EXHIBIT 13.1
The Charles Schwab Corporation
2003 Annual Report to Stockholders
(Only those portions specifically incorporated by reference into
The Charles Schwab Corporation 2003 Annual Report on Form 10-K)
Selected Financial and Operating Data The Charles Schwab Corporation
(In Millions, Except Per Share Amounts, Ratios, Number of Domestic Offices,
Average Revenue Per Revenue Trade, and as Noted)
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Growth Rates
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Compounded Annual
5-Year 1-Year
1998-2003 2002-2003 2003 2002 2001 2000 1999
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Results of Operations
Revenues (1) 6% - $ 4,087 $ 4,091 $ 4,292 $ 5,695 $ 4,405
Expenses excluding interest (1) 7% (13%) $ 3,377 $ 3,864 $ 4,115 $ 4,433 $ 3,292
Income from continuing operations before
extraordinary items 3% 250% $ 472 $ 135 $ 106 $ 738 $ 676
Net income 3% 333% $ 472 $ 109 $ 199 $ 718 $ 666
Income from continuing operations per share - basic 2% 250% $ .35 $ .10 $ .08 $ .54 $ .52
Income from continuing operations per share - diluted 2% 250% $ .35 $ .10 $ .08 $ .53 $ .49
Basic earnings per share (2) 2% 338% $ .35 $ .08 $ .14 $ .53 $ .51
Diluted earnings per share (2) 2% 338% $ .35 $ .08 $ .14 $ .51 $ .49
Dividends declared per common share (3) 7% 14% $ .050 $ .044 $ .044 $ .041 $ .037
Weighted-average common shares outstanding - diluted 1,364 1,375 1,399 1,404 1,373
Non-trading revenues as a percentage of revenues (4) 66% 66% 63% 51% 47%
Trading revenues as a percentage of revenues (4) 34% 34% 37% 49% 53%
Effective income tax rate 33.5% 42.6% 44.1% 41.7% 39.3%
Capital expenditures - cash purchases of equipment,
office facilities, property, and internal-use
software development costs, net (5%) (4%) $ 153 $ 160 $ 301 $ 705 $ 370
Capital expenditures as a percentage of revenues 3.7% 3.9% 7.0% 12.4% 8.4%
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Performance Measures
Revenue growth (decline) - (5%) (25%) 29% 42%
Pre-tax profit margin - reported 17.4% 4.6% 8.3% 21.6% 24.9%
After-tax profit margin - reported 11.5% 2.7% 4.6% 12.6% 15.1%
Return on stockholders' equity 11% 3% 5% 21% 31%
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Financial Condition (at year end)
Total assets 12% 16% $45,866 $39,705 $40,464 $38,154 $34,322
Long-term debt 13% 20% $ 772 $ 642 $ 730 $ 770 $ 518
Stockholders' equity 22% 11% $ 4,461 $ 4,011 $ 4,163 $ 4,230 $ 2,576
Assets to stockholders' equity ratio 10 10 10 9 13
Long-term debt to total financial capital
(long-term debt plus stockholders' equity) 15% 14% 15% 15% 17%
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Client Information (at year end)
Active client accounts (5) 6% (6%) 7.5 8.0 7.8 7.5 6.6
Client assets (in billions) 10% 26% $ 966.7 $ 764.8 $ 845.9 $ 871.7 $ 846.0
Total mutual fund assets (in billions) 12% 19% $ 386.8 $ 323.8 $ 342.8 $ 330.3 $ 294.0
Independent investment advisor client
accounts (in thousands) (6) 12% 5% 1,238.8 1,182.4 1,081.7 986.5 848.3
Independent investment advisor client
assets (in billions) (6) 14% 29% $ 287.1 $ 222.4 $ 235.0 $ 231.3 $ 213.1
Number of domestic offices 4% (11%) 376 422 429 415 368
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Employee Information
Full-time equivalent employees
(at year end, in thousands) 2% (2%) 16.3 16.7 19.6 26.3 20.1
Revenues per average full-time equivalent
employee (in thousands) 3% 14% $ 251 $ 220 $ 192 $ 239 $ 249
Compensation and benefits expense as a
percentage of revenues 43.3% 45.1% 44.2% 42.2% 37.0%
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Clients' Daily Average Trading Volume (in thousands) (7)
Daily average revenue trades (8) 8% 5% 140.8 134.1 159.7 242.0 163.1
Mutual Fund OneSource and other asset-based trades 8% 3% 57.9 56.1 54.0 58.1 45.6
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Daily average trades 8% 4% 198.7 190.2 213.7 300.1 208.7
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Average Revenue Per Revenue Trade (7%) (3%) $ 36.72 $ 37.78 $ 35.02 $ 37.38 $ 45.55
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(1) Periods have been adjusted to summarize the impact of The Charles Schwab Corporation's sale of its U.K. brokerage subsidiary,
Charles Schwab Europe, in loss from discontinued operations.
(2) Both basic and diluted earnings per share include discontinued operations and extraordinary items.
(3) Dividends declared per common share do not include dividends declared by USTC prior to the completion of the merger in 2000.
(4) Non-trading revenues include asset management and administration fees, net interest revenue, and other revenues. Trading
revenues include commission and principal transaction revenues.
(5) Reflects the removal of 192,000 accounts in 2003 related to the Company's withdrawal from the Employee Stock Purchase Plan
business and the transfer of those accounts to other providers. Active accounts are defined as accounts with balances or
activity within the preceding eight months.
(6) Represents amounts related to Schwab's Services for Investment Managers unit.
(7) Effective in the third quarter of 2003, the Company considers reduced exchange trading sessions as half days in calculating
daily average trades.
(8) Revenue trades include all client trades (both individuals and institutions) that generate either commission revenue or revenue
from principal markups (i.e., fixed income); also known as DART. This data is reported on a trade date basis.
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The Charles Schwab Corporation
Management's Discussion and Analysis
of Results of Operations and Financial Condition
(Tabular Amounts in Millions, Except Trades, Average
Revenue Per Revenue Trade, and as noted)
DESCRIPTION OF BUSINESS
Overview
Following three consecutive years of declines in securities market indices,
2003 began with heightened geopolitical uncertainties and mixed economic news,
placing continued pressure on short-term interest rates, client asset valuations
and trading activity.
The disappointing market environment of the first quarter of 2003 was
gradually reversed as the economy gained momentum over the last three quarters
of the year. Investor uncertainty started to lift following the military action
in Iraq, and, despite the initiation of investigations into questionable trading
practices in the mutual fund industry, investors slowly began to regain
confidence in the market. By year end the market had been revived by an economic
recovery coupled with the continuation of the lowest interest rate environment
in decades. The Dow Jones Industrial Average ended 2003 up 25% over the previous
year end, its best performance since 1999. The Nasdaq Composite Index and the
Standard and Poor's 500 Index ended 2003 up 50% and 26%, respectively. As
securities markets improved, investors increased their trading activity and
asset valuations recovered.
While the Company experienced improvements in non-trading and trading
revenue as the year progressed, the Company's 2003 revenues were flat with the
prior year - even after considering that revenues for the first quarter of 2003
were 14% lower than in 2002. The Company's continued expense discipline enabled
a substantial improvement in earnings, with an after-tax profit margin of 11.5%
in 2003, compared to 2.7% in 2002 and 4.6% in 2001.
The Charles Schwab Corporation (CSC), headquartered in San Francisco,
California, and its subsidiaries (collectively referred to as the Company and
primarily located in San Francisco except as indicated) provide securities
brokerage, banking, and related financial services for 7.5 million active client
accounts(a). Client assets in these accounts totaled $966.7 billion at
December 31, 2003. Charles Schwab & Co., Inc. (Schwab) is a securities
broker-dealer with 339 domestic branch offices in 48 states, as well as a branch
in the Commonwealth of Puerto Rico. U.S. Trust Corporation (USTC, and with its
subsidiaries collectively referred to as U.S. Trust), located in New York City,
New York, is a wealth management firm that through its subsidiaries also
provides fiduciary services and private banking services with 37 offices in 15
states. Other subsidiaries include Charles Schwab Investment Management, Inc.
(CSIM), the investment advisor for Schwab's proprietary mutual funds, Schwab
Capital Markets L.P. (SCM), located in Jersey City, New Jersey, a market maker
in Nasdaq, exchange-listed, and other securities providing trade execution
services primarily to broker-dealers and institutional clients, CyberTrader,
Inc. (CyberTrader), located in Austin, Texas, an electronic trading technology
and brokerage firm providing services to highly active, online traders, and
Charles Schwab Bank, N.A. (Schwab Bank), a retail bank located in Reno, Nevada,
which commenced operations in April 2003.
The Company provides financial services to individuals, institutional
clients, and broker-dealers through four segments - Individual Investor,
Institutional Investor, Capital Markets, and U.S. Trust. The Individual Investor
segment includes the Company's retail brokerage and banking operations.
Consistent with its evolving strategy, at the end of 2002, management made a
strategic decision, which was executed in early 2003, to exit its remaining
local-currency based international operations, previously included in the
Individual Investor segment, including its United Kingdom (U.K.) brokerage
subsidiary, Charles Schwab Europe (CSE). The Institutional Investor segment
provides custodial, trading and support services to independent investment
advisors (IAs), serves company 401(k) plan sponsors and third-party
administrators, and supports company stock option plans. The Capital Markets
segment provides trade execution services in Nasdaq, exchange-listed, and other
securities primarily to broker-dealers, including Schwab, and institutional
clients. The U.S. Trust segment provides investment, wealth management, custody,
fiduciary, and private banking services to individual and institutional clients.
The Company generates cash primarily through the revenues of its brokerage
and banking subsidiaries, as well as through external financing. The Company's
revenues are classified into non-trading and trading categories. The Company
earns non-trading revenues primarily through:
- - Asset management and administration fees earned through its proprietary and
third-party mutual fund offerings, as well as fee-based investment
management and advisory services; and
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(a) Accounts with balances or activity within the preceding eight months.
Reflects the removal of 192,000 accounts in June 2003 related to the
Company's withdrawal from the Employee Stock Purchase Plan business and the
transfer of those accounts to other providers.
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- - Interest revenue earned on margin loans, loans to banking clients, and
investments.
Non-trading revenues are impacted by securities valuations, interest rates,
the Company's ability to attract new clients, and client transaction levels. The
Company earns trading revenues through:
- - Commissions earned for executing trades for clients; and
- - Principal transaction revenues for trading activity in fixed income
securities, and market-making activities in equity securities.
Trading revenues are impacted by trading volumes, the volatility of equity
prices in the securities markets and commission rates.
Management of the Company focuses on several key financial and
non-financial metrics (as shown in the following table) in evaluating the
Company's financial position and operating performance:
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Growth Rate
1-year
Key Metrics 2002-2003 2003 2002 2001
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Client Activity Metrics:
Net new client assets
(in billions) (1) 18% $ 56.2 $ 47.6 $ 73.6
Client assets
(in billions, at year end) 26% $966.7 $764.8 $845.9
Daily average revenue trades
(in thousands) 5% 140.8 134.1 159.7
Company Financial Metrics:
Revenue growth (decline) - (5%) (25%)
After-tax profit margin 11.5% 2.7% 4.6%
Return on stockholders' equity 11% 3% 5%
Net income growth (decline) 333% (45%) (72%)
Revenue per average full-time
equivalent employee
(in thousands) 14% $ 251 $ 220 $ 192
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(1) Includes inflows of $12.1 billion in 2003 at U.S. Trust related to the
acquisition of State Street Corporation's Private Asset Management group.
- - Net new client assets is defined as the total inflows of client cash and
securities to the firm less client outflows. Management believes that this
metric depicts how well the Company's products and services appeal to new
and existing clients.
- - Client assets is the market value of all client assets housed at the
Company. Management considers client assets to be indicative of the
Company's appeal in the marketplace. Additionally, growth in certain
components of client assets (e.g., money market funds) directly impacts
asset management and administration fees revenues.
- - Schwab's daily average revenue trades (DART) is deemed by management to be
a key indicator of client engagement with securities markets and the most
prominent driver of commission revenues.
- - From an overall long-term financial perspective, management has articulated
corporate goals of 20% annual revenue growth, an after-tax profit margin of
at least 12%, and 20% return on stockholders' equity. Although these
objectives had been consistently achieved in 2000 and prior years, the
Company did not achieve these goals in 2001, 2002, or 2003.
- - Revenue per average full-time equivalent employee (revenue per FTE) is
considered by management to be the Company's broadest measure of
productivity. With the Company's restructuring initiatives over the past
three years, revenue per FTE has greatly improved to $251,000 in 2003, the
highest figure since 1999 when revenue per FTE was $249,000.
Management continues to believe that the key to sustaining and improving
the Company's competitive position will be its ability to combine people and
technology in ways that are intended to provide investors with the access,
information, guidance, advice and control they expect - as well as high-quality
service - all at a lower cost than traditional providers of financial services.
In 2004, the Company will face the challenge of further improving its financial
performance while managing higher expenses related to the full restoration of
the Company's 401(k) employee contribution match, which was suspended in 2003,
and management's intentions to increase marketing communications and employee
variable compensation from the 2003 levels.
As more fully detailed in the "Business Strategy" section below, the
Company is actively engaged in offering an increasing array of investing and
financial services to help clients achieve better outcomes and thereby establish
and reinforce long-lasting relationships; further broadening the Company's
product footprint by adding products that existing clients may be utilizing
elsewhere; and diversifying into businesses that leverage the Company's core
franchise to strengthen its ability to reach and serve core clients and to
develop a more varied revenue stream.
Business Strategy
The Company's primary strategy is to meet the financial services needs of
individual investors and independent IAs. To sustain and advance this core
franchise, the Company remains focused on improving service for these clients
and building stronger relationships with them. The Company provides investors
and IAs with products and services that are tailored to (a) support a full
spectrum of investment styles and life stages, and (b) utilize its scale in
trading, operations, distribution and marketing.
Given that product and service offerings are frequently replicable across
financial services firms, management
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believes that the Company's strategy is differentiated much more by how it
approaches client service than by what is actually offered. The Company's vision
is to be the most useful and ethical provider of financial services in the
world. This goal is pursued by combining people and technology in unique ways.
People provide the client focus and personal touch that serving investors
requires - the attitudes, training, and incentives of Company employees
reinforce the "ethical" part of the vision. Technology helps create services
that are scaleable, consistent, and great value for the money, enabling the
delivery of highly useful and relevant offerings to the broadest possible array
of clients.
Management believes that its ability to combine people and technology is
key to improving its competitive position - other investment firms either offer
technology-based self-service investing, or relationship-based investing built
around individual brokers with inconsistent advice and high pricing. The Company
endeavors to offer a range of choices, which combine people and technology to
provide the best of personal touch, consistency, insight, and value. Actively
trading investors have access to information, guidance and technology through
both Schwab and CyberTrader. Investors with a longer-term focus who wish to
manage and administer their investments independently can access help and
guidance, as well as extensive investment research, news and information,
through Schwab's live and automated channels. Investors looking for ongoing
access to advice have the choice - depending on the degree and nature of the
investment insight, money management and wealth services they desire - of
working with Schwab investment consultants, independent IAs, or U.S. Trust's
client service officers. IAs can access custody, trading, technology and other
support services through Schwab's Services for Investment Managers unit. All
clients have access to a broad and growing array of banking and lending
services, mutual funds, individual equities and fixed income securities.
The Company is currently concentrating on three main avenues for growth:
Offering an increasing array of investing and financial services that are
designed to help clients achieve better outcomes and thereby establish and
reinforce long-lasting relationships. A growing selection of value-added
services can also help to increase the Company's scale and productivity and
maximize the value of its marketing and service investments. Current examples
include portfolio and financial planning for individual investors, succession
planning support for independent advisors, estate and wealth planning for high
net worth individuals, and trading strategy seminars for active traders.
Further broadening the product footprint by adding products that existing
clients may be utilizing elsewhere, which in turn enables the Company to
maximize relationship value - clients gain increased convenience, utility and
benefits while the firm gains enhanced revenues. Examples of products added or
expanded in recent years include options and futures trading for active traders,
banking services for long-term investors, specialized mutual funds for
independent advisors, and private banking for high net worth individuals.
Diversifying into businesses that leverage the Company's core, to
strengthen its ability to reach and serve core clients and to develop a more
varied revenue stream. For example, SCM's institutional equities trading
business brings together both retail and institutional order flow in a way that
supports high quality trade executions for all clients, as well as provides
institutional investors with research that can also be offered to certain IA and
individual clients. Schwab's Corporate Services unit serves the retirement plan
needs of corporations, levering the Company's technology, open-architecture
mutual fund offering and brand for the benefit of their employees, who, in turn,
can become Schwab clients in their own right.
In general, initiatives undertaken by the Company combine three key
elements: a deep understanding of current and prospective clients' needs; the
recognition that services or products offered must address those needs while
providing structural competitive advantage - value to the client and value back
to the Company that is sustainable and differentiated; and a consistent effort
to ensure that training and incentives are structured to align the interests of
front-line sales and service staff with those of clients. In 2003, the Company's
new initiatives included the following:
Service/offer expansion
The Company established several new services to help IAs manage and build
their practices. The Company introduced Schwab Advisor Transition Support(TM), a
suite of services designed to help advisors deal with succession planning
issues. Additionally, The Schwab Fund for Charitable Giving(R) introduced
Charitable Asset Management, a service which enables IAs working with our
Services for Investment Managers group or U.S. Trust to manage the donated
assets in client Charitable Giving Accounts of $500,000 or more in a flexible,
personalized manner. The Company also enhanced its Advisor WebCenter(R) website
design and maintenance offering, held a series of workshops to provide IA back
office staff with training and suggestions for improving operating efficiency,
and held a series of regional conferences to share ideas on practices and
strategies for growth.
For clients who seek occasional access to tailored guidance in managing
their investments, the Company enhanced its offering of for-fee advice
consultations; as well as expanded the investing insight available to clients
through a series of online panel discussions that offer expert perspectives on
topics ranging from macroeconomic conditions to international investing.
Additionally in 2003, the Company piloted certain new offers that were the
precursors of Schwab Personal Choice(TM) (see Subsequent Event).
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For actively trading clients, the Company added access to specialized
trading consultants during 2003, as well as two new online seminars as part of
an ongoing series designed to help clients measurably improve their trading
results.
In October 2003, U.S. Trust acquired State Street Corporation's Private
Asset Management group (PAM), a provider of wealth management services to
clients in the New England area. This transaction provides U.S. Trust with a
presence in an important wealth market, as well as enables the Company to add a
full array of private banking capabilities to complement the investment
management and fiduciary services provided by PAM.
Product expansion
Schwab Bank commenced operations as a retail bank in April 2003. During
2003, Schwab Bank originated $1.7 billion in first mortgages and borrowings
under home equity lines of credit totaled $292 million at year end. Schwab Bank
had total assets of $2.7 billion and deposits from banking clients of
$2.4 billion at December 31, 2003.
Additionally, Schwab introduced two additional proprietary mutual funds
(collectively referred to as the SchwabFunds) which utilize Schwab Equity
Ratings(TM) to help guide stock selection: the Schwab Small-Cap Equity Fund(TM),
which primarily invests in small U.S. companies, and the Schwab Dividend Equity
Fund(TM), which primarily invests in dividend-paying stocks. Schwab also
introduced the Schwab GNMA Fund, a core fixed income mutual fund which invests
primarily in Government National Mortgage Association bonds. Additionally, U.S.
Trust launched the Excelsior Equity Income Fund, which focuses on stocks that
pay above-average dividends. At December 31, 2003, total client assets in the
Schwab Small-Cap Equity Fund, Schwab Dividend Equity Fund, Schwab GNMA Fund, and
Excelsior Equity Income Fund were $45 million, $282 million, $45 million, and
$47 million, respectively.
The Company also recently announced the adoption of AXA Rosenberg LLC's
entire U.S. family of 11 mutual funds, which will become known as the Laudus
Funds(TM) upon completion of the adoption in 2004.
For clients using the Schwab Private Client(TM) service, the Company
introduced two Schwab Personal Portfolio(TM) accounts - Dividend Equity and Core
Equity - which combine the features of managed accounts with the stock
evaluation capability of Schwab Equity Ratings.
Business diversification
The Company launched a new service for participants in bundled 401(k) plans
serviced by Schwab, which provides either online, telephonic, or in-person
access to customized advice provided by a third party, including specific
recommendations about savings rates and the core investment fund choices
available in a given retirement plan.
Additionally, the Company expanded its trade execution capabilities through
the introduction of the Schwab Liquidity Network(TM), a market-making system
that pools the orders of the Company's individual investor client base with
those of broker-dealers and institutional investment firms in a manner designed
to offer greater opportunities for the best possible price on most stock trades.
The Company also extended automated electronic execution to most Nasdaq stock
trades of up to 20,000 shares for retail orders, and expanded the number of
securities traded by the Liquidity Network to over 11,000 at year end. Further,
the Company increased its institutional equities trading capabilities by
building a team of over 170 professionals. During 2003, SCM invested in
upgrading its trading systems, as well as revamping its trading floor to support
its expanding business. In November 2003, the Company announced an agreement to
acquire SoundView Technology Group, Inc., a research-driven securities firm
providing institutional investors with fundamental research on companies in
selected growth-related industries. For further information, see note "29 -
Subsequent Events."
SUBSEQUENT EVENT
On February 10, 2004 the Company announced Schwab Personal Choice, its
suite of investing and advice services for individual investors. Schwab Personal
Choice consists of eight different offers that range from low-priced,
technology-based active trading to highly customized wealth management delivered
by IAs, with a range of self-directed and advised investing services in between.
In combination with services from U.S. Trust and CyberTrader, Schwab Personal
Choice is designed to give investors control over the level of trading
technology, service and advice they utilize, the level of professional
involvement in their portfolio management they receive, and how they pay for
those services. In addition, Schwab Personal Choice is designed so that clients
are guided to appropriate service solutions based primarily on their needs and
preferences, rather than portfolio size or trading frequency.
FORWARD-LOOKING STATEMENTS
In addition to historical information, this Annual Report contains
forward-looking statements that reflect management's beliefs, objectives and
expectations as of the date hereof. These statements relate to, among other
things, revenue growth, after-tax profit margin, and return on stockholders'
equity (see Overview); the Company's ability to sustain and improve its
competitive position, and management's intentions to increase marketing
communications and variable compensation (see Overview); the Company's ability
to pursue its business strategy (see Business Strategy); the impact of changes
in management's
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estimates on the Company's results of operations (see Description of Business -
Critical Accounting Policies); the impact of the restructuring initiatives on
the Company's results of operations (see Results of Operations - Financial
Overview); management's expected increase in marketing communications (see
Results of Operations - Expenses Excluding Interest); cash and cash equivalents,
capital expenditures, and capital structure (see Liquidity and Capital Resources
- - Cash and Capital Resources); sources of liquidity and capital (see Liquidity
and Capital Resources - Liquidity and - Commitments); the Company's ability to
maintain its revenue yields on its SchwabFunds money market funds (see Risk
Management - Net Interest Revenue Simulation); the impact of potential new
regulations concerning mutual fund distribution, trading, and servicing (see
Risk Management - Legal and Compliance Risk); the potential impact of future
strategic transactions (see Risk Management - Potential Strategic Transactions);
contingent liabilities (see note "24 - Commitments and Contingent Liabilities"
in the Notes to Consolidated Financial Statements); and net interest expense
under interest rate swaps (see note "25 - Financial Instruments Subject to
Off-Balance Sheet Risk, Credit Risk or Market Risk" in the Notes to Consolidated
Financial Statements). Achievement of the expressed beliefs, objectives and
expectations described in these statements is subject to certain risks and
uncertainties that could cause actual results to differ materially from the
expressed beliefs, objectives, and expectations.
Important factors that may cause such differences include, but are not
limited to: the Company's success in building fee-based relationships with its
clients; the effect of client trading patterns on Company revenues and earnings;
changes in revenues and profit margin due to cyclical securities markets and
fluctuations in interest rates; the level and continuing volatility of equity
prices; a significant downturn in the securities markets over a short period of
time or a sustained decline in securities prices, trading volumes, and investor
confidence; geopolitical developments affecting the securities markets, the
economy, and investor sentiment; the size and number of the Company's insurance
claims; and a significant decline in the real estate market, including the
Company's ability to sublease certain properties. Other more general factors
that may cause such differences include, but are not limited to: the Company's
inability to attract and retain key personnel; the timing and impact of changes
in the Company's level of investments in personnel, technology, or advertising;
changes in technology; computer system failures and security breaches; evolving
legislation, regulation and changing industry practices adversely affecting the
Company; adverse results of litigation or regulatory matters; the inability to
obtain external financing at acceptable rates; the effects of competitors'
pricing, product and service decisions; and intensified industry competition and
consolidation. Certain of these factors are discussed in greater detail in this
Annual Report and in the Company's Annual Report on Form 10-K.
CRITICAL ACCOUNTING POLICIES
The consolidated financial statements of the Company have been prepared in
accordance with accounting principles generally accepted in the U.S. While the
majority of the Company's revenues, expenses, assets and liabilities are not
based on estimates, there are certain critical accounting policies that require
management to make estimates regarding matters that are uncertain and
susceptible to change where such change may result in a material adverse impact
on the Company's financial position and reported financial results. These
critical accounting policies are described below. Management regularly reviews
the estimates and assumptions used in the preparation of the Company's financial
statements for reasonableness and adequacy.
Valuation of Goodwill: Under the provisions of Statement of Financial Accounting
Standards (SFAS) No. 142 - Goodwill and Other Intangible Assets, goodwill is
required to be tested for impairment at least annually, or whenever indications
of impairment exist. An impairment exists when the carrying amount of goodwill
exceeds its implied fair value, resulting in an impairment charge for this
excess. The Company's goodwill balances, net of accumulated amortization, were
$835 million and $603 million at December 31, 2003 and 2002, respectively.
The Company has elected April 1 as its annual goodwill impairment testing
date. In testing for a potential impairment of goodwill on April 1, 2003,
management estimated the fair value of each of the Company's reporting units
(generally defined as the Company's businesses for which financial information
is available and reviewed regularly by management) and compared this value to
the carrying value of the reporting unit. The estimated fair value of each
reporting unit was greater than its carrying value, and therefore management
concluded that no amount of goodwill was impaired. The estimated fair value of
the reporting units was established using a discounted cash flow model that
includes significant assumptions about the future operating results and cash
flows of each reporting unit. Adverse changes in the Company's planned business
operations such as unanticipated competition, a loss of key personnel, the sale
of a reporting unit or a significant portion of a reporting unit, or other
unforeseen developments could result in an impairment of the Company's recorded
goodwill.
Valuation and Estimated Useful Lives of Intangible Assets Other than Goodwill:
The Company's intangible assets represent purchased assets that lack physical
substance but can be distinguished from goodwill, principally the value of
client relationships. Management generally obtains
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independent valuations to estimate the initial valuation and expected
amortization period for client-related intangible assets. These valuations are
primarily based on the present value of the estimated net cash flows expected to
be derived from the client relationships, and assumptions about future client
attrition. At each balance sheet date, management compares the actual and
estimated attrition for client-related intangible assets to evaluate whether
revisions to the amortization period are necessary. Also, management evaluates
the client-related intangible assets for impairment whenever events or changes
in circumstances indicate that the carrying amount of the asset may not be
recoverable. Therefore, higher than expected client attrition may result in
higher future amortization charges or an impairment charge for client-related
intangible assets. The Company's intangible asset balances, net of accumulated
amortization, were $144 million and $6 million at December 31, 2003 and 2002,
respectively. The increase in 2003 was primarily due to the addition of client
relationships related to U.S. Trust's acquisition of PAM in October 2003.
