UnionBanCal 10-Q 2011
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
For the transition period from to
Commission file number 1-15081
(Exact name of registrant as specified in its charter)
Registrants telephone number: (415) 765-2969
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 þ No o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 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 þ No o
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 Exchange Act). Yes o No þ
Number of shares of Common Stock outstanding at July 31, 2011: 136,330,829
THE REGISTRANT MEETS THE CONDITIONS SET FORTH IN GENERAL INSTRUCTION H (1) (a) AND (b) OF FORM 10-Q AND IS THEREFORE FILING THIS FORM WITH THE REDUCED DISCLOSURE FORMAT.
UnionBanCal Corporation and Subsidiaries
Table of Contents
This report includes forward-looking statements, which include expectations for our operations and business and our assumptions for those expectations. Do not rely unduly on forward-looking statements. Actual results might differ significantly compared to our expectations. See Part I, Item 1A. Risk Factors, in our 2010 Annual Report on Form 10-K, Part II, Item 1A. Risk Factors in this report, and the other risks described in this report and in our 2010 Annual Report on Form 10-K 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 known to our management 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 cause actual outcomes and 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 Item 1A Risk Factors of Part II and Item 2 Managements Discussion and Analysis of Financial Condition and Results of Operations of Part I of this Form 10-Q.
Readers of this document should not rely unduly on any forward-looking statements, which reflect only our managements belief as of the date of this report 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.
UnionBanCal Corporation and Subsidiaries
Consolidated Financial Highlights
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This report includes forward-looking statements, which include expectations for our operations and business and our assumptions for those expectations. Do not rely unduly on forward-looking statements. Actual results might differ significantly compared to our expectations. Please refer to Part II Item 1A Risk Factors of our Quarterly Report on Form 10-Q (this Form 10-Q) for a discussion of some factors that may cause results to differ.
Please refer to our Consolidated Financial Statements and the Notes to Consolidated Financial Statements included in our Annual Report on Form 10-K for the year ended December 31, 2010 (2010 Form 10-K) along with the following discussion and analysis of our consolidated financial condition and results of operations for the period ended June 30, 2011 in this Form 10-Q. Averages, as presented in the following tables, are substantially all based upon daily average balances.
As used in this Form 10-Q, the term UnionBanCal or the Company 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 commercial bank holding company whose major subsidiary, Union Bank, N.A. (the Bank), is a commercial bank. We provide 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. We had consolidated assets of $80.1 billion at June 30, 2011.
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 privatization transaction, BTMU owned approximately 64 percent of our outstanding shares of common stock.
We are providing you with an overview of what we believe are the most significant factors and developments that impacted our second quarter 2011 results and that could impact our future results. Further detailed information can be found elsewhere in this Form 10-Q. In addition, we ask that you carefully read this entire document and any other reports that we refer to in this Form 10-Q for more detailed information that will assist your understanding of trends, events and uncertainties that impact us.
Our sources of revenue are net interest income and noninterest income. Net interest income is generated predominantly from interest received from loans, investment securities and other interest-earning assets, less interest paid on deposits and borrowings. The primary sources of noninterest income are revenues from service charges on deposit accounts, trust and investment management fees, and trading account activities. Changes in interest rates, credit quality, economic trends and the capital markets are primary factors that impact our revenue sources. A summary of our key financial results are presented below:
In the second quarter of 2011, net income was $242 million, up from $154 million in the second quarter of 2010. The increase was primarily due to the reversal of provision for credit losses of $112 million in the second quarter of 2011 compared to a total provision for credit losses of $45 million in the second quarter of 2010. The decrease in the provision for credit losses was primarily due to improved credit quality of the loan portfolio reflected by the lower level of criticized and nonaccrual loans during the second quarter of 2011 compared to the second quarter of 2010, and due to lower loss factors. Our ratio of nonaccrual loans to total loans held for investment, excluding FDIC covered loans decreased from 2.86 percent at June 30, 2010 to 1.37 percent at June 30, 2011. See further discussion below under Allowance for Credit Losses.
Total revenue was comprised of 72 percent net interest income and 28 percent noninterest income for the second quarter of 2011. Our net interest income increased $13 million, or 2 percent, compared to the second quarter of 2010, to $614 million in the second quarter of 2011. The increase was due to growth in the net interest margin, partially offset by a decrease in average interest earning assets. Our net interest margin increased 33 basis points to 3.44 percent compared to the same period last year. The increase in net interest margin was primarily driven by a decrease in lower yielding interest bearing deposits in banks and by a higher yield on investment securities, partially offset by a lower yield on average total loans. Our average interest bearing deposits in banks decreased by 65 percent to $2.1 billion compared to the second quarter of 2010, reflecting the planned action to reduce lower yielding earning assets. As a result of our targeted rate reductions, our average interest bearing deposits decreased by 24 percent compared to the second quarter of 2010 to $40.4 billion. Average noninterest bearing deposits increased, representing 31 percent of average total deposits in the second quarter of 2011 compared to 22 percent in the second quarter of 2010.
