recover damages in an amount to be proven at trial, including interest, attorneys’ and expert fees and costs. The Company intends to vigorously defend itself against these claims.

Based upon the same facts and circumstances alleged in the Freudenberg consolidated actions discussed above, a verified shareholder derivative complaint was filed in the United States District Court for the Southern District of New York on October 4, 2007 by Catherine Rubery, against the Company and its then Chief Executive Officer, President/Chief Operating Officer, Chief Financial Officer and individual members of its board of directors. The Rubery complaint was consolidated with another shareholder derivative complaint brought by shareholder Marilyn Clark in the same court and against the same named defendants. On July 26, 2010, Plaintiffs served their consolidated amended complaint, in which they also named Dennis Webb, the Company’s former Capital Markets Division President, as a defendant. Plaintiffs allege, among other things, causes of action for breach of fiduciary duty, waste of corporate assets, unjust enrichment, and violation of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. The complaint seeks, among other things, unspecified monetary damages in favor of the Company, changes to corporate governance procedures and various forms of injunctive relief. Pursuant to a stipulation, defendants’ motion to dismiss the consolidated federal derivative actions is not due until July 2012.

Three similar derivative actions, based on the same facts and circumstances as the federal derivative actions, but alleging exclusively state causes of action, were filed in the Supreme Court of the State of New York, New York County and were ordered consolidated in that court. In these state derivative actions, plaintiffs Frank Fosbre, Brian Kallinen and Alexander Guiseppone filed a consolidated amended complaint on March 23, 2009. Plaintiffs in the foregoing actions sought unspecified monetary damages against the Individual Defendants in favor of the Company, plus an injunction compelling changes to the Company’s corporate governance policies. As a result of the decision denying the motion to dismiss in the Freudenberg consolidated actions discussed above, the stay in this action was lifted and defendants moved to dismiss the amended complaint on July 12, 2010. Briefing on the motion to dismiss concluded on October 25, 2010. The motion was scheduled for oral argument on February 7, 2011, but instead, the plaintiffs withdrew their claims by filing a Stipulation of Dismissal, which was so ordered by the Court on February 4, 2011.

On April 2, 2008, a class action complaint alleging violations of the federal securities laws was filed by John W. Oughtred on his own behalf and on behalf of all others similarly situated in the United States District Court for the Southern District of New York against the Company. Plaintiff contends, among other things, that the Company committed various sales practice violations in the sale of certain auction rate securities to investors between April 2, 2003, and February 13, 2008 by allegedly misrepresenting that these securities were highly liquid and safe investments for short term investing. On December 18, 2008, plaintiffs filed their first amended class action complaint. Defendants filed their pending motion to dismiss plaintiffs’ amended complaint on February 5, 2009, and briefing on defendants’ motion to dismiss was completed on April 15, 2009. Plaintiffs seek to recover damages in an amount to be proven at trial, or, in the alternative, rescission of auction rate securities purchases, plus interest and attorney’s fees and costs. On March 18, 2010, the District Court dismissed the

 

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complaint without prejudice. On April 22, 2010, Plaintiffs amended their complaint. The Company has moved to dismiss the amended complaint. Decision on this motion is pending. The Company intends to continue to vigorously defend itself against the claims raised in this action.

Beginning in approximately August 2008, representatives of various states attorneys general and FINRA initiated inquiries regarding the purchase of auction rate securities by E*TRADE Securities LLC’s customers. On February 9, 2011, E*TRADE Securities LLC received a “Wells Notice” from FINRA Staff stating that they have made a preliminary determination to recommend that disciplinary action be brought against E*TRADE Securities LLC for alleged violations of certain FINRA rules in connection with the purchases of auction rate securities by customers of E*TRADE Securities LLC. E*TRADE Securities LLC is cooperating with these inquiries and will submit a Wells response to FINRA setting forth the bases for E*TRADE Securities’ belief that disciplinary action is not warranted. As of December 31, 2010, the total amount of auction rate securities held by all E*TRADE Securities LLC customers was approximately $138.2 million.

Prior to Lehman Brothers’ declaration of bankruptcy in September 2008, E*TRADE Bank was a counterparty to interest rate derivative contracts with a subsidiary of Lehman Brothers. The declaration of bankruptcy by Lehman Brothers triggered an event of default and early termination under E*TRADE Bank’s International Swap Dealers Association Master Agreement. As of the date of the event of default, E*TRADE Bank’s net amount due to the Lehman Brothers subsidiary was approximately $101 million, the majority of which was collateralized by securities held by or on behalf of the Lehman Brothers subsidiary. In April 2010, E*TRADE Bank reached an agreement with Lehman Brothers to pay its remaining obligations to Lehman’s bankruptcy estate.

On January 19, 2010, the North Carolina Securities Division filed an administrative petition before the North Carolina Secretary of State against E*TRADE Securities LLC seeking to revoke the North Carolina securities dealer registration of E*TRADE Securities LLC or, alternatively, to suspend that registration until all North Carolina residents are made whole for their investments in auction rate securities purchased through E*TRADE Securities LLC. E*TRADE Securities LLC is defending that action. As of December 31, 2010, no existing North Carolina customers held any auction rate securities.

On February 3, 2010, a class action complaint was filed in the United States District Court for the Northern District of California against E*TRADE Securities LLC by Joseph Roling on his own behalf and on behalf of all others similarly situated. The lead plaintiff alleges that E*TRADE Securities LLC unlawfully charged and collected certain account activity fees from its customers. Claimant, on behalf of himself and the putative class, asserts breach of contract, unjust enrichment and violation of California Civil Code Section 1671 and seeks equitable and injunctive relief for alleged illegal, unfair and fraudulent practices under California’s Unfair Competition Law, California Business and Professional Code Section 17200 et seq. The plaintiff seeks, among other things, certification of the class action on behalf of alleged similarly situated plaintiffs, unspecified damages and restitution of amounts allegedly wrongfully collected by E*TRADE Securities LLC, attorneys fees and expenses and injunctive relief. The Company moved to transfer venue on the case to the Southern District of New York; that motion was denied. The Court granted E*TRADE’s motion to dismiss in part and denied the motion to dismiss in part. The Court bifurcated discovery to permit initial discovery on individual claims and class certification. Discovery on the merits will not commence until a class could be certified; the Court set March 6, 2011 as the date on which the initial phase of discovery will conclude. The Company intends to vigorously defend itself against the claims raised in this action.

On March 8, 2010, Lindsay Lohan filed a complaint in the New York Supreme Court, Nassau County, against E*TRADE Bank and E*TRADE Securities LLC. The Plaintiff alleged that E*TRADE’s television advertising made unauthorized use of her characterization and likeness in violation of Section 51 of the New York State Civil Rights Law. The Claimant sought $100 million in damages. This matter was settled in September 2010 pursuant to a confidential agreement for an amount that had no material impact on the Company.

 

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On July 21, 2010, the Colorado Division of Securities filed an administrative complaint in the Colorado Office of Administrative Courts against E*TRADE Securities LLC based upon purchases of auction rate securities through E*TRADE Securities LLC by Colorado residents. The complaint seeks to revoke, suspend, or otherwise impose conditions upon the Colorado broker-dealer license of E*TRADE Securities LLC. E*TRADE Securities LLC is defending that action. As of December 31, 2010, the total amount of auction rate securities held by Colorado customers was approximately $3.7 million.

On August 24, 2010, the South Carolina Securities Division filed an administrative complaint before the Securities Commissioner of South Carolina against E*TRADE Securities LLC based upon purchases of auction rate securities through E*TRADE Securities LLC by South Carolina residents. The complaint seeks to suspend the South Carolina broker-dealer license of E*TRADE Securities LLC until South Carolina customers who purchased auction rate securities through E*TRADE Securities LLC and who wish to liquidate those positions are able to do so, and seeks a fine not to exceed $10,000 for each violation of South Carolina statutes or rules that is proven by the Division. E*TRADE Securities LLC is defending that action. As of December 31, 2010, the total amount of auction rate securities held by South Carolina customers was approximately $0.5 million.

In addition to the matters described above, the Company is subject to various legal proceedings and claims that arise in the normal course of business which could have a material adverse effect on its financial position, results of operations or cash flows. In each pending matter, the Company contests liability or the amount of claimed damages. In view of the inherent difficulty of predicting the outcome of such matters, particularly in cases where claimants seek substantial or indeterminate damages, or where investigation or discovery have yet to be completed, the Company cannot reasonably estimate the loss or range of loss related to such matters, how such matters will be resolved, when they will ultimately be resolved, or what any eventual settlement, fine, penalty or other relief might be. Subject to the foregoing, the Company believes that the outcome of any such pending matter will not have a material adverse effect on the consolidated financial condition of the Company, although the outcome could be material to the Company’s or a business segment’s operating results in the future, depending, among other things, upon the Company’s or business segment’s income for such period.

An unfavorable outcome in any matter that is not covered by insurance could have a material adverse effect on the Company’s business, financial condition, results of operations or cash flows. In addition, even if the ultimate outcomes are resolved in the Company’s favor, the defense of such litigation could entail considerable cost or the diversion of the efforts of management, either of which could have a material adverse effect on the Company’s business, financial condition, results of operations or cash flows.

The Company maintains insurance coverage that management believes is reasonable and prudent. The principal insurance coverage it maintains covers commercial general liability; property damage; hardware/software damage; cyber liability; directors and officers; employment practices liability; certain criminal acts against the Company; and errors and omissions. The Company believes that such insurance coverage is adequate for the purpose of its business. The Company’s ability to maintain this level of insurance coverage in the future, however, is subject to the availability of affordable insurance in the marketplace.

