Table of Contents and
Form 10-Q
Cross Reference Index
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Part I — Financial Information | | | | |
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Part II — Other Information | | | | |
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“Safe Harbor” Statement under the Private Securities Litigation Reform Act of 1995.
This quarterly report on
Form 10-Q
contains forward-looking statements about U.S. Bancorp. Statements that are not historical or current facts, including statements about beliefs and expectations, are forward-looking statements and are based on the information available to, and assumptions and estimates made by, management as of the date hereof. These forward-looking statements cover, among other things, anticipated future revenue and expenses and the future plans and prospects of U.S. Bancorp. Forward-looking statements involve inherent risks and uncertainties, and important factors could cause actual results to differ materially from those anticipated. The
COVID-19
pandemic is adversely affecting U.S. Bancorp, its customers, counterparties, employees, and third-party service providers, and the ultimate extent of the impacts on its business, financial position, results of operations, liquidity, and prospects is uncertain. Continued deterioration in general business and economic conditions or turbulence in domestic or global financial markets could adversely affect U.S. Bancorp’s revenues and the values of its assets and liabilities, reduce the availability of funding to certain financial institutions, lead to a tightening of credit, and increase stock price volatility. In addition, changes to statutes, regulations, or regulatory policies or practices could affect U.S. Bancorp in substantial and unpredictable ways. U.S. Bancorp’s results could also be adversely affected by changes in interest rates; further increases in unemployment rates; deterioration in the credit quality of its loan portfolios or in the value of the collateral securing those loans; deterioration in the value of its investment securities; legal and regulatory developments; litigation; increased competition from both banks and
non-banks;
changes in the level of tariffs and other trade policies of the United States and its global trading partners; changes in customer behavior and preferences; breaches in data security; failures to safeguard personal information; effects of mergers and acquisitions and related integration; effects of critical accounting policies and judgments; and management’s ability to effectively manage credit risk, market risk, operational risk, compliance risk, strategic risk, interest rate risk, liquidity risk and reputation risk.
For discussion of these and other risks that may cause actual results to differ from expectations, refer to the other information in this report, including the section entitled “Risk Factors” and U.S. Bancorp’s Annual Report on Form
10-K
for the year ended December 31, 2019, on file with the Securities and Exchange Commission, including the sections entitled “Corporate Risk Profile” and “Risk Factors” contained in Exhibit 13, and all subsequent filings with the Securities and Exchange Commission under Sections 13(a), 13(c), 14 or 15(d) of the Securities Exchange Act of 1934. In addition, factors other than these risks also could adversely affect U.S. Bancorp’s results, and the reader should not consider these risks to be a complete set of all potential risks or uncertainties. Forward-looking statements speak only as of the date hereof, and U.S. Bancorp undertakes no obligation to update them in light of new information or future events.
Management’s Discussion and Analysis
U.S. Bancorp and its subsidiaries (the “Company”) reported net income attributable to U.S. Bancorp of $689 million for the second quarter of 2020, or $0.41 per diluted common share, compared with $1.8 billion, or $1.09 per diluted common share, for the second quarter of 2019. Return on average assets and return on average common equity were 0.51 percent and 5.3 percent, respectively, for the second quarter of 2020, compared with 1.55 percent and 15.0 percent, respectively, for the second quarter of 2019. During a challenging period adversely impacted by the
COVID-19
pandemic, the Company’s diversified business mix generated growth in net revenue and supported a provision for credit losses of $1.7 billion resulting in a $1.3 billion increase in the allowance for credit losses in the second quarter of 2020.
Total net revenue for the second quarter of 2020 was $16 million (0.3 percent) higher than the second quarter of 2019, reflecting a 5.0 percent increase in noninterest income, partially offset by a 3.2 percent decrease in net interest income. The decrease in net interest income from the second quarter of 2019 was primarily due to the impact of declining interest rates, partially offset by changes in deposit and funding mix, and loan growth. The noninterest income increase was driven by significant growth in mortgage banking revenue due to refinancing activities, strong growth in commercial products revenue, and an increase in gains on the sale of investment securities. Growth in these fee categories was partially offset by a decline in payment services revenue and deposit service charges related to lower consumer and commercial spending as well as higher fee waivers related to customers impacted by
COVID-19.
Additionally, other noninterest income declined from the second quarter of 2019 due to lower equity investment income, lower tax credit syndication revenues, and asset impairments as a result of property damage from civil unrest occurring during the second quarter of 2020.
Noninterest expense in the second quarter of 2020 was $165 million (5.2 percent) higher than the second quarter of 2019, reflecting costs related to
COVID-19
and an increase in revenue-related production expenses in the second quarter of 2020. Additionally, noninterest expense reflected an increase in personnel and technology and communications expenses related to developing digital capabilities and related business investment, partially offset by lower marketing and business development expense.
The provision for credit losses for the second quarter of 2020 of $1.7 billion was $1.4 billion higher than the second quarter of 2019, reflecting an increase in the allowance for credit losses during the second quarter of 2020 due to deteriorating economic conditions driven by the impact of
COVID-19
on the domestic and global economies. Net charge-offs in the second quarter of 2020 were $437 million, compared with $350 million in the second quarter of 2019. Refer to “Corporate Risk Profile” for further information on the provision for credit losses, net charge-offs, nonperforming assets and other factors considered by the Company in assessing the credit quality of the loan portfolio and establishing the allowance for credit losses.
Net income attributable to U.S. Bancorp for the first six months of 2020 was $1.9 billion, or $1.12 per diluted common share, compared with $3.5 billion, or $2.10 per diluted common share, for the first six months of 2019. Return on average assets and return on average common equity were 0.72 percent and 7.5 percent, respectively, for the first six months of 2020, compared with 1.52 percent and 14.7 percent, respectively, for the first six months of 2019.
Total net revenue for the first six months of 2020 was $211 million (1.9 percent) higher than the first six months of 2019, reflecting a 7.5 percent increase in noninterest income, partially offset by a 2.1 percent decrease in net interest income (2.2 percent on a taxable-equivalent basis). The decrease in net interest income from the first six months of 2019 was primarily due to the impact of declining interest rates, partially offset by changes in deposit and funding mix, and loan growth. The noninterest income increase was driven by significant growth in mortgage banking revenue due to refinancing activities, strong growth in commercial products revenue and trust and investment management fees, and an increase in gains on the sale of investment securities. Growth in these fee categories was partially offset by a decline in payment services revenue and deposit service charges related to lower consumer and commercial spending as well as higher fee waivers related to customers impacted by
COVID-19.
Additionally, other noninterest income declined from the prior year due to lower equity investment income, lower tax credit syndication revenues, and asset impairments recorded in
the first six months of 2020, partially offset by gains on sale of certain businesses in the first six months of 2020.
Noninterest expense in the first six months of 2020 was $394 million (6.3 percent) higher than the first six months of 2019, reflecting costs related to
COVID-19
and an increase in revenue-related production expenses in the first six months of 2020. Additionally, noninterest expense reflected an increase in personnel and technology and communications expenses related to developing digital capabilities and related business investment, partially offset by lower marketing and business development expense.
The provision for credit losses for the first six months of 2020 of $2.7 billion was $2.0 billion higher than the first six months of 2019, reflecting an increase in the allowance for credit losses during the first six months of 2020 due to deteriorating economic conditions driven by the impact of
COVID-19
on the domestic and global economies. Net charge-offs in the first six months of 2020 were $830 million, compared with $717 million in the first six months of 2019. Refer to “Corporate Risk Profile” for further information on the provision for credit losses, net charge-offs, nonperforming assets and other factors considered by the Company in assessing the credit quality of the loan portfolio and establishing the allowance for credit losses.
STATEMENT OF INCOME ANALYSIS
Net interest income, on a taxable-equivalent basis, was $3.2 billion in the second quarter and $6.5 billion in the first six months of 2020, representing decreases of $108 million (3.2 percent) and $147 million (2.2 percent), respectively, compared with the same periods of 2019. The decreases were principally driven by the impact of declining interest rates, partially offset by changes in deposit and funding mix, and loan growth. Average earning assets were $67.2 billion (15.7 percent) higher in the second quarter and $47.7 billion (11.3 percent) higher in the first six months of 2020, compared with the same periods of 2019, reflecting increases in loans, investment securities and other earning assets. The net interest margin, on a taxable-equivalent basis, in the second quarter and first six months of 2020 was 2.62 percent and 2.76 percent, respectively, compared with 3.13 percent and 3.14 percent in the second quarter and first six months of 2019, respectively. The decrease in net interest margin from the prior year was primarily due to the impact of the lower yield curve and a decision to retain higher cash balances to maintain liquidity given the environment, partially offset by changes in deposit pricing and funding mix. The Company expects its net interest margin to be relatively stable in the third quarter of 2020, as compared with the second quarter of 2020. Refer to the “Consolidated Daily Average Balance Sheet and Related Yields and Rates” tables for further information on net interest income.
Average total loans in the second quarter and first six months of 2020 were $28.9 billion (10.0 percent) and $20.2 billion (7.0 percent) higher, respectively, than the same periods of 2019. The increases were primarily due to higher commercial loans, reflecting the utilization of bank credit facilities by customers to support liquidity requirements as well as the impact of loans made under the Small Business Administration’s (“SBA”) Paycheck Protection Program, along with growth in residential mortgages given the lower interest rate environment. These increases were partially offset by lower credit card loans reflecting lower consumer spending during the first six months of 2020, as well as lower other retail loans.
Average investment securities in the second quarter and first six months of 2020 were $5.4 billion (4.7 percent) and $6.0 billion (5.3 percent) higher, respectively, than the same periods of 2019, primarily due to purchases of mortgage-backed securities, net of prepayments and maturities, partially offset by U.S. Treasury securities sales and maturities, net of purchases.
Average total deposits for the second quarter and first six months of 2020 were $58.1 billion (16.8 percent) and $42.7 billion (12.6 percent) higher, respectively, than the same periods of 2019. Average total savings deposits for the second quarter and first six months of 2020 were $39.7 billion (17.6 percent) and $35.1 billion (15.9 percent) higher, respectively, than the same periods of the prior year, driven by increases in Corporate and Commercial Banking, Consumer and Business Banking, and Wealth Management and Investment Services balances. Average noninterest-bearing deposits for the second quarter and first six months of 2020 were $22.0 billion (30.1 percent) and $11.4 billion (15.5 percent) higher, respectively, than the same periods of 2019, primarily due to increases in Corporate and Commercial Banking, Consumer and Business Banking, and Wealth Management and Investment Services balances. The growth in average total savings and noninterest-bearing deposits was primarily a result of the actions by the federal government to increase liquidity in the financial system, customers maintaining balance sheet liquidity by utilizing existing credit facilities and government stimulus programs. Average time deposits for the second quarter and first six months of 2020 were $3.6 billion (7.7 percent) and $3.7 billion (8.0 percent) lower, respectively, than the same periods of the prior year, primarily driven by decreases in those deposits managed as an alternative to other funding sources, based largely on relative pricing and liquidity characteristics, partially offset by increases in Consumer and Business Banking balances.
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| (Dollars in Millions) | | 2020 | | | 2019 | | | Percent
Change | | | 2020 | | | 2019 | | | Percent
Change | |
| | $ | 1,685 | | | $ | 1,574 | | | | 7.1 | % | | $ | 3,305 | | | $ | 3,133 | | | | 5.5 | % |
| | | 314 | | | | 314 | | | | – | | | | 666 | | | | 647 | | | | 2.9 | |
Net occupancy and equipment | | | 271 | | | | 281 | | | | (3.6 | ) | | | 547 | | | | 558 | | | | (2.0 | ) |
| | | 106 | | | | 106 | | | | – | | | | 205 | | | | 201 | | | | 2.0 | |
Marketing and business development | | | 67 | | | | 111 | | | | (39.6 | ) | | | 141 | | | | 200 | | | | (29.5 | ) |
Technology and communications | | | 309 | | | | 270 | | | | 14.4 | | | | 598 | | | | 527 | | | | 13.5 | |
Postage, printing and supplies | | | 72 | | | | 73 | | | | (1.4 | ) | | | 144 | | | | 145 | | | | (.7 | ) |
| | | 43 | | | | 42 | | | | 2.4 | | | | 85 | | | | 82 | | | | 3.7 | |
| | | 451 | | | | 382 | | | | 18.1 | | | | 943 | | | | 747 | | | | 26.2 | |
Total noninterest expense | | $ | 3,318 | | | $ | 3,153 | | | | 5.2 | % | | $ | 6,634 | | | $ | 6,240 | | | | 6.3 | % |
| | | 57.6 | % | | | 54.3 | % | | | | | | | 57.8 | % | | | 54.8 | % | | | | |
| a) | See Non-GAAP Financial Measures beginning on page 32. |
to improve from the levels seen in late March and early April, and the Company expects continued gradual improvement in sales volumes throughout the remainder of the year. Deposit service charges decreased primarily due to lower volume and higher fee waivers related to customers impacted by
COVID-19.
Other noninterest income decreased due to lower equity investment income, lower
tax-advantaged
investment syndication revenue and asset impairments as a result of property damage from civil unrest in the second quarter of 2020. The decrease in other noninterest income in the first six months of 2020, compared with the first six months of 2019, was partially offset by gains on sale of certain businesses in the first quarter of 2020.
