Form 10-Q
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2009

Commission File Number: 1-9700

THE CHARLES SCHWAB CORPORATION

(Exact name of Registrant as specified in its charter)

 

Delaware   94-3025021

(State or other jurisdiction

of incorporation or organization)

  (I.R.S. Employer Identification No.)

211 Main Street, San Francisco, CA 94105

(Address of principal executive offices and zip code)

Registrant’s telephone number, including area code: (415) 636-7000

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨

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

 

Large accelerated filer   x      Accelerated filer   ¨
Non-accelerated filer   ¨  (Do not check if a smaller reporting company)      Smaller reporting company   ¨

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

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

1,160,852,817 shares of $.01 par value Common Stock

Outstanding on July 24, 2009

 

 

 


Table of Contents

THE CHARLES SCHWAB CORPORATION

Quarterly Report on Form 10-Q

For the Quarter Ended June 30, 2009

INDEX

 

         Page
Part I - Financial Information   
    Item 1.   Condensed Consolidated Financial Statements (Unaudited):   
  Statements of Income    1
  Balance Sheets    2
  Statements of Cash Flows    3
  Notes    4 – 20
    Item 2.   Management’s Discussion and Analysis of Financial Condition and Results of Operations    21 – 42
    Item 3.   Quantitative and Qualitative Disclosures About Market Risk    43 – 44
    Item 4.   Controls and Procedures    44
Part II - Other Information
    Item 1.   Legal Proceedings    44
    Item 1A.   Risk Factors    45
    Item 2.   Unregistered Sales of Equity Securities and Use of Proceeds    45
    Item 3.   Defaults Upon Senior Securities    45
    Item 4.   Submission of Matters to a Vote of Security Holders    46
    Item 5.   Other Information    46
    Item 6.   Exhibits    47
Signature    48


Table of Contents

Part I – FINANCIAL INFORMATION

Item 1. Condensed Consolidated Financial Statements

THE CHARLES SCHWAB CORPORATION

Condensed Consolidated Statements of Income

(In millions, except per share amounts)

(Unaudited)

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2009     2008     2009     2008  

Net Revenues

        

Asset management and administration fees

   $        486      $        618      $        988      $     1,231   

Interest revenue

     361        478        707        988   

Interest expense

     (59     (51     (99     (142
                                

Net interest revenue

     302        427        608        846   

Trading revenue

     272        230        531        476   

Other

     38        33        96        62   

Total other-than-temporary impairment losses

     (37            (187       

Noncredit portion of loss recognized in other comprehensive income

     24               160          
                                

Net impairment losses on securities

     (13            (27       
                                

Total net revenues

     1,085        1,308        2,196        2,615   
                                

Expenses Excluding Interest

        

Compensation and benefits

     377        438        802        875   

Professional services

     64        84        124        168   

Occupancy and equipment

     97        72        178        146   

Advertising and market development

     49        58        107        134   

Communications

     54        52        107        104   

Depreciation and amortization

     41        37        83        75   

Other

     68        53        105        91   
                                

Total expenses excluding interest

     750        794        1,506        1,593   
                                

Income from continuing operations before taxes on income

     335        514        690        1,022   

Taxes on income

     (130     (201     (267     (404
                                

Income from continuing operations

     205        313        423        618   

Loss from discontinued operations, net of tax

            (18            (18
                                

Net Income

   $ 205      $ 295      $ 423      $ 600   
                                

Weighted-Average Common Shares Outstanding — Diluted

     1,160        1,154        1,158        1,157   
                                

Earnings Per Share — Basic

        

Income from continuing operations

   $ .18      $ .27      $ .37      $ .54   

Loss from discontinued operations, net of tax

   $      $ (.01   $      $ (.02

Net income

   $ .18      $ .26      $ .37      $ .52   

Earnings Per Share — Diluted

        

Income from continuing operations

   $ .18      $ .27      $ .36      $ .53   

Loss from discontinued operations, net of tax

   $      $ (.01   $      $ (.01

Net income

   $ .18      $ .26      $ .36      $ .52   
                                

Dividends Declared Per Common Share

   $ .06      $ .05      $ .12      $ .10   
                                

See Notes to Condensed Consolidated Financial Statements.

 

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Table of Contents

THE CHARLES SCHWAB CORPORATION

Condensed Consolidated Balance Sheets

(In millions, except share and per share amounts)

(Unaudited)

 

    June 30,
2009
    December 31,
2008
 

Assets

   

Cash and cash equivalents

  $          9,362      $     5,442   

Cash and investments segregated and on deposit for regulatory purposes (including resale agreements of $6,795 at June 30, 2009 and $6,701 at December 31, 2008)

    15,524        14,685   

Receivables from brokers, dealers, and clearing organizations

    490        759   

Receivables from brokerage clients — net

    7,704        7,129   

Other securities owned — at fair value

    381        626   

Securities available for sale

    17,249        14,446   

Securities held to maturity (fair value — $2,721 at June 30, 2009 and $244 at December 31, 2008)

    2,680        243   

Loans to banking clients — net

    6,539        6,044   

Loans held for sale

    169        41   

Equipment, office facilities, and property — net

    650        661   

Goodwill

    528        528   

Other assets

    985        1,071   
               

Total assets

  $ 62,261      $ 51,675   
               

Liabilities and Stockholders’ Equity

   

Deposits from banking clients

  $ 31,705      $ 23,841   

Payables to brokers, dealers, and clearing organizations

    1,466        1,100   

Payables to brokerage clients

    21,601        20,256   

Accrued expenses and other liabilities

    1,315        1,534   

Long-term debt

    1,560        883   
               

Total liabilities

    57,647        47,614   
               

Stockholders’ equity:

   

Preferred stock — 9,940,000 shares authorized; $.01 par value per share; none issued

             

Common stock — 3 billion shares authorized; $.01 par value per share; 1,392,091,544 shares issued

    14        14   

Additional paid-in capital

    2,253        2,214   

Retained earnings

    7,019        6,735   

Treasury stock, at cost — 231,767,899 shares at June 30, 2009 and 234,991,565 shares at December 31, 2008

    (4,310     (4,349

Accumulated other comprehensive loss

    (362     (553
               

Total stockholders’ equity

    4,614        4,061   
               

Total liabilities and stockholders’ equity

  $ 62,261      $ 51,675   
               

See Notes to Condensed Consolidated Financial Statements.

 

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Table of Contents

THE CHARLES SCHWAB CORPORATION

Condensed Consolidated Statements of Cash Flows

(In millions)

(Unaudited)

 

     Six Months Ended
June 30,
 
     2009     2008  

Cash Flows from Operating Activities

    

Net income

   $ 423      $ 600   

Adjustments to reconcile net income to net cash provided by (used for) operating activities:

    

Loss from discontinued operations, net of tax

            18   

Depreciation and amortization expense

     83        75   

Stock-based compensation expense

     35        33   

Net impairment losses on securities

     27          

Other

     (20     (29

Originations of loans held for sale

     (1,900     (1,054

Proceeds from sales of loans held for sale

     1,777        1,019   

Net change in:

    

Cash and investments segregated and on deposit for regulatory purposes

     (839     (551

Other securities owned

     245        203   

Receivables from brokers, dealers, and clearing organizations

     275        212   

Receivables from brokerage clients

     (577     (614

Other assets

     28        15   

Payables to brokers, dealers, and clearing organizations

     416        865   

Payables to brokerage clients

     1,345        (788

Accrued expenses and other liabilities

     (212     (228
                

Net cash provided by (used for) operating activities

     1,106        (224
                

Cash Flows from Investing Activities

    

Purchases of securities available for sale

     (5,511     (6,294

Proceeds from sales of securities available for sale

     85          

Principal payments on securities available for sale

     2,869        826   

Purchases of securities held to maturity

     (2,464       

Principal payments on securities held to maturity

     28          

Net increase in loans to banking clients

     (581     (1,461

Purchase of equipment, office facilities, and property

     (69     (81

Other investing activities

     (1     (5
                

Net cash used for investing activities

     (5,644     (7,015
                

Cash Flows from Financing Activities

    

Net change in deposits from banking clients

     7,864        6,087   

Issuance of long-term debt

     747          

Repayment of long-term debt

     (40     (17

Dividends paid

     (139     (115

Purchase of treasury stock

            (350

Proceeds from stock options exercised and other

     31        75   

Other financing activities

     (5     34   
                

Net cash provided by financing activities

     8,458        5,714   
                

Increase (decrease) in Cash and Cash Equivalents

     3,920        (1,525

Cash and Cash Equivalents at Beginning of Period

     5,442        6,764   
                

Cash and Cash Equivalents at End of Period

   $     9,362      $     5,239   
                

Supplemental Cash Flow Information

    

Cash paid during the period for:

    

Interest

   $ 68      $ 142   

Income taxes

   $ 203      $ 428   

See Notes to Condensed Consolidated Financial Statements.

 

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Table of Contents

THE CHARLES SCHWAB CORPORATION

Notes to Condensed Consolidated Financial Statements

(Tabular Amounts in Millions, Except Per Share Data, Ratios, or as Noted)

(Unaudited)

 

1.   Basis of Presentation

The Charles Schwab Corporation (CSC) is a savings and loan holding company engaged, through its subsidiaries, in securities brokerage, banking, and related financial services. Charles Schwab & Co., Inc. (Schwab) is a securities broker-dealer with 304 domestic branch offices in 45 states, as well as a branch in each of the Commonwealth of Puerto Rico and London, U.K. In addition, Schwab serves clients in Hong Kong through one of CSC’s subsidiaries. Other subsidiaries include Charles Schwab Bank (Schwab Bank), a federal savings bank, and Charles Schwab Investment Management, Inc. (CSIM), the investment advisor for Schwab’s proprietary mutual funds, which are referred to as the Schwab Funds®.

The accompanying unaudited condensed consolidated financial statements include CSC and its majority-owned subsidiaries (collectively referred to as the Company). All material intercompany balances and transactions have been eliminated. These condensed consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the U.S. (GAAP), which require management to make certain estimates and assumptions that affect the reported amounts in the accompanying financial statements. Certain estimates include other-than-temporary impairment of securities available for sale and securities held to maturity, the valuation of goodwill, the allowance for credit losses, and legal reserves. Actual results could differ from those estimates. These condensed consolidated financial statements reflect all adjustments that are, in the opinion of management, necessary for a fair statement of the results for the periods presented. These adjustments are of a normal recurring nature. Certain prior-year amounts have been reclassified to conform to the 2009 presentation. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2008. The Company’s results for any interim period are not necessarily indicative of results for a full year or any other interim period.

Management has evaluated subsequent events through the date the condensed consolidated financial statements were issued, which was August 6, 2009.

 

2.   New Accounting Standards

Statement of Financial Accounting Standards No. 141R – Business Combinations (SFAS No. 141R), was effective beginning January 1, 2009. This statement generally requires an acquirer to recognize the assets acquired, the liabilities assumed, contingent purchase consideration, and any noncontrolling interest in the acquiree, at fair value on the date of acquisition. SFAS No. 141R also requires an acquirer to expense most transaction and restructuring costs as incurred, and not include such items in the cost of the acquired entity. SFAS No. 141R applies to any business acquisition with an acquisition date on or after January 1, 2009.

SFAS No. 160 – Noncontrolling Interests in Consolidated Financial Statements, was effective beginning January 1, 2009. This statement amends Accounting Research Bulletin No. 51 – Consolidated Financial Statements by establishing financial statement presentation and disclosure requirements for reporting noncontrolling ownership interests. SFAS No. 160 also establishes consistent accounting methods for changes in ownership interest and for the valuation of retained noncontrolling investments upon deconsolidation. The adoption of SFAS No. 160 did not have a material impact on the Company’s financial position, results of operations, earnings per share (EPS), or cash flows.

SFAS No. 161 – Disclosures about Derivative Instruments and Hedging Activities, was effective beginning January 1, 2009. This statement amends the disclosure requirements of SFAS No. 133 – Accounting for Derivative Instruments and Hedging Activities by requiring qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about fair values and gains and losses on derivative instruments, and disclosures about credit-risk related contingent features in derivative agreements. SFAS No. 161 does not require any new derivative or hedging measurements. The adoption of SFAS No. 161 did not have a material impact to the Company’s disclosures about derivative instruments and hedging activities.

SFAS No. 165 – Subsequent Events, was issued in May 2009 and was effective for interim and annual reporting periods ending after June 15, 2009. This statement establishes general standards of accounting for and disclosure of subsequent events. The Company adopted this statement in the second quarter of 2009, and the adoption did not have a material impact

 

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THE CHARLES SCHWAB CORPORATION

Notes to Condensed Consolidated Financial Statements

(Tabular Amounts in Millions, Except Per Share Data, Ratios, or as Noted)

(Unaudited)

 

on the Company’s financial position, results of operations, EPS or cash flows. See note “1 – Basis of Presentation,” for disclosures pursuant to SFAS No. 165.

SFAS No. 166 – Accounting for Transfers of Financial Assets, was issued in June 2009 and is effective for financial asset transfers occurring after January 1, 2010. This statement removes the concept of a qualifying special-purpose entity and amends the standards of accounting for a transfer of a portion of a financial asset as a sale and related disclosures. The adoption of SFAS No. 166 is not expected to have a material impact on the Company’s financial position, results of operations, EPS or cash flows.

SFAS No. 167 – Amendments to Financial Accounting Standards Board (FASB) Interpretation No. 46(R), was issued in June 2009 and is effective January 1, 2010. This statement amends the consolidation guidance applicable to variable interest entities (VIEs), including changing the approach to determining a VIE’s primary beneficiary (the reporting entity that must consolidate the VIE) and the frequency of reassessment. The Company is currently evaluating the impact of the adoption of SFAS No. 167 on its financial position, results of operations, EPS or cash flows.

SFAS No. 168 – The FASB Accounting Standards Codification and the Hierarchy of GAAP, was issued in June 2009 and is effective for interim and annual reporting periods ending after September 15, 2009. This statement establishes the FASB Accounting Standards Codification as the source of authoritative accounting principles in the preparation of financial statements in conformity with GAAP. Rules and interpretive releases of the Securities and Exchange Commission (SEC) under authority of federal securities laws are also sources of authoritative GAAP for SEC registrants. The adoption of SFAS No. 168 will not have an impact on the Company’s financial position, results of operations, EPS or cash flows.

FASB Staff Position (FSP) on Emerging Issues Task Force (EITF) Issue 03-6-1 (FSP EITF 03-6-1) – Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities, was effective beginning January 1, 2009. This FSP requires the inclusion of unvested share-based payment awards with non-forfeitable rights to dividends or dividend equivalents as participating securities in the computation of EPS under the two-class method described in SFAS No. 128 – Earnings Per Share. This FSP requires retrospective adjustment to all prior-period EPS data presented. The Company does have participating securities in the form of unvested restricted common shares related to the Company’s stock incentive plans. However, these participating securities do not have a material impact on the Company’s EPS data presented.

FSP on SFAS No. 115-2 and SFAS No. 124-2 (FSP SFAS 115-2 and 124-2) – Recognition and Presentation of Other-Than-Temporary Impairments, was issued in April 2009 and is effective for interim and annual reporting periods ending after June 15, 2009, with early adoption permitted for interim periods ending after March 15, 2009. This FSP modifies the requirements for recognizing impairment charges on other-than-temporarily impaired (OTTI) debt securities and expands the disclosures related to OTTI debt and equity securities. The Company adopted this FSP in the first quarter of 2009. See note “3 – Securities Available for Sale and Securities Held to Maturity,” for additional information and disclosures pursuant to FSP SFAS 115-2 and 124-2.

FSP on SFAS No. 157-4 (FSP SFAS 157-4) – Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That are Not Orderly, was issued in April 2009 and is effective for interim and annual reporting periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. This FSP provides additional guidance for estimating fair value in accordance with SFAS No. 157 – Fair Value Measurements (SFAS No. 157) when the volume and level of activity for an asset or liability have significantly decreased, including guidance on identifying circumstances that indicate a transaction is not orderly. This FSP also requires additional disclosures for instruments within the scope of SFAS No. 157. The Company adopted this FSP in the first quarter of 2009, and the adoption did not have a material impact on the Company’s financial position, results of operations, EPS or cash flows. See note “7 – Fair Values of Assets and Liabilities,” for disclosures pursuant to FSP SFAS 157-4.

