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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
(Mark One)
| x | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934. |
For the fiscal year ended December 31, 2009.
| ¨ | 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
Securities registered pursuant to section 12(b) of the act:
| Title of Each Class |
Name of Each Exchange on Which Registered | |
| Common Stock, $.01 Par Value | New York Stock Exchange |
Securities Registered Pursuant to Section 12(g) of the Act:
None
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes x No ¨
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15 (d) of the Act. Yes ¨ No x
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 Website, 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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨
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 Act.) Yes ¨ No x
The aggregate market value of the voting stock held by non-affiliates of the registrant as of the close of business on June 30, 2009.
Common Stock, $.01 Par Value: $9,845,379,877*
| * | In determining this figure, the registrant assumed that the executive officers of the registrant and the registrant’s directors are affiliates of the registrant. Such assumption shall not be deemed to be conclusive for any other purpose. The number of shares outstanding of the registrant’s common stock as of the close of business on January 31, 2010. |
Common Stock, $.01 Par Value: 455,293,746 shares
DOCUMENTS INCORPORATED BY REFERENCE
| 1. | Portions of the Proxy Statement for the annual meeting of stockholders to be held on April 24, 2010 are incorporated by reference into Part III. |
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CAPITAL ONE FINANCIAL CORPORATION
2009 ANNUAL REPORT ON FORM 10-K
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PART I
| Item 1. | Business. |
Capital One Financial Corporation (the “Corporation”) is one of the largest financial institutions in the United States, incorporated in Delaware on July 21, 1994. The Corporation’s 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 Corporation and its subsidiaries are collectively referred to as the “Company.” Unless indicated otherwise, the terms “Corporation” “Capital One” “we” “us” and “our” refer to the Corporation and its consolidated subsidiaries.
As of December 31, 2009, we had $115.8 billion in deposits and $136.8 billion in managed loans outstanding. We are the fourth largest issuer of Visa® (“Visa”) and MasterCard® (“MasterCard”) credit cards in the United States based on managed credit card loans outstanding, and we are the eighth largest depository institution in the United States based on deposits.
We offer our products throughout the United States. We also offer our products outside of the United States principally through Capital One Bank (Europe) plc, an indirect subsidiary of COBNA organized and located in the United Kingdom (the “U.K. Bank”), and through a branch of COBNA in Canada. Our U.K. Bank has authority, among other things, to accept deposits and provide credit card and installment loans. Our branch of COBNA in Canada has the authority to provide credit card loans.
Our common stock is listed on the New York Stock Exchange under the symbol COF and as of January 31, 2010, the Company’s common stock was held by 16,955 shareholders. Our principal executive office is located at 1680 Capital One Drive, McLean, Virginia 22102 (telephone number (703) 720-1000). The Corporation maintains a website at www.capitalone.com. Documents available on our website include (i) Codes of Business Conduct and Ethics for the Corporation; (ii) the Corporation’s Corporate Governance Principles; and (iii) charters for the Audit and Risk, Compensation, Finance and Trust Oversight, and Governance and Nominating Committees of the Board of Directors. These documents are also available in print to any shareholder who requests a copy. In addition, we make available free of charge through our website our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports as soon as reasonably practicable after electronic filing or furnishing such material to the SEC.
Capital One is one of the largest financial institutions in the United States. We focus on consumer and commercial lending and deposit taking. Our principal business segments are Credit Card, Commercial Banking and Consumer Banking. For further discussion of our segments, see Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Reportable Segment Summary for Continuing Operations” and “Note 5 – Segments”.
Credit Card Segment. The credit card segment includes the Company’s domestic consumer and small business card lending, domestic national small business lending, national closed end installment lending and the international card lending businesses in Canada and the United Kingdom.
Commercial Banking Segment. Commercial Banking includes the Company’s lending, deposit gathering and treasury management services to commercial real estate and middle market customers. The Commercial segment also includes the financial results of a national portfolio of small ticket commercial real estate loans that are in run-off mode.
Consumer Banking Segment. Consumer Banking includes the Company’s branch based lending and deposit gathering activities for small business customers as well as its branch based consumer deposit gathering and lending activities, national deposit gathering, national automobile lending, consumer mortgage lending and servicing activities.
Chevy Chase Bank Acquisition
On February 27, 2009, the Company acquired all of the outstanding common stock of Chevy Chase Bank F.S.B., (“Chevy Chase Bank”), one of the largest retail depository institutions in the Washington DC region, in exchange for Capital One common stock and cash with a total value of $475.9 million. Under the terms of the stock purchase agreement, Chevy Chase Bank common shareholders received $445 million in cash and 2.56 million shares of Capital One common stock. The acquisition of Chevy Chase Bank greatly expanded our banking footprint in one of the strongest markets in the country.
Our consumer loan portfolios, including credit cards, are diversified across the United States with modest concentration in New York, New Jersey, Louisiana, and Texas. We also have credit card loans in the U.K. and Canada. Our commercial loans are concentrated in
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New York, New Jersey, Louisiana and Texas. See Item 7 “Management’s Discussion and Analysis of Financial Condition and results of Operations – Loans Held for Investment”, “Management’s Discussion and Analysis of Financial Condition and results of Operations – Credit Concentration” and “Note 24—Significant Concentration of Credit Risk” for further details.
Capital One’s policy is to identify, assess, and mitigate risks that affect or have the potential to affect our business, to target financial returns commensurate with the Company’s risk appetite, and to avoid excessive risk-taking. We follow three key principles related to this policy.
| 1. | Individual businesses take and manage risk in pursuit of strategic, financial, and other business objectives |
| 2. | Independent risk management organizations support individual businesses by providing risk management tools and policies, and by aggregating risks; in some cases, risks are managed centrally |
| 3. | The Board of Directors and top management review our aggregate risk position and establish the risk appetite |
Our approach is reflected in four critical risk management practices of particular importance in today’s environment.
First, we recognize liquidity risk as among the critical risks facing financial institutions today. We seek to mitigate this risk strategically and tactically. From a strategic perspective, we have acquired and built deposit gathering businesses and significantly reduced our loan to deposit ratio. From a tactical perspective, we have accumulated a very large liquidity reserve comprising cash, high-quality, unencumbered securities, and committed collateralized credit lines and conduit facilities.
Second, we recognize that credit issues are a frequent cause of financial institution stress and that we are exposed to cyclical changes in credit quality. Consequently, we try to ensure our credit portfolio is resilient to economic downturns. Our most important tool is sound underwriting, using what we deem to be conservative assumptions. In unsecured consumer loan underwriting, we assume that loans will be subject to an environment in which losses are significantly higher than those prevailing at the time of underwriting. In commercial underwriting, we insist on strong cash flow, strong collateral, and strong covenants and guarantees. In addition to conservative underwriting, we aggressively monitor our portfolio and aggressively collect or work out distressed loans.
Third, we recognize that reputational risk is of particular concern in today’s turbulent environment. Consequently, our CEO and executive team manage both tactical and strategic reputation issues and build our relationships with the government, media, and other constituencies to help strengthen the reputations of both Capital One and our industry. This includes taking public positions in support of better consumer practices in our industry and, where possible, unilaterally implementing those practices in our business.
Finally, we recognize that maintaining appropriate capital levels is a concern in today’s environment. See Item 7 “Management’s Discussion and Analysis of Financial Condition and results of Operations – Capital,” for further information regarding capital.
Risk Management Roles and Responsibilities
The Board of Directors is responsible for establishing Capital One’s overall risk framework; approving and overseeing execution of the Enterprise Risk Management Policy and key risk category policies; establishing the Company’s risk appetite; and regularly reviewing Capital One’s risk profile.
The Chief Risk Officer, who reports to the CEO, is responsible for overseeing Capital One’s risk management program and driving appropriate action to resolve any weaknesses. The risk management program begins with a set of policies and risk appetites approved by the Board that are implemented through a system of risk committees and senior executive risk stewards. The company has established risk committees at both the corporate and divisional level to identify and manage risk. In addition, we have assigned a senior executive expert to each of eight risk categories (the risk stewards). These executive risk stewards work with the Chief Risk Officer and the risk committees to ensure that risks are identified and given appropriate priority and attention. The Chief Risk Officer aggregates the results of these processes to assemble a view of the company’s risk profile. Both management and the Board regularly review the risk profile.
Risk Management and Control Framework
Capital One uses a consistent framework to manage risk. The framework applies at all levels, from the development of the Enterprise Risk Management Program itself to the tactical operations of the front-line business team. The framework has six key elements:
| 1. | Objective Setting; |
| 2. | Risk Assessment; |
| 3. | Control Activities; |
| 4. | Communication and Information; |
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| 5. | Program Monitoring; and |
| 6. | Organization and Culture. |
Objective Setting is at the beginning of our risk management approach. We set strategic, financial, operational, and other objectives during our strategic and annual planning processes and throughout the year. These objectives cascade through the organization to individual teams of associates.
Risk Assessment is the process of identifying risks to our objectives, evaluating the impact of those risks and choosing a response. Responses include avoidance, mitigation, or acceptance. Risk responses are guided by our established risk appetite. In certain risk categories, risk assessment is largely conducted by central risk groups or jointly between business areas and central groups (market, liquidity, legal, credit, compliance). In other risk categories, risk assessment is primarily the responsibility of business areas with more limited central support (strategic, operational, reputation).
Control Activities are the day-to-day backbone of our Enterprise Risk Management Program. Controls provide reasonable assurance that financial accounting and reporting, legal, regulatory, and business requirements are met, and identified risks are being mitigated, avoided, or accepted according to our risk appetite. We have practices in place to ensure key controls are established, evaluated, and effective in preventing a breakdown. Control activities include the monitoring of adherence to current requirements, regular reporting to management, and regular reviews and sign-offs. They also include the resolution of regulatory and audit findings and issues and the procedures that trigger objective setting and risk assessments when new business opportunities are evaluated or business hierarchy changes occur.
Communication and Information must provide a solid infrastructure to support the objective setting, risk assessment, and control activities described above. We have established policies for each risk category which define the specific reports to be used and the communication infrastructure. Robust risk management requires well-functioning communication channels to inform associates of their responsibilities, alert them to issues or changes that might affect their activities, and to enable an open flow of information up, down, and across the company.
Program Monitoring is critical to the Enterprise Risk Management Program itself because it assesses the accuracy, sufficiency, and effectiveness of current objectives, risk assessments, controls, ownership, communication, and management support. Where deficiencies are discovered, the Enterprise Risk Management Program must be updated to resolve the deficiencies in a timely manner. Clear accountability must also be defined when resolving deficiencies to ensure the desired outcome is achieved. Risk management programs are monitored at every level; from the overall Enterprise Risk Management Program to the individual risk management activities in each business area.
Our Organization and Culture promote risk management as a key factor in making important business decisions. An effective risk management culture starts with a well-defined risk management philosophy. It requires established risk management objectives that align to business objectives and make targeted risk management activities part of ongoing business management activities.
We have a corporate Code of Business Conduct and Ethics (the “Code”) (available on the Corporate Governance page of our website at www.capitalone.com/about) under which each associate is obligated to behave with integrity in dealing with customers and business partners and to comply with applicable laws and regulations. We disclose any waivers to the Code on our website. We also have an associate performance management process that emphasizes achieving business results while ensuring integrity, compliance, and sound business management. Our risk management culture is also encouraged through frequent direction and communications from the Board of Directors, senior leadership, corporate and departmental risk management policies, risk management and compliance training programs and on-going risk assessment activities in the business areas.
Risk Appetite
Capital One organizes its Enterprise Risk Management Program around eight risk categories. The risk categories enable us to efficiently aggregate risks, provide a mechanism to discuss risk appetite, and facilitate the assignment of expert risk resources to support our business activities. We customize specific risk objectives and control methodologies to each risk category; they share, at the highest level, a common approach to describing and measuring risk appetite. Risk appetites are approved by the Board of Directors and are used both to monitor the company’s evolving risk position and to guide strategic and tactical decision making.
Risk Categories
Capital One’s risk management program is organized around eight risk categories. They are:
Liquidity Risk: is the risk that future financial obligations are not met or future asset growth cannot occur because of an inability to obtain funds at a reasonable price within a reasonable time. The Chief Financial Officer is the accountable executive for liquidity risk.
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Liquidity strength is assessed through balance sheet metrics, and stress testing is used to ensure that Capital One can withstand significant degradation in the funding markets (particularly in the wholesale funding markets). We regularly evaluate our liquidity position under various liquidity stress scenarios with management’s Asset/Liability Management Committee and the Finance and Trust Oversight Committee of the Board, providing recommendations for any necessary actions to ensure our liquidity risk exposure is well managed. Management reports liquidity metrics to the Finance and Trust Oversight Committee no less than quarterly. Breaches in liquidity policy limits are reported to the Treasurer as soon as they are identified and to the Asset/Liability Management Committee at the next regularly scheduled committee meeting, unless said breach activates the Liquidity Contingency Plan. Breaches are also reported to the Finance and Trust Oversight Committee no later than the next regularly scheduled meeting. Detailed processes, requirements and controls are contained in our policies and supporting procedures.
Credit Risk: is the risk of loss from a borrower’s failure to meet the terms of any contract or failure to otherwise perform as agreed. There are four primary sources of credit risk: (1) changing economic conditions, which affect borrowers’ ability to pay and the value of any collateral; (2) a changing competitive environment, which affects customer debt loads, borrowing patterns and loan terms; (3) our underwriting strategies and standards, which determine to whom we offer credit and on what terms; and (4) the quality of our internal controls, which establish a process to test that underwriting conforms to our standards and identifies credit quality issues so we can act upon them in a timely manner. The Chief Risk Officer is the accountable executive for credit risk.
We have quantitative credit risk guidelines for each of our lines of business. We conduct portfolio and decision level monitoring and stress tests using economic and legislative stress scenarios. Credit risk objectives are achieved by establishing a credit governance framework and by establishing policies, procedures, and controls for each step in the credit process. The Board, Chief Executive Officer, Chief Risk Officer, Chief Consumer and Commercial Credit Officers, and Division Presidents have specific accountable roles in the management of credit risk. These include policy approval, creation of credit strategy, review of credit position, and delegation of authority. Our evolving credit risk position and recommendations to address issues are reviewed by management’s Credit Policy Committee and the Board of Directors.
Reputation Risk: is the risk to market value, recruitment, and retention of talented associates and a loyal customer base due to the negative perceptions of Capital One’s internal and external stakeholders regarding Capital One’s business strategies and activities. The Company’s General Counsel is the accountable executive for reputation risk.
Reputation risk is managed and owned by business areas in accordance with our Reputation Risk Policy. Each Division President is responsible for highlighting potential reputational issues and executing appropriate risk mitigation activities. Our Corporate Affairs Department assists these executives in evaluating the reputation risk of new and existing business activities and is responsible for assessing and reporting our aggregate reputation risk and the state of Capital One’s reputation with specific stakeholders, to the General Counsel, Chief Risk Officer, and management’s Risk Management Committee.
Market Risk: is the risk that earnings or the economic value of equity will under-perform due to changes in interest rates, foreign exchange rates (market rates), or other financial market asset prices. Our ability to manage market risks contributes to our overall capital management. The Chief Financial Officer is the accountable executive for market risk.
The market risk positions of Capital One’s banking entities and the consolidated Company are calculated separately and in total, are compared to the pre-established limits, and are reported to management’s Asset/Liability Management Committee and the Finance and Trust Oversight Committee of the Board no less than quarterly. Management is authorized to utilize financial instruments to actively manage market risk exposure. Detailed processes, requirements and controls are contained in our policies and supporting procedures.
Strategic Risk: is the risk that Capital One fails to achieve short and long-term business objectives because we fail to develop the products, capabilities, and competitive position necessary to attract consumers, compete with competitors and withstand market volatility. The result is a failure to deliver returns expected by stakeholders (customers, associates, shareholders, investors, communities, and regulators). The Chief Executive Officer is the accountable executive for Capital One strategy.
The Chief Executive Officer develops an overall corporate strategy and leads alignment of the entire organization with this strategy through definition of strategic imperatives and top-down communication. The Chief Executive Officer and other senior executives spend significant time throughout the entire company sharing the Company’s strategic imperatives to promote an understanding of our strategy and connect it to day-to-day associate activities to enable effective execution. Division Presidents are accountable for defining business strategy within the context of the overall corporate level strategy and Strategic Imperatives. Business strategies are integrated into the Corporate Strategic Plan and are reviewed and approved separately and together on an annual basis by the Chief Executive Officer and the Board of Directors.
Operational Risk: is the risk of direct or indirect financial loss from failed or inadequate processes, associate capabilities or systems, or exposure to external events. The risk of financial loss associated with litigation is also included under operational risk. The Chief Compliance Officer is the accountable executive for establishment of risk management standards and for governance and monitoring
of operational risk at a corporate level. Division Presidents have primary accountability for management of operational risk within their business areas.
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While most operational risks are managed and controlled by business areas, the Operational Risk Management Program establishes requirements and control processes that assure certain consistent practices in the management of operational risk, and provides transparency to the corporate operational risk profile. Our Operational Risk Management Program also includes two primary additional functions. Operational Risk Reporting involves independent assessments of the control and sustainability of key business processes at a corporate and business area level, and such assessments are provided to the Chief Risk Officer, management’s Risk Management Committee, and the Audit and Risk Committee of the Board. The Operational Risk Capital function, in conjunction with the corporate capital process managed by Global Finance, establishes necessary operational risk capital levels to assure resiliency against extreme operational risk event scenarios.
Operational Risk results and trends are reported to the Risk Management Committee and the Audit and Risk Committee of the Board.
Compliance Risk: is the risk of financial loss due to regulatory fines or penalties, restriction or suspension of business, or cost of mandatory corrective action as a result of failing to adhere to applicable laws, regulations, and supervisory guidance. Division Presidents are the accountable executives for compliance risk and are responsible for building and maintaining compliance processes. With the Chief Compliance Officer, Division Presidents are jointly accountable for ensuring the Compliance Management Program requirements are met for their division.
We ensure compliance by maintaining an effective Compliance Management Program consisting of sound policies, systems, processes, and reports. The Compliance Management Program provides management with guidance, training, and monitoring to provide reasonable assurance of our compliance with internal and external compliance requirements. Additionally, management and the Corporate Compliance department jointly and separately conduct on-going monitoring and assess the state of compliance. The assessment provides the basis for performance reporting to management and the Board, allows business areas to determine if their compliance performance is acceptable, and confirms effective compliance controls are in place. Business areas embed compliance requirements and controls into their business policies, standards, processes and procedures. They regularly monitor and report on the efficiency of their compliance controls. Corporate Compliance, jointly working with the business, defines and validates a standard compliance monitoring and reporting methodology. Compliance results and trends are reported to management’s Risk Management Committee and the Audit and Risk Committee of the Board.
Legal Risk: is the risk of material adverse impact due to: (i) new and changed laws and regulations; (ii) new interpretations of law; (iii) the drafting, interpretation and enforceability of contracts; (iv) adverse decisions or consequences arising from litigation or regulatory scrutiny; (v) the establishment, management and governance of our legal entity structure; and (vi) the failure to seek or follow appropriate Legal counsel when needed. The company’s General Counsel is the accountable executive for monitoring and controlling legal risk.
We leverage information technology to achieve our business objectives and to develop and deliver products and services that satisfy our customers’ needs. A key part of our strategic focus is the development of efficient, flexible computer and operational systems to support complex marketing and account management strategies, the servicing of our customers, and the development of new and diversified products. Our commitment to managing risk and ensuring effective controls is built into all of our strategies. We believe that the continued development and integration of these systems is an important part of our efforts to reduce costs, improve quality and provide faster, more flexible technology services. Consequently, we continuously review capabilities and develop or acquire systems, processes and competencies to meet our unique business requirements.
As part of our continuous efforts to review and improve our technologies, we may either develop such capabilities internally or rely on third party outsourcers who have the ability to deliver technology that is of higher quality, lower cost, or both. Over time, we have increasingly relied on third party outsourcers to help us deliver systems and operational infrastructure. These relationships include (but are not limited to): Total System Services Inc. (“TSYS”) for processing services for Capital One’s North American and United Kingdom portfolios of consumer and small business credit card accounts, Fidelity National Information Services (“Fidelity”) for the Capital One banking systems, and IBM Corporation for management of our North American data centers.
The Card division has a program in place to address systems changes associated with the Credit Card Accountability Responsibility and Disclosure Act of 2009 (the “Credit CARD Act”), including the recent clarifications from the Federal Reserve. We are on track to meet all systems changes required by the first quarter of 2010.
We also remain on target to complete the systems integration of Chevy Chase Bank in the third quarter of 2010. Additionally, a multi-year effort is underway to build a scalable banking infrastructure.
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A discussion of our funding programs and liquidity has been included in Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Funding.”
As a diversified financial institution that markets credit cards and consumer and commercial financial products and services, we face intense competition in all aspects of our business from numerous bank and non-bank providers of financial services.
We compete with national and state banks for deposits, commercial loans and trust accounts and with savings and loan associations and credit unions for loans and deposits. We also compete with other financial services providers for loans, deposits, and other services and products. In addition, we compete against non-depository institutions that are able to offer products and services that were typically banking products and services. In general, in the current economic environment, customers are attracted to depository institutions that are perceived as stable, with solid liquidity and funding.
We compete with international, national, regional and local issuers of Visa® and MasterCard® credit cards, as well as with American Express®, Discover Card® and, to a certain extent, debit cards. In general, customers are attracted to credit card issuers largely on the basis of price, credit limit and other product features, and customer loyalty is often limited.
In our Auto Finance business, we face competition from banks and non-bank lenders who provide financing for dealer-originated loans.
We believe that we are able to compete effectively in our current markets. There can be no assurance, however, that our ability to market products and services successfully or to obtain adequate returns on our products and services will not be impacted by the nature of the competition that now exists or may later develop, or by the broader economic environment. For a discussion of the risks related to our competitive environment, please refer to Item 1A. Risk Factors “We Face Intense Competition in All of Our Markets.”
As part of our overall and ongoing strategy to protect and enhance our intellectual property, we rely on a variety of protections, including copyrights, trademarks, trade secrets, patents and certain restrictions on disclosure and competition. We also undertake other measures to control access to and distribution of our other proprietary information. Despite these precautions, it may be possible for a third party to copy or otherwise obtain and use certain intellectual property or proprietary information without authorization. Our precautions may not prevent misappropriation or infringement of our intellectual property or proprietary information. In addition, our competitors also file patent applications for innovations that are used in our industry. The ability of our competitors to obtain such patents may adversely affect our ability to compete. Conversely, our ability to obtain such patents may increase our competitive advantage. There can be no assurance that we will be successful in such efforts, or that the ability of our competitors to obtain such patents may not adversely impact our financial results.
A central part of our philosophy is to attract and retain a highly capable staff. As of December 31, 2009, we employed approximately 28,000 employees, whom we refer to as “associates,” and almost 2,900 of whom were formerly employees of Chevy Chase Bank. We view current associate relations to be satisfactory, and none of our associates is covered under a collective bargaining agreement.
General
The Company is a bank holding company (“BHC”) under Section 3 of the Bank Holding Company Act of 1956, as amended (the “BHC Act”) (12 U.S.C. § 1842) and is subject to the requirements of the BHC Act, including its capital adequacy standards and limitations on the Company’s nonbanking activities. The Company is also subject to supervision, examination and regulation by the Federal Reserve Board (the “Federal Reserve”). Permissible activities for a BHC include those activities that are so closely related to banking as to be a proper incident thereto such as consumer lending and other activities that have been approved by the Federal Reserve by regulation or order. Certain servicing activities are also permissible for a BHC if conducted for or on behalf of the BHC or any of its affiliates. Impermissible activities for BHCs include activities that are related to commerce such as retail sales of nonfinancial products. Under Federal Reserve policy, the Corporation is expected to act as a source of financial and managerial strength to any banks that it controls, including COBNA and CONA (the “Banks”), and to commit resources to support them.
On May 27, 2005, the Company became a “financial holding company” under the Gramm-Leach-Bliley Act amendments to the BHC Act (the “GLBA”). The GLBA removed many of the restrictions on the activities of BHCs that become financial holding companies. A financial holding company, and the non-bank companies under its control, are permitted to engage in activities considered financial in nature (including, for example, insurance underwriting, agency sales and brokerage, securities underwriting and dealing and merchant banking activities); incidental to financial activities; or complementary to financial activities if the Federal Reserve determines that they pose no risk to the safety or soundness of depository institutions or the financial system in general.
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The Company’s election to become a financial holding company under the GLBA certifies that the depository institutions the Company controls meet certain criteria, including capital, management and Community Reinvestment Act (“CRA”) requirements. If the Company were to fail to continue to meet the criteria for financial holding company status, it could, depending on which requirements it failed to meet, face restrictions on new financial activities or acquisitions and/or be required to discontinue existing activities that are not generally permissible for bank holding companies.
COBNA and CONA are national associations chartered under the laws of the United States, the deposits of which are insured by the Deposit Insurance Fund of the Federal Deposit Insurance Corporation (the “FDIC”) up to applicable limits. In addition to regulatory requirements imposed as a result of COBNA’s international operations (discussed below), COBNA and CONA are subject to comprehensive regulation and periodic examination by the Office of the Comptroller of the Currency (“OCC”) and the FDIC.
The Company is also registered as a financial institution holding company under Virginia law and, as such, is subject to periodic examination by Virginia’s Bureau of Financial Institutions. The Company also faces regulation in the international jurisdictions in which it conducts business (see below under Regulation of International Business by Non – U.S. Authorities).
Regulation of Business Activities
The activities of the Banks as consumer lenders also are subject to regulation under various federal laws, including the Truth-in-Lending Act, the Equal Credit Opportunity Act, the Fair Credit Reporting Act (the “FCRA”), the CRA and the Service members Civil Relief Act, as well as under various state laws. Depending on the underlying issue and applicable law, regulators are often authorized to impose penalties for violations of these statutes and, in certain cases, to order the Banks to compensate injured borrowers. Borrowers may also have a private right of action for certain violations. Federal bankruptcy and state debtor relief and collection laws also affect the ability of the Banks to collect outstanding balances owed by borrowers. These laws plus state sales finance laws also affect the ability of our automobile financing business to collect outstanding balances.
New Regulations of Consumer Lending Activities
On January 12, 2010, the Federal Reserve released a final rule under Regulation Z (“Truth in Lending”). This final rule incorporates the provisions required to implement the Credit CARD Act by February 22, 2010 and the amendments to Truth in Lending under the December 2008 final rule. Now superseded, the Federal Reserve retracted its previous final rules issued to amend Truth in Lending and AA.
Under a previous rulemaking which became effective on August 20, 2009, the Federal Reserve adopted requirements relating to the provision of 45-day prior written notice for any significant changes to a credit card account, including, in some instances, a right to reject such changes. These provisions also adopted new statement delivery requirements. Capital One has implemented the interim final rules for these provisions.
The Federal Reserve’s final rule implementing the provisions of the Credit CARD Act that became effective on February 22, 2010, among other things:
| • | Restricts increases in the rates charged on pre-existing credit card balances; |
| • | prevents “over-the-limit” fees unless a cardholder has agreed to receive over-the-limit protection, and limit the number of such fees that can be charged for the same violation; |
| • | Limits the amount of fees charged to credit card accounts with lower credit lines; |
| • | Mandates delivery of periodic statements 21 days before the due date and before the end of any grace period; |
| • | Requires that payments above the minimum payment be applied to balances with the highest interest rates first; and |
| • | Prohibits the imposition of interest charges using the “two-cycle” billing method. |
The final rule also retains the Federal Reserve’s previous disclosure requirements and other obligations for credit cards and other open-end loans. Among other things, the provisions in the final rule will require extensive changes to disclosures for solicitations and applications, account opening, periodic statements, changes in terms, and convenience checks by July 1, 2010.
After this final rule, only two remaining provisions of the Credit CARD Act remain open for rulemaking. These provisions, effective on August 22, 2010, will ensure that the amount of any penalty fee or charge is “reasonable and proportional to the omission or violation” and may require issuers to reverse interest rates increased since January 1, 2009 on a rolling six-month basis.
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For a discussion of the risks posed to the Company as a result of these new regulations, please refer to “Compliance With New and Existing Laws and Regulations May Increase Our Costs, Limit Our Ability To Pursue Business Opportunities, And Increase Compliance Challenges” under Item 1A. Risk Factors.
Dividends and Transfers of Funds
Traditionally dividends to the Company from its direct and indirect subsidiaries have represented a major source of funds for the Company to pay dividends on its stock, make payments on corporate debt securities and meet its other obligations. There are various federal and state law limitations on the extent to which the Banks can finance or otherwise supply funds to the Company through dividends and loans. These limitations include minimum regulatory capital requirements, federal and state banking law requirements concerning the payment of dividends out of net profits or surplus, Sections 23A and 23B of the Federal Reserve Act and Regulation W governing transactions between an insured depository institution and its affiliates, as well as general federal and state regulatory oversight to prevent unsafe or unsound practices. In general, federal and applicable state banking laws prohibit, without first obtaining regulatory approval, insured depository institutions, such as the Banks, from making dividend distributions if such distributions are not paid out of available earnings or would cause the institution to fail to meet applicable capital adequacy standards. However, we expect that the Company may receive a material amount of its funding in the form of dividends from its direct and indirect subsidiaries.
