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THE BANK OF NEW YORK COMPANY, INC.
Quarterly Report on Form 10-Q
For the quarterly period ended September 30, 2004
The Quarterly Report on Form 10-Q and cross reference index is on page 58.
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
- Third Quarter 2004 Highlights 3
- Consolidated Income Statement Review 5
- Other Developments 9
- Business Segments Review 10
- Consolidated Balance Sheet Review 23
- Critical Accounting Policies 31
- Liquidity 33
- Capital Resources 35
- Trading Activities 37
- Asset/Liability Management 39
- Statistical Information 41
- Forward Looking Statements and
Factors That Could Affect Future Results 43
- Website Information 44
- Supplemental Information 45
Consolidated Financial Statements
- Consolidated Balance Sheets
September 30, 2004 and December 31, 2003 46
- Consolidated Statements of Income
For the Three Months and Nine Months
Ended September 30, 2004 and 2003 47
- Consolidated Statement of Changes In
Shareholders' Equity For the Nine
Months Ended September 30, 2004 48
- Consolidated Statements of Cash Flows
For the Nine Months Ended September 30, 2004 and 2003 49
- Notes to Consolidated Financial Statements 50 - 57
Form 10-Q
- Cover 58
- Controls and Procedures 59
- Legal Proceedings 59
- Changes in Securities, Use of Proceeds, and
Issuer Purchases of Equity Securities 60
- Exhibits 60
- Signature 61
1
THE BANK OF NEW YORK COMPANY, INC.
Financial Highlights
(Dollars in millions, except per share amounts)
(Unaudited)
September 30, June 30, September 30,
2004 2004 2003
------------ ------------ ------------
Quarter
-------
Revenue (tax equivalent basis) $ 1,747 $ 1,775 $ 1,647
Net Income 354 371 260
Basic EPS 0.46 0.48 0.34
Diluted EPS 0.46 0.48 0.34
Cash Dividends Per Share 0.20 0.20 0.19
Return on Average Common
Shareholders' Equity 15.90% 17.14% 12.82%
Return on Average Assets 1.45 1.49 1.06
Efficiency Ratio 65.2 63.9 70.7
Year-to-date
------------
Revenue (tax equivalent basis) $ 5,197 $ 3,450 $ 4,676
Net Income 1,089 735 850
Basic EPS 1.41 0.95 1.14
Diluted EPS 1.40 0.94 1.13
Cash Dividends Per Share 0.59 0.39 0.57
Return on Average Common
Shareholders' Equity 16.73% 17.15% 15.23%
Return on Average Assets 1.47 1.48 1.27
Efficiency Ratio 66.0 66.3 65.5
Assets $ 93,175 $ 97,536 $ 95,193
Loans 37,119 38,205 37,540
Securities 23,246 22,986 22,862
Deposits - Domestic 34,786 36,279 35,660
- Foreign 23,654 24,781 23,283
Long-Term Debt 6,137 6,025 6,298
Common Shareholders' Equity 9,054 8,785 8,223
Common Shareholders'
Equity Per Share $ 11.66 $ 11.29 $ 10.63
Market Value Per Share
of Common Stock 29.17 29.48 29.11
Allowance for Loan Losses as
a Percent of Total Loans 1.61% 1.57% 1.77%
Allowance for Loan Losses as
a Percent of Non-Margin Loans 1.92 1.86 2.07
Allowance for Credit Losses as
a Percent of Total Loans 2.04 2.03 2.18
Allowance for Credit Losses as
a Percent of Non-Margin Loans 2.42 2.42 2.55
Tier 1 Capital Ratio 8.09 7.70 7.08
Total Capital Ratio 12.09 11.63 11.18
Leverage Ratio 6.38 6.00 5.64
Tangible Common Equity Ratio 5.49 4.95 4.65
Employees 23,034 23,001 22,926
Assets Under Custody (In trillions)
Total Assets Under Custody $ 8.9 $ 8.7 $ 7.9
Equity Securities 33% 34% 32%
Fixed Income Securities 67 66 68
Cross-Border Assets Under Custody $ 2.5 $ 2.4 $ 2.2
Assets Under Administration
(In billions) $ 31 $ 32 $ 32
Assets Under Management (In billions)
Total Assets Under Management 97 93 85
Equity Securities 35% 36% 31%
Fixed Income Securities 21 22 22
Alternative Investments 15 14 10
Liquid Assets 29 28 37
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," "target, " 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.
3
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
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.
THIRD QUARTER 2004 HIGHLIGHTS
The Company reported third quarter net income of $354 million and diluted
earnings per share of 46 cents, compared with net income of $371 million and
diluted earnings per share of 48 cents in the second quarter of 2004, and net
income of $260 million and diluted earnings per share of 34 cents in the third
quarter of 2003. On an operating basis, third quarter 2003 net income was
$322 million and diluted earnings per share were 42 cents. Third quarter of
2003 reported results included merger and integration costs associated with
the Pershing acquisition of 2 cents per share and the cost of the settlement
of claims related to the Company's 1999 sale of BNY Financial Corporation to
General Motors Acceptance Corporation ("GMAC") of 6 cents per share.
Year-to-date net income was $1,089 million, or $1.40 diluted earnings per
share, compared to $850 million, or $1.13 diluted earnings per share in 2003.
These 2003 reported results included Pershing merger and integration costs of
4 cents and GMAC settlement costs of 6 cents per share. In 2003 on an
operating basis, year-to-date net income was $928 million while diluted
earnings per share were $1.23.
Third quarter highlights include strong sequential fee performance in
global payment services, broker-dealer services and asset management. Net
interest income was up $7 million, or 2%, on a sequential quarter basis. The
Company continues to be positioned to benefit from a rise in interest rates.
The Company made no provision for credit losses as credit quality trends
remained excellent.
The weak capital markets environment, particularly in equities and
foreign exchange, where volumes were lackluster and volatility very low,
adversely impacted the Company's securities servicing and trading businesses.
Securities servicing, where execution and clearing revenues were particularly
affected, declined by 4% sequentially, although servicing revenues were up 4%
versus a year ago demonstrating the benefits of the Company's diverse business
model. Foreign exchange and other trading revenues decreased sharply both
sequentially and versus a year ago to $67 million, which represents the lowest
quarter for trading revenues since the first quarter of 2003.
The performance this quarter in a challenging environment reinforces the
value of the breadth and diversification of the Company's securities servicing
and fiduciary businesses. The market environment this quarter was weak,
continuing a trend the Company first saw in June which intensified through the
seasonally slow summer months. The Company's equity-linked and foreign
exchange businesses were most directly affected, yet the Company's fixed
income-linked and asset management areas performed reasonably well, cushioning
the softness in the global capital markets.
The Company's balance sheet continues to be appropriately positioned for
the expected gradual rise in interest rates and credit quality remains strong.
Expense control was important to the Company's performance in the third
quarter, and will continue to be a major focus as the Company continues to
implement its reengineering initiatives.
While the Company cannot predict when the market environment will
improve, economic indicators remain favorable. Geopolitical factors still
appear to be restraining investment activity, yet untapped liquidity in the
market continues to increase, offering a basis for future growth. The Company
is confident that its diverse businesses and client base position the Company
to capitalize as market volumes and investment flows increase.
4
During the third 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. New business
momentum remains strong as the Company is gaining traction with growth
initiatives such as hedge fund servicing, Pershing's registered investment
advisor ("RIA") offering and independent research. The outlook for Ivy Asset
Management ("Ivy") continues to be very positive, given increased allocations
by institutions to alternative investments, including hedge funds, as an asset
class.