FSP on SFAS 107-1 and Accounting Principles Board Opinion (APB) 28-1 – Interim Disclosures About Fair Value of Financial Instruments, was issued in April 2009 and is effective for interim and annual reporting periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. This FSP expands the fair value disclosures required for all financial instruments within the scope of SFAS No. 107 – Disclosures about Fair Value of Financial Instruments to interim periods and requires entities to disclose the methods and significant assumptions used to

 

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THE CHARLES SCHWAB CORPORATION

Notes to Condensed Consolidated Financial Statements

(Tabular Amounts in Millions, Except Per Share Data, Ratios, or as Noted)

(Unaudited)

 

estimate the fair value of financial instruments in financial statements on an interim and annual basis and to highlight any changes from prior periods. The Company adopted this FSP in the first quarter of 2009. See note “7 – Fair Values of Assets and Liabilities,” for disclosures pursuant to FSP SFAS 107-1 and APB 28-1.

 

3.   Securities Available for Sale and Securities Held to Maturity

The amortized cost, gross unrealized gains and losses, and fair value of securities available for sale and securities held to maturity are as follows:

 

June 30, 2009

   Amortized
Cost
   Gross
Unrealized
Gains
   Gross
Unrealized
Losses
   Fair
Value

Securities available for sale:

           

U.S. agency residential mortgage-backed securities

   $ 8,714    $ 169    $ 41    $ 8,842

Corporate debt securities

     2,443      15      3      2,455

Non-agency residential mortgage-backed securities

     2,678           739      1,939

Certificates of deposit

     1,576      1      2      1,575

U.S. agency notes

     1,386      4           1,390

Asset-backed securities

     1,008      7      2      1,013

Commercial paper

     35                35
                           

Total securities available for sale

   $     17,840    $          196    $          787    $     17,249
                           

Securities held to maturity:

           

U.S. agency residential mortgage-backed securities

   $ 1,252    $ 22    $    $ 1,274

Asset-backed securities

     1,173      15           1,188

Corporate debt securities

     255      4           259
                           

Total securities held to maturity

   $ 2,680    $ 41    $    $ 2,721
                           

December 31, 2008

   Amortized
Cost
   Gross
Unrealized
Gains
   Gross
Unrealized
Losses
   Fair
Value

Securities available for sale:

           

U.S. agency residential mortgage-backed securities

   $ 8,203    $ 108    $ 82    $ 8,229

Corporate debt securities

     1,762      2      31      1,733

Non-agency residential mortgage-backed securities

     3,085           862      2,223

Certificates of deposit

     925           3      922

U.S. agency notes

     515      2           517

Asset-backed securities

     866           44      822
                           

Total securities available for sale

   $ 15,356    $ 112    $ 1,022    $ 14,446
                           

Securities held to maturity:

           

Asset-backed securities

   $ 243    $ 1    $    $ 244
                           

Total securities held to maturity

   $ 243    $ 1    $    $ 244
                           

 

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THE CHARLES SCHWAB CORPORATION

Notes to Condensed Consolidated Financial Statements

(Tabular Amounts in Millions, Except Per Share Data, Ratios, or as Noted)

(Unaudited)

 

A summary of securities with unrealized losses, aggregated by category and period of continuous unrealized loss, is as follows:

 

      Less than 12 months    12 months or longer    Total

June 30, 2009

   Fair
Value
   Unrealized
Losses
   Fair
Value
   Unrealized
Losses
   Fair
Value
   Unrealized
Losses

Securities available for sale:

                 

U.S. agency residential mortgage-backed securities

   $ 1,072    $ 10    $ 2,319    $ 31    $ 3,391    $ 41

Corporate debt securities

     524      1      288      2      812      3

Non-agency residential mortgage-backed securities

               1,934      739      1,934      739

Certificates of deposit

     699      1      99      1      798      2

Asset-backed securities

     210      1      266      1      476      2
                                         

Total securities with unrealized losses (1)

   $     2,505    $ 13    $     4,906    $ 774    $     7,411    $    787
                                         

 

(1)

The number of investment positions with unrealized losses totaled 332.

 

      Less than 12 months    12 months or longer    Total

December 31, 2008

   Fair
Value
   Unrealized
Losses
   Fair
Value
   Unrealized
Losses
   Fair
Value
   Unrealized
Losses

Securities available for sale:

                 

U.S. agency residential mortgage-backed securities

   $ 2,231    $ 63    $ 381    $ 19    $ 2,612    $ 82

Corporate debt securities

     477      11      436      20      913      31

Non-agency residential mortgage-backed securities

     1,704      512      513      350      2,217      862

Certificates of deposit

     647      3                647      3

Asset-backed securities

     822      44                822      44
                                         

Total securities with unrealized losses

   $     5,881    $ 633    $     1,330    $ 389    $     7,211    $ 1,022
                                         

Unrealized losses in securities available for sale were $787 million as of June 30, 2009, and were concentrated in non-agency residential mortgage-backed securities. U.S. agency residential mortgage-backed securities do not have explicit credit ratings, however management considers these to be of the highest credit quality given the guarantee of principal and interest by the U.S. agencies. Included in non-agency residential mortgage-backed securities are securities collateralized by loans that are considered to be “Prime” (defined as loans to borrowers with a Fair Isaac & Company credit score of 620 or higher at origination), and “Alt-A” (defined as Prime loans with reduced documentation at origination). At June 30, 2009, the amortized cost and fair value of Alt-A mortgage-backed securities were $709 million and $382 million, respectively. Corporate debt securities at June 30, 2009, included $983 million of securities issued by financial institutions and guaranteed under the Federal Deposit Insurance Corporation Temporary Liquidity Guarantee Program.

Assessment of Other-Than-Temporary Impairment

Management evaluates whether securities available for sale and securities held to maturity are OTTI on a quarterly basis. Debt securities with unrealized losses are considered OTTI if the Company intends to sell the security or if the Company will be required to sell such security prior to any anticipated recovery. If management determines that a security is OTTI under these circumstances, the impairment recognized in earnings is measured as the entire difference between the amortized cost and then-current fair value. A security is also OTTI if management does not expect to recover the amortized cost of the security. However, if the Company does not intend to sell the security and will not be required to sell the security, management utilizes cash flow models to estimate the expected future cash flow from the securities and to assess the probability that the Company will experience a loss. In this circumstance, the impairment recognized in earnings equals the estimated credit losses as measured by the difference between the present value of expected cash flows and the amortized cost of the security. Expected cash flows are discounted using the security’s effective interest rate.

 

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THE CHARLES SCHWAB CORPORATION

Notes to Condensed Consolidated Financial Statements

(Tabular Amounts in Millions, Except Per Share Data, Ratios, or as Noted)

(Unaudited)

 

The evaluation of whether the Company expects to recover the amortized cost of a security is inherently judgmental. The evaluation includes the assessment of several bond performance indicators including: the portion of the underlying loans that are delinquent (30 days, 60 days, 90+ days), in bankruptcy, in foreclosure or converted to real estate owned; the actual amount of loss incurred on the underlying loans in which the property was foreclosed and sold; the amount of credit support provided by the structure of the security available to absorb credit losses on the underlying loans; the current credit ratings issued by either Standard & Poor’s, Fitch Ratings, or Moody’s; the current price and magnitude of the unrealized loss; and whether the Company has received all scheduled principal and interest payments.

Certain Alt-A and Prime mortgage-backed securities experienced deteriorating credit characteristics in the first half of 2009, including increased payment delinquencies and decreased prepayments due to the slowing of general economic activity and increased unemployment. Losses on foreclosures of underlying mortgages increased as a result of housing price declines. Management uses cash flow models to further assess the likelihood of other-than-temporary impairment for all Alt-A securities, as well as Prime securities with deteriorating bond performance indicators such as those described above. To develop the cash flow models, the Company uses forecasted loss severity, prepayment speeds (i.e. the rate at which the principal on underlying loans are paid down), and default rates over the securities’ remaining maturities. Forecasted home price fluctuations are an important variable in forecasting the expected loss severity and default rates. Based on these cash flow projections, management determined that it does not expect to recover all of the amortized cost of certain securities and therefore determined that these securities were OTTI.

The Company does not intend to sell these securities and it will not be required to sell these securities before anticipated recovery. The Company employs a buy and hold strategy relative to its mortgage-related securities. Further, the Company has an adequate liquidity position at June 30, 2009, with cash and cash equivalents totaling $9.4 billion, a loan-to-deposit ratio of 21%, adequate access to short-term borrowing facilities and regulatory capital ratios in excess of “well capitalized” levels. Because the Company does not intend to sell these securities and will not be required to sell these securities, the Company recognized an impairment charge equal to the securities’ expected credit losses of $13 million and $27 million during the second quarter and first half of 2009, respectively. The expected credit losses were measured as the difference between the present value of expected cash flows and the amortized cost of the securities.

As of June 30, 2009, the Company has not realized an actual credit loss on any of its residential mortgage-backed securities. Further deterioration in the performance of the underlying loans in the Company’s residential mortgage-backed securities portfolio could result in the recognition of additional future impairment charges.

 

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THE CHARLES SCHWAB CORPORATION

Notes to Condensed Consolidated Financial Statements

(Tabular Amounts in Millions, Except Per Share Data, Ratios, or as Noted)

(Unaudited)

 

The maturities of securities available for sale and securities held to maturity at June 30, 2009, are as follows:

 

     Within 1
year
   After 1 year
through

5 years
   After 5 years
through

10 years
   After 10
years
   Total

Securities available for sale:

              

U.S. agency residential mortgage-backed securities (1)

   $    $    $ 206    $ 8,636    $ 8,842

Corporate debt securities

     647      1,808                2,455

Non-agency residential mortgage-backed securities (1)

               36      1,903      1,939

Certificates of deposit

     1,275      300                1,575

U.S. agency notes

     300      1,090                1,390

Asset-backed securities

          684      329           1,013

Commercial Paper

     35                     35
                                  

Total fair value

   $ 2,257    $ 3,882    $ 571    $ 10,539    $ 17,249

Total amortized cost

   $       2,257    $       3,863    $          567    $     11,153    $     17,840
                                  

Securities held to maturity:

              

U.S. agency residential mortgage-backed securities (1)

   $    $    $    $ 1,274    $ 1,274

Asset-backed securities

          923      265           1,188

Corporate debt securities

     12      247                259
                                  

Total fair value

   $ 12    $ 1,170    $ 265    $ 1,274    $ 2,721

Total amortized cost

   $ 12    $ 1,150    $ 266    $ 1,252    $ 2,680
                                  

 

(1)

Mortgage-backed securities have been allocated over maturity groupings based on final contractual maturities. Actual maturities will differ from final contractual maturities because a certain portion of loans underlying these securities require scheduled principal payments and borrowers have the right to prepay obligations.

Proceeds from sales of securities available for sale were $85 million in the second quarter and first half of 2009. Gross realized gains and losses on sales of securities available for sale were less than $500,000 in the second quarter and first half of 2009. There were no proceeds or gross realized gains or losses from the sale of securities available for sale in the second quarter and first half of 2008. Other-than-temporary impairment charges recognized in earnings were $13 million and $27 million in the second quarter and first half of 2009, respectively. There were no impairment charges recognized in earnings in the second quarter or first half of 2008. Realized gains and losses from sales of securities available for sale are included in other revenue. Impairment charges recognized in earnings are included in net impairment losses on securities.

The following table is a rollforward of the amount of credit losses recognized in earnings for OTTI securities held by the Company during the period for which a portion of the impairment was recognized in other comprehensive income:

 

     Three Months
Ended
June 30, 2009
   Six Months
Ended
June 30, 2009

Balance at beginning of period

   $ 14    $

Credit losses recognized into current period earnings on debt securities for which an other-than-temporary impairment was not previously recognized

     5      27

Credit losses recognized into current period earnings on debt securities for which an other-than-temporary impairment was previously recognized

     8     
             

Balance at end of period

   $ 27    $             27
             

 

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THE CHARLES SCHWAB CORPORATION

Notes to Condensed Consolidated Financial Statements

(Tabular Amounts in Millions, Except Per Share Data, Ratios, or as Noted)

(Unaudited)

 

4.   Loans to Banking Clients and Related Allowance for Credit Losses

The composition of the loan portfolio is as follows:

 

     June 30,
2009
    December 31,
2008
 

Residential real estate mortgages

   $        3,244      $     3,195   

Home equity lines of credit

     3,083        2,662   

Secured personal loans

     233        187   

Other

     20        20   
                

Total loans to banking clients

     6,580        6,064   

Allowance for credit losses

     (41     (20
                

Total loans to banking clients – net

   $ 6,539      $ 6,044   
                

Included in the loan portfolio are nonaccrual loans totaling $17 million and $8 million at June 30, 2009 and December 31, 2008, respectively. Nonperforming assets, which include nonaccrual loans and other real estate owned, totaled $20 million and $9 million at June 30, 2009 and December 31, 2008, respectively. There were no loans accruing interest that were contractually 90 days or more past due at June 30, 2009 or December 31, 2008. The amount of interest revenue that would have been earned on non-accrual loans, versus interest revenue recognized on these loans, was not material to the Company’s results of operations for the first halves of 2009 and 2008.

Changes in the allowance for credit losses were as follows:

 

     Three Months
Ended

June 30,
    Six Months
Ended

June 30,
 
     2009     2008     2009     2008  

Balance at beginning of period

   $ 28      $ 9      $ 20      $ 7   

Charge-offs

     (4     (1     (5     (1

Recoveries

                            

Provision for credit losses

     17        4        26        6   
                                

Balance at end of period

   $     41      $     12      $     41      $     12   
                                

 

5.   Long-term Debt

Long-term debt net of unamortized debt discounts, where applicable, consists of the following:

 

     June 30,
2009
   December 31,
2008

Senior Notes

   $ 747    $

Senior Medium-Term Notes, Series A

     458      458

Junior Subordinated Notes

     235      300

Finance lease obligation

     114      116

Fair value adjustment

     6      9
             

Total long-term debt

   $        1,560    $    883
             

In June 2009, the Company issued $750 million of Senior Notes that mature in 2014. The Senior Notes have a fixed interest rate of 4.950% with interest payable semiannually.

 

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THE CHARLES SCHWAB CORPORATION

Notes to Condensed Consolidated Financial Statements

(Tabular Amounts in Millions, Except Per Share Data, Ratios, or as Noted)

(Unaudited)

 

In the first quarter of 2009, the Company repurchased $64 million of trust preferred securities related to its Junior Subordinated Notes for a cash payment of $38 million. The repurchase of the trust preferred securities was accounted for as an extinguishment of a portion of the Junior Subordinated Notes and resulted in a gain of $26 million.

 

6.   Commitments and Contingent Liabilities

The Company has clients that sell (i.e., write) listed option contracts that are cleared by various clearing houses. The clearing houses establish margin requirements on these transactions. The Company satisfies the margin requirements by arranging unsecured standby letter of credit agreements (LOCs), in favor of the clearing houses, which are issued by multiple banks. At June 30, 2009, the aggregate face amount of these LOCs totaled $445 million. In connection with its securities lending activities, Schwab is required to provide collateral to certain brokerage clients. Schwab satisfies the collateral requirements by arranging LOCs, in favor of these brokerage clients, which are issued by multiple banks. At June 30, 2009, the aggregate face amount of these LOCs totaled $52 million. There were no funds drawn under any of these LOCs at June 30, 2009.

The Company also provides guarantees to securities clearing houses and exchanges under their standard membership agreement, which requires members to guarantee the performance of other members. Under the agreement, if another member becomes unable to satisfy its obligations to the clearing houses and exchanges, other members would be required to meet shortfalls. The Company’s liability under these arrangements is not quantifiable and may exceed the cash and securities it has posted as collateral. However, the potential requirement for the Company to make payments under these arrangements is remote. Accordingly, no liability has been recognized for these transactions.

Legal contingencies: The Company is subject to claims and lawsuits in the ordinary course of business, including arbitrations, class actions and other litigation, some of which include claims for substantial or unspecified damages. The Company is also the subject of inquiries, investigations, and proceedings by regulatory and other governmental agencies. In addition, the Company is responding to certain litigation claims brought against former subsidiaries pursuant to indemnities it has provided to purchasers of those entities. Certain of these matters are described below.

The Company believes it has strong defenses in all significant matters currently pending and is contesting liability and the damages claimed. Nevertheless, some of these matters may result in adverse judgments or awards, including penalties, injunctions, or other relief, and the Company may also determine to settle a matter because of the uncertainty and risks of litigation. Based on current information and consultation with counsel, management believes that the resolution of matters currently pending will not have a material impact on the financial condition or cash flows of the Company, but could be material to the Company’s operating results for a particular future period, depending on results for that period. However, predicting the outcome of a matter is inherently difficult, particularly where claims are brought on behalf of various classes of claimants, claimants seek substantial or unspecified damages, or when investigations or legal proceedings are at an early stage, and in many cases, including those matters described below, it is not possible to determine whether a loss will be incurred or to estimate the range of that loss until the matter is closer to resolution.

