UnionBanCal 10-K 2010
400 California Street
Registrant's telephone number: (415) 765-2969
registered pursuant to Section 12(b) of the Act:
registered pursuant to Section 12(g) of the Act:
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No ý
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No ý
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 ý No o
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 o No o
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ý
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act.
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes o No ý
Aggregate market value of voting and non-voting common equity held by non-affiliates of the registrant: Not applicable; all of the voting stock of the registrant is owned by its parent, The Bank of Tokyo-Mitsubishi UFJ, Ltd.
As of January 31, 2010, the number of shares outstanding of the registrant's Common Stock was 136,330,829.
DOCUMENTS INCORPORATED BY REFERENCE
THE REGISTRANT MEETS THE CONDITIONS SET FORTH IN GENERAL INSTRUCTION (I) (1) (a) AND (b) OF FORM 10-K AND IS THEREFORE FILING THIS FORM WITH THE REDUCED DISCLOSURE FORMAT.
This report includes forward-looking statements, which include forecasts of our financial results and condition, expectations for our operations and business, and our assumptions for those forecasts and expectations. Do not rely unduly on forward-looking statements. Actual results might differ significantly compared to our forecasts and expectations. See Part I, Item 1A. "Risk Factors," and the other risks described in this report for factors to be considered when reading any forward-looking statements in this filing.
This report includes forward-looking statements, which are subject to the "safe harbor" created by section 27A of the Securities Act of 1933, as amended, and section 21E of the Securities Exchange Act of 1934, as amended. We may make forward-looking statements in our Securities and Exchange Commission (SEC) filings, press releases, news articles and when we are speaking on behalf of UnionBanCal Corporation. Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts. Often, they include the words "believe," "expect," "target," "anticipate," "intend," "plan," "seek," "estimate," "potential," "project," or words of similar meaning, or future or conditional verbs such as "will," "would," "should," "could," "might," or "may." These forward-looking statements are intended to provide investors with additional information with which they may assess our future potential. All of these forward-looking statements are based on assumptions about an uncertain future and are based on information available to us at the date of these statements. We do not undertake to update forward-looking statements to reflect facts, circumstances, assumptions or events that occur after the date the forward-looking statements are made.
In this document, for example, we make forward-looking statements, which discuss our expectations about:
There are numerous risks and uncertainties that could and will cause actual results to differ materially from those discussed in our forward-looking statements. Many of these factors are beyond our ability to control or predict and could have a material adverse effect on our financial condition and results of operations or prospects. Such risks and uncertainties include, but are not limited to those listed in Part I, Item 1A "Risk Factors" and Part II, Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations."
Readers of this document should not rely unduly on forward-looking information and should consider all uncertainties and risks disclosed throughout this document and in our other reports to the SEC, including, but not limited to, those discussed below. Any factor described in this report could by itself, or together with one or more other factors, adversely affect our business, future prospects, results of operations or financial condition.
Item 1. Business
All reports that we file electronically with the Securities and Exchange Commission (SEC), including the Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, and current reports on Form 8-K, as well as any amendments to those reports, are accessible at no cost on our internet website at www.unionbank.com as soon as reasonably practicable after we electronically file such reports with, or furnish them to, the SEC. These filings are also accessible on the SEC's website at www.sec.gov.
As used in this Form 10-K, the term "UnionBanCal" and terms such as "we," "us" and "our" refer to UnionBanCal Corporation, Union Bank, N.A., one or more of their consolidated subsidiaries, or to all of them together.
We are a California-based, financial holding and commercial bank holding company whose major subsidiary, Union Bank, N.A., is a commercial bank. (On December 18, 2008, Union Bank, N.A. changed its name from Union Bank of California, N.A.) Union Bank provides a wide range of financial services to consumers, small businesses, middle-market companies and major corporations, primarily in California, Oregon, Washington and Texas, as well as nationally and internationally.
On November 4, 2008, we became a privately held company pursuant to the Agreement and Plan of Merger, dated as of August 18, 2008, by and among UnionBanCal, The Bank of Tokyo-Mitsubishi UFJ, Ltd. (BTMU), a wholly-owned subsidiary of Mitsubishi UFJ Financial Group, Inc. (MUFG), and Blue Jackets, Inc., a Delaware corporation and a wholly-owned subsidiary of BTMU (Merger Sub) (the Merger Agreement). All of our issued and outstanding shares of common stock are now owned by BTMU. Prior to the transaction, BTMU owned approximately 64 percent of our outstanding shares of common stock.
The Merger Agreement provided, among other things, for a cash tender offer by BTMU (the Offer) to purchase all of the publicly held outstanding shares of our common stock at a price of $73.50 per share in cash (the Offer Price). The offer expired on September 26, 2008, with purchase of the shares being effective on October 1, 2008. After the Offer, BTMU owned approximately 97 percent of our outstanding common stock. On November 4, 2008, pursuant to the Merger Agreement, Merger Sub was merged with and into UnionBanCal (the Merger), the separate corporate existence of Merger Sub ceased and UnionBanCal continued as the surviving corporation in the Merger. All remaining publicly held shares of our common stock issued and outstanding immediately prior to the closing of the Merger were converted into the right to receive an amount in cash equal to the Offer Price.
For further information regarding the privatization transaction, refer to Note 2 to our Consolidated Financial Statements included in this Form 10-K Report.
Our operations are divided into two reportable segments. These segments and their financial information are described more fully in "Business Segments" of our Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) and in Note 24 to our Consolidated Financial Statements included in this Form 10-K Report.
Retail Banking. Retail Banking offers our customers a wide spectrum of financial products under one convenient umbrella. Our broad line of checking and savings, investment, loan and fee-based banking products is designed to meet individual and business needs. These products are offered in 339 full-service branches, primarily in California. In addition, Retail Banking offers e-banking through our website, check cashing services at our Cash & Save® locations.
Corporate Banking. Corporate Banking offers a variety of commercial financial services, including commercial loans and project financing, real estate financing, asset-based financing, trade finance and letters of credit, lease financing, customized deposit and global treasury management solutions and selected capital markets products. The Corporate Banking customers include middle-market companies, large corporations, real estate companies and other more specialized industry customers. In addition, specialized depository services are offered to title and escrow companies, retailers, domestic financial institutions, bankruptcy trustees and other customers with significant deposit volumes. Corporate Banking includes a registered broker-dealer and a registered investment advisor, which provide securities brokerage and investment advisory services and manage a proprietary mutual fund family. Corporate Banking also offers loan, deposit and trust and investment products tailored to our high net worth customers, professional service firms, foundations and endowments through our Private Banking offices. Institutional customers are offered corporate trust, securities lending and custody (global and domestic) services.
At January 31, 2010, we had 9,676 full-time equivalent employees.
Banking is a highly competitive business. We compete actively for loan, deposit, and other financial services business in California, Oregon, Washington and Texas, as well as nationally and internationally. Our competitors include a large number of state and national banks, thrift institutions, credit unions, finance companies, mortgage banks and major foreign-affiliated or foreign banks, as well as many financial and nonfinancial firms that offer services similar to those offered by us, including many large securities firms. Some of our competitors are insurance companies or community or regional banks that have strong local market positions. Other competitors include large financial institutions that have substantial capital, technology and marketing resources, which are well in excess of ours. Competition in our industry may intensify as a result of the recent and increasing level of consolidation of financial services companies, particularly in our principal markets resulting from adverse economic and financial market conditions. Such larger financial institutions may have greater access to capital at a lower cost than us, which may adversely affect our ability to compete effectively. We also experience competition, especially for deposits, from internet-based banking institutions, which have grown rapidly in recent years. Given the recent financial crises affecting the banking system and financial markets and related volatility and tightening of liquidity in the credit markets, many banks have been aggressively seeking deposits by utilizing interest rates which lack correlation to the current federal funds market. Although we have not been required to do so, net interest income could be adversely affected should competitive pressures cause us to increase our interest rates paid on deposits in order to maintain our market share.
Banks, securities firms, and insurance companies can now combine as a "financial holding company." Financial holding companies can offer virtually any type of financial service, including banking, securities underwriting, insurance (both agency and underwriting), and merchant banking. Many of our competitors have elected to become financial holding companies, including several large finance companies, securities firms and insurance companies. A number of foreign banks have either acquired financial holding companies or obtained financial holding company status in the U.S., further increasing competition in the U.S. market. On October 6, 2008, UnionBanCal Corporation, BTMU and MUFG obtained approval from the Board of Governors of the Federal Reserve System to become financial holding companies under the Bank Holding Company Act of 1956, as amended (the BHCA). We sought this new status from the Federal Reserve Board to provide us maximum flexibility to pursue new business opportunities as the banking and financial services industry undergoes rapid and profound changes.
Technology and other changes increasingly allow parties to complete financial transactions electronically, and in many cases, without banks. For example, consumers can pay bills and transfer funds over the internet and by telephone without banks. Many non-bank financial service providers have lower overhead costs and are
subject to fewer regulatory constraints. If consumers do not use banks to complete their financial transactions, we could potentially lose fee income, deposits and income generated from those deposits.
Current federal law has made it easier for out-of-state banks to enter and compete in the states in which we operate. The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the Riegle-Neal Act), among other things, eliminated substantially all state law barriers to the acquisition of banks by out-of-state bank holding companies. A bank holding company may acquire banks in states other than its home state, without regard to the permissibility of such acquisitions under state law, but subject to any state requirement that the acquired bank has been organized and operating for a minimum period of time (not to exceed five years), and the requirement that the acquiring bank holding company, prior to or following the proposed acquisition, controls no more than 10 percent of the total amount of deposits of the insured depository institutions in the United States and no more than 30 percent of such deposits in that state (or such lesser or greater amount as may be established by state law). The Riegle-Neal Act also permits banks to acquire branches located in another state by purchasing or merging with a bank chartered in that state or a national banking association having its headquarters located in that state.
We believe that continued emphasis on enhanced services and distribution systems, an expanded customer base, increased productivity and strong credit quality, together with a substantial capital base, will better position us to meet the challenges provided by this competition.
Our earnings and businesses are affected not only by general economic conditions (both domestic and international), but also by the monetary policies of various governmental regulatory authorities of the United States and foreign governments and international agencies. In particular, our earnings and growth may be affected by actions of the Federal Reserve Board in connection with its implementation of national monetary policy through its open market operations in United States Government securities, control of the discount rate for borrowings by financial institutions and the federal funds rate and establishment of reserve requirements against both member and non-member financial institutions' deposits. These actions have a significant effect on the overall growth and distribution of loans and leases, investments and deposits, as well as on the rates earned on securities, loans and leases or paid on deposits. It is difficult to predict future changes in monetary policies and their effect on our business, particularly in light of the current challenging economic conditions.
Overview. Bank holding companies and banks are extensively regulated under both federal and state law. This regulation is intended primarily for the protection of depositors, the deposit insurance fund, and other clients of the institution, and not for the benefit of the investors in the stock or other securities of the bank holding company. Set forth below is a summary description of material laws and regulations that relate to our operation and those of our subsidiaries, including Union Bank. This summary description of applicable laws and regulations does not purport to be complete and is qualified in its entirety by reference to such laws and regulations.
Bank Holding Company Act (BHCA) and the Gramm-Leach-Bliley (GLB) Act. We, MUFG and BTMU are subject to regulation under the BHCA, which also subjects us to Federal Reserve Board reporting and examination requirements. Generally, the BHCA restricts our ability to invest in non-banking entities, and we may not acquire more than 5 percent of the voting shares of any domestic bank without the prior approval of the Federal Reserve Board. Our activities are limited, with some exceptions, to banking, the business of managing or controlling banks, and other activities that the Federal Reserve Board deems to be so closely related to banking as to be a proper incident thereto.
The GLB Act allows "financial holding companies" to offer banking, insurance, securities and other financial products. Among other things, the GLB Act amended the BHCA in order to provide a framework for engaging in new financial activities by bank holding companies. In 2008, UnionBanCal Corporation, BTMU
and MUFG obtained approval from the Federal Reserve Board to become financial holding companies under the BHCA.
Under the GLB Act, "financial subsidiaries" of banks may engage in some types of activities beyond those permitted to banks themselves, provided certain conditions are met. At this time, Union Bank has no plans to form any "financial subsidiaries."
Under Federal Reserve Board regulations, a bank holding company is required to serve as a source of financial and managerial strength to its subsidiary banks and may not conduct its operations in an unsafe or unsound manner. Under this policy, the Federal Reserve Board may require a holding company to contribute additional capital to an undercapitalized subsidiary bank.
Comptroller of the Currency. Union Bank, as a national banking association, is subject to broad federal regulation and oversight extending to all its operations by the Office of the Comptroller of the Currency (OCC), its primary regulator, and also by the Federal Reserve Board and the Federal Deposit Insurance Corporation (FDIC). As part of this authority, Union Bank is required to file periodic reports with the OCC and is subject to ongoing examination by the OCC.