Restructuring Reserves: A portion of the reserves under the Company's
restructuring initiatives are based on assumptions, including the Company's
ability to successfully sublease certain real estate properties. The initial
restructuring reserves and any subsequent changes in estimates of such reserves
are recorded in restructuring and other charges on the Company's consolidated
statement of income. Factors and uncertainties which may adversely affect the
estimates of sublease income include further deterioration in the respective
properties' real estate markets, including Northern California, Texas, and New
Jersey, and prolonged vacancy periods prior to execution of tenant subleases.
The Company's total facilities reserves related to its restructuring initiatives
were $201 million and $227 million at December 31, 2003 and 2002, respectively.
As of December 31, 2003, the remaining facilities restructuring reserve is
net of estimated future sublease income of approximately $300 million. At year
end, approximately 65% of the total square footage targeted for sublease under
the restructuring initiatives has been subleased, up from approximately 25% at
December 31, 2002. This estimated future sublease income amount is determined
based upon a number of factors, including current and expected commercial real
estate lease rates in the respective properties' real estate markets, and
estimated vacancy periods prior to execution of tenant subleases. In 2003,
following a continued deterioration of the commercial real estate market, the
Company recorded additional facilities restructuring charges primarily due to
decreases in estimated sublease rates and increases in the estimated vacancy
periods prior to sublease. For a further discussion on the Company's
restructuring reserves, see "Results of Operations - Financial Overview."
Pension and Other Postretirement Benefits: Under U.S. Trust's trusteed,
noncontributory, qualified defined benefit pension plan, the benefit obligation
and related plan assets are based on certain estimates - years of employee
service, rate of increase in salary, discount rate and expected rate of return
on plan assets - which are made by management with recommendations by actuaries.
Following market declines in the fair value of pension plan assets in 2001 and
2002, U.S. Trust decreased its expected rate of return on pension plan assets
from 9.00% to 8.25% and its discount rate from 7.50% to 6.75%, both effective in
2003. In addition to the years of employee service, rate of increase in salary,
and discount rate, U.S. Trust's postretirement medical and life insurance
benefit obligation is based on the health care cost trend rate which is an
actuarial estimated rate of future increases in per capita cost of health care
benefits. The Company's benefit obligation at December 31, 2003 and 2002 was
$283 million and $281 million, respectively. The related pension expense
(credit) is included in compensation and benefits on the Company's consolidated
statement of income and was immaterial for both 2003 and 2002.
Derivative Instruments and Hedging Activities: As part of its asset and
liability management process, the Company has entered into interest rate swap
agreements (Swaps) to hedge the interest rate risk associated with U.S. Trust's
variable rate deposits from banking clients. The Company has designated these
Swaps as cash flow hedges, as allowed by SFAS No. 133 - Accounting for
Derivative Instruments and Hedging Activities. Therefore, principally all of the
cumulative change in the fair value of these Swaps from inception, totaling an
aggregate $33 million liability at December 31, 2003, has been recorded in
accumulated other comprehensive loss, which is a component of stockholders'
equity that is not recognized in current earnings. Any actual hedge
ineffectiveness, which was immaterial for 2003, is recorded in interest expense
on the Company's consolidated statement of income. In order to maintain hedge
accounting treatment, management performs a quarterly assessment of its
expectation that these Swaps are effective in achieving the desired hedging
results.
Additionally, the Company has entered into Swaps that effectively convert
the interest rate characteristics of a portion of the Company's Senior
Medium-Term Notes, Series A (Medium-Term Notes) from fixed to variable. The
Company has designated such Swaps as fair value hedges, as allowed by
SFAS No. 133. Since the notional amount, fixed interest rate, and maturity of
these Swaps exactly match the terms of the corresponding Medium-Term Notes, the
Company has concluded that these Swaps are completely effective in achieving the
desired hedging results, as permitted under SFAS No. 133. Consequently, changes
in the fair value of these Swaps, totaling an aggregate $19 million asset at
December 31, 2003, are completely offset by changes
- 7 -
in the fair value of the hedged Medium-Term Notes. Accordingly, there has not
been any impact on earnings as a result of this hedging program except for the
conversion from a fixed to a floating rate of interest on a portion of the
Medium-Term Notes.
Allowance for Credit Losses: The Company regularly evaluates its portfolio of
loans to banking clients and provides allowances for the portion management
believes may be uncollectible. Several factors are taken into consideration in
this evaluation including current economic conditions, the composition of the
loan portfolio, past loss experience, and risks inherent in the loan portfolio.
For Schwab Bank and U.S. Trust portfolios, which primarily consist of mortgage
loans, a risk-based methodology is used to determine the allowance for credit
losses. Mortgage loans are categorized into portfolios by loan type and risk
characteristics. A probable loss rate, based on company and industry experience,
is used to determine the credit allowance for each portfolio of loans. At
December 31, 2003 and 2002, the Company's allowance for credit losses was
$27 million and $24 million, respectively, on loan portfolios of $5.8 billion
and $4.6 billion, respectively. Total charge-offs and total recoveries were
immaterial for 2003 and 2002.
The Company's management has discussed the development and selection of
these critical accounting estimates with the Audit Committee of the Board of
Directors (Audit Committee). Additionally, the Audit Committee has reviewed the
Company's disclosures relating to the estimates discussed in this Management's
Discussion and Analysis of Results of Operations and Financial Condition.
For further information on the Company's accounting policies, see note "2 -
Significant Accounting Policies" in the Notes to Consolidated Financial
Statements.
RESULTS OF OPERATIONS
Financial Overview
Total revenues were $4.1 billion in each of 2003 and 2002. The Company's
non-trading revenues totaled $2.7 billion in each of 2003 and 2002, as a
decrease in net interest revenue resulting from continued interest rate spread
pressure was substantially offset by an increase in asset management and
administration fees resulting primarily from higher levels of client assets.
Trading revenues totaled $1.4 billion in each of 2003 and 2002, as an increase
in commission revenues resulting from higher client trading activity was
substantially offset by a decrease in principal transaction revenues resulting
from lower average revenue per equity share traded.
Total expenses excluding interest for 2003 were $3.4 billion, down
$487 million, or 13%, from 2002. This decrease was primarily due to a combined
$309 million, or 78%, decline in restructuring and impairment charges, and a
$178 million, or 5%, aggregate decline in all remaining expense categories as a
result of the Company's continued expense reduction measures.
Income from continuing operations before taxes on income and extraordinary
gain for 2003 was $710 million, up $483 million, or 213% from 2002, and net
income for 2003 was $472 million, or $.35 per share, up 333% from 2002, with
both increases primarily due to the combination of factors discussed above -
lower restructuring charges and declines in most expense categories. The
Company's after-tax profit margin for 2003 was 11.5%, up from 2.7% for 2002.
Return on stockholders' equity was 11% for 2003, compared to 3% in 2002.
Certain reclassifications have been made to prior year amounts to conform
to the current presentation. All references to earnings per share (EPS)
information in this Management's Discussion and Analysis of Results of
Operations and Financial Condition reflect diluted earnings per share unless
otherwise noted.
Segment Information: In evaluating the Company's financial performance,
management uses adjusted operating income, a non-generally accepted accounting
principles (non-GAAP) income measure which excludes items described in the
following paragraph. Management believes that adjusted operating income is a
useful indicator of the ongoing financial performance of the Company's segments,
and a tool that can provide meaningful insight into financial performance
without the effects of certain material items that are not expected to be an
ongoing part of operations (e.g., extraordinary items, non-operating revenues,
restructuring and other charges, impairment charges, acquisition- and
merger-related charges, and discontinued operations).
In 2003, net income of $472 million included the following items which in
total had the effect of decreasing after-tax income by $18 million: $51 million
of restructuring charges, a $5 million investment write-down related to the
Company's U.K. market-making operation, a $16 million tax benefit associated
with the Company's sale of its U.K. market-making operation, an $11 million gain
on the sale of an investment, and an $11 million tax benefit associated with the
Company's merger with U.S. Trust. In 2002, net income of $109 million included
the following items which in total had the effect of decreasing after-tax income
by $300 million: $221 million of restructuring charges, a $37 million investment
write-down related to the Company's U.K. market-making operation, a $38 million
loss from discontinued operations, $16 million of acquisition-related charges,
and a $12 million extraordinary gain on the sale of U.S. Trust's Corporate Trust
business. In 2001, net income of $199 million included the following items which
in total had the effect of decreasing after-tax income by $225 million:
- 8 -
$244 million of restructuring charges, $90 million of acquisition-related
charges, a $28 million loss from discontinued operations, a $16 million gain on
the sale of an investment, and a $121 million extraordinary gain on the sale of
U.S. Trust's Corporate Trust business.
As detailed in note "27 - Segment Information" in the Notes to Consolidated
Financial Statements, the Company's adjusted operating income before taxes was
$779 million for 2003, up $130 million, or 20%, from 2002 due to increases of
$127 million, or 41%, in the Individual Investor segment, and $30 million, or
14%, in the Institutional Investor segment, partially offset by decreases of
$7 million, or 100%, in the Capital Markets segment, and $20 million, or 17%, in
the U.S. Trust segment. The increases in the Individual and Institutional
Investor segments were primarily due to lower expenses as a result of the
Company's expense reduction measures. The decrease in the U.S. Trust segment was
primarily due to lower average client assets related to declines in market
valuations. The decrease in the Capital Markets segment was primarily due to
expense growth, primarily compensation expense, which exceeded revenue growth as
the Company increased its institutional equities trading team.
Restructuring: The Company recorded pre-tax restructuring charges for 2003,
2002, and 2001 as follows:
- --------------------------------------------------------------------------------
Restructuring Charges 2003 2002 2001
- --------------------------------------------------------------------------------
2003 Initiatives:
Workforce reduction $ 35 - -
Facilities reduction 16 - -
- --------------------------------------------------------------------------------
Total 2003 Initiatives 51 - -
- --------------------------------------------------------------------------------
2002 Initiatives:
Workforce reduction - $ 138 -
Facilities reduction (1) 124 -
Systems removal - 1 -
- --------------------------------------------------------------------------------
Total 2002 Initiatives (1) 263 -
- --------------------------------------------------------------------------------
2001 Initiatives:
Workforce reduction (3) 17 $ 182
Facilities reduction 34 78 139
Systems removal - - 61
- --------------------------------------------------------------------------------
Total 2001 Initiatives 31 95 382
- --------------------------------------------------------------------------------
Total $ 81 $ 358 $ 382
================================================================================
2003 Initiatives
In the third quarter of 2003, the Company commenced additional
restructuring initiatives to further adjust the Company's workforce and
facilities in response to the market environment. The Company recorded pre-tax
restructuring charges of $51 million in 2003, primarily reflecting severance
costs for approximately 250 employees and the consolidation of certain
facilities, including 33 Schwab domestic branch offices. The Company estimates
that its 2003 restructuring initiatives, which were substantially completed in
2003, will reduce pre-tax operating expenses for full-year 2004 by approximately
$40 million compared to annualized third quarter of 2003 operating expenses. The
Company expects, however, that these reductions will be substantially offset by
reinvestment in other areas of the Company.
2001 and 2002 Initiatives
The Company's 2001 and 2002 restructuring initiatives included workforce
reductions, reductions in operating facilities, the removal of certain systems
hardware, software and equipment from service, and the withdrawal from certain
international operations. These initiatives reduced operating expenses and
adjusted the Company's organizational structure to improve productivity, enhance
efficiency, and increase profitability. During 2003, the Company recorded
pre-tax restructuring charges of $30 million related to its 2001 and 2002
restructuring initiatives primarily due to changes in estimates of sublease
income associated with previously announced efforts to sublease excess
facilities.
For further information on the Company's restructuring initiatives, see
note "3 - Restructuring and Other Charges" in the Notes to Consolidated
Financial Statements. The actual costs of these restructuring initiatives could
differ from the estimated costs, depending primarily on the Company's ability to
sublease properties. For further information on the Company's facilities
restructuring reserves, see "Critical Accounting Policies."
Sale of Corporate Trust Business: In June 2001, USTC sold its Corporate Trust
business to The Bank of New York Company, Inc. (Bank of NY). The Company
recognized extraordinary gains in 2001 and 2002 related to this sale, including
amounts recognized upon satisfaction of certain client retention requirements.
For further information, see note "5 - Sale of Corporate Trust Business" in the
Notes to Consolidated Financial Statements.
Discontinued Operations: In January 2003, the Company sold its U.K. brokerage
subsidiary, CSE, to Barclays PLC. The results of CSE's operations have been
summarized as loss from discontinued operations, net of tax, on the Company's
consolidated statement of income. The Company's consolidated prior period
revenues, expenses, and taxes on income have been adjusted to reflect this
presentation. For further information, see note "6 - Discontinued Operations" in
the Notes to Consolidated Financial Statements.
Business Divestiture: In June 2003, the Company sold its investment in Aitken
Campbell, a market-making joint
- 9 -
venture in the U.K., to the Company's joint venture partner, TD Waterhouse
Group, Inc. In 2003, the Company recorded an impairment charge to reduce the
carrying value of its investment and an income tax benefit. The Company's share
of Aitken Campbell's historical earnings, which was accounted for under the
equity method, has not been material to the Company's results of operations,
EPS, or cash flows. For further information, see note "7 - Business Acquisitions
and Divestiture" in the Notes to Consolidated Financial Statements.
REVENUES
The Company categorizes its revenues as either non-trading or trading. As
shown in the following table, non-trading, trading, and total revenues in 2003
were all comparable to the prior year.
- --------------------------------------------------------------------------------
Growth Rate
1-year
Composition of Revenues 2002-2003 2003 2002 2001
- --------------------------------------------------------------------------------
Non-trading revenues:
Asset management and
administration fees 4% $ 1,825 $ 1,749 $ 1,663
Net interest revenue (12%) 729 824 911
Other 10% 158 144 134
- --------------------------------------------------------------------------------
Total non-trading revenues - 2,712 2,717 2,708
- --------------------------------------------------------------------------------
Trading revenues:
Commissions 1% 1,207 1,190 1,329
Principal transactions (9%) 168 184 255
- --------------------------------------------------------------------------------
Total trading revenues - 1,375 1,374 1,584
- --------------------------------------------------------------------------------
Total - $ 4,087 $ 4,091 $ 4,292
================================================================================
Percentage of total revenues:
Non-trading revenues 66% 66% 63%
Trading revenues 34% 34% 37%
- --------------------------------------------------------------------------------
While the Individual Investor and Institutional Investor segments generate
both non-trading and trading revenues, the Capital Markets segment generates
primarily trading revenues and the U.S. Trust segment generates primarily
non-trading revenues. Revenues by segment are as shown in the following table:
- --------------------------------------------------------------------------------
Growth Rate
1-year
Revenues by Segment 2002-2003 2003 2002 2001
- --------------------------------------------------------------------------------
Individual Investor (1%) $ 2,329 $ 2,345 $ 2,447
Institutional Investor (2%) 820 835 822
Capital Markets 13% 293 260 343
U.S. Trust (4%) 628 651 654
- --------------------------------------------------------------------------------
Total segment revenues (1%) 4,070 4,091 4,266
Non-segment revenues (1) n/m 17 - 26
- --------------------------------------------------------------------------------
Total revenues - $ 4,087 $ 4,091 $ 4,292
================================================================================
(1) Primarily consists of gains on sales of investments.
n/m Not meaningful.
The increase in revenues in the Capital Markets segment was primarily due
to the growth of the Company's institutional trading business. See note "27 -
Segment Information" in the Notes to Consolidated Financial Statements for
financial information by segment for the last three years.
Asset Management and Administration Fees
Asset management and administration fees, as shown in the table below,
include mutual fund service fees, as well as fees for other asset-based
financial services provided to individual and institutional clients. The Company
earns mutual fund service fees for recordkeeping and shareholder services
provided to third-party funds, and for transfer agent services, shareholder
services, administration, and investment management provided to its proprietary
funds. These fees are based upon the daily balances of client assets invested in
third-party funds and upon the average daily net assets of the Company's
proprietary funds. Mutual fund service fees are earned through the Individual
Investor, Institutional Investor, and U.S. Trust segments. The Company also
earns asset management and administration fees for financial services, including
investment management and consulting, trust and fiduciary services, custody
services, financial and estate planning, and private banking services, provided
to individual and institutional clients. These fees are primarily based on the
value and composition of assets under management and are earned through the
U.S. Trust, Individual Investor, and Institutional Investor segments.
- 10 -
- --------------------------------------------------------------------------------
Asset Management and Administration Fees 2003 2002 2001
- --------------------------------------------------------------------------------
Mutual fund service fees:
Proprietary funds (SchwabFunds,
Excelsior, and other) $ 883 $ 874 $ 818
Mutual Fund OneSource 283 264 282
Other 50 41 42
Asset management and related services 609 570 521
- --------------------------------------------------------------------------------
Total $ 1,825 $ 1,749 $ 1,663
================================================================================
The increase in asset management and related service fees from 2002 to 2003
was primarily due to higher asset-based fees from certain client relationships,
partially offset by a decrease in account fees. The increase in mutual fund
service fees from 2002 to 2003 was due to higher service fees earned on and
average assets in Schwab's Mutual Fund OneSource service, and higher service
fees earned on SchwabFunds. The increase in asset management and related service
fees from 2001 to 2002 was primarily due to higher account fees, partially
offset by a decrease in average U.S. Trust client assets primarily due to
declines in market valuations. The increase in mutual fund service fees from
2001 to 2002 was primarily due to higher average assets in and service fees
earned on SchwabFunds, and higher service fees earned on assets in Schwab's
Mutual Fund OneSource service, partially offset by a decrease in average assets
in Schwab's Mutual Fund OneSource service.
Commissions
The Company earns commission revenues, as shown in the following table, by
executing client trades primarily through the Individual Investor and
Institutional Investor segments, as well as the Capital Markets segment. These
revenues are affected by the number of client accounts that trade, the average
number of revenue-generating trades per account, and the average revenue earned
per revenue trade.
- --------------------------------------------------------------------------------
Commissions 2003 2002 2001
- --------------------------------------------------------------------------------
Equity and other securities $ 1,002 $ 980 $ 1,119
Mutual funds 110 111 96
Options 95 99 114
- --------------------------------------------------------------------------------
Total $ 1,207 $ 1,190 $ 1,329
================================================================================
The increase in commission revenues from 2002 to 2003 was primarily due to
higher daily average trades, partially offset by lower revenue per revenue
trade. The decrease in commission revenues from 2001 to 2002 was primarily due
to lower daily average trades, partially offset by higher revenue per revenue
trade. Commission revenues include $105 million in 2003, $52 million in 2002,
and $29 million in 2001, related to Schwab's institutional trading business.
Schwab's institutional trading business also generates principal transaction
revenues, as well as other revenues. Additionally, commission revenues include
$68 million in 2003, $67 million in 2002, and $59 million in 2001 related to
certain securities serviced by Schwab's fixed income division, including
exchange-traded unit investment trusts, real estate investment trusts, and
corporate debt. Schwab's fixed income division also generates principal
transaction revenues.
As illustrated in the following table, daily average revenue trades
executed by the Company increased 5% in 2003. Average revenue earned per revenue
trade decreased 3% from 2002 to 2003, primarily due to decreased pricing of
certain equity trades made through online channels as well as decreased pricing
of fixed income securities trades. Average revenue earned per revenue trade
increased 8% from 2001 to 2002, mainly due to higher client fixed income
securities trades and increased pricing of equity trades made through automated
telephone channels and broker-assisted trades.
- --------------------------------------------------------------------------------
Trading Activity 2003 2002 2001
- --------------------------------------------------------------------------------
Daily average revenue trades
(in thousands) (1) 140.8 134.1 159.7
Accounts that traded during the year
(in thousands) 2,734 2,871 3,028
Average revenue trades
per account that traded 12.9 11.8 13.1
Trading frequency proxy (2) 3.8 3.8 4.2
Number of trading days (3) 250.0 252.0 248.0
Average revenue earned
per revenue trade $ 36.72 $ 37.78 $ 35.02
Online trades as a percentage of
total trades 87% 83% 80%
- --------------------------------------------------------------------------------
(1) Includes all client trades (both individuals and institutions) that
generate either commission revenue or revenue from principal markups (i.e.,
fixed income).
(2) Represents revenue trades per $100,000 in total client assets.
(3) Effective in the third quarter of 2003, the Company considers reduced
exchange trading sessions as half days.
Net Interest Revenue
Net interest revenue, as shown in the following table, is the difference
between interest earned on certain assets (mainly margin loans to clients,
investments of segregated client cash balances, loans to banking clients, and
securities available for sale) and interest paid on supporting liabilities
(mainly deposits from banking clients and brokerage client cash balances). Net
interest revenue is affected by changes in the volume and mix of these assets
and liabilities, as well as by fluctuations in interest rates and hedging
strategies.
Substantially all of the Company's net interest revenue is earned through
the Individual Investor, Institutional Investor, and U.S. Trust segments. In
clearing its clients' trades, Schwab holds cash balances payable to clients. In
most cases, Schwab pays its clients interest on cash balances awaiting
investment, and may invest these funds and earn interest revenue. Margin loans
arise when Schwab lends funds to clients on a secured basis to purchase
securities. Pursuant to Securities and Exchange Commission (SEC) regulations,
- 11 -
client cash balances that are not used for margin lending are generally
segregated into investment accounts that are maintained for the exclusive
benefit of clients.
When investing segregated client cash balances, Schwab must adhere to SEC
regulations that restrict investments to U.S. government securities,
participation certificates, mortgage-backed securities guaranteed by the
Government National Mortgage Association, certificates of deposit issued by U.S.
banks and thrifts, and resale agreements collateralized by qualified securities.
Schwab's policies for credit quality and maximum maturity requirements are more
restrictive than these SEC regulations. In each of the last three years, resale
agreements accounted for over 75% of Schwab's investments of segregated client
cash balances. The average maturities of Schwab's total investments of
segregated client cash balances were 161 days for 2003 and 66 days for both 2002
and 2001. U.S. Trust and Schwab Bank lend funds to banking clients primarily in
the form of mortgage loans. These loans are largely funded by interest-bearing
deposits from banking clients.
- --------------------------------------------------------------------------------
2003 2002 2001
- --------------------------------------------------------------------------------
Interest Revenue:
Margin loans to clients $ 347 $ 459 $ 832
Investments, client-related 284 337 555
Loans to banking clients 230 236 240
Securities available for sale 74 76 79
Other 35 50 115
- --------------------------------------------------------------------------------
Total 970 1,158 1,821
- --------------------------------------------------------------------------------
Interest Expense:
Deposits from banking clients 96 94 128
Brokerage client cash balances 76 164 678
Long-term debt 35 46 55
Short-term borrowings 14 23 27
Other 20 7 22
- --------------------------------------------------------------------------------
Total 241 334 910
- --------------------------------------------------------------------------------
Net interest revenue $ 729 $ 824 $ 911
================================================================================
The Company's interest-earning assets are financed primarily by
interest-bearing brokerage client cash balances and deposits from banking
clients. Other funding sources include noninterest-bearing brokerage client cash
balances, proceeds from stock-lending activities, short-term borrowings and
long-term debt, as well as stockholders' equity. Client-related daily average
balances, interest rates, and average net interest spread are summarized as
follows:
- --------------------------------------------------------------------------------
2003 2002 2001
- --------------------------------------------------------------------------------
Interest-Earning Assets (client-related and other):
Investments (client-related):
Average balance outstanding $21,912 $17,950 $13,499
Average interest rate 1.30% 1.88% 4.11%
Margin loans to clients:
Average balance outstanding $ 7,026 $ 8,018 $11,427
Average interest rate 4.94% 5.72% 7.29%
Loans to banking clients:
Average balance outstanding $ 5,034 $ 4,204 $ 3,469
Average interest rate 4.56% 5.62% 6.91%
Securities available for sale:
Average balance outstanding $ 1,904 $ 1,508 $ 1,317
Average interest rate 3.91% 5.02% 5.98%
Average yield on interest-earning assets 2.62% 3.50% 5.74%
Funding Sources (client-related and other):
Interest-bearing brokerage client cash balances:
Average balance outstanding $23,140 $22,432 $21,649
Average interest rate .33% .73% 3.13%
Interest-bearing banking deposits:
Average balance outstanding $ 5,395 $ 4,046 $ 3,365
Average interest rate 1.79% 2.33% 3.80%
Other interest-bearing sources:
Average balance outstanding $ 2,843 $ 1,094 $ 1,117
Average interest rate 1.05% 2.03% 3.99%
Average noninterest-bearing portion $ 4,498 $ 4,108 $ 3,581
Average interest rate on funding sources .56% .88% 2.86%
Summary:
Average yield on interest-earning assets 2.62% 3.50% 5.74%
Average interest rate on funding sources .56% .88% 2.86%
- --------------------------------------------------------------------------------
Average net interest spread 2.06% 2.62% 2.88%
================================================================================
The decreases in net interest revenue from 2001 to 2003 were primarily due
to changes in the composition of interest-earning assets, including the decline
in margin loan balances and the corresponding increase in client-related
investments. In addition, the decline in yields on interest-earning assets due
to changes in the interest rate environment was only partially offset by lower
yields on funding sources.
Since the Company establishes the rates paid on brokerage client cash
balances and certain banking deposits and the rates charged on margin loans, it
manages a substantial portion of its net interest spread. However, the spread is
influenced by external factors such as the interest rate environment and
competition. The Company's average net
- 12 -
interest spread decreased from 2001 to 2003 as the average yield on
interest-earning assets, primarily client-related investments, declined more
than the average interest rate on funding sources.
Principal Transactions
Principal transaction revenues, as shown in the following table, are
primarily comprised of revenues from client fixed income securities trading
activity, which are included in the Capital Markets, Individual Investor, and
Institutional Investor segments, and net gains from market-making activities in
equity securities, which are included in the Capital Markets segment. Factors
that influence principal transaction revenues include the volume of client
trades, market price volatility, average revenue per equity share traded, and
changes in regulations and industry practices. While substantially all Nasdaq
security trades originated by the clients of Schwab are directed to SCM, a
substantial portion of SCM's trading volume comes from parties other than
Schwab.
- --------------------------------------------------------------------------------
Principal Transactions 2003 2002 2001
- --------------------------------------------------------------------------------
Fixed income securities $ 89 $ 92 $ 65
Equity securities 79 92 190
- --------------------------------------------------------------------------------
Total (1) $ 168 $ 184 $ 255
================================================================================
(1) Includes $15 million in 2003 and $23 million in each of 2002 and 2001
related to Schwab's institutional trading business.
