10-Q 1 form10q063004.txt FORM 10-Q FOR THE QUARTER ENDED JUNE 30, 2004 ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q |X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2004 COMMISSION FILE NUMBER 1-15081 UNIONBANCAL CORPORATION (Exact name of registrant as specified in its charter) DELAWARE 94-1234979 (State of Incorporation) (I.R.S. Employer Identification No.) 400 CALIFORNIA STREET SAN FRANCISCO, CALIFORNIA 94104-1302 (Address and zip code of principal executive offices) Registrant's telephone number: (415) 765-2969 Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No --- --- Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes X No --- --- Number of shares of Common Stock outstanding at July 31, 2004: 147,775,010 ================================================================================ UNIONBANCAL CORPORATION AND SUBSIDIARIES TABLE OF CONTENTS PAGE NUMBER ------ PART I FINANCIAL INFORMATION Consolidated Financial Highlights........................................ 2 Item 1. Financial Statements: Condensed Consolidated Statements of Income............................ 4 Condensed Consolidated Balance Sheets.................................. 5 Condensed Consolidated Statements of Changes in Stockholders' Equity... 6 Condensed Consolidated Statements of Cash Flows........................ 7 Notes to Condensed Consolidated Financial Statements................... 8 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations: Introduction........................................................... 23 Executive Overview..................................................... 23 Financial Performance.................................................. 25 Net Interest Income.................................................... 29 Noninterest Income..................................................... 32 Noninterest Expense.................................................... 33 Income Tax Expense..................................................... 33 Loans.................................................................. 34 Cross-Border Outstandings.............................................. 36 Provision for Credit Losses............................................ 36 Allowance for Credit Losses............................................ 36 Nonperforming Assets................................................... 42 Loans 90 Days or More Past Due and Still Accruing...................... 43 Quantitative and Qualitative Disclosures About Market Risk............. 43 Liquidity Risk......................................................... 46 Regulatory Capital..................................................... 47 Business Segments...................................................... 48 Certain Business Risk Factors.......................................... 57 Item 3. Quantitative and Qualitative Disclosures about Market Risk....... 61 Item 4. Controls and Procedures.......................................... 61 PART II OTHER INFORMATION Item 1. Legal Proceedings................................................ 62 Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities...................................................... 63 Item 4. Submission of Matters to a Vote of Security Holders.............. 63 Item 6. Exhibits and Reports on Form 8-K................................. 63 Signatures............................................................... 65 PART I. FINANCIAL INFORMATION UnionBanCal Corporation and Subsidiaries Consolidated Financial Highlights (Unaudited)
AS OF AND FOR THE THREE MONTHS ENDED -------------------------- JUNE 30, JUNE 30, PERCENT (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 2003 2004 CHANGE --------------------------------------------------------- ----------- ----------- ------- RESULTS OF OPERATIONS: Net interest income(1)................................. $ 386,422 $ 400,661 3.68% (Reversal of) provision for credit losses.............. 25,000 (10,000) nm Noninterest income..................................... 203,171 331,010 62.92 Noninterest expense.................................... 351,004 376,402 7.24 ----------- ----------- Income before income taxes(1).......................... 213,589 365,269 71.01 Taxable-equivalent adjustment.......................... 645 803 24.50 Income tax expense..................................... 68,186 133,369 95.60 ----------- ----------- Net income............................................. $ 144,758 $ 231,097 59.64 =========== =========== PER COMMON SHARE: Net income--basic...................................... $ 0.96 $ 1.56 62.50% Net income--diluted.................................... 0.96 1.54 60.42 Dividends(2)........................................... 0.31 0.36 16.13 Book value (end of period)............................. 25.79 26.98 4.61 Common shares outstanding (end of period)(3)........... 149,993,652 147,845,160 (1.43) Weighted average common shares outstanding--basic(3)... 150,046,659 147,687,350 (1.57) Weighted average common shares outstanding--diluted(3). 151,489,337 150,183,938 (0.86) BALANCE SHEET (END OF PERIOD): Total assets........................................... $42,668,834 $46,295,831 8.50% Total loans............................................ 25,668,660 27,594,271 7.50 Nonaccrual loans....................................... 379,487 178,062 (53.08) Nonperforming assets................................... 379,758 183,913 (51.57) Total deposits......................................... 35,365,260 39,367,911 11.32 Medium and long-term debt.............................. 420,853 800,988 90.32 Junior subordinated debt............................... -- 16,017 nm Trust preferred securities............................. 360,166 -- (100.00) Stockholders' equity................................... 3,868,959 3,988,676 3.09 BALANCE SHEET (PERIOD AVERAGE): Total assets........................................... $39,776,349 $44,611,351 12.16% Total loans............................................ 26,517,316 26,838,622 1.21 Earning assets......................................... 36,074,488 40,351,016 11.85 Total deposits......................................... 32,587,173 37,810,048 16.03 Stockholders' equity................................... 3,919,276 3,933,788 0.37 FINANCIAL RATIOS: Return on average assets(4)............................ 1.46% 2.08% Return on average stockholders' equity(4).............. 14.81 23.63 Efficiency ratio(5).................................... 59.53 51.44 Net interest margin(1)................................. 4.29 3.98 Dividend payout ratio.................................. 32.29 23.08 Tangible equity ratio.................................. 8.59 7.88 Tier 1 risk-based capital ratio........................ 11.44 10.46 Total risk-based capital ratio......................... 13.06 13.07 Leverage ratio......................................... 9.63 8.36 Allowance for credit losses to total loans............. 2.17 1.82 Allowance for credit losses to nonaccrual loans........ 147.11 281.60 Net loans charged off to average total loans(4)........ 0.80 0.15 Nonperforming assets to total loans and foreclosed assets.................................... 1.48 0.67 Nonperforming assets to total assets................... 0.89 0.40 ---------------------------------------- (1) Amounts are on a taxable-equivalent basis using the federal statutory tax rate of 35 percent. (2) Dividends per share reflect dividends declared on UnionBanCal Corporation's common stock outstanding as of the declaration date. (3) Common shares outstanding reflects common shares issued less treasury shares. (4) Annualized. (5) The efficiency ratio is noninterest expense, excluding foreclosed asset expense (income), as a percentage of net interest income (taxable-equivalent basis) and noninterest income. Foreclosed asset expense (income) was $(0.5) thousand in the second quarter of 2003 and $16.5 thousand in the second quarter of 2004. nm--not meaningful
2 PART I. FINANCIAL INFORMATION UnionBanCal Corporation and Subsidiaries Consolidated Financial Highlights (Unaudited)
AS OF AND FOR THE SIX MONTHS ENDED -------------------------- JUNE 30, JUNE 30, PERCENT (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 2003 2004 CHANGE --------------------------------------------------------- ----------- ----------- ------- RESULTS OF OPERATIONS: Net interest income(1)................................. $ 777,826 $ 801,884 3.09% (Reversal of) provision for credit losses.............. 55,000 (15,000) nm Noninterest income..................................... 388,942 542,215 39.41 Noninterest expense.................................... 693,604 749,508 8.06 ----------- ----------- Income before income taxes(1).......................... 418,164 609,591 45.78 Taxable-equivalent adjustment.......................... 1,269 1,605 26.48 Income tax expense..................................... 136,620 219,402 60.59 ----------- ----------- Net income............................................. $ 280,275 $ 388,584 38.64 =========== =========== PER COMMON SHARE: Net income--basic...................................... $ 1.86 $ 2.63 41.40% Net income--diluted.................................... 1.85 2.59 40.00 Dividends(2)........................................... 0.59 0.67 13.56 Book value (end of period)............................. 25.79 26.98 4.61 Common shares outstanding (end of period)(3)........... 149,993,652 147,845,160 (1.43) Weighted average common shares outstanding--basic(3)... 150,329,939 147,543,824 (1.85) Weighted average common shares outstanding--diluted(3). 151,746,328 149,991,567 (1.16) BALANCE SHEET (END OF PERIOD): Total assets........................................... $42,668,834 $46,295,831 8.50% Total loans............................................ 25,668,660 27,594,271 7.50 Nonaccrual loans....................................... 379,487 178,062 (53.08) Nonperforming assets................................... 379,758 183,913 (51.57) Total deposits......................................... 35,365,260 39,367,911 11.32 Medium and long-term debt.............................. 420,853 800,988 90.32 Junior subordinated debt............................... -- 16,017 nm Trust preferred securities............................. 360,166 -- (100.00) Stockholders' equity................................... 3,868,959 3,988,676 3.09 BALANCE SHEET (PERIOD AVERAGE): Total assets........................................... $39,066,221 $43,831,266 12.20% Total loans............................................ 26,619,618 26,490,239 (0.49) Earning assets......................................... 35,454,075 39,613,622 11.73 Total deposits......................................... 31,836,948 36,874,787 15.82 Stockholders' equity................................... 3,896,909 3,941,855 1.15 FINANCIAL RATIOS: Return on average assets(4)............................ 1.45% 1.78% Return on average stockholders' equity(4).............. 14.50 19.82 Efficiency ratio(5).................................... 59.44 55.72 Net interest margin(1)................................. 4.41 4.07 Dividend payout ratio.................................. 31.72 25.48 Tangible equity ratio.................................. 8.59 7.88 Tier 1 risk-based capital ratio........................ 11.44 10.46 Total risk-based capital ratio......................... 13.06 13.07 Leverage ratio......................................... 9.63 8.36 Allowance for credit losses to total loans............. 2.17 1.82 Allowance for credit losses to nonaccrual loans........ 147.11 281.60 Net loans charged off to average total loans(4)........ 0.80 0.17 Nonperforming assets to total loans and foreclosed assets.................................... 1.48 0.67 Nonperforming assets to total assets................... 0.89 0.40 ---------------------------------------- (1) Amounts are on a taxable-equivalent basis using the federal statutory tax rate of 35 percent. (2) Dividends per share reflect dividends declared on UnionBanCal Corporation's common stock outstanding as of the declaration date. (3) Common shares outstanding reflects common shares issued less treasury shares. (4) Annualized. (5) The efficiency ratio is noninterest expense, excluding foreclosed asset expense (income), as a percentage of net interest income (taxable-equivalent basis) and noninterest income. Foreclosed asset expense was $0.1 million in the first six months of 2003 and $0.5 million in the first six months of 2004. nm--not meaningful
3 ITEM 1. FINANCIAL STATEMENTS UnionBanCal Corporation and Subsidiaries Condensed Consolidated Statements of Income (Unaudited)
FOR THE THREE MONTHS FOR THE SIX MONTHS ENDED JUNE 30, ENDED JUNE 30, ---------------------- ----------------------- (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 2003 2004 2003 2004 ---------------------------------------------------- ---------- ---------- ---------- ---------- INTEREST INCOME Loans............................................. $ 354,913 $ 328,372 $ 717,888 $ 663,701 Securities........................................ 78,036 108,064 157,899 213,910 Interest bearing deposits in banks................ 1,130 1,121 2,092 2,029 Federal funds sold and securities purchased under resale agreements......................... 4,001 2,928 5,678 4,887 Trading account assets............................ 943 861 1,870 1,418 ---------- ---------- ---------- ---------- Total interest income........................... 439,023 441,346 885,427 885,945 ---------- ---------- ---------- ---------- INTEREST EXPENSE Domestic deposits................................. 40,217 32,123 81,788 65,733 Foreign deposits.................................. 2,811 2,761 6,017 4,893 Federal funds purchased and securities sold under repurchase agreements..................... 747 552 2,074 1,233 Commercial paper.................................. 2,946 1,051 5,674 2,186 Medium and long-term debt......................... 1,818 3,693 3,684 6,832 Preferred securities and trust notes.............. 3,652 130 7,323 2,311 Other borrowed funds.............................. 1,055 1,178 2,310 2,478 ---------- ---------- ---------- ---------- Total interest expense.......................... 53,246 41,488 108,870 85,666 ---------- ---------- ---------- ---------- NET INTEREST INCOME................................. 385,777 399,858 776,557 800,279 (Reversal of) provision for credit losses......... 25,000 (10,000) 55,000 (15,000) ---------- ---------- ---------- ---------- Net interest income after (reversal of) provision for credit losses................... 360,777 409,858 721,557 815,279 ---------- ---------- ---------- ---------- NONINTEREST INCOME Service charges on deposit accounts............... 77,942 90,031 150,229 171,127 Trust and investment management fees.............. 33,141 36,788 65,816 72,610 Insurance commissions............................. 16,024 18,652 29,242 40,387 International commissions and fees................ 16,856 18,102 32,201 35,647 Card processing fees, net......................... 9,340 15,456 19,022 24,248 Foreign exchange gains, net....................... 6,958 8,294 13,892 16,638 Brokerage commissions and fees.................... 8,412 8,023 17,066 16,320 Merchant banking fees............................. 6,191 7,714 12,209 15,181 Securities gains (losses), net.................... 9,660 (4) 9,660 1,618 Other............................................. 18,647 127,954 39,605 148,439 ---------- ---------- ---------- ---------- Total noninterest income........................ 203,171 331,010 388,942 542,215 ---------- ---------- ---------- ---------- NONINTEREST EXPENSE Salaries and employee benefits.................... 198,929 217,597 397,036 437,020 Net occupancy..................................... 32,866 32,173 60,502 63,755 Equipment......................................... 16,354 16,883 33,025 34,154 Communications.................................... 13,354 13,035 27,198 26,445 Software.......................................... 10,849 12,908 22,925 25,903 Professional services............................. 13,566 10,290 25,580 21,593 Foreclosed asset expense.......................... -- 17 51 536 Other............................................. 65,086 73,499 127,287 140,102 ---------- ---------- ---------- ---------- Total noninterest expense....................... 351,004 376,402 693,604 749,508 ---------- ---------- ---------- ---------- Income before income taxes........................ 212,944 364,466 416,895 607,986 Income tax expense................................ 68,186 133,369 136,620 219,402 ---------- ---------- ---------- ---------- NET INCOME.......................................... $ 144,758 $ 231,097 $ 280,275 $ 388,584 ========== ========== ========== ========== NET INCOME PER COMMON SHARE--BASIC.................. $ 0.96 $ 1.56 $ 1.86 $ 2.63 ========== ========== ========== ========== NET INCOME PER COMMON SHARE--DILUTED................ $ 0.96 $ 1.54 $ 1.85 $ 2.59 ========== ========== ========== ========== WEIGHTED AVERAGE COMMON SHARES OUTSTANDING--BASIC................................ 150,047 147,687 150,330 147,544 ========== ========== ========== ========== WEIGHTED AVERAGE COMMON SHARES OUTSTANDING--DILUTED.............................. 151,489 150,184 151,746 149,992 ========== ========== ========== ==========
See accompanying notes to condensed consolidated financial statements. 4
UnionBanCal Corporation and Subsidiaries Condensed Consolidated Balance Sheets (UNAUDITED) (UNAUDITED) JUNE 30, DECEMBER 31, JUNE 30, (DOLLARS IN THOUSANDS) 2003 2003 2004 --------------------------------------------------------- ----------- ------------ ----------- ASSETS Cash and due from banks.................................. $ 3,096,509 $ 2,494,127 $ 2,287,708 Interest bearing deposits in banks....................... 212,746 235,158 630,451 Federal funds sold and securities purchased under resale agreements...................................... 1,624,552 769,720 1,156,650 ----------- ------------ ----------- Total cash and cash equivalents.......................... 4,933,807 3,499,005 4,074,809 Trading account assets................................... 387,928 252,929 307,334 Securities available for sale: Securities pledged as collateral....................... 154,961 106,560 77,532 Held in portfolio...................................... 9,438,110 10,660,332 12,151,635 Loans (net of allowance for credit losses: June 30, 2003, $558,282; December 31, 2003, $532,970; June 30, 2004, $501,419)............................... 25,110,378 25,411,658 27,092,852 Due from customers on acceptances........................ 81,560 71,078 52,867 Premises and equipment, net.............................. 498,708 509,734 502,204 Intangible assets........................................ 46,240 49,592 56,696 Goodwill................................................. 178,591 226,556 315,356 Other assets............................................. 1,838,551 1,711,023 1,664,546 ----------- ------------ ----------- Total assets........................................... $42,668,834 $ 42,498,467 $46,295,831 =========== ============ =========== LIABILITIES Domestic deposits: Noninterest bearing.................................... $17,198,024 $ 16,668,773 $19,255,245 Interest bearing....................................... 16,494,167 17,146,858 17,982,340 Foreign deposits: Noninterest bearing.................................... 490,314 619,249 733,394 Interest bearing....................................... 1,182,755 1,097,403 1,396,932 ----------- ------------ ----------- Total deposits....................................... 35,365,260 35,532,283 39,367,911 Federal funds purchased and securities sold under repurchase agreements................................. 337,785 280,968 294,597 Commercial paper......................................... 835,268 542,270 552,038 Other borrowed funds..................................... 238,239 212,088 180,426 Acceptances outstanding.................................. 81,560 71,078 52,867 Other liabilities........................................ 1,160,744 934,916 1,042,311 Medium and long-term debt................................ 420,853 820,488 800,988 Junior subordinated debt payable to subsidiary grantor trust......................................... -- 363,940 16,017 UnionBanCal Corporation--obligated mandatorily redeemable preferred securities of subsidiary grantor trust.......................................... 360,166 -- -- ----------- ------------ ----------- Total liabilities........................................ 38,799,875 38,758,031 42,307,155 ----------- ------------ ----------- Commitments and contingencies STOCKHOLDERS' EQUITY Preferred stock: Authorized 5,000,000 shares, no shares issued or outstanding as of June 30, 2003, December 31, 2003, and June 30, 2004.................................... -- -- -- Common stock, no stated value per share at June 30, 2003, and par value of $1 per share at December 31, 2003 and June 30, 2004(1): Authorized 300,000,000 shares, issued 149,993,652 shares as of June 30, 2003, 146,000,156 shares as of December 31, 2003, and 149,126,860 shares as of June 30, 2004..................................... 894,979 146,000 149,127 Additional paid-in capital............................... -- 555,156 712,255 Treasury stock--242,000 shares as of December 31, 2003 and 1,281,700 shares as of June 30, 2004.......... -- (12,846) (68,557) Retained earnings........................................ 2,783,314 2,999,884 3,289,676 Accumulated other comprehensive income (loss)............ 190,666 52,242 (93,825) ----------- ------------ ----------- Total stockholders' equity............................... 3,868,959 3,740,436 3,988,676 ----------- ------------ ----------- Total liabilities and stockholders' equity............... $42,668,834 $ 42,498,467 $46,295,831 =========== ============ =========== ------------------------------ (1) On September 30, 2003, UnionBanCal Corporation changed its state of incorporation from California to Delaware, establishing a par value of $1 per share of common stock.
See accompanying notes to condensed consolidated financial statements. 5
UnionBanCal Corporation and Subsidiaries Condensed Consolidated Statements of Changes in Stockholders' Equity (Unaudited) ACCUMULATED TOTAL ADDITIONAL OTHER STOCK- NUMBER COMMON PAID-IN TREASURY RETAINED COMPREHENSIVE HOLDERS' (IN THOUSANDS, EXCEPT SHARES) OF SHARES STOCK(1) CAPITAL STOCK EARNINGS INCOME (LOSS) EQUITY ------------------------------- ----------- -------- ---------- -------- ---------- -------------- ---------- BALANCE DECEMBER 31, 2002...... 150,702,363 $926,460 $ -- $ -- $2,591,635 $ 240,094 $3,758,189 -------- ---------- -------- ---------- -------------- ---------- Comprehensive income Net income--For the six months ended June 30, 2003. 280,275 280,275 Other comprehensive income, net of tax: Net change in unrealized gains on cash flow hedges (7,985) (7,985) Net change in unrealized gains on securities available for sale....... (41,561) (41,561) Foreign currency transla- tion adjustment.......... 118 118 ---------- Total comprehensive income..... 230,847 Dividend reinvestment plan..... 5,047 24 24 Deferred compensation - restricted stock awards...... -- -- 111 111 Stock options exercised........ 402,078 13,324 13,324 Common stock repurchased(2).... (1,115,836) (44,829) (44,829) Dividends declared on common stock, $0.59 per share(3).... (88,707) (88,707) -------- ---------- -------- ---------- -------------- ---------- Net change..................... (31,481) -- -- 191,679 (49,428) 110,770 ----------- -------- ---------- -------- ---------- -------------- ---------- BALANCE JUNE 30, 2003.......... 149,993,652 $894,979 $ -- $ -- $2,783,314 $ 190,666 $3,868,959 =========== ======== ========== ======== ========== ============== ========== BALANCE DECEMBER 31, 2003.... 146,000,156 $146,000 $ 555,156 $(12,846) $2,999,884 $ 52,242 $3,740,436 -------- ---------- -------- ---------- -------------- ---------- Comprehensive income Net income--For the six months ended June 30, 2004. 388,584 388,584 Other comprehensive income, net of tax: Net change in unrealized gains on cash flow hedges (37,753) (37,753) Net change in unrealized losses on securities available for sale....... (108,834) (108,834) Foreign currency transla- tion adjustment.......... 520 520 ---------- Total comprehensive income..... 242,517 Dividend reinvestment plan..... 308 -- 17 17 Deferred compensation - restricted stock awards...... -- -- 130 130 Stock options exercised........ 1,117,677 1,118 44,687 45,805 Stock issued in acquisitions... 2,008,719 2,009 112,569 114,578 Common stock repurchased(2).... -- -- (174) (55,711) (55,885) Dividends declared on common stock, $0.67 per share(3).... (98,922) (98,922) -------- ---------- -------- ---------- -------------- ---------- Net change..................... 3,127 157,082 (55,711) 289,792 (146,067) 248,240 ----------- -------- ---------- -------- ---------- -------------- ---------- BALANCE JUNE 30, 2004.......... 149,126,860 $149,127 $ 712,255 $(68,557) $3,289,676 $ (93,825) $3,988,676 =========== ======== ========== ======== ========== ============== ========== --------------------------- (1) On September 30, 2003, UnionBanCal Corporation changed its state of incorporation from California to Delaware, establishing a par value of $1 per share of common stock. (2) Common stock repurchased includes commission costs. All repurchases subsequent to September 29, 2003, are reflected in Treasury Stock. (3) Dividends are based on UnionBanCal Corporation's shares outstanding as of the declaration date.
