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E Trade Financial Corp – ‘10-K’ for 12/31/03

On:  Wednesday, 3/10/04, at 6:19pm ET   ·   As of:  3/11/04   ·   For:  12/31/03   ·   Accession #:  1193125-4-38392   ·   File #:  1-11921

Previous ‘10-K’:  ‘10-K’ on 3/27/03 for 12/31/02   ·   Next:  ‘10-K/A’ on 1/21/05 for 12/31/03   ·   Latest:  ‘10-K’ on 2/21/18 for 12/31/17

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  As Of                Filer                Filing    For·On·As Docs:Size              Issuer               Agent

 3/11/04  E Trade Financial Corp            10-K       12/31/03    8:2.9M                                   RR Donnelley/FA

Annual Report   —   Form 10-K
Filing Table of Contents

Document/Exhibit                   Description                      Pages   Size 

 1: 10-K        Annual Report on Form 10-K                          HTML   2.53M 
 2: EX-10.63    Settlement Agreement Dated December 10, 2003        HTML     33K 
 3: EX-12.1     Statement of Earnings to Fixed Charges              HTML     37K 
 4: EX-21.1     Subsidiaries of the Registrant                      HTML     16K 
 5: EX-23.1     Consent of Independent Auditors                     HTML     13K 
 6: EX-31.1     Certification of Mitchell H. Caplan Under Item 307  HTML     14K 
                          of Regulation S-K                                      
 7: EX-31.2     Certification of Robert J. Simmons Under Item 307   HTML     14K 
                          of Regulation S-K                                      
 8: EX-32.1     Cert of Mitchell Caplan and Robert Simmons Under    HTML      8K 
                          Section 906                                            


10-K   —   Annual Report on Form 10-K
Document Table of Contents

Page (sequential) | (alphabetic) Top
 
11st Page   -   Filing Submission
"Table of Contents
"Business
"Overview
"Brokerage
"Banking
"Competition
"Regulation
"Required Financial Data
"Properties
"Legal and Administrative Proceedings
"Submission of Matters to a Vote of Security Holders
"Market for Registrant's Common Equity and Related Shareholder Matters
"Selected Consolidated Financial Data
"Management's Discussion and Analysis of Financial Condition and Results of Operations
"Summary of Critical Accounting Policies and Estimates
"Results of Operations
"Liquidity and Capital Resources
"Risk Factors
"Quantitative and Qualitative Disclosures about Market Risk
"Brokerage Operations
"Banking Operations
"Consolidated Financial Statements and Supplementary Data
"Index to Consolidated Financial Statements
"Index to Financial Statements
"Independent Auditors' Report
"Consolidated Balance Sheets
"Consolidated Balance Sheets as of December 31, 2003 and 2002
"Consolidated Statements of Operations
"Consolidated Statements of Operations for the Years Ended December 31, 2003, 2002 and 2001
"Consolidated Statements of Comprehensive Income (Loss)
"Consolidated Statements of Comprehensive Income (Loss) for the Years Ended December 31, 2003, 2002 and 2001
"Consolidated Statements of Shareholders' Equity
"Consolidated Statements of Shareholders' Equity for the Years Ended December 31, 2003, 2002 and 2001
"Consolidated Statements of Cash Flows
"Consolidated Statements of Cash Flows for the Years Ended December 31, 2003, 2002 and 2001
"Notes to Consolidated Financial Statements
"Note 1-Organization and Basis of Presentation
"Note 2-Summary of Significant Accounting Policies
"Note 3-Business Combinations
"Note 4-Brokerage Receivables, Net and Brokerage Payables
"Note 5-Available-for-Sale Mortgage-Backed and Investment Securities
"Note 6-Other Investments
"Note 7-Loans Receivable, Net
"Note 8-Property and Equipment, Net
"Note 9-Goodwill and Other Intangibles, Net
"Note 10-Other Assets
"Note 11-Asset Securitization
"Note 12-Related Party Transactions
"Note 13-Deposits
"Note 14-Securities Sold Under Agreements to Repurchase and Other Borrowings by Bank Subsidiary
"Note 15-Convertible Subordinated Notes
"Note 16-Accounts Payable, Accrued and Other Liabilities
"Note 17-Income Taxes
"Note 18-Shareholders' Equity
"Note 19-Employee Benefit Plans
"Note 20-Facility Restructuring and Other Exit Charges
"Note 21-Executive Agreement and Loan Settlement
"Note 22-Income (Loss) Per Share
"Note 23-Regulatory Requirements
"Note 24-Lease Arrangements
"Note 25-Commitments, Contingencies and Other Regulatory Matters
"Note 26-Accounting for Derivative Financial Instruments and Hedging Activities
"Note 27-Fair Value Disclosure of Financial Instruments
"Note 28-Segment and Geographic Information
"Note 29-Condensed Financial Information (Parent Company Only)
"Note 30-Subsequent Events
"Note 31-Quarterly Data (Unaudited)
"Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
"Evaluation of Disclosure Controls and Procedures
"Exhibits, Consolidated Financial Statement Schedules and Reports on Form 8-K
"Exhibit Index
"Signatures

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  Prepared by R.R. Donnelley Financial -- Annual Report on Form 10-K  
Table of Contents
Index to Financial Statements

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


 

FORM 10-K

 


 

(Mark One)

 

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 2003.

 

or

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM                          TO                         .

 

Commission file number 1-11921

 


 

E*TRADE Financial Corporation

(Exact name of registrant as specified in its charter)

 

Delaware   94-2844166
(State or other jurisdiction
of incorporation or organization)
 

(I.R.S. Employer

Identification Number)

 

135 East 57th Street, New York, New York 10022

(Address of principal executive offices and zip code)

 

(646) 521-4300

(Registrant’s telephone number, including area code)

 


 

Securities Registered Pursuant to Section 12(b) of the Act:

Title of each class

Common Stock—$0.01 par value

 

Securities Registered Pursuant to Section 12(g) of the Act:

None

 


 

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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x

 

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

 

At June 30, 2003, the aggregate market value of voting stock, comprised of the registrant’s common stock and shares exchangeable into common stock, held by nonaffiliates of the registrant was approximately $2,993,301,000 (based upon the closing price for shares of the registrant’s common stock as reported by the New York Stock Exchange on that date). Shares of common stock held by each officer, director and holder of 5% or more of the outstanding common stock have been excluded in that such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes.

 

At February 27, 2004, there were 368,386,666 shares of common stock and 1,371,125 shares exchangeable into common stock outstanding. The Exchangeable Shares, which were issued by EGI Canada Corporation in connection with the acquisition of VERSUS Technologies, Inc. (renamed E*TRADE Technologies Corporation effective January 2, 2001), are exchangeable at any time into common stock on a one-for-one basis and entitle holders to dividend, voting and other rights equivalent to holders of the registrant’s common stock.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Definitive Proxy Statement relating to the Company’s Annual Meeting of Shareholders to be held May 27, 2004, to be filed hereafter (incorporated into Part III hereof).

 



Table of Contents
Index to Financial Statements

E*TRADE FINANCIAL CORPORATION

 

FORM 10-K ANNUAL REPORT

For the Year ended December 31, 2003

 

TABLE OF CONTENTS

 

     Page

PART I    1

Item 1.  

Business

   1
   

Overview

   1
   

Brokerage

   1
   

Banking

   3
   

Competition

   3
   

Regulation

   4
   

Required Financial Data

   5
Item 2.  

Properties

   17
Item 3.  

Legal and Administrative Proceedings

   17
Item 4.  

Submission of Matters to a Vote of Security Holders

   18
PART II    19

Item 5.  

Market for Registrant’s Common Equity and Related Shareholder Matters

   19
Item 6.  

Selected Consolidated Financial Data

   20
Item 7.  

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

   21
   

Overview

   21
   

Summary of Critical Accounting Policies and Estimates

   22
   

Results of Operations

   24
   

Liquidity and Capital Resources

   31
   

Risk Factors

   34
Item 7A.  

Quantitative and Qualitative Disclosures about Market Risk

   39
   

Brokerage Operations

   39
   

Banking Operations

   40
Item 8.  

Consolidated Financial Statements and Supplementary Data

   42
   

Index to Consolidated Financial Statements

   42
   

Independent Auditors’ Report

   43
   

Consolidated Balance Sheets

   44
   

Consolidated Statements of Operations

   45
   

Consolidated Statements of Comprehensive Income (Loss)

   46
   

Consolidated Statements of Shareholders’ Equity

   47
   

Consolidated Statements of Cash Flows

   49
   

Notes to Consolidated Financial Statements

   51
   

Note 1—Organization and Basis of Presentation

   51
   

Note 2—Summary of Significant Accounting Policies

   52
   

Note 3—Business Combinations

   59
   

Note 4—Brokerage Receivables, Net and Brokerage Payables

   62
   

Note 5—Available-for-Sale Mortgage-Backed and Investment Securities

   63
   

Note 6—Other Investments

   66
   

Note 7—Loans Receivable, Net

   68
   

Note 8—Property and Equipment, Net

   70
   

Note 9—Goodwill and Other Intangibles, Net

   71

 

i


Table of Contents
Index to Financial Statements
         Page

   

Note 10—Other Assets

   73
   

Note 11—Asset Securitization

   74
   

Note 12—Related Party Transactions

   77
   

Note 13—Deposits

   78
   

Note 14—Securities Sold Under Agreements to Repurchase and Other Borrowings by Bank Subsidiary

   79
   

Note 15—Convertible Subordinated Notes

   80
   

Note 16—Accounts Payable, Accrued and Other Liabilities

   81
   

Note 17—Income Taxes

   82
   

Note 18—Shareholders’ Equity

   84
   

Note 19—Employee Benefit Plans

   85
   

Note 20—Facility Restructuring and Other Exit Charges

   88
   

Note 21—Executive Agreement and Loan Settlement

   91
   

Note 22—Income (Loss) Per Share

   92
   

Note 23—Regulatory Requirements

   93
   

Note 24—Lease Arrangements

   94
   

Note 25—Commitments, Contingencies and Other Regulatory Matters

   95
   

Note 26—Accounting for Derivative Financial Instruments and Hedging Activities

   97
   

Note 27—Fair Value Disclosure of Financial Instruments

   101
   

Note 28—Segment and Geographic Information

   102
   

Note 29—Condensed Financial Information (Parent Company Only)

   105
   

Note 30—Subsequent Events

   108
   

Note 31—Quarterly Data (Unaudited)

   109
Item 9.  

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

   110
Item 9A.  

Evaluation of Disclosure Controls and Procedures

   110
PART III    110

Items 10-14.    110
PART IV    110

Item 15.  

Exhibits, Consolidated Financial Statement Schedules and Reports on Form 8-K

   110
Exhibit Index    111
Signatures    116

 


 

Unless otherwise indicated, references to the Company,” “We,” “Our” and “E*TRADE” mean E*TRADE Financial Corporation and/or its subsidiaries.

 

E*TRADE, the E*TRADE logo, etrade.com, E*TRADE Bank, ClearStation, Equity Edge, Equity Resource, OptionsLink and E*TRADE FINANCIAL, are trademarks or registered trademarks of E*TRADE Financial Corporation or its subsidiaries in the United States. Some of these and other trademarks are also registered outside the United States.

 

ii


Table of Contents
Index to Financial Statements

PART I

 

ITEM 1.     BUSINESS

 

OVERVIEW

 

E*TRADE Financial Corporation offers a wide range of financial products and services under the brand “E*TRADE FINANCIAL.” We offer value to our customers by using technology to provide brokerage, banking and lending products, primarily through electronic delivery channels. We serve retail, corporate and institutional customers. Retail customers can move money electronically between brokerage, banking and lending accounts and have access to physical touchpoints that include E*TRADE FINANCIAL Centers in selected cities and over 15,000 E*TRADE FINANCIAL automated teller machines (“ATMs”) located throughout the United States and Canada. Corporate clients use our employee stock plan administration and options management tools. Institutional customers enjoy access to a broad range of brokerage products and services, including cross-border trading and third party independent research.

 

E*TRADE FINANCIAL’s corporate offices are located at 135 East 57th Street, New York, New York 10022. We also maintain significant corporate and operational offices in Arlington, Virginia, Menlo Park, California, Irvine, California, Chicago, Illinois and major administrative and operational facilities in Rancho Cordova, California and Alpharetta, Georgia. E*TRADE FINANCIAL was incorporated in California in 1982 and reincorporated in Delaware in July 1996. We have approximately 3,500 employees.

 

Our website address is http://www.etrade.com. We make our annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, available free of charge at our website as soon as reasonably practicable after they have been filed with the Securities and Exchange Commission (“SEC”).

 

Our business is analyzed in two segments, Brokerage and Banking, which have different characteristics. The Brokerage Segment produces revenues primarily from commissions and margin lending. The Banking Segment earns interest from its diversified interest-earning assets and generates fee-based income.

 

The Brokerage business continues to be the primary point of introduction for the majority of our customers, and we have added Banking products and services, which complement our Brokerage business. During 2003, we lowered our cost of funds in the Bank by sweeping Brokerage customer money market balances into an FDIC-insured Sweep Deposit Account product, allowing the Bank to obtain lower cost of funds and provide our Brokerage customers a higher rate of return. In addition, the Bank has added higher-yielding consumer loans to its portfolio of products that we will continue to introduce to Brokerage customers.

 

In 2004, we see an opportunity in the current market for growth in retail Brokerage daily average revenue trades, customers and assets. To take advantage of this opportunity we plan to increase our investment in marketing by targeting this segment of our business. Additionally, we will continue to focus on lowering the cost of providing bank and brokerage services to our customers through innovative technology and operating efficiencies through additional integration of back office systems and processes.

 

BROKERAGE

 

Our Brokerage business is primarily composed of the activities of E*TRADE Securities LLC (“E*TRADE Securities”), a registered broker-dealer, its securities clearing firm, E*TRADE Clearing LLC (“E*TRADE Clearing”), a member of the New York Stock Exchange (“NYSE”); Dempsey & Company, LLC (“Dempsey”), and GVR Company, LLC (“GVR”), specialists and market-making firms; Engelman Securities, Inc. (“Engelman”), a registered broker-dealer and member of the Chicago Stock Exchange; E*TRADE Professional Trading, LLC (“E*TRADE Professional”), a registered broker-dealer; E*TRADE Financial Corporate Services,

 

1


Table of Contents
Index to Financial Statements

Inc., (“E*TRADE Financial Corporate Services”), formerly E*TRADE Business Solutions Group Inc., a provider of stock plan administration and options management tools; E*TRADE Securities Limited, incorporated in the U.K., E*TRADE Securities Limited, incorporated in Hong Kong, and E*TRADE Canada Securities Corp., providers of brokerage services to both retail and institutional customers.

 

Products and Services.    Brokerage services are based upon proprietary transaction-enabling technology and are designed primarily to serve the needs of self-directed investors. Our services include: automated order placement and execution of market and limit equity orders; streaming quotes; advanced trading platforms for active traders; personalized portfolio tracking; access to nearly 5,000 non-proprietary and proprietary mutual funds; futures; options trading; bond trading and proprietary bond funds; individual retirement accounts; college savings plan products; real-time market commentary and news; and stock option plan administration products and services. In 2003, we began offering customers the opportunity to move some of their money market fund investments into an E*TRADE Financial Sweep Deposit Account (an FDIC-insured bank account through E*TRADE Bank).

 

We offer our services to customers 24 hours a day, seven days a week through the Internet, automated telephone service, Internet-enabled wireless devices and direct modem access. Customers can access us in person at any one of our E*TRADE FINANCIAL Centers for help in opening a new account or for assistance with an existing account. E*TRADE FINANCIAL Centers in New York City, San Francisco, Alpharetta, Beverly Hills, Boston, Denver, La Jolla and Orlando offer personal access to our team of licensed relationship specialists. We offer, either alone or with our partners, branded retail brokerage websites in the U.S., Australia, Canada, Denmark, Germany, Hong Kong, Korea, Sweden, Japan and the United Kingdom.

 

We provide institutional customers with online brokerage and financial services, as well as direct access to international exchanges through a web-based platform. The platform also offers our institutional customers real-time, online access to statements and electronic settlement capabilities. A significant part of our institutional business includes providing our customers worldwide access to research provided by third parties. Our customers select research data they consider relevant and use it to assist in reaching trading decisions. Customers may use a portion of the commissions that they generate in trading securities to pay for the research services. We use our proprietary system to track the commissions a customer has generated and the corresponding research credits awarded.

 

Market-Making Activities.    Market-making activities in listed and over-the-counter issues are conducted by Dempsey, a Chicago Stock Exchange specialist. A specialist is a broker-dealer authorized by an exchange to be a party through which trading on the floor of the exchange is transacted. The specialist is responsible for facilitating an underlying market, and frequently takes or is required to make, principal positions in the securities it trades. Trading gains and losses result from these activities. While a significant portion of security trades originated by E*TRADE Securities’ customers are directed to Dempsey, a large percentage of Dempsey’s trading volume comes from parties other than E*TRADE Securities. GVR, a wholly owned subsidiary of Dempsey is a market-maker in the National Market System (“Nasdaq”) and bulletin board securities.

 

Margin Lending.    We make margin loans to customers and employees that are collateralized by their securities. Our margin lending is subject to the margin rules of the Board of Governors of the Federal Reserve System, NYSE margin requirements and our own internal policies, which are more stringent than the Federal Reserve and NYSE requirements. In permitting customers and employees to purchase securities on margin, we take the risk of a market decline that could reduce the value of the collateral held by us below the customers’ indebtedness before the collateral can be sold, which could result in losses to us. In overseas markets, the rules regarding margin lending vary significantly and are generally not as well defined as the rules within the U.S.

 

Clearing Operations.    Clearing operations include the confirmation, receipt, settlement, custody and delivery functions involved in securities transactions. Performing most of our own clearing operations allows E*TRADE Clearing to retain customer free credit balances and securities for use in margin and stock lending

 

2


Table of Contents
Index to Financial Statements

activities. E*TRADE Clearing has an agreement with BETA Systems, through January 2006, for the provision of computer services to support order entry, order routing, securities processing, customer statement preparation, tax reporting, regulatory reporting and other services necessary to manage a brokerage clearing business. E*TRADE Clearing has signed an agreement with ADP Services to replace BETA Systems upon completion of certain contract milestones. We anticipate transitioning to ADP (terminating our agreement with Beta Systems) during 2004. We outsource clearing of all international institutional transactions with the exception of the Japanese, Hong Kong, Singapore and Thai markets.