5
CONSOLIDATED INCOME STATEMENT REVIEW
Noninterest Income
- ------------------
3rd 2nd 3rd
Quarter Quarter Quarter Year-to-date
------- ------- ------- ----------------
(Dollars in millions) 2004 2004 2003 2004 2003
------- ------- ------- ----------------
Servicing Fees
Securities $ 685 $ 717 $ 657 $ 2,117 $ 1,728
Global Payment Services 84 81 80 245 238
------- ------- ------- ------- -------
769 798 737 2,362 1,966
Private Client Services
and Asset Management Fees 113 113 97 333 281
Service Charges and Fees 98 94 89 287 278
Foreign Exchange and
Other Trading Activities 67 100 92 273 246
Securities Gains 14 12 9 59 26
Other 49 49 39 191 107
------- ------- ------- ------- -------
Total Noninterest Income $ 1,110 $ 1,166 $ 1,063 $ 3,505 $ 2,904
======= ======= ======= ======= =======
Total noninterest income for the third quarter of 2004 was $1,110
million, a decrease of 5% sequentially but an increase of 4% from the third
quarter of 2003. Noninterest income for the nine months ended September 30,
2004 was $3,505 million, an increase of 21% over the comparable 2003 period.
Securities servicing fees were up $28 million, or 4%, from the third
quarter of 2003. On a year-to-date basis, securities servicing fees were
$2,117 million up $389 million from 2003. For a discussion of securities
servicing fees see "Securities Servicing Fees" in the segment results section
under "Servicing and Fiduciary Businesses."
Global payment services fees were up $3 million, or 4%, from the second
quarter of 2004, and $4 million, or 5% from the third quarter of 2003,
primarily resulting from new business wins. Global payment services increased
by 3% on a year-to-date basis over 2003.
Private client services and asset management fees for the third quarter
were flat from the prior quarter and increased 16% from the third quarter of
2003. For the nine months ended September 30, 2004, private client services
and asset management fees were $333 million, a 19% increase over the same
period in 2003. The increase from the third quarter of 2003 and on a year-to-
date basis reflects strong growth in Ivy Asset Management as well as higher
equity price levels. Total assets under management were $97 billion at
September 30, 2004, up from $93 billion at June 30, 2004 and $85 billion a
year ago.
Service charges and fees were up 4% from the second quarter of 2004 and
10% from the third quarter of 2003 due to higher capital market fees and
improved pricing on retail products.
Foreign exchange and other trading revenues declined sharply to $67
million, down 33% from the second quarter and 27% from the third quarter of
2003, reflecting lower exchange rate volatility and lower levels of cross-
border trading activity as well as weak demand for interest rate hedging
products. For the nine months ended September 30, 2004, foreign exchange and
other trading activities were up 11% over the nine months ended September 30,
2003 due to more active and volatile markets in the first half of 2004.
Securities gains in the third quarter were $14 million, compared with $12
million in the second quarter of 2004 and $9 million in the third quarter of
2003. The gains in the third quarter were primarily attributable to the
6
Company's private equity portfolio. For the nine months ended September 30,
2004, securities gains were $59 million, up $33 million from the nine months
ended September 30, 2003, primarily reflecting realized gains of $19 million
in the first quarter on four sponsor fund investments.
Other noninterest income was $49 million, compared with $49 million in
the second quarter of 2004 and $39 million in the third quarter of 2003. For
the first nine months of 2004, other noninterest income was $191 million, an
increase of $84 million from $107 million for the first nine months of 2003.
The increase primarily reflects the $48 million pre-tax gain on the sale of a
portion of the Company's investment in Wing Hang Bank Limited in the first
quarter of 2004.
Net Interest Income
- -------------------
3rd 2nd 3rd
Quarter Quarter Quarter Year-to-date
(Dollars in millions) -------- -------- -------- ------------------------
Reported Reported Reported Reported Core** Reported
-------- -------- -------- -------- ------ --------
2004 2004 2003 2004 2004 2003
-------- -------- -------- -------- ------- -------
Net Interest Income $ 428 $ 421 $ 407 $ 1,118 $ 1,263 $ 1,190
Tax Equivalent Adjustment* 8 8 9 20 20 27
-------- -------- -------- -------- ------- -------
Net Interest Income on a
Tax Equivalent Basis $ 436 $ 429 $ 416 $ 1,138 $ 1,283 $ 1,217
======== ======== ======== ======== ======= =======
Net Interest Rate
Spread 1.88% 1.84% 1.87% 1.62% 1.86% 1.99%
Net Yield on Interest
Earning Assets 2.18 2.08 2.10 1.87 2.11 2.24
* 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 $436 million in the
third quarter of 2004, compared with $429 million in the second quarter of
2004, and $416 million in the third quarter of 2003. The net interest income
rate spread was 1.88% in the third quarter of 2004, compared with 1.84% in the
second quarter of 2004, and 1.87% in the third quarter of 2003. The net yield
on interest earning assets was 2.18% in the third quarter of 2004, compared
with 2.08% in the second quarter of 2004, and 2.10% in the third quarter of
2003.
The sequential quarter increase in net interest income in the third
quarter of 2004 reflects the collection of past due interest on nonperforming
loans as well as the benefit of a rise in short-term interest rates. This was
partially offset by a reduction in liquid earning assets during the quarter, a
result of less active capital markets. The increase in net interest income
from the third quarter of 2003 reflects the benefit of higher short-term
rates, the collection of past due interest on non-performing loans, and a
higher level of investment securities.
For the first nine months of 2004, reported net interest income on a
taxable equivalent basis was $1,138 million, compared with $1,217 million in
the first nine months of 2003, as the full year impact of Pershing and the
benefit of rising rates were outweighed by the first quarter 2004 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"). Excluding this charge, net interest income on
a taxable equivalent basis for the first nine months of 2004 equaled $1,283
million, an increase of $66 million from last year. The reported year-to-date
net interest income spread was 1.62% in 2004 compared with 1.99% in 2003,
while the net yield on interest earning assets was 1.87% in 2004 and 2.24% in
2003.
7
Noninterest Expense and Income Taxes
- ------------------------------------
3rd 2nd 3rd
Quarter Quarter Quarter Year-to-date
------- ------- ------- --------------
(Dollars in millions) 2004 2004 2003 2004 2003
------- ------- ------- ------ ------
Salaries and Employee Benefits $ 564 $ 570 $ 533 $1,708 $1,454
Net Occupancy 77 72 69 230 192
Furniture and Equipment 51 51 50 153 134
Clearing 39 44 42 131 111
Sub-custodian Expenses 21 22 18 65 53
Software 52 50 45 151 123
Communications 22 23 24 69 68
Amortization of Intangibles 9 8 8 26 18
Merger and Integration Costs - - 23 - 48
GMAC Settlement - - 78 - 78
Other 164 172 149 492 402
------- ------- ------- ------ ------
Total Noninterest Expense $ 999 $ 1,012 $ 1,039 $3,025 $2,681
======= ======= ======= ====== ======
Noninterest expense for the third quarter of 2004 was $999 million,
compared with $1,012 million in the prior quarter and $1,039 million in the
third quarter of 2003. The decrease principally reflects lower incentive
compensation tied to revenues, lower volume-related clearing and sub-custodian
expenses as well as a decline in legal and travel & entertainment expenses.
Incentive compensation was lower in the quarter reflecting the lower revenues
partially offset by higher outside help and merit increases. Net occupancy
increased by $5 million reflecting expansion of regional facilities, including
the opening of the new Brooklyn facility which is part of the Company's
business continuity plans. In the third quarter of 2004, the Company
continued to engage in a multi-year effort to expand operations from the New
York metropolitan area to lower cost areas such as Utica and Syracuse.
The third quarter of 2003 results included $23 million of merger and
integration costs related to the Pershing acquisition and $78 million of net
costs related to the GMAC settlement. After excluding these items, the net
growth in expenses from a year ago principally reflects higher staff and
occupancy costs. Salaries and employee benefits were up reflecting higher
staffing levels due to business expansion as well as higher stock option
expense and a lower pension credit. Occupancy increased due to the expansion
of regional facilities.
For the first nine months of 2004, noninterest expense was $3,025
million, up 13% compared to $2,681 million from the equivalent period of 2003.
Noninterest expense in 2003 includes $126 million of costs related to the
Pershing merger and integration and the GMAC settlement. The growth in
expenses versus a year ago mainly reflects the full period impact of the
Pershing acquisition as well as the same factors affecting the comparisons
with last year's third quarter.
