Form 10-Q
Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


 

FORM 10-Q

 


 

(Mark One)

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

 

or

 

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

 

For the quarterly period ended September 30, 2005

 

Commission file number 1-11921

 


 

E*TRADE Financial Corporation

(Exact name of registrant as specified in its charter)

 


 

Delaware   94-2844166

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification Number)

 

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

(Address of principal executive offices and zip code)

 

(646) 521-4300

(Registrant’s telephone number, including area code)

 


 

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

 

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

 

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

 

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

 

As of October 25, 2005, there were 373,883,781 shares of common stock and 897,337 shares exchangeable into common stock outstanding (the “Exchangeable Shares.”) The Exchangeable Shares, which were issued by EGI Canada Corporation in connection with the acquisition of VERSUS Technologies, Inc. (renamed E*TRADE Technologies Corporation effective January 2, 2001), are exchangeable at any time into common stock on a one-for-one basis and entitle holders to dividend, voting, and other rights equivalent to holders of the registrant’s common stock. As discussed in Note 19, the Company has begun to call these Exchangeable Shares.

 



Table of Contents

E*TRADE FINANCIAL CORPORATION AND SUBSIDIARIES

FORM 10-Q QUARTERLY REPORT

For the Three Months Ended September 30, 2005

 

TABLE OF CONTENTS

 

          Page

PART I—FINANCIAL INFORMATION

    

Item 1.

   Unaudited Condensed Consolidated Financial Statements    3
    

Consolidated Balance Sheets

   3
    

Consolidated Statements of Operations

   4
    

Consolidated Statements of Comprehensive Income

   5
    

Consolidated Statements of Shareholders’ Equity

   6
    

Consolidated Statements of Cash Flows

   7
     Notes to Unaudited Condensed Consolidated Financial Statements    9
    

Note 1 – Organization and Basis of Presentation

   9
    

Note 2 – Recent Accounting Pronouncements

   11
    

Note 3 – Discontinued Operations

   12
    

Note 4 – Brokerage Receivables, Net and Payables

   13
    

Note 5 – Available-for-Sale Mortgage-Backed and Investment Securities

   14
    

Note 6 – Loans, Net

   17
    

Note 7 – Goodwill and Intangible Assets

   17
    

Note 8 – Deposits

   18
    

Note 9 – Other Borrowings by Bank Subsidiary

   18
    

Note 10 – Corporate Debt

   18
    

Note 11 – Share Repurchases

   19
    

Note 12 – Stock-Based Compensation

   19
    

Note 13 – Facility Restructuring and Other Exit Charges

   22
    

Note 14 – Income Per Share

   24
    

Note 15 – Regulatory Requirements

   25
    

Note 16 – Commitments, Contingencies and Other Regulatory Matters

   26
    

Note 17 – Accounting for Derivative Financial Instruments and Hedging Activities

   28
    

Note 18 – Segment Information

   33
    

Note 19 – Subsequent Events

   38

Item 2.

  

Management’s Discussion and Analysis of Financial Condition and Results of Operations

   39
    

Overview

   39
    

Earnings Overview

   41
    

Segment Results Review

   48
    

Balance Sheet Overview

   50
    

Liquidity and Capital Resources

   54
    

Critical Accounting Policies and Estimates

   55
    

Risk Factors

   56

Item 3.

  

Quantitative and Qualitative Disclosures About Market Risk

   63

Item 4.

  

Controls and Procedures

   64

PART II—OTHER INFORMATION

    

Item 1.

  

Legal Proceedings

   65

Item 2.

  

Unregistered Sales of Equity Securities and Use of Proceeds

   65

Item 3.

  

Defaults Upon Senior Securities

   65

Item 4.

  

Submission of Matters to a Vote of Security Holders

   65

Item 5.

  

Other Information

   66

Item 6.

  

Exhibits

   66

Signatures

   67

 

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

 

E*TRADE, E*TRADE FINANCIAL, E*TRADE Bank, ClearStation, Equity Edge, Equity Resource, OptionsLink and the converging arrows logo, are registered trademarks of E*TRADE Financial Corporation in the United States and in other countries.


Table of Contents

PART I.    FINANCIAL INFORMATION

ITEM 1.    UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

E*TRADE FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(in thousands, except share amounts)

(unaudited)

 

     September 30,
2005


    December 31,
2004


 
ASSETS                 

Cash and equivalents

   $ 1,389,562     $ 939,906  

Cash and investments required to be segregated under Federal or other regulations

     199,463       724,026  

Brokerage receivables, net

     3,764,410       3,034,548  

Trading securities

     227,381       593,245  

Available-for-sale mortgage-backed and investment securities (includes securities pledged to creditors with the right to sell or repledge of $9,036,396 at September 30, 2005 and $10,113,049 at December 31, 2004)

     11,174,666       12,543,818  

Other investments

     45,281       46,269  

Loans receivable (net of allowance for loan losses of $59,854 at September 30, 2005 and $47,681 at December 31, 2004)

     17,534,081       11,505,755  

Loans held-for-sale, net

     151,247       279,280  

Property and equipment, net

     306,601       302,291  

Derivative assets

     152,749       115,867  

Accrued interest receivable

     150,728       117,131  

Investment in Federal Home Loan Bank Stock

     219,400       92,005  

Goodwill

     397,671       395,043  

Other intangibles, net

     120,752       134,121  

Other assets

     368,479       209,278  
    


 


Total assets

   $ 36,202,471     $ 31,032,583  
    


 


LIABILITIES AND SHAREHOLDERS’ EQUITY                 

Brokerage payables

   $ 3,734,558     $ 3,618,892  

Deposits

     14,550,696       12,302,974  

Securities sold under agreements to repurchase

     9,072,914       9,897,191  

Other borrowings by Bank subsidiary

     4,594,813       1,760,732  

Derivative liabilities

     34,599       52,208  

Senior notes

     853,654       400,452  

Convertible subordinated notes

     185,165       185,165  

Accounts payable, accrued and other liabilities

     661,777       586,767  
    


 


Total liabilities

     33,688,176       28,804,381  
    


 


Commitments and contingencies

     —         —    

Shareholders’ equity:

                

Preferred stock, shares authorized: 1,000,000; issued and outstanding: none at September 30, 2005 and December 31, 2004

     —         —    

Shares exchangeable into common stock, $0.01 par value, shares authorized: 10,644,223; issued and outstanding: 1,300,085 at September 30, 2005 and 1,302,801 at December 31 2004

     13       13  

Common stock, $0.01 par value, shares authorized: 600,000,000; issued and outstanding: 372,961,819 at September 30, 2005 and 369,623,604 at December 31, 2004

     3,730       3,696  

Additional paid-in capital

     2,237,421       2,234,093  

Deferred stock compensation

     —         (18,419 )

Retained earnings

     451,070       150,018  

Accumulated other comprehensive loss

     (177,939 )     (141,199 )
    


 


Total shareholders’ equity

     2,514,295       2,228,202  
    


 


Total liabilities and shareholders’ equity

   $ 36,202,471     $ 31,032,583  
    


 


 

See accompanying notes to unaudited condensed consolidated financial statements.

 

3


Table of Contents

E*TRADE FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share amounts)

(unaudited)

 

    Three Months
Ended
September 30,


    Nine Months Ended
September 30,


 
    2005

    2004

    2005

    2004

 

Revenues:

                               

Commissions

  $ 117,165     $ 84,869     $ 333,392     $ 332,901  

Principal transactions

    23,793       24,391       75,547       91,417  

Gain on sales of loans and securities, net

    21,850       28,415       84,121       107,078  

Service charges and fees

    32,960       21,653       100,863       73,245  

Other revenues

    22,920       20,798       67,717       68,254  

Interest income

    424,142       293,004       1,148,532       822,564  

Interest expense

    (207,101 )     (128,852 )     (535,532 )     (369,616 )
   


 


 


 


Net interest income

    217,041       164,152       613,000       452,948  

Provision for loan losses

    (12,909 )     (9,145 )     (37,946 )     (25,701 )
   


 


 


 


Net interest income after provision for loan losses

    204,132       155,007       575,054       427,247  
   


 


 


 


Total net revenues

    422,820       335,133       1,236,694       1,100,142  

Expenses excluding interest:

                               

Compensation and benefits

    103,310       82,061       282,933       266,386  

Occupancy and equipment

    16,546       18,119       52,617       54,086  

Communications

    18,609       18,075       55,854       53,888  

Professional services

    16,144       16,581       51,752       45,390  

Commissions, clearance and floor brokerage

    36,557       28,350       106,715       109,392  

Advertising and market development

    21,188       9,293       74,257       45,813  

Servicing and other banking expenses

    12,989       9,069       34,667       26,081  

Fair value adjustments of financial derivatives

    1,269       (696 )     3,905       (2,817 )

Depreciation and amortization

    19,011       19,940       54,583       59,373  

Amortization of other intangibles

    4,644       4,615       14,538       15,217  

Facility restructuring and other exit charges

    (469 )     (227 )     495       (1,233 )

Other

    21,969       18,290       62,546       62,871  
   


 


 


 


Total expenses excluding interest

    271,767       223,470       794,862       734,447  

Income before other income, income taxes, discontinued operations and cumulative effect of accounting change

    151,053       111,663       441,832       365,695  

Other income:

                               

Corporate interest income

    3,409       1,698       7,796       4,755  

Corporate interest expense

    (13,783 )     (11,873 )     (36,975 )     (35,751 )

Gain on sale and impairment of investments

    22,092       47,229       68,322       107,506  

Loss on early extinguishment of debt

    —         (18,615 )     —         (22,972 )

Equity in income of investments and venture funds

    3,103       84       7,142       3,076  
   


 


 


 


Total other income

    14,821       18,523       46,285       56,614  

Income before income taxes, discontinued operations and cumulative effect of accounting change

    165,874       130,186       488,117       422,309  

Income tax expense

    57,263       43,016       169,472       141,599  

Minority interest in subsidiaries

    —         47       56       876  
   


 


 


 


Net income from continuing operations before cumulative effect of accounting change

    108,611       87,123       318,589       279,834  

Discontinued operations, net of tax:

                               

Net loss from discontinued operations

    (2,937 )     (8,013 )     (16,763 )     (20,587 )

Net gain (loss) on disposal of discontinued operations

    171       164       (2,420 )     31,408  
   


 


 


 


Net income (loss) from discontinued operations

    (2,766 )     (7,849 )     (19,183 )     10,821  

Cumulative effect of accounting change, net of tax

    1,646       —         1,646       —    
   


 


 


 


Net income

  $ 107,491     $ 79,274     $ 301,052     $ 290,655  
   


 


 


 


Basic income per share

                               

Basic income per share from continuing operations

  $ 0.29     $ 0.23     $ 0.87     $ 0.76  

Basic income (loss) per share from discontinued operations

    (0.00 )     (0.02 )     (0.05 )     0.03  

Basic income per share from cumulative effect of accounting change

    0.00       —         0.00       —    
   


 


 


 


    $ 0.29     $ 0.21     $ 0.82     $ 0.79  
   


 


 


 


Basic net income per share

                               

Diluted income per share from continuing operations

  $ 0.28     $ 0.23     $ 0.84     $ 0.72  

Diluted income (loss) per share from discontinued operations

    (0.00 )     (0.02 )     (0.05 )     0.03  

Diluted income per share from cumulative effect of accounting change

    0.00       —         0.00       —    
   


 


 


 


Diluted net income per share

  $ 0.28     $ 0.21     $ 0.79     $ 0.75  
   


 


 


 


Shares used in computation of per share data:

                               

Basic

    367,342       369,103       366,215       366,244  

Diluted

    382,031       380,557       379,768       411,073  

 

See accompanying notes to unaudited condensed consolidated financial statements.

 

4


Table of Contents

E*TRADE FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(in thousands)

(unaudited)

 

     Three Months Ended
September 30,


   

Nine Months Ended

September 30,


 
     2005

    2004

    2005

    2004

 

Net income

   $ 107,491     $ 79,274     $ 301,052     $ 290,655  

Other comprehensive income (loss)

                                

Available-for-sale securities:

                                

Unrealized gains (losses)

     (34,358 )     173,036       38,482       46,254  

Less impact of realized gains (transferred out of AOCI) included in net income

     (24,211 )     (64,519 )     (102,787 )     (156,853 )

Tax effect

     24,542       (41,368 )     25,797       52,499  
    


 


 


 


Net change from available-for-sale securities

     (34,027 )     67,149       (38,508 )     (58,100 )
    


 


 


 


Cash flow hedging instruments:

                                

Unrealized gains (losses)

     135,348       (186,772 )     (25,807 )     (77,870 )

Amortization of losses into interest expense from de-designated cash flow hedges deferred in AOCI

     14,056       22,811       57,490       70,945  

Tax effect

     (57,755 )     63,518       (12,796 )     2,519  
    


 


 


 


Net change from cash flow hedging instruments

     91,649       (100,443 )     18,887       (4,406 )
    


 


 


 


Foreign currency translation loss

     (2,631 )     (5,023 )     (17,119 )     (14,155 )
    


 


 


 


Other comprehensive income (loss)

     54,991       (38,317 )     (36,740 )     (76,661 )
    


 


 


 


Comprehensive income

   $ 162,482     $ 40,957     $ 264,312     $ 213,994  
    


 


 


 


 

 

See accompanying notes to unaudited condensed consolidated financial statements.

 

5


Table of Contents

E*TRADE FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

(in thousands)

(unaudited)

 

    Shares
Exchangeable
into
Common Stock


  Common Stock

    Additional
Paid-in
Capital


    Deferred
Stock
Compensation


    Retained
Earnings


  Accumulated
Other
Comprehensive
Loss


    Total
Shareholders’
Equity


 
    Shares

    Amount

  Shares

    Amount

           

Balance, December 31, 2004

  1,303     $ 13   369,624     $ 3,696     $ 2,234,093     $ (18,419 )   $ 150,018   $ (141,199 )   $ 2,228,202  

Net income

                                              301,052             301,052  

Other comprehensive loss

                                                    (36,740 )     (36,740 )

Exercise of stock options and warrants, including tax benefit

              7,302       73       68,483                             68,556  

Issuance of common stock upon acquisition

              300       3       4,038                             4,041  

Repurchases of common stock

              (4,548 )     (45 )     (58,170 )                           (58,215 )

Issuance of restricted stock

              830       8       9,892       (9,900 )                   —    

Cancellation of restricted stock

              (517 )     (5 )     (2,952 )     2,957                     —    

Retirement of restricted stock to pay taxes

              (32 )     —         (448 )                           (448 )

Amortization of deferred stock compensation prior to adoption of SFAS No. 123(R)

                                      1,974                     1,974  

Cumulative effect of accounting change

                                      (2,777 )                   (2,777 )

Stock-based compensation under SFAS No. 123(R)

                              8,608                             8,608  

Other

  (3 )     —     3       —         42                             42  
   

 

 

 


 


 


 

 


 


Balance, September 30, 2005

  1,300     $ 13   372,962     $ 3,730     $ 2,263,586     $ (26,165 )   $ 451,070   $ (177,939 )   $ 2,514,295  
   

 

 

 


 


 


 

 


 


 

    Shares
Exchangeable
into
Common Stock


    Common Stock

    Additional
Paid-in
Capital


    Deferred
Stock
Compensation


    Retained
Earnings


    Accumulated
Other
Comprehensive
Loss


    Total
Shareholders’
Equity


 
    Shares

    Amount

    Shares

    Amount

           

Balance, December 31, 2003

  1,386     $ 14     366,636     $ 3,666     $ 2,247,930     $ (12,874 )   $ (230,465 )   $ (89,977 )   $ 1,918,294  

Net income

                                                290,655               290,655  

Other comprehensive loss

                                                        (76,661 )     (76,661 )

Exercise of stock options and warrants, including tax benefit

                7,067       71       50,203                               50,274  

Repurchases of common stock

                (9,626 )     (96 )     (119,714 )                             (119,810 )

Issuance of restricted stock

                698       7       8,201       (8,108 )                     100  

Cancellation of restricted stock

                (138 )     (1 )     (1,181 )     859                       (323 )

Shares issued upon debt conversion

                7,438       74       79,889                               79,963  

Amortization of deferred stock compensation

                                        3,234                       3,234  

Other

  (60 )     (1 )   221       2       5,117                               5,118  
   

 


 

 


 


 


 


 


 


Balance, September 30, 2004

  1,326     $ 13     372,296     $ 3,723     $ 2,270,445     $ (16,889 )   $ 60,190     $ (166,638 )   $ 2,150,844  
   

 


 

 


 


 


 


 


 


 

See accompanying notes to unaudited condensed consolidated financial statements.

 

6


Table of Contents

E*TRADE FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

 

    

Nine Months Ended

September 30,


 
     2005

    2004

 

CASH FLOWS FROM OPERATING ACTIVITIES:

                

Net income

   $ 301,052     $ 290,655  

Adjustments to reconcile net income to net cash provided by operating activities:

                

Cumulative effect of accounting change, net of tax

     (1,646 )     —    

Provision for loan losses

     37,946       25,701  

Depreciation, amortization and accretion

     265,686       297,134  

Realized loss and impairment of investments

     38,343       17,914  

Equity in income of subsidiaries and investments

     (6,583 )     (8,611 )

Non-cash restructuring costs and other exit charges

     3,764       (1,884 )

Stock-based compensation expense

     10,582       3,234  

Gain on sale of investments

     (182,511 )     (228,892 )

Gain on disposition of assets

     —         (57,451 )

Unrealized (gains) losses on venture funds

     (811 )     5,405  

Other

     (9,155 )     2,967  

Net effect of changes in brokerage-related assets and liabilities:

                

Decrease in cash and investments required to be segregated under Federal or other regulations

     527,443       928,560  

Increase in brokerage receivables

     (733,025 )     (1,409,996 )

Increase in brokerage payables

     133,776       431,089  

Net effect of changes in banking-related assets and liabilities:

                

Proceeds from sales, repayments and maturities of loans held-for-sale

     5,610,773       5,283,401  

Purchases of loans held-for-sale

     (3,096,313 )     (4,819,757 )

Proceeds from sales, repayments and maturities of trading securities

     3,134,296       7,499,672  

Purchases of trading securities

     (5,265,037 )     (7,327,018 )

Other changes, net:

                

Other assets

     70,226       (83,837 )

Accrued interest receivable and payable, net

     (15,699 )     (15,669 )

Accounts payable, accrued and other liabilities

     (154,553 )     26,270  

Restructuring liabilities

     (7,301 )     (12,598 )
    


 


Net cash provided by operating activities

   $ 661,253     $ 846,289  
    


 


 

See accompanying notes to unaudited condensed consolidated financial statements.

 

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E*TRADE FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS – (Continued)

(in thousands)

(unaudited)

 

    

Nine Months Ended

September 30,


 
     2005

    2004

 

CASH FLOWS FROM INVESTING ACTIVITIES:

                

Purchase of mortgage-backed securities, available-for-sale securities and other investments

   $ (11,910,529 )   $ (16,406,991 )

Proceeds from sales, maturities of and principal payments on mortgage-backed securities, available-for-sale securities and other investments

     13,189,651       14,182,109  

Net increase in loans receivable

     (6,007,625 )     (2,255,364 )

Purchases of Federal Home Loan Bank stock

     (127,395 )     (21,224 )

Purchases of property and equipment

     (58,302 )     (68,095 )

Proceeds from sales of property and equipment

     —         119  

Proceeds from venture fund distribution

     17,673       —    

Net cash flow from derivatives hedging assets

     (26,414 )     (32,063 )

Proceeds from sale of E*TRADE Access

     —         106,868  

Cash used in acquisitions

     (5,737 )     (2,020 )

Other

     3,105       1,759  
    


 


Net cash used in investing activities

     (4,925,573 )     (4,494,902 )
    


 


CASH FLOWS FROM FINANCING ACTIVITIES:

                

Net increase (decrease) in banking deposits

     2,267,717       (481,055 )

Advances from the Federal Home Loan Bank

     17,018,000       4,109,000  

Payments on advances from the Federal Home Loan Bank

     (14,187,000 )     (3,668,000 )

Net increase (decrease) in securities sold under agreements to repurchase

     (831,856 )     3,756,328  

Net decrease in other borrowed funds

     (14,941 )     (51,225 )

Payments on call of convertible subordinated notes

     —         (428,902 )

Proceeds from issuance of senior notes

     447,452       394,000  

Issuance of loans to related parties

     (330 )     (241 )

Proceeds from issuance of common stock from employee stock transactions

     48,299       37,020  

Tax benefit from tax deductions in excess of compensation cost recognized

     19,126       14,378  

Proceeds from issuance of subordinated debentures and trust preferred securities

     20,000       45,880  

Payments on trust preferred securities

     —         (23,375 )

Proceeds from Company loans and lines of credit

     —         77,900  

Payments on Company loans and lines of credit

     —         (46,700 )

Purchases of treasury stock

     (58,215 )     (119,810 )

Repayment of capital lease obligations

     (128 )     (599 )

Net cash flow from derivatives hedging liabilities

     (14,148 )     (156,319 )
    


 


Net cash provided by financing activities

     4,713,976       3,458,280  
    


 


INCREASE (DECREASE) IN CASH AND EQUIVALENTS

     449,656       (190,333 )

CASH AND EQUIVALENTS—Beginning of period

     939,906       921,364  
    


 


CASH AND EQUIVALENTS—End of period

   $ 1,389,562     $ 731,031  
    


 


SUPPLEMENTAL DISCLOSURES:

                

Cash paid for interest

   $ 547,932     $ 317,538  
    


 


Cash paid for income taxes

   $ 88,023     $ 60,524  
    


 


Non-cash investing and financing activities:

                

Reclassification of loans held-for-sale to loans held-for-investment

   $ 126,887     $ —    
    


 


Transfer from loans to other real estate owned and repossessed assets

   $ 36,788     $ 32,966  
    


 


Common stock issued upon conversion of convertible subordinated notes by election of debtholders

   $ —       $ 79,963  
    


 


 

See accompanying notes to unaudited condensed consolidated financial statements.

 

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E*TRADE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

NOTE 1—ORGANIZATION AND BASIS OF PRESENTATION

 

Organization

 

E*TRADE Financial Corporation (the “Company,” “Parent” or “E*TRADE FINANCIAL”) is a family of companies that provide financial services including trading, investing, banking and lending for retail and institutional customers.

 

Trading and investing products and services are primarily offered by the Company’s broker-dealer subsidiaries. The Company’s significant broker-dealers include:

 

    E*TRADE Securities LLC (“E*TRADE Securities”);

 

    E*TRADE Clearing LLC (“E*TRADE Clearing”), the clearing firm for some of the Company’s broker-dealers;

 

    E*TRADE Professional Trading, LLC and E*TRADE Professional Securities, LLC (“ETPS”), which was closed on May 31, 2005 (collectively “E*TRADE Professional”); and

 

    E*TRADE Capital Markets—Execution Services, LLC and E*TRADE Capital Markets, LLC (collectively, “E*TRADE Capital Markets”), formerly Dempsey & Company and GVR, respectively.

