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, 2010

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) 667-7000

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.

1,193,865,665 shares of $.01 par value Common Stock

Outstanding on July 23, 2010

 

 

 


Table of Contents

THE CHARLES SCHWAB CORPORATION

Quarterly Report on Form 10-Q

For the Quarter Ended June 30, 2010

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 – 18
    Item 2.   Management’s Discussion and Analysis of Financial Condition and Results of Operations    19 – 38
    Item 3.   Quantitative and Qualitative Disclosures About Market Risk    39 – 40
    Item 4.   Controls and Procedures    40

Part II - Other Information

  
    Item 1.   Legal Proceedings    41
    Item 1A.   Risk Factors    41
    Item 2.   Unregistered Sales of Equity Securities and Use of Proceeds    42
    Item 3.   Defaults Upon Senior Securities    42
    Item 5.   Other Information    42
    Item 6.   Exhibits    43

Signature

   44


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,
 
     2010     2009     2010     2009  

Net Revenues

        

Asset management and administration fees

   $ 437      $ 486      $ 857      $ 988   

Interest revenue

     428        361        819        707   

Interest expense

     (46     (59     (111     (99
                                

Net interest revenue

     382        302        708        608   

Trading revenue

     233        272        442        531   

Other

     36        38        67        96   

Net impairment losses on securities (1)

     (8     (13     (16     (27
                                

Total net revenues

     1,080        1,085        2,058        2,196   
                                

Expenses Excluding Interest

        

Compensation and benefits

     393        377        795        802   

Professional services

     84        64        164        124   

Occupancy and equipment

     68        97        136        178   

Advertising and market development

     43        49        105        107   

Communications

     53        54        105        107   

Depreciation and amortization

     36        41        73        83   

Class action litigation reserve

                   196          

Other

     65        68        133        105   
                                

Total expenses excluding interest

     742        750        1,707        1,506   
                                

Income before taxes on income

     338        335        351        690   

Taxes on income

     (133     (130     (140     (267
                                

Net Income

   $ 205      $ 205      $ 211      $ 423   
                                

Weighted-Average Common Shares Outstanding — Diluted

     1,195        1,160        1,191        1,158   
                                

Earnings Per Share — Basic

   $ .17      $ .18      $ .18      $ .37   

Earnings Per Share — Diluted

   $ .17      $ .18      $ .18      $ .36   
                                

 

(1)

Net impairment losses on securities include total other-than-temporary impairment losses of $13 and $37, net of $5 and $24 recognized in other comprehensive income, for the three months ended June 30, 2010 and 2009, respectively. Net impairment losses on securities include total other-than-temporary impairment losses of $41 and $187, net of $25 and $160 recognized in other comprehensive income, for the six months ended June 30, 2010 and 2009, respectively.

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,
2010
    December 31,
2009
 

Assets

    

Cash and cash equivalents

   $          9,510      $          8,241   

Cash and investments segregated and on deposit for regulatory purposes (including resale agreements of $10,151 at June 30, 2010 and $8,346 at December 31, 2009)

     18,873        18,373   

Receivables from brokers, dealers, and clearing organizations

     506        560   

Receivables from brokerage clients — net

     9,874        8,627   

Other securities owned — at fair value

     401        916   

Securities available for sale

     23,703        22,120   

Securities held to maturity (fair value — $9,738 at June 30, 2010 and $6,880 at
December 31, 2009)

     9,470        6,839   

Loans to banking clients — net

     7,825        7,348   

Loans held for sale

     49        104   

Equipment, office facilities, and property — net

     617        641   

Goodwill

     528        528   

Other assets

     939        1,134   
                

Total assets

   $ 82,295      $ 75,431   
                

Liabilities and Stockholders’ Equity

    

Deposits from banking clients

   $ 45,887      $ 38,820   

Payables to brokers, dealers, and clearing organizations

     1,405        2,373   

Payables to brokerage clients

     26,416        26,246   

Accrued expenses and other liabilities

     1,400        1,407   

Long-term debt

     1,308        1,512   
                

Total liabilities

     76,416        70,358   
                

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; 1,421,761,844 shares issued at June 30, 2010 and 1,392,091,544 shares issued at December 31, 2009

     14        14   

Additional paid-in capital

     2,888        2,298   

Retained earnings

     7,310        7,243   

Treasury stock, at cost — 228,034,290 shares at June 30, 2010 and 229,983,936 shares at December 31, 2009

     (4,268     (4,291

Accumulated other comprehensive loss

     (65     (191
                

Total stockholders’ equity

     5,879        5,073   
                

Total liabilities and stockholders’ equity

   $ 82,295      $ 75,431   
                

See Notes to Condensed Consolidated Financial Statements.

 

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THE CHARLES SCHWAB CORPORATION

 

Condensed Consolidated Statements of Cash Flows

(In millions)

(Unaudited)

 

     Six Months Ended
June 30,
 
     2010     2009  

Cash Flows from Operating Activities

    

Net income

   $ 211      $ 423   

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

    

Net impairment losses on securities

     16        27   

Stock-based compensation

     43        35   

Depreciation and amortization

     73        83   

Other

     (2     (20

Originations of loans held for sale

     (810     (1,900

Proceeds from sales of loans held for sale

     870        1,777   

Net change in:

    

Cash and investments segregated and on deposit for regulatory purposes

     (500     (839

Receivables from brokers, dealers, and clearing organizations

     57        275   

Receivables from brokerage clients

     (1,248     (577

Other securities owned

     517        245   

Other assets

     116        28   

Payables to brokers, dealers, and clearing organizations

     299        416   

Payables to brokerage clients

     441        1,345   

Accrued expenses and other liabilities

     193        (212
                

Net cash provided by operating activities

     276        1,106   
                

Cash Flows from Investing Activities

    

Purchases of securities available for sale

     (8,542     (5,511

Proceeds from sales of securities available for sale

     125        85   

Principal payments on securities available for sale

     7,028        2,869   

Purchases of securities held to maturity

     (4,506     (2,464

Principal payments on securities held to maturity

     598        28   

Net increase in loans to banking clients

     (504     (581

Purchase of equipment, office facilities, and property

     (54     (69

Other investing activities

     4        (1
                

Net cash used for investing activities

     (5,851     (5,644
                

Cash Flows from Financing Activities

    

Net change in deposits from banking clients

     6,625        7,864   

Issuance of long-term debt

            747   

Repayment of long-term debt

     (203     (40

Net proceeds from common stock offering

     543          

Dividends paid

     (143     (139

Proceeds from stock options exercised and other

     19        31   

Other financing activities

     3        (5
                

Net cash provided by financing activities

     6,844        8,458   
                

Increase in Cash and Cash Equivalents

     1,269        3,920   

Cash and Cash Equivalents at Beginning of Period

     8,241        5,442   
                

Cash and Cash Equivalents at End of Period

   $     9,510      $     9,362   
                

Supplemental Cash Flow Information

    

Cash paid during the period for:

    

Interest

   $ 93      $ 68   

Income taxes

   $ 130      $ 203   

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.   Introduction and 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 302 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 United States (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 2010 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, 2009. The Company’s results for any interim period are not necessarily indicative of results for a full year or any other interim period.

 

2.   New Accounting Standards

Adoption of New Accounting Standards

Transfers of Financial Assets: On January 1, 2010, the Company adopted new guidance on accounting for transfers of financial assets for transfers occurring after January 1, 2010. This new guidance removes the concept of a qualifying special-purpose entity and amends the requirements for a transfer of a portion of a financial asset to be accounted for as a sale and related disclosures. This new standard applies to transfers of financial assets after January 1, 2010. There were no transfers of financial assets during the first half of 2010 for which this guidance was applicable.

Consolidation of Variable Interest Entities: On January 1, 2010, the Company adopted new guidance on consolidation of variable interest entities (VIEs). This new guidance amends the consolidation guidance applicable to 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 adoption of this new guidance did not have a material impact on the Company’s financial position, results of operations, earnings per share (EPS), or cash flows.