 

Securities Lending and Borrowing.    We borrow securities both to cover customer short sales and to complete customer transactions in the event a customer fails to deliver securities by the required settlement date. We collateralize such borrowings by depositing cash or securities with the lender and receive a rebate (in the case of cash collateral) or pay a fee calculated to yield a negotiated rate of return. When lending securities, we receive cash or securities and generally pay a rebate (in the case of cash collateral) to the other party in the transaction. Securities lending and borrowing transactions are generally conducted pursuant to written and/or oral agreements with counterparties requiring that the securities borrowed be “marked-to-market” on a daily basis through the facilities of the various national clearing organizations.

 

Proprietary Trading.    Proprietary trading activities involve employing registered proprietary traders. Proprietary traders at E*TRADE Professional trade with the Company’s capital, which consist of E*TRADE Professional’s members’ capital and retained profits. Traders are assigned buying power based upon their trading experience and performance, trading strategy and relationship with E*TRADE Professional’s clearing firm. Trading gains and losses result from these activities.

 

BANKING

 

We offer retail banking products and services through E*TRADE Bank (the “Bank”), which is the nation’s sixth largest Office of Thrift Supervision (“OTS”) regulated financial institution, based on total assets at September 30, 2003. Our branchless structure permits us to serve customers nationwide. Besides the Bank, our Banking Segment includes four subsidiaries: E*TRADE Mortgage Corporation (“E*TRADE Mortgage”), a direct-to-consumer mortgage loan originator; E*TRADE Consumer Finance Corporation (“E*TRADE Consumer Finance”), formerly Ganis Credit Corporation, an originator of recreational vehicle (“RV”), marine and other consumer loans; E*TRADE Global Asset Management, Inc. (“ETGAM”), a registered broker-dealer and investment advisor that manages asset portfolios for the Banking and Brokerage Segments; and E*TRADE Access, Inc. (“E*TRADE Access”), which operates an independent network of ATMs in the United States and Canada.

 

Products and Services.    The Bank offers a full suite of consumer banking products and services. We offer interest-earning checking accounts, money market and savings accounts, Sweep Deposit Accounts (where cash that will be invested through E*TRADE Securities is held pending investment) and certificates of deposit. We offer residential mortgage loans, home equity loans and home equity lines of credit (“HELOC”). We also offer credit card, automobile, RV, marine and other consumer loans. We offer our services to customers 24 hours a day, seven days a week through the Internet, automated telephone service, Internet-enabled wireless devices and direct modem access. See further discussion of our Banking activities in “Required Financial Data.”

 

COMPETITION

 

The electronic financial services market, over the Internet and other alternative channels, continues to evolve rapidly and is intensely competitive. We do not expect this environment to change in the future. As we continue to diversify and expand our services beyond online financial service offerings the number of our competitors increase. We are in direct competition with full commission brokerage firms, discount brokerage firms, online brokerage firms, Internet banks, mortgage companies and traditional “brick & mortar” retail banks and thrifts. These competitors also provide touchtone telephone, voice response and online banking services,

 

3


Table of Contents
Index to Financial Statements

electronic bill payment services and a host of other financial products. In addition, we compete with mutual fund companies that provide money market funds and cash management accounts.

 

REGULATION

 

Our business is subject to stringent regulation by U.S. Federal and state regulatory agencies and securities exchanges and by various non-U.S. governmental agencies or regulatory bodies, securities exchanges and central banks, each of which has been charged with the protection of the financial markets and the protection of the interests of those participating in those markets. These regulatory agencies in the United States include, among others, the SEC, the National Association of Securities Dealers (“NASD”), the NYSE, the Federal Deposit Insurance Corporation (“FDIC”), the Municipal Securities Rulemaking Board and the OTS. We are also subject to extensive regulation outside of the United States. Additional legislation, regulations and rulemaking may directly affect our manner of operation and profitability.

 

Our broker-dealers are registered with the SEC and are subject to regulation by the SEC and by self-regulatory organizations, such as the NYSE, NASD and the securities exchanges of which each is a member.

 

E*TRADE Asset Management, Inc. and E*TRADE Securities act as investment advisers and principal underwriters and distributors, respectively, of E*TRADE Funds. E*TRADE Funds is a registered management investment company regulated under the Investment Company Act of 1940.

 

E*TRADE Financial Corporation, E*TRADE Re, LLC and ETB Holdings, Inc. (“ETBH”), the parent of E*TRADE Bank, as savings and loan holding companies, and E*TRADE Bank, as a Federally chartered savings bank, are subject to extensive regulation, supervision and examination by the OTS, and also, in the case of the Bank, the FDIC. Such regulation covers all aspects of the banking business, including lending practices, safeguarding deposits, capital structure, transactions with affiliates and conduct and qualifications of personnel.

 

4


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Index to Financial Statements

REQUIRED FINANCIAL DATA

 

This section presents information required by the SEC’s Industry Guide 3, Statistical Disclosure by Bank Holding Companies.” Prior to its acquisition by E*TRADE FINANCIAL in January 2000, the Bank reported its results of operations on a calendar year basis. Prior to 2001, E*TRADE FINANCIAL reported on a year ending September 30. The financial information that follows for 1999 includes the results of the Bank for the twelve-month period ended December 31.

 

Distribution of Assets, Liabilities and Shareholder’s Equity; Interest Rates and Interest Differential

 

The following table presents average balance data and income and expense data for our banking operations, as well as the related interest yields and rates and interest spread (dollars in thousands):

 

    Year Ended December 31,

 
    2003

    2002

    2001

 
    Average
Balance


  Interest
Inc./Exp.


  Average
Yield/Cost


    Average
Balance


  Interest
Inc./Exp.


  Average
Yield/Cost


    Average
Balance


  Interest
Inc./Exp.


  Average
Yield/Cost


 

Interest-earning banking assets:

                                                     

Loans receivable, net(1)

  $ 7,659,793   $ 384,005   5.01 %   $ 7,520,665   $ 477,955   6.36 %   $ 6,701,905   $ 495,768   7.40 %

Interest-bearing deposits

    203,356     4,560   2.24 %     196,419     5,042   2.57 %     145,077     4,263   2.94 %

Mortgage-backed and related available-for-sale securities

    6,707,070     255,802   3.81 %     4,730,552     226,785   4.79 %     4,164,081     273,690   6.57 %

Available-for-sale investment securities

    2,026,646     87,340   4.31 %     951,789     46,639   4.90 %     1,175,669     77,116   6.60 %

Investment in FHLB stock

    79,642     3,047   3.83 %     75,713     4,304   5.69 %     65,988     4,224   6.40 %

Trading securities

    488,372     16,159   3.31 %     228,848     7,128   3.11 %     84,759     3,981   4.70 %
   

 

       

 

       

 

     

Total interest-earning banking assets(2)

    17,164,879   $ 750,913   4.37 %     13,703,986   $ 767,853   5.60 %     12,337,479   $ 859,042   6.96 %
         

             

             

     

Non-interest-earning banking assets

    833,296                 629,341                 529,233            
   

             

             

           

Total banking assets

  $ 17,998,175               $ 14,333,327               $ 12,866,712            
   

             

             

           

Interest-bearing banking liabilities:

                                                     

Retail deposits

  $ 9,263,881   $ 263,017   2.84 %   $ 8,243,543   $ 335,730   4.07 %   $ 7,166,789   $ 421,064   5.88 %

Brokered certificates of deposit

    365,162     10,147   2.78 %     205,239     5,975   2.91 %     29,236     1,810   6.19 %

FHLB advances

    935,043     42,579   4.55 %     970,226     56,952   5.87 %     1,223,724     78,439   6.41 %

Other borrowings

    5,976,730     160,081   2.68 %     3,835,442     150,002   3.91 %     3,180,272     190,493   5.99 %
   

 

       

 

       

 

     

Total interest-bearing banking liabilities

    16,540,816   $ 475,824   2.87 %     13,254,450   $ 548,659   4.14 %     11,600,021   $ 691,806   5.96 %
         

             

             

     

Non-interest-bearing banking liabilities

    562,357                 310,086                 552,513            
   

             

             

           

Total banking liabilities

    17,103,173                 13,564,536                 12,152,534            

Total banking shareholder’s equity

    895,002                 768,791                 714,178            
   

             

             

           

Total banking liabilities and shareholder’s equity

  $ 17,998,175               $ 14,333,327               $ 12,866,712            
   

             

             

           

Excess of interest-earning banking assets over interest-bearing banking liabilities/net interest income

  $ 624,063   $ 275,089         $ 449,536   $ 219,194         $ 737,458   $ 167,236      
   

 

       

 

       

 

     

Net interest:

                                                     

Spread

              1.50 %               1.46 %               1.00 %
               

             

             

Margin (net yield on interest-earning banking assets)

              1.60 %               1.60 %               1.36 %
               

             

             

Ratio of interest-earning banking assets to interest-bearing banking liabilities

              103.77 %               103.39 %               106.36 %
               

             

             

Return by Bank on average:

                                                     

Total banking assets

              0.74 %               0.79 %               0.43 %
               

             

             

Total banking assets, as adjusted(3)

              0.74 %               0.79 %               0.53 %
               

             

             

Equity

              14.93 %               14.77 %               7.82 %
               

             

             

Equity, as adjusted(3)

              14.93 %               14.77 %               9.46 %
               

             

             

Equity to average total banking assets

              4.97 %               5.36 %               5.55 %
               

             

             


(1) Nonperforming loans are included in the respective average loan balances. Income on these nonperforming loans is recognized on a cash basis.
(2) Amount includes a taxable equivalent increase in interest income in 2003 and 2002 of $2.4 million and $0.3 million, respectively. There was no such increase in 2001.
(3) Ratio calculations exclude Employee Stock Ownership Plan, merger-related and restructuring costs of $11.7 million (net of tax) for 2001; there were no such costs for 2003 or 2002.

 

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Table of Contents
Index to Financial Statements

Increases and decreases in interest income and interest expense result from changes in average balances (volume) of interest-earning banking assets and liabilities, as well as changes in average interest rates (rate). The following table shows the effect that these factors had on the interest earned on the Company’s interest-earning banking assets and the interest expense on the Company’s interest-earning banking liabilities. The effect of changes in volume is determined by multiplying the change in volume by the previous year’s average yield/cost. Similarly, the effect of rate changes is calculated by multiplying the change in interest by the previous year’s volume. Changes applicable to both volume and rate have been allocated proportionately (in thousands):

 

    

2003 Compared to 2002

Increase (Decrease) Due To


   

2002 Compared to 2001

Increase (Decrease) Due To


 
     Volume

    Rate

    Total

    Volume

    Rate

    Total

 

Interest-earning banking assets:

                                                

Loans receivable, net

   $ 8,691     $ (102,641 )   $ (93,950 )   $ 56,604     $ (74,417 )   $ (17,813 )

Interest-bearing deposits

     173       (655 )     (482 )     1,368       (589 )     779  

Mortgage-backed and related available-for-sale securities

     81,747       (52,730 )     29,017       33,861       (80,766 )     (46,905 )

Available-for-sale investment securities

     46,934       (6,233 )     40,701       (13,089 )     (17,387 )     (30,476 )

Investment in FHLB stock

     214       (1,471 )     (1,257 )     583       (503 )     80  

Trading securities

     8,561       470       9,031       4,866       (1,720 )     3,146  
    


 


 


 


 


 


Total interest-earning banking assets(1)

     146,320       (163,260 )     (16,940 )     84,193       (175,382 )     (91,189 )
    


 


 


 


 


 


Interest-bearing banking liabilities:

                                                

Retail deposits

     1,929       (74,642 )     (72,713 )     (10,301 )     (75,033 )     (85,334 )

Brokered certificates of deposit

     4,455       (283 )     4,172       5,590       (1,425 )     4,165  

FHLB advances

     (2,001 )     (12,372 )     (14,373 )     (15,276 )     (6,211 )     (21,487 )

Other borrowings

     66,875       (56,796 )     10,079       34,170       (74,661 )     (40,491 )
    


 


 


 


 


 


Total interest-bearing banking liabilities

     71,258       (144,093 )     (72,835 )     14,183       (157,330 )     (143,147 )
    


 


 


 


 


 


Change in net interest income

   $ 75,062     $ (19,167 )   $ 55,895     $ 70,010     $ (18,052 )   $ 51,958  
    


 


 


 


 


 



(1) Amount includes a taxable equivalent increase in interest income of $2.4 million in 2003, $0.3 million in 2002 and none in 2001.

 

6


Table of Contents
Index to Financial Statements

Lending Activities

 

The following table presents the balance and associated percentage of each major loan category in our portfolio (dollars in thousands):

 

    December 31,

    September 30,

 
    2003

    2002

    2001

    2000

    1999

 

Real estate loans:

                                                                     

One-to four-family:

                                                                     

Fixed-rate

  $ 1,345,369     14.97 %   $ 1,877,265     26.05 %   $ 3,672,512     45.95 %   $ 1,583,129     37.45 %   $ 1,391,254     63.69 %

Adjustable-rate

    1,910,161     21.26       1,502,224     20.86       2,645,952     33.11       2,635,955     62.36       785,821     35.98  

Home equity lines of credit and second mortgage

    1,511,767     16.83       354,768     4.93       23,059     0.29       4,042     0.10       1,024     0.05  

Multi-family

    97     —         106     —         183     —         203     0.01       1,330     0.06  

Commercial

    12,279     0.14       13,397     0.19       1,981     0.03       2,717     0.06       3,050     0.14  

Mixed-use and land

    72     —         121     —         635     0.01       503     0.01       1,224     0.05  
   


 

 


 

 


 

 


 

 


 

Total real estate loans(1)(2)

    4,779,745     53.20       3,747,881     52.03       6,344,322     79.39       4,226,549     99.99       2,183,703     99.97  
   


 

 


 

 


 

 


 

 


 

Consumer and other loans:

                                                                     

Recreational vehicle

    2,285,451     25.43       1,366,876     18.98       198,643     2.49       —       —         —       —    

Automobile

    1,162,339     12.94       1,481,695     20.57       1,436,407     17.97       224     0.01       430     0.02  

Marine

    627,975     6.99       453,783     6.30       —       —         —       —         —       —    

Credit card

    113,434     1.26       —       —         —       —         —       —         —       —    

Lease financing

    2,651     0.03       3,621     0.05       —       —         —       —         —       —    

Other

    13,567     0.15       149,024     2.07       12,237     0.15       82     —         255     0.01  
   


 

 


 

 


 

 


 

 


 

Total consumer and other loans

    4,205,417     46.80       3,454,999     47.97       1,647,287     20.61       306     0.01       685     0.03  
   


 

 


 

 


 

 


 

 


 

Total loans(1)

    8,985,162     100.00 %     7,202,880     100.00 %     7,991,609     100.00 %     4,226,855     100.00 %     2,184,388     100.00 %
   


 

 


 

 


 

 


 

 


 

Add (deduct):

                                                                     

Premiums (discounts) and deferred fees on loans

    184,078             190,506             38,722             (43,171 )           (22,718 )      

Allowance for loan losses

    (37,847 )           (27,666 )           (19,874 )           (10,930 )           (7,161 )      
   


       


       


       


       


     

Total

    146,231             162,840             18,848             (54,101 )           (29,879 )      
   


       


       


       


       


     

Loans receivable, net(1)(2)

  $ 9,131,393           $ 7,365,720           $ 8,010,457           $ 4,172,754           $ 2,154,509        
   


       


       


       


       


     

(1) Includes loans held-for-sale, principally one- to four-family real estate loans. These loans were $1.0 billion at December 31, 2003, $1.8 billion at December 31, 2002, $1.6 billion at December 31, 2001, $0.1 billion at September 30, 2000 and $0.1 billion at September 30, 1999.
(2) The geographic concentrations of mortgage loans are described in Note 7 to the Consolidated Financial Statements.

 

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Index to Financial Statements

The following table shows the distribution of those loans that mature in more than one year between fixed and adjustable interest rate loans at December 31, 2003 (in thousands):

 

     Interest Rate Type

   Total

     Fixed

   Adjustable

  

Real estate loans:

                    

One-to four-family

   $ 1,345,337    $ 1,910,148    $ 3,255,485

Home equity lines of credit and second mortgage

     116,027      1,395,728      1,511,755

Multi-family

     —        97      97

Commercial

     1,003      712      1,715

Mixed-use and land

     70      —        70
    

  

  

Total real estate loans

     1,462,437      3,306,685      4,769,122
    

  

  

Consumer and other loans:

                    

Recreational vehicle

     2,285,045      —        2,285,045

Automobile

     1,138,858      —        1,138,858

Marine

     627,847      —        627,847

Credit card

     —        —        —  

Lease financing

     2,651      —        2,651

Other

     13,225      —        13,225
    

  

  

Total consumer and other loans

     4,067,626      —        4,067,626
    

  

  

Total loans

   $ 5,530,063    $ 3,306,685    $ 8,836,748
    

  

  

 

Maturity of Loan Portfolio.    The following table shows the contractual maturities of our loan portfolio at December 31, 2003, including scheduled principal repayments. This table does not, however, include any estimate of prepayments. These prepayments could significantly shorten the average loan lives and cause the actual timing of the loan repayments to differ from those shown in the following table (in thousands):

 

     Due in

    
     < 1 Year

   1-5 Years

   > 5 Years

   Total

Real estate loans:

                           

One- to four-family:

                           

Fixed-rate

   $ 32    $ 3,640    $ 1,341,697    $ 1,345,369

Adjustable-rate

     13      369      1,909,779      1,910,161

Home equity lines of credit and second mortgage

     12      4,450      1,507,305      1,511,767

Multi-family

     —        —        97      97

Commercial

     10,564      1,469      246      12,279

Mixed-use and land

     2      —        70      72
    

  

  

  

Total real estate loans

     10,623      9,928      4,759,194      4,779,745
    

  

  

  

Consumer and other loans:

                           

Recreational vehicle

     406      26,878      2,258,167      2,285,451

Automobile

     23,481      1,066,255      72,603      1,162,339

Marine

     128      6,919      620,928      627,975

Credit card

     113,434      —        —        113,434

Lease financing

     —        2,651      —        2,651

Other

     342      11,380      1,845      13,567
    

  

  

  

Total consumer and other loans

     137,791      1,114,083      2,953,543      4,205,417
    

  

  

  

Total loans

   $ 148,414    $ 1,124,011    $ 7,712,737    $ 8,985,162
    

  

  

  

 

8


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Index to Financial Statements

The following table shows our loan purchase, sale and repayment activity, including loans acquired through business combinations (in thousands):

 

     Year Ended December 31,

 
     2003

    2002

    2001

 

Loans receivable—net, beginning of year

   $ 7,365,720     $ 8,010,457     $ 5,039,602  
    


 


 


Loan purchases and originations:

                        

One- to four-family variable-rate

     4,035,699       3,565,449       4,451,489  

One- to four-family fixed-rate

     10,582,799       8,921,213       6,988,688  

Consumer and other loans

     4,528,864       2,756,830       2,017,950  
    


 


 


Total loan purchases and originations

     19,147,362       15,243,492       13,458,127  
    


 


 


Loans sold

     (13,515,811 )     (12,011,864 )     (7,899,991 )

Loans repurchased

     1,418       —         1,189  

Loans repaid

     (3,885,916 )     (3,948,424 )     (2,653,385 )
    


 


 


Total loans sold, repurchased and repaid

     (17,400,309 )     (15,960,288 )     (10,552,187 )

Net change in deferred discounts and loan fees

     54,846       105,715       74,010  

Net transfers to real estate owned and repossessed assets

     (26,045 )     (25,864 )     (1,786 )

Net change in allowance for loan losses

     (10,181 )     (7,792 )     (7,309 )
    


 


 


Increase (decrease) in total loans receivable

     1,765,673       (644,737 )     2,970,855  
    


 


 


Loans receivable—net, end of year

   $ 9,131,393     $ 7,365,720     $ 8,010,457  
    


 


 


 

We primarily purchase pools of loans on the secondary market using our correspondent network. The following table shows the number of pools and the associated number of loans that we purchased:

 

     Year Ended December 31,

     2003

   2002

   2001

Number of pools

   5,686    4,448    1,649

Number of loans

   18,767    10,527    15,346

 

Delinquent, Nonperforming and Other Problem Assets

 

We continually monitor our loan portfolio to anticipate and address potential and actual delinquencies. Based on the length of the delinquency period, we reclassify these assets as nonperforming and, if necessary, take possession of the underlying collateral. Once we take possession of the underlying collateral, we classify the property as other assets on our consolidated balance sheets.