See accompanying notes to condensed consolidated financial statements. 6
UnionBanCal Corporation and Subsidiaries Condensed Consolidated Statements of Cash Flows (Unaudited) FOR THE SIX MONTHS ENDED JUNE 30, ------------------------- (DOLLARS IN THOUSANDS) 2003 2004 --------------------------------------------------------------------- ---------- ---------- CASH FLOWS FROM OPERATING ACTIVITIES: Net income......................................................... $ 280,275 $ 388,584 Adjustments to reconcile net income to net cash provided by (used in) operating activities: (Reversal of) provision for credit losses........................ 55,000 (15,000) Depreciation, amortization and accretion......................... 61,742 66,191 Provision for deferred income taxes.............................. 44,876 36,430 Gains on securities available for sale........................... (9,660) (1,618) Net increase in prepaid expenses................................. (83,845) (85,933) Net (increase) decrease in fees and other charges receivable..... (94,140) 40,498 Net increase (decrease) in accrued expenses and other liabilities 45,635 92,632 Net (increase) decrease in other assets, net of acquisitions..... (105,724) 255,613 Net increase in trading account assets........................... (111,907) (54,405) Loans originated for resale...................................... (80,608) (263,412) Net proceeds from sale of loans originated for resale............ 127,629 227,434 Other, net....................................................... 25,987 4,610 ---------- ---------- Total adjustments................................................ (125,015) 303,040 ---------- ---------- Net cash provided by (used in) operating activities................ 155,260 691,624 ---------- ---------- CASH FLOWS FROM INVESTING ACTIVITIES: Proceeds from sales of securities available for sale............... 35,978 9,970 Proceeds from matured and called securities available for sale..... 1,506,572 2,004,222 Purchases of securities available for sale......................... (3,907,936) (3,664,523) Net (increase) decrease in loans, net of acquisitions.............. 598,059 (1,213,276) Net cash used in acquisitions...................................... (29,860) (2,287) Other, net......................................................... (46,405) (36,533) ---------- ---------- Net cash provided by (used in) investing activities.............. (1,843,592) (2,902,427) ---------- ---------- CASH FLOWS FROM FINANCING ACTIVITIES: Net increase (decrease) in deposits, net of acquisitions........... 2,524,445 3,255,271 Net increase (decrease) in federal funds purchased and securities sold under repurchase agreements................................. 3,406 13,629 Net decrease in commercial paper and other borrowed funds.......... (232,522) (21,894) Repayment of junior subordinated debt.............................. -- (360,825) Common stock repurchased........................................... (44,829) (55,885) Payments of cash dividends......................................... (84,413) (90,925) Other, net......................................................... 13,466 46,342 ---------- ---------- Net cash provided by (used in) financing activities.............. 2,179,553 2,785,713 Net increase (decrease) in cash and cash equivalents................. 491,221 574,910 Cash and cash equivalents at beginning of period..................... 4,442,122 3,499,005 Effect of exchange rate changes on cash and cash equivalents......... 464 894 ---------- ---------- Cash and cash equivalents at end of period........................... $4,933,807 $4,074,809 ========== ========== CASH PAID DURING THE PERIOD FOR: Interest........................................................... $ 117,463 $ 88,860 Income taxes....................................................... 51,197 95,764 SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING AND FINANCING ACTIVITIES: Acquisitions: Fair value of assets acquired.................................... $ 47,988 $ 803,713 Purchase price: Cash........................................................... (40,300) (21,772) Stock issued................................................... -- (114,578) ---------- ---------- Liabilities assumed.............................................. $ 7,688 $ 667,363 ========== ==========
See accompanying notes to condensed consolidated financial statements. 7 UnionBanCal Corporation and Subsidiaries Notes to Condensed Consolidated Financial Statements NOTE 1--BASIS OF PRESENTATION AND NATURE OF OPERATIONS The unaudited condensed consolidated financial statements of UnionBanCal Corporation and subsidiaries (the Company) have been prepared in accordance with accounting principles generally accepted in the United States of America (U.S. GAAP) for interim financial reporting and the instructions to Form 10-Q and Rule 10-01 of Regulation S-X of the Rules and Regulations of the Securities and Exchange Commission. However, they do not include all of the disclosures necessary for annual financial statements in conformity with U.S. GAAP. The results of operations for the period ended June 30, 2004 are not necessarily indicative of the operating results anticipated for the full year. Accordingly, these unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements included in the Company's Form 10-K for the year ended December 31, 2003. The preparation of financial statements in conformity with U.S. GAAP also requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expense during the reporting period. Actual results could differ from those estimates. UnionBanCal Corporation is a commercial bank holding company and has, as its major subsidiary, a banking subsidiary, Union Bank of California, N.A. (the Bank). The Company provides a wide range of financial services to consumers, small businesses, middle-market companies and major corporations, primarily in California, Oregon, and Washington, but also nationally and internationally. Since November 1999 through June 30, 2004, the Company has announced stock repurchase plans totaling $700 million and as of June 30, 2004 has repurchased $454 million of common stock under these repurchase plans. The Company repurchased $58 million, $44 million, and $12 million of common stock in 2003, the first quarter of 2004, and the second quarter of 2004, respectively, as part of these repurchase plans. As of June 30, 2004, $246 million of the Company's common stock is authorized for repurchase. Under separate stock repurchase agreements, the Company purchased $600 million of its common stock, $300 million in August 2002 and $300 million in September 2003, from its majority owner, The Bank of Tokyo-Mitsubishi, Ltd. (BTM), which is a wholly-owned subsidiary of Mitsubishi Tokyo Financial Group, Inc. At June 30, 2004, BTM owned approximately 62 percent of the Company's outstanding common stock. Certain amounts for prior periods have been reclassified to conform to current financial statement presentation. STOCK-BASED COMPENSATION As allowed under the provisions of Statement of Financial Accounting Standards (SFAS) No. 123, "Accounting for Stock-Based Compensation," as amended, the Company has chosen to continue to recognize compensation expense using the intrinsic value-based method of valuing stock options prescribed in Accounting Principles Board Opinion (APB) No. 25, "Accounting for Stock Issued to Employees" and related Interpretations. Under the intrinsic value-based method, compensation cost is measured as the amount by which the quoted market price of the Company's stock at the date of grant exceeds the stock option exercise price. At June 30, 2004, the Company has two stock-based employee compensation plans. For further discussion concerning our stock-based employee compensation plans see Note 14--"Management Stock Plan" of the Notes to Consolidated Financial Statements included in the Form 10-K for the year ended December 31, 2003. The value of the restricted stock awards issued under the plans has been reflected in compensation expense. Options granted under the plans had an exercise price equal to the market value of 8 UnionBanCal Corporation and Subsidiaries Notes to Condensed Consolidated Financial Statements (Continued) NOTE 1--BASIS OF PRESENTATION AND NATURE OF OPERATIONS (CONTINUED) the underlying common stock on the date of grant and, therefore, were not included in compensation expense as allowed by current U.S. GAAP. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123 to stock-based employee compensation.
FOR THE THREE MONTHS FOR THE SIX MONTHS ENDED JUNE 30, ENDED JUNE 30, -------------------- -------------------- (DOLLARS IN THOUSANDS) 2003 2004 2003 2004 ----------------------------------------------------- -------- -------- -------- -------- AS REPORTED NET INCOME............................... $144,758 $231,097 $280,275 $388,584 Stock option-based employee compensation expense (determined under fair value based method for all awards, net of taxes).......................... (6,527) (6,683) (12,483) (13,215) -------- -------- -------- -------- Pro forma net income, after stock option-based employee compensation expense...................... $138,231 $224,414 $267,792 $375,369 ======== ======== ======== ======== EARNINGS PER SHARE--BASIC As reported.......................................... $ 0.96 $ 1.56 $ 1.86 $ 2.63 Pro forma............................................ $ 0.92 $ 1.52 $ 1.78 $ 2.54 EARNINGS PER SHARE--DILUTED As reported.......................................... $ 0.96 $ 1.54 $ 1.85 $ 2.59 Pro forma............................................ $ 0.91 $ 1.49 $ 1.76 $ 2.50
Compensation cost associated with the Company's unvested restricted stock issued under the management stock plan is measured based on the market price of the stock at the grant date and is expensed over the vesting period. Compensation expense related to restricted stock awards for the second quarters of 2003 and 2004 was not significant. NOTE 2--RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS ACCOUNTING FOR ASSET RETIREMENT OBLIGATIONS In June 2001, the Financial Accounting Standards Board (FASB) issued SFAS No. 143, "Accounting for Asset Retirement Obligations." This Statement addresses the financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. It requires an entity to record a liability for an obligation associated with the retirement of an asset at the time the liability is incurred by capitalizing the cost as part of the carrying value of the related asset and depreciating it over the remaining useful life of the asset. This Statement was effective for the Company on January 1, 2003 and did not have a material impact on the Company's financial position or results of operations. ACCOUNTING FOR COSTS ASSOCIATED WITH EXIT OR DISPOSAL ACTIVITIES In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities." This Statement replaces the accounting and reporting provisions of Emerging Issues Task Force (EITF) Issue No. 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)." It requires that costs associated with an exit or disposal activity be recognized when a liability is incurred rather than at the date 9 UnionBanCal Corporation and Subsidiaries Notes to Condensed Consolidated Financial Statements (Continued) NOTE 2--RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS (CONTINUED) an entity commits to an exit plan. This Statement was effective on January 1, 2003 and did not have a material impact on the Company's financial position or results of operations. ACCOUNTING FOR GUARANTORS AND DISCLOSURE REQUIREMENTS FOR GUARANTEES, INCLUDING INDIRECT GUARANTEES OF INDEBTEDNESS OF OTHERS In November 2002, the FASB issued Interpretation No. 45 (FIN 45), "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others." The Interpretation elaborates on the existing disclosure requirements for most guarantees and requires that guarantors recognize a liability for the fair value of certain guarantees at inception. The disclosure requirements of this Interpretation were effective for financial statements ending after December 15, 2002. The initial recognition and measurement provisions of this Interpretation were applied on a prospective basis to guarantees issued or modified after December 31, 2002. The adoption of this Interpretation did not have a material impact on the Company's financial position or results of operations. ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities." This Statement amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities under SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." SFAS No. 149 was effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003. The provisions of the Statement, with certain exceptions, are required to be applied prospectively. The adoption of this Statement did not have a material impact on the Company's financial position or results of operations. ACCOUNTING FOR CERTAIN FINANCIAL INSTRUMENTS WITH CHARACTERISTICS OF BOTH LIABILITIES AND EQUITY In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity." The Statement establishes standards for how the Company should classify and measure certain financial instruments with characteristics of both liabilities and equity. This Statement was effective for financial instruments entered into or modified after May 31, 2003, and to other instruments effective at the beginning of the first interim period beginning after June 15, 2003. Adoption of this Statement did not have a material impact on the Company's financial position or results of operations. CONSOLIDATION OF VARIABLE INTEREST ENTITIES In January 2003, the FASB issued Interpretation No. 46 (FIN 46), "Consolidation of Variable Interest Entities". FIN 46 provides guidance on how to identify a variable interest entity (VIE), and when the assets, liabilities, noncontrolling interests and result of operations of a VIE need to be included in a company's consolidated financial statements. A VIE exists when either the total equity investment at risk is not sufficient to permit the entity to finance its activities by itself, or the equity investors lack a controlling financial interest or they have voting rights that are not proportionate to their economic interest. A company that holds variable interests in an entity will need to consolidate that entity if the company's interest in the VIE is such that the company will absorb a majority of the VIE's expected losses and/or 10 UnionBanCal Corporation and Subsidiaries Notes to Condensed Consolidated Financial Statements (Continued) NOTE 2--RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS (CONTINUED) receive a majority of the VIE's expected residual returns, if they occur. FIN 46 also requires additional disclosures by primary beneficiaries and other significant variable interest holders. In December 2003, the FASB issued FIN 46R, a revision of FIN 46. FIN 46R clarifies that only the holder of a variable interest can ever be a VIE's primary beneficiary. FIN 46R delays the effective date of FIN 46 for all entities created subsequent to January 31, 2003 and non-SPE's (special-purpose entities) created prior to February 1, 2003 to reporting periods ending after March 15, 2004. Entities created prior to February 1, 2004 and defined as SPE's must apply either the provisions of FIN 46 or early adopt the provisions of FIN 46R by the first reporting period ending after December 15, 2003. The adoption of FIN 46R on January 1, 2004 did not have a material impact on the Company's financial position or results of operations. ACCOUNTING FOR EMPLOYERS' DISCLOSURES ABOUT PENSIONS AND OTHER POSTRETIREMENT BENEFITS In December 2003, the FASB issued SFAS No. 132R, a revision of SFAS No. 132, "Employers' Disclosures about Pensions and Other Postretirement Benefits, an amendment of FASB Statements No. 87, 88, and 106." The Statement expands the disclosure requirements of SFAS No. 132 to include information describing types of plan assets, investment strategy, measurement date(s), plan obligations, cash flows, and components of net period benefit costs of defined pension plans and other defined benefit postretirement plans. The Statement is effective for financial statements with fiscal years ending after December 15, 2003. The expanded disclosures required by SFAS No. 132R are disclosed in Note 7 of the Notes to Consolidated Financial Statements in the Form 10-K for the year ended December 31, 2003. Periodic disclosures under SFAS No. 132R are contained in Note 8 of this report. ACCOUNTING FOR CERTAIN LOANS ACQUIRED IN A TRANSFER In December 2003, under clearance of the FASB, the Accounting Standards Executive Committee (AcSEC) of the AICPA issued Statement of Position (SOP) 03-3, "Accounting for Certain Loans or Debt Securities Acquired in a Transfer." This SOP establishes accounting standards for discounts on purchased loans when the discount is attributable to credit quality. The SOP requires that the loan discount, rather than contractual amounts, establishes the investor's estimate of undiscounted expected future principal and interest cash flows as a benchmark for yield and impairment measurements. The SOP prohibits the carryover or creation of a valuation allowance in the initial accounting for these loans. This SOP is effective for loans acquired in years ending after December 15, 2004. Management believes that adoption of this Statement will not have a material impact on the Company's financial position or results of operations at adoption. THE MEANING OF OTHER-THAN-TEMPORARY IMPAIRMENT AND ITS APPLICATION TO CERTAIN INVESTMENTS In March 2004, the Emerging Issues Task Force (EITF) reached consensus on certain incremental issues related to Issue No. 03-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments." In addition to disclosure requirements that were effective for fiscal years ending after December 15, 2003, EITF Issue No. 03-1 requires that companies recognize impairment equal to the difference between the investment's cost and fair value if the investor does not have the ability and intent to hold the investment for a period of time sufficient for a forecasted recovery of fair value up to or beyond the cost of the investment. EITF Issue No. 03-1 is effective for interim periods beginning after June 15, 11 UnionBanCal Corporation and Subsidiaries Notes to Condensed Consolidated Financial Statements (Continued) NOTE 2--RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS (CONTINUED) 2004. The Company is currently assessing the implications of EITF No. 03-1 and has not concluded what impact, if any, will result from its adoption. NOTE 3--EARNINGS PER SHARE Basic earnings per share (EPS) is computed by dividing net income by the weighted average number of common shares outstanding during the period. Diluted EPS incorporates the dilutive effect of common stock equivalents outstanding on an average basis during the period. Stock options are a common stock equivalent. The following table presents a reconciliation of basic and diluted EPS for the three months and six months ended June 30, 2003 and 2004.
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30, ------------------------------------- ------------------------------------ 2003 2004 2003 2004 ----------------- ----------------- ----------------- ----------------- (AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA) BASIC DILUTED BASIC DILUTED BASIC DILUTED BASIC DILUTED ------------------------- -------- -------- -------- -------- -------- -------- -------- -------- Net Income............... $144,758 $144,758 $231,097 $231,097 $280,275 $280,275 $388,584 $388,584 ======== ======== ======== ======== ======== ======== ======== ======== Weighted average common shares outstanding..... 150,047 150,047 147,687 147,687 150,330 150,330 147,544 147,544 Additional shares due to: Assumed conversion of dilutive stock options. -- 1,442 -- 2,497 -- 1,416 -- 2,448 -------- -------- -------- -------- -------- -------- -------- -------- Adjusted weighted average common shares outstanding............ 150,047 151,489 147,687 150,184 150,330 151,746 147,544 149,992 ======== ======== ======== ======== ======== ======== ======== ======== Net income per share..... $ 0.96 $ 0.96 $ 1.56 $ 1.54 $ 1.86 $ 1.85 $ 2.63 $ 2.59 ======== ======== ======== ======== ======== ======== ======== ========
12 UnionBanCal Corporation and Subsidiaries Notes to Condensed Consolidated Financial Statements (Continued) NOTE 4--ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS) The following table presents the components of other comprehensive income (loss) and the related tax effect allocated to each component.
BEFORE TAX TAX NET OF (DOLLARS IN THOUSANDS) AMOUNT EFFECT TAX ------------------------------------------------------ ---------- --------- --------- FOR THE SIX MONTHS ENDED JUNE 30, 2003: Cash flow hedge activities: Unrealized net gains on hedges...................... $ 58,272 $ (22,289) $ 35,983 Less: reclassification adjustment for net gains on hedges included in net income.................. (71,204) 27,236 (43,968) ---------- --------- --------- Net change in unrealized gains on hedges.............. (12,932) 4,947 (7,985) ---------- --------- --------- Securities available for sale: Unrealized holding losses arising during the period on securities available for sale........... (57,645) 22,049 (35,596) Less: reclassification adjustment for net gains on securities available for sale included in net income........................................ (9,660) 3,695 (5,965) ---------- --------- --------- Net change in unrealized gains on securities available for sale.................................. (67,305) 25,744 (41,561) ---------- --------- --------- Foreign currency translation adjustment............... 191 (73) 118 ---------- --------- --------- Net change in accumulated other comprehensive income (loss)....................................... $ (80,046) $ 30,618 $ (49,428) ========== ========= ========= FOR THE SIX MONTHS ENDED JUNE 30, 2004: Cash flow hedge activities: Unrealized net losses on hedges..................... $ (15,832) $ 6,056 $ (9,776) Less: reclassification adjustment for net gains on hedges included in net income.................. (45,307) 17,330 (27,977) ---------- --------- --------- Net change in unrealized gains on hedges.............. (61,139) 23,386 (37,753) ---------- --------- --------- Securities available for sale: Unrealized holding losses arising during the period on securities available for sale........... (174,632) 66,797 (107,835) Less: reclassification adjustment for net gains on securities available for sale included in net income........................................ (1,618) 619 (999) ---------- --------- --------- Net change in unrealized losses on securities available for sale.................................. (176,250) 67,416 (108,834) ---------- --------- --------- Foreign currency translation adjustment............... 842 (322) 520 ---------- --------- --------- Net change in accumulated other comprehensive income (loss)....................................... $ (236,547) $ 90,480 $(146,067) ========== ========= =========
13 UnionBanCal Corporation and Subsidiaries Notes to Condensed Consolidated Financial Statements (Continued) NOTE 4--ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS)(CONTINUED) The following table presents accumulated other comprehensive income (loss) balances.
NET NET UNREALIZED UNREALIZED GAINS (LOSSES) GAINS (LOSSES) FOREIGN MINIMUM ACCUMULATED ON CASH ON SECURITES CURRENCY PENSION OTHER FLOW AVAILABLE TRANSLATION LIABILITY COMPREHENSIVE (DOLLARS IN THOUSANDS) HEDGES FOR SALE ADJUSTMENT ADJUSTMENT INCOME (LOSS) ------------------------------- ------------- ------------- ----------- ---------- ------------- BALANCE, DECEMBER 31, 2002..... $ 104,368 $ 147,450 $ (10,649) $ (1,075) $ 240,094 Change during the period....... (7,985) (41,561) 118 -- (49,428) ------------- ------------- ----------- ---------- ------------- BALANCE, JUNE 30, 2003......... $ 96,383 $ 105,889 $ (10,531) $ (1,075) $ 190,666 ============= ============= =========== ========== ============= BALANCE, DECEMBER 31, 2003..... $ 43,786 $ 22,535 $ (10,293) $ (3,786) $ 52,242 Change during the period....... (37,753) (108,834) 520 -- (146,067) ------------- ------------- ----------- ---------- ------------- BALANCE, JUNE 30, 2004......... $ 6,033 $ (86,299) $ (9,773) $ (3,786) $ (93,825) ============= ============= =========== ========== =============
NOTE 5--BUSINESS SEGMENTS The Company is organized based on the products and services that it offers and operates in four principal areas: o The Community Banking and Investment Services Group offers a range of banking services, primarily to individuals and small businesses, delivered generally through a tri-state (California, Washington and Oregon) network of branches and ATM's. These services include commercial loans, mortgages, home equity lines of credit, consumer loans, deposit services and cash management as well as fiduciary, private banking, investment and asset management services for individuals and institutions, and risk management and insurance products for businesses and individuals. o The Commercial Financial Services Group provides credit and cash management services to large corporate and middle-market companies. Services include commercial and project loans, real estate financing, asset-based financing, trade finance and letters of credit, lease financing, customized cash management services and selected capital markets products. o The International Banking Group primarily provides correspondent banking and trade-finance products and services to financial institutions. The group's revenue predominately relates to foreign customers. o The Global Markets Group is responsible for the Company's market risk management including liquidity, interest rate and price risks, and offers a broad range of risk management and trading products and services to the Company's clients through the groups described above. The information, set forth in the tables on the following pages, reflects selected income statement and balance sheet items by business unit. The information presented does not necessarily represent the business units' financial condition and results of operations were they independent entities. Unlike financial accounting, there is no authoritative body of guidance for management accounting equivalent to U.S. GAAP. Consequently, reported results are not necessarily comparable with those presented by other companies. Included in the total asset line of the table are the amounts of goodwill for each reporting unit 14 UnionBanCal Corporation and Subsidiaries Notes to Condensed Consolidated Financial Statements (Continued) NOTE 5--BUSINESS SEGMENTS (CONTINUED) as of June 30, 2003 and 2004. Substantially all of the goodwill reflected on the Consolidated Balance Sheet is attributed to the Community Banking and Investment Services Group. The information in these tables is derived from the internal management reporting system used by management to measure the performance of the business segments and the Company overall. The management reporting system assigns balance sheet and income statement items to each business segment based on internal management accounting policies. Net interest income is determined by the Company's internal funds transfer pricing system, which assigns a cost of funds or a credit for funds to assets or liabilities based on their type, maturity or repricing characteristics. Noninterest income and expense directly attributable to a business segment are assigned to that business. Certain indirect costs, such as operations and technology expense, are allocated to the segments based on studies of billable unit costs for product or data processing. Other indirect costs, such as corporate overhead, are allocated to the business segments based on a predetermined percentage of usage. Under the Company's risk-adjusted return on capital (RAROC) methodology, credit expense is charged to business segments based upon expected losses arising from credit risk. In addition, the attribution of economic capital is related to unexpected losses arising from credit, market and operational risks. "Other" is comprised of certain parent company non-bank subsidiaries, the elimination of the fully taxable-equivalent basis amount, the amount of the (reversal of) provision for credit losses over/(under) the RAROC expected loss for the period, the earnings associated with the unallocated equity capital and allowance for credit losses, and the residual costs of support groups. In addition, it includes the Pacific Rim Corporate Group, which offers financial products to Japanese-owned subsidiaries located in the U.S. On an individual basis, none of the items in "Other" are significant to the Company's business. Included in noninterest income for the second quarter of 2004 are two significant items: a $93.0 million gain resulting from the sale of the Company's merchant card portfolio and an $8.5 million gain resulting from the sale of real property. 15 UnionBanCal Corporation and Subsidiaries Notes to Condensed Consolidated Financial Statements (Continued) NOTE 5--BUSINESS SEGMENTS (CONTINUED) The business units' results for the prior periods have been restated to reflect changes in the transfer pricing methodology and any reorganization changes that may have occurred.
