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 June 30, 2007

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.)

120 Kearny Street, San Francisco, CA 94108

(Address of principal executive offices and zip code)

Registrant’s telephone number, including area code: (415) 636-7000

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 is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large accelerated filer  x            Accelerated filer  ¨            Non-accelerated filer  ¨

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.

1,254,087,543 shares of $.01 par value Common Stock

Outstanding on July 31, 2007

 



Table of Contents

THE CHARLES SCHWAB CORPORATION

 

Quarterly Report on Form 10-Q

For the Quarter Ended June 30, 2007

 

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 – 35

Item 3.

   Quantitative and Qualitative Disclosures About Market Risk    36 – 37

Item 4.

   Controls and Procedures    37

Part II - Other Information

    

Item 1.

   Legal Proceedings    37 – 38

Item 1A.

   Risk Factors    38

Item 2.

   Unregistered Sales of Equity Securities and Use of Proceeds    38

Item 3.

   Defaults Upon Senior Securities    38

Item 4.

   Submission of Matters to a Vote of Security Holders    39

Item 5.

   Other Information    39

Item 6.

   Exhibits    40
Signature         41


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
June 30,


    Six Months Ended
June 30,


 
     2007

    2006

    2007

    2006

 

Net Revenues

                                

Asset management and administration fees

     $ 586       $     479       $     1,120       $ 938  

Interest revenue

     553       533       1,104         1,022  

Interest expense

     (164 )     (168 )     (331 )     (319 )
    


 


 


 


Net interest revenue

     389       365       773       703  

Trading revenue

     198       210       400       437  

Other

     32       39       65       69  
    


 


 


 


Total net revenues

     1,205       1,093       2,358       2,147  
    


 


 


 


Expenses Excluding Interest

                                

Compensation and benefits

     449       407       879       816  

Professional services

     81       71       155       134  

Occupancy and equipment

     70       66       138       128  

Advertising and market development

     52       55       118       104  

Communications

     51       47       100       91  

Depreciation and amortization

     39       39       78       80  

Other

     39       39       75       72  
    


 


 


 


Total expenses excluding interest

     781       724       1,543       1,425  
    


 


 


 


Income from continuing operations before taxes on income

     424       369       815       722  

Taxes on income

     (168 )     (146 )     (323 )     (285 )
    


 


 


 


Income from continuing operations

     256       223       492       437  

Income from discontinued operations, net of tax

     36       28       73       57  
    


 


 


 


Net Income

     $ 292       $       251       $ 565       $ 494  
    


 


 


 


Weighted-Average Common Shares Outstanding — Diluted

     1,257       1,294       1,262       1,295  
    


 


 


 


Earnings Per Share - Basic

                                

Income from continuing operations

     $ .21       $ .17       $ .39       $ .34  

Income from discontinued operations, net of tax

     $ .03       $ .03       $ .06       $ .05  

Net income

     $ .24       $ .20       $ .45       $ .39  

Earnings Per Share - Diluted

                                

Income from continuing operations

     $ .20       $ .17       $ .39       $ .34  

Income from discontinued operations, net of tax

     $ .03       $ .02       $ .06       $ .04  

Net income

     $ .23       $ .19       $ .45       $ .38  
    


 


 


 


Dividends Declared Per Common Share

     $ .050       $ .030       $ .100       $ .055  
    


 


 


 


 

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)

 

     June 30,
2007


    December 31,
2006


 

Assets

                

Cash and cash equivalents

     $ 3,471       $ 4,507  

Cash and investments segregated and on deposit for federal or other regulatory purposes (1) (including resale agreements of $3,616 in 2007 and $4,740 in 2006)

     9,148       10,862  

Securities owned — at market value (including securities pledged of $8 in 2007 and $5 in 2006)

     8,249       6,386  

Receivables from brokers, dealers, and clearing organizations

     1,022       650  

Receivables from brokerage clients — net

     11,339       10,927  

Loans to banking clients — net

     2,727       2,334  

Loans held for sale

     43       30  

Equipment, office facilities, and property — net

     609       602  

Goodwill

     524       419  

Deferred tax assets

     405       406  

Other assets

     554       524  

Assets retained from discontinued operations

           749  

Assets of discontinued operations

     10,913       10,596  
    


 


Total

     $   49,004       $ 48,992  
    


 


Liabilities and Stockholders’ Equity

                

Deposits from banking clients

     $ 11,685       $ 11,020  

Drafts payable

     294       324  

Payables to brokers, dealers, and clearing organizations

     2,151       1,498  

Payables to brokerage clients

     18,758       20,621  

Accrued expenses and other liabilities

     1,082       1,069  

Long-term debt

     384       388  

Liabilities of discontinued operations

     9,576       9,064  
    


 


Total liabilities

     43,930       43,984  
    


 


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; 1,392,091,544 shares issued

     14       14  

Additional paid-in capital

     1,985       1,868  

Retained earnings

     5,308       4,901  

Treasury stock — 140,211,421 and 126,904,699 shares in 2007 and 2006, respectively, at cost

     (2,177 )     (1,739 )

Accumulated other comprehensive loss

     (56 )     (36 )
    


 


Total stockholders’ equity

     5,074       5,008  
    


 


Total

     $   49,004       $ 48,992  
    


 



(1)

Amounts included represent actual balances on deposit, whereas cash and investments required to be segregated for federal or other regulatory purposes at June 30, 2007 and December 31, 2006, excluding $201 million of intercompany repurchase agreements and associated interest at December 31, 2006, were $9,494 million and $11,063 million, respectively. The Company deposited a net amount of $690 million and $554 million into its segregated bank accounts on July 3 and January 3, 2007, respectively.

 

See Notes to Condensed Consolidated Financial Statements.

 

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Table of Contents

THE CHARLES SCHWAB CORPORATION

 

Condensed Consolidated Statements of Cash Flows

(In millions)

(Unaudited)

 

    

Six Months Ended

June 30,


 
     2007

    2006

 

Cash Flows from Operating Activities

                

Net income

     $ 565       $ 494  

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

                

Income from discontinued operations, net of tax

     (73 )     (57 )

Depreciation and amortization

     78       80  

Stock-based compensation expense

     26       18  

Excess tax benefits from stock-based compensation

     (59 )     (34 )

Provision for deferred income taxes

     16       (3 )

Other

     6       (6 )

Originations of loans held for sale

     (418 )     (358 )

Proceeds from sales of loans held for sale

     406       352  

Net change in:

                

Cash and investments segregated and on deposit for federal or other regulatory purposes

     1,714       3,471  

Securities owned (excluding securities available for sale)

     55       165  

Receivables from brokers, dealers, and clearing organizations

     (372 )     186  

Receivables from brokerage clients

     (415 )     (152 )

Other assets

     (26 )     12  

Drafts payable

     (30 )     (30 )

Payables to brokers, dealers, and clearing organizations

     653       441  

Payables to brokerage clients

     (1,863 )     (3,181 )

Accrued expenses and other liabilities

     (11 )     (17 )

Net change provided by discontinued operations

     389       378  
    


 


Net cash provided by operating activities

     641       1,759  
    


 


Cash Flows from Investing Activities

                

Purchases of securities available for sale

     (2,904 )     (2,752 )

Proceeds from sales of securities available for sale

           81  

Proceeds from maturities, calls, and mandatory redemptions of securities available for sale

     997       382  

Net increase in loans to banking clients

     (408 )     (204 )

Purchase of equipment, office facilities, and property

     (83 )     (49 )

Proceeds from sales of equipment, office facilities, and property

           62  

Cash payments for business combinations, net of cash acquired

     (117 )      

Cash payments for investments, net

           6  

Net cash provided by (used for) discontinued operations

     67       (177 )
    


 


Net cash used for investing activities

     (2,448 )     (2,651 )
    


 


Cash Flows from Financing Activities

                

Net change in deposits from banking clients

     665       2,290  

Excess tax benefits from stock-based compensation

     59       34  

Repayment of long-term debt

           (40 )

Dividends paid

     (125 )     (71 )

Purchase of treasury stock

     (624 )     (455 )

Proceeds from stock options exercised and other

     233       142  

Net cash provided by discontinued operations

     563        
    


 


Net cash provided by financing activities

     771       1,900  
    


 


(Decrease) Increase in Cash and Cash Equivalents

     (1,036 )     1,008  

Cash and Cash Equivalents at Beginning of Period

     4,507       1,905  
    


 


Cash and Cash Equivalents at End of Period

     $     3,471       $     2,913  
    


 


 

See Notes to Condensed Consolidated Financial Statements.

 

 

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Table of Contents

THE CHARLES SCHWAB CORPORATION

Notes to Condensed Consolidated Financial Statements

(Tabular Amounts in Millions, Except Per Share Data, Option Price Amounts, Ratios, and as Noted)

(Unaudited)

 

1. Basis of Presentation

 

The Charles Schwab Corporation (CSC) is a financial 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 305 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, N.A. (Schwab Bank), a retail bank; Charles Schwab Investment Management, Inc., the investment advisor for Schwab’s proprietary mutual funds; CyberTrader, Inc., an electronic trading technology and brokerage firm providing services to highly active, online traders; and The Charles Schwab Trust Company, a trustee for employee benefit plans, primarily 401(k) plans.

 

The accompanying unaudited condensed consolidated financial statements include CSC and its majority-owned subsidiaries (collectively referred to as the Company). These financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (SEC) and, in the opinion of management, reflect all adjustments necessary to present fairly the financial position, results of operations, and cash flows for the periods presented in conformity with generally accepted accounting principles in the U.S. (GAAP). All adjustments were of a normal recurring nature. Certain prior-year amounts have been reclassified to conform to the 2007 presentation. All material intercompany balances and transactions have been eliminated. These financial statements should be read in conjunction with the consolidated financial statements and notes thereto for the year ended December 31, 2006 included in the Company’s Current Report on Form 8-K, as filed with the SEC on July 17, 2007. The Company’s results for any interim period are not necessarily indicative of results for a full year or any other interim period.

