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THE BANK OF NEW YORK COMPANY, INC.
Quarterly Report on Form 10-Q
For the quarterly period ended June 30, 2004
The Quarterly Report on Form 10-Q and cross reference index is on page 55.
THE BANK OF NEW YORK COMPANY, INC.
FINANCIAL REVIEW
TABLE OF CONTENTS
Consolidated Financial Highlights 1
Management's Discussion and Analysis of Financial
Condition and Results of Operations
- Introduction 2
- Overview 2
- Second Quarter 2004 Highlights 3
- Consolidated Income Statement Review 4
- Other Developments 8
- Business Segments Review 9
- Consolidated Balance Sheet Review 21
- Critical Accounting Policies 29
- Liquidity 31
- Capital Resources 33
- Trading Activities 35
- Asset/Liability Management 37
- Statistical Information 39
- Forward Looking Statements and
Factors That Could Affect Future Results 41
- Website Information 42
Consolidated Financial Statements
- Consolidated Balance Sheets
June 30, 2004 and December 31, 2003 43
- Consolidated Statements of Income
For the Three Months and Six Months Ended
June 30, 2004 and 2003 44
- Consolidated Statement of Changes In
Shareholders' Equity for the Six
Months Ended June 30, 2004 45
- Consolidated Statements of Cash Flows
For the Six Months Ended June 30, 2004 and 2003 46
- Notes to Consolidated Financial Statements 47
Form 10-Q
- Cover 55
- Controls and Procedures 56
- Legal Proceedings 56
- Changes in Securities, Use of Proceeds and
Issuer Purchases of Equity Securities 56
- Submission of Matters to Vote of Security Holders 57
- Exhibits and Reports on Form 8-K 59
- Signature 60
1
THE BANK OF NEW YORK COMPANY, INC.
Financial Highlights
(Dollars in millions, except per share amounts)
(Unaudited)
June 30, March 31, June 30,
2004 2004 2003
---------- ---------- ----------
Quarter
-------
Revenue (tax equivalent basis) $ 1,775 $ 1,677 $ 1,601
Net Income 371 364 295
Basic EPS 0.48 0.47 0.39
Diluted EPS 0.48 0.47 0.39
Cash Dividends Per Share 0.20 0.19 0.19
Return on Average Common
Shareholders' Equity 17.14% 17.17% 15.56%
Return on Average Assets 1.49 1.47 1.30
Efficiency Ratio 63.93 68.90 64.80
Year-to-date
------------
Revenue (tax equivalent basis) $ 3,450 $ 1,677 $ 3,031
Net Income 735 364 590
Basic EPS 0.95 0.47 0.80
Diluted EPS 0.94 0.47 0.80
Cash Dividends Per Share 0.39 0.19 0.38
Return on Average Common
Shareholders' Equity 17.15% 17.17% 16.61%
Return on Average Assets 1.48 1.47 1.39
Efficiency Ratio 66.30 68.90 62.50
Assets $ 97,536 $ 92,652 $ 99,759
Loans 38,205 36,070 37,796
Securities 22,986 24,083 20,392
Deposits - Domestic 36,279 33,639 37,319
- Foreign 24,781 22,443 27,336
Long-Term Debt 6,025 6,276 6,515
Common Shareholders' Equity 8,785 8,760 8,113
Common Shareholders'
Equity Per Share $ 11.29 $ 11.27 $ 10.50
Market Value Per Share
of Common Stock 29.48 31.50 28.75
Allowance for Credit Losses as
a Percent of Total Loans 2.03% 2.19% 2.18%
Allowance for Credit Losses as
a Percent of Non-Margin Loans 2.42 2.64 2.50
Allowance for Loan Losses as
a Percent of Total Loans 1.57 1.75 1.77
Allowance for Loan Losses as
a Percent of Non-Margin Loans 1.86 2.11 2.03
Tier 1 Capital Ratio 7.70 7.60 6.83
Total Capital Ratio 11.63 11.70 11.07
Leverage Ratio 6.00 5.83 5.85
Tangible Common Equity Ratio 4.95 5.22 4.32
Employees 23,001 22,820 23,106
Assets Under Custody (In trillions)
Total Assets Under Custody $ 8.7 $ 8.6 $ 7.8
Equity Securities 34% 33% 32%
Fixed Income Securities 66 67 68
Cross-Border Assets Under Custody $ 2.4 $ 2.4 $ 2.2
Assets Under Administration
(In billions) $ 32 $ 33 $ 27
Assets Under Management (In billions)
Total Assets Under Management 93 92 83
Equity Securities 36% 36% 32%
Fixed Income Securities 22 22 23
Alternative Investments 14 13 9
Liquid Assets 28 29 36
2
Management's Discussion and Analysis of Financial Condition and
- ---------------------------------------------------------------
Results of Operations
- ---------------------
INTRODUCTION
The Bank of New York Company, Inc.'s (the "Company") actual results of
future operations may differ from those estimated or anticipated in certain
forward-looking statements contained herein for reasons which are discussed
below and under the heading "Forward Looking Statements and Factors That Could
Affect Future Results." When used in this report, the words "estimate,"
"forecast," "project," "anticipate," "expect," "intend," "believe," "plan,"
"goal," "should," "may," "strategy," and words of similar meaning are intended
to identify forward looking statements in addition to statements specifically
identified as forward looking statements.
OVERVIEW
The Bank of New York Company, Inc. (NYSE: BK) is a global leader in
securities servicing for investors, financial intermediaries and issuers. The
Company plays an integral role in the infrastructure of the capital markets,
servicing securities in more than 100 markets worldwide. The Company provides
services based on leading technology for global financial institutions, asset
managers, governments, non-profit organizations, corporations, and individuals.
Its principal subsidiary, The Bank of New York, founded in 1784, is the oldest
bank in the United States and has a distinguished history of serving clients
around the world through its five primary businesses: Securities Servicing and
Global Payment Services, Private Client Services and Asset Management,
Corporate Banking, Global Market Services, and Retail Banking.
The Company has executed a consistent strategy over the past decade by
focusing on highly scalable, fee-based securities servicing and fiduciary
businesses, with top three market share in most of its major product lines.
The Company distinguishes itself competitively by offering the broadest array
of products and services around the investment lifecycle. These include:
advisory and asset management services to support the investment decision;
extensive trade execution, clearance and settlement capabilities; custody,
securities lending, accounting and administrative services for investment
portfolios; and sophisticated risk and performance measurement tools for
analyzing portfolios. The Company also provides services for issuers of both
equity and debt securities. By providing integrated solutions for clients'
needs, the Company strives to be the preferred partner in helping its clients
succeed in the world's rapidly evolving financial markets.
The Company has grown both through internal reinvestment as well as
execution of strategic acquisitions to expand product offerings and increase
market share in its scale businesses. Internal reinvestment occurs through
increased technology spending, staffing levels, marketing/branding initiatives,
quality programs, and product development. The Company consistently invests in
technology to improve the breadth and quality of its product offerings, and to
increase economies of scale. With respect to acquisitions, the Company has
acquired 57 businesses since 1998, almost exclusively in its securities
servicing and fiduciary segment. The acquisition of Pershing in 2003 for $2
billion was the largest of these acquisitions.
As part of the transformation to a leading securities servicing provider,
the Company has also de-emphasized or exited its slower growth traditional
banking businesses over the past decade. The Company's more significant
actions include selling its credit card business in 1997 and its factoring
business in 1999, and most recently, significantly reducing non-financial
corporate credit exposures by 44% from December 31, 2000 to December 31, 2003.
Capital generated by these actions has been reallocated to the Company's higher
growth businesses.
The Company's business model is well positioned to benefit from a number
of long-term secular trends. These include the growth of worldwide financial
3
assets, globalization of investment activity, structural market changes, and
increased outsourcing. These trends benefit the Company by driving higher
levels of financial asset trading volume and other transactional activity, as
well as higher asset price levels and growth in client assets, all factors by
which the Company prices its services. In addition, international markets
offer excellent growth opportunities.
SECOND QUARTER 2004 HIGHLIGHTS
After a strong overall market environment in the first quarter, the equity
markets fell off in the second quarter, as equity trading volumes and
volatility declined. Fixed income activity levels and foreign exchange
activity and volatility remained high, providing an offset. Against this back
drop, the Company's diversified business model performed well, achieving its
fifth consecutive quarter of sequential core earnings growth.
The Company reported second quarter net income of $371 million and diluted
earnings per share of 48 cents compared with net income of $364 million and
diluted earnings per share of 47 cents in the first quarter of 2004, and net
income of $295 million and diluted earnings per share of 39 cents in the second
quarter of 2003. Year-to-date net income was $735 million, or 94 cents of
diluted earnings per share, compared to $590 million, or 80 cents of diluted
earnings per share in 2003. Second quarter and year-to-date 2003 results
included dilution of 2 cents per share from merger and integration costs
associated with the Pershing acquisition.
Securities servicing fees held steady at $717 million for the second
quarter. Securities servicing fees were up $119 million or 20% over the second
quarter of 2003. While the noticeable drop in equity market trading volumes
impacted the Company's execution and clearing business, its fixed-income linked
businesses, including securities lending, corporate trust and global collateral
management, generated strong revenue growth. In addition, the Company's
depositary receipts ("DR") business continues to build momentum, driven by
seasonal dividend activity and higher levels of capital raisings. Continued
new business wins across the board further supported growth in revenues and
assets under custody.
At June 30, 2004 assets under custody rose to $8.7 trillion, from $8.6
trillion at March 31, 2004 and $7.8 trillion at June 30, 2003. Cross-border
custody assets were $2.4 trillion at June 30, 2004. Equity securities composed
34% of the assets under custody at June 30, 2004, while fixed income securities
were 66%.
The Company's asset management business continues to perform well,
responding to growing institutional investor interest in alternative
investments. Private client services and asset management fees increased 5% on
a sequential quarter basis. In addition, foreign exchange results continued to
benefit from currency volatility and increased cross-border investing. Foreign
exchange and other trading revenues declined by 6% relative to the first
quarter to $100 million, but remained at historically high levels, up 14%
versus a year ago.
Net interest income, excluding the first quarter impact of the leveraged
lease adjustment, was up 2% sequentially, reflecting modest growth in liquid
earning assets. On a year-over-year basis, net interest income for the quarter
increased 6%, reflecting the full impact of the Pershing acquisition and an
increase in investment securities.
The Company remains very focused on managing its expense base and
continuing to implement reengineering and profitability programs. Credit
quality remains strong, reflecting the success of the Company's risk management
program as well as the improved economic environment. As a result, the loan
loss provision came in at $10 million in the second quarter, slightly better
than the $12 million provision in the first quarter.