The effective tax rate for the third quarter of 2004 was 34.3%, compared
to 34.2% in the second quarter and 33.4% in the third quarter of 2003. The
increase from the third quarter of 2003 reflects the tax benefit on the GMAC
settlement in 2003. The effective tax rate for the nine month period ended
September 30, 2004 was 30.9%, compared with 34.3% for the nine month period
ended September 30, 2003. The year-over-year decrease reflects the benefit
associated with the SFAS 13 adjustment in the first quarter of 2004.
8
Credit Loss Provision and Net Charge-Offs
- -----------------------------------------
3rd 2nd 3rd
Quarter Quarter Quarter Year-to-date
------- ------- ------- --------------
(Dollars in millions) 2004 2004 2003 2004 2003
------- ------- ------- ------ ------
Provision $ - $ 10 $ 40 $ 22 $ 120
======= ======= ======= ====== ======
Net Charge-offs:
Commercial $ (4) $ (11) $ (25) $ (21) $ (85)
Foreign (9) (8) (12) (26) (18)
Other (1) - (4) (1) (15)
Consumer (5) (6) (6) (22) (16)
------- ------- ------- ------ ------
Total $ (19) $ (25) $ (47) $ (70) $ (134)
======= ======= ======= ====== ======
Other Real Estate Expenses $ - $ - $ - $ - $ -
No provision was taken in the third quarter of 2004 compared to $10
million in the second quarter of 2004 and $40 million in the third quarter of
2003. The absence of any provision reflects the improved quality of the loan
portfolio and the continued decline in nonperforming and criticized assets.
For the first nine months of 2004, the provision was $22 million compared with
$120 million in 2003.
The allowance for credit losses was $756 million at September 30, 2004,
$775 million at June 30, 2004, and $817 million at September 30, 2003. The
allowance for credit losses as a percent of non-margin loans was 2.42% at
September 30, 2004, compared with 2.42% at June 30, 2004, and 2.55% at
September 30, 2003.
Net charge-offs were $19 million in the third quarter of 2004 versus $25
million in the second quarter of 2004 and $47 million in the third quarter of
2003. These represent 0.21% of total loans in the most recent quarter, down
from 0.26% and 0.50% in the respective prior periods. For the first nine
months ended September 30, 2004, net charge-offs were $70 million, compared to
$134 million for the same period in 2003.
9
OTHER DEVELOPMENTS
In September 2004, the Company formed a strategic alliance with Wilshire
Associates, one of the world's leading providers of global risk services, to
meet the increasingly sophisticated risk management demands of institutional
investors. As part of the strategic alliance, the Company and Wilshire
Analytics, a business unit of Wilshire Associates, will integrate their
comprehensive selection of risk services, including performance measurement,
analytics, fixed income and equity attribution, universe comparisons,
compliance, risk budgeting, and advanced risk measures. Altogether, the
Company and Wilshire provide global risk services to more than 600
institutional investor clients that manage approximately $14 trillion in
assets.
In September 2004, the Company agreed to acquire the execution and
commission management assets of Wilshire Associates. Under the terms of the
agreement, BNY Brokerage will assume Wilshire's client relationships in these
businesses.
In September the Company announced its appointment by RCM (UK) Ltd, part
of the Allianz Dresdner Asset Management Group, to offer comprehensive middle
and back office outsourcing services in the UK for $8.75 billion of assets
under management. This follows the Company's appointment earlier this year by
RCM Capital Management LLC to provide outsourcing services to its San
Francisco operations. Taken together these two appointments mark the first
time an asset manager has outsourced operations on two continents to a single
strategic global platform, demonstrating the Company's market leading
capabilities.
In August the Company announced its appointment by Threadneedle
Investments to outsource its fund administration and transfer agency
operations in the UK. This deal provides the Company with added scale and
expertise in these businesses, positioning it well for further expansion in
continental Europe.
10
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 within reconciling amounts.
The Company reports data for the four business segments: Servicing and
Fiduciary, 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.
11
In issuer services, the Company's American and global depositary receipt
business has over 1,180 programs representing over 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 maintained on its recordkeeping system.
The Company is the second largest custodian with $8.9 trillion of assets
under custody and administration at September 30, 2004. The Company is the
second largest mutual fund custodian for U.S. funds and one of the largest
providers of fund services in the world with over $1.6 trillion in total
assets. The Company is the largest U.K. custodian. The Company services more
than $35 billion or 20% of total U.S. 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 and financial services
outsourcing in over 80 global markets, executing trades for nearly 575 million
shares and clearing 600,000 trades daily. The Company has 21 seats on the New
York Stock Exchange. Pershing services nearly 1,100 institutional and retail
financial organizations and independent investment advisors who collectively
represent more than 5 million individual investors.
Global payment services facilitates 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 on 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.
12
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.
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
- ----------------------------------
3rd 2nd 3rd
Quarter Quarter Quarter Year-to-date
------- ------- ------- ----------------
(Dollars in millions) 2004 2004 2003 2004 2003
------- ------- ------- ------- -------
Net Interest Income $ 144 $ 144 $ 132 $ 428 $ 357
Provision for
Credit Losses 1 1 - 2 -
Noninterest Income 953 994 905 2,937 2,439
Noninterest Expense 749 764 707 2,270 1,883
Income Before Taxes 347 373 330 1,093 913
Average Assets $20,937 $22,891 $20,902 $22,195 $14,799
Average Deposits 33,370 35,520 34,039 34,671 32,899
Nonperforming Assets 3 3 16 3 16
(Dollars in billions)
Assets Under Custody $ 8,906 $ 8,662 $ 7,878 $ 8,906 $ 7,878
Equity Securities 33% 34% 32% 33% 32%
Fixed Income Securities 67 66 68 67 68
Cross-Border Assets $ 2,494 $ 2,425 $ 2,206 $ 2,494 $ 2,206
Assets Under Administration $ 31 $ 32 $ 32 $ 31 $ 32
Assets Under Management 97 93 85 97 85
Equity Securities 35% 36% 31% 35% 31%
Fixed Income Securities 21 22 22 21 22
Alternative Investments 15 14 10 15 10
Liquid Assets 29 28 37 29 37
S&P 500 Index (Period End) 1,115 1,141 996 1,115 996
NASDAQ Index (Period End) 1,897 2,048 1,787 1,897 1,787
NYSE Volume (In billions) 84.9 90.8 87.3 271.1 266.9
NASDAQ Volume (In billions) 99.6 108.3 110.7 334.2 312.0
Third quarter results showed continued strength in several of the
Company's primary businesses, including global payment services, broker-dealer
services and asset management. Offsetting this strength were volume related
declines in the Company's execution and clearing services businesses. In the
third quarter of 2004, pre-tax income was $347 million, compared with $373
million in the second quarter of 2004 and $330 million a year ago. On a year-
to-date basis, pre-tax income was $1,093 million, up 20% from $913 million in
2003.
Noninterest income decreased by 4% to $953 million from $994 million in
the second quarter of 2004 but increased by $48 million, or 5%, compared with
$905 million in the third quarter of 2003.
13
Securities Servicing Fees
- -------------------------
3rd 2nd 3rd
Quarter Quarter Quarter
------- ------- -------
(Dollars in millions) 2004 2004 2003
------- ------- -------
Execution and Clearing Services $ 262 $ 280 $ 271
Investor Services 228 229 212
Issuer Services 141 155 127
Broker-Dealer Services 54 53 47
------- ------- -------
Securities Servicing Fees $ 685 $ 717 $ 657
======= ======= =======
Securities servicing fees were $685 million in the third quarter, a
decrease of $32 million, or 4%, from the second quarter of 2004, but up $28
million, or 4% from the third quarter of 2003. For the first nine months of
2004, securities servicing fees were $2,117 million, an increase of $389
million from the first nine months of 2003, principally due to the full period
impact of the Pershing acquisition which closed on May 1, 2003 and better
market conditions for most of the servicing businesses.