 

Nonperforming Assets.    We classify loans as nonperforming whenever principal or interest payments are more than 90 days past due or when we have reason to believe the loan is uncollectible. When a loan is classified as nonperforming, we: 1) stop recognizing interest income on the loan; 2) reverse any interest we accrued during the initial 90-day period; and 3) discontinue the accretion of deferred loan fees. Whenever we receive a payment from a nonperforming loan, we apply the full payment to principal if we continue to doubt that both principal and interest will be collected in full. We only recognize payments as interest income when the principal and interest on the loan is expected to be collected in full or when the principal has been fully repaid.

 

Repossessed Assets and Nonperforming Loans.    When we acquire the collateral underlying uncollectible loans, we record this Real Estate Owned (“REO”) and other repossessed assets at estimated fair value, less estimated selling costs. We use appraisals and other appropriate valuation methods to estimate the fair value of these assets. If the net estimated fair value of the collateral is less than the loan balance, the difference is charged to the allowance for loan losses. We perform periodic valuations and establish a valuation allowance for REO and repossessed assets through a charge to income, if the carrying value of a property exceeds its estimated fair

 

9


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Index to Financial Statements

value less estimated selling costs. At December 31, 2003, the estimated fair value of REO and other repossessed assets totaled $2.5 million of one- to four-family real estate loans, $2.6 million of RV loans, $0.6 million of automobile loans and $1.0 million of marine loans.

 

The following table presents information about our nonperforming assets (in thousands):

 

     December 31,

    September 30,

 
     2003

    2002

    2001

    2000

    1999

 

Loans:

                                        

Real estate loans:

                                        

One- to four-family

   $ 18,094     $ 22,497     $ 20,595     $ 11,391     $ 7,595  

Home equity lines of credit and second mortgage

     269       81       —         —         21  

Commercial

     —         —         —         657       664  
    


 


 


 


 


Total real estate loans

     18,363       22,578       20,595       12,048       8,280  
    


 


 


 


 


Consumer and other loans:

                                        

Recreational vehicles

     1,399       1,486       —         —         —    

Automobiles

     1,602       2,277       91       —         —    

Marine

     1,067       94       —         —         —    

Credit card

     2,147       —         —         —         —    

Other

     16       53       —         —         60  
    


 


 


 


 


Total consumer and other loans

     6,231       3,910       91       —         60  
    


 


 


 


 


Total nonperforming loans, net

     24,594       26,488       20,686       12,048       8,340  

REO and other repossessed assets, net

     6,690       6,723       3,328       850       539  
    


 


 


 


 


Total nonperforming assets, net

   $ 31,284     $ 33,211     $ 24,014     $ 12,898     $ 8,879  
    


 


 


 


 


Total nonperforming assets, net, as a percentage of total bank assets

     0.15 %     0.19 %     0.18 %     0.14 %     0.21 %
    


 


 


 


 


Total allowance for loan losses as a percentage of total nonperforming loans, net

     153.89 %     104.45 %     96.07 %     90.72 %     85.86 %
    


 


 


 


 


 

During 2003, our nonperforming assets decreased by $1.9 million, or 5.8%, primarily because of the continued seasoning of our real estate loans. This decrease was partially offset by an increase in our consumer and other loan portfolios that reflects the Bank’s decision to shift a portion of its assets into higher-yielding consumer loans that have higher risk. During 2003, we recognized $0.2 million of interest on nonperforming loans. If our nonperforming loans at December 31, 2003 had been performing in accordance with their terms, we would have recorded additional interest income of approximately $1.1 million in 2003.

 

Special Mention Loans.    In certain situations, a borrower’s past credit history may cast doubt on the borrower’s ability to repay a loan, whether or not the loan is delinquent. Such loans, classified as “special mention” loans, continue to accrue interest and remain as a component of the loans receivable balance. These loans represented $43.3 million of the total loan portfolio at December 31, 2003 and are actively monitored.

 

Allowance for Loan Losses.    As an investor in mortgage and consumer loans, we experience credit losses. We believe the risk of credit loss varies based on a variety of factors including:

 

    type of loan;
    creditworthiness of the borrower;
    general economic conditions; and
    the type and quality of the loan’s security, if any, and the loan-to-value ratio.

 

10


Table of Contents
Index to Financial Statements

In determining our allowance for loan losses, we have established both specific and general allowances. The amount of the specific allowance is determined through a loan-by-loan analysis of certain large dollar real estate loans. Loans not individually reviewed are evaluated as a group using expected loss ratios, which are based on our historical charge-off experience, industry loss experience and current market and economic conditions. Our internal policy requires that the provision for loan losses is at least equal to twelve months of projected losses for all loan types. We believe this level is representative of probable losses inherent in the loan portfolio. The general allowances set by management are subject to review and approval by the Bank’s Board of Directors. Each month, management reviews the allowance for adequacy, based on our assessment of the risk in our loan portfolio as a whole, considering the following factors:

 

    the composition and quality of the portfolio;
    delinquency levels and trends;
    expected losses for the next twelve months;
    current and historical charge-off and loss experience;
    current industry charge-off and loss experience;
    the condition of the real estate market and geographic concentrations within the loan portfolio; and
    current general economic and market conditions.

 

Based on the above factors, we regularly consider whether it is appropriate to increase the general allowance to more than the twelve-month minimum of probable loan losses. In determining the adequacy of the general allowance, we validate the assumptions underlying the twelve-month loss projection by analyzing our actual loss experience, industry loss experience and changes in portfolio quality and also consider changes in economic conditions and the potential impact on the loan portfolio’s performance. When loans are unseasoned and lack sufficient data to project future losses, we apply appropriate industry charge-off and loss rates as a proxy for the Bank’s actual loss experience. However, as our loan portfolios season and we have sufficient historical data to project future losses, we only use industry loss experience to validate our own loss projections.

 

11


Table of Contents
Index to Financial Statements

Our allowance for loan losses at December 31, 2003 totaled $37.8 million or 0.46% of total loans held-for-investment and at December 31, 2002 totaled $27.7 million or 0.50% of total loans held-for-investment. Based on the loan portfolio’s historical loss experience and our estimate of projected losses inherent in the loan portfolio, we believe our allowance for loan losses during the reported periods was appropriate and complied with our internal policy, generally accepted accounting principles and applicable regulatory requirements. Our financial condition and earnings could be adversely affected, if the actual loan losses realized by the Company were to significantly exceed the amounts assumed by management in its determination of the allowance for loan losses. The following table provides an analysis of the Bank’s allowance for loan losses during the past five years (in thousands):

 

     Year Ended December 31,

    Three Months
Ended
December 31,
2000


    Year Ended
September 30,


 
     2003

    2002

    2001

      2000

    1999

 

Allowance for loan losses, beginning of year

   $ 27,666     $ 19,874     $ 12,565     $ 10,930     $ 7,161     $ 4,715  
    


 


 


 


 


 


Charge-offs:

                                                

Real estate loans

     (364 )     (460 )     (94 )     (12 )     (240 )     (400 )

Home equity lines of credit and second mortgage loans

     (75 )     —         (79 )     —         (13 )     (56 )

RV loans

     (20,341 )     (3,456 )     —         —         —         —    

Automobile loans

     (22,695 )     (28,046 )     (5,395 )     —         —         —    

Marine loans

     (7,369 )     —         —         —         —         —    

Credit card loans

     (919 )     —         —         —         —         —    

Other loans

     (1,971 )     —         —         —         —         (2 )
    


 


 


 


 


 


Total charge-offs

     (53,734 )     (31,962 )     (5,568 )     (12 )     (253 )     (458 )
    


 


 


 


 


 


Recoveries:

                                                

Real estate loans

     223       30       29       —         19       38  

Home equity lines of credit and second mortgage loans

     —         —         4       —         —         79  

RV loans

     9,738       —         —         —         —         —    

Automobile loans

     8,335       10,632       669       —         —         —    

Marine loans

     3,806       —         —         —         —         —    

Credit card loans

     1       —         —         —         —         —    

Other loans

     541       —         —         —         —         4  
    


 


 


 


 


 


Total recoveries

     22,644       10,662       702       —         19       121  
    


 


 


 


 


 


Net charge-offs

     (31,090 )     (21,300 )     (4,866 )     (12 )     (234 )     (337 )

Allowance acquired through acquisitions(1)

     2,748       14,428       4,699       —         —         —    

Provision for loan losses

     38,523       14,664       7,476       1,647       4,003       2,783  
    


 


 


 


 


 


Allowance for loan losses, end of year

   $ 37,847     $ 27,666     $ 19,874     $ 12,565     $ 10,930     $ 7,161  
    


 


 


 


 


 


Net charge-offs to average loans outstanding

     0.41 %     0.28 %     0.07 %     0.00 %     0.01 %     0.03 %
    


 


 


 


 


 



(1) Acquisition of credit card portfolio in 2003, E*TRADE Consumer Finance loan portfolio in 2002 and automobile portfolio in 2001.

 

12


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Index to Financial Statements

The following table allocates the allowance for loan losses by loan category. This allocation does not necessarily restrict the use of the allowance for loan losses to the categories shown below (dollars in thousands):

 

    December 31,

    September 30,

 
    2003

    2002

    2001

    2000

    1999

 
    Amount

 

% of

Loans in
Category

to Total
Loans


    Amount

  % of
Loans in
Category
to Total
Loans


    Amount

  % of
Loans in
Category
to Total
Loans


    Amount

  % of
Loans in
Category
to Total
Loans


    Amount

  % of
Loans in
Category
to Total
Loans


 

Real estate loans:

                                                           

One-to four-family

  $ 2,360   36.23 %   $ 3,343   46.92 %   $ 8,716   79.06 %   $ 10,554   99.81 %   $ 7,055   99.67 %

Home equity lines of credit and second mortgage

    3,117   16.83       649   4.93       115   0.29       29   0.10       9   0.05  

Multi-family

    —     —         —     —         3   —         3   0.01       23   0.06  

Commercial

    184   0.14       201   0.19       30   0.03       336   0.06       53   0.14  

Mixed-use and land

    1   —         1   —         9   0.01       8   0.01       17   0.05  
   

 

 

 

 

 

 

 

 

 

Total real estate loans

    5,662   53.20       4,194   52.04       8,873   79.39       10,930   99.99       7,157   99.97  
   

 

 

 

 

 

 

 

 

 

Consumer loans:

                                                           

Recreational vehicle

    11,386   25.43       9,480   18.98       —     —         —     —         —     —    

Automobile

    11,876   12.94       8,190   20.57       11,001   20.46       —     —         —     —    

Marine

    2,503   6.99       3,108   6.30       —     —         —     —         —     —    

Credit card

    5,583   1.26       —     —         —     —         —     —         —     —    

Lease financing

    493   0.03       511   0.04       —     —         —     —         —     —    

Other consumer

    344   0.15       2,183   2.07       —     0.15       —     0.01       4   0.03  
   

 

 

 

 

 

 

 

 

 

Total consumer loans

    32,185   46.80       23,472   47.96       11,001   20.61       —     0.01       4   0.03  
   

 

 

 

 

 

 

 

 

 

Total allowance for loan losses

  $ 37,847   100.00 %   $ 27,666   100.00 %   $ 19,874   100.00 %   $ 10,930   100.00 %   $ 7,161   100.00 %
   

 

 

 

 

 

 

 

 

 

 

The preceding table includes specific reserves related to nonperforming loans totaling $0.1 million at December 31, 2003, $0.2 million at December 31, 2002, $2.1 million at December 31, 2001, $0.4 million at September 30, 2000 and $0.4 million at September 30, 1999.

 

Available-for-sale and trading securities

 

We have portfolios of mortgage-backed securities and investments, which we classify in one of three categories: trading, available-for-sale or held-to-maturity in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 115, Accounting for Certain Investments in Debt and Equity Securities. None of our mortgage-backed securities or other investments were classified as held-to-maturity during 2003, 2002 or 2001.

 

Our portfolio of mortgage-backed securities is primarily composed of the following:

 

    privately insured mortgage pass-through securities;
    Government National Mortgage Association (“Ginnie Mae”) participation certificates, guaranteed by the full faith and credit of the United States;
    Federal National Mortgage Association (“Fannie Mae”) participation certificates, guaranteed by Fannie Mae;
    Federal Home Loan Mortgage Corporation (“Freddie Mac”) participation certificates, guaranteed by Freddie Mac; and
    securities issued by other non-agency organizations.

 

We buy and hold mortgage-backed trading securities principally for the purpose of selling them in the near term. These securities are carried at market value and any realized or unrealized gains and losses are reflected in our consolidated statements of operations as gain on sales of loans held-for-sale and securities, net. The amount of trading securities the Bank held was $821.2 million at December 31, 2003, $391.8 million at December 31,

 

13


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Index to Financial Statements

2002 and $70.9 million at December 31, 2001. The Bank recognized a loss from the sale of trading assets of $21.5 million for 2003, realized gains of $3.9 million for 2002 and $20.3 million for 2001. In addition, we had unrealized trading assets appreciation of $4.8 million for 2003 and depreciation of $0.9 million for 2002 and $11.0 million for 2001.

 

Our investments classified as available-for-sale are carried at estimated fair value with the unrealized gains and losses reflected as a component of accumulated other comprehensive income.

 

The following table shows the cost basis and fair value of our mortgage-backed securities and investment portfolio that the Bank held and classified as available-for-sale (in thousands):

 

     December 31,

     2003

   2002

   2001

     Cost Basis

   Fair Value

   Cost Basis

   Fair Value

   Cost Basis

   Fair Value

Mortgage-backed securities

   $ 7,313,908    $ 7,157,389    $ 6,940,380    $ 6,932,394    $ 3,620,656    $ 3,556,619
    

  

  

  

  

  

Investment securities:

                                         

Asset-backed securities

     2,000,239      2,010,729      750,221      737,582      386      386

Publicly traded equity securities

     161,000      160,892      135,000      134,538      —        —  

Corporate bonds

     122,583      116,030      377,731      352,590      884,246      871,510

Municipal bonds

     44,906      45,646      32,005      32,561      67,104      66,959

Obligations of U.S. government agencies

     —        —        —        —        13,297      11,874

Other investments

     86,217      79,637      1,093      939      29,282      28,407
    

  

  

  

  

  

Total investment securities

     2,414,945      2,412,934      1,296,050      1,258,210      994,315      979,136
    

  

  

  

  

  

Total available-for-sale securities

   $ 9,728,853    $ 9,570,323    $ 8,236,430    $ 8,190,604    $ 4,614,971    $ 4,535,755
    

  

  

  

  

  

 

In addition to the available-for-sale investment securities listed in the preceding table, we had an investment in Federal Home Loan Bank (“FHLB”) stock, as required of members of the FHLB System. The stock is recorded at cost, which approximates fair value. The balance of FHLB stock was $79.2 million at December 31, 2003, $80.7 million at December 31, 2002 and $56.5 million at December 31, 2001.

 

14


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Index to Financial Statements

The following table shows the scheduled maturities, carrying values and current yields for the Bank’s available-for-sale and trading investment portfolio at December 31, 2003 (dollars in thousands):

 

    After One But
Within Five Years


   

After Five But
Within

Ten Years


    After Ten Years

    Total

 
    Balance
Due


  Weighted-
Average
Yield


   

Balance

Due


  Weighted-
Average
Yield


    Balance Due

  Weighted-
Average
Yield


    Balance
Due


  Weighted-
Average
Yield


 

Mortgage-backed securities:

                                               

Fannie Mae

  $ —     —   %   $ —     —   %   $ 2,860,218   5.06 %   $ 2,860,218   5.06 %

CMO

    —     —   %     60   6.50 %     2,649,455   5.25 %     2,649,515   5.25 %

Ginnie Mae

    —     —   %     —     —   %     2,339,065   5.43 %     2,339,065   5.43 %

Freddie Mac

    —     —   %     5   10.00 %     138,224   4.30 %     138,229   4.30 %

Private issuer and other

    —     —   %     3,861   4.22 %     6,604   6.01 %     10,465   5.33 %
   

       

       

       

     

Total mortgage-backed securities

    —     —   %     3,926   4.25 %     7,993,566   5.22 %     7,997,492   5.22 %
   

       

       

       

     

Investment securities:

                                               

Municipal bonds(1)

    675   4.64 %     1,145   4.85 %     43,086   5.26 %     44,906   5.24 %

Corporate debt

    16,136   6.88 %     10,688   6.88 %     95,759   2.64 %     122,583   3.53 %

Asset-backed

    48,660   3.61 %     74,686   3.25 %     1,876,893   4.10 %     2,000,239   4.05 %

Publicly traded equity securities(2)

    —     —   %     —     —   %     161,000   4.03 %     161,000   4.03 %

Other investments

    —     —   %     85,152   4.38 %     1,065   —   %     86,217   4.28 %
   

       

       

       

     

Total investment (trading) securities

    65,471   4.38 %     171,671   4.02 %     2,177,803   4.05 %     2,414,945   4.05 %
   

       

       

       

     

Total available-for-sale and trading securities

  $ 65,471         $ 175,597         $ 10,171,369         $ 10,412,437      
   

       

       

       

     

(1) Yields on tax-exempt obligations are computed on a tax-equivalent basis.
(2) Preferred stock in Freddie Mac and Fannie Mae, no stated maturity date.

