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

September 30, 2011 For the quarterly period ended September 30, 2011

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

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

(Not applicable)

 

 

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 October 31, 2011, there were 459,677,105 shares of the registrant’s Common Stock, par value $.01 per share, outstanding.

 

 

 


Table of Contents

TABLE OF CONTENTS

 

          Page  

PART I—FINANCIAL INFORMATION

     1   

Item 1.      

  

Financial Statements

     69   
  

Condensed Consolidated Statements of Income

     69   
  

Condensed Consolidated Balance Sheets

     70   
  

Condensed Consolidated Statements of Changes in Stockholders’ Equity

     71   
  

Condensed Consolidated Statements of Cash Flows

     72   
  

Notes to Consolidated Financial Statements 

     73   
  

Note   1—Summary of Significant Accounting Policies

     73   
  

Note   2—Acquisitions

     75   
  

Note   3—Discontinued Operations

     77   
  

Note   4—Investment Securities

     78   
  

Note   5—Loans

     86   
  

Note   6—Allowance for Loan and Lease Losses

     108   
  

Note   7—Variable Interest Entities and Securitizations

     110   
  

Note   8—Goodwill and Other Intangible Assets

     120   
  

Note   9—Deposits and Borrowings

     124   
  

Note 10—Derivative Instruments and Hedging Activities

     127   
  

Note 11—Stockholders’ Equity

     133   
  

Note 12—Earnings Per Common Share

     134   
  

Note 13—Fair Value of Financial Instruments

     135   
  

Note 14—Business Segments

     146   
  

Note 15—Commitments, Contingencies and Guarantees

     149   

Item 2.      

  

Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”)

     1   
  

Summary of Selected Financial Data

     1   
  

Introduction

     4   
  

Executive Summary and Business Outlook

     6   
  

Critical Accounting Policies and Estimates

     11   
  

Consolidated Results of Operations

     13   
  

Business Segment Financial Performance

     20   
  

Consolidated Balance Sheet Analysis and Credit Performance

     33   
  

Off-Balance Sheet Arrangements and Variable Interest Entities

     52   
  

Risk Management

     52   
  

Liquidity and Capital Management

     53   
  

Market Risk Management

     60   
  

Supervision and Regulatory Developments

     63   
  

Accounting Changes and Developments

     63   
  

Forward-Looking Statements

     63   
  

Supplemental Tables

     66   

Item 3.      

  

Quantitative and Qualitative Disclosures about Market Risk

     161   

Item 4.      

  

Controls and Procedures

     161   

PART II—OTHER INFORMATION

  

Item 1.      

  

Legal Proceedings

     162   

Item 1A.  

  

Risk Factors

     162   

Item 2.      

  

Unregistered Sales of Equity Securities and Use of Proceeds

     162   

Item 3.      

  

Defaults upon Senior Securities

     162   

Item 5.      

  

Other Information

     162   

Item 6.      

  

Exhibits

     162   

SIGNATURES

     163   

INDEX TO EXHIBITS

     164   

 

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Table of Contents

INDEX OF MD&A TABLES AND SUPPLEMENTAL TABLES

 

Table

  

Description

  

Page

 

  

MD&A Tables:

  

1

  

Consolidated Financial Highlights (Unaudited)

     1   

2

  

Business Segments Results

     5   

3

  

Average Balances, Net Interest Income and Net Interest Yield

     14   

4

  

Rate/Volume Analysis of Net Interest Income

     16   

5

  

Non-Interest Income

     18   

6

  

Non-Interest Expense

     19   

7

  

Credit Card Business Results

     22   

7.1

  

Domestic Credit Card Business Results

     24   

7.2

  

International Credit Card Business Results

     26   

8

  

Consumer Banking Business Results

     28   

9

  

Commercial Banking Business Results

     31   

10

  

Investment Securities

     33   

11

  

Loan Portfolio Composition

     35   

12

  

30+ Day Delinquencies

     37   

13

  

Aging of 30+ Day Delinquent Loans

     38   

14

  

90+ Day Delinquent Loans Accruing Interest

     38   

15

  

Nonperforming Loans and Other Nonperforming Assets

     39   

16

  

Net Charge-Offs

     40   

17

  

Loan Modifications and Restructurings

     41   

18

  

Allowance for Loan and Lease Losses Activity

     44   

19

  

Allocation of the Allowance for Loan and Lease Losses

     45   

20

  

Unpaid Principal Balance of Mortgage Loans Originated and Sold to Third Parties Based on Category of Purchaser

     47   

21

  

Open Pipeline All Vintages (all entities)

     49   

22

  

Changes in Representation and Warranty Reserve

     51   

23

  

Allocation of Representation and Warranty Reserve

     51   

24

  

Liquidity Reserves

     53   

25

  

Deposits

     53   

26

  

Expected Maturity Profile of Short-term Borrowings and Long-term Debt

     55   

27

  

Borrowing Capacity

     56   

28

  

Senior Unsecured Debt Credit Ratings

     56   

29

  

Capital Ratios Under Basel I

     57   

30

  

Risk-Based Capital Components Under Basel I

     58   

31

  

Interest Rate Sensitivity Analysis

     62   

  

Supplemental Tables:

  

A

  

Reconciliation of Non-GAAP Measures and Calculation of Regulatory Capital Measures

     66   

B

  

Reconciliation of Basel III Capital Measures

     68   

 

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Table of Contents

PART I—FINANCIAL INFORMATION

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

This Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) should be read in conjunction with our unaudited condensed consolidated financial statements and related notes in this Report and the more detailed information contained in our 2010 Annual Report on Form 10-K (“2010 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. Please review “Forward-Looking Statements” for more information on the forward-looking statements in this Report. 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,” in our 2010 Form 10-K in “Part I—Item 1A. Risk Factors” and in Exhibit 99.5 to our Current Report on Form 8-K filed on July 13, 2011.

 

 

SUMMARY OF SELECTED FINANCIAL DATA

 

Below we provide selected consolidated financial data from our results of operations for the three and nine months ended September 30, 2011 and 2010, and selected comparative consolidated balance sheet data as of September 30, 2011, and December 31, 2010. We also provide selected key metrics we use in evaluating our performance.

Table 1: Consolidated Financial Highlights (Unaudited)

 

    Three Months Ended September 30,     Nine Months Ended September 30,  
(Dollars in millions)       2011             2010             Change             2011             2010             Change      

Income statement

           

Net interest income(1)

  $ 3,283      $ 3,109        6   $ 9,559      $ 9,434        1

Non-interest income

    871        907        (4     2,670        2,775        (4
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total revenue

    4,154        4,016        3        12,229        12,209          **   

Provision for loan and lease losses(1)

    622        867        (28     1,499        3,069        (51

Non-interest expense

    2,297        1,996        15        6,714        5,843        15   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Income from continuing operations before income taxes

    1,235        1,153        7        4,016        3,297        22   

Income tax provision

    370        335        10        1,174        948        24   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Income from continuing operations, net of taxes

    865        818        6        2,842        2,349        21   

Loss from discontinued operations, net of taxes(2)

    (52     (15     247        (102     (303     (66
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income

  $ 813      $ 803        1   $ 2,740      $ 2,046        34
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Common share statistics

           

Earnings per common share:

           

Basic earnings per common share

  $ 1.78      $ 1.78        **   $ 6.02      $ 4.53        33

Diluted earnings per common share

    1.77        1.76        1        5.95        4.49        33   

Weighted average common shares outstanding:

           

Basic earnings per common share

    456.0        452.5        1        455.2        451.9        1   

Diluted earnings per common share

    460.4        456.6        1        461.0        456.0        1   

Dividends per common share

    0.05        0.05        **        0.15        0.15        **   

Stock price per common share at period end

    39.63        39.55        **        39.63        39.55        **   

Total market capitalization at period end

    18,075        17,900        1        18,075        17,900        1   

 

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Table of Contents
     Three Months Ended September 30,     Nine Months Ended September 30,  
     2011     2010     Change     2011     2010     Change  

Average balances

            

Loans held for investment

   $ 129,043      $ 126,307        2   $ 127,360      $ 129,565        (2 )% 

Interest-earning assets

     177,710        172,473        3        175,147        176,332        (1

Total assets

     201,611        196,598        3        199,616        200,931        (1

Interest-bearing deposits

     110,750        104,186        6        109,552        104,119        5   

Total deposits

     128,268        118,255        8        126,102        118,095        7   

Borrowings

     37,366        45,910        (19     39,107        52,044        (25

Stockholders’ equity

     29,316        25,307        16        28,202        24,498        15   

Performance metrics

            

Purchase volume(3)

   $ 34,918      $ 27,039        29   $ 96,941      $ 77,533        25

Revenue margin (1) (4)

     9.35     9.31     4 bps      9.31     9.23     8 bps 

Net interest margin (1) (5)

     7.39        7.21        18        7.28        7.13        15   

Net charge-off rate (1) (6)

     2.52        4.82        (230     3.02        5.41        (239

Return on average assets(7)

     1.72        1.66        6        1.90        1.56        34   

Return on average equity(8)

     11.80        12.93        (113     13.44        12.78        66   

Non-interest expense as a % of average loans held for investment(9)

     7.12        6.32        80        7.03        6.01        102   

Efficiency ratio(10)

     55.30        49.70        560        54.90        47.86        704   

Effective income tax rate

     29.96        29.05        91        29.23        28.75        48   
     September 30,
2011
    December 31,
2010
    Change                    

Balance sheet (period end)

            

Loans held for investment

   $ 129,952      $ 125,947        3      

Interest-earning assets

     174,308        172,024        1         

Total assets

     200,148        197,503        1         

Interest-bearing deposits

     110,777        107,162        3         

Total deposits

     128,318        122,210        5         

Borrowings

     34,315        41,796        (18      

Total liabilities

     170,770        170,962        **         

Stockholders’ equity

     29,378        26,541        11         

Tangible common equity (“TCE”)(11)

     15,425        12,558        23         

Credit quality metrics (period end)

            

Allowance for loan and lease losses

   $ 4,280      $ 5,628        (24 )%       

Allowance as a % of loans held for investment

     3.29     4.47     (118 )bps       

30+ day performing delinquency rate(12)

     3.13        3.52        (39      

30+ day delinquency rate

     3.81        4.23        (42      

Capital ratios

            

Tier 1 common equity ratio(13)

     10.0     8.8     120 bps       

Tier 1 risk-based capital ratio(14)

     12.4        11.6        80         

Total risk-based capital ratio(15)

     15.4        16.8        (140      

Tangible common equity ratio (“TCE ratio”)(16)

     8.3        6.9        140         

 

** Change is less than one percent.
(1) 

Interest income was reduced by $206 million and $421 million in the third quarter and first nine months of 2011, respectively, for amounts earned by Kohl’s Department Stores (‘Kohl’s”). The reduction in the provision for loan and lease losses attributable to Kohl’s was $236 million for the first nine months of 2011. Loss-sharing amounts attributable to Kohl’s reduced net charge-offs by $39 million and $80 million in the third quarter and first nine

 

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Table of Contents
  months of 2011, respectively. The expected loss reimbursement from Kohl’s netted in our allowance for loan and lease losses was approximately $156 million as of September 30, 2011. See “Note 2—Acquisitions” for additional information.
(2) 

Discontinued operations reflect ongoing costs related to the mortgage origination operations of GreenPoint’s wholesale mortgage banking unit, GreenPoint Mortgage Funding, Inc. (“GreenPoint”), which we closed in 2007.

(3) 

Consists of credit card purchase transactions for the period, net of returns. Excludes cash advance transactions.

(4) 

Calculated based on annualized total revenue for the period divided by average interest-earning assets for the period.

(5) 

Calculated based on annualized net interest income for the period divided by average interest-earning assets for the period.

(6) 

Calculated based on annualized net charge-offs for the period divided by average loans held for investment for the period. Average loans held for investment include purchased credit-impaired loans acquired as part of the Chevy Chase Bank acquisition.

(7) 

Calculated based on annualized income from continuing operations, net of tax, for the period divided by average total assets for the period.

(8) 

Calculated based on annualized income from continuing operations, net of tax, for the period divided by average stockholders’ equity for the period.

(9) 

Calculated based on annualized non-interest expense, excluding restructuring and goodwill impairment charges, for the period divided by average loans held for investment for the period.

(10) 

Calculated based on non-interest expense, excluding restructuring and goodwill impairment charges, for the period divided by total revenue for the period.

(11) 

Tangible common equity is a non-GAAP measure consisting of total assets less assets from discontinued operations and intangible assets. See “Supplemental Tables—Table A: Reconciliation of Non-GAAP Measures and Calculation of Regulatory Capital Measures” for the calculation of this measure and reconciliation to the comparative GAAP measure.

(12) 

See “Consolidated Balance Sheet Analysis and Credit Performance—Credit Performance—Nonperforming Assets” for our policies for classifying loans as nonperforming by loan category.

