Form 10-Q
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2010

Commission File Number: 1-9700

THE CHARLES SCHWAB CORPORATION

(Exact name of registrant as specified in its charter)

 

Delaware   94-3025021

(State or other jurisdiction

of incorporation or organization)

  (I.R.S. Employer Identification No.)

211 Main Street, San Francisco, CA 94105

(Address of principal executive offices and zip code)

Registrant’s telephone number, including area code: (415) 667-7000

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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer  x      Accelerated filer  ¨
Non-accelerated filer    ¨   (Do not check if a smaller reporting company)    Smaller reporting company  ¨

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

1,194,827,651 shares of $.01 par value Common Stock

Outstanding on October 22, 2010

 

 

 


Table of Contents

 

THE CHARLES SCHWAB CORPORATION

Quarterly Report on Form 10-Q

For the Quarter Ended September 30, 2010

Index

 

         Page  

Part I - Financial Information

  

    Item 1.

  Condensed Consolidated Financial Statements (Unaudited):   
  Statements of Income      1   
  Balance Sheets      2   
  Statements of Cash Flows      3   
  Notes      4 – 18   
    Item 2.   Management’s Discussion and Analysis of Financial Condition and Results of Operations      19 – 39   
    Item 3.   Quantitative and Qualitative Disclosures About Market Risk      40 – 41   
    Item 4.   Controls and Procedures      41   

Part II - Other Information

  
    Item 1.   Legal Proceedings      42   
    Item 1A.   Risk Factors      42   
    Item 2.   Unregistered Sales of Equity Securities and Use of Proceeds      43   
    Item 3.   Defaults Upon Senior Securities      43   
    Item 5.   Other Information      43   
    Item 6.   Exhibits      44   

Signature

     45   


Table of Contents

 

Part I – FINANCIAL INFORMATION

Item 1. Condensed Consolidated Financial Statements

THE CHARLES SCHWAB CORPORATION

Condensed Consolidated Statements of Income

(In millions, except per share amounts)

(Unaudited)

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
     2010     2009     2010     2009  

Net Revenues

        

Asset management and administration fees

   $     468      $     451      $ 1,325      $ 1,439   

Interest revenue

     442        356        1,261        1,063   

Interest expense

     (58     (62     (169     (161
                                

Net interest revenue

     384        294        1,092        902   

Trading revenue

     182        241        624        772   

Other

     32        36        99        132   

Net impairment losses on securities (1)

     (3     (11     (19     (38
                                

Total net revenues

     1,063        1,011        3,121        3,207   
                                

Expenses Excluding Interest

        

Compensation and benefits

     381        371        1,176        1,173   

Professional services

     85        70        249        194   

Occupancy and equipment

     66        67        202        245   

Advertising and market development

     34        34        139        141   

Communications

     49        48        154        155   

Depreciation and amortization

     35        38        108        121   

Class action litigation reserve

                   196          

Money market mutual fund charges

     132               132          

Other

     82        63        215        168   
                                

Total expenses excluding interest

     864        691        2,571        2,197   
                                

Income before taxes on income

     199        320        550        1,010   

Taxes on income

     (75     (120     (215     (387
                                

Net Income

   $ 124      $ 200      $     335      $     623   
                                

Weighted-Average Common Shares Outstanding — Diluted

     1,194        1,163        1,192        1,160   
                                

Earnings Per Share — Basic

   $ .10      $ .17      $ .28      $ .54   

Earnings Per Share — Diluted

   $ .10      $ .17      $ .28      $ .54   
                                

 

(1)

Net impairment losses on securities include total other-than-temporary impairment losses of $0 million and $52 million, net of $(3) million and $41 million recognized in other comprehensive income, for the three months ended September 30, 2010 and 2009, respectively, and total other-than-temporary impairment losses of $41 million and $239 million, net of $22 million and $201 million recognized in other comprehensive income, for the nine months ended September 30, 2010 and 2009, respectively.

See Notes to Condensed Consolidated Financial Statements.

 

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Table of Contents

THE CHARLES SCHWAB CORPORATION

 

Condensed Consolidated Balance Sheets

(In millions, except share and per share amounts)

(Unaudited)

 

     September 30,
2010
    December 31,
2009
 

Assets

    

Cash and cash equivalents

   $         5,701      $         8,241   

Cash and investments segregated and on deposit for regulatory purposes (including resale agreements of $11,642 at September 30, 2010 and $8,346 at December 31, 2009)

     20,066        18,373   

Receivables from brokers, dealers, and clearing organizations

     510        560   

Receivables from brokerage clients — net

     9,842        8,627   

Other securities owned — at fair value

     341        916   

Securities available for sale

     26,017        22,120   

Securities held to maturity (fair value — $14,826 at September 30, 2010 and $6,880 at December 31, 2009)

     14,390        6,839   

Loans to banking clients — net

     8,178        7,348   

Loans held for sale

     121        104   

Equipment, office facilities, and property — net

     610        641   

Goodwill

     528        528   

Other assets

     994        1,134   
                

Total assets

   $ 87,298      $ 75,431   
                

Liabilities and Stockholders’ Equity

    

Deposits from banking clients

   $ 48,836      $ 38,820   

Payables to brokers, dealers, and clearing organizations

     1,483        2,373   

Payables to brokerage clients

     27,676        26,246   

Accrued expenses and other liabilities

     1,260        1,407   

Long-term debt

     2,008        1,512   
                

Total liabilities

     81,263        70,358   
                

Stockholders’ equity:

    

Preferred stock — 9,940,000 shares authorized; $.01 par value per share; none issued

              

Common stock — 3 billion shares authorized; $.01 par value per share; 1,421,761,844 shares issued at September 30, 2010 and 1,392,091,544 shares issued at December 31, 2009

     14        14   

Additional paid-in capital

     2,912        2,298   

Retained earnings

     7,363        7,243   

Treasury stock, at cost — 227,014,531 shares at September 30, 2010 and 229,983,936 shares at December 31, 2009

     (4,257     (4,291

Accumulated other comprehensive income (loss)

     3        (191
                

Total stockholders’ equity

     6,035        5,073   
                

Total liabilities and stockholders’ equity

   $ 87,298      $ 75,431   
                

See Notes to Condensed Consolidated Financial Statements.

 

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THE CHARLES SCHWAB CORPORATION

 

Condensed Consolidated Statements of Cash Flows

(In millions)

(Unaudited)

 

     Nine Months Ended
September 30,
 
     2010     2009  

Cash Flows from Operating Activities

    

Net income

   $ 335      $ 623   

Adjustments to reconcile net income to net cash provided by operating activities:

    

Net impairment losses on securities

     19        38   

Stock-based compensation

     64        54   

Depreciation and amortization

     108        121   

Other

     12        (26

Originations of loans held for sale

     (1,277     (2,279

Proceeds from sales of loans held for sale

     1,267        2,264   

Net change in:

    

Cash and investments segregated and on deposit for regulatory purposes

     (1,693     (2,754

Receivables from brokers, dealers, and clearing organizations

     51        189   

Receivables from brokerage clients

     (1,218     (751

Other securities owned

     577        (39

Other assets

     57        11   

Payables to brokers, dealers, and clearing organizations

     377        195   

Payables to brokerage clients

     1,701        3,187   

Accrued expenses and other liabilities

     62        (133
                

Net cash provided by operating activities

     442        700   
                

Cash Flows from Investing Activities

    

Purchases of securities available for sale

     (13,791     (11,144

Proceeds from sales of securities available for sale

     220        107   

Principal payments on securities available for sale

     9,979        4,613   

Purchases of securities held to maturity

     (10,149     (2,808

Principal payments on securities held to maturity

     1,314        73   

Net increase in loans to banking clients

     (897     (921

Purchase of equipment, office facilities, and property

     (82     (108

Other investing activities

     4          
                

Net cash used for investing activities

     (13,402     (10,188
                

Cash Flows from Financing Activities

    

Net change in deposits from banking clients

     9,574        11,659   

Issuance of long-term debt

     701        747   

Repayment of long-term debt

     (204     (79

Net proceeds from common stock offering

     543          

Dividends paid

     (215     (209

Proceeds from stock options exercised and other

     23        46   

Other financing activities

     (2     (2
                

Net cash provided by financing activities

     10,420        12,162   
                

(Decrease) Increase in Cash and Cash Equivalents

     (2,540     2,674   

Cash and Cash Equivalents at Beginning of Period

     8,241        5,442   
                

Cash and Cash Equivalents at End of Period

   $     5,701      $     8,116   
                

Supplemental Cash Flow Information

    

Cash paid during the period for:

    

Interest

   $ 131      $ 111   

Income taxes

   $ 281      $ 350   

See Notes to Condensed Consolidated Financial Statements.

 

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THE CHARLES SCHWAB CORPORATION

Notes to Condensed Consolidated Financial Statements

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

(Unaudited)

1.   Introduction and Basis of Presentation

The Charles Schwab Corporation (CSC) is a savings and loan holding company engaged, through its subsidiaries, in securities brokerage, banking, and related financial services. Charles Schwab & Co., Inc. (Schwab) is a securities broker-dealer with 302 domestic branch offices in 45 states, as well as a branch in each of the Commonwealth of Puerto Rico and London, U.K. In addition, Schwab serves clients in Hong Kong through one of CSC’s subsidiaries. Other subsidiaries include Charles Schwab Bank (Schwab Bank), a federal savings bank, and Charles Schwab Investment Management, Inc. (CSIM), the investment advisor for Schwab’s proprietary mutual funds, which are referred to as the Schwab Funds®.

The accompanying unaudited condensed consolidated financial statements include CSC and its majority-owned subsidiaries (collectively referred to as the Company). All material intercompany balances and transactions have been eliminated. These condensed consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States, which require management to make certain estimates and assumptions that affect the reported amounts in the accompanying financial statements. Certain estimates include other-than-temporary impairment of securities available for sale and securities held to maturity, the valuation of goodwill, the allowance for credit losses, and legal reserves. Actual results could differ from those estimates. These condensed consolidated financial statements reflect all adjustments that are, in the opinion of management, necessary for a fair statement of the results for the periods presented. These adjustments are of a normal recurring nature. Certain prior-year amounts have been reclassified to conform to the 2010 presentation. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2009. The Company’s results for any interim period are not necessarily indicative of results for a full year or any other interim period.

 

2.   New Accounting Standards

Adoption of New Accounting Standards

Transfers of Financial Assets: On January 1, 2010, the Company adopted new guidance on accounting for transfers of financial assets for transfers occurring after January 1, 2010. This new guidance removes the concept of a qualifying special-purpose entity and amends the requirements for a transfer of a portion of a financial asset to be accounted for as a sale and related disclosures. There were no transfers of financial assets during the first nine months of 2010 for which this guidance was applicable.

Consolidation of Variable Interest Entities: On January 1, 2010, the Company adopted new guidance on consolidation of variable interest entities (VIEs). This new guidance amends the consolidation guidance applicable to VIEs, including changing the approach to determining a VIE’s primary beneficiary (the reporting entity that must consolidate the VIE) and the frequency of reassessment. The adoption of this new guidance did not have a material impact on the Company’s financial position, results of operations, earnings per share (EPS), or cash flows.

