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Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

(Mark One)

 

x   QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended September 30, 2009

or

 

¨   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission File Number 1-11921

 

 

E*TRADE Financial Corporation

(Exact Name of Registrant as Specified in its Charter)

 

 

 

Delaware   94-2844166

(State or Other Jurisdiction

of Incorporation or Organization)

 

(I.R.S. Employer

Identification Number)

135 East 57th Street, New York, New York 10022

(Address of Principal Executive Offices and Zip Code)

(646) 521-4300

(Registrant’s Telephone Number, including Area Code)

 

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ¨    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer  x

    Accelerated filer  ¨

Non-accelerated filer  ¨ (Do not check if a smaller reporting company)

  Smaller reporting company  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:

As of November 2, 2009, there were 1,865,498,830 shares of common stock outstanding.

 

 

 


Table of Contents

E*TRADE FINANCIAL CORPORATION

FORM 10-Q QUARTERLY REPORT

For the Quarter Ended September 30, 2009

TABLE OF CONTENTS

 

PART I—FINANCIAL INFORMATION

    

Item 1. Consolidated Financial Statements (Unaudited)

   3

Consolidated Statement of Loss

   53

Consolidated Balance Sheet

   54

Consolidated Statement of Comprehensive Loss

   55

Consolidated Statement of Shareholders’ Equity

   56

Consolidated Statement of Cash Flows

   57

Notes to Consolidated Financial Statements (Unaudited)

   59

Note 1—Organization, Basis of Presentation and Summary of Significant Accounting Policies

   59

Note 2—Operating Interest Income and Operating Interest Expense

   66

Note 3—Fair Value Disclosures

   66

Note 4—Available-for-Sale Mortgage-Backed and Investment Securities

   74

Note 5—Loans, Net

   77

Note 6—Accounting for Derivative Instruments and Hedging Activities

   79

Note 7—Deposits

   84

Note 8—Securities Sold Under Agreements to Repurchase and Other Borrowings

   84

Note 9—Corporate Debt

   85

Note 10—Shareholders’ Equity

   86

Note 11—Loss per Share

   88

Note 12—Regulatory Requirements

   88

Note 13—Commitments, Contingencies and Other Regulatory Matters

   90

Note 14—Segment Information

   94

Note 15—Subsequent Events

   99

Item  2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

   3

Overview

   3

Earnings Overview

   8

Segment Results Review

   20

Balance Sheet Overview

   24

Liquidity and Capital Resources

   28

Risk Management

   33

Concentrations of Credit Risk

   34

Summary of Critical Accounting Policies and Estimates

   42

Glossary of Terms

   47

Item 3.   Quantitative and Qualitative Disclosures about Market Risk

   51

Item 4.   Controls and Procedures

   99

PART II —OTHER INFORMATION

    

Item 1.   Legal Proceedings

   99

Item 1A. Risk Factors

   102

Item 2.   Unregistered Sales of Equity Securities and Use of Proceeds

   102

Item 3.   Defaults Upon Senior Securities

   102

Item 4.   Submission of Matters to a Vote of Security Holders

   103

Item 5.   Other Information

   103

Item 6.   Exhibits

   103

Signatures

   104

 

 

Unless otherwise indicated, references to “the Company,” “We,” “Us,” “Our” and “E*TRADE” mean E*TRADE Financial Corporation or its subsidiaries.

E*TRADE, E*TRADE Financial, E*TRADE Bank, Equity Edge, OptionsLink and the Converging Arrows logo are registered trademarks of E*TRADE Financial Corporation in the United States and in other countries.

 

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Table of Contents

ITEM 1.    CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

This information is set forth immediately following Item 3, “Quantitative and Qualitative Disclosures about Market Risk.”

ITEM 2.    MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion should be read in conjunction with the consolidated financial statements and the related notes that appear elsewhere in this document.

FORWARD-LOOKING STATEMENTS

This report contains forward-looking statements involving risks and uncertainties. These statements relate to our future plans, objectives, expectations and intentions. These statements may be identified by the use of words such as “expect,” “may,” “anticipate,” “intend,” “plan” and similar expressions. Our actual results could differ materially from those discussed in these forward-looking statements, and we caution that we do not undertake to update these statements. Factors that could contribute to our actual results differing from any forward-looking statements include those discussed under “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere in this report. The cautionary statements made in this report should be read as being applicable to all forward-looking statements wherever they appear in this report. Important factors that may cause actual results to differ materially from any forward-looking statements are set forth in our 2008 Form 10-K filed with the Securities and Exchange Commission (“SEC”) under the heading “Risk Factors,” as well as the factors set forth in or incorporated by reference in this report under Part II, Item 1A “Risk Factors”.

We further caution that there may be risks associated with owning our securities other than those discussed in such filings.

GLOSSARY OF TERMS

In analyzing and discussing our business, we utilize certain metrics, ratios and other terms that are defined in the “Glossary of Terms,” which is located at the end of Item 2, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

OVERVIEW

Strategy

Our core business is our trading and investing customer franchise. Our strategy is designed to profitably grow this business by focusing on several key factors. These key factors include development of innovative online brokerage products and services, a concerted effort to deliver superior customer service, creative and cost-effective marketing and sales, and expense discipline. In addition, we have and continue to invest significantly for long-term growth so that we remain competitive among the largest online brokers. We believe our focus on these key factors will lead to continued growth in our core business.

In addition to focusing on our customer franchise, our strategy includes an intense focus on addressing the balance sheet issues caused by the mortgage crisis. We are focused primarily on improving our capital structure as well as mitigating the credit losses inherent in our loan portfolio. We believe the recapitalization transactions executed in the second and third quarters of 2009 significantly improve our capital structure and better position the Company for future growth in the online brokerage business.

 

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Key Factors Affecting Financial Performance

Our financial performance is affected by a number of factors outside of our control, including:

 

   

customer demand for financial products and services;

 

   

the weakness or strength of the residential real estate and credit markets;

 

   

the performance, volume and volatility of the equity and capital markets;

 

   

customer perception of the financial strength of our franchise;

 

   

market demand and liquidity in the secondary market for mortgage loans and securities; and

 

   

market demand and liquidity in the wholesale borrowings market, including securities sold under agreements to repurchase.

In addition to the items noted above, our success in the future will depend upon, among other things:

 

   

continuing our success in the acquisition, growth and retention of brokerage customers;

 

   

our ability to assess and manage credit risk;

 

   

our ability to generate capital sufficient to meet our operating needs, particularly at a level sufficient to offset loan losses;

 

   

our ability to assess and manage interest rate risk; and

 

   

disciplined expense control and improved operational efficiency.

Management monitors a number of metrics in evaluating the Company’s performance. The most significant of these are shown in the table and discussed in the text below:

 

    As of or For the
Three Months Ended
September 30,
    Variance     As of or For the
Nine Months Ended
September 30,
    Variance  
    2009     2008     2009 vs. 2008     2009     2008     2009 vs. 2008  

Customer Activity Metrics:

           

Daily average revenue trades

    196,413        183,691      7     204,143        178,814      14

Average commission per trade

  $ 11.50      $ 11.10      4   $ 11.05      $ 11.07      (0 )% 

End of period brokerage accounts

    2,729,137        2,520,102      8     2,729,137        2,520,102      8

Customer assets (dollars in billions)

  $ 148.7      $ 142.2      5   $ 148.7      $ 142.2      5

Net new customer assets (dollars in billions)(1)

  $ (0.2   $ 0.8      *      $ 4.2      $ 2.0      *   

Brokerage related cash (dollars in billions)

  $ 20.3      $ 17.7      15   $ 20.3      $ 17.7      15

Other customer cash and deposits (dollars in billions)

    14.2        15.7      (10 )%      14.2        15.7      (10 )% 
                                   

Customer cash and deposits (dollars in billions)

  $ 34.5      $ 33.4      3   $ 34.5      $ 33.4      3

Company Financial Metrics:

           

Corporate cash (dollars in millions)

  $ 501.1      $ 665.6      (25 )%    $ 501.1      $ 665.6      (25 )% 

E*TRADE Bank excess risk-based capital (dollars in millions)

  $ 985.4      $ 523.9      88   $ 985.4      $ 523.9      88

Allowance for loan losses (dollars in millions)

  $ 1,214.5      $ 874.2      39   $ 1,214.5      $ 874.2      39

Allowance for loan losses as a % of nonperforming loans

    82.37     109.45   (27.08 )%      82.37     109.45   (27.08 )% 

Enterprise net interest spread (basis points)

    282        263      7     269        261      3

Enterprise interest-earning assets (average in billions)

  $ 44.3      $ 46.6      (5 )%    $ 44.7      $ 47.7      (6 )% 

 

 *  

Percentage not meaningful

(1)  

For the nine months ended September 30, 2008, net new customer assets were $2.9 billion excluding the sale of Retirement Advisors of America (“RAA”).

 

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Table of Contents

Customer Activity Metrics

 

   

Daily average revenue trades (“DARTs”) are the predominant driver of commissions revenue from our customers.

 

   

Average commission per trade is an indicator of changes in our customer mix, product mix and/or product pricing. As a result, this metric is impacted by both the mix between our domestic and international businesses and the mix between active traders, mass affluent and main street customers.

 

   

End of period brokerage accounts are an indicator of our ability to attract and retain trading and investing customers.

 

   

Changes in customer assets are an indicator of the value of our relationship with the customer. An increase in customer assets generally indicates that the use of our products and services by existing and new customers is expanding. Changes in this metric are also driven by changes in the valuations of our customers’ underlying securities, which declined substantially towards the end of 2008 and into 2009.

 

   

Net new customer assets are total inflows to all new and existing customer accounts less total outflows from all closed and existing customer accounts and are a general indicator of the use of our products and services by existing and new customers.

 

   

Customer cash and deposits, particularly our brokerage related cash, are an indicator of a deepening engagement with our customers and are a key driver of net operating interest income.

Company Financial Metrics

 

   

Corporate cash is an indicator of the liquidity at the parent company. It is also a source of cash that can be deployed in our regulated subsidiaries.

 

   

E*TRADE Bank excess risk-based capital is the excess capital that E*TRADE Bank has compared to the regulatory minimum well-capitalized threshold and is an indicator of E*TRADE Bank’s ability to absorb future loan losses.

 

   

Allowance for loan losses is an estimate of the losses inherent in our loan portfolio as of the balance sheet date and is typically equal to the expected charge-offs in our loan portfolio over the next twelve months as well as the estimated charge-offs, including economic concessions to borrowers, over the estimated remaining life of loans modified in troubled debt restructurings.

 

   

Allowance for loan losses as a percentage of nonperforming loans is a general indicator of the adequacy of our allowance for loan losses. Changes in this ratio are also driven by changes in the mix of our loan portfolio.

 

   

Enterprise net interest spread is a broad indicator of our ability to generate net operating interest income.

 

   

Enterprise interest-earning assets, in conjunction with our enterprise net interest spread, are indicators of our ability to generate net operating interest income.

Significant Events in the Third Quarter of 2009

Completion of Our Previously Announced $1.7 Billion Debt Exchange

 

   

We obtained shareholder approval for and completed an offer to exchange $1.7 billion aggregate principal amount of our corporate debt, including $1.3 billion principal amount of our 12 1/2% springing lien notes due 2017 (“12 1/2% Notes”) and $0.4 billion principal amount of our 8% Senior Notes due 2011 (“8% Notes”), for an equal principal amount of newly-issued non-interest-bearing convertible debentures (“Debt Exchange”);

 

   

As a result of the Debt Exchange, we reduced our annual corporate interest payments from approximately $360 million to approximately $160 million and eliminated any substantial debt maturities until 2013; and

 

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The completion of the Debt Exchange resulted in a pre-tax non-cash charge of $968.3 million ($772.9 million after tax) and an increase of $707.5 million to additional paid-in capital. The net effect of the exchange to shareholders’ equity was a reduction of $65.4 million. For further details regarding this charge, see Note 1—Organization, Basis of Presentation and Summary of Significant Accounting Policies and Note 9—Corporate Debt of Item 1. Consolidated Financial Statements (Unaudited).

Conversions of the Newly-Issued Convertible Debentures into Equity

 

   

The newly-issued non-interest-bearing convertible debentures are convertible into shares of our common stock at any time at the election of the holder; and

 

   

As of September 30, 2009, $592.3 million principal amount, or 34%, of the convertible debentures had been converted into 572.2 million shares of our common stock(1).

Launched and Completed an At the Market Common Stock Offering

 

   

We raised $150 million in gross proceeds ($147 million in net proceeds) from our common stock offering that was launched and completed in September 2009 (the “At the Market Offering”) in which a total of 80.2 million shares of common stock were issued; and

 

   

The completion of the At the Market Offering brings our total cash equity raised during the second and third quarters of 2009 to $765 million of gross proceeds ($733.2 million in net proceeds).

Summary Financial Results

Income Statement Highlights for the Three and Nine Months Ended September 30, 2009 (dollars in millions, except per share amounts)

 

    Three Months Ended
September 30,
    Variance     Nine Months Ended
September 30,
    Variance  
    2009     2008     2009 vs. 2008     2009     2008     2009 vs. 2008  

Net operating interest income

  $ 321.4      $ 324.8      (1 )%    $ 939.6      $ 993.9      (5 )% 

Commissions

  $ 144.5      $ 129.5      12   $ 424.2      $ 374.0      13

Fees and service charges

  $ 50.4      $ 49.6      2   $ 145.0      $ 155.5      (7 )% 

Principal transactions

  $ 24.9      $ 20.7      20   $ 65.2      $ 59.5      10

Gains (losses) on loans and securities, net

  $ 42.0      $ (141.9   *      $ 150.4      $ (122.4   *   

Net impairment

  $ (19.2   $ (17.9   *      $ (67.7   $ (61.6   *   

Other revenues

  $ 11.4      $ 13.0      (12 )%    $ 36.7      $ 40.3      (9 )% 

Total net revenue

  $ 575.3      $ 377.7      52   $ 1,693.6      $ 1,439.2      18

Provision for loan losses

  $ 347.2      $ 517.8      (33 )%    $ 1,205.7      $ 1,070.8      13

Total operating expense

  $ 301.7      $ 295.9      2   $ 924.9      $ 968.8      (5 )% 

Operating margin

  $ (73.6   $ (436.0   *      $ (437.1   $ (600.4   *   

Net loss from continuing operations

  $ (831.7   $ (320.8   *      $ (1,207.6   $ (533.2   *   

Less: net loss on the Debt Exchange

    (772.9     —        *        (772.9     —        *   
                                   

Net loss from continuing operations excluding the Debt Exchange(2)

  $ (58.8   $ (320.8   *      $ (434.7   $ (533.2   *   
                                   

Diluted net loss per share from continuing operations

  $ (0.66   $ (0.60   *      $ (1.45   $ (1.07   *   

Less: diluted net loss per share on the Debt Exchange

    (0.61     —        *        (0.93     —        *   
                                   

Diluted net loss per share from continuing operations excluding the Debt Exchange(2)

  $ (0.05   $ (0.60   *      $ (0.52   $ (1.07   *   
                                   

 

 *  

Percentage not meaningful

(1)  

As of October 26, 2009, a total of $688.2 million of the convertible debentures had been converted into 664.9 million shares of common equity.

(2)  

Net loss excluding the non-cash charge on the Debt Exchange represents net loss plus the non-cash charge on the Debt Exchange, net of tax and is a non-GAAP measure. Loss per share excluding the non-cash charge on the Debt Exchange represents net loss plus the non-cash charge on the Debt Exchange, net of tax, divided by diluted shares and is a non-GAAP measure. Management believes that excluding the non-cash charge associated with the Debt Exchange from net loss and loss per share provides a useful additional measure of the Company’s ongoing operating performance because the charge is not directly related to our performance and is non-recurring. The reconciliation of these non-GAAP measures is provided in the table above.