Capital Adequacy
The Banks are subject to capital adequacy guidelines adopted by federal banking regulators. For a further discussion of the capital adequacy guidelines, see Item 7 “Management Discussion and Analysis of Financial Condition and Results of Operations – Section X. Capital” and “Note 23—Regulatory Matters”. The Banks were well capitalized under these guidelines as of December 31, 2009.
Basel II
Implementation of the international accord on revised risk-based capital rules known as “Basel II” continues to progress. U.S. Federal banking regulators finalized the “Advanced” version of Basel II in December 2007 and they issued a Notice of Proposed Rulemaking for the “Standardized” version in June 2008. In December 2009, the Basel Committee on Banking Supervision released a proposal for additional capital and liquidity requirements, though it is not clear how these proposals will impact current regulations. Neither the “Advanced” nor “Standardized” version is mandatory for the Company, but the Advanced version could become so, due to growth in the Company’s reported assets. Alternatively, the Company might elect to comply with either the Advanced or Standardized versions of Basel II in the future. Application of the new capital rules could require us to increase the minimum level of capital that we hold. Compliance might also require a material investment of resources. We will continue to closely monitor regulators’ implementation of the new rules with respect to the large institutions that are subject to it and assess the potential impact to us.
Deposits and Deposit Insurance
Each of the Banks, as an insured depository institution, is a member of the Deposit Insurance Fund (“DIF”) maintained by the FDIC. Through the DIF, the FDIC insures the deposits of insured depository institutions up to prescribed limits for each depositor. The DIF was formed on March 31, 2006, upon the merger of the Bank Insurance Fund and the Savings Association Insurance Fund in accordance with the Federal Deposit Insurance Reform Act of 2005 (the “Reform Act”). The Reform Act permits the FDIC to set a Designated Reserve Ratio (“DRR”) for the DIF. To maintain the DIF, member institutions may be assessed an insurance premium and the FDIC may take action to increase insurance premiums if the DRR falls below its required level.
The FDIC has established a plan to restore the DIF in the face of recent insurance losses and future loss projections. As such, in the past year, the FDIC has issued rules that generally increase deposit insurance rates and are expected to improve risk differentiation so that riskier institutions bear a greater share of insurance premiums. As part of the restoration plan, the FDIC imposed a five basis point special assessment on a bank’s assets minus its Tier 1 capital as of June 30, 2009. The FDIC recently increased annual assessment rates again by three basis points beginning 2011. The FDIC also recently issued a final rule that required banks to prepay on December 31, 2009 their estimated quarterly risk-based assessment for the fourth quarter of 2009 and for 2010, 2011, and 2012. In connection with the rule, the Company has prepaid approximately $700 million, which is included within Other Assets.
On October 14, 2008, the FDIC announced its Temporary Liquidity Guarantee Program (“TLGP”), which included the Transaction Account Guarantee Program (“TAGP”). The TAGP provides unlimited deposit insurance coverage for non-interest bearing transaction accounts (including accounts swept from a non-interest bearing transaction account into a non-interest bearing savings deposit account) and certain interest-bearing accounts (negotiable order of withdrawal (NOW) accounts with interest rates of 0.5 percent or less and lawyers trust accounts) at FDIC-insured depository institutions. The TAGP was originally scheduled to expire on December 31, 2009, but was extended through June 30, 2010 for those institutions that choose to participate. The Banks are participating in the TAGP extension. Extension assessment costs are an annualized 15 basis point fee on the balance of each covered account in excess of the current FDIC insurance limit of $250,000.
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The FDIC is authorized to terminate a bank’s deposit insurance upon a finding by the FDIC that the bank’s financial condition is unsafe or unsound or that the institution has engaged in unsafe or unsound practices or has violated any applicable rule, regulation, order or condition enacted or imposed by the bank’s regulatory agency. The termination of deposit insurance for a bank could have a material adverse effect on its liquidity and its earnings.
Banks may accept brokered deposits as part of their funding. Under the Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”), as discussed in Item 7 “Management Discussion and Analysis of Financial Condition and Results of Operations—Section X. Capital”, only “well-capitalized” and “adequately-capitalized” institutions may accept brokered deposits. Adequately-capitalized institutions, however, must first obtain a waiver from the FDIC before accepting brokered deposits, and such deposits may not pay rates that significantly exceed the rates paid on deposits of similar maturity from the institution’s normal market area or, for deposits from outside the institution’s normal market area, the national rate on deposits of comparable maturity.
Overdraft Protection
The Federal Reserve amended Regulation E on November 12, 2009, to limit the ability to assess overdraft fees for paying ATM and one-time debit card transactions that overdraw a consumer’s account, unless the consumer opts into such payment of overdrafts. The new rule does not apply to overdraft services with respect to checks, ACH transactions, or recurring debit card transactions, or to the payment of overdrafts pursuant to a line of credit or a service that transfers funds from another account. We are required to provide to customers written notice describing our overdraft service, fees imposed, and other information, and to provide customers with a reasonable opportunity to opt in to the service. Before we may assess fees for paying discretionary overdrafts, a customer must affirmatively opt in, which could negatively impact our deposit business revenue.
Liability for Commonly-Controlled Institutions
Under the “cross-guarantee” provision of the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (“FIRREA”), insured depository institutions such as the Banks may be liable to the FDIC with respect to any loss incurred or reasonably anticipated to be incurred, by the FDIC in connection with the default of, or FDIC assistance to, any commonly controlled insured depository institution. The Banks are commonly controlled within the meaning of the FIRREA cross-guarantee provision.
FFIEC Account Management Guidance
On January 8, 2003, the Federal Financial Institutions Examination Council (“FFIEC”) released Account Management and Loss Allowance Guidance (the “Guidance”). The Guidance applies to all credit lending of regulated financial institutions and generally requires that banks properly manage several elements of their lending programs, including line assignments, over-limit practices, minimum payment and negative amortization, workout and settlement programs, and the accounting methodology used for various assets and income items related to loans.
We believe that our account management and loss allowance practices are prudent and appropriate and, therefore, consistent with the Guidance. We caution, however, the Guidance provides wide discretion to bank regulatory agencies in the application of the Guidance to any particular institution and its account management and loss allowance practices. Accordingly, under the Guidance, bank examiners could require changes in our account management or loss allowance practices in the future, and such changes could have an adverse impact on our financial condition or results of operation.
Privacy and Fair Credit Reporting
The Gramm-Leach-Bliley Act (“GLBA”) requires a financial institution to describe in a privacy notice certain of its privacy and data collection practices and requires that customers or consumers, before their nonpublic personal information is shared with nonaffiliated third parties, be given a choice (through an opt-out notice) to limit the sharing of such information about them with nonaffiliated third persons unless the sharing is required or permitted under the GLBA as implemented. The Company and the Banks have written privacy notices that are available through the website of the Company, the relevant legal entity, or both, and are delivered to consumers and customers when required under the GLBA. In accordance with the privacy notices noted above, the Company and the Banks protect the security of information about their customers, educate their employees about the importance of protecting customer privacy, and allow their customers to remove their names from the solicitation lists they use and share with others to the extent they use or share such lists. The Company and the Banks require business partners with whom they share such information to have adequate security safeguards and to abide by the redisclosure and reuse provisions of the GLBA. To the extent that the GLBA and the FCRA require the Company or one or more of the Banks to provide customers and consumers the opportunity to opt out of sharing information, then the relevant entity or entities provide such options in the privacy notice. In addition to adopting federal requirements regarding privacy, the GLBA also permits individual states to enact stricter laws relating to the use of customer information. To date, at least California and Vermont have done so by statute, regulation or referendum, and other states may consider proposals which impose additional requirements or restrictions on the Company and/or the Banks. If the federal or state regulators of the financial subsidiaries establish further guidelines for addressing customer privacy issues, the Company and/or one or more of the Banks may need to amend their privacy policies and adapt their internal procedures.
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Under Section 501(b) of the GLBA, among other sources of statutory authority, including state law, the Banks and the Company are required to observe various data security-related requirements, including establishing information security and data security breach response programs and properly authenticating customers before processing or enabling certain types of transactions or interactions. The failure to observe any one or more of these requirements could subject the Banks or the Company to enforcement action or litigation.
Like other lending institutions, the Banks utilize credit bureau data in their underwriting activities. Use of such data is regulated under the FCRA on a uniform, nationwide basis, including credit reporting, prescreening, sharing of information between affiliates, and the use of credit data. The Fair and Accurate Credit Transactions Act of 2003 (the “FACT Act”), which was enacted by Congress and signed into law in December 2003, extends the federal preemption of the FCRA permanently, although the law authorizes states to enact identity theft laws that are not inconsistent with the conduct required by the provisions of the FACT Act. If financial institutions and credit bureaus fail to alleviate the costs and consumer frustration associated with the growing crime of identity theft, financial institutions could face increased legislative/regulatory and litigation risks.
Investment in the Company and the Banks
Certain acquisitions of capital stock may be subject to regulatory approval or notice under federal or state law. Investors are responsible for ensuring that they do not, directly or indirectly, acquire shares of capital stock of the Company in excess of the amount which can be acquired without regulatory approval. Each of the Banks is an “insured depository institution” within the meaning of the Change in Bank Control Act. Consequently, federal law and regulations prohibit any person or company from acquiring control of the Corporation without, in most cases, prior written approval of the Federal Reserve or the OCC, as applicable. Control is conclusively presumed if, among other things, a person or company acquires more than 25% of any class of voting stock of the Company. A rebuttable presumption of control arises if a person or company acquires more than 10% of any class of voting stock and is subject to any of a number of specified “control factors” as set forth in the applicable regulations. Additionally, COBNA and CONA are “banks” within the meaning of Chapter 13 of Title 6.1 of the Code of Virginia governing the acquisition of interests in Virginia financial institutions (the “Financial Institution Holding Company Act”). The Financial Institution Holding Company Act prohibits any person or entity from acquiring, or making any public offer to acquire, control of a Virginia financial institution or its holding company without making application to, and receiving prior approval from, the Bureau of Financial Institutions.
Non-Bank Activities
The Company’s non-bank subsidiaries are subject to supervision and regulation by various other federal and state authorities. Insurance agency subsidiaries are regulated by state insurance regulatory agencies in the states in which they operate. Capital One Agency LLC is a licensed insurance agency that is regulated by the New York State Insurance Department in its home state and by the state insurance regulatory agencies in the states in which it operates. Capital One Agency LLC provides both personal and business insurance services to retail and commercial clients. Chevy Chase Insurance Agency, Inc. is a licensed insurance agency that is regulated by the Maryland State Insurance Administration in its home state and by the state insurance regulatory agencies in the states in which it operates. The Company plans to merge Chevy Chase Insurance Agency, Inc. with and into Capital One Agency LLC in 2010.
Capital One Investment Services LLC, Capital One Southcoast Capital, Inc., and Chevy Chase Securities, Inc. are registered broker-dealers regulated by the Securities and Exchange Commission and the Financial Industry Regulatory Authority. The Company’s broker-dealer subsidiaries are subject to, among other things, net capital rules designed to measure the general financial condition and liquidity of a broker-dealer. Under these rules, broker-dealers are required to maintain the minimum net capital deemed necessary to meet their continuing commitments to customers and others, and are required to keep a substantial portion of their assets in relatively liquid form. These rules also limit the ability of broker-dealers to transfer large amounts of capital to parent companies and other affiliates. Broker-dealers are also subject to other regulations covering their business operations, including sales and trading practices, public offerings, publication of research reports, use and safekeeping of client funds and securities, capital structure, record-keeping and the conduct of directors, officers and employees. The Company plans to merge Chevy Chase Securities, Inc. with and into Capital One Investment Services LLC in 2010.
Capital One Asset Management LLC, Capital One Financial Advisors LLC and Chevy Chase Securities, Inc. are registered investment advisers regulated under the Investment Advisers Act of 1940. Capital One Asset Management provides investment advice to institutions, foundations and endowments, and high net worth individuals. Chevy Chase Securities, Inc. provides investment advice to institutions, foundations and endowments, and high net worth individuals, as well as being a registered broker-dealer as described above. The Company plans to transfer the investment advisory services and licenses associated with Chevy Chase Securities, Inc. to Capital One Financial Advisors, LLC in 2010.
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USA PATRIOT Act of 2001
The USA PATRIOT Act of 2001 (the “Patriot Act”) contains sweeping anti-money laundering and financial transparency laws as well as enhanced information collection tools and enforcement mechanisms for the U.S. government, including due diligence requirements for private banking and correspondent accounts; standards for verifying customer identification at account opening; rules to promote cooperation among financial institutions, regulators, and law enforcement in identifying parties that may be involved in terrorism or money laundering; reporting requirements applicable to the receipt of coins and currency of more than $10,000 in nonfinancial trades or businesses; and more broadly applicable suspicious activity reporting requirements.
The Department of Treasury in consultation with the Federal Reserve and other federal financial institution regulators has promulgated rules and regulations implementing the Patriot Act that prohibit correspondent accounts for foreign shell banks at U.S. financial institutions; require financial institutions to maintain certain records relating to correspondent accounts for foreign banks; require financial institutions to produce certain records upon request of the appropriate federal banking agency; require due diligence with respect to private banking and correspondent banking accounts; facilitate information sharing between government and financial institutions; require verification of customer identification; and require financial institutions to have an anti-money laundering program in place.
Interstate Taxation
Several states have passed legislation which attempts to tax the income from interstate financial activities, including credit cards, derived from accounts held by local state residents. The Company has accounted for this matter applying the recognition and measurement criteria of FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an Interpretation of FASB Statement No. 109, (“ASC 740-10/FIN 48”).
Legislation
Preamble
The information contained in this section is current as of February 19, 2010.
Credit Card
In May 2009, the President signed the Credit CARD Act into law. Different provisions of this legislation become effective on February 22, 2010 and August 22, 2010. For further information on the Credit CARD Act, see “Supervision and Regulation – New Regulations of Consumer Lending Activities.”
The Credit CARD Act also requires the Government Accountability Office (GAO) to conduct a study on interchange fees. The GAO released their report, “Credit Cards: Rising Interchange Fees Have Increased Costs for Merchants, but Options for Reducing Fees Pose Challenges” on November 19, 2009.
In 2009, legislation to regulate interchange fees was also introduced in the U.S. House and the U.S. Senate. House Judiciary Chairman John Conyers (D-MI) and Congressman Bill Shuster (R-PA) have introduced legislation in the U.S. House and Senator Dick Durbin (D-IL) has introduced legislation in the U.S. Senate that provides an antitrust exemption to allow merchants to collectively bargain with the networks and the banks regarding the rates (including merchant discount) and terms (including rules) for payment card acceptance. The Senate bill also includes a three judge panel who would determine the rates and terms if an agreement is not reached under the antitrust exemption. This legislation is under the jurisdiction of the Judiciary Committees. It is expected that attempts to regulate interchange fees will continue to be raised at the state level as well.
In addition, Congressman Peter Welch (D-VT) has also introduced a bill that attempts to change many of the fundamental rules of the networks and focuses on: (i) honoring all cards: (ii) minimum/maximum transaction amounts; and (iii) premium card pricing, among other issues. To date, a companion bill has not been introduced in the Senate. A legislative hearing was held on October 8, 2009 in the House Financial Services Committee; however, no additional action is currently scheduled.
Financial Regulatory Reform
In June 2009, the Treasury Department released the Administration’s proposal for Regulatory Reform. This proposal overhauls the financial regulatory structure in several significant respects. Among other changes, the proposal would give authority to the Federal Reserve Board to serve as the nation’s financial services systemic risk regulator, with new enhanced scrutiny over financial institutions that are deemed “too big to fail.”
The Administration’s proposal would also establish a Consumer Financial Protection Agency (CFPA), a new government agency with sole rule writing authority for consumer financial protection statutes. As proposed, the CFPA’s authority would cover all consumer financial products including any loan, deposit account or other financial product. The proposal would also give states the authority to enforce federal laws regardless of a bank’s charter, and it would abolish federal preemption of conflicting state consumer protection laws, requiring national banks to meet up to 50 separate sets of standards.
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In January 2010, the President also proposed implementing “Volcker Rule” limitations that would place new restrictions on the size and scope of banks and other financial institutions. Specifically, no bank would be permitted to “own, invest in or sponsor a hedge fund or a private equity fund, or proprietary trading operations unrelated to serving customers for its own profit” and broader limits would be placed on increases in the market share of liabilities at the largest financial firms to supplement existing limitations with respect to the market share of deposits. We do not expect that this proposed rule would affect any of our existing businesses.
On December 11, 2009, the House passed the Wall Street Reform and Consumer Protection Act (the “Wall Street Reform Act”) The legislation would create the CFPA and the new agency would have oversight over most consumer protection laws (except the Community Reinvestment Act) 180 days after the bill is enacted into law. The Wall Street Reform Act allows for federal preemption of state consumer protection laws only in cases where the state laws “prevent, significantly interfere with, or materially impair” the ability of national banks to engage in the business of banking.
Additionally, the Wall Street Reform Act addresses systemic risk and resolution authority in a number of ways. First, it would create an inter-agency Financial Services Oversight Council that would identify and regulate financial institutions that pose systemic risks, and these institutions would be subject to heightened oversight and regulation. The Wall Street Reform Act also establishes a process for dismantling failing, systemically risky firms and requires assessments of financial companies with over $50 billion in assets to pay for a Systemic Dissolution Fund.
The Wall Street Reform Act would also make certain changes to the manner in which fees are assessed against financial institutions by the FDIC. First, the amount of the FDIC’s assessment would be determined based on average total assets less average tangible equity as opposed to total domestic deposits. Second, the considerations that the FDIC utilizes in its risk-based assessment formula would be modified to include the risks to the deposit insurance fund posed by the uninsured affiliates of the depository institution. Third, the FDIC would be required to consider off-balance sheet exposures when setting its rates. The FDIC’s current authority to establish separate assessment systems for large and small institutions would be eliminated. Furthermore, regulatory agencies would be required to adopt joint regulations requiring creditors and securitizers to retain at least five percent of the credit risk with respect to such credit or security and prohibit the hedge or transfer of such risk. The agencies could reduce or increase the five percent requirement depending on the circumstances.
The Wall Street Reform Act also addresses shareholder measures, including requiring public companies to provide shareholders with a non-binding vote with respect to executive compensation and to have a compensation committee comprised solely of independent directors. Additionally, the federal banking regulators, the Securities and Exchange Commission (SEC), and the Federal Housing Finance Agency (FHFA) would be required to jointly issue regulations prohibiting any compensation package that encourages executives to take risks that could seriously affect the economy or threaten a financial institution’s safety and soundness. The act also includes substantial portions of H.R. 1728, the Mortgage Reform and Anti-Predatory Lending Act, which the House passed in May 2009 (and discussed below in “Housing and Mortgage Lending”).
No companion bill to the Wall Street Reform Act has yet been introduced in the Senate.
Proposed TARP Assessment
In January 2010, the President announced additional proposals that would impact financial institutions. The first proposal would levy a new tax on institutions within the financial sector to recoup the benefits certain institutions have received under government assistance programs, including TARP. The annual fee would be assessed at a rate of 15 basis points of “covered liabilities” for financial firms with more than $50 billion in consolidated assets (excluding Tier 1 capital, FDIC-assessed deposits and insurance policy reserves). To date, Congress has not put forth legislation on this issue. If the proposal is enacted as described above, the impact to the Company is estimated to be $154 million.
Housing and Mortgage Lending
Since 2008, Congress has also focused on the housing market, looking at both retrospective and prospective solutions. In July 2008, legislation was enacted to create additional federal backstops and strengthen regulation of the Government Sponsored Enterprises (“GSEs”), including an overhaul of the Federal Housing Administration (“FHA”) programs. In May 2009, H.R. 1728, the “Mortgage Reform and Anti-Predatory Lending Act” was passed in the House. The legislation would place a federal duty of care on mortgage originators, lower the threshold for loans covered under the Home Ownership and Equity Protection Act (HOEPA), as well as address assignee liability and require that securitizers retain access to all loans packaged and sold. As discussed above, in December 2009, this legislation was included in the Wall Street Reform Act that passed the U.S. House.
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In May 2009, the President signed the “Helping Families Save Their Homes Act” which provides various types of foreclosure relief and changes to the mortgage marketplace. Among other things, the law would require the OCC, OTS and HUD to report to Congress on the number and type of loan modifications made by entities under their supervision; provide a limited safe harbor for any mortgage loan servicer that enters into a “qualified loss mitigation plan” with a borrower whose loan is held in a securitization vehicle; make various changes to the HOPE for Homeowners Act of 2008 (H4H) by providing greater incentives for mortgage servicers to engage in modifications and reducing administrative burdens on loan underwriters; require new owners of mortgage loans to give notice to borrowers of the sale, transfer or assignment of the loan within 30 days of such sale, transfer or assignment and to provide certain information; and require 90 days notice to terminate the lease of a bona fide tenant of a foreclosed-upon dwelling.
Bankruptcy
There have been several proposals in Congress to modify the bankruptcy laws to permit homeowners at risk of foreclosure to receive a modification of their primary mortgages. On October 20, 2008, President Bush signed the “National Guard and Reservists Debt Relief Act of 2008,” making bankruptcy filings easier for national guardsmen and reservists.
Broad bankruptcy legislation that could be seen as creating incentives for consumers to choose Chapter 13 bankruptcy as a primary remedy for mortgage related problems was also introduced in 2009. This legislation passed the U.S. House in March 2009; however, when it was offered as an amendment to a separate bill in the U.S. Senate, it was defeated. The Senate sponsor, Senator Dick Durbin, has stated he intends to continue working to enact the legislation and will use other available legislative vehicles, including reintroducing the amendment at a later date. During the House consideration of the comprehensive regulatory reform bill in December 2009, the bankruptcy amendment was offered, but failed. Finally, Senators Whitehouse (D-RI) and Durbin have introduced legislation to disallow claims arising from “high cost consumer credit” in bankruptcy proceedings. The Senate Judiciary Committee has yet to take action on the bill; however, the bill was placed on the Committee calendar for consideration but has not been brought up for debate and vote.
Please see “Compliance With New and Existing Laws and Regulations May Increase Our Costs, Limit Our Ability To Pursue Business Opportunities, And Increase Compliance Challenges” under Item 1A. Risk Factors for a discussion of the risks posed to the Company as a result of the current legislative environment.
Regulation of International Business by Non—U.S. Authorities
COBNA faces regulation in foreign jurisdictions where it currently operates. In the United Kingdom, COBNA operates through the U.K. Bank, which was established in 2000. The U.K. Bank is regulated by the Financial Services Authority (“FSA”) and licensed by the Office of Fair Trading (“OFT”). The U.K. Bank is an “authorized deposit taker” and thus is able to take consumer deposits in the U.K. However, the U.K Bank no longer takes deposits following the sale of its deposits business in 2009. The U.K. Bank also has been granted a full license by the OFT to issue consumer credit under the U.K.’s Consumer Credit Act. The FSA requires the U.K. Bank to maintain certain regulatory capital ratios at all times and it may modify those requirements at any time. Effective January 1, 2008, the U.K. Bank became subject to new capital adequacy requirements implemented by the FSA as a result of the U.K.’s adoption of the European Capital Requirements Directive, itself an implementation of the Basel II Accord. The U.K. Bank obtains capital through earnings or through capital infusion from COBNA, subject to prior notice requirements under Regulation K of the rules administered by the Federal Reserve. If the U.K. Bank is unable to generate or maintain sufficient capital on favorable terms, it may choose to restrict its growth to reduce the regulatory capital required. Following the introduction of the Capital Requirements Directive, the U.K. Bank continues to have a capital surplus and the impact of the new capital regime has been fully factored into the U.K. Bank’s financial and capital planning. In addition, the U.K. Bank is limited by the U.K. Companies Act in its distribution of dividends to COBNA via its immediate parent undertakings, Capital One Investment Limited and Capital One Holdings Limited, since dividends may only be paid out of the U.K. Bank’s “distributable profits.”
In July 2009, the U.K. government published “Review of the Regulation of Credit and Store Cards,” a report on the credit card industry, and issued a formal consultation in October 2009. The report and consultation focus on the allocation of payments, minimum payment increases, unsolicited credit limit increases, and repricing. The U.K. government is soliciting comments from consumers and the credit card industry, and is expected to propose legislative changes in the second quarter of 2010.
In addition, the U.K. government has proposed a Financial Services Bill which is currently before Parliament that would restrict the issuance of unsolicited credit card checks. If passed as proposed, credit card issuers would not be able to issue credit card checks unless requested by a cardholder and each request would be limited to up to three checks.
Following the passing of the Consumer Credit Directive (the “CCD”) by the European Commission (the “EC”), the U.K consumer credit regime, including the laws and regulations with respect to the marketing of consumer credit products and the design of and disclosure in consumer credit agreements, is due to change significantly. The CCD is also introducing new regulations requiring that certain information be provided to consumers before a credit agreement is entered into and explicit requirements to ensure that any such consumer is creditworthy. The CCD is required to be implemented into U.K law by June 11, 2010, although there are indications that there may be a delay in this implementation timeframe.
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The OFT is investigating Visa and MasterCard’s current methods of setting interchange fees applicable to U.K. domestic transactions. Cross-border interchange fees are also coming under scrutiny from the European Commission, which in December 2007 issued a decision notice stating that MasterCard’s interchange fees applicable to cross border transactions are in breach of European Competition Law. MasterCard has appealed this decision. A similar decision is expected in relation to Visa’s cross border interchange fees. The timing of any final resolution of the matter by EC or OFT is uncertain and it is unlikely that there will be any determination before the end of 2011. However, it is likely that interchange fees will be reduced, which could adversely affect the yield on U.K. credit card portfolios.
Following a referral by the OFT, the Competition Commission (the “CC”) launched a market investigation into the supply of Payment Protection Insurance (“PPI”) in the U.K. PPI on mortgages, credit cards, unsecured loans (personal loans, motor loans and hire purchase) and secured loans is included. The CC published its final report on remedies on January 29, 2009, which included point of sale changes and the introduction of an annual PPI statement to customers. At the end of 2009, Barclays Bank successfully challenged the remedies package at the Competition Appeals Tribunal (the “CAT”) and the CC is currently revisiting its proposals. The new provisional remedies package is expected to be delivered in May 2010, followed by a consultation period at which point the U.K Bank will be able to assess the impact of the proposed new remedies. The U.K. Bank is now expecting the remedies will not be implemented until 2011.
As in the U.S., in non-U.S. jurisdictions where we operate, we face a risk that the laws and regulations that are applicable to us (or the interpretations of existing laws by relevant regulators) may change in ways that adversely impact our business.
The statistical information required by Item 1 can be found in Item 6 “Selected Financial Data”, Item 7 “Management Discussion and Analysis of Financial Condition and Results of Operations” and in Item 8, “Financial Statements and Supplementary Data”.
| Item 1A. | Risk Factors |
This Annual Report on Form 10-K contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. We also may make written or oral forward-looking statements in our periodic reports to the Securities and Exchange Commission on Forms 10-Q and 8-K, in our annual report to shareholders, in our proxy statements, in our offering circulars and prospectuses, in press releases and other written materials and in statements made by our officers, directors or employees to third parties.
Statements that are not about historical facts, including statements about our beliefs and expectations, are forward-looking statements. Forward looking statements include, but are not limited to, information relating to our future earnings per share, growth in managed loans outstanding, product mix, segment growth, tangible common equity, managed revenue margin, funding costs, operations costs, employment growth, marketing expense, delinquencies and charge-offs. Forward looking statements also include statements using words such as “expect,” “anticipate,” “hope,” “intend,” “plan,” “believe,” “estimate” or similar expressions as well as conditional verbs such as “will,” “should,” “would” and “could.” We have based these forward-looking statements on our current plans, estimates and projections, and you should not unduly rely on them.
Forward-looking statements are not guarantees of future results or performance. They involve risks, uncertainties and assumptions, including the risks discussed below. Our future performance and actual results may differ materially from those expressed in forward-looking statements. Many of the factors that will determine these results and values are beyond our ability to control or predict. Forward-looking statements speak only as of the date that they are made, and we undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.
This section highlights specific risks that could affect our business. Although we have tried to discuss all material risks, please be aware that other risks may prove to be important in the future. In addition to the factors discussed elsewhere in this report, among the other factors that could cause actual results to differ materially from our forward looking statements are the following:
The Current Business Environment, Including a Prolonged Economic Recovery, May Adversely Affect Our Industry, Business, Results Of Operations And Capital Levels
The recent global recession has resulted in a general tightening in the credit markets, lower levels of liquidity, reduced asset values (including residential and commercial properties), reduced business profits, increased rates of business and consumer delinquency, and increased rates of unemployment and consumer bankruptcy, some of which have had a negative impact on our results of operation. The absence of recovery, or a recovery that is only shallow and very gradual, including continued elevated unemployment rates and reduced home prices, may have a material adverse effect on our financial condition and results of operations as customers default on their loans or maintain lower deposit levels, or in the case of credit card accounts, carry lower balances and reduce credit card purchase activity.