COMMUNITY BANKING AND INVESTMENT COMMERCIAL FINANCIAL INTERNATIONAL SERVICES GROUP SERVICES GROUP BANKING GROUP --------------------------------------------------------------- AS OF AND FOR THE THREE MONTHS ENDED JUNE 30, --------------------------------------------------------------- 2003 2004 2003 2004 2003 2004 -------------------------------- -------- -------- -------- -------- ------- ------- RESULTS OF OPERATIONS (DOLLARS IN THOUSANDS): Net interest income............. $163,613 $185,829 $180,956 $191,471 $ 8,160 $ 9,222 Noninterest income.............. 111,878 129,793 61,552 72,543 26,090 22,261 -------- -------- -------- -------- ------- ------- Total revenue................... 275,491 315,622 242,508 264,014 34,250 31,483 Noninterest expense............. 197,289 223,645 105,097 104,003 15,398 16,957 Credit expense (income)......... 8,064 7,797 42,145 26,480 547 645 -------- -------- -------- -------- ------- ------- Income (loss) before income tax expense (benefit)............. 70,138 84,180 95,266 133,531 18,305 13,881 Income tax expense (benefit).... 26,828 32,199 29,547 45,321 7,001 5,310 -------- -------- -------- -------- ------- ------- Net income (loss)............... $ 43,310 $ 51,981 $ 65,719 $ 88,210 $11,304 $ 8,571 ======== ======== ======== ======== ======= ======= TOTAL ASSETS, END OF PERIOD (dollars in millions):........ $ 12,249 $ 14,040 $ 14,976 $ 14,852 $ 1,937 $ 2,379 ======== ======== ======== ======== ======= =======
GLOBAL UNIONBANCAL MARKETS GROUP OTHER CORPORATION ------------------- ------------------- ------------------- AS OF AND FOR THE THREE MONTHS ENDED JUNE 30, ---------------------------------------------------------------- 2003 2004 2003 2004 2003 2004 -------------------------------- -------- -------- -------- -------- -------- -------- RESULTS OF OPERATIONS (DOLLARS IN THOUSANDS): Net interest income............. $ 17,139 $(15,802) $ 15,909 $ 29,138 $385,777 $399,858 Noninterest income.............. 1,882 1,394 1,769 105,019 203,171 331,010 -------- -------- -------- -------- -------- -------- Total revenue................... 19,021 (14,408) 17,678 134,157 588,948 730,868 Noninterest expense............. 3,744 4,441 29,476 27,356 351,004 376,402 Credit expense (income)......... 50 177 (25,806) (45,099) 25,000 (10,000) -------- -------- -------- -------- -------- -------- Income (loss) before income tax expense (benefit)............. 15,227 (19,026) 14,008 151,900 212,944 364,466 Income tax expense (benefit).... 5,824 (7,277) (1,014) 57,816 68,186 133,369 -------- -------- -------- -------- -------- -------- Net income (loss)............... $ 9,403 $(11,749) $ 15,022 $ 94,084 $144,758 $231,097 ======== ======== ======== ======== ======== ======== TOTAL ASSETS, END OF PERIOD (dollars in millions):........ $ 11,824 $ 13,957 $ 1,683 $ 1,068 $ 42,669 $ 46,296 ======== ======== ======== ======== ======== ========
16 UnionBanCal Corporation and Subsidiaries Notes to Condensed Consolidated Financial Statements (Continued) NOTE 5--BUSINESS SEGMENTS (CONTINUED)
COMMUNITY BANKING COMMERCIAL AND INVESTMENT FINANCIAL INTERNATIONAL SERVICES GROUP SERVICES GROUP BANKING GROUP ------------------- ------------------- ------------------ AS OF AND FOR THE SIX MONTHS ENDED JUNE 30, --------------------------------------------------------------- 2003 2004 2003 2004 2003 2004 -------------------------------- -------- -------- -------- -------- ------- ------- RESULTS OF OPERATIONS (DOLLARS IN THOUSANDS): Net interest income............. $331,474 $368,496 $360,187 $374,978 $17,117 $17,030 Noninterest income.............. 213,503 246,394 119,464 142,170 41,573 40,450 -------- -------- -------- -------- ------- ------- Total revenue................... 544,977 614,890 479,651 517,148 58,690 57,480 Noninterest expense............. 397,179 442,629 203,856 208,645 30,333 32,640 Credit expense (income)......... 15,783 15,584 84,607 57,706 1,052 1,249 -------- -------- -------- -------- ------- ------- Income (loss) before income tax expense (benefit)............. 132,015 156,677 191,188 250,797 27,305 23,591 Income tax expense (benefit).... 50,496 59,929 60,227 83,570 10,444 9,024 -------- -------- -------- -------- ------- ------- Net income (loss)............... $ 81,519 $ 96,748 $130,961 $167,227 $16,861 $14,567 ======== ======== ======== ======== ======= ======= TOTAL ASSETS, END OF PERIOD (dollars in millions):........ $ 12,249 $ 14,040 $ 14,976 $ 14,852 $ 1,937 $ 2,379 ======== ======== ======== ======== ======= =======
GLOBAL UNIONBANCAL MARKETS GROUP OTHER CORPORATION ------------------- ------------------- --------------------- AS OF AND FOR THE SIX MONTHS ENDED JUNE 30, ------------------------------------------------------------------ 2003 2004 2003 2004 2003 2004 -------------------------------- -------- -------- -------- -------- ---------- ---------- RESULTS OF OPERATIONS (DOLLARS IN THOUSANDS): Net interest income............. $ 38,231 $(14,651) $ 29,548 $ 54,426 $ 776,557 $ 800,279 Noninterest income.............. 3,408 2,936 10,994 110,265 388,942 542,215 -------- -------- -------- -------- ---------- ---------- Total revenue................... 41,639 (11,715) 40,542 164,691 1,165,499 1,342,494 Noninterest expense............. 8,232 10,868 54,004 54,726 693,604 749,508 Credit expense (income)......... 100 227 (46,542) (89,766) 55,000 (15,000) -------- -------- -------- -------- ---------- ---------- Income (loss) before income tax expense (benefit)............. 33,307 (22,810) 33,080 199,731 416,895 607,986 Income tax expense (benefit).... 12,740 (8,725) 2,713 75,604 136,620 219,402 -------- -------- -------- -------- ---------- ---------- Net income (loss)............... $ 20,567 $(14,085) $ 30,367 $124,127 $ 280,275 $ 388,584 ======== ======== ======== ======== ========== ========== TOTAL ASSETS, END OF PERIOD (dollars in millions):........ $ 11,824 $ 13,957 $ 1,683 $ 1,068 $ 42,669 $ 46,296 ======== ======== ======== ======== ========== ==========
NOTE 6--DERIVATIVE INSTRUMENTS AND OTHER FINANCIAL INSTRUMENTS USED FOR HEDGING Derivative positions are integral components of the Company's designated asset and liability management activities. The Company uses interest rate derivatives to manage the sensitivity of the Company's net interest income to changes in interest rates. These instruments are used to manage interest rate risk relating to specified groups of assets and liabilities, primarily LIBOR-based commercial loans, certificates of deposit, medium-term notes and subordinated debt. CASH FLOW HEDGES HEDGING STRATEGIES FOR VARIABLE RATE LOANS AND CERTIFICATES OF DEPOSIT The Company engages in several types of cash flow hedging strategies for which the hedged transactions are forecasted future loan interest payments, and the hedged risk is the variability in those 17 UnionBanCal Corporation and Subsidiaries Notes to Condensed Consolidated Financial Statements (Continued) NOTE 6--DERIVATIVE INSTRUMENTS AND OTHER FINANCIAL INSTRUMENTS USED FOR HEDGING (CONTINUED) payments due to changes in the designated benchmark rate, e.g., U.S. dollar LIBOR. In these strategies, the hedging instruments are matched with groups of variable rate loans such that the tenor of the variable rate loans and that of the hedging instrument is identical. Cash flow hedging strategies include the utilization of purchased floor, cap, corridor options and interest rate swaps. At June 30, 2004, the weighted average remaining life of these cash flow hedges was approximately 1.2 years. The Company uses purchased interest rate floors to hedge the variable cash flows associated with 1-month LIBOR or 3-month LIBOR indexed loans. Payments received under the floor contract offset the decline in loan interest income caused by the relevant LIBOR index falling below the floor's strike rate. The Company uses interest rate floor corridors to hedge the variable cash flows associated with 1-month LIBOR or 3-month LIBOR indexed loans. Net payments to be received under the floor corridor contracts offset the decline in loan interest income caused by the relevant LIBOR index falling below the corridor's upper strike rate, but only to the extent the index falls to the lower strike rate. The corridor will not provide protection from declines in the relevant LIBOR index to the extent it falls below the corridor's lower strike rate. The Company uses interest rate collars to hedge the variable cash flows associated with 1-month LIBOR or 3-month LIBOR indexed loans. Net payments to be received under the collar contracts offset the decline in loan interest income caused by the relevant LIBOR index falling below the collar's floor strike rate while net payments to be paid will reduce the increase in loan interest income caused by the LIBOR index rising above the collar's cap strike rate. The Company uses interest rate swaps to hedge the variable cash flows associated with 1-month LIBOR or 3-month LIBOR indexed loans. Payments to be received (or paid) under the swap contracts will offset the fluctuations in loan interest income caused by changes in the relevant LIBOR index. As such, these instruments hedge all fluctuations in the loans' interest income caused by changes in the relevant LIBOR index. The Company uses purchased interest rate caps to hedge the variable interest cash flows associated with the forecasted issuance and rollover of short-term, fixed rate, negotiable certificates of deposit (CDs). In these hedging relationships, the Company hedges the LIBOR component of the CD rates, which is either 3-month LIBOR or 6-month LIBOR, based on the CDs' original term to maturity, which reflects their repricing frequency. Net payments to be received under the cap contract offset the increase in interest expense caused by the relevant LIBOR index rising above the cap's strike rate. The Company uses interest rate cap corridors to hedge the variable cash flows associated with the forecasted issuance and rollover of short-term, fixed rate, negotiable CDs. In these hedging relationships, the Company hedges the LIBOR component of the CD rates, either 1-month LIBOR, 3-month LIBOR, or 6-month LIBOR, based on the original term to maturity of the CDs, which reflects their repricing frequency. Net payments to be received under the cap corridor contracts offset the increase in deposit interest expense caused by the relevant LIBOR index rising above the corridor's lower strike rate, but only to the extent the index rises to the upper strike rate. The corridor will not provide protection from increases in the relevant LIBOR index to the extent it rises above the corridor's upper strike rate. Hedging transactions are structured at inception so that the notional amounts of the hedge are matched with an equal principal amount of loans or CDs, the index and repricing frequencies of the hedge matches those of the loans or CDs, and the period in which the designated hedged cash flows occurs is equal to the term of the hedge. As such, most of the ineffectiveness in the hedging relationship results from 18 UnionBanCal Corporation and Subsidiaries Notes to Condensed Consolidated Financial Statements (Continued) NOTE 6--DERIVATIVE INSTRUMENTS AND OTHER FINANCIAL INSTRUMENTS USED FOR HEDGING (CONTINUED) the mismatch between the timing of reset dates on the hedge versus those of the loans or CDs. In the second quarter of 2004, the Company recognized a net loss of $0.3 million due to ineffectiveness, which is recognized in noninterest expense, compared to a net gain of $0.3 million in the second quarter of 2003. FAIR VALUE HEDGES HEDGING STRATEGY FOR UNIONBANCAL CORPORATION--JUNIOR SUBORDINATED DEBT PAYABLE TO SUBSIDIARY GRANTOR TRUST (TRUST NOTES) Prior to February 19, 2004, when the Company terminated its fair value hedge and called its Trust Notes, the Company engaged in an interest rate hedging strategy in which an interest rate swap was associated with a specific interest bearing liability, UnionBanCal Corporation's Trust Notes, in order to convert the liability from a fixed rate to a floating rate instrument. This strategy mitigated the changes in fair value of the hedged liability caused by changes in the designated benchmark interest rate, U.S. dollar LIBOR. Fair value hedging transactions were structured at inception so that the notional amounts of the swap matched an associated principal amount of the Trust Notes. The interest payment dates, the expiration date, and the embedded call option of the swap matched those of the Trust Notes. Because the interest rate swap was terminated in the first quarter of 2004, there was no ineffectiveness on the fair value hedges during the second quarter of 2004 compared to a net loss of less than $0.1 million in the second quarter of 2003. HEDGING STRATEGY FOR MEDIUM-TERM NOTES The Company engages in an interest rate hedging strategy in which an interest rate swap is associated with a specified interest bearing liability, UnionBanCal Corporation's five-year, medium-term debt issuance, in order to convert the liability from a fixed rate to a floating rate instrument. This strategy mitigates the changes in fair value of the hedged liability caused by changes in the designated benchmark interest rate, U.S. dollar LIBOR. The fair value hedging transaction for the medium-term notes was structured at inception to mirror all of the provisions of the medium-term notes, which allows the Company to assume that no ineffectiveness exists. HEDGING STRATEGY FOR SUBORDINATED DEBT The Company engages in an interest rate hedging strategy in which an interest rate swap is associated with a specified interest bearing liability, UnionBanCal Corporation's ten-year, subordinated debt issuance, in order to convert the liability from a fixed rate to a floating rate instrument. This strategy mitigates the changes in fair value of the hedged liability caused by changes in the designated benchmark interest rate, U.S. dollar LIBOR. The fair value hedging transaction for the subordinated debt was structured at inception to mirror all of the provisions of the subordinated debt, which allows the Company to assume that no ineffectiveness exists. 19 UnionBanCal Corporation and Subsidiaries Notes to Condensed Consolidated Financial Statements (Continued) NOTE 6--DERIVATIVE INSTRUMENTS AND OTHER FINANCIAL INSTRUMENTS USED FOR HEDGING (CONTINUED) OTHER The Company uses To-Be-Announced (TBA) contracts to fix the price and yield of anticipated purchases or sales of mortgage-backed securities that will be delivered at an agreed upon date. This strategy hedges the risk of variability in the cash flows to be paid or received upon settlement of the TBA contract. NOTE 7--GUARANTEES Standby and commercial letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party. Standby letters of credit generally are contingent upon the failure of the customer to perform according to the terms of the underlying contract with the third party, while commercial letters of credit are issued specifically to facilitate foreign or domestic trade transactions. The majority of these types of commitments have terms of one year or less. Collateral may be obtained based on management's credit assessment of the customer. As of June 30, 2004, the Company's maximum exposure to loss for standby and commercial letters of credit was $2.9 billion and $232.2 million, respectively. At June 30, 2004, the carrying value of the Company's standby and commercial letters of credit, which is included in other liabilities on the consolidated balance sheet, totaled $5.5 million. Principal investments include direct investments in private and public companies and indirect investments in private equity funds. The Company issues commitments to provide equity and mezzanine capital financing to private and public companies through either direct investments in specific companies or through investment funds and partnerships. The timing of future cash requirements to fund such commitments is generally dependent on the investment cycle. This cycle, the period over which privately-held companies are funded by private equity investors and ultimately sold, merged, or taken public through an initial offering, can vary based on overall market conditions as well as the nature and type of industry in which the companies operate. At June 30, 2004, the Company had commitments to fund principal investments of $59.6 million. The Company has contingent consideration agreements that guarantee additional payments to acquired insurance agencies' stockholders based on the agencies' future performance in excess of established revenue and/or earnings before interest, taxes, depreciation and amortization (EBITDA) thresholds. If the insurance agencies' future performance exceeds these thresholds during a three-year period, the Company will be liable to make payments to those former stockholders. As of June 30, 2004, the Company had a maximum exposure of $7.5 million for these agreements, the last of which expire in December 2006. The Company is fund manager for limited liability corporations issuing low-income housing credit (LIHC) investments. LIHC investments provide tax benefits to investors in the form of tax deductions from operating losses and tax credits. To facilitate the sale of these LIHC investments, the Company guarantees the timely completion of projects and delivery of tax benefits throughout the investment term. Guarantees may include a minimum rate of return, the availability of tax credits, and operating deficit thresholds over a ten-year average period. Additionally, the Company receives project completion and tax credit guarantees from the limited liability corporations issuing the LIHC investments that reduce the Company's ultimate exposure to loss. As of June 30, 2004, the Company's maximum exposure to loss under these guarantees was limited to a return of investor capital and minimum investment yield, or $103.6 million. The Company maintains a reserve of $4.0 million for these guarantees. 20 UnionBanCal Corporation and Subsidiaries Notes to Condensed Consolidated Financial Statements (Continued) NOTE 7--GUARANTEES (CONTINUED) The Company has guarantees that obligate it to perform if its affiliates are unable to discharge their obligations. These obligations include guarantee of trust preferred securities, commercial paper obligations and leveraged lease transactions. Guarantees issued by the Bank for an affiliate's commercial paper program are done in order to facilitate their sale. As of June 30, 2004, the Bank had a maximum exposure to loss under these guarantees, which have an average term of less than one year, of $561.0 million. The Bank's guarantee is fully collateralized by a pledged deposit. UnionBanCal Corporation guarantees its subsidiaries' leveraged lease transactions, which have terms ranging from 15 to 30 years. Following the original funding of the leveraged lease transactions, UnionBanCal Corporation has no material obligation to be satisfied. As of June 30, 2004, UnionBanCal Corporation had no material exposure to loss under these guarantees. The Company conducts securities lending transactions for institutional customers as a fully disclosed agent. At times, securities lending indemnifications are issued to guarantee that a security lending customer will be made whole in the event the borrower does not return the security subject to the lending agreement and collateral held is insufficient to cover the market value of the security. All lending transactions are collateralized, primarily by cash. The amount of securities lent with indemnifications was $1.6 billion at June 30, 2004. The market value of the associated collateral was $1.7 billion at June 30, 2004. NOTE 8--PENSION AND OTHER POSTRETIREMENT BENEFITS The following tables summarize the components of net periodic benefit costs for the three months and six months ended June 30, 2003 and 2004.
PENSION BENEFITS OTHER BENEFITS -------------------- -------------------- FOR THE THREE MONTHS FOR THE THREE MONTHS ENDED JUNE 30, ENDED JUNE 30, -------------------- -------------------- (DOLLARS IN THOUSANDS) 2003 2004 2003 2004 ----------------------------------------- -------- -------- ------- -------- COMPONENTS OF NET PERIODIC BENEFIT COST Service cost............................. $ 8,217 $ 9,511 $ 1,295 $ 1,815 Interest cost............................ 11,875 13,518 2,641 2,908 Expected return on plan assets........... (18,203) (20,778) (1,687) (2,370) Amortization of prior service cost....... 267 267 (24) (24) Amortization of transition amount........ -- -- 637 638 Recognized net actuarial loss............ 1,042 4,395 1,599 1,950 -------- -------- ------- -------- Total net periodic benefit cost.......... $ 3,198 $ 6,913 $ 4,461 $ 4,917 ======== ======== ======= ========
PENSION BENEFITS OTHER BENEFITS -------------------- -------------------- FOR THE SIX MONTHS FOR THE SIX MONTHS ENDED JUNE 30, ENDED JUNE 30, -------------------- -------------------- (DOLLARS IN THOUSANDS) 2003 2004 2003 2004 ----------------------------------------- -------- --------- ------- -------- COMPONENTS OF NET PERIODIC BENEFIT COST Service cost............................. $ 16,434 $ 18,829 $ 2,590 $ 3,383 Interest cost............................ 23,750 26,120 5,281 5,680 Expected return on plan assets........... (36,406) (41,565) (3,373) (4,467) Amortization of prior service cost....... 534 534 (48) (48) Amortization of transition amount........ -- -- 1,275 1,275 Recognized net actuarial loss............ 2,085 7,217 3,197 3,536 -------- -------- ------- -------- Total net periodic benefit cost.......... $ 6,396 $ 11,135 $ 8,922 $ 9,359 ======== ======== ======= ========
21 UnionBanCal Corporation and Subsidiaries Notes to Condensed Consolidated Financial Statements (Continued) NOTE 8--PENSION AND OTHER POSTRETIREMENT BENEFITS (CONTINUED) As previously disclosed in its consolidated financial statements for the year ended December 31, 2003, the Company expected to make discretionary cash contributions of $80 million to its defined benefit plan in 2004. The Company made cash contributions of $80 million and $20 million in March and June 2004, respectively. The Company does not expect to make any further contributions to the plan for the remainder of 2004. NOTE 9--SUBSEQUENT EVENTS On July 1, 2004, the Bank signed a definitive agreement to acquire Jackson Federal Bank, a $1.9 billion-asset bank headquartered in Brea, California, with 14 full-service branches and approximately 250 employees. At closing, the Bank will pay $305 million, comprising $168 million in cash and $137 million in the Company's common stock. The acquisition is expected to be completed in the fourth quarter of 2004 following the receipt of regulatory approvals and the satisfaction of other closing conditions. On July 28, 2004, the Company's Board of Directors declared a quarterly cash dividend of $0.36 per share of common stock. The dividend will be paid on October 1, 2004 to stockholders of record as of September 3, 2004. On August 1, 2004, the Company's subsidiary, Union Bank of California, N.A. (the Bank), completed its acquisition of the business portfolio of CNA Trust Company (CNAT), a leading provider of retirement plan trust and outsourcing services to the institutional market place. The Company acquired total assets and assumed liabilities of $167 million, each, for a cash consideration of $12 million. CNAT, based in Costa Mesa, California, was a subsidiary of Chicago-based CNA Financial Corporation. 22 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS THIS DOCUMENT INCLUDES FORWARD-LOOKING INFORMATION, WHICH IS SUBJECT TO THE "SAFE HARBOR" CREATED BY SECTION 27A OF THE SECURITIES ACT OF 1933, AS AMENDED, AND SECTION 21E OF THE SECURITIES EXCHANGE ACT OF 1934, AS AMENDED. WE MAY MAKE FORWARD-LOOKING STATEMENTS IN OTHER UNITED STATES SECURITIES AND EXCHANGE COMMISSION (SEC) FILINGS, PRESS RELEASES, NEWS ARTICLES, CONFERENCE CALLS WITH WALL STREET ANALYSTS AND STOCKHOLDERS AND WHEN WE ARE SPEAKING ON BEHALF OF UNIONBANCAL CORPORATION. FORWARD-LOOKING STATEMENTS CAN BE IDENTIFIED BY THE FACT THAT THEY DO NOT RELATE STRICTLY TO HISTORICAL OR CURRENT FACTS. OFTEN, THEY INCLUDE THE WORDS "BELIEVE," "EXPECT," "ANTICIPATE," "INTEND," "PLAN," "ESTIMATE," "PROJECT," OR WORDS OF SIMILAR MEANING, OR FUTURE OR CONDITIONAL VERBS SUCH AS "WILL," "WOULD," "SHOULD," "COULD," OR "MAY." THESE FORWARD-LOOKING STATEMENTS ARE INTENDED TO PROVIDE INVESTORS WITH ADDITIONAL INFORMATION WITH WHICH THEY MAY ASSESS OUR FUTURE POTENTIAL. ALL OF THESE FORWARD-LOOKING STATEMENTS ARE BASED ON ASSUMPTIONS ABOUT AN UNCERTAIN FUTURE AND ARE BASED ON INFORMATION AVAILABLE AT THE DATE SUCH STATEMENTS ARE ISSUED. WE DO NOT UNDERTAKE TO UPDATE FORWARD-LOOKING STATEMENTS TO REFLECT FACTS, CIRCUMSTANCES, ASSUMPTIONS OR EVENTS THAT OCCUR AFTER THE DATE THE FORWARD-LOOKING STATEMENTS ARE MADE. THERE ARE NUMEROUS RISKS AND UNCERTAINTIES THAT COULD AND WILL CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY FROM THOSE DISCUSSED IN OUR FORWARD-LOOKING STATEMENTS. MANY OF THESE FACTORS ARE BEYOND OUR ABILITY TO CONTROL OR PREDICT AND COULD HAVE A MATERIAL ADVERSE EFFECT ON OUR STOCK PRICE, FINANCIAL CONDITION, AND RESULTS OF OPERATIONS OR PROSPECTS. SUCH RISKS AND UNCERTAINTIES INCLUDE, BUT ARE NOT LIMITED TO, THE FOLLOWING FACTORS: ADVERSE ECONOMIC AND FISCAL CONDITIONS IN CALIFORNIA, GLOBAL POLITICAL AND GENERAL ECONOMIC CONDITIONS RELATED TO THE WAR ON TERRORISM, ADVERSE ECONOMIC CONDITIONS AFFECTING CERTAIN INDUSTRIES, FLUCTUATIONS IN INTEREST RATES, THE CONTROLLING INTEREST IN US OF THE BANK OF TOKYO-MITSUBISHI, LTD. (BTM), WHICH IS A WHOLLY-OWNED SUBSIDIARY OF MITSUBISHI TOKYO FINANCIAL GROUP, INC. (MTFG), COMPETITION IN THE BANKING INDUSTRY, STATUTORY RESTRICTIONS ON DIVIDENDS, ADVERSE EFFECTS OF CURRENT AND FUTURE BANKING RULES, REGULATIONS AND LEGISLATION, AND RISKS ASSOCIATED WITH VARIOUS STRATEGIES WE MAY PURSUE, INCLUDING POTENTIAL ACQUISITIONS, DIVESTITURES AND RESTRUCTURINGS. SEE ALSO THE SECTION ENTITLED "CERTAIN BUSINESS RISK FACTORS" LOCATED NEAR THE END OF "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS." ALL REPORTS THAT WE FILE ELECTRONICALLY WITH THE SEC, INCLUDING ANNUAL REPORTS ON FORM 10-K, QUARTERLY REPORTS ON FORM 10-Q, AND CURRENT REPORTS ON FORM 8-K, AS WELL AS ANY AMENDMENTS TO THOSE REPORTS, ARE ACCESSIBLE AT NO COST ON OUR INTERNET WEBSITE AT WWW.UBOC.COM AS SOON AS REASONABLY PRACTICABLE AFTER WE ELECTRONICALLY FILE SUCH REPORTS WITH, OR FURNISH THEM TO, THE SEC. THESE FILINGS ARE ALSO ACCESSIBLE ON THE SEC'S WEBSITE AT WWW.SEC.GOV. INTRODUCTION We are a California-based, commercial bank holding company with consolidated assets of $46.3 billion at June 30, 2004. During 2003, UnionBanCal Corporation changed its state of incorporation from California to Delaware. UnionBanCal Corporation and its banking subsidiary, Union Bank of California, N.A. (the Bank), were created on April 1, 1996, by the combination of Union Bank with BanCal Tri-State Corporation and its banking subsidiary, The Bank of California, N.A. The combination was accounted for as a reorganization of entities under common control, similar to a pooling of interests. At June 30, 2004, BTM, our majority owner, owned approximately 62 percent of our outstanding common stock. EXECUTIVE OVERVIEW We are providing you with an overview of what we believe are the most significant events that impacted our results for the second quarter of 2004. You should carefully read the rest of this document for more detailed information that will assist your understanding of trends, events and uncertainties that may impact us. 23 Our largest subsidiary is Union Bank of California, N.A., a commercial bank that derives most of its revenues from lending, deposit taking and trust services to customers primarily in California. We also service customers in the western United States, nationally and internationally. Interest rates, business conditions and customer confidence all affect our ability to generate revenues. In addition, the regulatory environment and competition can challenge our ability to generate those revenues. Overall credit quality in the commercial lending area continued to improve in the second quarter of 2004. The improvements came from positive financial results and outlooks of our borrowers, payoffs, and a slow down in net inflows of nonaccrual loans. Nonaccrual loans totaled $178 million at June 30, 2004, compared with $257 million at March 31, 2004. Although commercial loans increased by $520 million, or 6 percent, during the second quarter, we recorded a reversal of provision for credit losses of $10.0 million and reduced our allowance for credit losses. We do not expect our credit quality to change significantly throughout the remainder of 2004, unless the economic outlook turns negative. In the second quarter of 2004, positive economic data and the prospect of higher interest rates in the future provided the impetus for the growth in our commercial loan portfolio. Low levels of interest rates continued to pressure our net interest income, as our assets reprice more quickly than our deposits. A significant contributor to the reduced asset yields was mortgage refinancings that further reduced our net interest income on our residential mortgage loans and our mortgage-backed securities portfolio. Derivative contracts, used to hedge the impact of falling interest rates on our lending activities, began to expire in late 2003, further compressing our net interest margin in the second quarter of 2004. A discussion of the impact of our hedges is included in our detailed analysis of net interest income. Despite these pressures, we have benefited from a higher level of earning assets, including a significantly higher mix of securities, strong deposit growth, and changes in our capital structure, including replacing higher cost debt with lower cost funding. We expect that if business activity continues to pick up and interest rates rise gradually, our net interest income will rise as well. Growth in core deposits was particularly strong in the second quarter of 2004, compared to the second quarter of 2003, providing us with a low cost of funding, which is a competitive advantage. Average demand deposits for the second quarter of 2004 were 48 percent of average total deposits compared to 46 percent for the second quarter of 2003, contributing to an average annualized all-in cost of funds (interest expense divided by total interest bearing liabilities and noninterest bearing deposits) of 0.61 percent and 0.42 percent in the second quarters of 2004 and 2003, respectively. We attract deposits by offering a variety of cash management products aimed at business clients, including web cash management, check imaging, remittance and depository services and disbursements. In addition, we made two bank acquisitions and opened a number of de novo branches in the second half of 2003 and the first half of 2004, which further expanded our business locations and deposits in California. Noninterest income rose 63 percent in the second quarter of 2004, compared to the second quarter of 2003, primarily as a result of the sale of our merchant card portfolio and the sale of real property in Southern California. The sale of our merchant card portfolio, which resulted in a gain of $93 million, was part of our strategic direction to divest ourselves of products and services that are not competitively advantageous to us and to invest in products and services that we believe will provide better opportunities for growing our noninterest income. The ongoing impact on earnings per share as a result of this divestiture is approximately ($0.01) per quarter, which is expected to be partially offset by share repurchases we expect to make in the second half of 2004. Excluding the gains from the sales mentioned above, noninterest income rose from service charges on deposits, trust and investment management fees, letters of credit and international commissions and fees. Increases in volumes were primarily responsible for our increases. Although noninterest expense rose 7 percent in the second quarter of 2004, compared to the second quarter of 2003, much of that increase related to investments that we made in bank acquisitions, de novo 24 branches and technology. We believe that these investments will bring opportunities for growth in our business by increasing our customer base and expanding the services we can provide. FINANCIAL PERFORMANCE SUMMARY OF FINANCIAL PERFORMANCE
FOR THE THREE MONTHS INCREASE (DECREASE) FOR THE SIX MONTHS INCREASE (DECREASE) ENDED JUNE 30, 2004 VERSUS 2003 ENDED JUNE 30, 2004 VERSUS 2003 -------------------- ------------------ ---------------------- ------------------ (DOLLARS IN THOUSANDS) 2003 2004 AMOUNT PERCENT 2003 2004 AMOUNT PERCENT --------------------------- -------- --------- -------- ------- ---------- ---------- -------- ------- RESULTS OF OPERATIONS Net interest income(1) $385,777 $ 399,858 $ 14,081 3.7% $ 776,557 $ 800,279 $ 23,722 3.1% Noninterest income Service charges on deposit accounts....... 77,942 90,031 12,089 15.5 150,229 171,127 20,898 13.9 Trust and investment management fees........ 33,141 36,788 3,647 11.0 65,816 72,610 6,794 10.3 Insurance commissions.... 16,024 18,652 2,628 16.4 29,242 40,387 11,145 38.1 International commissions and fees............... 16,856 18,102 1,246 7.4 32,201 35,647 3,446 10.7 Card processing fees, net 9,340 15,456 6,116 65.5 19,022 24,248 5,226 27.5 Gain on sale of merchant card portfolio......... -- 93,000 93,000 nm -- 93,000 93,000 nm Other noninterest income. 49,868 58,981 9,113 18.3 92,432 105,196 12,764 13.8 -------- --------- -------- ---------- ---------- -------- Total noninterest income... 203,171 331,010 127,839 62.9 388,942 542,215 153,273 39.4 Total revenue.............. 588,948 730,868 141,920 24.1 1,165,499 1,342,494 176,995 15.2 (Reversal of) provision for credit losses............ 25,000 (10,000) (35,000) (140.0) 55,000 (15,000) (70,000) (127.3) Noninterest expense Salaries and employee benefits............... 198,929 217,597 18,668 9.4 397,036 437,020 39,984 10.1 Net occupancy............ 32,866 32,173 (693) (2.1) 60,502 63,755 3,253 5.4 Intangible asset amortization........... 3,227 4,485 1,258 39.0 5,704 8,705 3,001 52.6 Other noninterest expense 115,982 122,147 6,165 5.3 230,362 240,028 9,666 4.2 -------- --------- -------- ---------- ---------- -------- Total noninterest expense.. 351,004 376,402 25,398 7.2 693,604 749,508 55,904 8.1 Income before income tax... 212,944 364,466 151,522 71.2 416,895 607,986 191,091 45.8 Income tax................. 68,186 133,369 65,183 95.6 136,620 219,402 82,782 60.6 -------- --------- -------- ---------- ---------- -------- Net income................. $144,758 $ 231,097 $ 86,339 59.6% $ 280,275 $ 388,584 $108,309 38.6% ======== ========= ======== ========== ========== ======== ------------------------------------------------------- (1) Net interest income does not include any adjustments for fully taxable equivalence. nm--not meaningful.