The decrease in principal transaction revenues from 2002 to 2003 was
primarily due to lower average revenue per equity share traded, partially offset
by higher equity share volume handled by SCM as a result of increased
institutional trading activity, as well as lower levels of revenues related to
Schwab's specialist operations and revenues from client fixed income securities
trading activity. The decrease in principal transaction revenues from 2001 to
2002 was primarily due to lower average revenue per equity share traded and
lower equity share volume handled by SCM, partially offset by higher revenues
from client fixed income securities trading activity. SCM's average revenue per
equity share traded decreased to .1(cents) in 2003 from .4(cents) in 2002 and
..8(cents) in 2001. The decrease from 2002 to 2003 was primarily due to a
significant increase in trading in equity securities with narrower spreads, as
well as difficult market conditions in the first half of the year. The decrease
from 2001 to 2002 was primarily due to market conditions as well as the change
to decimal pricing, which was fully implemented by April 2001.
Other Revenues
Other revenues include net gains and losses on certain investments, fees
for services (such as order handling fees), account service fees, and software
maintenance fees. Other revenues are earned primarily through the Individual
Investor, Institutional Investor and U.S. Trust segments.
EXPENSES EXCLUDING INTEREST
As shown in the table below, total expenses excluding interest declined in
2003 primarily due to lower restructuring charges and decreases in most expense
categories as a result of the Company's continued expense reduction measures.
- --------------------------------------------------------------------------------
Growth Rate
Composition of Expenses, 1-year
Excluding Interest 2002-2003 2003 2002 2001
- --------------------------------------------------------------------------------
Compensation and benefits (4%) $ 1,771 $ 1,846 $ 1,895
Occupancy and equipment (3%) 441 456 470
Depreciation and amortization (10%) 284 317 331
Communications (5%) 243 256 331
Professional services 5% 180 172 186
Advertising and market
development (33%) 139 208 243
Commissions, clearance and
floor brokerage 10% 77 70 89
Restructuring and other charges (77%) 81 358 402
Impairment charges (86%) 5 37 -
Goodwill amortization - - - 63
Other 8% 156 144 105
- --------------------------------------------------------------------------------
Total expenses (13%) $ 3,377 $ 3,864 $ 4,115
================================================================================
Expenses as a percentage of total revenues:
Total expenses, excluding interest 83% 94% 96%
Compensation and benefits 43% 45% 44%
Advertising and market development 3% 5% 6%
- --------------------------------------------------------------------------------
Compensation and Benefits
Compensation and benefits expense includes salaries and wages, incentive
and variable compensation, related employee benefits and taxes, and retention
program costs arising from certain acquisitions and mergers. Employees receive
variable compensation that is tied to the achievement of specified objectives
relating primarily to revenue growth and profit margin. Additionally, at
management's discretion, employees may receive incentive compensation relating
to progress on the Company's strategic priorities. Therefore, a significant
portion of compensation and benefits expense will fluctuate with these measures.
- 13 -
The decrease in compensation and benefits expense from 2002 to 2003 was
primarily due to a reduction in full-time equivalent employees and lower levels
of employee benefits, partially offset by higher levels of incentive
compensation and discretionary bonuses to employees. The decrease from 2001 to
2002 was primarily due to a reduction in full-time equivalent employees,
partially offset by the accrual of higher discretionary and incentive
compensation, and higher employee benefits. The following table shows a
comparison of certain compensation and benefits components and employee data:
- --------------------------------------------------------------------------------
Compensation and Benefits 2003 2002 2001
- --------------------------------------------------------------------------------
Salaries and wages $ 1,193 $ 1,244 $ 1,352
Incentive and variable compensation 327 280 209
Employee benefits and other 250 300 278
Retention programs (1) 1 22 56
- --------------------------------------------------------------------------------
Total $ 1,771 $ 1,846 $ 1,895
================================================================================
Full-time equivalent employees
(at year end, in thousands) (2) 16.3 16.7 19.6
- --------------------------------------------------------------------------------
(1) Relates to programs put in place to retain certain employees related to
acquisitions and mergers.
(2) Includes full-time, part-time and temporary employees, and persons employed
on a contract basis.
Employee benefits and other expense decreased from 2002 primarily due to
the suspension of the Company's 401(k) employer contribution in 2003 (except for
a discretionary award to certain non-officer employees made in the fourth
quarter of 2003). Additionally, employee benefits and other expense includes net
pension expense of $8 million in 2003 related to U.S. Trust's defined benefit
pension plan, compared to net pension income (which is a reduction to this
expense line item) of less than $1 million for 2002, and $12 million for 2001.
The increase in pension expense in 2003 was primarily due to changes in certain
assumptions used to calculate pension expense, including the expected rate of
return on pension plan assets and the discount rate, both effective in 2003. The
decrease in net pension income in 2002 was primarily due to a decline in the
fair value of pension plan assets, as well as an increase in the number of
employees covered under the pension plan, and a lower assumed discount rate.
In 2003, management significantly reduced the number of stock option grants
to employees. Additionally in 2003, the Company awarded to eligible officers
long-term incentive plan (LTIP) units and restricted stock under a new long-term
incentive program. These awards are restricted from transfer or sale and
generally vest over a four-year period. The cash payout of the LTIP units at the
end of the vesting period is based on the Company achieving certain cumulative
EPS levels.
Expenses Excluding Compensation and Benefits
The decreases in advertising and market development expense from 2001 to
2003 were primarily due to reductions, as part of the Company's expense
reduction measures, in brand-focused television and other media spending. As
discussed in "Description of Business - Overview," management intends to
increase marketing communications in 2004 above 2003 levels. The decreases in
occupancy and equipment expense and depreciation and amortization expense from
2001 to 2003 were primarily due to the Company's restructuring initiatives and
other expense reduction measures (see Results of Operations - Financial Overview
- - Restructuring for a discussion of the expected impact on 2004 expenses). The
increase in professional services expense from 2002 to 2003 was primarily due to
higher levels of consulting fees in several areas, including new and expanded
products and services, and information technology projects.
Taxes on Income
The Company's effective income tax rate was 33.5% in 2003, 42.6% in 2002,
and 44.1% in 2001. The decrease from 2002 to 2003 was primarily due to tax
benefits in 2003 related to the deductibility of certain costs associated with
the Company's merger with U.S. Trust and the Company's sale of its U.K.
market-making operation.
LIQUIDITY AND CAPITAL RESOURCES
CSC is a financial holding company, which is a type of bank holding company
subject to supervision and regulation by the Board of Governors of the Federal
Reserve System (Federal Reserve Board) under the Bank Holding Company Act of
1956, as amended. CSC conducts virtually all business through its wholly owned
subsidiaries. The capital structure among CSC and its subsidiaries is designed
to provide each entity with capital and liquidity to meet its operational needs
and regulatory requirements. See note "23 - Regulatory Requirements" in the
Notes to Consolidated Financial Statements.
Liquidity
CSC
CSC's liquidity needs are generally met through cash generated by its
subsidiaries, as well as cash provided by external financing. As discussed
below, Schwab, CSC's depository institution subsidiaries, and SCM are subject to
regulatory requirements that may restrict them from certain transactions with
CSC. Management believes that funds generated by the operations of CSC's
subsidiaries will continue to be the primary funding source in meeting CSC's
liquidity needs, providing adequate liquidity to meet CSC's depository
institution subsidiaries' capital guidelines, and maintaining Schwab's and SCM's
net capital. Based on their
- 14 -
respective regulatory capital ratios at December 31, 2003 and 2002, the Company
and its depository institution subsidiaries are considered well capitalized.
CSC has liquidity needs that arise from its Senior Medium-Term Notes,
Series A (Medium-Term Notes), as well as from the funding of cash dividends,
acquisitions, and other investments. The Medium-Term Notes, of which
$466 million was issued and outstanding at December 31, 2003, have maturities
ranging from 2004 to 2010 and fixed interest rates ranging from 6.04% to 8.05%
with interest payable semiannually. CSC has entered into Swaps that effectively
convert the interest rate characteristics of a portion of the Medium-Term Notes
from fixed to variable. For a complete discussion of the Swaps, see note "25 -
Financial Instruments Subject to Off-Balance Sheet Risk, Credit Risk or Market
Risk" in the Notes to Consolidated Financial Statements. The Medium-Term Notes
are rated A2 by Moody's Investors Service (Moody's), A- by Standard & Poor's
Ratings Group (S&P), and A by Fitch IBCA, Inc. (Fitch).
CSC has a prospectus supplement on file with the SEC enabling CSC to issue
up to $750 million in Senior or Senior Subordinated Medium-Term Notes, Series A.
At December 31, 2003, all of these notes remained unissued.
CSC has authorization from its Board of Directors (Board) to issue
commercial paper up to the amount of CSC's committed, unsecured credit facility
(see below), not to exceed $1.5 billion. At December 31, 2003, no commercial
paper has been issued. CSC's ratings for these short-term borrowings are P-1 by
Moody's, A-2 by S&P, and F1 by Fitch.
CSC maintains an $800 million committed, unsecured credit facility with a
group of twenty banks which is scheduled to expire in June 2004. This facility
replaced a facility that expired in June 2003. These facilities were unused in
2003. Any issuances under CSC's commercial paper program (see above) will reduce
the amount available under this facility. The funds under this facility are
available for general corporate purposes and CSC pays a commitment fee on the
unused balance of this facility. The financial covenants in this facility
require CSC to maintain a minimum level of tangible net worth, and Schwab and
SCM to maintain specified levels of net capital, as defined. Management believes
that these restrictions will not have a material effect on its ability to meet
foreseeable dividend or funding requirements.
CSC also has direct access to $778 million of the $828 million uncommitted,
unsecured bank credit lines, provided by nine banks, that are primarily utilized
by Schwab to manage short-term liquidity. The amount available to CSC under
these lines is lower than the amount available to Schwab because the credit line
provided by one of these banks is only available to Schwab. These lines were not
used by CSC in 2003.
Schwab
Most of Schwab's assets are readily convertible to cash, consisting
primarily of short-term (i.e., less than 150 days) investment-grade,
interest-earning investments (the majority of which are segregated for the
exclusive benefit of clients pursuant to regulatory requirements), receivables
from brokerage clients, and receivables from brokers, dealers and clearing
organizations. Client margin loans are demand loan obligations secured by
readily marketable securities. Receivables from and payables to brokers, dealers
and clearing organizations primarily represent current open transactions, which
usually settle, or can be closed out, within a few business days.
Liquidity needs relating to client trading and margin borrowing activities
are met primarily through cash balances in brokerage client accounts, which were
$25.6 billion, $24.9 billion and $25.0 billion at December 31, 2003, 2002, and
2001, respectively. Management believes that brokerage client cash balances and
operating earnings will continue to be the primary sources of liquidity for
Schwab in the future.
Upon adoption of Financial Accounting Standards Board Interpretation
(FIN) No. 46 - Consolidation of Variable Interest Entities, an Interpretation of
Accounting Research Bulletin No. 51 - Consolidated Financial Statements in the
first quarter of 2003, the Company consolidated a special purpose trust and
recorded a note payable of $235 million. See note "2 - Significant Accounting
Policies - New Accounting Standards" in the Notes to Consolidated Financial
Statements for further discussion of this consolidation.
To manage short-term liquidity, Schwab maintains uncommitted, unsecured
bank credit lines with a group of nine banks totaling $828 million at
December 31, 2003 (as noted previously, $778 million of these lines are also
available for CSC to use). The need for short-term borrowings arises primarily
from timing differences between cash flow requirements and the scheduled
liquidation of interest-bearing investments. Schwab used such borrowings for 7
days in 2003, with the daily amounts borrowed averaging $27 million. There were
no borrowings outstanding under these lines at December 31, 2003.
To satisfy the margin requirement of client option transactions with the
Options Clearing Corporation (OCC), Schwab has unsecured letter of credit
agreements with nine banks in favor of the OCC aggregating $630 million at
December 31, 2003. Schwab pays a fee to maintain these letters of credit. No
funds were drawn under these letters of credit at December 31, 2003.
Schwab is subject to regulatory requirements that are intended to ensure
the general financial soundness and liquidity of broker-dealers. These
regulations prohibit Schwab from repaying subordinated borrowings to CSC, paying
cash dividends, or making unsecured advances or loans to its parent or employees
if such payment would result
- 15 -
in net capital of less than 5% of aggregate debit balances or less than 120% of
its minimum dollar requirement of $1 million. At December 31, 2003, Schwab's net
capital was $1.2 billion (14% of aggregate debit balances), which was $1.1
billion in excess of its minimum required net capital and $797 million in excess
of 5% of aggregate debit balances. Schwab has historically targeted net capital
to be at least 10% of its aggregate debit balances, which primarily consist of
client margin loans.
To manage Schwab's regulatory capital requirement, CSC provides Schwab with
a $1.4 billion subordinated revolving credit facility which is scheduled to
expire in September 2004. The amount outstanding under this facility at
December 31, 2003 was $220 million. Borrowings under this subordinated lending
arrangement qualify as regulatory capital for Schwab.
U.S. Trust
U.S. Trust's liquidity needs are generally met through deposits from
banking clients, equity capital, and borrowings.
Beginning in the fourth quarter of 2003, certain Schwab brokerage clients
can sweep the excess cash held in their accounts into a money market deposit
account at U.S. Trust. At December 31, 2003, these balances totaled
$119 million.
In addition to traditional funding sources such as deposits, federal funds
purchased, and repurchase agreements, USTC's depository institution subsidiaries
have established their own external funding sources. At December 31, 2003,
U.S. Trust had $52 million in Trust Preferred Capital Securities outstanding
with a fixed interest rate of 8.41%. Certain of USTC's depository institution
subsidiaries have established credit facilities with the Federal Home Loan Bank
System (FHLB) totaling $758 million. At December 31, 2003, $625 million was
outstanding under these facilities. Additionally, at December 31, 2003,
U.S. Trust had $243 million of federal funds purchased and $128 million of
repurchase agreements outstanding with third parties.
Beginning in 2003, U.S. Trust also engages in intercompany repurchase
agreements with Schwab Bank. At December 31, 2003, U.S. Trust had $200 million
in repurchase agreements outstanding with Schwab Bank.
CSC provides U.S. Trust with a $300 million short-term credit facility
maturing in December 2006. Borrowings under this facility do not qualify as
regulatory capital for U.S. Trust. The amount outstanding under this facility
was $45 million at December 31, 2003.
U.S. Trust is subject to the Federal Reserve Board's risk-based and
leverage capital guidelines. These regulations require banks and bank holding
companies to maintain minimum levels of capital. In addition, USTC's depository
institution subsidiaries are subject to limitations on the amount of dividends
they can pay to USTC.
SCM
SCM's capital needs are generally met through its equity capital and
borrowings from CSC. Most of SCM's assets are liquid, consisting primarily of
cash and cash equivalents, marketable securities, and receivables from brokers,
dealers and clearing organizations.
SCM may borrow up to $150 million under a subordinated lending arrangement
with CSC which is scheduled to expire in August 2004. Borrowings under this
arrangement qualify as regulatory capital for SCM. The amount outstanding under
this facility at December 31, 2003 was $50 million. The advances under this
facility satisfy increased intra-day capital needs at SCM to support the
expansion of its institutional equities and trading businesses. In addition, CSC
provides SCM with a $50 million short-term credit facility. Borrowings under
this arrangement do not qualify as regulatory capital for SCM. No funds were
drawn under this facility at December 31, 2003.
SCM is subject to the same net capital regulatory requirements as Schwab
(see discussion above). At December 31, 2003, SCM's net capital was $74 million,
which was $73 million in excess of its minimum required net capital.
Schwab Bank
Schwab Bank's current liquidity needs are generally met through deposits
from banking clients and equity capital.
Beginning in 2003, certain Schwab brokerage clients can sweep the excess
cash held in their accounts into a money market deposit account at Schwab Bank.
At December 31, 2003, these balances totaled $1.5 billion.
Schwab Bank has access to traditional funding sources such as deposits,
federal funds purchased, and repurchase agreements. Additionally, CSC provides
Schwab Bank with a $100 million short-term credit facility which matures in
December 2005. Borrowings under this facility do not qualify as regulatory
capital for Schwab Bank. No funds were drawn under this facility at December 31,
2003.
Schwab Bank is subject to the same risk-based and leverage capital
guidelines as U.S. Trust (see discussion above), except that Schwab Bank is
subject to a minimum tier 1 leverage ratio of 8% for its first three years of
operations. In addition, Schwab Bank is subject to limitations on the amount of
dividends it can pay to CSC.
- 16 -
Liquidity Risk Factors
The Company manages risk by maintaining sufficient liquid financial
resources to fund its balance sheet and meet its obligations. The Company's
liquidity needs are met primarily through cash generated by operations, as well
as cash provided by external financing. Risks in meeting these needs may arise
with fluctuations in client cash or deposit balances, as well as changes in
market conditions.
Specific risk factors which may affect the Company's liquidity position
include:
- - a dramatic increase in the Company's client lending activities (including
margin, mortgage, and personal lending) which may reduce the Company's
liquid resources and capital position;
- - a significant increase in client order flow in SCM's market-making
activities, creating an imbalance of long or short securities positions
which may reduce the Company's liquid resources and excess capital
position;
- - a reduction in cash held in banking or brokerage client accounts which may
affect the amount of the Company's liquid assets; and
- - a significant downgrade in the Company's credit ratings which could
increase its borrowing costs and limit its access to the capital markets.
Cash and Capital Resources
The Company's cash position (reported as cash and cash equivalents on the
Company's consolidated balance sheet) and cash flows are affected by changes in
brokerage client cash balances and the associated amounts required to be
segregated under federal or other regulatory guidelines. Timing differences
between cash and investments actually segregated on a given date and the amount
required to be segregated for that date may arise in the ordinary course of
business and are addressed by the Company in accordance with applicable
regulations. Other factors which affect the Company's cash position and cash
flows include investment activity in securities owned, levels of capital
expenditures, acquisition activity, banking client deposit and loan activity,
financing activity in short-term borrowings and long-term debt, payments of
dividends, and repurchases of CSC's common stock.
In 2003, cash and cash equivalents decreased $282 million, or 9%, to
$2.8 billion primarily due to higher levels of securities owned and increases in
loans to banking clients, offset by increases in deposits from banking clients,
including sweep deposit accounts. Management does not believe that this decline
in cash and cash equivalents is an indication of a trend.
The Company's capital expenditures were $153 million in 2003 and
$160 million in 2002, or 4% of revenues in each year. In 2003, 83% of capital
expenditures were for information technology and 17% for facilities expansion
and improvements. Capital expenditures as described above include the
capitalized costs for developing internal-use software of $67 million in 2003
and $71 million in 2002.
Management currently anticipates that 2004 capital expenditures will be
approximately 35% higher than 2003 spending, primarily due to increased spending
on information technology hardware. As has been the case in recent years, the
Company may adjust its capital expenditures from period to period as business
conditions change.
During 2003, the Company:
- - Repaid $100 million of Medium-Term Notes;
- - Received cash proceeds of $34 million on the exercise of 6 million of the
Company's stock options, with a weighted-average exercise price of $6.21,
and a related tax benefit of $6 million; and
- - Paid common stock dividends of $68 million.
The Company monitors both the relative composition and absolute level of
its capital structure. The Company's total financial capital (long-term debt
plus stockholders' equity) at December 31, 2003 was $5.2 billion, up
$580 million, or 12%, from a year ago, due to higher stockholders' equity and a
net increase in long-term debt. At December 31, 2003, the Company had long-term
debt of $772 million, or 15% of total financial capital, bearing interest at a
weighted-average rate of 5.6%. At December 31, 2003, the Company's stockholders'
equity was $4.5 billion, or 85% of total financial capital. Management currently
anticipates that long-term debt will remain below 30% of total financial
capital.
- 17 -
Commitments
A summary of the Company's principal contractual obligations and other
commitments as of December 31, 2003 is shown in the following table. Management
believes that funds generated by its operations, as well as cash provided by
external financing, will continue to be the primary funding sources in meeting
these obligations and commitments.
Payments due Less than 1-3 4-5 After 5
by period 1 Year Years Years Years Total
- --------------------------------------------------------------------------------
Operating leases (1) $ 239 $ 514 $ 271 $ 517 $1,541
Long-term debt (2) 81 397 24 251 753
Credit-related financial
instruments (3) 980 184 - 516 1,680
Purchase obligations (4) 242 161 17 - 420
Other commitments (5) 4 - - - 4
- --------------------------------------------------------------------------------
Total $1,546 $1,256 $ 312 $1,284 $4,398
================================================================================
(1) Includes minimum rental commitments, net of sublease commitments, and
maximum guaranteed residual values under noncancelable leases for
equipment. See Note 24 to the Consolidated Financial Statements.
(2) See Note 17 to the Consolidated Financial Statements. Excludes the effect
of interest swaps, see Item 3 - Quantitative and Qualitative Disclosures
About Market Risk - Financial Instruments Held for Purposes Other Than
Trading - Interest Rate Swaps.
(3) Includes U.S. Trust and Schwab Bank firm commitments to extend credit
primarily for loans to banking clients and standby letters of credit. See
Note 25 to the Consolidated Financial Statements.
(4) Includes purchase obligations of $149 million which can be canceled by the
Company without penalty.
(5) Includes committed capital contributions to venture capital funds.
Share Repurchases
CSC repurchased 4 million shares of its common stock for $32 million in
2003 and 32 million shares of its common stock for $299 million in 2002. As of
December 31, 2003, CSC has authority to repurchase up to $318 million of its
common stock.
Dividend Policy
Since the initial dividend in 1989, CSC has paid 59 consecutive quarterly
dividends and has increased the dividend 13 times, including a 27% increase in
the third quarter of 2003. Since 1989, dividends have increased by a 25%
compounded annual growth rate. CSC paid common stock dividends of $.050 per
share in 2003, and $.044 per share in each of 2002 and 2001. While the payment
and amount of dividends are at the discretion of the Board, subject to certain
regulatory and other restrictions, the Company currently targets its cash
dividend at approximately 10% to 20% of net income.
RISK MANAGEMENT
Overview
The Company's business and activities expose it to different types of risks
including, but not limited to, those discussed below. Proper identification,
assessment and management of these risks are essential to the success and
financial soundness of the Company.
Risk management and oversight at the Company begins with the Board. The
Audit Committee reviews major risk exposures and the steps management has taken
to monitor and control such exposures, and reports on these issues to the full
Board. The Audit Committee delegates the formulation of policies and day-to-day
risk oversight and management to the Executive Committee of the Company. The
Executive Committee provides guidance regarding strategies and risk tolerance
and is responsible for an integrated approach to risk exposures. The Executive
Committee both delegates to, and has several members who actively participate
in, risk management at the Company through the Global Risk Steering Committee.
The Global Risk Steering Committee is responsible for reviewing and monitoring
the Company's risk exposures, leading in the continued development of the
Company's risk management policies and practices, reviewing changes in
regulations and other risk-related developments, and reporting to the Audit
Committee. Various other functional risk committees consisting of members of
senior management report into the Global Risk Steering Committee on a frequent
basis. These committees include:
- - Technology and Operations Risk Committee, which focuses on the integrity of
operational controls and operating capacity of the Company's technology and
operations systems;
- - Financial Risk Oversight Committee, which focuses on the credit exposures
resulting from client activity (i.e., margin lending activities and loans
to banking clients), the investing activities of certain of the Company's
proprietary funds, corporate credit activities (i.e., counterparty and
corporate investing activities), the Company's liquidity, capital
resources, interest rate risk, and the market risk resulting from
securities positioning activities;
- - Fiduciary Risk Committee, which focuses on overseeing the activities of the
Company that are deemed to have a fiduciary component; and
- - Disclosure Committee, which focuses on the oversight of disclosure and
internal controls as recommended pursuant to the Sarbanes-Oxley Act of
2002.
Additionally, the Finance, Risk Management, Compliance, and Internal Audit
Departments and the Office of Corporate Counsel assist management and the
various risk committees in evaluating and monitoring the Company's risk profile.
Risk is inherent in the Company's business. Consequently, despite the
Company's attempts to identify areas of risk, oversee operational areas
involving risk, and implement policies and procedures designed to mitigate risk,
there can be no assurance that the Company will not suffer unexpected losses due
to operating or other risks.
The following discussion highlights the Company's principal risks and some
of the policies and procedures for
- 18 -
risk identification, assessment, and mitigation. See Liquidity and Capital
Resources for a discussion on liquidity risk and note "25 - Financial
Instruments Subject to Off-Balance Sheet Risk, Credit Risk or Market Risk" in
the Notes to Consolidated Financial Statements for additional discussion on
credit risk and market risk.
Technology and Operating Risk
Technology and operating risk is the potential for loss due to deficiencies
in control processes or technology systems that constrain the Company's ability
to gather, process and communicate information efficiently and securely, without
interruptions. The Company's operations are highly dependent on the integrity of
its technology systems and the Company's success depends, in part, on its
ability to make timely enhancements and additions to its technology in
anticipation of client demands. To the extent the Company experiences system
interruptions, errors or downtime (which could result from a variety of causes,
including changes in client use patterns, technological failure, changes to its
systems, linkages with third-party systems, and power failures), the Company's
business and operations could be significantly negatively impacted.
Additionally, rapid increases in client demand may strain the Company's ability
to enhance its technology and expand its operating capacity. To minimize
business interruptions, Schwab has two data centers intended, in part, to
further improve the recovery of business processing in the event of an
emergency.
Technology and operating risk also includes human error, fraud, a terrorist
attack, and natural disaster. The Company attempts to mitigate technology and
operating risk by maintaining a comprehensive internal control system and by
employing experienced personnel. Also, the Company maintains backup and recovery
functions, including facilities for backup and communications, and conducts
periodic testing of a disaster recovery plan. Each functional area deemed to be
potentially of medium to high risk by management performs a risk self assessment
on an annual basis, with updates, to evaluate the effectiveness of these
internal controls and recovery plans. The Company's risk committees and various
policies and procedures, combined with these risk self assessments, are used in
part to provide a vehicle for the Chief Executive Officer and Chief Financial
Officer to attest to the adequacy of the Company's controls. The Company is
committed to an ongoing process of upgrading, enhancing, and testing its
technology systems. This effort is focused on meeting client demands, meeting
market and regulatory changes, and deploying standardized technology platforms.
The Company is engaged in the research and development of new technologies,
services, and products. The Company endeavors to protect its research and
development efforts, and its brands, through the use of copyrights, patents,
trade secrets, and contracts. From time to time, third parties indicate that
they believe the Company may be infringing on their intellectual property (e.g.,
patents) rights. Under some circumstances, litigation may result from questions
regarding infringement, ownership, validity, and scope of intellectual property.
Such litigation can require the expenditure of significant Company resources. If
the Company were found to have infringed a third-party patent, or other
intellectual property rights, it could incur substantial liability, and in some
circumstances could be enjoined from using certain technology, or providing
certain products or services.
Credit Risk
Credit risk is the potential for loss due to a client or counterparty
failing to perform its contractual obligations, or the value of collateral held
to secure obligations proving to be inadequate. The Company's direct exposure to
credit risk mainly results from margin lending activities, securities lending
activities, role as a counterparty in financial contracts, and investing
activities, and indirectly from the investing activities of certain of the
Company's proprietary funds. To mitigate the risks of such losses, the Company
has established policies and procedures which include: establishing and
reviewing credit limits, monitoring of credit limits and quality of
counterparties, and adjusting margin requirements for certain securities. In
addition, most of the Company's credit extensions, such as margin loans to
clients, securities lending agreements, and resale agreements, are supported by
collateral arrangements. These arrangements are subject to requirements to
provide additional collateral in the event that market fluctuations result in
declines in the value of collateral received.