Noninterest expense was $3.3 billion in the second quarter and $6.6 billion in the first six months of 2020, representing increases of $165 million (5.2 percent) and $394 million (6.3 percent), respectively, over the same periods of 2019. The increases from a year ago were driven by incremental costs related to
COVID-19
and revenue-related expenses due to higher mortgage production and capital markets activities of $150 million in the second quarter and $299 million in the first six months of 2020, in addition to business investments, including increased digital capabilities. The categories of expense impacted include higher personnel expense, technology and communications expense, and other noninterest expense, partially offset by lower marketing and business development expense. Compensation expense increased due to the impacts of merit increases and higher variable compensation related to business production within mortgage banking and fixed income capital markets. Technology and communications expense increased primarily due to capital expenditures supporting business growth. Other noninterest expense increased, reflecting $79 million and $179 million of expenses in the second quarter and first six months of 2020, respectively, related to
COVID-19,
and higher state franchise taxes, partially offset by lower costs related to
tax-advantaged
projects in 2020. Incremental costs related to
COVID-19
include increased liabilities driven by the Company’s exposure as a credit card processor to charge-back risk on undelivered goods and services, including prepaid airline tickets, as well as expenses related to paying premium compensation to front-line workers and providing a safe working environment for employees. The Company expects these incremental
COVID-19
costs to begin to dissipate in the second half of 2020. Marketing and business development expense decreased due to the timing of marketing campaigns and a reduction in travel as a result of
COVID-19.
The provision for income taxes was $64 million (an effective rate of 8.4 percent) for the second quarter and $324 million (an effective rate of 14.7 percent) for the first six months of 2020, compared with $449 million (an effective rate of 19.7 percent) and $827 million (an effective rate of 19.0 percent) for the same periods of 2019. The reduced tax rates for 2020 were primarily a result of reduced pretax income being impacted by current economic conditions, including the higher provision for credit losses. For further information on income taxes, refer to Note 11 of the Notes to Consolidated Financial Statements.
The Company’s loan portfolio was $310.3 billion at June 30, 2020, compared with $296.1 billion at December 31, 2019, an increase of $14.2 billion (4.8 percent). The increase was driven by higher commercial loans, commercial real estate loans and residential mortgages, partially offset by lower credit card loans and other retail loans.
Commercial loans increased $16.4 billion (15.8 percent) at June 30, 2020, compared with December 31, 2019, reflecting the utilization of bank credit facilities by customers to support liquidity
| | |
| | Available-for-Sale Investment Securities |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | June 30, 2020 | | | | | | December 31, 2019 | |
| (Dollars in Millions) | | Amortized
Cost | | | Fair Value | | | Weighted-
Average
Maturity in
Years | | | Weighted-
Average
Yield (d) | | | | | | Amortized
Cost | | | Fair Value | | | Weighted-
Average
Maturity in
Years | | | Weighted-
Average
Yield (d) | |
U.S. Treasury and agencies | | $ | 19,397 | | | $ | 19,978 | | | | 2.7 | | | | 1.64 | % | | | | | | $ | 19,845 | | | $ | 19,839 | | | | 2.7 | | | | 1.68 | % |
Mortgage-backed securities (a) | | | 97,272 | | | | 99,765 | | | | 2.8 | | | | 1.97 | | | | | | | | 95,385 | | | | 95,564 | | | | 4.4 | | | | 2.39 | |
Asset-backed securities (a) | | | 361 | | | | 368 | | | | 2.9 | | | | 3.58 | | | | | | | | 375 | | | | 383 | | | | 3.1 | | | | 3.09 | |
Obligations of state and political subdivisions (b) (c) | | | 7,470 | | | | 7,996 | | | | 6.5 | | | | 4.15 | | | | | | | | 6,499 | | | | 6,814 | | | | 6.6 | | | | 4.29 | |
| | | 13 | | | | 13 | | | | .6 | | | | 1.65 | | | | | | | | 13 | | | | 13 | | | | .3 | | | | 2.66 | |
Total investment securities | | $ | 124,513 | | | $ | 128,120 | | | | 3.0 | | | | 2.05 | % | | | | | | $ | 122,117 | | | $ | 122,613 | | | | 4.2 | | | | 2.38 | % |
| (a) | Information related to asset and mortgage-backed securities included above is presented based upon weighted-average maturities that take into account anticipated future prepayments. |
| (b) | Information related to obligations of state and political subdivisions is presented based upon yield to first optional call date if the security is purchased at a premium, and yield to maturity if the security is purchased at par or a discount. |
| (c) | Maturity calculations for obligations of state and political subdivisions are based on the first optional call date for securities with a fair value above par and the contractual maturity date for securities with a fair value equal to or below par. |
| (d) | Yields on investment securities are computed based on amortized cost balances. Weighted-average yields for obligations of state and political subdivisions are presented on a fully-taxable equivalent basis based on a federal income tax rate of 21 percent. |
requirements as well as the impact of loans made under the SBA’s Paycheck Protection Program.
Commercial real estate loans increased $1.3 billion (3.3 percent) at June 30, 2020, compared with December 31, 2019, primarily the result of new originations, partially offset by customers paying down balances.
Residential mortgages held in the loan portfolio increased $743 million (1.1 percent) at June 30, 2020, compared with December 31, 2019, as origination activity more than offset the effect of customers paying down balances in the first six months of 2020 given the lower interest rate environment. Residential mortgages originated and placed in the Company’s loan portfolio include well-secured jumbo mortgages and branch-originated first lien home equity loans to borrowers with high credit quality.
Credit card loans decreased $3.5 billion (14.2 percent) at June 30, 2020, compared with December 31, 2019, reflecting reduced consumer spending in 2020 driven by the impact of
COVID-19.
Other retail loans decreased $706 million (1.2 percent) at June 30, 2020, compared with December 31, 2019, the result of decreases in home equity loans, auto loans and revolving credit balances, partially offset by an increase in installment loans.
The Company generally retains portfolio loans through maturity; however, the Company’s intent may change over time based upon various factors such as ongoing asset/liability management activities, assessment of product profitability, credit risk, liquidity needs, and capital implications. If the Company’s intent or ability to hold an existing portfolio loan changes, it is transferred to loans held for sale.
Loans held for sale, consisting primarily of residential mortgages to be sold in the secondary market, were $8.2 billion at June 30, 2020, compared with $5.6 billion at December 31, 2019. The increase in loans held for sale was principally due to a higher level of mortgage loan closings in the second quarter of 2020 given the lower interest rate environment, compared with the fourth quarter of 2019. Almost all of the residential mortgage loans the Company originates or purchases for sale follow guidelines that allow the loans to be sold into existing, highly liquid secondary markets; in particular in government agency transactions and to government-sponsored enterprises (“GSEs”).
investment securities totaled $128.1 billion at June 30, 2020, compared with $122.6 billion at December 31, 2019. The $5.5 billion (4.5 percent) increase was primarily due to a $3.1 billion favorable change in net unrealized gains (losses) on
investment securities and $2.3 billion of net investment purchases. The Company had no outstanding investment securities classified as
at June 30, 2020 and December 31, 2019.
The Company’s
investment securities are carried at fair value with changes in fair value reflected in other comprehensive income (loss) unless a portion of a security’s unrealized loss is related to credit and an allowance for credit losses is necessary. At June 30, 2020, the Company’s net unrealized gains on
investment securities were $3.6 billion, compared with $496 million at December 31, 2019. The favorable change in net unrealized gains was primarily due to increases in the fair value of U.S. Treasury, mortgage-backed, and state and political securities as a result of changes in interest rates. Gross unrealized losses on
investment securities totaled $39 million at June 30, 2020, compared with
$448 million at December 31, 2019. At June 30, 2020, the Company had no plans to sell securities with unrealized losses, and believes it is more likely than not that it would not be required to sell such securities before recovery of their amortized cost.
Refer to Notes 3 and 14 in the Notes to Consolidated Financial Statements for further information on investment securities.
Total deposits were $413.3 billion at June 30, 2020, compared with $361.9 billion at December 31, 2019. The $51.4 billion (14.2 percent) increase in total deposits reflected increases in noninterest-bearing and total savings deposits, partially offset by a decrease in time deposits. Noninterest-bearing deposits increased $34.1 billion (45.2 percent) at June 30, 2020, compared with December 31, 2019, primarily due to higher Corporate and Commercial Banking, Consumer and Business Banking, and Wealth Management and Investment Services balances. Money market deposit balances increased $9.0 billion (7.5 percent) at June 30, 2020, compared with December 31, 2019, primarily due to higher Corporate and Commercial Banking, and Consumer and Business Banking balances, partially offset by a decrease in Wealth Management and Investment Services balances. Interest checking balances increased $7.6 billion (10.0 percent), while savings account balances increased $5.2 billion (11.1 percent), both driven by higher Consumer and Business Banking balances. The growth in noninterest-bearing and total savings deposits was primarily a result of the economic impact of the
COVID-19
pandemic on the world economy resulting in actions by the federal government to increase liquidity in the financial system, customers maintaining balance sheet liquidity by utilizing existing credit facilities and government stimulus programs. Time deposits decreased $4.6 billion (10.7 percent) at June 30, 2020, compared with December 31, 2019, driven by a decrease in those deposits managed as an alternative to other funding sources, based largely on relative pricing and liquidity characteristics.
The Company utilizes both short-term and long-term borrowings as part of its asset/liability management and funding strategies. Short-term borrowings, which include federal funds purchased, commercial paper, repurchase agreements, borrowings secured by high-grade assets and other short-term borrowings, were $20.6 billion at June 30, 2020, compared with $23.7 billion at December 31, 2019. The $3.1 billion (13.2 percent) decrease in short-term borrowings was primarily due to a decrease in short-term Federal Home Loan Bank (“FHLB”) advances and other short-term borrowings balances, partially offset by higher commercial paper, repurchase agreement and federal funds purchased balances. Long-term debt was $42.6 billion at June 30, 2020, compared with $40.2 billion at December 31, 2019. The $2.4 billion (6.0 percent) increase was primarily due to $3.3 billion of bank note and $1.5 billion of medium-term note issuances, partially offset by $3.2 billion of bank note repayments and maturities. Refer to the “Liquidity Risk Management” section for discussion of liquidity management of the Company.
Managing risks is an essential part of successfully operating a financial services company. The Company’s Board of Directors has approved a risk management framework which establishes governance and risk management requirements for all risk-taking activities. This framework includes Company and business line risk appetite statements which set boundaries for the types and amount of risk that may be undertaken in pursuing business objectives and initiatives. The Board of Directors, primarily through its Risk Management Committee, oversees performance relative to the risk management framework, risk appetite statements, and other policy requirements.
The Executive Risk Committee (“ERC”), which is chaired by the Chief Risk Officer and includes the Chief Executive Officer and other members of the executive management team, oversees execution against the risk management framework and risk appetite statements. The ERC focuses on current and emerging risks, including strategic and reputation risks, by directing timely and comprehensive actions. Senior operating committees have also been established, each responsible for overseeing a specified category of risk.
The Company’s most prominent risk exposures are credit, interest rate, market, liquidity, operational, compliance, strategic, and reputation. Leveraging the Company’s risk management framework, the specific impacts of
COVID-19
and related risks are identified for each of the most prominent exposures. Oversight and governance is managed through a centralized command center which escalates through the ERC. The Board of Directors also oversees the Company’s responsiveness to the
COVID-19
pandemic. Credit risk is the risk of not collecting the interest and/or the principal balance of a loan, investment or derivative contract when it is due. Interest rate risk is the potential reduction of net interest income or market valuations as a result of changes in interest rates. Market risk arises from fluctuations in interest rates, foreign exchange rates, and security prices that may result in changes in the values of financial
instruments, such as trading and
securities, mortgage loans held for sale (“MLHFS”), MSRs and derivatives that are accounted for on a fair value basis. Liquidity risk is the possible inability to fund obligations or new business at a reasonable cost and in a timely manner. Operational risk is the risk to current or projected financial condition arising from inadequate or failed internal processes or systems, people, or adverse external events, including the risk of loss resulting from breaches in data security. Operational risk can also include the risk of loss due to failures by third parties with which the Company does business. Compliance risk is the risk that the Company may suffer legal or regulatory sanctions, financial losses, and reputational damage if it fails to adhere to compliance requirements. Strategic risk is the risk to current or projected financial condition arising from adverse business decisions, poor implementation of business decisions, or lack of responsiveness to changes in the banking industry and operating environment. Reputation risk is the risk to current or anticipated earnings, capital, or franchise or enterprise value arising from negative public opinion. This risk may impair the Company’s competitiveness by affecting its ability to establish new relationships or services offer new services or continue serving existing relationships. In addition to the risks identified above, other risk factors exist that may impact the Company. Refer to “Risk Factors” in this report and in the Company’s Annual Report on Form
10-K
for the year ended December 31, 2019, for a detailed discussion of these factors.
The Company’s Board and management-level governance committees are supported by a “three lines of defense” model for establishing effective checks and balances. The first line of defense, the business lines, manages risks in conformity with established limits and policy requirements. In turn, business line leaders and their risk officers establish programs to ensure conformity with these limits and policy requirements. The second line of defense, which includes the Chief Risk Officer’s organization as well as policy and oversight activities of corporate support functions, translates risk appetite and strategy into actionable risk limits and policies. The second line of defense monitors first line of defense conformity with limits and policies, and provides reporting and escalation of emerging risks and other concerns to senior management and the Risk Management Committee of the Board of Directors. The third line of defense, internal audit, is responsible for providing the Audit Committee of the Board of Directors and senior management with independent assessment and assurance regarding the effectiveness of the Company’s governance, risk management and control processes.
Management regularly provides reports to the Risk Management Committee of the Board of Directors. The Risk Management Committee discusses with management the Company’s risk management performance, and provides a summary of key risks to the entire Board of Directors, covering the status of existing matters, areas of potential future concern and specific information on certain types of loss events. The Risk Management Committee considers quarterly reports by management assessing the Company’s performance relative to the risk appetite statements and the associated risk limits, including:
| • | | Macroeconomic environment and other qualitative considerations, such as regulatory and compliance changes, litigation developments, and technology and cybersecurity; |
| • | | Credit measures, including adversely rated and nonperforming loans, leveraged transactions, credit concentrations and lending limits; |
| • | | Interest rate and market risk, including market value and net income simulation, and trading-related Value at Risk (“VaR”); |
| • | | Liquidity risk, including funding projections under various stressed scenarios; |
| • | | Operational and compliance risk, including losses stemming from events such as fraud, processing errors, control breaches, breaches in data security or adverse business decisions, as well as reporting on technology performance, and various legal and regulatory compliance measures; |
| • | | Capital ratios and projections, including regulatory measures and stressed scenarios; and |
| • | | Strategic and reputation risk considerations, impacts and responses. |
The Company’s strategy for credit risk management includes well-defined, centralized credit policies, uniform underwriting criteria, and ongoing risk monitoring and review processes for all commercial and consumer credit exposures. In evaluating its credit risk, the Company considers changes, if any, in underwriting activities, the loan portfolio composition (including product mix and geographic, industry or customer-specific concentrations), collateral values, trends in loan performance and macroeconomic factors, such as changes in unemployment rates, gross domestic product and consumer bankruptcy filings, as well as the potential impact on customers and the domestic economy resulting from new tariffs or increases in existing tariffs, and the
COVID-19
pandemic. The Risk Management Committee oversees the Company’s credit risk management process.