4
During the second quarter of 2004, the Company continued to invest in
enhancing its service offerings, critical to sustaining top line growth through
all types of markets, while maintaining its commitment to expense discipline to
ensure a competitive cost base. Service offerings enhancements were the result
of both internal development and acquisitions. In investor services, the
Company rolled out major enhancements to INFORM, the primary day to day
electronic interface between clients and the Company. In execution and
clearing, the Company acquired a leading electronic trading platform from Sonic
Financial which offers clients access to sophisticated trading tools and smart
routing capabilities. At Pershing, the Company introduced enhancements to its
platform for introducing broker-dealers enabling them to more effectively
manage and sell to their clients. The results of these investments were
demonstrated by consistent new business wins, which were key drivers for growth
in revenues and assets under custody in the quarter.
CONSOLIDATED INCOME STATEMENT REVIEW
Noninterest Income
- ------------------
2nd 1st 2nd
Quarter Quarter Quarter Year-to-Date
(Dollars in millions) 2004 2004 2003 2004 2003
------- ------- ------- ------- -------
Servicing Fees
Securities $ 717 $ 716 $ 598 $ 1,433 $ 1,071
Global Payment Services 81 79 80 160 158
------- ------- ------- ------- -------
798 795 678 1,593 1,229
Private Client Services
and Asset Management Fees 113 108 94 221 184
Service Charges and Fees 94 96 92 190 189
Foreign Exchange and
Other Trading Activities 100 106 88 206 154
Securities Gains 12 33 9 45 16
Other 49 92 35 141 69
------- ------- ------- ------- -------
Total Noninterest Income $ 1,166 $ 1,230 $ 996 $ 2,396 $ 1,841
======= ======= ======= ======= =======
Total noninterest income for the second quarter of 2004 was $1,166
million. Excluding the $48 million pre-tax gain on sale of a portion of the
Company's investment in Wing Hang Bank, Ltd. and the $19 million gain on four
sponsor fund investments in the first quarter of 2004, noninterest income
increased by $3 million. Total noninterest income for the second quarter was
up 17% over the second quarter of last year reflecting the full quarter impact
of the Pershing acquisition as well as strong performance in private client
services and asset management and improved results from foreign exchange and
other trading activities. Excluding the aforementioned gains in the first
quarter of 2004, noninterest income for the six months ended June 30, 2004 was
$2,329 million, an increase of 27% over the comparable 2003 period, reflecting
the impact of the Pershing acquisition and organic growth.
Notwithstanding the noticeable drop in sequential equity trading volumes,
the diversity of the securities servicing businesses allowed fees to hold
steady at $717 million for the second quarter. Securities servicing fees were
up $119 million or 20% over the second quarter of 2003. For the first six
months of 2004, securities servicing fees were $1,433 million, an increase of
$362 million from $1,071 million for the first six months of 2003. The
principal reason for the increase over last year is the inclusion of Pershing
for full periods in 2004 compared with two months in the 2003 periods.
Execution and clearing services fees decreased $23 million sequentially,
or 8%, to $280 million in the second quarter. The execution business was
impacted by lower equity market trading volumes in the second quarter, as
combined NYSE and NASDAQ trading volumes, excluding program trading, were down
15% from the first quarter. Pershing's correspondent clearing business was
also impacted by lower retail activity in May and June which reduced billable
trades.
5
Investor services fees were up slightly to $229 million, reflecting higher
securities lending, domestic custody, and global funds services fees driven by
new business wins, partially offset by slightly lower average asset price
levels over the quarter. As of June 30, 2004, assets under custody rose to
$8.7 trillion, from $8.6 trillion at March 31, 2004 and $7.8 trillion at June
30, 2003.
Issuer services fees recorded a strong quarter, increasing 13%
sequentially reflecting good growth in depositary receipts and corporate trust
and stable results in stock transfer. Depositary receipts benefited from an
increase in seasonal dividend activity, continued active cross-border
investing, and an increase in new capital issuances. Corporate trust activity
benefited from strength in issuance of global securities.
Broker-dealer services fees also showed good growth, increasing $3
million, or 6%, on a sequential quarter basis, as a result of higher volumes
due to new business wins in the collateral management businesses and higher
levels of mortgage backed and government trading activity.
Global payment services fees were up $2 million, or 3%, compared with the
prior quarter and up $1 million or 1% from a year ago resulting from higher
volumes and conversion of new business. Global payment services fees increased
by 1% on a year-to-date basis over 2003.
Private client services and asset management fees for the second quarter
were up 5% from the prior quarter and 20% from the second quarter of 2003. The
sequential quarter increase reflects continued strong growth at Ivy Asset
Management and seasonally higher private client fees related to tax services.
The increase from the second quarter of 2003 and on a year-to-date basis
reflects growth in Ivy Asset Management as well as higher equity price levels.
Total assets under management were $93 billion at June 30, 2004, up from $92
billion at March 31, 2004 and $83 billion a year ago.
Service charges and fees were down 2% from the prior quarter, as higher
retail service fees were offset by weaker demand for capital market services.
Compared to 2003, service charges and fees were up 2% on a quarterly basis and
up 1% on a year-to-date basis, reflecting higher retail services fees.
Foreign exchange and other trading revenues decreased $6 million from the
record first quarter but increased $12 million, or 14%, from a year ago. The
continued strong performance this quarter in foreign exchange reflects high
levels of client activity, tied to cross-border investing and hedging against
currency volatility. For the six months ended June 30, 2004, foreign exchange
and other trading activities were up 34% over the six months ended June 30,
2003, reflecting the same factors outlined for the second quarter.
Securities gains in the second quarter were $12 million, compared with $33
million in the first quarter of 2004 and $9 million in the second quarter of
2003. In the first quarter of 2004, securities gains included realized gains
of $19 million on four sponsor fund investments. For the six months ended June
30, 2004, securities gains were $45 million, up $29 million from the six months
ended June 30, 2003.
Other noninterest income was $49 million in the second quarter, compared
with $92 million in the first quarter of 2004 when other noninterest income
included a pre-tax gain of $48 million from the sale of a portion of the
Company's investment in Wing Hang Bank Limited. Compared to the second quarter
of 2003, other noninterest income was $49 million up from $35 million last
year. In the six months ended June 30, 2004, other noninterest income was $141
million, up from $69 million in the six months ended June 30, 2003 primarily
reflecting the gain on the sale of a portion of its investment in Wing Hang
Bank Limited.
6
Net Interest Income
- -------------------
2nd 1st 1st 2nd
Quarter Quarter Quarter Quarter Year-to-Date
-------- -------- ------- -------- -------------------------
Reported Reported Core** Reported Reported Core** Reported
(Dollars in millions) -------- -------- ------- -------- -------- ------- --------
2004 2004 2004 2003 2004 2004 2003
-------- -------- ------- -------- -------- ------- --------
Net Interest Income $ 421 $ 268 $ 413 $ 398 $ 689 $ 834 $ 784
Tax Equivalent Adjustment* 8 6 6 9 14 14 19
-------- -------- ------- -------- -------- ------- --------
Net Interest Income on a
Tax Equivalent Basis $ 429 $ 274 $ 419 $ 407 $ 703 $ 848 $ 803
======== ======== ======= ======== ======== ======= ========
Net Interest Rate
Spread 1.84% 1.13% 1.85% 1.96% 1.49% 1.84% 2.06%
Net Yield on Interest
Earning Assets 2.08 1.36 2.08 2.21 1.72 2.08 2.32
* A number of amounts related to net interest income are presented on a
"taxable equivalent basis." The Company believes that this presentation
provides comparability of net interest income arising from both taxable
and tax-exempt sources and is consistent with industry standards.
** Excludes SFAS 13 adjustment
Net interest income on a taxable equivalent basis was $429 million in the
second quarter of 2004, compared with $274 million reported in the first
quarter of 2004, and $407 million in the second quarter of 2003. The net
interest income rate spread was 1.84% in the second quarter of 2004, compared
with 1.13% reported in the first quarter of 2004, and 1.96% in the second
quarter of 2003. The net yield on interest earning assets was 2.08% in the
second quarter of 2004, compared with 1.36% reported in the first quarter of
2004, and 2.21% in the second quarter of 2003. In the first quarter of 2004,
net interest income included a pre-tax charge of $145 million resulting from a
cumulative adjustment to the leasing portfolio, which was triggered under
Statement of Financial Accounting Standards No. 13 ("SFAS 13") "Accounting for
Leases". Excluding the SFAS 13 adjustment, net interest income on a taxable
equivalent basis was $419 million in the first quarter of 2004, which reflected
a net interest rate spread of 1.85% and a net yield on interest earning assets
of 2.08%.
The increase in net interest income from the core first quarter of 2004
results is primarily due to a slightly higher level of liquid earning assets,
which resulted from the greater deposit flows from servicing customers, as well
as a modest shift from fixed rate investment securities to short-term floating
assets to better position for higher rates. The increase in net interest
income from the second quarter of 2003 reflects the full quarter impact of the
Pershing acquisition.
For the first six months of 2004, net interest income on a taxable
equivalent basis was $703 million, compared with $803 million in the first half
of 2003, reflecting the SFAS 13 adjustment partially offset by the full impact
of the Pershing acquisition. The year-to-date net interest income spread was
1.49% in 2004 (core of 1.84%) compared with 2.06% in 2003, while the net yield
on interest earning assets was 1.72% in 2004 (core of 2.08%) and 2.32% in 2003.
7
Noninterest Expense and Income Taxes
- ------------------------------------
2nd 1st 2nd
Quarter Quarter Quarter Year-to-date
(Dollars in million) 2004 2004 2003 2004 2003
------- ------- ------- ------- -------
Salaries and Employee Benefits $ 570 $ 574 $ 498 $ 1,144 $ 921
Net Occupancy 72 81 64 153 122
Furniture and Equipment 51 51 49 102 85
Clearing 44 48 40 92 69
Sub-custodian Expenses 22 22 19 44 35
Software 50 49 43 99 78
Communications 23 24 23 47 44
Amortization of Intangibles 8 8 7 16 10
Merger and Integration Costs - - 25 - 25
Other 172 156 135 328 253
------- ------- ------- ------- -------
Total Noninterest Expense $ 1,012 $ 1,013 $ 903 $ 2,025 $ 1,642
======= ======= ======= ======= =======
Noninterest expense for the second quarter of 2004 was $1,012 million,
compared with $1,013 million in the prior quarter, and $903 million in the
second quarter of 2003. Noninterest expense in the first quarter included $18
million related to cost reduction initiatives, including lease terminations,
severance and relocation expenses.
After adjusting for the $4 million step-up in stock option expensing this
quarter as well as $10 million in severance and $8 million in lease termination
costs in the first quarter, sequential expense growth was only 1.3%. Salaries
and employee benefits were well controlled increasing just $2 million, or 0.4%,
after the aforementioned adjustments. Headcount was up 181 for the quarter
increasing by only 85 excluding acquisitions. Option expense levels will not
increase in the third and fourth quarter of 2004 with the last step-up in
option expensing coming in the second quarter of 2005, reflecting the
completion of the three year phase-in period. Clearing expenses in the second
quarter, which are tied to transaction volumes, were down $4 million
sequentially to $44 million while sub-custodian expenses, which are also tied
to volumes, held steady at $22 million due to stronger activity trends in
Europe. The increase in other operating expenses of $16 million on a
sequential quarter basis was driven largely by higher legal costs, increased
use of consultants in connection with cost restructuring programs, and seasonal
travel and entertainment.