Our net interest margin decreased 5 basis points to 3.44 percent in the second quarter of 2011 from 3.49 percent in the first quarter of 2011. This decrease was largely attributable to higher average rates paid on large time deposits, a higher average balance of lower-yielding interest bearing deposits in banks, and a higher proportion of borrowed funds within our interest bearing liabilities in the second quarter of 2011, compared to the first quarter of 2011. A higher average yield on our securities portfolio, reflecting our continued portfolio remix, and a higher average balance of noninterest bearing deposits, partially offset the decline in the margin.
In the second quarter of 2011, our noninterest income decreased $4 million, or 2 percent, from the second quarter of 2010 to $240 million, primarily due to a decrease in indemnification asset accretion and lower service charges on deposit accounts, reflecting lower overdraft volumes, partially offset by an increase in merchant banking fees. Our noninterest expense decreased $6 million, or 1 percent, to $578 million compared to the same period last year, primarily due to higher reversals for provision for losses on off-balance sheet loan commitments, lower regulatory assessment expense, and lower intangible asset amortization from the privatization transaction. These decreases were partially offset by higher base salaries, largely driven by the growth in the number of employees and higher benefit costs.
We continued to build capital during the first half of 2011. Our Tier 1 risk-based capital ratio increased to 13.08 percent from 12.44 percent, the total risk-based capital ratio increased to 15.41 percent from 15.01 percent and our tangible common equity ratio increased to 10.29 percent from 9.67 percent, at June 30, 2011 from December 31, 2010, respectively. The growth in our capital ratios was the result of strong internal capital generation.
UnionBanCal Corporations 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, which include management estimates and judgments. 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. For example, we use discount factors and other assumptions to determine the fair value of certain 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 the fair values of our acquired loans (see Note 5 in this Form 10-Q), FDIC indemnification asset, and certain derivatives and securities (see Notes 10 and 11 in this Form 10-Q), assumptions used in measuring our pension obligations, and assumptions regarding our effective income tax rates.
For each financial reporting period, our most significant estimates are presented to and discussed with the Audit & Finance Committee of our Board of Directors.
Understanding our accounting policies is fundamental to understanding our consolidated financial condition and consolidated results of operations. Accordingly, both our Critical Accounting Estimates and our significant accounting policies are discussed in detail in our 2010 Form 10-K filed with the SEC. There have been no material changes to these critical accounting estimates during the first half of 2011.
Net Interest Income
The following table shows the major components of net interest income and net interest margin.
Net interest income for the second quarter of 2011 increased $13 million, or 2 percent, compared to the second quarter of 2010. The increase was due to growth in the net interest margin, partially offset by a decrease in average interest earning assets. Our net interest margin in the second quarter of 2011 increased by 33 basis points, compared to the second quarter of 2010, to 3.44 percent. These results were primarily due to the following:
The following tables detail our noninterest income and noninterest expense for the three and six months ended June 30, 2011 and 2010.
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The primary contributors to the changes in our noninterest income and noninterest expense for the second quarter of 2011 compared to the second quarter of 2010 are presented below.
The decrease in our noninterest income was the result of several factors:
The decrease in our noninterest expense was the result of several factors:
The primary contributors to the changes in noninterest income and noninterest expense for the six months ended June 30, 2011 compared to the six months ended June 30, 2010 are presented below.
The increase in our noninterest income was the result of several factors:
The increase in our noninterest expense was the result of several factors:
Our card processing fees are substantially composed of debit card interchange fees. We expect our debit card interchange fees to decline beginning October 1, 2011 due to the Dodd-Frank Act and the recently enacted Federal Reserve final rule, which sets a cap on interchange fees at a rate below current levels. Management believes that the impact of these developments on our interchange fee income will not be material relative to our total revenue.
The core efficiency ratio, excluding the privatization transaction, is a non-GAAP financial measure that is used by management to measure the efficiency of our operations, focusing on those costs management believes to be most relevant to our core activities. The following table shows the calculation of this ratio for the three and six months ended June 30, 2011 and 2010.
Our effective tax rate in the second quarter of 2011 was 36 percent, compared to 31 percent for the second quarter of 2010. Our effective tax rate for the six months ended June 30, 2011 was 34 percent, compared to 27 percent for the six months ended June 30, 2010. The change in the effective tax rate was primarily due to higher income before taxes in the second quarter of 2011 as compared to 2010 and the proportionally lower benefit from our income tax credits, the amount of which remained consistent from year to year.