 

On November 19, 2006, the Company entered into a definitive agreement with Bank of America Corporation (Bank of America) pursuant to which Bank of America agreed to acquire all of the outstanding common stock of U.S. Trust Corporation (USTC, and with its subsidiaries collectively referred to as U.S. Trust), a subsidiary which provides wealth management services. The transaction was completed on July 1, 2007; accordingly, these financial statements reflect U.S. Trust as a discontinued operation for all periods.

 

2. Significant Accounting Policies

 

Asset management and administration fees: Asset management and administration fees, which include mutual fund service fees and fees for other asset-based financial services provided to individual and institutional clients, are recognized as revenue over the period that the related service is provided, based upon average net asset balances. The Company earns mutual fund service fees for transfer agent services, shareholder services, administration, and investment management provided to its proprietary funds, and recordkeeping and shareholder services provided to third-party funds. Mutual fund service fees are based upon the daily balances of client assets invested in third-party funds and the Company’s proprietary funds. These daily asset balances are based upon quoted market prices. 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.

 

Interest revenue: Interest revenue represents interest earned on certain assets, which include margin loans to brokerage clients, investments of segregated client cash balances, loans to banking clients, and securities available for sale. Interest revenue is recognized in the period earned based upon average daily asset balances and respective interest rates.

 

Securities transactions: Trading revenue includes commission revenues and revenues from principal transactions. Clients’ securities transactions are recorded on the date that they settle, while the related commission revenues and expenses are recorded on the date that the trade occurs. Principal transactions are recorded on the date that the trade occurs.

 

Cash and cash equivalents: The Company considers all highly liquid investments, including money market funds, interest-bearing deposits with banks, federal funds sold, commercial paper and treasury securities, with original

 

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Table of Contents

THE CHARLES SCHWAB CORPORATION

Notes to Condensed Consolidated Financial Statements

(Tabular Amounts in Millions, Except Per Share Data, Option Price Amounts, Ratios, and as Noted)

(Unaudited)

 

maturities of three months or less that are not segregated and on deposit for federal or other regulatory purposes to be cash equivalents.

 

Cash and investments segregated and on deposit for federal or other regulatory purposes include securities purchased under agreements to resell (resale agreements), which are collateralized by U.S. government securities, and certificates of deposit. Resale agreements are collateralized investing transactions that are recorded at their contractual amounts plus accrued interest. The Company obtains control of collateral (U.S. government and agency securities) with a market value equal to or in excess of the principal amount loaned and accrued interest under resale agreements. Collateral is valued daily by the Company, with additional collateral obtained when necessary. Certificates of deposit are recorded at market value.

 

Securities owned include securities available for sale which are recorded at fair value based on quoted market prices, where available. Mortgage-backed securities are not exchange traded and are valued based on dealer quotes or discounted cash flow models with expected cash flow and yield assumption inputs. Long-term certificates of deposit are recorded at market value. Unrealized gains and losses are reported, net of taxes, in accumulated other comprehensive income (loss) included in stockholders’ equity. Realized gains and losses from sales of securities available for sale are determined on a specific identification basis and are included in other revenue.

 

Securities owned also includes Schwab Funds® money market funds, fixed income securities, equity and other securities, and equity and bond mutual funds recorded at estimated fair value based on quoted market prices. Unrealized gains and losses are included in trading revenue.

 

Securities borrowed and securities loaned: Securities borrowed require the Company to deliver cash to the lender in exchange for securities and are included in receivables from brokers, dealers, and clearing organizations. For securities loaned, the Company receives collateral in the form of cash in an amount equal to the market value of securities loaned. Securities loaned are included in payables to brokers, dealers, and clearing organizations. The Company monitors the market value of securities borrowed and loaned, with additional collateral obtained or refunded when necessary. Fees received or paid are recorded in interest revenue or interest expense.

 

Receivables from brokerage clients include margin loans to clients and are stated net of allowance for doubtful accounts of $1 million at June 30, 2007 and $2 million at December 31, 2006. Cash receivables from brokerage clients that remain unsecured or partially secured for more than 30 days are fully reserved. There were no significant losses recognized during the periods presented. At June 30, 2007 and December 31, 2006, the weighted-average interest rate charged on margin loan balances was 8.0% and 8.2%, respectively.

 

Loans to banking clients are stated net of allowance for loan losses of $5 million and $4 million at June 30, 2007 and December 31, 2006, respectively. The allowance is established through charges to income based on management’s evaluation of the existing portfolio. The adequacy of the allowance is reviewed regularly by management, taking into consideration current economic conditions, the existing loan portfolio composition, past loss experience and risks inherent in the portfolio, including the value of impaired loans.

 

Nonperforming assets included in loans to banking clients consist of financial instruments where the Company has stopped accruing interest (non-accrual financial instruments). Interest accruals are discontinued when principal or interest is contractually past due 90 days or more (unless the loans are both well-secured and in the process of collection), or when the full timely collection of interest or principal becomes uncertain. Non-accrual financial instruments are returned to accrual status only when all delinquent principal and interest payments become current and the collectibility of future principal and interest on a timely basis is reasonably assured.

 

Loans held for sale consist of fixed-rate and adjustable-rate mortgage loans intended for sale. Loans held for sale are stated at lower of cost or market value. Market value is estimated using quoted market prices for securities backed by similar types of loans.

 

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THE CHARLES SCHWAB CORPORATION

Notes to Condensed Consolidated Financial Statements

(Tabular Amounts in Millions, Except Per Share Data, Option Price Amounts, Ratios, and as Noted)

(Unaudited)

 

Equipment, office facilities, and property: Equipment and office facilities are depreciated on a straight-line basis over the estimated useful life of the asset of three to ten years. Buildings are depreciated on a straight-line basis over twenty years. Leasehold improvements are amortized on a straight-line basis over the lesser of the estimated useful life of the asset or the term of the lease. Software and certain costs incurred for purchasing or developing software for internal use are amortized on a straight-line basis over an estimated useful life of three or five years. Equipment, office facilities, and property are stated at cost net of accumulated depreciation and amortization, except for land, which is stated at cost. Equipment, office facilities, and property are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable.

 

Drafts Payable represent outstanding checks and electronic transfers that have not yet been presented for payment at a bank.

 

Derivative financial instruments are recorded on the balance sheet in other assets and other liabilities at fair value based upon dealer quotes and third-party pricing services. As part of its consolidated asset and liability management process, the Company utilizes interest rate swap agreements (Swaps) to effectively convert the interest rate characteristics of a portion of its Medium-Term Notes from fixed to variable. These Swaps have been designated as fair value hedges and therefore, changes in the fair value of the Swaps are offset by changes in the fair value of the hedged Medium-Term Notes.

 

Schwab Bank’s loans held for sale portfolio consists of fixed- and adjustable-rate mortgages, which are subject to a loss in value when market interest rates rise. Schwab Bank uses forward sale commitments to manage this risk. These forward sale commitments have been designated as cash flow hedging instruments with respect to the loans held for sale. Accordingly, the fair values of these forward sale commitments are recorded on the Company’s consolidated balance sheet, with gains or losses recorded in other comprehensive income (loss).

 

Additionally, Schwab Bank uses forward sale commitments to hedge interest rate lock commitments issued on mortgage loans that will be held for sale. Schwab Bank considers the fair value of these commitments to be zero at the commitment date, with subsequent changes in fair value determined solely based on changes in market interest rates. Any changes in fair value of the interest rate lock commitments are completely offset by changes in fair value of the related forward sale commitments.

 

Income taxes: The Company provides for income taxes on all transactions that have been recognized in the consolidated financial statements in accordance with Statement of Financial Accounting Standards No. 109 – Accounting for Income Taxes (SFAS No. 109). Accordingly, deferred tax assets are adjusted to reflect the tax rates at which future taxable amounts will likely be settled or realized. The effects of tax rate changes on future deferred tax assets and deferred tax liabilities, as well as other changes in income tax laws, are recorded in earnings in the period during which such changes are enacted. Beginning January 1, 2007, the Company records uncertain tax positions in accordance with Financial Accounting Standards Board (FASB) Interpretation (FIN) No. 48, Accounting for Uncertainty in Income Taxes. See note 4, “Accounting for Income Taxes,” for disclosures pursuant to FIN No. 48.

 

Stock-based compensation: SFAS No. 123 (revised 2004) – Share-Based Payment (SFAS No. 123R) requires the measurement and recognition of compensation expense based on estimated fair values for all share-based payment arrangements including employee and director stock option and restricted stock awards.

 

Stock-based compensation expense is based on awards expected to vest, and therefore has been reduced for estimated forfeitures. Forfeitures are estimated at the time of grant based on the Company’s historical forfeiture experience and revised in subsequent periods if actual forfeitures differ from those estimates.

 

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THE CHARLES SCHWAB CORPORATION

Notes to Condensed Consolidated Financial Statements

(Tabular Amounts in Millions, Except Per Share Data, Option Price Amounts, Ratios, and as Noted)

(Unaudited)

 

A summary of the Company’s stock-based compensation expense and related income tax benefit is as follows:

 

    

Three Months
Ended

June 30,


  

Six Months
Ended

June 30,


     2007

   2006

   2007

   2006

Stock option expense

     $ 4      $ 4      $     7      $ 8

Restricted stock expense

     10      5      19      10
    

  

  

  

Total stock-based compensation

     $ 14      $ 9      $ 26      $   18
    

  

  

  

Income tax benefit on stock-based compensation

     $ 5      $   3      $ 10      $ 7
    

  

  

  

 

Long-term incentive compensation: Eligible officers may receive cash long-term incentive plan units under a long-term incentive plan (LTIP). These awards are restricted from transfer or sale and vest annually over a three- to four-year period. Each award provides for a one-time cash payment for an amount that varies based upon the Company’s cumulative EPS over the respective performance period of each grant. The Company accrues the estimated total cost for each grant on a straight-line basis over each LTIP’s vesting period, with periodic cumulative adjustments to expense as estimates of the total grant cost are revised.