(13) 

Tier 1 common equity ratio is a non-GAAP measure calculated based on Tier 1 common equity divided by risk-weighted assets. See “Liquidity and Capital Management—Capital Management” and “Supplemental Tables—Table A: Reconciliation of Non-GAAP Measures and Calculation of Regulatory Capital Measures” for additional information, including the calculation of this ratio and non-GAAP reconciliation.

(14) 

Tier 1 risk-based capital ratio is a regulatory measure calculated based on Tier 1 capital divided by risk-weighted assets. See “Liquidity and Capital Management—Capital Management” and “Supplemental Tables—Table A: Reconciliation of Non-GAAP Measures and Calculation of Regulatory Capital Measures” for additional information, including the calculation of this ratio.

(15) 

Total risk-based capital ratio is a regulatory measure calculated based on total risk-based capital divided by risk-weighted assets. See “Liquidity and Capital Management—Capital Management” and “Supplemental Tables—Table A: Reconciliation of Non-GAAP Measures and Calculation of Regulatory Capital Measures” for additional information, including the calculation of this ratio.

(16) 

Tangible common equity ratio (“TCE ratio”) is a non-GAAP measure calculated based on tangible common equity divided by tangible assets. See “Supplemental Tables—Table A: Reconciliation of Non-GAAP Measures and Calculation of Regulatory Capital Measures” for the calculation of this measure and reconciliation to the comparative GAAP measure.

 

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INTRODUCTION

 

Capital One Financial Corporation (the “Company”) is a diversified financial services holding company with banking and non-banking subsidiaries that offer a broad array of financial products and services to consumers, small businesses and commercial clients through branches, the internet and other distribution channels. 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; and

 

   

Capital One, National Association (“CONA”), which offers a broad spectrum of banking products and financial services to consumers, small businesses and commercial clients.

The Company and its subsidiaries are collectively referred to as “we,” “us” or “our” in this Report. CONA and COBNA are collectively referred to as the “Banks” in this Report.

We had $130.0 billion in total loans outstanding and $128.3 billion in deposits as of September 30, 2011, compared with $125.9 billion in total loans outstanding and $122.2 billion in deposits as of December 31, 2010.

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.

Our principal operations are currently organized, for management reporting purposes, into three major business segments, which are defined based on the products and services provided or the type of customer served: Credit Card, Consumer Banking and Commercial Banking. The operations of acquired businesses have been integrated into our existing business segments.

 

   

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

 

   

Consumer Banking: Consists of our branch-based lending and deposit gathering activities for consumers and small businesses, national deposit gathering, national automobile lending and consumer home loan lending and servicing activities.

 

   

Commercial Banking: Consists of our lending, deposit gathering and treasury management services to commercial real estate and middle market customers. Our middle market customers typically include commercial and industrial companies with annual revenues between $10 million to $1.0 billion.

Certain activities that are not part of a segment are included in our “Other” category.

Table 2 summarizes our business segment results, which we report based on income from continuing operations, net of tax, for the three and nine months ended September 30, 2011 and 2010. We provide a reconciliation of our total business segment results to our consolidated results using generally accepted accounting principles in the U.S. (“U.S. GAAP”) in “Note 14—Business Segments” of this Report.

 

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Table 2: Business Segment Results

 

     Three Months Ended September 30,  
     2011     2010  
     Total  Revenue(1)     Net Income  (Loss)(2)     Total  Revenue(1)     Net Income  (Loss)(2)  
(Dollars in millions)    Amount     % of
Total
    Amount     % of
Total
    Amount     % of
Total
    Amount     % of
Total
 

Credit Card

   $ 2,720        65   $ 663        76   $ 2,605        65   $ 631        77

Consumer Banking

     1,285        31        190        22        1,142        28        175        21   

Commercial Banking

     415        10        145        17        355        9        39        5   

Other(3)

     (266     (6     (133     (15     (86     (2     (27     (3
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total from continuing operations

   $ 4,154        100   $ 865        100   $ 4,016        100   $ 818        100
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

     Nine Months Ended September 30,  
     2011     2010  
     Total  Revenue(1)     Net Income  (Loss)(2)     Total  Revenue(1)     Net Income  (Loss)(2)  
(Dollars in millions)    Amount     % of
Total
    Amount     % of
Total
    Amount     % of
Total
    Amount     % of
Total
 

Credit Card

   $ 7,844        64   $ 1,924        68   $ 8,072        66   $ 1,688        72

Consumer Banking

     3,699        30        692        24        3,451        28        785        33   

Commercial Banking

     1,202        10        435        15        1,088        9        67        3   

Other(3)

     (516     (4     (209     (7     (397     (3     (191     (8
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total from continuing operations

   $ 12,229        100   $ 2,842        100   $ 12,214        100   $ 2,349        100
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

(1) 

Total revenue consists of net interest income and non-interest income.

(2) 

Net income (loss) for our business segments reflects income from continuing operations, net of tax.

(3)

Includes the residual impact of the allocation of our centralized Corporate Treasury group activities, such as management of our corporate investment portfolio and asset/liability management, to our business segments as well as other items as described in “Note 14—Business Segments.”

 

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EXECUTIVE SUMMARY AND BUSINESS OUTLOOK

 

Financial Highlights

We reported net income of $813 million ($1.77 per diluted share) in the third quarter of 2011, with each of our three business segments contributing to our earnings. In comparison, we reported net income of $911 million ($1.97 per diluted share) in the second quarter of 2011 and net income of $803 million ($1.76 per diluted share) in the third quarter of 2010. Net income totaled $2.7 billion ($5.95 per diluted share) for the first nine months of 2011, compared with net income of $2.0 billion ($4.49 per diluted share) for the first nine months of 2010.

Our capital levels continued to increase during the third quarter of 2011, with total stockholders’ equity up $2.8 billion from year-end 2010. Our Tier 1 risk-based capital ratio under Basel I was 12.4% and our Tier 1 common equity ratio, a non-GAAP measure, was 10.0% as of September 30, 2011, both up 60 basis points from the end of the second quarter of 2011, reflecting strong internal capital generation as well as the continued decline in the amount of disallowed deferred tax assets. Based on our current understanding of the Basel III framework, which has not been implemented by the U.S. banking agencies and is subject to change, we estimate that our Tier 1 common equity ratio was 10.1% as of September 30, 2011. Our stockholders’ equity and capital ratios do not reflect any impact from the equity forward sale agreements executed in July 2011 referenced below, as they have not been settled in whole or in part as of the date of this Report. We present the calculation of our regulatory capital ratios and a reconciliation of our supplemental non-GAAP capital measures below under “Supplemental Tables.”

Our strategies and actions are designed to deliver profitable long-term growth through the acquisition and retention of franchise-enhancing customer relationships across our businesses. We believe that franchise-enhancing customer relationships produce strong long-term economics through low credit costs, low customer attrition and a gradual build in loan balances and revenues over time. Examples of franchise-enhancing customer relationships include rewards customers and new partnerships in our Credit Card business, long-term retail deposit customers in our Consumer Banking business and primary banking relationships with commercial customers in our Commercial Banking business. We intend to grow these customer relationships by continuing to invest in our bank infrastructure to allow us to provide more convenient and flexible customer banking options, including a broader range of fee-based and credit products and services, by leveraging our direct bank customer franchise with national reach and by continued marketing investments to further strengthen our brand. We believe our actions have created a well-positioned balance sheet and strong capital and liquidity levels which have provided us with investment flexibility to take advantage of attractive opportunities and adjust, where we believe appropriate, to changing market conditions.

As previously announced, in June 2011, we entered into a definitive agreement with ING Groep N.V., ING Bank N.V., ING Direct N.V., ING Direct Bancorp, collectively, the Sellers, under which we will acquire substantially all of the Sellers’ ING Direct business in the United States (“ING Direct”), in exchange for $6.2 billion in cash and approximately 55.9 million shares of our common stock, subject to certain adjustments. We continue to expect the ING Direct acquisition to close in late 2011 or early 2012, subject to customary closing conditions, including certain governmental clearances and approvals. In the third quarter of 2011, we closed a public underwritten offering of our senior notes, from which we received total proceeds of approximately $3.0 billion, and a public underwritten offering of 40 million shares of our common stock at a price per share of $50.00, subject to forward sale agreements. After underwriter’s discounts and commissions, the net proceeds to us from the equity offering will be at an initial forward sale price per share of $48.50. The forward sale price is subject to adjustment under the forward sale agreements. We have not received any proceeds from this public offering of our shares of common stock yet. Under the terms of the forward sale agreements, we must settle the forward sale agreements on or before February 15, 2012. We expect to settle the forward sale agreements entirely by physical delivery of shares of common stock in exchange for cash proceeds from the forward purchasers of approximately $1.9 billion based on the initial forward price. However, we may, subject to certain conditions, elect cash or net share settlement of all or a portion of our obligation to deliver shares of common stock. We expect to

 

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use the net proceeds from the debt and equity offerings, along with cash sourced from our current liquidity, to fund the $6.2 billion in cash consideration payable in connection with the ING Direct acquisition.

In addition to the pending ING Direct acquisition, we announced in August 2011 that we had entered into a purchase agreement with HSBC Finance Corporation, HSBC USA Inc. and HSBC Technology and Services (USA) Inc. (collectively, “HSBC”), to acquire substantially all of the assets and assume liabilities of HSBC’s credit card and private-label credit card business in the United States for a premium estimated at $2.6 billion as of June 30, 2011. We currently expect the HSBC acquisition to close in the second quarter of 2012, subject to customary closing conditions, including certain governmental clearances and approvals.

We took several actions during the quarter to manage the anticipated impact of the pending ING Direct acquisition on our market risk exposure and regulatory capital requirements. Since the date we entered into the agreement to acquire ING Direct, interest rates have declined substantially, and our current estimate of the fair value of the ING Direct net assets and liabilities has increased correspondingly. In order to capture some of the anticipated benefits to regulatory capital on the closing date attributable to this decline in interest rates, in August 2011, we entered into various pay-fixed/receive-floating interest-rate swap transactions with a total notional principal amount of approximately $23.8 billion. These swap transactions are designed to mitigate the effect of a rise in interest rates on the fair values of a significant portion of the ING Direct assets and liabilities during the period from when we entered into the swap transactions to the anticipated closing date of the ING Direct acquisition in late 2011 or early 2012. Although the interest-rate swaps represent economic hedges, they are not designated for hedge accounting. Accordingly, changes in the fair value are recorded in earnings. Our results for the third quarter of 2011 include a mark-to-market loss of $266 million related to these interest-rate swaps, which was attributable to a decline in interest rates as of the end of the quarter. Changes in the fair value of these interest-rate swaps will continue to be recorded in earnings until the swaps are terminated. We also sold approximately $6.4 billion of investment securities, consisting predominantly of agency mortgage-backed securities (“MBS”). We recorded a gain of $239 million on the sale of these securities, which largely offsets the mark-to-market loss recognized on the interest-rate swaps. We will continue to evaluate market conditions and may take additional balance sheet management actions, such as entering into similar swap transactions or selling additional investment securities, to manage the anticipated impact of the pending ING Direct and HSBC acquisitions on our market risk exposure and regulatory capital requirements. For additional detail, see “Market Risk Management” section of this Report and “Note 10—Derivative Instruments and Hedging Activities.”

Below are additional highlights of our performance for the third quarter and first nine months of 2011. These highlights generally are based on a comparison to the same prior year periods. The changes in our financial condition and credit performance are generally based on our financial condition and credit performance as of September 30, 2011, compared with our financial condition and credit performance as of December 31, 2010. We provide a more detailed discussion of our financial performance in the sections following this “Executive Summary and Business Outlook.”

Total Company

 

   

Earnings: Our earnings of $813 million in the third quarter of 2011 increased by $10 million, or 1%, from the third quarter of 2010, while our earnings of $2.7 billion for the first nine months of 2011 increased by $694 million, or 34%, from the first nine months of 2010. The increase in net income for each period was primarily attributable to significantly lower credit costs due to improvements in loan credit quality. The increase in net income for the first nine months of 2011 also reflected a substantial reduction in the provision for mortgage repurchase losses for legacy mortgage-related representation and warranty claims. These factors were partially offset by higher operating expenses related to our recent acquisitions and increased marketing expenditures.

 

   

Total Loans: Period-end loans held for investment increased by $4.0 billion, or 3%, during the first nine months of 2011, to $130.0 billion as of September 30, 2011, from $125.9 billion as of December 31, 2010. The increase was primarily attributable to the additions of the $3.7 billion private-label credit card loan

 

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portfolio of Kohl’s in the second quarter of 2011 and the $1.4 billion credit card loan portfolio of Hudson’s Bay Company (“HBC”) in the first quarter of 2011, as well as growth in our auto finance, commercial and revolving domestic card balances. Excluding the impact of the addition of the Kohl’s and HBC portfolios, total loans decreased by $1.1 billion, or 1%, in the first nine months of 2011, due to the continued expected run-off of installment loans in our Credit Card business and legacy home loans in our Consumer Banking business, other loan paydowns and charge-offs. The impact from these factors more than offset the strong purchase volume growth across the Domestic Card business, a significant increase in auto loan originations and steady loan growth in our Commercial Banking business.