 

Banking and lending products and services are primarily offered through subsidiaries of E*TRADE Bank (the “Bank”), a Federally chartered savings bank that provides deposit accounts that are insured by the Federal Deposit Insurance Corporation (“FDIC”). The Bank’s significant subsidiaries include:

 

    E*TRADE Consumer Finance Corporation (“E*TRADE Consumer Finance”), a consumer loan originator and servicer, which was sold effective October 31, 2005; and

 

    E*TRADE Mortgage Corporation (“E*TRADE Mortgage”), a direct-to-customer mortgage loan originator.

 

Basis of Presentation

 

These condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and Regulation S-X, Article 10 under the Securities Exchange Act of 1934. They are unaudited and exclude some of the disclosures for annual financial statements. Management believes it has made all necessary adjustments so that the financial statements are presented fairly. The results of operations for the three and nine months ended September 30, 2005 may not be indicative of future results. Certain prior period items in these condensed consolidated financial statements have been reclassified to conform to the current period presentation. As discussed in Note 3, the operations of certain businesses have been accounted for as discontinued operations in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. Accordingly, results of operations from prior periods have been reclassified to discontinued operations. Unless noted, discussions herein pertain to the Company’s continuing operations. Because the Company operates in the financial services industry, it follows certain accounting guidance used by the brokerage and banking industries.

 

These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements of E*TRADE Financial Corporation included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2004 (portions of which have been reclassified in the Company’s Current Report on Form 8-K filed on October 17, 2005).

 

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New Revenue Reporting Format

 

Beginning in 2005, we revised our presentation of revenue in our consolidated statements of operations. In our new format, we show total revenues in an integrated view rather than separately by brokerage and banking. Commission revenues include commissions generated by our retail customers and now also include the commission-based portion of our global execution and settlement service business, which were previously reported as principal transactions. We have also combined our previously reported gains on originated loans with gains on loans held-for-sale and securities, net. Items previously reported as other brokerage- and banking-related revenues have been combined and presented as service charges and fees and other revenues. Finally, brokerage and banking interest income and expense have been combined.

 

Significant Accounting Policy

 

Effective July 1, 2005, the Company early adopted SFAS No. 123(R), Share-Based Payment and Staff Accounting Bulletin No. 107, Share-Based Payment, using the modified prospective application method to account for its share-based compensation plans. The combined impact of the adoption totaled $7.5 million in compensation and benefits and a pre-tax credit of $2.8 million in cumulative effect of accounting change for the three months ended September 30, 2005. Results for prior periods have not been restated. Prior to July 1, 2005, the Company accounted for its employee stock option plans under Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations, and accordingly, did not record compensation costs for grants to employees when the exercise price equaled the fair market value on the grant date.

 

Under this transition method, compensation cost in 2005 includes the portion of options vesting in the period for (1) all share-based payments granted prior to, but not vested as of July 1, 2005, based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123, Accounting for Stock-Based Compensation and (2) all share-based payments granted subsequent to July 1, 2005, based on the grant date fair value estimated in accordance with the provisions of SFAS No. 123(R). Compensation cost for options granted prior to July 1, 2005 is recognized on an accelerated amortization method over the vesting period of the options using an estimated forfeiture rate. Compensation cost for options granted on or after July 1, 2005 is recognized on a straight-line basis over the vesting period using an estimated forfeiture rate. Also under SFAS No. 123(R), the Company has reflected the tax benefit from tax deductions in excess of compensation recognized as a financing activity in the statements of cash flows.

 

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The following table illustrates the effect on the Company’s reported net income and net income per share if the Company had applied the fair value recognition provisions of SFAS No. 123, to stock-based employee compensation in periods prior to July 1, 2005 (in thousands, except per share amounts):

 

     Three Months
Ended
September 30,


    Nine Months Ended
September 30,


 
     2004

    2005

    2004

 

Net income, as reported(1)

   $ 79,274     $ 301,052     $ 290,655  

Add back: Stock-based employee compensation expense included in reported net income, net of tax(2)

     772       6,568       2,145  

Deduct: Total stock-based employee compensation expense determined under fair value-based method for all awards, net of tax(2)

     (5,683 )     (13,944 )     (14,559 )
    


 


 


Pro forma net income

   $ 74,363     $ 293,676     $ 278,241  
    


 


 


Net income per share:

                        

Basic—as reported

   $ 0.21     $ 0.82     $ 0.79  
    


 


 


Basic—pro forma

   $ 0.20     $ 0.80     $ 0.76  
    


 


 


Diluted—as reported

   $ 0.21     $ 0.79     $ 0.75  
    


 


 


Diluted—pro forma

   $ 0.20     $ 0.77     $ 0.72  
    


 


 



(1)   The three months ended September 30, 2005 are not presented as the Company’s adoption of SFAS No. 123(R) was effective for the entire period.
(2)   For the nine months ended September 30, 2005, amounts include impact of adoption of SFAS No. 123(R) for the three months ended September 30, 2005.

 

See Note 12 for further details regarding the Company’s adoption of SFAS No. 123(R) and the underlying assumptions to these fair value calculations.

 

NOTE 2—RECENT ACCOUNTING PRONOUNCEMENTS

 

SFAS No. 154—Accounting Changes and Error Corrections

 

In June 2005, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 154, Accounting Changes and Error Corrections. This statement supersedes APB Opinion No. 20, Accounting Changes, and SFAS No. 3, Reporting Accounting Changes in Interim Financial Statements. The statement applies to all voluntary changes in accounting principle, and changes the requirements for accounting for and reporting of a change in accounting principle. SFAS No. 154 requires retrospective application to prior periods’ financial statements of a voluntary change in accounting principle unless it is impracticable. The statement requires that a change in method of depreciation, amortization, or depletion for long-lived, nonfinancial assets be accounted for as a change in accounting estimate that is effected by a change in accounting principle. SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The statement does not change the transition provisions of any existing accounting pronouncements, including those that are in a transition phase as of the effective date of this statement. The Company will adopt SFAS No. 154, as applicable, beginning in 2006.

 

SOP No. 03-3—Accounting for Certain Loans or Debt Securities Acquired in a Transfer

 

In December 2003, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants issued Statement of Position (“SOP”) No. 03-3, Accounting for Certain Loans or Debt Securities Acquired in a Transfer to address accounting for differences between the contractual cash flows of certain loans and debt securities and the cash flows expected to be collected when loans or debt securities are acquired in a transfer and those cash flow differences are attributable, at least in part, to credit quality. As such,

 

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SOP No. 03-3 applies to loans and debt securities purchased or acquired in purchase business combinations and does not apply to originated loans. The application of SOP No. 03-3 limits the interest income, including accretion of purchase price discounts, that may be recognized for certain loans and debt securities. Additionally, SOP No. 03-3 requires that the excess of contractual cash flows over cash flows expected to be collected (nonaccretable difference) not be recognized as an adjustment of yield or valuation allowance, such as the allowance for credit losses. Subsequent to the initial investment, increases in expected cash flows generally should be recognized prospectively through adjustment of the yield on the loan or debt security over its remaining life. Decreases in expected cash flows should be recognized as impairment. SOP No. 03-3 is effective for loans and debt securities acquired in fiscal years beginning after December 15, 2004, with early application encouraged. In 2005, the Company adopted this new pronouncement, which effect was not material to the Company’s financial condition, results of operations or cash flows.

 

NOTE 3—DISCONTINUED OPERATIONS

 

Proprietary Trading

 

On May 9, 2005, the Company’s institutional segment closed its E*TRADE Professional unit responsible for both proprietary and hybrid proprietary trading models. In June 2005, the Company filed to withdraw its broker-dealer license related to this business, for ETPS, with an effective date of May 31, 2005. ETPS was a Philadelphia Stock Exchange member and a standalone entity which employed less than 200 traders. This closure resulted in a $2.4 million, net of tax, loss on disposal of discontinued operations, which included employee terminations, facility closure and write-off of goodwill and intangibles.

 

The Company will not have significant continuing involvement in the operations of this proprietary trading business and will not continue any significant revenue-producing or cost-generating activities of this proprietary trading business. Therefore, the results of operations, net of income taxes, of this proprietary trading business are presented as discontinued operations on the Company’s unaudited consolidated statements of operations for all periods presented.

 

The following table summarizes the results of discontinued operations for this proprietary trading business (in thousands):

 

     Three Months Ended
September 30,


    Nine Months Ended
September 30,


 
     2005

    2004

    2005

    2004

 

Net revenues

   $ —       $ 3,290     $ 6,996     $ 17,674  
    


 


 


 


Loss from discontinued operations before income taxes

   $ (260 )   $ (3,875 )   $ (6,064 )   $ (7,313 )

Income tax benefit

     103       1,259       2,392       2,375  
    


 


 


 


Net loss from discontinued operations

   $ (157 )   $ (2,616 )   $ (3,672 )   $ (4,938 )
    


 


 


 


 

Consumer Lending

 

Effective October 31, 2005, the Company sold its recreational vehicle and marine loan origination and servicing businesses.

 

The Company will not have significant continuing involvement in the operations of the origination business and will not continue any significant revenue-producing or cost-generating activities of this origination business. Therefore, the results of operations, net of income taxes, of this origination business are presented as discontinued operations on the Company’s unaudited consolidated statements of operations for all periods presented.

 

The Company will not have significant continuing involvement in the operations of the servicing business but will continue to have significant cost-generating activities in the form of a servicing agreement. As such,

 

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classification of the servicing business as a discontinued operation is not appropriate and, therefore, the servicing business is deemed “held-for-sale.”

 

The following table summarizes the results of discontinued operations for the origination business (in thousands):

 

     Three Months Ended
September 30,


    Nine Months Ended
September 30,


 
     2005

    2004

    2005

    2004

 

Net revenues

   $ (552 )   $ (1,286 )   $ (7,285 )   $ 648  
    


 


 


 


Loss from discontinued operations before income taxes

   $ (4,502 )   $ (7,964 )   $ (21,201 )   $ (23,627 )

Income tax benefit

     1,722       3,295       8,110       9,757  
    


 


 


 


Net loss from discontinued operations

   $ (2,780 )   $ (4,669 )   $ (13,091 )   $ (13,870 )
    


 


 


 


 

NOTE 4—BROKERAGE RECEIVABLES, NET AND PAYABLES

 

Brokerage receivables, net and payables consist of the following (in thousands):

 

    

September 30,

2005


   December 31,
2004


Receivable from customers and non-customers (less allowance for doubtful accounts of $6,843 at September 30, 2005 and $1,970 at December 31, 2004)

   $ 2,028,750    $ 2,214,210

Receivable from brokers, dealers and clearing organizations:

             

Net settlement and deposits with clearing organizations

     655,528      158,780

Deposits paid for securities borrowed

     1,025,395      613,546

Securities failed to deliver

     4,858      11,762

Other

     49,879      36,250
    

  

Total brokerage receivables, net

   $ 3,764,410    $ 3,034,548
    

  

Payable to customers and non-customers

   $ 2,403,176    $ 2,805,662

Payable to brokers, dealers and clearing organizations:

             

Deposits received for securities loaned

     1,144,689      735,622

Securities failed to receive

     10,723      10,604

Other

     175,970      67,004
    

  

Total brokerage payables

   $ 3,734,558    $ 3,618,892
    

  

 

Receivable from customers primarily represents credit extended to customers to finance their purchases of securities on margin, as well as commission receivables from customers upon settlement of their trades. Receivable from non-customers primarily represents credit extended to principal officers and directors of the Company to finance their purchase of securities on margin. Securities owned by customers and non-customers are held as collateral for amounts due on margin balances, the value of which is not reflected in the consolidated balance sheets. In many cases, the Company is permitted to sell or repledge these securities held as collateral and use the securities to enter into securities lending transactions, to collateralize borrowings or for delivery to counterparties to cover customer short positions. At September 30, 2005, the fair value of securities that the Company has received as collateral, where the Company is permitted to sell or repledge the securities is approximately $4.3 billion. Of this amount, $1.5 billion has been pledged or sold at September 30, 2005 in connection with securities loans, bank borrowings and deposits with clearing organizations.

 

Receivable from and payable to brokers, dealers and clearing organizations result from the Company’s brokerage activities. Payable to customers and non-customers represents free credit balances and other customer and non-customer funds pending completion of securities transactions. The Company pays interest on certain customer and non-customer credit balances.

 

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Table of Contents

NOTE 5—AVAILABLE-FOR-SALE MORTGAGE-BACKED AND INVESTMENT SECURITIES

 

The amortized cost basis and estimated fair value of available-for-sale mortgage-backed and investment securities are shown in the following table (in thousands):

 

     Amortized
Cost


   Gross
Unrealized
Gains


   Gross
Unrealized
Losses


    Estimated
Fair Value


September 30, 2005:

                            

Mortgage-backed securities:

                            

U.S. Government sponsored enterprise obligations:

                            

Federal National Mortgage Association

   $ 6,363,807    $ —      $ (161,801 )   $ 6,202,006

Government National Mortgage Association

     2,289,571      —        (58,358 )     2,231,213

Federal Home Loan Mortgage Corporation

     21,051      —        (1,073 )     19,978
    

  

  


 

Total U.S. Government sponsored enterprise

     8,674,429      —        (221,232 )     8,453,197

Collateralized mortgage obligations

     917,510      338      (16,848 )     901,000

Private issuer and other

     5,050      32      (67 )     5,015
    

  

  


 

Total mortgage-backed securities

     9,596,989      370      (238,147 )     9,359,212
    

  

  


 

Investment securities:

                            

Debt securities:

                            

Asset-backed securities

     1,127,886      2,617      (8,934 )     1,121,569

Municipal bonds

     128,604      1,269      (790 )     129,083

Corporate bonds

     75,941      —        (2,843 )     73,098

Other debt securities

     79,110      —        (5,198 )     73,912
    

  

  


 

Total debt securities

     1,411,541      3,886      (17,765 )     1,397,662

Publicly traded equity securities

     313,553      82,850      (3,261 )     393,142

Retained interests from securitizations

     22,968      1,682      —         24,650
    

  

  


 

Total investment securities

     1,748,062      88,418      (21,026 )     1,815,454
    

  

  


 

Total available-for-sale securities

   $ 11,345,051    $ 88,788    $ (259,173 )   $ 11,174,666
    

  

  


 

December 31, 2004:

                            

Mortgage-backed securities:

                            

U.S. Government sponsored enterprise obligations:

                            

Federal National Mortgage Association

   $ 5,149,991    $ 203    $ (87,990 )   $ 5,062,204

Government National Mortgage Association

     2,767,087      349      (56,628 )     2,710,808

Federal Home Loan Mortgage Corporation

     21,057      —        (862 )     20,195
    

  

  


 

Total U.S. Government sponsored enterprise

     7,938,135      552      (145,480 )     7,793,207

Collateralized mortgage obligations

     1,259,497      4,983      (12,539 )     1,251,941

Private issuer and other

     7,239      25      (343 )     6,921
    

  

  


 

Total mortgage-backed securities

     9,204,871      5,560      (158,362 )     9,052,069
    

  

  


 

Investment securities:

                            

Debt securities:

                            

Asset-backed securities

     2,789,471      21,662      (14,704 )     2,796,429

Municipal bonds

     136,362      1,391      (1,082 )     136,671

Corporate bonds

     87,959      —        (3,444 )     84,515

Other debt securities

     80,189      —        (4,767 )     75,422
    

  

  


 

Total debt securities

     3,093,981      23,053      (23,997 )     3,093,037

Publicly traded equity securities

     295,593      81,304      (2,055 )     374,842

Retained interests from securitizations

     23,870      —        —         23,870
    

  

  


 

Total investment securities

     3,413,444      104,357      (26,052 )     3,491,749
    

  

  


 

Total available-for-sale securities

   $ 12,618,315    $ 109,917    $ (184,414 )   $ 12,543,818
    

  

  


 

 

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Table of Contents

Other-Than-Temporary Impairment of Investments

 

The following table shows the fair value and unrealized losses on investments, aggregated by investment category and the length of time that individual securities have been in a continuous unrealized loss position (in thousands):

 

     Less than 12 months

    12 months or more

    Total

 
     Fair
Value


  Unrealized
Losses


    Fair
Value


  Unrealized
Losses


    Fair
Value


  Unrealized
Losses


 

September 30, 2005:

                                          

Mortgage-backed securities:

                                          

U.S. Government sponsored enterprise

   $ 5,833,821   $ (146,111 )   $ 2,619,364   $ (75,121 )   $ 8,453,185   $ (221,232 )

Other

     283,176     (3,951 )     590,850     (12,964 )     874,026     (16,915 )
    

 


 

 


 

 


Total mortgage-backed securities

     6,116,997     (150,062 )     3,210,214     (88,085 )     9,327,211     (238,147 )
    

 


 

 


 

 


Investment securities:

                                          

Asset-backed securities

     514,275     (3,780 )     181,257     (5,154 )     695,532     (8,934 )

Municipal bonds

     32,208     (261 )     22,960     (529 )     55,168     (790 )

Corporate bonds

     —       —         72,237     (2,843 )     72,237     (2,843 )

Other debt securities

     —       —         73,912     (5,198 )     73,912     (5,198 )

Publicly traded equity securities

     65,894     (1,931 )     12,176     (1,330 )     78,070     (3,261 )
    

 


 

 


 

 


Total investment securities

     612,377     (5,972 )     362,542     (15,054 )     974,919     (21,026 )
    

 


 

 


 

 


Total temporarily impaired securities

   $ 6,729,374   $ (156,034 )   $ 3,572,756   $ (103,139 )   $ 10,302,130   $ (259,173 )
    

 


 

 


 

 


December 31, 2004:

                                          

Mortgage-backed securities:

                                          

U.S. Government sponsored enterprise

   $ 5,504,676   $ (85,020 )   $ 2,135,727   $ (60,460 )   $ 7,640,403   $ (145,480 )

Other

     704,369     (6,715 )     175,678     (6,167 )     880,047     (12,882 )
    

 


 

 


 

 


Total mortgage-backed securities

     6,209,045     (91,735 )     2,311,405     (66,627 )     8,520,450     (158,362 )
    

 


 

 


 

 


Investment securities:

                                          

Asset-backed securities

     771,250     (5,851 )     20,769     (8,853 )     792,019     (14,704 )

Municipal bonds

     72,146     (1,082 )     —       —         72,146     (1,082 )

Corporate bonds

     —       —         84,515     (3,444 )     84,515     (3,444 )

Other debt securities

     —       —         74,700     (4,767 )     74,700     (4,767 )

Publicly traded equity securities

     52,717     (2,055 )     —       —         52,717     (2,055 )
    

 


 

 


 

 


Total investment securities

     896,113     (8,988 )     179,984     (17,064 )     1,076,097     (26,052 )
    

 


 

 


 

 


Total temporarily impaired securities

   $ 7,105,158   $ (100,723 )   $ 2,491,389   $ (83,691 )   $ 9,596,547   $ (184,414 )
    

 


 

 


 

 


 

The Company regularly analyzes certain available-for-sale investments for other-than-temporary impairment in accordance with its accounting policies, which can be found in the Company’s Annual Report on Form 10-K for the year ended December 31, 2004. The Company has the intent and ability to hold these securities for the foreseeable future and has not made the decision to dispose of these securities as of September 30, 2005. Based on its evaluation, the Company recorded other-than-temporary charges of $7.4 million and $38.3 million for the three and nine months ended September 30, 2005, respectively. For the three and nine months ended September 30, 2004, the Company recorded other-than-temporary charges of $9.3 million and $13.5 million, respectively.

 

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Table of Contents

Publicly Traded Equity Securities

 

The following table shows the fair value and unrealized gains (losses) on publicly traded equity securities (in thousands):

 

     Fair Value

   Unrealized
Gains (Losses)


 

September 30, 2005:

               

Federal National Mortgage Association

   $ 187,340    $ (963 )

Federal Home Loan Mortgage Corporation

     100,135      (1,802 )

International Securities Exchange

     38,747      37,795  

IL & FS Investmart Limited (“Investmart”)

     25,583      19,539  

Softbank Investment Corporation (“SBI”)

     15,531      13,253  

E*TRADE Japan

     13,150      3,278  

E*TRADE Australia

     9,051      7,664  

Other

     3,605      825  
    

  


Total publicly traded equity securities

   $ 393,142    $ 79,589  
    

  


December 31, 2004:

               

Federal National Mortgage Association

   $ 187,610    $ (693 )

Federal Home Loan Mortgage Corporation

     87,009      1,107  

SBI

     78,608      66,257  

Archipelago Holdings, Incorporated

     11,280      5,612  

E*TRADE Australia

     8,156      6,769  

Other

     2,179      197  
    

  


Total publicly traded equity securities

   $ 374,842    $ 79,249  
    

  


 

During the three and nine months ended September 30, 2005, the Company recognized gains on sales of its publicly traded equity securities of $22.6 million and $68.6 million, respectively. These gains included $22.6 million and $50.4 million, for the three and nine months ended September 30, 2005, respectively, on sales of the Company’s holdings in SBI, reducing the Company’s ownership to 0.55%; and for the nine months ended September 30, 2005, sales of all of its holdings in Archipelago, recognizing gains of $9.8 million; and sales of all of its holdings in Ameritrade Holding Corporation, recognizing gains of $8.4 million.

