ITEM 1. BUSINESS
OVERVIEW
E*TRADE Financial Corporation is a financial services company that provides online brokerage and related products and services primarily to individual retail investors, under the brand “E*TRADE Financial.” Our products and services include investor-focused banking, primarily sweep deposits and savings products, and asset gathering. Our competitive strategy is to attract and retain customers by emphasizing low-cost, ease of use and innovation, with delivery of our products and services primarily through online and technology-intensive channels.
Our corporate offices are located at 135 East 57th Street, New York, New York 10022. We were incorporated in California in 1982 and reincorporated in Delaware in July 1996. We have approximately 3,400 employees. We operate directly and through numerous subsidiaries many of which are overseen by governmental and self-regulatory organizations. Our most significant subsidiaries are described below:
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E*TRADE Bank is a Federally chartered savings bank that provides investor-focused banking services to retail customers nationwide and deposit accounts insured by the Federal Deposit Insurance Corporation (“FDIC”);
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E*TRADE Capital Markets, LLC (“ETCM”) is a registered broker-dealer and market-maker;
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E*TRADE Clearing LLC is the clearing firm for our brokerage subsidiaries and is a wholly-owned operating subsidiary of E*TRADE Bank. Its main purpose is to transfer securities from one party to another; and
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E*TRADE Securities LLC is a registered broker-dealer and the primary provider of brokerage services to our customers.
A complete list of our subsidiaries can be found in Exhibit 21.1.
We provide services primarily to customers in the U.S. through our website at www.etrade.com. We also offer, either alone or with our partners, branded retail websites outside of the U.S. the most significant of which are: Denmark, Estonia, Finland, France, Germany, Hong Kong, Iceland, the Netherlands, Norway, Singapore, Sweden, the United Arab Emirates and the United Kingdom.
In addition to our websites, we also provide services through our network of customer service representatives, relationship managers and investment advisors. We provide these services over the phone or in person through our 29 E*TRADE Financial Centers. Information on our website is not a part of this report.
STRATEGY
Our strategy is to profitably grow our retail customer franchise and mitigate the risks associated with our balance sheet. We plan to grow our retail customer franchise by offering online brokerage and related products and services, including investor-focused banking and asset gathering products and services. We believe we can accomplish this growth by appealing to retail investors, especially customers of traditional brokerages, who are attracted to our low-cost, easy to use and innovative capabilities.
Our plan to mitigate the risks associated with our balance sheet contains three core goals: reduce credit risk in our loan portfolio, reduce our level of corporate debt and reduce operating expenses. We believe that the successful completion of this plan will significantly improve our financial strength.
We are also focused on simplifying and streamlining the business by exiting and/or restructuring certain non-core operations. We believe these changes will better align our business with the retail investor.
DISPOSITIONS AND EXIT ACTIVITIES
A key component of our strategy in 2008 was to exit and/or restructure certain non-core operations. We believe we made considerable progress toward achieving this long-term goal by selling our Canadian brokerage business, selling our equity shares in IL&FS Investsmart, Ltd.(1) (“Investsmart”) and exiting our retail mortgage lending business, which was our last remaining loan origination channel.
PRODUCTS AND SERVICES
We offer a wide range of products and services to assist our customers with their financial needs. Our primary retail products and services consist of:
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Brokerage-includes automated order placement and execution of U.S. and international equities, currencies, futures, options, exchange-traded funds, mutual funds and bonds. We also offer quick transfer, wireless account access, extended hours trading, quotes, research and advanced planning tools; and
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Banking-includes checking, savings, sweep, money market and certificates of deposit (“CD”) products that offer online bill pay, quick transfer, unlimited ATM transactions on eligible accounts and wireless account access.
Our institutional segment manages the balance sheet of the Company with a specific focus on managing credit risk. Our institutional segment also includes market-making activities which match buyers and sellers of securities from both the retail segment and unrelated third parties.
Retail
Our retail segment offers a full suite of financial products and services to retail customers including brokerage and banking products. The most significant of these products and services are as follows:
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automated order placement and execution of U.S. equities, futures, options, exchange-traded funds and bond orders;
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access to international equities in Canada, France, Germany, Hong Kong, Japan and the United Kingdom and foreign currencies, including the Canadian dollar, Euro, Hong Kong dollar, Yen and Sterling;
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two-second execution guarantee on all Standard & Poor’s (“S&P”) 500 stocks and exchange-traded funds;
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margin accounts allowing customers to borrow against their securities;
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access to over 7,000 non-proprietary mutual funds;
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educational services through the Internet, phone or in person and flexible advisory services, including full-service portfolio management;
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no fee and no minimum individual retirement accounts;
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FDIC-insured sweep deposit accounts that automatically transfer funds from customer brokerage accounts;
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interest-earning checking, money market, savings and CD products with FDIC insurance; and
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access to deposit account balances and transactions, through the Internet, phone or in person.
Retail customers are offered brokerage and banking products and services via our website, over the phone and in person. Customers have the ability to transfer funds quickly and easily among their brokerage and banking accounts, thereby giving them the opportunity to optimize the yield and liquidity of their funds.
(1) The equity shares of Investsmart were sold by our wholly-owned subsidiary, E*TRADE Mauritius.
In addition to the services above, our retail segment includes employee stock option management software and services which are provided to corporate customers. This software system facilitates the management of employee option plans, employee stock purchase plans and restricted stock plans, including necessary accounting and reporting functions. This business is a component of the retail segment since it serves as an introduction to E*TRADE for many retail customers who conduct equity option transactions as employees of our corporate customers, with our goal being that these individuals will also use our other products and services.
Institutional
The institutional segment includes the management of our balance sheet, focusing on asset allocation and managing credit, liquidity and interest rate risks. The retail segment originates margin receivables and customer deposits that are managed by the institutional segment.
Our institutional segment also includes market-making activities which match buyers and sellers of securities from both the retail segment and unrelated third parties. As a market maker, we take positions in securities and function as a wholesale trader by combining trading lots to match buyers and sellers of securities. Trading gains and losses result from these activities. Our revenues are influenced by overall trading volumes, the number of stocks for which we act as a market maker and the trading volumes and volatility of those specific stocks.
For additional statistical information regarding products and customers, see Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) beginning on page 22. Three years of segment financial performance and data can be found in the MD&A beginning on page 40 and in Note 24-Segment and Geographic Information of Item 8. Financial Statements and Supplementary Data beginning on page 149.
CUSTOMER SERVICE
We believe providing superior customer service is fundamental to our business. We strive to maintain a high standard of customer service by staffing the customer support team with appropriately trained personnel who are equipped to handle customer inquiries in a prompt yet thorough manner. Our customer service representatives utilize our proprietary web-based platform to provide customers with answers to their inquiries. We also have specialized customer service programs that are tailored to the needs of each customer segment.
We provide customer support through the following channels:
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Financial Centers-we have 29 Financial Centers located in the U.S. where retail customers can go to service any of their needs while receiving face to face customer support.
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Online-we have an online service center where customers can request services on their accounts and obtain answers to frequently asked questions. The online service center also provides customers with the ability to send a secure message to one of our customer service representatives.
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Telephonic-we have a toll free number that connects customers to an automated phone system which will help ensure that they are directed to the appropriate department for their inquiry. We have been improving the expertise within our customer service team as the vast majority of our customer service representatives now hold a Series 7 license.
TECHNOLOGY
We believe our focus on being a technological leader in the financial services industry enhances our competitive position. This focus allows us to deploy a secure, scalable technology and back office platform that promotes innovative product development and delivery. We continued to invest in these critical platforms in 2008 by delivering advanced mobile capabilities with our Mobile Pro for Blackberry® offering, and by making
numerous enhancements to our other advanced trading and research tools while still maintaining what we believe to be industry leading reliability and performance during unprecedented volatility in the marketplace.
COMPETITION
The online financial services market continues to evolve rapidly and we expect competition to continue to increase. Our retail segment competes with full commission brokerage firms, discount brokerage firms, online brokerage firms, Internet banks and traditional “brick & mortar” retail banks and thrifts. Some of these competitors also provide Internet trading and banking services, investment advisor services, touchtone telephone and voice response banking services, electronic bill payment services and a host of other financial products. Our institutional segment, in addition to the competitors above, competes with market-making firms, investment banking firms and other users of market liquidity in its quest for the least expensive source of funding.
Many of our competitors have longer operating histories and greater resources than we do and offer a wider range of financial products and services. Many also have greater name recognition, greater market acceptance and larger customer bases. In recent years, the financial services industry has become more concentrated, as companies involved in a broad range of financial services have been acquired, merged or have declared bankruptcy. During 2008, this trend accelerated considerably, as a significant number of U.S. financial institutions consolidated, were forced to merge, or received substantial government assistance. These developments could result in our remaining competitors having greater capital and other resources, such as the ability to offer a broader range of products and services.
We believe we can continue to attract customers by appealing to retail investors within large established financial institutions by providing them with low-cost, easy to use and innovative financial products and services. However, our exposure to the crisis in the residential real estate and credit markets has created some uncertainty surrounding the Company. These concerns, if not resolved, may make it more difficult to retain our current customer base as well as hinder our ability to attract new customers.
We also face intense competition in attracting and retaining qualified employees. Our ability to compete effectively in financial services will depend upon our ability to attract new employees and retain and motivate our existing employees while efficiently managing compensation related costs.
PERFORMANCE MEASUREMENT
We assess the performance of our business based on our primary customer segments, retail and institutional.
We consider multiple factors, including the competitiveness of our pricing compared to similar products and services in the market, the overall profitability of our businesses and customer relationships when pricing our various products and services. We manage the performance of our business using various customer activity and financial metrics, including daily average revenue trades (“DARTs”), net new customer assets, enterprise net interest spread, average enterprise interest-earning assets, nonperforming loans as a percentage of gross loans receivable, allowance for loan losses and allowance for loan losses as a percentage of nonperforming loans. The overall performance of our business is also based on the management of our expenses related to our various products and services. The same or similar products and services may be offered to both segments, utilizing the same infrastructure or in some circumstances, a single infrastructure may be used to support multiple products and services offered to our customers. As such, we do not separately disclose the costs associated with products and services sold or our general and administrative costs. All operating expenses incurred are integral to the operation of the business and are considered when evaluating the profitability of our business.
INTERNATIONAL OPERATIONS
We offer services in international markets directly through our website at www.etrade.com as well as through additional branded retail brokerage websites. During 2008, we sold our Canadian brokerage business and no longer offer brokerage services in Canada.
See Note 24-Segment and Geographic Information of Item 8. Financial Statements and Supplementary Data for detailed information on non-U.S. geographic locations.
REGULATION
Our business is subject to regulation by U.S. federal and state regulatory agencies and securities exchanges and by various non-U.S. governmental agencies or regulatory bodies, securities exchanges and central banks, each of which has been charged with the protection of the financial markets and the protection of the interests of those participating in those markets. In light of the current conditions in the global financial markets and the global economy, regulators have increased their focus on the regulation of the financial services industry. Substantial regulatory and legislative initiatives, including a comprehensive overhaul of the regulatory system in the U.S., is possible in future periods. Any such action could have a materially adverse effect on our business, financial condition and results of operations.
Our regulators in the U.S. include, among others, the Securities and Exchange Commission (“SEC”), the Financial Industry Regulatory Authority (“FINRA”), the New York Stock Exchange (“NYSE”), the National Association of Securities Dealers Automated Quotations (“NASDAQ”), the FDIC, the Federal Reserve, the Municipal Securities Rulemaking Board and the Office of Thrift Supervision (“OTS”). Additional legislation, regulations and rulemaking may directly affect our manner of operation and profitability. Our broker-dealers are registered with the SEC and are subject to regulation by the SEC and by self-regulatory organizations, such as the NYSE, the NASDAQ, FINRA and the securities exchanges of which each is a member, as well as various state regulators. Our banking entities are subject to regulation, supervision and examination by the OTS, the Federal Reserve and also, in the case of the Bank, the FDIC. Such regulation covers all aspects of the banking business, including lending practices, safeguarding deposits, capital structure, transactions with affiliates and conduct and qualifications of personnel. Our international broker-dealers are regulated by their respective local regulators such as the Financial Services Authority (“FSA”), and Securities & Futures Commission. For additional regulatory information, see Note 21-Regulatory Requirements of Item 8. Financial Statements and Supplementary Data beginning on page 143.
We make our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports, available free of charge at our website as soon as reasonably practicable after they have been filed with the SEC. Our website address is www.etrade.com.
ITEM 1A.
ITEM 1A. RISK FACTORS
Risks Relating to the Nature and Operation of Our Business
We have incurred significant losses and cannot assure that we will be profitable
We incurred a net loss of $511.8 million, or $1.00 loss per share, for the year ended December 31, 2008, due primarily to losses in our home equity portfolio. Although we have taken a significant number of steps to reduce our credit exposure, we likely will continue to suffer significant credit losses in 2009 and 2010. In late 2007, we experienced a substantial diminution of customer assets and accounts as a result of customer concerns regarding our credit related exposures. While we were able to stabilize and return our retail franchise to growth during 2008, it could take a significant amount of time to fully mitigate the credit issues in our loan portfolio and return to profitability.
We will continue to experience losses in our mortgage loan portfolio
At December 31, 2008, the principal balance of our home equity loan portfolio was $10.0 billion. During 2008, the allowance for loan losses in this portfolio increased by $374.7 million to $833.8 million, primarily due to a rapid deterioration in performance in the second half of 2007 and continuing into 2008. While losses on the one-to-four family loan portfolio are much smaller in scope than the losses on the home equity loan portfolio, and may be offset somewhat by the value of the real estate held upon foreclosure, the allowance for loan losses in this portfolio increased by $166.3 million to $185.1 million during 2008. As the crisis in the residential real estate and credit markets continues, we expect credit losses to continue at historically high levels. There can be no assurance that our provision for loan losses will be adequate if the residential real estate and credit markets continue to deteriorate beyond our expectations. We may be required under such circumstances to further increase our provision for loan losses, which could have an adverse effect on our regulatory capital position and our results of operations in future periods.
We could experience significant losses on other securities held on the balance sheet of E*TRADE Bank
At December 31, 2008, we held $920.5 million in amortized cost of collateralized mortgage obligations (“CMO”) on the consolidated balance sheet. While the majority of this portfolio remains AAA-rated, we incurred impairment charges of $95.0 million during 2008, which was a result of the deterioration in the expected credit performance of the underlying loans in the securities. In the event that these securities have a further decline in credit quality, this could result in additional impairment charges which would have an adverse effect on our regulatory capital position and our results of operations in future periods.
Losses of customers and assets could destabilize the Company or result in lower revenues in future periods
During November 2007, well-publicized concerns about the Bank’s holdings of asset-backed securities led to widespread concerns about our continued viability. From the beginning of this crisis through December 31, 2007 when the situation stabilized, customers withdrew approximately $5.6 billion of net cash and approximately $12.2 billion of net assets from our bank and brokerage businesses. Many of the accounts that were closed belonged to sophisticated and active customers with large cash and securities balances. While we were able to stabilize and return our retail franchise to growth in 2008, concerns about our viability may recur, which could lead to destabilization and asset and customer attrition. If such destabilization should occur, there can be no assurance that we will be able to successfully rebuild our franchise by reclaiming customers and growing assets. If we are not successful, our revenues and earnings in future periods will be lower than we have experienced historically.
We have a large amount of debt
We have issued a substantial amount of high-yield debt, with restrictive financial covenants, in connection with the Citadel Limited Partnership (“Citadel”) transaction in which we issued a total of approximately $2.1
billion of 12 1/2% springing lien notes in 2007 and 2008. The annual interest cost of these securities alone is approximately $257 million. Our total long-term debt is $3.2 billion and the expected annual interest cash outlay is approximately $342 million, $257 million of which we have the option to pay in the form of additional 12 1/2% springing lien notes through May 2010. Our ratio of debt (our senior debt and term loans) to equity (expressed as a percentage) was 106% at December 31, 2008. The degree to which we are leveraged could have important consequences, including (i) a substantial portion of our cash flow from operations is dedicated to the payment of principal and interest on our indebtedness, thereby reducing the funds available for other purposes; (ii) our ability to obtain additional financing for working capital, capital expenditures, acquisitions and other corporate needs is significantly limited; and (iii) our substantial leverage may place us at a competitive disadvantage, hinder our ability to adjust rapidly to changing market conditions and make us more vulnerable in the event of a further downturn in general economic conditions or our business. If regulatory requirements change in the future to impose capital ratios at the holding company level, we could be required to significantly restructure our capital position. In addition, a significant reduction in revenues could have a material adverse affect on our ability to meet our obligations under our debt securities.
We are subject to investigations and lawsuits as a result of our losses from mortgage loans and asset-backed securities
In 2007, we recognized an increased provision expense totaling $640 million and asset losses and impairments of $2.45 billion, including the sale of our asset-backed securities portfolio to Citadel. As a result, various plaintiffs filed class actions and derivative lawsuits, which have subsequently been consolidated into one class action and one derivative lawsuit, alleging disclosure violations regarding our home equity, mortgage and securities portfolios during 2007. In addition, the SEC initiated an informal inquiry into matters related to our loan and securities portfolios. The defense of these matters has and will continue to entail considerable cost and will be time-consuming for our management. Unfavorable outcomes in any of these matters could have a material adverse effect on our business, financial condition, results of operations and cash flows.
Many of our competitors have greater financial, technical, marketing and other resources
The financial services industry is highly competitive, with multiple industry participants competing for the same customers. Many of our competitors have longer operating histories and greater resources than we do and offer a wider range of financial products and services. Other of our competitors offer a more narrow range of financial products and services and have not been as susceptible to the disruptions in the credit markets that have impacted our Company, and therefore have not suffered the losses we have. The impact of competitors with superior name recognition, greater market acceptance, larger customer bases or stronger capital positions could adversely affect our revenue growth and customer retention. Our competitors may also be able to respond more quickly to new or changing opportunities and demands and withstand changing market conditions better than we can. Competitors may conduct extensive promotional activities, offering better terms, lower prices and/or different products and services or combination of products and services that could attract current E*TRADE customers and potentially result in price wars within the industry. Some of our competitors may also benefit from established relationships among themselves or with third parties enhancing their products and services.
The continuing turmoil in the global financial markets could reduce trade volumes and margin borrowing and increase our dependence on our more active customers who receive lower pricing
Online investing services to the retail customer, including trading and margin lending, account for a significant portion of our revenues. The continuing turmoil in the global financial markets could lead to changes in volume and price levels of securities and futures transactions which may, in turn, result in lower trading volumes and margin lending. In particular, a decrease in trading activity within our lower activity accounts or our accounts related to stock plan administration products and services would significantly impact revenues and increase dependence on more active trading customers who receive more favorable pricing based on their trade volume. A decrease in trading activity or securities prices would also typically be expected to result in a decrease
in margin borrowing, which would reduce the revenue that we generate from interest charged on margin borrowing. More broadly, any reduction in overall transaction volumes would likely result in lower revenues and may harm our operating results because many of our overhead costs are fixed.
We depend on payments from our subsidiaries
We depend on dividends, distributions and other payments from our subsidiaries to fund payments on our obligations, including our debt obligations. Regulatory and other legal restrictions may limit our ability to transfer funds to or from our subsidiaries. Many of our subsidiaries are subject to laws and regulations that authorize regulatory bodies to block or reduce the flow of funds to us, or that prohibit such transfers altogether in certain circumstances. These laws and regulations may hinder our ability to access funds that we may need to make payments on our obligations.
We rely heavily on technology, and technology can be subject to interruption and instability
We rely on technology, particularly the Internet, to conduct much of our activity. Our technology operations are vulnerable to disruptions from human error, natural disasters, power loss, computer viruses, spam attacks, unauthorized access and other similar events. Disruptions to or instability of our technology or external technology that allows our customers to use our products and services could harm our business and our reputation. In addition, technology systems, whether they be our own proprietary systems or the systems of third parties on whom we rely to conduct portions of our operations, are potentially vulnerable to security breaches and unauthorized usage. An actual or perceived breach of the security of our technology could harm our business and our reputation.
Vulnerability of our customers’ computers could lead to significant losses related to identity theft or other fraud and harm our reputation and financial performance
Because our business model relies heavily on our customers’ use of their own personal computers and the Internet, our business and reputation could be harmed by security breaches of our customers and third parties. Computer viruses and other attacks on our customers’ personal computer systems could create losses for our customers even without any breach in the security of our systems, and could thereby harm our business and our reputation. As part of our E*TRADE Complete Protection Guarantee, we reimburse our customers for losses caused by a breach of security of the customers’ own personal systems. Such reimbursements could have a material impact on our financial performance.
Downturns in the securities markets increase the credit risk associated with margin lending or stock loan transactions
We permit customers to purchase securities on margin. A downturn in securities markets may impact the value of collateral held in connection with margin receivables and may reduce its value below the amount borrowed, potentially creating collections issues with our margin receivables. In addition, we frequently borrow securities from and lend securities to other broker-dealers. Under regulatory guidelines, when we borrow or lend securities, we must generally simultaneously disburse or receive cash deposits. A sharp change in security market values may result in losses if counterparties to the borrowing and lending transactions fail to honor their commitments.
We may be unsuccessful in managing the effects of changes in interest rates and the enterprise interest-earning assets in our portfolio
Net operating interest income has become an increasingly important source of our revenue. Our ability to manage interest rate risk could impact our financial condition. Our results of operations depend, in part, on our level of net operating interest income and our effective management of the impact of changing interest rates and
varying asset and liability maturities. We use derivatives to help manage interest rate risk. However, the derivatives we utilize may not be completely effective at managing this risk and changes in market interest rates and the yield curve could reduce the value of our financial assets and reduce net operating interest income. Among other items, we periodically enter into repurchase agreements to support the funding and liquidity requirements of our Bank. Several market participants have reduced or terminated their participation in the repurchase agreement market. If we are unsuccessful in maintaining our relationships with counterparties, we could recognize substantial losses on the derivatives we utilized to hedge repurchase agreements.
If we do not successfully manage consolidation opportunities, we could be at a competitive disadvantage
There has recently been significant consolidation in the financial services industry and this consolidation is likely to continue in the future. Should we be excluded from or fail to take advantage of viable consolidation opportunities, our competitors may be able to capitalize on those opportunities and create greater scale and cost efficiencies to our detriment.
We have acquired a number of businesses and, although currently constrained by the terms of our corporate debt, may continue to acquire businesses in the future. The primary assets of these businesses are their customer accounts. Our retention of these assets and the customers of businesses we acquire may be impacted by our ability to successfully continue to integrate the acquired operations, products (including pricing) and personnel. Diversion of management attention from other business concerns could have a negative impact. In the event that we are not successful in our continued integration efforts, we may experience significant attrition in the acquired accounts or experience other issues that would prevent us from achieving the level of revenue enhancements and cost savings that we expect with respect to an acquisition.
Risks associated with principal trading transactions could result in trading losses
A majority of our market-making revenues are derived from trading as a principal. We may incur trading losses relating to the purchase, sale or short sale of securities for our own account, as well as trading losses in our market maker stocks. From time to time, we may have large positions in securities of a single issuer or issuers engaged in a specific industry. Sudden changes in the value of these positions could impact our financial results.
Reduced spreads in securities pricing, levels of trading activity and trading through market makers could harm our market maker business
Computer-generated buy/sell programs and other technological advances and regulatory changes in the marketplace may continue to tighten securities spreads. Tighter spreads could reduce revenue capture per share by our market maker, thus reducing revenues for this line of business.
Advisory services subject us to additional risks
We provide advisory services to investors to aid them in their decision making and also provide full service portfolio management. Investment decisions and suggestions are based on publicly available documents and communications with investors regarding investment preferences and risk tolerances. Publicly available documents may be inaccurate and misleading, resulting in recommendations or transactions that are inconsistent with the investors’ intended results. In addition, advisors may not understand investor needs or risk tolerances, failures that may result in the recommendation or purchase of a portfolio of assets that may not be suitable for the investor. To the extent that we fail to know our customers or improperly advise them, we could be found liable for losses suffered by such customers, which could harm our reputation and business.
Our international operations subject us to additional risks and regulation, which could impair our business growth
We conduct business in a number of international locations, sometimes through joint venture and/or licensee relationships. Action or inaction in any of these operations, including the failure to follow proper practices with respect to regulatory compliance and/or corporate governance, could harm our operations and/or our reputation.
We have a significant deferred tax asset and cannot assure it will be fully realized
We had net deferred tax assets of $1.0 billion as of December 31, 2008. We did not establish a valuation allowance against our federal net deferred tax assets as of December 31, 2008 as we believe that it is more likely than not that all of these assets will be realized. In evaluating the need for a valuation allowance, we estimated future taxable income based on management approved forecasts. This process required significant judgment by management about matters that are by nature uncertain. If future events differ significantly from our current forecasts, a valuation allowance may need to be established, which would have a material adverse effect on our results of operations, financial condition and our regulatory capital position at E*TRADE Bank. In addition, a significant portion of the net deferred tax asset relates to a $2.3 billion federal tax loss carryforward, the utilization of which may be further limited in the event of certain material changes in the ownership of the Company.
Risks Relating to the Regulation of Our Business
We are subject to extensive government regulation, including banking and securities rules and regulations, which could restrict our business practices
The securities and banking industries are subject to extensive regulation. All of our broker-dealer subsidiaries have to comply with many laws and rules, including rules relating to sales practices and the suitability of recommendations to customers, possession and control of customer funds and securities, margin lending, execution and settlement of transactions and anti money-laundering. We are also subject to additional laws and rules as a result of our market maker operations.
Similarly, E*TRADE Financial Corporation and ETB Holdings, Inc., as savings and loan holding companies, and E*TRADE Bank, E*TRADE Savings Bank and United Medical Bank, as federally chartered savings banks, are subject to extensive regulation, supervision and examination by the OTS and, in the case of the savings banks, also the FDIC. Such regulation covers all banking business, including lending practices, safeguarding deposits, capital structure, recordkeeping, transactions with affiliates and conduct and qualifications of personnel.
If we fail to comply with applicable securities and banking laws, rules and regulations, either domestically or internationally, we could be subject to disciplinary actions, damages, penalties or restrictions that could significantly harm our business
The SEC, FINRA and other self-regulatory organizations and state securities commissions, among other things, can censure, fine, issue cease-and-desist orders or suspend or expel a broker-dealer or any of its officers or employees. The OTS may take similar action with respect to our banking activities. Similarly, the attorneys general of each state could bring legal action on behalf of the citizens of the various states to ensure compliance with local laws. Regulatory agencies in countries outside of the U.S. have similar authority. The ability to comply with applicable laws and rules is dependent in part on the establishment and maintenance of a reasonable compliance system. The failure to establish and enforce reasonable compliance procedures, even if unintentional, could subject us to significant losses or disciplinary or other actions.
If we do not maintain the capital levels required by regulators, we may be fined or even forced out of business
The SEC, FINRA, OTS and various other regulatory agencies have stringent rules with respect to the maintenance of specific levels of net capital by securities broker-dealers and regulatory capital by banks. Net capital is the net worth of a broker or dealer (assets minus liabilities), less deductions for certain types of assets. Failure to maintain the required net capital could result in suspension or revocation of registration by the SEC and suspension or expulsion by FINRA, and could ultimately lead to the firm’s liquidation. In the past, our broker-dealer subsidiaries have depended largely on capital contributions by us in order to comply with net capital requirements. If such net capital rules are changed or expanded, or if there is an unusually large charge
against net capital, operations that require an intensive use of capital could be limited. Such operations may include investing activities, marketing and the financing of customer account balances. Also, our ability to withdraw capital from brokerage subsidiaries could be restricted, which in turn could limit our ability to repay debt and redeem or purchase shares of our outstanding stock.
Similarly, the Bank is subject to various regulatory capital requirements administered by the OTS. Failure to meet minimum capital requirements can trigger certain mandatory, and possibly additional discretionary actions by regulators that, if undertaken, could harm a bank’s operations and financial statements. A bank must meet specific capital guidelines that involve quantitative measures of a bank’s assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. A bank’s capital amounts and classification are also subject to qualitative judgments by the regulators about the strength of components of its capital, risk weightings of assets, off-balance sheet transactions and other factors.
Quantitative measures established by regulation to ensure capital adequacy require a bank to maintain minimum amounts and ratios of Total and Tier 1 Capital to Risk-weighted Assets and of Tier 1 Capital to adjusted total assets. To satisfy the capital requirements for a “well capitalized” financial institution, a bank must maintain higher Total and Tier 1 Capital to Risk-weighted Assets and Tier 1 Capital to adjusted total assets ratios.
As a non-grandfathered savings and loan holding company, we are subject to regulations that could restrict our ability to take advantage of certain business opportunities
We are required to file periodic reports with the OTS and are subject to examination by the OTS. The OTS also has certain types of enforcement powers over us, ETB Holdings, Inc. and certain of its subsidiaries, including the ability to issue cease-and-desist orders, force divestiture of the Bank and impose civil and monetary penalties for violations of federal banking laws and regulations or for unsafe or unsound banking practices. In addition, under the Gramm-Leach-Bliley Act, our activities are restricted to those that are financial in nature and certain real estate-related activities. We may make merchant banking investments in companies whose activities are not financial in nature if those investments are made for the purpose of appreciation and ultimate resale of the investment and we do not manage or operate the company. Such merchant banking investments may be subject to maximum holding periods and special recordkeeping and risk management requirements. In 2007, the Company moved its subsidiary, E*TRADE Clearing, LLC to become an operating subsidiary of E*TRADE Bank, resulting in increased regulatory oversight and restrictions on the activities of E*TRADE Clearing, LLC.
We believe all of our existing activities and investments are permissible under the Gramm-Leach-Bliley Act, but the OTS has not yet fully interpreted these provisions. Even if our existing activities and investments are permissible, we are unable to pursue future activities that are not financial in nature. We are also limited in our ability to invest in other savings and loan holding companies.
In addition, the Bank is subject to extensive regulation of its activities and investments, capitalization, community reinvestment, risk management policies and procedures and relationships with affiliated companies. Acquisitions of and mergers with other financial institutions, purchases of deposits and loan portfolios, the establishment of new Bank subsidiaries and the commencement of new activities by Bank subsidiaries require the prior approval of the OTS, and in some cases the FDIC, which may deny approval or limit the scope of our planned activity. These regulations and conditions could place us at a competitive disadvantage in an environment in which consolidation within the financial services industry is prevalent. Also, these regulations and conditions could affect our ability to realize synergies from future acquisitions, could negatively affect us following the acquisition and could also delay or prevent the development, introduction and marketing of new products and services.
Risks Relating to Owning Our Stock
We are substantially restricted by the terms of our corporate debt
In June 2004, we issued an aggregate principal amount of $400 million of senior notes due June 2011. In September and November 2005, we issued an additional aggregate principal amount of $100 million of senior notes due June 2011, $600 million of senior notes due September 2013 and $300 million of senior notes due December 2015. In November 2007 and January 2008, we issued a total of $2.1 billion of 12 1/2% springing lien notes due 2017. The indentures governing these notes contain various covenants and restrictions that limit our ability and certain of our subsidiaries’ ability to, among other things:
•
incur additional indebtedness;
•
create liens;
•
pay dividends or make other distributions;
•
repurchase or redeem capital stock;
•
make investments or other restricted payments;
•
enter into transactions with our stockholders or affiliates;
•
sell assets or shares of capital stock of our subsidiaries;
•
receive dividend or other payments from our subsidiaries; and
•
merge, consolidate or transfer substantially all of our assets.
As a result of the covenants and restrictions contained in the indentures, we are limited in how we conduct our business and we may be unable to raise additional debt or equity financing to compete effectively or to take advantage of new business opportunities. Each of these series of senior notes contain a limitation, subject to important exceptions, on our ability to incur additional debt if our Consolidated Fixed Charge Coverage Ratio is less than or equal to 2.50 to 1.0. As of December 31, 2008, our Consolidated Fixed Charge Coverage Ratio was (0.5) to 1.0. The terms of any future indebtedness could include more restrictive covenants.
We cannot assure that we will be able to remain in compliance with these covenants in the future and, if we fail to do so, that we will be able to obtain waivers from the appropriate parties and/or amend the covenants.