THE PRIMARY CONTRIBUTORS TO OUR FINANCIAL PERFORMANCE FOR THE SECOND QUARTER OF 2004 COMPARED TO THE SECOND QUARTER OF 2003 ARE PRESENTED BELOW. o We recorded a $10.0 million reversal of provision for credit losses in the second quarter of 2004, which reflects continued improvement in credit quality. Reductions in criticized and classified credits in our commercial loan portfolio resulted from pay-offs, loan grade improvements, and loan sales, which allowed us to lower our reserve for credit losses. (See additional discussion under "Allowance for Credit Losses.") o Although net interest income continues to be negatively impacted by the lower interest rate environment, net interest income was favorably influenced by higher earning asset volumes, including a significantly higher mix of securities and an increase in the average balances of our commercial loan portfolio. Strong deposit growth, including an attractive mix of average noninterest bearing deposits to total deposits, also contributed favorably to our net interest income. (See additional discussion under "Net Interest Income.") 25 o Our noninterest income was impacted by several factors: o Service charges on deposit accounts rose primarily due to a 23 percent increase in average demand deposits, net of title and escrow deposits, in the second quarter of 2004 over the second quarter of 2003 and higher overdraft and return fees of $5.5 million primarily associated with changes in our check processing introduced in April 2004; o Trust and investment management fees increased from the second quarter of 2003 primarily due to increased assets under administration. Trust fees began growing in the second half of 2003 as trust assets started to recover with the strengthening of the equity markets and a strong increase in new sales. In the second quarter of 2004, managed assets increased by 5 percent and non-managed assets increased by 10 percent from the second quarter of 2003. Total assets under administration increased by 9 percent, to $158.9 billion, between June 30, 2003 and June 30, 2004; o Insurance commissions increased primarily as a result of the December 2003 acquisition of Knight Insurance Agency; o International commissions and fees grew, reflecting strong growth in the foreign remittances product in almost all of our markets, from a combination of increased pricing, product enhancements and higher market penetration; o Card processing fees, net, increased primarily due to $6.5 million attributable to the recognition of the last month of merchant card revenue earned before the sale of the merchant card portfolio, resulting from merchant card revenue being recorded on a one month lag behind the related interchange expense; o The sale of our merchant card portfolio in the second quarter of 2004 resulted in a gain of $93.0 million. Our merchant accounts were acquired by NOVA Information Systems (NOVA). As a result of the long-term marketing alliance we formed with NOVA, we will receive marketing fees in the future; and o In other income, the second quarter of 2004 included an $8.5 million gain on the sale of real property, net gains in private capital investment sales of $4.0 million, and a $3.7 million final insurance recovery settlement for our losses related to the World Trade Center terrorist attacks of September 11, 2001. In addition, the second quarter of 2003 included a $9.0 million gain on the redemption of a Mexican Brady Bond and net gains in private capital investment sales of $1.0 million. o Contributing to our higher noninterest expense were several factors: o Salaries and employee benefits increased primarily as a result of: o acquisitions and new branch openings, which accounted for 39 percent of the increase in our salaries and other compensation; o higher performance-related incentive expense from goal achievements; o annual merit increases; and o increased employee benefits expense due to: o acquisitions and new branch openings, which accounted for 30 percent of our employee benefits expense increase; o increasing healthcare costs for current employees and retirees from rising insurance premiums and a greater number of participants; 26 o the impact of the lower discount rate we are using to calculate our future pension and other postretirement liabilities; o Net occupancy costs decreased primarily as a result of a $4.2 million write-off of leasehold improvements in the second quarter of 2003, partially offset by increased expenses resulting from our acquisitions and new branch openings, capitalized property improvements recorded in December 2003, and reduced rental income resulting from increased vacancies in bank-owned property; o Intangible asset amortization increased primarily as a result of our recent acquisitions; and o Other noninterest expense rose primarily as a result of higher software expenses, resulting from increased software purchases and development to support strategic technology initiatives, and losses attributable to operations and litigation. THE PRIMARY CONTRIBUTORS TO OUR FINANCIAL PERFORMANCE FOR THE FIRST SIX MONTHS OF 2004 COMPARED TO THE FIRST SIX MONTHS OF 2003 ARE PRESENTED BELOW. o We recorded a $15.0 million reversal of provision for credit losses in the first six months of 2004, which reflects continued improvement in credit quality. Reductions in criticized and classified credits in our commercial loan portfolio resulted from pay-offs, loan grade improvements, and loan sales, and allowed us to lower our reserve for credit losses. (See additional discussion under "Allowance for Credit Losses.") o Although net interest income continues to be negatively impacted by the lower interest rate environment and a decline in the average balances of our commercial loan portfolio, net interest income was favorably influenced by higher other earning asset volumes, including a significantly higher mix of securities. Strong deposit growth, including an attractive mix of average noninterest bearing deposits to total deposits, also contributed favorably to our net interest income. (See additional discussion under "Net Interest Income.") o Our noninterest income was impacted by several factors: o Service charges on deposit accounts rose primarily from a 23 percent increase in average demand deposits, net of title and escrow deposits, in the first six months of 2004 over the first six months of 2003 and higher overdraft and return fees of $10.2 million primarily associated with charges in our check processing introduced in April 2004; o Trust and investment management fees increased from the first six months of 2003 primarily due to increased assets under administration. Trust fees began growing in the second half of 2003 as trust assets started to recover with the strengthening of the equity markets and a strong increase in new sales; o Insurance commissions increased primarily as a result of the April 2003 acquisition of Tanner Insurance Brokers and the December 2003 acquisition of Knight Insurance Agency; o International commissions and fees grew, reflecting strong growth in the foreign remittances product in almost all of our markets, from a combination of increased pricing, product enhancements and higher market penetration; o Card processing fees, net, increased primarily due to $6.5 million attributable to the recognition of the last month of revenue earned before the sale of the merchant card portfolio, resulting from merchant card revenue being recorded on a one month lag behind the related interchange expense; o The first six months of 2004 included a $93.0 million gain on the sale of our merchant card portfolio; and 27 o The first six months of 2004 also included an $8.5 million gain on the sale of real property and net gains in private capital investment sales of $9.0 million. In addition, the first six months of 2003 included a $9.0 million gain on the redemption of a Mexican Brady Bond and net gains in private capital investment sales of $0.9 million. o Contributing to our higher noninterest expense were several factors: o Salaries and employee benefits increased primarily as a result of: o acquisitions and new branch openings, which accounted for 42 percent of the increase in our salaries and other compensation; o higher performance-related incentive expense from goal achievements; o annual merit increases; and o increased employee benefits expense due to: acquisitions and new branch openings, which accounted for 38 percent of our employee benefits expense increase; o increasing healthcare costs for current employees and retirees from rising insurance premiums and a greater number of participants; o the impact of the lower discount rate we are using to calculate our future pension and other postretirement liabilities; and o the impact of a higher state unemployment tax rate, which rose from 2.0 percent in the first six months of 2003 to 3.7 percent in the first six months of 2004; o Net occupancy costs increased primarily as a result of our acquisitions and new branch openings, and reduced rental income resulting from increased vacancies in bank-owned property, partially offset by a $4.2 million write-off of leasehold improvements in the second quarter of 2003; o Intangible asset amortization increased primarily as a result of our recent acquisitions; and o Other noninterest expense rose primarily as a result of higher software expenses, resulting from increased software purchases and development to support strategic technology initiatives, and losses attributable to operations and litigation. 28 NET INTEREST INCOME The following tables show the major components of net interest income and net interest margin.
FOR THE THREE MONTHS ENDED ---------------------------------------------------------------------- JUNE 30, 2003 JUNE 30, 2004 --------------------------------- ---------------------------------- INTEREST AVERAGE INTEREST AVERAGE AVERAGE INCOME/ YIELD/ AVERAGE INCOME/ YIELD/ (DOLLARS IN THOUSANDS) BALANCE EXPENSE(1) RATE(1)(2) BALANCE EXPENSE(1) RATE(1)(2) --------------------------- ----------- --------- --------- ----------- --------- --------- ASSETS Loans:(3) Domestic................. $24,916,936 $ 346,204 5.63% $24,967,825 $ 319,829 5.14% Foreign(4)............... 1,600,380 8,995 2.28 1,870,797 8,818 1.90 Securities--taxable........ 7,685,140 77,341 4.03 11,696,096 107,146 3.66 Securities--tax-exempt..... 40,984 1,016 9.91 69,654 1,424 8.18 Interest bearing deposits in banks................. 221,004 1,130 2.05 280,892 1,121 1.61 Federal funds sold and securities purchased under resale agreements.. 1,276,224 4,001 1.26 1,143,901 2,928 1.03 Trading account assets..... 333,820 981 1.18 321,851 883 1.10 ----------- --------- ----------- --------- Total earning assets... 36,074,488 439,668 4.88 40,351,016 442,149 4.40 --------- --------- Allowance for credit losses (585,597) (525,435) Cash and due from banks.... 2,099,440 2,233,586 Premises and equipment, net 509,372 514,122 Other assets............... 1,678,646 2,038,062 ----------- ----------- Total assets........... $39,776,349 $44,611,351 =========== =========== LIABILITIES Domestic deposits: Interest bearing......... $9,928,211 18,799 0.76 $11,498,339 16,198 0.57 Savings and consumer time 3,871,674 11,277 1.17 4,225,435 8,540 0.81 Large time............... 2,532,971 10,141 1.61 2,298,403 7,385 1.29 Foreign deposits(4)........ 1,224,201 2,811 0.92 1,476,450 2,761 0.75 ----------- --------- ----------- --------- Total interest bearing deposits............. 17,557,057 43,028 0.98 19,498,627 34,884 0.72 ----------- --------- ----------- --------- Federal funds purchased and securities sold under repurchase agreements.... 333,415 747 0.90 344,416 552 0.64 Commercial paper........... 995,048 2,946 1.19 517,333 1,051 0.82 Other borrowed funds....... 138,074 1,055 3.06 176,449 1,178 2.69 Medium and long-term debt.. 399,745 1,818 1.82 819,595 3,693 1.81 Preferred securities and trust notes(5)........... 351,553 3,652 4.16 16,119 130 3.23 ----------- --------- ----------- --------- Total borrowed funds... 2,217,835 10,218 1.85 1,873,912 6,604 1.42 ----------- --------- ----------- --------- Total interest bearing liabilities.......... 19,774,892 53,246 1.08 21,372,539 41,488 0.78 --------- --------- Noninterest bearing deposits................. 15,030,116 18,311,421 Other liabilities.......... 1,052,065 993,603 ----------- ----------- Total liabilities...... 35,857,073 40,677,563 STOCKHOLDERS' EQUITY Common equity.............. 3,919,276 3,933,788 ----------- ----------- Total stockholders' equity............... 3,919,276 3,933,788 ----------- ----------- Total liabilities and stockholders' equity. $39,776,349 $44,611,351 =========== =========== Net interest income/margin (taxable-equivalent basis) 386,422 4.29% 400,661 3.98% Less: taxable-equivalent adjustment............... 645 803 --------- --------- Net interest income.... $ 385,777 $ 399,858 ========= ========= ------------------------ (1) Yields and interest income are presented on a taxable-equivalent basis using the federal statutory tax rate of 35 percent. (2) Annualized (3) Average balances on loans outstanding include all nonperforming loans. The amortized portion of net loan origination fees (costs) is included in interest income on loans, representing an adjustment to the yield. (4) Foreign loans and deposits are those loans and deposits originated in foreign branches. (5) Includes interest expense for both trust preferred securities and trust notes.
29
FOR THE SIX MONTHS ENDED ---------------------------------------------------------------------- JUNE 30, 2003 JUNE 30, 2004 --------------------------------- ---------------------------------- INTEREST AVERAGE INTEREST AVERAGE AVERAGE INCOME/ YIELD/ AVERAGE INCOME/ YIELD/ (DOLLARS IN THOUSANDS) BALANCE EXPENSE(1) RATE(1)(2) BALANCE EXPENSE(1) RATE(1)(2) --------------------------- ----------- --------- --------- ----------- --------- --------- ASSETS Loans:(3) Domestic................. $25,051,062 $ 701,277 5.63% $24,750,113 $ 647,762 5.26% Foreign(4)............... 1,568,556 17,161 2.21 1,740,126 16,496 1.91 Securities--taxable........ 7,351,834 156,520 4.26 11,546,375 212,139 3.67 Securities--tax-exempt..... 41,461 2,030 9.79 67,733 2,759 8.15 Interest bearing deposits in banks................. 212,266 2,092 1.99 244,373 2,029 1.67 Federal funds sold and securities purchased under resale agreements.. 908,213 5,678 1.26 965,448 4,887 1.02 Trading account assets..... 320,683 1,938 1.22 299,454 1,478 0.99 ----------- --------- ----------- --------- Total earning assets... 35,454,075 886,696 5.03 39,613,622 887,550 4.50 --------- --------- Allowance for credit losses (594,370) (529,803) Cash and due from banks.... 2,097,220 2,254,820 Premises and equipment, net 508,175 517,042 Other assets............... 1,601,121 1,975,585 ----------- ----------- Total assets........... $39,066,221 $43,831,266 =========== =========== LIABILITIES Domestic deposits: Interest bearing......... $ 9,648,251 37,608 0.79 $11,444,366 32,755 0.58 Savings and consumer time 3,845,754 23,593 1.24 4,181,065 17,258 0.83 Large time............... 2,473,968 20,587 1.68 2,365,502 15,720 1.34 Foreign deposits(4)........ 1,303,747 6,017 0.93 1,351,837 4,893 0.73 ----------- --------- ----------- --------- Total interest bearing deposits............. 17,271,720 87,805 1.03 19,342,770 70,626 0.73 ----------- --------- ----------- --------- Federal funds purchased and securities sold under repurchase agreements.... 424,955 2,074 0.98 369,941 1,233 0.67 Commercial paper........... 959,386 5,674 1.19 530,093 2,186 0.83 Other borrowed funds....... 155,375 2,310 3.00 182,139 2,478 2.74 Medium and long-term debt.. 399,737 3,684 1.86 812,829 6,832 1.69 Preferred securities and trust notes(5)........... 351,603 7,323 4.17 109,571 2,311 4.22 ----------- --------- ----------- --------- Total borrowed funds... 2,291,056 21,065 1.85 2,004,573 15,040 1.51 ----------- --------- ----------- --------- Total interest bearing liabilities.......... 19,562,776 108,870 1.12 21,347,343 85,666 0.81 --------- --------- Noninterest bearing deposits................. 14,565,228 17,532,017 Other liabilities.......... 1,041,308 1,010,051 ----------- ----------- Total liabilities...... 35,169,312 39,889,411 STOCKHOLDERS' EQUITY Common equity.............. 3,896,909 3,941,855 ----------- ----------- Total stockholders' equity............... 3,896,909 3,941,855 ----------- ----------- Total liabilities and stockholders' equity. $39,066,221 $43,831,266 =========== =========== Net interest income/margin (taxable-equivalent basis) 777,826 4.41% 801,884 4.07% Less: taxable-equivalent adjustment............... 1,269 1,605 --------- --------- Net interest income.... $ 776,557 $ 800,279 ========= ========= ------------------------------------------- (1) Yields and interest income are presented on a taxable-equivalent basis using the federal statutory tax rate of 35 percent. (2) Annualized (3) Average balances on loans outstanding include all nonperforming loans. The amortized portion of net loan origination fees (costs) is included in interest income on loans, representing an adjustment to the yield. (4) Foreign loans and deposits are those loans and deposits originated in foreign branches. (5) Includes interest expense for both trust preferred securities and trust notes.