In addition, credit quality ratings as defined by the Company, are an important part of the Company’s
overall credit risk management and evaluation of its allowance for credit losses. Loans with a pass rating represent those loans not classified on the Company’s rating scale for problem credits, as minimal risk has been identified. Loans with a special mention or classified rating, including loans that are 90 days or more past due and still accruing, nonaccrual loans, those loans considered troubled debt restructurings (“TDRs”), and loans in a junior lien position that are current but are behind a modified or delinquent loan in a first lien position, encompass all loans held by the Company that it considers to have a potential or well-defined weakness that may put full collection of contractual cash flows at risk. The Company’s internal credit quality ratings for consumer loans are primarily based on delinquency and nonperforming status, except for a limited population of larger loans within those portfolios that are individually evaluated. For this limited population, the determination of the internal credit quality rating may also consider collateral value and customer cash flows. Refer to Note 4 in the Notes to Consolidated Financial Statements for further discussion of the Company’s loan portfolios including internal credit quality ratings. In addition, refer to “Management’s Discussion and Analysis — Credit Risk Management” in the Company’s Annual Report on
Form 10-K
for the year ended December 31, 2019, for a more detailed discussion on credit risk management processes.
The Company manages its credit risk, in part, through diversification of its loan portfolio which is achieved through limit setting by product type criteria, such as industry, and identification of credit concentrations. As part of its normal business activities, the Company offers a broad array of lending products. The Company categorizes its loan portfolio into two segments, which is the level at which it develops and documents a systematic methodology to determine the allowance for credit losses. The Company’s two loan portfolio segments are commercial lending and consumer lending.
The commercial lending segment includes loans and leases made to small business, middle market, large corporate, commercial real estate, financial institution,
non-profit
and public sector customers. Key risk characteristics relevant to commercial lending segment loans include the industry and geography of the borrower’s business, purpose of the loan, repayment source, borrower’s debt capacity and financial flexibility, loan covenants, and nature of pledged collateral, if any. These risk characteristics, among others, are considered in determining estimates about the likelihood of default by the borrowers and the severity of loss in the event of default. The Company considers these risk characteristics in assigning internal risk ratings to, or forecasting losses on, these loans, which are the significant factors in determining the allowance for credit losses for loans in the commercial lending segment.
The consumer lending segment represents loans and leases made to consumer customers, including residential mortgages, credit card loans, and other retail loans such as revolving consumer lines, auto loans and leases, home equity loans and lines, and student loans, a
run-off
portfolio. Home equity or second mortgage loans are junior lien
closed-end
accounts fully disbursed at origination. These loans typically are fixed rate loans, secured by residential real estate, with a
10-
or
15-year
fixed payment amortization schedule. Home equity lines are revolving accounts giving the borrower the ability to draw and repay balances repeatedly, up to a maximum commitment, and are secured by residential real estate. These include accounts in either a first or junior lien position. Typical terms on home equity lines in the portfolio are variable rates benchmarked to the prime rate, with a
10-
or
15-year
draw period during which a minimum payment is equivalent to the monthly interest, followed by a
20-
or
10-year
amortization period, respectively. At June 30, 2020, substantially all of the Company’s home equity lines were in the draw period. Approximately $1.2 billion, or 10 percent, of the outstanding home equity line balances at June 30, 2020, will enter the amortization period within the next 36 months. Key risk characteristics relevant to consumer lending segment loans primarily relate to the borrowers’ capacity and willingness to repay and include unemployment rates and other economic factors, customer payment history and credit scores, and in some cases, updated
(“LTV”) information reflecting current market conditions on real estate-based loans. These and other risk characteristics, including elevated risk resulting from the
COVID-19
pandemic, are reflected in forecasts of delinquency levels, bankruptcies and losses which are the primary factors in determining the allowance for credit losses for the consumer lending segment.
The Company further disaggregates its loan portfolio segments into various classes based on their underlying risk characteristics. The two classes within the commercial lending segment are commercial loans and commercial real estate loans. The three classes within the consumer lending segment are residential mortgages, credit card loans and other retail loans.
The Company’s consumer lending segment utilizes several distinct business processes and channels to originate consumer credit, including traditional branch lending, mobile and
on-line
banking, indirect lending, correspondent banks and loan brokers. Each distinct
underwriting and origination activity manages unique credit risk characteristics and prices its loan production commensurate with the differing risk profiles.
Residential mortgage originations are generally limited to prime borrowers and are performed through the Company’s branches, loan production offices, mobile and
on-line
services and a wholesale network of originators. The Company may retain residential mortgage loans it originates on its balance sheet or sell the loans into the secondary market while retaining the servicing rights and customer relationships. Utilizing the secondary markets enables the Company to effectively reduce its credit and other asset/liability risks. For residential mortgages that are retained in the Company’s portfolio and for home equity and second mortgages, credit risk is also diversified by geography and managed by adherence to LTV and borrower credit criteria during the underwriting process.
The Company estimates updated LTV information on its outstanding residential mortgages quarterly, based on a method that combines automated valuation model updates and relevant home price indices. LTV is the ratio of the loan’s outstanding principal balance to the current estimate of property value. For home equity and second mortgages, combined
(“CLTV”) is the combination of the first mortgage original principal balance and the second lien outstanding principal balance, relative to the current estimate of property value. Certain loans do not have an LTV or CLTV, primarily due to lack of availability of relevant automated valuation model and/or home price indices values, or lack of necessary valuation data on acquired loans.
The following tables provide summary information of residential mortgages and home equity and second mortgages by LTV and borrower type at June 30, 2020:
| | | | | | | | | | | | | | | | |
| | Interest
Only | | | Amortizing | | | Total | | | Percent
of Total | |
| | | | | | | | | | | | | | | | |
Less than or equal to 80% | | $ | 2,907 | | | $ | 58,651 | | | $ | 61,558 | | | | 86.3 | % |
| | | 13 | | | | 5,346 | | | | 5,359 | | | | 7.5 | |
| | | — | | | | 500 | | | | 500 | | | | .7 | |
| | | — | | | | 129 | | | | 129 | | | | .2 | |
| | | — | | | | 20 | | | | 20 | | | | — | |
Loans purchased from GNMA mortgage pools (a) | | | — | | | | 3,763 | | | | 3,763 | | | | 5.3 | |
| | $ | 2,920 | | | $ | 68,409 | | | $ | 71,329 | | | | 100.0 | % |
| | | | | | | | | | | | | | | | |
| | $ | 2,920 | | | $ | 64,086 | | | $ | 67,006 | | | | 93.9 | % |
| | | — | | | | 560 | | | | 560 | | | | .8 | |
Loans purchased from GNMA mortgage pools (a) | | | — | | | | 3,763 | | | | 3,763 | | | | 5.3 | |
| | $ | 2,920 | | | $ | 68,409 | | | $ | 71,329 | | | | 100.0 | % |
| (a) | Represents loans purchased from Government National Mortgage Association (“GNMA”) mortgage pools whose payments are primarily insured by the Federal Housing Administration or guaranteed by the United States Department of Veterans Affairs. |
| | | | | | | | | | | | | | | | |
Home Equity and Second Mortgages
(Dollars in Millions) | | Lines | | | Loans | | | Total | | | Percent
of Total | |
| | | | | | | | | | | | | | | | |
Less than or equal to 80% | | $ | 10,652 | | | $ | 836 | | | $ | 11,488 | | | | 82.4 | % |
| | | 1,411 | | | | 548 | | | | 1,959 | | | | 14.1 | |
| | | 224 | | | | 51 | | | | 275 | | | | 2.0 | |
| | | 97 | | | | 7 | | | | 104 | | | | .7 | |
| | | 101 | | | | 5 | | | | 106 | | | | .8 | |
| | $ | 12,485 | | | $ | 1,447 | | | $ | 13,932 | | | | 100.0 | % |
| | | | | | | | | | | | | | | | |
| | $ | 12,456 | | | $ | 1,415 | | | $ | 13,871 | | | | 99.6 | % |
| | | 29 | | | | 32 | | | | 61 | | | | .4 | |
| | $ | 12,485 | | | $ | 1,447 | | | $ | 13,932 | | | | 100.0 | % |
Home equity and second mortgages were $13.9 billion at June 30, 2020, compared with $15.0 billion at December 31, 2019, and included $3.6 billion of home equity lines in a first lien position and $10.3 billion of home equity and second mortgage loans and lines in a junior lien position. Loans and lines in a junior lien position at June 30, 2020, included approximately $4.0 billion of loans and lines for which the Company also serviced the related first lien loan, and approximately $6.3 billion where the Company did not service the related first lien loan. The Company was able to determine the status of the related first liens using information the Company has as the servicer of the first lien or information reported on customer credit bureau files. The Company also evaluates other indicators of credit risk for these junior lien loans and lines including delinquency, estimated average CLTV ratios and updated weighted-average credit scores in making its assessment of credit risk, related loss estimates and determining the allowance for credit losses.
The following table provides summary delinquency information for residential mortgages, credit card and other retail loans included in the consumer lending segment:
| | | | | | | | | | | | | | | | | | | | |
| | | Amount | | | | | | As a Percent of Ending
Loan Balances | |
| (Dollars in Millions) | | June 30,
2020 | | | December 31,
2019 | | | | | | June 30,
2020 | | | December 31,
2019 | |
Residential Mortgages (a) | | | | | | | | | | | | | | | | | | | | |
| | $ | 241 | | | $ | 154 | | | | | | | | .34 | % | | | .22 | % |
| | | 115 | | | | 120 | | | | | | | | .16 | | | | .17 | |
| | | 242 | | | | 241 | | | | | | | | .34 | | | | .34 | |
| | $ | 598 | | | $ | 515 | | | | | | | | .84 | % | | | .73 | % |
| | | | | | | | | | | | | | | | | | | | |
| | $ | 230 | | | $ | 321 | | | | | | | | 1.08 | % | | | 1.30 | % |
| | | 259 | | | | 306 | | | | | | | | 1.22 | | | | 1.23 | |
| | | — | | | | — | | | | | | | | — | | | | — | |
| | $ | 489 | | | $ | 627 | | | | | | | | 2.30 | % | | | 2.53 | % |
| | | | | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | |
| | $ | 43 | | | $ | 45 | | | | | | | | .51 | % | | | .53 | % |
| | | 5 | | | | 4 | | | | | | | | .06 | | | | .05 | |
| | | 19 | | | | 13 | | | | | | | | .23 | | | | .15 | |
| | $ | 67 | | | $ | 62 | | | | | | | | .80 | % | | | .73 | % |
Home Equity and Second Mortgages | | | | | | | | | | | | | | | | | | | | |
| | $ | 64 | | | $ | 77 | | | | | | | | .46 | % | | | .51 | % |
| | | 52 | | | | 48 | | | | | | | | .37 | | | | .32 | |
| | | 110 | | | | 116 | | | | | | | | .79 | | | | .77 | |
| | $ | 226 | | | $ | 241 | | | | | | | | 1.62 | % | | | 1.60 | % |
| | | | | | | | | | | | | | | | | | | | |
| | $ | 147 | | | $ | 271 | | | | | | | | .43 | % | | | .81 | % |
| | | 33 | | | | 45 | | | | | | | | .10 | | | | .13 | |
| | | 49 | | | | 36 | | | | | | | | .14 | | | | .11 | |
| | $ | 229 | | | $ | 352 | | | | | | | | .67 | % | | | 1.05 | % |
| (a) | Excludes $656 million of loans 30-89 days past due and $1.7 billion of loans 90 days or more past due at June 30, 2020, purchased from GNMA mortgage pools that continue to accrue interest, compared with $428 million and $1.7 billion at December 31, 2019, respectively. |
| (b) | Includes revolving credit, installment, automobile and student loans. |
In certain circumstances, the Company may modify the terms of a loan to maximize the collection of amounts due when a borrower is experiencing financial difficulties or is expected to experience difficulties in the near-term. In most cases the modification is either a concessionary reduction in interest rate, extension of the maturity date or reduction in the principal balance that would otherwise not be considered.
Troubled Debt Restructurings
Concessionary modifications are classified as TDRs unless the modification results in only an insignificant delay in the payments to be received. TDRs accrue interest if the borrower complies with the revised terms and conditions and has demonstrated repayment performance at a level commensurate with the modified terms over several payment cycles, which is generally six months or greater. At June 30, 2020, performing TDRs were $3.5 billion, compared with $3.8 billion at December 31, 2019.
The Company continues to work with customers to modify loans for borrowers who are experiencing financial difficulties. Many of the Company’s TDRs are determined on a
basis in connection with ongoing loan collection processes. The modifications vary within each of the Company’s loan classes. Commercial lending segment TDRs generally include extensions of the maturity date and may be accompanied by an increase or decrease to the interest rate. The Company may also work with the borrower to make other changes to the loan to mitigate losses, such as obtaining additional collateral and/or guarantees to support the loan.