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In particular, we may face the following risks in connection with these events:
| • | Market developments may affect consumer confidence levels and may cause declines in credit card usage and adverse changes in payment patterns, causing increases in delinquencies and default rates, which could have a negative impact on our results of operations. In addition, changes in consumer behavior, including decreased consumer spending and a shift in consumer payment strategies towards avoiding late fees, over-limit fees, finance charges and other fees, could have an adverse impact on our revenues. |
| • | Continued increases in consumer bankruptcies could cause increases in our charge-off rates, which could have a negative impact on our revenues. |
| • | Our ability to recover debt that we have previously charged-off may be limited, which could have a negative impact on our revenues. |
| • | The processes we use to estimate inherent losses may no longer be reliable because they rely on complex judgments, including forecasts of economic conditions, which may no longer be capable of accurate estimation, which could have a negative impact on our business. |
| • | Our ability to assess the creditworthiness of our customers may be impaired if the criteria and/or models we use to underwrite and manage our customers become less predictive of future losses, which could cause our losses to rise and have a negative impact on our results of operations. |
| • | Our ability to borrow from other financial institutions or to engage in funding transactions on favorable terms or at all could be adversely affected by further disruptions in the capital markets or other events, including actions by rating agencies and deteriorating investor expectations, which could limit our access to funding. As a result of these market conditions, we have increased our reliance on deposit funding. This shift results in higher levels of owned loan receivables and related increases in our allowance for loan and lease losses. |
| • | Increased charge-offs, rising LIBOR and other events may cause our securitization transactions to amortize earlier than scheduled, which could accelerate our need for additional funding. |
| • | An inability to accept or maintain deposits or to obtain other sources of funding could materially affect our liquidity position and our ability to fund our business. Many other financial institutions are increasing their reliance on deposit funding and, as such, we expect increased competition in the deposit markets. We cannot predict how this increased competition will affect our costs. If we are required to offer higher interest rates to attract or maintain deposits, our funding costs will be adversely impacted. In addition, our ability to maintain existing or obtain additional deposits may be impacted by factors beyond our control, including perceptions about our financial strength, which could lead to consumers choosing not to make deposits with us. |
| • | Regulators, rating agencies or investors could change their standards regarding appropriate capital levels for banks in general or our company in particular. If we are unable to meet any such new standards, it could have negative impacts on our ability to lend, to grow deposits, and on our business results. |
| • | Increased prepayments, refinancings or other factors could lead to a reduction in the value of our mortgage servicing rights, which could have a negative impact on our financial results. |
Compliance With New And Existing Laws And Regulations May Increase Our Costs, Reduce Our Revenue, Limit Our Ability To Pursue Business Opportunities, And Increase Compliance Challenges
There has been increased legislation and regulation with respect to the financial services industry in the last few years, and we expect that oversight of our business will continue to expand in scope and complexity. A wide array of banking, consumer lending, and deposit laws apply to almost every aspect of our business. Failure to comply with these laws and regulations could result in financial, structural and operational penalties, including receivership. In addition, establishing systems and processes to achieve compliance with these laws and regulations may increase our costs and/or limit our ability to pursue certain business opportunities.
On January 12, 2010, the Federal Reserve Board released a final rule under Regulation Z (“Truth in Lending”) which incorporates the provisions required to implement the Credit Card Act and the Federal Reserve’s amendments to Truth in Lending under its December 2008 final rule. These provisions impact credit card’s primarily, but will also impact other open-end loans. The Credit CARD Act will prohibit or limit a number of industry practices such as repricing starting February 22, 2010. The provisions in the final rule also will require extensive changes to disclosures for solicitations and applications, account opening, periodic statements, changes in terms, and convenience checks by July 1, 2010. Although the Company has not engaged in many of the practices prohibited by the amendments, the rules could have a material adverse effect on future revenues in our U.S. credit card business and could make the card business generally less resilient in future economic downturns. In particular, the rules will prohibit an increase in the interest rates applied to existing credit card balances except in limited circumstances. Forthcoming regulations addressing unrepricing requirements and reasonableness of penalty fees for credit cards also may have further impacts to revenues and costs. Unrepricing requirements could require issuers to reverse all or part of any APR price increases instituted since January 1, 2009. Rules regarding “reasonable and proportional” penalty fees could limit the amount of such fees. Likewise, several bills pending before Congress could impact credit card pricing and other terms.
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In June 2009, the Treasury Department released a proposal to reform the financial services industry. This proposal gives the Federal Reserve Board authority to serve as the nation’s financial services systemic risk regulator, with enhanced scrutiny over financial institutions that are deemed “too big to fail.” The proposal could also establish a Consumer Financial Protection Agency (the “CFPA”), a new government agency with sole rule writing authority for consumer financial protection statutes. As proposed, the CFPA’s authority would cover all consumer financial products including any loan, deposit account or other financial product.
In addition, legislation has been introduced that could enable merchants to negotiate interchange fees, which are the discounts on the payment due from the card-issuing bank to the merchant bank through the interchange network. If enacted, any subsequent negotiations with merchants could reduce the interchange fees that the Company is able to collect. The future of these bills is uncertain, but each, or additional legislation, could be introduced or reintroduced in 2010. We face similar risks with respect to our international businesses, where changing laws and regulations may have an adverse impact on our results.
Finally, broad bankruptcy legislation that could create incentives for consumers to choose Chapter 13 bankruptcy as a primary remedy for mortgage related problems was introduced in Congress in 2009. Such legislation, if enacted, could result in an increase in bankruptcy filings, which could lead to increased credit losses in certain of our lending businesses, such as credit cards and Auto Finance, and could have an overall negative impact on our results of operation.
Certain laws and regulations, and any interpretations and applications with respect thereto, may benefit consumers, borrowers and depositors, not stockholders. The legislative and regulatory environment is beyond our control, may change rapidly and unpredictably and may negatively influence our revenue, costs, earnings, growth and capital levels. Our success depends on our ability to maintain compliance with both existing and new laws and regulations. For a description of the laws and regulations to which we are subject, please refer to Supervision and Regulation in Item 1.
We May Experience Increased Delinquencies And Credit Losses
Like other lenders, we face the risk that our customers will not repay their loans. Rising losses or leading indicators of rising losses (such as higher delinquencies, non-performing loans, or bankruptcy rates; lower collateral values; elevated unemployment rates) may require us to increase our allowance for loan and lease losses, which may degrade our profitability if we are unable to raise revenue or reduce costs to compensate for higher losses. In particular, we face the following risks in this area:
| • | Missed Payments. Our customers may miss payments. Loan charge-offs (including from bankruptcies) are generally preceded by missed payments or other indications of worsening financial condition. Our reported delinquency levels measure these trends. Customers are more likely to miss payments during an economic downturn or prolonged periods of slow economic growth. In addition, we face the risk that consumer and commercial customer behavior may change (i.e. an increased unwillingness or inability to repay debt), causing a long-term rise in delinquencies and charge-offs. |
| • | Estimates of inherent losses. The credit quality of our portfolio can have a significant impact on our earnings. We allow for and reserve against credit risks based on our assessment of credit losses inherent in our loan portfolios. This process, which is critical to our financial results and condition, requires complex judgments, including forecasts of economic conditions. We may underestimate our inherent losses and fail to hold a loan loss allowance sufficient to account for these losses. Incorrect assumptions could lead to material underestimates of inherent losses and inadequate allowance for loan and lease losses. In addition, our estimate of inherent losses impacts the amount of allowances we build to account for those losses. The increase or release of allowances impacts our current financial results. |
| • | Underwriting. Our ability to assess the credit worthiness of our customers may diminish. If the models and approaches we use to select, manage, and underwrite our consumer and commercial customers become less predictive of future charge-offs (due, for example, to rapid changes in the economy, including the unemployment rate), our credit losses may increase and our returns may deteriorate. |
| • | Business mix. Our business mix could change in ways that could adversely affect credit losses. We participate in a mix of businesses with a broad range of credit loss characteristics. Consequently, changes in our business mix may change our charge-off rate. |
| • | Charge-off recognition. The rules governing charge-off recognition could change. We record charge-offs according to accounting and regulatory guidelines and rules. These guidelines and rules, including the FFIEC Account Management Guidance, could require changes in our account management or loss allowance practices and cause our charge-offs to increase for reasons unrelated to the underlying performance of our portfolio. Such changes could have an adverse impact on our financial condition or results of operation. |
| • | Industry practices. Our charge-off and delinquency rates may be negatively impacted by industry developments, including new regulations applicable to our industry. |
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| • | Collateral. Collateral, when we have it, could be insufficient to compensate us for loan losses. When customers default on their loans and we have collateral, we attempt to seize it. However, the value of the collateral may not be sufficient to compensate us for the amount of the unpaid loan and we may be unsuccessful in recovering the remaining balance from our customers. Particularly with respect to our commercial lending and mortgage activities, decreases in real estate values could adversely affect the value of property used as collateral for our loans and investments. Thus, the recovery of such property could be insufficient to compensate us for the value of these loans. |
| • | New York Concentration. Although our lending is geographically diversified, in general, approximately 45% of our commercial loan portfolio is concentrated in the New York metropolitan area. The regional economic conditions in the New York area affect the demand for our commercial products and services as well as the ability of our customers to repay their commercial loans and the value of the collateral securing these loans. A prolonged decline in the general economic conditions in the New York region could have a material adverse effect on the performance of our commercial loan portfolio and our results of operations. |
We May Experience Increased Losses Associated with Mortgage Repurchases and Indemnification Obligations
Certain of our subsidiaries, including GreenPoint and CONA, as successor to Chevy Chase Bank, may be required to repurchase mortgage loans that have been sold to investors in the event there are certain breaches of certain representations and warranties contained within the sales agreements. We may be required to repurchase mortgage loans that we sell to investors in the event that there was improper underwriting or fraud, or in the event that the loans become delinquent shortly after they are originated. These subsidiaries also may be required to indemnify certain purchasers and others against losses they incur in the event of breaches of representations and warranties and in various other circumstances, and the amount of such losses could exceed the repurchase amount of the related loans. Consequently, we may be exposed to credit risk associated with sold loans. We have established a reserve in the consolidated financial statements for potential losses that are considered to be both probable and reasonably estimable related to the mortgage loans sold by our originating subsidiaries. The adequacy of the reserve and the ultimate amount of losses incurred will depend on, among other things, the actual future mortgage loan performance, the actual level of future repurchase and indemnification requests, the actual success rate of claimants, developments in Company and industry litigation, actual recoveries on the collateral, and macroeconomic conditions (including unemployment levels and housing prices). Due to uncertainties relating to these factors, we cannot reasonably estimate the total amount of losses that will actually be incurred as a result of our subsidiaries’ repurchase and indemnification obligations, and there can be no assurance that our reserves will be adequate or that the total amount of losses incurred will not have a material adverse effect upon the Company’s financial condition or results of operations. For additional information related to the Company’s mortgage loan operations, mortgage loan repurchase and indemnification obligations and related reserves, see Item 7 “Management Discussion and Analysis of Financial Conditions and Results of Operations – Valuation of Representation and Warranty Reserve”.
We may not be able to maintain adequate capital levels, which could have a negative impact on our business results
As a result of recent economic and market developments, financial institutions may become subject to new and increased capital requirements. While it is not clear what form these requirements might take or whether they will apply to the Company, it is possible that we could be required to increase our capital buffers more quickly than we can generate additional capital. Thus, such new requirements could have a negative impact on our ability to lend, to grow deposit balances and/or on our returns.
Among the proposals under consideration:
| • | Under the Wall Street Reform and Consumer Protection Act as passed by the House in December 2009, financial holding companies that are deemed to pose systemic risks would be subject to heightened oversight and scrutiny, including increased risk-based capital requirements and leverage limits under regulations to be promulgated by the Federal Reserve. The legislation also would require the Federal Reserve to take prompt corrective action with respect to systemically important firms that do not meet minimum capital requirements and authorizes the Federal Reserve to require systemically important firms to maintain a minimum amount of long-term hybrid debt that would be convertible to equity under certain circumstances. No companion bill for to the Wall Street Reform Act has yet been introduced in the Senate. |
| • | In December 2009, the Basel Committee on Banking Supervision released for comment a proposal to strengthen global capital regulations. The key elements of the proposal include raising the quality, consistency and transparency of the capital base, strengthening the risk coverage of the capital framework, introducing a leverage ratio that is different from the U.S. leverage ratio measures and promoting the build-up of capital buffers. The U.S. banking agencies are expected to issue a similar version of the proposal later this year. Although any U.S. proposal would apply to banking organizations subject to the Basel II regime to which the Company is not currently subject, the proposal might also impact the Company and other banking organizations. |
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| • | In January 2010, the OCC and the Federal Reserve announced a final rule regarding capital requirements related to the adoption of ASC 860/SFAS 166 and ASC 810/SFAS 167. Under the final rule, the Company and its subsidiary banks will be required to hold capital against those risk-weighted assets consolidated as a result of the application of ASC 860/SFAS 166 and ASC 810/SFAS 167. |
| • | We maintain a substantial deferred tax asset on our balance sheet, and we include this asset when calculating our regulatory capital levels. However, for regulatory capital purposes, deferred tax assets that are dependent on future taxable income are limited to the lesser of: (i) the amount of deferred tax assets we expect to realize within one year of the calendar quarter-end date, based on our projected future taxable income for that year; or (ii) 10% of the amount of our Tier 1 capital. In addition, the Basel Committee’s capital proposal would require a reduction from capital for any deferred tax assets that are dependent on future earnings. As a result, we may not be able to consider the full value of the deferred tax asset when calculating our regulatory capital levels. |
We Face Risk Related To The Strength Of Our Operational, Technological And Organizational Infrastructure
Our ability to grow and compete is dependent on our ability to build or acquire the necessary operational, technological and organizational infrastructure. The Company is currently engaged in significant development projects to complete the systems integration of Chevy Chase Bank and to build a scalable banking infrastructure. Implementation of such infrastructure changes and upgrades may, at least temporarily, cause disruptions to our business, including, but not limited to, systems interruptions, transaction processing errors, and system conversion delays, all of which could have a negative impact on our Company.
Similar to other large corporations, we are exposed to operational risk that can manifest itself in many ways, such as errors related to failed or inadequate processes, faulty or disabled computer systems, fraud by employees or persons outside of the Company and exposure to external events. In addition, we are heavily dependent on the strength and capability of our technology systems which we use to manage our internal financial and other systems, interface with our customers and develop and implement effective marketing campaigns. Our ability to develop and deliver new products that meet the needs of our existing customers and attract new ones and to run our business in compliance with applicable laws and regulations depends on the functionality of our operational and technology systems. Any disruptions or failures of our operational and technology systems, including those associated with improvements or modifications to such systems, could cause us to be unable to market and manage our products and services and to report our financial results in a timely and accurate manner, all of which could have a negative impact on our results of operations.
In some cases, we outsource the maintenance and development of our operational and technological functionality to third parties. These third parties may experience errors or disruptions that could adversely impact us and over which we may have limited control. Any increase in the amount of our infrastructure that we outsource to third parties may increase our exposure to these risks.
We May Fail To Realize All Of The Anticipated Benefits Of Our Mergers And Acquisitions
Capital One has engaged in merger and acquisition activity over the past several years. If we are not able to achieve the anticipated benefits of such mergers and acquisitions, including cost savings and other synergies, our business could be negatively affected. In addition, it is possible that the ongoing integration processes could result in the loss of key employees, errors or delays in systems implementation, the disruption of each company’s ongoing businesses or inconsistencies in standards, controls, procedures and policies that adversely affect our ability to maintain relationships with clients, customers, depositors and employees or to achieve the anticipated benefits of the merger or acquisition. Integration efforts also may divert management attention and resources. These integration matters may have an adverse effect on the Company during any transition period.
Our recent acquisitions also involve our entry into new businesses and new geographic or other markets which present risks resulting from our relative inexperience in these new areas and/or these new businesses. These new businesses change the overall character of our consolidated portfolio of businesses and could react differently to economic and other external factors. We face the risk that we will not be successful in these new businesses and/or in these new markets.
We Face The Risk Of Fluctuations In Our Expenses And Other Costs That May Hurt Our Financial Results
Our expenses and other costs, such as operating, labor and marketing expenses, directly affect our earnings results. In light of the extremely competitive environment in which we operate, and because the size and scale of many of our competitors provide them with increased operational efficiencies, it is important that we are able to successfully manage our expenses. Many factors can influence the amount of our expenses, as well as how quickly they may increase. Our on-going investments in infrastructure, which may be necessary to maintain a competitive business, integrate newly-acquired businesses, and establish scalable operations, may increase our expenses. In addition, as our business develops, changes or expands, additional expenses can arise as a result of a reevaluation of business strategies, management of outsourced services, asset purchases, structural reorganization, compliance with new laws or regulations or the integration of newly acquired businesses. If we are unable to successfully manage our expenses, our financial results will be negatively affected.
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The Soundness of Other Financial Institutions Could Adversely Affect Us
Our ability to engage in routine funding transactions could be adversely affected by the stability and actions of other financial services institutions. Financial services institutions are interrelated as a result of trading, clearing, counterparty and other relationships. We have exposure to many different industries and counterparties, and we routinely execute transactions with counterparties in the financial services industry, including brokers and dealers, commercial banks, investment banks, mutual and hedge funds, and other institutional clients, resulting in a significant credit concentration with respect to the financial services industry overall. As a result, defaults by, or even rumors or questions about, one or more financial services institutions, or the financial services industry generally, have led to market-wide liquidity problems and could lead to losses or defaults by us or by other institutions.
Likewise, adverse developments affecting the overall strength and soundness of our competitors or the financial services industry as a whole could have a negative impact on perceptions about the strength and soundness of our business even if we are not subject to the same adverse developments. In addition, adverse developments with respect to third parties with whom we have important relationships also could negatively impact perceptions about us. These perceptions about us could cause our business to be negatively affected and exacerbate the other risks that we face.
Reputational Risk And Social Factors May Impact Our Results
Our ability to originate and maintain accounts is highly dependent upon the perceptions of consumer and commercial borrowers and deposit holders and other external perceptions of our business practices and/or our financial health. Adverse perceptions regarding our reputation in the consumer, commercial and funding markets could lead to difficulties in generating and maintaining accounts as well as in financing them. Particularly, negative perceptions regarding our reputation could lead to decreases in the levels of deposits that consumer and commercial customers and potential customers choose to maintain with us.
In addition, a variety of social factors may cause changes in borrowing activity, including credit card use, payment patterns and the rate of defaults by accountholders and borrowers domestically and internationally. These social factors include changes in consumer confidence levels, the public’s perception regarding consumer debt, including credit card use, and changing attitudes about the stigma of personal bankruptcy. If consumers develop negative attitudes about incurring debt or if consumption trends continue to decline, our business and financial results will be negatively affected.
We Face Intense Competition in All of Our Markets
We operate in a highly competitive environment, and we expect competitive conditions to continue to intensify. In such a competitive environment, we may lose entire accounts, or may lose account balances, to competing financial institutions, or find it more costly to maintain our existing customer base. Customer attrition from any or all of our lending products, together with any lowering of interest rates or fees that we might implement to retain customers, could reduce our revenues and therefore our earnings. Similarly, customer attrition from our deposit products, in addition to an increase in rates and/or services that we may offer to retain those deposits, may increase our expenses and therefore reduce our earnings. We expect that competition will continue to increase with respect to most of our products. Some of our competitors may be substantially larger than we are, which may give those competitors advantages, including a more diversified product and customer base, the ability to reach out to more customers and potential customers, operational efficiencies, more versatile technology platforms, broad-based local distribution capabilities, lower-cost funding, and larger existing branch networks. In addition, some of our competitors may not be subject to the same regulatory requirements or legislative scrutiny to which we are subject, which also could place us at a competitive disadvantage.
Fluctuations In Market Interest Rates Or The Capital Markets Could Adversely Affect Our Revenue And Expense, The Value Of Assets And Obligations, Our Cost Of Capital Or Our Liquidity
Like other financial institutions, our business may be sensitive to market interest rate movement and the performance of the financial markets. Changes in interest rates or in valuations in the debt or equity markets could directly impact us. First, we borrow money from other institutions and depositors, which we use to make loans to customers and invest in debt securities and other earning assets. We earn interest on these loans and assets and pay interest on the money we borrow from institutions and depositors. Fluctuations in interest rates, including changes in the relationship between short term rates and long term rates and in the relationship between our funding basis rate and our lending basis rate, may have negative impacts on our net interest income and therefore our earnings. In addition, interest rate fluctuations and competitor responses to those changes may effect the rate of customer pre-payments for mortgage, auto and other term loans and may affect the balances customers carry on their credit cards. These changes can reduce the overall yield on our earning asset portfolio. Changes in interest rates and competitor responses to these changes may also impact customer decisions to maintain balances in the deposit accounts they have with us. In addition, changes in valuations in the debt and equity markets could have a negative impact on the assets we hold in our investment portfolio. Finally, such market changes could also have a negative impact on the valuation of assets for which we provide servicing.
We assess our interest rate risk by estimating the effect on our earnings under various scenarios that differ based on assumptions about the direction and the magnitude of interest rate changes. We take risk mitigation actions based on those assessments. We face the risk that changes in interest rates could reduce our net interest income and our earnings in material amounts, especially if actual conditions turn out to be materially different than those we assumed.
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See Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Interest Rate Risk” for additional information.
The Company’s Business Could Be Negatively Affected If It Is Unable To Attract, Retain and Motivate Skilled Senior Leaders
The Company’s success depends, in large part, on its ability to retain key senior leaders, and competition for such senior leaders can be intense in most areas of the Company’s business. The executive compensation provisions of the proposed Wall Street Reform and Consumer Protection Act, and any further legislation or regulation restricting executive compensation, may limit the types of compensation arrangements that the Company may enter into with its most senior leaders and could have a negative impact on the Company’s ability to attract, retain and motivate such leaders in support of the Company’s long-term strategy. If we are unable to retain talented senior leadership, our business could be negatively affected.
Certain Of Our Businesses Are Subject To Increased Litigation Risks
Our credit card business is subject to increased litigation as a result of the structure of the credit card industry, and we face risks from the outcomes of such industry litigation. Substantial legal liability against the Company could have a material adverse financial effect or cause significant reputational harm to us, which could seriously harm our business. For a full description of the litigation risks that we face, see “Note 21 – Commitments, Contingencies and Guarantees”.
We Face Risks From Unpredictable Catastrophic Events
Despite our substantial business contingency plans, the impact from natural disasters and other catastrophic events, including terrorist attacks, may have a negative effect on our business and infrastructure, including our information technology systems. The impact of such events and other catastrophes on the overall economy may also adversely affect our financial condition and results of operations.
We Face Risks From The Use Of Estimates In Our Financial Statements
Pursuant to United States Generally Accepted Accounting Principles (“US GAAP”), we are required to use certain assumptions and estimates in preparing our financial statements, including in determining the fair value of certain assets and liabilities, among other items. If the assumptions or estimates underlying the Company’s financial statements are incorrect, the Company may experience unexpected material losses. For a discussion of how we use estimates in accordance with US GAAP, see “Note 1 – Significant Accounting Policies.”
| Item 1B. | Unresolved Staff Comments. |
None.
| Item 2. | Properties. |
Our corporate real estate portfolio is used to support our business segments. We own our 587,000 square foot headquarters building in McLean, Virginia which houses our executive offices and northern Virginia staff. We own approximately 316 acres of land in Goochland County, Virginia which contains nearly 1.2 million square feet of office space to house various business and staff groups. Additionally, we own 72 acres of land in Plano, Texas which includes nearly 450,000 square feet of office space to support our Auto Finance business and other functions.
Our Commercial and Consumer Banking segments utilize approximately 3.3 million square feet in owned properties and 5.2 million square feet in leased locations across the District of Columbia, Louisiana, New Jersey, Maryland, New York, Texas and Virginia for office and branch operations.
Our corporate real estate portfolio also includes leased or owned space totaling, in the aggregate, 2.7 million square feet in Richmond, Toronto, Melville, New York City and various other locations.
| Item 3. | Legal Proceedings. |
The information required by Item 3 is included in Item 8, “Financial Statements and Supplementary Data—Notes to the Consolidated Financial Statements—“Note 21-Commitments Contingencies and Guarantees”.
| Item 4. | Submission of Matters to a Vote of Security Holders. |
During the fourth quarter of our fiscal year ending December 31, 2009, no matters were submitted for a vote of our stockholders.
