================================================================================
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF
THE SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2004
COMMISSION FILE NUMBER 1-15081
UNIONBANCAL CORPORATION
(Exact name of registrant as specified in its charter)
DELAWARE 94-1234979
(State of Incorporation) (I.R.S. Employer
Identification No.)
400 CALIFORNIA STREET
SAN FRANCISCO, CALIFORNIA 94104-1302
(Address and zip code of principal executive offices)
Registrant's telephone number: (415) 765-2969
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes X No
--- ---
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes X No
--- ---
Number of shares of Common Stock outstanding at July 31, 2004: 147,775,010
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UNIONBANCAL CORPORATION AND SUBSIDIARIES
TABLE OF CONTENTS
PAGE
NUMBER
------
PART I
FINANCIAL INFORMATION
Consolidated Financial Highlights........................................ 2
Item 1. Financial Statements:
Condensed Consolidated Statements of Income............................ 4
Condensed Consolidated Balance Sheets.................................. 5
Condensed Consolidated Statements of Changes in Stockholders' Equity... 6
Condensed Consolidated Statements of Cash Flows........................ 7
Notes to Condensed Consolidated Financial Statements................... 8
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations:
Introduction........................................................... 23
Executive Overview..................................................... 23
Financial Performance.................................................. 25
Net Interest Income.................................................... 29
Noninterest Income..................................................... 32
Noninterest Expense.................................................... 33
Income Tax Expense..................................................... 33
Loans.................................................................. 34
Cross-Border Outstandings.............................................. 36
Provision for Credit Losses............................................ 36
Allowance for Credit Losses............................................ 36
Nonperforming Assets................................................... 42
Loans 90 Days or More Past Due and Still Accruing...................... 43
Quantitative and Qualitative Disclosures About Market Risk............. 43
Liquidity Risk......................................................... 46
Regulatory Capital..................................................... 47
Business Segments...................................................... 48
Certain Business Risk Factors.......................................... 57
Item 3. Quantitative and Qualitative Disclosures about Market Risk....... 61
Item 4. Controls and Procedures.......................................... 61
PART II
OTHER INFORMATION
Item 1. Legal Proceedings................................................ 62
Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of
Equity Securities...................................................... 63
Item 4. Submission of Matters to a Vote of Security Holders.............. 63
Item 6. Exhibits and Reports on Form 8-K................................. 63
Signatures............................................................... 65
PART I. FINANCIAL INFORMATION
UnionBanCal Corporation and Subsidiaries
Consolidated Financial Highlights
(Unaudited)
AS OF AND FOR THE
THREE MONTHS ENDED
--------------------------
JUNE 30, JUNE 30, PERCENT
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 2003 2004 CHANGE
- --------------------------------------------------------- ----------- ----------- -------
RESULTS OF OPERATIONS:
Net interest income(1)................................. $ 386,422 $ 400,661 3.68%
(Reversal of) provision for credit losses.............. 25,000 (10,000) nm
Noninterest income..................................... 203,171 331,010 62.92
Noninterest expense.................................... 351,004 376,402 7.24
----------- -----------
Income before income taxes(1).......................... 213,589 365,269 71.01
Taxable-equivalent adjustment.......................... 645 803 24.50
Income tax expense..................................... 68,186 133,369 95.60
----------- -----------
Net income............................................. $ 144,758 $ 231,097 59.64
=========== ===========
PER COMMON SHARE:
Net income--basic...................................... $ 0.96 $ 1.56 62.50%
Net income--diluted.................................... 0.96 1.54 60.42
Dividends(2)........................................... 0.31 0.36 16.13
Book value (end of period)............................. 25.79 26.98 4.61
Common shares outstanding (end of period)(3)........... 149,993,652 147,845,160 (1.43)
Weighted average common shares outstanding--basic(3)... 150,046,659 147,687,350 (1.57)
Weighted average common shares outstanding--diluted(3). 151,489,337 150,183,938 (0.86)
BALANCE SHEET (END OF PERIOD):
Total assets........................................... $42,668,834 $46,295,831 8.50%
Total loans............................................ 25,668,660 27,594,271 7.50
Nonaccrual loans....................................... 379,487 178,062 (53.08)
Nonperforming assets................................... 379,758 183,913 (51.57)
Total deposits......................................... 35,365,260 39,367,911 11.32
Medium and long-term debt.............................. 420,853 800,988 90.32
Junior subordinated debt............................... -- 16,017 nm
Trust preferred securities............................. 360,166 -- (100.00)
Stockholders' equity................................... 3,868,959 3,988,676 3.09
BALANCE SHEET (PERIOD AVERAGE):
Total assets........................................... $39,776,349 $44,611,351 12.16%
Total loans............................................ 26,517,316 26,838,622 1.21
Earning assets......................................... 36,074,488 40,351,016 11.85
Total deposits......................................... 32,587,173 37,810,048 16.03
Stockholders' equity................................... 3,919,276 3,933,788 0.37
FINANCIAL RATIOS:
Return on average assets(4)............................ 1.46% 2.08%
Return on average stockholders' equity(4).............. 14.81 23.63
Efficiency ratio(5).................................... 59.53 51.44
Net interest margin(1)................................. 4.29 3.98
Dividend payout ratio.................................. 32.29 23.08
Tangible equity ratio.................................. 8.59 7.88
Tier 1 risk-based capital ratio........................ 11.44 10.46
Total risk-based capital ratio......................... 13.06 13.07
Leverage ratio......................................... 9.63 8.36
Allowance for credit losses to total loans............. 2.17 1.82
Allowance for credit losses to nonaccrual loans........ 147.11 281.60
Net loans charged off to average total loans(4)........ 0.80 0.15
Nonperforming assets to total loans and
foreclosed assets.................................... 1.48 0.67
Nonperforming assets to total assets................... 0.89 0.40
- ----------------------------------------
<FN>
(1) Amounts are on a taxable-equivalent basis using the federal statutory tax
rate of 35 percent.
(2) Dividends per share reflect dividends declared on UnionBanCal Corporation's
common stock outstanding as of the declaration date.
(3) Common shares outstanding reflects common shares issued less treasury
shares.
(4) Annualized.
(5) The efficiency ratio is noninterest expense, excluding foreclosed asset
expense (income), as a percentage of net interest income
(taxable-equivalent basis) and noninterest income. Foreclosed asset expense
(income) was $(0.5) thousand in the second quarter of 2003 and $16.5
thousand in the second quarter of 2004.
nm--not meaningful
</FN>
2
PART I. FINANCIAL INFORMATION
UnionBanCal Corporation and Subsidiaries
Consolidated Financial Highlights
(Unaudited)
AS OF AND FOR THE
SIX MONTHS ENDED
--------------------------
JUNE 30, JUNE 30, PERCENT
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 2003 2004 CHANGE
- --------------------------------------------------------- ----------- ----------- -------
RESULTS OF OPERATIONS:
Net interest income(1)................................. $ 777,826 $ 801,884 3.09%
(Reversal of) provision for credit losses.............. 55,000 (15,000) nm
Noninterest income..................................... 388,942 542,215 39.41
Noninterest expense.................................... 693,604 749,508 8.06
----------- -----------
Income before income taxes(1).......................... 418,164 609,591 45.78
Taxable-equivalent adjustment.......................... 1,269 1,605 26.48
Income tax expense..................................... 136,620 219,402 60.59
----------- -----------
Net income............................................. $ 280,275 $ 388,584 38.64
=========== ===========
PER COMMON SHARE:
Net income--basic...................................... $ 1.86 $ 2.63 41.40%
Net income--diluted.................................... 1.85 2.59 40.00
Dividends(2)........................................... 0.59 0.67 13.56
Book value (end of period)............................. 25.79 26.98 4.61
Common shares outstanding (end of period)(3)........... 149,993,652 147,845,160 (1.43)
Weighted average common shares outstanding--basic(3)... 150,329,939 147,543,824 (1.85)
Weighted average common shares outstanding--diluted(3). 151,746,328 149,991,567 (1.16)
BALANCE SHEET (END OF PERIOD):
Total assets........................................... $42,668,834 $46,295,831 8.50%
Total loans............................................ 25,668,660 27,594,271 7.50
Nonaccrual loans....................................... 379,487 178,062 (53.08)
Nonperforming assets................................... 379,758 183,913 (51.57)
Total deposits......................................... 35,365,260 39,367,911 11.32
Medium and long-term debt.............................. 420,853 800,988 90.32
Junior subordinated debt............................... -- 16,017 nm
Trust preferred securities............................. 360,166 -- (100.00)
Stockholders' equity................................... 3,868,959 3,988,676 3.09
BALANCE SHEET (PERIOD AVERAGE):
Total assets........................................... $39,066,221 $43,831,266 12.20%
Total loans............................................ 26,619,618 26,490,239 (0.49)
Earning assets......................................... 35,454,075 39,613,622 11.73
Total deposits......................................... 31,836,948 36,874,787 15.82
Stockholders' equity................................... 3,896,909 3,941,855 1.15
FINANCIAL RATIOS:
Return on average assets(4)............................ 1.45% 1.78%
Return on average stockholders' equity(4).............. 14.50 19.82
Efficiency ratio(5).................................... 59.44 55.72
Net interest margin(1)................................. 4.41 4.07
Dividend payout ratio.................................. 31.72 25.48
Tangible equity ratio.................................. 8.59 7.88
Tier 1 risk-based capital ratio........................ 11.44 10.46
Total risk-based capital ratio......................... 13.06 13.07
Leverage ratio......................................... 9.63 8.36
Allowance for credit losses to total loans............. 2.17 1.82
Allowance for credit losses to nonaccrual loans........ 147.11 281.60
Net loans charged off to average total loans(4)........ 0.80 0.17
Nonperforming assets to total loans and
foreclosed assets.................................... 1.48 0.67
Nonperforming assets to total assets................... 0.89 0.40
- ----------------------------------------
<FN>
(1) Amounts are on a taxable-equivalent basis using the federal statutory tax
rate of 35 percent.
(2) Dividends per share reflect dividends declared on UnionBanCal Corporation's
common stock outstanding as of the declaration date.
(3) Common shares outstanding reflects common shares issued less treasury
shares.
(4) Annualized.
(5) The efficiency ratio is noninterest expense, excluding foreclosed asset
expense (income), as a percentage of net interest income
(taxable-equivalent basis) and noninterest income. Foreclosed asset expense
was $0.1 million in the first six months of 2003 and $0.5 million in the
first six months of 2004.
nm--not meaningful
</FN>
3
ITEM 1. FINANCIAL STATEMENTS
UnionBanCal Corporation and Subsidiaries
Condensed Consolidated Statements of Income
(Unaudited)
FOR THE THREE MONTHS FOR THE SIX MONTHS
ENDED JUNE 30, ENDED JUNE 30,
---------------------- -----------------------
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 2003 2004 2003 2004
- ---------------------------------------------------- ---------- ---------- ---------- ----------
INTEREST INCOME
Loans............................................. $ 354,913 $ 328,372 $ 717,888 $ 663,701
Securities........................................ 78,036 108,064 157,899 213,910
Interest bearing deposits in banks................ 1,130 1,121 2,092 2,029
Federal funds sold and securities purchased
under resale agreements......................... 4,001 2,928 5,678 4,887
Trading account assets............................ 943 861 1,870 1,418
---------- ---------- ---------- ----------
Total interest income........................... 439,023 441,346 885,427 885,945
---------- ---------- ---------- ----------
INTEREST EXPENSE
Domestic deposits................................. 40,217 32,123 81,788 65,733
Foreign deposits.................................. 2,811 2,761 6,017 4,893
Federal funds purchased and securities sold
under repurchase agreements..................... 747 552 2,074 1,233
Commercial paper.................................. 2,946 1,051 5,674 2,186
Medium and long-term debt......................... 1,818 3,693 3,684 6,832
Preferred securities and trust notes.............. 3,652 130 7,323 2,311
Other borrowed funds.............................. 1,055 1,178 2,310 2,478
---------- ---------- ---------- ----------
Total interest expense.......................... 53,246 41,488 108,870 85,666
---------- ---------- ---------- ----------
NET INTEREST INCOME................................. 385,777 399,858 776,557 800,279
(Reversal of) provision for credit losses......... 25,000 (10,000) 55,000 (15,000)
---------- ---------- ---------- ----------
Net interest income after (reversal of)
provision for credit losses................... 360,777 409,858 721,557 815,279
---------- ---------- ---------- ----------
NONINTEREST INCOME
Service charges on deposit accounts............... 77,942 90,031 150,229 171,127
Trust and investment management fees.............. 33,141 36,788 65,816 72,610
Insurance commissions............................. 16,024 18,652 29,242 40,387
International commissions and fees................ 16,856 18,102 32,201 35,647
Card processing fees, net......................... 9,340 15,456 19,022 24,248
Foreign exchange gains, net....................... 6,958 8,294 13,892 16,638
Brokerage commissions and fees.................... 8,412 8,023 17,066 16,320
Merchant banking fees............................. 6,191 7,714 12,209 15,181
Securities gains (losses), net.................... 9,660 (4) 9,660 1,618
Other............................................. 18,647 127,954 39,605 148,439
---------- ---------- ---------- ----------
Total noninterest income........................ 203,171 331,010 388,942 542,215
---------- ---------- ---------- ----------
NONINTEREST EXPENSE
Salaries and employee benefits.................... 198,929 217,597 397,036 437,020
Net occupancy..................................... 32,866 32,173 60,502 63,755
Equipment......................................... 16,354 16,883 33,025 34,154
Communications.................................... 13,354 13,035 27,198 26,445
Software.......................................... 10,849 12,908 22,925 25,903
Professional services............................. 13,566 10,290 25,580 21,593
Foreclosed asset expense.......................... -- 17 51 536
Other............................................. 65,086 73,499 127,287 140,102
---------- ---------- ---------- ----------
Total noninterest expense....................... 351,004 376,402 693,604 749,508
---------- ---------- ---------- ----------
Income before income taxes........................ 212,944 364,466 416,895 607,986
Income tax expense................................ 68,186 133,369 136,620 219,402
---------- ---------- ---------- ----------
NET INCOME.......................................... $ 144,758 $ 231,097 $ 280,275 $ 388,584
========== ========== ========== ==========
NET INCOME PER COMMON SHARE--BASIC.................. $ 0.96 $ 1.56 $ 1.86 $ 2.63
========== ========== ========== ==========
NET INCOME PER COMMON SHARE--DILUTED................ $ 0.96 $ 1.54 $ 1.85 $ 2.59
========== ========== ========== ==========
WEIGHTED AVERAGE COMMON SHARES
OUTSTANDING--BASIC................................ 150,047 147,687 150,330 147,544
========== ========== ========== ==========
WEIGHTED AVERAGE COMMON SHARES
OUTSTANDING--DILUTED.............................. 151,489 150,184 151,746 149,992
========== ========== ========== ==========
See accompanying notes to condensed consolidated financial statements.
4
UnionBanCal Corporation and Subsidiaries
Condensed Consolidated Balance Sheets
(UNAUDITED) (UNAUDITED)
JUNE 30, DECEMBER 31, JUNE 30,
(DOLLARS IN THOUSANDS) 2003 2003 2004
- --------------------------------------------------------- ----------- ------------ -----------
ASSETS
Cash and due from banks.................................. $ 3,096,509 $ 2,494,127 $ 2,287,708
Interest bearing deposits in banks....................... 212,746 235,158 630,451
Federal funds sold and securities purchased under
resale agreements...................................... 1,624,552 769,720 1,156,650
----------- ------------ -----------
Total cash and cash equivalents.......................... 4,933,807 3,499,005 4,074,809
Trading account assets................................... 387,928 252,929 307,334
Securities available for sale:
Securities pledged as collateral....................... 154,961 106,560 77,532
Held in portfolio...................................... 9,438,110 10,660,332 12,151,635
Loans (net of allowance for credit losses: June 30,
2003, $558,282; December 31, 2003, $532,970;
June 30, 2004, $501,419)............................... 25,110,378 25,411,658 27,092,852
Due from customers on acceptances........................ 81,560 71,078 52,867
Premises and equipment, net.............................. 498,708 509,734 502,204
Intangible assets........................................ 46,240 49,592 56,696
Goodwill................................................. 178,591 226,556 315,356
Other assets............................................. 1,838,551 1,711,023 1,664,546
----------- ------------ -----------
Total assets........................................... $42,668,834 $ 42,498,467 $46,295,831
=========== ============ ===========
LIABILITIES
Domestic deposits:
Noninterest bearing.................................... $17,198,024 $ 16,668,773 $19,255,245
Interest bearing....................................... 16,494,167 17,146,858 17,982,340
Foreign deposits:
Noninterest bearing.................................... 490,314 619,249 733,394
Interest bearing....................................... 1,182,755 1,097,403 1,396,932
----------- ------------ -----------
Total deposits....................................... 35,365,260 35,532,283 39,367,911
Federal funds purchased and securities sold under
repurchase agreements................................. 337,785 280,968 294,597
Commercial paper......................................... 835,268 542,270 552,038
Other borrowed funds..................................... 238,239 212,088 180,426
Acceptances outstanding.................................. 81,560 71,078 52,867
Other liabilities........................................ 1,160,744 934,916 1,042,311
Medium and long-term debt................................ 420,853 820,488 800,988
Junior subordinated debt payable to subsidiary
grantor trust......................................... -- 363,940 16,017
UnionBanCal Corporation--obligated mandatorily
redeemable preferred securities of subsidiary
grantor trust.......................................... 360,166 -- --
----------- ------------ -----------
Total liabilities........................................ 38,799,875 38,758,031 42,307,155
----------- ------------ -----------
Commitments and contingencies
STOCKHOLDERS' EQUITY
Preferred stock:
Authorized 5,000,000 shares, no shares issued or
outstanding as of June 30, 2003, December 31, 2003,
and June 30, 2004.................................... -- -- --
Common stock, no stated value per share at June 30,
2003, and par value of $1 per share at December 31,
2003 and June 30, 2004(1):
Authorized 300,000,000 shares, issued 149,993,652
shares as of June 30, 2003, 146,000,156 shares as
of December 31, 2003, and 149,126,860 shares as
of June 30, 2004..................................... 894,979 146,000 149,127
Additional paid-in capital............................... -- 555,156 712,255
Treasury stock--242,000 shares as of December 31,
2003 and 1,281,700 shares as of June 30, 2004.......... -- (12,846) (68,557)
Retained earnings........................................ 2,783,314 2,999,884 3,289,676
Accumulated other comprehensive income (loss)............ 190,666 52,242 (93,825)
----------- ------------ -----------
Total stockholders' equity............................... 3,868,959 3,740,436 3,988,676
----------- ------------ -----------
Total liabilities and stockholders' equity............... $42,668,834 $ 42,498,467 $46,295,831
=========== ============ ===========
- ------------------------------
<FN>
(1) On September 30, 2003, UnionBanCal Corporation changed its state of
incorporation from California to Delaware, establishing a par value of $1
per share of common stock.
</FN>
See accompanying notes to condensed consolidated financial statements.
5
UnionBanCal Corporation and Subsidiaries
Condensed Consolidated Statements of Changes in Stockholders' Equity
(Unaudited)
ACCUMULATED TOTAL
ADDITIONAL OTHER STOCK-
NUMBER COMMON PAID-IN TREASURY RETAINED COMPREHENSIVE HOLDERS'
(IN THOUSANDS, EXCEPT SHARES) OF SHARES STOCK(1) CAPITAL STOCK EARNINGS INCOME (LOSS) EQUITY
- ------------------------------- ----------- -------- ---------- -------- ---------- -------------- ----------
BALANCE DECEMBER 31, 2002...... 150,702,363 $926,460 $ -- $ -- $2,591,635 $ 240,094 $3,758,189
-------- ---------- -------- ---------- -------------- ----------
Comprehensive income
Net income--For the six
months ended June 30, 2003. 280,275 280,275
Other comprehensive income,
net of tax:
Net change in unrealized
gains on cash flow hedges (7,985) (7,985)
Net change in unrealized
gains on securities
available for sale....... (41,561) (41,561)
Foreign currency transla-
tion adjustment.......... 118 118
----------
Total comprehensive income..... 230,847
Dividend reinvestment plan..... 5,047 24 24
Deferred compensation -
restricted stock awards...... -- -- 111 111
Stock options exercised........ 402,078 13,324 13,324
Common stock repurchased(2).... (1,115,836) (44,829) (44,829)
Dividends declared on common
stock, $0.59 per share(3).... (88,707) (88,707)
-------- ---------- -------- ---------- -------------- ----------
Net change..................... (31,481) -- -- 191,679 (49,428) 110,770
----------- -------- ---------- -------- ---------- -------------- ----------
BALANCE JUNE 30, 2003.......... 149,993,652 $894,979 $ -- $ -- $2,783,314 $ 190,666 $3,868,959
=========== ======== ========== ======== ========== ============== ==========
BALANCE DECEMBER 31, 2003.... 146,000,156 $146,000 $ 555,156 $(12,846) $2,999,884 $ 52,242 $3,740,436
-------- ---------- -------- ---------- -------------- ----------
Comprehensive income
Net income--For the six
months ended June 30, 2004. 388,584 388,584
Other comprehensive income,
net of tax:
Net change in unrealized
gains on cash flow hedges (37,753) (37,753)
Net change in unrealized
losses on securities
available for sale....... (108,834) (108,834)
Foreign currency transla-
tion adjustment.......... 520 520
----------
Total comprehensive income..... 242,517
Dividend reinvestment plan..... 308 -- 17 17
Deferred compensation -
restricted stock awards...... -- -- 130 130
Stock options exercised........ 1,117,677 1,118 44,687 45,805
Stock issued in acquisitions... 2,008,719 2,009 112,569 114,578
Common stock repurchased(2).... -- -- (174) (55,711) (55,885)
Dividends declared on common
stock, $0.67 per share(3).... (98,922) (98,922)
-------- ---------- -------- ---------- -------------- ----------
Net change..................... 3,127 157,082 (55,711) 289,792 (146,067) 248,240
----------- -------- ---------- -------- ---------- -------------- ----------
BALANCE JUNE 30, 2004.......... 149,126,860 $149,127 $ 712,255 $(68,557) $3,289,676 $ (93,825) $3,988,676
=========== ======== ========== ======== ========== ============== ==========
- ---------------------------
<FN>
(1) On September 30, 2003, UnionBanCal Corporation changed its state of
incorporation from California to Delaware, establishing a par value of $1
per share of common stock.
(2) Common stock repurchased includes commission costs. All repurchases
subsequent to September 29, 2003, are reflected in Treasury Stock.
(3) Dividends are based on UnionBanCal Corporation's shares outstanding as of
the declaration date.
</FN>
See accompanying notes to condensed consolidated financial statements.
6
UnionBanCal Corporation and Subsidiaries
Condensed Consolidated Statements of Cash Flows
(Unaudited)
FOR THE SIX MONTHS
ENDED JUNE 30,
-------------------------
(DOLLARS IN THOUSANDS) 2003 2004
- --------------------------------------------------------------------- ---------- ----------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income......................................................... $ 280,275 $ 388,584
Adjustments to reconcile net income to net cash provided by (used
in) operating activities:
(Reversal of) provision for credit losses........................ 55,000 (15,000)
Depreciation, amortization and accretion......................... 61,742 66,191
Provision for deferred income taxes.............................. 44,876 36,430
Gains on securities available for sale........................... (9,660) (1,618)
Net increase in prepaid expenses................................. (83,845) (85,933)
Net (increase) decrease in fees and other charges receivable..... (94,140) 40,498
Net increase (decrease) in accrued expenses and other liabilities 45,635 92,632
Net (increase) decrease in other assets, net of acquisitions..... (105,724) 255,613
Net increase in trading account assets........................... (111,907) (54,405)
Loans originated for resale...................................... (80,608) (263,412)
Net proceeds from sale of loans originated for resale............ 127,629 227,434
Other, net....................................................... 25,987 4,610
---------- ----------
Total adjustments................................................ (125,015) 303,040
---------- ----------
Net cash provided by (used in) operating activities................ 155,260 691,624
---------- ----------
CASH FLOWS FROM INVESTING ACTIVITIES:
Proceeds from sales of securities available for sale............... 35,978 9,970
Proceeds from matured and called securities available for sale..... 1,506,572 2,004,222
Purchases of securities available for sale......................... (3,907,936) (3,664,523)
Net (increase) decrease in loans, net of acquisitions.............. 598,059 (1,213,276)
Net cash used in acquisitions...................................... (29,860) (2,287)
Other, net......................................................... (46,405) (36,533)
---------- ----------
Net cash provided by (used in) investing activities.............. (1,843,592) (2,902,427)
---------- ----------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net increase (decrease) in deposits, net of acquisitions........... 2,524,445 3,255,271
Net increase (decrease) in federal funds purchased and securities
sold under repurchase agreements................................. 3,406 13,629
Net decrease in commercial paper and other borrowed funds.......... (232,522) (21,894)
Repayment of junior subordinated debt.............................. -- (360,825)
Common stock repurchased........................................... (44,829) (55,885)
Payments of cash dividends......................................... (84,413) (90,925)
Other, net......................................................... 13,466 46,342
---------- ----------
Net cash provided by (used in) financing activities.............. 2,179,553 2,785,713
Net increase (decrease) in cash and cash equivalents................. 491,221 574,910
Cash and cash equivalents at beginning of period..................... 4,442,122 3,499,005
Effect of exchange rate changes on cash and cash equivalents......... 464 894
---------- ----------
Cash and cash equivalents at end of period........................... $4,933,807 $4,074,809
========== ==========
CASH PAID DURING THE PERIOD FOR:
Interest........................................................... $ 117,463 $ 88,860
Income taxes....................................................... 51,197 95,764
SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING AND FINANCING ACTIVITIES:
Acquisitions:
Fair value of assets acquired.................................... $ 47,988 $ 803,713
Purchase price:
Cash........................................................... (40,300) (21,772)
Stock issued................................................... -- (114,578)
---------- ----------
Liabilities assumed.............................................. $ 7,688 $ 667,363
========== ==========
See accompanying notes to condensed consolidated financial statements.