 

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PART II

 

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED SHAREHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Price Range of Common Stock

The following table shows the high and low sale prices of our common stock as reported by the NASDAQ for the periods indicated, as adjusted for the 1-for-10 reverse stock split of our common stock on June 2, 2010:

 

     High      Low  

2010:

     

First Quarter

   $ 18.50      $ 14.10  

Second Quarter

   $ 19.90      $ 11.73  

Third Quarter

   $ 15.60      $ 11.15  

Fourth Quarter

   $ 16.24      $ 13.73  

2009:

     

First Quarter

   $ 15.80      $ 5.90  

Second Quarter

   $ 29.00      $ 11.70  

Third Quarter

   $ 20.80      $ 11.50  

Fourth Quarter

   $ 18.40      $ 13.30  

The closing sale price of our common stock as reported on the NASDAQ on February 17, 2011 was $17.88 per share. At that date, there were 1,318 holders of record of our common stock.

Dividends

We have never declared or paid cash dividends on our common stock. The terms of our corporate debt currently prohibit the payment of dividends and will continue to for the foreseeable future. E*TRADE Bank may not pay dividends to the parent company without approval from the OTS. This dividend restriction includes E*TRADE Securities LLC and E*TRADE Clearing LLC as they are subsidiaries of E*TRADE Bank.

Equity Compensation Plan Information

Refer to Note 19—Employee Shared-Based Payments and Other Benefits of Item 8. Financial Statements and Supplementary Data for equity compensation plan information.

 

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Performance Graph

The following performance graph shows the cumulative total return to a holder of the Company’s common stock, assuming dividend reinvestment, compared with the cumulative total return, assuming dividend reinvestment, of the S&P 500 and the S&P Super Cap Diversified Financials during the period from December 31, 2005 through December 31, 2010.

LOGO

 

     12/05      12/06      12/07      12/08      12/09      12/10  

E*TRADE Financial Corporation

     100.00        107.48        17.02        5.51        8.44        7.67  

S&P 500

     100.00        115.80        122.16        76.96        97.33        111.99  

S&P Super Cap Diversified Financials

     100.00        123.55        104.73        47.69        63.14        67.62  

 

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ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA

(Dollars in millions, shares in thousands, except per share amounts):

 

     Year Ended December 31,       Variance  
     2010     2009     2008     2007     2006      2010 vs. 2009  

Results of Operations:(1)

             

Net operating interest income

   $ 1,226.3     $ 1,260.6     $ 1,268.0     $ 1,583.6     $ 1,385.5        (3 )% 

Total net revenue

   $ 2,077.9     $ 2,217.0     $ 1,925.6     $ 161.7     $ 2,368.6        (6 )% 

Provision for loan losses

   $ 779.4     $ 1,498.1     $ 1,583.7     $ 640.1     $ 45.0        (48 )% 

Income (loss) from continuing operations

   $ (28.5   $ (1,297.8   $ (809.4   $ (1,442.3   $ 626.9        *   

Net income (loss)

   $ (28.5   $ (1,297.8   $ (511.8   $ (1,441.8   $ 628.9        *   

Basic earnings (loss) per share from continuing operations(2)

   $ (0.13   $ (11.85   $ (15.88   $ (33.98   $ 14.88        *   

Diluted earnings (loss) per share from continuing operations(2)

   $ (0.13   $ (11.85   $ (15.88   $ (33.98   $ 14.37        *   

Basic net earnings (loss) per share(2)

   $ (0.13   $ (11.85   $ (10.04   $ (33.97   $ 14.93        *   

Diluted net earnings (loss) per share(2)

   $ (0.13   $ (11.85   $ (10.04   $ (33.97   $ 14.41        *   

Weighted average shares—basic(2)

     211,302       109,544       50,986       42,444       42,113        93

Weighted average shares—diluted(2)

     211,302       109,544       50,986       42,444       43,636        93

 

* Percentage not meaningful.
(1)

In 2008, the Company sold its Canadian brokerage business and exited its direct retail lending business. In 2006, the Company completed the sale of its professional agency trading business.

(2)

In 2010, the Company completed a 1-for-10 reverse stock split. All prior periods presented have been adjusted to reflect the impact of the reverse stock split, including the impact on basic and diluted weighted-average shares.

(Dollars in millions):

 

     December 31,      Variance  
     2010      2009      2008      2007      2006      2010 vs. 2009  

Financial Condition:

                 

Available-for-sale securities

   $ 14,805.7      $ 13,319.7      $ 10,806.1      $ 11,255.0      $ 13,677.8        11

Held-to-maturity securities

   $ 2,462.7      $ —         $ —         $ —         $ —           100

Margin receivables

   $ 5,120.6      $ 3,827.2      $ 2,791.2      $ 7,179.2      $ 6,828.4        34

Loans, net

   $ 15,127.4      $ 19,174.9      $ 24,451.8      $ 30,139.4      $ 26,656.2        (21 )% 

Total assets

   $ 46,373.0      $ 47,366.5      $ 48,538.2      $ 56,845.9      $ 53,739.3        (2 )% 

Deposits

   $ 25,240.3      $ 25,597.7      $ 26,136.2      $ 25,884.8      $ 24,071.0        (1 )% 

Corporate debt

                 

Interest-bearing

   $ 1,441.9      $ 1,437.8      $ 2,750.5      $ 3,022.7      $ 1,842.2        0

Non-interest-bearing

   $ 704.0      $ 1,020.9      $ —         $ —         $ —           (31 )% 

Shareholders’ equity

   $ 4,052.4      $ 3,749.6      $ 2,591.5      $ 2,829.1      $ 4,196.4        8

 

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(Dollars in billions, except per trade amounts):

 

     As of or For the Year Ended December 31,     Variance  
     2010     2009     2008     2007     2006     2010 vs. 2009  

Key Measures:(1)

           

DARTs

    150,532       179,183       169,075       161,119       141,984       (16 )% 

Average commission per trade

  $ 11.21     $ 11.33     $ 10.98     $ 11.57       N/A        (1 )% 

End of period brokerage accounts

    2,684,311       2,630,079       2,515,806       2,373,265       2,368,577       2

Customer assets

  $ 176.2     $ 150.5     $ 110.1     $ 181.3     $ 187.9       17

Customer cash and deposits

  $ 33.5     $ 33.3     $ 31.9     $ 32.2     $ 32.5       1

Enterprise net interest spread

    2.91     2.72     2.52     2.64     2.85     0.19

Enterprise interest-earning assets (average)

  $ 41.1     $ 44.5     $ 46.9     $ 56.1     $ 44.9       (8 )% 

Total employees (period end)

    2,962       3,084       3,249       3,757       4,126       (4 )% 

 

(1)

Metrics have been represented to exclude activity from discontinued operations and international local market trading.

The selected consolidated financial data should be read in conjunction with Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations and Item 8. Financial Statements and Supplementary Data.

 

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ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion should be read in conjunction with the consolidated financial statements and the related notes that appear elsewhere in this document.

GLOSSARY OF TERMS

In analyzing and discussing our business, we utilize certain metrics, ratios and other terms that are defined in the Glossary of Terms, which is located at the end of Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

OVERVIEW

Strategy

Our core business is our trading and investing customer franchise. Building on the strengths of this franchise, our growth strategy is focused on four areas: retail brokerage, corporate services and market making, wealth management, and banking.

 

   

Our retail brokerage business is our foundation. We believe a focus on these key factors will position us for future growth in this business: growing our sales force with a focus on long-term investing, optimizing our marketing spend, continuing to develop innovative products and services and minimizing account attrition.

 

   

Our corporate services and market making businesses enhance our strategy by allowing us to realize additional economic benefit from our retail brokerage business. Our corporate services business is a leading provider of software and services for managing equity compensation plans and is an important source of new retail brokerage accounts. Our market making business allows us to increase the economic benefit on the order flow from the retail brokerage business as well as generate additional revenues through external order flow.

 

   

We also plan to expand our wealth management offerings. Our vision is to provide wealth management services that are enabled by innovative technology and supported by guidance from professionals when needed.

 

   

Our retail brokerage business generates a significant amount of customer cash and we plan to continue to utilize our bank to optimize the value of these customer deposits.

Our strategy also includes an intense focus on mitigating the credit losses in our legacy loan portfolio and maintaining disciplined expense management. We remain focused on strengthening our overall capital structure and positioning the Company for future growth.

Key Factors Affecting Financial Performance

Our financial performance is affected by a number of factors outside of our control, including:

 

   

customer demand for financial products and services;

 

   

weakness or strength of the residential real estate and credit markets;

 

   

performance, volume and volatility of the equity and capital markets;

 

   

customer perception of the financial strength of our franchise;

 

   

market demand and liquidity in the secondary market for mortgage loans and securities;

 

   

market demand and liquidity in the wholesale borrowings market, including securities sold under agreements to repurchase;

 

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our ability to obtain regulatory approval to move capital from our bank to our parent company; and

 

   

changes to the rules and regulations governing the financial services industry.

In addition to the items noted above, our success in the future will depend upon, among other things:

 

   

continuing our success in the acquisition, growth and retention of trading customers;

 

   

our ability to generate meaningful growth in the long-term investing customer group;

 

   

our ability to assess and manage credit risk;

 

   

our ability to generate capital sufficient to meet our operating needs, particularly a level sufficient to offset loan losses;

 

   

our ability to assess and manage interest rate risk; and

 

   

disciplined expense control and improved operational efficiency.

