-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, TyI1OwsPKT2Xq55LFTVvlxqTOOY7ZdY+8S30sc6ZeAN7nSU9YLPHVl8dO5eaEz37 +086dNnpZzeefURIX9AuRg== 0001011659-04-000025.txt : 20041105 0001011659-04-000025.hdr.sgml : 20041105 20041105164908 ACCESSION NUMBER: 0001011659-04-000025 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 5 CONFORMED PERIOD OF REPORT: 20040930 FILED AS OF DATE: 20041105 DATE AS OF CHANGE: 20041105 FILER: COMPANY DATA: COMPANY CONFORMED NAME: UNIONBANCAL CORP CENTRAL INDEX KEY: 0001011659 STANDARD INDUSTRIAL CLASSIFICATION: NATIONAL COMMERCIAL BANKS [6021] IRS NUMBER: 941234979 STATE OF INCORPORATION: CA FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: 1934 Act SEC FILE NUMBER: 001-15081 FILM NUMBER: 041123305 BUSINESS ADDRESS: STREET 1: 400 CALIFORNIA STREET CITY: SAN FRANCISCO STATE: CA ZIP: 94104-1476 BUSINESS PHONE: 4157652969 MAIL ADDRESS: STREET 1: 400 CALIFORNIA STREET CITY: SAN FRANCISCO STATE: CA ZIP: 94104-1476 10-Q 1 form10q093004.txt SEPTEMBER 30, 2004 FORM 10-Q ================================================================================ 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 SEPTEMBER 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 October 29, 2004: 149,502,442 ================================================================================ 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......................................................... 24 Executive Overview................................................... 24 Critical Accounting Policies......................................... 25 Financial Performance................................................ 27 Net Interest Income.................................................. 31 Noninterest Income................................................... 34 Noninterest Expense.................................................. 35 Income Tax Expense................................................... 35 Loans................................................................ 36 Cross-Border Outstandings............................................ 38 Provision for Credit Losses.......................................... 38 Allowance for Credit Losses.......................................... 38 Nonperforming Assets................................................. 41 Loans 90 Days or More Past Due and Still Accruing.................... 43 Quantitative and Qualitative Disclosures About Market Risk........... 43 Liquidity Risk....................................................... 47 Regulatory Capital................................................... 48 Business Segments.................................................... 49 Regulatory Matters................................................... 57 Certain Business Risk Factors........................................ 58 Item 3. Quantitative and Qualitative Disclosures about Market Risk..... 62 Item 4. Controls and Procedures........................................ 62 PART II OTHER INFORMATION Item 1. Legal Proceedings.............................................. 63 Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.... 63 Item 6. Exhibits....................................................... 64 Signatures............................................................. 65 PART I. FINANCIAL INFORMATION UNIONBANCAL CORPORATION AND SUBSIDIARIES CONSOLIDATED FINANCIAL HIGHLIGHTS (UNAUDITED)
AS OF AND FOR THE THREE MONTHS ENDED ---------------------------- SEPTEMBER 30, SEPTEMBER 30, PERCENT (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 2003 2004 CHANGE - -------------------------------------------------- ------------- ------------- ------- RESULTS OF OPERATIONS: Net interest income(1).......................... $ 401,736 $ 413,102 2.83% (Reversal of) provision for credit losses....... 20,000 (10,000) nm Noninterest income.............................. 201,470 215,954 7.19 Noninterest expense............................. 348,861 372,391 6.74 ------------- ------------- Income before income taxes(1)................... 234,345 266,665 13.79 Taxable-equivalent adjustment................... 647 1,012 56.41 Income tax expense.............................. 78,653 102,215 29.96 ------------- ------------- Net income...................................... $ 155,045 $ 163,438 5.41 ============= ============= PER COMMON SHARE: Net income--basic............................... $ 1.04 $ 1.11 6.73% Net income--diluted............................. 1.02 1.09 6.86 Dividends(2).................................... 0.31 0.36 16.13 Book value (end of period)...................... 25.32 28.04 10.74 Common shares outstanding (end of period)(3).... 145,105,566 147,163,392 1.42 Weighted average common shares outstanding --basic(3).................................... 149,528,298 147,554,853 (1.32) Weighted average common shares outstanding --diluted(3).................................. 151,561,790 150,379,127 (0.78) BALANCE SHEET (END OF PERIOD): Total assets.................................... $ 42,602,745 $ 46,990,605 10.30% Total loans..................................... 26,047,376 28,625,086 9.90 Nonaccrual loans................................ 341,039 180,156 (47.17) Nonperforming assets............................ 344,347 190,763 (44.60) Total deposits.................................. 35,957,805 39,342,229 9.41 Medium and long-term debt....................... 417,369 820,460 96.58 Junior subordinated debt........................ -- 15,904 nm Trust preferred securities...................... 356,629 -- nm Stockholders' equity............................ 3,674,107 4,126,159 12.30 BALANCE SHEET (PERIOD AVERAGE): Total assets.................................... $ 41,913,515 $ 45,713,280 9.07% Total loans..................................... 26,331,986 28,147,293 6.89 Earning assets.................................. 37,855,869 41,427,609 9.44 Total deposits.................................. 34,902,964 38,114,310 9.20 Stockholders' equity............................ 3,834,834 4,067,953 6.08 FINANCIAL RATIOS: Return on average assets(4)..................... 1.47% 1.42% Return on average stockholders' equity(4)....... 16.04 15.98 Efficiency ratio(5)............................. 57.85 59.20 Net interest margin(1).......................... 4.22 3.98 Dividend payout ratio........................... 29.81 32.43 Tangible equity ratio........................... 8.05 8.03 Tier 1 risk-based capital ratio................. 10.96 9.99 Total risk-based capital ratio.................. 12.58 12.52 Leverage ratio.................................. 8.73 8.27 Allowance for credit losses to total loans...... 2.11 1.69 Allowance for credit losses to nonaccrual loans. 161.43 267.97 Net loans charged off to average total loans(4). 0.58 0.12 Nonperforming assets to total loans and foreclosed assets............................. 1.32 0.67 Nonperforming assets to total assets............ 0.81 0.41 - --------------------------------- (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. nm--not meaningful
2 PART I. FINANCIAL INFORMATION UNIONBANCAL CORPORATION AND SUBSIDIARIES CONSOLIDATED FINANCIAL HIGHLIGHTS (UNAUDITED)
AS OF AND FOR THE NINE MONTHS ENDED ---------------------------- SEPTEMBER 30, SEPTEMBER 30, PERCENT (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 2003 2004 CHANGE - -------------------------------------------------- ------------- ------------- ------- RESULTS OF OPERATIONS: Net interest income(1).......................... $ 1,179,562 $ 1,214,986 3.00% (Reversal of) provision for credit losses....... 75,000 (25,000) nm Noninterest income.............................. 590,412 758,169 28.41 Noninterest expense............................. 1,042,465 1,121,899 7.62 ------------- ------------- Income before income taxes(1)................... 652,509 876,256 34.29 Taxable-equivalent adjustment................... 1,916 2,617 36.59 Income tax expense.............................. 215,273 321,617 49.40 ------------- ------------- Net income...................................... $ 435,320 $ 552,022 26.81 ============= ============= PER COMMON SHARE: Net income--basic............................... $ 2.90 $ 3.74 28.97% Net income--diluted............................. 2.87 3.68 28.22 Dividends(2).................................... 0.90 1.03 14.44 Book value (end of period)...................... 25.32 28.04 10.74 Common shares outstanding (end of period)(3).... 145,105,566 147,163,392 1.42 Weighted average common shares outstanding --basic(3).................................... 150,059,789 147,547,527 (1.67) Weighted average common shares outstanding --diluted(3).................................. 151,544,757 150,026,647 (1.00) BALANCE SHEET (END OF PERIOD): Total assets.................................... $ 42,602,745 $ 46,990,605 10.30% Total loans..................................... 26,047,376 28,625,086 9.90 Nonaccrual loans................................ 341,039 180,156 (47.17) Nonperforming assets............................ 344,347 190,763 (44.60) Total deposits.................................. 35,957,805 39,342,229 9.41 Medium and long-term debt....................... 417,369 820,460 96.58 Junior subordinated debt........................ -- 15,904 nm Trust preferred securities...................... 356,629 -- nm Stockholders' equity............................ 3,674,107 4,126,159 12.30 BALANCE SHEET (PERIOD AVERAGE): Total assets.................................... $ 40,025,749 $ 44,463,183 11.09% Total loans..................................... 26,522,687 27,046,262 1.97 Earning assets.................................. 36,263,471 40,222,338 10.92 Total deposits.................................. 32,870,184 37,290,976 13.45 Stockholders' equity............................ 3,875,990 3,984,194 2.79 FINANCIAL RATIOS: Return on average assets(4)..................... 1.45% 1.66% Return on average stockholders' equity(4)....... 15.02 18.51 Efficiency ratio(5)............................. 58.90 56.83 Net interest margin(1).......................... 4.35 4.03 Dividend payout ratio........................... 31.03 27.54 Tangible equity ratio........................... 8.05 8.03 Tier 1 risk-based capital ratio................. 10.96 9.99 Total risk-based capital ratio.................. 12.58 12.52 Leverage ratio.................................. 8.73 8.27 Allowance for credit losses to total loans...... 2.11 1.69 Allowance for credit losses to nonaccrual loans. 161.43 267.97 Net loans charged off to average total loans(4). 0.73 0.15 Nonperforming assets to total loans and foreclosed assets............................. 1.32 0.67 Nonperforming assets to total assets............ 0.81 0.41 - -------------------------------------- (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. nm--not meaningful
3 ITEM 1. FINANCIAL STATEMENTS UNIONBANCAL CORPORATION AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)
FOR THE THREE MONTHS FOR THE NINE MONTHS ENDED SEPTEMBER 30, ENDED SEPTEMBER 30, -------------------- ---------------------- (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 2003 2004 2003 2004 - ----------------------------------------------------- -------- -------- ---------- ---------- INTEREST INCOME Loans............................................. $349,918 $350,587 $1,067,806 $1,014,288 Securities........................................ 93,252 106,172 251,151 320,082 Interest bearing deposits in banks................ 922 2,744 3,014 4,773 Federal funds sold and securities purchased under resale agreements............................... 2,532 1,616 8,210 6,503 Trading account assets............................ 870 1,140 2,740 2,558 -------- -------- ---------- ---------- Total interest income........................... 447,494 462,259 1,332,921 1,348,204 -------- -------- ---------- ---------- INTEREST EXPENSE Domestic deposits................................. 34,984 34,876 116,772 100,609 Foreign deposits.................................. 1,991 5,007 8,008 9,900 Federal funds purchased and securities sold under repurchase agreements........................... 689 2,861 2,763 4,094 Commercial paper.................................. 1,723 1,697 7,397 3,883 Medium and long-term debt......................... 1,738 4,369 5,422 11,201 Preferred securities and trust notes.............. 3,607 242 10,930 2,553 Other borrowed funds.............................. 1,673 1,117 3,983 3,595 -------- -------- ---------- ---------- Total interest expense.......................... 46,405 50,169 155,275 135,835 -------- -------- ---------- ---------- NET INTEREST INCOME................................. 401,089 412,090 1,177,646 1,212,369 (Reversal of) provision for credit losses......... 20,000 (10,000) 75,000 (25,000) -------- -------- ---------- ---------- Net interest income after (reversal of) provision for credit losses................... 381,089 422,090 1,102,646 1,237,369 -------- -------- ---------- ---------- NONINTEREST INCOME Service charges on deposit accounts............... 81,832 87,555 232,061 258,682 Trust and investment management fees.............. 35,429 39,089 101,245 111,699 Insurance commissions............................. 15,814 17,463 45,056 57,850 International commissions and fees................ 17,380 18,906 49,581 54,553 Card processing fees, net......................... 10,335 4,653 29,357 28,901 Merchant banking fees............................. 9,312 11,682 21,521 26,863 Foreign exchange gains, net....................... 7,574 8,548 21,466 25,186 Brokerage commissions and fees.................... 7,549 8,527 24,614 24,847 Securities gains (losses), net.................... (2,618) (6) 7,042 1,612 Other............................................. 18,863 19,537 58,469 167,976 -------- -------- ---------- ---------- Total noninterest income........................ 201,470 215,954 590,412 758,169 -------- -------- ---------- ---------- NONINTEREST EXPENSE Salaries and employee benefits.................... 205,302 216,767 602,338 653,787 Net occupancy..................................... 31,342 33,206 91,844 96,961 Equipment......................................... 15,680 16,289 48,705 50,443 Software.......................................... 11,996 13,560 34,921 39,463 Communications.................................... 12,661 12,850 39,859 39,295 Professional services............................. 12,676 12,375 38,256 33,968 Foreclosed asset expense (income)................. (79) (10) (28) 526 Other............................................. 59,283 67,354 186,570 207,456 -------- -------- ---------- ---------- Total noninterest expense....................... 348,861 372,391 1,042,465 1,121,899 -------- -------- ---------- ---------- Income before income taxes........................ 233,698 265,653 650,593 873,639 Income tax expense................................ 78,653 102,215 215,273 321,617 -------- -------- ---------- ---------- NET INCOME.......................................... $155,045 $163,438 $ 435,320 $ 552,022 ======== ======== ========== ========== NET INCOME PER COMMON SHARE--BASIC.................. $ 1.04 $ 1.11 $ 2.90 $ 3.74 ======== ======== ========== ========== NET INCOME PER COMMON SHARE--DILUTED................ $ 1.02 $ 1.09 $ 2.87 $ 3.68 ======== ======== ========== ========== WEIGHTED AVERAGE COMMON SHARES OUTSTANDING--BASIC... 149,528 147,555 150,060 147,548 ======== ======== ========== ========== WEIGHTED AVERAGE COMMON SHARES OUTSTANDING--DILUTED. 151,562 150,379 151,545 150,027 ======== ======== ========== ========== See accompanying notes to condensed consolidated financial statements.
