Form 10-Q
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

 

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

For the quarterly period ended March 31, 2010

OR

 

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

For the transition period from              to             

Commission File No. 1-13300

 

 

CAPITAL ONE FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

 

 

 

Delaware   54-1719854

(State or Other Jurisdiction of

Incorporation or Organization)

 

(I.R.S. Employer

Identification No.)

1680 Capital One Drive McLean, Virginia   22102
(Address of Principal Executive Offices)   (Zip Code)

Registrant’s telephone number, including area code:

(703) 720-1000

(Not applicable)

(Former name, former address and former fiscal year, if changed since last report)

 

 

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 (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    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 the 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   ¨    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

As of April 30, 2010, there were 456,534,936 shares of the registrant’s Common Stock, par value $.01 per share, outstanding.

 

 

 


Table of Contents

TABLE OF CONTENTS

 

PART I—FINANCIAL INFORMATION    1

Item 1.

  Financial Statements    54
 

Consolidated Balance Sheets

   54
 

Consolidated Statements of Income

   55
 

Consolidated Statements of Changes in Stockholders’ Equity

   56
 

Consolidated Statements of Cash Flows

   57
 

Notes to Consolidated Financial Statements

   58
    Note   1 —   Summary of Significant Accounting Policies    58
    Note   2 —   Loans Acquired in a Transfer    61
    Note   3 —   Discontinued Operations    62
    Note   4 —   Business Segments    63
    Note   5 —   Securities Available for Sale    65
    Note   6 —   Loans Held for Investment, Allowance for Loan and Lease Losses and Unfunded Lending Commitments    72
    Note   7 —   Fair Value of Financial Instruments    73
    Note   8 —   Goodwill and Other Intangible Assets    80
    Note   9 —   Deposits and Borrowings    82
    Note 10 —   Shareholders’ Equity, Other Comprehensive Income and Earnings Per Common Share    84
    Note 11 —   Mortgage Servicing Rights    85
    Note 12 —   Derivative Instruments and Heding Activities    86
    Note 13 —   Securitizations    92
    Note 14 —   Commitments, Contingencies and Guarantees    102
    Note 15 —   Other Variable Interest Entities    105
    Note 16 —   Subsequent Events    106

Item 2.

  Management’s Discussion and Analysis of Financial Condition and Results of Operations    1
  I.  

Introduction

   1
  II.  

Impact from Adoption of New Consolidation Accounting Standards

   2
  III.  

Executive Summary and Business Outlook

   3
  IV.  

Critical Accounting Policies and Estimates

   8
  V.  

Recent Accounting Pronouncements

   9
  VI.  

Off-Balance Sheet Arrangements and Variable Interest Entities

   9
  VII.  

Consolidated Financial Performance

   10
  VIII.  

Consolidated Balance Sheet Analysis and Credit Performance

   15
  IX.  

Business Segment Financial Performance

   24
  X.  

Liquidity and Funding

   31
  XI.  

Market Risk Management

   36
  XII.  

Capital

   38
  XIV.  

Supervision and Regulation

   39
  XV.  

Enterprise Risk Management

   43
  XVI.  

Forward-Looking Statements

   44
  XVII.  

Supplemental Statistical Tables

   46

Item 3.

  Quantitative and Qualitative Disclosures about Market Risk    107

Item 4.

  Controls and Procedures    107
PART II—Other Information    107

Item 1.

  Legal Proceedings    107

Item 1A.

  Risk Factors    107

Item 2.

  Unregistered Sales of Equity Securities and Use of Proceeds    107

Item 3.

  Defaults upon Senior Securities    108

Item 4.

  (Removed and Reserved)    108

Item 5.

  Other Information    108

Item 6.

  Exhibits    108
SIGNATURES    109
INDEX TO EXHIBITS    E-1

 

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INDEX OF MD&A AND SUPPLEMENTAL TABLES

 

Table

  

Description

   Page

   MD&A Tables:   

1

   Consolidated Corporate Financial Summary and Selected Metrics    10

2

   Net Interest Income    12

3

   Non-Interest Income    13

4

   Non-Interest Expense    14

5

   Securities Available for Sale    15

6

   Loan Portfolio Composition    16

7

   30+ Day Performing Delinquencies    17

8

   Nonperforming Loans    18

9

   Net Charge-Offs    19

10

   Loan Modifications and Restructurings    20

11

   Summary of Allowance for Loan and Lease Losses    21

12

   Allocation of the Allowance for Loan and Lease Losses    22

13

   Credit Card Business    25

14

   Commercial Banking Business    28

15

   Consumer Banking Business    29

16

   Liquidity Reserves    32

17

   Deposits    33

18

   Deposit Composition and Average Deposit Rates    34

19

   Borrowing Capacity    35

20

   Senior Unsecured Debt Credit Ratings    36

21

   Interest Rate Sensitivity Analysis    37

22

   Capital Ratios    38

   Supplemental Statistical Tables:   

A

   Statements of Average Balances, Income and Expense, Yields and Rates    46

B

   Interest Variance Analysis    48

C

   Managed Loan Portfolio    49

D

   Composition of Reported Loan Portfolio    51

E

   Delinquencies    51

F

   Net Charge-Offs    52

G

   Nonperforming Assets    52

 

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PART I—FINANCIAL INFORMATION

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

You should read this Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) in conjunction with our unaudited condensed consolidated financial statements and related notes, and the more detailed information contained in our 2009 Annual Report on Form 10-K (“2009 Form 10-K”). This discussion contains forward-looking statements that are based upon management’s current expectations and are subject to significant uncertainties and changes in circumstances. Our actual results may differ materially from those included in these forward-looking statements due to a variety of factors including, but not limited to, those described in this report in “Part II —Item 1A. Risk Factors” and in our 2009 Form 10-K in “Part I—Item 1A. Risk Factors.”

 

 

I. INTRODUCTION

 

Capital One Financial Corporation (the “Corporation”) is a diversified financial services company with banking and non-banking subsidiaries that market a variety of financial products and services. We continue to deliver on our strategy of combining the power of national scale lending and local scale banking. Our principal subsidiaries include:

 

 

Capital One Bank (USA), National Association (“COBNA”) which currently offers credit and debit card products, other lending products and deposit products.

 

 

Capital One, National Association (“CONA”) which offers a broad spectrum of banking products and financial services to consumers, small businesses and commercial clients. On July 30, 2009, we merged Chevy Chase Bank, F.S.B. (“Chevy Chase Bank”) into CONA.

Our revenues are primarily driven by lending to consumers and commercial customers and by deposit-taking activities which generate net interest income, and by activities that generate non-interest income, including the sale and servicing of loans and providing fee-based services to customers. Customer usage and payment patterns, credit quality, levels of marketing expense and operating efficiency all affect our profitability. Our expenses primarily consist of the cost of funding our assets, our provision for loan and lease losses, operating expenses (including associate salaries and benefits, infrastructure maintenance and enhancements, and branch operations and expansion costs), marketing expenses, and income taxes. We had $130.1 billion in total loans outstanding and $117.8 billion in deposits as of March 31, 2010, compared with $136.8 billion in total managed loans outstanding and $115.8 billion in deposits as of December 31, 2009.

We evaluate our financial performance and report our results through three operating segments: Credit Card, Commercial Banking and Consumer Banking.

 

 

Credit Card: Consists of our domestic consumer and small business card lending, domestic national small business lending, national closed end installment lending and the international card lending businesses in Canada and the United Kingdom.

 

 

Commercial Banking: Consists of our lending, deposit gathering and treasury management services to commercial real estate and middle market customers. Our Commercial Banking business results also include the results of a national portfolio of small ticket commercial real-estate loans that are in run-off mode.

 

 

Consumer Banking: Consists of our branch-based lending and deposit gathering activities for small business customers, as well as branch-based consumer deposit gathering and lending activities, national deposit gathering, national automobile lending, consumer mortgage lending and servicing activities.

 

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II. IMPACT FROM ADOPTION OF NEW CONSOLIDATION ACCOUNTING STANDARDS

 

Impact on Reported Financial Information

Effective January 1, 2010, we prospectively adopted two new accounting standards that have a significant impact on our accounting for entities previously considered to be off-balance sheet arrangements. The adoption of these new accounting standards resulted in the consolidation of our credit card securitization trusts, one of our installment loan trusts and certain option-ARM mortgage loan trusts originated by Chevy Chase Bank. Prior to January 1, 2010, transfers of our credit card receivables, installment loans and certain option-adjustable rate mortgage loans to our securitization trusts were accounted for as sales and treated as off-balance sheet. At adoption of these new accounting standards on January 1, 2010, we added to our reported consolidated balance sheet approximately $41.9 billion of assets, consisting primarily of credit card loan receivables underlying the consolidated securitization trusts, along with approximately $44.3 billion of related debt issued by these trusts to third-party investors. We also recorded an after-tax charge to retained earnings on January 1, 2010 of $2.9 billion, reflecting the net cumulative effect of adopting these new accounting standards. This charge primarily related to the addition of $4.3 billion to our allowance for loan and lease losses for the newly consolidated loans and the recording of $1.6 billion in related deferred tax assets. The initial recording of these amounts on our reported balance sheet as of January 1, 2010 had no impact on our reported results of operations. We provide additional information on the impact on our financial statements from the adoption of these new accounting standards in “Note 1—Summary of Significant Accounting Policies” and “Note 13—Securitizations.” We discuss the impact on our capital ratios below in “Capital.”

Although the adoption of these new accounting standards does not change the economic risk to our business, specifically Capital One’s exposure to liquidity, credit, and interest rate risks, the prospective adoption of these rules has a significant impact on our capital ratios and the presentation of our reported consolidated financial statements, including changes in the classification of specific income statement line items. The most significant changes to our reported consolidated financial statements are outlined below:

 

Financial Statement

  

Accounting and Presentation Changes

Balance Sheet

  

•  Significant increase in restricted cash, securitized loans and securitized debt resulting from the consolidation of securitization trusts.

 

•  Significant increase in the allowance for loan and lease losses resulting from the establishment of a loan loss reserve for the loans underlying the consolidated securitization trusts.

 

•  Significant reduction in accounts receivable from securitizations resulting from the reversal of retained interests held in securitization trusts that have been consolidated.

Statement of Income

  

•  Significant increase in interest income and interest expense attributable to the securitized loans and debt underlying the consolidated securitization trusts.

 

•  Provision for loan and lease losses reflects the impact of the establishment of an allowance for loan and lease losses for the loans underlying the consolidated securitization trusts.

 

•  Amounts previously recorded as servicing and securitization income are now classified in our results of operations in the same manner as the earnings on loans not held in securitization trusts.

Statement of Cash Flows

  

•  Significant change in the amounts of cash flows from investing and financing activities.

Beginning with the first quarter of 2010, our reported consolidated income statements no longer reflect securitization and servicing income related to newly consolidated loans. Instead, we report interest income, net charge-offs and certain other income associated with securitized loan receivables and interest expense associated with the debt securities issued from the trust to third party investors in the same income statement categories as loan receivables and corporate debt. Additionally, we no longer record initial gains on new securitization activity since the majority of our securitized loans will no longer receive sale accounting treatment. Because our securitization transactions are being accounted for under the new consolidation accounting rules as secured borrowings rather than asset sales, the cash flows from these transactions

 

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are presented as cash flows from financing activities rather than as cash flows from operating or investing activities. Notwithstanding this change in accounting, our securitization transactions are structured to legally isolate the receivables from Capital One, and we do not expect to be able to access the assets of our securitization trusts. We do, however, continue to have the rights associated with our retained interests in the assets of these trusts.

Because we prospectively adopted the new consolidation accounting standards, our historical reported results and consolidated financial statements for periods prior to January 1, 2010 reflect our securitization trusts as off-balance sheet in accordance with the applicable accounting guidance in effect during this period. Accordingly, our reported results and consolidated financial statements subsequent to January 1, 2010 are not presented on a basis consistent with our reported results and consolidated financial statements for periods prior to January 1, 2010. This inconsistency limits the comparability of our post-January 1, 2010 reported results to our prior period results.

Impact on Non-GAAP Managed Financial Information

In addition to analyzing our results on a reported basis, management historically evaluated our total company and business segment results on a non-GAAP “managed” basis. Our managed presentations reflected the results from both our on-balance sheet loans and off-balance-sheet loans, and excluded the impact of card securitization activity. Our managed presentations assumed that our securitized loans had not been sold and that the earnings from securitized loans were classified in our results of operations in the same manner as the earnings on loans that we owned. Our managed results also reflected differences in accounting for the valuation of retained interests and the recognition of gains and losses on the sale interest-only strips. Our managed results did not include the addition of an allowance for loan and lease losses for the loans underlying our off-balance securitization trusts. Prior to January 1, 2010, we used our supplemental non-GAAP managed basis presentation to evaluate the credit performance and overall financial performance of our entire managed loan portfolio because the same underwriting standards and ongoing risk monitoring are used for both securitized loans and loans that we own. In addition, we used the managed presentation as the basis for making decisions about funding our operations and allocating resources, such as employees and capital. Because management used our managed basis presentation to evaluate our performance, we also provided this information to investors. We believed that our managed basis information was useful to investors because it portrayed the results of both on- and off-balance sheet loans that we managed, which enabled investors to understand the credit risks associated with the portfolio of loans reported on our consolidated balance sheet and our retained interests in securitized loans.

In periods prior to January 1, 2010, certain of our non-GAAP managed measures differed from the comparable reported measures. The adoption on January 1, 2010 of the new consolidation accounting standards resulted in accounting for the loans in our securitization trusts in our reported financial statements in a manner similar to how we account for these loans on a managed basis. As a result, our reported and managed basis presentations are generally comparable for periods beginning after January 1, 2010.

We believe that investors will be able to better understand our financial results and evaluate trends in our business if our period-over-period data are reflected on a more comparable basis. Accordingly, unless otherwise noted, this MD&A compares our reported GAAP financial information as of and for the three months ended March 31, 2010 with our non-GAAP managed based financial information as of and for the three months ended March 31, 2009 and as of December 31, 2009. We provide a reconciliation of our non-GAAP managed based information for periods prior to January 1, 2010 to the most comparable reported GAAP information in “Exhibit 99.3— Reconciliation to GAAP Financial Measures.”

 

 

III. EXECUTIVE SUMMARY AND BUSINESS OUTLOOK

 

First Quarter 2010 Financial Highlights

We reported net income of $636.3 million, or $1.40 per diluted share, for the first quarter of 2010. In comparison, we had a net loss of $172.3 million, or $(0.44) per diluted share, on both a reported and managed basis for the first quarter of 2009. As noted above, the presentation of our results on a non-GAAP managed basis prior to January 1, 2010 assumed that our securitized loans had not been sold and that the earnings from securitized loans were classified in our results of operations in the same manner as the earnings on loans that we owned. These classification differences resulted in differences in certain revenue and expense components of our results of operations on a reported basis and our results of operations on a managed basis, although net income was the same.

 

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Our acquisition of Chevy Chase Bank on February 27, 2009 also has a significant impact on the comparability of our results between the first quarter of 2010 and the first quarter of 2009. Our results for the first quarter of 2010 include a full quarter impact from Chevy Chase Bank, whereas our results for the first quarter of 2009 include only a partial quarter impact from Chevy Chase Bank.

The primary factors contributing to the improvement in our reported results for the first quarter of 2010 compared with our reported and managed results for the first quarter of 2009 were an increase in revenues, attributable to an expansion of our net interest margin, and a reduction in our provision for loan and lease losses. Our net interest margin reflected the benefit of lower funding costs and higher asset yields. We continued to see our mix of funding shift from higher-cost wholesale sources to lower-cost consumer and commercial banking deposits. In addition, lower interest rates and disciplined pricing drove a decrease in our average deposit interest rate. The decrease in our provision for loan and lease losses reflected the positive impact of improved credit performance, as economic conditions began to reflect signs of stabilization and improvement. If we excluded the impact from the adoption of the new consolidation accounting standards on our provision for loan and lease losses in the first quarter of 2010, the decrease in our provision would have been lower because the population of loans included in determining our allowance for loan and lease losses would not have included loans held in our securitization trusts that were previously off-balance sheet. In comparison, we recorded an incremental build to our allowance for loan and lease losses in the first quarter of 2009 and a higher provision for loan and lease losses due to deterioration in overall credit performance as a result of a trend of continued and severe economic weakness.

Below are additional highlights of our first quarter 2010 performance. The highlights of our results of operations are generally based on a comparison of our reported results for the first quarter of 2010 with our managed results for the first quarter of 2009. The highlights of changes in our financial condition and credit performance are generally based on our reported financial condition and credit statistics as of March 31, 2010, compared with our financial condition and credit performance on a managed basis as of December 31, 2009. We provide a more detailed discussion of our results of operation, financial condition and credit performance in “Consolidated Corporate Financial Performance,” “Consolidated Balance Sheet Analysis and Credit Performance” and “Business Segment Performance.”

 

 

Credit Card: Our Credit Card business generated net income of $489.6 million in the first quarter of 2010, up from $3.3 million in the first quarter of 2009. The primary drivers of the improvement in our Credit Card business results were an increase in the net interest margin and a significant decrease in the provision for loan and lease losses. The increase in the net interest margin was attributable to the combined impact of higher asset yields and lower funding costs. The increase in the average yield on our credit card loan portfolio reflected the benefit of pricing changes that we implemented during 2009, while the decrease in our funding costs reflected the continued shift in the mix of our funding to lower cost consumer deposits from higher cost wholesale sources. The decrease in the provision for loan and lease losses was due to more favorable credit quality trends and a decline in outstanding loan balances. As indicated above, the decrease in our provision was higher than it otherwise would have been due to the adoption of the new consolidation accounting standards.

 

 

Commercial Banking: Our Commercial Banking business generated a net loss of $49.5 million in the first quarter of 2010, compared with net income of $17.9 million in the first quarter of 2009. The stress on our commercial real estate portfolio from the weak economy continued to have an adverse impact on our Commercial Banking business, although we are seeing some signs that commercial real-estate values are beginning to stabilize.

 

 

Consumer Banking: Our Consumer Banking business generated net income of $305.4 million in the first quarter of 2010, up from $25.3 million in the first quarter of 2009. The strong profitability in our Consumer Banking business was attributable to improved credit conditions and consumer credit performance, particularly within our auto loan portfolio. Although our mortgage portfolio includes the stressed portfolio we acquired from Chevy Chase Bank, the fair value that we recorded for this portfolio at the date of acquisition already includes an estimate of credit losses expected to be realized over the remaining lives of the loans. The credit performance of these loans has been fairly consistent with our estimate of credit losses at the acquisition date; therefore, no impairment has been recognized on these loans.

 

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Charge-off and Delinquency Statistics: Although net charge-off and delinquency rates remain elevated, these rates showed signs of improvement in the first quarter of 2010. The net charge-off rate decreased to 6.01%, from 6.33% in the fourth quarter of 2009, and the 30+ day performing delinquency rate decreased to 4.22%, from 4.73% in the fourth quarter of 2009. In comparison, the net charge-off rate was 5.41% in the first quarter of 2009 and the 30+ day performing delinquency rate was 4.10%.

 

 

Allowance for Loan and Lease Losses: As a result of the adoption of the new consolidation accounting guidance, we increased our allowance for loan and lease losses by $4.3 billion to $8.4 billion on January 1, 2010. The initial recording of this amount on our reported balance sheet as of January 1, 2010 reduced our stockholders’ equity but had no impact on our reported results of operations. We reduced the amount of our allowance for loan and lease losses as of January 1, 2010, excluding the impact of deconsolidated trusts, by $565.9 million during the first quarter of 2010, to $7.8 billion as of March 31, 2010. The decrease in our allowance during the quarter reflected an improvement in overall credit quality, as well as a decrease in the balance of our loan portfolio.

 

 

Total Loans: Total loans held for investment decreased by $6.7 billion, or 5%, during the first quarter of 2010 to $130.1 billion as of March 31, 2010 from $136.8 billion as of December 31, 2009. This decrease was primarily due to charge-offs and run-off of loans in our Credit Card and Consumer Banking businesses.

 

 

Deconsolidation of Securitization Trusts: We sold certain interest-only mortgage bonds in the first quarter of 2010, which resulted in the deconsolidation of the related option-ARM mortgage trusts, which had an outstanding unpaid principal balance of $1.5 billion as of the date of the deconsolidation. Our results of operations for the first quarter of 2010 include a net gain of $127.6 million from the sale of these bonds and deconsolidation of the securitization trusts.