Management monitors a number of metrics in evaluating the Company’s performance. The most significant of these are shown in the table and discussed in the text below:

 

     As of or For the Year Ended December 31,     Variance  
     2010      2009     2008     2010 vs. 2009  
Customer Activity Metrics:(1)         

DARTs

     150,532       179,183       169,075       (16 )% 

Average commission per trade

   $ 11.21     $ 11.33     $ 10.98       (1 )% 

Margin receivables (dollars in billions)

   $ 5.1     $ 3.7     $ 2.7       38

End of period brokerage accounts

     2,684,311       2,630,079       2,515,806       2

Net new brokerage accounts

     54,232       114,273       142,541       *   

Customer assets (dollars in billions)

   $ 176.2     $ 150.5     $ 110.1       17

Net new brokerage assets (dollars in billions)

   $ 8.1     $ 7.2     $ 3.9       *   

Brokerage related cash (dollars in billions)

   $ 24.5     $ 20.4     $ 15.8       20

Company Financial Metrics:

        

Corporate cash (dollars in millions)

   $ 470.5     $ 393.2     $ 434.9       20

E*TRADE Bank excess risk-based capital (dollars in millions)

   $ 1,105.6     $ 899.1     $ 714.7       23

Special mention loan delinquencies (dollars in millions)

   $ 589.4     $ 804.5     $ 1,035.1       (27 )% 

Allowance for loan losses (dollars in millions)

   $ 1,031.2     $ 1,182.7     $ 1,080.6       (13 )% 

Enterprise net interest spread

     2.91     2.72     2.52     0.19

Enterprise interest-earning assets (average in billions)

   $ 41.1     $ 44.5     $ 46.9       (8 )% 

 

 *

Percentage not meaningful.

(1)

The prior periods presented have been updated to exclude international local market trading.

Customer Activity Metrics

 

   

DARTs are the predominant driver of commissions revenue from our customers.

 

   

Average commission per trade is an indicator of changes in our customer mix, product mix and/or product pricing and is impacted by the mix between our customer groups.

 

   

Margin receivables represent credit extended to customers and non-customers to finance their purchases of securities by borrowing against securities they currently own. Margin receivables are a key driver of net operating interest income.

 

   

End of period brokerage accounts and net new brokerage accounts are indicators of our ability to attract and retain trading and investing customers.

 

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Changes in customer assets are an indicator of the value of our relationship with the customer. An increase in customer assets generally indicates that the use of our products and services by existing and new customers is expanding. Changes in this metric are also driven by changes in the valuations of our customers’ underlying securities.

 

   

Net new brokerage assets are total inflows to all new and existing brokerage accounts less total outflows from all closed and existing brokerage accounts and are a general indicator of the use of our products and services by existing and new brokerage customers.

 

   

Customer cash and deposits, particularly brokerage related cash, are an indicator of a deepening engagement with our customers and are a key driver of net operating interest income.

Company Financial Metrics

 

   

Corporate cash is an indicator of the liquidity at the parent company. It is also a source of cash that can be deployed in our regulated subsidiaries.

 

   

E*TRADE Bank excess risk-based capital is the excess capital that E*TRADE Bank has compared to the regulatory minimum to be considered well-capitalized and is an indicator of E*TRADE Bank’s ability to absorb future losses. It is also a potential source of additional corporate cash as this capital, if requested by us and approved by our regulators, could be sent as a dividend or otherwise distributed up to the parent company.

 

   

Special mention loan delinquencies are loans 30-89 days past due and are an indicator of the expected trend for charge-offs in future periods as these loans have a greater propensity to migrate into nonaccrual status and ultimately charge-off.

 

   

Allowance for loan losses is an estimate of the losses inherent in our loan portfolio as of the balance sheet date and is typically equal to the expected charge-offs in our loan portfolio over the next twelve months as well as the estimated charge-offs, including economic concessions to borrowers, over the estimated remaining life of loans modified in troubled debt restructurings. The general allowance for loan losses also includes a specific qualitative component to account for a variety of economic and operational factors, including the uncertainty of how modified loans will perform over the long term, which we believe may impact our level of credit losses.

 

   

Enterprise interest-earning assets, in conjunction with our enterprise net interest spread, are indicators of our ability to generate net operating interest income.

Significant Events in 2010

Enhancements to Our Trading and Investing Products and Services

 

   

We expanded our advice offering by introducing managed investment portfolio advisory services to long-term investors with an investment of $25,000 or more, and unified managed account advisory services to long-term investors with an investment of $250,000 or more;

 

   

We expanded Power E*TRADE Pro’s customization capabilities, navigation tools, and news and information, including CNBC Plus streaming video;

 

   

We launched the E*TRADE Mobile Pro application for Apple iPad™ and Android™ Smartphones, expanding our suite of mobile applications, which already included Blackberry® and Apple iPhone™;

 

   

We created Open API for third-party and independent software developers, which allows customers to have access to technical information and documentation, reference guides, and other resources to help network external applications and programs with our active trader platform; and

 

   

We introduced new research and trade idea generation tools that we believe help our customers identify investment opportunities and make informed decisions. These new tools include market commentary from Dreyfus and Minyanville’s Buzz & Banter, a business and finance site.

 

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Simplified Commission and Fee Structure

 

   

In February 2010, we announced several changes to the pricing structure in our brokerage business. We eliminated the $12.99 commission tier, account activity fees and a per share commission applied to market trades larger than 2,000 shares. We believe these changes simplified our overall pricing structure.

Market Recognition

 

   

Our corporate services business rated highest in overall satisfaction and loyalty among broker plan administrators for full and partial outsourced stock plan administration by GROUP FIVE, an independent consulting and research firm, in their 2010 Stock Plan Administration Benchmarking Study.

Completed the Sale of Approximately $1 Billion in Deposits

 

   

We sold approximately $1 billion of savings accounts to Discover Financial Services in March 2010. This transaction is in line with our overall strategy of reducing our balance sheet and growing our brokerage business as the savings accounts sold were predominantly with customers not affiliated with an active brokerage account.

Completion of 1-for-10 Reverse Stock Split

 

   

In June 2010, we completed a 1-for-10 reverse stock split. All prior periods presented have been adjusted to reflect the impact of this reverse stock split, including the impact on basic and diluted weighted-average shares and shares issued and outstanding.

EARNINGS OVERVIEW

2010 Compared to 2009

We incurred a net loss of $28.5 million for the year ended December 31, 2010, due primarily to provision for loan losses of $779.4 million. Our provision for loan losses reported in our balance sheet management segment more than offset the strong performance of our trading and investing segment, which generated segment income of $721.8 million for the year ended December 31, 2010. The provision for loan losses has declined for two consecutive years and we expect it to continue to decline in 2011 when compared to 2010, although performance is subject to variability in any given quarter.

The following sections describe in detail the changes in key operating factors and other changes and events that have affected our net revenue, provision for loan losses, operating expense, other income (expense) and income tax expense (benefit).

 

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Revenue

The components of net revenue and the resulting variances are as follows (dollars in millions):

 

           Variance  
     Year Ended December 31,     2010 vs. 2009  
          2010               2009          Amount     %  

Net operating interest income

   $ 1,226.3     $ 1,260.6     $ (34.3     (3 )% 

Commissions

     431.0       548.0       (117.0     (21 )% 

Fees and service charges

     142.4       192.5       (50.1     (26 )% 

Principal transactions

     103.4       88.1       15.3       17

Gains on loans and securities, net

     166.2       169.1       (2.9     (2 )% 

Net impairment

     (37.7     (89.1     *        *   

Other revenues

     46.3       47.8       (1.5     (3 )% 
                          

Total non-interest income

     851.6       956.4       (104.8     (11 )% 
                          

Total net revenue

   $ 2,077.9     $ 2,217.0     $ (139.1     (6 )% 
                          

 

* Percentage not meaningful.

Total net revenue decreased 6% to $2.1 billion for the year ended December 31, 2010 compared to 2009. This was driven by lower commissions, fees and service charges and net operating interest income, which was slightly offset by a decrease in net impairment and an increase in principal transactions.

Net Operating Interest Income

Net operating interest income decreased 3% to $1.2 billion for the year ended December 31, 2010 compared to 2009. Net operating interest income is earned primarily through investing customer cash and deposits in interest-earning assets, which include margin receivables, real estate loans, mortgage-backed securities and investment securities. The slight decrease in net operating interest income was due primarily to a decrease in our average interest earning assets of $3.4 billion during the year ended December 31, 2010, which was offset by an increase in our net operating interest spread during the same period.