Auction Rate Securities Regulatory Inquiries: Schwab has been responding to industry wide inquiries from federal and state regulators regarding sales of auction rate securities to clients who were unable to sell their holdings when the normal auction process for those securities froze unexpectedly in February 2008. By letter dated July 17, 2009, Schwab was notified by the Office of the Attorney General of the State of New York of its intention to pursue civil claims against the firm; the letter alleges material misrepresentations and omissions by the firm regarding the risks of auction rate securities, and indicates that the attorney general’s office intends to seek injunctive relief, restitution, penalties and other damages. As reflected in a statement issued July 20, 2009, Schwab has responded that the allegations are without merit and that the firm intends to contest any charges.

YieldPlus Fund Litigation and Regulatory Inquiries: The Company is the subject of nine purported class action lawsuits filed between March and May 2008 on behalf of investors in the Schwab YieldPlus Fund® alleging violations of state law and federal securities law in connection with the fund’s investment policy, disclosures and fund marketing. Allegations include changes to the investment policy of the fund regarding limits on positions in mortgage-backed securities without obtaining a shareholder vote; inadequate disclosure of the risks associated with fund investments in mortgage-backed securities; inaccurate reporting of the fund’s weighted-average duration; and failure to disclose redemptions of positions in YieldPlus

 

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THE CHARLES SCHWAB CORPORATION

Notes to Condensed Consolidated Financial Statements

(Tabular Amounts in Millions, Except Per Share Data, Ratios, or as Noted)

(Unaudited)

 

by other Schwab investment funds. Defendants named in one or more of the lawsuits include the Company, Schwab, CSIM, the fund itself, Schwab Investments (registrant and issuer of the fund’s shares), Charles R. Schwab, Randall W. Merk (current president of the fund), and current and former trustees and officers of the fund and/or Schwab. Claimants seek unspecified compensatory and rescission damages, unspecified equitable and injunctive relief, and costs and attorneys fees. On July 3, 2008, the U.S. District Court for the Northern District of California consolidated all nine lawsuits into a single action for purposes of pre-trial proceedings and appointed a group of fund investors as lead plaintiff. On October 2, 2008, plaintiffs filed a consolidated amended complaint which seeks certification of two separate classes of plaintiffs for the federal and state law claims. On February 4, 2009, the court denied defendants’ motion to dismiss plaintiffs’ federal law claims, dismissed all but one state law claim without prejudice, and lifted a stay on discovery. On May 15, 2009, the court denied plaintiffs’ request to amend those state law claims previously dismissed. On June 18, 2009, the court held a hearing on class certification to determine which investors in the fund are appropriate to include as plaintiffs in the class action; a decision of the court remains pending. Separately, the Company has been responding to investigations by federal and state regulators regarding these matters. At this time the Company is unable to estimate whether it will incur a liability or the range of any such liability in these matters; any liability could exceed the limits of applicable insurance policies.

Total Bond Market Fund Litigation: On August 28, 2008, a class action lawsuit was filed in the U.S. District Court for the Northern District of California on behalf of investors in the Schwab Total Bond Market Fund™. The lawsuit, which alleges violations of state law and federal securities law in connection with the fund’s investment policy, names the fund, Schwab Investments (registrant and issuer of the fund’s shares), Schwab, and CSIM as defendants. Allegations include that the fund improperly deviated from its stated investment objectives by investing in collateralized mortgage obligations (CMOs) and investing more than 25% of fund assets in CMOs and mortgage-backed securities without obtaining a shareholder vote. Claimants seek unspecified compensatory and rescission damages, unspecified equitable and injunctive relief, and costs and attorneys fees. On February 19, 2009, the court denied defendants’ motion to dismiss plaintiffs’ federal securities law claim, and dismissed certain state law claims with leave to amend. On April 27, 2009, the court issued a stay of proceedings while defendants appeal the court’s February 19, 2009 decision refusing to dismiss plaintiffs’ federal securities law claim, currently under review by the U.S. Court of Appeals for the Ninth Circuit.

SoundView Litigation: As part of the sale of Schwab Capital Markets L.P. and all of the outstanding capital stock of SoundView Technology Group, Inc. (SoundView), (collectively referred to as Schwab Soundview Capital Markets, or SSCM), to UBS Securities LLC and UBS Americas Inc. (collectively referred to as UBS), the Company agreed to indemnify UBS for certain litigation. SoundView and certain of its subsidiaries are among the numerous financial institutions named as defendants in multiple purported securities class actions filed in the United States District Court for the Southern District of New York (the IPO Allocation Litigation) between June and December 2001. The IPO Allocation Litigation was brought on behalf of persons who either directly or in the aftermarket purchased IPO securities between March 1997 and December 2000. The plaintiffs allege that SoundView entities and the other underwriters named as defendants required customers receiving allocations of IPO shares to pay excessive and undisclosed commissions on unrelated trades and to purchase shares in the aftermarket at prices higher than the IPO price, in violation of the federal securities laws. SoundView entities have been named in 31 of the actions, each involving a different company’s IPO, and had underwriting commitments in approximately 90 other IPOs that are the subject of lawsuits. SoundView entities have not been named as defendants in these cases, although the lead underwriters in those IPOs have asserted that depending on the outcome of the cases, SoundView entities may have indemnification or contribution obligations based on underwriting commitments in the IPOs. The parties, with the assent of the District Court, selected 17 cases as focus cases for the purpose of case-specific discovery, and on October 13, 2004, the District Court allowed six of the focus cases to proceed as class actions. Defendants appealed that decision to the United States Court of Appeals for the Second Circuit, which issued an order on December 5, 2006, reversing the District Court’s decision to allow the six focus cases to proceed as class actions. On April 6, 2007, the Court of Appeals denied the plaintiffs’ request for rehearing. In August and September 2007, plaintiffs filed amended class action complaints and renewed motions for class certification, which again seek approval for the cases to proceed as class actions. On March 26, 2008, the District Court denied defendants’ motion to dismiss the amended class action complaints, except with respect to certain claims of a limited number of plaintiffs who sold securities at prices in excess of the initial offering price or who purchased securities outside the class period. On June 9, 2009, the District Court preliminarily approved a global settlement reached with lead underwriters. The Company’s liability in connection with contribution amounts for SoundView entities under the proposed settlement would not be material.

 

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THE CHARLES SCHWAB CORPORATION

Notes to Condensed Consolidated Financial Statements

(Tabular Amounts in Millions, Except Per Share Data, Ratios, or as Noted)

(Unaudited)

 

7.   Fair Values of Assets and Liabilities

SFAS No. 157 defines fair value as the price that would be received to sell an asset or the price paid to transfer a liability in an orderly transaction between market participants at the measurement date. SFAS No. 157 also establishes a hierarchy for disclosing assets and liabilities measured at fair value based on the inputs used to value them. The fair value hierarchy maximizes the use of observable inputs and minimizes the use of unobservable inputs. Observable inputs are based on market pricing data obtained from sources independent of the Company. A quoted price in an active market provides the most reliable evidence of fair value and is generally used to measure fair value whenever available. Unobservable inputs reflect management’s judgment about the assumptions market participants would use in pricing the asset or liability. Where inputs used to measure fair value of an asset or liability are from different levels of the hierarchy, the asset or liability is categorized based on the lowest level input that is significant to the fair value measurement in its entirety. Assessing the significance of a particular input requires judgment. The fair value hierarchy includes three levels based on the objectivity of the inputs as follows:

 

   

Level 1 inputs are quoted prices in active markets as of the measurement date for identical assets or liabilities that the Company has the ability to access. This category includes active exchange-traded money market funds, mutual funds, and equity securities.

 

   

Level 2 inputs are inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. Level 2 inputs include quoted prices for similar assets and liabilities in active markets, and inputs other than quoted prices that are observable for the asset or liability, such as interest rates, benchmark yields, issuer spreads, new issue data, and collateral performance. This category includes residential mortgage-backed securities, asset-backed securities, corporate debt securities, certificates of deposit, commercial paper, U.S. agency and municipal debt securities, U.S. Treasury securities, and derivative contracts.

 

   

Level 3 inputs are unobservable inputs for the asset or liability, and include situations where there is little, if any, market activity for the asset or liability. The Company did not have any financial assets or liabilities utilizing Level 3 inputs as of June 30, 2009 or December 31, 2008.

Assets and Liabilities Recorded at Fair Value

The Company’s assets recorded at fair value include certain investments segregated and on deposit for regulatory purposes, other securities owned, and securities available for sale. The Company uses prices obtained from an independent third-party pricing service to measure the fair value of certain investment securities. The Company validates prices received from the pricing service using various methods including comparison to prices received from additional pricing services, comparison to quoted market prices, where available, comparison to internal valuation models, and review of other relevant market data including implied yields of major categories of securities. The Company does not adjust the prices received from the independent third-party pricing service unless such prices are inconsistent with SFAS No. 157 and result in a material difference in the recorded amounts. At June 30, 2009 and December 31, 2008, the Company did not adjust prices received from the independent third-party pricing service. Liabilities recorded at fair value are not material.

 

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THE CHARLES SCHWAB CORPORATION

Notes to Condensed Consolidated Financial Statements

(Tabular Amounts in Millions, Except Per Share Data, Ratios, or as Noted)

(Unaudited)

 

The following tables present the Company’s fair value hierarchy for assets and liabilities measured at fair value:

 

June 30, 2009

   Quoted Prices
in Active Markets
for Identical
Assets

(Level 1)
   Significant
Other Observable
Inputs

(Level 2)
   Significant
Unobservable
Inputs

(Level 3)
   Balance at
Fair Value

Assets

           

Investments segregated and on deposit for regulatory purposes

           

Certificates of deposit

   $    $ 2,525    $    $ 2,525

Corporate debt securities

          2,041           2,041

U.S. Government securities

          1,701           1,701

Commercial paper

          100           100
                           

Total investments segregated and on deposit for regulatory purposes

          6,367           6,367

Other securities owned

           

Schwab Funds® money market funds

     226                226

Equity and bond mutual funds

     94                94

State and municipal debt obligations

          35           35

Equity, U.S. Government and corporate debt, and other securities

     2      24           26
                           

Total other securities owned

     322      59           381

Securities available for sale

           

U.S. agency residential mortgage-backed securities

          8,842           8,842

Corporate debt securities

          2,455           2,455

Non-agency residential mortgage-backed securities

          1,939           1,939

Certificates of deposit

          1,575           1,575

U.S. agency notes

          1,390           1,390

Asset-backed securities

          1,013           1,013

Commercial paper

          35           35
                           

Total securities available for sale

          17,249           17,249

Other assets (1)

          10           10
                           

Total assets at fair value

   $ 322    $ 23,685    $                   —    $            24,007
                           

Liabilities

           

Accrued expenses and other liabilities (2)

   $    $ 2    $    $ 2
                           

 

(1)

Other assets recorded at fair value include derivative contracts.

 

(2)

Accrued expenses and other liabilities include securities sold, not yet purchased, and derivative contracts.

 

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THE CHARLES SCHWAB CORPORATION

Notes to Condensed Consolidated Financial Statements

(Tabular Amounts in Millions, Except Per Share Data, Ratios, or as Noted)

(Unaudited)

 

December 31, 2008

   Quoted Prices
in Active Markets
for Identical
Assets
(Level 1)
   Significant
Other Observable
Inputs

(Level 2)
   Significant
Unobservable
Inputs

(Level 3)
   Balance at
Fair Value

Assets

           

Investments segregated and on deposit for regulatory purposes

           

Certificates of deposit

   $    $ 3,888    $    $ 3,888

Corporate debt securities

          1,501           1,501

U.S. Government securities

          1,190           1,190

Commercial paper

          250           250
                           

Total investments segregated and on deposit for regulatory purposes

          6,829           6,829

Other securities owned

           

Schwab Funds® money market funds

     440                440

Equity and bond mutual funds

     135                135

State and municipal debt obligations

          37           37

Equity, U.S. Government and corporate debt, and other securities

     3      11           14
                           

Total other securities owned

     578      48           626

Securities available for sale

           

U.S. agency residential mortgage-backed securities

          8,229           8,229

Corporate debt securities

          1,733           1,733

Non-agency residential mortgage-backed securities

          2,223           2,223

Certificates of deposit

          922           922

U.S. agency notes

          517           517

Asset-backed securities

          822           822
                           

Total securities available for sale

          14,446           14,446

Other assets (1)

          11           11
                           

Total assets at fair value

   $ 578    $       21,334    $    $ 21,912
                           

Liabilities

           

Accrued expenses and other liabilities (2)

   $ 2    $ 3    $                   —    $                     5
                           

 

(1)

Other assets recorded at fair value include derivative contracts.

 

(2)

Accrued expenses and other liabilities include securities sold, not yet purchased, and derivative contracts.

Fair Value of Assets and Liabilities Not Recorded at Fair Value

Descriptions of the valuation methodologies and assumptions used to estimate the fair value of assets and liabilities not recorded at fair value are described below. There were no significant changes in these methodologies or assumptions during the second half of 2009.

Cash and cash equivalents, receivables, payables, and accrued expenses and other liabilities include cash and highly liquid investments, receivables and payables from/ to brokers, dealers and clearing organizations, receivables and payables from/ to brokerage clients, and drafts, accounts, taxes, interest, and compensation payable. Assets and liabilities in these categories are short-term in nature and accordingly are recorded at amounts that approximate fair value.

Cash and investments segregated and on deposit for regulatory purposes include securities purchased under resale agreements. Securities purchased under resale agreements are recorded at par value plus accrued interest. Securities purchased under resale agreements are short-term in nature and are backed by collateral that both exceeds the carrying value of the resale agreement and is highly liquid in nature. Accordingly, the carrying value approximates fair value.

Securities held to maturity include asset-backed securities collateralized by credit card and student loans and agency mortgage-backed securities. Securities held to maturity are recorded at amortized cost. The fair value of these securities is obtained using an independent third-party pricing service, as discussed above.

 

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Table of Contents

THE CHARLES SCHWAB CORPORATION

Notes to Condensed Consolidated Financial Statements

(Tabular Amounts in Millions, Except Per Share Data, Ratios, or as Noted)

(Unaudited)

 

Loans to banking clients primarily include adjustable-rate first-mortgage and HELOC loans. Loans to banking clients are recorded at carrying value net of an allowance for credit losses. The fair value of the Company’s loans to banking clients is estimated based on market prices for mortgage-backed securities collateralized by similar types of loans.

Loans held for sale include fixed rate first-mortgage and HELOC loans. Loans held for sale are recorded at the lower of cost or fair value. The fair value of the Company’s loans held for sale is estimated using quoted market prices for securities backed by similar types of loans.

Other assets include cost method investments, including the Company’s investment in Federal Home Loan Bank (FHLB) stock. The cost method investments’ carrying values approximate their fair values.

Deposits from banking clients: The Company considers the fair value of deposits with no stated maturity, such as deposits from banking clients to be equal to the amount payable on demand as of the balance sheet date.

Long-term debt includes Senior Notes, Medium-Term Notes, and Junior Subordinated Notes, and a finance lease obligation. The fair value of the Company’s long-term debt is estimated using indicative, non-binding quotes from independent brokers.

Firm commitments to extend credit: The Company extends credit to banking clients through HELOC commitments. The Company considers the fair value of unused HELOC commitments to be not material because the interest rate earned on HELOC outstanding balances is based on the Prime rate and resets monthly. Future utilization of HELOC commitments will earn a then-current market interest rate. The Company does not charge a fee to maintain a HELOC.

The table below presents the Company’s fair value estimates for financial instruments excluding short-term financial assets and liabilities, for which carrying amounts approximate fair value, and excluding financial instruments recorded at fair value.

