Northern Trust 10-Q 2012
Documents found in this filing:
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
For the Quarterly Period Ended March 31, 2012
For the transition period from to
Commission File No. 0-5965
NORTHERN TRUST CORPORATION
(Exact name of registrant as specified in its charter)
Registrants telephone number, including area code: (312) 630-6000
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of large accelerated filer, accelerated filer, and small reporting company in Rule 12b-2 of the Exchange Act. (Check one):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
241,149,572 Shares - $1.66 2/3 Par Value
(Shares of Common Stock Outstanding on March 31, 2012)
CONSOLIDATED FINANCIAL HIGHLIGHTS
($ In Millions Except Per Share Information)
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
FIRST QUARTER CONSOLIDATED RESULTS OF OPERATIONS
Northern Trust Corporation (the Corporation) and its subsidiaries is a leading provider of asset servicing, fund administration, asset management, fiduciary and banking solutions for corporations, institutions, families, and individuals worldwide. Northern Trust focuses on servicing and managing client assets through its two primary business units, Personal Financial Services (PFS) and Corporate & Institutional Services (C&IS). Asset management and related services to PFS and C&IS clients are provided primarily by a third business unit, Northern Trust Global Investments (NTGI). Northern Trust emphasizes quality through a high level of service complemented by the effective use of technology, delivered by a fourth business unit, Operations & Technology (O&T). Except where the context otherwise requires, the term Northern Trust refers to Northern Trust Corporation and its subsidiaries on a consolidated basis.
The following should be read in conjunction with the consolidated financial statements and related footnotes included in this report. Investors should also read the section entitled Factors Affecting Future Results.
Net income for the first quarter of 2012 totaled $161.2 million compared with $151.0 million in the first quarter of 2011. Net income per common share on a diluted basis was $0.66 compared with $0.61 in the prior year quarter.
The performance in the current quarter produced an annualized return on average common equity of 9.0% compared to 8.9% in the prior year quarter. The annualized return on average assets was 0.7% in both the current and prior year quarters.
Consolidated revenue of $965.4 million increased $67.5 million, or 8%, in the current quarter from $897.9 million in the prior year quarter, partly due to acquisitions completed in June and July of 2011. Noninterest income, which represented 73% of revenue, increased $45.5 million, or 7%, to $709.0 million from the prior year quarters $663.5 million, primarily reflecting higher trust, investment and other servicing fees, partially offset by lower foreign exchange trading income. Trust, investment and other servicing fees, which represented 60% of current quarter revenue, were $575.2 million in the current quarter, up $60.3 million, or 12%, from $514.9 million in the prior year quarter. Foreign exchange trading income totaled $61.9 million, down $22.9 million, or 27%, compared with $84.8 million in the prior year quarter.
Net interest income for the quarter increased $22.0 million, or 9%, to $256.4 million compared to $234.4 million in the prior year quarter.
Noninterest expense totaled $723.6 million for the current quarter compared to $652.9 million in the prior year quarter, an increase of $70.7 million, or 11%. The current quarter
includes expense attributable to the acquisitions completed in June and July of 2011, higher equipment and software expense, and restructuring and integration related charges of $3.9 million ($2.6 million after tax, or $0.01 per common share), primarily related to outside services expense. The prior year quarter included restructuring and integration related charges of $3.8 million ($3.2 million after tax, or $0.02 per common share). The prior year quarter also included the pre-tax benefit of $10.1 million ($6.4 million after tax, or $0.02 per common share) that was recorded in connection with the reduction of a liability related to potential losses from indemnified litigation involving Visa, Inc. (Visa).
The components of noninterest income are provided below.
Trust, investment and other servicing fees are based generally on the market value of assets held in custody, managed and serviced; the volume of transactions; securities lending volume and spreads; and fees for other services rendered. Certain market value calculations on which fees are based are performed on a monthly or quarterly basis in arrears. Certain investment management fee arrangements also may provide for performance fees based on client portfolio returns that exceed predetermined levels. Based on an analysis of historical trends and current asset and product mix, management estimates that a 10% rise or fall in overall equity markets would cause a corresponding increase or decrease in Northern Trusts trust, investment and other servicing fees of approximately 3% and in total revenues of approximately 2%.
Noninterest Income (continued)
The following table presents Northern Trusts assets under custody and assets under management by business segment.
Corporate & Institutional Services (C&IS) assets under custody totaled $4.2 trillion, up 5% from the prior year quarter, and included $2.6 trillion of global custody assets, 4% higher compared to the prior year quarter. C&IS assets under management included $96.5 billion of securities lending collateral, a 12% decrease from the prior year quarter. Changes in assets under custody and under management are in comparison to the twelve month increase in the S&P 500 index of 6% and decline in the EAFE index (USD) of 9%.
Custodied and managed assets at the current and prior year quarter ends were invested as follows:
Noninterest Income (continued)
Trust, investment and other servicing fees from C&IS increased $45.7 million, or 17%, totaling $317.0 million compared to the prior year quarters $271.3 million.
Custody and fund administration fees, the largest component of C&IS fees, increased 24%, primarily reflecting revenue attributable to the 2011 acquisitions and other new business. C&IS investment management fees declined 8% as the benefit of new business was offset by waived fees in money market mutual funds due to the persistent low short-term interest rates. Money market mutual fund fee waivers in C&IS totaled $10.6 million in the current quarter compared with $4.6 million in the prior year quarter.