 

 

Capital Adequacy: Our Tier 1 risk-based capital ratio was 9.6% as of March 31, 2010, well above the regulatory well-capitalized minimum ratio. Our reported Tier 1 risk-based capital ratio was 13.8% as of December 31, 2009. Our Tier 1 risk-based capital ratio, including the January 1, 2010 impact from the adoption of the new consolidation accounting standards, would have been 9.9% as of December 31, 2009. The decline in our Tier 1 ratio in the first quarter of 2010 reflected the impact of regulatory rules that allow us to phase-in, for regulatory capital purposes, the new consolidation accounting rules over the course of 2010. The decline also reflects the disallowance, for purposes of calculating our Tier 1 ratio, of some of the deferred tax assets associated with the incremental allowance for loan and lease losses we recorded as a result of the adoption of the new consolidation accounting standards. See “Capital” below for additional information on the capital phase-in requirements related to the impact from the adoption of the new consolidation accounting standards.

Our ratio of tangible common equity to tangible assets (“TCE ratio”) was 5.5% as of March 31, 2010, down from 6.3% as of December 31, 2009. Our TCE ratio, including the January 1, 2010 impact from the adoption of the new consolidation accounting standards, would have been 4.8% as of December 31, 2009. The 70 basis point increase in our TCE ratio in the first quarter of 2010 over the pro forma ratio of 4.8% as of December 31, 2009 was driven by strong earnings in the first quarter, coupled with the $11.7 billion decline in managed assets.

 

 

Adoption of New Consolidation Accounting Standards: As indicated above, we added approximately $41.9 billion of assets, consisting primarily of credit card loan receivables underlying the consolidated securitization trusts, along with approximately $44.3 billion of related debt issued by these trusts to third-party investors to our balance sheet on January 1, 2010 as a result of the adoption of the new consolidation accounting standards.

Business Environment and Significant Developments

Economic conditions, while still challenging, continued to show signs of stabilization and improvement in the first quarter of 2010. Although the unemployment rate remained high at 9.7% in March 2010 and is likely to remain elevated for some time, it is down from a high of 10.1% in October 2009. The fundamentals of the labor market, which is a driving force in the economic recovery, appear to be moving in the right direction with signs of a slowdown in layoffs and a pick up in hiring. Consumer spending improved during the first quarter of 2010, but spending remains soft due to pressure from the weak labor and housing markets, which impacts our purchase volume and growth outlook for 2010.

 

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Business Outlook

The statements contained in this section are based on our current expectations regarding the Company’s outlook for its financial results and business strategies. Certain statements are forward looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Actual results could differ materially from those in our forward looking statements. See “Forward Looking Statements” and “Item 1A. Risk Factors” of our 2009 Form 10-K for factors that could materially influence our results.

Business Segment Expectations

We discuss below our current expectations regarding the performance of each of our business segments over the near-term based on current market conditions, the regulatory environment and our business strategies. Following this discussion, we summarize how the expected performance of our business segments will impact our overall near-term corporate financial performance.

Credit Card Business

For the remainder of 2010 and into early 2011, we expect that quarterly Domestic Card revenue margin will decline, as credit trends, seasonality, and consumer and competitor responses to the Credit CARD Act play out. Several factors drive the expected decline, including the following:

 

 

The credit-related benefit to revenue we experienced in the first quarter of 2010 is likely to diminish. As the company was able to recognize a greater portion of the finance charges and fees it billed in the first quarter as revenue, it will have a smaller backlog of first quarter billings currently deemed uncollectible that could be recognized in future quarters as credit improves.

 

 

Beginning in the second quarter, we expect to experience an additional modest decline in overlimit fee revenue resulting from the February 22, 2010 implementation of Credit CARD Act regulations.

 

 

We expect that the August 22, 2010 implementation of “reasonable and proportional” fee regulations will reduce revenue margin in the Domestic Card business. We expect a “half-quarter” revenue impact in the third quarter of 2010, and a “full quarter” effect in the fourth quarter of 2010.

 

 

As Domestic Card originations grow for the remainder of 2010, the percentage of total Domestic Card loan balances at promotional interest rates is likely to increase, reducing weighted average annual percentage rates for the Domestic Card portfolio.

By the end of 2010 or early in 2011, we expect that the quarterly Domestic Card revenue margin will be around 15%. We expect non-interest expense as a percentage of loans to increase in the near-term, largely due to the impact of the declining loan balances and the expected increase in marketing expenses. We expect that marketing expenses will increase to more normal levels over the next several quarters. The pace and extent of the expected increase in marketing expense will depend upon consumer demand and the competitive landscape. We expect that our marketing efforts, coupled with reduced charge-offs, will generate modest growth in our revolving card balances over the remainder of 2010. However, we expect that Domestic Card loan balances will be relatively flat for the remaining quarters of 2010, as growth in revolving credit cards is offset by elevated charge-offs and the continuing run-off of installment loans.

We expect the provision for loan and lease losses for our Domestic Card business to decline over the next several quarters. We believe that credit losses for our Domestic Card business peaked in the first quarter of 2010. As a result, we expect a modest reduction in charge-offs beginning in the second quarter of 2010. We believe that further reductions in the Domestic Card allowance for loan and lease losses are possible for the remainder of 2010.

As a result of these revenue and expense trends, we believe that it is likely that the pre-provision earnings as a percentage of loans for our Domestic Card business will decline through 2010 and perhaps into early 2011. We expect that this decline will be cushioned by an expected reduction in the provision for loan and lease losses for our Domestic Card business. We believe that the long-term overall economics of our Domestic Card business will continue to be very attractive.

 

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Commercial Banking Business

Although the commercial banking portfolio remained relatively flat in the first quarter of 2010, attractive lending opportunities are beginning to emerge. Based on these opportunities, we expect modest growth in our commercial banking portfolio over the course of 2010. Nonperforming loans and charge-offs will likely remain elevated across our Commercial Banking business due to continued stress on our commercial loan portfolio from the decline in commercial real estate values and continued deterioration in our commercial loan portfolio, although the pace of deterioration has slowed. We continue to believe that our commercial banking loan portfolio is well positioned to weather the downturn in commercial real estate.

Consumer Banking Business

We continue to expect an overall decline in the balance of loans in our Consumer Banking business, attributable to our auto and mortgage loan portfolios. Our auto loan balances have been declining as a result of our decision to retrench and reposition our origination volume in 2008. We expect the balance of loans in our auto finance business to continue to decline by approximately $1.5 billion; however, we are beginning to approach a point where our new auto loan originations are close to offsetting the run-offs from our previous business. We expect the balance of loans in our mortgage portfolio, which largely remains in a run-off mode, to decline by approximately $2.5 billion during 2010.

Total Company Earnings Expectations

Over the next several quarters, we expect our quarterly margins to decline to more normal historical levels, driven by an expected decrease in Domestic Card revenue margin, as well as the stabilization of funding costs. We expect that the balance of total loans will continue to decline over the next few quarters before reaching a bottom at the end of 2010 or early in 2011. We expect the continuing run-off of businesses that we exited or repositioned during the economic recession to drive the decline in total outstanding loans. We expect expenses to increase during this period, as we ramp up marketing expenses to more normal historical levels and continue to make investments in our banking infrastructure to support future growth. We expect that total operating expenses, excluding marketing expense, will remain near current levels, with modest quarterly variability, as continuing infrastructure investments are offset by continuing operating efficiency improvements. We believe the combined impact of these expected trends will result in lower quarterly “pre-provision” earnings (earnings excluding our provision for loan and lease losses) into 2011. We expect pre-provision earnings to establish a positive trend over the course of 2011.

We anticipate a continued reduction in the level of charge-offs, resulting in a decline in our provision expense for loan and lease losses. We expect the declining provision for loan and lease losses to cushion the bottom-line impact of the expected decline in pre-provision earnings.

Balance Sheet Expectations

We have discontinued the origination of national installment loans within our Domestic Card business, stopped national mortgage loan and small-ticket commercial real estate loan originations and repositioned and retrenched our auto finance business. As a result of the run-off of these businesses, which we exited or repositioned during the recession, we expect total loans to decline by approximately $7.0 billion from year-end 2009 to year-end 2010. Approximately $2.6 billion of the expected decline occurred in the first quarter of 2010. Therefore, we expect an additional decline for the remainder of 2010 of approximately $4.4 billion, which includes expected declines of approximately $2.0 billion in installment loans, $1.5 billion in mortgages, and $500 million in auto loans.

We expect that the impact of run-off portfolios will be partially offset by modest growth in revolving credit card loans in our Domestic Card business and commercial loans in the Commercial Banking business. As a result of the ongoing attrition related to businesses that we exited or repositioned during the recession, we continue to expect a mid-single digit percentage decline in total ending loan balances in 2010. Based on the rapid shrinkage in our loan balances during 2009, we expect a high-single digit percentage decline in average loan balances in 2010 compared with 2009.

Given the historically high levels of coverage, and underlying business and economic trends, further reduction in the allowance for loan and lease losses is possible over the remainder of 2010. The combination of declining outstanding loan balances and more favorable credit trends may create the potential for significant allowance releases. We expect the

 

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balance of securitized loans, which decreased by approximately $9.0 billion in the first quarter of 2010, to decrease by an additional $11 billion over the remainder of 2010. Assuming this level of decline, the balance of securitized loans at the end of 2010 would be approximately 43% lower than the balance at the end of 2009.

We previously indicated that trends in our Tier 1 capital and TCE ratios would diverge in 2010 and early 2011 as a result of our adoption of the new consolidation accounting standards. The change in these ratios during the first quarter of 2010 reflected this expectation. As permitted under the capital rules issued by banking regulators in January 2010, we elected to phase in the impact from the adoption of the new consolidation accounting standards on risk-based capital over 2010 and the first quarter of 2011. During the phase in period, we expect that our Tier 1 ratios will continue to be adversely affected by a decrease in the numerator resulting from the disallowance of a portion of the deferred tax assets associated with the increase in our allowance for loan and lease losses from consolidation and an increase in the denominator through the first quarter of 2011 due in part to the new consolidation accounting standards. We expect, however, that our Tier 1 capital ratios will remain above well capitalized minimum levels throughout the regulatory capital phase-in period for the new consolidation standards. Because regulatory capital ratios are more pro-cyclical than the TCE ratio, we expect that as credit loss levels begin to normalize, our Tier 1 ratios will more than proportionately follow the fundamental upward trajectory of the TCE ratios.

 

 

IV. CRITICAL ACCOUNTING POLICIES AND ESTIMATES

 

The preparation of financial statements in accordance with GAAP requires management to make a number of judgments, estimates and assumptions that affect the reported amount of assets, liabilities, income and expenses in the consolidated financial statements. Understanding our accounting policies and the extent to which we use management judgment and estimates in applying these policies is integral to understanding our financial statements. We describe our most significant accounting policies in “Note 1—Significant Accounting Policies” of our 2009 Form 10-K.

The use of fair value to measure our financial instruments is fundamental to the preparation of our consolidated financial statements because we account for and record a substantial portion of our assets and liabilities at fair value. The fair value accounting rules provide a three-level fair value hierarchy for classifying financial instruments. This hierarchy is based on whether the inputs to the valuation techniques used to measure fair value are observable or unobservable. Each asset or liability is assigned to a level based on the lowest level of any input that is significant to the fair value measurement. The three levels of the fair value hierarchy are described below:

 

Level 1:   Quoted prices (unadjusted) in active markets for identical assets or liabilities.
Level 2:   Observable market-based inputs, other than quoted prices in active markets for identical assets or liabilities.
Level 3:   Unobservable inputs.

 

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In the determination of the classification of financial instruments in Level 2 or Level 3 of the fair value hierarchy, we consider all available information, including observable market data, indications of market liquidity and orderliness, and our understanding of the valuation techniques and significant inputs used. Based upon the specific facts and circumstances of each instrument or instrument category, judgments are made regarding the significance of the Level 3 inputs to the instruments’ fair value measurement in its entirety. If Level 3 inputs are considered significant, the instrument is classified as Level 3. The process for determining fair value using unobservable inputs is generally more subjective and involves a high degree of management judgment and assumptions.

Our financial instruments recorded at fair value on a recurring basis represented approximately 20% of our total reported assets of $200.7 billion as of March 31, 2010, compared with 26% of our total reported assets of $169.6 billion as of December 31, 2009. Financial assets for which fair values were measured using significant Level 3 inputs represented approximately 4% of these financial instruments (1% of total assets) as of March 31, 2010, and approximately 14% (4% of total assets) as of December 31, 2009. The decreases in the percentage of financial instruments measured at a fair value on a recurring basis and the percentage of financial instruments measured using Level 3 inputs were primarily attributable to the increase in our assets from the adoption of the new consolidation accounting standards, as the consolidated loans are generally classified as held for investment and are therefore not measured at fair value on a recurring basis. We discuss changes in the valuation inputs and assumptions used in determining the fair value of our financial instruments, including the extent to which we have relied on significant unobservable inputs to estimate fair value and our process for corroborating these inputs, in “Note 7—Fair Value of Financial Instruments.”

We provide additional information on our critical accounting policies and estimates in our 2009 Form 10-K in “Item 7. MD&A—Critical Accounting Policies.”

 

 

V. RECENT ACCOUNTING PRONOUNCEMENTS

 

New accounting pronouncements or changes in existing accounting pronouncements may have a significant effect on our results of operations, financial condition, stockholders’ equity, capital ratios or business operations. As discussed above, effective January 1, 2010, we adopted two new accounting standards that had a significant impact on the manner in which we account for our securitization transactions, our consolidated financial statements and our capital ratios. These new accounting standards eliminated the concept of qualified special purpose entities (“QSPEs”), revised the accounting for transfers of financial assets and changed the consolidation criteria for VIEs. Under the new accounting guidance, the determination to consolidate a VIE is based on a qualitative assessment of which party to the VIE has “power” combined with potentially significant benefits or losses, instead of the previous quantitative risks and rewards model. Consolidation is required when an entity has the power to direct matters which significantly impact the economic performance of the VIE, together with either the obligation to absorb losses or the rights to receive benefits that could be significant to the VIE. The prospective adoption of this new accounting guidance resulted in our consolidating substantially all our existing securitization trusts that had previously been off-balance sheet and eliminated sales treatment for new transfers of loans to securitization trusts. We provide additional information on the impact of these new accounting standards above in “Impact from Adoption of New Consolidation Accounting Standards” and in “Note 1—Summary of Significant Accounting Policies.” We also identify and discuss the impact of other significant recently issued accounting pronouncements, including those not yet adopted, in “Note 1—Summary of Significant Accounting Policies.”

 

 

VI. OFF-BALANCE SHEET ARRANGEMENTS AND VARIABLE INTEREST ENTITIES

 

In the ordinary course of business, we are involved in various types of transactions with limited liability companies, partnerships or trusts that often involve special purpose entities (“SPEs”) and variable interest entities (“VIEs”). Some of these arrangements are not recorded on our consolidated balance sheets or may be recorded in amounts different from the full contract or notional amount of the transaction, depending on the nature or structure of, and accounting required to be applied to, the arrangement. Because these arrangements involve separate legal entities that have significant limitations on their activities, they are commonly referred to as “off-balance sheet arrangements.” These arrangements may expose us to potential losses in excess of the amounts recorded in the consolidated balance sheets. Our involvement in these arrangements can take many forms, including securitization and servicing activities, the purchase or sale of mortgage-backed or other asset-backed securities in connection with our mortgage portfolio, and loans to VIEs that hold debt, equity, real estate or other assets. Under previous accounting guidance, we were not required to consolidate the majority of our securitization trusts because they were QSPEs. Accordingly, we considered these trusts to be off-balance sheet arrangements.

 

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In June 2009, the Financial Accounting Standards Board (“FASB”) issued two new accounting standards that eliminated the concept of QSPEs, revised the accounting for transfers of financial assets and changed the consolidation criteria for VIEs. As discussed above in “Impact from Adoption of New Consolidation Accounting Standards,” these standards were effective January 1, 2010 and resulted in the consolidation of our credit card securitization trusts, one installment loan trust and certain option-ARM mortgage loan trusts originated by Chevy Chase Bank for which we provide servicing.

Our continuing involvement in unconsolidated VIEs primarily consists of certain mortgage loan trusts and community reinvestment and development entities. The carrying amount of assets and liabilities of these unconsolidated VIEs was $1.2 billion and $305.3 million, respectively, as of March 31, 2010, and our maximum exposure to loss was $1.2 billion. We provide a discussion of our activities related to these VIEs in “Note 15—Other Variable Interests.”

 

 

VII. CONSOLIDATED FINANCIAL PERFORMANCE

 

Table 1 presents a summary of our total company financial performance on a reported basis for the first quarter of 2010, compared with our total company financial performance on both a reported and on a managed basis for the first quarter of 2009, along with selected performance metrics that we believe are useful in evaluating changes in our results between periods.

Table 1: Consolidated Corporate Financial Summary and Selected Metrics

 

(Dollars in thousands)

  Three Month Ended March 31,  
    2010     2009(1 )     Change  
    Reported     Reported     Managed     Reported     Managed  

Earnings:

         

Net interest income

  $ 3,228,153      $ 1,792,988      $ 2,749,990      $ 1,435,165      $ 478,163   

Non-interest income

    1,061,458        1,089,844        985,662        (28,386     75,796   
                                       

Total revenue( 2)

    4,289,611        2,882,832        3,735,652        1,406,779        553,959   

Provision for loan and lease losses

    1,478,200        1,279,137        2,131,957        199,063        (653,757

Restructuring expenses(3)

    0        17,627        17,627        (17,627     (17,627

Other non-interest expenses

    1,847,601        1,727,662        1,727,662        119,939        119,939   
                                       

Income (loss) from continuing operations before taxes

    963,810        (141,594     (141,594     1,105,404        1,105,404   

Income taxes

    244,359        (58,490     (58,490     302,849        302,849   
                                       

Income (loss) from continuing operations, net of tax

    719,451        (83,104     (83,104     802,555        802,555   

Loss from discontinued operations, net of tax(2)

    (83,188     (24,958     (24,958     (58,230     (58,230
                                       

Net income (loss)

  $ 636,263      $ (108,062   $ (108,062   $ 744,325      $ 744,325   

Net income (loss) available to common shareholders

  $ 636,263      $ (172,252   $ (172,252   $ 808,515      $ 808,515   

Earnings per common share:

         

Basic earnings per common share:

         

Income (loss) from continuing operations, net of tax

  $ 1.59      $ (0.38   $ (0.38   $ 1.97      $ 1.97   

Loss from discontinued operations, net of tax( 4)

    (0.18     (0.06     (0.06     (0.12     (0.12
                                       

Net income (loss) per common share

  $ 1.41      $ (0.44   $ (0.44   $ 1.85      $ 1.85   

Diluted earnings per common share:

         

Income (loss) from continuing operations, net of tax

  $ 1.58      $ (0.38   $ (0.38   $ 1.96      $ 1.96   

Loss from discontinued operations, net of tax( 4)

    (0.18     (0.06     (0.06     (0.12     (0.12
                                       

Net income (loss) per common share

  $ 1.40      $ (0.44   $ (0.44   $ 1.84      $ 1.84   

Average balances:

         

Reported loans held for investment

  $ 134,206,161      $ 103,242,406      $ 147,182,092      $ 30,963,755      $ (12,975,931

Investment securities

    38,086,936        34,209,102        34,209,102        3,877,834        3,877,834   

Interest bearing deposits

    104,017,325        100,886,478        100,886,478        3,130,847        3,130,847   

Total deposits

    117,530,424        112,136,745        112,136,745        5,393,679        5,393,679   

Other borrowings

    51,195,247        15,697,078        57,463,694        35,498,169        (6,268,447

 

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(Dollars in thousands)

  Three Month Ended March 31,  
    2010     2009(1 )     Change  
    Reported     Reported     Managed     Reported     Managed  

Selected company metrics :

         

Return on average assets (ROA)

  1.39   (0.20 )%    (0.16 )%    1.59   1.55

Return on average equity (ROE)

  12.15      (1.23   (1.23   13.38      13.38   

Net charge-off rate

  6.01      4.41      5.41      1.60      0.60   

Delinquency rate (30+ days performing)

  4.22      3.65      4.10      0.57      0.12   

Net interest margin

  7.10      4.94      5.89      2.16      1.21   

Revenue margin

  9.43      7.94      8.01      1.49      1.42   

Risk-adjusted margin ( 5)

  5.00      4.81      3.74      0.19      1.26   

 

(1)

Effective February 27, 2009, we acquired Chevy Chase Bank. Accordingly, our results for the first quarter of 2009 include only a partial quarter impact from Chevy Chase Bank.

(2)

In accordance with our finance charge and fee revenue recognition policy, the amounts billed to customers but not recognized as revenue on a reported and managed basis totaled $354.4 million and $544.4 million for the three months ended March 31, 2010 and 2009, respectively.

(3)

In 2009, we completed the restructuring that was initiated in 2007.

(4)

Discontinued operations reflect costs related to the mortgage origination operations of GreenPoint’s wholesale mortgage banking unit, which was closed in 2007.

(5)

Calculated based on total revenue less net charge-offs divided by average earning assets.