 

   

Charge-off and Delinquency Statistics: Net charge-off rates continued to decline during the third quarter of 2011. The net charge-off rate decreased to 2.52%, from 2.91% in the second quarter of 2011 and 4.82% in the third quarter of 2010. The net charge-off rate was 3.02% for the first nine months of 2011, a decrease of 239 basis points from the first nine months of 2010. The 30+ day delinquency rate was 3.81% as of September 30, 2011, compared with 3.57% as of June 30, 2011, and 4.23% as of December 31, 2010. As overall credit trends are stabilizing after almost two years of rapidly declining charge-offs, our quarterly credit metrics are increasingly driven by seasonal patterns.

 

   

Allowance for Loan and Lease Losses: We reduced our allowance by $208 million in the third quarter of 2011 and by $1.3 billion in the first nine months of 2011 to $4.3 billion as of September 30, 2011. In comparison, we reduced our allowance by $624 million in the third quarter of 2010 and by $2.0 billion in the first nine months of 2010. The significant reductions in our allowance releases in the third quarter and first nine months of 2011 from the same prior year periods reflect the impact of stabilizing credit trends. While our net-charge off rate improved by 239 basis points in the first nine months of 2011, compared with the same prior year period, the allowance coverage ratio fell by only 118 basis points to 3.29% as of September 30, 2011, from 4.47% as of December 31, 2010.

 

   

Representation and Warranty Reserve: Our representation and warranty reserve totaled $892 million as of September 30, 2011, compared with $816 million as of December 31, 2010. This reserve relates to our mortgage loan repurchase exposure for legacy mortgage loans sold by our subsidiaries to various parties under contractual provisions that include various representations and warranties. The reserve reflects losses as of each balance sheet date that we consider to be both probable and reasonably estimable. We recorded a provision for this exposure of $72 million and $153 million in the third quarter and first nine months of 2011, respectively, compared with a provision of $16 million and $644 million in the third quarter and first nine months of 2010, respectively.

Business Segments

 

   

Credit Card Business: Our Credit Card business generated net income from continuing operations of $663 million and $1.9 billion in the third quarter and first nine months of 2011, respectively, compared with net income from continuing operations of $631 million and $1.7 billion in the third quarter and first nine months of 2010, respectively. The improvement in credit performance was the primary driver of the improvement in our Credit Card business, resulting in a significant decrease in the provision for loan and lease losses. The provision decrease for the first nine months of 2011 was partially offset by an increase in non-interest expense attributable to increased operating and integration costs related to the acquisitions of the credit card loan portfolios of Sony, HBC and Kohl’s and increased marketing expenditures. New account originations have continued to grow in our Credit Card business.

 

   

Consumer Banking Business: Our Consumer Banking business generated net income from continuing operations of $190 million and $692 million in the third quarter and first nine months of 2011, respectively, compared with net income from continuing operations of $175 million and $785 million in the third quarter and first nine months of 2010, respectively. The increase in net income for the third quarter of 2011 was primarily due to revenue growth resulting from improved loan margins attributable to an increase in average loan yields, coupled with a decrease in the cost of funds. The decrease in net income for the first nine months of 2011 reflected the impact of the absence of a one-time pre-tax gain of $128 million recorded in

 

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the first quarter of 2010 from the deconsolidation of certain option-adjustable rate mortgage trusts and an increase in the provision for loan and lease losses due to growth in auto loans. These factors were partially offset by an increase in total revenue due to a shift in our loan product mix toward higher priced auto loan originations, coupled with deposit growth resulting from our continued strategy to leverage our bank outlets to attract lower cost deposit funding. Strong growth in auto loan originations during the third quarter and first nine months of 2011 has more than offset the continued run-off in legacy home loans.

 

   

Commercial Banking: Our Commercial Banking business generated net income from continuing operations of $145 million and $435 million in the third quarter and first nine months of 2011, respectively, compared with net income from continuing operations of $39 million and $67 million in the third quarter and first nine months of 2010, respectively. The improvement in results for our Commercial Banking business reflected an increase in revenues, a decrease in non-interest expense and a decrease in the provision for loan and lease losses due to the improvement in credit quality. As a result of this improvement, we reduced our allowance for loan and lease losses and recorded a negative provision for loan and lease losses of $10 million and $43 million in the third quarter and first nine months of 2011, respectively. In comparison, we recorded a provision for loan and lease losses of $95 million and $395 million in the third quarter and first nine months of 2010, respectively, related to our Commercial Banking business. We continued to experience steady loan growth in our Commercial Banking business, with loan demand expanding beyond refinancing to include demand for new credit to finance growth for our commercial customers.

Business Environment and Recent Developments

Recent Business and Regulatory Developments

The challenging economic environment intensified during the third quarter of 2011, due to concerns about the U.S. debt ceiling and subsequent downgrade of the U.S. debt, the continued elevated U.S. unemployment rate and the European debt crisis. These concerns resulted in increased economic uncertainty and market volatility. We have continued to monitor our portfolio credit performance for signs that these difficult market conditions are causing deterioration in our credit results. Our credit metrics are stabilizing with normal seasonality re-emerging after a long period of cyclical improvement. We believe actions we made in underwriting and managing our business through the recession, including focusing on our most resilient businesses, have continued to drive our strong credit performance. In addition, our recent partnerships and acquisitions have contributed to new account originations and a continued increase in purchase volumes in our Credit Card business.

Recent Acquisitions and Related Developments

During the past several years, we have explored opportunities to acquire financial services companies and financial assets and enter into strategic partnerships as part of our growth strategy. Our financial strength and flexibility and our experience in the credit card and direct banking businesses are key factors that we believe have enabled us to take advantage of our recent investment opportunities, including the acquisition of HBC’s existing credit card loan portfolio in the first quarter of 2011, the acquisition of Kohl’s existing credit card loan portfolio in the second quarter of 2011 and our pending acquisitions of ING Direct and HSBC’s U.S. credit card business. We continue to evaluate and anticipate engaging in additional strategic partnerships and selected acquisitions of financial institutions and other financial assets, including credit card and other loan portfolios. We may issue common stock or debt in connection with future acquisitions, including in public offerings, to fund such acquisitions.

Business Outlook

We discuss below our current expectations regarding our total company performance and the performance of each of our business segments over the near-term based on market conditions, the regulatory environment and our business strategies as of the time we filed this Report. The statements contained in this section are based on our current expectations regarding our outlook for our financial results and business strategies. Our expectations take into account, and should be read in conjunction with, our expectations regarding economic trends and

 

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analysis of our business as discussed in “Part I—Item 1. Business” and “Part I—Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our 2010 Form 10-K. 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. Forward-looking statements do not reflect (i) any change in current dividend or repurchase strategies, (ii) the effect of any acquisitions, divestitures or similar transactions or (iii) any changes in laws, regulations or regulatory interpretations, in each case after the date as of which such statements are made. See “Forward-Looking Statements” in this Report, “Item 1A. Risk Factors” in our 2010 Form 10-K and the risk factors set forth in Exhibit 99.5 to our Current Report on Form 8-K filed on July 13, 2011, for factors that could materially influence our results.

Total Company Expectations

Our third quarter results continue to demonstrate the impact of our strategy to deliver profitable long-term growth through the acquisition and retention of franchise-enhancing customer relationships across our businesses. We believe we remain well-positioned to win in the marketplace and deliver shareholder value. We expect that the combined acquisitions of ING Direct and the HSBC U.S. credit card business will deliver attractive financial results in the near-term and put us in an even stronger position to enhance and sustain the value we can deliver to our customers, our communities and our shareholders over the long-term. We believe strong earnings will enable us to maintain strong capital levels and trajectory and that deep access to deposits will bolster our already-strong liquidity. Based on recent trends, including modest loan growth, and our targeted initiatives to attract new business and develop franchise-enhancing customer relationships, we believe the period of shrinking loans during the recession has come to an end. We expect modest year-over-year growth in ending loan balances in 2011. Although we expect an increase in period- end loans, we expect that average loan balances for 2011 will be comparable to average loan balances for 2010 given the lower loan balance starting point in 2011. Following the completion of the planned acquisitions of ING Direct and the HSBC U.S. credit card business, we expect our loan growth rate trajectory will be muted by the larger base of loans and the expected run-off of several of our legacy and acquired business loan portfolios.

Business Segments Expectations

Credit Card Business

We believe that our Domestic Card loan balances reached a low point in the first quarter of 2011. We expect seasonal loan growth in the fourth quarter of 2011. We believe we remain well positioned to gain market share in the new level playing field resulting from the CARD Act. We believe the credit results in our Domestic Card business are stabilizing and exhibiting expected seasonal patterns.

Consumer Banking Business

In our Consumer Banking business, we expect that auto originations and returns will remain strong and drive growth in auto loans for 2011. We expect that the continuing run-off of the legacy home loan portfolio will largely offset the growth in auto loans. We believe we have reached a cyclical low point for auto finance charge-offs. We expect that the auto finance charge-off rate will increase in the fourth quarter of 2011, driven by seasonal patterns. Over the long run, competitive factors and moderation in auction prices for used vehicles is likely to create higher charge-off rates.

Commercial Banking Business

In our Commercial Banking business, we believe that the worst of the commercial credit downturn is behind us and there is positive credit performance trajectory. However, we continue to expect some quarterly uncertainty and variability in commercial charge-offs and nonperforming loans. We have been growing commercial loans with lower credit risk and expect further modest growth to continue in the fourth quarter of 2011.

 

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CRITICAL ACCOUNTING POLICIES AND ESTIMATES

 

The preparation of financial statements in accordance with U.S. 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 provide a summary of our significant accounting policies in “Note 1—Summary of Significant Accounting Policies” of our 2010 Form 10-K.

We have identified the following accounting policies as critical because they require significant judgments and assumptions about highly complex and inherently uncertain matters and the use of reasonably different estimates and assumptions could have a material impact on our reported results of operations or financial condition. These critical accounting policies govern:

 

   

Fair value

   

Allowance for loan and lease losses

   

Asset impairment

   

Representation and warranty reserve

   

Revenue recognition

   

Derivative and hedge accounting

   

Income taxes

We evaluate our critical accounting estimates and judgments on an ongoing basis and update them as necessary based on changing conditions. 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 significant portion of our assets and liabilities at fair value. Accordingly, we provide information below on financial instruments recorded at fair value in our consolidated balance sheets. We also discuss below refinements we made in the third quarter of 2011 in determining the estimated amount of uncollectible finance charges and fees for credit card loans. Management has discussed our critical accounting policies and estimates with the Audit and Risk Committee of the Board of Directors.

Fair Value

Fair value is defined as the price that would be received for an asset or paid to transfer a liability in an orderly transaction between market participants on the measurement date (also referred to as an exit price). The fair value accounting guidance provides 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. Fair value measurement of a financial asset or liability is assigned to a level based on the lowest level of any input that is significant to the fair value measurement in its entirety. 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.

The degree of management judgment involved in determining the fair value of a financial instrument is dependent upon the availability of quoted prices in active markets or observable market parameters. When quoted prices and observable data in active markets are not fully available, management judgment is necessary to estimate fair value. Changes in market conditions, such as reduced liquidity in the capital markets or changes in secondary market activities, may reduce the availability and reliability of quoted prices or observable data used to determine fair value.

 

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We have developed policies and procedures to determine when markets for our financial assets and liabilities are inactive if the level and volume of activity has declined significantly relative to normal conditions. If markets are determined to be inactive, it may be appropriate to adjust price quotes received. When significant adjustments are required to price quotes or inputs, it may be appropriate to utilize an estimate based primarily on unobservable inputs.

Significant judgment may be required to determine whether certain financial instruments measured at fair value are included in Level 2 or Level 3. In making this determination, we consider all available information that market participants use to measure the fair value of the financial instrument, 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 assets of $200.1 billion as of September 30, 2011, compared with 22% of our total assets of $197.5 billion as of December 31, 2010. Financial assets for which the fair value was determined using significant Level 3 inputs represented approximately 2% of these financial instruments (less than 1% of total assets) as of September 30, 2011, and approximately 2% of these financial instruments (less than 1% of total assets) as of December 31, 2010.

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 13—Fair Value of Financial Instruments.”

Key Controls Over Fair Value Measurement

We have a governance framework and a number of key controls that are intended to ensure that our fair value measurements are appropriate and reliable. Our governance framework provides for independent oversight and segregation of duties. Our control processes include review and approval of new transaction types, price verification and review of valuation judgments, methods, models, process controls and results. Groups independent from our trading and investing functions, including our Valuations Group and Valuations Advisory Committee, participate in the review and validation process. The Valuation Advisory Committee includes senior representation from business areas, our Enterprise Risk Oversight division and our Finance division.