Trust, investment and other servicing fees from PFS totaled $258.2 million in the current quarter, increasing $14.6 million, or 6%, from $243.6 million in the prior year quarter. The increase in the current quarter primarily reflects strong new business and revised fee structures, partially offset by higher waived fees in money market mutual funds. Money market mutual fund fee waivers in PFS totaled $14.8 million in the current quarter compared with $12.1 million in the prior year quarter.
Foreign exchange trading income totaled $61.9 million, down $22.9 million, or 27%, compared with $84.8 million in the prior year quarter. The current quarter decrease is attributable to reduced market volatility and client trading volumes.
Other operating income totaled $38.6 million, up 8% from $35.7 million in the prior year quarter. The components of other operating income are provided below.
The increase in other operating income is primarily attributable to increases in loan service fees and miscellaneous other income items.
Net investment security losses totaled $2.4 million in the current quarter compared to $5.5 million in the prior year quarter. The current quarter included credit-related other-than-temporary impairment of residential mortgage-backed securities and auction rate securities totaling $3.1 million. The prior year quarter included $5.1 million of other-than-temporary impairment of residential mortgage-backed securities.
Net Interest Income
Net interest income for the quarter stated on a fully taxable equivalent (FTE) basis totaled $266.3 million, up $21.4 million, or 9%, from $244.9 million reported in the prior year quarter. The increase is primarily attributable to higher average earning assets, partially offset by a decline in the net interest margin. Net interest income is defined as the total of interest income and amortized fees on earning assets, less interest expense on deposits and borrowed funds, adjusted for the impact of interest-related hedging activity. Net interest income stated on an FTE basis is a non-GAAP financial measure that facilitates the analysis of asset yields. When adjusted to an FTE basis, yields on taxable, nontaxable, and partially taxable assets are comparable; however, the adjustment to an FTE basis has no impact on net income. A reconciliation of net interest income on a GAAP basis to net interest income on an FTE basis is provided on page 19.
Average earning assets for the quarter increased $10.7 billion, or 14%, to $86.1 billion from $75.4 billion in the prior year quarter, while the net interest margin was 1.24%, down from 1.32% in the prior year quarter. Average earning assets increased primarily due to increases in demand deposits and non-U.S. office interest-bearing deposits, which were invested primarily in investment securities and interest-bearing deposits with banks. The benefit of higher deposits was limited as yields on high quality investments declined resulting in a lower net interest margin.
Average investment securities increased $9.1 billion, or 41%, to $31.3 billion in the current quarter compared to $22.2 billion in the prior year quarter. Average interest-bearing deposits with banks totaled $18.2 billion for the current quarter compared to $16.2 billion for the prior year quarter, an increase of $2.0 billion, or 13%.
Loans and leases averaged $28.6 billion, an increase of $820.6 million, or 3%, from $27.8 billion in the prior year quarter. The increase was primarily attributable to growth in commercial and institutional loans, which averaged $7.0 billion in the current quarter, up $1.0 billion, or 17%, from the prior year quarters average of $6.0 billion.
Northern Trust utilizes a diverse mix of funding sources. Total interest-bearing deposits averaged $56.7 billion in the current quarter compared to $53.8 million in the prior year quarter. The increase of $2.9 billion, or 5%, was primarily attributable to non-U.S. office interest-bearing deposits. Other interest-related funds averaged $8.6 billion in the quarter, a decrease of $1.4 billion, or 14%, as compared to $10.0 billion in the prior year quarter, primarily due to lower levels of short-term borrowings and long-term debt. The balances within these classifications vary based on funding requirements and strategies, interest rate levels, changes in the volume of lower-cost deposit sources, and the availability of collateral to secure these borrowings. Average net noninterest-related funds utilized to fund earning assets increased $9.2 billion, or 80%, to $20.8 billion from $11.6 billion in the prior year quarter, resulting primarily from higher levels of U.S. office demand and other noninterest-bearing deposits. Deposit balances are down from the December 31, 2011 levels, however, with March 31, 2012 interest-bearing deposits totaling $54.0 billion, down $2.4 billion, or 4%, and noninterest-bearing deposits totaling $19.9 billion, down $6.4 billion, or 24%, as client deposits declined in the current quarter.
Net Interest Income (continued)
For additional analysis of average balances and interest rate changes affecting net interest income, refer to the Average Consolidated Balance Sheet with Analysis of Net Interest Income and the Analysis of Net Interest Income Changes Due To Volume and Rate on page 20.
Provision for Credit Losses
The provision for credit losses was $5.0 million in the current quarter and $15.0 million in the prior year quarter. Net charge-offs totaled $5.8 million for the current quarter and included $8.6 million of recoveries, compared to $21.6 million of net charge-offs in the prior year quarter which included $13.8 million of recoveries. Nonperforming loans decreased $63.0 million, or 19%, from the prior year quarter. Commercial and institutional loans and commercial real estate loans reflect improvement from the prior year quarter, while weakness persists within residential real estate loans. Other real estate owned decreased $33.9 million, or 60%, compared to the prior year quarter, primarily reflecting sales of properties. For additional discussion of the provision and allowance for credit losses, refer to the Asset Quality section below.
The components of noninterest expense are provided below.
The increase in noninterest expense in the current quarter primarily reflects the acquisitions completed in June and July of 2011, higher equipment and software expense, and the pre-tax benefit of $10.1 million that was recorded in the prior year quarter from the reduction of the Visa indemnification liability.