7
UnionBanCal Corporation and Subsidiaries
Notes to Condensed Consolidated Financial Statements
NOTE 1--BASIS OF PRESENTATION AND NATURE OF OPERATIONS
The unaudited condensed consolidated financial statements of UnionBanCal
Corporation and subsidiaries (the Company) have been prepared in accordance with
accounting principles generally accepted in the United States of America (U.S.
GAAP) for interim financial reporting and the instructions to Form 10-Q and Rule
10-01 of Regulation S-X of the Rules and Regulations of the Securities and
Exchange Commission. However, they do not include all of the disclosures
necessary for annual financial statements in conformity with U.S. GAAP. The
results of operations for the period ended June 30, 2004 are not necessarily
indicative of the operating results anticipated for the full year. Accordingly,
these unaudited condensed consolidated financial statements should be read in
conjunction with the audited consolidated financial statements included in the
Company's Form 10-K for the year ended December 31, 2003. The preparation of
financial statements in conformity with U.S. GAAP also requires management to
make estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenue and expense during
the reporting period. Actual results could differ from those estimates.
UnionBanCal Corporation is a commercial bank holding company and has, as
its major subsidiary, a banking subsidiary, Union Bank of California, N.A. (the
Bank). The Company provides a wide range of financial services to consumers,
small businesses, middle-market companies and major corporations, primarily in
California, Oregon, and Washington, but also nationally and internationally.
Since November 1999 through June 30, 2004, the Company has announced stock
repurchase plans totaling $700 million and as of June 30, 2004 has repurchased
$454 million of common stock under these repurchase plans. The Company
repurchased $58 million, $44 million, and $12 million of common stock in 2003,
the first quarter of 2004, and the second quarter of 2004, respectively, as part
of these repurchase plans. As of June 30, 2004, $246 million of the Company's
common stock is authorized for repurchase. Under separate stock repurchase
agreements, the Company purchased $600 million of its common stock, $300 million
in August 2002 and $300 million in September 2003, from its majority owner, The
Bank of Tokyo-Mitsubishi, Ltd. (BTM), which is a wholly-owned subsidiary of
Mitsubishi Tokyo Financial Group, Inc. At June 30, 2004, BTM owned approximately
62 percent of the Company's outstanding common stock.
Certain amounts for prior periods have been reclassified to conform to
current financial statement presentation.
STOCK-BASED COMPENSATION
As allowed under the provisions of Statement of Financial Accounting
Standards (SFAS) No. 123, "Accounting for Stock-Based Compensation," as amended,
the Company has chosen to continue to recognize compensation expense using the
intrinsic value-based method of valuing stock options prescribed in Accounting
Principles Board Opinion (APB) No. 25, "Accounting for Stock Issued to
Employees" and related Interpretations. Under the intrinsic value-based method,
compensation cost is measured as the amount by which the quoted market price of
the Company's stock at the date of grant exceeds the stock option exercise
price.
At June 30, 2004, the Company has two stock-based employee compensation
plans. For further discussion concerning our stock-based employee compensation
plans see Note 14--"Management Stock Plan" of the Notes to Consolidated
Financial Statements included in the Form 10-K for the year ended December 31,
2003. The value of the restricted stock awards issued under the plans has been
reflected in compensation expense. Options granted under the plans had an
exercise price equal to the market value of
8
UnionBanCal Corporation and Subsidiaries
Notes to Condensed Consolidated Financial Statements (Continued)
NOTE 1--BASIS OF PRESENTATION AND NATURE OF OPERATIONS (CONTINUED)
the underlying common stock on the date of grant and, therefore, were not
included in compensation expense as allowed by current U.S. GAAP.
The following table illustrates the effect on net income and earnings per
share if the Company had applied the fair value recognition provisions of SFAS
No. 123 to stock-based employee compensation.
FOR THE THREE MONTHS FOR THE SIX MONTHS
ENDED JUNE 30, ENDED JUNE 30,
-------------------- --------------------
(DOLLARS IN THOUSANDS) 2003 2004 2003 2004
- ----------------------------------------------------- -------- -------- -------- --------
AS REPORTED NET INCOME............................... $144,758 $231,097 $280,275 $388,584
Stock option-based employee compensation expense
(determined under fair value based method for
all awards, net of taxes).......................... (6,527) (6,683) (12,483) (13,215)
-------- -------- -------- --------
Pro forma net income, after stock option-based
employee compensation expense...................... $138,231 $224,414 $267,792 $375,369
======== ======== ======== ========
EARNINGS PER SHARE--BASIC
As reported.......................................... $ 0.96 $ 1.56 $ 1.86 $ 2.63
Pro forma............................................ $ 0.92 $ 1.52 $ 1.78 $ 2.54
EARNINGS PER SHARE--DILUTED
As reported.......................................... $ 0.96 $ 1.54 $ 1.85 $ 2.59
Pro forma............................................ $ 0.91 $ 1.49 $ 1.76 $ 2.50
Compensation cost associated with the Company's unvested restricted stock
issued under the management stock plan is measured based on the market price of
the stock at the grant date and is expensed over the vesting period.
Compensation expense related to restricted stock awards for the second quarters
of 2003 and 2004 was not significant.
NOTE 2--RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
ACCOUNTING FOR ASSET RETIREMENT OBLIGATIONS
In June 2001, the Financial Accounting Standards Board (FASB) issued SFAS
No. 143, "Accounting for Asset Retirement Obligations." This Statement addresses
the financial accounting and reporting for obligations associated with the
retirement of tangible long-lived assets and the associated asset retirement
costs. It requires an entity to record a liability for an obligation associated
with the retirement of an asset at the time the liability is incurred by
capitalizing the cost as part of the carrying value of the related asset and
depreciating it over the remaining useful life of the asset. This Statement was
effective for the Company on January 1, 2003 and did not have a material impact
on the Company's financial position or results of operations.
ACCOUNTING FOR COSTS ASSOCIATED WITH EXIT OR DISPOSAL ACTIVITIES
In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities." This Statement replaces the
accounting and reporting provisions of Emerging Issues Task Force (EITF) 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)." It requires that costs associated with an exit or disposal
activity be recognized when a liability is incurred rather than at the date
9
UnionBanCal Corporation and Subsidiaries
Notes to Condensed Consolidated Financial Statements (Continued)
NOTE 2--RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS (CONTINUED)
an entity commits to an exit plan. This Statement was effective on January 1,
2003 and did not have a material impact on the Company's financial position or
results of operations.
ACCOUNTING FOR GUARANTORS AND DISCLOSURE REQUIREMENTS FOR GUARANTEES,
INCLUDING INDIRECT GUARANTEES OF INDEBTEDNESS OF OTHERS
In November 2002, the FASB issued Interpretation No. 45 (FIN 45),
"Guarantor's Accounting and Disclosure Requirements for Guarantees, Including
Indirect Guarantees of Indebtedness of Others." The Interpretation elaborates on
the existing disclosure requirements for most guarantees and requires that
guarantors recognize a liability for the fair value of certain guarantees at
inception. The disclosure requirements of this Interpretation were effective for
financial statements ending after December 15, 2002. The initial recognition and
measurement provisions of this Interpretation were applied on a prospective
basis to guarantees issued or modified after December 31, 2002. The adoption of
this Interpretation did not have a material impact on the Company's financial
position or results of operations.
ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES
In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133 on
Derivative Instruments and Hedging Activities." 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 was effective for contracts entered into
or modified after June 30, 2003 and for hedging relationships designated after
June 30, 2003. The provisions of the Statement, with certain exceptions, are
required to be applied prospectively. The adoption of this Statement did not
have a material impact on the Company's financial position or results of
operations.
ACCOUNTING FOR CERTAIN FINANCIAL INSTRUMENTS WITH CHARACTERISTICS OF BOTH
LIABILITIES AND EQUITY
In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equity." The
Statement establishes standards for how the Company should classify and measure
certain financial instruments with characteristics of both liabilities and
equity. This Statement was effective for financial instruments entered into or
modified after May 31, 2003, and to other instruments effective at the beginning
of the first interim period beginning after June 15, 2003. Adoption of this
Statement did not have a material impact on the Company's financial position or
results of operations.
CONSOLIDATION OF VARIABLE INTEREST ENTITIES
In January 2003, the FASB issued Interpretation No. 46 (FIN 46),
"Consolidation of Variable Interest Entities". FIN 46 provides guidance on how
to identify a variable interest entity (VIE), and when the assets, liabilities,
noncontrolling interests and result of operations of a VIE need to be included
in a company's consolidated financial statements. A VIE exists when either the
total equity investment at risk is not sufficient to permit the entity to
finance its activities by itself, or the equity investors lack a controlling
financial interest or they have voting rights that are not proportionate to
their economic interest. A company that holds variable interests in an entity
will need to consolidate that entity if the company's interest in the VIE is
such that the company will absorb a majority of the VIE's expected losses and/or
10
UnionBanCal Corporation and Subsidiaries
Notes to Condensed Consolidated Financial Statements (Continued)
NOTE 2--RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS (CONTINUED)
receive a majority of the VIE's expected residual returns, if they occur. FIN 46
also requires additional disclosures by primary beneficiaries and other
significant variable interest holders.
In December 2003, the FASB issued FIN 46R, a revision of FIN 46. FIN 46R
clarifies that only the holder of a variable interest can ever be a VIE's
primary beneficiary. FIN 46R delays the effective date of FIN 46 for all
entities created subsequent to January 31, 2003 and non-SPE's (special-purpose
entities) created prior to February 1, 2003 to reporting periods ending after
March 15, 2004. Entities created prior to February 1, 2004 and defined as SPE's
must apply either the provisions of FIN 46 or early adopt the provisions of FIN
46R by the first reporting period ending after December 15, 2003. The adoption
of FIN 46R on January 1, 2004 did not have a material impact on the Company's
financial position or results of operations.
ACCOUNTING FOR EMPLOYERS' DISCLOSURES ABOUT PENSIONS AND OTHER
POSTRETIREMENT BENEFITS
In December 2003, the FASB issued SFAS No. 132R, a revision of SFAS No.
132, "Employers' Disclosures about Pensions and Other Postretirement Benefits,
an amendment of FASB Statements No. 87, 88, and 106." The Statement expands the
disclosure requirements of SFAS No. 132 to include information describing types
of plan assets, investment strategy, measurement date(s), plan obligations, cash
flows, and components of net period benefit costs of defined pension plans and
other defined benefit postretirement plans. The Statement is effective for
financial statements with fiscal years ending after December 15, 2003. The
expanded disclosures required by SFAS No. 132R are disclosed in Note 7 of the
Notes to Consolidated Financial Statements in the Form 10-K for the year ended
December 31, 2003. Periodic disclosures under SFAS No. 132R are contained in
Note 8 of this report.
ACCOUNTING FOR CERTAIN LOANS ACQUIRED IN A TRANSFER
In December 2003, under clearance of the FASB, the Accounting Standards
Executive Committee (AcSEC) of the AICPA issued Statement of Position (SOP)
03-3, "Accounting for Certain Loans or Debt Securities Acquired in a Transfer."
This SOP establishes accounting standards for discounts on purchased loans when
the discount is attributable to credit quality. The SOP requires that the loan
discount, rather than contractual amounts, establishes the investor's estimate
of undiscounted expected future principal and interest cash flows as a benchmark
for yield and impairment measurements. The SOP prohibits the carryover or
creation of a valuation allowance in the initial accounting for these loans.
This SOP is effective for loans acquired in years ending after December 15,
2004. Management believes that adoption of this Statement will not have a
material impact on the Company's financial position or results of operations at
adoption.
THE MEANING OF OTHER-THAN-TEMPORARY IMPAIRMENT AND ITS APPLICATION TO
CERTAIN INVESTMENTS
In March 2004, the Emerging Issues Task Force (EITF) reached consensus on
certain incremental issues related to Issue No. 03-1, "The Meaning of
Other-Than-Temporary Impairment and Its Application to Certain Investments." In
addition to disclosure requirements that were effective for fiscal years ending
after December 15, 2003, EITF Issue No. 03-1 requires that companies recognize
impairment equal to the difference between the investment's cost and fair value
if the investor does not have the ability and intent to hold the investment for
a period of time sufficient for a forecasted recovery of fair value up to or
beyond the cost of the investment. EITF Issue No. 03-1 is effective for interim
periods beginning after June 15,
11
UnionBanCal Corporation and Subsidiaries
Notes to Condensed Consolidated Financial Statements (Continued)
NOTE 2--RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS (CONTINUED)
2004. The Company is currently assessing the implications of EITF No. 03-1 and
has not concluded what impact, if any, will result from its adoption.
NOTE 3--EARNINGS PER SHARE
Basic earnings per share (EPS) is computed by dividing net income by the
weighted average number of common shares outstanding during the period. Diluted
EPS incorporates the dilutive effect of common stock equivalents outstanding on
an average basis during the period. Stock options are a common stock equivalent.
The following table presents a reconciliation of basic and diluted EPS for the
three months and six months ended June 30, 2003 and 2004.
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30,
------------------------------------- ------------------------------------
2003 2004 2003 2004
----------------- ----------------- ----------------- -----------------
(AMOUNTS IN THOUSANDS,
EXCEPT PER SHARE DATA) BASIC DILUTED BASIC DILUTED BASIC DILUTED BASIC DILUTED
- ------------------------- -------- -------- -------- -------- -------- -------- -------- --------
Net Income............... $144,758 $144,758 $231,097 $231,097 $280,275 $280,275 $388,584 $388,584
======== ======== ======== ======== ======== ======== ======== ========
Weighted average common
shares outstanding..... 150,047 150,047 147,687 147,687 150,330 150,330 147,544 147,544
Additional shares due to:
Assumed conversion of
dilutive stock options. -- 1,442 -- 2,497 -- 1,416 -- 2,448
-------- -------- -------- -------- -------- -------- -------- --------
Adjusted weighted average
common shares
outstanding............ 150,047 151,489 147,687 150,184 150,330 151,746 147,544 149,992
======== ======== ======== ======== ======== ======== ======== ========
Net income per share..... $ 0.96 $ 0.96 $ 1.56 $ 1.54 $ 1.86 $ 1.85 $ 2.63 $ 2.59
======== ======== ======== ======== ======== ======== ======== ========
12
UnionBanCal Corporation and Subsidiaries
Notes to Condensed Consolidated Financial Statements (Continued)
NOTE 4--ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS)
The following table presents the components of other comprehensive income
(loss) and the related tax effect allocated to each component.
BEFORE TAX TAX NET OF
(DOLLARS IN THOUSANDS) AMOUNT EFFECT TAX
- ------------------------------------------------------ ---------- --------- ---------
FOR THE SIX MONTHS ENDED JUNE 30, 2003:
Cash flow hedge activities:
Unrealized net gains on hedges...................... $ 58,272 $ (22,289) $ 35,983
Less: reclassification adjustment for net gains
on hedges included in net income.................. (71,204) 27,236 (43,968)
---------- --------- ---------
Net change in unrealized gains on hedges.............. (12,932) 4,947 (7,985)
---------- --------- ---------
Securities available for sale:
Unrealized holding losses arising during the
period on securities available for sale........... (57,645) 22,049 (35,596)
Less: reclassification adjustment for net gains
on securities available for sale included in
net income........................................ (9,660) 3,695 (5,965)
---------- --------- ---------
Net change in unrealized gains on securities
available for sale.................................. (67,305) 25,744 (41,561)
---------- --------- ---------
Foreign currency translation adjustment............... 191 (73) 118
---------- --------- ---------
Net change in accumulated other comprehensive
income (loss)....................................... $ (80,046) $ 30,618 $ (49,428)
========== ========= =========
FOR THE SIX MONTHS ENDED JUNE 30, 2004:
Cash flow hedge activities:
Unrealized net losses on hedges..................... $ (15,832) $ 6,056 $ (9,776)
Less: reclassification adjustment for net gains
on hedges included in net income.................. (45,307) 17,330 (27,977)
---------- --------- ---------
Net change in unrealized gains on hedges.............. (61,139) 23,386 (37,753)
---------- --------- ---------
Securities available for sale:
Unrealized holding losses arising during the
period on securities available for sale........... (174,632) 66,797 (107,835)
Less: reclassification adjustment for net gains
on securities available for sale included in
net income........................................ (1,618) 619 (999)
---------- --------- ---------
Net change in unrealized losses on securities
available for sale.................................. (176,250) 67,416 (108,834)
---------- --------- ---------
Foreign currency translation adjustment............... 842 (322) 520
---------- --------- ---------
Net change in accumulated other comprehensive
income (loss)....................................... $ (236,547) $ 90,480 $(146,067)
========== ========= =========
13
UnionBanCal Corporation and Subsidiaries
Notes to Condensed Consolidated Financial Statements (Continued)
NOTE 4--ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS)(CONTINUED)
The following table presents accumulated other comprehensive income (loss)
balances.
NET NET
UNREALIZED UNREALIZED
GAINS (LOSSES) GAINS (LOSSES) FOREIGN MINIMUM ACCUMULATED
ON CASH ON SECURITES CURRENCY PENSION OTHER
FLOW AVAILABLE TRANSLATION LIABILITY COMPREHENSIVE
(DOLLARS IN THOUSANDS) HEDGES FOR SALE ADJUSTMENT ADJUSTMENT INCOME (LOSS)
- ------------------------------- ------------- ------------- ----------- ---------- -------------
BALANCE, DECEMBER 31, 2002..... $ 104,368 $ 147,450 $ (10,649) $ (1,075) $ 240,094
Change during the period....... (7,985) (41,561) 118 -- (49,428)
------------- ------------- ----------- ---------- -------------
BALANCE, JUNE 30, 2003......... $ 96,383 $ 105,889 $ (10,531) $ (1,075) $ 190,666
============= ============= =========== ========== =============
BALANCE, DECEMBER 31, 2003..... $ 43,786 $ 22,535 $ (10,293) $ (3,786) $ 52,242
Change during the period....... (37,753) (108,834) 520 -- (146,067)
------------- ------------- ----------- ---------- -------------
BALANCE, JUNE 30, 2004......... $ 6,033 $ (86,299) $ (9,773) $ (3,786) $ (93,825)
============= ============= =========== ========== =============
NOTE 5--BUSINESS SEGMENTS
The Company is organized based on the products and services that it offers
and operates in four principal areas:
o The Community Banking and Investment Services Group offers a range of
banking services, primarily to individuals and small businesses,
delivered generally through a tri-state (California, Washington and
Oregon) network of branches and ATM's. These services include
commercial loans, mortgages, home equity lines of credit, consumer
loans, deposit services and cash management as well as fiduciary,
private banking, investment and asset management services for
individuals and institutions, and risk management and insurance
products for businesses and individuals.
o The Commercial Financial Services Group provides credit and cash
management services to large corporate and middle-market companies.
Services include commercial and project loans, real estate financing,
asset-based financing, trade finance and letters of credit, lease
financing, customized cash management services and selected capital
markets products.
o The International Banking Group primarily provides correspondent
banking and trade-finance products and services to financial
institutions. The group's revenue predominately relates to foreign
customers.
o The Global Markets Group is responsible for the Company's market risk
management including liquidity, interest rate and price risks, and
offers a broad range of risk management and trading products and
services to the Company's clients through the groups described above.
The information, set forth in the tables on the following pages, reflects
selected income statement and balance sheet items by business unit. The
information presented does not necessarily represent the business units'
financial condition and results of operations were they independent entities.
Unlike financial accounting, there is no authoritative body of guidance for
management accounting equivalent to U.S. GAAP. Consequently, reported results
are not necessarily comparable with those presented by other companies. Included
in the total asset line of the table are the amounts of goodwill for each
reporting unit
14
UnionBanCal Corporation and Subsidiaries
Notes to Condensed Consolidated Financial Statements (Continued)
NOTE 5--BUSINESS SEGMENTS (CONTINUED)
as of June 30, 2003 and 2004. Substantially all of the goodwill reflected on the
Consolidated Balance Sheet is attributed to the Community Banking and Investment
Services Group.
The information in these tables is derived from the internal management
reporting system used by management to measure the performance of the business
segments and the Company overall. The management reporting system assigns
balance sheet and income statement items to each business segment based on
internal management accounting policies. Net interest income is determined by
the Company's internal funds transfer pricing system, which assigns a cost of
funds or a credit for funds to assets or liabilities based on their type,
maturity or repricing characteristics. Noninterest income and expense directly
attributable to a business segment are assigned to that business. Certain
indirect costs, such as operations and technology expense, are allocated to the
segments based on studies of billable unit costs for product or data processing.
Other indirect costs, such as corporate overhead, are allocated to the business
segments based on a predetermined percentage of usage. Under the Company's
risk-adjusted return on capital (RAROC) methodology, credit expense is charged
to business segments based upon expected losses arising from credit risk. In
addition, the attribution of economic capital is related to unexpected losses
arising from credit, market and operational risks.
"Other" is comprised of certain parent company non-bank subsidiaries, the
elimination of the fully taxable-equivalent basis amount, the amount of the
(reversal of) provision for credit losses over/(under) the RAROC expected loss
for the period, the earnings associated with the unallocated equity capital and
allowance for credit losses, and the residual costs of support groups. In
addition, it includes the Pacific Rim Corporate Group, which offers financial
products to Japanese-owned subsidiaries located in the U.S. On an individual
basis, none of the items in "Other" are significant to the Company's business.
Included in noninterest income for the second quarter of 2004 are two
significant items: a $93.0 million gain resulting from the sale of the Company's
merchant card portfolio and an $8.5 million gain resulting from the sale of real
property.
15
UnionBanCal Corporation and Subsidiaries
Notes to Condensed Consolidated Financial Statements (Continued)
NOTE 5--BUSINESS SEGMENTS (CONTINUED)
The business units' results for the prior periods have been restated to
reflect changes in the transfer pricing methodology and any reorganization
changes that may have occurred.
COMMUNITY BANKING
AND INVESTMENT COMMERCIAL FINANCIAL INTERNATIONAL
SERVICES GROUP SERVICES GROUP BANKING GROUP
---------------------------------------------------------------
AS OF AND FOR THE THREE MONTHS ENDED JUNE 30,
---------------------------------------------------------------
2003 2004 2003 2004 2003 2004
- -------------------------------- -------- -------- -------- -------- ------- -------
RESULTS OF OPERATIONS (DOLLARS
IN THOUSANDS):
Net interest income............. $163,613 $185,829 $180,956 $191,471 $ 8,160 $ 9,222
Noninterest income.............. 111,878 129,793 61,552 72,543 26,090 22,261
-------- -------- -------- -------- ------- -------
Total revenue................... 275,491 315,622 242,508 264,014 34,250 31,483
Noninterest expense............. 197,289 223,645 105,097 104,003 15,398 16,957
Credit expense (income)......... 8,064 7,797 42,145 26,480 547 645
-------- -------- -------- -------- ------- -------
Income (loss) before income tax
expense (benefit)............. 70,138 84,180 95,266 133,531 18,305 13,881
Income tax expense (benefit).... 26,828 32,199 29,547 45,321 7,001 5,310
-------- -------- -------- -------- ------- -------
Net income (loss)............... $ 43,310 $ 51,981 $ 65,719 $ 88,210 $11,304 $ 8,571
======== ======== ======== ======== ======= =======
TOTAL ASSETS, END OF PERIOD
(dollars in millions):........ $ 12,249 $ 14,040 $ 14,976 $ 14,852 $ 1,937 $ 2,379
======== ======== ======== ======== ======= =======
GLOBAL UNIONBANCAL
MARKETS GROUP OTHER CORPORATION
------------------- ------------------- -------------------
AS OF AND FOR THE THREE MONTHS ENDED JUNE 30,
----------------------------------------------------------------
2003 2004 2003 2004 2003 2004
- -------------------------------- -------- -------- -------- -------- -------- --------
RESULTS OF OPERATIONS (DOLLARS
IN THOUSANDS):
Net interest income............. $ 17,139 $(15,802) $ 15,909 $ 29,138 $385,777 $399,858
Noninterest income.............. 1,882 1,394 1,769 105,019 203,171 331,010
-------- -------- -------- -------- -------- --------
Total revenue................... 19,021 (14,408) 17,678 134,157 588,948 730,868
Noninterest expense............. 3,744 4,441 29,476 27,356 351,004 376,402
Credit expense (income)......... 50 177 (25,806) (45,099) 25,000 (10,000)
-------- -------- -------- -------- -------- --------
Income (loss) before income tax
expense (benefit)............. 15,227 (19,026) 14,008 151,900 212,944 364,466
Income tax expense (benefit).... 5,824 (7,277) (1,014) 57,816 68,186 133,369
-------- -------- -------- -------- -------- --------
Net income (loss)............... $ 9,403 $(11,749) $ 15,022 $ 94,084 $144,758 $231,097
======== ======== ======== ======== ======== ========
TOTAL ASSETS, END OF PERIOD
(dollars in millions):........ $ 11,824 $ 13,957 $ 1,683 $ 1,068 $ 42,669 $ 46,296
======== ======== ======== ======== ======== ========
16
UnionBanCal Corporation and Subsidiaries
Notes to Condensed Consolidated Financial Statements (Continued)
NOTE 5--BUSINESS SEGMENTS (CONTINUED)
COMMUNITY BANKING COMMERCIAL
AND INVESTMENT FINANCIAL INTERNATIONAL
SERVICES GROUP SERVICES GROUP BANKING GROUP
------------------- ------------------- ------------------
AS OF AND FOR THE SIX MONTHS ENDED JUNE 30,
---------------------------------------------------------------
2003 2004 2003 2004 2003 2004
- -------------------------------- -------- -------- -------- -------- ------- -------
RESULTS OF OPERATIONS (DOLLARS
IN THOUSANDS):
Net interest income............. $331,474 $368,496 $360,187 $374,978 $17,117 $17,030
Noninterest income.............. 213,503 246,394 119,464 142,170 41,573 40,450
-------- -------- -------- -------- ------- -------
Total revenue................... 544,977 614,890 479,651 517,148 58,690 57,480
Noninterest expense............. 397,179 442,629 203,856 208,645 30,333 32,640
Credit expense (income)......... 15,783 15,584 84,607 57,706 1,052 1,249
-------- -------- -------- -------- ------- -------
Income (loss) before income tax
expense (benefit)............. 132,015 156,677 191,188 250,797 27,305 23,591
Income tax expense (benefit).... 50,496 59,929 60,227 83,570 10,444 9,024
-------- -------- -------- -------- ------- -------
Net income (loss)............... $ 81,519 $ 96,748 $130,961 $167,227 $16,861 $14,567
======== ======== ======== ======== ======= =======
TOTAL ASSETS, END OF PERIOD
(dollars in millions):........ $ 12,249 $ 14,040 $ 14,976 $ 14,852 $ 1,937 $ 2,379
======== ======== ======== ======== ======= =======
GLOBAL UNIONBANCAL
MARKETS GROUP OTHER CORPORATION
------------------- ------------------- ---------------------
AS OF AND FOR THE SIX MONTHS ENDED JUNE 30,
------------------------------------------------------------------
2003 2004 2003 2004 2003 2004
- -------------------------------- -------- -------- -------- -------- ---------- ----------
RESULTS OF OPERATIONS (DOLLARS
IN THOUSANDS):
Net interest income............. $ 38,231 $(14,651) $ 29,548 $ 54,426 $ 776,557 $ 800,279
Noninterest income.............. 3,408 2,936 10,994 110,265 388,942 542,215
-------- -------- -------- -------- ---------- ----------
Total revenue................... 41,639 (11,715) 40,542 164,691 1,165,499 1,342,494
Noninterest expense............. 8,232 10,868 54,004 54,726 693,604 749,508
Credit expense (income)......... 100 227 (46,542) (89,766) 55,000 (15,000)
-------- -------- -------- -------- ---------- ----------
Income (loss) before income tax
expense (benefit)............. 33,307 (22,810) 33,080 199,731 416,895 607,986
Income tax expense (benefit).... 12,740 (8,725) 2,713 75,604 136,620 219,402
-------- -------- -------- -------- ---------- ----------
Net income (loss)............... $ 20,567 $(14,085) $ 30,367 $124,127 $ 280,275 $ 388,584
======== ======== ======== ======== ========== ==========
TOTAL ASSETS, END OF PERIOD
(dollars in millions):........ $ 11,824 $ 13,957 $ 1,683 $ 1,068 $ 42,669 $ 46,296
======== ======== ======== ======== ========== ==========
NOTE 6--DERIVATIVE INSTRUMENTS AND OTHER FINANCIAL INSTRUMENTS USED FOR HEDGING
Derivative positions are integral components of the Company's designated
asset and liability management activities. The Company uses interest rate
derivatives to manage the sensitivity of the Company's net interest income to
changes in interest rates. These instruments are used to manage interest rate
risk relating to specified groups of assets and liabilities, primarily
LIBOR-based commercial loans, certificates of deposit, medium-term notes and
subordinated debt.