Our unrecognized tax benefits balance increased by $26 million to $259 million at June 30, 2011 from December 31, 2010, and the amount of unrecognized tax benefits that would affect the effective tax rate, if recognized, increased by $5 million. The increase in our unrecognized tax benefits balance relates to tax positions taken in prior periods.
For further information regarding income tax expense, see Managements Discussion and Analysis of Financial Condition and Results of Operations Income Tax Expense and Changes in our tax rates could affect our future results in Risk Factors in Part I, Item 1A and Note 12 to the consolidated financial statements in our 2010 Form 10-K.
Management of the securities portfolio involves the maximization of return while maintaining prudent levels of quality, market risk and liquidity. At June 30, 2011, approximately 95 percent of our securities, based upon amortized cost, were investment grade. The amortized cost, gross unrealized gains, gross unrealized losses and fair values of securities are detailed in Note 4 to our consolidated financial statements included in this Form 10-Q. Substantially all of our securities available for sale are held for Asset and Liability Management (ALM) purposes.
Our securities held to maturity consist of collateralized loan obligations (CLO) securities, which primarily consist of 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.
Loans Held for Investment
The following table shows loans held for investment outstanding by loan type at the end of each period presented.
Commercial and Industrial Loans
The commercial and industrial loan category is the second largest category in our loan portfolio. These loans are extended principally to corporations, middle-market businesses and small businesses. Our commercial market lending originates loans 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 variety of financial services to major corporations. These services include traditional commercial banking and specialized financing tailored to the needs of each customers specific industry. We are active in, among other sectors, power and utilities, oil and gas, manufacturing, wholesale trade, communications, entertainment, healthcare, retailing, and financial services. These industries comprise the majority of our commercial and industrial portfolio. While loans extended within these sectors comprise the majority of our commercial and industrial portfolio, no individual industry sector exceeded 10 percent of our total loans held for investment at either June 30, 2011 or December 31, 2010.
The commercial and industrial portfolio increased $692 million, or 5 percent, from December 31, 2010 to June 30, 2011, reflecting improved lending conditions. The overall credit quality of our portfolio of commercial
and industrial loans continues to improve as borrowers financial condition improves and as they have access to more refinancing options.
We engage in real estate lending that includes commercial mortgage loans and construction loans secured by deeds of trust. The commercial mortgage loan portfolio consists of loans secured by commercial income properties, 77 percent of which are located in California, 6 percent in Washington, and the remaining 17 percent in various other states. The commercial mortgage portfolio decreased 1 percent from December 31, 2010 to June 30, 2011 due primarily to disposition of problem loans, early repayments and normal loan paydowns, partially offset by new originations.
Construction loans are extended primarily to commercial property developers and to residential builders. As of June 30, 2011, the construction loan portfolio consisted of approximately 85 percent of commercial income producing real estate and 15 percent with residential homebuilders. The construction loan portfolio decreased 28 percent from December 31, 2010 to June 30, 2011 mainly due to declines of $358 million, or 29 percent, in the income property portfolio and $31 million, or 17 percent, in the homebuilder portfolio. The income property portfolio reductions were concentrated mostly in the office and apartment property types. Geographically, the outstanding construction loan portfolio was concentrated 42 percent in California and 58 percent out-of-state as of June 30, 2011. The largest out-of-state concentration was 13 percent in Washington. The California outstandings were distributed as follows: 51 percent in the Los Angeles/Orange County region, including the Inland Empire, 16 percent in the San Francisco Bay Area, 11 percent in Sacramento and the Central Valley, 11 percent in San Diego, and 11 percent in the Central Coast region.
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 telephone centers) throughout California, Oregon and Washington, and we periodically purchase loans in our market area. We hold substantially all of the loans we originate. The residential mortgage portfolio increased $1.1 billion, or 6 percent, from December 31, 2010 to June 30, 2011, as we experienced strong new origination activity.
At June 30, 2011, 73 percent of our residential mortgage loans were interest only, none of which are negative amortizing. At origination, these interest only loans had strong credit profiles and had weighted average loan-to-value (LTV) ratios of approximately 67 percent. The remainder of the portfolio consists of a small amount of balloon loans and regularly amortizing loans.
We do not have a program for originating or purchasing subprime loan products. The Banks no doc and low doc loan origination programs were discontinued in 2008, except for a streamlined refinance process for existing Bank mortgages. At June 30, 2011, the outstanding balances of the no doc and low doc portfolios were approximately 36 percent of our total residential loan portfolio, and the loan delinquency rates with respect to these portfolios remained low compared to the industry average for California prime loans. At June 30, 2011, the aggregate balance of no doc and low doc loans past due 30 days or more was $158 million, compared to $175 million at December 31, 2010.