 

Goodwill represents the cost of acquired businesses in excess of the fair value of the related net assets acquired. Goodwill is tested for impairment annually and whenever indications of impairment exist. In testing for a potential impairment of goodwill, management estimates the fair value of each of the Company’s reporting units (defined as the Company’s businesses for which financial information is available and reviewed regularly by management), and compares it to their carrying value. If the estimated fair value of a reporting unit is less than its carrying value, management is required to estimate the fair value of all assets and liabilities of the reporting unit, including goodwill. If the carrying value of the reporting unit’s goodwill is greater than the estimated fair value, an impairment charge is recognized for the excess. The Company has elected April 1 as its annual impairment testing date. At June 30, 2007 and December 31, 2006, the Company’s goodwill balance was $524 million and $419 million, respectively.

 

The carrying amount of goodwill by reportable segment is presented in the following table:

 

    

June 30,

2007


   December 31,
2006


Schwab Investor Services

     $   416      $   416

Schwab Corporate and Retirement Services

     108      3
    

  

Total

     $           524      $   419
    

  

 

New Accounting Standards

 

SFAS No. 155 – Accounting for Certain Hybrid Financial Instruments was effective for all financial instruments acquired or issued after December 31, 2006. This statement allows financial instruments that contain an embedded derivative to be accounted for as a whole (i.e., eliminating the need to account for the embedded derivative separately) if an election is made to report the whole instrument on a fair value basis. The Company made no such election and therefore, the adoption of SFAS No. 155 did not impact the Company’s financial position, results of operations, EPS, or cash flows.

 

SFAS No. 156 – Accounting for Servicing of Financial Assets was effective beginning January 1, 2007. This statement amends the requirements under SFAS No. 140 – Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, for accounting for mortgage servicing assets and servicing liabilities. Previously, servicing assets and servicing liabilities were amortized over the expected period of estimated net servicing income or loss and assessed for impairment or increased obligation at each reporting date. SFAS No. 156 requires that all separately recognized servicing assets and servicing liabilities be initially measured at fair value, and permits, but does not require, the subsequent measurement of servicing assets and servicing liabilities at fair value. The adoption of SFAS No. 156 did not impact the Company’s financial position, results of operations, EPS, or cash flows.

 

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Table of Contents

THE CHARLES SCHWAB CORPORATION

Notes to Condensed Consolidated Financial Statements

(Tabular Amounts in Millions, Except Per Share Data, Option Price Amounts, Ratios, and as Noted)

(Unaudited)

 

SFAS No. 157 – Fair Value Measurements is effective beginning January 1, 2008. This statement defines fair value, establishes a framework for measuring fair value in GAAP, and expands disclosures about fair value measurements. SFAS No. 157 does not require any new fair value measurements. The adoption of SFAS No. 157 is not expected to have a material impact on the Company’s financial position, results of operations, EPS, or cash flows.

 

SFAS No. 159 – The Fair Value Option for Financial Assets and Financial Liabilities was issued in February 2007 and is effective beginning January 1, 2008. This statement permits entities to elect to measure eligible financial instruments, commitments, and certain other arrangements at fair value at specified election dates with changes in fair value recognized in earnings at each subsequent reporting period. The Company is currently evaluating the impact of the adoption of SFAS No. 159 on its financial position, results of operations, EPS, and cash flows.

 

Emerging Issues Task Force Issue (EITF) No. 06-02 – Accounting for Sabbatical Leave and Other Similar Benefits Pursuant to FASB Statement No. 43 – Accounting for Compensated Absences was effective beginning January 1, 2007. This issue requires the recognition of compensation expense associated with a sabbatical leave or other similar benefit arrangement that does not vest over the requisite service period. The Company previously recorded compensation expense related to its sabbatical program in the period the sabbatical was taken by an employee. As a result of this change in accounting principle, the Company recorded a charge, net of estimated forfeitures, to retained earnings as of January 1, 2007 of $17 million after tax. This accounting change did not have a material impact on the Company’s results of operations, EPS, or cash flows.

 

FIN No. 48 – Accounting for Uncertainty in Income Taxes - An Interpretation of SFAS No. 109 was effective beginning January 1, 2007. This interpretation provides new requirements for the recognition, measurement, and disclosure in the financial statements of a tax position taken or expected to be taken in a tax return when there is uncertainty about whether that tax position will ultimately be sustained. The adoption of FIN No. 48 resulted in a charge to retained earnings as of January 1, 2007 of $17 million. The adoption of FIN No. 48 did not have a material impact on the Company’s results of operations, EPS, or cash flows.

 

3. Business Acquisition

 

On March 31, 2007, the Company completed its acquisition of The 401(k) Company, which offers defined contribution plan services, for $115 million in cash. As of June 30, 2007, the Company’s condensed consolidated financial statements include The 401(k) Company as a wholly-owned subsidiary of CSC. Pro-forma financial information for The 401(k) Company is not presented as it is not material to the Company’s condensed consolidated financial statements.

 

The initial recording of goodwill and other intangibles requires subjective judgments concerning estimates of the fair value of acquired assets. Any excess of the purchase price over the fair value of the acquired net assets is recorded as goodwill. As a result of a purchase price allocation, the Company recorded goodwill of $105 million and intangible assets of $8 million, both of which are deductible for tax purposes over a period of 15 years. The intangible assets, which relate to customer relationships, will be amortized on a straight-line basis over 16 years. The goodwill is attributable to the Schwab Corporate and Retirement Services segment.

 

The purchase price and resultant recognition of goodwill reflect the Company’s increased ability to meet the needs of retirement plans of all sizes, as well as the opportunity to capture rollover accounts from retirement plans served by The 401(k) Company and by cross-selling the Company’s other investment and banking services to such accounts.

 

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Table of Contents

THE CHARLES SCHWAB CORPORATION

Notes to Condensed Consolidated Financial Statements

(Tabular Amounts in Millions, Except Per Share Data, Option Price Amounts, Ratios, and as Noted)

(Unaudited)

 

4. Taxes on Income

 

With the implementation of FIN No. 48 on January 1, 2007, the Company recorded a charge to retained earnings of $17 million related to various federal and state income tax matters, including estimated interest. The balance of the Company’s unrecognized tax benefits at June 30 and January 1, 2007 is approximately $21 million and $20 million, respectively, which includes $16 million and $15 million, respectively, related to discontinued operations. The Company’s unrecognized tax benefits, which are included in accrued expenses and other liabilities on the Company’s condensed consolidated balance sheets, represent the difference between positions taken on tax return filings compared to the requirements under FIN No. 48 to consider potential tax settlement outcomes. Resolving these uncertain tax matters in the Company’s favor would reduce income tax expense from continuing operations by $5 million.

 

The Company recognizes interest and penalties related to unrecognized tax benefits in taxes on income. Interest charges for the second quarter and first half of 2007 were $1 million. At June 30, 2007, the Company had a liability for estimated interest on the unrecognized tax benefits of $5 million, which includes $3 million related to discontinued operations.

 

CSC and its subsidiaries file income tax returns in the federal jurisdiction, as well as most state and local jurisdictions and are subject to routine examinations by the respective taxing authorities. Based upon the expected completion of audits within the next 12 months, management does not expect a change in the unrecognized tax benefits to be material to the financial statements. The federal returns have been audited through 2004 and those audits are complete subject to the resolution of a 1989 tax matter that is pending final decision by the 9th Circuit Court of Appeals. Until final resolution of this matter, all federal and state income tax returns for the years 1989 and after remain technically open for examination.

 

5. Comprehensive Income

 

Comprehensive income includes net income and changes in equity except those resulting from investments by, or distributions to, stockholders. Comprehensive income is presented in the following table:

 

    

Three Months

Ended

June 30,


   

Six Months

Ended

June 30,


 
     2007

    2006

    2007

    2006

 

Net income

   $       292     $       251     $       565     $       494  

Other comprehensive loss:

                                

Change in unrealized gain on cash flow hedging instruments:

                                

Unrealized gain

     3       9       1       20  

Income tax expense

     (1 )     (4 )           (9 )
    


 


 


 


Net

     2       5       1       11  
    


 


 


 


Change in unrealized loss on securities available for sale:

                                

Unrealized loss

     (49 )     (32 )     (36 )     (69 )

Income tax benefit

     20       13       15       30  
    


 


 


 


Net

     (29 )     (19 )     (21 )     (39 )
    


 


 


 


Total other comprehensive loss

     (27 )     (14 )     (20 )     (28 )
    


 


 


 


Comprehensive income

   $       265     $       237     $       545     $       466  
    


 


 


 


 

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Table of Contents

THE CHARLES SCHWAB CORPORATION

Notes to Condensed Consolidated Financial Statements

(Tabular Amounts in Millions, Except Per Share Data, Option Price Amounts, Ratios, and as Noted)

(Unaudited)

 

6. Earnings Per Share

 

Basic EPS is computed by dividing net income by the weighted-average number of common shares outstanding for the period. Diluted EPS is computed by dividing net income by the weighted-average number of common shares plus the effect of dilutive potential common shares outstanding for the period using the treasury stock method. Dilutive potential common shares include outstanding stock options and unvested restricted stock awards. EPS under the basic and diluted computations are presented in the following table:

 

    

Three Months

Ended

June 30,


  

Six Months

Ended

June 30,


     2007

   2006

   2007

   2006

Net income

   $       292    $       251    $       565    $       494
    

  

  

  

Weighted-average common shares outstanding – basic

     1,243      1,278      1,247      1,280

Common stock equivalent shares related to stock incentive plans

     14      16      15      15
    

  

  

  

Weighted-average common shares outstanding – diluted (1)

     1,257      1,294      1,262      1,295
    

  

  

  

Basic EPS:

                           

Income from continuing operations

   $       .21    $       .17    $       .39    $       .34

Income from discontinued operations, net of tax

   $       .03    $       .03    $       .06    $       .05

Net income

   $       .24    $       .20    $       .45    $       .39
    

  

  

  

Diluted EPS:

                           

Income from continuing operations

   $       .20    $       .17    $       .39    $       .34

Income from discontinued operations, net of tax

   $       .03    $       .02    $       .06    $       .04

Net income

   $       .23    $       .19    $       .45    $       .38
    

  

  

  


(1)

Antidilutive stock options excluded from the calculation of diluted earnings per share were 24 million and 34 million shares for the second quarters of 2007 and 2006, respectively, and 27 million and 35 million shares for the first halves of 2007 and 2006, respectively.

