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SVB Financial Group 10-Q 2008 Table of Contents
UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
FORM 10-Q
(Mark One)
For the quarterly period ended June 30, 2008 OR
For the transition period from to . Commission File Number: 000-15637
SVB FINANCIAL GROUP (Exact name of registrant as specified in its charter)
(408) 654-7400 (Registrant’s telephone number, including area code)
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 is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. Large accelerated filer x Accelerated filer ¨ Non-accelerated filer ¨ 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 July 31, 2008, 32,495,314 shares of the registrant’s common stock ($0.001 par value) were outstanding.
Table of ContentsTABLE OF CONTENTS
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Table of ContentsPART I - FINANCIAL INFORMATION
SVB FINANCIAL GROUP AND SUBSIDIARIES INTERIM CONSOLIDATED BALANCE SHEETS (UNAUDITED)
See accompanying notes to interim consolidated financial statements (unaudited).
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Table of ContentsSVB FINANCIAL GROUP AND SUBSIDIARIES INTERIM CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)
See accompanying notes to interim consolidated financial statements (unaudited).
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Table of ContentsSVB FINANCIAL GROUP AND SUBSIDIARIES INTERIM CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (UNAUDITED)
See accompanying notes to interim consolidated financial statements (unaudited).
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Table of ContentsSVB FINANCIAL GROUP AND SUBSIDIARIES INTERIM CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
See accompanying notes to interim consolidated financial statements (unaudited).
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Table of ContentsSVB FINANCIAL GROUP AND SUBSIDIARIES NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 1. Basis of Presentation SVB Financial Group (“SVB Financial” or the “Parent”) is a diversified financial services company, as well as a bank holding company and financial holding company. SVB Financial was incorporated in the state of Delaware in March 1999. Through our various subsidiaries and divisions, we offer a variety of banking and financial products and services to support our clients throughout their life cycles. In this Quarterly Report on Form 10-Q, when we refer to “SVB Financial Group,” the “Company,” “we,” “our,” “us” or use similar words, we mean SVB Financial Group and all of its subsidiaries collectively, including Silicon Valley Bank (the “Bank”, unless the context requires otherwise). When we refer to “SVB Financial” or the “Parent” we are referring only to the parent company, SVB Financial Group, unless the context requires otherwise. The accompanying unaudited interim consolidated financial statements reflect all adjustments of a normal and recurring nature that are, in the opinion of management, necessary to fairly present our financial position, results of operations and cash flows in accordance with accounting principles generally accepted in the United States of America (“GAAP”). Such interim financial statements have been prepared in accordance with the instructions to Form 10-Q pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such rules and regulations. The results of operations for the three and six months ended June 30, 2008 are not necessarily indicative of results to be expected for any future periods. These interim consolidated financial statements should be read in conjunction with our Annual Report on Form 10-K for the year ended December 31, 2007 (“2007 Form 10-K”). The accompanying interim consolidated financial statements have been prepared on a consistent basis with the accounting policies described in Consolidated Financial Statements and Supplementary Data—Note 2 (Summary of Significant Accounting Policies) under Part II, Item 8 of our 2007 Form 10-K. The preparation of interim consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Estimates may change as new information is obtained. Significant items that are subject to such estimates include the valuation of non-marketable securities, the adequacy of the allowance for loan losses, valuation of equity warrant assets, the recognition and measurement of income tax assets and liabilities, the adequacy of the reserve for unfunded credit commitments, goodwill and share-based compensation. In July 2007, we reached a decision to cease operations at SVB Alliant, our investment banking subsidiary, which provided advisory services in the areas of mergers and acquisitions, corporate finance, strategic alliances and private placements. We elected to have SVB Alliant complete a limited number of client transactions before finalizing its shut-down. As of March 31, 2008 all such client transactions have been completed. All operations at SVB Alliant were ceased as of March 31, 2008. Accordingly, SVB Alliant is no longer reported as an operating segment as of the second quarter of 2008. We have not presented the results of operations of SVB Alliant in discontinued operations for the three and six months ended June 30, 2008 or for any comparative period presented based on our assessment of the materiality of SVB Alliant’s results to our consolidated results of operations. Reclassifications Certain prior period amounts have been reclassified to conform to the current period presentations. 2. Recent Accounting Pronouncements We adopted Statement of Financial Accounting Standard (“SFAS”) No. 157, Fair Value Measurements (“SFAS No. 157”) on January 1, 2008. SFAS No. 157 defines fair value, establishes a market-based framework or hierarchy for measuring fair value, and expands disclosures about fair value measurements. SFAS No. 157 is applicable whenever another accounting pronouncement requires or permits assets and liabilities to be measured at fair value. SFAS No. 157 does not expand or require any new fair value measures. In February 2008, the Financial Accounting Standards Board (“FASB”) decided that an entity need not apply this standard to nonfinancial assets and liabilities that are recognized or disclosed at fair value in the financial statements on a nonrecurring basis until 2009. Accordingly, our adoption of this standard in 2008 was limited to financial assets and liabilities. The adoption of SFAS No. 157 did not have a material effect on our financial condition or results of operations. We are still in the process of evaluating this standard with respect to its effect on nonfinancial assets and liabilities and therefore have not yet determined the impact that it may have on our financial statements upon full adoption on January 1, 2009. Nonfinancial assets and liabilities for which we have not applied the provisions of SFAS No. 157 include those measured at fair value in impairment testing and those initially measured at fair value in a business combination.
