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SCHW > SEC Filings for SCHW > Form 10-Q on 6-Nov-2012All Recent SEC Filings

Show all filings for SCHWAB CHARLES CORP

Form 10-Q for SCHWAB CHARLES CORP


6-Nov-2012

Quarterly Report

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

(Tabular Amounts in Millions, Except Ratios, or as Noted)

Item 2.  Management's Discussion and Analysis of Financial Condition and Results
         of Operations


OVERVIEW

Management of The Charles Schwab Corporation (CSC) and its subsidiaries
(collectively referred to as the Company) focuses on several key client activity
and financial metrics in evaluating the Company's financial position and
operating performance. Results for the third quarters and first nine months of
2012 and 2011 are:



                                                              Three Months Ended                                      Nine Months Ended
                                                                 September 30,                  Percent                 September 30,                Percent
                                                            2012              2011               Change             2012            2011              Change
Client Activity Metrics:
Net new client assets (1) (in billions)                  $      20.4       $      86.0                 (76 %)     $    75.3       $   124.4                 (39 %)
Client assets (in billions, at quarter end)              $   1,890.4       $   1,576.4                  20 %
Clients' daily average trades (2) (in thousands)               402.4             475.4                 (15 %)         438.0           448.3                  (2 %)

Company Financial Metrics:
Net revenues                                             $     1,196       $     1,181                   1 %      $   3,668       $   3,578                   3 %
Expenses excluding interest                                      835               821                   2 %          2,562           2,438                   5 %

Income before taxes on income                                    361               360                   -            1,106           1,140                  (3 %)
Taxes on income                                                  114               140                 (19 %)           389             439                 (11 %)

Net income                                               $       247       $       220                  12 %      $     717       $     701                   2 %

Earnings per common share - diluted                      $       .19       $       .18                   6 %      $     .54       $     .57                  (5 %)
Net revenue growth from prior year                                 1 %              11 %                                  3 %            15 %
Pre-tax profit margin                                           30.2 %            30.5 %                               30.2 %          31.9 %
Return on average common stockholders'equity
(annualized) (3)                                                  11 %              12 %                                 11 %            13 %
Annualized net revenue per average full-time
equivalent employee (in thousands)                       $       352       $       350                   1 %      $     354       $     361                  (2 %)

(1) Includes outflows of $1.3 billion as a result of the closure and/or sale of certain subsidiaries of optionsXpress Holdings, Inc. in the third quarter of 2012. Includes inflows of $12.0 billion from a mutual fund clearing services client in the first quarter of 2012. Includes inflows of $60.9 billion from mutual fund clearing services clients and $7.5 billion from the acquisition of optionsXpress Holdings, Inc. in the third quarter of 2011.

(2) Amounts include revenue trades from commissions or principal mark-ups (i.e., fixed income), trades by clients in asset-based pricing relationships, and all commission-free trades, including the Company's Mutual Fund OneSourceŽ funds and Exchange-Traded Funds, and other proprietary products.

(3) Return on average common stockholders' equity is calculated using net income available to common stockholders divided by average common stockholders' equity.

The broad equity markets improved during the third quarter of 2012 compared to the third quarter of 2011, as the Nasdaq Composite Index, Standard & Poor's 500 Index, and Dow Jones Industrial Average increased 29%, 27%, and 23%, respectively. While the federal funds target rate remained unchanged at a range of zero to 0.25%, the average three-month Treasury Bill yield increased by 8 basis points to 0.09% during the third quarter of 2012 compared to the third quarter of 2011. At the same time, the average 10-year Treasury yield decreased by 78 basis points to 1.62%.

Clients remained engaged in the third quarter of 2012 despite the challenging economic and market environment that continued during the period. Net new client assets before significant one-time flows totaled $21.7 billion in the third quarter of 2012, up 23% from the third quarter of 2011. Total client assets ended the quarter at a record $1.89 trillion, up 20% from the third quarter of 2011. Clients' daily average trades were 402,400 in the third quarter of 2012, down 15% on a year-over-year basis.