The Company has also implemented certain residential mortgage loan restructuring programs that may result in TDRs. The Company modifies residential mortgage loans under Federal Housing Administration, United States Department of Veterans Affairs, and its own internal programs. Under these programs, the Company offers qualifying homeowners the opportunity to permanently modify their loan and achieve more affordable monthly payments by providing loan concessions. These concessions may include adjustments to interest rates, conversion of adjustable rates to fixed rates, extensions of maturity dates or deferrals of payments, capitalization of accrued interest and/or outstanding advances, or in limited situations, partial forgiveness of loan principal. In most instances, participation in residential mortgage loan restructuring
programs requires the customer to complete a short-term trial period. A permanent loan modification is contingent on the customer successfully completing the trial period arrangement, and the loan documents are not modified until that time. The Company reports loans in a trial period arrangement as TDRs and continues to report them as TDRs after the trial period.
Credit card and other retail loan TDRs are generally part of distinct restructuring programs providing customers modification solutions over a specified time period, generally up to 60 months.
In accordance with regulatory guidance, the Company considers secured consumer loans that have had debt discharged through bankruptcy where the borrower has not reaffirmed the debt to be TDRs. If the loan amount exceeds the collateral value, the loan is charged down to collateral value and the remaining amount is reported as nonperforming.
Loan modifications or concessions granted to customers resulting directly from the effects of the
COVID-19
pandemic, who were otherwise in current payment status, are not considered to be TDRs.
The following table provides a summary of TDRs by loan class, including the delinquency status for TDRs that continue to accrue interest and TDRs included in nonperforming assets:
| | | | | | | | | | | | | | | | | | | | |
| | | | | | As a Percent of Performing TDRs | | | | | | | |
| | Performing
TDRs | | | 30-89 Days
Past Due | | | 90 Days or More
Past Due | | | Nonperforming
TDRs | | | Total
TDRs | |
| | $ | 189 | | | | 10.7 | % | | | 4.3 | % | | $ | 236 | (a) | | $ | 425 | |
| | | 180 | | | | .8 | | | | — | | | | 52 | (b) | | | 232 | |
| | | 1,215 | | | | 4.2 | | | | 3.8 | | | | 139 | | | | 1,354 | (d) |
| | | 260 | | | | 9.8 | | | | 5.7 | | | | — | | | | 260 | |
| | | 150 | | | | 6.9 | | | | 6.5 | | | | 27 | (c) | | | 177 | (e) |
TDRs, excluding loans purchased from GNMA mortgage pools | | | 1,994 | | | | 5.4 | | | | 4.0 | | | | 454 | | | | 2,448 | |
Loans purchased from GNMA mortgage pools (g) | | | 1,522 | | | | — | | | | — | | | | — | | | | 1,522 | (f) |
| | $ | 3,516 | | | | 3.1 | % | | | 2.2 | % | | $ | 454 | | | $ | 3,970 | |
| (a) | Primarily represents loans less than six months from the modification date that have not met the performance period required to return to accrual status (generally six months) and small business credit cards with a modified rate equal to 0 percent. |
| (b) | Primarily represents loans less than six months from the modification date that have not met the performance period required to return to accrual status (generally six months). |
| (c) | Primarily represents loans with a modified rate equal to 0 percent. |
| (d) | Includes $294 million of residential mortgage loans to borrowers that have had debt discharged through bankruptcy and $30 million in trial period arrangements or previously placed in trial period arrangements but not successfully completed. |
| (e) | Includes $83 million of other retail loans to borrowers that have had debt discharged through bankruptcy and $18 million in trial period arrangements or previously placed in trial period arrangements but not successfully completed. |
| (f) | Includes $141 million of Federal Housing Administration and United States Department of Veterans Affairs residential mortgage loans to borrowers that have had debt discharged through bankruptcy and $303 million in trial period arrangements or previously placed in trial period arrangements but not successfully completed. |
| (g) | Approximately 9.2 percent and 41.2 percent of the total TDR loans purchased from GNMA mortgage pools are 30-89 days past due and 90 days or more past due, respectively, but are not classified as delinquent as their repayments are insured by the Federal Housing Administration or guaranteed by the United States Department of Veterans Affairs. |
The level of nonperforming assets represents another indicator of the potential for future credit losses. Nonperforming assets include nonaccrual loans, restructured loans not performing in accordance with modified terms and not accruing interest, restructured loans that have not met the performance period required to return to accrual status, other real estate owned (“OREO”) and other nonperforming assets owned by the Company. Interest payments collected from assets on nonaccrual status are generally applied against the principal balance and not recorded as income. However, interest income may be recognized for interest payments if the remaining carrying amount of the loan is believed to be collectible.
At June 30, 2020, total nonperforming assets were $1.2 billion, compared to $829 million at December 31, 2019. The $344 million (41.5 percent) increase in nonperforming assets was driven by increases in nonperforming commercial and commercial real estate loans. The ratio of total nonperforming assets to total loans and other real estate was 0.38 percent at June 30, 2020, compared with 0.28 percent at December 31, 2019. The Company expects nonperforming assets to increase given current economic conditions.
OREO was $52 million at June 30, 2020, compared with $78 million at December 31, 2019, and was related to foreclosed properties that previously secured loan balances. These balances exclude foreclosed GNMA loans whose repayments are primarily insured by the Federal Housing Administration or guaranteed by the United States Department of Veterans Affairs.
The following table provides an analysis of OREO, as a percent of their related loan balances, including geographical location detail for residential (residential mortgage, home equity and second mortgage) and commercial (commercial and commercial real estate) loan balances:
| | | | | | | | | | | | | | | | | | | | |
| | | Amount | | | | | | As a Percent of Ending
Loan Balances | |
| (Dollars in Millions) | | June 30,
2020 | | | December 31,
2019 | | | | | | June 30,
2020 | | | December 31,
2019 | |
| | | | | | | | | | | | | | | | | | | | |
| | $ | 6 | | | $ | 10 | | | | | | | | .14 | % | | | .22 | % |
| | | 4 | | | | 6 | | | | | | | | .07 | | | | .10 | |
| | | 4 | | | | 6 | | | | | | | | .42 | | | | .66 | |
| | | 4 | | | | 7 | | | | | | | | .01 | | | | .03 | |
| | | 3 | | | | 4 | | | | | | | | .09 | | | | .12 | |
| | | 28 | | | | 41 | | | | | | | | .06 | | | | .09 | |
| | | 49 | | | | 74 | | | | | | | | .06 | | | | .09 | |
| | | | | | | | | | | | | | | | | | | | |
| | | 3 | | | | 3 | | | | | | | | .01 | | | | .01 | |
| | | — | | | | 1 | | | | | | | | — | | | | — | |
| | | 3 | | | | 4 | | | | | | | | — | | | | — | |
| | $ | 52 | | | $ | 78 | | | | | | | | .02 | % | | | .03 | % |
| | |
| | Net Charge-offs as a Percent of Average Loans Outstanding |
| | | | | | | | | | | | | | | | | | | | |
| | | Three Months Ended
June 30 | | | | | | Six Months Ended
June 30 | |
| | | 2020 | | | 2019 | | | | | | 2020 | | | 2019 | |
| | | | | | | | | | | | | | | | | | | | |
| | | .34 | % | | | .23 | % | | | | | | | .31 | % | | | .26 | % |
| | | .43 | | | | .22 | | | | | | | | .39 | | | | .18 | |
| | | .35 | | | | .23 | | | | | | | | .32 | | | | .26 | |
| | | | | | | | | | | | | | | | | | | | |
| | | .25 | | | | .03 | | | | | | | | .12 | | | | .01 | |
Construction and development | | | .11 | | | | (.04 | ) | | | | | | | .04 | | | | (.02 | ) |
Total commercial real estate | | | .22 | | | | .01 | | | | | | | | .10 | | | | .01 | |
| | | (.02 | ) | | | .02 | | | | | | | | (.01 | ) | | | .02 | |
| | | 4.28 | | | | 3.99 | | | | | | | | 4.11 | | | | 4.01 | |
| | | | | | | | | | | | | | | | | | | | |
| | | 1.58 | | | | .09 | | | | | | | | 1.24 | | | | .14 | |
Home equity and second mortgages | | | — | | | | (.03 | ) | | | | | | | .01 | | | | (.03 | ) |
| | | .54 | | | | .71 | | | | | | | | .67 | | | | .76 | |
| | | .56 | | | | .42 | | | | | | | | .58 | | | | .44 | |
| | | .55 | % | | | .49 | % | | | | | | | .54 | % | | | .50 | % |
Analysis of Loan Net Charge-Offs
Total loan net charge-offs were $437 million for the second quarter and $830 million for the first six months of 2020, compared with $350 million and $717 million, respectively, for the same periods of 2019. The ratio of total loan net charge-offs to average loans outstanding on an annualized basis for the second quarter and first six months of 2020 was 0.55 percent and 0.54 percent, respectively, compared with 0.49 percent and 0.50 percent, respectively, for the same periods of 2019. The year-over-year increases in net charge-offs reflected higher commercial loan, commercial real estate loan and retail leasing net charge-offs, partially offset by a decrease in other retail loan net charge-offs. The increase in retail leasing charge-offs reflected the inclusion of end of term losses on residual lease values as of January 1, 2020. The Company expects net charge-offs to increase given current economic conditions.
Analysis and Determination of the Allowance for Credit Losses
Prior to January 1, 2020, the allowance for credit losses was established to reserve for probable and estimable losses incurred in the Company’s loan and lease portfolio, including unfunded credit commitments. Effective January 1, 2020, the Company adopted new accounting guidance which changed previous impairment recognition to a model that is based on expected losses rather than incurred losses. The allowance for credit losses is increased through provisions charged to earnings and reduced by net charge-offs. Management evaluates the appropriateness of the allowance for credit losses on a quarterly basis. The allowance considers expected losses for the remaining lives of the applicable assets, inclusive of expected recoveries. Multiple economic scenarios are considered over a three-year reasonable and supportable forecast period, which incorporates historical loss experience in years two and three. After the forecast period, the Company fully reverts to long-term historical loss experience, adjusted for prepayments and characteristics of the current loan and lease portfolio, to estimate losses over the remaining lives. The economic scenarios are updated at least quarterly, and are designed to provide a range of reasonable estimates, both better and worse than current expectations. Scenarios are weighted based on the Company’s expectation of future conditions. Final loss estimates also consider factors affecting credit losses not reflected in the scenarios, due to the unique aspects of current conditions and expectations. These factors may include loan servicing practices, regulatory guidance, and/or fiscal and monetary policy actions. Because business processes and credit risks associated with unfunded credit commitments are essentially the same as for loans, the Company utilizes similar processes to estimate its liability for unfunded credit commitments, which is included in other liabilities in the Consolidated Balance Sheet. Both the allowance for loan losses and the liability for unfunded credit commitments are included in the Company’s analysis of credit losses and reported reserve ratios.
The allowance recorded for credit losses utilizes forward-looking expected loss models to consider a variety of factors affecting lifetime credit losses. These factors include loan and borrower characteristics, such as internal risk ratings on commercial loans and consumer credit scores, delinquency status, collateral type and available valuation information, consideration of
losses on lease residuals, and the remaining term of the loan, adjusted for expected prepayments. Where loans do not exhibit similar risk characteristics, an individual analysis is performed to consider expected credit losses. For each loan portfolio, model estimates are adjusted as necessary to consider any relevant changes in portfolio composition, lending policies, underwriting standards, risk management practices or economic conditions that would affect the accuracy of the model.
The results of the analysis are evaluated quarterly to confirm the estimates are appropriate for each loan portfolio. Expected credit loss estimates also include consideration of expected cash recoveries on loans previously charged-off, or expected recoveries on collateral-dependent loans where recovery is expected through sale of the collateral. The allowance recorded for individually evaluated loans greater than $5 million in the commercial lending segment is based on an analysis utilizing expected cash flows discounted using the original effective interest rate, the observable market price of the loan, or the fair value of the collateral, less selling costs, for collateral-dependent loans.
The allowance recorded for TDR loans in the consumer lending segment is determined on a homogenous pool basis utilizing expected cash flows discounted using the original effective interest rate of the pool. The expected cash flows on TDR loans consider subsequent payment defaults since modification, the borrower’s ability to pay under the restructured terms, and the timing and amount of payments. The allowance for collateral-dependent loans in the consumer lending segment is determined based on the current fair value of the collateral less costs to sell.
When evaluating the appropriateness of the allowance for credit losses for any loans and lines in a junior lien position, the Company considers the delinquency and modification status of the first lien. At June 30, 2020, the Company serviced the first lien on 39 percent of the home equity loans and lines in a junior lien position. The Company also considers the status of first lien mortgage accounts reported on customer credit bureau files when the first lien is not serviced by the Company. Regardless of whether the Company services the first lien, an assessment is made of economic conditions, problem loans, recent loss experience and other factors in determining the allowance for credit losses. Based on the available information, the Company estimated $330 million or 2.4 percent of its total home equity portfolio at June 30, 2020, represented non-delinquent junior liens where the first lien was delinquent or modified, excluding loans on COVID-related forbearance programs.
The Company considers historical loss experience on the loans and lines in a junior lien position to establish loss estimates for junior lien loans and lines the Company services that are current, but the first lien is delinquent or modified. Historically, the number of junior lien defaults has been a small percentage of the total portfolio (approximately 1 percent annually), while the long-term average loss rate on loans that default has been approximately 80 percent. In addition, the Company obtains updated credit scores on its home equity portfolio each quarter, and in some cases more frequently, and uses this information in its loss estimation methods. In its evaluation of the allowance for credit losses, the Company also considers the increased risk of loss associated with home equity lines that are contractually scheduled to convert from a revolving status to a fully amortizing payment and with residential lines and loans that have a balloon payoff provision.
Beginning January 1, 2020, when a loan portfolio is purchased, the acquired loans are divided into those considered purchased with more than insignificant credit deterioration (“PCD”) and those not considered purchased with more than insignificant credit deterioration. An allowance is established for each population and considers product mix, risk characteristics of the portfolio, bankruptcy experience, delinquency status, refreshed LTV ratios when possible, and portfolio growth. The allowance established for purchased loans not considered PCD is recognized through provision expense upon acquisition, whereas the allowance established for loans considered PCD at acquisition is offset by an increase in the basis of the acquired loans. Any subsequent increases and decreases in the allowance related to purchased loans are recognized through provision expense, with future charge-offs charged to the allowance. The Company did not have a material amount of PCD loans included in its loan portfolio at June 30, 2020.