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Table of ContentsWe adopted SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities – Including an Amendment of FASB Statement No. 115 (“SFAS No. 159”) on January 1, 2008. SFAS No. 159 permits entities to choose to measure many financial instruments and certain other items at fair value. Entities that elect the fair value option will report unrealized gains and losses in earnings at each subsequent reporting date. The fair value option may be elected on an instrument-by-instrument basis, with a few exceptions. SFAS No. 159 also establishes presentation and disclosure requirements to facilitate comparisons between companies that choose different measurement attributes for similar assets and liabilities. The adoption of SFAS No. 159 did not have an effect on our financial condition or results of operations as we did not elect this fair value option. In May 2007, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants (“AICPA”) issued Statement of Position (“SOP”) 07-1, Clarification of the Scope of the Audit and Accounting Guide ‘Investment Companies’ and Accounting by Parent Companies and Equity Method Investors for Investments in Investment Companies (“SOP 07-1”). This new standard provides guidance for determining whether an entity is an “investment company,” as defined in the pronouncement, and whether the specialized industry accounting principles for investment companies should be retained in the consolidated financial statements of the parent or of an equity method investor. As originally issued, SOP 07-1 was effective for the year beginning January 1, 2008; however, on February 14, 2008, the FASB issued FASB Staff Position No. SOP 07-1-1, Effective Date of AICPA Statement of Position 07-1, which delayed indefinitely the effective date of SOP 07-1. We are currently monitoring any changes to the existing guidance. In December 2007, the FASB issued SFAS No. 141 (revised 2007), Business Combinations (“SFAS No. 141R”). SFAS No. 141R establishes principles and requirements for how an acquirer recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, any noncontrolling interest in the acquiree and the goodwill acquired. SFAS No. 141R also establishes disclosure requirements to enable the evaluation of the nature and financial effects of the business combination. SFAS No. 141R is effective for fiscal years beginning after December 15, 2008 and applies prospectively to business combinations for which the acquisition date is on or after January 1, 2009. In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements—an amendment of Accounting Research Bulletin No. 51 (“SFAS No. 160”). SFAS No. 160 establishes accounting and reporting standards for ownership interests in subsidiaries held by parties other than the parent, the amount of consolidated net income attributable to the parent and to the noncontrolling interest, changes in a parent’s ownership interest, and the valuation of retained noncontrolling equity investments when a subsidiary is deconsolidated. SFAS No. 160 also establishes disclosure requirements that clearly identify and distinguish between the interests of the parent and the interests of the noncontrolling owners. SFAS No. 160 is effective for fiscal years beginning after December 15, 2008. We are currently assessing the impact of SFAS No. 160 on our consolidated financial position and results of operations. In March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities (“SFAS No. 161”). SFAS No. 161 requires companies with derivative instruments to provide enhanced disclosure information that should enable financial statement users to better understand how and why a company uses derivative instruments, how derivative instruments and related hedged items are accounted for under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities (“SFAS No. 133”) and how derivative instruments and related hedged items affect a company’s financial position, financial performance and cash flows. SFAS No. 161 is effective for fiscal years and interim periods beginning after November 15, 2008. While we are currently assessing the full impact of SFAS No. 161 on our consolidated financial position and results of operations, the principal impact of SFAS No. 161 will require us to expand our disclosures regarding our derivative instruments. In May 2008, the FASB issued FASB Staff Position (“FSP”) Accounting Principles Board (“APB”) 14-1, Accounting for Convertible Debt Instruments That May Be Settled in Cash upon Conversion (Including Partial Cash Settlement) (“FSP APB 14-1”). FSP APB 14-1 requires the issuer of certain convertible debt instruments that may be settled in cash (or other assets) upon conversion to separately account for the liability (debt) and equity (conversion option) components of the instrument in a manner that reflects the issuer’s non-convertible debt borrowing rate when interest cost is recognized in subsequent periods. FSP APB 14-1 is effective for fiscal years beginning after December 15, 2008 and is applicable retrospectively for all periods presented. We are currently assessing the impact of FSP APB 14-1 on our consolidated financial position and results of operations.
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Table of Contents3. Earnings Per Share (“EPS”) The following is a reconciliation of basic EPS to diluted EPS:
Stock options with exercise prices greater than the average market price of our common stock were excluded from the diluted EPS calculation as their inclusion would have been anti-dilutive. Our $150 million zero-coupon convertible subordinated notes (“2003 Convertible Notes”) and $250 million of 3.875% convertible senior notes (“2008 Convertible Notes”) are included in the calculation of diluted EPS using the treasury stock method, in accordance with the provisions of Emerging Issues Task Force (“EITF”) 04-8, The Effect of Contingently Convertible Instruments on Diluted EPS, EITF No. 90-19, Convertible Bonds With Issuer Option to Settle in Cash Upon Conversion and SFAS No. 128, Earnings Per Share. Prior to maturity on June 15, 2008, we included the weighted average dilutive effect of the 2003 Convertible Notes in our diluted EPS calculation as their conversion price was lower than the average market price of our common stock for the three and six months ended June 30, 2008. The issuance of the 2008 Convertible Notes in April 2008 did not impact our weighted average diluted common shares as their conversion price was higher than the average market price of our common stock for the three and six months ended June 30, 2008. The following table summarizes the potential common shares excluded from the diluted EPS calculation:
4. Share-Based Compensation For the three months ended June 30, 2008 and 2007, we recorded share-based compensation expense of $3.8 million and $4.4 million, respectively, resulting in the recognition of $1.0 million in related tax benefits for both the three months ended June 30, 2008 and 2007. For the six months ended June 30, 2008 and 2007, we recorded share-based compensation expense of $7.4 million and $8.2 million, respectively, resulting in the recognition of $1.7 million in related tax benefits for both the six months ended June 30, 2008 and 2007.
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Table of ContentsUnrecognized Compensation Expense At June 30, 2008, unrecognized share-based compensation expense was as follows:
Share-Based Payment Award Activity The table below provides stock option information related to the 1989 Stock Option Plan, the 1997 Equity Incentive Plan and the 2006 Equity Incentive Plan for the six months ended June 30, 2008:
The aggregate intrinsic value of outstanding options shown in the table above represents the pretax intrinsic value based on our closing stock price of $48.11 at June 30, 2008. The total intrinsic value of options exercised during the three and six months ended June 30, 2008 was $5.2 million and $8.6 million, respectively, and the total intrinsic value of options exercised during the three and six months ended June 30, 2007 was $10.8 million and $16.3 million, respectively. The table below provides information for restricted stock awards and restricted stock units under the 1989 Stock Option Plan, the 1997 Equity Incentive Plan and the 2006 Equity Incentive Plan for the six months ended June 30, 2008:
5. Securities Purchased under Agreement to Resell and Other Short-Term Investment Securities The following table details the securities purchased under agreement to resell and other short-term investment securities at June 30, 2008 and December 31, 2007, respectively:
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Table of Contents6. Investment Securities The detailed composition of our investment securities at June 30, 2008 and December 31, 2007 is presented as follows:
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The following table summarizes our unrealized losses on our available-for-sale investment securities portfolio into categories of less than 12 months, or 12 months or longer, at June 30, 2008:
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Table of ContentsThe following table summarizes our unrealized losses on our available-for-sale investment securities portfolio into categories of less than 12 months, or 12 months or longer, as of December 31, 2007:
The following table presents the components of gains and losses on investment securities for the three and six months ended June 30, 2008 and 2007:
Net gains on investment securities of $2.0 million for the three months ended June 30, 2008 were mainly attributable to net gains from one of our managed co-investment funds of $2.4 million, primarily due to net realized gains from certain investments arising from merger and acquisition activities, and net gains from our sponsored debt funds of $2.2 million, which included $1.5 million of net gains mainly attributable to increases in the share prices of certain investments and higher valuations related to investments within our sponsored debt funds, $0.4 million of net gains from the sale of certain investments within the funds and $0.3 million of net gains from distributions. These net gains were partially offset by net losses from our managed funds of funds of $1.7 million, which included $5.0 million in net losses from decreases in valuations, partially offset by $3.3 million of net gains primarily from distributions, and net losses of $0.5 million from the sale of certain equity securities, which are publicly-traded shares acquired upon exercise of equity warrant assets. Net losses on investment securities were $4.1 million for the six months ended June 30, 2008, compared to net gains of $25.9 million for the comparable 2007 period. Net losses on investment securities of $4.1 million for the six months ended June 30, 2008 were mainly attributable to $6.1 million of net losses from one of our sponsored debt funds primarily due to a decrease in the
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Table of Contentsshare price of one investment, and $1.3 million of net losses from the sale of certain equity securities. These net losses were partially offset by net gains of $2.0 million from one of our managed co-investment funds and $1.1 million in net gains from our managed funds of funds. 7. Loans and Allowance for Loan Losses The composition of loans, net of unearned income of $33.3 million and $26.4 million at June 30, 2008 and December 31, 2007, respectively, is presented in the following table:
The activity in the allowance for loan losses for the three and six months ended June 30, 2008 and 2007 was as follows:
The aggregate investment in loans for which impairment has been determined in accordance with SFAS No. 114, Accounting by Creditors for Impairment of a Loan, totaled $8.5 million and $7.6 million at June 30, 2008 and December 31, 2007, respectively. The allocation of the allowance for loan losses related to impaired loans was $2.9 million and $1.4 million at June 30, 2008 and December 31, 2007, respectively. Average impaired loans for the three months ended June 30, 2008 and 2007 was $11.0 million and $10.5 million, respectively, and average impaired loans for the six months ended June 30, 2008 and 2007 was $9.6 million and $10.5 million, respectively. If these loans had not been impaired, $0.1 million and $0.2 million in interest income would have been recorded for the three months ended June 30, 2008 and 2007, respectively, and $0.3 million and $0.6 million in interest income would have been recorded for the six months ended June 30, 2008 and 2007, respectively. 8. Goodwill Goodwill at both June 30, 2008 and December 31, 2007 was $4.1 million, which resulted from our acquisition of a majority ownership interest in eProsper in 2006, an equity ownership data management services company. During the second quarter of 2007, we conducted our annual assessment of goodwill of SVB Alliant. We concluded at that time that we had an impairment of goodwill based on forecasted discounted net cash flows for that reporting unit. The impairment resulted from changes in our outlook for SVB Alliant’s future financial performance. As required by SFAS No. 142, Goodwill and Other Intangible Assets, in measuring the amount of goodwill impairment, we made a hypothetical allocation of the reporting unit’s estimated fair value to the tangible and intangible assets (other than goodwill) for the reporting unit. Based on this allocation, we concluded that the entire amount of the remaining $17.2 million of goodwill was impaired and was required to be expensed as a noncash charge to continuing operations during the second quarter of 2007. Subsequently in July 2007, we reached a decision to cease operations at SVB Alliant. All operations at SVB Alliant were ceased as of March 31, 2008.