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PART II
| Item 5. | Market for Company’s Common Equity and Related Stockholder Matters. |
| (Dollars in thousands, except per share information) |
Total Number of Shares Purchased(1) |
Average Price Paid per Share |
Total Number of Shares Purchased as Part of Publicly Announced Plans(1) |
Maximum Amount That May Yet be Purchased Under the Plan or Program(1) | ||||||
| October 1-31, 2009 |
70 | $ | 39.35 | 0 | $ | 2,000,000 | ||||
| November 1-30, 2009 |
4,468 | 39.89 | 0 | $ | 2,000,000 | |||||
| December 1-31, 2009 |
204,784 | 38.63 | 0 | $ | 2,000,000 | |||||
| Total |
209,322 | 0 | ||||||||
| (1) | Shares purchased represent shares purchased and share swaps made in connection with stock option exercises and the withholding of shares to cover taxes on restricted stock lapses. The stock repurchase program is intended to comply with Rules 10b5-1(c) (1) (i) and 10b-18 of the Securities Exchange Act of 1934, as amended. See “Note 12 – Stock Plans” for further details. |
Cumulative Shareholder Return
The following graph compares cumulative total stockholder return on our common stock with the S&P Composite 500 Stock Index (“S&P 500 Index”) and an industry index, the S&P Financial Composite Index (“S&P 500 Financials Index”), for the period from December 31, 2004 to December 31, 2009. The graph assumes an initial investment of $100 in common stock of the specified securities. The cumulative returns include stock price appreciation and assume full reinvestment of dividends. The stock price performance on the graph below is not necessarily indicative of future performance.
| 2004 | 2005 | 2006 | 2007 | 2008 | 2009 | |||||||
| Capital One |
100.00 | 102.60 | 91.22 | 56.12 | 37.87 | 45.53 | ||||||
| S&P 500 Index |
100.00 | 103.00 | 117.03 | 121.16 | 74.53 | 92.01 | ||||||
| S&P 500 Financials Index |
100.00 | 103.72 | 120.49 | 95.37 | 41.06 | 47.14 | ||||||
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The remaining information required by Item 5 is included under the following:
| Item 1 | “Business—Overview” | Page 3 | ||
| Item 1 | “Business—Supervision and Regulation—Dividends and Transfers of Funds” | Page 8 | ||
| Item 7 | “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Market Risk Management” | Pages 77-79 | ||
| Item 7 | “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Capital” | Pages 80-81 | ||
| Item 7 | “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Dividend Policy” | Page 81 | ||
| Item 8 | “Financial Statements and Supplementary Data—Notes to the Consolidated Financial Statements” | Pages 94-169 | ||
| Item 8 | “Financial Statements and Supplementary Data—Selected Quarterly Financial Data” | Page 173 |
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| Item 6. | Selected Financial Data |
| (Dollars in millions, Except Per Share Data) |
2009(7) | 2008 | 2007 | 2006(3) | 2005(2) | Five Year Compound Growth Rate |
|||||||||||||||||
| Income Statement Data: |
|||||||||||||||||||||||
| Interest income |
$ | 10,664.6 | $ | 11,112.0 | $ | 11,078.1 | $ | 8,164.7 | $ | 5,726.9 | 13.24 | % | |||||||||||
| Interest expense |
2,967.5 | 3,963.3 | 4,548.3 | 3,073.3 | 2,046.6 | 7.71 | % | ||||||||||||||||
| Net interest income |
7,697.1 | 7,148.7 | 6,529.8 | 5,091.4 | 3,680.3 | 15.90 | % | ||||||||||||||||
| Provision for loan and lease losses |
4,230.1 | 5,101.0 | 2,636.5 | 1,476.4 | 1,491.1 | 23.19 | % | ||||||||||||||||
| Net interest income after provision for loan and lease losses |
3,467.0 | 2,047.7 | 3,893.3 | 3,615.0 | 2,189.2 | 9.63 | % | ||||||||||||||||
| Non-interest income |
5,286.2 | 6,744.0 | 8,054.2 | 7,001.0 | 6,358.1 | (3.63 | )% | ||||||||||||||||
| Restructuring expense |
119.4 | 134.5 | 138.2 | — | — | N/A | |||||||||||||||||
| Goodwill impairment charge(6) |
— | 810.9 | — | — | — | N/A | |||||||||||||||||
| Other non-interest expense |
7,297.7 | 7,264.7 | 7,939.8 | 6,943.6 | 5,718.3 | 5.00 | % | ||||||||||||||||
| Income before income taxes |
1,336.1 | 581.6 | 3,869.5 | 3,672.4 | 2,829.0 | (13.93 | )% | ||||||||||||||||
| Income taxes |
349.5 | 497.1 | 1,277.8 | 1,246.0 | 1,019.9 | (19.28 | )% | ||||||||||||||||
| Income from continuing operations, net of tax |
$ | 986.6 | $ | 84.5 | $ | 2,591.7 | $ | 2,426.4 | $ | 1,809.1 | (11.42 | )% | |||||||||||
| Loss from discontinued operations, net of tax(4) |
(102.8 | ) | (130.5 | ) | (1,021.4 | ) | (11.9 | ) | — | N/A | |||||||||||||
| Net income (loss) |
$ | 883.8 | $ | (46.0 | ) | $ | 1,570.3 | $ | 2,414.5 | $ | 1,809.1 | (13.35 | )% | ||||||||||
| Net income (loss) available to common shareholders(9) |
319.9 | (78.7 | ) | 1,570.3 | 2,414.5 | 1,809.1 | (29.29 | )% | |||||||||||||||
| Dividend payout ratio |
66.80 | % | 722.06 | % | 2.68 | % | 1.34 | % | 1.52 | % | 113.09 | % | |||||||||||
| Per Common Share: |
|||||||||||||||||||||||
| Basic earnings per common share: |
|||||||||||||||||||||||
| Income from continuing operations, net of tax |
$ | 0.99 | $ | 0.14 | $ | 6.64 | $ | 7.84 | $ | 6.98 | (32.34 | )% | |||||||||||
| Loss from discontinued operations, net of tax(4) |
(0.24 | ) | (0.35 | ) | (2.62 | ) | (0.04 | ) | — | N/A | |||||||||||||
| Net income (loss) per common share |
$ | 0.75 | $ | (0.21 | ) | $ | 4.02 | $ | 7.80 | $ | 6.98 | (35.99 | )% | ||||||||||
| Diluted earnings per common share: |
|||||||||||||||||||||||
| Income from continuing operations, net of tax |
$ | 0.98 | $ | 0.14 | $ | 6.55 | $ | 7.65 | $ | 6.73 | (31.98 | )% | |||||||||||
| Loss from discontinued operations, net of tax(4) |
(0.24 | ) | (0.35 | ) | (2.58 | ) | (0.03 | ) | — | N/A | |||||||||||||
| Net income (loss) per common share |
$ | 0.74 | $ | (0.21 | ) | $ | 3.97 | $ | 7.62 | $ | 6.73 | (35.70 | )% | ||||||||||
| Dividends paid per common share |
0.53 | 1.50 | 0.11 | 0.11 | 0.11 | 36.70 | % | ||||||||||||||||
| Book value as of year-end |
59.04 | 68.38 | 65.18 | 61.56 | 46.97 | 4.68 | % | ||||||||||||||||
| Selected Year-End Reported Balances(1) : |
|||||||||||||||||||||||
| Loans held for investment |
$ | 90,619.0 | $ | 101,017.8 | $ | 101,805.0 | $ | 96,512.1 | $ | 59,847.7 | 8.65 | % | |||||||||||
| Allowance for loan and lease losses |
4,127.4 | 4,524.0 | 2,963.0 | 2,180.0 | 1,790.0 | 18.19 | % | ||||||||||||||||
| Total assets |
169,622.5 | 165,878.4 | 150,499.1 | 144,360.8 | 88,701.4 | 13.84 | % | ||||||||||||||||
| Interest-bearing deposits |
102,370.4 | 97,326.9 | 71,714.6 | 73,913.9 | 43,092.1 | 18.89 | % | ||||||||||||||||
| Total deposits |
115,809.1 | 108,620.8 | 82,761.2 | 85,562.0 | 47,933.3 | 19.29 | % | ||||||||||||||||
| Borrowings |
20,994.7 | 23,159.9 | 37,491.2 | 29,876.8 | 22,278.1 | (1.18 | )% | ||||||||||||||||
| Stockholders’ equity |
26,589.4 | 26,612.4 | 24,294.1 | 25,235.2 | 14,128.9 | 13.48 | % | ||||||||||||||||
| Selected Average Reported Balances(1): |
|||||||||||||||||||||||
| Loans held for investment |
$ | 99,787.3 | $ | 98,970.9 | $ | 93,541.8 | $ | 63,577.3 | $ | 40,734.2 | 19.63 | % | |||||||||||
| Allowance for loan and lease losses |
4,470.2 | 3,266.8 | 2,182.7 | 1,791.2 | 1,482.9 | 24.69 | % | ||||||||||||||||
| Average earning assets |
145,293.0 | 133,083.6 | 121,420.4 | 84,086.7 | 55,537.0 | 21.21 | % | ||||||||||||||||
| Total assets |
171,573.6 | 156,226.4 | 144,999.1 | 95,254.7 | 61,360.5 | 22.83 | % | ||||||||||||||||
| Interest-bearing deposits |
103,078.2 | 82,735.6 | 73,764.9 | 45,592.4 | 28,370.7 | 29.44 | % | ||||||||||||||||
| Total deposits |
115,600.7 | 93,507.6 | 85,211.6 | 50,526.8 | 29,019.7 | 31.84 | % | ||||||||||||||||
| Borrowings |
23,504.9 | 31,096.5 | 30,101.5 | 24,451.7 | 18,031.9 | 5.44 | % | ||||||||||||||||
| Stockholders’ equity |
26,605.7 | 25,277.8 | 25,203.1 | 16,203.4 | 10,594.3 | 20.22 | % | ||||||||||||||||
| Reported Metrics(1): |
|||||||||||||||||||||||
| Revenue margin |
8.94 | % | 10.44 | % | 12.01 | % | 14.38 | % | 18.08 | % | (13.14 | )% | |||||||||||
| Net interest margin |
5.30 | % | 5.37 | % | 5.38 | % | 6.05 | % | 6.63 | % | (4.38 | )% | |||||||||||
| Risk adjusted margin |
5.79 | % | 7.83 | % | 10.40 | % | 12.71 | % | 15.47 | % | (17.84 | )% | |||||||||||
| Delinquency rate |
4.13 | % | 4.37 | % | 3.66 | % | 2.74 | % | 3.14 | % | 5.63 | % | |||||||||||
| Net charge-off rate |
4.58 | % | 3.51 | % | 2.10 | % | 2.21 | % | 3.55 | % | 5.23 | % | |||||||||||
| Return on average assets |
0.58 | % | 0.05 | % | 1.79 | % | 2.55 | % | 2.95 | % | (27.77 | )% | |||||||||||
| Return on average equity |
3.71 | % | 0.33 | % | 10.28 | % | 14.97 | % | 17.08 | % | (26.32 | )% | |||||||||||
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| (Dollars in millions, Except Per Share Data) |
2009(7) | 2008 | 2007 | 2006(3) | 2005(2) | Five Year Compound Growth Rate |
|||||||||||||||||
| Average equity to average assets |
15.51 | % | 16.18 | % | 17.38 | % | 17.01 | % | 17.27 | % | (2.13 | )% | |||||||||||
| Non-interest expense as a % of average loans held for investment(5) |
7.43 | % | 7.48 | % | 8.64 | % | 10.92 | % | 14.04 | % | (11.95 | )% | |||||||||||
| Efficiency ratio(5) |
56.21 | % | 52.29 | % | 54.44 | % | 57.42 | % | 56.96 | % | (0.26 | )% | |||||||||||
| Allowance as a % of loans held for investment |
4.55 | % | 4.48 | % | 2.91 | % | 2.26 | % | 2.99 | % | 8.76 | % | |||||||||||
| Managed Metrics(1) (8): |
|||||||||||||||||||||||
| Revenue margin |
9.05 | % | 9.39 | % | 9.85 | % | 10.66 | % | 12.45 | % | (6.18 | )% | |||||||||||
| Net interest margin |
6.50 | % | 6.37 | % | 6.46 | % | 6.88 | % | 7.80 | % | (3.58 | )% | |||||||||||
| Risk adjusted margin |
4.53 | % | 5.81 | % | 7.40 | % | 8.23 | % | 8.76 | % | (12.36 | )% | |||||||||||
| Delinquency rate |
4.73 | % | 4.49 | % | 3.87 | % | 3.02 | % | 3.24 | % | 7.86 | % | |||||||||||
| Net charge-off rate |
5.87 | % | 4.35 | % | 2.88 | % | 2.84 | % | 4.25 | % | 6.67 | % | |||||||||||
| Return on average assets |
0.46 | % | 0.04 | % | 1.33 | % | 1.70 | % | 1.72 | % | (23.19 | )% | |||||||||||
| Non-interest expense as a % of average loans held for investment(5) |
5.17 | % | 5.01 | % | 5.58 | % | 6.24 | % | 6.71 | % | (5.08 | )% | |||||||||||
| Efficiency ratio(5) |
43.35 | % | 43.14 | % | 47.30 | % | 50.17 | % | 46.81 | % | (1.52 | )% | |||||||||||
| Average loans held for investment |
$ | 143,514.4 | $ | 147,812.3 | $ | 144,727.0 | $ | 111,328.6 | $ | 85,265.0 | 10.97 | % | |||||||||||
| Average earning assets |
$ | 185,958.7 | $ | 179,348.1 | $ | 170,496.1 | $ | 129,812.8 | $ | 98,097.2 | 13.65 | % | |||||||||||
| Year-end loans held for investment |
$ | 136,802.9 | $ | 146,936.8 | $ | 151,362.4 | $ | 146,151.3 | $ | 105,527.5 | 5.33 | % | |||||||||||
| Year-end total loan accounts |
37.8 | 45.4 | 49.1 | 50.0 | 49.7 | (5.33 | )% | ||||||||||||||||
| (1) | Based on continuing operations. |
| (2) | On November 16, 2005, the Company acquired 100% of the outstanding common stock of Hibernia Corporation for total consideration of $5.0 billion. |
| (3) | On December 1, 2006, the Company acquired 100% of the outstanding common stock of North Fork Bancorporation for total consideration of $13.2 billion. |
| (4) | Discontinued operations related to the shutdown of mortgage origination operations of GreenPoint Mortgage’s (“GreenPoint”) wholesale mortgage banking unit in 2007. |
| (5) | Excludes restructuring expenses and goodwill impairment charges. |
| (6) | In 2008 the Company recorded impairment of goodwill in its Auto Finance business of $810.9 million. |
| (7) | Effective February 27, 2009 the Company acquired Chevy Chase Bank, FSB for $475.9 million, which included a cash payment of $445.0 million and an issuance of 2.6 million shares valued at $30.9 million. |
| (8) | The Company’s “managed” consolidated financial statements reflect adjustments made related to effects of securitization transactions qualifying as sales under GAAP. Refer to Section “IV Reconciliation to GAAP Financial Measures and “Managed” View Information” for additional information. |
| (9) | The 2009 and 2008 net income (loss) available to common shareholders reflects the impact of participating in the TARP program. Refer to “Note 13 – Shareholders’ Equity, Other Comprehensive Income and Earnings per Common Share” for further details. |
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| Item 7. | Management’s Discussion and Analysis of Financial Condition and Results of Operations |
I. Introduction
Capital One Financial Corporation (the “Corporation”) is a diversified financial services company whose banking and non-banking subsidiaries market a variety of financial products and services. The Corporation’s principal subsidiaries are:
| • | Capital One Bank, (USA), National Association (“COBNA”) which currently offers credit and debit card products, other lending products and deposit products. |
| • | Capital One, National Association (“CONA”) which offers a broad spectrum of banking products and financial services to consumers, small businesses and commercial clients. |
The Company continues to deliver on its strategy of combining the power of national scale lending and local scale banking. As of December 31, 2009, the Company had $115.8 billion in deposits and $136.8 billion in managed loans outstanding.
The Company’s earnings 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 the Company’s profitability.
The Company’s primary expenses are the costs of funding assets, 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.
On February 27, 2009, the Corporation acquired Chevy Chase Bank for $475.9 million comprised of cash of $445.0 million and 2.56 million shares of common stock valued at $30.9 million. Chevy Chase Bank has the largest retail branch presence in the Washington D.C. region. See “Note 2 – Acquisition of Chevy Chase Bank” for further details. On July 30, 2009 the Company merged Chevy Chase Bank with and into CONA, which is primarily regulated by the Office of the Comptroller of the Currency.
During the third quarter of 2009, the Company realigned its business segment reporting structure to better reflect the manner in which the performance of the Company’s operations is evaluated. The Company now reports the results of its business through three operating segments: Credit Card, Commercial Banking and Consumer Banking.
Segment results where presented have been recast for all periods presented. The three segments consist of the following:
| • | Credit Card includes the Company’s domestic consumer and small business card lending, domestic national small business lending, national closed end installment lending and the international card lending businesses in Canada and the United Kingdom. |
| • | Commercial Banking includes the Company’s lending, deposit gathering and treasury management services to commercial real estate and middle market customers. The Commercial segment also includes the financial results of a national portfolio of small ticket commercial real estate loans that are in run-off mode. |
| • | Consumer Banking includes the Company’s branch based lending and deposit gathering activities for small business customers as well as its branch based consumer deposit gathering and lending activities, national deposit gathering, consumer mortgage lending and servicing activities and national automobile lending. |
The segment reorganization includes the allocation of Chevy Chase Bank to the appropriate segments. Chevy Chase Bank’s operations are included in Commercial Banking and Consumer Banking beginning in the second quarter, but remained in Other for the first quarter due to the timing of close on the transaction. The Other category includes GreenPoint originated consumer mortgages originated for sale but held for investment since originations were suspended in 2007, the results of corporate treasury activities, including asset-liability management and the investment portfolio, the net impact of transfer pricing, brokered deposits, certain unallocated expenses, gains/losses related to the securitization of assets, and restructuring charges related to the Company’s cost initiative and Chevy Chase Bank acquisition.
II. Critical Accounting Estimates
The Notes to the Consolidated Financial Statements contain a summary of the Company’s significant accounting policies, including a discussion of recently issued accounting pronouncements. Several of these policies are considered to be more critical to the portrayal of the Company’s financial condition and results of operations, since they require management to make difficult, complex or subjective judgments, some of which may relate to matters that are inherently uncertain. Areas with significant judgment and/or estimates or that are materially dependent on management judgment include: fair value measurements including assessments of other-than-temporary impairments of securities available for sale; determination of the level of allowance for loan and lease losses;
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valuation of goodwill and other intangibles; finance charge, interest and fee revenue recognition; valuation of mortgage servicing rights; valuation of representation and warranty reserves; valuation of retained interests from securitization transactions; recognition of customer reward liability; treatment of derivative instruments and hedging activities; and accounting for income taxes.
Additional information about accounting policies can be found in Item 8 “Financial Statements and Supplementary Data—Notes to the Consolidated Financial Statements—“Note 1—Significant Accounting Policies”.”
During the second quarter of 2009, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards SFAS No. 168, The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles—a replacement of FASB Statement No. 162 (“ASC 105-10-65/SFAS 168”). This standard establishes the Accounting Standards Codification for the FASB (“Codification” or “ASC”) as the single source of authoritative U.S. GAAP. The Codification does not change GAAP, but rather how the guidance is organized and presented to users. Effective July 1, 2009, changes to the source of authoritative U.S. GAAP are communicated through an Accounting Standards Update (“ASU”). ASUs will be published for all authoritative U.S. GAAP promulgated by the FASB, regardless of the form in which such guidance may have been issued prior to release of the FASB Codification (e.g., FASB Statements, EITF Abstracts, FASB Staff Positions, etc.). ASUs also will be issued for amendments to the SEC content in the FASB Codification as well as for editorial changes. Subsequently, the Codification will require companies to change how they reference GAAP throughout the financial statements. The Company adopted the Codification for the year ended December 31, 2009 and has provided the pre-Codification references along with the related ASC references to allow readers an opportunity to see the impact of the Codification on our financial statements and disclosures.
Fair Value Measurements
Certain financial instruments are reported under generally accepted accounting principles, or GAAP, at fair value. The estimated fair value of other financial instruments not recorded at fair value must be disclosed. Securities available for sale, derivatives, mortgage servicing rights and retained interest in securitizations are financial instruments recorded at fair value on a recurring basis. Additionally, from time to time, we may be required to record at fair value other financial instruments on a nonrecurring basis, such as loans held for investment and mortgage loans held for sale. We include in “Note 9—Fair Value of Assets and Liabilities” information about the extent to which fair value is used to measure assets and liabilities, the valuation methodologies used and impact to earnings. Additionally, for financial instruments not recorded at fair value we disclose the estimate of their fair value.
Effective January 1, 2008, the Company adopted “SFAS” No. 157, Fair Value Measurements (“ASC 820-10/SFAS 157”) for all financial assets and liabilities and for nonfinancial assets and liabilities measured at fair value on a recurring basis. ASC 820-10/SFAS 157 defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. ASC 820-10/SFAS 157 also establishes a fair value hierarchy which prioritizes the valuation inputs into three broad levels. Based on the underlying inputs, each fair value measurement in its entirety is reported in one of the three levels. These levels are:
| • | Level 1 – Valuation is based upon quoted prices for identical instruments traded in active markets. Level 1 assets and liabilities include debt and equity securities traded in an active exchange market, as well as U.S. Treasury securities. |
| • | Level 2 – Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model based valuation techniques for which all significant assumptions are observable in the market or can be corroborated by observable market data for substantially the full term of the assets or liabilities. |
| • | Level 3 – Valuation is determined using model-based techniques with significant assumptions not observable in the market. These unobservable assumptions reflect the Company’s own estimates of assumptions that market participants would use in pricing the asset or liability. Valuation techniques include the use of third party pricing services, option pricing models, discounted cash flow models and similar techniques. |
ASC 820-10/SFAS 157 requires that valuation techniques maximize the use of observable inputs and minimize the use of unobservable inputs. When available, we use quoted market prices to measure fair value. If market prices are not available, fair value measurement is based upon models that use primarily market-based or independently-sourced market parameters, including interest rate yield curves, prepayment speeds, option volatilities and currency rates. When market observable inputs for model-based valuation techniques may not be readily available, we are required to make judgments about assumptions market participants would use in estimating the fair value of the financial instrument.
The extent of management judgment involved in measuring the fair value of financial instruments is dependent upon the availability of quoted prices or observable market data. For financial instruments that have quoted prices in active markets or whose fair value is measured using data observable in the market, there is minimal management judgment involved in measuring fair value. When quoted prices or observable market data is not fully available, management judgment is necessary to estimate fair value. In addition, changes
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in market conditions may reduce the availability of quoted prices or observable market data. For example, an increase in dislocation and corresponding decrease in new issuance and trading volumes could result in observable market data becoming unavailable. When market data is not available, we use valuation techniques with assumptions that management believes other market participants would also use to estimate fair value.
Effective January 1, 2008, the Company adopted SFAS No. 159, The Fair Value Option for Financial Assets and Liabilities (“ASC 825-10/SFAS 159”). ASC 825-10/SFAS 159 permits entities to choose to measure many financial instruments and certain other items at fair value with changes in fair value included in current earnings. The election is made on specified election dates, can be made on an instrument by instrument basis, and is irrevocable. The initial adoption of ASC 825-10/SFAS 159 did not have a material impact on the consolidated earnings and financial position of the Company.
The acquisition of Chevy Chase Bank is accounted for under the acquisition method of accounting following the provisions of ASC 805-10/SFAS No. 141(R), which requires an acquirer to recognize the assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree at the acquisition date, at their fair values as of that date, with limited exceptions, thereby replacing SFAS 141’s cost-allocation process. See “Note 2 – Acquisition of Chevy Chase Bank” for further discussion of this acquisition.
Impairment for Securities Available for Sale
The Company performs an other-than-temporary impairment analysis to determine whether it should recognize a loss in earnings when investments in its available for sale securities are impaired, which occurs when the fair value of an investment is less than its amortized cost basis. The Company selects securities for its analysis based on the period of time a security has been in an unrealized loss position, the credit rating of the security, the extent to which amortized cost exceeds fair value, and current market conditions, among other considerations. The Company also considers any intent to sell a security in an unrealized loss position and the likelihood it will be required to sell a security before its anticipated recovery. In the analysis of the selected securities, the Company determines its best estimate of the present value of cash flows expected to be collected for each security. If that value is less than the amortized cost basis of the security, a loss exists and an other than temporary impairment is considered to have occurred. Credit related impairment is recognized in earnings and impairment due to all other factors is recognized in other comprehensive income.
Determination of Allowance for Loan and Lease Losses
The allowance for loan and lease losses is maintained at an amount estimated to be sufficient to absorb losses, net of principal recoveries (including recovery of collateral), inherent in the existing reported loan portfolios. The provision for loan and lease losses is the periodic cost of maintaining an adequate allowance.
The amount of allowance necessary is based on distinct allowance methodologies depending on the type of loan. Allowance methodologies for consumer loans such as credit card, automobile loans and mortgages are primarily based upon delinquency migration analysis, forecasted forward loss curves and historical loss trends. The methodology for credit cards includes estimated recoveries, while methodologies for automobile loans and mortgages consider estimated collateral values. Allowance methodologies for commercial loans are largely based upon specifically identified criticized loans, trends in criticized loans, estimated collateral values, and recent historical loss trends.
In evaluating the sufficiency of the allowance for loan and lease losses, management takes into consideration many factors including, but not limited to, recent trends in delinquencies and charge-offs including bankruptcy, deceased and recovered amounts, economic conditions, the value of collateral securing the loans, legal and regulatory guidance, credit evaluation and underwriting policies, seasonality, the degree of assumed risk inherent in the portfolio, and uncertainties in the Company’s forecasting and modeling. In particular, unemployment rates, housing prices and the valuation of commercial properties, consumer real estate, and automobiles are factors which significantly impact the allowance for loan and lease losses. Management examines a variety of externally available data as well as the Company’s recent experience in the consideration of these factors. See “Table 17—Summary of Allowance for Loan and Lease Losses” for additional detail on activity in the allowance.
The evaluation process for determining the adequacy of the allowance for loan and lease losses and the periodic provisioning for estimated losses is undertaken on a quarterly basis, unless conditions arise that would require more frequent evaluation. Conditions giving rise to such action could be business combinations or other acquisitions or dispositions of large quantities of loans, dispositions of non-performing and marginally performing loans by bulk sale or any development which may indicate a significant trend not currently contemplated in the allowance methodology.
Commercial and small business loans are considered to be impaired in accordance with the provisions of SFAS No. 114, Accounting by Creditors for Impairment of a Loan, (“ASC 310-10/SFAS 114”) when it is probable that all amounts due in accordance with the contractual terms will not be collected. Specific allowances are determined in accordance with ASC 310-10/SFAS 114. Impairment is measured based on the present value of the loan’s expected cash flows, the loan’s observable market price or the fair value of the loan’s collateral.
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For purposes of determining impairment, consumer loans are collectively evaluated as they are considered to be comprised of large groups of smaller-balance homogeneous loans and therefore are not individually evaluated for impairment under the provisions of ASC 310-10/SFAS 114.
Troubled debt restructurings (“TDR”) occur when the Company agrees to significantly modify the original terms of a loan due to the deterioration in the financial condition of the borrower. During 2009, the Company modified $279.6 million of loans that meet the requirements of a TDR. See “Table 16 – Loan Modifications and Restructurings” for additional details.
As of December 31, 2009 and 2008, the balance in the allowance for loan and lease losses was $4.1 billion and $4.5 billion, respectively. The loans acquired from Chevy Chase Bank were initially recorded at fair value with no separate valuation allowance recorded at the date of acquisition. Instead, the Company recorded net expected principal losses of approximately $2.2 billion as a component of the fair value adjustment for which actual losses will be applied. As long as expected cash flows and credit losses are consistent with the original net expected principal losses, an additional allowance will not be recorded and these assets will be considered performing. See “Table 19—Summary of Acquired Loans” for further details.
Valuation of Goodwill and Other Intangible Assets
As of December 31, 2009 and 2008, goodwill of $13.6 billion and $12.0 billion and net intangibles of $905.9 million and $862.3 million, respectively, were included in the Consolidated Balance Sheet. In connection with the acquisition of Chevy Chase Bank, an additional $1.6 billion of goodwill and $278.3 million of intangible assets were recorded. The goodwill related to Chevy Chase Bank was initially recorded in “Other” and then assigned to Commercial and Consumer Banking segments along with the operations of Chevy Chase Bank. See “Note 2 – Acquisition of Chevy Chase Bank” and “Note 10—Goodwill and Other Intangible Assets” for further details.
Goodwill and other intangible assets, primarily core deposit intangibles, reflected on the Consolidated Balance Sheet arose from acquisitions accounted for under the purchase method. At the date of acquisition, the Company recorded the assets acquired and liabilities assumed at fair value. The excess of the cost of the acquired business over the fair value of the net assets acquired is recorded on the balance sheet as goodwill. The cost includes the consideration paid and all direct costs associated with the acquisition. Indirect costs relating to the acquisition were expensed when incurred.
Goodwill
During the third quarter of 2009, the Company realigned its business segment reporting structure to better reflect the manner in which the performance of the Company’s operations is evaluated. The Company now reports the results of its business through three operating segments: Credit Card, Commercial Banking and Consumer Banking. As a result, goodwill was reassigned to the new reporting units using a relative fair value allocation approach and an interim impairment test was performed at that time. All segment data, including goodwill allocation was restated into new segment presentation for all periods presented. As part of the segment reorganization, the goodwill associated with the Chevy Chase Bank acquisition was assigned to the Commercial Banking and Consumer Banking segments. See “Note 10—Goodwill and Other Intangible Assets” for additional information regarding the reallocation of goodwill.
In accordance with the requirements of SFAS No. 142, Goodwill and Other Intangible Assets, (“ASC 350-10/SFAS 142”), goodwill is not amortized but is tested for impairment at the reporting unit level, which is at the operating segment level or one level below an operating segment. Impairment is the condition that exists when the carrying amount of goodwill exceeds its implied fair value. Goodwill is required to be tested for impairment annually and between annual tests if events or circumstances change, such as adverse changes in the business climate, that would more likely than not reduce the fair value of the reporting unit below its carrying value. Goodwill is assigned to one or more reporting units at the date of acquisition. The Company’s reporting units are Domestic Card, International Card, Commercial Banking, Consumer Banking and Auto Finance, which is included in the consumer banking segment. The goodwill impairment test, performed at October 1 of each year, is a two-step test. The first step identifies whether there is potential impairment by comparing the fair value of a reporting unit to the carrying amount, including goodwill. If the fair value of a reporting unit is less than its carrying amount, the second step of the impairment test is required to measure the amount of any impairment loss.
For the 2009 annual impairment test, the fair value of reporting units was calculated using a discounted cash flow analysis, a form of the income approach, using each reporting unit’s internal forecast and a terminal value calculated using a growth rate reflecting the nominal growth rate of the economy as a whole and appropriate discount rates for the respective reporting units. Cash flows were adjusted as necessary in order to maintain each reporting unit’s equity capital requirements. Our discounted cash flow analysis required management to make judgments about future loan and deposit growth, revenue growth, credit losses, and capital rates. The cash flows were discounted to present value using reporting unit specific discount rates that are largely based on the Company’s external cost of equity with adjustments for risk inherent in each reporting unit. Discount rates used for the reporting units ranged from 10.0% to 14.3%. The key inputs into the discounted cash flow analysis were corroborated with market data, where available, indicating that assumptions used were within a reasonable range of observable market data.
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Based on the comparison of fair value to carrying amount, as calculated using the methodology summarized above, fair value exceeded carrying amount for all reporting units as of the Company’s annual testing date; therefore, the goodwill of those reporting units was considered not impaired, and the second step of impairment testing was unnecessary. However, if all others factors were held constant, a 30.36% decline in the fair value of the Domestic Card reporting unit, a 21.67% decline in the fair value the International Card reporting unit, a 16.72% decline in the fair value of the Auto reporting unit, a 18.98% decline in the fair value of the Commercial Banking reporting unit and a 28.43% decline in the fair value of the Consumer Banking reporting unit would have caused the carrying amount for those reporting units to be in excess of fair value which would require the second step to be performed.
As part of the annual impairment test, the Company assessed its market capitalization based on the prior month average market price relative to the aggregate fair value of its reporting units and determined that the excess fair value in its reporting units at that time could be attributed to a reasonable control premium. Throughout 2008 and early 2009, the lack of liquidity in the financial markets and the continued economic deterioration not only led to extreme volatility from period to period but also declines in market capitalization for many financial service institutions. This resulted in significantly higher control premiums then what was seen historically. The Company’s control premium has declined throughout the year and we will continue to regularly monitor our market capitalization in 2010, overall economic conditions and other events or circumstances that might result in an impairment of goodwill in the future.