 

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THE CHARLES SCHWAB CORPORATION

Notes to Condensed Consolidated Financial Statements

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

(Unaudited)

 

 

3.   Securities Available for Sale and Securities Held to Maturity

The amortized cost, gross unrealized gains and losses, and fair value of securities available for sale and securities held to maturity are as follows:

 

September 30, 2010

   Amortized
Cost
     Gross
Unrealized
Gains
     Gross
Unrealized
Losses
     Fair
Value
 

Securities available for sale:

           

U.S. agency residential mortgage-backed securities

   $ 13,421       $ 249       $ 1       $ 13,669   

Non-agency residential mortgage-backed securities

     1,943         4         297         1,650   

Corporate debt securities

     2,795         8                 2,803   

Certificates of deposit

     2,799         3                 2,802   

U.S. agency notes

     2,757         28                 2,785   

Asset-backed securities

     2,197         11                 2,208   

Commercial paper

     100                         100   
                                   

Total securities available for sale

   $     26,012       $ 303       $ 298       $ 26,017   
                                   

Securities held to maturity:

           

U.S. agency residential mortgage-backed securities

   $ 13,074       $ 416       $       $ 13,490   

Asset-backed securities

     978         13                 991   

Corporate debt securities

     338         7                 345   
                                   

Total securities held to maturity

   $ 14,390       $ 436       $       $ 14,826   
                                   

December 31, 2009

   Amortized
Cost
     Gross
Unrealized
Gains
     Gross
Unrealized
Losses
     Fair
Value
 

Securities available for sale:

           

U.S. agency residential mortgage-backed securities

   $ 11,601       $ 199       $ 21       $ 11,779   

Non-agency residential mortgage-backed securities

     2,460                 519         1,941   

Corporate debt securities

     2,368         13         1         2,380   

Certificates of deposit

     1,950         3                 1,953   

U.S. agency notes

     2,975         4         1         2,978   

Asset-backed securities

     1,077         12                 1,089   
                                   

Total securities available for sale

   $     22,431       $         231       $         542       $     22,120   
                                   

Securities held to maturity:

           

U.S. agency residential mortgage-backed securities

   $ 5,105       $ 36       $ 27       $ 5,114   

Asset-backed securities

     1,389         25                 1,414   

Corporate debt securities

     345         7                 352   
                                   

Total securities held to maturity

   $ 6,839       $ 68       $ 27       $ 6,880   
                                   

 

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THE CHARLES SCHWAB CORPORATION

Notes to Condensed Consolidated Financial Statements

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

(Unaudited)

 

 

A summary of securities with unrealized losses, aggregated by category and period of continuous unrealized loss, is as follows:

 

     Less than
12  months
     12 months
or longer
     Total  

September 30, 2010

   Fair
Value
       Unrealized  
Losses
     Fair
Value
       Unrealized  
Losses
     Fair
Value
       Unrealized  
Losses
 

Securities available for sale:

                 

U.S. agency residential mortgage-backed securities

   $ 495       $ 1       $       $       $ 495       $ 1   

Non-agency residential mortgage-backed securities

     8         1         1,364         296         1,372         297   
                                                     

Total securities with unrealized losses (1)

   $ 503       $ 2       $     1,364       $ 296       $     1,867       $ 298   
                                                     

 

(1)     The number of investment positions with unrealized losses totaled 173.

 

  

     Less than
12 months
     12 months
or  longer
     Total  

December 31, 2009

   Fair
Value
       Unrealized  
Losses
     Fair
Value
       Unrealized  
Losses
     Fair
Value
       Unrealized  
Losses
 

Securities available for sale:

                 

U.S. agency residential mortgage-backed securities

   $ 3,801       $ 11       $ 1,994       $ 10       $ 5,795       $ 21   

Non-agency residential mortgage-backed securities

     171         10         1,770         509         1,941         519   

Corporate debt securities

     374         1                         374         1   

U.S. agency notes

     864         1                         864         1   
                                                     

Total

   $ 5,210       $ 23       $ 3,764       $ 519       $ 8,974       $ 542   
                                                     

Securities held to maturity:

                 

U.S. agency residential mortgage-backed securities

   $ 1,885       $ 27       $       $       $ 1,885       $ 27   
                                                     

Total

   $ 1,885       $ 27       $       $       $ 1,885       $ 27   
                                                     

Total securities with unrealized losses (1)

   $     7,095       $ 50       $     3,764       $ 519       $     10,859       $ 569   
                                                     

 

(1)

The number of investment positions with unrealized losses totaled 333 for securities available for sale and 30 for securities held to maturity.

Unrealized losses in securities available for sale of $298 million as of September 30, 2010, were concentrated in non-agency residential mortgage-backed securities. Included in non-agency residential mortgage-backed securities are securities collateralized by loans that are considered to be “Prime” (defined as loans to borrowers with a Fair Isaac & Company credit score of 620 or higher at origination), and “Alt-A” (defined as Prime loans with reduced documentation at origination). At September 30, 2010, the amortized cost and fair value of Alt-A residential mortgage-backed securities were $536 million and $374 million, respectively.

Assessment of Other-Than-Temporary Impairment

Management evaluates whether securities available for sale and securities held to maturity are other-than-temporarily impaired (OTTI) on a quarterly basis. Debt securities with unrealized losses are considered OTTI if the Company intends to sell the security or if it is more likely than not that the Company will be required to sell such security prior to any anticipated recovery. If management determines that a security is OTTI under these circumstances, the impairment recognized in earnings is measured as the entire difference between the amortized cost and then-current fair value.

A security is also OTTI if management does not expect to recover the amortized cost of the security. In this circumstance, management utilizes cash flow models to estimate the expected future cash flow from the securities and to estimate the credit loss. The impairment recognized in earnings is measured by the difference between the present value of expected cash flows and the amortized cost of the security. Expected cash flows are discounted using the security’s effective interest rate.

 

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THE CHARLES SCHWAB CORPORATION

Notes to Condensed Consolidated Financial Statements

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

(Unaudited)

 

 

The evaluation of whether the Company expects to recover the amortized cost of a security is inherently judgmental. The evaluation includes the assessment of several bond performance indicators including: the portion of the underlying loans that are delinquent (30 days, 60 days, 90+ days), in bankruptcy, in foreclosure or converted to real estate owned; the actual amount of loss incurred on the underlying loans in which the property has been foreclosed and sold; the amount of credit support provided by the structure of the security available to absorb credit losses on the underlying loans; the current credit ratings issued by either Standard & Poor’s, Fitch Ratings, or Moody’s; the current price and magnitude of the unrealized loss; and whether the Company has received all scheduled principal and interest payments. Management uses cash flow models to further assess the likelihood of other-than-temporary impairment for the Company’s non-agency residential mortgage-backed securities. To develop the cash flow models, the Company uses forecasted loss severity, prepayment speeds (i.e. the rate at which the principal on underlying loans are paid down), and default rates over the securities’ expected remaining maturities.

Certain Alt-A and Prime residential mortgage-backed securities experienced deteriorating credit characteristics in the first nine months of 2010, including increased payment delinquencies and increased losses on foreclosures of underlying mortgages as a result of housing price declines. Additionally, the securities have experienced a decrease in prepayment rates due to the slowing of general economic activity and heightened levels of unemployment. Forecasted home price fluctuations are an important variable in forecasting the expected loss severity and default rates. Based on the Company’s cash flow projections, management determined that it does not expect to recover all of the amortized cost of these securities and therefore determined that these securities were OTTI. The Company does not intend to sell the securities available for sale and it will not be required to sell these securities before anticipated recovery. The Company employs a buy and hold strategy relative to its mortgage-related securities. Further, the Company has an adequate liquidity position at September 30, 2010, with cash and cash equivalents totaling $5.7 billion, a loan-to-deposit ratio of 17%, adequate access to short-term borrowing facilities and regulatory capital ratios in excess of “well capitalized” levels. Because the Company does not intend to sell these securities and it is not “more likely than not” that the Company will be required to sell these securities, the Company recognized an impairment charge equal to the securities’ expected credit losses of $3 million and $19 million during the third quarter and first nine months of 2010, respectively. The expected credit losses were measured as the difference between the present value of expected cash flows and the amortized cost of the securities. Impairment charges recognized in earnings are included in net impairment losses on securities. Further deterioration in the performance of the underlying loans in the Company’s residential mortgage-backed securities portfolio could result in the recognition of additional impairment charges.

Actual credit losses on the Company’s residential mortgage-backed securities were not material during the third quarter or first nine months of 2010.

The following table is a rollforward of the amount of credit losses recognized in earnings for OTTI securities held by the Company during the period for which a portion of the impairment was recognized in other comprehensive income:

 

     Three Months Ended
September 30,
     Nine Months Ended
September 30,
 
     2010      2009      2010      2009  

Balance at beginning of period

   $      76       $      27       $     60       $     —   

Credit losses recognized into current period earnings on debt securities for which an other-than-temporary impairment was not previously recognized

             6         4         38   

Credit losses recognized into current period earnings on debt securities for which an other-than-temporary impairment was previously recognized

     3         5         15           
                                   

Balance at end of period

   $ 79       $ 38       $ 79       $ 38   
                                   

 

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THE CHARLES SCHWAB CORPORATION

Notes to Condensed Consolidated Financial Statements

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

(Unaudited)

 

 

The maturities of securities available for sale and securities held to maturity at September 30, 2010, are as follows:

 

     Within
1 year
     After 1 year
through

5 years
     After 5 years
through
10 years
     After
10 years
     Total  

Securities available for sale:

              

U.S. agency residential mortgage-backed securities (1)

   $       $       $ 106       $ 13,563       $ 13,669   

Non-agency residential mortgage-backed securities (1)

                     24         1,626         1,650   

Corporate debt securities

     1,547         1,256                         2,803   

Certificates of deposit

     2,277         525                         2,802   

U.S. agency notes

             2,785                         2,785   

Asset-backed securities

             701         362         1,145         2,208   

Commercial paper

     100                                 100   
                                            

Total fair value

   $       3,924       $       5,267       $          492       $     16,334       $     26,017   

Total amortized cost

   $ 3,919       $ 5,227       $ 485       $ 16,381       $ 26,012   
                                            

Securities held to maturity:

              

U.S. agency residential mortgage-backed securities (1)

   $       $       $ 393       $ 13,097       $ 13,490   

Asset-backed securities

             898         93                 991   

Corporate debt securities

     174         171                         345   
                                            

Total fair value

   $ 174       $ 1,069       $ 486       $ 13,097       $ 14,826   

Total amortized cost

   $ 172       $ 1,052       $ 484       $ 12,682       $ 14,390   
                                            

 

 

(1)

Residential mortgage-backed securities have been allocated over maturity groupings based on final contractual maturities. Actual maturities will differ from final contractual maturities because a certain portion of loans underlying these securities require scheduled principal payments and borrowers have the right to prepay obligations.

Proceeds and gross realized gains (losses) from sales of securities available for sale are as follows:

 

     Three Months  Ended
September 30,
    Nine Months  Ended
September 30,
 
     2010      2009     2010      2009  

Proceeds

   $      95       $      22      $     220       $     107   

Gross realized gains

   $       $      $       $ 1   

Gross realized losses

   $       $ (3   $       $ (4
                                  

Realized gains and losses from sales of securities available for sale are included in other revenue.