 

     June 30,
2009
   December 31,
2008
     Carrying
Amount
   Fair
Value
   Carrying
Amount
   Fair
Value

Financial Assets:

           

Securities held to maturity

   $ 2,680    $ 2,721    $ 243    $ 244

Loans to banking clients – net

   $     6,539    $     5,670    $     6,044    $     5,389

Loans held for sale

   $ 169    $ 174    $ 41    $ 42

Financial Liabilities:

           

Long-term debt

   $ 1,560    $ 1,556    $ 883    $ 705

 

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Table of Contents

THE CHARLES SCHWAB CORPORATION

Notes to Condensed Consolidated Financial Statements

(Tabular Amounts in Millions, Except Per Share Data, Ratios, or as Noted)

(Unaudited)

 

8.   Comprehensive Income and Accumulated Other Comprehensive Loss

The components of comprehensive income are as follows:

 

     Three Months
Ended
June 30,
    Six Months
Ended
June 30,
 
     2009     2008     2009     2008  

Net income

   $     205      $     295      $     423      $     600   

Other comprehensive income (loss):

        

Change in net unrealized gain (loss) on securities available for sale:

        

Unrealized gain (loss) on Non-OTTI securities

     265        (11     344        (207

Unrealized loss on OTTI securities

     (50            (52       

OTTI charges recognized in earnings

     13               27          

Income tax effect

     (90     4        (128     82   
                                

Total other comprehensive income (loss)

     138        (7     191        (125
                                

Comprehensive income

   $ 343      $ 288      $ 614      $ 475   
                                

Accumulated other comprehensive loss represents cumulative gains and losses that are not reflected in earnings. Accumulated other comprehensive loss balances were:

 

     Net unrealized loss
on securities available for sale
    Foreign
currency
translation
adjustment
   Total accumulated
other
comprehensive
loss
 
     Portion of
unrealized loss
on Non-OTTI
securities
    Portion of
unrealized loss
on OTTI

securities
      

Balance at December 31, 2007

   $ (18   $                      —      $ 1    $ (17

Net change

     (125                 (125
                               

Balance at June 30, 2008

   $ (143   $      $ 1    $ (142
                               

Balance at December 31, 2008

   $ (553   $      $                      —    $ (553

Reclassification of OTTI securities

                           97        (97            

Other net changes

     191                    191   
                               

Balance at June 30, 2009

   $ (265   $ (97   $    $ (362
                               

 

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Table of Contents

THE CHARLES SCHWAB CORPORATION

Notes to Condensed Consolidated Financial Statements

(Tabular Amounts in Millions, Except Per Share Data, Ratios, or as Noted)

(Unaudited)

 

9.   Earnings Per Share

Basic EPS is computed by dividing net income available to common shareholders by the weighted-average number of common shares outstanding during the period. The computation of diluted EPS is similar to the computation of basic EPS except that the denominator is increased to include the number of additional common shares that would have been outstanding if dilutive potential common shares had been issued. Dilutive potential common shares are determined using the treasury stock method, and include outstanding stock options and unvested restricted stock awards. EPS under the basic and diluted computations are as follows:

 

     Three Months
Ended

June 30,
    Six Months
Ended
June 30,
 
     2009    2008     2009    2008  

Net income available to common shareholders (1)

   $     205    $     295      $     423    $     600   
                              

Weighted-average common shares outstanding – basic

     1,156      1,145        1,154      1,147   

Common stock equivalent shares related to stock incentive plans

     4      9        4      10   
                              

Weighted-average common shares outstanding – diluted (2)

     1,160      1,154        1,158      1,157   
                              

Basic EPS:

          

Income from continuing operations

   $ .18    $ .27      $ .37    $ .54   

Loss from discontinued operations, net of tax

   $    $ (.01   $    $ (.02

Net income

   $ .18    $ .26      $ .37    $ .52   

Diluted EPS:

          

Income from continuing operations

   $ .18    $ .27      $ .36    $ .53   

Loss from discontinued operations, net of tax

   $    $ (.01   $    $ (.01

Net income

   $ .18    $ .26      $ .36    $ .52   

 

(1)

Net income available to participating securities (unvested restricted shares) was not material for the second quarters and first halves of 2009 or 2008.

 

(2)

Total antidilutive stock options and restricted stock awards excluded from the calculation of diluted EPS were 39 million and 22 million shares for the second quarters of 2009 and 2008, respectively, and 39 million and 23 million shares for the first halves of 2009 and 2008, respectively.

 

10.   Regulatory Requirements

CSC is a savings and loan holding company and Schwab Bank, CSC’s depository institution subsidiary, is a federal savings bank. CSC and Schwab Bank are both subject to supervision and regulation by the Office of Thrift Supervision. As a savings and loan holding company, CSC is not subject to specific statutory capital requirements. However, CSC is required to maintain capital that is sufficient to support the holding company and its subsidiaries’ business activities, and the risks inherent in those activities.

Schwab Bank is required to maintain a capital level that at least equals minimum capital levels specified in federal banking laws and regulations. Failure to meet the minimum levels will result in certain mandatory and possibly additional discretionary actions by the regulators that, if undertaken, could have a direct material effect on Schwab Bank. At June 30, 2009, CSC and Schwab Bank met the capital level requirements.

 

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Table of Contents

THE CHARLES SCHWAB CORPORATION

Notes to Condensed Consolidated Financial Statements

(Tabular Amounts in Millions, Except Per Share Data, Ratios, or as Noted)

(Unaudited)

 

The regulatory capital and ratios for Schwab Bank at June 30, 2009, are as follows:

 

     Actual     Minimum Capital
Requirement
    Minimum to be
Well Capitalized
 
     Amount        Ratio         Amount        Ratio         Amount        Ratio      

Tier 1 Capital

   $     2,339    16.8   $     555    4.0   $     833    6.0

Total Capital

   $ 2,381    17.2   $ 1,111    8.0   $ 1,388    10.0

Leverage

   $ 2,339    6.8   $ 1,380    4.0   $ 1,725    5.0

Tangible Equity

   $ 2,339    6.8   $ 690    2.0     N/A   

 

N/A Not applicable.

Based on its regulatory capital ratios at June 30, 2009, Schwab Bank is considered well capitalized (the highest category) pursuant to banking regulatory guidelines. There are no conditions or events since June 30, 2009, that management believes have changed Schwab Bank’s capital category.

Schwab is subject to Rule 15c3-1 under the Securities Exchange Act of 1934 (the Uniform Net Capital Rule). Schwab computes net capital under the alternative method permitted by the Uniform Net Capital Rule. This method requires the maintenance of minimum net capital, as defined, of the greater of 2% of aggregate debit balances arising from client transactions or a minimum dollar requirement, which is based on the type of business conducted by the broker-dealer. At June 30, 2009, 2% of aggregate debits was $170 million, which exceeded the minimum dollar requirement for Schwab of $250,000. At June 30, 2009, Schwab’s net capital was $1.1 billion (13% of aggregate debit balances), which was $909 million in excess of its minimum required net capital and $654 million in excess of 5% of aggregate debit balances. 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 requirement.

 

11.   Segment Information

The Company structures its segments according to its various types of clients and the services provided to those clients. The Company’s two reportable segments are Investor Services and Institutional Services. As a result of organizational and related business changes in the first quarter of 2009, the segments formerly reported as Advisor Services and Corporate and Retirement Services have been combined into a single segment called Institutional Services. Previously-reported segment information has been revised to reflect this change. The Company evaluates the performance of its segments on a pre-tax basis excluding items such as impairment charges on non-financial assets, discontinued operations, extraordinary items, and other significant restructuring charges. Segment assets and liabilities are not disclosed because the balances are not used for evaluating segment performance and deciding how to allocate resources to segments. There are no revenues from transactions with other segments within the Company.

 

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Table of Contents

THE CHARLES SCHWAB CORPORATION

Notes to Condensed Consolidated Financial Statements

(Tabular Amounts in Millions, Except Per Share Data, Ratios, or as Noted)

(Unaudited)

 

Financial information for the Company’s reportable segments is presented in the following table:

 

     Three Months
Ended

June 30,
    Six Months
Ended
June 30,
 
     2009     2008     2009     2008  

Net revenues:

        

Investor Services

   $ 705      $ 873      $ 1,411      $ 1,737   

Institutional Services

     380        432        785        871   

Unallocated

            3               7   
                                

Total net revenues

   $ 1,085      $ 1,308      $ 2,196      $ 2,615   
                                

Income from continuing operations before taxes on income:

        

Investor Services

   $     216      $     332      $     458      $     654   

Institutional Services

     146        180        318        367   

Unallocated

     (27     2        (86     1   
                                

Income from continuing operations before taxes on income

     335        514        690        1,022   

Taxes on income

     (130     (201     (267     (404

Loss from discontinued operations, net of tax

            (18            (18
                                

Net income

   $ 205      $ 295      $ 423      $ 600   
                                

 

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Table of Contents

THE CHARLES SCHWAB CORPORATION

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

(Tabular Amounts in Millions, Except Ratios, or as Noted)

 

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

OVERVIEW

Management of The Charles Schwab Corporation (CSC) and its subsidiaries (collectively referred to as the Company) focuses on several key financial and non-financial metrics in evaluating the Company’s financial position and operating performance. Results for the second quarters and first halves of 2009 and 2008 are shown in the following table:

 

     Three Months
Ended
June 30,
    Percent
  Change  
    Six Months
Ended
June 30,
    Percent
  Change  
 
     2009     2008       2009     2008    

Client Activity Metrics:

            

Net new client assets (in billions)

   $ 17.3      $ 26.0      (33 %)    $        42.6      $        67.3      (37 %) 

Client assets (in billions, at quarter end)

   $   1,224.3      $   1,396.9      (12 %)       

Clients’ daily average trades (in thousands)

     349.7        299.4      17     354.4        312.9      13

Company Financial Metrics:

            

Net revenues

   $ 1,085      $ 1,308      (17 %)    $ 2,196      $ 2,615      (16 %) 

Expenses excluding interest

     750        794      (6 %)      1,506        1,593      (5 %) 
                                            

Income from continuing operations before taxes on income

     335        514      (35 %)      690        1,022      (32 %) 

Taxes on income

     (130     (201   (35 %)      (267     (404   (34 %) 
                                            

Income from continuing operations

     205        313      (35 %)      423        618      (32 %) 

Loss from discontinued operations, net of tax

            (18   N/M               (18   N/M   
                                            

Net income

   $ 205      $ 295      (31 %)    $ 423      $ 600      (30 %) 
                                            

Earning per share from continuing operations – diluted

   $ .18      $ .27      (33 %)    $ .36      $ .53      (32 %) 

Earnings per share – diluted

   $ .18      $ .26      (31 %)    $ .36      $ .52      (31 %) 

Net revenue (decline) growth from prior year

     (17 %)      9       (16 %)      11  

Pre-tax profit margin from continuing operations

     30.9     39.3       31.4     39.1  

Return on stockholders’ equity (annualized)

     18     32       20     31  

Annualized net revenue per average full-time equivalent employee (in thousands)

   $ 356      $ 390      (9 %)    $ 351      $ 391      (10 %) 

 

N/M Not meaningful.

Economic and market conditions remained challenging in the second quarter of 2009, marked by tight credit markets, continued liquidity concerns, increases in home foreclosures and delinquencies, and unsettled equity markets. Although the Nasdaq Composite Index, the Standard and Poor’s 500 Index, and the Dow Jones Industrial Average increased 20%, 15%, and 11%, respectively, during the second quarter, these indices ended the quarter down 20%, 28%, and 26%, respectively, from the second quarter of 2008. In addition, the depressed interest rate environment continued in the second quarter as the federal funds rate remained unchanged at a range of zero to 0.25% and the three-month LIBOR decreased by 65 basis points from 1.27% in March 2009 to 0.62% in June 2009.

During the second quarter of 2009, clients remained actively engaged with the Company. Clients’ daily average trades increased 17% on a year-over-year basis to 349,700 in the second quarter of 2009. Net new client assets totaled $17.3 billion in the second quarter of 2009, down 33% from the second quarter of 2008. Lower equity valuations affected total client assets, which ended the second quarter of 2009 at $1.22 trillion, down 12% from the prior year.

Net revenues decreased by 17% and 16% in the second quarter and first half of 2009 compared to the same periods in 2008, respectively, primarily due to the decreases in asset management and administration fees and net interest revenue, which resulted from lower equity valuations and the low interest rate environment. The decrease in net revenues was partially offset by the increase in trading revenue. For the first half of 2009, the decrease in net revenues was partially offset by the recognition of a $26 million gain on the repurchase of a portion of the Company’s long-term debt in the first quarter of 2009.

 

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THE CHARLES SCHWAB CORPORATION

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

(Tabular Amounts in Millions, Except Ratios, or as Noted)

 

Net revenues were also negatively impacted by net impairment charges of $13 million and $27 million in the second quarter and first half of 2009, respectively, relating to certain residential mortgage-backed securities available for sale.

Expenses excluding interest decreased by 6% and 5% in the second quarter and first half of 2009 compared to the same periods in 2008, respectively, due to decreases in compensation and benefits expense, professional services expense, and advertising and market development expense, partially offset by increases in occupancy and equipment expense and other expense. Expenses excluding interest in the second quarter and first half of 2009 include total facilities and severance charges of $40 million and $99 million, respectively, relating to the Company’s cost reduction measures. Additionally, the Company incurred a $16 million Federal Deposit Insurance Corporation (FDIC) special industry assessment in the second quarter. Expenses excluding interest in the second quarter and first half of 2009 were reduced by a net credit of $2 million and $13 million, respectively, relating to insurance recoveries of certain charges for individual client complaints and arbitration claims relating to Schwab YieldPlus Fund investments.

As a result of the Company’s cost reduction measures and ongoing expense discipline, the Company achieved a pre-tax profit margin of 30.9% and return on stockholders’ equity of 18% in the second quarter of 2009. Annualized net revenue per average full-time equivalent employee decreased 9% and 10% in the second quarter and first half of 2009 due to lower net revenues, partially offset by the decrease in average full-time equivalent employees.

CURRENT MARKET ENVIRONMENT

The market conditions discussed above continue to negatively impact the Company’s revenues.

The Company earns mutual fund service fees and asset management fees based upon daily balances of certain client assets. Fluctuations in these client asset balances caused by changes in equity valuations directly impact the amount of fee revenue earned by the Company. If reduced equity valuations continue in 2009, asset management and administration fees will be negatively impacted on a year-over-year basis. Additionally, mutual fund service fees may be further reduced if the current interest rate environment persists. The overall yields on certain money market mutual funds have fallen to levels at or below the management fees on those funds, and the Company is waiving a portion of its fees in order to continue providing some return to clients. To the extent these and other money market mutual funds find it necessary to replace maturing securities with lower yielding securities on an ongoing basis, the amount of fees waived may increase.

Given the low interest rate environment, the Company’s revenue from interest-earning assets, such as securities held and loans to clients, has been declining more than the rates that the Company pays on funding sources, such as customer deposits. The Company’s ability to reduce those rates has been limited as short-term rates have approached zero. Continuation of the current interest rate environment through 2009 will negatively impact net interest revenue on a year-over-year basis.

The level at which clients utilize margin loans will also impact net interest revenue. Although the average balance of margin loans for the second quarter of 2009 increased $168 million, or 3%, from the first quarter of 2009, the average balance decreased by $5.4 billion, or 47%, from the second quarter of 2008. The average yield earned on margin loans decreased to 5.25% for the second quarter of 2009 from 5.52% for the first quarter of 2009 and from 5.77% for the second quarter of 2008. The average balance of margin loans decreased in the first half of 2009 by $5.3 billion, or 46%, from the first half of 2008 and the average yield earned on margin loans decreased to 5.39% from 6.13% for the same periods.

The Company recorded net impairment charges of $13 million and $27 million related to certain non-agency residential mortgage-backed securities in the second quarter and first half of 2009, respectively, due to credit deterioration of the securities’ underlying collateral. Further deterioration in the performance of the underlying loans in the Company’s residential mortgage-backed securities portfolio could result in the recognition of additional future impairment charges.

 

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Table of Contents

THE CHARLES SCHWAB CORPORATION

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

(Tabular Amounts in Millions, Except Ratios, or as Noted)

 

RESULTS OF OPERATIONS

The following discussion presents an analysis of the Company’s results of operations for the second quarter and first half of 2009 compared to the same periods in 2008.

Net Revenues

The Company’s major sources of net revenues are asset management and administration fees, net interest revenue, and trading revenue. Asset management and administration fees and net interest revenue decreased while trading revenue increased in the second quarter and first half of 2009 compared to the same periods in 2008.

 

Three Months Ended June 30,          2009     2008  
     Percent
Change
    Amount     % of
Total Net
 Revenues 
    Amount     % of
Total Net
 Revenues 
 

Asset management and administration fees

          

Mutual fund service fees:

          

Proprietary funds (Schwab Funds® and Laudus Funds®)

   (15 %)    $     269      25   $     315      24

Mutual Fund OneSource®

   (32 %)      105      10     155      12

Clearing and other

   (24 %)      22      2     29      2

Investment management and trust fees

   (31 %)      64      6     93      7

Other

          26      2     26      2
                                  

Asset management and administration fees

   (21 %)      486      45     618      47
                                  

Net interest revenue

          

Interest revenue

   (24 %)      361      33     478      37

Interest expense

   16     (59   (5 %)      (51   (4 %) 
                                  

Net interest revenue

   (29 %)      302      28     427      33
                                  

Trading revenue

          

Commissions

   17     233      21     199      16

Principal transactions

   26     39      4     31      2
                                  

Trading revenue

   18     272      25     230      18
                                  

Other

   15     38      3     33      2
                                  

Net impairment losses on securities

          N/M        (13   (1 %)             
                                  

Total net revenues

   (17 %)    $     1,085      100   $     1,308      100
                                  

 

N/M Not meaningful.