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Table of Contents9. Short-Term Borrowings and Long-Term Debt The following table represents outstanding short-term borrowings and long-term debt outstanding at June 30, 2008 and December 31, 2007:
Interest expense related to short-term borrowings and long-term debt was $10.6 million and $12.6 million for the three months ended June 30, 2008 and 2007, respectively, and $21.9 million and $23.0 million for the six months ended June 30, 2008 and 2007, respectively. The weighted average interest rates associated with our short-term borrowings and long-term debt outstanding were 3.27 percent and 4.96 percent for the three months ended June 30, 2008 and 2007, respectively, and 3.62 percent and 4.81 percent for the six months ended June 30, 2008 and 2007, respectively. Zero-Coupon Convertible Subordinated Notes (“2003 Convertible Notes”) Our 2003 Convertible Notes, previously issued with an original aggregate total principal amount of $150 million, matured on June 15, 2008. As of the maturity date, convertible notes for the aggregate total principal amount of $141.9 million were outstanding and had not yet been converted. Based on the conversion terms of these notes, on June 23, 2008, we made an aggregate conversion settlement payment in cash and in shares of our common stock. The total value of both cash and shares as calculated based on the terms of the notes and as of the payment date was $212.8 million. Of the $212.8 million, we paid $141.9 million in cash, representing the portion of the conversion payment as the total principal amount of the notes converted. We also issued 1,406,034 shares of our common stock, valued at $70.9 million as calculated based on the terms of the notes, representing the portion of the conversion premium value that exceeded the total principal amount of the notes. In connection with this conversion settlement payment, we exercised call options pursuant to a call-spread arrangement with a certain counterparty, under which the counterparty delivered to us 1,406,043 shares of our common stock, valued at $70.9 million. Accordingly, there was no net impact on our total stockholders’ equity for the second quarter of 2008 with respect to settling the conversion premium value. During the three months ended June 30, 2008 but prior to the maturity date of our 2003 Convertible Notes, we received a conversion notice to convert notes in the total principal amount of $7.8 million. Consistent with prior early conversions, we elected to settle the conversion fully in cash and paid a total of $11.6 million in cash, which included $3.9 million representing the conversion premium value of the converted notes. Accordingly, we recorded a non-tax deductible loss of $3.9 million as noninterest expense. In connection with this early conversion settlement payment, we exercised call options pursuant to our call-spread arrangement and received a corresponding cash payment of $3.9 million from the counterparty to the call-spread arrangement. Accordingly, we recorded an increase in stockholders’ equity of $3.9 million, representing such payment received, which was reflected as additional paid-in capital. As a result, the $3.9 million in noninterest expense we recorded due to this early conversion settlement had no net impact on our total stockholders’ equity. 3.875% Convertible Senior Notes (“2008 Convertible Notes”) In April 2008, we issued our 2008 Convertible Notes, due April 15, 2011 in the aggregate principal amount of $250 million to qualified institutional buyers pursuant to Rule 144A under the Securities Act of 1933. The issuance costs related to the 2008
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Table of ContentsConvertible Notes were $6.8 million and the net proceeds from the offering were $243.2 million. We used $141.9 million of the net proceeds to settle the conversion of our 2003 Convertible Notes, which matured in June 2008, and $20.6 million to enter a call-spread arrangement. All of the remaining proceeds will be used for general corporate purposes. The 2008 Convertible Notes are initially convertible, subject to certain conditions, into cash up to the principal amount of notes and, with respect to any excess conversion value, into shares of our common stock or cash or a combination, at our option. Holders may convert their 2008 Convertible Notes beginning any fiscal quarter commencing after June 30, 2008, if: (i) the price of our common stock issuable upon conversion of the note reaches a specific threshold, (ii) specified corporate transactions occur, or (iii) the trading price for the note falls below certain thresholds. The notes have an initial conversion rate of 18.8525 shares of common stock per $1,000 principal amount of notes, which represents an initial effective conversion price of $53.04 per share. Upon maturity, we intend to settle the outstanding principal amount in cash and we have the option to settle any amount exceeding the principal value of the 2008 Convertible Notes in either cash or shares of our common stock. Concurrent with the issuance of the 2008 Convertible Notes, we entered into a convertible note hedge and warrant agreement (See Note 10 (Derivative Financial Instruments)), which effectively increased the economic conversion price of the 2008 Convertible Notes to $64.43 per share of common stock, as applicable to us. The terms of the hedge agreement are not part of the terms of the notes and will not affect the rights of the holders of the notes. Available Lines of Credit At June 30, 2008, we had available $1.38 billion in uncommitted federal funds lines of credit, of which $1.12 billion were unused. We have repurchase agreements with multiple securities dealers, which allow us to access short-term borrowings by using fixed income securities as collateral. At June 30, 2008, we had not borrowed against our repurchase lines. We also pledge securities to the Federal Home Loan Bank of San Francisco and the discount window at the Federal Reserve Bank. The market value of collateral pledged to the Federal Home Loan Bank of San Francisco at June 30, 2008 totaled $251.5 million, of which $31.5 million was unused. The market value of collateral pledged at the discount window of the Federal Reserve Bank in accordance with our risk management practices totaled $35.1 million at June 30, 2008. We have not borrowed against this pledged collateral. 10. Derivative Financial Instruments The total notional or contractual amounts, credit risk amount and estimated net fair value for derivatives at June 30, 2008 and December 31, 2007, respectively, were as follows:
Fair Value Hedges The interest rate swap agreement for our 5.70% senior notes provided a cash benefit of $1.3 million and $1.6 million for the three and six months ended June 30, 2008, respectively, compared to interest expense of $0.1 million for both the comparable 2007 periods. The interest rate swap agreement for our 6.05% subordinated notes provided a cash benefit of $1.4 million and $1.7 million for the three and six months ended June 30, 2008, respectively, compared to interest expense of $0.1 million for both the comparable 2007 periods. The cash benefit was recognized in the consolidated statements of income as a reduction in interest expense. The 5.70% senior notes and the 6.05% subordinated notes were issued by the Bank. The interest rate swap agreement for our 7.0% junior subordinated debentures provided a cash benefit of $0.4 million and $0.5 million for the three and six months ended June 30, 2008, respectively, compared to $19.2 thousand and $0.1 million for the comparable 2007 periods. The cash benefit was recognized in the consolidated statements of income as a reduction in interest expense. We recorded net gains resulting from non-cash increases in fair value of the hedge agreement of $0.9 million and $0.4 million for the three and six months ended June 30, 2008, respectively, compared to net gains of $0.6 million and $0.3 million for the comparable 2007 periods, which was reflected in gains on derivative instruments, net.