4
UNIONBANCAL CORPORATION AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED) (UNAUDITED) SEPTEMBER 30, DECEMBER 31, SEPTEMBER 30, (DOLLARS IN THOUSANDS) 2003 2003 2004 - ----------------------------------------------------------- ------------- ------------ ------------- ASSETS Cash and due from banks.................................... $ 2,619,580 $ 2,494,127 $ 2,229,306 Interest bearing deposits in banks......................... 341,230 235,158 544,520 Federal funds sold and securities purchased under resale agreements............................................... 1,325,470 769,720 1,045,275 ------------- ------------ ------------- Total cash and cash equivalents.......................... 4,286,280 3,499,005 3,819,101 Trading account assets..................................... 320,199 252,929 288,814 Securities available for sale: Securities pledged as collateral......................... 68,440 106,560 124,896 Held in portfolio........................................ 9,930,281 10,660,332 11,868,627 Loans (net of allowance for credit losses: September 30, 2003, $550,550; December 31, 2003, $532,970; September 30, 2004, $482,762)............................ 25,496,826 25,411,658 28,142,324 Due from customers on acceptances.......................... 52,816 71,078 64,752 Premises and equipment, net................................ 506,321 509,734 501,962 Intangible assets.......................................... 49,288 49,592 60,977 Goodwill................................................... 215,903 226,556 320,835 Other assets............................................... 1,676,391 1,711,023 1,798,317 ------------- ------------ ------------- Total assets............................................. $ 42,602,745 $ 42,498,467 $ 46,990,605 ============= ============ ============= LIABILITIES Domestic deposits: Noninterest bearing...................................... $ 16,854,483 $ 16,668,773 $ 19,021,245 Interest bearing......................................... 17,320,728 17,146,858 17,919,160 Foreign deposits: Noninterest bearing...................................... 556,687 619,249 719,792 Interest bearing......................................... 1,225,907 1,097,403 1,682,032 ------------- ------------ ------------- Total deposits......................................... 35,957,805 35,532,283 39,342,229 Federal funds purchased and securities sold under repurchase agreements.................................... 284,764 280,968 648,864 Commercial paper........................................... 678,903 542,270 615,816 Other borrowed funds....................................... 240,803 212,088 150,503 Acceptances outstanding.................................... 52,816 71,078 64,752 Other liabilities.......................................... 939,549 934,916 1,205,918 Medium and long-term debt.................................. 417,369 820,488 820,460 Junior subordinated debt payable to subsidiary grantor trust.................................................... -- 363,940 15,904 UnionBanCal Corporation--obligated mandatorily redeemable preferred securities of subsidiary grantor trust......... 356,629 -- -- ------------- ------------ ------------- Total liabilities........................................ 38,928,638 38,758,031 42,864,446 ------------- ------------ ------------- Commitments and contingencies STOCKHOLDERS' EQUITY Preferred stock: Authorized 5,000,000 shares, no shares issued or outstanding as of September 30, 2003, December 31, 2003, and September 30, 2004........................... -- -- -- Common stock, par value $1 per share at September 30, 2003, December 31, 2003 and September 30, 2004: Authorized 300,000,000 shares, issued 145,105,566 shares as of September 30, 2003, 146,000,156 shares as of December 31, 2003, and 149,529,292 shares as of September 30, 2004.................................. 145,106 146,000 149,529 Additional paid-in capital................................. 520,876 555,156 728,791 Treasury stock--242,000 shares as of December 31, 2003 and 2,365,900 shares as of September 30, 2004............ -- (12,846) (131,464) Retained earnings.......................................... 2,893,240 2,999,884 3,400,117 Accumulated other comprehensive income (loss).............. 114,885 52,242 (20,814) ------------- ------------ ------------- Total stockholders' equity............................... 3,674,107 3,740,436 4,126,159 ------------- ------------ ------------- Total liabilities and stockholders' equity............... $ 42,602,745 $ 42,498,467 $ 46,990,605 ============= ============ ============= 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 nine months ended September 30, 2003..... 435,320 435,320 Other comprehensive income, net of tax: Net change in unrealized gains on cash flow hedges.. (37,889) (37,889) Net change in unrealized gains on securities available for sale........ (88,167) (88,167) Foreign currency translation adjustment................. 847 847 ---------- Total comprehensive income 310,111 Reincorporation(1)............... (520,876) 520,876 -- Dividend reinvestment plan....... 5,289 34 34 Deferred compensation--restricted stock awards................... 6,000 282 (112) 170 Stock options exercised.......... 1,018,175 35,792 35,792 Stock issued in acquisitions..... 1,149,106 48,254 48,254 Common stock repurchased(2)...... (7,775,367) (344,840) (344,840) Dividends declared on common stock, $0.90 per share(3)...... (133,603) (133,603) -------- ---------- --------- ---------- ------------- ---------- Net change....................... (781,354) 520,876 -- 301,605 (125,209) (84,082) ----------- -------- ---------- --------- ---------- ------------- ---------- BALANCE SEPTEMBER 30, 2003....... 145,105,566 $145,106 $ 520,876 $ -- $2,893,240 $ 114,885 $3,674,107 =========== ======== ========== ========= ========== ============= ========== 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 nine months ended September 30, 2004..... 552,022 552,022 Other comprehensive income, net of tax: Net change in unrealized gains on cash flow hedges.. (30,285) (30,285) Net change in unrealized losses on securities available for sale......... (43,404) (43,404) Foreign currency translation adjustment................. 633 633 ---------- Total comprehensive income....... 478,966 Dividend reinvestment plan....... 308 17 17 Deferred compensation--restricted stock awards................... 185 185 Stock options exercised.......... 1,520,109 1,520 61,223 62,743 Stock issued in acquisitions..... 2,008,719 2,009 112,569 114,578 Common stock repurchased(2)...... (174) (118,618) (118,792) Dividends declared on common stock, $1.03 per share(3)...... (151,974) (151,974) -------- ---------- --------- ---------- ------------- ---------- Net change....................... 3,529 173,618 (118,618) 400,233 (73,056) 385,723 ----------- -------- ---------- --------- ---------- ------------- ---------- BALANCE SEPTEMBER 30, 2004....... 149,529,292 $149,529 $ 728,791 $(131,464) $3,400,117 $ (20,814) $4,126,159 =========== ======== ========== ========= ========== ============= ========== - ----------------------------- (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 NINE MONTHS ENDED SEPTEMBER 30, ------------------------- (DOLLARS IN THOUSANDS) 2003 2004 - ---------------------------------------------------------------------- ----------- ---------- CASH FLOWS FROM OPERATING ACTIVITIES: Net income.......................................................... $ 435,320 $ 552,022 Adjustments to reconcile net income to net cash provided by (used in) operating activities: (Reversal of) provision for credit losses......................... 75,000 (25,000) Depreciation, amortization and accretion.......................... 87,332 100,631 Provision for deferred income taxes............................... 60,425 29,411 Gains on securities available for sale............................ (7,042) (1,612) Net increase in prepaid expenses.................................. (89,272) (96,009) Net increase (decrease) in accrued expenses and other liabilities. (189,413) 230,364 Net (increase) decrease in other assets, net of acquisitions...... (101,842) 183,393 Net increase in trading account assets............................ (44,178) (35,885) Loans originated for resale....................................... (269,186) (661,342) Net proceeds from sale of loans originated for resale............. 291,198 518,739 Other, net........................................................ 27,716 19,606 ----------- ---------- Total adjustments................................................. (159,262) 262,296 ----------- ---------- Net cash provided by (used in) operating activities................. 276,058 814,318 ----------- ---------- CASH FLOWS FROM INVESTING ACTIVITIES: Proceeds from sales of securities available for sale................ 308,051 13,479 Proceeds from matured and called securities available for sale...... 2,689,120 3,177,262 Purchases of securities available for sale, net of acquisitions..... (5,849,353) (4,386,300) Net (increase) decrease in loans, net of acquisitions............... 758,743 (2,152,469) Net cash provided by (paid in) acquisitions......................... (60,920) 28,086 Purchases of premises and equipment................................. (70,192) (58,064) Other, net.......................................................... 823 1,866 ----------- ---------- Net cash provided by (used in) investing activities............... (2,223,728) (3,376,140) ----------- ---------- CASH FLOWS FROM FINANCING ACTIVITIES: Net increase (decrease) in deposits, net of acquisitions............ 2,650,264 3,066,571 Net increase (decrease) in federal funds purchased and securities sold under repurchase agreements.................................. (49,615) 367,896 Net increase (decrease) in commercial paper and other borrowed funds (386,323) 11,961 Repayment of junior subordinated debt............................... -- (360,825) Common stock repurchased............................................ (344,840) (118,792) Payments of cash dividends.......................................... (130,896) (144,146) Stock options exercised............................................. 35,792 62,743 Other, net.......................................................... 881 650 ----------- ---------- Net cash provided by (used in) financing activities............... 1,775,263 2,886,058 ----------- ---------- Net increase (decrease) in cash and cash equivalents.................. (172,407) 324,236 Cash and cash equivalents at beginning of period...................... 4,442,122 3,499,005 Effect of exchange rate changes on cash and cash equivalents.......... 16,565 (4,140) ----------- ---------- Cash and cash equivalents at end of period............................ $ 4,286,280 $3,819,101 =========== ========== CASH PAID DURING THE PERIOD FOR: Interest............................................................ $ 155,469 $ 122,236 Income taxes........................................................ 187,723 230,094 SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING AND FINANCING ACTIVITIES: Acquisitions: Fair value of assets acquired..................................... $ 721,749 $ 991,887 Purchase price: Cash............................................................ (83,597) (33,772) Stock issued.................................................... (48,254) (114,578) ----------- ---------- Liabilities assumed............................................... $ 589,898 $ 843,537 =========== ==========
See accompanying notes to condensed consolidated financial statement. 7 UNIONBANCAL CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 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 September 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 September 30, 2004, the Company has announced stock repurchase plans totaling $700 million and as of September 30, 2004 has repurchased $517 million of common stock under these repurchase plans. The Company repurchased $58 million, $44 million, $12 million and $63 million of common stock in 2003, the first quarter of 2004, the second quarter of 2004, and the third quarter of 2004, respectively, as part of these repurchase plans. As of September 30, 2004, $183 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 September 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 September 30, 2004, the Company has two stock-based employee compensation plans. For further discussion concerning our stock-based employee compensation plans see Note 14 of the Notes to Consolidated Financial Statements included in the Form 10-K for the year ended December 31, 2003. The 8 UNIONBANCAL CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) NOTE 1--BASIS OF PRESENTATION AND NATURE OF OPERATIONS (CONTINUED) 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 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 NINE MONTHS ENDED SEPTEMBER 30, ENDED SEPTEMBER 30, -------------------- ------------------- (DOLLARS IN THOUSANDS) 2003 2004 2003 2004 - --------------------------------------------- -------- -------- -------- --------- AS REPORTED NET INCOME....................... $155,045 $163,438 $435,320 $552,022 Stock option-based employee compensation expense (determined under fair value based method for all awards, net of taxes)..................................... (6,479) (6,710) (18,962) (19,925) -------- -------- -------- --------- Pro forma net income, after stock option- based employee compensation expense........ $148,566 $156,728 $416,358 $532,097 ======== ======== ======== ========= EARNINGS PER SHARE--BASIC As reported.................................. $ 1.04 $ 1.11 $ 2.90 $ 3.74 Pro forma.................................... $ 0.99 $ 1.06 $ 2.77 $ 3.61 EARNINGS PER SHARE--DILUTED As reported.................................. $ 1.02 $ 1.09 $ 2.87 $ 3.68 Pro forma.................................... $ 0.98 $ 1.04 $ 2.75 $ 3.55
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 three and nine months ended September 30, 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 9 UNIONBANCAL CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) NOTE 2--RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS (CONTINUED) 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 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 results 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 10 UNIONBANCAL CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) NOTE 2--RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS (CONTINUED) 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 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. For further information on the impact of adoption and disclosure required under SFAS No. 132R, see Note 10 of the Notes to Condensed Consolidated Financial Statements included in this Form 10-Q. 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 reached consensus on certain incremental issues related to Issue No. 03-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to 11 UNIONBANCAL CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) NOTE 2--RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS (CONTINUED) 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, 2004. However, certain guidance contained in the EITF has been delayed by FASB Staff Position (FSP) EITF Issue 03-1-1, "The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments." The Company adopted the disclosure provisions of EITF Issue No. 03-1 on December 31, 2003 and any impact arising from the reissuance of EITF No. 03-1 with respect to the recognition of other-than-temporary impairment will be assessed at that time. PRESCRIPTION DRUG BENEFITS In May 2004, the FASB issued FSP Financial Accounting Standards (FAS) No. 106-2, "Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003." This FSP provides guidance on the accounting for the effects of the Medicare prescription drug benefit and the federal subsidy to sponsors of retiree healthcare benefit plans that offer prescription drug coverage to retirees that is actuarially equivalent to the Medicare benefit. In accordance with the FSP, sponsoring companies must recognize the subsidy in the measurement of their plan's accumulated postretirement benefit obligation (APBO) and net postretirement benefit cost. The Company adopted FSP FAS No. 106-2 on July 1, 2004. For further information on the impact of adoption and disclosure required under FSP FAS No. 106-2, see Note 10 of the Notes to Condensed Consolidated Financial Statements included in this Form 10-Q. 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 nine months ended September 30, 2003 and 2004.
THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30, ------------------------------------- ------------------------------------- 2003 2004 2003 2004 ------------------ ------------------ ------------------------------------- (AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA) BASIC DILUTED BASIC DILUTED BASIC DILUTED BASIC DILUTED - --------------------------- -------- --------- -------- --------- -------- --------- -------- --------- Net Income................. $155,045 $ 155,045 $163,438 $ 163,438 $435,320 $ 435,320 $552,022 $ 552,022 ======== ========= ======== ========= ======== ========= ======== ========= Weighted average common shares outstanding....... 149,528 149,528 147,555 147,555 150,060 150,060 147,548 147,548 Additional shares due to: Assumed conversion of dilutive stock options... -- 2,034 -- 2,824 -- 1,485 -- 2,479 -------- --------- -------- --------- -------- --------- -------- --------- Adjusted weighted average common shares outstanding 149,528 151,562 147,555 150,379 150,060 151,545 147,548 150,027 ======== ========= ======== ========= ======== ========= ======== ========= Net income per share....... $ 1.04 $ 1.02 $ 1.11 $ 1.09 $ 2.90 $ 2.87 $ 3.74 $ 3.68 ======== ========= ======== ========= ======== ========= ======== =========
12 UNIONBANCAL CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) 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 NINE MONTHS ENDED SEPTEMBER 30, 2003: Cash flow hedge activities: Unrealized net gains on hedges arising during the period............................................. $ 48,126 $(18,408) $ 29,718 Less: reclassification adjustment for net gains on hedges included in net income.................. (109,485) 41,878 (67,607) --------- -------- --------- Net change in unrealized gains on hedges............... (61,359) 23,470 (37,889) --------- -------- ---------- Securities available for sale: Unrealized holding losses arising during the period on securities available for sale................... (135,739) 51,920 (83,819) Less: reclassification adjustment for net gains on securities available for sale included in net income......................................... (7,042) 2,694 (4,348) --------- -------- --------- Net change in unrealized gains on securities available for sale............................................. (142,781) 54,614 (88,167) --------- -------- --------- Foreign currency translation adjustment................ 1,372 (525) 847 --------- -------- --------- Net change in accumulated other comprehensive income (loss)........................................ $(202,768) $ 77,559 $(125,209) ========= ======== ========= FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2004: Cash flow hedge activities: Unrealized net gains on hedges arising during the period............................................. $ 12,680 $ (4,850) $ 7,830 Less: reclassification adjustment for net gains on hedges included in net income.................. (61,725) 23,610 (38,115) --------- -------- --------- Net change in unrealized gains on hedges............... (49,045) 18,760 (30,285) --------- -------- --------- Securities available for sale: Unrealized holding losses arising during the period on securities available for sale................... (68,679) 26,270 (42,409) Less: reclassification adjustment for net gains on securities available for sale included in net income..................................... (1,612) 617 (995) --------- -------- --------- Net change in unrealized losses on securities available for sale................................... (70,291) 26,887 (43,404) --------- -------- --------- Foreign currency translation adjustment................ 1,025 (392) 633 --------- -------- --------- Net change in accumulated other comprehensive income (loss)........................................ $(118,311) $ 45,255 $ (73,056) ========= ======== =========
13 UNIONBANCAL CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) 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..... (37,889) (88,167) 847 -- (125,209) -------- -------- -------- ------- -------- BALANCE, SEPTEMBER 30, 2003.. $ 66,479 $ 59,283 $ (9,802) $(1,075) $114,885 -------- -------- -------- ------- -------- BALANCE, DECEMBER 31, 2003... $ 43,786 $ 22,535 $(10,293) $(3,786) $ 52,242 Change during the period..... (30,285) (43,404) 633 -- (73,056) -------- -------- -------- ------- -------- BALANCE, SEPTEMBER 30, 2004.. $ 13,501 $(20,869) $ (9,660) $(3,786) $(20,814) ======== ======== ======== ======= ========
NOTE 5--BUSINESS COMBINATIONS The Company has regularly sought opportunities to acquire financial services companies and businesses. Generally, the Company does not make a public announcement about an acquisition opportunity until a definitive agreement has been signed. 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 core deposit intangibles are being amortized on an accelerated basis over their economic useful life of a weighted average 6 years. 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). The Company acquired total assets and assumed liabilities of $173 million, each, for a cash consideration of $12 million. CNAT, based in Costa Mesa, California, was a subsidiary of Chicago-based CNA Financial Corporation. The identifiable intangibles are being amortized on an accelerated basis over their economic useful life of a weighted average 7 years. 14 UNIONBANCAL CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) NOTE 6--GOODWILL AND INTANGIBLE ASSETS The changes in the carrying amount of goodwill and intangible assets for the nine months ended September 30, 2004 are as follows:
IDENTIFIABLE INTANGIBLE ASSETS -------------------------------------------- CORE DEPOSIT RIGHTS-TO- TOTAL IDENTIFIABLE GOODWILL INTANGIBLES EXPIRATION INTANGIBLE ASSETS -------- ------------ ---------- ------------------ Balance, December 31, 2003......................... $226,556 $22,117 $27,475 $49,592 Amounts recorded during the year................. 94,279 25,167 0 25,167 Amortization expense............................. 0 (10,077) (3,706) (13,782) -------- ------- ------- ------- Balance, September 30, 2004........................ $320,835 $37,207 $23,769 $60,977 ======== ======= ======= ======= Estimated amortization expense for the years ending: Remaining 2004..................................... $ 4,104 $ 1,236 $ 5,340 2005............................................... 13,540 4,311 17,851 2006............................................... 8,201 3,672 11,873 2007............................................... 4,775 3,113 7,888 2008............................................... 2,821 2,622 5,443 thereafter......................................... 3,767 8,815 12,582 ------- ------- ------- Total amortization expense after September 30, 2004 $37,208 $23,769 $60,977 ======= ======= =======
NOTE 7--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. 15 UNIONBANCAL CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) NOTE 7--BUSINESS SEGMENTS (CONTINUED) 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 as of September 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 first nine months of 2004 is a $93.0 million gain resulting from the sale of the Company's merchant card portfolio, which has not been included in the results of the Community Banking and Investment Services Group. 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. 16 UNIONBANCAL CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) NOTE 7--BUSINESS SEGMENTS (CONTINUED)
COMMUNITY BANKING AND INVESTMENT COMMERCIAL FINANCIAL INTERNATIONAL SERVICES GROUP SERVICES GROUP BANKING GROUP ------------------ ------------------- ------------------ AS OF AND FOR THE THREE MONTHS ENDED SEPTEMBER 30, ----------------------------------------------------------- 2003 2004 2003 2004 2003 2004 - -------------------------------------------- -------- -------- -------- -------- ------- ------- RESULTS OF OPERATIONS (DOLLARS IN THOUSANDS): Net interest income......................... $173,733 $203,040 $186,249 $203,288 $ 8,537 $ 9,802 Noninterest income.......................... 110,912 125,042 67,591 64,317 18,117 19,069 -------- -------- -------- -------- ------- ------- Total revenue............................... 284,645 328,082 253,840 267,605 26,654 28,871 Noninterest expense......................... 202,283 235,883 103,277 108,519 15,323 16,728 Credit expense (income)..................... 7,996 8,400 39,397 24,781 511 566 -------- -------- -------- -------- ------- ------- Income (loss) before income tax expense (benefit)................................. 74,366 83,799 111,166 134,305 10,820 11,577 -------- -------- -------- -------- ------- ------- Income tax expense (benefit)................ 28,445 32,053 36,128 44,414 4,139 4,428 Net income (loss)........................... $ 45,921 $ 51,746 $ 75,038 $ 89,891 $ 6,681 $ 7,149 ======== ======== ======== ========= ======= ======= TOTAL ASSETS, END OF PERIOD (dollars in millions):................................ $ 12,958 $ 14,697 $ 14,255 $ 15,750 $ 2,012 $ 2,224 ======== ======== ======== ========= ======= ======= GLOBAL UNIONBANCAL MARKETS GROUP OTHER CORPORATION ------------------ ------------------- ------------------- AS OF AND FOR THE THREE MONTHS ENDED SEPTEMBER 30, ------------------------------------------------------------ 2003 2004 2003 2004 2003 2004 - -------------------------------------------- -------- -------- -------- --------- -------- -------- RESULTS OF OPERATIONS (DOLLARS IN THOUSANDS): Net interest income......................... $18,140 $(35,642) $ 14,430 $ 31,602 $401,089 $412,090 Noninterest income.......................... (1,097) 1,561 5,947 5,965 201,470 215,954 -------- -------- -------- --------- -------- -------- Total revenue............................... 17,043 (34,081) 20,377 37,567 602,559 628,044 Noninterest expense......................... 3,926 5,225 24,052 6,036 348,861 372,391 Credit expense (income)..................... 50 54 (27,954) (43,801) 20,000 (10,000) -------- -------- -------- --------- -------- -------- Income (loss) before income tax expense (benefit)................................. 13,067 (39,360) 24,279 75,332 233,698 265,653 Income tax expense (benefit)................ 4,998 (15,055) 4,943 36,375 78,653 102,215 -------- -------- -------- --------- -------- -------- Net income (loss)........................... $ 8,069 $(24,305) $ 19,336 $ 38,957 $155,045 $163,438 ======== ======== ======== ========= ======== ======== TOTAL ASSETS, END OF PERIOD (dollars in millions):................................ $ 12,046 $ 13,139 $ 1,332 $ 1,181 $ 42,603 $ 46,991 ======== ======== ======== ========= ======== ======== COMMUNITY BANKING AND INVESTMENT COMMERCIAL FINANCIAL INTERNATIONAL SERVICES GROUP SERVICES GROUP BANKING GROUP ------------------ ------------------- ------------------- AS OF AND FOR THE NINE MONTHS ENDED SEPTEMBER 30, ------------------------------------------------------------ 2003 2004 2003 2004 2003 2004 - -------------------------------------------- -------- -------- -------- --------- -------- -------- RESULTS OF OPERATIONS (DOLLARS IN THOUSANDS): Net interest income......................... $505,206 $571,536 $546,437 $ 578,265 $ 25,654 $ 26,832 Noninterest income.......................... 324,416 371,436 187,055 206,483 59,690 59,519 -------- -------- -------- --------- -------- -------- Total revenue............................... 829,622 942,972 733,492 784,748 85,344 86,351 Noninterest expense......................... 599,400 678,512 307,132 317,208 45,656 49,368 Credit expense (income)..................... 23,840 23,984 124,006 82,443 1,563 1,815 -------- -------- -------- --------- -------- -------- Income (loss) before income tax expense (benefit)................................. 206,382 240,476 302,354 385,097 38,125 35,168 Income tax expense (benefit)................ 78,941 91,982 96,355 127,983 14,583 13,451 -------- -------- -------- --------- -------- -------- Net income (loss)........................... $127,441 $148,494 $205,999 $ 257,114 $ 23,542 $ 21,717 ======== ======== ======== ========= ======== ======== TOTAL ASSETS, END OF PERIOD (dollars in millions):................................ $ 12,958 $ 14,697 $ 14,255 $ 15,750 $ 2,012 $ 2,224 ======== ======== ======== ========= ======== ======== GLOBAL UNIONBANCAL MARKETS GROUP OTHER CORPORATION ------------------ ------------------- --------------------- AS OF AND FOR THE NINE MONTHS ENDED SEPTEMBER 30, -------------------------------------------------------------- 2003 2004 2003 2004 2003 2004 - -------------------------------------------- -------- -------- -------- --------- ---------- ---------- RESULTS OF OPERATIONS (DOLLARS IN THOUSANDS): Net interest income......................... $ 56,371 $(50,293) $ 43,978 $ 86,029 $1,177,646 $1,212,369 Noninterest income.......................... 2,311 4,497 16,940 116,234 590,412 758,169 -------- -------- -------- --------- ---------- ---------- Total revenue............................... 58,682 (45,796) 60,918 202,263 1,768,058 1,970,538 Noninterest expense......................... 12,158 16,093 78,119 60,718 1,042,465 1,121,899 Credit expense (income)..................... 150 280 (74,559) (133,522) 75,000 (25,000) -------- -------- -------- --------- ---------- ---------- Income (loss) before income tax expense (benefit)................................. 46,374 (62,169) 57,358 275,067 650,593 873,639 Income tax expense (benefit)................ 17,738 (23,780) 7,656 111,981 215,273 321,617 -------- -------- -------- --------- ---------- ---------- Net income (loss)........................... $ 28,636 $(38,389) $ 49,702 $ 163,086 $ 435,320 $ 552,022 ======== ======== ======== ========= ========== ========== TOTAL ASSETS, END OF PERIOD (dollars in millions):................................ $ 12,046 $ 13,139 $ 1,332 $ 1,181 $ 42,603 $ 46,991 ======== ======== ======== ========= ========== ==========
17 UNIONBANCAL CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) NOTE 8--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 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 September 30, 2004, the weighted average remaining life of the currently active (excluding any forward positions) cash flow hedges was approximately 1.0 year. 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. 18 UNIONBANCAL CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) NOTE 8--DERIVATIVE INSTRUMENTS AND OTHER FINANCIAL INSTRUMENTS USED FOR HEDGING 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 the mismatch between the timing of reset dates on the hedge versus those of the loans or CDs. In the third quarter of 2004, the Company recognized a net gain of $0.1 million due to ineffectiveness, which is recognized in noninterest expense, compared to a net gain of less than $0.1 million in the third 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. The fair value hedging transaction was structured at inception so that the notional amount 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 hedge during the third quarter of 2004 compared to a net gain of less than $0.1 million in the third 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. 19 UNIONBANCAL CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) NOTE 8--DERIVATIVE INSTRUMENTS AND OTHER FINANCIAL INSTRUMENTS USED FOR HEDGING 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. 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 9--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 September 30, 2004, the Company's maximum exposure to loss for standby and commercial letters of credit was $3.0 billion and $297.8 million, respectively. At September 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 $5.3 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 September 30, 2004, the Company had commitments to fund principal investments of $66.8 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 September 30, 2004, the Company had a maximum exposure of $7.4 million for these agreements, the last of which expire in December 2006. 20 UNIONBANCAL CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) NOTE 9--GUARANTEES (CONTINUED) 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 September 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. The Company has guarantees that obligate it to perform if its affiliates are unable to discharge their obligations. These obligations include guarantee of 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 September 30, 2004, the Bank had a maximum exposure to loss under these guarantees, which have an average term of less than one year, of $627.5 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 September 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 $1.7 billion at September 30, 2004. The market value of the associated collateral was $1.8 billion at September 30, 2004. 21 UNIONBANCAL CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) NOTE 10--PENSION AND OTHER POSTRETIREMENT BENEFITS The following tables summarize the components of net periodic benefit costs for the three months and nine months ended September 30, 2003 and 2004.