The interests of our largest shareholder may conflict with the interests of other shareholders
At December 31, 2008, Citadel owned approximately 89.4 million shares of our common stock, which represents approximately 16% of the outstanding shares. In addition, Citadel is our largest creditor through its ownership of approximately $2.1 billion of our corporate debt. Citadel is an independent entity with its own investors and is entitled to act in its own economic interest with respect to its equity and debt investments in E*TRADE. For example, following April 29, 2008, Citadel was generally free under the terms of the Investment Agreement to sell the equity securities it received under the Investment Agreement and any such sales may have a depressing effect on the trading price of our common stock. In addition, Citadel’s 12 1/2% springing lien notes contain restrictive covenants and as a holder of in excess of a majority of the springing lien notes, Citadel has a right to declare defaults and enforce remedies just like any other lender for so long as Citadel retains a majority of the springing lien notes. Finally, in pursuing its economic interests, Citadel may make decisions with respect to fundamental corporate transactions which may be different than the decisions of shareholders who own only common shares.
The market price of our common stock may continue to be volatile
From January 1, 2006 through December 31, 2008, the price per share of our common stock ranged from a low of $0.79 to a high of $27.76. The market price of our common stock has been, and is likely to continue to be, highly volatile and subject to wide fluctuations. In the past, volatility in the market price of a company’s
securities has often led to securities class action litigation. Such litigation could result in substantial costs to us and divert our attention and resources, which could harm our business. As discussed in Note 23-Commitments, Contingencies and Other Regulatory Matters in Item 8. Financial Statements and Supplementary Data, the Company is currently a party to litigation related to the decline in the market price of our stock, and such litigation could occur again in the future. Declines in the market price of our common stock or failure of the market price to increase could also harm our ability to retain key employees, reduce our access to capital and otherwise harm our business.
We may need additional funds in the future, which may not be available and which may result in dilution of the value of our common stock
In the future, we may need to raise additional funds via debt and/or equity instruments, which may not be available on favorable terms, if at all. If adequate funds are not available on acceptable terms, we may be unable to fund our plans for the growth of our business. In addition, if funds are available, the issuance of equity securities could significantly dilute the value of our shares of our common stock and cause the market price of our common stock to fall.
During the second half of 2008, the global financial markets were in turmoil and the equity and credit markets experienced extreme volatility, which caused already weak economic conditions to worsen. Continued turmoil in the global financial markets could further restrict our access to the public equity and debt markets.
In October 2008, we applied to participate in the Troubled Asset Relief Program (“TARP”) Capital Purchase Program established under the Emergency Economic Stabilization Act of 2008. To date, our application has not been approved or rejected. If our application is approved, the acceptance of this funding by us would result in significant dilution to the holders of our common stock as the terms of this program would require us to issue equity instruments to the federal government. In addition, the approval would likely be conditional upon additional capital raising activities by us, including possible transactions with existing security holders, which likely would result in further substantial dilution to the holders of our common stock. We expect that our participation in the TARP program will require bondholder consent and any additional capital raising activities may require stockholder approval. No assurance can be given that our TARP application will be approved or that we will receive bondholder consent or stockholder approval, if required. Recent announcements by the U.S. Treasury have indicated that there will be changes to the program going forward, and our application may be approved under a program with different terms than those of the current Capital Purchase Program. If our application is not approved, customers could view this as a negative assessment of our viability, which could in turn lead to destabilization and asset and customer attrition.
We have various mechanisms in place that may discourage takeover attempts
Certain provisions of our certificate of incorporation and bylaws may discourage, delay or prevent a third party from acquiring control of us in a merger, acquisition or similar transaction that a shareholder may consider favorable. Such provisions include:
•
authorization for the issuance of “blank check” preferred stock;
•
provision for a classified Board of Directors (“Board”) with staggered, three-year terms;
•
the prohibition of cumulative voting in the election of directors;
•
a super-majority voting requirement to effect business combinations or certain amendments to our certificate of incorporation and bylaws;
•
limits on the persons who may call special meetings of shareholders;
•
the prohibition of shareholder action by written consent; and
•
advance notice requirements for nominations to the Board or for proposing matters that can be acted on by shareholders at shareholder meetings.
Attempts to acquire control of the Company may also be delayed or prevented by our stockholder rights plan, which is designed to enhance the ability of our Board to protect shareholders against unsolicited attempts to acquire control of the Company that do not offer an adequate price to all shareholders or are otherwise not in the best interests of the Company and our shareholders. In addition, certain provisions of our stock incentive plans, management retention and employment agreements (including severance payments and stock option acceleration), and Delaware law may also discourage, delay or prevent someone from acquiring or merging with us.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None.
ITEM 2.
ITEM 2. PROPERTIES
A summary of our significant locations at December 31, 2008 is shown in the following table. All facilities are leased, except for 165,000 square feet of our office in Alpharetta, Georgia. Square footage amounts are net of space that has been sublet or part of a facility restructuring.
All of our facilities are used by either our retail or institutional segments. All other leased facilities with space of less than 25,000 square feet are not listed by location. In addition to the significant facilities above, we also lease all of our 29 E*TRADE Financial Centers, ranging in space from approximately 2,500 to 13,000 square feet. We believe our facilities space is adequate to meet our needs in 2009.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
On October 27, 2000, a complaint was filed in the Superior Court for the State of California, County of Santa Clara, entitled, “Ajaxo, Inc., a Delaware corporation, Plaintiff, versus E*TRADE GROUP, INC., a Delaware corporation; and Everypath, Inc., a California corporation; and Does 1 through 50, inclusively, Defendants.” Through this complaint, Ajaxo sought damages and certain non-monetary relief for the Company’s alleged breach of a non-disclosure agreement with Ajaxo pertaining to certain wireless technology offered to the Company by Ajaxo as well as damages and other relief against both the Company and defendant Everypath, Inc., for their alleged misappropriation of Ajaxo’s trade secrets. Following a jury trial, a judgment was entered in 2003 in favor of Ajaxo against the Company for $1.3 million dollars for breach of the Ajaxo non-disclosure agreement. Although the jury also found in favor of Ajaxo on its misappropriation of trade secrets claim against the Company and defendant Everypath, the trial court subsequently denied Ajaxo’s requests for additional damages and relief on these claims. Thereafter, all parties appealed, and on December 21, 2005, the California Court of Appeal affirmed the above-described award against the Company for breach of the nondisclosure agreement but remanded the case to the trial court for the limited purpose of determining what, if any, additional damages Ajaxo may be entitled to as a result of the jury’s previous finding in favor of Ajaxo on its misappropriation of trade secrets claim against the Company and defendant Everypath. Following the foregoing ruling by the Court of Appeal, defendant Everypath ceased operations and made an assignment for the benefit of its creditors in January, 2006. As a result, defendant Everypath is no longer defending the case. Although the Company paid Ajaxo the full amount due on the judgment against it above, the case, consistent with the rulings issued by the Court of Appeal, was remanded back to the trial court, and on May 30, 2008, a jury returned a verdict in favor of E*TRADE denying all claims raised and demands for damages against the Company by Ajaxo. Following the
trial court’s filing on September 5, 2008, of entry of judgment in favor of E*TRADE, Ajaxo filed post trial motions asking the trial court to grant a new trial and to vacate its September 5, 2008, entry of judgment in favor of the Company. By order dated November 4, 2008, the court denied these motions, and on December 2, 2008, Ajaxo filed its notice of appeal.
On October 2, 2007, a class action complaint alleging violations of the federal securities laws was filed in the United States District Court for the Southern District of New York against the Company and its then Chief Executive Officer and Chief Financial Officer entitled, “Larry Freudenberg, Individually and on Behalf of All Others Similarly Situated, Plaintiff, versus E*TRADE Financial Corporation, Mitchell H. Caplan and Robert J. Simmons, Defendants.” By order dated July 17, 2008, the trial court consolidated the Freudenberg action with four other purported class actions, all of which were filed in the United States District Court for the Southern District of New York and which were based on the same facts and circumstances as the Freudenberg action. By the same July 17, 2008 order, the trial court appointed the “Kristen-Straxton Group” and Ira Newman co-lead plaintiffs and Brower Piven and Levi & Korsinski, respectively, as lead and co-lead plaintiffs’ counsel. Thereafter, on January 16, 2009, Plaintiffs served their “Consolidated Amended Class Action Complaint for Violations of the Federal Securities Laws.” In their amended complaint, Plaintiffs again name the Company’s former chief executive and financial officers as defendants as well as Dennis Webb, the Company’s former Capital Markets Division President. In their amended complaint, Plaintiffs allege causes of action for violations of Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”) and Rule 10b-5 against all defendants; and violations of Section 20(a) of the Exchange Act against the individual defendants. In specific, Plaintiffs contend, among other things, that the value of E*TRADE’s stock between April 19, 2006, and November 9, 2007, (the “class period”) was artificially inflated because defendants, among other things, issued materially false and misleading statements and failed to disclose that the Company was experiencing a rise in delinquency rates in its mortgage and home equity portfolios; failed to timely record an impairment on its mortgage and home equity portfolios; materially overvalued its securities portfolio, which includes assets backed by mortgages; and based on the foregoing, lacked a reasonable basis for the positive statements it made about the Company’s earnings and prospects. Plaintiffs seek to recover damages in an amount to be proven at trial, including interest and attorneys’ fees and costs. By prior order of the court, Defendants are to file their motion to dismiss by April 2, 2009; and all parties are to complete briefing on Defendants’ motion to dismiss by August 17, 2009. The Company intends to vigorously defend itself against these claims.
On August 15, 2008, an action entitled, “Ronald M. Tate, Trustee of the Ronald M. Tate Trust Dtd 4/13/88, and George Avakian, an Individual, Plaintiffs, versus E*TRADE Financial Corporation, Mitchell H. Caplan, an Individual, and Robert J. Simmons, an Individual, Defendants” was filed in the United States District Court for the Southern District of New York. The Tate action is based on the same facts and circumstances, and contains the same claims, as the Freudenberg consolidated actions discussed above. By agreement of the parties and approval of the court, the Tate action has been consolidated with the Freudenberg consolidated actions for the purpose of pre-trial discovery.
Based upon the same facts and circumstances alleged in the Freudenberg class action complaint above, a verified shareholder derivative complaint was filed in United States District Court for the Southern District of New York on October 4, 2007, against the Company’s then Chief Executive Officer, President/Chief Operating Officer, Chief Financial Officer and individual members of its board of directors entitled, “Catherine Rubery, Derivatively on behalf of E*TRADE Financial Corporation, Plaintiff, versus Mitchell H. Caplan, R. Jarrett Lilien, Robert J. Simmons, George A. Hayter, Daryl Brewster, Ronald D. Fisher, Michael K. Parks, C. Catherine Raffaeli, Lewis E. Randall, Donna L. Weaver, and Stephen H. Willard, Defendants, -and- E*TRADE Financial Corporation, a Delaware corporation, Nominal Defendant.” Plaintiff alleges, among other things, causes of action for breach of fiduciary duty, waste of corporate assets, unjust enrichment, and violation of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. The above shareholder derivative complaint has been consolidated with another shareholder derivative complaint brought in the same court and against the same named defendants entitled, “Marilyn Clark, Derivatively On Behalf of E*TRADE Financial Corporation, Plaintiff, versus Mitchell H. Caplan, et al., Defendants” (collectively, with the Rubery case, the “federal derivative actions”). Three similar derivative actions, based on the same facts and circumstances as the federal
derivative actions but alleging exclusively state causes of action, have been filed in the Supreme Court of the State of New York, New York County. These three cases have been ordered consolidated in that court under the caption “In re: E*Trade Financial Corporation Derivative Litigation, Lead Index No. 07-603736” (the “state derivative actions”). By agreement of the parties and approval of the respective courts, proceedings in both these federal and state derivative actions will continue to trail those in the federal securities actions discussed above.
On April 2, 2008, a class action complaint alleging violations of the federal securities laws was filed in the United States District Court for the Southern District of New York against the Company entitled, “John W. Oughtred, Individually, and on Behalf of all Others Similarly Situated, Plaintiff, v. E*TRADE Financial Corporation and E*TRADE Securities, LLC, Defendants.” Plaintiff contends, among other things, that the Company committed various sales practice violations in the sale of certain auction rate securities to investors between April 2, 2003, and February 13, 2008 (the “class period”) by allegedly misrepresenting that these securities were highly liquid and safe investments for short term investing. On April 17, 2008, the trial court entered an order relieving the Company of its obligation to move, answer or otherwise respond to the complaint until such time as the court may deem appropriate. Thereafter, plaintiff Oughtred joined plaintiffs in twelve other actions involving auction rate securities (in which the Company is not named as defendant) in filing a motion seeking to centralize all 13 actions in the Southern District of New York or in the alternative, the Northern District of California. By order filed October 9, 2008, a United States Judicial Panel on Multi-District Litigation denied plaintiffs’ motion to transfer, and on December 18, 2008, Plaintiff filed his first amended class action complaint. The Company intends to vigorously defend itself against the claims raised in this complaint.
On October 11, 2006, a state class action entitled, “Nikki Greenberg, and all those similarly situated, plaintiffs, versus E*TRADE FINANCIAL Corporation, defendant” was filed in the Superior Court for the State of California, County of Los Angeles on behalf of all customers or consumers who allegedly made or received telephone calls from E*TRADE that were recorded without their knowledge or consent following a telephone call from plaintiff Greenberg to the Company’s Beverly Hills financial center on August 8, 2006, that was recorded during a brief period when the Company’s automated notice system was out of order. On February 7, 2008, class certification was granted and the class defined to consist of (1) all persons in California who received telephone calls from E*TRADE and whose calls were recorded without their consent within three years of October 11, 2006, and (2) all persons who made calls from California to the Beverly Hills financial center of the Company on August 8, 2006. In the interim, the Company has filed motions seeking to de-certify or further limit the defined class, and plaintiffs have filed competing motions seeking to expand it. The hearing of these motions, formerly set for September 19, 2008, is now scheduled to take place on March 6, 2009. The Company has denied the allegations of the complaint.
The SEC, in conjunction with various regional securities exchanges, is conducting an inquiry into the trading activities of certain specialist firms, including the Company’s subsidiary ETCM, on various regional exchanges in order to determine whether such firms executed proprietary orders in a given security prior to a customer order in the same security (a practice commonly known as “trading ahead”) during the period 1999-2005. ETCM was a specialist on the Chicago Stock Exchange during the period under review. The SEC has indicated that it will seek disgorgement, prejudgment interest, and penalties from any firm found to have engaged in trading ahead activity to the detriment of its customers during that time period. It is possible that such sanctions, if imposed against ETCM, could have a material impact on the financial results of the Company during the period in which such sanctions are imposed. The Company and ETCM are cooperating with the investigation.
On October 17, 2007, the SEC initiated an informal inquiry into matters related to the Company’s loan and securities portfolios. That inquiry is continuing. The Company is cooperating fully with the SEC in this matter.
Representatives of various states attorneys general have made informal inquiries regarding the auction rate securities held by the Company’s customers. The Company is cooperating with these inquiries, which are continuing.
An unfavorable outcome in any matter that is not covered by insurance could have a material adverse effect on the Company’s business, financial condition, results of operations or cash flows. In addition, even if the ultimate outcomes are resolved in the Company’s favor, the defense of such litigation could entail considerable cost or the diversion of the efforts of management, either of which could have a material adverse effect on the Company’s business, financial condition, results of operations or cash flows. In addition to the matters described above, the Company is subject to various legal proceedings and claims that arise in the normal course of business which could have a material adverse effect on its financial position, results of operations or cash flows.
The Company maintains insurance coverage that management believes is reasonable and prudent. The principal insurance coverage it maintains covers commercial general liability; property damage; hardware/software damage; cyber liability; directors and officers; employment practices liability; certain criminal acts against the Company; and errors and omissions. The Company believes that such insurance coverage is adequate for the purpose of its business. The Company’s ability to maintain this level of insurance coverage in the future, however, is subject to the availability of affordable insurance in the marketplace.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED SHAREHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Price Range of Common Stock
The following table shows the high and low sale prices of our common stock as reported by the NASDAQ for the periods indicated:
The closing sale price of our common stock as reported on the NASDAQ on February 23, 2009 was $0.87 per share. At that date, there were 1,861 holders of record of our common stock.
Dividends
We have never declared or paid cash dividends on our common stock. The terms of our corporate debt currently prohibit the payment of dividends and will continue to for the foreseeable future.
Equity Compensation Plan Information
Refer to Note 21-Employee Shared-Based Payments and Other Benefits in Item 8. Financial Statements and Supplementary Data for equity compensation plan information.
Performance Graph
The following performance graph shows the cumulative total return to a holder of the Company’s common stock, assuming dividend reinvestment, compared with the cumulative total return, assuming dividend reinvestment, of the S&P 500 and the S&P Super Cap Diversified Financials during the period from December 31, 2003 through December 31, 2008.
* $100 invested on 12/31/03 in stock or index-including reinvestment of dividends. Fiscal year ending December 31.
*
Copyright © 2009, Standard & Poor’s, a division of The McGraw-Hill Companies, Inc. All rights reserved. (www.researchdatagroup.com/S&P.htm)
ITEM 6.
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
In 2008, the Company sold its Canadian brokerage business and exited its direct retail lending business. Results of operations from these businesses have been reclassified to discontinued operations for all periods presented.
(Dollars in millions, shares in thousands, except per share and per trade amounts):
* Percentage not meaningful.
(1)
No cash dividends have been declared in any of the periods presented.
(2)
The amounts for year ended December 31, 2004 excludes the results from BrownCo and Harrisdirect acquisitions, which occurred during the fiscal year ended December 31, 2005.
(3)
In 2008, the Company sold its Canadian brokerage business and exited its direct retail lending business. In 2006, the Company completed the sale of its professional agency trading business. In 2005, the Company exited the professional proprietary business and completed the sale of E*TRADE Consumer Finance Corporation. In 2004, the Company completed the sale of substantially all of the assets and liabilities of E*TRADE Access, Inc. The Company has reflected the results of these operations as discontinued operations for all periods presented.
(4)
In 2005, the Company recorded a credit of $1.6 million, net of tax, as a cumulative effect of accounting change, to reflect the amount by which compensation expense would have been reduced in periods prior to adoption of Statement of Financial Accounting Standards (“SFAS”) No. 123(R) revised 2004, Share-Based Payment (“SFAS No. 123(R)”), for restricted stock awards outstanding on July 1, 2005.
(5)
For 2004, diluted earnings per share is calculated using the “if converted” method, which includes the additional dilutive impact assuming conversion of the Company’s subordinated convertible debt. Under the “if converted” method, the per share numerator excludes the interest expense and related amortization of offering costs from the convertible debt, net of tax, of $20.0 million. The denominator includes the shares issuable from the assumed conversion of the convertible debt of 25.8 million. For all other periods presented, the “if converted” method is not used as its effect would be anti-dilutive.
(Dollars in millions):
(Dollars in billions, except per trade amounts):
(1)
Metrics have been represented to exclude activity from discontinued operations.
(2)
The enterprise net interest spread and enterprise interest-earning assets, average for 2004 are not presented as the information was not tracked on an enterprise level during that period.
The selected consolidated financial data should be read in conjunction with Item 7.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion should be read in conjunction with the consolidated financial statements and the related notes that appear elsewhere in this document.
GLOSSARY OF TERMS
In analyzing and discussing our business, we utilize certain metrics, ratios and other terms that are defined in the Glossary of Terms, which is located at the end of Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Overview
Strategy
Our strategy is to profitably grow our retail customer franchise and mitigate the risks associated with our balance sheet. We plan to grow our retail customer franchise by offering online brokerage and related products and services, including investor-focused banking and asset gathering products and services. We believe we can accomplish this growth by appealing to retail investors, especially customers of traditional brokerages, who are attracted to our low-cost, easy to use and innovative capabilities.
Our plan to mitigate the risks associated with our balance sheet contains three core goals: reduce credit risk in our loan portfolio, reduce our level of corporate debt and reduce operating expenses. We believe that the successful completion of this plan will significantly improve our financial strength.
We are also focused on simplifying and streamlining the business by exiting and/or restructuring certain non-core operations. We believe these changes will better align our business with the retail investor.
Key Factors Affecting Financial Performance
Our financial performance is affected by a number of factors outside of our control, including:
•
customer demand for financial products and services;
•
the weakness or strength of the residential real estate and credit markets;
•
the performance, volume and volatility of the equity and capital markets;
•
customer perception of the financial strength of our franchise;
•
market demand and liquidity in the secondary market for mortgage loans and securities; and
•
market demand and liquidity in the wholesale borrowings market, including securities sold and agreements to repurchase.
In addition to the items noted above, our success in the future will depend upon, among other things:
•
continuing our success in the acquisition, growth and retention of customers;
•
deepening customer acceptance of our products and services;
•
our ability to assess and manage credit risk;
•
our ability to assess and manage interest rate risk; and
•
disciplined expense control and improved operational efficiency.
Management monitors a number of metrics in evaluating the Company’s performance. The most significant of these are shown in the table and discussed in the text below:
* Percentage not meaningful.
(1)
Metrics have been represented to exclude activity from discontinued operations. All discussions, unless otherwise noted, are based on metrics from continuing operations.
(2)
For the year ended December 31, 2008, net new customer assets were $6.4 billion excluding the sale of Retirement Advisors of America (“RAA”).
Customer Activity Metrics
•
Changes in retail customer assets are an indicator of the value of our relationship with the customer. An increase in retail customer assets generally indicates that the use of our products and services by existing and new customers is expanding. Changes in this metric are also driven by changes in the valuations of our customers’ underlying securities, which declined substantially in 2008.
•
Net new customer assets are total inflows to all new and existing customer accounts less total outflows from all closed and existing customer accounts and are a general indicator of the use of our products and services by existing and new customers.
•
Customer cash and deposits are an indicator of a deepening engagement with our customers and are a key driver of net operating interest income.
•
DARTs are the predominant driver of commission revenue from our retail customers.
•
Average commission per trade is an indicator of changes in our customer mix, product mix and/or product pricing. As a result, this metric is impacted by both the mix between our retail domestic and international businesses and the mix between active traders, mass affluent and main street customers.
•
End of period total accounts is an indicator of the Company’s ability to attract and retain customers.
Company Financial Metrics
•
Corporate cash is an indicator of the liquidity at the parent company. It is the primary source of capital above and beyond the capital deployed in our regulated subsidiaries.
•
E*TRADE Bank excess risk-based capital is the excess capital that E*TRADE Bank has compared to the regulatory minimum well-capitalized threshold and is an indicator of E*TRADE Bank’s ability to absorb future loan losses.
•
Allowance for loan losses is an estimate of the losses inherent in our loan portfolio as of the balance sheet date and is typically equal to the expected charge-offs in our loan portfolio over the next twelve months.
•
Allowance for loan losses as a percentage of nonperforming loans is a general indicator of the adequacy of our allowance for loan losses. Changes in this ratio are also driven by changes in the mix of our loan portfolio.
•
Nonperforming loans receivable as a percentage of gross loans receivable is an indicator of the performance of our total loan portfolio.
•
Enterprise net interest spread is a broad indicator of our ability to generate net operating interest income.
•
Enterprise interest-earning assets, in conjunction with our enterprise net interest spread, are indicators of our ability to generate net operating interest income.
Significant Events in 2008
Strengthening Our Core Asset - the Retail Customer
One of our key strategic objectives for 2008 was to strengthen our retail customer base and ensure the credit issues in our balance sheet did not negatively impact our customer base. We believe we have made significant progress in this area throughout 2008. Highlights of our progress during the year ended December 31, 2008 are as follows:
•
Opened 1,032,000 gross new accounts and produced 246,000 net new accounts;
•
Net new customer asset flows of $5.4 billion ($6.4 billion excluding the sale of RAA);
•
Customer cash and deposit balances decreased slightly to $32.3 billion; and
•
Total DARTs of 188,000, up 6% from the prior year.
Execution of Our Capital Plan
•
E*TRADE Bank had excess risk-based capital (excess to the regulatory minimum well-capitalized threshold) of $714.7 million, including $650 million of capital contributed by the parent company, E*TRADE Financial Corporation;
•
We had corporate cash of $434.9 million; and
•
We completed four key non-core asset sales resulting in net proceeds of approximately $750 million: the corporate aircraft-related assets; RAA; the Canadian brokerage business; and our equity shares in Investsmart(1).
Exit of the Direct Retail Lending Business
We announced the exit of our direct retail lending business, which was our last remaining loan origination channel (we exited our wholesale mortgage lending channel in 2007). Therefore, the results of operations of the entire direct retail lending business are reported as discontinued operations on our consolidated statement of income (loss) for all periods presented. In future periods, we plan to partner with a third party company to provide access to real estate loans for our customers.
Retirement of Corporate Debt
In November 2008, we retired the entire balance of our $450 million 6.125% subordinated notes due 2019. The notes were part of the mandatory convertible debt securities issued in 2005 and were retired in connection
(1) The equity shares of Investsmart were sold by our wholly-owned subsidiary, E*TRADE Mauritius.
with the issuance of 25 million shares of our common stock at $18 per share. Additionally, we exchanged $120.8 million in principal of our senior notes through debt for equity exchanges.
Completion of Citadel Investment
In January 2008, the Company issued an additional $150.0 million of springing lien notes in accordance with the terms of the agreement with Citadel. This was the final note issuance under the agreement with Citadel and brought the total springing lien notes outstanding to $1.9 billion in principal(1). In connection with this issuance, the Company received $150.0 million in cash. Additionally, the Company issued to Citadel the remaining 46.7 million shares of common stock that had been required to be issued under the agreement.
Enhancements to our Retail Investor Focused Products and Services
•
We introduced E*TRADE Mobile Pro, which offers wireless customers access to their E*TRADE accounts. Mobile Pro offers BlackBerry® smartphone users real-time streaming stock and options quotes, the ability to trade equities and options and brokerage and bank account cash transfers, among other features.
•
We began offering expanded tools and services, including improved charting capabilities and redesigned our “Global Markets,” “US Markets,” and “Market News” pages. We also began offering customization, expanded our mutual fund center with research capabilities and improved charting and analytics for Power E*TRADE Pro.
•
We launched Retirement QuickPlan, which provides a quick assessment of an individual’s or family’s retirement savings and investing plan as well as guidelines to get on track with personal retirement goals.
Ranked #1 Online Broker by SmartMoney Magazine
For the second year in a row, SmartmoneyTM ranked the Company as the #1 Online Discount Broker. The Company earned five out of five stars in the Research, Trading Tools, Banking Service and Mutual Funds and Investment Products categories.
Significant Events in 2007
Citadel Investment of $2.5 Billion Including Sale of Asset-Backed Securities Portfolio
The operating environment during 2007, particularly during the second half of the year, was extremely challenging as our exposure to the crisis in the residential real estate and credit markets adversely impacted our financial performance and led to a disruption in our customer base. As a result, we believe it was necessary to obtain a significant infusion of cash, which would in turn stabilize our balance sheet and our customer base.
On November 29, 2007, we entered into an agreement to receive a $2.5 billion cash infusion from Citadel. In consideration for the cash infusion, Citadel received three primary items: substantially all of our asset-backed securities portfolio, 84.7 million shares of common stock (2) in the Company and approximately $1.8 billion in 12 1/2% springing lien notes(3). We believe this transaction provided timely stability for our business and helped alleviate customer concerns.
(1) The $1.9 billion in principal does not include the $121.0 million of capitalized interest in November 2008, which resulted in $2.1 billion in principal of springing lien notes outstanding to Citadel as of December 31, 2008.
(2) The 84.7 million shares of common stock were issued in increments: 14.8 million upon initial closing in November 2007; 23.2 million upon Hart-Scott-Rodino Antitrust Improvements Act approval in December 2007; and 46.7 million shares are expected to be issued in the first quarter of 2008 as the Company has received all necessary regulatory approvals.
(3)
Included in the $1.8 billion issuance is $186 million of 12 1/2% springing lien notes in exchange for $186 million of the Company’s senior notes that were owned by Citadel. The $1.8 billion in 12 1 /2% springing lien notes includes $100 million in notes issued to BlackRock in connection with the transaction. The $1.8 billion in 12 1/2% springing lien notes represents the amount outstanding as of December 31, 2007 and does not include the additional $150 million of springing lien notes issued in January 2008 in accordance with the terms of the agreement with Citadel.
Launch of Global Trading Platform
We launched our Global Trading Platform, which provides the ability to buy, sell and hold foreign equities in local currencies to investors who seek liquidity and diversity in their portfolios. Our U.S. customers now have access to foreign stocks and currencies in six major international markets: Canada, France, Germany, Hong Kong, Japan and the United Kingdom.
Introduction of the Max-Rate Checking Account
E*TRADE Bank introduced a Max-Rate Checking Account which features an annual percentage yield up to 3.25%, unlimited check writing and free online bill pay, among other benefits.
Ranked #1 Premium Broker by SmartMoney Magazine
SmartMoney Magazine recognized the Company as the #1 “premium broker” in its 2007 broker survey. SmartMoney noted the Company for its improved service, new global trading capabilities, intuitive trade tools and easy search capabilities and numerous banking products.
Summary Financial Results
Income Statement Highlights for the Year Ended December 31, 2008 (dollars in millions, except per share amounts)
* Percentage not meaningful.
The continued deterioration in the residential real estate and credit markets, as well as the nearly unprecedented turmoil in the global financial markets, had a significant impact on our financial performance during 2008. The losses in our institutional segment caused by this deterioration more than offset the strong underlying performance of our retail segment, resulting in a net loss from continuing operations of $809.4 million for the year ended December 31, 2008. Our retail customer base showed positive growth trends during the year, including the addition of approximately 246,000 net new accounts and net inflows of customer assets of approximately $5.4 billion. We believe these are indications that our retail segment has not only stabilized, but has returned to modest growth.
Balance Sheet Highlights (dollars in billions)
The decrease in total assets was attributable primarily to a decrease of $5.7 billion in loans, net and a decrease of $4.4 billion in margin receivables. These decreases were partially offset by an increase in cash and equivalents and cash and investments required to be segregated under federal or other regulations of $2.9 billion. For the foreseeable future, we plan to allow our home equity loans to pay down resulting in an overall decline in the balance of the loan portfolio. During this period, we plan to maintain excess regulatory capital at E*TRADE Bank as we focus on mitigating the credit risk inherent in our loan portfolios. During the year ended December 31, 2008, we increased our excess risk-based capital at E*TRADE Bank by 64% to $714.7 million compared to prior year. In connection with this strategy and the Citadel Investment, we have updated our secondary market purchase policies to prohibit the acquisition of asset-backed securities, collateralized debt obligations (“CDO”) and certain other instruments with a high level of credit risk through January 1, 2010.
EARNINGS OVERVIEW
2008 Compared to 2007
We had a net loss from continuing operations of $809.4 million for the year ended December 31, 2008. The loss for the year ended December 31, 2008 was due principally to an increase in our provision for loan losses of $943.6 million to $1.6 billion. In addition, we incurred losses of $153.8 million, net of hedges, on our preferred stock in Federal National Mortgage Association (“Fannie Mae”) and Federal Home Loan Mortgage Corporation (“Freddie Mac”) during the period ended December 31, 2008. The losses in our institutional segment, which included both of these items, more than offset our retail segment income, which was $608.1 million for the year ended December 31, 2008.
In the second quarter of 2008, we made the decision to sell our Canadian brokerage business and we decided to close our direct retail lending business. As a result, the financial results for both the Canadian brokerage business and the direct retail lending business have been reported in discontinued operations for all periods presented. Additionally, we re-defined “Total net revenue” by removing “Provision for loan losses” and separately stating it as its own line item and reclassified hedge ineffectiveness recorded in accordance with SFAS No. 133, as amended Accounting for Derivative Instruments and Hedging Activities (“SFAS No. 133”), from “Other operating expense” to the “Gain (loss) on loans and securities, net” line item.
We report corporate interest income and corporate interest expense separately from operating interest income and operating interest expense. We believe reporting these two items separately provides a clearer picture of the financial performance of our operations than would a presentation that combined these two items. Our operating interest income and operating interest expense is generated from the operations of the Company and is a broad indicator of the performance in our banking and balance sheet management businesses. Our corporate debt, which is the primary source of our corporate interest expense, has been issued primarily in connection with the Citadel Investment and past acquisitions, such as Harrisdirect and BrownCo.