Second quarter of 2003 included $25 million of merger and integration
costs related to the Pershing acquisition. After excluding merger and
integration costs, noninterest expense for the second quarter of 2004 was
$1,012 million compared with $878 million in the second quarter of 2003. On
the same basis, noninterest expense for the first six months of 2004 was $2,025
million compared with $1,617 million last year. The increases mainly reflect
higher business activity and the full impact of the Pershing acquisition in the
second quarter and first half of 2004.
The effective tax rate for the second quarter of 2004 was 34.2%, compared
to 23.1% in the first quarter and 34.6% in the second quarter of 2003. The
effective tax rate for the six months period ended June 30, 2004 was 29.2%,
compared with 34.6% for the six months period ended June 30, 2003. The year-
over-year decreases reflect the benefit associated with the SFAS 13 adjustment
in the first quarter of 2004.
8
Credit Loss Provision and Net Charge-offs
- -----------------------------------------
2nd 1st 2nd
Quarter Quarter Quarter Year-to-Date
(Dollars in millions) 2004 2004 2003 2004 2003
------- ------- ------- ------- -------
Provision $ 10 $ 12 $ 40 $ 22 $ 80
======= ======= ======= ======= =======
Net Charge-offs:
Commercial $ (11) $ (5) $ (34) $ (16) $ (59)
Foreign (8) (10) (7) (18) (7)
Other - - - - (10)
Consumer (6) (11) (5) (17) (10)
------- ------- ------- ------- -------
Total $ (25) $ (26) $ (46) $ (51) $ (86)
======= ======= ======= ======= =======
Other Real Estate Expenses $ - $ - $ - $ - $ -
The provision was $10 million in the second quarter of 2004 compared to
$12 million in the first quarter of 2004 and $40 million in the second quarter
of 2003. For the first six months of 2004, the provision was $22 million
compared with $80 million in 2003. The lower provision compared with the
second quarter of 2003 reflects the Company's improved risk profile as well as
improvements in the U.S. economy. Declines in nonperforming and criticized
assets, improved borrower ratings, and reductions in large exposures are
indicative of the Company's reduced credit risk.
Net charge-offs were $25 million in the second quarter of 2004 versus $26
million and $46 million in the first quarter of 2004 and second quarter of
2003. These represent 0.26% of total loans in the most recent quarter, down
from 0.29% and 0.49% in the prior periods, respectively.
OTHER DEVELOPMENTS
In May 2004, the Company made a strategic investment in London-based
Netik, LLC. Netik provides market-leading data management and consolidated
reporting capabilities that leverage its data warehouse for portfolio and
investment information, reference data, and analytics. The Company uses Netik
products as part of its BNY SmartSource(service mark) outsourcing solution,
and will also partner with Netik to make the product available to other
financial institutions.
Late in the second quarter of 2004, the Company acquired a unit investment
trust business that services approximately $20 billion in assets for over 4,200
different series of unit investment trusts.
During the second quarter of 2004, the Company agreed to acquire Osprey
Partners LLC's portfolio accounting technology to broaden its managed account
services offering. The acquisition will allow the Company to integrate the
portfolio accounting function within its proprietary managed account services
offering and fully support the comprehensive portfolio view created by unified
managed account platforms.
In July 2004, the Company's new $2 billion shelf registration became
effective. Combined with the existing shelf registration the Company now has
the capacity to issue approximately $2.5 billion of debt, preferred stock,
preferred trust securities, or common stock.
9
BUSINESS SEGMENTS REVIEW
The Company has an internal information system that produces performance
data for its four business segments along product and service lines.
Business Segments Accounting Principles
- ---------------------------------------
The Company's segment data has been determined on an internal management
basis of accounting, rather than the generally accepted accounting principles
used for consolidated financial reporting. These measurement principles are
designed so that reported results of the segments will track their economic
performance. Segment results are subject to restatement whenever improvements
are made in the measurement principles or organizational changes are made. In
the first quarter of 2004, the Company changed its methodology for allocating
its pension credit to the segments. Prior periods have been restated.
The measure of revenues and profit or loss by operating segment has been
adjusted to present segment data on a taxable equivalent basis. The provision
for credit losses allocated to each reportable segment is based on management's
judgment as to average credit losses that will be incurred in the operations of
the segment over a credit cycle of a period of years. Management's judgment
includes the following factors among others: historical charge-off experience
and the volume, composition, and size of the loan portfolio. This method is
different from that required under generally accepted accounting principles as
it anticipates future losses, which are not yet probable, and therefore not
recognizable under generally accepted accounting principles. Assets and
liabilities are match funded. Support and other indirect expenses are allocated
to segments based on general internal guidelines.
Description of Business Segments
- --------------------------------
The results of individual business segments exclude unusual items such as
the GMAC settlement and the Pershing related merger and integration costs of
2003, which are included with reconciling amounts.
The Company reports data for the four business segments: Servicing and
Fiduciary Businesses, Corporate Banking, Retail Banking, and Financial Markets.
The Servicing and Fiduciary Businesses segment comprises the Company's
core services, including securities servicing, global payment services, and
private client services and asset management. These businesses all share
certain favorable attributes: they are well diversified and fee-based; the
Company serves the role of an intermediary rather than principal, thereby
limiting risk and generating more stable earnings streams; and the businesses
are scalable, which result in higher margins as revenues grow. Long-term
trends that favor these businesses include the growth of financial assets
worldwide, the globalization of investment activity, heightened demand for
financial servicing outsourcing, and continuing structural changes in financial
markets.
Securities servicing provides financial institutions, corporations and
financial intermediaries with a broad array of products and customized services
for every step of the investment lifecycle. The Company facilitates the
movement, settlement, recordkeeping and accounting of financial assets around
the world by delivering timely and accurate information to issuers, investors
and broker-dealers. The Company groups its securities servicing businesses
into four categories, each comprised of separate, but related businesses.
Issuer services include corporate trust, depositary receipts and stock
transfer. Investor services include global fund services, global custody,
securities lending, global liquidity services and outsourcing. Broker-dealer
services include government securities clearance and collateral management.
Execution and clearing services include in the execution area institutional
agency brokerage, electronic trading, transition management services, and
independent research. Through Pershing, the clearing part of the business
provides clearing, execution, financing, and custody for introducing
brokers/dealers. The Servicing and Fiduciary Businesses segment also includes
customer-related foreign exchange.
10
In issuer services, the Company's American and global depositary receipt
("DR") business has over 1,180 programs representing 60 countries. As a
trustee, the Company provides diverse services for corporate, municipal,
mortgage-backed, asset-backed, derivative and international debt securities.
Over 90,000 appointments for more than 30,000 worldwide clients have resulted
in the Company being trustee for more than $1 trillion in outstanding debt
securities. The Company is the third largest stock transfer agent representing
over 1,950 publicly traded companies with over 19 million shareholder accounts.
In investor services, the Company is the second largest custodian with
$8.7 trillion of assets at June 30, 2004. The Company is the second largest
mutual fund custodian with $1.4 trillion in assets. The Company is the largest
U.K. custodian. The Company services over 25% of total exchange traded fund
industry assets. In securities lending, the Company is the largest lender of
U.S. Treasury securities and depositary receipts.
The Company's broker-dealer services business clears approximately 50% of
U.S. Government securities. With over $800 billion in tri-party balances
worldwide, the Company is the world's largest collateral management agent.
The Company's execution and clearing services business is the largest
global institutional agency brokerage organization. In addition, it is the
largest institutional electronic broker for non-U.S. dollar equity execution.
The Company provides execution and clearing services in over 80 markets,
executing trades for more than 600 million shares and clearing 650,000 trades
daily. The Company has 21 seats on the New York Stock Exchange. Pershing
services nearly 1,100 introducing brokerage firms and registered investment
advisors who collectively represent more than 5 million individual investors.
Global payment services facilitate the flow of funds between the Company's
customers and their clients through such business lines as funds transfer, cash
management and trade services. Private client services and asset management
includes traditional banking and trust services to affluent clients and
investment management services for institutional and high net worth clients.
The Company's strategy is to be a market leader in these businesses and
continue to build out its product and service capabilities and add new
clients. The Company has completed 57 acquisitions since 1998 in this segment,
has made significant investments in technology to maintain its industry-leading
position, and has continued the development of new products and services to
meet its clients' needs.
The Corporate Banking segment provides lending and credit-related services
to large public and private financial institutions and corporations nationwide,
as well as to public and private mid-size businesses in the New York
metropolitan area. Special industry groups focus on industry segments such as
banks, broker-dealers, insurance, media and telecommunications, energy, real
estate, retailing, and government banking institutions. Through BNY Capital
Markets, Inc., the Company provides syndicated loans, bond underwriting,
private placements of corporate debt and equity securities, and merger,
acquisition, and advisory services.
Corporate Banking coordinates delivery of all of the Company's services to
customers through its global relationship managers. The two main client bases
served are financial institution clients and corporate clients. The Company's
strategy is to focus on those clients and industries that are major users of
securities servicing and global payment services.
The Company believes that credit is an important product for many of its
customers to execute their business strategies. However, the Company has
continued to reduce its credit exposures in recent years by culling its loan
portfolio of non-strategic exposures, focusing on increasing total relationship
returns through cross-selling and limiting the size of its individual credit
exposures and industry concentrations to reduce earnings volatility.
The Retail Banking segment includes retail deposit services, branch
banking, and consumer and residential mortgage lending. The Company operates
341 branches in 23 counties in the Tri-State region. The retail network is a
stable source of low cost funding and provides a platform to cross-sell core
services from the Servicing and Fiduciary Businesses to both individuals and
small businesses in the New York metropolitan area.
11
The Financial Markets segment includes trading of foreign exchange and
interest rate risk management products, investing and leasing activities, and
treasury services to other business segments. The segment offers a
comprehensive array of multi-currency hedging and yield enhancement strategies,
and complements the other business segments. The Financial Markets segment
centralizes interest rate risk management for the Company.
There were no major customers from whom revenues were individually
material to the Company's performance.