Execution and clearing services fees decreased $18 million, or 6%, from
the second quarter of 2004 and $9 million, or 3% from the third quarter of
2003. The execution business was impacted by lower equity market trading
volumes in the third quarter, as combined NYSE and NASDAQ trading volumes,
excluding program trading, were down 10% from the second quarter and 15% from
the third quarter of 2003. BNY Brokerage volumes were down 4% from the second
quarter, while institutional B-Trade volumes and G-Trade principal volumes
were down 1% and 8%, respectively. The sluggish market environment has
pressured revenues in these businesses but the Company is encouraged that it
has continued to gain market share. BNY Research and commission management
performed well as the Company's positioning in the independent research space
continued to be well received by the marketplace. The Company's correspondent
clearing business conducted by its Pershing subsidiary was impacted by lower
volumes and lower equity prices both sequentially and compared to the third
quarter of 2003. As a result, domestic billable trades declined by 7%,
slightly better than the market trend. The majority of Pershing's revenues
are generated from non-transactional activities, such as asset gathering and
technology services to broker-dealers, with revenues tied to both assets under
administration and services provided. Despite a 2% sequential decline in the
S&P 500 Index, Pershing's assets under administration were $649 billion at
quarter-end, compared with $647 billion at June 30, 2004.
Investor services fees held steady at $228 million, down $1 million from
the second quarter of 2004, but up $16 million, or 8% from the third quarter
of 2003. The sequential quarter decrease reflects lower transaction activity
and seasonally lower securities lending revenues, offset in part by new
business wins in global fund services, as well as the continued addition of
new clients to the Company's hedge fund servicing platform. At quarter-end,
hedge fund assets under administration totaled $48 billion up from $30 billion
at year-end 2003. The increase in investor service fees relative to the third
quarter of 2003 was a result of good organic growth in most areas. This was
offset in part by weaker equity and fixed income transaction volumes, and
lower average equity price levels. Securities lending fees declined modestly
relative to the second quarter because of slightly lower spreads resulting
from the timing of the Federal Reserve interest rate increases, as well as the
decline in equity lending the Company typically experiences following the
second quarter European dividend season. Global liquidity services fees were
up, benefiting from higher fees related to rising interest rates.
At September 30, 2004 assets under custody rose to $8.9 trillion, from
$8.7 trillion at June 30, 2004 and $7.9 trillion at September 30, 2003.
Cross-border custody assets were $2.5 trillion at September 30, 2004. A
substantial portion of the increase in assets under custody was due to new
business, as well as the acquisition of a unit investment trust ("UIT")
14
business. In addition, while equity prices declined during the quarter, fixed
income values rose as the yield curve flattened and longer term interest rates
declined. As a result, the market value of fixed income assets under custody
increased, and the percentage of fixed income assets under custody rose from
66% to 67%.
Issuer services fees were $141 million in the third quarter, down $14
million or 9% from the second quarter of 2004, but up $14 million or 11% from
the third quarter of 2003.
Depositary receipts ("DR") revenues decreased sequentially due to
seasonally lower trading and dividend activity. While issue/cancel fees were
negatively impacted by the seasonal slowdown in DR trading volumes, which were
down 6% sequentially, the Company continued to experience positive net DR
issuance in the third quarter, demonstrating investors' commitment to cross-
border investing. Dividend-related activity decreased from the seasonally
strong second quarter, while other corporate actions such as initial public
offerings, mergers and acquisitions, secondary offerings and rights issues
declined in the third quarter.
Corporate trust revenues declined sequentially but the Company continues
to perform near record levels as a slowdown in overall issuance levels was
partially offset by strength in global issuance as well as demand for
corporate specialty products in the third quarter.
The increase in issuer services revenues relative to the third quarter of
2003 primarily reflects growth in corporate trust, due to higher debt issuance
as well as acquisitions, and in DR, because of higher volumes
and dividend activity.
Broker-dealer services fees showed good growth, increasing $1 million, or
2%, from the second quarter of 2004 and $7 million, or 15% from the third
quarter of 2003. On a sequential basis, new business wins offset lower market
volumes. Year-over-year, new business was the dominant driver, particularly
in collateral management, as volumes have been relatively stable.
Global payment services fees were up $3 million, or 4%, from the second
quarter of 2004, and $4 million, or 5% from the third quarter of 2003,
primarily resulting from new business wins. Global payment services increased
by 3% on a year-to-date basis over 2003. The year-over-year growth is
attributable to higher funds transfer volumes and increased multi-currency
activity from existing clients as well as the addition of new clients.
Private client services and asset management fees continues to
demonstrate solid performance with fees up 16% from the third quarter of 2003
and stable on a sequential quarter basis despite lower equity market prices.
For the nine months ended September 30, 2004, private client services and
asset management fees were $333 million, a 19% increase over the same period
in 2003. The increase from the third quarter of 2003 and on a year-to-date
basis reflects strong growth in Ivy. The Company is also experiencing good
new business momentum in institutional equity management as a result of
improved sales efforts.
Assets under management ("AUM") were $97 billion at September 30, 2004,
up from $93 billion at June 30, 2004 and $85 billion at September 30, 2003.
Assets under administration were $31 billion compared with $32 billion at June
30, 2004 and $32 billion at September 30, 2003. The sequential quarter and
year-over-year increases in AUM reflect growth in the Company's alternative
investments business as assets at Ivy grew to $14.6 billion. In addition, the
growth in AUM reflects an inflow of funds into personal trust assets and
short-term money market product for institutional/corporate investors.
Institutional clients represent 67% of AUM while individual clients equal 33%.
AUM at September 30, 2004, are 35% invested in equities, 21% in fixed income,
15% in alternative investments and the remainder in liquid assets.
Foreign exchange and other trading revenues declined sharply to $67
million, down 33% from the second quarter and 27% from the third quarter of
2003, reflecting lower exchange rate volatility and lower levels of cross-
15
border trading activity. Foreign exchange experienced a slow down in client
activity beginning in late June that persisted through the end of September,
which was exacerbated by a 25% sequential quarter drop in exchange rate
volatility. For the nine months ended September 30, 2004, foreign exchange
and other trading activities were up 11% over the nine months ended
September 30, 2003 due to more active and volatile markets in the first half
of 2004.
Net interest income in the Servicing and Fiduciary businesses segment was
$144 million for the third quarter of 2004 compared with $144 million for the
second quarter of 2004 and $132 million in the third quarter of 2003. The
increase in net interest income from the third quarter of 2003 is primarily
due to the rise in interest rates. Net interest income for the nine months
ended September 30, 2004 was $428 million compared with $357 million in the
first nine months of 2003. The increase in net interest income primarily
reflects the Pershing acquisition and the rise in interest rates. Average
assets for the quarter ended September 30, 2004 were $20.9 billion compared
with $22.9 billion in the second quarter of 2004 and $20.9 billion in the
third quarter of 2003. Average assets for the nine months ended September 30,
2004 were $22.2 billion compared with $14.8 billion in the first nine months
of 2003. The increase in assets in the year-to-date 2004 average compared
with 2003 is attributable to the Pershing acquisition. The third quarter of
2004 average deposits were $33.4 billion compared with $35.5 billion in the
second quarter of 2004 and $34.0 billion in the third quarter of 2003. The
sequential quarter decline in deposits reflects lower market volumes in the
third quarter of 2004. Average deposits for the first nine months of 2004
were $34.7 billion compared with $32.9 billion for the first nine months of
2003.
Net charge-offs in the Servicing and Fiduciary Businesses segment were
$10 million in the third quarter of 2004, compared with zero in the second
quarter of 2004 and the third quarter of 2003. The increase in charge-offs
reflects a credit loss in Pershing's UK clearing business as a result of an
alleged deceptive scheme perpetrated on Pershing. On a year-to-date
basis, net charge-offs were $15 million in 2004, compared to zero in 2003.
Nonperforming assets were $3 million at September 30, 2004, compared with $3
million at June 30, 2004 and $16 million at September 30, 2003.