Similarly, we report gain (loss) on sales of investments, net separately from gain (loss) on loans and securities, net. We believe reporting these two items separately provides a clearer picture of the financial performance of our operations than would a presentation that combined these two items. Gain (loss) on loans and
securities, net is the result of activities in our operations, namely our balance sheet management business, including impairment on our available-for sale mortgage-backed and investment securities portfolio. Gain (loss) on sales of investments, net relates to historical equity investments of the Company at the corporate level and are not related to the ongoing business of our operating subsidiaries.
The following sections describe in detail the changes in key operating factors and other changes and events that have affected our consolidated net revenue, operating expense, other income (expense) and income tax expense (benefit).
Revenue
The components of net revenue and the resulting variances are as follows (dollars in thousands):
* Percentage not meaningful
Total net revenue increased to $1.9 billion for the year ended December 31, 2008 compared to 2007. This increase was primarily due to the $2.2 billion loss on the sale of our asset-backed securities portfolio for the year ended December 31, 2007.
Net Operating Interest Income
Net operating interest income decreased 20% to $1.3 billion for the year ended December 31, 2008 compared to December 31, 2007. Net operating interest income is earned primarily through holding credit balances, which include margin, real estate and consumer loans, and by holding customer cash and deposits, which are a low cost source of funding. The decrease in net operating interest income was due primarily to the planned decline in enterprise interest-earning assets during 2008.
The following table presents enterprise average balance sheet data and enterprise income and expense data for our operations, as well as the related net interest spread, yields and rates and has been prepared on the basis required by the SEC’s Industry Guide 3, “Statistical Disclosure by Bank Holding Companies” (dollars in thousands):
Reconciliation from enterprise net interest income to net operating interest income (dollars in thousands):
(1)
Nonaccrual loans are included in the respective average loan balances. Income on such nonaccrual loans is recognized on a cash basis.
(2)
Includes segregated cash balances.
(3)
Amount includes a taxable equivalent increase in operating interest income of $9.1 million, $30.9 million and $19.3 million for 2008, 2007 and 2006, respectively.
(4)
Non-operating interest-earning assets consist of property and equipment, net, goodwill, other intangibles, net and other assets that do not generate operating interest income. Some of these assets generate corporate interest income.
(5)
Non-operating interest-bearing liabilities consist of corporate debt, accounts payable, accrued and other liabilities that do not generate operating interest expense. Some of these liabilities generate corporate interest expense.
(6)
Enterprise net interest income is taxable equivalent basis net operating interest income excluding corporate interest income and corporate interest expense, stock conduit interest income and expense and interest earned on customer cash held by third parties. Management believes this non-GAAP measure is useful to analysts and investors as it is a measure of the net operating interest income generated by our operations.
(7)
Includes interest earned on average customer assets of $3.2 billion, $3.9 billion and $3.6 billion for the years ended December 31, 2008, 2007 and 2006, respectively, held by parties outside E*TRADE Financial, including third party money market funds and sweep deposit accounts at unaffiliated financial institutions. Other consists of net operating interest earned on average stock conduit assets of $1.3 million and $303.5 million for the years ended December 31, 2007 and 2006, respectively. There were not any stock conduit assets at December 31, 2008.
Average enterprise interest-earning assets decreased 16% to $46.9 billion for the year ended December 31, 2008 compared to 2007, primarily the result of a decrease in our available-for-sale portfolio, margin receivables and loans, net, offset by an increase in cash and equivalents. Average available-for-sale mortgage-backed and investment securities decreased 41% to $9.6 billion for the year ended December 31, 2008 compared to 2007. This decrease was primarily due to the sale of certain mortgage-backed securities in the first quarter of 2008 and the sale of our asset-backed securities portfolio towards the end of the fourth quarter of 2007. Average margin receivables decreased 17% to $5.8 billion for the year ended December 31, 2008 compared to 2007. We believe this decrease was due to customers deleveraging and reducing their risk exposure given the substantial volatility in the financial markets. Average loans, net decreased 10% to $27.8 billion for the year ended December 31, 2008 compared to 2007 as a result of our focus on growing the one- to four-family loan portfolio in the first and second quarters of 2007. Beginning in the second half of 2007, we altered our strategy and halted the focus on growing the balance sheet. For the foreseeable future, we plan to allow our home equity loans to pay down resulting in an overall decline in the balance of the loan portfolio.
Average enterprise interest-bearing liabilities decreased 17% to $44.5 billion for the year ended December 31, 2008 compared to 2007. The decrease in average enterprise interest-bearing liabilities was primarily due to a decrease in repurchase agreements and other borrowings, FHLB advances and customer payables. Average repurchase agreements and other borrowings decreased 37% to $7.7 billion for the year ended December 31, 2008 compared to 2007. Average FHLB advances decreased 34% to $4.7 billion for the year ended December 31, 2008 compared to 2007. Repurchase agreements and other borrowings are the primary wholesale funding sources for our loans, net and available-for-sale securities portfolios. The decreases in these balances were the result of paying down these liabilities as we decreased the size of our balance sheet during 2008. Average customer payables decreased 25% to $4.3 billion for the year ended December 31, 2008 compared to 2007, which was related primarily to the sale of our Canadian brokerage business during the third quarter of 2008.
Enterprise net interest spread decreased by 12 basis points to 2.52% for the year ended December 31, 2008 compared to 2007. This decrease was driven in part by an atypical spread among two key benchmark interest rates: federal funds and the London Interbank Offered Rate (“LIBOR”). The majority of our interest-earning assets and liabilities are linked, either directly or indirectly, to these benchmark interest rates. We believe this spread will return to more normalized levels in future periods. In addition, we plan to reduce the rates paid on our Complete Savings Account to be more consistent with current market rates. We believe the combined impact of these two items will result in a modest increase to our net interest spread in future periods.
Operating interest income and operating interest expense reflect income and expense on hedges that qualify for hedge accounting under SFAS No. 133, as amended. The following table shows the income (expense) on hedges that are included in operating interest income and expense (dollars in thousands):
* Percentage not meaningful
Commission
Commission revenue decreased 22% to $515.6 million for the year ended December 31, 2008, compared to the same period in 2007. This decrease was due almost entirely to a decrease of $142.6 million, or 99%, in our institutional commission revenue as a result of the exit of our institutional brokerage operations. Commission revenue from our retail segment, which is the sole source of commission revenue in future periods, remained stable for the year ended December 31, 2008 declining by only 1% compared to 2007. The primary factors that affect our retail commission revenue are DARTs and average commission per trade, which is impacted by both trade types and the mix between our domestic and international businesses. Each business has a different pricing structure, unique to its customer base and local market practices, and as a result, a change in the relative number of executed trades in these businesses impacts average commission per trade. Each business also has different trade types (e.g. equities, options, fixed income, exchange-traded funds, contract for difference and mutual funds) that can have different commission rates. As a result, changes in the mix of trade types within either of these businesses may impact average commission per trade.
DARTs increased 6% to 188,116 for the year ended December 31, 2008 compared to 2007. Our U.S. DART volume increased 5% and our international DARTs grew by 9% for the year ended December 31, 2008 compared to 2007, driven entirely by organic growth. In addition, option-related DARTs as a percentage of our total U.S. DARTs represented 15% and 16% of U.S. trading volume for the periods ending December 31, 2008 and 2007, respectively.
Average commission per trade decreased 7% to $10.88 for the year ended December 31, 2008 compared to 2007. The decrease was primarily a function of the product and customer mix. The overall poor performance of the equity markets for the year ended December 31, 2008 disproportionately impacted higher commission products, such as corporate services transactions and mutual funds. Main Street Investors, who generally have a higher commission per trade, traded less during the period compared to Active Traders and Mass Affluent customers, who generally have a lower commission per trade. Customer appreciation, win-back and other promotional campaigns also contributed to the decrease in average commission per trade.
Fees and Service Charges
Fees and service charges decreased 13% to $200.0 million for the year ended December 31, 2008 compared to 2007. This decrease was primarily due to a lower order flow revenue, advisory management fees and CDO
management fees. The decrease in advisory management fees was primarily due to our sale of RAA. The decrease in CDO management fees was due to the sale of our collateral management agreements during the first quarter of 2008.
Principal Transactions
Principal transactions decreased 17% to $84.9 million for the year ended December 31, 2008 compared to 2007. The decrease in principal transactions resulted from lower institutional trading volumes. Our principal transactions revenue is influenced by overall trading volumes, the number of stocks for which we act as a market maker, the trading volumes of those specific stocks and the performance of our proprietary trading activities.
Loss on Loans and Securities, Net
Loss on loans and securities, net was $195.5 million and $2.5 billion for the year ended December 31, 2008 and 2007, respectively, as shown in the following table (dollars in thousands):
* Percentage not meaningful
The loss on loans and securities, net during the year ended December 31, 2008 was due principally to losses on our preferred stock in Fannie Mae and Freddie Mac, which experienced record price declines and volatility during the third quarter of 2008. Based upon our concerns about continuing market instability, all of our positions were liquidated during the third quarter of 2008, resulting in a pre-tax loss of $153.8 million, net of hedges, that was recognized in loss on trading securities, net.
We recognized $95.0 million of impairment on certain securities in our CMO portfolio during the year ended December 31, 2008, which was a result of the deterioration in the expected credit performance of the underlying loans in the securities. Further declines in the performance of our CMO portfolio could result in additional impairments in future periods. In addition, we recognized $7.7 million of impairment related to the funds held in the Reserve Funds’ Primary Fund. For additional information about the Primary Fund, refer to Liquidity and Capital Resources on page 48.
The loss on loans and securities, net during the year ended December 31, 2007 was due primarily to the $2.2 billion loss on the sale of our asset-backed securities portfolio in the fourth quarter of 2007.
Other Revenue
Other revenue increased 12% to $52.7 million for the year ended December 31, 2008 compared to 2007. The increase in other revenue was due to income from the cash surrender value of Bank-Owned Life Insurance (“BOLI”), which was entered into during the third quarter of 2007.
Provision for Loan Losses
Provision for loan losses increased $943.6 million to $1.6 billion for the year ended December 31, 2008 compared to 2007. The increase in the provision for loan losses was related primarily to deterioration in the performance of our home equity loan portfolio, which began in the second half of 2007. During the year ended December 31, 2008, we also experienced deterioration in the performance of our one- to four-family loan portfolio. We believe the deterioration in both of these portfolios was caused by several factors, including: home price depreciation in virtually all key markets; growing inventories of unsold homes; rising foreclosure rates; sustained contraction in the availability of credit; and a severe downturn in the economy. While we do believe the provision for loan losses will be at historically high levels in future periods, we do not expect those levels to be in excess of those incurred in 2008.
Operating Expense
The components of operating expense and the year-over-year variances are as follows (dollars in thousands):
* Percentage not meaningful.
Operating expense decreased 18% to $1.3 billion for the year ended December 31, 2008 compared to 2007. The decrease in expense excluding interest was driven primarily by decreases in compensation and benefits, clearing and servicing, impairment of goodwill and other expense. These decreases were offset slightly by an increase in advertising and market development expense.
Compensation and Benefits
Compensation and benefits decreased 12% to $383.4 million for the year ended December 31, 2008 compared to 2007. The decrease resulted primarily from lower salary expense due to a reduction in our employee base and decreased variable compensation during the year ended December 31, 2008 when compared to 2007.
Clearing and Servicing
Clearing and servicing expense decreased 32% to $185.1 million for the year ended December 31, 2008 compared to 2007. This decrease is related primarily to the exit of our institutional brokerage operations, which resulted in lower clearing expenses.
Advertising and Market Development
Advertising and market development expense increased 26% to $175.3 million for the year ended December 31, 2008 compared to 2007. This planned increase was aimed at restoring customer confidence as well as expanded efforts to promote our products and services to retail investors.
Impairment of Goodwill
Impairment of goodwill was $101.2 million for the year ended December 31, 2007. This impairment represents the entire amount of goodwill associated with our balance sheet management business, which had a significant decline in fair value during the fourth quarter of 2007. There was no such impairment for the year ended December 31, 2008.
Facility Restructuring and Other Exit Activities
Facility restructuring and other exit activities expense was $29.5 million for the year ended December 31, 2008. These costs were due primarily to the exit of certain facilities during the year ended December 31, 2008. Slightly offsetting the restructuring expense is the gain on the sale of RAA of $2.8 million which was recorded in the second quarter of 2008.
Other
Other expense decreased 37% to $122.1 million for the year ended December 31, 2008 compared to 2007, which was primarily due to items that are not expected to recur in future periods. During the first quarter of 2008, we sold our corporate aircraft related assets, which resulted in a $23.7 million gain on sale. During the second quarter of 2008, we realized approximately $13 million of insurance recoveries of fraud losses incurred in prior periods as well as other recoveries to legal reserves. The decrease is also due to $35.1 million in expense recorded for certain legal and regulatory matters for the year ended December 31, 2007.
Other Income (Expense)
Other income (expense) increased to an expense of $330.6 million for 2008 compared to an expense of $123.1 million for 2007, as shown in the following table (dollars in thousands):
* Percentage not meaningful.
Total other income (expense) for the year ended December 31, 2008 consisted primarily of corporate interest expense resulting from our corporate debt, which included the springing lien notes, senior notes and mandatory convertible notes. Corporate interest expense increased 110% to $362.2 million for the year ended December 31, 2008 compared to 2007, primarily due to the interest expense on the springing lien notes that were issued in the fourth quarter of 2007 and first quarter of 2008. During 2008, our wholly owned subsidiary, E*TRADE Mauritius, sold its equity shares in Investsmart for proceeds of approximately $145 million, which
resulted in a gain on sale of $22.3 million recorded in equity in income of investments and venture funds. During 2007, we sold our investments in E*TRADE Australia and E*TRADE Korea, which resulted in $37.0 million in gain on sales of investments, net.
The gain on early extinguishment of debt is primarily due to a gain of $21.5 million recognized on the exchange of our senior notes for shares of our common stock for the year ended December 31, 2008. The gain of $21.5 million is offset by a loss of $10.8 million related to the early extinguishment of FHLB advances and a loss of $0.6 million on the prepayment of debt related to the sale of the corporate aircraft.
Income Tax Benefit
The income tax benefit from continuing operations was $469.5 million and $732.9 million for the years ended December 31, 2008 and 2007, respectively. Our effective tax rate for 2008 was (36.7)% compared to (33.7)% for 2007. For additional information, see Note 17-Income Taxes to the consolidated financial statements.
Our 2008 effective tax rate included a number of tax benefits and expenses which were incremental to the amount of tax accrued based on the statutory tax rates in the jurisdictions in which we operate. The most significant items are summarized in the following table (dollars in millions):
The Company expects the 2009 effective tax rate to increase when compared to the tax rates for 2008. More specifically, we expect the 2009 effective tax rate to be based on a pro-forma effective tax rate of approximately 37-38% plus an additional fixed amount of income tax expense between $25 and $30 million.
During the year ended December 31, 2008 we did not provide for a valuation allowance against our federal deferred tax assets. We are required to establish a valuation allowance for deferred tax assets and record a charge to income if we determine, based on available evidence at the time the determination is made, that it is more likely than not that some portion or all of the deferred tax assets will not be realized. If we did conclude that a valuation allowance was required, the resulting loss would have a material adverse effect on our results of operations, financial condition and our regulatory capital position at E*TRADE Bank. As of December 31, 2008, we had net deferred tax assets of $1.0 billion.
We did not establish a valuation allowance against our federal deferred tax assets as of December 31, 2008 as we believe that it is more likely than not that all of these assets will be realized. Our evaluation focused on identifying significant, objective evidence that we will be able to realize our deferred tax assets in the future. We
reviewed the estimated future taxable income for our retail and institutional segments separately and determined that our net operating losses in 2007 and 2008 were due solely to the credit losses in our institutional segment. We believe these losses were caused by the crisis in the residential real estate and credit markets which significantly impacted our asset-backed securities and home equity loan portfolios in 2007 and continued to generate credit losses in 2008. We estimate that these credit losses will continue in future periods; however, we ceased the business activities which we believe are the root cause of these losses. Therefore, while we do expect credit losses to continue in future periods, we do expect these amounts to decline when compared to our credit losses in 2007 and 2008. Our retail segment generated substantial book taxable income for each of the last six years and we estimate that it will continue to generate taxable income in future periods at a level sufficient enough to generate taxable income for the Company as a whole. We consider this to be significant, objective evidence that we will be able to realize our deferred tax assets in the future.
Our analysis of the need for a valuation allowance recognizes that we are in a cumulative book taxable loss position as of the three-year period ended December 31, 2008, which is considered significant, objective evidence that we may not be able to realize some portion of our deferred tax assets in the future. However, we believe we are able to rely on our forecasts of future taxable income and overcome the uncertainty created by the cumulative loss position.
The crisis in the residential real estate and credit markets has created significant volatility in our results of operations. This volatility is isolated almost entirely to our institutional segment. Our forecasts for this segment include assumptions regarding our estimate of future expected credit losses, which we believe to be the most variable component of our forecasts of future taxable income. We believe this variability could create a book loss in our overall results for an individual reporting period while not significantly impacting our overall estimate of taxable income over the period in which we expect to realize our deferred tax assets. Conversely, we believe our retail segment will continue to produce a stable stream of income which we believe we can reliably estimate in both individual reporting periods as well as over the period in which we estimate we will realize our deferred tax assets.
In evaluating the need for a valuation allowance, we estimated future taxable income based on management approved forecasts. This process required significant judgment by management about matters that are by nature uncertain. If future events differ significantly from our current forecasts, a valuation allowance may need to be established, which would have a material adverse effect on our results of operations, financial condition and our regulatory capital position at E*TRADE Bank. In addition, a significant portion of the net deferred tax asset relates to a $2.3 billion federal tax loss carryforward, the utilization of which may be further limited in the event of certain material changes in the ownership of the Company. We will continue to monitor and update our assumptions and forecasts of future taxable income and assess the need for a valuation allowance.
Income from Discontinued Operations, Net of Tax
During the year ended December 31, 2008, we sold our Canadian brokerage business to Scotiabank. The sale resulted in proceeds of approximately $515 million, including $54 million in repatriation of capital prior to the close and a pre-tax gain of $429.0 million. We also exited our direct retail lending business, which was our last remaining loan origination channel (we exited our wholesale mortgage lending channel in 2007). Therefore, the results of operations of our Canadian brokerage business, including the gain on sale, and the entire direct retail lending business are reported as discontinued operations on our consolidated statement of income (loss) for all periods presented. The following table outlines the components of discontinued operations (dollars of thousands):
* Percentage not meaningful.
The benefit of excess tax basis over book basis is related to our Canadian brokerage business, which resulted from the difference between the tax and financial reporting bases of the business. We recognized this difference in the second quarter of 2008 because a commitment to sell the Canadian brokerage business was in place. The sale of the Canadian brokerage business was completed in the third quarter of 2008 for a gain of $268.8 million, net of tax.
2007 Compared to 2006
Income (loss) from continuing operations was a loss of $1.4 billion for the year ended December 31, 2007 compared to income of $626.9 million for the year ended December 31, 2006. The loss from continuing operations for the year ended December 31, 2007 was due principally to the $2.2 billion loss on the sale of our asset-backed securities portfolio and an increase in our provision for loan losses of $595.1 million to $640.1 million. These losses in our institutional segment more than offset the increase in our retail segment income, which increased $91.3 million to $794.4 million for the year ended December 31, 2007 compared to 2006.
Revenue
Net Operating Interest Income
Net operating interest income increased 14% to $1.6 billion for the year ended December 31, 2007 compared to 2006. The increase in net operating interest income was due primarily to the increase in enterprise interest-earning assets. Average enterprise interest-earning assets increased 25% to $56.1 billion for the year ended December 31, 2007 compared to 2006. Average loans, net grew 39% to $30.9 billion for the year ended December 31, 2007 compared to 2006 as a result of our focus on growing the one- to four-family loan portfolio in the first and second quarters of 2007. Beginning in the second half of 2007, we altered our strategy and halted the focus on growing the balance sheet.
Average enterprise interest-bearing liabilities increased 26% to $53.4 billion for the year ended December 31, 2007 compared to 2006. The increase in average enterprise interest-bearing liabilities was primarily in retail deposits. Average retail deposits increased 30% to $26.5 billion for the year ended December 31, 2007 compared to 2006. Increases in average retail deposits were driven by growth in the Complete Savings Account.
Enterprise net interest spread decreased by 21 basis points to 2.64% for the year ended December 31, 2007 compared to 2006. This decrease was primarily the result of a challenging interest rate environment throughout 2007 as well as growth in our Complete Savings Account, which pays a higher interest rate than the majority of our other deposit products.
Commission
Commission revenue increased 11% to $663.6 million for the year ended December 31, 2007 compared to 2006, which was driven by an increase of $61.8 million, or 13%, in our retail commission revenue.
DARTs increased 16% to 177,900 for the year ended December 31, 2007 compared to 2006. Our U.S. DART volume increased 13% for the year ended December 31, 2007 compared to 2006. Our international DARTs grew by 42% for the year ended December 31, 2007 compared to 2006, driven entirely by organic growth. In addition, option-related DARTs further increased as a percentage of total U.S. DARTs and represented 16% of trading volume versus 13% in 2006.
Average commission per trade decreased 2% to $11.72 for the year ended December 31, 2007 compared to 2006. The decrease was primarily a function of the mix of customers. Main Street Investors, who generally have a higher commission per trade, traded less during the period compared to Active Traders and Mass Affluent, who generally have a lower commission per trade. Customer appreciation and win-back campaigns, particularly in the fourth quarter of 2007, also contributed to the decrease in average commission per trade.
Fees and Service Charges
Fees and service charges increased 5% to $230.6 million for the year ended December 31, 2007 compared to 2006. This increase was due to an increase in order flow payment, advisor management fees, foreign currency margin revenue, fixed income product revenue and mutual fund fees, partially offset by a decrease in account maintenance fees and mortgage servicing fees.
Principal Transactions
Principal transactions decreased 7% to $102.2 million for the year ended December 31, 2007 compared to 2006. The decrease in principal transactions resulted from lower institutional trading volumes.
Gain (Loss) on Loans and Securities, Net
Gain (loss) on loans and securities, net was a loss of $2.5 billion for the year ended December 31, 2007 compared to a gain of $21.2 million for the same period in 2006. The decline in the total gain (loss) on loans and securities, net during 2007 was due primarily to the $2.2 billion loss on the sale of our asset-backed securities portfolio in the fourth quarter of 2007.
Other Revenue
Other revenue increased 36% to $47.2 million for the year ended December 31, 2007 compared to 2006. The increase in other revenue was due to income from the cash surrender value of BOLI, an increase in fees earned in connection with distribution of shares during initial public offerings and software consulting fees from our Corporate Services business.
Provision for Loan Losses
Provision for loan losses increased $595.1 million to $640.1 million for the year ended December 31, 2007 compared to 2006. The increase in the provision for loan losses was related primarily to deterioration in the performance of our home equity loan portfolio in the second half of 2007.
Operating Expense
Operating expense increased 19% to $1.6 billion for 2007 compared to 2006. The increase in expense excluding interest was driven primarily by increases in clearing and servicing, advertising and market development, impairment of goodwill and other expense.
Compensation and Benefits
Compensation and benefits increased 1% to $434.8 million for the year ended December 31, 2007 compared to 2006. The slight increase resulted primarily from increased benefit costs offset slightly by lower incentive based compensation in the current year.
Clearing and Servicing
Clearing and servicing expense increased 11% to $270.2 million for the year ended December 31, 2007 compared to 2006. This increase is due primarily to higher loan balances during the period, which resulted in higher servicing costs, and increased trading activity, which resulted in higher clearing expenses.
Advertising and Market Development
Advertising and market development expense increased 31% to $138.7 million for the year ended December 31, 2007 compared to 2006. This planned increase is a result of expanded efforts to promote our products and services to retail investors.
Impairment of Goodwill
Impairment of goodwill was $101.2 million for the year ended December 31, 2007. This impairment represents the entire amount of goodwill associated with our balance sheet management business, which had a significant decline in fair value during the fourth quarter of 2007.
Facility Restructuring and Other Exit Activities
Facility restructuring and other exit activities expense was $27.2 million for the year ended December 31, 2007. The majority of this expense was incurred during the fourth quarter of 2007 and was driven primarily by the shut down of the international portion of our institutional brokerage business.
Other
Other expense increased 51% to $195.4 million for the year ended December 31, 2007 compared to 2006. The increase for the year ended December 31, 2007 is due primarily to higher expense for certain legal and regulatory matters and higher FDIC premiums.
Other Income (Expense)
Other income (expense) increased 71% to $123.1 million for 2007 compared to 2006. Total other income (expense) for the year ended December 31, 2007 consisted primarily of corporate interest expense which increased 13% to $172.5 million, compared to 2006. The interest expense was partially offset by the sale of our investments in E*TRADE Australia and E*TRADE Korea, which resulted in $37.0 million in gain on sales of investments, net. During 2006, we sold shares of our investments in Softbank Investment Corporation and International Securities Exchange Holdings, Inc. resulting in gains of $71.7 million.
Income Tax Expense (Benefit)
The income tax benefit from continuing operations was $732.9 million for the year ended December 31, 2007 compared to an income tax expense of $305.4 million for the same period in 2006. Our effective tax rate for
2007 was (33.7)% compared to 32.8% for 2006. For additional information, see Note 17-Income Taxes to the consolidated financial statements.
Discontinued Operations
Our income from discontinued operations, net of tax was $0.6 million for the year ended December 31, 2007 compared to $1.9 million for the same period in 2006. During 2007 and 2006, discontinued operations included operating results from our Canadian brokerage business and our direct retail lending business. During 2006, discontinued operations also included the results from our professional agency business, E*TRADE Professional Trading, LLC.
SEGMENT RESULTS REVIEW
Retail
The following table summarizes retail financial and key metrics for the periods ended December 31, 2008, 2007 and 2006 (dollars in thousands, except for key metrics):
* Percentage not meaningful.
(1)
Metrics have been represented to exclude activity from discontinued operations. All discussions, unless otherwise noted, are based on metrics from continuing operations.
(2)
For the year ended December 31, 2008, net new customer assets were $6.4 billion excluding the sale of RAA.
Our retail segment generates revenue from brokerage and banking relationships with retail customers. These relationships essentially drive five sources of revenue: net operating interest income; commission; fees and service charges; gain (loss) on loans and securities, net; and other revenue. Other revenue includes results from our stock plan administration products and services, as we ultimately service retail customers through these corporate relationships.
2008 Compared to 2007
During the fourth quarter of 2007, we experienced a disruption in our customer base which caused a decline in the core drivers of our retail segment, including: net new accounts, customer cash and deposits, DARTs,
margin debt and retail customer assets. We believe this disruption was due to the uncertainty surrounding the Company in connection with the credit related losses in our institutional segment. While we anticipate credit related losses will be at historically high levels in future periods, primarily in our home equity loan portfolio, we believe our retail customer base has stabilized. During the year ended December 31, 2008, our retail customer base showed positive growth trends, including adding almost 246,000 net new accounts and growth in net new customer assets of approximately $5.4 billion ($6.4 billion excluding the sale of RAA). We believe these are indications that our retail segment has not only stabilized but has returned to modest growth.
Retail segment income decreased 23% to $608.1 million for the year ended December 31, 2008 compared to 2007. This was due primarily to a decrease in net operating interest income and an increase in total segment expense.
Retail net operating interest income decreased 14% to $829.7 million for the year ended December 31, 2008 compared to 2007. This decrease was driven primarily by a decrease in margin debt as well as the above market rate on our Complete Savings Account. We plan to reduce the rate on this product in future periods which we believe will result in an improvement to retail net operating interest income.
Retail commission revenue decreased 1% to $514.7 million for the year ended December 31, 2008 compared to 2007. The slight decrease in commission revenue was primarily the result of a decrease in average commission per trade of 7%, offset by an increase in DARTs of 6%.
Retail segment expense increased 3% to $975.5 billion for the year ended December 31, 2008 compared to 2007. This increase related primarily to our planned growth in marketing spend as we expanded efforts to promote our products and services to retail investors.
As of December 31, 2008, we had approximately 2.6 million active brokerage accounts, 1.0 million active stock plan accounts and 0.9 million active banking accounts. For the years ended December 31, 2008 and 2007, our retail brokerage products contributed 67% for both years, and our banking products contributed 28% and 27%, respectively, of total retail net revenue. All other products contributed less than 10% of total retail net revenue for the years ended December 31, 2008 and 2007.
2007 Compared to 2006
Retail segment income increased 13% to $794.4 million for the year ended December 31, 2007 compared to 2006. The increase in retail segment income during the year ended December 31, 2007 compared to 2006 was due to an increase in net operating interest income and commission revenue, offset by lower gain on sales of loans and securities, net.
Retail net operating interest income increased 11% to $962.6 million for the year ended December 31, 2007 compared to 2006. This increase was driven by customer cash and deposits, which generally translate into a lower cost of funds. The growth in customer cash and deposits during the first three quarters of 2007 was largely offset by the decline in customer cash during the fourth quarter of 2007.
Retail commission revenue increased 13% to $520.2 million for the year ended December 31, 2007 compared to 2006. The increase in commission revenue was primarily the result of increased trading volumes in the overall domestic equity market and in our international commissions.
Retail segment expense increased 9% to $947.9 million for the year ended December 31, 2007 compared to 2006. This increase related to our targeted growth in marketing spend as we expanded efforts to promote our products and services to retail investors.
As of December 31, 2007, we had approximately 2.5 million active brokerage accounts, 1.1 million active stock plan accounts and 0.8 million active banking accounts. For the years ended December 31, 2007 and 2006, our retail brokerage products contributed 67% and 69%, respectively, and our banking products contributed 27% and 25%, respectively, of total retail net revenue. All other products contributed less than 10% of total retail net revenue for the years ended December 31, 2007 and 2006.
Institutional
The following table summarizes institutional financial and key metrics for the periods ended December 31, 2008, 2007 and 2006 (dollars in thousands, except for key metrics):
* Percentage not meaningful
(1)
Metrics have been represented to exclude activity from discontinued operations. All discussions, unless otherwise noted, are based on metrics from continuing operations.
Our institutional segment generates revenue from balance sheet management activities and market-making activities. Balance sheet management activities include managing loans previously purchased from the retail segment as well as third parties, and leveraging these loans and retail customer cash and deposit relationships to generate additional net operating interest income.
2008 Compared to 2007
As a result of our exposure to the credit crisis in the residential real estate and credit markets, our institutional segment incurred a loss of $1.6 billion for the year ended December 31, 2008. The loss was driven primarily by an increase in our provision for loan losses for our loan portfolio of $943.6 million to $1.6 billion for the year ended December 31, 2008 compared to 2007.
Net operating interest income decreased 29% to $438.3 million for the year ended December 31, 2008 compared to 2007. The decrease in net operating interest income was due primarily to the decrease in average enterprise interest-earning assets of 16% to $46.9 billion as of December 31, 2008 compared to 2007.
Institutional commission revenue decreased to $0.8 million for the year ended December 31, 2008 compared to 2007. The decrease was a result of the exit of our institutional brokerage operations.
Fees and service charges revenue decreased 61% to $8.4 million for the year ended December 31, 2008 compared to 2007. The decrease is primarily the result of a decrease in CDO management fees, which are no longer a revenue stream due to the sale of our collateral management agreements during the first quarter of 2008.
The total loss on loans and securities, net during year ended December 31, 2008 was due principally to losses on our preferred stock in Fannie Mae and Freddie Mac, which experienced record price declines and volatility during the third quarter of 2008. Based upon our concerns about continuing market instability, all of our positions were liquidated during the third quarter of 2008, resulting in a pre-tax loss of $153.8 million, net of hedges, that was recognized in loss on trading securities, net.
In addition, we recognized $95.0 million of impairment on certain securities in our CMO portfolio during the year ended December 31, 2008, which was a result of the deterioration in the expected credit performance of the underlying loans in the securities. Further declines in the performance of our CMO portfolio could result in additional impairments in future periods.