 

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During the third quarter of 2009, our brokerage business continued to perform very well, increasing the level of income generated in the trading and investing segment as well as achieving record levels of brokerage accounts. This strong performance was more than offset by the provision for loan losses reported in our balance sheet management segment. Although we expect our provision for loan losses to continue at historically high levels in future periods, the level of provision for loan losses in the third quarter of 2009 represents the fourth consecutive quarter in which the provision for loan losses has declined when compared to the prior quarter. While we cannot state with certainty that this trend will continue, we believe it is a positive indicator that our loan portfolio may be stabilizing.

We also continued to make significant progress during the third quarter of 2009 on our comprehensive plan to strengthen the Company’s capital structure. We obtained shareholder approval for and completed an offer to exchange $1.7 billion aggregate principal amount of our corporate debt, including $1.3 billion principal amount of the 12 1/2% Notes and $0.4 billion principal amount of the 8% Notes, for an equal principal amount of newly-issued non-interest-bearing convertible debentures. The Debt Exchange resulted in a $968.3 million pre-tax non-cash loss on extinguishment of debt and an increase to additional paid-in capital of $707.5 million during the third quarter of 2009. The net effect of the Debt Exchange to shareholders’ equity was a reduction of $65.4 million(1). As a result of the completion of this exchange, we reduced our annual corporate interest payments from approximately $360 million to approximately $160 million and eliminated any substantial debt maturities until 2013.

In addition to the Debt Exchange, we successfully raised an additional $147.0 million in net proceeds from our At the Market Offering. The completion of this offering brings our total cash equity raised during the second and third quarters of 2009 to $765 million of gross proceeds (net proceeds of $733.2 million).

Balance Sheet Highlights (dollars in millions)

 

     September 30,
2009
    December 31,
2008
    Variance  
       2009 vs. 2008  

Total assets

   $ 48,487.0      $ 48,538.2      (0 )% 

Less: Goodwill and other intangibles, net

     (2,316.2     (2,324.5   (0 )% 

Add: Deferred tax liability related to goodwill

     158.1        127.7      24
                  

Tangible assets(2)

   $ 46,328.9      $ 46,341.4      (0 )% 
                  

Loans, net

   $ 20,260.0      $ 24,451.9      (17 )% 

Corporate debt(3)

      

Interest-bearing

   $ 1,537.0      $ 3,150.4      (51 )% 

Non-interest-bearing

   $ 1,149.6      $ —        *   

Shareholders’ equity

   $ 3,645.9      $ 2,591.5      41

Less: Goodwill and other intangibles, net

     (2,316.2     (2,324.5   (0 )% 

Add: Deferred tax liability related to goodwill

     158.1        127.7      24
                  

Tangible common equity(4)

   $ 1,487.8      $ 394.7      277
                  

Tangible common equity to tangible assets(5)

     3.21     0.85   2.36

 

 *  

Percentage not meaningful

(1)  

For further details regarding the loss on extinguishment of debt, see “Earnings Overview” in Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations, Note 1—Organization, Basis of Presentation and Summary of Significant Accounting Policies and Note 9—Corporate Debt of Item 1. Consolidated Financial Statements (Unaudited).

(2)  

Tangible assets is calculated as total assets less goodwill, net of related deferred tax liability and intangible assets and is a non-GAAP measure. Management believes that tangible assets is a measure of the Company’s capital strength and is additional useful information that supplements the regulatory capital ratios of E*TRADE Bank.

(3)  

The corporate debt balances represent the amount of principal outstanding.

(4)  

Tangible common equity is calculated as shareholders’ equity less goodwill, net of related deferred tax liability and intangible assets and is a non-GAAP measure. Management believes that tangible common equity is a measure of the Company’s capital strength and is additional useful information that supplements the regulatory capital ratios of E*TRADE Bank.

(5)  

Tangible common equity to tangible assets is calculated as shareholders’ equity less goodwill, net of related deferred tax liability and intangible assets divided by total assets less goodwill, net of related deferred tax liability and intangible assets and is a non-GAAP measure. Management believes that tangible common equity to tangible assets is a measure of the Company’s capital strength and is additional useful information that supplements the regulatory capital ratios of E*TRADE Bank.

 

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During the third quarter of 2009, we exchanged $1.7 billion principal amount of our interest-bearing debt for an equal principal amount of non-interest-bearing convertible debentures. Subsequent to the Debt Exchange, $592.3 million debentures were converted into 572.2 million shares of common stock during the quarter ended September 30, 2009. The considerable increase in tangible common equity during the period was a result of the common stock issued in connection with our equity offerings and the debt conversions that occurred in the third quarter of 2009.

EARNINGS OVERVIEW

We incurred a net loss of $831.7 million and $1.2 billion for the three and nine months ended September 30, 2009, respectively. The net loss for the three and nine months ended September 30, 2009 was due principally to the Debt Exchange that resulted in a non-cash loss of $772.9 million (pre-tax loss of $968.3 million) on early extinguishment of debt during the third quarter of 2009. Our brokerage business continued to perform very well, resulting in trading and investing segment income of $202.5 million and $502.8 million for the three and nine months ended September 30, 2009, respectively. However, the provision for loan losses in our balance sheet management segment more than offset this strong performance, resulting in an overall segment loss of $276.1 million and $939.8 million for the three and nine months ended September 30, 2009, respectively.

On April 1, 2009, we adopted the amended guidance for the recognition of other-than-temporary impairment (“OTTI”) for debt securities as well as the presentation of OTTI on the consolidated financial statements. As a result of the adoption, we recognized a $20.2 million after-tax increase to beginning retained earnings and a corresponding offset in accumulated other comprehensive loss on our consolidated balance sheet. This adjustment represents the after-tax difference between the impairment reported in prior periods for securities on our balance sheet as of April 1, 2009 and the level of impairment that would have been recorded on these same securities under the new accounting guidance. Additionally, in accordance with the new guidance, we changed the presentation of the consolidated statement of loss to state “Net impairment” as a separate line item, as well as the credit and noncredit components of net impairment. Prior to this new presentation, OTTI was included in the “Gains (losses) on loans and securities, net” line item on the consolidated statement of loss.

During the third quarter of 2009, we added a new operating expense line item to the consolidated statement of loss for Federal Deposit Insurance Corporation (“FDIC”) insurance premiums. During the nine months ended September 30, 2009, these expenses increased to a level at which we believe a separate line item on the consolidated statement of loss is appropriate. FDIC insurance premium expenses were previously presented in the “Other operating expenses” line item.

We report corporate interest income and corporate interest expense separately from operating interest income and operating interest expense. We believe reporting these two items separately provides a clearer picture of the financial performance of our operations than would a presentation that combined these two items. Our operating interest income and operating interest expense is generated from the operations of the Company. Our corporate debt, which is the primary source of our corporate interest expense, has been issued primarily in connection with our transaction with Citadel Investment Group LLC and its affiliates (“Citadel”) in 2007 and past acquisitions, such as Harrisdirect and BrownCo.

Similarly, we report gains (losses) on sales of investments, net separately from gains (losses) on loans and securities, net. We believe reporting these two items separately provides a clearer picture of the financial performance of our operations than would a presentation that combined these two items. Gains (losses) on loans and securities, net are the result of activities in our operations, namely our balance sheet management segment. Gains (losses) on sales of investments, net relate to historical equity investments of the Company at the corporate level and are not related to the ongoing business of our operating subsidiaries.

 

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The following sections describe in detail the changes in key operating factors and other changes and events that have affected our consolidated revenue, provision for loan losses, operating expense, other income (expense) and income tax benefit.

Revenue

The components of net revenue and the resulting variances are as follows (dollars in thousands):

 

    Three Months Ended
September 30,
    Variance     Nine Months Ended
September 30,
    Variance  
    2009 vs. 2008       2009 vs. 2008  
    2009     2008     Amount     %     2009     2008     Amount     %  

Revenue:

               

Net operating interest income

  $ 321,378      $ 324,774      $ (3,396   (1 )%    $ 939,630      $ 993,909      $ (54,279   (5 )% 

Commissions

    144,533        129,513        15,020      12     424,222        374,003        50,219      13

Fees and service charges

    50,373        49,612        761      2     145,022        155,515        (10,493   (7 )% 

Principal transactions

    24,888        20,664        4,224      20     65,223        59,546        5,677      10

Gains (losses) on loans and securities, net

    41,979        (141,915     183,894      *        150,439        (122,434     272,873      *   

Net impairment

    (19,229     (17,884     (1,345   *        (67,683     (61,639     (6,044   *   

Other revenues

    11,405        12,968        (1,563   (12 )%      36,723        40,263        (3,540   (9 )% 
                                                   

Total non-interest income

    253,949        52,958        200,991      380     753,946        445,254        308,692      69
                                                   

Total net revenue

  $ 575,327      $ 377,732      $ 197,595      52   $ 1,693,576      $ 1,439,163      $ 254,413      18
                                                   

 

*   Percentage not meaningful

Total net revenue increased 52% to $575.3 million and 18% to $1.7 billion for the three and nine months ended September 30, 2009, respectively, compared to the same periods in 2008. This was driven by our gains (losses) on loans and securities, net, which increased from net losses of $141.9 million to net gains of $42.0 million and from net losses of $122.4 million to net gains of $150.4 million for the three and nine months ended September 30, 2009, respectively, compared to the same periods in 2008. Commission revenue also increased 12% to $144.5 million and 13% to $424.2 million for the three and nine months ended September 30, 2009, respectively, compared to the same periods in 2008.

Net Operating Interest Income

Net operating interest income decreased 1% to $321.4 million and 5% to $939.6 million for the three and nine months ended September 30, 2009, respectively, compared to the same periods in 2008. Net operating interest income is earned primarily through holding credit balances, which include margin, real estate and consumer loans, and by holding customer cash and deposits, which are a low cost source of funding. The slight decrease in net operating interest income was due primarily to a decrease in our average interest earning assets of $2.3 billion and $3.0 billion for the three and nine months ended September 30, 2009, respectively, compared to the same periods in 2008, which was mostly offset by a decrease in the yields paid on our deposits for both the three and nine months ended September 30, 2009.

 

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The following table presents enterprise average balance sheet data and enterprise income and expense data for our operations, as well as the related net interest spread, yields and rates and has been prepared on the basis required by the SEC’s Industry Guide 3, “Statistical Disclosure by Bank Holding Companies” (dollars in thousands):

 

    Three Months Ended September 30,  
    2009     2008  
    Average
Balance
  Operating
Interest
Inc./Exp.
  Average
Yield/
Cost
    Average
Balance
  Operating
Interest
Inc./Exp.
  Average
Yield/
Cost
 

Enterprise interest-earning assets:

           

Loans(1)

  $ 22,527,378   $ 276,846   4.92   $ 26,928,190   $ 379,195   5.63

Margin receivables

    3,197,894     37,832   4.69     6,420,090     72,291   4.48

Available-for-sale mortgage-backed securities

    9,584,503     99,518   4.15     9,494,421     108,511   4.57

Available-for-sale investment securities

    761,969     6,078   3.19     131,332     2,140   6.52

Trading securities

    14,870     680   18.30     272,677     3,211   4.71

Cash and cash equivalents(2)

    7,511,328     4,894   0.26     2,630,478     17,850   2.70

Stock borrow and other

    689,693     11,085   6.38     741,127     14,531   7.80
                           

Total enterprise interest-earning assets

    44,287,635     436,933   3.94     46,618,315     597,729   5.12
                   

Non-operating interest-earning assets(3)

    3,941,934         4,694,410    
                   

Total assets

  $ 48,229,569       $ 51,312,725    
                   

Enterprise interest-bearing liabilities:

           

Retail deposits

  $ 26,329,314     35,487   0.53   $ 26,151,874     136,148   2.07

Brokered certificates of deposit

    138,513     1,833   5.25     883,289     10,984   4.95

Customer payables

    5,070,584     2,127   0.17     4,368,391     7,444   0.68

Repurchase agreements and other borrowings

    6,901,475     48,527   2.75     7,581,472     71,648   3.70

Federal Home Loan Bank (“FHLB”) advances

    2,559,578     30,150   4.61     4,166,643     50,062   4.70

Stock loan and other

    571,406     517   0.36     1,055,662     2,848   1.07
                           

Total enterprise interest-bearing liabilities

    41,570,870     118,641   1.12     44,207,331     279,134   2.49
                   

Non-operating interest-bearing liabilities(4)

    3,637,656         4,550,263    
                   

Total liabilities

    45,208,526         48,757,594    

Total shareholders’ equity

    3,021,043         2,555,131    
                   

Total liabilities and shareholders’ equity

  $ 48,229,569       $ 51,312,725    
                   

Excess of enterprise interest-earning assets over enterprise interest-bearing liabilities/Enterprise net interest income/Spread

  $ 2,716,765   $ 318,292   2.82   $ 2,410,984   $ 318,595   2.63
                           

Enterprise net interest margin (net yield on enterprise interest-earning assets)

      2.87       2.73

Ratio of enterprise interest-earning assets to enterprise interest-bearing liabilities

      106.54       105.45

Return on average:

           

Total assets

      (6.90 )%        (0.39 )% 

Total shareholders’ equity

      (110.12 )%        (7.90 )% 

Average equity to average total assets

      6.26       4.98

Reconciliation from enterprise net interest income to net operating interest income (dollars in thousands):

 

     Three Months
Ended
September 30,
 
     2009     2008  

Enterprise net interest income(5)

   $ 318,292      $ 318,595   

Taxable equivalent interest adjustment

     (333     (1,526

Customer cash held by third parties and other(6)

     3,419        7,705   
                

Net operating interest income

   $ 321,378      $ 324,774   
                

 

(1)  

Loans represent the gross loan balances including premium/discount but excluding the allowance for loan losses. Nonaccrual loans are included in the respective average loan balances. Income on such nonaccrual loans is recognized on a cash basis.

(2)  

Includes segregated cash and investment balances.

(3)  

Non-operating interest-earning assets consist of property and equipment, net, goodwill, other intangibles, net, other assets that do not generate operating interest income. Some of these assets generate corporate interest income.

(4)  

Non-operating interest-bearing liabilities consist of corporate debt, accounts payable, accrued and other liabilities that do not generate operating interest expense. Some of these liabilities generate corporate interest expense.

(5)  

Enterprise net interest income is taxable equivalent basis net operating interest income excluding corporate interest income and corporate interest expense and interest earned on customer cash held by third parties. Management believes this non-GAAP measure is useful to analysts and investors as it is a measure of the net interest income generated by our operations.

(6)  

Includes interest earned on average customer assets of $3.0 billion and $3.3 billion for the three months ended September 30, 2009 and 2008, respectively, held by parties outside E*TRADE Financial, including third party money market funds and sweep deposit accounts at unaffiliated financial institutions.