The Company’s methodology for determining the appropriate allowance for credit losses for each loan segment also considers the imprecision inherent in the methodologies used. As a result, amounts determined under the methodologies described above are adjusted by management to consider the potential impact of other qualitative factors which include, but are not limited to, the following: model imprecision, imprecision in economic scenario assumptions, and emerging risks related to either changes in the economic environment that are affecting specific portfolio segments, or changes in portfolio concentrations over time that may affect model performance. The consideration of these items results in adjustments to allowance amounts included in the Company’s allowance for credit losses for each portfolio class.
Although the Company determined the amount of each element of the allowance separately and considers this process to be an important credit management tool, the entire allowance for credit losses is available for the entire loan portfolio. The actual amount of losses can vary significantly from the estimated amounts.
Residual Value Risk Management
The Company manages its risk to changes in the residual value of leased vehicles, office and business equipment, and other assets through disciplined residual valuation setting at the inception of a lease, diversification of its leased assets, regular residual asset valuation reviews and monitoring of residual value gains or losses upon the disposition of assets. As of June 30, 2020, no significant change in the amount of residual values or concentration of the portfolios had occurred since December 31, 2019. Refer to “Management’s Discussion and Analysis — Residual Value Risk Management” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2019, for further discussion on residual value risk management.
Operational Risk Management
Operational risk is inherent in all business activities, and the management of this risk is important to the achievement of the Company’s objectives. Business lines have direct and primary responsibility and accountability for identifying, controlling, and monitoring operational risks embedded in their business activities. The Company maintains a system of controls with the objective of providing proper transaction authorization and execution, proper system operations, proper oversight of third parties with whom it does business, safeguarding of assets from misuse or theft, and ensuring the reliability and security of financial and other data. Refer to “Management’s Discussion and Analysis — Operational Risk Management” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2019, for further discussion on operational risk management.
Compliance Risk Management
The Company may suffer legal or regulatory sanctions, material financial loss, or damage to its reputation through failure to comply with laws, regulations, rules, standards of good practice, and codes of conduct, including those related to compliance with Bank Secrecy Act/anti-money laundering requirements, sanctions compliance requirements as administered by the Office of Foreign Assets Control, consumer protection and other requirements. The Company has controls and processes in place for the assessment, identification, monitoring, management and reporting of compliance risks and issues. Refer to “Management’s Discussion and Analysis — Compliance Risk Management” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2019, for further discussion on compliance risk management.
Interest Rate Risk Management
In the banking industry, changes in interest rates are a significant risk that can impact earnings and the safety and soundness of an entity. The Company manages its exposure to changes in interest rates through asset and liability management activities within guidelines established by its Asset Liability Management Committee (“ALCO”) and approved by the Board of Directors. The ALCO has the responsibility for approving and ensuring compliance with the ALCO management policies, including interest rate risk exposure. One way the Company measures and analyzes its interest rate risk is through net interest income simulation analysis.
Simulation analysis incorporates substantially all of the Company’s assets and liabilities and off-balance sheet instruments, together with forecasted changes in the balance sheet and assumptions that reflect the current interest rate environment. Through this simulation, management estimates the impact on net interest income of various interest rate changes that differ in the direction, amount and speed of change over time, as well as the shape of the yield curve. This simulation includes assumptions about how the balance sheet is likely to be affected by changes in loan and deposit growth. Assumptions are made to project interest rates for new loans and deposits based on historical analysis, management’s outlook and re-pricing strategies. These assumptions are reviewed and validated on a periodic basis with sensitivity analysis being provided for key variables of the simulation. The results are reviewed monthly by the ALCO and are used to guide asset/liability management strategies.
The Company manages its interest rate risk position by holding assets with desired interest rate risk characteristics on its balance sheet, implementing certain pricing strategies for loans and deposits and selecting derivatives and various funding and investment portfolio strategies.
Table 9 summarizes the projected impact to net interest income over the next 12 months of various potential interest rate changes. The sensitivity of the projected impact to net interest income over the next 12 months is dependent on balance sheet growth, product mix, deposit behavior, pricing and funding decisions. While the Company utilizes models and assumptions based on historical information and expected behaviors, actual outcomes could vary significantly.
| | |
| | Sensitivity of Net Interest Income |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | June 30, 2020 | | | | | | December 31, 2019 | |
| | | Down 50 bps
Immediate | | | Up 50 bps
Immediate | | | Down 200 bps
Gradual | | | Up 200 bps
Gradual | | | | | | Down 50 bps
Immediate | | | Up 50 bps
Immediate | | | Down 200 bps
Gradual | | | Up 200 bps
Gradual | |
| | | (3.87 | )% | | | 3.82 | % | | | * | | | | 5.71 | % | | | | | | | (1.43 | )% | | | .83 | % | | | * | | | | .21 | % |
| * | Given the level of interest rates, downward rate scenario is not computed. |
Use of Derivatives to Manage Interest Rate and Other Risks
To manage the sensitivity of earnings and capital to interest rate, prepayment, credit, price and foreign currency fluctuations (asset and liability management positions), the Company enters into derivative transactions. The Company uses derivatives for asset and liability management purposes primarily in the following ways:
| • | | To convert fixed-rate debt from fixed-rate payments to floating-rate payments; |
| • | | To convert the cash flows associated with floating-rate debt from floating-rate payments to fixed-rate payments; |
| • | | To mitigate changes in value of the Company’s unfunded mortgage loan commitments, funded MLHFS and MSRs; |
| • | | To mitigate remeasurement volatility of foreign currency denominated balances; and |
| • | | To mitigate the volatility of the Company’s net investment in foreign operations driven by fluctuations in foreign currency exchange rates. |
In addition, the Company enters into interest rate and foreign exchange derivative contracts to support the business requirements of its customers (customer-related positions). The Company minimizes the market and liquidity risks of customer-related positions by either entering into similar offsetting positions with broker-dealers, or on a portfolio basis by entering into other derivative or non-derivative financial instruments that partially or fully offset the exposure from these customer-related positions. The Company may enter into derivative contracts that are either exchange-traded, centrally cleared through clearinghouses or over-the-counter. The Company does not utilize derivatives for speculative purposes.
The Company does not designate all of the derivatives that it enters into for risk management purposes as accounting hedges because of the inefficiency of applying the accounting requirements and may instead elect fair value accounting for the related hedged items. In particular, the Company enters into interest rate swaps, swaptions, forward commitments to buy to-be-announced securities (“TBAs”), U.S. Treasury and Eurodollar futures and options on U.S. Treasury futures to mitigate fluctuations in the value of its MSRs, but does not designate those derivatives as accounting hedges.
Additionally, the Company uses forward commitments to sell TBAs and other commitments to sell residential mortgage loans at specified prices to economically hedge the interest rate risk in its residential mortgage loan production activities. At June 30, 2020, the Company had $15.0 billion of forward commitments to sell, hedging $6.8 billion of MLHFS and $13.3 billion of unfunded mortgage loan commitments. The forward commitments to sell and the unfunded mortgage loan commitments on loans intended to be sold are considered derivatives under the accounting guidance related to accounting for derivative instruments and hedging activities. The Company has elected the fair value option for the MLHFS.
Derivatives are subject to credit risk associated with counterparties to the contracts. Credit risk associated with derivatives is measured by the Company based on the probability of counterparty default, including consideration of the COVID-19 pandemic. The Company manages the credit risk of its derivative positions by diversifying its positions among various counterparties, by entering into master netting arrangements, and, where possible, by requiring collateral arrangements. The Company may also transfer counterparty credit risk related to interest rate swaps to third parties through the use of risk participation agreements. In addition, certain interest rate swaps, interest rate forwards and credit contracts are required to be centrally cleared through clearinghouses to further mitigate counterparty credit risk.
For additional information on derivatives and hedging activities, refer to Notes 12 and 13 in the Notes to Consolidated Financial Statements.
In July 2017, the United Kingdom’s Financial Conduct Authority announced that it would no longer require banks to submit rates for the London InterBank Offered Rate (“LIBOR”) after 2021. The Company holds financial instruments that will be impacted by the discontinuance of LIBOR, including certain loans, investment securities, derivatives, borrowings and other financial instruments that use LIBOR as the benchmark rate. The Company also provides various services to customers in its capacity as trustee, which involve financial instruments that will be similarly impacted by the discontinuance of LIBOR. The Company anticipates these financial instruments will
require transition to a new reference rate. This transition will occur over time as many of these arrangements do not have an alternative rate referenced in their contracts or a clear path for the parties to agree upon an alternative reference rate. In order to facilitate the transition process, the Company has instituted a LIBOR Transition Office and commenced an enterprise-wide project to identify, assess and monitor risks associated with the expected discontinuance or unavailability of LIBOR, actively engage with industry working groups and regulators, achieve operational readiness and engage impacted customers. It is currently unclear what impact COVID-19 may have on the LIBOR transition or on the timing thereof. Refer to “Risk Factors” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2019, for further discussion on potential risks that could adversely affect the Company’s financial results as a result of the LIBOR transition.
In addition to interest rate risk, the Company is exposed to other forms of market risk, principally related to trading activities which support customers’ strategies to manage their own foreign currency, interest rate risk and funding activities. For purposes of its internal capital adequacy assessment process, the Company considers risk arising from its trading activities, as well as the remeasurement volatility of foreign currency denominated balances included on its Consolidated Balance Sheet (collectively, “Covered Positions”), employing methodologies consistent with the requirements of regulatory rules for market risk. The Company’s Market Risk Committee (“MRC”), within the framework of the ALCO, oversees market risk management. The MRC monitors and reviews the Company’s Covered Positions and establishes policies for market risk management, including exposure limits for each portfolio. The Company uses a VaR approach to measure general market risk. Theoretically, VaR represents the statistical risk of loss the Company has to adverse market movements over a one-day time horizon. The Company uses the Historical Simulation method to calculate VaR for its Covered Positions measured at the ninety-ninth percentile using a one-year look-back period for distributions derived from past market data. The market factors used in the calculations include those pertinent to market risks inherent in the underlying trading portfolios, principally those that affect the Company’s corporate bond trading business, foreign currency transaction business, client derivatives business, loan trading business and municipal securities business, as well as those inherent in the Company’s foreign denominated balances and the derivatives used to mitigate the related measurement volatility. On average, the Company expects the one-day VaR to be exceeded by actual losses two to three times per year related to these positions. The Company monitors the accuracy of internal VaR models and modeling processes by back-testing model performance, regularly updating the historical data used by the VaR models and regular model validations to assess the accuracy of the models’ input, processing, and reporting components. All models are required to be independently reviewed and approved prior to being placed in use. If the Company were to experience market losses in excess of the estimated VaR more often than expected, the VaR models and associated assumptions would be analyzed and adjusted.
The average, high, low and period-end one-day VaR amounts for the Company’s Covered Positions were as follows:
| | | | | | | | |
| | 2020 | | | 2019 | |
| | $ | 2 | | | $ | 1 | |
| | | 3 | | | | 2 | |
| | | 1 | | | | 1 | |
| | | 3 | | | | 1 | |
Given the market volatility resulting from effects of the COVID-19 pandemic, the Company experienced actual losses for its combined Covered Positions that exceeded VaR five times during the six months ended June 30, 2020. The Company did not experience any actual losses for its combined Covered Positions that exceeded VaR during the six months ended June 30, 2019. The Company stress tests its market risk measurements to provide management with perspectives on market events that may not be captured by its VaR models, including worst case historical market movement combinations that have not necessarily occurred on the same date.
The Company calculates Stressed VaR using the same underlying methodology and model as VaR, except that a historical continuous one-year look-back period is utilized that reflects a period of significant financial stress appropriate to the Company’s Covered Positions. The period selected by the Company includes the significant market volatility of the last four months of 2008.
The average, high, low and period-end one-day Stressed VaR amounts for the Company’s Covered Positions were as follows:
| | | | | | | | |
| | 2020 | | | 2019 | |
| | $ | 6 | | | $ | 6 | |
| | | 8 | | | | 9 | |
| | | 4 | | | | 4 | |
| | | 7 | | | | 7 | |
Valuations of positions in client derivatives and foreign currency activities are based on discounted cash flow or other valuation techniques using market-based assumptions. These valuations are compared to third party quotes or other market prices to determine if there are significant variances. Significant variances are approved by senior management in the Company’s corporate functions. Valuation of positions in the corporate bond trading, loan trading and municipal securities businesses are based on trader marks. These trader marks are evaluated against third party prices, with significant variances approved by senior management in the Company’s corporate functions.
The Company also measures the market risk of its hedging activities related to residential MLHFS and MSRs using the Historical Simulation method. The VaRs are measured at the ninety-ninth percentile and employ factors pertinent to the market risks inherent in the valuation of the assets and hedges. A one-year look-back period is used to obtain past market data for the models.
The average, high and low VaR amounts for the residential MLHFS and related hedges and the MSRs and related hedges were as follows:
| | | | | | | | |
| | 2020 | | | 2019 | |
Residential Mortgage Loans Held For Sale and Related Hedges | | | | | | | | |
| | $ | 7 | | | $ | 2 | |
| | | 22 | | | | 4 | |
| | | 2 | | | | – | |
Mortgage Servicing Rights and Related Hedges | | | | | | | | |
| | $ | 18 | | | $ | 6 | |
| | | 54 | | | | 8 | |
| | | 6 | | | | 4 | |
Liquidity Risk Management
The Company’s liquidity risk management process is designed to identify, measure, and manage the Company’s funding and liquidity risk to meet its daily funding needs and to address expected and unexpected changes in its funding requirements. The Company engages in various activities to manage its liquidity risk. These activities include diversifying its funding sources, stress testing, and holding readily-marketable assets which can be used as a source of liquidity if needed. In addition, the Company’s profitable operations, sound credit quality and strong capital position have enabled it to develop a large and reliable base of core deposit funding within its market areas and in domestic and global capital markets. During the six months ended June 30, 2020, the Company effectively managed its liquidity position while funding significant loan growth during the period.