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Table of ContentsDerivatives - Other Our derivative contracts are carried at fair value with changes in fair value recorded as gains (losses) on derivatives, net as part of our noninterest income, a component of consolidated net income. We obtain equity warrant assets to purchase an equity position in a client company’s stock in consideration for providing credit facilities and less frequently for providing other services. The change in fair value of equity warrant assets is recorded as gains (losses) on derivative instruments, net, in noninterest income, a component of consolidated net income. Total net gains on equity warrant assets from gains on exercise and changes in fair value were $2.1 million and $4.6 million for the three months ended June 30, 2008 and 2007, respectively, and $7.5 million and $6.0 million for the six months ended June 30, 2008 and 2007, respectively. Derivative Fair Value Instruments Indexed to and Potentially Settled in a Company’s Own Stock 2003 Convertible Notes Concurrent with the issuance of our 2003 Convertible Notes, we entered into a convertible note hedge agreement (purchased call option) at a cost of $39.3 million, and a warrant agreement providing proceeds of $17.4 million with respect to our common stock, with the objective of decreasing our exposure to potential dilution from conversion of the 2003 Convertible Notes. At issuance, under the terms of the convertible note hedge, upon the occurrence of conversion events, we had the right to purchase up to 4,460,610 shares of our common stock from the counterparty at a price of $33.6277 per common share. The cost of the convertible note hedge was included in stockholders’ equity in accordance with the guidance in EITF 00-19, Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s own Stock (“EITF 00-19”). Upon maturity of the 2003 Convertible Notes on June 15, 2008, we exercised the right to purchase 1,406,043 shares under the terms of the convertible note hedge agreement. The convertible note hedge agreement expired on June 15, 2008. At issuance, under the warrant agreement, the counterparty could purchase up to 4,460,608 shares of our common stock at $51.34 per share, upon the occurrence of conversion events. The remaining warrants under the warrant agreement expired unexercised on June 15, 2008. 2008 Convertible Notes Concurrent with the issuance of our 2008 Convertible Notes, we entered into a convertible note hedge agreement (purchased call option) at a cost of $41.8 million, and a warrant agreement providing proceeds of $21.2 million with respect to our common stock, with the objective of decreasing our exposure to potential dilution from conversion of the 2008 Convertible Notes. At issuance, under the terms of the convertible note hedge, upon the occurrence of conversion events, we have the right to purchase up to 4,713,125 shares of our common stock from the counterparty at a price of $53.04 per common share. The convertible note hedge agreement will expire on April 7, 2011. We have the option to settle any amounts due under the convertible hedge either in cash or net shares of our common stock. The cost of the convertible note hedge is included in stockholders’ equity in accordance with the guidance in EITF 00-19. The call option under the convertible note hedge was not exercisable during the three months ended June 30, 2008. At issuance, under the warrant agreement, the counterparty can purchase up to 4,713,125 shares of our common stock at $64.43 per share, upon the occurrence of conversion events defined above. The warrant transaction will expire ratably on a series of expiration dates commencing on July 15, 2011. The warrants were not exercisable during the three months ended June 30, 2008. 11. Other Noninterest Income The following table presents the components of other noninterest income for the three and six months ended June 30, 2008 and 2007, respectively:
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Table of Contents12. Common Stock Repurchases In July 2007, our Board of Directors approved a stock repurchase program, authorizing us to purchase up to $250.0 million of our common stock on or before July 31, 2008. We repurchased 1.0 million shares of our common stock for the six months ended June 30, 2008 totaling $45.6 million, compared to 0.8 million shares for the comparable 2007 period totaling $39.3 million. Subsequently on July 24, 2008, our Board of Directors approved a stock repurchase program authorizing us to purchase up to $150 million of our common stock on or before December 31, 2009, which replaced all prior share repurchase programs. (See Note 19 (Subsequent Events)). 13. Segment Reporting SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information (“SFAS No. 131”), requires that we report certain financial and descriptive information about our reportable operating segments, as well as related disclosures about products and services, geographic areas and major customers. Our reportable operating segments results are regularly reviewed internally by our chief operating decision maker (“CODM”) when evaluating segment performance and deciding how to allocate resources and in assessing performance. Our CODM is our Chief Executive Officer (“CEO”). For management reporting purposes, we offer clients financial products and services through three strategic operating segments: Commercial Banking, SVB Capital, and Other Business Services. Our Other Business Services group includes SVB Global, SVB Private Client Services, SVB Analytics and SVB Wine Division. In July 2007, we reached a decision to cease operations at SVB Alliant, our investment banking subsidiary, which provided advisory services in the areas of mergers and acquisitions, corporate finance, strategic alliances and private placements. We elected to have SVB Alliant complete a limited number of client transactions before finalizing its shut-down. As of March 31, 2008 all such client transactions were completed. All operations at SVB Alliant were ceased as of March 31, 2008. Accordingly, SVB Alliant is no longer reported as an operating segment as of the second quarter of 2008. The results of operations for SVB Alliant have been included as part of the Reconciling Items column for all prior periods presented. Unlike financial reporting, which benefits from the comprehensive structure provided by GAAP, the internal profitability reporting process is highly subjective, as there is no comprehensive, authoritative guidance for management reporting. Our management reporting process measures the performance of our operating segments based on our internal operating structure and is not necessarily comparable with similar information for other financial services companies. In addition, changes in an individual client’s primary relationship designation have resulted, and may in the future result, in the inclusion of certain clients in different segments in different periods. We have reclassified certain prior period amounts to conform to the current period’s presentation. An operating segment is separately reportable if it exceeds any one of several quantitative thresholds specified in SFAS No. 131. Of our operating segments, only Commercial Banking and SVB Capital were determined to be reportable segments as of June 30, 2008. SVB Global, SVB Private Client Services, SVB Analytics and SVB Wine Division did not separately meet the reporting thresholds and as a result, in the table below, have been aggregated in a column labeled “Other Business Services” for segment reporting purposes. The Reconciling Items column reflects adjustments necessary to reconcile the results of the operating segments based on our internal profitability reporting process to the consolidated financial statements prepared in conformity with GAAP. Net interest income in the Reconciling Items column primarily consisted of interest income recognized from our fixed income investment portfolio. Noninterest income in the Reconciling Items column primarily consisted of noninterest income attributable to minority interests and gains (losses) on equity warrant assets. Noninterest expense in the Reconciling Items column primarily consisted of expenses associated with corporate support functions such as information technology, finance and legal. Additionally, average assets in the Reconciling Items column primarily consisted of our fixed income investment portfolio balances. Our CODM allocates resources to and assesses the performance of each operating segment based on net interest income, noninterest income and noninterest expense, which are presented as components of segment operating profit or loss before income taxes. Net interest income, our primary source of revenue, is reported net of funds transfer pricing (“FTP”). FTP is an internal measurement framework designed to assess the financial impact of a financial institution’s sources and uses of funds. It is the mechanism by which an earnings credit is given for deposits raised and an earnings charge is made for funded loans. In addition, we evaluate assets based on average balances; therefore, period-end asset balances are not presented for segment reporting purposes. We have not reached reportable levels of revenue, net income or assets outside the United States and as such we do not present geographic segment information. FTP is calculated by applying a transfer rate to pooled, or aggregated, loan and deposit volumes, effective January 1, 2008. Prior to January 1, 2008, FTP was calculated at an instrument level based on account characteristics. Effective January 1, 2008, expenses reported under each operating segment relate only to the direct and allocated direct costs associated with each segment. Prior to January 1, 2008, costs associated with corporate support functions were allocated to the operating segments. Total average assets equals total average assets from the general ledger effective January 1, 2008. Prior to January 1, 2008, total average assets was calculated as the greater of total average assets or total average deposits and total average stockholder’s equity combined. We have reclassified all prior period amounts to conform to the current period’s presentation.