CASH FLOW HEDGES
HEDGING STRATEGIES FOR VARIABLE RATE LOANS AND CERTIFICATES OF DEPOSIT
The Company engages in several types of cash flow hedging strategies for
which the hedged transactions are forecasted future loan interest payments, and
the hedged risk is the variability in those
17
UnionBanCal Corporation and Subsidiaries
Notes to Condensed Consolidated Financial Statements (Continued)
NOTE 6--DERIVATIVE INSTRUMENTS AND OTHER FINANCIAL INSTRUMENTS USED FOR HEDGING
(CONTINUED)
payments due to changes in the designated benchmark rate, e.g., U.S. dollar
LIBOR. In these strategies, the hedging instruments are matched with groups of
variable rate loans such that the tenor of the variable rate loans and that of
the hedging instrument is identical. Cash flow hedging strategies include the
utilization of purchased floor, cap, corridor options and interest rate swaps.
At June 30, 2004, the weighted average remaining life of these cash flow hedges
was approximately 1.2 years.
The Company uses purchased interest rate floors to hedge the variable cash
flows associated with 1-month LIBOR or 3-month LIBOR indexed loans. Payments
received under the floor contract offset the decline in loan interest income
caused by the relevant LIBOR index falling below the floor's strike rate.
The Company uses interest rate floor corridors to hedge the variable cash
flows associated with 1-month LIBOR or 3-month LIBOR indexed loans. Net payments
to be received under the floor corridor contracts offset the decline in loan
interest income caused by the relevant LIBOR index falling below the corridor's
upper strike rate, but only to the extent the index falls to the lower strike
rate. The corridor will not provide protection from declines in the relevant
LIBOR index to the extent it falls below the corridor's lower strike rate.
The Company uses interest rate collars to hedge the variable cash flows
associated with 1-month LIBOR or 3-month LIBOR indexed loans. Net payments to be
received under the collar contracts offset the decline in loan interest income
caused by the relevant LIBOR index falling below the collar's floor strike rate
while net payments to be paid will reduce the increase in loan interest income
caused by the LIBOR index rising above the collar's cap strike rate.
The Company uses interest rate swaps to hedge the variable cash flows
associated with 1-month LIBOR or 3-month LIBOR indexed loans. Payments to be
received (or paid) under the swap contracts will offset the fluctuations in loan
interest income caused by changes in the relevant LIBOR index. As such, these
instruments hedge all fluctuations in the loans' interest income caused by
changes in the relevant LIBOR index.
The Company uses purchased interest rate caps to hedge the variable
interest cash flows associated with the forecasted issuance and rollover of
short-term, fixed rate, negotiable certificates of deposit (CDs). In these
hedging relationships, the Company hedges the LIBOR component of the CD rates,
which is either 3-month LIBOR or 6-month LIBOR, based on the CDs' original term
to maturity, which reflects their repricing frequency. Net payments to be
received under the cap contract offset the increase in interest expense caused
by the relevant LIBOR index rising above the cap's strike rate.
The Company uses interest rate cap corridors to hedge the variable cash
flows associated with the forecasted issuance and rollover of short-term, fixed
rate, negotiable CDs. In these hedging relationships, the Company hedges the
LIBOR component of the CD rates, either 1-month LIBOR, 3-month LIBOR, or 6-month
LIBOR, based on the original term to maturity of the CDs, which reflects their
repricing frequency. Net payments to be received under the cap corridor
contracts offset the increase in deposit interest expense caused by the relevant
LIBOR index rising above the corridor's lower strike rate, but only to the
extent the index rises to the upper strike rate. The corridor will not provide
protection from increases in the relevant LIBOR index to the extent it rises
above the corridor's upper strike rate.
Hedging transactions are structured at inception so that the notional
amounts of the hedge are matched with an equal principal amount of loans or CDs,
the index and repricing frequencies of the hedge matches those of the loans or
CDs, and the period in which the designated hedged cash flows occurs is equal to
the term of the hedge. As such, most of the ineffectiveness in the hedging
relationship results from
18
UnionBanCal Corporation and Subsidiaries
Notes to Condensed Consolidated Financial Statements (Continued)
NOTE 6--DERIVATIVE INSTRUMENTS AND OTHER FINANCIAL INSTRUMENTS USED FOR HEDGING
(CONTINUED)
the mismatch between the timing of reset dates on the hedge versus those of the
loans or CDs. In the second quarter of 2004, the Company recognized a net loss
of $0.3 million due to ineffectiveness, which is recognized in noninterest
expense, compared to a net gain of $0.3 million in the second quarter of 2003.
FAIR VALUE HEDGES
HEDGING STRATEGY FOR UNIONBANCAL CORPORATION--JUNIOR SUBORDINATED DEBT
PAYABLE TO SUBSIDIARY GRANTOR TRUST (TRUST NOTES)
Prior to February 19, 2004, when the Company terminated its fair value
hedge and called its Trust Notes, the Company engaged in an interest rate
hedging strategy in which an interest rate swap was associated with a specific
interest bearing liability, UnionBanCal Corporation's Trust Notes, in order to
convert the liability from a fixed rate to a floating rate instrument. This
strategy mitigated the changes in fair value of the hedged liability caused by
changes in the designated benchmark interest rate, U.S. dollar LIBOR.
Fair value hedging transactions were structured at inception so that the
notional amounts of the swap matched an associated principal amount of the Trust
Notes. The interest payment dates, the expiration date, and the embedded call
option of the swap matched those of the Trust Notes. Because the interest rate
swap was terminated in the first quarter of 2004, there was no ineffectiveness
on the fair value hedges during the second quarter of 2004 compared to a net
loss of less than $0.1 million in the second quarter of 2003.
HEDGING STRATEGY FOR MEDIUM-TERM NOTES
The Company engages in an interest rate hedging strategy in which an
interest rate swap is associated with a specified interest bearing liability,
UnionBanCal Corporation's five-year, medium-term debt issuance, in order to
convert the liability from a fixed rate to a floating rate instrument. This
strategy mitigates the changes in fair value of the hedged liability caused by
changes in the designated benchmark interest rate, U.S. dollar LIBOR.
The fair value hedging transaction for the medium-term notes was structured
at inception to mirror all of the provisions of the medium-term notes, which
allows the Company to assume that no ineffectiveness exists.
HEDGING STRATEGY FOR SUBORDINATED DEBT
The Company engages in an interest rate hedging strategy in which an
interest rate swap is associated with a specified interest bearing liability,
UnionBanCal Corporation's ten-year, subordinated debt issuance, in order to
convert the liability from a fixed rate to a floating rate instrument. This
strategy mitigates the changes in fair value of the hedged liability caused by
changes in the designated benchmark interest rate, U.S. dollar LIBOR.
The fair value hedging transaction for the subordinated debt was structured
at inception to mirror all of the provisions of the subordinated debt, which
allows the Company to assume that no ineffectiveness exists.
19
UnionBanCal Corporation and Subsidiaries
Notes to Condensed Consolidated Financial Statements (Continued)
NOTE 6--DERIVATIVE INSTRUMENTS AND OTHER FINANCIAL INSTRUMENTS USED FOR HEDGING
(CONTINUED)
OTHER
The Company uses To-Be-Announced (TBA) contracts to fix the price and yield
of anticipated purchases or sales of mortgage-backed securities that will be
delivered at an agreed upon date. This strategy hedges the risk of variability
in the cash flows to be paid or received upon settlement of the TBA contract.
NOTE 7--GUARANTEES
Standby and commercial letters of credit are conditional commitments issued
to guarantee the performance of a customer to a third party. Standby letters of
credit generally are contingent upon the failure of the customer to perform
according to the terms of the underlying contract with the third party, while
commercial letters of credit are issued specifically to facilitate foreign or
domestic trade transactions. The majority of these types of commitments have
terms of one year or less. Collateral may be obtained based on management's
credit assessment of the customer. As of June 30, 2004, the Company's maximum
exposure to loss for standby and commercial letters of credit was $2.9 billion
and $232.2 million, respectively. At June 30, 2004, the carrying value of the
Company's standby and commercial letters of credit, which is included in other
liabilities on the consolidated balance sheet, totaled $5.5 million.
Principal investments include direct investments in private and public
companies and indirect investments in private equity funds. The Company issues
commitments to provide equity and mezzanine capital financing to private and
public companies through either direct investments in specific companies or
through investment funds and partnerships. The timing of future cash
requirements to fund such commitments is generally dependent on the investment
cycle. This cycle, the period over which privately-held companies are funded by
private equity investors and ultimately sold, merged, or taken public through an
initial offering, can vary based on overall market conditions as well as the
nature and type of industry in which the companies operate. At June 30, 2004,
the Company had commitments to fund principal investments of $59.6 million.
The Company has contingent consideration agreements that guarantee
additional payments to acquired insurance agencies' stockholders based on the
agencies' future performance in excess of established revenue and/or earnings
before interest, taxes, depreciation and amortization (EBITDA) thresholds. If
the insurance agencies' future performance exceeds these thresholds during a
three-year period, the Company will be liable to make payments to those former
stockholders. As of June 30, 2004, the Company had a maximum exposure of $7.5
million for these agreements, the last of which expire in December 2006.
The Company is fund manager for limited liability corporations issuing
low-income housing credit (LIHC) investments. LIHC investments provide tax
benefits to investors in the form of tax deductions from operating losses and
tax credits. To facilitate the sale of these LIHC investments, the Company
guarantees the timely completion of projects and delivery of tax benefits
throughout the investment term. Guarantees may include a minimum rate of return,
the availability of tax credits, and operating deficit thresholds over a
ten-year average period. Additionally, the Company receives project completion
and tax credit guarantees from the limited liability corporations issuing the
LIHC investments that reduce the Company's ultimate exposure to loss. As of June
30, 2004, the Company's maximum exposure to loss under these guarantees was
limited to a return of investor capital and minimum investment yield, or $103.6
million. The Company maintains a reserve of $4.0 million for these guarantees.
20
UnionBanCal Corporation and Subsidiaries
Notes to Condensed Consolidated Financial Statements (Continued)
NOTE 7--GUARANTEES (CONTINUED)
The Company has guarantees that obligate it to perform if its affiliates
are unable to discharge their obligations. These obligations include guarantee
of trust preferred securities, commercial paper obligations and leveraged lease
transactions. Guarantees issued by the Bank for an affiliate's commercial paper
program are done in order to facilitate their sale. As of June 30, 2004, the
Bank had a maximum exposure to loss under these guarantees, which have an
average term of less than one year, of $561.0 million. The Bank's guarantee is
fully collateralized by a pledged deposit. UnionBanCal Corporation guarantees
its subsidiaries' leveraged lease transactions, which have terms ranging from 15
to 30 years. Following the original funding of the leveraged lease transactions,
UnionBanCal Corporation has no material obligation to be satisfied. As of June
30, 2004, UnionBanCal Corporation had no material exposure to loss under these
guarantees.
The Company conducts securities lending transactions for institutional
customers as a fully disclosed agent. At times, securities lending
indemnifications are issued to guarantee that a security lending customer will
be made whole in the event the borrower does not return the security subject to
the lending agreement and collateral held is insufficient to cover the market
value of the security. All lending transactions are collateralized, primarily by
cash. The amount of securities lent with indemnifications was $1.6 billion at
June 30, 2004. The market value of the associated collateral was $1.7 billion at
June 30, 2004.
NOTE 8--PENSION AND OTHER POSTRETIREMENT BENEFITS
The following tables summarize the components of net periodic benefit costs
for the three months and six months ended June 30, 2003 and 2004.
PENSION BENEFITS OTHER BENEFITS
-------------------- --------------------
FOR THE THREE MONTHS FOR THE THREE MONTHS
ENDED JUNE 30, ENDED JUNE 30,
-------------------- --------------------
(DOLLARS IN THOUSANDS) 2003 2004 2003 2004
- ----------------------------------------- -------- -------- ------- --------
COMPONENTS OF NET PERIODIC BENEFIT COST
Service cost............................. $ 8,217 $ 9,511 $ 1,295 $ 1,815
Interest cost............................ 11,875 13,518 2,641 2,908
Expected return on plan assets........... (18,203) (20,778) (1,687) (2,370)
Amortization of prior service cost....... 267 267 (24) (24)
Amortization of transition amount........ -- -- 637 638
Recognized net actuarial loss............ 1,042 4,395 1,599 1,950
-------- -------- ------- --------
Total net periodic benefit cost.......... $ 3,198 $ 6,913 $ 4,461 $ 4,917
======== ======== ======= ========
PENSION BENEFITS OTHER BENEFITS
-------------------- --------------------
FOR THE SIX MONTHS FOR THE SIX MONTHS
ENDED JUNE 30, ENDED JUNE 30,
-------------------- --------------------
(DOLLARS IN THOUSANDS) 2003 2004 2003 2004
- ----------------------------------------- -------- --------- ------- --------
COMPONENTS OF NET PERIODIC BENEFIT COST
Service cost............................. $ 16,434 $ 18,829 $ 2,590 $ 3,383
Interest cost............................ 23,750 26,120 5,281 5,680
Expected return on plan assets........... (36,406) (41,565) (3,373) (4,467)
Amortization of prior service cost....... 534 534 (48) (48)
Amortization of transition amount........ -- -- 1,275 1,275
Recognized net actuarial loss............ 2,085 7,217 3,197 3,536
-------- -------- ------- --------
Total net periodic benefit cost.......... $ 6,396 $ 11,135 $ 8,922 $ 9,359
======== ======== ======= ========
21
UnionBanCal Corporation and Subsidiaries
Notes to Condensed Consolidated Financial Statements (Continued)
NOTE 8--PENSION AND OTHER POSTRETIREMENT BENEFITS (CONTINUED)
As previously disclosed in its consolidated financial statements for the
year ended December 31, 2003, the Company expected to make discretionary cash
contributions of $80 million to its defined benefit plan in 2004. The Company
made cash contributions of $80 million and $20 million in March and June 2004,
respectively. The Company does not expect to make any further contributions to
the plan for the remainder of 2004.
NOTE 9--SUBSEQUENT EVENTS
On July 1, 2004, the Bank signed a definitive agreement to acquire Jackson
Federal Bank, a $1.9 billion-asset bank headquartered in Brea, California, with
14 full-service branches and approximately 250 employees. At closing, the Bank
will pay $305 million, comprising $168 million in cash and $137 million in the
Company's common stock. The acquisition is expected to be completed in the
fourth quarter of 2004 following the receipt of regulatory approvals and the
satisfaction of other closing conditions.
On July 28, 2004, the Company's Board of Directors declared a quarterly
cash dividend of $0.36 per share of common stock. The dividend will be paid on
October 1, 2004 to stockholders of record as of September 3, 2004.
On August 1, 2004, the Company's subsidiary, Union Bank of California, N.A.
(the Bank), completed its acquisition of the business portfolio of CNA Trust
Company (CNAT), a leading provider of retirement plan trust and outsourcing
services to the institutional market place. The Company acquired total assets
and assumed liabilities of $167 million, each, for a cash consideration of $12
million. CNAT, based in Costa Mesa, California, was a subsidiary of
Chicago-based CNA Financial Corporation.
22
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
THIS DOCUMENT INCLUDES FORWARD-LOOKING INFORMATION, WHICH IS SUBJECT TO THE
"SAFE HARBOR" CREATED BY SECTION 27A OF THE SECURITIES ACT OF 1933, AS AMENDED,
AND SECTION 21E OF THE SECURITIES EXCHANGE ACT OF 1934, AS AMENDED. WE MAY MAKE
FORWARD-LOOKING STATEMENTS IN OTHER UNITED STATES SECURITIES AND EXCHANGE
COMMISSION (SEC) FILINGS, PRESS RELEASES, NEWS ARTICLES, CONFERENCE CALLS WITH
WALL STREET ANALYSTS AND STOCKHOLDERS AND WHEN WE ARE SPEAKING ON BEHALF OF
UNIONBANCAL CORPORATION. FORWARD-LOOKING STATEMENTS CAN BE IDENTIFIED BY THE
FACT THAT THEY DO NOT RELATE STRICTLY TO HISTORICAL OR CURRENT FACTS. OFTEN,
THEY INCLUDE THE WORDS "BELIEVE," "EXPECT," "ANTICIPATE," "INTEND," "PLAN,"
"ESTIMATE," "PROJECT," OR WORDS OF SIMILAR MEANING, OR FUTURE OR CONDITIONAL
VERBS SUCH AS "WILL," "WOULD," "SHOULD," "COULD," OR "MAY." THESE
FORWARD-LOOKING STATEMENTS ARE INTENDED TO PROVIDE INVESTORS WITH ADDITIONAL
INFORMATION WITH WHICH THEY MAY ASSESS OUR FUTURE POTENTIAL. ALL OF THESE
FORWARD-LOOKING STATEMENTS ARE BASED ON ASSUMPTIONS ABOUT AN UNCERTAIN FUTURE
AND ARE BASED ON INFORMATION AVAILABLE AT THE DATE SUCH STATEMENTS ARE ISSUED.
WE DO NOT UNDERTAKE TO UPDATE FORWARD-LOOKING STATEMENTS TO REFLECT FACTS,
CIRCUMSTANCES, ASSUMPTIONS OR EVENTS THAT OCCUR AFTER THE DATE THE
FORWARD-LOOKING STATEMENTS ARE MADE.
THERE ARE NUMEROUS RISKS AND UNCERTAINTIES THAT COULD AND WILL CAUSE ACTUAL
RESULTS TO DIFFER MATERIALLY FROM THOSE DISCUSSED IN OUR FORWARD-LOOKING
STATEMENTS. MANY OF THESE FACTORS ARE BEYOND OUR ABILITY TO CONTROL OR PREDICT
AND COULD HAVE A MATERIAL ADVERSE EFFECT ON OUR STOCK PRICE, FINANCIAL
CONDITION, AND RESULTS OF OPERATIONS OR PROSPECTS. SUCH RISKS AND UNCERTAINTIES
INCLUDE, BUT ARE NOT LIMITED TO, THE FOLLOWING FACTORS: ADVERSE ECONOMIC AND
FISCAL CONDITIONS IN CALIFORNIA, GLOBAL POLITICAL AND GENERAL ECONOMIC
CONDITIONS RELATED TO THE WAR ON TERRORISM, ADVERSE ECONOMIC CONDITIONS
AFFECTING CERTAIN INDUSTRIES, FLUCTUATIONS IN INTEREST RATES, THE CONTROLLING
INTEREST IN US OF THE BANK OF TOKYO-MITSUBISHI, LTD. (BTM), WHICH IS A
WHOLLY-OWNED SUBSIDIARY OF MITSUBISHI TOKYO FINANCIAL GROUP, INC. (MTFG),
COMPETITION IN THE BANKING INDUSTRY, STATUTORY RESTRICTIONS ON DIVIDENDS,
ADVERSE EFFECTS OF CURRENT AND FUTURE BANKING RULES, REGULATIONS AND
LEGISLATION, AND RISKS ASSOCIATED WITH VARIOUS STRATEGIES WE MAY PURSUE,
INCLUDING POTENTIAL ACQUISITIONS, DIVESTITURES AND RESTRUCTURINGS. SEE ALSO THE
SECTION ENTITLED "CERTAIN BUSINESS RISK FACTORS" LOCATED NEAR THE END OF
"MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS."
ALL REPORTS THAT WE FILE ELECTRONICALLY WITH THE SEC, INCLUDING ANNUAL
REPORTS ON FORM 10-K, QUARTERLY REPORTS ON FORM 10-Q, AND CURRENT REPORTS ON
FORM 8-K, AS WELL AS ANY AMENDMENTS TO THOSE REPORTS, ARE ACCESSIBLE AT NO COST
ON OUR INTERNET WEBSITE AT WWW.UBOC.COM AS SOON AS REASONABLY PRACTICABLE AFTER
WE ELECTRONICALLY FILE SUCH REPORTS WITH, OR FURNISH THEM TO, THE SEC. THESE
FILINGS ARE ALSO ACCESSIBLE ON THE SEC'S WEBSITE AT WWW.SEC.GOV.
INTRODUCTION
We are a California-based, commercial bank holding company with
consolidated assets of $46.3 billion at June 30, 2004. During 2003, UnionBanCal
Corporation changed its state of incorporation from California to Delaware.
UnionBanCal Corporation and its banking subsidiary, Union Bank of
California, N.A. (the Bank), were created on April 1, 1996, by the combination
of Union Bank with BanCal Tri-State Corporation and its banking subsidiary, The
Bank of California, N.A. The combination was accounted for as a reorganization
of entities under common control, similar to a pooling of interests. At June 30,
2004, BTM, our majority owner, owned approximately 62 percent of our outstanding
common stock.
EXECUTIVE OVERVIEW
We are providing you with an overview of what we believe are the most
significant events that impacted our results for the second quarter of 2004. You
should carefully read the rest of this document for more detailed information
that will assist your understanding of trends, events and uncertainties that may
impact us.
23
Our largest subsidiary is Union Bank of California, N.A., a commercial bank
that derives most of its revenues from lending, deposit taking and trust
services to customers primarily in California. We also service customers in the
western United States, nationally and internationally. Interest rates, business
conditions and customer confidence all affect our ability to generate revenues.
In addition, the regulatory environment and competition can challenge our
ability to generate those revenues.
Overall credit quality in the commercial lending area continued to improve
in the second quarter of 2004. The improvements came from positive financial
results and outlooks of our borrowers, payoffs, and a slow down in net inflows
of nonaccrual loans. Nonaccrual loans totaled $178 million at June 30, 2004,
compared with $257 million at March 31, 2004. Although commercial loans
increased by $520 million, or 6 percent, during the second quarter, we recorded
a reversal of provision for credit losses of $10.0 million and reduced our
allowance for credit losses. We do not expect our credit quality to change
significantly throughout the remainder of 2004, unless the economic outlook
turns negative.
In the second quarter of 2004, positive economic data and the prospect of
higher interest rates in the future provided the impetus for the growth in our
commercial loan portfolio.
Low levels of interest rates continued to pressure our net interest income,
as our assets reprice more quickly than our deposits. A significant contributor
to the reduced asset yields was mortgage refinancings that further reduced our
net interest income on our residential mortgage loans and our mortgage-backed
securities portfolio. Derivative contracts, used to hedge the impact of falling
interest rates on our lending activities, began to expire in late 2003, further
compressing our net interest margin in the second quarter of 2004. A discussion
of the impact of our hedges is included in our detailed analysis of net interest
income. Despite these pressures, we have benefited from a higher level of
earning assets, including a significantly higher mix of securities, strong
deposit growth, and changes in our capital structure, including replacing higher
cost debt with lower cost funding. We expect that if business activity continues
to pick up and interest rates rise gradually, our net interest income will rise
as well.
Growth in core deposits was particularly strong in the second quarter of
2004, compared to the second quarter of 2003, providing us with a low cost of
funding, which is a competitive advantage. Average demand deposits for the
second quarter of 2004 were 48 percent of average total deposits compared to 46
percent for the second quarter of 2003, contributing to an average annualized
all-in cost of funds (interest expense divided by total interest bearing
liabilities and noninterest bearing deposits) of 0.61 percent and 0.42 percent
in the second quarters of 2004 and 2003, respectively. We attract deposits by
offering a variety of cash management products aimed at business clients,
including web cash management, check imaging, remittance and depository services
and disbursements. In addition, we made two bank acquisitions and opened a
number of de novo branches in the second half of 2003 and the first half of
2004, which further expanded our business locations and deposits in California.
Noninterest income rose 63 percent in the second quarter of 2004, compared
to the second quarter of 2003, primarily as a result of the sale of our merchant
card portfolio and the sale of real property in Southern California. The sale of
our merchant card portfolio, which resulted in a gain of $93 million, was part
of our strategic direction to divest ourselves of products and services that are
not competitively advantageous to us and to invest in products and services that
we believe will provide better opportunities for growing our noninterest income.