The Company’s Board of Directors approves the Company’s liquidity policy. The Risk Management Committee of the Company’s Board of Directors oversees the Company’s liquidity risk management process and approves a contingency funding plan. The ALCO reviews the Company’s liquidity policy and limits, and regularly assesses the Company’s ability to meet funding requirements arising from adverse company-specific or market events.
The Company regularly projects its funding needs under various stress scenarios and maintains a contingency funding plan consistent with the Company’s access to diversified sources of contingent funding. The Company maintains a substantial level of total available liquidity in the form of on-balance sheet and off-balance sheet funding sources. These liquidity sources include cash at the Federal Reserve Bank and certain European central banks, unencumbered liquid assets, and capacity to borrow from the FHLB and at Federal Reserve Bank’s Discount Window. At June 30, 2020, the fair value of unencumbered investment securities totaled $116.3 billion, compared with $114.2 billion at December 31, 2019. Refer to Note 3 of the Notes to Consolidated Financial Statements and “Balance Sheet Analysis” for further information on investment securities maturities and trends. Asset liquidity is further enhanced by the Company’s practice of pledging loans to access secured borrowing facilities through the FHLB and Federal Reserve Bank. At June 30, 2020, the Company could have borrowed a total of an additional $97.8 billion from the FHLB and Federal Reserve Bank based on collateral available for additional borrowings.
The Company’s diversified deposit base provides a sizeable source of relatively stable and low-cost funding, while reducing the Company’s reliance on the wholesale markets. Total deposits were $413.3 billion at June 30, 2020, compared with $361.9 billion at December 31, 2019. Refer to “Balance Sheet Analysis” for further information on the Company’s deposits.
Additional funding is provided by long-term debt and short-term borrowings. Long-term debt was $42.6 billion at June 30, 2020, and is an important funding source because of its multi-year borrowing structure. Short-term borrowings were $20.6 billion at June 30, 2020, and supplement the Company’s other funding sources. Refer to “Balance Sheet Analysis” for further information on the Company’s long-term debt and short-term borrowings.
In addition to assessing liquidity risk on a consolidated basis, the Company monitors the parent company’s liquidity. The Company establishes limits for the minimal number of months into the future where the parent company can meet existing and forecasted obligations with cash and securities held that can be readily monetized. The Company measures and manages this limit in both normal and adverse conditions. The Company maintains sufficient
funding to meet expected capital and debt service obligations for 24 months without the support of dividends from subsidiaries and assuming access to the wholesale markets is maintained. The Company maintains sufficient liquidity to meet its capital and debt service obligations for 12 months under adverse conditions without the support of dividends from subsidiaries or access to the wholesale markets. The parent company is currently well in excess of required liquidity minimums.
At June 30, 2020, parent company long-term debt outstanding was $20.9 billion, compared with $18.6 billion at December 31, 2019. The increase was primarily due to $1.5 billion of medium-term note issuances. As of June 30, 2020, there was no parent company debt scheduled to mature in the remainder of 2020.
The Company is subject to a regulatory Liquidity Coverage Ratio (“LCR”) requirement which requires banks to maintain an adequate level of unencumbered high quality liquid assets to meet estimated liquidity needs over a 30-day stressed period. At June 30, 2020, the Company was compliant with this requirement.
Refer to “Management’s Discussion and Analysis — Liquidity Risk Management” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2019, for further discussion on liquidity risk management.
The Company provides merchant processing and corporate trust services in Europe either directly or through banking affiliations in Europe. Revenue generated from sources in Europe represented approximately 1 percent of the Company’s total net revenue for both the three and six months ended June 30, 2020. Operating cash for these businesses is deposited on a short-term basis typically with certain European central banks. For deposits placed at other European banks, exposure is mitigated by the Company placing deposits at multiple banks and managing the amounts on deposit at any bank based on institution-specific deposit limits. At June 30, 2020, the Company had an aggregate amount on deposit with European banks of approximately $9.1 billion, predominately with the Central Bank of Ireland and Bank of England.
In addition, the Company provides financing to domestic multinational corporations that generate revenue from customers in European countries, transacts with various European banks as counterparties to certain derivative-related activities, and through a subsidiary, manages money market funds that hold certain investments in European sovereign debt. Any further deterioration in economic conditions in Europe, including the potential negative impact of the United Kingdom’s withdrawal from the European Union (“Brexit”), is not expected to have a significant effect on the Company related to these activities. The Company is focused on providing continuity of services, with minimal disruption resulting from Brexit, to customers with activities in European countries. The Company has made certain structural changes to its legal entities and operations in the United Kingdom and European Union, where needed, and migrated certain business activities to the appropriate jurisdictions to continue to provide such services and generate revenue.
Off-Balance Sheet Arrangements
Off-balance sheet arrangements include any contractual arrangements to which an unconsolidated entity is a party, under which the Company has an obligation to provide credit or liquidity enhancements or market risk support. In the ordinary course of business, the Company enters into an array of commitments to extend credit, letters of credit and various forms of guarantees that may be considered off-balance sheet arrangements. Refer to Note 15 of the Notes to Consolidated Financial Statements for further information on these arrangements. The Company does not utilize private label asset securitizations as a source of funding. Off-balance sheet arrangements also include any obligation related to a variable interest held in an unconsolidated entity that provides financing, liquidity, credit enhancement or market risk support. Refer to Note 5 of the Notes to Consolidated Financial Statements for further information related to the Company’s interests in variable interest entities.
The Company is committed to managing capital to maintain strong protection for depositors and creditors and for maximum shareholder benefit. The Company also manages its capital to exceed regulatory capital requirements for banking organizations. The regulatory capital requirements effective for the Company follow Basel III, with the Company being subject to calculating its capital adequacy as a percentage of risk-weighted assets under the standardized approach. During 2020, the Company elected to adopt an interim final rule issued in March 2020 by its regulators which permits banking organizations who adopt accounting guidance related to the impairment of financial instruments based on the current expected credit losses methodology during 2020, the option to defer the impact of the effect of that guidance at adoption plus 25 percent of its quarterly credit reserve increases over the next two years on its regulatory capital requirements, followed by a three-year transition period to phase in the cumulative deferred impact. Table 10 provides a summary of statutory regulatory capital ratios in effect for the Company at June 30, 2020 and December 31, 2019. All regulatory ratios exceeded regulatory “well-capitalized” requirements.
| | |
| | Regulatory Capital Ratios |
| | | | | | | | |
| (Dollars in Millions) | | June 30,
2020 | | | December 31,
2019 | |
Basel III standardized approach: | | | | | | | | |
Common equity tier 1 capital | | $ | 36,351 | | | $ | 35,713 | |
| | | 42,781 | | | | 41,721 | |
| | | 51,457 | | | | 49,744 | |
| | | 401,832 | | | | 391,269 | |
| | |
Common equity tier 1 capital as a percent of risk-weighted assets | | | 9.0 | % | | | 9.1 | % |
Tier 1 capital as a percent of risk-weighted assets | | | 10.6 | | | | 10.7 | |
Total risk-based capital as a percent of risk-weighted assets | | | 12.8 | | | | 12.7 | |
Tier 1 capital as a percent of adjusted quarterly average assets (leverage ratio) | | | 8.0 | | | | 8.8 | |
Tier 1 capital as a percent of total on- and off-balance sheet leverage exposure (total leverage exposure ratio) | | | 7.1 | | | | 7.0 | |
The Company believes certain other capital ratios are useful in evaluating its capital adequacy. At June 30, 2020, the Company’s tangible common equity, as a percent of tangible assets and as a percent of risk-weighted assets determined in accordance with transitional regulatory capital requirements related to the current expected credit losses methodology under the standardized approach, was 6.7 percent and 9.0 percent, respectively. This compares to the Company’s tangible common equity, as a percent of tangible assets and as a percent of risk-weighted assets under the standardized approach, of 7.5 percent and 9.3 percent, respectively, at December 31, 2019. In addition, the Company’s common equity tier 1 capital to risk-weighted assets ratio, reflecting the full implementation of the current expected credit losses methodology was 8.7 percent at June 30, 2020. Refer to “Non-GAAP Financial Measures” beginning on page 32 for further information on these other capital ratios.
Total U.S. Bancorp shareholders’ equity was $51.9 billion at June 30, 2020, unchanged from December 31, 2019, resulting from a reduction to retained earnings due to the January 1, 2020 adoption of accounting guidance related to the impairment of financial instruments, common share repurchases and dividends, offset by changes in unrealized gains and losses on available-for-sale investment securities included in other comprehensive income (loss) and corporate earnings.
During 2019, the Company announced its Board of Directors had approved authorizations to repurchase up to $5.5 billion of its common stock, from July 1, 2019 through June 30, 2020. Beginning in March 2020, the Company suspended all common stock repurchases except for those done exclusively in connection with its stock-based compensation programs, to maintain strong capital levels given the impact and uncertainties of COVID-19 on the economy and global markets. In addition, the Federal Reserve announced in June 2020 that it will require all large bank holding companies to preserve capital during the third quarter of 2020 through the suspension of share repurchase programs and capping dividends at existing rates, which may not be in excess of the average of the last four quarters’ earnings, due to the continued economic uncertainty resulting from COVID-19. The Company will continue to monitor the impact of COVID-19 and will adjust its capital distributions as circumstances warrant. Additional capital distributions are subject to the approval of the Company’s Board of Directors, and will be consistent with regulatory requirements.
The following table provides a detailed analysis of all shares purchased by the Company or any affiliated purchaser during the second quarter of 2020:
| | | | | | | | | | | | | | | | |
| Period | | Total Number
of Shares
Purchased | | | Average
Price
Paid Per
Share | | | Total Number of
Shares Purchased
as Part of Publicly
Announced
Program (a) | | | Approximate Dollar
Value of Shares
that May Yet Be
Purchased Under
the Program
(In Millions) | |
| | | 365,131 | (b) | | $ | 32.91 | | | | 5,131 | | | $ | 756 | |
| | | 190,072 | (c) | | | 33.08 | | | | 72 | | | | 756 | |
| | | 10 | | | | 37.13 | | | | 10 | | | | – | |
| | | 555,213 | (d) | | $ | 32.97 | | | | 5,213 | | | $ | – | |
| (a) | All shares were purchased under the common stock repurchase authorization programs announced in 2019 and represent shares acquired by the Company in connection with satisfaction of tax withholding obligations on vested restricted stock and unit awards and exercises under other compensation plans. |
| (b) | Includes 360,000 shares of common stock purchased, at an average price per share of $32.88, in open-market transactions by U.S. Bank National Association, the Company’s banking subsidiary, in its capacity as trustee of the U.S. Bank 401(k) Savings Plan, which is the Company’s employee retirement savings plan. |
| (c) | Includes 190,000 shares of common stock purchased, at an average price per share of $33.08, in open-market transactions by U.S. Bank National Association in its capacity as trustee of the U.S. Bank 401(k) Savings Plan. |
| (d) | Includes 550,000 shares of common stock purchased, at an average price per share of $32.95, in open-market transactions by U.S. Bank National Association in its capacity as trustee of the U.S. Bank 401(k) Savings Plan. |
Refer to “Management’s Discussion and Analysis — Capital Management” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2019, for further discussion on capital management.
LINE OF BUSINESS FINANCIAL REVIEW
The Company’s major lines of business are Corporate and Commercial Banking, Consumer and Business Banking, Wealth Management and Investment Services, Payment Services, and Treasury and Corporate Support. These operating segments are components of the Company about which financial information is prepared and is evaluated regularly by management in deciding how to allocate resources and assess performance.
Basis for Financial Presentation
Business line results are derived from the Company’s business unit profitability reporting systems by specifically attributing managed balance sheet assets, deposits and other liabilities and their related income or expense. Refer to Note 16 of the Notes to Consolidated Financial Statements for further information on the business lines’ basis for financial presentation.
Designations, assignments and allocations change from time to time as management systems are enhanced, methods of evaluating performance or product lines change or business segments are realigned to better respond to the Company’s diverse customer base. During 2020, certain organization and methodology changes were made and, accordingly, 2019 results were restated and presented on a comparable basis.
Corporate and Commercial Banking
Corporate and Commercial Banking offers lending, equipment finance and small-ticket leasing, depository services, treasury management, capital markets services, international trade services and other financial services to middle market, large corporate, commercial real estate, financial institution, non-profit and public sector clients. Corporate and Commercial Banking contributed $598 million of the Company’s net income in the second quarter and $767 million in the first six months of 2020, or an increase of $133 million (28.6 percent) and a decrease of $114 million (12.9 percent), respectively, compared with the same periods of 2019.
Net revenue increased $212 million (20.8 percent) in the second quarter and $297 million (14.8 percent) in the first six months of 2020, compared with the same periods of 2019. Net interest income, on a taxable-equivalent basis, increased $116 million (15.0 percent) in the second quarter and $136 million (8.8 percent) in the first six months of 2020, compared with the same periods of 2019. The increases were primarily due to strong loan growth as well as higher noninterest-bearing and interest-bearing deposits, partially offset by the impact on net interest margin due to changes in loan mix and lower spreads on loans, reflecting changing interest rates given the economic environment. Noninterest income increased $96 million (39.3 percent) in the second quarter and $161 million (35.6 percent) in the first six months of 2020, compared with the same periods of 2019, primarily due to higher capital markets and trading revenue as corporate customers accessed the fixed income capital markets for bond issuances.
Noninterest expense decreased $3 million (0.7 percent) in the second quarter and increased $10 million (1.2 percent) in the first six months of 2020, compared with the same periods of 2019, reflecting lower net shared services expense, lower other noninterest expense due to a reduction in travel as a result of COVID-19, and lower loan costs, offset by higher variable compensation related to fixed income capital markets business production. The provision for credit losses increased $37 million in the second quarter of 2020, compared with the second quarter of 2019, primarily due to higher net charge-offs, partially offset by a favorable change in the reserve allocation driven by payoffs of funded exposures net of the impact of credit risk rating downgrades. The provision for credit losses increased $439 million in the first six months of 2020, compared with the first six months of 2019, primarily due to an unfavorable change in the reserve allocation based on economic risks related to COVID-19 in the portfolio, along with higher net charge-offs.