 

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The following table presents enterprise average balance sheet data and enterprise income and expense data for our operations, as well as the related net interest spread, yields and rates and has been prepared on the basis required by the SEC’s Industry Guide 3, “Statistical Disclosure by Bank Holding Companies” (dollars in millions):

 

    Year Ended December 31,  
    2010      2009     2008  
    Average
Balance
    Operating
Interest
Inc./Exp.
    Average
Yield/
Cost
    Average
Balance
    Operating
Interest
Inc./Exp.
    Average
Yield/

Cost
    Average
Balance
    Operating
Interest
Inc./Exp.
    Average
Yield/

Cost
 

Enterprise interest-earning assets:

                 

Loans(1)

    $18,302.2       $879.0       4.80     $23,113.6       $1,138.1       4.92     $27,761.9       $1,587.8       5.72

Margin receivables

    4,532.5       200.3       4.42     3,103.5       138.5       4.46     5,833.6       278.2       4.77

Available-for-sale mortgage-backed securities

    9,901.1       305.6       3.09     10,365.7       436.9       4.22     9,455.4       435.9       4.61

Available-for-sale investment securities

    3,374.8       81.9       2.43     1,227.6       36.2       2.95     141.2       9.4       6.63

Held-to-maturity securities

    1,085.8       35.9       3.31     —          —          —          —          —          —     

Cash and equivalents

    2,414.3       5.4       0.22     4,215.7       14.8       0.35     2,239.1       55.3       2.47

Segregated cash and investments

    857.1       1.9       0.22     1,785.7       4.2       0.23     307.2       5.3       1.73

Securities borrowed and other

    662.9       29.4       4.43     690.4       50.4       7.30     1,113.0       77.3       6.95
                                                     

Total enterprise interest-earning assets

    41,130.7       1,539.4       3.74     44,502.2       1,819.1       4.09     46,851.4       2,449.2       5.22
                                   

Non-operating interest-earning and non-interest-earning assets(2)

    4,395.1           3,873.3           5,002.3      
                                   

Total assets

    $45,525.8           $48,375.5           $51,853.7      
                                   

Enterprise interest-bearing liabilities:

                 

Retail deposits:

                 

Sweep deposits

    $14,014.4       10.1       0.07     $11,022.3       7.6       0.07     $9,904.7       40.0       0.40

Complete savings deposits

    7,577.0       28.6       0.38     11,539.9       140.1       1.21     9,790.2       331.0       3.37

Other money market and savings deposits

    1,114.6       2.8       0.25     1,243.7       5.9       0.47     1,844.9       38.9       2.10

Certificates of deposit

    795.3       14.5       1.82     1,750.4       45.2       2.58     3,258.9       137.4       4.22

Checking deposits

    761.9       0.9       0.11     797.5       3.0       0.37     908.0       19.7       2.17

Brokered certificates of deposit

    115.3       5.9       5.14     193.8       10.0       5.17     976.1       48.9       5.01

Customer payables

    4,713.2       7.0       0.15     4,662.9       8.8       0.19     4,288.8       29.7       0.69

Securities sold under agreements to repurchase

    6,154.3       129.6       2.11     6,725.4       200.1       2.98     7,284.0       291.6       4.00

Federal Home Loan Bank (“FHLB”) advances and other borrowings

    2,754.3       119.3       4.33     3,392.0       148.8       4.38     5,120.3       245.6       4.80

Securities loaned and other

    622.4       1.6       0.26     513.0       2.4       0.46     1,075.5       18.6       1.73
                                                     

Total enterprise interest-bearing liabilities

    38,622.7       320.3       0.83     41,840.9       571.9       1.37     44,451.4       1,201.4       2.70
                                   

Non-operating interest-bearing and non-interest-bearing liabilities(3)

    2,876.4           3,558.5           4,706.3      
                                   

Total liabilities

    41,499.1           45,399.4           49,157.7      

Total shareholders’ equity

    4,026.7           2,976.1           2,696.0      
                                   

Total liabilities and shareholders’ equity

    $45,525.8           $48,375.5           $51,853.7      
                                   

Excess of enterprise interest-earning assets over enterprise interest-bearing liabilities/Enterprise net interest income/Spread

    $2,508.0       $1,219.1       2.91     $2,661.3       $1,247.2       2.72     $2,400.0       $1,247.8       2.52
                                                     

 

Reconciliation

from enterprise net interest income to net operating interest income (dollars in millions):

 

     Year Ended December 31,  
     2010      2009     2008  

Enterprise net interest income

     $1,219.1     $ 1,247.2     $ 1,247.8  

Taxable equivalent interest adjustment

     (1.2     (2.1     (9.1

Customer cash held by third parties and other(4)

     8.4       15.5       29.3  
                        

Net operating interest income

     $1,226.3     $ 1,260.6     $ 1,268.0  
                        

 

(1)

Nonaccrual loans are included in the respective average loan balances. Income on such nonaccrual loans is recognized on a cash basis.

(2)

Non-operating interest-earning and non-interest-earning assets consist of property and equipment, net, goodwill, other intangibles, net and other assets that do not generate operating interest income. Some of these assets generate corporate interest income.

(3)

Non-operating interest-bearing and non-interest-bearing liabilities consist of corporate debt and other liabilities that do not generate operating interest expense. Some of these liabilities generate corporate interest expense.

(4)

Includes interest earned on average customer assets of $3.1 billion, $2.9 billion and $3.2 billion for the years ended December 31, 2010, 2009 and 2008, respectively, held by parties outside the Company, including third party money market funds and sweep deposit accounts at unaffiliated financial institutions.

 

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     Year Ended December 31,  
     2010     2009     2008  

Enterprise net interest:

      

Spread

     2.91     2.72     2.52

Margin (net yield on interest-earning assets)

     2.96     2.80     2.66

Ratio of enterprise interest-earning assets to enterprise interest- bearing liabilities

     106.49     106.36     105.40

Return on average:

      

Total assets

     (0.06 )%      (2.68 )%      (0.99 )% 

Total shareholders’ equity

     (0.71 )%      (43.61 )%      (18.98 )% 

Average equity to average total assets

     8.84     6.15     5.20

Average enterprise interest-earning assets decreased 8% to $41.1 billion for the year ended December 31, 2010 compared to 2009. This decrease was primarily a result of the decrease in our average loans portfolio, average available-for-sale mortgage-backed securities and average cash and equivalents, partially offset by an increase in average margin receivables, average available-for-sale investment securities and average held-to-maturity securities.

Average enterprise interest-bearing liabilities decreased 8% to $38.6 billion for the year ended December 31, 2010 compared to 2009. The decrease in average enterprise interest-bearing liabilities was primarily due to decreases in average complete savings deposits and average certificates of deposit offset by an increase in average sweep deposits.

Enterprise net interest spread increased by 19 basis points to 2.91% for the year ended December 31, 2010 compared to 2009. This increase was largely driven by a decrease in the yields paid on our deposits and lower wholesale borrowing costs, partially offset by a decrease in higher yielding enterprise interest-earning assets.

Commissions

Commissions decreased 21% to $431.0 million for the year ended December 31, 2010 compared to 2009. The main factors that affect our commissions are DARTs, average commission per trade and the number of trading days during the period. Average commission per trade is impacted by different trade types (e.g. equities, options, fixed income, stock plan, exchange-traded funds, mutual funds and cross border) that can have different commission rates. Accordingly, changes in the mix of trade types will impact average commission per trade.

Our DART volume decreased 16% to 150,532 for the year ended December 31, 2010 compared 2009. Option-related DARTs as a percentage of our total DARTs represented 17% and 13% of trading volume for the years ended December 31, 2010 and 2009, respectively. Exchange-traded funds-related DARTs as a percentage of our total DARTs represented 10% and 14% of trading volume for the years ended December 31, 2010 and 2009, respectively.

Average commission per trade decreased 1% to $11.21 for the year ended December 31, 2010 compared to 2009. The slight decrease in the average commission per trade was due primarily to the elimination of the $12.99 commission tier and the per share commission applied to market trades larger than 2,000 shares, which became effective in the second quarter of 2010, partially offset by an improvement in the product and customer mix when compared to the same period in 2009.

Fees and Service Charges

Fees and service charges decreased 26% to $142.4 million for the year ended December 31, 2010 compared to 2009. The decrease was primarily due to the elimination of all account activity fees, which became effective in the second quarter of 2010, and lower order flow revenue.

 

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Principal Transactions

Principal transactions increased 17% to $103.4 million for the year ended December 31, 2010 compared to 2009. Our principal transactions are derived from our market making business in which we act as a market maker for our brokerage customers’ orders as well as orders from third party customers. The increase in principal transactions was driven by an increase in the volume of orders from our third party customers which was partially offset by a decrease in our average revenue earned per share traded when compared to the same period in 2009.

Gains on Loans and Securities, Net

Gains on loans and securities, net were $166.2 million and $169.1 million for years ended December 31, 2010 and 2009, respectively, as shown in the following table (dollars in millions):

 

           Variance  
     Year Ended December 31,     2010 vs. 2009  
         2010             2009         Amount     %  

Gains (losses) on loans, net

   $ 6.3     $ (12.5   $ 18.8       *   
                          

Gains on available-for-sale securities and other investments, net

     160.7       173.2       (12.5     (7 )% 

Gains on trading securities, net

     0.2       7.8       (7.6     (98 )% 

Hedge ineffectiveness

     (1.0     0.6       (1.6     *   
                          

Gains on securities, net

     159.9       181.6       (21.7     (12 )% 
                          

Gains on loans and securities, net

   $ 166.2     $ 169.1     $ (2.9     (2 )% 
                          

 

* Percentage not meaningful.

Net Impairment

We recognized $37.7 million and $89.1 million of net impairment during the years ended December 31, 2010 and 2009, respectively, on certain securities in our non-agency CMO portfolio due to continued deterioration in the expected credit performance of the underlying loans in the securities. The gross other-than-temporary impairment (“OTTI”) and the noncredit portion of OTTI, which was or had been previously recorded through other comprehensive income (loss), are shown in the table below (dollars in millions):

 

     Year Ended December 31,  
         2010             2009      

Other-than-temporary impairment (“OTTI”)

   $ (41.5   $ (232.1

Less: noncredit portion of OTTI recognized into other comprehensive income (loss) (before tax)

     3.8       143.0  
                

Net impairment

   $ (37.7   $ (89.1
                

Other Revenues

Other revenues decreased 3% to $46.3 million for the year ended December 31, 2010 compared to 2009. The decrease was due to a decline in the income from the cash surrender value of our bank-owned life insurance, partially offset by the gain on the sale of approximately $1 billion in savings accounts to Discover Financial Services in the first quarter of 2010.