Compensation expense, the largest component of noninterest expense, equaled $321.6 million, up $27.6 million, or 9%, compared to $294.0 million in the prior year quarter. The increase primarily reflects higher full-time equivalent staff levels, the majority of the increase being attributable to the 2011 acquisitions, and annual merit increases. Staff on a full-time equivalent basis at March 31, 2012 totaled approximately 13,900, up 7% from a year ago.
Employee benefit expense equaled $68.1 million, up $13.3 million, or 24%, compared to $54.8 million in the prior year quarter. Employee benefit expense for the prior year quarter included a $9.7 million reversal of an employee benefit related accrual for which
Noninterest Expense (continued)
the 2010 goal was not met. The current quarter reflects higher full-time equivalent staff levels and higher federal and unemployment insurance expense.
Expense associated with outside services totaled $128.2 million, up 3% from $124.0 million in the prior year quarter. The increase was primarily due to higher expense associated with technical services, due in part to the 2011 acquisitions, partially offset by lower consulting and third-party advisory fees.
Equipment and software expense totaled $90.8 million, an increase of $17.4 million, or 24%, from $73.4 million in the prior year quarter. The current quarter reflects a $4.6 million software write-off and higher levels of software amortization and related software support costs from the continued investment in capital assets.
The components of other operating expense are provided below.
The decrease in Federal Deposit Insurance Corporation (FDIC) premiums primarily reflects lower premiums resulting from changes in the FDICs assessment methodology. Other intangible amortization for the current quarter includes expense associated with intangible assets acquired in 2011. The increase in other expenses reflects increases within various other miscellaneous expense categories.
Provision for Income Taxes
Income tax expense was $75.6 million in the current quarter, representing an effective tax rate of 31.9%, and $79.0 million in the prior year quarter, representing an effective tax rate of 34.3%. The prior year quarter included adjustments to deferred tax provisions as a result of the Illinois corporate income tax rate increase which was enacted in January 2011.
BUSINESS UNIT REPORTING
The following table reflects the earnings contributions and average assets of Northern Trusts business units for the three month periods ended March 31, 2012 and 2011. Business unit financial information, presented on an internal management-reporting basis, is determined by accounting systems that are used to allocate revenue and expense related to each segment and incorporates processes for allocating assets, liabilities, and equity, and the applicable interest income and expense.
Corporate and Institutional Services
C&IS net income for the quarter was $68.0 million compared with $82.2 million in the prior year quarter, a decrease of $14.2 million, or 17%.
The increase in C&IS trust, investment and other servicing fees primarily reflects revenue attributable to the 2011 acquisitions and other new business, partially offset by increased money market mutual fund fee waivers. Custody and fund administration fees, the largest component of C&IS fees, increased 24%, primarily as a result of the 2011 acquisitions and other new business. The decrease in investment management fees is primarily due to higher waived fees in money market mutual funds attributable to the persistent low level of short-term interest rates, partially offset by new business. Money market mutual fund fee waivers in C&IS totaled $10.6 million in the current quarter compared with $4.6 million in the prior year quarter. Securities lending revenue increased 27%, primarily due to higher spreads on the investment of cash collateral.
Corporate and Institutional Services (continued)
Other noninterest income decreased $18.2 million, or 15%, in the current quarter as compared to the prior year quarter, as a result of lower foreign exchange trading income. The decrease in foreign exchange trading income is attributable to reduced market volatility and client volumes.
Net interest income stated on an FTE basis was up $15.3 million, or 25%, from the prior year quarter, primarily reflecting an increase in average earning assets. The net interest margin equaled 0.74% compared with 0.62% reported in the prior year quarter. The higher net interest margin is primarily attributable to increased interest rates earned on investments in short-term interest-bearing deposits with banks that were funded by lower yielding interest-bearing deposits. Earning assets averaged $41.7 billion for the quarter, an increase of $3.5 billion, or 9%, from $38.2 billion the prior year quarter, funded chiefly by higher non-U.S. custody related interest-bearing deposits which were primarily invested in low yielding short-term interest-bearing deposits with banks and in securities.
A provision for credit losses of $0.5 million was recorded in the current quarter, reflecting improvement in underlying asset quality metrics within commercial and institutional loans and commercial real estate loans. Total loans and leases averaged $5.9 billion in the current quarter up $1.3 billion, or 27%, from the prior year quarter. The prior year quarters negative provision totaled $14.6 million, partially attributable to a high level of charge-off recoveries in the period.
Total C&IS noninterest expense, which includes the direct expense of the business unit, indirect expense allocations from NTGI and O&T for product and operating support, and indirect expense allocations for certain corporate support services, totaled $398.0 million compared with $339.9 million for the prior year quarter, an increase of $58.1 million, or 17%. The increase reflects higher compensation and outside service expenses, partly due to the 2011 acquisitions, and increased indirect expense allocations.
Personal Financial Services
PFS net income for the current quarter was $85.9 million compared to $63.1 million reported in the prior year quarter, an increase of $22.8 million, or 36%. Noninterest income was $285.3 million, up $10.1 million, or 4%, from $275.2 million in the prior year quarter. Trust, investment and other servicing fees totaled $258.2 million in the current quarter, increasing $14.6 million, or 6%, from $243.6 million in the prior year quarter. The increase in trust, investment and other servicing fees was primarily the result of strong new business and revised fee structures, partially offset by higher waived fees in money market mutual funds. PFS waived fees in money market mutual funds, attributable to the continued low level of short-term interest rates, totaled $14.8 million in the current quarter compared with $12.1 million in the prior year quarter. Other noninterest income totaled $27.1 million, down 14% from $31.6 million in the prior year quarter due to decreases within various miscellaneous noninterest income categories.