Total residential mortgage loans 30 days or more delinquent were $352 million at June 30, 2011, compared to $350 million at December 31, 2010. Our residential loan delinquency rates have remained low when compared to the industry average for California prime loans.
Home Equity and Other Consumer Loans
We originate home equity and other consumer loans and lines, principally through our branch network and Private Banking Offices. Our total home equity loans and lines delinquent 30 days or more were $40 million at June 30, 2011, compared to $36 million at December 31, 2010. To manage risk associated with lending commitments, we review all equity-secured lines annually for creditworthiness and reduce or freeze limits, as permitted by laws and regulations.
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 June 30, 2011, we had leveraged leases of $538 million, which were net of non-recourse debt of approximately $868 million. 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 for leveraged leases, 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 in the event of lessee default.
FDIC Covered Loans
We acquired loans as part of the FDIC-assisted acquisitions of certain assets and assumption of certain liabilities of Frontier Bank (Frontier) and Tamalpais Bank (Tamalpais) during the second quarter of 2010. All of the acquired loans are covered under loss share agreements with the FDIC and are referred to as FDIC covered loans. We will be reimbursed for a substantial portion of any future losses on the FDIC covered loans under the terms of the FDIC loss share agreements. Total FDIC covered loans outstanding at June 30, 2011 were $1.2 billion, which consisted of $662 million of commercial mortgage loans, $332 million of commercial and industrial loans, $155 million of construction loans and $100 million of other loans. See Notes 1 and 2 to our consolidated financial statements included in our 2010 Form 10-K for more information on covered assets and FDIC loss share agreements.
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. Our total cross-border outstandings for Canada, the only country where such outstandings exceeded one percent of total assets, were $947 million and $804 million, as of June 30, 2011 and December 31, 2010, respectively. The cross-border outstandings are based on 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.
Allowance for Credit Losses
We maintain an allowance 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. Understanding our policies on the allowance for credit losses is fundamental to understanding our consolidated financial condition and consolidated results of operations. Accordingly, our significant policies and methodology on the allowance for credit losses are discussed in detail in Note 1 to our consolidated financial statements and in the section Allowances for Credit Losses included in our Managements Discussion and Analysis of Financial Condition and Results of Operations in our 2010 Form 10-K.
Total Allowances and Related Provision for Credit Losses
At June 30, 2011 and December 31, 2010, our total allowance for credit losses, excluding FDIC covered loans, was $940 million, or 1.97 percent of total loans held for investment, and $1.3 billion, or 2.85 percent of total loans held for investment, respectively. At June 30, 2011, our total allowance for credit losses, excluding FDIC covered loans, of $940 million consisted of $809 million for loan losses and $131 million for losses on off-balance sheet commitments, and was comprised of $757 million of allocated allowance and $183 million
of unallocated allowance. At June 30, 2011 and December 31, 2010, our allowance for loan losses on FDIC covered loans was $17 million and $25 million, respectively.
We recorded a reversal of the provision for loan losses, excluding FDIC covered loans, of $92 million in the second quarter of 2011, compared to a provision for loan losses of $44 million during the second quarter of 2010. In the second quarter of 2011, the reversal of the provision, excluding FDIC covered loans, was primarily attributable to the improved credit quality of the loan portfolio and lower loss factors. The improved credit quality of the loan portfolio was particularly evident in lower levels of criticized credits in the commercial segment, which declined from $3.4 billion at December 31, 2010 to $2.5 billion at June 30, 2011, continuing the significant downward trend that was observed during the second half of 2010. The ratio of nonaccrual loans to total loans held for investment, excluding FDIC covered loans, decreased to 1.37 percent at June 30, 2011 from 1.82 percent at December 31, 2010. In addition, annualized net loans charged off to average loans outstanding, excluding FDIC covered loans, for the second quarter of 2011 increased to 0.92 percent from 0.81 percent for the second quarter of 2010, primarily reflecting the charge-off of a single large lease financing credit, a majority of which had been reserved for in prior quarters.
At June 30, 2011, the allocated portion of the allowance for credit losses included $289 million related to criticized credits, compared to $468 million at December 31, 2010. Criticized credits are those that are internally risk graded as special mention, substandard or doubtful. Special mention credits are potentially weak, as the borrower has begun to exhibit deteriorating trends, which, if not corrected, could jeopardize repayment of the loan and result in further downgrade. Substandard credits have well-defined weaknesses, which, if not corrected, could jeopardize the full satisfaction of the debt. A credit classified as doubtful has critical weaknesses that make full collection improbable.