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Table of ContentsOur segment information at and for the three and six months ended June 30, 2008 and 2007 is as follows:
14. Obligations Under Guarantees In the normal course of business, we use financial instruments with off-balance sheet risk to meet the financing needs of our customers. These financial instruments include commitments to extend credit, commercial and standby letters of credit, credit card guarantees and commitments to invest in private equity fund investments. These instruments involve, to varying degrees, elements of credit risk. Credit risk is defined as the possibility of sustaining a loss because other parties to the financial instrument fail to perform in accordance with the terms of the contract.
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Table of ContentsCommitments to Extend Credit The following table summarizes information related to our commitments to extend credit at June 30, 2008 and December 31, 2007, respectively:
Commercial and Standby Letters of Credit The table below summarizes our commercial and standby letters of credit at June 30, 2008. The maximum potential amount of future payments represents the amount that could be remitted under letters of credit if there were a total default by the guaranteed parties, without consideration of possible recoveries under recourse provisions or from the collateral held or pledged.
At June 30, 2008 and December 31, 2007, deferred fees related to financial and performance standby letters of credit were $4.5 million and $3.8 million, respectively. At June 30, 2008, collateral in the form of cash and investment securities available to us to reimburse losses, if any, under financial and performance standby letters of credit was $309.2 million. Credit Card Guarantees The total amount of credit card guarantees was $84.5 million at June 30, 2008. We do not believe that any losses, if any, incurred by the Bank as a result of these guarantees will be material in nature. Credit card fees totaled $1.5 million for both the three months ended June 30, 2008 and 2007, and $3.2 million and $2.8 million for the six months ended June 30, 2008 and 2007, respectively.
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Table of ContentsCommitments to Invest in Private Equity Funds The following table details our total capital commitments and our unfunded capital commitments at June 30, 2008:
15. Income Taxes The following table provides a summary of changes in our unrecognized tax benefit (including interest and penalties) for the six months ended June 30, 2008:
At June 30, 2008, the total amount of unrecognized tax benefits was $0.3 million, the recognition of which would reduce our income tax expense by $0.3 million. At January 1, 2008, the total amount of unrecognized tax benefits was $1.1 million, the recognition of which would have reduced our income tax expense by $0.3 million. The decrease in the amount of unrecognized tax benefits was due to the expiration of the applicable statue of limitations for income tax exposures in California. Total accrued interest and penalties at June 30, 2008 were $0.1 million. We expect that our unrecognized tax benefit will change in the next 12 months, however we do not expect the change to have a material impact on our financial position or our results of operations. We are subject to income tax in the U.S. federal jurisdiction and various state and foreign jurisdictions and have identified our federal tax return and tax returns in California and Massachusetts as “major” tax filings. U.S. federal tax examinations through 1998 have been concluded. The U.S. federal tax return for 2004 and subsequent years remain open to examination by the Internal Revenue Service. Our California and Massachusetts tax returns for the years 2003 and 2004, respectively, and subsequent years remain open to examination. 16. Fair Value Measurements Our marketable investment securities, non-marketable investment securities and derivatives are financial instruments recorded at fair value on a recurring basis. We make estimates regarding valuation of assets and liabilities measured at fair value in preparing our consolidated financial statements.
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Table of ContentsFair Value Measurement – Definition and Hierarchy SFAS No. 157 defines fair value as the price that would be received to sell an asset or paid to transfer a liability (i.e., the “exit price”) in an orderly transaction between market participants at the measurement date. Fair value is a market-based measure considered from the perspective of a market participant who holds the asset or owes the liability rather than an entity-specific measure. SFAS No. 157 establishes a three-level hierarchy for disclosure of assets and liabilities recorded at fair value. The classification of assets and liabilities within the hierarchy is based on whether the inputs to the valuation methodology used for measurement are observable or unobservable. Observable inputs reflect market-derived or market-based information obtained from independent sources, while unobservable inputs reflect our estimates about market data. The three levels for measuring fair value are based on the reliability of inputs and are as follows:
To the extent that valuation is based on models or inputs that are less observable or unobservable in the market, the determination of fair value requires more judgment. Accordingly, the degree of judgment that we use to determine fair value is greatest for instruments categorized in Level 3. In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, for disclosure purposes the level in the fair value hierarchy within which the fair value measurement in its entirety falls is determined based on the lowest level input that is significant to the fair value measurement in its entirety. Determination of Fair Value Fair value measurements for assets and liabilities where there exists limited or no observable market data and, therefore, are based primarily upon our own estimates, are often calculated based on current pricing policy, the economic and competitive environment, the characteristics of the asset or liability and other such factors. Therefore, the results cannot be determined with precision and may not be realized in an actual sale or immediate settlement of the asset or liability. Additionally, there may be inherent weaknesses in any calculation technique, and changes in the underlying assumptions used, including discount rates and estimates of future cash flows, that could significantly affect the results of current or future values. Following is a description of valuation methodologies used for assets and liabilities recorded at fair value. Marketable Securities Marketable securities, consisting of our available-for-sale debt and equity securities, are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted prices, if available. If quoted prices are not available, fair values are measured using broker or dealer quotations, independent pricing models or other model-based valuation techniques such as the present value of future cash flows, taking into consideration the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions. Level 1 securities include those traded on an active exchange, such as the NASDAQ Stock Market. Level 2 securities include U.S. treasuries, U.S. agency debentures, investment grade mortgage securities and state and municipal obligations.