 

4.   Loans to Banking Clients and Related Allowance for Credit Losses

The composition of the loan portfolio is as follows:

 

     September 30,
2010
    December 31,
2009
 

Residential real estate mortgages

   $ 4,219      $ 3,710   

Home equity lines of credit

     3,480        3,304   

Personal loans secured by securities

     510        366   

Other

     19        13   
                

Total loans to banking clients

     8,228        7,393   

Allowance for credit losses

     (50     (45
                

Total loans to banking clients – net

   $ 8,178      $ 7,348   
                

 

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THE CHARLES SCHWAB CORPORATION

Notes to Condensed Consolidated Financial Statements

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

(Unaudited)

 

 

Included in the loan portfolio are nonaccrual loans totaling $48 million and $34 million at September 30, 2010, and December 31, 2009, respectively. Nonperforming assets, which include nonaccrual loans and other real estate owned, totaled $52 million and $37 million at September 30, 2010, and December 31, 2009, respectively. There were no loans accruing interest that were contractually 90 days or more past due at September 30, 2010, or December 31, 2009. The amount of interest revenue that would have been earned on nonaccrual loans, versus interest revenue recognized on these loans, was not material to the Company’s results of operations for the first nine months of 2010 or 2009.

Changes in the allowance for credit losses were as follows:

 

     Three Months  Ended
September 30,
    Nine Months  Ended
September 30,
 
     2010     2009     2010     2009  

Balance at beginning of period

   $     51      $     41      $     45      $     20   

Charge-offs

     (4     (4     (14     (9

Recoveries

                   1          

Provision for credit losses

     3        7        18        33   
                                

Balance at end of period

   $ 50      $ 44      $ 50      $ 44   
                                

 

5.   Long-term Debt

Long-term debt net of unamortized debt discounts and premiums, where applicable, consists of the following:

 

     September 30,
2010
     December 31,
2009
 

Senior Notes

   $ 1,449       $ 747   

Senior Medium-Term Notes, Series A

     250         450   

Junior Subordinated Notes

     202         202   

Finance lease obligation

     107         111   

Fair value adjustment

             2   
                 

Total long-term debt

   $     2,008       $     1,512   
                 

CSC has a universal automatic shelf registration statement on file with the Securities and Exchange Commission (SEC), which enables CSC to issue debt, equity and other securities. In the third quarter of 2010, the Company issued $700 million of Senior Notes that mature in 2020 under this registration statement. The Senior Notes have a fixed interest rate of 4.45% with interest payable semi-annually.

 

6.   Commitments and Contingent Liabilities

The Company has clients that sell (i.e., write) listed option contracts that are cleared by various clearing houses. The clearing houses establish margin requirements on these transactions. The Company satisfies the margin requirements by arranging unsecured standby letter of credit agreements (LOCs), in favor of the clearing houses, which are issued by multiple banks. At September 30, 2010, the aggregate face amount of these LOCs totaled $445 million. In connection with its securities lending activities, Schwab is required to provide collateral to certain brokerage clients. Schwab satisfies the collateral requirements by arranging LOCs, in favor of these brokerage clients, which are issued by multiple banks. At September 30, 2010, the aggregate face amount of these LOCs totaled $14 million. There were no funds drawn under any of these LOCs at September 30, 2010.

The Company also provides guarantees to securities clearing houses and exchanges under their standard membership agreement, which requires members to guarantee the performance of other members. Under the agreement, if another member becomes unable to satisfy its obligations to the clearing houses and exchanges, other members would be required to meet shortfalls. The Company’s liability under these arrangements is not quantifiable and may exceed the cash and securities

 

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THE CHARLES SCHWAB CORPORATION

Notes to Condensed Consolidated Financial Statements

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

(Unaudited)

 

it has posted as collateral. However, the potential requirement for the Company to make payments under these arrangements is remote. Accordingly, no liability has been recognized for these guarantees.

Legal contingencies: The Company is subject to claims and lawsuits in the ordinary course of business, including arbitrations, class actions and other litigation, some of which include claims for substantial or unspecified damages. The Company is also the subject of inquiries, investigations, and proceedings by regulatory and other governmental agencies. In addition, the Company is responding to certain litigation claims brought against former subsidiaries pursuant to indemnities it has provided to purchasers of those entities. Certain of these matters are described below.

The Company believes it has strong defenses in all significant matters currently pending and is contesting liability and the damages claimed. Nevertheless, some of these matters may result in adverse judgments or awards, including penalties, injunctions, or other relief, and the Company may also determine to settle a matter because of the uncertainty and risks of litigation. Except as otherwise noted below, based on current information and consultation with counsel, management believes that the resolution of matters currently pending will not have a material impact on the financial condition or cash flows of the Company, but could be material to the Company’s operating results for a particular future period, depending on results for that period. However, predicting the outcome of a matter is inherently difficult, particularly where claims are brought on behalf of various classes of claimants, claimants seek substantial or unspecified damages, or when investigations or legal proceedings are at an early stage, and in many cases, including certain matters described below, it is not possible to determine whether a loss will be incurred or to estimate the range of that loss until the matter is closer to resolution.

Auction Rate Securities Regulatory Inquiries: Schwab has been responding to industry wide inquiries from federal and state regulators regarding sales of auction rate securities to clients who were unable to sell their holdings when the normal auction process for those securities froze unexpectedly in February 2008. On August 17, 2009, a civil complaint was filed against Schwab in New York state court by the Attorney General of the State of New York (NYAG) alleging material misrepresentations and omissions by Schwab regarding the risks of auction rate securities, and seeking restitution, disgorgement, penalties and other relief, including repurchase of securities held in client accounts. As reflected in a statement issued August 17, 2009, Schwab has responded that the allegations are without merit and that Schwab intends to contest any charges. On March 15, 2010, Schwab filed a motion to dismiss the case and various claims in the civil complaint.

Separately, on November 19, 2009, Schwab received a Wells notice from the Financial Industry Regulatory Authority (FINRA) regarding a preliminary determination to recommend disciplinary action against Schwab for possible rule violations regarding sales of auction rate securities through the Company. On February 9, 2010, Schwab received a second letter from FINRA regarding additional disciplinary charges. A Wells notice provides recipients an opportunity to respond to issues raised in an investigation prior to any decision on an enforcement proceeding, and is neither a formal allegation nor a finding of wrongdoing. The Company has responded to FINRA to explain why it believes enforcement charges are unwarranted.

YieldPlus Fund Litigation and Regulatory Inquiries: The Company is the subject of consolidated class action litigation, regulatory investigations and individual investor arbitration claims relating to the Schwab YieldPlus Fund®, an ultra-short bond fund (“Bond Fund”). The Bond Fund was designed to invest in a variety of fixed income instruments, including corporate bonds, asset-backed securities, mortgage-backed securities and other fixed income investments. The credit crisis that began in mid-2007 led to a decline in the value of a majority of fixed income investments market wide. As a result, certain Schwab clients who chose to invest in the Bond Fund experienced a decline in their investments, leading to the litigation.

Nine class action lawsuits were filed between March and May 2008 on behalf of investors in the Bond Fund alleging violations of state law and federal securities law in connection with the fund’s investment policy, disclosures and marketing. These cases were consolidated in a single action on July 3, 2008, in the U.S. District Court for the Northern District of California. Specific allegations include changes to the investment policy of the fund regarding limits on positions in mortgage-backed securities without obtaining a shareholder vote; inadequate disclosure of the risks associated with fund investments in mortgage-backed securities and fund risk management; inaccurate reporting of the fund’s weighted-average duration; and failure to disclose redemptions of positions in YieldPlus by other Schwab investment funds. The lawsuit seeks unspecified compensatory and rescission damages, unspecified equitable and injunctive relief, and costs and attorneys’ fees. Defendants named in the lawsuit include the Company, Schwab, CSIM, the fund itself, Schwab Investments (registrant and

 

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THE CHARLES SCHWAB CORPORATION

Notes to Condensed Consolidated Financial Statements

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

(Unaudited)

 

issuer of the fund’s shares), Charles R. Schwab, Randall W. Merk (current president of the fund), and current and former trustees and officers of the fund and/or Schwab. On February 4, 2009, the court denied defendants’ motion to dismiss plaintiffs’ federal law claims and dismissed all but one state law claim. On August 21, 2009, the court certified two classes of plaintiffs for purposes of the federal law claims and a single class of plaintiffs for purposes of the remaining state law claim.

On March 30, 2010, the court granted plaintiffs’ motion for summary judgment holding defendants liable for plaintiffs’ state law claim regarding changes to the investment policy of the Bond Fund, which plaintiffs alleged were made without shareholder approval in violation of Section 13(a) of the Investment Company Act of 1940. On April 5, 2010, defendants filed a motion for interlocutory appeal of this ruling, which the court denied at a hearing on April 26, 2010. On April 8, 2010, the court issued an order denying defendants’ motion for summary judgment on plaintiffs’ federal law claims. On April 23, 2010, the Company entered into a settlement agreement with plaintiffs in which the Company, without admitting liability, agreed to a total of $200 million to resolve plaintiffs’ federal law claims. On May 14, 2010, the Company entered into a settlement agreement with plaintiffs in which the Company, without admitting liability, agreed to resolve plaintiffs’ state law claim for $35 million. Pursuant to a joint motion by plaintiffs and defendants in support of the proposed settlements, the settlement agreements were preliminarily approved by the court on May 26, 2010, and have been awaiting final court approval. On October 14, 2010, the court issued an opinion interpreting the proposed settlement terms and holding that federal securities law class members resident outside of California would not be precluded under the proposed settlement agreements from bringing further claims under California law against the defendants. In light of the court’s opinion, the Company is evaluating its litigation options, including whether to seek termination of the proposed federal and state settlements.

For the nine months ended September 30, 2010, the Company has accrued a reserve of $196 million in connection with the lawsuit, reflecting the preliminary settlements, net of insurance proceeds of $39 million under applicable policies. The Company will continue to evaluate the reserve pending final resolution of the litigation; actual liability could be higher or lower than the amount reserved.

Separately, the Company has been responding to investigations by federal and state regulators regarding these matters. On October 14, 2009, the Company received a Wells notice from the staff of the Securities and Exchange Commission (SEC) regarding the staff’s preliminary determination to recommend the filing of a civil enforcement action against Schwab Investments, CSIM, Schwab, and the president of the Bond Fund for possible violations of the securities laws with respect to the fund. On October 27, 2009, the Company also received a Wells notice from FINRA regarding a preliminary determination to recommend disciplinary action against Schwab for possible violation of securities laws and FINRA rules with respect to the fund. The Company has responded to the notices to explain why it believes enforcement charges are unwarranted, and has been in discussions with the SEC and FINRA staff and state regulators regarding potential settlement of civil regulatory charges. Given the status of those discussions, the Company is unable to predict whether a settlement with the SEC or other regulators can be reached, or to estimate the range of any potential liability, and therefore has not established a reserve in connection therewith. Although the Company believes it has strong defenses if enforcement proceedings were instituted, any adverse judgment could result in the imposition of disgorgement, penalties, and other monetary and injunctive relief against the Company.

In addition to the above matters, as of September 30, 2010, the Company remained the subject of 68 individual arbitration claims seeking $17 million in damages relating to investments in the Bond Fund, for which the Company has been accruing reserves.