 

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Table of Contents

THE CHARLES SCHWAB CORPORATION

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

(Tabular Amounts in Millions, Except Ratios, or as Noted)

 

Six Months Ended June 30,          2009     2008  
     Percent
Change
    Amount     % of
Total Net
Revenues
    Amount     % of
Total Net
Revenues
 

Asset management and administration fees

          

Mutual fund service fees:

          

Proprietary funds (Schwab Funds® and Laudus Funds®)

   (10 %)    $     573      26   $     637      24

Mutual Fund OneSource®

   (36 %)      195      9     303      12

Clearing and other

   (26 %)      43      2     58      2

Investment management and trust fees

   (30 %)      129      6     183      7

Other

   (4 %)      48      2     50      2
                                  

Asset management and administration fees

   (20 %)      988      45     1,231      47
                                  

Net interest revenue

          

Interest revenue

   (28 %)      707      32     988      38

Interest expense

   (30 %)      (99   (4 %)      (142   (6 %) 
                                  

Net interest revenue

   (28 %)      608      28     846      32
                                  

Trading revenue

          

Commissions

   12     462      21     412      15

Principal transactions

   8     69      3     64      3
                                  

Trading revenue

   12     531      24     476      18
                                  

Other

   55     96      4     62      3
                                  

Net impairment losses on securities

          N/M        (27   (1 %)             
                                  

Total net revenues

   (16 %)    $     2,196      100   $     2,615      100
                                  

 

N/M Not meaningful.

Asset Management and Administration Fees

Asset management and administration fees include mutual fund service fees and fees for other asset-based financial services provided to individual and institutional clients. The Company earns mutual fund service fees for transfer agent services, shareholder services, administration, and investment management provided to its proprietary funds, and recordkeeping and shareholder services provided to third-party funds. These fees are based upon the daily balances of client assets invested in third-party funds and the Company’s proprietary funds. The Company also earns asset management fees for advisory and managed account services, which are based on the daily balances of client assets subject to the specific fee for service. The fair values of client assets, which include proprietary and third-party mutual funds, are based on quoted market prices and other observable market data. Asset management and administration fees may vary with changes in the balances of client assets due to market fluctuations and client activity. For discussion of the impact of current market conditions on asset management and administration fees, see “Current Market Environment”.

Asset management and administration fees decreased by $132 million, or 21%, and $243 million, or 20%, in the second quarter and first half of 2009 compared to the same periods in 2008, respectively, primarily due to decreases in mutual fund service fees and investment management and trust fees, which resulted from lower equity valuations of client assets and an increase in money market mutual fund waivers due to the low interest rate environment.

Mutual fund service fees decreased by $103 million, or 21%, and $187 million, or 19%, in the second quarter and first half of 2009 compared to the same periods in 2008, respectively. The decrease was primarily due to a 24% decrease in the Company’s Mutual Fund OneSource client asset balances, a 22% decrease in mutual fund clearing services client asset balances, and a 4% decrease in the Company’s proprietary funds client asset balances. Given the low interest rate environment in the second quarter and first half of 2009, the overall yields on certain of the Company’s money market mutual funds have fallen to levels at or below the management fees on those funds. As a result, the Company waived a

 

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Table of Contents

THE CHARLES SCHWAB CORPORATION

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

(Tabular Amounts in Millions, Except Ratios, or as Noted)

 

portion of its fees which totaled $30 million and $36 million in the second quarter and first half of 2009, respectively, in order to provide some return to clients.

Investment management and trust fees decreased by $29 million, or 31%, and $54 million, or 30%, in the second quarter and first half of 2009 compared to the same periods in 2008, respectively, primarily due to lower client asset balances participating in advisory and managed account services programs, as well as temporary fee waivers relating to these programs which totaled $14 million and $18 million in the second quarter and first half of 2009, respectively.

Net Interest Revenue

Net interest revenue is the difference between interest earned on interest-earning assets and interest paid on funding sources. Net interest revenue is affected by changes in the volume and mix of these assets and liabilities, as well as by fluctuations in interest rates and portfolio management strategies. The Company is positioned so that the consolidated balance sheet produces an increase in net interest revenue when interest rates rise and, conversely, a decrease in net interest revenue when interest rates fall (i.e., interest-earning assets generally reprice more quickly than interest-bearing liabilities). When interest rates fall, the Company attempts to mitigate some of this negative impact by extending the maturities of assets in investment portfolios to lock-in asset yields as well as by lowering rates paid to clients on interest-bearing liabilities. Since the Company establishes the rates paid on certain brokerage client cash balances and deposits from banking clients, as well as the rates charged on receivables from brokerage clients, and also controls the composition of its investment securities, it has some ability to manage its net interest spread. However, the spread is influenced by external factors such as the interest rate environment and competition. For discussion of the impact of current market conditions on net interest revenue, see “Current Market Environment.”

In clearing its clients’ trades, Charles Schwab & Co., Inc. (Schwab) holds cash balances payable to clients. In most cases, Schwab pays its clients interest on cash balances awaiting investment, and may invest these funds and earn interest revenue. Receivables from brokerage clients consist primarily of margin loans to brokerage clients. Margin loans are loans made by Schwab to clients on a secured basis to purchase securities. Pursuant to Securities and Exchange Commission (SEC) regulations, client cash balances that are not used for margin lending are generally segregated into investment accounts that are maintained for the exclusive benefit of clients.

The Company’s interest-earning assets are financed primarily by brokerage client cash balances and deposits from banking clients. Other funding sources include non-interest-bearing brokerage client cash balances and proceeds from stock-lending activities, as well as stockholders’ equity.

The amount of excess cash held in certain Schwab brokerage client accounts that is swept into deposit accounts at Charles Schwab Bank (Schwab Bank) has increased significantly since the program’s inception in 2003. Additionally, balances in Schwab Bank’s investor checking and investor savings deposit accounts have grown significantly since the products were introduced in 2005 and the beginning of 2009, respectively. Average interest-bearing deposits from banking clients increased $10.9 billion, or 59%, in the second quarter of 2009 and $10.4 billion, or 63%, in the first half of 2009, compared to the same periods in 2008. The average balance of securities available for sale increased $6.2 billion, or 57%, in the second quarter of 2009 and $6.8 billion, or 72%, in the first half of 2009, while the average balance of loans to banking clients increased $1.9 billion, or 43%, and $2.2 billion, or 54%, in the same periods.

 

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Table of Contents

THE CHARLES SCHWAB CORPORATION

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

(Tabular Amounts in Millions, Except Ratios, or as Noted)

 

The following table presents net interest revenue information corresponding to interest-earning assets and funding sources on the condensed consolidated balance sheet:

 

Three Months Ended June 30,    2009     2008  
     Average
Balance
   Interest
Revenue/
Expense
   Average
Yield/

Rate
    Average
Balance
   Interest
Revenue/
Expense
   Average
Yield/

Rate
 

Interest-earning assets:

                

Cash and cash equivalents

   $ 8,462    $ 10    0.47   $ 4,935    $ 32    2.61

Cash and investments segregated

     16,287      22    0.54     10,247      68    2.67

Broker-related receivables (1)

     329         0.17     510      2    1.58

Receivables from brokerage clients

     6,262      82    5.25     11,709      168    5.77

Securities available for sale (2)

     17,056      128    3.01     10,860      116    4.30

Securities held to maturity

     986      10    4.07               

Loans to banking clients

     6,470      59    3.66     4,535      54    4.79

Loans held for sale

     148      2    5.42     89      1    4.52
                                        

Total interest-earning assets

     56,000      313    2.24     42,885      441    4.14
                                        

Other interest revenue

        48           37   
                        

Total interest-earning assets

   $     56,000    $          361              2.58   $     42,885    $          478              4.48
                                        

Funding sources:

                

Deposits from banking clients

   $ 29,423    $ 26    0.35   $ 18,507    $ 21    0.46

Payables to brokerage clients

     17,459      1    0.02     15,031      9    0.24

Short-term borrowings (3)

                    95         2.17

Long-term debt

     1,028      15    5.85     894      15    6.75
                                        

Total interest-bearing liabilities

     47,910      42    0.35     34,527      45    0.52
                                        

Non-interest-bearing funding sources

     8,090           8,358      

Provision for credit losses

        17           4   

Other interest expense

                  2   
                        

Total funding sources

   $ 56,000    $ 59    0.42   $ 42,885    $ 51    0.48
                                        

Net interest revenue

      $ 302    2.16      $ 427    4.00
                                

 

(1)

Includes receivables from brokers, dealers, and clearing organizations. Interest revenue on broker-related receivables was less than $500,000 in the second quarter of 2009.

 

(2 )

Amounts have been calculated based on amortized cost.

 

( 3)

Interest expense on short-term borrowings was less than $500,000 in the second quarter of 2008.

 

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Table of Contents

THE CHARLES SCHWAB CORPORATION

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

(Tabular Amounts in Millions, Except Ratios, or as Noted)

 

The following table presents net interest revenue information corresponding to interest-earning assets and funding sources on the condensed consolidated balance sheet:

 

Six Months Ended June 30,    2009     2008  
     Average
Balance
   Interest
Revenue/
Expense
   Average
Yield/

Rate
    Average
Balance
   Interest
Revenue/
Expense
   Average
Yield/

Rate
 

Interest-earning assets:

                

Cash and cash equivalents

   $ 6,996    $ 20    0.58   $ 5,048    $ 81    3.23

Cash and investments segregated

     15,424      51    0.67     10,271      167    3.27

Broker-related receivables (1)

     341         0.27     534      6    2.26

Receivables from brokerage clients

     6,178      165    5.39     11,456      349    6.13

Securities available for sale (2)

     16,368      262    3.23     9,537      215    4.53

Securities held to maturity

     716      15    4.22               

Loans to banking clients

     6,346      116    3.69     4,116      102    4.98

Loans held for sale

     147      4    5.49     85      2    4.73
                                        

Total interest-earning assets

     52,516      633    2.43     41,047      922    4.52
                                        

Other interest revenue

        74           66   
                        

Total interest-earning assets

   $     52,516    $          707              2.71   $     41,047    $          988              4.84
                                        

Funding sources:

                

Deposits from banking clients

   $ 26,994    $ 41    0.31   $ 16,570    $ 57    0.69

Payables to brokerage clients

     16,843      2    0.02     15,174      44    0.58

Short-term borrowings (3)

                    48         2.17

Long-term debt

     932      29    6.27     898      30    6.72
                                        

Total interest-bearing liabilities

     44,769      72    0.32     32,690      131    0.81
                                        

Non-interest-bearing funding sources

     7,747           8,357      

Provision for credit losses

        26           6   

Other interest expense

        1           5   
                        

Total funding sources

   $ 52,516    $ 99    0.38   $ 41,047    $ 142    0.70
                                        

Net interest revenue

      $ 608    2.33      $ 846    4.14
                                

 

(1)

Includes receivables from brokers, dealers, and clearing organizations. Interest revenue on broker-related receivables was less than $500,000 in the first half of 2009.

 

(2 )

Amounts have been calculated based on amortized cost.

 

(3 )

Interest expense on short-term borrowings was less than $500,000 in the first half of 2008.

Net interest revenue decreased in the second quarter and first half of 2009 compared to the same periods in 2008, due to the impact of a decrease in the average net interest yield in the current periods. As a result of the low interest rate environment in the second quarter and first half of 2009, the Company experienced declines in the yields of almost all interest-earning assets compared to the second quarter and first half of 2008. The average rates on deposits to banking clients and payables to brokerage clients were reduced in the second quarter and first half of 2009 compared to the second quarter and first half of 2008.

Trading Revenue

Trading revenue includes commission and principal transaction revenues. Commission revenues are affected by the number of revenue trades executed and the average revenue earned per revenue trade. Principal transaction revenues are primarily comprised of revenues from client fixed income securities trading activity. Factors that influence principal transaction revenues include the volume of client trades, market price volatility, and competitive pressures.

Trading revenue increased by $42 million, or 18%, and $55 million, or 12%, in the second quarter and first half of 2009 compared to the same periods in 2008, respectively, due to higher daily average revenue trades and higher investment gains, offset by lower average revenue earned per revenue trade.

 

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Table of Contents

THE CHARLES SCHWAB CORPORATION

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

(Tabular Amounts in Millions, Except Ratios, or as Noted)

 

As shown in the following table, daily average revenue trades increased 18% and 14% in the second quarter and first half of 2009, respectively. The increase in daily average revenue trades was due to higher volumes of equity, principal transaction, and mutual fund trades, offset by a lower volume of option trades. Average revenue earned per revenue trade decreased 4% and 3% in the second quarter and first half of 2009, respectively, primarily due to lower average revenue earned per revenue trade for principal transactions and mutual funds.

 

     Three Months
Ended
June 30,
   Percent     Six Months
Ended
June 30,
   Percent  
     2009    2008    Change     2009    2008    Change  

Daily average revenue trades (in thousands) (1)

     301.2      254.7    18     302.1      264.4    14

Number of trading days

     63.0      64.0    (2 %)      124.0      125.0    (1 %) 

Average revenue earned per revenue trade

   $     13.84    $     14.38                (4 %)    $     13.95    $     14.42                (3 %) 

 

(1)

Includes all client trades that generate trading revenue (i.e., commission revenue or revenue from fixed income securities trading).

Other Revenue

Other revenue includes gains on repurchases of long-term debt, gains and losses on sales of loans held for sale, service fees, and software maintenance fees. Other revenue increased by $34 million, or 55%, in the first half of 2009 from the first half of 2008 primarily due to the recognition of a gain on the repurchase of a portion of the Company’s long-term debt in the first quarter of 2009. The Company repurchased $64 million of trust preferred securities related to its Junior Subordinated Notes for a cash payment of $38 million in the first quarter of 2009. The repurchase of the trust preferred securities was accounted for as an extinguishment of a portion of the Junior Subordinated Notes and resulted in a gain of $26 million.

Net Impairment Losses on Securities

The Company recorded net impairment charges of $13 million and $27 million related to certain non-agency residential mortgage-backed securities in the second quarter and first half of 2009, respectively, due to credit deterioration of the securities’ underlying collateral. See note “3 – Securities Available for Sale and Securities Held to Maturity” for further discussion.

 

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Table of Contents

THE CHARLES SCHWAB CORPORATION

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

(Tabular Amounts in Millions, Except Ratios, or as Noted)

 

Expenses Excluding Interest

As shown in the table below, expenses excluding interest decreased in the second quarter and first half of 2009 compared to the same periods in 2008, due to decreases in compensation and benefits expense, professional services expense, and advertising and market development expense, partially offset by increases in occupancy and equipment expense and other expense.

 

     Three Months
Ended
June 30,
    Percent     Six Months
Ended
June 30,
    Percent  
     2009     2008     Change     2009     2008     Change  

Compensation and benefits

   $ 377      $ 438      (14 %)    $ 802      $ 875      (8 %) 

Professional services

     64        84      (24 %)      124        168      (26 %) 

Occupancy and equipment

     97        72      35     178        146      22

Advertising and market development

     49        58      (16 %)      107        134      (20 %) 

Communications

     54        52      4     107        104      3

Depreciation and amortization

     41        37      11     83        75      11

Other

     68        53      28     105        91      15
                                            

Total expenses excluding interest

   $        750      $        794                  (6 %)    $     1,506      $     1,593                  (5 %) 
                                            

Expenses as a percentage of total net revenues:

            

Total expenses excluding interest

     69     61       69     61  

Advertising and market development

     5     4       5     5  

Compensation and Benefits

Compensation and benefits expense includes salaries and wages, incentive compensation, and related employee benefits and taxes. Incentive compensation is based on the achievement of specified performance objectives, including revenue growth and profit margin, and therefore will fluctuate with these measures.