Personal Financial Services (continued)
Net interest income stated on an FTE basis was $161.1 million in the current quarter, an increase of $11.9 million, or 8%, compared to $149.2 million in the prior year quarter. The net interest margin was 2.82% in the current quarter compared to 2.60% in the prior year quarter. The higher net interest margin is primarily due to a change in the application of internal funds transfer pricing used in determining net interest income, as well as a decline in the average cost of interest-bearing funds.
A provision for credit losses of $4.5 million was recorded in the current quarter. The prior year quarters provision totaled $29.6 million. The current quarter provision reflects improvement in the underlying asset quality metrics within commercial and institutional loans and commercial real estate loans, partially offset by continued weakness in residential real estate loans. For a fuller discussion of the consolidated allowance and provision for credit losses refer to the Asset Quality section below.
Total PFS noninterest expense, which includes the direct expense of the business unit, indirect expense allocations from NTGI and O&T for product and operating support, and indirect expense allocations for certain corporate support services, totaled $303.7 million compared with $290.0 million in the prior year quarter, an increase of $13.7 million, or 5%. The increase was primarily attributable to higher indirect expense allocations.
Treasury and Other
Treasury and Other includes income and expense associated with the wholesale funding activities and the investment portfolios of the Corporation and its principal subsidiary, The Northern Trust Company (Bank), and certain corporate-based expense, executive level compensation, and nonrecurring items not allocated to the business units. Other noninterest income for the current quarter totaled $0.6 million, compared with negative $7.3 million in the prior year quarter. The change in other noninterest income is due to increases within various miscellaneous noninterest income categories and lower levels of investment security losses. The current quarter included charges of $3.1 million for credit-related other-than-temporary impairment of residential mortgage-backed securities and auction rate securities. The prior year quarter included charges of $5.1 million for credit-related other-than-temporary impairment of residential mortgage-backed securities. Net interest income in the current quarter was $28.2 million, compared to $34.0 million in the prior year quarter, a decrease of $5.8 million, or 17%. The decrease reflects a change in the application of internal funds transfer pricing used in determining net interest income, as well as lower yields on securities in the prolonged low interest rate environment. Average assets increased $6.0 billion, or 38%, to $21.9 billion in the current quarter, reflecting higher levels of interest-bearing deposits and investment securities, funded primarily by non-U.S interest-bearing deposits and allocated capital. Noninterest expense for the quarter totaled $21.9 million compared with $23.0 million in the prior year quarter, a decrease of 5%.
Total assets at March 31, 2012 were $91.6 billion and averaged $95.1 billion for the current quarter, compared with total assets of $92.7 billion at March 31, 2011 and average total assets of $83.3 billion in the prior year quarter. Average balances are considered to be a better measure of balance sheet trends as period-end balances can be impacted on a short term basis by deposit and withdrawal activity involving large balances of short-term client funds. Loans and leases totaled $29.2 billion at March 31, 2012 and averaged $28.6 billion in the current quarter as compared to $27.9 billion at March 31, 2011 and a $27.8 billion average in the prior year quarter. Securities totaled $32.1 billion at March 31, 2012 and averaged $31.3 billion for the quarter, up 38% and 41%, respectively, compared with $23.2 billion at March 31, 2011 and $22.2 billion on average in the prior year quarter. Federal funds sold and securities purchased under agreements to resell, interest-bearing deposits with banks, and Federal Reserve deposits and other interest-bearing assets in aggregate totaled $21.4 billion at March 31, 2012 and averaged $26.2 billion in the current quarter, down 33% and up 3%, respectively, from the year-ago quarter balances. The increase in average total assets was funded primarily by higher levels of demand and other non-interest bearing balances and non-U.S. office interest-bearing deposits.
Total stockholders equity averaged $7.2 billion, up $314.5 million, or 5%, from the prior year quarters average of $6.9 billion. The current quarter increase primarily reflects earnings, partially offset by dividend declarations and the repurchase of common stock pursuant to the Corporations share buyback program. During the current quarter, the Corporation repurchased 328,687 shares at a cost of $14.5 million ($43.98 average price per share). The Corporations common stock repurchase authorization was replaced in March of 2012, pursuant to which the Corporation is authorized to purchase up to 10.0 million shares after March 31, 2012.
Northern Trusts risk-based capital ratios remained strong at March 31, 2012 and were well above the minimum regulatory requirements established by U.S. banking regulators of 4% for tier 1 capital, 8% for total capital (risk-based), and 3% for leverage (tier 1 capital to period average assets). The Corporation and the Bank each had capital ratios at March 31, 2012 that were above the level required for classification as a well capitalized institution. Shown below are the March 31, 2012 and December 31, 2011 capital ratios of the Corporation and the Bank for the three months ended March 31, 2012 and December 31, 2011.
BALANCE SHEET (continued)
The following table provides a reconciliation of the Corporations tier 1 common equity to tier 1 capital calculated in accordance with applicable regulatory requirements and GAAP.
Northern Trust is providing the ratio of tier 1 common equity to risk-weighted assets in addition to its capital ratios prepared in accordance with regulatory requirements and GAAP as it is a measure that the Corporation and investors use to assess capital adequacy.