Additionally, the Company has exposure to credit risk associated with the
Company's banking loan portfolios held at U.S. Trust and Schwab Bank. This
counterparty credit exposure is actively managed through individual and
portfolio reviews performed by account officers and senior line management.
Periodic assessment of the validity of credit ratings, credit quality and the
credit management process is conducted by a risk review department which is
separate from the loan origination and monitoring department. Management
regularly reviews asset quality including concentrations, delinquencies,
non-performing loans to banking clients, losses and recoveries. All are factors
in the determination of an appropriate allowance for credit losses, which is
reviewed quarterly by senior management. See notes "10 - Loans to Banking
Clients and Related Allowance for Credit Losses" and "25 - Financial Instruments
Subject to Off-Balance Sheet Risk, Credit Risk or Market Risk" in the Notes to
Consolidated Financial Statements for an analysis of the Company's loan
portfolios and allowance for credit losses, and for an additional discussion on
credit risk, respectively.
There were no troubled debt restructurings at December 31, 2003 or 2002. As
of December 31, 2003,
- 19 -
management is not aware of any significant potential problem loans other than
the amounts disclosed in note "10 - Loans to Banking Clients and Related
Allowance for Credit Losses" in the Notes to Consolidated Financial Statements.
Fiduciary Risk
Fiduciary risk is the potential for financial or reputational loss through
the breaching of fiduciary duties to a client. Fiduciary activities include, but
are not limited to, individual and institutional trust, investment management,
custody, and cash and securities processing. The Company attempts to mitigate
this risk by establishing procedures to ensure that obligations to clients are
discharged faithfully and in compliance with applicable legal and regulatory
requirements. Business units have the primary responsibility for adherence to
the procedures applicable to their business. Guidance and control are provided
through the creation, approval, and ongoing review of applicable policies by
business units and various fiduciary risk committees.
Market Risk
Market risk is the potential for loss due to a change in the value of a
financial instrument held by the Company as a result of fluctuations in interest
rates, equity prices or currency exchange rates.
The Company is exposed to interest rate risk primarily from changes in the
interest rates on its interest-earning assets (mainly margin loans to clients,
investments, loans to banking clients, mortgage-backed securities, and other
fixed-rate investments) and its funding sources (including brokerage client cash
balances, banking deposits, proceeds from stock-lending activities, long-term
debt, and stockholders' equity) which finance these assets. To mitigate the risk
of loss, the Company has established policies and procedures which include
setting guidelines on the amount of net interest revenue at risk, and by
monitoring the net interest margin and average maturity of its interest-earning
assets and funding sources. The Company also has the ability to adjust the rates
paid on certain brokerage client cash balances and certain banking deposits and
the rates charged on margin loans. Additionally, the Company uses Swaps to
mitigate interest rate exposure associated with short-term floating
interest-rate deposits.
The Company is exposed to equity price risk through its role as a financial
intermediary in client-related transactions, and by holding financial
instruments mainly in its capacity as a market maker and relating to its
proprietary equity trading operations. To mitigate the risk of losses, these
financial instruments are monitored by management to assure compliance with
limits established by the Company. In addition, these financial instruments are
marked to market on a daily basis. Also, the Company purchases and sells from
time to time exchange-traded futures and options to mitigate market risk on
these inventories. The Company's exposure to currency exchange risk is not
material.
Additional qualitative and quantitative disclosures about market risk are
summarized in the following paragraphs. See note "25 - Financial Instruments
Subject to Off-Balance Sheet Risk, Credit Risk or Market Risk" in the Notes to
Consolidated Financial Statements for an additional discussion on market risk.
Financial Instruments Held For Trading Purposes
The Company holds fixed income securities, which include municipal and
government securities, and corporate bonds, in inventory to meet clients'
trading needs. The fair value of such inventory was approximately $74 million
and $34 million at December 31, 2003 and 2002, respectively. These securities,
and the associated interest rate risk, are not material to the Company's
financial position, results of operations, or cash flows.
The Company maintains inventories in exchange-listed, Nasdaq, and other
equity securities on both a long and short basis. The fair value of these
securities is shown in the following table:
- --------------------------------------------------------------------------------
December 31, 2003 2002
- --------------------------------------------------------------------------------
Equity Securities:
Long positions $ 97 $ 79
Short positions (74) (7)
- --------------------------------------------------------------------------------
Net long positions $ 23 $ 72
================================================================================
Using a hypothetical 10% increase or decrease in prices, the potential loss
or gain in fair value is estimated to be approximately $2 million and $7 million
at December 31, 2003 and 2002, respectively.
- 20 -
In addition, the Company may enter into exchange-traded futures and options
contracts based on equity market indices to hedge potential losses in equity
inventory positions. There were no open futures or options contracts at
December 31, 2003. The notional amounts and fair values of these futures and
options contracts are shown in the following table:
- --------------------------------------------------------------------------------
December 31, 2003 2002
- --------------------------------------------------------------------------------
Exchange-traded Contracts:
Net Short Futures (1):
Notional Amount - $ 63
Fair Value - $ 61
Long Put Options:
Notional Amount - $ 4
Fair Value (2) - -
- --------------------------------------------------------------------------------
(1) Notional amount represents original contract price of the futures. Fair
value represents the index price. The difference between the notional and
fair value amounts are settled daily in accordance with futures market
requirements.
(2) Amount was less than $1 million at December 31, 2002.
Using a hypothetical 10% increase or decrease in the underlying indices,
the potential loss or gain in fair value was estimated to be approximately
$6 million at December 31, 2002, which would substantially offset the potential
loss or gain on the equity securities previously discussed.
Value-At-Risk
All trading activities are subject to market risk limits established by the
Company's businesses and approved by senior management who are independent of
the businesses. The Company manages trading risk through position policy limits,
value-at-risk (VaR) measurement methodology, and other market sensitivity
measures. Based on certain assumptions and historical relationships, VaR
estimates a potential loss from adverse changes in the fair values of the
Company's overnight trading positions. To calculate VaR, the Company uses a 99%
confidence level with a one-day holding period for most instruments. Stress
testing is performed on a regular basis to estimate the potential loss from
severe market conditions. It is the responsibility of the Company's Risk
Management department, in conjunction with the businesses, to develop stress
scenarios and use the information to assess the ongoing appropriateness of
exposure levels and limits.
The Company holds fixed income securities and equities for trading
purposes. The estimated VaR for both fixed income securities and equities at
December 31, 2003 and the high, low, and daily average during the year then
ended was $1 million or less for each category and stated period.
The VaR model is a risk analysis tool that attempts to measure the
potential losses in fair value, earnings, or cash flows from changes in market
conditions and may not represent actual losses in fair value that may be
incurred by the Company. VaR relies on historical data and statistical
relationships. As a result, VaR must be interpreted with an understanding of the
method's strengths and limitations.
Financial Instruments Held For Purposes Other Than Trading
Debt Issuances
At December 31, 2003 and 2002, CSC had $466 million and $566 million
aggregate principal amount of Medium-Term Notes outstanding, respectively, with
fixed interest rates ranging from 6.04% to 8.05%. At December 31, 2003 and 2002,
U.S. Trust had $52 million Trust Preferred Capital Securities outstanding, with
a fixed interest rate of 8.41%.
The Company has fixed cash flow requirements regarding these long-term debt
obligations due to the fixed rate of interest. The fair value of these
obligations at December 31, 2003 and 2002, based on estimates of market rates
for debt with similar terms and remaining maturities, was $584 million and $674
million, respectively, which approximated their carrying amounts of $537 million
and $642 million, respectively.
Interest Rate Swaps
As part of its consolidated asset and liability management process, the
Company utilizes Swaps to manage interest rate risk. For a discussion of such
Swaps, see note "25 - Financial Instruments Subject to Off-Balance Sheet Risk,
Credit Risk or Market Risk" in the Notes to Consolidated Financial Statements.
Loans Held for Sale
Schwab Bank's loans held for sale portfolio consists of fixed- and
adjustable-rate mortgages, which are subject to a loss in value when market
interest rates rise. Schwab Bank uses forward sale commitments to manage this
risk. At December 31, 2003, the forward sale commitments were designated as cash
flow hedging instruments of the loans held for sale. Accordingly, the fair
values of the forward sale commitments are recorded on the Company's
consolidated balance sheet, with gains or losses recorded in other comprehensive
income (loss). At December 31, 2003, the derivative liability recorded by Schwab
Bank for these forward sale commitments was immaterial.
Net Interest Revenue Simulation
The Company uses net interest revenue simulation modeling techniques to
evaluate and manage the effect of changing interest rates. The simulation model
(the model) includes all interest-sensitive assets and liabilities, as well as
Swaps utilized by the Company to hedge its interest rate risk. Key variables in
the model include assumed balance growth or decline for client loans, deposits,
and brokerage client cash, changes in the level and term structure of interest
rates, the repricing of financial instruments, prepayment and
- 21 -
reinvestment assumptions, and product pricing assumptions. The simulations
involve assumptions that are inherently uncertain and, as a result, cannot
precisely estimate net interest revenue or precisely predict the impact of
changes in interest rates on net interest revenue. Actual results may differ
from simulated results due to the timing, magnitude, and frequency of interest
rate changes as well as changes in market conditions and management strategies,
including changes in asset and liability mix.
As demonstrated by the simulations presented below, the Company is
positioned so that the consolidated balance sheet produces an increase in net
interest revenue when interest rates rise and, conversely, a decrease in net
interest revenue when interest rates fall (i.e., interest-earning assets are
repricing more quickly than interest-bearing liabilities).
The simulations in the following table assume that the asset and liability
structure of the consolidated balance sheet would not be changed as a result of
the simulated changes in interest rates. As the Company actively manages its
consolidated balance sheet and interest rate exposure, in all likelihood the
Company would take steps to manage any additional interest rate exposure that
could result from changes in the interest rate environment. The following table
shows the results of a gradual 100 basis point increase or decrease in interest
rates relative to the Company's current base rate forecast on simulated net
interest revenue over the next twelve months at December 31, 2003 and 2002. The
simulations demonstrate a decreased sensitivity to changes in interest rates as
of December 31, 2003 than in the prior year. This is primarily due to an
increase in assets such as fixed-rate mortgages and long-term investment
securities that reprice more slowly than other assets such as margin loans and
money market instruments.
- --------------------------------------------------------------------------------
Impact on Net Interest Revenue
Percentage Increase (Decrease)
December 31, 2003 2002
- --------------------------------------------------------------------------------
Increase of 100 basis points 1.7% 5.3%
Decrease of 100 basis points (6.4%) (12.1%)
================================================================================
In addition to fluctuations in net interest revenue, interest rate declines
may adversely affect the Company's ability to maintain its revenue yields on its
SchwabFunds money market funds.
Legal and Compliance Risk
Legal and compliance risk refers to the possibility that the Company will
be found, by a court, arbitration panel or regulatory authority, not to have
complied with an applicable legal or regulatory requirement. The Company may be
subject to lawsuits or arbitration claims by clients, employees or other third
parties in the different jurisdictions in which it conducts business. Claims
against the Company may increase if clients suffer losses during a period of
deteriorating equity market conditions, as the Company increases the level of
advice it provides to clients, and as the Company strengthens its relationship
with IAs. In addition, the Company is subject to extensive regulation by the
SEC, the National Association of Securities Dealers, Inc., the New York Stock
Exchange (NYSE), the Commodity Futures Trading Commission, the Federal Reserve
Board, the FDIC, the Superintendent of Banks of the State of New York, and other
federal, state and market regulators, as well as certain foreign regulatory
authorities. New rules and changes in application of current rules could affect
the Company's manner of operations and profitability.
As with other major mutual fund companies and broker-dealers that
distribute mutual fund shares, affiliates of the Company have been responding to
inquiries and subpoenas from federal and state authorities as part of an
industry-wide review of mutual fund trading, distribution, and servicing. The
Company has been cooperating with authorities and has been conducting its own
review of fund distribution, servicing, and trading practices at or through
Company affiliates.
With respect to SchwabFunds, to date the Company's review has found no
evidence of arrangements with clients to permit late trading or market timing.
With respect to U.S. Trust, as disclosed previously, among the issues under
investigation are circumstances in which a small number of parties were
permitted to engage in short-term trading of certain Excelsior Funds. The
short-term trading activities permitted under these arrangements were terminated
when U.S. Trust strengthened its policies and procedures in July 2003. U.S.
Trust is assessing the impact of this short-term trading activity on the
Excelsior Funds, and has committed to taking remedial action as appropriate.
As disclosed previously, the Company has been reviewing the processing of
trades through Schwab's Mutual Fund MarketPlace service. The review has
identified a small percentage of trades that were received by Schwab from
clients prior to market close, but were modified shortly after market close, in
each case after employees contacted the client when the order could not be
processed as originally submitted. To date, the review has found no evidence of
arrangements with clients to permit late trading or market timing in funds
offered through the Mutual Fund MarketPlace, and no evidence of trading activity
by clients or employees to take advantage of post-market close information.
The Company's internal reviews are ongoing, and the Company has taken steps
to enhance its existing policies and procedures to further discourage, detect,
and prevent market timing and late trading.
Lawsuits have been filed against the Company and U.S. Trust and affiliates
alleging breaches of duties and violations of law and regulations with respect
to market timing in Excelsior Funds. See note "24 - Commitments and
- 22 -
Contingent Liabilities - Legal Contingencies" in the Notes to Consolidated
Financial Statements.
In addition, Congress and securities regulators are considering new
regulations concerning mutual fund distribution some of which, if adopted, could
possibly have a significant negative impact on mutual fund investing generally,
including investments through mutual fund supermarkets such as the Company's
Mutual Fund MarketPlace service. The Company is currently unable to predict
whether any such regulations will be adopted or the final form of any potential
new regulations.
The Company attempts to mitigate legal and compliance risk through policies
and procedures that it believes are reasonably designed to prevent or detect
violations of applicable statutory and regulatory requirements (see note "24 -
Commitments and Contingent Liabilities" in the Notes to Consolidated Financial
Statements). However, violations of applicable statutory and regulatory
requirements could subject the Company and/or its directors, officers or
employees to disciplinary proceedings or civil or criminal liability. Any such
proceeding could cause a significant negative impact on the Company's business
and operations.
Competition
The Company faces significant competition from companies seeking to attract
client financial assets, including traditional, discount and online brokerage
firms, mutual fund companies, banks, and asset management and wealth management
companies. Certain of these competitors have greater financial resources than
the Company. As the Company makes progress in its development of advice
offerings for clients as well as banking and other financial products, it may
face increased competition from different companies. The widespread practice of
conducting financial transactions online, as well as through wireless
applications, have also attracted competition from providers of online services,
software development companies and other providers of financial services.
Finally, the formation of ECNs and new exchanges may intensify competition.
Increased competition may have a negative impact on the Company's business and
operations.
Potential Strategic Transactions
The Company expects to continue to evaluate and consider a wide array of
potential strategic transactions, including business combinations, acquisitions
and dispositions of businesses, services, and other assets. At any given time,
the Company may be engaged in discussions or negotiations with respect to one or
more of such transactions. Any such transaction could have a material impact on
the Company's financial position, results of operations, EPS, or cash flows.
There is no assurance that any such discussions or negotiations will result in
the consummation of any transaction.
The process of integrating any acquisition may create unforeseen challenges
for our operational, financial and management information systems, as well as
unforeseen expenditures and other risks, including diversion of management's
attention from other business concerns, the potential loss of key clients,
employees and business partners, difficulties in managing facilities and
employees in different geographic areas, and difficulties in entering markets in
which we have no or limited direct prior experience and where competitors in
such markets have stronger market positions. In addition, an acquisition may
cause us to assume liabilities or become subject to litigation. Further, there
can be no assurance that the Company will realize a positive return on any
acquisition or that future acquisitions will not be dilutive to our current
stockholders' percentage ownership or to EPS. The Company has allocated
significant value to goodwill and other intangible assets related to prior
acquisitions. Goodwill and certain indefinite-life intangible assets are not
amortized, but are subject to impairment testing on a regular basis. If the
individual businesses do not perform as expected or if expected synergies are
not achieved, the Company may incur impairment charges, accelerated amortization
charges, restructuring charges, or other related expenses.
CORPORATE GOVERNANCE
The Company is committed to a strong culture of corporate governance and
ethical decision-making. The Nominating and Corporate Governance Committee, a
Board committee composed of independent directors, recommends corporate
governance guidelines, policies and procedures for the Company. The Company has
a Corporate Governance Office, headed by the General Counsel, to assist the
Board in fulfilling its oversight responsibilities and to promote corporate
governance within the firm.
Copies of the Company's Code of Conduct and Business Ethics, Corporate
Governance Guidelines, and charters for the Audit Committee, Compensation
Committee, and Nominating and Corporate Governance Committee are available on
the Company's website at www.aboutschwab.com/corpgov.
- 23 -
Consolidated Statement of Income The Charles Schwab Corporation
(In Millions, Except Per Share Amounts)
Year Ended December 31, 2003 2002 2001
- ------------------------------------------------------------------------------------------------------------------------------------
Revenues
Asset management and administration fees $ 1,825 $ 1,749 $ 1,663
Commissions 1,207 1,190 1,329
Interest revenue 970 1,158 1,821
Interest expense (241) (334) (910)
-------- -------- --------
Net interest revenue 729 824 911
Principal transactions 168 184 255
Other 158 144 134
- ------------------------------------------------------------------------------------------------------------------------------------
Total 4,087 4,091 4,292
- ------------------------------------------------------------------------------------------------------------------------------------
Expenses Excluding Interest
Compensation and benefits 1,771 1,846 1,895
Occupancy and equipment 441 456 470
Depreciation and amortization 284 317 331
Communications 243 256 331
Professional services 180 172 186
Advertising and market development 139 208 243
Commissions, clearance and floor brokerage 77 70 89
Restructuring and other charges 81 358 402
Impairment charges 5 37 -
Goodwill amortization - - 63
Other 156 144 105
- ------------------------------------------------------------------------------------------------------------------------------------
Total 3,377 3,864 4,115
- ------------------------------------------------------------------------------------------------------------------------------------
Income from continuing operations before taxes on income and extraordinary gain 710 227 177
Taxes on income 238 92 71
- ------------------------------------------------------------------------------------------------------------------------------------
Income from continuing operations before extraordinary gain 472 135 106
Loss from discontinued operations, net of tax - (38) (28)
Extraordinary gain on sale of corporate trust business, net of tax - 12 121
- ------------------------------------------------------------------------------------------------------------------------------------
Net Income $ 472 $ 109 $ 199
====================================================================================================================================
Weighted-Average Common Shares Outstanding - Diluted 1,364 1,375 1,399
====================================================================================================================================
Earnings Per Share - Basic
Income from continuing operations before extraordinary gain $ .35 $ .10 $ .08
Loss from discontinued operations, net of tax - $ (.03) $ (.02)
Extraordinary gain, net of tax - $ .01 $ .08
Net income $ .35 $ .08 $ .14
Earnings Per Share - Diluted
Income from continuing operations before extraordinary gain $ .35 $ .10 $ .08
Loss from discontinued operations, net of tax - $ (.03) $ (.02)
Extraordinary gain, net of tax - $ .01 $ .08
Net income $ .35 $ .08 $ .14
====================================================================================================================================
Dividends Declared Per Common Share $ .050 $ .044 $ .044
====================================================================================================================================
2002 and 2001 have been adjusted to summarize the impact of The Charles Schwab Corporation's sale of its U.K. brokerage subsidiary,
Charles Schwab Europe, in loss from discontinued operations.
See Notes to Consolidated Financial Statements.
- 24 -
Consolidated Balance Sheet The Charles Schwab Corporation
(In Millions, Except Share and Per Share Amounts)
December 31, 2003 2002
- ------------------------------------------------------------------------------------------------------------------------------------
Assets
Cash and cash equivalents $ 2,832 $ 3,114
Cash and investments segregated and on deposit for federal or other regulatory
purposes (1) (including resale agreements of $16,824 in 2003 and $16,111 in 2002) 21,343 21,005
Securities owned - at market value (including securities pledged of $131 in 2003
and $337 in 2002) 4,023 1,716
Receivables from brokers, dealers and clearing organizations 556 222
Receivables from brokerage clients - net 8,581 6,845
Loans to banking clients - net 5,736 4,555
Loans held for sale 29 -
Equipment, office facilities and property - net 956 868
Goodwill - net 835 603
Intangible assets - net 144 6
Other assets 831 771
- ------------------------------------------------------------------------------------------------------------------------------------
Total $45,866 $39,705
====================================================================================================================================
Liabilities and Stockholders' Equity
Deposits from banking clients $ 8,308 $ 5,231
Drafts payable 154 134
Payables to brokers, dealers and clearing organizations 2,661 1,476
Payables to brokerage clients 27,184 26,401
Accrued expenses and other liabilities 1,330 1,302
Short-term borrowings 996 508
Long-term debt 772 642
- ------------------------------------------------------------------------------------------------------------------------------------
Total liabilities 41,405 35,694
- ------------------------------------------------------------------------------------------------------------------------------------
Stockholders' equity:
Preferred stock - 9,940,000 shares authorized; $.01 par value per share; none issued - -
Common stock - 3 billion shares authorized; $.01 par value per share;
1,392,091,544 and 1,391,991,180 shares issued in 2003 and 2002, respectively 14 14
Additional paid-in capital 1,749 1,744
Retained earnings 3,125 2,769
Treasury stock - 34,452,710 and 47,195,631 shares in 2003 and 2002, respectively, at cost (319) (465)
Unamortized stock-based compensation (95) (33)
Accumulated other comprehensive loss (13) (18)
- ------------------------------------------------------------------------------------------------------------------------------------
Total stockholders' equity 4,461 4,011
- ------------------------------------------------------------------------------------------------------------------------------------
Total $45,866 $39,705
====================================================================================================================================
(1) Amounts included represent actual balances on deposit, whereas cash and investments required to be segregated for federal or
other regulatory purposes were $21,005 million and $21,252 million at December 31, 2003 and 2002, respectively. On January 5,
2004 and January 2, 2003, the Company deposited $221 million and $655 million, respectively, into its segregated reserve bank
accounts.
See Notes to Consolidated Financial Statements.
- 25 -
Consolidated Statement of Cash Flows The Charles Schwab Corporation
(In Millions)
Year Ended December 31, 2003 2002 2001
- ------------------------------------------------------------------------------------------------------------------------------------
Cash Flows from Operating Activities
Net income $ 472 $ 109 $ 199
Adjustments to reconcile net income to net cash provided by (used for)
operating activities:
Depreciation and amortization 284 317 331
Impairment charges 5 37 -
Goodwill amortization - - 63
Tax benefits from, and amortization of, stock-based awards 29 31 69
Deferred income taxes 27 4 (79)
Non-cash restructuring and other charges 13 42 80
Extraordinary gain on sale of corporate trust business, net of tax - (12) (121)
Other (26) 27 6
Originations of loans held for sale (1,606) - -
Proceeds from sales of loans held for sale 1,585 - -
Net change in:
Cash and investments segregated and on deposit for federal
or other regulatory purposes (1,066) (3,302) (8,334)
Securities owned (excluding securities available for sale) (191) 105 14
Receivables from brokers, dealers and clearing organizations (351) 220 (89)
Receivables from brokerage clients (1,741) 2,745 6,709
Other assets (92) 10 (37)
Drafts payable 20 (261) (150)
Payables to brokers, dealers and clearing organizations 1,208 643 (335)
Payables to brokerage clients 1,479 (527) 1,291
Accrued expenses and other liabilities (42) (16) (203)
- ------------------------------------------------------------------------------------------------------------------------------------
Net cash provided by (used for) operating activities 7 172 (586)
- ------------------------------------------------------------------------------------------------------------------------------------
Cash Flows from Investing Activities
Purchases of securities available for sale (3,264) (1,147) (1,025)
Proceeds from sales of securities available for sale 397 636 473
Proceeds from maturities, calls and mandatory redemptions of
securities available for sale 819 415 611
Net increase in loans to banking clients (1,538) (705) (835)
Proceeds from sales of banking client loans 355 196 -
Purchase of equipment, office facilities and property - net (153) (160) (301)
Cash payments for business combinations and investments,
net of cash received (374) - (52)
Proceeds from sales of subsidiaries and investments 70 26 49
Proceeds from sale of corporate trust business - - 273
- ------------------------------------------------------------------------------------------------------------------------------------
Net cash used for investing activities (3,688) (739) (807)
- ------------------------------------------------------------------------------------------------------------------------------------
Cash Flows from Financing Activities
Net change in deposits from banking clients 3,077 (217) 1,139
Net change in short-term borrowings 488 (70) 224
Proceeds from long-term debt - 100 -
Repayment of long-term debt (100) (214) (40)
Dividends paid (68) (60) (61)
Purchase of treasury stock (32) (299) (368)
Proceeds from stock options exercised and other 34 34 30
- ------------------------------------------------------------------------------------------------------------------------------------
Net cash provided by (used for) financing activities 3,399 (726) 924
- ------------------------------------------------------------------------------------------------------------------------------------
Decrease in Cash and Cash Equivalents (282) (1,293) (469)
Cash and Cash Equivalents at Beginning of Year 3,114 4,407 4,876
- ------------------------------------------------------------------------------------------------------------------------------------
Cash and Cash Equivalents at End of Year $ 2,832 $ 3,114 $ 4,407
====================================================================================================================================
See Notes to Consolidated Financial Statements.
- 26 -
Consolidated Statement of Stockholders' Equity The Charles Schwab Corporation
(In Millions)
Accumulated
Additional Unamortized Other
Common Paid-In Retained Treasury Stock-based Comprehensive
Stock Capital Earnings Stock Compensation Income (Loss) Total
- ------------------------------------------------------------------------------------------------------------------------------------
Balance at December 31, 2000 $ 14 $ 1,588 $ 2,713 $ - $ (71) $ (14) $ 4,230
- ------------------------------------------------------------------------------------------------------------------------------------
Comprehensive income:
Net income - - 199 - - - 199
Net unrealized gain (loss) on
securities available for sale,
net of reclassification adjustment
and tax - - - - - 10 10
Cumulative effect of accounting change,
net of tax - - - - - (12) (12)
Net gain (loss) on cash flow hedging
instruments, net of tax - - - - - (19) (19)
Foreign currency translation adjustment - - - - - (2) (2)
------
Total comprehensive income 176
Dividends declared on common stock - - (61) - - - (61)
Purchase of treasury stock - - - (368) - - (368)
Stock options exercised, and shares
and stock options issued under
stock-based compensation plans - 48 (57) 77 (3) - 65
Non-cash stock-based compensation expense
related to restructuring - 19 - - 1 - 20
Issuance of shares for acquisitions - 71 - - - - 71
Receipt of shares in settlement of
accounts receivable - - - (4) - - (4)
Amortization of stock-based compensation
awards - - - - 34 - 34
- ------------------------------------------------------------------------------------------------------------------------------------
Balance at December 31, 2001 14 1,726 2,794 (295) (39) (37) 4,163
- ------------------------------------------------------------------------------------------------------------------------------------
Comprehensive income:
Net income - - 109 - - - 109
Net unrealized gain (loss) on securities
available for sale, net of
reclassification adjustment and tax - - - - - 17 17
Net gain (loss) on cash flow hedging
instruments, net of tax - - - - - (6) (6)
Foreign currency translation adjustment - - - - - 8 8
------
Total comprehensive income 128
Dividends declared on common stock - - (60) - - - (60)
Purchase of treasury stock - - - (299) - - (299)
Stock options exercised, and shares and
stock options issued under stock-based
compensation plans - 5 (74) 129 (22) - 38
Non-cash stock-based compensation expense
related to restructuring - 9 - - 1 - 10
Issuance of shares for acquisitions - 4 - - - - 4
Amortization of stock-based compensation
awards - - - - 27 - 27
- ------------------------------------------------------------------------------------------------------------------------------------
Balance at December 31, 2002 14 1,744 2,769 (465) (33) (18) 4,011
- ------------------------------------------------------------------------------------------------------------------------------------
Comprehensive income:
Net income - - 472 - - - 472
Net unrealized gain (loss) on securities
available for sale, net of
reclassification adjustment and tax - - - - - (19) (19)
Net gain (loss) on cash flow hedging
instruments, net of tax - - - - - 19 19
Foreign currency translation adjustment - - - - - 5 5
------
Total comprehensive income 477
Dividends declared on common stock - - (68) - - - (68)
Purchase of treasury stock - - - (32) - - (32)
Stock options exercised, and shares and
stock options issued under stock-based
compensation plans - (4) (47) 174 (97) - 26
Non-cash stock-based compensation expense
related to restructuring - 8 - - 1 - 9
Issuance of shares for acquisitions - 1 (1) 4 - - 4
Amortization of stock-based compensation
awards - - - - 34 - 34
- ------------------------------------------------------------------------------------------------------------------------------------
Balance at December 31, 2003 $ 14 $ 1,749 $ 3,125 $ (319) $ (95) $ (13) $ 4,461
====================================================================================================================================
See Notes to Consolidated Financial Statements.