 

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NOTE 6—LOANS, NET

 

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

 

     Held-for-
Investment


    Held-for-
Sale


   Total
Loans


 

September 30, 2005:

                       

Real estate loans:

                       

One- to four-family

   $ 7,217,843     $ 129,306    $ 7,347,149  

Home equity line of credit (“HELOC”) and second mortgage

     6,035,013       73      6,035,086  

Other

     1,570       76      1,646  
    


 

  


Total real estate loans

     13,254,426       129,455      13,383,881  
    


 

  


Consumer and other loans:

                       

Recreational vehicle (“RV”)

     2,751,985       17,393      2,769,378  

Marine

     773,876       4,253      778,129  

Automobile

     298,686       10      298,696  

Credit card

     188,732       —        188,732  

Commercial

     48,471       —        48,471  

Other

     10,006       —        10,006  
    


 

  


Total consumer and other loans

     4,071,756       21,656      4,093,412  
    


 

  


Total loans

     17,326,182       151,111      17,477,293  

Unamortized premiums, net

     267,753       136      267,889  

Allowance for loan losses

     (59,854 )     —        (59,854 )
    


 

  


Total loans, net

   $ 17,534,081     $ 151,247    $ 17,685,328  
    


 

  


December 31, 2004:

                       

Real estate loans:

                       

One- to four-family

   $ 3,669,594     $ 244,593    $ 3,914,187  

HELOC and second mortgage

     3,617,074       3,009      3,620,083  

Other

     1,666       86      1,752  
    


 

  


Total real estate loans

     7,288,334       247,688      7,536,022  
    


 

  


Consumer and other loans:

                       

RV

     2,542,645       25,246      2,567,891  

Marine

     720,513       3,612      724,125  

Automobile

     583,354       35      583,389  

Credit card

     203,169       —        203,169  

Commercial

     3,012       —        3,012  

Other

     16,481       —        16,481  
    


 

  


Total consumer and other loans

     4,069,174       28,893      4,098,067  
    


 

  


Total loans

     11,357,508       276,581      11,634,089  

Unamortized premiums, net

     195,928       2,699      198,627  

Allowance for loan losses

     (47,681 )     —        (47,681 )
    


 

  


Total loans, net

   $ 11,505,755     $ 279,280    $ 11,785,035  
    


 

  


 

NOTE 7—GOODWILL AND INTANGIBLE ASSETS

 

In April 2005, the Company completed its acquisition of SV International, an institutional broker regulated in France, with a client base trading primarily in French and U.S. equities. The Company paid initial consideration of $2.8 million in cash. Additional consideration will be contingent upon the target gross revenue

 

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for the two consecutive twelve-month periods commencing April 1, 2005. In connection with the acquisition, the Company recorded $1.8 million in goodwill and $1.6 million in intangible assets.

 

As discussed in Note 3, in May 2005, the Company closed its proprietary and hybrid proprietary trading businesses within E*TRADE Professional. As a result, the Company wrote off $2.4 million in intangible assets and reduced its goodwill by $1.1 million, which comprised a write-off of $0.3 million and a reduction in deferred taxes of $0.8 million.

 

NOTE 8—DEPOSITS

 

Deposits are summarized as follows (dollars in thousands):

 

    Weighted-Average Rate

    Balance at

  Percent

 
   

September 30,

2005


    December 31,
2004


   

September 30,

2005


  December 31,
2004


 

September 30,

2005


    December 31,
2004


 

Sweep deposit account

  0.58 %   0.40 %   $ 7,442,479   $ 6,167,436   51.1 %   50.1 %

Money market accounts

  2.79 %   1.52 %     3,791,669     3,340,245   26.0     27.2  

Certificates of deposit

  3.63 %   3.40 %     2,408,694     2,069,674   16.6     16.8  

Brokered certificates of deposit

  3.78 %   2.51 %     519,582     294,587   3.6     2.4  

Passbook savings accounts

  1.14 %   1.18 %     432     691   —       —    

Checking accounts:

                                   

Interest-bearing

  0.71 %   0.66 %     387,721     430,022   2.7     3.5  

Non-interest-bearing

  —   %   —   %     119     319   —       —    
               

 

 

 

Total deposits

  1.78 %   1.27 %   $ 14,550,696   $ 12,302,974   100.0 %   100.0 %
               

 

 

 

 

NOTE 9—OTHER BORROWINGS BY BANK SUBSIDIARY

 

Other borrowings by Bank subsidiary are summarized as follows (in thousands):

 

    

September 30,

2005


  

December 31,

2004


Federal Home Loan Bank (“FHLB”) advances

   $ 4,316,683    $ 1,487,841

Subordinated debentures

     275,480      255,300

Other

     2,650      17,591
    

  

Total other borrowings by Bank subsidiary

   $ 4,594,813    $ 1,760,732
    

  

 

NOTE 10—CORPORATE DEBT

 

7 3/8% Senior Notes due September 2013

 

In September 2005, the Company completed a private offering of an aggregate principal amount of $350 million in senior notes due September 2013. The senior notes bear interest at 7 3/8%, payable semi-annually, and are non-callable for four years and may then be called by the Company at a premium, which declines over time. Original debt issuance costs of $5.1 million are included in other assets and are being amortized over the term of the senior notes.

 

8.00% Senior Notes due June 2011

 

In September 2005, the Company also completed a private offering of an additional principal amount of $100 million to our existing 8.00% senior notes due June 2011. The senior notes bear interest at 8.00%, payable semi-annually, and are non-callable for three years and may then be called by the Company at a premium, which

 

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declines over time. Additional debt issuance costs of $1.5 million are included in other assets and are being amortized over the term of the senior notes. The senior notes were issued at a premium of $3.5 million which will be amortized over the term of the senior notes.

 

Both the 8.00% and 7 3/8% Notes are unsecured and will rank equal in right of payment with all of the Company’s existing and future unsubordinated indebtedness and will rank senior in right of payment to all our existing and future subordinated indebtedness.

 

Senior notes are summarized as follows (in thousands):

 

    

September 30,

2005


   December 31,
2004


Senior 7 3/8% Notes, due 2013

   $ 350,000    $ —  

Senior 8.00% Notes, due 2011

     503,654      400,452
    

  

Total senior notes

   $ 853,654    $ 400,452
    

  

 

Senior Secured Revolving Credit Facility

 

In September 2005, the Company entered into a $250 million, three-year senior secured revolving credit facility. The facility is secured by certain assets of the Company. The facility will be used for general corporate purposes, including regulatory capital needs arising from acquisitions. Draws under the facility currently bear interest, at our option, at adjusted LIBOR plus 2% or prime plus 1%. Undrawn facility funds currently bear commitment fees of 0.25% per annum payable quarterly in arrears. Terms of the facility include customary restrictive financial covenants and events of default. At September 30, 2005, as well as October 31, 2005, no amounts were outstanding under this credit facility. Issuance costs of $2.2 million are included in other assets and are being amortized over the term of the facility.

 

NOTE 11—SHARE REPURCHASES

 

During 2005, the Company repurchased common stock under two Board approved $200 million repurchase programs approved in April 2004 (the “April Plan”) and in December 2004 (the “December Plan”). These plans are open-ended and provide the flexibility to buy back common stock, redeem for cash its outstanding convertible subordinated notes, retire debt in the open market or a combination of all three. During the three and nine months ended September 30, 2005, the Company repurchased 0.6 million shares of its common stock for an aggregate of $9.3 million and 4.5 million shares of its common stock for an aggregate of $58.2 million, respectively. As of September 30, 2005, the Company completed the April Plan and authorization to repurchase an additional $179.8 million remains under the December Plan.

 

NOTE 12—STOCK-BASED COMPENSATION

 

Adoption of SFAS No. 123(R)

 

As discussed in Note 1, effective July 1, 2005, the Company early adopted SFAS No. 123(R). The adoption resulted in compensation and benefit expense for the Company’s employee stock option plans, restricted stock awards and employee stock purchase plan. The combined impact of the adoption is as follows: $7.1 million in compensation expense for stock options; $0.4 million compensation expense for the stock purchase plan; and a pre-tax credit of $2.8 million in cumulative effect of accounting change for the three months ended September 30, 2005. Results for prior periods have not been restated. Total compensation expense for stock-based compensation also includes $1.1 million for restricted stock awards, which were previously expensed by the Company under APB No. 25, prior to the adoption of SFAS No. 123(R).

 

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Employee Stock Option Plans

 

For the three months ended September 30, 2005, the Company recorded $7.1 million in compensation expense for employee stock options.

 

In 2005, the Company adopted and the shareholders approved the 2005 Stock Incentive Plan (the “2005 Plan”) to replace the 1996 Stock Incentive Plan (the “1996 Plan”) which provides for the grant of nonqualified or incentive stock options to officers, directors, key employees and consultants for the purchase of newly issued shares of the Company’s common stock at a price determined by the Board of Directors (the “Board”) at the date the option is granted. Options are generally exercisable ratably over a four-year period from the date the option is granted and expire within ten years from the date of grant. Certain options provide for accelerated vesting upon a change in control. Exercise prices are generally equal to the fair market value of the shares on the grant date.

 

The 1996 Plan included a shareholder approved automatic annual 5% increase, or evergreen provision, in the number of shares available to be issued. On January 1, 2005, 18.5 million shares were added to the 1996 Plan pursuant to the evergreen provision, which the majority of shares were ultimately included in the 2005 Plan. Therefore, a total of 85.4 million shares has been authorized under the 2005 Plan since inception and 41.5 million shares were available for grant at January 1, 2005.

 

The fair value of each option award is estimated on the date of grant using a Black-Scholes-Merton option pricing model that uses the assumptions noted in the table below. Expected volatility is based on a combination of historical volatility of the Company’s stock and implied volatility of publicly traded options on the Company’s stock. The expected term represents the period of time that options granted are expected to be outstanding. Risk-free interest rate is based on the U.S. treasury zero-coupon with a remaining term approximate of the expected term. Dividend yield is zero as the Company has not, nor does it plan to, issue dividends to its shareholders.

 

    

Three Months Ended

September 30,


   

Nine Months Ended

September 30,


 
     2005

    2004

    2005

    2004

 

Expected volatility

   31 %   47 %   34 %   52 %

Expected term

   5.08     4.32     4.89     4.28  

Risk-free interest rate

   3.89 %   2.56 %   3.60 %   1.93 %

Dividend yield

   —       —       —       —    

 

The weighted-average fair values of options granted were $5.56 and $4.48 for the three and nine months ended September 30, 2005 and $4.50 and $5.52 for the three and nine months ended September 30, 2004, respectively. Intrinsic value of options exercised were $36.4 million and $94.1 million for the three and nine months ended September 30, 2005 and $5.4 million and $44.7 million for the three and nine months ended September 30, 2004, respectively.

 

A summary of option activity under the 2005 Plan is presented below:

 

    

Shares

(in thousands)


    Weighted-Average
Exercise Price


   Weighted-Average
Remaining
Contractual Life


  

Aggregate
Intrinsic Value

(in thousands)


Outstanding at December 31, 2004:

   42,789     $ 9.68            

Granted

   6,601     $ 12.59            

Exercised

   (6,401 )   $ 6.24            

Canceled

   (3,725 )   $ 12.53            
    

                 

Outstanding at September 30, 2005:

   39,264     $ 10.45    6.94    $ 280,791
    

                 

Exercisable at September 30, 2005:

   22,394     $ 9.58    5.91    $ 179,557
    

                 

 

As of September 30, 2005, there was $37.0 million of total unrecognized compensation cost related to non-vested options. This cost is expected to be recognized over a weighted-average period of 2.2 years. The total

 

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fair value of shares vested was $2.9 million and $34.6 million for the three and nine months ended September 30, 2005 and $7.8 million and $47.8 million for the three and nine months ended September 30, 2004, respectively.

 

Restricted Stock Awards

 

The Company recorded $1.1 million and $1.3 million for the three months ended September 30, 2005 and 2004, respectively, and $3.1 million and $3.2 million for the nine months ended September 30, 2005 and 2004, respectively, in compensation expense relating to restricted stock awards. In addition, the Company recorded a $2.8 million credit in cumulative effect of accounting change as a result of adopting SFAS No. 123(R).

 

Since 2001, the Company has issued restricted stock awards to its officers and senior executives. These awards are issued at the fair market value on the date of grant and generally vest ratably over four years. In 2003, certain awards were made to officers and senior executives that became fully vested on the fifth anniversary of the date of grant, but were unvested at any time earlier. The fair value is calculated as the market price upon issuance.

 

Prior to its adoption of SFAS No. 123(R), the Company recorded compensation expense for restricted stock awards on a straight-line basis over their vesting period. If an employee did not serve the requisite service period and forfeited the award prior to vesting, the Company reversed out the previously expensed amounts in the period of forfeiture. As required upon adoption of SFAS No. 123(R), the Company must base its accruals of compensation expense on the estimated number of awards for which the requisite service period is expected to be rendered. Actual forfeitures are no longer recorded in the period of forfeiture as they are included in the estimated expense recorded each period. The Company recorded a pre-tax credit of $2.8 million in cumulative effect of accounting change, that represents the amount by which compensation expense would have been reduced in periods prior to adoption of SFAS No. 123(R) for restricted stock awards outstanding on July 1, 2005.

 

Under the provision of SFAS No. 123(R), the recognition of deferred compensation, a contra-equity account representing the amount of unrecognized restricted stock expense, is no longer required. Therefore, as of July 1, 2005, “Deferred Stock Compensation” was combined with “Additional Paid-in Capital” in the Company’s consolidated balance sheet.

 

A summary of non-vested restricted stock activity is presented below:

 

    

Shares

(in thousands)


   

Weighted-Average

Grant Date Fair

Value


Non-vested at December 31, 2004:

   2,615     $ 9.35

Issued

   830     $ 11.93

Released

   (225 )   $ 9.46

Canceled

   (516 )   $ 9.18
    

     

Non-vested at September 30, 2005:

   2,704     $ 10.17
    

     

 

As of September 30, 2005, there was $15.2 million of total unrecognized compensation cost related to non-vested awards. This cost is expected to be recognized over a weighted-average period of 3.1 years.

 

Employee Stock Purchase Plan

 

For the three months ended September 30, 2005, the Company recorded $0.4 million in compensation expense for its employee stock purchase plan.

 

In May 2002, the shareholders of the Company approved the 2002 Employee Stock Purchase Plan (the “2002 Purchase Plan”), and reserved 5,000,000 shares of common stock for sale to employees at a price no less than 85% of the lower of the fair market value of the common stock at the beginning of the one-year offering

 

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period or the end of each of the six-month purchase periods. Under SFAS No. 123(R), the 2002 Purchase Plan was considered compensatory. As a result, the Company recorded $0.4 million of compensation expense for the subscription period ended July 31, 2005. Effective August 1, 2005, the Company changed the terms of its purchase plan to reduce the discount to 5% and not allow any look back provision on the purchase date. As a result, the purchase plan will not be compensatory beginning August 1, 2005 and will result in no compensation expense going forward. At September 30, 2005, 1,083,195 shares were available for purchase under the 2002 Purchase Plan.

 

NOTE 13—FACILITY RESTRUCTURING AND OTHER EXIT CHARGES

 

In 2005, the Company updated its estimated costs associated with its restructuring plans and other exit activities. Restructuring liabilities are included in accounts payable, accrued and other liabilities in the consolidated balance sheets.

 

The following table summarizes the amount recognized by the Company as restructuring and other exit charges for the periods presented (in thousands):

 

     Three Months Ended
September 30,


   

Nine Months Ended

September 30,


 
         2005    

        2004    

        2005    

        2004    

 

2003 Restructuring Plan

   $ (416 )   $ 83     $ (419 )   $ (355 )

2001 Restructuring Plan

     (69 )     (284 )     323       (1,124 )

Other exit activity

     16       (26 )     591       246  
    


 


 


 


Total facility restructuring and other exit charges

   $ (469 )   $ (227 )   $ 495     $ (1,233 )
    


 


 


 


 

2003 Restructuring Plan

 

The rollforward of the 2003 Restructuring Plan reserve is presented below (in thousands):

 

     Facility
Consolidation


    Other

    Total

 

Original 2003 restructuring reserve:

                        

Facility restructuring and other exit charges recorded in 2003 & 2004

   $ 57,468     $ 57,359     $ 114,827  

Cash payments

     (16,446 )     (18,618 )     (35,064 )

Non-cash charges

     (19,254 )     (38,370 )     (57,624 )
    


 


 


Restructuring liabilities at December 31, 2004

     21,768       371       22,139  
    


 


 


2005 activity on original 2003 restructuring reserve:

                        

Adjustment and additional charges recorded in 2005

     (379 )     (40 )     (419 )

Cash payments

     (3,911 )     (132 )     (4,043 )

Non-cash charges

     —         20       20  
    


 


 


Restructuring liabilities at September 30, 2005

   $ 17,478     $ 219     $ 17,697  
    


 


 


 

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Table of Contents

2001 Facility Restructuring Plan

 

The rollforward of the 2001 Restructuring Plan reserve is presented below (in thousands):

 

     Facility
Consolidation


    Asset
Write-Off


    Other

    Total

 

Total 2001 facility restructuring and other nonrecurring charges recorded in 2001

   $ 128,469     $ 52,532     $ 21,764     $ 202,765  

Activity through December 31, 2004:

                                

Adjustments and additional charges

     21,404       2,072       3,499       26,975  

Cash payments

     (98,370 )     (67 )     (19,287 )     (117,724 )

Non-cash charges

     (41,263 )     (53,877 )     (5,810 )     (100,950 )
    


 


 


 


Restructuring liabilities at December 31, 2004

     10,240       660       166       11,066  
    


 


 


 


2005 activity on original 2001 restructuring reserve:

                                

Adjustments and additional charges recorded in 2005

     543       (220 )     —         323  

Cash payments

     (2,573 )     (440 )     —         (3,013 )

Non-cash charges

     —         —         3       3  
    


 


 


 


Restructuring liabilities at September 30, 2005

   $ 8,210     $ —       $ 169     $ 8,379  
    


 


 


 


 

Other Exit Activity

 

For the three and nine months ended September 30, 2005, other exit activity was primarily related to the following:

 

    Liquidation of certain E*TRADE Money Market Funds. The liquidation costs primarily represent costs relating to customer notification, severance and reimbursement of losses taken on sales of securities;

 

    Closure of a correspondent mortgage origination channel; and

 

    Revisions to previous estimates for past exit activities

 

For the three and nine months ended September 30, 2004, other exit activity was primarily related to the following:

 

    Costs, net of recoveries, for the exit of the Company’s proprietary institutional research business; and

 

    Costs associated with the Company’s transfer of its consumer automobile loan operations from Arlington, Virginia to Irvine, California

 

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Table of Contents

NOTE 14—INCOME PER SHARE

 

The following table is a reconciliation of basic and diluted income per share (in thousands, except per share data):

 

    

Three Months Ended

September 30,


   

Nine Months Ended

September 30,


     2005

    2004

    2005

    2004

BASIC:

                              

Numerator:

                              

Income from continuing operations

   $ 108,611     $ 87,123     $ 318,589     $ 279,834

Net income (loss) from discontinued operations

     (2,766 )     (7,849 )     (19,183 )     10,821

Cumulative effect of accounting change, net of tax

     1,646       —         1,646       —  
    


 


 


 

Net income

   $ 107,491     $ 79,274     $ 301,052     $ 290,655
    


 


 


 

Denominator:

                              

Basic weighted-average shares outstanding

     367,342       369,103       366,215       366,244
    


 


 


 

Per Share:

                              

Income per share from continuing operations

   $ 0.29     $ 0.23     $ 0.87     $ 0.76

Net income (loss) per share from discontinued operations

     (0.00 )     (0.02 )     (0.05 )     0.03

Cumulative effect of accounting change, net of tax

     0.00       —         0.00       —  
    


 


 


 

Net income per share

   $ 0.29     $ 0.21     $ 0.82     $ 0.79
    


 


 


 

DILUTED:

                              

Numerator:

                              

Income from continuing operations

   $ 108,611     $ 87,123     $ 318,589     $ 279,834

Interest on convertible subordinated notes, net of tax

     —         —         —         17,547
    


 


 


 

Income from continuing operations, as adjusted

     108,611       87,123       318,589       297,381

Net income (loss) from discontinued operations

     (2,766 )     (7,849 )     (19,183 )     10,821

Cumulative effect of accounting change, net of tax

     1,646       —         1,646       —  
    


 


 


 

Net income, as adjusted

   $ 107,491     $ 79,274     $ 301,052     $ 308,202
    


 


 


 

Denominator:

                              

Basic weighted-average shares outstanding

     367,342       369,103       366,215       366,244

Effect of dilutive securities:

                              

Weighted-average options and restricted stock issued to employees

     12,072       8,759       10,936       10,312

Weighted-average warrants and contingent shares outstanding

     2,617       2,695       2,617       2,676

Shares issuable for assumed conversion of convertible subordinated notes

     —         —         —         31,841
    


 


 


 

Diluted weighted-average shares outstanding

     382,031       380,557       379,768       411,073
    


 


 


 

Per Share:

                              

Income per share from continuing operations

   $ 0.28     $ 0.23     $ 0.84     $ 0.72

Net income (loss) per share from discontinued operations

     (0.00 )     (0.02 )     (0.05 )     0.03

Cumulative effect of accounting change, net of tax

     0.00       —         0.00       —  
    


 


 


 

Net income per share

   $ 0.28     $ 0.21     $ 0.79     $ 0.75
    


 


 


 

 

Excluded from the calculation of diluted income per share are 7.8 million shares of common stock for the three and nine months ended September 30, 2005, and 10.4 million shares of common stock for the three months ended September 30, 2004, issuable under convertible subordinated notes as the effect of applying treasury stock method on an if-converted basis would be anti-dilutive.

 

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The following options to purchase shares of common stock have been excluded from the computation of diluted income per share because the options’ exercise price was greater than the average market price of the Company’s common stock for the periods stated, and, therefore, the effect would be anti-dilutive (in thousands, except exercise price data):

 

    

Three Months Ended

September 30,


  

Nine Months Ended

September 30,


     2005

   2004

   2005

   2004

Options

     3,427      11,939      9,877      10,856

Exercise price ranges:

                           

High

   $ 58.19    $ 58.19    $ 58.19    $ 58.19

Low

   $ 8.04    $ 11.21    $ 4.15    $ 12.19

 

NOTE 15—REGULATORY REQUIREMENTS

 

Registered Broker-Dealers

 

The Company’s U.S. broker-dealer subsidiaries are subject to the Uniform Net Capital Rule (the “Rule”) under the Securities Exchange Act of 1934 administered by the SEC, the New York Stock Exchange (“NYSE”), the Chicago Stock Exchange (“CHX”) and the NASD Inc. (“NASD”), which requires the maintenance of minimum net capital. E*TRADE Securities, E*TRADE Clearing and E*TRADE Professional Trading, LLC have elected to use the alternative method to compute net capital permitted by the Rule, which requires that they maintain minimum net capital equal to the greater of $250,000 or two percent of aggregate debit balances arising from customer transactions, as defined.

 

Under the alternative method, a broker-dealer may not repay subordinated borrowings, pay cash dividends or make any unsecured advances or loans to its parent or employees if such payment would result in net capital of less than 5% of aggregate debit balances or less than 120% of its minimum dollar amount requirement.

 

The table below summarizes the minimum excess capital requirements for the Company’s broker-dealer subsidiaries (in thousands):

 

     September 30, 2005

     Required
Net Capital


   Net Capital

  

Excess

Net Capital


E*TRADE Clearing LLC

   $ 54,457    $ 324,561    $ 270,104

E*TRADE Capital Markets, LLC

     1,044      43,114      42,070

E*TRADE Securities LLC

     250      36,394      36,144

E*TRADE Global Asset Management, Inc.