Servicing and Fiduciary Businesses
- ----------------------------------
2nd 1st 2nd
Quarter Quarter Quarter Year-to-date
(Dollars in millions) 2004 2004 2003 2004 2003
--------- --------- --------- --------- ---------
Net Interest Income $ 144 $ 140 $ 120 $ 284 $ 225
Provision for Credit Losses 1 - - 1 -
Noninterest Income 994 990 843 1,984 1,534
Noninterest Expense 764 757 651 1,521 1,176
Income Before Taxes 373 373 312 746 583
Average Assets $ 22,891 $ 22,771 $ 15,727 $ 22,831 $ 11,695
Average Deposits 35,520 35,138 33,499 35,329 32,320
Nonperforming Assets 3 3 16 3 16
(In billions)
Assets Under Custody $ 8,662 $ 8,577 $ 7,787 $ 8,662 $ 7,787
Equity Securities 34% 33% 32% 34% 32%
Fixed Income Securities 66 67 68 66 68
Cross-Border Assets $ 2,425 $ 2,401 $ 2,180 $ 2,425 $ 2,180
(In billions)
Assets Under Administration $ 32 $ 33 $ 27 $ 32 $ 27
Assets Under Management 93 92 83 93 83
Equity Securities 36% 36% 32% 36% 32%
Fixed Income Securities 22 22 23 22 23
Alternative investments 14 13 9 14 9
Liquid Assets 28 29 36 28 36
S&P 500 Index (Period End) 1,141 1,126 975 1,141 975
NASDAQ Index (Period End) 2,048 1,994 1,623 2,048 1,623
NYSE Volume (In billions) 90.8 95.4 93.0 186.2 179.6
NASDAQ Volume (In billions) 108.3 126.3 112.5 234.6 201.3
Second quarter results showed continued strength in the Company's primary
businesses, including securities servicing and private client services and
asset management. In the second quarter of 2004, pre-tax income was $373
million, compared with $373 million in the first quarter of 2004 and $312
million a year ago. On a year-to-date basis, pre-tax income was $746 million,
up 28% from $583 million in 2003.
Noninterest income increased to $994 million from $990 million in the
first quarter of 2004 and $843 million in the second quarter of 2003.
Notwithstanding the noticeable drop in sequential equity trading volumes, fees
held steady at $717 million for the second quarter given the diversity of the
securities servicing businesses. Second quarter securities servicing fees
increased $119 million, or 20%, over the second quarter of 2003, and on a year-
to-date basis, securities servicing fees were $1,433 million, up 34% over the
comparable 2003 period principally due to the inclusion of Pershing for six
months in 2004 compared with two months in the first half of 2003.
12
Securities Servicing Fees
- -------------------------
2nd 1st 4th 3rd
Quarter Quarter Quarter Quarter
(Dollars in millions) 2004 2004 2003 2003
------- ------- ------- -------
Execution and Clearing Services $ 280 $ 303 $ 290 $ 271
Investor Services 229 226 210 212
Issuer Services 155 137 136 127
Broker-Dealer Services 53 50 48 47
------- ------- ------- -------
Securities Servicing Fees $ 717 $ 716 $ 684 $ 657
======= ======= ======= =======
Execution and clearing services fees decreased $23 million sequentially,
or 8%, to $280 million in the second quarter. The execution business was
impacted by lower equity market trading volumes in the second quarter, as
combined NYSE and NASDAQ trading volumes, excluding program trading, were down
15% from the first quarter. BNY Brokerage, B-Trade, and G-Trade volumes were
down, but less than the overall market decline. The execution business also
experienced a slowdown in transition management activity from the robust first
and fourth quarter levels consistent with overall trends in the fund industry.
The impact of lower trading volumes was partly offset by new business wins
across the Company's product lines and several significant wins with existing
public fund clients. The Company has received a favorable response to Sonic,
the electronic trading portal it acquired in March. Since the acquisition, the
Company has installed 30 money managers on the platform that are responsible
for $700 billion in assets under management. Lower trading volumes had a more
muted impact on Pershing which generates the majority of its revenues from non-
transactional activities like asset gathering and technology services.
Pershing's correspondent clearing business was impacted by lower retail
activity in May and June which reduced billable trades. Margin loans held
steady at $6.1 billion which indicates that retail investor sentiment remains
positive. In addition, as a result of new business wins and organic growth,
other key metrics like total active accounts, retirement accounts, and client
assets were all up for the quarter and year-to-date.
Investor services fees were up slightly to $229 million, reflecting higher
securities lending, domestic custody, and global funds services fees driven by
new business wins, partially offset by slightly lower average asset price
levels over the quarter. As of June 30, 2004, assets under custody rose to
$8.7 trillion, from $8.6 trillion at March 31, 2004 and $7.8 trillion at June
30, 2003. The sequential quarter increase in assets under custody primarily
reflects new business wins. Cross-border custody assets were $2.4 trillion at
June 30, 2004. Equity securities composed 34% of the assets under custody at
June 30, 2004 compared with 32% at June 30, 2003, while fixed income securities
were 66% compared with 68% last year. Securities lending fees showed good
growth relative to the first quarter benefiting from increased loan assets due
to new business wins and slightly higher spreads due to seasonal factors.
Issuer services fees recorded a strong quarter, increasing 13%
sequentially reflecting good growth in depositary receipts and corporate trust
and stable results in stock transfer. Depositary receipts benefited from an
increase in seasonal dividend activity, continued active cross-border
investing, and an increase in new capital issuances. Net DR issuance has
occurred for ten straight months and in 15 of the last 18 months, demonstrating
the continued strengthened interest in cross-border investing activity.
Corporate trust activity benefited from strength in issuance of international
securities which more than offset flat performance on the municipal side.
13
Broker-dealer services fees increased $3 million, or 6%, on a sequential
quarter basis, as a result of higher volumes due to new business wins in the
collateral management businesses and higher levels of mortgage backed and
government trading activity. The Company now processes approximately $850
billion of financing for the Company's broker-dealer clients daily through tri-
party collateralized financing agreements, up 26% from a year ago.
Global payment services fees were up $2 million, or 3%, compared with the
prior quarter and up $1 million, or 1% from a year ago, resulting from higher
volumes and conversion of new business. Global payment services increased by
1% on a year-to-date basis over 2003.
Private client services and asset management fees for the second quarter
were up 5% from the prior quarter and 20% from the second quarter of 2003. The
sequential quarter increase reflects continued strong growth at Ivy Asset
Management and seasonally higher private client fees related to tax services.
The increase from the second quarter of 2003 and on a year-to-date basis
reflects growth in Ivy Asset Management as well as higher equity price levels.
Assets under management ("AUM") were $93 billion at June 30, 2004, up from
$92 billion at March 31, 2004 and $83 billion at June 30, 2003. Assets under
administration were $32 billion compared with $33 billion at March 31, 2004 and
$27 billion at June 30, 2003. The sequential quarter and year-over-year
increases in assets under management reflect growth in the Company's
alternative investments business and a rise in equity market value.
Institutional clients represent 67% of AUM while individual clients equal 33%.
AUM at June 30, 2004, are 36% invested in equities, 22% in fixed income, 14% in
alternative investments and the remainder in liquid assets. At Ivy, AUM
climbed to $13.2 billion at June 30, 2004 from $11.7 billion at March 31, 2003
and $7.3 billion at June 30, 2003 reflecting continued strong demand from
institutional and foreign investors.
Foreign exchange and other trading revenues decreased $6 million from the
prior quarter and increased $12 million, or 14%, from one year ago. The
continued strong performance this quarter in foreign exchange reflects high
levels of client activity, tied to cross-border investing and hedging against
currency volatility. Other trading was down sequentially due to a slowdown in
client driven activity at Pershing which acts as a riskless principal taker to
facilitate customer order flow. For the six months ended June 30, 2004,
foreign exchange and other trading activities were up 34% over the six months
ended June 30, 2003, reflecting the same factors outlined for the second
quarter.
Net interest income in the Servicing and Fiduciary Businesses segment was
$144 million for the second quarter of 2004 compared with $140 million for the
first quarter of 2004 and $120 million in the second quarter of 2003. The
increase in net interest income on a sequential quarter basis is primarily
attributable to higher levels of client activity which led to an increase in
the average level of assets and deposits. The increase in net interest income
from the second quarter of 2003 is primarily due to the Pershing acquisition.
Net interest income for the six months ended June 30, 2004 was $284 million
compared with $225 million in the first half of 2003, mainly due to the
Pershing acquisition. Average assets for the quarter ended June 30, 2004 were
$22.9 billion compared with $22.8 billion in the first quarter of 2004 and
$15.7 billion in the second quarter of 2003. Average assets for the six months
ended June 30, 2004 were $22.8 billion compared with $11.7 billion in the first
six months of 2003. The increase in assets in 2004 compared with 2003 is
primarily attributable to the Pershing acquisition. The second quarter of 2004
average deposits were $35.5 billion compared with $35.1 billion in the first
quarter of 2004 and $33.5 billion in the second quarter of 2003. Average
deposits for the first half of 2004 were $35.3 billion compared with $32.3
billion for the first half of 2003.
14
Net charge-offs in the Servicing and Fiduciary Businesses segment were
zero in the second quarter of 2004, compared with $5 million in the first
quarter of 2004 and zero in the second quarter of 2003. Nonperforming assets
were $3 million at June 30, 2004, compared with $3 million at March 31, 2004
and $16 million at June 30, 2003.
Noninterest expense for the second quarter of 2004 was $764 million,
compared with $757 million in the first quarter of 2004 and $651 million in the
second quarter of 2003. The rise in noninterest expense from first quarter of
2004 was primarily due to the Company's continued investment in technology, as
well as higher volume-related expenses related to revenue growth. Noninterest
expense for the first six months of 2004 was $1,521 million, compared with
$1,176 million for the same period in 2003. The increase over last year's
quarter and year-to-date periods reflects the Pershing acquisition.
Corporate Banking
- -----------------
2nd 1st 2nd
Quarter Quarter Quarter Year-to-date
(Dollars in millions) 2004 2004 2003 2004 2003
-------- -------- -------- -------- --------
Net Interest Income $ 87 $ 89 $ 95 $ 176 $ 187
Provision for Credit Losses 15 20 30 35 60
Noninterest Income 84 80 82 164 153
Noninterest Expense 54 53 51 107 99
Income Before Taxes 102 96 96 198 181
Average Assets $ 17,308 $ 17,358 $ 19,851 $ 17,333 $ 20,189
Average Deposits 6,345 6,800 6,583 6,573 6,899
Nonperforming Assets 293 325 410 293 410
Net Charge-offs 9 11 42 20 77
In the second quarter of 2004, pre-tax income was $102 million, compared
with $96 million in the first quarter of 2004 and the second quarter of 2003.
On a year-to-date basis, pre-tax income was $198 million, up 9% from $181
million in 2003. The improvement in all periods is primarily attributable to a
reduction in credit risk, resulting in a lower provision for credit losses.
The Company has achieved its principal risk management objectives, and assets
are now flat to slightly growing.
The Corporate Banking segment's net interest income was $87 million in the
second quarter of 2004, compared with $89 million in the first quarter of 2004
and $95 million in the second quarter of 2003. The decline from both the first
quarter of 2004 and second quarter of 2003 reflects continued reduction in
lending to corporate borrowers as well as a decline in deposits. On a year-to-
date basis, net interest income for 2004 was $176 million compared with $187
million in 2003. Average assets for the quarter were $17.3 billion compared
with $17.4 billion in the first quarter of 2004 and $19.9 billion in the second
quarter of last year. Average deposits in the corporate bank were $6.3 billion
versus $6.8 billion in the first quarter of 2004 and $6.6 billion in 2003. For
the six months ended June 30, 2004, average assets were $17.3 billion compared
to $20.2 billion for the first six months of 2003. For the first half of 2004
and 2003, average deposits were $6.6 billion and $6.9 billion.