Total Bond Market Fund Litigation: On August 28, 2008, a class action lawsuit was filed in the U.S. District Court for the Northern District of California on behalf of investors in the Schwab Total Bond Market Fund™. The lawsuit, which alleges violations of state law and federal securities law in connection with the fund’s investment policy, names Schwab Investments (registrant and issuer of the fund’s shares) and CSIM as defendants. Allegations include that the fund improperly deviated from its stated investment objectives by investing in collateralized mortgage obligations (CMOs) and investing more than 25% of fund assets in CMOs and mortgage-backed securities without obtaining a shareholder vote. Plaintiffs seek unspecified compensatory and rescission damages, unspecified equitable and injunctive relief, and costs and attorneys’ fees. On February 19, 2009, the court denied defendants’ motion to dismiss plaintiffs’ federal securities law claim, and dismissed certain state law claims with leave to amend. On April 27, 2009, the court issued a stay of proceedings while defendants

 

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THE CHARLES SCHWAB CORPORATION

Notes to Condensed Consolidated Financial Statements

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

(Unaudited)

 

appealed the court’s February 19, 2009 decision refusing to dismiss plaintiffs’ federal securities law claim. On August 12, 2010, the Ninth Circuit Court of Appeals ruled in favor of the defendants and dismissed plaintiffs’ federal securities law claim. On September 28, 2010, plaintiffs filed a second amended class action complaint dropping the federal securities law claim and certain of its state law claims. On September 3, 2010, a second class action lawsuit by a different law firm was filed in the U.S. District Court for the Northern District of California on behalf of investors in the fund. The new lawsuit, which also names Schwab Investments and CSIM as defendants, alleges violations of state law in connection with the fund’s deviation from the performance of its benchmark index and concentration in mortgage-backed securities, and seeks restitution and disgorgement of management or other fees. On October 11, 2010, defendants filed a motion to consolidate the two class actions.

The SEC Wells notice received by the Company on October 14, 2009, concerning the Bond Fund, also provided notice of the SEC staff’s intention to recommend the inclusion of additional charges against Schwab Investments and CSIM for possible violations of the securities laws with respect to the Total Bond Market Fund. The Company has responded to the SEC Wells notice to explain why the proposed charges regarding the Total Bond Market Fund are unwarranted, and has also addressed the proposed charges in the discussions with SEC staff described above concerning the Bond Fund.

 

7.   Fair Values of Assets and Liabilities

Fair value is defined as the price that would be received to sell an asset or the price paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value measurement accounting guidance describes the fair value hierarchy for disclosing assets and liabilities measured at fair value based on the inputs used to value them. The fair value hierarchy maximizes the use of observable inputs and minimizes the use of unobservable inputs. Observable inputs are based on market pricing data obtained from sources independent of the Company. A quoted price in an active market provides the most reliable evidence of fair value and is generally used to measure fair value whenever available. Unobservable inputs reflect management’s judgment about the assumptions market participants would use in pricing the asset or liability. Where inputs used to measure fair value of an asset or liability are from different levels of the hierarchy, the asset or liability is categorized based on the lowest level input that is significant to the fair value measurement in its entirety. Assessing the significance of a particular input requires judgment. The fair value hierarchy includes three levels based on the objectivity of the inputs as follows:

 

   

Level 1 inputs are quoted prices in active markets as of the measurement date for identical assets or liabilities that the Company has the ability to access. This category includes active exchange-traded money market funds, mutual funds, and equity securities. The Company did not transfer any assets or liabilities between Level 1 and Level 2 as of September 30, 2010, or December 31, 2009.

 

   

Level 2 inputs are inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. Level 2 inputs include quoted prices for similar assets and liabilities in active markets, and inputs other than quoted prices that are observable for the asset or liability, such as interest rates, benchmark yields, issuer spreads, new issue data, and collateral performance. This category includes residential mortgage-backed securities, asset-backed securities, corporate debt securities, certificates of deposit, commercial paper, U.S. agency and municipal debt securities, and U.S. Treasury securities.

 

   

Level 3 inputs are unobservable inputs for the asset or liability, and include situations where there is little, if any, market activity for the asset or liability. The Company did not have any financial assets or liabilities utilizing Level 3 inputs as of September 30, 2010, or December 31, 2009.

Assets and Liabilities Recorded at Fair Value

The Company’s assets recorded at fair value include certain cash equivalents, investments segregated and on deposit for regulatory purposes, other securities owned, and securities available for sale. The Company uses prices obtained from an independent third-party pricing service to measure the fair value of investment securities categorized as Level 2. The Company validates prices received from the pricing service using various methods including comparison to prices received from additional pricing services, comparison to quoted market prices, where available, comparison to internal valuation

 

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THE CHARLES SCHWAB CORPORATION

Notes to Condensed Consolidated Financial Statements

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

(Unaudited)

 

models, and review of other relevant market data. The Company does not adjust the prices received from the independent third-party pricing service unless such prices are inconsistent with the definition of fair value and result in a material difference in the recorded amounts. At September 30, 2010, and December 31, 2009, the Company did not adjust prices received from the independent third-party pricing service. Liabilities recorded at fair value are not material, and therefore are not included in the following tables.

The following tables present the fair value hierarchy for assets measured at fair value:

 

September 30, 2010

   Quoted Prices
in Active Markets
for Identical
Assets

(Level 1)
     Significant
Other Observable
Inputs

(Level 2)
     Significant
Unobservable
Inputs

(Level 3)
     Balance at
Fair Value
 

Cash equivalents:

           

Money market funds

   $ 1,656       $       $       $ 1,656   

Certificates of deposit

             250                 250   

Commercial paper

             525                 525   
                                   

Total cash equivalents

     1,656         775                 2,431   

Investments segregated and on deposit for regulatory purposes:

           

U.S. Government securities

             1,086                 1,086   

Corporate debt securities

             2,179                 2,179   

Certificates of deposit

             2,176                 2,176   
                                   

Total investments segregated and on deposit for regulatory purposes

             5,441                 5,441   

Other securities owned:

           

Schwab Funds® money market funds

     164                         164   

Equity and bond mutual funds

     96                         96   

State and municipal debt obligations

             54                 54   

Equity, U.S. Government and corporate debt, and other securities

     2         25                 27   
                                   

Total other securities owned

     262         79                 341   

Securities available for sale:

           

U.S. agency residential mortgage-backed securities

             13,669                 13,669   

Non-agency residential mortgage-backed securities

             1,650                 1,650   

Corporate debt securities

             2,803                 2,803   

Certificates of deposit

             2,802                 2,802   

U.S. agency notes

             2,785                 2,785   

Asset-backed securities

             2,208                 2,208   

Commercial paper

             100                 100   
                                   

Total securities available for sale

             26,017                 26,017   
                                   

Total

   $ 1,918       $ 32,312       $                   —       $           34,230   
                                   

 

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THE CHARLES SCHWAB CORPORATION

Notes to Condensed Consolidated Financial Statements

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

(Unaudited)

 

December 31, 2009

   Quoted Prices
in Active Markets
for Identical
Assets

(Level 1)
     Significant
Other Observable
Inputs

(Level 2)
     Significant
Unobservable
Inputs

(Level 3)
     Balance at
Fair Value
 

Cash equivalents (1) :

           

Money market funds

   $ 2,278       $       $       $ 2,278   

Commercial paper

             370                 370   
                                   

Total cash equivalents

     2,278         370                 2,648   

Investments segregated and on deposit for regulatory purposes:

           

U.S. Government securities

             2,681                 2,681   

Corporate debt securities

             2,135                 2,135   

Certificates of deposit

             2,091                 2,091   

Commercial paper

             100                 100   
                                   

Total investments segregated and on deposit for regulatory purposes

             7,007                 7,007   

Other securities owned:

           

Schwab Funds® money market funds

     321                         321   

Commercial paper

             220                 220   

Certificates of deposit

             200                 200   

Equity and bond mutual funds

     103                         103   

State and municipal debt obligations

             49                 49   

Equity, U.S. Government and corporate debt, and other securities

     2         21                 23   
                                   

Total other securities owned

     426         490                 916   

Securities available for sale:

           

U.S. agency residential mortgage-backed securities

             11,779                 11,779   

Non-agency residential mortgage-backed securities

             1,941                 1,941   

Corporate debt securities

             2,380                 2,380   

Certificates of deposit

             1,953                 1,953   

U.S. agency notes

             2,978                 2,978   

Asset-backed securities

             1,089                 1,089   
                                   

Total securities available for sale

             22,120                 22,120   
                                   

Total

   $ 2,704       $ 29,987       $                   —       $           32,691   
                                   

 

(1)

Beginning in the first quarter of 2010, the fair value information for certain cash equivalents was included. Information as of December 31, 2009, was recast to reflect this change.

Fair Value of Assets and Liabilities Not Recorded at Fair Value

Descriptions of the valuation methodologies and assumptions used to estimate the fair value of assets and liabilities not recorded at fair value are described below. There were no significant changes in these methodologies or assumptions during the first nine months of 2010.

Other cash equivalents, receivables, payables, and accrued expenses and other liabilities include cash and highly liquid investments, receivables and payables from/ to brokers, dealers and clearing organizations, receivables and payables from/ to brokerage clients, and drafts, accounts, taxes, interest, and compensation payable. Assets and liabilities in these categories are short-term in nature and accordingly are recorded at amounts that approximate fair value.

Cash and investments segregated and on deposit for regulatory purposes include securities purchased under resale agreements. Securities purchased under resale agreements are recorded at par value plus accrued interest. Securities purchased under resale agreements are short-term in nature and are backed by collateral that both exceeds the carrying value of the resale agreement and is highly liquid in nature. Accordingly, the carrying value approximates fair value.

 

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THE CHARLES SCHWAB CORPORATION

Notes to Condensed Consolidated Financial Statements

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

(Unaudited)

 

 

Securities held to maturity include U.S. agency residential mortgage-backed securities, asset-backed securities collateralized by credit card, student, and auto loans, and corporate debt securities. Securities held to maturity are recorded at amortized cost. The fair value of these securities is obtained using an independent third-party pricing service, as discussed above.

Loans to banking clients primarily include adjustable rate residential first-mortgage and home equity lines of credit (HELOC) loans. Loans to banking clients are recorded at carrying value net of an allowance for credit losses. The fair value of the Company’s loans to banking clients is estimated based on market prices for mortgage-backed securities collateralized by similar types of loans.

Loans held for sale include fixed rate residential first-mortgage loans intended for sale. Loans held for sale are recorded at the lower of cost or fair value. The fair value of the Company’s loans held for sale is estimated using quoted market prices for securities backed by similar types of loans.

Other assets include cost method investments whose carrying values approximate their fair values. Other assets also include Federal Home Loan Bank stock recorded at par, which approximates fair value.

Deposits from banking clients: The Company considers the fair value of deposits with no stated maturity, such as deposits from banking clients, to be equal to the amount payable on demand as of the balance sheet date.

Long-term debt includes Senior Notes, Senior Medium-Term Notes, Series A, Junior Subordinated Notes, and a finance lease obligation. The fair value of the Senior Notes, Senior Medium-Term Notes, Series A, and Junior Subordinated Notes is estimated using indicative, non-binding quotes from independent brokers. The finance lease obligation is recorded at carrying value, which approximates fair value.

Firm commitments to extend credit: The Company extends credit to banking clients through HELOC commitments. The Company considers the fair value of unused HELOC commitments to be not material because the interest rate earned on HELOC outstanding balances is based on the Prime rate and resets monthly. Future utilization of HELOC commitments will earn a then-current market interest rate. The Company does not charge a fee to maintain a HELOC.

The table below presents the Company’s fair value estimates for financial instruments excluding short-term financial assets and liabilities, for which carrying amounts approximate fair value, and excluding financial instruments recorded at fair value.