PENSION BENEFITS OTHER BENEFITS -------------------- -------------------- FOR THE THREE MONTHS FOR THE THREE MONTHS ENDED SEPTEMBER 30, ENDED SEPTEMBER 30, -------------------- -------------------- (DOLLARS IN THOUSANDS) 2003 2004 2003 2004 - -------------------------------------------- -------- -------- ------- -------- COMPONENTS OF NET PERIODIC BENEFIT COST Service cost................................ $ 8,217 $ 9,415 $ 1,295 $ 849 Interest cost............................... 11,875 13,059 2,641 1,399 Expected return on plan assets.............. (18,203) (20,782) (1,687) (2,292) Amortization of prior service cost.......... 267 266 (24) (24) Amortization of transition amount........... -- -- 637 637 Recognized net actuarial loss (gain)........ 1,042 3,609 1,599 (539) -------- -------- ------- -------- Total net periodic benefit cost............. $ 3,198 $ 5,567 $ 4,461 $ 30 ======== ======== ======= ======== PENSION BENEFITS OTHER BENEFITS -------------------- -------------------- FOR THE NINE MONTHS FOR THE NINE MONTHS ENDED SEPTEMBER 30, ENDED SEPTEMBER 30, -------------------- -------------------- (DOLLARS IN THOUSANDS) 2003 2004 2003 2004 - -------------------------------------------- -------- -------- ------- -------- COMPONENTS OF NET PERIODIC BENEFIT COST Service cost................................ $ 24,650 $ 28,244 $ 3,885 $ 4,232 Interest cost............................... 35,625 39,179 7,921 7,079 Expected return on plan assets.............. (54,608) (62,347) (5,060) (6,759) Amortization of prior service cost.......... 800 800 (72) (72) Amortization of transition amount........... -- -- 1,912 1,912 Recognized net actuarial loss............... 3,127 10,826 4,796 2,997 -------- -------- ------- -------- Total net periodic benefit cost............. $ 9,594 $ 16,702 $13,382 $ 9,389 ======== ======== ======= ========
In the third quarter of 2004, the Company recorded a $4.7 million reduction in employee benefit expense associated with the remeasurement of our postretirement benefits as a result of the Medicare Prescription Drug, Improvement and Modernization Act of 2003 ("The Act"). The reduction is attributable to a federal subsidy provided by The Act to employers that sponsor retiree health care plans with drug benefits that are equivalent to those offered under Medicare Part D. The effect of the subsidy on the measurement of net periodic postretirement benefit cost for the year-to-date period ending September 30, 2004 includes a $2.3 million actuarial experience gain, a $0.9 million reduction in service cost, and a $1.5 million reduction in interest cost on the accumulated postretirement benefit obligation (APBO). The effect of the subsidy related to benefits attributed to past service in measuring the Company's January 1, 2004 APBO was a reduction of $30.8 million related to benefits attributed to past service. 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 did not make any contributions to the plan in the third quarter of 2004 and does not expect to make any further contributions for the remainder of 2004. 22 UNIONBANCAL CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) NOTE 11--SUBSEQUENT EVENTS On October 27, 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 January 7, 2005 to stockholders of record as of December 10, 2004. On October 28, 2004, the Company's subsidiary, Union Bank of California, N.A., completed its acquisition of Jackson Federal Bank, a savings bank headquartered in Brea, California. The Company acquired approximately $1.4 billion in total assets and fourteen branches. The Company paid approximately $305 million, consisting of $168 million in cash and $137 million in the Company's common stock. 23 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 LOOKING AT THE FACT THAT THEY DO NOT RELATE STRICTLY TO HISTORICAL OR CURRENT FACTS. OFTEN, THEY INCLUDE THE WORDS "BELIEVE," "EXPECT," "ANTICIPATE," "INTEND," "PLAN," "ESTIMATE," "POTENTIAL," "PROJECT," OR WORDS OF SIMILAR MEANING, OR FUTURE OR CONDITIONAL VERBS SUCH AS "WILL," "WOULD," "SHOULD," "COULD," OR "MAY." THEY MAY ALSO CONSIST OF ANNUALIZED AMOUNTS BASED ON HISTORICAL INTERIM PERIOD RESULTS. IN THIS DOCUMENT, FOR EXAMPLE, WE MAKE FORWARD-LOOKING STATEMENTS DISCUSSING OUR EXPECTATIONS ABOUT THE IMPACT ON UNIONBANCAL CORPORATION OF: RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS; BANK SECRECY ACT-RELATED MATTERS; INCREASES IN BUSINESS ACTIVITY AND INTEREST RATES; INVESTMENTS IN BANK ACQUISITIONS, DE NOVO BRANCHES AND TECHNOLOGY; MATURING DERIVATIVE HEDGES; CHANGES IN OUR CALIFORNIA EFFECTIVE TAX RATE RELATED TO PROJECTED PROFIT INCREASES FOR MITSUBISHI TOKYO FINANCIAL GROUP, INC.; CREDIT-RELATED TRENDS REFLECTED IN THE UNALLOCATED PORTION OF OUR ALLOWANCE FOR CREDIT LOSSES; CHANGES IN OUR NET INTEREST INCOME DUE TO POSSIBLE CHANGES IN INTEREST RATES AND OTHER FACTORS; AND CERTAIN PENDING LEGAL ACTIONS. 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: FLUCTUATIONS IN INTEREST RATES, GOVERNMENT POLICIES, REGULATIONS, AND THEIR ENFORCEMENT (INCLUDING MONETARY AND FISCAL POLICIES AND BANK SECRECY ACT-RELATED MATTERS), LEGISLATION, ECONOMIC CONDITIONS, CREDIT QUALITY OF BORROWERS, OPERATIONAL FACTORS, COMPETITION IN THE GEOGRAPHIC AND BUSINESS AREAS IN WHICH THE COMPANY CONDUCTS ITS OPERATIONS, GLOBAL POLITICAL CONDITIONS, 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), 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 $47.0 billion at September 30, 2004. During 2003, UnionBanCal Corporation changed its state of incorporation from California to Delaware. Our majority owner, BTM, owned approximately 62 percent of our outstanding common stock at September 30, 2004. EXECUTIVE OVERVIEW We are providing you with an overview of what we believe are the most significant events that impacted our results for the third quarter of 2004. You should carefully read the rest of this document for 24 more detailed information that will assist your understanding of trends, events and uncertainties that may impact us. 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 third quarter of 2004. The improvements came from positive financial results and economic outlooks of our borrowers, as well as payoffs, partially offset by a slight increase in our nonperforming assets. Nonaccrual loans increased slightly from June 30, 2004 to $180 million, but have declined significantly from December 31, 2003. With credit quality improvements partially offset by growth in commercial lending, we recorded a reversal of provision for credit losses of $10.0 million for the quarter. Continuing low levels of interest rates have hampered growth in net interest income, as our assets have continued to reprice at relatively low levels. Significant contributors to the reduced asset yields were mortgage refinancings, which 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 third 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 amount 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 third quarter of 2004, compared to the third quarter of 2003, providing us with a low cost of funding, which is a competitive advantage. Average demand deposits for the third quarter of 2004 were 48 percent of average total deposits compared to 47 percent for the third 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 0.49 percent and 0.50 percent in the third 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 acquisitions during the first nine months of 2004 and opened a number of de novo branches, which further expanded our business locations and deposits in California. A third acquisition, Jackson Federal Bank, closed in October 2004. Noninterest income rose in the third quarter of 2004, compared to the third quarter of 2003, primarily as a result of higher service charges on deposits, trust and investment management fees, letters of credit and international commissions and fees. Increases in volumes, as well as our acquisitions, were primarily responsible for the increases in our noninterest income. Although noninterest expense rose in the third quarter of 2004, compared to the third quarter of 2003, much of that increase related to investments that we made in bank acquisitions, de novo 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. CRITICAL ACCOUNTING POLICIES UnionBanCal Corporation's consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (US GAAP) and the general practices of the banking industry. 25 The financial information contained within our statements is, to a significant extent, financial information that is based on approximate measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability. In many instances, we use a discount factor to determine the present value of assets and liabilities. A change in the discount factor could increase or decrease the values of those assets and liabilities and such a change would result in either a beneficial or adverse impact to our financial results. We use historical loss factors, adjusted for current conditions, to determine the inherent loss that may be present in our loan and lease portfolio. Actual losses could differ significantly from the loss factors that we use. Other estimates that we use are employee turnover factors for pension purposes, residual values in our leasing portfolio, fair value of our derivatives and securities, expected useful lives of our depreciable assets and assumptions regarding our effective income tax rates. We enter into derivative contracts to accommodate our customers and for our own risk management purposes. The derivative contracts are generally foreign exchange, interest rate swap and interest rate option contracts, and we plan to offer energy-related derivatives to accommodate our customers in the oil and gas industry. We value these contracts at fair value, using either readily available, market quoted prices or from information that can be extrapolated to approximate a market price. We have not historically entered into derivative contracts for our customers or for ourselves, which relate to credit, commodity or weather-related indices. We are subject to US GAAP that may change from one previously acceptable method to another method. Although the economics of our transactions would be the same, the timing of events that would impact our transactions could change. Our most significant estimates are approved by our Chief Executive Officer (CEO) Forum, which is comprised of our most senior executives. At each financial reporting period, a review of these estimates is then presented to the Audit Committee of our Board of Directors. Understanding our accounting policies is fundamental to understanding our consolidated financial position and consolidated results of operations. Accordingly, our significant accounting policies are discussed in detail in Note 1 in the "Notes to Consolidated Financial Statements" in our 2003 Annual Report on Form 10-K filed with the Securities and Exchange Commission. 26 FINANCIAL PERFORMANCE SUMMARY OF FINANCIAL PERFORMANCE
FOR THE THREE MONTHS INCREASE (DECREASE) FOR THE NINE MONTHS INCREASE (DECREASE) -------------------- ------------------ ---------------------- ------------------ ENDED SEPTEMBER 30, 2004 VERSUS 2003 ENDED SEPTEMBER 30, 2004 VERSUS 2003 -------------------- ------------------ ---------------------- ------------------ (DOLLARS IN THOUSANDS) 2003 2004 AMOUNT PERCENT 2003 2004 AMOUNT PERCENT - -------------------------------- -------- -------- ------- ------- ---------- ---------- -------- ------- RESULTS OF OPERATIONS Net interest income(1).......... $401,089 $412,090 $11,001 2.7% $1,177,646 $1,212,369 $34,723 2.9% Noninterest income Service charges on deposit accounts.................... 81,832 87,555 5,723 7.0 232,061 258,682 26,621 11.5 Trust and investment management fees............. 35,429 39,089 3,660 10.3 101,245 111,699 10,454 10.3 Insurance commissions......... 15,814 17,463 1,649 10.4 45,056 57,850 12,794 28.4 International commissions and fees........................ 17,380 18,906 1,526 8.8 49,581 54,553 4,972 10.0 Card processing fees, net..... 10,335 4,653 (5,682) (55.0) 29,357 28,901 (456) (1.6) Gain on sale of merchant card portfolio................... -- -- -- nm -- 93,000 93,000 nm Other noninterest income...... 40,680 48,288 7,608 18.7 133,112 153,484 20,372 15.3 -------- -------- ------- ---------- ---------- -------- Total noninterest income........ 201,470 215,954 14,484 7.2 590,412 758,169 167,757 28.4 Total revenue................... 602,559 628,044 25,485 4.2 1,768,058 1,970,538 202,480 11.5 (Reversal of) provision for credit losses................. 20,000 (10,000)(30,000) nm 75,000 (25,000) (100,000) nm Noninterest expense Salaries and employee benefits 205,302 216,767 11,465 5.6 602,338 653,787 51,449 8.5 Net occupancy................. 31,342 33,206 1,864 5.9 91,844 96,961 5,117 5.6 Intangible asset amortization. 2,587 5,077 2,490 96.3 8,291 13,783 5,492 66.2 Other noninterest expense..... 109,630 117,341 7,711 7.0 339,992 357,368 17,376 5.1 -------- -------- ------- ---------- ---------- -------- Total noninterest expense....... 348,861 372,391 23,530 6.7 1,042,465 1,121,899 79,434 7.6 Income before income tax........ 233,698 265,653 31,955 13.7 650,593 873,639 223,046 34.3 Income tax...................... 78,653 102,215 23,562 30.0 215,273 321,617 106,344 49.4 -------- -------- ------- ---------- ---------- -------- Net income...................... $155,045 $163,438 $ 8,393 5.4% $ 435,320 $ 552,022 $116,702 26.8% ======== ======== ======= ========== ========== ======== - --------------------------------- (1) Net interest income does not include any adjustments for fully taxable equivalence.
THE PRIMARY CONTRIBUTORS TO OUR FINANCIAL PERFORMANCE FOR THE THIRD QUARTER OF 2004 COMPARED TO THE THIRD QUARTER OF 2003 ARE PRESENTED BELOW. o We recorded a reversal of provision for credit losses in the third quarter of 2004, which reflects continued improvement in credit quality as discussed earlier in our executive overview. (See additional discussion under "Allowance for Credit Losses.") o Our net interest income was favorably influenced by higher earning asset volumes, including a significantly higher amount of securities and an increase in the average balances of our commercial loan and residential real estate loan portfolios. Strong deposit growth, including an attractive mix of average noninterest bearing deposits to total deposits, also contributed favorably to our net interest income. (See our discussion under "Net Interest Income.") o Our noninterest income was attributable to several factors: o Service charges on deposit accounts rose due to an 18 percent increase in average retail demand deposits in the third quarter of 2004 over the third quarter of 2003 and higher overdraft and return fees of $5.2 million, primarily associated with changes in our check processing introduced in April 2004; o Trust and investment management fees increased from the third quarter of 2003 primarily due to increased assets under administration due to continued strong sales and the addition of 27 $3.7 billion from our acquisition of the business portfolio of CNA Trust Company (CNAT). Year-to-date, trust fees have grown approximately 10 percent from the first nine months of 2003. Managed assets increased by approximately 9 percent and non-managed assets increased by approximately 13 percent from the third quarter of 2003 to the third quarter of 2004. Total assets under administration increased by approximately 13 percent, to $165.8 billion, for the same period; o Insurance commissions increased primarily as a result of our 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, decreased primarily due to the sale of our merchant card portfolio to NOVA Information Systems (NOVA) in the second quarter of 2004; o In other income, the third quarter of 2004 included higher merchant banking fees related to loan syndications. o Our higher noninterest expense was attributable to several factors: o Salaries and employee benefits increased primarily as a result of: o acquisitions and new branch openings, which accounted for 35 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 decreased employee benefits expense due to: o a $4.7 million reduction associated with the Medicare Prescription Drug and Improvement Act of 2003. For a further discussion regarding this reduction, see Note 10 of the Notes to Condensed Consolidated Financial Statements included in this Form 10-Q; partly offset by o increased employee benefits expense of approximately $1.4 million associated with our acquisitions and new branch openings; o increasing healthcare costs for current employees and retirees from rising insurance premiums and a greater number of participants; and o the impact of the lower discount rate we are using to calculate our future pension and other postretirement liabilities; o Intangible asset amortization expense increased primarily as a result of our recent acquisitions; and o Other noninterest expense rose primarily as a result of higher operational losses and litigation. THE PRIMARY CONTRIBUTORS TO OUR FINANCIAL PERFORMANCE FOR THE FIRST NINE MONTHS OF 2004 COMPARED TO THE FIRST NINE MONTHS OF 2003 ARE PRESENTED BELOW. o We recorded a reversal of provision for credit losses, which reflects continued improvement in credit quality. (See additional discussion under "Allowance for Credit Losses.") 28 o Our net interest income was favorably influenced by higher earning asset volumes, including a significantly higher amount 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 our discussion under "Net Interest Income.") o Our noninterest income was attributable to several factors: o Service charges on deposit accounts rose primarily due to a 20 percent increase in average retail demand deposits in the first nine months of 2004 over the first nine months of 2003 and higher overdraft and return fees of $15.3 million primarily associated with changes in check processing introduced in April 2004; o Trust and investment management fees increased from the first nine months of 2003 primarily due to increased assets under administration from continued strong sales and our acquisition of the business portfolio of CNAT. Trust fees have grown steadily since mid-2003 as the equity markets and the economy continued to stabilize; o Insurance commissions increased primarily as a result of our 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 The first nine months of 2004 included a $93.0 million gain on the sale of our merchant card portfolio, which was acquired by NOVA. The sale of our merchant card portfolio reflects our ongoing effort to sharpen our strategic focus. The long-term marketing alliance we formed with NOVA will provide us with marketing fees in the future; o The first nine months of 2004 also included net gains in private capital investment sales of $9.4 million, an $8.5 million gain on the sale of real property, higher merchant banking fees of $5.3 million, and higher foreign exchange currency profits of $3.7 million. In addition, the first nine 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 $1.5 million. o Our higher noninterest expense was attributable to several factors: o Salaries and employee benefits increased primarily as a result of: o acquisitions and new branch openings, which accounted for 40 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 increased employee benefits expense of approximately $4.9 million associated with our recent acquisitions and new branch openings; 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 29 o the impact of a higher state unemployment tax rate, which rose from 2.0 percent in the first nine months of 2003 to 3.7 percent in the first nine months of 2004; partly offset by o a $4.7 million reduction associated with the Medicare Prescription Drug and Improvement Act of 2003. For a further discussion regarding this reduction, see Note 10 of the Notes to Condensed Consolidated Financial Statements included in this Form 10-Q; o Net occupancy costs increased primarily as a result of our acquisitions and new branch openings, and reduced rental income as we relocate personnel to previously tenant-occupied premises, partially offset by a $4.2 million write-off of leasehold improvements in the third quarter of 2003; o Intangible asset amortization expense 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 operational losses and litigation. 30 NET INTEREST INCOME The following tables show the major components of net interest income and net interest margin.