 

7. Regulatory Requirements

 

CSC is a financial holding company, which is a type of bank holding company subject to supervision and regulation by the Board of Governors of the Federal Reserve System (the Federal Reserve Board) under the Bank Holding Company Act of 1956, as amended (the Act). In July 2006, USTC (currently reflected as a discontinued operation for financial statement purposes) became a financial holding company.

 

Under the Act, the Federal Reserve Board has established consolidated capital requirements for bank holding companies. CSC and USTC are subject to those guidelines. CSC’s primary depository institution subsidiaries are Schwab Bank and United States Trust Company, National Association (United States Trust NA).

 

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Table of Contents

THE CHARLES SCHWAB CORPORATION

Notes to Condensed Consolidated Financial Statements

(Tabular Amounts in Millions, Except Per Share Data, Option Price Amounts, Ratios, and as Noted)

(Unaudited)

 

The regulatory capital and ratios including discontinued operations are as follows:

 

          Actual

    Minimum Capital
Requirement


   

Minimum to be

Well Capitalized (1)


 

June 30, 2007


        Amount

   Ratio

    Amount

   Ratio

    Amount

   Ratio

 
Tier 1 Capital:    Company      $  4,057    15.2 %     $  1,067    4.0 %   N/A       
     Schwab Bank      $     808    15.4 %     $     210    4.0 %     $     315    6.0 %
     U.S. Trust      $     832    12.9 %     $     257    4.0 %   N/A       
     United States Trust NA      $     730    11.6 %     $     251    4.0 %     $     376    6.0 %
Total Capital:    Company      $  4,089    15.3 %     $  2,135    8.0 %   N/A       
     Schwab Bank      $     814    15.5 %     $     421    8.0 %     $     526    10.0 %
     U.S. Trust      $     857    13.3 %     $     515    8.0 %   N/A       
     United States Trust NA      $     756    12.0 %     $     502    8.0 %     $     627    10.0 %
Leverage:    Company      $  4,057    8.6 %     $  1,895    4.0 %   N/A       
     Schwab Bank      $     808    6.6 %     $     493    4.0 %     $     616    5.0 %
     U.S. Trust      $     832    8.0 %     $     416    4.0 %   N/A       
     United States Trust NA      $     730        7.2 %     $     407        4.0 %     $     509        5.0 %
          Actual

    Minimum Capital
Requirement


    Minimum to be
Well Capitalized (1)


 

December 31, 2006


        Amount

   Ratio

    Amount

   Ratio

    Amount

   Ratio

 
Tier 1 Capital:    Company      $  4,137    15.5 %     $  1,066    4.0 %   N/A       
     Schwab Bank      $     705    14.1 %     $     200    4.0 %     $     300    6.0 %
     U.S. Trust      $     875    13.6 %     $     258    4.0 %   N/A       
     United States Trust NA      $     735    11.7 %     $     252    4.0 %     $     377    6.0 %
Total Capital:    Company      $  4,168    15.6 %     $  2,132    8.0 %   N/A       
     Schwab Bank      $     709    14.2 %     $     400    8.0 %     $     500    10.0 %
     U.S. Trust      $     901    14.0 %     $     516    8.0 %   N/A       
     United States Trust NA      $     761    12.1 %     $     503    8.0 %     $     629    10.0 %
Leverage:    Company      $  4,137    8.9 %     $  1,857    4.0 %   N/A       
     Schwab Bank      $     705    6.7 %     $     420    4.0 %     $     525    5.0 %
     U.S. Trust      $     875    7.9 %     $     443    4.0 %   N/A       
     United States Trust NA      $     735        6.8 %     $     434        4.0 %     $     543        5.0 %

N/A Not applicable.

 

(1)

Applicable only to depository institutions.

 

Based on their respective regulatory capital ratios at June 30, 2007 and December 31, 2006, Schwab Bank and United States Trust NA are considered well capitalized (the highest category) pursuant to banking regulatory guidelines.

 

Schwab is subject to the Uniform Net Capital Rule under the Securities Exchange Act of 1934 (the Rule). Schwab computes net capital under the alternative method permitted by this 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. At June 30, 2007, 2% of aggregate debits was $242 million, which exceeded the minimum dollar requirement for Schwab of $250,000. At June 30, 2007, Schwab’s net capital was $1.1 billion (9.3% of aggregate debit balances), which was $886 million in excess of its minimum required net capital and $523 million in excess of 5% of aggregate debit balances. Under the alternative method, a broker-dealer may not repay subordinated borrowings, pay cash dividends, or make any

 

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Table of Contents

THE CHARLES SCHWAB CORPORATION

Notes to Condensed Consolidated Financial Statements

(Tabular Amounts in Millions, Except Per Share Data, Option Price Amounts, Ratios, and as Noted)

(Unaudited)

 

unsecured advances or loans to its parent 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.

 

8. Commitments and Contingent Liabilities

 

Guarantees: The Company recognizes, at the inception of a guarantee, a liability for the estimated fair value of the obligation undertaken in issuing the guarantee. The fair values of the obligations relating to standby letters of credit (LOCs) are estimated based on fees charged to enter into similar agreements, considering the creditworthiness of the counterparties. The fair values of the obligations relating to other guarantees are estimated based on transactions for similar guarantees or expected present value measures.

 

In the normal course of business, the Company provides certain indemnifications (i.e., protection against damage or loss) to counterparties in connection with the disposition of certain of its assets. Such indemnifications are generally standard contractual terms with various expiration dates and typically relate to title to the assets transferred, ownership of intellectual property rights (e.g., patents), accuracy of financial statements, compliance with laws and regulations, failure to pay, satisfy or discharge any liability, or to defend claims, as well as errors, omissions, and misrepresentations. The maximum potential future liability under these indemnifications cannot be estimated. The Company has not recorded a liability for these indemnifications and believes that the occurrence of events that would trigger payments under these agreements is remote.

 

Separately, the Company has guaranteed certain payments in the event of a termination of certain mutual fund sub-advisor agreements, related to the adoption of AXA Rosenberg LLC’s U.S. family of mutual funds, known as the Laudus Funds®. Additionally, the Company has provided indemnifications related to facility leases and technology services to a counterparty in connection with the disposition of certain of its assets. At June 30, 2007, the Company’s maximum potential future liability under these agreements was approximately $140 million. Further, as discussed below under “Legal contingencies,” the Company provided an indemnification to UBS Securities LLC and UBS Americas Inc. (collectively referred to as UBS) for expenses associated with certain litigation. At June 30, 2007, the Company has a recorded liability of approximately $30 million reflecting the estimated fair value of these guarantees and indemnifications. The fair value of these guarantees and indemnifications is not necessarily indicative of amounts that would be paid in the event a payment was required.

 

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 LOCs, in favor of the clearing houses, which are issued by multiple banks. At June 30, 2007, the aggregate face amount of these outstanding LOCs totaled $1.1 billion. 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 June 30, 2007, the aggregate face amount of these outstanding LOCs totaled $201 million. No funds were drawn under these LOCs at June 30, 2007.

 

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 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 transactions.

 

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

 

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Table of Contents

THE CHARLES SCHWAB CORPORATION

Notes to Condensed Consolidated Financial Statements

(Tabular Amounts in Millions, Except Per Share Data, Option Price Amounts, Ratios, and as Noted)

(Unaudited)

 

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.

 

The Company believes it has strong defenses in all significant matters currently pending and is vigorously 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. Predicting the outcome of a matter is inherently difficult, particularly where claimants seek substantial or unspecified damages, or when investigations or legal proceedings are at an early stage. In many cases, including those 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 close to resolution. However, based on current information and consultation with counsel, management believes that the resolution of matters currently pending, including those described below, will not have a material adverse 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.

 

SoundView Litigation: As part of the sale of Schwab Capital Markets L.P. and all of the outstanding capital stock of SoundView Technology Group, Inc. (SoundView), (collectively referred to as Schwab Soundview Capital Markets, or SSCM), to UBS, the Company agreed to indemnify UBS for certain litigation, including the claims described below.

 

SoundView and certain of its subsidiaries are among the numerous financial institutions named as defendants in multiple purported securities class actions filed in the United States District Court for the Southern District of New York (the IPO Allocation Litigation) between June and December 2001. The IPO Allocation Litigation was brought on behalf of persons who either directly or in the aftermarket purchased IPO securities between March 1997 and December 2000. The plaintiffs allege that SoundView entities and the other underwriters named as defendants required customers receiving allocations of IPO shares to pay excessive and undisclosed commissions on unrelated trades and to purchase shares in the aftermarket at prices higher than the IPO price, in violation of the federal securities laws. SoundView entities have been named in 31 of the actions, each involving a different company’s IPO, and had underwriting commitments in approximately 90 other IPOs that are the subject of lawsuits. SoundView entities have not been named as defendants in these cases, although the lead underwriters in those IPOs have asserted that depending on the outcome of the cases, SoundView entities may have indemnification or contribution obligations based on underwriting commitments in the IPOs. The parties, with the assent of the District Court, selected 17 cases as focus cases for the purpose of case-specific discovery, and in October 2004, the District Court allowed 6 of the focus cases to proceed as class actions. Defendants appealed that decision to the United States Court of Appeals for the Second Circuit, which issued an order on December 5, 2006 reversing the District Court’s decision to allow the 6 focus cases to proceed as class actions. On April 6, 2007, the Court of Appeals denied the plaintiffs’ request for rehearing. The Company will continue to vigorously contest these claims on behalf of SoundView pursuant to the indemnity with UBS.