The section below provides a comparative discussion of our consolidated corporate financial performance for the three months ended March 31, 2010 and 2009. Following this section, we provide a discussion of our business segment results. You should read this section together with our “Executive Summary” where we discuss trends and other factors that we expect will affect our future results of operations.

Net Interest Income

Net interest income represents the difference between the interest income and applicable fees earned on our interest-earning assets, which includes loans held for investment and investment securities, and the interest expense on our interest-bearing liabilities, which includes interest-bearing deposits, senior and subordinated notes, securitized debt and other borrowings. We include in interest income any past due fees on loans that we deem are collectible. Our net interest margin represents the difference between the yield on our interest-earning assets and the cost of our debt, including the impact of non-interest bearing funding. Prior to the adoption of the new consolidation accounting standards on January 1, 2010, our reported net interest income did not include interest income from loans in our off-balance sheet securitization trusts or the interest expense on third-party debt issued by these securitization trusts. Beginning January 1, 2010, servicing fees, finance charges, other fees, net charge-offs and interest paid to third party investors related to consolidated securitization trusts are included in net interest income.

Table 2 below displays the major sources of our interest income and interest expense for the three months ended March 31, 2010 and 2009. We expect net interest income and our net interest margin to fluctuate based on changes in interest rates and changes in the amount and composition of our interest-earning assets and interest-bearing liabilities. We provide additional supplemental tables in “Supplemental Statistical Tables” to assist in analyzing changes in our net interest income. Table A under “Supplemental Statistical Tables” presents, for each major category of our interest-earning assets and interest-bearing liabilities, the average outstanding balances, the interest earned or paid, and the average yield or cost during the period. Table B under “Supplemental Statistical Tables” presents a rate/volume analysis that shows the variance in our net interest income between periods and the extent to which that variance is attributable to (i) changes in the volume of our interest-earning assets and interest-bearing liabilities or (ii) changes in the interest rates of these assets and liabilities.

 

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Table 2: Net Interest Income

 

     Three Months Ended March 31,
     2010    2009(1)

(Dollars in thousands)

   Reported    Reported    Managed

Interest income:

        

Consumer loans

   $ 3,266,320    $ 1,817,545    $ 3,105,576

Commercial loans( 2)

     391,415      374,073      374,073
                    

Loans held for investment, including past-due fees

     3,657,735      2,191,618      3,479,649

Investment securities

     348,715      395,274      395,274

Other

     23,379      63,117      15,743
                    

Total interest income

   $ 4,029,829    $ 2,650,009    $ 3,890,666

Interest expense:

        

Deposits

   $ 398,730    $ 627,392    $ 627,392

Securitized debt obligations

     241,735      90,733      374,388

Senior and subordinated notes

     68,224      58,044      58,044

Other borrowings

     92,987      80,852      80,852
                    

Total interest expense

     801,676      857,021      1,140,676
                    

Total net interest income

   $ 3,228,153    $ 1,792,988    $ 2,749,990
                    

 

(1)

Effective February 27, 2009, we acquired Chevy Chase Bank. Accordingly, our results for the first quarter of 2009 include only a partial quarter impact from Chevy Chase Bank.

( 2 )

Interest income generated from small business credit cards is included in consumer loans.

Our reported net interest income of $3.2 billion for the first quarter of 2010 reflected an increase of 17% over our managed net interest income of $2.7 billion for the first quarter of 2009, driven by a 21% (or 121 basis points) expansion of our net interest margin to 7.10%, which was partially offset by a 3% decrease in our average interest-earning assets.

The 121 basis point increase in our reported net interest margin in the first quarter of 2010 over our managed net interest margin in the first quarter of 2009 was primarily attributable to significant reduction in our average cost of funds of 79 basis points, coupled with an increase in the average yield on our interest-earning assets of 52 basis points. Our cost of funds continued to benefit from the shift in the mix of our funding to lower cost consumer and commercial banking deposits from higher cost wholesale sources. In addition, the overall interest rate environment, combined with our disciplined pricing, drove a decrease in our average deposit interest rates. The increase in the average yield on our interest-earning assets reflected the benefit of pricing changes that we implemented during 2009, which contributed to an increase in the average yields on our loan portfolio, as well as improved credit conditions, which allowed us to recognize a greater proportion of uncollected finance charges in income during the first quarter of 2010.

The decrease in our average interest-earning assets was attributable to the combined impact of the run-off of our installment loan portfolio, declining consumer auto and mortgage loans and elevated charge-offs. Our decision to curb our auto origination volume beginning in 2008 was the primary factory driving the decline in auto loans, while our mortgage portfolio largely remains in a run-off mode.

Non-Interest Income

Non-interest income consists of servicing and securitizations income, service charges and other customer-related fees, mortgage servicing and other, interchange income and other non-interest income. Table 3 displays the components of non-interest income for the three months ended March 31, 2010 and 2009. Prior to the adoption of the new consolidation accounting standards on January 1, 2010, our reported non-interest income included servicing fees, finance charges, other fees, net charge-offs and interest paid to third party investors related to our securitization trusts as a component of non-interest income. In addition, when we created securitization trusts, we recognized gains or losses on the transfer of loans to these trusts and recorded our initial retained interests in the trusts. Beginning January 1, 2010, unless we qualify for sale accounting under the new consolidation accounting standards, we will no longer recognize a gain or loss or record

 

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retained interests when we transfer loans into securitization trusts. The servicing fees, finance charges, other fees, net of charge-offs and interest paid to third party investors related to our consolidated securitization trusts are now reported as a component of net interest income instead of as a component of non-interest income.

Table 3: Non-Interest Income

 

     Three Months Ended March 31,  

(Dollars in thousands)

   2010     2009(1)  
     Reported     Reported     Managed  

Non-interest income:

      

Servicing and securitizations

   $ (36,368   $ 453,144      $ (129,538

Service charges and other customer-related fees

     584,973        506,129        779,911   

Interchange

     311,407        140,090        344,808   

Net other-than-temporary impairment losses recognized in earnings

     (31,256     (363     (363

Other

     232,702        (9,156     (9,156
                        

Total non-interest income

   $ 1,061,458      $ 1,089,844      $ 985,662   
                        

 

(1)

Effective February 27, 2009, we acquired Chevy Chase Bank. Accordingly, our results for the first quarter of 2009 include only a partial quarter impact from Chevy Chase Bank.

Non-interest income of $1.1 billion for the first quarter of 2010 increased by $75.8 million, or 8%, over managed non-interest income of $985.7 million for the first quarter of 2009. The increase of $75.8 million was primarily due to a net gain of $127.6 million recognized in the first quarter of 2010 from the sale of interest-only bonds and the related deconsolidation of certain option-adjustable rate mortgage trusts that were consolidated on January 1, 2010 as a result of our adoption of the new consolidation accounting standards. This gain was partially offset by an increase of $30.9 million in other-than-temporary impairment losses in the first quarter of 2010 over the first quarter of 2009. The other-than-temporary impairment losses related to certain non-agency mortgage-related securities, attributable to further deterioration in the credit performance of these securities resulting from the continued weakness in the housing market and high unemployment, and certain other non-agency mortgage-related securities where we expect to sell the securities at a loss. We also experienced an increase in the “other” component of non-interest income due to the recognition of $100.4 million of expense in the first quarter of 2010 for reserves for mortgage repurchase claims related to our acquisition of Chevy Chase Bank. See “Consolidated Balance Sheet Analysis and Credit Performance—Potential Mortgage Representation and Warranty Liabilities” below for additional information.

Provision for Loan and Lease losses

We build our allowance for loan and lease losses through the provision for loan and lease losses. Our provision for loan and lease losses in each period is driven by charge-offs and the level of allowance for loan and lease losses that we determine is necessary to provide for probable credit losses inherent in our loan portfolio as of each balance sheet date. Table 11 below under “Consolidated Balance Sheet Analysis—Allowance for Loan and Lease Losses” summarizes changes in our allowance for loan and lease losses and details the provision for loan and lease losses recognized in our income statement and the charge-offs recorded against our allowance for loan and lease losses for the three months ended March 31, 2010 and 2009.

We recorded a provision expense for loan and lease losses of $1.5 billion for the first quarter of 2010, compared with a managed provision expense for loan and lease losses of $2.1 billion for the first quarter of 2009. Reported net charge-offs totaled $2.0 billion during the first quarter of 2010, the same level as our managed net charge-offs during the first quarter of 2009. The decrease in our provision expense for loan and lease losses was primarily due to a $565.9 million reduction, excluding the impact of deconsolidated trusts, in our allowance for loan and lease losses in the first quarter of 2010, attributable to an improvement in underlying credit conditions and trends, and the decrease in our outstanding loans. Although we reduced our allowance for loan and lease losses during the first quarter of 2010, the coverage ratio of our allowance for loan and lease losses as a percentage of total loans increased to 5.96% as of March 31, 2010, from 4.55% of reported loans as of December 31, 2009. The increase was due to the establishment of an allowance for loan and lease losses for newly consolidated loans as a result of our January 1, 2010 adoption of the new consolidation accounting standards.

 

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Non-Interest Expense

Non-interest expense consists of ongoing operating costs, such as salaries and associated employee benefits, communications and other technology expenses, supplies and equipment and occupancy costs, and miscellaneous expenses. Marketing expenses also are included in non-interest expense. Table 4 displays the components of non-interest expense for the three months ended March 31, 2010 and 2009.

Table 4: Non-Interest Expense

 

     Three Months Ended March 31,

(Dollars in thousands)

   2010    2009
     Reported    Reported/Managed(1)

Non-interest expense:

     

Salaries and associated benefits

   $ 646,436    $ 554,431

Marketing

     180,459      162,712

Communications and data processing

     169,327      199,104

Supplies and equipment

     123,624      118,900

Occupancy

     119,779      100,185

Restructuring expense

     —        17,627

Other

     607,976      592,330
             

Total non-interest expense

   $ 1,847,601    $ 1,745,289
             

 

(1)

Non-interest expense reported and managed amounts were the same for the three months ended March 31, 2009.

Non-interest expense of $1.8 billion for the first quarter of 2010 increased by $102.3 million, or 6%, over non-interest expense of $1.7 billion for the first quarter of 2009. The increase of $102.3 million was primarily due to higher salary and benefits and occupancy costs resulting from the full-quarter impact in the first quarter of 2010 of expenses related to our Chevy Chase Bank operations. Our increased marketing and infrastructure investments to attract and support new business volume also contributed to the increase in non-interest expense.

Other non-interest expense for the first quarter of 2010 consists of professional services expenses of $187.4 million, credit collection costs of $168.8 million, fee assessments of $54.8 million and intangible amortization expense of $55.0 million. Other non-interest expense for the first quarter of 2009 consists of professional services expenses of $193.3 million, credit collection costs of $158.9 million, fee assessments of $55.5 million and intangible amortization expense of $50.4 million.

Income Taxes

The Company recorded an income tax expense of $244.4 million for the first three months of 2010, compared with an income tax benefit of $58.5 million for the first three months of 2009. The related effective income tax rates were 25.3% and 41.3%, respectively. The decrease in the effective income tax rate was primarily due to the impact of business tax credits and permanent tax items, including tax-exempt interest, relative to the positive net income before tax in 2010, and a $50.0 million tax benefit from the settlement of certain pre-acquisition tax liabilities related to North Fork and resolution of certain tax issues before the U.S. Tax Court. We provide additional information on items affecting our income taxes and effective tax rate in our 2009 Form 10-K under “Note 18—Income Taxes.”

 

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VIII. CONSOLIDATED BALANCE SHEET ANALYSIS AND CREDIT PERFORMANCE

 

Total assets of $200.7 billion as of March 31, 2010 decreased by $10.8 billion, or 5%, from adjusted total assets of $211.5 billion as of January 1, 2010. Adjusted total assets includes the impact on January 1, 2010 from our adoption of the new consolidation accounting standards. Total liabilities of $176.3 billion decreased by $11.5 billion, or 6%, from adjusted total liabilities $187.9 billion as of January 1, 2010. Our stockholders’ equity, after taking into account the cumulative effect after-tax charge of $2.9 billion to retained earnings on January 1, 2010 from the adoption of the new consolidation accounting standards, increased by $723.9 million to $24.4 billion as of March 31, 2010. The increase in stockholders’ equity was primarily attributable to our net income of $636.3 million in the first quarter of 2010. Following is a discussion of material changes in the major components of our assets and liabilities during the first quarter of 2010, excluding the impact from our January 1, 2010 adoption of the new consolidation accounting standards.

Securities Available for Sale

Our investment securities classified as available for sale consist of U.S. Treasury and agency securities, non-agency mortgage-backed securities and other asset-backed securities. Table 5 shows the components of our available-for-sale investment securities as of March 31, 2010 and December 31, 2009.

Table 5: Securities Available for Sale

 

     As of

(Dollars in thousands)

   March 31, 2010    December 31, 2009

U.S. Treasury and other U.S. Government agency obligations

   $ 839,245    $ 868,706

Collateralized mortgage obligations

     13,348,679      9,638,028

Mortgage-backed securities

     14,895,737      20,684,181

Non mortgage asset-backed securities

     8,705,458      7,191,606

Other

     461,898      447,041
             

Total

   $ 38,251,017    $ 38,829,562
             

We had gross unrealized gains of $870.7 million and gross unrealized losses of $354.2 million on available-for sale securities as of March 31, 2010, compared with gross unrealized gains of $839.9 million and gross unrealized losses of $549.1 million as of December 31, 2009. The decrease in gross unrealized losses in the first quarter of 2010 was primarily due to the sale of some of our mortgage securities that were in an unrealized loss position as of December 31, 2009. Of the $354.2 million gross unrealized losses as of March 31, 2010, $343.3 million related to securities that had been in a loss position for more than 12 months.

We evaluate available-for-sale securities in an unrealized loss position as of the end of each quarter for other-than-temporary impairment based on a number of criteria, including the extent and duration of the decline in value, the severity and duration of the impairment; recent events specific to the issuer and/or industry to which the issuer belongs; the payment structure of the security; external credit ratings and the failure of the issuer to make scheduled interest or principal payments; the value of underlying collateral, our intent and ability to hold the security and current market conditions.

Other-than-temporary impairment is recognized in earnings if one of the following conditions exists: (1) a decision to sell the security has been made; (2) it is more likely than not that we will be required to sell the security before the impairment is recovered; or (3) the amortized cost basis is not expected to be recovered. If, however, we have not made a decision to sell the security and we do not expect that we will be required to sell prior to recovery of the amortized cost basis, only the credit component of other-than-temporary impairment is recognized in earnings. The noncredit component is recorded in other comprehensive income (“OCI”). The credit component is the difference between the security’s amortized cost basis and the present value of its expected future cash flows discounted based on the original yield, while the noncredit component is the remaining difference between the security’s fair value and the present value of expected future cash flows.

We recognized net other-than-temporary impairment of $26.8 million on available-for-sale securities in the first quarter of 2010, due in part to deterioration in the credit performance of certain securities resulting from the continued weakness in the housing market and high unemployment and our decision to sell certain other securities before recovery of the impairment amount.

 

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We provide additional information on our available-for-sale securities in “Note 5—Securities Available for Sale.”

Total Loans

Total loans consists of loans held for investment and restricted loans for securitization investors. Total reported declined by $6.7 billion, or 5%, during the first quarter of 2010 to $130.1 billion as of March 31, 2010, from total managed loans of $136.8 billion as of December 31, 2009. The decline was primarily due to charge-offs and run-off of loans in businesses that we either exited or repositioned early in the economic recession. The run-offs are related to installment loans in our Credit Card business and mortgage loans in our Consumer Banking business. Table 6 presents the composition our loan portfolio by business segments.

Table 6: Loan Portfolio Composition

 

(Dollars in thousands)

   March 31, 2010    December 31, 2009
     Reported    Reported    Managed

Domestic credit card

   $ 56,077,250    $ 20,066,548    $ 60,299,827

International credit card

     7,578,110      2,273,211      8,223,835
                    

Total credit card

   $ 63,655,360    $ 22,339,759    $ 68,523,662

Commercial and multifamily real estate(1)

     13,617,900      13,843,158      13,843,158

Middle market

     10,310,156      10,061,819      10,061,819

Specialty lending

     3,618,987      3,554,563      3,554,563
                    

Total commercial lending

   $ 27,547,043    $ 27,459,540    $ 27,459,540

Small ticket commercial real estate

     2,065,095      2,153,510      2,153,510
                    

Total commercial banking

   $ 29,612,138    $ 29,613,050    $ 29,613,050

Automobile

     17,446,430      18,186,064      18,186,064

Mortgage

     13,966,471      14,893,187      14,893,187

Other retail

     4,969,775      5,135,242      5,135,242
                    

Total consumer banking

   $ 36,382,676    $ 38,214,493    $ 38,214,493

Other loans

     464,347      451,697      451,697
                    

Total company

   $ 130,114,521    $ 90,618,999    $ 136,802,902
                    

 

(1)

Includes construction and land development loans totaling $2.5 billion as of both March 31, 2010 and December 31 2009.

Credit Performance

We closely monitor economic conditions and loan performance trends to manage and evaluate our exposure to credit risk. Key metrics that we track and use in evaluating the credit quality of our loan portfolio include delinquency rates, nonperforming loans, charge-off rates. High unemployment, the decline in home prices and continued weak economic conditions have adversely affected the ability of consumers and businesses to meet their debt obligations, which has contributed to elevated rates of delinquencies, nonperforming loans and charge-offs. We present information in the section below on the credit performance of our total loans, including the key metrics that we use in tracking changes in the credit quality of our loan portfolio.

Delinquent and Nonperforming Loans

We consider the entire balance of an account to be delinquent if the minimum contractually required payment is not received by the due date. Our policies for classifying loans as nonperforming and placing them on nonaccrual status are as follows:

 

 

Credit card loans: We continue to classify credit card loans as performing until the loan is charged off. We also continue to accrue finance charges and fees on credit card loans until the account is charged-off. We reduce, however, the carrying amount of credit card loan balances by the amount of finance charges and fees billed but not expected to be collected and exclude this amount from revenue.

 

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Consumer loans: If we determine that collectability of principal and interest is reasonably assured, we classify delinquent consumer loans as performing and continue to accrue interest until the loan is 90 days past due for auto and mortgage loans and until the loan is 120 days past due for other non-credit card consumer loans. If we determine that collectability is not reasonably assured, or the loan is 90 days past due for auto and mortgage loans and 120 days past due for other non-credit card consumer loans, we consider the loan to be nonperforming and it is placed on nonaccrual status.

 

 

Commercial loans: We classify commercial loans as nonperforming and place them on nonaccrual status at the earlier of the date we determine that the collectability of interest or principal on the loan is not reasonably assured or the loan is 90 days past due.

 

 

Loans acquired from Chevy Chase Bank: Loans that we acquired from Chevy Chase Bank were recorded at fair value, including those considered to be impaired at the date of purchase. We therefore do not classify loans that we acquired from Chevy Chase Bank as delinquent or nonperforming unless they do not perform in accordance with our expectations as of the purchase date.

Table 7 compares 30+ day performing loan delinquency rates, by loan category, as of March 31, 2010 and December 31, 2009. Delinquency rates for all loan categories, except commercial and multifamily real estate, showed signs of improvement during the first quarter of 2010, reflecting positive trends in credit conditions. In addition, expected seasonal trends and the diminishing initial adverse impact from the pricing changes we made during 2009 contributed to a reduction in the delinquency rate for domestic credit cards.

Table 7: 30+ Day Performing Delinquencies( 1)

 

     March 31, 2010     December 31, 2009(2)  

(Dollars in thousands)

   Amount    Rate     Amount    Rate  

Domestic credit card

   $ 2,979,316    5.31   $ 3,487,390    5.78

International credit card

     484,087    6.39        539,030    6.55   
                          

Total credit card

   $ 3,463,403    5.44   $ 4,026,420    5.88

Commercial and multifamily real estate

     277,177    2.04        84,385    0.61   

Middle market

     45,252    0.44        46,148    0.46   

Specialty lending

     57,081    1.58        59,958    1.69   

Small ticket commercial real estate

     107,596    5.21        120,392    5.59   
                          

Total commercial banking

   $ 487,106    1.64   $ 310,883    1.05

Automobile

     1,322,948    7.58        1,824,255    10.03   

Mortgages

     129,951    0.93        187,940    1.26   

Retail banking

     50,624    1.02        63,243    1.23   
                          

Total consumer banking

   $ 1,503,523    4.13   $ 2,075,438    5.43

Other

     42,138    9.07        52,417    11.60   
                          

Total company

   $ 5,496,170    4.22   $ 6,465,158    4.73
                          

 

(1)

Loans acquired from Chevy Chase Bank are not classified as delinquent unless they do not perform in accordance with our expectations as of the purchase date. We do, however, include these loans in the denominator used in calculating our delinquency rates. The 30 day+ delinquency rates, excluding loans acquired from Chevy Chase Bank, for commercial banking, mortgages, retail banking and total consumer banking were 1.69%, 1.58%, 1.07% and 4.95%, respectively, as of March 31, 2010, compared with 1.08%% , 2.18%, 1.30% and 6.56%, respectively, as of December 31, 2009.