 

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Table of Contents

THE CHARLES SCHWAB CORPORATION

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

(Tabular Amounts in Millions, Except Ratios, or as Noted)

 

Compensation and benefits expense decreased by $61 million, or 14%, and $73 million, or 8%, in the second quarter and first half of 2009 compared to the same periods in 2008, respectively, due to decreases in incentive compensation and salaries and wages expense. The following table shows a comparison of certain compensation and benefits components and employee data:

 

     Three Months
Ended

June 30,
    Percent     Six Months
Ended
June 30,
    Percent  
     2009     2008     Change     2009     2008     Change  

Salaries and wages

   $ 226      $ 255      (11 %)    $ 499      $ 505      (1 %) 

Incentive compensation (1)

     85        117      (27 %)      170        233      (27 %) 

Employee benefits and other

     66        66             133        137      (3 %) 
                                            

Total compensation and benefits expense

   $     377      $     438             (14 %)    $     802      $     875               (8 %) 
                                            

Compensation and benefits expense as a percentage of total net revenues:

            

Salaries and wages

     21     19       23     19  

Incentive compensation

     8     9       8     9  

Employee benefits and other

     6     5       6     5  
                                    

Total compensation and benefits expense

     35     33       37     33  
                                    

Full-time equivalent employees (in thousands) (2)

            

At quarter end

     12.1        13.4      (10 %)       

Average

     12.2        13.4      (9 %)      12.5        13.4      (7 %) 

 

(1)

Includes incentives, discretionary bonus costs, stock-based compensation, and employee stock purchase plan expense.

 

(2)

Includes full-time, part-time and temporary employees, and persons employed on a contract basis, and excludes employees of outsourced service providers.

Salaries and wages decreased in the second quarter and first half of 2009 compared to the same periods in 2008 primarily due to lower expense as a result of decreases in full-time employees and persons employed on a contract basis. The decrease in salaries and wages in the first half of 2009 was offset by severance expense of $56 million relating to the Company’s cost reduction measures.

Incentive compensation decreased in the second quarter and first half of 2009 compared to the same periods in 2008 primarily due to lower discretionary bonus costs and variable compensation based on actual performance in the second quarter and first half of 2009. In addition, incentive compensation in the second quarter and first half of 2008 included long-term incentive plan compensation. The last performance period under the Company’s long-term incentive program ended on December 31, 2008.

Expenses Excluding Compensation and Benefits

Professional services expense decreased in the second quarter and first half of 2009 compared to the same periods in 2008 primarily due to a decrease in fees paid to outsourced service providers and consultants.

Occupancy and equipment expense in the second quarter and first half of 2009 included facilities charges of $28 million and $43 million, respectively, relating to the Company’s cost reduction measures.

Advertising and market development expense decreased in the second quarter and first half of 2009 compared to the same periods in 2008 due to lower media spending relating to the Company’s “Talk to Chuck TM” national advertising campaign. Media spending decreased by $7 million and $17 million and marketing expense decreased by $2 million and $10 million in the second quarter and first half of 2009, respectively.

Other expense increased primarily due to a $16 million FDIC special industry assessment and higher FDIC insurance premiums in the second quarter of 2009, partially offset by a decrease in employee travel expenses. Other expense in the second quarter and first half of 2009 also included charges of $2 million and $21 million, respectively, for individual client

 

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Table of Contents

THE CHARLES SCHWAB CORPORATION

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

(Tabular Amounts in Millions, Except Ratios, or as Noted)

 

complaints and arbitration claims relating to Schwab YieldPlus Fund® investments. These expenses were offset by $4 million and $34 million of insurance recoveries, resulting in a net credit of $2 million and $13 million for the second quarter and first half of 2009, respectively.

Taxes on Income

The Company’s effective income tax rate on income from continuing operations before taxes was 38.8% and 39.1% for the second quarters of 2009 and 2008, respectively. The Company’s effective income tax rate on income from continuing operations before taxes was 38.7% and 39.5% for the first half of 2009 and 2008, respectively. The decrease in the second quarter and first half of 2009 was primarily due to lower effective state income tax rates.

Segment Information

The Company provides financial services to individuals and institutional clients through two segments – Investor Services and Institutional Services. As a result of organizational and related business changes in the first quarter of 2009, the segments formerly reported as Advisor Services and Corporate and Retirement Services have been combined into a single segment called Institutional Services. Previously reported segment information has been revised to reflect this change. The Investor Services segment includes the Company’s retail brokerage and banking operations. The Institutional Services segment provides custodial, trading, and support services to independent investment advisors, as well as retirement plan services, plan administrator services, stock plan services, and mutual fund clearing services. In addition, the Institutional Services segment supports the availability of Schwab proprietary mutual funds on third-party platforms. The Company evaluates the performance of its segments on a pre-tax basis excluding items such as impairment charges on non-financial assets, discontinued operations, extraordinary items, and other significant restructuring charges.

Financial information for the Company’s reportable segments is presented in the following table:

 

     Three Months
Ended
June 30,
   Percent     Six Months
Ended
June 30,
   Percent  
     2009     2008    Change     2009     2008    Change  

Investor Services:

              

Net revenues

   $ 705      $ 873    (19 %)    $ 1,411      $ 1,737    (19 %) 

Expenses excluding interest

     489        541    (10 %)      953        1,083    (12 %) 
                                          

Contribution margin

   $ 216      $ 332    (35 %)    $ 458      $ 654    (30 %) 
                                          

Institutional Services:

              

Net revenues

   $ 380      $ 432    (12 %)    $ 785      $ 871    (10 %) 

Expenses excluding interest

     234        252    (7 %)      467        504    (7 %) 
                                          

Contribution margin

   $ 146      $ 180    (19 %)    $ 318      $ 367    (13 %) 
                                          

Unallocated:

              

Net revenues

   $      $ 3    N/M      $      $ 7    N/M   

Expenses excluding interest

     27        1    N/M        86        6    N/M   
                                          

Contribution margin

   $ (27   $ 2            N/M      $ (86   $ 1            N/M   
                                          

Total:

              

Net revenues

   $     1,085      $     1,308    (17 %)    $     2,196      $     2,615    (16 %) 

Expenses excluding interest

     750        794    (6 %)      1,506        1,593    (5 %) 
                                          

Contribution margin

   $ 335      $ 514    (35 %)    $ 690      $ 1,022    (32 %) 
                                          

 

N/M Not meaningful.

Investor Services

Net revenues decreased by $168 million, or 19%, and $326 million, or 19%, in the second quarter and first half of 2009 compared to the same periods in 2008, respectively, due to decreases in asset management and administration fees and net interest revenue, offset by increases in trading revenue and other revenue. Asset management and administration fees

 

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Table of Contents

THE CHARLES SCHWAB CORPORATION

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

(Tabular Amounts in Millions, Except Ratios, or as Noted)

 

decreased as a result of lower equity valuations of client assets and an increase in money market mutual fund waivers due to the low interest rate environment. Net interest revenue decreased primarily due to the impact of a decrease in the average net yield earned on interest-earning assets as a result of the low interest rate environment. Trading revenue increased due to higher daily average revenue trades, partially offset by lower average revenue earned per revenue trade. Other revenue increased due to the recognition of a gain on the repurchase of a portion of the Company’s long-term debt in the first quarter of 2009, offset by net impairment charges on investments in the Company’s securities available for sale portfolio. Expenses excluding interest decreased by $52 million, or 10%, and $130 million, or 12%, in the second quarter and first half of 2009 compared to the same periods in 2008, respectively, primarily due to lower compensation and benefits, professional services, and advertising and market development expenses, offset by an FDIC special industry assessment in the second quarter of 2009. Expenses excluding interest in the second quarter and first half of 2009 were also reduced by a net credit resulting from recording insurance recoveries of charges for individual client complaints and arbitration claims relating to Schwab YieldPlus Fund® investments.

Institutional Services

Net revenues decreased by $52 million, or 12%, and $86 million, or 10%, in the second quarter and first half of 2009 compared to the same periods in 2008, respectively, due to decreases in asset management and administration fees and net interest revenue, partially offset by an increase in trading revenue. Asset management and administration fees decreased as a result of lower equity valuations of client assets. Net interest revenue decreased primarily due to the impact of a decrease in the average net yield earned on interest-earning assets as a result of the low interest rate environment. Trading revenue increased due to higher daily average revenue trades, partially offset by lower average revenue earned per revenue trade. Net revenues in the first half of 2009 included the recognition of a gain on the repurchase of a portion of the Company’s long-term debt in the first quarter of 2009. Expenses excluding interest decreased by $18 million, or 7%, and $37 million, or 7%, in the second quarter and first half of 2009 compared to the same periods in 2008, respectively, primarily due to lower compensation and benefits and professional services expenses, offset by an FDIC special industry assessment in the second quarter of 2009.

Unallocated

Expenses excluding interest in the second quarter and first half of 2009 include facilities and severance charges relating to the Company’s cost reduction measures.

LIQUIDITY AND CAPITAL RESOURCES

CSC conducts substantially all of its business through its wholly-owned subsidiaries. The capital structure among CSC and its subsidiaries is designed to provide each entity with capital and liquidity to meet its operational needs and regulatory requirements.

CSC is a savings and loan holding company and Schwab Bank, CSC’s depository institution, is a federal savings bank. CSC and Schwab Bank are both subject to supervision and regulation by the Office of Thrift Supervision.

Liquidity

CSC

As a savings and loan holding company, CSC is not subject to specific statutory capital requirements. However, CSC is required to maintain capital that is sufficient to support the holding company and its subsidiaries’ business activities, and the risks inherent in those activities. To manage capital adequacy, CSC currently utilizes a target Tier 1 Leverage Ratio, as defined by the Board of Governors of the Federal Reserve System, of at least 6%. At June 30, 2009, CSC’s Tier 1 Leverage Ratio was 7.9%.

CSC’s liquidity needs are generally met through cash generated by its subsidiaries, as well as cash provided by external financing. CSC maintains excess liquidity in the form of overnight cash deposits and short-term investments to cover daily funding needs and to support growth in the Company’s business. Generally, CSC does not hold liquidity at its subsidiaries in excess of amounts deemed sufficient to support the subsidiaries’ operations, including any regulatory capital requirements.

 

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THE CHARLES SCHWAB CORPORATION

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

(Tabular Amounts in Millions, Except Ratios, or as Noted)

 

Schwab and Schwab Bank are subject to regulatory requirements that may restrict them from certain transactions with CSC. Management believes that funds generated by the operations of CSC’s subsidiaries will continue to be the primary funding source in meeting CSC’s liquidity needs, providing adequate liquidity to meet Schwab Bank’s capital guidelines, and maintaining Schwab’s net capital.

CSC has liquidity needs that arise from its Senior Medium-Term Notes, Series A (Medium-Term Notes), Junior Subordinated Notes, and Senior Notes, as well as from the funding of cash dividends, acquisitions, and other investments. The Medium-Term Notes, of which $458 million was outstanding at June 30, 2009, have maturities ranging from 2009 to 2017 and fixed interest rates ranging from 6.375% to 8.05% with interest payable semiannually. The Medium-Term Notes are rated A2 by Moody’s Investors Service (Moody’s), A by Standard & Poor’s Ratings Group (S&P), and A by Fitch Ratings, Ltd. (Fitch). At June 30, 2009, $236 million of Junior Subordinated Notes were outstanding and have a fixed interest rate of 7.50% until 2017 and a floating rate thereafter. The Junior Subordinated Notes are not rated, however the trust preferred securities related to these notes are rated A3 by Moody’s, BBB+ by S&P, and A- by Fitch. In the first quarter of 2009, CSC repurchased $64 million of trust preferred securities related to its Junior Subordinated Notes for a cash payment of $38 million. The repurchase of the trust preferred securities was accounted for as an extinguishment of a portion of the Junior Subordinated Notes and resulted in a gain of $26 million.

CSC has a universal automatic shelf registration statement on file with the SEC which enables CSC to issue debt, equity and other securities. In June 2009, the Company issued $750 million of Senior Notes that mature in 2014 under this registration statement. The Senior Notes have a fixed interest rate of 4.950% with interest payable semiannually. The Senior Notes are rated A2 by Moody’s, A by S&P, and A by Fitch.

CSC has authorization from its Board of Directors to issue unsecured commercial paper notes (Commercial Paper Notes) not to exceed $1.5 billion. Management has set a current limit for the commercial paper program of $800 million. The maturities of the Commercial Paper Notes may vary, but are not to exceed 270 days from the date of issue. The commercial paper is not redeemable prior to maturity and is not subject to voluntary prepayment. The proceeds of the commercial paper program are to be used for general corporate purposes. There were no Commercial Paper Notes outstanding at June 30, 2009. CSC’s ratings for these short-term borrowings are P-1 by Moody’s, A-1 by S&P, and F1 by Fitch.

CSC maintains an $800 million committed, unsecured credit facility with a group of 12 banks which is scheduled to expire in June 2010. This facility replaced a similar facility that expired in June 2009. These facilities were unused during the first half of 2009. The funds under this facility are available for general corporate purposes, including repayment of the Commercial Paper Notes discussed above. If any Commercial Paper Notes are outstanding, the amount of this facility that CSC could use for other general corporate purposes will be reduced. The financial covenants under this facility require Schwab to maintain a minimum net capital ratio, as defined, Schwab Bank to be well capitalized, as defined, and CSC to maintain a minimum level of stockholders’ equity. At June 30, 2009, the minimum level of stockholders’ equity required under this facility was $3.1 billion. Management believes that these restrictions will not have a material effect on CSC’s ability to meet foreseeable dividend or funding requirements.

CSC also has direct access to $689 million of the $739 million uncommitted, unsecured bank credit lines discussed below, that are primarily utilized by Schwab to manage short-term liquidity. These lines were not used by CSC during the second quarter of 2009.

In addition, Schwab provides CSC with a $1.0 billion credit facility maturing in December 2009. No funds were drawn under this facility at June 30, 2009.

Schwab

Schwab is subject to regulatory requirements that are intended to ensure the general financial soundness and liquidity of broker-dealers. These regulations prohibit Schwab from repaying subordinated borrowings to CSC, paying cash dividends, or making 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 requirement of $250,000. At June 30, 2009, Schwab’s net capital was $1.1 billion (13% of aggregate debit balances), which was $909 million in excess of its minimum required net capital and $654 million in excess of 5% of aggregate debit balances.

 

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Table of Contents

THE CHARLES SCHWAB CORPORATION

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

(Tabular Amounts in Millions, Except Ratios, or as Noted)

 

Most of Schwab’s assets are readily convertible to cash, consisting primarily of short-term (i.e., less than 150 days) investment-grade, interest-earning investments (the majority of which are segregated for the exclusive benefit of clients pursuant to regulatory requirements), receivables from brokerage clients, and receivables from brokers, dealers, and clearing organizations. Client margin loans are demand loan obligations secured by readily marketable securities. Receivables from and payables to brokers, dealers, and clearing organizations primarily represent current open transactions, which usually settle, or can be closed out, within a few business days.

Liquidity needs relating to client trading and margin borrowing activities are met primarily through cash balances in brokerage client accounts, which were $20.8 billion and $19.2 billion at June 30, 2009 and December 31, 2008, respectively. Management believes that brokerage client cash balances and operating earnings will continue to be the primary sources of liquidity for Schwab in the future.

Schwab has a finance lease obligation related to an office building and land under a 20-year lease. The remaining finance lease obligation of $114 million at June 30, 2009, is being reduced by a portion of the lease payments over the remaining lease term of approximately 15 years.

To manage short-term liquidity, Schwab maintains uncommitted, unsecured bank credit lines with a group of five banks totaling $739 million at June 30, 2009. The need for short-term borrowings arises primarily from timing differences between cash flow requirements, scheduled liquidation of interest-earning investments, and movements of cash to meet segregation requirements. Schwab used such borrowings for three days during the first half of 2009, with daily amounts borrowed averaging $12 million. There were no borrowings outstanding under these lines at June 30, 2009.

To satisfy the margin requirement of client option transactions with the Options Clearing Corporation (OCC), Schwab has unsecured standby letter of credit agreements (LOCs) with six banks in favor of the OCC aggregating $445 million at June 30, 2009. In connection with its securities lending activities, Schwab is required to provide collateral to certain brokerage clients. Schwab satisfies the collateral requirements by arranging LOCs, in favor of these brokerage clients, which are issued by multiple banks. At June 30, 2009, the aggregate face amount of these LOCs totaled $52 million. There were no funds drawn under any of these LOCs during the first half of 2009.

To manage Schwab’s regulatory capital requirement, CSC provides Schwab with a $1.4 billion subordinated revolving credit facility which is scheduled to expire in March 2010. The amount outstanding under this facility at June 30, 2009, was $220 million. Borrowings under this subordinated lending arrangement qualify as regulatory capital for Schwab.

In addition, CSC provides Schwab with a $1.5 billion credit facility which is scheduled to expire in 2011. Borrowings under this facility do not qualify as regulatory capital for Schwab. There were no funds drawn under this facility at June 30, 2009.