Northern Trust maintains a high quality securities portfolio, with 85% of the combined available for sale, held to maturity, and trading account portfolios at March 31, 2012 composed of U.S. Treasury and government sponsored agency securities and triple-A rated corporate notes, asset-backed securities, covered bonds, supranational bonds, auction rate securities and obligations of states and political subdivisions. The remaining portfolio was composed of corporate notes, asset-backed securities, negotiable certificates of deposit, obligations of states and political subdivisions, supranational bonds, auction rate securities and other securities, of which as a percentage of the total securities portfolio, 4% was rated double-A, 1% was rated below double-A, and 10% was not rated by Standard and Poors or Moodys Investors Service (primarily negotiable certificates of deposits of banks whose long term ratings are at least A).
Total gross unrealized losses within the investment securities portfolio at March 31, 2012 were $66.8 million as compared to $85.0 million at December 31, 2011. Of the total gross unrealized losses on securities at March 31, 2012, $23.9 million relate to non-agency residential mortgage-backed securities. Non-agency residential mortgage-backed securities rated below double-A at March 31, 2012 represented 85% of the total fair value of non-agency residential mortgage-backed securities, were comprised primarily of sub-prime and Alt-A securities, and had a total amortized cost and fair value of $140.5 million and $117.2 million, respectively.
Northern Trust has evaluated non-agency residential mortgage-backed securities, and all other securities with unrealized losses, for possible OTTI in accordance with GAAP and
ASSET QUALITY (continued)
Northern Trusts security impairment review policy. Credit related losses recognized in earnings on other-than-temporarily impaired securities totaled $3.1 million for the three months ended March 31, 2012. There were $5.1 million of credit-related losses recognized in earnings for the three months ended March 31, 2011 on other-than-temporarily impaired securities.
Northern Trust is a participant in the repurchase agreement market. This market provides a relatively low cost alternative for short-term funding. Securities purchased under agreements to resell and securities sold under agreements to repurchase are accounted for as collateralized financings and recorded at the amounts at which the securities were acquired or sold plus accrued interest. To minimize potential credit risk associated with these transactions, the fair value of the securities purchased or sold is monitored, limits are set on exposure with counterparties, and the financial condition of counterparties is regularly assessed. It is Northern Trusts policy to take possession of securities purchased under agreements to resell. Securities sold under agreements to repurchase are held by the counterparty until the repurchase.
As of March 31, 2012, Northern Trusts gross exposure to obligors in Portugal, Italy, Ireland, Greece and Spain, eurozone countries considered by Northern Trust to be experiencing significant economic, fiscal and/or political strains, totaled approximately $610 million, or less than 1% of Northern Trusts total consolidated assets. The largest such exposure, totaling $608 million, was to obligors in Ireland, of which $6 million was to banks and $602 million was to commercial and other borrowers, primarily funds domiciled in Ireland whose assets and investment activities are broadly diversified by investment strategy, issuer type, country of risk, and/or instrument type. Exposures to these borrowers in Ireland may be secured or unsecured, committed or uncommitted, but are typically for short periods of a year or less for foreign exchange, overdraft accommodations, and loans. The remaining exposure reflects $2 million to banks in Spain in connection with foreign exchange contracts. There was negligible exposure to obligors in Portugal, Italy, or Greece. Exposure levels at March 31, 2012 reflect Northern Trusts risk management policies and practices, which operated to limit exposures to higher risk European financial and sovereign entities.
ASSET QUALITY (continued)
Nonperforming Loans and Other Real Estate Owned
Nonperforming assets consist of nonperforming loans and Other Real Estate Owned (OREO). OREO is comprised of commercial and residential properties acquired in partial or total satisfaction of loans.
The following table provides the amounts of nonperforming loans, by segment and class, and of OREO that were outstanding at the dates shown, as well as the balance of loans that were delinquent 90 days or more and still accruing interest. The balance of loans delinquent 90 days or more and still accruing interest can fluctuate widely based on the timing of cash collections, renegotiations and renewals.
Maintaining a low level of nonperforming assets is important to the ongoing success of a financial institution. In addition to the negative impact on both net interest income and credit losses, nonperforming assets also increase operating costs due to the expense associated with collection efforts. The duration and severity of the economic downturn which began in 2008, together with its impact on equity and real estate values, had a negative effect on Northern Trusts credit portfolio and resulted in increases from prior historical levels of credits downgraded to nonperforming, primarily the residential real estate and commercial real estate loan classes, and of OREO properties. The $30.4 million decrease in nonperforming assets during the current quarter primarily reflects nonperforming loan payoffs and sales as well as amounts charged off, partially offset by additional loans classified as nonperforming, though at a lower level than in the more recent periods.
Importantly, Northern Trust focuses its lending efforts on clients who are looking to utilize a full range of financial services with Northern Trust. Northern Trusts underwriting standards do not allow for the origination of loan types generally considered to be of high risk in nature, such as option ARM loans, subprime loans, loans with initial teaser rates, and loans with excessively high loan-to-value ratios. Residential real estate loans consist of conventional home mortgages and equity credit lines, which generally require a loan to collateral value of no more than 65% to 80% at inception. Revaluations of supporting
ASSET QUALITY (continued)
collateral are obtained upon refinancing or default or when otherwise considered warranted. Collateral revaluations for mortgages are performed by independent third parties. The commercial real estate portfolio consists of commercial mortgages and construction, acquisition and development loans extended primarily to highly experienced developers and/or investors well known to Northern Trust. Underwriting standards generally reflect conservative loan-to-value ratios and debt service coverage requirements. Recourse to borrowers through guarantees is also commonly required.