(2)

Delinquency statistics are based on our total loan portfolio, which we previously referred to as our “managed” loan portfolio. The total loan portfolio includes loans recorded on our balance sheet and loans held in our securitization trusts.

 

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Table 8 presents the amount of nonperforming loans and the ratio of nonperforming loans to total loans, by loan category, as of March 31, 2010 and December 31, 2009. The increase in our nonperforming ratio to 1.04% as of March 31, 2010, from 0.94% as of December 31, 2009 was primarily attributable to our commercial and mortgage loan portfolios. The weak economy, decline in property values and high unemployment continued to have an adverse impact on our commercial and mortgage loan portfolios.

Table 8: Nonperforming Loans(1)(2)

 

     March 31, 2010     December 31, 2009( 3)  

(Dollars in thousands)

   Amount    As a
Percentage of
Loans Held for
Investment
    Amount    As a
Percentage of
Loans Held for
Investment
 

Commercial and multifamily real estate

   $ 473,993    3.48   $ 428,754    3.10

Middle market

     112,410    1.09        104,272    1.04   

Specialty lending

     73,323    2.03        73,866    2.08   

Small-ticket commercial real estate

     74,979    3.63        94,674    4.40   
                          

Total commercial banking

   $ 734,705    2.48   $ 701,566    2.37

Automobile

     83,682    0.48        143,341    0.79   

Mortgages

     429,716    3.08        322,473    2.17   

Retail banking

     74,678    1.50        86,842    1.69   
                          

Total consumer banking

   $ 588,076    1.62   $ 552,656    1.45

Other

     36,623    7.89        34,484    7.63   
                          

Total company

   $ 1,359,404    1.04   $ 1,288,706    0.94
                          

 

(1)

Loans acquired from Chevy Chase Bank are not classified as nonperforming unless they do not perform in accordance with our expectations as of the purchase date. We do, however, include these loans in the denominator used in calculating our nonperforming loan ratios. The nonperforming loan ratios, excluding loans acquired from Chevy Chase Bank, for commercial and multifamily real estate, middle market, total commercial banking, mortgages, retail banking and total consumer banking were 3.54%, 1.16%, 2.55%, 5.22%, 1.58% and 1.93%, respectively, as of March 31, 2010, compared with 3.18%, 1,07%, 2.43%, 3.75%, 1.78% and 1.75%, respectively, as of December 31, 2009.

(2)

In accordance with our policy, we continue to classify credit card loans as performing until the loan is charged off.

(3)

Nonperforming loans are based on our total loan portfolio, which we previously referred to as our “managed” loan portfolio. The total loan portfolio includes loans recorded on our balance sheet and loans held in our securitization trusts.

Net Charge-Offs

Our net charge-offs consist of the unpaid principal balance of accounts that are charged off net of recoveries of principal amounts. We exclude accrued and unpaid finance charges and fees and fraud losses from net charge-offs. Our charge-off time frame for loans varies based on the loan type. We generally charge off credit card loans when the account is 180 days past due from the statement cycle date. We charge-off consumer loans at the earlier of the date when the account is 120 days past due or upon repossession of the underlying collateral. We generally charge off mortgage loans when the account is 180 days past due. The charge-off amount is based on the estimated home value as of the date of the charge-off. We update our home value estimates quarterly and recognize additional charge-offs for declines in home values below our initial estimate at the date mortgage loans are charged off. We charge off commercial loans when we determine that amounts are uncollectible. Credit card loans in bankruptcy are charged off within 30 days of notification, and other non-credit card consumer loans are charged off within 60 days. Credit card and other non-credit card consumer loans of deceased account holders are charged off within 60 days of notification. Costs incurred to recover charged-off loans are recorded as collection expense and included in our consolidated statements of income as a component of other non-interest expense. Our net charge-offs do not include losses related to the loans we acquired from Chevy Chase Bank, which we considered to be impaired at the date of purchase. We recorded the purchased impaired Chevy Chase loan portfolio at fair value at acquisition, which already takes into account estimated credit losses.

Table 9 presents our net charge-off rates, by loan category, for the three months ended March 31, 2010 and 2009. We present the dollar amount of charge-offs below in Table 11 under “Allowance for Loan and Lease Losses.” The net charge-off ratio increased by 60 basis points to 6.01% for the first quarter of 2010, from 5.41% in the first quarter of 2009.

 

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Table 9: Net Charge-Offs

 

     Three Months Ended  
     March 31, 2010     December 31, 2009(1)     March 31,  2009(1)  

Credit card

   10.30   9.58   8.27

Commercial banking (2)(3)

   1.37      2.91      0.56   

Consumer banking(2)(3)

   2.03      2.85      3.30   

Other

   18.82      28.25      4.58   
                  

Total company

   6.01   6.33   5.41
                  

 

(1)

Net charge-offs reflect charge-offs related to our total loan portfolio, which we previously referred to as our “managed” loan portfolio. The total loan portfolio includes loans recorded on our balance sheet and loans held in our securitization trusts.

(2)

Excludes losses on the purchased credit-impaired loans acquired from Chevy Chase Bank.

(3)

Loans acquired as part of the Chevy Chase Bank acquisition are included in the total average loans held for investment used in calculating the net charge-off rates. Excluding these loans, the charge-off rates would have been 1.41% and 2.93% for the commercial banking and 2.28% and 3.45% for the consumer banking for the three months ended March 31, 2010 and December 31, 2009, respectively.

The increase in our total company net charge-off rate reflected higher charge-off rates across all of our loan categories, except consumer banking, primarily attributable to the continued impact of weak economic conditions and high unemployment. Declining loan balances and the initial adverse impact on charge-offs as a result of pricing changes that we made during 2009 also contributed to the increase in the net charge-off rate for credit card loans. The increase in our commercial banking net charge-off rate was driven by continued elevation of construction loan charge-offs and increased charge-offs in our office building loan portfolio and across our middle market and small-ticket commercial real-estate portfolios. Improved credit performance from our more recent automobile loan originations, coupled with stabilization in the auction prices of repossessed automobiles, contributed to the reduction in the net charge-off rate for consumer banking.

Although our net charge-off rates increased in the first quarter of 2010, there were signs of improvement in credit conditions and trends relative to the fourth quarter of 2009. As a result, our net charge-off rates declined in the first quarter of 2010 relative to the fourth quarter of 2009.

Loan Modifications and Restructurings

As part of our loss mitigation effort, we may provide short-term or long-term modifications to a borrower experiencing financial difficulty to improve long-term loan performance and collectability. Our modifications typically result in a reduction in the borrower’s initial monthly principal and interest payment through an extension of the loan term, a reduction in the interest rate, or a combination of both. In some cases, we may curtail the amount of principal owed by the borrower. A troubled debt restructuring is a form of loan modification in which an economic concession is granted to a borrower experiencing financial difficulty. Other modifications may result in our receiving the full amount due, or certain installments due, under the loan over a period of time that is longer than the period of time originally provided for under the terms of the loan. We classify restructured loans for which the principal balance of the loan has not been reduced as performing if the borrower complies with the terms of the modified loan and makes payments over several payment cycles in accordance with the modified loan terms.

Table 10 provides a summary of the unpaid principal balance of restructured and modified loans as of March 31, 2010 and December 31, 2009 that are performing in accordance with their modified term. We do not include acquired loans from Chevy Chase Bank that were restructured prior to our acquisition in our loan modification and restructuring amounts, as the initial fair value at acquisition recorded for these loans reflected the terms of the loans that existed at the date of purchase.

 

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Table 10: Loan Modifications and Restructurings

 

     As of

(Dollars in thousands)

   March 31, 2010    December 31,  2009(1)

Commercial and multifamily real estate

   $ 36,405    $ 41,061

Mortgages

     21,996      10,083

Credit card

     663,731      678,195

Other

     7,000      3,742
             

Total company

   $ 729,132    $ 733,081
             

 

(1)

Reflects modifications and restructuring of loans in our total loan portfolio, which we previously referred to as our “managed” loan portfolio. The total loan portfolio includes loans recorded on our balance sheet and loans held in our securitization trusts. Certain prior period amounts have been reclassified to conform with the current period presentation.

Purchased Credit-Impaired Loans

Purchased credit-impaired loans totaled $6.8 billion as of March 31, 2010, compared with $7.3 billion as of December 31, 2009. Our portfolio of purchased credit-impaired loans consists of loans acquired in the Chevy Chase Bank transaction, which were recorded at fair value at the date of acquisition. The fair value of these loans included an estimate of credit losses expected to be realized over the remaining lives of the loans. Therefore, no allowance for loan and lease losses was recorded for these loans as of the acquisition date. We do not report these loans as delinquent or nonperforming or include in net-charge offs as long as they continue to perform in accordance with our expectations as of the date of acquisition. However, we regularly update the amount of expected principal and interest to be collected from these loans. If we determine that it is probable that the amount of expected cash flows for these loans is less than our recorded investment, we would recognize impairment through our provision for loan and lease losses. The credit performance of these loans has been fairly consistent with our estimate of credit losses at the acquisition date. Accordingly, no impairment has been recognized on these loans. We provided additional information on the loans acquired from Chevy Chase Bank in “Note 2—Loans Acquired in a Transfer.”

Allowance for Loan and Lease Losses

Our allowance for loan and lease losses provides for probable credit losses inherent in our loan portfolio as of each balance sheet date. We build our allowance for loan and lease loss reserves through the provision for loan and lease losses for credit losses that we believe have been incurred and will eventually be reflected over time in our charge-offs. When we determine that a loan is uncollectible, we record the charge-off against our allowance for loan and lease losses.

We have an established process, using analytical tools, benchmarks and management judgment, to determine our allowance for loan and lease losses. We calculate the allowance for loan and lease losses by estimating probable losses separately for segments of our loan portfolio with similar risk characteristics. We describe the methodologies and policies for determining our allowance for loan and lease losses for each of our loan portfolio segments in our 2009 Form 10-K in “Part I—Item 7. MD&A—Critical Accounting Estimates.” Although we examine a variety of externally available data, as well as our internal loan performance data, the process for determining our allowance for loan and lease losses is subject to risks and uncertainties, including a reliance on historical loss and trend information that may not be representative of current conditions. Accordingly, we have identified our estimation of our allowance for loan and lease losses as a critical accounting policy.

We generally review and assess our allowance methodologies and adequacy of the allowance for loan and lease losses on a quarterly basis. Our assessment involves evaluating many factors including, but not limited to, recent trends in delinquencies and charge-offs, risk ratings, the impact of bankruptcy filings, deceased and recovered amounts, the value of collateral underlying secured loans, account seasoning, changes in our credit evaluation, underwriting and collection management policies, seasonality, general economic conditions, changes in the legal and regulatory environment, guidance, and uncertainties in forecasting and modeling techniques used in estimating our allowance for loan and lease losses. Key factors that have a significant impact on our allowance for loan and lease losses include assumptions about unemployment rates, home prices, and the valuation of commercial properties, consumer real estate, and automobiles. During the first quarter of 2010, we did not make any significant changes to the methodologies or policies used in determining our allowance for loan and lease losses.

 

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Table 11, which displays changes in our allowance for loan and lease losses for the three months ended March 31, 2010 and 2009, details, by loan type, the provision for credit losses recognized in our consolidated statements of income each period and the charge-offs recorded against our allowance for loan and lease losses. Table 12 presents an allocation of our allowance for loan and lease losses by loan categories as of March 31, 2010 and December  31, 2009.

Table 11: Summary of Allowance for Loan and Lease Losses

 

     Three Months Ended  

(Dollars in thousands)

   March 31, 2010     March 31, 2009  

Balance at beginning of period, as reported

   $ 4,127,395      $ 4,523,960   

Impact from January 1, 2010 adoption of new consolidation accounting standards

     4,263,383        —     
                

Balance at beginning of period, adjusted

     8,390,778        4,523,960   

Charge-offs:

    

Domestic credit card

     (1,806,799     (801,875

International credit card

     (212,841     (68,082
                

Total credit card

   $ (2,019,640   $ (869,957

Commercial and multifamily real estate

     (50,011     (21,083

Middle market

     (23,175     (2,028

Specialty lending

     (8,735     (7,740
                

Total commercial lending

   $ (81,921   $ (30,851

Small ticket commercial real estate

     (24,007     (11,297
                

Total commercial banking

   $ (105,928   $ (42,148

Automobile

     (192,486     (317,820

Mortgages

     (37,184     (11,394

Retail banking

     (32,796     (38,241
                

Total consumer banking

   $ (262,466   $ (367,455

Other loans

     (30,511     (43,621
                

Total charge-offs

   $ (2,418,545   $ (1,323,181

Recoveries:

    

Domestic credit card

   $ 286,916      $ 105,160   

International credit card

     40,393        12,972   
                

Total credit card

   $ 327,309      $ 118,132   

Commercial and multifamily real estate

     341        0   

Middle market

     2,125        192   

Specialty lending

     585        241   
                

Total commercial lending

   $ 3,051      $ 433   

Small ticket commercial real estate

     1,060        0   
                

Total commercial banking

   $ 4,111      $ 433   

Automobile

     60,749        60,293   

Mortgages

     1,074        376   

Retail banking

     6,191        5,550   
                

Total consumer banking

   $ 68,014      $ 66,219   

Other loans

     1,328        610   
                

Total recoveries

   $ 400,762      $ 185,394   
                

Total net charge-offs

   $ (2,017,783   $ (1,137,787

Provision for loan and lease losses

     1,478,200        1,279,137   

Impact from acquisitions, sales and other changes(1)

     (99,450     (17,279
                

Balance at end of period

   $ 7,751,745      $ 4,648,031   
                

 

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(1)

Includes a reduction in our allowance for loan and lease losses of $73.2 million in the first quarter of 2010 as a result of the sale of certain interest-only option-ARM bonds and the deconsolidation of the related securitization trusts.

Table 12: Allocation of the Reported Allowance for Loan and Lease Losses

 

    March 31, 2010     December 31, 2009  

(Dollars in thousands)

  Amount   % of Total Loans     Amount   % of Total Loans  

Credit Card:

       

Domestic credit card

  $ 5,162,402   9.21   $ 1,926,724   9.60

International credit card

    611,807   8.07        198,919   8.75   
                       

Total credit card

  $ 5,774,209   9.07   $ 2,125,643   9.52
                       

Commercial Banking:

       

Commercial and multifamily real estate

    537,180   3.94        471,308   3.40   

Middle market

    171,990   1.67        130,691   1.30   

Specialty lending

    107,721   2.98        90,219   2.54   
                       

Total commercial lending

  $ 816,891   2.97   $ 692,218   2.52

Small ticket commercial real estate

    97,873   4.74        93,380   4.34   
                       

Total commercial banking

  $ 914,764   3.09   $ 785,598   2.65
                       

Consumer Banking:

       

Automobile

    522,477   2.99        665,132   3.66   

Mortgage

    153,239   1.10        175,076   1.18   

Other retail

    258,632   5.20        236,330   4.60   
                       

Total consumer banking

  $ 934,348   2.57   $ 1,076,538   2.82
                       

Other loans

    128,424   27.66        139,616   30.91   
                       

Total company

  $ 7,751,745   5.96   $ 4,127,395   4.55
                       

Allowance for loan and lease losses as a percentage of:

       

Period-end loans

  $ 130,114,521   5.96   $ 90,618,999   4.55

Nonperforming loans

  $ 1,359,404   570.23   $ 1,288,706   320.27

As a result of our prospective adoption on January 1, 2010 of the new consolidation accounting standards, we added to our consolidated balance sheet approximately $41.9 billion of assets, consisting primarily of credit card loan receivables underlying our consolidated securitization trusts. As indicated above in Table 11, we also increased our allowance for loan and lease losses for the newly consolidated loans by $4.3 billion. Our allowance for loan and lease losses, excluding the $4.3 billion addition from the January 1, 2010 adoption of the new consolidation accounting standards and the impact of deconsolidated trusts, decreased by $565.9 million during the first quarter of 2010 to $7.8 billion, or 5.96% of our total loan portfolio, as of March 31, 2010. In comparison, our allowance for loan and lease losses represented 4.55% of our total loan portfolio as of December 31, 2009.

The $565.9 million decrease of in our allowance for loan and lease losses, excluding the impact from the January 1, 2010 adoption of the new consolidation accounting standards, was primarily driven by a decline in the allowance for our consumer banking loan portfolio that was partially offset by an increase in the allowance for our commercial banking loan portfolio. The reduction in the allowance for loan and lease losses related to our consumer banking loan portfolio was primarily attributable to improving economic conditions, including more stable home prices and modest reductions in unemployment, which contributed to a decline in consumer loan delinquencies and charge-offs. As a result of these more favorable indicators, we reduced our estimate of incurred losses and released a portion of the allowance for loan and lease related to consumer loans as of March 31, 2010. The increase in the allowance for loan and lease losses related to our commercial loan portfolio was driven by a continued, although slowing, decline in the credit quality of our commercial loan portfolio.

While we reduced the amount of our allowance for loan and lease losses in the first quarter of 2010, our allowance for loan and lease losses remains high by historical standards due to high unemployment and continued weak economic conditions.

 

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Deposits

Our deposits have become our largest source of funding our operations and asset growth. Total deposits increased by $2.0 billion in the first quarter of 2010 to $117.8 billion as of March 31, 2010. The increase in deposits was primarily driven by an increase of $5.2 billion in savings account and money market deposits, which was partially offset by a decrease of $3.3 billion in other consumer time deposits and certificate of deposits $100,000 or more, reflecting our shift to more relationship driven, lower cost liquid savings and transaction accounts. We provide additional information on deposits, including the composition of our deposits, average outstanding balances, interest expense and yields, below in “Liquidity and Funding.”

Senior and Subordinated Notes and Other Borrowings

Senior and subordinated notes and other borrowings totaled $14.8 billion as of March 31, 2010, down from $17.0 billion as of December 31, 2009. The $2.2 billion decrease was primarily attributable to a reduction in Federal Home Loan Bank (“FHLB”) advances. Because of the decrease in our loan portfolio during the first quarter of 2010, our funding needs were lower which provided us with an opportunity to reduce outstanding borrowings. We provide additional information on our borrowings in “Note 9—Deposits and Borrowings.”

Securitized Debt Obligations

Borrowings owed to securitization investors increased to $37.8 billion as of March 31, 2010, from $4.0 billion as of December 31, 2009. The increase was attributable to our January 1, 2010 adoption of the new consolidation accounting standards, which resulted in our recording on our balance sheet as of January 1, 2010, debt issued to third-party investors by securitization trusts that we were required to consolidate totaling $44.3 billion.

Potential Mortgage Representation and Warranty Liabilities

As part of broader acquisitions, the Company acquired three subsidiaries that originated residential mortgage loans and sold them to various purchasers, including securitization trusts. These subsidiaries are Capital One Home Loans, which was acquired in February 2005; GreenPoint, which was acquired in December 2006 as part of the North Fork acquisition; and Chevy Chase Bank, which was acquired in February 2009 and subsequently merged into CONA. In connection with their sales of mortgage loans, the subsidiaries entered into agreements containing representations and warranties about, among other things, the mortgage loans and the origination process. Each subsidiary may be required to repurchase mortgage loans in the event of certain breaches of these representations and warranties. In the event of a repurchase, the subsidiary is typically required to pay the then unpaid principal balance of the loan together with interest and certain expenses (including, in certain cases, legal costs incurred by the purchaser and/or others), and the subsidiary then recovers the underlying collateral. Each subsidiary is exposed to any losses on the repurchased loans after giving effect to recoveries on the collateral. Each subsidiary may also be required to indemnify certain purchasers and others against losses they incur in the event of breaches of representations and warranties and in various other circumstances, and the amount of such losses could exceed the repurchase amount of the related loans. These subsidiaries, in total, originated and sold an aggregate of approximately $121.9 billion original principal balance of mortgage loans between 2005 and 2008, the years with respect to which most of the repurchase requests and other claims relate. Some of this original principal balance has been repaid, but we believe a significant amount of it remains outstanding.

At March 31, 2010, the subsidiaries had open repurchase requests relating to approximately $1.2 billion original principal balance of mortgage loans (up from $699 million at March 31, 2009 and $966 million at December 31, 2009). The Company considers open requests to be requests with respect to mortgage loans received within the past 24 months that are in the process of being paid, are under review, or have been denied by the subsidiary but not rescinded by the party requesting repurchase, as well as specifically identified mortgage loans currently subject to actual or threatened litigation. In addition to the foregoing loan-specific open repurchase requests, GreenPoint is also a defendant in a lawsuit seeking, among other things, to require it to repurchase an entire portfolio of approximately 30,000 mortgage loans with an aggregate principal balance of $1.8 billion within a certain securitization trust based on alleged breaches of representations and warranties relating to a limited sampling of loans in the portfolio. See discussion within the Litigation section below for a discussion related to U.S. Bank. GreenPoint has also received requests for indemnification in connection with a number of lawsuits in which GreenPoint is not a party, including both representation and warranty litigation and securities class actions brought on behalf of investors in securitization trusts that in the aggregate hold a

 

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significant principal balance of mortgage loans for which GreenPoint was identified as the originator. The Company believes that a significant number of mortgage loans at issue in the litigations referred to above as well as a significant number of mortgage loans sold by the subsidiaries as to which no repurchase or indemnification requests have been received are currently delinquent or already foreclosed on.