The OCC has extensive enforcement authority over all national banks. If, as a result of an examination of a bank, the OCC determines that the financial condition, capital resources, asset quality, earnings prospects, management, liquidity, or other aspects of the bank's operations are unsatisfactory or that the bank or its management is violating or has violated any law or regulations, various remedies are available to the OCC. These remedies include the power to enjoin "unsafe or unsound" practices, to require affirmative action to correct any conditions resulting from any violation or practice, to issue an administrative order that can be judicially enforced to direct an increase in capital, to restrict the growth of the bank, to assess civil monetary penalties, to remove officers and directors, and ultimately to terminate the bank's deposit insurance. The OCC, as well as other federal agencies, have adopted regulations and guidelines establishing safety and soundness standards, including but not limited to such matters as loan underwriting and documentation, internal controls and audit systems, interest rate risk exposure, asset quality and earnings and compensation and other employee benefits.
Other Regulatory Oversight. Our subsidiaries are also subject to extensive regulation, supervision, and examination by various other federal and state regulatory agencies. In addition, Union Bank and its subsidiaries are subject to certain restrictions under the Federal Reserve Act and related regulations, including restrictions on affiliate transactions. As a holding company, the principal source of our cash has been dividends and interest received from Union Bank. Dividends payable by Union Bank to us are subject to restrictions under a formula imposed by the OCC unless express approval is given to exceed these limitations. For more information regarding restrictions on loans and dividends by Union Bank to its affiliates and on transactions with affiliates, see Notes 19 and 23 to our Consolidated Financial Statements included in this Form 10-K Report.
The Federal Deposit Insurance Act, as amended (FDIA) requires federal bank regulatory authorities to take "prompt corrective action" in dealing with inadequately capitalized banks. The FDIA establishes five tiers of capital measurement ranging from "well-capitalized" to "critically undercapitalized." It is our policy to maintain capital ratios above the minimum regulatory requirements for "well-capitalized" institutions for both Union Bank and us. Management believes that, at December 31, 2009, Union Bank and we met the requirements for "well-capitalized" institutions.
Deposits of Union Bank are insured up to statutory limits by the FDIC and, accordingly, are subject to deposit insurance assessments. Amendments to the FDIA in 2005-2006 created a new assessment system designed to more closely tie what banks pay for deposit insurance to the risks they pose and adopted a new base schedule of rates that the FDIC can adjust up or down, depending on the revenue needs of the insurance fund. As a result of this legislation, Union Bank has been subject to annual assessments on deposits since 2007. The initial assessment rate was approximately 5 basis points. Prior to this change, Union Bank was not
paying any insurance assessments on deposits under the FDIC's risk-related assessment system. An FDIC credit for prior contributions offset the assessment in 2007 and part of 2008. As part of the Deposit Insurance Fund Restoration Plan adopted by the FDIC in October 2008, beginning on April 1, 2009, the FDIC initial base assessment rates were set between 12 and 45 basis points. In addition, on June 30, 2009, the FDIC imposed a special assessment on banks. Union Bank's special assessment totaled $34 million and was paid on September 30, 2009.
In November 2009, in light of the challenge to the federal deposit insurance fund from the severe U.S. recession, the FDIC issued a rule mandating that insured depository institutions prepay their quarterly risk-based assessments to the FDIC for the fourth quarter of 2009, and all of 2010, 2011 and 2012. Union Bank's prepayment totaled $352.6 million and was paid on December 30, 2009. Under this rule, each depository institution was required to record the entire amount of its prepayment as an asset, or a prepaid expense, and is allowed to count the payments as a depreciating asset. The prepaid assessments bear a zero-percent risk weight for risk-based capital purposes. The FDIC will not refund or collect additional prepaid assessments because of a decrease or growth in deposits over the next three years. However, if the prepaid assessment is not exhausted by June 30, 2013, the remaining amount of the prepayment will be returned to the depository institution. The prepaid assessments are in lieu of additional special assessments at this time; however, there can be no assurance that the FDIC will not impose additional special assessments or increase annual assessments in the future. Refer to "Management's Discussion and Analysis of Financial Condition and Results of OperationsExecutive Overview" in Item 7 of this Form 10-K for a discussion of the recently-proposed "financial crisis responsibility fee" which could be imposed by the federal government on larger financial institutions to repay part of the cost of the government's support of the banking industry in 2008-2009.
There are additional requirements and restrictions in the laws of the United States and the states of California, Oregon, Texas, and Washington, as well as other states in which Union Bank and its subsidiaries may conduct operations. These include restrictions on the levels of lending and the nature and amount of investments, as well as activities as an underwriter of securities, the opening and closing of branches and the acquisition of other financial institutions. The consumer lending and finance activities of Union Bank are also subject to extensive regulation under various Federal and state laws. These statutes impose requirements on the making, enforcement and collection of consumer loans and on the types of disclosures that must be made in connection with such loans.
Union Bank is also subject to the Community Reinvestment Act (CRA). The CRA generally requires the federal banking agencies to evaluate the record of a financial institution in meeting the needs of local communities, including low- and moderate-income neighborhoods. In addition to substantial penalties and corrective measures that may be required for a violation of certain fair lending laws, the federal banking agencies may take compliance with such laws and the CRA into account when regulating and supervising other activities, and in evaluating whether to approve applications for permission to engage in new activities or for acquisitions of other banks or companies or de novo branching. An unsatisfactory rating may be the basis for denying the application. Based on the most current examination report dated June 1, 2009, Union Bank's compliance with CRA was rated "outstanding."
Union Bank has branches in Canada and the Cayman Islands. Any international activities of Union Bank are also subject to the laws and regulations of the jurisdiction where business is being conducted, which may change from time to time and affect Union Bank's business opportunities and competitiveness in these jurisdictions. Furthermore, due to BTMU's controlling ownership of us, regulatory requirements adopted or enforced by the Government of Japan may have an effect on the activities and investments of Union Bank and us in the future.
The activities of Union Bank subsidiaries, HighMark Capital Management, Inc. and UnionBanc Investment Services LLC, are subject to the rules and regulations of the SEC, as well as those of state securities
regulators. UnionBanc Investment Services LLC is also subject to the rules and regulations of the Financial Industry Regulatory Authority (FINRA).
Under Federal Reserve Board rules, Union Bank is affiliated with the HighMark Funds. The HighMark Funds is a registered investment company, subject to the rules and regulations of the SEC.
Broker/Dealer Regulation. Union Bank is not registered as a broker or dealer. The GLB Act and applicable regulations require us to conduct non-exempted securities brokerage or dealer activities through our registered broker-dealer, UnionBanc Investment Services LLC. These laws and regulations also limit compensation we may pay our bank employees for referrals of brokerage business and limit Union Bank's ability to advertise securities brokerage services.
Bank Secrecy Act. The banking industry is now subject to significantly increased regulatory controls and processes regarding the Bank Secrecy Act and anti-money laundering laws. Failure to comply with these additional requirements may adversely affect the ability to obtain regulatory approvals for future initiatives requiring regulatory approval, including acquisitions. Under the USA PATRIOT Act, federal banking regulators must consider the effectiveness of a financial institution's anti-money laundering program prior to approving an application for a merger, acquisition or other activities requiring regulatory approval. Failure to comply with these requirements can also subject an insured depository institution to monetary fines, penalties and other sanctions.
Sarbanes-Oxley Act. In November 2008, we became a privately-held company. All of our issued and outstanding shares of common stock are now owned by BTMU. We file periodic reports with the SEC in accordance with the reduced disclosure format permitted for certain wholly-owned subsidiaries, and the Sarbanes-Oxley Act applies to us.
Among other provisions, Section 302(a) of the Sarbanes-Oxley Act requires our Chief Executive Officer and Chief Financial Officer to certify that our quarterly and annual reports do not contain any untrue statement or omission of a material fact and to make additional certifications as to the adequacy of our internal controls over financial reporting and other matters.
In response to these requirements, we have established a Disclosure Committee to monitor compliance with these rules. Membership of the Disclosure Committee is comprised of senior management from throughout our organization whom we believe collectively provide an extensive understanding of our operations. As part of our compliance with the Sarbanes-Oxley Act, we evaluate our internal control process quarterly and we test and assess our internal controls over financial reporting annually.
Basel Committee Capital Standards. The Basel Committee on Banking Supervision (BIS) proposed new international capital standards for banking organizations (Basel II) in June 2004, and the new framework is currently being evaluated and implemented by bank supervisory authorities worldwide. Basel II is an effort to update the original international bank capital accord (Basel I), which has been in effect since 1988. Basel II is intended to improve the consistency of capital regulations internationally, make regulatory capital more risk sensitive, and promote enhanced risk-management practices among large, internationally active banking organizations.
We do not meet the criteria in the new U.S. rules which would make adoption of the new Basel II rules mandatory. However, MUFG, which owns all of our issued and outstanding shares of common stock through its wholly-owned subsidiary BTMU, is subject to the requirements of the new Basel II under the rules of the Japan Financial Services Agency (JFSA). In addition, the rules of the JFSA require subsidiaries of Japanese banks and bank holding companies that represent more than 2 percent of the parent's consolidated risk-weighted assets to also comply with Basel II. Because we meet this criterion, the JFSA requirement will be applicable to us. In order to facilitate the JFSA requirements, we expect to adopt the new Basel II rules as in effect in the U.S., subject to approval by our U.S. bank regulators. BTMU is reimbursing us for expenditures that we are incurring
for Basel II projects that we would not have undertaken for our own risk management purposes. At this time, the impact on our minimum capital requirements under Basel II is not known.
Customer Information Security. The federal bank regulatory agencies have adopted guidelines for safeguarding confidential, personal customer information. The guidelines require each financial institution, under the supervision and ongoing oversight of its Board of Directors or an appropriate committee, to create, implement and maintain a comprehensive written information security program designed to ensure the security and confidentiality of customer information, protect against any anticipated threats or hazards to the security or integrity of such information and protect against unauthorized access to or use of such information that could result in substantial harm or inconvenience to any customer. Union Bank has adopted a customer information security program that has been approved by its Board of Directors.
Congress, Treasury and the federal banking regulators have taken broad action since September 2008 to address volatility in the U.S. financial system and the U.S. recession. In October 2008, the Emergency Economic Stabilization Act of 2008 (the EESA) was enacted. Pursuant to the EESA, the maximum deposit insurance amount has been increased from $100,000 to $250,000 per depositor through December 31, 2013. Pursuant to its Temporary Liquidity Guarantee Program, the FDIC has guaranteed newly issued senior unsecured debt of participating financial institutions and their qualifying holding companies. Union Bank elected to participate and, during the first quarter of 2009, issued $1 billion principal amount of FDIC-guaranteed senior notes under this program.
In October 2008, the U.S. Treasury enacted a voluntary Capital Purchase Program under its Troubled Asset Relief Program (TARP) pursuant to which the Treasury purchased senior preferred stock of qualifying U.S. financial institutions. Many banks and bank holding companies participated in this program. UnionBanCal, as a wholly-owned subsidiary of a foreign bank, was not eligible to participate in the Capital Purchase Program.
Possible Future Legislation and Regulatory Initiatives
The recent economic and political environment has led to a number of proposed legislative, governmental and regulatory initiatives that may significantly impact our industry. For example, Congress is considering a variety of proposals that would make significant changes to the financial regulatory system and affect the financial services industry, including greater powers to regulate risk across the financial system; a new Financial Services Oversight Council; a Consumer Financial Protection Agency; potential limits on the scope of federal preemption of state laws as applied to national banks; restrictions on bank activities intended to protect consumers, such as "cram-down" provisions which would allow courts to modify mortgage terms in bankruptcy proceedings; and changes in the regulatory agencies. In addition, there have been recent proposals to place new restrictions on the size and activities of large financial institutions, restrict compensation paid to bank officers, substantially increase fees and taxes, and substantially increase capital and liquidity requirements. These and other initiatives could significantly change the competitive and operating environment in which we and our subsidiaries operate. We cannot predict whether these or any other
proposals will be enacted or the ultimate impact of any such initiatives on our operations, competitive situation, financial condition or results of operations.
Other Recent Developments
In November 2009, the Federal Reserve Board adopted amendments under its Regulation E that impose new restrictions on banks' abilities to charge overdraft services and fees. The final rule prohibits financial institutions from charging fees for paying overdrafts on ATM and one-time debit card transactions, unless a consumer consents, or opts in, to the overdraft service for those types of transactions. We expect these amendments to result in decreased revenues and increased compliance costs for the banking industry and Union Bank.
See our Consolidated Financial Statements starting on page F-53 for financial information about UnionBanCal Corporation and its subsidiaries.
Item 1A. Risk Factors
We are subject to numerous risks and uncertainties, including but not limited to the following information:
U.S. and global economies have experienced a serious recession, unprecedented volatility in the financial markets, and significant deterioration in sectors of the U.S consumer and business economy, all of which present challenges for the banking and financial services industry and for UnionBanCal Corporation; the U.S. Government has responded to these circumstances with a variety of measures; there can be no assurance that these measures will successfully address these circumstances
Commencing in 2007 and continuing throughout 2008 and 2009, adverse financial developments have impacted the U.S. and global economies and financial markets and present challenges for the banking and financial services industry and for UnionBanCal Corporation. These developments include a general recession both globally and in the U.S. and have contributed to substantial volatility in the financial markets.