Other Intangible Assets
Other intangible assets having finite useful lives are separately recognized and amortized over their estimated useful lives and reviewed for impairment. An impairment loss is recognized if the carrying amount of the intangible assets is not recoverable and its carrying amount exceeds its fair value. There were no impairment losses recognized for other intangible assets during the years ended December 31, 2009, 2008 and 2007. However, amortization of $234.6 million, $200.6 million and $235.1 million was recognized in 2009, 2008, and 2007, respectively.
Revenue Recognition
The Company earns revenue from various sources including lending, securities portfolio, customer deposits and loan servicing. We also earn revenue from selling loans and securities. Revenue is recognized as it is earned based on contractual terms, as the transactions occur or services are provided and collectibility is reasonably assured. For credit card loans, when the Company does not expect full payment of finance charges and fees, it does not accrue the estimated uncollectible portion as income (hereafter the “suppression amount”). To calculate the suppression amount, the Company first estimates the uncollectible portion of credit card finance charge and fee receivables using a formula based on an estimate of future non-principal losses. This formula is consistent with that used to estimate the allowance related to expected principal losses on reported loans. The suppression amount is calculated by adding any current period change in the estimate of the uncollectible portion of finance charge and fee receivables to the amount of finance charges and fees charged-off (net of recoveries) during the period. The Company subtracts the suppression amount from the total finance charges and fees billed during the period to arrive at total reported revenue.
The amount of finance charges and fees suppressed were $2.1 billion, $1.9 billion and $1.1 billion for the years ended December 31, 2009, 2008 and 2007, respectively.
Nonperforming Assets
Nonperforming assets include nonaccrual loans, impaired loans, foreclosed and repossessed assets and certain restructured loans on which interest rates or terms of repayment have been materially revised.
Commercial loans, consumer real estate and auto loans are placed in nonaccrual status at 90 days past due or sooner if, in management’s opinion, there is doubt concerning full collectibility of both principal and interest. All other consumer credit card loans and small business credit card loans are not placed in nonaccrual status prior to charge-off. For other consumer loans, the Company places the loans in a non-accrual status, which prevents the accrual of further interest income, when a loan reaches a pre-determined delinquency status, generally 90 to 120 days past due.
At the time a loan is placed on nonaccrual status, interest and fees accrued, but not collected and systematically reversed and charged against income. Interest payments received on nonaccrual loans are applied to principal if there is doubt as to the collectibility of the principal; otherwise, these receipts are recorded as interest income. A loan remains in nonaccrual status until it is current as to principal and interest and the borrower demonstrates the ability to fulfill the contractual obligation.
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Upon foreclosure or repossession, loans are adjusted, if necessary, to the estimated fair value of the underlying collateral and transferred to other assets, net of a valuation allowance for selling costs. We estimate market values primarily based on appraisals when available or quoted market prices on liquid assets.
Valuation of Mortgage Servicing Rights
Mortgage servicing rights (“MSRs”) are recognized at fair value when mortgage loans are sold in the secondary market and the right to service these loans is retained for a fee; changes in fair value are recognized in mortgage servicing and other income. The Company continues to operate the mortgage servicing business and to report the changes in the fair value of MSRs in continuing operations. To evaluate and measure fair value, the underlying loans are stratified based on certain risk characteristics, including loan type, note rate and investor servicing requirements. Fair value of the MSRs is determined using the present value of the estimated future cash flows of net servicing income. The Company uses assumptions in the valuation model that market participants use when estimating future net servicing income, including prepayment speeds, discount rates, default rates, cost to service, escrow account earnings, contractual servicing fee income, ancillary income and late fees. This model is highly sensitive to changes in certain assumptions. Different anticipated prepayment speeds, in particular, can result in substantial changes in the estimated fair value of MSRs. If actual prepayment experience differs from the anticipated rates used in the Company’s model, this difference could result in a material change in MSR value.
As of December 31, 2009 and 2008, the MSR balance was $239.7 million and $150.5 million, respectively. Included in the December 31, 2009 MSR balance is $109.5 million added by the acquisition of Chevy Chase Bank. In January 2010, the Company was notified by the insurer of certain Chevy Chase Bank mortgage securitization transactions that it will be removed as servicer of mortgage loans with an aggregate unpaid principal balance of $3.1 billion as of December 31, 2009. The fair value of mortgage servicing rights at December 31, 2009 reflects this expected loss of servicing.
Upon adoption of ASU 2009-16 (ASC 860/SFAS 166) and ASU 2009-17 (ASC 810/SFAS 167), certain mortgage loans that have been securitized and accounted for as a sale will be subject to consolidation and accounted for as a secured borrowing. Accordingly, effective January 1, 2010, mortgage securitization trusts that contain approximately $1.6 billion of mortgage loans and related debt securities issued to third party investors will be consolidated at their respective carrying values. The mortgage servicing rights related to these newly consolidated trusts will be eliminated in consolidation. See “Note 1- Significant Accounting Policies” for expected financial statement impacts and “Note 15—Mortgage Servicing Rights” for further information about the accounting for mortgage servicing rights.
Valuation of Representation and Warranty Reserve
The representation and warranty reserve is available to cover probable losses inherent with the sale of mortgage loans in the secondary market. In the normal course of business, certain of the Company’s subsidiaries certain originated residential mortgage loans and sold them to various purchasers. Most of these mortgage loans were resold to securitizations trusts and others. In connection with its sales, the Company’s subsidiaries entered into agreements containing representations and warranties about, among other things, the mortgage loans and the origination process. The Company’s subsidiaries may be required to repurchase the mortgage loans in the event of certain breaches of these representations and warranties. In the event of a repurchase, the subsidiary is typically required to pay the then unpaid principal balance of the loan together with interest and certain expenses (including, in certain cases, legal costs incurred by the purchaser and/or others), and the subsidiary recovers the underlying collateral. The subsidiary is exposed to any losses on the repurchased loans after giving effect to recoveries on the collateral. The subsidiary may also be required to indemnify certain purchasers and others against losses they incur in the event of breaches of representations and warranties and in various other circumstances, and the amount of such losses could exceed the repurchase amount of the related loans.
At December 31, 2009, the Company’s subsidiaries had open repurchase requests relating to approximately $966.2 million original principal balance of mortgage loans. The Company considers open requests to be requests with respect to specific mortgage loans received within the past 24 months that are in the process of being paid, are under review or have been denied by the subsidiary but not rescinded by the party requesting repurchase. Most of the open requests fall in this last category. In addition to the foregoing open repurchase requests, GreenPoint is also a defendant in a lawsuit seeking, among other things, to require it to repurchase an entire portfolio of approximately 30,000 GreenPoint mortgage loans within a certain securitization trust based on alleged breaches of representations and warranties relating to a limited sampling of loans in the portfolio. (See “Note 21—Commitments, Contingencies and Guarantees” for a discussion of the U.S. Bank litigation). GreenPoint has also received requests for indemnification in connection with a number of lawsuits in which GreenPoint is not a party, including both representation and warranty litigation and securities class actions brought on behalf of investors in securitization trusts that in the aggregate hold a significant principal balance of mortgage loans for which GreenPoint was identified as the originator. The Company believes that a significant number of mortgage loans at issue in the litigations referred to above as well as a significant number of mortgage loans sold by the subsidiaries as to which no repurchase or indemnification requests have been received are currently delinquent or already foreclosed on.
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The Company has established a reserve in its consolidated financial statements for potential losses that are considered to be both probable and reasonably estimable related to the mortgage loans sold by the subsidiaries. The adequacy of the reserve is evaluated on a quarterly basis and changes in the reserve are reported in non-interest income, except for changes in the reserve related to GreenPoint which are reported in discontinued operations. Factors considered in the evaluation process include the amount of open repurchase requests, including any repurchase requests for specifically identified loans subject to representation and warranty litigation against the Company or against others demanding indemnification, the estimated amount of additional repurchase requests to be received over the next 12 months (beyond which the Company does not believe that a reasonable assessment can be made) based on the historical relationship between mortgage loan performance and repurchase requests and the estimated level of future mortgage loan performance, litigation activity, the estimated success rate of claimants in pursuing requests, and the estimated recoveries on the underlying collateral. The Company expects that over the next 12 months both the delinquency rates on mortgage loans and the severity of losses on collateral recoveries will continue to be high. The reserve does not include amounts for the portfolio-wide repurchase claim relating to 30,000 loans with an aggregate original principal balance of $1.8 billion at issue in the U.S. Bank litigation (See “Note 21—Commitments, Contingencies and Guarantees” for a discussion of the U.S. Bank litigation) or for the indemnification requests with respect to securities class actions, in each case as referred to above because neither is sufficiently probable and estimable. As noted, the reserve does include amounts for repurchase requests for specifically identified loans (other than the portfolio-wide repurchase claim) at issue in the U.S. Bank litigation and for repurchase requests for specifically identified loans at issue in other representation and warranty litigation for which Company indemnification is sought.
The adequacy of the reserve and the ultimate amount of losses incurred will depend on, among other things, the actual future mortgage loan performance, the actual level of future repurchase and indemnification requests, the actual success rate of claimants, development in Company subsidiary and industry litigation, the Company subsidiaries’ actual recoveries on the collateral, and macroeconomic conditions (including unemployment levels and housing prices).
As of December 31, 2009, 2008 and 2007, the representation and warranty reserve was $238.4 million, $140.2 million and $93.4 million, respectively, of which $210.2 million, $122.2 million, and $84.5 million were attributable to the discontinued wholesale mortgage origination business of GreenPoint, respectively. The remainder of the representation and warranty claims relate to loans acquired from Chevy Chase Bank and those originated by Capital One Home Loans, LLC. More specifically, in connection with the acquisition of Chevy Chase, the Company established a reserve of $16 million for potential losses related to mortgage loans sold by Chevy Chase. The amount of the reserve for Chevy Chase’s potential losses was approximately proportional (based on the amount of loans sold by Chevy Chase) to the amount of the reserve established for mortgage loans sold by GreenPoint. To date, although it has received requests for information from an insurer of the securitization trusts that purchased some of the Chevy Chase mortgage loans, Chevy chase does not have any material repurchase or indemnification requests and is not subject to any litigation related to these loans.
Due to the uncertainties discussed above, the Company cannot reasonably estimate the total amount of losses that will actually be incurred as a result of repurchase and indemnification obligations, and there can be no assurance that the Company’s current reserves will be adequate or that the total amount of losses incurred will not have a material adverse effect upon the Company’s financial condition or results of operations.
Valuation of Retained Interests in Securitization Transactions
The Company’s retained residual interests in off-balance sheet securitizations are recorded in accounts receivable from securitizations and are comprised of interest-only strips, retained tranches, cash collateral accounts, cash reserve accounts and unpaid interest and fees on the investors’ portion of the transferred principal receivables.
The Company removes loan receivables from its Consolidated Balance Sheet and records a gain on sale for securitization transactions that qualify as sales (“off-balance sheet securitizations”). The gain is recorded net of transaction costs and is based on the estimated present value of the net income stream of the assets sold and assets retained or liabilities incurred. The related receivable is the interest-only strip, which is based on the present value of the estimated future cash flows from excess finance charges and past-due fees over the sum of the return paid to security holders, estimated contractual servicing fees and credit losses. Retained assets are recorded in accounts receivable from securitizations at estimated fair value. The Company’s retained residual interests are generally restricted or subordinated to investors’ interests and their value is subject to substantial credit, repayment and interest rate risks on transferred assets if the off-balance sheet receivables are not paid when due. As such, the interest-only strip and subordinated retained interests are classified as trading, and changes in the estimated fair value are recorded in servicing and securitization income. Additionally, the Company may retain senior tranches in the securitization transactions which are considered to be investment grade securities and subject to a lower risk of loss. These senior tranches are also recorded in accounts receivable from securitizations at estimated fair value. The Company classifies senior retained tranches as available for sale securities and related changes in the estimated fair value are recorded in other comprehensive income.
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The fair value of retained interest is highly sensitive to changes in certain assumptions. To the extent assumptions used by management do not prevail, the estimated fair value of retained interests could be materially impacted.
As of December 31, 2009 and 2008, accounts receivable from securitization totaled $7.6 billion and $6.3 billion, respectively. This balance consists of retained residual interests that are recorded at estimated fair value and totaled $4.0 billion and $2.3 billion at December 31, 2009 and 2008, respectively. The remaining balance relates to cash collections held at financial institutions that are expected to be returned to the Company on future distribution dates and principal collections accumulated for expected maturities of securitization transactions with a subsequent return of loans receivables.
As described above, the Company has accounted for loan securitization transactions as sales and accordingly, the transferred loans were removed from the consolidated financial statements as of and for the years ending December 31, 2009, 2008 and 2007. However, beginning January 1, 2010, the Company will consolidate certain securitization trusts pursuant to ASU 2009-17 (ASC 810/SFAS 167) and the securitization of loan receivables will be accounted for as a secured borrowing. The securitized loans and the corresponding debt securities issued to third party investors will be consolidated at their respective carrying values. The retained interests in securitized assets will be eliminated or reclassified, generally as loan receivables, accrued interest receivable or restricted cash, as appropriate. See “Note 1 – Significant Accounting Policies” for expected financial statement impact and “Note 20 – Securitizations” for further information about the accounting for securitized loans.
Recognition of Customer Rewards Liability
The Company offers products, primarily credit cards, that provide program members with various rewards such as airline tickets, free or deeply discounted products or cash rebates, based on account activity. The Company establishes a rewards liability based on points earned which are ultimately expected to be redeemed and the average cost per point redemption. As points are redeemed, the rewards liability is relieved. The cost of reward programs is primarily reflected as a reduction to interchange income. The rewards liability will be affected over time as a result of changes in the number of account holders in the reward programs, the actual amount of points earned and redeemed, the actual costs of the rewards, changes made by reward partners and changes that the Company may make to the reward programs in the future. To the extent assumptions used by management do not prevail, rewards costs could differ significantly, resulting in either a higher or lower future rewards liability, as applicable.
As of December 31, 2009 and 2008, the rewards liability was $1.3 billion and $1.4 billion, respectively.
Derivative Instruments and Hedging Activities
The Company utilizes certain derivative instruments to minimize significant unplanned fluctuations in earnings caused by interest rate and foreign exchange rate volatility. The Company’s goal is to manage sensitivity to changes in rates by offsetting the repricing or maturity characteristics of certain assets and liabilities, thereby limiting the impact on earnings. The use of derivative instruments does expose the Company to credit and market risk. The Company manages credit risk through strict counterparty credit risk limits and/or collateralization agreements. See “Note 19—Derivative Instruments and Hedging Activities” for additional information on derivatives and hedging.
At inception, the Company determines if a derivative instrument meets the criteria for hedge accounting. Ongoing effectiveness evaluations are made for instruments that are designated and qualify as hedges. If the derivative does not qualify for hedge accounting, no assessment of effectiveness is needed by management.
Accounting for Income Taxes
The Company accounts for income taxes in accordance with SFAS No. 109, Accounting for Income Taxes (“ASC 740-10/SFAS 109”), recognizing the current and deferred tax consequences of all transactions that have been recognized in the financial statements using the provisions of the enacted tax laws. Deferred tax assets and liabilities are determined based on differences between the financial reporting and tax basis of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. The Company adopted the provisions of FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an Interpretation of FASB Statement No. 109, (“ASC 740-10/FIN 48”) effective January 1, 2007.
The calculation of the Company’s income tax provision is complex and requires the use of estimates and judgments. When analyzing business strategies, the Company considers the tax laws and regulations that apply to the specific facts and circumstances for any transaction under evaluation. This analysis includes the amount and timing of the realization of income tax provisions or benefits. Management closely monitors tax developments in order to evaluate the effect they may have on its overall tax position and the estimates and judgments utilized in determining the income tax provision and records adjustments as necessary.
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The Company records valuation allowances to reduce deferred tax assets to the amount that is more likely than not to be realized. In making this assessment, management analyzes future taxable income, reversing temporary differences and ongoing tax planning strategies. Should a change in circumstances lead to a change in judgment about the ability to realize deferred tax assets in future years, the Company would adjust related valuation allowances in the period that the change in circumstances occurs, along with a corresponding increase or charge to income.
For the years ended December 31, 2009 and 2008, the provision for income taxes on continuing operations was $349.5 million and $497.1 million, respectively, and as of December 31, 2009 and 2008, the valuation allowance was $108.5 million and $67.7 million, respectively.
III. Off-Balance Sheet Arrangements
The Company is involved in various types of off-balance sheet arrangements in the ordinary course of business. Off-balance sheet activities typically utilize special purpose entities (“SPEs”) that may be in the form of limited liability companies, partnerships or trusts. The SPEs raise funds by issuing debt to third party investors. The SPEs hold various types of financial assets whose cash flows are the primary source of repayment for the liabilities of the SPE. Investors only have recourse to the assets held by the SPE but may also benefit from other credit enhancements. The Company’s involvement in these arrangements can take many different forms, including securitization activities, servicing activities, the purchase or sale of mortgage-backed and other asset backed securities in connection with our investment portfolio, and loans to variable interest entities (“VIEs”) that hold debt, equity, real estate or other assets. In certain instances, the Company also provides guarantees to VIEs or holders of variable interests in VIEs. See “Note 15 – Mortgage Servicing Rights”; “Note 20 – Securitizations”; “Note 21 – Commitments, Contingencies and Guarantees”; and “Note 22 – Other Variable Interest Entities” for further detail on the Company’s involvement and exposure related to off-balance sheet arrangements.
In June 2009, the FASB issued Statement of Financial Accounting Standards No. 166, An Amendment of FASB Statement No. 140 (“SFAS 166”) and Statement of Financial Accounting Standards No. 167, Amendments to FASB Interpretation No. 46(R) (“SFAS 167”). In December 2009, the FASB issued ASU No. 2009-16, Transfers and Servicing (Topic 860): Accounting for Transfers of Financial Assets (“ASU 2009-16”) and ASU No. 2009-17, Consolidations (Topic 810): Improvements to Financial Reporting by Enterprises Involved with Variable Interest Entities (“ASU 2009-17”), which provided amendments to various parts of SFAS 166 and SFAS 167.
ASU 2009-16 (Topic 860/SFAS 166) removes the concept of a qualifying special-purpose entity (“QSPE”) from SFAS 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities (“ASC 860-10/SFAS 140”) and removes the exception from applying FASB Interpretation No. 46, Consolidation of Variable Interest Entities (“ASC 810-10/FIN 46(R)”), to qualifying special-purpose entities. ASU 2009-17 (ASC 810/SFAS 167) eliminates the quantitative approach previously required for determining the primary beneficiary of a variable interest entity, which was based on determining which enterprise absorbs the majority of the entity’s expected losses, receives a majority of the entity’s expected residual returns, or both. Under ASU 2009-17 the primary beneficiary would be the entity that has (i) the power to direct the activities of a variable interest entity that most significantly impact the entity’s economic performance and (ii) the obligation to absorb losses of the entity that could potentially be significant to the VIE or the right to receive benefits from the entity that could potentially be significant to the VIE. ASU 2009-16 and ASU 2009-17 are effective for the Company’s annual reporting period beginning January 1, 2010.
Applying a qualitative assessment of control and with the elimination of the QSPE exemption, the Company will be required to consolidate certain securitization structures previously used in the transfer of loans which were accounted for as sales and treated as off-balance sheet loan securitizations. Additionally, certain VIE structures previously accounted for as investments in an unconsolidated entity or under the equity method of accounting are also subject to consolidation under the new requirements.
Effective January 1, 2010, the Company expects to record a $47.6 billion increase in loan receivables, a $4.3 billion increase in Allowance for Loan and Lease Losses related to the newly consolidated loans, a $44.9 billion increase in liabilities and a $3.0 billion reduction in stockholders’ equity. See “Note 1 – Significant Accounting Policies” for further details.
Special Purpose Entities
A special purpose entity (“SPE”) is an entity in the form of a trust or other legal vehicle designed to fulfill a specific limited need of the Company that was initially involved in the organization of the SPE. The primary use of SPEs is to obtain liquidity and favorable capital treatment by securitizing certain assets of the Company. In a securitization, a company transfers assets to an SPE and receives cash proceeds for the assets that have been transferred upon the issuance of debt and equity instruments, certificates or other notes of indebtedness. The transferred assets and the related debt issuances are recorded on the balance sheet of the SPE and are not reflected on the Company’s balance sheet. Investors usually have recourse to the assets in the SPE and may also benefit from other credit enhancements, such as a collateral account or over collateralization in the form of excess assets in the SPE, or from other liquidity guarantees. The SPE can typically obtain a more favorable credit rating from rating agencies than the transferor could obtain for its own debt issuances, resulting in less expensive financing costs. The SPE may also enter into derivative contracts in order to convert the yield or currency of the underlying assets to match the needs of the SPE investors, or to limit or change the credit risk of the SPE. The Company may be the provider of certain credit enhancements as well as the counterparty to any related derivative contracts.
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Qualifying SPEs
Qualifying special purpose entities (“QSPEs”) are a special class of SPEs which are defined in FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities (“ASC 860-10/SFAS 140”). These SPEs have significant limitations on the types of assets and derivative instruments they may own and may not actively manage their assets through discretional sales and are generally limited to making decisions inherent in servicing activities and issuance of liabilities. QSPEs are passive entities designed to purchase assets and pass through the cash flows from the transferred assets to the investors of the QSPE. QSPEs are generally exempt from consolidation by the transferor of assets to the QSPE and any investor or counterparty. As noted above, the Company will adopt ASU 2009-16 and ASU 2009-17 on January 1, 2010 which will have a significant impact on accounting for transfers of financials assets, due to elimination of the concept of a QSPE, and will change the criteria for determining whether to consolidate a VIE. As of December 31, 2009, the total assets of QSPEs to which the Company has transferred and received sales treatment were $46.2 billion.
Variable Interest Entities
VIEs are entities defined in ASC 810-10/FIN 46(R), and are entities that have either a total equity investment that is insufficient to permit the entity to finance its activities without additional subordinated financial support or whose equity investors lack the characteristics of a controlling financial interest (i.e., ability to make significant decisions through voting rights, right to receive the expected residual returns of the entity, and obligation to absorb the expected losses of the entity). Investors that finance the VIE through debt or equity interests, or other counterparties that provide other forms of support, such as guarantees, subordinated fee arrangements, or certain types of derivative contracts, are variable interest holders in the entity. The variable interest holder, if any, that will absorb a majority of the entity’s expected losses, receive a majority of the entity’s expected residual returns, or both, is deemed to be the primary beneficiary and must consolidate the VIE. Consolidation under ASC 810-10/FIN 46(R) is based on expected losses and residual returns, which consider various scenarios on a probability weighted basis. Consolidation of a VIE is determined based primarily on variability generated in scenarios that are considered most likely to occur, rather than based on scenarios that are considered more remote. Certain variable interests may absorb significant amounts of losses or residual returns contractually, but if those scenarios are considered very unlikely to occur, they may not lead to consolidation of the VIE. All these facts and circumstances are taken into consideration when determining whether the Company has variable interest that would deem it to be the primary beneficiary and require consolidation of the VIE or otherwise rise to the level where disclosure would provide useful information to the users of the Company’s financial statements. In some cases, it is qualitatively clear based on the extent of the Company’s involvement or the seniority of its investments that the Company is not the primary beneficiary of the VIE. In other cases, a more detailed and quantitative analysis may be required to make such a determination.
Securitization Activities
The securitization of loans has been a significant source of liquidity for the Company. The Company typically uses QSPEs to securitize its credit card loans. QSPEs are generally exempt from consolidation by the transferor of assets to the QSPE and any investor or counterparty.
Recourse Exposure
The Company retains residual interests in the trusts as credit enhancements to support the credit quality of the receivables transferred to the trust. The Company’s retained residual interests are generally restricted or subordinated to investors’ interests and their value is subject to substantial credit, repayment and interest rate risks on the transferred financial assets. The value of the retained residual interests represents the Company’s only exposure to loss resulting from its continuing involvement in the trusts. The investors and the trusts have no recourse to the Company’s assets if the off-balance sheet loans are not paid when due. The Company has not provided any financial or other support during the periods presented that it was not previously contractually required to provide. The Company’s retained residual interests in the off-balance sheet securitizations are recorded in accounts receivable from securitizations and are comprised of interest-only strips, retained senior tranches, retained subordinated interests, cash collateral accounts, cash reserve accounts and unpaid interest and fees on the investors’ portion of the transferred principal receivables. See “Note 20—Securitizations” for quantitative information regarding retained interests.
Collections and Amortization
Collections of interest and fees received on securitized receivables are used to pay interest to investors, servicing and other fees, and are available to absorb the investors’ share of credit losses. Amounts collected in excess of that needed to pay the above amounts are remitted, in general, to the Company. Under certain conditions, some of the cash collected may be retained in spread accounts to ensure future payments to investors. See “Note 20—Securitizations” for quantitative information regarding revenues, expenses and cash flows that arise from securitization transactions.
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Maturity terms of the existing securitizations vary from 2010 to 2025 and, for revolving securitizations, have accumulation periods during which principal payments are aggregated to make payments to investors. As payments on the loans are accumulated and are no longer reinvested in new loans, the Company’s funding requirements for loans increase accordingly. The Company believes that it has the ability to continue to utilize securitization arrangements as a source of liquidity; however, a significant reduction, termination or change in sale accounting for the Company’s off-balance sheet securitizations could require the Company to draw down existing liquidity and/or to obtain additional funding through the issuance or recognition of secured borrowings or unsecured debt, the raising of additional deposits or the slowing of asset growth to offset or to satisfy liquidity needs.
The amounts of investor principal from off-balance sheet loans as of December 31, 2009 that are expected to amortize into the Company’s loans, or be otherwise paid over the periods indicated, are summarized in “Table 28 – Contractual Funding Obligations”. Of the Company’s total managed loans, 34% and 31% were included in off-balance sheet securitizations for the years ended December 31, 2009 and 2008, respectively.
Servicing Activities
The Company services mortgage loans that have been sold through either whole loans sales or securitizations with servicing retained. MSRs, are recognized when mortgage loans are sold in the secondary market and the right to service these loans are retained for a fee, and are carried at fair value; changes in fair value are recognized in mortgage servicing and other. The Company enters into derivatives to economically hedge changes in fair value of MSRs. The Company typically does not have any continuing involvement other than its right to service the loans and the Company generally does not hold subordinate residual interests or enter into other guarantees or liquidity agreements with these structures. The Company did, however, obtain certain retained interest-only bonds, negative amortization bonds and other retained interests related to certain mortgage loan securitizations performed by Chevy Chase Bank as a result of the Chevy Chase Bank acquisition during 2009. The Company records the MSR at estimated fair value and has no other loss exposure over and above the recorded fair value. See “Note 15 – Mortgage Servicing Rights” for quantitative information regarding MSRs.
Community Development Activities
As part of its community reinvestment initiatives, the Company invests in private investment funds that make investments in common stock of VIEs or provide debt financing to VIEs to support multi-family affordable housing properties. The Company receives affordable housing tax credits for these investments. The activities of these entities are financed with a combination of invested equity capital and debt. The Company is not required to consolidate these entities because it does not absorb the majority of the entities’ expected losses nor does it receive a majority of the entities’ expected residual returns. The Company records its interests in these unconsolidated VIEs in loans held for investment, other assets and other liabilities. The Company’s maximum exposure to these entities is limited to its variable interests in the entities and the creditors of the VIEs have no recourse to the general credit of the Company. The Company has not provided additional financial or other support during the period that it was not previously contractually required to provide. See “Note 22—Other Variable Interest Entities” for quantitative information regarding Other Variable Interest Entities.
The Company holds variable interests in entities (“Investor Entities”) that invest in community development entities (“CDEs”) that provide debt financing to businesses and non-profit entities in low-income and rural communities. Investments of the consolidated Investor Entities are also variable interests of the Company. The activities of the Investor Entities are financed with a combination of invested equity capital and debt. The activities of the CDEs are financed solely with invested equity capital. The Company receives federal and state tax credits for these investments. The Company consolidates the VIEs of which it absorbs the majority of the entities’ expected losses or receives a majority of the entities’ expected residual returns. The assets of the entities consolidated by the Company at December 31, 2009 and December 31, 2008 were approximately $155.4 million and $135.7 million, respectively. The assets and liabilities of these consolidated VIEs were recorded in cash, loans held for investment, interest receivable, other assets and other liabilities. In addition to the amounts above, the Company had involvement with entities where we held a significant variable interest in the VIE but were not deemed to be the primary beneficiary as the Company would not absorb the majority of expected losses or receive a majority of the expected residual returns. Accordingly, these entities were not consolidated by the Company. The assets of the entities that the Company held a significant variable interest in but was not required to consolidate at December 31, 2009 and December 31, 2008 were approximately $58.4 million and $46.6 million, respectively. The Company records its interests in these unconsolidated VIEs in loans held for investment and other assets. The Company’s maximum exposure to these entities is limited to its variable interests in the entities. The creditors of the VIEs have no recourse to the general credit of the Company. The Company has not provided additional financial or other support during the period that it was not previously contractually required to provide. See “Note 22—Other Variable Interest Entities” for quantitative information regarding Other Variable Interest Entities.