 

     September 30,
2010
     December 31,
2009
 
     Carrying
Amount
     Fair
Value
     Carrying
Amount
     Fair
Value
 

Financial Assets:

           

Securities held to maturity

   $     14,390       $     14,826       $     6,839       $     6,880   

Loans to banking clients – net

   $ 8,178       $ 8,095       $ 7,348       $ 6,888   

Loans held for sale

   $ 121       $ 127       $ 104       $ 107   

Financial Liabilities:

           

Long-term debt

   $ 2,008       $ 2,223       $ 1,512       $ 1,580   

 

8.   Equity Offering

On January 26, 2010, the Company completed the sale of 29,670,300 shares of its common stock, $.01 par value, at a public offering price of $19.00 per share. Net proceeds received from the offering were $543 million and were used to support the Company’s balance sheet growth, including expansion of its deposit base and migration of certain client balances from money market funds into Schwab Bank.

 

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THE CHARLES SCHWAB CORPORATION

Notes to Condensed Consolidated Financial Statements

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

(Unaudited)

 

 

9. Comprehensive Income and Accumulated Other Comprehensive Income (Loss)

The components of comprehensive income are as follows:

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
     2010     2009     2010     2009  

Net income

   $     124      $     200      $     335      $     623   

Other comprehensive income:

        

Change in net unrealized gain (loss) on securities available for sale:

        

Net unrealized gain

     108        177        297        469   

Reclassification of OTTI charges included in earnings

     3        11        19        38   

Other reclassifications of net losses included in earnings

            3               3   

Income tax effect

     (43     (75     (122     (203
                                

Total other comprehensive income

     68        116        194        307   
                                

Comprehensive income

   $ 192      $ 316      $ 529      $ 930   
                                

Accumulated other comprehensive income (loss) represents cumulative gains and losses that are not reflected in earnings. Accumulated other comprehensive income (loss) balances were:

 

     Net unrealized gain (loss)
on securities available for  sale
       
     Portion of
unrealized gain

(loss) on Non-OTTI
securities
    Portion of
unrealized loss

on OTTI
securities
    Total accumulated
other
comprehensive
income (loss)
 

Balance at December 31, 2008

   $ (553   $                      —      $ (553

Reclassification of OTTI securities

     121        (121       

Other net changes

     307               307   
                        

Balance at September 30, 2009

   $ (125   $ (121   $ (246
                        

Balance at December 31, 2009

   $ (77   $ (114   $ (191

Reclassification of OTTI securities

                          21        (21       

Other net changes

     150        44        194   
                        

Balance at September 30, 2010

   $ 94      $ (91   $ 3   
                        

 

10. Money Market Mutual Fund Charges

In the third quarter of 2010, the Company decided to cover the net remaining losses recognized by Schwab money market mutual funds as a result of their investments in a single structured investment vehicle that defaulted in 2008 and recorded a charge of $132 million.

 

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THE CHARLES SCHWAB CORPORATION

Notes to Condensed Consolidated Financial Statements

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

(Unaudited)

 

 

11.   Earnings Per Share

Basic EPS is computed by dividing net income available to common stockholders by the weighted-average number of common shares outstanding during the period. The computation of diluted EPS is similar to the computation of basic EPS except that the denominator is increased to include the number of additional common shares that would have been outstanding if dilutive potential common shares had been issued. Dilutive potential common shares include the effect of outstanding stock options and unvested restricted stock awards and units. EPS under the basic and diluted computations is as follows:

 

     Three Months Ended
September 30,
     Nine Months Ended
September 30,
 
     2010      2009      2010      2009  

Net income available to common stockholders (1)

   $     124       $     200       $     335       $     623   
                                   

Weighted-average common shares outstanding — basic

     1,192         1,157         1,189         1,155   

Common stock equivalent shares related to stock incentive plans

     2         6         3         5   
                                   

Weighted-average common shares outstanding — diluted (2)

     1,194         1,163         1,192         1,160   
                                   

Basic EPS

   $ .10       $ .17       $ .28       $ .54   

Diluted EPS

   $ .10       $ .17       $ .28       $ .54   

 

(1)

Net income available to participating securities (unvested restricted shares) was not material for the third quarters and first nine months of 2010 or 2009.

(2)

Total antidilutive stock options and restricted stock awards excluded from the calculation of diluted EPS were 49 million and 28 million shares for the third quarters of 2010 and 2009, respectively, and 40 million and 35 million shares for the first nine months of 2010 and 2009, respectively.

 

12.   Regulatory Requirements

CSC is a savings and loan holding company and Schwab Bank, CSC’s depository institution subsidiary, is a federal savings bank. CSC and Schwab Bank are both subject to supervision and regulation by the Office of Thrift Supervision. As a savings and loan holding company, CSC is not subject to specific statutory capital requirements. However, CSC is required to maintain capital that is sufficient to support the holding company and its subsidiaries’ business activities, and the risks inherent in those activities.

Schwab Bank is required to maintain a capital level that at least equals minimum capital levels specified in federal banking laws and regulations. Failure to meet the minimum levels will result in certain mandatory, and possibly additional discretionary, actions by the regulators that, if undertaken, could have a direct material effect on Schwab Bank. At September 30, 2010, CSC and Schwab Bank met the capital level requirements.

The regulatory capital and ratios for Schwab Bank at September 30, 2010, are as follows:

 

     Actual     Minimum Capital
Requirement
    Minimum to be
Well Capitalized
 
     Amount            Ratio           Amount            Ratio           Amount            Ratio        

Tier 1 Capital

   $ 4,008         23.6   $ 678         4.0   $ 1,017         6.0

Total Capital

   $ 4,057         23.9   $ 1,356         8.0   $ 1,695         10.0

Tier 1 Leverage

   $     4,008         7.6   $     2,119         4.0   $     2,649         5.0

Tangible Equity

   $ 4,008         7.6   $ 1,060         2.0     N/A      

 

N/A Not applicable.

Based on its regulatory capital ratios at September 30, 2010, Schwab Bank is considered well capitalized (the highest category) pursuant to banking regulatory guidelines. There are no conditions or events since September 30, 2010, that management believes have changed Schwab Bank’s capital category.

 

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THE CHARLES SCHWAB CORPORATION

Notes to Condensed Consolidated Financial Statements

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

(Unaudited)

 

 

Schwab is subject to Rule 15c3-1 under the Securities Exchange Act of 1934 (the Uniform Net Capital Rule). Schwab computes net capital under the alternative method permitted by the Uniform Net Capital Rule. This method requires the maintenance of minimum net capital, as defined, of the greater of 2% of aggregate debit balances arising from client transactions or a minimum dollar requirement, which is based on the type of business conducted by the broker-dealer. Under the alternative method, a broker-dealer may not repay subordinated borrowings, pay cash dividends, or make any unsecured advances or loans to its parent company or employees if such payment would result in net capital of less than 5% of aggregate debit balances or less than 120% of its minimum dollar requirement. At September 30, 2010, 2% of aggregate debit balances was $224 million, which exceeded the minimum dollar requirement for Schwab of $250,000. At September 30, 2010, Schwab’s net capital was $1.1 billion (10% of aggregate debit balances), which was $887 million in excess of its minimum required net capital and $550 million in excess of 5% of aggregate debit balances.

 

13.   Segment Information

The Company structures its operating segments according to its various types of clients and the services provided to those clients. The Company’s two reportable segments are Investor Services and Institutional Services. The Company evaluates the performance of its segments on a pre-tax basis excluding items such as impairment charges on non-financial assets, discontinued operations, extraordinary items, and significant restructuring and other charges. Segment assets and liabilities are not disclosed because the balances are not used for evaluating segment performance and deciding how to allocate resources to segments. There are no revenues from transactions with other segments within the Company.

Selected financial information for the Company’s reportable segments is presented in the following table:

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
     2010     2009     2010     2009  

Net revenues:

        

Investor Services

   $ 718      $ 658      $ 2,080      $ 2,069   

Institutional Services

     346        353        1,042        1,138   

Unallocated

     (1            (1       
                                

Total net revenues

   $     1,063      $     1,011      $     3,121      $     3,207   
                                

Income before taxes on income:

        

Investor Services

   $ 215      $ 196      $ 545      $ 654   

Institutional Services

     114        125        327        443   

Unallocated (1, 2)

     (130     (1     (322     (87
                                

Income before taxes on income

     199        320        550        1,010   

Taxes on income

     (75     (120     (215     (387
                                

Net income

   $ 124      $ 200      $ 335      $ 623   
                                

 

(1)

Includes money market mutual fund charges of $132 million in the third quarter of 2010.

(2)

Includes a class action litigation reserve of $196 million in the first nine months of 2010 and facilities and severance charges relating to the Company’s cost reduction measures in the first nine months of 2009.

 

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THE CHARLES SCHWAB CORPORATION

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

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

 

 

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

OVERVIEW

Management of The Charles Schwab Corporation (CSC) and its subsidiaries (collectively referred to as the Company) focuses on several key financial and non-financial metrics in evaluating the Company’s financial position and operating performance. Results for the third quarters and first nine months of 2010 and 2009 are shown in the following table:

 

     Three Months Ended
September 30,
    Percent
Change
    Nine Months  Ended
September 30,
    Percent
Change
 
     2010     2009       2010     2009    

Client Activity Metrics:

            

Net new client assets (1) (in billions)

   $ 14.6      $ 19.9        (27 %)    $ 0.4      $ 62.5        (99 %) 

Client assets (in billions, at quarter end)

   $  1,471.3      $  1,363.6        8      

Clients’ daily average trades (2) (in thousands)

     352.6        399.2        (12 %)      401.1        423.6        (5 %) 

Company Financial Metrics:

            

Net revenues

   $ 1,063      $ 1,011        5   $     3,121      $     3,207        (3 %) 

Expenses excluding interest

     864        691        25     2,571        2,197        17
                                                

Income before taxes on income

     199        320        (38 %)      550        1,010        (46 %) 

Taxes on income

     (75     (120     (38 %)      (215     (387     (44 %) 
                                                

Net income

   $ 124      $ 200        (38 %)    $ 335      $ 623        (46 %) 
                                                

Earnings per share – diluted

   $ .10      $ .17        (41 %)    $ .28      $ .54        (48 %) 

Net revenue growth (decline) from prior year

     5     (19 %)        (3 %)      (17 %)   

Pre-tax profit margin

     18.7     31.7       17.6     31.5  

Return on stockholders’ equity (annualized)

     8     17       8     19  

Annualized net revenue per average full-time equivalent employee (in thousands)

   $ 340      $ 331        3   $ 330      $ 345        (4 %) 

 

(1)

Includes net outflows of $51.5 billion in the first nine months of 2010 related to the planned deconversion of a mutual fund clearing services client.

(2)

Beginning in the first quarter of 2010, amounts include all commission free trades, including the Company’s Mutual Fund OneSource® funds and Exchange-Traded Funds, and other proprietary products. Prior period amounts have been recast to reflect this change.

The equity markets showed sequential improvement during the third quarter as the Nasdaq Composite Index, the Standard & Poor’s 500 Index, and the Dow Jones Industrial Average increased 12%, 11%, and 10%, respectively. These indices also increased 12%, 8%, and 11%, respectively, from the first nine months of 2009. The low interest rate environment continued in the third quarter as the federal funds target rate remained unchanged during the quarter at a range of zero to 0.25% and the three-month LIBOR decreased by 24 basis points to 0.29%.