In response, various significant economic and monetary stimulus measures were enacted by the U.S. Congress. Refer to "Supervision and Regulation" in Item 1 of this Form 10-K for discussion of these measures.
It cannot be predicted whether the U.S. governmental actions in the past two years will result in lasting improvement in financial and economic conditions affecting the U.S. banking industry and the U.S. economy. It also cannot be predicted whether and to what extent the efforts of the U.S. government to combat the recessionary conditions will continue. If, notwithstanding the government's fiscal and monetary measures, the U.S. economy were to remain in a recessionary condition for an extended period, this would present additional significant challenges for the U.S. banking and financial services industry and for our company. In addition, as a wholly-owned subsidiary of a foreign bank, we have not been eligible to participate in some federal programs such as the Department of Treasury's Capital Purchase Program and may not qualify for participation in future federal programs.
Recently, certain sovereign borrowers have encountered difficulties in financing renewals of their indebtedness. If this trend continues or worsens, it could have adverse impacts on costs in the global debt markets which could increase funding costs for banks generally.
Difficult market conditions have adversely affected the U.S. banking industry
Dramatic declines in the housing market in the U.S. in general, and in California in particular, during 2008 and continuing in 2009, with falling home prices and increasing foreclosures, unemployment and under-employment, have negatively impacted the credit performance of mortgage loans and resulted in significant write-downs of asset values by financial institutions, including government-sponsored entities as well as commercial and investment banks. These write-downs, initially of mortgage-backed securities but spreading to credit default swaps and other derivative and cash securities and, more recently, residential, commercial real estate loans and small business and other commercial loans, in turn, have caused many financial institutions to seek additional capital, to merge with larger and stronger institutions and, in some cases, to fail. These adverse economic conditions have led to an increased level of commercial and consumer delinquencies, reduced consumer confidence, increased market volatility and widespread reduction of business activity generally. The resulting economic pressure on consumers and lack of confidence in the financial markets adversely affected our business, financial condition and results of operations in 2009. In addition, turbulent political and economic conditions in foreign countries have negatively impacted the U.S. financial markets and economy in general. A worsening of these conditions would likely exacerbate the adverse effects of these difficult market conditions on us and others in the financial institutions industry. In particular, we may face the following risks in connection with these events:
The effects of changes of or increases in, or supervisory enforcement of, banking or other laws and regulations or governmental fiscal or monetary policies could adversely affect us
We are subject to significant federal and state regulation and supervision, which is primarily for the benefit and protection of our customers and the Deposit Insurance Fund and not for the benefit of investors in our securities. In the past, our business has been materially affected by these regulations. This will continue and likely intensify in the future. Laws, regulations or policies, including accounting standards and interpretations, currently affecting us and our subsidiaries may change at any time. Regulatory authorities may also change their interpretation of these statutes and regulations. Therefore, our business may be adversely affected by changes in laws, regulations, policies or interpretations or regulatory approaches to compliance and enforcement, as well as by supervisory action or criminal proceedings taken as a result of noncompliance which could result in the imposition of significant civil money penalties or fines. Changes in laws and regulations may also increase our expenses by imposing additional fees or taxes or restrictions on our operations. Compliance with laws and regulations, especially new laws and regulations, increases our expenses and diverts management attention from our business operations.
International laws, regulations and policies affecting us, our subsidiaries and the business we conduct may change at any time and affect our business opportunities and competitiveness in these jurisdictions. Due to our ownership by BTMU, laws, regulations, policies, fines and other supervisory actions adopted or enforced by the Government of Japan and the Federal Reserve Board may adversely affect our activities and investments and those of our subsidiaries in the future.
We maintain systems and procedures designed to comply with applicable laws and regulations. However, some legal/regulatory frameworks provide for the imposition of criminal or civil penalties (which can be substantial) for noncompliance. In some cases, liability may attach even if the noncompliance was inadvertent or unintentional and even if compliance systems and procedures were in place at the time. There may be other negative consequences from a finding of noncompliance, including restrictions on certain activities and damage to our reputation.
Additionally, our business is affected significantly by the fiscal and monetary policies of the U.S. federal government and its agencies. We are particularly affected by the policies of the Federal Reserve Board, which regulates the supply of money and credit in the U.S. Under long-standing policy of the Federal Reserve Board, a bank holding company is expected to act as a source of financial and managerial strength for its subsidiary banks. As a result of that policy, we may be required to commit financial and other resources to our subsidiary bank in circumstances where we might not otherwise do so. Among the instruments of monetary policy available to the Federal Reserve Board are (a) conducting open market operations in U.S. government securities, (b) changing the discount rates on borrowings by depository institutions and the federal funds rate, and (c) imposing or changing reserve requirements against certain borrowings by banks and their affiliates. These methods are used in varying degrees and combinations to directly affect the availability of bank loans and deposits, as well as the interest rates charged on loans and paid on deposits. The policies of the Federal Reserve Board may have a material effect on our business, prospects, results of operations and financial condition.
Refer to "Supervision and Regulation" in Item 1 of this Form 10-K for discussion of certain recently enacted and proposed laws and regulations that may affect our business.
Higher credit losses could require us to increase our allowance for credit losses through a charge to earnings
When we loan money or commit to loan money, we incur credit risk, or the risk of losses if our borrowers do not repay their loans. We reserve for credit losses by establishing an allowance through a charge to earnings. The amount of this allowance is based on our assessment of credit losses inherent in our loan portfolio and our unfunded credit commitments. The process for determining the amount of the allowance is critical to our financial results and condition. It requires difficult, subjective and complex judgments about the
future impact from current economic conditions that might impair the ability of our borrowers to repay their loans.
We might underestimate the credit losses inherent in our loan portfolio and have credit losses in excess of the amount reserved. Or, we might increase the allowances because of changing economic conditions, which we conclude have caused losses to be sustained in our portfolio. For example, in a rising interest rate environment, borrowers with adjustable rate loans could see their payments increase. In the absence of offsetting factors such as increased economic activity and higher wages, this could reduce borrowers' ability to repay their loans, resulting in our increasing the allowances. Continued volatility in fuel and energy costs could also adversely impact some borrowers' ability to repay their loans. We might also increase the allowances because of unexpected events. Any increase in the allowances would result in a charge to earnings.
Future legislative or regulatory actions responding to perceived financial and market problems could impair our rights against borrowers and decrease our revenue from other customers
Under current bankruptcy laws, courts cannot force a modification of mortgage and home equity loans secured by primary residences. In response to the recent financial crisis, legislation has been proposed to allow mortgage loan "cram-downs," which would empower courts to modify the terms of mortgage and home equity loans including to reduce the principal amount to reflect lower underlying property values. This could result in our writing down the value of our residential mortgage and home equity loans to reflect their lower loan values. There is also risk that home equity loans in a second lien position (i.e., behind a mortgage) could experience significantly higher losses to the extent they become unsecured as a result of a cram-down. The availability of principal reductions or other mortgage loan modifications could make bankruptcy a more attractive option for troubled borrowers, leading to increased bankruptcy filings and accelerated defaults.
Recent changes in federal rules have imposed new restrictions on banks' abilities to charge overdraft services and fees and can be expected to result in decreased revenues and increased compliance costs for the industry and Union Bank. See "Supervision and RegulationOther Recent Developments."
We report certain assets, including investments and securities, at fair value. Generally, for assets that are reported at fair value, we use quoted market prices or valuation models that utilize market data inputs and assumptions to estimate fair value. Because generally accepted accounting principles require fair value measurements to reflect appropriate adjustments for risks related to liquidity and the use of unobservable assumptions, we may recognize unrealized losses even if we believe that the asset in question presents minimal credit risk. Given the continued adverse conditions in the capital markets, we may be required to recognize other-than-temporary impairments in future periods with respect to securities in our portfolio. The amount and timing of any impairment recognized will depend on the severity and duration of the decline in fair value of the securities and our estimation of the anticipated recovery period.
Significant increases in market interest rates on loans, or the perception that an increase may occur, could adversely affect both our ability to originate new loans and our ability to grow. Conversely, decreases in interest rates could result in an acceleration of loan prepayments. An increase in market interest rates could also adversely affect the ability of our floating-rate borrowers to meet their higher payment obligations. If this occurred, it could cause an increase in nonperforming assets and charge offs, which could adversely affect our business.
Fluctuations in interest rates on deposits or other funding sources could adversely affect our margin spread
Changes in market interest rates on deposits or other funding sources, including changes in the relationship between short-term and long-term market interest rates or between different interest rate indices, can impact and has in past years impacted our margin spread, that is, the difference between the interest rates we charge on interest earning assets, such as loans, and the interest rates we pay on interest bearing liabilities, such as deposits or other borrowings. This impact could result in a decrease in our interest income relative to interest expense. Recently, the banking industry has operated in an extremely low interest rate environment relative to historical averages. If a rising rate environment were to ensue, it could present new challenges for the industry and Union Bank.
Our deposit customers may pursue alternatives to bank deposits or seek higher yielding deposits, which may increase our funding costs and adversely affect our liquidity position
Checking and savings account balances and other forms of deposits can decrease when our deposit customers perceive alternative investments, such as the stock market, other non-depository investments or higher yielding deposits, as providing superior expected returns. Technology and other changes have made it more convenient for bank customers to transfer funds into alternative investments or other deposit accounts, including products offered by other financial institutions or non-bank service providers. Future increases in short-term interest rates could increase such transfers of deposits to higher yielding deposits or other investments either with us or with external providers. In addition, our level of deposits may be affected by lack of consumer confidence in financial institutions, which have caused fewer depositors to be willing to maintain deposits that are not fully insured by the FDIC. While transaction accounts at FDIC-insured banks have been fully-guaranteed by the FDIC since October 2008, this guarantee expired as of December 31, 2009, unless individual banks elected to extend the guarantee, for an additional fee to the FDIC. Union Bank determined not to extend the guarantee as to its deposits. Those developments may cause depositors to withdraw deposits and place them in other institutions or to invest uninsured funds in investments perceived as being more secure, such as securities issued by the U.S. Treasury. These consumer preferences may force us to pay higher interest rates or reduce fees to retain deposits and may constrain liquidity as we seek to meet funding needs caused by reduced deposit levels.
In addition, we have benefited from a "flight to quality" by consumers and businesses seeking the relative safety of bank deposits over the past two years. As interest rates rise from historically low levels during the current period, our newly acquired deposits may not be as stable or as interest rate insensitive as similar deposits may have been in the past, and as a recovery in the economy ensues, some existing or prospective deposit customers of banks generally, including Union Bank, may be inclined to pursue other investment alternatives.
Efforts and initiatives we undertake to retain and increase deposits, including deposit pricing, can increase our costs. When bank customers move money out of bank deposits in favor of alternative investments or into higher yielding deposits, we can lose a relatively inexpensive source of funds, increasing our funding cost.
Banking is a highly competitive business. We compete actively for loan, deposit, and other financial services business in California, Oregon and Washington, as well as nationally and internationally. Our competitors include a large number of state and national banks, thrift institutions, credit unions and major foreign-affiliated or foreign banks, as well as many financial and nonfinancial firms that offer services similar to those offered by us, including many large securities firms. Some of our competitors are community or regional banks that have strong local market positions. Other competitors include large financial institutions that have substantial capital, technology and marketing resources that are well in excess of ours. Competition in our
industry may further intensify as a result of the recent and increasing level of consolidation of financial services companies, including in our principal markets resulting from adverse economic and market conditions. Such large financial institutions may have greater access to capital at a lower cost than us, which may adversely affect our ability to compete effectively. We also experience competition, especially for deposits, from internet-based banking institutions, which have grown rapidly in recent years.
From time to time the Financial Accounting Standards Board and the SEC change the financial accounting and reporting standards that govern the preparation of our financial statements or new interpretations of existing standards emerge as standard industry practice. These changes can be very difficult to predict and can materially impact how we record and report our financial condition and results of operations. In some cases, we could be required to apply a new or revised standard retroactively, resulting in our restating prior period financial statements.
Technology and other changes increasingly allow parties to complete financial transactions electronically, and in many cases, without banks. For example, consumers can pay bills and transfer funds over the internet and by telephone without banks. Many non-bank financial service providers have lower overhead costs and are subject to fewer regulatory constraints. If consumers do not use banks to complete their financial transactions, we could potentially lose fee income, deposits and income generated from those deposits.
The continuing war on terrorism and overseas military conflicts could adversely affect U.S. and global economic conditions
Acts or threats of terrorism and actions taken by the U.S. or other governments as a result of such acts or threats and other international hostilities may result in a disruption of U.S. and global economic and financial conditions and could adversely affect business, economic and financial conditions in the U.S. and globally and in our principal markets.