 

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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)

 

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, 2010

   Amortized
Cost
   Gross
Unrealized
Gains
   Gross
Unrealized
Losses
   Fair
Value

Securities available for sale:

           

U.S. agency residential mortgage-backed securities

   $ 12,310    $ 218    $ 3    $ 12,525

Non-agency residential mortgage-backed securities

     2,127      1      369      1,759

U.S. agency notes

     3,796      32           3,828

Corporate debt securities

     2,342      5      1      2,346

Certificates of deposit

     2,050      1      1      2,050

Asset-backed securities

     984      11           995

Commercial paper

     200                200
                           

Total securities available for sale

   $     23,809    $          268    $          374    $     23,703
                           

Securities held to maturity:

           

U.S. agency residential mortgage-backed securities

   $ 7,941    $ 261    $ 15    $ 8,187

Asset-backed securities

     1,170      16           1,186

Corporate debt securities

     359      6           365
                           

Total securities held to maturity

   $ 9,470    $ 283    $ 15    $ 9,738
                           

 

December 31, 2009

   Amortized
Cost
   Gross
Unrealized
Gains
   Gross
Unrealized
Losses
   Fair
Value

Securities available for sale:

           

U.S. agency residential mortgage-backed securities

   $ 11,601    $ 199    $ 21    $ 11,779

Non-agency residential mortgage-backed securities

     2,460           519      1,941

U.S. agency notes

     2,975      4      1      2,978

Corporate debt securities

     2,368      13      1      2,380

Certificates of deposit

     1,950      3           1,953

Asset-backed securities

     1,077      12           1,089
                           

Total securities available for sale

   $     22,431    $ 231    $ 542    $     22,120
                           

Securities held to maturity:

           

U.S. agency residential mortgage-backed securities

   $ 5,105    $ 36    $ 27    $ 5,114

Asset-backed securities

     1,389      25           1,414

Corporate debt securities

     345      7           352
                           

Total securities held to maturity

   $ 6,839    $ 68    $ 27    $ 6,880
                           

 

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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, 2010

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

Securities available for sale:

                 

U.S. agency residential mortgage-backed securities

   $ 271    $ 2    $ 307    $ 1    $ 578    $ 3

Non-agency residential mortgage-backed securities

     105      4      1,569      365      1,674      369

Corporate debt securities

     750      1                750      1

Certificates of deposit

     949      1                949      1
                                         

Total

   $     2,075    $ 8    $     1,876    $ 366    $     3,951    $ 374
                                         

Securities held to maturity:

                 

U.S. agency residential mortgage-backed securities

   $ 442    $ 15    $    $    $ 442    $ 15
                                         

Total

   $ 442    $ 15    $    $    $ 442    $ 15
                                         

Total securities with unrealized losses (1)

   $ 2,517    $ 23    $ 1,876    $ 366    $ 4,393    $ 389
                                         

 

(1)

The number of investment positions with unrealized losses totaled 213 for securities available for sale and 3 for securities held to maturity.

 

     Less than 12 months    12 months or longer    Total

December 31, 2009

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

Securities available for sale:

                 

U.S. agency residential mortgage-backed securities

   $ 3,801    $ 11    $ 1,994    $ 10    $ 5,795    $ 21

Non-agency residential mortgage-backed securities

     171      10      1,770      509      1,941      519

U.S. agency notes

     864      1                864      1

Corporate debt securities

     374      1                374      1
                                         

Total

   $     5,210    $ 23    $     3,764    $ 519    $     8,974    $ 542
                                         

Securities held to maturity:

                 

U.S. agency residential mortgage-backed securities

   $ 1,885    $ 27    $    $    $ 1,885    $ 27
                                         

Total

   $ 1,885    $ 27    $    $    $ 1,885    $ 27
                                         

Total securities with unrealized losses (1)

   $ 7,095    $ 50    $ 3,764    $ 519    $ 10,859    $ 569
                                         

 

(1)

The number of investment positions with unrealized losses totaled 333 for securities available for sale and 30 for securities held to maturity.

Unrealized losses in securities available for sale of $374 million as of June 30, 2010, were concentrated in non-agency residential mortgage-backed securities. 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, 2010, the amortized cost and fair value of Alt-A residential mortgage-backed securities were $563 million and $368 million, respectively.

 

Assessment   of Other-Than-Temporary Impairment

Management evaluates whether securities available for sale and securities held to maturity are other-than-temporarily impaired (OTTI) on a quarterly basis. Debt securities with unrealized losses are considered OTTI if the Company intends to sell the security or if it is more likely than not that 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.

 

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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 security is also OTTI if management does not expect to recover the amortized cost of the security. In this circumstance, management utilizes cash flow models to estimate the expected future cash flow from the securities and to estimate the credit loss. The impairment recognized in earnings is 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.

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 has been 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 the Company’s non-agency residential mortgage-backed securities. 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.

Certain Alt-A and Prime residential mortgage-backed securities experienced deteriorating credit characteristics in the first half of 2010, including increased payment delinquencies and increased losses on foreclosures of underlying mortgages as a result of housing price declines. Additionally, the securities have experienced a decrease in prepayment rates due to the slowing of general economic activity and heightened levels of unemployment. Forecasted home price fluctuations are an important variable in forecasting the expected loss severity and default rates. Based on the Company’s cash flow projections, management determined that it does not expect to recover all of the amortized cost of these securities and therefore determined that these securities were OTTI. The Company does not intend to sell the securities available for sale 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, 2010, with cash and cash equivalents totaling $9.5 billion, a loan-to-deposit ratio of 17%, 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 it is not “more likely than not” that the Company will be required to sell these securities, the Company recognized an impairment charge equal to the securities’ expected credit losses of $8 million and $16 million during the second quarter and first half of 2010, 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. Impairment charges recognized in earnings are included in net impairment losses on 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 impairment charges.

Actual credit losses on the Company’s residential mortgage-backed securities were not material during the second quarter or first half of 2010.

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,
   Six Months Ended
June  30,
     2010    2009    2010    2009

Balance at beginning of period

   $          68    $ 14    $          60    $          —

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

     1      5      4      27

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

     7      8      12     
                           

Balance at end of period

   $ 76    $          27    $ 76    $ 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)

 

The maturities of securities available for sale and securities held to maturity at June 30, 2010, 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)

   $    $    $ 122    $ 12,403    $ 12,525

Non-agency residential mortgage-backed securities (1)

               27      1,732      1,759

U.S. agency notes

     50      3,778                3,828

Corporate debt securities

     1,702      644                2,346

Certificates of deposit

     1,850      200                2,050

Asset-backed securities

          829      166           995

Commercial paper

     200                     200
                                  

Total fair value

   $ 3,802    $ 5,451    $ 315    $ 14,135    $ 23,703

Total amortized cost

   $       3,797    $       5,412    $          308    $       14,292    $     23,809
                                  

Securities held to maturity:

              

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

   $    $    $    $ 8,187    $ 8,187

Asset-backed securities

          1,075      111           1,186

Corporate debt securities

     195      170                365
                                  

Total fair value

   $ 195    $ 1,245    $ 111    $ 8,187    $ 9,738

Total amortized cost

   $ 192    $ 1,226    $ 111    $ 7,941    $ 9,470
                                  

 

(1)

Residential 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 and gross realized gains (losses) from sales of securities available for sale are as follows:

 

     Three Months Ended
June 30,
   Six Months Ended
June 30,
     2010    2009    2010    2009

Proceeds

   $          125    $          85    $          125    $          85

Gross realized gains

   $    $    $    $

Gross realized losses

   $    $    $    $
                           

Realized gains and losses from sales of securities available for sale, if any, are included in other revenue.

 

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

The composition of the loan portfolio is as follows:

 

     June 30,
2010
    December 31,
2009
 

Residential real estate mortgages

   $       3,962      $       3,710   

Home equity lines of credit

     3,418        3,304   

Secured personal loans

     479        366   

Other

     17        13   
                

Total loans to banking clients

     7,876        7,393   

Allowance for credit losses

     (51     (45
                

Total loans to banking clients – net

   $ 7,825      $ 7,348   
                

 

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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)

 

Included in the loan portfolio are nonaccrual loans totaling $39 million and $34 million at June 30, 2010, and December 31, 2009, respectively. Nonperforming assets, which include nonaccrual loans and other real estate owned, totaled $43 million and $37 million at June 30, 2010, and December 31, 2009, respectively. There were no loans accruing interest that were contractually 90 days or more past due at June 30, 2010, or December 31, 2009. The amount of interest revenue that would have been earned on nonaccrual loans, versus interest revenue recognized on these loans, was not material to the Company’s results of operations for the first half of 2010 or 2009.

Changes in the allowance for credit losses were as follows:

 

     Three Months Ended
June  30,
    Six Months Ended
June  30,
 
     2010     2009     2010     2009  

Balance at beginning of period

   $ 53      $ 28      $ 45      $ 20   

Charge-offs

     (4     (4     (10     (5

Recoveries

     1               1          

Provision for credit losses

     1        17        15        26   
                                

Balance at end of period

   $     51      $     41      $     51      $     41   
                                

 

5.   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, 2010, 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, 2010, the aggregate face amount of these LOCs totaled $13 million. There were no funds drawn under any of these LOCs at June 30, 2010.

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 guarantees.

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. Except as otherwise noted below, 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 certain 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.

 

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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)

 

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. On August 17, 2009, a civil complaint was filed against Schwab in New York state court by the Attorney General of the State of New York (NYAG) alleging material misrepresentations and omissions by Schwab regarding the risks of auction rate securities, and seeking restitution, disgorgement, penalties and other relief, including repurchase of securities held in client accounts. As reflected in a statement issued August 17, 2009, Schwab has responded that the allegations are without merit and that Schwab intends to contest any charges. On March 15, 2010, Schwab filed a motion to dismiss the case and various claims in the civil complaint.