For the third quarter of 2012, net revenues remained relatively flat compared to the third quarter of 2011 as the increase in asset management and administration fees was largely offset by a decrease in trading revenue. Asset management and administration fees increased primarily due to increases in mutual fund service fees and advice solutions fees. Trading

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Table of Contents

THE CHARLES SCHWAB CORPORATION

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

(Tabular Amounts in Millions, Except Ratios, or as Noted)

revenue decreased primarily due to lower daily average revenue trades. Net interest revenue was relatively flat, reflecting higher balances of interest-earning assets offset by the effect of lower interest rate spreads during the third quarter of 2012 due to the continued low interest rate environment.

For the first nine months of 2012, net revenues increased by 3% compared to the first nine months of 2011 primarily due to increases in asset management and administration fees and other revenue, partially offset by a decrease in trading revenue. Asset management and administration fees increased due to increases in advice solutions fees and other asset management and administration fees, offset by a decrease in mutual fund service fees. Other revenue increased primarily due to a pre-tax gain of $70 million relating to a confidential resolution of a vendor dispute in the second quarter of 2012. Trading revenue decreased primarily due to lower daily average revenue trades, partially offset by the inclusion of optionsXpress' option, future, and equity trades from its acquisition in September 2011. Net interest revenue was flat as higher average balances of interest-earning assets were offset by lower interest rate spreads during the first nine months of 2012 due to the continued pressure on market interest rates.

Expenses excluding interest increased by 2% and 5% in the third quarter and first nine months of 2012 compared to the same periods in 2011, respectively, primarily due to the inclusion of optionsXpress. Taxes on income in the third quarter of 2012 include a non-recurring state tax benefit of $20 million. Overall, net income increased by 12% and 2% in the third quarter and first nine months of 2012 compared to the same periods in 2011, respectively.

In comparison to the second quarter of 2012, the broad equity markets increased in the third quarter of 2012 as the Nasdaq Composite Index, Standard & Poor's 500 Index, and Dow Jones Industrial Average increased 6%, 6%, and 4%, respectively, while the average three-month Treasury Bill yield remained relatively flat at 0.09%. The average 10-year Treasury yield decreased by 19 basis points to 1.62% from the second quarter of 2012. Despite the challenging economic environment, the Company's growing client base and ongoing expense discipline helped maintain a pre-tax profit margin of 30.2% in the third quarter of 2012. Net income in the third quarter and second quarter of 2012 include the non-recurring state tax benefit of $20 million and pre-tax gain of $70 million (after-tax of $44 million), respectively, discussed above.

CURRENT MARKET AND REGULATORY ENVIRONMENT AND OTHER DEVELOPMENTS

The broad equity markets and short-term interest rates showed improvement from 2011, however the low interest rate environment continues to constrain growth in the Company's net revenues.

As discussed above, interest rates remained at low levels during the third quarter of 2012. To the extent rates remain at these low levels, the Company's net interest revenue will continue to be constrained, even as growth in average balances helps to increase such revenue. The low interest rate environment also affects asset management and administration fees. While net money market mutual fund fees improved in the third quarter of 2012 from the second quarter of 2012 primarily due to sustained improvement in short-term interest rates, the overall yields on certain Schwab-sponsored money market mutual funds have remained at levels at or below the management fees on those funds. The Company continues to waive a portion of its management fees so that the funds can maintain a positive return to clients. These and other money market mutual funds may not be able to replace maturing securities with securities of equal or higher yields. As a result, the yields on such funds may remain around or decline from their current levels, and therefore below the management fees on those funds. To the extent this occurs, asset management and administration fees may be negatively affected.