 

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     Nine Months Ended September 30,  
     2009     2008  
     Average
Balance
   Operating
Interest
Inc./Exp.
   Average
Yield/
Cost
    Average
Balance
   Operating
Interest
Inc./Exp.
   Average
Yield/
Cost
 

Enterprise interest-earning assets:

                

Loans(1)

   $ 23,824,135    $ 882,683    4.94   $ 28,354,314    $ 1,232,872    5.80

Margin receivables

     2,907,877      96,181    4.42     6,633,365      238,610    4.80

Available-for-sale mortgage-backed securities

     10,845,173      352,790    4.34     9,141,068      317,170    4.63

Available-for-sale investment securities

     382,902      11,374    3.96     144,550      7,123    6.57

Trading securities

     24,590      1,851    10.04     457,320      23,070    6.73

Cash and cash equivalents(2)

     6,092,829      15,354    0.34     2,155,474      49,460    3.07

Stock borrow and other

     654,323      40,804    8.34     814,133      46,698    7.66
                                

Total enterprise interest-earning assets

     44,731,829      1,401,037    4.18     47,700,224      1,915,003    5.35
                        

Non-operating interest-earning assets(3)

     3,850,848           5,218,220      
                        

Total assets

   $ 48,582,677         $ 52,918,444      
                        

Enterprise interest-bearing liabilities:

                

Retail deposits

   $ 26,588,811      179,557    0.90   $ 25,871,958      445,210    2.30

Brokered certificates of deposit

     214,926      8,293    5.16     1,081,185      40,337    4.98

Customer payables

     4,455,148      7,027    0.21     4,422,244      25,303    0.76

Repurchase agreements and other borrowings

     7,303,376      170,209    3.07     7,678,211      235,212    4.02

FHLB advances

     3,101,768      105,506    4.49     4,920,804      172,473    4.61

Stock loan and other

     499,183      1,893    0.51     1,291,261      16,742    1.73
                                

Total enterprise interest-bearing liabilities

     42,163,212      472,485    1.49     45,265,663      935,277    2.74
                        

Non-operating interest-bearing liabilities(4)

     3,689,948           4,937,795      
                        

Total liabilities

     45,853,160           50,203,458      

Total shareholders’ equity

     2,729,517           2,714,986      
                        

Total liabilities and shareholders’ equity

   $ 48,582,677         $ 52,918,444      
                        

Excess of enterprise interest-earning assets over enterprise interest-bearing liabilities/Enterprise net interest income/Spread

   $ 2,568,617    $ 928,552    2.69   $ 2,434,561    $ 979,726    2.61
                                

Enterprise net interest margin (net yield on enterprise interest-earning assets)

         2.77         2.74

Ratio of enterprise interest-earning assets to enterprise interest-bearing liabilities

         106.09         105.38

Return on average:

                

Total assets

         (3.31 )%          (0.60 )% 

Total shareholders’ equity

         (58.99 )%          (11.60 )% 

Average equity to average total assets

         5.62         5.13

Reconciliation from enterprise net interest income to net operating interest income (dollars in thousands):

 

     Nine Months Ended
September 30,
 
     2009     2008  

Enterprise net interest income(5)

   $ 928,552      $ 979,726   

Taxable equivalent interest adjustment

     (1,763     (8,429

Customer cash held by third parties and other(6)

     12,841        22,612   
                

Net operating interest income

   $ 939,630      $ 993,909   
                

 

(1)  

Loans represent the gross loan balances including premium/discount but excluding the allowance for loan losses. Nonaccrual loans are included in the respective average loan balances. Income on such nonaccrual loans is recognized on a cash basis.

(2)  

Includes segregated cash and investment balances.

(3)  

Non-operating interest-earning assets consist of property and equipment, net, goodwill, other intangibles, net, other assets that do not generate operating interest income. Some of these assets generate corporate interest income.

(4)  

Non-operating interest-bearing liabilities consist of corporate debt, accounts payable, accrued and other liabilities that do not generate operating interest expense. Some of these liabilities generate corporate interest expense.

(5)  

Enterprise net interest income is taxable equivalent basis net operating interest income excluding corporate interest income and corporate interest expense and interest earned on customer cash held by third parties. Management believes this non-GAAP measure is useful to analysts and investors as it is a measure of the net interest income generated by our operations.

(6)  

Includes interest earned on average customer assets of $2.9 billion and $3.3 billion for the nine months ended September 30, 2009 and 2008, respectively, held by parties outside E*TRADE Financial, including third party money market funds and sweep deposit accounts at unaffiliated financial institutions.

 

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Average enterprise interest-earning assets decreased 5% to $44.3 billion and 6% to $44.7 billion for the three and nine months ended September 30, 2009, respectively, compared to the same periods in 2008. This decrease was primarily a result of the decrease in our loans, net portfolio and our margin receivables, partially offset by an increase in cash and equivalents. Average loans, net decreased 16% to $22.5 billion and 16% to $23.8 billion for the three and nine months ended September 30, 2009, respectively, compared to the same periods in 2008. For the foreseeable future, we plan to allow our loan portfolio to pay down. Average margin receivables decreased 50% to $3.2 billion and 56% to $2.9 billion for the three and nine months ended September 30, 2009, respectively, compared to the same periods in 2008. We believe this decrease was due to customers deleveraging and reducing their risk exposure given the substantial volatility in the financial markets. These decreases were offset by an increase in average cash and cash equivalents. Average cash and cash equivalents increased 186% to $7.5 billion and 183% to $6.1 billion for the three and nine months ended September 30, 2009, respectively, compared to the same periods in 2008.

Average enterprise interest-bearing liabilities decreased 6% to $41.6 billion and 7% to $42.2 billion for the three and nine months ended September 30, 2009, respectively, compared to the same periods in 2008. The decrease in average enterprise interest-bearing liabilities was primarily due to a decrease in FHLB advances, brokered certificates of deposit and stock loan and other. Average FHLB advances decreased 39% to $2.6 billion and 37% to $3.1 billion for the three and nine months ended September 30, 2009, respectively, compared to the same periods in 2008. Brokered certificates of deposit decreased 84% to $0.1 billion and 80% to $0.2 billion for the three and nine months ended September 30, 2009, respectively, compared to the same periods in 2008. Average stock loan and other decreased 46% to $0.6 billion and 61% to $0.5 billion for the three and nine months ended September 30, 2009, compared to the same periods in 2008. While our average retail deposits increased by $0.2 billion and $0.7 billion for the three and nine months ended September 30, 2009, respectively, when compared to the same periods in 2008, we expect the non-sweep deposit balances to decrease over the remainder of 2009.

Enterprise net interest spread increased by 19 basis points to 2.82% and 8 basis points to 2.69% for the three and nine months ended September 30, 2009, respectively, compared to the same periods in 2008. This increase was largely driven by a decrease in the yields paid on our deposits and lower wholesale borrowing costs, partially offset by a decrease in higher yielding enterprise interest-earning assets.

Commissions

Commissions revenue increased 12% to $144.5 million and 13% to $424.2 million for the three and nine months ended September 30, 2009, respectively, compared to the same periods in 2008. The main factors that affect our commissions revenue are DARTs, average commission per trade and the number of trading days during the period. Average commission per trade is impacted by both trade types and the mix between our domestic and international businesses. Each business has a different pricing structure, unique to its customer base and local market practices and, as a result, a change in the relative number of executed trades in these businesses impacts average commission per trade. Each business also has different trade types (e.g. equities, options, fixed income, exchange-traded funds, contract for difference and mutual funds) that can have different commission rates. Accordingly, changes in the mix of trade types within either of these businesses may impact average commission per trade.

DARTs increased 7% to 196,413 and 14% to 204,143 for the three and nine months ended September 30, 2009, respectively, compared to the same periods in 2008. Our U.S. DART volume increased 8% and 16% for the three and nine months ended September 30, 2009, respectively, compared to the same periods in 2008, driven entirely by organic growth. Option-related DARTs as a percentage of our total U.S. DARTs represented 12% and 16% of U.S. trading volume for the nine months ended September 30, 2009 and 2008, respectively. Exchange-traded funds-related DARTs as a percentage of our total U.S. DARTs represented 14% and 9% of U.S. trading volume for the nine months ended September 30, 2009 and 2008, respectively.

 

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Table of Contents

Average commission per trade increased 4% to $11.50 and decreased slightly to $11.05 for the three and nine months ended September 30, 2009, respectively, compared to the same periods in 2008. The increase in the average commission per trade for the third quarter was due primarily to the product and customer mix when compared to same period in 2008. The slight decrease in the average commission per trade for the nine months ended September 30, 2009, was primarily a function of international product mix and the impact of foreign currency exchange as a result of the strengthening U.S. dollar, partially offset by an improvement in domestic product and customer mix, compared to the same period in 2008.

Fees and Service Charges

Fees and service charges increased 2% to $50.4 million and decreased 7% to $145.0 million for the three and nine months ended September 30, 2009, respectively, compared to the same periods in 2008. The increase in the third quarter of 2009 was primarily due to an increase in order flow revenue which was partially offset by a decrease in account service fees, compared to the same period in 2008. For the nine months ended September 30, 2009, the decline was driven by a decrease in account service fee and advisory management fee revenue, which was partially offset by an increase in order flow revenue, compared to the same period in 2008. The decrease in advisory management fees was primarily due to our sale of RAA in the second quarter of 2008. Declines in foreign currency margin revenue, fixed income product revenue and mutual fund fees also contributed to the decrease in fees and service charges.

Principal Transactions

Principal transactions increased 20% to $24.9 million and 10% to $65.2 million for the three and nine months ended September 30, 2009, respectively, compared to the same periods in 2008. Our principal transactions revenue is influenced by overall trading volumes, the number of stocks for which we act as a market-maker, the trading volumes of those specific stocks and the performance of our proprietary trading activities. The increase in principal transactions revenue was driven by an increase in the volume of equity shares that were traded, which was partially offset by a decrease in our average revenue earned per share traded for the three and nine months ended September 30, 2009, respectively.

Gains (Losses) on Loans and Securities, Net

Gains (losses) on loans and securities, net were gains of $42.0 million and $150.4 million for the three and nine months ended September 30, 2009, respectively, as shown in the following table (dollars in thousands):

 

    Three Months Ended
September 30,
    Variance     Nine Months Ended
September 30,
    Variance  
    2009 vs. 2008       2009 vs. 2008  
    2009     2008     Amount     %     2009     2008     Amount     %  

Losses on sales of loans, net

  $ (12,629   $ —        $ (12,629   *      $ (12,552   $ (783   $ (11,769   *   

Gains on securities and other investments, net

    48,303        5,489        42,814      780     157,133        17,966        139,167      775

Gains (losses) on trading securities, net

    6,174        (147,777     153,951      *        5,336        (142,508     147,844      *   

Hedge ineffectiveness

    131        373        (242   (65 )%      522        2,891        (2,369   (82 )% 
                                                   

Gains (losses) on securities, net

    54,608        (141,915     196,523      *        162,991        (121,651     284,642      *   
                                                   

Gains (losses) on loans and securities, net

  $ 41,979      $ (141,915   $ 183,894      *      $ 150,439      $ (122,434   $ 272,873      *   
                                                   

 

*   Percentage not meaningful

 

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The gains on loans and securities, net for the three and nine months ended September 30, 2009, were due primarily to gains on the sale of certain agency mortgage-backed securities, which were partially offset by net losses on the sales of loans. The losses on the sales of loans were due to the sale of a $0.4 billion pool of home equity loans during the three months ended September 30, 2009. We purchased this particular pool of loans from the originator of the loans in a prior period. This same originator, who continued to service the loans subsequent to our purchase, made an unsolicited offer to repurchase the loans back from us at a price of 98% of the balance of the loan portfolio and we accepted this offer. We believe transactions of this nature are rare and are unlikely to occur again in future periods. The losses on loans and securities, net during the three and nine months ended September 30, 2008 were due to losses on our preferred stock in Federal National Mortgage Association (“Fannie Mae”) and Federal Home Loan Mortgage Corporation (“Freddie Mac”).

Net Impairment

In accordance with the OTTI accounting guidance that became effective in the second quarter of 2009, we changed the presentation of the consolidated statement of loss to state “Net impairment” as a separate line item, as well as the credit and noncredit components of net impairment. Prior to this new presentation, OTTI was included in the “Gains (losses) on loans and securities, net” line item on the consolidated statement of loss.

We recognized $19.2 million and $67.7 million of net impairment during the three and nine months ended September 30, 2009, respectively, on certain securities in our non-agency collateralized mortgage obligation (“CMO”) portfolio due to continued deterioration in the expected credit performance of the underlying loans in the securities. The net impairment included gross OTTI of $9.3 million and $227.8 million for the three and nine months ended September 30, 2009. For the three months ended September 30, 2009, net impairment included $9.9 million of previously recognized noncredit OTTI that was reclassified from accumulated other comprehensive loss into earnings. Of the $227.8 million of gross OTTI for the nine months ended September 30, 2009, $160.2 million related to the noncredit portion of OTTI, which was recorded through other comprehensive income (loss).

We had net impairment of $17.9 million and $61.6 million for the three and nine months ended September 30, 2008, which represented the total decline in the fair value of impaired securities in accordance with the OTTI accounting guidance that was in effect prior to April 1, 2009.

Other Revenues

Other revenues decreased 12% to $11.4 million and 9% to $36.7 million for the three and nine months ended September 30, 2009, respectively, compared to the same periods in 2008. The decrease in other revenue was driven by lower software consulting fees from our Corporate Services business.

Provision for Loan Losses

Provision for loan losses decreased $170.6 million to $347.2 million and increased $134.9 million to $1.2 billion for the three and nine months ended September 30, 2009, respectively, compared to the same periods in 2008. The provision for loan losses for the three and nine months ended September 30, 2009 was due primarily to the high levels of delinquent loans in our one- to four-family and home equity loan portfolios. We believe the delinquencies in both of these portfolios were caused by several factors, including: home price depreciation in key markets; growing inventories of unsold homes; rising foreclosure rates; significant contraction in the availability of credit; and a general decline in economic growth. In addition, the combined impact of home price depreciation and the reduction of available credit made it increasingly difficult for borrowers to refinance existing loans. Although we expect these factors will cause the provision for loan losses to continue at historically high levels in future periods, the level of provision for loan losses in the third quarter of 2009 represents the fourth consecutive quarter in which the provision for loan losses has declined when compared to the prior quarter. While we cannot state with certainty that this trend will continue, we believe it is a positive indicator that our loan portfolio may be stabilizing.

 

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Table of Contents

Operating Expense

The components of operating expense and the resulting variances are as follows (dollars in thousands):

 

    Three Months Ended
September 30,
  Variance     Nine Months Ended
September 30,
  Variance  
    2009 vs. 2008       2009 vs. 2008  
  2009   2008   Amount     %     2009   2008   Amount     %  

Operating expense:

               

Compensation and benefits

  $ 97,984   $ 83,644   $ 14,340      17   $ 272,181   $ 302,854   $ (30,673   (10 )% 

Clearing and servicing

    43,245     46,105     (2,860   (6 )%      129,988     137,112     (7,124   (5 )% 

Advertising and market development

    19,438     30,381     (10,943   (36 )%      88,015     130,566     (42,551   (33 )% 

FDIC insurance premiums

    19,993     7,721     12,272      159     74,834     24,172     50,662      210

Communications

    20,502     23,029     (2,527   (11 )%      63,065     72,623     (9,558   (13 )% 

Professional services

    20,592     16,862     3,730      22     61,696     66,256     (4,560   (7 )% 

Occupancy and equipment

    19,569     20,470     (901   (4 )%      59,082     62,666     (3,584   (6 )% 

Depreciation and amortization

    21,149     20,569     580      3     62,638     62,607     31      0

Amortization of other intangibles

    7,433     7,937     (504   (6 )%      22,303     27,982     (5,679   (20 )% 

Facility restructuring and other exit activities

    2,497     5,526     (3,029   (55 )%      6,832     28,525     (21,693   (76 )% 

Other operating expenses

    29,312     33,646     (4,334   (13 )%      84,290     53,403     30,887      58
                                           

Total operating expense

  $ 301,714   $ 295,890   $ 5,824      2   $ 924,924   $ 968,766   $ (43,842   (5 )% 
                                           

Operating expense increased 2% to $301.7 million and decreased 5% to $924.9 million for the three and nine months ended September 30, 2009, respectively, compared to the same periods in 2008. The fluctuation was driven by an increase in variable compensation and FDIC insurance premiums during the three months ended September 30, 2009, compared to the three months ended September 30, 2008. The decrease during the nine months ended September 30, 2009, was driven by a decrease in compensation and benefits and advertising and market development, partially offset by an increase in FDIC insurance premiums, compared to the nine months ended September 30, 2008.