Noninterest expense for the third quarter of 2004 was $749 million,
compared with $764 million in the second quarter of 2004 and $707 million in
the third quarter of 2003. The decline in noninterest expense from second
quarter of 2004 was primarily due to lower incentive compensation tied to
revenues as well as lower volume-related clearing and sub-custodian expenses.
The increase in noninterest expense from third quarter of 2003 reflects the
Pershing acquisition. Noninterest expense for the first nine months of 2004
was $2,270 million, compared with $1,883 million for the same period in 2003,
reflecting the Pershing acquisition.
16
Corporate Banking
- -----------------
3rd 2nd 3rd
Quarter Quarter Quarter Year-to-date
------- ------- ------- ----------------
(Dollars in millions) 2004 2004 2003 2004 2003
------- ------- ------- ------- -------
Net Interest Income $ 89 $ 87 $ 95 $ 265 $ 282
Provision for Credit Losses 15 15 27 50 87
Noninterest Income 81 84 71 245 224
Noninterest Expense 53 54 53 160 152
Income Before Taxes 102 102 86 300 267
Average Assets $17,485 $17,308 $19,378 $17,384 $19,916
Average Deposits 6,422 6,345 6,699 6,522 6,832
Nonperforming Assets 269 293 368 269 368
Net Charge-offs 3 9 41 24 118
In the third quarter of 2004, pre-tax income was $102 million, compared
with $102 million in the second quarter of 2004 and $86 million in the third
quarter of 2003. On a year-to-date basis, pre-tax income was $300 million, up
12% from $267 million in 2003. The improvement over the prior year 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 $89 million in
the third quarter of 2004, compared with $87 million in the second quarter of
2004 and $95 million in the third quarter of 2003. The sequential quarter
increase reflects the collection of past due interest on nonperforming loans
and slightly higher loan volumes. The decline from the third quarter of 2003
reflects continued reduction in lending to corporate borrowers as well as a
decline in deposits. Average assets for the quarter were $17.5 billion
compared with $17.3 billion in the second quarter of 2004 and $19.4 billion in
the third quarter of last year. Average deposits in the Corporate Banking
segment were $6.4 billion versus $6.3 billion in the second quarter of 2004
and $6.7 billion in third quarter of 2003. On a year-to-date basis, net
interest income for 2004 was $265 million compared with $282 million in 2003.
For the nine months ended September 30, 2004, average assets were $17.4
billion compared to $19.9 billion for the first nine months of 2003. For the
first nine months of 2004 and 2003, average deposits were $6.5 billion and
$6.8 billion.
The third quarter of 2004 provision for credit losses was $15 million
compared with $15 million in the second quarter of 2004 and $27 million in the
third quarter of last year. On a year-to-date basis, the provision for credit
losses was $50 million for 2004 and $87 million for 2003. The decline in the
provision from the third 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 $3 million in the third quarter of 2004, $9
million in the second quarter of 2004, and $41 million in the third quarter of
2003. Net charge-offs for the first nine months of 2004 were $24 million
compared with $118 million in 2003. The charge-offs for the first nine months
of 2004 primarily relate to loans to media and foreign borrowers.
Nonperforming assets were $269 million at September 30, 2004, down from $293
million at June 30, 2004 and $368 million at September 30, 2003. The decrease
in nonperforming assets from the third quarter of 2003 primarily reflects
paydowns and charge-offs of foreign loans.
Noninterest income was $81 million in the current quarter, compared with
$84 million in the second quarter of 2004 and $71 million in the third quarter
of 2003. On a sequential quarter basis, the decrease reflects lower credit
derivatives and foreign exchange revenues partially offset by higher advisory
fees. The increase year-over-year reflects increased advisory fees and higher
income from the Company's investment in Wing Hang Bank. On a year-to-date
basis, noninterest income was $245 million, up $21 million from $224 million
in 2003, reflecting increased advisory fees and foreign exchange revenues as
well as higher income from the Company's investment in Wing Hang Bank.
17
Noninterest expense in the third quarter was $53 million, compared with
$54 million in the second quarter of 2004 and $53 million in the third quarter
of 2003. On a year-to-date basis, noninterest expense was $160 million,
compared with $152 million in 2003, reflecting higher stock option expense and
performance related incentives.
Retail Banking
- --------------
3rd 2nd 3rd
Quarter Quarter Quarter Year-to-date
------- ------- ------- ----------------
(Dollars in millions) 2004 2004 2003 2004 2003
------- ------- ------- ----------------
Net Interest Income $ 128 $ 126 $ 120 $ 377 $ 354
Provision for Credit Losses 6 5 5 16 14
Noninterest Income 28 28 30 85 92
Noninterest Expense 97 95 90 285 268
Income Before Taxes 53 54 55 161 164
Average Assets $ 5,639 $ 5,317 $ 5,023 $ 5,445 $ 5,246
Average Noninterest
Bearing Deposits 5,398 5,209 4,738 5,212 4,711
Average Deposits 15,312 15,162 14,585 15,094 14,321
Nonperforming Assets 15 15 4 15 4
Net Charge-offs 6 5 6 17 16
Number of Branches 341 341 341 341 341
Total Deposit Accounts
(In Thousands) 1,124 1,129 1,170 1,124 1,170
Number of ATMs 379 379 377 379 377
The Retail Banking segment continues to demonstrate stable results in
spite of increased competition in the New York metropolitan area. In the
third quarter of 2004, pre-tax income was $53 million, compared with $54
million in the second quarter of 2004 and $55 million a year ago. On a year-
to-date basis, pre-tax income was $161 million, compared with $164 million in
2003. The Company has been able to steadily grow its deposit balances, with
average deposits reaching $15.3 billion during the quarter.
Net interest income in the third quarter of 2004 was $128 million,
compared with $126 million in the second quarter of 2004 and $120 million in
the third quarter of 2003. Net interest income on a year-to-date basis for
2004 and 2003 was $377 million and $354 million. Net interest income has
increased as rates have risen and as the segment has been able to increase its
deposit base. 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 Online and the
debit card along with promotional campaigns have helped build deposit volumes.
Noninterest income was $28 million for the quarter compared with $28
million in the second quarter and $30 million in the third quarter of last
year. Noninterest income for the first nine months of 2004 was $85 million
compared with $92 million in the first nine months of 2003. The decreases in
noninterest income compared to 2003 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.
Noninterest expense in the third quarter of 2004 was $97 million,
compared with $95 million in the second quarter of 2004 and $90 million last
year. The increase from the third quarter of 2003 reflects higher
compensation and marketing costs. Noninterest expense for the first nine
months of 2004 was $285 million compared with $268 million in the first nine
months of 2003. The year-over-year change reflects same factors influencing
the quarterly increase.
Net charge-offs were $6 million in the third quarter of 2004, compared
with $5 million in the second quarter of 2004 and $6 million in the third
quarter of 2003. For the first nine months of 2004, net charge-offs were $17
18
million compared with $16 million for the first nine months of 2003.
Nonperforming assets were $15 million at September 30, 2004, compared with $15
million at June 30, 2004, and $4 million at September 30, 2003.
Average deposits generated by the Retail Banking segment were $15.3
billion in the third quarter of 2004, compared with $15.2 billion in the
second quarter of 2004 and $14.6 billion in the third quarter of 2003. For
the first nine months of 2004, average deposits were $15.1 billion compared to
$14.3 billion in the first nine months of 2003. Average noninterest bearing
deposits for the first nine months of 2004 were $5.2 billion compared with
$4.7 billion in the first nine months of 2003. Average assets in the Retail
Banking sector were $5.6 billion, compared with $5.3 billion in the second
quarter of 2004 and $5.0 billion in the third quarter of 2003. On a year-to-
date basis, average assets were $5.4 billion for 2004 and $5.2 billion in
2003.