     1,131      16,079      14,948

E*TRADE Capital Markets—Execution Services, LLC

     281      7,182      6,901

E*TRADE Professional Trading, LLC

     250      1,782      1,532

VERSUS Brokerage Service (U.S.) Inc.

     100      766      666

International broker-dealers

     32,308      75,126      42,818
    

  

  

Totals

   $ 89,821    $ 505,004    $ 415,183
    

  

  

 

Banking

 

The Bank is subject to various regulatory capital requirements administered by Federal banking agencies. Failure to meet minimum capital requirements can trigger certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Bank’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank’s assets, liabilities, and

 

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certain off-balance sheet items as calculated under regulatory accounting practices. The Bank’s capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.

 

Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios of Total and Tier I Capital to Risk-weighted assets and Tier I Capital to Adjusted total assets. As shown in the table below, at September 30, 2005, the most recent date of notification, the Office of Thrift Supervision (“OTS”) categorized the Bank as “well capitalized” under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes have changed the Bank’s category. At September 30, 2005, management believes that the Bank meets all capital adequacy requirements to which it is subject. However, events beyond management’s control, such as fluctuations in interest rates or a downturn in the economy in areas in which the Bank’s loans or securities are concentrated, could adversely affect future earnings and consequently, the Bank’s ability to meet its future capital requirements.

 

The Bank’s required actual capital amounts and ratios are presented in the table below (dollars in thousands):

 

    Actual

   

Required for Capital

Adequacy Purposes


   

Required to be Well
Capitalized Under

Prompt Corrective

Action Provisions


 
    Amount

  Ratio

    Amount

  Ratio

    Amount

   Ratio

 

September 30, 2005:

                                    

Total Capital to Risk-weighted assets

  $ 1,816,171   >11.13 %   >$ 1,305,836   >8.0 %   >$ 1,632,295    >10.0 %

Tier I Capital to Risk-weighted assets

  $ 1,756,317   >10.76 %   >$ 652,918   >4.0 %   >$ 979,377    >6.0 %

Tier I Capital to Adjusted total assets

  $ 1,756,317   >5.87 %   >$ 1,197,636   >4.0 %   >$ 1,497,045    >5.0 %

December 31, 2004:

                                    

Total Capital to Risk-weighted assets

  $ 1,533,934   >11.09 %   >$ 1,106,778   >8.0 %   >$ 1,383,472    >10.0 %

Tier I Capital to Risk-weighted assets

  $ 1,486,422   >10.74 %   >$ 553,389   >4.0 %   >$ 830,083    >6.0 %

Tier I Capital to Adjusted total assets

  $ 1,486,422   >5.83 %   >$ 1,019,659   >4.0 %   >$ 1,274,574    >5.0 %

 

NOTE 16—COMMITMENTS, CONTINGENCIES AND OTHER REGULATORY MATTERS

 

Legal Matters

 

In June 2002, the Company acquired from MarketXT Holdings, Inc. (formerly known as Tradescape Corporation) (“MarketXT”) certain entities referred to as Tradescape Securities, LLC, Tradescape Technologies, LLC and Momentum Securities, LLC. Numerous disputes have arisen between and among the parties regarding the value of and responsibility for various liabilities that first became apparent following the sale. The parties have been unable to resolve these disputes and have asserted claims against each other. On April 8, 2004, MarketXT filed a complaint in the United States District Court for the Southern District of New York against the Company, certain of its officers and directors and other third parties, including Softbank Finance Corporation and Softbank Corporation, alleging that the defendants acted improperly in preventing plaintiffs from obtaining certain contingent payments and claiming damages of $1.5 billion. On April 9, 2004, the Company filed a complaint in the United States District Court for the Southern District of New York against certain directors and officers of MarketXT seeking declaratory relief and monetary damages in an amount to be proven at trial for defendants’ fraud in connection with the 2002 sale transaction, including, but not limited to, having presented the Company with fraudulent financial statements of the condition of Momentum Securities during the due diligence process. The Company amended its complaint in October 2005 to add additional defendants. In January 2005, the Company filed an adversary proceeding against MarketXT and others seeking compensatory and punitive damages, and certain declaratory relief in those Chapter 11 bankruptcy proceedings in the United States Bankruptcy Court for the Southern District of New York entitled, “In re MarketXT Holdings Corp., Debtor” and

 

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Table of Contents

a separate adversary proceeding against Omar Amanat, in the same bankruptcy court in those Chapter 7 bankruptcy proceedings entitled, “In re Amanat, Omar Shariff.” In October 2005, MarketXT answered the Company’s adversary proceeding and asserted various counterclaims, including some of the claims MarketXT had asserted in its district court action, seeking unspecified damages according to proof at trial. The Company continues to believe that MarketXT’s complaint and counterclaims and Omar Amanat’s claims are without merit and intends both to vigorously defend all such claims and to fully pursue its own claims as described above.

 

The Company is subject to various other legal proceedings and claims that arise in the normal course of business, which we believe will not have a material adverse effect on our financial condition, results of operations or cash flows.

 

Regulatory Matters

 

The securities and banking industries are subject to extensive regulation under Federal, state and applicable international laws. As a result, the Company is required to comply with many complex laws and rules and its ability to so comply is dependent in part on the establishment and maintenance of a qualified compliance system. From time to time, the Company has been threatened with, or named as a defendant in, lawsuits, arbitrations and administrative claims involving securities, banking and other matters. The Company is also subject to periodic regulatory audits and inspections. Compliance and trading problems that are reported to regulators, such as the SEC, the NYSE, the NASD or the OTS by dissatisfied customers or others are investigated by such regulators, and may, if pursued, result in formal claims being filed against the Company by customers and/or disciplinary action being taken against the Company by regulators. The regulators may also initiate investigations and take disciplinary action against the Company or its employees. Any such claims or disciplinary actions that are decided against the Company could harm the Company’s business.

 

Commitments—Loans

 

In the normal course of business, the Bank makes various commitments to extend credit and incur contingent liabilities that are not reflected in the consolidated balance sheets. The Bank had the following loan commitments (in thousands):

 

     September 30, 2005

     Variable
Rate


   Fixed
Rate


   Total

Commitments to purchase loans:

                    

Mortgage loans

   $ 42,651    $ 92,788    $ 135,439

Other loans

     —        6,055      6,055
    

  

  

Total commitments to purchase loans

   $ 42,651    $ 98,843    $ 141,494
    

  

  

Commitments to originate loans:

                    

Mortgage loans

   $ 35,065    $ 217,458    $ 252,523

Other loans

     —        370,561      370,561
    

  

  

Total commitments to originate loans

   $ 35,065    $ 588,019    $ 623,084
    

  

  

Commitments to sell mortgage loans

   $ 11,159    $ 44,115    $ 55,274
    

  

  

 

Significant changes in the economy or interest rates influence the impact that these commitments and contingencies have on the Company in the future.

 

At September 30, 2005, the Bank had commitments to purchase $1.5 billion and sell $1.1 billion in securities. In addition, the Bank had approximately $2.0 billion of certificates of deposit scheduled to mature in less than one year and $4.1 billion of unfunded commitments to extend credit.

 

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Table of Contents

Guarantees

 

The Bank provides guarantees to investors purchasing mortgage loans, which are considered standard representations and warranties within the mortgage industry. The primary guarantees are as follows:

 

    The mortgage and the mortgage note have been duly executed and each is the legal, valid and binding obligation of the Bank, enforceable in accordance with its terms. The mortgage has been duly acknowledged and recorded and is valid. The mortgage and the mortgage note are not subject to any right of rescission, set-off, counterclaim or defense, including, without limitation, the defense of usury, and no such right of rescission, set-off, counterclaim or defense has been asserted with respect thereto. If these claims prove to be untrue, the investor can require the Bank to repurchase the loan and return all loan purchase and servicing release premiums.

 

    Should any eligible mortgage loan delivered pay off prior to the receipt of the first payment, the loan purchase and servicing release premiums shall be fully refunded.

 

    Should any eligible mortgage loan delivered to an investor pay off between the receipt of the first payment and a contractually designated period of time (typically 60—120 days from the date of purchase), the servicing release premiums shall be fully refunded.

 

Management has determined that the maximum potential liability under these guarantees is $29.7 million and $38.1 million based on all available information at September 30, 2005 and December 31, 2004, respectively. The current carrying amount of the liability recorded at September 30, 2005 is $0.8 million and is considered adequate based upon analysis of historical trends and current economic conditions for these guarantees.

 

ETB Holdings, Inc. (“ETBH”) raises capital through the formation of trusts, which sell trust preferred stock in the capital markets. The capital securities are mandatorily redeemable in whole at the due date, which is generally 30 years after issuance. Each trust issues Floating Rate Cumulative Preferred Securities at par, with a liquidation amount of $1,000 per capital security. The proceeds from the sale of issuances are invested in ETBH’s Floating Rate Junior Subordinated Debentures.

 

In July 2005, the Company formed ETBH Capital Trust XXI, which issued 20,000 shares of Floating Rate Cumulative Preferred Securities for a total of $20 million. Net proceeds from the issuance were invested in Floating Rate Junior Subordinated Debentures that mature in 2035 and have a variable annual dividend rate at 2.40% above the three-month LIBOR, payable quarterly beginning in September 2005.

 

During the 30-year period prior to the redemption of these securities, ETBH guarantees the accrued and unpaid distributions on these securities, as well as the redemption price of the securities and certain costs that may be incurred in liquidating, terminating or dissolving the trusts (all of which would otherwise be payable by the trusts). At September 30, 2005, management estimated that the maximum potential liability under this arrangement is equal to approximately $288 million or the total face value of these securities plus dividends, that may be unpaid at the termination of the trust arrangement.

 

NOTE 17—ACCOUNTING FOR DERIVATIVE FINANCIAL INSTRUMENTS AND HEDGING ACTIVITIES

 

The Company enters into derivative transactions to protect against the risk of market price or interest rate movements on the value of certain assets and future cash flows. The Company is also required to recognize certain contracts and commitments as derivatives when the characteristics of those contracts and commitments meet the definition of a derivative as promulgated by SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended.

 

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Table of Contents

Fair Value Hedges

 

Overview of Fair Value Hedges

 

The Company uses a combination of interest rate swaps and purchased options on forward-starting swaps, floors and caps to offset its exposure to changes in value of certain fixed rate assets. In calculating the effective portion of the fair value hedges under SFAS No. 133, the change in the fair value of the derivative is recognized currently in earnings, as is the change in value of the hedged asset attributable to the risk being hedged. Accordingly, the net difference or hedge ineffectiveness, if any, is recognized currently in fair value adjustments of financial derivatives in the consolidated statements of operations.

 

The following table summarizes information related to financial derivatives in fair value hedge relationships (dollars in thousands):

 

   

Notional

Amount of

Derivative


  Fair Value of Derivative

    Weighted-Average

       

Pay

Rate


   

Receive

Rate


   

Strike

Rate


   

Remaining

Life (Years)


      Asset

  Liability

    Net

         

September 30, 2005:

                                                 

Pay-fixed interest rate swaps:

                                                 

Mortgage-backed securities

  $ 860,000   $ 7,853   $ (1,640 )   $ 6,213     4.45 %   3.81 %   N/A     5.56

Investment securities

    141,485     1,105     (3,508 )     (2,403 )   4.73 %   3.63 %   N/A     8.87

Receive-fixed interest rate swaps:

                                                 

Brokered certificates of deposit

    133,004     —       (2,792 )     (2,792 )   3.75 %   5.22 %   N/A     12.75

Federal Home Loan Bank advances

    100,000     —       (3,317 )     (3,317 )   3.77 %   3.64 %   N/A     4.04

Purchased interest rate options(1):

                                                 

Forward-starting swaps

    1,555,000     22,192     —         22,192     N/A     N/A     4.86 %   7.56

Floors

    1,325,000     4,887     —         4,887     N/A     N/A     3.82 %   3.97

Caps

    920,000     22,631     —         22,631     N/A     N/A     4.87 %   4.72
   

 

 


 


                     

Total fair value hedges

  $ 5,034,489   $ 58,668   $ (11,257 )   $ 47,411     4.35 %   3.93 %   4.50 %   5.86
   

 

 


 


                     

December 31, 2004:

                                                 

Pay-fixed interest rate swaps:

                                                 

Mortgage-backed securities

  $ 1,045,000   $ 3,157   $ (5,099 )   $ (1,942 )   4.42 %   2.23 %   N/A     6.06

Investment securities

    160,885     —       (3,747 )     (3,747 )   4.63 %   2.09 %   N/A     8.83

Receive-fixed interest rate swaps:

                                                 

Certificates of deposit

    315,000     —       (1,901 )     (1,901 )   2.26 %   3.39 %   N/A     2.90

Federal Home Loan Bank advances

    100,000     —       (1,159 )     (1,159 )   2.40 %   3.64 %   N/A     4.80

Brokered certificates of deposit

    10,000     —       (160 )     (160 )   2.50 %   5.00 %   N/A     10.01

Senior notes (2)

    50,000     452     —         452     5.98 %   8.00 %   N/A     6.46

Purchased interest rate forward-starting swaps:

                                                 

Brokered certificates of deposit

    20,000     12     (60 )     (48 )   5.25 %   N/A     N/A     12.55

Mortgage-backed securities

    209,000     978     —         978     3.60 %   N/A     N/A     3.43

Purchased interest rate options(1):

                                                 

Forward-starting swaps

    335,000     9,065     —         9,065     N/A     N/A     5.98 %   13.30

Floors

    100,000     352     —         352     N/A     N/A     4.25 %   2.75

Caps

    485,000     7,221     —         7,221     N/A     N/A     6.09 %   5.01
   

 

 


 


                     

Total fair value hedges

  $ 2,829,885   $ 21,237   $ (12,126 )   $ 9,111     3.93 %   2.71 %   5.85 %   6.25
   

 

 


 


                     

(1)   Purchased interest rate options were used to hedge the Bank’s mortgage-backed securities.
(2)   Interest rate swap agreement on the Company’s $400.0 million senior notes was none and $50.0 million at September 30, 2005 and December 31, 2004, respectively. Fair value of the senior notes of $503.7 million and $400.5 million at September 30, 2005 and December 31, 2004, respectively, are shown in Note 10.

 

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Table of Contents

De-designated Fair Value Hedges

 

During the three and nine months ended September 30, 2005, certain fair value hedges were de-designated and, therefore, hedge accounting was discontinued during those periods. The net gain or loss on these derivative instruments at the time of de-designation is amortized to interest expense over the original forecasted period of the underlying transactions being hedged. Changes in the fair value of these derivative instruments after the discontinuance of fair value hedge accounting are recorded in gain on sales of loans and securities, net in the consolidated statements of operations.

 

Cash Flow Hedges

 

Overview of Cash Flow Hedges

 

The Company uses a combination of interest rate swaps and purchased options on caps and floors to hedge the variability of future cash flows associated with existing variable-rate liabilities and forecasted issuances of liabilities. These cash flow hedge relationships are treated as effective hedges as long as the future issuances of liabilities remain probable and the hedges continue to meet the requirements of SFAS No. 133. The Company also enters into interest rate swaps to hedge changes in the future variability of cash flows of certain investment securities resulting from changes in a benchmark interest rate. Additionally, the Company enters into forward purchase and sale agreements, which are considered cash flow hedges, when the terms of the commitments exactly match the terms of the securities purchased or sold.

 

Changes in the fair value of derivatives that hedge cash flows associated with repurchase agreements and FHLB advances are reported in accumulated other comprehensive income (“AOCI”) as unrealized gains or losses. The amounts in AOCI are then included in interest expense as a yield adjustment during the same periods in which the related interest on the fundings or investment securities affect earnings. During the upcoming twelve months, the Company expects to include a pre-tax amount of approximately $0.7 million of net unrealized gains that are currently reflected in AOCI in interest expense as a yield adjustment in the same periods in which the related items affect earnings. The Company expects to hedge the majority of forecasted issuance of liabilities over a one-to-sixteen year period.

 

The Company also recognizes cash flow hedge ineffectiveness. Cash flow hedge ineffectiveness is recorded to the extent that the market value of derivatives used in the hedge relationship outperforms or has a greater increase in market value than a hypothetical derivative, created to match the exact terms of the underlying debt being hedged. The Company recognized this cash flow ineffectiveness as fair value adjustments of financial derivatives in the consolidated statements of operations. Cash flow ineffectiveness is re-measured on a quarterly basis.

 

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The following table summarizes information related to our financial derivatives in cash flow hedge relationships, hedging variable-rate liabilities and the forecasted issuances of liabilities (dollars in thousands):

 

    Notional
Amount of
Derivative


                  Weighted-Average

      Fair Value of Derivative

   

Pay

Rate


   

Receive

Rate


   

Strike

Rate


    Remaining
Life (Years)


      Asset

  Liability

    Net

         

September 30, 2005:

                                                 

Pay-fixed interest rate swaps:

                                                 

Repurchase agreements

  $ 1,025,000   $ 2,104   $ (14,139 )   $ (12,035 )   4.94 %   3.76 %   N/A     11.45

Federal Home Loan Bank advances

    150,000     —       (1,857 )     (1,857 )   4.94 %   3.80 %   N/A     9.64

Purchased interest rate forward-starting swaps:

                                                 

Repurchase agreements

    2,300,000     1,490     (6,299 )     (4,809 )   4.81 %   N/A     N/A     8.80

Federal Home Loan Bank advances

    400,000     2,524     (818 )     1,706     4.71 %   N/A     N/A     8.16

Purchased interest rate options(1):

                                                 

Caps

    3,325,000     81,547     —         81,547     N/A     N/A     4.46 %   4.83

Floor

    1,900,000     4,290     —         4,290     N/A     N/A     5.50 %   3.79
   

 

 


 


                     

Total cash flow hedges

  $ 9,100,000   $ 91,955   $ (23,113 )   $ 68,842     4.84 %   3.76 %   4.84 %   6.59
   

 

 


 


                     

December 31, 2004:

                                                 

Pay-fixed interest rate swaps:

                                                 

Repurchase agreements

  $ 1,675,000   $ —     $ (33,121 )   $ (33,121 )   4.91 %   2.28 %   N/A     11.12

Federal Home Loan Bank advances

    425,000     —       (6,093 )     (6,093 )   4.68 %   2.13 %   N/A     9.25

Purchased interest rate forward- starting swaps:

                                                 

Repurchase agreements

    595,000     —       (868 )     (868 )   4.74 %   N/A     N/A     11.16

Purchased interest rate options(1):

                                                 

Caps

    2,775,000     94,340     —         94,340     N/A     N/A     4.43 %   6.13
   

 

 


 


                     

Total cash flow hedges

  $ 5,470,000   $ 94,340   $ (40,082 )   $ 54,258     4.84 %   2.25 %   4.43 %   8.45
   

 

 


 


                     

(1)   Purchased interest rate options were used to hedge the Bank’s repurchase agreements, Federal Home Loan Bank advances and HELOCs.

 

Under SFAS No. 133, we are required to record the fair value of gains and losses on derivatives designated as cash flow hedges in AOCI in the consolidated balance sheets. In addition, during the normal course of business, the Company terminates certain interest rate swaps and options.

 

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Table of Contents

The following tables show: 1) amounts recorded in AOCI related to derivative instruments accounted for as cash flow hedges; 2) the notional amounts and fair values of derivatives terminated for the periods presented; and 3) the amortization of terminated interest rate swaps included in interest expense (in thousands):

 

     Three Months Ended
September 30,


    Nine Months Ended
September 30,


 
     2005

    2004

    2005

    2004

 

Impact on AOCI (net of taxes):

                                

Beginning balance

   $ (190,780 )   $ (27,717 )   $ (118,018 )   $ (123,754 )

Gains (losses) on cash flow hedges related to derivatives, net

     82,960       (114,417 )     (16,643 )     (47,748 )

Reclassifications to earnings, net

     8,689       13,974       35,530       43,342  
    


 


 


 


Ending balance

   $ (99,131 )   $ (128,160 )   $ (99,131 )   $ (128,160 )
    


 


 


 


Derivatives terminated during the quarter:

                                

Notional

   $ 5,025,000     $ 2,970,000     $ 12,670,000     $ 4,453,500  

Fair value of net gains (losses) recognized in AOCI

   $ 30,320     $ (30,079 )   $ (44,845 )   $ (57,561 )

Amortization of terminated interest rate swaps and options included in interest expense

   $ (14,027 )   $ (24,522 )   $ (57,446 )   $ (77,001 )

 

The gains (losses) accumulated in AOCI on the derivative instruments terminated shown in the preceding table will be included in interest expense over the periods the hedged forecasted issuance of liabilities will affect earnings, ranging from 11 days to 15 years.

 

The following table represents the balance in AOCI attributable to open cash flow hedges and discontinued cash flow hedges (in thousands):

 

     At September 30,

 
     2005

    2004

 

AOCI balance (net of taxes) related to:

                

Open cash flow hedges

   $ (31,415 )   $ (45,147 )

Discontinued cash flow hedges

     (67,716 )     (83,013 )
    


 


Total cash flow hedges

   $ (99,131 )   $ (128,160 )
    


 


 

Hedge Ineffectiveness

 

In accordance with SFAS No. 133, the Company recognizes hedge ineffectiveness on both fair value and cash flow hedge relationships. These amounts are reflected in fair value adjustments of financial derivatives in the consolidated statements of operations. The following table summarizes the income (expense) recognized by the Company as fair value and cash flow hedge ineffectiveness (in thousands):

 

    

Three Months Ended

September 30,


   

Nine Months Ended

September 30,


 
     2005

    2004

    2005

    2004

 

Fair value hedges

   $ (1,240 )   $ (1,015 )   $ (3,861 )   $ (3,239 )

Cash flow hedges

     (29 )     1,711       (44 )     6,056  
    


 


 


 


Total fair value adjustments of financial derivatives

   $ (1,269 )   $ 696     $ (3,905 )   $ 2,817  
    


 


 


 


 

Mortgage Banking Activities

 

The Company enters into commitments to originate loans whereby the interest rate on the loan is determined prior to funding; these commitments are referred to as Interest Rate Lock Commitments (“IRLCs”). IRLCs on

 

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loans the Bank intends to sell are considered to be derivatives and are, therefore, recorded at fair value with changes in fair value recorded in earnings. For purposes of determining their fair value, the Company performs a net present value analysis of the anticipated cash flows associated with these IRLCs. The net present value analysis performed excludes the market value associated with the anticipated sale of servicing rights related to each loan commitment. The fair value of these IRLCs was a $0.5 million liability and a $1.5 million asset at September 30, 2005 and December 31, 2004, respectively.

 

IRLCs, as well as closed loans held-for-sale, expose the Company to interest rate risk. The Company manages this risk by selling mortgages or mortgage-backed securities on a forward basis referred to as forward sale agreements. Changes in the fair value of these derivatives are included as gain on sales of loans and securities, net in the consolidated statements of operations.