The ongoing impact on earnings per share as a result of this divestiture is
approximately ($0.01) per quarter, which is expected to be partially offset by
share repurchases we expect to make in the second half of 2004. Excluding the
gains from the sales mentioned above, noninterest income rose from service
charges on deposits, trust and investment management fees, letters of credit and
international commissions and fees. Increases in volumes were primarily
responsible for our increases.
Although noninterest expense rose 7 percent in the second quarter of 2004,
compared to the second quarter of 2003, much of that increase related to
investments that we made in bank acquisitions, de novo
24
branches and technology. We believe that these investments will bring
opportunities for growth in our business by increasing our customer base and
expanding the services we can provide.
FINANCIAL PERFORMANCE
SUMMARY OF FINANCIAL PERFORMANCE
FOR THE THREE MONTHS INCREASE (DECREASE) FOR THE SIX MONTHS INCREASE (DECREASE)
ENDED JUNE 30, 2004 VERSUS 2003 ENDED JUNE 30, 2004 VERSUS 2003
-------------------- ------------------ ---------------------- ------------------
(DOLLARS IN THOUSANDS) 2003 2004 AMOUNT PERCENT 2003 2004 AMOUNT PERCENT
- --------------------------- -------- --------- -------- ------- ---------- ---------- -------- -------
RESULTS OF OPERATIONS
Net interest income(1) $385,777 $ 399,858 $ 14,081 3.7% $ 776,557 $ 800,279 $ 23,722 3.1%
Noninterest income
Service charges on
deposit accounts....... 77,942 90,031 12,089 15.5 150,229 171,127 20,898 13.9
Trust and investment
management fees........ 33,141 36,788 3,647 11.0 65,816 72,610 6,794 10.3
Insurance commissions.... 16,024 18,652 2,628 16.4 29,242 40,387 11,145 38.1
International commissions
and fees............... 16,856 18,102 1,246 7.4 32,201 35,647 3,446 10.7
Card processing fees, net 9,340 15,456 6,116 65.5 19,022 24,248 5,226 27.5
Gain on sale of merchant
card portfolio......... -- 93,000 93,000 nm -- 93,000 93,000 nm
Other noninterest income. 49,868 58,981 9,113 18.3 92,432 105,196 12,764 13.8
-------- --------- -------- ---------- ---------- --------
Total noninterest income... 203,171 331,010 127,839 62.9 388,942 542,215 153,273 39.4
Total revenue.............. 588,948 730,868 141,920 24.1 1,165,499 1,342,494 176,995 15.2
(Reversal of) provision for
credit losses............ 25,000 (10,000) (35,000) (140.0) 55,000 (15,000) (70,000) (127.3)
Noninterest expense
Salaries and employee
benefits............... 198,929 217,597 18,668 9.4 397,036 437,020 39,984 10.1
Net occupancy............ 32,866 32,173 (693) (2.1) 60,502 63,755 3,253 5.4
Intangible asset
amortization........... 3,227 4,485 1,258 39.0 5,704 8,705 3,001 52.6
Other noninterest expense 115,982 122,147 6,165 5.3 230,362 240,028 9,666 4.2
-------- --------- -------- ---------- ---------- --------
Total noninterest expense.. 351,004 376,402 25,398 7.2 693,604 749,508 55,904 8.1
Income before income tax... 212,944 364,466 151,522 71.2 416,895 607,986 191,091 45.8
Income tax................. 68,186 133,369 65,183 95.6 136,620 219,402 82,782 60.6
-------- --------- -------- ---------- ---------- --------
Net income................. $144,758 $ 231,097 $ 86,339 59.6% $ 280,275 $ 388,584 $108,309 38.6%
======== ========= ======== ========== ========== ========
- -------------------------------------------------------
<FN>
(1) Net interest income does not include any adjustments for fully taxable equivalence.
nm--not meaningful.
</FN>
THE PRIMARY CONTRIBUTORS TO OUR FINANCIAL PERFORMANCE FOR THE SECOND
QUARTER OF 2004 COMPARED TO THE SECOND QUARTER OF 2003 ARE PRESENTED BELOW.
o We recorded a $10.0 million reversal of provision for credit losses in
the second quarter of 2004, which reflects continued improvement in
credit quality. Reductions in criticized and classified credits in our
commercial loan portfolio resulted from pay-offs, loan grade
improvements, and loan sales, which allowed us to lower our reserve
for credit losses. (See additional discussion under "Allowance for
Credit Losses.")
o Although net interest income continues to be negatively impacted by
the lower interest rate environment, net interest income was favorably
influenced by higher earning asset volumes, including a significantly
higher mix of securities and an increase in the average balances of
our commercial loan portfolio. Strong deposit growth, including an
attractive mix of average noninterest bearing deposits to total
deposits, also contributed favorably to our net interest income. (See
additional discussion under "Net Interest Income.")
25
o Our noninterest income was impacted by several factors:
o Service charges on deposit accounts rose primarily due to a 23
percent increase in average demand deposits, net of title and
escrow deposits, in the second quarter of 2004 over the second
quarter of 2003 and higher overdraft and return fees of $5.5
million primarily associated with changes in our check processing
introduced in April 2004;
o Trust and investment management fees increased from the second
quarter of 2003 primarily due to increased assets under
administration. Trust fees began growing in the second half of
2003 as trust assets started to recover with the strengthening of
the equity markets and a strong increase in new sales. In the
second quarter of 2004, managed assets increased by 5 percent and
non-managed assets increased by 10 percent from the second
quarter of 2003. Total assets under administration increased by 9
percent, to $158.9 billion, between June 30, 2003 and June 30,
2004;
o Insurance commissions increased primarily as a result of the
December 2003 acquisition of Knight Insurance Agency;
o International commissions and fees grew, reflecting strong growth
in the foreign remittances product in almost all of our markets,
from a combination of increased pricing, product enhancements and
higher market penetration;
o Card processing fees, net, increased primarily due to $6.5
million attributable to the recognition of the last month of
merchant card revenue earned before the sale of the merchant card
portfolio, resulting from merchant card revenue being recorded on
a one month lag behind the related interchange expense;
o The sale of our merchant card portfolio in the second quarter of
2004 resulted in a gain of $93.0 million. Our merchant accounts
were acquired by NOVA Information Systems (NOVA). As a result of
the long-term marketing alliance we formed with NOVA, we will
receive marketing fees in the future; and
o In other income, the second quarter of 2004 included an $8.5
million gain on the sale of real property, net gains in private
capital investment sales of $4.0 million, and a $3.7 million
final insurance recovery settlement for our losses related to the
World Trade Center terrorist attacks of September 11, 2001. In
addition, the second quarter of 2003 included a $9.0 million gain
on the redemption of a Mexican Brady Bond and net gains in
private capital investment sales of $1.0 million.
o Contributing to our higher noninterest expense were several factors:
o Salaries and employee benefits increased primarily as a result
of:
o acquisitions and new branch openings, which accounted for 39
percent of the increase in our salaries and other
compensation;
o higher performance-related incentive expense from goal
achievements;
o annual merit increases; and
o increased employee benefits expense due to:
o acquisitions and new branch openings, which accounted
for 30 percent of our employee benefits expense
increase;
o increasing healthcare costs for current employees and
retirees from rising insurance premiums and a greater
number of participants;
26
o the impact of the lower discount rate we are using to
calculate our future pension and other postretirement
liabilities;
o Net occupancy costs decreased primarily as a result of a $4.2
million write-off of leasehold improvements in the second quarter
of 2003, partially offset by increased expenses resulting from
our acquisitions and new branch openings, capitalized property
improvements recorded in December 2003, and reduced rental income
resulting from increased vacancies in bank-owned property;
o Intangible asset amortization increased primarily as a
result of our recent acquisitions; and
o Other noninterest expense rose primarily as a result of
higher software expenses, resulting from increased software
purchases and development to support strategic technology
initiatives, and losses attributable to operations and
litigation.
THE PRIMARY CONTRIBUTORS TO OUR FINANCIAL PERFORMANCE FOR THE FIRST SIX
MONTHS OF 2004 COMPARED TO THE FIRST SIX MONTHS OF 2003 ARE PRESENTED BELOW.
o We recorded a $15.0 million reversal of provision for credit losses in
the first six months of 2004, which reflects continued improvement in
credit quality. Reductions in criticized and classified credits in our
commercial loan portfolio resulted from pay-offs, loan grade
improvements, and loan sales, and allowed us to lower our reserve for
credit losses. (See additional discussion under "Allowance for Credit
Losses.")
o Although net interest income continues to be negatively impacted by
the lower interest rate environment and a decline in the average
balances of our commercial loan portfolio, net interest income was
favorably influenced by higher other earning asset volumes, including
a significantly higher mix of securities. Strong deposit growth,
including an attractive mix of average noninterest bearing deposits to
total deposits, also contributed favorably to our net interest income.
(See additional discussion under "Net Interest Income.")
o Our noninterest income was impacted by several factors:
o Service charges on deposit accounts rose primarily from a 23
percent increase in average demand deposits, net of title and
escrow deposits, in the first six months of 2004 over the first
six months of 2003 and higher overdraft and return fees of $10.2
million primarily associated with charges in our check processing
introduced in April 2004;
o Trust and investment management fees increased from the first six
months of 2003 primarily due to increased assets under
administration. Trust fees began growing in the second half of
2003 as trust assets started to recover with the strengthening of
the equity markets and a strong increase in new sales;
o Insurance commissions increased primarily as a result of the
April 2003 acquisition of Tanner Insurance Brokers and the
December 2003 acquisition of Knight Insurance Agency;
o International commissions and fees grew, reflecting strong growth
in the foreign remittances product in almost all of our markets,
from a combination of increased pricing, product enhancements and
higher market penetration;
o Card processing fees, net, increased primarily due to $6.5
million attributable to the recognition of the last month of
revenue earned before the sale of the merchant card portfolio,
resulting from merchant card revenue being recorded on a one
month lag behind the related interchange expense;
o The first six months of 2004 included a $93.0 million gain on the
sale of our merchant card portfolio; and
27
o The first six months of 2004 also included an $8.5 million gain
on the sale of real property and net gains in private capital
investment sales of $9.0 million. In addition, the first six
months of 2003 included a $9.0 million gain on the redemption of
a Mexican Brady Bond and net gains in private capital investment
sales of $0.9 million.
o Contributing to our higher noninterest expense were several factors:
o Salaries and employee benefits increased primarily as a result
of:
o acquisitions and new branch openings, which accounted for 42
percent of the increase in our salaries and other
compensation;
o higher performance-related incentive expense from goal
achievements;
o annual merit increases; and
o increased employee benefits expense due to: acquisitions and
new branch openings, which accounted for 38 percent of our
employee benefits expense increase;
o increasing healthcare costs for current employees and
retirees from rising insurance premiums and a greater
number of participants;
o the impact of the lower discount rate we are using to
calculate our future pension and other postretirement
liabilities; and
o the impact of a higher state unemployment tax rate,
which rose from 2.0 percent in the first six months of
2003 to 3.7 percent in the first six months of 2004;
o Net occupancy costs increased primarily as a result of our
acquisitions and new branch openings, and reduced rental income
resulting from increased vacancies in bank-owned property,
partially offset by a $4.2 million write-off of leasehold
improvements in the second quarter of 2003;
o Intangible asset amortization increased primarily as a result of
our recent acquisitions; and
o Other noninterest expense rose primarily as a result of higher
software expenses, resulting from increased software purchases
and development to support strategic technology initiatives, and
losses attributable to operations and litigation.
28
NET INTEREST INCOME
The following tables show the major components of net interest income and
net interest margin.
FOR THE THREE MONTHS ENDED
----------------------------------------------------------------------
JUNE 30, 2003 JUNE 30, 2004
--------------------------------- ----------------------------------
INTEREST AVERAGE INTEREST AVERAGE
AVERAGE INCOME/ YIELD/ AVERAGE INCOME/ YIELD/
(DOLLARS IN THOUSANDS) BALANCE EXPENSE(1) RATE(1)(2) BALANCE EXPENSE(1) RATE(1)(2)
- --------------------------- ----------- --------- --------- ----------- --------- ---------
ASSETS
Loans:(3)
Domestic................. $24,916,936 $ 346,204 5.63% $24,967,825 $ 319,829 5.14%
Foreign(4)............... 1,600,380 8,995 2.28 1,870,797 8,818 1.90
Securities--taxable........ 7,685,140 77,341 4.03 11,696,096 107,146 3.66
Securities--tax-exempt..... 40,984 1,016 9.91 69,654 1,424 8.18
Interest bearing deposits
in banks................. 221,004 1,130 2.05 280,892 1,121 1.61
Federal funds sold and
securities purchased
under resale agreements.. 1,276,224 4,001 1.26 1,143,901 2,928 1.03
Trading account assets..... 333,820 981 1.18 321,851 883 1.10
----------- --------- ----------- ---------
Total earning assets... 36,074,488 439,668 4.88 40,351,016 442,149 4.40
--------- ---------
Allowance for credit losses (585,597) (525,435)
Cash and due from banks.... 2,099,440 2,233,586
Premises and equipment, net 509,372 514,122
Other assets............... 1,678,646 2,038,062
----------- -----------
Total assets........... $39,776,349 $44,611,351
=========== ===========
LIABILITIES
Domestic deposits:
Interest bearing......... $9,928,211 18,799 0.76 $11,498,339 16,198 0.57
Savings and consumer time 3,871,674 11,277 1.17 4,225,435 8,540 0.81
Large time............... 2,532,971 10,141 1.61 2,298,403 7,385 1.29
Foreign deposits(4)........ 1,224,201 2,811 0.92 1,476,450 2,761 0.75
----------- --------- ----------- ---------
Total interest bearing
deposits............. 17,557,057 43,028 0.98 19,498,627 34,884 0.72
----------- --------- ----------- ---------
Federal funds purchased and
securities sold under
repurchase agreements.... 333,415 747 0.90 344,416 552 0.64
Commercial paper........... 995,048 2,946 1.19 517,333 1,051 0.82
Other borrowed funds....... 138,074 1,055 3.06 176,449 1,178 2.69
Medium and long-term debt.. 399,745 1,818 1.82 819,595 3,693 1.81
Preferred securities and
trust notes(5)........... 351,553 3,652 4.16 16,119 130 3.23
----------- --------- ----------- ---------
Total borrowed funds... 2,217,835 10,218 1.85 1,873,912 6,604 1.42
----------- --------- ----------- ---------
Total interest bearing
liabilities.......... 19,774,892 53,246 1.08 21,372,539 41,488 0.78
--------- ---------
Noninterest bearing
deposits................. 15,030,116 18,311,421
Other liabilities.......... 1,052,065 993,603
----------- -----------
Total liabilities...... 35,857,073 40,677,563
STOCKHOLDERS' EQUITY
Common equity.............. 3,919,276 3,933,788
----------- -----------
Total stockholders'
equity............... 3,919,276 3,933,788
----------- -----------
Total liabilities and
stockholders' equity. $39,776,349 $44,611,351
=========== ===========
Net interest income/margin
(taxable-equivalent basis) 386,422 4.29% 400,661 3.98%
Less: taxable-equivalent
adjustment............... 645 803
--------- ---------
Net interest income.... $ 385,777 $ 399,858
========= =========
- ------------------------
<FN>
(1) Yields and interest income are presented on a taxable-equivalent basis
using the federal statutory tax rate of 35 percent.
(2) Annualized
(3) Average balances on loans outstanding include all nonperforming loans. The
amortized portion of net loan origination fees (costs) is included in
interest income on loans, representing an adjustment to the yield.
(4) Foreign loans and deposits are those loans and deposits originated in
foreign branches.
(5) Includes interest expense for both trust preferred securities and trust
notes.
</FN>
29
FOR THE SIX MONTHS ENDED
----------------------------------------------------------------------
JUNE 30, 2003 JUNE 30, 2004
--------------------------------- ----------------------------------
INTEREST AVERAGE INTEREST AVERAGE
AVERAGE INCOME/ YIELD/ AVERAGE INCOME/ YIELD/
(DOLLARS IN THOUSANDS) BALANCE EXPENSE(1) RATE(1)(2) BALANCE EXPENSE(1) RATE(1)(2)
- --------------------------- ----------- --------- --------- ----------- --------- ---------
ASSETS
Loans:(3)
Domestic................. $25,051,062 $ 701,277 5.63% $24,750,113 $ 647,762 5.26%
Foreign(4)............... 1,568,556 17,161 2.21 1,740,126 16,496 1.91
Securities--taxable........ 7,351,834 156,520 4.26 11,546,375 212,139 3.67
Securities--tax-exempt..... 41,461 2,030 9.79 67,733 2,759 8.15
Interest bearing deposits
in banks................. 212,266 2,092 1.99 244,373 2,029 1.67
Federal funds sold and
securities purchased
under resale agreements.. 908,213 5,678 1.26 965,448 4,887 1.02
Trading account assets..... 320,683 1,938 1.22 299,454 1,478 0.99
----------- --------- ----------- ---------
Total earning assets... 35,454,075 886,696 5.03 39,613,622 887,550 4.50
--------- ---------
Allowance for credit losses (594,370) (529,803)
Cash and due from banks.... 2,097,220 2,254,820
Premises and equipment, net 508,175 517,042
Other assets............... 1,601,121 1,975,585
----------- -----------
Total assets........... $39,066,221 $43,831,266
=========== ===========
LIABILITIES
Domestic deposits:
Interest bearing......... $ 9,648,251 37,608 0.79 $11,444,366 32,755 0.58
Savings and consumer time 3,845,754 23,593 1.24 4,181,065 17,258 0.83
Large time............... 2,473,968 20,587 1.68 2,365,502 15,720 1.34
Foreign deposits(4)........ 1,303,747 6,017 0.93 1,351,837 4,893 0.73
----------- --------- ----------- ---------
Total interest bearing
deposits............. 17,271,720 87,805 1.03 19,342,770 70,626 0.73
----------- --------- ----------- ---------
Federal funds purchased and
securities sold under
repurchase agreements.... 424,955 2,074 0.98 369,941 1,233 0.67
Commercial paper........... 959,386 5,674 1.19 530,093 2,186 0.83
Other borrowed funds....... 155,375 2,310 3.00 182,139 2,478 2.74
Medium and long-term debt.. 399,737 3,684 1.86 812,829 6,832 1.69
Preferred securities and
trust notes(5)........... 351,603 7,323 4.17 109,571 2,311 4.22
----------- --------- ----------- ---------
Total borrowed funds... 2,291,056 21,065 1.85 2,004,573 15,040 1.51
----------- --------- ----------- ---------
Total interest bearing
liabilities.......... 19,562,776 108,870 1.12 21,347,343 85,666 0.81
--------- ---------
Noninterest bearing
deposits................. 14,565,228 17,532,017
Other liabilities.......... 1,041,308 1,010,051
----------- -----------
Total liabilities...... 35,169,312 39,889,411
STOCKHOLDERS' EQUITY
Common equity.............. 3,896,909 3,941,855
----------- -----------
Total stockholders'
equity............... 3,896,909 3,941,855
----------- -----------
Total liabilities and
stockholders' equity. $39,066,221 $43,831,266
=========== ===========
Net interest income/margin
(taxable-equivalent basis) 777,826 4.41% 801,884 4.07%
Less: taxable-equivalent
adjustment............... 1,269 1,605
--------- ---------
Net interest income.... $ 776,557 $ 800,279
========= =========
- -------------------------------------------
<FN>
(1) Yields and interest income are presented on a taxable-equivalent basis
using the federal statutory tax rate of 35 percent.
(2) Annualized
(3) Average balances on loans outstanding include all nonperforming loans. The
amortized portion of net loan origination fees (costs) is included in
interest income on loans, representing an adjustment to the yield.
(4) Foreign loans and deposits are those loans and deposits originated in
foreign branches.
(5) Includes interest expense for both trust preferred securities and trust
notes.
</FN>
30
Net interest income in the second quarter of 2004, on a taxable-equivalent
basis, increased 4 percent, from the second quarter of 2003. Our results were
attributable to the following factors:
o Average earning assets grew 12 percent in the second quarter of 2004,
compared to the second quarter of 2003, to $40.4 billion. This growth
was primarily attributable to a $4.0 billion, or 52 percent, increase
in average securities and a $321.3 million, or 1 percent, increase in
average loans. The increase in average securities, which was comprised
primarily of fixed rate securities, reflected liquidity and interest
rate risk management actions. Securities held for Asset and Liability
Management (ALM) purposes were $11.7 billion at June 30, 2004 and had
an overall estimated effective duration of 2.7. The increase in
average loans was largely due to a $1.0 billion increase in average
residential mortgages, resulting from a strategic portfolio shift from
more volatile commercial loans, which we feel we have achieved,
partially offset by a $0.7 billion decrease in average commercial,
financial and industrial loans;
o Deposit growth has contributed significantly to our lower cost of
funds in the second quarter of 2004, compared to the second quarter of
2003. Average noninterest bearing deposits were $3.3 billion or 22
percent higher in the second quarter of 2004, compared to the second
quarter of 2003. Average business demand deposits, including demand
deposits from our title and escrow clients which grew by $0.5 billion,
increased by $2.8 billion in the second quarter of 2004, compared to
the second quarter of 2003, with the balance of our noninterest
bearing deposits increase coming from consumer demand deposit growth.
We anticipate that the growth rates in average noninterest bearing
deposits will decline in the latter half of 2004 as rising interest
rates will cause our customers to divert those deposits to more
attractive interest bearing investments and will slow the activity in
mortgage loan refinancings, which will impact our title and escrow
deposits;
o Yields on our earning assets were negatively impacted by decreasing
interest rates for much of the period in 2003, resulting in a lower
average yield of 48 basis points on average earning assets, which was
negatively impacted by lower interest rate hedge income of $14.4
million;
o Market rates on our interest bearing liabilities were favorably
impacted by the decreasing interest rate environment resulting in a
lower cost of funds on interest bearing liabilities of 30 basis
points, which included lower interest rate hedge income of $0.3
million; and
o During 2004, our strategy has been to take advantage of our higher
noninterest bearing deposit balances by reducing our balances in
higher interest rate liabilities such as large certificates of
deposit, foreign deposits, and other borrowed funds.
As a result of these changes, and as long-term interest rates declined, our
net interest margin decreased by 31 basis points.
We use derivatives to hedge expected changes in the yields on our variable
rate loans, term certificates of deposit (CDs), and long-term borrowings. During
2004, these derivative positions will provide less in net interest income, than
in 2003, as positions mature and, to a lesser extent, as interest rates rise.
However, we expect the declines in hedge income to be partially offset by
increased yields on the underlying variable rate loans. For the quarters ended
June 30, 2003 and 2004, we had gross hedge income of $41.5 million and $26.8
million, respectively.
Net interest income in the first six months of 2004, on a
taxable-equivalent basis, increased 3 percent, from the first six months of
2003. Our results were attributable to the following factors:
o Average earning assets grew 12 percent in the first six months of
2004, compared to the first six months of 2003, to $39.6 billion. This
growth was primarily attributable to a $4.2 billion, or 57 percent,
increase in average securities, partly offset by a $129.4 million, or
less than 1 percent, decrease in average loans. The increase in
average securities, which was comprised primarily of fixed rate
securities, reflected liquidity and interest rate risk management
actions. The decrease in
31
average loans was largely due to a $1.1 billion decrease in average
commercial, financial and industrial loans, partially offset by a $0.9
billion increase in average residential mortgages, resulting from a
strategic portfolio shift from more volatile commercial loans, which
we feel we have achieved;
o Deposit growth has contributed significantly to our lower cost of
funds in the first six months of 2004, compared to the first six
months of 2003. Average noninterest bearing deposits were $3.0 billion
or 20 percent higher in the first six months of 2004, compared to the
first six months of 2003. Average business demand deposits, including
demand deposits from our title and escrow clients which grew by $0.2
billion, increased by $2.5 billion in the first six months of 2004,
compared to the first six months of 2003, with the balance of our
noninterest bearing deposits increase coming from consumer demand
deposit growth. We anticipate that the growth rates in average
noninterest bearing deposits will decline in the latter half of 2004
as rising interest rates will cause our customers to divert those
deposits to more attractive interest bearing investments and will slow
the activity in mortgage loan refinancings, which will impact our
title and escrow deposits;
o Yields on our earning assets were negatively impacted by decreasing
interest rates for much of the period, resulting in a lower average
yield of 53 basis points on average earning assets, which was
negatively impacted by lower interest rate hedge income of $24.2
million;
o Market rates on our interest bearing liabilities were favorably
impacted by the decreasing interest rate environment resulting in a
lower cost of funds on interest bearing liabilities of 31 basis
points, which included higher interest rate hedge income of $1.8
million; and
o During 2004, our strategy has been to take advantage of our higher
noninterest bearing deposit balances by reducing our balances in
higher interest rate liabilities such as large certificates of
deposit, foreign deposits, and other borrowed funds.
As a result of these changes, and as long-term interest rates declined, our
net interest margin decreased by 34 basis points.
As explained previously, derivative hedges will provide less in net
interest income than in 2003, as positions mature and, to a lesser extent, as
interest rates rise. For the six months ended June 30, 2003 and 2004, we had
gross hedge income of $81.4 million and $59.0 million, respectively.