Provision for loan losses increased $943.6 million to $1.6 billion for the year ended December 31, 2008 compared to 2007. The increase in the provision for loan losses was related primarily to deterioration in the performance of our home equity loan portfolio, which began in the second half of 2007. During the year ended December 31, 2008, we also experienced deterioration in the performance of our one- to four-family loan portfolio. We believe the deterioration in both of these portfolios was caused by several factors, including: home price depreciation in virtually all key markets; growing inventories of unsold homes; rising foreclosure rates; sustained contraction in the availability of credit; and a severe downturn in the economy. While we do believe the provision for loan losses will be at historically high levels in future periods, we do not expect those levels to be in excess of those incurred in 2008.
Total institutional segment expense decreased 49% to $324.0 million for the year ended December 31, 2008 compared to 2007. This decrease was due primarily to the goodwill impairment recorded for the year ended December 31, 2007 associated with our balance sheet management business. There was also a decline in our clearing expense related to the exit of our institutional brokerage operations, as well as a reduction in corporate overhead expenses, the majority of which are allocated to the institutional segment.
Compared to 2006
As a result of our exposure to the credit crisis in the residential real estate and credit markets, our institutional segment incurred a loss of $2.8 billion for the year ended December 31, 2007. The loss was driven primarily by losses in our asset-backed securities portfolio of approximately $2.5 billion as well as provision for loan losses for our loan portfolio of $640.1 million for the year ended December 31, 2007.
Net operating interest income increased 21% to $621.0 million for the year ended December 31, 2007 compared to 2006. The increase in net operating interest income was due primarily to the increase in average interest-earning assets of 25% to $56.1 as of December 31, 2007.
Institutional commission revenue increased 3% to $143.4 million for the year ended December 31, 2007 compared to 2006. The increase was due to higher trading volumes as a result of volatility in global equity markets.
Fees and service charges revenue decreased 15% to $21.6 million for the year ended December 31, 2007 compared to 2006. The decrease for the year ended December 31, 2007 is related to a $4.5 million decline in service fee income as a result of lower rates and lower home equity, credit card and CDO management fees.
Gain (loss) on loans and securities, net decreased to a loss of $2.5 billion for the year ended December 31, 2007. This decline was due primarily to the $2.2 billion loss on the sale of our asset-backed securities portfolio in the fourth quarter of 2007.
Provision for loan losses increased $595.1 million to $640.1 million for the year ended December 31, 2007 compared to the same period in 2006. This increase was largely due to the deterioration in the performance of our home equity loan portfolio.
Total institutional segment expense increased 38% to $636.2 million for the year ended December 31, 2007 compared to 2006 and was due primarily to the impairment of goodwill associated with the decline in fair value of our balance sheet management business during the fourth quarter of 2007. The increase was also driven by the expenses associated with certain legal and regulatory matters.
BALANCE SHEET OVERVIEW
The following table sets forth the significant components of our consolidated balance sheet (dollars in thousands):
(1)
Includes balance sheet line items cash and equivalents and cash and investments required to be segregated under federal or other regulations.
(2)
Includes balance sheet line items property and equipment, net, goodwill, other intangibles, net and other assets.
(3)
Includes balance sheet line items securities sold under agreements to repurchase and other borrowings.
The decrease in total assets was attributable primarily to a decrease of $5.7 billion in loans, net and a decrease of $4.4 billion in margin receivables for the period ended December 31, 2008 compared to 2007. These decreases were partially offset by an increase in cash of $2.9 billion. The decrease in loans, net is due to our strategy of reducing balance sheet risk and halting our previous focus on growing the balance sheet. For the foreseeable future, we plan to allow our home equity loans to pay down resulting in an overall decline in the balance of the loan portfolio. During this period, we plan to maintain excess regulatory capital at E*TRADE Bank as we focus on strengthening our capital position. We believe the decrease in our margin receivables is due to customers deleveraging and reducing their risk exposure due to the volatility in the financial markets and is not due to a specific issue with the terms or competitiveness of our margin product.
The decrease in total liabilities was attributable primarily to a decrease of $4.6 billion in wholesale borrowings, a decrease in customer payables of $1.8 billion and a decrease of $1.6 billion in accounts payable, accrued and other liabilities for the period ended December 31, 2008 compared to 2007. Repurchase agreements
and other borrowings are the primary wholesale funding sources for our loans, net and available-for-sale securities portfolios. The decreases in these balances were the result of paying down these liabilities as we decreased the size of our balance sheet during 2008. The decrease in our customer payables is related primarily to the sale of our Canadian brokerage business during the year ended December 31, 2008. In addition, stock loan, which is reported within the accounts payable, accrued and other liabilities line item, decreased $1.7 billion to $0.3 billion at December 31, 2008 compared to 2007.
Available-for-Sale Mortgage-Backed and Investment Securities
Available-for-sale securities are summarized as follows (dollars in thousands):
* Percentage not meaningful.
(1)
On January 1, 2008, the Company elected the fair value option for preferred stock in accordance with SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities-Including an Amendment of FASB Statement No. 115 (“SFAS No. 159”). As a result of this election, preferred stock was classified on the balance sheet as trading securities during 2008; however, during the third quarter of 2008, all preferred stock positions were sold.
Available-for-sale securities represented 22% and 20% of total assets at December 31, 2008 and 2007, respectively. Available-for-sale securities decreased 4% to $10.8 billion at December 31, 2008 compared to December 31, 2007, due primarily to the sale of certain mortgage-backed securities in the first half of 2008, offset by the purchase of highly-rated securities backed by U.S. Government sponsored and federal agencies in the second half of 2008. All mortgage-backed securities backed by U.S. Government sponsored and federal agencies are AAA-rated.
Margin Receivables
The margin receivables balance is a component of the margin debt balance, which is reported as a key retail metric of $2.8 billion and $7.0 billion at December 31, 2008 and 2007, respectively. The total margin debt balance is summarized as follows (dollars in thousands):
* Percentage not meaningful.
(1)
Margin held by the Canadian brokerage business prior to its sale was excluded as it is part of discontinued operations.
We believe the decrease in our margin receivables is due to customers deleveraging and reducing their risk exposure given the substantial volatility in the financial markets and is not due to an issue with the terms or competitiveness of our margin product.
Loans, Net
Loans, net are summarized as follows (dollars in thousands):
* Percentage not meaningful.
Loans, net decreased 19% to $24.5 billion at December 31, 2008 from $30.1 billion at December 31, 2007. This decline was due primarily to our strategy of reducing balance sheet risk and halting our previous focus on growing the balance sheet. We do not expect to grow our loan portfolio for the foreseeable future. In addition, we plan to allow our home equity loans to pay down resulting in an overall decline in the balance of the loan portfolio.
In 2007, we entered into a credit default swap (“CDS”) on $4.0 billion of our first-lien residential real estate loan portfolio through a synthetic securitization structure. As of December 31, 2008, the balance of the loans
covered by the CDS was $2.9 billion. A CDS provides, for a fee, an assumption by a third party of a portion of the credit risk related to the underlying loans. The CDS provides protection for losses in excess of $4.0 million, but not to exceed approximately $30.3 million. In addition, our regulatory risk-weighted assets were reduced as a result of this transaction because we transferred a portion of our credit risk to an unaffiliated third party. During the year ended December 31, 2008, we recognized $1.6 million in losses on the portion of the loans covered under the CDS. We have not yet realized any recoveries from the CDS; however, the estimated recoveries from the CDS for the next twelve months were $13.9 million at December 31, 2008, which is reflected in the allowance for loan losses.
Deposits
Deposits are summarized as follows (dollars in thousands):
Deposits represented 57% and 48% of total liabilities at December 31, 2008 and 2007, respectively. Deposits increased $0.3 billion to $26.1 billion at December 31, 2008 compared to December 31, 2007, driven by a $2.7 billion increase in money market and savings accounts. This increase was offset by a decrease in certificates of deposit and brokered certificates of deposits by $2.4 billion. Deposits generally provide us the benefit of lower interest costs, compared with wholesale funding alternatives.
The deposits balance is a component of the total customer cash and deposits balance reported as a customer activity metric of $32.3 billion and $32.7 billion at December 31, 2008 and 2007, respectively. The total customer cash and deposits balance is summarized as follows (dollars in thousands):
* Percentage not meaningful.
(1)
Customer cash balances held by the Canadian brokerage business prior to its sale were excluded as it is part of discontinued operations.
Wholesale Borrowings
Wholesale borrowings, which consist of securities sold under agreements to repurchase and other borrowings are summarized as follows (dollars in thousands):
Wholesale borrowings represented 26% and 30% of total liabilities at December 31, 2008 and 2007, respectively. The decrease in other borrowings of $3.1 billion for the period ended December 31, 2008 was due primarily to a decrease in FHLB advances. Securities sold under agreements to repurchase coupled with FHLB advances are the primary wholesale funding sources of the Bank. As a result, we expect these balances to fluctuate over time as our deposits and our interest-earning assets fluctuate.
Corporate Debt
Corporate debt is summarized as follows (dollars in thousands):
* Percentage not meaningful.
Corporate debt decreased to $2.8 billion at December 31, 2008 compared to $3.0 billion at December 31, 2007, primarily due to the retirement of the $450 million in mandatory convertible notes during the fourth quarter of 2008 and a decline in senior notes of $121 million in principal related to debt for equity exchanges. Offsetting these decreases was an additional $150.0 million of 12 1/2% springing lien notes issued to Citadel in the first quarter of 2008 and the issuance of $121 million of 12 1/2% springing lien notes in satisfaction of the November 2008 interest payment on these notes.
LIQUIDITY AND CAPITAL RESOURCES
We have established liquidity and capital policies. The objectives of these policies are to support the successful execution of our business strategies while ensuring ongoing and sufficient liquidity through the business cycle. These policies are especially important during periods of stress in the financial markets, which have been ongoing since the fourth quarter of 2007 and will likely continue for the foreseeable future. During the fourth quarter of 2007, we experienced a disruption in our customer base, which caused a significant decline in customer deposits. We believe this disruption was due to uncertainty in connection with the credit related losses in our institutional segment. Deposits are the primary source of liquidity for E*TRADE Bank, so this sudden and rapid decline created a substantial amount of liquidity risk. We followed our existing liquidity policies and
contingency plans and successfully met our liquidity needs during this extraordinary period. We believe that our ability to meet liquidity needs during this time validates the effectiveness of the liquidity policies and contingency plans. While the liquidity risk associated with our customer deposits remains at historically high levels, we believe the current level of risk is substantially lower than it was during the fourth quarter of 2007.
Capital is generated primarily through our business operations and our capital market activities. During the second half of 2007, our institutional segment incurred a significant amount of losses as a result of its exposure to the crisis in the residential real estate and credit markets. Consequently, this segment required a significant capital infusion during the fourth quarter of 2007. The Company raised $2.5 billion in cash from Citadel, the majority of which was used to provide capital to the institutional segment. While this segment continues to have exposure to the crisis in the residential real estate and credit markets, our retail segment remains profitable and continues to generate capital through retained earnings.
We maintain capital in excess of regulatory minimums at our regulated subsidiaries, the most significant of which is E*TRADE Bank. As of December 31, 2008, we held $714.7 million of risk-based capital at E*TRADE Bank in excess of the regulatory minimum level required to be considered “well capitalized.”
We raised additional capital in 2008 by issuing shares of common stock in exchange for existing corporate debt, primarily our senior notes, commonly referred to as “3(a)9 exchanges.” We completed several 3(a)9 exchanges in the first half of 2008, which resulted in a retirement of $120.8 million of existing corporate debt. We did not complete any of these transactions during the second half of 2008 as the relative prices of our common stock and corporate debt made it unattractive to do so.
In addition, we raised approximately $750 million in cash through non-core asset sales, including the sale of our Canadian brokerage business and our equity shares in Investsmart(1).
We believe the combination of the capital generated in the transactions detailed above, the excess capital held at E*TRADE Bank and the capital that continues to be generated in our retail segment will be sufficient to meet our capital needs for at least the next twelve months.
During the fourth quarter of 2008, we applied to the U.S. Treasury for funding under the TARP Capital Purchase Program. Our application remains under active consideration and we cannot predict when a final decision will be reached. We estimate this program could provide up to approximately $800 million in new preferred equity, at rates substantially discounted to current market rates. If our application is approved, it would likely be conditional upon additional capital raising activities by us, including possible transactions with existing security holders. Our ability to issue preferred equity under the TARP program would be dependent upon receiving approval from certain of our bond holders and possibly our shareholders. While we do not believe we need this capital to fund our operations, it does have the potential to significantly improve the capital position of both E*TRADE Bank and the parent company, which would enhance our ability to maintain the balance sheet at its current level.
(1)
The equity shares of Investsmart were sold by our wholly-owned subsidiary, E*TRADE Mauritius.
Corporate Cash
Corporate cash is the primary source of liquidity at the parent company and is available to invest in our regulated subsidiaries. We define corporate cash as cash held at the parent company as well as cash held in certain subsidiaries that can distribute cash to the parent company without any regulatory approval. The components of corporate cash as of December 31, 2008 and 2007 are as follows (dollars in thousands):
(1)
Converging Arrows, Inc. and other consists of corporate subsidiaries that can distribute cash to the parent company without any regulatory approval and includes E*TRADE Mauritius.
(2)
Total corporate cash at December 31, 2008 includes $45.3 million that we invested in The Primary Fund and is included as a receivable in the other assets line item, as The Reserve Fund has not indicated when the funds will be distributed back to investors.
Parent company cash decreased $35.1 million to $216.5 million as of December 31, 2008 when compared to December 31, 2007. The cash received from the sale of the Canadian brokerage business was offset by the $500 million in capital infusions made to E*TRADE Bank during the second half of 2008. The $157.6 million increase in cash to $218.3 million at Converging Arrows, Inc. and other as of December 31, 2008 when compared to December 31, 2007 was due almost entirely to the sale of E*TRADE Mauritius’ equity shares in Investsmart.
Cash and Equivalents
The consolidated cash and equivalents balance increased by $2.1 billion to $3.9 billion at December 31, 2008 compared to 2007. The majority of this balance is cash held in regulated subsidiaries, primarily our Bank and Brokerage, outlined as follows:
(1)
Cash reported in other assets at December 31, 2008 consists of cash that we invested in The Reserve Funds’ Primary Fund and is included as a receivable in the other assets line item, as The Reserve Fund has not indicated when the funds will be distributed back to investors.
The cash held in our regulated subsidiaries serves as a source of liquidity for those subsidiaries and is not a primary source of capital for the parent company.
Cash and Equivalents Held in the Reserve Fund
At December 31, 2008, we held cash in The Reserve Funds’ Primary Fund (“the Fund”) of $146.3 million, which is included as a receivable in other assets line item on the balance sheet. On September 16, 2008, the Fund reported that its shares had fallen below the standard of $1 per share, which is commonly referred to as “breaking the buck.” Prior to the fund “breaking the buck,” we submitted a redemption request for our entire balance in the
fund. The following table details our cash held in the Fund at the date the Fund was reported as “breaking the buck” and at December 31, 2008 (dollars in thousands):
On October 31, 2008 and December 3, 2008, the Fund made a distribution to its investors of approximately $26 billion and $14 billion, respectively. We received $377.7 million and $209.2 million, respectively, in connection with these distributions. On December 3, 2008, the Reserve indicated that they are required to distribute the remaining assets of the Fund ratably among the holders of outstanding shares, irrespective of whether the investor made a redemption request before or after the Fund “breaking the buck.” The statement indicated, assuming a pro-rata distribution, the net asset value per share would be $0.985. As a result of that statement, we no longer believe it is probable that we will receive the full amount of our remaining position in the Fund; therefore, we recorded an impairment charge of $11.2 million(1) related to this investment. The impairment charge of $3.5 million related to our corporate cash was included in gain (loss) on sales of investments, net line item. The impairment charge of $7.7 million related to our banking and brokerage subsidiaries is included in gain (loss) on loans and securities, net line item. The remaining amount of $146.3 million, net of the $11.2 million impairment charge, that we invested in the Fund is included as a receivable in the other assets line item.
On February 26, 2009, the Reserve announced that it had adopted a Plan of Liquidation for the orderly liquidation of the assets of the Fund. Under the terms of the plan, which is subject to the supervision of the SEC, the Reserve will continue to make interim distributions up to $0.9172 per share. The Reserve indicated in this announcement that they were taking this approach in order to provide liquidity to investors without prejudicing the legal rights and remedies of any shareholder’s claims. This announcement does not change our belief that we will receive the full amount of our remaining position upon the ultimate distribution of the fund; however, we cannot state with certainty that we will not ultimately incur additional loss on our remaining position. In addition, we believe it will take a significant amount of time to eventually receive these funds.
Liquidity Available from Subsidiaries
Liquidity available to the Company from its subsidiaries, other than Converging Arrows, Inc. (“Converging Arrows”) and E*TRADE Mauritius, a wholly-owned subsidiary of Converging Arrows, is limited by regulatory requirements.
Any loans by E*TRADE Bank to the parent company and its other non-bank subsidiaries are subject to various quantitative, arm’s length, collateralization and other requirements. At December 31, 2008, E*TRADE Bank had approximately $714.7 million of risk-based capital above the “well capitalized” level. In the current credit environment, we plan to keep this significant amount of excess risk-based capital at E*TRADE Bank in order to enhance our ability to absorb credit losses while still maintaining “well capitalized” status. However, events beyond management’s control, such as a continued deterioration in residential real estate and credit markets, could adversely affect future earnings and E*TRADE Bank’s ability to meet its future capital requirements.
The Company’s broker/dealer subsidiaries are subject to capital requirements determined by their respective regulators. At December 31, 2008 and 2007, all of our brokerage subsidiaries met their minimum net capital requirements. The Company’s broker-dealer subsidiaries had excess net capital of $717.6(2) million at December 31, 2008. While we cannot assure that we would obtain regulatory approval to withdraw any of this excess net capital, $619.4 million is available for dividend while still maintaining a capital level above regulatory “early warning” guidelines.
(1)
The impairment charge was calculated based on the Company’s investment balance as of September 15, 2008 (the day the Fund “broke the buck”), which totaled $744.3 million.
(2)
The excess net capital of the broker dealer subsidiaries included $620.7 million of excess net capital at E*TRADE Clearing, which is a subsidiary of E*TRADE Bank and is also included in the excess risk-based capital of E*TRADE Bank.
Other Sources of Liquidity
We also maintain $325.0 million in uncommitted financing to meet margin lending needs. At December 31, 2008, there were no outstanding balances, and the full $325.0 million was available.
We rely on borrowed funds, such as FHLB advances and securities sold under agreements to repurchase, to provide liquidity for the Bank. Our ability to borrow these funds is dependent upon the continued availability of funding in the wholesale borrowings market. At December 31, 2008, the Bank had approximately $9.8 billion in additional borrowing capacity with the FHLB.
We have the option to make interest payments on our springing lien notes in the form of either cash or additional springing lien notes through May 2010. During the second quarter of 2008, we elected to make our first interest payment of approximately $121 million in cash. During the fourth quarter of 2008, we elected to make our second interest payment of $121 million in the form of additional springing lien notes. We expect to make our next three interest payments, which equates to all interest payments on the springing lien notes through May 2010 in the form of additional springing lien notes. The November 2010 payment is the first interest payment we are required to pay in cash.
Corporate Debt
Our current senior debt ratings are B2 by Moody’s Investor Service, B (developing) by S&P and B (high) by Dominion Bond Rating Service (“DBRS”). The Company’s long-term deposit ratings are Ba3 by Moody’s Investor Service, BB- (developing) by S&P and BB by DBRS. A significant change in these ratings may impact the rate and availability of future borrowings.
Off-Balance Sheet Arrangements
We enter into various off-balance-sheet arrangements in the ordinary course of business, primarily to meet the needs of our customers and to reduce our own exposure to interest rate risk. These arrangements include firm commitments to extend credit and letters of credit. Additionally, we enter into guarantees and other similar arrangements as part of transactions in the ordinary course of business. For additional information on each of these arrangements, see Item 8. Financial Statements and Supplementary Data.
Contractual Obligations and Commitments
The following summarizes our contractual obligations at December 31, 2008 and the effect such obligations are expected to have on our liquidity and cash flow in future periods (dollars in thousands):
(1)
Does not include sweep deposit accounts, money market and savings accounts or checking accounts as there are no maturities and /or scheduled contractual payments.
(2)
Includes annual interest based on the contractual features of each transaction, using market rates at December 31, 2008. Interest rates are assumed to remain at current levels over the life of all adjustable rate instruments.
(3)
For mandatorily redeemable preferred securities included in other borrowings, does not assume early redemption under current conversion provisions.
(4)
Includes annual interest payments; does not assume early redemption under current call provisions. See Note 15-Corporate Debt for further details.
(5)
Includes facilities restructuring leases and excludes estimated future sublease income.
(6)
Includes purchase obligations for goods and services covered by non-cancelable contracts and contracts including cancellation fees. Excluded from the table are purchase obligations expected to be settled in cash within one year of the end of the reporting period.
As of December 31, 2008, the Company had $2.5 billion of unused lines of credit available to customers under home equity lines of credit and $0.5 billion of unused credit card and commercial lines. As of December 31, 2008, the Company had no commitments to originate, purchase or sell loans. The Company had a commitment to purchase and sell securities of $0.8 billion and $1.8 billion, respectively. The Company also had equity funding commitments of $9.7 million as of December 31, 2008, based on investment plans of venture capital funds, low income housing tax credit partnerships and joint ventures. Additional information related to commitments and contingent liabilities is detailed in Note 23-Commitments, Contingencies and Other Regulatory Matters.
Other Liquidity Matters
We currently anticipate that our available cash resources and credit will be sufficient to meet our anticipated working capital and capital expenditure requirements for at least the next 12 months. We may need to raise additional funds in order to support regulatory capital needs at our Bank, reduce holding company debt, support more rapid expansion, develop new or enhanced products and services, respond to competitive pressures, acquire businesses or technologies or take advantage of unanticipated opportunities.
RISK MANAGEMENT
As a financial services company, we are exposed to risks in every component of our business. The identification and management of existing and potential risks are the keys to effective risk management. Our risk management framework, principles and practices support decision-making, improve the success rate for new initiatives and strengthen the organization. Our goal is to balance risks and rewards through effective risk management. Risks cannot be completely eliminated; however, we do believe risks can be identified and managed within the Company’s risk tolerance.
Our businesses expose us to the following four major categories of risk that often overlap:
•
Credit Risk-Credit risk is the risk of loss resulting from adverse changes in the ability or willingness of a borrower or counterparty to meet the agreed-upon terms of their financial obligations.
•
Liquidity Risk-Liquidity risk is the risk of loss resulting from the inability to meet current and future cash flow and collateral needs.
•
Interest Rate Risk-Interest rate risk is the risk of loss from adverse changes in interest rates, which could cause fluctuations in our long-term earnings or in the value of the Company’s net assets.
•
Operational Risk-Operational risk is the risk of loss resulting from fraud, inadequate controls or the failure of the internal controls process, third party vendor issues, processing issues and external events.
We also are subject to other risks that could impact our business, financial condition, results of operations or cash flows in future periods. See Part I-Item 1A. Risk Factors.
We manage risk through a governance structure involving the various boards, senior management and several risk committees. We use management level risk committees to help ensure that business decisions are executed within our desired risk profile. A variety of methodologies and measures are used to monitor, quantify, assess and forecast risk. Measurement criteria, methodologies and calculations are reviewed periodically to assure that risks are represented appropriately. Risks are managed and controlled under policies and related limits that are approved by the Board of Directors and delegated to senior management.
The Finance and Risk Oversight Committee, which was established in the second quarter of 2008 and consists of members of the Board of Directors, monitors the risk process and significant risks throughout the
Company. In addition to this committee, various enterprise risk committees and departments throughout the Company aid in the identification and management of risks, including:
•
Asset Liability Committee-E*TRADE Bank’s Asset Liability Committee (“ALCO”) has primary responsibility for managing liquidity risk and interest rate risk and reviews balance sheet trends, market interest rate and sensitivity analyses.
•
Credit Risk Committee-The Credit Risk Committee monitors asset quality trends, evaluates market conditions, determines the adequacy for allowance of loan losses, establishes underwriting standards, approves large credit exposures, approves large portfolio purchases and delegates credit approval authority.
We use various departments throughout the Company to aid in the identification and management of risks. These departments include internal audit, compliance, finance, legal, treasury, credit and enterprise risk management. Risk reporting occurs at the business or operating units and is aggregated across the Company through the enterprise risk management process.
Credit Risk Management
Our primary sources of credit risk are our loan and securities portfolios, where it results from extending credit to customers and purchasing securities, respectively. The degree of credit risk associated with our loans and securities varies based on many factors including the size of the transaction, the credit characteristics of the borrower, features of the loan product or security, the contractual terms of the related documents and the availability and quality of collateral. Credit risk is one of the most common risks in financial services and is one of our most significant risks.
Credit risk is monitored by our Credit Risk Committee. The Credit Risk Committee uses detailed tracking and analysis to measure credit performance and reviews and modifies credit policies as appropriate.
Housing Market Conditions
Conditions in the residential real estate and credit markets, which deteriorated sharply during 2007, continued to be extremely challenging during 2008. The significant and abrupt evaporation of secondary market liquidity for various types of mortgage loans, particularly home equity loans, has decreased the overall availability of housing credit. As a result, many borrowers, particularly those in markets with declining housing prices, have been unable to refinance existing loans. This combination of a decline in the availability of credit and a decline in housing prices creates significant credit risk in our loan portfolio, particularly in our home equity loan portfolio.
Loss Mitigation
Given the deterioration in the performance of our loan portfolio, particularly in our home equity loan portfolio, we formed a special credit management team to focus on the mitigation of potential losses in the home equity loan portfolio.
This team’s primary focus is reducing our exposure to open home equity lines. As of December 31, 2007, we had $6.3 billion of unused lines of credit available under home equity lines of credit. Through a variety of strategies, including voluntary line closures, automatically freezing lines on all delinquent accounts, and freezing lines on loans with materially reduced home equity, we have reduced this amount to $2.5 billion as of December 31, 2008.
The team has several other initiatives either in progress or in development which are focused on mitigating losses in our home equity loan portfolio. Those initiatives include improving collection efforts and practices of our servicers as well as increasing our loss recovery efforts to minimize the level of loss on a loan that goes to charge-off.
We also initiated a loan modification program that resulted in an insignificant number of minor modifications in 2008. Based on the programs we now have in place, we expect the number of modifications to increase significantly in 2009 when compared to 2008. On February 18, 2009, the U.S. Department of the Treasury announced the Homeowner Affordability and Stability Plan. The primary focus of this plan is to create requirements and provide incentives to modify mortgages with the goal of avoiding foreclosure. We are analyzing the details of this recently announced program and do not yet know whether it would have a significant impact on our current loan modification programs.
In addition, we continue to review our purchased mortgage loan portfolio in order to identify loans to be repurchased by the originator. Our review is primarily focused on identifying loans with early payment defaults, violations of transaction representations and warranties, or material misrepresentation on the part of the seller. Any loans identified with these deficiencies are submitted to the original seller for repurchase. During the year ended December 31, 2008, approximately $105.6 million of loans were repurchased by the original sellers.
Underwriting Standards-Originated Loans
During the second half of 2007, we exited our wholesale mortgage origination channel and no longer originate loans through brokers. During the second quarter of 2008, we exited our retail mortgage origination business, which represented our last remaining loan origination channel.
We did not originate any loans during the second half of 2008. Prior to the exit of our retail mortgage origination business in the second quarter of 2008, we did originate approximately $158 million in one- to four-family loans during the first half of 2008. These loans were predominantly prime credit quality first-lien mortgage loans secured by a single-family residence.
We priced our loans primarily based on the risk elements inherent in the loan. We evaluated criteria such as, but not limited to: borrower credit score, loan-to-value ratio (“LTV”), documentation type, occupancy type and other risk elements. In the first quarter of 2008, we further adjusted our loan origination practices and pricing to significantly curtail originations of higher risk loans, particularly home equity loans with Fair Isaac Credit Organization (“FICO”) scores below 700 or a combined loan-to-value ratio (“CLTV”) greater than 80%.
Our underwriting guidelines were established with a focus on both the credit quality of the borrower as well as the adequacy of the collateral securing the loan. We designed our underwriting guidelines so that our one- to four-family loans were salable in the secondary market. These guidelines included limitations on loan amount, LTV ratio, debt-to-income ratio, documentation type and occupancy type. We also required borrowers to obtain mortgage insurance on higher loan-to-value first lien mortgage loans.
As of December 31, 2008, we did not offer any mortgage loan products to our customers. In the future, we expect to partner with a third party company to provide access to real estate loans for our customers.
Underwriting Standards-Purchased Loans
In the second half of 2007, we altered our business strategy and halted the focus on growing the balance sheet. As a result, we did not purchase loans during the year ended December 31, 2008 and we do not anticipate purchasing a significant amount of loans for the foreseeable future. However, we have significantly tightened our underwriting policies for any future loan purchases that do occur. These criteria focus on limiting the acquisition of loans with a high risk of credit loss and require the exclusion of loans with the following attributes: second lien; home equity line of credit; CLTV ratio above 80%; FICO score below 700 at time of origination; and documentation type is not full documentation.
Liquidity Risk Management
Liquidity risk is monitored and managed primarily by the ALCO. We have in place a comprehensive set of liquidity and funding policies that are intended to maintain our flexibility to address liquidity events specific to us or the market in general.
We believe liquidity risk management is especially important during periods of stress in the financial markets. During the fourth quarter of 2007, we experienced a disruption in our customer base, which caused a significant decline in customer deposits. These deposits are the primary source of liquidity for E*TRADE Bank, so this sudden and rapid decline created a substantial amount of liquidity risk. We followed our existing liquidity policies and contingency plans and successfully met our liquidity needs during this extraordinary period. We believe that our ability to meet liquidity needs during this time validates the effectiveness of our liquidity policies and contingency plans.
See Item 7 Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources for additional information.
Interest Rate Risk Management
Interest rate risks are monitored and managed by the ALCO. The analysis of interest sensitivity to changes in market interest rates under various scenarios is reviewed by ALCO. The scenarios assume both parallel and non-parallel shifts in the yield curve. See Item 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The following discussion about our market risk disclosure includes forward-looking statements. Actual results could differ materially from those projected in the forward-looking statements as a result of certain factors, including, but not limited to, those set forth in Item 1A. “Risk Factors.” Market risk is our exposure to changes in interest rates, foreign exchange rates and equity and commodity prices. Our exposure to interest rate risk is related primarily to interest-earning assets and interest-bearing liabilities.
Interest Rate Risk
The management of interest rate risk is essential to profitability. Interest rate risk is our exposure to changes in interest rates. In general, we manage our interest rate risk by balancing variable-rate and fixed-rate assets and liabilities and we utilize derivatives in a way that reduces our overall exposure to changes in interest rates. In recent years, we have managed our interest rate risk to achieve a minimum to moderate risk profile with limited exposure to earnings volatility resulting from interest rate fluctuations. Exposure to interest rate risk requires management to make complex assumptions regarding maturities, market interest rates and customer behavior. Changes in interest rates, including the following, could impact interest income and expense:
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Interest-earning assets and interest-bearing liabilities may re-price at different times or by different amounts creating a mismatch.
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The yield curve may flatten or change shape affecting the spread between short- and long-term rates. Widening or narrowing spreads could impact net interest income.
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Market interest rates may influence prepayments resulting in maturity mismatches. In addition, prepayments could impact yields as premium and discounts amortize.
Exposure to market risk is dependent upon the distribution and composition of interest-earning assets, interest-bearing liabilities and derivatives. The differing risk characteristics of each product are managed to mitigate our exposure to interest rate fluctuations. At December 31, 2008, 93% of our total assets were enterprise interest-earning assets.
At December 31, 2008, approximately 70% of our total assets were residential real estate loans and available-for-sale mortgage-backed securities. The values of these assets are sensitive to changes in interest rates, as well as expected prepayment levels. As interest rates increase, fixed rate residential real estate loans and mortgage-backed securities tend to exhibit lower prepayments. The inverse is true in a falling rate environment.
When real estate loans prepay, unamortized premiums are written off. Depending on the timing of the prepayment, the write-offs of unamortized premiums may result in lower than anticipated yields. The ALCO reviews estimates of the impact of changing market rates on loan production volumes and prepayments. This information is incorporated into our interest rate risk management strategy.