 

The net change in IRLCs, closed loans and the related hedging instruments generated net gains of $0.1 million and $0.6 million for the three and nine months ended September 30, 2005, respectively, and a net loss of $0.1 million and a net gain of $3.3 million for the corresponding periods in 2004.

 

NOTE 18—SEGMENT INFORMATION

 

In January 2005, the Company revised its financial reporting to reflect the manner in which its chief operating decision maker has begun assessing the Company’s performance and makes resource allocation decisions. As a result, the Company now reports its operating results in two segments, retail and institutional, rather than its former brokerage and banking segments.

 

Retail includes:

 

    investing, trading, banking and lending products and services to individuals; and

 

    stock plan administration products and services activity

 

Institutional includes:

 

    balance sheet management, including generation of institutional net interest spread, gain on sales of loans and securities, net and management income;

 

    market-making; and

 

    global execution and settlement services

 

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The Company evaluates the performance of its segments based on segment contribution (net revenues less expenses excluding interest). All corporate overhead, administrative and technology charges are allocated to segments either in proportion to their respective direct costs or based upon specific operating criteria. Financial information for the Company’s reportable segments is presented in the following tables (in thousands):

 

     Three Months Ended September 30, 2005

 
     Retail

    Institutional

    Eliminations(1)

    Total

 

Revenues:

                                

Commissions

   $ 86,642     $ 30,523     $ —       $ 117,165  

Principal transactions

     —         23,793       —         23,793  

Gain on sales of loans and securities, net

     17,534       4,316       —         21,850  

Service charges and fees

     27,000       5,960       —         32,960  

Other revenues

     27,929       2,901       (7,910 )     22,920  
    


 


 


 


       159,105       67,493       (7,910 )     218,688  

Interest income

     175,357       362,548       (113,763 )     424,142  

Interest expense

     (63,223 )     (257,641 )     113,763       (207,101 )
    


 


 


 


Net interest income

     112,134       104,907       —         217,041  

Provision for loan losses

     —         (12,909 )     —         (12,909 )
    


 


 


 


Net interest income after provision for loan losses

     112,134       91,998       —         204,132  
    


 


 


 


Total revenues

     271,239       159,491       (7,910 )     422,820  
    


 


 


 


Expense excluding interest:

                                

Compensation and benefits

     59,125       44,185       —         103,310  

Occupancy and equipment

     14,568       1,978       —         16,546  

Communications

     15,788       2,821       —         18,609  

Professional services

     10,550       5,594       —         16,144  

Commissions, clearance and floor brokerage

     11,282       27,315       (2,040 )     36,557  

Advertising and market development

     19,363       1,825       —         21,188  

Servicing and other banking expenses

     1,603       17,256       (5,870 )     12,989  

Fair value adjustments of financial derivatives

     —         1,269       —         1,269  

Depreciation and amortization

     14,947       4,064       —         19,011  

Amortization of other intangibles

     2,455       2,189       —         4,644  

Facility restructuring and other exit charges

     (270 )     (199 )     —         (469 )

Other

     13,439       8,530       —         21,969  
    


 


 


 


Total expenses excluding interest

     162,850       116,827       (7,910 )     271,767  
    


 


 


 


Segment income

   $ 108,389     $ 42,664     $ —       $ 151,053  
    


 


 


 



(1)   Reflects elimination of transactions between retail and institutional segments, which include deposit transfer pricing, servicing and order flow rebates.

 

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     Three Months Ended September 30, 2004

 
     Retail

    Institutional

    Eliminations(1)

    Total

 

Revenues:

                                

Commissions

   $ 64,005     $ 20,864     $ —       $ 84,869  

Principal transactions

     —         24,391       —         24,391  

Gain on sales of loans and securities, net

     17,170       11,245       —         28,415  

Service charges and fees

     18,117       3,536       —         21,653  

Other revenues

     24,772       3,394       (7,368 )     20,798  
    


 


 


 


       124,064       63,430       (7,368 )     180,126  

Interest income

     121,327       247,226       (75,549 )     293,004  

Interest expense

     (40,296 )     (164,105 )     75,549       (128,852 )
    


 


 


 


Net interest income

     81,031       83,121       —         164,152  

Provision for loan losses

     —         (9,145 )     —         (9,145 )
    


 


 


 


Net interest income after provision for loan losses

     81,031       73,976       —         155,007  
    


 


 


 


Total revenues

     205,095       137,406       (7,368 )     335,133  
    


 


 


 


Expense excluding interest:

                                

Compensation and benefits

     56,843       25,218       —         82,061  

Occupancy and equipment

     15,198       2,921       —         18,119  

Communications

     16,078       1,997       —         18,075  

Professional services

     10,816       5,765       —         16,581  

Commissions, clearance and floor brokerage

     10,892       19,738       (2,280 )     28,350  

Advertising and market development

     8,485       808       —         9,293  

Servicing and other banking expenses

     2,230       11,927       (5,088 )     9,069  

Fair value adjustments of financial derivatives

     —         (696 )     —         (696 )

Depreciation and amortization

     17,099       2,841       —         19,940  

Amortization of other intangibles

     2,411       2,204       —         4,615  

Facility restructuring and other exit charges

     (64 )     (163 )     —         (227 )

Other

     11,130       7,160       —         18,290  
    


 


 


 


Total expenses excluding interest

     151,118       79,720       (7,368 )     223,470  
    


 


 


 


Segment income

   $ 53,977     $ 57,686     $ —       $ 111,663  
    


 


 


 



(1)   Reflects elimination of transactions between retail and institutional segments, which include deposit transfer pricing, servicing and order flow rebates.

 

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Table of Contents
    Nine Months Ended September 30, 2005

 
    Retail

    Institutional

    Eliminations(1)

    Total

 

Revenues:

                               

Commissions

  $ 246,040     $ 87,352     $ —       $ 333,392  

Principal transactions

    —         75,386       161       75,547  

Gain on sales of loans and securities, net

    51,746       32,375       —         84,121  

Service charges and fees

    86,907       13,956       —         100,863  

Other revenues

    83,295       8,412       (23,990 )     67,717  
   


 


 


 


      467,988       217,481       (23,829 )     661,640  

Interest income

    464,213       983,790       (299,471 )     1,148,532  

Interest expense

    (161,581 )     (673,260 )     299,309       (535,532 )
   


 


 


 


Net interest income

    302,632       310,530       (162 )     613,000  

Provision for loan losses

    —         (37,946 )     —         (37,946 )
   


 


 


 


Net interest income after provision for loan losses

    302,632       272,584       (162 )     575,054  
   


 


 


 


Total revenues

    770,620       490,065       (23,991 )     1,236,694  
   


 


 


 


Expense excluding interest:

                               

Compensation and benefits

    174,397       108,536       —         282,933  

Occupancy and equipment

    43,646       8,971       —         52,617  

Communications

    47,788       8,066       —         55,854  

Professional services

    37,072       14,680       —         51,752  

Commissions, clearance and floor brokerage

    33,326       79,815       (6,426 )     106,715  

Advertising and market development

    66,849       7,408       —         74,257  

Servicing and other banking expenses

    4,675       47,557       (17,565 )     34,667  

Fair value adjustments of financial derivatives

    —         3,905       —         3,905  

Depreciation and amortization

    44,599       9,984       —         54,583  

Amortization of other intangibles

    7,713       6,825       —         14,538  

Facility restructuring and other exit charges

    (170 )     665       —         495  

Other

    33,834       28,712       —         62,546  
   


 


 


 


Total expenses excluding interest

    493,729       325,124       (23,991 )     794,862  
   


 


 


 


Segment income

  $ 276,891     $ 164,941     $ —       $ 441,832  
   


 


 


 



(1)   Reflects elimination of transactions between retail and institutional segments, which include deposit transfer pricing, servicing and order flow rebates.

 

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    Nine Months Ended September 30, 2004

 
    Retail

    Institutional

    Eliminations(1)

    Total

 

Revenues:

                               

Commissions

  $ 255,391     $ 77,510     $ —       $ 332,901  

Principal transactions

    —         91,417       —         91,417  

Gain on sales of loans and securities, net

    73,752       33,326       —         107,078  

Service charges and fees

    63,021       10,224       —         73,245  

Other revenues

    80,752       11,726       (24,224 )     68,254  
   


 


 


 


      472,916       224,203       (24,224 )     672,895  

Interest income

    361,807       684,867       (224,110 )     822,564  

Interest expense

    (125,691 )     (468,035 )     224,110       (369,616 )
   


 


 


 


Net interest income

    236,116       216,832       —         452,948  

Provision for loan losses

    —         (25,701 )     —         (25,701 )
   


 


 


 


Net interest income after provision for loan losses

    236,116       191,131       —         427,247  
   


 


 


 


Total revenues

    709,032       415,334       (24,224 )     1,100,142  
   


 


 


 


Expense excluding interest:

                               

Compensation and benefits

    174,603       91,783       —         266,386  

Occupancy and equipment

    45,221       8,865       —         54,086  

Communications

    47,644       6,244       —         53,888  

Professional services

    28,779       16,611       —         45,390  

Commissions, clearance and floor brokerage

    44,335       74,233       (9,176 )     109,392  

Advertising and market development

    41,756       4,057       —         45,813  

Servicing and other banking expenses

    6,046       35,083       (15,048 )     26,081  

Fair value adjustments of financial derivatives

    —         (2,817 )     —         (2,817 )

Depreciation and amortization

    49,822       9,551       —         59,373  

Amortization of other intangibles

    10,102       5,115       —         15,217  

Facility restructuring and other exit charges

    (764 )     (469 )     —         (1,233 )

Other

    33,349       29,522       —         62,871  
   


 


 


 


Total expenses excluding interest

    480,893       277,778       (24,224 )     734,447  
   


 


 


 


Segment income

  $ 228,139     $ 137,556     $ —       $ 365,695  
   


 


 


 


Segment Assets:

                               

As of September 30, 2005

  $ 5,442,884     $ 30,759,587     $ —       $ 36,202,471  

As of December 31, 2004

  $ 5,294,487     $ 25,738,096     $ —       $ 31,032,583  

(1)   Reflects elimination of transactions between retail and institutional segments, which include deposit transfer pricing, servicing and order flow rebates.

 

No single customer accounted for more than 10% of total revenues in the three and nine months ended September 30, 2005 or 2004.

 

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NOTE 19—SUBSEQUENT EVENTS

 

Acquisition of BrownCo

 

On September 29, 2005, the Company signed a definitive agreement to acquire BrownCo, an online brokerage service of JP Morgan Chase & Co, for $1.6 billion in cash. The transaction is expected to close in late 2005.

 

Acquisition of Harrisdirect

 

On October 6, 2005, the Company completed the acquisition of the U.S.-based online brokerage operations of Harrisdirect from BMO Financial Group for an aggregate amount of $700 million in cash.

 

Exchangeable Shares

 

On October 19, 2005, the Company began the process to call and exchange all of its outstanding Exchangeable Shares. Upon exchange, these shares will be converted on a one-for-one basis for the Company’s common stock.

 

Additional Senior Note Offering

 

On October 28, 2005, the Company issued $250 million in 7 3/8% senior notes due in 2013. This offering is an add-on to $350 million of senior notes issued in September 2005 and pursuant to the indenture dated September 19, 2005. The notes were issued at a discount of $2.5 million which will be accreted over the term of the notes. The Company intends to apply substantially all of the net proceeds from this offering toward the financing of its acquisition of BrownCo.

 

Universal Shelf Registration

 

On October 28, 2005, the Company filed a universal shelf registration statement for the purposes of issuing, in the future, various securities not to exceed $2.5 billion. The securities which the Company may issue in any combination pursuant to the shelf registration statement include: senior notes; debt securities, subordinated debt securities; common stock; preferred stock; warrants; purchase contracts and units. As of October 31, 2005, the Company has not issued any securities under this shelf registration statement.

 

Sale of Consumer Lending Business

 

On October 31, 2005, the Company completed the sale of the origination and servicing business of E*TRADE Consumer Finance to GE Consumer Finance’s Retail Sales Finance unit, for a $58.0 million premium over book value. The Company may receive an additional $2.0 million upon reaching other milestones. The Company expects to record a gain of approximately $45 million upon close of the sale.

 

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Table of Contents

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

 

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

 

FORWARD-LOOKING STATEMENTS

 

Statements made in this document, other than statements of historical information, are forward-looking statements that are made pursuant to the safe harbor provisions of Section 21E of the Securities Exchange Act of 1934. These forward-looking statements may sometimes be identified by words such as “expect,” “may,” “looking forward,” “we plan,” “we believe,” “are planned,” “could be” and “currently anticipate.” Although we believe these statements, as well as other oral and written forward-looking statements made by us or on behalf of E*TRADE Financial Corporation from time to time, to be true and reasonable, we can give no assurance that these plans, intentions or expectations will be achieved. Actual results, performance or achievements could differ materially from those contemplated, expressed or implied by the forward-looking statements. Important factors that could cause actual results to differ materially from our forward-looking statements are set forth in our other filings with the SEC and in this document under the heading “Risk Factors.” We caution that the risks and factors discussed below and in such filings are not exclusive. We do not undertake to update any forward-looking statements that may be made from time to time by or on behalf of E*TRADE FINANCIAL.

 

OVERVIEW

 

Key Strategy

 

Our strategy to enhance shareholder value centers on achieving growth in our retail business and leveraging that growth in our institutional business. The primary drivers of growth are the acquisition, expansion and retention of customer relationships. We strive to achieve such growth in our customer base by providing product offerings built around price, functionality and service. We also intend to grow through appropriate and targeted acquisitions which leverage our existing business platform.

 

During the third quarter of 2005, we signed definitive purchase agreements to acquire Harrisdirect and BrownCo. Each transaction brings a high quality customer base with significant asset, cash and credit relationships. In addition, both transactions will bring us Daily Average Revenue Trades (“DART”s), which add scale to our trading business and carry a high incremental margin.

 

Key Factors Affecting Financial Performance

 

Our financial performance is affected by several external factors outside of our control, including:

 

    general economic conditions;

 

    customer demand for our products and services;

 

    competitor pricing on similar products and services;

 

    interest rates and the shape of the interest rate yield curve; and

 

    the performance of the equity and capital markets.

 

In addition to the items noted above, our success for the remainder of 2005 will depend upon, among other things:

 

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

 

    deepening customer acceptance of E*TRADE Complete, which includes our investing, deposits and lending products;

 

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Table of Contents
    disciplined expense control and improved operational efficiency;

 

    maintaining strong overall asset quality; and

 

    prudent risk and capital management.

 

Earnings Highlights

 

Consolidated net income for the three months ended September 30, 2005 was $107.5 million, or $0.28 per diluted share, compared with net income of $79.3 million, or $0.21 per diluted share for the same period in 2004.

 

Consolidated net income for the nine months ended September 30, 2005 was $301.1 million, or $0.79 per diluted share, compared with net income of $290.7 million, or $0.75 per diluted share for the same period in 2004.

 

Highlights of the three months ended September 30, 2005 include:

 

    DARTs increased 29% compared with the third quarter 2004. This increase was driven by a combination of our overall focus on price, functionality and service for our retail trading customers as well as overall market performance.

 

    Net interest income increased 32% compared with the third quarter of 2004. This increase was a result of higher interest-earning assets as well as an increase in interest rate spread. The continued growth of customer cash is the primary factor that led to the increase in interest rate spread.

 

    Asset quality remained very strong. The ratio of nonperforming loans to total loans fell to 0.13% at September 30, 2005 from 0.17% at September 30, 2004.

 

    Average retail deposits increased $1.6 billion, or 14% compared with the same period in 2004. This increase was partially driven by organic growth in certificates of deposit, money market and demand deposit accounts as well as organic growth of and conversion into the Sweep Deposit Account (“SDA”).

 

Balance Sheet Highlights

 

Total assets were $36.2 billion at September 30, 2005, up $5.2 billion from December 31, 2004. This increase was primarily attributable to a $5.9 billion increase in loans receivable, net, slightly offset by a $1.4 billion decrease in available-for-sale mortgage-backed and investment securities.

 

Loans receivable, net were $17.5 billion at September 30, 2005 and $11.5 billion at December 31, 2004. This increase was driven by a targeted effort to grow our one- to four-family and Home Equity Line of Credit (“HELOC”) and second mortgage portfolios. The one- to four-family portfolio grew $3.4 billion and the HELOCs and second mortgage portfolio grew $2.4 billion during the first nine months of 2005. Loans receivable, net represented 48% of total assets at September 30, 2005 up from 37% at December 31, 2004.

 

The growth in loans was offset by a decline in our available-for-sale mortgage-backed and investment securities portfolio. This portfolio declined by $1.4 billion during the first nine months of 2005. This decrease was due to the planned growth in loans noted above.

 

Deposits were $14.6 billion, up 18% during the first nine months of 2005. The increase was driven by organic growth in certificates of deposit, money market and demand deposit accounts as well as by conversions into the SDA. Deposits are our lowest cost source of funding and an important contributor to growth in net interest income.

 

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Table of Contents

Other borrowings by Bank subsidiary were up 161%, or $2.8 billion, during the first nine months of 2005. The increase was driven by growth in FHLB advances, shifting our funding sources from securities sold under agreements to repurchase. The Bank’s primary sources of wholesale funding are from FHLB advances and securities sold under agreements to repurchase. We determine which source of funding to use based on pricing, liquidity and capacity during each period.

 

Segment Highlights

 

Total segment income increased 35% to $151.1 million for the three months ended September 30, 2005 and 21% to $441.8 million for the nine months ended September 30, 2005 from the comparable periods in 2004. A summary of results for both the third quarter 2005 and the nine months ended September 30, 2005 follows:

 

Retail

 

Retail segment income totaled $108.4 million for the third quarter 2005 compared with $54.0 million for the third quarter 2004. This 100% increase in income was primarily driven by growth in deposits, margin balance, and DARTs.

 

Retail segment income totaled $276.9 million for the first nine months of 2005 compared with $228.1 million for the first nine months of 2004. This 21% growth in income was primarily driven by growth in deposits and margin balances.

 

Institutional

 

Institutional segment income totaled $42.7 million for the third quarter 2005 compared with $57.7 million for the third quarter 2004. This 26% decrease in income compared to the prior year was driven by increased compensation expense due to the adoption of SFAS No. 123(R) and increased volume-related compensation, slightly offset by increased net interest income.

 

Institutional segment income totaled $164.9 million for the first nine months of 2005 compared with $137.6 million for the first nine months of 2004. This 20% increase in income compared to the prior year was driven by increased net interest income. The increase in net interest income was driven by increased retail deposits which were then leveraged by the institutional segment to grow the balance sheet, thereby, increasing average interest-earning banking assets by 25% to $27.0 billion for the nine months ended September 30, 2005 from $21.5 billion for the same period in 2004.

 

EARNINGS OVERVIEW

 

During the three months ended September 30, 2005, net income from continuing operations was $108.6 million, an increase of $21.5 million, or 25%, compared to $87.1 million for the three months ended September 30, 2004. During the nine months ended September 30, 2005, net income from continuing operations was $318.6 million compared to $279.8 million for the nine months ended September 30, 2004. We produced strong growth in deposits, margin balances and DARTs, revenue growth exceeded expense growth and we saw further improvement in the Bank net interest rate spread. The following sections describe in more detail the changes in key operating factors, and other changes and events that have affected our consolidated net revenues, expenses excluding interest and other income.

 

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Table of Contents

Revenues

 

As shown in the following table, net revenues increased 26% to $422.8 million for the three months ended September 30, 2005 and 12% to $1.2 billion for the nine months ended September 30, 2005 from the comparable periods in 2004 (dollars in thousands):

 

   

Three Months Ended

September 30,


    Variance

    Percentage
Change


   

Nine Months Ended

September 30,


    Variance

    Percentage
Change


 
    2005

    2004

        2005

    2004

     

Revenues:

                                                           

Commissions

  $ 117,165     $ 84,869     $ 32,296     38  %   $ 333,392     $ 332,901     $ 491     —    %

Principal transactions

    23,793       24,391       (598 )   (2 )%     75,547       91,417       (15,870 )   (17 )%

Gain on sales of loans and securities, net

    21,850       28,415       (6,565 )   (23 )%     84,121       107,078       (22,957 )   (21 )%

Service charges and fees

    32,960       21,653       11,307     52  %     100,863       73,245       27,618     38  %

Other revenues

    22,920       20,798       2,122     10  %     67,717       68,254       (537 )   (1 )%

Interest income

    424,142       293,004       131,138     45  %     1,148,532       822,564       325,968     40  %

Interest expense

    (207,101 )     (128,852 )     (78,249 )   (61 )%     (535,532 )     (369,616 )     (165,916 )   (45 )%
   


 


 


       


 


 


     

Net interest income

    217,041       164,152       52,889     32  %     613,000       452,948       160,052     35  %

Provision for loan losses

    (12,909 )     (9,145 )     (3,764 )   (41 )%     (37,946 )     (25,701 )     (12,245 )   (48 )%
   


 


 


       


 


 


     

Net interest income after provision for loan losses

    204,132       155,007       49,125     32  %     575,054       427,247       147,807     35  %
   


 


 


       


 


 


     

Total net revenues

  $ 422,820     $ 335,133     $ 87,687     26  %   $ 1,236,694     $ 1,100,142     $ 136,552     12  %
   


 


 


       


 


 


     

 

An overview of the key revenue drivers that we use to measure and explain the results of our operations are presented in the following table:

 

    

Three Months Ended

September 30,


  

Percentage

Change


    Nine Months Ended
September 30,


  

Percentage

Change


 
     2005

   2004

     2005

   2004

  

DARTs

     125,534      97,404    29 %     125,047      126,973    (2 )%

Average commission per revenue trade

   $ 10.78    $ 10.27    5 %   $ 10.41    $ 10.70    (3 )%

Average margin balances (in millions)

   $ 2,286    $ 2,043    12 %   $ 2,241    $ 2,052    9  %

Average Bank net interest spread (basis points)

     223      213    5 %     221      202    9  %

Average interest-earning banking assets (in millions)

   $ 28,303    $ 23,091    23 %   $ 26,980    $ 21,510    25  %

 

Commission revenues increased 38% to $117.2 million for the three months ended September 30, 2005 and were flat for the nine months ended September 30, 2005, from the comparable periods in 2004. The combination of a higher average commission per revenue trade and higher volumes led to the increase in total commission for the quarter. Despite the decline in average commission per revenue trade and lower volumes for the nine months ended September 30, 2005, commission revenues increased slightly for the nine months ended September 30, 2005 from the comparable period in 2004 due to an increase in institutional commission revenues. We earn commissions when retail and institutional customers execute trades. The primary factors that affect our commissions are DARTs and average commission per revenue trade. The average commission per revenue trade is impacted by the mix between and within our domestic, international and professional businesses. Each business has a different pricing structure, unique to its customer base and local market practices, and as a result, a change in the executed trades between these businesses impacts average commission per revenue trade. Each business also has different trade types (e.g. equities, options, fixed income and mutual funds) that can have different commission rates and as a result, changes in the mix of trade types within these businesses impact average commission per revenue trade. The Company also provides institutional customers with global trading and settlement services, as well as worldwide access to research provided by third parties, in exchange for commissions based on negotiated rates, which differ by customer.