The unallocated allowance at June 30, 2011 and December 31, 2010 was $183 million and $298 million, respectively. The decrease from December 31, 2010 to June 30, 2011 was primarily due to several key factors, including improvement in our commercial mortgage and residential mortgage loan portfolios. The unallocated allowance balance continues to reflect the negative impact of persistent high unemployment (in particular in California), elevated foreclosure levels and extended collection periods for residential mortgage loans, the fiscal challenges for the State of California and local governments, the impact of volatile natural gas prices and crude oil prices on energy companies, and the impact of the recent natural disasters in Japan on our commercial and industrial loan portfolios.
Change in the Total Allowance for Credit Losses
The following table sets forth a reconciliation of changes in our allowance for credit losses.
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Nonperforming assets consist of nonaccrual loans, including restructured loans that are nonperforming and other real estate owned (OREO). Nonaccrual loans are those for which management has discontinued accrual of interest because there exists significant uncertainty as to the full and timely collection of either principal or interest or such loans have become contractually past due 90 days with respect to principal or interest. For a more detailed discussion of the accounting for nonaccrual loans, see Note 1 to our consolidated financial statements included in our 2010 Form 10-K.
OREO includes property where the Bank acquired title through foreclosure or deed in lieu of foreclosure.
The following table sets forth an analysis of nonperforming assets.
During the second quarters of 2011 and 2010, we sold nonperforming loans of $27 million and $129 million, respectively. During the six months ended June 30, 2011 and 2010, we sold nonperforming loans of $86 million and $163 million, respectively.
Troubled Debt Restructurings
Troubled debt restructurings (TDRs) are those loans for which we have granted a concession to a borrower experiencing financial difficulty and, consequently, we receive less than the current market-based compensation for loans with similar risk characteristics. Such loans are classified as impaired and are reviewed for specific reserves either individually or in pools with similar risk characteristics. Our loss mitigation strategies are designed to minimize economic loss and, at times, may result in changes to original terms, including maturity date extensions, loan-to-value requirements, and interest rates. These changes, and other actions, may cause the loan to be classified as a TDR. We evaluate whether these changes to the terms and conditions of our loans meet the TDR criteria after considering the specific situation of the borrower and all relevant facts and circumstances related to the modification. A TDR loan being considered for return to accrual status must have reasonable assurance of repayment and must be performing according to the modified terms and also be supported by a current well-documented credit evaluation under the modified terms. Generally, a minimum of six consecutive months of sustained performance is required in the evaluation of whether a TDR loan should be returned to accrual status.
Acquired loans restructured after acquisition are not considered TDRs for purposes of our accounting and disclosure if the loans evidenced credit deterioration as of the acquisition date and are accounted for in pools, in accordance with the accounting standards for purchased credit-impaired loans.
The following table provides a summary of total TDRs, including nonaccrual loans and loans that have been returned to accrual status, as of June 30, 2011 and December 31, 2010.
Loans held for investment 90 days or more past due and still accruing totaled $2 million at both June 30, 2011 and December 31, 2010. These amounts exclude $251 million and $312 million at June 30, 2011 and December 31, 2010, respectively, of FDIC covered loans accounted for in accordance with the accounting standards for purchased credit-impaired loans that were 90 days or more past due and still accruing.
The table below presents our deposits as of June 30, 2011 and December 31, 2010.
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The decline in money market balances was primarily driven by targeted rate reductions in conjunction with ongoing internal balance sheet management strategies. Factors driving growth in noninterest bearing deposits included availability of unlimited FDIC deposit insurance, the current low rate environment and ongoing business development activity. Customers have displayed a propensity to maintain higher noninterest bearing balances in the current prolonged low rate environment to obtain unlimited FDIC deposit insurance on eligible deposits.
Our exposure to market risk primarily exists in interest rate risk in our non-trading balance sheet and, to a much lesser degree, in price risk in our trading portfolio. The objective of market risk management is to mitigate any undue adverse impact on earnings and capital arising from changes in interest rates and other market variables. This risk management objective supports our broad objective of enhancing shareholder value, which encompasses stable earnings growth and capital stability over time.
The Board of Directors (Board), directly or through its appropriate committee, approves our Asset Liability Management Policy (ALM Policy), which governs the management of market and liquidity risks and guides our
investment, derivatives, trading and funding activities. The ALM Policy establishes the Banks risk tolerance guidelines by outlining standards for measuring market and liquidity risks, creates Board-level limits for specific market risks, establishes guidelines for reporting market and liquidity risk and requires independent review and oversight of market and liquidity risk activities.