The Company recorded net impairment losses of $3 million and $28 million related to certain non-agency residential mortgage-backed securities in the third quarter and first nine months of 2012, respectively, due to further credit deterioration of the securities' underlying loans. Net impairment losses in the first nine months of 2012 were also due to an increase in projected default rates for modified loans in the first quarter of 2012. Further deterioration in the performance of the underlying loans in the Company's residential mortgage-backed securities portfolio could result in the recognition of additional impairment charges.

The "Dodd-Frank Wall Street Reform and Consumer Protection Act" (the Dodd-Frank Act) was signed into law in July 2010. Among other things, the legislation transferred the supervision and regulation of CSC from the Office of Thrift Supervision (OTS) to the Board of Governors of the Federal Reserve System (the Federal Reserve) and supervision and

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Table of Contents

THE CHARLES SCHWAB CORPORATION

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

(Tabular Amounts in Millions, Except Ratios, or as Noted)

regulation of Schwab Bank from the OTS to the Office of the Comptroller of the Currency (OCC); both transfers were effective July 21, 2011. The Federal Reserve recently issued notices of proposed rulemaking (NPRs) to meet certain requirements of the Dodd-Frank Act and to align current capital rules with the BASEL III capital standards. The NPRs would subject all savings and loan holding companies, including CSC, to consolidated capital requirements. In addition, the NPRs would establish more restrictive capital definitions, higher risk-weightings for certain asset classes, higher minimum capital ratios and capital buffers. The NPRs would be phased in under an extended timeframe, beginning January 2013. The comment period for the NPRs ended on October 22, 2012 and the NPRs are subject to further modification. CSC is currently evaluating the impact of the NPRs but does not expect them to have a material impact on the Company's business, financial condition, and results of operations.

The Company is pursuing lawsuits in state court in San Francisco for rescission and damages against issuers, underwriters, and dealers of individual non-agency residential mortgage-backed securities on which the Company has experienced realized and unrealized losses. The lawsuits allege that offering documents for the securities contained material untrue and misleading statements about the securities and the underwriting standards and credit quality of the underlying loans. On January 27, 2012, and July 24, 2012, the court denied defendants' motions to dismiss the claims with respect to all but 3 of the 51 securities, and discovery is proceeding.

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Table of Contents

THE CHARLES SCHWAB CORPORATION

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

(Tabular Amounts in Millions, Except Ratios, or as Noted)

RESULTS OF OPERATIONS

The following discussion presents an analysis of the Company's results of operations for the third quarter and first nine months of 2012 compared to the same periods in 2011.

Net Revenues

The Company's major sources of net revenues are asset management and
administration fees, net interest revenue, and trading revenue. Asset management
and administration fees increased and net interest revenue was relatively flat,
while trading revenue decreased in the third quarter and first nine months of
2012 compared to the same periods in 2011, respectively.



Three Months Ended September 30,                                2012                              2011
                                                                        % of                              % of
                                      Percent                        Total Net                         Total Net
                                      Change          Amount          Revenues          Amount          Revenues
Asset management and
administration fees
Schwab money market funds before
fee waivers                                  -       $     221                         $     220
Fee waivers                                (15 %)         (136 )                            (160 )

Schwab money market funds after
fee waivers                                 42 %            85                 7 %            60                 5 %
Equity and bond funds                       10 %            32                 3 %            29                 2 %
Mutual Fund OneSourceŽ                       2 %           171                14 %           168                14 %

Total mutual funds                          12 %           288                24 %           257                21 %
Advice solutions                            15 %           148                12 %           129                11 %
Other                                       10 %            88                 8 %            80                 7 %

Asset management and
administration fees                         12 %           524                44 %           466                39 %


Net interest revenue
Interest revenue                            (2 %)          478                40 %           487                41 %
Interest expense                           (11 %)          (39 )              (3 %)          (44 )              (3 %)

Net interest revenue                        (1 %)          439                37 %           443                38 %


Trading revenue
Commissions                                (18 %)          190                16 %           233                20 %
Principal transactions                      (7 %)           14                 1 %            15                 1 %