 

Deposits and Other Sources of Funds

 

The following table presents information about the Bank’s deposits by category (dollars in thousands):

 

    Year Ended December 31,

 
    2003

    2002

    2001

 
    Average
Balance for
the Year


  Percentage
of Deposits


    Average
Rate


    Average
Balance for
the Year


  Percentage
of Deposits


    Average
Rate


    Average
Balance for
the Year


  Percentage
of Deposits


    Average
Rate


 

Money market

  $ 4,368,697   45.37 %   1.69 %   $ 3,796,466   44.94 %   2.35 %   $ 1,644,951   22.86 %   2.78 %

Sweep deposit account

    877,322   9.11     0.15 %     —     —       —   %     —     —       —   %

Certificates of deposit

    3,749,320   38.94     3.52 %     4,223,899   49.99     4.56 %     5,337,933   74.18     5.28 %

Brokered certificates of deposit

    365,162   3.79     2.78 %     205,239   2.43     2.91 %     29,236   0.40     6.86 %

Demand accounts

    267,763   2.78     0.93 %     222,953   2.64     1.12 %     183,530   2.55     1.44 %

Passbook savings

    780   0.01     1.79 %     225   —       3.11 %     375   0.01     2.99 %
   

 

       

 

       

 

     

Total

  $ 9,629,044   100.00 %         $ 8,448,782   100.00 %         $ 7,196,025   100.00 %      
   

 

       

 

       

 

     

 

In 2003, we introduced the E*TRADE FINANCIAL Sweep Deposit Account (“SDA”). The SDA is a sweep product that transfers Brokerage Segment customer balances, previously held in money market funds not on our balance sheet, to the Banking Segment. The Bank carries these balances as customer deposits in FDIC-insured money market accounts. The Banking Segment pays the Brokerage Segment a negotiated fee on the average SDA balances, which is eliminated in consolidation.

 

15


Table of Contents
Index to Financial Statements

Note 13 to the consolidated financial statements provides additional information about these deposits, including the range of interest rates paid on deposits and scheduled maturities of certificates of deposits, including certificates of deposits of $100,000 or more.

 

Borrowings

 

Deposits represent a significant component of our current funds. In addition, we borrow from the FHLB and sell securities under repurchase agreements.

 

We are a member of, and own capital stock in, the FHLB system. In part, the FHLB provides us with a reserve credit capacity and authorizes us to apply for advances on the security of FHLB stock and various home mortgages and other assets—principally securities that are obligations of, or guaranteed by, the United States government—provided we meet certain creditworthiness standards. At December 31, 2003, our outstanding advances from the FHLB totaled $920.0 million at interest rates ranging from 1.15% to 6.96% and at a weighted-average rate of 1.85%.

 

We also raise funds by selling securities to nationally recognized investment banking firms under agreements to repurchase the same securities. The investment banking firms hold the securities in custody. We treat repurchase agreements as borrowings and secure them with designated fixed- and variable-rate securities. We also participate in the Federal Reserve Bank’s special direct investment and treasury, tax and loan borrowing programs. We use the proceeds from these transactions to meet our cash flow or asset/liability matching needs.

 

The following table sets forth information regarding the weighted-average interest rates and the highest and average month-end balances of our borrowings (dollars in thousands):

 

     Ending
Balance


   Weighted-
Average
Rate(1)


    Maximum Amount
At Month-End


   Yearly
Weighted-Average


 
             Balance

   Rate

 

At or for the year ended December 31, 2003:

                                 

Advances from the FHLB

   $ 920,000    1.85 %   $ 1,058,300    $ 935,043    4.55 %

Securities sold under agreement to repurchase and other borrowings

   $ 5,365,498    1.30 %   $ 6,696,506    $ 5,976,730    2.68 %

At or for the year ended December 31, 2002:

                                 

Advances from the FHLB

   $ 1,310,300    1.89 %   $ 1,414,300    $ 970,226    5.87 %

Securities sold under agreement to repurchase and other borrowings

   $ 5,918,622    1.04 %   $ 6,628,670    $ 3,835,442    3.91 %

At or for the year ended December 31, 2001:

                                 

Advances from the FHLB

   $ 906,300    2.72 %   $ 1,737,000    $ 1,223,724    6.41 %

Securities sold under agreement to repurchase and other borrowings

   $ 3,272,100    1.89 %   $ 4,167,387    $ 3,180,272    5.99 %

(1) Excludes hedging costs.

 

16


Table of Contents
Index to Financial Statements

ITEM 2.     PROPERTIES

 

Our principal locations are as follows:

 

Location


  

Business Segment Use


  

Approximate size

(in square feet)


Alpharetta, Georgia

   Administration, Brokerage and Banking    203,000

Rancho Cordova, California

   Administration and Brokerage    176,000

Arlington, Virginia

   Administration and Banking    161,000

Irvine, California

   Banking    133,000

Menlo Park, California

   Administration and Brokerage    70,000

New York, New York

   Administration and Brokerage    53,000

Chicago, Illinois

   Brokerage    33,000

 

We lease the above facilities, except for one facility in Alpharetta, which we own. Our Brokerage and Banking Segments lease additional facilities in the United States, Canada, Southeast Asia and Europe. We also lease facilities in New York City, Boston, Beverly Hills, Denver, La Jolla, Orlando and San Francisco where our E*TRADE Financial Centers are located.

 

In 2003 and 2001, we restructured our operations and, as a result, reduced facility usage and consolidated some sites creating additional space available for sublease. These exited facilities are not included above. We believe our facility space is adequate to meet our needs in 2004.

 

ITEM 3.     LEGAL AND ADMINISTRATIVE PROCEEDINGS

 

In 1999, certain putative class actions were filed against the Company, generally seeking damages and/or injunctive relief arising out of allegations of an inability to access the Company’s website during certain periods. Two actions remain outstanding. In each of these two actions, the plaintiffs sought class certification, and the Company has successfully obtained court orders denying class certification. In one matter, pending in the Court of Common Pleas, Cuyahoga County, Ohio, the plaintiff, Truc Q. Hoang, has sought leave from the lower court to file an amended action attempting to redefine the class of potential plaintiffs. In the other matter, the Company and plaintiff Elie Wurtman, have entered into a settlement agreement pursuant to which plaintiff has agreed to dismiss this action with prejudice. Under the parties’ settlement agreement, the Company will pay nothing to plaintiff.

 

In September 2001, the Company engaged in certain stock loan transactions that resulted in litigation between the Company and three counterparties. The Company has now settled with two counterparties, Fiserv Securities, Inc. and Wedbush Morgan Securities, in 2003 and 2004 for certain undisclosed amounts and other terms that are subject to confidentiality agreements. Litigation continues between the Company and the third counterparty, Nomura Securities, Inc. and certain of its affiliates (“Nomura”) in a lawsuit pending in the United States District Court for the District of Minnesota. In that action, Nomura is seeking approximately $10.0 million in damages and has asserted the right to keep an additional $5.0 million, plus interest, unspecified punitive damages, attorneys fees, and other relief from the Company for conversion and breach of contract. Further, the Company has asserted claims and defenses against Nomura relating to the same amount and alleges, inter alia, that the defendants, which included Deutsche Bank AG, its affiliates and Nomura, among others, participated in a stock lending fraud and violated federal and state securities laws among other allegations. Through this lawsuit, the Company seeks, among other things, compensatory damages for all expenses and losses that it has incurred to date or may incur in the future in connection with the stock lending litigation. In May 2003, E*TRADE Securities and the Deutsche Bank entities and a former employee of Deutsche Bank entered into an agreement to settle the allegations with no admission of liability by the Deutsche defendants. Pursuant to that agreement, the Deutsche defendants, in exchange for certain monetary and other commitments, have been dismissed from the Company’s claims described above, and the parties are in the process of documenting mutual releases. The case remains pending with respect to all other defendants, including Nomura and its affiliates. Depositions in this

 

17


Table of Contents
Index to Financial Statements

matter have commenced. At this time, we are unable to predict the ultimate outcome of this dispute in relation to the parties with which we have not settled. However, the ultimate resolution of this litigation may be material to the Company’s operating results or cash flows for any particular period. The Company believes that its current reserves are adequate in view of its assessment of exposure at this time.

 

In April 2002, a putative class action was filed in the Superior Court of California and for the County of Orange entitled, “Lisa Arroyo, et al., v. E*TRADE Financial, et al., alleging that E*TRADE Mortgage misclassified certain classes of employees as “exempt,” rather than as “non-exempt” employees. The Company agreed to a proposed settlement and established a reserve under the terms of which the Company received an unconditional general release from all participating class members and in exchange paid a total of approximately $7.2 million (including payroll taxes and withholdings). Plaintiffs dismissed this action against the Company with prejudice on January 14, 2004.

 

Except as to matters that we have reported as settled or tentatively settled, we intend to defend vigorously against the foregoing claims. An unfavorable outcome in any matter that is not covered by insurance could have a material adverse effect on our business, financial condition, results of operations and cash flows. In addition, even if the ultimate outcomes are resolved in our favor, the defense of such litigation could entail considerable cost and the diversion of the efforts of management, either of which could have a material adverse effect on our results of operation. In addition to the matters described above, the Company is subject to various legal proceedings and claims that arise in the normal course of business, which we believe will not have a material adverse effect on our financial position, results of operations or cash flows.

 

The Company maintains insurance coverage that management believes is reasonable and prudent. The principal insurance coverage it maintains covers commercial general liability, property damage, hardware/software damage, directors and officers, employment practices liability, certain criminal acts against the Company and errors and omissions. We believe that such insurance coverage is adequate for the purpose of our business. Our ability to maintain this level of insurance coverage in the future, however, is subject to the availability of affordable insurance in the marketplace.

 

ITEM 4.    SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

 

None.

 

18


Table of Contents
Index to Financial Statements

PART II

 

ITEM 5.   MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED SHAREHOLDER
MATTERS

 

Price Range of Common Stock

 

The following table shows the high and low sale prices of our common stock as reported by the NYSE for the periods indicated:

 

     High

   Low

2003:

             

First Quarter

   $ 5.56    $ 3.65

Second Quarter

   $ 9.51    $ 4.14

Third Quarter

   $ 10.64    $ 8.30

Fourth Quarter

   $ 12.91    $ 9.25

2002:

             

First Quarter

   $ 12.64    $ 7.61

Second Quarter

   $ 9.54    $ 4.60

Third Quarter

   $ 5.47    $ 2.81

Fourth Quarter

   $ 5.98    $ 3.61

 

The closing sale price of the Company’s common stock as reported on the NYSE on February 27, 2004 was $14.31 per share. At that date there were 2,462 holders of record of the Company’s common stock.

 

Dividends

 

The Company has never declared or paid cash dividends on its capital stock. The Company currently intends to retain all of its earnings for use in its business and does not anticipate paying any cash dividends for the foreseeable future.

 

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Index to Financial Statements

ITEM 6.    SELECTED CONSOLIDATED FINANCIAL DATA

(In thousands, except per share amounts)

 

     Year Ended December 31,

    Three Months
Ended(1)
December 31,
2000


  

Year Ended

September 30,


 
     2003

    2002

    2001

       2000

    1999

 

Consolidated Statement of Operations Data:

                                               

Net revenues

   $ 1,483,708     $ 1,325,864     $ 1,275,364     $ 333,766    $ 1,368,318     $ 671,448  

Facility restructuring and other exit charges

   $ (134,561 )   $ (16,519 )   $ (202,765 )   $ —      $ —       $ —    

Operating income (loss)

   $ 206,364     $ 255,905     $ (185,958 )   $ 6,909    $ (80,326 )   $ (149,193 )

Gain (loss) on investments

   $ 147,471     $ (18,507 )   $ (49,812 )   $ 3,582    $ 211,149     $ 54,093  

Income (loss) before cumulative effect of accounting changes(2)

   $ 203,027     $ 107,264     $ (241,532 )   $ 1,436    $ 19,152     $ (56,300 )

Net income (loss)

   $ 203,027     $ (186,405 )   $ (241,532 )   $ 1,353    $ 19,152     $ (56,769 )

Income (loss) per share before cumulative effect of accounting changes(2):

                                               

Basic

   $ 0.57     $ 0.30     $ (0.73 )   $ —      $ 0.06     $ (0.21 )

Diluted

   $ 0.55     $ 0.30     $ (0.73 )   $ —      $ 0.06     $ (0.21 )

Income (loss) per share:

                                               

Basic

   $ 0.57     $ (0.52 )   $ (0.73 )   $ —      $ 0.06     $ (0.21 )

Diluted

   $ 0.55     $ (0.52 )   $ (0.73 )   $ —      $ 0.06     $ (0.21 )

Shares used in computation of per share data:

                                               

Basic

     358,320       355,090       332,370       311,413      301,926       272,832  

Diluted

     367,361       361,051       332,370       321,430      319,336       272,832  

 

     December 31,

   September 30,

     2003

   2002

   2001

   2000

   1999

Consolidated Balance Sheet Data:

                                  

Cash and equivalents

   $ 921,439    $ 773,605    $ 836,201    $ 433,377    $ 267,073

Brokerage receivables, net

   $ 2,297,778    $ 1,421,766    $ 2,139,153    $ 6,542,508    $ 2,982,076

Mortgage-backed securities

   $ 7,157,389    $ 6,932,394    $ 3,556,619    $ 4,188,553    $ 1,426,053

Loans, net

   $ 9,131,393    $ 7,365,720    $ 8,010,457    $ 4,172,754    $ 2,154,509

Total assets

   $ 26,049,216    $ 21,455,925    $ 18,172,414    $ 17,317,437    $ 8,032,174

Convertible subordinated notes and capital lease liability

   $ 696,226    $ 699,727    $ 778,459    $ 676,903    $ —  

Mandatorily redeemable capital preferred securities

   $ —      $ 143,365    $ 69,503    $ 30,647    $ 30,584

Shareholders’ equity

   $ 1,918,294    $ 1,505,789    $ 1,570,914    $ 1,856,833    $ 1,451,795

(1) On January 22, 2001, the Company changed its fiscal year-end from September 30 to December 31. Accordingly, results are separately disclosed for the three-month transition period ended December 31, 2000.
(2) In 2002, a cumulative effect of accounting change resulted from the adoption of SFAS No. 142, Goodwill and Other Intangible Assets. This standard prohibits the amortization of goodwill and intangible assets with indefinite lives and requires the testing of these assets for impairment upon adoption of SFAS No. 142 and at least annually thereafter. Impairment of goodwill that was identified upon adoption in January 2002 is reported as a cumulative effect of accounting change. In 2002, the Company adopted SFAS No. 145, Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections, resulting in a reclassification of previously reported extraordinary gain (loss) on early extinguishment of debt, net of tax, to gain on early extinguishment of debt in non-operating income (expense); along with an adjustment of previously reported tax expense (benefit). In the three months ended December 31, 2000, a cumulative effect of a change in accounting principle resulted from the implementation of SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, which requires that all derivatives be recorded on the balance sheet at fair value, with the initial application reported as the cumulative effect of a change in accounting principle. In 1999, the cumulative effect of change in accounting principle resulted from the implementation of Statement of Position 98-5, Reporting on the Cost of Start-Up Activities, which requires that the cost of start-up activities be expensed as incurred rather than capitalized, with the initial application reported as the cumulative effect of a change in accounting principle.

 

The selected consolidated financial data should be read in conjunction with Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations and Item 8. Consolidated Financial Statements and Supplementary Data.

 

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ITEM 7.   MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

The following discussion should be read in conjunction with the Consolidated Financial Statements and the related notes that appear elsewhere in this document.

 

OVERVIEW

 

We are a global financial services company offering retail, corporate and institutional customers an integrated and complementary array of investing, banking and lending products and services. Since we offer and deliver our products and services primarily through the Internet and other electronic media, our current and potential customer base is geographically dispersed and we have a lower operating cost structure than traditional “brick and mortar” financial services companies. During the past two years, we have focused on broadening our portfolio of products and services to increase our customer base, improve profitability and reduce risk to the Company and our shareholders. The results of this strategy have allowed our Company to perform better during the recent economic downturn and report an increase in net income over the period. In the future, we intend to continue to seek opportunities to streamline, diversify, expand and seamlessly integrate our services to provide greater value to our customers and our shareholders. It must be recognized, however, that we face numerous challenges, obstacles and risks in responding to the dynamics of the financial services industry, which is characterized by increasingly rapid change, evolving customer demands and intense competition. We encourage you to review closely the “Risk Factors” beginning on page 34 to understand the risks that we face that could have a significant impact on our future financial performance.

 

Our business is analyzed in two segments, Brokerage and Banking, which have different characteristics. The Brokerage Segment produces revenues primarily from commissions and margin lending. The Banking Segment earns interest from its diversified interest-earning assets and generates fee-based income.

 

The Brokerage business continues to be the primary point of introduction for the majority of our customers, and we have added Banking products and services, which complement our Brokerage business. During 2003, we lowered our cost of funds in the Bank by sweeping Brokerage customer money market balances into an FDIC-insured Sweep Deposit Account product, allowing the Bank to obtain lower cost of funds and provide our Brokerage customers a higher rate of return. In addition, the Bank has added higher-yielding consumer loans to its portfolio of products that we will continue to introduce to Brokerage customers.

 

In 2004, we see an opportunity in the current market for growth in retail Brokerage daily average revenue trades, customers and assets. To take advantage of this opportunity we plan to increase our investment in marketing by targeting this segment of our business. Additionally, we will continue to focus on lowering the cost of providing bank and brokerage services to our customers through innovative technology and operating efficiencies through additional integration of back office systems and processes.

 

This Management’s Discussion and Analysis of Financial Condition and Results of Operations is divided into the following sections:

 

    Summary of Critical Accounting Policies and Estimates describes key accounting policies and estimates that are critical to the way we measure and report on our financial performance;

 

    Results of Operations provides insight into the reasons that the financial performance of our Company changed during the past three years;

 

    Liquidity and Capital Resources describes how we obtained and used cash to operate the business; and

 

    Risk Factors describes the risks, obstacles and challenges that we face that could adversely affect our future operations and financial performance.

 

 

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Index to Financial Statements

SUMMARY OF CRITICAL ACCOUNTING POLICIES AND ESTIMATES

 

Our discussion and analysis of our financial condition and results of operations are based on our Consolidated Financial Statements, which have been prepared in conformity with accounting principles generally accepted in the United States of America. Note 2 to the Consolidated Financial Statements contains a summary of our significant accounting policies, many of which require the use of estimates and assumptions. We believe that of our significant accounting policies, the following are noteworthy because they are based on estimates and assumptions that require complex, subjective judgments by management, which can materially impact reported results. Changes in these estimates or assumptions could materially impact our financial condition and results of operation.