The Company’s continued investment in expanding and improving product and service capabilities for its clients was reflected in continued strength in its key client activity metrics during the third quarter of 2010 — net new client assets totaled $14.6 billion and total client assets ended the third quarter at $1.47 trillion, up 8% from the third quarter of 2009. Client trading activity slowed in the third quarter as clients’ daily average trades decreased 12% on a year-over-year basis to 352,600.

Net revenues increased by 5% in the third quarter of 2010 compared to the third quarter of 2009 primarily due to increases in net interest revenue and asset management and administration fees, partially offset by a decrease in trading revenue. Net interest revenue increased due to higher average balances of interest-earning assets during the quarter. Asset management and administration fees increased due to higher average asset valuations combined with continued asset inflows, offset by money market mutual fund fee waivers of $93 million. Money market mutual fund fee waivers were $78 million in the third quarter of 2009. Trading revenue decreased due to lower daily average revenue trades and lower average revenue earned per revenue trade resulting from improved online trade pricing for clients, which was implemented in January 2010.

 

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THE CHARLES SCHWAB CORPORATION

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

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

 

 

Net revenues decreased by 3% in the first nine months of 2010 compared to the first nine months of 2009 primarily due to decreases in asset management and administration fees, trading revenue, and other revenue, partially offset by an increase in net interest revenue. Asset management and administration fees decreased primarily due to money market mutual fund fee waivers of $331 million, partially offset by the effect of higher average asset valuations combined with continued asset inflows. Money market mutual fund fee waivers were $114 million in the first nine months of 2009. Trading revenue decreased due to lower daily average revenue trades and lower average revenue earned per revenue trade. Other revenue decreased due to a gain of $31 million on the repurchase of a portion of the Company’s long-term debt in the first nine months of 2009. The increase in net interest revenue resulted from higher average balances of interest-earning assets during the first nine months of 2010, partially offset by a decrease in the average yield earned compared to the year earlier period.

Expenses excluding interest increased by 25% in the third quarter of 2010 compared to the third quarter of 2009 primarily due to the recognition of two charges in the third quarter of 2010. The Company decided to cover the net remaining losses recognized by Schwab money market mutual funds as a result of their investments in a single structured investment vehicle that defaulted in 2008 and recorded a charge of $132 million. Additionally, the Company recorded a charge of $21 million relating to the Company’s Invest First® and WorldPoints(a) Visa(b) credit cards, as the Company ended its sponsorship due to challenging credit card industry economics. This charge is included in other expense on the Company’s condensed consolidated statements of income.

Expenses excluding interest increased by 17% in the first nine months of 2010 compared to the first nine months of 2009 primarily due to the recognition of a class action litigation reserve of $196 million relating to the Schwab YieldPlus Fund® in the first quarter of 2010 and the two charges previously discussed above in the third quarter of 2010. For further discussion of the Schwab YieldPlus Fund litigation and regulatory matters, see “Item 1 – Condensed Consolidated Financial Statements (Unaudited) – Notes – 6. Commitments and Contingent Liabilities.”

Business Acquisition

On August 30, 2010, the Company announced an agreement to acquire Windward Investment Management, Inc., for $150 million in stock and cash. The transaction is expected to close in the fourth quarter of 2010, subject to customary closing conditions. Windward Investment Management, Inc., is an investment advisory firm that manages diversified investment portfolios comprised primarily of exchange-traded fund securities.

CURRENT MARKET AND REGULATORY ENVIRONMENT

While the equity markets have improved from their March 2009 lows, which helped to strengthen the Company’s net revenues in the third quarter and first nine months of 2010, the interest rate environment remains challenging and may continue to limit growth in the Company’s net revenues.

Short-term interest rates remained at historically low levels throughout the period with certain rates, such as the one-month and three-month LIBOR, declining from the previous quarter end. To the extent rates remain at these low levels, the Company’s net interest revenue will continue to be constrained. The low rate environment also affects asset management and administration fees. The overall yields on certain Schwab-sponsored money market mutual funds have fallen to levels at or below the management fees on those funds. The Company continues to waive a portion of its management fees, which it began to do in the first quarter of 2009, so that the funds may continue providing a positive return to clients. These and other money market mutual funds may continue to find it necessary to replace maturing securities with low yielding securities and the overall yield on such funds may remain below the management fees on those funds. To the extent this occurs, fees may continue to be waived and could increase from the third quarter 2010 level, which would negatively affect asset management and administration fees.

The Company recorded net impairment charges of $3 million and $19 million related to certain non-agency residential

 

(a) WorldPoints is a registered trademark of FIA Card Services, N.A.
(b) Visa is a registered trademark of Visa International Service Association.

 

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THE CHARLES SCHWAB CORPORATION

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

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

 

mortgage-backed securities in the third quarter and first nine months of 2010, respectively, due to credit deterioration of the securities’ underlying collateral. Further deterioration in the performance of the underlying loans in the Company’s residential mortgage-backed securities portfolio could result in the recognition of additional impairment charges.

The “Dodd-Frank Wall Street Reform and Consumer Protection Act” was signed into law on July 21, 2010. Among other things, the legislation authorizes various assessments and fees, requires the establishment of minimum leverage and risk-based capital requirements for insured depository institutions and contains several provisions that could increase the Federal Deposit Insurance Corporation (FDIC) deposit insurance premiums paid by the Company. CSC is reviewing the impact the legislation will have on the Company’s business, financial condition, and results of operations.

RESULTS OF OPERATIONS

The following discussion presents an analysis of the Company’s results of operations for the third quarter and first nine months of 2010 compared to the same periods in 2009.

Net Revenues

The Company’s major sources of net revenues are asset management and administration fees, net interest revenue, and trading revenue. Asset management and administration fees and net interest revenue increased, while trading revenue decreased in the third quarter of 2010 compared to the third quarter of 2009. Asset management and administration fees and trading revenue decreased, while net interest revenue increased in the first nine months of 2010 compared to the first nine months of 2009.

 

Three Months Ended September 30,          2010     2009  
     Percent
  Change  
    Amount     % of
Total Net
 Revenues 
    Amount     % of
Total Net
 Revenues 
 

Asset management and administration fees

          

Mutual fund service fees:

          

Proprietary funds (Schwab Funds® and Laudus Funds®)

     (22 %)    $ 162        15   $ 207        21

Mutual Fund OneSource®

     24     156        15     126        12

Clearing and other

            23        2     23        2

Investment management and trust fees

     41     99        9     70        7

Other

              12     28        3     25        3
                                        

Asset management and administration fees

     4     468        44     451        45
                                        

Net interest revenue

          

Interest revenue

     24     442        42     356        35

Interest expense

     (6 %)      (58     (6 %)      (62     (6 %) 
                                        

Net interest revenue

     31     384        36     294        29
                                        

Trading revenue

          

Commissions

     (23 %)      168        16     217        21

Principal transactions

     (42 %)      14        1     24        3
                                        

Trading revenue

     (24 %)      182        17     241        24
                                        

Other

     (11 %)      32        3     36        3
                                        

Net impairment losses on securities

     (73 %)      (3            (11     (1 %) 
                                        

Total net revenues

     5   $     1,063          100   $     1,011          100
                                        

 

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THE CHARLES SCHWAB CORPORATION

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

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

 

 

Nine Months Ended September 30,          2010     2009  
     Percent
  Change  
    Amount     % of
Total Net
 Revenues 
    Amount     % of
Total Net
 Revenues 
 

Asset management and administration fees

          

Mutual fund service fees:

          

Proprietary funds (Schwab Funds® and Laudus Funds®)

     (43 %)    $     447        14   $     780        24

Mutual Fund OneSource®

     43     458        15     321        10

Clearing and other

     18     78        3     66        2

Investment management and trust fees

     31     260        8     199        6

Other

     12     82        3     73        3
                                        

Asset management and administration fees

     (8 %)      1,325        43     1,439        45
                                        

Net interest revenue

          

Interest revenue

              19     1,261        40     1,063        33

Interest expense

     5     (169     (5 %)      (161     (5 %) 
                                        

Net interest revenue

     21     1,092        35     902        28
                                        

Trading revenue

          

Commissions

     (15 %)      575        18     679        21

Principal transactions

     (47 %)      49        2     93        3
                                        

Trading revenue

     (19 %)      624        20     772        24
                                        

Other

     (25 %)      99        3     132        4
                                        

Net impairment losses on securities

     (50 %)      (19     (1 %)      (38     (1 %) 
                                        

Total net revenues

     (3 %)    $     3,121          100   $     3,207          100
                                        

Asset Management and Administration Fees

Asset management and administration fees include mutual fund service fees and fees for other asset-based financial services provided to individual and institutional clients. The Company earns mutual fund service fees for shareholder services, administration, investment management, and transfer agent services (through July 2009) provided to its proprietary funds, and recordkeeping and shareholder services provided to third-party funds. These fees are based upon the daily balances of client assets invested in the Company’s proprietary funds and third-party funds. The Company also earns asset management fees for advisory and managed account services, which are based on the daily balances of client assets subject to the specific fee for service. The fair values of client assets included in proprietary and third-party mutual funds are based on quoted market prices and other observable market data. Asset management and administration fees may vary with changes in the balances of client assets due to market fluctuations and client activity. For discussion of the impact of current market conditions on asset management and administration fees, see “Current Market and Regulatory Environment.”

 

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THE CHARLES SCHWAB CORPORATION

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

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

 

 

Asset management and administration fees increased by $17 million, or 4%, in the third quarter of 2010 compared to the third quarter of 2009 primarily due to an increase in investment management and trust fees, offset by a decrease in mutual fund service fees. Asset management and administration fees decreased by $114 million, or 8%, in the first nine months of 2010 compared to the first nine months of 2009 primarily due to the decrease in mutual fund service fees, partially offset by an increase in investment management and trust fees.

 

     Three Months  Ended
September 30,
    Percent
Change
    Nine Months  Ended
September 30,
    Percent
Change
 
     2010     2009       2010     2009    

Asset management and administration fees before money market mutual fund fee waivers

   $        561      $        529        6   $     1,656      $     1,553        7

Money market mutual fund fee waivers

     (93     (78     19     (331     (114              190
                                                

Asset management and administration fees

   $ 468      $ 451                     4   $ 1,325      $ 1,439        (8 %) 
                                                

Mutual fund service fees decreased by $15 million, or 4%, and $184 million, or 16%, in the third quarter and first nine months of 2010 compared to the same periods in 2009, respectively, primarily due to money market mutual fund fee waivers. Given the low interest rate environment in the third quarters and first nine months of 2010 and 2009, the overall yields on certain Schwab-sponsored money market mutual funds have fallen to levels at or below the management fees on those funds. As a result, the Company waived a portion of its fees in the third quarters and first nine months of 2010 and 2009, in order to provide a positive return to clients. The decrease in mutual fund service fees was partially offset by higher average balances of client assets invested in the Company’s Mutual Fund OneSource funds as a result of higher average asset valuations combined with continued asset inflows.

Investment management and trust fees increased by $29 million, or 41%, and $61 million, or 31%, in the third quarter and first nine months of 2010 compared to the same periods in 2009, respectively, primarily due to higher average balances of client assets participating in advisory and managed account services programs. This increase was partially offset by temporary fee rebates of $10 million and $62 million in the third quarter and first nine months of 2010, respectively, offered to qualifying clients for choosing to participate in these programs.