Trading revenue                            (18 %)          204                17 %           248                21 %


Other                                       (7 %)           42                 3 %            45                 4 %

Provision for loan losses                   25 %           (10 )              (1 %)           (8 )              (1 %)

Net impairment losses on
securities                                 (77 %)           (3 )               -             (13 )              (1 %)

Total net revenues                           1 %     $   1,196               100 %     $   1,181               100 %

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Table of Contents

                         THE CHARLES SCHWAB CORPORATION

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

           (Tabular Amounts in Millions, Except Ratios, or as Noted)



Nine Months Ended September 30,                                  2012                                2011
                                                                         % of                                % of
                                     Percent                          Total Net                           Total Net
                                     Change           Amount           Revenues           Amount           Revenues
Asset management and
administration fees
Schwab money market funds before
fee waivers                                 4 %      $     663                           $     639
Fee waivers                                11 %           (445 )                              (400 )

Schwab money market funds after
fee waivers                                (9 %)           218                  6 %            239                  7 %
Equity and bond funds                       7 %             95                  2 %             89                  2 %
Mutual Fund OneSourceŽ                     (4 %)           501                 14 %            520                 15 %

Total mutual funds                         (4 %)           814                 22 %            848                 24 %
Advice solutions                            9 %            427                 12 %            392                 11 %
Other                                      14 %            263                  7 %            230                  6 %

Asset management and
administration fees                         2 %          1,504                 41 %          1,470                 41 %


Net interest revenue
Interest revenue                           (1 %)         1,447                 39 %          1,464                 41 %
Interest expense                          (13 %)          (116 )               (3 %)          (134 )               (4 %)

Net interest revenue                        -            1,331                 36 %          1,330                 37 %


Trading revenue
Commissions                                (4 %)           624                 17 %            647                 18 %
Principal transactions                    (11 %)            42                  1 %             47                  1 %

Trading revenue                            (4 %)           666                 18 %            694                 19 %


Other                                      76 %            209                  6 %            119                  4 %

Provision for loan losses                   8 %            (14 )                -              (13 )                -

Net impairment losses on
securities                                 27 %            (28 )               (1 %)           (22 )               (1 %)

Total net revenues                          3 %      $   3,668                100 %      $   3,578                100 %

Asset Management and Administration Fees

Asset management and administration fees include mutual fund service fees and fees for other asset-based financial services provided to individual and institutional clients. The Company earns mutual fund service fees for shareholder services, administration, and investment management provided to its proprietary funds, and recordkeeping and shareholder services provided to third-party funds. These fees are based upon the daily balances of client assets invested in these funds. The Company also earns asset management fees for advice solutions, which include advisory and managed account services that are based on the daily balances of client assets subject to the specific fee for service. The fair values of client assets included in proprietary and third-party mutual funds are based on quoted market prices and other observable market data. Other asset management and administration fees include various asset based fees, such as trust fees, 401k record keeping fees, and mutual fund clearing and other service fees. Asset management and administration fees may vary with changes in the balances of client assets due to market fluctuations and client activity. For discussion of the impact of current market conditions on asset management and administration fees, see "Current Market and Regulatory Environment and Other Developments."

Asset management and administration fees increased by $58 million, or 12%, in the third quarter of 2012 compared to the third quarter of 2011 primarily due to increases in mutual fund service fees and advice solutions fees. Asset management and administration fees increased by $34 million, or 2%, in the first nine months of 2012 compared to the first nine months of 2011 due to increases in advice solutions fees and other asset management and administration fees, offset by a decrease in mutual fund service fees.