Our Valuations Group performs monthly independent verification of fair value measurements by comparing the methodology driven price to other market source data (to the extent available), and uses independent analytics to determine if assigned fair values are reasonable. The Valuations Advisory Committee regularly reviews and approves our valuation methodologies to ensure that our methodologies and practices are consistent with industry standards and adhere to regulatory and accounting guidance.

Revenue Recognition

We recognize finance charges and fees on credit card loans when the amounts are billed to the customer and include these amounts in the loan balance, net of the estimated uncollectible amount of finance charges and fees. Our process for estimating the uncollectible amount of billed finance charges and fees is consistent with the process we use to estimate the allowance for incurred principal losses on our credit card loan receivables.

We determine the adequacy of the uncollectible finance charge and fee reserve on a quarterly basis, primarily based on the use of a roll-rate methodology. We refine our estimation process and key assumptions used in

 

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determining our loss reserves as additional information becomes available. In the third quarter of 2011, we revised the manner in which we estimate expected recoveries of finance charge and fee amounts previously considered to be uncollectible. Our revised recovery assumptions better reflect the post-recession pattern of relatively low delinquency roll-rates combined with increased recoveries of finance charges and fees previously considered uncollectible. This reduced the uncollectible finance charge and fee reserves by approximately $83 million as of September 30, 2011, and resulted in a corresponding increase in revenues of $83 million in the third quarter of 2011. We also applied these revised assumptions to the estimated recovery of principal charge-offs in determining our allowance for loan and lease losses. The revision, however, had an insignificant impact on the overall determination of our allowance for lease and loan losses as of September 30, 2011.

For additional information on our critical accounting policies and estimates, see “Part II—Item 7. MD&A—Critical Accounting Policies and Estimates” of our 2010 Form 10-K.

 

 

CONSOLIDATED RESULTS OF OPERATIONS

 

The section below provides a comparative discussion of our consolidated financial performance for the three and nine months ended September 30, 2011 and 2010. Following this section, we provide a discussion of our business segment results. You should read this section together with our “Executive Summary and Business Outlook” 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 include loans held for investment and investment securities, and the interest expense on our interest-bearing liabilities, which include 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 interest-bearing liabilities, including the impact of non-interest bearing funding. 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.

Table 3 below presents, for each major category of our interest-earning assets and interest-bearing liabilities, the average outstanding balances, interest income earned or interest expense incurred, and the average yield or cost for the three and nine months ended September 30, 2011 and 2010.

 

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Table 3: Average Balances, Net Interest Income and Net Interest Yield

 

    Three Months Ended September 30,  
    2011     2010  
(Dollars in millions)   Average
Balance
    Interest
Income/
Expense(1)
    Yield/
Rate
    Average
Balance
    Interest
Income/
Expense(1)
    Yield/
Rate
 

Assets:

           

Interest-earning assets:

           

Consumer loans:(2)

           

Domestic(3)

  $ 88,995      $ 2,828        12.71   $ 89,530      $ 2,767        12.36

International

    8,703        354        16.27        7,342        302        16.45   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total consumer loans(3)

    97,698        3,182        13.03        96,872        3,069        12.67   

Commercial loans(3)

    31,345        368        4.69        29,435        378        5.13   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total loans held for investment

    129,043        3,550        11.00        126,307        3,447        10.92   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Investment securities

    37,189        264        2.84        39,872        347        3.48   

Other interest-earning assets:

           

Domestic

    10,711        18        0.67        5,793        20        1.38   

International

    767        3        1.56        501        1       0.80   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total other interest-earning assets

    11,478        21        0.73        6,294        21        1.33   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total interest-earning assets(4)

  $ 177,710      $ 3,835        8.63   $ 172,473      $ 3,815        8.85
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Cash and due from banks

    1,742            2,014       

Allowance for loan and lease losses

    (4,488         (6,803    

Premises and equipment, net

    2,731            2,709       

Other assets

    23,916            26,205       
 

 

 

       

 

 

     

Total assets

  $ 201,611          $ 196,598       
 

 

 

       

 

 

     

Liabilities and equity:

           

Interest-bearing liabilities:

           

Deposits

  $ 110,750      $ 294        1.06   $ 104,186      $ 358        1.37

Securitized debt obligations:

           

Domestic

    14,734        73        1.98        25,928        159        2.45   

International

    3,744        16        1.71        4,822        32        2.65   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total securitized debt obligations

    18,478        89        1.93        30,750        191        2.48   

Senior and subordinated notes

    10,519        84        3.19        8,677        72        3.32   

Other borrowings

    8,369        85        4.06        6,483        85        5.24   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total interest-bearing liabilities

  $ 148,116      $ 552        1.49   $ 150,096      $ 706        1.88
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Non-interest bearing deposits

    17,518            14,069       

Other liabilities

    6,661            7,126       
 

 

 

       

 

 

     

Total liabilities

    172,295            171,291       

Stockholders’ equity

    29,316            25,307       
 

 

 

       

 

 

     

Total liabilities and stockholders’ equity

  $ 201,611          $ 196,598       
 

 

 

       

 

 

     

Net interest income/spread(4)

    $ 3,283        7.14     $ 3,109        6.97
   

 

 

   

 

 

     

 

 

   

 

 

 

Interest income to average interest-earning assets

        8.63         8.85

Interest expense to average interest-earning assets

        1.24            1.64   
     

 

 

       

 

 

 

Net interest margin

        7.39         7.21
     

 

 

       

 

 

 

 

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Table of Contents
    Nine Months Ended September 30,  
    2011     2010  
(Dollars in millions)   Average
Balance
    Interest
Income/
Expense(1)
    Yield/
Rate
    Average
Balance
    Interest
Income/
Expense(1)
    Yield/
Rate
 

Assets:

           

Interest-earning assets:

           

Consumer loans:(2)

           

Domestic(3)

  $ 88,129      $ 8,194        12.40   $ 92,476      $ 8,563        12.35

International

    8,741        1,056        16.11        7,526        903        16.00   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total consumer loans(3)

    96,870        9,250        12.73        100,002        9,466        12.62   

Commercial loans(3)

    30,490        1,084        4.74        29,563        1,116        5.03   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total loans held for investment

    127,360        10,334        10.82        129,565        10,582        10.89   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Investment securities

    39,684        893        3.00        38,979        1,037        3.55   

Other interest-earning assets:

           

Domestic

    7,388        49        0.88        7,216        58        1.07   

International

    715        10        1.86        572        2        0.47   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total other interest-earning assets

    8,103        59        0.97        7,788        60        1.03   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total interest-earning assets(4)

  $ 175,147      $ 11,286        8.59   $ 176,332      $ 11,679        8.83
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Cash and due from banks

    1,851            2,214       

Allowance for loan and lease losses

    (5,058         (7,623    

Premises and equipment, net

    2,722            2,719       

Other assets

    24,954            27,289       
 

 

 

       

 

 

     

Total assets

  $ 199,616          $ 200,931       
 

 

 

       

 

 

     

Liabilities and equity:

           

Interest-bearing liabilities:

           

Deposits

  $ 109,552      $ 923        1.12   $ 104,119      $ 1,125        1.44

Securitized debt obligations:

           

Domestic

    18,214        281        2.06        31,275        548        2.34   

International

    3,827        61        2.13        5,092        96        2.51   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total securitized debt obligations

    22,041        342        2.07        36,367        644        2.36   

Senior and subordinated notes

    8,910        211        3.16        8,731        211        3.22   

Other borrowings

    8,156        251        4.10        6,946        265        5.09   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total interest-bearing liabilities

  $ 148,659      $ 1,727        1.55   $ 156,163      $ 2,245        1.92
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Non-interest bearing deposits

    16,550            13,976       

Other liabilities

    6,205            6,294       
 

 

 

       

 

 

     

Total liabilities

    171,414            176,433       

Stockholders’ equity

    28,202            24,498       
 

 

 

       

 

 

     

Total liabilities and stockholders’ equity

  $ 199,616          $ 200,931       
 

 

 

       

 

 

     

Net interest income/spread(4)

    $ 9,559        7.04     $ 9,434        6.91
   

 

 

   

 

 

     

 

 

   

 

 

 

Interest income to average interest-earning assets

        8.59         8.83

Interest expense to average interest-earning assets

        1.31            1.70   
     

 

 

       

 

 

 

Net interest margin

        7.28         7.13
     

 

 

       

 

 

 

 

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(1)

Past due fees included in interest income totaled approximately $303 million and $249 million for the three months ended September 30, 2011 and 2010, respectively, and approximately $793 million and $893 million for the nine months ended September 30, 2011 and 2010, respectively.

(2)

Interest income on credit card, auto, home and retail banking loans is reflected in consumer loans. Interest income generated from small business credit cards also is included in consumer loans.

(3) 

In the first quarter of 2011, we revised previously reported interest income on interest-earning assets and average yield on loans held for investment for 2010 to conform to the internal management accounting methodology used in our segment reporting. The interest income and average loan yields presented reflect this revision. The previously reported interest income and average yields for the third quarter of 2010 were as follows: domestic consumer loans ($2,846 million and 12.72%); total consumer loans ($3,148 million and 13.00%); and commercial loans ($299 million and 4.06%). The previously reported interest income and average yields for the first nine months of 2010 were as follows: domestic consumer loans ($8,691 million and 12.53%); total consumer loans ($9,594 million and 12.79%); and commercial loans ($988 million and 4.46%).

(4)

Interest income was reduced by $206 million and $421 million in the third quarter and first nine months of 2011, respectively, for amounts earned by Kohl’s.

Table 4 presents the variance between our net interest income for the three months ended September 30, 2011 and 2010, and for the nine months ended September 30, 2011 and 2010, and the extent to which the variance was 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.

Table 4: Rate/Volume Analysis of Net Interest Income(1)

 

     Three Months Ended September 30,
2011 vs. 2010
    Nine Months Ended September 30,
2011 vs. 2010
 

(Dollars in millions)

   Total
   Variance  
    Variance Due to     Total
   Variance  
    Variance Due to  
       Volume         Rate           Volume         Rate    

Interest income:

            

Loans held for investment:

            

Consumer loans

   $ 113      $ 26      $ 87      $ (216   $ (299   $ 83   

Commercial loans

     (10     24        (34     (32     35        (67
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total loans held for investment, including past-due fees

     103        50        53        (248     (264     16   

Investment securities

     (83     (22     (61     (144     18        (162

Other

     —          12        (12     (1     2        (3
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total interest income

     20        40        (20     (393     (244     (149
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Interest expense:

            

Deposits

     (64     21        (85     (202     56        (258

Securitized debt obligations

     (102     (65     (37     (302     (230     (72

Senior and subordinated notes

     12        15        (3     —          5        (5

Other borrowings

     —          22        (22     (14     42        (56
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total interest expense

     (154     (7     (147     (518     (127     (391
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net interest income

   $ 174      $ 47      $ 127      $ 125      $ (117   $ 242   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

(1)

We calculate the change in interest income and interest expense separately for each item. The change in net interest income attributable to both volume and rates is allocated based on the relative dollar amount of each item.

 

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Our net interest income of $3.3 billion for the third quarter of 2011 increased by $174 million, or 6%, from the third quarter of 2010, driven by a 2% (18 basis points) expansion in our net interest margin to 7.39% and a 3% increase in average interest-earning assets.

 

   

Net Interest Margin: The increase in our net interest margin in the third quarter of 2011 was primarily attributable to a reduction in our cost of funds, which was partially offset by a decline in the yield on our interest-earning assets. 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 prevailing low interest rate environment, combined with our disciplined pricing, contributed to the decrease in our average deposit interest rates.

 

   

Average Interest-Earning Assets: The increase in average interest-earning assets in the third quarter of 2011 was attributable to the additions of the existing HBC credit card loan portfolio of $1.4 billion in the first quarter of 2011 and the $3.7 billion Kohl’s credit card loan portfolio in the second quarter of 2011, coupled with growth in auto loan originations, commercial loans and revolving credit card purchase volumes. The impact of these factors more than offset the continued run-off of businesses that we exited or repositioned, including our installment, home loan and small-ticket commercial real estate loan portfolios.

Our net interest income of $9.6 billion for the first nine months of 2011 increased by $125 million, or 1%, from the first nine months of 2010, driven by a 2% (15 basis points) expansion in our net interest margin to 7.28%, which was partially offset by a 1% decrease in average interest-earning assets.

 

   

Net Interest Margin: The increase in our net interest margin in the first nine months of 2011 reflected the benefit from the improvement in our cost of funds, as we shifted the mix of our funding to lower cost consumer and commercial banking deposits from higher cost wholesale sources and the decline in deposit interest rates as a result of the overall interest rate environment. The decrease in yield on interest-earning assets was attributable to a reduction in late payment fees resulting from the Federal Reserve guidelines regarding reasonable fees that went into effect in the third quarter of 2010 and the addition of the Kohl’s portfolio. Under our partnership agreement with Kohl’s, we share a fixed percentage of revenues, consisting of finance charges and late fees. We report revenues related to Kohl’s credit card loans on a net basis in our consolidated financial statements, which has the effect of reducing the yield on our average interest-earning assets. The impact of these factors was partially offset by the run-off of lower margin installment loans, a reduced level of new accounts with low introductory promotional rates, and an increase in the recognition of billed finance charges and fees due to the improvement in credit performance as well as the change we made in the third quarter of 2011 in our estimation of non-principal recoveries used in determining our uncollectible finance charge and fee reserve.