Net Interest Revenue

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

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

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

 

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Table of Contents

THE CHARLES SCHWAB CORPORATION

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

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

 

 

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

 

Three Months Ended September 30,    2010     2009  
     Average
Balance
     Interest
Revenue/
Expense
     Average
Yield/

Rate
    Average
Balance
     Interest
Revenue/
Expense
     Average
Yield/

Rate
 

Interest-earning assets:

                

Cash and cash equivalents

   $ 8,265       $ 6         0.29   $ 9,366       $ 7         0.30

Cash and investments segregated

     19,286         16         0.33     16,584         16         0.38

Broker-related receivables (1)

     287                 0.12     383                 0.14

Receivables from brokerage clients

     9,151         111         4.81     7,006         89         5.04

Other securities owned (2)

                            158                 0.87

Securities available for sale (3)

     25,148         124         1.96     18,942         127         2.66

Securities held to maturity

     10,776         95         3.50     2,874         28         3.87

Loans to banking clients

     8,052         69         3.40     6,795         61         3.56

Loans held for sale

     69         1         4.72     69         1         5.75
                                                    

Total interest-earning assets

     81,034         422         2.07     62,177         329         2.10
                                                    

Other interest revenue

        20              27      
                            

Total interest-earning assets

   $     81,034       $          442                   2.16   $     62,177       $          356                   2.27
                                                    

Funding sources:

                

Deposits from banking clients

   $ 46,942       $ 29         0.25   $ 33,792       $ 32         0.38

Payables to brokerage clients (2)

     22,882         1         0.02     18,474                 0.01

Long-term debt

     1,827         25         5.43     1,535         22         5.69
                                                    

Total interest-bearing liabilities

     71,651         55         0.30     53,801         54         0.40
                                                    

Non-interest-bearing funding sources

     9,383              8,376         

Other interest expense

                     1      
                            

Total funding sources

   $ 81,034       $ 55         0.27   $ 62,177       $ 55         0.35
                                                    

Net interest revenue before provision for credit losses

      $ 387         1.89      $ 301         1.92
                                        

Provision for credit losses

        3              7      
                            

Net interest revenue

      $ 384         1.88      $ 294         1.88
                                        

 

(1)

Includes receivables from brokers, dealers, and clearing organizations. Interest revenue on broker-related receivables was less than $500,000 in the third quarters of 2010 and 2009.

(2)

Interest revenue on other securities owned and interest expense on payables to brokerage clients was less than $500,000 in the third quarter of 2009.

(3)

Amounts have been calculated based on amortized cost.

 

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Table of Contents

THE CHARLES SCHWAB CORPORATION

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

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

 

 

Nine Months Ended September 30,    2010     2009  
     Average
Balance
     Interest
Revenue/
Expense
     Average
Yield/
Rate
    Average
Balance
     Interest
Revenue/
Expense
     Average
Yield/
Rate
 

Interest-earning assets:

                

Cash and cash equivalents

   $ 7,848       $ 16         0.27   $ 7,795       $ 27         0.46

Cash and investments segregated

     19,046         41         0.29     15,815         67         0.57

Broker-related receivables (1)

     297                 0.04     355         1         0.38

Receivables from brokerage clients

     8,720         322         4.94     6,457         254         5.26

Other securities owned (2)

     98                 0.45     53                 0.88

Securities available for sale (3)

     23,841         376         2.11     17,235         389         3.02

Securities held to maturity

     8,799         240         3.65     1,443         43         3.98

Loans to banking clients

     7,802         204         3.50     6,497         177         3.64

Loans held for sale

     69         3         4.84     121         5         5.52
                                                    

Total interest-earning assets

     76,520         1,202         2.10     55,771         963         2.31
                                                    

Other interest revenue

        59              100      
                            

Total interest-earning assets

   $     76,520       $ 1,261                   2.20   $     55,771       $ 1,063                   2.55
                                                    

Funding sources:

                

Deposits from banking clients

   $ 43,434       $ 85         0.26   $ 29,285       $ 73         0.33

Payables to brokerage clients

     22,103         2         0.01     17,393         2         0.02

Long-term debt

     1,527         64         5.60     1,134         51         6.01
                                                    

Total interest-bearing liabilities

     67,064         151         0.30     47,812         126         0.35
                                                    

Non-interest-bearing funding sources

     9,456              7,959         

Other interest expense

                     2      
                            

Total funding sources

   $ 76,520       $          151         0.26   $ 55,771       $          128         0.31
                                                    

Net interest revenue before provision for credit losses

      $ 1,110         1.94      $ 935         2.24
                                        

Provision for credit losses

        18              33      
                            

Net interest revenue

      $ 1,092         1.91      $ 902         2.16
                                        

 

(1)

Includes receivables from brokers, dealers, and clearing organizations. Interest revenue on broker-related receivables was less than $500,000 in the first nine months of 2010.

(2)

Interest revenue on other securities owned was less than $500,000 in the first nine months of 2010 and 2009.

(3)

Amounts have been calculated based on amortized cost.

Net interest revenue increased in the third quarter and first nine months of 2010 compared to the same periods in 2009 due to higher average balances of interest-earning assets. This resulted from significant growth in average balances of deposits from banking clients, which in turn funded increases in the average balances of securities held to maturity, securities available for sale, and loans to banking clients. These interest-earning assets are invested at rates above the cost of supporting funding sources. The increase in net interest revenue was partially offset by the low interest rate environment that persisted in the third quarter and first nine months of 2010, which resulted in the decline in the yields of all interest-earning assets compared to the third quarter and first nine months of 2009.

Trading Revenue

Trading revenue includes commission and principal transaction revenues. Commission revenues are affected by the number of revenue trades executed and the average revenue earned per revenue trade. Principal transaction revenues are primarily comprised of revenues from client fixed income securities trading activity. Factors that influence principal transaction revenues include the volume of client trades, market price volatility, and competitive pressures.

 

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Table of Contents

THE CHARLES SCHWAB CORPORATION

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

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

 

 

Trading revenue decreased by $59 million, or 24%, and $148 million, or 19%, in the third quarter and first nine months of 2010 compared to the same periods in 2009 due to lower daily average revenue trades and lower average revenue earned per revenue trade.

As shown in the following table, daily average revenue trades decreased 15% and 8% in the third quarter and first nine months of 2010 primarily due to lower volumes of equity and principal transaction trades, partially offset by a higher volume of option trades. Average revenue earned per revenue trade decreased 12% and 11% in the third quarter and first nine months of 2010, respectively, primarily due to lower online equity trade commissions, which were implemented in January 2010.

 

     Three Months  Ended
September 30,
    Percent
Change
    Nine Months  Ended
September 30,
    Percent
Change
 
     2010     2009       2010     2009    

Daily average revenue trades (in thousands) (1)

     233.2        273.7        (15 %)      270.3        292.4        (8 %) 

Number of trading days

     64.0        64.0                   —        188.0        188.0                   —   

Average revenue earned per revenue trade

   $     12.32        $     13.93          (12 %)    $     12.35        $     13.94          (11 %) 

 

(1)

Includes all client trades that generate trading revenue (i.e., commission revenue or revenue from fixed income securities trading).

Other Revenue

Other revenue includes gains on the repurchases of long-term debt, gains and losses on sales of loans held for sale, service fees, and software maintenance fees. Other revenue decreased by $33 million, or 25%, in the first nine months of 2010 from the first nine months of 2009 due to a gain of $31 million on the repurchase of a portion of the Company’s long-term debt in the first nine months of 2009.

Net Impairment Losses on Securities

The Company recorded net impairment charges of $3 million and $19 million in the third quarter and first nine months of 2010, respectively. Net impairment charges were $11 million and $38 million in the third quarter and first nine months of 2009, respectively. These charges related to certain non-agency residential mortgage-backed securities in the Company’s available for sale portfolio as a result of credit deterioration of the securities’ underlying collateral. See “Item 1 – Condensed Consolidated Financial Statements (Unaudited) – Notes – 3. Securities Available for Sale and Securities Held to Maturity” for further discussion.

 

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Table of Contents

THE CHARLES SCHWAB CORPORATION

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

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

 

 

Expenses Excluding Interest

As shown in the table below, expenses excluding interest increased in the third quarter of 2010 compared to the third quarter of 2009, primarily due to the recognition of two charges in the third quarter of 2010 relating to losses recognized by Schwab money market mutual funds and the termination of the Company’s Invest First and WorldPoints Visa credit card program. These charges and the recognition of a class action litigation reserve relating to the Schwab YieldPlus Fund in the first quarter of 2010 resulted in the increase of expenses excluding interest in the first nine months of 2010 compared to the first nine months of 2009. Expenses excluding interest also increased in the first nine months of 2010 due to increases in professional services expense and other expense, partially offset by a decrease in occupancy and equipment expense.

 

     Three Months  Ended
September 30,
    Percent
Change
    Nine Months  Ended
September 30,
    Percent
Change
 
     2010     2009       2010     2009    

Compensation and benefits

   $        381      $        371        3   $ 1,176      $ 1,173          

Professional services

     85        70        21     249        194        28

Occupancy and equipment

     66        67        (1 %)      202        245        (18 %) 

Advertising and market development

     34        34               139        141        (1 %) 

Communications

     49        48                     2     154        155        (1 %) 

Depreciation and amortization

     35        38        (8 %)      108        121        (11 %) 

Class action litigation reserve

                          196               N/M   

Money market mutual fund charges

     132               N/M        132               N/M   

Other

     82        63        30            215               168                   28
                                                

Total expenses excluding interest

   $ 864      $ 691        25   $ 2,571      $ 2,197        17
                                                

Expenses as a percentage of total net revenues:

            

Total expenses excluding interest

     81     68       82     69  

Advertising and market development

     3     3       4     4  

 

N/M Not meaningful.

Compensation and Benefits

Compensation and benefits expense includes salaries and wages, incentive compensation, and related employee benefits and taxes. Incentive compensation primarily includes variable compensation and discretionary bonus costs. Variable compensation includes payments to certain individuals based on their sales performance. Discretionary bonus costs are based on the Company’s overall performance as measured by earnings per share, and therefore will fluctuate with this measure.

 

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Table of Contents

THE CHARLES SCHWAB CORPORATION

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

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

 

 

Compensation and benefits expense increased by $10 million, or 3%, in the third quarter of 2010 compared to the third quarter of 2009 primarily due to an increase in salaries and wages expense. Compensation and benefits expense was relatively flat in the first nine months of 2010 compared to the first nine months of 2009 primarily due to an increase in incentive compensation, partially offset by a decrease in salaries and wages expense. The following table shows a comparison of certain compensation and benefits components and employee data:

 

     Three Months  Ended
September 30,
    Percent
Change
    Nine Months  Ended
September 30,
    Percent
Change
 
     2010     2009       2010     2009    

Salaries and wages

   $ 228      $ 214                  7   $     701      $     713        (2 %) 

Incentive compensation (1)

     88        91        (3 %)      283        261        8

Employee benefits and other

     65        66        (2 %)      192        199        (4 %) 
                                                

Total compensation and benefits expense

   $     381      $     371        3   $ 1,176      $ 1,173          
                                                

Compensation and benefits expense as a percentage of total net revenues:

            

Salaries and wages

     21     21       22     22  

Incentive compensation

     8     9       9     8  

Employee benefits and other

     7     7       7     7  
                                    

Total compensation and benefits expense

     36     37       38     37  
                                    

Full-time equivalent employees (in thousands) (2)

            

At quarter end

     12.5        12.2        2      

Average

     12.5        12.2        2     12.6        12.4                  2

 

(1)

Includes variable compensation, discretionary bonus costs, stock-based compensation, and employee stock purchase plan expense.