Mutual fund service fees increased by $31 million, or 12%, in the third quarter of 2012 compared to the third quarter of 2011 primarily due to an increase in net money market mutual fund fees as a result of improved short-term rates. Mutual fund

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Table of Contents

THE CHARLES SCHWAB CORPORATION

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

(Tabular Amounts in Millions, Except Ratios, or as Noted)

service fees decreased by $34 million, or 4%, in the first nine months of 2012 compared to the first nine months of 2011 primarily due to a decrease in net money market mutual fund fees as a result of lower yields on fund assets and a decrease in Mutual Fund OneSource fees.

Advice solutions fees increased by $19 million, or 15%, and $35 million, or 9%, in the third quarter and first nine months of 2012 compared to the same periods in 2011, respectively, primarily due to growth in client assets enrolled in retail advisory and managed account programs, which includes WindhavenŽ.

Other asset management and administration fees increased by $8 million, or 10%, and $33 million, or 14%, in the third quarter and first nine months of 2012 compared to the same periods in 2011 primarily due to an increase in third-party mutual fund service fees.

Net Interest Revenue

Net interest revenue is the difference between interest earned on interest-earning assets and interest paid on funding sources. Net interest revenue is affected by changes in the volume and mix of these assets and liabilities, as well as by fluctuations in interest rates and portfolio management strategies. The Company's investment strategy is structured to produce an increase in net interest revenue when interest rates rise and, conversely, a decrease in net interest revenue when interest rates fall (i.e., interest-earning assets generally reprice more quickly than interest-bearing liabilities). When interest rates fall, the Company may attempt to mitigate some of this negative impact by extending the maturities of assets in investment portfolios to lock in asset yields, and by lowering rates paid to clients on interest-bearing liabilities. Since the Company establishes the rates paid on certain brokerage client cash balances and deposits from banking clients, as well as the rates charged on receivables from brokerage clients, and also controls the composition of its investment securities, it has some ability to manage its net interest spread. The current low interest rate environment limits the extent to which the Company can reduce interest expense paid on funding sources. However, the spread is influenced by external factors such as the interest rate environment and competition. For discussion of the impact of current market conditions on net interest revenue, see "Current Market and Regulatory Environment and Other Developments."

In clearing its clients' trades, Charles Schwab & Co., Inc. (Schwab) and optionsXpress, Inc. hold cash balances payable to clients. In most cases, Schwab and optionsXpress, Inc. pay their clients interest on cash balances awaiting investment, and in turn invest these funds and earn interest revenue. Receivables from brokerage clients consist primarily of margin loans to brokerage clients. Margin loans are loans made to clients on a secured basis to purchase securities. Pursuant to applicable regulations, client cash balances that are not used for margin lending are generally segregated into investment accounts that are maintained for the exclusive benefit of clients, which are recorded in cash and investments segregated on the Company's condensed consolidated balance sheet.

Schwab Bank maintains investment portfolios for liquidity as well as to invest funds from deposits in excess of loans to banking clients and liquidity limits. Schwab Bank's securities available for sale include residential mortgage-backed securities, certificates of deposit, corporate debt securities, U.S. agency notes, and asset-backed and other securities. Schwab Bank's securities held to maturity include residential mortgage-backed and other securities. Schwab Bank lends funds to banking clients primarily in the form of mortgage loans and home equity lines of credit (HELOCs). These loans are largely funded by interest-bearing deposits from banking clients.

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

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Table of Contents

THE CHARLES SCHWAB CORPORATION

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

(Tabular Amounts in Millions, Except Ratios, or as Noted)

The following tables present net interest revenue information corresponding to interest-earning assets and funding sources on the condensed consolidated balance sheet:

Three Months Ended September 30,                               2012                                             2011
                                                            Interest         Average                         Interest         Average
                                             Average        Revenue/         Yield/           Average        Revenue/         Yield/
                                             Balance         Expense          Rate            Balance         Expense          Rate
Interest-earning assets:
Cash and cash equivalents                   $    7,942      $       4             0.20 %     $    6,025      $       3             0.20 %
Cash and investments segregated                 23,516             12             0.20 %         26,597              7             0.10 %
. . .
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