Separately, on November 19, 2009, Schwab received a Wells notice from the Financial Industry Regulatory Authority (FINRA) regarding a preliminary determination to recommend disciplinary action against Schwab for possible rule violations regarding sales of auction rate securities through the Company. On February 9, 2010, Schwab received a second letter from FINRA regarding additional disciplinary charges. A Wells notice provides recipients an opportunity to respond to issues raised in an investigation prior to any decision on an enforcement proceeding, and is neither a formal allegation nor a finding of wrongdoing. The Company has responded to FINRA to explain why it believes enforcement charges are unwarranted.

YieldPlus Fund Litigation and Regulatory Inquiries: The Company is the subject of consolidated class action litigation, regulatory investigations and individual investor arbitration claims relating to the Schwab YieldPlus Fund®, an ultra-short bond fund (“Bond Fund”). The Bond Fund was designed to invest in a variety of fixed income instruments, including corporate bonds, asset-backed securities, mortgage-backed securities and other fixed income investments. The credit crisis that began in mid-2007 led to a decline in the value of a majority of fixed income investments market wide. As a result, certain Schwab clients who chose to invest in the Bond Fund experienced a decline in their investments, leading to the litigation.

Nine class action lawsuits were filed between March and May 2008 on behalf of investors in the Bond Fund alleging violations of state law and federal securities law in connection with the fund’s investment policy, disclosures and marketing. These cases were consolidated in a single action on July 3, 2008, in the U.S. District Court for the Northern District of California. Specific 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 and fund risk management; inaccurate reporting of the fund’s weighted-average duration; and failure to disclose redemptions of positions in YieldPlus by other Schwab investment funds. The lawsuit seeks unspecified compensatory and rescission damages, unspecified equitable and injunctive relief, and costs and attorneys’ fees. Defendants named in the lawsuit 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. On February 4, 2009, the court denied defendants’ motion to dismiss plaintiffs’ federal law claims and dismissed all but one state law claim. On August 21, 2009, the court certified two classes of plaintiffs for purposes of the federal law claims and a single class of plaintiffs for purposes of the remaining state law claim.

On March 30, 2010, the court granted plaintiffs’ motion for summary judgment holding defendants liable for plaintiffs’ state law claim regarding changes to the investment policy of the Bond Fund, which plaintiffs alleged were made without shareholder approval in violation of Section 13(a) of the Investment Company Act of 1940. On April 5, 2010, defendants filed a motion for interlocutory appeal of this ruling, which the court denied at a hearing on April 26, 2010. On April 8, 2010, the court issued an order denying defendants’ motion for summary judgment on plaintiffs’ federal law claims. On April 23, 2010, the Company entered into a settlement agreement with plaintiffs in which the Company, without admitting liability, agreed to a total of $200 million to resolve plaintiffs’ federal law claims. On May 14, 2010, the Company entered into a settlement agreement with plaintiffs in which the Company, without admitting liability, agreed to resolve plaintiffs’ state law claim for $35 million. The settlement agreements were preliminarily approved by the court on May 26, 2010, and remain subject to final court approval. For the six months ended June 30, 2010, the Company has accrued a reserve of $196 million in connection with the lawsuit, reflecting the preliminary settlements, net of insurance proceeds of $39 million under applicable policies. The Company will continue to evaluate the reserve pending final resolution of the litigation; actual liability could be higher or lower than the amount reserved.

 

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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)

 

Separately, the Company has been responding to investigations by federal and state regulators regarding these matters. On October 14, 2009, the Company received a Wells notice from the staff of the Securities and Exchange Commission (SEC) regarding the staff’s preliminary determination to recommend the filing of a civil enforcement action against Schwab Investments, CSIM, Schwab, and the president of the Bond Fund for possible violations of the securities laws with respect to the fund. On October 27, 2009, the Company also received a Wells notice from FINRA regarding a preliminary determination to recommend disciplinary action against Schwab for possible violation of securities laws and FINRA rules with respect to the fund. The Company has responded to the notices to explain why it believes enforcement charges are unwarranted, and has been in discussions with the SEC and FINRA staff and state regulators regarding potential settlement of civil regulatory charges. Given the status of those discussions, the Company is unable to predict whether a settlement with the SEC or other regulators is probable, or to estimate the range of any potential liability, and therefore has not established a reserve in connection therewith. Although the Company believes it has strong defenses if enforcement proceedings were instituted, any adverse judgment could result in the imposition of disgorgement, penalties, and other monetary and injunctive relief against the Company.

In addition to the above matters, as of June 30, 2010, the Company remained the subject of 145 individual arbitration claims seeking $26 million in damages relating to investments in the Bond Fund, for which the Company has been accruing reserves.

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 Schwab Investments (registrant and issuer of the fund’s shares) 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. Plaintiffs 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. A hearing on the appeal was held on April 12, 2010, before the U.S. Court of Appeals for the Ninth Circuit, but no ruling has been issued.

The SEC Wells notice received by the Company on October 14, 2009, concerning the Bond Fund, also provided notice of the SEC staff’s intention to recommend the inclusion of additional charges against Schwab Investments and CSIM for possible violations of the securities laws with respect to the Total Bond Market Fund. The Company has responded to the SEC Wells notice to explain why the proposed charges regarding the Total Bond Market Fund are unwarranted, and has also addressed the proposed charges in the discussions with SEC staff described above concerning the Bond Fund.

 

6.   Fair Values of Assets and Liabilities

Fair value is defined 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. Fair value measurement accounting guidance describes the fair value 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

 

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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)

 

 

funds, and equity securities. The Company did not transfer any assets or liabilities between Level 1 and Level 2 as of June 30, 2010, or December 31, 2009.

 

   

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, and U.S. Treasury securities.

 

   

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, 2010, or December 31, 2009.

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 investment securities categorized as Level 2. 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. The Company does not adjust the prices received from the independent third-party pricing service unless such prices are inconsistent with the definition of fair value and result in a material difference in the recorded amounts. At June 30, 2010, and December 31, 2009, 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 fair value hierarchy for assets and liabilities measured at fair value:

 

June 30, 2010

   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

           

Cash equivalents:

           

Money market funds

   $ 1,097    $    $    $ 1,097

Certificates of deposit

          950           950

Commercial paper

          1,522           1,522
                           

Total cash equivalents

     1,097      2,472           3,569

Investments segregated and on deposit for regulatory purposes:

           

U.S. Government securities

          1,505           1,505

Corporate debt securities

          2,181           2,181

Certificates of deposit

          2,024           2,024
                           

Total investments segregated and on deposit for regulatory purposes

          5,710           5,710

Other securities owned:

           

Schwab Funds® money market funds

     233                233

Equity and bond mutual funds

     94                94

State and municipal debt obligations

          48           48

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

     3      23           26
                           

Total other securities owned

     330      71           401

Securities available for sale:

           

U.S. agency residential mortgage-backed securities

          12,525           12,525

Non-agency residential mortgage-backed securities

          1,759           1,759

U.S. agency notes

          3,828           3,828

Corporate debt securities

          2,346           2,346

Certificates of deposit

          2,050           2,050

Asset-backed securities

          995           995

Commercial paper

          200           200
                           

Total securities available for sale

          23,703           23,703
                           

Total assets at fair value

   $ 1,427    $ 31,956    $                   —    $           33,383
                           

 

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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)

 

December 31, 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

           

Cash equivalents (1) :

           

Money market funds

   $ 2,278    $    $    $ 2,278

Commercial paper

          370           370
                           

Total cash equivalents

     2,278      370           2,648

Investments segregated and on deposit for regulatory purposes:

           

U.S. Government securities

          2,681           2,681

Corporate debt securities

          2,135           2,135

Certificates of deposit

          2,091           2,091

Commercial paper

          100           100
                           

Total investments segregated and on deposit for regulatory purposes

          7,007           7,007

Other securities owned:

           

Schwab Funds® money market funds

     321                321

Commercial paper

          220           220

Certificates of deposit

          200           200

Equity and bond mutual funds

     103                103

State and municipal debt obligations

          49           49

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

     2      21           23
                           

Total other securities owned

     426      490           916

Securities available for sale:

           

U.S. agency residential mortgage-backed securities

          11,779           11,779

Non-agency residential mortgage-backed securities

          1,941           1,941

U.S. agency notes

          2,978           2,978

Corporate debt securities

          2,380           2,380

Certificates of deposit

          1,953           1,953

Asset-backed securities

          1,089           1,089
                           

Total securities available for sale

          22,120           22,120

Other assets (2)

          9           9
                           

Total assets at fair value

   $ 2,704    $ 29,996    $                   —    $           32,700
                           

Liabilities

           

Accrued expenses and other liabilities (3)

   $ 1    $ 6    $    $ 7
                           

 

(1)

Beginning in the first quarter of 2010, the fair value information for certain cash equivalents was included. Information as of December 31, 2009 was recast to reflect this change.