Provision for Loan Losses

Provision for loan losses decreased 48% to $779.4 million for the year ended December 31, 2010 compared 2009. The decrease in our provision for loan losses was driven by lower levels of at-risk (30-179 days delinquent) loans in our one- to four-family and home equity loan portfolios. We believe the delinquencies in

 

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both of these portfolios were caused by several factors, including: significant continued home price depreciation; weak demand for homes and high inventories of unsold homes; significant contraction in the availability of credit; and a general decline in economic growth along with higher levels of unemployment. In addition, the combined impact of home price depreciation and the reduction of available credit made it difficult for borrowers to refinance existing loans. The provision for loan losses has declined for two consecutive years and we expect it to continue to decline in 2011 when compared to 2010, although performance is subject to variability in any given quarter.

Operating Expenses

The components of operating expense and the resulting variances are as follows (dollars in millions):

 

            Variance  
     Year Ended December 31,      2010 vs. 2009  
          2010                2009           Amount     %  

Compensation and benefits

   $ 325.0      $ 366.2      $ (41.2     (11 )% 

Clearing and servicing

     147.5        170.7        (23.2     (14 )% 

Advertising and market development

     132.2        114.4        17.8       16

Professional services

     81.2        78.7        2.5       3

FDIC insurance premiums

     77.7        94.3        (16.6     (18 )% 

Communications

     73.3        84.4        (11.1     (13 )% 

Occupancy and equipment

     70.9        78.4        (7.5     (10 )% 

Depreciation and amortization

     87.9        83.3        4.6       6

Amortization of other intangibles

     28.5        29.7        (1.2     (4 )% 

Facility restructuring and other exit activities

     14.4        20.7        (6.3     (31 )% 

Other operating expenses

     104.0        122.5        (18.5     (15 )% 
                            

Total operating expense

   $ 1,142.6      $ 1,243.3      $ (100.7     (8 )% 
                            

Operating expense decreased 8% to $1.1 billion for the year ended December 31, 2010 compared to 2009. The fluctuation was driven by decreases in the majority of operating expense categories, offset by a planned increase in advertising and market development.

Compensation and Benefits

Compensation and benefits decreased 11% to $325.0 million for the year ended December 31, 2010 compared to 2009. This decrease resulted from lower incentive compensation expense and lower salary expense due to a reduction in our employee base compared to the same period in 2009.

Clearing and Servicing

Clearing and servicing expense decreased 14% to $147.5 million for the year ended December 31, 2010 compared to 2009. This decrease resulted primarily from lower trading volumes and lower loan balances compared to the same period in 2009.

Advertising and Market Development

Advertising and market development expense increased 16% to $132.2 million for the year ended December 31, 2010 compared to 2009. This fluctuation was due largely to a planned increase in advertising expense to attract new accounts and customer assets during the year ended December 31, 2010.

 

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FDIC Insurance Premiums

FDIC insurance premiums decreased 18% to $77.7 million for the year ended December 31, 2010 compared to 2009. The decrease was due primarily to an industry wide special assessment that resulted in an additional $21.6 million of expense in the second quarter of 2009. There were no similar assessments made during the year ended December 31, 2010.

Other Operating Expenses

Other operating expenses decreased 15% to $104.0 million for the year ended December 31, 2010 compared to 2009. The decrease was driven primarily by a decline in bad debt expense, real-estate owned and legal reserves compared to 2009.

Other Income (Expense)

Other income (expense) was an expense of $159.0 million and $1.3 billion for the years ended December 31, 2010 and 2009, respectively, as shown in the following table (dollars in millions):

 

                 Variance  
     Year Ended December 31,     2010 vs. 2009  
         2010             2009         Amount      %  

Corporate interest income

   $ 6.2     $ 0.9     $ 5.3        620

Corporate interest expense

     (167.1     (282.7     115.6        (41 )% 

Gains (losses) on sales of investments, net

     2.7       (1.7     4.4        *   

Losses on early extinguishment of debt

     —          (1,018.9     1,018.9        (100 )% 

Equity in loss of investments and venture funds

     (0.8     (8.6     7.8        (91 )% 
                           

Total other income (expense)

   $ (159.0   $ (1,311.0   $ 1,152.0        (88 )% 
                           

 

* Percentage not meaningful.

Total other income (expense) for the year ended December 31, 2010 primarily consisted of corporate interest expense resulting from our interest-bearing corporate debt. Corporate interest expense decreased 41% to $167.1 million for the year ended December 31, 2010 compared to 2009. This was due to the reduction in interest-bearing debt in connection with our Debt Exchange in 2009. The losses on early extinguishment of debt for the year ended December 31, 2009 were related primarily to the Debt Exchange. The loss on the Debt Exchange resulted from the de-recognition of the debt that was exchanged and the corresponding recognition of the newly-issued non-interest-bearing convertible debentures at fair value. Corporate interest income increased to $6.2 million for the year ended December 31, 2010 when compared to 2009 due to a benefit of $6.0 million in connection with a legal settlement.

Income Tax Expense (Benefit)

Income tax expense was $25.3 million and a benefit of $537.7 million for the years ended December 31, 2010 and 2009, respectively. Our effective tax rates were 806.3% and (29.3)% for the years ended December 31, 2010 and 2009, respectively. The effective tax rate for the year ended December 31, 2010 was higher than in 2009 for two reasons: 1) our pre-tax loss included items not deductible for tax purposes, predominantly about one-third of the interest expense on the 12 1/2% springing lien notes; and 2) our reported pre-tax loss is relatively close to breakeven for the year ended December 31, 2010. As a result, our income subject to taxation is higher, resulting in an unusually high effective tax rate for the year ended December 31, 2010. We expect our effective tax rate to be volatile in periods where pre-tax income or loss is relatively close to breakeven, but expect a more normalized rate as, and to the extent, we become profitable in future periods.

 

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Valuation Allowance

We are required to establish a valuation allowance for deferred tax assets and record a charge to income if we determine, based on available evidence at the time the determination is made, that it is more likely than not that some portion or all of the deferred tax assets will not be realized. If we did conclude that a valuation allowance was required, the resulting loss would have a material adverse effect on our results of operations and financial condition.

We did not establish a valuation allowance against our federal deferred tax assets as of December 31, 2010 as we believe that it is more likely than not that all of these assets will be realized. Our evaluation focused on identifying significant, objective evidence that we will be able to realize our deferred tax assets in the future. We reviewed the estimated future taxable income for our trading and investing and balance sheet management segments separately and determined that our net operating losses since 2007 are due solely to the credit losses in our balance sheet management segment. We believe these losses were caused by the crisis in the residential real estate and credit markets which significantly impacted our asset-backed securities and home equity loan portfolios in 2007 and continued to generate credit losses in 2008, 2009 and 2010. We estimate that these credit losses will continue in future periods; however, we ceased purchasing asset-backed securities and home equity loans which we believe are the root cause of the majority of these losses. Therefore, while we do expect credit losses to continue in future periods, we do expect these amounts to decline when compared to our credit losses in the three-year period ending in 2010. Our trading and investing segment generated substantial taxable income for each of the last seven years and we estimate that it will continue to generate taxable income in future periods at a level sufficient to generate taxable income for the Company as a whole. We consider this to be significant, objective evidence that we will be able to realize our deferred tax assets in the future.

A key component of our evaluation of the need for a valuation allowance was our level of corporate interest expense, which represents our most significant non-operating related expense. Our estimates of future taxable income included this expense, which reduces the amount of segment income available to utilize our federal deferred tax assets. Therefore, a decrease in this expense in future periods would increase the level of estimated taxable income available to utilize our federal deferred tax assets. As a result of the Debt Exchange in 2009, we reduced our annual cash interest payments by approximately $200 million. We believe this decline in cash interest payments significantly improves our ability to utilize our federal deferred tax assets in future periods when compared to evaluations in prior periods which did not include this decline in corporate interest payments.

Our analysis of the need for a valuation allowance recognizes that we are in a cumulative book taxable loss position as of the three-year period ended December 31, 2010, which is considered significant and objective evidence that we may not be able to realize some portion of our deferred tax assets in the future. However, in 2010, we generated taxable income consistent with our forecast that resulted in the utilization of significant net operating loss carryforwards. Accordingly, we believe we are able to continue relying on our forecasts of future taxable income and overcome the uncertainty created by the cumulative loss position.

The crisis in the residential real estate and credit markets has created significant volatility in our results of operations. This volatility is isolated almost entirely to our balance sheet management segment. Our forecasts for this segment include assumptions regarding our estimate of future expected credit losses, which we believe to be the most variable component of our forecasts of future taxable income. We believe this variability could create a book loss in our overall results for an individual reporting period while not significantly impacting our overall estimate of taxable income over the period in which we expect to realize our deferred tax assets. Conversely, we believe our trading and investing segment will continue to produce a stable stream of income which we believe we can reliably estimate in both individual reporting periods as well as over the period in which we estimate we will realize our deferred tax assets.

In evaluating the need for a valuation allowance, we estimated future taxable income based on management approved forecasts. This process required significant judgment by management about matters that are by nature uncertain. If future events differ significantly from our current forecasts, a valuation allowance may need to be established, which would have a material adverse effect on our results of operations and our financial condition.