Adverse economic factors affecting certain industries we serve could adversely affect our business
We are subject to certain industry-specific economic factors. For example, a significant portion of our total loan portfolio is related to residential real estate, especially in California. Increases in residential mortgage loan interest rates could have an adverse effect on our operations by depressing new mortgage loan originations, and could negatively impact our title and escrow deposit levels. Additionally, a continued or further downturn in the residential real estate and housing industries in California could have an adverse effect on our operations and the quality of our real estate loan portfolio. These factors could adversely impact the quality of our residential construction and residential mortgage portfolios in various ways, including by decreasing the value of the collateral for our mortgage loans. These factors could also negatively affect the economy in general and thereby our overall loan portfolio.
We provide financing to businesses in a number of other industries that may be particularly vulnerable to industry-specific economic factors and are impacting the performance of our commercial real estate and commercial and industrial portfolios. The commercial real estate industry in the U.S., and in California in particular, is being increasingly adversely impacted by the recessionary environment and lack of liquidity in the financial markets. The home building industry in California has been especially adversely impacted by the deterioration in residential real estate markets. Poor economic conditions and financial access for commercial real estate developers and homebuilders could continue to adversely affect commercial property values, resulting in higher nonperforming assets and charge offs in this sector. Our commercial and industrial portfolio, and the communications/media industry, the retail industry, the energy industry and the technology industry in
particular, are also being impacted by recessionary market conditions. Continued volatility in fuel prices and energy costs could adversely affect businesses in several of these industries. Conditions in the commercial real estate and commercial and industrial markets have led us to take additional provisions against credit losses in these portfolios, as to which we expect a higher level of charge offs during 2010. Industry-specific risks are beyond our control and could adversely affect our portfolio of loans, potentially resulting in an increase in nonperforming loans or charge offs and a slowing of growth or reduction in our loan portfolio.
The government of the State of California currently faces economic and fiscal challenges, the long-term impact of which on the State's economy cannot be predicted with any certainty. A substantial majority of our assets, deposits and fee income are generated in California. As a result, poor economic conditions in California may cause us to incur losses associated with higher default rates and decreased collateral values in our loan portfolio. Economic conditions in California are subject to various uncertainties at this time, including significant deterioration in the residential real estate sector and the California state government's budgetary and fiscal difficulties. Under the budget plan approved by the California Legislature and signed by Governor Arnold Schwarzenegger on February 20, 2009, the State of California reduced services, increased sales and income taxes and other fees and enacted other expense reduction measures. In addition, California funded a portion of the deficit through additional borrowings, which included registered warrants, a relatively high-cost form of financing. California voters did not approve ballot measures required to enact the budget during a special election held on May 19, 2009. The rejection of all of the revenue-related ballot measures resulted in budget deficits which were addressed, at least temporarily, in a California State Budget adopted on July 28, 2009.
On January 8, 2010, Governor Arnold Schwarzenegger submitted his proposed budget for the 2010 fiscal year. This budget provides for significant spending cuts to services, including healthcare, transportation and housing. The proposed budget also requires California to obtain $6.9 billion in federal funding. However, there have been no assurances from the federal government that such funds will be furnished to California. If such funds are not awarded, California may be forced to further cut state services or raise taxes or fees.
If the California state government's budgetary and fiscal difficulties continue or economic conditions in California decline further, we expect that our level of problem assets could increase and our prospects for growth could be impaired.
As of November 4, 2008, BTMU, a wholly-owned subsidiary of MUFG, owned all of the outstanding shares of our common stock. As a result, BTMU can elect all of our directors and can control the vote on all matters, including: approval of mergers or other business combinations; a sale of all or substantially all of our assets; issuance of any additional common stock or other equity securities; incurrence of debt other than in the ordinary course of business; the selection and tenure of our Chief Executive Officer; payment of dividends with respect to our common stock or other equity securities; and other matters that might be favorable to BTMU or MUFG.
A majority of our directors are independent of BTMU and are not officers or employees of UnionBanCal Corporation or any of our affiliates, including BTMU. However, because of BTMU's control over the election of our directors, it could at any time change the composition of our Board of Directors so that the Board would not have a majority of independent directors.
The Bank of Tokyo-Mitsubishi UFJ's and Mitsubishi UFJ Financial Group's financial or regulatory condition could adversely affect our operations
We generally fund our operations independently of BTMU and MUFG and believe our business is not necessarily closely related to the business or outlook of BTMU or MUFG. However, if BTMU and MUFG's credit ratings were to decline, this could adversely affect our credit ratings.
BTMU and MUFG are also subject to regulatory oversight, review and supervisory action (which can include fines or penalties) by Japanese and U.S. regulatory authorities. Our business operations and expansion plans could be negatively affected by regulatory concerns or supervisory action in the U.S. and in Japan against BTMU or MUFG.
The views of BTMU and MUFG regarding possible new businesses, strategies, acquisitions, divestitures or other initiatives, including compliance and risk management processes, may differ from ours. This may delay or hinder us from pursuing individual initiatives or cause us to incur additional costs and subject us to additional oversight.
Also, as part of BTMU's risk management processes, BTMU manages global credit and other types of exposures and concentrations on an aggregate basis, including exposures and concentrations at UnionBanCal. Therefore, at certain levels or in certain circumstances, our ability to approve certain credits or other banking transactions and categories of customers is subject to the concurrence of BTMU. We may wish to extend credit or furnish other banking services to the same customers as BTMU. Our ability to do so may be limited for various reasons, including BTMU's aggregate exposure and marketing policies.
Certain directors' and officers' ownership interests in MUFG's common stock or service as a director or officer or other employee of both us and BTMU could create or appear to create potential conflicts of interest, especially since both we and BTMU compete in U.S. banking markets.
As a holding company, a substantial portion of our cash flow typically comes from dividends our bank and non-bank subsidiaries pay to us. Various statutory provisions restrict the amount of dividends our subsidiaries can pay to us without regulatory approval. In addition, if any of our subsidiaries were to liquidate, that subsidiary's creditors will be entitled to receive distributions from the assets of that subsidiary to satisfy their claims against it before we, as a holder of an equity interest in the subsidiary, will be entitled to receive any of the assets of the subsidiary.
Risks associated with potential acquisitions or divestitures or restructurings may adversely affect us
We have in the past, and may in the future, seek to expand our business by acquiring other businesses which we believe will enhance our business. We cannot predict the frequency, size or timing of our acquisitions, as this will depend on the availability of prospective target opportunities at valuation levels we find attractive and the competition for such opportunities from other parties. There can be no assurance that our acquisitions will have the anticipated positive results, including results related to: the total cost of integration; the time required to complete the integration; the amount of longer-term cost savings; continued growth; or the overall performance of the acquired company or combined entity. We also may encounter difficulties in obtaining required regulatory approvals and unexpected contingent liabilities can arise from the businesses we acquire. Integration of an acquired business can be complex and costly. If we are not able to integrate successfully past or future acquisitions, there is a risk that results of operations could be adversely affected. We may not be successful in completing any acquisition or investment as this will depend on the
availability of prospective target opportunities at valuation levels we find attractive and the competition for such opportunities from other parties.
In addition, we continue to evaluate the performance of all of our businesses and may sell or restructure a business. Any divestitures or restructurings may result in significant write-offs, including those related to goodwill and other intangible assets, which could have a material adverse effect on our business, results of operations and financial condition and may involve additional risks including difficulties in obtaining any required regulatory approvals, the diversion of management's attention from other business concerns, the disruption of our business and the potential loss of key employees.
We may not be successful in addressing these or any other significant risks encountered in connection with any acquisition, divestiture or restructuring we might make.
Our business model relies, in part, upon cross-marketing the products and services offered by us and our subsidiaries to our customers. Laws that restrict our ability to share information about customers within our corporate organization could adversely affect our business, results of operations and financial condition.
Third-party vendors provide key components of our business infrastructure such as internet connections, network access and mutual fund distribution and we do not control their actions. Among other services provided by these vendors, third-party vendors play a key role in the implementation of our integrated banking platform. Any problems caused by these third parties, including those as a result of their not providing us their services for any reason or their performing their services poorly, could adversely affect our ability to deliver products and services to our customers, implement our integrated banking platform and otherwise to conduct our business. Replacing these third-party vendors could also entail significant delay and expense.
Our business could suffer if we fail to attract, retain and successfully integrate skilled personnel
Our success depends, in large part, on our ability to attract and retain key personnel, including executives. Any of our current employees, including our senior management, may terminate their employment with us at any time. Competition for qualified personnel in our industry can be intense. We may not be successful in attracting and retaining sufficient qualified personnel. We may also incur increased expenses and be required to divert the attention of other senior executives to recruit replacements for the loss of any key personnel.
In the past few years, we have experienced significant turnover among members of management, primarily due to retirement. We must successfully integrate any new management personnel that we bring into the organization in order to achieve our operating objectives as new management becomes familiar with our business.
In recent months, the federal bank regulators have published guidance relating to incentive compensation policies at insured depository institutions and a release seeking comment on whether the FDIC's risk-based deposit insurance assessment system should be changed to account for risks arising from employee compensation programs. Specifically, the FDIC has requested comment on whether a bank's compensation program should be a basis for adjusting the bank's FDIC assessment rate. It cannot be predicted whether these regulatory initiatives will result in definitive regulations or policies that will affect compensation at depository institutions, nor whether the effect of any such regulations or policies will be to make it more difficult for banks to attract and retain skilled personnel.
The challenging operating environment and current operational initiatives may strain our available resources
There are an increasing number of matters in addition to our core operations which require our attention and resources. These matters include implementation of our integrated banking platform, adoption of the Basel II capital guidelines, various strategic initiatives, a disruptive economic environment, a challenging regulatory environment and integration of new employees, including key members of management. Our ability to execute our core operations and to implement other important initiatives may be adversely affected if our resources are insufficient or if we are unable to allocate available resources effectively.
Significant legal or regulatory proceedings could subject us to substantial uninsured liabilities
We are from time to time subject to claims and proceedings related to our present or previous operations. These claims, which could include supervisory or enforcement actions by bank regulatory authorities, or criminal proceedings by prosecutorial authorities, could involve demands for large monetary amounts, including civil money penalties or fines imposed by government authorities, and significant defense costs. To mitigate the cost of some of these claims, we maintain insurance coverage in amounts and with deductibles that we believe are appropriate for our operations. However, our insurance coverage does not cover any civil money penalties or fines imposed by government authorities and may not cover all other claims that might be brought against us or continue to be available to us at a reasonable cost. As a result, we may be exposed to substantial uninsured liabilities, which could adversely affect our business, prospects, results of operations and financial condition.
The State of California requires us to file our franchise tax returns as a member of a unitary group that includes MUFG and either all worldwide affiliates or only U.S. affiliates. Prior to 2009, we elected to file our California franchise tax returns on a worldwide unitary basis. We intend to file our 2009 California tax return under a water's-edge election. If a water's-edge election is made, it will be effective as of April 1, 2009, and MUFG will be included in our California franchise tax return through March 31, 2009, MUFG's fiscal year-end. Increases or decreases in MUFG's taxable profits will increase or decrease our effective tax rate. We review MUFG's financial information on a quarterly basis to determine the rate at which to recognize our California income taxes. However, all of the information relevant to determining the effective California tax rate may not be available until after the end of the period to which the tax relates, primarily due to MUFG's later fiscal year-end. Our California effective tax rate can change during the calendar year, or between calendar years, as additional information becomes available. If we understate our tax obligations we could be subject to penalties. Our effective tax rates are also affected by valuation changes in our deferred tax assets and liabilities, changes in tax laws or their interpretation and by the outcomes of examinations of our income tax returns by the tax authorities.
Our credit ratings are important in order to maintain liquidity.
Major credit rating agencies regularly evaluate the securities of UnionBanCal Corporation and the securities and deposits of Union Bank, and their ratings of our long-term debt and other securities and also of our short-term obligations are based on a number of factors, including our financial strength, ability to generate earnings, and other factors, some of which are not entirely within our control, such as conditions affecting the financial services industry and the economy. In light of the difficulties in the financial services industry, the financial markets and the economy, there can be no assurance that we will maintain our current long-term and short-term ratings.
If our long-term or short-term credit ratings suffer downgrades, such downgrades could adversely affect access to liquidity and could significantly increase our cost of funds, trigger additional collateral or funding
requirements, and decrease the number of commercial depositors, investors and counterparties willing to lend to us, thereby curtailing our business operations and reducing our ability to generate income.
Certain of our derivative instruments contain provisions that require us to maintain a specified credit rating. If our credit rating were to fall below the specified rating, the counterparties to these derivative instruments could terminate the contract and demand immediate payment or demand immediate and ongoing full overnight collateralization for those derivative instruments in net liability positions.
Adverse changes in the credit ratings of our parent companies, BTMU and MUFG, could also adversely impact our credit ratings.