 

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Table of Contents

Principal transactions decreased 2% to $23.8 million for the three months ended September 30, 2005 and 17% to $75.5 million for the nine months ended September 30, 2005 from the comparable periods in 2004. Principal transactions decreased due to lower market-making volumes and lower market volatility. Principal transactions primarily include revenues from market-making. As such, our principal transactions revenues are influenced by overall trading volumes, the number of stocks for which we act as a market maker, the trading volumes of those specific stocks and the trading performance of our proprietary trading activities.

 

As shown in the following table, gain on sales of loans and securities, net decreased 23% to $21.9 million for the three months ended September 30, 2005 and 21% to $84.1 million for the nine months ended September 30, 2005 from the comparable periods in 2004 (dollars in thousands):

 

    Three Months Ended
September 30,


    Variance

   

Nine Months Ended

September 30,


    Variance

 
    2005

    2004

    $ Amount

    %

    2005

    2004

    $
Amount


    %

 

Gain on sales of originated loans:

                                                           

Mortgage loans

  $ 12,371     $ 10,933     $ 1,438     13 %   $ 32,513     $ 54,429     $ (21,916 )   (40 )%

Consumer loans(1)

    2,440       4,203       (1,763 )   (42 )%     14,634       10,400       4,234     41 %
   


 


 


       


 


 


     

Gain on sales of originated loans

    14,811       15,136       (325 )   (2 )%     47,147       64,829       (17,682 )   (27 )%
   


 


 


       


 


 


     

Loss on sales of loans held-for-sale, net:

                                                           

Gain (loss) on sales of loans held-for-sale

    (853 )     1,610       (2,463 )   *       (1,297 )     5,159       (6,456 )   *  

Gain (loss) on hedges

    345       (3,201 )     3,546     *       95       (6,774 )     6,869     *  

Loss on loan prepayments

    (35 )     (241 )     206     85 %     (240 )     (1,226 )     986     80 %
   


 


 


       


 


 


     

Loss on sales of loans held-for-sale, net

    (543 )     (1,832 )     1,289     70 %     (1,442 )     (2,841 )     1,399     49 %
   


 


 


       


 


 


     

Gain on sales of securities, net:

                                                           

Gain on sales of securities

    15,025       24,375       (9,350 )   (38 )%     77,740       58,633       19,107     33 %

Impairment

    (7,393 )     (9,264 )     1,871     20 %     (38,343 )     (13,543 )     (24,800 )   *  

Loss on hedges

    (50 )     —         (50 )   *       (981 )     —         (981 )   *  
   


 


 


       


 


 


     

Gain on sales of securities, net

    7,582       15,111       (7,529 )   (50 )%     38,416       45,090       (6,674 )   (15 )%
   


 


 


       


 


 


     

Total gain on sales of loans and securities, net

  $ 21,850     $ 28,415     $ (6,565 )   (23 )%   $ 84,121     $ 107,078     $ (22,957 )   (21 )%
   


 


 


       


 


 


     

*   Percentage not meaningful.
(1)   Consumer loans originated by our retail segment and sold to our institutional segment were sold at an arm’s length transfer price. The gains/losses associated with our retail segment were reclassified to discontinued operations and the amounts related to our institutional segment remained in continuing operations.

 

The decline in the total gain on sales of loans and securities, net for the three and nine months ended September 30, 2005 was primarily due to the following reasons:

 

    Decline of $17.7 million in gain on sales of originated loans for the nine months ended September 30, 2005. The decline in gain on sales of originated loans for the period was mainly due to higher interest rates, which resulted in lower volumes of mortgage loans.

 

    Declines of $7.5 million and $6.7 million, respectively, in gain on sales of securities, net. The decline in gain on sales of securities, net for the three months ended September 30, 2005 was primarily attributable to a $9.4 million decline in gain on sales of mortgage-backed and investment securities, partially offset by a decrease in the recognition of other-than-temporary impairments on securities. The gain on sales of securities, net for the nine months ended September 30, 2005 declined primarily due to the recognition of $38.3 million other-than-temporary impairments on asset-backed and interest-only securities compared to the $13.5 million other-than-temporary impairments for the same period in 2004. These impairments were partially offset by increases of $19.1 million from the net gains on sales of interest-only and investment securities.

 

 

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Table of Contents

Service charges and fees increased 52% to $33.0 million for the three months ended September 30, 2005 and 38% to $100.9 million for the nine months ended September 30, 2005 from the comparable periods in 2004. These increases are primarily due to increases in account service fees of $6.7 million and $20.4 million for the three and nine months ended September 30, 2005 compared to the same periods in 2004. The increase in account service fees is due to an increase in account service fees charged from $25 to $40 per quarter, beginning the first quarter of 2005, for customers who did not meet certain criteria for balance and/or activity levels. Service charges and fees represent account service fees, servicing fee income and other customer service fees.

 

Other revenues increased 10% to $22.9 million for the three months ended September 30, 2005 and decreased 1% to $67.7 million for the nine months ended September 30, 2005 from the comparable periods in 2004. Other revenues increased during the third quarter due to increased options and foreign exchange margin revenues, offset by decreases relating to the closure of certain of our proprietary funds during the second quarter of 2005. Other revenues represent foreign exchange margin revenues, stock plan administration products revenues and other revenues ancillary to our retail customer transactions.

 

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Table of Contents

The following tables present average balance, income and expense data, related interest yields and rates, and Bank net interest spread for the three and nine months ended September 30, 2005 and 2004 (dollars in thousands):

 

   

Three Months Ended

September 30, 2005


   

Three Months ended

September 30, 2004


 
   

Average

Balance


 

Interest

Income/

Expense


 

Average

Annualized

Yield/Cost


   

Average

Balance


 

Interest

Income/

Expense


 

Average

Annualized

Yield/Cost


 

Interest-earning banking assets:

                                   

Loans receivable, net(1)

  $ 17,024,600   $ 232,004   5.45 %   $ 10,305,473   $ 124,835   4.85 %

Mortgage-backed and related available-for-sale securities

    9,059,130     97,537   4.31 %     8,579,174     86,137   4.02 %

Available-for-sale investment securities

    1,728,134     24,122   5.58 %     3,314,544     33,981   4.10 %

Trading securities

    186,377     2,792   5.99 %     681,326     5,528   3.24 %

Other

    304,856     2,485   3.23 %     210,596     1,845   3.48 %
   

 

       

 

     

Total interest-earning banking assets(2)

    28,303,097   $ 358,940   5.07 %     23,091,113   $ 252,326   4.37 %
         

             

     

Non-interest-earning banking assets

    528,215                 419,246            
   

             

           

Total banking assets

  $ 28,831,312               $ 23,510,359            
   

             

           

Interest-bearing banking liabilities:

                                   

Retail deposits

  $ 13,095,471   $ 57,710   1.75 %   $ 11,516,741   $ 41,042   1.42 %

Brokered callable certificates of deposit

    540,575     4,815   3.53 %     378,241     2,381   2.50 %

Repurchase agreements and other borrowings

    9,510,214     91,520   3.77 %     9,038,526     67,902   2.94 %

FHLB advances

    4,093,294     40,914   3.91 %     1,117,619     12,732   4.46 %
   

 

       

 

     

Total interest-bearing banking liabilities

    27,239,554   $ 194,959   2.84 %     22,051,127   $ 124,057   2.24 %
         

             

     

Non-interest-bearing banking liabilities

    273,685                 346,631            
   

             

           

Total banking liabilities

    27,513,239                 23,397,758            

Total banking shareholder’s equity

    1,318,073                 1,112,601            
   

             

           

Total banking liabilities and shareholder’s equity

  $ 28,831,312               $ 23,510,359            
   

             

           

Excess of interest-earning banking assets over interest-bearing banking liabilities/net interest income

  $ 1,063,543   $ 163,981         $ 1,039,986   $ 128,269      
   

 

       

 

     

Bank net interest:

                                   

Spread

              2.23 %               2.13 %
               

             

Margin (net yield on interest-earning banking assets)

              2.32 %               2.22 %
               

             

Average interest-earning banking assets to interest-bearing banking liabilities

              103.90 %               104.72 %
               

             

Return on average(3) (4):

                                   

Total banking assets

              0.96 %               0.91 %
               

             

Total banking shareholder’s equity

              21.06 %               19.24 %
               

             

Average equity to average total banking assets

              4.57 %               4.73 %
               

             


(1)   Nonaccrual loans are included in the respective average loan balances. Income on such nonaccrual loans is recognized on a cash basis.
(2)   Includes a taxable equivalent increase in interest income of $2.6 million and $2.2 million for the three months ended September 30, 2005 and 2004, respectively.
(3)   Ratio calculations exclude discontinued operations.
(4)   Ratio calculated based on standalone Bank results.

 

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Table of Contents
   

Nine Months Ended

September 30, 2005


   

Nine Months ended

September 30, 2004


 
   

Average

Balance


 

Interest

Income/

Expense


 

Average

Annualized

Yield/Cost


   

Average

Balance


 

Interest

Income/

Expense


 

Average

Annualized

Yield/Cost


 

Interest-earning banking assets:

                                   

Loans receivable, net(1)

  $ 14,517,416   $ 569,191   5.23 %   $ 9,523,482   $ 346,666   4.85 %

Mortgage-backed and related available-for-sale securities

    9,139,878     285,366   4.16 %     8,055,147     241,896   4.00 %

Available-for-sale investment securities

    2,796,517     107,410   5.12 %     2,958,567     87,133   3.93 %

Trading securities

    308,240     9,631   4.17 %     756,926     18,146   3.20 %

Other

    218,262     5,800   3.55 %     215,629     5,548   3.44 %
   

 

       

 

     

Total interest-earning banking assets(2)

    26,980,313   $ 977,398   4.83 %     21,509,751   $ 699,389   4.34 %
         

             

     

Non-interest-earning banking assets

    467,642                 479,059            
   

             

           

Total banking assets

  $ 27,447,955               $ 21,988,810            
   

             

           

Interest-bearing banking liabilities:

                                   

Retail deposits

  $ 12,407,871   $ 147,570   1.59 %   $ 11,681,921   $ 132,845   1.52 %

Brokered callable certificates of deposit

    429,568     10,818   3.37 %     369,877     6,996   2.53 %

Repurchase agreements and other borrowings

    9,995,414     261,492   3.45 %     7,546,832     184,128   3.21 %

FHLB advances

    3,026,553     86,358   3.76 %     1,002,062     33,598   4.41 %
   

 

       

 

     

Total interest-bearing banking liabilities

    25,859,406   $ 506,238   2.62 %     20,600,692   $ 357,567   2.32 %
         

             

     

Non-interest-bearing banking liabilities

    320,168                 323,384            
   

             

           

Total banking liabilities

    26,179,574                 20,924,076            

Total banking shareholder’s equity

    1,268,381                 1,064,734            
   

             

           

Total banking liabilities and shareholder’s equity

  $ 27,447,955               $ 21,988,810            
   

             

           

Excess of interest-earning banking assets over interest-bearing banking liabilities/net interest income

  $ 1,120,907   $ 471,160         $ 909,059   $ 341,822      
   

 

       

 

     

Bank net interest:

                                   

Spread

              2.21 %               2.02 %
               

             

Margin (net yield on interest-earning banking assets)

              2.33 %               2.12 %
               

             

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

              104.33 %               104.41 %
               

             

Return on average(3) (4):

                                   

Total banking assets

              0.99 %               0.90 %
               

             

Total banking shareholder’s equity

              21.43 %               18.59 %
               

             

Average equity to average total banking assets

              4.62 %               4.84 %
               

             


(1)   Nonaccrual loans are included in the respective average loan balances. Income on such nonaccrual loans is recognized on a cash basis.
(2)   Includes a taxable equivalent increase in interest income of $7.9 million and $4.6 million for the nine months ended September 30, 2005 and 2004, respectively.
(3)   Ratio calculations exclude discontinued operations.
(4)   Ratio calculated based on standalone Bank results.

 

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Table of Contents

Net interest income increased 32% to $217.0 million for the three months ended September 30, 2005 and 35% to $613.0 million for the nine months ended September 30, 2005 from the comparable periods in 2004. The increase in net interest income is primarily due to an increase in interest-earning banking assets, margin loan balances and an increase in net interest spread. Net interest income represents interest earned on interest-earning banking assets (primarily loans receivable and mortgage-backed and related available-for-sale securities), margin loans, stock borrow balances, cash required to be segregated under regulatory guidelines and fees on customer assets invested in money market accounts, net of interest paid on interest-bearing banking liabilities (primarily customer deposits, repurchase agreements, other borrowings and advances from the FHLB), paid to customers on certain credit balances and to banks and other broker-dealers through our brokerage subsidiary’s stock loan program. Net interest spread is the difference between the weighted-average yields earned on interest-earning banking assets less the weighted-average rate paid on interest-bearing banking liabilities.

 

In recent years, we have managed our interest rate risk at our Bank to achieve a minimum to moderate risk profile with limited exposure to earnings volatility resulting from interest rate fluctuations. Our actions have created a balance sheet characterized by strong asset quality and flexibility to take advantage of, where appropriate, changing interest rates and to adjust to changing market conditions. We anticipate that interest rates will continue to rise in 2005 and that the overall impact of a rise in long-term interest rates will be beneficial to net interest income. If the interest rate yield curve continues to flatten or inverts, we expect these conditions to have a negative impact on net interest income. We believe growth in customer cash balances will offset this risk of a decline in net interest income.

 

Average interest-earning banking assets increased 23% to $28.3 billion for the three months ended September 30, 2005 and increased 25% to $27.0 billion for the nine months ended September 30, 2005 from the comparable periods in 2004. Bank net interest spread increased to 223 and 221 basis points for the three and nine months ended September 30, 2005 from 213 and 202 basis points for the comparable periods in 2004. The increase in average interest-earning banking assets is mainly driven by an increase in loans receivable, net. The increase in Bank net interest spread for the three months ended September 30, 2005 primarily reflects an increase of 70 basis points, in the average annualized yield on interest-earning banking assets, with only an increase of 60 basis points in the average annualized cost of interest-bearing banking liabilities. The yields on liabilities increased at a lower rate than assets due to growth in low cost retail deposits, including the SDA. For the nine months ended September 30, 2005, we also saw these same trends in our average annual yield and cost, also resulting in higher Bank net interest spread.

 

Provision for loan losses increased 41% to $12.9 million for the three months ended September 30, 2005 and 48% to $37.9 million for the nine months ended September 30, 2005 from the comparable periods in 2004. The provision for loan losses reflects the Company’s estimate of loan losses that occurred in the current period and adjustments to prior period estimates. We adjust this provision to reflect changes in the size, composition and seasoning of the loans that the Bank holds. A seasoned loan is a loan that has been in existence long enough for the borrower to demonstrate a history of good payments. For the three months ended September 30, 2005, the increase in the provision for loan losses is related to increased provisions in the consumer loan portfolio. For the nine months ended September 30, 2005, the increase in the provision for loan losses is primarily related to growth in our one- to four-family and HELOC portfolios. We expect loan growth to continue to impact the provision for loan losses during the remainder of 2005. See “Balance Sheet Overview” for additional information regarding factors impacting the provision for loan losses.

 

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Table of Contents

Expenses Excluding Interest

 

As shown in the following table, expenses excluding interest increased 22% to $271.8 million for the three months ended September 30, 2005 and 8% to $794.9 million for the nine months ended September 30, 2005 from the comparable periods in 2004 (dollars in thousands):

 

   

Three Months Ended

September 30,


    Variance

    Percentage
Change


   

Nine Months Ended

September 30,


    Variance

    Percentage
Change


 
    2005

    2004

        2005

  2004

     

Expenses excluding interest:

                                                         

Compensation and benefits

  $ 103,310     $ 82,061     $ 21,249     26  %   $ 282,933   $ 266,386     $ 16,547     6  %

Occupancy and equipment

    16,546       18,119       (1,573 )   (9 )%     52,617     54,086       (1,469 )   (3 )%

Communications

    18,609       18,075       534     3  %     55,854     53,888       1,966     4  %

Professional services

    16,144       16,581       (437 )   (3 )%     51,752     45,390       6,362     14  %

Commissions, clearance and floor brokerage

    36,557       28,350       8,207     29  %     106,715     109,392       (2,677 )   (2 )%

Advertising and marketing development

    21,188       9,293       11,895     *       74,257     45,813       28,444     62  %

Servicing and other banking expenses

    12,989       9,069       3,920     43  %     34,667     26,081       8,586     33  %

Fair value adjustments of financial derivatives

    1,269       (696 )     1,965     *       3,905     (2,817 )     6,722     *  

Depreciation and amortization

    19,011       19,940       (929 )   (5 )%     54,583     59,373       (4,790 )   (8 )%

Amortization of other intangibles

    4,644       4,615       29       1%     14,538     15,217       (679 )   (4 )%

Facility restructuring and other exit charges

    (469 )     (227 )     (242 )   *       495     (1,233 )     1,728     *  

Other

    21,969       18,290       3,679     20  %     62,546     62,871       (325 )   (1 )%
   


 


 


       

 


 


     

Total expenses excluding interest

  $ 271,767     $ 223,470     $ 48,297     22 %   $ 794,862   $ 734,447     $ 60,415     8 %
   


 


 


       

 


 


     

*   Percentage not meaningful

 

Increases in compensation and benefits are due to the initial adoption of expensing employee stock options, under SFAS No. 123(R), in the third quarter, and increases in volume- and performance-based compensation. Increases in expenses for commissions, clearance and floor brokerage are due to an increase in overall trading volumes resulting in higher variable commissions, clearance and floor brokerage costs for the three and nine months ended September 30, 2005. Increases in advertising and marketing development are due to increased advertising spend associated with our launch of E*TRADE Complete in 2005. Increases in servicing and other banking expenses are due primarily to higher servicing expense related to an increase in mortgage loans serviced.

 

Other Income

 

Other income was $14.8 million and $46.3 million for the three and nine months ended September 30, 2005 as compared to $18.5 million and $56.6 million for the comparable periods in 2004. The decreases are primarily related to lower gain on sale of investments, offset by the loss on early extinguishment of debt in 2004. During the nine months ended September 30, 2005, we sold shares of our investments in SBI, Archipelago Holdings and Ameritrade Holding Corporation resulting in gains of $68.6 million. During the nine months ended September 30, 2004, gain on sale and impairment of investments was primarily related to gain on sale of our investments in SBI in the amount of $109.9 million.

 

Income Tax Expense

 

Income tax expense from continuing operations increased 33% to $57.3 million for the three months ended September 30, 2005 and 20% to $169.5 million for the nine months ended September 30, 2005 from the comparable periods in 2004. The increase in income tax expense is principally related to the increase in income over the comparable periods.

 

SEGMENT RESULTS REVIEW

 

Retail

 

Retail segment income increased over 100% to $108.4 million for the three months ended September 30, 2005 and 21% to $276.9 million for the nine months ended September 30, 2005 from the comparable periods in

 

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2004. Our retail segment generates revenues and earnings through our investing, trading, banking and lending relationships with our retail customers. These relationships drive essentially five sources of revenues including commissions, gain on loan originations, net interest income, service charges and fees and other revenues. This segment also includes results from our stock plan administration products and services, as we are ultimately servicing a retail customer through these corporate relationships.

 

The increase in retail segment income for the three and nine months ended September 30, 2005 was due to an increase in net revenue primarily driven by an increase in commissions and net interest income. DARTs increased 29% for the three months ended September 30, 2005 compared to the same period in 2004. Average commission per trade increased 5% to $10.78 for the three months ended September 30, 2005 compared to $10.27 for the same period in 2004. The increase in retail segment revenue for the nine months ended September 30, 2005 is primarily due to an increase in net interest income, partially offset by a decrease in commissions. For the nine months ended September 30, 2005, DARTs declined 2% compared to the same period in 2004. Average commission per trade declined 3% to $10.41 for the nine months ended September 30, 2005 compared to $10.70 for the same period in 2004. For the three and nine months ended September 30, 2005, retail net interest income increased approximately $31.1 million and $66.5 million compared to the same periods in 2004. The increases were driven by an increase in both the balance and the net interest spread we earn on our retail deposits for the three and nine months ended September 30, 2005. In addition, the increase was driven by higher average margin debt which continues to be strong for the retail segment, with average balances increasing 12% and 9%, to $2.29 billion and $2.24 billion for the three and nine months ended September 30, 2005, respectively, compared to $2.04 billion and $2.05 billion for the same periods in 2004. Gain on sales of loans and securities, net increased 2% for the three months ended September 30, 2005 compared to the same period in 2004; however, it declined 30% in 2005 compared to the nine months ended September 30, 2004. Service charges and fees increased by 49% and 38% in 2005 compared to the three and nine months ended September 30, 2004, respectively, primarily due to an increase in account service fees.

 

Institutional

 

Institutional segment income decreased 26% to $42.7 million for the three months ended September 30, 2005 from the comparable period in 2004. Institutional segment income increased 20% to $164.9 million for the nine months ended September 30, 2005 from the comparable period in 2004. Our institutional segment generates revenues and earnings from Bank balance sheet management activities, market-making and global execution and settlement services.

 

The decline in segment income for the three months ended September 30, 2005 was due to a 16% increase in segment revenue while total expenses increased by 47%. The increase in segment income for the nine months ended September 30, 2005 was attributable to an 18% increase in segment revenue while total expenses only increased by 17%. The increase in revenues resulted from higher net interest income due to higher average interest-earning banking assets and increased net interest spread. The increase in net interest spread was partially driven by a shift from lower yielding securities to higher yielding loans. The increase in expenses was driven by an increase in compensation expense as a result of our initial adoption of expensing options under SFAS No 123(R) and increases in volume- and performance-based compensation, as well as by higher commissions, clearance and floor brokerage due to an increase in overall trading volumes and higher servicing expenses related to an increase in loans serviced. We continue to benefit from our balance sheet integration across the retail and institutional segments. These efforts partly led to an increase in average interest-earning banking assets, primarily loans receivable, of $5.2 billion and $5.5 billion during the three and nine months ended September 30, 2005 compared to the same periods in 2004. Bank net interest spread increased to 223 basis points and 221 basis points for the three and nine months ended September 30, 2005, from 213 basis points and 202 basis points for the three and nine months ended September 30, 2004. This increase in Bank net interest spread was achieved despite a continued flattening of the yield curve during 2005 as higher yields on higher interest-earning banking assets more than offset the increase in the cost of short-term borrowings resulting from higher short-term interest rates.