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Trust Preferred Securities
The Company has raised financing through the issuance of trust preferred securities. In these transactions, the Company forms a statutory business trust and owns all of the voting equity shares of the trust. The trust issues preferred equity securities to third-party investors and invests the gross proceeds in junior subordinated deferrable interest debentures issued by the Company. These trusts have no assets, operations, revenues or cash flows other than those related to the issuance, administration, and repayment of the preferred equity securities held by third-party investors. These trusts’ obligations are fully and unconditionally guaranteed by the Company.
Because the sole asset of the trust is a receivable from the Company, the Company is not permitted to consolidate the trusts under ASC 810-10/FIN 46R, even though the Company owns all of the voting equity shares of the trust, has fully guaranteed the trusts’ obligations, and has the right to redeem the preferred securities in certain circumstances. The Company recognizes the subordinated debentures on its balance sheet as long-term liabilities. See “Note 11 – Deposits and Borrowings” for quantitative information regarding Deposits and Other Borrowings.
IV. Reconciliation to GAAP Financial Measures and “Managed” View Information
The Company’s consolidated financial statements prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) are referred to as its “reported” financial statements. Loans included in securitization transactions which qualify as sales under GAAP have been removed from the Company’s “reported” balance sheet. However, servicing fees, finance charges, and other fees, net of charge-offs, and interest paid to investors of securitizations are recognized as servicing and securitizations income on the “reported” income statement. The Company will adopt ASU 2009-16 (ASC 860/SFAS 166) and ASU 2009-17 (ASC 810/SFAS 167) for annual reporting periods beginning after January 1, 2010. As discussed more fully in Note 1 – Significant Accounting Policies, loans previously securitized by the Company and accounted for as sales will be consolidated in the Company’s financial statements. As a result, the Company does not anticipate that there will be a material difference between “reported” and “managed” financial statements in the future.
The Company’s “managed” consolidated financial statements reflect adjustments made related to effects of securitization transactions qualifying as sales under GAAP. The Company generates earnings from its “managed” loan portfolio which includes both the on-balance sheet loans and off-balance sheet loans. The Company’s “managed” income statement takes the components of the servicing and securitizations income generated from the securitized portfolio and distributes the revenue and expense to appropriate income statement line items from which it originated. For this reason, the Company believes the “managed” consolidated financial statements and related managed metrics to be useful to stakeholders.
Table 1: Managed View Reconciliation summarizes the difference between “reported” and “managed” views for certain income statement and balance sheet measures as of and for the years ended December 31, 2009, 2008 and 2007.
Table 1: Managed View Reconciliations
| As of December 31, 2009 | ||||||||||
| (Dollars in thousands) |
Total Reported | Securitization Adjustments(1) |
Total Managed(2) | |||||||
| Income Statement Measures(3) |
||||||||||
| Net interest income |
$ | 7,697,115 | $ | 4,392,380 | $ | 12,089,495 | ||||
| Non-interest income |
5,286,152 | (539,380 | ) | 4,746,772 | ||||||
| Total revenue |
$ | 12,983,267 | $ | 3,853,000 | $ | 16,836,267 | ||||
| Provision for loan losses |
4,230,111 | 3,853,000 | 8,083,111 | |||||||
| Net charge-offs |
4,567,634 | 3,853,000 | 8,420,634 | |||||||
| Balance Sheet Measures |
||||||||||
| Loans held for investment |
$ | 90,618,999 | $ | 46,183,903 | $ | 136,802,902 | ||||
| Total assets |
169,646,363 | 42,767,131 | 212,413,494 | |||||||
| Total liabilities |
143,056,953 | 42,767,131 | 185,824,084 | |||||||
| Average loans held for investment |
99,787,285 | 43,727,131 | 143,514,416 | |||||||
| Average earning assets |
145,310,458 | 40,665,701 | 185,976,159 | |||||||
| Average total assets |
171,597,613 | 41,059,675 | 212,657,288 | |||||||
| Average total liabilities |
144,991,937 | 41,059,675 | 186,051,612 | |||||||
| Delinquencies |
$ | 3,746,264 | $ | 2,718,894 | $ | 6,465,158 | ||||
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| As of December 31, 2009 | ||||||||
| (Dollars in thousands) |
Total Reported | Securitization Adjustments(1) |
Total Managed(2) | |||||
| Selected Company Metrics(3) |
||||||||
| Return on average assets |
0.58 | % | 0.46 | % | ||||
| Net charge-off rate |
4.58 | % | 5.87 | % | ||||
| 30+ day performing delinquency rate |
4.13 | % | 4.73 | % | ||||
| Net interest margin |
5.30 | % | 6.50 | % | ||||
| Revenue margin |
8.94 | % | 9.05 | % | ||||
| Risk adjusted margin |
5.79 | % | 4.53 | % | ||||
| (1) | Income statement adjustments for the year ended December 31, 2009 reclassify the finance charge of $4.9 billion, past due fees of $757.9 million, other interest income of $(173.9) million and interest expense of $1.1 billion; from non –interest income to net interest income. Net charge-offs of $3.9 billion are reclassified from non-interest income to net interest income to provision for loan losses. |
| (2) | The managed loan portfolio does not include automobile or mortgage loans which have been sold in whole loan sale transactions where the Company has retained servicing rights. |
| (3) | Based on continuing operations. |
| As of December 31, 2008 | ||||||||||||
| (Dollars in thousands) |
Total Reported | Securitization Adjustments(1) |
Total Managed(2) | |||||||||
| Income Statement Measures(3) |
||||||||||||
| Net interest income |
$ | 7,148,715 | $ | 4,273,340 | $ | 11,422,055 | ||||||
| Non-interest income |
6,743,971 | (1,326,573 | ) | 5,417,398 | ||||||||
| Total revenue |
$ | 13,892,686 | $ | 2,946,767 | $ | 16,839,453 | ||||||
| Provision for loan losses |
5,101,040 | 2,946,767 | 8,047,807 | |||||||||
| Net charge-offs |
3,478,171 | 2,946,767 | 6,424,938 | |||||||||
| Balance Sheet Measures |
||||||||||||
| Loans held for investment |
$ | 101,017,771 | $ | 45,918,983 | $ | 146,936,754 | ||||||
| Total assets |
165,913,452 | 43,961,156 | 209,874,608 | |||||||||
| Total liabilities |
139,301,019 | 43,961,156 | 183,262,175 | |||||||||
| Average loans held for investment |
98,970,903 | 48,841,363 | 147,812,266 | |||||||||
| Average earning assets |
133,122,964 | 46,264,456 | 179,387,420 | |||||||||
| Average total assets |
156,291,528 | 47,262,416 | 203,553,944 | |||||||||
| Average total liabilities |
131,013,698 | 47,262,416 | 178,276,114 | |||||||||
| Delinquencies |
$ | 4,417,823 | $ | 2,178,400 | $ | 6,596,223 | ||||||
| Selected Company Metrics(3) |
||||||||||||
| Return on average assets |
0.05 | % | 0.04 | % | ||||||||
| Net charge-off rate |
3.51 | % | 4.35 | % | ||||||||
| 30+ day performing delinquency rate |
4.37 | % | 4.49 | % | ||||||||
| Net interest margin |
5.37 | % | 6.37 | % | ||||||||
| Revenue margin |
10.44 | % | 9.39 | % | ||||||||
| Risk adjusted margin |
7.83 | % | 5.81 | % | ||||||||
| (1) | Income statement adjustments for the year ended December 31, 2008 reclassify the finance charge of $5.6 billion, past due fees of $933.6 million, other interest income of $(158.1) million and interest expense of $2.1 billion; from non – interest income to net interest income. Net charge-offs of $2.9 billion are reclassified from non-interest income to net interest income to provision for loan losses. |
| (2) | The managed loan portfolio does not include automobile or mortgage loans which have been sold in whole loan sale transactions where the Company has retained servicing rights. |
| (3) | Based on continuing operations. |
| As of December 31, 2007 | ||||||||||
| (Dollars in thousands) |
Total Reported | Securitization Adjustments(1) |
Total Managed(2) | |||||||
| Income Statement Measures(3) |
||||||||||
| Net interest income |
$ | 6,529,845 | $ | 4,489,905 | $ | 11,019,750 | ||||
| Non-interest income |
8,054,223 | (2,288,455 | ) | 5,765,768 | ||||||
| Total revenue |
$ | 14,584,068 | $ | 2,201,450 | $ | 16,785,518 | ||||
| Provision for loan losses |
2,636,502 | 2,201,450 | 4,837,952 | |||||||
| Net charge-offs |
1,960,545 | 2,201,450 | 4,161,995 | |||||||
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| As of December 31, 2007 | |||||||||||
| (Dollars in thousands) |
Total Reported | Securitization Adjustments(1) |
Total Managed(2) | ||||||||
| Balance Sheet Measures |
|||||||||||
| Loans held for investment |
$ | 101,805,027 | $ | 49,557,390 | $ | 151,362,417 | |||||
| Total assets |
150,590,369 | 48,706,677 | 199,297,046 | ||||||||
| Total liabilities |
126,296,257 | 48,706,677 | 175,002,934 | ||||||||
| Average loans held for investment |
93,836,760 | 51,185,182 | 145,021,942 | ||||||||
| Average earning assets |
124,426,473 | 49,075,710 | 173,502,183 | ||||||||
| Average total assets |
148,983,192 | 50,410,103 | 199,393,295 | ||||||||
| Average total liabilities |
123,780,056 | 50,411,179 | 174,191,235 | ||||||||
| Delinquencies |
$ | 3,721,444 | $ | 2,142,353 | $ | 5,863,797 | |||||
| Selected Company Metrics(3) |
|||||||||||
| Return on average assets |
1.79 | % | 1.33 | % | |||||||
| Net charge-off rate |
2.10 | % | 2.88 | % | |||||||
| 30+ day performing delinquency rate |
3.66 | % | 3.87 | % | |||||||
| Net interest margin |
5.38 | % | 6.46 | % | |||||||
| Revenue margin |
12.01 | % | 9.85 | % | |||||||
| Risk adjusted margin |
10.40 | % | 7.40 | % | |||||||
| (1) | Income statement adjustments for the year ended December 31, 2007 reclassify the finance charge of $6.3 billion, past due fees of $1.0 billion, other interest income of $(167.3) million and interest expense of $2.7 billion; from non –interest income to net interest income. Net charge-offs of $2.2 billion are reclassified from non-interest income to net interest income to provision for loan losses. |
| (2) | The managed loan portfolio does not include automobile or mortgage loans which have been sold in whole loan sale transactions where the Company has retained servicing rights. |
| (3) | Based on continuing operations. |
Managed Loan Portfolio Distribution provides summary data on the composition of the period end and average balances of the managed loan portfolio. The difference between managed and reported loans, both period end and average, relates to securitized domestic credit card loans that are accounted for as sales under GAAP.
Table 2: Managed Loan Portfolio Distribution
| As of December 31, | |||||||||
| (Dollars in thousands) |
2009 | 2008 | 2007 | ||||||
| Period end outstanding |
|||||||||
| Domestic credit card |
$ | 60,299,827 | $ | 70,944,581 | $ | 69,723,169 | |||
| International credit card |
8,223,835 | 8,720,642 | 11,656,922 | ||||||
| Total Credit Card |
68,523,662 | 79,665,223 | 81,380,091 | ||||||
| Commercial and multi-family real estate |
13,843,158 | 13,303,081 | 12,414,263 | ||||||
| Middle market |
10,061,819 | 10,081,823 | 8,288,476 | ||||||
| Specialty lending |
3,554,563 | 3,547,287 | 2,948,402 | ||||||
| Total Commercial Lending |
27,459,540 | 26,932,191 | 23,651,141 | ||||||
| Small ticket commercial real estate |
2,153,510 | 2,609,123 | 3,396,100 | ||||||
| Total Commercial Banking |
$ | 29,613,050 | $ | 29,541,314 | $ | 27,047,241 | |||
| Automobile |
18,186,064 | 21,494,436 | 25,128,352 | ||||||
| Mortgage |
14,893,187 | 10,098,430 | 11,561,533 | ||||||
| Other retail |
5,135,242 | 5,603,696 | 5,659,411 | ||||||
| Total Consumer Banking |
$ | 38,214,493 | $ | 37,196,562 | $ | 42,349,296 | |||
| Other loans |
451,697 | 533,655 | 585,789 | ||||||
| Total Company |
$ | 136,802,902 | $ | 146,936,754 | $ | 151,362,417 | |||
| Average outstandings |
|||||||||
| Domestic credit card |
$ | 64,670,269 | $ | 68,634,756 | $ | 66,774,914 | |||
| International credit card |
8,405,250 | 10,570,791 | 11,310,239 | ||||||
| Total Credit Card |
$ | 73,075,519 | $ | 79,208,971 | $ | 78,085,153 | |||
| Commercial and multi-family real estate |
13,857,522 | 12,829,870 | 11,905,715 | ||||||
| Middle market |
10,098,454 | 9,172,541 | 7,404,313 | ||||||
| Specialty lending |
3,566,693 | 3,595,866 | 2,923,702 | ||||||
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| As of December 31, | |||||||||
| (Dollars in thousands) |
2009 | 2008 | 2007 | ||||||
| Total Commercial Lending |
$ | 27,522,669 | $ | 25,598,277 | $ | 22,233,730 | |||
| Small ticket commercial real estate |
2,491,123 | 3,115,436 | 2,669,621 | ||||||
| Total Commercial Banking |
$ | 30,013,792 | $ | 28,713,713 | $ | 24,903,351 | |||
| Automobile |
19,950,123 | 23,490,015 | 24,150,217 | ||||||
| Mortgage |
14,434,281 | 10,406,251 | 11,805,524 | ||||||
| Other retail |
5,489,641 | 5,449,185 | 5,565,075 | ||||||
| Total Consumer Banking |
$ | 39,874,045 | $ | 39,345,451 | $ | 41,520,816 | |||
| Other loans |
551,060 | 544,131 | 217,687 | ||||||
| Total Company |
$ | 143,514,416 | $ | 147,812,266 | $ | 144,727,007 | |||
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V. Management Summary and Business Outlook
Management Summary
The following discussion provides a summary of 2009 results compared to 2008 results and 2008 results compared to 2007 results on a continuing operations basis, unless otherwise noted. Each component is discussed in further detail in subsequent sections of this analysis. The results of the Company’s mortgage origination operations of GreenPoint, which was acquired as part of the North Fork Bancorporation acquisition in December 2006 and discontinued in August 2007, are accounted for as discontinued operations.
Year Ended December 31, 2009 Compared to Year Ended December 31, 2008
The Company had net income of $883.8 million, or $0.74 per share (diluted) for the year ended December 31, 2009, compared to net loss of $46.0 million, or $(0.21) per share (diluted) for the year ended December 31, 2008. Net income for 2009 included an after-tax loss from discontinued operations of $102.8 million, or $(0.24) per share (diluted), compared to an after-tax loss from discontinued operations of $130.5 million, or $(0.35) per share (diluted) in 2008.
Income from continuing operations for 2009 was $986.6 million, an increase of $0.9 billion from $84.5 million in 2008. Diluted earnings per share from continuing operations for 2009 was $0.98, compared to $0.14 in 2008.
2009 Summary of Significant Events
U.S. Economic Recession and Credit Deterioration
The economic recession in the U.S. has continued to impact the Company in multiple ways. While the second half of 2009 began to show some positive signs, we have continued to see deterioration in credit performance across our loan portfolios. The Company continues to fortify its financial position for success once the recession begins to abate. The following demonstrates how the U.S. economic recession and credit deterioration, and the Company’s actions to respond to continued economic worsening, have impacted the Company:
| • | Managed charge-off rate increased and the managed delinquency rate increased by 152 basis points and 24 basis points, respectively, to 5.87% and 4.73%, respectively, |
| • | The allowance for loan and lease losses decreased by $396.6 million to $4.1 billion driven primarily by releases in Credit Card due to lower on balance sheet loans, a release in Auto Finance due to lower loan volume and improving credit trends, partially offset by increased reserves in Commercial and Mortgage Banking, |
| • | Decreased our provision for loan and lease losses by $870.9 million to $4.2 billion, primarily due to a 2008 allowance build of $1.6 billion versus a 2009 allowance release of 396.6 million, |
| • | Reduced the fair value of the retained interests in securitization by $160.7 million, |
| • | Revenue suppression, which is the amounts billed to customers but not recognized as revenue, increased to $2.1 billion from $1.9 billion, |
| • | Experienced a $10.1 billion reduction in managed loans held for investment, due to reduced demand for consumer loans, prior decisions to exit certain businesses and an increase in charge-offs despite the addition of loans acquired from the Chevy Chase Bank acquisition, |
| • | Deposits increased $7.2 billion with the acquisition of Chevy Chase Bank while being offset by the sale of the U.K. deposit business, |
| • | Our securities available for sale portfolio increased by $7.8 billion to $38.8 billion with the acquisition of Chevy Chase’s portfolio, and increased deposits and reduced investment in loan receivables which allows our continued investment in high-quality agency mortgage-backed and other highly rated securities. |
Chevy Chase Bank Acquisition
On February 27, 2009, the Company acquired all of the outstanding common stock of Chevy Chase Bank in exchange for Capital One common stock and cash with a total value of $475.9 million. This acquisition improves the Company’s core deposit funding base, increases readily available and committed liquidity, adds additional scale in bank operations, and brings a strong customer base in an attractive banking market. Under the terms of the stock purchase agreement, Chevy Chase Bank common shareholders received $445.0 million in cash and 2.56 million shares of Capital One common stock. In addition, to the extent that losses on certain of Chevy Chase Bank’s mortgage loans are less than the level reflected in the net expected principal losses estimated at the time the deal was signed, the Company will share a portion of the benefit with the former Chevy Chase Bank common shareholders (the “Earn-Out”). The maximum payment under the Earn-Out is $300.0 million and would occur after December 31, 2013. As of December 31, 2009, the Company has not recognized a liability nor does it expect to make any payments associated with the Earn-Out based on our expectations for credit losses on the acquired portfolio. Subsequent to the closing of the acquisition all of the outstanding shares of preferred stock of Chevy Chase Bank and the subordinated debt of its wholly-owned REIT subsidiary, were redeemed. Chevy Chase Bank’s results of operations are included in the Company’s results after the acquisition date of February 27, 2009.
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The purchase price was allocated to the acquired assets and liabilities based on their estimated fair values at the Chevy Chase Bank acquisition date. The initial goodwill of $1.1 billion was calculated as the purchase premium after adjusting for the fair value of net assets acquired and represents the value expected from the synergies created through the scale, operational and product enhancement benefits that will result from combining the operations of the two companies. During the remainder of 2009 subsequent to the acquisition, the Company continued the analysis of the fair values and purchase price allocation of Chevy Chase Bank’s assets and liabilities. The Company recorded an increase to goodwill of $510.9 million as a result. The change was predominantly related to changes in the timing of expected cash flows related to loans. In accordance with the ASC 350-20/SFAS 142, the decrease in the estimated fair value of loans as of the acquisition date was offset by an increase in goodwill. The Company has completed the analysis and considers goodwill to be final. Upon completion of the analysis, the Company recast previously presented information as if all adjustments to the purchase price allocation had occurred at the date of acquisition. The fair value of the non-controlling interest was calculated based on the redemption price of the interests, as well as any accrued but unpaid dividends. The shares of preferred stock of Chevy Chase Bank have been redeemed as noted above, and therefore, there is no longer a non-controlling interest.
Stress Test Results
On May 5, 2009, examiners from the Board of Governors of the Federal Reserve System, the Federal Reserve Bank of Richmond, the Office of the Comptroller of the Currency and representatives from other federal bank supervisors (together the “Supervisors”) delivered a report to the Company under the U.S. Department of the Treasury’s completed Supervisory Capital Assessment Program, also known as its “Stress Test.” In this report, the Supervisors provided the results of their estimates of the Company’s credit losses, resources available to absorb those losses and any necessary additions to capital under the “more adverse” Stress Test scenario. Resources available to absorb losses included the Company’s estimated pre-provision net revenues in 2009 and 2010, estimated loan loss allowance levels in 2009 and 2010, and existing capital resources. The Supervisors concluded that the Company did not need to raise any additional Tier 1 capital or Tier 1 common equity under the “more adverse” Stress Test scenario. It should be noted that this was a point in time analysis and changes in assumptions could negatively impact the results.
U.S. Treasury Department’s Capital Purchase Program
On June 17, 2009, the Company repurchased all 3,555,199 Series A Preferred Shares, at par. The total amount repurchased, including accrued dividends, was approximately $3.57 billion, compared to a book value of $3.1 billion. The difference represented unaccreted discount of $461.7 billion, which was recorded as a dividend in the second quarter of 2009, reducing income available to common shareholders. On December 11, 2009, the Warrants were sold by the U.S. Treasury for $11.75 per warrant. The sale by the U.S. Treasury had no impact on the Company’s equity and the Warrants remain outstanding and continue to be included in paid in capital.
FDIC Assessment
In June 2009, The Federal Deposit Insurance Corporation (“FDIC”) issued a rule that would impose a 5 basis point special assessment on a bank’s assets minus its Tier 1 capital as of June 30, 2009. The rule would also allow the FDIC to impose additional special assessments if it believes that the Deposit Insurance Fund reserve ratio will fall to a level that would adversely affect public confidence or would be close to or below zero. The special assessment was, and any future special assessment will be, capped at 10 basis points times a bank’s assessment base for the relevant quarter’s risk-based assessment. As a result, the Company recorded an expense of $80.5 million during 2009.
Sale of MasterCard Shares
During the second quarter of 2009, the Company recognized a gain of $65.5 million in other non-interest income from the sale of 404,508 shares of MasterCard class B common stock.
Equity Offering
On May 11, 2009, the Company raised approximately $1.5 billion in proceeds through the issuance of 56 million shares of common stock at $27.75 per share.
Debt Issuances
On May 19, 2009, the Company issued Senior Notes of $1.0 billion aggregate principal amount of non-guaranteed unsecured parent debt at 7.375% due May 23, 2014.
On June 18, 2009, COBNA issued $1.5 billion aggregate principal amount of 8.800% Subordinated Notes due July 15, 2019.
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On July 29, 2009, the Company issued $1.0 billion of trust preferred securities at a fixed rate of 10.25% due August 15, 2039.
On November 13, 2009, the Company issued $1.0 billion of trust preferred securities at a fixed rate of 8.875% due May 15, 2040.
Year Ended December 31, 2008 Compared to Year Ended December 31, 2007
The Company had a net loss of $46.0 million, or $(0.21) per share (diluted) for the year ended December 31, 2008, compared to net income of $1.6 billion, or $3.97 per share (diluted) for the year ended December 31, 2007. The net loss for 2008 included an after-tax loss from discontinued operations of $130.5 million, or $(0.35) per share (diluted), compared to an after-tax loss from discontinued operations of $1.0 billion, or $(2.58) per share (diluted) in 2007.
Income from continuing operations for 2008 was $84.5 million, a decrease of $2.5 billion, or 96.7% from $2.6 billion in 2007. Diluted earnings per share from continuing operations for 2008 was $0.14, a decrease of 97.9% from $6.55 in 2007.
2008 Summary of Significant Events
U.S. Economic Recession and Credit Deterioration
The U.S. economic recession has impacted the Company in multiple ways during the year. Most notably we have seen significant deterioration in credit performance. As the recession deepened, the Company responded by fortifying its balance sheet, exiting the riskiest areas we operated in and reducing costs as appropriate. The following demonstrates how the U.S. economic recession and credit deterioration, and the Company’s actions to anticipate and respond to economic worsening, have impacted the Company:
| • | Increased managed charge-off rate and managed delinquency rate by 147 basis points and 62 basis points, respectively, to 4.35% and 4.49%, respectively, |
| • | Increased the allowance for loan and lease losses by $1.6 billion to $4.5 billion, increasing the coverage ratio of allowance as a percentage of loans held for investment by 157 basis points to 4.48%, |
| • | Increased our provision for loan and lease losses by $2.5 billion to $5.1 billion, |
| • | Reduced the fair value of the interest-only strips and other retained interests by $224.8 million, |
| • | Revenue suppression, which is the amounts billed to customers but not recognized as revenue, increased to $1.9 billion from $1.1 billion, |
| • | Experienced a $4.4 billion reduction in managed loans held for investment, due to weaker spending and loan demand from credit-worthy customers, tightening underwriting, an exit from lending activities not resilient to the economic downturn and an increase in charge-offs, |
| • | Deposit growth was primarily invested in high-quality agency mortgage backed securities and AAA-rated securities backed by consumer loans. Increasing our securities available for sale by $11.2 billion to $31.0 billion. |
U.S. Treasury Department’s Capital Purchase Program Participation
On November 14, 2008 the Company entered into an agreement (the “Securities Purchase Agreement”) to issue 3,555,199 Fixed Rate Cumulative Perpetual Preferred Shares, Series A, par value $0.01 per share (the “Series A Preferred Stock”), to the United States Department of the Treasury (“U.S. Treasury”) as part of the Company’s participation in the U.S. Treasury’s Troubled Asset Relief Program Capital Purchase Program (“CPP”), having a liquidation amount per share equal to $1,000. The Series A Preferred Stock pays cumulative dividends at a rate of 5% per year for the first five years and thereafter at a rate of 9% per year. As noted above, the Company redeemed the Series A Preferred Stock in June 2009 at the liquidation amount per share.
In addition, the Company issued Warrants to purchase 12,657,960 of the Company’s common shares to the U.S. Treasury as part of the Securities Purchase Agreement. The Warrants have an exercise price of $42.13 per share. The Warrants expire ten years from the issuance date. As noted above, the U.S. Treasury sold the Warrants on December 9, 2009 for $11.75 per warrant.
The Company received proceeds of $3.55 billion for the Series A Preferred Stock and the Warrants. The Company allocated the proceeds based on a relative fair value basis between the Series A Preferred Stock and the Warrants, recording $3.06 billion and $491.5 million, respectively. The fair value of the preferred stock was estimated using independent quotes from third party sources who considered the structure, subordination and size of the preferred stock issuance in comparison to the trust preferred securities issued by special purpose trusts established by the Company. Fair value of the stock warrants was estimated using a pricing model with the most significant assumptions being the forward dividend yield and implied volatility of the Company’s stock price. The $3.06 billion of Series A Preferred Stock is net of a discount of $491.5 million. The discount will be accreted to the $3.55 billion liquidation preference amount over a five year period. The accretion of the discount and dividends on the preferred stock reduce net income available to common shareholders.
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OCC Minimum Payment Rules
In March 2008, COBNA converted from a Virginia state-chartered bank to a national association, which is regulated by the OCC. The OCC has minimum payment policies for the credit card industry designed to force modest positive amortization for all card accounts.
Under the new policy, the monthly minimum payment is set at 1% of principal balance, plus all interest assessed in the prior cycle, plus any past due fees and certain other fees assessed in the prior cycle. This compares to the Company’s previous policy, which for most accounts was a flat 3% of principal balance. This will have the effect of increasing the minimum payment for delinquent customers, while lowering it for many customers who are current.
The Company has converted substantially all accounts to comply with OCC minimum payment policies for the year ended December 31, 2009.
Secondary Equity Offering
On September 30, 2008, the Company raised $760.8 million through the issuance of 15,527,000 shares of common stock at $49.00 per share.
Goodwill Impairment
During the fourth quarter of 2008, the Company recorded an impairment to goodwill of $810.9 million. The impairment was recorded in the Auto Finance business. The deficit was primarily a result of a reduced estimate of the fair value of the Auto Finance business due to the decision to scale that business back beginning in 2008.
Sale of MasterCard Shares
During the second quarter of 2008, the Company recognized a gain of $44.9 million in other non-interest income from the sale of 154,991 shares of MasterCard class B common stock.
Visa IPO
During the first quarter of 2008, Visa completed an initial public offering (“IPO”) of its stock. With IPO proceeds Visa established an escrow account for the benefit of member banks to fund certain litigation settlements and claims. As a result, in the first quarter of 2008, the Company reduced its Visa-related indemnification liabilities of $90.9 million recorded in other liabilities with a corresponding reduction of other non-interest expense. In addition, the Company recognized a gain of $109.0 million in non-interest income for the redemption of 2.5 million shares related to the Visa IPO. Both items were included in the Other category.
Debt Refinancing
During the first quarter of 2008, the Company repurchased approximately $1.0 billion of certain senior unsecured debt, recognizing a gain of $52.0 million in non-interest income. The Company initiated the repurchases to take advantage of the current market environment and replaced the repurchased debt with lower-rate unsecured funding.
2007 Summary of Significant Events
Shut Down of Mortgage Origination Operations of Wholesale Mortgage Banking Unit
See “Note 4 – Discontinued Operations” for further details.