30 Net interest income in the second quarter of 2004, on a taxable-equivalent basis, increased 4 percent, from the second quarter of 2003. Our results were attributable to the following factors: o Average earning assets grew 12 percent in the second quarter of 2004, compared to the second quarter of 2003, to $40.4 billion. This growth was primarily attributable to a $4.0 billion, or 52 percent, increase in average securities and a $321.3 million, or 1 percent, increase in average loans. The increase in average securities, which was comprised primarily of fixed rate securities, reflected liquidity and interest rate risk management actions. Securities held for Asset and Liability Management (ALM) purposes were $11.7 billion at June 30, 2004 and had an overall estimated effective duration of 2.7. The increase in average loans was largely due to a $1.0 billion increase in average residential mortgages, resulting from a strategic portfolio shift from more volatile commercial loans, which we feel we have achieved, partially offset by a $0.7 billion decrease in average commercial, financial and industrial loans; o Deposit growth has contributed significantly to our lower cost of funds in the second quarter of 2004, compared to the second quarter of 2003. Average noninterest bearing deposits were $3.3 billion or 22 percent higher in the second quarter of 2004, compared to the second quarter of 2003. Average business demand deposits, including demand deposits from our title and escrow clients which grew by $0.5 billion, increased by $2.8 billion in the second quarter of 2004, compared to the second quarter of 2003, with the balance of our noninterest bearing deposits increase coming from consumer demand deposit growth. We anticipate that the growth rates in average noninterest bearing deposits will decline in the latter half of 2004 as rising interest rates will cause our customers to divert those deposits to more attractive interest bearing investments and will slow the activity in mortgage loan refinancings, which will impact our title and escrow deposits; o Yields on our earning assets were negatively impacted by decreasing interest rates for much of the period in 2003, resulting in a lower average yield of 48 basis points on average earning assets, which was negatively impacted by lower interest rate hedge income of $14.4 million; o Market rates on our interest bearing liabilities were favorably impacted by the decreasing interest rate environment resulting in a lower cost of funds on interest bearing liabilities of 30 basis points, which included lower interest rate hedge income of $0.3 million; and o During 2004, our strategy has been to take advantage of our higher noninterest bearing deposit balances by reducing our balances in higher interest rate liabilities such as large certificates of deposit, foreign deposits, and other borrowed funds. As a result of these changes, and as long-term interest rates declined, our net interest margin decreased by 31 basis points. We use derivatives to hedge expected changes in the yields on our variable rate loans, term certificates of deposit (CDs), and long-term borrowings. During 2004, these derivative positions will provide less in net interest income, than in 2003, as positions mature and, to a lesser extent, as interest rates rise. However, we expect the declines in hedge income to be partially offset by increased yields on the underlying variable rate loans. For the quarters ended June 30, 2003 and 2004, we had gross hedge income of $41.5 million and $26.8 million, respectively. Net interest income in the first six months of 2004, on a taxable-equivalent basis, increased 3 percent, from the first six months of 2003. Our results were attributable to the following factors: o Average earning assets grew 12 percent in the first six months of 2004, compared to the first six months of 2003, to $39.6 billion. This growth was primarily attributable to a $4.2 billion, or 57 percent, increase in average securities, partly offset by a $129.4 million, or less than 1 percent, decrease in average loans. The increase in average securities, which was comprised primarily of fixed rate securities, reflected liquidity and interest rate risk management actions. The decrease in 31 average loans was largely due to a $1.1 billion decrease in average commercial, financial and industrial loans, partially offset by a $0.9 billion increase in average residential mortgages, resulting from a strategic portfolio shift from more volatile commercial loans, which we feel we have achieved; o Deposit growth has contributed significantly to our lower cost of funds in the first six months of 2004, compared to the first six months of 2003. Average noninterest bearing deposits were $3.0 billion or 20 percent higher in the first six months of 2004, compared to the first six months of 2003. Average business demand deposits, including demand deposits from our title and escrow clients which grew by $0.2 billion, increased by $2.5 billion in the first six months of 2004, compared to the first six months of 2003, with the balance of our noninterest bearing deposits increase coming from consumer demand deposit growth. We anticipate that the growth rates in average noninterest bearing deposits will decline in the latter half of 2004 as rising interest rates will cause our customers to divert those deposits to more attractive interest bearing investments and will slow the activity in mortgage loan refinancings, which will impact our title and escrow deposits; o Yields on our earning assets were negatively impacted by decreasing interest rates for much of the period, resulting in a lower average yield of 53 basis points on average earning assets, which was negatively impacted by lower interest rate hedge income of $24.2 million; o Market rates on our interest bearing liabilities were favorably impacted by the decreasing interest rate environment resulting in a lower cost of funds on interest bearing liabilities of 31 basis points, which included higher interest rate hedge income of $1.8 million; and o During 2004, our strategy has been to take advantage of our higher noninterest bearing deposit balances by reducing our balances in higher interest rate liabilities such as large certificates of deposit, foreign deposits, and other borrowed funds. As a result of these changes, and as long-term interest rates declined, our net interest margin decreased by 34 basis points. As explained previously, derivative hedges will provide less in net interest income than in 2003, as positions mature and, to a lesser extent, as interest rates rise. For the six months ended June 30, 2003 and 2004, we had gross hedge income of $81.4 million and $59.0 million, respectively. NONINTEREST INCOME
FOR THE THREE MONTHS ENDED FOR THE SIX MONTHS ENDED -------------------------------------- -------------------------------------- INCREASE (DECREASE) INCREASE (DECREASE) JUNE 30, JUNE 30, ------------------ JUNE 30, JUNE 30, ------------------ (DOLLARS IN THOUSANDS) 2003 2004 AMOUNT PERCENT 2003 2004 AMOUNT PERCENT -------------------------- -------- -------- -------- ------- -------- -------- -------- ------- Service charges on deposit accounts................ $ 77,942 $ 90,031 $ 12,089 15.51% $150,229 $171,127 $ 20,898 13.91% Trust and investment management fees......... 33,141 36,788 3,647 11.00 65,816 72,610 6,794 10.32 Insurance commissions..... 16,024 18,652 2,628 16.40 29,242 40,387 11,145 38.11 International commissions and fees................ 16,856 18,102 1,246 7.39 32,201 35,647 3,446 10.70 Card processing fees, net. 9,340 15,456 6,116 65.48 19,022 24,248 5,226 27.47 Foreign exchange gains, net..................... 6,958 8,294 1,336 19.20 13,892 16,638 2,746 19.77 Brokerage commissions and fees.................... 8,412 8,023 (389) (4.62) 17,066 16,320 (746) (4.37) Merchant banking fees..... 6,191 7,714 1,523 24.60 12,209 15,181 2,972 24.34 Securities gains (losses), net..................... 9,660 (4) (9,664) nm 9,660 1,618 (8,042) (83.25) Gain on sale of merchant card portfolio.......... -- 93,000 93,000 nm -- 93,000 93,000 nm Other..................... 18,647 34,954 16,307 87.45 39,605 55,439 15,834 39.98 -------- -------- -------- -------- -------- -------- Total noninterest income $203,171 $331,010 $127,839 62.92% $388,942 $542,215 $153,273 39.41% ======== ======== ======== ======== ======== ======== ------------------------ nm--not meaningful
32 NONINTEREST EXPENSE
FOR THE THREE MONTHS ENDED FOR THE SIX MONTHS ENDED -------------------------------------- -------------------------------------- INCREASE (DECREASE) INCREASE (DECREASE) JUNE 30, JUNE 30, ------------------ JUNE 30, JUNE 30, ------------------ (DOLLARS IN THOUSANDS) 2003 2004 AMOUNT PERCENT 2003 2004 AMOUNT PERCENT -------------------------- -------- -------- -------- ------- -------- -------- -------- ------- Salaries and other compensation............ $161,567 $174,894 $ 13,327 8.25% $314,627 $345,324 $ 30,697 9.76% Employee benefits......... 37,362 42,703 5,341 14.30 82,409 91,696 9,287 11.27 -------- -------- -------- -------- -------- -------- Salaries and employee benefits.............. 198,929 217,597 18,668 9.38 397,036 437,020 39,984 10.07 Net occupancy............. 32,866 32,173 (693) (2.11) 60,502 63,755 3,253 5.38 Equipment................. 16,354 16,883 529 3.23 33,025 34,154 1,129 3.42 Communications............ 13,354 13,035 (319) (2.39) 27,198 26,445 (753) (2.77) Software.................. 10,849 12,908 2,059 18.98 22,925 25,903 2,978 12.99 Professional services..... 13,566 10,290 (3,276) (24.15) 25,580 21,593 (3,987) (15.59) Advertising and public relations............... 9,693 10,814 1,121 11.57 19,360 19,541 181 0.93 Data processing........... 7,744 7,659 (85) (1.10) 16,228 15,284 (944) (5.82) Intangible asset amortization............ 3,227 4,485 1,258 38.98 5,704 8,705 3,001 52.61 Foreclosed asset expense.. -- 17 17 nm 51 536 485 nm Other..................... 44,422 50,541 6,119 13.77 85,995 96,572 10,577 12.30 -------- -------- -------- -------- -------- -------- Total noninterest expense............... $351,004 $376,402 $ 25,398 7.24% $693,604 $749,508 $ 55,904 8.06% ======== ======== ======== ======== ======== ======== ------------------------ nm--not meaningful
INCOME TAX EXPENSE Income tax expense in the second quarter of 2004 was $133.4 million, resulting in a 37 percent effective income tax rate compared with an effective tax rate of 32 percent for the second quarter of 2003. The increase in the effective tax rate was due to higher California state taxes in 2004, lower low-income housing tax credits in proportion to pre-tax income in 2004, and a one-time adjustment of $2.7 million in the second quarter of 2003 for a refund on income taxes paid in 1998, 1999, and 2000, resulting from the settlement of several tax issues with the Internal Revenue Service. Income tax expense in the first six months of 2004 was $219.4 million, resulting in a 36 percent effective income tax rate compared with an effective tax rate of 33 percent for the first six months of 2003. The State of California requires us to file our franchise tax returns as a member of a unitary group that includes MTFG and either all worldwide affiliates or only U.S. affiliates. Since 1996, we have elected to file our California franchise tax returns on a worldwide unitary basis. The inclusion of MTFG's financial results, which in some years were net losses, has partially offset our net profits subject to California income tax. The inclusion of MTFG's worldwide property, payroll and sales in the calculation of the California apportionment factor has also reduced the percentage of our income subject to California income tax. As a result, our effective tax rate for California has been significantly lower than the statutory rate, net of federal benefit, of 7.05 percent. Changes in MTFG's taxable profits affect our California taxes. MTFG's taxable profits are impacted most significantly by changes in the worldwide economy, especially in Japan, and decisions that they may make about the timing of the recognition of credit losses. When MTFG's worldwide taxable profits rise, our effective tax rate in California will rise. We review MTFG's financial information on a quarterly basis in order to determine the rate at which to recognize our California income taxes. However, all of the information relevant to determining the effective tax rate may not be available until after the end of the period to which the tax relates. The determination of the California effective tax rate involves management judgment and estimates, and can change during the calendar year or between calendar years, as additional information becomes available. Our effective tax rates in the second quarter and the first six months of 2004, when compared to the same periods in 2003, are higher partially as a result of increased profits reported by MTFG for its most recent reporting period, as well as projected profit increases for MTFG due to improving economic conditions in Japan. 33 LOANS The following table shows loans outstanding by loan type.
PERCENT CHANGE TO JUNE 30, 2004 FROM: --------------------- JUNE 30, DECEMBER 31, JUNE 30, JUNE 30, DECEMBER 31, (DOLLARS IN THOUSANDS) 2003 2003 2004 2003 2003 --------------------------------------- ----------- ------------ ----------- -------- ------------ Domestic: Commercial, financial and industrial. $ 9,404,285 $ 8,817,679 $ 9,237,338 (1.78)% 4.76% Construction......................... 1,110,794 1,101,166 1,078,630 (2.90) (2.05) Mortgage: Residential........................ 6,784,221 7,463,538 8,224,715 21.23 10.20 Commercial......................... 4,172,864 4,195,178 4,288,867 2.78 2.23 ----------- ------------ ----------- Total mortgage................... 10,957,085 11,658,716 12,513,582 14.21 7.33 Consumer: Installment........................ 851,857 818,746 794,428 (6.74) (2.97) Revolving lines of credit.......... 1,179,961 1,222,220 1,379,751 16.93 12.89 ----------- ------------ ----------- Total consumer................... 2,031,818 2,040,966 2,174,179 7.01 6.53 Lease financing...................... 704,353 663,632 605,358 (14.05) (8.78) ----------- ------------ ----------- Total loans in domestic offices.... 24,208,335 24,282,159 25,609,087 5.79 5.46 Loans originated in foreign branches... 1,444,672 1,650,204 1,981,815 37.18 20.10 ----------- ------------ ----------- Total loans held to maturity....... 25,653,007 25,932,363 27,590,902 7.55 6.40 Total loans held for sale.......... 15,653 12,265 3,369 (78.48) (72.53) ----------- ------------ ----------- Total loans...................... $25,668,660 $ 25,944,628 $27,594,271 7.50% 6.36% =========== ============ ===========
COMMERCIAL, FINANCIAL AND INDUSTRIAL LOANS Commercial, financial and industrial loans are extended principally to corporations, middle-market businesses, and small businesses, with no industry concentration exceeding 10 percent of total loans. This portfolio has a high degree of geographic diversification based upon our customers' revenue bases, which we believe lowers our vulnerability to changes in the economic outlook of any particular region of the U.S. Our commercial market lending originates primarily through our commercial banking offices. These offices, which rely extensively on relationship-oriented banking, provide a variety of services including cash management services, lines of credit, accounts receivable and inventory financing. Separately, we originate or participate in a wide variety of financial services to major corporations. These services include traditional commercial banking and specialized financing tailored to the needs of each customer's specific industry. Presently, we are active in, among other sectors, the oil and gas, communications, media, entertainment, retailing and financial services industries. The commercial, financial and industrial loan portfolio decreased $166.9 million, or 2 percent, at June 30, 2004, compared to June 30, 2003, primarily due to economic conditions that reduced loan demand in some segments. Loan sales and managed exits also contributed to the decline, consistent with our strategy to reduce our exposure to certain commercial loans while increasing our investment in more stable consumer loans (including residential mortgages). However, at June 30, 2004 commercial loans had increased from June 30, 2003, indicating that loan demand may be on the rise. 34 CONSTRUCTION AND COMMERCIAL MORTGAGE LOANS We engage in non-residential real estate lending that includes commercial mortgage loans and construction loans secured by deeds of trust. Construction loans are made primarily to commercial property developers and to residential builders. The construction loan portfolio decrease of $32.2 million, or 3 percent, at June 30, 2004, compared to June 30, 2003, was primarily attributable to slowing growth in capital assets and employment and higher office vacancy rates in our markets. These factors impacted the level of development and construction projects we financed. The commercial mortgage loan portfolio consists of loans on commercial and industrial projects primarily in California. The increase in commercial mortgages of $116.0 million, or 3 percent, at June 30, 2004, compared to June 30, 2003, was primarily due to our acquisitions of Monterey Bay Bank in the third quarter of 2003 and Business Bank of California in the first quarter of 2004. RESIDENTIAL MORTGAGE LOANS We originate residential mortgage loans, secured by one-to-four family residential properties, through our multiple channel network (including branches, mortgage brokers, and loan-by-phone) throughout California, Oregon and Washington, and we periodically purchase loans in our market area. The residential mortgages increase of $1.4 billion, or 21 percent, at June 30, 2004, compared to June 30, 2003, was influenced by an active refinance market driven by low interest rates throughout the period. While we hold most of the loans we originate, we sell most of our 30-year, fixed rate, non-Community Reinvestment Act (CRA) residential mortgage loans. CONSUMER LOANS We originate consumer loans, such as auto loans and home equity loans and lines, through our branch network. Consumer loans increased $142.4 million, or 7 percent, from June 30, 2003 compared to June 30, 2004, primarily as a result of an increase in home equity loans and partially offset by pay-offs related to the run-off of the automobile dealer lending business that we exited in the third quarter of 2000. The indirect automobile dealer lending portfolio at June 30, 2004 was $34.9 million. LEASE FINANCING We offer primarily two types of leases to our customers: direct financing leases, where the assets leased are acquired without additional financing from other sources; and leveraged leases, where a substantial portion of the financing is provided by debt with no recourse to us. The lease financing decrease of $99.0 million, or 14 percent, at June 30, 2004, compared to June 30, 2003, was attributable to our announced discontinuance of our auto leasing activity, effective April 20, 2001. At June 30, 2004, our auto lease portfolio had declined to $52.3 million and is projected to decline 60 percent by December 2004, and fully mature by mid-year 2006. Included in our lease portfolio are leveraged leases of $540.1 million, which are net of non-recourse debt of approximately $1.2 billion. We utilize a number of special purpose entities for our leveraged leases. These entities serve legal and tax purposes and do not function as vehicles to shift liabilities to other parties or to deconsolidate affiliates for financial reporting purposes. As allowed by U.S. GAAP and by law, the gross lease receivable is offset by the qualifying non-recourse debt. In leveraged lease transactions, the third-party lender may only look to the collateral value of the leased assets for repayment. 35 LOANS ORIGINATED IN FOREIGN BRANCHES Our loans originated in foreign branches consist primarily of short-term extensions of credit to financial institutions. The loans originated in foreign branches at June 30, 2004 increased $537.1 million, or 37 percent, compared to June 30, 2003. CROSS-BORDER OUTSTANDINGS Our cross-border outstandings reflect certain additional economic and political risks that are not reflected in domestic outstandings. These risks include those arising from exchange rate fluctuations and restrictions on the transfer of funds. The following table sets forth our cross-border outstandings as of June 30, 2003, December 31, 2003 and June 30, 2004, for any country where such outstandings exceeded 1 percent of total assets. The cross-border outstandings were compiled based upon category and domicile of ultimate risk and are comprised of balances with banks, trading account assets, securities available for sale, securities purchased under resale agreements, loans, accrued interest receivable, acceptances outstanding and investments with foreign entities. The amounts outstanding exclude local currency outstandings. For any country shown in the table below, we do not have significant local currency outstandings that are not hedged or are not funded by local currency borrowings. PUBLIC CORPORATIONS FINANCIAL SECTOR AND OTHER TOTAL (DOLLARS IN MILLIONS) INSTITUTIONS ENTITIES BORROWERS OUTSTANDINGS ------------------------- ------------ -------- ------------ ------------ June 30, 2003 Korea.................... $559 $-- $73 $632 December 31, 2003 Korea.................... $630 $-- $28 $658 June 30, 2004 Korea.................... $769 $-- $ 4 $773 PROVISION FOR CREDIT LOSSES We recorded a reversal of provision for credit losses of $10 million in the second quarter of 2004, compared with a $25 million provision for credit losses in the second quarter of 2003. Provisions for credit losses are charged to income to bring our allowance for credit losses to a level deemed appropriate by management based on the factors discussed under "Allowance for Credit Losses" below. Reversals of provisions for credit losses increase our income and reduce the allowance. ALLOWANCE FOR CREDIT LOSSES ALLOWANCE POLICY AND METHODOLOGY We maintain an allowance for credit losses to absorb losses inherent in the loan portfolio. The allowance is based on our regular, quarterly assessments of the probable estimated losses inherent in the loan portfolio, and, to a lesser extent, unused commitments to provide financing. Our methodology for measuring the appropriate level of the allowance relies on several key elements, which include the formula allowance, specific allowances for identified problem loans and portfolio segments, and the unallocated allowance. The formula allowance is calculated by applying loss factors to outstanding loans and certain unused commitments, in each case based on the internal risk grade of such loans, leases and commitments. Changes in risk grades affect the amount of the formula allowance. Loss factors are based on our historical 36 loss experience and may be adjusted for significant factors that, in management's judgment, affect the collectibility of the portfolio as of the evaluation date. Loss factors are developed in the following ways: o loss factors for individually graded credits are derived from a migration model that tracks historical losses over a period, which we believe captures the inherent losses in our loan portfolio; and o pooled loan loss factors (not individually graded loans) are based on expected net charge-offs. Pooled loans are loans that are homogeneous in nature, such as consumer installment, home equity, residential mortgage loans and automobile leases. We believe that an economic cycle is a period in which both upturns and downturns in the economy have been reflected. We calculate loss factors over a time interval that spans what we believe constitutes a complete and representative economic cycle. Loan loss factors, which are used in determining our formula allowance, are adjusted quarterly primarily based upon the level of historical net charge-offs and losses expected by management in the near term. Prior to the quarter ended June 30, 2004, our loan loss factors for non-criticized graded credits captured estimated losses that were expected to occur in the next twelve months. Beginning with the quarter ended June 30, 2004, we have refined our methodology to estimate our expected losses based on a loss confirmation period. The loss confirmation period is the estimated average period of time between a material adverse event affecting the credit-worthiness of a borrower and the subsequent recognition of a loss. Based upon our evaluation process, we believe that, for our risk-graded loans, on average, losses are sustained approximately 10 quarters after an adverse event in the creditor's financial condition has taken place. Similarly, for retail, pool-managed credits, the loss confirmation period varies by product, but ranges between one and two years. Furthermore, based on management's judgment, our refined methodology permits adjustments to any loss factor used in the computation of the formula allowance for significant factors, which affect the collectibility of the portfolio as of the evaluation date, but are not reflected in the loss factors. By assessing the probable estimated losses inherent in the loan portfolio on a quarterly basis, we are able to adjust specific and inherent loss estimates based upon the most recent information that has become available. This includes changing the number of periods that are included in the calculation of the loss factors and adjusting qualitative factors to be representative of the economic cycle that we expect will impact the portfolio. Specific allowances are established in cases where management has identified significant conditions or circumstances related to a credit or a portfolio segment that management believes indicate the probability that a loss has been incurred. This amount may be determined either by a method prescribed by SFAS No. 114, or methods that include a range of probable outcomes based upon certain qualitative factors. The unallocated allowance is based on management's evaluation of conditions that are not directly reflected in the determination of the formula and specific allowances. As discussed elsewhere, certain losses that had previously been considered in the determination of the unallocated allowance have been incorporated into our formula allowance, thereby eliminating the need to reflect them in our unallocated allowance. The evaluation of the inherent loss with respect to these conditions is subject to a higher degree of uncertainty because they may not be identified with specific problem credits or portfolio segments. The conditions evaluated in connection with the unallocated allowance include the following, which existed at the balance sheet date: o general economic and business conditions affecting our key lending areas; o credit quality trends (including trends in nonperforming loans expected to result from existing conditions); o collateral values; 37 o loan volumes and concentrations; o seasoning of the loan portfolio; o specific industry conditions within portfolio segments; o recent loss experience in particular segments of the portfolio; o duration of the current economic cycle; o bank regulatory examination results; and o findings of our internal credit examiners. Executive management reviews these conditions quarterly in discussion with our senior credit officers. To the extent that any of these conditions is evidenced by a specifically identifiable problem credit or portfolio segment as of the evaluation date, management's estimate of the effect of such conditions may be reflected as a specific allowance, applicable to such credit or portfolio segment. Where any of these conditions is not evidenced by a specifically identifiable problem credit or portfolio segment as of the evaluation date, management's evaluation of the probable loss related to such condition is reflected in the unallocated allowance. The allowance for credit losses is based upon estimates of probable losses inherent in the loan portfolio. The actual losses can vary from the estimated amounts. Our methodology includes several features that are intended to reduce the differences between estimated and actual losses. The loss migration model that is used to establish the loan loss factors for individually graded loans is designed to be self-correcting by taking into account our loss experience over prescribed periods. In addition, by basing the loan loss factors over a period reflective of an economic cycle, recent loss data that may not be reflective of prospective losses going forward will not have an undue influence on the calculated loss factors. COMPARISON OF THE TOTAL ALLOWANCE AND RELATED PROVISION FOR CREDIT LOSSES FROM DECEMBER 31, 2003 At December 31, 2003, our total allowance for credit losses was $533 million, or 2.05 percent of the total loan portfolio and 190 percent of total nonaccrual loans. At June 30, 2004, our total allowance for credit losses was $501 million (consisting of $413 million and $88 million of allocated and unallocated allowance, respectively), or 1.82 percent of the total loan portfolio and 282 percent of total nonaccrual loans. In addition, the allowance incorporates the results of measuring impaired loans as provided in SFAS No. 114 as amended by SFAS No. 118, "Accounting by Creditors for Impairment of a Loan--Income Recognition and Disclosures." These accounting standards prescribe the measurement methods, income recognition and disclosures related to impaired loans. At December 31, 2003, total impaired loans were $230 million, and the associated impairment allowance was $55 million, compared with $141 million and $32 million, respectively, at June 30, 2004. On June 30, 2004 and December 31, 2003, the total allowance for credit losses for off-balance sheet commitments, which is included within our total allowance for credit losses, was $48 million and $86 million, respectively. In the second quarter of 2004, we made some adjustments on how we allocate our allowance for credit losses between off-balance sheet commitments and loans. These adjustments, offset by the increases in our loss factors, contributed to the decline in that allocation from December 31, 2003. These adjustments had no impact on the allowance as a whole, since commitments and funded loans are considered together in determining the adequacy of our allowance for credit losses. During the first quarter of 2004, there were no material changes in estimation methods or assumptions that affected our methodology for assessing the appropriateness of the formula and specific allowances for credit losses, except that the period used to calculate the cumulative loss rates on criticized loans was expanded from 12 to 24 quarters to better estimate losses over the life of the loans. Changes in 38 estimates and assumptions regarding the effects of economic and business conditions on borrowers and other factors, which are described below, affected the assessment of the unallocated allowance. During the second quarter of 2004, as discussed above, we adjusted our pass graded loan loss factors to reflect expected losses in the next 10 quarters based upon an estimated loss confirmation period. In addition, refinements in our loss factors for commercial real estate and construction lending were made to more accurately capture probable loss inherent in the portfolio. As a result of management's assessment of factors, including the continued improvement in the U.S. economy, improving conditions in the communications/media, power, and other sectors in domestic markets in which we operate, and growth and changes in the composition of the loan portfolio, offset by the adverse impact of increasing fuel costs across the whole economy, fears of terrorism on the airline industry; and the fiscal and budgetary difficulties of the State of California, we recorded a reversal of provision for credit losses of $10 million in the second quarter of 2004. The refinements we made in the manner in which we segment our allowance for credit losses had no impact on the overall level of the allowance. CHANGES IN THE ALLOCATED (FORMULA AND SPECIFIC) ALLOWANCE At June 30, 2004, the formula allowance was $364 million, compared to $280 million at December 31, 2003, an increase of $84 million. The increase was due primarily to the impact of the introduction of the loss confirmation period into the determination of our loan loss factors, which was approximately $125 million, the modifications to the commercial real estate and construction loss factors, which was approximately $18 million, the expansion of the period used to calculate cumulative loss rates on criticized credits, which was $9 million, and growth in our commercial loan portfolio, offset by significant improvements in the credit quality of our loan portfolio. Since a portion of the impact for the use of the loss confirmation period had already been considered in our attributions in the unallocated allowance, a reallocation between the formula and unallocated portions of the allowance was made. The specific allowance was $49 million at June 30, 2004, compared to $80 million at December 31, 2003, a decrease of $31 million. This decrease is reflective of decreases in impaired loans and the renegotiation of terms for certain aircraft leases that are now reported as operating leases. CHANGES IN THE UNALLOCATED ALLOWANCE At June 30, 2004, the unallocated allowance declined by $85 million to $88 million from $173 million at December 31, 2003. The reasons for the decrease, and for which an unallocated allowance is warranted, are detailed below. In our assessment as of June 30, 2004, management focused, in particular, on the factors and conditions set out below. There can be no assurance that the adverse impact of any of these conditions on us will not be in excess of the ranges set forth. Although in certain instances the downgrading of a loan resulting from the effects of the conditions described below has been reflected in the formula allowance, management believes that the impact of these events on the collectibility of the applicable loans may not have been reflected in the level of nonperforming loans or in the internal risk grading process with respect to such loans. In addition, our formula allowance does not take into consideration a change in the severity of losses that are expected to arise from current economic conditions compared with our historical losses. Accordingly, our evaluation of the probable losses related to the impact of these factors was reflected in the unallocated allowance. The evaluations of the inherent losses with respect to these factors are subject to higher degrees of uncertainty because they are not identified with specific problem credits. As previously mentioned, we refined our formula allowance to include certain losses based upon a loss confirmation period, which has eliminated the need to consider those losses in the attributions of our unallocated allowance. 39 In evaluating the results of this methodology change, we considered the effect of underlying conditions on expected future credit migration for each of our lending segments. In several cases, we concluded that this experience is not likely to be more severe than the long-run average embedded in the loss factors that drive the formula allowance calculation. In these cases, we determined that our attribution, previously established for the retail, technology and consumer sectors, was no longer required. Similarly, in certain cases, we believe that credit migration is likely to be somewhat more severe than the long-run average, but a greater share of the inherent probable loss associated with this credit migration is now captured in the allocated allowance as a result of the previously mentioned refinement in methodology. In these cases, it is appropriate to reduce the corresponding unallocated allowance attributions. o With respect to fuel prices, we considered the sustained high prices of oil and petroleum products, and the impact across virtually all sectors of the economy, and established an attribution for probable losses which could be in the range of $10 million to $35 million. o With respect to the State of California, we considered the underlying uncertainties confronting the administration in Sacramento, including the major shortfall in the state's budgetary position for fiscal year 2005, despite the passage of State Propositions 57 and 58, and established an attribution for probable losses which could be in the range of $3 million to $6 million. o With respect to commercial real estate, we considered slightly improving high vacancy rates and stagnant rent growth being experienced nationally, with specific weakness in Northern California, and established an attribution for probable losses which could be in the range of $12 million to $24 million, a reduction from the December 31, 2003 level of $16 million to $32 million. o With respect to leasing, we considered the worsening situation for airlines in the wake of increased fears of terrorism and surging fuel prices, and established an attribution for probable losses which could be in the range of $7 million to $13 million. o With respect to cross-border exposures in certain foreign countries, we considered the improving economic performances in many countries of our key international markets, as well as better financial results of our customers, and reduced the attribution range, which provides for certain weaknesses in the banking sector of some of our markets, to $8 million to $17 million. o With respect to power companies/utilities, we considered the effects of lower excess capacity and evidence that a slow recovery is beginning in this industry, coupled with the refinement in the formula allowance mentioned above in reducing the attribution for probable losses from a range of $13 million to $27 million at December 31, 2003 to a range of $4 million to $8 million at June 30, 2004. o With respect to the communications/media industry, we considered the significant improvements seen in the industry, coupled with the refinement in the formula allowance in reducing the attribution for probable losses from a range of $10 million to $30 million at December 31, 2003 to a range of $2 million to $4 million at June 30, 2004. Although in certain instances the downgrading of a loan resulting from these effects was reflected in the allocated allowance, management believes that in most instances the impact of these events on the collectibility of the applicable loans may not have been reflected in the level of nonperforming loans or in the internal risk grading process with respect to such loans. Accordingly, our evaluation of the probable losses related to the impact of these factors was reflected in the unallocated allowance. The evaluations of the inherent losses with respect to these factors were subject to higher degrees of uncertainty because they were not identified with specific problem credits. 40 CHANGE IN THE TOTAL ALLOWANCE FOR CREDIT LOSSES The following table sets forth a reconciliation of changes in our allowance for credit losses:
FOR THE THREE MONTHS FOR THE SIX MONTHS ENDED JUNE 30, ENDED JUNE 30, -------------------- -------------------- (DOLLARS IN THOUSANDS) 2003 2004 2003 2004 -------------------------------------------- -------- -------- -------- -------- Balance, beginning of period................ $586,197 $521,111 $609,190 $532,970 Loans charged off: Commercial, financial and industrial...... 51,130 20,721 88,956 40,510 Mortgage.................................. -- 43 -- 43 Consumer.................................. 2,429 1,460 5,085 3,275 Lease financing........................... 13,190 1,666 32,208 2,024 -------- -------- -------- -------- Total loans charged off................. 66,749 23,890 126,249 45,852 Recoveries of loans previously charged off: Commercial, financial and industrial...... 13,008 12,091 18,587 20,911 Mortgage.................................. 44 1,571 150 1,571 Consumer.................................. 697 456 1,420 891 Lease financing........................... 50 77 168 150 -------- -------- -------- -------- Total recoveries of loans previously charged off........................... 13,799 14,195 20,325 23,523 -------- -------- -------- -------- Net loans charged off................. 52,950 9,695 105,924 22,329 (Reversal of) provision for credit losses... 25,000 (10,000) 55,000 (15,000) Foreign translation adjustment and other net additions (deductions)(1)............. 35 3 16 5,778 -------- -------- -------- -------- Balance, end of period...................... $558,282 $501,419 $558,282 $501,419 ======== ======== ======== ======== Allowance for credit losses to total loans.. 2.17% 1.82% 2.17% 1.82% (Reversal of) provision for credit losses to net loans charged off.................. 47.21 nm 51.92 nm Net loans charged off to average loans outstanding for the period(2)............. 0.80 0.15 0.80 0.17 -------------------------------- (1) Includes a transfer of $5.7 million related to the Business Bank of California acquisition in the first quarter of 2004. (2) Annualized. nm--not meaningful
Total loans charged off in the second quarter of 2004 decreased by $42.9 million from the second quarter of 2003, primarily due to a $30.4 million decrease in commercial, financial and industrial loans charged off and an $11.5 million decrease in lease financing charge-offs reflecting the charge-offs related to several airline losses in the second quarter of 2003. Charge-offs reflect the realization of losses in the portfolio that were recognized previously through provisions for credit losses. Second quarter 2004 recoveries of loans previously charged off increased by $0.4 million from the second quarter of 2003. The percentage of net loans charged off to average loans outstanding for the second quarter of 2004 decreased by 65 basis points from the same period in 2003. At June 30, 2004, the allowance for credit losses exceeded the annualized net loans charged off during the second quarter of 2004, reflecting management's belief, based on the foregoing analysis, that there are additional losses inherent in the portfolio. Historical net charge-offs are not necessarily indicative of the amount of net charge-offs that we will realize in the future. 41 NONPERFORMING ASSETS Nonperforming assets consist of nonaccrual loans and foreclosed assets. Nonaccrual loans are those for which management has discontinued accrual of interest because there exists significant uncertainty as to the full and timely collection of either principal or interest or such loans have become contractually past due 90 days with respect to principal or interest. For a more detailed discussion of the accounting for nonaccrual loans, see Note 1 to our Consolidated Financial Statements included in the Form 10-K for the year ended December 31, 2003. Foreclosed assets include property where we acquired title through foreclosure or "deed in lieu" of foreclosure. The following table sets forth an analysis of nonperforming assets.