The Risk & Capital Committee (RCC), composed of selected senior officers of the Bank, among other things, strives to ensure that the Bank has an effective process to identify, monitor, measure, and manage market risk as required by the ALM
Policy. The RCC provides the broad and strategic guidance of market risk management by defining the risk/return direction for the Bank, delegating to and reviewing market risk management activities of the Asset Liability Management Committee (ALCO) and by approving the investment, derivatives and trading policies that govern the Banks activities. ALCO, as authorized by the RCC, is responsible for the management of market risk and approves specific risk management programs including those related to interest rate hedging, investment securities, wholesale funding and trading activities.
The Treasurer is primarily responsible for the implementation of risk management strategies approved by ALCO and for operational management of market risk through the funding, investment and derivatives hedging activities of Corporate Treasury. The manager of the Global Capital Markets Group (GCMG) is responsible for managing price risk through the trading activities conducted in GCMG. The Market Risk Management (MRM) unit is responsible for the monitoring of market risk and functions independently of all operating and management units.
The Bank has separate and distinct methods for managing the market risk associated with our asset and liability management activities and our trading activities, as described below.
ALCO monitors interest rate risk monthly through a variety of modeling techniques that are used to quantify the sensitivity of Net Interest Income (NII) to changes in interest rates. (NII was previously referred to as Accounting NII in the full year 2010 and first quarter of 2011.) In managing interest rate risk, ALCO monitors NII sensitivity over various time horizons and in response to a variety of interest rate changes.
Our NII policy measurement typically involves a simulation of Earnings-at-Risk (EaR) in which we estimate the earnings impact of gradual parallel shifts in the yield curve of up and down 200 basis points over a 12-month horizon, given our projected balance sheet profile. Given the current and persistently low interest rate environment, the -200 basis point parallel scenario was replaced with a -100 basis point parallel scenario. Our EaR simulations use a 12-month projected balance sheet in order to model the impact of interest rate changes. Assumptions are made to model the future behavior of deposit rates and loan spreads based on statistical analysis, managements outlook and historical experience. The prepayment risks related to residential loans and mortgage-backed securities are measured using a calibrated third-party model that estimates prepayment speeds.
Earnings at Risk
The table below presents the estimated increase (decrease) in NII given a gradual parallel shift in the yield curve up 200 basis points and down 100 basis points over a 12-month horizon.
Generally, our short-term assets re-price faster than short-term non-maturity liabilities. As a result, higher short-term rates would improve NII. Alternatively, gradually lower short-term rates would contract NII. With
regard to the curve shape, curve steepening would improve NII while curve flattening would slightly decrease NII.
We believe that our EaR simulation provides management with a reasonably comprehensive view of the sensitivity of NII to changes in interest rates, over the measurement horizon. However, as with any financial model, the underlying assumptions are inherently uncertain and subject to refinement as modeling techniques and theory evolve. Actual and simulated NII will differ to the extent there are variances between actual and assumed interest rate changes, balance sheet volumes and management strategies, among other factors. Key underlying assumptions include prepayment speeds on mortgage-related assets, changes in market conditions, loan volume and pricing, deposit volume and price sensitivity, customer preferences and cash flows and maturities of derivative financial instruments.
During the first half of 2011, the Banks asset sensitive EaR profile increased largely due to changes in forecasted activity related to deposit composition, loan mix and a reduction of low yielding investments pending greater regulatory clarity on Basel III liquidity rules. In managing the interest rate sensitivity of our balance sheet, we use the ALM investment securities portfolio and derivatives positions as the primary tools to adjust our interest rate risk profile, if necessary.
At June 30, 2011 and December 31, 2010, our available for sale securities portfolio included $17.9 billion and $20.6 billion, respectively, of securities for ALM purposes. Our ALM securities portfolio consists of available for sale U.S. government, state and municipal, mortgage-backed securities, and asset-backed securities and has an expected weighted average maturity of 2.8 years. At June 30, 2011, approximately $5.0 billion of the portfolio was pledged to secure trust and public deposits and for other purposes as required or permitted by law. During the second quarter of 2011, we purchased $504 million and sold $1.8 billion of securities, as part of our investment portfolio strategy, while $979 million of ALM securities matured or were called.
Based on current prepayment projections, the estimated ALM securities portfolios effective duration was 1.87 at June 30, 2011, compared to 2.2 at December 31, 2010. Effective duration is a measure of price sensitivity of a bond portfolio to immediate parallel shifts in interest rates. An effective duration of 1.87 suggests an expected price decrease of approximately 1.87 percent for an immediate 1.0 percent parallel increase in interest rates.
During the first half of 2011, the ALM derivatives portfolio decreased by $350 million notional amount due to terminations of $1.0 billion in pay fixed rate swaps associated with issuance of fixed rate debt, partially offset by the addition of $650 million of pay fixed rate swaps to hedge additional debt issuances and variable rate borrowings.