 

9. Financial Instruments Subject to Off-Balance Sheet Risk, Credit Risk, or Market Risk

 

Interest rate swaps: CSC uses Swaps to effectively convert the interest rate characteristics of a portion of its Medium-Term Notes from fixed to variable. These Swaps are structured for CSC to receive a fixed rate of interest and pay a variable rate of interest based on the three-month LIBOR rate. The variable interest rates reset every three months. Information on these Swaps is summarized in the following table:

 

    

June 30,

2007


   

December 31,

2006


 

Notional principal amount

     $         253       $   253  

Weighted-average variable interest rate

     7.91 %     7.91 %

Weighted-average fixed interest rate

     7.78 %     7.78 %

Weighted-average maturity (in years)

     2.2       2.7  

 

These Swaps have been designated as fair value hedges under SFAS No. 133. Changes in the fair value of the Swaps

 

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Table of Contents

THE CHARLES SCHWAB CORPORATION

Notes to Condensed Consolidated Financial Statements

(Tabular Amounts in Millions, Except Per Share Data, Option Price Amounts, Ratios, and as Noted)

(Unaudited)

 

are offset by changes in fair value of the hedged Medium-Term Notes. At June 30, 2007 and December 31, 2006, CSC recorded a derivative liability of $1 million and a derivative asset of approximately $500,000, respectively, for these Swaps.

 

Forward sale and interest rate lock commitments: Schwab Bank’s loans held for sale portfolio consists of fixed- and adjustable-rate mortgages, which are subject to a loss in value when market interest rates rise. Schwab Bank uses forward sale commitments to manage this risk. These forward sale commitments have been designated as cash flow hedging instruments with respect to the loans held for sale. Accordingly, the fair values of these forward sale commitments are recorded on the Company’s condensed consolidated balance sheets, with gains or losses recorded in other comprehensive income (loss). Amounts included in other comprehensive income (loss) are reclassified into earnings when the related loan is sold. At both June 30, 2007 and December 31, 2006, the derivative asset and liability recorded by Schwab Bank for these forward sale commitments was immaterial.

 

Additionally, Schwab Bank uses forward sale commitments to hedge interest rate lock commitments issued on mortgage loans that will be held for sale. Schwab Bank considers the fair value of these commitments to be zero at the commitment date, with subsequent changes in fair value determined solely based on changes in market interest rates. Any changes in fair value of the interest rate lock commitments are completely offset by changes in fair value of the related forward sale commitments. Schwab Bank had interest rate lock commitments on mortgage loans to be held for sale with principal balances totaling approximately $158 million and $122 million at June 30, 2007 and December 31, 2006, respectively. At both June 30, 2007 and December 31, 2006, the derivative asset and liability recorded by Schwab Bank for these interest rate lock commitments and the related forward sale commitments was immaterial.

 

10. Segment Information

 

The Company structures its segments according to its various types of clients and the services provided to those clients. The Company’s three reportable segments are Schwab Investor Services, Schwab Institutional®, and Schwab Corporate and Retirement Services. As a result of organizational and related business changes in the second quarter of 2007, the corporate and retirement services business, which was historically included within the Schwab Investor Services segment, has been separated into its own segment called Schwab Corporate and Retirement Services. Additionally, the mutual fund clearing services business, which was historically included in unallocated and other, is included within the Schwab Corporate and Retirement Services segment. Previously-reported segment information has been revised to reflect these changes. As a result of the Company’s sale of U.S. Trust in 2007, the previously-reported U.S. Trust segment has been eliminated. The Company evaluates the performance of its segments on a pre-tax basis excluding items such as restructuring charges, impairment charges, discontinued operations, and extraordinary items. Intersegment net revenues are not material and are therefore not disclosed.

 

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Table of Contents

THE CHARLES SCHWAB CORPORATION

Notes to Condensed Consolidated Financial Statements

(Tabular Amounts in Millions, Except Per Share Data, Option Price Amounts, Ratios, and as Noted)

(Unaudited)

 

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

 

    

Three Months

Ended

June 30,


   

Six Months

Ended

June 30,


 
     2007

    2006

    2007

    2006

 

Net revenues:

                                

Schwab Investor Services

     $ 811       $ 757       $ 1,588       $   1,488  

Schwab Institutional

     270       243       531       481  

Schwab Corporate and Retirement Services

     127       89       237       177  

Unallocated and other (1)

     (3 )     4       2       1  
    


 


 


 


Total net revenues

     $   1,205       $   1,093       $   2,358       $   2,147  
    


 


 


 


Income from continuing operations before taxes on income:

                                

Schwab Investor Services

     $ 291       $ 253       $ 543       $ 480  

Schwab Institutional

     108       97       217       206  

Schwab Corporate and Retirement Services

     34       24       64       48  

Unallocated and other

     (9 )     (5 )     (9 )     (12 )
    


 


 


 


Income from continuing operations before taxes on income

     424       369       815       722  

Taxes on income

     (168 )     (146 )     (323 )     (285 )

Income from discontinued operations, net of tax

     36       28       73       57  
    


 


 


 


Net income

     $ 292       $ 251       $ 565       $ 494  
    


 


 


 



(1)

Includes gains (losses) on investments.

 

11. Supplemental Cash Flow Information

 

Certain information affecting the cash flows of the Company is presented in the following table:

 

    

Six Months

Ended

June 30,


     2007

   2006

Income taxes paid (1)

     $   222      $   270
    

  

Interest paid:

             

Brokerage client cash balances

     $   187      $   218

Deposits from banking clients

     123      67

Long-term debt

     10      12

Other

     11      10
    

  

Total interest paid

     $   331      $   307
    

  

Non-cash investing and financing activities:

             

Treasury Stock (2)

     $ 18      $

(1)

Includes discontinued operations.

 

(2)

Amount purchased during the period, but settled after period end.

 

12. Discontinued Operations

 

On November 19, 2006, CSC entered into a definitive agreement with Bank of America pursuant to which Bank of America agreed to acquire all of the outstanding common stock of U.S. Trust for $3.3 billion in cash. See note “14 – Subsequent Events” for a discussion of the completion of the sale of U.S. Trust.

 

The results of operations, net of income taxes, and cash flows of U.S. Trust have been presented as discontinued operations on the Company’s condensed consolidated statements of income and of cash flows for all periods, and the

 

 

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Table of Contents

THE CHARLES SCHWAB CORPORATION

Notes to Condensed Consolidated Financial Statements

(Tabular Amounts in Millions, Except Per Share Data, Option Price Amounts, Ratios, and as Noted)

(Unaudited)

 

assets and liabilities of U.S. Trust have each been combined and presented as assets and liabilities of discontinued operations on the Company’s condensed consolidated balance sheets. The Company’s consolidated prior period revenues, expenses, taxes on income, assets, liabilities, and cash flows also reflect this presentation.

 

Summarized financial information for discontinued operations related to U.S. Trust is as follows:

 

     June 30,
2007


   December 31,
2006


 

Assets

               

Cash and cash equivalents

     $ 289      $ 625  

Cash and investment segregated and on deposit for federal and other regulatory purposes

     7      11  

Loans to banking clients – net

     7,229      7,090  

Securities owned

     2,336      2,571  

Equipment, office facilities, and property – net

     103      97  

Goodwill

     390      390  

Intangible assets – net

     119      119  

Other assets

     440      442  

Assets retained from discontinued operations

          (749 )
    

  


Total assets

     $   10,913      $   10,596  
    

  


Liabilities

               

Deposits from banking clients (net of liabilities retained)

     $ 8,574      $ 8,532  

Accrued expenses and other liabilities

     328      379  

Short-term borrowings

     674      101  

Long-term debt

          52  
    

  


Total liabilities

     $ 9,576      $ 9,064  
    

  


 

The components of income from discontinued operations related to U.S. Trust are as follows:

 

    

Three Months

Ended

June 30,


   

Six Months

Ended

June 30,


 
     2007

    2006

    2007

    2006

 

Net revenues

     $     227       $     218       $     446       $     443  

Income, before taxes

     $ 58       $ 42       $   116       $ 88  

Taxes on income

     $ (21 )     $ (15 )     $ (43 )     $ (33 )

Income, net of tax

     $ 37       $ 27       $ 73       $ 55  

 

In the fourth quarter of 2006, the Company recorded a $205 million income tax benefit related to the estimated difference between the tax and book bases of the Company’s U.S. Trust stock. This amount is included in income from discontinued operations, net of tax on the Company’s consolidated statements of income. When calculating the Company’s gain on the sale of U.S. Trust for income tax purposes, the tax basis will be the basis of U.S. Trust’s prior stockholders in their shares as of the date U.S. Trust was acquired by the Company, since the transaction qualified as a tax-free exchange. This tax benefit is management’s current estimate and is based on publicly available information, including information on the composition of U.S. Trust’s stockholders at the acquisition date and the market price of U.S. Trust stock during relevant periods. The final amount of the basis difference, which could differ from management’s estimate, will be determined following a survey of former U.S. Trust stockholders that the Company expects to complete in the third quarter of 2007.

 

The assets retained from discontinued operations reflect the excess cash held in certain Schwab brokerage client accounts that was previously swept into a money market deposit account at U.S. Trust. In May 2007, Schwab terminated this intercompany arrangement and moved all of these balances to a similar existing arrangement with

 

 

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Table of Contents

THE CHARLES SCHWAB CORPORATION

Notes to Condensed Consolidated Financial Statements

(Tabular Amounts in Millions, Except Per Share Data, Option Price Amounts, Ratios, and as Noted)

(Unaudited)

 

Schwab Bank. At December 31, 2006, these balances totaled $749 million and were included in deposits from banking clients with a corresponding amount in assets retained from discontinued operations on the Company’s condensed consolidated balance sheets. The interest expense related to these client deposit balances maintained at U.S. Trust is included in interest expense from continuing operations on the Company’s condensed consolidated statements of income of $1 million and $3 million for the second quarters of 2007 and 2006, respectively, and $4 million and $5 million for the first halves of 2007 and 2006, respectively. The corresponding interest revenue on the invested cash balances related to these deposits is included in interest revenue from continuing operations on the Company’s condensed consolidated statements of income of $4 million and $10 million for the second quarters of 2007 and 2006, respectively, and $14 million and $18 million for the first halves of 2007 and 2006, respectively. The interest revenue amount is calculated using the Company’s funds transfer pricing methodology, which is used by management to estimate the interest earned on the investment of these deposit balances.