Compensation and Benefits

Compensation and benefits increased 17% to $98.0 million and decreased 10% to $272.2 million for the three and nine months ended September 30, 2009, respectively, compared to the same periods in 2008. The increase for the three months ended September 30, 2009 was due to an increase in variable compensation as a result of our strong trading and investing segment results, compared to the three months ended September 30, 2008. The decrease for the nine months ended September 30, 2009 resulted primarily from lower salary expense due to a reduction in our employee base compared to the nine months ended September 30, 2008.

Advertising and Market Development

Advertising and market development expense decreased 36% to $19.4 million and 33% to $88.0 million for the three and nine months ended September 30, 2009, respectively, compared to the same periods in 2008. This decrease was due to higher expense in the first half of 2008 that was aimed at restoring customer confidence as well as an overall decline in advertising rates in the three and nine months ended September 30, 2009.

FDIC Insurance Premiums

FDIC insurance premiums increased 159% to $20.0 million and 210% to $74.8 million for the three and nine months ended September 30, 2009, respectively, compared to the same periods in 2008. The increase was primarily due to an increase in the ongoing FDIC insurance rates as well as an industry wide special assessment of $21.6 million in the second quarter of 2009.

 

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Other Operating Expenses

Other operating expenses decreased 13% to $29.3 million and increased 58% to $84.3 million for the three and nine months ended September 30, 2009, respectively, compared to the same periods in 2008. The decrease during the three months ended September 30, 2009, was primarily due to a decrease in our fraud related expenses, compared to the same period in 2008. The increase for the nine months ended September 30, 2009, was primarily due to a $23.7 million gain on the sale of our corporate aircraft related assets during the nine months ended September 30, 2008, which reduced other operating expenses during that period.

Other Income (Expense)

Other income (expense) increased to an expense of $1.1 billion and $1.3 billion for the three and nine months ended September 30, 2009, respectively, compared to the same periods in 2008, as shown in the following table (dollars in thousands):

 

    Three Months Ended
September 30,
    Variance     Nine Months Ended
September 30,
    Variance  
    2009 vs. 2008       2009 vs. 2008  
  2009     2008     Amount     %     2009     2008     Amount     %  

Other income (expense):

               

Corporate interest income

  $ 192      $ 1,387      $ (1,195   (86 )%    $ 793      $ 5,619      $ (4,826   (86 )% 

Corporate interest expense

    (69,035     (88,772     19,737      (22 )%      (242,791     (274,262     31,471      (11 )% 

Gains (losses) on sales of investments, net

    —          (213     213      *        (2,025     307        (2,332   *   

Loss on the Debt Exchange

    (968,254     —          (968,254   *        (968,254     —          (968,254   *   

Gains (losses) on extinguishment of FHLB advances and other

    (37,239     —          (37,239   *        (50,594     10,084        (60,678   *   
                                                   

Gains (losses) on early extinguishment of debt

    (1,005,493     —          (1,005,493   *        (1,018,848     10,084        (1,028,932   *   

Equity in income (loss) of investments and venture funds

    (3,404     21,965        (25,369   *        (6,972     25,070        (32,042   *   
                                                   

Total other income (expense)

  $ (1,077,740   $ (65,633   $ (1,012,107   *      $ (1,269,843   $ (233,182   $ (1,036,661   *   
                                                   

 

*   Percentage not meaningful

Total other income (expense) for the three and nine months ended September 30, 2009 decreased significantly as a result of the $968.3 million pre-tax non-cash loss on the early extinguishment of debt related to our Debt Exchange. The loss on the Debt Exchange resulted from the de-recognition of the debt that was exchanged and the corresponding recognition of the newly-issued non-interest-bearing convertible debentures at fair value. The loss was composed of two main components: 1) the difference between the fair value of the newly-issued convertible debentures and the face amount of the exchanged debt, which resulted in a $725.0 million premium on the new debt; and 2) the realization of the $243.3 million discount on the debt that was exchanged. The fair value(1) of the newly-issued convertible debentures was greater than the face amount of the debt that was exchanged primarily due to the significant increase in our stock price from June 22, 2009, the date on which the conversion price was established, to August 25, 2009, the date on which the Debt Exchange was consummated. The time delay was due to the required shareholder approval prior to the consummation of the Debt Exchange, which occurred at a special meeting on August 19, 2009. This component of the loss did not significantly impact our shareholders’ equity as it was substantially offset by a simultaneous increase in additional paid-in capital(2). The remaining $243.3 million component of the loss represented an acceleration of

 

(1)   For further details on the calculation of the fair value of the non-interest-bearing convertible debentures, see Note 3—Fair Value Disclosures of Item 1. Consolidated Financial Statements (Unaudited).
(2)   For further details on the accounting for the Debt Exchange see, Note 1—Organization, Basis of Presentation and Summary of Significant Accounting Policies of Item 1. Consolidated Financial Statements (Unaudited).

 

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the interest expense that otherwise would have been recorded in future periods. Prior to the consummation of the Debt Exchange, this discount was being accreted into interest expense over the life of the exchanged debt under the effective interest method.

Total other income (expense) also consists of corporate interest expense resulting from our interest-bearing corporate debt. Corporate interest expense decreased 22% to $69.0 million and 11% to $242.8 million for the three and nine months ended September 30, 2009, respectively, primarily due to the reduction in interest-bearing debt in connection with our Debt Exchange. Based on our remaining balance of interest-bearing debt subsequent to the Debt Exchange, we estimate that our annual corporate interest payments in future periods will be approximately $160 million on an annual basis, which is approximately $200 million lower than our estimated annual corporate interest payments prior to the Debt Exchange.

Income Tax Benefit

Income tax benefit was $319.7 million and $499.3 million during the three and nine months ended September 30, 2009, respectively, compared to $180.8 million and $300.4 million, respectively, for the same periods in 2008. Our effective tax rates were (27.8)% and (36.0)% for the three months ended September 30, 2009 and 2008, respectively, and (29.3)% and (36.0)% for the nine months ended September 30, 2009 and 2008, respectively. We expect our overall 2009 effective tax rate to be in the range of 33% to 35%.

Debt Exchange

The effective tax rate on the Debt Exchange of 20% was below our statutory federal tax rate of 35%. This was primarily due to certain components of the loss on the Debt Exchange not being deductible for tax purposes, which are summarized in the following table (dollars in thousands):

 

     Three Months Ended
September 30, 2009
 
     Amount of Loss    Tax Rate     Tax Benefit  

Deductible portion of the loss on the Debt Exchange

   $ 722,952    35   $ 253,033   

Non-deductible portion of the loss on the Debt Exchange

     245,302    —       —     

Prior period interest expense on the 12 1/2% Notes not deductible as a result of the Debt Exchange

     N/A    N/A        (57,687
                     

Total

   $ 968,254    20   $ 195,346   
                     

Tax Ownership Change

During the third quarter of 2009, we exchanged $1.7 billion principal amount of our interest-bearing debt for an equal principal amount of non-interest-bearing convertible debentures. Subsequent to the Debt Exchange, $592.3 million debentures were converted into 572.2 million shares of common stock during the quarter ended September 30, 2009. As a result of these conversions, we believe we experienced a tax ownership change during the third quarter of 2009.

As of September 30, 2009, we have federal net operating losses (“NOLs”) available to carry forward of approximately $1.6 billion. Section 382 of the Internal Revenue Code of 1986, as amended, imposes restrictions on the use of a corporation’s NOLs, certain recognized built-in losses and other carryovers after an “ownership change” occurs. Section 382 rules governing when a change in ownership occurs are complex and subject to interpretation; however, an ownership change generally occurs when there has been a cumulative change in the stock ownership of a corporation by certain “5% shareholders” of more than 50 percentage points over a rolling three-year period.

Section 382 imposes an annual limitation on the amount of post-ownership change taxable income a corporation may offset with pre-ownership change NOLs. In general, the annual limitation is determined by multiplying the value of the corporation’s stock immediately before the ownership change (subject to certain

 

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adjustments) by the applicable long-term tax-exempt rate. Any unused portion of the annual limitation is available for use in future years until such NOLs are scheduled to expire (in general, our NOLs may be carried forward 20 years). In addition, the limitation may, under certain circumstances, be decreased by built-in losses which may be present with respect to assets held at the time of the ownership change that are recognized in the five-year period (one-year for loans) after the ownership change. The use of NOLs arising after the date of an ownership change would not be affected unless a corporation experienced an additional ownership change in a future period.

We believe the tax ownership change will extend the period of time it will take to fully utilize our pre-ownership change NOLs, but will not limit the total amount of pre-ownership change NOLs we can utilize. Our preliminary estimate is that we will be subject to an overall annual limitation on the use of our pre-ownership change NOLs of approximately $111 million; however, this amount is subject to change in future periods as we finalize the tax change of control analysis. Since the statutory carry forward period for our overall pre-ownership change NOLs, which are approximately $1.6 billion, is 20 years (the majority of which expire in 19 years), we believe we will be able to fully utilize these NOLs in future periods.

Our ability to utilize the pre-ownership change NOLs is dependent on our ability to generate sufficient taxable income over the duration of the carry forward periods and will not be impacted by our ability or inability to generate taxable income in an individual year.

Valuation Allowance

During the three and nine months ended September 30, 2009, we did not provide for a valuation allowance against our federal deferred tax assets. We are required to establish a valuation allowance for deferred tax assets and record a charge to income if we determine, based on available evidence at the time the determination is made, that it is more likely than not that some portion or all of the deferred tax assets will not be realized. If we did conclude that a valuation allowance was required, the resulting loss would have a material adverse effect on our results of operations and financial condition.

We did not establish a valuation allowance against our federal deferred tax assets as of September 30, 2009 as we believe that it is more likely than not that all of these assets will be realized. Our evaluation focused on identifying significant, objective evidence that we will be able to realize our deferred tax assets in the future. We reviewed the estimated future taxable income for our trading and investing and balance sheet management segments separately and determined that our net operating losses in 2007 and 2008 were due solely to the credit losses in our balance sheet management segment. We believe these losses were caused by the crisis in the residential real estate and credit markets which significantly impacted our asset-backed securities and home equity loan portfolios in 2007 and continued to generate credit losses in 2008. We estimate that these credit losses will continue in future periods; however, we ceased purchasing asset-backed securities and home equity loans which we believe are the root cause of the majority of these losses. Therefore, while we do expect credit losses to continue in future periods, we do expect these amounts to decline when compared to our credit losses in 2007 and 2008. Our trading and investing segment generated substantial book taxable income for each of the last six years and we estimate that it will continue to generate taxable income in future periods at a level sufficient to generate taxable income for the Company as a whole. We consider this to be significant, objective evidence that we will be able to realize our deferred tax assets in the future.

A key component of our evaluation of the need for a valuation allowance was our level of corporate interest expense, which represents our most significant non-segment related expense. Our estimates of future taxable income included this expense, which reduces the amount of segment income available to utilize our federal deferred tax assets. Therefore, a decrease in this expense in future periods would increase the level of estimated taxable income available to utilize our federal deferred tax assets. As a result of the Debt Exchange, we reduced our annual cash interest payments from approximately $360 million to $160 million. We believe this decline in cash interest payments significantly improves our ability to utilize our federal deferred tax assets in future periods when compared to evaluations in prior periods which did not include this decline in corporate interest payments.

 

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Our analysis of the need for a valuation allowance recognizes that we are in a cumulative book taxable loss position as of the three-year period ended December 31, 2008 and the three and nine months ended September 30, 2009, which is considered significant and objective evidence that we may not be able to realize some portion of our deferred tax assets in the future. However, we believe we are able to rely on our forecasts of future taxable income and overcome the uncertainty created by the cumulative loss position.

The crisis in the residential real estate and credit markets has created significant volatility in our results of operations. This volatility is isolated almost entirely to our balance sheet management segment. Our forecasts for this segment include assumptions regarding our estimate of future expected credit losses, which we believe to be the most variable component of our forecasts of future taxable income. We believe this variability could create a book loss in our overall results for an individual reporting period while not significantly impacting our overall estimate of taxable income over the period in which we expect to realize our deferred tax assets. Conversely, we believe our trading and investing segment will continue to produce a stable stream of income which we believe we can reliably estimate in both individual reporting periods as well as over the period in which we estimate we will realize our deferred tax assets.

In evaluating the need for a valuation allowance, we estimated future taxable income based on management approved forecasts. This process required significant judgment by management about matters that are by nature uncertain. If future events differ significantly from our current forecasts, a valuation allowance may need to be established, which would have a material adverse effect on our results of operations and our financial condition.

 

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SEGMENT RESULTS REVIEW

Beginning in the first quarter of 2009, we revised our segment financial reporting to reflect the manner in which our chief operating decision maker had begun assessing the Company’s performance and making resource allocation decisions. As a result, we now report our operating results in two segments: 1) “Trading and Investing,” which includes the businesses that were formerly in the “Retail” segment and now includes our market-making business; and 2) “Balance Sheet Management,” which includes the businesses from the former “Institutional” segment, other than the market-making business. Our segment financial information from prior periods has been reclassified in accordance with the new segment financial reporting.

Trading and Investing

The following table summarizes trading and investing financial and key metrics as of and for the three and nine months ended September 30, 2009 and 2008 (dollars in thousands, except for key metrics):

 

    As of and For the Three
Months Ended

September 30,
    Variance     As of and For the Nine
Months Ended

September 30,
    Variance  
    2009 vs. 2008       2009 vs. 2008  
    2009     2008     Amount     %     2009     2008     Amount     %  

Trading and investing segment income:

               

Net operating interest income

  $ 206,762      $ 217,173      $ (10,411   (5 )%    $ 577,337      $ 645,374      $ (68,037   (11 )% 

Commissions

    144,533        129,459        15,074      12     424,222        373,252        50,970      14

Fees and service charges

    49,723        47,908        1,815      4     139,788        147,296        (7,508   (5 )% 

Principal transactions

    24,888        20,694        4,194      20     65,223        59,462        5,761      10

Losses on loans and securities, net

    —          (37     37      *        (60     (21     (39   186

Other revenues

    8,466        9,316        (850   (9 )%      26,985        29,379        (2,394   (8 )% 
                                                   

Net segment revenue

    434,372        424,513        9,859      2     1,233,495        1,254,742        (21,247   (2 )% 

Total segment expense

    231,840        248,264        (16,424   (7 )%      730,718        784,282        (53,564   (7 )% 
                                                   

Total trading and investing segment income

  $ 202,532      $ 176,249      $ 26,283      15   $ 502,777      $ 470,460      $ 32,317      7
                                                   

Key Metrics:

               

DARTs

    196,413        183,691        12,722      7     204,143        178,814        25,329      14

Average commission per trade

  $ 11.50      $ 11.10      $ 0.40      4   $ 11.05      $ 11.07      $ (0.02   (0 )% 

End of period brokerage accounts

    2,729,137        2,520,102        209,035      8     2,729,137        2,520,102        209,035      8

Customer assets (dollars in billions)

  $ 148.7      $ 142.2      $ 6.5      5   $ 148.7      $ 142.2      $ 6.5      5

Net new customer assets (dollars in billions)(1)

  $ (0.2   $ 0.8        *      *      $ 4.2      $ 2.0        *      *   

Brokerage related cash (dollars in billions)

  $ 20.3      $ 17.7      $ 2.6      15   $ 20.3      $ 17.7      $ 2.6      15

Other customer cash and deposits (dollars in billions)

    14.2        15.7        (1.5   (10 )%      14.2        15.7        (1.5   (10 )% 
                                                   

Customer cash and deposits (dollars in billions)

  $ 34.5      $ 33.4      $ 1.1      3   $ 34.5      $ 33.4      $ 1.1      3

 

 *  

Not meaningful

(1)  

For the nine months ended September 30, 2008, net new customer assets were $2.9 billion excluding the sale of RAA.