 

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Table of Contents

BALANCE SHEET OVERVIEW

 

The following table sets forth the significant components of the Company’s balance sheets (dollars in thousands):

 

     September 30,
2005


   December 31,
2004


   Percentage
Change


 

Assets:

                    

Cash and equivalents

   $ 1,389,562    $ 939,906    48  %

Brokerage receivables, net

     3,764,410      3,034,548    24  %

Trading securities

     227,381      593,245    (62 )%

Available-for-sale mortgage-backed and investment securities

     11,174,666      12,543,818    (11 )%

Loans receivable, net

     17,534,081      11,505,755    52  %

Loans held-for-sale

     151,247      279,280    (46 )%

Other assets

     1,961,124      2,136,031    (8 )%
    

  

      

Total assets

   $ 36,202,471    $ 31,032,583    17  %
    

  

      

Liabilities and shareholders’ Equity:

                    

Brokerage payables

   $ 3,734,558    $ 3,618,892    3  %

Deposits

     14,550,696      12,302,974    18  %

Securities sold under agreements to repurchase

     9,072,914      9,897,191    (8 )%

Other borrowings by Bank subsidiary

     4,594,813      1,760,732    161  %

Corporate debt

     1,038,819      585,617    77  %

Other liabilities

     696,376      638,975    9  %
    

  

      

Total liabilities

     33,688,176      28,804,381    17  %
    

  

      

Shareholders’ equity

     2,514,295      2,228,202    13  %
    

  

      

Total liabilities and shareholders’ equity

   $ 36,202,471    $ 31,032,583    17  %
    

  

      

 

Total assets increased 17% during the nine months ended September 30, 2005. This increase was driven primarily by an increase in loans receivable, offset by a decrease in available-for-sale mortgage-backed and investment securities. An analysis of changes in certain balance sheet components follows:

 

Loans Receivable, net

 

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

 

     September 30,
2005


    December 31,
2004


    Percentage
Change


 

Real estate loans:

                      

One- to four-family

   $ 7,217,843     $ 3,669,594     97  %

HELOC and second mortgage

     6,035,013       3,617,074     67  %

Consumer loans:

                      

RV

     2,751,985       2,542,645     8  %

Marine

     773,876       720,513     7  %

Automobile

     298,686       583,354     (49 )%

Credit card

     188,732       203,169     (7 )%

Other

     60,047       21,159     184  %

Unamortized premiums, net

     267,753       195,928     37  %

Allowance for loan losses

     (59,854 )     (47,681 )   26  %
    


 


     

Total loans receivable, net

   $ 17,534,081     $ 11,505,755     52  %
    


 


     

 

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Loans receivable, net represented 48% of total assets at September 30, 2005 and 37% of total assets at December 31, 2004. The increase of $6.0 billion to $17.5 billion at September 30, 2005 was due to a targeted effort to grow our one- to four-family and HELOC portfolios. These two portfolios now represent 76% of total loans, net up from 63% at December 31, 2004.

 

Allowance for Loan Losses

 

The allowance for loan losses is management’s estimate of credit losses inherent in the Company’s loan portfolio as of the balance sheet date. The estimate of the allowance is based on a variety of factors, including past loan loss experience, the current credit profile of borrowers, adverse situations that have occurred that may affect the borrower’s ability to repay, the estimated value of underlying collateral, the interest rate climate as it affects adjustable-rate loans and general economic conditions. Determining the adequacy of the allowance is complex and requires judgment by management about the effect of matters that are inherently uncertain. Subsequent evaluations of the loan portfolio, in light of the factors then prevailing, may result in significant changes in the allowance for loan losses in future periods. Our internal policy requires that the allowance for loan losses should be at least equal to twelve months of projected losses for all loan types. We believe this level is representative of probable losses inherent in the loan portfolio at the balance sheet date.

 

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

 

     Consumer & Other (1)

    Real Estate

    Total

 
     Allowance

  

Allowances as %

of consumer

loans held-for-

investment


    Allowance

  

Allowances as %

of real estate

loans held-for-

Investment


    Allowance

  

Allowances as %

of total

loans held-for-
investment


 

September 30, 2005

   $ 31,338    0.76 %   $ 28,516    0.21 %   $ 59,854    0.34 %

June 30, 2005

   $ 29,826    0.72 %   $ 25,592    0.22 %   $ 55,418    0.35 %

March 31, 2005

   $ 29,732    0.70 %   $ 22,152    0.25 %   $ 51,844    0.40 %

December 31, 2004

   $ 29,686    0.72 %   $ 17,995    0.24 %   $ 47,681    0.41 %

(1)   Primarily RV, marine, automobile and credit card loans.
(2)   Primarily one- to four-family mortgage loans and HELOCs.

 

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

 

Activity in the allowance for loan losses is summarized as follows (in thousands):

 

    

Three Months Ended

September 30,


   

Nine Months Ended

September 30,


 
     2005

    2004

    2005

    2004

 

Allowance for loan losses, beginning of period

   $ 55,418     $ 40,938     $ 47,681     $ 37,847  

Provision for loan losses

     12,909       9,145       37,946       25,701  

Purchased reserve

     —         1,548       —         1,548  

Charge-offs

     (13,037 )     (14,111 )     (40,347 )     (38,125 )

Recoveries

     4,564       5,374       14,574       15,923  
    


 


 


 


Net charge-offs

     (8,473 )     (8,737 )     (25,773 )     (22,202 )
    


 


 


 


Allowance for loan losses, end of period

   $ 59,854     $ 42,894     $ 59,854     $ 42,894  
    


 


 


 


 

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For the three months ended September 30, 2005, net charge-offs were moderately lower than the prior period as lower net charge-offs on automobile and RV loans more than offset higher net charge-offs on our credit card portfolio. For the nine months ended September 30, 2005, net charge-offs were 16% higher than the prior period due primarily to higher net charge-offs on our credit card and real estate loan portfolios, offset partially by lower net charge-offs on automobile loans. The increase in net charge-offs was due to growth in loans receivable during the period and not indicative of a decline in credit quality.

 

Nonperforming Assets

 

We classify loans as nonperforming when full and timely collection of interest or principal becomes uncertain or when they are 90 days past due. The following table shows the comparative data for nonperforming loans and assets (in thousands):

 

    

September 30,

2005


   

December 31,

2004


 

Real estate loans

   $ 17,154     $ 13,784  

Consumer and other loans

     6,219       6,171  
    


 


Total nonperforming loans, net

     23,373       19,955  

REO and other repossessed assets, net

     3,051       5,367  
    


 


Total nonperforming assets, net

   $ 26,424     $ 25,322  
    


 


Total nonperforming assets, net, as a percentage of total Bank assets

     0.08 %     0.10 %
    


 


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

     256 %     239 %
    


 


 

We expect that the amount of nonperforming loans will change due to portfolio growth, portfolio seasoning, and resolution through collections, sales or charge-offs. The performance of any loan can be affected by external factors, such as economic conditions, or factors particular to a borrower.

 

The increase in total nonperforming assets, net from December 31, 2004 reflects an increase in real estate nonperforming loans, offset by a decrease in REO and other repossessed assets. The increase in real estate nonperforming loans was driven by growth in the overall size of the portfolio to $17.5 billion, up $6.0 billion from December 31, 2004. The decrease in REO and other repossessed assets, net was due to a combination of sales and charge-offs during the first nine months of 2005.

 

During the nine months ended September 30, 2005, we recognized $0.6 million of interest on loans that were in nonperforming status at September 30, 2005. If our nonperforming loans at September 30, 2005 had been performing in accordance with their terms, we would have recorded additional interest income of approximately $0.7 million during the three months ended September 30, 2005.

 

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Table of Contents

Mortgage-Backed and Investment Securities Available-for-Sale

 

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

 

     September 30,
2005


   December 31,
2004


   Percentage
Change


 

Mortgage-backed securities:

                    

Federal National Mortgage Association

   $ 6,202,006    $ 5,062,204    23 %

Government National Mortgage Association

     2,231,213      2,710,808    (18 )%

Collateralized mortgage obligations

     901,000      1,251,941    (28 )%

Other

     24,993      27,116    (8 )%
    

  

      

Total mortgage-backed securities

     9,359,212      9,052,069    3 %
    

  

      

Investment securities:

                    

Asset-backed securities

     1,121,569      2,796,429    (60 )%

Publicly traded equity securities

     393,142      374,842    5 %

Other

     300,743      320,478    (6 )%
    

  

      

Total investment securities

     1,815,454      3,491,749    (48 )%
    

  

      

Total available-for-sale securities

   $ 11,174,666    $ 12,543,818    (11 )%
    

  

      

 

Available-for-sale securities represented 31% of total assets at September 30, 2005 and 40% of total assets at December 31, 2004. The decrease of $1.4 billion to $11.2 billion at September 30, 2005 was driven by a planned reduction in our asset-back securities portfolio. We evaluate our portfolio of securities available-for-sale in light of changing market conditions and other factors and, where appropriate, take steps intended to improve our overall positioning. During the period, we performed a balance sheet review and decided to reduce our securities portfolio of asset-backed securities in light of the anticipated interest rate environment.

 

Deposits

 

Deposits are summarized as follows (in thousands):

 

     September 30,
2005


   December 31,
2004


   Percentage
Change


 

Sweep deposit account

   $ 7,442,479    $ 6,167,436    21 %

Money market accounts

     3,791,669      3,340,245    14 %

Certificates of deposit

     2,408,694      2,069,674    16 %

Other

     907,854      725,619    25 %
    

  

      

Total deposits

   $ 14,550,696    $ 12,302,974    18 %
    

  

      

 

Deposits represented 43% of total liabilities at September 30, 2005 and December 31, 2004. Deposits increased $2.2 billion to $14.6 billion at September 30, 2005, driven by a $1.3 billion increase in the SDA, a $0.5 billion increase in money market accounts and a $0.3 billion increase in certificates of deposit.

 

The increase in the SDA was driven equally by organic growth of existing customer balance and conversions from money market funds. The increase in money market accounts was the result of our focused attention to sales and retention efforts for these customers, as well as the overall impact of E*TRADE Complete. The SDA, money market accounts and certificates of deposit generally provide us the benefit of lower interest costs, compared with wholesale funding. The increases in the balances of these accounts are the product of the core customer relationship that we maintain within our retail segment. The increase in certificates of deposit reflects the renewed customer interest in the product as a result of focused retention efforts coupled with a higher overall interest rates offered in this product.

 

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Table of Contents

Other Borrowings by Bank Subsidiary

 

Other borrowings by Bank subsidiary are summarized as follows (in thousands):

 

     September 30,
2005


   December 31,
2004


   Percentage
Change


 

FHLB advances

   $ 4,316,683    $ 1,487,841    190 %

Subordinated debentures

     275,480      255,300    8 %

Other

     2,650      17,591    (85 )%
    

  

      

Total other borrowings by Bank subsidiary

   $ 4,594,813    $ 1,760,732    161 %
    

  

      

 

Other borrowings by Bank subsidiary represented 14% of total liabilities at September 30, 2005 and 6% of total liabilities at December 31, 2004. The increase of $2.8 billion during the nine months ended September 30, 2005 was primarily due to an increase in FHLB advances. The Bank’s primary sources of wholesale funding are from FHLB advances and securities sold under agreements to repurchase. We determine which source of funding to use based on pricing, liquidity and capacity during each period. We anticipate that the relative level of FHLB advances will decline as we grow customer cash balances, which we believe will occur in the periods following the close of both the Harrisdirect and BrownCo acquisitions.

 

Corporate Debt

 

Corporate debt increased $0.5 billion during the nine months ended September 30, 2005. This increase was due to the issuance of additional senior notes during the period, the proceeds of which will be used to fund the acquisition of Harrisdirect.

 

LIQUIDITY AND CAPITAL RESOURCES

 

In addition to our cash flows from operations, we have historically met our liquidity needs primarily through investing and financing activities, consisting principally of equity and debt offerings, increases in core deposit accounts, other borrowings and sales of loans or securities. We believe that we will be able to renew or replace our funding sources at prevailing market rates, which may be higher or lower than current rates, as well as to supplement these funding sources with cash flow from operations.

 

Cash Provided by Operating Activities

 

Cash provided by operating activities decreased by approximately $185 million from $846 million for the nine months ended September 30, 2004 to $661 million for the nine months ended September 30, 2005. During the nine months ended September 30, 2005, the decrease in cash provided by operating activities was primarily due to a decrease in cash flows from the net sales and purchases of loans and trading securities.

 

Cash Provided by (Used in) Investing and Financing Activities

 

Cash used in investing activities was $4,926 million for the nine months ended September 30, 2005 and $4,495 million for the comparable period in 2004. Cash used in investing activities increased primarily from a net decrease in loans receivable offset by a decrease in net purchases of mortgage-backed and investment securities, available-for-sale.

 

Cash provided by financing activities was $4,714 million for the nine months ended September 30, 2005 and $3,458 million for the comparable period in 2004. For the nine months ended September 30, 2005, cash provided by financing activities increased primarily due to increase in deposits and increase in advances from FHLB net of repayments, partially offset by decrease in securities sold under agreements to repurchase. Cash provided by financing activities for the nine months ended September 30, 2005 includes $447 million proceeds from the 8.00% and 7 3/8% senior notes. Cash provided by financing activities for the nine months ended September 30, 2004 includes $394 million proceeds from the 8.00% senior notes.

 

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Table of Contents

Stock Repurchases

 

From time to time the Company’s Board of Directors authorizes share repurchase and debt retirement plans, as they determine that they are likely to create long-term value for its shareholders. These plans are open-ended and provide the flexibility to buy back common stock, redeem for cash its outstanding convertible subordinated notes, retire debt in the open market or a combination of all three. Under these authorized plans, the Company has repurchased some of its common stock and retired some of its convertible subordinated notes.

 

During the three and nine months ended September 30, 2005, the Company repurchased 0.6 million and 4.5 million shares, respectively, of its common stock for an aggregate $9.3 million and $58.2 million. As of September 30, 2005, the Company had approximately $179.8 million available under its authorized share repurchase and debt retirement plans to purchase additional shares of its common stock or retire additional debt.

 

Other Sources of Liquidity

 

In September 2005, the Company entered into a $250 million, three-year senior secured revolving credit facility. The facility is secured by certain assets of the Company. The facility will be used for general corporate purposes, including regulatory capital needs arising from acquisitions. Draws under the facility currently bear interest, at our option, at adjusted LIBOR plus 2% or prime plus 1%. Undrawn facility funds currently bear commitment fees of 0.25% per annum payable quarterly in arrears. Terms of the facility include customary restrictive financial covenants and events of default. At September 30, 2005, as well as October 31, 2005, no amounts were outstanding under this credit facility.

 

At September 30, 2005, we had financing facilities totaling $400 million to meet the needs of E*TRADE Clearing. These facilities, if used, may be collateralized by customer securities. No amounts were outstanding as of September 30, 2005 and December 31, 2004 under these lines. We also have multiple loans, primarily collateralized by equipment owned by us, for which $40.8 million was outstanding as of September 30, 2005. In addition, we have entered into numerous agreements with other broker-dealers to provide financing under our stock loan program.

 

We also rely on borrowed funds, such as FHLB advances and securities sold under agreements to repurchase to provide liquidity for the Bank. At September 30, 2005, the Bank had approximately $4.7 billion in additional borrowing capacity.

 

Other Liquidity Matters

 

We currently anticipate that our available cash resources and credit will be sufficient to meet our currently anticipated working capital and capital expenditure requirements for at least the next 12 months. We may need to raise additional funds in order to support more rapid expansion, develop new or enhanced products and services, respond to competitive pressures, acquire complementary businesses or technologies and/or take advantage of unanticipated opportunities.

 

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

 

The preparation of our financial results of operations and financial position requires us to make judgments and estimates that may have a significant impact upon the financial results of the Company. We believe that of our significant accounting policies, the following require estimates and assumptions that require complex, subjective judgments by management, which can materially impact reported results: allowance for loan losses and uncollectible margin loans, classification and valuation of certain investments, valuation and accounting for financial derivatives, estimates of effective tax rate, deferred taxes and valuation allowances and valuation of goodwill and other intangibles. These are more fully described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K for the year ended December 31, 2004. In addition, as discussed in Note 1, the Company early adopted SFAS No. 123(R) during the three months ended September 30, 2005.

 

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Table of Contents

RISK FACTORS

 

RISKS RELATING TO THE NATURE OF THE FINANCIAL SERVICES BUSINESS

 

Many of our competitors have greater financial, technological, marketing and other resources

 

Many of our competitors have longer operating histories and greater resources than we do and offer a wider range of financial products and services. Many also have greater name recognition, greater market acceptance and larger customer bases. These competitors may conduct extensive promotional activities and offer better terms, lower prices and/or different products and services than we do. Moreover, some of our competitors have established relationships among themselves or with third parties to enhance their products and services. This means that our competitors may be able to respond more quickly to new or changing opportunities and demands and withstand changing market conditions better than we can.

 

If we do not successfully manage consolidation opportunities, we could be at a competitive disadvantage

 

There has recently been significant consolidation in the online financial services industry, and the consolidation is likely to continue in the future. Should we be excluded from or fail to take advantage of viable consolidation opportunities or if we acquire businesses and we are unable to integrate or manage them properly, we could be placed at a competitive disadvantage.

 

Recently, we announced our acquisition of Harrisdirect, LLC (“Harrisdirect”) and our plans to acquire the online brokerage business known as BrownCo. The primary asset of each of these businesses is their customer accounts. Acquisitions entail numerous risks, including retaining or hiring skilled personnel, integrating acquired operations, products (including pricing) and personnel and the diversion of management attention from other business concerns, all of which will affect the retention or attrition of acquired customer accounts. In the event that we are not successful in our integration efforts, we may experience significant attrition in the acquired accounts or experience other issues that would prevent us from achieving the level of revenue enhancements and cost savings that we expect with respect to an acquisition. Finally, while the Harrisdirect acquisition has closed, there can be no assurance that we will successfully close our acquisition of BrownCo.

 

We expect to pursue additional acquisitions of companies in our industry, which may require us to obtain additional financing and subject us to integration risks. In addition, there can be no assurance that we will realize a positive return on any acquisition or that future acquisitions will not be dilutive to earnings.

 

Downturns or disruptions in the securities markets could reduce trade volumes and margin borrowing and increase our dependence on our more active customers who receive lower pricing

 

A significant portion of our revenues in recent years has been from online investing services, and although we continue to diversify our revenue sources, we expect this business to continue to account for a significant portion of our revenues in the foreseeable future. Like other financial services firms, we are affected directly by national and global economic, political and market conditions, broad trends in business and finance, disruptions to the securities markets and changes in volume and price levels of securities and futures transactions. Decrease in trade volume may be more significant for us with respect to our less active customers, increasing our dependence on our more active trading customers who receive more favorable pricing based on their trade volume. Decreases in volumes, as well as securities prices, are also typically associated with a decrease in margin borrowing. Because we generate revenue from interest charged on margin borrowing, such decreases result in a reduction of revenue. When transaction volume is low, our operating results may be harmed in part because some of our overhead costs may remain relatively fixed.

 

We rely heavily on technology to deliver products and services

 

Disruptions to or instability of our technology, including an actual or perceived breach of the security of our technology, could harm our business and our reputation. Similarly, a significant disruption to or instability of one

 

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or more major technology systems other than ours, including the actual or perceived breach of the security of such systems, could have a general negative effect that would harm our business.

 

Downturns in the securities markets increase the credit risk associated with margin lending or stock loan transactions

 

We permit customers to purchase securities on margin. When the market declines rapidly, there is an increased risk that the value of the collateral we hold in connection with these transactions could fall below the amount of a customer’s indebtedness. Similarly, as part of our broker-dealer operations, we frequently enter into arrangements with other broker-dealers for the lending of various securities. Under regulatory guidelines, when we borrow or lend securities, we must generally simultaneously disburse or receive cash deposits. We may risk losses if there are sharp changes in market values of many securities and the counterparties to the borrowing and lending transactions fail to honor their commitments. Any downturn in public equity markets may lead to a greater risk that parties to stock lending transactions may fail to meet their commitments.

 

We may be unsuccessful in managing the effects of changes in interest rates and the interest-bearing banking assets in our portfolio

 

Our results of operations depend in significant part upon our level of net interest income, that is, the difference between interest income from interest-earning banking assets (such as loans and mortgage-backed and other asset-backed securities) and interest expense on interest-bearing banking liabilities (such as deposits and borrowings). E*TRADE Bank (the “Bank”) uses derivatives to help manage its interest rate risk. However, derivatives utilized may not be entirely effective and changes in market interest rates and the yield curve could reduce the value of the Bank’s financial assets and reduce net interest income. Many factors affect interest rates, including governmental monetary policies and domestic and international economic and political conditions.

 

An increase in our delinquency rate could adversely affect our results of operations

 

Our underwriting criteria or collection methods may not afford adequate protection against the risks inherent in the loans comprising our consumer loan portfolio. In the event of a default, the collateral value of the financed item may not cover the outstanding loan balance and costs of recovery. In the event our portfolio of consumer finance receivables experiences higher delinquencies, foreclosures, repossessions or losses than anticipated, our results of operations or financial condition could be adversely affected.

 

Risks associated with principal trading transactions could result in trading losses

 

A majority of our specialist and market-making revenues are derived from trading as a principal. We may incur trading losses relating to the purchase, sale or short sale of securities for our own account, as well as trading losses in our specialist stocks and market maker stocks. From time to time, we may have large positions in securities of a single issuer or issuers engaged in a specific industry.

 

Reduced grants by companies of employee stock options could adversely affect our results of operations

 

We are a provider of stock plan administration and options management tools. In December 2004, the Financial Accounting Standards Board (“FASB”) issued new rules that upon adoption, will require companies to value and expense employee stock options they grant to their employees and employee stock purchase plan transactions in which the terms are more favorable to those available to all holders of the same class of shares. This may result in companies granting fewer employee options and modifying their existing employee stock purchase plans, potentially reducing the amount of products and services we provide these companies and compelling us to incur additional costs so that our tools comply with the new FASB statement. Additionally, we may see a reduction in commission revenues as fewer employee stock options would be available for exercise and sale by the employees of these companies.