The second quarter of 2004 provision for credit losses was $15 million
compared with $20 million in the first quarter of 2004 and $30 million last
year. On a year-to-year basis, the provision for credit losses was $35 million
for 2004 and $60 million for 2003. The decline in the provision from the
second quarter and year-to-date 2003 reflects reduced credit exposures and an
improvement in overall asset quality. Net charge-offs in the Corporate Banking
segment were $9 million in the second quarter of 2004, $11 million in the first
quarter of 2004, and $42 million in the second quarter of 2003. Net charge-
offs for the first six months of 2004 were $20 million compared with $77
million in 2003. The charge-offs for the first six months of 2004 primarily
relate to loans to media and foreign borrowers. Nonperforming assets were $293
15
million at June 30, 2004, down from $325 million at March 31, 2004 and $410
million at June 30, 2003. The decrease in nonperforming assets from the second
quarter of 2003 primarily reflects paydowns and charge-offs of commercial and
foreign loans.
Noninterest income was $84 million in the current quarter, compared with
$80 million in the first quarter of 2004 and $82 million in the second quarter
of 2003. On a sequential quarter basis, the increase reflects higher
syndication fees. The increase year-over-year reflects higher income from
unconsolidated subsidiaries. On a year-to-date basis, noninterest income was
$164 million, up $11 million from $153 million in 2003, reflecting higher
income from the Company's investment in Wing Hang Bank as well as higher
capital markets fees and trading income.
Noninterest expense in the second quarter was $54 million, compared with
$53 million in the first quarter of 2004 and $51 million in the second quarter
of 2003. The increase over 2003 reflects higher compensation costs due in part
to a reduced pension credit and higher stock option expense. On a year-to-date
basis, noninterest expense was $107 million, compared with $99 million in 2003,
reflecting higher compensation and medical costs.
Retail Banking
- --------------
2nd 1st 2nd
Quarter Quarter Quarter Year-to-date
(Dollars in millions) 2004 2004 2003 2004 2003
------- ------- ------- ------- -------
Net Interest Income $ 126 $ 123 $ 118 $ 249 $ 234
Provision for Credit Losses 5 5 5 10 9
Noninterest Income 28 29 33 57 62
Noninterest Expense 95 93 91 188 178
Income Before Taxes 54 54 55 108 109
Average Assets $ 5,317 $ 5,377 $ 5,333 $ 5,347 $ 5,360
Average Noninterest
Bearing Deposits 5,209 5,028 4,565 5,118 4,697
Average Deposits 15,162 14,807 14,252 14,985 14,187
Nonperforming Assets 15 15 11 15 11
Net Charge-offs 5 6 5 11 10
Number of Branches 341 341 341 341 341
Total Deposit Accounts
(In Thousands) 1,129 1,133 1,183 1,129 1,183
Number of ATMS 379 378 371 379 371
The Retail Banking segment continues to demonstrate stable results in
spite of increased competition in the New York metropolitan area. In the
second quarter of 2004, pre-tax income was $54 million, compared with $54
million in the first quarter of 2004 and $55 million a year ago. On a year-to-
date basis, pre-tax income was $108 million, compared with $109 million in
2003. The Company has been able to steadily grow its deposit balances, with
average deposits reaching $15.2 billion during the quarter.
Net interest income in the second quarter of 2004 was $126 million,
compared with $123 million in the first quarter of 2004 and $118 million in the
second quarter of 2003. On a sequential quarter basis, net interest income
increased slightly reflecting higher levels of deposits. Net interest income
on a year-to-year basis for 2004 and 2003 was $249 million and $234 million.
The increases from 2003 reflect increased noninterest bearing deposits and
interest bearing deposits from municipalities in the retail bank's service area
as well as increased asset yield. The rise in deposits reflects the segment's
focus on small business owners and professionals such as lawyers, doctors and
certified public accountants. In addition, product offerings such as BNY On-
Line and the debit card along with promotional campaigns have helped build
deposit volumes.
16
Noninterest income was $28 million for the quarter compared with $29
million on a sequential quarter basis and $33 million in last year's second
quarter. Noninterest income for the first six months of 2004 was $57 million
compared with $62 million in the first six months of 2003. The decreases in
noninterest income reflect lower monthly service fees and lower debit card
fees. Monthly service charges are down as a result of promotional offerings
made in response to the competitive environment. Other deposit service fees
increased over 2003. Although the average size of a debit card transaction and
the number of transactions are up, debit card fees are down due to an industry
wide settlement that reduced intercharge income by 30%. The second quarter of
2003 included a gain on the sale of $230 million of mortgage loans.
Noninterest expense in the second quarter of 2004 was $95 million,
compared with $93 million in the first quarter of 2004 and $91 million last
year. The increase from the second quarter of 2003 reflects higher
compensation and marketing costs. Noninterest expense for the first half of
2004 was $188 million compared with $178 million in the first half of 2003.
The year-over-year change reflects the same factors influencing the quarterly
increase as well as higher legal expenses.
Net charge-offs were $5 million in the second quarter of 2004, compared
with $6 million in the first quarter of 2004 and $5 million in the second
quarter of 2003. Nonperforming assets were $15 million at June 30, 2004,
compared with $15 million at March 31, 2004, and $11 million at June 30, 2003.
The rise over the second quarter of 2003 is attributable to an increase in the
level of nonperforming small business loans. For the first six months of 2004,
net charge-offs were $11 million, up $1 million from $10 million for the first
six months of 2003.
Average deposits generated by the Retail Banking segment were $15.2
billion in the second quarter of 2004, compared with $14.8 billion in the first
quarter of 2004 and $14.3 billion in the second quarter of 2003. For the first
half of 2004 average deposits were $15.0 billion compared to $14.2 billion in
the first half of 2003. Average noninterest bearing deposits for the first six
months of 2004 were $5.1 billion compared with $4.7 billion in the first six
months of 2003. Average assets in the Retail Banking sector were $5.3 billion,
compared with $5.4 billion in the first quarter of 2004 and $5.3 billion in the
second quarter of 2003. On a year-to-year basis, average assets were $5.3
billion for 2004 and $5.4 billion in 2003.
Financial Markets
- -----------------
2nd 1st 2nd
Quarter Quarter Quarter Year-to-date
(Dollars in millions) 2004 2004 2003 2004 2003
-------- -------- -------- -------- --------
Net Interest Income $ 83 $ 80 $ 80 $ 163 $ 157
Provision for Credit Losses 5 5 6 10 11
Noninterest Income 43 50 33 93 83
Noninterest Expense 28 27 25 55 49
Income Before Taxes 93 98 82 191 180
Average Assets $ 50,728 $ 50,051 $ 46,463 $ 50,390 $ 45,404
Average Deposits 5,460 3,864 4,153 4,662 4,533
Average Investment Securities 22,982 22,997 18,720 22,989 18,351
Net Charge-offs 10 4 - 14 -
In the second quarter of 2004, pre-tax income was $93 million, compared
with $98 million in the first quarter of 2004 and $82 million in the second
quarter of 2003. The sequential quarter decline is due to a drop in trading
revenue. On a year-to-date basis, pre-tax income was $191 million, up 6% from
$180 million in 2003. The increases over the second quarter and year-to-date
2003 periods are primarily due to a rise in both trading income and net
interest income.
17
Net interest income for the second quarter was $83 million compared with
$80 million on a sequential quarter and year-over-year basis. The increase
from the first quarter of 2004 reflects a slightly higher level of liquid
earning assets, which resulted from greater deposit flows from servicing
customers as well as a modest shift from fixed rate investment securities to
short-term floating assets to better position for higher rates. The increase
from the second quarter of 2003 reflects higher average balances of investment
securities partially offset by lower yields. Net interest income was $163
million in the first six months of 2004 compared to $157 million in the first
six months of 2003. Average second quarter 2004 assets in the Financial
Markets segment composed primarily of short-term liquid assets and investment
securities were $50.7 billion, up from $50.1 billion on a sequential quarter
basis and $46.5 billion last year. Average assets for the first half of 2004
were $50.4 billion compared to $45.4 billion for the first half of 2003. The
increase in assets reflects the Company's continuing strategy to reduce
investment in higher risk corporate loans and increase holdings of highly
rated, more liquid investment securities. The Company continues to invest in
adjustable or short life classes of structured mortgage-backed securities, both
of which have short durations.
Noninterest income was $43 million in the second quarter of 2004, compared
with $50 million in the first quarter of 2004 and $33 million in the second
quarter of 2003. On a year-to-date basis, noninterest income was $93 million
in 2004 and $83 million in 2003. The negative variance versus the first
quarter of 2004 reflects a slowdown in client driven activity in fixed income
trading.
Net charge-offs were $10 million in the second quarter of 2004, compared
with $4 million in the first quarter of 2004 and zero a year ago. Net charge-
offs for the first six months of 2004 and 2003 were $14 million and zero,
respectively. Charge-offs in 2004 are primarily related to the Company's
airline exposure. Noninterest expense was $28 million in the second quarter of
2004, compared with $27 million in the first quarter of 2004 and $25 million in
last year's second quarter. The increase from last year's second quarter is
attributable to higher employee incentive and other compensation. Noninterest
expense for the six months ended June 30, 2004 was $55 million, compared with
$49 million for the first six months ended June 30, 2003.
18
The consolidating schedule below shows the contribution of the Company's
segments to its overall profitability.