 

Allowances for loan losses and uncollectible margin loans

 

Management evaluates the Bank’s loan portfolio and establishes an allowance that it believes is at least equal to the probable losses inherent in its loan portfolio. When establishing this allowance, management considers a number of factors including historical and industry loss rates, estimated cash flows and collateral values as well as quantitative factors such as adjustments to policies and procedures, changes affecting third-party service providers and other market factors that may influence the overall credit performance of the Bank’s loans. This analysis is performed both for individual loans with large balances, as well as for groups of loans with similar risk characteristics. Although the Company has considerable experience in performing these reviews, if management’s underlying assumptions prove to be inaccurate or significant unanticipated changes to the national or regional economies occur, the allowance for loan losses would have to be adjusted. If the loan losses that we actually incur are significantly different from our estimates, it may be necessary to increase or decrease the allowance for loan losses in the future. If we do not provide for an adequate allowance for loan losses, we may incur additional charges to loan losses. At December 31, 2003, our allowance for loan losses was $37.8 million on $8.2 billion of loans we intend to hold for investment.

 

In addition to our banking loans, we sometimes extend credit to brokerage customers in the form of margin loans. At December 31, 2003, margin accounts had approximately $1.8 billion in outstanding margin loans for which we provided an allowance for uncollectible margin loans of $1.1 million based on historical experience, as well as the review of certain individual customer accounts and the specific identification of uncollectible amounts.

 

Classification and valuation of certain investments

 

The classification of an investment determines its accounting treatment. We generally classify our investments in debt instruments (including corporate, government and municipal bonds), mortgage-backed securities, asset-backed securities and marketable equity securities as either available-for-sale or trading. We have not classified any investments as held-to-maturity. Investment classifications are subject to ongoing review and change. When possible, the fair value of securities is determined by obtaining quoted market prices. We also make estimates about the fair value of investments and the timing for recognizing losses based on market conditions and other factors. If our estimates change, we may recognize additional losses. Both unrealized and realized gains and losses on trading securities held by our Bank are recognized in gain on sales of loans held-for-sale and securities, net. Our brokerage operations hold trading securities for market-making purposes and record the net gains in revenues as principal transactions. Unrealized gains and losses on available-for-sale securities are included in accumulated other comprehensive income. Declines in fair value, which we believe to be other-than-temporary are included in gain on sales of loans held-for-sale and securities, net for our banking investments and gain (loss) on investments for our non-banking investments.

 

Impairment of mortgage-backed or asset-backed securities is recognized when management estimates the fair value of a security is less than its amortized cost and if the current present value of estimated cash flows has decreased since the last periodic estimate. If the security fails both tests, the Company writes the security down to fair value. The Company assesses securities for impairment at each reported balance sheet date.

 

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Index to Financial Statements

We have investments in certain publicly traded and privately held companies, which we evaluate for other-than-temporary declines in market value. During 2003, we recognized $8.0 million of losses from other-than-temporary declines in market value related to our investments in privately held companies.

 

Valuation and accounting for financial derivatives

 

The Bank’s principal assets are residential mortgages and mortgage-backed securities, which typically pay a fixed interest rate over an extended period of time. However, the principal sources of funds for the Bank are customer deposits and other short-term borrowings with interest rates that are fixed for a shorter period of time, if at all. The Bank purchases interest rate derivatives, including interest rate swaps, caps and floors, to manage this difference between long-term and short-term interest rates.

 

Accounting for derivatives differs significantly depending on whether a derivative is designated as a “hedge,” which is a transaction intended to reduce a risk associated with a specific balance sheet item or future expected cash flow at the time it is purchased. In order to qualify as a hedge, a derivative must be designated as such by management, who must also continue to demonstrate that the instrument effectively reduces the risk associated with that item. We designated substantially all derivatives we held on December 31, 2003 as hedges. By doing so, the balance sheet items that we determine are hedged in fair value hedge relationships and the derivatives themselves are adjusted to market value, resulting in a net offset in the statements of operations to the extent the hedge is ineffective.

 

To determine whether a derivative instrument will continue to meet the effectiveness requirements, we must make assumptions and judgments about the continued effectiveness of our hedging strategies and the nature and timing of forecasted transactions. If our hedging strategies were to become significantly ineffective or our assumptions about the nature and timing of forecasted transactions were to be inaccurate, we could no longer apply hedge accounting and our reported results would be significantly affected.

 

Estimates of effective tax rates, deferred taxes and valuation allowances

 

When we prepare our consolidated financial statements, we estimate our income taxes based on the various jurisdictions where we conduct business. This requires us to estimate our current tax exposure and to assess temporary differences that result from differing treatments of certain items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which we show on our consolidated balance sheets in other assets. We must then assess the likelihood that our deferred tax assets will be realized. To the extent we believe that realization is not more likely than not, we establish a valuation allowance. When we establish a valuation allowance or increase this allowance in a reporting period, we record a corresponding tax expense on our statements of operations. Conversely, when it subsequently becomes apparent that a valuation allowance is no longer required due to changes in circumstances, this portion of the valuation allowance is reversed and reduces our overall income tax expense.

 

Management must make significant judgments to determine our provision for income taxes, our deferred tax assets and liabilities and any valuation allowance to be recorded against our net deferred tax asset. Our net deferred tax asset as of December 31, 2003 and 2002 was $84.5 million and $112.2 million respectively, net of the valuation allowance of $70.2 million and $92.2 million respectively. We recorded the valuation allowance to reflect uncertainties about whether we will be able to utilize some of our deferred tax assets consisting primarily of certain net operating losses carried forward by both international and domestic subsidiaries as well as certain capital loss carryforwards before they expire. The valuation allowance is based on our estimates of taxable income or capital gains expected to arise in the jurisdictions in which we operate and the period over which our deferred tax assets will be realizable. During 2003, we reversed a portion of the valuation allowance on capital loss carryforwards as a result of our gains associated with our investment in Softbank Investment Corporation (“SBI”).

 

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Index to Financial Statements

We could be required to increase the valuation allowances to take into account additional deferred tax assets that we may be unable to realize. An increase in the valuation allowance would have an adverse impact, which could be material, on our income tax provision and net income in the period in which we make the increase.

 

Valuation of goodwill and other intangibles

 

We review goodwill and purchased intangible assets with indefinite lives for impairment annually and whenever events or changes indicate the carrying value of an asset may not be recoverable in accordance with SFAS No. 142, Goodwill and Other Assets. In 2002, we recorded a $293.7 million charge, primarily attributable to the goodwill impairment of our international acquisitions as determined by our evaluation of each operating unit’s forecasted operating results and our estimates of fair values of the tangible and intangible assets of these units. This impairment was due to the change in the evaluation from an undiscounted cash flow approach to a discounted approach. In 2003, we performed our annual impairment test of goodwill with the assistance of a third party. This evaluation indicated that no additional impairment charge was necessary. The Company’s recorded goodwill at December 31, 2003 of $402.5 million, will continue to be evaluated for impairment at least annually.

 

We evaluate the remaining useful lives on intangible assets each reporting period to determine whether events and circumstances warrant a revision to the remaining period of amortization in accordance with SFAS No. 142. If estimates of useful lives are changed, the unamortized cost is allocated to the revised useful life and amortized over that period in a manner consistent with which that asset is consumed or contributes to the net revenues of the Company. The Company changed the name of Ganis Credit Corporation to E*TRADE Consumer Finance Corporation, and as a result, the Company accelerated and fully amortized its intangible asset associated with the Ganis Credit Corporation name. There have been no other events or circumstances that have warranted a revision to the originally estimated useful lives of intangible assets. The Company’s recorded intangible assets at December 31, 2003 and 2002 were $144.0 million and $157.9 million, respectively, which have useful lives between three and thirty years.

 

Our estimates of fair value of goodwill and other intangible assets depend on a number of factors, including estimates of future market growth and trends, forecasted revenue and costs, expected useful lives of the assets, appropriate discount rates and other variables.

 

RESULTS OF OPERATIONS

 

Consolidated E*TRADE Financial Results

 

During 2003, our net income was $203.0 million compared to 2002 when we incurred a net loss of $186.4 million and a net loss of $241.5 million in 2001. The following sections describe the changes in key operating factors, and other changes and events that have affected the Company’s consolidated revenues, cost of services, operating expenses and non-operating income from 2001 to 2003.

 

Net Revenues

 

Net revenues increased in 2003 to $1.5 billion compared to $1.3 billion in 2002. Of our two segments, the Bank generated greater operating income in the first three quarters of 2003, as a result of high volumes of new mortgage origination spurred by low interest rates. However, by the end of 2003, the Brokerage Segment was generating more operating income due to increased activity in the equity markets and strong retail investor activity levels; the contributions of our mortgage operations during that period declined dramatically as refinancing activity declined. Trading volumes increased in each of the last three quarters of 2003, with the strongest growth in our U.S. retail market. If market activity continues at strong levels, we expect the Brokerage Segment to continue to generate more operating income than the Banking Segment in 2004. Increased market activity leads to expected higher trading volumes at the Brokerage Segment, while fewer pre-payments, and a lower cost of funds contribute to a continuing increase in our net interest spread in the Banking Segment. In total, the Brokerage Segment reported $879.1 million of net revenues in 2003, compared to $862.2 million in 2002 and

 

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Index to Financial Statements

$911.4 million in 2001. The Banking Segment reported $604.6 million of net revenues in 2003, compared to $463.7 million in 2002 and $363.9 million in 2001. See the section titled “Analysis of Segment Revenues” for a detailed discussion about the changes in revenue for each segment.

 

Cost of Services and Operating Expenses

 

In each of 2003 and 2002, the Company implemented a number of initiatives to restructure and streamline our operations to improve the overall efficiency of the Company. Cost of services, which represents the compensation, transaction, infrastructure and overhead costs that we incur to provide service to our customers, increased to $618.4 million in 2003 from $567.2 million in 2002 and $595.6 million in 2001. The increase in 2003 is largely attributable to the cost associated with offering new products and services, including the cost of service associated with the operations of E*TRADE Consumer Finances of $19.8 million, which we purchased in December 2002. However, cost of services, as a percentage of net revenues, decreased to 42% in 2003 from 43% in 2002 and 47% in 2001. The decrease in cost of services as a percentage of net revenue was caused primarily by scale efficiencies in the brokerage business. E*TRADE Professional was acquired in June 2002 and the operations added $26.2 million in cost of services in 2003, over the amount in 2002. Other brokerage businesses experienced a reduction in cost of services despite a significant increase in customer trading activity.

 

General and administrative expense, which consists principally of compensation and overhead for executive and administrative personnel and other corporate costs, increased 21% from $210.6 million in 2002 to $255.7 million in 2003 and decreased 11% from $236.4 million in 2001 to 2002. The increase in 2003 was caused primarily by an increase in employee bonus of $28.5 million and litigation settlement accruals of $14.3 million. In addition, the increase in general and administrative expenses reflects the operations of E*TRADE Consumer Finance of $11.5 million, which we acquired in December 2002 and the operations of E*TRADE Professional which we acquired in June 2002 of $5.0 million. The decrease from 2001 to 2002 related to our 2001 restructuring plan and savings from execution of a new employment agreement with our former CEO.

 

Selling and marketing reflects expenditures for advertising campaigns, independent research provided to our institutional customers and fees paid by our market makers to outside broker-dealers for orders received for execution. Selling and marketing expenses decreased 15% from $203.6 million in 2002 to $173.1 million in 2003 primarily due to the end of a significant rebranding campaign, which included sponsorship of the 2002 Superbowl. In addition, we realized savings from the recent closure of E*TRADE FINANCIAL Centers and Zones, which were part of our 2003 restructuring plan. Selling and marketing expenses decreased 20% from $253.4 million in 2001 to 2002, primarily due to the implementation of a strategy that focuses on higher-value customers, which allowed a reduction in advertising, online, direct mailing and other promotion activities. We expect to increase brokerage-related advertising spending in 2004 in an effort to acquire additional customers and increase volume in a rising equity market environment.

 

Facility restructuring and other exit charges were $134.6 million in 2003, $16.5 million in 2002 and $202.8 million in 2001. The charges for 2003 resulted from the 2003 restructuring plan of $113.0 million, recognition of additional facility restructuring expense of $16.4 million, resulting from updated estimates of sublease income and a delay in sublease start dates anticipated in our 2001 restructuring plan and $5.2 million related to other exit activity. In 2001, we announced a restructuring plan aimed at streamlining operations primarily by consolidating facilities in the United States and Europe. This restructuring resulted in a charge of $202.8 million in 2001. The charge also included a write-off of leasehold improvements and furniture and fixtures totaling $38.6 million for 2001. In 2001, we also recorded a non-cash charge of $52.5 million related to the write-off of capitalized software and hardware, related to certain technology projects and other fixed assets, which are longer used.

 

Non-Operating Income (Expense)

 

Corporate interest expense primarily reflects the interest expense resulting from the issuance of $325 million of 6.75% convertible subordinated notes in 2001 and $650 million of 6% convertible subordinated notes in 2000.

 

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Index to Financial Statements

Corporate interest expense was $45.6 million in 2003, $47.7 million in 2002 and $52.9 million in 2001. On December 31, 2003, we had $695 million outstanding of convertible subordinated notes. We have retired $280 million of our convertible subordinated notes through share and cash exchanges since 2001.

 

Gain (loss) on investments was a gain of $147.5 million for 2003, a loss of $18.5 million for 2002 and $49.8 million for 2001. The gain in 2003 was primarily due to a change in accounting treatment for our holding in E*TRADE Japan K.K., as well as subsequent sales of these holdings. On June 2, 2003, E*TRADE Japan K.K. merged with SBI. Upon closing of the merger, we owned 19.8% of SBI and determined that we no longer exercised significant influence or control over SBI to account for our ownership under the equity method and, therefore, began to account for our investment in SBI at fair value as an available-for-sale investment security. We recognized a $29.5 million gain on investment based on the fair value of the SBI shares received in excess of our book value on the June 2, 2003 exchange date. During 2003, we sold shares of SBI resulting in a gain of $122.2 million. At December 31, 2003, we owned 9.07% of SBI and the fair value of our investment in SBI was $216.8 million, with a gross unrealized gain of $178.4 million. We also recorded other-than-temporary impairment charges related to investments in privately held companies accounted for under the cost method of $8.0 million for 2003, $12.5 million for 2002 and $30.0 million for 2001.

 

Income Tax Expense (Benefit)

 

Income tax expense (benefit) represents the expense for worldwide income taxes at an effective tax rate of 36.2% for 2003, 43.9% for 2002 and a benefit of 7.6% for 2001. The rate for 2003 reflects a decrease in tax expense due to the reversal of valuation allowance resulting from the realization of capital gains on our shares of SBI; offset by a tax expense increase due to valuation allowances for operating losses in foreign jurisdictions, and valuation allowances on deferred tax assets related to investments and joint ventures. The rate for 2002 reflects a decrease in taxes due to reversal of foreign loss valuation allowances as operations in certain jurisdictions became profitable, an increase in taxes due to valuation allowance for losses in certain foreign jurisdictions and capital losses for which no benefit was recognized. The rate for 2001 reflects a decrease in the tax benefit for non-deductible expenses, such as certain compensation and the amortization of goodwill, differences between our statutory and foreign effective tax rates and losses in certain foreign jurisdictions for which no benefit was recognized.

 

Cumulative Effect of Accounting Change

 

Cumulative effect of accounting change was $293.7 million in 2002, which was due to our adoption of SFAS No. 142, effective January 1, 2002. Goodwill was tested for impairment using fair value tests and, as a result, we wrote-down goodwill associated with certain of our international subsidiaries acquired in previous years.

 

Analysis of Segment Revenues

 

Brokerage Segment Revenues

 

During 2003, our Brokerage Segment generated nearly 60% of the Company’s net revenues. Our net brokerage revenues increased 2% to $879.1 million in 2003 from $862.2 million in 2002 mainly due to an increase in commissions as a result of a resurgence in market activity offset by a decrease in net brokerage interest income attributable to lower interest rates and tightening of the spread between free credit balances and margin lending. Net brokerage revenues decreased 5% in 2002 from $911.4 million in 2001 because of lower average commission per brokerage revenue trade reflecting the implementation of a simplified $9.99 flat commission rate program for the most active trader segment in June 2002 and lower customer margin balances.

 

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The following table sets forth the components of both gross and net revenues for our Brokerage Segment and percentage change information for the periods indicated (dollars in thousands):

 

     Year Ended December 31,

    Percentage Change

 
     2003

    2002

    2001

    2003
Versus
2002


    2002
Versus
2001


 

Brokerage revenues:

                                    

Commissions

   $ 337,468     $ 294,791     $ 377,704     14 %   (22 )%

Principal transactions

     229,846       223,531       157,949     3 %   42 %

Other brokerage-related

     177,682       174,263       156,690     2 %   11 %

Brokerage interest income

     144,379       182,103       305,581     (21 )%   (40 )%

Brokerage interest expense

     (10,305 )     (12,515 )     (86,489 )   (18 )%   (86 )%
    


 


 


           

Net brokerage revenues

   $ 879,070     $ 862,173     $ 911,435     2 %   (5 )%
    


 


 


           

 

Other key criteria that we use to measure the performance of our Brokerage Segment and explain the results of our Brokerage operations are presented in the following table:

 

     December 31,

   Percentage Change

 
     2003

   2002

   2001

   2003
versus
2002


    2002
versus
2001


 

Total brokerage revenue trades(1)

     29,814,930      21,866,047      21,942,944    36 %   —   %

Brokerage daily average revenue trades (“DARTs”)(1)

     119,260      87,464      89,018    36 %   (2 )%

Average commission per revenue trade

   $ 11.32    $ 13.48    $ 17.21    (16 )%   (22 )%

Average (dollars in millions):

                                 

Customer margin balances

   $ 1,225    $ 1,250    $ 2,092    (2 )%   (40 )%

Customer money market fund balances

   $ 7,536    $ 7,743    $ 8,525    (3 )%   (9 )%

Stock borrow balances

   $ 366    $ 317    $ 1,270    15 %   (75 )%

Stock loan balances

   $ 675    $ 441    $ 1,761    53 %   (75 )%

Customer credit balances

   $ 2,134    $ 1,471    $ 1,568    45 %   (6 )%

(1) Total brokerage revenue trades and daily average revenue trades (“DARTs”) include domestic, international and professional revenue trades. DARTs differ from daily average transactions, which we reported in the past, in that transactions include both revenue and non-revenue executions, while excluding professional and other commission-based revenue trades. We believe DARTs offer a more comparable commission per trade measure.