We are subject to many types of operational risks throughout our organization. Operational risk is the potential loss from our operations due to factors, such as failures in internal control, systems failures or external events, that do not fall into the market risk or credit risk categories described in "Management's Discussion and Analysis of Financial Condition and Results of OperationsBusiness Segments." Operational risk includes execution risk related to operational initiatives, including implementation of our integrated banking platform, reputational risk, legal and compliance risk, the risk of fraud or theft by employees, customers or outsiders, unauthorized transactions by employees or operational errors, including clerical or record-keeping errors or those resulting from faulty or disabled computer or telecommunications systems. A discussion of risks associated with regulatory compliance appears above under the caption "The effects of changes in, or supervisory enforcement of, banking or other laws and regulations or governmental fiscal or monetary policies could adversely affect us."
We depend on the continued efficacy of our technical systems, operational infrastructure, relationships with third parties and our employees in our day-to-day and ongoing operations. Our dependence upon automated systems to record and process transactions may further increase the risk that technical system flaws or employee tampering or manipulation of those systems will result in losses that are difficult to detect. Failures in our internal control or operational systems could impair our ability to operate our business and result in potential liability to customers, reputational damage and regulatory intervention, any of which could harm our operating results and financial condition.
We may also be subject to disruptions of our operating systems arising from events that are wholly or partially beyond our control, such as computer hacking or viruses, electrical or telecommunications outages or unexpected difficulties with the implementation of our integrated banking platform, which may give rise to disruption of service to customers and to financial loss or liability. Our business recovery plan may not work as intended or may not prevent significant interruptions of our operations.
As a financial institution, our earnings and capital are subject to risks associated with negative public opinion. Negative public opinion could result from our actual or alleged conduct in any number of activities, including lending practices, the failure of any product or service sold by us to meet our customers' expectations or applicable regulatory requirements, governmental enforcement actions, corporate governance and acquisitions, or from actions taken by regulators and community organizations in response to those activities. We generally fund our operations independently of BTMU and MUFG and believe our business is not necessarily closely related to the business or outlook of BTMU or MUFG. However, negative public opinion could also result from regulatory concerns regarding, or supervisory or other governmental actions in the U.S. or Japan against, us or Union Bank, or BTMU or MUFG. Negative public opinion can adversely affect our ability to keep and attract and/or retain lending and deposit customers and employees and can expose us to litigation and regulatory action and increased liquidity risk. Actual or alleged conduct by one of our businesses can result in negative public opinion about our other businesses. Negative public opinion could also affect our credit
ratings, which are important for some commercial deposit customers and also to our access to unsecured wholesale or other borrowings; significant changes in these ratings could change the cost and availability of these sources of funding.
Our risk management framework is made up of various processes and strategies to manage our risk exposure. Types of risk to which we are subject include liquidity risk, credit risk, market risk, interest rate risk, operational risk, legal risk, compliance risk, reputation risk, fiduciary risk and private equity risk, among others. Our framework to manage risk, including the framework's underlying assumptions, may not be effective under all conditions and circumstances. If our risk management framework proves ineffective, we could suffer unexpected losses and could be materially adversely affected.
On November 4, 2008, we became a privately held company pursuant to the Agreement and Plan of Merger, dated as of August 18, 2008, by and among UnionBanCal, BTMU and Blue Jackets, Inc., a Delaware corporation and a wholly-owned subsidiary of BTMU. All of our issued and outstanding shares of common stock are now owned by MUFG through its wholly-owned subsidiary BTMU. As such, we would have been no longer required to file periodic reports with the SEC pursuant to the Securities Exchange Act of 1934 (the Exchange Act); however, we have elected to voluntarily register our common stock under the Exchange Act and for so long as we maintain that registration in effect we will be required to continue to file such periodic reports with the SEC in accordance with a reduced disclosure format permitted for certain wholly-owned subsidiaries.
Our disclosure controls and procedures are designed to provide reasonable assurance that information required to be disclosed by us in reports we file or submit under the Exchange Act is accumulated and communicated to management, and recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms. Any disclosure controls and procedures or internal controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met.
These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people or by an unauthorized override of the controls. Accordingly, because of the inherent limitations in our control system, misstatements due to error or fraud may occur and not be detected.
Item 2. Properties
At December 31, 2009, we operated 335 full service branches in California, 4 full service branches in Oregon and Washington, 1 branch in Texas and 2 foreign branches. We own the property occupied by 117 of the domestic offices and lease the remaining properties for periods of five to twenty years.
We own 2 administrative facilities in San Francisco, 2 in Los Angeles, and 3 in San Diego. Other administrative offices in Arizona, California, Illinois, Nevada, New York, Oregon, Virginia, Texas and Washington operate under leases expiring in one to twenty-six years.
Rental expense for branches and administrative premises is described in Note 6 to our Consolidated Financial Statements included in this Form 10-K Report.
Item 3. Legal Proceedings
We are subject to various pending and threatened legal actions that arise in the normal course of business. We maintain reserves for losses from legal actions that are both probable and estimable. In addition, we believe the disposition of all claims currently pending will not have a material adverse effect on our consolidated financial condition, operating results or liquidity.
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
On November 4, 2008 we became a wholly-owned subsidiary of BTMU and our common stock was delisted from the New York Stock Exchange. All of our issued and outstanding shares of common stock are now held by BTMU, and there is presently no established public trading market for our common stock.
For the period from January 1 through November 3, 2008, the average daily trading volume of our common stock was 1,550,976 shares. At November 3, 2008, our common stock closed at $73.48 per share. The following table presents stock quotations for the first three quarters in 2008 and the fourth quarter in 2008 through November 3, 2008.
The following table presents quarterly per share cash dividends declared for 2008.
See page F-1 of this Form 10-K Report.
See pages F-1 through F-51 of this Form 10-K Report.
See pages F-35 through F-39 of this Form 10-K Report.
See pages F-53 through F-136 of this Form 10-K Report.
Item 9A. Controls and Procedures
Disclosure Controls. Our Chief Executive Officer (principal executive officer) and Chief Financial Officer (principal financial officer) have concluded that the design and operation of our disclosure controls and procedures are effective as of December 31, 2009. This conclusion is based on an evaluation conducted under the supervision, and with the participation, of management. Disclosure controls and procedures are those controls and procedures which ensure that information required to be disclosed in this filing is accumulated and communicated to management and is recorded, processed, summarized and reported in a timely manner and in accordance with the SEC's rules and regulations.
Internal Controls Over Financial Reporting. Management's Report on Internal Control Over Financial Reporting regarding the effectiveness of internal controls over financial reporting is presented on page F-140. The Report of Independent Registered Public Accounting Firm is presented on page F-137. During the quarter ended December 31, 2009, there were no changes in our internal controls over financial reporting that materially affected, or are reasonably likely to affect, our internal controls over financial reporting.
Item 9B. Other Information
Item 10. Directors, Executive Officers and Corporate Governance
Certain information called for by this item has been omitted pursuant to General Instruction I(2) of Form 10-K.
Code of Ethics
We have adopted a Code of Ethics applicable to senior financial officers, including our Chief Executive Officer, Chief Financial Officer and Controller. A copy of this Code of Ethics is posted on our website. To the extent required by SEC rules, we intend to disclose promptly any amendment to, or waiver from any provision of, the Code of Ethics applicable to senior financial officers on our website. Our website address is www.unionbank.com.
Item 11. Executive Compensation
The information called for by this item has been omitted pursuant to General Instruction I(2) of Form 10-K.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
The information called for by this item has been omitted pursuant to General Instruction I(2) of Form 10-K.
Item 13. Certain Relationships and Related Transactions, and Director Independence
The information called for by this item has been omitted pursuant to General Instruction I(2) of Form 10-K.
Item 14. Principal Accountant Fees and Services
The following is a description of the fees billed to UnionBanCal by Deloitte & Touche LLP for each of the last two fiscal years. All fees for 2008 and 2009 were approved by our Audit & Finance Committee.
The Audit & Finance Committee also considered whether the provision of the services other than audit services is compatible with maintaining Deloitte & Touche LLP's independence. All of the services described above were approved by the Audit & Finance Committee in accordance with the following policy.
Pre-approval of Services by Deloitte & Touche LLP
The Audit & Finance Committee has adopted a policy for pre-approval of audit and permitted non-audit services by Deloitte & Touche LLP. The Audit & Finance Committee will consider annually and, if appropriate, approve the provision of audit services by its independent registered public accounting firm and consider and, if appropriate, pre-approve the provision of certain defined audit and non-audit services; provided, however, that:
The Audit & Finance Committee will also consider on a case-by-case basis and, if appropriate, approve, specific engagements that are not otherwise pre-approved.
Any proposed engagement that does not fit within the definition of a pre-approved service may be presented to the Audit & Finance Committee for consideration at its next regular meeting or, if earlier consideration is required, to the Audit & Finance Committee Chair. The Chair reports any specific approval of services at the Audit & Finance Committee's next regular meeting. The Audit & Finance Committee regularly reviews summary reports detailing all services being provided by its independent registered public accounting firm.
Item 15. Exhibits and Consolidated Financial Statement Schedules
(a)(1) Financial Statements
Our Consolidated Financial Statements, Management's Report on Internal Control Over Financial Reporting, and the Report of Independent Registered Public Accounting Firm are set forth on pages F-53 through F-140. (See index on page F-52).
(a)(2) Financial Statement Schedules
All schedules to our Consolidated Financial Statements are omitted because of the absence of the conditions under which they are required or because the required information is included in our Consolidated Financial Statements or accompanying notes.
Selected Financial Data
This report includes forward-looking statements, which include forecasts of our financial results and condition, expectations for our operations and business, and our assumptions for those forecasts and expectations. Do not rely unduly on forward-looking statements. Actual results might differ significantly from our forecasts and expectations. Please also refer to Part I, Item 1A "Risk Factors" for a discussion of some factors that may cause results to differ.
You should read the following discussion and analysis of our consolidated financial position and results of our operations for the years ended December 31, 2007, 2008 and 2009 together with our Consolidated Financial Statements and the Notes to Consolidated Financial Statements included in this Form 10-K Report. Averages, as presented in the following tables, are substantially all based upon daily average balances.
As used in this Form 10-K Report, the term "UnionBanCal" and terms such as "we," "us" and "our" refer to UnionBanCal Corporation, Union Bank, N.A., one or more of their consolidated subsidiaries, or to all of them together.
We are a California-based, financial holding company and bank holding company whose major subsidiary, Union Bank, N.A. (the Bank), is a commercial bank. We had consolidated assets of approximately $86 billion at December 31, 2009.
On November 4, 2008, we became a privately held company (privatization transaction). All of our issued and outstanding shares of common stock are owned by The Bank of Tokyo Mitsubishi UFJ, Ltd. (BTMU). Prior to the transaction, BTMU owned approximately 64 percent of our outstanding shares of common stock. For further information on UnionBanCal's privatization transaction, refer to Note 2 to our consolidated financial statements included in this Form 10-K report.
We are providing you with an overview of what we believe are the most significant factors and developments that impacted our 2009 results and that could impact our future results. Further detailed information can be found elsewhere in this Form 10-K Report. In addition, we ask that you carefully read this entire document and any other reports that we refer to in this Form 10-K Report for more detailed information that will assist your understanding of trends, events and uncertainties that impact us.
U.S. and global economies have experienced a serious recession, unprecedented volatility in the financial markets, and significant deterioration in sectors of the U.S consumer and business economy, all of which present challenges for the banking and financial services industry. Despite the continued uncertain economic environment, we generated significant deposit growth, as well as growth in net interest income.
In 2009, our average total loans grew 6 percent from 2008 to $49 billion. This growth was spread across residential real estate, construction, consumer and commercial real estate, due to increased loan demand and reduced competition.
During 2009, we provided $1,165 million for our allowances for credit losses compared to $550 million in 2008. The increase, which reflects weak economic conditions, was primarily attributable to higher criticized assets, especially in the commercial real estate portfolio, higher nonaccrual loans, increased uncertainty related to the timing and severity of losses to be realized in the commercial real estate portfolio and increases in loss factors related to several portfolio sectors, including our consumer and small business loan portfolios. We anticipate that the economic environment will remain weak and will result in further deterioration in our loan portfolio. See further discussion below in "Allowances for Credit Losses."
Our nonperforming assets totaled $437 million and $1.3 billion at December 31, 2008 and 2009, respectively. The increase in nonperforming assets was primarily due to higher nonaccrual loans in all categories, reflecting weak economic conditions, and a previously disclosed change in accounting policy for
residential and home equity loans 90 days or more past due, which accounted for $225 million of the increase. Net loans charged off were $499 million in 2009, compared to $170 million in 2008. The increase in net loans charged off was primarily due to higher commercial, financial, and industrial loan charge offs.
At December 31, 2008 and 2009, our allowances for credit losses as a percent of total loans were 1.74 percent and 3.25 percent, respectively. At December 31, 2008 and 2009, our allowances for credit losses as a percent of nonaccrual loans were 208 percent and 116 percent, respectively. At December 31, 2008 and 2009, our allowance for loan losses as a percent of total loans were 1.49 percent and 2.87 percent, respectively. At December 31, 2008 and 2009, our allowance for loan losses as a percent of nonaccrual loans were 178 percent and 103 percent, respectively.