Our trading and investing segment generates revenue from brokerage and banking relationships with investors and from market-making activities. This segment generates six main sources of revenue: net operating interest income; commissions; fees and service charges; principal transactions; gains (losses) on loans and securities, net; and other revenues. Other revenues include results from our stock plan administration products and services, as we ultimately service customers through these corporate relationships.

Our brokerage business continued to perform very well during the third quarter of 2009, resulting in an increase in the level of income generated in the trading and investing segment as well as achieving record levels of brokerage accounts. Trading and investing segment income increased 15% to $202.5 million and 7% to $502.8 million for the three and nine months ended September 30, 2009, respectively, compared to the same periods in

 

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2008. Trading activity was strong during the third quarter of 2009 resulting in total DARTs of 196,413 and an average commission per trade of $11.50. We also continued to generate new brokerage accounts, ending the quarter with a record 2.7 million accounts. Our brokerage related cash, which is one of our most profitable sources of funding, increased by $2.6 billion when compared to the third quarter of 2008. We believe these metrics are indicators of a brokerage business that is able to compete effectively in a volatile environment and we believe we are positioned for continued growth in our trading and investing segment.

Trading and investing net operating interest income decreased 5% to $206.8 million and 11% to $577.3 million for the three and nine months ended September 30, 2009, respectively, compared to the same periods in 2008. This decrease was driven primarily by a decrease in the balance of our margin receivables during the comparable periods, which was partially offset by a decrease in yields paid on our deposits.

Trading and investing commissions revenue increased 12% to $144.5 million and 14% to $424.2 million for the three and nine months ended September 30, 2009, respectively, compared to the same periods in 2008. The increase in commissions revenue was primarily the result of an increase in DARTs of 7% to 196,413 and 14% to 204,143 for the three and nine months ended September 30, 2009, respectively, compared to the same periods in 2008.

Trading and investing principal transactions revenue increased 20% to $24.9 million and 10% to $65.2 million for the three and nine months ended September 30, 2009, respectively, compared to the same periods in 2008. Our principal transactions revenue is influenced by overall trading volumes, the number of stocks for which we act as a market-maker, the trading volumes of those specific stocks and the performance of our proprietary trading activities. The increase in principal transactions revenue was driven by an increase in the volume of equity shares that were traded, which was partially offset by a decrease in our average revenue earned per share traded for the three and nine months ended September 30, 2009, respectively.

Trading and investing segment expense decreased 7% to $231.8 million and $730.7 million for the three and nine months ended September 30, 2009, respectively, compared to the same periods in 2008. The decrease for the three and nine months ended September 30, 2009 related primarily to a decrease in advertising and market development expense and a decrease in bad debt expense, which were offset by an increase in FDIC insurance premiums. Additionally, there was a decrease in compensation and benefits expense which also contributed to the decrease in trading and investing segment expense for the nine months ended September 30, 2009. The decrease was due to lower salary expense as a result of a reduction in our employee base.

As of September 30, 2009, we had approximately 2.7 million active brokerage accounts, 1.0 million stock plan accounts and 0.8 million active banking accounts. For the three months ended September 30, 2009 and 2008, our brokerage products contributed 62% and 64%, respectively, and our banking products, which include sweep products, contributed 28% and 26%, respectively, of total trading and investing net revenue. For the nine months ended September 30, 2009 and 2008, our brokerage products contributed 64% for both periods, and our banking products contributed 27% and 26%, respectively, of total trading and investing net revenue. All other products contributed less than 10% of total trading and investing net revenue for the three and nine months ended September 30, 2009 and 2008.

 

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Balance Sheet Management

The following table summarizes balance sheet management financial and key metrics as of and for the three and nine months ended September 30, 2009 and 2008 (dollars in thousands, except for key metrics):

 

    As of and For the Three
Months Ended

September 30,
    Variance     As of and For the Nine
Months Ended
September 30,
    Variance  
    2009 vs. 2008       2009 vs. 2008  
    2009     2008     Amount     %     2009     2008     Amount     %  

Balance sheet management segment loss:

               

Net operating interest income

  $ 114,616      $ 107,601      $ 7,015      7   $ 362,293      $ 348,535      $ 13,758      4

Commissions

    —          54        (54   *        —          751        (751   *   

Fees and service charges

    650        1,704        (1,054   (62 )%      5,234        8,219        (2,985   (36 )% 

Principal transactions

    —          (30     30      *        —          84        (84   *   

Gains (losses) on loans and securities, net

    41,979        (141,878     183,857      *        150,499        (122,413     272,912      *   

Net impairment

    (19,229     (17,884     (1,345   (8 )%      (67,683     (61,639     (6,044   10

Other revenues

    2,939        3,665        (726   (20 )%      9,738        10,926        (1,188   (11 )% 
                                                   

Net segment revenue

    140,955        (46,768     187,723      *        460,081        184,463        275,618      149

Provision for loan losses

    347,222        517,800        (170,578   (33 )%      1,205,710        1,070,792        134,918      13

Total segment expense

    69,874        47,639        22,235      47     194,206        184,526        9,680      5
                                                   

Total balance sheet management segment loss

  $ (276,141   $ (612,207   $ 336,066      (55 )%    $ (939,835   $ (1,070,855   $ 131,020      (12 )% 
                                                   

Key Metrics:

               

Allowance for loan losses (dollars in millions)

  $ 1,214.5      $ 874.2      $ 340.3      39   $ 1,214.5      $ 874.2      $ 340.3      39

Allowance for loan losses as a % of nonperforming loans

    82.37     109.45     *      (27.08 )%      82.37     109.45     *      (27.08 )% 

 

*   Percentage not meaningful

Our balance sheet management segment generates revenue from managing loans previously originated or purchased from third parties, and leveraging these loans and customer cash and deposit relationships to generate additional net operating interest income.

The balance sheet management segment reported a loss of $276.1 million and $939.8 million for the three and nine months ended September 30, 2009, respectively. We believe the losses in this segment are the result of the high levels of delinquent loans in our one- to four-family and home equity loan portfolios, which in turn resulted in provision for loan losses of $347.2 million and $1.2 billion for the three and nine months ended September 30, 2009, respectively.

Net operating interest income increased 7% to $114.6 million and 4% to $362.3 million for the three and nine months ended September 30, 2009, respectively, compared to the same periods in 2008. This increase was due to the increase in enterprise net interest spread of 19 basis points to 2.82% and 8 basis points to 2.69% for the three and nine months ended September 30, 2009, compared to the same periods in 2008.

Gains (losses) on loans and securities, net were gains of $42.0 million and $150.5 million for the three and nine months ended September 30, 2009, respectively, compared to losses of $141.9 million and $122.4 million for the same periods in 2008. The increase was due primarily to gains on the sale of certain agency mortgage-backed securities, which were partially offset by net losses on the sales of loans during the three and nine months ended September 30, 2009, respectively, compared to the same periods in 2008. The losses on the sales of loans were due to the sale of a $0.4 billion pool of home equity loans during the three months ended September 30, 2009. We purchased this particular pool of loans from the originator of the loans in a prior period. This same

 

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originator, who continued to service the loans subsequent to our purchase, made an unsolicited offer to repurchase the loans back from us at a price of 98% of the balance of the loan portfolio and we accepted this offer. We believe transactions of this nature are rare and are unlikely to occur again in future periods. The losses on loans and securities, net during the three and nine months ended September 30, 2008 were due to losses on our preferred stock in Fannie Mae and Freddie Mac.

We recognized $19.2 million and $67.7 million of net impairment during the three and nine months ended September 30, 2009, respectively, on certain securities in our non-agency CMO portfolio due to continued deterioration in the expected credit performance of the underlying loans in the securities. The net impairment included gross OTTI of $9.3 million and $227.8 million for the three and nine months ended September 30, 2009. For the three months ended September 30, 2009, net impairment included $9.9 million of previously recognized noncredit OTTI that was reclassified from accumulated other comprehensive loss into earnings. Of the $227.8 million of gross OTTI for the nine months ended September 30, 2009, $160.2 million related to the noncredit portion of OTTI, which was recorded through other comprehensive income (loss). We had net impairment of $17.9 million and $61.6 million for the three and nine months ended September 30, 2008, which represented the total decline in the fair value of impaired securities in accordance with the OTTI accounting guidance that was in effect prior to April 1, 2009.

Provision for loan losses decreased $170.6 million to $347.2 million and increased $134.9 million to $1.2 billion for the three and nine months ended September 30, 2009, respectively, compared to the same periods in 2008. The provision for loan losses for the three and nine months ended September 30, 2009 was due primarily to the high levels of delinquent loans in our one- to four-family and home equity loan portfolios. We believe the delinquencies in both of these portfolios were caused by several factors, including: home price depreciation in key markets; growing inventories of unsold homes; rising foreclosure rates; significant contraction in the availability of credit; and a general decline in economic growth. In addition, the combined impact of home price depreciation and the reduction of available credit made it increasingly difficult for borrowers to refinance existing loans. Although we expect these factors will cause the provision for loan losses to continue at historically high levels in future periods, the level of provision for loan losses in the third quarter of 2009 represents the fourth consecutive quarter in which the provision for loan losses has declined when compared to the prior quarter. While we cannot state with certainty that this trend will continue, we believe it is a positive indicator that our loan portfolio may be stabilizing.

Total balance sheet management segment expense increased 47% to $69.9 million and 5% to $194.2 million for the three and nine months ended September 30, 2009, respectively, compared to the same periods in 2008. The increase for the three months ended September 30, 2009 was due primarily to higher corporate expenses and higher expense related to real estate owned (“REO”) and other repossessed assets. The increase in corporate expenses, the majority of which are allocated to the balance sheet management segment, was due primarily to an increase in variable compensation when compared to the same period in prior year. The slight increase for the nine months ended September 30, 2009 was due primarily to an increase in expenses related to corporate expenses and REO and other repossessed assets, partially offset by lower facility restructuring expense in the balance sheet management segment.

 

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BALANCE SHEET OVERVIEW

The following table sets forth the significant components of our consolidated balance sheet (dollars in thousands):

 

     September 30,
2009
   December 31,
2008
   Variance  
         2009 vs. 2008  
         Amount     %  

Assets:

          

Cash(1)

   $ 7,526,449    $ 4,995,447    $ 2,531,002      51

Trading securities

     40,883      55,481      (14,598   (26 )% 

Available-for-sale mortgage-backed and investment securities

     11,509,690      10,806,094      703,596      7

Margin receivables

     3,435,428      2,791,168      644,260      23

Loans, net

     20,259,974      24,451,852      (4,191,878   (17 )% 

Investment in FHLB stock

     183,863      200,892      (17,029   (8 )% 

Other assets(2)

     5,530,689      5,237,281      293,408      6
                        

Total assets

   $ 48,486,976    $ 48,538,215    $ (51,239   (0 )% 
                        

Liabilities and shareholders’ equity:

          

Deposits

   $ 26,368,402    $ 26,136,246    $ 232,156      1

Wholesale borrowings(3)

     9,225,699      11,735,056      (2,509,357   (21 )% 

Customer payables

     5,270,722      3,753,332      1,517,390      40

Corporate debt

     2,532,232      2,750,532      (218,300   (8 )% 

Accounts payable, accrued and other liabilities

     1,444,049      1,571,553      (127,504   (8 )% 
                        

Total liabilities

     44,841,104      45,946,719      (1,105,615   (2 )% 

Shareholders’ equity

     3,645,872      2,591,496      1,054,376      41
                        

Total liabilities and shareholders’ equity

   $ 48,486,976    $ 48,538,215    $ (51,239   (0 )% 
                        

 

(1)  

Includes balance sheet line items cash and equivalents and cash and investments required to be segregated under federal or other regulations.

(2)  

Includes balance sheet line items property and equipment, net, goodwill, other intangibles, net and other assets.

(3)  

Includes balance sheet line items securities sold under agreements to repurchase and other borrowings.

The slight decrease in total assets was attributable primarily to a decrease of $4.2 billion in loans, net, offset by increases of $2.5 billion in cash, $0.7 billion in available-for-sale mortgage-backed and investment securities and $0.6 billion in margin receivables. The decrease in loans, net was due to our strategy of reducing balance sheet risk by allowing our loan portfolio to pay down, which we plan to do for the foreseeable future. The increase in cash was primarily related to our high levels of customer deposits, particularly our non-sweep deposits. For further details on cash, see Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources).

The decrease in total liabilities was attributable primarily to the decrease of $2.5 billion in wholesale borrowings, which was partially offset by an increase of $1.5 billion in customer payables. The decrease in wholesale borrowings was a result of paying down our FHLB advances and securities sold under agreements to repurchase. Customer payables increased due to higher trading activity and net new brokerage customer acquisition.

The increase in shareholders’ equity was related to the issuance of 620.9 million shares of common stock related to our common stock offerings and the completion of our Debt Exchange along with the subsequent conversions of the newly-issued convertible debentures into 572.2 million shares of common stock as of September 30, 2009.

 

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Available-for-Sale Mortgage-Backed and Investment Securities

Available-for-sale securities are summarized as follows (dollars in thousands):

 

     September 30,
2009
   December 31,
2008
   Variance  
         2009 vs. 2008  
         Amount     %  

Residential mortgage-backed securities:

          

Agency mortgage-backed securities and CMOs

   $ 7,792,390    $ 10,110,813    $ (2,318,423   (23 )% 

Non-agency CMOs and other

     475,089      602,376      (127,287   (21 )% 
                        

Total residential mortgage-backed securities

     8,267,479      10,713,189      (2,445,710   (23 )% 

Investment securities

     3,242,211      92,905      3,149,306      3390
                        

Total available-for-sale securities

   $ 11,509,690    $ 10,806,094    $ 703,596      7
                        

Available-for-sale securities represented 24% and 22% of total assets at September 30, 2009 and December 31, 2008, respectively. Total available-for-sale securities increased 7% to $11.5 billion at September 30, 2009 when compared to December 31, 2008, due primarily to the purchase of agency debentures, which increased investment securities to $3.2 billion. This increase was partially offset by the sale of certain agency mortgage-backed securities and CMOs. During the third quarter of 2009, we decided to reduce our interest rate risk exposure in our available-for-sale securities portfolio. We accomplished this objective by reducing our position in mortgage-backed securities and increasing our position in agency debentures, which have a lower sensitivity to changes in interest rates when compared to mortgage-backed securities.