FOR THE THREE MONTHS ENDED ---------------------------------------------------------------- INCREASE (DECREASE) IN SEPTEMBER 30, 2003 SEPTEMBER 30, 2004 ---------------------------------- ------------------------------- -------------------------------- AVERAGE INCOME/ INTEREST AVERAGE INTEREST AVERAGE BALANCE EXPENSE(1) AVERAGE INCOME/ YIELD/ AVERAGE INCOME/ YIELD/ ------------------ --------------- (DOLLARS IN THOUSANDS) BALANCE EXPENSE(1)RATE(1)(2) BALANCE EXPENSE(1) RATE(1)(2) AMOUNT PERCENT AMOUNT PERCENT - -------------------------------- ----------- --------- --------- ----------- --------- --------- ---------- ------- ------- ------- ASSETS Loans:(3) Domestic...................... $24,858,766 $342,629 5.48% $26,169,937 $ 340,401 5.18% $1,311,171 5.3% $(2,228) (0.7)% Foreign(4).................... 1,473,220 7,581 2.04 1,977,356 10,588 2.13 504,136 34.2 3,007 39.7 Securities--taxable............. 9,928,708 92,553 3.73 11,912,985 105,256 3.53 1,984,277 20.0 12,703 13.7 Securities--tax-exempt.......... 40,592 1,015 10.00 68,884 1,416 8.22 28,292 69.7 401 39.5 Interest bearing deposits in banks......................... 246,897 922 1.48 568,071 2,744 1.92 321,174 130.1 1,822 197.6 Federal funds sold and securities purchased under resale agreements............. 980,271 2,532 1.02 431,138 1,616 1.49 (549,133) (56.0) (916)(36.2) Trading account assets.......... 327,415 909 1.10 299,238 1,250 1.66 (28,177) (8.6) 341 37.5 ----------- -------- ----------- --------- ---------- -------- Total earning assets...... 37,855,869 448,141 4.71 41,427,609 463,271 4.46 3,571,740 9.4 $ 15,130 3.4% -------- --------- ---------- -------- Allowance for credit losses..... (570,773) (501,259) 69,514 (12.2) Cash and due from banks......... 2,324,389 2,229,980 (94,409) (4.1) Premises and equipment, net..... 510,205 504,348 (5,857) (1.1) Other assets.................... 1,793,825 2,052,602 258,777 14.4 ----------- ----------- ---------- Total assets.............. $41,913,515 $45,713,280 $3,799,765 9.1% =========== =========== ========== LIABILITIES Domestic deposits: Interest bearing.............. $10,952,652 16,586 0.60 $11,807,430 18,603 0.63 $ 854,778 7.8% $ 2,017 12.2% Savings and consumer time..... 4,116,669 9,990 0.96 4,383,745 9,029 0.82 267,076 6.5 (961 (9.6) Large time.................... 2,303,754 8,408 1.45 1,986,815 7,244 1.45 (316,939) (13.8) (1,164)(13.8) Foreign deposits(4)............. 1,200,668 1,991 0.66 1,729,290 5,007 1.15 528,622 44.0 3,016 151.5 ----------- -------- ----------- --------- ---------- -------- Total interest bearing deposits................ 18,573,743 36,975 0.79 19,907,280 39,883 0.80 1,333,537 7.2 2,908 7.9 ----------- -------- ----------- --------- ---------- -------- Federal funds purchased and securities sold under repurchase agreements......... 393,772 689 0.69 867,988 2,861 1.31 474,216 120.4 2,172 315.2 Commercial paper................ 781,552 1,723 0.87 639,345 1,697 1.06 (142,207) (18.2) (26) (1.5) Other borrowed funds............ 262,512 1,673 2.53 161,504 1,117 2.75 (101,008) (38.5) (556)(33.2) Medium and long-term debt....... 399,761 1,738 1.73 792,083 4,369 2.19 392,322 98.1 2,631 151.4 Preferred securities and trust notes(5)...................... 351,575 3,607 4.10 15,959 242 6.07 (335,616) (95.5) (3,365)(93.3) ----------- -------- ----------- --------- ---------- -------- Total borrowed funds...... 2,189,172 9,430 1.71 2,476,879 10,286 1.65 287,707 13.1 856 9.1 Total interest bearing liabilities............. 20,762,915 46,405 0.89 22,384,159 50,169 0.89 1,621,244 7.8 $ 3,764 8.1% -------- ----------- --------- ---------- -------- Noninterest bearing deposits.... 16,329,221 18,207,030 1,877,809 11.5 Other liabilities............... 986,545 1,054,138 67,593 6.9 ----------- ----------- ---------- Total liabilities......... 38,078,681 41,645,327 3,566,646 9.4 ----------- ----------- ---------- STOCKHOLDERS' EQUITY Total stockholders' equity 3,834,834 4,067,953 233,119 6.1 ----------- ----------- ---------- Total liabilities and stockholders' equity.... $41,913,515 $45,713,280 $3,799,765 9.1% =========== =========== ========== Net interest income/margin (taxable-equivalent basis).... 401,736 4.22% 413,102 3.98% Less: taxable-equivalent adjustment.................... 647 1,012 -------- --------- Net interest income....... $401,089 $ 412,090 ======== ========= - ---------------------- (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.
31
FOR THE NINE MONTHS ENDED ----------------------------------------------------------------- INCREASE (DECREASE) IN SEPTEMBER 30, 2003 SEPTEMBER 30, 2004 ---------------------------------- -------------------------------- -------------------------------- AVERAGE INCOME/ INTEREST AVERAGE INTEREST AVERAGE BALANCE EXPENSE(1) AVERAGE INCOME/ YIELD/ AVERAGE INCOME/ YIELD/ ------------------ --------------- (DOLLARS IN THOUSANDS) BALANCE EXPENSE(1) RATE(1)(2) BALANCE EXPENSE(1) RATE(1)(2) AMOUNT PERCENT AMOUNT PERCENT - ------------------------------- ----------- ---------- --------- ----------- ---------- --------- --------- ------- ------- ------- ASSETS Loans:(3) Domestic..................... $24,986,259 $1,043,906 5.58% $25,226,482 $ 988,164 5.23% $ 240,223 1.0% $(55,742) (5.3)% Foreign(4)................... 1,536,428 24,742 2.15 1,819,780 27,083 1.99 283,352 18.4 2,341 9.5 Securities--taxable............ 8,220,231 249,073 4.04 11,669,470 317,395 3.63 3,449,239 42.0 68,322 27.4 Securities--tax-exempt......... 41,168 3,045 9.86 68,120 4,175 8.17 26,952 65.5 1,130 37.1 Interest bearing deposits in banks........................ 223,937 3,014 1.80 353,060 4,773 1.81 129,123 57.7 1,759 58.4 Federal funds sold and securities purchased under resale agreements............ 932,496 8,210 1.18 786,045 6,503 1.11 (146,451) (15.7) (1,707) (20.8) Trading account assets......... 322,952 2,847 1.18 299,381 2,728 1.22 (23,571) (7.3) (119) (4.2) ----------- ---------- ----------- ---------- --------- ------- Total earning assets..... 36,263,471 1,334,837 4.92 40,222,338 1,350,821 4.49 3,958,867 10.9 $15,984 1.2% ---------- ---------- --------- ------- Allowance for credit losses.... (586,418) (520,219) 66,199 (11.3) Cash and due from banks........ 2,173,775 2,246,479 72,704 3.3 Premises and equipment, net.... 508,859 512,780 3,921 0.8 Other assets................... 1,666,062 2,001,805 335,743 20.2 ----------- ----------- ---------- Total assets............. $40,025,749 $44,463,183 $4,437,434 11.1% =========== =========== ========== LIABILITIES Domestic deposits: Interest bearing............. $10,087,830 54,194 0.72 $11,566,270 51,357 0.59 $1,478,440 14.7% $(2,837) (5.2)% Savings and consumer time.... 3,937,051 33,583 1.14 4,249,118 26,288 0.83 312,067 7.9 (7,295) (21.7) Large time................... 2,416,606 28,995 1.60 2,238,352 22,964 1.37 (178,254) (7.4) (6,031) (20.8) Foreign deposits(4)............ 1,269,010 8,008 0.84 1,478,573 9,900 0.89 209,563 16.5 1,892 23.6 ----------- ---------- ----------- ---------- --------- ------- Total interest bearing deposits............... 17,710,497 124,780 0.94 19,532,313 110,509 0.76 1,821,816 10.3 (14,271) (11.4) ----------- ---------- ----------- ---------- --------- ------- Federal funds purchased and securities sold under repurchase agreements........ 414,446 2,763 0.89 537,169 4,094 1.02 122,723 29.6 1,331 48.2 Commercial paper............... 899,456 7,397 1.10 566,776 3,883 0.92 (332,680) (37.0) (3,514) (47.5) Other borrowed funds........... 191,480 3,983 2.78 175,211 3,595 2.74 (16,269) (8.5) (388) (9.7) Medium and long-term debt...... 399,745 5,422 1.81 805,863 11,201 1.86 406,118 101.6 5,779 106.6 Preferred securities and trust notes(5)..................... 351,594 10,930 4.15 78,139 2,553 4.36 (273,455) (77.8) (8,377) (76.6) ----------- ---------- ----------- ---------- --------- ------- Total borrowed funds..... 2,256,721 30,495 1.80 2,163,158 25,326 1.56 (93,563) (4.1) (5,169) (17.0) ----------- ---------- ----------- ---------- --------- ------- Total interest bearing liabilities............ 19,967,218 155,275 1.04 21,695,471 135,835 0.84 1,728,253 8.7 $(19,440)(12.5)% ---------- ---------- --------- -------- Noninterest bearing deposits... 15,159,687 17,758,663 2,598,976 17.1 Other liabilities.............. 1,022,854 1,024,855 2,001 0.2 ----------- ----------- --------- Total liabilities........ 36,149,759 40,478,989 4,329,230 12.0 ----------- ----------- --------- STOCKHOLDERS' EQUITY Common equity.................. 3,875,990 3,984,194 108,204 2.8 ----------- ----------- --------- Total stockholders' equity................. 3,875,990 3,984,194 108,204 2.8 ----------- ----------- --------- Total liabilities and stockholders' equity... $40,025,749 $44,463,183 $4,437,434 11.1% =========== =========== ========== Net interest income/margin (taxable-equivalent basis)... 1,179,562 4.35% 1,214,986 4.03% Less: taxable-equivalent adjustment................... 1,916 2,617 ---------- ---------- Net interest income...... $1,177,646 $1,212,369 ========== ========== - --------------------- (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.
32 Net interest income in the third quarter of 2004, on a taxable-equivalent basis, increased 3 percent, from the third quarter of 2003. Our results were attributable to the following factors: o The growth in average earning assets was primarily attributable to an increase in average securities and 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 $11.1 billion at September 30, 2004, compared to $10.4 billion at December 30, 2003. For further information on securities held for ALM purposes, see the section, "Quantitative and Qualitative Disclosures About Market Risk" included in this Form 10-Q. The increase in average loans was largely due to a $1.4 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 third quarter of 2004, compared to the third quarter of 2003. Average noninterest bearing deposits were higher in the third quarter of 2004, compared to the third quarter of 2003, mainly attributable to higher average business demand deposits of $1.5 billion, despite declines in demand deposits from our title and escrow clients, which decreased by $0.4 billion, and higher consumer demand deposit growth. We anticipate that the growth rates in average noninterest bearing deposits will decline in 2005 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 the generally, lower level of interest rates, resulting in a lower average yield of 25 basis points on average earning assets, which was also negatively impacted by lower hedge income of $21.9 million; o Although market rates on our interest bearing deposits were unfavorably impacted by increasing interest rates and lower hedge income of $0.9 million, the redemption of our higher yielding trust preferred securities in February 2004 contributed to our market rates on interest bearing liabilities remaining relatively unchanged; 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, commercial paper and other borrowed funds. As a result of these changes and as long-term interest rates declined, our net interest margin decreased by 24 basis points. We use derivatives to hedge expected changes in the yields on our variable rate loans and term certificates of deposit (CDs), and to convert our long-term, fixed-rate borrowings to floating rate. 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 September 30, 2003 and 2004, we had hedge income of $43.2 million and $20.4 million, respectively. Net interest income in the first nine months of 2004, on a taxable-equivalent basis, increased 3 percent, from the first nine months of 2003. Our results were attributable to the following factors: o The growth in average earning assets was primarily attributable to an increase in average securities and 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 increase in average loans was largely due to a $1.1 billion increase in average residential mortgages and a decrease of $0.6 billion in average commercial loans; 33 o Deposit growth has contributed significantly to our lower cost of funds in the first nine months of 2004, compared to the first nine months of 2003. Average noninterest bearing deposits were higher in the first nine months of 2004, compared to the first nine months of 2003, mainly attributable to higher average business demand deposits of $6.5 billion, including demand deposits from our title and escrow clients which increased less than $0.1 billion, and higher consumer demand deposit growth; 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 43 basis points on average earning assets, which was also negatively impacted by lower hedge income of $46.2 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 20 basis points, which included higher hedge income of $1.0 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, commercial paper and other borrowed funds. As a result of these changes and as long-term interest rates declined, our net interest margin decreased by 32 basis points. As explained previously, derivative hedges will provide less net interest income than in 2003, as positions mature and, to a lesser extent, as interest rates rise. For the nine months ended September 30, 2003 and 2004, we had hedge income of $124.6 million and $79.4 million, respectively. NONINTEREST INCOME
FOR THE THREE MONTHS ENDED FOR THE NINE MONTHS ENDED --------------------------------------------- --------------------------------------------- INCREASE INCREASE (DECREASE) (DECREASE) SEPTEMBER 30, SEPTEMBER 30, ---------------- SEPTEMBER 30, SEPTEMBER 30, ---------------- (DOLLARS IN THOUSANDS) 2003 2004 AMOUNT PERCENT 2003 2004 AMOUNT PERCENT - ------------------------------- ------------- ------------- ------- ------- ------------- ------------- -------- ------- Service charges on deposit accounts..................... $ 81,832 $87,555 $ 5,723 7.0% $232,061 $258,682 $ 26,621 11.5% Trust and investment management fees......................... 35,429 39,089 3,660 10.3 101,245 111,699 10,454 10.3 Insurance commissions.......... 15,814 17,463 1,649 10.4 45,056 57,850 12,794 28.4 International commissions and fees......................... 17,380 18,906 1,526 8.8 49,581 54,553 4,972 10.0 Card processing fees, net...... 10,335 4,653 (5,682) (55.0) 29,357 28,901 (456) (1.6) Merchant banking fees.......... 9,312 11,682 2,370 25.5 21,521 26,863 5,342 24.8 Foreign exchange gains, net.... 7,574 8,548 974 12.9 21,466 25,186 3,720 17.3 Brokerage commissions and fees. 7,549 8,527 978 13.0 24,614 24,847 233 0.9 Securities gains (losses), net. (2,618) (6) 2,612 (99.8) 7,042 1,612 (5,430)(77.1) Gain on sale of merchant card portfolio.................... -- -- -- -- -- 93,000 93,000 nm Other.......................... 18,863 19,537 674 3.6 58,469 74,976 16,507 28.2 -------- -------- ------- -------- -------- -------- Total noninterest income..... $201,470 $215,954 $14,484 7.2% $590,412 $758,169 $167,757 28.4% ======== ======== ======= ======== ======== ======== - -------------------- nm--not meaningful
34 NONINTEREST EXPENSE
FOR THE THREE MONTHS ENDED FOR THE NINE MONTHS ENDED --------------------------------------------- --------------------------------------------- INCREASE INCREASE (DECREASE) (DECREASE) SEPTEMBER 30, SEPTEMBER 30, ---------------- SEPTEMBER 30, SEPTEMBER 30, ---------------- (DOLLARS IN THOUSANDS) 2003 2004 AMOUNT PERCENT 2003 2004 AMOUNT PERCENT - ------------------------------- ------------- ------------- ------- ------- ------------- ------------- -------- ------- Salaries and other compensation $169,705 $181,497 $11,792 6.9% $ 484,333 $ 526,821 $42,488 8.8% Employee benefits.............. 35,597 35,270 (327) (0.9) 118,005 126,966 8,961 7.6 Salaries and employee benefits 205,302 216,767 11,465 5.6 602,338 653,787 51,449 8.5 Net occupancy.................. 31,342 33,206 1,864 5.9 91,844 96,961 5,117 5.6 Equipment...................... 15,680 16,289 609 3.9 48,705 50,443 1,738 3.6 Software....................... 11,996 13,560 1,564 13.0 34,921 39,463 4,542 13.0 Communications................. 12,661 12,850 189 1.5 39,859 39,295 (564) (1.4) Professional services.......... 12,676 12,375 (301) (2.4) 38,256 33,968 (4,288) (11.2) Advertising and public relations 9,227 7,954 (1,273) (13.8) 28,587 27,495 (1,092) (3.8) Data processing................ 7,659 8,364 705 9.2 23,887 23,648 (239) (1.0) Intangible asset amortization.. 2,587 5,077 2,490 96.3 8,291 13,783 5,492 66.2 Foreclosed asset expense....... (79) (10) 69 nm (28) 526 554 nm Other.......................... 39,810 45,959 6,149 15.4 125,805 142,530 16,725 13.3 -------- -------- ------- ---------- ---------- ------- Total noninterest expense.... $348,861 $372,391 $23,530 6.7% $1,042,465 $1,121,899 $79,434 7.6% ======== ======== ======= ========== ========== ======= - --------------------- nm--not meaningful
INCOME TAX EXPENSE Income tax expense in the third quarter of 2004 resulted in a 38 percent effective income tax rate compared with an effective tax rate of 34 percent for the third quarter of 2003. The increase in the effective tax rate was due to higher California state taxes in 2004 and an adjustment of $7.8 million in the third quarter of 2004 for 2003 state taxes. The adjustment was due primarily to the difference between our estimate of California state tax expense for last year and the taxes reported in our 2003 tax return. Income tax expense in the first nine months of 2004 resulted in a 37 percent effective income tax rate compared with an effective tax rate of 33 percent for the first nine 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. The unitary method of taxation requires us to incorporate MTFG's financial results, adjusted to reflect income tax reporting standards, in determining our California tax. Changes between MTFG's estimated and actual income for the fiscal year ended March 31, 2004, as reported in Form 20-F, filed with the SEC on September 28, 2004, affected our California taxes for the 2003 tax year. We have filed our California tax returns on the worldwide unitary basis since 1996. 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. 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, including MTFG's results on a U.S. GAAP basis, 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 third quarter and the first nine 35 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. LOANS The following table shows loans outstanding by loan type.