- 27 -
The Charles Schwab Corporation
Notes to Consolidated Financial Statements
(Tabular Amounts in Millions, Except Per Share and Option Price Amounts)
1. Introduction and Basis of Presentation
The Charles Schwab Corporation (CSC) is a financial holding company
engaged, through its subsidiaries, in securities brokerage, banking, and related
financial services. Charles Schwab & Co., Inc. (Schwab) is a securities
broker-dealer with 339 domestic branch offices in 48 states, as well as a branch
in the Commonwealth of Puerto Rico. U.S. Trust Corporation (USTC, and with its
subsidiaries collectively referred to as U.S. Trust) is a wealth management firm
that through its subsidiaries also provides fiduciary services and private
banking services with 37 offices in 15 states. Other subsidiaries include
Charles Schwab Investment Management, Inc., the investment advisor for Schwab's
proprietary mutual funds, Schwab Capital Markets L.P. (SCM), a market maker in
Nasdaq, exchange-listed, and other securities providing trade execution services
primarily to broker-dealers and institutional clients, CyberTrader, Inc.
(CyberTrader), an electronic trading technology and brokerage firm providing
services to highly active, online traders, and Charles Schwab Bank, N.A. (Schwab
Bank), a retail bank which commenced operations in April 2003.
The consolidated financial statements include CSC and its majority-owned
subsidiaries (collectively referred to as the Company). Investments in equity
securities of other firms where the Company has significant influence, but owns
less than a majority of the voting securities, are generally accounted for by
the equity method. Under the equity method, the investment is initially recorded
at cost with the carrying amount subsequently adjusted to recognize the
Company's proportionate share of the earnings or losses of the investee.
The consolidated financial statements are prepared in conformity with
accounting principles generally accepted in the U.S., which require management
to make certain estimates and assumptions that affect the reported amounts in
the accompanying financial statements. Such estimates relate to capitalized
development costs for internal-use software; useful lives of intangible assets,
equipment, office facilities, and property; valuation of goodwill, intangible
assets, and equity investments; fair value of financial instruments and
investments; allowance for credit losses on banking loans; allowance for
doubtful accounts of brokerage clients; retirement and postretirement benefits;
future tax benefits; restructuring reserves; and legal reserves. Actual results
could differ from such estimates. Certain prior-year amounts have been
reclassified to conform to the 2003 presentation. All material intercompany
balances and transactions have been eliminated.
2. Significant Accounting Policies
Securities transactions: Clients' securities transactions are recorded on the
date that they settle, while the related commission revenues and expenses are
recorded on the date that the trade occurs. Principal transactions are recorded
on a trade date basis.
Cash and cash equivalents: The Company considers all highly liquid investments,
including money market funds, interest-bearing deposits with banks, federal
funds sold, commercial paper and treasury securities, with original maturities
of three months or less that are not segregated and on deposit for federal or
other regulatory purposes to be cash equivalents.
Cash and investments segregated and on deposit for federal or other regulatory
purposes consist primarily of securities purchased under agreements to resell
(resale agreements), which are collateralized by U.S. government securities, and
certificates of deposit. Resale agreements are collateralized investing
transactions that are recorded at their contractual amounts plus accrued
interest. The Company obtains possession of collateral (U.S. government
securities) with a market value equal to or in excess of the principal amount
loaned and accrued interest under resale agreements. Collateral is valued daily
by the Company, with additional collateral obtained when necessary. Certificates
of deposit are recorded at market value.
Securities borrowed, securities loaned, and securities sold under agreements to
repurchase (repurchase agreements) are collateralized investing and financing
transactions. Securities borrowed require the Company to deliver cash to the
lender in exchange for securities and are included in receivables from brokers,
dealers and clearing organizations. For securities loaned, the Company receives
collateral in the form of cash in an amount generally equal to the market value
of securities loaned. Securities loaned are included in payables to brokers,
dealers and clearing organizations. The Company monitors the market value of
securities borrowed and loaned, with additional collateral obtained or refunded
when necessary. Repurchase agreements are recorded at their contractual amounts
plus accrued interest and are included in short-term borrowings.
Securities owned include securities available for sale that are recorded at
estimated fair value using quoted market prices, where available, or third-party
pricing services. Unrealized gains and losses are reported, net of taxes, in
accumulated
- 28 -
other comprehensive income (loss) included in stockholders' equity. Realized
gains and losses from sales of securities available for sale are determined on a
specific identification basis and are included in other revenues.
Securities owned also include equity, fixed income and other securities,
SchwabFunds money market funds, and equity and bond mutual funds and are
recorded at estimated fair value. Unrealized gains and losses are included in
principal transaction revenues.
Receivables from brokerage clients are stated net of allowance for doubtful
accounts of $2 million and $4 million at December 31, 2003 and 2002,
respectively. Cash receivables from brokerage clients that remain unsecured or
partially secured for more than 30 days are fully reserved.
Nonperforming assets included in the loan portfolio consist of financial
instruments where the Company has stopped accruing interest (non-accrual
financial instruments). Interest accruals are discontinued when principal or
interest is contractually past due 90 days or more unless collectibility of the
loan is reasonably assured. Non-accrual financial instruments are generally
returned to accrual status only when all delinquent principal and interest
payments become current and the collectibility of future principal and interest
on a timely basis is reasonably assured.
Loans to banking clients are stated net of allowance of $27 million and
$24 million at December 31, 2003 and 2002, respectively. The allowance is
established through charges to income based on management's evaluation of the
adequacy of the allowance for credit losses in the existing portfolio.
The adequacy of the allowance is reviewed regularly by management, taking
into consideration current economic conditions, the existing loan portfolio
composition, past loss experience and risks inherent in the portfolio, including
the value of impaired loans.
Loans held for sale consist of fixed- and adjustable-rate mortgage loans
originated by Schwab Bank and intended for sale. Loans held for sale are stated
at lower of cost or market value. Market value is determined using quoted market
prices.
Equipment, office facilities and property: Equipment and office facilities are
depreciated on a straight-line basis over the estimated useful life of the asset
of two to fifteen years. Buildings are depreciated on a straight-line basis over
twenty years. Leasehold improvements are amortized on a straight-line basis over
the lesser of the estimated useful life of the asset or the term of the lease.
Software and certain costs incurred for purchasing or developing software for
internal use are amortized on a straight-line basis over an estimated useful
life of three or five years. Equipment, office facilities and property are
stated at cost net of accumulated depreciation and amortization, except for
land, which is stated at cost. Equipment, office facilities and property are
reviewed for impairment whenever events or changes in circumstances indicate
that the carrying amount of such assets may not be recoverable.
Derivative financial instruments are recorded on the balance sheet at fair value
based upon dealer quotes and third-party pricing services. As part of its
consolidated asset and liability management process, the Company utilizes
interest rate swap agreements (Swaps) to manage interest rate risk of both
fixed-rate and variable-rate financial instruments. The Company applies hedge
accounting to these swaps and therefore gains and losses are generally deferred
and recognized in interest expense to offset the impact of changing interest
rates on the hedged financial instruments. Other derivative activities primarily
consist of exchange-traded futures and options to hedge potential losses in
equity inventory positions. These futures and options are recorded at fair value
in securities owned on the consolidated balance sheet, and gains and losses are
included in principal transaction revenues. For further discussion on these
derivative financial instruments, see note "25 - Financial Instruments Subject
to Off-Balance Sheet Risk, Credit Risk or Market Risk."
Income taxes: The Company files a consolidated U.S. federal income tax return
and uses the asset and liability method in recording income tax expense. Under
this method, deferred tax assets and liabilities are recorded for temporary
differences between the tax basis of assets and liabilities and their recorded
amounts for financial reporting purposes, using currently enacted tax law.
Stock-based compensation: The Company applies Accounting Principles Board
Opinion (APB) No. 25 - Accounting for Stock Issued to Employees, and related
interpretations, for its stock-based employee compensation plans. Because the
Company grants stock option awards at market value, there is no compensation
expense recorded, except for restructuring-related expense for modifications of
officers' stock options. Compensation expense for restricted stock awards is
based on the market value of the shares awarded at the date of grant and is
amortized on a straight-line basis over the vesting period. The unamortized
portion of the award is recorded as unamortized stock-based compensation in
stockholders' equity.
Had compensation expense for the Company's stock option awards been
determined based on the Black-Scholes fair value at the grant dates for awards
under those plans consistent with the fair value method of SFAS No. 123 -
Accounting for Stock-Based Compensation, the Company would have recorded
additional compensation expense and its net income and earnings per share (EPS)
would have been reduced to the pro forma amounts presented in the following
table:
- 29 -
- --------------------------------------------------------------------------------
Year Ended December 31, 2003 2002 2001
- --------------------------------------------------------------------------------
Compensation expense for stock
options (after tax):
As reported $ 6 $ 6 $ 13
Pro forma (1) $ 112 $ 154 $ 181
- --------------------------------------------------------------------------------
Net income (loss):
As reported $ 472 $ 109 $ 199
Pro forma $ 366 $ (39) $ 31
- --------------------------------------------------------------------------------
EPS (2):
As reported $ .35 $ .08 $ .14
Pro forma $ .27 $ (.03) $ .02
- --------------------------------------------------------------------------------
(1) Includes pro forma compensation expense related to stock options granted in
both current and prior periods. Pro forma stock option compensation is
amortized on a straight-line basis over the vesting period beginning with
the month in which the option was granted.
(2) Represents both basic and diluted EPS.
The fair value of each option granted is estimated as of the grant date
using the Black-Scholes option pricing model with the following assumptions:
- --------------------------------------------------------------------------------
2003 2002 2001
- --------------------------------------------------------------------------------
Expected dividend yield .30% .30% .30%
Expected volatility (1) 49% 51% 50%
Risk-free interest rate (1) 2.7% 3.5% 4.3%
Expected life (in years) 5 5 5
- --------------------------------------------------------------------------------
(1) Computed based on quarterly weighted-average amounts.
Goodwill represents the cost of acquired businesses in excess of the fair value
of the related net assets acquired. Goodwill is accounted for under SFAS No. 142
- - Goodwill and Other Intangible Assets. This statement requires that goodwill be
tested for impairment at least annually or whenever indications of impairment
exist. In testing for a potential impairment of goodwill, SFAS No. 142 requires
management to estimate the fair value of each of the Company's reporting units
(generally defined as the Company's businesses for which financial information
is available and reviewed regularly by management), and compare it to their
carrying value. If the estimated fair value of a reporting unit is less than its
carrying value, management is required to estimate the fair value of all assets
and liabilities of the reporting unit, including goodwill. If the carrying value
of the reporting unit's goodwill is greater than the estimated fair value, an
impairment charge is recognized for the excess. The Company has elected April 1
as its annual impairment testing date. See "Accounting Change" below and note "4
- - Impairment Charges."
Accounting change: The Company adopted SFAS No. 142 on January 1, 2002. Under
SFAS No. 142, companies are no longer permitted to amortize goodwill and certain
intangible assets with an indefinite useful life. Instead, these assets must be
reviewed for impairment as discussed above.
The following table compares net income and EPS for 2003 and 2002, which
excludes goodwill amortization, with net income and EPS for 2001, which has been
adjusted to exclude goodwill amortization.
- --------------------------------------------------------------------------------
2003 2002 2001
(Reported) (Reported) (Adjusted)
- --------------------------------------------------------------------------------
Net income:
Reported income from
continuing operations
before extraordinary gain $ 472 $ 135 $ 106
Add: Goodwill amortization,
net of tax - - 61
- --------------------------------------------------------------------------------
Reported/adjusted income
from continuing operations
before extraordinary gain 472 135 167
Loss from discontinued
operations, net of tax - (38) (28)
Extraordinary gain, net of tax - 12 121
- --------------------------------------------------------------------------------
Reported/adjusted
net income $ 472 $ 109 $ 260
================================================================================
EPS (1):
Reported EPS from
continuing operations
before extraordinary gain $ .35 $ .10 $ .08
Add: Goodwill amortization - - .04
- --------------------------------------------------------------------------------
Reported/adjusted EPS from
continuing operations
before extraordinary gain .35 .10 .12
Loss from discontinued
operations, net of tax - (.03) (.02)
Extraordinary gain, net of tax - .01 .08
- --------------------------------------------------------------------------------
Reported/adjusted EPS $ .35 $ .08 $ .18
===============================================================================
(1) Represents both basic and diluted EPS.
The Company's goodwill balance increased during 2003 due to $232 million of
goodwill related to U.S. Trust's acquisition of State Street Corporation's
Private Asset Management group (PAM) in October 2003. The carrying amount of
goodwill, net of accumulated amortization, attributable to each of the Company's
reportable segments is presented in the following table:
- --------------------------------------------------------------------------------
December 31, 2003 2002
- --------------------------------------------------------------------------------
Individual Investor $ 414 $ 414
Institutional Investor 3 3
Capital Markets 27 27
U.S. Trust 391 159
- --------------------------------------------------------------------------------
Total $ 835 $ 603
================================================================================
Intangible assets consist primarily of client lists. Under SFAS No. 142,
intangible assets which have finite lives continue to be amortized over their
estimated useful lives and are subject to impairment testing under the
provisions of
- 30 -
SFAS No. 144 - Accounting for the Impairment or Disposal of Long-Lived Assets.
SFAS No. 144 requires that intangible assets other than goodwill be tested for
impairment whenever events or changes in circumstances indicate that its
carrying amount may not be recoverable. In testing for a potential impairment of
intangible assets, SFAS No. 144 requires management to assess whether the future
cash flows related to the asset will be greater than its carrying value at the
time of the test. Accordingly, the process of evaluating a potential impairment
is based on estimates and is subjective. The Company's intangible asset
balances, net of accumulated amortization, were $144 million and $6 million at
December 31, 2003 and 2002, respectively. The increase in 2003 was due to $138
million of intangible assets (primarily client lists) related to U.S. Trust's
acquisition of PAM in October 2003. These intangible assets have a
weighted-average estimated useful life of 20 years.
New accounting standards:
SFAS No. 146 - Accounting for Costs Associated with Exit or Disposal
Activities was issued in June 2002 and addresses accounting for restructuring
and similar costs. SFAS No. 146 supersedes previous accounting guidance,
principally Emerging Issues Task Force Issue No. 94-3 - Liability Recognition
for Certain Employee Termination Benefits and Other Costs to Exit an Activity
(including Certain Costs Incurred in a Restructuring). The Company adopted this
statement for exit or disposal activities initiated after December 31, 2002. The
adoption of SFAS No. 146 did not have a material impact on the Company's
financial position, results of operations, EPS, or cash flows.
Financial Accounting Standards Board Interpretation (FIN) No. 45 -
Guarantor's Accounting and Disclosure Requirements for Guarantees, Including
Indirect Guarantees of Indebtedness of Others, was issued in November 2002. This
interpretation addresses the disclosures to be made by a guarantor in its
interim and annual financial statements about its obligations under certain
guarantees that it has issued. FIN No. 45 also clarifies that a guarantor is
required to recognize, at the inception of a guarantee, a liability for the fair
value of the obligation undertaken in issuing the guarantee. In accordance with
FIN No. 45, the Company adopted the disclosure requirements on December 31, 2002
and the recognition requirements on January 1, 2003. The adoption of FIN No. 45
did not have a material impact on the Company's financial position, results of
operations, EPS, or cash flows.
FIN No. 46 - Consolidation of Variable Interest Entities, an Interpretation
of Accounting Research Bulletin No. 51 - Consolidated Financial Statements, was
issued in January 2003 and revised in December 2003. This interpretation
provides new criteria for determining whether a company is required to
consolidate (i.e., record the assets and liabilities on the balance sheet) a
variable interest entity. Upon adoption of this interpretation in the first
quarter of 2003, the Company consolidated a special purpose trust (Trust) that
was formed in 2000 to finance the acquisition and renovation of an office
building and land. The Trust, through an agent, raised the $245 million needed
to acquire and renovate the building and land by issuing a note payable
($235 million) and raising equity capital ($10 million). Upon adoption, the
Company recorded the building and land at a cost of $245 million; accumulated
depreciation of $16 million; a note payable of $235 million; and a net reduction
of accrued expenses and other liabilities of $7 million. The cumulative effect
of this accounting change was immaterial.
The building is being depreciated on a straight-line basis over twenty
years. The note payable carries a variable-rate and matures in June 2005. The
interest rate on the note was 1.58% at December 31, 2003, and ranged from 1.54%
to 1.82% during the year. The building and land have been pledged as collateral
for the note payable. At December 31, 2003, the carrying value of the building
and land was $218 million (net of accumulated depreciation of $27 million).
Additionally, the Company has guaranteed the debt of the Trust up to a maximum
of $202 million. The lender does not have recourse to any other assets of the
Company.
The annual impact of the adoption of FIN No. 46 on the Company's
consolidated statement of income is to cease both amortizing the shortfall of
the residual value guarantee and recording rent expense on the lease and to
record both the depreciation on the building and the interest expense associated
with the debt. The adoption of FIN No. 46 did not have and is not expected to
have a material impact on the Company's results of operations, EPS, or cash
flows.
SFAS No. 149 - Amendment of Statement 133 on Derivative Instruments and
Hedging Activities was issued in April 2003. This statement amends and clarifies
financial accounting and reporting for derivative instruments, including certain
derivative instruments embedded in other contracts and for hedging activities
under SFAS No. 133 - Accounting for Derivative Instruments and Hedging
Activities. SFAS No. 149 also amends certain other existing pronouncements. The
Company adopted the provisions of this statement on June 30, 2003. The adoption
of this statement did not have and is not expected to have a material impact on
the Company's financial position, results of operations, EPS, or cash flows.
SFAS No. 150 - Accounting for Certain Financial Instruments with
Characteristics of both Liabilities and Equity was issued in May 2003. This
statement establishes standards for how to classify and measure certain
financial instruments with characteristics of both liabilities and equity (e.g.,
redeemable preferred stock). The Company adopted the provisions of this
statement on July 1, 2003. The adoption of this statement did not have an impact
on the Company's financial position, results of operations, EPS, or cash flows.
SFAS No. 132 - Employers' Disclosures about Pensions and Other
Postretirement Benefits was revised in December 2003. This revised statement
retains the disclosure requirements contained in the original SFAS No. 132,
which it
- 31 -
replaces, and requires additional disclosures about the assets, obligations,
cash flows, and net periodic benefit cost of defined benefit pension plans and
other defined benefit postretirement plans. The Company adopted the provisions
of this revised statement on December 31, 2003. The adoption of this revised
statement did not have an impact on the Company's financial position, results of
operations, EPS, or cash flows.
3. Restructuring and Other Charges
Restructuring
The Company recorded pre-tax restructuring charges as follows:
- --------------------------------------------------------------------------------
2003 2002 2001
- --------------------------------------------------------------------------------
2003 Initiatives $ 51 - -
2002 Initiatives (1) $ 263 -
2001 Initiatives 31 95 $ 382
- --------------------------------------------------------------------------------
Total restructuring charges $ 81 $ 358 $ 382
================================================================================
2003 Initiatives
In 2003, the Company completed additional restructuring initiatives to
further adjust the Company's workforce and facilities in response to the market
environment.
Workforce: During 2003, the Company reduced full-time equivalent employees by
250 through mandatory staff reductions.
Facilities: The restructuring charges recognized under the 2003 initiatives
included facility exit costs which are net of estimated sublease income. These
charges related to the consolidation of 33 Schwab domestic branch offices, as
well as reductions of administrative office space.
A summary of pre-tax restructuring charges related to the Company's 2003
restructuring initiatives is as follows:
- --------------------------------------------------------------------------------
2003
- --------------------------------------------------------------------------------
Workforce reduction:
Severance pay and benefits $ 26
Non-cash compensation expense for officers' stock options 9
- --------------------------------------------------------------------------------
Total workforce reduction 35
- --------------------------------------------------------------------------------
Facilities reduction:
Non-cancelable lease costs, net of estimated sublease income 12
Write-downs of leasehold improvements 4
- --------------------------------------------------------------------------------
Total facilities reduction 16
- --------------------------------------------------------------------------------
Total restructuring charges $ 51
================================================================================
2001 and 2002 Initiatives
The Company's 2001 and 2002 restructuring initiatives included workforce
reductions, reductions in operating facilities, the removal of certain systems
hardware, software and equipment from service, and the withdrawal from certain
international operations. These initiatives reduced operating expenses and
adjusted the Company's organizational structure to improve productivity, enhance
efficiency, and increase profitability. During 2003, the Company recorded
pre-tax restructuring charges of $30 million related to its 2001 and 2002
restructuring initiatives, primarily due to changes in estimates of sublease
income associated with previously announced efforts to sublease excess
facilities.
- 32 -
A summary of the activity in the restructuring reserve related to the
Company's 2003, 2002, and 2001 restructuring initiatives for the years ended
December 31, 2003, 2002, and 2001 is as follows:
- --------------------------------------------------------------------------------
Workforce Facilities Systems
Reduction Reduction Removal Total
- --------------------------------------------------------------------------------
Initial restructuring
charges in 2001 $ 182 $ 139 $ 61 $ 382
Restructuring charges related
to discontinued operations 5 2 2 9
Cash payments (93) (8) (43) (144)
Non-cash charges (1) (20) (36) (16) (72)
- --------------------------------------------------------------------------------
Balance at
December 31, 2001 $ 74 $ 97 $ 4 $ 175
Restructuring charges 155 202 (2) 1 358
Restructuring charges related
to discontinued operations 5 6 4 15
Cash payments (156) (50) (5) (211)
Non-cash charges (1) (10) (28) (4) (42)
- --------------------------------------------------------------------------------
Balance at
December 31, 2002 $ 68 $ 227 - $ 295
Balance related to
discontinued operations - (3) - (3)
Restructuring charges 32 49 (2) - 81
Cash payments (68) (75) - (143)
Non-cash charges (1) (9) (4) - (13)
Other (3) - 7 - 7
- --------------------------------------------------------------------------------
Balance at December 31, 2003 $ 23 (4) $ 201 (5) - $ 224
================================================================================
(1) In 2003, primarily includes charges for officers' stock option compensation
and write-downs of fixed assets. In 2002, primarily includes charges for
officers' stock-based compensation. In 2001, includes charges for officers'
stock-based compensation, write-downs, and accelerated depreciation.
(2) Includes $31 million and $65 million, in 2003 and 2002, respectively,
primarily due to changes in estimates of sublease income resulting from a
continued deterioration in the commercial real estate market.
(3) Primarily includes the accretion of facilities restructuring reserves,
which are initially recorded at net present value. Accretion expense is
recorded in occupancy and equipment expense on the Company's consolidated
statement of income.
(4) Includes $13 million, $7 million, and $3 million related to the Company's
2003, 2002, and 2001 restructuring initiatives, respectively. The Company
expects to substantially utilize the remaining workforce reduction reserve
through cash payments for severance pay and benefits over the respective
severance periods through 2005.
(5) Includes $10 million, $76 million, and $115 million related to the
Company's 2003, 2002, and 2001 restructuring initiatives, respectively. The
Company expects to substantially utilize the remaining facilities reduction
reserve through cash payments for the net lease expense over the respective
lease terms through 2017.
The actual costs of these restructuring initiatives could differ from the
estimated costs, depending primarily on the Company s ability to sublease
properties.
4. Impairment Charges
The Company recorded impairment charges of $5 million and $37 million in
2003 and 2002, respectively, for write-downs of its investment in Aitken
Campbell, a market-making joint venture in the U.K., which was sold in 2003.
5. Sale of Corporate Trust Business
In 2001, U.S. Trust sold its Corporate Trust business to The Bank of New
York Company, Inc. Total proceeds received were $273 million. During 2001, the
Company recognized a pre-tax extraordinary gain of $221 million on this sale, or
$121 million after tax. In 2002, the Company recorded a pre-tax extraordinary
gain of $22 million, or $12 million after tax, which represented the remaining
proceeds from this sale that were realized upon satisfaction of certain client
retention requirements.
6. Discontinued Operations
On January 31, 2003, the Company sold its United Kingdom (U.K.) brokerage
subsidiary, Charles Schwab Europe (CSE), to Barclays PLC (Barclays) and
transferred client-related assets of approximately $760 million (consisting
primarily of cash and investments segregated and on deposit for federal or other
regulatory purposes and receivables from brokers, dealers and clearing
organizations) and liabilities of approximately $735 million (consisting
primarily of payables to brokerage clients) to Barclays. The results of the
operations of CSE, net of income taxes, have been presented as discontinued
operations on the Company's consolidated statement of income. A summary of
revenues, pre-tax losses, and after-tax losses for CSE is as follows:
- --------------------------------------------------------------------------------
December 31, 2003 2002 2001
- --------------------------------------------------------------------------------
Revenues $ 4 $ 44 $ 61
Pre-tax losses $ - $(58) $(42)
After-tax losses $ - $(38) $(28)
- --------------------------------------------------------------------------------
CSE was included in the Company's restructuring initiatives and recorded
pre-tax restructuring charges of $15 million and $9 million in 2002 and 2001,
respectively. The Company retained certain restructuring-related facility lease
obligations following the sale of CSE. The Company's facilities restructuring
reserve balance related to CSE, which is net of estimated sublease income, is
$12 million at December 31, 2003.
- 33 -
7. Business Acquisitions and Divestiture
In June 2003, the Company sold its investment in Aitken Campbell, a
market-making joint venture in the U.K., to the Company's joint venture partner,
TD Waterhouse Group, Inc. In 2003, the Company recorded an impairment charge of
$5 million pre tax to reduce the carrying value of its investment and an income
tax benefit of $16 million. The Company's share of Aitken Campbell's historical
earnings, which was accounted for under the equity method, has not been material
to the Company's results of operations, EPS, or cash flows.