 

   

Average Interest-Earning Assets: The decrease in average interest-earning assets in the first nine months of 2011 reflected the continued run-off of businesses that we exited or repositioned, including our installment, home loan and small-ticket commercial real estate loan portfolios, which more than offset the impact of modest revolving credit card loan growth and the addition of the existing HBC credit card loan portfolio of $1.4 billion in the first quarter of 2011 and the addition of the existing Kohl’s private-label credit card loan portfolio of $3.7 billion in the second quarter of 2011.

Non-Interest Income

Non-interest income consists of servicing and securitizations income, service charges and other customer-related fees, interchange income (net of rewards expense) and other non-interest income. 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 reported as a component of non-interest income. We also record the provision for mortgage repurchase losses related to continuing operations in non-interest income. The “other” component of non-interest income includes gains and losses on derivatives not accounted for in hedge accounting relationships

 

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and gains and losses from the sale of investment securities, which we generally do not allocate to our business segments because they relate to centralized asset/liability and market risk management activities undertaken by our Corporate Treasury group.

Table 5 displays the components of non-interest income for the three and nine months ended September 30, 2011 and 2010.

Table 5: Non-Interest Income

 

     Three Months Ended September 30,     Nine Months Ended September 30,  
(Dollars in millions)        2011             2010             2011             2010      

Servicing and securitizations

   $ 12      $ 13      $ 35      $ (3

Service charges and other customer-related fees

     542        496        1,527        1,577   

Interchange

     321        346        972        991   

Net other-than-temporary impairment

     (6     (5     (15     (62

Provision for mortgage repurchase losses(1)

     3        (16     (5     (211

Other(2)

     (1     73        156        483   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total non-interest income

   $ 871      $ 907      $ 2,670      $ 2,775   
  

 

 

   

 

 

   

 

 

   

 

 

 

 

(1)

We recorded a total provision for mortgage repurchase losses of $72 million and $16 million for the three months ended September 30, 2011 and 2010, respectively, and $153 million and $644 million for the nine months ended September 30, 2011 and 2010, respectively. The remaining portion of the provision for repurchase losses is included in discontinued operations.

(2)

“Other” for the three and nine months ended September 30, 2011 includes a gain of $239 million recognized on the sale of investment securities and a mark-to-market derivative loss of $266 million related to interest-rate swaps we entered into in August 2011 to partially hedge the interest rate risk of the net assets associated with the pending ING acquisition.

Non-interest income of $871 million for the third quarter of 2011 decreased by $36 million, or 4%, from non-interest income of $907 million for the third quarter of 2010. The decrease in non-interest income for the third quarter of 2011 reflects the net impact of two significant items recorded during the quarter resulting from actions taken to reposition our balance sheet and manage the anticipated impact of the pending ING Direct acquisition on our market risk exposure and regulatory capital requirements.

First, in August 2011, we entered into various pay-fixed/receive-floating interest-rate swap transactions with a total notional principal amount of approximately $23.8 billion. Since the date we entered into the agreement to acquire ING Direct, interest rates have declined substantially, and our current estimate of the fair value of the ING Direct net assets and liabilities has increased correspondingly. These swap transactions are intended to capture some of the anticipated benefits to regulatory capital on the closing date attributable to this decline in interest rates and designed to mitigate the effect of a rise in interest rates on the fair values of a significant portion of the ING Direct assets and liabilities during the period from when we entered into the swap transactions to the anticipated closing date of the ING Direct acquisition in late 2011 or early 2012. Although the interest-rate swaps represent economic hedges, they are not designated for hedge accounting. Accordingly, changes in the fair value are recorded in earnings. We recognized a mark-to-market loss of $266 million on these interest-rate swaps in the third quarter of 2011, which was attributable to the decline in interest rates as of the end of the quarter. Changes in the fair value of these interest-rate swaps will continue to be recorded in earnings until the swaps are terminated.

Second, we sold approximately $6.4 billion of investment securities, consisting predominantly of agency MBS, during the third quarter of 2011. We recorded a gain of $239 million on the sale of these securities. The combined impact of the mark-to-market derivative loss and the gain on the sale of investment securities accounted for $27 million of the reduction in non-interest income in the third quarter of 2011.

 

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Non-interest income of $2.7 billion for the first nine months of 2011 decreased by $105 million, or 4%, from non-interest income of $2.8 billion for the first nine months of 2010. This decrease was primarily due to the absence of a one-time pre-tax gain of $128 million recorded in the first quarter of 2010 and net gains on the sale of securities in 2010.

We provide additional information on the reserve for representation and warranty claims below in “Consolidated Balance Sheet Analysis and Credit Performance—Potential Mortgage Representation and Warranty Liabilities.”

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. Our provision for loan and lease losses declined by $245 million to $622 million in the third quarter of 2011 and by $1.6 billion in the first nine months of 2011 to $ 1.5 billion, relative to the same prior year periods. The decrease in the provision was largely driven by a substantial decline in net charge-offs across all of our business segments, reflecting the improvement in the credit performance of our loan portfolio. The net charge-off rate was 2.52% and 3.02% for the third quarter and first nine months of 2011, respectively, compared with 4.82% and 5.41% for the third quarter and first nine months of 2010, respectively. As charge-offs declined, we recorded an allowance release of $208 million and $1.3 billion in the third quarter and first nine months of 2011, respectively. Our allowance releases have been significantly lower in 2011 relative to 2010, reflecting a stabilization of the improvement in credit trends.

See “Consolidated Balance Sheet Analysis and Credit Performance—Allowance for Loan and Lease Losses” for a discussion of changes in our allowance for loan and lease losses and details of our provision for loan and lease losses and charge-offs by loan category for the three and nine months ended September 30, 2011 and 2010.

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, occupancy costs and miscellaneous expenses. Marketing expenses also are included in non-interest expense. Table 6 displays the components of non-interest expense for the three and nine months ended September 30, 2011 and 2010.

Table 6: Non-Interest Expense

 

     Three Months Ended September 30,      Nine Months Ended September 30,  
(Dollars in millions)        2011              2010              2011              2010      

Salaries and associated benefits

   $ 750       $ 641       $ 2,206       $ 1,937   

Marketing

     312         250         917         650   

Communications and data processing

     178         178         504         512   

Supplies and equipment

     143         129         402         381   

Occupancy

     122         135         359         371   

Other(1)

     792         663         2,326         1,992   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total non-interest expense

   $ 2,297       $ 1,996       $ 6,714       $ 5,843   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

(1)

Consists of professional services expenses, credit collection costs, fee assessments and intangible amortization expense.

Non-interest expense of $2.3 billion for the third quarter of 2011 was up $301 million, or 15%, from the third quarter of 2010. Non-interest expense of $6.7 billion for the first nine months of 2011 was up $871 million, or 15%, from the first nine months of 2010. The increase reflects the recognition of expense of $60 million and $90 million in the third quarter and first nine months of 2011, respectively, for contingent payments related to

 

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acquisitions and partnership agreements. In addition, our operating costs have increased due in part to the integration of the recent acquisitions of the Sony, HBC and Kohl’s loan portfolios, as well as higher marketing costs. We have expanded our marketing efforts to attract and support targeted customers and new business volume through a variety of channels. We provide additional information on contingent payment arrangements in “Note 15—Commitments, Contingencies and Guarantees.”

Income Taxes

We recorded an income tax provision based on income from continuing operations of $370 million (30.0% effective income tax rate) in the third quarter of 2011, compared with an income tax provision of $335 million (29.1 % effective income tax rate) in the third quarter of 2010, and $1.2 billion (29.2% effective income tax rate) for the first nine months of 2011, compared with $948 million (28.8% effective income tax rate) for the first nine months of 2010.

We recorded tax benefits of $98 million in the first nine months of 2011, which were related to the release of a valuation allowance against certain state deferred tax assets and net operating loss carryforwards and the resolution of certain tax issues and audits. We monitor the status of our deferred tax assets on a regular basis. The release of the deferred tax valuation allowance reflects our projected ability to utilize the deferred tax assets to offset future taxable income based on our achieving sustained profitability in certain tax jurisdictions. We recorded tax benefits of $71 million in the first nine months of 2010, which were related to adjustments for the resolution of certain tax issues and audits.

Our effective income tax rate excluding the benefit from these discrete tax benefit items was 31.7% and 30.9% for the first nine months of 2011 and 2010, respectively. The higher effective income tax rate for the first nine months of 2011 was primarily attributable to the recognition of expense for non-deductible contingent payments related to certain acquisitions.

We provide additional information on items affecting our income taxes and effective tax rate in our 2010 Form 10-K under “Note 18—Income Taxes.”

Loss from Discontinued Operations, Net of Tax

Loss from discontinued operations reflects ongoing costs, which primarily consist of mortgage loan repurchase representation and warranty charges, related to the mortgage origination operations of GreenPoint’s wholesale mortgage banking unit, which we closed in 2007. We recorded a loss from discontinued operations, net of tax, of $52 million and $102 million in the third quarter and first nine months of 2011, respectively. In comparison, we recorded a loss from discontinued operations, net of tax, of $15 million and $303 million in the third quarter and first nine months of 2010, respectively.

The increase in the loss from discontinued operations in the third quarter of 2011 was attributable to the recognition of an additional provision for mortgage repurchase losses due to an increase in repurchase activity with respect to certain uninsured investors. The decrease in the loss from discontinued operations in the first nine months of 2011 was attributable to a significant reduction in the provision for mortgage repurchase losses. We provide information on our reserve for representation and warranty claims in “Consolidated Balance Sheet Analysis and Credit Performance—Potential Mortgage Representation and Warranty Liabilities.”

 

 

BUSINESS SEGMENT FINANCIAL PERFORMANCE

 

Our principal operations are currently organized into three major business segments, which are defined based on the products and services provided or the type of customer served: Credit Card, Consumer Banking and Commercial Banking. The operations of acquired businesses have been integrated into our existing business segments.

 

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The results of our individual businesses, which we report on a continuing operations basis, reflect the manner in which management evaluates performance and makes decisions about funding our operations and allocating resources. Our business segment results are intended to reflect each segment as if it were a stand-alone business. We use an internal management and reporting process to derive our business segment results. Our internal management and reporting process employs various allocation methodologies, including funds transfer pricing, to assign certain balance sheet assets, deposits and other liabilities and their related revenue and expenses directly or indirectly attributable to each business segment. We may periodically change our business segments or reclassify business segment results based on modifications to our management reporting methodologies and changes in organizational alignment. Certain activities that are not part of a segment, such as management of our corporate investment portfolio and asset/liability management by our centralized Corporate Treasury group are included in the “Other” category. See “Note 20—Business Segments” of our 2010 Form 10-K for information on the allocation methodologies used to derive our business segment results.

We summarize our business segment results for the three and nine months ended September 30, 2011 and 2010 in the tables below and provide a comparative discussion of these results. We also discuss changes in our financial condition and credit performance statistics as of September 30, 2011, compared with December 31, 2010. See “Note 14—Business Segments” of this Report for a reconciliation of our business segment results to our consolidated U.S. GAAP results. Information on the outlook for each of our business segments is presented above under “Executive Summary and Business Outlook.”

Credit Card Business

Our Credit Card business generated net income from continuing operations of $663 million and $1.9 billion in the third quarter and first nine months of 2011, respectively, compared with net income from continuing operations of $631 million and $1.7 billion in the third quarter and first nine months of 2010, respectively. The primary sources of revenue for our Credit Card business are net interest income and non-interest income from customer and interchange fees. Expenses primarily consist of ongoing operating costs, such as salaries and associated benefits, communications and other technology expenses, supplies and equipment, occupancy costs and marketing expenses.

Table 7 summarizes the financial results of our Credit Card business, which is comprised of the Domestic Card and International Card operations, and displays selected key metrics for the periods indicated. Our Credit Card business results for 2011 reflect the impact of the acquisitions of the existing portfolio credit card loan portfolios of Kohl’s and HBC. The results related to the Kohl’s loan portfolio, which totaled approximately $3.7 billion at acquisition on April 1, 2011, are included in our Domestic Card business. The results related to the HBC loan portfolio, which totaled approximately $1.4 billion at acquisition on January 7, 2011, are included in our International Card business.

Under the terms of the partnership agreement with Kohl’s, we share a fixed percentage of revenues, consisting of finance charges and late fees, with Kohl’s, and Kohl’s is required to reimburse us for a fixed percentage of credit losses incurred. Revenues and losses related to the Kohl’s credit card program are reported on a net basis in our consolidated financial statements. The revenue sharing amounts earned by Kohl’s are reflected as an offset against our revenues in our consolidated statements of income, which has the effect of reducing our net interest income and revenue margins. The loss sharing amounts from Kohl’s are reflected as a reduction in our provision for loan and lease losses in our consolidated statements of income. We also report the related allowance for loan and lease losses attributable to the Kohl’s portfolio in our consolidated balance sheets net of the loss sharing amount due from Kohl’s.