(2)

Other assets recorded at fair value include derivative contracts.

(3)

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 first half of 2010.

Other 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.

 

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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)

 

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 U.S. agency residential mortgage-backed securities, asset-backed securities collateralized by credit card, student, and auto loans, and corporate debt 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.

Loans to banking clients primarily include adjustable rate residential first-mortgage and home equity lines of credit (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 residential first-mortgage loans intended for sale. 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 whose carrying values approximate their fair values. Other assets also include Federal Home Loan Bank stock recorded at par, which approximates fair value.

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,
2010
   December  31,
2009
     Carrying
Amount
   Fair
Value
   Carrying
Amount
   Fair
Value

Financial Assets:

           

Securities held to maturity

   $     9,470    $     9,738    $     6,839    $     6,880

Loans to banking clients – net

   $ 7,825    $ 7,732    $ 7,348    $ 6,888

Loans held for sale

   $ 49    $ 51    $ 104    $ 107

Financial Liabilities:

           

Long-term debt

   $ 1,308    $ 1,401    $ 1,512    $ 1,580

 

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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.   Equity Offering

On January 26, 2010, the Company completed the sale of 29,670,300 shares of its common stock, $.01 par value, at a public offering price of $19.00 per share. Net proceeds received from the offering were $543 million and were used to support the Company’s balance sheet growth, including expansion of its deposit base and migration of certain client balances from money market funds into Schwab Bank.

 

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,
 
     2010     2009     2010     2009  

Net income

   $ 205      $ 205      $ 211      $ 423   

Other comprehensive income:

        

Change in net unrealized loss on securities available for sale:

        

Unrealized gain on Non-OTTI securities

     91        265        188        344   

Unrealized (loss) gain on OTTI securities

     (24     (50     1        (52

OTTI charges recognized in earnings

     8        13        16        27   

Income tax effect

     (29     (90     (79     (128
                                

Total other comprehensive income

     46        138        126        191   
                                

Comprehensive income

   $     251      $     343      $     337      $     614   
                                

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
    Total  accumulated
other
comprehensive

loss
 
     Portion of
unrealized loss

on Non-OTTI
securities
    Portion of
unrealized loss

on OTTI
securities
   

Balance at December 31, 2008

   $ (553   $                      —      $ (553

Reclassification of OTTI securities

     97        (97                          —   

Other net change

     191               191   
                        

Balance at June 30, 2009

   $ (265   $ (97   $ (362
                        

Balance at December 31, 2009

   $ (77   $ (114   $ (191

Reclassification of OTTI securities

                           21        (21       

Other net change

     101        25        126   
                        

Balance at June 30, 2010

   $ 45      $ (110   $ (65
                        

 

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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 and units. EPS under the basic and diluted computations are as follows:

 

     Three Months Ended
June 30,
   Six Months Ended
June 30,
     2010    2009    2010    2009

Net income available to common shareholders (1)

   $ 205    $ 205    $ 211    $ 423
                           

Weighted-average common shares outstanding – basic

     1,191      1,156      1,187      1,154

Common stock equivalent shares related to stock incentive plans

     4      4      4      4
                           

Weighted-average common shares outstanding – diluted (2)

     1,195      1,160      1,191      1,158
                           

Basic EPS

   $ .17    $ .18    $ .18    $ .37

Diluted EPS

   $ .17    $ .18    $ .18    $ .36

 

(1)

Net income available to participating securities (unvested restricted shares) was not material for the second quarters and first halves of 2010 or 2009.

 

(2)

Total antidilutive stock options and restricted stock awards excluded from the calculation of diluted EPS were 38 million and 39 million shares for the second quarters of 2010 and 2009, respectively, and 38 million and 39 million shares for the first halves of 2010 and 2009, 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, 2010, CSC and Schwab Bank met the capital level requirements.

The regulatory capital and ratios for Schwab Bank at June 30, 2010, are as follows:

 

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

Tier 1 Capital

   $ 3,788    24.0   $ 631    4.0   $ 947    6.0

Total Capital

   $ 3,839    24.3   $ 1,262    8.0   $ 1,578    10.0

Tier 1 Leverage

   $      3,788    7.6   $     1,993    4.0   $     2,491    5.0

Tangible Equity

   $ 3,788    7.6   $ 996    2.0     N/A   

 

N/A Not applicable.

Based on its regulatory capital ratios at June 30, 2010, Schwab Bank is considered well capitalized (the highest category) pursuant to banking regulatory guidelines. There are no conditions or events since June 30, 2010, that management believes have changed Schwab Bank’s capital category.

 

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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)

 

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. 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 company 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. At June 30, 2010, 2% of aggregate debit balances was $221 million, which exceeded the minimum dollar requirement for Schwab of $250,000. At June 30, 2010, Schwab’s net capital was $1.2 billion (11% of aggregate debit balances), which was $986 million in excess of its minimum required net capital and $655 million in excess of 5% of aggregate debit balances.

 

11.   Segment Information

The Company structures its operating 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. 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 significant restructuring and other 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.

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

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2010     2009     2010     2009  

Net revenues:

        

Investor Services

   $ 721      $ 705      $ 1,362      $ 1,411   

Institutional Services

     359        380        696        785   

Unallocated

                            
                                

Total net revenues

   $ 1,080      $ 1,085      $ 2,058      $ 2,196   
                                

Income before taxes on income:

        

Investor Services

   $ 218      $ 216      $ 330      $ 458   

Institutional Services

     118        146        213        318   

Unallocated (1)

     2        (27     (192     (86
                                

Income before taxes on income

     338        335        351        690   

Taxes on income

     (133     (130     (140     (267
                                

Net income

   $ 205      $ 205      $ 211      $ 423   
                                

 

(1)

Includes the recognition of a class action litigation reserve of $196 million in the first half of 2010 and facilities and severance charges relating to the Company’s cost reduction measures in the second quarter and first half of 2009.

 

12.   Subsequent Event

On July 22, 2010, the Company issued $600 million of Senior Notes that mature in 2020 under CSC’s universal automatic shelf registration statement on file with the SEC. The Senior Notes have a fixed interest rate of 4.45% with interest payable semi-annually.

 

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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 2010 and 2009 are shown in the following table:

 

     Three Months Ended
June  30,
    Percent
Change
    Six Months Ended
June  30,
    Percent
    Change    
 
     2010     2009       2010     2009    

Client Activity Metrics:

            

Net new client assets (1) (in billions)

   $ (37.5   $ 17.3      N/M      $ (14.2   $ 42.6      N/M   

Client assets (in billions, at quarter end)

     1,361.5        1,224.3      11      

Clients’ daily average trades (2) (in thousands)

     436.6        430.8      1     426.2        436.3      (2 %) 

Company Financial Metrics:

            

Net revenues

   $     1,080      $     1,085           $     2,058      $     2,196      (6 %) 

Expenses excluding interest

     742        750      (1 %)      1,707        1,506      13
                                            

Income before taxes on income

     338        335      1     351        690      (49 %) 

Taxes on income

     (133     (130   2     (140     (267   (48 %) 
                                            

Net income

   $ 205      $ 205           $ 211      $ 423      (50 %) 
                                            

Earnings per share – diluted

   $ .17      $ .18      (6 %)    $ .18      $ .36      (50 %) 

Net revenue decline from prior year

            (17 %)        (6 %)      (16 %)   

Pre-tax profit margin

     31.3     30.9       17.1     31.4  

Return on stockholders’ equity (annualized)

     14     18       8     20  

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

   $ 343      $ 356      (4 %)    $ 327      $ 351      (7 %) 

 

(1)

Includes net outflows of $51.5 billion in the second quarter of 2010 related to the planned deconversion of a mutual fund clearing services client.

(2)

Beginning in the first quarter of 2010, amounts include all commission free trades, including the Company’s Mutual Fund OneSource® funds and Exchange-Traded Funds, and other proprietary products. Prior period amounts have been recast to reflect this change.

N/M Not meaningful.

Short-term interest rates showed sequential improvement during the second quarter as the three-month LIBOR rose by 24 basis points to 0.53% (while remaining below year-earlier levels). The federal funds target rate remained unchanged during the quarter at a range of zero to 0.25%. At the same time, while the Nasdaq Composite Index, the Standard and Poor’s 500 Index, and the Dow Jones Industrial Average decreased sequentially during the second quarter, these indices ended the quarter up by 15%, 12%, and 16%, respectively, from the second quarter of 2009.

The Company’s ongoing focus on expanding and improving products, services, and value for its clients was reflected in continued strength in its key client activity metrics during the second quarter of 2010 — net new client assets totaled $14.0 billion, excluding outflows relating to a single Mutual Fund Clearing client who completed a planned transfer to an internal platform in the second quarter, and total client assets ended the second quarter at $1.36 trillion, up 11% from the second quarter of 2009. In addition, clients’ daily average trades of 436,600 were the highest in four quarters.