 

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Table of Contents

THE CHARLES SCHWAB CORPORATION

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

(Tabular Amounts in Millions, Except Ratios, or as Noted)

 

Schwab Bank

Schwab Bank is required to maintain a capital level that at least equals minimum capital levels specified in federal banking laws and regulations. Failure to meet the minimum levels will result in certain mandatory, and possibly additional discretionary, actions by the regulators that, if undertaken, could have a direct material effect on Schwab Bank. Based on its regulatory capital ratios at June 30, 2009, Schwab Bank is considered well capitalized. Schwab Bank’s regulatory capital and ratios are as follows:

 

     Actual     Minimum Capital
Requirement
    Minimum to be
Well Capitalized
 

June 30, 2009

   Amount    Ratio     Amount    Ratio     Amount    Ratio  

Tier 1 Capital

   $ 2,339            16.8   $ 555              4.0   $ 833    6.0

Total Capital

   $     2,381    17.2   $     1,111    8.0   $     1,388            10.0

Leverage

   $ 2,339    6.8   $ 1,380    4.0   $ 1,725    5.0

Tangible Equity

   $ 2,339    6.8   $ 690    2.0     N/A   

 

N/A Not applicable.

Schwab Bank’s current liquidity needs are generally met through deposits from banking clients and equity capital.

The excess cash held in certain Schwab brokerage client accounts is swept into deposit accounts at Schwab Bank. At June 30, 2009, these balances totaled $20.6 billion.

Additionally, Schwab Bank has access to traditional funding sources such as deposits, federal funds purchased, and repurchase agreements. Schwab Bank has access to short-term funding through the Federal Reserve Bank (FRB) discount window. Amounts available under the FRB discount window are dependent on the amount of certain of Schwab Bank’s securities available for sale and securities held to maturity that are pledged as collateral. At June 30, 2009, $1.0 billion was available under this arrangement. There were no funds drawn under this arrangement during the first half of 2009.

Schwab Bank maintains a credit facility with the Federal Home Loan Bank System (FHLB). Amounts available under this facility are dependent on the amount of Schwab Bank’s home equity lines of credit that are pledged as collateral. At June 30, 2009, $565 million was available under this facility. There were no funds drawn under this facility during the first half of 2009.

CSC provides Schwab Bank with a $100 million short-term credit facility which is scheduled to expire in December 2009. Borrowings under this facility do not qualify as regulatory capital for Schwab Bank. There were no funds drawn under this facility during the first half of 2009.

Capital Resources

The Company monitors both the relative composition and absolute level of its capital structure. Management is focused on limiting the Company’s use of capital and currently targets a long-term debt to total financial capital ratio of less than 30%. The Company’s total financial capital (long-term debt plus stockholders’ equity) at June 30, 2009, was $6.2 billion, up $1.2 billion, or 25%, from December 31, 2008.

At June 30, 2009, the Company had long-term debt of $1.6 billion, or 25% of total financial capital, that bears interest at a weighted-average rate of 6.01%. At December 31, 2008, the Company had long-term debt of $883 million, or 18% of total financial capital. In June 2009, the Company issued $750 million of Senior Notes that mature in 2014 and have a fixed interest rate of 4.950%. The Company repaid $2 million of long-term debt in the first half of 2009. In addition, the Company repurchased $64 million of trust preferred securities related to its Junior Subordinated Notes for a cash payment of $38 million in the first quarter of 2009. The repurchase of the trust preferred securities was accounted for as an extinguishment of a portion of the Junior Subordinated Notes and resulted in a gain of $26 million.

 

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Table of Contents

THE CHARLES SCHWAB CORPORATION

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

(Tabular Amounts in Millions, Except Ratios, or as Noted)

 

The Company’s cash position (reported as cash and cash equivalents on its condensed consolidated balance sheet) and cash flows are affected by changes in brokerage client cash balances and the associated amounts required to be segregated under regulatory guidelines. Timing differences between cash and investments actually segregated on a given date and the amount required to be segregated for that date may arise in the ordinary course of business and are addressed by the Company in accordance with applicable regulations. Other factors which affect the Company’s cash position and cash flows include investment activity in securities, levels of capital expenditures, acquisition and divestiture activity, banking client deposit activity, brokerage and banking client loan activity, financing activity in long-term debt, payments of dividends, and repurchases of CSC’s common stock. The combination of these factors can cause significant fluctuations in the levels of cash and cash equivalents during specific time periods.

Capital Expenditures

The Company’s capital expenditures were $72 million and $81 million in the first halves of 2009 and 2008, respectively. Capital expenditures in the first half of 2009 were primarily for leasehold improvements, equipment relating to the Company’s information technology systems, and building improvements. Capital expenditures in the first half of 2008 were primarily for software and equipment relating to the Company’s information technology systems. Capital expenditures include capitalized costs for developing internal-use software of $9 million in the first half of 2009 and $25 million in the first half of 2008.

Dividends

CSC paid common stock cash dividends of $139 million and $115 million in the first halves of 2009 and 2008, respectively.

Share Repurchases

There were no share repurchases of CSC’s common stock in the first half of 2009. CSC repurchased 17 million shares of its common stock for $350 million in the first half of 2008. As of June 30, 2009, CSC had remaining authority from the Board of Directors to repurchase up to $596 million of its common stock.

Off-Balance-Sheet Arrangements

The Company enters into various off-balance-sheet arrangements in the ordinary course of business, primarily to meet the needs of its clients. These arrangements include firm commitments to extend credit. Additionally, the Company enters into guarantees and other similar arrangements as part of transactions in the ordinary course of business. For discussion on the Company’s off-balance-sheet arrangements, see “Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Capital Resources” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2008, and note “6 – Commitments and Contingent Liabilities” in the Notes to Condensed Consolidated Financial Statements.

RISK MANAGEMENT

The Company’s business activities expose it to a variety of risks, including technology and operations risk, credit, market and liquidity risk, and legal and reputational risk. Identification and management of these risks are essential to the success and financial soundness of the Company.

Senior management takes an active role in the Company’s risk management process and has developed policies and procedures under which specific business and control units are responsible for identifying, measuring, and controlling various risks. Oversight of risk management has been delegated to the Global Risk Committee, which is comprised of senior managers of major business and control functions. The Global Risk Committee is responsible for reviewing and monitoring the Company’s risk exposures and leading the continued development of the Company’s risk management policies and practices.

 

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Table of Contents

THE CHARLES SCHWAB CORPORATION

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

(Tabular Amounts in Millions, Except Ratios, or as Noted)

 

Functional risk sub-committees focusing on specific areas of risk report into the Global Risk Committee. These sub-committees include the:

 

   

Corporate Asset-Liability Management and Pricing Committee, which focuses on the Company’s liquidity, capital resources, interest rate risk, and investments;

 

   

Credit and Market Risk Oversight Committee, which focuses on the credit exposures resulting from client activity (e.g., margin lending activities and loans to banking clients), the investing activities of certain of the Company’s proprietary funds, corporate credit activities (e.g., counterparty and corporate investing activities), and market risk resulting from the Company taking positions in certain securities to facilitate client trading activity;

 

   

Information Security and Privacy Steering Committee, which oversees information security and privacy programs and policies;

 

   

Investment Advisory and ERISA Committee, which oversees activities in which the Company and its principals operate in an investment advisory capacity or as an ERISA fiduciary; and

 

   

Investment Products Review Board, which provides senior level oversight of products and services made available to clients.

The Global Risk Committee reports regularly to the Audit Committee of the Board of Directors (Audit Committee), which reviews major risk exposures and the steps management has taken to monitor and control such exposures.

The Company’s Disclosure Committee is responsible for monitoring and evaluating the effectiveness of the Company’s (a) disclosure controls and procedures and (b) internal control over financial reporting as of the end of each fiscal quarter. The Disclosure Committee reports on this evaluation to the CEO and CFO prior to their certification required by Sections 302 and 906 of the Sarbanes Oxley Act of 2002.

Additionally, the Company’s compliance, finance, internal audit, legal, and risk and credit management departments assist management and the various risk committees in evaluating, testing, and monitoring the Company’s risk management.

Risk is inherent in the Company’s business. Consequently, despite the Company’s efforts to identify areas of risk and implement risk management policies and procedures, there can be no assurance that the Company will not suffer unexpected losses due to operating or other risks.

For a discussion on risks that the Company faces, see “Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations – Risk Management” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2008. For updated information on the Company’s credit risk and concentration risk exposures, see below. See “Item 3 – Quantitative and Qualitative Disclosures About Market Risk” for additional information relating to market risk.

Credit Risk Exposures

The Company has exposure to credit risk associated with the Company’s loans to banking clients. The Company’s loan portfolios primarily include first lien 3-, 5- and 7- year adjustable rate residential mortgage loans (First Mortgage portfolio) of $3.2 billion and home equity lines of credit (HELOC portfolio) of $3.1 billion at June 30, 2009.

The Company’s First Mortgage portfolio underwriting requirements are generally consistent with the underwriting requirements in the secondary market for loan portfolios. The Company’s guidelines include maximum loan-to-value (LTV) ratios, cash out limits, and minimum Fair Isaac & Company (FICO) credit scores. The specific guidelines are dependent on the individual characteristics of a loan (for example, whether the property is a primary or secondary residence, whether the loan is for investment property, whether the loan is for an initial purchase of a home or refinance of an existing home, and whether the loan is conforming or jumbo). These credit underwriting standards have limited the exposure to the types of loans that experienced high foreclosures and loss rates elsewhere in the industry during 2008 and the first half of 2009. There have been no significant changes to the LTV ratio or FICO credit score guidelines related to the Company’s First Mortgage or HELOC portfolios during the first half of 2009. At June 30, 2009, the weighted-average originated LTV ratios were 63% and 59% for the First Mortgage and HELOC portfolios, respectively, and the weighted-average originated FICO credit scores were 758 and 767 for the First Mortgage and HELOC portfolios, respectively.

 

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Table of Contents

THE CHARLES SCHWAB CORPORATION

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

(Tabular Amounts in Millions, Except Ratios, or as Noted)

 

The Company does not offer loans that allow for negative amortization and does not originate or purchase subprime loans (generally defined as extensions of credit to borrowers with a FICO credit score of less than 620 at origination), unless the borrower has compensating credit factors. At June 30, 2009, approximately 2% of both the First Mortgage and HELOC portfolios consisted of loans to borrowers with FICO credit scores of less than 620.

The following table presents certain of the Company’s loan quality metrics as a percentage of total outstanding loans:

 

     June 30,
2009
    December 31,
2008
 

Loan delinquencies (1)

                   0.64   0.54

Nonaccrual loans

   0.26   0.13

Allowance for credit losses

   0.62   0.33

 

(1)

Loan delinquencies are defined as loans that are 30 days or more past due.

The Company has exposure to credit risk associated with its securities available for sale and securities held to maturity portfolios which totaled $17.2 billion and $2.7 billion, respectively, at June 30, 2009. These portfolios include U.S. agency residential mortgage-backed securities, corporate debt securities, non-agency residential mortgage-backed securities, certificates of deposit, U.S. agency notes, asset-backed securities, and commercial paper. U.S. agency residential mortgage-backed securities do not have explicit credit ratings, however management considers these to be of the highest credit quality and rating given the guarantee of principal and interest by the U.S. agencies. Included in non-agency residential mortgage-backed securities are securities collateralized by loans that are considered to be “Prime” (defined by the Company as loans to borrowers with a FICO credit score of 620 or higher at origination), and “Alt-A” (defined by the Company as Prime loans with reduced documentation at origination).

 

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Table of Contents

THE CHARLES SCHWAB CORPORATION

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

(Tabular Amounts in Millions, Except Ratios, or as Noted)

 

The table below presents the credit ratings for U.S. agency and non-agency residential mortgage-backed securities available for sale and securities held to maturity, including Prime and Alt-A mortgage-backed securities, by year of origination. In some instances securities have divergent ratings from Moody’s, Fitch Ratings, or Standard and Poor’s. In these instances, the Company has used the lowest rating as of June 30, 2009, for purposes of presenting the table below. Residential mortgage-backed securities, particularly Alt-A securities, experienced deteriorating credit characteristics, including increased delinquencies and valuation pressure, in the first half of 2009. For a discussion of the impact of current market conditions on residential mortgage-backed securities, see “Current Market Environment.”

 

    AAA     AA to A     BBB     BB or Lower     Total  
    Amortized
Cost
    Net
Unrealized
Gain (Loss)
    Amortized
Cost
    Net
Unrealized
Loss
    Amortized
Cost
    Net
Unrealized
Loss
    Amortized
Cost
    Net
Unrealized
Loss
    Amortized
Cost
    Net
Unrealized
Gain (Loss)
 

U.S. agency residential mortgage-backed securities:

                   

2005

  $ 693      $ 2      $      $      $      $      $      $      $ 693      $ 2   

2006

    447        (4                                               447        (4

2007

    906        26                                                  906        26   

2008

    5,004        101                                                  5,004        101   

2009

    2,916        25                                                  2,916        25   
                                                                               

Total

    9,966        150                                                  9,966        150   
                                                                               

Non-agency residential mortgage-backed securities:

                   

2003

    98        (11     9        (1                                 107        (12

2004

    223        (24     41        (15     10        (5                   274        (44

2005

    205        (30     226        (68     229        (58     270        (86     930        (242

2006

    80        (25     90        (26     40        (9     583        (248     793        (308

2007

    160        (12     37        (7     34        (5     343        (109     574        (133
                                                                               

Total

    766        (102     403        (117     313        (77     1,196        (443     2,678        (739
                                                                               

Total residential mortgage-backed securities

  $ 10,732      $ 48      $ 403      $ (117   $ 313      $ (77   $ 1,196      $ (443   $ 12,644      $ (589
                                                                               

% of Total residential mortgage-backed securities

    85       3       3       9       100  
                                                 

At June 30, 2009, the corporate debt securities and non-mortgage asset-backed securities were rated investment grade (defined as a rating equivalent to a Moody’s rating of “Baa” or higher, or a Standard and Poor’s rating of “BBB-” or higher), except for one corporate debt security with an amortized cost and fair value of $25 million.

Concentration Risk Exposures

The Company has concentration risk exposure when holding large positions in financial instruments collateralized by assets with similar economic characteristics or in securities of a single issuer or industry.

The fair value of the Company’s investments in residential mortgage-backed securities totaled $12.0 billion at June 30, 2009. Of these, $10.1 billion were U.S. agency securities and $1.9 billion were non-agency securities. The U.S. agency securities are included in securities available for sale and securities held to maturity and the non-agency securities are included in securities available for sale. Included in non-agency residential mortgage-backed securities are securities collateralized by Alt-A loans. At June 30, 2009, the amortized cost and fair value of Alt-A mortgage-backed securities were $709 million and $382 million, respectively.

The Company’s investments in corporate debt securities and commercial paper totaled $5.7 billion at June 30, 2009, with the majority issued by institutions in the financial services industry. These securities are included in securities available for sale, securities held to maturity, cash and investments segregated and on deposit for regulatory purposes, cash and cash equivalents, and other securities owned in the Company’s condensed consolidated balance sheets. Included in corporate debt securities and commercial paper at June 30, 2009, were $3.1 billion of securities issued by financial institutions and guaranteed under the FDIC Temporary Liquidity Guarantee Program.

 

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Table of Contents

THE CHARLES SCHWAB CORPORATION

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

(Tabular Amounts in Millions, Except Ratios, or as Noted)

 

The Company’s loans to banking clients include $3.2 billion of first lien residential real estate mortgage loans at June 30, 2009. Approximately 80% of these mortgages consisted of loans with interest-only payment terms. The interest rates on approximately 75% of these interest-only loans are not scheduled to reset for three or more years. The Company’s interest-only loans do not include interest terms described as temporary introductory rates below current market rates. At June 30, 2009, 36% of the residential real estate mortgages and 47% of the home equity lines of credit balances were secured by properties which are located in California. The Company is also subject to concentration risk from its margin and securities lending activities collateralized by securities of a single issuer or industry.

The Company is subject to indirect exposure to U.S. Government and agency securities held as collateral to secure its resale agreements. The Company’s primary credit exposure on these resale transactions is with its counterparty. The Company would have exposure to the U.S. Government and agency securities only in the event of the counterparty’s default on the resale agreements. U.S. Government and agency securities held as collateral for resale agreements totaled $6.9 billion at June 30, 2009.