The Company has established reserves in its consolidated financial statements for inherent losses that are considered to be both probable and estimable related to the mortgage loans sold by each subsidiary. The adequacy of each reserve is evaluated on a quarterly basis and changes in the reserves are reported in non-interest expense. Factors considered in the evaluation process for establishing the reserves include identity of counterparty, amount of open repurchase requests, current level of loan losses, estimated success rate of claimants, estimated recoveries by the subsidiary on the underlying collateral, and whether there is actual or threatened litigation. For counterparties other than actual or threatened litigants, factors considered in the evaluation process also include an estimated amount of probable repurchase requests to be received over the next 12 months based on the historical relationship between mortgage loan performance and repurchase requests and the estimated level of future mortgage loan performance. The Company expects that both the delinquency rates on subsidiary-originated mortgage loans and the severity of losses on collateral recoveries will continue to be high, but the reserve setting process does not include an attempt to predict lifetime losses on the loans. The reserves also do not include amounts for the portfolio-wide repurchase claim at issue in the U.S. Bank litigation or for the indemnification requests with respect to securities class actions, in each case as referred to above, because neither exposure, if any, is currently considered to be both probable and estimable. The reserves do include amounts for the loan-by-loan theory of recovery alleged in the U.S. Bank litigation, in the indemnification requests with respect to third-party representation and warranty litigation, and in various other actual or threatened litigation matters

The adequacy of the reserves and the ultimate amount of losses incurred will depend on, among other things, the actual future mortgage loan performance, the actual level of future repurchase and indemnification requests, the actual success rates of claimants, developments in litigation, actual recoveries on the collateral, and macroeconomic conditions (including unemployment levels and housing prices).

At March 31, 2010, the aggregate reserve for all three subsidiaries was $454 million, compared to $238 million at December 31, 2009. The $216 million change in the reserve from December 31, 2009 was the result of $8 million in repurchase claims settlements in the quarter that were applied against the reserve and an expense of $224 million resulting primarily from updated estimates related to actual and threatened litigation. Due to the uncertainties discussed above, the Company cannot reasonably estimate the total amount of losses that will actually be incurred as a result of each subsidiary’s repurchase and indemnification obligations, and there can be no assurance that the Company’s current reserves will be adequate or that the total amount of losses incurred will not have a material adverse effect upon the Company’s financial condition or results of operations. We provide additional information on the representation and warranty and litigation claims related to GreenPoint in “Note 14—Commitments, Contingencies and Guarantees.”

 

 

IX. BUSINESS SEGMENT FINANCIAL PERFORMANCE

 

During the third quarter of 2009, we realigned our business segment reporting structure based on changes in how management evaluates financial performance. As a result of this change, we evaluate our financial performance and report our results through three operating segments. We have recast prior period segment results to reflect this change. Our three segments consist of the following: Credit Card, Commercial Banking and Consumer Banking.

 

 

Credit Card: Consists of our domestic consumer and small business card lending, domestic national small business lending, national closed end installment lending and the international card lending businesses in Canada and the United Kingdom.

 

 

Commercial Banking: Consists of our lending, deposit gathering and treasury management services to commercial real estate and middle market customers. Our Commercial Banking business results also include the results of a national portfolio of small ticket commercial real-estate loans that are in run-off mode.

 

 

Consumer Banking: Consists of our branch-based lending and deposit gathering activities for small business customers, as well as branch-based consumer deposit gathering and lending activities, national deposit gathering, national automobile lending, consumer mortgage lending and servicing activities.

 

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The segment reorganization included the allocation of the operations of Chevy Chase Bank to the appropriate segments. Chevy Chase Bank’s operations are included in the Commercial Banking and Consumer Banking segments beginning in the second quarter 2009. Chevy Chase Bank’s operations for the first quarter of 2009 remain in the Other category due to the timing of the acquisition. The Other category includes GreenPoint originated consumer mortgages originated for sale but held for investment since originations were suspended in 2007, the results of corporate treasury activities, including asset-liability management and the investment portfolio, the net impact of transfer pricing, brokered deposits, certain unallocated expenses, gains/losses related to the securitization of assets, and restructuring charges related to the Company’s cost initiative and Chevy Chase Bank acquisition.

We maintain our books and records on a legal entity basis for the preparation of financial statements in conformity with U.S. GAAP. The following table presents information prepared from our internal management information system, which includes securitized loans in our managed loan portfolio, and is maintained on a line of business level through allocations from legal entities.

Table 13: Credit Card

 

     Three Months Ended March 31,  

(Dollars in thousands)

   2010     2009  

Earnings

    

Net interest income

   $ 2,113,075      $ 1,691,688   

Non-interest income

     718,632        985,481   
                

Total revenue

   $ 2,831,707      $ 2,677,169   

Provision for loan and lease losses

     1,175,217        1,682,786   

Non-interest expense

     914,052        988,652   
                

Income before taxes

     742,438        5,731   

Income taxes

     252,853        2,402   
                

Net income

   $ 489,585      $ 3,329   
                

Selected Metrics

    

Period end loans held for investment

   $ 63,806,122      $ 75,085,127   

Average loans held for investment

   $ 65,922,058      $ 77,570,383   

Loans held for investment yield

     14.88     11.51

Revenue margin

     17.18     13.81

Net charge-off rate

     10.29     8.27

30+day performing delinquency rate

     5.43     5.20

Purchase volume (1)

   $ 23,923,514      $ 23,473,560   

Domestic Card sub-segment

 

     Three Months Ended March 31,  

(Dollars in thousands)

   2010     2009  

Earnings

    

Net interest income

   $ 1,865,280      $ 1,504,695   

Non-interest income

     618,507        883,891   
                

Total revenue

   $ 2,483,787      $ 2,388,586   

Provision for loan and lease losses

     1,096,215        1,521,997   

Non-interest expense

     809,423        865,460   
                

Income before taxes

     578,149        1,129   

Income taxes

     205,937        396   
                

Net income

   $ 372,212      $ 733   
                

Selected Metrics

    

Period end loans held for investment

   $ 56,228,012      $ 67,015,166   

Average loans held for investment

   $  58,107,647      $  69,187,704   

Loans held for investment yield

     14.78     11.40

Revenue margin

     17.10     13.81

Net charge-off rate

     10.48     8.39

30+day performing delinquency rate

     5.30     5.08

Purchase volume (1)

   $ 21,987,661      $ 21,601,837   

 

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International Card Sub-Segment

 

     Three Months Ended March 31,  

(Dollars in thousands)

   2010     2009  

Earnings

    

Net interest income

   $ 247,795      $ 186,993   

Non-interest income

     100,125        101,590   
                

Total revenue

   $ 347,920      $ 288,583   

Provision for loan and lease losses

     79,002        160,789   

Non-interest expense

     104,629        123,192   
                

Income before taxes

     164,289        4,602   

Income taxes

     46,916        2,006   
                

Net income

   $ 117,373      $ 2,596   
                

Selected Metrics

    

Period end loans held for investment

   $ 7,578,110      $ 8,069,961   

Average loans held for investment

   $ 7,814,411      $ 8,382,679   

Loans held for investment yield

     15.65     12.41

Revenue margin

     17.81     13.77

Net charge-off rate

     8.83     7.30

30+day performing delinquency rate

     6.39     6.25

Purchase volume (1)

   $ 1,935,853      $ 1,871,723   

 

(1) Includes all purchase transactions net of returns and excludes cash advance transactions.

Our Credit Card business recorded net income of $489.6 million in the first quarter of 2010, compared with net income of $3.3 million in the first quarter of 2009. The $486.3 million increase in net income was primarily driven by an increase in total revenue, coupled with a decrease in the provision for loan and lease losses. The increase in revenues was driven by higher net interest income due to the combined impact of higher asset yields and lower funding costs. The increase in the average yield on our credit card loan portfolio reflected the benefit of pricing changes that we implemented during 2009, while the decrease in our funding costs reflected the continued shift in the mix of our funding to lower cost consumer deposits from higher cost wholesale sources. The decrease in the provision for loan and lease losses was primarily due to a reduction in our allowance for loan and lease losses for the Consumer Banking business, attributable to improving economic conditions that contributed to a decline in consumer loan delinquencies and charge-offs.

Our Domestic Card business, which accounted for $372.2 million of the net income generated by our Credit Card business in the first quarter of 2010, compared with $0.7 million in first quarter of 2009, was the primary driver of the increase in net income for our Credit Business in the first quarter of 2010. Net income for our International Card business also increased in the first quarter of 2010 to $117.4 million, compared with net income of $2.6 million in the first quarter of 2009. The increase in net income for our International Card business also was due to the combined impact of an increase in revenues and a decrease in the provision for loan and lease losses.

The Credit Card segment’s managed loans decreased year over year by $11.3 billion, or 15%, to $63.8 billion. Of the total, Domestic Card decreased $10.8 billion and International decreased $0.5 billion. Excluding the effect of foreign currency exchange rate fluctuations, the outstanding loans for the International Card segment decreased by $1.5 billion.

 

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The British pound sterling appreciated 6% against the U.S. dollar from March 31, 2009 to March 31, 2010, while the Canadian dollar appreciated 24%.

As noted above, the Domestic Card loan portfolio decreased by $10.8 billion, or 16%, ending the quarter at $56.2 billion. The marketing cut backs during 2009, the high level of charge-offs, as well as the general de-leveraging of the consumer caused the decrease. In addition, as has been the case in previous quarters, the closed-end installment loan business is in run off and contributed 40% of the decrease. Despite declining loan balances, purchase volume increased in the first quarter of 2010 by $0.4 billion, or 2%, over the first quarter of 2009.

The International Card loan portfolio decreased by $0.5 billion or 6% to $7.6 billion. Excluding the impact of foreign currency exchange rate fluctuations, the International Card portfolio decreased by $1.5 billion. As with Domestic Card, both our U.K. and Canadian businesses significantly decreased marketing expenditures in 2009. This decrease was a primary driver of the decrease in the loan portfolio; however, purchase volume increased in the first quarter of 2010 over the first quarter of 2009 by $64.1 million, or 3%, to $1.9 billion.

Total revenue of $2.8 billion in the first quarter of 2010 for the Credit Card segment was up $154.5 million, or 6%, over the first quarter of 2009. Net interest income was $421.4 million or 25% higher, while non-interest income was $266.8 million or 27% lower.

Total revenue of $2.5 billion in the first quarter of 2010 for the Domestic Card segment was up $95.2 million, or 4%, over the first quarter of 2009. Net interest income increased $360.6 million or 24% to $1.9 billion. Improved margins resulted from 2009 pricing actions and a lower portion of the portfolio having teaser pricing as our origination levels were low throughout 2009. Non-interest income was down $265.4 million or 30% to $618.5 million. The lower number of loan accounts on file along with the partial-quarter impact of the implementation of the Credit CARD Act was the cause of the declining non-interest income

For International, total revenue increased $59.3 million or 21% to $347.9 million from the prior year quarter. Over $37.2 million of the increase was due to exchange rate movements. Similar to Domestic Card, the underlying increase in revenue was a result of actions taken to enhance margins during the previous year.

The Credit Card segment’s net provision decreased $507.6 million to $1.2 billion in the first quarter in 2010. Net adjusted charge-offs increased by $91.1 million, or 6%, from the first quarter of 2009 to the first quarter of 2010. The net adjusted charge-off rate increased to 10.29% from 8.27% due to both the increase in dollars charged off as well as the denominator impact of a shrinking loan book, as average loans decreased by $11.6 billion from first quarter 2009. The decrease in the net provision in the first quarter of 2010 was attributable to a reduction in the allowance for loan and lease losses due to improved credit performance, coupled with a reduction in outstanding loans. In contrast, we increased the allowance for loan and lease losses in the first quarter of 2009 due to the significant deterioration in economic conditions and credit performance. Excluding the impact from the adoption of the new consolidation accounting standards on our provision for loan and lease losses in the first quarter of 2010, would have reduced the decrease in our provision for loan because the population of loans included in determining our allowance for loan and lease losses would not have included loans held in our securitization trusts that were previously off-balance sheet.

On the Domestic Card side, the stabilizing credit environment caused net adjusted charge-offs to increase by $71.3 million, or 5%, from the first quarter of 2009 to the same quarter in 2010. The net adjusted charge-off rate increased to 10.48% from 8.39% during the same time period. We reduced the allowance for loan and lease losses by $426.9 million in the first quarter of 2010, compared with an increase of $70.3 million in the first quarter of 2009. The reduction in the allowance for loan and lease losses in the first quarter of 2010 was primarily driven by the decline in total loans, coupled with improved economic conditions and credit performance of the loans in our Domestic Card portfolio. The increase in net adjusted charge offs and release of allowance resulted in a $1.1 billion net provision for loan and lease losses in the first quarter of 2010, a decrease of $425.8 million, or 28%, over the same quarter of 2009.

International experienced an increase in net adjusted charge-offs of $19.5 million, or 13%, from first quarter 2009 to first quarter 2010. All but $2.0 million of this increase was due to a weakening U.S. Dollar versus the Pound Sterling and Canadian Dollar. The net adjusted charge-off rate increased from 7.30% to 8.83%. In the first quarter of 2010, the allowance for loan and lease losses experienced a release of $93.4 million versus a build of $8.1 million in the same quarter of 2009. The release was mainly due to the impact of improved credit performance, which more than offset the increase in net adjusted charge offs resulting in the net provision for loan and lease losses decreasing by $81.8 million or

 

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50.9% to $79.0 million. Excluding the impact from the adoption of the new consolidation accounting standards on our provision for loan and lease losses in the first quarter of 2010, would have reduced the decrease in our provision for loan relative to the first quarter of 2009 because the population of loans included in determining our allowance for loan and lease losses would not have included loans held in our securitization trusts that were previously off-balance sheet.

Non-interest expense for the Credit Card business was $914.1 million for the quarter which is a decline of $74.6 million, or 8%, from the same quarter last year.

Non-interest expense in Domestic Card, non-interest expense of $809.4 million in the first quarter of 2010 reflected a decline of $56.0 million, or 7%, from the first quarter of 2009. The decline was attributable to improved operating efficiencies, which were partially offset by a moderate increase in marketing expenditures.

International’s non-interest expense declined by $18.6 million, or 15%, to $104.6 million. Excluding the impact of foreign currency exchange rate fluctuations, non-interest expense declined by $33.9 million. In addition to the expense reduction as a result of a smaller loan portfolio, the International Card division has continued to reduce its marketing expenditures.

Table 14: Commercial Banking

 

     Three Months Ended March 31,  

(Dollars in thousands)

   2010     2009 (1)  

Earnings:

    

Net interest income

   $ 311,401      $ 245,459   

Non-interest income

     42,375        41,214   
                

Total revenue

   $ 353,776      $ 286,673   

Provision for loan and lease losses

     238,209        117,304   

Non-interest expense

     192,420        141,805   
                

Income (loss) before taxes

     (76,853     27,564   

Income taxes (benefit)

     (27,375     9,647   
                

Net income (loss)

   $ (49,478   $ 17,917   
                

Selected Metrics:

    

Period end loans held for investment

    

Commercial and multifamily real estate

   $ 13,617,900      $ 13,522,154   

Middle market

     10,310,156        9,850,735   

Specialty lending

     3,618,987        3,489,813   
                

Total commercial lending

   $ 27,547,043      $ 26,862,702   

Small-ticket commercial real estate

     2,065,095        2,568,395   
                

Total commercial banking

   $ 29,612,138      $ 29,431,097   

Average loans held for investment

    

Commercial and multifamily real estate

   $ 13,716,376      $ 13,437,351   

Middle market

     10,323,528        10,003,213   

Specialty lending

     3,609,231        3,504,544   
                

Total commercial lending

   $ 27,649,135      $ 26,945,108   

Small ticket commercial real estate

     2,073,539        2,600,169   
                

Total commercial banking

   $ 29,722,674      $ 29,545,277   

Loans held for investment yield

     5.03     4.92

Period end deposits

   $ 21,605,482      $ 15,691,679   

Average deposits

   $ 21,858,792      $ 16,045,943   

Deposit interest expense rate

     0.72     0.92

Core deposit intangible amortization

   $ 14,389      $ 9,092   

Net charge-off rate( 2)

     1.37     0.56

Nonperforming loans as a percentage of loans held for investment( 2)

     2.48     1.85

Nonperforming asset rate( 2)

     2.64     1.95

 

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(1) The operations of Chevy Chase Bank, which we acquired on February 27, 2009, were not reflected in our Consumer or Commercial Banking segments until the second quarter of 2009. The operations of Chevy Chase Bank were reflected in the “Other category” in the first quarter of 2009.
(2) The denominator used in calculating these rates for the first quarter of 2009 excludes loans acquired from Chevy Chase Bank, as these loans were not classified as part of our Consumer or Commercial Banking segments until the second quarter of 2009. Loans acquired from Chevy Chase Bank were included in the “Other category” in the first quarter of 2009.

The Commercial Banking segment includes the financial results of small-ticket commercial real estate portfolio, which is a $2.1 billion portfolio of national broker-originated real estate loans that we acquired in the North Fork Bank acquisition. We exited this business in 2007.

The Commercial Banking business reported a net loss of $49.5 million in the first quarter of 2010, compared with net income of $17.9 million in the first quarter of 2009.

Total revenue increased by $67.1 million, or 23%, over the first quarter of 2009 to $353.8 million. Excluding the impact from Chevy Chase Bank, total revenue increased by $41.1 million, or 14%. The increase in revenues was driven by a $41.0 million increase in net interest income, attributable to a widening of the net interest margin due to the combined impact of an increase in average asset yields and a decrease in the average cost of deposits.

In the first quarter of 2010, the Commercial Banking segment’s ending balance for loans held for investment was $29.6 billion, an increase of $0.2 billion, or 1%, from the first quarter of 2009. Excluding the impact from Chevy Chase Bank, the ending balance of loans held for investment declined $1.2 billion, or 4%, from the first quarter of 2009, driven by a decline in loan originations and the continued expected run-off of the small-ticket commercial real estate loan portfolio.

Average deposits for the Commercial Banking of $21.9 billion in the first quarter of 2010 increased by $5.8 billion, or 36%, from the first quarter of 2009. Excluding the impact from Chevy Chase Bank, average deposits increased by $4.3 billion, or 27%, driven by increases in direct-deposit accounts, NOW accounts and money-market accounts. The growth in our deposit business was due in part to our focused efforts on managing core relationships while maintaining a disciplined approach to pricing. Deposit interest expense declined 20 basis points in the first quarter of 2010 from the first quarter of 2009, reflecting the movement in short-term interest rates, coupled with a series of targeted price cuts that we implemented during 2009.

In the first quarter of 2010, the Commercial Banking segment total provision for loans and lease losses was $238.2 million, an increase of $120.9 million, or 103% from the first quarter of 2009. The increase was driven by an incremental increase in the allowance for loan and lease losses due to increases in nonperforming loans and net charge-offs, which reflected deterioration in the credit quality of the commercial loan portfolio. The net charge-off rate was 1.37% in the first quarter of 2010, an increase of 81 basis points from the first quarter of 2009. Non-performing loans as a percentage of loans held for investment was 2.48% for the first quarter of 2010, increasing 63 basis points from the first quarter of 2009.

In the first quarter of 2010, total non-interest expense was $192.4 million, an increasing of $50.6 million, or 36%, over the first quarter of 2009. The primary drivers were the addition of Chevy Chase Bank, increased investment in risk mitigation, continued investment in our bank infrastructure, and higher core deposit intangible amortization as a result of the Chevy Chase acquisition.