Net revenues were relatively flat in the second quarter of 2010 compared to the second quarter of 2009 primarily due to an increase in net interest revenue, offset by decreases in asset management and administration fees and trading revenue. Net interest revenue increased due to higher average balances of interest-earning assets during the quarter. Asset management and administration fees decreased due to money market mutual fund fee waivers of $113 million, partially offset by the effect of higher average equity market valuations combined with continued asset inflows. Money market mutual fund fee waivers were $30 million in the second quarter of 2009. Trading revenue decreased due to lower average revenue earned per revenue trade as a result of lower online trade commissions, which were implemented in January 2010.

 

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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)

 

Net revenues decreased by 6% in the first half of 2010 compared to the first half of 2009 primarily due to decreases in asset management and administration fees, trading revenue, and other revenue, offset by an increase in net interest revenue. Asset management and administration fees decreased primarily due to money market mutual fund fee waivers of $238 million, partially offset by the effect of higher average equity market valuations combined with continued asset inflows. Money market mutual fund fee waivers were $36 million in the first half of 2009. Trading revenue decreased due to lower average revenue earned per revenue trade and lower daily average revenue trades. Other revenue decreased due to a gain of $26 million on the repurchase of a portion of the Company’s long-term debt in the first half of 2009. The increase in net interest revenue resulted from higher average balances of interest-earning assets during the first half of 2010, partially offset by a decrease in the average yield earned compared to the year earlier period.

Expenses excluding interest were also relatively flat in the second quarter of 2010 compared to the second quarter of 2009 as a result of the Company’s ongoing expense discipline.

Expenses excluding interest increased by 13% in the first half of 2010 compared to the first half of 2009 primarily due to the recognition of a class action litigation reserve of $196 million relating to the Schwab YieldPlus Fund® in the first quarter of 2010. For further discussion of the Schwab YieldPlus Fund litigation and regulatory matters, see “Item 1 – Condensed Consolidated Financial Statements (Unaudited) – Notes – 5. Commitments and Contingent Liabilities.”

Subsequent Event

On July 22, 2010, the Company issued $600 million of Senior Notes that mature in 2020 under CSC’s universal automatic shelf registration statement on file with the Securities and Exchange Commission (SEC). The Senior Notes have a fixed interest rate of 4.45% with interest payable semi-annually.

CURRENT MARKET AND REGULATORY ENVIRONMENT

While improvements in the equity markets from their March 2009 lows and increases in short-term interest rates helped to strengthen the Company’s net revenues in the second quarter and first half of 2010, the interest rate environment remains challenging and may continue to limit growth in the Company’s net revenues.

Although short-term interest rates began to rise at the end of the quarter, they remained at historically low levels throughout the period. To the extent rates remain at these low levels, the Company’s net interest revenue will continue to be constrained. The low rate environment also affects asset management and administration fees. The overall yields on certain Schwab-sponsored money market mutual funds have fallen to levels at or below the management fees on those funds. The Company continues to waive a portion of its management fees, which it began to do in the first quarter of 2009, so that the funds may continue providing a positive return to clients. These and other money market mutual funds may continue to find it necessary to replace maturing securities with low yielding securities and the overall yield on such funds may remain below the management fees on those funds. To the extent this occurs, fees may continue to be waived, which would negatively affect asset management and administration fees.

The Company recorded net impairment charges of $8 million and $16 million related to certain non-agency residential mortgage-backed securities in the second quarter and first half of 2010, 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 impairment charges.

The “Dodd-Frank Wall Street Reform and Consumer Protection Act” was signed into law on July 21, 2010. Among other things, the legislation authorizes various assessments and fees, requires the establishment of minimum leverage and risk-based capital requirements for insured depository institutions and contains several provisions that could increase the Federal Deposit Insurance Corporation (FDIC) deposit insurance premiums paid by the Company. CSC is currently reviewing the impact the legislation will have on the Company’s business, financial condition, and results of operations.

 

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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 2010 compared to the same periods in 2009.

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 trading revenue decreased, while net interest revenue increased in the second quarter and first half of 2010 compared to the same periods in 2009.

 

Three Months Ended June 30,          2010     2009  
     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®)

   (46 %)    $     144      13   $     269      25

Mutual Fund OneSource®

   46     153      14     105      10

Clearing and other

   27     28      3     22      2

Investment management and trust fees

   33     85      8     64      6

Other

   4     27      2     26      2
                                  

Asset management and administration fees

   (10 %)      437      40     486      45
                                  

Net interest revenue

          

Interest revenue

   19     428      39     361      33

Interest expense

   (22 %)      (46   (4 %)      (59   (5 %) 
                                  

Net interest revenue

   26     382      35     302      28
                                  

Trading revenue

          

Commissions

   (8 %)      214      20     233      21

Principal transactions

   (51 %)      19      2     39      4
                                  

Trading revenue

   (14 %)      233      22     272      25
                                  

Other

   (5 %)      36      4     38      3
                                  

Net impairment losses on securities

   (38 %)      (8   (1 %)      (13   (1 %) 
                                  

Total net revenues

        $     1,080      100   $     1,085      100
                                  

 

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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,          2010     2009  
     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®)

   (50 %)    $     285      14   $     573      26

Mutual Fund OneSource®

              55     302      15     195      9

Clearing and other

   28     55      3     43      2

Investment management and trust fees

   25     161      8     129      6

Other

   13     54      2     48      2
                                  

Asset management and administration fees

   (13 %)      857      42     988      45
                                  

Net interest revenue

          

Interest revenue

   16     819      40     707      32

Interest expense

   12     (111   (6 %)      (99   (4 %) 
                                  

Net interest revenue

   16     708      34     608      28
                                  

Trading revenue

          

Commissions

   (12 %)      407      20     462      21

Principal transactions

   (49 %)      35      1     69      3
                                  

Trading revenue

   (17 %)      442      21     531      24
                                  

Other

   (30 %)      67      4     96      4
                                  

Net impairment losses on securities

   (41 %)      (16   (1 %)      (27   (1 %) 
                                  

Total net revenues

   (6 %)    $     2,058      100   $     2,196      100
                                  

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 shareholder services, administration, investment management, and transfer agent services (through July 2009) 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 the Company’s proprietary funds and third-party 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 included in 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 and Regulatory Environment.”

As shown in the following table, asset management and administration fees decreased by $49 million, or 10%, and $131 million, or 13%, in the second quarter and first half of 2010 compared to the same periods in 2009, respectively. This decrease was due to the decrease in mutual fund service fees, offset by increases in investment management and trust and other fees.

 

     Three Months Ended
June 30,
    Percent
  Change  
    Six Months Ended
June 30,
    Percent
Change  
 
     2010     2009       2010     2009    

Asset management and administration fees before money market mutual fund fee waivers

   $        550      $        516      7   $     1,095      $     1,024      7

Money market mutual fund fee waivers

     (113     (30          N/M        (238     (36           N/M   
                                            

Asset management and administration fees

   $ 437      $ 486      (10 %)    $ 857      $ 988      (13 %) 
                                            

 

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)

 

Mutual fund service fees decreased by $71 million, or 18%, and $169 million, or 21%, in the second quarter and first half of 2010 compared to the same periods in 2009, respectively, primarily due to money market mutual fund fee waivers. Given the low interest rate environment in the second quarters and first halves of 2010 and 2009, the overall yields on certain Schwab-sponsored money market mutual funds have fallen to levels at or below the management fees on those funds. As a result, the Company waived a portion of its fees in the second quarters and first halves of 2010 and 2009, in order to provide a positive return to clients. The decrease in mutual fund service fees was partially offset by higher average balances of client assets invested in the Company’s Mutual Fund OneSource funds as a result of higher average equity market valuations combined with continued asset inflows.

Investment management and trust fees increased by $21 million, or 33%, and $32 million, or 25%, in the second quarter and first half of 2010 compared to the same periods in 2009, respectively, primarily due to higher average balances of client assets participating in advisory and managed account services programs. This increase was partially offset by temporary fee rebates of $23 million and $52 million in the second quarter and first half of 2010, respectively, offered to qualifying clients for choosing to participate in these programs.

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 may attempt 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 and Regulatory 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 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, which are recorded in cash and investments segregated on the Company’s condensed consolidated balance sheet.