INCREASE (DECREASE) SEPTEMBER 30, 2004 FROM: -------------------------------------- SEPTEMBER 30, DECEMBER 31, SEPTEMBER 30, SEPTEMBER 30, DECEMBER 31, 2003 2003 2004 2003 2003 ------------------ ------------------ (DOLLARS IN THOUSANDS) ------------- ------------ ------------- AMOUNT PERCENT AMOUNT PERCENT - ------------------------------------ ---------- ------- ---------- ------- Domestic: Commercial, financial and industrial...................... $ 9,277,969 $8,817,679 $9,555,618 $277,649 3.0% $ 737,939 8.4% Construction...................... 1,127,915 1,101,166 1,103,970 (23,945) (2.1) 2,804 0.3 Mortgage: Residential..................... 7,095,436 7,463,538 8,821,566 1,726,130 24.3 1,358,028 18.2 Commercial...................... 4,310,957 4,195,178 4,356,052 45,095 1.0 160,874 3.8 ------------- ------------ ------------- ---------- ---------- Total mortgage................ 11,406,393 11,658,716 13,177,618 1,771,225 15.5 1,518,902 13.0 Consumer: Installment..................... 867,133 818,746 779,857 (87,276) (10.1) (38,889) (4.7) Revolving lines of credit....... 1,168,374 1,222,220 1,496,584 328,210 28.1 274,364 22.4 ------------- ------------ ------------- ---------- ---------- Total consumer................ 2,035,507 2,040,966 2,276,441 240,934 11.8 235,475 11.5 Lease financing................... 668,074 663,632 612,054 (56,020) (8.4) (51,578) (7.8) ------------- ------------ ------------- ---------- ---------- Total loans in domestic offices..................... 24,515,858 24,282,159 26,725,701 2,209,843 9.0 2,443,542 10.1 Loans originated in foreign branches 1,520,856 1,650,204 1,897,091 376,235 24.7 246,887 15.0 ------------- ------------ ------------- ---------- ---------- Total loans held to maturity.. 26,036,714 25,932,363 28,622,792 2,586,078 9.9 2,690,429 10.4 Total loans held for sale..... 10,662 12,265 2,294 (8,368) (78.5) (9,971) (81.3) ------------- ------------ ------------- ---------- ---------- Total loans................. $26,047,376 $25,944,628 $28,625,086 $2,577,710 9.9% $2,680,458 10.3% ============= ============ ============= ========== ==========
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. As of September 30, 2004, the increase in the commercial, financial and industrial loan portfolio compared to September 30, 2003, was primarily attributable to an increase in loan demand in the third quarter of 2004 much of which was in our energy portfolio. 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. 36 As of September 30, 2004, the construction loan portfolio increased from December 31, 2003, mainly reflecting growth in the demand for new single family homes, and decreased from September 30, 2003. The growth in new single family homes has been offset by slowing growth in capital assets and employment and higher office vacancy rates in our markets, which were factors that 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. As of September 30, 2004, the increase in the commercial mortgage portfolio compared to September 30, 2003 was primarily attributable to our acquisition of 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. As of September 30, 2004, the increase in the residential mortgage portfolio compared to September 30, 2003, was primarily attributable to 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. Third quarter 2004 growth was driven by our broker channel contributing approximately two-thirds of the growth and the remaining growth attributable to retail, loan-by-phone and internet channels. Purchase money loans accounted for 50 percent of this third quarter 2004 growth with the remaining growth attributable to refinancings. CONSUMER LOANS We originate consumer loans, such as auto loans and home equity loans and lines, through our branch network. As of September 30, 2004, the consumer loan portfolio increased compared to September 30, 2003, 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 September 30, 2004 was $23.7 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. As of September 30, 2004, the decrease in the lease financing portfolio compared to September 30, 2003, was primarily attributable to our announced discontinuance of our auto leasing activity, effective April 20, 2001. At September 30, 2004, our auto lease portfolio had declined to $32.9 million. Included in our lease portfolio are leveraged leases of $566.7 million, which are net of non-recourse debt of approximately $1.3 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. LOANS ORIGINATED IN FOREIGN BRANCHES Our loans originated in foreign branches consist primarily of short-term extensions of credit to financial institutions. As of September 30, 2004, the increase in loans originated in foreign branches, compared to September 30, 2003, was primarily borrowings from financial institutions related to an increase in trade financing activity and increased energy-related lending in Canada. 37 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 September 30, 2003, December 31, 2003 and September 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 OUSTANDINGS - ------------------------------------ ------------- -------- ------------ ----------- September 30, 2003 Korea............................... $636 $-- $42 $678 December 31, 2003 Korea............................... $630 $-- $28 $658 September 30, 2004 Korea............................... $623 $-- $4 $627
PROVISION FOR CREDIT LOSSES We recorded a reversal of provision for credit losses of $10 million in the third quarter of 2004, compared with a $20 million provision for credit losses in the third 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. Understanding our policies on allowance for credit losses is fundamental to understanding our consolidated financial position and consolidated results of operations. Accordingly, our significant policies and methodology on allowance for credit losses are discussed in detail in Note 1 in the "Notes to Consolidated Financial Statements" and in the section "Allowance for Credit Losses" included in our "Management's Discussion and Analysis of Financial Conditions and Results of Operation" in our 2003 Annual Report on Form 10-K, which was filed with the Securities and Exchange Commission. 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 September 30, 2004, our total allowance for credit losses was $483 million (consisting of $407 million and $76 million of allocated and unallocated allowance, respectively), or 1.69 percent of the total loan portfolio and 268 percent of total nonaccrual loans. In addition, the allowance incorporates the results of measuring impaired loans as provided in SFAS No. 114, "Accounting by Creditors for Impairment of a Loan" 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 38 allowance was $55 million, compared with $126 million and $29 million, respectively, at September 30, 2004. On September 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 $50 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 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 for the following refinements: we refined our loss factors for commercial real estate and construction lending in order to more accurately capture probable loss inherent in the portfolio, we adjusted the period used to calculate the cumulative loss rates on criticized loans from 12 to 24 quarters to better estimate losses over the life of the loans and we revised our method of estimating 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. During 2004, changes in estimates and assumptions regarding the effects of economic and business conditions on borrowers and other factors also affected the assessment of the unallocated allowance. 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, we recorded a reversal of provision for credit losses of $10 million in the third quarter of 2004. The refinements we made in the manner in which we segment our allowance for credit losses, as previously described, had no impact on the overall level of the allowance. CHANGES IN THE ALLOCATED (FORMULA AND SPECIFIC) ALLOWANCE At September 30, 2004, the formula allowance increased to $354 million, compared to $280 million at December 31, 2003. The increase was due primarily to the impact of the introduction in the second quarter of 2004 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 decreased to $53 million at September 30, 2004, compared to $80 million at December 31, 2003. 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 September 30, 2004, the unallocated allowance decreased to $76 million from $173 million at December 31, 2003. The reasons for the decrease, and for which an unallocated allowance is warranted, are detailed below. 39 In our assessment as of September 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 sector-specific 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. 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, we have reduced certain 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 commercial real estate, we considered slightly improving vacancy rates and stagnant rent growth being experienced nationally, with specific weakness in Northern California, which could be in the range of $10 million to $20 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 some electric service providers, combined with continued weakness in the airline industry in the wake of surging fuel prices, which could be in the range of $10 million to $20 million, an increase from the December 31, 2003 level of $5 million to $11 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 $4 million to $8 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. We reduced 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 September 30, 2004. 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 NINE MONTHS ENDED SEPTEMBER 30, INCREASE (DECREASE) ENDED SEPTEMBER 30, INCREASE (DECREASE) -------------------- ------------------ ------------------- ------------------ (DOLLARS IN THOUSANDS) 2003 2004 AMOUNT PERCENT 2003 2004 AMOUNT PERCENT - ---------------------- -------- -------- -------- -------- -------- -------- -------- -------- Balance, beginning of period.............. $558,282 $501,419 $(56,863) (10.2)% $609,190 $532,970 $(76,220) (12.5)% Loans charged off: Commercial, financial and industrial........ 41,457 15,358 (26,099) (63.0) 130,413 55,868 (74,545) (57.2) Construction........ -- 200 200 nm -- 200 200 nm Commercial mortgage. 7,286 -- (7,286) 100.0) 7,286 43 (7,243) (99.4) Consumer............ 2,058 1,520 (538) (26.1) 7,143 4,795 (2,348) (32.9) Lease financing..... 518 183 (335) (64.7) 32,726 2,207 (30,519) (93.3) Foreign(1).......... 2,220 -- (2,220) (100.0) 2,220 -- (2,220) (100.0) -------- -------- -------- -------- -------- -------- Total loans charged off..... 53,539 17,261 (36,278) (67.8) 179,788 63,113 (116,675) (64.9) Recoveries of loans previously charged off: Commercial, financial and industrial........ 13,845 8,216 (5,629) (40.7) 32,432 29,127 (3,305) (10.2) Commercial mortgage -- -- -- nm 150 1,571 1,421 nm Consumer............ 1,276 350 (926) (72.6) 2,695 1,241 (1,454) (54.0) Lease financing..... 183 41 (142) (77.6) 352 191 (161) (45.7) -------- -------- -------- -------- -------- -------- Total recoveries of loans previously charged off..... 15,304 8,607 (6,697) (43.8) 35,629 32,130 (3,499) (9.8) -------- -------- -------- -------- -------- -------- Net loans charged off... 38,235 8,654 (29,581) (77.4) 144,159 30,983 (113,176) (78.5) (Reversal of) provision for credit losses....... 20,000 (10,000) (30,000) (150.0) 75,000 (25,000) (100,000) (133.3) Foreign translation adjustment and other net additions (deductions)(2)..... 10,503 (3) (10,506) (100.0) 10,519 5,775 (4,744) (45.1) -------- -------- -------- -------- -------- -------- Balance, end of period $550,550 $482,762 $(67,788) (12.3)% $550,550 $482,762 $(67,788) (12.3)% ======== ======== ======== ======== ======== ======== Allowance for credit losses to total loans............... 2.11% 1.69% 2.11% 1.69% (Reversal of) provision for credit losses to net loans charged off 52.31 nm 52.03 nm Net loans charged off to average loans outstanding for the period(3)........... 0.58 0.12 0.73 0.15 - --------------- (1) Foreign loans are those loans originated in foreign branches. (2) Includes $10.3 million related to the Monterey Bay Bank acquisition in the third quarter of 2003 and $5.7 million related to the Business Bank of California acquisition in the first quarter of 2004. (3) Annualized.
Total loans charged off in the third quarter of 2004 decreased from the third quarter of 2003, as problem loans in the commercial, financial and industrial industries declined. Charge offs reflect the realization of losses in the portfolio that were recognized previously through provisions for credit losses. In addition, third quarter 2004 recoveries of loans previously charged off decreased from the third quarter of 2003. At September 30, 2004, the allowance for credit losses exceeded the annualized net loans charged off during the third 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. 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 41 due 90 days with respect to principal or interest. For a more detailed discussion of the accounting for nonaccrual loans, see Note 1 in the "Notes to Consolidated Financial Statements" included in our 2003 Annual Report on Form 10-K. 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.