In October 2003, U.S. Trust acquired State Street Corporation's Private
Asset Management group, a provider of wealth management services to clients in
the New England area, for $365 million.
In November 2003, the Company announced that it had entered into a
definitive agreement with SoundView Technology Group, Inc. (SoundView), a
research-driven securities firm providing institutional investors with
fundamental research on companies in technology, media, telecom, healthcare, and
other growth-related industries, to acquire SoundView for $15.50 per SoundView
share to be paid in cash. See note "29 - Subsequent Events" for further
discussion on this acquisition.
8. Securities Owned
A summary of securities owned is as follows:
- --------------------------------------------------------------------------------
December 31, 2003 2002
- --------------------------------------------------------------------------------
Securities available for sale $ 3,437 $ 1,322
SchwabFunds money market funds 306 197
Equity, fixed income, and other securities 256 126
Equity and bond mutual funds 24 71
- --------------------------------------------------------------------------------
Total $ 4,023 $ 1,716
================================================================================
The amortized cost, estimated fair value, and gross unrealized gains and
losses on securities available for sale are as follows:
- --------------------------------------------------------------------------------
December 31, 2003 2002
- --------------------------------------------------------------------------------
U.S. treasury securities:
Amortized cost $ 301 $ 290
Aggregate fair value $ 302 $ 296
Gross unrealized gains $ 1 $ 6
Gross unrealized losses - -
U.S. government sponsored agencies
and corporations:
Amortized cost 1,421 701
Aggregate fair value 1,421 727
Gross unrealized gains 5 26
Gross unrealized losses 5 -
State and municipal obligations:
Amortized cost 148 169
Aggregate fair value 155 178
Gross unrealized gains 7 9
Gross unrealized losses - -
Collateralized mortgage obligations (1):
Amortized cost 1,508 88
Aggregate fair value 1,508 87
Gross unrealized gains 4 -
Gross unrealized losses 4 1
Other securities:
Amortized cost 51 33
Aggregate fair value 51 34
Gross unrealized gains - 1
Gross unrealized losses - -
- --------------------------------------------------------------------------------
Total securities available for sale:
Amortized cost $ 3,429 $ 1,281
Aggregate fair value $ 3,437 $ 1,322
Gross unrealized gains $ 17 $ 42
Gross unrealized losses $ 9 $ 1
================================================================================
(1) Collateralized by either GNMA, FNMA or FHLC obligations.
- 34 -
A summary of investments with unrealized losses, aggregated by category and
period of continuous unrealized loss, at December 31, 2003, is as follows:
- --------------------------------------------------------------------------------
Less than 12 months
12 months or longer Total
---------------- ---------------- ----------------
Description of Fair Unrealized Fair Unrealized Fair Unrealized
Securities Value Losses Value Losses Value Losses
- --------------------------------------------------------------------------------
U.S. government
sponsored agencies
and corporations $ 891 $ 5 $ 2 - $ 893 $ 5
Collateralized
mortgage
obligations 522 4 3 - 525 4
- --------------------------------------------------------------------------------
Total temporarily
impaired securities $1,413 $ 9 $ 5 - $1,418 $ 9
================================================================================
Management views the unrealized losses noted above as temporary. The
determination of whether or not other-than-temporary impairment exists is a
matter of judgment. Factors considered in evaluating whether a decline in value
is other than temporary include: the financial conditions and near-term
prospects of the issuer; the Company's intent and ability to retain the
investment for a period of time sufficient to allow for any anticipated
recovery; and the length of time and the extent to which the fair value has been
less than cost.
The maturities of debt securities available for sale at December 31, 2003,
and the related weighted-average yield on such debt securities are as follows:
- --------------------------------------------------------------------------------
Within 1 - 5 5 - 10 Over 10
1 Year Years Years Years Total
- --------------------------------------------------------------------------------
U.S. treasury securities $ 145 $ 156 - - $ 301
U.S. government sponsored
agencies and corporations - 39 $1,350 $ 32 1,421
State and municipal obligations 16 132 - - 148
Collateralized mortgage
obligations (1) - 16 29 1,463 1,508
Other debt securities 8 43 - - 51
- --------------------------------------------------------------------------------
Total at amortized cost 169 386 1,379 1,495 3,429
Estimated fair value 170 394 1,378 1,495 3,437
- --------------------------------------------------------------------------------
Net unrealized gains (losses) $ 1 $ 8 $ (1) $ - $ 8
================================================================================
Weighted-average yield (2) 3.24% 5.94% 4.45% 2.38% 3.64%
================================================================================
(1) Collateralized mortgage obligations have been allocated over maturity
groupings based on contractual maturities. Expected maturities may differ
from contractual maturities because borrowers have the right to prepay
obligations with or without prepayment penalties.
(2) Yields have been computed by dividing annualized interest revenue, on a
taxable equivalent basis, by the amortized cost of the respective
securities at December 31, 2003.
The Company's positions in SchwabFunds money market funds arise from
certain overnight funding of clients' redemption, check-writing, and debit card
activities. Equity and other securities include the Company's inventories
resulting from proprietary equity trading and market making. Fixed income
securities are held to meet clients' trading activities. Equity and bond mutual
funds include investments made by the Company relating to its deferred
compensation plan and inventory maintained to facilitate certain SchwabFunds and
third-party mutual fund clients' transactions.
Securities sold, but not yet purchased, of $95 million and $26 million at
December 31, 2003 and 2002, respectively, consist primarily of equity positions
resulting from market-making activity and mutual fund shares that are
distributed to clients to satisfy their dividend reinvestment requests. These
securities are recorded at market value in accrued expenses and other
liabilities.
9. Receivables from Brokerage Clients
Receivables from brokerage clients consist primarily of margin loans to
brokerage clients of $8.5 billion and $6.6 billion at December 31, 2003 and
2002, respectively. Securities owned by brokerage clients are held as collateral
for margin loans. Such collateral is not reflected in the consolidated financial
statements.
10. Loans to Banking Clients and Related Allowance for Credit Losses
An analysis of the composition of the loan portfolio is as follows:
- --------------------------------------------------------------------------------
December 31, 2003 2002
- --------------------------------------------------------------------------------
Residential real estate mortgages $ 4,624 $ 3,580
Consumer loans 735 630
Other 404 369
- --------------------------------------------------------------------------------
Total loans 5,763 4,579
- --------------------------------------------------------------------------------
Less: allowance for credit losses (27) (24)
- --------------------------------------------------------------------------------
Loans to banking clients - net $ 5,736 $ 4,555
================================================================================
Included in the loan portfolio are non-accrual loans totaling $1 million at
both December 31, 2003 and 2002, respectively. Non-accrual loans are considered
impaired by the Company, and represent all the Company's nonperforming assets at
both December 31, 2003 and 2002. For 2003 and 2002, the impact of interest
revenue which would have been earned on non-accrual loans versus interest
revenue recognized on these loans was not material to the Company's results of
operations.
The amount of loans accruing interest that were contractually 90 days or
more past due was immaterial at both December 31, 2003 and 2002.
Recoveries and charge-offs related to the allowance for credit losses on
the loan portfolio were not material for each of 2003, 2002, and 2001.
- 35 -
11. Loan Securitizations
In the fourth quarter of 2003 and the second quarter of 2002, U.S. Trust
sold $354 million and $193 million, respectively, of residential mortgage loans
originated through its private banking business in securitization transactions.
In these securitizations, the senior mortgage pass-through certificates that
were created by the securitization process were sold to third parties, and
U.S. Trust retained certain other securities created by the securitization
process, primarily comprised of subordinated securities and servicing rights.
The fair values of retained securities are primarily determined based on quoted
market prices, incorporating key economic assumptions. Gains or losses on
securitizations are determined based upon the previous carrying amount of the
securitized loans, allocated between the loans sold and the retained securities
based on their relative fair values at the date of sale. U.S. Trust received
$355 million and $196 million from these sales, respectively, retained certain
securities with total par values of $7 million and $5 million, respectively,
and, after payment of transaction expenses, recognized immaterial net gains.
These securitization transactions are accounted for as sales under the
requirements of SFAS No. 140 - Accounting for Transfers and Servicing of
Financial Assets and Extinguishments of Liabilities.
The estimated total fair values of the retained securities were $12 million
and $5 million at December 31, 2003 and 2002, respectively, and were included in
securities owned on the Company's consolidated balance sheet. A hypothetical
change of 50 or 100 basis points in any of the underlying key economic
assumptions would not have a material impact on the Company's financial
condition at December 31, 2003 or 2002. Cash flows received from the retained
securities, including servicing fees, were immaterial in both 2003 and 2002.
Any credit losses on the securitized loans are assigned to U.S. Trust, as
holder of the subordinated securities, up to the par value. U.S. Trust has not
guaranteed the mortgage loans as these transactions are structured without
recourse to U.S. Trust or the Company.
12. Equipment, Office Facilities and Property
Equipment, office facilities and property are detailed below:
- --------------------------------------------------------------------------------
December 31, 2003 2002
- --------------------------------------------------------------------------------
Land $ 55 $ 24
Buildings 479 265
Leasehold improvements 364 400
Furniture and equipment 220 233
Telecommunications equipment 162 172
Information technology equipment 438 437
Software 559 501
Construction and software development
in progress 85 82
- --------------------------------------------------------------------------------
Subtotal 2,362 2,114
Accumulated depreciation and amortization (1,406) (1,246)
- --------------------------------------------------------------------------------
Total $ 956 $ 868
================================================================================
Upon adoption of FIN No. 46 in the first quarter of 2003, the Company
consolidated a special purpose trust and recorded land and building at a cost of
$245 million, and accumulated depreciation of $16 million. See note "2 -
Significant Accounting Policies - New Accounting Standards" for further
discussion of this consolidation.
13. Deposits from Banking Clients
Deposits from banking clients consist of money market and other savings
deposits, certificates of deposit, and noninterest-bearing deposits. Deposits
from banking clients are as follows:
- --------------------------------------------------------------------------------
December 31, 2003 2002
- --------------------------------------------------------------------------------
Interest-bearing deposits $ 7,585 $ 4,471
Noninterest-bearing deposits 723 760
- --------------------------------------------------------------------------------
Total $ 8,308 $ 5,231
================================================================================
During the years ended December 31, 2003 and 2002, the Company paid an
average rate of 1.8% and 2.3%, respectively, on its interest-bearing deposits
from banking clients.
14. Payables to Brokers, Dealers and Clearing Organizations
Payables to brokers, dealers and clearing organizations consist primarily
of securities loaned of $2.6 billion and $1.4 billion at December 31, 2003 and
2002, respectively. The cash collateral received from counterparties under
securities lending transactions was equal to or greater than the market value of
the securities loaned.
- 36 -
15. Payables to Brokerage Clients
The principal source of funding for Schwab's margin lending is cash
balances in brokerage client accounts. At December 31, 2003, Schwab was paying
interest at .2% on $23.8 billion of cash balances in brokerage client accounts,
which were included in payables to brokerage clients. At December 31, 2002,
Schwab was paying interest at .4% on $23.0 billion of such cash balances.
16. Short-term Borrowings
CSC may borrow under its $800 million committed, unsecured credit facility
with a group of twenty banks which is scheduled to expire in June 2004. CSC
plans to establish a similar facility to replace this one when it expires. This
facility replaced a facility that expired in June 2003. The funds under this
facility are available for general corporate purposes and CSC pays a commitment
fee on the unused balance of this facility. The financial covenants in this
facility require CSC to maintain a minimum level of tangible net worth, and
Schwab and SCM to maintain specified levels of net capital, as defined. These
facilities were unused at December 31, 2003 and 2002.
To manage short-term liquidity, Schwab maintains uncommitted, unsecured
bank credit lines with a group of nine banks totaling $828 million at
December 31, 2003. CSC has access to $778 million of these credit lines. The
amount available to CSC under these lines is lower than the amount available to
Schwab because the credit line provided by one of these banks is only available
to Schwab. There were no borrowings outstanding under these lines at
December 31, 2003 and 2002.
To satisfy the margin requirement of client option transactions with the
Options Clearing Corporation (OCC), Schwab has unsecured letter of credit
agreements with nine banks in favor of the OCC aggregating $630 million at
December 31, 2003. Schwab pays a fee to maintain these letters of credit. No
funds were drawn under these letters of credit at December 31, 2003 and 2002.
Other short-term borrowings include Federal Home Loan Bank System
borrowings, federal funds purchased, repurchase agreements, and other borrowed
funds. At December 31, 2003 and 2002, these other short-term borrowings totaled
$996 million and $508 million, respectively, with weighted-average interest
rates ranging from .87% to 1.22% and 1.13% to 2.00%, respectively.
17. Long-term Debt
Long-term debt consists of the following:
- --------------------------------------------------------------------------------
December 31, 2003 2002
- --------------------------------------------------------------------------------
Senior Medium-Term Notes, Series A $ 466 $ 566
Note payable 235 -
8.41% Trust Preferred Capital Securities 52 50
Fair value adjustment (1) 19 26
- --------------------------------------------------------------------------------
Total $ 772 $ 642
================================================================================
(1) Represents the fair value adjustment related to hedged Medium-Term Notes.
See note "25 - Financial Instruments Subject to Off-Balance Sheet Risk,
Credit Risk or Market Risk."
The aggregate principal amount of Senior Medium-Term Notes, Series A
(Medium-Term Notes) outstanding at December 31, 2003 had maturities ranging from
2004 to 2010. The aggregate principal amount of Medium-Term Notes outstanding at
both December 31, 2003 and 2002 had fixed interest rates ranging from 6.04% to
8.05%. At December 31, 2003 and 2002, the Medium-Term Notes carried a
weighted-average interest rate of 7.31% and 7.29%, respectively.
Upon adoption of FIN No. 46 in the first quarter of 2003, the Company
consolidated a special purpose trust and recorded a note payable of
$235 million. See note "2 - Significant Accounting Policies - New Accounting
Standards" for further discussion of this consolidation.
The Trust Preferred Capital Securities qualify as tier 1 capital under
guidelines of the Board of Governors of the Federal Reserve System (Federal
Reserve Board) and have no voting rights. Holders of the Trust Preferred Capital
Securities are entitled to receive cumulative cash distributions semi-annually.
The Company has the right to redeem the Trust Preferred Capital Securities prior
to their stated maturity of February 1, 2027, on or after February 1, 2007, upon
approval (if then required) of the Federal Reserve Board.
Annual maturities on long-term debt outstanding at December 31, 2003 are as
follows:
- --------------------------------------------------------------------------------
2004 $ 81
2005 291
2006 68
2007 38
2008 15
Thereafter 260
- --------------------------------------------------------------------------------
Total maturities 753
Fair value adjustment 19
- --------------------------------------------------------------------------------
Total $ 772
================================================================================
- 37 -
18. Taxes on Income
Income tax expense is as follows:
- --------------------------------------------------------------------------------
Year Ended December 31, 2003 2002 2001
- --------------------------------------------------------------------------------
Current:
Federal $ 191 $ 92 $ 212
State 20 (1) 35
- --------------------------------------------------------------------------------
Total current 211 91 247
- --------------------------------------------------------------------------------
Deferred:
Federal 30 (4) (67)
State (3) 15 (9)
- --------------------------------------------------------------------------------
Total deferred 27 11 (76)
- --------------------------------------------------------------------------------
Taxes on income 238 102 171
Current tax expense on
extraordinary gain - (10) (100)
- --------------------------------------------------------------------------------
Taxes on income before
extraordinary gain $ 238 $ 92 $ 71
================================================================================
The above amounts do not include tax benefits or expense from the exercise
of stock options and the vesting of restricted stock awards, which for
accounting purposes are recorded in additional paid-in capital. Such tax amounts
totaled a net tax expense of $3 million in 2003, compared to net tax benefits of
$4 million and $37 million in 2002 and 2001, respectively.
The temporary differences that created deferred tax assets and liabilities,
included in other assets, and accrued expenses and other liabilities, are
detailed below:
- --------------------------------------------------------------------------------
December 31, 2003 2002
- --------------------------------------------------------------------------------
Deferred tax assets:
Reserves and allowances $ 125 $ 143
Deferred compensation and employee benefits 103 95
Property and equipment leasing 26 28
Net loss on cash flow hedging instruments 12 25
Foreign investments - 19
Other 11 11
- --------------------------------------------------------------------------------
Total deferred assets 277 321
- --------------------------------------------------------------------------------
Deferred tax liabilities:
Capitalized internal-use software development
costs (55) (65)
Depreciation and amortization (13) (7)
Net unrealized gains on securities
available for sale (3) (16)
- --------------------------------------------------------------------------------
Total deferred liabilities (71) (88)
- --------------------------------------------------------------------------------
Net deferred tax asset $ 206 $ 233
================================================================================
The Company determined that no valuation allowance against deferred tax
assets at December 31, 2003 and 2002 was necessary.
The effective income tax rate on income before loss from discontinued
operations and extraordinary gain differs from the amount computed by applying
the federal statutory income tax rate as follows:
- --------------------------------------------------------------------------------
Year Ended December 31, 2003 2002 2001
- --------------------------------------------------------------------------------
Federal statutory income tax rate 35.0% 35.0% 35.0%
State income taxes, net of
federal tax benefit 1.6 1.1 1.1
Goodwill amortization - - 11.5
Variable life insurance (.4) 1.0 (5.1)
Restructuring of international operations - - (3.8)
Non-deductible penalties - - 2.0
(Gain) write-down on investment (2.0) 5.6 -
Merger-related costs (1.5) - -
Other charges .8 (2.2) (.6)
- --------------------------------------------------------------------------------
Effective income tax rate 33.5% 40.5% 40.1%
================================================================================
The effective income tax rate including loss from discontinued operations
and extraordinary gain was 33.5% in 2003, 42.6% in 2002, and 44.1% in 2001.
19. Employee Incentive and Deferred Compensation Plans
Stock Option Plans
The Company's stock incentive plans provide for granting options to
employees, officers, and directors. Options are granted for the purchase of
shares of common stock at an exercise price not less than market value on the
date of grant, and expire within ten years from the date of grant. Options
generally vest over a four-year period from the date of grant.
- 38 -
A summary of option activity follows:
- ------------------------------------------------------------------------------------------------------------------------------------
2003 2002 2001
-------------------------- ---------------------------- ----------------------------
Weighted- Weighted- Weighted-
Number Average Number Average Number Average
of Exercise of Exercise of Exercise
Options Price Options Price Options Price
- ------------------------------------------------------------------------------------------------------------------------------------
Outstanding at
beginning of year 156 $ 15.38 153 $ 16.20 97 $ 16.46
Granted 2 $ 9.39 26 $ 11.32 68 $ 15.43
Exercised (6) $ 6.21 (6) $ 6.59 (6) $ 4.73
Canceled (1) (16) $ 18.84 (17) $ 19.39 (6) $ 24.10
- ------------------------------------------------------------------------------------------------------------------------------------
Outstanding at
end of year 136 $ 15.25 156 $ 15.38 153 $ 16.20
====================================================================================================================================
Exercisable at
end of year 90 $ 15.03 77 $ 12.93 54 $ 11.31
- ------------------------------------------------------------------------------------------------------------------------------------
Available for
future grant at
end of year 44 41 50
- ------------------------------------------------------------------------------------------------------------------------------------
Weighted-average
fair value of
options granted
during the year (2) $ 4.20 $ 5.35 $ 7.26
- ------------------------------------------------------------------------------------------------------------------------------------
(1) In 2002, 5 million options were voluntarily rescinded by the Chief Executive Officer and the Chairman of the Board. The
weighted-average exercise price of these options is $17.04 and the weighted-average fair value is $8.03.
(2) The fair value of options granted is estimated as of the grant date using the Black-Scholes option pricing model. See
discussion in note "2 - Significant Accounting Policies - Stock-based Compensation."
Options outstanding and exercisable are as follows:
- ------------------------------------------------------------------------------------------------------------------------------------
December 31, 2003
- ------------------------------------------------------------------------------------------------------------------------------------
Options Outstanding Options Exercisable
--------------------------------------------- -------------------------------------
Weighted-
Average Weighted- Weighted-
Remaining Average Average
Range of Number Contractual Exercise Number Exercise
Exercise Prices of Options Life (in years) Price of Options Price
- ------------------------------------------------------------------------------------------------------------------------------------
$ 1.00 to $ 7.00 15 2.0 $ 3.94 15 $ 3.94
$ 7.01 to $ 10.00 25 5.7 $ 8.74 17 $ 8.34
$ 10.01 to $ 15.00 31 7.7 $ 11.95 14 $ 11.95
$ 15.01 to $ 19.00 26 7.1 $ 15.43 16 $ 15.45
$ 19.01 to $ 26.00 17 5.8 $ 22.05 13 $ 22.51
$ 26.01 to $ 40.00 22 6.0 $ 29.62 15 $ 29.63
-----------------------------------------------------------------------------------------------------------------------------------
$ 1.00 to $ 40.00 136 6.0 $ 15.25 90 $ 15.03
====================================================================================================================================
Restricted Stock and Long-term Incentive Plans
The Company's stock incentive plans provide for granting restricted stock
awards to employees and officers. Restricted stock awards are restricted from
transfer or sale and generally vest over a four-year period, but some vest based
upon the Company achieving certain financial or other measures.
In 2003, the Company awarded to eligible officers long-term incentive plan
(LTIP) units and restricted stock under a new long-term incentive program. These
awards are restricted from transfer or sale and generally vest over a four-year
period. The cash payout of the LTIP units at the end of the vesting period is
based upon the Company achieving certain cumulative EPS levels.
Restricted stock and LTIP unit information is as follows:
- --------------------------------------------------------------------------------
2003 2002 2001
- --------------------------------------------------------------------------------
Restricted stock awards (shares) 11 2 -
Average market price of awarded shares $ 8.75 $10.44 $18.15
Restricted shares outstanding (at year end) 13 4 5
Restricted stock amortization $ 27 $ 22 $ 27
LTIP unit compensation amortization $ 9 - -
- --------------------------------------------------------------------------------
Other Deferred Compensation Plans
The Company sponsors deferred compensation plans for both officers and
non-employee directors. The Company's deferred compensation plan for officers
permits participants to defer the payment of certain cash compensation. The
deferred compensation liability was $207 million and $184 million at
December 31, 2003 and 2002, respectively. The Company's deferred compensation
plan for non-employee directors permits participants to defer receipt of all or
a portion of their directors' fees and to receive either a grant of stock
options, or upon ceasing to serve as a director, the number of shares of CSC's
common stock that would have resulted from investing the deferred fee amount
into CSC's common stock.
20. Retirement and Other Employee Benefit Plans
The Company's retirement and other employee benefit plans consist of CSC's
and U.S. Trust's plans that were in effect prior to the merger with USTC in
2000. The following summarizes such plans.
Retirement Plans
Eligible employees of the Company who have met certain service requirements
may participate in the Company's qualified retirement plan, the SchwabPlan(R)
401(k) Retirement Savings and Investment Plan (SchwabPlan). The Company may
match certain employee contributions or make additional contributions to this
plan at its discretion. Total company contribution expense was $3 million in
2003, $47 million in 2002, and $49 million in 2001. The decrease in expense in
2003 was due to the Company's suspension of contributions beginning in the first
quarter of 2003, except for a discretionary award to certain non-officer
employees made in the fourth quarter of 2003.
U.S. Trust sponsors a 401(k) Plan and ESOP covering all U.S. Trust
employees who have met the specified service requirement. U.S. Trust matches
certain employees' U.S. Trust 401(k) plan contributions in the form of common
stock. Total contribution expense under the U.S. Trust 401(k) Plan was
$9 million in 2002 and $7 million in 2001. There was no expense in 2003 as the
Company suspended contributions beginning in the first quarter of 2003. At both
December 31, 2003 and 2002, the U.S. Trust ESOP held a total of 6 million shares
of common stock.
- 39 -
Pension and Other Postretirement Benefits
U.S. Trust maintains a trustee managed, noncontributory, qualified defined
benefit pension plan for the benefit of eligible U.S. Trust employees, the U.S.
Trust Corporation Employees' Retirement Plan (the Pension Plan).
U.S. Trust provides certain health care and life insurance benefits for
active employees and certain qualifying retired employees and their dependents.
Postretirement medical and life insurance benefits are accrued during the years
that the employee renders service to reflect the expected cost of providing
health care and life insurance and other benefits to an employee upon
retirement.
The following table summarizes the components of retirement and
postretirement benefit expenses (credits), the funded status of U.S. Trust's
qualified retirement plan, changes in the benefit obligations related to these
plans and the major assumptions used to determine these amounts.
- 40 -
2003 2002 2001
---------------------------- ---------------------------- ----------------------------
Pension Health Pension Health Pension Health
Plan & Life(1) Total Plan & Life Total Plan & Life Total
- ------------------------------------------------------------------------------------------------------------------------------------
Change in benefit obligation:
Benefit obligation at beginning
of year $ 281 $ 21 $ 302 $ 248 $ 20 $ 268 $ 211 $ 20 $ 231
Service cost, including expenses 13 - 13 13 - 13 9 - 9
Interest cost 19 1 20 18 2 20 17 1 18
Amendments (2) (49) - (49) (1) - (1) 4 - 4
Actuarial loss 31 - 31 13 1 14 16 - 16
Benefits and expenses paid (12) (1) (13) (10) (2) (12) (9) (1) (10)
- ------------------------------------------------------------------------------------------------------------------------------------
Pension benefit obligation at end
of year $ 283 $ 21 $ 304 $ 281 $ 21 $ 302 $ 248 $ 20 $ 268
====================================================================================================================================
Change in plan assets:
Fair value of plan assets at
beginning of year $ 252 - $ 252 $ 281 - $ 281 $ 369 - $ 369
Actual gain (loss) on plan assets 44 - 44 (19) - (19) (78) - (78)
Employer contribution - $ 1 1 - $ 1 1 - $ 1 1
Benefits and expenses paid (12) (1) (13) (10) (1) (11) (10) (1) (11)
- ------------------------------------------------------------------------------------------------------------------------------------
Fair value of plan assets at end
of year $ 284 - $ 284 $ 252 - $ 252 $ 281 - $ 281
====================================================================================================================================
Funded Status $ 1 $ (21) $ (20) $ (29) $ (21) $ (50) $ 34 $ (20) $ 14
Unrecognized net actuarial loss
(gain) 85 (1) 84 74 - 74 10 (1) 9
Unrecognized prior service cost
(benefit) (45) - (45) 4 (1) 3 5 (1) 4
- ------------------------------------------------------------------------------------------------------------------------------------
Net amount recognized $ 41 $ (22) $ 19 $ 49 $ (22) $ 27 $ 49 $ (22) $ 27
====================================================================================================================================
Amount recognized in the balance
sheet consists of:
Prepaid benefit cost $ 41 - $ 41 $ 49 - $ 49 $ 49 - $ 49
Accrued benefit costs - $ (22) (22) - $ (22) (22) - $ (22) (22)
- ------------------------------------------------------------------------------------------------------------------------------------
Net amount recognized $ 41 $ (22) $ 19 $ 49 $ (22) $ 27 $ 49 $ (22) $ 27
====================================================================================================================================
Components of net periodic
benefit cost:
Service cost and expenses $ 13 - $ 13 $ 13 - $ 13 $ 9 - $ 9
Interest cost 19 $ 1 20 18 $ 1 19 17 $ 1 18
Expected return on plan assets (24) - (24) (30) - (30) (31) - (31)
Amortization of net gain - - - (1) - (1) (5) - (5)
Amortization of transition asset - - - - - - (2) - (2)
- ------------------------------------------------------------------------------------------------------------------------------------
Net periodic benefit expense
(credit) (3) $ 8 $ 1 $ 9 $ - $ 1 $ 1 $ (12) $ 1 $ (11)
====================================================================================================================================
Additional information
Increase in additional minimum
liability included in other
comprehensive income - N/A - N/A - N/A
- ------------------------------------------------------------------------------------------------------------------------------------
Weighted-average assumptions used
to determine benefit obligations
Discount rate 6.00% 6.00% 6.75% 6.75% 7.50% 7.50%
Rate of increase in
compensation (4) 5.25% 5.25% 5.30% 5.30% 6.10% 6.10%
Measurement date Sept. 30, Sept. 30, Sept. 30, Sept. 30, Sept. 30, Sept. 30,
2003 2003 2002 2002 2001 2001
Weighted-average assumptions used
to determine net periodic
benefit cost
Discount rate 6.75% 6.75% 7.50% 7.50% 8.00% 8.00%
Rate of increase in
compensation (4) 5.30% 5.30% 6.18% 6.18% 6.10% 6.10%
Expected rate of return on plan
assets 8.25% N/A 9.00% N/A 9.00% N/A
- ------------------------------------------------------------------------------------------------------------------------------------
(1) The Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the Medicare Act) became effective in December 2003
and may impact the measurement of postretirement medical benefits costs through a federal subsidy. The impact of the Medicare
Act is not included in the year-end benefit obligation or net expense. Specific authoritative guidance on accounting for the
federal subsidy is pending and the issued guidance could require the Company to change previously reported information.