 

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We have maintained a valuation allowance for certain of our state deferred tax assets as it is more likely than not that they will not be realized. At December 31, 2010, we had a deferred tax asset of approximately $108.9 million that related to our state net operating loss carryforwards with a valuation allowance of $34.0 million against such deferred tax asset. The change in our valuation allowance during 2010 was primarily due to reclassification of unrealized tax benefit offset by current year activity. The majority of the reclassified unrecognized tax benefit relates to the application of Section 382 to state net operating losses.

Tax Ownership Change

During the third quarter of 2009, we exchanged $1.7 billion principal amount of our interest-bearing debt for an equal principal amount of non-interest-bearing convertible debentures. Subsequent to the Debt Exchange, $592.3 million and $720.9 million debentures were converted into 57.2 million and 69.7 million shares of common stock during the third and fourth quarters of 2009, respectively. As a result of these conversions, we believe we experienced a tax ownership change during the third quarter of 2009.

As of the date of the ownership change, we had federal NOLs available to carryforward of approximately $1.4 billion. Section 382 imposes restrictions on the use of a corporation’s NOLs, certain recognized built-in losses and other carryovers after an “ownership change” occurs. Section 382 rules governing when a change in ownership occurs are complex and subject to interpretation; however, an ownership change generally occurs when there has been a cumulative change in the stock ownership of a corporation by certain “5% shareholders” of more than 50 percentage points over a rolling three-year period.

Section 382 imposes an annual limitation on the amount of post-ownership change taxable income a corporation may offset with pre-ownership change NOLs. In general, the annual limitation is determined by multiplying the value of the corporation’s stock immediately before the ownership change (subject to certain adjustments) by the applicable long-term tax-exempt rate. Any unused portion of the annual limitation is available for use in future years until such NOLs are scheduled to expire (in general, our NOLs may be carried forward 20 years). In addition, the limitation may, under certain circumstances, be increased or decreased by built-in gains or losses, respectively, which may be present with respect to assets held at the time of the ownership change that are recognized in the five-year period (one-year for loans) after the ownership change. The use of NOLs arising after the date of an ownership change would not be affected unless a corporation experienced an additional ownership change in a future period.

We believe the tax ownership change will extend the period of time it will take to fully utilize our pre-ownership change NOLs, but will not limit the total amount of pre-ownership change NOLs we can utilize. Our updated estimate is that we will be subject to an overall annual limitation on the use of our pre-ownership change NOLs of approximately $194 million. Our overall pre-ownership change NOLs, which were approximately $1.4 billion, have a statutory carryforward period of 20 years (the majority of which expire in 17 years). As a result, we believe we will be able to fully utilize these NOLs in future periods.

Our ability to utilize the pre-ownership change NOLs is dependent on our ability to generate sufficient taxable income over the duration of the carryforward periods and will not be impacted by our ability or inability to generate taxable income in an individual year.

2009 Compared to 2008

We incurred a net loss of $1.3 billion for the year ended December 31, 2009 due principally to the Debt Exchange that resulted in a non-cash loss of $772.9 million (pre-tax loss of $968.3 million) on early extinguishment of debt during the third quarter of 2009. Our trading and investing segment income was $760.2 million for the year ended December 31, 2009. However, the provision for loan losses in our balance sheet management segment more than offset this strong performance, resulting in a consolidated loss before income taxes of $1.8 billion for the year ended December 31, 2009.

 

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On April 1, 2009, we adopted the amended guidance for the recognition of OTTI for debt securities as well as the presentation of OTTI on the consolidated financial statements. As a result of the adoption, we recognized a $20.2 million after-tax decrease to beginning accumulated deficit and a corresponding offset in accumulated other comprehensive loss on our consolidated balance sheet. This adjustment represents the after-tax difference between the impairment reported in prior periods for securities on our balance sheet as of April 1, 2009 and the level of impairment that would have been recorded on these same securities under the new accounting guidance. Additionally, in accordance with the new guidance, we changed the presentation of the consolidated statement of loss to state net impairment as a separate line item, as well as the credit and noncredit components of net impairment. Prior to this new presentation, OTTI was included in the gains (losses) on loans and securities, net line item on the consolidated statement of loss.

Revenue

The components of net revenue and the resulting variances are as follows (dollars in millions):

 

                 Variance  
     Year Ended December 31,     2009 vs. 2008  
           2009                 2008           Amount     %  

Net operating interest income

   $ 1,260.6     $ 1,268.0     $ (7.4     (1 )% 

Commissions

     548.0       515.5       32.5       6

Fees and service charges

     192.5       200.0       (7.5     (4 )% 

Principal transactions

     88.1       84.9       3.2       4

Gains (losses) on loans and securities, net

     169.1       (100.5     269.6       *   

Net impairment

     (89.1     (95.0     *        *   

Other revenues

     47.8       52.7       (4.9     (9 )% 
                          

Total non-interest income

     956.4       657.6       298.8       45
                          

Total net revenue

   $ 2,217.0     $ 1,925.6     $ 291.4       15
                          

 

* Percentage not meaningful.

Total net revenue increased 15% to $2.2 billion for the year ended December 31, 2009 compared to 2008. This was driven by our gains (losses) on loans and securities, net, which increased from net losses of $100.5 million to net gains of $169.1 million for the year ended December 31, 2009 compared to 2008. Commissions also increased $32.5 million to $548.0 million for the year ended December 31, 2009 compared to 2008.

Net Operating Interest Income

Net operating interest income decreased 1% to $1.3 billion for the year ended December 31, 2009 compared to 2008. The slight decrease in net operating interest income was due primarily to a decrease in our average interest earning assets of $2.3 billion during the year ended December 31, 2009, which was largely offset by an increase in our net operating interest spread during the same period.

Average enterprise interest-earning assets decreased 5% to $44.5 billion for the year ended December 31, 2009 compared to 2008. This decrease was primarily a result of the decrease in our average loans portfolio and our average margin receivables, partially offset by an increase in average cash and equivalents.

Average enterprise interest-bearing liabilities decreased 6% to $41.8 billion for the year ended December 31, 2009 compared to 2008. The decrease in average enterprise interest-bearing liabilities was primarily due to a decrease in average FHLB advances, average brokered certificates of deposit and average securities loaned and other.

 

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Enterprise net interest spread increased by 20 basis points to 2.72% for the year ended December 31, 2009 compared to 2008. This increase was largely driven by a decrease in the yields paid on our deposits and lower wholesale borrowing costs, partially offset by a decrease in higher yielding enterprise interest-earning assets.

Commissions

Commissions increased 6% to $548.0 million for the year ended December 31, 2009 compared to 2008. Our DART volume increased 6% to 179,183 for the year ended December 31, 2009 compared to 2008. Option-related DARTs as a percentage of our total DARTs represented 13% and 15% of trading volume for the years December 31, 2009 and 2008, respectively. Exchange-traded funds-related DARTs as a percentage of our total DARTs represented 14% and 11% of trading volume for the years ended December 31, 2009 and 2008, respectively.

Average commission per trade increased 3% to $11.33 for the year ended December 31, 2009 compared to 2008. The increase in the average commission per trade for the year ended December 31, 2009 was primarily due to an improvement in product and customer mix compared to 2008.

Fees and Service Charges

Fees and service charges decreased 4% to $192.5 million for the year ended December 31, 2009 compared to 2008. The decline was driven by a decrease in account service fee and advisory management fee revenue, which was partially offset by an increase in order flow revenue compared to 2008. The decrease in advisory management fees was primarily due to the sale of an advisor business in the second quarter of 2008. Declines in foreign currency margin revenue, fixed income product revenue and mutual fund fees also contributed to the decrease in fees and service charges.

Principal Transactions

Principal transactions increased 4% to $88.1 million for the year ended December 31, 2009 compared to 2008. The increase in principal transactions was driven by an increase in the volume of equity shares that were traded, which was partially offset by a decrease in our average revenue earned per share traded for the year ended December 31, 2009.

Gains (Losses) on Loans and Securities, Net

Gains (losses) on loans and securities, net were gains of $169.1 million and losses of $100.5 million for the years ended December 31, 2009 and 2008, respectively, as shown in the following table (dollars in millions):

 

           Variance  
     Year Ended December 31,     2009 vs. 2008  
           2009                 2008           Amount     %  

Losses on sales of loans, net

   $ (12.5   $ (0.8   $ (11.7     1496
                          

Gains on available-for-sale securities and other investments, net

     173.2       32.4       140.8       435

Gains (losses) on trading securities, net

     7.8       (134.3     142.1       *   

Hedge ineffectiveness

     0.6       2.2       (1.6     (74 )% 
                          

Gains (losses) on securities, net

     181.6       (99.7     281.3       *   
                          

Gains (losses) on loans and securities, net

   $ 169.1     $ (100.5   $ 269.6       *   
                          

 

* Percentage not meaningful.

Gains on loans and securities, net for the year ended December 31, 2009, were due primarily to gains on the sale of certain agency mortgage-backed securities, which were partially offset by net losses on the sales of loans.

 

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Losses on the sales of loans were due to the sale of a $0.4 billion pool of home equity loans during the third quarter of 2009. Losses on loans and securities, net during the year ended December 31, 2008 were due primarily to losses on our preferred stock in Federal National Mortgage Association (“Fannie Mae”) and Federal Home Loan Mortgage Corporation (“Freddie Mac”).

Net Impairment

We recognized $89.1 million of net impairment during the year ended December 31, 2009, on certain securities in our non-agency CMO portfolio due to continued deterioration in the expected credit performance of the underlying loans in the securities. The net impairment included gross OTTI of $232.1 million for the year ended December 31, 2009. Of the $232.1 million of gross OTTI for the year ended December 31, 2009, $143.0 million related to the noncredit portion of OTTI, which was recorded through other comprehensive income (loss).