INCREASE (DECREASE) SEPTEMBER 30, 2004 FROM: ------------------------------------- SEPTEMBER 30, DECEMBER 31, 2004 2003 SEPTEMBER 30, DECEMBER 31, SEPTEMBER 30, ------------------ ----------------- (DOLLARS IN THOUSANDS) 2003 2003 2004 AMOUNT PERCENT AMOUNT PERCENT - ------------------------------ ------------- ------------ ------------- --------- ------- -------- ------- Commercial, financial and industrial.................. $243,877 $190,404 $91,612 $(152,265) (62.4)% $(98,792) (51.9)% Construction.................. 1,554 -- 6,180 4,626 297.7 6,180 na Commercial mortgage........... 42,758 38,354 28,396 (14,362) (33.6) (9,958) (26.0) Lease financing............... 52,085 51,603 53,758 1,673 3.2 2,155 4.2 Loan originated in foreign branches.................... 765 840 210 (555) (72.5) (630) (75.0) ------------- ------------ ------------- --------- -------- Total nonaccrual loans.... 341,039 281,201 180,156 (160,883) (47.2) (101,045) (35.9) Foreclosed assets............. 3,308 5,689 10,607 7,299 220.6 4,918 86.4 ------------- ------------ ------------- --------- -------- Total nonperforming assets $344,347 $286,890 $190,763 $(153,584) (44.6) $(96,127) (33.5) ============= ============ ============= ========= ======== Allowance for credit losses... $550,550 $532,970 $482,762 $(67,788) (12.3)% $(50,208) (9.4)% ============= ============ ============= ========= ======== Nonaccrual loans to total loans....................... 1.31% 1.08% 0.63% Allowance for credit losses to nonaccrual loans......... 161.43 189.53 267.97 Nonperforming assets to total. loans and foreclosed assets. 1.32 1.11 0.67 Nonperforming assets to total assets...................... 0.81 0.68 0.41
As of September 30, 2004, our nonperforming assets included approximately $55.1 million in aircraft leases and $52.4 million in acquired syndicated loans. The decrease in nonaccrual loans was primarily due to pay-downs, charge-offs, and loan sales, coupled with significantly reduced inflows. During the third quarter of 2004, we had no sales of nonperforming loans compared to $67 million of loan commitments sold in the third quarter of 2003, which reduced our credit exposures. Losses from these sales were reflected in our charge-offs. 42 LOANS 90 DAYS OR MORE PAST DUE AND STILL ACCRUING
INCREASE (DECREASE) SEPTEMBER 30, 2004 FROM: ----------------------------------- SEPTEMBER 30, DECEMBER 31, SEPTEMBER 30, SEPTEMBER 30, DECEMBER 31, 2003 2003 2004 2003 2003 ------------- ------------ ------------- ----------------- ---------------- (DOLLARS IN THOUSANDS) AMOUNT PERCENT AMOUNT PERCENT - --------------------- -------- ------- ------- ------- Commercial, financial and industrial..... $21,598 $893 $1,892 $(19,706) (91.2)% $ 999 111.9% Construction......... -- -- 2,137 2,137 na 2,137 na Mortgage: Residential........ 1,777 1,878 3,353 1,576 88.7 1,475 78.5 Commercial......... 982 -- -- (982) (100.0) -- na ------- ------ ------ -------- ------- Total mortgage... 2,759 1,878 3,353 594 21.5 1,475 78.5 Consumer and other... 1,706 1,123 1,249 (457) (26.8) 126 11.2 ------- ------ ------ -------- ------- Total loans 90 days or more past due and still accruing. $26,063 $3,894 $8,631 $(17,432) (66.9)% $ 4,737 121.6% ======= ====== ====== ======== =======
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 (GMG). 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. 43 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. 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 non-interest 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 third quarter of 2004, we modestly decreased the size of our securities portfolio from June 30, 2004, due to run-off of maturing securities combined with slower purchases, reducing average balances by approximately $105 million from the second quarter of 2004. Effective duration was reduced from 2.7 to 2.4, both of which are relatively short. In addition during the third quarter of 2004, 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 $200 million of interest rate floors during the third quarter of 2004 to hedge some of our variable rate loans. For a further discussion of derivative instruments and our hedging strategies, see Note 8 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, still 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 44 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 September 30, 2004(1): DECEMBER 31, SEPTEMBER 30, (DOLLARS IN MILLIONS) 2003 2004 - ---------------------- ------------ ------------- + 200 basis points........................ $ 17.2 $ 13.1 as a percentage of base case NII.......... 1.20% 0.81% - - 200 basis points........................ $(19.8) $(27.6) as a percentage of base case NII.......... 1.38% 1.70% - ------------------ (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 $27.6 million, or 1.70 percent of adjusted NII in the base case scenario, well within the Board's guidelines. However, with Federal Funds and LIBOR rates currently close to two percent, a downward ramp scenario of 200 basis points would result in short-term rate levels near zero. As a result, we believe that a downward ramp scenario of 100 basis points provides a more reasonable measure of asset sensitivity in a falling interest rate environment. As of September 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 $3.7 million, or 0.23 percent of the base case scenario. In order to reflect more fully and accurately the anticipated NII impact of interest rate shocks at a specified future point in time, we have over the past quarter made a transition from a constant to a projected balance sheet as the basis for our EaR simulations. Such an approach aligns our interest rate risk analysis with the Bank's management goals and processes. 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. This includes alternate scenarios for volume growth for key balance sheet items. In addition to EaR, we measure the sensitivity of Economic Value of Equity (EVE) to interest rate shocks. Limits on EVE-at-Risk are set by ALCO and monitored monthly for compliance. We believe that, together, our NII and EVE simulations provide management with a reasonably comprehensive view of the sensitivity of our operating results and value profile 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 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 September 30, 2004, our securities available for sale portfolio included $10.4 billion and $11.1 billion, respectively, of securities for ALM purposes with an estimated effective duration of 2.4, compared to 2.5 at December 31, 2003. Effective duration is a measure of price sensitivity of a bond portfolio to immediate changes in interest rates. An effective duration of 2.4 suggests an expected price change of approximately 2.4 percent for an immediate one percent change in interest rates. At September 30, 2004, the ALM portfolio included $6.1 billion in mortgage-backed securities with an estimated effective duration of 2.8. The ALM portfolio's effective duration, in the context of our total 45 balance sheet, after giving consideration to the composition of our core deposits, contributes to the maintenance of our interest rate risk profile as near-neutral for NII over the next 12 months. 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 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 September 30, 2004. DECEMBER 31, 2003 SEPTEMBER 30, 2004 --------------------- --------------------- AVERAGE HIGH LOW AVERAGE HIGH LOW (DOLLARS IN THOUSANDS) VAR VAR VAR VAR VAR VAR - --------------------------- ------- ---- --- ------- ---- --- Foreign exchange........... $143 $428 $57 $119 $173 $64 Securities................. 206 463 97 407 484 322 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, UnionBanc Investment Services LLC. 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 September 30, 2004, $4.1 billion notional amount of derivative contracts entered into as an accommodation for customers. We act as an intermediary and 46 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 time deposits, combined with average common stockholders' equity, funded 84 percent of average total assets of $45.7 billion in the third 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 as of 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 September 30, 2004, a liquidity need could have been met by transferring under repurchase agreements a substantial portion of our unencumbered available for sale securities, which totaled approximately $8.8 billion. 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 $1.3 billion in the third 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. 47 REGULATORY CAPITAL The following tables summarize our risk-based capital, risk-weighted assets, and risk-based capital ratios. UNIONBANCAL CORPORATION
MINIMUM SEPTEMBER 30, DECEMBER 31, SEPTEMBER 30, REGULATORY (DOLLARS IN THOUSANDS) 2003 2003 2004 REQUIREMENT - ----------------------- ---------------- ---------------- ---------------- ----------------- CAPITAL COMPONENTS Tier 1 capital......... $ 3,632,898 $ 3,747,884 $ 3,760,291 Tier 2 capital......... 537,737 936,189 949,091 ---------------- ---------------- ---------------- Total risk-based capital.............. $ 4,170,635 $ 4,684,073 $ 4,709,382 ================ ================ ================ Risk-weighted assets... $33,144,336 $33,133,407 $37,622,266 ================ ================ ================ Quarterly average assets............... $41,624,946 $41,506,828 $45,444,623 ================ ================ ================
CAPITAL RATIOS AMOUNT RATIO AMOUNT RATIO AMOUNT RATIO AMOUNT RATIO - ----------------------- ---------- ----- ---------- ----- ------ ----- ---------- ----- Total capital (to risk- weighted assets)..... $4,170,635 12.58% $4,684,073 14.14% $4,709,382 12.52% >$3,009,781 8.0% Tier 1 capital (to - risk-weighted assets) 3,632,898 10.96 3,747,884 11.31 3,760,291 9.99 >1,504,891 4.0 - Leverage(1)............ 3,632,898 8.73 3,747,884 9.03 3,760,291 8.27 >1,817,785 4.0 - - -------------- (1) Tier 1 capital divided by quarterly average assets (excluding certain intangible assets).
UNION BANK OF CALIFORNIA, N.A.
MINIMUM "WELL-CAPITALIZED" SEPTEMBER 30, DECEMBER 31, SEPTEMBER 30, REGULATORY REGULATORY (DOLLARS IN THOUSANDS) 2003 2003 2004 REQUIREMENT REQUIREMENT - ----------------------- ---------------- ---------------- ---------------- ----------------- ------------------- CAPITAL COMPONENTS Tier 1 capital......... $ 3,306,884 $ 3,395,519 $ 3,791,489 Tier 2 capital......... 467,814 467,619 487,480 ---------------- ---------------- ---------------- Total risk-based capital.............. $ 3,774,698 $ 3,863,138 $ 4,278,969 ================ ================ ================ Risk-weighted assets... $32,520,713 $32,526,017 $36,919,037 ================ ================ ================ Quarterly average assets............... $41,044,744 $40,921,517 $44,943,543 ================ ================ ================
CAPITAL RATIOS AMOUNT RATIO AMOUNT RATIO AMOUNT RATIO AMOUNT RATIO AMOUNT RATIO - ----------------------- ---------- ----- ---------- ----- ---------- ----- ---------- ----- ---------- ----- Total capital (to risk- weighted assets...... $3,774,698 11.61% $3,863,138 11.88% $4,278,969 11.59% >$2,953,523 8.0% >$3,691,904 10.0 Tier 1 capital (to - - risk-weighted assets).............. 3,306,884 10.17 3,395,519 10.44 3,791,489 10.27 > 1,476,761 4.0 > 2,215,142 6.0 - - Leverage(1)............ 3,306,884 8.06 3,395,519 8.30 3,791,489 8.44 > 1,797,742 4.0 > 2,247,177 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 Tier 1 capital ratio at September 30, 2004, compared with September 30, 2003 and December 31, 2003. In December 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 in the "Notes to Consolidated Financial Statements" included in our 2003 Annual Report on Form 10-K). Compared with September 30, 2003, in addition to the changes to our capital structure mentioned in the above paragraph, the decrease in our capital ratios was also attributable to higher risk-weighted assets. Our leverage ratio decrease was primarily attributable to a $4 billion, or 9 percent, increase in quarterly average assets, which was substantially the result of increases in both our securities and residential mortgage loan portfolios. 48 As of September 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 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 SERVICES INTERNATIONAL SERVICES GROUP SERVICES GROUP BANKING GROUP ------------------ ------------------ ----------------- AS OF AND FOR THE THREE MONTHS ENDED SEPTEMBER 30, ------------------------------------------------------------- 2003 2004 2003 2004 2003 2004 -------- -------- -------- -------- ------- ------- RESULTS OF OPERATIONS AFTER PERFORMANCE CENTER EARNINGS (DOLLARS IN THOUSANDS): Net interest income............................ $173,733 $203,040 $186,249 $203,288 $ 8,537 $ 9,802 Noninterest income............................. 110,912 125,042 67,591 64,317 18,117 19,069 -------- -------- -------- -------- ------- ------- Total revenue.................................. 284,645 328,082 253,840 267,605 26,654 28,871 Noninterest expense............................ 202,283 235,883 103,277 108,519 15,323 16,728 Credit expense (income)........................ 7,996 8,400 39,397 24,781 511 566 -------- -------- -------- -------- ------- ------- Income (loss) before income tax expense (benefit)............................ 74,366 83,799 111,166 134,305 10,820 11,577 Income tax expense (benefit)................... 28,445 32,053 36,128 44,414 4,139 4,428 -------- -------- -------- -------- ------- ------- Net income (loss).............................. $ 45,921 $ 51,746 $ 75,038 $ 89,891 $ 6,681 $ 7,149 ======== ======== ======== ======== ======= ======= PERFORMANCE CENTER EARNINGS (DOLLARS IN THOUSANDS): Net interest income............................ $ 186 $ 67 $ (99) $ (26) $ 10 $ 17 Noninterest income............................. (9,835) (2,631) 16,697 10,383 305 258 Noninterest expense............................ (8,904) (2,760) 9,513 4,063 59 2 Net income (loss).............................. (477) 103 4,412 3,961 158 169 Total loans (dollars in millions).............. 24 21 (43) (42) -- -- AVERAGE BALANCES (DOLLARS IN MILLIONS): Total loans(1)................................. $ 11,801 $ 13,105 $ 12,483 $ 12,712 $ 1,457 $ 1,883 Total assets................................... 12,904 14,386 14,347 15,381 1,913 2,281 Total deposits(1).............................. 17,463 19,355 13,767 14,344 1,555 2,259 FINANCIAL RATIOS: Risk adjusted return on capital(2)............. 25% 30% 19% 24% 43% 44% Return on average assets(2).................... 1.41 1.43 2.08 2.33 1.39 1.25 Efficiency ratio(3)............................ 71.1 71.9 40.7 40.6 57.5 57.9 GLOBAL UNIONBANCAL MARKETS GROUP OTHER CORPORATION ------------------ ------------------ ------------------ AS OF AND FOR THE THREE MONTHS ENDED SEPTEMBER 30, -------------------------------------------------------------- 2003 2004 2003 2004 2003 2004 -------- -------- -------- -------- -------- -------- RESULTS OF OPERATIONS AFTER PERFORMANCE CENTER EARNINGS (DOLLARS IN THOUSANDS): Net interest income............................ $ 18,140 $(35,642) $ 14,430 $ 31,602 $401,089 $412,090 Noninterest income............................. (1,097) 1,561 5,947 5,965 201,470 215,954 -------- -------- -------- -------- -------- -------- Total revenue.................................. 17,043 (34,081) 20,377 37,567 602,559 628,044 Noninterest expense............................ 3,926 5,225 24,052 6,036 348,861 372,391 -------- -------- -------- -------- -------- -------- Credit expense (income)........................ 50 54 (27,954) (43,801) 20,000 (10,000) Income (loss) before income tax expense (benefit)............................ 13,067 (39,360) 24,279 75,332 233,698 265,653 Income tax expense (benefit)................... 4,998 (15,055) 4,943 36,375 78,653 102,215 -------- -------- -------- -------- -------- -------- Net income (loss).............................. $ 8,069 $(24,305) $ 19,336 $ 38,957 $155,045 $163,438 ======== ======== ======== ======== ======== ======== PERFORMANCE CENTER EARNINGS (DOLLARS IN THOUSANDS): Net interest income............................ $ (203) $ (176) $ 106 $ 118 $ -- $-- Noninterest income............................. (10,605) (11,294) 3,438 3,284 -- -- Noninterest expense............................ (2,123) (1,989) 1,455 684 -- -- Net income (loss).............................. (5,362) (5,854) 1,269 1,621 -- -- Total loans (dollars in millions).............. -- -- 19 21 -- -- AVERAGE BALANCES (DOLLARS IN MILLIONS): Total loans(1)................................. $ 333 $ 192 $ 258 $ 255 $ 26,332 $ 28,147 Total assets................................... 11,506 12,544 1,244 1,121 41,914 45,713 Total deposits(1).............................. 837 737 1,281 1,419 34,903 38,114 FINANCIAL RATIOS: Risk adjusted return on capital(2)............. 3% (15)% na na na na Return on average assets(2).................... 0.28 (0.77) na na 1.47% 1.42% Efficiency ratio(3)............................ 23.0 (15.3) na na 57.9 59.2 - -------------------------- (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 ($79 thousand) and ($10 thousand) in the third quarters of 2003 and 2004, respectively. na = not applicable
50
COMMUNITY BANKING COMMERCIAL AND INVESTMENT FINANCIAL SERVICES INTERNATIONAL SERVICES GROUP GROUP BANKING GROUP AS OF AND FOR THE NINE MONTHS ENDED SEPTEMBER 30, ------------------------------------------------------------- 2003 2004 2003 2004 2003 2004 -------- -------- -------- -------- ------- ------- RESULTS OF OPERATIONS AFTER PERFORMANCE CENTER EARNINGS (DOLLARS IN THOUSANDS): Net interest income............................ $505,206 $571,536 $546,437 $578,265 $25,654 $26,832 Noninterest income............................. 324,416 371,436 187,055 206,483 59,690 59,519 -------- -------- -------- -------- ------- ------- Total revenue.................................. 829,622 942,972 733,492 784,748 85,344 86,351 Noninterest expense............................ 599,400 678,512 307,132 317,208 45,656 49,368 Credit expense (income)........................ 23,840 23,984 124,006 82,443 1,563 1,815 -------- -------- -------- -------- ------- ------- Income (loss) before income tax expense (benefit)............................ 206,382 240,476 302,354 385,097 38,125 35,168 Income tax expense (benefit)................... 78,941 91,982 96,355 127,983 14,583 13,451 -------- -------- -------- -------- ------- ------- Net income (loss).............................. $127,441 $148,494 $205,999 $257,114 $23,542 $21,717 ======== ======== ======== ======== ======= ======= PERFORMANCE CENTER EARNINGS (DOLLARS IN THOUSANDS): Net interest income............................ $ 589 $ 388 $ (500) $(231) $ 24 $52 Noninterest income............................. (28,245) (22,804) 46,112 42,273 887 874 Noninterest expense............................ (25,458) (19,262) 26,706 21,654 393 67 Net income (loss).............................. (1,414) (2,000) 11,799 12,737 320 531 Total loans (dollars in millions).............. 25 25 (45) (44) -- -- AVERAGE BALANCES (DOLLARS IN MILLIONS): Total loans(1)................................. $ 11,383 $ 12,486 $ 13,025 $ 12,314 $ 1,529 $1,757 Total assets................................... 12,392 13,722 15,028 14,683 1,948 2,180 Total deposits(1).............................. 16,568 19,105 12,461 14,022 1,515 1,989 FINANCIAL RATIOS: Risk adjusted return on capital(2)............. 25% 29% 16% 23% 50% 47% Return on average assets(2).................... 1.37 1.45 1.83 2.34 1.62 1.33 Efficiency ratio(3)............................ 72.2 72.0 41.9 40.4 53.5 57.2