Provision and Allowance for Credit Losses
The provision for credit losses is the charge to current earnings that is determined by management, through a disciplined credit review process, to be the amount needed to maintain the allowance for credit losses at an appropriate level to absorb probable credit losses that have been identified with specific borrower relationships (specific loss component) and probable losses that are believed to be inherent in the loan and lease portfolios, unfunded commitments, and standby letters of credit (inherent loss component). Control processes and analyses employed to evaluate the appropriateness of the allowance for credit losses are reviewed on at least an annual basis and modified as considered necessary.
The amount of specific allowance is determined through an individual evaluation of loans and lending-related commitments considered impaired that is based on expected future cash flows, the value of collateral, and other factors that may impact the borrowers ability to pay. Changes in collateral values, delinquency ratios, portfolio volume and concentration, and other asset quality metrics, including managements subjective evaluation of economic and business conditions, result in adjustments of qualitative allowance factors that are applied in the determination of inherent allowance requirements.
A $5.0 million provision for credit losses was recorded in the current quarter and a $15.0 million provision was recorded in the prior year first quarter. The current quarter provision reflects improvement in the commercial and institutional loan class, partially offset by continued weakness in the commercial real estate and residential real estate loan classes.
Note 6 to the consolidated financial statements includes a table that details the changes in the allowance for credit losses during the three months ended March 31, 2012 and 2011 due to charge-offs, recoveries, and the provision for credit losses.
ASSET QUALITY (continued)
The following table shows the specific portion of the allowance and the inherent portion of the allowance and its components, each by loan and lease segment and class.
MARKET RISK MANAGEMENT
As described in the 2011 Annual Report to Shareholders, Northern Trust manages its interest rate risk through two primary measurement techniques: simulation of earnings and simulation of economic value of equity. Also, as part of its risk management activities, it regularly measures the risk of loss associated with foreign currency positions using a Value-at-Risk (VaR) model.
Based on this continuing evaluation process, Northern Trusts interest rate risk position, as measured by current market implied forward interest rates and sensitivity analyses, and the VaR associated with the foreign exchange trading portfolio, have not changed significantly since December 31, 2011.
RECONCILIATION OF REPORTED NET INTEREST INCOME TO FULLY TAXABLE EQUIVALENT
The table below presents a reconciliation of interest income and net interest income prepared in accordance with GAAP to interest income and net interest income on a fully taxable equivalent (FTE) basis, a non-GAAP financial measure. Management believes this presentation provides a clearer indication of net interest margins for comparative purposes.
The following schedule should be read in conjunction with the Net Interest Income section of Managements
Discussion and Analysis of Financial Condition and Results of Operations.
Interest revenue on cash collateral positions is reported above within interest-bearing deposits with banks and within loans and leases. Interest expense on cash collateral positions is reported above within non-U.S. offices interest-bearing deposits. Related cash collateral received from and deposited with derivative counterparties is recorded net of the associated derivative contract within other assets and other liabilities, respectively.
FACTORS AFFECTING FUTURE RESULTS
This report contains statements that may be considered forward-looking, such as the statements relating to Northern Trusts financial goals, capital adequacy, dividend policy, expansion and business development plans, risk management policies, anticipated expense levels and projected profit improvements, business prospects and positioning with respect to market, demographic and pricing trends, strategic initiatives, reengineering and outsourcing activities, new business results and outlook, changes in securities market prices, credit quality including allowance levels, planned capital expenditures and technology spending, anticipated tax benefits and expenses, and the effects of any extraordinary events and various other matters (including developments with respect to litigation, other contingent liabilities and obligations, and regulation involving Northern Trust and changes in accounting policies, standards and interpretations) on Northern Trusts business and results.
Forward-looking statements are typically identified by words or phrases such as believe, expect, anticipate, intend, estimate, may increase, may fluctuate, plan, goal, target, strategy, and similar expressions or future or conditional verbs such as may, will, should, would, and could. Forward-looking statements are Northern Trusts current estimates or expectations of future events or future results. Actual results could differ materially from the results indicated by these statements because the realization of those results is subject to many risks and uncertainties including: the health of the U.S. and international economies and particularly the continuing uncertainty in Europe; the recent downgrade of U.S. Government issued securities; the health and soundness of the financial institutions and other counterparties with which Northern Trust conducts business; changes in financial markets, including debt and equity markets, that impact the value, liquidity, or credit ratings of financial assets in general, or financial assets in particular investment funds, client portfolios, or securities lending collateral pools, including those funds, portfolios, collateral pools, and other financial assets with respect to which Northern Trust has taken, or may in the future take, actions to provide asset value stability or additional liquidity; the impact of the recent disruption and stress in the financial markets, the effectiveness of governmental actions taken in response, and the effect of such governmental actions on Northern Trust, its competitors and counterparties, financial markets generally and availability of credit specifically, and the U.S. and international economies, including special deposit assessments or potentially higher FDIC premiums; changes in foreign exchange trading client volumes, fluctuations and volatility in foreign currency exchange rates, and Northern Trusts success in assessing and mitigating the risks arising from such changes, fluctuations and volatility; decline in the value of securities held in Northern Trusts investment portfolio, particularly asset-backed securities, the liquidity and pricing of which may be negatively impacted by periods of economic turmoil and financial market disruptions; uncertainties inherent in the complex and subjective judgments required to assess credit risk and establish appropriate allowances therefor; difficulties in measuring, or determining whether there is other-than-temporary impairment in, the value of securities held in Northern Trusts investment portfolio; Northern Trusts success in managing various risks inherent in its business, including credit risk, operational risk, interest rate risk and liquidity risk, particularly during times of economic uncertainty and volatility in the credit and other markets; geopolitical risks and the risks of extraordinary events such as natural disasters, terrorist events, war and the U.S. and other governments responses to those events; the pace and extent of