Restructuring Charges Associated with Cost Initiative
During the second quarter of 2007, we announced a broad-based initiative to reduce expenses and improve our competitive cost position. We recognized $138.2 million in restructuring charges in 2007.
Share Repurchase
During 2007, we executed a $3.0 billion stock repurchase program, resulting in a net share retirement of 43,717,110 shares.
Litigation Settlements and Reserves
During the fourth quarter of 2007, we recognized a pre-tax charge of $79.8 million for liabilities in connection with the antitrust lawsuit settlement with American Express. Additionally, we recorded a legal reserve of $59.1 million for estimated possible damages in connection with other pending Visa litigation, reflecting our share of such potential damages as a Visa member.
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Sale of Interest in Spain
During 2007, the Company completed the sale of its interest in a relationship agreement to develop and market consumer credit products in Spain and recorded a net gain related to this sale of $31.3 million consisting of a $41.6 million increase in non-interest income partially offset by a $10.3 million increase in non-interest expense.
Gain on Sale of MasterCard Shares
As a result of MasterCard’s IPO in 2006, Capital One owned class B shares of MasterCard common stock, with sale restrictions that were originally scheduled to expire on May 31, 2010. In 2007 shareholders approved an amendment to the MasterCard Certificate of Incorporation that provides for an accelerated conversion of class B common stock into class A common stock. The MasterCard Board of Directors approved a conversion window running from August 4 to October 5, 2007, during which time owners of class B shares may voluntarily elect to convert and sell a certain number of their shares. During the conversion period, Capital One elected to convert and sell 300,482 shares of MasterCard class B common stock. The Company recognized gains of $43.4 million on these transactions in non-interest income.
Gain on Sale of Equity Interest in DealerTrack
In 2001 we acquired a 7% stake in the privately held company DealerTrack, a leading provider of on-demand software and data solutions for the automotive retail industry. DealerTrack went public in 2005. During the first quarter of 2007 we sold our remaining interest of 1,832,767 shares for $52.2 million resulting in a pre-tax gain of $46.2 million in non-interest income.
Senior Note Issuance
During the third quarter 2007, we closed the public offering of $1.5 billion aggregate principal amount of our Senior Notes Due 2017 (the “Notes”). The Notes were issued pursuant to a Senior Indenture dated as of November 1, 1996 (the “Indenture”) between the Corporation and The Bank of New York Trust Company, N.A. (as successor to Harris Trust and Savings Bank), as Indenture Trustee. Proceeds from the sale of the notes will be used for general corporate purposes, which may include repurchases of shares of our common stock.
Acceleration of Equity Awards
During the second quarter of 2007, a charge of $39.8 million was taken against salaries and associate benefits. This charge was taken as a result of the accelerated vesting of equity awards in conjunction with the transition of the Banking leadership team, consistent with the terms of the awards. This charge is not included as a restructuring charge associated with our 2007 cost initiative.
Income Taxes
We recognized a $69.0 million one-time tax benefit in the second quarter of 2007 resulting from previously unrecognized tax benefits related to our international tax position. In addition, we recognized a $29.7 million reduction in retained earnings associated with the adoption of ASU 740-10/FIN 48 in 2007.
Business Outlook
The statements contained in this section are based on our current expectations regarding the Company’s 2010 financial results and business strategies. Certain statements are forward looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Actual results could differ materially from those in our forward looking statements. Factors that could materially influence results are set forth throughout this section and in Item 1A “Risk Factors”.
The Company expects continuing cyclical economic challenges in 2010, although the pace of economic deterioration has slowed during the second half of 2009. The Company expects that the U.S. Unemployment Rate will remain above 10% throughout 2010, and that the Case-Schiller 20-City Index of home prices will fall 11% from its year end 2009 level.
The Company expects that credit trends will continue to be a key driver of its near-term results. While charge-offs in the Company’s consumer lending businesses other than the mortgage portfolio are nearing a cyclical peak, the Company does not expect a rapid recovery. Rather, the Company expects charge-offs in the consumer lending businesses other than the mortgage portfolio to remain stubbornly high in 2010 as they begin a gradual recovery. The Company expects that charge-offs in the mortgage portfolio and the Commercial Banking business will continue to deteriorate in 2010.
In addition to credit trends, the Company expects that its near-term results will reflect the mechanics of delivering value through the cycle. The Company expects that loans will continue to decline into 2010, driven largely by continuing runoff of businesses the Company exited or repositioned earlier in the recession. As the Company’s consumer businesses other than the mortgage portfolio near the peak of charge-off dollars, the Company expects that the combination of declining loan balances and moderating credit outlook creates the potential for significant allowance releases. The Company expects that potential allowance releases could coincide
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with expected investments in marketing and infrastructure. The Company expects that any future loan growth and returns that may result from the marketing and infrastructure investments would lag the investments, as they have in the past. The Company believes that potential returns generated by marketing and other investments would be attractive and sustainable over the long-term.
2010 Expectations:
| • | The Company expects a mid-single digit percentage decline in ending managed loan balances compared to 2009, driven by continuing runoff of loans in businesses the Company exited or repositioned earlier in the recession, including nationally originated installment loans in its Domestic Card business, small ticket Commercial real Estate, mortgages, and auto loans. The Company expects a high-single digit percentage decline in average loan balances compared to 2009, driven by continuing runoff as well as lower beginning loan balances. |
| • | The Company expects annual margins for 2010 to be similar to annual margins for 2009. |
| • | Consistent with declining loan balances and relatively stable margins, the Company expects that annual revenues will decline in 2010 compared to 2009. |
| • | The Company expects non-interest expenses to increase in 2010. Media and marketing costs were unusually low in 2009. In 2010, the Company expects these costs to increase toward more normal levels, depending upon the Company’s assessment of market opportunities through the year. The Company expects that operating expenses in 2010 will be similar to 2009, as ongoing efficiency improvements are offset by investments in banking and mortgage infrastructure. |
| • | The Company expects the efficiency ratio to rise year over year, consistent with the revenue and expense trends mentioned above. |
| • | The Company expects that the combination of declining loan balances and a moderating charge-off outlook could create the potential for significant allowance releases in 2010. |
Credit Card Business:
The Company expects further increases in the Domestic Card charge-off rate into 2010. The Domestic Card charge-off rate for the first quarter could cross 11%, driven by declining loan balances and elevated delinquencies in the second half of 2009 flowing through to charge-off. The Company expects to reach the quarterly peak in Domestic Card charge-off dollars in the first quarter of 2010, although declining loan balances may cause Domestic Card charge-off rates to remain elevated for a bit longer.
The Company expects Domestic Card loans to decline in 2010 because of the continuing runoff of about $3 billion of installment loans. If normal seasonal patterns hold, the Company expects most or all of the decline would come in the first quarter. In subsequent quarters the Company expects loan balances for the Domestic Card segment to be relatively flat, as originations roughly offset both elevated charge-offs and installment loan runoff.
In 2010 the Company expects that Domestic Card marketing expenses will increase toward more normal levels depending on our assessment of the market opportunities for profitable and resilient origination growth.
The Company expects that quarterly Domestic Card revenue margin will be in the mid-15% range in 2010, although the revenue margin in the first quarter may be above the mid-15% range.
Longer term, the Company expects the Credit CARD Act, as well as market and competitive responses to the Credit CARD Act, will result in the continuing redistribution of where revenue comes from within the Domestic Card business. The Company expects declining revenues from over limit fees and increasing revenues from up front pricing. This redistribution was evident in 2009 quarterly trends in net interest income and non-interest income in the Domestic Card business. In the aggregate, the Company expects its Domestic Card revenue margin to remain largely intact over time. Over the long-term, the Company expects that returns in the Domestic Card business will diminish modestly from pre-recession levels, but will remain very attractive and well above hurdle rates.
The Company expects that credit trends in the International Card business will reflect continuing economic weakness in the U.K and Canada.
Commercial Banking:
The Company expects that the continuing recession will drive continuing declines in commercial real estate values, and that non-performing loans and charge-offs will remain elevated across our Commercial Banking businesses in 2010. The Company expects continuing growth in low-cost commercial deposits with disciplined pricing in 2010.
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Consumer Lending:
The Company expects ending loans in the Auto Finance business to decrease approximately $1.5 billion in 2010. The Company expects ending loans in the mortgage portfolio to decline by approximately $2.5 billion in 2010. In contrast, the Company expects continuing growth in consumer deposits with disciplined pricing in 2010.
VI. Financial Summary
Table 3 provides a summary view of the consolidated income statement and selected metrics at and for the years ended December 31, 2009, 2008 and 2007.
CAPITAL ONE FINANCIAL CORPORATION
Table 3: Financial Summary
| Year Ended December 31, | Change | |||||||||||||||||||
| (Dollars in thousands) |
2009(6) | 2008 | 2007 | 2009 vs. 2008 | 2008 vs. 2007 | |||||||||||||||
| Earnings: |
||||||||||||||||||||
| Net interest income |
$ | 7,697,115 | $ | 7,148,715 | $ | 6,529,845 | $ | 548,400 | $ | 618,870 | ||||||||||
| Non-interest income |
5,286,152 | 6,743,971 | 8,054,223 | (1,457,819 | ) | (1,310,252 | ) | |||||||||||||
| Total Revenue(1) |
12,983,267 | 13,892,686 | 14,584,068 | (909,419 | ) | (691,382 | ) | |||||||||||||
| Provision for loan and lease losses |
4,230,111 | 5,101,040 | 2,636,502 | (870,929 | ) | 2,464,538 | ||||||||||||||
| Restructuring expenses |
119,395 | 134,464 | 138,237 | (15,069 | ) | (3,773 | ) | |||||||||||||
| Goodwill impairment charge(5) |
— | 810,876 | — | (810,876 | ) | 810,876 | ||||||||||||||
| Other non-interest expenses |
7,297,659 | 7,264,687 | 7,939,773 | 32,972 | (675,086 | ) | ||||||||||||||
| Income from continuing operations before taxes |
1,336,102 | 581,619 | 3,869,556 | 754,483 | (3,287,937 | ) | ||||||||||||||
| Income taxes |
349,485 | 497,102 | 1,277,837 | (147,617 | ) | (780,735 | ) | |||||||||||||
| Income from continuing operations, net of tax |
986,617 | 84,517 | 2,591,719 | 902,100 | (2,507,202 | ) | ||||||||||||||
| Loss from discontinued operations, net of tax(3) |
(102,836 | ) | (130,515 | ) | (1,021,387 | ) | 27,679 | 890,872 | ||||||||||||
| Net income (loss) |
$ | 883,781 | $ | (45,998 | ) | $ | 1,570,332 | $ | 929,779 | $ | (1,616,330 | ) | ||||||||
| Net income (loss) available to common shareholders |
$ | 319,873 | $ | (78,721 | ) | $ | 1,570,332 | $ | 398,594 | $ | (1,649,053 | ) | ||||||||
| Earnings Per Common Share: |
||||||||||||||||||||
| Basic earnings per common share: |
||||||||||||||||||||
| Income from continuing operations, net of tax |
$ | 0.99 | $ | 0.14 | $ | 6.64 | $ | 0.85 | $ | (6.50 | ) | |||||||||
| Loss from discontinued operations, net of tax(3) |
(0.24 | ) | (0.35 | ) | (2.62 | ) | 0.11 | 2.27 | ||||||||||||
| Net income (loss) per common share |
$ | 0.75 | $ | (0.21 | ) | $ | 4.02 | $ | 0.96 | $ | (4.23 | ) | ||||||||
| Diluted earnings per common share: |
||||||||||||||||||||
| Income from continuing operations, net of tax |
$ | 0.98 | $ | 0.14 | $ | 6.55 | $ | 0.84 | $ | (6.41 | ) | |||||||||
| Loss from discontinued operations, net of tax(3) |
(0.24 | ) | (0.35 | ) | (2.58 | ) | 0.11 | 2.23 | ||||||||||||
| Net income (loss) per common share |
$ | 0.74 | $ | (0.21 | ) | $ | 3.97 | $ | 0.95 | $ | (4.18 | ) | ||||||||
| Selected Balance Sheet Data(2): |
||||||||||||||||||||
| Year-end balances: |
||||||||||||||||||||
| Reported loans held for investment |
$ | 90,618,999 | $ | 101,017,771 | $ | 101,805,027 | $ | (10,398,772 | ) | $ | (787,256 | ) | ||||||||
| Securities available for sale |
38,829,562 | 31,003,271 | 19,781,587 | 7,829,291 | 11,221,684 | |||||||||||||||
| Allowance for loan and lease losses |
4,127,395 | 4,523,960 | 2,963,000 | (396,565 | ) | 1,560,960 | ||||||||||||||
| Interest bearing deposits |
102,370,437 | 97,326,937 | 71,714,627 | 5,043,500 | 25,612,310 | |||||||||||||||
| Total deposits |
115,809,096 | 108,620,789 | 82,761,176 | 7,188,307 | 25,859,613 | |||||||||||||||
| Other borrowings |
11,968,461 | 14,869,648 | 26,812,969 | (2,901,187 | ) | (11,943,321 | ) | |||||||||||||
| Average balances: |
||||||||||||||||||||
| Reported loans held for investment |
$ | 99,787,285 | $ | 98,970,903 | $ | 93,541,825 | $ | 816,383 | $ | 5,429,077 | ||||||||||
| Securities available for sale |
36,836,779 | 25,042,506 | 18,933,750 | 11,794,273 | 6,108,756 | |||||||||||||||
| Interest bearing deposits |
103,078,208 | 82,735,627 | 73,764,911 | 20,342,581 | 8,970,716 | |||||||||||||||
| Total deposits |
115,600,744 | 93,507,646 | 85,211,616 | 22,093,098 | 8,296,030 | |||||||||||||||
| Other borrowings |
14,897,331 | 22,214,986 | 20,261,449 | (7,317,655 | ) | 1,953,537 | ||||||||||||||
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| Year Ended December 31, | Change | ||||||||||||||
| (Dollars in thousands) |
2009(6) | 2008 | 2007 | 2009 vs. 2008 | 2008 vs. 2007 | ||||||||||
| Selected Company Metrics(2): |
|||||||||||||||
| Return on average assets (ROA) |
0.58 | % | 0.05 | % | 1.79 | % | 0.53 | (1.74 | ) | ||||||
| Return on average equity (ROE) |
3.71 | % | 0.33 | % | 10.28 | % | 3.38 | (9.95 | ) | ||||||
| Net charge-off rate |
4.58 | % | 3.51 | % | 2.10 | % | 1.07 | 1.41 | |||||||
| Delinquency rate (30+ days) |
4.13 | % | 4.37 | % | 3.66 | % | (0.24 | ) | 0.71 | ||||||
| Net interest margin |
5.30 | % | 5.37 | % | 5.38 | % | (0.07 | ) | (0.01 | ) | |||||
| Revenue margin |
8.94 | % | 10.44 | % | 12.01 | % | (1.50 | ) | (1.57 | ) | |||||
| Risk adjusted margin (4) |
5.79 | % | 7.83 | % | 10.40 | % | (2.04 | ) | (2.57 | ) | |||||
| (1) | In accordance with the Company’s finance charge and fee revenue recognition policy, the amounts billed to customers but not recognized as revenue were $2.1 billion, $1.9 billion and $1.1 billion for the years ended December 31, 2009, 2008 and 2007, respectively. |
| (2) | Based on continuing operations. |
| (3) | Discontinued operations related to the shutdown of mortgage origination operations of GreenPoint’s wholesale mortgage banking unit in 2007. |
| (4) | Risk adjusted margin equals total revenue less net charge-offs as a percentage of average earning assets. |
| (5) | In 2008, the Company recorded impairment of goodwill in its Auto Finance business of $810.9 million. |
| (6) | Effective February 27, 2009 the Company acquired Chevy Chase Bank, FSB for $475.9 million, which included a cash payment of $445.0 million and an issuance of 2.56 million shares valued at $30.9 million. |
Summary of the Reported Income Statement
The following is a detailed description of the financial results reflected in Table 3. Additional information is provided in Section XI, Tabular Summary as detailed in sections below.
The following discussion provides a summary of 2009 results compared to 2008 results and 2008 results compared to 2007 results on a continuing operations basis, unless otherwise noted. Each component is discussed in further detail in subsequent sections of this analysis.
Net Interest Income
Table 4: Net interest income
| Year Ended December 31, | |||||||||
| (Dollars in thousands) |
2009 | 2008 | 2007 | ||||||
| Interest Income |
|||||||||
| Consumer loans |
$ | 7,237,013 | $ | 7,748,642 | $ | 7,802,817 | |||
| Commercial loans (1) |
1,520,053 | 1,711,736 | 1,697,311 | ||||||
| Loans held for investment, including past-due fees |
8,757,066 | 9,460,378 | 9,500,128 | ||||||
| Investment securities |
1,610,210 | 1,224,012 | 950,972 | ||||||
| Other |
297,309 | 427,609 | 627,056 | ||||||
| Total interest income |
$ | 10,664,585 | $ | 11,111,999 | $ | 11,078,156 | |||
| Interest Expense |
|||||||||
| Deposits |
$ | 2,093,019 | $ | 2,512,040 | $ | 2,906,351 | |||
| Senior and Subordinated Notes |
260,282 | 444,854 | 577,128 | ||||||
| Other borrowings |
614,169 | 1,006,390 | 1,064,832 | ||||||
| Total interest expense |
2,967,470 | 3,963,284 | 4,548,311 | ||||||
| Total net interest income |
$ | 7,697,115 | $ | 7,148,715 | $ | 6,529,845 | |||
| (1) | Interest income for small business credit cards is reflected in consumer loans. |
Net interest income is comprised of interest income and past-due fees earned and deemed collectible from the Company’s loans and interest income earned on securities, less interest expense on interest-bearing deposits, senior and subordinated notes, and other borrowings.
Interest income on loans held for investment decreased to $8.8 billion at December 31, 2009 from $9.5 billion at the end of 2008. The decline in interest income reflects reduced consumer spending due to the current economic conditions as evidenced by the decline in purchase volume in our Credit Card segment as well as continued declines in outstandings in our Card and Auto Finance businesses due to the Company’s decisions to scale back those businesses. The increase of non-performing loans experienced during 2009 contributed to the decrease in interest income within the Commercial segment. In addition, declines in interest rates, which impact our variable rate products, continued throughout 2009.
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Interest income on investment securities increased $386.2 million driven by increases in the average portfolio from $25.0 billion in 2008 to $36.9 billion in 2009. As a result of holding a majority of fixed rate securities, the Company’s portfolio continued to generate interest income while yields fluctuated throughout 2009. The increase in the securities available for sale portfolio came as the Company continued to grow its deposit base and maintained our approach of holding high quality, low risk investments. Also, the addition of Chevy Chase Bank’s $1.4 billion portfolio helped drive the increase in interest income in 2009 as compared to 2008.
Interest expense declined by $995.8 million from 2008. Approximately half of this decline occurred in our interest bearing deposits due to a decline in average rate from 3.04% in 2008 to 2.03% during 2009. In addition the Company’s average other borrowings declined by $7.3 billion driven by a decrease of FHLB debt and run-off of auto securitizations during 2009. The remainder of the decrease occurred in the Company’s Senior and Subordinated notes where the Company took advantage of lower interest rates. Average senior and subordinated rates declined to 3.02% for 2009 from 5.01% in 2008.
For the year ended December 31, 2009, reported net interest income increased 7.7%, or $548.4 million, compared to 2008. The increase was largely driven by the decrease in deposit related expenses, maturities of outstanding notes and run-off of auto securitizations during 2009. Net interest margin decreased slightly by 8 basis points to 5.30% for the year ended December 31, 2009.
For the year ended December 31, 2008, reported net interest income increased 9.5%, or $618.9 million. Interest income on loans held for investment decreased modestly to $9.46 billion from $9.50 billion at the end of 2007 as the increase in average loans held for investment from $93.5 billion to $99.0 billion was offset by the impact of increasing delinquencies which caused our revenue suppression to increase to $1.9 billion from $1.1 billion in 2007, and by lower interest rates on our variable rate products as interest rates declined throughout the year.
Interest income on securities available for sale increased $273.0 million driven by increases in the average portfolio from $18.9 billion to $25.0 billion in 2008 while yields remained stable. The increase in the securities available for sale portfolio came as the Company continued to grow its deposit base and maintained our approach of holding high quality, low risk investments rather than taking excessive credit risk to generate incremental earnings. While interest rates declined throughout 2008, the Company maintained stable yields in growing the securities portfolio by taking advantage of market illiquidity to purchase securities at an attractive yield.
Interest expense on interest-bearing deposits decreased $394.3 million from 2007. The average balance on interest-bearing deposits increased to $82.7 billion from $74.0 billion while the yield decreased to 3.04% in 2008 from 3.94% as the Federal Reserve reduced the federal funds rate throughout 2008.
For additional information, see “Table A – Statement of Average Balances, Income and Expense, Yields and Rates” and “Table B – Interest Variance Analysis” for further details.
Table 5: Non-interest income
Non-Interest Income
| Year Ended December 31, | |||||||||||
| (Dollars in thousands) |
2009 | 2008 | 2007 | ||||||||
| Non-interest income |
|||||||||||
| Servicing and securitizations |
$ | 2,279,826 | $ | 3,384,468 | $ | 4,840,677 | |||||
| Service charges and other customer-related fees |
1,997,013 | 2,232,363 | 2,057,854 | ||||||||
| Mortgage servicing and other |
14,729 | 105,038 | 166,776 | ||||||||
| Interchange |
501,798 | 562,117 | 500,484 | ||||||||
| Net impairment losses recognized in earnings |
(31,951 | ) | (10,916 | ) | — | ||||||
| Other |
524,737 | 470,901 | 488,432 | ||||||||
| Total non-interest income |
$ | 5,286,152 | $ | 6,743,971 | $ | 8,054,223 | |||||
Non-interest income is comprised of servicing and securitizations income, service charges and other customer-related fees, mortgage servicing and other, interchange income and other non-interest income.
For the year ended December 31, 2009, non-interest income decreased 21.6% compared to 2008. For the year ended December 31, 2008, non-interest income decreased 16.3% compared to 2007. See detailed discussion of the components of non-interest income below.
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Servicing and Securitizations Income
Servicing and securitizations income represents servicing fees, excess spread and other fees derived from the off-balance sheet loan portfolio, adjustments to the fair value of retained interests derived through securitization transactions, as well as gains and losses resulting from securitization and other sales transactions.
Servicing and securitizations income decreased 32.6% for the year ended December 31, 2009. The decrease was attributable to continuous reductions in average securitized loans and reduction in the fair value of retained interests and higher charge offs on the securitized portfolio as a result of continued stress in the economic environment. In addition, average securitized loans continued to decline to $43.7 billion for 2009 compared to $48.8 billion for 2008.
Servicing and securitizations income decreased 30.1% for the year ended December 31, 2008. The decrease was attributable to reductions in average securitized loans year over year and to reductions in fair value of retained interests due to the worsening global credit environment. Average securitized loans were $48.8 billion for 2008 compared to $51.2 billion in 2007.
Beginning January 1, 2010, the Company will be required to consolidate certain loans previously transferred to VIE’s and accounted for as sales. The loans will be included as loans held for investment and the corresponding income from these securitized loans will no longer be reflected as securitization income. Interest income, net charge-offs and certain other income associated with securitized loan receivables and interest expense associated with the debt securities issued from the trusts to third party investors will be reporting in the same line as non-securitized loan receivables and corporate debt. Additionally, we will no longer record gains on new securitization activity or valuation adjustments on retained interests including the interest-only strip, retained senior and subordinate tranches and restricted cash collateral accounts unless the Company achieves sale accounting under ASU 2009-16 (ASC 860/SFAS 166) and achieves deconsolidation under ASU 2009-17 (ASC 810/SFAS 167). See “Item III. Off-Balance Sheet Arrangements” and “Note 1 – Significant Accounting Policies” for the pro forma impacts on our consolidated financial statements.
Service Charges and Other Customer-Related Fees
For 2009, service charges and other customer-related fees declined by 10.5% primarily due to a reduction in collectable overlimit and cash advance fees.
For 2008, service charges and other customer-related fees grew 8.5% due to higher overlimit and cash advance fees.
Mortgage Servicing and Other Income
Mortgage servicing and other income is comprised of non-interest income related to our mortgage servicing business and other mortgage related income. For the year ended December 31, 2009, mortgage servicing and other income decreased 86.0% from the prior year due to the changes in fair value of the mortgage servicing rights attributable to the run-off of the portfolio, recognition of impairment, and reduced gains on sales due to lower originations in 2009. The Company has been notified by the insurer of certain Chevy Chase Bank mortgage securitization transactions that it will be removed as servicer of mortgage loans with an aggregate unpaid principal balance of $3.1 billion as of December 31, 2009. The fair value of mortgage servicing rights at December 31, 2009 reflects this expected loss of servicing, which is included in the table above. See “Note 15 – Mortgage Servicing Rights” for further details.
For the year ended December 31, 2008, mortgage servicing and other income decreased 37.0% from prior year due to the changes in fair value of the mortgage servicing rights attributable to the run-off of the portfolio and reduced gains on sales due to lower originations in 2008.
Interchange
Interchange income, net of rewards expense, decreased 10.7% for the year ended December 31, 2009 on a reported basis due to a decrease in purchase volume of 8.6% as compared to 2008. Interchange on a managed basis decreased 3.9% due to decreases in managed purchase volume of 10.3% offset by decreases in rewards expense. Costs associated with the Company’s rewards programs in 2009 were $191.7 million on a reported basis and $582.6 million on a managed basis.
Interchange income, net of rewards expense, increased 12.3% for the year ended December 31, 2008 on a reported basis due to a shift in loans from our off-balance sheet securitized loans to our reported on-balance sheet loans during 2008. Interchange on a managed basis decreased 7.8% due to decreases in managed purchase volume of 1.2% and increases in rewards expense. Costs associated with the Company’s rewards programs in 2008 were $221.4 million on a reported basis and $709.2 million on a managed basis. The increase in the rewards expense was due to an expansion of our rewards programs.
Other Non-Interest Income
Other non-interest income includes, among other items, gains and losses on sales of securities and gains and losses associated with hedging transactions.
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Other non-interest income for the year ended December 31, 2009 increased $53.8 million or 11.4%. The increase was related to additional income generated by sales of securities during 2009 and the effects of a hedge program on brokered CDs offset by decreases in the fair value of the Company’s free standing derivatives.
Other non-interest income for the year ended December 31, 2008 decreased $28.4 million or 5.8%. The decrease was primarily due to reduced commission income and changes in exchange rates from 2007. Other non-interest income for 2008 also includes a $109.0 million gain from the redemption of shares related to the Visa IPO and a gain of $44.9 million from the sale of MasterCard stock.
Provision for loan and lease losses
Provision for loan and lease losses decreased $870.9 million, or 17.1% for the year ended December 31, 2009. The decrease was due an allowance release of $396.6 million in 2009 compared to an allowance build of $1.6 billion in 2008 offset by an increase in charge offs of $1.1 billion. The reduction in allowance was driven by a smaller reported book and actual credit performance that has been better than expected partially offset by an increase in the charge-off rate of 107 basis points to 4.58% during 2009. The increase in reported charge offs is a result of continued deterioration of the economy the Company operates.
For the year ended December 31, 2008, provision for loan and lease losses increased $2.5 billion, or 93%. The increase in the provision is a result of continued worsening of the economy which rapidly deteriorated during the later part of 2008 as evidenced by increases in both the charge-off rate and delinquency rate, rising to 3.51% and 4.37%, respectively, from 2.10% and 3.66%, respectively. The provision for loan and lease loses increased $1.0 billion in the fourth quarter alone as the Company increased the allowance for loan and lease losses as the unemployment rate and housing prices showed significant worsening during the fourth quarter of 2008.
Non-Interest Expense
Table 6: Non-interest expense
Non-interest expense consists of marketing and operating expenses.
| Year Ended December 31, | |||||||||
| (Dollars in thousands) |
2009 | 2008 | 2007 | ||||||
| Non-interest expense |
|||||||||
| Salaries and associated benefits |
$ | 2,477,655 | $ | 2,335,737 | $ | 2,592,534 | |||
| Marketing |
588,338 | 1,118,208 | 1,347,836 | ||||||
| Communications and data processing |
740,543 | 755,989 | 758,820 | ||||||
| Supplies and equipment |
499,582 | 519,687 | 531,238 | ||||||
| Occupancy |
450,871 | 377,192 | 322,510 | ||||||
| Restructuring expense |
119,395 | 134,464 | 138,237 | ||||||
| Goodwill impairment charge |
— | 810,876 | — | ||||||
| Other |
2,540,670 | 2,157,874 | 2,386,835 | ||||||
| Total non-interest expense |
$ | 7,417,054 | $ | 8,210,027 | $ | 8,078,010 | |||
For the year ended December 31, 2009, non-interest expense increased 0.2%, excluding the goodwill impairment in 2008. For the year ended December 31, 2008, non-interest expense, excluding goodwill impairment decreased 8.4%. See detailed discussion of the components of non-interest expense below.