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Table of ContentsNon-Marketable Securities Our non-marketable securities consist of our investments made by the following funds:
For GAAP purposes, these funds are investment companies under the AICPA Audit and Accounting Guide for Investment Companies. Accordingly, these funds report their investments at estimated fair value, with unrealized gains and losses resulting from changes in fair value reflected as investment gains or losses in our consolidated net income. We have retained the specialized accounting of our consolidated funds pursuant to EITF Issue No. 85-12, Retention of Specialized Accounting for Investments in Consolidation. We have valued our investments, in the absence of observable market prices, using the valuation methodologies described below applied on a consistent basis. Investments in private equity funds are stated at fair value, based on the information provided by the investee funds’ management, which reflects our share of the fair value of the net assets of the investment fund on the valuation date. For direct private company investments, valuations are based upon consideration of a range of factors including, but not limited to, the price at which the investment was acquired, the term and nature of the investment, local market conditions, values for comparable securities, and as it relates to the private company issue, the current and projected operating performance, exit strategies and financing transactions subsequent to the acquisition of the investment. These valuation methodologies involve a significant degree of management judgment. Estimating the fair value of these investments requires management to make assumptions regarding future performance, financial condition, and relevant market conditions, along with other pertinent information. Structured loans made by the special situation debt fund are measured using pricing models that use observable inputs, such as yield curves and publicly-traded equity prices, and unobservable inputs, such as private company equity prices. Investments in private equity funds and direct private company investments are categorized within Level 3 of the fair value hierarchy since pricing inputs are unobservable and include situations where there is little, if any, market activity for such investments. Investments in structured loans are categorized within Level 2 or Level 3 of the fair value hierarchy based on the observability and significance of the pricing inputs. Derivative Instruments Interest Rate Swaps, Foreign Currency Forward and Option Contracts Our interest rate swaps, foreign currency forward and option contracts are traded in OTC markets where quoted market prices are not readily available. For these derivatives, we measure fair value using pricing models that use primarily market observable inputs, such as yield curves and option volatilities, and, accordingly, classify these as Level 2. When appropriate, valuations are adjusted for various factors such as liquidity and credit considerations. Such adjustments are generally based on available market evidence. In the absence of such evidence, management’s best estimate is used. Consistent with market practice, we have individually negotiated agreements with certain counterparties to exchange collateral (“margining”) based on the level of fair values of the derivative contracts they have executed. Through this margining process, one party or both parties to a derivative contract provides the other party with information about the fair value of the derivative contract to calculate the amount of collateral required. This sharing of fair value information provides additional support for the recorded fair value. Equity Warrant Assets As part of negotiated credit facilities and certain other services, we frequently obtain rights to acquire stock in the form of equity warrant assets in certain client companies. Our warrant agreements contain net share settlement provisions, which permit us to receive upon exercise a share count equal to the intrinsic value of the warrant divided by the share price (otherwise known as a “cashless” exercise). Because we can net settle our warrant agreements, our equity warrant assets qualify as derivative instruments. Equity warrant assets for shares of private and public company capital stock are recorded at fair value on the grant date and adjusted to fair value on a quarterly basis through consolidated net income. We value our equity warrant assets using a modified Black-Scholes option pricing model, which incorporates assumptions about underlying asset value, volatility, expected remaining life and risk-free interest rate. Valuation adjustments, such as a marketability discount, are made to equity warrant assets for shares of private company capital stock. These valuation adjustments are estimated based on management’s judgment about the general industry environment, combined with specific information about the issuing company.
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Table of ContentsThe valuation of equity warrant assets for shares of public company capital stock is based on market observable inputs and these are classified as Level 2. Since the valuation of equity warrant assets for shares of private company capital stock involves significant unobservable inputs they are categorized as Level 3. The following fair value hierarchy table presents information about our assets and liabilities that are measured at fair value on a recurring basis as of June 30, 2008:
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Table of ContentsThe following table presents additional information about Level 3 assets measured at fair value on a recurring basis:
The following table presents unrealized gains (losses) for Level 3 assets held at June 30, 2008:
17. Related Party Transactions SVB Financial has a commitment under a revolving line of credit facility to Gold Hill Venture Lending 03, LP, a venture debt fund (“Gold Hill”), and its affiliated funds. SVB Financial has a 9.3% effective ownership interest in Gold Hill, as well as a 90.7% majority interest in its general partner, GHLLC. The line of credit bears an interest rate of prime plus one percent. In January 2007, SVB Financial increased the revolving line of credit facility to Gold Hill from a total commitment amount of $40.0 million to $75.0 million. Contemporaneously with the increase, SVB Financial syndicated $35.0 million, or 46.667% of the total facility, to another lender. The highest outstanding balance under the facility for the six months ended June 30, 2008 was $69.0 million. At June 30, 2008, Gold Hill’s outstanding balance totaled $69.0 million. During the six months ended June 30, 2008, the Bank made loans to related parties, including companies with which certain of our directors are affiliated. Such loans: (a) were made in the ordinary course of business, (b) were made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with other persons, and (c) did not involve more than the normal risk of collectibility or present other unfavorable features.
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Table of Contents18. Legal Matters On October 4, 2007, a consolidated class action was filed in the United States District Court for the Central District of California, purportedly on behalf of a class of investors who purchased the common stock of Vitesse Semiconductor Corporation (“Vitesse”). The complaint asserted claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, as amended, against Vitesse, the Bank and other named defendants in connection with alleged fraudulent recognition of revenue by Vitesse, specifically with respect to sales of certain accounts receivable to the Bank. The relief sought under the complaint included rescission of the Vitesse shares held by plaintiffs and other class members or the appropriate measure of damages, as well as prejudgment and post-judgment interest and certain fees, costs and expenses. On January 28, 2008, the court dismissed with prejudice all claims against the Bank under the action. Additionally, certain lawsuits and claims arising in the ordinary course of business have been filed or are pending against us or our affiliates. Based upon information available to us, our review of such claims to date and consultation with our outside legal counsel, management believes the liability relating to these actions, if any, will not have a material adverse effect on our liquidity, consolidated financial position, and/or results of operations. Where appropriate, as we determine, we establish reserves in accordance with SFAS No. 5, Accounting For Contingencies. The outcome of litigation and other legal and regulatory matters is inherently uncertain, however, and it is possible that one or more of the legal or regulatory matters currently pending or threatened could have a material adverse effect on our liquidity, consolidated financial position, and/or results of operation. 19. Subsequent Events On July 24, 2008, our Board of Directors approved a new stock repurchase program that authorizes us to purchase up to $150 million of our common stock. This program expires on December 31, 2009 and replaced all prior share repurchase programs. As of close of business on August 1, 2008, $150 million of our common shares may still be repurchased under our current common stock repurchase program.