We had net impairment of $95.0 million for the year ended December 31, 2008, which represented the total decline in the fair value of impaired securities in accordance with the OTTI accounting guidance that was in effect prior to April 1, 2009.

Other Revenues

Other revenues decreased 9% to $47.8 million for the year ended December 31, 2009 compared to 2008. The decrease in other revenue was driven by lower employee stock option management fees from our corporate services business.

Provision for Loan Losses

Provision for loan losses decreased $85.6 million to $1.5 billion for the year ended December 31, 2009 compared to 2008. The provision for loan losses for the year ended December 31, 2009 was due primarily to the high levels of delinquent loans in our one- to four-family and home equity loan portfolios.

Operating Expenses

The components of operating expense and the resulting variances are as follows (dollars in millions):

 

            Variance  
     Year Ended December 31,      2009 vs. 2008  
           2009                  2008            Amount     %  

Compensation and benefits

   $ 366.2      $ 383.4      $ (17.2     (4 )% 

Clearing and servicing

     170.7        185.1        (14.4     (8 )% 

Advertising and market development

     114.4        175.2        (60.8     (35 )% 

Professional services

     78.7        94.1        (15.4     (16 )% 

FDIC insurance premiums

     94.3        31.2        63.1       202

Communications

     84.4        96.8        (12.4     (13 )% 

Occupancy and equipment

     78.4        85.8        (7.4     (9 )% 

Depreciation and amortization

     83.3        82.5        0.8       1

Amortization of other intangibles

     29.7        35.7        (6.0     (17 )% 

Facility restructuring and other exit activities

     20.7        29.5        (8.8     (30 )% 

Other operating expenses

     122.5        90.9        31.6       35
                            

Total operating expense

   $ 1,243.3      $ 1,290.2      $ (46.9     (4 )% 
                            

Operating expense decreased 4% to $1.2 billion for the year ended December 31, 2009 compared to 2008. The decrease during the year ended December 31, 2009 compared to 2008 was driven by decreases in the majority of the operating expense categories, offset by increases in FDIC insurance premiums and other operating expenses.

 

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Compensation and Benefits

Compensation and benefits decreased 4% to $366.2 million for the year ended December 31, 2009 compared to 2008. The decrease for the year ended December 31, 2009 resulted primarily from lower salary expense due to a reduction in our employee base of 5% compared to the year ended December 31, 2008.

Advertising and Market Development

Advertising and market development expense decreased 35% to $114.4 million for the year ended December 31, 2009 compared to 2008. This decrease was due to high levels of advertising in the first half of 2008 that was aimed at restoring customer confidence as well as an overall decline in advertising rates in the year ended December 31, 2009.

FDIC Insurance Premiums

FDIC insurance premiums increased 202% to $94.3 million for the year December 31, 2009 compared to 2008. The increase was primarily due to an increase in the ongoing FDIC insurance rates as well as an industry wide special assessment in the second quarter of 2009. Our portion of this special assessment was $21.6 million.

Facility Restructuring and Other Exit Activities

Facility restructuring and other exit activities were $20.7 million for the year ended December 31, 2009. These costs were due primarily to the restructuring of our international brokerage business.

Other Operating Expenses

Other operating expenses increased 35% to $122.5 million for the year ended December 31, 2009 compared to 2008. The increase for the year ended December 31, 2009, was primarily due to a $23.7 million gain on the sale of our corporate aircraft related assets during the year ended December 31, 2008, which reduced other operating expenses during that period and to higher real estate owned expenses during the year ended December 31, 2009.

Other Income (Expense)

Other income (expense) was an expense of $1.3 billion for the year ended December 31, 2009 compared to an expense of $330.6 million for the year ended December 31, 2008. Total other expense of $1.3 billion for the year ended December 31, 2009 was largely due to the $968.3 million pre-tax non-cash loss on the early extinguishment of debt related to our Debt Exchange. The loss on the Debt Exchange resulted from the de-recognition of the debt that was exchanged and the corresponding recognition of the newly-issued non-interest-bearing convertible debentures at fair value.

Total other income (expense) also includes corporate interest expense resulting from our interest-bearing corporate debt. Corporate interest expense decreased 22% to $282.7 million for the year ended December 31, 2009, primarily due to the reduction in interest-bearing debt in connection with our Debt Exchange.

Income Tax Benefit

Income tax benefit from continuing operations was $537.7 million and $469.5 million for the years ended December 31, 2009 and 2008, respectively. Our effective tax rates were (29.3)% and (36.7)% for the years ended December 31, 2009 and 2008, respectively.

 

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Debt Exchange

The effective tax rate on the Debt Exchange of 20% was below our statutory federal tax rate of 35%. This was primarily due to certain components of the loss on the Debt Exchange not being deductible for tax purposes, which are summarized in the following table (dollars in millions):

 

     Year Ended December 31, 2009  
     Amount of Loss      Tax Rate     Tax Benefit  

Deductible portion of the loss on the Debt Exchange

   $ 723.0        35   $ 253.0  

Non-deductible portion of the loss on the Debt Exchange

     245.3        —          —     

Prior period interest expense on the 12 1/2% Notes not deductible as a result of the Debt Exchange

     N/A         N/A        (57.7
                   

Total

   $ 968.3        20   $ 195.3  
                   

Valuation Allowance

During the year ended December 31, 2009, we did not provide for a valuation allowance against our federal deferred tax assets as we believed that it was more likely than not that all of these assets will be realized. Our evaluation focused on identifying significant, objective evidence that we will be able to realize our deferred tax assets in the future. Our analysis of the need for a valuation allowance recognizes that we were in a cumulative book taxable loss position as of the three-year period ended December 31, 2009, which is considered significant and objective evidence that we may not be able to realize some portion of our deferred tax assets in the future. However, we believed we were able to rely on our forecasts of future taxable income and overcome the uncertainty created by the cumulative loss position.

SEGMENT RESULTS REVIEW

We report our operating results in two segments: 1) trading and investing; and 2) balance sheet management. Trading and investing includes retail brokerage products and services; investor-focused banking products; market making; and corporate services. Balance sheet management includes the management of asset allocation and credit, liquidity and interest rate risk; loans previously originated or purchased from third parties; and customer cash and deposits. Costs associated with certain functions that are centrally managed are separately reported in a “Corporate/Other” category. For more information on our segments, see Note 23—Segment and Geographic Information in Item 8. Financial Statements and Supplementary Data beginning on page 160.

 

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Trading and Investing

The following table summarizes trading and investing financial information and key metrics as of and for the periods ended December 31, 2010, 2009, and 2008 (dollars in millions, except for key metrics):

 

                          Variance  
     Year Ended December 31,      2010 vs. 2009  
     2010      2009      2008      Amount     %  

Net operating interest income

   $ 763.0      $ 699.6      $ 800.3      $ 63.4       9

Commissions

     431.0        548.0        514.7        (117.0     (21 )% 

Fees and service charges

     139.1        185.6        191.6        (46.5     (25 )% 

Principal transactions

     103.4        88.1        84.8        15.3       17

Other revenues

     37.9        35.5        38.5        2.4       7
                                     

Total net revenue

     1,474.4        1,556.8        1,629.9        (82.4     (5 )% 

Total operating expense

     752.6        796.6        926.6        (44.0     (6 )% 
                                     

Trading and investing segment income

   $ 721.8      $ 760.2      $ 703.3      $ (38.4     (5 )% 
                                     

Key Metrics:(1)

             

DARTs

     150,532        179,183        169,075        (28,651     (16 )% 

Average commission per trade

   $ 11.21      $ 11.33      $ 10.98      $ (0.12     (1 )% 

Margin receivables (dollars in billions)

   $ 5.1      $ 3.7      $ 2.7      $ 1.4       38

End of period brokerage accounts

     2,684,311        2,630,079        2,515,806        54,232       2

Net new brokerage accounts

     54,232        114,273        142,541        (60,041     *   

Customer assets (dollars in billions)

   $ 176.2      $ 150.5      $ 110.1      $ 25.7       17

Net new brokerage assets (dollars in billions)

   $ 8.1      $ 7.2      $ 3.9      $ 0.9       *   

Brokerage related cash (dollars in billions)

   $ 24.5      $ 20.4      $ 15.8      $ 4.1       20

 

*

Percentage not meaningful.

(1)

The prior periods presented have been updated to exclude international local market trading.

Our trading and investing segment generates revenue from brokerage and banking relationships with investors and from market making and corporate services activities. This segment generates five main sources of revenue: net operating interest income; commissions; fees and service charges; principal transactions; and other revenues. Other revenues include results from our software and services for managing equity compensation plans from our corporate customers, as we ultimately service retail investors through these corporate relationships.

2010 Compared to 2009

Trading and investing segment income decreased 5% to $721.8 million for the year ended December 31, 2010 compared to 2009. We continued to generate new brokerage accounts, ending the year with 2.7 million accounts. Our brokerage related cash, which is one of our most profitable sources of funding, increased by $4.1 billion when compared to 2009.

Trading and investing net operating interest income increased 9% to $763.0 million for the year ended December 31, 2010 compared to 2009. This increase was driven primarily by a decrease in yields paid on customer deposits and an increase in the average balance of margin receivables during the period.

Trading and investing commissions decreased 21% to $431.0 million for the year ended December 31, 2010 compared to 2009. The decrease in commissions was primarily the result of a decrease in DARTs of 16% to 150,532 and a decrease in the average commission per trade of 1% to $11.21 for the year ended December 31, 2010 compared to 2009. The slight decrease in the average commission per trade was due primarily to the elimination of the $12.99 commission tier and the per share commission applied to market trades larger than 2,000 shares, which became effective in the second quarter of 2010, partially offset by an improvement in the product and customer mix when compared to the same period in 2009.