FACTORS AFFECTING FUTURE RESULTS (continued)
continued globalization of investment activity and growth in worldwide financial assets; regulatory and monetary policy developments; failure to obtain regulatory approvals when required, including for the use and distribution of capital; changes in tax laws, accounting requirements or interpretations and other legislation in the U.S. or other countries that could affect Northern Trust or its clients, including changes in accounting rules for fair value measurements and recognizing impairments; changes in the nature and activities of Northern Trusts competition, including increased consolidation within the financial services industry; Northern Trusts success in maintaining existing business and continuing to generate new business in its existing markets; Northern Trusts success in identifying and penetrating targeted markets, through acquisition, strategic alliance or otherwise; Northern Trusts success in integrating acquisitions and strategic alliances; Northern Trusts success in addressing the complex needs of a global client base across multiple time zones and from multiple locations, and managing compliance with legal, tax, regulatory and other requirements in areas of faster growth in its businesses, especially in immature markets; Northern Trusts ability to maintain a product mix that achieves acceptable margins; Northern Trusts ability to continue to generate investment results that satisfy its clients and continue to develop its array of investment products; Northern Trusts success in generating revenues in its securities lending business for itself and its clients, especially in periods of economic and financial market uncertainty; Northern Trusts success in recruiting and retaining the necessary personnel to support business growth and expansion and maintain sufficient expertise to support increasingly complex products and services; Northern Trusts success in implementing its revenue enhancement and expense management initiatives; Northern Trusts ability, as products, methods of delivery, and client requirements change or become more complex, to continue to fund and accomplish innovation, improve risk management practices and controls, and address operating risks, including human errors or omissions, data security breach risks, pricing or valuation of securities, fraud, systems performance or defects, systems interruptions, and breakdowns in processes or internal controls; Northern Trusts success in controlling expenses, particularly in a difficult economic environment; uncertainties inherent in Northern Trusts assumptions concerning its pension plan, including discount rates and expected contributions, returns and payouts; increased costs of compliance and other risks associated with changes in regulation and the current regulatory environment, including the requirements of the Basel II capital regime and the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act), areas of increased regulatory emphasis and oversight in the U.S. and other countries such as anti-money laundering, anti-bribery, and client privacy and the potential for substantial changes in the legal, regulatory and enforcement framework and oversight applicable to financial institutions in reaction to recent adverse financial market events, including changes pursuant to the Dodd-Frank Act that may, among other things, affect the leverage limits and risk-based capital and liquidity requirements for certain financial institutions, including Northern Trust, require those financial institutions to pay higher assessments, expose them to certain liabilities of their subsidiary depository institutions, and restrict or increase the regulation of certain activities, including foreign exchange, carried on by financial institutions, including Northern Trust; risks that evolving regulations, such as Basel II, and potential legislation and regulations, including Basel III and regulations that may be promulgated under the Dodd-Frank Act, could affect required
FACTORS AFFECTING FUTURE RESULTS (continued)
regulatory capital for financial institutions, including Northern Trust, potentially resulting in changes to the cost and composition of capital for Northern Trust; risks and uncertainties inherent in the litigation and regulatory process, including the adequacy of contingent liability, tax, and other accruals; and the risk of events that could harm Northern Trusts reputation and so undermine the confidence of clients, counterparties, rating agencies, and stockholders.
Some of these and other risks and uncertainties that may affect future results are discussed in more detail in the section of Managements Discussion and Analysis of Financial Condition and Results of Operations captioned Risk Management in the 2011 Annual Report to Shareholders (pages 49-61), in the section of the Notes to Consolidated Financial Statements in the 2011 Annual Report to Shareholders captioned Note 25 Contingent Liabilities (pages 111 and 112), in the sections of Item 1 Business of the 2011 Annual Report on Form 10-K captioned Government Monetary and Fiscal Policies, Competition and Regulation and Supervision (pages 3-14), and in Item 1A Risk Factors of the 2011 Annual Report on Form 10-K (pages 28-37). All forward-looking statements included in this report are based upon information presently available, and Northern Trust assumes no obligation to update any forward-looking statements.
See accompanying notes to the consolidated financial statements.
See accompanying notes to the consolidated financial statements.
See accompanying notes to the consolidated financial statements.
See accompanying notes to the consolidated financial statements.
Notes to Consolidated Financial Statements
1. Basis of Presentation The consolidated financial statements include the accounts of Northern Trust Corporation (Corporation) and its subsidiaries (collectively, Northern Trust). Significant intercompany balances and transactions have been eliminated. The consolidated financial statements, as of and for the periods ended March 31, 2012 and 2011, have not been audited by the Corporations independent registered public accounting firm. In the opinion of management, all accounting entries and adjustments, including normal recurring accruals, necessary for a fair presentation of the financial position and the results of operations for the interim periods have been made. Certain prior period balances have been reclassified consistent with the current periods presentations. For a description of Northern Trusts significant accounting policies, refer to Note 1 of the Notes to Consolidated Financial Statements in the 2011 Annual Report to Shareholders.
2. Recent Accounting Pronouncements There are no accounting pronouncements that were issued during the quarter ended March 31, 2012 but not yet adopted that are expected to impact Northern Trusts consolidated financial position or results of operations.