Our liability structure consists of two central sources of funding: deposits and wholesale borrowings. Cash provided to us through deposits is the primary source of our funding. Our key deposit products include sweep accounts, money market and savings accounts and certificates of deposit. Our wholesale borrowings include securities sold under agreements to repurchase and other borrowings. Customer payables, which represents customer cash contained within our broker dealers, is an additional source of funding. In addition, the parent company has issued a significant amount of corporate debt.
Our deposit accounts and customer payables tend to be less rate-sensitive than wholesale borrowings. Agreements to repurchase securities re-price as interest rates change. Sweep, money market and savings accounts re-price at management’s discretion Certificates of deposit re-price over time depending on maturities. FHLB advances and corporate debt generally have fixed rates.
Derivative Financial Instruments
We use derivative financial instruments to help manage our interest rate risk. Interest rate swaps involve the exchange of fixed-rate and variable-rate interest payments between two parties based on a contractual underlying notional amount, but do not involve the exchange of the underlying notional amounts. Option products are utilized primarily to decrease the market value changes resulting from the prepayment dynamics of the mortgage portfolio, as well as to protect against increases in funding costs. The types of options employed include Cap Options (“Caps”) and Floor Options (“Floors”), “Payor Swaptions” and “Receiver Swaptions.” Caps mitigate the market risk associated with increases in interest rates while Floors mitigate the risk associated with decreases in market interest rates. Similarly, Payor and Receiver Swaptions mitigate the market risk associated with the respective increases and decreases in interest rates. See derivative financial instruments discussion at Note 9-Accounting for Derivative Financial Instruments and Hedging Activities in Item 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
MANAGEMENT REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
The management of E*TRADE Financial Corporation is responsible for establishing and maintaining adequate internal control over financial reporting. E*TRADE Financial Corporation’s internal control system was designed to provide reasonable assurance to the company’s management and board of directors regarding the preparation and fair presentation of published financial statements. Internal control over financial reporting is defined in Rule 13a-15(f) or 15d-15(f) promulgated under the Securities Exchange Act of 1934 as a process designed by, or under the supervision of, the company’s principal executive and principal financial officers and effected by the company’s board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with GAAP and includes those policies and procedures that:
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pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company;
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provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with GAAP, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and
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provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the company’s assets that could have a material effect on the financial statements.
Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
E*TRADE Financial Corporation’s management assessed the effectiveness of its internal control over financial reporting as of December 31, 2008. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission in “Internal Control-Integrated Framework.” Based on management’s assessment, management believes as of December 31, 2008, that E*TRADE Financial Corporation’s internal control over financial reporting is effective based on those criteria.
E*TRADE Financial Corporation’s Independent Registered Public Accounting Firm, Deloitte & Touche LLP, has issued an audit report regarding E*TRADE Financial Corporation’s internal control over financial reporting. The report of Deloitte & Touche LLP appears on the next page.
REPORTS OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders of
E*TRADE Financial Corporation
Arlington, Virginia
We have audited the internal control over financial reporting of E*TRADE Financial Corporation and subsidiaries (the “Company”) as of December 31, 2008, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2008, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements as of and for the year ended December 31, 2008 of the Company and our report dated February 26, 2009 expressed an unqualified opinion on those consolidated financial statements and included an explanatory paragraph regarding the Company’s adoption of new accounting standards.
/s/ Deloitte & Touche LLP
McLean, Virginia
February 26, 2009
To the Board of Directors and Shareholders of
E*TRADE Financial Corporation
Arlington, Virginia
We have audited the accompanying consolidated balance sheets of E*TRADE Financial Corporation and subsidiaries (the “Company”) as of December 31, 2008 and 2007, and the related consolidated statements of income (loss), comprehensive income (loss), shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2008. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall consolidated financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of E*TRADE Financial Corporation and subsidiaries as of December 31, 2008 and 2007, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2008, in conformity with accounting principles generally accepted in the United States of America.
As discussed in Note 1 to the consolidated financial statements, the Company adopted Financial Accounting Standards Board (“FASB”) Interpretation No. 48, Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109, as of January 1, 2007. The Company also adopted Statement of Financial Accounting Standard (“SFAS”) No. 157, Fair Value Measurement, and SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, on January 1, 2008.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of December 31, 2008, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 26, 2009 expressed an unqualified opinion on the Company’s internal control over financial reporting.
/s/ Deloitte & Touche LLP
McLean, Virginia
February 26, 2009
E*TRADE FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF INCOME (LOSS)
(In thousands, except per share amounts)
See accompanying notes to consolidated financial statements
E*TRADE FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET
(In thousands, except share amounts)
See accompanying notes to consolidated financial statements
E*TRADE FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME (LOSS)
(In thousands)
(1)
Amounts are net of benefit from income taxes of $7.4 million, $286.2 million, and $1.2 million for the years ended December 31 2008, 2007, and 2006, respectively.
(2)
Amounts are net of benefit from income taxes of $18.4 million, $217.8 million the years ended December 31 2008 and 2007, respectively, and provision for income taxes of $42.9 million for the year ended December 31, 2006.
(3)
Amounts are net of benefit from income taxes of $185.5 million, $68.9 million the years ended December 31 2008 and 2007, respectively, and provision for income taxes of $22.4 million for the year ended December 31, 2006.
(4)
Amounts are net of benefit from income taxes of $9.5 million, $16.8 million, and $3.8 million for the years December 31 ended 2008, 2007, and 2006, respectively.
See accompanying notes to consolidated financial statements
E*TRADE FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY
(In thousands)
(1)
Additional paid-in capital included the proceeds received on November 29, 2007 for the 46.7 million shares of common stock that were issued in 2008 in connection with the Citadel investment. Common stock did not include these shares as they had not been issued as of December 31, 2007.
See accompanying notes to consolidated financial statements
E*TRADE FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY-(Continued)
(In thousands)
(1)
Common stock includes 46.7 million shares of common stock that were issued in 2008 in connection with the Citadel investment. The proceeds received on November 29, 2007 related to the transaction were included in additional paid-in capital for the year ended of December 31, 2007.
(2)
Common stock includes 27.1 million shares of common stock issued in exchange of the Senior Notes and 25.0 million shares issued in retirement of the Mandatory Convertible Notes.
(3)
Amounts represent additional contingent consideration issued in connection with prior acquisitions.
See accompanying notes to consolidated financial statements
E*TRADE FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS
(In thousands)
(1)
Includes the $22.3 million gain on sale of equity shares of Investsmart by E*TRADE Mauritius.
See accompanying notes to consolidated financial statements
E*TRADE FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS-(Continued)
(In thousands)
(1)
Includes the proceeds received on November 29, 2007 for the 46.7 million shares of common stock that were issued in the first quarter of 2008 in connections with the Citadel Investment.
(2)
For December 31, 2008, amounts related to additional contingent consideration issued in connection with prior acquisitions.
See accompanying notes to consolidated financial statements
E*TRADE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1-ORGANIZATION, BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Organization-E*TRADE Financial Corporation is a financial services company that provides online brokerage and related products and services primarily to individual retail investors under the brand “E*TRADE Financial.” Our products and services include investor-focused banking, primarily sweep deposits and savings products and asset gathering. The Company’s most significant subsidiaries are described below:
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E*TRADE Bank is a Federally chartered savings bank that provides investor-focused banking services to retail customers nationwide and deposit accounts insured by the FDIC;
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ETCM is a registered broker-dealer and market-maker;
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E*TRADE Clearing LLC is the clearing firm for the Company’s brokerage subsidiaries and is a wholly-owned operating subsidiary of E*TRADE Bank. Its main purpose is to transfer securities from one party to another; and
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E*TRADE Securities LLC is a registered broker-dealer and the primary provider of brokerage services to the Company’s customers.
Basis of Presentation-The consolidated financial statements include the accounts of the Company and its majority-owned subsidiaries. Entities in which the Company holds at least a 20% ownership or in which there are other indicators of significant influence are generally accounted for by the equity method. Entities in which the Company holds less than 20% ownership and does not have the ability to exercise significant influence are generally carried at cost. Intercompany accounts and transactions are eliminated in consolidation. The Company evaluates investments including joint ventures, low income housing tax credit partnerships and other limited partnerships to determine if the Company is required to consolidate the entities under the guidance of Financial Accounting Standards Board (“FASB”) Interpretation No. 46 revised, Consolidation of Variable Interest Entities-an interpretation of ARB No. 51 (“FIN 46R”).
Certain prior period items in these consolidated financial statements have been reclassified to conform to the current period presentation. As discussed in Note 3-Discontinued Operations, the operations of certain businesses have been accounted for as discontinued operations in accordance with the SFAS No. 144. Accordingly, results of operations from prior periods have been reclassified to discontinued operations. Unless noted, discussions herein pertain to the Company’s continuing operations. These consolidated financial statements reflect all adjustments, which are normal and recurring in nature, necessary to present fairly the financial position, results of operations and cash flows for the periods presented.
The Company reports corporate interest income and corporate interest expense separately from operating interest income and operating interest expense. The Company believes reporting these two items separately provides a clearer picture of the financial performance of the Company’s operations than would a presentation that combined these two items. Operating interest income and operating interest expense is generated from the operations of the Company and is a broad indicator of the Company’s performance in its banking and balance sheet management businesses. Corporate debt, which is the primary source of the corporate interest expense, has been issued primarily in connection with the Citadel Investment and past acquisitions, such as Harrisdirect and BrownCo.
Similarly, the Company reports gain (loss) on sales of investments, net separately from gain (loss) on loans and securities, net. The Company believes reporting these two items separately provides a clearer picture of the financial performance of its operations than would a presentation that combined these two items. Gain (loss) on loans and securities, net is the result of activities in the Company’s operations, namely its balance sheet
management business, including impairment on its available-for-sale mortgage-backed and investment securities portfolio. Gain (loss) on sales of investments, net relates to historical equity investments of the Company at the corporate level and are not related to the ongoing business of the Company’s operating subsidiaries.
New Income Statement Reporting Format-During the year ended December 31, 2008, the Company re-defined the line item “Total net revenue” by removing “Provision for loan losses” and separately stating it as its own line item and reclassified hedge ineffectiveness recorded in accordance with SFAS No. 133, as amended, from “Other operating expense” to the “Gain (loss) on loans and securities, net” line item on the consolidated statement of income (loss).
Use of Estimates-The consolidated financial statements were prepared in accordance with GAAP, which require management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and related notes for the periods presented. Actual results could differ from management’s estimates. Material estimates in which management believes near-term changes could reasonably occur include allowance for loan losses; fair value measurements; classification and valuation of certain investments; accounting for financial derivatives; estimates of effective tax rates, deferred taxes and valuation allowances; valuation of goodwill and other intangibles; and valuation and expensing of share-based payments.
Citadel Investment-On November 29, 2007, the Company entered into an agreement to receive a $2.5 billion cash infusion from Citadel. In consideration for the cash infusion, Citadel received three primary items: substantially all of the Company’s asset-backed securities portfolio (approximately $3.0 billion in amortized cost), 84.7 million shares of common stock(1) in the Company and approximately $1.8 billion in 12 1/2% springing lien notes(2).
The items in this transaction were negotiated at arms length and transacted simultaneously and in contemplation of one another. As a result, the $2.5 billion in proceeds were allocated to each item based on their relative fair values at the time of the transaction.
The key components of the Company’s accounting for this transaction were as follows:
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Asset-backed securities portfolio sale, which resulted in a pre-tax loss on sale of approximately $2.2 billion;
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Issuance of common stock, which resulted in an increase to common stock/paid in capital of approximately $340 million; and
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Issuance of springing lien notes, which had approximately $500 million of discount assigned to them and will be amortized as an increase to interest expense using the effective interest method over the 10 year term of the notes.
(1) The 84.7 million shares of common stock were issued in increments: 14.8 million upon initial closing in November 2007; 23.2 million upon Hart-Scott-Rodino Antitrust Improvements Act approval in December 2007; and 46.7 million shares were issued in May 2008.
(2)
Included in the $1.8 billion issuance is $186 million of 12 1/2% springing lien notes in exchange for $186 million of the Company’s senior notes that were owned by Citadel. The $1.8 billion in 12 1 /2% springing lien notes includes $100 million in notes issued to BlackRock in connection with the transaction. The $1.8 billion in 12 1/2% springing lien notes represents the amount outstanding as of December 31, 2007 and does not include the additional $150 million of springing lien notes issued in January 2008 or the $121 million of springing lien notes capitalized in lieu of an interest payment in November 2008 in accordance with the terms of the agreement with Citadel.
Financial Statement Descriptions and Related Accounting Policies-Below are descriptions and accounting policies for the Company’s financial statement categories.
Cash and Equivalents-For the purpose of reporting cash flows, the Company considers all highly liquid investments with original or remaining maturities of three months or less at the time of purchase that are not required to be segregated under federal or other regulations to be cash and equivalents. Cash and equivalents are composed of interest-bearing and non-interest-bearing deposits, certificates of deposit, commercial paper, funds due from banks and federal funds. Cash and equivalents included $2.7 billion and $54.2 million at December 31, 2008 and 2007, respectively, of overnight cash deposits that the Company is required to maintain with the Federal Reserve Bank.
Cash and Investments Required to be Segregated Under Federal or Other Regulations-Cash and investments required to be segregated under federal or other regulations consist primarily of interest-bearing cash accounts. Certain cash balances, related to collateralized financing transactions by the Company’s brokerage subsidiaries, are required to be segregated for the exclusive benefit of the Company’s brokerage customers.
Trading Securities-Trading securities are bought and held principally for the purpose of selling them in the near term and are carried at estimated fair value. Realized and unrealized gains and losses on securities classified as trading held by the Bank are included in the gain (loss) of loans and securities, net line item and are derived using the specific identification method. Realized and unrealized gains and losses on trading securities held by broker-dealers are recorded in the principal transactions line item and are also derived by the specific identification method.
Available-for-Sale Mortgage-Backed and Investment Securities-The Company classified its debt securities, mortgage-backed securities and marketable equity securities as either trading or available-for-sale. None of the Company’s mortgage-backed or investment securities were classified as held-to-maturity at December 31, 2008 or 2007.
Available-for-sale securities consist of mortgage-backed securities, corporate bonds, municipal bonds, publicly traded equity securities and other debt securities. Securities classified as available-for-sale are carried at fair value, with the unrealized gains and losses reflected as a component of accumulated other comprehensive loss, net of tax. As of January 1, 2008, the Company adopted SFAS No. 157 for the fair value measurement of available-for-sale mortgage-backed and investment securities. Realized and unrealized gains or losses on available-for-sale securities, except for publicly traded equity securities, are computed using the specific identification method. Amortization or accretion of premiums and discounts are recognized in interest income using the interest method over the life of the security. Realized gains and losses and declines in fair value judged to be other-than-temporary are included in gain (loss) on loans and securities, net; other amounts relating to corporate investments are included in gain (loss) on sales of investments, net line item in the consolidated statement of income (loss). Interest earned is included in operating interest income for banking and balance sheet management operations or corporate interest income for corporate investments.
Available-for-sale securities that have an unrealized loss are evaluated for impairment in accordance with SFAS No. 115. Management uses judgment to estimate the future cash flows associated with each security held at a loss and to assess the probability of collecting those cash flows. Management uses a qualitative and quantitative risk approach to evaluate each security held at a loss, which includes assessing underlying collateral characteristics to determine if there has been an adverse change in the amount or timing of the estimated future cash flows, which would indicate other-than-temporary impairment. The Company recognizes an impairment charge by writing the amortized cost basis of the security down to its fair market value when the Company believes that there has been a probable adverse change in the estimated future cash flows of the security. When it is determined that a security has other-than-temporary impairment, the Company recognizes an impairment charge in the gain (loss) on loans and securities, net line item in the consolidated statement of income (loss). Subsequent to the sale of the asset-backed securities portfolio in 2007, the Company no longer holds a significant
number of securities that were rated below “AA” at the time of purchase and are subject to Emerging Issues Task Force (“EITF”) 99-20, Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets (“EITF 99-20”).
Margin Receivables-Margin receivables represent credit extended to customers and non-customers to finance their purchases of securities by borrowing against securities they currently own. Receivables from non-customers represent credit extended to principal officers and directors of the Company to finance their purchase of securities by borrowing against securities owned by them. Margin receivables to the Company’s principal officers totaled less than $0.1 million for both December 31, 2008 and 2007. Securities owned by customers and non-customers are held as collateral for amounts due on the margin receivables, the value of which is not reflected in the consolidated balance sheet. In many cases, the Company is permitted to sell or re-pledge these securities held as collateral and use the securities to enter into securities lending transactions, to collateralize borrowings or for delivery to counterparties to cover customer short positions. At December 31, 2008, the fair value of securities that the Company received as collateral in connection with margin receivables and stock borrowing activities, where the Company is permitted to sell or re-pledge the securities, was approximately $3.8 billion. Of this amount, $1.0 billion had been pledged or sold at December 31, 2008 in connection with securities loans, bank borrowings and deposits with clearing organizations.
Loans, Net-Loans, net consists of loans that are held-for-sale and real estate and consumer loans that management has the intent and ability to hold for the foreseeable future or until maturity, also known as loans held for investment. Loans that are held for investment are carried at amortized cost adjusted for charge-offs, net, allowance for loan losses, deferred fees or costs on originated loans and unamortized premiums or discounts on purchased loans. Loan fees and certain direct loan origination costs are deferred and the net fee or cost is recognized in operating interest income using the interest method over the contractual life of the loans. Premiums and discounts on purchased loans are amortized or accreted into income using the interest method over the remaining period to contractual maturity and adjusted for actual prepayments. The Company classifies loans as nonperforming when full and timely collection of interest or principal becomes uncertain or when they are 90 days past due. Interest previously accrued, but not collected, is reversed against current income when a loan is placed on nonaccrual status and is considered nonperforming. Accretion of deferred fees is discontinued for nonperforming loans. Payments received on nonperforming loans are recognized as interest income when the loan is considered collectible and applied to principal when it is doubtful that full payment will be collected. The Company’s policy for one- to four-family loan charge-offs prior to January 1, 2008 was to charge-off to the extent that the carrying value of the loan exceeds the estimated net realizable value of the underlying collateral at the time of foreclosure. For home equity loans, the Company’s policy prior to January 1, 2008 was to charge-off at time of foreclosure or when the loan has been delinquent for 180 days. As of January 1, 2008, the Company adjusted its charge-off policy mainly for loans in the process of foreclosure. The updated policy for both one- to four-family and home equity loans is to assess the value of the property when the loans has been delinquent for 180 days or it is in bankruptcy, regardless of whether or not the property is in foreclosure, and charge-off the amount of the loan balance in excess of the estimated current property value. Credit cards are charged-off when collection is not probable or the loan has been delinquent for 180 days. Consumer loans are charged-off when the loan has been delinquent for 120 days or when it is determined that collection is not probable.
Allowance for Loan Losses-The allowance for loan losses is management’s estimate of credit losses inherent in the Company’s loan portfolio as of the balance sheet date. The estimate of the allowance is based on a variety of factors, including the composition and quality of the portfolio; delinquency levels and trends; probable expected losses for the next twelve months; current and historical charge-off and loss experience; current industry charge-off and loss experience; the condition of the real estate market and geographic concentrations within the loan portfolio; the interest rate climate; the overall availability of housing credit; and general economic conditions. Determining the adequacy of the allowance is complex and requires judgment by management about the effect of matters that are inherently uncertain. Subsequent evaluations of the loan portfolio, in light of the factors then prevailing, may result in significant changes in the allowance for loan losses in future periods. In general, the allowance for loan losses should be at least equal to twelve months of projected
losses for all loan types. Management believes this level is representative of probable losses inherent in the loan portfolio at the balance sheet date. Loan losses are charged and recoveries are credited to the allowance for loan losses.
Property and Equipment, Net-Property and equipment are carried at cost and depreciated on a straight-line basis over their estimated useful lives, generally three to ten years. Leasehold improvements are amortized over the lesser of their estimated useful lives or lease terms. Buildings are depreciated over the lesser of their estimated useful lives or forty years. Land is carried at cost. Technology development costs are charged to operations as incurred. Technology development costs include costs incurred in the development and enhancement of software used in connection with services provided by the Company that do not otherwise qualify for capitalization treatment as internally developed software costs in accordance with Statement of Position (“SOP”) 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use.
In accordance with SOP 98-1, the cost of internally developed software is capitalized and included in property and equipment at the point at which the conceptual formulation, design and testing of possible software project alternatives are complete and management authorizes and commits to funding the project. The Company does not capitalize pilot projects and projects where it believes that future economic benefits are less than probable. Internally developed software costs include the cost of software tools and licenses used in the development of the Company’s systems, as well as specifically identified payroll and consulting costs.
Goodwill and Other Intangibles, Net-Goodwill and other intangibles, net represents the excess of the purchase price over the fair value of net tangible assets acquired through the Company’s business combinations. The Company tests goodwill and intangible assets with indefinite lives for impairment on at least an annual basis or when certain events occur. The Company evaluates the remaining useful lives of other intangible assets with finite lives each reporting period to determine whether events and circumstances warrant a revision to the remaining period of amortization.
Servicing Rights-Servicing rights are recognized when the Company sells a loan and retains the related servicing rights. In March 2006, the FASB issued SFAS No. 156, Accounting for Servicing of Financial Assets (“SFAS No. 156”). This statement establishes, among other things, the accounting for all separately recognized servicing assets and liabilities. The Company adopted this statement on January 1, 2007 and the impact was not material to the Company’s financial condition, results of operations or cash flows. As of January 1, 2008, the Company elected to account for servicing rights under the fair value measurement method. The transition adjustment to opening retained earnings as of January 1, 2008 related to the fair value measurement election was $0.3 million.
Real Estate Owned and Repossessed Assets-Included in the other assets line item in the consolidated balance sheet is real estate acquired through foreclosure and repossessed consumer assets. Real estate properties acquired through foreclosures, commonly referred to as REO and repossessed assets, are recorded at the lower of its carrying value or fair value, less estimated selling costs.
Income Taxes-The Company accounts for income taxes in accordance with SFAS No. 109, Accounting for Income Taxes (“SFAS No. 109”), which prescribes the use of the asset and liability method whereby deferred tax asset or liability account balances are calculated at the balance sheet date using current tax laws and rates in effect. Valuation allowances are established, when necessary, to reduce deferred tax assets when it is more likely than not that a portion or all of a given deferred tax asset will not be realized. In accordance with SFAS No. 109, income tax expense includes (i) deferred tax expense, which generally represents the net change in the deferred tax asset or liability balance during the year plus any change in valuation allowances and (ii) current tax expense, which represents the amount of tax currently payable to or receivable from a taxing authority. Uncertain tax positions are only recognized to the extent they satisfy the criteria under FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes (“FIN 48”), which states that an uncertain tax position must be more likely than not of being sustained upon examination. The amount of tax benefit recognized is the largest amount of tax benefit that is more than fifty percent likely of being sustained on ultimate settlement of an uncertain tax position.
Securities Sold Under Agreements to Repurchase-Securities sold under agreements to repurchase similar securities, also known as repurchase agreements, are collateralized by fixed- and variable-rate mortgage-backed securities or investment grade securities. Repurchase agreements are treated as secured borrowings for financial statement purposes and the obligations to repurchase securities sold are reflected as such in the consolidated balance sheet.
Customer Payables-Customer payables to customers and non-customers represent credit balances in customer accounts arising from deposits of funds and sales of securities and other funds pending completion of securities transactions. The Company pays interest on certain customer payables balances.
Mandatory Convertible Debt-The Company accounted for its mandatory convertible debt by allocating the proceeds using the relative fair value of the stock purchase contracts and the debt securities on the date of issuance. The issue costs were deferred and allocated to the debt securities and the stock purchase contracts based on their relative fair values at issuance date. The portion of issuance costs allocated to the debt was amortized to corporate interest expense over the life of the debt using the interest method. In 2008, the Company retired the entire $450 million principal amount of the mandatory convertible notes with the issuance of 25 million shares of common stock at $18 per share (the mandatory conversion price).
Foreign Currency Translation-Assets and liabilities of consolidated subsidiaries whose functional currency is not the U.S. dollar are translated into U.S. dollars, the functional currency of the Company, using the exchange rate in effect at each period end. Revenues and expenses are translated at the weighted average exchange rate during the period. The effects of foreign currency translation adjustments arising from differences in exchange rates from period to period are deferred and included in accumulated other comprehensive loss for subsidiaries whose functional currency is their local currency. Currency transaction gains or losses, derived on monetary assets and liabilities stated in a currency other than the functional currency, are recognized in current operations and have not been significant to the Company’s operating results in any period.
Comprehensive Income (Loss)-The Company’s comprehensive income (loss) is comprised of net income (loss), foreign currency translation gains (losses), unrealized gains (losses) on available-for-sale securities and the effective portion of the unrealized gains (losses) on financial derivatives in cash flow hedge relationships, net of reclassification adjustments and related tax.
Earnings (Loss) Per Share-Basic earnings (loss) per share is computed by dividing net income (loss) by the weighted-average common shares outstanding for the period. Diluted earnings (loss) per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock.
Financial Derivative Instruments and Hedging Activities-The Company enters into derivative transactions to hedge against the risk of market price or interest rate movements on the value of certain assets, liabilities and future cash flows. The Company must also recognize certain contracts and commitments as derivatives, whether freestanding or embedded, when the characteristics of those contracts and commitments meet the definition of a derivative promulgated by SFAS No. 133, as amended.
Each derivative is recorded on the balance sheet at fair value as a freestanding asset or liability. Financial derivative instruments in hedging relationships that mitigate exposure to changes in the fair value of assets or liabilities are considered fair value hedges under SFAS No. 133, as amended. Financial derivative instruments designated in hedging relationships that mitigate the exposure to the variability in expected future cash flows or other forecasted transactions are considered cash flow hedges. The Company formally documents at inception all relationships between hedging instruments and hedged items and the risk management objective and strategy for each hedge transaction. For financial statement purposes, the Company’s policy is to not offset fair value amounts recognized for derivative instruments and fair value amounts related to collateral arrangements under master netting arrangements.
Fair value hedges are accounted for by recording the fair value of the financial derivative instrument and the change in fair value of the asset or liability being hedged on the consolidated balance sheet with the net difference, or hedge ineffectiveness, reported as fair value adjustments of financial derivatives in the gain (loss) on loans and securities, net line item in the consolidated statement of income (loss). Cash payments or receipts and related accruals during the reporting period on derivatives included in fair value hedge relationships are recorded as an adjustment to interest income on the hedged asset or liability. If a financial derivative in a fair value hedging relationship is no longer effective, de-designated from its hedging relationship or terminated, the Company discontinues fair value hedge accounting for the derivative and the hedged item. Changes in the fair value of these derivative instruments no longer designated in an accounting hedge relationship are recorded in the gain (loss) on loans and securities, net, line item in the consolidated statement of income (loss). The accumulated adjustment of the carrying amount of the hedged interest-earning asset or liability is recognized in earnings as an adjustment to interest income over the expected remaining life of the asset using the effective interest method.
Cash flow hedges are accounted for by recording the fair value of the financial derivative instrument as either a freestanding asset or a freestanding liability in the consolidated balance sheet, with the effective portion of the change in fair value of the financial derivative recorded in accumulated other comprehensive loss, net of tax in the consolidated balance sheet. Amounts are then included in net operating interest income as a yield adjustment in the same period the hedged forecasted transaction affects earnings. The ineffective portion of the change in fair value of the financial derivative is reported as fair value adjustments of financial derivatives in the gain (loss) on loans and securities, net line item in the consolidated statement of income (loss). If it becomes probable that a hedged forecasted transaction will not occur, amounts included in accumulated other comprehensive loss related to the specific hedging instruments are reported in the gain (loss) on loans and securities, net line item in the consolidated statement of income (loss). If a financial derivative ceases to be highly effective as a hedge, hedge accounting is discontinued prospectively and the financial derivative instrument continues to be recorded at fair value with changes in fair value being reported in the gain (loss) on loans and securities, net line item in the consolidated statement of income (loss).
Derivative gains and losses that are not held as accounting hedges are recognized in the gain (loss) on loans and securities, net line item in the consolidated statement of income (loss) as these derivatives do not qualify for hedge accounting under SFAS No. 133, as amended.
Fair Value-Effective January 1, 2008, the Company adopted SFAS No. 157 which defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The Company determines the fair value of its financial instruments and for nonfinancial assets and nonfinancial liabilities that are recognized or disclosed at fair value in the financial statements on a recurring basis in accordance with SFAS No. 157. The Company will not adopt certain provisions of this statement until January 1, 2009 as they relate to nonfinancial assets and nonfinancial liabilities that are not recognized or disclosed at fair value in the financial statements on a recurring basis. Examples of assets and liabilities for which the Company has not applied the provisions of SFAS No. 157 include reporting units and indefinite-lived intangible assets measured at fair value in impairment tests under SFAS No. 142, nonfinancial long-lived assets measured at fair value for an impairment assessment under SFAS No. 144, as well as nonfinancial liabilities for exit or disposal activities initially measured at fair value under SFAS No. 146. See Note 6-Fair Value Disclosures.
Fair Value Option-Effective January 1, 2008, the Company elected to carry investments in Fannie Mae and Freddie Mac preferred stock at fair value through earnings under SFAS No. 159. The Company elected to carry the investment in preferred stock at fair value through earnings to allow the Company to economically hedge the portfolio without the burden of complying with SFAS No. 133, as amended. The impact of this adoption was an after-tax decrease to opening retained earnings as of January 1, 2008 of approximately $86.9 million ($134.9 million before taxes). As of December 31, 2007, the Company’s investment in preferred stock was reported in the balance sheet line item available-for-sale mortgage-backed and investment securities. In accordance with SFAS No. 159, as a result of the fair value election the investment in preferred stock was
reported in the balance sheet line item trading securities, at a fair value of $371.4 million, as of January 1, 2008. Realized and unrealized gains and losses on securities classified as trading are included in the gain (loss) on loans and securities, net line item. The Company liquidated its investment in preferred stock during the year ended December 31, 2008, which resulted in a pre-tax loss of $153.8 million, net of hedges.
Operating Interest Income-Operating interest income is recognized as earned primarily through holding credit balances, including margin, real estate and consumer loans. Other interest-earning assets include mortgage-backed and investment securities, stock borrow balances and cash and equivalents, including cash required to be segregated under regulatory guidelines. Operating interest income includes the impact of effective hedges on interest-earning assets.
Operating Interest Expense-Operating interest expense is recognized as incurred primarily through holding customer cash and deposits. Other interest-bearing liabilities include repurchase agreements and other borrowings, FHLB advances and stock loan balances. Operating interest expense includes the impact of effective hedges on interest-bearing liabilities.
Commission-Commission revenue is derived primarily from the Company’s retail customers and is impacted by both trade types and the mix between the Company’s domestic and international businesses. Commission revenue from securities transactions are recognized on a trade date basis.
Fees and Service Charges-Fees and service charges consist of account maintenance fees, payments for order flow, foreign exchange margin revenue, 12b-1 fees, fixed income product revenue and advisor management fee revenue. Account maintenance fees are charges to the customer either quarterly or annually and are accrued as earned. Payments for order flow are accrued in the same period in which the related securities transactions are completed or related services are rendered.
Principal Transactions-Principal transactions consist primarily of revenue from market-making activities. Market-making activities are the matching of buyers and sellers of securities and include transactions where the Company will purchase securities for its balance sheet with the intention of resale to transact the customer’s buy or sell order.
Gain (Loss) on Loans and Securities, Net-Gain (loss) on loans and securities, net includes gains or losses resulting from the sale or impairment of available-for-sale securities; gains or losses on trading securities; gains or losses resulting from sales of loans; hedge ineffectiveness; and gains or losses on financial derivatives that are not accounted for as hedging instruments under SFAS No. 133, as amended. Gains or losses resulting from the sale of loans are recognized at the date of settlement and are based on the difference between the cash received and the carrying value of the related loans, less related transaction costs. Nonrefundable fees and direct costs associated with the origination of mortgage loans are deferred and recognized when the related loans are sold. Gains or losses resulting from the sale of available-for-sale securities are recognized at the trade date, based on the difference between the anticipated proceeds and the amortized cost of the specific securities sold.