GLOBAL UNIONBANCAL MARKETS GROUP OTHER CORPORATION ------------------ ------------------ ---------------------- AS OF AND FOR THE NINE MONTHS ENDED SEPTEMBER 30, ------------------------------------------------------------------ 2003 2004 2003 2004 2003 2004 -------- -------- -------- -------- ---------- ---------- RESULTS OF OPERATIONS AFTER PERFORMANCE CENTER EARNINGS (DOLLARS IN THOUSANDS): Net interest income............................ $ 56,371 $(50,293) $ 43,978 $ 86,029 $1,177,646 $1,212,369 Noninterest income............................. 2,311 4,497 16,940 116,234 590,412 758,169 Total revenue.................................. 58,682 (45,796) 60,918 202,263 1,768,058 1,970,538 Noninterest expense............................ 12,158 16,093 78,119 60,718 1,042,465 1,121,899 Credit expense (income)........................ 150 280 (74,559) (133,522) 75,000 (25,000) Income (loss) before income tax expense (benefit).................................... 46,374 (62,169) 57,358 275,067 650,593 873,639 Income tax expense (benefit)................... 17,738 (23,780) 7,656 111,981 215,273 321,617 Net income (loss).............................. $ 28,636 $(38,389) $ 49,702 $163,086 $ 435,320 $ 552,022 PERFORMANCE CENTER EARNINGS (DOLLARS IN THOUSANDS): Net interest income............................ $ (433) $ (531) $ 320 $ 322 $ -- $ -- Noninterest income............................. (28,553) (31,012) 9,799 10,669 -- -- Noninterest expense............................ (5,776) (5,741) 4,135 3,282 -- -- Net income (loss).............................. (14,332) (15,933) 3,627 4,665 -- -- Total loans (dollars in millions).............. -- -- 20 19 -- -- AVERAGE BALANCES (DOLLARS IN MILLIONS): Total loans(1)................................. $ 279 $ 228 $ 307 $ 261 $ 26,523 $ 27,046 Total assets................................... 9,655 12,732 1,003 1,146 40,026 44,463 Total deposits(1).............................. 1,037 838 1,289 1,337 32,870 37,291 FINANCIAL RATIOS: Risk adjusted return on capital(2)............. 4% (6)% na na na na Return on average assets(2).................... 0.40 (0.40) na na 1.45% 1.66% Efficiency ratio(3)............................ 20.7 (35.1) na na 58.9 56.8 - -------------------------- (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 (income) was ($28 thousand) and $526 thousand in the first nine months of 2003 and 2004, respectively. na = not applicable
51 COMMUNITY BANKING AND INVESTMENT SERVICES GROUP In the third quarter of 2004, net income increased $5.8 million, or 13 percent, compared to the third quarter of 2003. In the third quarter of 2004, total revenue increased $43.4 million, or 15 percent, compared to the third quarter of 2003. Increased asset and deposit volumes, partly offset by the effect of a lower interest rate environment led to an increase of $29.3 million, or 17 percent, in net interest income over the third quarter of 2003. In the third quarter of 2004, noninterest income was $14.1 million, or 13 percent, higher than the third quarter of 2003 primarily due to higher deposit fees and trust fees. Noninterest expense increased $33.6 million, or 17 percent, in the third quarter of 2004 compared to the third 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 September 30, 2004, residential mortgages grew by $1.7 billion, or 24 percent, from September 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. 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. On October 28, 2004, we completed our acquisition of Jackson Federal Bank, a savings bank headquartered in Brea, California, with $1.4 billion in assets and fourteen full-service branches in Southern California. 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 301 full-service branches in California, Washington and Oregon and a network of 571 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 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. Our recent acquisition of the business portfolio of CNAT, which was completed on August 1, 2004, added outsourcing capability for direct distributors of retirement products and strengthened capacity to support smaller plans. The newly acquired products and services of CNAT will be marketed under the name "TruSource." 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. 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 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, UnionBanc Investment Services LLC 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 UnionBanc Investment Services LLC, a registered broker/dealer offering investment products to individuals and institutional clients, whose primary strategy is to further penetrate our existing client base. 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 53 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 third quarter of 2004, net income increased $14.9 million, or 20 percent, compared to the third quarter of 2003. In the third quarter of 2004, net interest income increased $17.0 million, or 9 percent, compared to the third quarter of 2003, partially attributable to the impact of increasing deposit balances. Noninterest income decreased $3.3 million, or 5 percent, mainly attributable to lower deposit-related service fees related to a higher earning credit rates in the current quarter on customer deposits used to pay for banking services. In the third quarter of 2004, noninterest expense increased $5.2 million, or 5 percent, mainly attributed higher expenses to support increased product sales and deposit volumes. Credit expense decreased $14.6 million mainly as a result of improving credit quality. 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. 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; 54 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 became 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 third quarter of 2004, net income increased $0.5 million, or 7 percent, compared to the third quarter of 2003. Total revenue increased $2.2 million or 8 percent, compared to the third quarter of 2003. Net interest income increased $1.3 million, or 15 percent, compared to the third quarter of 2003 mainly attributable to higher demand deposit balances. Noninterest income was $1.0 million, or 5 percent, higher compared to the third quarter of 2003 primarily attributable to higher payment and trade activities in the current quarter. Noninterest expense increased $1.4 million, or 9 percent, compared to the third quarter of 55 2003 primarily due to incremental costs associated with strengthening our Bank Secrecy Act controls and processes in our Union Bank of California, International--New York subsidiary. In the third quarter of 2004, credit expense of $0.1 million was slightly higher compared to the third 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 UnionBanc Investment Services LLC, the Bank's brokerage subsidiary. The UnionBanc 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 third quarter of 2004, net loss was $24.3 million compared to net income of $8.1 million in the third quarter of 2003. Total revenue in the third quarter of 2004 decreased by $51.1 million, compared to the third quarter of 2003, resulting from a $53.8 million decrease in net interest income. The decrease in net interest income was primarily attributable to a higher transfer pricing residual in the third 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 credited at shorter-term lending and investment rates. Noninterest income increased $2.7 million compared to the third quarter of 2003. Noninterest expense in the third quarter of 2004 increased $1.3 million, or 33 percent, compared to the previous year's quarter as we incurred costs for technology improvements and added to our staff. 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; 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; 56 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 $279 million at September 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 third quarter of 2004 was $39.0 million. The results were impacted by the following factors: o Credit expense (income) of ($43.8) 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 $33.8 million in expected losses for the reportable business segments, which utilizes the RAROC methodology; o Net interest income of $31.6 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 $6.0 million; and o Noninterest expense of $6.0 million compared with $24.1 million for the quarter ending September 30, 2003. The decline resulted from decreases in post-retirement healthcare expense, technology, consulting, and marketing expenses. Net income for "Other" in the third quarter of 2003 was $19.3 million. The results were impacted by the following factors: o Credit expense (income) of ($28.0) million was due to the difference between the $20.0 million provision for credit losses calculated under our U.S. GAAP methodology and the $48.0 million in expected losses for the reportable business segments, which utilizes the RAROC methodology; o Net interest income of $14.4 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 $5.9 million; and o Noninterest expense of $24.1 million. REGULATORY MATTERS Union Bank of California International has entered into a written agreement with the Federal Reserve Bank of New York relating to Union Bank of California International's Bank Secrecy Act controls and processes. Union Bank of California International is wholly owned by Union Bank of California, N.A., which is wholly owned by UnionBanCal Corporation. Union Bank of California International is headquartered in New York City and, as an Edge Act subsidiary, is limited to engaging in international banking activities. Union Bank of California International is implementing a plan to strengthen its Bank Secrecy Act controls and processes. UnionBanCal Corporation filed a Form 8-K containing Union Bank of California International's agreement with the Federal Reserve Bank of New York. The banking industry, including Union Bank of California, N.A., is subject to significantly increased regulatory scrutiny and enforcement regarding Bank Secrecy Act matters. Union Bank of California International's agreement with the Federal Reserve Bank of New York and this general increase in regulatory scrutiny and enforcement of Bank Secrecy Act matters have resulted in Union Bank of California, N.A. initiating enhanced efforts to strengthen its Bank Secrecy Act controls and processes. 57 The increased regulatory scrutiny and enforcement of Bank Secrecy Act matters and Union Bank of California International's agreement with the Federal Reserve Bank of New York will adversely affect Union Bank of California International's, and may adversely affect UnionBanCal Corporation's and Union Bank of California, N.A.'s, ability to obtain regulatory approvals for future initiatives requiring regulatory approval, including acquisitions. However, neither this effect, nor the terms of Union Bank of California International's agreement with the Federal Reserve Bank of New York, nor the financial impact of enhanced Bank Secrecy Act controls and processes, are expected to have a material adverse impact on the financial condition or results of operations of Union Bank of California, N.A. or UnionBanCal Corporation. 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 pace and scope of the recovery 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 have provided 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 and the quality of our real estate loan portfolio. 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 have adversely affected 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 58 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 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. 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 of Mitsubishi Tokyo Financial Group, Inc. with UFJ Holdings, Inc. However, The Bank of Tokyo-Mitsubishi, Ltd.'s credit ratings may affect our credit ratings. The Bank of 59 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., and other developments concerning 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. 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. 60 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 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), 61 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 September 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 September 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. 62 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. We have reached an agreement 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 has been submitted to the court for approval. The disposition of this claim will not have a material adverse effect on our financial position or results of operations, since a reserve has been established for the loss. Another suit, Grafton Partners LP v. Union Bank of California, is pending in Alameda County Superior Court (filed March 12, 2003). That suit concerns a "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. ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS Repurchases of equity securities are presented in the table below.
TOTAL NUMBER OF MAXIMUM NUMBER (OR SHARES (OR UNITS) APPROXIMATE DOLLAR VALUE) TOTAL NUMBER OF PURCHASED AS PART OF OF SHARES (OR UNITS) THAT SHARES (OR UNITS) AVERAGE PRICE PAID PUBLICLY ANNOUNCED MAY YET BE PURCHASED UNDER PERIOD PURCHASED PER SHARE (OR UNIT) PLANS OR PROGRAMS THE PLANS OR PROGRAMS - --------------------------- ----------------- ------------------- -------------------- -------------------------- JULY 2004 (July 23 - 30, 2004)....... 274,200 $57.28 274,200 $230,443,532 AUGUST 2004 (August 2 - 31, 2004)...... 530,000 $58.09 530,000 $199,653,218 SEPTEMBER 2004 (September 1 - 30, 2004)... 280,000 $58.42 280,000 $183,294,679(1) --------- --------- Total...................... 1,084,200 $57.97 1,084,200 ========= ========= - -------------------- (1) In the third quarter of 2004, we used the remaining $46 million from the $200 million repurchase program announced on April 22, 2003. In addition, $183 million is available from a $200 million repurchase program announced on April 28, 2004.
63 ITEM 6. 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) 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 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 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 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 - ------------------------------- (1) Incorporated by reference to the UnionBanCal Corporation current report on Form 8-K, dated July 1, 2004
64 SIGNATURES Pursuant to the requirements 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) Date: November 5, 2004 By: /S/ NORIMICHI KANARI ---------------------------------------- Norimichi Kanari PRESIDENT AND CHIEF EXECUTIVE OFFICER (Principal Executive Officer) Date: November 5, 2004 By: /S/ DAVID I. MATSON ----------------------------------------- David I. Matson EXECUTIVE VICE PRESIDENT AND CHIEF FINANCIAL OFFICER (Principal Financial Officer) Date: November 5, 2004 By: /S/ DAVID A. ANDERSON ----------------------------------------- David A. Anderson SENIOR VICE PRESIDENT AND CONTROLLER (Principal Accounting Officer) 65 EX-31 2 exhibit31-1093004.txt NORIMICHI KANARI CERTIFICATION Exhibit 31.1 CERTIFICATION I, Norimichi Kanari, certify that: 1. I have reviewed this quarterly report on Form 10-Q of UnionBanCal Corporation (the "Registrant"); 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the Registrant as of, and for, the periods presented in this report; 4. The Registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the Registrant and we have: a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the Registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) evaluated the effectiveness of the Registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; c) disclosed in this report any change in the Registrant's internal control over financial reporting that occurred during the Registrant's most recent fiscal quarter (the Registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the Registrant's internal control over financial reporting; and 5. The Registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the Registrant's auditors and the audit committee of Registrant's board of directors (or persons performing the equivalent function): a) all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the Registrant's ability to record, process, summarize and report financial information; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the Registrant's internal control over financial reporting. Date: November 5, 2004 By: /S/ NORIMICHI KANARI -------------------------------------- Norimichi Kanari PRESIDENT AND CHIEF EXECUTIVE OFFICER EX-31 3 exhibit31-2093004.txt DAVID MATSON CERTIFICATION Exhibit 31.2 CERTIFICATION I, David I. Matson, certify that: 1. I have reviewed this quarterly report on Form 10-Q of UnionBanCal Corporation (the "Registrant"); 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the Registrant as of, and for, the periods presented in this report; 4. The Registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the Registrant and we have: a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the Registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) evaluated the effectiveness of the Registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; c) disclosed in this report any change in the Registrant's internal control over financial reporting that occurred during the Registrant's most recent fiscal quarter (the Registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the Registrant's internal control over financial reporting; and 5. The Registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the Registrant's auditors and the audit committee of Registrant's board of directors (or persons performing the equivalent function): a) all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the Registrant's ability to record, process, summarize and report financial information; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the Registrant's internal control over financial reporting. Date: November 5, 2004 By: /S/ DAVID I. MATSON -------------------------------------- David I. Matson EXECUTIVE VICE PRESIDENT AND CHIEF FINANCIAL OFFICER EX-32 4 exhibit32-1093004.txt NORIMICHI KANARI CERTIFICATION Exhibit 32.1 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with this Quarterly Report of UnionBanCal Corporation (the "Company") on Form 10-Q for the quarter ending September 30, 2004 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Norimichi Kanari, Chief Executive Officer of the Company, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that, to my knowledge: (1) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. Dated: November 5, 2004 By: /S/ NORIMICHI KANARI -------------------------------------- Norimichi Kanari Chief Executive Officer EX-32 5 exhibit32-2093004.txt DAVID MATSON CERTIFICATION Exhibit 32.2 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with this Quarterly Report of UnionBanCal Corporation (the "Company") on Form 10-Q for the quarter ending September 30, 2004 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, David I. Matson, Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that, to my knowledge: (1) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. Dated: November 5, 2004 By: /S/ DAVID I. MATSON -------------------------------------- David I. Matson Chief Financial Officer -----END PRIVACY-ENHANCED MESSAGE-----