Interest income was reduced by $206 million and $421 million in the third quarter and first nine months of 2011, respectively, for amounts earned by Kohl’s. Loss sharing amounts attributable to Kohl’s reduced charge-offs by $39 million and $80 million in the third quarter and first nine months of 2011, respectively. In addition, the

 

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expected reimbursement from Kohl’s netted in our allowance for loan and lease losses was approximately $156 million as of September 30, 2011. The reduction in the provision for loan and lease losses attributable to Kohl’s was $236 million for the first nine months of 2011.

We provide additional information on the acquisition of the existing credit card loan portfolios of Kohl’s and HBC in “Note 2—Acquisitions.”

Table 7: Credit Card Business Results

 

    Three Months Ended September 30,     Nine Months Ended September 30,  
(Dollars in millions)       2011        

    2010    

        Change             2011             2010             Change      

Selected income statement data:

           

Net interest income

  $ 2,042      $ 1,934        6   $ 5,873      $ 6,024        (3 )% 

Non-interest income

    678        671        1        1,971        2,048        (4
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total revenue

    2,720        2,605        4        7,844        8,072        (3

Provision for loan and lease losses

    511        660        (23     1,270        2,600        (51

Non-interest expense

    1,188        978        21        3,604        2,894        25   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Income from continuing operations before income taxes

    1,021        967        6        2,970        2,578        15   

Income tax provision

    358        336        7        1,046        890        18   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Income from continuing operations, net of tax

  $ 663      $ 631        5   $ 1,924      $ 1,688        14
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Selected performance metrics:

           

Average loans held for investment

  $ 62,371      $ 61,391        2   $ 61,889      $ 63,314        (2 )% 

Average yield on loans held for investment(1)

    14.84     14.65     19 bps      14.45     14.74     (29 )bps 

Revenue margin(2)

    17.44        16.97        47        16.90        17.00        (10

Net charge-off rate(3)

    4.23        8.16        (393     5.13        9.30        (417

Purchase volume(4)

  $ 34,918      $ 27,039        29   $ 96,941      $ 77,533        25
    September 30,
2011
    December 31,
2010
    Change                    

Selected period-end data:

           

Loans held for investment

  $ 62,030      $ 61,371        1      

30+ day delinquency rate(5)

    3.87     4.29     (42 )bps       

Allowance for loan and lease losses

  $ 2,915      $ 4,041        (28 )%       

 

(1) 

Average yield on loans held for investment is calculated by dividing annualized interest income for the period by average loans held for investment during the period. In preparing our Report on Form 10-Q for the first quarter of 2011, we determined that beginning in the second quarter of 2010, our management accounting processes excluded certain accounts that should have been included in the calculation of the average yield on loans held for investment. The mapping error was limited to the average yields on loans held for investment for our Credit Card business and had no impact on income statement amounts or the yields reported for any of our other business segments or for the total company. The previously reported average loan yield for our Credit Card business was 14.27% and 14.48% for the three and nine months ended September 30, 2010, respectively.

(2)

Revenue margin is calculated by dividing annualized revenues for the period by average loans held for investment during the period for the specified loan category.

(3)

The net charge-off rate is calculated by loan category by dividing annualized net charge-offs for the period by average loans held for investment during the period for the specified loan category.

(4)

Consists of purchase transactions for the period, net of returns. Excludes cash advance transactions.

 

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(5) 

The delinquency rate is calculated by loan category by dividing 30+ day delinquent loans as of the end of the period by period-end loans held for investment for the specified loan category. The 30+ day performing delinquency rate is the same as the 30+ day delinquency rate for our Credit Card business, as credit card loans remain on accrual status until the loan is charged-off.

Key factors affecting the results of our Credit Card business for the third quarter and first nine months of 2011, compared with the third quarter and first nine months of 2010 included the following:

 

   

Net Interest Income: Net interest income increased by $108 million, or 6%, in the third quarter of 2011, due in part to a 2% increase in average loan balances coupled with an increase in the average yield on loans held for investment. The growth in average loan balances reflect the additions of the HBC and Kohl’s portfolios, which were partially offset by the continued expected run-off of the installment loan portfolio. The average yield for the third quarter of 2011 reflects the benefit from a revision we made in the third quarter of 2011 in estimating non-principal recoveries to determine the uncollectible finance charge and fee reserve, which we discuss above in “Critical Accounting Policies and Estimates.” This revision accounted for approximately $83 million of the increase in net interest income. Net interest income decreased by $151 million, or 3%, in the first nine months of 2011, reflecting the impact of a 2% decline in average loan balances. The expected run-off of the installment loan portfolio was the primary driver of the decline in average loan balances in the first nine months of 2011, more than offsetting modest revolving card loan growth and the additions of the HBC and Kohl’s portfolios. The decrease in the average loan yields in the first nine months of 2011 reflects the impact of the Kohl’s revenue-sharing agreement.

 

   

Non-Interest Income: Non-interest income was relatively stable in the third quarter of 2011, compared with the third quarter of 2010. Non-interest income, however, decreased by $77 million, or 4%, in the first nine months of 2011. The decrease in the first nine months of 2011 reflects the impact of contra-revenue amounts recorded in the second quarter of 2011, including a provision of $52 million for anticipated refunds to U.K. customers related to retrospective regulatory requirements pertaining to payment protection insurance (“PPI”) in our U.K. business and the recognition of expense of $21 million related to the periodic adjustment of our customer rewards points liability to reflect the estimated cost of points earned to date that are ultimately expected to be redeemed. These decreases were partially offset by higher interchange fees during the first nine months of 2011, attributable to increased purchase volume from our higher spend customer segments.

 

   

Provision for Loan and Lease Losses: The provision for loan and lease losses related to our Credit Card business decreased by $149 million in the third quarter of 2011, to $511 million and by $1.3 billion in the first nine months of 2011, to $1.3 billion. The significant reduction in the provision was primarily attributable to the continued improvement in credit performance, including reduced delinquency rates, lower bankruptcy losses and higher recoveries. As a result of the reduction in charge-offs and improvement in the net charge-off rate, we recorded an allowance release for the Credit Card business of $178 million and $1.1 billion in the third quarter and first nine months of 2011, respectively.

 

   

Non-Interest Expense: Non-interest expense increased by $210 million, or 21%, in the third quarter of 2011 and $710 million, or 25%, in the first nine months of 2011. The increase was attributable to increased operating and integration costs related to the acquisitions of the credit card loan portfolios of Sony, HBC and Kohl’s, coupled with increased marketing expenditures. We have expanded our marketing efforts to drive new business volume through a variety of channels.

 

   

Total Loans: Period-end loans in our Credit Card business increased by $659 million, or 1%, in the first nine months of 2011, to $62.0 billion as of September 30, 2011, from $61.4 billion as of December 31, 2010. The increase was primarily attributable to the acquisitions of the Kohl’s credit card portfolio of $3.7 billion and the HBC credit card portfolio of $1.4 billion, which were partially offset by the continued run-off of the installment loan portfolio and seasonal paydowns from year-end levels.

 

   

Charge-off and Delinquency Statistics: Net charge-off and delinquency rates continued to improve in the third quarter and first nine months of 2011. The net charge-off rate decreased to 4.23% and 5.13% in the

 

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third quarter and first nine months of 2011, respectively, from 8.16% and 9.30% in the third quarter and first nine months of 2010, respectively. The 30+ day delinquency rate decreased to 3.87% as of September 30, 2011, from 4.29% as of December 31, 2010. The improvement in the net charge-off and delinquency rates reflects the impact of improved credit quality across our credit card portfolio, tighter underwriting standards implemented over the last several years, and ongoing normalization of credit performance in the portfolio.

Domestic Credit Card Business

Table 7.1 summarizes the financial results for Domestic Card and displays selected key metrics for the periods indicated. Domestic Card accounted for 86% of total revenues for our Credit Card business in both the third quarter and first nine months of 2011, compared with 87% in both the third quarter and first nine months of 2010. Because our Domestic Card business currently accounts for the substantial majority of our Credit Card business, the key factors driving the results for this division are similar to the key factors affecting our total Credit Card business.

Table 7.1: Domestic Card Business Results

 

    Three Months Ended September 30,     Nine Months Ended September 30,  
(Dollars in millions)   2011     2010     Change     2011     2010         Change      

Selected income statement data:

           

Net interest income

  $ 1,753      $ 1,691        4   $ 5,011      $ 5,291        (5 )% 

Non-interest income

    588        575        2        1,755        1,753          ** 
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total revenue

    2,341        2,266        3        6,766        7,044        (4

Provision for loan and lease losses

    381        577        (34     798        2,348        (66

Non-interest expense

    972        844        15        2,970        2,522        18   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Income from continuing operations before income taxes

    988        845        17        2,998        2,174        38   

Income tax provision

    351        301        17        1,065        775        37   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Income from continuing operations, net of tax

  $ 637      $ 544        17   $ 1,933      $ 1,399        38
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Selected performance metrics:

           

Average loans held for investment

  $ 53,668      $ 54,049        (1 )%    $ 53,148      $ 55,788        (5 )% 

Average yield on loans held for investment(1)

    14.62     14.40     22 bps      14.18     14.57     (39 )bps 

Revenue margin(2)

    17.45        16.77        68        16.97        16.84        13   

Net charge-off rate(3)

    3.92        8.23        (431     4.94        9.43        (449

Purchase volume(4)

  $ 31,686      $ 24,858        27   $ 87,780      $ 71,359        23
    September 30,
2011
    December 31,
2010
        Change                        

Selected period-end data:

           

Loans held for investment

  $ 53,820      $ 53,849        **      

30+ day delinquency rate(5)

    3.65     4.09     (44 )bps       

Allowance for loan and lease losses

  $ 2,409      $ 3,581        (33 )%       

 

** Change is less than one percent.
(1)

Average yield on loans held for investment is calculated by dividing annualized interest income for the period by average loans held for investment during the period. As indicated above, in preparing our Report on Form 10-Q for the first quarter of 2011, we determined that beginning in the second quarter of 2010, our management accounting processes excluded certain accounts that affected the calculation of the average yield on loans held for investment for our Credit Card business. The previously reported average loan yield for our Domestic Credit Card business was 13.95% and 14.25% for three and nine months ended September 30, 2010, respectively.

 

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(2) 

Revenue margin is calculated by dividing annualized revenues for the period by average loans held for investment during the period for the specified loan category.

(3)

The net charge-off rate is calculated by loan category by dividing annualized net charge-offs for the period by average loans held for investment during the period for the specified loan category.

(4)

Consists of purchase transactions for the period, net of returns. Excludes cash advance transactions.

(5) 

The delinquency rate is calculated by loan category by dividing 30+ day delinquent loans as of the end of the period by period-end loans held for investment for the specified loan category. The 30+ day performing delinquency rate is the same as the 30+ day delinquency rate for our Credit Card business, as credit card loans remain on accrual status until the loan is charged-off. The September 30, 2011 30+ day delinquency rate for Domestic Card reflects the impact of a revision in the way we estimate recoveries in determining the uncollectible amount of finance charges and fees, which resulted in an increase of 11 basis points as of September 30, 2011. See “Critical Accounting Policies and Estimates” above for additional information.

Domestic Card generated net income from continuing operations of $637 million and $1.9 billion in the third quarter and first nine months of 2011, respectively, compared with net income from continuing operations of $544 million and $1.4 billion in the third quarter and first nine months of 2010, respectively.

The increase in Domestic Card net income from continuing operations in the third quarter of 2011, compared with the third quarter of 2010 was driven by: (1) an increase in total revenue attributable to a benefit of approximately $78 million in the third quarter of 2011 from the revision we made in the way we estimate recoveries in determining the uncollectible amount of finance charges and fees; (2) a significant reduction in the provision for loan and lease losses due to the improvement in credit performance metrics, including decreases in delinquency and charge-off rates; and (3) an increase in non-interest expense attributable to higher operating and integration costs related to the acquisitions of the credit card loan portfolios of Sony and Kohl’s, coupled with increased marketing expenditures.

The increase in Domestic Card net income from continuing operations in the first nine months of 2011, compared with the first nine months of 2010 was driven by: (1) a decline in total revenue attributable to lower average loan balances and a decrease in average loan yields as a result of reduced fees and the impact of the addition of the Kohl’s loan portfolio; (2) a significant reduction in the provision for loan and lease losses due to the improvement in credit performance metrics, including decreases in delinquency and charge-off rates; and (3) an increase in non-interest expense attributable to increased operating costs associated with higher purchase volumes and higher legal expenses and increased marketing expenditures.