Other Revenue-Other revenue primarily consists of stock plan administration services, other revenue ancillary to the Company’s retail customer transactions and income from the cash surrender value of BOLI. Stock plan administration services are recognized in accordance with applicable accounting guidance, including SOP 97-2, Software Revenue Recognition.
Advertising and Market Development-Advertising production costs are expensed when the initial advertisement is run. Costs of print advertising are expensed as the services are received.
Share-Based Payments-The Company records share-based payment expense in accordance with SFAS No. 123(R) and Staff Accounting Bulletin No. 107, Share-Based Payment. SFAS No. 123(R) requires that the Company record compensation cost at the grant date fair value of a share-based payment award over the vesting period less estimated forfeitures. The underlying assumptions to these fair value calculations are discussed in
Note 20-Employee Share-Based Payments and Other Benefits. Additionally, the Company elected to adopt FASB Staff Position No. FAS 123(R)-3-Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards. This allows the Company to use the alternative transition method provided for calculating the tax effects of share-based compensation pursuant to SFAS No. 123(R).
New Accounting Standards-Below are the new accounting pronouncements that relate to activities in which the Company is engaged.
SFAS No. 156-Accounting for Servicing Financial Assets
In March 2006, the FASB issued SFAS No. 156. This statement establishes, among other things, the accounting for all separately recognized servicing assets and liabilities. The Company adopted this statement on January 1, 2007. As of January 1, 2008, the Company elected to account for servicing rights under the fair value measurement method. The transition adjustment to opening retained earnings as of January 1, 2008 related to the fair value measurement election was $0.3 million.
SFAS No. 157-Fair Value Measurements
In September 2006, the FASB issued SFAS No. 157, which establishes, among other things, a framework for measuring fair value and expands disclosure requirements as they relate to fair value measurements. The Company adopted this statement on January 1, 2008 for financial assets and financial liabilities and for nonfinancial assets and nonfinancial liabilities that are recognized or disclosed at fair value in the consolidated financial statements on a recurring basis, the effects of which were not material to the financial condition, results of operations or cash flows. The Company will not adopt certain provisions of this statement until January 1, 2009 as they relate to nonfinancial assets and nonfinancial liabilities that are not recognized or disclosed at fair value in the consolidated financial statements on a recurring basis. The Company does not expect the adoption of these provisions to have a material impact on the Company’s financial condition, results of operations or cash flows in future periods. In October 2008, the FASB issued FASB Staff Position (“FSP”) No. FAS 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active (“FSP No. FAS 157-3”), which clarifies the application of SFAS No. 157 in a market that is not active. The adoption of FSP No. FAS 157-3, which was effective upon issuance for prior periods for which the financial statements had not been issued, did not have a material impact on the Company’s financial condition, results of operations or cash flows. For additional information regarding the adoption of SFAS No. 157, see Note 6-Fair Value Disclosures.
SFAS No. 159-The Fair Value Option for Financial Assets and Financial Liabilities
In February 2007, the FASB issued SFAS No. 159, which provides an option under which a company may irrevocably elect fair value as the initial and subsequent measurement attribute for certain financial assets and financial liabilities. This fair value option is available on a contract-by-contract basis with changes in fair value recognized in earnings as those changes occur. The Company adopted this statement on January 1, 2008 and elected the fair value option for its Fannie Mae and Freddie Mac preferred stock. The impact of this adoption was an after-tax decrease to opening retained earnings as of January 1, 2008 of approximately $86.9 million.
SFAS No. 141R-Business Combinations
In December 2007, the FASB issued SFAS No. 141R, Business Combinations. This statement applies to all transactions or other events in which an entity obtains control of one or more businesses, including those sometimes referred to as “true mergers” or “mergers of equals” and combinations achieved without the transfer of consideration, for example, by contract alone or through the lapse of minority veto rights. This statement will be applied prospectively to business combinations for which the acquisition date is on or after the first annual reporting period beginning on or after December 15, 2008, or January 1, 2009 for the Company.
SFAS No. 160-Noncontrolling Interests in Consolidated Financial Statements
In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements. This statement applies to all entities that prepare consolidated financial statements, except not-for-profit organizations, but will affect only those entities that have an outstanding noncontrolling interest in one or more subsidiaries or that deconsolidate a subsidiary. This Statement will be applied prospectively as of the beginning of the fiscal year in which this Statement is initially adopted, or January 1, 2009 for the Company. The Company does not expect the adoption of this statement to have a material impact its financial condition, results of operations or cash flows in future periods.
SFAS No. 161-Disclosures About Derivative Instruments and Hedging Activities
In March 2008, the FASB issued SFAS No. 161, Disclosures About Derivative Instruments and Hedging Activities. This statement establishes, among other things, the disclosure requirements for derivative instruments and hedging activities. This statement is effective at the beginning of an entity’s first interim period beginning after November 15, 2008, or January 1, 2009 for the Company. The Company’s disclosures about derivative instruments and hedging activities will reflect the adoption of this statement in the first quarter of 2009.
SFAS No. 162-The Hierarchy of Generally Accepted Accounting Principles
In May 2008, the FASB issued SFAS No. 162, The Hierarchy of Generally Accepted Accounting Principles. This statement identifies the sources of accounting principles and the framework for selecting the principles to be used in the preparation of financial statements that are presented in conformity with GAAP. This statement will be effective 60 days following the SEC’s approval of the Public Company Accounting Oversight Board amendments to AU Section 411, The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles. The Company does not expect the adoption of this statement to have a material impact on its financial condition, results of operations or cash flows in future periods.
FSP No. FAS 140-3-Accounting for Transfers of Financial Assets and Repurchase Financing Transactions
In February 2008, the FASB issued FSP No. FAS 140-3, Accounting for Transfers of Financial Assets and Repurchase Financing Transactions (“FSP No. FAS 140-3”). FSP No. FAS 140-3 applies to repurchase agreements that relate to previously transferred financial assets between the same counterparties that are entered into contemporaneously with, or in contemplation of, the initial transfer (“repurchase financings”). FSP No. FAS 140-3 is effective for fiscal years beginning after November 15, 2008, or January 1, 2009 for the Company, and will be applied prospectively to initial transfers and repurchase financings for which the initial transfer is executed on or after January 1, 2009. The Company does not expect the adoption of this FSP to have a material impact on its financial condition, results of operations or cash flows in future periods.
FSP No. FAS 142-3-Determination of the Useful Life of Intangible Assets
In April 2008, the FASB issued FSP No. FAS 142-3, Determination of the Useful Life of Intangible Assets (“FSP No. FAS 142-3”). FSP No. FAS 142-3 applies to recognized intangible assets that are accounted for pursuant to SFAS No. 142. FSP No. FAS 142-3 is effective for fiscal years beginning after December 15, 2008, or January 1, 2009 for the Company. The guidance for determining the useful life of a recognized intangible asset will be applied prospectively to intangible assets acquired after the effective date. The disclosure requirements will be applied prospectively to all intangible assets recognized as of, and subsequent to, the effective date. The Company does not expect the adoption of this FSP to have a material impact on its financial condition, results of operations or cash flows in future periods.
FSP No. FAS 140-4 and FIN 46R-8-Disclosures by Public Entities (Enterprises) About Transfers of Financial Assets and Interests in Variable Interest Entities
In December 2008, the FASB issued FSP No. FAS 140-4 and FIN 46R-8, Disclosures by Public Entities (Enterprises) About Transfers of Financial Assets and Interests in Variable Interest Entities (“FSP No. FAS 140-4 and FIN 46R-8”). FSP No. FAS 140-4 and FIN 46R-8 amends the disclosure requirements of SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, and FIN 46R and is effective for the first reporting period ending after December 15, 2008, or December 31, 2008 for the Company. The adoption of FSP No. FAS 140-4 and FIN 46R-8 did not have a material impact on the Company’s financial condition, results of operations or cash flows.
FSP No. EITF 99-20-1-Amendments to the Impairment Guidance of EITF Issue No. 99-20
In January 2009, the FASB issued FSP No. EITF 99-20-1, Amendments to the Impairment Guidance of EITF Issue No. 99-20 (“FSP No. EITF 99-20-1”). FSP No. EITF 99-20-1 amends the impairment guidance in EITF No. 99-20 to align impairment guidance in EITF 99-20 with that in SFAS No. 115 and related impairment guidance. FSP No. EITF 99-20-1 applies to beneficial interests within the scope of EITF 99-20 and is effective for periods ending after December 15, 2008, or December 31, 2008 for the Company. The adoption of FSP No. EITF 99-20-1 did not have a material impact on the Company.
Staff Accounting Bulletin (“SAB”) No. 109-Written Loan Commitments Recorded at Fair Value Through Earnings
In November 2007, the SEC issued Staff Accounting Bulletin No. 109, Written Loan Commitments Recorded at Fair Value Through Earnings (“SAB No. 109”), which became effective for the Company on January 1, 2008. SAB No. 109 supersedes SAB No. 105, Application of Accounting Principles to Loan Commitments (“SAB No. 105”), and states, consistent with the guidance in SFAS No. 156 and SFAS No. 159, that the expected net future cash flows related to the associated servicing of the loan should be included in the measurement of all written loan commitments that are accounted for at fair value through earnings. SAB No. 109 retains the view expressed in SAB No. 105 that internally developed intangible assets (such as customer relationship intangible assets) should not be recorded as part of the fair value of a derivative loan commitment and broadens its application to all written loan commitments that are accounted for at fair value through earnings. The Company adopted this statement on January 1, 2008 and the impact of adoption was not material to its financial condition, results of operations or cash flows.
NOTE 2-BUSINESS COMBINATIONS
The Company did not complete any business combinations in 2008 or 2007. On August 1, 2006, the Company completed its acquisition of RAA, a Dallas, Texas-based investment advisor managing over $1 billion in assets. The aggregate purchase price of approximately $24.9 million included $19.8 million, or 0.8 million shares, in common stock issued and $5.1 million in cash. At acquisition, the purchase price included approximately $0.1 million in net assets acquired, $9.5 million in customer list and other intangibles and $1.6 million held in escrow, with the remaining $13.7 million recorded as goodwill. The purchase price has been allocated to the net assets acquired and the liabilities assumed based on their estimated fair values at the date of acquisition. The results of operations of each are included in the Company’s consolidated statement of income from the date of the acquisition.
The Company subsequently sold RAA in 2008. The sale of RAA did not qualify as a discontinued operation. For additional information, see Note 4-Facility Restructuring and Other Exit Activities.
NOTE 3-DISCONTINUED OPERATIONS
In 2008, the Company sold its Canadian brokerage business and exited its direct retail lending business. In 2006, the Company completed the sale of E*TRADE Professional Trading, LLC. Results of operations from these businesses have been reclassified to discontinued operations for the years ended December 31, 2008, 2007 and 2006.
Sale of Canadian Brokerage Business
The Company made the decision to sell its Canadian brokerage business and completed the sale to Scotiabank in 2008. The transaction resulted in a pre-tax gain of $429.0 million and associated income tax expense of $160.2 million. The Company does not have significant continuing involvement in the Canadian brokerage business, and its operations and cash flows have been eliminated from the ongoing operations of the Company. As a result, the Canadian brokerage business qualifies as a discontinued operation, in accordance with SFAS No. 144. The Company’s results of operations, net of income tax, include the Canadian brokerage business as a discontinued operation on the Company’s consolidated statement of income (loss) for all periods presented. Prior to the Canadian brokerage business being recorded as a discontinued operation, it was included in the results of operations of both the retail and institutional segments.
The following table summarizes the results of discontinued operations for the Canadian brokerage business (dollars in thousands):
Exit of the Direct Retail Lending Business
In 2008, the Company exited its direct retail lending business, which was the Company’s last remaining loan origination channel (the Company exited the wholesale mortgage lending business in 2007). As such, the entire direct retail lending business, including the wholesale mortgage lending business, met the requirements under SFAS No. 144 to be recorded and reported as discontinued operations. The operations and cash flows of the direct retail lending business have been eliminated from the ongoing operations of the Company and the Company did not have any significant continuing involvement in the direct retail lending business after its closure. Therefore, the Company’s results of operations, net of income tax, include direct retail lending business as a discontinued operation on the Company’s consolidated statement of income (loss) for all periods presented. Prior to the direct retail lending business being recorded as a discontinued operation, it was included in the results of operations of the retail segment.
The following table summarizes the results of discontinued operations for the direct retail lending business (dollars in thousands):
Sale of E*TRADE Professional Trading, LLC
In 2005, the Company decided to sell its professional agency business, E*TRADE Professional Trading, LLC. The Company executed and settled this transaction during the year ended December 31, 2006 and recorded approximately $2.6 million in gain, net of tax, on the sale.
The Company does not have significant continuing involvement in the operations of its professional agency business and does not continue any significant revenue-producing or cost-generating activities of this business. Therefore, the Company’s results of operations, net of income tax, include this business as a discontinued operation on the Company’s consolidated statement of income (loss) for all periods presented. Prior to this business being recorded as a discontinued operation, it was included in the results of the institutional segment.
The following table summarizes the results of discontinued operations for the agency trading business (dollars in thousands):
NOTE 4-FACILITY RESTRUCTURING AND OTHER EXIT ACTIVITIES
Restructuring and other exit activities liabilities are included in accounts payable, accrued and other liabilities in the consolidated balance sheet. The following table summarizes the changes in the facility restructuring and other exit activities liabilities for the years ended December 31, 2008 and 2007 (dollars in thousands):
(1)
Includes $6.0 million of charges reclassified to discontinued operations for the year ended December 31, 2007. Refer to Note 3-Discontinued Operations for more information.
(2)
Non-cash charges primarily relate to fixed assets that were written off related to the restructuring or exit activity.
The following table summarizes the expense recognized by the Company as facility restructuring and other exit activities from continuing operations for the periods presented (dollars in thousands):
Exit of Non-Core Operations
Institutional Brokerage Operations
In 2007, the Company announced a plan to simplify and streamline the business by exiting and/or restructuring certain non-core operations and took steps to restructure the institutional brokerage business to focus on areas that complement order flow generated by retail customers. In 2008, the Company announced the decision to exit certain institutional trading operations in the U.S. that do not align with the core retail business. As a result of these exits, the Company recognized $5.6 million and $9.1 million for facilities consolidation and asset write-off costs, $3.1 million and $7.0 million in severance costs and $1.5 million and $1.0 million of other costs related to these exits for the years ended December 31, 2008 and 2007, respectively. All of these charges have been recorded in the institutional segment.
The Company expects to incur charges in future periods as it periodically evaluates the estimates made in connection with this activity; however, the Company does not expect these charges to be significant.
Sale of RAA
In 2008, the Company sold substantially all of the assets of RAA to PHH Investments, Ltd for approximately $25 million. The sale of RAA resulted in a pre-tax gain of $2.8 million, which has been recorded in the retail segment.
Other Exit Activities
In 2007, the Company decided to consolidate and relocate certain of its facilities, which continued into 2008. The Company incurred $21.4 million and $7.5 million of charges for the years ended December 31, 2008 and 2007, primarily related to the exit of certain operating leases. These charges have been recorded in both the institutional and retail segments. Additionally, in 2007 the Company incurred $3.1 million in connection with reorganizing the management structure of the balance sheet management business, including changing the nature and focus of its operations, which has been recorded in the institutional segment.
In 2006, the Company decided to relocate certain functions out of the state of California as well as outsource certain clearing operations and costs related to the relocation of certain accounting functions. The Company incurred charges of $0.9 million and $29.2 million for the years ended December 31, 2007 and 2006, respectively, related to costs for exiting those facilities. The total charge for this exit activity was $30.1 million, all of which has been recorded in the retail segment.
The Company expects to incur charges in future periods as it periodically evaluates the estimates made in connection with this activity; however, the Company does not expect those costs to be significant.
Facility Consolidation Obligations
The components of the facility consolidation obligations for the Company’s restructuring and other exit activities at December 31, 2008 and their timing are as follows (dollars in thousands):
NOTE 5-OPERATING INTEREST INCOME AND OPERATING INTEREST EXPENSE
The following table shows the components of operating interest income and operating interest expense from continuing operations (dollars in thousands):
NOTE 6-FAIR VALUE DISCLOSURES
Effective January 1, 2008, the Company adopted SFAS No. 157 which defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The Company determines the fair value of its financial instruments and for nonfinancial assets and nonfinancial liabilities that are recognized or disclosed at fair value in the financial statements on a recurring basis in accordance with SFAS No. 157. The Company will not adopt certain provisions of this statement until January 1, 2009 as they relate to nonfinancial assets and nonfinancial liabilities that are not recognized or disclosed at fair value in the financial statements on a recurring basis. Examples of assets and liabilities for which the Company has not applied the provisions of SFAS No. 157 include reporting units and indefinite-lived intangible assets measured at fair value in impairment tests under SFAS No. 142, nonfinancial long-lived assets measured at fair value for an impairment assessment under SFAS No. 144, as well as nonfinancial liabilities for exit or disposal activities initially measured at fair value under SFAS No. 146.
In determining fair value, the Company uses various valuation approaches, including market, income and/or cost approaches. The fair value hierarchy established in SFAS No. 157 requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. Fair value is a market-based measure considered from the perspective of a market participant. As such, even when market assumptions are not readily available, the Company’s own assumptions reflect those that market participants would use in pricing the asset or liability at the measurement date. The standard describes the following three levels used to classify fair value measurements:
•
Level 1-Quoted prices in active markets for identical assets or liabilities. Examples of assets and liabilities utilizing Level 1 inputs as of December 31, 2008 include actively traded equity securities and U.S. Treasuries.
•
Level 2-Quoted prices in markets that are not active or for which all significant inputs are observable, either directly or indirectly. Examples of assets and liabilities utilizing Level 2 inputs as of December 31, 2008 include mortgage-backed securities backed by U.S. Government sponsored and federal agencies, certain CMOs, most investment securities and most derivatives.
•
Level 3-Unobservable inputs that are significant to the fair value of the assets or liabilities. Examples of assets and liabilities utilizing significant Level 3 inputs or those that require significant management judgment as of December 31, 2008 include certain CMOs, servicing rights and certain derivatives. In certain securities, including a portion of the CMO portfolio, where there has been limited activity or less transparency around inputs to the valuation, securities are classified as Level 3 even though the Company believes that Level 2 inputs could likely be obtainable in a more active market.
The availability of observable inputs can vary from instrument to instrument and in certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, an instrument’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement. The Company’s assessment of the significance of a particular input to the fair value measurement of an instrument requires judgment and consideration of factors specific to the instrument.
Recurring Fair Value Measurement Valuation Techniques
The fair value for certain financial instruments is derived using pricing models and other valuation techniques that involve significant management judgment. The price transparency of financial instruments is a key determinant of the degree of judgment involved in determining the fair value of the Company’s financial instruments. Financial instruments for which actively quoted prices or pricing parameters are available will generally have a higher degree of price transparency than financial instruments that are thinly traded or not quoted. In accordance with SFAS No. 157, the criteria used to determine whether the market for a financial instrument is active or inactive is based on the particular asset or liability. For equity securities, the Company’s definition of actively traded was based on average daily volume and other market trading statistics. The Company considered the market for other types of financial instruments, including certain CMOs, to be inactive as of December 31, 2008. As a result, the valuation of these financial instruments included significant management judgment in determining the relevance and reliability of market information available. The Company considered the inactivity of the market to be evidenced by several factors, including decreased price transparency caused by decreased volume of trades relative to historical levels.
Mortgage-backed Securities Backed by U.S. Government Sponsored and Federal Agencies
Mortgage-backed securities backed by U.S. Government sponsored and federal agencies include TBA securities and mortgage pass-through certificates. The fair value of mortgage-backed securities backed by U.S. Government sponsored and federal agencies is determined using quoted market prices, recent market transactions and spread data for similar instruments. Mortgage-backed securities backed by U.S. Government sponsored and federal agencies are generally categorized in Level 2 of the fair value hierarchy.
Collateralized Mortgage Obligations
CMOs, generally non-agency mortgage-backed securities, are typically valued using market observable data, when available, including recent external market transactions for similar instruments. The Company also utilized a pricing service to corroborate the market observability of the Company’s inputs used in the fair value measurements. The valuations of CMOs reflect the Company’s best estimate of what market participants would consider in pricing the financial instruments. The Company considers the price transparency for these financial instruments to be a key determinant of the degree of judgment involved in determining the fair value. Due to the limited activity and low level of transparency around inputs to their valuation, a portion of these securities are classified as Level 3 even though the Company believes that Level 2 inputs could likely be obtainable in a more active market.
Investment Securities
As of December 31, 2008, investment securities include municipal bonds and corporate bonds. For municipal bonds, the Company utilized recent market transactions for identical or similar bonds to corroborate
pricing service fair value measurements. Municipal bonds are generally categorized in Level 2 of the fair value hierarchy. The fair value of corporate bonds is estimated using market price quotes corroborated by recently executed transactions observable in the market. Corporate bonds are generally categorized in Level 2 of the fair value hierarchy.
Derivative Financial Instruments
The majority of the Company’s derivative financial instruments, interest rate swap and option contracts, are valued with pricing models commonly used by the financial services industry using market observable pricing inputs. The Company does not consider these models to involve significant judgment on the part of management and corroborated the fair value measurements with counterparty valuations. The majority of the Company’s derivative financial instruments are categorized in Level 2 of the fair value hierarchy. During the year ended December 31, 2008, the consideration of credit risk, the Company’s or the counterparty’s, did not result in an adjustment to the valuation of its derivative financial instruments.
U.S. Treasuries
The fair value of U.S. Treasuries is based on quoted market prices in active markets. U.S. Treasuries are classified as Level 1 of the fair value hierarchy.
Securities Owned and Securities Sold, Not Yet Purchased
Securities transactions entered into by certain broker-dealer subsidiaries are included in trading securities and securities sold, not yet purchased in the Company’s SFAS No. 157 disclosures. The fair value of securities owned and securities sold, not yet purchased is determined using listed or quoted market prices and are generally categorized in Level 1 or Level 2 of the fair value hierarchy.
Servicing Rights
On January 1, 2008, the Company elected to account for servicing rights under the fair value measurement method in accordance with SFAS No. 156. The fair value of the servicing rights is determined using models that include observable inputs, if available. To the extent observable inputs are not available, the Company estimates fair value based on the present value of expected future cash flows using its best estimate of the key assumptions, including anticipated loan prepayments and discount rates. Servicing rights are categorized as Level 3 in the fair value hierarchy when unobservable inputs are significant to the fair value measurements.
Recurring Fair Value Measurements
Assets and liabilities measured at fair value on a recurring basis are summarized below (dollars in thousands):
(1)
Deposits with clearing organizations includes U.S. Treasuries and investment securities deposited with clearing organizations by broker-dealer subsidiaries.
Both observable and unobservable inputs may be used to determine the fair value of positions that the Company has classified within the Level 3 category. As a result, the realized and unrealized gains and losses for assets and liabilities within the Level 3 category presented in the tables below may include changes in fair value that were attributable to both observable and unobservable inputs. The following table presents additional information about Level 3 assets and liabilities measured at fair value on a recurring basis for the year ended December 31, 2008 (dollars in thousands):
(1)
The majority of realized and unrealized gains (losses) included in earnings are reported in the gain (loss) on loans and securities, net line item.
(2)
The majority of total realized and unrealized gains (losses) were related to Level 3 instruments held at December 31, 2008.
(3)
The Company’s transfers in and out of Level 3 are as of the beginning of the reporting period on a quarterly basis.
(4)
The level classification transfers of certain CMOs were driven by changes in price transparency for the securities.
(5)
Represents Derivative assets net of Derivative liabilities for presentation purposes only.
Level 3 Assets and Liabilities
Level 3 assets and liabilities include instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation. As of December 31, 2008, 23% and 1% of the Company’s total assets and total liabilities, respectively, represented instruments measured at fair value on a recurring basis. Instruments measured at fair value on a recurring basis categorized as Level 3 as of December 31, 2008 represented less than 1% of the Company’s total assets and total liabilities.
In general, level classification transfers in and out of Level 3 during the year ended December 31, 2008 were driven by changes in price transparency in the CMO market throughout the year. The Company’s transfers in and out of Level 3 are as of the beginning of the reporting period on a quarterly basis. Level 3 assets as of December 31, 2008 include $3.9 million of CMOs classified as Level 2 on January 1, 2008. While the Company’s fair value estimates of Level 3 instruments as of December 31, 2008 utilized observable inputs where available, the valuation included significant management judgment in determining the relevance and reliability of market information considered and the financial instruments were therefore classified as Level 3. The Company recorded a $118.8 million loss in other comprehensive loss during the year ended December 31, 2008 on CMOs classified as Level 3 as of December 31, 2008. The Company recorded a $1.0 million loss in other comprehensive loss during the year ended December 31, 2008 related to CMOs classified as Level 2 on January 1, 2008 and Level 3 as of December 31, 2008. Of the $95.0 million impairment recorded for the year ended December 31, 2008 related to the CMO portfolio, $93.6 million related to CMOs classified as Level 3 as of January 1, 2008 and December 31, 2008.
Nonrecurring Fair Value Measurements
The Company also measures certain other financial assets at fair value on a nonrecurring basis in accordance with GAAP. As of December 31, 2008, loans, net included impaired loans with a current value of approximately $360 million that were measured at fair value on a nonrecurring basis. The majority of the fair value measurements of these loans were based on estimates of the current property value. The Company classified these fair value measurements as Level 3 of the fair value hierarchy as the valuations included Level 3 inputs that were significant to the estimate of fair value. The adjustments to fair value of these loans resulted in a loss of $132.2 million for the year ended December 31, 2008.
Disclosures about Fair Value of Financial Instruments
SFAS No. 107, Disclosures about Fair Value of Financial Instruments, requires the disclosure of the estimated fair value of financial instruments. The following disclosure of the estimated fair value of financial instruments, not otherwise disclosed above pursuant to SFAS No. 157, is made by the Company in accordance with SFAS No. 157. Different market assumptions and estimation methodologies could significantly affect estimated fair value amounts.
The fair value of financial instruments, not otherwise disclosed above pursuant to SFAS No. 157, whose estimated fair value approximates carrying value is summarized as follows:
•
Cash and equivalents, cash and investments required to be segregated, margin receivables and customer payables-Fair value is estimated to be carrying value.
•
Investment in FHLB stock-FHLB stock is carried at cost, which is considered to be a reasonable estimate of fair value.
The fair value of financial instruments whose estimated fair values were different from their carrying values is summarized below (dollars in thousands):
(1)
The carrying value of loans, net includes the allowance for loan losses of $1.1 billion and $0.5 billion as of December 31, 2008 and 2007, respectively.
•
Loans, net-For the held-for-investment portfolio, including one- to four-family, home equity, recreational vehicle, marine and auto loans, fair value is estimated by differentiating loans based on their individual characteristics, such as product classification, loan category, pricing features and remaining maturity. Management adjusts assumptions for expected losses, prepayments and discount rates to reflect the individual characteristics of the loans, such as credit risk, coupon, term, and payment characteristics, as well as the secondary market conditions for these types of loans. For commercial and credit card loans, fair value is estimated based on both individual and portfolio characteristics and recent market transactions, when available.
•
Deposits-For sweep deposit accounts, money market and savings accounts and checking accounts, fair value is the amount payable on demand at the reporting date. For certificates of deposit and brokered certificates of deposits, fair value is estimated by discounting future cash flows at the currently offered rates for deposits of similar remaining maturities.
•
Securities sold under agreements to repurchase-Fair value is determined by discounting future cash flows at the rate implied for other similar instruments with similar remaining maturities.
•
Other borrowings-For FHLB advances, fair value is estimated by discounting future cash flows at the current offered rates for borrowings of similar remaining maturities. For Floating Rate Junior Subordinated Debentures issued by ETBH, fair value is estimated by discounting future cash flows at the rate implied by dealer pricing quotes. For margin collateral, overnight and other short-term borrowings and collateralized borrowings, fair value approximates carrying value.
•
Corporate debt-Fair value is estimated using dealer pricing quotes.
In the normal course of business, the Company makes various commitments to extend credit and incur contingent liabilities that are not reflected in the consolidated balance sheet. Significant changes in the economy or interest rates influence the impact that these commitments and contingencies have on the Company in the future. Information related to such commitments and contingent liabilities is detailed in Note 23-Commitments, Contingencies and Other Regulatory Matters.
NOTE 7-AVAILABLE-FOR-SALE MORTGAGE-BACKED AND INVESTMENT SECURITIES
The amortized cost basis and estimated fair values of available-for-sale mortgage-backed and investment securities are shown in the following tables (dollars in thousands):
Contractual Maturities
The contractual maturities of available-for-sale debt securities, including mortgage-backed and debt securities, at December 31, 2008 are shown below (dollars in thousands):
The Company pledged $8.4 billion and $10.1 billion at December 31, 2008 and 2007, respectively, of available-for-sale securities as collateral for federal reserves, repurchase agreements and short-term borrowings.
Other-Than-Temporary Impairment of Investments
The following tables show the fair values and unrealized losses on investments, aggregated by investment category, and the length of time that individual securities have been in a continuous unrealized loss position (dollars in thousands):
The Company does not believe that any individual unrealized loss in the available-for-sale portfolio as of December 31, 2008 represents an other-than-temporary impairment. The majority of the unrealized losses on mortgage-backed securities are attributable to changes in interest rates and a re-pricing of risk in the market. Substantially all mortgage-backed securities backed by U.S. Government sponsored and federal agencies are “AAA” rated. Municipal bonds and corporate bonds are evaluated by reviewing the credit-worthiness of the issuer and general market conditions. The Company has the intent and ability to hold the securities in an unrealized loss position at December 31, 2008 until the market value recovers or the securities mature.
Within the securities portfolio, the asset-backed securities portfolio, which was sold in the fourth quarter of 2007, represented the highest concentration of credit risk. The Company recorded other-than-temporary impairment charges for asset-backed securities of $168.7 million and $1.5 million for years ended December 31, 2007 and 2006, respectively. Subsequent to the sale of that portfolio, the highest concentration of remaining credit risk, while considerably lower than the credit risk inherent in asset-backed securities, is the CMO portfolio. While the majority of this portfolio is AAA-rated, the Company concluded during 2008 that approximately $181.2 million of these securities had a probable risk of future loss as a result of the deterioration in the expected credit performance of the underlying loans in the securities. These securities were written down to their estimated fair market value by recording $95.0 million impairment during the year ended December 31, 2008.
Our intent to hold securities in an unrealized loss position at December 31, 2008 until the market value recovers or the securities mature was based on the facts and circumstances that existed as of that date. The Emergency Economic Stabilization Act of 2008 (the “Act”) was signed into law on October 3, 2008. This Act grants the Treasury authority to purchase debt securities from financial institutions under the TARP Capital Purchase Program. The administration in place at the Treasury on December 31, 2008 had not utilized this particular authority granted to them in this Act. Therefore, the Company’s ability and intent to hold securities in an unrealized loss position at December 31, 2008 until the market value recovers or the securities mature was based on this fact.
Subsequent to December 31, 2008, a new administration was put in place at the Treasury. On February 10, 2009, this new administration provided a high level outline of its plans to help resolve the credit crisis. As part of this plan, they announced their intentions to create the “Public-Private Investment Fund”. They stated that the purpose of this fund will be to purchase both loans and securities from financial institutions allowing them to cleanse their balance sheets of what are often referred to as “legacy” assets. The Company does not yet know enough about the details of this program to determine if it would be of interest to the Company. Therefore the Company cannot make an assessment of whether the Treasury’s plans under the Act will impact the Company’s intent with respect to these securities and its loans in future periods.
The Company elected the fair value option for its preferred stock under SFAS No. 159 as of January 1, 2008. Subsequent to the adoption, preferred stock was classified as trading securities. As of December 31, 2008, the Company no longer held preferred stock securities as all positions were sold during the year ended December 31, 2008.
The detailed components of the gain (loss) on loans and securities, net and gain (loss) on sales of investments, net line items on the consolidated statement of income (loss) are shown below.
Gain (Loss) on Loans and Securities, Net
Gain (loss) on loans and securities, net from continuing operations are as follows (dollars in thousands):
Gain (loss) on Sales of Investments, Net
Gain (loss) on sales of investments, net are as follows (dollars in thousands):
NOTE 8-LOANS, NET
Loans, net are summarized as follows (dollars in thousands):
In addition to these loans, the Company had no commitments to originate, buy or sell loans at December 31, 2008 (see Note 23-Commitments, Contingencies and Other Regulatory Matters).