The fair value of the ALM derivatives portfolio decreased primarily due to the erosion of time value on interest rate cap contracts, the negative impact of a decrease in interest rates on the majority of pay fixed rate interest rate swaps and as a result of the termination of pay fixed rate swaps in the first quarter of 2011. For additional discussion of derivative instruments and our hedging strategies, see Note 11 to our consolidated financial statements in this Form 10-Q and Note 18 to our consolidated financial statements included in our 2010 Form 10-K.
We enter into trading account activities primarily as a financial intermediary for customers and, to some extent, for our own account. By acting as a financial intermediary, we are able to provide our customers with access to a range of products supporting the securities, foreign exchange and derivatives markets. In acting for our own account, we may take positions in certain securities, foreign exchange and interest rate instruments, subject to various limits in amount, tenor and other respects, with the objective of generating trading profits.
We believe that the risks associated with these positions are conservatively managed. We utilize a combination of position limits, Value-at-Risk (VaR), and stop-loss limits, applied at an aggregated level and to various sub-components within those limits. Positions are controlled and reported both in notional and VaR terms. Our calculation of VaR estimates how high the loss in fair value might be, at a 99 percent confidence level, due to an adverse shift in market prices over a period of ten business days. VaR at the trading activity level is managed within the maximum limit of $14 million established by Board policy for total trading positions. The VaR model incorporates assumptions on key parameters, including holding period and historical volatility.
Consistent with our business strategy of focusing on the sale of capital markets products to customers, we manage our trading risk exposures at relatively low levels. Our foreign exchange business continues to derive the majority of its revenue from customer-related transactions. We take trading positions with other banks only on a limited basis and we do not take any large or long-term strategic positions in the market for our own portfolio. Similarly, we continue to generate most of our securities trading income from customer-related transactions.
As of June 30, 2011, we had $30.4 billion notional amount of interest rate derivative contracts. We enter into these agreements for customer accommodations and for our own account, accepting risks up to management approved VaR levels. As of June 30, 2011, we had $3.1 billion notional amount of foreign exchange derivative contracts. We enter into these agreements for customer accommodations to support their hedging and operating needs and for our own account, accepting risks up to management approved VaR levels. As of June 30, 2011, we had $4.9 billion notional amount of commodity derivative contracts. We enter into such contracts to satisfy the needs of our customers, and remove our exposure to market risk by entering into matching contracts with other counterparties. As of June 30, 2011, we had $2.1 billion notional amount of equity contracts representing our exposure to the embedded derivatives and the related hedges contained in our market-link CDs.
The following table provides the notional value and the fair value of our trading derivatives portfolio as of June 30, 2011 and December 31, 2010 and the change in fair value between June 30, 2011 and December 31, 2010.
Liquidity risk is the risk that the Banks financial condition or overall safety and soundness is adversely affected by an inability, or perceived inability, to meet its contractual obligations. The objective of liquidity risk management is to maintain a sufficient amount of liquidity and diversity of funding sources to allow the Bank to meet expected obligations in both stable and adverse conditions.
The management of liquidity risk is governed by the ALM Policy under the oversight of the RCC and the Audit & Finance Committee of the Board. ALCO oversees liquidity risk management activities. Corporate Treasury formulates the Banks liquidity and contingency planning strategies and is responsible for identifying, managing and reporting on liquidity risk. MRM which is part of the Enterprise Wide Risk Reporting and Analysis unit, partners with Corporate Treasury to establish sound policy and effective risk controls. RCC and ALCO also maintain a Contingency Funding Plan that identifies actions to be taken to help ensure adequate liquidity if an event should occur that disrupts or adversely affects the Banks normal funding activities.
Liquidity risk is managed using a total balance sheet perspective that analyzes all sources and uses of liquidity including loans, investments, deposits and borrowings, as well as off-balance sheet exposures. Management does not rely on any one source of liquidity and manages availability in response to changing balance sheet needs. Various tools are used to measure and monitor liquidity, including pro-forma forecasting of the sources and uses of cash flows over a 12-month time horizon, stress testing of the pro-forma forecast and assessment of the Banks capacity to raise incremental unsecured and secured funding. Stress testing, which incorporates both bank-specific and systemic market scenarios that would adversely affect the Banks liquidity position, facilitates the identification of appropriate remedial measures to help ensure that the Bank maintains adequate liquidity in adverse conditions. Such measures may include extending the maturity profile of liabilities, optimizing liability levels through pricing strategies, adding new funding sources, altering dependency on certain funding sources and/or selling assets.