JUNE 30, DECEMBER 31, JUNE 30, (DOLLARS IN THOUSANDS) 2003 2003 2004 -------------------------------------------- -------- ------------ -------- Commercial, financial and industrial........ $273,896 $ 190,404 $111,015 Construction................................ 1,559 -- 5,401 Commercial mortgage......................... 48,479 38,354 22,717 Lease financing............................. 52,568 51,603 36,719 Loan originated in foreign branches......... 2,985 840 2,210 -------- ------------ -------- Total nonaccrual loans.................... 379,487 281,201 178,062 Foreclosed assets........................... 271 5,689 5,851 -------- ------------ -------- Total nonperforming assets................ $379,758 $ 286,890 $183,913 ======== ============ ======== Allowance for credit losses................. $558,282 $ 532,970 $501,419 ======== ============ ======== Nonaccrual loans to total loans............. 1.48% 1.08% 0.65% Allowance for credit losses to nonaccrual loans..................................... 147.11 189.53 281.60 Nonperforming assets to total loans and foreclosed assets......................... 1.48 1.11 0.67 Nonperforming assets to total assets........ 0.89 0.68 0.40
At June 30, 2004, nonaccrual loans totaled $178 million, a decrease of $201 million, or 53 percent, from June 30, 2003. Our nonperforming assets are concentrated in our non-agented syndicated loan portfolio and approximately 41 percent of our total nonaccrual loans are syndicated loans. In addition, nonaccrual loans include $37 million in aircraft leases. The decrease in nonaccrual loans was primarily due to pay-downs, charge-offs, and loan sales, coupled with significantly reduced inflows. During the second quarters of 2004 and 2003, respectively, we sold approximately $9 million and $206 million of loan commitments to reduce our credit exposures. Losses from these sales are reflected in our charge-offs. Nonaccrual loans as a percentage of total loans were 0.65 percent at June 30, 2004, compared with 1.48 percent at June 30, 2003. Nonperforming assets as a percentage of total loans and foreclosed assets decreased to 0.67 percent at June 30, 2004, from 1.48 percent at June 30, 2003. At June 30, 2004, approximately 62 percent of nonaccrual loans were related to commercial, financial and industrial credits, compared to 72 percent at June 30, 2003. 42 LOANS 90 DAYS OR MORE PAST DUE AND STILL ACCRUING JUNE 30, DECEMBER 31, JUNE 30, (DOLLARS IN THOUSANDS) 2003 2003 2004 -------------------------------------------- -------- ------------ -------- Commercial, financial and industrial........ $ 1,728 $ 893 $ 798 Construction................................ 2,311 -- 2,919 Mortgage: Residential................................. 3,915 1,878 4,588 Commercial.................................. 540 -- -- -------- ------------ -------- Total mortgage............................ 4,455 1,878 4,588 Consumer and other.......................... 1,879 1,123 1,535 -------- ------------ -------- Total loans 90 days or more past due and still accruing........................ $ 10,373 $3,894 $ 9,840 ======== ============ ======== QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Market risk is the risk of loss to future earnings, to fair values, or to future cash flows that may result from changes in the price of a financial instrument. The value of a financial instrument may change as a result of changes in interest rates, foreign currency exchange rates, commodity prices, equity prices, and other market changes that affect market risk sensitive instruments. Market risk is attributable to all market risk sensitive financial instruments, including securities, loans, deposits, and borrowings, as well as derivative instruments. Our exposure to market risk is a function of our asset and liability management activities, our trading activities for our own account, and our role as a financial intermediary in customer-related transactions. The objective of market risk management is to mitigate an undue adverse impact on earnings and capital arising from changes in interest rates and prices of financial instruments. This risk management objective supports our broad objective of preserving shareholder value, which encompasses earnings growth over time and capital stability. The Board of Directors, through its Finance and Capital Committee, establishes the Bank's ALM Policy, which governs the management of market risk. In the administration of market risk management, the Chief Executive Officer (CEO) Forum provides broad and strategic guidance to the Asset & Liability Management Committee (ALCO). ALCO is a committee comprised of senior executives, with the chairman designated by the Chief Executive Officer. ALCO is responsible for management of liquidity, interest rate and price risks in the implementation of ALM Policy, including formulation of risk management strategies, guidelines and trading policy limits, in accordance with the CEO Forum's directives. The Treasurer of the Bank is primarily responsible for the implementation of risk management strategies approved by ALCO and for operating management of market risk through the funding, investment, derivatives hedging, and trading functions of the Bank's Global Markets Group. The Market Risk Monitoring (MRM) unit is structured as an independent unit responsible for the measurement and monitoring of market risk, including the preparation of reports in sufficient detail to ensure that ALCO, the Bank's senior management, and the Board are kept fully informed as to the Bank's market risk profile and compliance with applicable limits, guidelines and policies. MRM functions independently of all operating and management units and reports directly to the ALCO Chairman. We have separate and distinct methods for managing the market risk associated with our trading activities and our asset and liability management activities, as described below. INTEREST RATE RISK MANAGEMENT (OTHER THAN TRADING) We engage in asset and liability management activities with the primary purposes of managing the sensitivity of net interest income (NII) to changes in interest rates within limits established by the Board and maintaining a risk profile that is consistent with management's strategic objectives. 43 The ALM Policy approved by our Board's Finance and Capital Committee requires monthly monitoring of interest rate risk by ALCO through a variety of modeling techniques that are used to quantify the sensitivity of NII to changes in interest rates. As directed by ALCO, and in consideration of the importance of our demand deposit accounts as a funding source, NII is adjusted in the official policy risk measure to incorporate the effect of certain noninterest expense items related to these deposits that are nevertheless sensitive to changes in interest rates. In managing interest rate risk, ALCO monitors NII sensitivity on both an adjusted and unadjusted basis over various time horizons. Our unhedged NII remains asset sensitive, meaning that our assets generally reprice more quickly than our liabilities, particularly our core deposits. Since the NII associated with an asset sensitive balance sheet tends to decrease when interest rates decline and increase when interest rates rise, derivative hedges and the investment portfolio are used to manage this risk. In the second quarter of 2004, we modestly increased the size of our securities portfolio, principally through purchases of intermediate term mortgage-backed and agency issued securities, adding approximately $300 million in average balances over the first quarter of 2004, while maintaining a relatively short effective duration of 2.7 (see further discussion of this on page 45). In addition, we entered into $300 million of interest rate cap corridors to offset the potential adverse impact that rising short-term interest rates could have on our cost of deposit funding. We also entered into $400 million of interest rate floors to hedge some of our variable rate loans. For a further discussion of derivative instruments and our hedging strategies, see Note 6 to our Notes to Condensed Consolidated Financial Statements included in this Form 10-Q. Together, our hedging and investment activities resulted in an essentially neutral interest rate risk profile for the hedged balance sheet with respect to parallel yield curve shifts in terms of simulated NII versus the no rate change base case scenario. However, our NII is also sensitive to non-parallel shifts in the yield curve. In general, our adjusted NII increases when the yield curve steepens (specifically when short rates, under one year, drop and long rates, beyond one year, rise), while a flattening curve tends to depress our adjusted NII. In this respect, our adjusted NII is asset sensitive when measured against changes in long rates and slightly liability sensitive when measured against changes in short rates. In the current low rate environment, run off of fixed rate assets, including prepayments, depresses NII even if interest rates do not change because the cash flows from the repaid and prepaid assets that were booked at higher rates must be reinvested at lower prevailing rates. Our official NII policy measure involves a simulation of "Earnings-at-Risk" (EaR) in which we estimate the impact that gradual, ramped-on parallel shifts in the yield curve would have on NII over a 12-month horizon. Under the Board's policy limits, the negative change in simulated NII in either the up or down 200 basis point shock scenarios may not exceed 4 percent of NII as measured in the base case, or no change, scenario. The following table sets forth the simulation results in both the up and down 200 basis point ramp scenarios as of December 31, 2003 and June 30, 2004(1):
DECEMBER 31, JUNE 30, (DOLLARS IN MILLIONS) 2003 2004 ------------------------------------------ ------------ -------- +200 basis points......................... $ 17.2 $ 17.2 as a percentage of base case NII.......... 1.20% 1.13% -200 basis points......................... $(19.8) $(23.1) as a percentage of base case NII.......... 1.38% 1.52% --------------------------- (1) For these policy simulations, NII is adjusted to incorporate the effect of certain noninterest expense items related to demand deposits that are nevertheless sensitive to changes in interest rates.
EaR in the down 200 basis point scenario was a negative $23.1 million, or 1.52 percent of adjusted NII in the base case scenario, well within the Board's guidelines. However, with Federal Funds and LIBOR rates currently below two percent, a downward ramp scenario of 200 basis points would result in short-term rate levels below zero. As a result, we believe that a 44 downward ramp scenario of 100 basis points provides a more reasonable measure of asset sensitivity in a falling interest rate environment. As of June 30, 2004, the difference between adjusted NII in the base case and adjusted NII after a gradual 100 basis point downward ramp was a negative $4.7 million, or 0.31 percent of the base case scenario. Management's goal in the NII simulations is to capture the risk embedded in the balance sheet. As a result, asset and liability balances are kept constant throughout the analysis horizon. Two exceptions are non-maturity deposits, which vary with levels of interest rates according to statistically derived balance equations, and discretionary derivative hedges and fixed income portfolios, which are allowed to mature without replacement. Additional assumptions are made to model the future behavior of deposit rates and loan spreads based on statistical analysis, management's outlook, and historical experience. The prepayment risks related to residential loans and mortgage-backed securities are measured using industry estimates of prepayment speeds. The sensitivity of the simulation results to the underlying assumptions is tested as a regular part of the risk measurement process by running simulations with different assumptions. In addition, management supplements the official risk measures based on the constant balance sheet assumption with volume-based simulations of NII based on forecasted balances and with value-based simulations that measure the sensitivity of economic-value-of-equity (EVE) to changes in interest rates. We believe that, together, these simulations provide management with a reasonably comprehensive view of the sensitivity of our operating results to changes in interest rates, at least over the measurement horizon. However, as with any financial model, the underlying assumptions are inherently uncertain and subject to refinement as modeling techniques and theory improve and historical data becomes more readily accessible. Consequently, our simulation models cannot predict with certainty how rising or falling interest rates might impact net interest income. Actual and simulated NII results will differ to the extent there are differences between actual and assumed interest rate changes, balance sheet volumes, and management strategies, among other factors. At December 31, 2003 and June 30, 2004, our securities available for sale portfolio included $10.4 billion and $11.7 billion, respectively, of securities for ALM purposes with an expected weighted average maturity of 2.9 years and 3.1 years, respectively. In addition, this portfolio had an overall estimated effective duration of 2.7 compared to 2.5 at December 31, 2003. Duration is a measure of price sensitivity of a bond portfolio to immediate changes in interest rates. An effective duration of 2.7 suggests an expected price change of approximately 2.7 percent for an immediate one percent change in interest rates. This portfolio included $6.4 billion in mortgage-backed securities with an estimated duration of 3.2. This securities portfolio duration, in the context of our total balance sheet, after giving consideration to the composition of our core deposits, contributes to the maintenance of our current, essentially neutral, interest rate risk profile. TRADING ACTIVITIES We enter into trading account activities primarily as a financial intermediary for customers, and, to a minor extent, for our own account. By acting as a financial intermediary, we are able to provide our customers with access to a wide range of products from the securities, foreign exchange, and derivatives markets. In acting for our own account, we may take positions in some of these instruments with the objective of generating trading profits. These activities expose us to two primary types of market risk: interest rate and foreign currency exchange risk. In order to manage interest rate and foreign currency exchange risk associated with the securities and foreign exchange trading activities for our own account, we utilize a variety of non-statistical methods including: position limits for each trading activity, daily marking of all positions to market, daily profit and loss statements, position reports, and independent verification of all inventory pricing. Additionally, MRM reports positions and profits and losses daily to the Treasurer and trading managers and weekly to the 45 ALCO Chairman. ALCO is provided reports on a monthly basis. We believe that these procedures, which stress timely communication between MRM and senior management, are the most important elements of the risk management process. We use a form of Value at Risk (VaR) methodology to measure the overall market risk inherent in our trading account activities. Under this methodology, management statistically calculates, with 97.5 percent confidence, the potential loss in fair value that we might experience if an adverse shift in market prices were to occur within a period of 5 business days. The amount of VaR is managed within limits well below the maximum limit established by Board policy at 0.5 percent of stockholders' equity. The VaR model incorporates a number of key assumptions, including assumed holding period and historical volatility based on 3 years of historical market data updated quarterly. The following table sets forth the average, high and low VaR for our trading activities for the year ended December 31, 2003 and the quarter ended June 30, 2004. DECEMBER 31, 2003 JUNE 30, 2004 -------------------- --------------------- AVERAGE HIGH LOW AVERAGE HIGH LOW (DOLLARS IN THOUSANDS) VAR VAR VAR VAR VAR VAR ------------------------------ ------- ---- --- ------- ---- --- Foreign exchange.............. $143 $428 $57 $119 $293 $49 Securities.................... 206 463 97 269 339 138 Consistent with our business strategy of focusing on the sale of capital markets products to customers, we manage our trading risk exposures at conservative levels, well below the trading risk policy limits established by the Finance and Capital Committee of the Board. As a result, our foreign exchange business continues to derive the bulk of its revenue from customer-related transactions. We take inter-bank trading positions only on a limited basis and we do not take any large or long-term strategic positions in the market for our own portfolio. We continue to grow our customer-related foreign exchange business while maintaining an essentially unchanged inter-bank trading risk profile as measured under our VaR methodology. The Securities Trading and Institutional Sales department serves the fixed income needs of our institutional clients and acts as the fixed income wholesaler for our broker/dealer subsidiary, UBOC Investment Services, Inc. As with our foreign exchange business, we continue to generate the vast majority of our securities trading income from customer-related transactions. Our interest rate derivative contracts included, as of June 30, 2004, $4.1 billion notional amount of derivative contracts entered into as an accommodation for customers. We act as an intermediary and match these contracts, at a credit spread, to contracts with major dealers, thus neutralizing the related market risk. LIQUIDITY RISK Liquidity risk represents the potential for loss as a result of limitations on our ability to adjust our future cash flows to meet the needs of depositors and borrowers and to fund operations on a timely and cost-effective basis. The ALM Policy approved by the Finance and Capital Committee of the Board requires regular reviews of our liquidity by ALCO. Additionally, ALCO conducts monthly ongoing reviews of our liquidity situation. Liquidity is managed through this ALCO coordination process on a company-wide basis, encompassing all major business units. The operating management of liquidity is implemented through the funding and investment functions of the Global Markets Group. Our liquidity management draws upon the strengths of our extensive retail and commercial core deposit franchise, coupled with the ability to obtain funds for various terms in a variety of domestic and international money markets. Our securities portfolio represents a significant source of additional liquidity. Core deposits provide us with a sizable source of relatively stable and low-cost funds. Our average core deposits, which include demand deposits, money market demand accounts, and savings and consumer 46 time deposits, combined with average common stockholders' equity, funded 85 percent of average total assets of $44.6 billion in the second quarter of 2004. Most of the remaining funding was provided by short-term borrowings in the form of negotiable certificates of deposit, large time deposits, foreign deposits, federal funds purchased, securities sold under repurchase agreements, commercial paper, and other borrowings. In the fourth quarter of 2003, we issued $400 million in long-term subordinated debt. In February 2004, we used a portion of the net proceeds (approximately $350 million) from the sale of these securities to redeem our Trust Notes that were outstanding at December 31, 2003. The remainder of the net proceeds from this offering is for general corporate purposes, which may include extending credit to or funding investments in our subsidiaries, repurchasing shares of our common stock, reducing our existing indebtedness or financing possible acquisitions. The securities portfolio provides additional enhancement to our liquidity position, which may be created through repurchase agreements. At June 30, 2004, a liquidity need could have been met by transferring under repurchase agreements approximately $9.4 billion of our available for sale securities, with no portion of this balance being encumbered at June 30, 2004. Liquidity may also be provided by the sale or maturity of other assets such as interest-bearing deposits in banks, federal funds sold, and trading account securities. The aggregate balance of these assets averaged approximately $1.7 billion in the second quarter of 2004. Additional liquidity may be provided through loan maturities and sales. In the third quarter of 2003, we terminated the issuance of commercial paper under UnionBanCal Corporation's commercial paper program. UnionBanCal Commercial Funding Corporation (a UnionBanCal Corporation subsidiary) continues to issue commercial paper under another commercial paper program. The proceeds of this commercial paper program are deposited in Union Bank of California, N.A. and used to fund our Bank operations. REGULATORY CAPITAL The following tables summarize our risk-based capital, risk-weighted assets, and risk-based capital ratios.
UNIONBANCAL CORPORATION MINIMUM JUNE 30, DECEMBER 31, JUNE 30, REGULATORY (DOLLARS IN THOUSANDS) 2003 2003 2004 REQUIREMENT ------------------------ ---------------- ---------------- ---------------- ---------------- CAPITAL COMPONENTS Tier 1 capital.......... $ 3,791,651 $ 3,747,884 $ 3,706,202 Tier 2 capital.......... 538,163 936,189 922,122 ----------- ----------- ----------- Total risk-based capital $ 4,329,814 $ 4,684,073 $ 4,628,324 =========== =========== =========== Risk-weighted assets.... $33,142,588 $33,133,407 $35,422,904 =========== =========== =========== Quarterly average assets $39,366,344 $41,506,828 $44,339,052 =========== =========== ===========
CAPITAL RATIOS AMOUNT RATIO AMOUNT RATIO AMOUNT RATIO AMOUNT RATIO ------------------------ ---------- ----- ---------- ----- ------ ----- ---------- ----- Total capital (to risk- weighted assets)...... $4,329,814 13.06% $4,684,073 14.14% $4,628,324 13.07% >$2,833,832 8.0% - Tier 1 capital (to risk- weighted assets)...... 3,791,651 11.44 3,747,884 11.31 3,706,202 10.46 > 1,416,916 4.0 - Leverage(1)............. 3,791,651 9.63 3,747,884 9.03 3,706,202 8.36 > 1,773,562 4.0 - ------------------ (1) Tier 1 capital divided by quarterly average assets (excluding certain intangible assets).
47
UNION BANK OF CALIFORNIA, N.A. MINIMUM "WELL-CAPITALIZED" JUNE 30, DECEMBER 31, JUNE 30, REGULATORY REGULATORY (DOLLARS IN THOUSANDS) 2003 2003 2004 REQUIREMENT REQUIREMENT ------------------------ ---------------- ---------------- ---------------- ---------------- ------------------ CAPITAL COMPONENTS Tier 1 capital.......... $ 3,490,596 $ 3,395,519 $ 3,695,565 Tier 2 capital.......... 467,613 467,619 476,900 ----------- ----------- ----------- Total risk-based capital $ 3,958,209 $ 3,863,138 $ 4,172,465 =========== =========== =========== Risk-weighted assets.... $32,492,833 $32,526,017 $34,925,361 =========== =========== =========== Quarterly average assets $38,811,257 $40,921,517 $43,688,650 =========== =========== ===========
CAPITAL RATIOS AMOUNT RATIO AMOUNT RATIO AMOUNT RATIO AMOUNT RATIO AMOUNT RATIO ------------------------ ---------- ----- ---------- ----- ---------- ----- ---------- ----- ---------- ----- Total capital (to risk- weighted assets)...... $3,958,209 12.18% $3,863,138 11.88% $4,172,465 11.95% >$2,794,029 8.0% >$3,492,536 10.0% - - Tier 1 capital (to risk- weighted assets)...... 3,490,596 10.74 3,395,519 10.44 3,695,565 10.58 > 1,397,014 4.0 > 2,095,522 6.0 - - Leverage(1)............. 3,490,596 8.99 3,395,519 8.30 3,695,565 8.46 > 1,747,546 4.0 > 2,184,433 5.0 - - ------------------ (1) Tier 1 capital divided by quarterly average assets (excluding certain intangible assets).