In 2009, our average total deposits increased 31 percent to $56.6 billion compared to 2008. In 2009, our average noninterest bearing deposits increased 10 percent to $13.9 billion compared to 2008. In 2009, our average interest bearing deposits increased by 40 percent compared to 2008 to $42.7 billion. The increase reflects the results of targeted retail and corporate deposit-gathering marketing initiatives throughout Union Bank, including a new industry strategy targeting retail brokerage firm clients and other long standing industry markets, as well as significant growth in money market account deposits from state and local governments, and institutional escrow clients. Average noninterest bearing deposits represented 25 percent of average total deposits in 2009, compared to 29 percent in 2008. The annualized average all-in-cost of funds improved to 0.84 percent in 2009, compared to 1.72 percent in 2008.
In 2009, our net interest income (on a taxable-equivalent basis) increased 10 percent from 2008 to $2.3 billion, primarily due to lower rates paid on interest bearing liabilities, investment securities growth, and purchase price accounting accretions related to our privatization, partially offset by lower yields on earning assets. However, our net interest margin contracted 36 basis points compared to the same period last year, primarily as a result of a decrease in our interest rate spread (the difference between our earning assets yield and total interest bearing liabilities rate) attributable to a significant growth in lower yielding interest bearing deposits in banks, which was driven by our excess liquidity.
In 2009, our noninterest income declined 6 percent from 2008 to $727 million, primarily due to lower trust and investment management fees, lower gains from the sales and distributions from, as well as impairments on, private capital investments and prior year gains on the partial redemption of our Visa Inc. and MasterCard Inc. common stocks. These decreases were partially offset by gains on the sale of U.S. Treasury and mortgage-backed securities.
In 2009, our noninterest expense grew by 10 percent from 2008 to $2.1 billion. The increase was primarily due to higher intangible asset amortization related to the privatization transaction, higher regulatory agency fees, higher provision for credit losses on off-balance sheet commitments, and higher expenses related to our low income housing investments (LIHC).
Our effective tax rate, reflecting a tax benefit was (71) percent in 2009, compared to 31 percent in 2008. The change in the effective tax rate was primarily due to pre-tax income in the prior year compared to pre-tax loss in the current year, as well as the impact of tax credits and state income taxes.
On September 29, 2009, we received a $2.0 billion capital contribution from BTMU. The contribution was made to provide us with additional capital to offset potential future credit losses consistent with a highly adverse economic scenario. To the extent actual credit losses are lower than those that would be incurred in the highly adverse scenario, we will have excess capital that could be deployed to support incremental organic growth and acquisitions.
In the fourth quarter of 2008, we elected to participate in the voluntary Temporary Liquidity Guarantee (TLG) Program established by the FDIC in October 2008. Under the TLG Program, all senior unsecured debt issued by insured depository institutions between October 14, 2008 and October 31, 2009 with a maturity of more than 30 days was guaranteed by the FDIC. In the first quarter of 2009, the Bank issued $1.0 billion
principal amount of Senior Floating Rate Notes guaranteed through the TLG Program, which remained outstanding as of December 31, 2009.
In January 2010, President Obama announced his intention to propose a Financial Crisis Responsibility Fee that would be imposed on U.S. financial firms with more than $50 billion in consolidated assets, regardless of whether or not such firms were eligible to receive TARP funds. (As a wholly-owned subsidiary of a foreign bank, we were not eligible for TARP.) The fee is intended to repay the cost of TARP. The proposed fee will be assessed at approximately 15 basis points of covered liabilities per year. Covered liabilities are defined as an institution's assets minus Tier 1 capital and FDIC assessed deposits, with adjustments for insurance liabilities covered by state guarantee funds. We cannot predict whether this proposal will be enacted in its current form or at all.
The discussion of our financial results is based on results from continuing operations, unless otherwise stated.
UnionBanCal Corporation's consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (US GAAP) and the general practices of the banking industry. The financial information contained within our statements is, to a significant extent, financial information that is based on approximate measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability. In many instances, we use a discount factor and other assumptions to determine the fair value of assets and liabilities. A change in the discount factor or another important assumption could significantly increase or decrease the values of those assets and liabilities and result in either a beneficial or an adverse impact to our financial results. We use historical loss factors, adjusted for current conditions, to estimate the inherent credit loss present in our loan and lease portfolio. Actual losses could differ significantly from the loss factors that we use. Other significant estimates that we use include employee turnover factors for our pension obligation, fair value of certain derivatives and securities, expected useful lives of our depreciable assets and assumptions regarding our effective income tax rates.
We enter into derivative contracts to accommodate our customers and for our own risk management purposes. The derivative contracts are primarily swaps and option contracts indexed to energy commodities, interest rates or foreign currencies. We record these contracts at fair value. When readily available quoted market prices are unavailable, we must extrapolate or estimate a market price from available observable market data.
Our most significant estimates are approved by our Risk & Capital Committee, which is comprised of selected senior officers of the Bank. For each financial reporting period, a review of these estimates is presented to and discussed with the Audit & Finance Committee of our Board of Directors.
All of our significant accounting policies are identified in Note 1 to our Consolidated Financial Statements included in this Form 10-K Report. The following describes our most critical accounting policies and our basis for estimating the allowances for credit losses, pension obligations, income taxes, asset impairment, valuation of financial instruments, annual goodwill impairment and hedge accounting.
The allowances for credit losses, which consist of the allowances for loan and off-balance sheet commitment losses, are estimates of the losses that may be sustained in our loan and lease portfolio as well as for certain off-balance sheet commitments such as unfunded loan commitments, standby letters of credit, and commercial lines of credit that are not for sale. The allowances are based on two methods of accounting. The
first requires that losses be accrued for groups of loans when they are probable of occurring and estimable; the second requires that losses be accrued for individually impaired loans based on the difference between the value of collateral, present value of estimated future cash flows or price that is observable in the secondary market and the loan balance.
Our allowances for credit losses have four components: the formula allowance, the specific allowance, the unallocated allowance and the allowance for off-balance sheet commitments, which is included in other liabilities. Each of these components is determined based upon estimates that can and do change when the actual events occur. The formula allowance uses a model based, in part, on historical losses as an indicator of future losses and, as a result, could differ from the losses incurred in the future. This history is updated quarterly to include data that, in management's judgment, makes the historical data more relevant. Moreover, management adjusts the historical loss estimates for current conditions that would more accurately capture probable losses inherent in the portfolio. The specific allowance uses various techniques to arrive at an estimate of loss. Historical loss information, discounted cash flows, fair market value of collateral and secondary market information are all used to estimate those losses. The use of these values is inherently subjective and our actual losses could be greater or less than the estimates. The unallocated allowance is intended to capture losses that are attributable to various economic events, as well as to industry or geographic sectors, whose impact on the portfolio have occurred but have yet to be recognized in either the formula or specific allowances. Our allowance for off-balance sheet commitments is measured in approximately the same manner as the allowance for our loans but includes an estimate of likely utilization based upon historical data. At December 31, 2009, our allowance for loan losses was $1,357 million and our allowance for off-balance sheet commitments was $176 million, based upon our assessment of the probability of loss. For further information regarding our allowance for loan losses, see "Allowances for Credit Losses" in this Form 10-K Report.
Our pension obligations and related assets of our defined retirement benefit plan are presented in Note 9 to our Consolidated Financial Statements included in this Form 10-K Report. Plan assets, which consist primarily of marketable equity and debt instruments, are valued using quoted market prices. Plan obligations and the annual benefit expense are estimated by management utilizing actuarially based data and key assumptions. Key assumptions in measuring the plan obligations and determining the pension benefit expense are the discount rate, the rate of compensation increases, and the estimated future return on plan assets. Our discount rate is calculated using a yield curve based on Aa3 or better rated bonds. This yield curve is matched to the anticipated timing of the actuarially determined estimated pension benefit payments to determine the weighted average discount rate. Compensation increase assumptions are based upon historical experience and anticipated future management actions. Asset returns are based upon the anticipated average rate of earnings expected on the invested funds of the plan.
Our net actuarial losses (pretax) decreased $225 million between December 31, 2008 and 2009. Of the total $527 million of net actuarial loss at December 31, 2009, $234 million, which is the excess of the fair value of plan assets over the market-related value of plan assets, is recognized separately through the asset smoothing method over four years. Approximately $121 million will be subject to amortization over 9.6 years. The remaining $172 million is not currently subject to amortization. The cumulative net actuarial loss resulted primarily from differences between expected and actual rate of return on plan assets and the discount rate. Included in our 2010 net periodic pension cost will be $12.7 million of amortization related to net actuarial losses. We estimate that our total 2010 net periodic pension cost will be approximately $3.7 million, assuming $100 million in contributions in 2010. The primary reason for the decrease in net periodic pension cost for 2010 compared to $7 million in 2009 is a higher asset base resulting in higher expected return on assets and an increase in the discount rate from 5.75 percent to 6.25 percent. The 2010 estimate for net periodic pension cost was actuarially determined using a discount rate of 6.25 percent, an expected return on plan assets of 8.00 percent and an expected compensation increase assumption of 4.70 percent.
A 50 basis point increase in the discount rate, expected return on plan assets, or the rate of increase in future compensation levels would increase (decrease) 2010 periodic pension cost by ($13.4) million, ($9.1) million, and $3.9 million, respectively. A 50 basis point decrease in the discount rate, expected return on plan assets, or the rate of increase in future compensation levels would increase (decrease) 2010 periodic benefit cost by $14.8 million, $9.1 million, and ($3.7) million, respectively.
UnionBanCal and its subsidiaries are subject to the income tax laws of the United States, its states, and other jurisdictions where we conduct business. These laws are complex and subject to different interpretations. The calculation of our provision for income taxes and related accruals requires the use of estimates and judgment. Income tax expense includes our estimate of amounts to be reported in our income tax returns, as well as deferred taxes, which arise principally from temporary differences between the period in which certain income and expenses are recognized for financial accounting purposes and the period in which they are reported in our tax returns. Deferred tax assets are evaluated for realization based on the expectation of future events, including the reversal of existing temporary differences and our ability to earn future taxable income.
We provide reserves for unrecognized tax benefits in accordance with the guidance related to accounting for uncertainty in income taxes. In applying the accounting guidance, we consider the relative risks and merits of positions taken in tax returns filed and to be filed, considering statutory, judicial, and regulatory guidance applicable to those positions. The guidance requires us to make assumptions and judgments about potential outcomes that lie outside management's control. To the extent the tax authorities disagree with our conclusions, and depending on the final resolution of those disagreements, our effective tax rate may be materially affected in the period of final settlement with the tax authorities.
The State of California requires us to file our franchise tax returns as a member of a unitary group that includes MUFG and either all worldwide affiliates or only U.S. affiliates. Prior to 2009, we filed our California franchise tax returns on a worldwide unitary basis. We intend to make a water's-edge election for our 2009 California tax return, and we have reflected that election in our 2009 income tax expense. If a water's-edge election is made, it will be effective as of April 1, 2009, and MUFG's worldwide taxable profits (or losses) will be included in our California franchise tax return through March 31, 2009, MUFG's fiscal year-end. Changes in MUFG's taxable profits will impact our effective tax rate. MUFG's taxable profits are impacted most significantly by changes in the worldwide economy, and decisions that they may make about the timing of the recognition of credit losses or other matters. When MUFG's taxable profits rise, our effective tax rate in California will rise, and when they decrease, our rate will decrease. We review MUFG's financial information on a quarterly basis in order to determine the rate at which to recognize our California income taxes. However, all of the information relevant to determining the effective California tax rate may not be available until after the end of the period to which the tax relates, primarily due to the difference between our and MUFG's fiscal year-ends. Our California effective tax rate can change during the calendar year or between calendar years as additional information becomes available. If we understate our tax obligations we could be subject to penalties. Recent amendments to California tax law now impose an automatic 20 percent penalty for an understatement of tax in excess of $1 million for any taxable year beginning on or after January 1, 2003 for which the statute of limitations on assessment has not expired.
Valuation of Financial Instruments
Effective January 1, 2008, we adopted new accounting guidance related to all financial assets and liabilities measured and reported on a fair value basis. At adoption, there was no impact on our financial position or results of operations. For detailed information on our use of fair valuation of financial instruments and our related valuation methodologies, see Note 17 to our Consolidated Financial Statements included in this Form 10-K Report.
Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability (i.e., exit price) in an orderly transaction between market participants at the measurement date. In determining fair value, we utilize valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs. Observable inputs reflect market-derived or market-based information obtained from independent sources (e.g., interest rates, yield curves, foreign exchange rates, volatilities and credit curves), while unobservable inputs reflect our estimates of assumptions that would be considered by market participants. Valuation adjustments may be made to ensure the financial instruments are recorded at fair value. These adjustments include amounts that reflect counterparty credit quality and that consider our creditworthiness in determining the fair value of our trading liabilities.