Financial Markets
- -----------------
3rd 2nd 3rd
Quarter Quarter Quarter Year-to-date
------- ------- ------- ----------------
(Dollars in millions) 2004 2004 2003 2004 2003
------- ------- ------- ------- -------
Net Interest Income $ 86 $ 83 $ 80 $ 249 $ 237
Provision for Credit Losses 5 5 5 15 16
Noninterest Income 36 43 53 129 136
Noninterest Expense 29 28 25 84 74
Income Before Taxes 88 93 103 279 283
Average Assets $49,148 $50,728 $47,920 $49,973 $46,252
Average Deposits 5,316 5,460 4,356 4,882 4,473
Average Investment
Securities 22,473 22,982 20,604 22,816 19,110
Net Charge-offs - 10 - 14 -
In the third quarter of 2004, pre-tax income was $88 million, compared
with $93 million in the second quarter of 2004 and $103 million a year ago.
The sequential quarter decline is due to a drop in trading revenue. On a
year-to-date basis, pre-tax income was $279 million, down 1% from $283 million
in 2003. The decreases over the third quarter and year-to-date 2003 periods
are primarily due to a decline in trading income and increased compensation
expense.
Net interest income for the third quarter was $86 million compared with
$83 million for the second quarter and $80 million a year ago. The increase
from the second quarter of 2004 reflects the benefit associated with having
positioned for a rising rate environment, as well as an additional day in the
quarter. The increase from the third quarter of 2003 reflects higher average
balances of investment securities as well as the benefit from the rising rate
environment. Net interest income was $249 million in the first nine months of
2004 compared to $237 million in the first nine months of 2003. Average third
quarter 2004 assets in the Financial Markets segment composed primarily of
short-term liquid assets and investment securities were $49.1 billion, down
from $50.7 billion on a sequential quarter basis and up compared with $47.9
billion in the third quarter last year. Average assets for the first nine
months of 2004 were $50.0 billion compared to $46.3 billion for the first nine
months of 2003. The increase in assets from 2003 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 $36 million in the third quarter of 2004, compared
with $43 million in the second quarter of 2004 and $53 million in the third
quarter of 2003. On a year-to-date basis, noninterest income was $129 million
in 2004 and $136 million in 2003. The negative variance versus the second
quarter of 2004 reflects weaker trading results, as there was an earlier than
expected flattening of the yield curve which hurt interest rate derivative
19
results, and demand for hedging products decreased given lower bond issuance
and a fall-off in mortgage prepayments.
Net charge-offs were zero in the third quarter of 2004, compared with $10
million in the second quarter of 2004 and zero a year ago. Net charge-offs
for the first nine months of 2004 and 2003 were $14 million and zero,
respectively. Charge-offs in 2004 are primarily related to the Company's
airline leasing exposure. Noninterest expense was $29 million in the third
quarter of 2004, compared with $28 million in the second quarter of 2004 and
$25 million in last year's third quarter. The increase from last year's third
quarter is attributable to higher employee incentive and other compensation.
Noninterest expense for the nine months ended September 30, 2004 was $84
million, compared with $74 million for the first nine months ended September
30, 2003.
20
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
September 30, 2004 Businesses Banking Banking Markets Items Total
- -------------------------- ---------- --------- --------- --------- ----------- ------------
Net Interest Income $ 144 $ 89 $ 128 $ 86 $ (19) $ 428
Provision for Credit Losses 1 15 6 5 (27) -
Noninterest Income 953 81 28 36 12 1,110
Noninterest Expense 749 53 97 29 71 999
---------- --------- --------- --------- ----------- ------------
Income Before Taxes $ 347 $ 102 $ 53 $ 88 $ (51) $ 539
========== ========= ========= ========= =========== ============
Contribution Percentage 59% 17% 9% 15%
Average Assets $ 20,937 $ 17,485 $ 5,639 $ 49,148 $ 4,146 $ 97,355
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
Servicing
and
For the Quarter Ended Fiduciary Corporate Retail Financial Reconciling Consolidated
September 30, 2003 Businesses Banking Banking Markets Items Total
- -------------------------- ---------- --------- --------- --------- ----------- ------------
Net Interest Income $ 132 $ 95 $ 120 $ 80 $ (20) $ 407
Provision for Credit Losses - 27 5 5 3 40
Noninterest Income 905 71 30 53 4 1,063
Noninterest Expense 707 53 90 25 164 1,039
---------- --------- --------- --------- ----------- ------------
Income Before Taxes $ 330 $ 86 $ 55 $ 103 $ (183) $ 391
========== ========= ========= ========= =========== ============
Contribution Percentage 57% 15% 10% 18%
Average Assets $ 20,902 $ 19,378 $ 5,023 $ 47,920 $ 3,930 $ 97,153
21
(Dollars in millions)
Servicing
and
For the Nine Months Ended Fiduciary Corporate Retail Financial Reconciling Consolidated
September 30, 2004 Businesses Banking Banking Markets Items Total
- -------------------------- ---------- --------- --------- --------- ----------- ------------
Net Interest Income $ 428 $ 265 $ 377 $ 249 $ (201) $ 1,118
Provision for Credit Losses 2 50 16 15 (61) 22
Noninterest Income 2,937 245 85 129 109 3,505
Noninterest Expense 2,270 160 285 84 226 3,025
---------- --------- --------- --------- ----------- ------------
Income Before Taxes $ 1,093 $ 300 $ 161 $ 279 $ (257) $ 1,576
========== ========= ========= ========= =========== ============
Contribution Percentage 60% 16% 9% 15%
Average Assets $ 22,195 $ 17,384 $ 5,445 $ 49,973 $ 4,132 $ 99,129
Servicing
and
For the Nine Months Ended Fiduciary Corporate Retail Financial Reconciling Consolidated
September 30, 2003 Businesses Banking Banking Markets Items Total
- -------------------------- ---------- --------- --------- --------- ----------- ------------
Net Interest Income $ 357 $ 282 $ 354 $ 237 $ (40) $ 1,190
Provision for Credit Losses - 87 14 16 3 120
Noninterest Income 2,439 224 92 136 13 2,904
Noninterest Expense 1,883 152 268 74 304 2,681
---------- --------- --------- --------- ----------- ------------
Income Before Taxes $ 913 $ 267 $ 164 $ 283 $ (334) $ 1,293
========== ========= ========= ========= =========== ============
Contribution Percentage 56% 17% 10% 17%
Average Assets $ 14,799 $ 19,916 $ 5,246 $ 46,252 $ 3,366 $ 89,579
22
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 nine months 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 $19 million. In the third
quarter of 2003, merger and integration costs associated with Pershing and the
GMAC settlement are also reconciling items.
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.
3rd 2nd 3rd
Quarter Quarter Quarter Year-to-date
--------- --------- --------- ------------------
(Dollars in millions) 2004 2004 2003 2004 2003
--------- --------- --------- -------- --------
Segments' revenue $ 1,545 $ 1,589 $ 1,486 $ 4,715 $ 4,121
Adjustments:
Earnings associated with
assignment of capital (21) (23) (33) (73) (81)
Securities gains - - - 19 -
SFAS 13 cumulative
lease adjustment - - - (145) -
Taxable equivalent basis and
other tax-related items 4 3 13 17 41
Other 10 18 4 90 13
--------- --------- --------- -------- --------
Subtotal-revenue adjustments (7) (2) (16) (92) (27)
--------- --------- --------- -------- --------
Consolidated revenue $ 1,538 $ 1,587 $ 1,470 $ 4,623 $ 4,094
========= ========= ========= ======== ========
Segments' income before tax $ 590 $ 623 $ 574 $ 1,833 $ 1,627
Adjustments:
Revenue adjustments (above) (7) (2) (16) (92) (27)
Provision for credit losses
different than GAAP 27 15 (3) 61 (3)
Severance - - (2) (11) (8)
Goodwill and
intangible amortization (9) (8) (8) (26) (18)
Pershing-related
integration expenses - - (23) - (48)
GMAC settlement - - (78) - (78)
Lease termination - - - (8) -
Corporate overhead (62) (63) (53) (181) (152)
--------- --------- --------- -------- --------
Consolidated income
before tax $ 539 $ 565 $ 391 $ 1,576 $ 1,293
========= ========= ========= ======== ========
Segments' total
average assets $ 93,209 $ 96,244 $ 93,223 $ 94,997 $ 86,213
Adjustments:
Goodwill and intangibles 4,146 4,129 3,930 4,132 3,366
--------- --------- --------- -------- --------
Consolidated average assets $ 97,355 $ 100,373 $ 97,153 $ 99,129 $ 89,579
========= ========= ========= ======== ========
23
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 associated with Pershing would be allocated to the
Securities and Fiduciary Businesses segment. The GMAC settlement would be
allocated to Corporate Banking.