We and Union Bank of California, N.A. are subject to various regulations of the federal banking agencies, including minimum capital requirements. We both are required to maintain minimum ratios of Total and Tier 1 capital to risk-weighted assets and of Tier 1 capital to quarterly average assets (the leverage ratio). Included in Tier 1 capital at year-end 2003 was $350 million in Trust Preferred Securities, which we redeemed on February 19, 2004 resulting in a decrease in our capital ratios at June 30, 2004 compared with June 30, 2003 and December 31, 2003. In December of 2003, we issued $400 million of long-term subordinated debt, which is included in Tier 2 capital as of December 31, 2003 (further discussion of our subordinated debt can be found in Note 11 of the Notes to Consolidated Financial Statements included in the Form 10-K for the year ended December 31, 2003). Compared with June 30, 2003, in addition to the changes to our capital structure mentioned in the above paragraph, the decrease in our capital ratios, with the exception of our total capital ratio, was also attributable to higher risk-weighted assets. Our total capital ratio increased slightly mainly due to higher equity. Our leverage ratio decrease was primarily attributable to a $5 billion, or 13 percent, increase in quarterly average assets, which was substantially the result of an increase in our securities portfolio. As of June 30, 2004, management believes the capital ratios of Union Bank of California, N.A. met all regulatory requirements of "well-capitalized" institutions, which are 10 percent for the Total risk-based capital ratio, 6 percent for the Tier 1 risk-based capital ratio and 5 percent for the leverage ratio. BUSINESS SEGMENTS We segregate our operations into four primary business units for the purpose of management reporting, as shown in the table that follows. The results show the financial performance of our major business units. The risk-adjusted return on capital (RAROC) methodology used seeks to attribute economic capital to business units consistent with the level of risk they assume. These risks are primarily credit risk, market risk and operational risk. Credit risk is the potential loss in economic value due to the likelihood that the obligor will not perform as agreed. Market risk is the potential loss in fair value due to changes in interest rates, currency rates and equity prices. Operational risk is the potential loss due to failures in internal control, system failures, or external events. The tables on the following pages reflect the condensed income statements, selected average balance sheet items and selected financial ratios for each of our primary business units. The information presented does not necessarily represent the business units' financial condition and results of operations as if they were independent entities. In addition, the tables include performance center earnings. A performance center is a special unit whose income generating activities, unlike typical profit centers, are based on other 48 business segment units' customer base. The revenues generated and expenses incurred for those transactions entered into to accommodate our customers are allocated to other business segments where the customer relationships reside. A performance center's purpose is to foster cross-selling with a total profitability view of the products and services it manages. For example, the Global Markets Trading and Sales unit, within the Global Markets Group, is a performance center that manages the foreign exchange, derivatives, and fixed income securities activities within the Global Markets organization. Unlike financial accounting, there is no authoritative body of guidance for management accounting equivalent to U.S. GAAP. Consequently, reported results are not necessarily comparable with those presented by other companies. The RAROC measurement methodology recognizes credit expense for expected losses arising from credit risk and attributes economic capital related to unexpected losses arising from credit, market and operational risks. As a result of the methodology used by the RAROC model to calculate expected losses, differences between the provision for credit losses and credit expense in any one period could be significant. However, over an economic cycle, the cumulative provision for credit losses and credit expense for expected losses should be substantially the same. Business unit results are based on an internal management reporting system used by management to measure the performance of the units and UnionBanCal Corporation as a whole. Our management reporting system identifies balance sheet and income statement items to each business unit based on internal management accounting policies. Net interest income is determined using our internal funds transfer pricing system, which assigns a cost of funds to assets or a credit for funds to liabilities and capital, based on their type, maturity or repricing characteristics. Noninterest income and expense directly or indirectly attributable to a business unit are assigned to that business. The business units are assigned the costs of products and services directly attributable to their business activity through standard unit cost accounting based on volume of usage. All other corporate expenses (overhead) are assigned to the business units based on a predetermined percentage of usage. 49 We have restated certain business units' results for the prior periods to reflect certain transfer pricing changes and any reorganization changes that may have occurred.
COMMUNITY BANKING COMMERCIAL AND INVESTMENT FINANCIAL INTERNATIONAL SERVICES GROUP SERVICES GROUP BANKING GROUP ------------------- ------------------- ----------------- AS OF AND FOR THE THREE MONTHS ENDED JUNE 30, ------------------------------------------------------------- 2003 2004 2003 2004 2003 2004 -------- -------- -------- -------- ------- ------- RESULTS OF OPERATIONS AFTER PERFORMANCE CENTER EARNINGS (DOLLARS IN THOUSANDS): Net interest income.................... $163,613 $185,829 $180,956 $191,471 $8,160 $ 9,222 Noninterest income..................... 111,878 129,793 61,552 72,543 26,090 22,261 -------- -------- -------- -------- ------- ------- Total revenue.......................... 275,491 315,622 242,508 264,014 34,250 31,483 Noninterest expense.................... 197,289 223,645 105,097 104,003 15,398 16,957 Credit expense (income)................ 8,064 7,797 42,145 26,480 547 645 -------- -------- -------- -------- ------- ------- Income (loss) before income tax expense (benefit)............................ 70,138 84,180 95,266 133,531 18,305 13,881 Income tax expense (benefit)........... 26,828 32,199 29,547 45,321 7,001 5,310 -------- -------- -------- -------- ------- ------- Net income (loss)...................... $ 43,310 $ 51,981 $ 65,719 $ 88,210 $11,304 $ 8,571 ======== ======== ======== ======== ======= ======= PERFORMANCE CENTER EARNINGS (DOLLARS IN THOUSANDS): Net interest income.................... $ 201 $ 149 $ (194) $ (87) $ 10 $ 26 Noninterest income..................... (8,046) (9,621) 14,566 15,271 253 343 Noninterest expense.................... (8,353) (7,308) 8,886 8,015 82 22 Net income (loss)...................... 294 (1,354) 3,430 4,464 110 215 Total loans (dollars in millions)...... 25 28 (45) (46) -- -- AVERAGE BALANCES (DOLLARS IN MILLIONS): Total loans(1)......................... $ 11,229 $ 12,256 $ 13,071 $ 12,140 $ 1,606 $ 1,820 Total assets........................... 12,236 13,463 15,161 14,467 2,009 2,254 Total deposits(1)...................... 16,432 19,291 12,236 14,379 1,471 2,042 FINANCIAL RATIOS: Risk adjusted return on capital(2)..... 26% 30% 15% 24% 67% 55% Return on average assets(2)............ 1.42 1.55 1.74 2.45 2.26 1.53 Efficiency ratio(3).................... 71.6 70.9 43.3 39.4 45.0 53.9 GLOBAL UNIONBANCAL MARKETS GROUP OTHER CORPORATION ------------------- ------------------- ------------------ AS OF AND FOR THE THREE MONTHS ENDED JUNE 30, -------------------------------------------------------------- 2003 2004 2003 2004 2003 2004 -------- -------- -------- -------- -------- -------- RESULTS OF OPERATIONS AFTER PERFORMANCE CENTER EARNINGS (DOLLARS IN THOUSANDS): Net interest income.................... $ 17,139 $(15,802) $ 15,909 $ 29,138 $385,777 $399,858 Noninterest income..................... 1,882 1,394 1,769 105,019 203,171 331,010 -------- -------- -------- -------- -------- -------- Total revenue.......................... 19,021 (14,408) 17,678 134,157 588,948 730,868 Noninterest expense.................... 3,744 4,441 29,476 27,356 351,004 376,402 Credit expense (income)................ 50 177 (25,806) (45,099) 25,000 (10,000) -------- -------- -------- -------- -------- -------- Income (loss) before income tax expense (benefit)............................ 15,227 (19,026) 14,008 151,900 212,944 364,466 Income tax expense (benefit)........... 5,824 (7,277) (1,014) 57,816 68,186 133,369 -------- -------- -------- -------- -------- -------- Net income (loss)...................... $ 9,403 $(11,749) $ 15,022 $ 94,084 $144,758 $231,097 ======== ======== ======== ======== ======== ======== PERFORMANCE CENTER EARNINGS (DOLLARS IN THOUSANDS): Net interest income...................... $ (128) $ (191) $ 111 $ 103 $ -- $ -- Noninterest income....................... (9,876) (9,523) 3,103 3,530 -- -- Noninterest expense...................... (2,025) (1,847) 1,410 1,118 -- -- Net income (loss)........................ (4,927) (4,858) 1,093 1,533 -- -- Total loans (dollars in millions)........ -- -- 20 18 -- -- AVERAGE BALANCES (DOLLARS IN MILLIONS): Total loans(1)........................... $ 287 $ 366 $ 324 $ 257 $ 26,517 $ 26,839 Total assets............................. 9,454 13,272 916 1,155 39,776 44,611 Total deposits(1)........................ 1,071 680 1,377 1,418 32,587 37,810 FINANCIAL RATIOS: Risk adjusted return on capital(2)....... 4% (5)% na na na na Return on average assets(2).............. 0.40 (0.36) na na 1.46% 2.08% Efficiency ratio(3)...................... 19.7 (30.8) na na 59.5 51.4 ------------------------------- (1) Represents loans and deposits for each business segment after allocation between the segments of loans and deposits originated in one segment but managed by another segment. (2) Annualized. (3) The efficiency ratio is noninterest expense, excluding foreclosed asset expense (income), as a percentage of net interest income and noninterest income. Foreclosed asset expense (income) was less than ($1 thousand) and $17 thousand in the second quarters of 2003 and 2004, respectively. na = not applicable
50
COMMUNITY BANKING COMMERCIAL AND INVESTMENT FINANCIAL INTERNATIONAL SERVICES GROUP SERVICES GROUP BANKING GROUP ------------------- ------------------- ------------------ AS OF AND FOR THE SIX MONTHS ENDED JUNE 30, -------------------------------------------------------------- 2003 2004 2003 2004 2003 2004 -------- -------- -------- -------- -------- -------- RESULTS OF OPERATIONS AFTER PERFORMANCE CENTER EARNINGS (DOLLARS IN THOUSANDS): Net interest income.................... $331,474 $368,496 $360,187 $374,978 $ 17,117 $ 17,030 Noninterest income..................... 213,503 246,394 119,464 142,170 41,573 40,450 -------- -------- -------- -------- -------- -------- Total revenue.......................... 544,977 614,890 479,651 517,148 58,690 57,480 Noninterest expense.................... 397,179 442,629 203,856 208,645 30,333 32,640 Credit expense (income)................ 15,783 15,584 84,607 57,706 1,052 1,249 -------- -------- -------- -------- -------- -------- Income (loss) before income tax expense (benefit)............................ 132,015 156,677 191,188 250,797 27,305 23,591 Income tax expense (benefit)........... 50,496 59,929 60,227 83,570 10,444 9,024 -------- -------- -------- -------- -------- -------- Net income (loss)...................... $ 81,519 $ 96,748 $130,961 $167,227 $ 16,861 $ 14,567 ======== ======== ======== ======== ======== ======== PERFORMANCE CENTER EARNINGS (DOLLARS IN THOUSANDS): Net interest income.................... $ 403 $ 322 $ (401) $ (204) $ 14 $ 35 Noninterest income..................... (18,410) (20,173) 29,415 31,889 582 616 Noninterest expense.................... (16,554) (16,503) 17,193 17,591 334 65 Net income (loss)...................... (937) (2,103) 7,387 8,776 162 362 Total loans (dollars in millions)...... 26 27 (46) (45) -- -- AVERAGE BALANCES (DOLLARS IN MILLIONS): Total loans(1)......................... $ 11,171 $ 12,174 $ 13,301 $ 12,112 $ 1,566 $ 1,692 Total assets........................... 12,132 13,387 15,375 14,330 1,966 2,129 Total deposits(1)...................... 16,113 18,978 11,797 13,859 1,494 1,853 FINANCIAL RATIOS: Risk adjusted return on capital(2)..... 25% 28% 15% 23% 54% 48% Return on average assets(2)............ 1.36 1.45 1.72 2.35 1.73 1.38 Efficiency ratio(3).................... 72.9 72.0 42.5 40.3 51.7 56.8 GLOBAL UNIONBANCAL MARKETS GROUP OTHER CORPORATION ------------------- ------------------- ---------------------- AS OF AND FOR THE SIX MONTHS ENDED JUNE 30, ------------------------------------------------------------------ 2003 2004 2003 2004 2003 2004 -------- -------- -------- -------- ---------- ---------- RESULTS OF OPERATIONS AFTER PERFORMANCE CENTER EARNINGS (DOLLARS IN THOUSANDS): Net interest income..................... $ 38,231 $(14,651) $ 29,548 $ 54,426 $ 776,557 $ 800,279 Noninterest income...................... 3,408 2,936 10,994 110,265 388,942 542,215 -------- -------- -------- -------- ---------- ---------- Total revenue........................... 41,639 (11,715) 40,542 164,691 1,165,499 1,342,494 Noninterest expense..................... 8,232 10,868 54,004 54,726 693,604 749,508 Credit expense (income)................. 100 227 (46,542) (89,766) 55,000 (15,000) -------- -------- -------- -------- ---------- ---------- Income (loss) before income tax expense (benefit)............................. 33,307 (22,810) 33,080 199,731 416,895 607,986 Income tax expense (benefit)............ 12,740 (8,725) 2,713 75,604 136,620 219,402 -------- -------- -------- -------- ---------- ---------- Net income (loss)....................... $ 20,567 $(14,085) $ 30,367 $124,127 $ 280,275 $ 388,584 ======== ======== ======== ======== ========== ========== PERFORMANCE CENTER EARNINGS (DOLLARS IN THOUSANDS): Net interest income..................... $ (230) $ (355) $ 214 $ 202 $ -- $ -- Noninterest income...................... (17,949) (19,719) 6,362 7,387 -- -- Noninterest expense..................... (3,653) (3,752) 2,680 2,599 -- -- Net income (loss)....................... (8,970) (10,079) 2,358 3,044 -- -- Total loans (dollars in millions)....... -- -- 20 18 -- -- AVERAGE BALANCES (DOLLARS IN MILLIONS): Total loans(1).......................... $ 251 $ 246 $ 331 $ 266 $ 26,620 $ 26,490 Total assets............................ 8,714 12,827 879 1,158 39,066 43,831 Total deposits(1)....................... 1,139 890 1,294 1,295 31,837 36,875 FINANCIAL RATIOS: Risk adjusted return on capital(2)...... 4% (3)% na na na na Return on average assets(2)............. 0.48 (0.22) na na 1.45% 1.78% Efficiency ratio(3)..................... 19.8 (92.8) na na 59.4 55.7 ------------------------------- (1) Represents loans and deposits for each business segment after allocation between the segments of loans and deposits originated in one segment but managed by another segment. (2) Annualized. (3) The efficiency ratio is noninterest expense, excluding foreclosed asset expense (income), as a percentage of net interest income and noninterest income. Foreclosed asset and noninterest income. Foreclosed asset expense was $51 thousand and $536 thousand in the first six months of 2003 and 2004, respectively. na = not applicable
51 COMMUNITY BANKING AND INVESTMENT SERVICES GROUP In the second quarter of 2004, net income increased $8.7 million, or 20 percent, compared to the second quarter of 2003. In the second quarter of 2004, total revenue increased $40.1 million, or 15 percent, compared to the second quarter of 2003. Increased asset and deposit volumes offset the effect of a lower interest rate environment leading to an increase of $22.2 million, or 14 percent, in net interest income over the second quarter of 2003. In the second quarter of 2004, noninterest income was $17.9 million, or 16 percent, higher than the second quarter of 2003 primarily due to higher deposit fees, increased card processing fees and increased insurance commissions. Noninterest expense increased $26.4 million, or 13 percent, in the second quarter of 2004 compared to the second quarter of 2003, with the majority of that increase being attributable to higher staff expenses related to our acquisitions and de novo branches, as well as increased deposit volumes and residential loan growth. In 2004, the Community Banking and Investment Services Group continues to emphasize growing the consumer asset portfolio, expanding wealth management services, extending the small business franchise, expanding the branch network, and expanding cross selling activities throughout the Bank. The strategy for growing the consumer asset portfolio primarily focused on mortgage and home equity products that may be originated through the branch network, as well as through channels such as wholesalers, correspondents, and whole loan purchases. As of June 30, 2004, residential mortgages grew by $1.4 billion, or 21 percent, from June 30, 2003. The Wealth Management division is focused on becoming a growing provider of banking and investment products for affluent individuals in geographic areas already served by us. We seek to provide quality service superior to that of our competitors and offer our customers an attractive product suite. Core elements of the initiative to extend our small business franchise include improving our sales force, increasing marketing activities, adding new locations, and developing online capabilities to complement physical distribution. It is anticipated that expansion of the distribution network will be achieved through acquisitions and new branch openings. On July 1, 2003, we completed the acquisition of Monterey Bay Bank, a $632 million asset savings and loan association headquartered in Watsonville, California, with eight full-service branches in the Greater Monterey Bay area. On January 16, 2004, we completed our acquisition of Business Bank of California, a commercial bank headquartered in San Bernardino, California, with $704 million in assets and fifteen full-service branches in the Southern California Inland Empire and the San Francisco Bay Area. The Community Banking and Investment Services Group is comprised of six major divisions: Community Banking, Wealth Management, Institutional Services and Asset Management, Consumer Asset Management, UBOC Markets and Insurance Services. COMMUNITY BANKING serves its customers through 297 full-service branches in California, and a network of 567 proprietary ATMs. Customers may also access our services 24 hours a day by telephone or through our WEBSITE at www.uboc.com. In addition, the division offers automated teller services. This division is organized by service delivery method, by markets and by geography. We serve our customers in the following ways: o through community banking branches, which serve consumers and businesses with checking and deposit services, as well as various types of consumer and business financing, brokerage products and services, and insurance services; o through on-line access to our internet banking services, which augment our physical delivery channels by providing an array of customer transaction, bill payment and loan payment services; o through branches and business banking centers, which serve businesses with annual sales up to $5 million; and o through in-store branches in supermarkets, which also serve consumers and businesses. 52 WEALTH MANAGEMENT provides private banking services to our affluent clientele. o The Private Bank focuses primarily on delivering financial services to high net worth individuals with sophisticated financial needs as well as to professional service firms. Specific products and services include trust and estate services, investment account management services, and deposit and credit products. A key strategy of The Private Bank is to expand its business by leveraging existing Bank client relationships. Through 14 existing locations in California, Oregon, and Washington, The Private Bank relationship managers offer all of our available products and services. INSTITUTIONAL SERVICES AND ASSET MANAGEMENT provides investment management and administration services for a broad range of individuals and institutions. o HighMark Capital Management, Inc., a registered investment advisor, provides investment advisory services to institutional clients and its proprietary mutual funds, the affiliated HighMark Funds. It also provides advisory services to Union Bank of California, N.A. trust and agency clients, including corporations, pension funds and individuals. HighMark Capital Management, Inc. also provides mutual fund support services. HighMark Capital Management, Inc.'s strategy is to increase assets under management by broadening its client base and expanding the distribution of shares of its mutual fund clients. o Institutional Services provides custody, corporate trust, and retirement plan services. Custody Services provides both domestic and international safekeeping/settlement services in addition to securities lending. Corporate Trust acts as trustee for corporate and municipal debt issues. Retirement Services provides a full range of defined benefit and defined contribution administrative services, including trustee services, administration, investment management, and 401(k) valuation services. The client base of Institutional Services includes financial institutions, corporations, government agencies, unions, insurance companies, mutual funds, investment managers, and non-profit organizations. Institutional Services' strategy is to continue to leverage and expand its position in our target markets. On May 17, 2004, Union Bank of California, N.A., signed a definitive agreement to acquire the business portfolio of CNA Trust Company. With this acquisition we expect that we will be better positioned to provide a more complete range of retirement services to our business clients. The transaction was completed on August 1, 2004. CONSUMER ASSET MANAGEMENT provides the centralized underwriting, processing, servicing, collection and administration for consumer assets including residential loans. On May 31, 2004, we completed the sale of our merchant card portfolio and formed a long-term marketing alliance with NOVA Information Systems (NOVA). NOVA acquired our merchant accounts and will provide processing services, customer service and support operations to our more than 10,000 merchant locations. We will market merchant services through our branch network in California, Oregon and Washington. o Consumer Asset Management is centralized in two California sites, one in San Diego and one in Brea, and o provides customer and credit management services for consumer loan products. UBOC MARKETS.In May 2004, the Bank announced a strategic move to realign the Bank's wholly owned brokerage subsidiary, UBOC Investment Services, Inc. and Personal Trust Sales with Securities Trading and Institutional Sales. The realignment advances our goals of leveraging and anchoring client relationships by enhancing the Bank's cross sell culture. o Our brokerage products and services are provided through UBOC Investment Services, Inc., a registered broker/dealer offering investment products to individuals and institutional clients, whose primary strategy is to further penetrate our existing client base. 53 INSURANCE SERVICES provides a range of risk management services and insurance products to business and retail customers. The group, which includes our 2001 acquisition of Armstrong/Robitaille, Inc., our 2002 acquisition of John Burnham and Company, and our 2003 acquisitions of Tanner Insurance Brokers, Inc. and Knight Insurance Agency, offers its risk management and insurance products through offices in California and Oregon. OTHER SERVICES Through alliances with other financial institutions, the Community Banking and Investment Services Group offers additional products and services, such as credit cards, leasing, and asset-based and leveraged financing. The group competes with larger banks by attempting to provide service quality superior to that of its major competitors. The group's primary means of competing with community banks include its branch network and its technology to deliver banking services. The group also offers convenient banking hours to consumers through our drive-through banking locations and selected branches that are open seven days a week. The group competes with a number of commercial banks, internet banks, savings associations and credit unions, as well as more specialized financial service providers such as investment brokerage companies, consumer finance companies, and residential real estate lenders. The group's primary competitors are other major depository institutions such as Bank of America, Citibank, Washington Mutual and Wells Fargo, as well as smaller community banks in the markets in which we operate. COMMERCIAL FINANCIAL SERVICES GROUP The Commercial Financial Services Group offers financing and cash management services to middle-market and large corporate businesses primarily headquartered in the western United States. The Commercial Financial Services Group has continued to focus specialized financing expertise to specific geographic markets and industry segments such as energy, entertainment, and real estate. Relationship managers in the Commercial Financial Services Group provide credit services, including commercial loans, accounts receivable and inventory financing, project financing, lease financing, trade financing and real estate financing. In addition to credit services, the group offers its customers access to cash management services delivered through deposit managers with experience in cash management solutions for businesses and government entities. In the second quarter of 2004, net income increased $22.5 million, or 34 percent, compared to the second quarter of 2003. In the second quarter of 2004, net interest income increased $10.5 million, or 6 percent, compared to the second quarter of 2003, partially attributable to the impact of increasing deposit balances and a lower cost of funds resulting from the lower interest rate environment. Excluding higher income in the private equity portfolio of $3.0 million, mainly related to higher net gains on private capital investments in the second quarter of 2004 compared to the second quarter of 2003, noninterest income increased $8.0 million, or 13 percent. This 13 percent increase was mainly attributable to higher deposit-related service fees. In the second quarter of 2004, noninterest expense decreased $1.1 million, or 1 percent. Credit expense decreased $15.7 million mainly as a result of a refinement in the RAROC allocation of capital and expected losses and lower loan balances year-over-year. The group's initiatives during 2004 continue to include expanding wholesale deposit activities and increasing domestic trade financing. Loan strategies include originating, underwriting and syndicating loans in core competency markets, such as the California middle-market, commercial real estate, energy, entertainment, equipment leasing and commercial finance. The Commercial Financial Services Group provides strong processing services, including services such as check processing and cash vault services. 