Forward-Looking Statements; Reclassifications This Quarterly Report on Form 10-Q, including in particular “Management’s Discussion and Analysis of Financial Condition and Results of Operations” under Part 1, Item 2 in this report, contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Management has in the past and might in the future make forward-looking statements orally to analysts, investors, the media and others. Forward-looking statements are statements that are not historical facts. Broadly speaking, forward-looking statements include, but are not limited to, the following:
In this Quarterly Report on Form 10-Q, we make forward-looking statements, including, but not limited to, those discussing our management’s expectations about:
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These and other forward-looking statements can be identified by our use of words such as “becoming”, “may”, “will”, “should”, “predicts”, “potential”, “continue”, “anticipates”, “believes”, “estimates”, “seeks”, “expects”, “plans”, “intends”, the negative of such words, or comparable terminology. Although we believe that the expectations reflected in these forward-looking statements are reasonable, we have based these expectations on our beliefs as well as our assumptions, and such expectations may prove to be incorrect. Our actual results of operations and financial performance could differ significantly from those expressed in or implied by our management’s forward-looking statements. For information with respect to factors that could cause actual results to differ from the expectations stated in the forward-looking statements, see “Risk Factors” under Part II, Item 1A in this report. We urge investors to consider all of these factors carefully in evaluating the forward-looking statements contained in this report. All subsequent written or oral forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by these cautionary statements. The forward-looking statements included in this filing are made only as of the date of this filing. We assume no obligation and do not intend to revise or update any forward-looking statements contained in this Quarterly Report on Form 10-Q. The following discussion and analysis of financial condition and results of operations should be read in conjunction with our interim unaudited consolidated financial statements and accompanying notes as presented in Part I, Item 1 in this report and in conjunction with our Annual Report on Form 10-K for the year ended December 31, 2007 (“2007 Form 10-K”), as filed with the Securities and Exchange Commission (“SEC”). Certain reclassifications have been made to prior years’ results to conform to the current period’s presentations. Such reclassifications had no effect on our results of operations or stockholders’ equity. Management’s Overview of Second Quarter 2008 Performance Our primary or “core” business consists of providing banking products and services to our clients in the technology, life science, private equity (including venture capital) and premium wine industries. We believe that our core banking business performed well during the three months ended June 30, 2008, compared to the comparable 2007 period. Our net income for the three months ended June 30, 2008 was $21.3 million, or $0.62 per diluted common share, compared to $22.9 million, or $0.61 per diluted common share for the comparable 2007 period. Our second quarter 2008 earnings included a non-tax deductible loss of $3.9 million, related to our cash settlement of the conversion of certain zero-coupon convertible subordinated notes (“2003 Convertible Notes”) prior to the notes’ maturity. Additionally, we recorded an increase to stockholders’ equity of $3.9 million, representing a corresponding cash receipt pursuant to a call-spread arrangement. Accordingly, this loss had no net impact on our total stockholders’ equity for the second quarter of 2008. For details refer to Note 9 (Short-Term Borrowings and Long-Term Debt) of the “Notes to Interim Consolidated Financial Statements (unaudited)” under Part I, Item 1 in this report. Exceptional loan growth, solid deposit growth and contained expenses contributed to this strong performance, despite the impact of significant interest rate reductions, lower valuations on our investment fund portfolio, lower gains from valuations of our equity warrant assets and the $3.9 million loss related to our 2003 Convertible Notes. Average loans grew by $893.2 million, or 26.1 percent, to $4.32 billion for the three months ended June 30, 2008, compared to $3.43 billion for the comparable 2007 period driven primarily by loan growth increases from all client industry segments, with strong growth in loans to software, hardware, private equity and life science industry clients, and loans to individual clients of SVB Private Client Services. We also had strong growth in both average and period end deposit balances, primarily due to the introduction of two new interest-bearing deposit products in mid-to-late 2007.
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Table of ContentsWe continued to preserve our good credit quality with net charge-offs in the second quarter of 2008 of 44 basis points (annualized) of total gross loans, compared to 53 basis points for the comparable 2007 period. Gross charge-offs increased by $2.8 million to $9.1 million compared to $6.3 million for the comparable 2007 period, but remained within our expectations. Gross charge-offs of $9.1 million for the three months ended June 30, 2008 were primarily related to gross charge-offs from our early-stage client portfolio, as well as from one loan transaction from a mid-stage technology client. Our net interest margin was 5.69 percent for the three months ended June 30, 2008, compared to 7.39 percent for the comparable 2007 period. This decline was consistent with our expectations and reflected the impact of interest rate cuts by the Federal Reserve in late 2007 and early 2008. Noninterest income was $43.9 million for the three months ended June 30, 2008, compared to $55.7 million for the comparable 2007 period. This decrease primarily related to decreases in net gains on investment securities from $13.6 million for the three months ended June 30, 2007, to $2.0 million for the three months ended June 30, 2008, primarily due to lower valuations from one of our sponsored debt funds and lower distributions related to our funds management business. Net gains on equity warrant assets, a component of net gains on derivatives instruments, also decreased from $4.6 million for the three months ended June 30, 2007, to $2.1 million for the three months ended June 30, 2008, mainly attributable to higher net gains recognized in the second quarter of 2007 due to valuation adjustments arising from initial public offerings of stock by certain companies in our warrant portfolio. Although total noninterest income decreased, noninterest income from our core fee-based products, which includes client investment fees, foreign exchange fees, deposit service charges and letter of credit and standby letter of credit income, increased by $6.0 million, or 24.2 percent, to $30.8 million for the three months ended June 30, 2008, compared to $24.8 million for the comparable 2007 period. We also controlled our noninterest expense growth. Noninterest expense was $87.2 million for the three months ended June 30, 2008, compared to $97.9 million for the comparable 2007 period. Noninterest expense for the three months ended June 30, 2008 included a non-tax deductible loss of $3.9 million, related to our cash settlement conversion of certain 2003 Convertible Notes. Noninterest expense for the three months ended June 30, 2007 included a $17.2 million pre-tax goodwill impairment charge. We continued to have strong levels of capital during the second quarter of 2008. Our ratio of tangible common equity to tangible assets was 9.47 percent in the three months ended June 30, 2008 compared to 10.39 percent in the comparable 2007 period. The decrease was due largely to strong loan growth in 2007 and the first half of 2008, as well as significant share repurchases in late 2007 and early 2008. The key highlights of our performance for the three and six months ended June 30, 2008 and 2007, respectively, are as follows:
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Critical Accounting Policies and Estimates The accompanying management’s discussion and analysis of results of operations and financial condition are based upon our unaudited interim consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). The preparation of these financial statements in accordance with GAAP requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosure of contingent assets and liabilities. Management evaluates estimates on an ongoing basis. Management bases its estimates on historical experiences and various other factors and assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ materially from these estimates under different assumptions or conditions. Other than the adoption of the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 157, Fair Value Measurements (“SFAS No. 157”), there have been no significant changes during the six months ended June 30, 2008 to the items that we disclosed as our critical accounting policies and estimates in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” under Part II, Item 7 of our 2007 Form 10-K. Fair Value Measurements Please refer to the discussion of our fair value measurements in Note 16 (Fair Value Measurements) of the “Notes to Interim Consolidated Financial Statements (unaudited)” under Part I, Item 1 in this report. Recent Accounting Pronouncements Please refer to the discussion of our recent accounting pronouncements in Note 2 (Recent Accounting Pronouncements) of the “Notes to Interim Consolidated Financial Statements (unaudited)” under Part I, Item 1 in this report. Results of Operations Net Interest Income and Margin (Fully Taxable-Equivalent Basis) Net interest income is defined as the difference between interest earned primarily on loans, investment securities, federal funds sold, securities purchased under agreement to resell and other short-term investment securities, and interest paid on funding sources. Net interest income is our principal source of revenue. Net interest margin is defined as the amount of annualized net interest income, on a fully taxable-equivalent basis, expressed as a percentage of average interest-earning assets. Net interest income and net interest margin are presented on a fully taxable-equivalent basis to consistently reflect income from taxable loans and securities and tax-exempt securities based on the federal statutory tax rate of 35.0 percent. Net Interest Income (Fully Taxable-Equivalent Basis) Net interest income decreased by $6.5 million, or 6.8 percent, to $88.4 million for the three months ended June 30, 2008, compared to $94.9 million for the comparable 2007 period. The decrease in net interest income was due to a $4.5 million decrease in interest income from our loan portfolio, a $0.9 million increase in interest expense, a $0.7 million decrease in interest income from our short-term investment portfolio, and a $0.4 million decrease in interest income from our investment securities portfolio. The decrease in interest income from our loan portfolio was primarily related to a decrease in our average base prime lending rate for the three months ended June 30, 2008, compared to the comparable 2007 period, partially offset by growth in our loan portfolio. Our average base prime lending rate decreased to 5.08 percent for the three months ended June 30, 2008, compared to 8.25 percent for the comparable 2007 period. The decrease in average rates was due to the effect of rate decreases in late 2007 and