CONSOLIDATED BALANCE SHEET REVIEW
Total assets were $93.2 billion at September 30, 2004, compared with
$97.5 billion at June 30, 2004, and $95.2 billion at September 30, 2003. The
decrease in assets reflects lower market activity levels throughout the
quarter, which resulted in a lower level of customer deposits at quarter end.
Total assets at the end of the second quarter was unusually high as clients
left funds on deposit rather than invested in the equity and fixed income
markets. Total shareholders' equity increased to $9.1 billion at September
30, 2004, compared with $8.8 billion at June 30, 2004, and $8.2 billion at
September 30, 2003. The increase in shareholders' equity from the prior
quarter reflects retention of earnings and an increase in the securities
valuation allowance. 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 third quarter of 2004 was 15.90%,
compared with 17.14% in the second quarter of 2004, and 12.82% in the third
quarter of 2003. Return on average assets for the third quarter of 2004 was
1.45%, compared with 1.49% in the second quarter of 2004, and 1.06% in the
third quarter of 2003. For the nine months of 2004, return on average common
equity was 16.73% compared with 15.23% in 2003, while return on average assets
was 1.47% compared with 1.27% in 2003. The 2003 ratios were impacted by the
Pershing merger and integration costs and the GMAC settlement.
24
Investment Securities
- ---------------------
The table below shows the distribution of the Company's securities
portfolio:
Investment Securities (at Fair Value)
(Dollars in millions) 09/30/04 12/31/03
---------- ----------
Fixed Income:
Mortgage-Backed Securities $ 18,991 $ 18,703
Asset-Backed Securities - 20
Corporate Debt 1,264 1,326
Short-Term Money Market Instruments 926 917
U.S. Treasury Securities 370 505
U.S. Government Agencies 393 241
State and Political Subdivisions 215 251
Emerging Market Debt 116 109
Other Foreign Debt 505 518
---------- ----------
Subtotal Fixed Income 22,780 22,590
Equity Securities:
Money Market Funds 343 200
Federal Reserve Bank Stock 99 96
Other 19 12
---------- ----------
Subtotal Equity Securities 461 308
---------- ----------
Total Securities $ 23,241 $ 22,898
========== ==========
Total investment securities were $23.2 billion at September 30, 2004,
compared with $23.0 billion at June 30, 2004, and $22.9 billion at December
31, 2003. Average investment securities were $22.5 billion in the third
quarter of 2004, compared with $23.0 billion in the second quarter of 2004 and
$20.6 billion in the third quarter of last year. Average investment
securities were $22.8 billion in the nine months ended September 30, 2004,
compared with $19.1 billion in the nine months ended September 30, 2003. The
increases were primarily due to growth in the Company's portfolio of highly
rated mortgage-backed securities which are 89% rated AAA, 6% AA, and 5% A.
Since December 31, 2002, the Company has added approximately $5.9 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 effective duration of the
Company's mortgage portfolio at September 30, 2004 was approximately 1.9
years.
Net unrealized gains for securities available-for-sale were $150 million
at September 30, 2004, compared with $14 million at June 30, 2004 and $201
million at December 31, 2003. The increase in unrealized gains since June 30,
2004 reflects the decline in long-term interest rates in the third quarter.
The decline in unrealized gains from the third quarter of 2003 reflects the
increase in these rates since last year. 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.
25
Loans
- -----
(Dollars in billions) Quarterly Year-to-date
Period End Average Average
------------------------- ------------------------- -------------------------
Total Non-Margin Margin Total Non-Margin Margin Total Non-Margin Margin
----- ---------- ------ ----- ---------- ------ ----- ---------- ------
Sept. 30, 2004 $37.1 $ 31.2 $ 5.9 $37.6 $ 31.3 $ 6.3 $37.2 $ 30.9 $ 6.3
December 31, 2003 35.3 29.6 5.7 37.3 31.5 5.8 35.6 31.8 3.8
Sept. 30, 2003 37.5 32.0 5.5 37.4 32.0 5.4 35.0 31.9 3.1
Total loans were $37.1 billion at September 30, 2004, compared with $38.2
billion at June 30, 2004 and $35.3 billion at December 31, 2003. The decline
in total loans from June 30, 2004 primarily reflects a decrease 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 $37.6
billion in the third quarter of 2004, compared with $37.4 billion in the third
quarter of 2003 while for the nine months ended September 30, 2004, average
loans were $37.2 billion compared with $35.0 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 credit
exposures and outstandings at September 30, 2004 in comparison to December 31,
2003.
Overall Loan Portfolio
- ----------------------
Unfunded Total Unfunded Total
(Dollars in billions) Loans Commitments Exposure Loans Commitments Exposure
---------------------------- ----------------------------
09/30/04 09/30/04 09/30/04 12/31/03 12/31/03 12/31/03
-------- -------- -------- -------- -------- --------
Financial Institutions $ 10.8 $ 22.0 $ 32.8 $ 9.2 $ 21.8 $ 31.0
Corporate 3.7 19.6 23.3 4.0 20.5 24.5
-------- -------- -------- -------- -------- --------
14.5 41.6 56.1 13.2 42.3 55.5
-------- -------- -------- -------- -------- --------
Consumer & Middle Market 8.8 4.3 13.1 8.2 4.1 12.3
Leasing Financings 5.7 0.1 5.8 5.8 - 5.8
Commercial Real Estate 2.2 0.9 3.1 2.4 0.8 3.2
Margin loans 5.9 - 5.9 5.7 - 5.7
-------- -------- -------- -------- -------- --------
Total $ 37.1 $ 46.9 $ 84.0 $ 35.3 $ 47.2 $ 82.5
======== ======== ======== ======== ======== ========
26
Financial Institutions
- ----------------------
The financial institutions portfolio exposure was $32.8 billion at
September 30, 2004 compared to $31.0 billion at December 31, 2003. These
exposures are of high quality, with 87% meeting the investment grade criteria
of the Company's rating system. The exposures are generally short-term, with
78% 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 accompanying table.
(Dollars in billions)
September 30, 2004 December 31, 2003
--------------------------- ----- ----- ---------------------------
Unfunded Total %Inv %due Unfunded Total
Lending Division Loans Commitments Exposures Grade <1 Yr Loans Commitments Exposures
- ------------------- ----- ----------- --------- ----- ----- ----- ----------- ---------
Banks $ 4.2 $ 3.7 $ 7.9 71% 88% $ 2.6 $ 3.1 $ 5.7
Securities Industry 2.4 3.3 5.7 89 96 1.9 3.5 5.4
Insurance 0.4 4.9 5.3 95 60 0.3 5.0 5.3
Government 0.1 5.1 5.2 99 64 0.2 5.6 5.8
Asset Managers 3.3 3.6 6.9 86 79 3.6 3.5 7.1
Mortgage Banks 0.3 0.6 0.9 84 72 0.4 0.5 0.9
Endowments 0.1 0.8 0.9 98 62 0.2 0.6 0.8
----- ----------- --------- ----- ----- ----- ----------- ---------
Total $10.8 $ 22.0 $ 32.8 87% 78% $ 9.2 $ 21.8 $ 31.0
===== =========== ========= ===== ===== ===== =========== =========
Corporate
- ---------
The corporate portfolio exposure declined to $23.3 billion at September
30, 2004 from $24.5 billion at year-end 2003. Approximately 76% of the
portfolio is investment grade while 27% of the portfolio matures within one
year.