Our primary sources of liquidity are core deposits (described below), our securities portfolio and wholesale funding. Wholesale funding includes unsecured funds raised from interbank and other sources, both domestic and international, including both senior and subordinated debt. Also included are secured funds raised by selling securities under repurchase agreements and by borrowing from the FHLB. We evaluate and monitor the
stability and reliability of our various funding sources to help ensure that we have sufficient liquidity in adverse circumstances. We generally view our core deposits to be relatively stable. Secured borrowings via repurchase agreements and advances from the FHLB are also recognized as highly reliable funding sources, and we, therefore, maintain these sources primarily to meet our contingency funding needs.
To support asset growth, wholesale funding increased by $2.9 billion from $9.9 billion at December 31, 2010 to $12.8 billion at June 30, 2011, more than offsetting the decline in deposit balances. Total deposits declined $2.8 billion from $60.0 billion at December 31, 2010 to $57.2 billion at June 30, 2011, largely due to planned interest bearing deposit declines resulting from targeted rate reductions.
Core deposits, which consist of total deposits excluding brokered deposits and time deposits of $100,000 and over, provide us with a sizable source of relatively stable and low-cost funds. At June 30, 2011, our core deposits totaled $46.4 billion and our total loan-to-total deposit ratio was 86 percent.
The Bank maintains a variety of other funding sources, secured and unsecured, which management believes will be adequate to meet the Banks liquidity needs, including the following:
We believe that these sources, in addition to our core deposits and equity capital, provide a stable funding base. As a result, we have not historically relied on BTMU for our funding needs.
Our costs and ability to raise funds in the capital markets are influenced by our credit ratings. Our credit ratings could be impacted by changes in the credit ratings of BTMU and MUFG. For further information, see The Bank of Tokyo Mitsubishi UFJs and Mitsubishi UFJ Financial Groups credit ratings and financial or regulatory condition could adversely affect our operations in Part II, Item 1A. Risk Factors of this Form 10-Q. The following table provides our credit ratings as of June 30, 2011.
The following tables summarize our risk-based capital, risk-weighted assets, and risk-based capital ratios.
Union Bank, N.A.
We and Union Bank are subject to various regulations of the federal banking agencies, including minimum capital requirements. We are both required to maintain minimum ratios of Total and Tier 1 capital to risk-weighted assets and of Tier 1 capital to quarterly average assets (the Leverage ratio). As of June 30, 2011, management believes the capital ratios of Union Bank met all regulatory requirements of well-capitalized institutions.
In addition to capital ratios determined in accordance with regulatory requirements, we consider various other measures when evaluating capital utilization and adequacy. These non-regulatory capital ratios are
viewed by management, and presented below, to further facilitate the understanding of our capital structure and for use in assessing and comparing the quality and composition of UNBCs capital structure to other financial institutions. These ratios are not defined by US GAAP or federal banking regulations. Therefore, these non-regulatory capital ratios disclosed are considered to be non-GAAP financial measures. Our tangible common equity ratio calculation methods may differ from those used by other financial services companies. Refer to Supervision and Regulation-Basel Committee Capital Standards in Part I, Item 1 of our 2010 Form 10-K for additional information regarding the Basel Committee capital standards.
The following table summarizes the calculation of our tangible common equity ratio and Tier 1 common capital ratio as of June 30, 2011 and December 31, 2010. The growth in our capital ratios was the result of strong internal capital generation.
We have three operating segments: Retail Banking Group, Corporate Banking Group and Pacific Rim Corporate Group. The Pacific Rim Corporate Group is included in Other. We have two reportable business segments: Retail Banking and Corporate Banking.
Unlike financial accounting, there is no authoritative body of guidance for management accounting equivalent to US GAAP. Consequently, reported results are not necessarily comparable with those presented by other companies, and they are not necessarily indicative of the results that would be reported by our business units if they were unique economic entities.
We reflect a market view perspective in measuring our business segments. The market view is a measurement of our customer markets aggregated to show all revenues generated and expenses incurred from all products and services sold to those customers regardless of where product areas organizationally report. Therefore, revenues and expenses are included in both the business segment that provides the service and the
business segment that manages the customer relationship. The duplicative results from this internal management accounting view are eliminated in Reconciling Items. The market view approach fosters cross-selling with a total profitability view of the products and services being managed.
The table that follows reflects the condensed income statements, selected average balance sheet items, and selected financial ratios, including changes from the prior year, for each of our reportable business segments. Business unit results are prepared using various management accounting methodologies to measure the performance of the individual units. Our management accounting methodologies, which are enhanced from time to time, measure segment profitability by assigning balance sheet and income statement items to each operating segment. Methodologies that are applied to the measurement of segment profitability include:
The reportable business segment results for the prior periods have been adjusted to reflect changes in the transfer pricing methodology that have occurred.