 

13. Restructuring Reserve

 

A summary of the activity in the facilities restructuring reserve related to the Company’s past restructuring initiatives, as well as certain retained restructuring-related obligations following the past sales of SSCM and Charles Schwab Europe, for the first half of 2007 is as follows:

 

     Three Months
Ended
June 30, 2007


    Six Months
Ended
June 30, 2007


 

Beginning balance

     $     101       $   112  

Restructuring credit (1)

     (1 )     (3 )

Cash payments - net

     (9 )     (19 )

Other (2)

     1       2  
    


 


Ending balance at June 30, 2007 (3)

     $ 92       $ 92  
    


 



(1)

Represents change in sublease assumptions.

 

(2)

Primarily includes the accretion of facilities restructuring reserves, which are initially recorded at net present value. Accretion expense is recorded in occupancy and equipment expense on the Company’s condensed consolidated statements of income.

 

(3)

The Company expects to substantially utilize the remaining facilities restructuring reserve through cash payments for the net lease expense over the respective lease terms through 2017.

 

The actual costs of the remaining restructuring reserve related to these restructuring initiatives could differ from the estimated costs, depending primarily on the Company’s ability to sublease properties.

 

14. Subsequent Events

 

On July 1, 2007, CSC completed the sale of U.S. Trust to Bank of America for $3.3 billion in cash. CSC will recognize a pre-tax gain on the sale of approximately $1.9 billion in the third quarter of 2007.

 

On July 2, 2007, CSC announced its plan to return approximately $3.5 billion in capital to stockholders and create a more efficient and cost-effective capital structure. The plan includes the following components:

 

   

CSC announced a special cash dividend of $1.00 per common share, which will return approximately $1.2 billion to stockholders. The special dividend is payable on August 24, 2007, to stockholders of record at the close of business on July 24, 2007.

 

   

CSC announced a share repurchase through a modified “Dutch Auction” Tender Offer (Tender Offer). CSC filed a Schedule TO Tender Offer Statement with the SEC on July 3, 2007. Pursuant to the Tender Offer, CSC offered to purchase up to 84 million shares of its common stock, par value $.01 per share, at a purchase price not greater than $22.50 nor less than $19.50 per share, net to the seller in cash, less any applicable

 

 

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Table of Contents

THE CHARLES SCHWAB CORPORATION

Notes to Condensed Consolidated Financial Statements

(Tabular Amounts in Millions, Except Per Share Data, Option Price Amounts, Ratios, and as Noted)

(Unaudited)

 

 

withholding taxes and without interest. The Tender Offer period closed on July 31, 2007 and CSC accepted for purchase 84 million shares of its common stock, at a purchase price of $20.50 per share, for a total purchase price of approximately $1.7 billion.

 

 

 

CSC entered into a separate Stock Purchase Agreement with Chairman and CEO Charles R. Schwab, CSC’s largest stockholder, and with certain additional stockholders whose shares Mr. Schwab is deemed to beneficially own. Under the Stock Purchase Agreement, Mr. Schwab and the other stockholders who are parties to the agreement agreed not to participate in the Tender Offer, and instead, have agreed to sell, and CSC has agreed to purchase, 18 million shares, at a purchase price ($20.50 per share), which is the same as was determined and paid in the Tender Offer, for a total purchase price of $369 million. The number of shares to be repurchased was calculated to result in Mr. Schwab maintaining the same beneficial ownership interest in CSC’s outstanding common stock that he currently has (approximately 18 percent, which does not take into consideration Mr. Schwab’s outstanding options to acquire stock). The purchase price under the Stock Purchase Agreement will be paid on August 15, 2007, which is the 11th business day following the expiration of the Tender Offer.

 

   

CSC announced its plan to offer debt of up to $750 million consisting of a combination of senior notes and hybrid capital securities.

Under the tender offer rules, CSC is prohibited from making open market repurchases of its common stock until August 15, 2007.

 

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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, and 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. All information contained in this Form 10-Q is presented on a continuing operations basis unless otherwise noted. Results for the second quarters and first halves of 2007 and 2006 are shown in the following table:

 

    

Three Months

Ended

June 30,


   

Percent
Change


   

Six Months

Ended

June 30,


   

Percent
Change


 
     2007

    2006

      2007

    2006

   

Client Activity Metrics:

                                            

Net new client assets (in billions) (1)

     $        26.4       $        18.7     41 %     $        77.7       $        45.1     72 %

Client assets (in billions, at quarter end)

     $   1,383.6       $   1,126.4     23 %                      

Clients’ daily average trades (in thousands)

     257.9       286.7     (10 %)     262.0       299.1     (12 %)

Company Financial Metrics:

                                            

Net revenue growth from prior year’s period

     10 %     24 %           10 %     24 %      

Pre-tax profit margin from continuing operations

     35.2 %     33.8 %           34.6 %     33.6 %      

Return on stockholders’ equity

     23 %     22 %           22 %     22 %      

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

     $         371       $         373     (1 %)     $         369       $         368      

(1)

The first half of 2007 includes $17.8 billion related to the acquisition of The 401(k) Company. Effective in the second quarter of 2007, amount includes balances covered by 401(k) record keeping-only services, which totaled $5.2 billion at May 31, 2007, related to the March 2007 acquisition of The 401(k) Company.

 

During the second quarter of 2007, the market environment improved and the Company continued to strengthen its operating and financial performance. Net new client assets of $26.4 billion for the second quarter of 2007 were 29% higher than the second quarter of 2006. Total client assets rose by 19% from the second quarter of 2006 to $1.384 trillion at June 30, 2007. Net revenues grew on a year-over-year basis, rising by 10% compared to the second quarter of 2006. This increase was primarily due to growth in client assets, as well as higher interest rate spreads resulting from the higher interest rate environment. These factors contributed to a 15% increase in asset-based and other revenues (which include asset management and administration fees, net interest revenue, and other revenues) to a record $1,007 million. Total expenses in the second quarter of 2007 increased $57 million, or 8%, compared to the second quarter of 2006, primarily due to higher compensation and benefits expense and professional services expense. Pre-tax profit margin from continuing operations was 35.2%, which represents an increase from 33.8% in the second quarter of 2006. Net income grew to $292 million, up 16% compared to the second quarter of 2006. Return on stockholders’ equity increased to 23% in the second quarter of 2007, compared to 22% in the second quarter of 2006, as earnings grew and the Company continued to actively manage its capital base.

 

Discontinued Operations

 

On November 19, 2006, CSC entered into a definitive agreement with Bank of America Corporation (Bank of America) pursuant to which Bank of America agreed to acquire all of the outstanding common stock of U.S. Trust Corporation (USTC, and with its subsidiaries collectively referred to as U.S. Trust) for $3.3 billion in cash. The transaction closed on July 1, 2007. The Company will recognize a pre-tax gain on the sale of approximately $1.9 billion in the third quarter of 2007.

 

The results of operations, net of income taxes, and cash flows of U.S. Trust have been presented as discontinued operations on the Company’s condensed consolidated statements of income and of cash flows, respectively, and the

 

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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, and as Noted)

 

assets and liabilities of U.S. Trust have been combined and presented as assets and liabilities of discontinued operations on the Company’s condensed consolidated balance sheets. The Company’s consolidated prior period revenues, expenses, taxes on income, assets, liabilities, and cash flows also reflect this presentation.

 

Business Acquisition

 

On March 31, 2007, the Company completed its acquisition of The 401(k) Company, which offers defined contribution plan services, for $115 million in cash. As a result of a purchase price allocation, the Company recorded goodwill of $105 million and intangible assets of $8 million. The intangible assets will be amortized over 16 years.

 

Subsequent Events

 

See note “14 – Subsequent Events” in the Notes to Condensed Consolidated Financial Statements for a discussion of the sale of U.S. Trust and the Company’s capital restructuring plan.

 

RESULTS OF OPERATIONS

 

    

Three Months

Ended

June 30,


   

Percent
Change


   

Six Months

Ended

June 30,


   

Percent
Change


 
     2007

    2006

      2007

    2006

   

Asset-based and other revenues

     $   1,007       $     883     14 %     $   1,958       $   1,710     15 %

Trading revenue

     198       210     (6 %)     400       437     (8 %)
    


 


 

 


 


 

Total net revenues

     1,205       1,093     10 %     2,358       2,147     10 %

Expenses excluding interest

     781       724     8 %     1,543       1,425     8 %
    


 


 

 


 


 

Income from continuing operations before taxes on income

     424       369     15 %     815       722     13 %

Taxes on income

     (168 )     (146 )   15 %     (323 )     (285 )   13 %
    


 


 

 


 


 

Income from continuing operations

     256       223     15 %     492       437     13 %

Income from discontinued operations, net of tax

     36       28     29 %     73       57     28 %
    


 


 

 


 


 

Net income

     $ 292       $   251     16 %     $ 565       $ 494     14 %
    


 


 

 


 


 

Earnings per share – diluted

     $ .23       $ .19     21 %     $ .45       $ .38     18 %

Pre-tax profit margin from continuing operations

     35.2 %     33.8 %           34.6 %     33.6 %      

Effective income tax rate on income from continuing operations

     39.6 %     39.6 %           39.6 %     39.5 %      

 

The increase in asset-based and other revenues from the second quarter and first half of 2006 was due to an increase in asset management and administration fees resulting from higher levels of client assets, and an increase in net interest revenue resulting from yields on assets increasing faster than those on liabilities. The decline in trading revenue from the second quarter and first half of 2006 was primarily due to lower daily average revenue trades, partially offset by higher average revenue earned per revenue trade.

 

The increase in expenses excluding interest from the second quarter and first half of 2006 was mainly due to higher compensation and benefits expense and professional services expense, as well as higher advertising and market development expense in the first half of 2007.

 

- 20 -


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, and as Noted)

 

Segment Information

 

The Company provides financial services to individuals, and institutional and corporate clients through three segments – Schwab Investor Services, Schwab Institutional®, and Schwab Corporate and Retirement Services. As a result of organizational and related business changes in the second quarter of 2007, the corporate and retirement services business, which was historically included within the Schwab Investor Services segment, has been separated into its own segment called Schwab Corporate and Retirement Services. Additionally, the mutual fund clearing services business, which was historically included in unallocated and other, is included within the Schwab Corporate and Retirement Services segment. Previously-reported segment information has been revised to reflect these changes. The Schwab Investor Services segment includes the Company’s retail brokerage and banking operations. The Schwab Institutional segment provides custodial, trading, and support services to independent investment advisors. The Schwab Corporate and Retirement Services segment provides retirement plan services, plan administrator services, stock plan services, and mutual fund clearing services and supports the availability of Schwab proprietary mutual funds on third-party platforms.