(Dollars in billions)
September 30, 2004 December 31, 2003
--------------------------- ----- ----- ---------------------------
Unfunded Total %Inv %due Unfunded Total
Lending Division Loans Commitments Exposures Grade <1 Yr Loans Commitments Exposures
- ------------------- ----- ----------- --------- ----- ----- ----- ----------- ---------
Media $ 1.0 $ 2.0 $ 3.0 62% 15% $ 0.9 $ 2.3 $ 3.2
Cable 0.6 0.5 1.1 30 1 0.7 0.7 1.4
Telecom 0.1 0.5 0.6 78 14 0.3 0.6 0.9
----- ----------- --------- ----- ----- ----- ----------- ---------
Subtotal 1.7 3.0 4.7 57% 12% 1.9 3.6 5.5
Energy 0.4 4.4 4.8 84 31 0.4 4.2 4.6
Retailing 0.2 2.2 2.4 80 43 0.1 2.3 2.4
Automotive 0.1 1.9 2.0 72 52 0.1 2.1 2.2
Healthcare 0.2 1.4 1.6 90 15 0.2 1.3 1.5
Other* 1.1 6.7 7.8 80 25 1.3 7.0 8.3
----- ----------- --------- ----- ----- ----- ----------- ---------
Total $ 3.7 $ 19.6 $ 23.3 76% 27% $ 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 of 2004 and exposures have since declined to $551 million.
The percentage of investment grade borrowers in the telecom portfolio has
increased to 78% 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 $548 million
leasing portfolio (including a $15 million real estate lease exposure) as well
as $23 million of direct lending. The airline leasing portfolio consists of
$254 million to major U.S. carriers, $205 million to foreign airlines and $89
million to U.S. regionals.
During the third quarter of 2004, the industry continued to face the
dilemma of an increasingly uncompetitive cost structure, weak demand, high
energy costs, and strong competition from the regionals. The industry's
27
stagnant demand and considerable excess capacity continues to negatively
impact 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.
Nonperforming Assets
- --------------------
Change Change
9/30/04 vs. 9/30/04 vs.
(Dollars in millions) 09/30/04 06/30/04 06/30/04 12/31/03 12/31/03
-------- -------- ---------- -------- ----------
Category of Loans:
Commercial $ 209 $ 208 $ 1 $ 219 $ (10)
Foreign 27 53 (26) 79 (52)
Other 50 50 - 51 (1)
-------- -------- ---------- -------- ----------
Total Nonperforming Loans 286 311 (25) 349 (63)
Other Real Estate 1 - 1 - 1
-------- -------- ---------- -------- ----------
Total Nonperforming Assets $ 287 $ 311 $ (24) $ 349 $ (62)
======== ======== ========== ======== ==========
Nonperforming Assets Ratio 0.9% 1.0% 1.2%
Allowance for Loan
Losses/Nonperforming Loans 209.0 192.2 191.2
Allowance for Loan
Losses/Nonperforming Assets 208.1 192.2 191.2
Allowance for Credit
Losses/Nonperforming Loans 264.4 249.1 230.2
Allowance for Credit
Losses/Nonperforming Assets 263.3 249.1 230.2
Nonperforming assets declined by $24 million, or 8% during the third
quarter of 2004 to $287 million and are down 26% from a year ago. The
sequential quarter decrease primarily reflects paydowns and charge-offs of
foreign loans. The ratio of the allowance for credit losses to nonperforming
assets increased to 263.3% at September 30, 2004, compared with 249.1% at June
30, 2004, and 210.5% at September 30, 2003.
28
Activity in Nonperforming Assets
(Dollars in millions) Quarter End Year-to-date
September 30, 2004 September 30, 2004
------------------ ------------------
Balance at Beginning of Period $ 311 $ 349
Additions 27 106
Charge-offs (7) (47)
Paydowns/Sales (44) (121)
------------------ ------------------
Balance at End of Period $ 287 $ 287
================== ==================
Interest income would have been increased by $1 million and $4 million
for the third quarters of 2004 and 2003 if loans on nonaccrual status at
September 30, 2004 and 2003 had been performing for the entire period.
Interest income would have been increased by $8 million and $12 million for
the nine months ended September 30, 2004 and 2003 if loans on nonaccrual
status at September 30, 2004 and 2003 had been performing for the entire
period.
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:
September 30, June 30, September 30,
(Dollars in millions) 2004 2004 2003
------------ -------- ------------
Impaired Loans with an Allowance $ 160 $ 168 $ 352
Impaired Loans without an Allowance(1) 108 121 -
------------ -------- ------------
Total Impaired Loans $ 268 $ 289 $ 352
============ ======== ============
Allowance for Impaired Loans(2) $ 57 $ 69 $ 150
Average Balance of Impaired Loans
during the Quarter $ 293 $ 305 $ 387
Interest Income Recognized on
Impaired Loans during the Quarter $ 2.4 $ 0.6 $ -
(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 credit losses.
Allowance
- ---------
September 30, June 30, September 30,
(Dollars in millions) 2004 2004 2003
------------ -------- ------------
Margin Loans $ 5,911 $ 6,114 $ 5,472
Non-Margin Loans 31,208 32,091 32,068
Total Loans 37,119 38,205 37,540
Allowance for Loan Losses 598 598 665
Allowance for Lending-Related
Commitments 158 177 152
Total Allowance for Credit Losses 756 775 817
Allowance for Loan Losses As a
Percent of Total Loans 1.61% 1.57% 1.77%
Allowance for Loan Losses As a
Percent of Non-Margin Loans 1.92 1.86 2.07
Allowance for Credit Losses
As a Percent of Total Loans 2.04 2.03 2.18
Allowance for Credit Losses As a
Percent of Non-Margin Loans 2.42 2.42 2.55
29
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.
The allowance for credit losses to total loans was $756 million, or 2.04%
of loans at September 30, 2004, compared with $775 million, or 2.03% of loans
at June 30, 2004, and $817 million, or 2.18% of loans at September 30, 2003.
The Company has $5.9 billion of secured margin loans on its balance sheet
at September 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 remained
at 2.42% at September 30, 2004, compared with 2.42% at June 30, 2004 and 2.55%
at September 30, 2003, reflecting continued improvement in the credit quality
in the third 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 have continued to improve.
Nonperforming assets declined another 8% this quarter, and have declined
by 26% from a year ago. The Company's criticized and classified loans
experienced a mid-teens decline from the second quarter of 2004 and are down
by approximately half from a year ago.
The ratio of the allowance for loan losses to nonperforming assets was
208.1% at September 30, 2004, up from 192.2% at June 30, 2004, and 191.2% at
December 31, 2003. Included in the Company's allowance for credit losses at
September 30, 2004 is an allocated transfer risk reserve related to Argentina
of $7 million.
The allowance for loan losses and the allowance for lending related
commitments consists of four elements: (1) an allowance for impaired credits
(nonaccrual commercial credits over $1 million), (2) an allowance for higher
risk rated credits, (3) an allowance for pass rated credits, and (4) an
unallocated allowance based on general economic conditions and risk factors in
the Company's individual 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
30
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 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:
September 30, December 31,
2004 2003
------------ -----------
Domestic
Real Estate 2% 2%
Commercial 77 74
Consumer 1 1
Foreign 4 9
Unallocated 16 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.
31
Deposits
- --------
Total deposits were $58.4 billion at September 30, 2004, compared with
$61.1 billion at June 30, 2004 and $58.9 billion at September 30, 2003. The
decrease on a sequential quarter basis was primarily due to lower market
activity levels, which resulted in a lower level of customer deposits at
quarter end. Noninterest-bearing deposits were $15.5 billion at September 30,
2004, compared with $14.8 billion at December 31, 2003. Interest-bearing
deposits were $42.9 billion at September 30, 2004, compared with $41.6 billion
at December 31, 2003.
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; and
- 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 September 30,
2004, the unallocated allowance was 16% of the total allowance. If the
unallocated allowance were five percent higher or lower, the allowance would
have increased or decreased by $38 million, respectively.
32
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 $64 million, while if each
pass credit were rated one grade worse, the allowance would have increased by
$157 million.
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 $21 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 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 September
30, 2004, approximately $2.8 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 $69 million.
Goodwill and Other Intangibles
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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 ($3,386 millio