(2)

Includes full-time, part-time and temporary employees, and persons employed on a contract basis, and excludes employees of outsourced service providers.

Salaries and wages increased in the third quarter of 2010 compared to the third quarter of 2009 due to an increase in full-time employees and persons employed on a contract basis. Salaries and wages decreased in the first nine months of 2010 compared to the first nine months of 2009 primarily due to severance expense of $56 million in the first nine months of 2009 relating to the Company’s cost reduction measures. This decrease was partially offset by an increase in persons employed on a contract basis.

Incentive compensation increased in the first nine months of 2010 compared to the first nine months of 2009 primarily due to higher variable compensation resulting from product sales performance in the Company’s branch offices.

Expenses Excluding Compensation and Benefits

Professional services expense increased in the third quarter and first nine months of 2010 compared to the same periods in 2009 primarily due to an increase in fees paid to outsourced service providers and consultants.

Occupancy and equipment expense decreased in the first nine months of 2010 compared to the first nine months of 2009 primarily due to facilities charges of $43 million in the first nine months of 2009 relating to the Company’s cost reduction measures.

Depreciation and amortization expense decreased in the third quarter and first nine months of 2010 compared to the same periods in 2009 primarily due to certain assets becoming fully depreciated.

In the first quarter of 2010, the Company recognized a class action litigation reserve of $196 million relating to the Schwab YieldPlus Fund. For further discussion of the Schwab YieldPlus Fund litigation and regulatory matters, see “Item 1 – Condensed Consolidated Financial Statements (Unaudited) – Notes – 6. Commitments and Contingent Liabilities.”

 

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Table of Contents

THE CHARLES SCHWAB CORPORATION

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

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

 

 

In the third quarter of 2010, the Company decided to cover the net remaining losses recognized by Schwab money market mutual funds as a result of their investments in a single structured investment vehicle that defaulted in 2008 and recorded a charge of $132 million.

Other expense increased in the third quarter and first nine months of 2010 compared to the same periods in 2009 primarily due to a charge of $21 million in the third quarter of 2010 relating to the Company’s Invest First and WorldPoints Visa credit cards, as the Company ended its sponsorship due to challenging credit card industry economics. A charge of $9 million was previously recognized in the first quarter of 2010 relating to this termination. Other expense also increased in the first nine months of 2010 due to an increase in employee travel expenses. Other expense in the first nine months of 2009 included charges of $21 million for individual client complaints and arbitration claims relating to Schwab YieldPlus Fund investments, offset by $34 million of insurance recoveries, resulting in a net credit of $13 million. These expenses were not material in the third quarter and first nine months of 2010.

Taxes on Income

The Company’s effective income tax rate on income before taxes was 37.7% and 37.5% for the third quarters of 2010 and 2009, respectively. The Company’s effective income tax rate on income before taxes was 39.1% and 38.3% for the first nine months of 2010 and 2009, respectively. The increase in the first nine months of 2010 was primarily due to the impact of non-recurring items on the computation of the effective income tax rate in relation to lower income before taxes.

Segment Information

The Company provides financial services to individuals and institutional clients through two segments – Investor Services and Institutional Services. The Investor Services segment includes the Company’s retail brokerage and banking operations. The Institutional Services segment provides custodial, trading, and support services to independent investment advisors, as well as retirement plan services, plan administrator services, equity compensation plan services, and mutual fund clearing services. In addition, the Institutional Services segment supports the availability of Schwab proprietary mutual funds and collective trust funds on third-party platforms. The Company evaluates the performance of its segments on a pre-tax basis, excluding items such as impairment charges on non-financial assets, discontinued operations, extraordinary items, and significant restructuring and other charges.

 

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Table of Contents

THE CHARLES SCHWAB CORPORATION

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

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

 

 

Financial information for the Company’s reportable segments is presented in the following table:

 

     Three Months  Ended
September 30,
    Percent
Change
    Nine Months  Ended
September 30,
    Percent
Change
 
     2010     2009       2010     2009    

Investor Services:

            

Net revenues

   $ 718      $ 658        9   $ 2,080      $ 2,069        1

Expenses excluding interest

     503        462        9     1,535        1,415        8
                                                

Contribution margin

   $ 215      $ 196        10   $ 545      $ 654        (17 %) 
                                                

Institutional Services:

            

Net revenues

   $ 346      $ 353        (2 %)    $ 1,042      $ 1,138        (8 %) 

Expenses excluding interest

     232        228        2     715        695        3
                                                

Contribution margin

   $ 114      $ 125        (9 %)    $ 327      $ 443        (26 %) 
                                                

Unallocated:

            

Net revenues

   $ (1   $               N/M      $ (1   $               N/M   

Expenses excluding interest

     129        1        N/M        321        87        N/M   
                                                

Contribution margin

   $ (130   $ (1     N/M      $ (322   $ (87     N/M   
                                                

Total:

            

Net revenues

   $     1,063      $     1,011        5   $     3,121      $     3,207        (3 %) 

Expenses excluding interest

     864        691        25     2,571        2,197        17
                                                

Contribution margin

   $ 199      $ 320        (38 %)    $ 550      $ 1,010        (46 %) 
                                                

 

N/M Not meaningful.

Investor Services

Net revenues increased by $60 million, or 9%, in the third quarter of 2010 compared to the third quarter of 2009 primarily due to increases in net interest revenue and asset management and administration fees, partially offset by a decrease in trading revenue. Net interest revenue increased due to higher average balances of interest earning assets during the quarter. Asset management and administration fees increased due to higher average asset valuations combined with continued asset inflows, partially offset by money market mutual fund fee waivers. Trading revenue decreased due to lower daily average revenue trades and lower average revenue earned per revenue trade resulting from improved online trade pricing for clients, which was implemented in January 2010. Expenses excluding interest increased by $41 million, or 9%, in the third quarter of 2010 compared to the third quarter of 2009 primarily due to increases in professional services expense and other expense. Other expense includes a charge relating to the Company’s Invest First and WorldPoints Visa credit cards, as the Company ended its sponsorship due to challenging credit card industry economics.

Net revenues were relatively flat in the first nine months of 2010 compared to the first nine months of 2009 primarily due to an increase in net interest revenue, offset by decreases in trading revenue, asset management and administration fees and other revenue. Net interest revenue increased due to higher average balances of interest earning assets during the first nine months of 2010. Trading revenue decreased due to lower daily average revenue trades and lower average revenue earned per revenue trade. Asset management and administration fees decreased primarily due to money market mutual fund fee waivers, partially offset by the effect of higher average asset valuations combined with continued asset inflows. Other revenue decreased due to a gain on the repurchase of a portion of the Company’s long-term debt in the first nine months of 2009. Expenses excluding interest increased by $120 million, or 8%, in the first nine months of 2010 compared to the first nine months of 2009 primarily due to increases in professional services expense and other expense. Other expense includes the termination charge relating to the Company’s Invest First and WorldPoints Visa credit card program in the third quarter of 2010 previously discussed.

Institutional Services

Net revenues were relatively flat in the third quarter of 2010 compared to the third quarter of 2009 primarily due to a decrease in trading revenue, offset by an increase in net interest revenue. Trading revenue decreased due to lower daily average revenue trades and lower average revenue earned per revenue trade. Net interest revenue increased due to higher

 

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Table of Contents

THE CHARLES SCHWAB CORPORATION

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

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

 

average balances of interest-earning assets during the quarter. Expenses excluding interest were also relatively flat in the third quarter of 2010 compared to the third quarter of 2009.

Net revenues decreased by $96 million, or 8%, in the first nine months of 2010 compared to the first nine months of 2009 primarily due to decreases in trading revenue, asset management and administration fees, and other revenue, partially offset by an increase in net interest revenue. Trading revenue decreased due to lower daily average revenue trades and lower average revenue earned per revenue trade. Asset management and administration fees decreased due to money market mutual fund fee waivers, partially offset by the effect of higher average asset valuations combined with continued asset inflows. Other revenue decreased due to a gain on the repurchase of a portion of the Company’s long-term debt in the first nine months of 2009. Net interest revenue increased due to higher average balances of interest-earning assets during the first nine months of 2010. Expenses excluding interest increased by $20 million, or 3%, in the first nine months of 2010 compared to the first nine months of 2009 primarily due to an increase in professional services expense.

Unallocated

Expenses excluding interest in the third quarter and first nine months of 2010 include the recognition of a charge relating to the Company’s decision to cover the net remaining losses recognized by Schwab money market mutual funds as a result of their investments in a single structured investment vehicle that defaulted in 2008. Expenses excluding interest in the first nine months of 2010 also include the recognition of a class action litigation reserve relating to the Schwab YieldPlus Fund in the first quarter of 2010. Expenses excluding interest in the first nine months of 2009 include facilities and severance charges relating to the Company’s cost reduction measures.

LIQUIDITY AND CAPITAL RESOURCES

CSC conducts substantially all of its business through its wholly-owned subsidiaries. The Company’s capital structure is designed to provide each subsidiary with capital and liquidity to meet its operational needs and any regulatory requirements.

CSC is a savings and loan holding company and Schwab Bank, CSC’s depository institution, is a federal savings bank. CSC and Schwab Bank are both subject to supervision and regulation by the Office of Thrift Supervision.

Liquidity

CSC

As a savings and loan holding company, CSC is not subject to specific statutory capital requirements. However, CSC is required to maintain capital that is sufficient to support the holding company and its subsidiaries’ business activities, and the risks inherent in those activities. To manage capital adequacy, CSC currently utilizes a target Tier 1 Leverage Ratio, as defined by the Board of Governors of the Federal Reserve System, of at least 6%. At September 30, 2010, CSC’s Tier 1 Leverage Ratio was 6.8%.

CSC’s liquidity needs are generally met through cash generated by its subsidiaries, as well as cash provided by external financing. CSC maintains excess liquidity in the form of overnight cash deposits and short-term investments to cover daily funding needs and to support growth in the Company’s business. Generally, CSC does not hold liquidity at its subsidiaries in excess of amounts deemed sufficient to support the subsidiaries’ operations, including any regulatory capital requirements. Schwab and Schwab Bank are subject to regulatory requirements that may restrict them from certain transactions with CSC. Management believes that funds generated by the operations of CSC’s subsidiaries will continue to be the primary funding source in meeting CSC’s liquidity needs, providing adequate liquidity to meet Schwab Bank’s capital guidelines, and maintaining Schwab’s net capital.

CSC has liquidity needs that arise from its Senior Medium-Term Notes, Series A (Medium-Term Notes), Junior Subordinated Notes, and Senior Notes, as well as from the funding of cash dividends, acquisitions, and other investments. The Medium-Term Notes, of which $250 million were outstanding at September 30, 2010, mature in 2017 and have a fixed interest rate of 6.375% with interest payable semi-annually. The Medium-Term Notes are rated A2 by Moody’s Investors Service (Moody’s), A by Standard & Poor’s Ratings Group (Standard & Poor’s), and A by Fitch Ratings, Ltd. (Fitch). At

 

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Table of Contents

THE CHARLES SCHWAB CORPORATION