 

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Reduced spreads in securities pricing, levels of trading activity and trading through market makers and/or specialists could harm our specialist and market maker business

 

The increase in computer generated buy/sell programs in the marketplace has continued to tighten spreads, resulting in reduced revenue capture per share by the specialist and market-making community and reduced payment for order flow revenues for us. Similarly, a reduction in the volume and/or volatility of trading activity could also reduce spreads that specialists and market makers receive, which adversely affect our market-making revenues.

 

Alternative trading systems that have developed over the past few years could also reduce the levels of trading of exchange-listed securities through specialists and the levels of over-the-counter trading through market makers. In addition, electronic communications networks, or ECNs, have emerged as an alternative forum to which broker-dealers and institutional investors can direct their limit orders. This allows broker-dealers and institutional investors to avoid directing their trades through market makers. As a result, we may experience a reduction in our flow of limit orders.

 

Our international efforts subject us to additional risks, which could impair our business growth

 

One component of our strategy has been an effort to build an international business. We have established certain joint venture and/or licensee relationships. We have limited control over the management and direction of these venture partners and/or licensees, and their action or inaction, including their failure to follow proper practices with respect to regulatory compliance and/or corporate governance, could harm our operations and/or our reputation.

 

RISKS RELATING TO THE REGULATION OF OUR BUSINESS

 

We are subject to extensive government regulation, including banking and securities rules and regulations, which could restrict our business practices

 

The securities and banking industries are subject to extensive regulation. All of our broker-dealer subsidiaries have to comply with many laws and rules, including rules relating to possession and control of customer funds and securities, margin lending and execution and settlement of transactions. We are also subject to additional laws and rules as a result of our specialist and market maker operations.

 

To the extent that, now or in the future, we solicit orders from our customers or make investment recommendations (or are deemed to have done so), or offer products and services, such as investing in futures, that are not suitable for all investors, we would become subject to additional rules and regulations governing, among other things, sales practices and the suitability of recommendations to customers.

 

As part of our institutional business we provide clients access to certain third-party research tools and other services in exchange for commissions earned. Currently, these activities are allowed by various regulatory bodies. However, changes to the regulations governing these activities have been proposed in the United Kingdom and the United States. If the regulations are changed in a way that limits or eliminates altogether the services we could provide to clients in exchange for commissions, we may realize a decrease in our institutional commission revenues.

 

Similarly, E*TRADE Financial Corporation, E*TRADE Re, LLC and ETB Holdings, Inc., as savings and loan holding companies, and the Bank, as a Federally chartered savings bank, are subject to extensive regulation, supervision and examination by the Office of Thrift Supervision (“OTS”), and, in the case of the Bank, also the FDIC. Such regulation covers all banking business, including lending practices, safeguarding deposits, capital structure, recordkeeping, transactions with affiliates and conduct and qualifications of personnel.

 

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If we fail to comply with applicable securities, banking and insurance laws, rules and regulations domestically and internationally, we could be subject to disciplinary actions, damages, penalties or restrictions that could significantly harm our business

 

The SEC, the NYSE, the NASD or other self-regulatory organizations and state securities commissions can, among other things, censure, fine, issue cease-and-desist orders or suspend or expel a broker-dealer or any of its officers or employees. The OTS may take similar action with respect to our banking activities. Similarly, the attorneys general of each state could bring legal action on behalf of the citizens of the various states to ensure compliance with local laws. Regulatory organizations in countries outside of the United States have similar authority. The ability to comply with applicable laws and rules is dependent in part on the establishment and maintenance of a reasonable compliance system. The failure to establish and enforce reasonable compliance procedures domestically and internationally, even if unintentional, could subject us to significant losses or disciplinary or other actions.

 

If we do not maintain the capital levels required by regulators, we may be fined or even forced out of business

 

The SEC, NYSE, NASD, OTS and various other regulatory agencies have stringent rules with respect to the maintenance of specific levels of net capital by securities broker-dealers and regulatory capital by banks. Net capital is the net worth of a broker or dealer (assets minus liabilities), less deductions for certain types of assets. Failure to maintain the required net capital could result in suspension or revocation of registration by the SEC and suspension or expulsion by the NYSE and/or NASD, and could ultimately lead to the firm’s liquidation. In the past, our broker-dealer subsidiaries have depended largely on capital contributions by us in order to comply with net capital requirements. If such net capital rules are changed or expanded, or if there is an unusually large charge against net capital, operations that require an intensive use of capital could be limited. Such operations may include investing activities, marketing and the financing of customer account balances. Also, our ability to withdraw capital from brokerage subsidiaries could be restricted, which in turn could limit our ability to repay debt and redeem or purchase shares of our outstanding stock.

 

Similarly, the Bank is subject to various regulatory capital requirements administered by the OTS. Failure to meet minimum capital requirements can trigger certain mandatory, and possibly additional discretionary actions by regulators that, if undertaken, could harm a bank’s operations and financial statements. A bank must meet specific capital guidelines that involve quantitative measures of a bank’s assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. A bank’s capital amounts and classification are also subject to qualitative judgments by the regulators about the strength of components of its capital, risk weightings of assets, off-balance sheet transactions and other factors.

 

Quantitative measures established by regulation to ensure capital adequacy require a bank to maintain minimum amounts and ratios of Total and Tier 1 Capital to risk-weighted assets and of Tier 1 Capital to adjusted total assets. To satisfy the capital requirements for a “well capitalized” financial institution, a bank must maintain higher Total and Tier 1 Capital to risk-weighted assets and Tier 1 Capital to adjusted total assets ratios.

 

As a non-grandfathered savings and loan holding company, we are subject to regulations that could restrict our ability to take advantage of certain business opportunities

 

We are required to file periodic reports with the OTS and are subject to examination by the OTS. The OTS also has certain types of enforcement powers over us, ETB Holdings, Inc. and E*TRADE Re, LLC, including the ability to issue cease-and-desist orders, force divestiture of the Bank and impose civil and monetary penalties for violations of Federal banking laws and regulations or for unsafe or unsound banking practices. In addition, under the Gramm-Leach-Bliley Act, our activities are restricted to those that are financial in nature and certain real estate-related activities. We may make merchant banking investments in companies whose activities are not financial in nature if those investments are made for the purpose of appreciation and ultimate resale of the investment and we do not manage or operate the company. Such merchant banking investments may be subject to maximum holding periods and special recordkeeping and risk management requirements.

 

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We believe all of our existing activities and investments are permissible under the Gramm-Leach-Bliley Act, but the OTS has not yet fully interpreted these provisions. Even if our existing activities and investments are permissible, we are unable to pursue future activities that are not financial in nature. We are also limited in our ability to invest in other savings and loan holding companies.

 

In addition, the Bank is subject to extensive regulation of its activities and investments, capitalization, community reinvestment, risk management policies and procedures and relationships with affiliated companies. Acquisitions of and mergers with other financial institutions, purchases of deposits and loan portfolios, the establishment of new Bank subsidiaries and the commencement of new activities by Bank subsidiaries require the prior approval of the OTS, and in some cases the FDIC, which may deny approval or limit the scope of our planned activity. These regulations and conditions could place us at a competitive disadvantage in an environment in which consolidation within the financial services industry is prevalent. Also, these regulations and conditions could affect our ability to realize synergies from future acquisitions, could negatively affect us following the acquisition and could also delay or prevent the development, introduction and marketing of new products and services.

 

RISKS RELATING TO OWNING OUR STOCK

 

We have incurred losses in the past and we cannot assure you that we will be profitable

 

We have incurred losses in the past and we may do so in the future. While we reported net income for the past two years, we reported a net loss of $186.4 million in 2002. We may incur losses in the future.

 

We expect that expensing stock options granted to our employees will have an impact on our financial results

 

We are not currently required to record any compensation expense in connection with stock option grants to employees that have an exercise price at or above fair market value. In December 2004, however, the FASB issued SFAS No. 123(R), which among other things requires public companies to expense employee stock options and other share-based payments at their fair value when issued. We have voluntarily elected to adopt stock option expensing for reporting periods beginning on or after July 1, 2005. As a result of its impact on our financial results, we may be forced to decrease or eliminate employee stock option grants, which could, in turn, have a negative impact on our ability to attract and retain qualified employees.

 

We are substantially restricted by the terms of our senior notes

 

In June 2004, we issued an aggregate principal amount of $400 million of senior notes due June 2011. In September 2005, we issued an additional aggregate principal amount of $100 million of senior notes due June 2011 under the same indenture plus $350 million aggregate principal amount of senior notes due September 2013 under a separate indenture. The indentures governing the senior notes contain various covenants and restrictions that limit our ability and certain of our subsidiaries’ ability to, among other things:

 

    incur additional indebtedness;

 

    create liens;

 

    pay dividends or make other distributions;

 

    repurchase or redeem capital stock;

 

    make investments or other restricted payments;

 

    enter into transactions with our stockholders or affiliates;

 

    sell assets or shares of capital stock of our subsidiaries;

 

    restrict dividend or other payments to us from our subsidiaries; and

 

    merge, consolidate or transfer substantially all of our assets.

 

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As a result of the covenants and restrictions contained in the indentures, we are limited in how we conduct our business and we may be unable to raise additional debt or equity financing to compete effectively or to take advantage of new business opportunities. The terms of any future indebtedness could include more restrictive covenants.

 

We cannot assure you that we will be able to remain in compliance with these covenants in the future and, if we fail to do so, that we will be able to obtain waivers from the appropriate parties and/or amend the covenants.

 

Our corporate debt levels may limit our ability to obtain additional financing

 

In September 2005, we entered into a $250 million three-year senior secured revolving credit facility and issued an additional $450.0 million in senior notes to facilitate our acquisition of Harrisdirect. Loans made under the senior secured revolving credit facility are secured by a perfected first-priority pledge of the capital stock of each of our first-tier domestic subsidiaries other than E*TRADE Re, LLC, subject to applicable law and by a pledge of promissory notes representing loans and other advances by us to our subsidiaries. At September 30, 2005, we had an outstanding balance of $850.0 million in senior notes, $185.2 million in convertible notes and $40.8 million in term loans. Our ratio of debt (our senior and convertible debt, capital lease obligations and term loans) to equity (expressed as a percentage) was 43% at September 30, 2005.

 

We may incur additional indebtedness in the future, including in connection with our planned acquisition of BrownCo. Our level of indebtedness, among other things, could:

 

    make it more difficult or costly for us to obtain any necessary financing in the future for working capital, capital expenditures, debt service requirements or other purposes;

 

    limit our flexibility in planning for, or reacting to, changes in our business; or

 

    make us more vulnerable in the event of a downturn in our business.

 

The market price of our common stock may continue to be volatile

 

From January 1, 2003 through September 30, 2005, the price per share of our common stock has ranged from a low of $3.65 to a high of $17.60. The market price of our common stock has been, and is likely to continue to be, highly volatile and subject to wide fluctuations. In the past, volatility in the market price of a company’s securities has often led to securities class action litigation. Such litigation could result in substantial costs to us and divert our attention and resources, which could harm our business. Declines in the market price of our common stock or failure of the market price to increase could also harm our ability to retain key employees, reduce our access to capital and otherwise harm our business.

 

We may need additional funds in the future, which may not be available and which may result in dilution of the value of our common stock

 

In the future, we may need to raise additional funds, which may not be available on favorable terms, if at all. If adequate funds are not available on acceptable terms, we may be unable to fund our business growth plans. In addition, if funds are available, the issuance of securities could dilute the value of shares of our common stock and cause the market price to fall.

 

We have various mechanisms in place that may discourage takeover attempts

 

Certain provisions of our certificate of incorporation and bylaws may discourage, delay or prevent a third party from acquiring control of us in a merger, acquisition or similar transaction that a shareholder may consider favorable. Such provisions include:

 

    authorization for the issuance of “blank check” preferred stock;

 

    provision for a classified Board of Directors with staggered, three-year terms;

 

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    the prohibition of cumulative voting in the election of directors;

 

    a super-majority voting requirement to effect business combinations or certain amendments to our certificate of incorporation and bylaws;

 

    limits on the persons who may call special meetings of shareholders;

 

    the prohibition of shareholder action by written consent; and

 

    advance notice requirements for nominations to the Board of Directors or for proposing matters that can be acted on by shareholders at shareholder meetings.

 

Attempts to acquire control of the company may also be delayed or prevented by our stockholder rights plan, which is designed to enhance the ability of our Board of Directors to protect shareholders against unsolicited attempts to acquire control of the company that do not offer an adequate price to all shareholders or are otherwise not in the best interests of the company and our shareholders. In addition, certain provisions of our stock incentive plans, management retention and employment agreements (including severance payments and stock option acceleration), and Delaware law may also discourage, delay or prevent someone from acquiring or merging with us.

 

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ITEM 3.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

For quantitative and qualitative disclosures about market risk, we separately evaluate such risks based on the different products and services offered by our broker-dealer and Bank subsidiaries. The following discussion about our market risk disclosure includes forward-looking statements. Actual results could differ materially from those projected in the forward-looking statements as a result of certain factors, including, but not limited to, those set forth in the section entitled “Risk Factors.”

 

Equity Security Price Risk

 

We currently hold investments in the International Securities Exchange, Investmart and SBI, which are publicly traded equity securities, in which we had unrealized gains of $37.8 million, $19.5 million and $13.3 million as of September 30, 2005, respectively. As each security’s market price fluctuates, we are exposed to risk of a loss with respect to these unrealized gains. We are exposed to additional risk of a loss with respect to foreign currency fluctuations on SBI and Investmart.

 

Interest Rate Risk

 

We had variable-rate brokerage and corporate term loans totaling approximately $40.8 million and $39.8 million at September 30, 2005 and December 31, 2004, respectively. The monthly interest payments on these term loans are subject to interest rate risk. If market interest rates were to have increased immediately and uniformly by 1% at September 30, 2005 and December 31, 2004, our interest payments would have increased by an immaterial amount.

 

The Bank’s exposure to market risk is dependent upon the distribution of all interest-sensitive assets, liabilities and derivatives. These items have differing risk characteristics that, if properly managed, can mitigate the Bank’s exposure to interest rate fluctuations. At September 30, 2005, approximately 52% of the market value of the Bank’s total assets was comprised of residential mortgages and mortgage-backed securities. The values of these assets are sensitive to changes in interest rates, as well as expected prepayment levels. The Bank’s liability structure consists primarily of transactional deposit relationships, such as money market accounts, shorter-term certificates of deposit and wholesale-collateralized borrowings from the FHLB and other entities. The derivative portfolio of the Bank is positioned to decrease the overall market risk resulting from the combination of assets and liabilities. The Bank’s market risk is discussed and quantified in more detail in the Scenario Analysis section below.

 

Most of the Bank’s assets are generally classified as non-trading portfolios and, as such, are not marked-to-market through earnings for accounting purposes. The Bank did maintain a trading portfolio of investment-grade securities at September 30, 2005 and December 31, 2004, with fair values of $200 million and $567 million, respectively.

 

Scenario Analysis

 

Scenario analysis is an advanced approach to estimating interest rate risk exposure. Under the Net Present Value of Equity (“NPVE”) approach, the present value of all existing assets, liabilities, derivatives and forward commitments are estimated and then combined to produce a NPVE figure. The sensitivity of this value to changes in interest rates is then determined by applying alternative interest rate scenarios, which include, but are not limited to, instantaneous parallel shifts up 100, 200 and 300 basis points and down 100 and 200 basis points. The down 300 basis point scenario is not presented at September 30, 2005 and December 31, 2004, because the Current Interest Rate Risk Guidelines provided by the OTS only apply to the worst of the down or up 200 basis point scenarios.

 

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The sensitivity of NPVE at September 30, 2005 and December 31, 2004 and the limits established by the Bank’s Board of Directors are listed below (dollars in thousands):

 

Parallel Change in

Interest Rates (bps)


   Change in NPVE

 
   September 30, 2005

    December 31, 2004

 
   Amount

   Percentage

    Board Limit

    Amount

   Percentage

    Board Limit

 

+300

   $ (424,322)    (20) %   (55) %   $ (158,207)    (9) %   (55) %

+200

   $ (247,939)    (12) %   (30) %   $ (69,671)    (4) %   (30) %

+100

   $ (85,946)    (4) %   (20) %   $ (2,321)     %   (15) %

 -100

   $ (84,230)    (4) %   (20) %   $ (149,651)    (9) %   (15) %

 -200

   $ (397,866)    (19) %   (30) %     *    *     *  

*   The Interest Rate Risk for down 200 is not presented as of December 31, 2004 because the OTS did not require the Bank to monitor this information as of that date.

 

Under criteria published by the OTS, the Bank’s overall interest rate risk exposure at September 30, 2005 was characterized as “moderate.”

 

Mortgage Production Activities

 

In the production of mortgage products, the Bank is exposed to interest rate risk between the commitment and funding dates of the loans. There were $0.3 billion at September 30, 2005 and December 31, 2004 in mortgage loan commitments awaiting funding. The associated interest rate risk results when the Bank enters into Interest Rate Lock Commitments (“IRLCs”), whereby determination of loan interest rates occurs prior to funding. When the intent is to sell originated loans, the associated IRLCs are considered derivatives and, accordingly, are recorded at fair value with associated changes recorded in earnings.

 

ITEM 4.    CONTROLS AND PROCEDURES

 

  (a)   Our Chief Executive Officer and our Chief Financial Officer, after evaluating the effectiveness of the Company’s “disclosure controls and procedures” (as defined in the Securities Exchange Act of 1934 (“Exchange Act”) Rules 13a-15(e) or 15d-15(e)) as of the end of the period covered by this quarterly report, have concluded that our disclosure controls and procedures are effective based on their evaluation of these controls and procedures required by paragraph (b) of Exchange Act Rules 13a-15 or 15d-15.

 

  (b)   Changes in internal control over financial reporting. There were no changes in our internal control over financial reporting identified in connection with the evaluation required by paragraph (d) of Exchange Act Rules 13a-15 or 15d-15 that occurred during our last fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

 

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PART II.    OTHER INFORMATION

 

ITEM 1.    LEGAL PROCEEDINGS

 

In June 2002, the Company acquired from MarketXT Holdings, Inc. (formerly known as Tradescape Corporation) (“MarketXT”) certain entities referred to as Tradescape Securities, LLC, Tradescape Technologies, LLC and Momentum Securities, LLC. Numerous disputes have arisen between and among the parties regarding the value of and responsibility for various liabilities that first became apparent following the sale. The parties have been unable to resolve these disputes and have asserted claims against each other. On April 8, 2004, MarketXT filed a complaint in the United States District Court for the Southern District of New York against the Company, certain of its officers and directors and other third parties, including Softbank Finance Corporation and Softbank Corporation, alleging that the defendants acted improperly in preventing plaintiffs from obtaining certain contingent payments and claiming damages of $1.5 billion. On April 9, 2004, the Company filed a complaint in the United States District Court for the Southern District of New York against certain directors and officers of MarketXT seeking declaratory relief and monetary damages in an amount to be proven at trial for defendants’ fraud in connection with the 2002 sale transaction, including, but not limited to, having presented the Company with fraudulent financial statements of the condition of Momentum Securities during the due diligence process. The Company amended its complaint in October 2005 to add additional defendants. In January 2005, the Company filed an adversary proceeding against MarketXT and others seeking compensatory and punitive damages, and certain declaratory relief in those Chapter 11 bankruptcy proceedings in the United States Bankruptcy Court for the Southern District of New York entitled, “In re MarketXT Holdings Corp., Debtor” and a separate adversary proceeding against Omar Amanat, in the same bankruptcy court in those Chapter 7 bankruptcy proceedings entitled, “In re Amanat, Omar Shariff.” In October 2005, MarketXT answered the Company’s adversary proceeding and asserted various counterclaims, including some of the claims MarketXT had asserted in its district court action, seeking unspecified damages according to proof at trial. The Company continues to believe that MarketXT’s complaint and counterclaims and Omar Amanat’s claims are without merit and intends both to vigorously defend all such claims and to fully pursue its own claims as described above.

 

ITEM 2.    UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

 

On April 29, 2004, the Company announced that its Board of Directors approved a $200 million repurchase program (the “April 2004 Plan”). The April 2004 Plan was open-ended and provided the flexibility to buy back common stock, redeem for cash its outstanding convertible subordinated notes, retire debt in the open market or a combination of all three. During the three months ended June 30, 2005, the Company completed the April 2004 Plan.

 

On December 15, 2004, the Company announced that its Board of Directors approved an additional $200 million repurchase plan (the “December 2004 Plan”). The December 2004 Plan is open-ended and provides the flexibility to buy back common stock, retire debt or a combination of both. The Company may conduct these repurchases on the open market, in private transactions or a combination of both.

 

During the three months ended September 30, 2005, the Company used the December 2004 Plan to repurchase the Company’s common stock as follows:

 

Month


   Total Number of Shares
Purchased


   Average Price Paid
per Share


   Total Number of
Shares Purchased
as Part of the
December 2004 Plan


   Maximum Dollar
Value of Shares
That May Yet be
Purchased Under
the 2004 Plan


July 2005

   597,200    $ 15.53    597,200    $ 179,764,356

 

ITEM 3.    DEFAULTS UPON SENIOR SECURITIES—NOT APPLICABLE

 

ITEM 4.    SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS—NONE

 

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ITEM 5.    OTHER INFORMATION—NONE

 

ITEM 6.    EXHIBITS

 

  4.1   First Supplemental Indenture dated September 19, 2005 by and between the Company and the Bank of New York, as Trustee

 

  4.2   Indenture dated September 19, 2005 by and between the Company and the Bank of New York, as Trustee

 

  4.3   Registration Rights Agreement dated as of September 19, 2005, among E*TRADE Financial Corporation and J.P. Morgan Securities Inc. and Morgan Stanley & Co. Incorporated, as Initial Purchasers, relating to the Company’s 8% Senior Notes Due 2011

 

  4.4   Registration Rights Agreement dated as of September 19, 2005, among E*TRADE Financial Corporation and J.P. Morgan Securities Inc. and Morgan Stanley & Co. Incorporated, as Initial Purchasers, relating to the Company’s 7 3/8% Senior Notes Due 2013

 

10.1   Credit Agreement dated September 19, 2005 between the Company and JP Morgan Chase Bank, N.A., as Administrative Agent

 

31.1   Rule 13a-14a/15d-14(a) Certification of Mitchell H. Caplan

 

31.2   Rule 13a-14a/15d-14(a) Certification of Robert J. Simmons

 

32.1   Section 1350 Certification of Mitchell H. Caplan and Robert J. Simmons

 

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SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

Dated: November 1, 2005

 

E*TRADE Financial Corporation

(Registrant)

    By  

/S/    MITCHELL H. CAPLAN        


       

Mitchell H. Caplan

Chief Executive Officer

    By  

/S/    ROBERT J. SIMMONS        


       

Robert J. Simmons

Chief Financial Officer

(Principal Financial and Accounting Officer)

 

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