 

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

 

    

Three Months

Ended

June 30,


   

Percent
Change


   

Six Months

Ended

June 30,


   

Percent
Change


 
     2007

    2006

      2007

    2006

   

Schwab Investor Services:

                                            

Net revenues

     $      811       $      757     7 %     $   1,588       $   1,488     7 %

Expenses excluding interest

     520       504     3 %     1,045       1,008     4 %
    


 


 

 


 


 

Contribution margin

     $      291       $      253     15 %     $      543       $      480     13 %
    


 


 

 


 


 

Schwab Institutional:

                                            

Net revenues

     $      270       $      243     11 %     $      531       $      481     10 %

Expenses excluding interest

     162       146     11 %     314       275     14 %
    


 


 

 


 


 

Contribution margin

     $      108       $ 97     11 %     $      217       $      206     5 %
    


 


 

 


 


 

Schwab Corporate and Retirement Services:

                                            

Net revenues

     $      127       $ 89     43 %     $      237       $      177     34 %

Expenses excluding interest

     93       65     43 %     173       129     34 %
    


 


 

 


 


 

Contribution margin

     $ 34       $ 24     42 %     $ 64       $ 48     33 %
    


 


 

 


 


 

Unallocated and other:

                                            

Net revenues

     $ (3 )     $ 4     N/M       $ 2       $ 1     100 %

Expenses excluding interest

     6       9     (33 %)     11       13     (15 %)
    


 


 

 


 


 

Contribution margin

     $ (9 )     $ (5 )   80 %     $ (9 )     $ (12 )   (25 %)
    


 


 

 


 


 

Total:

                                            

Net revenues

     $   1,205       $   1,093     10 %     $   2,358       $   2,147     10 %

Expenses excluding interest

     781       724     8 %     1,543       1,425     8 %
    


 


 

 


 


 

Contribution margin

     $      424       $      369     15 %     $      815       $      722     13 %
    


 


 

 


 


 


N/M Not meaningful.

 

- 21 -


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, and as Noted)

 

Schwab Investor Services

 

Net revenues increased by $54 million, or 7%, and $100 million, or 7%, from the second quarter and first half of 2006, respectively, due to higher asset management and administration fees and net interest revenue, partially offset by lower trading revenues. Asset management and administration fees increased as a result of higher balances of client assets in the Company’s proprietary mutual funds and Mutual Fund OneSource® service, as well as balances participating in advisory and managed account service programs. Net interest revenue increased due to higher levels of market interest rates and changes in the composition of interest-earning assets, including increases in securities available for sale and loans to banking clients, as well as generally higher yields on earning assets, partially offset by higher interest rates on banking deposits. Trading revenue decreased primarily due to lower daily average revenue trades, partially offset by higher average revenue earned per revenue trade. Expenses excluding interest increased by $16 million, or 3%, and $37 million, or 4%, from the second quarter and first half of 2006, respectively, primarily due to higher client servicing and other related expenses. The increases were partially offset by lower advertising and market development expense from the second quarter of 2006 as a result of decreased media spending.

 

Schwab Institutional

 

Net revenues increased by $27 million, or 11%, and $50 million, or 10%, from the second quarter and first half of 2006, respectively, due to higher asset management and administration fees as a result of increases in the balances of client assets in the Company’s proprietary mutual funds and Mutual Fund OneSource service. Expenses excluding interest increased by $16 million, or 11%, and $39 million, or 14%, from the second quarter and first half of 2006, respectively, primarily due to higher business development and other related expenses resulting from higher project spending.

 

Schwab Corporate and Retirement Services

 

Net revenues increased by $38 million, or 43%, and $60 million, or 34%, from the second quarter and first half of 2006, respectively, due to higher asset management and administration fees as a result of increases in balances of client assets in the Company’s proprietary mutual funds and Mutual Fund OneSource service. Expenses excluding interest increased by $28 million, or 43%, and $44 million, or 34%, from the second quarter and first half of 2006, respectively, primarily due to higher account servicing and related costs as a result of an 118% increase in the number of corporate retirement plan participants and 42% increase in client assets. Additionally, both net revenues and expenses excluding interest increased from the second quarter and first half of 2006 related to the recent acquisition of The 401(k) Company.

 

Net Revenues

 

The Company categorizes its revenues as either asset-based and other revenues or trading revenue. As shown in the following tables, asset-based and other revenues and total net revenues increased, while trading revenues decreased, in the second quarter and first half of 2007 from the same periods in 2006.

 

- 22 -


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, and as Noted)

 

Sources of Net Revenues

 

Three Months Ended June 30,

 

           2007

    2006

 
    

Percent
Change


    Amount

   % of
Total Net
Revenues


    Amount

   % of
Total Net
Revenues


 

Asset-based and other revenues

                                

Asset management and administration fees (1)

                                

Mutual fund service fees:

                                

Proprietary funds (Schwab Funds® and Laudus Funds®)

   22 %     $     285    24 %     $     234    21 %

Mutual Fund OneSource®

   21 %     164    14 %     135    12 %

Other

   29 %     18    1 %     14    1 %

Investment management and trust fees

   23 %     107    9 %     87    8 %

Other

   33 %     12    1 %     9    2 %
    

 

  

 

  

Asset management and administration fees

   22 %     586    49 %     479    44 %
    

 

  

 

  

Net interest revenue

                                

Interest revenue:

                                

Margin loans to clients

         211    18 %     212    19 %

Investments, client-related

   (14 %)     137    11 %     159    15 %

Securities available for sale

   22 %     96    8 %     79    7 %

Loans to banking clients

   29 %     40    3 %     31    3 %

Short-term investments

   N/M       31    3 %     10    1 %

Other

   (10 %)     38    3 %     42    4 %
    

 

  

 

  

Interest revenue

   4 %     553    46 %     533    49 %

Interest expense:

                                

Brokerage client cash balances

   (17 %)     89    7 %     107    10 %

Deposits from banking clients

   34 %     63    5 %     47    4 %

Long-term debt

   (13 %)     7    1 %     8    1 %

Other

   (17 %)     5    1 %     6    1 %
    

 

  

 

  

Interest expense

   (2 %)     164    14 %     168    16 %
    

 

  

 

  

Net interest revenue

   7 %     389    32 %     365    33 %
    

 

  

 

  

Other

   (18 %)     32    3 %     39    4 %
    

 

  

 

  

Total asset-based and other revenues

   14 %     1,007    84 %     883    81 %
    

 

  

 

  

Trading revenue

                                

Commissions

   (9 %)     175    15 %     193    18 %

Principal transactions

   35 %     23    1 %     17    1 %
    

 

  

 

  

Total trading revenue

   (6 %)     198    16 %     210    19 %
    

 

  

 

  

Total net revenues

   10 %     $   1,205    100 %     $   1,093    100 %
    

 

  

 

  


N/M Not meaningful.

 

(1)

Certain prior-year amounts have been reclassified to conform to the 2007 presentation.

 

- 23 -


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, and as Noted)

 

Sources of Net Revenues

 

Six Months Ended June 30,

 

           2007

    2006

 
     Percent
Change


    Amount

   % of
Total Net
Revenues


    Amount

   % of
Total Net
Revenues


 

Asset-based and other revenues

                                

Asset management and administration fees (1)

                                

Mutual fund service fees:

                                

Proprietary funds (Schwab Funds® and Laudus Funds®)

   20 %     $     553    23 %     $     459    21 %

Mutual Fund OneSource®

   18 %     312    13 %     265    12 %

Other

   14 %     32    1 %     28    1 %

Investment management and trust fees

   23 %     206    9 %     168    8 %

Other

   (6 %)     17    1 %     18    2 %
    

 

  

 

  

Asset management and administration fees

   19 %     1,120    47 %     938    44 %
    

 

  

 

  

Net interest revenue

                                

Interest revenue:

                                

Margin loans to clients

   2 %     419    18 %     411    19 %

Investments, client-related

   (13 %)     279    12 %     319    15 %

Securities available for sale

   36 %     187    8 %     137    6 %

Loans to banking clients

   31 %     77    3 %     59    3 %

Short-term investments

   N/M       64    3 %     18    1 %

Other

         78    3 %     78    4 %
    

 

  

 

  

Interest revenue

   8 %     1,104    47 %     1,022    48 %

Interest expense:

                                

Brokerage client cash balances

   (14 %)     185    8 %     216    10 %

Deposits from banking clients

   58 %     122    5 %     77    4 %

Long-term debt

   (7 %)     14    1 %     15    1 %

Other

   (9 %)     10          11     
    

 

  

 

  

Interest expense

   4 %     331    14 %     319    15 %
    

 

  

 

  

Net interest revenue

   10 %     773    33 %     703    33 %
    

 

  

 

  

Other

   (6 %)     65    3 %     69    3 %
    

 

  

 

  

Total asset-based and other revenues

   15 %     1,958    83 %     1,710    80 %
    

 

  

 

  

Trading revenue

                                

Commissions

   (13 %)     350    15 %     401    19 %

Principal transactions

   39 %     50    2 %     36    1 %
    

 

  

 

  

Total trading revenue

   (8 %)     400    17 %     437    20 %
    

 

  

 

  

Total net revenues

   10 %     $   2,358    100 %     $   2,147    100 %
    

 

  

 

  


N/M Not meaningful.

 

(1)

Certain prior-year amounts have been reclassified to conform to the 2007 presentation.

 

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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, and as Noted)

 

Asset Management and Administration Fees

 

Asset management and administration fees include mutual fund service fees, as well as fees for other asset-based financial services provided to individual and institutional clients. The Company earns mutual fund service fees for transfer agent services, shareholder services, administration, and investment management provided to its proprietary funds, and recordkeeping and shareholder services provided to third-party funds. These fees are based upon the daily balances of client assets invested in third-party funds and the Company’s proprietary 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, which include proprietary and third-party mutual funds, are primarily based on quoted market prices. Asset management and administration fees may vary with changes in the balances of client assets due to market fluctuations and levels of net new client assets.