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Table of Contentsearly 2008 in response to Federal Reserve rate cuts. At June 30, 2008, our base prime lending rate was 5.00 percent, compared to 8.25 percent at June 30, 2007. The average yield on our loan portfolio was 7.87 percent for the three months ended June 30, 2008, compared to 10.42 percent for the comparable 2007 period. On an average basis, for the three months ended June 30, 2008, 73.12 percent, or $3.23 billion, of our outstanding gross loans were variable-rate loans that adjust at a prescribed measurement date upon a change in our prime-lending rate or other variable indices, compared to 72.01 percent or $2.55 billion, for the comparable 2007 period. Average loans outstanding for the three months ended June 30, 2008 totaled $4.32 billion, compared to $3.43 billion for the comparable 2007 period. The increase in average loans outstanding of $893.2 million was driven primarily by loan growth from all client industry segments, with strong growth in loans to software, hardware, private equity and life science industry clients, and loans to individual clients of SVB Private Client Services. The increase in interest expense was primarily related to an increase in interest expense of $2.8 million from deposits and $2.5 million from long-term debt, partially offset by a decrease in interest expense of $4.5 million from short-term borrowings. The increase in interest expense from deposits was primarily related to our money market deposit product for early stage clients introduced in May 2007 and our Eurodollar sweep deposit product introduced in late October 2007, which both bear higher yields compared to our other money market products. For the three months ended June 30, 2008, the average balance of our early stage money market deposit product was $425.5 million and interest expense incurred was $1.4 million, compared to $24.1 million and $0.2 million, respectively, for the comparable 2007 period. The average balance of our Eurodollar sweep deposit product for the three months ended June 30, 2008 was $322.4 million and interest expense incurred was $1.4 million. The increase in interest expense from long-term debt was primarily due to the issuance of $500 million in senior and subordinated notes in May 2007 and $250 million in 3.875% convertible senior notes (“2008 Convertible Notes”) in April 2008. Accordingly, average long-term debt increased by $497.6 million to $1.10 billion for the three months ended June 30, 2008, compared to $602.2 million for the comparable 2007 period. The proceeds from the issuance of the senior and subordinated notes were used to fund loan growth and to pay down our short-term borrowings. As a result, average short-term borrowings decreased by $209.1 million to $206.0 million for the three months ended June 30, 2008, compared to $415.1 million for the comparable 2007 period. Short-term borrowings and FHLB advances were used to fund growth of our loan portfolio. The proceeds from the issuance of the 2008 Convertible Notes were used primarily to settle the conversion of our 2003 Convertible Notes, which matured in June 2008, and for other general corporate purposes. The decrease in interest income from our short-term investment securities portfolio was primarily driven by declining short-term market interest rates. This decrease was partially offset by increases in interest income related to growth in average short-term investment portfolio balances, which included net proceeds from the issuance of our 2008 Convertible Notes in April 2008. The decrease in interest income from our investment securities portfolio primarily reflects lower levels of taxable investment securities due to principal prepayments of mortgage-backed securities and collateralized mortgage obligations, partially offset by growth in average balances of our non-taxable investment securities portfolio. Average interest-earning investment securities decreased by $54.3 million to $1.34 billion for the three months ended June 30, 2008, compared to $1.39 billion for the comparable 2007 period, as a result of our use of portfolio cash flows to support the growth of our loan portfolio. Net interest income decreased by $7.6 million, or 4.0 percent to $181.0 million for the six months ended June 30, 2008, compared to $188.6 million for the comparable 2007 period. The decrease in net interest income was primarily due to a $4.7 million increase in interest expense, a $2.4 million decrease in interest income from our investment securities portfolio, and a slight decrease in interest income from our loan portfolio. The increase in interest expense for the six months ended June 30, 2008 was primarily related to increases in interest expense of $8.8 million from long-term debt and $5.8 million from deposits, partially offset by a decrease in interest expense of $9.9 million from short-term borrowings. Average long-term debt increased by $510.4 million to $993.6 million for the six months ended June 30, 2008, compared to $483.2 million for the comparable 2007 period, primarily due to the issuance of $500 million in senior and subordinated notes in May 2007 and our 2008 Convertible Notes in April 2008. The increase in interest expense from deposits was primarily related to the introduction of our two new interest-bearing deposit products. Average short-term borrowings decreased by $261.1 million to $220.5 million for the six months ended June 30, 2008, compared to $481.6 million for the comparable 2007 period. The decrease in interest income for the six months ended June 30, 2008 from our investment securities portfolio reflects lower levels of taxable investment securities due to principal prepayments of mortgage-backed securities and collateralized mortgage obligations, partially offset by growth in average balances of our non-taxable investment securities portfolio. Average interest-earning investment securities decreased by $124.9 million to $1.30 billion for the six months ended June 30, 2008, compared to $1.42 billion for the comparable 2007 period. The slight decrease in interest income from our loan portfolio for the six months ended June 30, 2008 was primarily related to a decrease in our average base prime lending rate for the six months ended June 30, 2008, compared to the comparable 2007 period, partially offset by growth in our loan portfolio. Our average base prime lending rate decreased to 5.66 percent for the six months ended June 30, 2008, compared to 8.25 percent for the comparable 2007 period. The decrease in average rates was due to the effect of rate decreases in late 2007 and early 2008 in response to Federal Reserve rate cuts. Average loans outstanding for the six months ended June 30, 2008 totaled $4.22 billion, compared to $3.34 billion for the comparable 2007 period.
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Table of ContentsAnalysis of Interest Changes Due to Volume and Rate (Fully Taxable-Equivalent Basis) Net interest income is affected by changes in the amount and mix of interest-earning assets and interest-bearing liabilities, referred to as “volume change.” Net interest income is also affected by changes in yields earned on interest-earning assets and rates paid on interest-bearing liabilities, referred to as “rate change.” Changes in our prime lending rate also impact the yields on our loans, and to a certain extent our interest-bearing deposits. The following table sets forth changes in interest income for each major category of interest-earning assets and interest expense for each major category of interest-bearing liabilities. The table also reflects the amount of simultaneous changes attributable to both volume and rate changes for the periods indicated. For this table, changes that are not solely due to either volume or rate are allocated in proportion to the percentage changes in average volume and average rate.
Net Interest Margin (Fully Taxable-Equivalent Basis) Our net interest margin was 5.69 percent and 6.01 percent for the three and six months ended June 30, 2008, respectively, compared to 7.39 percent and 7.48 percent for the comparable 2007 periods. The decreases in net interest margin were due to decreases in yields of our loan portfolio due to reductions in our prime-lending rate and increases in rates paid on our deposits due to the introduction of two new interest-bearing deposit products, partially offset by decreases in rates paid on our short-term borrowings. Our net interest margin also decreased due to the impact of our decision to partially decrease the interest rates we offer on certain deposit products, rather than lower them in conformity with Federal Reserve rate cuts. Average Balances, Yields and Rates Paid (Fully Taxable-Equivalent Basis) The average yield earned on interest-earning assets is the amount of annualized fully taxable-equivalent interest income expressed as a percentage of average interest-earning assets. The average rate paid on funding sources is the amount of annualized interest expense expressed as a percentage of average funding sources. The following tables set forth average assets, liabilities, minority interest and stockholders’ equity, interest income, interest expense, annualized yields and rates, and the composition of our annualized net interest margin for the three and six months ended June 30, 2008 and 2007, respectively.
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