3. Fair Value Measurements Fair Value Hierarchy. The following describes the hierarchy of valuation inputs (Levels 1, 2, and 3) used to measure fair value and the primary valuation methodologies used by Northern Trust for financial instruments measured at fair value on a recurring basis. Observable inputs reflect market data obtained from sources independent of the reporting entity; unobservable inputs reflect the entitys own assumptions about how market participants would value an asset or liability based on the best information available. GAAP requires an entity measuring fair value to maximize the use of observable inputs and minimize the use of unobservable inputs and establishes a fair value hierarchy of inputs. Financial instruments are categorized within the hierarchy based on the lowest level input that is significant to their valuation. Northern Trusts policy is to recognize transfers into and transfers out of fair value levels as of the end of the reporting period in which the transfer occurred.
Level 1 Quoted, active market prices for identical assets or liabilities.
Northern Trusts Level 1 assets are comprised of available for sale investments in U.S. treasury securities.
Level 2 Observable inputs other than Level 1 prices, such as quoted active market prices for similar assets or liabilities, quoted prices for identical or similar assets in inactive markets, and model-derived valuations in which all significant inputs are observable in active markets.
Northern Trusts Level 2 assets include available for sale and trading account securities. Their fair values are determined by external pricing vendors, or in limited cases internally, using widely accepted income-based (discounted cash flow) models that incorporate observable current market yield curves and assumptions regarding anticipated prepayments and defaults.
Notes to Consolidated Financial Statements (continued)
Level 2 assets and liabilities also include derivative contracts which are valued using widely accepted income-based models that incorporate inputs readily observable in actively quoted markets and reflect the contractual terms of the contracts. Observable inputs include foreign exchange rates and interest rates for foreign exchange contracts; credit spreads, default probabilities, and recovery rates for credit default swap contracts; interest rates for interest rate swap contracts and forward contracts; and interest rates and volatility inputs for interest rate option contracts. Northern Trust evaluates the impact of counterparty credit risk and its own credit risk on the valuation of its derivative instruments. Factors considered include the likelihood of default by Northern Trust and its counterparties, the remaining maturities of the instruments, net exposures after giving effect to master netting agreements, available collateral, and other credit enhancements in determining the appropriate fair value of derivative instruments. The resulting valuation adjustments have not been considered material.
Level 3 Valuation techniques in which one or more significant inputs are unobservable in the marketplace.
Northern Trusts Level 3 assets consist of auction rate securities purchased in 2008 from Northern Trust clients. To estimate the fair value of auction rate securities, for which trading is limited and market prices are generally unavailable, Northern Trust developed and maintains a pricing model that discounts estimated cash flows over their estimated remaining lives. Significant inputs to the model include the contractual terms of the securities, credit risk ratings, discount rates, forward interest rates, credit/liquidity spreads, and Northern Trusts own assumptions about the estimated remaining lives of the securities. The significant unobservable inputs used in the fair value measurement are Northern Trusts own assumptions about the estimated remaining lives of the securities and the applicable discount rates. Significant increases (decreases) in the estimated remaining lives or the discount rates in isolation would result in a significantly lower (higher) fair value measurement. Level 3 liabilities include financial guarantees relating to standby letters of credit and acquisition related contingent consideration liabilities. Northern Trusts recorded liability for standby letters of credit, reflecting the obligation that Northern Trust has undertaken, is measured as the amount of unamortized fees on these instruments. Fees are determined by applying basis points to the principal amounts of the letters of credit. The significant unobservable inputs used in the fair value measurement are the market fees on the instruments. Significant increases (decreases) in the market fees would result in significantly higher (lower) fair value measurements. The fair values of contingent purchase consideration liabilities are determined using an income-based (discounted cash flow) model that incorporates Northern Trusts own assumptions about business growth rates and applicable discount rates, which represent unobservable inputs to the model. Significant increases (decreases) in projected growth rates in isolation would result in significantly higher (lower) fair value measurements, while significant increases (decreases) in the discount rate in isolation would result in significantly lower (higher) fair value measurements.
Notes to Consolidated Financial Statements (continued)
Northern Trust believes its valuation methods for its assets and liabilities carried at fair value are appropriate; however, the use of different methodologies or assumptions, particularly as applied to Level 3 assets and liabilities, could have a material effect on the computation of their estimated fair values.
Management of various businesses and departments of Northern Trust (including Loan Operations, Treasury Risk Management, Credit Policy, Business Practice & Marketing, and Northern Trust Hedge Fund services) determine the valuation policies and procedures for Level 3 assets and liabilities. Each business and department represents a component of Northern Trusts business units, and reports to management of their respective business units. Generally, valuation policies are reviewed by management of each business or department. Fair value measurements are performed upon acquisitions of an asset or liability. As necessary, the valuation models are reviewed by management of the appropriate business or department, and adjusted for changes in inputs. Management of each business or department reviews the inputs in order to substantiate the unobservable inputs used in each fair value measurement. When appropriate, management reviews forecasts used in the valuation process in light of other relevant financial projections to understand any variances between current and previous fair value measurements. In certain circumstances, third party information is used to support the fair value measurements. If certain third party information seems inconsistent with consensus views, a review of the information is performed by management of the respective business of department to conclude as to the appropriate fair value of the asset or liability.
The following presents the valuation techniques, significant unobservable inputs, and quantitative information used to develop significant unobservable inputs for Northern Trusts Level 3 assets and liabilities as of March 31, 2012 and December 31, 2011.
Notes to Consolidated Financial Statements (continued)
The following presents assets and liabilities measured at fair value on a recurring basis as of March 31, 2012 and December 31, 2011, segregated by fair value hierarchy level.
Notes to Consolidated Financial Statements (continued)