The following table shows the percentage of adjustable and fixed-rate loans in the Company’s portfolio (dollars in thousands):
(1)
Includes the principal of held-for-sale loans of $0.1 billion at December 31, 2007. There were no held-for-sale loans at December 31, 2008. Loans held-for-sale are accounted for at lower of cost or fair value with adjustments recorded in the gain (loss) on loans and securities, net line item and are not considered in the allowance for loan losses.
The weighted-average remaining maturity of mortgage loans secured by one- to four-family residences was 326 and 337 months at December 31, 2008 and 2007, respectively. Additionally, all mortgage loans outstanding at December 31, 2008 and 2007 in the held-for-investment portfolio were serviced by other companies.
Activity in the allowance for loan losses is summarized as follows (dollars in thousands):
During 2008, the allowance for loan losses increased by $572.4 million. This increase was driven primarily by an increase of $374.7 million in the allowance allocated to the home equity loan portfolio, which began to deteriorate during the second half of 2007. During the year ended December, 31 2008, the Company also experienced deterioration in the performance of its one- to four-family loan portfolio.
Net charge-offs for the year ended December 31, 2008 increased by $811.7 million compared to the same period in 2007. The overall increase was primarily due to higher net charge-offs on home equity loans.
We classify loans as nonperforming when they are 90 days past due. The following table provides the breakout of nonperforming loans by type (dollars in thousands):
If the Company’s nonperforming loans at December 31, 2008 had been performing in accordance with their terms, the Company would have recorded additional interest income of approximately $45.9 million, $19.9 million and $1.9 million for the years ended December 31, 2008, 2007 and 2006, respectively. During 2008, the Company recognized $33.1 million in interest on loans that were in nonperforming status at December 31, 2008. At December 31, 2008 and 2007, there were no commitments to lend additional funds to any of these borrowers.
In 2007, the Company entered into a CDS on $4.0 billion of its first-lien residential real estate loan portfolio through a synthetic securitization structure. As of December 31, 2008, the balance of the loans covered by the CDS was $2.9 billion. A CDS provides, for a fee, an assumption by a third party of a portion of the credit risk related to the underlying loans. The CDS provides protection for losses in excess of $4.0 million, but not to exceed approximately $30.3 million. In addition, the Company’s regulatory risk-weighted assets were reduced as a result of this transaction because the Company transferred a portion of its credit risk to an unaffiliated third party. During the year ended December 31, 2008, the Company recognized $1.6 million in losses on the portion of the loans covered under the CDS. The Company has not yet realized any recoveries from the CDS; however, the estimated recoveries from the CDS for the next twelve months were $13.9 million at December 31, 2008, which is reflected in the allowance for loan losses.
NOTE 9-ACCOUNTING FOR DERIVATIVE FINANCIAL INSTRUMENTS AND HEDGING ACTIVITIES
The Company enters into derivative transactions to protect against the risk of market price or interest rate movements on the value of certain assets, liabilities and future cash flows. The Company is also required to recognize certain contracts and commitments as derivatives when the characteristics of those contracts and commitments meet the definition of a derivative as promulgated by SFAS No. 133, as amended.
Fair Value Hedges
The Company uses a combination of interest rate swaps, forward-starting swaps and purchased options on swaps to offset its exposure to changes in value of certain fixed-rate assets and liabilities. Changes in the fair value of the derivatives are recognized currently in earnings. To the extent that the hedge is ineffective, the changes in the fair values will not offset and the difference, or hedge ineffectiveness, is reflected in other expense excluding interest in the gain (loss) on loans and securities, net line item in the consolidated statement of income (loss).
The following table summarizes information related to financial derivatives in fair value hedge relationships (dollars in thousands):
(1)
Purchased interest rate options were used to hedge mortgage loans and mortgage-backed securities.
De-designated Fair Value Hedges
During the years ended December 31, 2008 and 2007, certain fair value hedges were de-designated; therefore, hedge accounting was discontinued during those periods. The net gain or loss on the underlying transactions being hedged is amortized to operating interest expense or operating interest income over the original forecasted period at the time of de-designation. Changes in the fair value of these derivative instruments after de-designation of fair value hedge accounting are recorded in the gain (loss) on loans and securities, net line item in the consolidated statement of income (loss).
Cash Flow Hedges
The Company uses a combination of interest rate swaps, forward-starting swaps and purchased options on caps and floors to hedge the variability of future cash flows associated with existing variable-rate liabilities and assets and forecasted issuances of liabilities. These cash flow hedge relationships are treated as effective hedges as long as the future issuances of liabilities remain probable and the hedges continue to meet the requirements of SFAS No. 133, as amended. The future issuance of these liabilities, including securities sold under agreements to repurchase, are largely dependent on the market demand and liquidity in the wholesale borrowings market. Additionally, the Company enters into forward purchase and sale agreements, which are considered cash flow hedges, when the terms of the commitments exactly match the terms of the securities purchased or sold.
As of December 31, 2008, the Company believes the forecasted issuance of all debt in cash flow hedge relationships is probable. However, unexpected changes in market conditions in future periods could impact the ability to issue this debt. The Company believes the forecasted issuance of debt in the form of repurchase agreements is most susceptible to an unexpected change in market conditions.
Changes in the fair value of derivatives that hedge cash flows associated with repurchase agreements, FHLB advances and home equity lines of credit are reported in accumulated other comprehensive loss as unrealized gains or losses, for both active and terminated hedges. If the derivatives are determined to be effective hedges, the amounts in accumulated other comprehensive loss are included in operating interest expense or operating interest income as a yield adjustment during the same periods in which the related interest on the funding affects earnings. If the derivatives are determined not to be effective hedges, the amount recorded in other comprehensive income would be reclassified into the gain (loss) on loans and securities, net line item in the consolidated statement of income (loss). During the upcoming twelve months, the Company expects to include a pre-tax amount of approximately $96 million of net unrealized loss that are currently reflected in accumulated other comprehensive loss in operating interest expense as a yield adjustment in the same periods in which the related items affect earnings.
The following table summarizes information related to the Company’s financial derivatives in cash flow hedge relationships, hedging variable-rate assets and liabilities and the forecasted issuances of liabilities (dollars in thousands):
(1)
Caps are used to hedge repurchase agreements and FHLB advances. Floors are used to hedge home equity lines of credit.
Under SFAS No. 133, as amended, the Company is required to record the fair value of gains and losses on derivatives designated as cash flow hedges in accumulated other comprehensive loss in the consolidated balance sheet. In addition, during the normal course of business, the Company terminates certain interest rate swaps and options.
The following tables show: 1) amounts recorded in accumulated other comprehensive loss related to derivative instruments accounted for as cash flow hedges; 2) the notional amounts and fair values of derivatives terminated for the periods presented; and 3) the amortization of terminated interest rate swaps included in operating interest expense and operating interest income (dollars in thousands):
The gains (losses) accumulated in other comprehensive loss on the derivative instruments terminated shown in the preceding table will be included in operating interest expense and operating interest income over the periods the variable rate liabilities and hedged forecasted issuance of liabilities will affect earnings, ranging from 188 days to approximately 14 years.
The following table shows the balance in accumulated other comprehensive loss attributable to open cash flow hedges and discontinued cash flow hedges (dollars in thousands):
The following table shows the balance in accumulated other comprehensive loss attributable to cash flow hedges by type of hedged item (dollars in thousands):
Hedge Ineffectiveness
In accordance with SFAS No. 133, as amended, the Company recognizes hedge ineffectiveness on both fair value and cash flow hedge relationships. The amount of ineffectiveness recorded in earnings for cash flow hedges is equal to the excess of the cumulative change in the fair value of the actual derivative over the cumulative change in the fair value of a hypothetical derivative which is created to match the exact terms of the underlying instruments being hedged. These amounts are reflected in the gain (loss) on loans and securities, net line item in the consolidated statement of income (loss). Cash flow and fair value ineffectiveness are re-measured on a quarterly basis. The following table summarizes income (expense) recognized by the Company as fair value and cash flow hedge ineffectiveness (dollars in thousands):
Economic Hedges
During the year ended December 31, 2008, the Company used equity put options and credit default swaps as economic hedges against potential changes in the value of the Fannie Mae and Freddie Mac preferred stock.
Derivatives used as economic hedges but not designated in a hedging relationship for accounting purposes are included in derivative assets or derivative liabilities. The mark and interest income or expense on the net hedged position is recognized in gain (loss) on loans and securities, net.
Liability to Lehman Brothers
Prior to Lehman Brothers’ declaration of bankruptcy in September 2008, the Bank was a counterparty to interest rate derivative contracts with a subsidiary of Lehman Brothers. Lehman Brothers’ declaration of bankruptcy triggered an event of default and early termination under the Bank’s International Swap Dealers Association Master Agreement. As of the date of the event of default, the Bank’s net amount due to the Lehman Brothers subsidiary was approximately $101 million, the majority of which was collateralized by securities held by or on behalf of the Lehman Brothers subsidiary. The Bank is currently pursuing a settlement of the obligation, including a return of the collateral and payment of cash for the net amount owed to Lehman Brothers.
Credit Risk
Credit risk is an element of the recurring fair value measurements for certain assets and liabilities, including derivative instruments. Credit risk is managed by limiting activity to approved counterparties and setting aggregate exposure limits for each approved counterparty. The Company also monitors collateral requirements on derivative instruments through credit support agreements, which reduce risk by permitting the netting of transactions with the same counterparty upon occurrence of certain events. The Company considered the impact of credit risk on the fair value measurement for derivative instruments, particularly those in net liability positions to counterparties, to be mitigated by the enforcement of credit support agreements, and the collateral requirements therein. The Company pledged approximately $441.4 million of its mortgage-backed securities as collateral related to its derivative contracts.
The Company’s credit risk analysis for derivative instruments also considered whether the cost to mitigate the credit loss exposure on derivative instruments in net asset positions would have resulted in material adjustments to the valuations. During the year ended December 31, 2008, the consideration of counterparty credit risk did not result in an adjustment to the valuation of its derivative financial instruments.
While the Company does not expect that any counterparty will fail to perform, the maximum exposure associated with each counterparty to interest rate swaps and purchased interest rate options at December 31, 2008 was $23.8 million, net of derivative liabilities. The exposure was concentrated in two counterparties (Credit Suisse First Boston and Royal Bank of Scotland).
NOTE 10-PROPERTY AND EQUIPMENT, NET
Property and equipment, net consists of the following (dollars in thousands):
(1)
As of December 31, 2007, equipment and transportation included $47.4 million of aircraft that met the criteria and were accounted for as being held-for-sale in accordance with SFAS No. 144. The net book value of the aircraft was $30.9 million at December 31, 2007. The aircraft was sold during the year ended December 31, 2008, resulting in a pre-tax gain of $23.7 million.
Depreciation and amortization expense from continuing operations related to property and equipment was $82.5 million, $83.2 million and $71.2 million for the years ended December 31, 2008, 2007 and 2006, respectively.
Software includes capitalized internally developed software costs. These costs were $65.5 million, $64.1 million and $37.3 million for the years ended December 31, 2008, 2007 and 2006, respectively. Completed projects are carried at cost and are amortized on a straight-line basis over their estimated useful lives, generally four years. Amortization expense from continuing operations for the capitalized amounts was $33.4 million, $27.2 million and $24.6 million for the years ended December 31, 2008, 2007 and 2006. Also included in software at December 31, 2008 is $54.0 million of internally developed software in the process of development for which amortization has not begun.
NOTE 11-GOODWILL AND OTHER INTANGIBLES, NET
The following table discloses the changes in the carrying value of goodwill that occurred in the retail and institutional segments for the periods presented (dollars in thousands):
(1)
The $43.0 million of goodwill related to Investsmart was moved to the Investsmart investment in the other assets line item during 2007.
For the year ended December 31, 2008, the changes in the carrying value of goodwill are the result of the Company paying additional purchase consideration in connection with prior acquisitions, offset by write-offs of goodwill related to certain exit activities and discontinued operations (see Note 2-Discontinued Operations and Note 3-Facility Restructuring and Other Exit Activities for further discussion).
For the year ended December 31, 2007, the changes in the carrying value of goodwill are the result of the Company recognizing an impairment of goodwill related the Company’s balance sheet management business. The impairment of goodwill for this business occurred during the fourth quarter of 2007 and was due primarily to the decline in fair value related to the crisis in the residential real-estate and credit markets. The method used for determining the fair value of the balance sheet management business was a combination of prices for comparable businesses and the expected present value of future cash flows of the business. In addition, there was a write-off of goodwill related to certain exit activities. These decreases were slightly offset by purchase accounting adjustments related to earn outs and escrow releases on prior acquisitions that were made by the Company.
Other intangible assets with finite lives, which are primarily amortized on an accelerated basis, consist of the following (dollars in thousands):
(1)
Fully amortized other intangible assets not included in the table above.
Assuming no future impairments of these assets or additional acquisitions, annual amortization expense will be as follows (dollars in thousands):
Amortization of other intangibles from continuing operations was $35.7 million, $40.5 million and $46.2 million for the years ended December 31, 2008, 2007 and 2006, respectively.
NOTE 12-OTHER ASSETS
Other assets consist of the following (dollars in thousands):
(1)
Represents the cash surrender value as of December 31, 2008 and 2007, respectively.
(2)
Represents the amount owed to the Company by the Fund as of December 31, 2008.
(3)
Includes an income tax receivable of less than $0.1 million and $365.1 million at December 31, 2008 and 2007, respectively.
Other Investments
The Company has made investments in low income housing tax credit partnerships, venture funds and several non-public, venture capital-backed, high technology companies. As of December 31, 2008, the Company had $9.7 million in commitments to fund low income housing tax credit partnerships, venture funds and joint ventures.
Equity Method Investments
Equity method investments are reported as part of the other investments balance within the other assets line item on the consolidated balance sheet and consist of the following (dollars in thousands):
NOTE 13-DEPOSITS
Deposits are summarized as follows (dollars in thousands):
(1)
A sweep product transfers brokerage customer balances to the Bank, which holds these funds as customer deposits in FDIC-insured demand deposits and money market deposit accounts.
Deposits, classified by rates are as follows (dollars in thousands):
At December 31, 2008, scheduled maturities of certificates of deposit and brokered certificates of deposit were as follows (dollars in thousands):
Scheduled maturities of certificates of deposit and brokered certificates of deposit with denominations greater than or equal to the FDIC deposit insurance coverage limits were as follows (dollars in thousands):
(1)
Reflects scheduled maturities of certificates of deposit and brokered certificates of deposit with denominations greater than or equal to $250,000, which was the FDIC deposit insurance coverage limit as of December 31, 2008.
(2)
Reflects scheduled maturities of certificates of deposit and brokered certificates of deposit with denominations greater than or equal to $100,000, which was the FDIC deposit insurance coverage limit as of December 31, 2007.
Operating interest expense on deposits is summarized as follows (dollars in thousands):
Accrued interest payable on these deposits, which is included in accounts payable, accrued and other liabilities, was $10.0 million and $15.6 million at December 31, 2008 and 2007, respectively.
NOTE 14-SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE AND OTHER BORROWINGS
The maturities of borrowings at December 31, 2008 and total borrowings at December 31, 2008 and 2007 are shown below (dollars in thousands):
Securities Sold Under Agreements to Repurchase
The Company sells repurchase agreements which are collateralized by fixed- and variable-rate mortgage-backed securities or investment grade securities. Repurchase agreements are treated as secured borrowings for financial statement purposes and obligations to repurchase securities sold are reflected as borrowings in the consolidated balance sheet. The brokers retain possession of the securities collateralizing the repurchase agreements until maturity. At December 31, 2008, the Company had $312.2 million and $268.5 million of collateral in excess of the repurchase agreement liability with Cantor Fitzgerald and Citigroup, respectively. The weighted average maturity of the repurchase agreements with these counterparties was approximately one year and six years for Cantor Fitzgerald and Citigroup, respectively. There were no other counterparties in which the amount of collateral in excess of the repurchase agreement liability exceeded 10% of shareholders’ equity.
Below is a summary of repurchase agreements and collateral associated with the repurchase agreements at December 31, 2008 (dollars in thousands):
Other Borrowings
FHLB Advances-The Company had $0.3 billion floating-rate and $3.6 billion fixed-rate FHLB advances at December 31, 2008. The floating-rate advances adjust quarterly based on the LIBOR. As a condition of its membership in the FHLB Atlanta, the Company is required to maintain a FHLB stock investment currently equal to the lesser of: a percentage of 0.2% of total Bank assets; or a dollar cap amount of $25 million. Additionally,
the Bank must maintain an Activity Based Stock investment which is currently equal to 4.5% of the Bank’s outstanding advances. The Company had an investment in FHLB stock of $200.9 million and $338.6 million at December 31, 2008 and 2007, respectively. The Company must also maintain qualified collateral as a percent of its advances, which varies based on the collateral type, and is further adjusted by the outcome of the most recent annual collateral audit and by FHLB’s internal ranking of the Bank’s creditworthiness. These advances are secured by a pool of mortgage loans and mortgage-backed securities. At December 31, 2008 and 2007, the Company pledged loans with a lendable value of $13.2 billion and $16.8 billion, respectively, of the one- to four-family and home equity loans as collateral in support of both its advances and unused borrowing lines.
Other-ETBH raised capital through the formation of trusts, which sell trust preferred stock in the capital markets. The capital securities must be redeemed in whole at the due date, which is generally 30 years after issuance. Each trust issued Floating Rate Cumulative Preferred Securities, at par with a liquidation amount of $1,000 per capital security. The trusts used the proceeds from the sale of issuances to purchase Floating Rate Junior Subordinated Debentures issued by ETBH, which guarantees the trust obligations and contributed proceeds from the sale of its subordinated debentures to E*TRADE Bank in the form of a capital contribution.
During 2007, ETBH formed three trusts, ETBH Capital Trust XXVIII, ETBH Capital Trust XXIX and ETBH Capital Trust XXX. These trusts issued a total of 60,000 shares of Floating Rate Cumulative Preferred Securities for a total of $60.0 million. Net proceeds from these issuances were invested in Floating Rate Junior Subordinated Debentures that mature in 2037 and have variable rates of 1.90%, 1.95%, or 2.00% above the three-month LIBOR, payable quarterly. ETBH did not form any trusts for the year ended December 31, 2008.
In April 2007, ETBH called ETBH Capital Trust IV which had sold $10.0 million of trust preferred stock in the capital markets in 2002 and generated a loss of $0.3 million. In June 2007, ETBH called Telebank Capital Trust I which had sold $9.0 million of trust preferred stock in the capital markets in 1997, and generated a loss of $0.9 million.
The face values of outstanding trusts at December 31, 2008 are shown below (dollars in thousands):
Other borrowings also includes $18.8 million of overnight and other short-term borrowings in connection with the Federal Reserve Bank’s term investment option and treasury, tax and loan programs. The Company pledged $14.1 million of securities to secure these borrowings from the Federal Reserve Bank.
NOTE 15-CORPORATE DEBT
The Company’s corporate debt by type is shown below (dollars in thousands):
(1)
The fair value adjustment is related to changes in fair value of the debt while in a fair value hedge relationship in accordance with SFAS No. 133, as amended.
Senior Notes
All of the Company’s senior notes are unsecured and will rank equal in right of payment with all of the Company’s existing and future
unsubordinated indebtedness and will rank senior in right of payment to all its existing and future subordinated indebtedness.
In 2008, the Company began exchanging debt for common stock to extinguish a portion of its outstanding senior notes. The details of these exchanges are discussed below.
8% Senior Notes Due June 2011
In 2005 and 2004, the Company issued an aggregate principal amount of $100 million and $400 million in senior notes due June 2011 (“8% Notes”), respectively. Interest is payable semi-annually and notes are non-callable for four years and may then be called by the Company at a premium, which declines over time.
In 2007, $46.2 million in principal of the 8% Notes were exchanged for an equal amount of the 12 1/2% Springing Lien notes discussed below. In 2008, the Company exchanged $18.3 million in principal of its 8% Senior Notes for 4.9 million shares of common stock. This exchange resulted in the Company recording a $0.8 million pre-tax gain on extinguishment.
7 3/8% Senior Notes due September 2013
In 2005, the Company issued an aggregate principal amount of $600 million in senior notes due September 2013 (“7 3/8% Notes”). Interest is payable semi-annually and the notes are non-callable for four years and may then be called by the Company at a premium, which declines over time.
In 2007, $87.8 million in principal of the 7 3/8% Notes were exchanged for an equal amount of the 12 1/2% Springing Lien notes discussed below. In 2008, the Company exchanged $97.5 million in principal of its 7 3/8% Senior Notes for 21.1 million shares of common stock. This exchange resulted in the Company recording a $19.7 million pre-tax gain on extinguishment.
7 7/8% Senior Notes Due December 2015
In 2005, the Company issued an aggregate principal amount of $300 million in senior notes due December 2015 (“7 7/8% Notes”). Interest is payable semi-annually and the notes are non-callable for four years and may then be called by the Company at a premium, which declines over time.
In 2007, $51.8 million in principal of the 7 7/8% Notes were exchanged for an equal amount of the 12 1/2% Springing Lien notes discussed below. In 2008, the Company exchanged $5.0 million in principal of its 7 7/8% Senior Notes for 1.1 million shares of common stock. This exchange resulted in the Company recording a $1.0 million pre-tax gain on extinguishment.
Springing Lien Notes
12 1/2 % Springing Lien Notes Due November 2017
In November 2007, the Company issued an aggregate principal amount of $1.8 billion in springing lien notes due November 2017 (“12 1/2 % Notes”). Interest is payable semi-annually and the notes are non-callable for five years and may then be called by the Company at a premium, which declines over time. The Company has the option to make interest payments on its 12 1/2% Notes in the form of either cash or additional 12 1/2% Notes through May 2010. During the second quarter of 2008, the Company elected to make its first interest payment of approximately $121 million in cash. During the fourth quarter of 2008, the Company elected to make its second interest payment of $121 million in the form of additional springing lien notes. The November 2010 payment is the first interest payment the Company is required to pay in cash.
The indenture for the Company’s 12 1/2% Notes requires the Company to secure the 12 1/2 % Notes with the property and assets of the Company and any future subsidiary guarantors (subject to certain exceptions). The requirement to secure the 12 1/2% Notes will occur on the earlier of: (1) the date on which the 8% Notes are redeemed or (2) the first date on which the Company is allowed to grant liens in excess of $300 million under the 8% Notes. The requirement to secure the 12 1/2% Notes is limited to the amount of debt under the 12 1/2% Notes that would not trigger a requirement for the Company to equally and ratably secure the existing 8% Notes, 7 3/8% Notes and the 7 7/8% Notes.
In 2008, the Company issued an additional $150.0 million of 12 1 /2% Notes, in accordance with the terms of the agreement with Citadel. This is the final issuance under the agreement with Citadel. In connection with this issuance, the Company received $150.0 million in cash.
Mandatory Convertible Notes
6 1/8% Mandatory Convertible Notes Due November 2018
In 2005, the Company issued 18.0 million of mandatory convertible notes (“Units”) with a face value of $450 million (“6 1/8% Notes”). In 2008, the Company retired the entire $450 million principal amount of the 6 1/8% Notes with the issuance of 25 million shares of common stock at $18 per share (the mandatory conversion price).
Corporate Debt Covenants
Certain of the Company’s corporate debt described above have terms which include customary financial covenants. As of December 31, 2008, the Company was in compliance with all such covenants.
Other Corporate Debt
The Company also has multiple term loans from financial institutions. These loans are collateralized by equipment and are included within other borrowings on the consolidated balance sheet. See Note 14-Securities Sold Under Agreement to Repurchase and Other Borrowings.
Future Maturities of Corporate Debt
Scheduled principal payments of corporate debt as of December 31, 2008 are as follows (dollars in thousands):
NOTE 16-ACCOUNTS PAYABLE, ACCRUED AND OTHER LIABILITIES
Accounts payable, accrued and other liabilities consist of the following (dollars in thousands):
NOTE 17-INCOME TAXES
Effective January 1, 2007, the Company adopted FIN 48. As a result of the implementation, the Company recognized a $14.9 million increase to its liability for unrecognized tax benefits, which was accounted for as a
reduction to the beginning balance of retained earnings. The total amount of gross unrecognized tax benefits as of January 1, 2007 was $150.4 million. Of this total amount at January 1, 2007, $51.6 million (net of the federal benefit on state issues) represents the amount of unrecognized tax benefits that, if recognized, would favorably affect the effective income tax rate in future periods. A reconciliation of the beginning and ending amount of unrecognized tax benefits as of December 31, 2007 and 2008 is as follows (dollars in thousands):
At December 31, 2008 and 2007, the unrecognized tax benefit was $64.7 million and $74.9 million, respectively. At December 31, 2008, $37.8 million (net of federal benefits on state issues) represents the amount of unrecognized tax benefits that, if recognized, would favorably affect the effective income tax in future periods.
The following table summarizes the tax years that are either currently under examination or remain open under the statute of limitations and subject to examination by the major tax jurisdictions in which the Company operates:
(1)
Includes California, Georgia, Illinois, New Jersey, New York and Virginia.
It is likely that certain examinations may be settled or the statute of limitations could expire with regards to other tax filings, in the next twelve months. In addition, proposed legislation could favorably impact certain of the Company’s unrecognized tax benefits. Such events would generally reduce the Company’s unrecognized tax benefits, either because the tax positions are sustained or because the Company agrees to the disallowance, by as much as $5.0 million, all of which could affect the Company’s total tax provision or the effective tax rate.
The Company’s practice is to recognize interest and penalties, if any, related to income tax matters in income tax expense. After the adoption of FIN 48, the Company has total gross reserves for interest and penalties of $5.9 million and $8.6 million as of December 31, 2008 and 2007, respectively. The tax benefit for the year ended December 31, 2008 includes a reduction in the accrual for interest of $2.7 million, principally related to the expiration of statute of limitations for the tax year ended December 31, 2004.
The components of income tax expense (benefit) from continuing operations are as follows (dollars in thousands)
The components of income (loss) before income tax expense (benefit) and discontinued operations are as follows (dollars in thousands):
Deferred income taxes are recorded when revenues and expenses are recognized in different periods for financial statement and tax return purposes. Prior year balances for the deferred tax asset and liabilities have been re-presented to ensure consistency between periods. The adjustments relate to the presentation of the federal benefit of the state deferred assets and liabilities. The temporary differences and tax carryforwards that created deferred tax assets and deferred tax liabilities are as follows (dollars in thousands):
During the year ended December 31, 2008, the Company generated a federal net operating loss of approximately $727.4 million and did not provide for a valuation allowance against the federal deferred tax assets. The Company is required to establish a valuation allowance for deferred tax assets and record a charge to income if it determines, based on available evidence at the time the determination is made, that it is more likely than not that some portion or all of the deferred tax assets will not be realized. If the Company did conclude that a valuation allowance was required, the resulting loss would have a material adverse effect on its results of operations, financial condition and regulatory capital position at E*TRADE Bank. As of December 31, 2008, the Company had net deferred tax assets of $1.0 billion.
The Company did not establish a valuation allowance against its federal deferred tax assets as of December 31, 2008 as it believes that it is more likely than not that all of these assets will be realized. The Company’s evaluation focused on identifying significant, objective evidence that it will be able to realize the deferred tax assets in the future. The Company reviewed the estimated future taxable income for its retail and institutional segments separately and determined that the net operating losses in 2007 and 2008 were due solely to the credit losses in its institutional segment. The Company believes these losses were caused by the crisis in the residential real estate and credit markets which significantly impacted its asset-backed securities and home equity loan portfolios in 2007 and continued to generate credit losses in 2008. The Company estimates that these credit losses will continue in future periods; however, the Company ceased the business activities which it believes are the root cause of these losses. Therefore, while the Company does expect credit losses to continue in
future periods, it does expect these amounts to decline when compared to the credit losses in 2007 and 2008. The retail segment generated substantial book taxable income for each of the last six years and the Company estimates that it will continue to generate taxable income in future periods at a level sufficient enough to generate taxable income for the Company as a whole. The Company considers this to be significant, objective evidence that it will be able to realize the deferred tax assets in the future.
The Company’s analysis of the need for a valuation allowance recognizes that it is in a cumulative book taxable loss position as of the three-year period ended December 31, 2008, which is considered significant, objective evidence that the Company may not be able to realize some portion of the deferred tax assets in the future. However, the Company believes it is able to rely on the forecasts of future taxable income and overcome the uncertainty created by the cumulative loss position.
The crisis in the residential real estate and credit markets has created significant volatility in the Company’s results of operations. This volatility is isolated almost entirely to the institutional segment. The forecasts for this segment include assumptions regarding the estimate of future expected credit losses, which the Company believes to be the most variable component of the forecasts of future taxable income. The Company believes this variability could create a book loss in the overall results for an individual reporting period while not significantly impacting the overall estimate of taxable income over the period in which the Company expects to realize the deferred tax assets. Conversely, the Company believes the retail segment will continue to produce a stable stream of income which it believes can reliably estimate in both individual reporting periods as well as over the period in which the Company estimates it will realize the deferred tax assets.
In evaluating the need for a valuation allowance, the Company estimated future taxable income based on management approved forecasts. This process required significant judgment by management about matters that are by nature uncertain. If future events differ significantly from the current forecasts, a valuation allowance may need to be established, which would have a material adverse effect on the results of operations, financial condition and regulatory capital position at E*TRADE Bank. In addition, a significant portion of the net deferred tax asset relates to a $2.3 billion federal tax loss carryforward, the utilization of which may be further limited in the event of certain material changes in the ownership of the Company. The Company will continue to monitor and update its assumptions and forecasts of future taxable income and assess the need for a valuation allowance.
For certain of the Company’s state and foreign country deferred tax assets, the Company maintains a valuation allowance of $127.7 million and $91.8 million at December 31, 2008 and 2007, respectively, as it is more likely than not that they will not be fully realized. The Company’s valuation allowance increased by $35.9 million for the year ended December 31, 2008. The principal components of the deferred tax assets for which a valuation allowance has been established include the following state and foreign country net operating loss carryforwards and excess tax bases in certain illiquid investments:
•
At December 31, 2008, the Company had foreign country net operating loss carryforwards of approximately $99 million for which a deferred tax asset of approximately $27 million was established. The foreign net operating losses represent the foreign tax loss carryforwards in numerous foreign countries, some of which are subject to expiration from in 2017. In most of these foreign countries, the Company has historical tax losses, and the Company continues to project to incur operating losses in most of these countries. Accordingly, the Company has provided a valuation allowance of $26 million against such deferred tax asset at December 31, 2008.
•
At December 31, 2008, the Company had gross state net operating loss carryforwards of $2.3 billion that expire between 2009 and 2027, most of which are subject to reduction for apportionment when utilized. A deferred tax asset of approximately $112.5 million has been established related to these state net operating loss carryforwards with a valuation allowance of $82.6 million against such deferred tax asset at December 31, 2008.
•
At December 31, 2008, the Company maintained a valuation allowance against the excess tax basis in certain capital assets of approximately $8.3 million. The capital assets in question are certain
investments in e-commerce and Internet startup venture funds that have no ready market or liquidity at December 31, 2008. The Company has concluded that the realization of these excess tax benefits on these capital assets are uncertain and not in the control of the Company, as there is no ready market or liquidity for these investments.
The Company has not provided $9.0 million of deferred income taxes on $25.0 of undistributed earnings and profits in its foreign subsidiaries at December 31, 2008 since the Company intends to permanently reinvest such earnings.
The effective tax rates differed from the federal statutory rates as follows:
NOTE 18-SHAREHOLDERS’ EQUITY
Preferred Stock
The Company has 1.0 million shares authorized in preferred stock. None were issued and outstanding at December 31, 2008 and 2007.
Issuance of Common Stock
In 2008, the Company exchanged a total of $120.8 million in principal of outstanding senior notes for 27.1 million shares of common stock. Also in 2008, the Company issued 25.0 million shares of common stock at $18 per share (the mandatory conversion price) to retire the entire $450 million principal amount of the 6 1/8% Notes. (See Note 15-Corporate Debt for additional details on the transaction.)