Table 15: Consumer Banking

 

     Three Months Ended March 31,

(Dollars in thousands)

   2010    2009 (1)

Earnings:

     

Net interest income

   $ 896,588    $ 723,654

Non-interest income

     315,612      163,257
             

Total revenue

   $ 1,212,200    $ 886,911

Provision for loan and lease losses

     49,526      268,233

Non-interest expense

     688,381      579,724
             

Income (loss) before taxes

   $ 474,293    $ 38,954

Income taxes (benefit)

     168,943      13,634
             

Net income (loss)

   $ 305,350    $ 25,320
             

 

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     Three Months Ended March 31,  

(Dollars in thousands)

   2010     2009 (1)  

Selected Metrics:

    

Period end loans held for investment

    

Automobile

   $ 17,446,430      $ 20,795,291   

Mortgages

     13,966,471        9,648,271   

Retail banking

     4,969,775        5,499,070   
                

Total consumer banking

   $ 36,382,676      $ 35,942,632   

Average loans held for investment

    

Automobile

   $ 17,768,721      $ 21,123,000   

Mortgages

     15,433,825        9,860,646   

Retail banking

     5,042,814        5,559,451   
                

Total consumer banking

   $ 38,245,360      $ 36,543,097   

Loans held for investment yield

     8.96     9.43

Auto loan originations

   $ 1,343,463      $ 1,463,402   

Period end deposits

   $ 76,883,450      $ 63,422,760   

Average deposits

   $ 75,115,342      $ 62,730,380   

Deposit interest expense rate

     1.27     2.04

Core deposit intangible amortization

   $ 37,735      $ 35,593   

Net charge-off rate( 2)

     2.03     3.30

Nonperforming loans as a percentage of loans held for investment( 2)

     1.62     0.98

Nonperforming asset rate2 )

     1.76     1.16

30+ day performing delinquency rate( 2)

     4.13     5.01

Period end loans serviced for others

   $ 26,777,607      $ 22,270,797   

 

(1) The operations of Chevy Chase Bank, which we acquired on February 27, 2009, were not reflected in our Consumer or Commercial Banking segments until the second quarter of 2009. The operations of Chevy Chase Bank were reflected in the “other category” in the first quarter of 2009.
(2) The denominator used in calculating these rates for the first quarter of 2009 excludes loans acquired from Chevy Chase Bank, as these loans were not classified as part of our Consumer or Commercial Banking segments until the second quarter of 2009. Loans acquired from Chevy Chase Bank were included in the “other category” in the first quarter of 2009.

The Consumer Banking segment recognized net income of $305.4 million in the first quarter of 2010 compared to net income of $25.3 million in the same quarter of 2009. Stronger revenue and improved credit caused the increase in net income.

Average deposits of $75.1 billion in the first quarter of 2010 were up by $12.4 billion, or 19.7%, over the first quarter of 2009, driven by growth in savings and money market deposits and the inclusion of Chevy Chase Bank deposits in the first quarter of 2010. Period end loans held for investment of $36.4 billion as of March 31, 2010 reflected an increase of $0.4 billion, or 1.2%.

Auto loans held for investment decreased $3.3 billion or 16.1% to $17.4 billion. The auto line of business continues to have higher run off of loans than originations as beginning in early 2008 the auto business tightened credit and shifted the portfolio towards better credit quality assets.

Retail Banking loans held for investment fell $0.5 billion or 9.6% to $5.0 billion. The decrease was from the small business portfolio as the consumer portfolio grew slightly.

Mortgage loans held for investment totaled $14.0 billion at the end of the first quarter of 2010, $4.3 billion or 44.8% higher than the first quarter of 2009. The increase was driven by the inclusion of Chevy Chase Bank loans in the first quarter of 2010, as these loans were included in the “Other” category in the first quarter of 2009.

 

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Total revenue of $1.2 billion in the first quarter of 2010 increased by $325.3 million, or 36.7%, over the first quarter of 2009. The majority of the increase in revenues was attributable to mortgage loans we acquired from Chevy Chase Bank.

As noted, loan outstandings were significantly lower in the Auto business, yet revenue only declined slightly. This is primarily driven by strong margins on new originations.

Retail Banking revenues increased due to the acquisition of Chevy Chase Bank, organic growth in deposits as well as margin expansion in deposits. Margin expansion was driven by run off of higher priced time deposits and our ability to re-price deposits amidst lower competition.

Revenue from the Mortgage business was significantly higher in the first quarter of 2010 than in the first quarter of 2009. The increase in revenue was due in part to the income generated from the loans we acquired from Chevy Chase Bank and a net gain in the first quarter of 2010 that resulted from the sale of interest-only bonds we acquired as part of our purchase of Chevy Chase Bank for which we received $58 million in proceeds. As a result of the sale of these interest-only bonds, we determined that we no longer had a controlling financial interest in the related securitization trusts and were therefore no longer the primary beneficiary. Accordingly, we deconsolidated the related securitization trusts, which had an unpaid principal balance of $1.5 billion. The sale of the interest-only bonds and deconsolidation of the related mortgage securitization trusts resulted in the recognition of a net gain of $127.6 million.

The Consumer Banking business net provision of $49.5 million in the first quarter of 2010 declined by $218.7 million, or 81.5%, from the first quarter of 2009. The net charge-off rate decreased to 2.03% in the first quarter of 2010, from 3.30% in the first quarter of 2009. Lower charge offs and a larger release of the allowance for loan and lease losses in the Auto portfolio combined with an allowance release in the first quarter of 2010 in Mortgage versus a build in the first quarter of 2009 were the reasons for the improvement. Mortgage’s release was due to an improved outlook for our home equity products.

The net charge-off rate in the Auto business improved to 2.97% from 4.88% even as loan volumes decreased during the same time period. The favorability was driven primarily by the growing portfolio share of newer, lower risk originations from 2008 and 2009 and improvement in auction prices

The Retail Banking business saw a decrease in net charge-off rate from 2.30% to 2.11%.

Mortgage had an increase in net charge-off rate from 0.45% in the first quarter of 2009 to 0.94% for the same quarter of 2010. Loss metrics in this quarter were impacted by new accounting consolidation standards where we were required to consolidate a portion of our off-balance sheet Chevy Chase loans for a period of time before we deconsolidated them pursuant to the sale of the interest-only bonds. Without the impact of temporarily consolidating these loans, net adjusted charge-offs for Q1 would have been 0.58%. Loss metrics continue to track with the industry and are in line with our expectations. The assets that were acquired and marked as part of the Chevy Chase Bank acquisition continue to perform in line with our expectations at the time of the mark, and are not contributing to reported charge-offs or allowance.

In the first quarter of 2010, non-interest expense was $688.4 million, an increase of $108.7 million or 18.7% from the previous year. The increase in non-interest expenses was primarily a result of the Chevy Chase Bank acquisition.

 

 

X. LIQUIDITY AND FUNDING

 

Liquidity risk is the risk that future financial obligations are not met or future asset growth cannot occur because of an inability to obtain funds at a reasonable price within a reasonable time. We manage liquidity risk to ensure that we can fund asset and loan growth, debt and deposit maturities and withdrawals, and payment of other corporate obligations under both normal operating conditions and under unpredictable adverse circumstances, such as the financial market disruptions that began in 2007 and continued to adversely impact the global economy and financial services industry throughout 2008 and into 2009. We provide information on our liquidity management framework and practices in “Part II—Item 7. MD&A—Liquidity and Funding” of our 2009 Form 10-K.

 

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Liquidity

We have established liquidity guidelines that are intended to ensure that we have sufficient asset-based liquidity to withstand the potential impact of deposit attrition or diminished liquidity in the funding markets. Our guidelines include maintaining a large liquidity reserve to cover our potential funding requirements and diversified funding sources to avoid over-dependence on volatile, less reliable funding markets. Our liquidity reserves consist of cash and cash equivalents, unencumbered available-for-sale securities and undrawn committed securitization borrowing facilities. Table 16 below presents the composition of our liquidity reserves as of March 31, 2010 and December 31, 2009. Our liquidity reserves increased by $1.2 billion in the first quarter of 2010, to $39.8 billion as of March 31, 2010.

Table 16: Liquidity Reserves

 

     As of  

(Dollars in thousands)

   March 31, 2010     December 31, 2009  

Cash and cash equivalents

   $ 7,498,366      $ 8,684,624   

Securities available for sale(1)

     38,251,017        38,829,562   

Less: Pledged securities available for sale

     (11,388,355     (11,881,801
                

Unencumbered available-for-sale securities

     26,862,662        26,947,761   

Undrawn committed securitization borrowing facilities(2)

     5,432,373        2,912,912   
                

Total liquidity reserves

   $ 39,793,401      $ 38,545,297   
                

 

(1) The weighted average life of our available-for-sale securities was approximately 4.9 years as of both March 31, 2010 and December 31, 2009.

Funding

Our funding objective is to establish an appropriate maturity profile using a cost-effective mix of both short-term and long-term funds. We use a variety of funding sources, including deposits, loan securitizations, debt and equity securities, borrowing facilities, and FHLB advances. We also have access to certain programs and facilities established on a temporary basis by a number of U.S. regulatory agencies.

Deposits

Our deposits provide a stable and relatively low-cost of funds and have become our largest source of funding. We have expanded our opportunities for deposit growth through direct and indirect marketing channels, our existing branch network and branch expansion. These channels offer a broad set of deposit products that include demand deposits, money market deposits, NOW accounts, and certificates of deposit. Table 17 presents the composition of our deposits as of March 31, 2010 and December 31, 2009. Total deposits increased by $2.0 billion, or 2%, in the first quarter of 2010, to $117.8 billion as of March 31, 2010.

 

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Table 17: Deposits

 

     As of

(Dollars in thousands)

   March 31, 2010    December 31, 2009

Non-interest bearing

   $ 13,773,082    $ 13,438,659

NOW accounts

     11,764,598      12,077,480

Savings accounts

     20,147,356      17,019,187

Money market deposit accounts

     40,195,535      38,094,228

Other consumer time deposits

     22,687,064      25,455,636
             

Total core deposits

   $ 108,567,635    $ 106,085,190

Public fund certificates of deposit $100,000 or more

     269,108      578,536

Certificates of deposit $100,000 or more

     7,968,962      8,248,008

Foreign time deposits

     980,854      897,362
             

Total company deposits

   $ 117,786,559    $ 115,809,096
             

Of our total deposits, approximately $980.9 million and $897.4 million were held in foreign banking offices as of March 31, 2010 and December 31, 2009, respectively. Large domestic denomination certificates of deposits of $100,000 or more represented $8.2 billion and $8.8 billion of our total deposits as of March 31, 2010 and December 31, 2009, respectively. Our funding and liquidity strategy takes into consideration the scheduled maturities of large denomination time deposits. Of the $8.2 billion in large domestic denomination certificates of deposit as of March 31, 2010, $1.4 billion is scheduled to mature within the next three months; $2.4 billion is scheduled to mature over three to 12 months; and $4.4 billion is scheduled to mature over 12 months. Based on past activity, we expect to retain a portion of these deposits as they mature.

We have some brokered deposits, which we obtained through the use of a third-party intermediary, that are included above in Table 17 in money market deposit accounts and other consumer time deposits. The Federal Deposit Insurance Corporation Improvement Act of 1991 limits the use of brokered deposits to “well-capitalized” insured depository institutions and, with a waiver from the Federal Deposit Insurance Corporation, to “adequately capitalized” institutions. The Banks and the Corporation were “well-capitalized,” as defined under the federal banking regulatory guidelines, as of March 31, 2010, and therefore permitted to maintain brokered deposits. Our brokered deposits totaled $17.4 billion, or 15% of total deposits, as of March 31, 2010. Brokered deposits totaled $18.8 billion, or 16% of total deposits, as of December 31, 2009. Based on our historical access to the brokered deposit market, we expect to replace maturing brokered deposits with new brokered deposits or direct deposits and branch deposits. If our brokered deposits do not renew at maturity, we would use our liquidity reserves or alternative funding to meet our liquidity needs.

Table 18 displays, by deposit type, the average balances, interest expense, and average rates on our deposits for the three months ended March 31, 2010 and 2009.

 

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Table 18: Deposit Composition and Average Deposit Rates

 

     March 31, 2010  

(Dollars in thousands)

   Average
Balance
   % of
Average
Deposits
    Interest
Expense
   Average
Deposit
Rate
 

Non-interest bearing

   $ 13,513,099    11.50   $ 0    N/A   

NOW accounts

     12,276,325    10.44        16,420    0.54

Money market deposit accounts

     39,364,028    33.49        95,966    0.98   

Savings accounts

     18,627,038    15.85        41,454    0.89   

Other consumer time deposits

     24,252,934    20.64        173,938    2.87   
                          

Total core deposits

     108,033,424    91.92        327,778    1.21   

Public fund certificates of deposit of $100,000 or more

     399,703    0.34        1,627    1.63   

Certificates of deposit of $100,000 or more

     8,179,641    6.96        68,061    3.33   

Foreign time deposits

     917,656    0.78        1,264    0.55   
                          

Total deposits

   $ 117,530,424    100.00   $ 398,730    1.36
                          
     March 31, 2009  
     Average
Balance
   % of
Average
Deposits
    Interest
Expense
   Average
Deposit
Rate
 

Non-interest bearing

   $ 11,285,555    10.06   $ 0    N/A   

NOW accounts

     10,842,552    9.67        19,440    0.72

Money market deposit accounts

     30,839,817    27.49        115,017    1.49   

Savings accounts

     7,631,999    6.81        7,210    0.38   

Other consumer time deposits

     37,132,194    33.10        358,852    3.87   
                          

Total core deposits

     97,732,117    87.13        500,519    2.05   

Public fund certificates of deposit of $100,000 or more

     1,209,347    1.08        5,146    1.70   

Certificates of deposit of $100,000 or more

     10,673,089    9.51        107,215    4.02   

Foreign time deposits

     2,557,479    2.28        14,512    2.27   
                          

Total deposits

   $ 112,172,032    100.00   $ 627,392    2.24
                          

Other Funding Sources

We also access the capital markets to meet our funding needs through loan securitization transactions and the issuance of senior and subordinated debt, including notes issued under COBNA’s Senior and Subordinated Global Bank Note Program (“The Program”). The Program gives COBNA the ability to issue securities to both U.S. and non-U.S. lenders and to raise funds in the U.S. and foreign currencies, subject to conditions customary for transactions of this nature. Notes may be issued under the Program with maturities of thirty days or more from the date of issue. The Program was last updated in June 2005. In addition, we utilize advances from the Federal Home Loan Bank that are secured by our investment securities, residential mortgage loan portfolio, multifamily loans, commercial real-estate loans and home equity lines of credit for our funding needs.

We have committed loan securitization conduit lines of $7.5 billion, of which $2.1 billion was outstanding as of March 31, 2010. Senior and subordinated notes and other borrowings, including FHLB advances, totaled $14.8 billion as of March 31, 2010, down from $17.0 billion as of December 31, 2009. The $2.2 billion decrease was primarily attributable to a reduction in FHLB advances. We did not issue any senior or subordinated debt during the first quarter of 2010. Our FHLB membership is secured by the Company’s investment in FHLB stock, which totaled $230.3 million as of March 31, 2010.

We are eligible or may be eligible to participate in a number of U.S. Government programs designed to support financial institutions and increase access to credit markets. We evaluate each of these programs, which we describe in “Part II—Item 7. MD&A—Liquidity and Funding” of our 2009 Form 10-K, and determine, based on the costs and benefits of each program, whether to participate. During the first quarter of 2010, we participated in or were eligible to

 

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participate in the U.S. Treasury Department’s Capital Purchase Program (“CPP”), the FDIC’s Temporary Liquidity Guarantee Program (“TLGP”), the Federal Reserve’s Discount Window (the “Discount Window”) and the Federal Reserve’s Term Auction Facility (“TAF”).

 

 

Federal Reserve’s Discount Window: The Discount Window allows eligible institutions to borrow funds from the Federal Reserve, typically on a short-term basis, to meet temporary liquidity needs. Borrowers must post collateral, which can be made up of securities or consumer or commercial loans. As of March 31, 2010, we were eligible to borrow up to $5.8 billion through the Discount Window. The eligible amount is reduced dollar for dollar by borrowing under the TAF program. We did not borrow funds from the Discount Window during the first quarter of 2010.

 

 

Federal Reserve’s Term Auction Facility: The TAF is designed to help increase liquidity in the U.S. credit markets. The Federal Reserve auctions collateral-backed short term loans under TAF. The auctions allow financial institutions to borrow funds at an interest rate below the Federal Reserve’s discount rate. As of March 31, 2010, we were eligible to borrow up to $2.9 billion under the TAF. The eligible amount is reduced dollar for dollar by borrowings made under the Discount Window. We did not borrow funds through the TAF during the first quarter of 2010.

 

 

Trust Asset-Backed Securities Loan Facility: In March 2009, the Federal Reserve Bank of New York (“FRBNY”), the U.S. Treasury and the Federal Reserve Board announced the launch of the TALF. TALF is a funding facility designed to help financial markets and institutions meet the credit needs of households and small businesses to support overall economic growth by supporting the issuance of ABS collateralized by student loans, auto loans, credit card loans, loans guaranteed by the Small Business Administration, as well as certain types of mortgage loans. The FRBNY will lend up to $200 billion to holders of certain AAA-rated ABS backed by newly and recently originated consumer and small business loans, as well as CMBS, private-label residential MBS, and certain other ABS. The FRBNY will lend an amount equal to the market value of the ABS less a discount and will be secured at all times by the ABS. The Company has not issued any ABS through TALF as of March 31, 2010.

Borrowing Capacity

As of March 31, 2010, we had an effective shelf registration statement filed with the U.S. Securities & Exchange Commission (“SEC”) under which, from time to time, we may offer and sell an indeterminate aggregate amount of senior or subordinated debt securities, preferred stock, depositary shares representing preferred stock, common stock, warrants, trust preferred securities, junior subordinated debt securities, guarantees of trust preferred securities and certain back-up obligations, purchase contracts and units. There is no limit under this shelf registration statement to the amount or number of such securities that we may offer and sell. Under SEC rules, the Automatic Shelf Registration Statement, which we last updated in May 2009, expires three years after filing. We did not issue any senior or subordinated debt securities, preferred stock, or common stock in the first quarter of 2010.

In addition to issuance capacity under the Automatic Shelf Registration Statement, we have access to other borrowing programs. Table 19 summarizes our borrowing capacity as of March 31, 2010 under the Global Bank Note Program, FHLB Advance capacity, securitization conduits and government programs.

Table 19: Borrowing Capacity

 

(Dollars or dollar equivalents in millions)

   Effective/
Issue Date
   Capacity  (1)    Outstanding    Availability(1)    Final
Maturity(2)

Senior and Subordinated Global Bank Note Program

   6/05    $ 3,129    $ 1,329    $ 1,800    —  

FHLB Advances (3)

   —      $ 10,292    $ 1,437    $ 8,855    —  

Committed Securitization Conduits(4)

   —      $ 7,507    $ 2,075    $ 5,432    11/11

Federal Reserve Discount Window

   —      $ 5,846    $ —      $ 5,846    —  

Federal Reserve Term Auction Facility

   —      $ 2,923    $ —      $ 2,923    —  

 

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(1) All funding sources are non-revolving. Funding availability under all other sources is subject to market conditions. Capacity is the maximum amount that can be borrowed. Availability is the amount that can still be borrowed against the facility
(2) Maturity date refers to the date the facility terminates, where applicable.
(3) There are no effective or final maturity dates on the available lines for FHLB Advances. The ability to draw down funding is based on membership status, and the amount is dependent upon the Banks’ ability to post collateral.
(4) Securitization committed capacity was established at various dates and is scheduled to terminate in November 2011.

Credit Ratings

Our credit ratings have a significant impact on our ability to access to the capital markets and our borrowing costs. Rating agencies base their ratings on numerous factors, including liquidity, capital adequacy, asset quality, quality of earnings and the probability of systemic support. The pending Financial Regulatory Reform bill has been cited as potentially impacting rating agency consideration of the benefit provided by systemic support. Significant changes in these factors could result in different ratings. Table 20 provides a summary of the credit ratings for the senior unsecured debt of Capital One Financial Corporation, COBNA and CONA as of March 31, 2010 and as of the date of this report.

Table 20: Senior Unsecured Debt Credit Ratings

 

     As of March 31, 2010
     Capital One Financial
Corporation
  Capital One
Bank (USA), N.A.
  Capital One, N.A.

Moody’s

   Baa1   A2   A2

S&P

   BBB   BBB+   BBB+

Fitch

   A-   A-   A-

DBRS

   BBB***   A*   A*

 

* low *** high

As of March 31, 2010, Moody’s Investors Services (“Moody’s), Standard & Poor’s (“S&P”), Fitch Ratings (“Fitch”) and Dominion Bond Rating Service Limited (“DBRS”) had the Company on a negative outlook. On April 1, 2010, Fitch revised the outlook trend for the Company to stable from negative. This action reflected Fitch’s view of the Company’s ability to generate earnings and build capital in preparation for the consolidation of off-balance sheet assets, despite the challenging credit and capital markets environment. On April 26, 2010, DBRS revised the outlook trend for the Company to stable from negative. This action reflected the recognition by DBRS of the progress the Company has made in restoring profitability and reducing balance sheet risk, while defending our franchise.