(2) In 2003, U.S. Trust amended the Pension Plan with respect to the computation of retirement benefits earned by qualifying
employees hired on or before December 31, 2001.
(3) The pension expense (credit) and postretirement benefit expense are determined using the assumptions as of the beginning of the
year. The benefit obligations and the funded status are determined using the assumptions as of the end of the year. The
measurement date of the Plan is September 30.
(4) In 2003, the assumed rate of increase in compensation is based on the age-related table with assumed rates of increase in
compensation ranging from 8.0% to 3.0%.
N/A Not applicable.
- 41 -
The accumulated benefit obligation for the Pension Plan was $283 million
and $240 million at December 31, 2003 and 2002, respectively.
To develop the expected long-term rate of return on assets assumption,
U.S. Trust considered the current level of expected returns on risk free
investments (primarily government bonds), the historical level of risk premium
associated with other classes in which the portfolio is invested and the
expectations for future returns of each asset class. The expected return for
each asset class was then weighted based on the target asset allocation to
develop the expected long-term rate of return on assets assumption for the
portfolio. This resulted in the selection of the 8.25% expected long-term rate
of return on assets assumption as of September 30, 2002 for the year 2003.
The assumed rate of future increases in per capita cost of health care
benefits (the health care cost trend rate) is 11.0% at December 31, 2003,
decreasing gradually to 5.5% by the year 2009. A one-percentage-point change in
the assumed health care cost trend rates would have an immaterial effect on the
postretirement benefit obligation, as well as on service and interest costs.
The Pension Plan's weighted average asset allocations at September 30, 2003
and 2002, by asset category are as follows:
- --------------------------------------------------------------------------------
Plan Assets
Asset category 2003 2002
- --------------------------------------------------------------------------------
Equity securities 60% 54%
Debt securities 34% 43%
Other 6% 3%
- --------------------------------------------------------------------------------
Total 100% 100%
================================================================================
The goals of the asset strategy are to ensure that the principal of the
Pension Plan is preserved and enhanced over the long term, both in real and
nominal terms, manage (control) risk exposure, and exceed the funding
requirement over a market cycle (3 to 5 years).
Risk is managed by investing in a broad range of asset classes, and within
those classes, a broad range of individual securities.
The Pension Plan's Investment Committee, which oversees the investment of
Pension Plan assets, conducted a review of the Investment Strategies and
Policies of the Pension Plan in the fourth quarter of 2003. This included a
review of the strategic asset allocation, including the relationship of Pension
Plan assets to Pension Plan liabilities and portfolio structure. As a result of
this review, the Investment Committee has adopted a target asset allocation and
modified the ranges:
- --------------------------------------------------------------------------------
Low Target High
- --------------------------------------------------------------------------------
Debt securities 30% 35% 40%
Equity securities 60% 65% 70%
- --------------------------------------------------------------------------------
The equity securities category includes real estate/Real Estate Investment
Trusts (REITS) and alternative investments. The allocation to real estate/REITS
and alternative investments is still to be determined. The new Investment
Strategy and Policies will be implemented in 2004. As a result of the review of
the Pension Plan's liability structure, the average duration of the debt
securities will be lengthened from approximately 4.5 years to 11 years to
provide a better match to the duration of the liabilities.
Equity securities include shares of the common stock of CSC in the amounts
of $3 million (1% of total plan assets) at both September 30, 2003 and 2002.
U.S. Trust's funding policy is to make contributions consistent with
Federal laws and regulations. No contributions are expected to be made to the
Pension Plan during 2004, while $1 million is expected to be paid with respect
to postretirement benefits plans in 2004.
- 42 -
21. Accumulated Other Comprehensive Income (Loss)
Accumulated other comprehensive income (loss) represents cumulative gains
and losses that are not reflected in earnings. The components of accumulated
other comprehensive income (loss) are as follows:
- --------------------------------------------------------------------------------
2003 2002 2001
- --------------------------------------------------------------------------------
Net loss on cash flow hedging
instruments, net of tax:
Beginning balance $ (37) $ (31) -
Cumulative effect of accounting
change for adoption
of SFAS No. 133 - - $ (12)
Change during the year 19 (6) (19)
- --------------------------------------------------------------------------------
Ending balance $ (18) $ (37) $ (31)
================================================================================
Net unrealized gain (loss) on securities
available for sale, net of tax:
Beginning balance $ 24 $ 7 $ (3)
Net unrealized (loss) gain arising
during the year (19) 15 8
Reclassification adjustment for
realized loss included in net income - 2 2
- --------------------------------------------------------------------------------
Ending balance $ 5 $ 24 $ 7
================================================================================
Foreign currency translation adjustment:
Beginning balance $ (5) $ (13) $ (11)
Change during the year 5 8 (2)
- --------------------------------------------------------------------------------
Ending balance - $ (5) $ (13)
================================================================================
Total accumulated other comprehensive
income (loss), net of tax:
Beginning balance $ (18) $ (37) $ (14)
Change during the year 5 19 (23)
- --------------------------------------------------------------------------------
Ending balance $ (13) $ (18) $ (37)
================================================================================
22. Earnings Per Share
Basic EPS excludes dilution and is computed by dividing net income by the
weighted-average number of common shares outstanding for the period. Diluted EPS
reflects the potential reduction in EPS that could occur if securities or other
contracts to issue common stock were exercised or converted into common stock.
EPS under the basic and diluted computations are as follows:
- --------------------------------------------------------------------------------
Year Ended December 31, 2003 2002 2001
- --------------------------------------------------------------------------------
Net income $ 472 $ 109 $ 199
================================================================================
Weighted-average common
shares outstanding - basic 1,342 1,358 1,373
Common stock equivalent shares
related to stock incentive plans 22 17 26
- --------------------------------------------------------------------------------
Weighted-average common
shares outstanding - diluted 1,364 1,375 1,399
================================================================================
Basic EPS:
Income from continuing operations
before extraordinary gain $ .35 $ .10 $ .08
Loss from discontinued operations,
net of tax - $ (.03) $ (.02)
Extraordinary gain, net of tax - $ .01 $ .08
Net income $ .35 $ .08 $ .14
================================================================================
Diluted EPS:
Income from continuing operations
before extraordinary gain $ .35 $ .10 $ .08
Loss from discontinued operations,
net of tax - $ (.03) $ (.02)
Extraordinary gain, net of tax - $ .01 $ .08
Net income $ .35 $ .08 $ .14
================================================================================
The computation of diluted EPS for the years ended December 31, 2003, 2002,
and 2001, respectively, excludes outstanding stock options to purchase
107 million, 111 million, and 83 million shares, respectively, because the
exercise prices for those options were greater than the average market price of
the common shares, and therefore the effect would be antidilutive.
23. Regulatory Requirements
CSC is a financial holding company, which is a type of bank holding company
subject to supervision and regulation by the Federal Reserve Board under the
Bank Holding Company Act of 1956, as amended (the Act).
The Gramm-Leach-Bliley Act (the GLB Act), permits financial holding
companies to engage in activities that are financial in nature, including
banking, securities brokerage, underwriting, dealing in or making a market in
securities, investment management services and insurance activities. The Federal
Reserve Board may impose limitations,
- 43 -
restrictions, or prohibitions on the activities or acquisitions of a financial
holding company if the Federal Reserve Board believes that the company does not
have the appropriate financial and managerial resources to commence or conduct
an activity, make an acquisition, or retain ownership of a company. The Federal
Reserve Board may also take actions as appropriate to enforce applicable federal
law.
Federal Reserve Board policy provides that a bank holding company generally
should not pay cash dividends unless its net income is sufficient to fully fund
the dividends and the company's prospective retained earnings appear to be
sufficient to meet the capital needs, asset quality and overall financial
condition of the holding company and its depository institution subsidiaries.
CSC's primary depository institution subsidiaries are United States Trust
Company of New York (U.S. Trust NY), U.S. Trust Company, National Association
(U.S. Trust NA), and Schwab Bank. The operations and financial condition of
CSC's depository institution subsidiaries are subject to regulation and
supervision and to various requirements and restrictions under federal and state
law, including requirements governing: transactions with CSC and its
non-depository institution subsidiaries, loans and other extensions of credit,
investments or asset purchases, or otherwise financing or supplying funds to
CSC; dividends; investments; and aspects of CSC's operations. The federal
banking agencies have broad powers to enforce these regulations, including the
power to terminate deposit insurance, impose substantial fines and other civil
and criminal penalties and appoint a conservator or receiver. CSC, U.S. Trust,
and their U.S.-based insured depository institution subsidiaries must meet
regulatory capital guidelines adopted by the federal banking agencies. Under the
Federal Deposit Insurance Act, the banking regulatory agencies are permitted or,
in certain cases, required to take certain substantial restrictive actions with
respect to institutions falling within one of the lowest three of five capital
categories.
Under the Act, the Federal Reserve Board has established consolidated
capital requirements for bank holding companies. CSC is subject to those
guidelines. The GLB Act prohibits the Federal Reserve Board from imposing
capital requirements on functionally regulated non-depository institution
subsidiaries of a financial holding company, such as broker-dealers and
investment advisors.
The regulatory capital and ratios of the Company, U.S. Trust, U.S. Trust
NY, U.S. Trust NA, and Schwab Bank are as follows:
- --------------------------------------------------------------------------------
2003 2002
--------------- ---------------
December 31, Amount Ratio(1) Amount Ratio(1)
- --------------------------------------------------------------------------------
Tier 1 Capital:
Company $ 3,569 20.3% $ 3,477 22.5%
U.S. Trust $ 653 15.4% $ 600 16.5%
U.S. Trust NY $ 357 10.4% $ 360 12.1%
U.S. Trust NA (2) $ 252 33.7% $ 220 36.0%
Schwab Bank (3) $ 277 35.1% - -
Total Capital:
Company $ 3,598 20.4% $ 3,505 22.7%
U.S. Trust $ 679 16.0% $ 624 17.1%
U.S. Trust NY $ 380 11.1% $ 380 12.8%
U.S. Trust NA (2) $ 255 34.1% $ 223 36.5%
Schwab Bank (3) $ 278 35.2% - -
Leverage:
Company $ 3,569 8.2% $ 3,477 9.2%
U.S. Trust $ 653 8.5% $ 600 9.2%
U.S. Trust NY $ 357 5.5% $ 360 6.8%
U.S. Trust NA (2) $ 252 18.5% $ 220 15.2%
Schwab Bank (3) $ 277 13.4% - -
- --------------------------------------------------------------------------------
(1) Minimum tier 1 capital, total capital, and tier 1 leverage ratios are 4%,
8%, and 3%-5%, respectively, for bank holding companies and banks.
Additionally, Schwab Bank is subject to a minimum tier 1 leverage ratio of
8% for its first three years of operations. Well-capitalized tier 1
capital, total capital, and tier 1 leverage ratios are 6%, 10%, and 5%,
respectively. Each of CSC's other depository institution subsidiaries
exceed the well-capitalized standards set forth by the banking regulatory
authorities.
(2) During 2003, U.S. Trust consolidated its regional subsidiary banks located
outside of New York and New Jersey into U.S. Trust NA, a single
nationally-chartered banking entity. 2002 amounts and ratios have been
calculated based on this consolidation.
(3) Schwab Bank commenced operations in the second quarter of 2003. Therefore,
Schwab Bank regulatory capital and ratios are not presented for 2002.
Based on their respective regulatory capital ratios at December 31, 2003
and 2002, the Company, U.S. Trust, U.S. Trust NY, and U.S. Trust NA are
considered well capitalized pursuant to Federal Reserve Board guidelines (the
highest category). Additionally, based on its regulatory capital ratios at
December 31, 2003, Schwab Bank is also considered well capitalized. There are no
conditions or events that management believes have changed the Company's,
U.S. Trust's, U.S. Trust NY's, U.S. Trust NA's, or Schwab Bank's
well-capitalized status.
In addition, financial holding companies must be well managed and their
depository institution subsidiaries must be rated satisfactory or better in
meeting the Community Reinvestment Act of 1977 lending requirements. At
December 31, 2003, CSC and its depository institution subsidiaries met all the
above requirements.
CSC's depository institution subsidiaries are required, under federal
regulations, to maintain reserve balances at the Federal Reserve Bank based on
deposit levels. These amounts are included in cash and investments segregated
and
- 44 -
on deposit for federal or other regulatory purposes. The average balances were
$57 million in 2003 and $49 million in 2002.
On May 13, 2003, the Federal Reserve Board and the Superintendent of Banks
of the State of New York terminated a cease and desist order issued in 2001 (the
2001 order) against USTC and U.S. Trust NY (collectively, USTC/USTNY) for
alleged violations of various reporting and recordkeeping requirements. The 2001
order had required USTC/USTNY to take a number of steps to review and improve
its risk management processes and systems with respect to the Bank Secrecy Act
and banking and securities laws. The termination of the 2001 order represents
the successful completion of USTC/USTNY's remediation efforts under the 2001
order.
In 2003, the Company implemented a value-at-risk (VaR) model to estimate
the market risks associated with its inventory portfolios. The Federal Reserve
Board requires certain bank holding companies to use VaR in determining their
tier 1 capital and total capital ratios. The implementation of VaR had the
effect of increasing both the Company's tier 1 capital and total capital ratios
by .6% at December 31, 2003.
Schwab and SCM are subject to the Uniform Net Capital Rule under the
Securities Exchange Act of 1934 (the Rule). Schwab and SCM compute net capital
under the alternative method permitted by this Rule. This method requires the
maintenance of minimum net capital, as defined, of the greater of 2% of
aggregate debit balances arising from client transactions or a minimum dollar
requirement, which is based on the type of business conducted by the
broker-dealer. The minimum dollar requirement for both Schwab and SCM is
$1 million. Under the alternative method, a broker-dealer may not repay
subordinated borrowings, pay cash dividends, or make any unsecured advances or
loans to its parent or employees if such payment would result in net capital of
less than 5% of aggregate debit balances or less than 120% of its minimum dollar
requirement. At December 31, 2003, Schwab's net capital was $1.2 billion (14% of
aggregate debit balances), which was $1.1 billion in excess of its minimum
required net capital and $797 million in excess of 5% of aggregate debit
balances. At December 31, 2003, SCM's net capital was $74 million, which was
$73 million in excess of its minimum required net capital.
Schwab and SCM had portions of their cash and investments segregated for
the exclusive benefit of clients at December 31, 2003, in accordance with
applicable regulations.
24. Commitments and Contingent Liabilities
Operating leases and other commitments: The Company has noncancelable
operating leases for office space and equipment. Future minimum rental
commitments, including guaranteed residual values (discussed below under
Guarantees) and which are net of sublease commitments, under these leases at
December 31, 2003 are as follows:
- --------------------------------------------------------------------------------
2004 $ 239
2005 188
2006 161
2007 165
2008 136
Thereafter 652
- --------------------------------------------------------------------------------
Total $ 1,541
================================================================================
Certain leases contain provisions for renewal options, purchase options and
rent escalations based on increases in certain costs incurred by the lessor.
Rent expense was $300 million in 2003, $312 million in 2002, and $345 million in
2001. At December 31, 2003, the Company had other commitments totaling
$4 million, which include committed capital contributions to venture capital
funds.
Guarantees: Upon adoption of FIN No. 46 in the first quarter of 2003, the
Company consolidated a special purpose trust and recorded a note payable of
$235 million, which the Company has guaranteed up to a maximum of $202 million.
See note "2 - Significant Accounting Policies - New Accounting Standards" for
further discussion of this consolidation.
The Company provides certain indemnifications (i.e., protection against
damage or loss) to counterparties in connection with the disposition of certain
of its assets. Such indemnifications typically relate to title to the assets
transferred, ownership of intellectual property rights (e.g., patents), accuracy
of financial statements, compliance with laws and regulations, failure to pay,
satisfy or discharge any liability, or to defend claims, as well as errors,
omissions, and misrepresentations. These indemnification agreements have various
expiration dates and the Company's liability under these agreements is generally
limited to certain maximum amounts. At December 31, 2003, the Company's maximum
potential liability under these indemnification agreements is limited to
approximately $100 million. The Company does not believe that any material loss
related to such indemnifications is likely and therefore no liability for these
indemnifications has been recognized.
Standby letters of credit (LOCs) are conditional commitments issued by
U.S. Trust to guarantee the performance of a client to a third party. For
example, LOCs can be used to guarantee performance under lease and other
agreements by professional business corporations and for other purposes. The
credit risk involved in issuing LOCs is essentially the same as that involved in
extending loans.
- 45 -
LOCs are generally partially or fully collateralized by cash, marketable equity
securities, marketable debt securities (including corporate and U.S. Treasury
debt securities), and other assets. At December 31, 2003, U.S. Trust had LOCs
outstanding totaling $64 million which are short-term in nature and generally
expire within one year. At December 31, 2003, the liability recorded for these
LOCs is immaterial.
The Company has clients that sell (i.e., write) listed option contracts
that are cleared by various clearing houses. The clearing houses establish
margin requirements on these transactions. The Company satisfies the margin
requirements by arranging LOCs, in favor of the clearing houses, that are
guaranteed by multiple banks. At December 31, 2003, the outstanding value of
these LOCs totaled $630 million. No funds were drawn under these LOCs at
December 31, 2003.
In accordance with FIN No. 45, the Company recognizes, at the inception of
a guarantee, a liability for the estimated fair value of the obligation
undertaken in issuing the guarantee. The fair values of the obligations relating
to LOCs are estimated based on fees charged to enter into similar agreements,
considering the creditworthiness of the counterparties. The fair values of the
obligations relating to other guarantees are estimated based on transactions for
similar guarantees or expected present value measures. The Company does not
believe that any material loss related to indemnification agreements or LOCs is
likely and therefore at December 31, 2003, the liabilities recorded for these
guarantees are immaterial.
The Company also provides guarantees to securities clearing houses and
exchanges under their standard membership agreement, which requires members to
guarantee the performance of other members. Under the agreement, if another
member becomes unable to satisfy its obligations to the clearing houses and
exchanges, other members would be required to meet shortfalls. The Company's
liability under these arrangements is not quantifiable and may exceed the cash
and securities it has posted as collateral. However, the potential requirement
for the Company to make payments under these arrangements is remote.
Accordingly, no liability has been recognized for these transactions.
The Company has provided residual value guarantees to the lessors in
connection with operating leases used to finance two corporate aircraft and a
fractional interest in a third airplane. These guarantees mean that if the
airplanes are sold to third parties at the expiration of the leases, the Company
is responsible for making up any shortfalls between the sales prices and
specified amounts. At December 31, 2003, the maximum amounts of residual value
guarantees under these leases totaled $15 million expiring in 2004 and
$19 million expiring in 2007. The Company believes that proceeds from the sales
of these airplanes would be sufficient to cover the residual value guarantees
and therefore no liabilities for these guarantees have been recognized.
Legal contingencies: Between November 2003 and January 2004, five purported
class action lawsuits were filed against CSC, USTC, U.S. Trust NY, Schwab, and
the Excelsior Funds in connection with alleged market-timing in the Excelsior
Funds. The lawsuits seek an unspecified amount of monetary damages on behalf of
a putative class of individuals who bought, sold, or held shares in the
Excelsior Funds between 1998 and 2003. The lawsuits allege that the defendants
breached their fiduciary duties and violated various federal securities laws,
including the Securities Act of 1933, the Securities Exchange Act of 1934 and
the Investment Company Act of 1940, by permitting market-timing in the Excelsior
Funds and by failing to disclose such timing in the fund prospectuses. Three of
the lawsuits are pending in federal courts in the Southern District of New York
and two of the lawsuits are pending in different federal courts in California.
In November 2003, the Charles Schwab Trust Company (CSTC) was named in two
lawsuits filed in U.S. District Court in the Northern District of Colorado as a
result of its role as directed trustee of the retirement plans for employees of
the Janus Capital Group (Janus). The lawsuits, which also name Janus and several
of its officers and directors, are brought on behalf of a putative class of
Janus employees. The lawsuits allege that CSTC knew or should have known that
there was market-timing and/or late trading in the Janus mutual funds and
breached its duties as trustee under the Employee Retirement Income Security Act
by permitting Janus employees to invest in Janus mutual funds or Janus common
stock in their retirement plans. The lawsuits seek an unspecified amount of
compensatory damages in the amount of the losses suffered by the retirement
plans to be allocated among the participants' individual accounts. CSTC has a
contract with Janus that requires Janus to indemnify CSTC for any expenses
associated with the litigation. The defendants intend to vigorously defend
against the lawsuits.
In 2001, three purported class action complaints and a number of related
individual cases were filed against U.S. Trust NY and other defendants. In some
of these cases, U.S. Trust NA was also named as a defendant. With the exception
of a small number of individual cases pending in state court in Montana, the
cases were all consolidated in a single proceeding pending in California state
court in Los Angeles. The plaintiffs in all of these cases are former personal
injury plaintiffs (Payees) who are entitled to future payments under "structured
settlement" agreements. The settlement payments are obligations of Stanwich
Financial Services Corp. (Stanwich), as Trustor of certain trusts, and Stanwich
defaulted on certain of those obligations. U.S. Trust NA served as Trustee of
the trusts from approximately December 1992 to March 1994, and U.S. Trust NY
served as Trustee from approximately September 1998 until approximately April
2001. At some time during the period from March 1994 to September 1998, while an
unrelated
- 46 -
trust company was the Trustee of the trusts, the U.S. Treasury securities held
by the trusts were pledged as collateral for a loan or loans and then lost
through foreclosure. In the complaints, the plaintiffs alleged that, as Trustee
during their respective tenures, U.S. Trust NY and U.S. Trust NA owed certain
duties to the Payees, and breached those duties in various ways. The plaintiffs
in these cases sought unspecified compensatory damages, punitive damages and
other relief. In October 2003, U.S. Trust NY and U.S. Trust NA reached a
settlement with the plaintiffs. Under the terms of this settlement, plaintiffs
released U.S. Trust NY and U.S. Trust NA of all liability in exchange for a
payment which, other than an immaterial deductible, was fully funded by U.S.
Trust's insurance carrier. See note "29 - Subsequent Events" for further
discussion on this case.
U.S. Trust Company of Texas, N.A. (US Trust Texas) was indenture trustee
for various offerings of approximately $130 million in municipal bonds that were
used to finance the development of healthcare facilities by the Heritage
entities (the Heritage Bonds), which subsequently went into default. Between
October 2001 and March 2003, a total of four individual and five class action
lawsuits have been filed against US Trust Texas and other defendants, including,
in some instances, USTC. The class actions and two of the individual actions
have been consolidated in the United States District Court for the Central
District of California. One individual action is pending in California state
court and one individual action is pending in Texas state court. In each of
these actions, plaintiffs seek to hold the defendants liable for losses that the
plaintiffs sustained in connection with the defaults of the Heritage Bond
Offerings.
Although USTC sold its Corporate Trust business in 2001, under the sale
agreement, USTC retains responsibility for certain litigation, including these
cases. In the complaints, the plaintiffs allege that, as indenture trustee, US
Trust Texas breached certain duties owed to the plaintiffs. In the consolidated
class action, the plaintiffs and putative class seek an unspecified amount of
compensatory damages, punitive damages, and other relief. In one of the federal
individual actions (Betker Action), plaintiffs seek unspecified compensatory
damages, punitive damages, and other relief. In the other federal individual
action (Heartland Action), the representative plaintiff seeks compensatory
damages of approximately $5 million, punitive damages, and other relief. In the
California state court action (Talley Action), plaintiff seeks unspecified
compensatory damages, punitive damages, and other relief. In the Texas state
court action (Dye Action), plaintiffs seek compensatory damages in excess of
$20 million, punitive damages, and other relief. US Trust Texas and USTC have
answered the complaints and brought cross-claims against certain third parties
whose actions they believe caused or contributed to the default of the bonds.
US Trust Texas and USTC intend to defend the cases vigorously.
The nature of the Company's business subjects it to claims, lawsuits,
regulatory examinations, and other proceedings in the ordinary course of
business. The ultimate outcome of the matters described above and the various
other lawsuits, arbitration proceedings, and claims pending against the Company
cannot be determined at this time, and the results of these matters cannot be
predicted with certainty. There can be no assurance that these matters will not
have a material adverse effect on the Company's results of operations in any
future period, depending partly on the results for that period, and a
substantial judgment could have a material adverse impact on the Company's
financial condition, results of operations, and cash flows. However, it is the
opinion of management, after consultation with legal counsel, that the ultimate
outcome of these existing claims and proceedings will not have a material
adverse impact on the financial condition, results of operations, or cash flows
of the Company.
25. Financial Instruments Subject to Off-Balance Sheet Risk, Credit Risk or
Market Risk
Securities lending: Through Schwab, the Company loans client securities
temporarily to other brokers in connection with its securities lending
activities. The Company receives cash as collateral for the securities loaned.
Increases in security prices may cause the market value of the securities loaned
to exceed the amount of cash received as collateral. In the event the
counterparty to these transactions does not return the loaned securities or
provide additional cash collateral, the Company may be exposed to the risk of
acquiring the securities at prevailing market prices in order to satisfy its
client obligations. The Company mitigates this risk by requiring credit
approvals for counterparties, by monitoring the market value of securities
loaned, and by requiring additional cash as collateral when necessary.