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

 

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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 tables present net interest revenue information corresponding to interest-earning assets and funding sources on

the condensed consolidated balance sheet:

 

Three Months Ended June 30,    2010     2009  
     Average
Balance
   Interest
Revenue/
Expense
   Average
Yield/
Rate
    Average
Balance
   Interest
Revenue/
Expense
   Average
Yield/
Rate
 

Interest-earning assets:

                

Cash and cash equivalents

   $ 7,226    $ 5    0.28   $ 8,462    $ 10    0.47

Cash and investments segregated

     19,007      14    0.30     16,287      22    0.54

Broker-related receivables (1)

     341         0.10     329         0.17

Receivables from brokerage clients

     8,917      111    4.99     6,262      82    5.25

Other securities owned (2)

     46         0.51               

Securities available for sale (3)

     23,615      124    2.11     17,056      128    3.01

Securities held to maturity

     9,168      86    3.76     986      10    4.07

Loans to banking clients

     7,785      68    3.50     6,470      59    3.66

Loans held for sale

     51      1    5.00     148      2    5.42
                                        

Total interest-earning assets

     76,156      409    2.15     56,000      313    2.24
                                        

Other interest revenue

        19           48   
                        

Total interest-earning assets

   $     76,156    $          428              2.25   $     56,000    $          361              2.58
                                        

Funding sources:

                

Deposits from banking clients

   $ 43,076    $ 25    0.23   $ 29,423    $ 26    0.35

Payables to brokerage clients

     22,168      1    0.02     17,459      1    0.02

Long-term debt

     1,309      19    5.82     1,028      15    5.85
                                        

Total interest-bearing liabilities

     66,553      45    0.27     47,910      42    0.35
                                        

Non-interest-bearing funding sources

     9,603           8,090      

Provision for credit losses

        1           17   
                        

Total funding sources

   $ 76,156    $ 46    0.24   $ 56,000    $ 59    0.42

Net interest revenue

      $ 382    2.01      $ 302    2.16
                                

 

(1)

Includes receivables from brokers, dealers, and clearing organizations. Interest revenue on broker-related receivables was less than $500,000 in the second quarters of 2010 and 2009.

(2)

Interest revenue on other securities owned was less than $500,000 in the second quarter of 2010.

(3)

Amounts have been calculated based on amortized cost.

 

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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,    2010     2009  
     Average
Balance
   Interest
Revenue/
Expense
   Average
Yield/
Rate
    Average
Balance
   Interest
Revenue/
Expense
   Average
Yield/
Rate
 

Interest-earning assets:

                

Cash and cash equivalents

   $ 7,636    $ 10    0.26   $ 6,996    $ 20    0.58

Cash and investments segregated

     18,924      25    0.27     15,424      51    0.67

Broker-related receivables (1)

     302                341         0.27

Receivables from brokerage clients

     8,501      211    5.01     6,178      165    5.39

Other securities owned (2)

     148         0.45               

Securities available for sale (3)

     23,177      252    2.19     16,368      262    3.23

Securities held to maturity

     7,795      145    3.75     716      15    4.22

Loans to banking clients

     7,675      135    3.55     6,346      116    3.69

Loans held for sale

     68      2    4.91     147      4    5.49
                                        

Total interest-earning assets

     74,226      780    2.12     52,516      633    2.43
                                        

Other interest revenue

        39           74   
                        

Total interest-earning assets

   $     74,226    $          819              2.22   $     52,516    $          707              2.71
                                        

Funding sources:

                

Deposits from banking clients

   $ 41,651    $ 56    0.27   $ 26,994    $ 41    0.31

Payables to brokerage clients

     21,708      1    0.01     16,843      2    0.02

Long-term debt

     1,375      39    5.72     932      29    6.27
                                        

Total interest-bearing liabilities

     64,734      96    0.30     44,769      72    0.32
                                        

Non-interest-bearing funding sources

     9,492           7,747      

Provision for credit losses

        15           26   

Other interest expense

                  1   
                    

Total funding sources

   $ 74,226    $ 111    0.30   $ 52,516    $ 99    0.38
                                        

Net interest revenue

      $ 708    1.92      $ 608    2.33
                                

 

(1)

Includes receivables from brokers, dealers, and clearing organizations. Interest revenue on broker-related receivables was less than $500,000 in the first halves of 2010 and 2009.

(2)

Interest revenue on other securities owned was less than $500,000 in the first half of 2010.

(3)

Amounts have been calculated based on amortized cost.

Net interest revenue increased in the second quarter and first half of 2010 compared to the same periods in 2009 due to higher average balances of interest-earning assets. This resulted from significant growth in average balances of deposits from banking clients, which in turn funded increases in the average balances of securities available for sale, securities held to maturity, and loans to banking clients. These interest-earning assets are invested at rates above the cost of supporting funding sources. The increase in net interest revenue was partially offset by the low interest rate environment that persisted in the second quarter and first half of 2010, which resulted in the decline in the yields of almost all interest-earning assets compared to the second quarter and first half of 2009.

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 decreased by $39 million, or 14%, in the second quarter of 2010 compared to the second quarter of 2009 due to lower average revenue earned per revenue trade. Trading revenue decreased by $89 million, or 17%, in the first half of 2010 compared to the first half of 2009 due to lower average revenue earned per revenue trade and lower daily average revenue trades.

 

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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 decreased 4% in the first half of 2010 primarily due to lower volumes of equity and principal transaction trades, partially offset by a higher volume of option trades. Average revenue earned per revenue trade decreased 12% and 11% in the second quarter and first half of 2010, respectively, primarily due to lower average revenue earned per revenue trade for equity securities as a result of lower online trade commissions, which were implemented in January 2010.

 

     Three Months Ended
June 30,
   Percent
Change
    Six Months Ended
June 30,
   Percent
Change
 
     2010    2009      2010    2009   

Daily average revenue trades (in thousands) (1)

     302.9      301.2    1     289.5      302.1    (4 %) 

Number of trading days

     63.0      63.0           124.0      124.0      

Average revenue earned per revenue trade

   $         12.15    $         13.84    (12 %)    $         12.36    $         13.95    (11 %) 

 

(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 the repurchases of long-term debt, gains and losses on sales of loans held for sale, service fees, and software maintenance fees. Other revenue decreased by $29 million, or 30%, in the first half of 2010 from the first half of 2009 due to a gain of $26 million on the repurchase of a portion of the Company’s long-term debt in the first half of 2009.

Net Impairment Losses on Securities

The Company recorded net impairment charges of $8 million and $16 million in the second quarter and first half of 2010, respectively. Net impairment charges were $13 million and $27 million in the second quarter and first half of 2009, respectively. These charges related to certain non-agency residential mortgage-backed securities in the Company’s available for sale portfolio as a result of credit deterioration of the securities’ underlying collateral. See “Item 1 – Condensed Consolidated Financial Statements (Unaudited) – Notes – 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 were relatively flat in the second quarter of 2010 compared to the second quarter of 2009, primarily due to decreases in occupancy and equipment expense and advertising and market development expense, partially offset by increases in professional services expense and compensation and benefits expense. Expenses excluding interest increased in the first half of 2010 compared to the first half of 2009, primarily due to the recognition of a class action litigation reserve relating to the Schwab YieldPlus Fund in the first quarter of 2010. Expenses excluding interest also increased in the first half of 2010 due to increases in professional services expense and other expense, partially offset by a decrease in occupancy and equipment expense.

 

     Three Months Ended
June  30,
    Percent
Change
    Six Months Ended
June  30,
    Percent
Change
 
     2010     2009       2010     2009    

Compensation and benefits

   $     393      $     377      4   $ 795      $ 802      (1 %) 

Professional services

     84        64      31     164        124      32

Occupancy and equipment

     68        97      (30 %)      136        178      (24 %) 

Advertising and market development

     43        49      (12 %)      105        107      (2 %) 

Communications

     53        54      (2 %)      105        107      (2 %) 

Depreciation and amortization

     36        41      (12 %)      73        83      (12 %) 

Class action litigation reserve

                        196             N/M   

Other

     65        68      (4 %)      133        105      27
                                            

Total expenses excluding interest

   $     742      $ 750      (1 %)    $     1,707      $     1,506      13
                                            

Expenses as a percentage of total net revenues:

            

Total expenses excluding interest

     69     69       83     69  

Advertising and market development

     4     5       5     5  
                                    

 

N/M Not meaningful.

Compensation and Benefits

Compensation and benefits expense includes salaries and wages, incentive compensation, and related employee benefits and taxes. Incentive compensation primarily includes variable compensation and discretionary bonus costs. Variable compensation includes payments to certain individuals based on their sales performance. Discretionary bonus costs are based on the Company’s overall performance as measured by earnings per share, and therefore will fluctuate with this measure.