Loans, Net

Loans, net are summarized as follows (dollars in thousands):

 

     September 30,
2009
    December 31,
2008
    Variance  
       2009 vs. 2008  
       Amount     %  

Loans held-for-sale

   $ 6,290      $ —        $ 6,290      *   

One- to four-family

     11,177,177        12,979,844        (1,802,667   (14 )% 

Home equity

     8,156,365        10,017,183        (1,860,818   (19 )% 

Consumer and other loans:

        

Recreational vehicle

     1,347,647        1,570,116        (222,469   (14 )% 

Marine

     366,516        424,595        (58,079   (14 )% 

Commercial

     152,407        214,084        (61,677   (29 )% 

Other

     83,268        89,875        (6,607   (7 )% 

Unamortized premiums, net

     184,822        236,766        (51,944   (22 )% 

Allowance for loan losses

     (1,214,518     (1,080,611     (133,907   12
                          

Total loans, net

   $ 20,259,974      $ 24,451,852      $ (4,191,878   (17 )% 
                          

 

*   Percentage not meaningful

Loans, net decreased 17% to $20.3 billion at September 30, 2009 from $24.5 billion at December 31, 2008. This decline was due primarily to our strategy of reducing balance sheet risk by allowing our loan portfolio to pay down, which we plan to do for the foreseeable future. In addition, we sold a $0.4 billion pool of home equity loans during the three months ended September 30, 2009. We purchased this particular pool of loans from the originator of the loans in a prior period. This same originator, who continued to service the loans subsequent to our purchase, made an unsolicited offer to repurchase the loans back from us at a price of 98% of the balance of the loan portfolio and we accepted this offer. We believe transactions of this nature are rare and are unlikely to occur again in future periods.

 

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Loans held-for-sale of $6.3 million as of September 30, 2009 represents loans originated through, but not yet purchased by, a third party company that we partnered with to provide access to real estate loans for our customers. The product is offered as a convenience to our customers and is not one of our primary product offerings. The third party company providing this product performs all processing and underwriting of these loans and is responsible for the credit risk associated with these loans, which minimizes our assumption of any of the typical risks commonly associated with mortgage lending. There is a short period of time after closing of the loans in which we record the originated loan as held-for-sale prior to the third party company purchasing the loan.

We have a credit default swap (“CDS”) on a portion of our first-lien residential real estate loan portfolio through a synthetic securitization structure that provides, for a fee, an assumption by a third party of a portion of the credit risk related to the underlying loans. As of September 30, 2009, the balance of the loans covered by the CDS was $2.4 billion, on which $26.4 million in losses had been recognized. The CDS provides protection for losses in excess of $4.0 million, but not to exceed approximately $30.3 million. During the second quarter of 2009, we began to receive cash recoveries from the CDS for amounts reported in excess of the $4.0 million threshold. We expect to recognize the remaining benefit over the next twelve months, which is reflected in the allowance for loan losses as of September 30, 2009.

Deposits

Deposits are summarized as follows (dollars in thousands):

 

     September 30,
2009
   December 31,
2008
   Variance  
         2009 vs. 2008  
         Amount     %  

Sweep deposit accounts

   $ 12,068,407    $ 9,650,431    $ 2,417,976      25

Money market and savings accounts

     11,963,920      12,692,729      (728,809   (6 )% 

Certificates of deposit

     1,438,331      2,363,385      (925,054   (39 )% 

Checking accounts

     764,161      991,477      (227,316   (23 )% 

Brokered certificates of deposit

     133,583      438,224      (304,641   (70 )% 
                        

Total deposits

   $ 26,368,402    $ 26,136,246    $ 232,156      1
                        

Deposits represented 59% and 57% of total liabilities at September 30, 2009 and December 31, 2008, respectively. Deposits generally provide us the benefit of lower interest costs compared with wholesale funding alternatives. While our deposits increased by $232.2 million during the nine months, we expect the non-sweep deposit balances to decrease over the remainder of 2009. At September 30, 2009, 95% of our customer deposits were covered by FDIC insurance.

The deposits balance is a component of the total customer cash and deposits balance reported as a customer activity metric of $34.5 billion and $32.3 billion at September 30, 2009 and December 31, 2008, respectively. The total customer cash and deposits balance is summarized as follows (dollars in thousands):

 

     September 30,
2009
    December 31,
2008
    Variance  
       2009 vs. 2008  
         Amount    %  

Deposits

   $ 26,368,402      $ 26,136,246      $ 232,156    1

Less: brokered certificates of deposit

     (133,583     (438,224     304,641    (70 )% 
                         

Retail deposits

     26,234,819        25,698,022        536,797    2

Customer payables

     5,270,722        3,753,332        1,517,390    40

Customer cash balances held by third parties and other

     2,955,627        2,805,101        150,526    5
                         

Total customer cash and deposits

   $ 34,461,168      $ 32,256,455      $ 2,204,713    7
                         

 

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Wholesale Borrowings

Wholesale borrowings, which consist of securities sold under agreements to repurchase and other borrowings are summarized as follows (dollars in thousands):

 

     September 30,
2009
   December 31,
2008
   Variance  
         2009 vs. 2008  
         Amount     %  

Securities sold under agreements to repurchase

   $ 6,469,589    $ 7,381,279    $ (911,690   (12 )% 
                        

FHLB advances

   $ 2,303,600    $ 3,903,600    $ (1,600,000   (41 )% 

Subordinated debentures

     427,393      427,328      65      0

Other

     25,117      22,849      2,268      10
                        

Total other borrowings

   $ 2,756,110    $ 4,353,777    $ (1,597,667   (37 )% 
                        

Total wholesale borrowings

   $ 9,225,699    $ 11,735,056    $ (2,509,357   (21 )% 
                        

Wholesale borrowings represented 21% and 26% of total liabilities at September 30, 2009 and December 31, 2008, respectively. The decrease in wholesale borrowings of $2.5 billion during the nine months ended September 30, 2009 was due primarily to the early termination of certain FHLB advances and a decrease in securities sold under agreements to repurchase. FHLB advances coupled with securities sold under agreements to repurchase are the primary wholesale funding sources of the Bank. As a result, we expect these balances to fluctuate over time as our deposits and our interest-earning assets fluctuate.

Corporate Debt

Corporate debt by type is shown as follows (dollars in thousands):

 

      Face Value    Discount     Fair Value
Adjustment
   Net

September 30, 2009

          

Interest-bearing notes:

          

Senior notes:

          

8% Notes, due 2011

   $ 3,644    $ —        $ —      $ 3,644

7 3/8% Notes, due 2013

     414,665      (3,618     23,342      434,389

7 7/8% Notes, due 2015

     243,177      (1,845     11,714      253,046
                            

Total senior notes

     661,486      (5,463     35,056      691,079

12 1/2% Springing lien notes, due 2017

     875,530      (192,570     8,597      691,557
                            

Total interest-bearing notes

     1,537,016      (198,033     43,653      1,382,636
                            

Non-interest-bearing debt:

          

0% Convertible debentures, due 2019

     1,149,596      —          —        1,149,596
                            

Total corporate debt

   $ 2,686,612    $ (198,033   $ 43,653    $ 2,532,232
                            
     Face Value    Discount     Fair Value
Adjustment
   Net

December 31, 2008

          

Senior notes:

          

8% Notes, due 2011

   $ 435,515    $ (1,763   $ 13,855    $ 447,607

7 3/8% Notes, due 2013

     414,665      (4,334     32,435      442,766

7 7/8% Notes, due 2015

     243,177      (2,071     13,183      254,289
                            

Total senior notes

     1,093,357      (8,168     59,473      1,144,662

12 1/2% Springing lien notes, due 2017

     2,057,000      (460,515     9,385      1,605,870
                            

Total corporate debt

   $ 3,150,357    $ (468,683   $ 68,858    $ 2,750,532
                            

 

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Table of Contents

In the third quarter of 2009, we obtained shareholder approval for and completed an offer to exchange $1.7 billion aggregate principal amount of our corporate debt, including $1.3 billion principal amount of the 12 1/2% Notes and $0.4 billion principal amount of the 8% Notes, for an equal principal amount of newly-issued non-interest-bearing convertible debentures. Subsequent to the Debt Exchange, $592.3 million of convertible debentures were converted into 572.2 million shares of common stock during the quarter ended September 30, 2009. For further details on the Debt Exchange, see Notes 1, 3 and 9 of Item 1. Consolidated Financial Statements (Unaudited).

Shareholders’ Equity

The activity in shareholders’ equity during the nine months ended September 30, 2009 is summarized as follows (dollars in thousands):

 

     Common Stock/
Additional Paid-

In Capital
   Accumulated
Deficit/Other
Comprehensive Loss
    Total  

Beginning balance, December 31, 2008

   $ 4,069,917    $ (1,478,421   $ 2,591,496   

Common stock offerings

     733,209      —          733,209   

Activity related to the Debt Exchange:

       

After-tax loss related to the Debt Exchange

     —        (772,908     (772,908

Amortization of premium on the convertible debentures

     707,549      —          707,549   

Conversions of convertible debentures

     592,275      —          592,275   

All other after-tax operating losses

     —        (434,700     (434,700

Other(1)

     34,915      194,036        228,951   
                       

Ending balance, September 30, 2009

   $ 6,137,865    $ (2,491,993   $ 3,645,872   
                       

 

(1)  

Other includes employee stock compensation accounting, additional purchase consideration paid in connection with prior acquisitions, and changes in other comprehensive income (loss) from foreign currency translation, noncredit losses on available-for-sale securities and fair value changes in cash flow hedges, net of taxes.

Shareholders’ equity increased 41% to $3.6 billion at September 30, 2009 from $2.6 billion at December 31, 2008. This increase was due primarily to the issuance of 620.9 million shares of common stock related to our common stock offerings and the completion of our Debt Exchange along with the subsequent conversions of the newly-issued convertible debentures into 572.2 million shares of common stock that occurred during the third quarter of 2009. The increase was also attributable to the amortization of the entire premium on the newly-issued convertible debentures, which was immediately amortized to additional paid-in capital since amortizing the premium into interest expense over the life of the non-interest-bearing convertible debentures would have resulted in recording interest income on a liability (a negative yield)(1).

LIQUIDITY AND CAPITAL RESOURCES

We have established liquidity and capital policies to support the successful execution of our business strategies, while ensuring ongoing and sufficient liquidity through the business cycle. These policies are especially important during periods of stress in the financial markets, which have been ongoing since the fourth quarter of 2007 and will likely continue for some time.

We believe liquidity is of critical importance to the Company and especially important within E*TRADE Bank. The objective of our policies is to ensure that we can meet our corporate and banking liquidity needs under both normal operating conditions and under periods of stress in the financial markets. Our corporate liquidity needs are primarily driven by the amount of principal and interest due on our corporate debt as well as any

 

(1)   See Note 1—Organization, Basis of Presentation and Summary of Significant Accounting Policies of Item 1. Consolidated Financial Statements (Unaudited) for a description of the accounting of the Debt Exchange.

 

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Table of Contents

capital needs at E*TRADE Bank. Our banking liquidity needs are driven primarily by the level and volatility of our customer deposits. Management maintains an extensive set of liquidity sources and monitors certain business trends and market metrics closely to ensure we have sufficient liquidity and to avoid dependence on other more expensive sources of funding. Management believes the following sources of liquidity are of critical importance in maintaining ample funding for liquidity needs: Corporate cash, Bank cash, deposits and unused FHLB borrowing capacity. Management believes that within deposits, sweep deposits are of particular importance as they are the most stable source of liquidity for E*TRADE Bank when compared to non-sweep deposits. Overall, management believes that these liquidity sources, which we expect to fluctuate in any given period, are more than sufficient to meet our needs for the foreseeable future.

Capital is generated primarily through our business operations and our capital market activities. Our trading and investing segment has been profitable and a generator of capital for the past six years and we expect that trend to continue. However, our provision for loan losses, which is reported in the balance sheet management segment, has more than offset the capital generated by both of our segments. While we cannot state this with certainty, we believe that this trend will reverse at some point in the foreseeable future and our business operations will again be a net generator of capital. However, in order to ensure that we have enough capital to withstand any further deterioration in the current credit and market conditions, management believed it was necessary to raise additional capital.

During the second and third quarters of 2009, our primary banking regulator, the Office of Thrift Supervision (“OTS”), advised us, and consistent with management’s belief stated above we agreed, to raise additional equity capital for E*TRADE Bank and to substantially reduce our corporate debt service burden. In response, we implemented a plan to strengthen our capital structure by raising cash equity primarily to support E*TRADE Bank and also to enhance our liquidity. As part of this plan, we raised $733.2 million in net proceeds from three separate stock offerings, as detailed in the table below (dollars and shares in millions):

 

     Net Proceeds    Shares

Equity Drawdown Program, May 2009

   $ 63    41

Public Equity Offering, June 2009

     523    500

At the Market Offering, September 2009

     147    80
           

Total

   $ 733    621
           

Also as part of our capital plan, we completed an exchange of $1.7 billion aggregate principal amount of our corporate debt, which included $1.3 billion principal amount of our 12 1/2% Notes and $0.4 billion principal amount of our 8% Notes, for an equal principal amount of newly-issued non-interest-bearing convertible debentures. As a result of the completion of this exchange, we reduced our annual corporate interest payments from approximately $360 million to approximately $160 million and eliminated any substantial debt maturities until 2013. As of September 30, 2009, $592.3 million of the newly-issued non-interest-bearing convertible debentures had been converted into 572.2 million shares of common stock(1).

We believe the combined impact of our common stock offerings and the Debt Exchange substantially improved our capital structure. As a result, we believe we will be in a position to respond opportunistically with regard to any additional capital planning actions, such as further debt-for-equity exchanges, additional cash capital raising activities or sales of any non-core assets.

During the fourth quarter of 2008, we applied to the U.S. Treasury for funding under the Troubled Asset Relief Program (“TARP”) Capital Purchase Program. The OTS recently requested that we declare our intentions with respect to our application. In light of our recent capital raising activities and the reduction in interest-bearing debt in connection with the completion of the Debt Exchange, we withdrew our application on October 30, 2009.

 

(1)   As of October 26, 2009, a total of $688.2 million of the convertible debentures had been converted into 664.9 million shares of common equity.

 

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Table of Contents

Corporate Cash

Corporate cash is the primary source of liquidity at the parent company and is available to invest in our regulated subsidiaries. We define corporate cash as cash held at the parent company as well as cash held in certain subsidiaries that can distribute cash to the parent company without any regulatory approval. The components of corporate cash as of September 30, 2009 and December 31, 2008 are as follows (dollars in thousands):

 

     September 30,
2009
   December 31,
2008
   Variance  
         2009 vs. 2008  

Parent company cash

   $ 481,536    $ 216,535    $ 265,001   

Converging Arrows, Inc. and other cash(1)

     19,581      218,318      (198,737
                      

Total corporate cash(2)

   $ 501,117    $ 434,853    $ 66,264   
                      

 

(1)  

Converging Arrows, Inc. and other cash consists of corporate subsidiaries that can distribute cash to the parent company without any regulatory approval.

(2)  

Total corporate cash at September 30, 2009 and December 31, 2008 includes $19.7 million and $45.3 million, respectively, that we invested in The Reserve Funds’ Primary Fund and is included as a receivable in the other assets line item, as The Reserve Fund has not indicated when the funds will be distributed back to investors.