FAIR VALUE OF FINANCIAL INSTRUMENTS

The Company uses fair value measurements to record certain financial assets and liabilities at fair value in accordance with SFAS No. 157 – Fair Value Measurements (SFAS No. 157), and to determine fair value disclosures. At June 30, 2009, $24.0 billion, or 39% of total assets, were recorded at fair value. At December 31, 2008, $21.9 billion, or 42% of total assets, were recorded at fair value. All of these assets were measured at fair value using quoted prices or market-based information and accordingly were classified as Level 1 or Level 2 measurements in accordance with SFAS No. 157. Liabilities recorded at fair value were not material at June 30, 2009 or December 31, 2008. See note “7 – Fair Values of Assets and Liabilities” for more information on the Company’s assets and liabilities accounted for at fair value.

The Company uses prices obtained from an independent third-party pricing service to measure the fair value of certain investment securities. The Company validates prices received from the pricing service using various methods including comparison to prices received from additional pricing services, comparison to available quoted market prices, internal valuation models, and review of other relevant market data including implied yields of major categories of securities. The Company does not adjust the prices received from the independent third-party pricing service unless such prices are inconsistent with SFAS No. 157 and result in a material difference in the recorded amounts. At June 30, 2009 and December 31, 2008, the Company did not adjust prices received from the independent third-party pricing service.

CRITICAL ACCOUNTING ESTIMATES

Certain of the Company’s accounting policies that involve a higher degree of judgment and complexity are discussed in “Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations – Critical Accounting Estimates” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2008. Other than the change noted below, there have been no material changes to these critical accounting estimates during the first half of 2009.

The Company adopted FASB Staff Position (FSP) on Statement of Financial Accounting Standards (SFAS) No. 115-2 and SFAS No. 124-2 (FSP SFAS 115-2 and 124-2) – Recognition and Presentation of Other-Than-Temporary Impairments in the first quarter of 2009. As a result of the adoption, management has revised its process for the quarterly evaluation of other-than-temporary impairment on securities available for sale and securities held to maturity. Debt securities with unrealized losses are considered other-than-temporarily impaired (OTTI) if the Company intends to sell the security or if the Company will be required to sell such security prior to any anticipated recovery. If management determines that a security is OTTI under these circumstances, the impairment recognized in earnings is measured as the entire difference between the amortized cost and then-current fair value. A security is also OTTI if management does not expect to recover the amortized cost of the security. However, if the Company does not intend to sell the security and will not be required to sell the security, management utilizes cash flow models to estimate the expected future cash flow from the securities and to assess the probability that the Company will experience a loss. In this circumstance, the impairment recognized in earnings equals the estimated credit losses as measured by the difference between the present value of expected cash flows and the amortized cost of the security. Expected cash flows are discounted using the security’s effective interest rate.

 

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Table of Contents

THE CHARLES SCHWAB CORPORATION

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

(Tabular Amounts in Millions, Except Ratios, or as Noted)

 

The evaluation of whether the Company expects to recover the amortized cost of a security is inherently judgmental. The evaluation includes the assessment of several bond performance indicators including: the portion of the underlying loans that are delinquent (30 days, 60 days, 90+ days), in bankruptcy, in foreclosure or converted to real estate owned; the actual amount of loss incurred on the underlying loans in which the property was foreclosed and sold; the amount of credit support provided by the structure of the security available to absorb credit losses on the underlying loans; the current credit ratings issued by either Standard & Poor’s, Fitch Ratings, or Moody’s; the current price and magnitude of the unrealized loss; and whether the Company has received all scheduled principal and interest payments.

Management uses cash flow models to further assess the likelihood of other-than-temporary impairment for all Alt-A securities, as well as Prime securities with deteriorating bond performance indicators such as those described above. To develop the cash flow models, the Company uses forecasted loss severity, prepayment speeds (i.e. the rate at which the principal on underlying loans are paid down), and default rates over the securities’ remaining maturities. Forecasted home price fluctuations are an important variable in forecasting the expected loss severity and default rates. Based on these cash flow projections, management determines if the Company expects to recover all of the amortized cost of the securities and therefore if the securities are OTTI.

As disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2008, the Company’s annual goodwill impairment testing date is April 1. In testing for a potential impairment of goodwill on April 1, 2009, management estimated the fair value of each of the Company’s reporting units (generally defined as the Company’s businesses for which financial information is available and reviewed regularly by management) and compared this value to the carrying value of the reporting unit. The estimated fair value of each reporting unit was greater than its carrying value, and therefore management concluded that no amount of goodwill was impaired.

FORWARD-LOOKING STATEMENTS

In addition to historical information, this Quarterly Report on Form 10-Q contains “forward-looking statements” within the meaning of Section 27A of the Securities Act, and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements are identified by words such as “believe,” “anticipate,” “expect,” “intend,” “plan,” “will,” “may,” “estimate,” “aim,” “target,” “could”, and other similar expressions. In addition, any statements that refer to expectations, projections, or other characterizations of future events or circumstances are forward-looking statements.

These forward-looking statements, which reflect management’s beliefs, objectives, and expectations as of the date hereof, are necessarily estimates based on the best judgment of the Company’s senior management. These statements relate to, among other things:

 

   

the impact of current market conditions on the Company’s results of operations (see note “3 – Securities Available for Sale and Securities Held to Maturity” in the Notes to Condensed Consolidated Financial Statements and “Current Market Environment”);

 

   

the impact of changes in the likelihood of guarantee payment obligations (see note “6 – Commitments and Contingent Liabilities” in the Notes to Condensed Consolidated Financial Statements);

 

   

the impact of legal proceedings and regulatory matters (see note “6 – Commitments and Contingent Liabilities” in the Notes to Condensed Consolidated Financial Statements and “Part II – Other Information, Item 1 – Legal Proceedings”);

 

   

target capital ratios (see “Liquidity and Capital Resources”); and

 

   

sources of liquidity and capital (see “Liquidity and Capital Resources – Liquidity”).

Achievement of the expressed beliefs, objectives, and expectations described in these statements is subject to certain risks and uncertainties that could cause actual results to differ materially from the expressed beliefs, objectives, and expectations. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this Quarterly Report on Form 10-Q or, in the case of documents incorporated by reference, as of the date of those documents.

 

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

(Tabular Amounts in Millions, Except Ratios, or as Noted)

 

Important factors that may cause actual results to differ include, but are not limited to:

 

   

changes in general economic and financial market conditions;

 

   

the performance of securities available for sale;

 

   

fluctuations in client asset values due to changes in equity valuations;

 

   

the level of interest rates, including yields available on money market mutual fund eligible instruments;

 

   

the amount of loans to the Company’s brokerage and banking clients;

 

   

unanticipated adverse developments in litigation or regulatory matters;

 

   

the level of the Company’s stock repurchase activity;

 

   

the level of brokerage client cash balances and deposits from banking clients; and

 

   

the availability and terms of external financing.

Certain of these factors, as well as general risk factors affecting the Company, are discussed in greater detail in “Item 1A – Risk Factors” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2008.

 

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Item 3. Quantitative and Qualitative Disclosures About Market Risk

Market risk is the potential for changes in revenue or the value of financial instruments held by the Company as a result of fluctuations in interest rates, equity prices or market conditions.

For the Company’s market risk related to interest rates, a sensitivity analysis, referred to as a net interest revenue simulation model, is shown below. The Company is exposed to interest rate risk primarily from changes in the interest rates on its interest-earning assets relative to changes in the costs of its funding sources which finance these assets.

Net interest revenue is affected by various factors, such as the distribution and composition of interest-earning assets and interest-bearing liabilities, the spread between yields earned on interest-earning assets and rates paid on interest-bearing liabilities, which may re-price at different times or by different amounts, and the spread between short and long-term interest rates. Interest-earning assets include residential real estate loans and mortgage-backed securities. These assets are sensitive to changes in interest rates and to changes to prepayment levels, which tend to increase in a declining rate environment.

To mitigate the risk of loss, the Company has established policies and procedures which include setting guidelines on the amount of net interest revenue at risk, and monitoring the net interest margin and average maturity of its interest-earning assets and funding sources. To remain within these guidelines, the Company manages the maturity, repricing, and cash flow characteristics of the investment portfolios. Because the Company establishes the rates paid on certain brokerage client cash balances and deposits from banking clients, the rates charged on margin loans, and controls the composition of its investment securities, it has some ability to manage its net interest spread, depending on competitive factors and market conditions.

The Company is also subject to market risk as a result of fluctuations in equity prices. The Company’s direct holdings of equity securities and its associated exposure to equity prices are not material. The Company is indirectly exposed to equity market fluctuations in connection with securities collateralizing margin loans to brokerage customers, and customers securities loaned out as part of the Company’s securities lending activities. Equity market valuations may also affect the level of brokerage client trading activity, margin borrowing, and overall client engagement with the Company. Additionally, the Company earns mutual fund service fees and asset management fees based upon daily balances of certain client assets. Fluctuations in these client asset balances caused by changes in equity valuations directly impact the amount of fee revenue earned by the Company.

Financial instruments held by the Company are also subject to liquidity risk – that is, the risk that valuations will be negatively affected by changes in demand and the underlying market for a financial instrument. Recent conditions in the credit markets have significantly reduced market liquidity in a wide range of financial instruments, including the types of instruments held by the Company, and fair value can differ significantly from the value implied by the credit quality and actual performance of the instrument’s underlying cash flows.

Financial instruments held by the Company are also subject to valuation risk as a result of changes in valuations of the underlying collateral, such as housing prices in the case of residential real estate loans and mortgage-backed securities.

For discussion of the impact of current market conditions on asset management and administration fees, net interest revenue, and securities available for sale, see “Item 2 – Management’s Discussion and Analysis of Financial Condition and Results of Operations – Current Market Environment”.

The Company’s market risk related to financial instruments held for trading, interest rate swaps related to a portion of its fixed interest rate Medium-Term Notes, and forward sale and interest rate lock commitments related to its loans held for sale portfolio is not material.

Net Interest Revenue Simulation

The Company uses net interest revenue simulation modeling techniques to evaluate and manage the effect of changing interest rates. The simulation model (the model) includes all interest-sensitive assets and liabilities, as well as interest rate swap agreements utilized by the Company to hedge its interest rate risk. Key variables in the model include the repricing of

 

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financial instruments, prepayment and reinvestment assumptions, and product pricing assumptions. The Company uses constant balances and market rates in the model assumptions in order to minimize the number of variables and to better isolate risks. The simulations involve assumptions that are inherently uncertain and, as a result, cannot precisely estimate net interest revenue or precisely predict the impact of changes in interest rates on net interest revenue. Actual results may differ from simulated results due to balance growth or decline and the timing, magnitude, and frequency of interest rate changes, as well as changes in market conditions and management strategies, including changes in asset and liability mix.

As represented by the simulations presented below, the Company is positioned so that the consolidated balance sheet produces an increase in net interest revenue when interest rates rise and, conversely, a decrease in net interest revenue when interest rates fall (i.e., interest-earning assets generally reprice more quickly than interest-bearing liabilities).

The simulations in the following table assume that the asset and liability structure of the consolidated balance sheet would not be changed as a result of the simulated changes in interest rates. As the Company actively manages its consolidated balance sheet and interest rate exposure, in all likelihood the Company would take steps to manage any additional interest rate exposure that could result from changes in the interest rate environment. The following table shows the results of a gradual 100 basis point increase or decrease in market interest rates relative to the Company’s current market rates forecast on simulated net interest revenue over the next 12 months at June 30, 2009 and December 31, 2008. While the Company typically uses a gradual 200 basis point change, it revised the methodology at June 30, 2008, due to the current low levels of interest rates. The Company will use a gradual 100 basis point change until such time as the level of interest rates justifies a return to the previous methodology.

 

     June 30,
2009
    December 31,
2008
 

Increase of 100 basis points

               18.3   6.4

Decrease of 100 basis points

   (5.3 %)    (6.8 %) 

The sensitivities shown reflect the fact that the rates paid on the majority of brokerage client cash balances and banking deposits had reached minimal levels by the end of the first half of 2009. With liability costs essentially fixed, lower rates earned on interest-earning assets would have a negative impact on net interest revenue.

 

Item 4. Controls and Procedures

Evaluation of disclosure controls and procedures: The management of the Company, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company’s disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934) as of June 30, 2009. Based on this evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that the Company’s disclosure controls and procedures were effective as of June 30, 2009.

Changes in internal control over financial reporting: No change in the Company’s internal control over financial reporting (as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934) was identified during the quarter ended June 30, 2009, that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II - OTHER INFORMATION

 

Item 1. Legal Proceedings

For a discussion of legal proceedings, see note “6 – Commitments and Contingent Liabilities” in the Notes to Condensed Consolidated Financial Statements.

 

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Item 1A. Risk Factors

During the first half of 2009, there have been no material changes to the risk factors in “Item 1A – Risk Factors” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2008.

 

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

Issuer Purchases of Equity Securities

The following table summarizes purchases made by or on behalf of CSC of its common stock for each calendar month in the second quarter of 2009:

 

Month

   Total Number
of Shares
Purchased
    (in thousands)    
           Average           
Price Paid
per Share
   Total Number of
Shares Purchased
as Part of Publicly
Announced
Program (1)
     (in thousands)
    
   Approximate
Dollar Value of
Shares that May
Yet be Purchased
under the Program 
(in millions)

April:

           

Share repurchase program (1)

      $       $ 596

Employee transactions (2)

   12    $ 17.34    N/A      N/A

May:

           

Share repurchase program (1)

      $       $ 596

Employee transactions (2)

   4    $ 18.07    N/A      N/A

June:

           

Share repurchase program (1)

      $       $ 596

Employee transactions (2)

   2    $ 18.25    N/A      N/A
                       

Total:

           

Share repurchase program (1)

      $       $ 596

Employee transactions (2)

   18    $ 17.61    N/A      N/A
                       

 

N/A Not applicable.

 

(1)

There were no share repurchases under the Share Repurchase Program during the second quarter. Repurchases under this program are under authorizations by CSC’s Board of Directors covering up to $500 million and $500 million of common stock publicly announced by the Company on April 25, 2007 and March 13, 2008, respectively. The remaining authorizations do not have an expiration date.

 

(2)

Includes restricted shares withheld (under the terms of grants under employee stock incentive plans) to offset tax withholding obligations that occur upon vesting and release of restricted shares. The Company may receive shares to pay the exercise price and/or to satisfy tax withholding obligations by employees who exercise stock options (granted under employee stock incentive plans), which are commonly referred to as stock swap exercises.

 

Item 3. Defaults Upon Senior Securities

None.

 

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

The Annual Meeting of Stockholders of CSC was held on May 14, 2009. There were a total of 1,158,323,238 shares entitled to vote at the Annual Meeting, and a total of 1,060,482,089 shares were present in person or by proxy at the Annual Meeting. The voting results are provided below:

 

               Shares
For
   Shares
Against
   Abstentions
1.    Election of Directors:            
  

(a) Nancy H. Bechtle

      1,037,833,854    19,331,372    3,316,863
  

(b) Walter W. Bettinger II

      1,039,600,750    18,493,093    2,388,246
  

(c) C. Preston Butcher

      1,034,055,790    22,594,993    3,831,306
          Shares
For
   Shares
Against
   Abstentions    Broker
Non-Votes
2.    Stockholder proposal regarding political contributions       227,869,653    614,942,130       102,184,902       115,485,404
3.    Stockholder proposal regarding senior executive death benefits    298,239,758    645,131,628    2,625,299    114,485,404
4.    Stockholder proposal regarding changes to the Corporate Executive Bonus Plan    226,384,549    716,364,963    3,247,173    114,485,404

All nominees for the election to the Board of Directors were elected. The stockholders did not approve any of the stockholder proposals.

 

Item 5. Other Information

None.

 

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Item 6. Exhibits

The following exhibits are filed as part of this Quarterly Report on Form 10-Q.

 

Exhibit
Number

  

Exhibit

      
  10.326    Credit Agreement (364-Day Commitment) dated as of June 12, 2009, between the Registrant and the financial institutions listed therein (supersedes Exhibit 10.315).   
12.1      Computation of Ratio of Earnings to Fixed Charges.   
31.1      Certification Pursuant to Rule 13a-14(a)/15d-14(a), As Adopted Pursuant to Section 302 of The Sarbanes-Oxley Act of 2002.   
31.2      Certification Pursuant to Rule 13a-14(a)/15d-14(a), As Adopted Pursuant to Section 302 of The Sarbanes-Oxley Act of 2002.   
32.1      Certification Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of The Sarbanes-Oxley Act of 2002.    (1
32.2      Certification Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of The Sarbanes-Oxley Act of 2002.    (1
101.INS    XBRL Instance Document    (1,2
101.SCH    XBRL Taxonomy Extension Schema    (1,2
101.CAL    XBRL Taxonomy Extension Calculation &nb