(Dollars in millions)
Servicing
and
For the Quarter Ended Fiduciary Corporate Retail Financial Reconciling Consolidated
June 30, 2004 Businesses Banking Banking Markets Items Total
- ------------------------ ---------- --------- --------- --------- ----------- ------------
Net Interest Income $ 144 $ 87 $ 126 $ 83 $ (19) $ 421
Provision for
Credit Losses 1 15 5 5 (16) 10
Noninterest Income 994 84 28 43 17 1,166
Noninterest Expense 764 54 95 28 71 1,012
---------- --------- --------- --------- ----------- ------------
Income Before Taxes $ 373 $ 102 $ 54 $ 93 $ (57) $ 565
========== ========= ========= ========= =========== ============
Contribution Percentage 60% 16% 9% 15%
Average Assets $ 22,891 $ 17,308 $ 5,317 $ 50,728 $ 4,129 $ 100,373
(Dollars in millions)
Servicing
and
For the Quarter Ended Fiduciary Corporate Retail Financial Reconciling Consolidated
March 31, 2004 Businesses Banking Banking Markets Items Total
- ------------------------- ---------- --------- --------- --------- ----------- ------------
Net Interest Income $ 140 $ 89 $ 123 $ 80 $ (164) $ 268
Provision for
Credit Losses - 20 5 5 (18) 12
Noninterest Income 990 80 29 50 81 1,230
Noninterest Expense 757 53 93 27 83 1,013
---------- --------- --------- --------- ----------- ------------
Income Before Taxes $ 373 $ 96 $ 54 $ 98 $ (148) $ 473
========== ========= ========= ========= =========== ============
Contribution Percentage 60% 15% 9% 16%
Average Assets $ 22,771 $ 17,358 $ 5,377 $ 50,051 $ 4,121 $ 99,678
(Dollars in millions)
Servicing
and
For the Quarter Ended Fiduciary Corporate Retail Financial Reconciling Consolidated
June 30, 2003 Businesses Banking Banking Markets Items Total
- ------------------------- ---------- --------- --------- --------- ----------- ------------
Net Interest Income $ 120 $ 95 $ 118 $ 80 $ (15) $ 398
Provision for
Credit Losses - 30 5 6 (1) 40
Noninterest Income 843 82 33 33 5 996
Noninterest Expense 651 51 91 25 85 903
---------- --------- --------- --------- ----------- ------------
Income Before Taxes $ 312 $ 96 $ 55 $ 82 $ (94) $ 451
========== ========= ========= ========= =========== ============
Contribution Percentage 57% 18% 10% 15%
Average Assets $ 15,727 $ 19,851 $ 5,333 $ 46,463 $ 3,550 $ 90,924
19
(Dollars in millions)
Servicing
and
For the Six Months Ended Fiduciary Corporate Retail Financial Reconciling Consolidated
June 30, 2004 Businesses Banking Banking Markets Items Total
- ------------------------- ---------- --------- --------- --------- ----------- ------------
Net Interest Income $ 284 $ 176 $ 249 $ 163 $ (183) $ 689
Provision for
Credit Losses 1 35 10 10 (34) 22
Noninterest Income 1,984 164 57 93 98 2,396
Noninterest Expense 1,521 107 188 55 154 2,025
---------- --------- --------- --------- ----------- ------------
Income Before Taxes $ 746 $ 198 $ 108 $ 191 $ (205) $ 1,038
========== ========= ========= ========= =========== ============
Contribution Percentage 60% 16% 9% 15%
Average Assets $ 22,831 $ 17,333 $ 5,347 $ 50,390 $ 4,125 $ 100,026
(Dollars in millions)
Servicing
and
For the Six Months Ended Fiduciary Corporate Retail Financial Reconciling Consolidated
June 30, 2003 Businesses Banking Banking Markets Items Total
- ------------------------- ---------- --------- --------- --------- ----------- ------------
Net Interest Income $ 225 $ 187 $ 234 $ 157 $ (19) $ 784
Provision for
Credit Losses - 60 9 11 - 80
Noninterest Income 1,534 153 62 83 9 1,841
Noninterest Expense 1,176 99 178 49 140 1,642
---------- --------- --------- --------- ----------- ------------
Income Before Taxes $ 583 $ 181 $ 109 $ 180 $ (150) $ 903
========== ========= ========= ========= =========== ============
Contribution Percentage 56% 17% 10% 17%
Average Assets $ 11,695 $ 20,189 $ 5,360 $ 45,404 $ 3,080 $ 85,728
20
Reconciling Items
- -----------------
Description - Reconciling items for net interest income primarily relate
to the recording of interest income on a taxable equivalent basis, reallocation
of capital and the funding of goodwill and intangibles. Reconciling items for
noninterest income primarily relate to the sale of certain securities and
certain other gains. Reconciling items for noninterest expense primarily
reflects corporate overhead as well as amortization of intangibles and
severance.
In the first quarter and first half of 2004, the following adjustments
were included in reconciling items:(i) SFAS 13 cumulative adjustment to the
leasing portfolio, which impacted net interest income by $145 million, (ii)
four large securities gains and the gain on sale of Wing Hang Bank, which
impacted noninterest income by $67 million, and (iii) severance and lease
termination expense, which impacted noninterest expense by $18 million.
The adjustment to the provision for credit losses reflects the difference
between the aggregate of the credit provision over a credit cycle for the
reportable segments and the Company's recorded provision. The reconciling
items for average assets consist of goodwill and other intangible assets.
2nd 1st 2nd
Quarter Quarter Quarter Year-to-date
(Dollars in millions) 2004 2004 2003 2004 2003
--------- --------- --------- --------- ---------
Segment's revenue $ 1,589 $ 1,581 $ 1,404 $ 3,170 $ 2,635
Adjustments:
Earnings associated with
assignment of capital (23) (29) (29) (52) (49)
Securities gains - 19 - 19 -
SFAS 13 cumulative lease adjustment - (145) - (145) -
Taxable equivalent basis and
other tax-related items 3 10 13 13 30
Other 18 62 6 80 9
--------- --------- --------- --------- ---------
Subtotal-revenue adjustments (2) (83) (10) (85) (10)
--------- --------- --------- --------- ---------
Consolidated revenue $ 1,587 $ 1,498 $ 1,394 $ 3,085 $ 2,625
========= ========= ========= ========= =========
Segment's income before tax $ 623 $ 621 $ 545 $ 1,244 $ 1,053
Adjustments:
Revenue adjustments (above) (2) (83) (10) (85) (10)
Provision for credit losses
different than GAAP 15 18 1 33 -
Severance - (11) (4) (11) (6)
Goodwill and
intangible amortization (8) (8) (7) (16) (10)
Pershing-related
integration expenses - - (25) - (25)
Lease termination - (8) - (8) -
Corporate overhead (63) (56) (49) (119) (99)
--------- --------- --------- --------- ---------
Consolidated income before tax $ 565 $ 473 $ 451 $ 1,038 $ 903
========= ========= ========= ========= =========
Segments' total average assets $ 96,244 $ 95,557 $ 87,374 $ 95,901 $ 82,648
Adjustments:
Goodwill and intangibles 4,129 4,121 3,550 4,125 3,080
--------- --------- --------- --------- ---------
Consolidated average assets $ 100,373 $ 99,678 $ 90,924 $ 100,026 $ 85,728
========= ========= ========= ========= =========
21
Allocation to Segments - Earnings associated with the assignment of capital
relate to preferred trust securities which are assigned as capital to segments.
Since the Company considers these issues to be capital, it does not allocate
the interest expense associated with these securities to individual segments.
If this interest expense were allocated to segments, it could be assigned based
on segment capital, assets, risks, or some other basis.
The reconciling item for securities gains relates to the Financial Markets
business. The taxable equivalent adjustment is not allocated to segments
because all segments contribute to the Company's taxable income and the Company
believes it is arbitrary to assign the tax savings to any particular segment.
Most of the assets that are attributable to the tax equivalent adjustment are
recorded in the Financial Markets segment. In the first quarter of 2004, the
$145 million reconciling item related to SFAS 13 cumulative lease adjustment
would be attributable to the Financial Markets segment. In addition, the first
quarter $48 million gain on the sale of Wing Hang recorded in Other would be
attributable to the Corporate Banking segment.
The reconciling item for the provision for loan losses primarily relates
to Corporate Banking. Goodwill and intangible amortization primarily relates
to the Securities Servicing and Fiduciary segment. Corporate overhead is
difficult to specifically identify with any particular segment. Approaches to
allocating corporate overhead to segments could be based on revenues, expenses,
number of employees, or a variety of other measures. In the first quarter of
2004, the $18 million of severance and lease termination would be allocated
primarily to the Servicing and Fiduciary Businesses segment. Merger and
integration charges would be allocated to the Securities and Fiduciary
Businesses segment.
CONSOLIDATED BALANCE SHEET REVIEW
Total assets were $97.5 billion at June 30, 2004, compared with $92.7
billion at March 31, 2004, and $99.8 billion at June 30, 2003. The increase in
assets from March 31, 2004 reflects the significant liquidity in the markets at
June 30, 2004 which the Company's clients left on deposit rather than invested
in the equity and fixed income markets. Total shareholders' equity was $8.8
billion at June 30, 2004, compared with $8.8 billion at March 31, 2004, and
$8.1 billion at June 30, 2003. Shareholders' equity at June 30, 2004 compared
to March 31, 2004 reflects a decline in the securities valuation allowance
offset by the retention of earnings. The decline in the securities valuation
allowance reflects the recent rise in interest rates. The major reason for the
increase in shareholders' equity from a year ago is the retention of earnings.
Return on average common equity for the second quarter of 2004 was 17.14%,
compared with 17.17% in the first quarter of 2004, and 15.56% in the second
quarter of 2003. For the first six months of 2004, return on average common
equity was 17.15% compared with 16.61% in 2003.
Return on average assets for the second quarter of 2004 was 1.49%,
compared with 1.47% in the first quarter of 2004, and 1.30% in the second
quarter of 2003. For the first six months of 2004, return on average assets
was 1.48% compared with 1.39% in 2003.
22
Investment Securities
- ---------------------
The table below shows the distribution of the Company's securities
portfolio:
Investment Securities (at Fair Value)
(Dollars in millions) 06/30/04 12/31/03
-------- --------
Fixed Income:
Mortgage-Backed Securities $ 18,782 $ 18,703
Asset-Backed Securities - 20
Corporate Debt 1,267 1,326
Short-Term Money Market Instruments 786 917
U.S. Treasury Securities 470 505
U.S. Government Agencies 241 241
State and Political Subdivisions 229 251
Emerging Market Debt 112 109
Other Foreign Debt 512 518
-------- --------
Subtotal Fixed Income 22,399 22,590
Equity Securities:
Money Market Funds 432 200
Federal Reserve Bank Stock 99 96
Other 20 12
-------- --------
Subtotal Equity Securities 551 308
-------- --------
Total Securities $ 22,950 $ 22,898
======== ========
Total investment securities were $23.0 billion at June 30, 2004, compared
with $24.1 billion at March 31, 2004, and $22.9 billion at December 31, 2003.
Average investment securities were $23.0 billion in the second quarter of 2004,
compared with $23.0 billion in the first quarter of 2004 and $18.7 billion in
the second quarter of last year. Average investment securities were $23.0
billion in the six months ended June 30, 2004, compared with $18.4 billion in
the six months ended June 30, 2003. On a year-to-date basis, the increase was
primarily due to growth in the Company's portfolio of highly rated mortgage-
backed securities which are 92% rated AAA, 3% AA, and 5% A. Since December 31,
2002, the Company has added approximately $5.7 billion of mortgage-backed
securities to its investment portfolio. The Company has been adding either
adjustable or short life classes of structured mortgage-backed securities, both
of which have short durations. The Company has maintained an effective
duration of approximately 2.2 years on its mortgage portfolio to better match
its liabilities and reduce the adverse impact from a rise in interest rates.
Net unrealized gains for securities available-for-sale were $14 million at
June 30, 2004, compared with $359 million at March 31, 2004 and $201 million at
December 31, 2003. The decline in unrealized gains reflects the rise in
interest rates in the second quarter. The asymmetrical accounting treatment of
the impact of a change in interest rates on the Company's balance sheet may
create a situation in which an increase in interest rates can adversely affect
reported equity and regulatory capital, even though economically there may be
no impact on the economic capital position of the Company. For example, an
increase in rates will result in a decline in the value of the fixed rate
portion of the Company's fixed income investment portfolio, which will be
reflected through a reduction in other comprehensive income in the Company's
shareholders' equity, thereby affecting the tangible common equity ("TCE")
ratio. Under current accounting rules, there is no corresponding change in
value of the Company's fixed rate liabilities, even though economically these
liabilities are more valuable as rates rise.