NONINTEREST INCOME
FOR THE THREE MONTHS ENDED FOR THE SIX MONTHS ENDED
-------------------------------------- --------------------------------------
INCREASE (DECREASE) INCREASE (DECREASE)
JUNE 30, JUNE 30, ------------------ JUNE 30, JUNE 30, ------------------
(DOLLARS IN THOUSANDS) 2003 2004 AMOUNT PERCENT 2003 2004 AMOUNT PERCENT
- -------------------------- -------- -------- -------- ------- -------- -------- -------- -------
Service charges on deposit
accounts................ $ 77,942 $ 90,031 $ 12,089 15.51% $150,229 $171,127 $ 20,898 13.91%
Trust and investment
management fees......... 33,141 36,788 3,647 11.00 65,816 72,610 6,794 10.32
Insurance commissions..... 16,024 18,652 2,628 16.40 29,242 40,387 11,145 38.11
International commissions
and fees................ 16,856 18,102 1,246 7.39 32,201 35,647 3,446 10.70
Card processing fees, net. 9,340 15,456 6,116 65.48 19,022 24,248 5,226 27.47
Foreign exchange gains,
net..................... 6,958 8,294 1,336 19.20 13,892 16,638 2,746 19.77
Brokerage commissions and
fees.................... 8,412 8,023 (389) (4.62) 17,066 16,320 (746) (4.37)
Merchant banking fees..... 6,191 7,714 1,523 24.60 12,209 15,181 2,972 24.34
Securities gains (losses),
net..................... 9,660 (4) (9,664) nm 9,660 1,618 (8,042) (83.25)
Gain on sale of merchant
card portfolio.......... -- 93,000 93,000 nm -- 93,000 93,000 nm
Other..................... 18,647 34,954 16,307 87.45 39,605 55,439 15,834 39.98
-------- -------- -------- -------- -------- --------
Total noninterest income $203,171 $331,010 $127,839 62.92% $388,942 $542,215 $153,273 39.41%
======== ======== ======== ======== ======== ========
- ------------------------
<FN>
nm--not meaningful
</FN>
32
NONINTEREST EXPENSE
FOR THE THREE MONTHS ENDED FOR THE SIX MONTHS ENDED
-------------------------------------- --------------------------------------
INCREASE (DECREASE) INCREASE (DECREASE)
JUNE 30, JUNE 30, ------------------ JUNE 30, JUNE 30, ------------------
(DOLLARS IN THOUSANDS) 2003 2004 AMOUNT PERCENT 2003 2004 AMOUNT PERCENT
- -------------------------- -------- -------- -------- ------- -------- -------- -------- -------
Salaries and other
compensation............ $161,567 $174,894 $ 13,327 8.25% $314,627 $345,324 $ 30,697 9.76%
Employee benefits......... 37,362 42,703 5,341 14.30 82,409 91,696 9,287 11.27
-------- -------- -------- -------- -------- --------
Salaries and employee
benefits.............. 198,929 217,597 18,668 9.38 397,036 437,020 39,984 10.07
Net occupancy............. 32,866 32,173 (693) (2.11) 60,502 63,755 3,253 5.38
Equipment................. 16,354 16,883 529 3.23 33,025 34,154 1,129 3.42
Communications............ 13,354 13,035 (319) (2.39) 27,198 26,445 (753) (2.77)
Software.................. 10,849 12,908 2,059 18.98 22,925 25,903 2,978 12.99
Professional services..... 13,566 10,290 (3,276) (24.15) 25,580 21,593 (3,987) (15.59)
Advertising and public
relations............... 9,693 10,814 1,121 11.57 19,360 19,541 181 0.93
Data processing........... 7,744 7,659 (85) (1.10) 16,228 15,284 (944) (5.82)
Intangible asset
amortization............ 3,227 4,485 1,258 38.98 5,704 8,705 3,001 52.61
Foreclosed asset expense.. -- 17 17 nm 51 536 485 nm
Other..................... 44,422 50,541 6,119 13.77 85,995 96,572 10,577 12.30
-------- -------- -------- -------- -------- --------
Total noninterest
expense............... $351,004 $376,402 $ 25,398 7.24% $693,604 $749,508 $ 55,904 8.06%
======== ======== ======== ======== ======== ========
- ------------------------
<FN>
nm--not meaningful
</FN>
INCOME TAX EXPENSE
Income tax expense in the second quarter of 2004 was $133.4 million,
resulting in a 37 percent effective income tax rate compared with an effective
tax rate of 32 percent for the second quarter of 2003. The increase in the
effective tax rate was due to higher California state taxes in 2004, lower
low-income housing tax credits in proportion to pre-tax income in 2004, and a
one-time adjustment of $2.7 million in the second quarter of 2003 for a refund
on income taxes paid in 1998, 1999, and 2000, resulting from the settlement of
several tax issues with the Internal Revenue Service. Income tax expense in the
first six months of 2004 was $219.4 million, resulting in a 36 percent effective
income tax rate compared with an effective tax rate of 33 percent for the first
six months of 2003.
The State of California requires us to file our franchise tax returns as a
member of a unitary group that includes MTFG and either all worldwide affiliates
or only U.S. affiliates. Since 1996, we have elected to file our California
franchise tax returns on a worldwide unitary basis. The inclusion of MTFG's
financial results, which in some years were net losses, has partially offset our
net profits subject to California income tax. The inclusion of MTFG's worldwide
property, payroll and sales in the calculation of the California apportionment
factor has also reduced the percentage of our income subject to California
income tax. As a result, our effective tax rate for California has been
significantly lower than the statutory rate, net of federal benefit, of 7.05
percent.
Changes in MTFG's taxable profits affect our California taxes. MTFG's
taxable profits are impacted most significantly by changes in the worldwide
economy, especially in Japan, and decisions that they may make about the timing
of the recognition of credit losses. When MTFG's worldwide taxable profits rise,
our effective tax rate in California will rise. We review MTFG's financial
information on a quarterly basis in order to determine the rate at which to
recognize our California income taxes. However, all of the information relevant
to determining the effective tax rate may not be available until after the end
of the period to which the tax relates. The determination of the California
effective tax rate involves management judgment and estimates, and can change
during the calendar year or between calendar years, as additional information
becomes available. Our effective tax rates in the second quarter and the first
six months of 2004, when compared to the same periods in 2003, are higher
partially as a result of increased profits reported by MTFG for its most recent
reporting period, as well as projected profit increases for MTFG due to
improving economic conditions in Japan.
33
LOANS
The following table shows loans outstanding by loan type.
PERCENT CHANGE TO
JUNE 30, 2004 FROM:
---------------------
JUNE 30, DECEMBER 31, JUNE 30, JUNE 30, DECEMBER 31,
(DOLLARS IN THOUSANDS) 2003 2003 2004 2003 2003
- --------------------------------------- ----------- ------------ ----------- -------- ------------
Domestic:
Commercial, financial and industrial. $ 9,404,285 $ 8,817,679 $ 9,237,338 (1.78)% 4.76%
Construction......................... 1,110,794 1,101,166 1,078,630 (2.90) (2.05)
Mortgage:
Residential........................ 6,784,221 7,463,538 8,224,715 21.23 10.20
Commercial......................... 4,172,864 4,195,178 4,288,867 2.78 2.23
----------- ------------ -----------
Total mortgage................... 10,957,085 11,658,716 12,513,582 14.21 7.33
Consumer:
Installment........................ 851,857 818,746 794,428 (6.74) (2.97)
Revolving lines of credit.......... 1,179,961 1,222,220 1,379,751 16.93 12.89
----------- ------------ -----------
Total consumer................... 2,031,818 2,040,966 2,174,179 7.01 6.53
Lease financing...................... 704,353 663,632 605,358 (14.05) (8.78)
----------- ------------ -----------
Total loans in domestic offices.... 24,208,335 24,282,159 25,609,087 5.79 5.46
Loans originated in foreign branches... 1,444,672 1,650,204 1,981,815 37.18 20.10
----------- ------------ -----------
Total loans held to maturity....... 25,653,007 25,932,363 27,590,902 7.55 6.40
Total loans held for sale.......... 15,653 12,265 3,369 (78.48) (72.53)
----------- ------------ -----------
Total loans...................... $25,668,660 $ 25,944,628 $27,594,271 7.50% 6.36%
=========== ============ ===========
COMMERCIAL, FINANCIAL AND INDUSTRIAL LOANS
Commercial, financial and industrial loans are extended principally to
corporations, middle-market businesses, and small businesses, with no industry
concentration exceeding 10 percent of total loans. This portfolio has a high
degree of geographic diversification based upon our customers' revenue bases,
which we believe lowers our vulnerability to changes in the economic outlook of
any particular region of the U.S.
Our commercial market lending originates primarily through our commercial
banking offices. These offices, which rely extensively on relationship-oriented
banking, provide a variety of services including cash management services, lines
of credit, accounts receivable and inventory financing. Separately, we originate
or participate in a wide variety of financial services to major corporations.
These services include traditional commercial banking and specialized financing
tailored to the needs of each customer's specific industry. Presently, we are
active in, among other sectors, the oil and gas, communications, media,
entertainment, retailing and financial services industries.
The commercial, financial and industrial loan portfolio decreased $166.9
million, or 2 percent, at June 30, 2004, compared to June 30, 2003, primarily
due to economic conditions that reduced loan demand in some segments. Loan sales
and managed exits also contributed to the decline, consistent with our strategy
to reduce our exposure to certain commercial loans while increasing our
investment in more stable consumer loans (including residential mortgages).
However, at June 30, 2004 commercial loans had increased from June 30, 2003,
indicating that loan demand may be on the rise.
34
CONSTRUCTION AND COMMERCIAL MORTGAGE LOANS
We engage in non-residential real estate lending that includes commercial
mortgage loans and construction loans secured by deeds of trust. Construction
loans are made primarily to commercial property developers and to residential
builders.
The construction loan portfolio decrease of $32.2 million, or 3 percent, at
June 30, 2004, compared to June 30, 2003, was primarily attributable to slowing
growth in capital assets and employment and higher office vacancy rates in our
markets. These factors impacted the level of development and construction
projects we financed.
The commercial mortgage loan portfolio consists of loans on commercial and
industrial projects primarily in California. The increase in commercial
mortgages of $116.0 million, or 3 percent, at June 30, 2004, compared to June
30, 2003, was primarily due to our acquisitions of Monterey Bay Bank in the
third quarter of 2003 and Business Bank of California in the first quarter of
2004.
RESIDENTIAL MORTGAGE LOANS
We originate residential mortgage loans, secured by one-to-four family
residential properties, through our multiple channel network (including
branches, mortgage brokers, and loan-by-phone) throughout California, Oregon and
Washington, and we periodically purchase loans in our market area.
The residential mortgages increase of $1.4 billion, or 21 percent, at June
30, 2004, compared to June 30, 2003, was influenced by an active refinance
market driven by low interest rates throughout the period. While we hold most of
the loans we originate, we sell most of our 30-year, fixed rate, non-Community
Reinvestment Act (CRA) residential mortgage loans.
CONSUMER LOANS
We originate consumer loans, such as auto loans and home equity loans and
lines, through our branch network. Consumer loans increased $142.4 million, or 7
percent, from June 30, 2003 compared to June 30, 2004, primarily as a result of
an increase in home equity loans and partially offset by pay-offs related to the
run-off of the automobile dealer lending business that we exited in the third
quarter of 2000. The indirect automobile dealer lending portfolio at June 30,
2004 was $34.9 million.
LEASE FINANCING
We offer primarily two types of leases to our customers: direct financing
leases, where the assets leased are acquired without additional financing from
other sources; and leveraged leases, where a substantial portion of the
financing is provided by debt with no recourse to us. The lease financing
decrease of $99.0 million, or 14 percent, at June 30, 2004, compared to June 30,
2003, was attributable to our announced discontinuance of our auto leasing
activity, effective April 20, 2001. At June 30, 2004, our auto lease portfolio
had declined to $52.3 million and is projected to decline 60 percent by December
2004, and fully mature by mid-year 2006. Included in our lease portfolio are
leveraged leases of $540.1 million, which are net of non-recourse debt of
approximately $1.2 billion. We utilize a number of special purpose entities for
our leveraged leases. These entities serve legal and tax purposes and do not
function as vehicles to shift liabilities to other parties or to deconsolidate
affiliates for financial reporting purposes. As allowed by U.S. GAAP and by law,
the gross lease receivable is offset by the qualifying non-recourse debt. In
leveraged lease transactions, the third-party lender may only look to the
collateral value of the leased assets for repayment.
35
LOANS ORIGINATED IN FOREIGN BRANCHES
Our loans originated in foreign branches consist primarily of short-term
extensions of credit to financial institutions. The loans originated in foreign
branches at June 30, 2004 increased $537.1 million, or 37 percent, compared to
June 30, 2003.
CROSS-BORDER OUTSTANDINGS
Our cross-border outstandings reflect certain additional economic and
political risks that are not reflected in domestic outstandings. These risks
include those arising from exchange rate fluctuations and restrictions on the
transfer of funds. The following table sets forth our cross-border outstandings
as of June 30, 2003, December 31, 2003 and June 30, 2004, for any country where
such outstandings exceeded 1 percent of total assets. The cross-border
outstandings were compiled based upon category and domicile of ultimate risk and
are comprised of balances with banks, trading account assets, securities
available for sale, securities purchased under resale agreements, loans, accrued
interest receivable, acceptances outstanding and investments with foreign
entities. The amounts outstanding exclude local currency outstandings. For any
country shown in the table below, we do not have significant local currency
outstandings that are not hedged or are not funded by local currency borrowings.
PUBLIC CORPORATIONS
FINANCIAL SECTOR AND OTHER TOTAL
(DOLLARS IN MILLIONS) INSTITUTIONS ENTITIES BORROWERS OUTSTANDINGS
- ------------------------- ------------ -------- ------------ ------------
June 30, 2003
Korea.................... $559 $-- $73 $632
December 31, 2003
Korea.................... $630 $-- $28 $658
June 30, 2004
Korea.................... $769 $-- $ 4 $773
PROVISION FOR CREDIT LOSSES
We recorded a reversal of provision for credit losses of $10 million in the
second quarter of 2004, compared with a $25 million provision for credit losses
in the second quarter of 2003. Provisions for credit losses are charged to
income to bring our allowance for credit losses to a level deemed appropriate by
management based on the factors discussed under "Allowance for Credit Losses"
below. Reversals of provisions for credit losses increase our income and reduce
the allowance.
ALLOWANCE FOR CREDIT LOSSES
ALLOWANCE POLICY AND METHODOLOGY
We maintain an allowance for credit losses to absorb losses inherent in the
loan portfolio. The allowance is based on our regular, quarterly assessments of
the probable estimated losses inherent in the loan portfolio, and, to a lesser
extent, unused commitments to provide financing. Our methodology for measuring
the appropriate level of the allowance relies on several key elements, which
include the formula allowance, specific allowances for identified problem loans
and portfolio segments, and the unallocated allowance.
The formula allowance is calculated by applying loss factors to outstanding
loans and certain unused commitments, in each case based on the internal risk
grade of such loans, leases and commitments. Changes in risk grades affect the
amount of the formula allowance. Loss factors are based on our historical
36
loss experience and may be adjusted for significant factors that, in
management's judgment, affect the collectibility of the portfolio as of the
evaluation date. Loss factors are developed in the following ways:
o loss factors for individually graded credits are derived from a
migration model that tracks historical losses over a period, which we
believe captures the inherent losses in our loan portfolio; and
o pooled loan loss factors (not individually graded loans) are based on
expected net charge-offs. Pooled loans are loans that are homogeneous
in nature, such as consumer installment, home equity, residential
mortgage loans and automobile leases.
We believe that an economic cycle is a period in which both upturns and
downturns in the economy have been reflected. We calculate loss factors over a
time interval that spans what we believe constitutes a complete and
representative economic cycle.
Loan loss factors, which are used in determining our formula allowance, are
adjusted quarterly primarily based upon the level of historical net charge-offs
and losses expected by management in the near term. Prior to the quarter ended
June 30, 2004, our loan loss factors for non-criticized graded credits captured
estimated losses that were expected to occur in the next twelve months.
Beginning with the quarter ended June 30, 2004, we have refined our methodology
to estimate our expected losses based on a loss confirmation period. The loss
confirmation period is the estimated average period of time between a material
adverse event affecting the credit-worthiness of a borrower and the subsequent
recognition of a loss. Based upon our evaluation process, we believe that, for
our risk-graded loans, on average, losses are sustained approximately 10
quarters after an adverse event in the creditor's financial condition has taken
place. Similarly, for retail, pool-managed credits, the loss confirmation period
varies by product, but ranges between one and two years.
Furthermore, based on management's judgment, our refined methodology
permits adjustments to any loss factor used in the computation of the formula
allowance for significant factors, which affect the collectibility of the
portfolio as of the evaluation date, but are not reflected in the loss factors.
By assessing the probable estimated losses inherent in the loan portfolio on a
quarterly basis, we are able to adjust specific and inherent loss estimates
based upon the most recent information that has become available. This includes
changing the number of periods that are included in the calculation of the loss
factors and adjusting qualitative factors to be representative of the economic
cycle that we expect will impact the portfolio.
Specific allowances are established in cases where management has
identified significant conditions or circumstances related to a credit or a
portfolio segment that management believes indicate the probability that a loss
has been incurred. This amount may be determined either by a method prescribed
by SFAS No. 114, or methods that include a range of probable outcomes based upon
certain qualitative factors.
The unallocated allowance is based on management's evaluation of conditions
that are not directly reflected in the determination of the formula and specific
allowances. As discussed elsewhere, certain losses that had previously been
considered in the determination of the unallocated allowance have been
incorporated into our formula allowance, thereby eliminating the need to reflect
them in our unallocated allowance. The evaluation of the inherent loss with
respect to these conditions is subject to a higher degree of uncertainty because
they may not be identified with specific problem credits or portfolio segments.
The conditions evaluated in connection with the unallocated allowance include
the following, which existed at the balance sheet date:
o general economic and business conditions affecting our key lending
areas;
o credit quality trends (including trends in nonperforming loans
expected to result from existing conditions);
o collateral values;
37
o loan volumes and concentrations;
o seasoning of the loan portfolio;
o specific industry conditions within portfolio segments;
o recent loss experience in particular segments of the portfolio;
o duration of the current economic cycle;
o bank regulatory examination results; and
o findings of our internal credit examiners.
Executive management reviews these conditions quarterly in discussion with
our senior credit officers. To the extent that any of these conditions is
evidenced by a specifically identifiable problem credit or portfolio segment as
of the evaluation date, management's estimate of the effect of such conditions
may be reflected as a specific allowance, applicable to such credit or portfolio
segment. Where any of these conditions is not evidenced by a specifically
identifiable problem credit or portfolio segment as of the evaluation date,
management's evaluation of the probable loss related to such condition is
reflected in the unallocated allowance.
The allowance for credit losses is based upon estimates of probable losses
inherent in the loan portfolio. The actual losses can vary from the estimated
amounts. Our methodology includes several features that are intended to reduce
the differences between estimated and actual losses. The loss migration model
that is used to establish the loan loss factors for individually graded loans is
designed to be self-correcting by taking into account our loss experience over
prescribed periods. In addition, by basing the loan loss factors over a period
reflective of an economic cycle, recent loss data that may not be reflective of
prospective losses going forward will not have an undue influence on the
calculated loss factors.
COMPARISON OF THE TOTAL ALLOWANCE AND RELATED PROVISION FOR CREDIT LOSSES
FROM DECEMBER 31, 2003
At December 31, 2003, our total allowance for credit losses was $533
million, or 2.05 percent of the total loan portfolio and 190 percent of total
nonaccrual loans. At June 30, 2004, our total allowance for credit losses was
$501 million (consisting of $413 million and $88 million of allocated and
unallocated allowance, respectively), or 1.82 percent of the total loan
portfolio and 282 percent of total nonaccrual loans. In addition, the allowance
incorporates the results of measuring impaired loans as provided in SFAS No. 114
as amended by SFAS No. 118, "Accounting by Creditors for Impairment of a
Loan--Income Recognition and Disclosures." These accounting standards prescribe
the measurement methods, income recognition and disclosures related to impaired
loans. At December 31, 2003, total impaired loans were $230 million, and the
associated impairment allowance was $55 million, compared with $141 million and
$32 million, respectively, at June 30, 2004. On June 30, 2004 and December 31,
2003, the total allowance for credit losses for off-balance sheet commitments,
which is included within our total allowance for credit losses, was $48 million
and $86 million, respectively. In the second quarter of 2004, we made some
adjustments on how we allocate our allowance for credit losses between
off-balance sheet commitments and loans. These adjustments, offset by the
increases in our loss factors, contributed to the decline in that allocation
from December 31, 2003. These adjustments had no impact on the allowance as a
whole, since commitments and funded loans are considered together in determining
the adequacy of our allowance for credit losses.
During the first quarter of 2004, there were no material changes in
estimation methods or assumptions that affected our methodology for assessing
the appropriateness of the formula and specific allowances for credit losses,
except that the period used to calculate the cumulative loss rates on criticized
loans was expanded from 12 to 24 quarters to better estimate losses over the
life of the loans. Changes in
38
estimates and assumptions regarding the effects of economic and business
conditions on borrowers and other factors, which are described below, affected
the assessment of the unallocated allowance.
During the second quarter of 2004, as discussed above, we adjusted our pass
graded loan loss factors to reflect expected losses in the next 10 quarters
based upon an estimated loss confirmation period. In addition, refinements in
our loss factors for commercial real estate and construction lending were made
to more accurately capture probable loss inherent in the portfolio.
As a result of management's assessment of factors, including the continued
improvement in the U.S. economy, improving conditions in the
communications/media, power, and other sectors in domestic markets in which we
operate, and growth and changes in the composition of the loan portfolio, offset
by the adverse impact of increasing fuel costs across the whole economy, fears
of terrorism on the airline industry; and the fiscal and budgetary difficulties
of the State of California, we recorded a reversal of provision for credit
losses of $10 million in the second quarter of 2004. The refinements we made in
the manner in which we segment our allowance for credit losses had no impact on
the overall level of the allowance.
CHANGES IN THE ALLOCATED (FORMULA AND SPECIFIC) ALLOWANCE
At June 30, 2004, the formula allowance was $364 million, compared to $280
million at December 31, 2003, an increase of $84 million. The increase was due
primarily to the impact of the introduction of the loss confirmation period into
the determination of our loan loss factors, which was approximately $125
million, the modifications to the commercial real estate and construction loss
factors, which was approximately $18 million, the expansion of the period used
to calculate cumulative loss rates on criticized credits, which was $9 million,
and growth in our commercial loan portfolio, offset by significant improvements
in the credit quality of our loan portfolio. Since a portion of the impact for
the use of the loss confirmation period had already been considered in our
attributions in the unallocated allowance, a reallocation between the formula
and unallocated portions of the allowance was made.
The specific allowance was $49 million at June 30, 2004, compared to $80
million at December 31, 2003, a decrease of $31 million. This decrease is
reflective of decreases in impaired loans and the renegotiation of terms for
certain aircraft leases that are now reported as operating leases.
CHANGES IN THE UNALLOCATED ALLOWANCE
At June 30, 2004, the unallocated allowance declined by $85 million to $88
million from $173 million at December 31, 2003. The reasons for the decrease,
and for which an unallocated allowance is warranted, are detailed below.
In our assessment as of June 30, 2004, management focused, in particular,
on the factors and conditions set out below. There can be no assurance that the
adverse impact of any of these conditions on us will not be in excess of the
ranges set forth.
Although in certain instances the downgrading of a loan resulting from the
effects of the conditions described below has been reflected in the formula
allowance, management believes that the impact of these events on the
collectibility of the applicable loans may not have been reflected in the level
of nonperforming loans or in the internal risk grading process with respect to
such loans. In addition, our formula allowance does not take into consideration
a change in the severity of losses that are expected to arise from current
economic conditions compared with our historical losses. Accordingly, our
evaluation of the probable losses related to the impact of these factors was
reflected in the unallocated allowance. The evaluations of the inherent losses
with respect to these factors are subject to higher degrees of uncertainty
because they are not identified with specific problem credits. As previously
mentioned, we refined our formula allowance to include certain losses based upon
a loss confirmation period, which has eliminated the need to consider those
losses in the attributions of our unallocated allowance.
39
In evaluating the results of this methodology change, we considered the
effect of underlying conditions on expected future credit migration for each of
our lending segments. In several cases, we concluded that this experience is not
likely to be more severe than the long-run average embedded in the loss factors
that drive the formula allowance calculation. In these cases, we determined that
our attribution, previously established for the retail, technology and consumer
sectors, was no longer required.
Similarly, in certain cases, we believe that credit migration is likely to
be somewhat more severe than the long-run average, but a greater share of the
inherent probable loss associated with this credit migration is now captured in
the allocated allowance as a result of the previously mentioned refinement in
methodology. In these cases, it is appropriate to reduce the corresponding
unallocated allowance attributions.
o With respect to fuel prices, we considered the sustained high prices
of oil and petroleum products, and the impact across virtually all
sectors of the economy, and established an attribution for probable
losses which could be in the range of $10 million to $35 million.
o With respect to the State of California, we considered the underlying
uncertainties confronting the administration in Sacramento, including
the major shortfall in the state's budgetary position for fiscal year
2005, despite the passage of State Propositions 57 and 58, and
established an attribution for probable losses which could be in the
range of $3 million to $6 million.
o With respect to commercial real estate, we considered slightly
improving high vacancy rates and stagnant rent growth being
experienced nationally, with specific weakness in Northern California,
and established an attribution for probable losses which could be in
the range of $12 million to $24 million, a reduction from the December
31, 2003 level of $16 million to $32 million.
o With respect to leasing, we considered the worsening situation for
airlines in the wake of increased fears of terrorism and surging fuel
prices, and established an attribution for probable losses which could
be in the range of $7 million to $13 million.
o With respect to cross-border exposures in certain foreign countries,
we considered the improving economic performances in many countries of
our key international markets, as well as better financial results of
our customers, and reduced the attribution range, which provides for
certain weaknesses in the banking sector of some of our markets, to $8
million to $17 million.
o With respect to power companies/utilities, we considered the effects
of lower excess capacity and evidence that a slow recovery is
beginning in this industry, coupled with the refinement in the formula
allowance mentioned above in reducing the attribution for probable
losses from a range of $13 million to $27 million at December 31, 2003
to a range of $4 million to $8 million at June 30, 2004.
o With respect to the communications/media industry, we considered the
significant improvements seen in the industry, coupled with the
refinement in the formula allowance in reducing the attribution for
probable losses from a range of $10 million to $30 million at December
31, 2003 to a range of $2 million to $4 million at June 30, 2004.
Although in certain instances the downgrading of a loan resulting from
these effects was reflected in the allocated allowance, management believes that
in most instances the impact of these events on the collectibility of the
applicable loans may not have been reflected in the level of nonperforming loans
or in the internal risk grading process with respect to such loans. Accordingly,
our evaluation of the probable losses related to the impact of these factors was
reflected in the unallocated allowance. The evaluations of the inherent losses
with respect to these factors were subject to higher degrees of uncertainty
because they were not identified with specific problem credits.