International Credit Card Business

Table 7.2 summarizes the financial results for International Card and displays selected key metrics for the periods indicated. International Card accounted for 14% of total revenues for our Credit Card business in the third quarter and first nine months of 2011, compared with 13% in both the third quarter and first nine months of 2010.

 

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Table 7.2: International Card Business Results

 

    Three Months Ended September 30,     Nine Months Ended September 30,  
(Dollars in millions)   2011     2010     Change         2011             2010           Change    

Selected income statement data:

           

Net interest income

  $ 289      $ 243        19   $ 862      $ 733        18

Non-interest income

    90        96        (6     216        295        (27
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total revenue

    379        339        12        1,078        1,028        5   

Provision for loan and lease losses

    130        83        57        472        252        87   

Non-interest expense

    216        134        61        634        372        70   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Income from continuing operations before income taxes

    33        122        (73     (28     404        (107

Income tax provision

    7        35        (80     (19     115        (117
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Income from continuing operations, net of tax

  $ 26      $ 87        (70 )%    $ (9   $ 289        (103 )% 
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Selected performance metrics:

           

Average loans held for investment

  $ 8,703      $ 7,342        19   $ 8,741      $ 7,526        16

Average yield on loans held for investment(1)

    16.24     16.40     (16 )bps      16.09     16.02     7 bps 

Revenue margin(2)

    17.42        18.47        (105     16.44        18.21        (177

Net charge-off rate(3)

    6.15        7.60        (145     6.31        8.28        (197

Purchase volume(4)

  $ 3,232      $ 2,181        48   $ 9,161      $ 6,174        48

Selected period-end data:

   
 
September 30,
2011
  
  
   

 

December 31,

2010

  

  

      Change           

Loans held for investment

  $ 8,210      $ 7,522        9      

30+ day delinquency rate(5)

    5.35     5.75     (40 )bps       

Allowance for loan and lease losses

  $ 506      $ 460        10      

 

(1)

Average yield on loans held for investment is calculated by dividing annualized interest income for the period by average loans held for investment during the period. As indicated above, in preparing our Report on Form 10-Q for the first quarter of 2011, we determined that beginning in the second quarter of 2010, our management accounting processes excluded certain accounts that affected the calculation of the average yield on loans held for investment for our Credit Card business. The previously reported average loan yield for our International Credit Card business was 16.62% and 16.16% for the three and nine months ended September 30, 2010, respectively.

(2)

Revenue margin is calculated by dividing annualized revenues for the period by average loans held for investment during the period for the specified loan category.

(3)

The net charge-off rate is calculated by loan category by dividing annualized net charge-offs for the period by average loans held for investment during the period for the specified loan category.

(4)

Consists of purchase transactions for the period, net of returns. Excludes cash advance transactions.

(5)

The delinquency rate is calculated by loan category by dividing delinquent loans as of the end of the period by period-end loans held for investment for the specified loan category. The 30+ day performing delinquency rate is the same as the 30+ day delinquency rate for our Credit Card business, as credit card loans remain on accrual status until the loan is charged-off.

Our International Card division generated net income from continuing operations of $26 million in the third quarter of 2011 and a net loss of $9 million in the first nine months of 2011, compared with net income from continuing operations of $87 million and $289 million in the third quarter and first nine months of 2010, respectively.

The decrease in International Card net income from continuing operations in the third quarter of 2011, compared with the third quarter of 2010 was driven by: (1) an increase in the provision for loan losses due to the addition of

 

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the HBC loan portfolio and lower allowance releases relative to the same prior year periods and (2) an increase in non-interest expense attributable to increased operating costs associated with HBC associates who joined us as a result of the acquisition. These factors were partially offset by an increase in non-interest income attributable to higher loan balances.

The International Card net loss from continuing operations in the first nine months of 2011, compared with net income in the first nine months of 2010 was driven by: (1) a decrease in non-interest income due to the contra-revenue provision of $52 million recorded in the second quarter of 2011 for the anticipated refunds to U.K. customers related to retrospective regulatory requirements pertaining to PPI insurance in our U.K. business; (2) an increase in the provision for loan losses due to the addition of the HBC loan portfolio and lower allowance releases relative to the same prior year periods; and (3) an increase in non-interest expense attributable to increased operating costs associated with HBC associates who joined us as a result of the acquisition. These factors were partially offset by an increase in interest income attributable to higher loan balances.

Consumer Banking Business

Our Consumer Banking business generated net income from continuing operations of $190 million and $692 million in the third quarter and first nine months of 2011, respectively, compared with $175 million and $785 million in the third quarter and first nine months of 2010, respectively. The primary sources of revenue for our Consumer Banking business are net interest income from loans and deposits and non-interest income from customer fees. Expenses primarily consist of ongoing operating costs, such as salaries and associated benefits, communications and other technology expenses, supplies and equipment and occupancy costs.

Table 8 summarizes the financial results of our Consumer Banking business and displays selected key metrics for the periods indicated.

 

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Table of Contents

Table 8: Consumer Banking Business Results

 

    Three Months Ended September 30,     Nine Months Ended September 30,  
(Dollars in millions)         2011                 2010             Change         2011         2010         Change    

Selected income statement data:

           

Net interest income

  $ 1,097      $ 946        16   $ 3,131      $ 2,777        13

Non-interest income

    188        196        (4     568        674        (16
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total revenue

    1,285        1,142        13        3,699        3,451        7   

Provision for loan and lease losses

    136        114        19        272        52        423   

Non-interest expense

    853        757        13        2,351        2,180        8   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Income from continuing operations before income taxes

    296        271        9        1,076        1,219        (12

Income tax provision

    106        96        10        384        434        (12
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Income from continuing operations, net of tax

  $ 190      $ 175        9   $ 692      $ 785        (12 )% 
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Selected performance metrics:

           

Average loans held for investment:

           

Auto

  $ 19,757      $ 17,397        14   $ 18,851      $ 17,479        8

Home loan

    11,126        13,024        (15     11,537        14,002        (18

Retail banking

    3,979        4,669        (15     4,127        4,840        (15
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total consumer banking

  $ 34,862      $ 35,090        (1 )%    $ 34,515      $ 36,321        (5 )% 
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Average yield on loans held for investment

    9.83     9.28     55 bps      9.65     9.07     58 bps 

Average deposits

  $ 88,266      $ 78,224        13   $ 86,375      $ 76,818        12

Average interest rate on deposits

    0.95     1.18     (23 )bps      0.98     1.21     (23 )bps 

Core deposit intangible amortization

  $ 32      $ 36        (11 )%    $ 100      $ 110        (9 )% 

Net charge-off rate(1)(2)

    1.32     1.79     (47 )bps      1.30     1.77     (47 )bps 

Automobile loan originations

  $ 3,409      $ 2,439        40   $ 8,890      $ 5,547        60

 

$88.26661 $88.26661 $88.26661 $88.26661 $88.26661 $88.26661

Selected period-end data:

   
 
September 30,
2011
  
  
   

 

December 31,

2010

  

  

      Change           

Loans held for investment:

           

Auto

  $ 20,422      $ 17,867        14      

Home loan

    10,916        12,103        (10      

Retail banking

    4,014        4,413        (9      
 

 

 

   

 

 

   

 

 

       

Total consumer banking

  $ 35,352      $ 34,383        3      
 

 

 

   

 

 

   

 

 

       

30+ day performing delinquency rate(1)(3)

    4.01     4.28     (27 )bps       

30+ day delinquency rate(1)(3)

    5.57        5.96        (29      

Nonperforming loan rate(1)(4)

    1.88        1.97        (9      

Nonperforming asset rate(1)(5)

    2.04        2.17        (13      

Allowance for loan and lease losses

  $ 620      $ 675        (8 )%       

Deposits

    88,589        82,959        7         

Loans serviced for others

    18,624        20,689        (10      

 

(1) 

Average loans held for investment used in the denominator in calculating net charge-off, delinquency and nonperforming loan and nonperforming asset rates includes the impact of loans acquired as part of the Chevy Chase Bank acquisition, which were considered purchased credit-impaired (“PCI”) loans. However, we separately track and report PCI loans and exclude these loans from our net charge-off, delinquency, nonperforming loan and nonperforming asset rates.

 

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(2)

The net charge-off rate is calculated by loan category by dividing annualized net charge-offs for the period by average loans held for investment during the period for the specified loan category. The net charge-off rate, excluding loans acquired from Chevy Chase Bank from the denominator, was 1.51% and 2.11% for the three months ended September 30, 2011 and 2010, respectively, and 1.50% and 2.10% for the nine months ended September 30, 2011 and 2010, respectively.

(3) 

The delinquency rate is calculated by loan category by dividing delinquent loans as of the end of the period by period-end loans held for investment for the specified loan category. The 30+ day performing delinquency rate, excluding loans acquired from Chevy Chase Bank from the denominator, was 4.57% as of September 30, 2011 and 5.01% as of December 31, 2010. The 30+ day delinquency rate, excluding loans acquired from Chevy Chase Bank from the denominator, was 6.36% as of September 30, 2011 and 6.98% as of December 31, 2010.

(4)

Nonperforming loans generally include loans that have been placed on nonaccrual status and certain restructured loans whose contractual terms have been restructured in a manner that grants a concession to a borrower experiencing financial difficulty. The nonperforming loan rate is calculated by loan category by dividing nonperforming loans as of the end of the period by period-end loans held for investment for the specified loan category. The nonperforming loan rate, excluding the impact of loans acquired from Chevy Chase Bank from the denominator, was 2.15% and 2.30% as of September 30, 2011 and December 31, 2010, respectively.

(5) 

Nonperforming assets consist of nonperforming loans and real estate owned (“REO”). The nonperforming asset rate is calculated by loan category by dividing nonperforming assets as of the end of the period by period-end loans held for investment and REO for the specified loan category. The nonperforming asset rate, excluding loans acquired from Chevy Chase Bank from the denominator, was 2.33% and 2.54% as of September 30, 2011 and December 31, 2010, respectively.

Key factors affecting the results of our Consumer Banking business for the third quarter and first nine months of 2011, compared with the third quarter and first nine months of 2010 included the following:

 

   

Net Interest Income: Net interest income increased by $151 million, or 16%, in the third quarter of 2011, and $354 million, or 13%, in the first nine months of 2011. The primary drivers of the increase in net interest income were improved loan margins attributable to an increase in average loan yields, coupled with a decrease in the cost of funds. The increase in loan yields reflects the shift in product mix as we replace the legacy home loan run-off with higher yielding auto loans. The decrease in the cost of funds reflects reduced deposit interest rates due to the prevailing low interest rate environment, combined with our disciplined pricing. Although average deposit rates have declined, we experienced strong deposit growth.

 

   

Non-Interest Income: Non-interest income decreased by $8 million, or 4%, in the third quarter of 2011 and decreased by $106 million, or 16%, in the first nine months of 2011. The decrease in non-interest income in the first nine months of 2011 from the same prior year period was primarily attributable to the combined impact of the absence of a net gain of $128 million recorded in the first quarter of 2010 related to the 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 and the absence of the impairment charge on mortgage servicing rights recorded in the second quarter of 2010.

 

   

Provision for Loan and Lease Losses: The provision for loan and lease losses increased by $22 million in the third quarter of 2011 to $136 million, and by $220 million in the first nine months of 2011 to $272 million. Although we experienced continued improvement in credit performance in our Consumer Banking business, including reduced delinquency and net charge-off rates, we recorded a higher provision for loan and lease losses in the third quarter and first nine months of 2011 relative to the same prior year periods due to the absence of significant allowance releases that we experienced in 2010, growth in our auto loan portfolio and an increase in the allowance for home equity loans we acquired from Chevy Chase Bank.

 

   

Non-Interest Expense: Non-interest expense increased by $96 million, or 13%, in the third quarter and by $171 million, or 8%, in the first nine months of 2011. The increases over the same prior year periods were largely attributable to the recognition of expense for contingent payments related to recent acquisitions, higher infrastructure expenditures resulting from investments in our mortgage business and growth in auto originations.

 

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Total Loans: Period-end loans in the Consumer Banking business increased by $969 million, or 3%, in the first nine months of 2011 to $35.4 billion as of September 30, 2011, from $34.4 billion as of December 31, 2010, primarily due to growth in auto loans that was partially offset by the continued run-off of our legacy home loan portfolios.

 

   

Deposits: Period-end deposits in the Consumer Banking business increased by $5.6 billion, or 7%, in the first nine months of 2011 to $88.6 billion as of September 30, 2011, reflecting the impact of our strategy to replace maturing higher cost wholesale funding sources with lower cost funding sources and our continued retail marketing efforts to attract new business to meet this objective.

 

   

Charge-off and Delinquency Statistics: The net charge-off rate decreased to 1.32% and 1.30% in the third quarter and first nine months of 2011, respectively, from 1.79% and 1.77% in the third quarter and first nine months of 2010, respectively. The 30+ day delinquency rate was 5.57% as of September 30, 2011, compared with 5.96% as of December 31, 2010. The improvement in the net charge-off and delinquency rates reflects the impact from strong underlying credit performance trends and the higher credit quality of our more recent auto loan vintages, as well as current favorable benefits from elevated auction prices.