 

We earn Brokerage commissions when customers execute trades. These commissions are primarily affected by brokerage revenue trade volume, average commission per brokerage revenue trade and trade mix. Total brokerage revenue trades increased from 2002 to 2003 and remained relatively flat from 2001 to 2002, because of general economic conditions and a resurgence in market activity during 2003. The decreases in average commission per revenue trade were due primarily to the implementation of a simplified $9.99 flat commission rate program in June 2002 for the active trader market, but were also due in part to changes in trade mix.

 

Principal transactions include institutional revenues, market-making revenues and certain net proprietary trading gains. The 2003 increase is due to resurgence in institutional and market-making activity. The increase in 2002 was due to the impact of a full year in 2002 of market-making revenue from Dempsey.

 

Other brokerage-related revenues include account maintenance fees, payments for order flow from outside market makers, stock plan administration products and services revenue, professional trading rebate revenues, proprietary fund revenues and fees for brokerage-related services. The increases from 2001 to 2003 are primarily due to an increase in professional trading rebate revenues, following the acquisition of E*TRADE Professional in June 2002, proprietary fund revenues and fees (in lieu of interest, which was previously recorded in brokerage

 

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interest income) received from the Bank as the Company began managing customer assets that had previously been managed by a third party, offset by decreases in payment for order flow revenue and account maintenance fee revenue. The 2002 increase also includes a $6.0 million gain on the sale of the Company’s shares in the Toronto Stock Exchange.

 

Brokerage interest income includes interest earned on margin loans and regulatory cash and investments and fees on customer assets invested in money market accounts. The decrease in 2003 was due to a reduction in average margin interest rates and a reduction in interest income associated with the internalization of the money market funds offered to our customers beginning in October 2002. The decrease in 2002 was due to the general market decline, and the resulting decline in the value of net assets held by investors and reduced borrowings on margin by customers.

 

Brokerage interest expense includes interest paid to customers on certain credit balances and interest paid to banks and interest paid to other broker-dealers through a brokerage subsidiary’s stock loan program. The decrease from 2002 to 2003 was due to an overall decrease in interest rates, offset by an increase in average stock loan balances. The decrease from 2001 to 2002 was also due to an overall decrease in interest rates and reduced margin borrowings.

 

Banking Segment Revenues

 

Net banking revenues increased 30% to $604.6 million in 2003 from $463.7 million in 2002 and 27% in 2002 from $363.9 million in 2001. These increases are primarily attributable to low interest rates in 2002 and 2003 that spurred mortgage originations and the associated gain on sales of originated loans. Banking revenues also benefited from an increase in other banking-related revenues, including management fees earned from proprietary mutual funds reflected in other banking-related revenues and from the acquisition of E*TRADE Consumer Finance in December 2002. The increase in net banking revenues from 2001 to 2003 was partially offset by increases in the provision for loan losses which were made to reflect changes in the size, composition and seasoning of the Bank’s loan portfolio. The components of our Banking segment’s net revenues and percentage change information were as follows (dollars in thousands):

 

     Year Ended December 31,

    Percentage Change

 
     2003

    2002

    2001

   

2003

Versus

2002


   

2002

Versus

2001


 

Banking revenues:

                                    

Gain on sales of originated loans

   $ 192,467     $ 128,506     $ 95,478     50 %   35 %

Gain on sales of loans held-for-sale and securities, net

     97,261       80,256       70,104     21 %   14 %

Other banking-related

     80,730       50,665       38,587     59 %   31 %

Banking interest income

     748,527       767,587       859,042     (2 )%   (11 )%

Banking interest expense

     (475,824 )     (548,659 )     (691,806 )   (13 )%   (21 )%

Provision for loan losses

     (38,523 )     (14,664 )     (7,476 )   *     *  
    


 


 


           

Net banking revenues

   $ 604,638     $ 463,691     $ 363,929     30 %   27 %
    


 


 


           

* Percentage change not meaningful

 

Gain on sales of originated loans includes gains on loans made by E*TRADE Mortgage and E*TRADE Consumer Finance. The increase from 2001 to 2003 was due to an increased level of direct-to-customer mortgage loan originations, which reflects higher refinance and home purchase volumes spurred by continuing low mortgage interest rates. In addition, 2003 results reflect $4.8 million of gains from the sales of RV and marine loans, following the acquisition of E*TRADE Consumer Finance.

 

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Gain on sales of loans held-for-sale and securities, net represents net gains from the sales of loans the Company intended to sell within one year, as well as gains from the sales of securities sold by the Bank. The following table presents the net gains that the Company earned from the sales of loans held-for-sale and securities for the periods indicated (dollars in thousands):

 

     Year Ended December 31,

   Percentage Change

 
     2003

   2002

   2001

   2003
Versus
2002


    2002
Versus
2001


 

Gain on sales of loans held-for-sale, net

   $ 186    $ 26,104    $ 24,306    (99 )%   7 %

Gain on sales of securities, net

     97,075      54,152      45,798    79 %   18 %
    

  

  

            

Total

   $ 97,261    $ 80,256    $ 70,104    21 %   14 %
    

  

  

            

 

Gain on sales of loans held-for-sale, net decreased in 2003 primarily because of a decline in the volume of correspondent loan sales and securitizations. The increase in gain on sales of securities, net in 2003 was due to the realization of a $34.6 million gain on sales of interest-only securities, net of associated impairment in 2003, contrasted with a $32.9 million loss in 2002. The increase in 2003 was partially offset by a $31.4 million decline in the gain from the sales of mortgage-backed securities and trading accounts from 2002 levels. The increase in the gain on sales of securities in 2002 compared to 2001 was primarily attributable to increased gains from the sales of mortgage-backed securities, partially offset by losses recognized on interest-only securities net of related impairment, derivative instruments and an investment security.

 

Other banking-related revenues include ATM transaction fees, credit card fees, servicing fees and other banking fees imposed on deposit and transactional accounts and management fees. Approximately 60%, or $17.8 million of the 2003 increase, was attributable to management fees resulting from the internalization of certain money market fund management fees to our customers. ATM and credit card fees also increased $6.1 million and $3.1 million, respectively, reflecting the purchases of XtraCash ATMs and a credit card portfolio in 2003. Finally, 2003 results include $4.5 million of fees that E*TRADE Consumer Finance receives for providing management services to Thor Credit Corporation, a joint-venture of which 50% was acquired in December 2002 as part of the E*TRADE Consumer Finance acquisition. In 2002, other banking-related revenues increased from 2001 primarily because of higher bank fees and higher ATM transaction surcharge volume resulting from the May 2000 acquisition of E*TRADE Access.

 

Banking interest income is received by the Bank from interest-earning assets (primarily loans receivable and mortgage-backed securities). Several factors affect interest income, including: the volume, pricing, mix and maturity of interest-earning assets; the use of derivative instruments to manage interest rate risk; market rate fluctuations and asset quality. The 2003 decrease reflects a lower average yield due to the decline in market interest rates, partially offset by increases in average interest-earning banking asset balances and increases in higher yielding interest-earning assets, such as consumer loans. Average interest-earning banking assets increased 25% from 2002 to 2003 and 11% from 2001 to 2002, offsetting the decrease from the average yield on interest-earning banking assets which were 4.37% for 2003, 5.60% for 2002 and 6.96% for 2001. Banking interest expense is incurred through interest-bearing banking liabilities that include customer deposits, advances from the FHLB and other borrowings. The decrease in banking interest expense reflects a lower average cost of borrowings, partially offset by an increase in average interest-bearing banking liability balances, which increased 25% from 2002 to 2003 and 14% from 2001 to 2002. The average cost of borrowings decreased to 2.87% in 2003 from 4.14% in 2002, which decreased from 5.96% in 2001.

 

Net interest spread is the difference between the weighted-average yield earned on interest-earning banking assets less the weighted-average rate paid on interest-bearing banking liabilities. Net interest spread increased to 1.50% in 2003 from 1.46% in 2002 and 1.00% in 2001. The increases in 2003 and 2002 reflect several initiatives put in place to lower our cost of funding by shifting the structure of our deposits from time deposits to transactional accounts that carry a lower cost of funds than certificates of deposit and improving overall spreads,

 

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Index to Financial Statements

including the Bank’s asset diversification strategy. The effect of these spread-widening initiatives was partially offset by continued downward pressure from increased prepayment and sale activity with respect to our mortgage products.

 

Allowance for loan losses is an accounting estimate of credit losses inherent in the Bank’s loan portfolio. Consistent with our existing policy, management believes the allowance for loan losses balance at December 31, 2003 is at least equal to the probable losses inherent in the loan portfolio for the next twelve months. The allowance for loan losses allocated to consumer loans rose from $23.5 million at December 31, 2002 to $32.2 million at December 31, 2003 primarily due to growth in the Company’s consumer loan portfolio. During 2003, the Bank purchased and originated $4.5 billion of consumer loans, including the acquisition of $1.2 billion of existing portfolios of automobile, credit card and home equity loans through the secondary market. Credit card loans typically have higher charge-off rates and loss severities than other types of consumer loans. As a result, the ratio of the allowance for consumer loan losses to consumer loans held-for-investment increased from 0.68% at December 31, 2002 to 0.75% at December 31, 2003.

 

The following table presents the allowance for loan losses by major loan category. This allocation does not necessarily prevent the Company from shifting the allowance for loan losses between categories to better align the allowance for loan losses with the actual performance of the portfolio (dollars in thousands):

 

    Consumer(1)

    Real Estate and Home Equity(2)

    Total

 
    Allowance

  

Allowances as % of
consumer

loans held-for-

investment


    Allowance

  

Allowances as % of
real estate

loans held-for-

investment


    Allowance

   Allowances as % of
total loans held-
for-investment


 

December 31, 2003

  $ 32,185    0.75 %   $ 5,662    0.15 %   $ 37,847    0.46 %

December 31, 2002

  $ 23,472    0.68 %   $ 4,194    0.21 %   $ 27,666    0.50 %

(1) Primarily RV, automobile, marine and credit card loans.
(2) Primarily one-to-four family mortgage loans and home equity lines of credit.

 

The increase in the allowance for loan losses allocated to real estate loans at December 31, 2003 was due, in part to the increase in the balance of real estate loans held-for-investment during 2003. The allowance allocated to real estate loans at December 31, 2002, reflects management’s assumption that losses within that portfolio would increase as the portfolio aged, as well as management’s expectation of higher losses based on an overall weaker economic outlook and indications of potential weakness in real estate values. During 2003, indications of economic improvement and stability in the real estate market contributed to adjustments in management’s estimates regarding probable losses inherent in the Bank’s real estate loan portfolio.

 

Provision for loan losses was $38.5 million for 2003, $14.7 million for 2002 and $7.5 million for 2001. As part of the previously described asset diversification strategy, which included the acquisition of E*TRADE Consumer Finance and the acquisition of credit card receivables during the second and third quarters of 2003, provision for loan losses for consumer loans at December 31, 2003 was 189% higher than the prior year. The Company’s provision for consumer loans consist primarily of loans secured by automobiles, recreational vehicles and marine assets which generally have higher delinquencies and charge-offs than mortgages. The increase in the level of consumer loans drove a corresponding net increase in provision for loan losses during the year ended December 31, 2003. These increases were partially offset by a $2.0 million reduction in the provision for loan losses related to our sale of substantially all of our keyboard loans during the third quarter of 2003.

 

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LIQUIDITY AND CAPITAL RESOURCES

 

In addition to our cash flows from operations, we have historically met our liquidity needs primarily through investing and financing activities, consisting principally of equity and debt offerings, increases in core deposit accounts, other borrowings and sales of loans or securities. We believe that we will be able to renew or replace our funding sources at prevailing market rates, which may be higher or lower than current rates, as well as to supplement these funding sources with cash flow from operations.

 

We currently anticipate that our available cash resources and credit will be sufficient to meet our anticipated working capital and capital expenditure requirements for at least the next twelve months. We may need to raise additional funds in order to support expansion, fund regulatory capital requirements, develop new or enhanced products and services, respond to competitive pressures, acquire complementary businesses or technologies and/or take advantage of unanticipated opportunities.

 

Cash Provided by Operating Activities

 

The following table presents those significant items affecting our operating cash position for the periods indicated (in thousands):

 

     Year Ended December 31,

 
     2003

    2002

    2001

 

Net income (loss)

   $ 203,027     $ (186,405 )   $ (241,532 )

Selected non-cash charges:

                        

Depreciation, amortization and discount accretion

     443,746       325,980       179,126  

Non-cash restructuring costs and other exit charges

     70,811       11,880       96,793  

Cumulative effect of accounting change

     —         293,669       —    

Net effect of changes in brokerage-related assets and liabilities

     (103,595 )     102,996       325,369  

Net loans held-for-sale activity

     710,378       2,533,052       (604,899 )

Net trading securities activity

     (454,905 )     (354,565 )     128,705  

Other assets

     75,329       (325,223 )     48,503  

Total other net activity*

     (257,442 )     (175,183 )     (157,583 )
    


 


 


Net cash provided by (used in) operating activities

   $ 687,349     $ 2,226,201     $ (225,518 )
    


 


 



* Refer to the Consolidated Statements of Cash Flows for further detail included in Item 8. Consolidated Financial Statements and Supplementary Data.

 

During 2003, cash provided from operating activities decreased primarily due to decreased cash flow in loans held-for-sale and trading activities. Offsetting these decreases were sales of our shares in SBI, generating approximately $122.2 million in gains.

 

During 2002, cash provided from operating activities increased from 2001 primarily due to an increase in loans held-for-sale activity. This increase reflects the decision to reclassify $2.7 billion in loans held-for-investment to loans held-for-sale and the subsequent sale of these loans to fund the purchase of a more diverse portfolio of loans, including consumer loans, and the acquisition of E*TRADE Consumer Finance. When considered in conjunction with additional cash provided through financing activities of $3.3 billion, available cash resources in 2002 related to our bank activities were used to finance investing activities, which included net purchases of mortgage-backed and investment securities totaling $3.5 billion and the purchase of E*TRADE Consumer Finance for $1.9 billion.

 

Equity and Debt Offerings and Retirements

 

In 2003, our Board of Directors approved a $100.0 million repurchase program. The open-ended plan provides the flexibility to buy back common stock and retire debt or a combination of both. At December 31,

 

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Index to Financial Statements

2003, no common stock had been repurchased, and no debt had been retired under the plan. As of February 27, 2004, the Company had not retired any debt, but had repurchased 1.8 million shares for an aggregate amount of $25.1 million under this plan.

 

In 2001 and 2002, we repurchased and retired 47.7 million shares of common stock for an aggregate purchase price of $282.6 million. In addition, we retired an additional 5.0 million shares of common stock, valued at $28.8 million, in connection with the satisfaction of shareholders’ notes receivable. Except for 7.0 million shares repurchased in 2001, these shares were repurchased under a multi-year stock buyback program approved by our Board of Directors in September 2001.

 

In 2000 and 2001, we completed private offerings of $975.0 million aggregate principal amount of convertible subordinated notes due in February 2007 and May 2008. The notes are convertible, at the option of the holder, into approximately 45.4 million shares of our common stock at conversion prices ranging from $10.925 to $23.60 per share. The notes bear interest at 6.00% and 6.75%, payable semiannually, and are non-callable for three years and may then be called by us at a premium, which declines over time. The holders have the right to require redemption at a premium in the event of a change in control or other defined redemption event. The net proceeds from these debt offerings were used to repurchase common shares, to pay the outstanding balance on a $150.0 million line of credit and to fund merger and acquisition activity during 2001, and for general corporate purposes, including capital expenditures and to meet working capital needs.

 

In 2002, we retired $64.9 million of the 6.00% notes in exchange for 6.5 million shares of our common stock. In 2001, we retired $214.8 million of these notes in exchange for 19.2 million shares of our common stock and $15.3 million in cash. See Note 15 to Consolidated Financial Statements.

 

Other Sources of Liquidity

 

At December 31, 2003, we had financing facilities totaling $325.0 million to meet the needs of E*TRADE Clearing. These facilities, if used, would be collateralized by customer securities. There were no amounts outstanding at December 31, 2003 and $5.5 million was outstanding at December 31, 2002, under these lines. At December 31, 2003, we also had a total of $17.2 million of loans outstanding, collateralized by equipment owned by us, as well as $0.9 million of capital leases outstanding, which we used to finance fixed-assets purchases. In addition, we have numerous agreements with other broker-dealers to provide financing under our stock loan program.

 

In our banking operations, we seek to maintain a stable funding source for future periods in part by attracting core deposit accounts, which are accounts that tend to be relatively stable even in a changing interest rate environment. Typically, time deposit accounts, transactional accounts and accounts that maintain a relatively high balance provide a relatively stable source of funding. In 2003, we began sweeping Brokerage customer money market fund balances to the Bank, which were previously held in money market funds not on our balance sheets. At December 31, 2003, our average retail banking deposit account balance was approximately $21,877 and our banking customers maintained an average of 1.56 accounts. Savings and transactional deposits increased from $4.3 billion at December 31, 2002 to $9.0 billion at December 31, 2003, an increase of 110%. Retail certificates of deposit decreased from $3.7 billion at December 31, 2002 to $3.2 billion at December 31, 2003, or 13%. Brokered certificates of deposit decreased from $0.4 billion at December 31, 2002 to $0.3 billion at December 31, 2003, or 27%.

 

We also rely on borrowed funds, such as FHLB advances and securities sold under agreements to repurchase to provide liquidity for the Bank. Total banking-related borrowings decreased 10% from $7.2 billion at December 31, 2002 to $6.5 billion at December 31, 2003. At December 31, 2003, the Bank had approximately $5.2 billion in additional borrowing capacity.