In 2008 and 2007, the Company issued $339.0 million or 84.7 million shares of common stock in conjunction with the Citadel Investment. The 84.7 million shares of common stock were issued in three increments: 14.8 million upon initial closing in November 2007; 23.2 million shares upon Hart-Scott-Rodino Antitrust Improvements Act approval in December 2007 and 46.7 million shares upon all required regulatory approvals in May 2008.
Share Repurchases
On April 18, 2007, the Company announced that its Board of Directors authorized a $250.0 million common stock repurchase program (the “April 2007 Plan”). The April 2007 Plan is open-ended and allows for the repurchase of common stock on the open market, in private transactions or a combination of both. The $200.0 million repurchase program approved by the Board in December 2004 (the “December 2004 Plan”) was completed in 2007.
The Company did not repurchase any shares of common stock in 2008. In 2007, the Company repurchased a total of 7.2 million shares of common stock for an aggregate $148.6 million under the April 2007 Plan and the December 2004 Plan. As of December 31, 2008 and 2007, the Company had approximately $158.5 million available to purchase additional shares under the April 2007 Plan.
NOTE 19-EARNINGS (LOSS) PER SHARE
The following table is a reconciliation of basic and diluted earnings (loss) per share (dollars and shares in thousands, except per share amounts):
The Company excluded from the calculations of diluted earnings (loss) per share 37.4 million and 21.0 million shares of stock options, restricted stock awards and restricted stock units for the years ended December 31, 2008 and 2007, respectively. Of the excluded shares, 1.4 million and 9.6 million shares were anti-dilutive because of the Company’s net loss for the years ended December 31, 2008 and 2007, respectively. Additionally, for the year ended December 31, 2007, there were 46.7 million shares that had not been issued in connection with the Citadel Investment of which 3.9 million shares were anti-dilutive because of the Company’s net loss for the period. The Company excluded from the calculations of diluted earnings per share 5.3 million shares of stock options that would have been anti-dilutive for the year ended December 31, 2006.
Excluded from the calculations of diluted earnings per share are 2.2 million shares of common stock for the year ended December 31, 2006, issuable under convertible subordinated notes as the effect of applying the treasury stock method on an if-converted basis would be anti-dilutive. There were not any shares issuable under convertible subordinated notes excluded from the years ended December 31, 2008 and 2007, respectively, as all convertible subordinated notes outstanding had been redeemed in 2006.
NOTE 20-EMPLOYEE SHARE-BASED PAYMENTS AND OTHER BENEFITS
Employee Stock Option Plans
In 2005, the Company adopted and the shareholders approved the 2005 Stock Incentive Plan (“2005 Plan”) to replace the 1996 Stock Incentive Plan (“1996 Plan”) which provides for the grant of nonqualified or incentive stock options to officers, directors, key employees and consultants for the purchase of newly issued shares of the Company’s common stock at a price determined by the Board at the date the option is granted. Options are generally exercisable ratably over a two to four-year period from the date the option is granted and most options expire within seven years from the date of grant. Certain options provide for accelerated vesting upon a change in control. Exercise prices are generally equal to the fair market value of the shares on the grant date. A total of 85.4 million shares had been authorized under the 1996 Plan. Under the 2005 Plan, the remaining unissued authorized shares of the 1996 Plan, up to 42.0 million shares, were authorized for issuance. Additionally, any shares that had been awarded but remained unissued under the 1996 Plan that were subsequently canceled, would be authorized for issuance under the 2005 Plan, up to 39.0 million shares. As of December 31, 2008, 13.8 million shares were available for grant under the 2005 Plan.
The Company recognized $26.6 million, $25.0 million and $21.7 million in compensation expense from continuing operations for stock options for the years ended December 31, 2008, 2007 and 2006, respectively. The Company recognized a tax benefit of $9.8 million, $8.1 million and $7.8 million related to the stock options for the years ended December 31, 2008, 2007 and 2006, respectively.
The fair value of each option award is estimated on the date of grant using a Black-Scholes-Merton option pricing model based on the assumptions noted in the table below. Expected volatility is based on a combination of historical volatility of the Company’s stock and implied volatility of publicly traded options on the Company’s stock. The expected term represents the period of time that options granted are expected to be outstanding. The expected term is estimated using employees’ actual historical behavior and projected future behavior based on expected exercise patterns. The risk-free interest rate is based on the U.S. Treasury zero-coupon bond where the remaining term equals the expected term. Dividend yield is zero as the Company has not, nor does it currently plan to, issue dividends to its shareholders.
The weighted-average fair values of options granted were $2.02, $7.48 and $8.60 for the years ended December 31, 2008, 2007 and 2006, respectively. Intrinsic value of options exercised were $0.1 million, $50.6 million and $89.1 million for the years ended December 31, 2008, 2007 and 2006, respectively.
A summary of options activity under the 2005 Plan is presented below:
As of December 31, 2008, there was $28.8 million of total unrecognized compensation cost related to non-vested stock options. This cost is expected to be recognized over a weighted-average period of 1.5 years.
Restricted Stock Awards and Restricted Stock Units
The Company issues restricted stock awards and restricted stock units to its employees. Each restricted stock unit can be converted into one share of the Company’s common stock upon vesting. These awards are issued at the fair market value on the date of grant and vest ratably over the period, generally two to four years. The fair value is calculated as the market price upon issuance.
In connection with the Company’s contract to hire the Chief Executive Officer (“CEO”), the Board made grants of restricted stock and stock options. The grants vest through October 2009, 62.5% of which time vests through January 1, 2009 and the balance of which time-vest through October 2009. In making these awards, the Board exercised its discretion to amend the 2005 Stock Incentive Plan and issue grants in excess of the stated maximum to any individual in any single year but did not increase the aggregate number of shares that may be issued under the 2005 Stock Incentive Plan; however, the Board will not issue any further equity, cash bonus or non-equity incentive plan payments to the CEO through at least the end of 2009. None of the restricted stock awards and no more than 37.5% of the stock option awards are expected to be deductible for federal income tax purposes.
The Company recorded $15.5 million, $9.4 million and $10.5 million for the years ended December 31, 2008, 2007 and 2006, respectively, in compensation expense from continuing operations related to restricted stock awards and restricted stock units. The Company recognized a tax benefit of $3.9 million, $3.2 million and $3.7 million related to restricted stock awards and restricted stock units for the years ended December 31, 2008, 2007 and 2006, respectively.
A summary of non-vested restricted stock award activity is presented below:
A summary of non-vested restricted stock unit activity is presented below:
As of December 31, 2008, there was $16.7 million of total unrecognized compensation cost related to non-vested awards. This cost is expected to be recognized over a weighted-average period of 1.0 year. The total fair value of restricted shares and restricted stock units vested was $5.6 million, $11.0 million and $7.5 million for the years ended December 31, 2008, 2007 and 2006, respectively.
Employee Stock Purchase Plan
The shareholders of the Company previously approved the 2002 Employee Stock Purchase Plan (“2002 Purchase Plan”), and reserved 5,000,000 shares of common stock for sale to employees at a price no less than 85% of the lower of the fair market value of the common stock at the beginning of the one-year offering period or the end of each of the six-month purchase periods. Under SFAS No. 123(R), the 2002 Purchase Plan was considered compensatory. Effective August 1, 2005, the Company changed the terms of its purchase plan to reduce the discount to 5% and discontinued the look-back provision. As a result, the purchase plan was not compensatory beginning August 1, 2005. In 2008, the Company temporarily suspended the 2002 Purchase Plan due to the low number of shares remaining for issuance. At December 31, 2008, 212,650 shares were available under the 2002 Purchase Plan.
401(k) Plan
The Company has a 401(k) salary deferral program for eligible employees who have met certain service requirements. The Company matches certain employee contributions; additional contributions to this plan are at the discretion of the Company. Total contribution expense from continuing operations under this plan was $4.6 million, $5.4 million and $5.3 million for the years ended December 31, 2008, 2007 and 2006, respectively.
NOTE 21-REGULATORY REQUIREMENTS
Registered Broker-Dealers
The Company’s U.S. broker-dealer subsidiaries are subject to the Uniform Net Capital Rule (the “Rule”) under the Securities Exchange Act of 1934 administered by the SEC and FINRA, which requires the maintenance of minimum net capital. The minimum net capital requirements can be met under either the Aggregate Indebtedness method or the Alternative method. Under the Aggregate Indebtedness method, a broker-dealer is required to maintain minimum net capital of the greater of 6 2/3% of its aggregate indebtedness, as defined, or a minimum dollar amount. Under the Alternative method, a broker-dealer is required to maintain net capital equal to the greater of $250,000 or 2% of aggregate debit balances arising from customer transactions. The method used depends on the individual U.S. broker-dealer subsidiary. The Company’s international broker-dealer subsidiaries, located in Europe and Asia, are subject to capital requirements determined by their respective regulators.
As of December 31, 2008, all of the Company’s broker-dealer subsidiaries met minimum net capital requirements. Total required net capital was $0.1 billion at December 31, 2008. In addition, the Company’s broker-dealer subsidiaries had excess net capital of $0.7 billion at December 31, 2008.
The table below summarizes the minimum excess capital requirements for the Company’s broker-dealer subsidiaries (dollars in thousands):
(1)
Elected to use the Alternative method to compute net capital.
(2)
Elected to use the Aggregate Indebtedness method to compute net capital.
Banking
E*TRADE Bank is subject to various regulatory capital requirements administered by federal banking agencies. Failure to meet minimum capital requirements can trigger certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on E*TRADE Bank’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, E*TRADE Bank must meet specific capital guidelines that involve quantitative measures of E*TRADE Bank’s assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. E*TRADE Bank’s capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.
Quantitative measures established by regulation to ensure capital adequacy require E*TRADE Bank to maintain minimum amounts and ratios of Total and Tier I Capital to Risk-weighted assets and Tier I Capital to adjusted total assets. As shown in the table below, at December 31, 2008, the OTS categorized E*TRADE Bank as “well capitalized” under the regulatory framework for prompt corrective action. However, events beyond management’s control, such as a continued deterioration in residential real estate and credit markets, could adversely affect future earnings and E*TRADE Bank’s ability to meet its future capital requirements.
E*TRADE Bank’s required actual capital amounts and ratios are presented in the table below (dollars in thousands):
NOTE 22-LEASE ARRANGEMENTS
The Company has non-cancelable operating leases for facilities through 2024. Future minimum lease payments and sublease proceeds under these leases, including leases involved in facility restructurings, are as follows (dollars in thousands):
Certain leases contain provisions for renewal options and rent escalations based on increases in certain costs incurred by the lessor. Rent expense from continuing operations, net of sublease income, was $25.6 million, $25.0 million and $23.0 million for the years ended December 31, 2008, 2007 and 2006, respectively. Rent expense excludes costs related to leases involved in facility restructurings, which are recorded in the facility restructuring and other exit activities line item in the consolidated statement of income (loss).
NOTE 23-COMMITMENTS, CONTINGENCIES AND OTHER REGULATORY MATTERS
Legal Matters
Litigation Matters
On October 27, 2000, a complaint was filed in the Superior Court for the State of California, County of Santa Clara, entitled, “Ajaxo, Inc., a Delaware corporation, Plaintiff, versus E*TRADE GROUP, INC., a Delaware corporation; and Everypath, Inc., a California corporation; and Does 1 through 50, inclusively, Defendants.” Through this complaint, Ajaxo sought damages and certain non-monetary relief for the Company’s alleged breach of a non-disclosure agreement with Ajaxo pertaining to certain wireless technology offered to the Company by Ajaxo as well as damages and other relief against both the Company and defendant Everypath, Inc., for their alleged misappropriation of Ajaxo’s trade secrets. Following a jury trial, a judgment was entered in 2003 in favor of Ajaxo against the Company for $1.3 million dollars for breach of the Ajaxo non-disclosure agreement. Although the jury also found in favor of Ajaxo on its misappropriation of trade secrets claim against the Company and defendant Everypath, the trial court subsequently denied Ajaxo’s requests for additional damages and relief on these claims. Thereafter, all parties appealed, and on December 21, 2005, the California Court of Appeal affirmed the above-described award against the Company for breach of the nondisclosure agreement but remanded the case to the trial court for the limited purpose of determining what, if any, additional damages Ajaxo may be entitled to as a result of the jury’s previous finding in favor of Ajaxo on its misappropriation of trade secrets claim against the Company and defendant Everypath. Following the foregoing ruling by the Court of Appeal, defendant Everypath ceased operations and made an assignment for the benefit of its creditors in January, 2006. As a result, defendant Everypath is no longer defending the case. Although the Company paid Ajaxo the full amount due on the judgment against it above, the case, consistent with the rulings issued by the Court of Appeal, was remanded back to the trial court, and on May 30, 2008, a jury returned a verdict in favor of E*TRADE denying all claims raised and demands for damages against the Company by Ajaxo. Following the trial court’s filing on September 5, 2008, of entry of judgment in favor of E*TRADE, Ajaxo filed post trial motions asking the trial court to grant a new trial and to vacate its September 5, 2008, entry of judgment in favor of the Company. By order dated November 4, 2008, the court denied these motions, and on December 2, 2008, Ajaxo filed its notice of appeal.
On October 2, 2007, a class action complaint alleging violations of the federal securities laws was filed in the United States District Court for the Southern District of New York against the Company and then its Chief Executive Officer and Chief Financial Officer entitled, “Larry Freudenberg, Individually and on Behalf of All Others Similarly Situated, Plaintiff, versus E*TRADE Financial Corporation, Mitchell H. Caplan and Robert J. Simmons, Defendants.” By order dated July 17, 2008, the trial court consolidated the Freudenberg action with four other purported class actions, all of which were filed in the United States District Court for the Southern District of New York and which were based on the same facts and circumstances as the Freudenberg action. By the same July 17, 2008 order, the trial court appointed the “Kristen-Straxton Group” and Ira Newman co-lead plaintiffs and Brower Piven and Levi & Korsinski, respectively, as lead and co-lead plaintiffs’ counsel. Thereafter, on January 16, 2009, Plaintiffs served their “Consolidated Amended Class Action Complaint for Violations of the Federal Securities Laws.” In their amended complaint, Plaintiffs again name the Company’s former chief executive and financial officers as defendants as well as Dennis Webb, the Company’s former Capital Markets Division President. In their amended complaint, Plaintiffs allege causes of action for violations of Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”) and Rule 10b-5 against all defendants, and (2) violations of Section 20(a) of the Exchange Act against the individual defendants. In specific, Plaintiffs contend, among other things, that the value of E*TRADE’s stock between April 19, 2006 and November 9, 2007 (the “class period”) was artificially inflated because defendants, among other things, issued materially false and misleading statements and failed to disclose that the Company was experiencing a rise in delinquency rates in its mortgage and home equity portfolios; failed to timely record an impairment on its mortgage and home equity portfolios; materially overvalued its securities portfolio, which includes assets backed by mortgages; and based on the foregoing, lacked a reasonable basis for the positive statements it made about the Company’s earnings and prospects. Plaintiffs seek to recover damages in an amount to be proven at trial, including interest and attorneys’ fees and costs. By prior order of the court, Defendants are to file their motion to dismiss by April 2, 2009; and all parties are to complete briefing on Defendants’ motion to dismiss by August 17, 2009. The Company intends to vigorously defend itself against these claims.
On August 15, 2008, an action entitled, “Ronald M. Tate, Trustee of the Ronald M. Tate Trust Dtd 4/13/88, and George Avakian, an Individual, Plaintiffs, versus E*TRADE Financial Corporation, Mitchell H. Caplan, an Individual, and Robert J. Simmons, an Individual, Defendants” was filed in the United States District Court for the Southern District of New York. The Tate action is based on the same facts and circumstances, and contains the same claims, as the Freudenberg consolidated actions discussed above. By agreement of the parties and approval of the court, the Tate action has been consolidated with the Freudenberg consolidated actions for the purpose of pre-trial discovery.
Based upon the same facts and circumstances alleged in the Freudenberg class action complaint above, a verified shareholder derivative complaint was filed in United States District Court for the Southern District of New York on October 4, 2007, against the Company’s then Chief Executive Officer, President/Chief Operating Officer, Chief Financial Officer and individual members of its board of directors entitled, “Catherine Rubery, Derivatively on behalf of E*TRADE Financial Corporation, Plaintiff, versus Mitchell H. Caplan, R. Jarrett Lilien, Robert J. Simmons, George A. Hayter, Daryl Brewster, Ronald D. Fisher, Michael K. Parks, C. Catherine Raffaeli, Lewis E. Randall, Donna L. Weaver, and Stephen H. Willard, Defendants, -and- E*TRADE Financial Corporation, a Delaware corporation, Nominal Defendant.” Plaintiff alleges, among other things, causes of action for breach of fiduciary duty, waste of corporate assets, unjust enrichment, and violation of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. The above shareholder derivative complaint has been consolidated with another shareholder derivative complaint brought in the same court and against the same named defendants entitled, “Marilyn Clark, Derivatively On Behalf of E*TRADE Financial Corporation, Plaintiff, versus Mitchell H. Caplan, et al., Defendants” (collectively, with the Rubery case, the “federal derivative actions”). Three similar derivative actions, based on the same facts and circumstances as the federal derivative actions but alleging exclusively state causes of action, have been filed in the Supreme Court of the State of New York, New York County. These three cases have been ordered consolidated in that court under the caption “In re: E*Trade Financial Corporation Derivative Litigation, Lead Index No. 07-603736” (the “state derivative actions”). By agreement of the parties and approval of the respective courts, proceedings in both these federal and state derivative actions will continue to trail those in the federal securities actions discussed above.
On April 2, 2008, a class action complaint alleging violations of the federal securities laws was filed in the United States District Court for the Southern District of New York against the Company entitled, “John W. Oughtred, Individually, and on Behalf of all Others Similarly Situated, Plaintiff, v. E*TRADE Financial Corporation and E*TRADE Securities, LLC, Defendants.” Plaintiff contends, among other things, that the Company committed various sales practice violations in the sale of certain auction rate securities to investors between April 2, 2003, and February 13, 2008 (the “class period”) by allegedly misrepresenting that these securities were highly liquid and safe investments for short term investing. On April 17, 2008, the trial court entered an order relieving the Company of its obligation to move, answer or otherwise respond to the complaint until such time as the court may deem appropriate. Thereafter, plaintiff Oughtred joined plaintiffs in twelve other actions involving auction rate securities (in which the Company is not named as defendant) in filing a motion seeking to centralize all 13 actions in the Southern District of New York or in the alternative, the Northern District of California. By order filed October 9, 2008, a United States Judicial Panel on Multi-District Litigation denied plaintiffs’ motion to transfer, and on December 18, 2008, Plaintiff filed his first amended class action complaint. The Company intends to vigorously defend itself against the claims raised in this complaint.
On October 11, 2006, a state class action entitled, “Nikki Greenberg, and all those similarly situated, plaintiffs, versus E*TRADE FINANCIAL Corporation, defendant” was filed in the Superior Court for the State of California, County of Los Angeles on behalf of all customers or consumers who allegedly made or received telephone calls from E*TRADE that were recorded without their knowledge or consent following a telephone call from plaintiff Greenberg to the Company’s Beverly Hills financial center on August 8, 2006, that was recorded during a brief period when the Company’s automated notice system was out of order. On February 7, 2008, class certification was granted and the class defined to consist of (1) all persons in California who received telephone calls from E*TRADE and whose calls were recorded without their consent within three years of October 11, 2006, and (2) all persons who made calls from California to the Beverly Hills financial center of the Company on August 8, 2006. In the interim, the Company has filed motions seeking to de-certify or further limit the defined class, and plaintiffs have filed competing motions seeking to expand it. The hearing of these motions, formerly set for September 19, 2008, is now scheduled to take place on March 6, 2009. The Company has denied the allegations of the complaint.
Representatives of various states attorneys general have made informal inquiries regarding the auction rate securities held by the Company’s customers. The Company is cooperating with these inquiries, which are continuing.
In addition to the matters described above, the Company is subject to various legal proceedings and claims that arise in the normal course of business which could have a material adverse effect on its financial position, results of operations or cash flows. In each pending matter, the Company contests liability or the amount of claimed damages. In view of the inherent difficulty of predicting the outcome of such matters, particularly in cases where claimants seek substantial or indeterminate damages, or where investigation or discovery have yet to be completed, the Company cannot predict with certainty the loss or range of loss related to such matters, how such matters will be resolved, when they will ultimately be resolved, or what any eventual settlement, fine, penalty or other relief might be. Subject to the foregoing, the Company believes that the outcome of any such pending matter will not have a material adverse effect on the consolidated financial condition of the Company, although the outcome could be material to the Company’s or a business segment’s operating results in the future, depending, among other things, upon the Company’s or business segment’s income for such period.
An unfavorable outcome in any matter that is not covered by insurance could have a material adverse effect on the Company’s business, financial condition, results of operations or cash flows. In addition, even if the ultimate outcomes are resolved in the Company’s favor, the defense of such litigation could entail considerable cost or the diversion of the efforts of management, either of which could have a material adverse effect on the Company’s business, financial condition, results of operations or cash flows.
Regulatory Matters
The securities and banking industries are subject to extensive regulation under federal, state and applicable international laws. From time to time, the Company has been threatened with or named as a defendant in, lawsuits, arbitrations and administrative claims involving securities, banking and other matters. The Company is also subject to periodic regulatory audits and inspections. Compliance and trading problems that are reported to regulators, such as the SEC, FINRA, OTS or FDIC by dissatisfied customers or others are investigated by such regulators, and may, if pursued, result in formal claims being filed against the Company by customers or disciplinary action being taken against the Company or its employees by regulators. Any such claims or disciplinary actions that are decided against the Company could have a material impact on the financial results of the Company or any of its subsidiaries.
The SEC, in conjunction with various regional securities exchanges, is conducting an inquiry into the trading activities of certain specialist firms, including the Company’s subsidiary ETCM, on various regional exchanges in order to determine whether such firms executed proprietary orders in a given security prior to a customer order in the same security (a practice commonly known as “trading ahead”) during the period 1999-2005. ETCM was a specialist on the Chicago Stock Exchange during the period under review. The SEC has indicated that it will seek disgorgement, prejudgment interest, and penalties from any firm found to have engaged in trading ahead activity to the detriment of its customers during that time period. It is possible that such sanctions, if imposed against ETCM, could have a material impact on the financial results of the Company during the period in which such sanctions are imposed. The Company and ETCM are cooperating with the investigation.
On October 17, 2007, the SEC initiated an informal inquiry into matters related to the Company’s loan and securities portfolios. That inquiry is continuing. The Company is cooperating fully with the SEC in this matter.
Insurance
The Company maintains insurance coverage that management believes is reasonable and prudent. The principal insurance coverage it maintains covers commercial general liability; property damage; hardware/software damage; cyber liability; directors and officers; employment practices liability; certain criminal acts against the Company; and errors and omissions. The Company believes that such insurance coverage is adequate for the purpose of its business. The Company’s ability to maintain this level of insurance coverage in the future, however, is subject to the availability of affordable insurance in the marketplace.
Reserves
For all legal matters, reserves are established in accordance with SFAS No. 5, Accounting for Contingencies. Once established, reserves are adjusted based on available information when an event occurs requiring an adjustment.
Commitments
In the normal course of business, the Company makes various commitments to extend credit and incur contingent liabilities that are not reflected in the consolidated balance sheet. Significant changes in the economy or interest rates influence the impact that these commitments and contingencies have on the Company in the future.
Loans
In 2008, the Company exited its direct retail lending business, which was the last remaining loan origination channel of the Company. As a result, the Company had no commitments to originate or sell mortgage loans at December 31, 2008. Additionally, the Company had no commitments to purchase loans at December 31, 2008.
Securities, Unused Lines of Credit and Certificates of Deposit
At December 31, 2008, the Company had commitments to purchase $0.8 billion and sell $1.8 billion in securities. In addition, the Company had approximately $2.2 billion of certificates of deposit scheduled to mature in less than one year and $3.0 billion of unfunded commitments to extend credit.
Guarantees
The Company provides guarantees to investors purchasing mortgage loans, which are considered standard representations and warranties within the mortgage industry. The primary guarantee is that the mortgage and the mortgage note have been duly executed and each is the legal, valid and binding obligation of the Company, enforceable in accordance with its terms. The mortgage has been duly acknowledged and recorded and is valid. The mortgage and the mortgage note are not subject to any right of rescission, set-off, counterclaim or defense, including, without limitation, the defense of usury, and no such right of rescission, set-off, counterclaim or defense has been asserted with respect thereto. If these claims prove to be untrue, the investor can require the Company to repurchase the loan and return all loan purchase and servicing release premiums.
Management has determined that quantifying the potential liability exposure is not meaningful due to the nature of the standard representations and warranties, which rarely result in loan repurchases.
ETBH raised capital through the formation of trusts, which sold trust preferred stock in the capital markets. The capital securities are mandatorily redeemable in whole at the due date, which is generally 30 years after issuance. Each trust issues Floating Rate Cumulative Preferred Securities at par, with a liquidation amount of $1,000 per capital security. The proceeds from the sale of issuances were invested in ETBH’s Floating Rate Junior Subordinated Debentures.
During the 30-year period prior to the redemption of the Floating Rate Cumulative Preferred Securities, ETBH guarantees the accrued and unpaid distributions on these securities, as well as the redemption price of the securities and certain costs that may be incurred in liquidating, terminating or dissolving the trusts (all of which would otherwise be payable by the trusts). At December 31, 2008, management estimated that the maximum potential liability under this arrangement is equal to approximately $437.9 million or the total face value of these securities plus dividends, which may be unpaid at the termination of the trust arrangement.
NOTE 24-SEGMENT AND GEOGRAPHIC INFORMATION
The segments presented below reflect the manner in which the Company’s chief operating decision maker assesses the Company’s performance. The Company has two segments: retail and institutional.
Retail includes:
•
brokerage and related asset gathering products and services;
•
investor-focused banking products and services; and
•
stock plan administration products and services.
Institutional includes:
•
balance sheet management activities; and
•
market-making.
The Company evaluates the performance of its segments based on segment contribution (net revenue less provision for loan losses and operating expense). All corporate overhead, administrative and technology charges are allocated to segments either in proportion to their respective direct costs or based upon specific operating criteria. Activities associated with discontinued operations have been excluded from the segment results.
Financial information for the Company’s reportable segments is presented in the following tables (dollars in thousands):
(1)
Reflects elimination of transactions between retail and institutional segments, which includes deposit and customer payable transfer pricing and order flow rebates.
(1)
Reflects elimination of transactions between retail and institutional segments, which includes deposit and customer payable transfer pricing and order flow rebates.
(1)
Reflects elimination of transactions between retail and institutional segments, which includes deposit and customer payable transfer pricing and order flow rebates.
Segment Assets
Total assets for each segment are shown in the following table (dollars in thousands):
Geographic Information
The Company operates in both U.S. and international markets. The Company’s international operations are conducted through offices in Europe and Asia. In 2008, the Company re-defined total net revenue by removing provision for loan losses and separately stating it as its own line item, and reclassified hedge ineffectiveness recorded in accordance with SFAS No. 133, as amended from other operating expense to the loss on loans and securities, net line item. Results of operations from the Canadian brokerage business and direct retail lending business have been reclassified to discontinued operations. Therefore, net revenue from these businesses has been excluded from total net revenue. The following information provides a representation of each region’s contribution to the consolidated amounts (dollars in thousands):
No single customer accounted for greater than 10% of gross revenues for the years ended December 31, 2008, 2007 and 2006.
NOTE 25-CONDENSED FINANCIAL INFORMATION (PARENT COMPANY ONLY)
The following presents the Parent’s condensed statement of income (loss) and comprehensive income (loss), balance sheet and statement of cash flows:
STATEMENT OF INCOME (LOSS) AND COMPREHENSIVE INCOME (LOSS)
(In thousands)
BALANCE SHEET
(In thousands)
STATEMENT OF CASH FLOWS
(In thousands)
(1)
Includes the proceeds received on November 29, 2007 for the 46.7 million shares of common stock that were issued in 2008 in connection with the Citadel Investment.
Parent Company Guarantees
Guarantees are contingent commitments issued by the Company for the purpose of guaranteeing the financial obligations of a subsidiary to a financial institution. The collective obligation of the corporation does not change by the existence of corporate guarantees. Rather, the guarantees shift ultimate payment responsibility of an existing financial obligation from a subsidiary to the parent company.
In support of the Company’s brokerage business, the Company has provided guarantees on the settlement of its subsidiaries’ financial obligations with several financial institutions related to its securities lending activities. Terms and conditions of the guarantees, although typically undefined in the guarantees themselves, are governed by the conditions of the underlying obligation that the guarantee covers. Thus, the Company’s obligation to pay under these guarantees coincides exactly with the terms and conditions of those underlying obligations. At December 31, 2008, no claims had been filed with the Company for payment under any guarantees. These guarantees are not collateralized.
In addition to guarantees issued on behalf of subsidiaries participating in securities lending programs, the Company also issues guarantees for the settlement of foreign exchange transactions. If a subsidiary fails to deliver currency on the settlement date of a foreign exchange arrangement, the beneficiary financial institution may seek payment from the Company. Terms are undefined, and are governed by the terms of the underlying financial obligation. At December 31, 2008, no claims had been made on the Company under these guarantees and thus, no obligations had been recorded. These guarantees are not collateralized.
NOTE 26-QUARTERLY DATA (UNAUDITED)
The information presented below reflects all adjustments, which, in the opinion of management, are of a normal and recurring nature necessary to present fairly the results of operations for the quarterly periods presented (dollars in thousands, except per share amounts):
The continued deterioration in the residential real estate and credit markets, as well as the nearly unprecedented turmoil in the global financial markets, had a significant impact on the Company’s financial performance during 2008. The decrease in income (loss) from continuing operations for the third and fourth quarter of 2008 was due primarily to the $517.8 million and $512.9 million in provision for loan losses, respectively. Additionally, the Company incurred losses of $153.8 million, net of hedges, on its preferred stock in Fannie Mae and Freddie Mac during the third quarter of 2008. The decrease in net income for the fourth quarter of 2007 was due principally to the $2.2 billion loss on the sale of the Company’s asset-backed securities portfolio and $402.3 million in provision for loan losses.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not applicable.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
(a) Our Chief Executive Officer and our Chief Financial Officer, after evaluating the effectiveness of the Company’s “disclosure controls and procedures” (as defined in the Securities Exchange Act of 1934 (“Exchange Act”) Rules 13a-15(e) and 15d-15(e)) as of the end of the period covered by this annual report, have concluded that our disclosure controls and procedures are effective based on their evaluation of these controls and procedures required by paragraph (b) of Exchange Act Rules 13a-15 or 15d-15.
(b) Our Chief Executive Officer and our Chief Financial Officer have evaluated the changes to the Company’s internal control over financial reporting that occurred during our last fiscal quarter ended December 31, 2008, as required by paragraph (d) of Exchange Act Rules 13a-15 and 15d-15, and have concluded that there were no such changes that materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting. The Management Report on Internal Control Over Financial Reporting and the Reports of Independent Registered Public Accounting Firm are included in Item 8. Financial Statements and Supplementary Data.
ITEM 9B.
ITEM 9B. OTHER INFORMATION
Not applicable.
PART III
The Company’s Proxy Statement for its 2009 Annual Meeting of Shareholders, which, when filed pursuant to Regulation 14A under the Securities Exchange Act of 1934, will be incorporated by reference in this Annual Report on Form 10-K pursuant to General Instruction G(3) of Form 10-K, provides the information required under Part III (Items 10, 11, 12, 13 and 14).
PART IV
ITEM 15.
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a) The following documents are filed as part of this report:
Consolidated Financial Statements and Financial Statement Schedules
Consolidated Financial Statement Schedules have been omitted because the required information is not present, or not present in amounts, sufficient to require submission of the schedules or because the required information is provided in the consolidated financial statements or notes thereto.
EXHIBIT INDEX
* Filed herein.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Dated: February 26, 2009
E*TRADE Financial Corporation
(Registrant)
By
/s/ DONALD H. LAYTON
Donald H. Layton
Chairman & Chief Executive Officer
By
/s/ BRUCE P. NOLOP
Bruce P. Nolop
Chief Financial Officer
(Principal Financial and Accounting Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.