40
CHANGE IN THE TOTAL ALLOWANCE FOR CREDIT LOSSES
The following table sets forth a reconciliation of changes in our allowance
for credit losses:
FOR THE THREE MONTHS FOR THE SIX MONTHS
ENDED JUNE 30, ENDED JUNE 30,
-------------------- --------------------
(DOLLARS IN THOUSANDS) 2003 2004 2003 2004
- -------------------------------------------- -------- -------- -------- --------
Balance, beginning of period................ $586,197 $521,111 $609,190 $532,970
Loans charged off:
Commercial, financial and industrial...... 51,130 20,721 88,956 40,510
Mortgage.................................. -- 43 -- 43
Consumer.................................. 2,429 1,460 5,085 3,275
Lease financing........................... 13,190 1,666 32,208 2,024
-------- -------- -------- --------
Total loans charged off................. 66,749 23,890 126,249 45,852
Recoveries of loans previously charged off:
Commercial, financial and industrial...... 13,008 12,091 18,587 20,911
Mortgage.................................. 44 1,571 150 1,571
Consumer.................................. 697 456 1,420 891
Lease financing........................... 50 77 168 150
-------- -------- -------- --------
Total recoveries of loans previously
charged off........................... 13,799 14,195 20,325 23,523
-------- -------- -------- --------
Net loans charged off................. 52,950 9,695 105,924 22,329
(Reversal of) provision for credit losses... 25,000 (10,000) 55,000 (15,000)
Foreign translation adjustment and other
net additions (deductions)(1)............. 35 3 16 5,778
-------- -------- -------- --------
Balance, end of period...................... $558,282 $501,419 $558,282 $501,419
======== ======== ======== ========
Allowance for credit losses to total loans.. 2.17% 1.82% 2.17% 1.82%
(Reversal of) provision for credit losses
to net loans charged off.................. 47.21 nm 51.92 nm
Net loans charged off to average loans
outstanding for the period(2)............. 0.80 0.15 0.80 0.17
- --------------------------------
<FN>
(1) Includes a transfer of $5.7 million related to the Business Bank of
California acquisition in the first quarter of 2004.
(2) Annualized.
nm--not meaningful
</FN>
Total loans charged off in the second quarter of 2004 decreased by $42.9
million from the second quarter of 2003, primarily due to a $30.4 million
decrease in commercial, financial and industrial loans charged off and an $11.5
million decrease in lease financing charge-offs reflecting the charge-offs
related to several airline losses in the second quarter of 2003. Charge-offs
reflect the realization of losses in the portfolio that were recognized
previously through provisions for credit losses.
Second quarter 2004 recoveries of loans previously charged off increased by
$0.4 million from the second quarter of 2003. The percentage of net loans
charged off to average loans outstanding for the second quarter of 2004
decreased by 65 basis points from the same period in 2003. At June 30, 2004, the
allowance for credit losses exceeded the annualized net loans charged off during
the second quarter of 2004, reflecting management's belief, based on the
foregoing analysis, that there are additional losses inherent in the portfolio.
Historical net charge-offs are not necessarily indicative of the amount of
net charge-offs that we will realize in the future.
41
NONPERFORMING ASSETS
Nonperforming assets consist of nonaccrual loans and foreclosed assets.
Nonaccrual loans are those for which management has discontinued accrual of
interest because there exists significant uncertainty as to the full and timely
collection of either principal or interest or such loans have become
contractually past due 90 days with respect to principal or interest. For a more
detailed discussion of the accounting for nonaccrual loans, see Note 1 to our
Consolidated Financial Statements included in the Form 10-K for the year ended
December 31, 2003.
Foreclosed assets include property where we acquired title through
foreclosure or "deed in lieu" of foreclosure.
The following table sets forth an analysis of nonperforming assets.
JUNE 30, DECEMBER 31, JUNE 30,
(DOLLARS IN THOUSANDS) 2003 2003 2004
- -------------------------------------------- -------- ------------ --------
Commercial, financial and industrial........ $273,896 $ 190,404 $111,015
Construction................................ 1,559 -- 5,401
Commercial mortgage......................... 48,479 38,354 22,717
Lease financing............................. 52,568 51,603 36,719
Loan originated in foreign branches......... 2,985 840 2,210
-------- ------------ --------
Total nonaccrual loans.................... 379,487 281,201 178,062
Foreclosed assets........................... 271 5,689 5,851
-------- ------------ --------
Total nonperforming assets................ $379,758 $ 286,890 $183,913
======== ============ ========
Allowance for credit losses................. $558,282 $ 532,970 $501,419
======== ============ ========
Nonaccrual loans to total loans............. 1.48% 1.08% 0.65%
Allowance for credit losses to nonaccrual
loans..................................... 147.11 189.53 281.60
Nonperforming assets to total loans and
foreclosed assets......................... 1.48 1.11 0.67
Nonperforming assets to total assets........ 0.89 0.68 0.40
At June 30, 2004, nonaccrual loans totaled $178 million, a decrease of $201
million, or 53 percent, from June 30, 2003. Our nonperforming assets are
concentrated in our non-agented syndicated loan portfolio and approximately 41
percent of our total nonaccrual loans are syndicated loans. In addition,
nonaccrual loans include $37 million in aircraft leases. The decrease in
nonaccrual loans was primarily due to pay-downs, charge-offs, and loan sales,
coupled with significantly reduced inflows. During the second quarters of 2004
and 2003, respectively, we sold approximately $9 million and $206 million of
loan commitments to reduce our credit exposures. Losses from these sales are
reflected in our charge-offs.
Nonaccrual loans as a percentage of total loans were 0.65 percent at June
30, 2004, compared with 1.48 percent at June 30, 2003. Nonperforming assets as a
percentage of total loans and foreclosed assets decreased to 0.67 percent at
June 30, 2004, from 1.48 percent at June 30, 2003. At June 30, 2004,
approximately 62 percent of nonaccrual loans were related to commercial,
financial and industrial credits, compared to 72 percent at June 30, 2003.
42
LOANS 90 DAYS OR MORE PAST DUE AND STILL ACCRUING
JUNE 30, DECEMBER 31, JUNE 30,
(DOLLARS IN THOUSANDS) 2003 2003 2004
- -------------------------------------------- -------- ------------ --------
Commercial, financial and industrial........ $ 1,728 $ 893 $ 798
Construction................................ 2,311 -- 2,919
Mortgage:
Residential................................. 3,915 1,878 4,588
Commercial.................................. 540 -- --
-------- ------------ --------
Total mortgage............................ 4,455 1,878 4,588
Consumer and other.......................... 1,879 1,123 1,535
-------- ------------ --------
Total loans 90 days or more past due
and still accruing........................ $ 10,373 $3,894 $ 9,840
======== ============ ========
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk is the risk of loss to future earnings, to fair values, or to
future cash flows that may result from changes in the price of a financial
instrument. The value of a financial instrument may change as a result of
changes in interest rates, foreign currency exchange rates, commodity prices,
equity prices, and other market changes that affect market risk sensitive
instruments. Market risk is attributable to all market risk sensitive financial
instruments, including securities, loans, deposits, and borrowings, as well as
derivative instruments. Our exposure to market risk is a function of our asset
and liability management activities, our trading activities for our own account,
and our role as a financial intermediary in customer-related transactions. The
objective of market risk management is to mitigate an undue adverse impact on
earnings and capital arising from changes in interest rates and prices of
financial instruments. This risk management objective supports our broad
objective of preserving shareholder value, which encompasses earnings growth
over time and capital stability.
The Board of Directors, through its Finance and Capital Committee,
establishes the Bank's ALM Policy, which governs the management of market risk.
In the administration of market risk management, the Chief Executive Officer
(CEO) Forum provides broad and strategic guidance to the Asset & Liability
Management Committee (ALCO). ALCO is a committee comprised of senior executives,
with the chairman designated by the Chief Executive Officer. ALCO is responsible
for management of liquidity, interest rate and price risks in the implementation
of ALM Policy, including formulation of risk management strategies, guidelines
and trading policy limits, in accordance with the CEO Forum's directives. The
Treasurer of the Bank is primarily responsible for the implementation of risk
management strategies approved by ALCO and for operating management of market
risk through the funding, investment, derivatives hedging, and trading functions
of the Bank's Global Markets Group.
The Market Risk Monitoring (MRM) unit is structured as an independent unit
responsible for the measurement and monitoring of market risk, including the
preparation of reports in sufficient detail to ensure that ALCO, the Bank's
senior management, and the Board are kept fully informed as to the Bank's market
risk profile and compliance with applicable limits, guidelines and policies. MRM
functions independently of all operating and management units and reports
directly to the ALCO Chairman.
We have separate and distinct methods for managing the market risk
associated with our trading activities and our asset and liability management
activities, as described below.
INTEREST RATE RISK MANAGEMENT (OTHER THAN TRADING)
We engage in asset and liability management activities with the primary
purposes of managing the sensitivity of net interest income (NII) to changes in
interest rates within limits established by the Board and maintaining a risk
profile that is consistent with management's strategic objectives.
43
The ALM Policy approved by our Board's Finance and Capital Committee
requires monthly monitoring of interest rate risk by ALCO through a variety of
modeling techniques that are used to quantify the sensitivity of NII to changes
in interest rates. As directed by ALCO, and in consideration of the importance
of our demand deposit accounts as a funding source, NII is adjusted in the
official policy risk measure to incorporate the effect of certain noninterest
expense items related to these deposits that are nevertheless sensitive to
changes in interest rates. In managing interest rate risk, ALCO monitors NII
sensitivity on both an adjusted and unadjusted basis over various time horizons.
Our unhedged NII remains asset sensitive, meaning that our assets generally
reprice more quickly than our liabilities, particularly our core deposits. Since
the NII associated with an asset sensitive balance sheet tends to decrease when
interest rates decline and increase when interest rates rise, derivative hedges
and the investment portfolio are used to manage this risk. In the second quarter
of 2004, we modestly increased the size of our securities portfolio, principally
through purchases of intermediate term mortgage-backed and agency issued
securities, adding approximately $300 million in average balances over the first
quarter of 2004, while maintaining a relatively short effective duration of 2.7
(see further discussion of this on page 45). In addition, we entered into $300
million of interest rate cap corridors to offset the potential adverse impact
that rising short-term interest rates could have on our cost of deposit funding.
We also entered into $400 million of interest rate floors to hedge some of our
variable rate loans. For a further discussion of derivative instruments and our
hedging strategies, see Note 6 to our Notes to Condensed Consolidated Financial
Statements included in this Form 10-Q.
Together, our hedging and investment activities resulted in an essentially
neutral interest rate risk profile for the hedged balance sheet with respect to
parallel yield curve shifts in terms of simulated NII versus the no rate change
base case scenario. However, our NII is also sensitive to non-parallel shifts in
the yield curve. In general, our adjusted NII increases when the yield curve
steepens (specifically when short rates, under one year, drop and long rates,
beyond one year, rise), while a flattening curve tends to depress our adjusted
NII. In this respect, our adjusted NII is asset sensitive when measured against
changes in long rates and slightly liability sensitive when measured against
changes in short rates.
In the current low rate environment, run off of fixed rate assets,
including prepayments, depresses NII even if interest rates do not change
because the cash flows from the repaid and prepaid assets that were booked at
higher rates must be reinvested at lower prevailing rates.
Our official NII policy measure involves a simulation of "Earnings-at-Risk"
(EaR) in which we estimate the impact that gradual, ramped-on parallel shifts in
the yield curve would have on NII over a 12-month horizon. Under the Board's
policy limits, the negative change in simulated NII in either the up or down 200
basis point shock scenarios may not exceed 4 percent of NII as measured in the
base case, or no change, scenario. The following table sets forth the simulation
results in both the up and down 200 basis point ramp scenarios as of December
31, 2003 and June 30, 2004(1):
DECEMBER 31, JUNE 30,
(DOLLARS IN MILLIONS) 2003 2004
- ------------------------------------------ ------------ --------
+200 basis points......................... $ 17.2 $ 17.2
as a percentage of base case NII.......... 1.20% 1.13%
- -200 basis points......................... $(19.8) $(23.1)
as a percentage of base case NII.......... 1.38% 1.52%
- ---------------------------
<FN>
(1) For these policy simulations, NII is adjusted to incorporate the effect of
certain noninterest expense items related to demand deposits that are
nevertheless sensitive to changes in interest rates.
</FN>
EaR in the down 200 basis point scenario was a negative $23.1 million, or
1.52 percent of adjusted NII in the base case scenario, well within the Board's
guidelines.
However, with Federal Funds and LIBOR rates currently below two percent, a
downward ramp scenario of 200 basis points would result in short-term rate
levels below zero. As a result, we believe that a
44
downward ramp scenario of 100 basis points provides a more reasonable measure of
asset sensitivity in a falling interest rate environment. As of June 30, 2004,
the difference between adjusted NII in the base case and adjusted NII after a
gradual 100 basis point downward ramp was a negative $4.7 million, or 0.31
percent of the base case scenario.
Management's goal in the NII simulations is to capture the risk embedded in
the balance sheet. As a result, asset and liability balances are kept constant
throughout the analysis horizon. Two exceptions are non-maturity deposits, which
vary with levels of interest rates according to statistically derived balance
equations, and discretionary derivative hedges and fixed income portfolios,
which are allowed to mature without replacement.
Additional assumptions are made to model the future behavior of deposit
rates and loan spreads based on statistical analysis, management's outlook, and
historical experience. The prepayment risks related to residential loans and
mortgage-backed securities are measured using industry estimates of prepayment
speeds. The sensitivity of the simulation results to the underlying assumptions
is tested as a regular part of the risk measurement process by running
simulations with different assumptions. In addition, management supplements the
official risk measures based on the constant balance sheet assumption with
volume-based simulations of NII based on forecasted balances and with
value-based simulations that measure the sensitivity of economic-value-of-equity
(EVE) to changes in interest rates. We believe that, together, these simulations
provide management with a reasonably comprehensive view of the sensitivity of
our operating results to changes in interest rates, at least over the
measurement horizon. However, as with any financial model, the underlying
assumptions are inherently uncertain and subject to refinement as modeling
techniques and theory improve and historical data becomes more readily
accessible. Consequently, our simulation models cannot predict with certainty
how rising or falling interest rates might impact net interest income. Actual
and simulated NII results will differ to the extent there are differences
between actual and assumed interest rate changes, balance sheet volumes, and
management strategies, among other factors.
At December 31, 2003 and June 30, 2004, our securities available for sale
portfolio included $10.4 billion and $11.7 billion, respectively, of securities
for ALM purposes with an expected weighted average maturity of 2.9 years and 3.1
years, respectively. In addition, this portfolio had an overall estimated
effective duration of 2.7 compared to 2.5 at December 31, 2003. Duration is a
measure of price sensitivity of a bond portfolio to immediate changes in
interest rates. An effective duration of 2.7 suggests an expected price change
of approximately 2.7 percent for an immediate one percent change in interest
rates. This portfolio included $6.4 billion in mortgage-backed securities with
an estimated duration of 3.2. This securities portfolio duration, in the context
of our total balance sheet, after giving consideration to the composition of our
core deposits, contributes to the maintenance of our current, essentially
neutral, interest rate risk profile.
TRADING ACTIVITIES
We enter into trading account activities primarily as a financial
intermediary for customers, and, to a minor extent, for our own account. By
acting as a financial intermediary, we are able to provide our customers with
access to a wide range of products from the securities, foreign exchange, and
derivatives markets. In acting for our own account, we may take positions in
some of these instruments with the objective of generating trading profits.
These activities expose us to two primary types of market risk: interest rate
and foreign currency exchange risk.
In order to manage interest rate and foreign currency exchange risk
associated with the securities and foreign exchange trading activities for our
own account, we utilize a variety of non-statistical methods including: position
limits for each trading activity, daily marking of all positions to market,
daily profit and loss statements, position reports, and independent verification
of all inventory pricing. Additionally, MRM reports positions and profits and
losses daily to the Treasurer and trading managers and weekly to the
45
ALCO Chairman. ALCO is provided reports on a monthly basis. We believe that
these procedures, which stress timely communication between MRM and senior
management, are the most important elements of the risk management process.
We use a form of Value at Risk (VaR) methodology to measure the overall
market risk inherent in our trading account activities. Under this methodology,
management statistically calculates, with 97.5 percent confidence, the potential
loss in fair value that we might experience if an adverse shift in market prices
were to occur within a period of 5 business days. The amount of VaR is managed
within limits well below the maximum limit established by Board policy at 0.5
percent of stockholders' equity. The VaR model incorporates a number of key
assumptions, including assumed holding period and historical volatility based on
3 years of historical market data updated quarterly.
The following table sets forth the average, high and low VaR for our
trading activities for the year ended December 31, 2003 and the quarter ended
June 30, 2004.
DECEMBER 31, 2003 JUNE 30, 2004
-------------------- ---------------------
AVERAGE HIGH LOW AVERAGE HIGH LOW
(DOLLARS IN THOUSANDS) VAR VAR VAR VAR VAR VAR
- ------------------------------ ------- ---- --- ------- ---- ---
Foreign exchange.............. $143 $428 $57 $119 $293 $49
Securities.................... 206 463 97 269 339 138
Consistent with our business strategy of focusing on the sale of capital
markets products to customers, we manage our trading risk exposures at
conservative levels, well below the trading risk policy limits established by
the Finance and Capital Committee of the Board. As a result, our foreign
exchange business continues to derive the bulk of its revenue from
customer-related transactions. We take inter-bank trading positions only on a
limited basis and we do not take any large or long-term strategic positions in
the market for our own portfolio. We continue to grow our customer-related
foreign exchange business while maintaining an essentially unchanged inter-bank
trading risk profile as measured under our VaR methodology.
The Securities Trading and Institutional Sales department serves the fixed
income needs of our institutional clients and acts as the fixed income
wholesaler for our broker/dealer subsidiary, UBOC Investment Services, Inc. As
with our foreign exchange business, we continue to generate the vast majority of
our securities trading income from customer-related transactions.
Our interest rate derivative contracts included, as of June 30, 2004, $4.1
billion notional amount of derivative contracts entered into as an accommodation
for customers. We act as an intermediary and match these contracts, at a credit
spread, to contracts with major dealers, thus neutralizing the related market
risk.
LIQUIDITY RISK
Liquidity risk represents the potential for loss as a result of limitations
on our ability to adjust our future cash flows to meet the needs of depositors
and borrowers and to fund operations on a timely and cost-effective basis. The
ALM Policy approved by the Finance and Capital Committee of the Board requires
regular reviews of our liquidity by ALCO. Additionally, ALCO conducts monthly
ongoing reviews of our liquidity situation. Liquidity is managed through this
ALCO coordination process on a company-wide basis, encompassing all major
business units. The operating management of liquidity is implemented through the
funding and investment functions of the Global Markets Group. Our liquidity
management draws upon the strengths of our extensive retail and commercial core
deposit franchise, coupled with the ability to obtain funds for various terms in
a variety of domestic and international money markets. Our securities portfolio
represents a significant source of additional liquidity.
Core deposits provide us with a sizable source of relatively stable and
low-cost funds. Our average core deposits, which include demand deposits, money
market demand accounts, and savings and consumer
46
time deposits, combined with average common stockholders' equity, funded 85
percent of average total assets of $44.6 billion in the second quarter of 2004.
Most of the remaining funding was provided by short-term borrowings in the form
of negotiable certificates of deposit, large time deposits, foreign deposits,
federal funds purchased, securities sold under repurchase agreements, commercial
paper, and other borrowings. In the fourth quarter of 2003, we issued $400
million in long-term subordinated debt. In February 2004, we used a portion of
the net proceeds (approximately $350 million) from the sale of these securities
to redeem our Trust Notes that were outstanding at December 31, 2003. The
remainder of the net proceeds from this offering is for general corporate
purposes, which may include extending credit to or funding investments in our
subsidiaries, repurchasing shares of our common stock, reducing our existing
indebtedness or financing possible acquisitions.
The securities portfolio provides additional enhancement to our liquidity
position, which may be created through repurchase agreements. At June 30, 2004,
a liquidity need could have been met by transferring under repurchase agreements
approximately $9.4 billion of our available for sale securities, with no portion
of this balance being encumbered at June 30, 2004. Liquidity may also be
provided by the sale or maturity of other assets such as interest-bearing
deposits in banks, federal funds sold, and trading account securities. The
aggregate balance of these assets averaged approximately $1.7 billion in the
second quarter of 2004. Additional liquidity may be provided through loan
maturities and sales. In the third quarter of 2003, we terminated the issuance
of commercial paper under UnionBanCal Corporation's commercial paper program.
UnionBanCal Commercial Funding Corporation (a UnionBanCal Corporation
subsidiary) continues to issue commercial paper under another commercial paper
program. The proceeds of this commercial paper program are deposited in Union
Bank of California, N.A. and used to fund our Bank operations.
REGULATORY CAPITAL
The following tables summarize our risk-based capital, risk-weighted
assets, and risk-based capital ratios.
UNIONBANCAL CORPORATION
MINIMUM
JUNE 30, DECEMBER 31, JUNE 30, REGULATORY
(DOLLARS IN THOUSANDS) 2003 2003 2004 REQUIREMENT
- ------------------------ ---------------- ---------------- ---------------- ----------------
CAPITAL COMPONENTS
Tier 1 capital.......... $ 3,791,651 $ 3,747,884 $ 3,706,202
Tier 2 capital.......... 538,163 936,189 922,122
----------- ----------- -----------
Total risk-based capital $ 4,329,814 $ 4,684,073 $ 4,628,324
=========== =========== ===========
Risk-weighted assets.... $33,142,588 $33,133,407 $35,422,904
=========== =========== ===========
Quarterly average assets $39,366,344 $41,506,828 $44,339,052
=========== =========== ===========
CAPITAL RATIOS AMOUNT RATIO AMOUNT RATIO AMOUNT RATIO AMOUNT RATIO
- ------------------------ ---------- ----- ---------- ----- ------ ----- ---------- -----
Total capital (to risk-
weighted assets)...... $4,329,814 13.06% $4,684,073 14.14% $4,628,324 13.07% >$2,833,832 8.0%
-
Tier 1 capital (to risk-
weighted assets)...... 3,791,651 11.44 3,747,884 11.31 3,706,202 10.46 > 1,416,916 4.0
-
Leverage(1)............. 3,791,651 9.63 3,747,884 9.03 3,706,202 8.36 > 1,773,562 4.0
-
- ------------------
<FN>
(1) Tier 1 capital divided by quarterly average assets (excluding certain intangible assets).
</FN>
47
UNION BANK OF CALIFORNIA, N.A.
MINIMUM "WELL-CAPITALIZED"
JUNE 30, DECEMBER 31, JUNE 30, REGULATORY REGULATORY
(DOLLARS IN THOUSANDS) 2003 2003 2004 REQUIREMENT REQUIREMENT
- ------------------------ ---------------- ---------------- ---------------- ---------------- ------------------
CAPITAL COMPONENTS
Tier 1 capital.......... $ 3,490,596 $ 3,395,519 $ 3,695,565
Tier 2 capital.......... 467,613 467,619 476,900
----------- ----------- -----------
Total risk-based capital $ 3,958,209 $ 3,863,138 $ 4,172,465
=========== =========== ===========
Risk-weighted assets.... $32,492,833 $32,526,017 $34,925,361
=========== =========== ===========
Quarterly average assets $38,811,257 $40,921,517 $43,688,650
=========== =========== ===========
CAPITAL RATIOS AMOUNT RATIO AMOUNT RATIO AMOUNT RATIO AMOUNT RATIO AMOUNT RATIO
- ------------------------ ---------- ----- ---------- ----- ---------- ----- ---------- ----- ---------- -----
Total capital (to risk-
weighted assets)...... $3,958,209 12.18% $3,863,138 11.88% $4,172,465 11.95% >$2,794,029 8.0% >$3,492,536 10.0%
- -
Tier 1 capital (to risk-
weighted assets)...... 3,490,596 10.74 3,395,519 10.44 3,695,565 10.58 > 1,397,014 4.0 > 2,095,522 6.0
- -
Leverage(1)............. 3,490,596 8.99 3,395,519 8.30 3,695,565 8.46 > 1,747,546 4.0 > 2,184,433 5.0
- -
- ------------------
<FN>
(1) Tier 1 capital divided by quarterly average assets (excluding certain
intangible assets).
</FN>
We and Union Bank of California, N.A. are subject to various regulations of
the federal banking agencies, including minimum capital requirements. We both
are required to maintain minimum ratios of Total and Tier 1 capital to
risk-weighted assets and of Tier 1 capital to quarterly average assets (the
leverage ratio).
Included in Tier 1 capital at year-end 2003 was $350 million in Trust
Preferred Securities, which we redeemed on February 19, 2004 resulting in a
decrease in our capital ratios at June 30, 2004 compared with June 30, 2003 and
December 31, 2003. In December of 2003, we issued $400 million of long-term
subordinated debt, which is included in Tier 2 capital as of December 31, 2003
(further discussion of our subordinated debt can be found in Note 11 of the
Notes to Consolidated Financial Statements included in the Form 10-K for the
year ended December 31, 2003).
Compared with June 30, 2003, in addition to the changes to our capital
structure mentioned in the above paragraph, the decrease in our capital ratios,
with the exception of our total capital ratio, was also attributable to higher
risk-weighted assets. Our total capital ratio increased slightly mainly due to
higher equity. Our leverage ratio decrease was primarily attributable to a $5
billion, or 13 percent, increase in quarterly average assets, which was
substantially the result of an increase in our securities portfolio.
As of June 30, 2004, management believes the capital ratios of Union Bank
of California, N.A. met all regulatory requirements of "well-capitalized"
institutions, which are 10 percent for the Total risk-based capital ratio, 6
percent for the Tier 1 risk-based capital ratio and 5 percent for the leverage
ratio.
BUSINESS SEGMENTS
We segregate our operations into four primary business units for the
purpose of management reporting, as shown in the table that follows. The results
show the financial performance of our major business units.