 

 

XI. MARKET RISK MANAGEMENT

 

Market risk generally represents the risk that our earnings or the values of our assets or liabilities will be adversely affected by changes in market conditions. Market risk is inherent in the financial instruments associated with our operations and activities, including loans, deposits, securities, short-term borrowings, long-term debt, and derivatives. Just a few of the market conditions that may change from time to time, thereby exposing us to market risk, include changes in interest and currency exchange rates, equity and futures prices, the implied volatility of interest rates, credit spreads and price deterioration or changes in value due to changes in market perception or actual credit quality of issuers.

Interest rate risk, which represents exposures to instruments whose values vary with the level or volatility of interest rates, is our most significant market risk exposure. Banks are inevitably exposed to interest rate risk due to the repricing and maturity mismatches of their assets and liabilities, as well as the need to invest most of their equity in financial assets. We manage the interest rate and market risks inherent in our asset and liability balances within established ranges, while ensuring adequate liquidity and funding. Our overall goal in managing interest risk is to position the interest rate risk profile of our portfolio (e.g., duration, convexity, volatility, yield curve, spread/basis) to an acceptable level of exposure so that movements in interest rates do not have a significant adverse impact on our projected long-term earnings or economic value. We use a variety of derivative instruments to manage our interest rate risk. See “Note 12—Derivative Instruments and Hedging Activities” for information on our derivatives activity.

 

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We use generally accepted, industry-standard market risk measurement techniques and analysis to measure the impact of changes in interest rates or foreign exchange rates on earnings and the economic value of our equity, including scenario analysis, stress testing and various interest rate sensitivity simulations. We consider the impact on both earnings and market values in measuring and managing our market risk. The measurement of the impact on our current earnings includes the impact on our net interest income and on the valuation of our mortgage servicing rights as a result of movements in interest rates. Under our current asset/liability management policy, we seek to limit the change in our projected earnings over the next 12 months resulting from a gradual plus or minus 200 basis point change in interest rates to less than 5% of our projected base-line net interest income over the next 12 months. Our current asset/liability management policy also includes limiting the pre-tax change in the economic value of our equity due to an instantaneous parallel interest rate shock of 200 basis points to less than 12%.

The federal funds rate remained at a target range of zero to 0.25% throughout the first quarter of 2010. Because interest rates have remained exceptionally low for an extended period of time, a scenario where interest rates would decline by 200 basis points is not plausible. We therefore revised our customary declining interest rate scenario of 200 basis points to reflect the impact of a gradual 50 basis point decrease in interest rates as of March 31, 2010 and December 31, 2009. Table 21 compares the impact on net interest income and the economic value of equity of our selected hypothetical interest rate scenarios as of March 31, 2010 and December 31, 2009.

Table 21: Interest Rate Sensitivity Analysis

 

          As of      

(Dollars in millions)

        March 31, 2010     December 31, 2009      

Impact to projected base-line net interest income:

         

+ 200 basis points (1)

      (0.3 )%    (0.4 )%   

- 50 basis points (1)

      (0.2   (0.1  

Impact to economic value of equity:

         

+ 200 basis points (2)

      (2.1 )%    (3.2 )%   

 

(1) Based on a hypothetical gradual increase in interest rates of 200 basis points and a hypothetical gradual decrease of 50 basis points.
(2) Based on a hypothetical instantaneous parallel shift in the level of interest rates of plus 200 basis points.

Our interest rate risk sensitivity measures are based on industry standard financial modeling techniques that depend to some extent on our internally developed assumptions and proprietary models. Our interest rate risk models contain many assumptions, including those regarding borrower and deposit behavior in certain interest rate environments. Other market inputs, such as interest rates, market prices and interest rate volatility, are also critical components of our interest rate risk measures. We regularly evaluate, update and enhance these assumptions, models and analytical tools as appropriate to reflect our best assessment of the market environment.

There are inherent limitations in any methodology used to estimate the exposure to changes in market interest rates. Our sensitivity analysis contemplate only certain movements in interest rates and are performed at a particular point in time based on the estimated fair value of our existing portfolio. These sensitivity analyses do not incorporate other factors that may have a significant effect, most notably the value from expected future business activities and strategic actions that management may take to manage interest rate risk. As such, these analyses are not intended to provide precise forecasts of the effect a change in market interest rates would have on our earnings or the economic value of equity.

We provide additional information on our market risk exposure and interest risk management process in our 2009 Form 10-K under “Part II—Item 7. MD&A—Market Risk Management.”

 

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XII. CAPITAL

 

Capital Standards and Prompt Corrective Action

Table 22 provides a comparison of our capital ratios as of March 31, 2010 and December 31, 2009. As of March 31, 2010, each of the Banks exceeded minimum regulatory requirements and, therefore, was considered “well-capitalized” under applicable capital adequacy guidelines. As of March 31, 2010, the company also exceeded minimum capital requirements and was considered “well-capitalized” under Federal Reserve capital standards for bank holding companies. For purposes of applying the prompt corrective action provisions under the Federal Deposit Insurance Corporation Act of 1991 (“FDICIA”), each of the banks met the requirements for a “well capitalized” institution. The regulatory framework for prompt corrective action is not applicable to bank holding companies. Accordingly, Capital One Financial Corp. is exempt from these provisions.

Table 22: Capital Ratios(1)

 

     Regulatory
Filing
Basis
Ratios
    Minimum for
Capital  Adequacy
Purposes
    To Be “Well Capitalized”
Under
Prompt Corrective  Action
Provisions
 

As of March 31, 2010:

      

Capital One Financial Corp.(2)

      

Tier 1 capital

   9.57   4.00   N/A   

Total capital

   16.90      8.00      N/A   

Tier 1 leverage

   6.04      4.00      N/A   

Capital One Bank (USA) N.A.

      

Tier 1 capital

   14.12   4.00   6.00

Total capital

   28.24      8.00      10.00   

Tier 1 leverage

   6.52      4.00      5.00   

Capital One, N.A.

      

Tier 1 capital

   10.25   4.00   6.00

Total capital

   11.59      8.00      10.00   

Tier 1 leverage

   7.42      4.00      5.00   

As of December 31, 2009:

      

Capital One Financial Corp.(2)

      

Tier 1 capital

   13.75   4.00   N/A   

Total capital

   17.70      8.00      N/A   

Tier 1 leverage

   10.28      4.00      N/A   

Capital One Bank (USA) N.A.

      

Tier 1 capital

   18.27   4.00   6.00

Total capital

   26.40      8.00      10.00   

Tier 1 leverage

   13.03      4.00      5.00   

Capital One, N.A.

      

Tier 1 capital

   10.22   4.00   6.00

Total capital

   11.46      8.00      10.00   

Tier 1 leverage

   7.42      4.00      5.00   

 

(1) Effective January 1, 2010, we are no longer required to apply the subprime capital provisions to credit card loans with a credit score equal to or greater than 660. Accordingly, we will no longer disclose these ratios. See our 2009 Form 10-K under “Part II—Item 7. MD&A—Capital” for these ratios as of December 31, 2009.
(2) The regulatory framework for prompt corrective action does not apply to Capital One Financial Corp., as it is a bank holding company.

The January 1, 2010 adoption of the new consolidation accounting standards had a significant impact on our capital ratios. Our Tier 1 risk-based capital ratio, including the January 1, 2010 impact from the adoption of the new consolidation accounting standards, would have been 9.9% as of December 31, 2009. The capital rules issued by banking regulators in January 2010 provides for an optional phase-in of the impact from the adoption of the new consolidation accounting standards on risk-based capital, including a two-quarter implementation delay followed by an optional two-quarter partial implementation of the effect on regulatory capital ratios. Because we elected the phase-in option, we will take into account 50% of our assets from consolidation in the third quarter of 2010 and the remaining 50% in the first quarter of 2011 for purposes of determining our regulatory capital ratios.

 

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The regulatory capital ratios as of March 31, 2010 reflect the benefit of the phase-in of the regulatory capital rules. As a result of the phase-in option, we expect that our regulatory capital ratios will be higher than they otherwise would be had we not elected the phase-in option for each quarter of 2010. The benefit from the phase-in election will be reduced in the third quarter and eliminated by the end of the first quarter of 2011 when the phase-in is completed.

Dividend Policy

The declaration and payment of dividends to the Capital One’s stockholders, as well as the amount thereof, are subject to the discretion of the our Board of Directors and will depend upon our results of operations, financial condition, cash requirements, future prospects and other factors deemed relevant by the Board of Directors. As a holding company, our ability to pay dividends is largely dependent upon the receipt of dividends or other payments from our subsidiaries. Regulatory restrictions exist that limit the ability of the Banks to transfer funds to the Company. As of March 31, 2010, funds available for dividend payments from COBNA and CONA were $801 million and zero, respectively. The funds of COBNA are available for payment as dividends to the Corporation without prior approval of the OCC while a dividend payment by CONA would require prior approval of the OCC. Additionally, applicable provisions that may be contained in our borrowing agreements or the borrowing agreements of our subsidiaries may limit our subsidiaries’ ability to pay dividends to us or our ability to pay dividends to our stockholders. There can be no assurance that we will declare and pay any dividends.

We provide additional information on capital in our 2009 Form 10-K in “Part I—Item 7. MD&A—Capital.”

 

 

XIV. SUPERVISION AND REGULATION

 

New Regulations of Consumer Lending Activities

On March 3, 2010 the Federal Reserve released its proposed rule for the two remaining provisions of the Credit CARD Act. These provisions, effective on August 22, 2010, require the amount of any penalty fee or charge to be “reasonable and proportional to the omission or violation” and require issuers to review interest rates increased since January 1, 2009 for possible reductions on a rolling six-month basis. Under the proposal, issuers will be limited to charging penalty fee amounts that do not exceed the dollar amount of the violation. Penalty fee amounts also may not exceed an amount justified on a cost or deterrence basis or permissible under a proposed safe harbor. For rates increased on or after January 1, 2009, every six months issuers must consider changes in either the factors used to increase the rate or the current factors used to determine rates. If a decrease is merited on such bases, it must take effect no later than 30 days from completion of the review; a decrease by a specific amount or a return to the original rate is not required. We are awaiting the final rule, including clarification of “reasonable and proportional” fee or charges, among other things, contemplated by the proposed rule.

Deposits and Deposit Insurance

On October 14, 2008, the FDIC announced its Temporary Liquidity Guarantee Program (“TLGP”), which included the Transaction Account Guarantee Program (“TAGP”). The TAGP provides unlimited deposit insurance coverage for non-interest bearing transaction accounts (including accounts swept from a non-interest bearing transaction account into a non-interest bearing savings deposit account) and certain interest-bearing accounts (negotiable order of withdrawal (NOW) accounts with interest rates of 0.5 percent or less and lawyers trust accounts) at FDIC-insured depository institutions. The TAGP was originally scheduled to expire on December 31, 2009, but was extended through June 30, 2010 for those institutions that choose to participate. The Banks are participating in that TAGP extension. Extension assessment costs are an annualized 15 basis point fee on the balance of each covered account in excess of the current FDIC insurance limit of $250,000. The FDIC recently extended the TAGP until December 31, 2010. We do not anticipate participating in TAGP. The FDIC also recently proposed significant changes in how deposit insurance assessments would be calculated for insured depository institutions with $10 billion or more of assets. When finalized, these provisions could result in an increase in the amount of assessments paid by each of the Banks.

 

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Legislation

Preamble

The information contained in this section is current as of April 29, 2010.

Credit Card

In May 2009, the President signed the Credit CARD Act into law. Certain provisions of this legislation became effective in August 2009 and February 2010, and other provisions become effective on August 22, 2010. For further information on the Credit CARD Act, see “New Regulations of Consumer Lending Activities” in our Annual Report on Form 10-K for the year ended December 31, 2009, Part I, Item 1 “Supervision and Regulation.”

The Credit CARD Act also requires the Government Accountability Office (GAO) to conduct a study on interchange fees. The GAO released their report, “Credit Cards: Rising Interchange Fees Have Increased Costs for Merchants, but Options for Reducing Fees Pose Challenges” on November 19, 2009.

In 2009, legislation to regulate interchange fees was also introduced in the U.S. House and the U.S. Senate. House Judiciary Chairman John Conyers (D-MI) and Congressman Bill Shuster (R-PA) have introduced legislation in the U.S. House and Senator Dick Durbin (D-IL) has introduced legislation in the U.S. Senate that provides an antitrust exemption to allow merchants to collectively bargain with the networks and the banks regarding the rates (including merchant discount) and terms (including rules) for payment card acceptance. The Senate bill also includes a three judge panel who would determine the rates and terms if an agreement is not reached under the antitrust exemption. This legislation is under the jurisdiction of the Judiciary Committees. The House Judiciary Committee held a hearing on the legislation on April 28, 2010.

In addition, Congressman Peter Welch (D-VT) has also introduced a bill that attempts to change many of the fundamental rules of the networks and focuses on: (i) honoring all cards: (ii) minimum/maximum transaction amounts; and (iii) premium card pricing, among other issues. To date, a companion bill has not been introduced in the Senate. A legislative hearing was held on October 8, 2009 in the House Financial Services Committee; however, no additional action is currently scheduled.

It is expected that attempts to regulate interchange fees will continue at the state level as well.

Financial Regulatory Reform

In June 2009, the Treasury Department released the Administration’s proposal for Financial Regulatory Reform. This proposal overhauls the financial regulatory structure in several significant respects. Among other changes, the proposal would give authority to the Federal Reserve Board to serve as the nation’s financial services systemic risk regulator, with new enhanced scrutiny over financial institutions that are deemed “too big to fail.”

The Administration’s proposal would also establish a Consumer Financial Protection Agency (CFPA), a new government agency with sole rule writing authority for consumer financial protection statutes. As proposed, the CFPA’s authority would cover all consumer financial products including any loan, deposit account or other financial product. The proposal would also give states the authority to enforce federal laws regardless of a bank’s charter, and it would abolish federal preemption of conflicting state consumer protection laws, requiring national banks to meet up to 50 separate sets of standards.

In January 2010, the President also proposed implementing “Volcker Rule” limitations that would prohibit insured depository institutions and certain other financial entities from engaging in proprietary trading and place new restrictions on the size and scope of banks and other financial institutions. Specifically, no bank would be permitted to “own, invest in or sponsor a hedge fund or a private equity fund, or proprietary trading operations unrelated to serving customers for its own profit” and broader limits would be placed on increases in the market share of liabilities at the largest financial firms to supplement existing limitations with respect to the market share of deposits.

On December 11, 2009, the House passed the Wall Street Reform and Consumer Protection Act (the “Wall Street Reform Act”). The legislation would create the CFPA and the new agency would have oversight over most consumer protection

 

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laws (except the Community Reinvestment Act) 180 days after the bill is enacted into law. The Wall Street Reform Act allows for federal preemption of state consumer protection laws only in cases where the state laws “prevent, significantly interfere with, or materially impair” the ability of national banks to engage in the business of banking.

Additionally, the Wall Street Reform Act addresses systemic risk and resolution authority in a number of ways. First, it would create an inter-agency Financial Services Oversight Council (FSOC) that would identify and regulate financial institutions that pose systemic risks, and these institutions would be subject to heightened oversight and regulation. The Wall Street Reform Act also establishes a process for dismantling failing, systemically risky firms and requires assessments of financial companies with over $50 billion in assets to pay for a Systemic Dissolution Fund.

The Wall Street Reform Act would also make certain changes to the manner in which fees are assessed against financial institutions by the FDIC. First, the amount of the FDIC’s assessment would be determined based on average total assets less average tangible equity as opposed to total domestic deposits. Second, the considerations that the FDIC utilizes in its risk-based assessment formula would be modified to include the risks to the deposit insurance fund posed by the uninsured affiliates of the depository institution. Third, the FDIC would be required to consider off-balance sheet exposures when setting its rates. The FDIC’s current authority to establish separate assessment systems for large and small institutions would be eliminated. Furthermore, regulatory agencies would be required to adopt joint regulations requiring creditors and securitizers to retain at least five percent of the credit risk with respect to such credit or security and prohibit the hedge or transfer of such risk. The agencies could reduce or increase the five percent requirement depending on the circumstances.

The Wall Street Reform Act also addresses shareholder measures, including requiring public companies to provide shareholders with a non-binding vote with respect to executive compensation and to have a compensation committee comprised solely of independent directors. Additionally, the federal banking regulators, the Securities and Exchange Commission (SEC), and the Federal Housing Finance Agency (FHFA) would be required to jointly issue regulations prohibiting any compensation package that encourages executives to take risks that could seriously affect the economy or threaten a financial institution’s safety and soundness. The act also includes substantial portions of H.R. 1728, the Mortgage Reform and Anti-Predatory Lending Act, which the House passed in May 2009 (and discussed below in “Housing and Mortgage Lending”).

On March 24, 2010, the Senate Banking Committee passed the Wall Street Transparency and Accountability Act of 2010 (the “Wall Street Transparency and Accountability Act”). The Senate legislation as passed by the Senate Banking Committee also includes a Consumer Financial Protection Bureau (CFBP) in place of the House CFPA model. The CFPB would be housed within the Federal Reserve but is autonomous under the statute. Similar to the House legislation as discussed above, the Wall Street Transparency and Accountability Act, if passed by the Senate, would create a FSOC to oversee systemic risk in the system, place a five percent risk retention requirement, and add corporate governance standards. The Wall Street Transparency and Accountability Act does not include the mortgage reform title; however, “Volcker Rule” prohibitions on proprietary trading and various limitations on the use of derivatives, including required central clearing and/or imposing new margin and capital requirements, were included. The full Senate began debate on the Wall Street Transparency and Accountability Act on Thursday, April 29, 2010, and the components of the legislation remain fluid as many amendments are contemplated. It is believed that the Senate will spend several weeks considering the legislation. It is too early to reliably assess the impact of the various measures outlined in the Wall Street Transparency and Accountability Act or the Wall Street Reform Act.

Proposed TARP Assessment

In January 2010, the President announced additional proposals that would impact financial institutions. The first proposal would levy a new tax on institutions within the financial sector to recoup the benefits certain institutions have received under government assistance programs, including TARP. The annual fee would be assessed at a rate of 15 basis points of “covered liabilities” for financial firms with more than $50 billion in consolidated assets (excluding Tier 1 capital, FDIC-assessed deposits and insurance policy reserves). To date, Congress has not put forth legislation on this issue. If the proposal is enacted as described above, the impact to the Company is estimated to be approximately $154 million.

Housing and Mortgage Lending

Since 2008, Congress has also focused on the housing market, looking at both retrospective and prospective solutions. In July 2008, legislation was enacted to create additional federal backstops and strengthen regulation of the Government

 

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Sponsored Enterprises (“GSEs”), including an overhaul of the Federal Housing Administration (“FHA”) programs. In May 2009, H.R. 1728, the “Mortgage Reform and Anti-Predatory Lending Act” was passed in the House. The legislation would place a federal duty of care on mortgage originators, lower the threshold for loans covered under the Home Ownership and Equity Protection Act (HOEPA), as well as address assignee liability and require that securitizers retain access to all loans packaged and sold. As discussed above, in December 2009, this legislation was included in the Wall Street Reform Act that passed the U.S. House.

In May 2009, the President signed the “Helping Families Save Their Homes Act” which provides various types of foreclosure relief and changes to the mortgage marketplace. Among other things, the law would require the OCC, OTS and HUD to report to Congress on the number and type of loan modifications made by entities under their supervision; provide a limited safe harbor for any mortgage loan servicer that enters into a “qualified loss mitigation plan” with a borrower whose loan is held in a securitization vehicle; make various changes to the HOPE for Homeowners Act of 2008 (H4H) by providing greater incentives for mortgage servicers to engage in modifications and reducing administrative burdens on loan underwriters; require new owners of mortgage loans to give notice to borrowers of the sale, transfer or assignment of the loan within 30 days of such sale, transfer or assignment and to provide certain information; and require 90 days notice to terminate the lease of a bona fide tenant of a foreclosed-upon dwelling.

Bankruptcy

There have been several proposals in Congress to modify the bankruptcy laws to permit homeowners at risk of foreclosure to receive a modification of their primary mortgages. On October 20, 2008, President Bush signed the “National Guard and Reservists Debt Relief Act of 2008,” making bankruptcy filings easier for national guardsmen and reservists.

Broad bankruptcy legislation that could be seen as creating incentives for consumers to choose Chapter 13 bankruptcy as a primary remedy for mortgage related problems was also introduced in 2009. This legislation passed the U.S. House in March 2009; however, when it was offered as an amendment to a separate bill in the U.S. Senate, it was defeated. The Senate sponsor, Senator Dick Durbin, has stated he intends to continue working to enact the legislation and will use other available legislative vehicles, including reintroducing the amendment at a later date. During the House consideration of the comprehensive regulatory reform bill in December 2009, the bankruptcy amendment was offered, but failed. Finally, Senators Whitehouse (D-RI) and Durbin have introduced legislation to disallow claims arising from “high cost consumer credit” in bankruptcy proceedings. The Senate Judiciary Committee has yet to take action on the bill; however, the bill was placed on the Committee calendar for consideration but has not been brought up for debate and vote.