Based on the observability of the inputs used in the valuation, we classify our financial assets and liabilities measured and disclosed at fair value within a three-level hierarchy (i.e., Level 1, Level 2 and Level 3). This hierarchy ranks the quality and reliability of the information used to determine fair values with Level 1 deemed most reliable and Level 3 having at least one significant unobservable input. The degree of management judgment required in measuring fair value increases with the higher level of measurement.
Included in the Level 3 category at December 31, 2008 are collateralized loan obligations (CLO), which are illiquid with limited market activity. These securities were transferred from securities available for sale to held to maturity in 2009. All of our CLO securities are known as "Cash Flow CLOs." A Cash Flow CLO is a structured finance product that securitizes a diversified pool of loan assets into multiple classes of notes from the cash flows generated by such loans. Cash Flow CLOs pay the note holders through the receipt of interest and principal repayments from the underlying loans unlike other types of CLOs that pay note holders through the trading and sale of underlying collateral. We estimate the fair value of our CLOs using a pricing model, as well as broker quotes. The model inputs are based on internally-developed assumptions, utilizing market data derived from market participants and credit rating agencies. These assumptions include, but are not limited to, estimated default rates, recovery rates, prepayment rates and reinvestment rates. The fair value of our CLOs increased by $0.3 billion from December 31, 2008 to $1.5 billion at December 31, 2009. Since no observable credit quality issues (i.e., no projected cash flow shortages) were present in our CLO portfolio at December 31, 2009, and we do not intend or it is not more likely than not that we will be required to sell the CLO securities before recovery, the securities were not other-than-temporarily impaired.
The following table reflects financial instruments measured at fair value on a recurring basis as of December 31, 2009.
We make estimates and assumptions when preparing our consolidated financial statements for which actual results will not be known for some time. This includes the recoverability of long-lived assets employed in our business, including those of acquired businesses.
On April 1, 2009, the Company adopted new accounting guidance related to the determination and recognition of other-than-temporary impairment related to debt securities. (FASB ASC 320-10, "InvestmentsDebt and Equity Securities"). The new guidance establishes new criteria for determining whether impairment is other-than-temporary and what portion of any such impairment is recognized in earnings. At adoption, there was no impact on our financial position or results of operations.
Debt securities available for sale and debt securities held to maturity are subject to impairment testing when a security's fair value is lower than its amortized cost. Debt securities with unrealized losses are considered other-than-temporarily impaired if we intend to sell the security, if it is more likely than not that we will be required to sell the security before recovery of its amortized cost basis, or if we do not expect to recover the entire amortized cost basis of the security. Any impairment on securities we intend, or are more likely than not required, to sell is recognized in earnings as the entire difference between the amortized cost and its fair value. Any impairment on securities we do not intend, or are not more likely than not required, to sell before recovery is separated into an amount representing the credit loss, which is recognized in earnings, and the amount related to all other factors, which is recognized in other comprehensive income. The credit loss is measured as the difference between the present value of expected cash flows, discounted using the security's effective interest rate, and the amortized cost of the security. During 2009, we recognized an insignificant amount of other-than-temporary impairment on two CLO securities.
Quarterly, we evaluate our private capital investments for impairment by reviewing the investee's business model, current and projected financial performance, liquidity and overall economic and market conditions. During 2009, we recognized an other-than-temporary impairment of $15.5 million for our private capital investment portfolio.
We review our goodwill for impairment on an annual basis, and whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. In testing for a potential impairment of goodwill, we estimate the fair value of goodwill allocated to our designated operating units and compare this value to the aggregate carrying value of goodwill for those operating units. At December 31, 2009, our goodwill balance was $2.4 billion.
Significant judgment is applied when goodwill is assessed for impairment. This judgment includes developing cash flow projections, selecting appropriate discount rates, identifying relevant market comparables, incorporating general economic and market conditions and selecting an appropriate control premium. Additionally, significant judgment is involved in determining if an indicator of impairment has occurred. Such indicators may include: a significant decline in expected future cash flows, a significant adverse change in the business climate, unanticipated competition and/or slower than expected growth rates.
The annual goodwill impairment test as of January 1, 2009 was performed during the first quarter of 2009, and no impairment was recognized.
During the second quarter of 2009, we changed the date of our annual goodwill impairment test from January 1 to April 1. The change was made to more closely align the impairment testing date with the testing date used by BTMU, as we became a wholly-owned subsidiary of BTMU in the fourth quarter of 2008.
The change in goodwill impairment testing date is deemed a change in accounting principle. Management believes that the change in accounting principle will not delay, accelerate, or avoid a goodwill impairment charge. Management determined that the change in accounting principle is preferable under the circumstances and does not result in adjustments to our financial statements when applied retrospectively.
In order to transition to the new annual goodwill impairment test date and to ensure that no more than twelve months elapse before the next annual goodwill impairment test is performed, goodwill impairment testing as of April 1, 2009 was performed during the second quarter of 2009. No impairment was recognized.
Due to the current uncertainties in the recessionary economic environment, there can be no assurance that our recent estimates relating to our recent goodwill impairment testing will prove to be accurate predictions of future circumstances. It is possible that we may be required to record charges relating to goodwill impairment losses in future periods either as a result of our annual impairment testing or upon the occurrence of other triggering events. Any changes relating to any such future impairment losses could be material.
In order to manage the risk of adverse changes in the fair value or cash flows of certain financial instruments (e.g., loans, debt and securities) associated with changes in interest rates, foreign currency exchange rates, or other factors, derivative instruments are acquired to mitigate such adverse changes that might occur in the future. Most of the derivative instruments acquired for this purpose qualify for hedge accounting treatment under generally accepted accounting principles.
The determination of whether a hedging relationship qualifies for hedge accounting requires judgment. For example, before hedge accounting can be applied, the hedging relationship must be expected to be highly effective, which involves an assessment of past results and future expectations. At the end of each reporting period, a retrospective assessment must be made as to whether the hedge was highly effective based on the
actual results for that period. The determination of changes in fair value of the hedged item attributable to the risk being hedged and the hedging instrument also may require judgment if quoted market prices or sufficient observable market data is unavailable. When a hedge is designated for a group of similar financial instruments, judgments must be made as to whether the individual items in that group share sufficient similar risks and characteristics to be hedged collectively.
If a derivative instrument is determined to no longer be highly effective as a designated hedge, hedge accounting is discontinued and the adjustment to the fair value of the derivative instrument would be recorded in earnings.
Summary of Financial Performance
The primary contributors to our financial performance for 2009 compared to 2008 are presented below.
The primary contributors to our financial performance for 2008 compared to 2007 are presented below.
The table below shows the major components of net interest income and net interest margin for the periods presented.
Net interest income in 2009, on a taxable-equivalent basis, increased 10 percent from 2008 and our net interest margin decreased by 36 basis points from 2008, primarily as a result of a decrease in our interest rate spread (the difference between our earning assets yield and total interest bearing liabilities rate) attributable to a significant growth in lower yielding interest bearing deposits in banks, which was driven by our excess liquidity. These results were primarily due to the following:
Net interest income in 2008, on a taxable-equivalent basis, increased 19 percent from 2007 and our net interest margin increased by 17 basis points. These results were primarily due to the following:
The following table shows the changes in the components of net interest income on a taxable-equivalent basis for 2007, 2008 and 2009. The changes in net interest income between periods have been reflected as attributable either to volume or to rate changes. For purposes of this table, changes that are not solely due to volume or rate changes are allocated to rate. Loan fees of $65 million, $82 million and $182 million for the years ended 2007, 2008 and 2009, respectively, are included in this table. Adjustments have not been made for interest received from a prior period.
The following tables detail our noninterest income and noninterest expense that exceeded 1 percent of our total revenues for the years ended December 31, 2007, 2008 and 2009.
nm = not meaningful
nm = not meaningful
A negative effective tax rate in the above table indicates a net income tax benefit.
The change in the effective tax rate in 2009 compared to 2008 was primarily due to pre-tax income in the prior year compared to pre-tax loss in the current year, as well as the impact of tax credits and state income taxes.
The lower effective tax rate in 2008 compared to 2007 was primarily due to the effect of higher tax credits and lower income before taxes.
We intend to make a water's-edge election for our 2009 California tax return, and we have reflected that election in our 2009 income tax expense. We filed our 2007 and 2008 California franchise tax returns on the worldwide unitary basis, incorporating the financial results of MUFG and its worldwide affiliates.
In the normal course of business, the tax returns of UnionBanCal and its subsidiaries are subject to review and examination by various tax authorities. In the course of its examination of our federal tax returns for the years 1998 through 2004, the IRS has disallowed the tax deductions claimed with respect to certain leveraged leasing transactions, referred to as "lease-in/lease-outs" (LILOs). We believe our tax treatment of these LILOs was consistent with applicable tax law, regulations and case law, and we intend to defend our position vigorously. We have paid the balance of tax and interest assessed, and have filed a refund suit in the Court of Federal Claims. A trial date has not yet been set.
Accounting for uncertain tax positions establishes a "more-likely-than-not" recognition threshold that must be met before a tax benefit can be recognized in the financial statements. For tax positions that meet the more-likely-than-not threshold, an enterprise should recognize the largest amount of tax benefit that is greater than 50 percent likely of being realized upon final settlement with the taxing authority. We recognized a $49.3 million reduction to the beginning balance of retained earnings upon adoption of the accounting guidance related to uncertain tax positions on January 1, 2007.
The amounts of unrecognized tax benefits at December 31, 2007, 2008 and 2009 were $137.7 million, $191.0 million and $201.7 million, respectively. Of these amounts, $53.1 million, $64.0 million and $71.0 million, respectively, would affect the effective tax rate, if recognized. Unrecognized tax benefits that do not affect the effective tax rate would result in adjustments to other income tax accounts, primarily deferred taxes. Accrued interest expense on unrecognized tax benefits at December 31, 2007, 2008 and 2009, was $10.5 million and $15.8 million and $0.6 million, respectively. The net changes to unrecognized tax benefits and accrued interest resulted in an increase in our effective tax rate of 0.1 percent in 2007, 3.5 percent in 2008 and 3.9 percent in 2009. The increases in 2008 and 2009 were due to the addition to our reserves for uncertain state income tax positions.
For additional information regarding income tax expense, including a reconciliation between the effective tax rate and the statutory tax rate and changes in unrecognized tax benefits, see Note 11 to our Consolidated Financial Statements included in this Form 10-K Report.
Our principal business activity is the extension of credit in the form of loans and credit substitutes to individuals and businesses. Our policies and applicable laws and regulations governing the extension of credit require risk analysis including an extensive evaluation of the purpose of the request and the borrower's ability and willingness to repay us as scheduled. Our evaluation also includes ongoing portfolio and credit management through portfolio diversification, lending limit constraints, credit review and approval policies, and extensive internal monitoring.
We manage and control credit risk through diversification of the portfolio by type of loan, industry concentration, dollar limits on multiple loans to the same borrower, geographic distribution and type of borrower. Geographic diversification of loans originated through our branch network is generally within California, Oregon, Washington and Texas, which we consider to be our principal markets. In addition, we originate and participate in lending activities outside these states, as well as internationally.
In analyzing our loan portfolios, we apply specific monitoring policies and procedures that vary according to the relative risk profile and other characteristics of the loans within the various portfolios. Our residential, consumer and certain small commercial loans and leases are relatively homogeneous and no single loan is individually significant in terms of its size or potential risk of loss. Therefore, we review these portfolios by analyzing their performance as a pool of loans. In contrast, our monitoring process for the larger commercial, financial and industrial, construction, commercial mortgage, leases, and foreign loan portfolios includes a periodic review of individual loans. Loans that are performing, but have shown some signs of weakness, are subjected to more stringent reporting and oversight. We review these loans to assess the ability of the borrowing entity to continue to service all of its interest and principal obligations and, as a result, may adjust the risk grade of the loan accordingly. In the event that we believe that full collection of principal and interest is not reasonably assured, the loan is appropriately downgraded and, if warranted, placed on nonaccrual status, even though the loan may be current as to principal and interest payments.
We have a Credit Risk Committee, chaired by the Chief Risk Officer and composed of the Chief Credit Officer for Corporate and Commercial Real Estate, the Chief Credit Officer for Retail Banking and other executive and senior officers, that establishes our overall risk appetite, portfolio concentration limits, and credit risk rating methodology. This committee is supported by the Credit Policy Forum, composed of Group Senior Credit Officers that have responsibility for establishing credit policy, credit underwriting criteria, and other risk management controls. Credit Administration, under the direction of the Chief Credit Officer and their designated Group Senior Credit Officers, are responsible for administering the credit approval process and related policies. Policies require an evaluation of credit requests and ongoing reviews of existing credits in order to verify that we know with whom we are doing business, that the purpose of the credit is acceptable, and that the borrower is able and willing to repay as agreed. Furthermore, policies require prompt identification and quantification of asset quality deterioration or potential loss.