The risk-adjusted return on capital (RAROC) methodology used seeks to
attribute economic capital to business units consistent with the level of risk
they assume. These risks are primarily credit risk, market risk and operational
risk. Credit risk is the potential loss in economic value due to the likelihood
that the obligor will not perform as agreed. Market risk is the potential loss
in fair value due to changes in interest rates, currency rates and equity
prices. Operational risk is the potential loss due to failures in internal
control, system failures, or external events.
The tables on the following pages reflect the condensed income statements,
selected average balance sheet items and selected financial ratios for each of
our primary business units. The information presented does not necessarily
represent the business units' financial condition and results of operations as
if they were independent entities. In addition, the tables include performance
center earnings. A performance center is a special unit whose income generating
activities, unlike typical profit centers, are based on other
48
business segment units' customer base. The revenues generated and expenses
incurred for those transactions entered into to accommodate our customers are
allocated to other business segments where the customer relationships reside. A
performance center's purpose is to foster cross-selling with a total
profitability view of the products and services it manages. For example, the
Global Markets Trading and Sales unit, within the Global Markets Group, is a
performance center that manages the foreign exchange, derivatives, and fixed
income securities activities within the Global Markets organization. Unlike
financial accounting, there is no authoritative body of guidance for management
accounting equivalent to U.S. GAAP. Consequently, reported results are not
necessarily comparable with those presented by other companies.
The RAROC measurement methodology recognizes credit expense for expected
losses arising from credit risk and attributes economic capital related to
unexpected losses arising from credit, market and operational risks. As a result
of the methodology used by the RAROC model to calculate expected losses,
differences between the provision for credit losses and credit expense in any
one period could be significant. However, over an economic cycle, the cumulative
provision for credit losses and credit expense for expected losses should be
substantially the same. Business unit results are based on an internal
management reporting system used by management to measure the performance of the
units and UnionBanCal Corporation as a whole. Our management reporting system
identifies balance sheet and income statement items to each business unit based
on internal management accounting policies. Net interest income is determined
using our internal funds transfer pricing system, which assigns a cost of funds
to assets or a credit for funds to liabilities and capital, based on their type,
maturity or repricing characteristics. Noninterest income and expense directly
or indirectly attributable to a business unit are assigned to that business. The
business units are assigned the costs of products and services directly
attributable to their business activity through standard unit cost accounting
based on volume of usage. All other corporate expenses (overhead) are assigned
to the business units based on a predetermined percentage of usage.
49
We have restated certain business units' results for the prior periods to
reflect certain transfer pricing changes and any reorganization changes that may
have occurred.
COMMUNITY BANKING COMMERCIAL
AND INVESTMENT FINANCIAL INTERNATIONAL
SERVICES GROUP SERVICES GROUP BANKING GROUP
------------------- ------------------- -----------------
AS OF AND FOR THE THREE MONTHS ENDED JUNE 30,
-------------------------------------------------------------
2003 2004 2003 2004 2003 2004
-------- -------- -------- -------- ------- -------
RESULTS OF OPERATIONS AFTER PERFORMANCE
CENTER EARNINGS (DOLLARS IN THOUSANDS):
Net interest income.................... $163,613 $185,829 $180,956 $191,471 $8,160 $ 9,222
Noninterest income..................... 111,878 129,793 61,552 72,543 26,090 22,261
-------- -------- -------- -------- ------- -------
Total revenue.......................... 275,491 315,622 242,508 264,014 34,250 31,483
Noninterest expense.................... 197,289 223,645 105,097 104,003 15,398 16,957
Credit expense (income)................ 8,064 7,797 42,145 26,480 547 645
-------- -------- -------- -------- ------- -------
Income (loss) before income tax expense
(benefit)............................ 70,138 84,180 95,266 133,531 18,305 13,881
Income tax expense (benefit)........... 26,828 32,199 29,547 45,321 7,001 5,310
-------- -------- -------- -------- ------- -------
Net income (loss)...................... $ 43,310 $ 51,981 $ 65,719 $ 88,210 $11,304 $ 8,571
======== ======== ======== ======== ======= =======
PERFORMANCE CENTER EARNINGS (DOLLARS IN
THOUSANDS):
Net interest income.................... $ 201 $ 149 $ (194) $ (87) $ 10 $ 26
Noninterest income..................... (8,046) (9,621) 14,566 15,271 253 343
Noninterest expense.................... (8,353) (7,308) 8,886 8,015 82 22
Net income (loss)...................... 294 (1,354) 3,430 4,464 110 215
Total loans (dollars in millions)...... 25 28 (45) (46) -- --
AVERAGE BALANCES (DOLLARS IN MILLIONS):
Total loans(1)......................... $ 11,229 $ 12,256 $ 13,071 $ 12,140 $ 1,606 $ 1,820
Total assets........................... 12,236 13,463 15,161 14,467 2,009 2,254
Total deposits(1)...................... 16,432 19,291 12,236 14,379 1,471 2,042
FINANCIAL RATIOS:
Risk adjusted return on capital(2)..... 26% 30% 15% 24% 67% 55%
Return on average assets(2)............ 1.42 1.55 1.74 2.45 2.26 1.53
Efficiency ratio(3).................... 71.6 70.9 43.3 39.4 45.0 53.9
GLOBAL UNIONBANCAL
MARKETS GROUP OTHER CORPORATION
------------------- ------------------- ------------------
AS OF AND FOR THE THREE MONTHS ENDED JUNE 30,
--------------------------------------------------------------
2003 2004 2003 2004 2003 2004
-------- -------- -------- -------- -------- --------
RESULTS OF OPERATIONS AFTER PERFORMANCE
CENTER EARNINGS (DOLLARS IN THOUSANDS):
Net interest income.................... $ 17,139 $(15,802) $ 15,909 $ 29,138 $385,777 $399,858
Noninterest income..................... 1,882 1,394 1,769 105,019 203,171 331,010
-------- -------- -------- -------- -------- --------
Total revenue.......................... 19,021 (14,408) 17,678 134,157 588,948 730,868
Noninterest expense.................... 3,744 4,441 29,476 27,356 351,004 376,402
Credit expense (income)................ 50 177 (25,806) (45,099) 25,000 (10,000)
-------- -------- -------- -------- -------- --------
Income (loss) before income tax expense
(benefit)............................ 15,227 (19,026) 14,008 151,900 212,944 364,466
Income tax expense (benefit)........... 5,824 (7,277) (1,014) 57,816 68,186 133,369
-------- -------- -------- -------- -------- --------
Net income (loss)...................... $ 9,403 $(11,749) $ 15,022 $ 94,084 $144,758 $231,097
======== ======== ======== ======== ======== ========
PERFORMANCE CENTER EARNINGS (DOLLARS IN
THOUSANDS):
Net interest income...................... $ (128) $ (191) $ 111 $ 103 $ -- $ --
Noninterest income....................... (9,876) (9,523) 3,103 3,530 -- --
Noninterest expense...................... (2,025) (1,847) 1,410 1,118 -- --
Net income (loss)........................ (4,927) (4,858) 1,093 1,533 -- --
Total loans (dollars in millions)........ -- -- 20 18 -- --
AVERAGE BALANCES (DOLLARS IN MILLIONS):
Total loans(1)........................... $ 287 $ 366 $ 324 $ 257 $ 26,517 $ 26,839
Total assets............................. 9,454 13,272 916 1,155 39,776 44,611
Total deposits(1)........................ 1,071 680 1,377 1,418 32,587 37,810
FINANCIAL RATIOS:
Risk adjusted return on capital(2)....... 4% (5)% na na na na
Return on average assets(2).............. 0.40 (0.36) na na 1.46% 2.08%
Efficiency ratio(3)...................... 19.7 (30.8) na na 59.5 51.4
- -------------------------------
<FN>
(1) Represents loans and deposits for each business segment after allocation
between the segments of loans and deposits originated in one segment but
managed by another segment.
(2) Annualized.
(3) The efficiency ratio is noninterest expense, excluding foreclosed asset
expense (income), as a percentage of net interest income and noninterest
income. Foreclosed asset expense (income) was less than ($1 thousand) and
$17 thousand in the second quarters of 2003 and 2004, respectively.
na = not applicable
</FN>
50
COMMUNITY BANKING COMMERCIAL
AND INVESTMENT FINANCIAL INTERNATIONAL
SERVICES GROUP SERVICES GROUP BANKING GROUP
------------------- ------------------- ------------------
AS OF AND FOR THE SIX MONTHS ENDED JUNE 30,
--------------------------------------------------------------
2003 2004 2003 2004 2003 2004
-------- -------- -------- -------- -------- --------
RESULTS OF OPERATIONS AFTER PERFORMANCE
CENTER EARNINGS (DOLLARS IN THOUSANDS):
Net interest income.................... $331,474 $368,496 $360,187 $374,978 $ 17,117 $ 17,030
Noninterest income..................... 213,503 246,394 119,464 142,170 41,573 40,450
-------- -------- -------- -------- -------- --------
Total revenue.......................... 544,977 614,890 479,651 517,148 58,690 57,480
Noninterest expense.................... 397,179 442,629 203,856 208,645 30,333 32,640
Credit expense (income)................ 15,783 15,584 84,607 57,706 1,052 1,249
-------- -------- -------- -------- -------- --------
Income (loss) before income tax expense
(benefit)............................ 132,015 156,677 191,188 250,797 27,305 23,591
Income tax expense (benefit)........... 50,496 59,929 60,227 83,570 10,444 9,024
-------- -------- -------- -------- -------- --------
Net income (loss)...................... $ 81,519 $ 96,748 $130,961 $167,227 $ 16,861 $ 14,567
======== ======== ======== ======== ======== ========
PERFORMANCE CENTER EARNINGS (DOLLARS IN
THOUSANDS):
Net interest income.................... $ 403 $ 322 $ (401) $ (204) $ 14 $ 35
Noninterest income..................... (18,410) (20,173) 29,415 31,889 582 616
Noninterest expense.................... (16,554) (16,503) 17,193 17,591 334 65
Net income (loss)...................... (937) (2,103) 7,387 8,776 162 362
Total loans (dollars in millions)...... 26 27 (46) (45) -- --
AVERAGE BALANCES (DOLLARS IN MILLIONS):
Total loans(1)......................... $ 11,171 $ 12,174 $ 13,301 $ 12,112 $ 1,566 $ 1,692
Total assets........................... 12,132 13,387 15,375 14,330 1,966 2,129
Total deposits(1)...................... 16,113 18,978 11,797 13,859 1,494 1,853
FINANCIAL RATIOS:
Risk adjusted return on capital(2)..... 25% 28% 15% 23% 54% 48%
Return on average assets(2)............ 1.36 1.45 1.72 2.35 1.73 1.38
Efficiency ratio(3).................... 72.9 72.0 42.5 40.3 51.7 56.8
GLOBAL UNIONBANCAL
MARKETS GROUP OTHER CORPORATION
------------------- ------------------- ----------------------
AS OF AND FOR THE SIX MONTHS ENDED JUNE 30,
------------------------------------------------------------------
2003 2004 2003 2004 2003 2004
-------- -------- -------- -------- ---------- ----------
RESULTS OF OPERATIONS AFTER PERFORMANCE
CENTER EARNINGS (DOLLARS IN THOUSANDS):
Net interest income..................... $ 38,231 $(14,651) $ 29,548 $ 54,426 $ 776,557 $ 800,279
Noninterest income...................... 3,408 2,936 10,994 110,265 388,942 542,215
-------- -------- -------- -------- ---------- ----------
Total revenue........................... 41,639 (11,715) 40,542 164,691 1,165,499 1,342,494
Noninterest expense..................... 8,232 10,868 54,004 54,726 693,604 749,508
Credit expense (income)................. 100 227 (46,542) (89,766) 55,000 (15,000)
-------- -------- -------- -------- ---------- ----------
Income (loss) before income tax expense
(benefit)............................. 33,307 (22,810) 33,080 199,731 416,895 607,986
Income tax expense (benefit)............ 12,740 (8,725) 2,713 75,604 136,620 219,402
-------- -------- -------- -------- ---------- ----------
Net income (loss)....................... $ 20,567 $(14,085) $ 30,367 $124,127 $ 280,275 $ 388,584
======== ======== ======== ======== ========== ==========
PERFORMANCE CENTER EARNINGS (DOLLARS IN
THOUSANDS):
Net interest income..................... $ (230) $ (355) $ 214 $ 202 $ -- $ --
Noninterest income...................... (17,949) (19,719) 6,362 7,387 -- --
Noninterest expense..................... (3,653) (3,752) 2,680 2,599 -- --
Net income (loss)....................... (8,970) (10,079) 2,358 3,044 -- --
Total loans (dollars in millions)....... -- -- 20 18 -- --
AVERAGE BALANCES (DOLLARS IN MILLIONS):
Total loans(1).......................... $ 251 $ 246 $ 331 $ 266 $ 26,620 $ 26,490
Total assets............................ 8,714 12,827 879 1,158 39,066 43,831
Total deposits(1)....................... 1,139 890 1,294 1,295 31,837 36,875
FINANCIAL RATIOS:
Risk adjusted return on capital(2)...... 4% (3)% na na na na
Return on average assets(2)............. 0.48 (0.22) na na 1.45% 1.78%
Efficiency ratio(3)..................... 19.8 (92.8) na na 59.4 55.7
- -------------------------------
<FN>
(1) Represents loans and deposits for each business segment after allocation
between the segments of loans and deposits originated in one segment but
managed by another segment.
(2) Annualized.
(3) The efficiency ratio is noninterest expense, excluding foreclosed asset
expense (income), as a percentage of net interest income and noninterest
income. Foreclosed asset and noninterest income. Foreclosed asset expense
was $51 thousand and $536 thousand in the first six months of 2003 and
2004, respectively.
na = not applicable
</FN>
51
COMMUNITY BANKING AND INVESTMENT SERVICES GROUP
In the second quarter of 2004, net income increased $8.7 million, or 20
percent, compared to the second quarter of 2003. In the second quarter of 2004,
total revenue increased $40.1 million, or 15 percent, compared to the second
quarter of 2003. Increased asset and deposit volumes offset the effect of a
lower interest rate environment leading to an increase of $22.2 million, or 14
percent, in net interest income over the second quarter of 2003. In the second
quarter of 2004, noninterest income was $17.9 million, or 16 percent, higher
than the second quarter of 2003 primarily due to higher deposit fees, increased
card processing fees and increased insurance commissions. Noninterest expense
increased $26.4 million, or 13 percent, in the second quarter of 2004 compared
to the second quarter of 2003, with the majority of that increase being
attributable to higher staff expenses related to our acquisitions and de novo
branches, as well as increased deposit volumes and residential loan growth.
In 2004, the Community Banking and Investment Services Group continues to
emphasize growing the consumer asset portfolio, expanding wealth management
services, extending the small business franchise, expanding the branch network,
and expanding cross selling activities throughout the Bank. The strategy for
growing the consumer asset portfolio primarily focused on mortgage and home
equity products that may be originated through the branch network, as well as
through channels such as wholesalers, correspondents, and whole loan purchases.
As of June 30, 2004, residential mortgages grew by $1.4 billion, or 21 percent,
from June 30, 2003. The Wealth Management division is focused on becoming a
growing provider of banking and investment products for affluent individuals in
geographic areas already served by us. We seek to provide quality service
superior to that of our competitors and offer our customers an attractive
product suite. Core elements of the initiative to extend our small business
franchise include improving our sales force, increasing marketing activities,
adding new locations, and developing online capabilities to complement physical
distribution. It is anticipated that expansion of the distribution network will
be achieved through acquisitions and new branch openings. On July 1, 2003, we
completed the acquisition of Monterey Bay Bank, a $632 million asset savings and
loan association headquartered in Watsonville, California, with eight
full-service branches in the Greater Monterey Bay area. On January 16, 2004, we
completed our acquisition of Business Bank of California, a commercial bank
headquartered in San Bernardino, California, with $704 million in assets and
fifteen full-service branches in the Southern California Inland Empire and the
San Francisco Bay Area.
The Community Banking and Investment Services Group is comprised of six
major divisions: Community Banking, Wealth Management, Institutional Services
and Asset Management, Consumer Asset Management, UBOC Markets and Insurance
Services.
COMMUNITY BANKING serves its customers through 297 full-service branches in
California, and a network of 567 proprietary ATMs. Customers may also access our
services 24 hours a day by telephone or through our WEBSITE at www.uboc.com. In
addition, the division offers automated teller services.
This division is organized by service delivery method, by markets and by
geography. We serve our customers in the following ways:
o through community banking branches, which serve consumers and
businesses with checking and deposit services, as well as various
types of consumer and business financing, brokerage products and
services, and insurance services;
o through on-line access to our internet banking services, which augment
our physical delivery channels by providing an array of customer
transaction, bill payment and loan payment services;
o through branches and business banking centers, which serve businesses
with annual sales up to $5 million; and
o through in-store branches in supermarkets, which also serve consumers
and businesses.
52
WEALTH MANAGEMENT provides private banking services to our affluent
clientele.
o The Private Bank focuses primarily on delivering financial services to
high net worth individuals with sophisticated financial needs as well
as to professional service firms. Specific products and services
include trust and estate services, investment account management
services, and deposit and credit products. A key strategy of The
Private Bank is to expand its business by leveraging existing Bank
client relationships. Through 14 existing locations in California,
Oregon, and Washington, The Private Bank relationship managers offer
all of our available products and services.
INSTITUTIONAL SERVICES AND ASSET MANAGEMENT provides investment management
and administration services for a broad range of individuals and institutions.
o HighMark Capital Management, Inc., a registered investment advisor,
provides investment advisory services to institutional clients and its
proprietary mutual funds, the affiliated HighMark Funds. It also
provides advisory services to Union Bank of California, N.A. trust and
agency clients, including corporations, pension funds and individuals.
HighMark Capital Management, Inc. also provides mutual fund support
services. HighMark Capital Management, Inc.'s strategy is to increase
assets under management by broadening its client base and expanding
the distribution of shares of its mutual fund clients.
o Institutional Services provides custody, corporate trust, and
retirement plan services. Custody Services provides both domestic and
international safekeeping/settlement services in addition to
securities lending. Corporate Trust acts as trustee for corporate and
municipal debt issues. Retirement Services provides a full range of
defined benefit and defined contribution administrative services,
including trustee services, administration, investment management, and
401(k) valuation services. The client base of Institutional Services
includes financial institutions, corporations, government agencies,
unions, insurance companies, mutual funds, investment managers, and
non-profit organizations. Institutional Services' strategy is to
continue to leverage and expand its position in our target markets.
On May 17, 2004, Union Bank of California, N.A., signed a definitive
agreement to acquire the business portfolio of CNA Trust Company. With this
acquisition we expect that we will be better positioned to provide a more
complete range of retirement services to our business clients. The transaction
was completed on August 1, 2004.
CONSUMER ASSET MANAGEMENT provides the centralized underwriting,
processing, servicing, collection and administration for consumer assets
including residential loans. On May 31, 2004, we completed the sale of our
merchant card portfolio and formed a long-term marketing alliance with NOVA
Information Systems (NOVA). NOVA acquired our merchant accounts and will provide
processing services, customer service and support operations to our more than
10,000 merchant locations. We will market merchant services through our branch
network in California, Oregon and Washington.
o Consumer Asset Management is centralized in two California sites, one
in San Diego and one in Brea, and
o provides customer and credit management services for consumer loan
products.
UBOC MARKETS.In May 2004, the Bank announced a strategic move to realign
the Bank's wholly owned brokerage subsidiary, UBOC Investment Services, Inc. and
Personal Trust Sales with Securities Trading and Institutional Sales. The
realignment advances our goals of leveraging and anchoring client relationships
by enhancing the Bank's cross sell culture.
o Our brokerage products and services are provided through UBOC
Investment Services, Inc., a registered broker/dealer offering
investment products to individuals and institutional clients, whose
primary strategy is to further penetrate our existing client base.
53
INSURANCE SERVICES provides a range of risk management services and
insurance products to business and retail customers. The group, which includes
our 2001 acquisition of Armstrong/Robitaille, Inc., our 2002 acquisition of John
Burnham and Company, and our 2003 acquisitions of Tanner Insurance Brokers, Inc.
and Knight Insurance Agency, offers its risk management and insurance products
through offices in California and Oregon.
OTHER SERVICES
Through alliances with other financial institutions, the Community Banking
and Investment Services Group offers additional products and services, such as
credit cards, leasing, and asset-based and leveraged financing.
The group competes with larger banks by attempting to provide service
quality superior to that of its major competitors. The group's primary means of
competing with community banks include its branch network and its technology to
deliver banking services. The group also offers convenient banking hours to
consumers through our drive-through banking locations and selected branches that
are open seven days a week.
The group competes with a number of commercial banks, internet banks,
savings associations and credit unions, as well as more specialized financial
service providers such as investment brokerage companies, consumer finance
companies, and residential real estate lenders. The group's primary competitors
are other major depository institutions such as Bank of America, Citibank,
Washington Mutual and Wells Fargo, as well as smaller community banks in the
markets in which we operate.
COMMERCIAL FINANCIAL SERVICES GROUP
The Commercial Financial Services Group offers financing and cash
management services to middle-market and large corporate businesses primarily
headquartered in the western United States. The Commercial Financial Services
Group has continued to focus specialized financing expertise to specific
geographic markets and industry segments such as energy, entertainment, and real
estate. Relationship managers in the Commercial Financial Services Group provide
credit services, including commercial loans, accounts receivable and inventory
financing, project financing, lease financing, trade financing and real estate
financing. In addition to credit services, the group offers its customers access
to cash management services delivered through deposit managers with experience
in cash management solutions for businesses and government entities.
In the second quarter of 2004, net income increased $22.5 million, or 34
percent, compared to the second quarter of 2003. In the second quarter of 2004,
net interest income increased $10.5 million, or 6 percent, compared to the
second quarter of 2003, partially attributable to the impact of increasing
deposit balances and a lower cost of funds resulting from the lower interest
rate environment. Excluding higher income in the private equity portfolio of
$3.0 million, mainly related to higher net gains on private capital investments
in the second quarter of 2004 compared to the second quarter of 2003,
noninterest income increased $8.0 million, or 13 percent. This 13 percent
increase was mainly attributable to higher deposit-related service fees. In the
second quarter of 2004, noninterest expense decreased $1.1 million, or 1
percent. Credit expense decreased $15.7 million mainly as a result of a
refinement in the RAROC allocation of capital and expected losses and lower loan
balances year-over-year.
The group's initiatives during 2004 continue to include expanding wholesale
deposit activities and increasing domestic trade financing. Loan strategies
include originating, underwriting and syndicating loans in core competency
markets, such as the California middle-market, commercial real estate, energy,
entertainment, equipment leasing and commercial finance. The Commercial
Financial Services Group provides strong processing services, including services
such as check processing and cash vault services.
54
The Commercial Financial Services Group is comprised of the following
business units:
o the Commercial Banking Division, which serves California middle-market
and large corporate companies with commercial lending, trade
financing, and asset- based loans;
o the Corporate Deposit and Treasury Management Division, which provides
deposit and cash management expertise to middle-market and large
corporate clients, government agencies and specialized industries;
o the Real Estate Industries Division, which provides real estate
lending products such as construction loans, commercial mortgages and
bridge financing;
o the Energy Capital Services Division, which provides custom financing
and project financing to oil and gas companies, as well as power and
utility companies, nationwide and internationally; and
o the Corporate Capital Markets Division, which provides custom
financing to middle-market and large corporate clients in their
defined industries and geographic markets, together with limited
merchant and investment banking related products and services.
The group's main strategy is to target industries and companies for which
the group can reasonably expect to be one of a customer's primary banks.
Consistent with its strategy, the group attempts to serve a large part of its
targeted customers' credit and depository needs. The group competes with other
banks primarily on the basis of the quality of its relationship managers, the
delivery of quality customer service, and its reputation as a "business bank."
The group also competes with a variety of other financial services companies.
Competitors include other major California banks, as well as regional, national
and international banks. In addition, the group competes with investment banks,
commercial finance companies, leasing companies, and insurance companies.
The Check Clearing for the 21st Century Act (Check 21) was signed into law
on October 28, 2003, and will become effective on October 28, 2004. Check 21 is
designed to foster innovation in the payments system and to enhance its
efficiency by reducing some of the legal impediments to check truncation (that
is, the banking process by which cancelled original checks are not returned to
the customer with the customer's regular bank statement). The law facilitates
check truncation by creating a new negotiable instrument called a substitute
check, which would permit banks to truncate original checks, to process check
information electronically, and to deliver substitute checks to banks that want
to continue receiving paper checks. A substitute check will be the legal
equivalent of the original check and will include all the information contained
on the original check. The law does not require banks to accept checks in
electronic form nor does it require banks to use the new authority granted by
Check 21 to create substitute checks. The final regulations regarding Check 21
were published in July 2004. In order to manage and control the changes which
may be necessitated by Check 21, we have established a "Check 21 Initiative
Project Management Structure," composed of representatives from many of our
operating and support units. The objective of this initiative is to allow us to
prioritize and allocate our resources and mitigate risk to our ongoing
operations. It is not possible at this time to predict the long-term financial
impact of Check 21, and regulations thereunder, on our business.
INTERNATIONAL BANKING GROUP
The International Banking Group primarily focuses on providing
correspondent banking and trade finance related products and services to
international financial institutions worldwide. This focus includes products and
services such as letters of credit, international payments, collections and
providing short-term financing. The majority of the revenue generated by the
International Banking Group is from financial institutions domiciled outside of
the U.S.
In the second quarter of 2004, net income decreased $2.7 million, or 24
percent, compared to the second quarter of 2003. Total revenue decreased $2.7
million or 8 percent, compared to the second quarter
55
of 2003. Net interest income increased $1.1 million, or 13 percent, compared to
the second quarter of 2003 mainly attributable to higher demand deposit
balances. Noninterest income was $3.8 million, or 15 percent, lower compared to
the second quarter of 2003 primarily attributable to a $9.0 million gain on an
early call of a Mexican Brady Bond in the second quarter of 2003 partially
offset by a $3.7 million insurance recovery and higher payment and trade
activities in the current quarter. Noninterest expense increased $1.6 million,
or 10 percent, compared to the second quarter of 2003. In the second quarter of
2004, credit expense of $0.6 million was slightly higher compared to the second
quarter of 2003. The International Banking Group's business revolves around
short-term financing, mostly to banks, which provides service-related income, as
well as significantly lower credit risk when compared to other lending
activities.