Consolidated Cash and Equivalents

The consolidated cash and equivalents balance increased by $0.9 billion to $4.8 billion for the nine months ended September 30, 2009. The majority of this balance is cash held in regulated subsidiaries, primarily the Bank, outlined as follows (dollars in thousands):

 

     September 30,
2009
    December 31,
2008
    Variance  
       2009 vs. 2008  

Corporate cash

   $ 501,117      $ 434,853      $ 66,264   

Bank cash(1)

     4,074,542        3,276,588        797,954   

International brokerage and other cash

     284,232        288,716        (4,484

Less:

      

Cash reported in other assets(2)

     (63,515     (146,308     82,793   
                        

Total consolidated cash

   $ 4,796,376      $ 3,853,849      $ 942,527   
                        

 

(1)  

During the second quarter of 2009, E*TRADE Securities LLC became a wholly-owned operating subsidiary of E*TRADE Bank. As a result, $110.6 million and $56.4 million in cash held at E*TRADE Securities LLC is included in Bank cash at September 30, 2009 and December 31, 2008, respectively.

(2)  

Cash reported in other assets consists of cash that we invested in The Reserve Funds’ Primary Fund and is included as a receivable in the other assets line item, as The Reserve Fund has not indicated when the funds will be distributed back to investors.

The cash held in our regulated subsidiaries serves as a source of liquidity for those subsidiaries and is not a primary source of capital for the parent company.

 

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Table of Contents

Cash and Equivalents Held in the Reserve Fund

At September 30, 2009, we held cash in The Reserve Funds’ Primary Fund (“the Fund”) of $63.5 million, which is included as a receivable in the other assets line item on the balance sheet. On September 16, 2008, the Fund reported that its shares had fallen below the standard of $1 per share, which is commonly referred to as “breaking the buck.” The following table details our cash held in the Fund at the date the Fund was reported as “breaking the buck” and at September 30, 2009 (dollars in thousands):

 

     September 30,
2009
   September 15,
2008
   Variance  
         September 30, 2009 vs.
September 15, 2008
 

Corporate cash

   $ 19,654    $ 230,326    $ (210,672

Bank cash(1)

     41,789      489,737      (447,948

International brokerage and other cash

     2,072      24,278      (22,206
                      

Total cash held in the Fund

   $ 63,515    $ 744,341    $ (680,826
                      

 

(1)  

During the second quarter of 2009, E*TRADE Securities LLC became a wholly-owned operating subsidiary of E*TRADE Bank. As a result, $5.9 million and $69.3 million in cash related to E*TRADE Securities LLC is included in Bank cash at September 30, 2009 and September 15, 2008, respectively.

On February 26, 2009, The Reserve announced that it had adopted a Plan of Liquidation for the orderly liquidation of the assets of the Fund. Under the terms of the plan, which is subject to the supervision of the SEC, The Reserve will continue to make interim distributions up to $0.9172 per share. The Reserve indicated in this announcement that it was taking this approach in order to provide liquidity to investors without prejudicing the legal right and remedies of any shareholder’s claims. As of September 30, 2009, we had received a total of $669.6 million in cash distributions made by the Fund. In the fourth quarter of 2008, we recorded an impairment charge of $11.2 million, which represented our estimate of the amount we would lose in a pro-rata distribution. We continue to believe that we will receive substantially all of our remaining investment; however, we cannot state with certainty that we will not ultimately incur additional losses on our remaining position. In addition, we believe it will take a significant amount of time to eventually receive these funds(1).

Liquidity Available from Subsidiaries

Liquidity available to the Company from its subsidiaries, other than Converging Arrows, Inc., is limited by regulatory requirements. In addition, E*TRADE Bank may not pay dividends to the parent company without approval from the OTS and any loans by E*TRADE Bank to the parent company and its other non-bank subsidiaries are subject to various quantitative, arm’s length, collateralization and other requirements.

We maintain capital in excess of regulatory minimums at our regulated subsidiaries, the most significant of which is E*TRADE Bank. As of September 30, 2009, we held $985.4 million of risk-based total capital at E*TRADE Bank in excess of the regulatory minimum level required to be considered “well capitalized.” In the current credit environment, we plan to maintain excess risk-based total capital at E*TRADE Bank in order to enhance our ability to absorb credit losses while still maintaining “well capitalized” status. However, events beyond management’s control, such as a continued deterioration in residential real estate and credit markets, could adversely affect future earnings and E*TRADE Bank’s ability to meet its future capital requirements.

The Company’s broker-dealer subsidiaries are subject to capital requirements determined by their respective regulators. At September 30, 2009 and December 31, 2008, all of our brokerage subsidiaries met their minimum net capital requirements. Our broker-dealer subsidiaries had excess net capital of $556.3 million(2) at

 

(1)   On October 2, 2009, we received an additional distribution from The Reserve Fund for $14.5 million, reducing our cash held in the Fund to $49.0 million.
(2)   The excess net capital of the broker-dealer subsidiaries at September 30, 2009 included $416.3 million and $65.5 million of excess net capital at E*TRADE Clearing and E*TRADE Securities LLC, respectively, which are subsidiaries of E*TRADE Bank and are also included in the excess risk-based capital of E*TRADE Bank.

 

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September 30, 2009, a decline of $161.3 million from December 31, 2008. This decline was due to dividends of $250 million and $26 million paid by E*TRADE Clearing to E*TRADE Bank during the first and third quarters of 2009(1), respectively. While we cannot assure that we would obtain regulatory approval again in the future to withdraw any of this excess net capital, $439.5 million is available for dividend while still maintaining a capital level above regulatory “early warning” guidelines.

Other Sources of Liquidity

We also maintain $375 million in uncommitted financing to meet margin lending needs. At September 30, 2009, there were no outstanding balances and the full $375 million was available.

We rely on borrowed funds, such as FHLB advances and securities sold under agreements to repurchase, to provide liquidity for the Bank. Our ability to borrow these funds is dependent upon the continued availability of funding in the wholesale borrowings market. At September 30, 2009, the Bank had approximately $5.8 billion in additional collateralized borrowing capacity with the FHLB. We will also have the ability to generate liquidity in the form of additional deposits by raising the yield on our customer deposit accounts.

We have the option to make the interest payments on our 12 1/2% Notes in the form of either cash or additional 12 1/2% Notes through May 2010. During the second quarter of 2008, we elected to make our first interest payment of approximately $121 million in cash. During the fourth quarter of 2008 and second quarter of 2009, we elected to make our second and third interest payments of $121 million and $129 million, respectively, in the form of additional 12 1/2% Notes. As a result of the Debt Exchange, the interest payments on the 12 1/2% Notes were reduced to approximately $109 million per annum. We intend to make our next interest payment of $55 million (November 2009) in the form of additional 12 1/2% Notes. We will determine whether to make the May 2010 interest payment in the form of cash or additional 12 1/2% Notes based on the facts and circumstances at that time. The November 2010 payment is the first interest payment we are required to pay in cash.

Corporate Debt

Our current senior debt ratings are B3 by Moody’s Investor Service, CCC by Standard & Poor’s and B (high) by Dominion Bond Rating Service (“DBRS”). The Company’s long-term deposit ratings are Ba3 by Moody’s Investor Service, B- by Standard & Poor’s and BB by DBRS. A significant change in these ratings may impact the rate and availability of future borrowings.

Off-Balance Sheet Arrangements

We enter into various off-balance-sheet arrangements in the ordinary course of business, primarily to meet the needs of our customers and to reduce our own exposure to interest rate risk. These arrangements include firm commitments to extend credit and letters of credit. Additionally, we enter into guarantees and other similar arrangements as part of transactions in the ordinary course of business. For additional information on each of these arrangements, see Item 1. Consolidated Financial Statements (Unaudited).

 

(1)   The dividends did not impact E*TRADE Bank’s regulatory capital as E*TRADE Clearing is a subsidiary of E*TRADE Bank and is already included in its consolidated capital base.

 

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RISK MANAGEMENT

As a financial services company, we are exposed to risks in every component of our business. The identification and management of existing and potential risks are the keys to effective risk management. Our risk management framework, principles and practices support decision-making, improve the success rate for new initiatives and strengthen the organization. Our goal is to balance risks and rewards through effective risk management. Risks cannot be completely eliminated; however, we do believe risks can be identified and managed within the Company’s risk tolerance.

Our businesses expose us to the following four major categories of risk that often overlap:

 

   

Credit Risk—Credit risk is the risk of loss resulting from adverse changes in the ability or willingness of a borrower or counterparty to meet the agreed-upon terms of their financial obligations.

 

   

Liquidity Risk—Liquidity risk is the risk of loss resulting from the inability to meet current and future cash flow and collateral needs.

 

   

Interest Rate Risk—Interest rate risk is the risk of loss from adverse changes in interest rates, which could cause fluctuations in our long-term earnings or in the value of the Company’s net assets.

 

   

Operational Risk—Operational risk is the risk of loss resulting from fraud, inadequate controls or the failure of the internal controls process, third party vendor issues, processing issues and external events.

For additional information on liquidity risk, see Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources. For additional information about our interest rate risks, see Item 3. Quantitative and Qualitative Disclosures about Market Risk. Operational risks and the management of risk are more fully described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Current Report on Form 8-K filed May 14, 2009. We are also subject to other risks that could impact our business, financial condition, results of operations or cash flows in future periods. See Part II-Item 1A. Risk Factors.

Credit Risk Management

Our primary sources of credit risk are our loan and securities portfolios, where risk results from extending credit to customers and purchasing securities, respectively. The degree of credit risk associated with our loans and securities varies based on many factors including the size of the transaction, the credit characteristics of the borrower, features of the loan product or security, the contractual terms of the related documents and the availability and quality of collateral. Credit risk is one of the most common risks in financial services and is one of our most significant risks.

Credit risk is monitored by our Credit Risk Committee. The Credit Risk Committee uses detailed tracking and analysis to measure credit performance and reviews and modifies credit policies as appropriate.

Loss Mitigation

Given the deterioration in the performance of our loan portfolio, particularly in our home equity loan portfolio, we formed a special credit management team in early 2008 to focus on the mitigation of potential losses in the home equity loan portfolio.

This team’s initial focus was to reduce our exposure to open home equity lines. Through a variety of strategies, including voluntary line closures, automatically freezing lines on all delinquent accounts, and freezing lines on loans with materially reduced home equity, we have reduced this amount from a high of over $7 billion in 2007 to $1.1 billion as of September 30, 2009.

We initiated a loan modification program in 2008 that in its early stages, resulted in an insignificant number of minor modifications. This loan modification program became more active during the first half of 2009 and is now the primary focus of the special credit management team. We consider modifications in which we made an

 

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economic concession to a borrower experiencing financial difficulty a troubled debt restructuring (“TDR”). As of September 30, 2009, we had modified $436.9 million of loans in which the modification was considered a TDR. We also modified a number of loans through traditional collections actions taken in the normal course of servicing delinquent accounts. These actions typically result in an insignificant delay in the timing of payments; therefore, the Company does not consider such activities to be economic concessions to the borrowers. On February 18, 2009, the U.S. Department of the Treasury announced the Homeowner Affordability and Stability Plan. The primary focus of this plan is to create requirements and provide incentives to modify mortgages with the goal of avoiding foreclosure. We believe our loan modification program goals are in line with the Homeowner Affordability and Stability Plan and we have aligned our servicer guidelines with the government’s program. Our loan modification programs target borrowers who demonstrate a willingness and ability to meet their loan obligations and stay in their homes. To date our programs have focused on modifications to the rate and term of loans, which often results in a lower monthly payment for the borrower.

The team has several other initiatives either in progress or in development which are focused on mitigating losses in our home equity loan portfolio. Those initiatives include improving collection efforts and practices of our servicers as well as increasing our loss recovery efforts to minimize the level of loss on a loan that goes to charge-off.

In addition, we continue to review our mortgage loan portfolio in order to identify loans to be repurchased by the originator. Our review is primarily focused on identifying loans with violations of transaction representations and warranties or material misrepresentation on the part of the seller. Any loans identified with these deficiencies are submitted to the original seller for repurchase. Approximately $62.3 million and $105.6 million of loans were repurchased by the original sellers for the nine months ended September 30, 2009 and for the year ended December 31, 2008, respectively.

Underwriting Standards—Originated Loans

During the second quarter of 2008, we exited our retail mortgage origination business, which represented our last remaining loan origination channel. During the three months ended September 30, 2008, we did not originate any one- to four-family loans. Prior to the exit of our retail mortgage origination business, we originated approximately $158 million in one- to four-family loans during the six months ended June 30, 2008. These loans were predominantly prime credit quality first-lien mortgage loans secured by a single-family residence. In the first quarter of 2009, we partnered with a third party company to provide access to real estate loans for our customers. This product is being offered as a convenience to our customers and is not one of our primary product offerings. We structured this arrangement to minimize our assumption of any of the typical risks commonly associated with mortgage lending. The third party company providing this product performs all processing and underwriting of these loans. Shortly after closing, the third party company purchases the loans from us and is responsible for the credit risk associated with these loans. We originated $77.6 million in loans during the nine months ended September 30, 2009 and we had commitments to originate mortgage loans of $28.2 million at September 30, 2009.

CONCENTRATIONS OF CREDIT RISK

Loans

We track and review many factors to predict and monitor credit risk in our loan portfolio, which is primarily made up of loans secured by residential real estate. These factors, which are documented at the time of origination, include: borrowers’ debt-to-income ratio, borrowers’ credit scores, housing prices, documentation type, occupancy type, and loan type. We also review estimated current loan-to-value (“LTV”) ratios when monitoring credit risk in our loan portfolios. In economic conditions in which housing prices generally appreciate, we believe that loan type, LTV ratios and credit scores are the key factors in determining future loan performance. In the current housing market with declining home prices and less credit available for refinance, we believe the LTV ratio becomes a more important factor in predicting and monitoring credit risk.

 

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We believe certain categories of loans inherently have a higher level of credit risk due to characteristics of the borrower and/or features of the loan. Two of these categories are sub-prime and option ARM loans. As a general matter, we did not originate or purchase these loans to hold on our balance sheet; however, in the normal course of purchasing large pools of real estate loans, we invariably ended up acquiring a de minimis amount of sub-prime loans. As of September 30, 2009, sub-prime(1) real estate loans represented less than one-fifth of one percent of our total real estate loan portfolio and we held no option ARM loans.

As noted above, we believe loan type, LTV ratios and borrowers’ credit scores are key determinants of future loan performance. Our home equity loan portfolio is primarily second lien loans(2) on residential real estate properties, which have a higher level of credit risk than first lien mortgage loans. We believe home equity loans with a combined loan-to-value (“CLTV”) of 90% or higher or a Fair Isaac Credit Organization (“FICO”) score below 700 are the loans with the highest levels of credit risk in our portfolios.