Consumer and Business Banking
Consumer and Business Banking delivers products and services through banking offices, telephone servicing and sales, on-line services, direct mail, ATM processing and mobile devices. It encompasses community banking, metropolitan banking and indirect lending, as well as mortgage banking. Consumer and Business Banking contributed $692 million of the Company’s net income in the second quarter and $1.3 billion in the first six months of 2020, or increases of $111 million (19.1 percent) and $162 million (13.8 percent), respectively, compared with the same periods of 2019.
Net revenue increased $243 million (11.2 percent) in the second quarter and $427 million (10.0 percent) in the first six months of 2020, compared with the same periods of 2019. Net interest income, on a taxable-equivalent basis, decreased $111 million (7.0 percent) in the second quarter and $149 million (4.7 percent) in the first six months of 2020, compared with the same periods of 2019. The decreases were primarily due to the impact of declining interest rates on the margin benefit from deposits, partially offset by growth in non-interest bearing and interest-bearing deposit balances and loan growth driven in part by loans made under the SBA’s Paycheck Protection Program. Noninterest income increased $354 million (62.4 percent) in the second
quarter and $576 million (52.3 percent) in the first six months of 2020, compared with the same periods of 2019, primarily due to higher mortgage banking revenue driven by mortgage production and related gain on sale margins, partially offset by changes in the valuation of MSRs, net of hedging activities. The increases in noninterest income were partially offset by lower deposit service charges due to lower volume and fee waivers related to customers impacted by COVID-19.
Noninterest expense increased $64 million (4.9 percent) in the second quarter and $127 million (5.0 percent) in the first six months of 2020, compared with the same periods of 2019, primarily due to higher variable compensation related to strong mortgage banking origination activities, and higher net shared services expense, reflecting the impact of investment in infrastructure supporting business growth. The provision for credit losses increased $31 million (39.2 percent) in the second quarter and $84 million (56.4 percent) in the first six months of 2020, compared with the same periods of 2019, due to higher net charge-offs and unfavorable changes in the reserve allocation reflecting deterioration in credit quality given the economic environment.
Wealth Management and Investment Services
Wealth Management and Investment Services provides private banking, financial advisory services, investment management, retail brokerage services, insurance, trust, custody and fund servicing through four businesses: Wealth Management, Global Corporate Trust & Custody, U.S. Bancorp Asset Management and Fund Services. Wealth Management and Investment Services contributed $204 million of the Company’s net income in the second quarter and $420 million in the first six months of 2020, or decreases of $31 million (13.2 percent) and $41 million (8.9 percent), respectively, compared with the same periods of 2019.
Net revenue decreased $31 million (4.1 percent) in the second quarter and $7 million (0.5 percent) in the first six months of 2020, compared with the same periods of 2019. Net interest income, on a taxable-equivalent basis, decreased $49 million (16.1 percent) in the second quarter and $59 million (9.9 percent) in the first six months of 2020, compared with the same periods of 2019, primarily due to the impact of declining interest rates on the margin benefit from deposits, partially offset by higher noninterest-bearing and interest-bearing deposit balances, and changes in deposit mix. Noninterest income increased $18 million (4.0 percent) in the second quarter and $52 million (5.9 percent) in the first six months of 2020, compared with the same periods of 2019, primarily due to the impact of favorable market conditions and business growth on trust and investment management fees.
Noninterest expense increased $14 million (3.2 percent) in the second quarter and $26 million (3.0 percent) in the first six months of 2020, compared with the same periods of 2019, reflecting increased net shared services expense due to technology development and higher compensation expense due to the impact of merit increases, increased staffing, and higher business incentives. The provision for credit losses decreased $4 million in the second quarter of 2020, compared with the second quarter of 2019, reflecting a favorable change in the reserve allocation driven by the strong credit quality of the loan portfolio. The provision for credit losses increased $22 million in the first six months of 2020, compared with the first six months of 2019, primarily due to an unfavorable change in the reserve allocation in the first quarter of 2020.
Payment Services includes consumer and business credit cards, stored-value cards, debit cards, corporate, government and purchasing card services, consumer lines of credit and merchant processing. Payment Services contributed $400 million of the Company’s net income in the second quarter and $716 million in the first six months of 2020, or increases of $46 million (13.0 percent) and $28 million (4.1 percent), respectively, compared with the same periods of 2019.
Net revenue decreased $277 million (18.0 percent) in the second quarter and $303 million (10.1 percent) in the first six months of 2020, compared with the same periods of 2019. Net interest income, on a taxable-equivalent basis, increased $17 million (2.9 percent) in the second quarter and $51 million (4.2 percent) in the first six months of 2020, compared with the same periods of 2019, primarily due to favorable loan spreads, partially offset by lower loan fees. The increase in net interest income in the second quarter of 2020, compared with the second quarter of 2019, was further offset by lower loan volume. Noninterest income decreased $294 million (30.9 percent) in the second quarter and $354 million (19.6 percent) in the first six months of 2020, compared with the same periods of 2019, mainly due to the impacts of COVID-19 on consumer and business spending volume in all payments businesses including merchant processing services, corporate payment products, and credit and debit card revenue.
Noninterest expense decreased $12 million (1.6 percent) in the second quarter and increased $10 million (0.7 percent) in the first six months of 2020, compared with the same periods of 2019, reflecting lower marketing and business development expense due to the timing of marketing campaigns and a reduction in costs related to equipment sales driven by lower volumes, offset
by higher software expense due to capital expenditures and acquisitions. The provision for credit losses decreased $326 million in the second quarter and $350 million (60.2 percent) in the first six months of 2020, compared with the same periods of 2019, reflecting favorable changes in the reserve allocation driven by lower outstanding loan balances and lower delinquency rates, partially offset by higher net charge-offs.
Treasury and Corporate Support
Treasury and Corporate Support includes the Company’s investment portfolios, funding, capital management, interest rate risk management, income taxes not allocated to the business lines, including most investments in tax-advantaged projects, and the residual aggregate of those expenses associated with corporate activities that are managed on a consolidated basis. Treasury and Corporate Support recorded net losses of $1.2 billion in the second quarter and $1.4 billion in the first six months of 2020, compared with net income of $186 million and $316 million, respectively, in the same periods of 2019.
Net revenue decreased $131 million (37.1 percent) in the second quarter and $203 million (32.0 percent) in the first six months of 2020, compared with the same periods of 2019. Net interest income, on a taxable-equivalent basis, decreased $81 million in the second quarter and $126 million in the first six months of 2020, compared with the same periods of 2019, primarily due to lower spreads within the investment portfolio. Noninterest income decreased $50 million (17.7 percent) in the second quarter and $77 million (14.1 percent) in the first six months of 2020, compared with the same periods of 2019, primarily due to lower equity investment income, lower tax-advantaged investment syndication revenue, and asset impairments as a result of property damage from civil unrest in the second quarter of 2020, partially offset by higher investment securities gains. The decrease in noninterest income in the first six months of 2020, compared with the first six months of 2019, was also due to higher credit valuation losses, partially offset by gains on the sale of certain businesses in the first quarter of 2020.
Noninterest expense increased $102 million (45.5 percent) in the second quarter and $221 million (45.6 percent) in the first six months of 2020, compared with the same periods of 2019, primarily due to COVID-related expenses, higher state franchise taxes, higher compensation expense reflecting merit increases and stock-based compensation, and higher implementation costs of capital investments to support business growth. These increases were partially offset by lower net shared services expense, lower costs related to tax-advantaged projects and a reduction in travel expenses as a result of COVID-19. The provision for credit losses increased $1.6 billion in the second quarter and $1.8 billion in the first six months of 2020, compared with the same periods of 2019, reflecting unfavorable changes in the reserve allocation due to adverse changes in economic conditions and the expected impact to credit losses in the current environment.
Income taxes are assessed to each line of business at a managerial tax rate of 25.0 percent with the residual tax expense or benefit to arrive at the consolidated effective tax rate included in Treasury and Corporate Support.
NON-GAAP FINANCIAL MEASURES
In addition to capital ratios defined by banking regulators, the Company considers various other measures when evaluating capital utilization and adequacy, including:
| • | | Tangible common equity to tangible assets, |
| • | | Tangible common equity to risk-weighted assets, and |
| • | | Common equity tier 1 capital to risk-weighted assets, reflecting the full implementation of the current expected credit losses methodology. |
These capital measures are viewed by management as useful additional methods of evaluating the Company’s utilization of its capital held and the level of capital available to withstand unexpected negative market or economic conditions. Additionally, presentation of these measures allows investors, analysts and banking regulators to assess the Company’s capital position relative to other financial services companies. These capital measures are not defined in generally accepted accounting principles (“GAAP”), or are not currently effective or defined in banking regulations. In addition, certain of these measures differ from currently effective capital ratios defined by banking regulations principally in that the currently effective ratios, which are subject to certain transitional provisions, temporarily exclude the impact of the 2020 adoption of accounting guidance related to impairment of financial instruments based on the current expected credit losses methodology. As a result, these capital measures disclosed by the Company may be considered non-GAAP financial measures. Management believes this information helps investors assess trends in the Company’s capital adequacy.
The Company also discloses net interest income and related ratios and analysis on a taxable-equivalent basis, which may also be considered non-GAAP financial measures. The Company believes this presentation to be the preferred industry measurement of net interest income as it provides a relevant comparison of net interest income arising from taxable and tax-exempt sources. In addition, certain performance measures, including the efficiency ratio and net interest margin utilize net interest income on a taxable-equivalent basis.
There may be limits in the usefulness of these measures to investors. As a result, the Company encourages readers to consider the consolidated financial statements and other financial information contained in this report in their entirety, and not to rely on any single financial measure.
The following table shows the Company’s calculation of these non-GAAP financial measures:
| | | | | | | | |
| (Dollars in Millions) | | June 30,
2020 | | | December 31,
2019 | |
| | $ | 52,480 | | | $ | 52,483 | |
| | | (5,984 | ) | | | (5,984 | ) |
| | | (630 | ) | | | (630 | ) |
Goodwill (net of deferred tax liability) (1) | | | (8,954 | ) | | | (8,788 | ) |
Intangible assets, other than mortgage servicing rights | | | (678 | ) | | | (677 | ) |
Tangible common equity (a) | | | 36,234 | | | | 36,404 | |
Common equity tier 1 capital, determined in accordance with transitional regulatory capital requirements related to the current expected credit losses methodology implementation | | | 36,351 | | | | | |
| | | (1,702 | ) | | | | |
Common equity tier 1 capital, reflecting the full implementation of the current expected credit losses methodology (b) | | | 34,649 | | | | | |
| | | 546,652 | | | | 495,426 | |
Goodwill (net of deferred tax liability) (1) | | | (8,954 | ) | | | (8,788 | ) |
Intangible assets, other than mortgage servicing rights | | | (678 | ) | | | (677 | ) |
| | | 537,020 | | | | 485,961 | |
Risk-weighted assets, determined in accordance with prescribed regulatory capital requirements effective for the Company (d) | | | 401,832 | | | | 391,269 | |
| | | (1,394 | ) | | | | |
Risk-weighted assets, reflecting the full implementation of the current expected credit losses methodology (e) | | | 400,438 | | | | | |
| | |
| | | | | | | | |
Tangible common equity to tangible assets (a)/(c) | | | 6.7 | % | | | 7.5 | % |
Tangible common equity to risk-weighted assets (a)/(d) | | | 9.0 | | | | 9.3 | |
Common equity tier 1 capital to risk-weighted assets, reflecting the full implementation of the current expected credit losses methodology (b)/(e) | | | 8.7 | | | | | |
| | | | | | | | | | | | | | | | | | | | |
| | | |
| | | Three Months Ended
June 30 | | | | | | Six Months Ended
June 30 | |
| | | 2020 | | | 2019 | | | | | | 2020 | | | 2019 | |
| | $ | 3,200 | | | $ | 3,305 | | | | | | | $ | 6,423 | | | $ | 6,564 | |
Taxable-equivalent adjustment (4) | | | 24 | | | | 27 | | | | | | | | 48 | | | | 54 | |
Net interest income, on a taxable-equivalent basis | | | 3,224 | | | | 3,332 | | | | | | | | 6,471 | | | | 6,618 | |
| | | | | |
Net interest income, on a taxable-equivalent basis (as calculated above) | | | 3,224 | | | | 3,332 | | | | | | | | 6,471 | | | | 6,618 | |
| | | 2,614 | | | | 2,490 | | | | | | | | 5,139 | | | | 4,781 | |
Less: Securities gains (losses), net | | | 81 | | | | 17 | | | | | | | | 131 | | | | 22 | |
Total net revenue, excluding net securities gains (losses) (f) | | | 5,757 | | | | 5,805 | | | | | | | | 11,479 | | | | 11,377 | |
| | | | | |
| | | 3,318 | | | | 3,153 | | | | | | | | 6,634 | | | | 6,240 | |
| | | | | |
| | | 57.6 | % | | | 54.3 | % | | | | | | | 57.8 | % | | | 54.8 | % |
| (1) | Includes goodwill related to certain investments in unconsolidated financial institutions per prescribed regulatory requirements. |
| (2) | Includes the estimated increase in the allowance for credit losses related to the adoption of the current expected credit losses methodology net of deferred taxes. |
| (3) | Includes the impact of the estimated increase in the allowance for credit losses related to the adoption of the current expected credit losses methodology. |
| (4) | Based on a federal income tax rate of 21 percent for those assets and liabilities whose income or expense is not included for federal income tax purposes. |
CRITICAL ACCOUNTING POLICIES
The accounting and reporting policies of the Company comply with accounting principles generally accepted in the United States and conform to general practices within the banking industry. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions. The Company’s financial position and results of operations can be affected by these estimates and assumptions, which are integral to understanding the Company’s financial statements. Critical accounting policies are those policies management believes are the most important to the portrayal of the Company’s financial condition and results, and require management to make estimates that are difficult, subjective or complex. Most accounting policies are not considered by management to be critical accounting policies. Management has discussed the development and the selection of critical accounting policies with the Company’s Audit Committee. Those policies considered to be critical accounting policies relate to the allowance for credit losses, fair value estimates, MSRs, and income taxes.