54 The Commercial Financial Services Group is comprised of the following business units: o the Commercial Banking Division, which serves California middle-market and large corporate companies with commercial lending, trade financing, and asset- based loans; o the Corporate Deposit and Treasury Management Division, which provides deposit and cash management expertise to middle-market and large corporate clients, government agencies and specialized industries; o the Real Estate Industries Division, which provides real estate lending products such as construction loans, commercial mortgages and bridge financing; o the Energy Capital Services Division, which provides custom financing and project financing to oil and gas companies, as well as power and utility companies, nationwide and internationally; and o the Corporate Capital Markets Division, which provides custom financing to middle-market and large corporate clients in their defined industries and geographic markets, together with limited merchant and investment banking related products and services. The group's main strategy is to target industries and companies for which the group can reasonably expect to be one of a customer's primary banks. Consistent with its strategy, the group attempts to serve a large part of its targeted customers' credit and depository needs. The group competes with other banks primarily on the basis of the quality of its relationship managers, the delivery of quality customer service, and its reputation as a "business bank." The group also competes with a variety of other financial services companies. Competitors include other major California banks, as well as regional, national and international banks. In addition, the group competes with investment banks, commercial finance companies, leasing companies, and insurance companies. The Check Clearing for the 21st Century Act (Check 21) was signed into law on October 28, 2003, and will become effective on October 28, 2004. Check 21 is designed to foster innovation in the payments system and to enhance its efficiency by reducing some of the legal impediments to check truncation (that is, the banking process by which cancelled original checks are not returned to the customer with the customer's regular bank statement). The law facilitates check truncation by creating a new negotiable instrument called a substitute check, which would permit banks to truncate original checks, to process check information electronically, and to deliver substitute checks to banks that want to continue receiving paper checks. A substitute check will be the legal equivalent of the original check and will include all the information contained on the original check. The law does not require banks to accept checks in electronic form nor does it require banks to use the new authority granted by Check 21 to create substitute checks. The final regulations regarding Check 21 were published in July 2004. In order to manage and control the changes which may be necessitated by Check 21, we have established a "Check 21 Initiative Project Management Structure," composed of representatives from many of our operating and support units. The objective of this initiative is to allow us to prioritize and allocate our resources and mitigate risk to our ongoing operations. It is not possible at this time to predict the long-term financial impact of Check 21, and regulations thereunder, on our business. INTERNATIONAL BANKING GROUP The International Banking Group primarily focuses on providing correspondent banking and trade finance related products and services to international financial institutions worldwide. This focus includes products and services such as letters of credit, international payments, collections and providing short-term financing. The majority of the revenue generated by the International Banking Group is from financial institutions domiciled outside of the U.S. In the second quarter of 2004, net income decreased $2.7 million, or 24 percent, compared to the second quarter of 2003. Total revenue decreased $2.7 million or 8 percent, compared to the second quarter 55 of 2003. Net interest income increased $1.1 million, or 13 percent, compared to the second quarter of 2003 mainly attributable to higher demand deposit balances. Noninterest income was $3.8 million, or 15 percent, lower compared to the second quarter of 2003 primarily attributable to a $9.0 million gain on an early call of a Mexican Brady Bond in the second quarter of 2003 partially offset by a $3.7 million insurance recovery and higher payment and trade activities in the current quarter. Noninterest expense increased $1.6 million, or 10 percent, compared to the second quarter of 2003. In the second quarter of 2004, credit expense of $0.6 million was slightly higher compared to the second quarter of 2003. The International Banking Group's business revolves around short-term financing, mostly to banks, which provides service-related income, as well as significantly lower credit risk when compared to other lending activities. The group has a long history of providing correspondent banking and trade-related products and services to international financial institutions. We believe the group continues to achieve strong customer loyalty in the correspondent banking market. The International Banking Group, headquartered in San Francisco, also maintains offices in Asia, Latin America and Europe; and an international banking subsidiary in New York. GLOBAL MARKETS GROUP The Global Markets Group conducts business to support all of our business groups and their customers. This group is responsible for our treasury management, which encompasses wholesale funding, liquidity management, interest rate risk management, including the ALM securities portfolio management and derivatives hedging activities. Associated with this function, this group's results include the transfer pricing activity for us, which allocates to the other business segments their cost of funds on all asset categories and credit for funds on all liability categories. Another important function of the Global Markets Group is the offering of a broad range of risk management products, such as foreign exchange contracts and interest rate derivative hedge products for our client's risk management needs. It also trades fixed income securities to meet investment needs of our institutional and business clients. In May 2004, with a strategic realignment of the market and investment product offering functions, the UBOC Markets unit was formed, encompassing the risk management and fixed income products offerings of the Global Markets Group and UBOC Investment Services, Inc., the Bank's brokerage subsidiary. The UBOC Investment Services' management dually reports to the Global Markets Group and the Community Banking and Investment Services Group. UBOC Markets' income attributable to business with our clients is allocated, through performance centers, to the business units. In the second quarter of 2004, net loss was $11.7 million compared to net income of $9.4 million in the second quarter of 2003. Total revenue in the second quarter of 2004 decreased by $33.4 million, compared to the second quarter of 2003, resulting from a $32.9 million decrease in net interest income. The decrease in net interest income was primarily attributable to a higher transfer pricing residual in the second quarter of 2004 resulting from the continuing growth in core deposits, which are priced on longer-term liability rates, compared to our portfolio of relatively short-term loans and securities, which are priced at their shorter-term lending rates. Noninterest income decreased $0.5 million compared to the second quarter of 2003. Noninterest expense in the second quarter of 2004 increased $0.7 million, or 19 percent, compared to the second quarter of 2003, mainly attributable to the ineffectiveness on our cash flow hedges, which is recognized in noninterest expense. OTHER "Other" includes the following items: o corporate activities that are not directly attributable to one of the four major business units. Included in this category are certain other nonrecurring items such as the results of operations of certain parent company non-bank subsidiaries and the elimination of the fully taxable-equivalent basis amount; 56 o the adjustment between the credit expense under RAROC and the provision for credit losses under U.S. GAAP and earnings associated with unallocated equity capital; o the adjustment between the tax expense reported under RAROC using a tax rate of 38.25 percent and the Company's effective tax rates; o the Pacific Rim Corporate Group, with assets of $293 million at June 30, 2004, which offers a range of credit, deposit, and investment management products and services to companies in the U.S. which are affiliated with companies headquartered in Japan; and o the residual costs of support groups. Net income for "Other" in the second quarter of 2004 was $94.1 million. The results were impacted by the following factors: o Credit expense (income) of ($45.1) million was due to the difference between the $10.0 million reversal of provision for credit losses calculated under our U.S. GAAP methodology and the $35.1 million in expected losses for the reportable business segments, which utilizes the RAROC methodology; o Net interest income of $29.1 million, which resulted from the differences between the credit for equity for the reportable segments under RAROC and the net interest income earned by UnionBanCal Corporation, and a credit for deposits in the Pacific Rim Corporate Group; o Noninterest income of $105.0 million, which included a $93.0 million gain on the sale of our merchant card portfolio and an $8.5 million gain on the sale of real property; and o Noninterest expense of $27.4 million. Net income for "Other" in the second quarter of 2003 was $15.0 million. The results were impacted by the following factors: o Credit expense (income) of ($25.8) million was due to the difference between the $25.0 million provision for credit losses calculated under our U.S. GAAP methodology and the $50.8 million in expected losses for the reportable business segments, which utilizes the RAROC methodology; o Net interest income of $15.9 million, which resulted from the differences between the credit for equity for the reportable segments under RAROC and the net interest income earned by UnionBanCal Corporation, and a credit for deposits in the Pacific Rim Corporate Group; o Noninterest income of $1.8 million; and o Noninterest expense of $29.5 million. CERTAIN BUSINESS RISK FACTORS ADVERSE CALIFORNIA ECONOMIC CONDITIONS COULD ADVERSELY AFFECT OUR BUSINESS A substantial majority of our assets, deposits and fee income are generated in California. As a result, poor economic conditions in California may cause us to incur losses associated with higher default rates and decreased collateral values in our loan portfolio. Economic conditions in California are subject to various uncertainties at this time, including the decline in the technology sector, the California state government's budgetary difficulties and continuing fiscal difficulties. We have various banking relationships with the California State government, including credit and deposit relationships and funds transfer arrangements. If economic conditions in California decline, we expect that our level of problem assets could increase and our prospects for growth could be impaired. On March 2, 2004, the California electorate approved certain ballot measures, including a one-time economic recovery bond issue of up to $15 billion to pay off the State's accumulated general fund deficit. While these measures are expected to 57 provide near-term relief for the State government's fiscal situation, the State of California continues to face fiscal challenges, the long-term impact of which, on the State's economy, cannot be predicted with any certainty. THE CONTINUING WAR ON TERRORISM COULD ADVERSELY AFFECT U.S. ECONOMIC CONDITIONS Acts or threats of terrorism and actions taken by the U.S. or other governments as a result of such acts or threats may result in a downturn in U.S. economic conditions and could adversely affect business and economic conditions in the U.S. generally and in our principal markets. ADVERSE ECONOMIC FACTORS AFFECTING CERTAIN INDUSTRIES COULD ADVERSELY AFFECT OUR BUSINESS We are subject to certain industry-specific economic factors. For example, a significant and increasing portion of our total loan portfolio is related to residential real estate. Accordingly, a downturn in the real estate and housing industries in California could have an adverse effect on our operations. Increases in residential mortgage loan interest rates could also have an adverse effect on our operations by depressing new mortgage loan originations. We provide financing to businesses in a number of other industries that may be particularly vulnerable to industry-specific economic factors, including the communications / media industry, the retail industry, the airline industry, the power industry and the technology industry. Recent increases in fuel prices could adversely affect businesses in several of these industries. Industry-specific risks are beyond our control and could adversely affect our portfolio of loans, potentially resulting in an increase in nonperforming loans or charge-offs. FLUCTUATIONS IN INTEREST RATES COULD ADVERSELY AFFECT OUR BUSINESS Significant increases in market interest rates, or the perception that an increase may occur, could adversely affect both our ability to originate new loans and our ability to grow. Conversely, decreases in interest rates could result in an acceleration in the prepayment of loans. An increase in market interest rates could also adversely affect the ability of our floating-rate borrowers to meet their higher payment obligations. If this occurred, it could cause an increase in nonperforming assets and charge-offs, which could adversely affect our business. FLUCTUATIONS IN INTEREST RATES COULD ADVERSELY AFFECT OUR MARGIN SPREAD Changes in market interest rates, including changes in the relationship between short-term and long-term market interest rates or between different interest rate indices, can impact our margin spread, that is, the difference between the interest rates we charge on interest earning assets, such as loans, and the interest rates we pay on interest bearing liabilities, such as deposits or other borrowings. The impact, particularly in a falling interest rate environment, could result in a decrease in our interest income relative to interest expense. STOCKHOLDER VOTES ARE CONTROLLED BY THE BANK OF TOKYO-MITSUBISHI, LTD.; OUR INTERESTS MAY NOT BE THE SAME AS THE BANK OF TOKYO-MITSUBISHI, LTD.'S INTERESTS The Bank of Tokyo-Mitsubishi, Ltd., a wholly owned subsidiary of Mitsubishi Tokyo Financial Group, Inc., owns a majority (approximately 62 percent as of June 30, 2004) of the outstanding shares of our common stock. As a result, The Bank of Tokyo-Mitsubishi, Ltd. can elect all of our directors and can control the vote on all matters, including determinations such as: approval of mergers or other business combinations; sales of all or substantially all of our assets; any matters submitted to a vote of our stockholders; issuance of any additional common stock or other equity securities; incurrence of debt other than in the ordinary course of business; the selection and tenure of our Chief Executive Officer; payment of dividends with respect to common stock or other equity securities; and other matters that might be favorable to The Bank of Tokyo-Mitsubishi, Ltd. 58 A majority of our directors are independent of The Bank of Tokyo-Mitsubishi, Ltd. and are not officers or employees of UnionBanCal Corporation or any of our affiliates, including The Bank of Tokyo-Mitsubishi, Ltd. However, because of The Bank of Tokyo-Mitsubishi, Ltd.'s control over the election of our directors, we could designate ourselves as a "controlled company" under the New York Stock Exchange Rules and could change the composition of our Board of Directors so that the Board would not have a majority of independent directors. The Bank of Tokyo-Mitsubishi, Ltd.'s ability to prevent an unsolicited bid for us or any other change in control could have an adverse effect on the market price for our common stock. POSSIBLE FUTURE SALES OF SHARES BY THE BANK OF TOKYO-MITSUBISHI, LTD. COULD ADVERSELY AFFECT THE MARKET FOR OUR STOCK The Bank of Tokyo-Mitsubishi, Ltd. may sell shares of our common stock in compliance with the federal securities laws. By virtue of The Bank of Tokyo-Mitsubishi, Ltd.'s current control of us, The Bank of Tokyo-Mitsubishi, Ltd. could sell large amounts of shares of our common stock by causing us to file a registration statement that would allow them to sell shares more easily. In addition, The Bank of Tokyo-Mitsubishi, Ltd. could sell shares of our common stock without registration. Although we can make no prediction as to the effect, if any, that such sales would have on the market price of our common stock, sales of substantial amounts of our common stock, or the perception that such sales could occur, could adversely affect the market price of our common stock. If The Bank of Tokyo-Mitsubishi, Ltd. sells or transfers shares of our common stock as a block, another person or entity could become our controlling stockholder. THE BANK OF TOKYO-MITSUBISHI, LTD.'S FINANCIAL CONDITION COULD ADVERSELY AFFECT OUR OPERATIONS We fund our operations independently of The Bank of Tokyo-Mitsubishi, Ltd. and believe our business is not necessarily closely related to The Bank of Tokyo-Mitsubishi, Ltd.'s business or outlook, including the proposed merger with UFJ Holdings, Inc. However, The Bank of Tokyo-Mitsubishi, Ltd.'s credit ratings may affect our credit ratings. The Bank of Tokyo-Mitsubishi, Ltd. is also subject to regulatory oversight and review by Japanese and US regulatory authorities. Our business operations and expansion plans could be negatively affected by regulatory concerns related to the Japanese financial system and The Bank of Tokyo-Mitsubishi, Ltd., including the proposed merger with UFJ Holdings, Inc. POTENTIAL CONFLICTS OF INTEREST WITH THE BANK OF TOKYO-MITSUBISHI, LTD. COULD ADVERSELY AFFECT US The Bank of Tokyo-Mitsubishi, Ltd.'s view of possible new businesses, strategies, acquisitions, divestitures or other initiatives may differ from ours. This may delay or hinder us from pursuing such initiatives. Also, as part of The Bank of Tokyo-Mitsubishi, Ltd.'s normal risk management processes, The Bank of Tokyo-Mitsubishi, Ltd. manages global credit exposures and concentrations on an aggregate basis, including UnionBanCal Corporation. Therefore, at certain levels or in certain circumstances, our ability to approve certain credits or other banking transactions and categories of customers is subject to the concurrence of The Bank of Tokyo-Mitsubishi, Ltd. We may wish to extend credit or furnish other banking services to the same customers as The Bank of Tokyo-Mitsubishi, Ltd. Our ability to do so may be limited for various reasons, including The Bank of Tokyo-Mitsubishi, Ltd.'s aggregate credit exposure and marketing policies. Certain directors' and officers' ownership interests in The Bank of Tokyo-Mitsubishi, Ltd.'s common stock or service as a director or officer or other employee of both us and The Bank of Tokyo-Mitsubishi, Ltd. could create or appear to create potential conflicts of interest, especially since both of us compete in the U.S. banking industry. 59 SUBSTANTIAL COMPETITION IN THE CALIFORNIA BANKING MARKET COULD ADVERSELY AFFECT US Banking is a highly competitive business. We compete actively for loan, deposit, and other financial services business in California, as well as nationally and internationally. Our competitors include a large number of state and national banks, thrift institutions, credit unions and major foreign- affiliated or foreign banks, as well as many financial and nonfinancial firms that offer services similar to those offered by us. Some of our competitors are community banks that have strong local market positions. Other competitors include large financial institutions that have substantial capital, technology and marketing resources. Such large financial institutions may have greater access to capital at a lower cost than us, which may adversely affect our ability to compete effectively. Banks, securities firms, and insurance companies can now combine as a "financial holding company." Financial holding companies can offer virtually any type of financial service, including banking, securities underwriting, insurance (both agency and underwriting), and merchant banking. Recently, a number of foreign banks have acquired financial services companies in the U.S., further increasing competition in the U.S. market. RESTRICTIONS ON DIVIDENDS AND OTHER DISTRIBUTIONS COULD LIMIT AMOUNTS PAYABLE TO US As a holding company, a substantial portion of our cash flow typically comes from dividends our bank and nonbank subsidiaries pay to us. Various statutory provisions restrict the amount of dividends our subsidiaries can pay to us without regulatory approval. In addition, if any of our subsidiaries liquidate, that subsidiary's creditors will be entitled to receive distributions from the assets of that subsidiary to satisfy their claims against it before we, as a holder of an equity interest in the subsidiary, will be entitled to receive any of the assets of the subsidiary. ADVERSE EFFECTS OF, OR CHANGES IN, BANKING OR OTHER LAWS AND REGULATIONS OR GOVERNMENTAL FISCAL OR MONETARY POLICIES COULD ADVERSELY AFFECT US We are subject to significant federal and state regulation and supervision, which is primarily for the benefit and protection of our customers and not for the benefit of investors. In the past, our business has been materially affected by these regulations. This trend is likely to continue in the future. Laws, regulations or policies, including accounting standards and interpretations currently affecting us and our subsidiaries may change at any time. Regulatory authorities may also change their interpretation of these statutes and regulations. Therefore, our business may be adversely affected by any future changes in laws, regulations, policies or interpretations or regulatory approaches to compliance and enforcement, including legislative and regulatory reactions to the terrorist attack on September 11, 2001, and future acts of terrorism, and the Enron Corporation, WorldCom, Inc. and other major U.S. corporate bankruptcies and reports of accounting irregularities at U.S. public companies, including various large and publicly traded companies. Additionally, our international activities may be subject to the laws and regulations of the jurisdiction where business is being conducted. International laws, regulations and policies affecting us and our subsidiaries may change at any time and affect our business opportunities and competitiveness in these jurisdictions. Due to The Bank of Tokyo-Mitsubishi, Ltd.'s controlling ownership of us, laws, regulations and policies adopted or enforced by the Government of Japan may adversely affect our activities and investments and those of our subsidiaries in the future. In addition, our business model relies, in part, upon cross-marketing the services offered by UnionBanCal Corporation and our subsidiaries to our customers. Laws that restrict our ability to share information about customers within our corporate organization could adversely affect our business, results of operations and financial condition. Additionally, our business is affected significantly by the fiscal and monetary policies of the federal government and its agencies. We are particularly affected by the policies of the Federal Reserve Board, which regulates the supply of money and credit in the U.S. Under long-standing policy of the Federal 60 Reserve Board, a bank holding company is expected to act as a source of financial strength for its subsidiary banks. As a result of that policy, we may be required to commit financial and other resources to our subsidiary bank in circumstances where we might not otherwise do so. Among the instruments of monetary policy available to the Federal Reserve Board are (a) conducting open market operations in U.S. government securities, (b) changing the discount rates of borrowings by depository institutions, and (c) imposing or changing reserve requirements against certain borrowings by banks and their affiliates. These methods are used in varying degrees and combinations to directly affect the availability of bank loans and deposits, as well as the interest rates charged on loans and paid on deposits. The policies of the Federal Reserve Board may have a material effect on our business, results of operations and financial condition. RISKS ASSOCIATED WITH POTENTIAL ACQUISITIONS OR DIVESTITURES OR RESTRUCTURINGS MAY ADVERSELY AFFECT US We may seek to acquire or invest in financial and non-financial companies, technologies, services or products that complement our business. There can be no assurance that we will be successful in completing any such acquisition or investment as this will depend on the availability of prospective target opportunities at valuation levels we find attractive and the competition for such opportunities from other bidders. In addition, we continue to evaluate the performance of all of our businesses and business lines and may sell a business or business line. Any acquisitions, divestitures or restructurings may result in the issuance of potentially dilutive equity securities, significant write-offs, including those related to goodwill and other intangible assets, and/or the incurrence of debt, any of which could have a material adverse effect on our business, results of operations and financial condition. Acquisitions, divestitures or restructurings could involve numerous additional risks including difficulties in obtaining any required regulatory approvals and in the assimilation or separation of operations, services, products and personnel, the diversion of management's attention from other business concerns, higher than expected deposit attrition (run-off), divestitures required by regulatory authorities, the disruption of our business, and the potential loss of key employees. There can be no assurance that we will be successful in addressing these or any other significant risks encountered. SIGNIFICANT LEGAL ACTIONS COULD SUBJECT US TO SUBSTANTIAL UNINSURED LIABILITIES We may be subject to claims related to our operations. Such legal actions could involve large claims and significant defense costs. To protect ourselves from the cost of these claims, we maintain insurance coverage in amounts and with deductibles that we believe are appropriate for our operations. However, our insurance coverage may not cover all claims against us or continue to be available to us at a reasonable cost. As a result, we may be exposed to substantial uninsured liabilities, which could adversely affect our business, results of operations and financial condition. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK A complete explanation concerning our market risk exposure is incorporated by reference to Part I, Item 2 of this document under the captions "Quantitative and Qualitative Disclosures about Market Risk," "Liquidity Risk," and "Certain Business Risk Factors." ITEM 4. CONTROLS AND PROCEDURES Our Chief Executive Officer (principal executive officer) and Chief Financial Officer (principal financial officer) have concluded that the design and operation of our disclosure controls and procedures are effective as of June 30, 2004. This conclusion is based on an evaluation conducted under the supervision and with the participation of management. Disclosure controls and procedures are those controls and procedures which ensure that information required to be disclosed in this filing is accumulated and communicated to management and is recorded, processed, summarized and reported in a timely manner and in accordance with Securities and Exchange Commission rules and regulations. During the quarter ended June 30, 2004, there were no changes in our internal controls over financial reporting that materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting. 61 PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS We are subject to various pending and threatened legal actions that arise in the normal course of business. We maintain reserves for losses from legal actions that are both probable and estimable. Union Bank of California, N.A., our major subsidiary (the Bank), was named in a suit pending in the United States District Court for the Central District of California, Neilson v. Union Bank of California et al (filed September 4, 2002). The plaintiffs in this suit sought in excess of $250 million, which was alleged to have been lost by those who invested money in various investment arrangements conducted by an individual named Reed Slatkin. Mr. Slatkin is alleged to have been operating a fraudulent investment scheme commonly referred to as a "Ponzi" scheme. The plaintiffs in the Neilson case included both investors in the arrangements conducted by Mr. Slatkin and the trustee of Mr. Slatkin's bankruptcy estate. A substantial majority of those who invested with Mr. Slatkin had no relationship with the Bank. A small minority, comprising less than five percent of the investors, had custodial accounts with the Bank. The Neilson case seeks to impose liability upon the Bank and two other financial institutions for both the losses suffered by those custodial customers as well as investors who had no relationship with the Bank. We have reached an agreement in principle to resolve the Nielson matter, which calls for a payment by the Company of $10 million, $6 million of which will be paid by the Company's insurance carrier. This agreement in principle is in the process of being documented and will thereafter require court approval. The disposition of this claim, on the basis described above, assuming that the settlement becomes final and approved, will not have a material adverse effect on our financial position or results of operations, since a reserve has been established for the loss. Two other suits naming the Bank, Christensen v. Union Bank of California (formerly captioned as Rockoff v. Union Bank of California et al.) (filed in the United States District Court for the Central District of California on December 21, 2001) and Kilpatrick v. Orrick Herrington & Sutcliffe, et al. (filed in Los Angeles County Superior Court on April 22, 2003 as to the Bank) related to the allegedly fraudulent investment scheme conducted by Mr. Slatkin. The dismissal of the Christensen case and the settlement of the Kilpatrick case were reported in the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 2004. Another suit, Grafton Partners LP v. Union Bank of California, is pending in Alameda County Superior Court (filed March 12, 2003). That suit concerns an unrelated "Ponzi" scheme perpetrated by PinnFund, USA, located in San Diego, California. The victims of this scheme seek $235 million from the Bank. They assert that the Bank improperly opened and administered a deposit account, which was used by PinnFund in furtherance of the fraud. The Bank has numerous legal defenses to the Grafton case. Based on our evaluation to date of this claim, management believes that this matter will not result in a material adverse effect on our financial position or results of operations. 62 ITEM 2. CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY SECURITIES Repurchases of equity securities are presented in the table below.
TOTAL NUMBER OF MAXIMUM NUMBER (OR TOTAL NUMBER SHARES (OR UNITS) APPROXIMATE DOLLAR VALUE) OF SHARES AVERAGE PRICE PURCHASED AS PART OF OF SHARES (OR UNITS) THAT (OR UNITS) PAID PER SHARE PUBLICLY ANNOUNCED MAY YET BE PURCHASED UNDER PERIOD PURCHASED (OR UNIT) PLANS OR PROGRAMS THE PLANS OR PROGRAMS ------- ------------ -------------- ----------------- -------------------------- APRIL 2004 (April 28, 2004)....... -- $ -- -- $257,764,104 MAY 2004 (May 7 - 28, 2004)..... 115,000 $54.10 115,000 $251,542,697 JUNE 2004 (June 1 - 4, 2004)..... 95,000 $56.77 95,000 $246,149,446(1) --------- ------ --------- TOTAL.................. 1,039,700 $53.54 1,039,700 ========= ====== ========= --------------------------------------- (1) $200 million is available from a $200 million repurchase program announced on April 28, 2004. $46 million remains available from a $200 million repurchase program announced on April 22, 2003.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS For information regarding matters submitted to a vote at the Annual Meeting of Shareholders on April 28, 2004, see Part II, Item 4 of our Report on Form 10-Q for the quarter ended March 31, 2004, incorporated by reference herein. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K. (A) EXHIBITS: NO. DESCRIPTION ---- --------------------------------------------------------------------------- 2.1 Agreement and Plan of Merger by and among UnionBanCal Corporation, Union Bank of California, N.A., Jackson National Insurance Company and Jackson Federal Bank dated as of July 1, 2004(1) 10.1 Philip B. Flynn Employment Agreement (Effective April 1, 2004)(2)* 10.2 Robert M. Walker Separation Agreement (Effective April 16, 2004)(3)* 31.1 Certification of the Chief Executive Officer pursuant to Rule 13a-14a/15d-14(a) of the Exchange Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002(3) 31.2 Certification of the Chief Financial Officer pursuant to Rule 13a-14a/15d-14(a) of the Exchange Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002(3) 32.1 Certification of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002(3) 32.2 Certification of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002(3) ------------------------------------ (1) Incorporated by reference to the UnionBanCal Corporation current report on Form 8-K, dated July 1, 2004 (2) Incorporated by reference to the UnionBanCal Corporation Quarterly Report on Form 10-Q for the quarter ended March 31, 2004 (SEC File No. 1-15081). (3) Filed herewith * Management contract or compensatory plan, contract or arrangement 63 (B) REPORTS ON FORM 8-K We furnished a report on Form 8-K dated April 20, 2004 reporting under Item 12 thereof that UnionBanCal Corporation issued a press release concerning earnings for the first quarter of 2004. 64 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, UnionBanCal Corporation has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. UNIONBANCAL CORPORATION (Registrant) By: /S/ NORIMICHI KANARI --------------------------------------- Norimichi Kanari PRESIDENT AND CHIEF EXECUTIVE OFFICER (Principal Executive Officer) By: /S/ DAVID I. MATSON --------------------------------------- David I. Matson EXECUTIVE VICE PRESIDENT AND CHIEF FINANCIAL OFFICER (Principal Financial Officer) By: /S/ DAVID A. ANDERSON --------------------------------------- David A. Anderson SENIOR VICE PRESIDENT AND CONTROLLER (Principal Accounting Officer) Date: August 6, 2004 65