The Company is obligated to settle transactions with brokers and other
financial institutions even if its clients fail to meet their obligations to the
Company. Clients are required to complete their transactions on settlement date,
generally three business days after trade date. If clients do not fulfill their
contractual obligations, the Company may incur losses. The Company has
established procedures to reduce this risk by requiring deposits from clients in
excess of amounts prescribed by regulatory requirements for certain types of
trades, and therefore the potential for Schwab to make payments under these
client transactions is remote. Accordingly, no liability has been recognized for
these transactions.
Margin lending: Schwab provides margin loans to its clients which are
collateralized by securities in their brokerage accounts. These clients have
agreed to allow Schwab to pledge those securities in accordance with federal
regulations. Schwab was allowed, under such regulations, to
- 47 -
pledge securities with a market value of $12.0 billion and $9.4 billion at
December 31, 2003 and 2002, respectively. The market value of Schwab's client
securities pledged to fulfill the short sales of its clients was $1.1 billion
and $824 million at December 31, 2003 and 2002, respectively, and the market
value of Schwab's client securities pledged in securities lending transactions
to other broker-dealers was $2.3 billion and $1.3 billion at December 31, 2003
and 2002, respectively. The market value of Schwab's client securities pledged
to fulfill Schwab's and SCM's proprietary short sales was $35 million and $12
million at December 31, 2003 and 2002, respectively. Additionally, Schwab
borrows securities from other broker-dealers to fulfill short sales of its
clients. The market value of these borrowed securities was $229 million and $57
million at December 31, 2003 and 2002, respectively. Schwab has also pledged a
portion of its securities owned in order to fulfill the short sales of clients
and in connection with securities lending transactions to other broker-dealers.
The market value of these pledged securities was $2 million and $3 million at
December 31, 2003 and 2002, respectively. The Company may also pledge client
securities to fulfill client margin requirements for open option contracts
established with the OCC. The market value of these pledged securities to the
OCC was $424 million at December 31, 2003.
In the normal course of its margin lending activities, Schwab may be liable
for the margin requirement of client margin securities transactions. As clients
write options or sell securities short, the Company may incur losses if the
clients do not fulfill their obligations and the collateral in client accounts
is not sufficient to fully cover losses which clients may incur from these
strategies. To mitigate this risk, the Company monitors required margin levels
and clients are required to deposit additional collateral, or reduce positions,
when necessary.
Financial instruments held for trading purposes: In its capacity as market
maker, SCM maintains inventories in Nasdaq and other securities on both a long
and short basis. While long inventory positions represent SCM's ownership of
securities, short inventory positions represent SCM's obligations to deliver
specified securities at a contracted price, which may differ from market prices
prevailing at the time of completion of the transaction. Accordingly, both long
and short inventory positions may result in losses or gains to SCM as market
values of securities fluctuate. The Company maintains inventories on both a long
and short basis in exchange-listed securities relating to its proprietary equity
trading operations. Additionally, the Company maintains inventories in
securities on a long and short basis relating to its fixed income operations.
The Company could incur losses or gains as a result of changes in the market
value of these securities. To mitigate the risk of losses, long and short
positions are marked to market and are monitored by management to assure
compliance with limits established by the Company.
The Company may enter into exchange-traded futures and options contracts to
mitigate market risk on its inventory positions. There were no open futures or
options contracts at December 31, 2003. The notional amounts and fair values of
futures and options contracts are shown in the following table:
- --------------------------------------------------------------------------------
December 31, 2003 2002
- --------------------------------------------------------------------------------
Exchange-traded Contracts:
Net Short Futures (1):
Notional Amount - $ 63
Fair Value - $ 61
Long Put Options:
Notional Amount - $ 4
Fair Value (2) - -
- --------------------------------------------------------------------------------
(1) Notional amount represents original contract price of the futures. Fair
value represents the index price. The difference between the notional and
fair value amounts are settled daily in accordance with futures market
requirements.
(2) Amount was less than $1 million at December 31, 2002.
Resale and repurchase agreements: Schwab enters into collateralized resale
agreements principally with other broker-dealers, which could result in losses
in the event the counterparty to the transaction does not purchase the
securities held as collateral for the cash advanced and the market value of
these securities declines. To mitigate this risk, Schwab requires that the
counterparty deliver securities to a custodian, to be held as collateral, with a
market value in excess of the resale price. Schwab also sets standards for the
credit quality of the counterparty, monitors the market value of the underlying
securities as compared to the related receivable, including accrued interest,
and requires additional collateral where deemed appropriate. At December 31,
2003 and 2002, the market value of collateral received in connection with resale
agreements that is available to be repledged or sold was $17.2 billion and
$16.5 billion, respectively. U.S. Trust enters into repurchase agreements where
it sells its fixed income securities with an agreement to repurchase the
securities at a future specified date.
At December 31, 2003 and 2002, financial instruments in the amount of
$1.3 billion and $674 million, respectively, were pledged to secure public
deposits, to qualify for fiduciary powers and for other purposes or as
collateral for borrowings. Included in the above amounts at December 31, 2003
and 2002, the fair value of collateral pledged under repurchase agreements that
is available to be repledged or sold by the counterparties is $131 million and
$334 million, respectively.
Concentration risk: The Company's most significant concentration of risk is
its exposure to securities issued by the U.S. Government and its agencies (U.S.
Government). The Company's direct market risk exposure, primarily from
investments in securities available for sale, amounted to $1.6 billion at
December 31, 2003. The Company maintains indirect exposure to U.S. Government
securities held as
- 48 -
collateral to secure its resale agreements. The Company's primary credit
exposure on these resale transactions is with its counterparty. The Company
would have exposure to the U.S. Government securities only in the event of the
counterparty's default on the resale agreements. Securities issued by the U.S.
Government held as collateral for resale agreements at December 31, 2003 totaled
$17.2 billion.
Commitments to extend credit and LOCs: In the normal course of business,
U.S. Trust and Schwab Bank enter into various transactions involving off-balance
sheet financial instruments to meet the needs of its clients and to reduce its
own exposure to interest rate risk. The credit risk associated with these
instruments varies depending on the creditworthiness of the client and the value
of any collateral held. Collateral requirements vary by type of instrument. The
contractual amounts of these instruments represent the amounts at risk should
the contract be fully drawn upon, the client default, and the value of any
existing collateral become worthless.
Credit-related financial instruments include firm commitments to extend
credit (firm commitments) and LOCs. Firm commitments are legally binding
agreements to lend to a client that generally have fixed expiration dates or
other termination clauses, may require payment of a fee and are not secured by
collateral until funds are advanced. Collateral held includes marketable
securities, real estate mortgages or other assets. The majority of U.S. Trust
and Schwab Bank's firm commitments are related to mortgage lending to banking
clients. Firm commitments totaled $1.6 billion and $622 million at December 31,
2003 and 2002, respectively. LOCs outstanding at December 31, 2003 and 2002
amounted to $64 million and $71 million, respectively.
Interest rate swaps: As part of its consolidated asset and liability
management process, the Company utilizes Swaps to manage interest rate risk. The
market values of Swaps can vary depending on movements in interest rates. The
amounts at risk upon default are generally limited to the unrealized market
value gains of the Swaps, if any. The risk of default depends on the
creditworthiness of the counterparty. The Company evaluates the creditworthiness
of its counterparties as part of its normal credit review procedures.
U.S. Trust uses Swaps to hedge the interest rate risk associated with its
variable rate deposits from banking clients. The Swaps are structured for U.S.
Trust to receive a variable rate of interest and pay a fixed rate of interest.
Information on these Swaps is summarized in the following table:
- --------------------------------------------------------------------------------
December 31, 2003 2002
- --------------------------------------------------------------------------------
Notional principal amount $ 705 $ 790
Weighted-average variable interest rate 1.17% 1.57%
Weighted-average fixed interest rate 6.41% 6.38%
Weighted-average maturity (in years) 1.0 1.8
- --------------------------------------------------------------------------------
These Swaps have been designated as cash flow hedges under SFAS No. 133 and
are recorded on the Company's consolidated balance sheet, with changes in their
fair values primarily recorded in other comprehensive income (loss), a component
of stockholders' equity. At December 31, 2003 and 2002, U.S. Trust recorded a
derivative liability of $33 million and $64 million, respectively, for these
Swaps. Based on current interest rate assumptions and assuming no additional
Swap agreements are entered into, U.S. Trust expects to reclassify approximately
$26 million, or $15 million after tax, from other comprehensive loss to interest
expense over the next twelve months.
CSC uses Swaps to effectively convert the interest rate characteristics of
a portion of its Medium-Term Notes from fixed to variable. These Swaps are
structured for CSC to receive a fixed rate of interest and pay a variable rate
of interest based on the three-month LIBOR rate. The variable interest rates
reset every three months. Information on these Swaps is summarized in the
following table:
- --------------------------------------------------------------------------------
December 31, 2003 2002
- --------------------------------------------------------------------------------
Notional principal amount $ 293 $ 293
Weighted-average variable interest rate 3.62% 3.87%
Weighted-average fixed interest rate 7.57% 7.57%
Weighted-average maturity (in years) 5.3 6.3
- --------------------------------------------------------------------------------
These Swaps have been designated as fair value hedges under SFAS No. 133,
and are recorded on the Company's consolidated balance sheet. Changes in fair
value of the Swaps are completely offset by changes in fair value of the hedged
Medium-Term Notes. Therefore, there is no effect on net income. At December 31,
2003 and 2002, CSC recorded a derivative asset of $19 million and $26 million,
respectively, for these Swaps. Concurrently, the carrying value of the
Medium-Term Notes was increased by $19 million and $26 million at December 31,
2003 and 2002, respectively.
- 49 -
26. Fair Value of Financial Instruments
Substantially all of the Company's financial instruments are recorded at
estimated fair value or amounts that approximate fair value. The carrying
amounts (as recorded on the Company's consolidated balance sheet) and estimated
fair values of the Company's financial instruments are as follows:
- --------------------------------------------------------------------------------
2003 2002
---------------- ----------------
Carrying Fair Carrying Fair
December 31, Amount Value Amount Value
- --------------------------------------------------------------------------------
Financial Assets:
Cash and cash equivalents $ 2,832 $ 2,832 $ 3,114 $ 3,114
Cash and investments segregated 21,343 21,343 21,005 21,005
Securities owned 4,023 4,023 1,716 1,716
Receivables from
brokers, dealers and
clearing organizations 556 556 222 222
Receivables from
brokerage clients - net 8,581 8,581 6,845 6,845
Loans to banking clients - net 5,736 5,640 4,555 4,651
Loans held for sale 29 29 - -
Swaps 19 19 26 26
- --------------------------------------------------------------------------------
Total $43,119 $43,023 $37,483 $37,579
================================================================================
Financial Liabilities:
Deposits from banking clients $ 8,308 $ 8,308 $ 5,231 $ 5,231
Drafts payable 154 154 134 134
Payables to brokers, dealers
and clearing organizations 2,661 2,661 1,476 1,476
Payables to brokerage clients 27,184 27,184 26,401 26,401
Accrued expenses and other
liabilities, excluding
interest rate swap agreements 1,297 1,297 1,238 1,238
Swaps 33 33 64 64
Short-term borrowings 996 996 508 508
Long-term debt 772 820 642 674
- --------------------------------------------------------------------------------
Total $41,405 $41,453 $35,694 $35,726
================================================================================
Cash and cash equivalents, cash and investments segregated, receivables,
deposits from banking clients, payables, accrued expenses and other liabilities,
and short-term borrowings are short-term in nature and accordingly are recorded
at fair value or amounts that approximate fair value.
Securities owned are recorded at estimated fair value. Such fair values are
estimated using quoted market prices, where available, or third-party pricing
services.
Loans to banking clients: The fair value of the Company's loans are estimated
using discounted contractual cash flows adjusted for current prepayment
estimates. The discount rates used are based on the interest rates charged to
current clients for comparable loans.
Loans held for sale: The fair value of the Company's loans held for sale are
estimated using the quoted market prices for securities backed by similar types
of loans.
Swaps: The fair value of the Company's Swaps are estimated by obtaining quotes
from dealers and third-party pricing services.
Long-term debt: A portion of the Company's long-term debt has been adjusted for
changes in the fair value of Swaps. See note "25 - Financial Instruments Subject
to Off-Balance Sheet Risk, Credit Risk or Market Risk." The fair value of the
Company's long-term debt is estimated using third-party pricing services and
discounted cash flow analyses utilizing discount rates currently available for
similar instruments.
Off-balance sheet financial instruments: In the normal course of business, the
Company is a party to certain off-balance sheet financial instruments, primarily
consisting of firm commitments and LOCs, which represent obligations of the
Company. As of December 31, 2003, the majority of these commitments mature
within one year. The fair value of firm commitments and LOCs are estimated based
on fees charged to enter into similar agreements, considering the
creditworthiness of the counterparties. The Company has reviewed the unfunded
portion of its firm commitments as well as its LOCs and determined that the fair
values of these instruments were immaterial at December 31, 2003 and 2002.
27. Segment Information
Segments are defined as components of a company in which separate financial
information is evaluated regularly by the chief operating decision maker, or
decision-making group, in deciding how to allocate resources and in assessing
performance. The Company structures its segments according to its various types
of clients and the services provided to those clients. These segments have been
aggregated, based on similarities in economic characteristics, types of clients,
services provided, distribution channels, and regulatory environment, into four
reportable segments - Individual Investor, Institutional Investor, Capital
Markets, and U.S. Trust. The Individual Investor segment includes the Company's
retail brokerage and banking operations. The Institutional Investor segment
provides custodial, trading, and support services to independent investment
advisors, serves company 401(k) plan sponsors and third-party administrators,
and supports company stock option plans. (The Company's mutual fund services are
considered a product and not a segment. Mutual fund service fees are included in
the Individual Investor, Institutional Investor, and U.S. Trust segments.) The
Capital Markets segment provides trade execution services in Nasdaq,
exchange-listed, and other securities primarily to broker-dealers, including
Schwab, and institutional clients. The U.S. Trust segment provides investment,
wealth management, custody, fiduciary, and private banking services to
individual and institutional
- 50 -
clients.
The accounting policies of the segments are the same as those described in
note "2 - Significant Accounting Policies." Financial information for the
Company's reportable segments is presented in the following table. The Company
periodically reallocates certain revenues and expenses among the segments to
align them with the changes in the Company's organizational structure.
Previously-reported segment information has been revised to reflect changes
during the year in the Company's internal organization. The Company evaluates
the performance of its segments based on adjusted operating income before taxes
(a non-GAAP income measure), which excludes extraordinary items, non-operating
revenues, restructuring and other charges, impairment charges, acquisition- and
merger-related charges, and discontinued operations. Segment assets are not
disclosed because they are not used for evaluating segment performance and
deciding how to allocate resources to segments. However, capital expenditures
are used in evaluating segment performance and are therefore disclosed.
Intersegment revenues, defined as revenues from transactions with other segments
within the Company, are not material and are therefore not disclosed. Except for
the U.S. Trust segment, for which expenses are directly incurred, technology,
corporate, and general administrative expenses are allocated to the remaining
segments generally in proportion to either their respective revenues or average
full-time equivalent employees. Total revenues, net interest revenue (i.e.,
interest revenue, net of interest expense), income from continuing operations
before taxes on income and extraordinary gain, and net income are equal to the
Company's consolidated amounts as reported in the consolidated financial
statements. Capital expenditures are reported gross, as opposed to net of
proceeds from the sale of fixed assets.
- --------------------------------------------------------------------------------
Year Ended December 31, 2003 2002 2001
- --------------------------------------------------------------------------------
Revenues
Individual Investor $ 2,329 $ 2,345 $ 2,447
Institutional Investor 820 835 822
Capital Markets 293 260 343
U.S. Trust 628 651 654
- --------------------------------------------------------------------------------
Operating revenues 4,070 4,091 4,266
Non-operating revenue (1) 17 - 26
- --------------------------------------------------------------------------------
Total $ 4,087 $ 4,091 $ 4,292
================================================================================
Net interest revenue
Individual Investor $ 438 $ 507 $ 573
Institutional Investor 84 107 134
Capital Markets 21 14 27
U.S. Trust 186 196 177
- --------------------------------------------------------------------------------
Total $ 729 $ 824 $ 911
================================================================================
Adjusted operating income
before taxes
Individual Investor $ 436 $ 309 $ 304
Institutional Investor 246 216 235
Capital Markets - 7 21
U.S. Trust (2) 97 117 112
- --------------------------------------------------------------------------------
Adjusted operating income
before taxes 779 649 672
Excluded items (3) (69) (422) (495)
- --------------------------------------------------------------------------------
Income from continuing
operations before taxes on
income and extraordinary gain 710 227 177
Taxes on income (238) (92) (71)
Loss from discontinued operations,
net of tax - (38) (28)
Extraordinary gain on sale of
corporate trust business,
net of tax - 12 121
- --------------------------------------------------------------------------------
Net Income $ 472 $ 109 $ 199
================================================================================
Capital expenditures
Individual Investor $ 97 $ 104 $ 203
Institutional Investor 31 30 51
Capital Markets 11 12 25
U.S. Trust 15 17 36
- --------------------------------------------------------------------------------
Total $ 154 $ 163 $ 315
================================================================================
Depreciation and amortization (4)
Individual Investor $ 188 $ 215 $ 281
Institutional Investor 54 57 52
Capital Markets 20 22 28
U.S. Trust 22 23 33
- --------------------------------------------------------------------------------
Total $ 284 $ 317 $ 394
================================================================================
(1) Primarily consists of pre-tax gains recorded on sales of investments.
(2) Excludes an extraordinary pre-tax gain of $22 million in 2002 and $221
million in 2001 relating to the sale of USTC's Corporate Trust business.
- 51 -
(3) In 2003, includes restructuring charges of $81 million (see note "3 -
Restructuring and Other Charges"), an impairment charge of $5 million (see
note "4 - Impairment Charges"), and a pre-tax gain recorded on the sale of
an investment of $17 million. In 2002, includes restructuring charges of
$358 million (see note "3 - Restructuring and Other Charges") and
impairment charges of $37 million (see note "4 - Impairment Charge"). In
2001, includes restructuring and other charges of $402 million (see note "3
- Restructuring and Other Charges") and a pre-tax gain recorded on the sale
of an investment of $26 million. In 2002 and 2001, also includes
acquisition- and merger-related charges of $27 million and $119 million,
respectively.
(4) For 2001, includes goodwill amortization, which ceased on January 1, 2002
upon the adoption of SFAS No. 142.
Fees received from Schwab's proprietary mutual funds represented
approximately 20% of the Company's consolidated revenues in both 2003 and 2002,
and 18% in 2001. Except for Schwab's proprietary mutual funds, which are
considered a single client for purposes of this computation, no single client
accounted for more than 10% of the Company's consolidated revenues in 2003, 2002
and 2001. Substantially all of the Company's revenues and assets are attributed
to or located in the U.S. The percentage of Schwab's total client accounts
located in California was approximately 27% at each of December 31, 2003, 2002,
and 2001.
28. Supplemental Cash Flow Information
- --------------------------------------------------------------------------------
Year Ended December 31, 2003 2002 2001
- --------------------------------------------------------------------------------
Income taxes paid $ 255 $ 91 $ 218
- --------------------------------------------------------------------------------
Interest paid:
Deposits from banking clients $ 91 $ 86 $ 128
Brokerage client cash balances 77 166 689
Long-term debt 37 55 56
Short-term borrowings 16 24 25
Other 19 6 25
- --------------------------------------------------------------------------------
Total interest paid $ 240 $ 337 $ 923
================================================================================
Non-cash investing and financing activities:
Consolidation of special purpose trust: (1)
Building and land $ 229 - -
Note payable and other liabilities $ 228 - -
Common stock and options issued
for purchases of businesses $ 4 $ 4 $ 71
- --------------------------------------------------------------------------------
(1) Upon adoption of FIN No. 46 in the first quarter 2003, the Company
consolidated a special purpose trust. See note "2 - Significant Accounting
Policies - New Accounting Standards."
29. Subsequent Events
The Company's acquisition of SoundView closed on January 15, 2004, with
total cash paid of approximately $340 million.
The court gave final approval to the settlement of the Stanwich case on
January 29, 2004.
- 52 -
Management's Report
To Our Stockholders:
Management of the Company is responsible for the preparation, integrity and
objectivity of the consolidated financial statements, and the other financial
information presented in this annual report. To meet these responsibilities we
maintain a system of internal control that is designed to provide reasonable
assurance as to the integrity and reliability of the financial statements, the
protection of Company and client assets from unauthorized use, and the execution
and recording of transactions in accordance with management's authorization. The
system is augmented by careful selection of our managers, by organizational
arrangements that provide an appropriate division of responsibility, and by
communications programs aimed at assuring that employees adhere to the highest
standards of personal and professional integrity. The Company's internal audit
function monitors and reports on the adequacy of and compliance with our
internal controls, policies, and procedures. Although no cost-effective internal
control system will preclude all errors and irregularities, we believe the
Company's system of internal control is adequate to accomplish the objectives
set forth above.
Management of the Company is also responsible for establishing and
maintaining disclosure controls and procedures for the Company. Disclosure
controls and procedures are designed to help ensure that information we disclose
to the public is recorded, processed, summarized and reported within required
time specifications and to enable management to make timely decisions regarding
required disclosures. To meet these responsibilities, management of the Company
has designed such disclosure controls and procedures to help ensure that
material information relating to the Company is evaluated and, where
appropriate, communicated to management, particularly during the period in which
a public report is being prepared. Additionally, management of the Company has
evaluated, on a quarterly basis, the effectiveness of the Company's disclosure
controls and procedures. Although no cost-effective disclosure controls and
procedures system will preclude all errors and irregularities, we believe the
Company's system of disclosure controls and procedures is adequate to accomplish
the objectives set forth above.
The consolidated financial statements have been prepared in conformity with
accounting principles generally accepted in the United States of America and
necessarily include some amounts that are based on estimates and our best
judgments. The financial statements have been audited by the independent
accounting firm of Deloitte & Touche LLP, who were given unrestricted access to
all the Company's financial records and related data. We believe that all
representations made to Deloitte & Touche LLP during their audit were valid and
appropriate.
The Board of Directors through its Audit Committee, which is comprised
entirely of nonmanagement directors, has an oversight role in the area of
financial reporting and internal control. The Audit Committee periodically meets
with Deloitte & Touche LLP, as well as our internal auditors, and Company
management to discuss accounting, auditing, internal controls over financial
reporting, and other matters.
/s/ David S. Pottruck
- -----------------------------
Chief Executive Officer
February 23, 2004
/s/ Christopher V. Dodds
- -----------------------------
Executive Vice President and Chief Financial Officer
February 23, 2004
- 53 -
Independent Auditors' Report
To the Stockholders and Board of Directors of
The Charles Schwab Corporation:
We have audited the accompanying consolidated balance sheets of The Charles
Schwab Corporation and subsidiaries (the Company) as of December 31, 2003 and
2002, and the related consolidated statements of income, stockholders' equity,
and cash flows for each of the three years in the period ended December 31,
2003. These financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements based on our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in
all material respects, the financial position of The Charles Schwab Corporation
and subsidiaries at December 31, 2003 and 2002, and the results of their
operations and their cash flows for each of the three years in the period ended
December 31, 2003 in conformity with accounting principles generally accepted in
the United States of America.
As discussed in Note 2 to the consolidated financial statements, the
Company adopted Statement of Financial Accounting Standards No. 142 - Goodwill
and Other Intangible Assets effective January 1, 2002.
/s/ Deloitte & Touche LLP
- -----------------------------
San Francisco, California
February 23, 2004
- 54 -
Quarterly Financial Information (Unaudited) The Charles Schwab Corporation
(In Millions, Except Per Share Data and Ratios)
- ------------------------------------------------------------------------------------------------------------------------------------
Weighted- Basic Diluted Dividends
Average Earnings Earnings Declared Range
Expenses Net Common (Loss) (Loss) Per of Common Range of
Excluding Income Shares - Per Per Common Stock Price Price/Earnings
Revenues(1) Interest(1) (Loss) Diluted Share(2) Share(2) Share (3) Per Share Ratio (4)
- ------------------------------------------------------------------------------------------------------------------------------------
2003 by Quarter
Fourth $ 1,118 $ 884 $ 148 1,371 $ .11 $ .11 $ .014 $13.98 - 10.90 40 - 31
Third dividend increase 1,051 854 127 1,366 .09 .09 .014 12.73 - 10.01 75 - 59
Second 1,018 836 126 1,360 .10 .09 .011 11.64 - 7.20 146 - 90
First 900 803 71 1,357 .05 .05 .011 12.46 - 6.25 208 - 104
- ------------------------------------------------------------------------------------------------------------------------------------
2002 by Quarter
Fourth $ 986 $ 1,055 $ (79) 1,340 $ (.06) $ (.06) $ .011 $12.00 - 7.22 150 - 90
Third 1,020 1,021 (4) 1,358 .00 .00 .011 11.89 - 7.51 91 - 58
Second 1,037 876 98 1,385 .07 .07 .011 13.19 - 9.60 94 - 69
First 1,048 912 94 1,389 .07 .07 .011 19.00 - 12.25 136 - 88
- ------------------------------------------------------------------------------------------------------------------------------------
2001 by Quarter
Fourth $ 1,047 $ 1,067 $ (13) 1,362 $ (.01) $ (.01) $ .011 $16.30 - 10.38 116 - 74
Third 1,005 978 13 1,395 .01 .01 .011 16.18 - 8.13 65 - 33
Second 1,057 1,059 102 1,405 .07 .07 .011 23.18 - 13.14 68 - 39
First 1,183 1,011 97 1,410 .07 .07 .011 33.00 - 14.50 92 - 40
- ------------------------------------------------------------------------------------------------------------------------------------
2000 by Quarter
Fourth $ 1,318 $ 1,084 $ 139 1,414 $ .10 $ .10 $ .011 $35.88 - 25.69 70 - 50
Third dividend increase 1,304 1,055 142 1,415 .10 .10 .011 40.50 - 30.00 74 - 55
Second stock split 1,382 1,117 137 1,407 .10 .09 .009 40.58 - 24.00 72 - 43
First 1,691 1,177 300 1,390 .23 .22 .009 44.75 - 22.46 76 - 38
- ------------------------------------------------------------------------------------------------------------------------------------
1999 by Quarter
Fourth $ 1,250 $ 933 $ 190 1,374 $ .15 $ .14 $ .009 $31.17 - 17.96 64 - 37
Third stock split 999 759 144 1,376 .11 .11 .009 37.67 - 21.33 84 - 47
Second 1,096 810 171 1,377 .13 .12 .009 51.67 - 26.67 123 - 64
First 1,060 790 161 1,366 .12 .12 .009 32.67 - 16.96 88 - 46
- ------------------------------------------------------------------------------------------------------------------------------------
(1) 1999 through 2002 have been adjusted to summarize the impact of The Charles Schwab Corporation's sale of its U.K. brokerage
subsidiary, Charles Schwab Europe, in loss from discontinued operations.
(2) Both basic and diluted earnings per share include loss from discontinued operations for all periods presented. The first
quarter of 2002 and second quarter of 2001 include an after-tax extraordinary gain of $12 million and $121 million,
respectively, or $.01 and $.08 per share, respectively.
(3) Dividends declared per common share do not include dividends declared by USTC prior to the completion of the merger in 2000.
(4) Price/earnings ratio is computed by dividing the high and low market prices by diluted earnings per share for the 12-month
period ended on the last day of the quarter presented.
- 55 -