 

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Trading and investing fees and service charges decreased 25% to $139.1 million for the year ended December 31, 2010 compared to 2009. The decreases were primarily due to lower order flow revenue and the elimination of all account activity fees, which became effective in the second quarter of 2010.

Trading and investing principal transactions increased 17% to $103.4 million for the year ended December 31, 2010 compared to 2009. The increase in principal transactions was driven by an increase in the volume of equity shares that were traded, which was partially offset by a decrease in our average revenue earned per share traded for the year ended December 31, 2010.

Trading and investing operating expense decreased 6% to $752.6 million for the year ended December 31, 2010 compared to 2009. The decrease related primarily to decreases in compensation and benefits, clearing and servicing, and communications expenses, which were partially offset by increases in advertising and market development expense and professional services.

As of December 31, 2010, we had approximately 2.7 million brokerage accounts, 1.0 million stock plan accounts and 0.5 million banking accounts. For the years ended December 31, 2010 and 2009, our brokerage products contributed 67% and 77%, respectively, and our banking products, which include sweep products, contributed 33% and 23%, respectively, of total trading and investing net revenue.

2009 Compared to 2008

Trading and investing segment income increased 8% to $760.2 million for the year ended December 31, 2009 compared to 2008. Trading activity was strong during 2009 resulting in total DARTs of 179,183 and an average commission per trade of $11.33. We also continued to generate new brokerage accounts, ending the year with 2.6 million accounts. Our brokerage related cash increased by $4.6 billion when compared to 2008.

Trading and investing net operating interest income decreased 13% to $699.6 million for the year ended December 31, 2009 compared to 2008. This decrease was driven primarily by a decrease in the average balance of margin receivables during the comparable periods, which was partially offset by a decrease in yields paid on customer deposits.

Trading and investing commissions increased 6% to $548.0 million for the year ended December 31, 2009 compared to 2008. The increase in commissions was the result of an increase in DARTs of 6% to 179,183 and an increase in the average commission per trade of 3% to $11.33 for the year ended December 31, 2009 compared to 2008.

Trading and investing principal transactions increased 4% to $88.1 million for the year ended December 31, 2009 compared to 2008. The increase in principal transactions was driven by an increase in the volume of equity shares that were traded, which was partially offset by a decrease in our average revenue earned per share traded for the year ended December 31, 2009.

Trading and investing operating expense decreased 14% to $796.6 million for the year ended December 31, 2009 compared to 2008. The decrease related primarily to a decrease in advertising and market development expense and a decrease in compensation and benefits expense.

As of December 31, 2009, we had approximately 2.6 million brokerage accounts, 1.0 million stock plan accounts and 0.7 million banking accounts. For the years ended December 31, 2009 and 2008, our brokerage products contributed 77% and 75%, respectively, and our banking products, which include sweep products, contributed 23% and 25%, respectively, of total trading and investing net revenue.

 

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Balance Sheet Management

The following table summarizes balance sheet management financial information and key metrics as of and for the periods ended December 31, 2010, 2009 and 2008 (dollars in millions):

 

                       Variance  
     Year Ended December 31,     2010 vs. 2009  
     2010     2009     2008     Amount     %  

Net operating interest income

   $ 463.3     $ 560.9     $ 467.6     $ (97.6     (17 )% 

Fees and service charges

     3.2       6.9       8.4       (3.7     (53 )% 

Gains (losses) on loans and securities, net

     166.3       169.2       (100.4     (2.9     (2 )% 

Net impairment

     (37.7     (89.1     (95.0     51.4       *   

Other revenues

     8.4       12.3       15.1       (3.9     (32 )% 
                                  

Total net revenue

     603.5       660.2       295.7       (56.7     (9 )% 

Provision for loan losses

     779.4       1,498.1       1,583.7       (718.7     (48 )% 

Total operating expense

     215.5       244.1       186.4       (28.6     (12 )% 

Losses from early extinguishment of debt

     —          (50.6     (10.9     50.6       *   
                                  

Balance sheet management segment loss

   $ (391.4   $ (1,132.6   $ (1,485.3   $ 741.2       (65 )% 
                                  

Key Metrics:

          

Special mention loan delinquencies

   $ 589.4     $ 804.5     $ 1,035.1     $ (215.1     (27 )% 

Allowance for loan losses

   $ 1,031.2     $ 1,182.7     $ 1,080.6     $ (151.5     (13 )% 

Allowance for loan losses as a % of gross loans receivable

     6.38     5.81     4.23     *        0.57

 

* Percentage not meaningful.

Our balance sheet management segment generates revenue from managing loans previously originated or purchased from third parties as well as our customer cash and deposit relationships to generate additional net operating interest income.

2010 Compared to 2009

The balance sheet management segment reported a loss of $391.4 million for the year ended December 31, 2010. The losses in this segment were due primarily to the provision for loan losses of $779.4 million for the year ended December 31, 2010.

Gains (losses) on loans and securities, net were gains of $166.3 million and $169.2 million for the years ended December 31, 2010 and 2009, respectively. The gains on loans and securities, net for the year ended December 31, 2010 were due primarily to gains on the sale of certain agency mortgage-backed securities and agency debentures.

We recognized $37.7 million and $89.1 million of net impairment during the years ended December 31, 2010 and 2009, respectively, on certain securities in our non-agency CMO portfolio due to continued deterioration in the expected credit performance of the underlying loans in the securities. The net impairment included gross OTTI of $41.5 million and $232.1 million for the years ended December 31, 2010 and 2009, respectively. Of the gross OTTI for the years ended December 31, 2010 and 2009, $3.8 million and $143.0 million related to the noncredit portion of OTTI, which was recorded through other comprehensive income (loss).

Provision for loan losses decreased 48% to $779.4 million for the year ended December 31, 2010 compared to 2009. The decrease in the provision for loan losses was driven by lower levels of at-risk (30-179 days delinquent) loans in our one- to four- family and home equity loan portfolios.

Total balance sheet management operating expense decreased 12% to $215.5 million for the year ended December 31, 2010 compared to 2009. The decrease for the year ended December 31, 2010 was due to decreases

 

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in clearing and servicing expense, FDIC insurance premiums and other expense. The decrease in the FDIC insurance premiums for the year ended December 31, 2010 was a result of an industry wide assessment that resulted in an additional $21.6 million of expense in the second quarter of 2009. There were no similar assessments made during the year ended December 31, 2010.

2009 Compared to 2008

The balance sheet management segment reported a loss of $1.1 billion for the year ended December 31, 2009. The losses in this segment were due primarily to the high levels of delinquent loans in our one- to four-family and home equity loan portfolios, which in turn resulted in provision for loan losses of $1.5 billion for the year ended December 31, 2009.

Gains (losses) on loans and securities, net were gains of $169.2 million for the year ended December 31, 2009, compared to losses of $100.4 million for the year ended December 31, 2008. The gains on loans and securities, net for the year ended December 31, 2009 were due primarily to gains on the sale of certain agency mortgage-backed securities, which were partially offset by net losses on the sales of loans.

We recognized $89.1 million net impairment during the year ended December 31, 2009 on certain securities in our non-agency CMO portfolio due to continued deterioration in the expected credit performance of the underlying loans in the securities. The net impairment included gross OTTI of $232.1 million for the year ended December 31, 2009. Of the $232.1 million of gross OTTI for the year ended December 31, 2009, $143.0 million related to the noncredit portion of OTTI, which was recorded through other comprehensive income (loss). We had net impairment of $95.0 million for the year ended December 31, 2008, which represented the total decline in the fair value of impaired securities in accordance with the OTTI accounting guidance that was in effect prior to April 1, 2009.

Provision for loan losses decreased $85.6 million to $1.5 billion for the year ended December 31, 2009 compared to 2008. The provision for loan losses for the year ended December 31, 2009 was due primarily to the high levels of delinquent loans in our one- to four-family and home equity loan portfolios.

Total balance sheet management operating expense increased 31% to $244.1 million for the year ended December 31, 2009 compared to 2008. The increase for the year ended December 31, 2009 was due primarily to an increase in FDIC insurance premiums and an increase in expenses related to real estate owned (“REO”) and other repossessed assets. These increases were partially offset by a decrease in clearing and servicing expenses.

Losses on early extinguishment of debt of $50.6 million and $10.9 million, respectively, for the years ended December 31, 2009 and 2008, were incurred on the early extinguishment of FHLB advances of $1.6 billion and $1.8 billion for the years ended December 31, 2009 and 2008, respectively.

 

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Corporate/Other

The following table summarizes corporate/other financial information for the periods ended December 31, 2010, 2009 and 2008 (dollars in millions):

 

                       Variance  
     Year Ended December 31,     2010 vs. 2009  
     2010     2009     2008     Amount     %  

Total net revenue

   $ (0.0   $ 0.0      $ 0.1     $ 0.0        *   
                                  

Compensation and benefits

     80.2       93.7       91.6       (13.5     (14 )% 

Professional services

     28.9       42.7       44.4       (13.8     (32 )% 

Communications

     1.7       1.9       2.2       (0.2     (12 )% 

Occupancy and equipment

     2.6       3.4       0.3       (0.8     (24 )% 

Depreciation and amortization

     21.0       19.1       20.5       1.9       10

Facility restructuring and other exit activities

     14.3       20.7       29.5