 

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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 increased by $16 million, or 4%, in the second quarter of 2010 compared to the second quarter of 2009 primarily due to increases in salaries and wages expense and incentive compensation. Compensation and benefits expense decreased by $7 million, or 1%, in the first half of 2010 compared to the first half of 2009 primarily due to a decrease in salaries and wages expense, partially offset by an increase in incentive compensation. The following table shows a comparison of certain compensation and benefits components and employee data:

 

     Three Months Ended
June 30,
          Six Months Ended
June 30,
       
     2010     2009     Percent
Change
    2010     2009     Percent
Change
 

Salaries and wages

   $         237      $         226            5   $       473      $         499      (5 %) 

Incentive compensation (1)

     97        85      14     195        170      15

Employee benefits and other

     59        66      (11 %)      127        133      (5 %) 
                                            

Total compensation and benefits expense

   $ 393      $ 377      4   $ 795      $ 802      (1 %) 
                                            

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

            

Salaries and wages

     22     21       23     23  

Incentive compensation

     9     8       10     8  

Employee benefits and other

     5     6       6     6  
                                    

Total compensation and benefits expense

     36     35       39     37  
                                    

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

            

At quarter end

     12.5        12.1      3      

Average

     12.6        12.2      3     12.6        12.5        1

 

(1)

Includes variable compensation, 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 increased in the second quarter of 2010 compared to the second quarter of 2009 primarily due to an increase in persons employed on a contract basis. Salaries and wages decreased in the first half of 2010 compared to the first half of 2009 primarily due to severance expense of $56 million in the first half of 2009 relating to the Company’s cost reduction measures. This decrease was partially offset by an increase in persons employed on a contract basis.

Incentive compensation increased in the second quarter and first half of 2010 compared to the same periods in 2009 primarily due to higher variable compensation based on sales performance in the Company’s branch offices.

Expenses Excluding Compensation and Benefits

Professional services expense increased in the second quarter and first half of 2010 compared to the same periods in 2009 primarily due to an increase in fees paid to outsourced service providers and consultants.

Occupancy and equipment expense decreased in the second quarter and first half of 2010 compared to the same periods in 2009 primarily due to facilities charges of $28 million and $43 million in the second quarter and first half of 2009, respectively, relating to the Company’s cost reduction measures.

Advertising and market development expense decreased in the second quarter of 2010 compared to the second quarter of 2009 primarily due to lower media spending.

Depreciation and amortization expense decreased in the second quarter and first half of 2010 compared to the same periods in 2009 due to lower capital expenditures.

In the first quarter of 2010, the Company recognized a class action litigation reserve of $196 million relating to the Schwab YieldPlus Fund. For further discussion of the Schwab YieldPlus Fund litigation and regulatory matters, see “Item 1 – Condensed Consolidated Financial Statements (Unaudited) – Notes – 5. Commitments and Contingent Liabilities.”

 

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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)

 

Other expense in the first half of 2009 included charges of $21 million for individual client complaints and arbitration claims relating to Schwab YieldPlus Fund investments, offset by $34 million of insurance recoveries, resulting in a net credit of $13 million, respectively. These expenses were not material in the second quarter and first half of 2010. Other expense also increased in the first half of 2010 compared to the first half of 2009 due to an increase in employee travel expenses.

Taxes on Income

The Company’s effective income tax rate on income before taxes was 39.3% and 38.8% for the second quarters of 2010 and 2009, respectively. The Company’s effective income tax rate on income before taxes was 39.9% and 38.7% for the first halves of 2010 and 2009, respectively. The increase in the first half of 2010 was primarily due to the impact of non-recurring items on the computation of the effective income tax rate in relation to lower income before taxes.

Segment Information

The Company provides financial services to individuals and institutional clients through two segments – Investor Services and Institutional Services. 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, equity compensation plan services, and mutual fund clearing services. In addition, the Institutional Services segment supports the availability of Schwab proprietary mutual funds and collective trust 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 significant restructuring and other 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  
     2010     2009         Change         2010     2009         Change      

Investor Services:

            

Net revenues

   $     721      $     705      2   $     1,362      $     1,411      (3 %) 

Expenses excluding interest

     503        489      3     1,032        953      8
                                            

Contribution margin

   $ 218      $ 216      1   $ 330      $ 458      (28 %) 
                                            

Institutional Services:

            

Net revenues

   $ 359      $ 380      (6 %)    $ 696      $ 785      (11 %) 

Expenses excluding interest

     241        234      3     483        467      3
                                            

Contribution margin

   $ 118      $ 146      (19 %)    $ 213      $ 318      (33 %) 
                                            

Unallocated:

            

Net revenues

   $      $      N/M      $      $      N/M   

Expenses excluding interest

     (2     27      N/M        192        86      N/M   
                                            

Contribution margin

   $ 2      $ (27   N/M      $ (192   $ (86   N/M   
                                            

Total:

            

Net revenues

   $ 1,080      $ 1,085           $ 2,058      $ 2,196      (6 %) 

Expenses excluding interest

     742        750      (1 %)      1,707        1,506      13
                                            

Contribution margin

   $ 338      $ 335      1   $ 351      $ 690      (49 %) 
                                            

 

N/M Not meaningful.

Investor Services

Net revenues were relatively flat in the second quarter of 2010 compared to the second quarter of 2009 primarily due to an increase in net interest revenue, offset by decreases in asset management and administration fees and trading revenue. Net interest revenue increased due to higher average balances of interest-earning assets during the quarter. Asset management and administration fees decreased due to money market mutual fund fee waivers, partially offset by higher average equity

 

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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)

 

valuations combined with continued asset inflows. Trading revenue decreased due to lower average revenue earned per revenue trade as a result of lower online trade commissions, which were implemented in January 2010. Expenses excluding interest were also relatively flat in the second quarter of 2010 compared to the second quarter of 2009.

Net revenues decreased by $49 million, or 3%, in the first half of 2010 compared to the first half of 2009 primarily due to decreases in asset management and administration fees, trading, and other revenue, partially offset by an increase in net interest revenue. Asset management and administration fees decreased due to money market mutual fund fee waivers, partially offset by higher average equity valuations combined with continued asset inflows. Trading revenue decreased due to lower average revenue earned per revenue trade and lower daily average revenue trades. Other revenue decreased due to a gain on the repurchase of a portion of the Company’s long-term debt in the first half of 2009. The increase in net interest revenue resulted from higher average balances of interest-earning assets during the first half of 2010, partially offset by a decrease in the average yield earned compared to the year earlier period. Expenses excluding interest increased by $79 million, or 8%, in the first half of 2010 compared to the first half of 2009 primarily due to increases in professional services expense and other expense.

Institutional Services

Net revenues decreased by $21 million, or 6%, in the second quarter of 2010 compared to the second quarter of 2009 primarily due to a decrease in asset management and administration fees, partially offset by an increase in net interest revenue. Asset management and administration fees decreased due to money market mutual fund fee waivers, partially offset by higher average equity valuations combined with continued asset inflows. Net interest revenue increased due to higher average balances of interest-earning assets during the quarter. Expenses excluding interest were also relatively flat in the second quarter of 2010 compared to the second quarter of 2009.

Net revenues decreased by $89 million, or 11%, in the first half of 2010 compared to the first half of 2009 primarily due to decreases in asset management and administration fees, trading, and other revenue, partially offset by an increase in net interest revenue. Asset management and administration fees decreased due to money market mutual fund fee waivers, partially offset by higher average equity valuations combined with continued asset inflows. Trading revenue decreased due to lower average revenue earned per revenue trade and lower daily average revenue trades. Other revenue decreased due to a gain on the repurchase of a portion of the Company’s long-term debt in the first half of 2009. The increase in net interest revenue resulted from higher average balances of interest-earning assets during the first half of 2010, partially offset by a decrease in the average yield earned compared to the year earlier period. Expenses excluding interest were relatively flat in the first half of 2010 compared to the first half of 2009.

Unallocated

Expenses excluding interest in the first half of 2010 primarily include the recognition of a class action litigation reserve relating to the Schwab YieldPlus Fund in the first quarter of 2010. Expenses excluding interest in the second quarter 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 Company’s capital structure is designed to provide each subsidiary with capital and liquidity to meet its operational needs and any 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

 

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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)

 

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, 2010, CSC’s Tier 1 Leverage Ratio was 7.2%.

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. 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 $250 million were outstanding at June 30, 2010, mature in 2017 and have a fixed interest rate of 6.375% 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 (Standard & Poor’s), and A by Fitch Ratings, Ltd. (Fitch). At June 30, 2010, $202 million of Junior Subordinated Notes, which mature in 2067, 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 Baa1 by Moody’s, BBB+ by Standard & Poor’s, and BBB+ by Fitch. The Senior Notes, of which $750 million were outstanding at June 30, 2010, mature in 2014 and have a fixed interest rate of 4.950% with interest payable semiannually. The Senior Notes are rated A2 by Moody’s, A by Standard & Poor’s, and A by Fitch.

CSC has a universal automatic shelf registration statement on file with the SEC which enables CSC to issue debt, equity and other securities. On July 22, 2010, the Company issued $600 million of additional Senior Notes that mature in 2020 under this registration statement. These Senior Notes have a fixed interest rate of 4.45% with interest payable semi-annually. In January 2010, the Company completed an equity offering of 29,670,300 shares of its common stock under this registration statement. Net proceeds received from the offering were $543 million and were used to support the Company’s balance sheet growth.