Allowance for Credit Losses
Management’s evaluation of the appropriate allowance for credit losses is often the most critical of all the accounting estimates for a banking institution. It is an inherently subjective process impacted by many factors as discussed throughout the Management’s Discussion and Analysis section of this Quarterly Report on Form 10-Q. Prior to January 1, 2020, the allowance for credit losses was established to provide for probable and estimable losses incurred in the Company’s credit portfolio. Effective January 1, 2020,
the Company adopted new accounting guidance which changed previous impairment recognition to a model that is based on expected losses rather than incurred losses. Refer to Note 2 of the Notes to Consolidated Financial Statements for discussion on the effect of the adoption of this guidance on the Company’s financial statements.
The methods utilized to estimate the allowance for credit losses, key assumptions and quantitative and qualitative information considered by management in determining the appropriate allowance for credit losses at June 30, 2020 are discussed in the “Credit Risk Management” section. Although methodologies utilized to determine each element of the allowance reflect management’s assessment of credit risk as identified through assessments completed of individual credits and of homogenous pools affected by material credit events, degrees of imprecision exist in these measurement tools due in part to subjective judgments involved and an inherent lag in the data available to quantify current conditions and events that affect credit loss reserve estimates. As discussed in the “Analysis and Determination of Allowance for Credit Losses” section, management considered the effect of changes in economic conditions, risk management practices, and other factors that contributed to imprecision of loss estimates in determining the allowance for credit losses. If not considered, expected losses in the credit portfolio related to imprecision and other subjective factors could have a dramatic adverse impact on the liquidity and financial viability of a banking institution.
Given the many quantitative variables and subjective factors affecting the credit portfolio, changes in the allowance for credit losses may not directly coincide with changes in the risk ratings of the credit portfolio reflected in the risk rating process. This is in part due to the timing of the risk rating process in relation to changes in the business cycle, the exposure and mix of loans within risk rating categories, levels of nonperforming loans and the timing of charge-offs and expected recoveries. The allowance for credit losses on commercial lending segment loans measures the expected loss content on the remaining portfolio exposure, while nonperforming loans and net charge-offs are measures of specific impairment events that have already been confirmed. Therefore, the degree of change in the forward-looking expected loss in the commercial lending allowance may differ from the level of changes in nonperforming loans and net charge-offs. Management maintains an appropriate allowance for credit losses by updating allowance rates to reflect changes in expected losses, including expected changes in economic or business cycle conditions.
Some factors considered in determining the appropriate allowance for credit losses are more readily quantifiable while other factors require extensive qualitative judgment. Management conducts an analysis with respect to the accuracy of risk ratings and the volatility of expected losses, and utilizes this analysis along with qualitative factors that can affect the precision of credit loss estimates, including economic conditions, such as changes in Gross Domestic Product, unemployment or bankruptcy rates, and concentration risks, such as risks associated with specific industries, collateral valuations, and loans to highly leveraged enterprises, in determining the overall level of the allowance for credit losses.
The Company considers a range of economic scenarios in its determination of the allowance for credit losses. These scenarios are constructed with interrelated projections of multiple economic variables, and loss estimates are produced that consider the historical correlation of those economic variables with credit losses, and also the expectation that conditions will eventually normalize over the longer run. Scenarios worse than the Company’s expected outcome at June 30, 2020 include risks that government stimulus in response to the COVID-19 pandemic is less broad or less effective than expected, or that a longer or more severe health crisis prolongs the downturn in economic activity, reducing the number of businesses that are ultimately able to resume operations after the crisis has passed.
The Company’s determination of the allowance for commercial lending segment loans is sensitive to the assigned credit risk ratings and expected loss rates at June 30, 2020. If 20 percent of period ending loan balances (including unfunded commitments) within each risk category of risk rated commercial lending loans experienced a downgrade to the next worse risk category, the allowance for credit losses would have increased by approximately $238 million at June 30, 2020. If quantitative loss estimates for commercial lending segment loans increased by 10 percent, the allowance for credit losses would have increased by approximately $358 million at June 30, 2020. The Company believes the allowance for credit losses appropriately considers the imprecision in estimating credit losses based on credit risk ratings and credit loss model estimates, but actual losses may differ from those estimates.
The Company’s determination of the allowance for consumer lending segment loans is sensitive to changes in estimated loss rates and estimated impairments on restructured loans. In the event that estimated losses for this segment of the loan portfolio increased by 10 percent, the allowance for credit losses would have increased by approximately $324 million at June 30, 2020. Because several quantitative and qualitative factors are considered in determining the allowance for credit
losses, these sensitivity analyses do not necessarily reflect the nature and extent of future changes in the allowance for credit losses. They are intended to provide insights into the impact of adverse changes in risk rating and loss model estimates and do not imply any expectation of future deterioration in the risk rating or loss rates. Given current processes employed by the Company, management believes the risk ratings and loss model estimates currently assigned are appropriate. It is possible that others, given the same information, may at any point in time reach different reasonable conclusions that could be significant to the Company’s financial statements. Refer to the “Analysis and Determination of the Allowance for Credit Losses” section for further information.
Accounting policies related to fair value estimates, MSRs, and income taxes are discussed in detail in “Management’s Discussion and Analysis — Critical Accounting Policies” and the Notes to Consolidated Financial Statements in the Company’s Annual Report on Form 10-K for the year ended December 31, 2019.
Under the supervision and with the participation of the Company’s management, including its principal executive officer and principal financial officer, the Company has evaluated the effectiveness of the design and operation of its disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”)). Based upon this evaluation, the principal executive officer and principal financial officer have concluded that, as of the end of the period covered by this report, the Company’s disclosure controls and procedures were effective.
During the most recently completed fiscal quarter, there was no change made in the Company’s internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.
extension of maturity dates or deferrals of payments, capitalization of accrued interest and/or outstanding advances, or in limited situations, partial forgiveness of loan principal. In most instances, participation in residential mortgage loan restructuring programs requires the customer to complete a short-term trial period. A permanent loan modification is contingent on the customer successfully completing the trial period arrangement, and the loan documents are not modified until that time. The Company reports loans in a trial period arrangement as TDRs and continues to report them as TDRs after the trial period.
Credit card and other retail loan TDRs are generally part of distinct restructuring programs providing customers experiencing financial difficulty with modifications whereby balances may be amortized up to 60 months, and generally include waiver of fees and reduced interest rates.
In addition, the Company considers secured loans to consumer borrowers that have debt discharged through bankruptcy where the borrower has not reaffirmed the debt to be TDRs.
Loan modifications or concessions granted to borrowers resulting directly from the effects of the COVID-19 pandemic, who were otherwise in current payment status, are not considered to be TDRs.
As of June 30, 2020, the Company had approved approximately $17.2 billion of loan modifications included on its consolidated balance sheet related to borrowers impacted by the
COVID-19
pandemic, consisting primarily of payment deferrals of 90 days or less.
The following table provides a summary of TDR loans that defaulted (fully or partially
charged-off
or became 90 days or more
past
due) during the periods presented that were modified as TDRs within 12 months previous to default:
| | | | | | | | | | | | | | | | | | | | |
| | | 2020 | | | | | | 2019 | |
| (Dollars in Millions) | | Number
of Loans | | | Amount
Defaulted | | | | | | Number
of Loans | | | Amount
Defaulted | |
Three Months Ended June 30 | | | | | | | | | | | | | | | | | | | | |
| | | 330 | | | $ | 8 | | | | | | | | 252 | | | $ | 4 | |
| | | 12 | | | | 6 | | | | | | | | 7 | | | | 4 | |
| | | 5 | | | | 1 | | | | | | | | 15 | | | | 3 | |
| | | 1,736 | | | | 9 | | | | | | | | 1,922 | | | | 10 | |
| | | 82 | | | | 1 | | | | | | | | 80 | | | | 1 | |
Total loans, excluding loans purchased from GNMA mortgage pools | | | 2,165 | | | | 25 | | | | | | | | 2,276 | | | | 22 | |
Loans purchased from GNMA mortgage pools | | | 51 | | | | 7 | | | | | | | | 310 | | | | 43 | |
| | | 2,216 | | | $ | 32 | | | | | | | | 2,586 | | | $ | 65 | |
| | | | | |
| | | | | | | | | | | | | | | | | | | | |
| | | 617 | | | $ | 28 | | | | | | | | 486 | | | $ | 9 | |
| | | 28 | | | | 16 | | | | | | | | 15 | | | | 10 | |
| | | 18 | | | | 2 | | | | | | | | 111 | | | | 13 | |
| | | 3,806 | | | | 19 | | | | | | | | 3,976 | | | | 19 | |
| | | 190 | | | | 2 | | | | | | | | 227 | | | | 8 | |
Total loans, excluding loans purchased from GNMA mortgage pools | | | 4,659 | | | | 67 | | | | | | | | 4,815 | | | | 59 | |
Loans purchased from GNMA mortgage pools | | | 355 | | | | 48 | | | | | | | | 434 | | | | 60 | |
| | | 5,014 | | | $ | 115 | | | | | | | | 5,249 | | | $ | 119 | |
In addition to the defaults in the table above, the Company had a total of 104 and 241 residential mortgage loans, home equity and second mortgage loans and loans purchased from GNMA mortgage pools for the three months and six months ended June 30, 2020, respectively, where borrowers did not successfully complete the trial period arrangement and, therefore, are no longer eligible for a permanent modification under the applicable modification program. These loans had aggregate outstanding balances of $15 million and $34 million for the three months and six months ended June 30, 2020, respectively.
As of June 30, 2020, the Company had $116 million of commitments to lend additional funds to borrowers whose terms of their outstanding owed balances have been modified in troubled debt restructurings.
The Company currently processes card transactions in the United States, Canada and Europe through wholly-owned subsidiaries and a network of other financial institutions. In the event a merchant was unable to fulfill product or services subject to future delivery, such as airline tickets, the Company could become financially liable for refunding the purchase price of such products or services purchased through the credit card associations under the charge-back provisions. Charge-back risk related to these merchants is evaluated in a manner similar to credit risk assessments and, as such, merchant processing contracts contain various provisions to protect the Company in the event of default.
At June 30, 2020, the value of airline tickets purchased to be delivered at a future date through card transactions processed by the Company was $9.5 billion. The Company held collateral of $743 million in escrow deposits, letters of credit and indemnities from financial institutions, and liens on various assets. In addition to specific collateral or other credit enhancements, the Company maintains a liability for its implied guarantees associated with future delivery. At June 30, 2020, the liability was $144 million primarily related to these airline processing arrangements.
The Company regularly sells loans to GSEs as part of its mortgage banking activities. The Company provides customary representations and warranties to GSEs in conjunction with these sales. These representations and warranties generally require the Company to repurchase assets if it is subsequently determined that a loan did not meet specified criteria, such as a documentation deficiency or rescission of mortgage insurance. If the Company is unable to cure or refute a repurchase request, the Company is generally obligated to repurchase the loan or otherwise reimburse the GSE for losses. At June 30, 2020, the Company had reserved $19 million for potential losses from representation and warranty obligations, compared with $9 million at December 31, 2019. The Company’s reserve reflects management’s best estimate of losses for representation and warranty obligations. The Company’s repurchase reserve is modeled at the loan level, taking into consideration the individual credit quality and borrower activity that has transpired since origination. The model applies credit quality and economic risk factors to derive a probability of default and potential repurchase that are based on the Company’s historical loss experience, and estimates loss severity based on expected collateral value. The Company also considers qualitative factors that may result in anticipated losses differing from historical loss trends.
As of June 30, 2020 and December 31, 2019, the Company had $11 million and $10 million, respectively, of unresolved representation and warranty claims from GSEs. The Company does not have a significant amount of unresolved claims from investors other than GSEs.
Litigation and Regulatory Matters
The Company is subject to various litigation and regulatory matters that arise in the ordinary course of its business. The Company establishes reserves for such matters when potential losses become probable and can be reasonably estimated. The Company believes the ultimate resolution of existing legal and regulatory matters will not have a material adverse effect on the financial condition, results of operations or cash flows of the Company. However, in light of the uncertainties inherent in these matters, it is possible that the ultimate resolution of one or more of these matters may have a material adverse effect on the Company’s results from operations for a particular period, and future changes in circumstances or additional information could result in additional accruals or resolution in excess of established accruals, which could adversely affect the Company’s results from operations, potentially materially.
Residential Mortgage-Backed Securities Litigation
Starting in 2011, the Company and other large financial institutions have been sued in their capacity as trustee for residential mortgage–backed securities trusts. In the lawsuits brought against the Company, the investors allege that the Company’s banking subsidiary, U.S. Bank National Association (“U.S. Bank”), as trustee caused them to incur substantial losses by failing to enforce loan repurchase obligations and failing to abide by appropriate standards of care after events of default allegedly occurred. The plaintiffs in these matters seek monetary damages in unspecified amounts and most also seek equitable relief.
The Company is continually subject to examinations, inquiries and investigations in areas of heightened regulatory scrutiny, such as compliance, risk management, third-party risk management and consumer protection. The Company is cooperating fully with all pending examinations, inquiries and investigations, any of which could lead to administrative or legal proceedings or settlements. Remedies in these proceedings or settlements may include fines, penalties, restitution or alterations in the Company’s business practices (which may increase the Company’s operating expenses and decrease its revenue).
Due to their complex nature, it can be years before litigation and regulatory matters are resolved. The Company may be unable to develop an estimate or range of loss where matters are in early stages, there are significant