 

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Contractual Obligations

 

The following summarizes our contractual obligations at December 31, 2003 and the effect such obligations are expected to have on our liquidity and cash flow in future periods (dollars in thousands):

 

     Due in

   Thereafter

   Total

 
     2004

    2005

   2006

   2007

   2008

     

General obligations:

                                                   

Convertible subordinated notes(1)

   $ 44,157     $ 44,157    $ 44,157    $ 403,377    $ 335,969    $ —      $ 871,817  

Operating lease payments

     26,823       22,446      21,802      20,581      19,951      46,929      158,532  

Purchase commitments(2)

     25,500       —        —        —        —        —        25,500  

Venture capital funding commitments(3)

     11,970       10,000      10,000      6,755      —        —        38,725  

Facilities offered for sublease, less estimated future sublease income(4)

     11,999       8,390      5,033      4,945      4,444      6,467      41,278  

Capital lease payments

     774       163      —        —        —        —        937  

Other commitments(5)

     1,500       680      —        —        —        —        2,180  
    


 

  

  

  

  

  


Total general obligations

     122,723       85,836      80,992      435,658      360,364      53,396      1,138,969  
    


 

  

  

  

  

  


Banking obligations:

                                                   

Mandatorily redeemable preferred securities(1)

     11,757       11,891      11,891      11,891      11,891      266,539      325,860  

Certificates of deposit(6)(7)

     2,501,404       825,041      269,042      193,793      99,029      14,631      3,902,940  

Other borrowings by bank subsidiary(7)

     5,855,939       321,588      107,423      52,612      —        201,665      6,539,227  

Loan commitments:

                                                   

Originate loans(8)

     767,962       —        —        —        —        —        767,962  

Purchase loans

     236,656       —        —        —        —        —        236,656  

Sell mortgages

     (303,711 )     —        —        —        —        —        (303,711 )

Security commitments:

                                                   

Purchase securities

     2,054,016       —        —        —        —        —        2,054,016  

Sell securities

     (3,013,853 )     —        —        —        —        —        (3,013,853 )
    


 

  

  

  

  

  


Total banking obligations

     8,110,170       1,158,520      388,356      258,296      110,920      482,835      10,509,097  
    


 

  

  

  

  

  


Total contractual obligations

   $ 8,232,893     $ 1,244,356    $ 469,348    $ 693,954    $ 471,284    $ 536,231    $ 11,648,066  
    


 

  

  

  

  

  



(1) Includes annual interest or dividend payments; does not assume early redemption under current call provisions.
(2) Commitments to purchase property and equipment.
(3) Estimated based on investment plans of the venture capital funds.
(4) Included in the facilities restructuring accrual.
(5) Remaining payments for our acquisition of Trading Relationships.
(6) Does not include demand deposit, money market or passbook savings accounts, as there are no maturities and/or scheduled contractual payments.
(7) Includes annual interest based on the contractual features of each transaction, using market rates at December 31, 2003. Interest rates were assumed to remain flat over the life of all adjustable rate instruments.
(8) Contains optional commitment to originate.

 

At December 31, 2003, the Bank also had commitments of $1.0 billion of unused lines of credit available to customers under HELOCs and $1.3 billion of unused credit card lines. Since these lines may be used at the customers’ discretion, there are no scheduled maturities or payments.

 

33


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Index to Financial Statements

RISK FACTORS

 

Risks Relating to the Nature of the Financial Services Business

 

Many of our competitors have greater financial, technical, marketing and other resources

 

We face direct competition from retail and institutional financial service companies in each of our lines of business. Many of our competitors have longer operating histories and greater resources than we do and offer a wider range of financial products and services. Many also have greater name recognition, greater market acceptance and larger customer bases. These competitors may conduct extensive promotional activities and offer better terms, lower prices and/or different products and services to customers than we do. Moreover, some of our competitors have established relationships among themselves or with third parties to enhance their products and services. This means that our competitors may be able to respond more quickly to new or changing opportunities and demands and withstand changing market conditions better than we can.

 

Downturns or disruptions in the securities markets could reduce transaction volumes and margin borrowing and increase our dependence on our more active customers who receive lower prices

 

A significant portion of our revenues in recent years has been from online investing services, and although we continue to diversify our revenue sources, we expect this business to continue to account for a significant portion of our revenues in the foreseeable future. Like other financial services firms, we are affected directly by national and global economic and political conditions, broad trends in business and finance, disruptions to the securities markets and changes in volume and price levels of securities and futures transactions.

 

A significant downturn in the U.S. securities markets commenced in March of 2000, resulting in industry-wide declines in transaction volume. While volumes recently have begun to increase, any decrease in transaction volume may be more significant for us with respect to our less active customers, increasing our dependence on our more active and professional trading customers who receive more favorable pricing based on their transaction volume. Decreases in volumes, as well as securities prices, are also typically associated with a decrease in margin borrowing. Because we generate revenue from interest charged on margin borrowing, such decreases result in a reduction of revenue to E*TRADE Clearing. When transaction volume is low, our operating results are harmed in part because some of our overhead costs remain relatively fixed.

 

Downturns in the securities markets increase the credit risk associated with margin lending or stock loan transactions

 

We permit customers to purchase securities on margin. When the market declines rapidly, there is an increased risk that the value of the collateral we hold in connection with these transactions could fall below the amount of a customer’s indebtedness. Similarly, as part of our broker-dealer operations, we frequently enter into arrangements with other broker-dealers for the lending of various securities. Under regulatory guidelines, when we borrow or lend securities, we must generally simultaneously disburse or receive cash deposits. We may risk losses if there are sharp changes in market values of many securities and the counterparties to the borrowing and lending transactions fail to honor their commitments. Any downturn in public equity markets may lead to a greater risk that parties to stock lending transactions may fail to meet their commitments.

 

We may be unsuccessful in managing the effects of changes in interest rates and the interest-bearing assets in our portfolio

 

The results of operations for the Bank depend in large part upon its level of net interest income, that is, the difference between interest income from interest-earning assets (such as loans and mortgage-backed and other asset-backed securities) and interest expense on interest-bearing liabilities (such as deposits and borrowings). The Bank has derivatives to help manage its interest rate risk. However, derivatives utilized may not be entirely effective and changes in market interest rates and the yield curve could reduce the value of the Bank’s financial assets and reduce net interest income. Many factors affect interest rates, including governmental monetary policies and domestic and international economic and political conditions.

 

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The Bank’s diversification of its asset portfolio may increase the level of charge-offs

 

As the Bank diversifies its asset portfolio through purchases and originations of higher-yielding asset classes, such as automobile, marine and recreational vehicle loans and credit card portfolios, we will have to manage assets that carry a higher risk of default than our mortgage portfolio. Consequently, the level of charge- offs associated with these assets may be higher than previously experienced. In addition, if the overall economy weakens, we could experience higher levels of charge-offs. If expectations of future charge-offs increase, a corresponding increase in the amount of our loan loss allowance would be required. The increased level of provision for loan losses recorded to meet additional loan loss allowance requirements could adversely affect our financial results if those higher yields do not cover the provision for loan losses.

 

An increase in our delinquency rate could adversely affect our results of operations

 

Our underwriting criteria or collection methods may not afford adequate protection against the risks inherent in the loans comprising our consumer loan portfolio. In the event of a default, the collateral value of the financed item may not cover the outstanding loan balance and costs of recovery. In the event our portfolio of consumer finance receivables experience higher delinquencies, foreclosures, repossessions or losses than anticipated, our results of operations or financial condition could be adversely affected.

 

We are exposed to risk in our credit card portfolio

 

In 2003, the Bank acquired credit card loans to further diversify its loan portfolio. Like other credit card lenders, we face the risk that we will not be able to collect on credit card accounts because accountholders may not repay their unsecured credit card loans. Consumers who miss payments on their credit cards often fail to repay them, and consumers who file for protection under the bankruptcy laws generally do not repay their credit card obligations. Therefore, the rate of missed payments, or “delinquencies” on our credit card portfolio and the rate at which consumers may be expected to file for bankruptcy can be used to predict the future rate at which we will charge-off our credit card loans.

 

Risks associated with principal trading transactions could result in trading losses

 

A majority of our specialist and market-making revenues at Dempsey are derived from trading by Dempsey as a principal. Dempsey may incur trading losses relating to the purchase, sale or short sale of securities for its own account, as well as trading losses in its specialist stocks and market maker stocks. From time to time, Dempsey may have large positions in securities of a single issuer or issuers engaged in a specific industry. Dempsey also operates a proprietary trading desk separately from its specialist and market maker operations, which may also incur trading losses.

 

Certain portions of our E*TRADE Professional business are also involved in proprietary trading, in which the firm provides capital that becomes traded by employees and others. Similar to Dempsey’s business, the proprietary trading positions of E*TRADE Professional may also incur trading losses.

 

Reduced spreads in securities pricing, levels of trading activity and trading through market makers and/or specialists could harm our specialist and market maker business

 

The increase in computer generated buy/sell programs in the marketplace has continued to tighten spreads, resulting in reduced revenue capture per share by the specialist market making community and reduced payment for order flow revenues for us. Similarly, a reduction in the volume and/or volatility of trading activity could also reduce spreads that specialists and market makers receive, also adversely affecting revenues generated by Dempsey.

 

Alternative trading systems that have developed over the past few years could also reduce the levels of trading of exchange-listed securities through specialists and the levels of over-the-counter trading through market makers. In addition, electronic communication networks have emerged as an alternative forum to which broker-

 

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Index to Financial Statements

dealers and institutional investors can direct their limit orders. This allows broker-dealers and institutional investors to avoid directing their trades through market makers. As a result, Dempsey may experience a reduction in its flow of limit orders.

 

If we do not successfully manage consolidation opportunities, we could be at a competitive disadvantage

 

There has been significant consolidation in the online financial services industry over the last several years, and the consolidation is likely to continue in the future. Should we fail to take advantage of viable consolidation opportunities or if we overextend our efforts by acquiring businesses that we are unable to integrate or manage properly, we could be placed at a competitive disadvantage. Acquisitions entail numerous risks including retaining or hiring skilled personnel, integrating acquired operations, products and personnel and the diversion of management attention from other business concerns. In addition, there can be no assurance that we will realize a positive return on any acquisition or that future acquisitions will not be dilutive to earnings.

 

We rely heavily on technology to deliver products and services

 

Disruptions to or instability of our technology, including an actual or perceived breach of the security of our technology, could harm our business and our reputation.

 

Our international efforts subject us to additional risks and regulation, which could impair our business growth

 

One component of our strategy has been an effort to build an international business. We have established certain joint venture and/or licensee relationships. We have limited control over the management and direction of these venture partners and/or licensees, and their action or inaction, including their failure to follow proper practices with respect to regulatory compliance and/or corporate governance, could harm our operations and/or our reputation.

 

Risks Relating to the Regulation of our Business

 

We are subject to extensive government regulation, including banking and securities rules and regulations, which could restrict our business practices

 

The securities and banking industries are subject to extensive regulation. All of our broker-dealer subsidiaries have to comply with many laws and rules, including rules relating to possession and control of customer funds and securities, margin lending and execution and settlement of transactions. We are also subject to additional laws and rules as a result of our specialist and market maker operations in Dempsey. In addition, to the extent that, now or in the future, we solicit orders from our customers or make investment recommendations (or are deemed to have done so), or offer products and services, such as investing in futures, that are not suitable for all investors, we would become subject to additional rules and regulations governing, among other things, sales practices and the suitability of recommendations to customers.

 

Similarly, E*TRADE Financial Corporation, E*TRADE Re, LLC and ETBH, as savings and loan holding companies, and E*TRADE Bank, as a Federally chartered savings bank, are subject to extensive regulation, supervision and examination by the OTS, and, in the case of the Bank, the FDIC. Such regulation covers all banking business, including lending practices, safeguarding deposits, capital structure, recordkeeping, transactions with affiliates and conduct and qualifications of personnel.

 

If we fail to comply with applicable securities, banking and insurance laws, rules and regulations, we could be subject to disciplinary actions, damages, penalties or restrictions that could significantly harm our business

 

The SEC, NYSE, NASD, Commodity Futures Trading Commission or other self-regulatory organizations and state securities commissions can, among other things, censure, fine, issue cease-and-desist orders or suspend

 

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or expel a broker-dealer or any of its officers or employees. The OTS may take similar action with respect to our banking activities. Similarly, the attorneys general of each state could bring legal action on behalf of the citizens of the various states to ensure compliance with local laws. The ability to comply with applicable laws and rules is dependent in part on the establishment, maintenance and enforcement of an effective compliance system. The failure to establish and enforce reasonable compliance procedures, even if unintentional, could subject us to significant losses or disciplinary or other actions.

 

If we do not maintain the capital levels required by regulators, we may be fined or even forced out of business

 

The SEC, NYSE, NASD, OTS and various other regulatory agencies have stringent rules with respect to the maintenance of specific levels of net capital by securities broker-dealers and regulatory capital by banks. Net capital is the net worth of a broker or dealer (assets minus liabilities), less deductions for certain types of assets. Failure to maintain the required net capital could result in suspension or revocation of registration by the SEC and suspension or expulsion by the NYSE and/or NASD, and could ultimately lead to the firm’s liquidation. In the past, our broker-dealer subsidiaries have depended largely on capital contributions by us in order to comply with net capital requirements. If such net capital rules are changed or expanded, or if there is an unusually large charge against net capital, operations that require an intensive use of capital could be limited. Such operations may include investing activities, marketing and the financing of customer account balances. Also, our ability to withdraw capital from brokerage subsidiaries could be restricted, which in turn could limit our ability to repay debt and redeem or purchase shares of our outstanding stock. See Note 23 of Item 8 Consolidated Financial Statements and Supplemental Data for the minimum net capital requirements for our domestic broker-dealer subsidiaries for the current reporting period.

 

Similarly, the Bank is subject to various regulatory capital requirements administered by the OTS. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary actions by regulators that, if undertaken, could harm a bank’s operations and financial statements. A bank must meet specific capital guidelines that involve quantitative measures of a bank’s assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. A bank’s capital amounts and classification are also subject to qualitative judgments by the regulators about the strength of components of its capital, risk weightings of assets, off-balance sheet transactions and other factors.

 

Quantitative measures established by regulation to ensure capital adequacy require a bank to maintain minimum amounts and ratios of Total and Tier 1 Capital to risk-weighted assets and of Tier I Capital to adjusted total assets. To satisfy the capital requirements for a “well capitalized” financial institution, a bank must maintain minimum Total and Tier 1 Capital to risk-weighted assets and Tier I Capital to adjusted total assets ratios. See Note 23 of Item 8 Consolidated Financial Statements and Supplemental Data for the Bank for the current reporting period.

 

As a non-grandfathered savings and loan holding company, we are subject to regulations that could restrict our ability to take advantage of certain business opportunities

 

We are required to file periodic reports with the OTS and are subject to examination by the OTS. The OTS also has certain types of enforcement powers over the Company, ETBH and E*TRADE Re, LLC, including the ability to issue cease-and-desist orders, force divestiture of the Bank and impose civil and monetary penalties for violations of Federal banking laws and regulations or for unsafe or unsound banking practices. In addition, under the Gramm-Leach-Bliley Act, our activities are restricted to those that are financial in nature and certain real estate-related activities. We may make merchant banking investments in companies whose activities are not financial in nature if those investments are made for the purpose of appreciation and ultimate resale of the investment and we do not manage or operate the company. Such merchant banking investments may be subject to maximum holding periods and special recordkeeping and risk management requirements.

 

 

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We believe all of our existing activities and investments are permissible under the Gramm-Leach-Bliley Act, but the OTS has not yet fully interpreted these provisions. Even if our existing activities and investments are permissible, we are unable to pursue future activities that are not financial in nature. We are also limited in our ability to invest in other savings and loan holding companies.

 

In addition, the Bank is subject to extensive regulation of its activities and investments, capitalization, community reinvestment, risk management policies and procedures and relationship with affiliated companies. Acquisitions of and mergers with other financial institutions, purchases of deposits and loan portfolios, the establishment of new Bank subsidiaries and the commencement of new activities by Bank subsidiaries require the prior approval of the OTS, and in some cases the FDIC, which may deny approval or limit the scope of our planned activity. These regulations and conditions could place us at a competitive disadvantage in an environment in which consolidation within the financial services industry is prevalent. Also, these regulations and conditions could affect our ability to realize synergies from future acquisitions, could negatively affect us following the acquisition and could also delay or prevent the development, introduction and marketing of new products and services.

 

Risks Relating to Owning Our Stock

 

We have incurred losses in the past and we cannot assure you that we will be profitable

 

We have incurred operating losses in prior periods and we may do so in the future. We reported net income of $203.0 million in 2003, which includes $134.6 million of pre-tax restructuring and other exit charges; net losses of $186.4 million in 2002, which includes a cumulative effect of accounting change of $293.7 million; and net losses of $241.5 million in 2001, which includes pre-tax facility restructuring and other exit charges of $202.8 million.

 

Our ratio of debt to equity may make it more difficult to make payments on our debts or to obtain financing

 

At December 31, 2003, we had an outstanding balance of $695.3 million in convertible subordinated notes. Our ratio of debt (our convertible debt, capital lease obligations and term loans) to equity (expressed as a percentage) was 47.7% at December 31, 2003. We may incur additional indebtedness in the future. The level of our indebtedness, among other things, could:

 

    make it more difficult to make payments on our debt;
    make it more difficult or costly for us to obtain any necessary financing in the future for working capital, capital expenditures, debt service requirements or other purposes;
    limit our flexibility in planning for, or reacting to, changes in our business; and
    make us more vulnerable in the event of a downturn in our business.

 

The market price of our common stock may continue to be volatile

 

From January 1, 2002 through December 31, 2003, the price per share of our common stock has ranged from a high of $12.91 to a low of $2.81. The market price of our common stock has been, and is likely to continue to be, highly volatile and subject to wide fluctuations. In the past, volatility in the market price of a company’s securities has often led to securities class action litigation. Such litigation could result in substantial costs to us and divert our attention and resources, which could harm our business. Declines in the market price of our common stock or failure of the market price to increase could also harm our ability to retain key employees, reduce our access to capital and otherwise harm our business.

 

We may need additional funds in the future, which may not be available and which may result in dilution of the value of our common stock

 

In the future, we may need to raise additional funds, which may not be available on favorable terms, if at all. If adequate funds are not available on acceptable terms, we may be unable to fund our business growth plans. In

 

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addition, if funds are available, the issuance of securities could dilute the value of shares of our common stock and cause the market price to fall.

 

We have various mechanisms in place that may discourage takeover attempts

 

Certain provisions of our certificate of incorporation and bylaws may discourage, delay or prevent a third party from acquiring control of us in a merger, acquisition or similar transaction that a shareholder may consider favorable. Such provisions include:

 

    authorization for the issuance of “blank check” preferred stock;
    provision for a classified Board of Directors with staggered, three-year terms;
    the prohibition of cumulative voting in the election of directors;
    a super-majority voting requirement to effect business combinations or certain amendments to our certificate of incorporation and bylaws;
    limits on the persons who may call special meetings of shareholders;
    the prohibition of shareholder action by written consent; and
    advance notice requirements for nominations to the Board of Directors or for proposing matters that can be acted on by shareholders at shareholder meetings.

 

Attempts to acquire control of E*TRADE may also be delayed or prevented by our stockholder rights plan, which is designed to enhance the ability of our Board of Directors to protect shareholders against unsolicited attempts to acquire control of E*TRADE that do not offer an adequate price to all shareholders or are otherwise not in the best interests of the company and our shareholders. In addition, certain provisions of our stock incentive plans, management retention and employment agreements (including severance payments and stock option acceleration), and Delaware law may also discourage, delay or prevent someone from acquiring or merging with us.