The breakdowns by LTV/CLTV and FICO score of our two main loan portfolios, one-to four-family and home equity, are as follows (dollars in thousands):

 

     One- to Four-Family     Home Equity  

LTV/CLTV

at Origination(3)

   September 30,
2009
    December 31,
2008
    September 30,
2009
    December 31,
2008
 

<=70%

   $ 4,814,097      $ 5,647,650      $ 2,510,460      $ 3,126,274   

70% - 80%

     6,010,759        7,008,860        1,512,232        1,822,797   

80% - 90%

     223,616        162,966        2,745,365        3,312,332   

>90%

     128,705        160,368        1,388,308        1,755,780   
                                

Total

   $ 11,177,177      $ 12,979,844      $ 8,156,365      $ 10,017,183   
                                

Average LTV/CLTV at loan origination(4)

     70.1     68.8     79.4     79.1

Average estimated current LTV/CLTV(5)

     92.9     90.1     101.8     99.7
     One- to Four-Family     Home Equity  

FICO at Origination

   September 30,
2009
    December 31,
2008
    September 30,
2009
    December 31,
2008
 

>=720

   $ 7,370,832      $ 8,680,892      $ 4,882,985      $ 6,005,837   

719 - 700

     1,548,012        1,750,294        1,313,034        1,591,380   

699 - 680

     1,187,413        1,342,967        1,127,737        1,379,218   

679 - 660

     691,423        784,449        475,782        595,776   

659 - 620

     371,379        412,514        347,830        432,862   

<620

     8,118        8,728        8,997        12,110   
                                

Total

   $ 11,177,177      $ 12,979,844      $ 8,156,365      $ 10,017,183   
                                

 

(1)   Defined as borrowers with FICO scores less than 620 at the time of origination.
(2)   Approximately 13% of the home equity portfolio is in the first lien position. For home equity loans that are in a second lien position, we also hold the first lien position on the same residential real estate property for less than 1% of the loans in this portfolio.
(3)   CLTV at origination calculations for home equity are based on drawn balances.
(4)   Average LTV/CLTV at loan origination calculations are based on LTV/CLTV at time of purchase for one- to four-family purchased loans and undrawn balances for home equity loans.
(5)   The average estimated current LTV ratio reflects the outstanding balance at the balance sheet date, divided by the estimated current property value. Current property values are updated on a quarterly basis using the most recent property value data available to us. For properties in which we did not have an updated valuation, we utilized home price indices to estimate the current property value.

 

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In addition to the factors described above, we monitor credit trends in loans by acquisition channel, vintage and geographic location, which are summarized below as of September 30, 2009 and December 31, 2008 (dollars in thousands):

 

     One- to Four-Family    Home Equity

Acquisition Channel

   September 30,
2009
   December 31,
2008
   September 30,
2009
   December 31,
2008

Purchased from a third party

   $ 9,150,272    $ 10,646,324    $ 7,150,614    $ 8,873,156

Originated by the Company

     2,026,905      2,333,520      1,005,751      1,144,027
                           

Total real estate loans

   $ 11,177,177    $ 12,979,844    $ 8,156,365    $ 10,017,183
                           
     One- to Four-Family    Home Equity

Vintage Year

   September 30,
2009
   December 31,
2008
   September 30,
2009
   December 31,
2008

2003 and prior

   $ 466,090    $ 577,408    $ 533,123    $ 754,054

2004

     1,086,624      1,309,985      751,054      990,138

2005

     2,338,390      2,695,718      1,988,820      2,426,000

2006

     4,186,301      4,890,407      3,865,219      4,668,721

2007

     3,071,700      3,475,661      1,002,704      1,161,667

2008

     28,072      30,665      15,445      16,603
                           

Total real estate loans

   $ 11,177,177    $ 12,979,844    $ 8,156,365    $ 10,017,183
                           
     One- to Four-Family    Home Equity

Geographic Location

   September 30,
2009
   December 31,
2008
   September 30,
2009
   December 31,
2008

California

   $ 5,124,429    $ 5,853,497    $ 2,597,851    $ 3,056,819

New York

     846,628      966,005      557,827      628,886

Florida

     751,002      859,806      594,011      725,810

Virginia

     461,855      541,058      342,174      397,722

Other states

     3,993,263      4,759,478      4,064,502      5,207,946
                           

Total real estate loans

   $ 11,177,177    $ 12,979,844    $ 8,156,365    $ 10,017,183
                           

Allowance for Loan Losses

The allowance for loan losses is management’s estimate of credit losses inherent in our loan portfolio as of the balance sheet date. The estimate of the allowance for loan losses is based on a variety of factors, including the composition and quality of the portfolio; delinquency levels and trends; current and historical charge-off and loss experience; current industry charge-off and loss experience; the condition of the real estate market and geographic concentrations within the loan portfolio; the interest rate climate; the overall availability of housing credit; and general economic conditions. The allowance for loan losses is typically equal to management’s estimate of loan charge-offs in the twelve months following the balance sheet date as well as the estimated charge-offs, including economic concessions to borrowers, over the estimated remaining life of loans modified in troubled debt restructurings. Determining the adequacy of the allowance is complex and requires judgment by management about the effect of matters that are inherently uncertain. Subsequent evaluations of the loan portfolio, in light of the factors then prevailing, may result in significant changes in the allowance for loan losses in future periods. We believe our allowance for loan losses at September 30, 2009 is representative of probable losses inherent in the loan portfolio at the balance sheet date.

In determining the allowance for loan losses, we allocate a portion of the allowance to various loan products based on an analysis of individual loans and pools of loans. However, the entire allowance is available to absorb credit losses inherent in the total loan portfolio as of the balance sheet date.

 

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The following table presents the allowance for loan losses by major loan category (dollars in thousands):

 

    One- to Four-Family     Home Equity     Consumer and Other     Total  
    Allowance   Allowance
as a % of
Loans
Receivable(1)
    Allowance   Allowance
as a % of
Loans
Receivable(1)
    Allowance   Allowance
as a % of
Loans
Receivable(1)
    Allowance   Allowance
as a % of
Loans
Receivable(1)
 

September 30, 2009

  $ 450,975   4.02   $ 693,185   8.37   $ 70,358   3.56   $ 1,214,518   5.66

December 31, 2008

  $ 185,163   1.42   $ 833,835   8.19   $ 61,613   2.65   $ 1,080,611   4.23

 

(1)  

Allowance as a percentage of loans receivable is calculated based on the gross loans receivable for each respective category.

During the nine months ended September 30, 2009, the allowance for loan losses increased by $133.9 million from the level at December 31, 2008. This increase was driven primarily by the increase in the allowance allocated to the one- to four-family loan portfolio, which began to deteriorate during 2008. However, the majority of the allowance as of September 30, 2009 related to the home equity portfolio, which began to deteriorate during the second half of 2007. We believe the deterioration in both of these portfolios was caused by several factors, including: home price depreciation in key markets; growing inventories of unsold homes; rising foreclosure rates; significant contraction in the availability of credit; and a general decline in economic growth. In addition, the combined impact of home price depreciation and the reduction of available credit made it increasingly difficult for borrowers to refinance existing loans. Although we expect these factors will cause the provision for loan losses to continue at historically high levels in future periods, the level of provision for loan losses in the third quarter of 2009 represents the fourth consecutive quarter in which the provision for loan losses has declined when compared to the prior quarter. While we cannot state with certainty that this trend will continue, we believe it is a positive indicator that our loan portfolio may be stabilizing.

Included in our allowance for loan losses at September 30, 2009 was a specific allowance of $144.1 million that was established for TDRs. The specific allowance for these individually impaired loans represents the expected loss, including the economic concession to the borrower, over the remaining life of the loan. The following table shows the TDRs and specific valuation allowance by loan portfolio (dollars in thousands):

 

     Recorded
Investment

in TDRs
   Specific
Valuation
Allowance
   Specific Valuation
Allowance as a % of
TDR Loans
 

September 30, 2009

           

One- to four-family

   $ 174,867    $ 25,958    15

Home equity

     261,995      118,125    45
                

Total(1)

   $ 436,862    $ 144,083    33
                

 

(1)  

The recorded investment in TDRs represents the balance of TDRs, net of charge-offs, at September 30, 2009.

The following table shows the TDRs by delinquency category (dollars in thousands):

 

     TDRs
Current
   TDRs
30-89 Days
Delinquent
   TDRs 90+
Days
Delinquent
   Total
Recorded
Investment
in TDRs

September 30, 2009

                   

One- to four-family

   $ 110,105    $ 35,698    $ 29,064    $ 174,867

Home equity

     218,418      30,691      12,886      261,995
                           

Total

   $ 328,523    $ 66,389    $ 41,950    $ 436,862
                           

 

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The following table provides an analysis of the net charge-offs for the three and nine months ended September 30, 2009 and 2008 (dollars in thousands):

 

     Charge-offs     Recoveries    Net
Charge-offs
    % of
Average Loans
(Annualized)
 

Three months ended September 30, 2009:

                  

One- to four-family

   $ (110,376   $ —      $ (110,376   3.84

Home equity

     (227,894     4,401      (223,493   9.93

Recreational vehicle

     (18,635     7,222      (11,413   3.24

Marine

     (4,129     1,548      (2,581   2.72

Other

     (4,035     255      (3,780   6.24
                         

Total

   $ (365,069   $ 13,426    $ (351,643   6.25
                         

Three months ended September 30, 2008:

                       

One- to four-family

   $ (33,511   $ —      $ (33,511   0.98

Home equity

     (233,616     2,044      (231,572   8.57

Recreational vehicle

     (14,155     4,155      (10,000   2.33

Marine

     (3,198     960      (2,238   1.95

Other

     (2,550     410      (2,140   2.54
                         

Total

   $ (287,030   $ 7,569    $ (279,461   4.15
                         

Nine months ended September 30, 2009:

                       

One- to four-family

   $ (254,489   $ —      $ (254,489   4.19

Home equity

     (765,656     10,152      (755,504   15.88

Recreational vehicle

     (60,638     19,035      (41,603   5.59

Marine

     (14,821     4,691      (10,130   5.07

Other

     (11,048     971      (10,077   7.61
                         

Total

   $ (1,106,652   $ 34,849    $ (1,071,803   9.00
                         

Nine months ended September 30, 2008:

                       

One- to four-family

   $ (80,740   $ 455    $ (80,285   0.75

Home equity

     (589,254     4,638      (584,616   6.87

Recreational vehicle

     (39,290     12,235      (27,055   2.00

Marine

     (9,364     3,469      (5,895   1.61

Other

     (8,399     1,516      (6,883   2.56
                         

Total

   $ (727,047   $ 22,313    $ (704,734   3.32
                         

Loan losses are recognized when it is probable that a loss will be incurred. Our policy for both one- to four-family and home equity loans is to assess the value of the property when the loan has been delinquent for 180 days or is in bankruptcy, regardless of whether or not the property is in foreclosure, and charge-off the amount of the loan balance in excess of the estimated current property value. Our policy is to charge-off credit cards when collection is not probable or the loan has been delinquent for 180 days and to charge-off closed-end consumer loans when the loan is 120 days delinquent or when we determine that collection is not probable.

 

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Net charge-offs for the three and nine months ended September 30, 2009 compared to the same periods in 2008 increased by $72.2 million and $367.1 million, respectively. The overall increase was primarily due to higher net charge-offs on our one- to four-family loans and home equity loans, which were driven mainly by the same factors as described above. We believe net charge-offs will begin to decline in future periods when compared to the level of charge-offs in the three months ended September 30, 2009 as a result of our decline in special mention delinquencies, which is discussed below. The following graph illustrates the net charge-offs by quarter:

LOGO

Nonperforming Assets

We classify loans as nonperforming when they are 90 days past due. The following table shows the comparative data for nonperforming loans and assets (dollars in thousands):

 

     September 30,
2009
    December 31,
2008
 

One- to four-family

   $ 1,185,607      $ 593,075   

Home equity

     274,233        341,255   

Consumer and other loans

     14,688        7,792   
                

Total nonperforming loans

     1,474,528        942,122   

REO and other repossessed assets, net

     89,710        108,105   
                

Total nonperforming assets, net

   $ 1,564,238      $ 1,050,227   
                

Nonperforming loans receivable as a percentage of gross loans receivable

     6.87     3.69

One- to four-family allowance for loan losses as a percentage of one- to four-family nonperforming loans

     38.04     31.22

Home equity allowance for loan losses as a percentage of home equity nonperforming loans

     252.77     244.34

Consumer and other allowance for loan losses as a percentage of consumer and other nonperforming loans

     479.02     790.72

Total allowance for loan losses as a percentage of total nonperforming loans

     82.37     114.70

During the nine months ended September 30, 2009, our nonperforming assets, net increased $514.0 million to $1.6 billion when compared to December 31, 2008. The increase was attributed primarily to a $479.7 million

 

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increase in our one- to four-family loans delinquent in excess of 180 days for the nine months ended September 30, 2009 when compared to December 31, 2008. This increase was due primarily to the extensive amount of time it takes to foreclose on a property in the current real estate market.

The following graph illustrates the nonperforming loans by quarter:

LOGO

The allowance as a percentage of total nonperforming loans receivable, net decreased from 114.70% at December 31, 2008 to 82.37% at September 30, 2009. This decrease was driven by an increase in one- to four-family nonperforming loans, which have a lower level of expected loss when compared to home equity loans as one- to four-family loans are generally secured in a first lien position by real estate assets. The balance of nonperforming loans includes loans delinquent 90 to 179 days as well as loans delinquent 180 days and greater. We believe the distinction between these two periods is important as loans delinquent 180 days and greater have been written down to their expected recovery value, whereas loans delinquent 90 to 179 days have not. We believe the allowance for loan losses expressed as a percentage of loans delinquent 90 to 179 days is an important measure of the adequacy of the allowance as these loans are expected to drive the vast majority of future charge-offs. Additional charge-offs on loans delinquent 180 days are possible if home prices decline beyond our current expectations, but we do not anticipate these charge-offs to be significant, particularly when compared to the expected charge-offs on loans delinquent 90 to 179 days. We consider this ratio especially important for one- to four-family loans as we expect the balances of loans delinquent 180 days and greater to increase in the future due to the extensive amount of time it takes to foreclose on a property in the current real estate market.

The following table shows the allowance for loan losses as a percentage of loans delinquent 90 to 179 days for each of our major loan categories (dollars in thousands):

 

     September 30,
2009
   Allowance as a % of Loans
Delinquent 90 to 179 days
 

One- to four-family loans

   $ 385,724    116.92

Home equity loans

     208,496    332.47

Consumer and other loans

     4,965    1417.08
         

Total loans delinquent 90 to 179 days

   $ 599,185    202.69
         

 

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In addition to nonperforming assets, we monitor loans where a borrower’s past credit history casts doubt on their ability to repay a loan (“special mention” loans). We classify loans as special mention when they are between 30 and 89 days past due. The following table shows the comparative data for special mention loans (dollars in thousands):

 

     September 30,
2009
    December 31,
2008
 

One- to four-family

   $ 527,617      $ 594,379   

Home equity

     269,803        407,386   

Consumer and other loans

     30,528        33,298   
                

Total special mention loans

   $ 827,948      $ 1,035,063   
                

Special mention loans receivable as a percentage of gross loans receivable

     3.86     4.05

The trend in special mention loan balances are generally indicative of the expected trend for charge-offs in future periods, as these loans have a greater propensity to migrate into nonaccrual status and ultimately charge-off. One- to four-family loans are generally secured in a first lien position by real estate assets, reducing the potential loss when compared to an unsecured loan. Our home equity loans are generally secured by real estate assets; however, the majority of these loans are secured in a second lien position, which substantially increases the potential loss when compared to a first lien position.

During the nine months ended September 30, 2009, special mention loans decreased by $207.1 million to $827.9 million. This decrease was almost entirely due to a decrease in home equity special mention loans. The decrease in home equity special mention loans includes the impact of our loan modification programs in which borrowers who were 30 to 89 days past due were made current(1). While our level of special mention loans can fluctuate significantly in any given period, we believe the decrease we observed in the first half of 2009 is an encouraging sign regarding the future credit performance of this portfolio.

The following graph illustrates the special mention loans by quarter:

LOGO

 

(1)   Loans modified as TDRs are accounted for as nonaccrual loans at the time of modification and return to accrual status after six consecutive payments are made in accordance with the modified terms.

 

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Securities

We focus primarily on security type and credit rating to monitor credit risk in our securities portfolios. We believe our highest concentration of credit risk within this portfolio is the non-agency CMO portfolio. The table below details the amortized cost by average credit ratings and type of asset as of September 30, 2009 and December 31, 2008 (dollars in thousands):

 

September 30, 2009

  AAA   AA