23
Loans
- -----
(Dollars in billions) Quarterly Year-to-date
Period End Average Average
------------------------- ------------------------- -------------------------
Total Non-Margin Margin Total Non-Margin Margin Total Non-Margin Margin
----- ---------- ------ ----- ---------- ------ ----- ---------- ------
June 30, 2004 $38.2 $ 32.1 $ 6.1 $37.7 $ 31.2 $ 6.5 $37.0 $ 30.7 $ 6.3
December 31, 2003 35.3 29.6 5.7 37.3 31.5 5.8 35.6 31.8 3.8
June 30, 2003 37.8 32.9 4.9 35.7 32.2 3.5 33.9 31.9 2.0
Total loans were $38.2 billion at June 30, 2004, compared with $35.3
billion at December 31, 2003. The rise in total loans primarily reflects an
increase in overdrafts, securities industry loans, and margin loans. The
Company continues to focus on its strategy of reducing non-strategic and
outsized corporate loan exposures to improve its credit risk profile. Average
total loans were $37.7 billion in the second quarter of 2004, compared with
$35.7 billion in the second quarter of 2003 while for the six months ended June
30, 2004, average loans were $37.0 billion compared with $33.9 billion for
2003. The increase in average loans in both periods results from higher margin
loans due to the Pershing acquisition.
The following tables provide additional details on the Company's loan
exposures and outstandings at June 30, 2004 in comparison to December 31, 2003.
Overall Loan Portfolio
- ----------------------
Unfunded Total Unfunded Total
(Dollars in billions) Loans Commitments Exposure Loans Commitments Exposure
---------------------------- ----------------------------
06/30/04 06/30/04 06/30/04 12/31/03 12/31/03 12/31/03
-------- -------- -------- -------- -------- --------
Financial Institutions $ 12.3 $ 21.2 $ 33.5 $ 9.2 $ 21.8 $ 31.0
Corporate 3.5 19.8 23.3 4.0 20.5 24.5
-------- ------- ------- -------- -------- --------
15.8 41.0 56.8 13.2 42.3 55.5
-------- ------- ------- -------- -------- --------
Consumer & Middle Market 8.5 4.4 12.9 8.2 4.1 12.3
Leasing Financings 5.6 0.1 5.7 5.8 - 5.8
Commercial Real Estate 2.2 0.9 3.1 2.4 0.8 3.2
Margin Loans 6.1 - 6.1 5.7 - 5.7
-------- -------- -------- -------- -------- --------
Total $ 38.2 $ 46.4 $ 84.6 $ 35.3 $ 47.2 $ 82.5
======== ======== ======== ======== ======== ========
Financial Institutions
- ----------------------
The financial institutions portfolio exposure was $33.5 billion June 30,
2004 compared to $31.0 billion at December 31, 2003. These exposures are of
high quality, with 86% meeting the investment grade criteria of the Company's
rating system. The exposures are generally short-term, with 77% expiring
within one year and are frequently secured. For example, mortgage banking,
securities industry, and investment managers often borrow against marketable
securities held in custody at the Company. The diversity of the portfolio is
shown in the following table.
24
(Dollars in billions)
06/30/04 12/31/03
---------------------------- ----------------------------
Unfunded Total %Inv %due Unfunded Total
Lending Division Loans Commitments Exposures Grade <1 Yr Loans Commitments Exposures
- ---------------- ------ ----------- --------- ----- ------ ------ ----------- ---------
Banks $ 4.7 $ 3.2 $ 7.9 69% 88% $ 2.6 $ 3.1 $ 5.7
Securities
Industry 2.5 3.0 5.5 87 95 1.9 3.5 5.4
Insurance 0.4 4.8 5.2 96 64 0.3 5.0 5.3
Government 0.1 5.4 5.5 100 57 0.2 5.6 5.8
Asset Managers 4.1 3.6 7.7 85 81 3.6 3.5 7.1
Mortgage Banks 0.4 0.5 0.9 86 73 0.4 0.5 0.9
Endowments 0.1 0.7 0.8 98 58 0.2 0.6 0.8
------ ----------- --------- ----- ------ ------ ----------- ---------
Total $ 12.3 $ 21.2 $ 33.5 86% 77% $ 9.2 $ 21.8 $ 31.0
====== =========== ========= ===== ====== ====== =========== =========
Corporate
- ---------
The corporate portfolio exposure declined to $23.3 billion at June 30,
2004 from $24.5 billion at year-end 2003. Approximately 77% of the portfolio
is investment grade while 29% of the portfolio matures within one year.
(Dollars in billions)
06/30/04 12/31/03
---------------------------- ----------------------------
Unfunded Total %Inv %due Unfunded Total
Lending Division Loans Commitments Exposures Grade <1 Yr Loans Commitments Exposures
- ---------------- ------ ----------- --------- ----- ------ ------ ----------- ---------
Media $ 0.8 $ 2.1 $ 2.9 66% 13% $ 0.9 $ 2.3 $ 3.2
Cable 0.6 0.5 1.1 29 1 0.7 0.7 1.4
Telecom 0.1 0.5 0.6 72 13 0.3 0.6 0.9
------ ----------- --------- ------ ----- ------ ----------- ---------
Subtotal 1.5 3.1 4.6 58% 10% 1.9 3.6 5.5
Energy 0.3 4.3 4.6 85 33 0.4 4.2 4.6
Retailing 0.2 2.4 2.6 82 46 0.1 2.3 2.4
Automotive 0.1 1.9 2.0 72 50 0.1 2.1 2.2
Healthcare 0.2 1.4 1.6 90 20 0.2 1.3 1.5
Other* 1.2 6.7 7.9 80 29 1.3 7.0 8.3
------ ---------- ---------- ------ ----- ------ ----------- ---------
Total $ 3.5 $ 19.8 $ 23.3 77% 29% $ 4.0 $ 20.5 $ 24.5
====== ========== ========== ====== ===== ====== =========== =========
* Diversified portfolio of industries and geographies
The Company had previously targeted the telecom exposure for reduction to
a total of $750 million by December 31, 2004. This goal was accomplished in
the first quarter and exposures have since declined to $559 million. The
percentage of investment grade borrowers in the telecom portfolio has increased
to 72% from 52% at year-end 2003. The improved quality of the portfolio is
largely due to reductions in lower rated credits.
The Company's exposure to the airline industry consists of a $556 million
leasing portfolio (including a $14 million real estate lease exposure) as well
as $23 million of direct lending. The airline leasing portfolio consists of
$265 million to major U.S. carriers, $202 million to foreign airlines and $89
million to U.S. regionals.
During the second quarter of 2004, the industry continued to face the
dilemma of an increasingly uncompetitive cost structure, weak demand and strong
competition from the regionals. The industry's stagnant demand and considerable
excess capacity have negatively impacted the valuations of the industry's
aircraft in the secondary market. Because of these factors, the Company
continues to maintain a sizable allowance for loan losses against these
exposures and to closely monitor the portfolio.
25
Nonperforming Assets
- -------------------------
Change Change
06/30/04 vs. 06/30/04 vs.
(Dollars in millions) 06/30/04 03/31/04 03/31/04 12/31/03 12/31/03
-------- -------- ----------- -------- ------------
Loans:
Commercial $ 208 $ 231 $ (23) $ 219 $ (11)
Foreign 53 66 (13) 79 (26)
Other 50 46 4 51 (1)
-------- -------- ----------- -------- ------------
Total Nonperforming Loans 311 343 (32) 349 (38)
Other Real Estate - - - - -
-------- -------- ----------- -------- ------------
Total Nonperforming Assets $ 311 $ 343 $ (32) $ 349 $ (38)
======== ======== =========== ======== ============
Nonperforming Assets Ratio 1.0% 1.1% 1.2%
Allowance for Loan
Losses/Nonperforming Loans 192.2 184.4 191.2
Allowance for Loan
Losses/Nonperforming Assets 192.2 184.4 191.2
Allowance for Credit
Losses/Nonperforming Loans 249.1 230.5 230.2
Allowance for Credit
Losses/Nonperforming Assets 249.1 230.5 230.2
Nonperforming assets declined by $32 million, or 9% during the second
quarter of 2004 to $311 million and are down 29% from a year ago. The
sequential quarter decrease primarily reflects paydowns and charge-offs of
commercial and foreign loans. The ratio of the allowance for credit losses to
nonperforming assets increased to 249.1% at June 30, 2004, compared with 230.5%
at March 31, 2004, and 188.6% at June 30, 2003.
Activity in Nonperforming Assets
(Dollars in millions) Quarter End Year-to-Date
June 30, 2004 June 30, 2004
------------- --------------
Balance at Beginning of Period $ 343 $ 349
Additions 45 79
Charge-offs (21) (40)
Paydowns/Sales (56) (77)
------------- --------------
Balance at End of Period $ 311 $ 311
============= ==============
Interest income would have been increased by $3 million for the second
quarters of 2004 and 2003 if loans on nonaccrual status at June 30, 2004 and
2003 had been performing for the entire period. Interest income would have
been increased by $7 million and $8 million for the six months ended June 30,
2004 and 2003 if loans on nonaccrual status at June 30, 2004 and 2003 had been
performing for the entire period.
26
Impaired Loans
- --------------
The table below sets forth information about the Company's impaired loans.
The Company uses the discounted cash flow, collateral value, or market price
methods for valuing its impaired loans:
June 30, March 31, June 30,
(Dollars in millions) 2004 2004 2003
---------- ----------- ----------
Impaired Loans with an Allowance $ 168 $ 197 $ 393
Impaired Loans without an Allowance(1) 121 124 4
---------- ----------- ----------
Total Impaired Loans $ 289 $ 321 $ 397
========== =========== ==========
Allowance for Impaired Loans(2) $ 69 $ 88 $ 189
Average Balance of Impaired Loans
during the Quarter $ 305 $ 306 $ 404
Interest Income Recognized on
Impaired Loans during the Quarter $ 0.6 $ 0.9 $ 0.4
(1) When the discounted cash flows, collateral value or market price equals
or exceeds the carrying value of the loan, then the loan does not require
an allowance under the accounting standard related to impaired loans.
(2) The allowance for impaired loans is included in the Company's allowance
for loan losses.
Allowance
- ---------
June 30, March 31, June 30,
(Dollars in millions) 2004 2004 2003
---------- ----------- ----------
Margin Loans $ 6,114 $ 6,130 $ 4,877
Non-Margin Loans 32,091 29,940 32,919
Total Loans 38,205 36,070 37,796
Allowance for Loan Losses 598 632 669
Allowance for Lending-Related
Commitments 177 158 155
Total Allowance for Credit Losses 775 790 824
Allowance for Credit Losses
As a Percent of Total Loans 2.03% 2.19% 2.18%
Allowance for Credit Losses
As a Percent of Non-Margin Loans 2.42 2.64 2.50
Allowance for Loan Losses
As a Percent of Total Loans 1.57 1.75 1.77
Allowance for Loan Losses
As a Percent of Non-Margin Loans 1.86 2.11 2.03
The Company adopts new accounting policies as they become accepted as a
best practice or required by generally accepted accounting principles.