Commercial Banking Business

Our Commercial Banking business generated net income from continuing operations of $145 million and $435 million for the third quarter and first nine months of 2011, respectively, compared with a net income from continuing operations of $39 million and $67 million in the third quarter and first nine months of 2010, respectively. The primary sources of revenue for our Commercial Banking business are net interest income from loans and deposits and non-interest income from customer fees. Expenses primarily consist of ongoing operating costs, such as salaries and associated benefits, communications and other technology expenses, supplies and equipment and occupancy costs.

Table 9 summarizes the financial results of our Commercial Banking business and displays selected key metrics for the periods indicated.

 

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Table 9: Commercial Banking Business Results

 

6666666 6666666 6666666 6666666 6666666 6666666
    Three Months Ended September 30,     Nine Months Ended September 30,  
(Dollars in millions)       2011             2010           Change           2011             2010           Change    

Selected income statement data:

           

Net interest income

  $ 353      $ 325        9   $ 1,007      $ 956        5

Non-interest income

    62        30        107        195        132        48   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total revenue

    415        355        17        1,202        1,088        10   

Provision (Benefit) for loan and lease losses

    (10     95        (111     (43     395        (111

Non-interest expense

    200        199        1        569        589        (3
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Income from continuing operations before income taxes

    225        61        269        676        104        550   

Income tax provision

    80        22        264        241        37        551   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Income from continuing operations, net of tax

  $ 145      $ 39        272   $ 435      $ 67        549
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Selected performance metrics:

           

Average loans held for investment:

           

Commercial and multifamily real estate

  $ 14,021      $ 13,411        5   $ 13,657      $ 13,556        1

Middle market

    11,572        10,352        12        11,075        10,317        7   

Specialty lending

    4,154        3,715        12        4,045        3,660        11   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total commercial lending

    29,747        27,478        8        28,777        27,533        5   

Small-ticket commercial real estate

    1,598        1,957        (18     1,713        2,030        (16
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total commercial banking

  $ 31,345      $ 29,435        6   $ 30,490      $ 29,563        3
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Average yield on loans held for investment

    4.69     5.13     (44 )bps      4.74     5.03     (29 )bps 

Average deposits

  $ 25,227      $ 21,899        15   $ 24,553      $ 21,976        12

Average interest rate on deposits

    0.48     0.67     (19 )bps      0.50     0.71     (21 )bps 

Core deposit intangible amortization

  $ 10      $ 14        (29 )%    $ 31      $ 42        (26 )% 

Net charge-off rate(1)(2)

    0.37     1.27     (90 )bps      0.55     1.28     (73 )bps 

 

6666666 6666666 6666666 6666666 6666666 6666666

Selected period-end data:

   
 
September 30,
2011
  
  
   

 

December 31,

2010

  

  

      Change           

Loans held for investment:

           

Commercial and multifamily real estate

  $ 14,389      $ 13,396        7      

Middle market

    11,924        10,484        14         

Specialty lending

    4,221        4,020        5         
 

 

 

   

 

 

   

 

 

       

Total commercial lending

    30,534        27,900        9         

Small-ticket commercial real estate

    1,571        1,842        (15      
 

 

 

   

 

 

   

 

 

       

Total commercial banking

  $ 32,105      $ 29,742        8      
 

 

 

   

 

 

   

 

 

       

Nonperforming loan rate(1)(3)

    1.43     1.66     (23 )bps       

Nonperforming asset rate(1)(4)

    1.55        1.80        (25      

Allowance for loan and lease losses

  $ 700      $ 826        (15 )%       

Deposits

    25,282        22,630        12         

 

(1) 

Average loans held for investment used in the denominator in calculating net charge-off, delinquency and nonperforming loan and nonperforming asset rates includes the impact of loans acquired as part of the Chevy Chase Bank acquisition, which were considered purchased credit-impaired (“PCI”) loans. However, we separately track and report PCI loans and exclude these loans from our net charge-off, delinquency, nonperforming loan and nonperforming asset rates.

 

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(2) 

The net charge-off rate is calculated by loan category by dividing annualized net charge-offs for the period by average loans held for investment during the period for the specified loan category. The net charge-off rate, excluding loans acquired from Chevy Chase Bank from the denominator, was 0.38% and 1.30% for the three months ended September 30, 2011 and 2010, respectively, and 0.56% and 1.32% for the nine months ended September 30, 2011 and 2010, respectively.

(3)

The nonperforming loan rate is calculated by loan category by dividing nonperforming loans as of the end of the period by period-end loans held for investment for the specified loan category. The nonperforming loan rate, excluding the impact of loans acquired from Chevy Chase Bank from the denominator, was 1.45% and 1.69% as of September 30, 2011 and December 31, 2010, respectively.

(4) 

The nonperforming asset rate is calculated by loan category by dividing nonperforming assets as of the end of the period by period-end loans held for investment and REO for the specified loan category. The nonperforming asset rate, excluding loans acquired from Chevy Chase Bank from the denominator, was 1.57% and 1.83% as of September 30, 2011 and December 31, 2010, respectively.

Key factors affecting the results of our Commercial Banking business for the third quarter and first nine months of 2011, compared with the third quarter and first nine months of 2010 included the following:

 

   

Net Interest Income: Net interest income increased by $28 million, or 9%, in the third quarter of 2011, and by $51 million, or 5%, in the first nine months of 2011. The primary drivers of the increase in net interest income from the same prior year periods were an increase in loans and deposits and continued downward pricing on deposits while growing loan yields.

 

   

Non-Interest Income: Non-interest income increased by $32 million, or 107%, in the third quarter of 2011 and $63 million, or 48%, in the first nine months of 2011. The increase in non-interest income from the same prior year periods was largely attributable to increased customer fees related to treasury management and public financing activities and the absence of a loss of $18 million recognized in the third quarter of 2010 from the sale of a legacy portfolio of small-ticket commercial real estate loans.

 

   

Provision for Loan and Lease Losses: The Commercial Banking business recorded a negative provision for loan and lease losses of $10 million and $43 million in the third quarter and first nine months of 2011, respectively, compared with provision expense of $95 million and $395 million in the third quarter and first nine months of 2010, respectively. The negative provision in the third quarter and first nine months of 2011 was attributable to lower loss severities resulting from improvements in underlying collateral asset values. As a result, we reduced the allowance related to the Commercial Banking business by $30 million and $126 million in the third quarter and first nine months of 2011, respectively. In comparison, we increased the allowance by $9 million in the third quarter of 2010 and by $106 million in the first nine months of 2010.

 

   

Non-Interest Expense: Non-interest expense of $200 million in the third quarter of 2011 was flat relative to the third quarter of 2010 despite an increase in loan volume, reflecting operational efficiency improvements. Non-interest expense decreased by $20 million, or 3%, in the first nine months of 2011 to $569 million, primarily due to a reduction in integration costs related to the Chevy Chase Bank acquisition.

 

   

Total Loans: Period-end loans increased by $2.4 billion, or 8%, in the first nine months of 2011 to $32.1 billion as of September 30, 2011, from $29.7 billion as of December 31, 2010. The increase was driven by stronger loan originations in the middle market and commercial real estate businesses, which was partially offset by the run-off and sale of a portion of the small-ticket commercial real estate loan portfolio.

 

   

Deposits: Period-end deposits in the Commercial Banking business increased by $2.7 billion, or 12%, in the first nine months of 2011 to $25.3 billion as of September 30, 2011, driven by our strategy to strengthen existing relationships and increase liquidity from commercial customers.

 

   

Charge-off and Nonperforming Loan Statistics: The net charge-off rate decreased to 0.37% and 0.55% in the third quarter and first nine months of 2011, respectively, from 1.27% and 1.28% in the third quarter and first nine months of 2010, respectively. The nonperforming loan rate decreased to 1.43% as of September 30, 2011, from 1.66% as of December 31, 2010. The improvement in the net charge-off and nonperforming loan rates was attributable to slowly improving underlying credit trends and improvements in underlying collateral asset values.

 

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CONSOLIDATED BALANCE SHEET ANALYSIS AND CREDIT PERFORMANCE

 

Total assets of $200.1 billion as of September 30, 2011 increased by $2.6 billion, or 1%, from $197.5 billion as of December 31, 2010. Total liabilities of $170.8 billion as of September 30, 2011, decreased by $192 million, or less than 1%, from $171.0 billion as of December 31, 2010. Stockholders’ equity increased by $2.8 billion during the first nine months of 2011, to $29.4 billion as of September 30, 2011 from $26.5 billion as of December 31, 2010. The increase in stockholders’ equity was primarily attributable to our net income of $2.7 billion in the first nine months of 2011. Following is a discussion of material changes in the major components of our assets and liabilities during the first nine months of 2011.

Investment Securities

Our investment securities portfolio, which had a fair value of $38.4 billion and $41.5 billion, as of September 30, 2011 and December 31, 2010, respectively, consists of the following: U.S. Treasury and U.S. agency debt obligations; agency and non-agency mortgage-backed securities; other asset-backed securities collateralized primarily by credit card loans, auto loans, student loans, auto dealer floor plan inventory loans and leases, equipment loans and home equity lines of credit; municipal securities; and limited Community Reinvestment Act (“CRA”) equity securities. Our investments in U.S. Treasury and agency securities, based on fair value, represented approximately 69% and 70% of our total investment securities portfolio as of September 30, 2011, and December 31, 2010, respectively.

All of our investment securities were classified as available for sale as of September 30, 2011 and December 31, 2010, and reported in our consolidated balance sheet at fair value. Table 10 presents the amortized cost and fair value of our investment securities, by investment type, as of September 30, 2011 and December 31, 2010.

Table 10: Investment Securities

 

     September 30, 2011      December 31, 2010  
(Dollars in millions)    Amortized
Cost
     Fair
Value
     Amortized
Cost
     Fair
Value
 

U.S. Treasury debt obligations

   $ 115       $ 125       $ 373       $ 386   

U.S. Agency debt obligations(1)

     166         175         301         314   

Residential mortgage-backed securities (“RMBS”):

           

Agency(2)

     25,139         25,747         27,980         28,504   

Non-agency

     1,405         1,273         1,826         1,700   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total RMBS

     26,544         27,020         29,806         30,204   

Commercial mortgage-backed securities (“CMBS”):

           

Agency(2)

     418         429         44         45   

Non-agency

     400         398         0         0   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total CMBS

     818         827         44         45   

Asset-backed securities (“ABS”)(3)

     9,691         9,734         9,901         9,966   

Other securities(4)

     467         519         563         622   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total securities available for sale

   $ 37,801       $ 38,400       $ 40,988       $ 41,537   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

(1)

Consists of debt securities issued by Fannie Mae and Freddie Mac with an amortized cost of $165 million and $200 million, as of September 30, 2011 and December 31, 2010, respectively, and fair value of $174 million and $213 million, as of September 30, 2011 and December 31, 2010, respectively.

(2)

Consists of MBS issued by Fannie Mae, Freddie Mac and Ginnie Mae with an amortized cost of $12.9 billion, $8.4 billion and $4.3 billion, respectively, and fair value of $13.2 billion, $8.6 billion and $4.4 billion, respectively, as of September 30, 2011. The book value of Fannie Mae, Freddie Mac and Ginnie Mae investments each exceeded 10% of our stockholders’ equity as of September 30, 2011.

 

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(3)

Consists of securities collateralized by credit card loans, auto dealer and floor plan inventory loans and leases, student loans, auto loans, equipment loans and other. The distribution among these asset types was approximately 73.2% credit card loans, 11.3% auto dealer floor plan inventory loans and leases, 6.8% auto loans, 4.6% student loans, 2.3% equipment loans, and 1.8% of other loans as of September 30, 2011. In comparison, the distribution was approximately 77.8% credit card loans, 5.6% auto dealer floor plan inventory loans and leases, 6.7% auto loans, 7.2% student loans, 2.5% equipment loans and 0.2% home equity lines of credit as of December 31, 2010. Approximately 89% of the securities in our asset-backed security portfolio were rated AAA or its equivalent as of September 30, 2011, compared with 90% as of December 31, 2010.

(4)

Consists of municipal securities and equity investments, primarily related to CRA activities.

We sold approximately $6.4 billion of investment securities, consisting predominantly of agency MBS, in the third quarter of 2011. We recorded a gain of $239 million on the sale of these securities. We provide additional information in “Market Risk Management.”

Unrealized gains and losses on our available-for-sale securities are recorded net of tax as a component of accumulated other comprehensive income (“AOCI”). We had gross unrealized gains of $776 million and gross unrealized losses of $177 million on available-for-sale securities as of September 30, 2011, compared with gross unrealized gains of $830 million and gross unrealized losses of $281 million as of December 31, 2010. Of the $177 million in gross unrealized losses as of September 30, 2011, $134 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 (“OTTI”) 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