Please see “Compliance With New and Existing Laws and Regulations May Increase Our Costs, Reduce Our Revenue, Limit Our Ability To Pursue Business Opportunities, And Increase Compliance Challenges” under Item 1A. Risk Factors in our 2009 Form 10-K for a discussion of the risks posed to the Company as a result of the current legislative environment.

Regulation of International Business by Non—U.S. Authorities

COBNA is subject to regulation in foreign jurisdictions where it currently operates. In the United Kingdom, COBNA operates through the U.K. Bank, which was established in 2000. The U.K. Bank is regulated by the Financial Services Authority (“FSA”) and licensed by the Office of Fair Trading (“OFT”). The U.K. Bank is an “authorized deposit taker” and thus is able to take consumer deposits in the U.K. However, the U.K Bank no longer takes deposits following the sale of its deposits business in 2009. The U.K. Bank also has been granted a full license by the OFT to issue consumer credit under the U.K.’s Consumer Credit Act. The FSA requires the U.K. Bank to maintain certain regulatory capital ratios at all times and it may modify those requirements at any time. Effective January 1, 2008, the U.K. Bank became subject to new capital adequacy requirements implemented by the FSA as a result of the U.K.’s adoption of the European Capital Requirements Directive, itself an implementation of the Basel II Accord. The U.K. Bank obtains capital through earnings or through capital infusion from COBNA, subject to prior notice requirements under Regulation K of the rules administered by the Federal Reserve. If the U.K. Bank is unable to generate or maintain sufficient capital on favorable terms, it may choose to restrict its growth to reduce the regulatory capital required. Following the introduction of the Capital Requirements Directive, the U.K. Bank continues to have a capital surplus and the impact of the new capital regime has been fully factored into the U.K. Bank’s financial and capital planning. In addition, the U.K. Bank is limited by the U.K. Companies Act in its distribution of dividends to COBNA via its immediate parent undertakings, Capital One Investment Limited and Capital One Holdings Limited, since dividends may only be paid out of the U.K. Bank’s “distributable profits.”

 

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In July 2009, the U.K. government published “Review of the Regulation of Credit and Store Cards,” a report on the credit card industry, and issued a formal consultation in October 2009. The report and consultation focus on the allocation of payments, minimum payment increases, unsolicited credit limit increases, and repricing. The U.K. government is soliciting comments from consumers and the credit card industry, and is expected to propose legislative changes in the second quarter of 2010.

In addition, the U.K. government has proposed a Financial Services Bill which is currently before Parliament that would restrict the issuance of unsolicited credit card checks. If passed as proposed, credit card issuers would not be able to issue credit card checks unless requested by a cardholder and each request would be limited to up to three checks.

Following the passing of the Consumer Credit Directive (the “CCD”) by the European Commission (the “EC”), the U.K consumer credit regime, including the laws and regulations with respect to the marketing of consumer credit products and the design of and disclosure in consumer credit agreements, is due to change significantly. The CCD is also introducing new regulations requiring that certain information be provided to consumers before a credit agreement is entered into and explicit requirements to ensure that any such consumer is creditworthy. The CCD is required to be implemented into U.K law by June 11, 2010, although there are indications that there may be a delay in this implementation timeframe.

The OFT is investigating Visa and MasterCard’s current methods of setting interchange fees applicable to U.K. domestic transactions. Cross-border interchange fees are also coming under scrutiny from the European Commission, which in December 2007 issued a decision notice stating that MasterCard’s interchange fees applicable to cross border transactions are in breach of European Competition Law. MasterCard has appealed this decision. A similar decision is expected in relation to Visa’s cross border interchange fees. The timing of any final resolution of the matter by EC or OFT is uncertain and it is unlikely that there will be any determination before the end of 2011. However, it is likely that interchange fees will be reduced, which could adversely affect the yield on U.K. credit card portfolios.

Following a referral by the OFT, the Competition Commission (the “CC”) launched a market investigation into the supply of Payment Protection Insurance (“PPI”) in the U.K. PPI on mortgages, credit cards, unsecured loans (personal loans, motor loans and hire purchase) and secured loans is included. The CC published its final report on remedies on January 29, 2009, which included point of sale changes and the introduction of an annual PPI statement to customers. At the end of 2009, Barclays Bank successfully challenged the remedies package at the Competition Appeals Tribunal and the CC is currently revisiting its proposals. The new provisional remedies package is expected to be delivered in May 2010, followed by a consultation period at which point the U.K Bank will be able to assess the impact of the proposed new remedies. The U.K. Bank is now expecting the remedies will not be implemented until 2011.

As in the U.S., in non-U.S. jurisdictions where we operate, we face a risk that the laws and regulations that are applicable to us (or the interpretations of existing laws by relevant regulators) may change in ways that adversely impact our business.

For additional information on our Supervision and Regulation activities, see our 2009 Form 10-K “Part I—Item 1. Business—Supervision and Regulation. We discuss the risks to the company resulting from the current legislative environment in our 2009 Form 10-K in “Part I—Item 1A. Risk Factors.”

 

 

XV. ENTERPRISE RISK MANAGEMENT

 

Our business activities expose us to four major categories of risks: liquidity risk, credit risk, reputational risk and capital adequacy. We also are exposed to market risk, strategic risk, operational risk, compliance risk and legal risk. Our risk management framework is intended to identify, assess, and mitigate risks that affect or have the potential to affect our business, to target financial returns commensurate with our risk appetite, and to avoid excessive risk-taking. We follow three key principles related to this policy.

 

1. Individual businesses take and manage risk in pursuit of strategic, financial, and other business objectives.

 

2. Independent risk management organizations support individual businesses by providing risk management tools and policies, and by aggregating risks; in some cases, risks are managed centrally.

 

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3. The Board of Directors and top management review our aggregate risk position and establish the risk appetite.

We provide additional information on our enterprise risk management framework and activities in our 2009 Form 10-K in “Part I—Item 1. Business—Enterprise Risk Management.”

 

 

XVI. FORWARD-LOOKING STATEMENTS

 

From time to time, we have made and will make forward-looking statements, including those that discuss, among other things, strategies, goals, outlook or other non-historical matters; projections, revenues, income, returns, earnings per share or other financial measures for Capital One; future financial and operating results; and Capital One’s plans, objectives, expectations and intentions; and the assumptions that underlie these matters. To the extent that any such information is forward-looking, it is intended to fit within the safe harbor for forward-looking information provided by the Private Securities Litigation Reform Act of 1995. Numerous factors could cause our actual results to differ materially from those described in such forward-looking statements, including, among other things:

 

 

general economic and business conditions in the U.S., the U.K., or Capital One’s local markets, including conditions affecting employment levels, interest rates, consumer income and confidence, spending and savings that may affect consumer bankruptcies, defaults, charge-offs and deposit activity;

 

 

an increase or decrease in credit losses (including increases due to a worsening of general economic conditions in the credit environment);

 

 

financial, legal, regulatory, tax or accounting changes or actions, including with respect to any litigation matter involving Capital One;

 

 

increases or decreases in interest rates;

 

 

the success of our marketing efforts in attracting and retaining customers;

 

 

the ability of the company to continue to securitize its credit cards and consumer loans and to otherwise access the capital markets at attractive rates and terms to capitalize and fund its operations and future growth;

 

 

with respect to financial and other products, increases or decreases in our aggregate loan balances and/or the number of customers and the growth rate and composition thereof, including increases or decreases resulting from factors such as shifting product mix, amount of actual marketing expenses made by Capital One and attrition of loan balances;

 

 

the amount and rate of deposit growth;

 

 

our ability to control costs;

 

 

changes in the reputation of or expectations regarding the financial services industry and/or Capital One with respect to practices, products or financial condition;

 

 

any significant disruption in our operations or technology platform;

 

 

our ability to maintain a compliance infrastructure suitable for its size and complexity;

 

 

the amount of, and rate of growth in, our expenses as our business develops or changes or as it expands into new market areas;

 

 

our ability to execute on its strategic and operational plans;

 

 

any significant disruption of, or loss of public confidence in, the United States Mail service affecting our response rates and consumer payments;

 

 

our ability to recruit and retain experienced personnel to assist in the management and operations of new products and services;

 

 

changes in the labor and employment markets;

 

 

the risk that cost savings and any other synergies from our acquisitions may not be fully realized or may take longer to realize than expected;

 

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disruptions from our acquisitions negatively impacting our ability to maintain relationships with customers, employees or suppliers;

 

 

competition from providers of products and services that compete with our businesses; and

 

 

other risk factors listed from time to time in reports that Capital One files with the Securities and Exchange Commission (the “SEC”), including, but not limited to, our 2009 Form 10-K.

 

 

Any forward-looking statements made by or on behalf of Capital One speak only as of the date they are made or as of the date indicated, and Capital One does not undertake any obligation to update forward-looking statements as a result of new information, future events or otherwise. You should carefully consider the factors discussed above in evaluating these forward-looking statements. For additional information on factors that could materially influence forward-looking statements included in this report, see the risk factors in this report in “Part II —Item 1A. Risk Factors” and in our 2009 Form 10-K in “Part I—Item 1A. Risk Factors.”

 

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XVII. SUPPLEMENTAL STATISTICAL TABLES

 

TABLE A—STATEMENTS OF AVERAGE BALANCES, INCOME AND EXPENSE, YIELDS AND RATES

Table A provides average balance sheet data and an analysis of net interest income, net interest spread (the difference between the yield on earning assets and the cost of interest-bearing liabilities) and net interest margin for the three months ended March 31, 2010 and 2009.

 

     March 31, 2010     March 31, 2009  
     Reported     Reported     Managed  

(Dollars in thousands)

   Average
Balance
    Income/
Expense
   Yield/
Rate
    Average
Balance
    Income/
Expense
   Yield/
Rate
    Average
Balance
    Income/
Expense
   Yield/
Rate
 

Assets:

                     

Interest-earning assets:

                     

Consumer loans(1)

                     

Domestic

   $ 96,669,076      $ 2,961,108    12.25   $ 70,710,644      $ 1,726,185    9.76   $ 109,254,136      $ 2,843,852    10.41

International

     7,814,411        305,212    15.62     2,986,485        91,360    12.24     8,382,679        261,724    12.49
                                                               

Total consumer loans

   $ 104,483,487      $ 3,266,320    12.50   $ 73,697,129      $ 1,817,545    9.86   $ 117,636,815      $ 3,105,576    10.56

Commercial loans

     29,722,674        391,415    5.27     29,545,277        374,073    5.06     29,545,277        374,073    5.06
                                                               

Total loans held for investment

   $ 134,206,161      $ 3,657,735    10.90   $ 103,242,406      $ 2,191,618    8.49   $ 147,182,092      $ 3,479,649    9.46
                                                               

Investment securities

     38,086,936        348,715    3.66     34,209,102        395,274    4.62     34,209,102        395,274    4.62

Other

                     

Domestic

     8,884,858        22,394    1.01     6,914,208        58,214    3.37     4,675,351        14,668    1.25

International

     702,901        985    0.56     806,041        4,903    2.43     547,365        1,075    0.79
                                                               

Total

   $ 9,587,759      $ 23,379    0.98   $ 7,720,249      $ 63,117    3.27   $ 5,222,716      $ 15,743    1.21
                                                               

Total interest-earning assets(3)

   $ 181,880,856      $ 4,029,829    8.86   $ 145,171,757      $ 2,650,009    7.30   $ 186,613,910      $ 3,890,666    8.34
                                                               

Cash and due from banks(3)

     6,712,290             3,158,569             3,158,569        

Allowance for loan and lease losses(3)

     (8,349,477          (4,522,910          (4,522,910     

Premises and equipment, net(3)

     2,726,392             2,485,680             2,485,680        

Other (3)

     24,237,438             22,196,383             22,433,529        

Total assets from discontinued operations

     24,324             22,033             22,033        
                                       

Total assets

   $ 207,231,823           $ 168,511,512           $ 210,190,811        
                                       

Liabilities and Equity:

                     

Interest-bearing liabilities

                     

Deposits

                     

Domestic

   $ 103,099,669      $ 397,466    1.54   $ 98,328,999      $ 612,880    2.49   $ 98,328,999      $ 612,880    2.49

International(4)

     917,656        1,264    0.55     2,557,479        14,512    2.27     2,557,479        14,512    2.27
                                                               

Total deposits

   $ 104,017,325      $ 398,730    1.53   $ 100,886,478      $ 627,392    2.49   $ 100,886,478      $ 627,392    2.49

Securitized debt

                     

Domestic

   $ 38,877,573      $ 208,586    2.15   $ 7,046,543        90,733    5.15   $ 43,516,804        332,416    3.06

International

     4,886,675        33,149    2.71     0        0    0.00     5,296,355        41,972    3.17
                                                               

Total securitized debt

   $ 43,764,248      $ 241,735    2.21   $ 7,046,543        90,733    5.15   $ 48,813,159      $ 374,388    3.07

 

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     March 31, 2010     March 31, 2009  
     Reported     Reported     Managed  

(Dollars in thousands)

   Average
Balance
   Income/
Expense
   Yield/
Rate
    Average
Balance
   Income/
Expense
   Yield/
Rate
    Average
Balance
   Income/
Expense
   Yield/
Rate
 

Senior and subordinated notes

     8,757,477      68,224    3.12     7,771,343      58,044    2.99     7,771,343      58,044    2.99

Other borrowings

                        

Domestic

   $ 5,056,474    $ 89,490    7.08   $ 8,544,863      78,966    3.70   $ 8,544,863      78,966    3.70

International

     2,374,525      3,497    0.59     105,672      1,886    7.14     105,672      1,886    7.14
                                                            

Total other borrowings

   $ 7,430,999    $ 92,987    5.01   $ 8,650,535    $ 80,852    3.74   $ 8,650,535    $ 80,852    3.74
                                                            

Total interest-bearing liabilities(3)

   $ 163,970,049    $ 801,676    1.96   $ 124,354,899      857,021    2.76   $ 166,121,515      1,140,676    2.75

Non-interest bearing deposits(3)

     13,513,099           11,250,267           11,250,267      

Other (3)

     5,840,271           5,763,775           5,676,457      

Total liabilities from discontinued operations

     227,710           138,231           138,231      
                                    

Total liabilities

   $ 183,551,129         $ 141,507,172         $ 183,186,470      

Equity(5)

     23,680,694           27,004,340           27,004,340      

Total liabilities and equity

   $ 207,231,823         $ 168,511,512         $ 210,190,810      
                                    

Net interest spread

         6.90         4.55         5.59
                                    

Interest income to average earning assets

         8.86         7.30         8.34

Interest expense to average earning assets

         1.76         2.36         2.45
                                    

Net interest margin

         7.10         4.94         5.89
                                    

 

(1) Interest income includes past due fees on loans totaling approximately $332.2 million for the three months ended March 31, 2010 and $162.0 million and $363.5 million on the reported and managed basis, respectively, for the three months ended March 31, 2009.
(2) Certain prior period amounts have been reclassified to conform with the current period presentation.
(3) Based on continuing operations.
(4) U.K. deposit business was sold during the third quarter of 2009.
(5) Includes a reduction of $2.9 billion due to consolidation impact of certain securitized trusts.

 

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TABLE B—INTEREST VARIANCE ANALYSIS

 

     Three Months Ended March 31,
2010 vs. 2009 Managed
 
           Change due to(1)  

(Dollars in thousands)

   Increase
(Decrease)
    Volume     Yield/ Rate  

Interest Income(3) :

      

Consumer loans

      

Domestic

   $ 117,256      $ (350,433   $ 467,689   

International

     43,488        (18,689     62,177   
                        

Total

   $ 160,744      $ (371,403   $ 532,147   
                        

Commercial loans

     17,342        2,258        15,084   
                        

Total loans held for investment

   $ 178,086      $ (323,925   $ 502,011   

Investment securities

     (46,559     41,522        (88,081

Other

      

Domestic

     7,726        11,075        (3,349

International

     (90     262        (352
                        

Total

   $ 7,636      $ 11,112      $ (3,476
                        

Total interest income

   $ 139,163      $ (100,460   $ 239,623   

Interest Expense(3) :

      

Deposits

      

Domestic (2)

   $ (215,414   $ 28,455      $ (243,869

International

     (13,248     (6,074     (7,174
                        

Total (2)

   $ (228,662   $ 18,911      $ (247,573
                        

Senior notes

     10,180        7,602        2,578   

Other borrowings

      

Domestic (2)

     10,524        (41,338     51,862   

International

     1,611        4,864        (3,253
                        

Total (2)

   $ 12,135      $ (12,533   $ 24,668   

Securitized debt

      

Domestic (2)

     (123,830     (32,656     (91,174

International

     (8,823     (3,083     (5,740
                        

Total (2)

   $ (132,653   $ (35,800   $ (96,853
                        

Total interest expense

   $ (339,000   $ (14,590   $ (324,410
                        

Net interest income

   $ 478,163      $ (71,322   $ 549,485   
                        

 

(1)

The change in net interest income attributable to both volume and rates has been allocated in proportion to the relationship of the absolute dollar amounts of the change in each. We calculate the change in interest income and interest expense separately for each item. As a result, the totals presented in the volume and yield/rate columns do not equal the sum of amounts presented in the individual categories presented.

(2)

Certain prior period amounts have been reclassified to conform with the current period presentation.

(3)

Based on continuing operations.

 

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TABLE C—MANAGED LOAN PORTFOLIO

 

(Dollars in thousands)

   March 31, 2010    December 31,  2009

Period-End Balances:

     

Reported loans held for investment:

     

Consumer loans

     

Credit cards

     

Domestic

   $ 50,092,848    $ 13,373,383

International

     7,548,484      2,229,321
             

Total credit card

   $ 57,641,332    $ 15,602,704

Installment loans

     

Domestic

     5,984,402      6,693,165

International

     29,626      43,890
             

Total installment loans

   $ 6,014,028    $ 6,737,055

Auto loans

     17,446,430      18,186,064

Mortgage loans

     13,966,471      14,893,187

Retail Banking

     4,969,775      5,135,242
             

Total consumer loans

   $ 100,038,036    $ 60,554,252

Commercial loans

     

Commercial and multi-family real estate

     13,617,900      13,843,158

Middle Market

     10,310,156      10,061,819

Specialty Lending

     3,618,987      3,554,563

Small ticket commercial real estate

     2,065,095      2,153,510
             

Total commercial loans

   $ 29,612,138    $ 29,613,050

Other loans

     464,347      451,697
             

Total reported loans held for investment

   $ 130,114,521    $ 90,618,999
             

Securitization adjustments(1):

     

Consumer loans

     

Credit cards

     

Domestic

   $ —      $ 39,827,572

International

     —        5,950,624
             

Total credit card

   $ —      $ 45,778,196

Installment loans – Domestic

     150,762      405,707
             

Total consumer loans

   $ 150,762    $ 46,183,903
             

Total securitization adjustments

   $ 150,762    $ 46,183,903
             

Managed loans held for investment:

     

Consumer loans

     

Credit cards

     

Domestic

   $ 50,092,848    $ 53,200,955

International

     7,548,484      8,179,945
             

Total credit card

   $ 57,641,332    $ 61,380,900

Installment loans

     

Domestic

     6,135,164      7,098,872

International

     29,626      43,890
             

Total installment loans

   $ 6,164,790    $ 7,142,762

Auto loans

     17,446,430      18,186,064

Mortgage loans

     13,966,471      14,893,187

Retail Banking

     4,969,775      5,135,242
             

Total consumer loans

   $ 100,188,798    $ 106,738,155

Commercial loans

     

Commercial and multi-family real estate

     13,617,900      13,843,158

Middle Market

     10,310,156      10,061,819

Specialty Lending

     3,618,987      3,554,563

Small ticket commercial real estate

     2,065,095      2,153,510
             

Total commercial loans

   $ 29,612,138    $ 29,613,050

Other loans

     464,347      451,697
             

Total managed loans held for investment

   $ 130,265,283    $ 136,802,902
             

 

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Table of Contents
     Three Months Ended March 31

(Dollars in thousands)

   2010    2009

Average Balances:

     

Reported loans held for investment:

     

Consumer loans

     

Credit cards

     

Domestic

   $ 51,702,084    $ 20,605,622

International

     7,777,848      2,881,940
             

Total credit card

   $ 59,479,932    $ 23,487,562

Installment loans

     

Domestic

     6,233,038      10,038,590

International

     36,563      104,545
             

Total installment loans

   $ 6,269,601    $ 10,143,135

Auto loans

     17,768,721      21,123,000

Mortgage loans

     15,433,825      9,860,646

Retail Banking

     5,042,814      5,559,451
             

Total consumer loans

   $ 103,994,893    $ 70,173,794

Commercial loans

     

Commercial and multi-family real estate

     13,716,376      13,437,351

Middle Market

     10,323,528      10,003,213

Specialty