Accordingly, at December 31, 2003, the Company split its allowance for credit
losses into an allowance for loan losses and an allowance for lending-related
commitments such as unfunded loan commitments, and standby letters of credit.
This resulted in a decrease in the allowance for loan losses of $136 million
and a corresponding increase in other liabilities (which includes the allowance
for lending-related commitments). Prior period balance sheets have been
restated. Credit expenses related to the allowance for loan losses and the
allowance for lending-related commitments are reported in the provision for
credit losses in the income statement. To aid in the comparison of the
Company's results with other companies that have not yet adopted this practice,
the Company provides various credit ratios based both on the allowance for
credit losses and the allowance for loan losses.
27
The allowance for credit losses was $775 million, or 2.03% of total loans
at June 30, 2004, compared with $790 million, or 2.19% of total loans at March
31, 2004, and $824 million, or 2.18% of total loans at June 30, 2003.
The Company has $6.1 billion of secured margin loans on its balance sheet
at June 30, 2004. The Company has rarely suffered a loss on these types of
loans and doesn't allocate any of its allowance for credit losses to these
loans. As a result, the Company believes the ratio of allowance for credit
losses to non-margin loans is a more appropriate metric to measure the adequacy
of the reserve.
The ratio of the allowance for credit losses to non-margin loans decreased
to 2.42% at June 30, 2004, compared with 2.64% at March 31, 2004 and 2.50% at
June 30, 2003, reflecting continued improvement in the credit quality in the
second quarter of 2004. The Company expects credit costs to remain at lower
levels through the remainder of the year as both external and internal credit
metrics continue to improve.
Nonperforming assets declined another 9% this quarter, and have declined
by 29% from a year ago. The Company's criticized and classified loans
experienced a mid-teens decline from the first quarter of 2004 and are down by
over a third from a year ago.
The ratio of the allowance for loan losses to nonperforming assets was
192.2% at June 30, 2004, up from 184.4% at March 31, 2004, and 153.09% at June
30, 2003. Included in the Company's allowance for credit losses at June 30,
2004 is an allocated transfer risk reserve related to Argentina of $13 million.
The allowance for loan losses and the allowance for lending-related
commitments consist of four elements: (1) an allowance for impaired credits,
(2) an allowance for higher risk rated loans and exposures, (3) an allowance
for pass rated loans and exposures, and (4) an unallocated allowance based on
general economic conditions and certain risk factors in the Company's
individual portfolio and markets.
The first element (impaired credits) is based on individual analyses of
all nonperforming commercial credits over $1 million. The allowance is
measured by the difference between the recorded value of impaired loans and
their fair value in accordance with FASB 114. Fair value is either the present
value of the expected future cash flows from borrowers, the market value of the
loan, or the fair value of the collateral securing the obligation.
The second element (higher risk rated credits) is based on the assignment
of loss factors for each specific risk category of higher risk credits. The
Company risk rates each credit in its portfolio that exceeds $1 million and
assigns the credits to specific pools. A potential loss factor is assigned to
each pool, and an amount is included in the allowance equal to the multiple of
the amount of the loan in the pool times a risk factor. Reviews of higher risk
rated loans and exposures are conducted at least quarterly and each loan's
rating is reaffirmed or updated, as necessary. The Company maintains and
updates loss migration analysis by comparing actual loss experiences to the
loss factors assigned to each exposure pool. Past due consumer obligations are
included in specific risk categories based on the length of time the loan is
past due.
The third element (pass rated credits) is based on the Company's expected
loss model. Borrowers are assigned to pools based on their credit rating, the
maturity of the loan, the estimated exposure at default, and the loss given a
default. The credit rating is derived from the borrower's probability of
default. The loss given default incorporates an analysis of structure and
collateral. These ratings are frequently reviewed by the relationship managers
and their respective division portfolio managers and more formally on a semi-
annual basis. The ratings are mapped to independent parties, including the
rating agencies in order to ensure consistency and validity. At the time of
approval, loans are individually analyzed and assigned a risk rating and loss
28
given default rating. Performing consumer loans are included in the pass rated
consumer pools. The Company uses an exposure at default estimate as a way of
quantifying the amount the Company will lose in case of default. This estimate
varies depending on the level of commitment, the type of exposure, and the
credit rating of the borrower.
The fourth element (the unallocated allowance) is based on management's
judgment regarding the following factors:
- Economic conditions including duration of the current cycle
- Past experience including recent loss experience
- Credit quality trends
- Collateral values
- Volume, composition, and growth of the loan portfolio
- Specific credits and industry conditions
- Results of bank regulatory and internal credit exams
- Actions by the Federal Reserve Board
- Delay in receipt of information to evaluate loans or confirm existing
credit deterioration
- Geopolitical issues and their impact on the economy
Based on an evaluation of these four elements, including individual
credits, historical credit losses, and global economic factors, the Company has
allocated its allowance for credit losses as follows:
June 30, 2004 December 31, 2003
------------- -----------------
Domestic
Real Estate 2% 2%
Commercial 75 74
Consumer 1 1
Foreign 7 9
Unallocated 15 14
------------- -----------------
100% 100%
============= =================
Such an allocation is inherently judgmental, and the entire allowance for
credit losses is available to absorb credit losses regardless of the nature of
the loss.
Deposits
- --------
Total deposits were $61.1 billion at June 30, 2004, compared with $56.1
billion at March 31, 2004 and $64.7 billion at June 30, 2003. The increase on
a sequential quarter basis was primarily due to the significant liquidity in
the markets at June 30, 2004 which the Company's clients left on deposit rather
than invested in the equity and fixed income markets. Noninterest-bearing
deposits were $16.1 billion at June 30, 2004, compared with $14.8 billion at
December 31, 2003. Interest-bearing deposits were $45.0 billion at June 30,
2004, compared with $41.6 billion at December 31, 2003.
29
CRITICAL ACCOUNTING POLICIES
The Company's significant accounting policies are described in the "Notes
to Consolidated Financial Statements" under "Summary of Significant Accounting
and Reporting Policies" in the Company's 2003 Annual Report on Form 10-K.
Three of the Company's more critical accounting policies are those related to
the allowance for credit losses, to the valuation of derivatives and securities
where quoted market prices are not available, and goodwill and other
intangibles.
Allowance for Credit Losses
- ---------------------------
The allowance for credit losses represents management's estimate of
probable losses inherent in the Company's loan portfolio. This evaluation
process is subject to numerous estimates and judgments. Probabilities of
default/borrower ratings are assigned after analyzing the credit quality of
each borrower/counterparty and the Company's internal ratings are consistent
with external rating agency default databases. Loss given default ratings are
driven by the collateral, structure, and seniority of each individual asset and
are consistent with external loss given default/recovery databases. The
Company uses an exposure at default estimate as a way of quantifying the amount
the Company could lose in case of default. This estimate varies depending on
the level of commitment, the type of exposure, and the credit rating of the
borrower. The portion of the allowance related to impaired credits is based on
the present value of future cash flows, market prices, or collateral values.
Changes in the estimates of probability of default, risk ratings, loss given
default/recovery rates, and cash flows could have a direct impact on the
allocated allowance for loan losses.
The Company's unallocated allowance is established via a process that
begins with estimates of probable loss inherent in the portfolio, based upon
the following factors:
- Economic conditions, including duration of the current cycle
- Past experience, including recent loss experience
- Credit quality trends
- Collateral values
- Volume, composition, and growth of the loan portfolio
- Specific credits and industry conditions
- Results of bank regulatory and internal credit exams
- Actions by the Federal Reserve Board
- Delay in receipt of information to evaluate loans or confirm existing
credit deterioration
- Geopolitical issues and their impact on the economy
To the extent actual results differ from forecasts or management's
judgment the allowance for credit losses may be greater or less than future
charge-offs.
The Company considers it difficult to quantify the impact of changes in
forecast on its allowance for credit losses. Nevertheless, the Company
believes the following discussion may enable investors to better understand the
variables that drive the allowance for credit losses.
One key variable in determining the allowance is management's judgment
around the size of the unallocated portion of the allowance. At June 30, 2004,
the unallocated allowance was 15% of the total allowance. If the unallocated
allowance were five percent higher or lower, the allowance would have increased
or decreased by $39 million, respectively.
The credit rating assigned to each pass credit is another significant
variable in determining the allowance. If each pass credit were rated one
grade better, the allowance would have decreased by $51 million, while if each
pass credit were rated one grade worse, the allowance would have increased by
$99 million.
30
For higher risk rated credits, if the loss given default were 10% worse,
the allowance would have increased by $19 million, while if the loss given
default were 10% better, the allowance would have decreased by $25 million.
For impaired credits, if the fair value of the loans were 10% higher or
lower, the allowance would have increased or decreased by $22 million,
respectively.
Valuation of Derivatives and Securities Where Quoted Market Prices Are Not
- --------------------------------------------------------------------------
Available
----------
When quoted market prices are not available for derivatives and securities
values, such values are determined at fair value, which is defined as the value
at which positions could be closed out or sold in a transaction with a willing
counterparty over a period of time consistent with the Company's trading or
investment strategy. Fair value for these instruments is determined based on
discounted cash flow analysis, comparison to similar instruments, and the use
of financial models. Financial models use as their basis independently sourced
market parameters including, for example, interest rate yield curves, option
volatilities, and currency rates. Discounted cash flow analysis is dependent
upon estimated future cash flows and the level of interest rates. Model-based
pricing uses inputs of observable prices for interest rates, foreign exchange
rates, option volatilities and other factors. Models are benchmarked and
validated by external parties. The Company's valuation process takes into
consideration factors such as counterparty credit quality, liquidity and
concentration concerns. The Company applies judgment in the application of
these factors. In addition, the Company must apply judgment when no external
parameters exist. Finally, other factors can affect the Company's estimate of
fair value including market dislocations, incorrect model assumptions, and
unexpected correlations.
These valuation methods could expose the Company to materially different
results should the models used or underlying assumptions be inaccurate. See
"Use of Estimates" in the footnote 1 "Summary of Significant Accounting and
Reporting Policies" in the Company's 2003 Annual Report on Form 10-K.
To assist in assessing the impact of a change in valuation, at June 30,
2004, approximately $2.2 billion of the Company's portfolio of securities and
derivatives is not priced based on quoted market prices. A change of 2.5% in
the valuation of these securities and derivatives would result in a change in
pre-tax income of $56 million.
Goodwill and Other Intangibles
- ------------------------------
The Company records all assets and liabilities acquired in purchase
acquisitions, including goodwill, indefinite-lived intangibles, and other
intangibles, at fair value as required by SFAS 141. Goodwill ($3,373 million
at June 30, 2004) and indefinite-lived intangible assets ($370 million at June
30, 2004) are not amortized but are subject to annual tests for impairment or
more often if events or circumstances indicate they may be impaired. Other
intangible assets are amortized over their estimated useful lives and are
subject to impairment if events or circumstances indicate a possible inability
to real