Another part of the control process is the Independent Risk Monitoring Group for Credit (IRMG-Credit), which reports to the Audit & Finance Committee of the Board of Directors and provides both the Board of Directors and executive management with an independent assessment of the level of credit risk and the effectiveness of the credit management process. IRMG-Credit routinely reviews the accuracy and timeliness of risk grades assigned to individual borrowers with the goal of ensuring that the business unit credit risk identification process is functioning properly. This group also assesses compliance with credit policies and underwriting standards at the business unit level. Additionally, IRMG-Credit reviews and provides commentary on proposed changes to credit policies, practices and underwriting guidelines. IRMG-Credit summarizes its significant findings on a regular basis and provides recommendations for corrective action when credit management or control deficiencies are identified.
The following table shows loans outstanding by loan type and as a percentage of total loans for 2005 through 2009.
Commercial, financial and industrial loans represent one of the largest categories in the loan portfolio. These loans are extended principally to corporations, middle-market businesses and small businesses, with no industry concentration exceeding 10 percent of total loans.
Our commercial market lending originates primarily through our commercial banking offices. These offices, which rely extensively on relationship-oriented banking, provide a variety of services including cash management services, lines of credit, accounts receivable and inventory financing. Separately, we originate or participate in a wide variety of financial services to major corporations. These services include traditional commercial banking and specialized financing tailored to the needs of each customer's specific industry. We are active in, among other sectors, the oil and gas, communications, entertainment, healthcare, retailing, power and utilities and financial services industries.
The commercial, financial and industrial loan portfolio decreased from December 31, 2008 to December 31, 2009 mainly due to a decline in the utilization rate of revolving credit lines by existing customers, our aggressive and proactive portfolio management, our tighter underwriting standards, and a slight decline in loan demand in many sectors as a result of the difficult economic environment. However, average commercial financial and industrial loans for 2009 increased by $194 million to $17.2 billion.
We engage in real estate lending that includes commercial mortgage loans and construction loans secured by deeds of trust.
Construction loans are extended primarily to commercial property developers and to residential builders. As of December 31, 2009, the construction loan portfolio consisted of approximately 90 percent in the commercial income producing real estate industry and 10 percent with residential homebuilders. The construction loan portfolio decreased 12 percent from December 31, 2008 to December 31, 2009 due to the decline in the homebuilder portfolio which decreased by approximately 57 percent, or $316 million.
Additionally, operating conditions continue to weaken for our commercial property developers, and as a result, we continue to experience negative risk grade trends in the overall portfolio.
Geographically, the outstanding construction loan portfolio was concentrated 45 percent in California and 55 percent out of state as of December 31, 2009. The largest out of state concentration was 14 percent in Washington. The California outstandings are distributed as follows: 39 percent in the Los Angeles/Orange County region, including the Inland Empire, 26 percent in the San Francisco Bay Area, 16 percent in Sacramento and the Central Valley, 14 percent in San Diego, and 5 percent in the Central Coast region.
The commercial mortgage loan portfolio consists of loans secured by commercial income properties primarily in California. The commercial mortgage portfolio increased slightly from December 31, 2008 to December 31, 2009 due to continued moderate originations and a reduced rate of early loan repayments associated with the tightening of the credit markets.
We originate residential mortgage loans, secured by one-to-four family residential properties, through our multiple channel network (including branches, private bankers, mortgage brokers, and loan-by-phone) throughout California, Oregon and Washington, and we periodically purchase loans in our market area.
At December 31, 2009, 71 percent of our residential mortgage loans were interest only, none of which are negative amortizing. At origination, these interest only loans had relatively high credit scores and had weighted average loan-to-value (LTV) ratios of approximately 66 percent. The remainder of the portfolio consists of a small amount of balloon loans and regular amortizing loans.
We do not have a program for originating or purchasing subprime loan products. However, we have loan products that allow a customer to move more quickly through the loan origination process by reducing the need to verify the income or assets of the customer. We refer to these as Portfolio Express loans. Portfolio Express loans are only available to existing clients for no-cash-out/rate and term refinance of existing residential mortgages with the Bank and eliminate the verification of both income and assets but must pass a reasonability test. "Low doc" and "no doc" (discontinued in 2008) loans comprise less than half of our residential loan portfolio, and the delinquency rates relative to the outstanding balances at December 31, 2009 were slightly less than fully documented loans. At December 31, 2009, the total amount of "no doc" and "low doc" loans past due 30 days or more was $178.6 million, compared to $75.3 million at December 31, 2008. The total amount of residential mortgages delinquent 30 days or more was $367.3 million at December 31, 2009, compared to $172.3 million at December 31, 2008. Although delinquencies have risen since December 31, 2008 as a result of the declining real estate market and downturn in the economy, the delinquency rate remains low compared to the industry average for California prime loans. We believe that our underwriting standards remain conservative and as described above, programs with higher risk have been discontinued.
We hold most of the loans we originate. However, we sell some of our 30-year, fixed rate loans, except for the Community Reinvestment Act (CRA) qualifying loans.
We originate consumer loans, such as auto loans and home equity loans and lines, through our branch network, Private Banking Offices and via the internet. The increase in consumer loans from December 31, 2008 was primarily in our FlexEquity line/loan product. The FlexEquity line/loan allows our customers the flexibility to manage a line of credit with as many as four fixed rate loans under a single product. When customers convert all or a portion of their FlexEquity lines to fixed rate loans, these new loans are classified as installment loans. As a result of the continuing decline in the overall property values in California, we have reduced our maximum loan to value limits on all second trust deed programs we offer. At origination, these loans had relatively high credit scores and had weighted-average loan-to-value (LTV) ratios of approximately
60 percent. Our total home equity loans and lines delinquent 30 days or more were $39.4 million at December 31, 2009, compared to $28.3 million at December 31, 2008. Our annual review program reviews all equity secured lines with a commitment amount of $200,000 or more and an origination date between 2004-2008, and includes obtaining an updated credit report as well as an updated value on the property to reassess our LTV position. Action is taken to reduce or freeze limits, as applicable and pursuant to applicable laws and regulations, to minimize additional exposure in a declining market. In addition, to help mitigate the overall effect of the declining real estate market on new originations, we reduced by 5 percent the maximum LTV allowable for any owner or non owner occupied property valued over $250,000. The change was effective January 1, 2009.
We offer two types of leases to our customers: direct financing leases, where the assets leased are acquired without additional financing from other sources; and leveraged leases, where a substantial portion of the financing is provided by debt with no recourse to us. At December 31, 2009, we had leveraged leases of $549.0 million, which were net of non-recourse debt of approximately $1.1 billion. We utilize a number of special purpose entities for our leveraged leases. These entities do not function as vehicles to shift liabilities to other parties or to deconsolidate affiliates for financial reporting purposes. As allowed by US GAAP and by law, the gross lease receivable is offset by the qualifying non-recourse debt. In leveraged lease transactions, the third-party lender may only look to the collateral value of the leased assets for repayment.
Our cross-border outstandings reflect certain additional economic and political risks that are not reflected in domestic outstandings. These risks include those arising from exchange rate fluctuations and restrictions on the transfer of funds. The following table sets forth our cross-border outstandings as of December 31, 2008 and 2009 for Canada, the only country where such outstandings exceeded one percent of total assets. The cross-border outstandings were compiled based upon category and domicile of ultimate risk and are comprised of balances with banks, trading account assets, securities available for sale, securities purchased under resale agreements, loans, accrued interest receivable, acceptances outstanding and investments with foreign entities. For the country shown in the table below, any significant local currency outstandings are funded by local currency borrowings.
We recorded a provision for loan losses of $515 million and $1,114 million in 2008 and 2009, respectively. We recorded a provision for losses on off-balance sheet commitments of $35 million and $51 million in 2008 and 2009, respectively. The provisions for loan losses and for losses on off-balance sheet commitments are charged to income to bring our total allowances for credit losses to a level deemed appropriate by management based on the factors discussed under "Allowances for Credit Losses" below.
We maintain allowances for credit losses (defined as both the allowance for loan losses and the allowance for off-balance sheet commitment losses) to absorb losses inherent in the loan portfolio as well as for leases and off-balance sheet commitments. The allowances are based on our regular, quarterly assessments of the probable estimated losses inherent in the loan portfolio and unused commitments to provide financing. Our methodology for measuring the appropriate level of the allowances relies on several key elements, which include the formula allowance, the specific allowance for identified problem credit exposures, the unallocated allowance and the allowance for off-balance sheet commitments.
The formula allowance is calculated by applying loss factors to outstanding loans and certain unused commitments, in each case based on the internal risk grade of such loans, leases and commitments. Changes in risk grades affect the amount of the formula allowance. Loss factors are based on our historical loss experience and may be adjusted for significant factors that, in management's judgment, affect the collectibility of the portfolio as of the evaluation date. Loss factors are developed in the following ways:
We believe that an economic cycle is a period in which both upturns and downturns in the economy have been reflected. We calculate loss factors over a time interval that spans what we believe constitutes a complete and representative economic cycle.
Loan loss factors, which are used in determining our formula allowance, are adjusted quarterly primarily based upon the changes in the level of historical net charge offs and parameter updates by management. We estimate our probable losses inherent in the portfolio based on a loss confirmation period. The loss confirmation period is the estimated average period of time between a material adverse event affecting the creditworthiness of a borrower and the subsequent recognition of a loss. Based upon our evaluation process, we believe that, for our non-criticized, risk-graded loans, on average, losses are sustained approximately 10 quarters after an adverse event in the creditor's financial condition has taken place. For our criticized risk-graded loans, we measure the losses based upon the remaining life of the loan. See definition of criticized credits under "Changes in the Allocated (Formula and Specific) Allowances" in this section of our Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A). For pool-managed credits, the loss confirmation period is 4 quarters for all products.
Furthermore, based on management's judgment, our methodology permits adjustments to any loss factor used in the computation of the formula allowance for significant factors, which affect the collectibility of the portfolio as of the evaluation date, but are not reflected in the loss factors. By assessing the probable estimated losses inherent in the loan portfolio on a quarterly basis, we are able to adjust specific and inherent loss estimates based upon the most recent information that has become available. This includes changing the number of periods that are included in the calculation of the loss factors and adjusting qualitative factors to be representative of the economic cycle that we expect will impact the portfolio. Updates of the loss confirmation period are done when significant events cause us to reexamine our data.
A specific allowance is established in cases where management has identified significant conditions or circumstances related to a credit or a portfolio segment that management believes indicate the probability that a loss has been incurred. This amount may be determined either by a method prescribed by accounting
guidance related to accounting for an impairment of a loan or methods that include a range of probable outcomes based upon certain qualitative factors.
The unallocated allowance is composed of attribution factors, which are based upon management's evaluation of various conditions that are not directly measured in the determination of the formula and specific allowances. The conditions evaluated in connection with the unallocated allowance may include existing general economic and business conditions affecting the key lending areas, credit quality trends, collateral values, loan volumes and concentrations, specific industry conditions within portfolio segments, recent loss experience in particular segments of the portfolio, duration of the current business cycle, bank regulatory examination results and findings of our internal credit examiners. Although our assessments of these conditions are reviewed quarterly with our senior credit officers, there can be no assurance that the adverse impact of any of these conditions on us will not be in excess of our expectations.
The allowances for credit losses are based upon estimates of probable losses inherent in the loan portfolio and certain off-balance sheet commitments. The actual losses can vary from the estimated amounts. Our methodology includes several features that are intended to reduce the differences between estimated and actual losses. The loss migration model that is used to establish the loan loss factors for individually graded loans is designed to be self-correcting by taking into account our loss experience over prescribed periods. In addition, by basing the loan loss factors over a period reflective of an economic cycle, recent loss data that may not be reflective of prospective losses going forward will not have an undue influence on the calculated loss factors.
The following table reflects the related allowance for loan losses allocated to a loan category at the period end and percentage of the allocation to the period end loan balance of that loan category, as set forth in the "Loans" table on page F-19.
At December 31, 2007, 2008 and 2009, our total allowances for credit losses were 885 percent, 208 percent and 116 percent of total nonaccrual loans, respectively. At December 31, 2007, 2008 and 2009, our total allowances for loan losses were 723 percent, 178 percent and 103 percent of total nonaccrual loans, respectively.
In addition, the allowances incorporate the results of measuring impaired loans as provided in the accounting standards that prescribe the measurement methods, income recognition and disclosures related to impaired loans. At December 31, 2007, 2008 and 2009, total impaired loans were $56 million, $415 million and $1,317 million, respectively, and the associated impairment allowances were $11 million, $107 million and $223 million, respectively.
As a result of management's assessment of the relevant factors, including the credit quality of our loan portfolio, the negative impact from the economic slowdown on our lending portfolios (especially our commercial real estate portfolio) and changes in the composition of the loan portfolio, we recorded a provision for loan losses of $1,114 million in 2009, compared to $515 million in 2008.