Marketing
Marketing expenses decreased 47.4% and 17.0% for the years ended December 31, 2009 and 2008. The decrease in marketing expenses was due to selective pull-backs in certain marketing channels and other reductions in response to the changes in the economic environment, which began in 2008 and continued through 2009.
Goodwill impairment
The Company recorded an impairment to goodwill of $810.9 million in 2008, as a result of a reduced estimate of the fair value of the Auto Finance business due to business decisions to scale back origination volume. For additional information, see Section II Critical Accounting Estimates, “Valuation of Goodwill and Other Intangible Assets”.
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Operating Expenses
Excluding marketing and the goodwill impairment, operating expenses increased 8.7% for the year ended December 31, 2009. The increase in operating expenses primarily relates to the increased costs incurred related to the acquisition of Chevy Chase Bank.
Operating expenses decreased 6.7% for the year ended December 31. 2008. The decrease in operating expenses was a direct result of benefits from the Company’s continued cost reduction initiatives.
Income Taxes
The Company’s effective tax rate was 26.2%, 85.5% and 33.0% for the years ended December 31, 2009, 2008 and 2007, respectively. The effective rate includes federal, state, and international tax components. The decrease in the 2009 rate compared to the 2008 rate and the increase in the 2008 rate compared to the 2007 rate were primarily due to the non-deductible portion of the goodwill impairment recognized during 2008. The Company’s 2008 effective tax rate excluding the goodwill impairment was 37.8%. The decrease in the 2009 rate compared to the 2008 rate excluding goodwill impairment was primarily attributable to changes in the Company’s international tax position, increases in certain tax credits, and reductions in unrecognized tax benefits due to 2009 U.S. Tax Court decisions and other tax settlements.
Balance Sheet
Securities Available for Sale
The Company held $38.8 billion in securities available for sale at December 31, 2009, compared to $31.0 billion at December 31, 2008. The increase in the portfolio of securities available for sale during 2009 reflects the Company’s continuing strategy to grow its deposit base and maintain our approach of holding high quality, lower risk investments. In addition, the Company added $1.3 billion of securities available for sale with the acquisition of Chevy Chase Bank in 2009. During 2009, the Company repositioned its investment portfolio by reducing the amount invested in Collateralized Mortgage Obligations (“CMO”) and selling off investments in Collateralized Mortgage Backed Securities (“CMBS”); while increasing amounts invested in Mortgage Backed Securities (“MBS”) and Asset Backed Securities (“ABS”) as risk adjusted returns became more attractive in the MBS market than in the CMO market. See “Note 6 – Securities Available for Sale” for further details.
Table 7: Securities Available for Sale
| As of December 31, | ||||||
| (Dollars in thousands) |
2009 | 2008 | ||||
| U.S. Treasury and other U.S. Government agency obligations |
$ | 868,706 | $ | 1,610,329 | ||
| Collateralized mortgage obligations |
9,638,028 | 11,102,225 | ||||
| Mortgage backed securities |
20,684,181 | 13,712,869 | ||||
| Asset backed securities |
7,191,606 | 4,096,057 | ||||
| Other |
447,041 | 481,791 | ||||
| Total |
$ | 38,829,562 | $ | 31,003,271 | ||
Loans Held for Investment
The Company’s reported loans outstanding at December 31, 2009 were $90.6 billion, compared to $101.0 billion at December 31, 2008, a decrease of $10.4 billion, as overall loan volumes were impacted by the economic environment in which the Company operated during 2009. The decline in the portfolio was primarily in the credit card and automobile portfolios, offset by increases in mortgage due to the acquisition of Chevy Chase Bank.
Declines in the credit card portfolio was driven by declines in consumer spending and reduced marketing levels during 2009, along with the continued run-off of the Company’s national closed-end installment loan portfolio, which declined $4.0 billion during the year. Automobile loans declined as the Company continued to focus on the most resilient customer segments in light of the economic environment.
Commercial lending declined slightly during 2009 as the pace of new originations slowed due to reductions in demand and more cautious underwriting, offset by $695.5 million of loans added from the Chevy Chase Bank acquisition. The small ticket commercial real estate portfolio continued to run-off during 2009, declining by $455.6 million which includes the transfer of a portion of the loans into loans held for sale.
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Table 8: Loan Portfolio Distribution
| Reported Loan Portfolio Distribution (Dollars in thousands) |
December 31, | |||||
| 2009 | 2008 | |||||
| Domestic credit card |
$ | 20,066,547 | $ | 30,754,627 | ||
| International credit card |
2,273,212 | 2,991,613 | ||||
| Total Credit Card |
$ | 22,339,759 | $ | 33,746,240 | ||
| Commercial and multi-family real estate (1) |
13,843,158 | 13,303,081 | ||||
| Middle market |
10,061,819 | 10,081,823 | ||||
| Specialty lending |
3,554,563 | 3,547,287 | ||||
| Total Commercial Lending |
$ | 27,459,540 | $ | 26,932,191 | ||
| Small ticket commercial real estate |
2,153,510 | 2,609,123 | ||||
| Total Commercial Banking |
$ | 29,613,050 | $ | 29,541,314 | ||
| Automobile |
18,186,064 | 21,494,436 | ||||
| Mortgage |
14,893,187 | 10,098,430 | ||||
| Other retail |
5,135,242 | 5,603,696 | ||||
| Total Consumer Banking |
$ | 38,214,493 | $ | 37,196,562 | ||
| Other loans |
451,697 | 533,655 | ||||
| Total Company |
$ | 90,618,999 | $ | 101,017,771 | ||
| Managed Loan Portfolio Distribution (Dollars in thousands) |
December 31, | |||||
| 2009 | 2008 | |||||
| Domestic credit card |
$ | 60,299,827 | $ | 70,944,581 | ||
| International credit card |
8,223,835 | 8,720,642 | ||||
| Total Credit Card |
$ | 68,523,662 | $ | 79,665,223 | ||
| Commercial and multi-family real estate (1) |
13,843,158 | 13,303,081 | ||||
| Middle market |
10,061,819 | 10,081,823 | ||||
| Specialty lending |
3,554,563 | 3,547,287 | ||||
| Total Commercial Lending |
$ | 27,459,540 | $ | 26,932,191 | ||
| Small ticket commercial real estate |
2,153,510 | 2,609,123 | ||||
| Total Commercial Banking |
$ | 29,613,050 | $ | 29,541,314 | ||
| Automobile |
18,186,064 | 21,494,436 | ||||
| Mortgage |
14,893,187 | 10,098,430 | ||||
| Other retail |
5,135,242 | 5,603,696 | ||||
| Total Consumer Banking |
$ | 38,214,493 | $ | 37,196,562 | ||
| Other loans |
451,697 | 533,655 | ||||
| Total Company |
$ | 136,802,902 | $ | 146,936,754 | ||
| (1) | Included in the total of commercial and multi-family real estate loans are construction and land development loans of $2.5 billion and $2.4 billion for the years ended December 31, 2009 and 2008, respectively. |
The Company markets its credit card products on a national basis throughout the United States, Canada and the United Kingdom. On a managed basis, the Credit Card segment represented $68.5 billion, or 50.3% of the Company’s overall loan portfolio at December 31, 2009, down from54.4% in 2008. Because of the diversity of the Company’s credit card products and national marketing approach, no single geographic concentration exists within the credit card portfolio. See “Table 9—Credit Card Concentrations” for further details.
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Table 9: Credit Card Concentrations (Managed)
| December 31, 2009 | December 31, 2008 | |||||||||||
| (Dollars in thousands) |
Loans | Percent | Loans | Percent | ||||||||
| Domestic Card |
||||||||||||
| California |
$ | 7,192,401 | 11.93 | % | $ | 8,478,567 | 11.95 | % | ||||
| Texas |
4,096,685 | 6.79 | % | 5,657,916 | 7.98 | % | ||||||
| New York |
3,916,966 | 6.50 | % | 5,171,520 | 7.29 | % | ||||||
| Florida |
3,759,220 | 6.24 | % | 4,746,580 | 6.69 | % | ||||||
| Illinois |
2,653,102 | 4.40 | % | 3,034,636 | 4.28 | % | ||||||
| Pennsylvania |
2,640,735 | 4.38 | % | 2,819,761 | 3.97 | % | ||||||
| Ohio |
2,383,837 | 3.95 | % | 2,674,512 | 3.77 | % | ||||||
| Virginia |
1,749,504 | 2.90 | % | 1,915,860 | 2.70 | % | ||||||
| Other |
31,907,377 | 52.91 | % | 36,445,229 | 51.37 | % | ||||||
| Total Domestic Card |
$ | 60,299,827 | 88.00 | % | $ | 70,944,581 | 89.05 | % | ||||
| International Card |
||||||||||||
| United Kingdom |
$ | 4,716,981 | 57.36 | % | $ | 5,527,237 | 63.38 | % | ||||
| Canada |
3,506,854 | 42.64 | % | 3,193,405 | 36.62 | % | ||||||
| Total International Card |
$ | 8,223,835 | 12.00 | % | $ | 8,720,642 | 10.95 | % | ||||
| Total Credit Card |
$ | 68,523,662 | 50.25 | % | $ | 79,665,223 | 54.41 | % | ||||
Commercial Banking represented $29.6 billion, or 21.7% of the Company’s managed loan portfolio at December 31, 2009. The Company operates its Commercial Banking business primarily in the geographies in which it maintains retail bank branches. As a result, most of the portfolio is located in New York, Louisiana and Texas, the Company’s largest retail banking markets. The small ticket commercial real estate portfolio was originated on a national basis through a broker network, and is in run-off mode. See “Table 10—Commercial Banking Concentrations” for further details.
Table 10: Commercial Banking Concentrations (Managed)
| December 31, 2009 | December 31, 2008 | |||||||||||
| (Dollars in thousands) |
Loans | Percent | Loans | Percent | ||||||||
| Commercial Lending |
||||||||||||
| New York |
$ | 12,565,715 | 45.76 | % | $ | 13,348,236 | 49.56 | % | ||||
| Louisiana |
3,592,447 | 13.08 | % | 3,582,074 | 13.30 | % | ||||||
| Texas |
2,784,960 | 10.14 | % | 2,446,243 | 9.08 | % | ||||||
| New Jersey |
2,252,663 | 8.20 | % | 2,369,315 | 8.80 | % | ||||||
| Massachusetts |
618,664 | 2.25 | % | 426,733 | 1.59 | % | ||||||
| California |
570,742 | 2.08 | % | 527,101 | 1.96 | % | ||||||
| Maryland |
509,199 | 1.86 | % | 99,622 | 0.37 | % | ||||||
| Virginia |
454,150 | 1.66 | % | 89,410 | 0.33 | % | ||||||
| Other |
4,111,000 | 14.97 | % | 4,043,457 | 15.01 | % | ||||||
| Total Commercial Lending |
$ | 27,459,540 | 92.73 | % | $ | 26,932,191 | 91.17 | % | ||||
| Small Ticket Commercial Real Estate |
||||||||||||
| New York |
$ | 863,790 | 40.11 | % | $ | 1,006,996 | 38.60 | % | ||||
| California |
468,183 | 21.74 | % | 519,018 | 19.89 | % | ||||||
| Massachusetts |
165,703 | 7.70 | % | 214,925 | 8.24 | % | ||||||
| New Jersey |
122,952 | 5.71 | % | 158,448 | 6.07 | % | ||||||
| Florida |
93,901 | 4.36 | % | 134,607 | 5.16 | % | ||||||
| Other |
438,981 | 20.38 | % | 575,129 | 22.04 | % | ||||||
| Total Small Ticket Commercial Real Estate |
$ | 2,153,510 | 7.27 | % | $ | 2,609,123 | 8.83 | % | ||||
| Total Commercial Banking |
$ | 29,613,050 | 21.72 | % | $ | 29,541,314 | 20.18 | % | ||||
Consumer Banking represented $38.2 billion, or 28.0% of the Company’s loan portfolio at December 31, 2009. The automobile portfolio was originated primarily on a national basis, with additional originations through the retail branch network. It is well diversified with some concentration in Texas and Louisiana. The mortgage portfolio is concentrated in New York, California and Louisiana which reflects the characteristics of the legacy Hibernia, North Fork and Chevy Chase portfolios that comprise the majority of our mortgages. Other retail lending includes the Company’s branch and banker based small business loans as well as other consumer lending products originated through the branch network. These portfolios are concentrated in the Company’s retail branch geographies. See “Table 11—Consumer Banking Concentrations” for further details. The increase in Maryland and Virginia is due to the acquisition of Chevy Chase Bank and reflects their primary market presence.
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Table 11: Consumer Banking Concentrations (Managed)
| December 31, 2009 | December 31, 2008 | |||||||||||
| (Dollars in thousands) |
Loans | Percent | Loans | Percent | ||||||||
| Automobile lending |
||||||||||||
| Texas |
$ | 2,900,861 | 15.95 | % | $ | 3,138,103 | 14.60 | % | ||||
| California |
1,675,107 | 9.21 | % | 2,258,622 | 10.51 | % | ||||||
| Louisiana |
1,393,027 | 7.66 | % | 1,690,226 | 7.86 | % | ||||||
| Florida |
1,072,433 | 5.90 | % | 1,365,526 | 6.35 | % | ||||||
| New York |
919,095 | 5.05 | % | 1,107,018 | 5.15 | % | ||||||
| Georgia |
841,009 | 4.63 | % | 931,939 | 4.34 | % | ||||||
| Illinois |
789,150 | 4.34 | % | 828,455 | 3.85 | % | ||||||
| Other |
8,595,382 | 47.26 | % | 10,174,547 | 47.34 | % | ||||||
| Total Automobile Lending |
$ | 18,186,064 | 47.59 | % | $ | 21,494,436 | 57.79 | % | ||||
| Mortgages |
||||||||||||
| New York |
$ | 2,907,533 | 19.52 | % | $ | 3,139,776 | 31.09 | % | ||||
| California |
2,813,533 | 18.89 | % | 1,171,364 | 11.60 | % | ||||||
| Louisiana |
2,226,111 | 14.95 | % | 2,508,243 | 24.84 | % | ||||||
| Maryland |
1,032,587 | 6.93 | % | 89,353 | 0.88 | % | ||||||
| Virginia |
989,268 | 6.64 | % | 114,636 | 1.14 | % | ||||||
| New Jersey |
858,786 | 5.77 | % | 654,543 | 6.48 | % | ||||||
| Other |
4,065,369 | 27.30 | % | 2,420,515 | 23.97 | % | ||||||
| Total Mortgages(1) |
$ | 14,893,187 | 38.97 | % | $ | 10,098,430 | 27.15 | % | ||||
| Other Retail |
||||||||||||
| Louisiana |
$ | 2,065,182 | 40.22 | % | $ | 2,463,934 | 43.97 | % | ||||
| Texas |
1,366,354 | 26.61 | % | 1,689,531 | 30.15 | % | ||||||
| New York |
981,446 | 19.11 | % | 1,019,364 | 18.19 | % | ||||||
| New Jersey |
381,870 | 7.44 | % | 297,651 | 5.32 | % | ||||||
| Virginia |
150,924 | 2.94 | % | 248 | 0.00 | % | ||||||
| Maryland |
134,790 | 2.62 | % | 188 | 0.00 | % | ||||||
| Other |
54,676 | 1.06 | % | 132,780 | 2.37 | % | ||||||
| Total Other Retail |
$ | 5,135,242 | 13.44 | % | $ | 5,603,696 | 15.07 | % | ||||
| Total Consumer Banking |
$ | 38,214,493 | 28.03 | % | $ | 37,196,562 | 25.41 | % | ||||
| (1) | Increase in mortgage loan during 2009 is primarily attributable to the acquisition of Chevy Chase Bank. |
Table 12: Reported Loan Maturity Schedule(1 )
| (in thousands) |
Amounts due in one year or less |
Amounts due after one year through five years |
Amounts due after five years |
Total | ||||||||
| Fixed Rate |
||||||||||||
| Total Credit Card |
$ | 12,510,870 | $ | 3,377,017 | $ | — | $ | 15,887,887 | ||||
| Total Commercial Banking |
2,793,762 | 10,414,144 | 2,968,980 | 16,176,886 | ||||||||
| Automobile |
457,007 | 14,686,310 | 3,288,796 | 18,432,113 | ||||||||
| Mortgage |
943,078 | 2,243,638 | 2,848,239 | 6,034,955 | ||||||||
| All other loans |
476,026 | 2,422,116 | 4,421,676 | 7,319,818 | ||||||||
| Total fixed rate loans |
$ | 17,180,743 | $ | 33,143,225 | $ | 13,527,691 | $ | 63,851,659 | ||||
| Variable Rate |
||||||||||||
| Total Credit Card |
$ | — | $ | — | $ | — | $ | — | ||||
| Total Commercial Banking |
7,464,024 | 5,068,349 | 1,037,288 | 13,569,661 | ||||||||
| Automobile |
— | — | — | — | ||||||||
| Mortgage |
1,175,149 | 233,489 | 6,375,635 | 7,784,273 | ||||||||
| All other loans |
3,380,507 | 1,761,629 | 271,270 | 5,413,406 | ||||||||
| Total variable loans |
$ | 12,019,680 | $ | 7,063,467 | $ | 7,684,193 | $ | 26,767,340 | ||||
| Total Company loans |
$ | 29,200,423 | $ | 40,206,692 | $ | 21,211,884 | $ | 90,618,999 | ||||
| (1) | Please note that the above balances are shown by product type and not by segment. |
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Credit Risk
Credit Risk is the risk of loss from a borrower’s failure to meet the terms of any contract or failure to otherwise perform as agreed. There are four primary sources of credit risk: (1) changing economic conditions, which affect borrowers’ ability to pay and the value of any collateral; (2) a changing competitive environment, which affects customer debt loads, borrowing patterns and loan terms; (3) our underwriting strategies and standards, which determine to whom we offer credit and on what terms; and (4) the quality of our internal controls, which establish a process to test that underwriting conforms to our standards and identifies credit quality issues so we can act upon them in a timely manner.
We have quantitative credit risk guidelines for each of our lines of business. We conduct portfolio and decision level monitoring and stress tests using economic and legislative stress scenarios. Credit risk objectives are achieved by establishing a credit governance framework and by establishing policies, procedures, and controls for each step in the credit process. The Board of Directors, Chief Executive Officer, Chief Risk Officer, Chief Consumer and Commercial Credit Officers, and Division Presidents have specific accountable roles in the management of credit risk. These include policy approval, creation of credit strategy, review of credit position, and delegation of authority. Our evolving credit risk position and recommendations to address issues are reviewed by the Credit Policy Committee and the Board of Directors.
Economic Factors
In evaluating credit risk, the Company considers changing economic conditions and their effects on borrowers’ ability to pay and the value of any collateral securing the loan. Beginning in mid-2007, economic conditions in the Company’s markets have deteriorated, with unemployment in the United States reaching 10% at the end of 2009. In addition, asset values, particularly home prices and, more recently, commercial real estate, have declined substantially. The deterioration in economic conditions during this time period has created pressure on consumers and businesses to service their debts, resulting in higher levels of delinquencies, charge-offs and additions to the Company’s allowance for loan and lease losses.
Credit Concentration
The Company believes that diversification of credit is another important element of evaluating credit risk. The Company maintains a diverse portfolio, offering a broad array of credit products to consumers, small businesses and commercial customers. We think our consumer portfolios are well diversified nationally and have limited exposure to regional weaknesses. Table 9: Credit Card Concentrations and Table 11: Consumer Banking Concentrations provide additional information on geographic concentrations of credit.
Our commercial real estate and middle market lending products are primarily concentrated in our local banking markets. To date, these markets have experienced less deterioration in their economic fundamentals than some of the hardest hit regions in the United States. We believe this has contributed to above average credit performance. Our most significant concentration is commercial real estate in New York. During 2009, conditions in the New York real estate market deteriorated, particularly residential construction/redevelopment and Class A office space. Within our $13.8 billion commercial real estate portfolio, $2.4 billion outstanding relates to real estate construction, of which $1.0 billion is in New York. We have $2.1 billion exposure to New York office properties, most of which is to Class B and C space. For our non-real estate lending, 32.5% of middle market lending is concentrated in Louisiana. Table 10: Commercial Banking Concentrations provides additional information on geographic concentrations.
Net Charge-Offs
Net charge-offs include the principal amount of losses (excluding accrued and unpaid finance charges and fees and fraud losses) less current period principal recoveries. We charge-off credit card loans at 180 days past due from the statement cycle date and charge-off consumer first lien mortgage loans down to estimated collateral value less cost to sell at 180 days past due. We generally charge-off other consumer loans at 120 days past the due date or upon repossession of collateral. Bankruptcies charge-off within 30 days of notification and deceased accounts charge-off within 60 days of notification. Commercial loans are charged-off when the amounts are deemed uncollectible. Costs to recover previously charged-off accounts are recorded as collection expenses in other non-interest expense.
Table 13: Net Charge-Offs
| Reported December 31 |
Managed December 31 |
|||||||||||||||||
| 2009(1) | 2008 | 2007 | 2009 | 2008 | 2007 | |||||||||||||
| Credit Card |
9.66 | % | 6.61 | % | 4.06 | % | 9.15 | % | 6.26 | % | 4.23 | % | ||||||
| Commercial Banking (1) |
1.45 | % | 0.29 | % | 0.05 | % | 1.45 | % | 0.29 | % | 0.05 | % | ||||||
| Consumer Banking (1) |
2.74 | % | 3.09 | % | 1.94 | % | 2.74 | % | 3.09 | % | 1.94 | % | ||||||
| Other |
37.11 | % | 30.87 | % | 14.05 | % | 37.11 | % | 30.87 | % | 14.05 | % | ||||||
| Total Company |
4.58 | % | 3.51 | % | 2.10 | % | 5.87 | % | 4.35 | % | 2.88 | % | ||||||
| (1) | Charge offs for 2009 do not include losses on the loans acquired from Chevy Chase Bank as they are applied against the credit mark. |
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For 2009, reported and managed net charge-off rates increased 107 basis points and 152 basis points to 4.58% and 5.87%, respectively. The increase in both the reported and managed charge-off rates was predominantly due to the continued economic downturn which persisted during 2009. In particular, commercial charge-offs increased significantly in 2009 due to the general economic downturn and particularly due to weakness in construction loans, which are included in the commercial and multi-family real estate portfolio, and in small ticket commercial real estate. The reported charge-off dollars totaled $4.6 billion during 2009, an increase of 31.3% from 2008. The managed charge-off dollars totaled $8.4 billion, increasing 31.1% from 2008.
For 2008, reported and managed net charge-off rates increased 141 basis points and 147 basis points to 3.51% and 4.35%, respectively. The increase in both the reported and managed charge-off rates was due to the continued worsening of the economy which rapidly deteriorated during the second half of 2008. The reported charge-off dollars totaled $3.5 billion during 2008, an increase of 77.4% from 2007. The managed charge-off dollars totaled $6.4 billion, increasing 54.4% from 2007.
For 2007 reported and managed net charge-off rates decreased 11 basis points to 2.10% and increased 4 basis points to 2.88%, respectively. The decrease in the reported charge-off rate was impacted by the higher credit quality North Fork loan portfolio for a full year in 2007 which more than offset the effects of continued consumer credit normalization and economic weakness during the latter part of 2007. The impacts of the continued credit normalization and economic weakness also had a significant impact on the managed charge-off rate for the Company’s credit card securitization programs. Year-to-date reported and managed net charge-off dollars increased 39% and 32%, respectively, compared to the prior year.
Delinquencies and Non performing loans
The Company believes the level of delinquencies and non performing loans to be indicators of loan portfolio credit quality at a point in time. The entire balance of an account is considered delinquent if the minimum contractually required payment is not received by the date it is due. Delinquent consumer loans are considered performing loans and accrue interest until 90 days past due for automobile and mortgage loans and 120 days for other consumer non credit card loans. Commercial loans are placed into non-accrual when the collection of principal and interest is in doubt. Credit card loans continue to accrue finance charges and fees until charged-off at 180 days. However, finance charges and fees not expected to be collected are reversed from revenue through the suppression account and loan balances are carried net of the amount not expected to be collected. Loans acquired from Chevy Chase Bank are not considered delinquent so long as they continue to perform in accordance with our expectations at the date acquired. Refer to the section “Acquired Loans” for additional information on these acquired loans.
Overall delinquency rates increased in all parts of the portfolio from December 31, 2008 to December 31, 2009. The increase is due to continued worsening of the economy, as unemployment rates continued to rise and home prices continued to decline, pressuring consumers and borrowings. Delinquency rates were also impacted by the declining loan balances for our credit card and auto finance portfolios which affected the delinquency rate far more than the slight increase in credit card delinquency dollars and the decline in auto finance delinquency dollars. Table 14: 30+ Performing Delinquencies provides summary delinquency information for the credit card, commercial and consumer banking portfolios.
Table 14: 30+ Performing Delinquencies (Managed)
| December 31, 2009 | December 31, 2008 | |||||||||||
| (Dollars in thousands) |
Amount | Rate | Amount | Rate | ||||||||
| Domestic credit card |
$ | 3,487,390 | 5.78 | % | $ | 3,389,971 | 4.78 | % | ||||
| International credit card |
539,030 | 6.55 | % | 480,534 | 5.51 | % | ||||||
| Total credit card |
$ | 4,026,420 | 5.88 | % | $ | 3,870,505 | 4.86 | % | ||||
| Commercial and multifamily real estate |
84,385 | 0.61 | % | 71,583 | 0.54 | % | ||||||
| Middle market |
46,148 | 0.46 | % | 43,854 | 0.43 | % | ||||||
| Specialty lending |
59,958 | 1.69 | % | 46,907 | 1.32 | % | ||||||
| Small ticket commercial real estate |
120,392 | 5.59 | % | 98,853 | 3.79 | % | ||||||
| Total commercial banking |
$ | 310,883 | 1.05 | % | $ | 261,197 | 0.88 | % | ||||
| Automobile |
1,824,255 | 10.03 | % | 2,128,352 | 9.90 | % | ||||||
| Mortgages |
187,940 | 1.26 | % | 158,429 | 1.57 | % | ||||||
| Retail banking |
63,243 | 1.23 | % | 59,674 | 1.06 | % | ||||||
| Total consumer banking |
$ | 2,075,438 | 5.43 | % | $ | 2,346,455 | 6.31 | % | ||||
| Other |
52,417 | 11.6 | % | 118,066 | 22.12 | % | ||||||
| Total company |
$ | 6,465,158 | 4.73 | % | $ | 6,596,223 | 4.49 | % | ||||
58
Table of Contents
Loans acquired from Chevy Chase Bank, which are accounted for under ASC 310-10/SOP 03-3, are included in our loans held for investment to calculate 30+ performing delinquencies; however, acquired loans are not considered delinquent unless they perform different than our initial expectation. Excluding the Chevy Chase Bank acquired portfolio, the delinquency rates as of December 31, 2009 would have been 2.18% for mortgages, 1.30% for retail banking and 6.56% for total consumer banking.
On a reported basis 30+ performing delinquencies is 5.85% and 5.06% for domestic credit card and 5.85% and 4.52% for international credit card at December 31, 2009 and 2008, respectively. Total credit card 30+ performing delinquencies is 4.13% and 4.37% at December 31, 2009 and 2008, respectively.
Commercial loans, automobile loans, mortgages and other retail loans are considered non performing when there is doubt concerning the full collectibility of both principal and interest or at 90 days past due, whichever is sooner. When loans are deemed non performing they are placed on non accrual status. Subsequent receipts of interest are applied to principal if there is doubt as to the collectibility of principal; otherwise these receipts are recorded as interest income when received.
Non performing loans increased $484.4 million from 2008 to $1.3 billion as of December 31, 2009. The increase occurred primarily in the Company’s commercial banking portfolio, particularly in the commercial and multifamily real estate portfolio for which non performing loans increased $286.5 million during the year. The increased level of non performing loans reflects the continued deterioration in economic factors and particularly in the value of the collateral underlying the Company’s loans.
Table 15: Non performing loans (Managed)
| As of December 31, | ||||||||||||
| 2009 (1)(2) | 2008 (1) | |||||||||||
| (Dollars in thousands) |
Amount | As a percentage of loans held for investment |
Amount | As a percentage of loans held for investment |
||||||||
| Commercial and multifamily real estate |
$ | 428,754 | 3.10 | % | $ | 142,261 | 1.07 | % | ||||
| Middle market |
104,272 | 1.04 | % | 38,677 | 0.38 | % | ||||||
| Specialty lending |
73,866 | 2.08 | % | 37,217 | 1.05 | % | ||||||
| Small ticket commercial real estate |
94,674 | 4.40 | % | 167,467 | 6.42 | % | ||||||
| Total commercial banking |
$ | 701,566 | 2.37 | % | $ | 385,622 | 1.31 | % | ||||
| Automobile |
143,341 | 0.79 | % | 164,646 | 0.77 | % | ||||||
| Mortgages |
322,473 | 2.17 | % | |||||||||