 

ITEM 7A.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

For quantitative and qualitative disclosures about market risk, we have evaluated such risks for our Brokerage and Banking Segments separately. The following discussion about our market risk disclosure includes forward-looking statements. Actual results could differ materially from those projected in the forward-looking statements as a result of certain factors, including, but not limited to, those set forth in the section entitled “Risk Factors.”

 

BROKERAGE OPERATIONS

 

Our Brokerage operations are exposed to market risk related to changes in interest rates, foreign currency exchange rates and equity security price risk.

 

Interest Rate Sensitivity

 

At December 31, 2003, we had variable-rate brokerage and corporate term loans outstanding of approximately $17.2 million and $23.7 million at December 31, 2002. The monthly interest payments on these term loans are subject to interest rate risk. If market interest rates were to increase immediately and uniformly by 1% at December 31, 2003 and 2002, the interest payments would increase by an immaterial amount.

 

Foreign Currency Exchange Risk

 

A portion of our operations consists of brokerage and investment services outside of the United States. As a result, our results of operations could be adversely affected by factors, such as changes in foreign currency exchange rates or economic conditions in the foreign markets in which we provide our services. We are primarily exposed to changes in exchange rates on the Japanese yen, the British pound, the Canadian dollar and the Euro.

 

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When the U.S. dollar strengthens against these currencies, the U.S. dollar value of non-U.S. dollar-based revenues decreases. Accordingly, changes in exchange rates may adversely affect our consolidated operating margins as expressed in U.S. dollars.

 

To mitigate the short-term effect of changes in currency exchange rates on our non-U.S. dollar-based revenues and operating expenses, we evaluate the costs and benefits to hedging our material net non-U.S. dollar-based exposures by entering into foreign exchange forward contracts. Currently, hedges of transactions are immaterial. Given the short-term nature of our foreign exchange forward contracts, our exposure to risk associated with currency market movement on the instruments is not material.

 

Financial Instruments

 

For our working capital and reserves, which are required to be segregated under Federal or other regulations, we primarily invest in money market funds, resale agreements, certificates of deposit and commercial paper. Money market funds do not have maturity dates and do not present a material market risk. The other financial instruments are fixed-rate investments with short maturities and do not present a material interest rate risk.

 

Equity Security Price Risk

 

We currently hold an investment in SBI which is a Japanese yen denominated publicly traded equity security with unrealized gains of $178.4 million as of December 31, 2003. As the security’s market price and yen fluctuates, we are exposed to a loss of some of the unrealized gains. We also held security positions related to our market-making business of $11.4 million and $4.8 million as of December 31, 2003 and 2002, respectively. If market prices fluctuate, we are exposed to a loss on some of these balances.

 

BANKING OPERATIONS

 

Our banking operations acquire and manage interest-bearing assets and liabilities in the normal course of business. Interest-bearing instruments include investment securities, loans, deposits, borrowings and derivative financial instruments. These instruments are subject to changes in market value as interest rates change.

 

Interest Rate Risk

 

The acquisition, maintenance and disposition of assets and liabilities are critical elements of the Bank’s operations. Throughout the process, these instruments are subject to interest rate risk, which is the potential for adverse declines in market values. Numerous factors may influence the speed and direction of market value changes including, but not limited to, liquidity, absolute interest rate levels, shape of the yield curve and implied volatility of future interest rate movements. The net market values of bank instruments may directly or indirectly impact the Bank’s current or future earnings and are subject to certain regulatory constraints.

 

Market risk management oversight is the responsibility of the Bank’s Asset Liability Management Committee (“ALCO”). The ALCO is responsible for measuring, managing and reporting the Bank’s aggregate market risk within established policy guidelines and limits, which are reviewed periodically. The Bank maintains a Risk Management Group, independent of the Bank’s portfolio management functions, to assist the ALCO in measuring and managing market risk.

 

The Bank’s exposure to market risk is dependent upon the distribution of all interest-sensitive assets, liabilities and derivatives. These items have differing risk characteristics that, if properly managed, can mitigate the Bank’s exposure to fluctuations in interest rates. At December 31, 2003, approximately 52.3% of the market value of the Bank’s total assets was comprised of residential mortgages and mortgage-backed securities. The values of these assets are sensitive to changes in interest rates, as well as expected prepayment levels. The Bank’s

 

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liability structure consists primarily of transactional deposit relationships, such as money market accounts, shorter-term certificates of deposit and wholesale collateralized borrowings from the FHLB and other entities. The derivative portfolio of the Bank is positioned to decrease the overall market risk resulting from the combination of assets and liabilities. The Bank’s market risk is discussed and quantified in more detail in the Scenario Analysis section below.

 

Most of the Bank’s assets are generally classified as non-trading portfolios and, as such, are not marked-to-market through earnings for accounting purposes. The Bank did maintain a trading portfolio of investment-grade securities throughout 2002 and 2003. The fair value of the trading portfolio was $821 million and $392 million at December 31, 2003 and 2002, respectively.

 

Scenario Analysis

 

Scenario analysis is an advanced approach to estimating interest rate risk exposure. Under the Net Present Value of Equity (“NPVE”) approach, the present value of all existing assets, liabilities, derivatives and forward commitments are estimated and then combined to produce a NPVE figure. The sensitivity of this value to changes in interest rates is then determined by applying alternative interest rate scenarios, which include, but are not limited to, instantaneous parallel shifts up 100, 200 and 300 basis points and down 100 basis points. The down 200 and 300 basis point scenarios are not presented at December 31, 2003 and 2002, because they result in negative interest rates. The sensitivity of NPVE at December 31, 2003 and 2002 and the limits established by the Bank’s Board of Directors are listed below (dollars in thousands):

 

     Change in Net Present Value of Equity

 
     At December 31,

   Board Limit

 

Parallel Change in Interest Rates (bps)


   2003

   2002

  

+300

   $ (278,901 )    (26)%    $ (240,693 )    (29)%    (55 )%

+200

   $ (175,696 )    (16)%    $ (149,554 )    (18)%    (30 )%

+100

   $ (76,145 )    (7)%    $ (57,255 )    (7)%    (15 )%

-100

   $ 18,418      2%     $ (19,354 )    (2)%    (15 )%

 

Under criteria published by the OTS, the Bank’s overall interest rate risk exposure at December 31, 2003 is characterized as “minimal.”

 

Derivative Financial Instruments

 

The Bank uses derivative financial instruments to help manage its interest rate risk. Interest rate swaps are used to lower the duration of specific fixed-rate assets or increase the duration of specific adjustable-rate liabilities. Interest rate swaps involve the exchange of fixed-rate and variable-rate interest payments between two parties based on a contractual underlying notional amount, but do not involve the exchange of the underlying notional amounts. Option products are utilized primarily to decrease the market value changes resulting from the prepayment dynamics of the Bank’s mortgage portfolios, as well as to protect against increases in funding costs. The types of options the Bank employs are primarily Cap Options (“Caps”) and Floor Options (“Floors”), “Payor Swaptions” and “Receiver Swaptions.” Caps mitigate the market risk associated with increases in interest rates, while Floors mitigate the risk associated with decreases in market interest rates. Similarly, Payor and Receiver Swaptions mitigate the market risk associated with the respective increases and decreases in interest rates.

 

Mortgage Production Activities

 

In the production of mortgage products, the Bank is exposed to interest rate risk between the commitment and funding dates of the loans. There were $0.3 billion at December 31, 2003 and $1.1 billion at December 31, 2002, in mortgage loan commitments awaiting funding. The associated interest rate risk results when the Bank enters into Interest Rate Lock Commitments (“IRLCs”), whereby determination of loan interest rates occurs prior to funding. When the intent is to sell originated loans, the associated IRLCs are considered derivatives and, accordingly, are recorded at fair value with associated changes recorded in earnings.

 

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ITEM 8.    CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

 

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

 

     Page

Independent Auditors’ Report

   43

Consolidated Balance Sheets as of December 31, 2003 and 2002

   44

Consolidated Statements of Operations for the Years Ended December 31, 2003, 2002 and 2001

   45

Consolidated Statements of Comprehensive Income (Loss) for the Years Ended December 31, 2003, 2002 and 2001

   46

Consolidated Statements of Shareholders’ Equity for the Years Ended December 31, 2003, 2002 and 2001 

   47

Consolidated Statements of Cash Flows for the Years Ended December 31, 2003, 2002 and 2001

   49

Notes to Consolidated Financial Statements:

    

Note 1—Organization and Basis of Presentation

   51

Note 2—Summary of Significant Accounting Policies

   52

Note 3—Business Combinations

   59

Note 4—Brokerage Receivables, Net and Brokerage Payables

   62

Note 5—Available-for-sale mortgage-backed and investment securities

   63

Note 6—Other Investments

   66

Note 7—Loans Receivable, Net

   68

Note 8—Property and Equipment, Net

   70

Note 9—Goodwill and Other Intangibles, Net

   71

Note 10—Other Assets

   73

Note 11—Asset Securitization

   74

Note 12—Related Party Transactions

   77

Note 13—Deposits

   78

Note 14—Securities Sold Under Agreements to Repurchase and Other Borrowings by Bank Subsidiary

   79

Note 15—Convertible Subordinated notes

   80

Note 16—Accounts Payable, Accrued and Other Liabilities

   81

Note 17—Income Taxes

   82

Note 18—Shareholders’ Equity

   84

Note 19—Employee Benefit Plans

   85

Note 20—Facility Restructuring And Other Exit Charges

   88

Note 21—Executive Agreement and Loan Settlement

   91

Note 22—Income (Loss) Per Share

   92

Note 23—Regulatory Requirements

   93

Note 24—Lease Arrangements

   94

Note 25—Commitments, Contingencies and Other Regulatory Matters

   95

Note 26—Accounting for Derivative Financial Instruments and Hedging Activities

   97

Note 27—Fair Value Disclosure Of Financial Instruments

   101

Note 28—Segment and Geographic Information

   102

Note 29—Condensed Financial Information (Parent Company Only)

   105

Note 30—Subsequent Events

   108

Note 31—Quarterly Data (Unaudited)

   109

 

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INDEPENDENT AUDITORS’ REPORT

 

To the Board of Directors and Shareholders of

E*TRADE Financial Corporation

Arlington, Virginia

 

We have audited the accompanying consolidated balance sheets of E*TRADE Financial Corporation and subsidiaries (the “Company”) as of December 31, 2003 and 2002, and the related consolidated statements of operations, comprehensive income (loss), shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2003. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the consolidated financial statements based on our audits.

 

We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall consolidated financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of E*TRADE Financial Corporation and subsidiaries as of December 31, 2003 and 2002, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States of America.

 

As discussed in Note 9, effective January 1, 2002, the Company changed its method of accounting for goodwill and other intangible assets to conform to Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets.

 

/S/ DELOITTE & TOUCHE LLP

 

McLean, Virginia

March 9, 2004

 

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E*TRADE FINANCIAL CORPORATION AND SUBSIDIARIES

 

CONSOLIDATED BALANCE SHEETS

(in thousands, except share amounts)

 

     December 31,

 
     2003

    2002

 

ASSETS

                

Cash and equivalents

   $ 921,439     $ 773,605  

Cash and investments required to be segregated under Federal or other regulations (includes repurchase agreements of $875,800 at December 31, 2003 and $1,273,000 at December 31, 2002)

     1,644,605       1,449,062  

Brokerage receivables, net

     2,297,778       1,421,766  

Trading securities

     832,889       396,579  

Available-for-sale mortgage-backed and investment securities (includes securities pledged to creditors with the right to sell or repledge of $5,706,325 at December 31, 2003 and $6,490,334 at December 31, 2002)

     9,826,940       8,193,066  

Other investments

     49,306       113,196  

Loans receivable (net of allowance for loan losses of $37,847 at December 31, 2003 and $27,666 at December 31, 2002)

     8,130,906       5,552,981  

Loans held-for-sale, net

     1,000,487       1,812,739  

Property and equipment, net

     301,258       370,944  

Derivative assets

     59,990       103,622  

Accrued interest receivable

     92,565       97,516  

Investment in Federal Home Loan Bank Stock

     79,236       80,732  

Goodwill

     402,496       385,144  

Other intangibles, net

     143,990       157,892  

Other assets

     265,331       547,081  
    


 


Total assets

   $ 26,049,216     $ 21,455,925  
    


 


LIABILITIES AND SHAREHOLDERS’ EQUITY

                

Brokerage payables

   $ 3,691,176     $ 2,713,687  

Deposits

     12,514,486       8,400,333  

Securities sold under agreements to repurchase

     5,283,609       5,628,338  

Other borrowings by Bank subsidiary

     1,203,554       1,600,584  

Derivative liabilities

     79,303       150,245  

Convertible subordinated notes

     695,330       695,330  

Accounts payable, accrued and other liabilities

     663,464       618,254  
    


 


Total liabilities

     24,130,922       19,806,771  
    


 


Company-obligated mandatorily redeemable preferred capital securities of subsidiary trusts holding solely junior subordinated debentures of ETBH

     —         143,365  

Commitments and contingencies

     —         —    

Shareholders’ equity:

                

Preferred stock, shares authorized: 1,000,000; issued and outstanding: none at December 31, 2003 and 2002

     —         —    

Shares exchangeable into common stock, $0.01 par value, shares authorized: 10,644,223; issued and outstanding: 1,386,125 at December 31, 2003 and 1,627,265 at December 31 2002

     14       16  

Common stock, $0.01 par value, shares authorized: 600,000,000; issued and outstanding: 366,636,406 at December 31, 2003 and 358,044,317 at December 31, 2002

     3,666       3,580  

Additional paid-in capital

     2,247,930       2,190,200  

Deferred stock compensation

     (12,874 )     (23,058 )

Accumulated deficit

     (230,465 )     (433,492 )

Accumulated other comprehensive loss

     (89,977 )     (231,457 )
    


 


Total shareholders’ equity

     1,918,294       1,505,789  
    


 


Total liabilities and shareholders’ equity

   $ 26,049,216     $ 21,455,925  
    


 


 

See accompanying notes to consolidated financial statements

 

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E*TRADE FINANCIAL CORPORATION AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share amounts)

 

     Year Ended December 31,

 
     2003

    2002

    2001

 

Brokerage revenues:

                        

Commissions

   $ 337,468     $ 294,791     $ 377,704  

Principal transactions

     229,846       223,531       157,949  

Other brokerage-related revenues

     177,682       174,263       156,690  

Brokerage interest income

     144,379       182,103       305,581  

Brokerage interest expense

     (10,305 )     (12,515 )     (86,489 )
    


 


 


Net brokerage revenues

     879,070       862,173       911,435  
    


 


 


Banking revenues:

                        

Gain on sales of originated loans

     192,467       128,506       95,478  

Gain on sales of loans held-for-sale and securities, net

     97,261       80,256       70,104  

Other banking-related revenues

     80,730       50,665       38,587  

Banking interest income

     748,527       767,587       859,042  

Banking interest expense

     (475,824 )     (548,659 )     (691,806 )

Provision for loan losses

     (38,523 )     (14,664 )     (7,476 )
    


 


 


Net banking revenues

     604,638       463,691       363,929  
    


 


 


Total net revenues

     1,483,708       1,325,864       1,275,364  
    


 


 


Cost of services

     618,385       567,224       595,590  
    


 


 


Operating expenses:

                        

Selling and marketing

     173,066       203,613       253,422  

Technology development

     60,741       55,712       88,717  

General and administrative

     255,709       210,645       236,353  

Amortization of goodwill and other intangibles

     33,023       28,258       43,091  

Acquisition-related expenses

     1,859       11,473       11,174  

Facility restructuring and other exit charges

     134,561       16,519       202,765  

Executive agreement and loan settlement

     —         (23,485 )     30,210  
    


 


 


Total operating expenses

     658,959       502,735       865,732  
    


 


 


Total cost of services and operating expenses

     1,277,344       1,069,959       1,461,322  
    


 


 


Operating income (loss)

     206,364       255,905       (185,958 )
    


 


 


Non-operating income (expense):

                        

Corporate interest income

     6,538       12,655       22,179  

Corporate interest expense

     (45,569 )     (47,740 )     (52,862 )

Gain (loss) on investments

     147,471       (18,507 )     (49,812 )

Equity in income (loss) of investments

     14,834       9,071       (6,174 )

Unrealized losses on venture funds

     (5,640 )     (9,683 )     (34,716 )

Fair value adjustments of financial derivatives

     (15,338 )     (11,662 )     (3,112 )

Gain on early extinguishment of debt, net

     —         5,346       49,318  

Other

     1,694       (1,444 )     200  
    


 


 


Total non-operating income (expense)

     103,990       (61,964 )     (74,979 )
    


 


 


Pre-tax income (loss)

     310,354       193,941       (260,937 )

Income tax expense (benefit)

     112,388       85,122       (19,885 )

Minority interest in subsidiaries

     (5,061 )     1,555       480  
    


 


 


Income (loss) before cumulative effect of accounting changes

     203,027       107,264       (241,532 )

Cumulative effect of accounting changes, net of tax

     —         (293,669 )     —    
    


 


 


Net income (loss)

   $ 203,027     $ (186,405 )   $ (241,532 )
    


 


 


Income (loss) per share before cumulative effect of accounting changes:

                        

Basic

   $ 0.57     $ 0.30     $ (0.73 )
    


 


 


Diluted

   $ 0.55     $ 0.30     $ (0.73 )
    


 


 


Income (loss) per share:

                        

Basic

   $ 0.57     $ (0.52 )   $ (0.73 )
    


 


 


Diluted

   $ 0.55     $ (0.52 )   $ (0.73 )
    


 


 


Shares used in computation of per share data:

                        

Basic

     358,320       355,090       332,370  

Diluted

     367,361       361,051       332,370  

 

See accompanying notes to consolidated financial statements

 

45


Table of Contents
Index to Financial Statements

E*TRADE FINANCIAL CORPORATION AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(in thousands)

 

     Year Ended December 31,

 
     2003

    2002

    2001

 

Net income (loss)

   $ 203,027     $ (186,405 )   $ (241,532 )

Other comprehensive income (loss):

                        

Available-for-sale securities:

                        

Unrealized gains (losses)

     187,503       48,672       (76,587 )

Less impact of realized gains (transferred out of AOCI) and included in net income (loss)

     (223,086 )     (54,340 )     (39,974 )

Tax effect

     80,579       2,918       47,523  
    


 


 


Net change from available-for-sale securities

     44,996       (2,750 )     (69,038 )
    


 


 


Cash flow hedging instruments:

                        

Unrealized losses

     (15,375 )     (137,143 )     (128,313 )

Amortization of losses deferred in AOCI into interest expense related to de-designated cash flow hedges

     121,414       67,937