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 cannot be voluntarily prepaid. 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, 2010. CSC’s ratings for these short-term borrowings are P1 by Moody’s, A1 by Standard & Poor’s, 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 2011. This facility replaced a similar facility that expired in June 2010. These facilities were unused during the first half of 2010. The funds under this facility are available for general corporate purposes, including repayment of the Commercial Paper Notes discussed above. The amount of this facility that CSC can use for other general corporate purposes is reduced by the amount of any Commercial Paper Notes outstanding. 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, 2010, the minimum level of stockholders’ equity required under this facility was $4.3 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 $706 million of the $831 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 first half of 2010.

 

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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)

 

In addition, Schwab provides CSC with a $1.0 billion credit facility maturing in December 2011. No funds were drawn under this facility at June 30, 2010.

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 from CSC, paying cash dividends, or making unsecured advances or loans to its parent company 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, 2010, Schwab’s net capital was $1.2 billion (11% of aggregate debit balances), which was $986 million in excess of its minimum required net capital and $655 million in excess of 5% of aggregate debit balances.

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 $25.7 billion and $25.3 billion at June 30, 2010 and December 31, 2009, 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 $109 million at June 30, 2010, is being reduced by a portion of the lease payments over the remaining lease term of approximately 14 years.

To manage short-term liquidity, Schwab maintains uncommitted, unsecured bank credit lines with a group of seven banks totaling $831 million at June 30, 2010. 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 17 days during the first half of 2010, with daily amounts borrowed averaging $33 million. There were no borrowings outstanding under these lines at June 30, 2010.

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 seven banks in favor of the OCC aggregating $445 million at June 30, 2010. 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, 2010, the aggregate face amount of these LOCs totaled $13 million. There were no funds drawn under any of these LOCs during the first half of 2010.

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 2012. The amount outstanding under this facility at June 30, 2010, 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 December 2011. Borrowings under this facility do not qualify as regulatory capital for Schwab. There were no funds drawn under this facility at June 30, 2010.

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

 

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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)

 

regulatory capital ratios at June 30, 2010, Schwab Bank is considered well capitalized. Schwab Bank’s regulatory capital and ratios at June 30, 2010, are as follows:

 

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

Tier 1 Capital

   $     3,788            24.0   $ 631              4.0   $ 947    6.0

Total Capital

   $ 3,839    24.3   $     1,262    8.0   $     1,578            10.0

Tier 1 Leverage

   $ 3,788    7.6   $ 1,993    4.0   $ 2,491    5.0

Tangible Equity

   $ 3,788    7.6   $ 996    2.0     N/A   

 

N/A Not applicable.

Beginning in the first quarter of 2010, in light of the evolving regulatory environment and capitalization trends observed across the banking industry, management established a target Tier 1 Leverage Ratio for Schwab Bank of at least 7.5%. 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, 2010, these balances totaled $28.1 billion.

Schwab Bank has access to traditional funding sources such as deposits, federal funds purchased, and repurchase agreements. Additionally, 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 fair value of certain of Schwab Bank’s securities available for sale and securities held to maturity that are pledged as collateral. At June 30, 2010, $940 million was available under this arrangement. There were no funds drawn under this arrangement during the first half of 2010.

Schwab Bank maintains a credit facility with the Federal Home Loan Bank System. Amounts available under this facility are dependent on the amount of Schwab Bank’s residential real estate mortgages and home equity lines of credit that are pledged as collateral. At June 30, 2010, $3.3 billion was available under this facility. There were no funds drawn under this facility during the first half of 2010.

CSC provides Schwab Bank with a $100 million short-term credit facility, which is scheduled to expire in December 2011. 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 2010.

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 not to exceed 30%. The Company’s total financial capital (long-term debt plus stockholders’ equity) at June 30, 2010, was $7.2 billion, up $602 million, or 9%, from December 31, 2009.

At June 30, 2010, the Company had long-term debt of $1.3 billion, or 18% of total financial capital, that bears interest at a weighted-average rate of 5.66%. At December 31, 2009, the Company had long-term debt of $1.5 billion, or 23% of total financial capital. The Company repaid $203 million of long-term debt in the first half of 2010, which included the maturity of $200 million of Medium-Term Notes in the first quarter of 2010.

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

 

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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)

 

repurchases and sales 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 $49 million and $72 million in the first halves of 2010 and 2009, respectively. Capital expenditures in the first half of 2010 were primarily for software and equipment relating to the Company’s information technology systems and leasehold improvements. 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 include capitalized costs for developing internal-use software of $10 million in the first half of 2010 and $9 million in the first half of 2009.

Equity Offering

On January 26, 2010, the Company completed the sale of 29,670,300 shares of its common stock, $.01 par value, at a public offering price of $19.00 per share. Net proceeds received from the offering were $543 million and were used to support the Company’s balance sheet growth, including expansion of its deposit base and migration of certain client balances from money market funds into Schwab Bank.

Dividends

CSC paid common stock cash dividends of $143 million and $139 million in the first halves of 2010 and 2009, respectively. CSC paid common stock cash dividends of $0.12 per share in the first halves of 2010 and 2009.

Share Repurchases

There were no repurchases of CSC’s common stock in the first half of 2010 or 2009. As of June 30, 2010, 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, 2009, and “Item 1 – Condensed Consolidated Financial Statements (Unaudited) – Notes – 5. Commitments and Contingent Liabilities.”

RISK MANAGEMENT

The Company’s business activities expose it to a variety of risks, including technology, operations, credit, market, liquidity, legal, and reputational risk. Identification and management of these risks are essential to the success and financial soundness of the Company. For a discussion on risks that the Company faces and the policies and procedures for risk identification, assessment, and management, 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, 2009. 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.

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.

 

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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)

 

Credit Risk Exposures

The Company has exposure to credit risk associated with the Company’s loans to banking clients. The Company’s mortgage loan portfolios primarily include first lien 3-, 5- and 7- year adjustable rate residential mortgage loans (First Mortgage portfolio) of $4.0 billion and home equity lines of credit (HELOC portfolio) of $3.4 billion at June 30, 2010.

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 2009 and the first half of 2010. 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 2010. At June 30, 2010, the weighted-average originated LTV ratios were 61% and 59% for the First Mortgage and HELOC portfolios, respectively, and the weighted-average originated FICO credit scores were 762 and 768 for the First Mortgage and HELOC portfolios, respectively.

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, 2010, 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,
2010
    December 31,
2009
 

Loan delinquencies (1)

                   0.85   0.87

Nonaccrual loans

   0.50   0.46

Allowance for credit losses

   0.65   0.61

 

(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, whose fair values totaled $23.7 billion and $9.7 billion at June 30, 2010, respectively. These portfolios include U.S. agency and non-agency residential mortgage-backed securities, U.S. agency notes, corporate debt securities, certificates of deposit, 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 residential mortgage-backed securities, by year of origination. In some instances securities have divergent ratings from Moody’s, Fitch, or Standard & Poor’s. In these instances, the Company has used the lowest rating as of June 30, 2010, 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 2010. For a discussion of the impact of current market conditions on residential mortgage-backed securities, see “Current Market and Regulatory 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

  $ 510      $ 7      $      $      $   $      $      $      $ 510      $ 7   

2006

    407        2                                               407        2   

2007

    424        11                                               424        11   

2008

    3,455        111                                               3,455        111   

2009

    8,107        193                                               8,107        193   

2010

    7,348        137                                               7,348        137   
                                                                             

Total

    20,251        461                                               20,251        461   
                                                                             

Non-agency residential mortgage-backed securities:

                   

2003

    67        (4     6                                        73        (4

2004

    109        (5     72        (9     12     (4                   193        (18

2005

    24               109        (12     57     (7     647        (115     837        (134

2006

    10                                        605        (151     615        (151

2007

    75        (2                              334        (59     409        (61
                                                                             

Total

    285        (11     187        (21     69     (11     1,586        (325     2,127        (368
                                                                             

Total residential mortgage-backed securities

  $ 20,536      $ 450      $ 187      $ (21   $ 69   $ (11   $ 1,586      $ (325   $ 22,378      $ 93   
                                                                             

% of Total residential mortgage-backed securities

    92       1             7       100  
                                               

At June 30, 2010, all of 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 & Poor’s rating of “BBB-” or higher).

Concentration Risk Exposures

The Company has exposure to concentration risk 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 $22.5 billion at June 30, 2010. Of these, $20.7 billion were U.S. agency securities and $1.8 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, 2010, the amortized cost and fair value of Alt-A mortgage-backed securities were $563 million and $368 million, respectively.

The Company’s investments in corporate debt securities and commercial paper totaled $6.6 billion at June 30, 2010, 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, 2010, were $3.2 billion of securities issued by financial institutions and guaranteed under the FDIC Temporary Liquidity Guarantee Program.

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