The group has a long history of providing correspondent banking and
trade-related products and services to international financial institutions. We
believe the group continues to achieve strong customer loyalty in the
correspondent banking market. The International Banking Group, headquartered in
San Francisco, also maintains offices in Asia, Latin America and Europe; and an
international banking subsidiary in New York.
GLOBAL MARKETS GROUP
The Global Markets Group conducts business to support all of our business
groups and their customers. This group is responsible for our treasury
management, which encompasses wholesale funding, liquidity management, interest
rate risk management, including the ALM securities portfolio management and
derivatives hedging activities. Associated with this function, this group's
results include the transfer pricing activity for us, which allocates to the
other business segments their cost of funds on all asset categories and credit
for funds on all liability categories. Another important function of the Global
Markets Group is the offering of a broad range of risk management products, such
as foreign exchange contracts and interest rate derivative hedge products for
our client's risk management needs. It also trades fixed income securities to
meet investment needs of our institutional and business clients. In May 2004,
with a strategic realignment of the market and investment product offering
functions, the UBOC Markets unit was formed, encompassing the risk management
and fixed income products offerings of the Global Markets Group and UBOC
Investment Services, Inc., the Bank's brokerage subsidiary. The UBOC Investment
Services' management dually reports to the Global Markets Group and the
Community Banking and Investment Services Group. UBOC Markets' income
attributable to business with our clients is allocated, through performance
centers, to the business units.
In the second quarter of 2004, net loss was $11.7 million compared to net
income of $9.4 million in the second quarter of 2003. Total revenue in the
second quarter of 2004 decreased by $33.4 million, compared to the second
quarter of 2003, resulting from a $32.9 million decrease in net interest income.
The decrease in net interest income was primarily attributable to a higher
transfer pricing residual in the second quarter of 2004 resulting from the
continuing growth in core deposits, which are priced on longer-term liability
rates, compared to our portfolio of relatively short-term loans and securities,
which are priced at their shorter-term lending rates. Noninterest income
decreased $0.5 million compared to the second quarter of 2003. Noninterest
expense in the second quarter of 2004 increased $0.7 million, or 19 percent,
compared to the second quarter of 2003, mainly attributable to the
ineffectiveness on our cash flow hedges, which is recognized in noninterest
expense.
OTHER
"Other" includes the following items:
o corporate activities that are not directly attributable to one of the
four major business units. Included in this category are certain other
nonrecurring items such as the results of operations of certain parent
company non-bank subsidiaries and the elimination of the fully
taxable-equivalent basis amount;
56
o the adjustment between the credit expense under RAROC and the
provision for credit losses under U.S. GAAP and earnings associated
with unallocated equity capital;
o the adjustment between the tax expense reported under RAROC using a
tax rate of 38.25 percent and the Company's effective tax rates;
o the Pacific Rim Corporate Group, with assets of $293 million at June
30, 2004, which offers a range of credit, deposit, and investment
management products and services to companies in the U.S. which are
affiliated with companies headquartered in Japan; and
o the residual costs of support groups.
Net income for "Other" in the second quarter of 2004 was $94.1 million. The
results were impacted by the following factors:
o Credit expense (income) of ($45.1) million was due to the difference
between the $10.0 million reversal of provision for credit losses
calculated under our U.S. GAAP methodology and the $35.1 million in
expected losses for the reportable business segments, which utilizes
the RAROC methodology;
o Net interest income of $29.1 million, which resulted from the
differences between the credit for equity for the reportable segments
under RAROC and the net interest income earned by UnionBanCal
Corporation, and a credit for deposits in the Pacific Rim Corporate
Group;
o Noninterest income of $105.0 million, which included a $93.0 million
gain on the sale of our merchant card portfolio and an $8.5 million
gain on the sale of real property; and
o Noninterest expense of $27.4 million.
Net income for "Other" in the second quarter of 2003 was $15.0 million. The
results were impacted by the following factors:
o Credit expense (income) of ($25.8) million was due to the difference
between the $25.0 million provision for credit losses calculated under
our U.S. GAAP methodology and the $50.8 million in expected losses for
the reportable business segments, which utilizes the RAROC
methodology;
o Net interest income of $15.9 million, which resulted from the
differences between the credit for equity for the reportable segments
under RAROC and the net interest income earned by UnionBanCal
Corporation, and a credit for deposits in the Pacific Rim Corporate
Group;
o Noninterest income of $1.8 million; and
o Noninterest expense of $29.5 million.
CERTAIN BUSINESS RISK FACTORS
ADVERSE CALIFORNIA ECONOMIC CONDITIONS COULD ADVERSELY AFFECT OUR BUSINESS
A substantial majority of our assets, deposits and fee income are generated
in California. As a result, poor economic conditions in California may cause us
to incur losses associated with higher default rates and decreased collateral
values in our loan portfolio. Economic conditions in California are subject to
various uncertainties at this time, including the decline in the technology
sector, the California state government's budgetary difficulties and continuing
fiscal difficulties. We have various banking relationships with the California
State government, including credit and deposit relationships and funds transfer
arrangements. If economic conditions in California decline, we expect that our
level of problem assets could increase and our prospects for growth could be
impaired. On March 2, 2004, the California electorate approved certain ballot
measures, including a one-time economic recovery bond issue of up to $15 billion
to pay off the State's accumulated general fund deficit. While these measures
are expected to
57
provide near-term relief for the State government's fiscal situation, the State
of California continues to face fiscal challenges, the long-term impact of
which, on the State's economy, cannot be predicted with any certainty.
THE CONTINUING WAR ON TERRORISM COULD ADVERSELY AFFECT U.S. ECONOMIC
CONDITIONS
Acts or threats of terrorism and actions taken by the U.S. or other
governments as a result of such acts or threats may result in a downturn in U.S.
economic conditions and could adversely affect business and economic conditions
in the U.S. generally and in our principal markets.
ADVERSE ECONOMIC FACTORS AFFECTING CERTAIN INDUSTRIES COULD ADVERSELY
AFFECT OUR BUSINESS
We are subject to certain industry-specific economic factors. For example,
a significant and increasing portion of our total loan portfolio is related to
residential real estate. Accordingly, a downturn in the real estate and housing
industries in California could have an adverse effect on our operations.
Increases in residential mortgage loan interest rates could also have an adverse
effect on our operations by depressing new mortgage loan originations. We
provide financing to businesses in a number of other industries that may be
particularly vulnerable to industry-specific economic factors, including the
communications / media industry, the retail industry, the airline industry, the
power industry and the technology industry. Recent increases in fuel prices
could adversely affect businesses in several of these industries.
Industry-specific risks are beyond our control and could adversely affect our
portfolio of loans, potentially resulting in an increase in nonperforming loans
or charge-offs.
FLUCTUATIONS IN INTEREST RATES COULD ADVERSELY AFFECT OUR BUSINESS
Significant increases in market interest rates, or the perception that an
increase may occur, could adversely affect both our ability to originate new
loans and our ability to grow. Conversely, decreases in interest rates could
result in an acceleration in the prepayment of loans. An increase in market
interest rates could also adversely affect the ability of our floating-rate
borrowers to meet their higher payment obligations. If this occurred, it could
cause an increase in nonperforming assets and charge-offs, which could adversely
affect our business.
FLUCTUATIONS IN INTEREST RATES COULD ADVERSELY AFFECT OUR MARGIN SPREAD
Changes in market interest rates, including changes in the relationship
between short-term and long-term market interest rates or between different
interest rate indices, can impact our margin spread, that is, the difference
between the interest rates we charge on interest earning assets, such as loans,
and the interest rates we pay on interest bearing liabilities, such as deposits
or other borrowings. The impact, particularly in a falling interest rate
environment, could result in a decrease in our interest income relative to
interest expense.
STOCKHOLDER VOTES ARE CONTROLLED BY THE BANK OF TOKYO-MITSUBISHI, LTD.; OUR
INTERESTS MAY NOT BE THE SAME AS THE BANK OF TOKYO-MITSUBISHI, LTD.'S
INTERESTS
The Bank of Tokyo-Mitsubishi, Ltd., a wholly owned subsidiary of Mitsubishi
Tokyo Financial Group, Inc., owns a majority (approximately 62 percent as of
June 30, 2004) of the outstanding shares of our common stock. As a result, The
Bank of Tokyo-Mitsubishi, Ltd. can elect all of our directors and can control
the vote on all matters, including determinations such as: approval of mergers
or other business combinations; sales of all or substantially all of our assets;
any matters submitted to a vote of our stockholders; issuance of any additional
common stock or other equity securities; incurrence of debt other than in the
ordinary course of business; the selection and tenure of our Chief Executive
Officer; payment of dividends with respect to common stock or other equity
securities; and other matters that might be favorable to The Bank of
Tokyo-Mitsubishi, Ltd.
58
A majority of our directors are independent of The Bank of
Tokyo-Mitsubishi, Ltd. and are not officers or employees of UnionBanCal
Corporation or any of our affiliates, including The Bank of Tokyo-Mitsubishi,
Ltd. However, because of The Bank of Tokyo-Mitsubishi, Ltd.'s control over the
election of our directors, we could designate ourselves as a "controlled
company" under the New York Stock Exchange Rules and could change the
composition of our Board of Directors so that the Board would not have a
majority of independent directors. The Bank of Tokyo-Mitsubishi, Ltd.'s ability
to prevent an unsolicited bid for us or any other change in control could have
an adverse effect on the market price for our common stock.
POSSIBLE FUTURE SALES OF SHARES BY THE BANK OF TOKYO-MITSUBISHI, LTD. COULD
ADVERSELY AFFECT THE MARKET FOR OUR STOCK
The Bank of Tokyo-Mitsubishi, Ltd. may sell shares of our common stock in
compliance with the federal securities laws. By virtue of The Bank of
Tokyo-Mitsubishi, Ltd.'s current control of us, The Bank of Tokyo-Mitsubishi,
Ltd. could sell large amounts of shares of our common stock by causing us to
file a registration statement that would allow them to sell shares more easily.
In addition, The Bank of Tokyo-Mitsubishi, Ltd. could sell shares of our common
stock without registration. Although we can make no prediction as to the effect,
if any, that such sales would have on the market price of our common stock,
sales of substantial amounts of our common stock, or the perception that such
sales could occur, could adversely affect the market price of our common stock.
If The Bank of Tokyo-Mitsubishi, Ltd. sells or transfers shares of our common
stock as a block, another person or entity could become our controlling
stockholder.
THE BANK OF TOKYO-MITSUBISHI, LTD.'S FINANCIAL CONDITION COULD ADVERSELY
AFFECT OUR OPERATIONS
We fund our operations independently of The Bank of Tokyo-Mitsubishi, Ltd.
and believe our business is not necessarily closely related to The Bank of
Tokyo-Mitsubishi, Ltd.'s business or outlook, including the proposed merger with
UFJ Holdings, Inc. However, The Bank of Tokyo-Mitsubishi, Ltd.'s credit ratings
may affect our credit ratings. The Bank of Tokyo-Mitsubishi, Ltd. is also
subject to regulatory oversight and review by Japanese and US regulatory
authorities. Our business operations and expansion plans could be negatively
affected by regulatory concerns related to the Japanese financial system and The
Bank of Tokyo-Mitsubishi, Ltd., including the proposed merger with UFJ Holdings,
Inc.
POTENTIAL CONFLICTS OF INTEREST WITH THE BANK OF TOKYO-MITSUBISHI, LTD.
COULD ADVERSELY AFFECT US
The Bank of Tokyo-Mitsubishi, Ltd.'s view of possible new businesses,
strategies, acquisitions, divestitures or other initiatives may differ from
ours. This may delay or hinder us from pursuing such initiatives.
Also, as part of The Bank of Tokyo-Mitsubishi, Ltd.'s normal risk
management processes, The Bank of Tokyo-Mitsubishi, Ltd. manages global credit
exposures and concentrations on an aggregate basis, including UnionBanCal
Corporation. Therefore, at certain levels or in certain circumstances, our
ability to approve certain credits or other banking transactions and categories
of customers is subject to the concurrence of The Bank of Tokyo-Mitsubishi, Ltd.
We may wish to extend credit or furnish other banking services to the same
customers as The Bank of Tokyo-Mitsubishi, Ltd. Our ability to do so may be
limited for various reasons, including The Bank of Tokyo-Mitsubishi, Ltd.'s
aggregate credit exposure and marketing policies.
Certain directors' and officers' ownership interests in The Bank of
Tokyo-Mitsubishi, Ltd.'s common stock or service as a director or officer or
other employee of both us and The Bank of Tokyo-Mitsubishi, Ltd. could create or
appear to create potential conflicts of interest, especially since both of us
compete in the U.S. banking industry.
59
SUBSTANTIAL COMPETITION IN THE CALIFORNIA BANKING MARKET COULD ADVERSELY
AFFECT US
Banking is a highly competitive business. We compete actively for loan,
deposit, and other financial services business in California, as well as
nationally and internationally. Our competitors include a large number of state
and national banks, thrift institutions, credit unions and major foreign-
affiliated or foreign banks, as well as many financial and nonfinancial firms
that offer services similar to those offered by us. Some of our competitors are
community banks that have strong local market positions. Other competitors
include large financial institutions that have substantial capital, technology
and marketing resources. Such large financial institutions may have greater
access to capital at a lower cost than us, which may adversely affect our
ability to compete effectively.
Banks, securities firms, and insurance companies can now combine as a
"financial holding company." Financial holding companies can offer virtually any
type of financial service, including banking, securities underwriting, insurance
(both agency and underwriting), and merchant banking. Recently, a number of
foreign banks have acquired financial services companies in the U.S., further
increasing competition in the U.S. market.
RESTRICTIONS ON DIVIDENDS AND OTHER DISTRIBUTIONS COULD LIMIT AMOUNTS
PAYABLE TO US
As a holding company, a substantial portion of our cash flow typically
comes from dividends our bank and nonbank subsidiaries pay to us. Various
statutory provisions restrict the amount of dividends our subsidiaries can pay
to us without regulatory approval. In addition, if any of our subsidiaries
liquidate, that subsidiary's creditors will be entitled to receive distributions
from the assets of that subsidiary to satisfy their claims against it before we,
as a holder of an equity interest in the subsidiary, will be entitled to receive
any of the assets of the subsidiary.
ADVERSE EFFECTS OF, OR CHANGES IN, BANKING OR OTHER LAWS AND REGULATIONS OR
GOVERNMENTAL FISCAL OR MONETARY POLICIES COULD ADVERSELY AFFECT US
We are subject to significant federal and state regulation and supervision,
which is primarily for the benefit and protection of our customers and not for
the benefit of investors. In the past, our business has been materially affected
by these regulations. This trend is likely to continue in the future. Laws,
regulations or policies, including accounting standards and interpretations
currently affecting us and our subsidiaries may change at any time. Regulatory
authorities may also change their interpretation of these statutes and
regulations. Therefore, our business may be adversely affected by any future
changes in laws, regulations, policies or interpretations or regulatory
approaches to compliance and enforcement, including legislative and regulatory
reactions to the terrorist attack on September 11, 2001, and future acts of
terrorism, and the Enron Corporation, WorldCom, Inc. and other major U.S.
corporate bankruptcies and reports of accounting irregularities at U.S. public
companies, including various large and publicly traded companies. Additionally,
our international activities may be subject to the laws and regulations of the
jurisdiction where business is being conducted. International laws, regulations
and policies affecting us and our subsidiaries may change at any time and affect
our business opportunities and competitiveness in these jurisdictions. Due to
The Bank of Tokyo-Mitsubishi, Ltd.'s controlling ownership of us, laws,
regulations and policies adopted or enforced by the Government of Japan may
adversely affect our activities and investments and those of our subsidiaries in
the future.
In addition, our business model relies, in part, upon cross-marketing the
services offered by UnionBanCal Corporation and our subsidiaries to our
customers. Laws that restrict our ability to share information about customers
within our corporate organization could adversely affect our business, results
of operations and financial condition.
Additionally, our business is affected significantly by the fiscal and
monetary policies of the federal government and its agencies. We are
particularly affected by the policies of the Federal Reserve Board, which
regulates the supply of money and credit in the U.S. Under long-standing policy
of the Federal
60
Reserve Board, a bank holding company is expected to act as a source of
financial strength for its subsidiary banks. As a result of that policy, we may
be required to commit financial and other resources to our subsidiary bank in
circumstances where we might not otherwise do so. Among the instruments of
monetary policy available to the Federal Reserve Board are (a) conducting open
market operations in U.S. government securities, (b) changing the discount rates
of borrowings by depository institutions, and (c) imposing or changing reserve
requirements against certain borrowings by banks and their affiliates. These
methods are used in varying degrees and combinations to directly affect the
availability of bank loans and deposits, as well as the interest rates charged
on loans and paid on deposits. The policies of the Federal Reserve Board may
have a material effect on our business, results of operations and financial
condition.
RISKS ASSOCIATED WITH POTENTIAL ACQUISITIONS OR DIVESTITURES OR
RESTRUCTURINGS MAY ADVERSELY AFFECT US
We may seek to acquire or invest in financial and non-financial companies,
technologies, services or products that complement our business. There can be no
assurance that we will be successful in completing any such acquisition or
investment as this will depend on the availability of prospective target
opportunities at valuation levels we find attractive and the competition for
such opportunities from other bidders. In addition, we continue to evaluate the
performance of all of our businesses and business lines and may sell a business
or business line. Any acquisitions, divestitures or restructurings may result in
the issuance of potentially dilutive equity securities, significant write-offs,
including those related to goodwill and other intangible assets, and/or the
incurrence of debt, any of which could have a material adverse effect on our
business, results of operations and financial condition. Acquisitions,
divestitures or restructurings could involve numerous additional risks including
difficulties in obtaining any required regulatory approvals and in the
assimilation or separation of operations, services, products and personnel, the
diversion of management's attention from other business concerns, higher than
expected deposit attrition (run-off), divestitures required by regulatory
authorities, the disruption of our business, and the potential loss of key
employees. There can be no assurance that we will be successful in addressing
these or any other significant risks encountered.
SIGNIFICANT LEGAL ACTIONS COULD SUBJECT US TO SUBSTANTIAL UNINSURED
LIABILITIES
We may be subject to claims related to our operations. Such legal actions
could involve large claims and significant defense costs. To protect ourselves
from the cost of these claims, we maintain insurance coverage in amounts and
with deductibles that we believe are appropriate for our operations. However,
our insurance coverage may not cover all claims against us or continue to be
available to us at a reasonable cost. As a result, we may be exposed to
substantial uninsured liabilities, which could adversely affect our business,
results of operations and financial condition.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
A complete explanation concerning our market risk exposure is incorporated
by reference to Part I, Item 2 of this document under the captions "Quantitative
and Qualitative Disclosures about Market Risk," "Liquidity Risk," and "Certain
Business Risk Factors."
ITEM 4. CONTROLS AND PROCEDURES
Our Chief Executive Officer (principal executive officer) and Chief
Financial Officer (principal financial officer) have concluded that the design
and operation of our disclosure controls and procedures are effective as of June
30, 2004. This conclusion is based on an evaluation conducted under the
supervision and with the participation of management. Disclosure controls and
procedures are those controls and procedures which ensure that information
required to be disclosed in this filing is accumulated and communicated to
management and is recorded, processed, summarized and reported in a timely
manner and in accordance with Securities and Exchange Commission rules and
regulations.
During the quarter ended June 30, 2004, there were no changes in our
internal controls over financial reporting that materially affected, or are
reasonably likely to materially affect, our internal controls over financial
reporting.
61
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
We are subject to various pending and threatened legal actions that arise
in the normal course of business. We maintain reserves for losses from legal
actions that are both probable and estimable.
Union Bank of California, N.A., our major subsidiary (the Bank), was named
in a suit pending in the United States District Court for the Central District
of California, Neilson v. Union Bank of California et al (filed September 4,
2002). The plaintiffs in this suit sought in excess of $250 million, which was
alleged to have been lost by those who invested money in various investment
arrangements conducted by an individual named Reed Slatkin. Mr. Slatkin is
alleged to have been operating a fraudulent investment scheme commonly referred
to as a "Ponzi" scheme. The plaintiffs in the Neilson case included both
investors in the arrangements conducted by Mr. Slatkin and the trustee of Mr.
Slatkin's bankruptcy estate. A substantial majority of those who invested with
Mr. Slatkin had no relationship with the Bank. A small minority, comprising less
than five percent of the investors, had custodial accounts with the Bank. The
Neilson case seeks to impose liability upon the Bank and two other financial
institutions for both the losses suffered by those custodial customers as well
as investors who had no relationship with the Bank. We have reached an agreement
in principle to resolve the Nielson matter, which calls for a payment by the
Company of $10 million, $6 million of which will be paid by the Company's
insurance carrier. This agreement in principle is in the process of being
documented and will thereafter require court approval. The disposition of this
claim, on the basis described above, assuming that the settlement becomes final
and approved, will not have a material adverse effect on our financial position
or results of operations, since a reserve has been established for the loss.
Two other suits naming the Bank, Christensen v. Union Bank of California
(formerly captioned as Rockoff v. Union Bank of California et al.) (filed in the
United States District Court for the Central District of California on December
21, 2001) and Kilpatrick v. Orrick Herrington & Sutcliffe, et al. (filed in Los
Angeles County Superior Court on April 22, 2003 as to the Bank) related to the
allegedly fraudulent investment scheme conducted by Mr. Slatkin. The dismissal
of the Christensen case and the settlement of the Kilpatrick case were reported
in the Company's Quarterly Report on Form 10-Q for the quarter ended March 31,
2004.
Another suit, Grafton Partners LP v. Union Bank of California, is pending
in Alameda County Superior Court (filed March 12, 2003). That suit concerns an
unrelated "Ponzi" scheme perpetrated by PinnFund, USA, located in San Diego,
California. The victims of this scheme seek $235 million from the Bank. They
assert that the Bank improperly opened and administered a deposit account, which
was used by PinnFund in furtherance of the fraud.
The Bank has numerous legal defenses to the Grafton case. Based on our
evaluation to date of this claim, management believes that this matter will not
result in a material adverse effect on our financial position or results of
operations.
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ITEM 2. CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY
SECURITIES
Repurchases of equity securities are presented in the table below.
TOTAL NUMBER OF MAXIMUM NUMBER (OR
TOTAL NUMBER SHARES (OR UNITS) APPROXIMATE DOLLAR VALUE)
OF SHARES AVERAGE PRICE PURCHASED AS PART OF OF SHARES (OR UNITS) THAT
(OR UNITS) PAID PER SHARE PUBLICLY ANNOUNCED MAY YET BE PURCHASED UNDER
PERIOD PURCHASED (OR UNIT) PLANS OR PROGRAMS THE PLANS OR PROGRAMS
- ------- ------------ -------------- ----------------- --------------------------
APRIL 2004
(April 28, 2004)....... -- $ -- -- $257,764,104
MAY 2004
(May 7 - 28, 2004)..... 115,000 $54.10 115,000 $251,542,697
JUNE 2004
(June 1 - 4, 2004)..... 95,000 $56.77 95,000 $246,149,446(1)
--------- ------ ---------
TOTAL.................. 1,039,700 $53.54 1,039,700
========= ====== =========
- ---------------------------------------
<FN>
(1) $200 million is available from a $200 million repurchase program announced
on April 28, 2004. $46 million remains available from a $200 million
repurchase program announced on April 22, 2003.
</FN>
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
For information regarding matters submitted to a vote at the Annual Meeting
of Shareholders on April 28, 2004, see Part II, Item 4 of our Report on Form
10-Q for the quarter ended March 31, 2004, incorporated by reference herein.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.
(A) EXHIBITS:
NO. DESCRIPTION
- ---- ---------------------------------------------------------------------------
2.1 Agreement and Plan of Merger by and among UnionBanCal Corporation, Union
Bank of California, N.A., Jackson National Insurance Company and Jackson
Federal Bank dated as of July 1, 2004(1)
10.1 Philip B. Flynn Employment Agreement (Effective April 1, 2004)(2)*
10.2 Robert M. Walker Separation Agreement (Effective April 16, 2004)(3)*
31.1 Certification of the Chief Executive Officer pursuant to Rule
13a-14a/15d-14(a) of the Exchange Act, as adopted pursuant to Section 302
of the Sarbanes-Oxley Act of 2002(3)
31.2 Certification of the Chief Financial Officer pursuant to Rule
13a-14a/15d-14(a) of the Exchange Act, as adopted pursuant to Section 302
of the Sarbanes-Oxley Act of 2002(3)
32.1 Certification of the Chief Executive Officer pursuant to 18 U.S.C. Section
1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
2002(3)
32.2 Certification of the Chief Financial Officer pursuant to 18 U.S.C. Section
1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
2002(3)
- ------------------------------------
(1) Incorporated by reference to the UnionBanCal Corporation current report on
Form 8-K, dated July 1, 2004
(2) Incorporated by reference to the UnionBanCal Corporation Quarterly Report
on Form 10-Q for the quarter ended March 31, 2004 (SEC File No. 1-15081).
(3) Filed herewith
* Management contract or compensatory plan, contract or arrangement
63
(B) REPORTS ON FORM 8-K
We furnished a report on Form 8-K dated April 20, 2004 reporting under Item
12 thereof that UnionBanCal Corporation issued a press release concerning
earnings for the first quarter of 2004.
64
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, UnionBanCal Corporation has duly caused this report to be
signed on its behalf by the undersigned, thereunto duly authorized.
UNIONBANCAL CORPORATION
(Registrant)
By: /S/ NORIMICHI KANARI
---------------------------------------
Norimichi Kanari
PRESIDENT AND CHIEF EXECUTIVE OFFICER
(Principal Executive Officer)
By: /S/ DAVID I. MATSON
---------------------------------------
David I. Matson
EXECUTIVE VICE PRESIDENT AND
CHIEF FINANCIAL OFFICER
(Principal Financial Officer)
By: /S/ DAVID A. ANDERSON
---------------------------------------
David A. Anderson
SENIOR VICE PRESIDENT AND CONTROLLER
(Principal Accounting Officer)
Date: August 6, 2004
65