 

The increase in asset management and administration fees from the second quarter and first half of 2006 was primarily due to higher mutual fund, advisory, and managed account asset balances. The $84 million, or 22%, and $145 million, or 19%, increase in mutual fund service fees from the second quarter and first half of 2006, respectively, was primarily due to a 28% rise in the Company’s proprietary mutual fund asset balances and a 22% increase in asset balances in Schwab’s Mutual Fund OneSource service. The $20 million, or 23%, and $38 million, or 23%, increase in investment management and trust fees from the second quarter and first half of 2006, respectively, was primarily due to higher balances of client assets participating in advisory and managed account services programs. At June 30, 2007, the Company’s total client assets increased $257.2 billion, or 23%, from June 30, 2006 due to $104.8 billion of net new client assets and $152.4 billion of net market gains.

 

Net Interest Revenue

 

Net interest revenue is the difference between interest earned on certain assets (mainly margin loans to clients, investments of segregated client cash balances, loans to banking clients, and securities available for sale) and interest paid on supporting liabilities (mainly deposits from banking clients and brokerage client cash balances). 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 reprice more quickly than interest-bearing liabilities). In the event of falling interest rates, the Company might 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.

 

In clearing its clients’ trades, 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. Margin loans arise when Schwab lends funds 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.

 

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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, and as Noted)

 

Client-related daily average balances, interest rates, and average net interest spread for the second quarters and first halves of 2007 and 2006 are summarized in the following table:

 

    

Three Months

Ended

June 30,


   

Six Months

Ended

June 30,


 
     2007

    2006

    2007

    2006

 

Interest-Earning Assets:

                                

Investments of segregated client cash balances:

                                

Average balance outstanding

     $   10,382       $   13,437       $   10,759       $   14,327  

Average interest rate

     5.29 %     4.75 %     5.23 %     4.50 %

Margin loans to clients:

                                

Average balance outstanding

     $   10,390       $   10,481       $   10,287       $   10,417  

Average interest rate

     8.18 %     8.12 %     8.22 %     7.96 %

Securities available for sale:

                                

Average balance outstanding (1)

     $ 7,379       $ 6,115       $ 7,104       $ 5,434  

Average interest rate

     5.21 %     5.21 %     5.31 %     5.09 %

Loans to banking clients:

                                

Average balance outstanding

     $ 2,600       $ 2,119       $ 2,500       $ 2,071  

Average interest rate

     6.09 %     5.86 %     6.17 %     5.76 %

Funding Sources:

                                

Interest-bearing brokerage client cash balances:

                                

Average balance outstanding

     $ 14,758       $ 18,673       $ 15,200       $ 19,529  

Average interest rate

     2.43 %     2.32 %     2.46 %     2.24 %

Interest-bearing banking deposits:

                                

Average balance outstanding (1)

     $ 12,159       $ 8,864       $ 11,722       $ 8,100  

Average interest rate

     2.07 %     2.12 %     2.10 %     1.91 %

Other interest-bearing sources:

                                

Average balance outstanding

     $ 2,043       $ 2,019       $ 1,890       $ 1,901  

Average interest rate

     2.03 %     2.27 %     2.19 %     2.26 %

Average noninterest-bearing portion

     $ 1,791       $ 2,596       $ 1,838       $ 2,719  

Summary:

                                

Total average balance on interest-earning assets

     $ 30,751       $ 32,152       $ 30,650       $ 32,249  

Average yield on interest-earning assets

     6.31 %     6.01 %     6.33 %     5.80 %

Total average balance on funding sources

     $ 30,751       $ 32,152       $ 30,650       $ 32,249  

Average interest rate on funding sources

     2.12 %     2.08 %     2.16 %     1.97 %
    


 


 


 


Average net interest spread

     4.19 %     3.93 %     4.17 %     3.83 %
    


 


 


 



(1)

Includes assets and liabilities retained from discontinued operations as discussed below.

 

The increase in net interest revenue from the second quarter and first half of 2006 was primarily due to higher levels of market interest rates and changes in the composition of interest-earning assets, including increases in securities available for sale and loans to banking clients, as well as generally higher yields on earning assets, partially offset by higher interest rates on banking deposits. Additionally, the Company’s average net interest spread increased from the second quarter and first half of 2006 as the average yield on interest-earning assets increased more than the average interest rate on funding sources.

 

The amount of excess cash held in certain Schwab brokerage client accounts that is swept into money market deposit accounts at Schwab Bank and (through May 2007) at U.S. Trust has increased significantly since the program’s inception in 2003. Average interest-bearing banking deposits increased $3.3 billion, or 37%, to $12.2 billion from the second quarter of 2006, and $3.6 billion, or 45%, to $11.7 billion from the first half of 2006. As a result, the average

 

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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, and as Noted)

 

securities available for sale balances increased $1.3 billion, or 21%, to $7.4 billion from the second quarter of 2006, and $1.7 billion, or 31%, to $7.1 billion from the first half of 2006, with higher levels of investments in corporate debt and mortgage-backed securities. Meanwhile, average interest-bearing brokerage client cash balances decreased $3.9 billion, or 21%, to $14.8 billion from the second quarter of 2006, and $4.3 billion, or 22%, to $15.2 billion from the first half of 2006. The decline in the average interest-bearing brokerage client cash balances led to a corresponding decline of $3.1 billion, or 23%, in average investments of segregated client cash balances to $10.4 billion from the second quarter of 2006, and $3.6 billion, or 25%, to $10.8 billion from the first half of 2006.

 

Certain interest-bearing assets and liabilities of U.S. Trust to be retained by the Company: The excess cash held in certain Schwab brokerage client accounts was previously swept into a money market deposit account at U.S. Trust. In May 2007, Schwab terminated this intercompany arrangement and moved all of these balances to a similar existing arrangement with Schwab Bank. At December 31, 2006, these balances totaled $749 million and were included in deposits from banking clients with a corresponding amount in assets retained from discontinued operations on the Company’s condensed consolidated balance sheets. The interest expense related to these client deposit balances maintained at U.S. Trust is included in interest expense from continuing operations on the Company’s condensed consolidated statements of income of $1 million and $3 million for the second quarters of 2007 and 2006, respectively, and $4 million and $5 million for the first halves of 2007 and 2006, respectively. The corresponding interest revenue on the invested cash balances related to these deposits is included in interest revenue from continuing operations on the Company’s condensed consolidated statements of income of $4 million and $10 million for the second quarters of 2007 and 2006, respectively, and $14 million and $18 million for the first halves of 2007 and 2006, respectively. The interest revenue amount is calculated using the Company’s funds transfer pricing methodology.

 

Trading Revenue

 

Trading revenue includes commission revenue (generated by executing client trades) and principal transaction revenues (from client fixed income securities trading activity). The decrease in trading revenue from the second quarter and first half of 2006 was primarily due to lower daily average revenue trades, partially offset by higher average revenue earned per revenue trade.

 

As shown in the following table, daily average revenue trades executed by the Company decreased 12% and 14% from the second quarter and first half of 2006, respectively, while average revenue earned per revenue trade increased 6% for each of the periods primarily due to higher revenue per trade for fixed income and equity securities trades.

 

    

Three Months

Ended

June 30,


  

Percent
Change


   

Six Months

Ended

June 30,


  

Percent
Change


 
     2007

   2006

     2007

   2006

  

Daily average revenue trades (in thousands) (1)

     221.4      250.7    (12 %)     225.8      262.9    (14 %)

Number of trading days

     63.0      63.0          124.0      125.0    (1 %)

Average revenue earned per revenue trade

     $   14.27      $   13.47    6 %     $   14.30      $   13.43    6 %

(1)

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

 

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Table of Contents

THE CHARLES SCHWAB CORPORATION

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

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

 

Expenses Excluding Interest

 

As shown in the table below, total expenses excluding interest increased in the second quarter and first half of 2007 primarily due to higher compensation and benefits expense and professional services expense.

 

    

Three Months

Ended

June 30,


   

Percent
Change


   

Six Months

Ended

June 30,


   

Percent
Change


 
     2007

    2006

      2007

    2006

   

Compensation and benefits

     $   449       $   407     10 %     $ 879       $ 816     8 %

Professional services

     81       71     14 %     155       134     16 %

Occupancy and equipment

     70       66     6 %     138       128     8 %

Advertising and market development

     52       55     (5 %)     118       104     13 %

Communications

     51       47     9 %     100       91     10 %

Depreciation and amortization

     39       39           78       80     (3 %)

Other

     39       39           75       72     4 %
    


 


 

 


 


 

Total expenses excluding interest

     $     781       $     724     8 %     $   1,543       $   1,425     8 %
    


 


 

 


 


 

Expenses as a percentage of total net revenues:

                                            

Total expenses excluding interest

     64.8 %     66.2 %           65.4 %     66.4 %      

Advertising and market development

     4.3 %     5.0 %           5.0 %     4.8 %      

 

Compensation and Benefits

 

The increase in compensation and benefits expense from the second quarter and first half of 2006 was primarily due to an increase in full-time equivalent employees, and higher payroll taxes, health insurance costs, and 401(k) employer match contributions. The following table shows a comparison of certain compensation and benefits components and employee data:

 

    

Three Months
Ended

June 30,


   

Percent
Change


   

Six Months

Ended

June 30,


   

Percent
Change


 
     2007

    2006

      2007

    2006

   

Salaries and wages

     $   240       $   211     14 %     $   477       $   443     8 %

Incentive compensation (1)

     137       137           253       246     3 %

Employee benefits and other

     72       59     22 %     149       127     17 %
    


 


 

 


 


 

Total compensation and benefits expense

     $ 449       $ 407     10 %     $ 879       $ 816     8 %
    


 


 

 


 


 

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

                                            

Salaries and wages

     19.9 %     19.3 %           20.2 %     20.6 %      

Incentive compensation

     11.4 %     12.5 %           10.7 %     11.5 %      

Employee benefits and other

     6.0 %     5.4 %           6.4 %     5.9 %      
    


 


       


 


     

Total compensation and benefits expense

     37.3 %     37.2 %           37.3 %     38.0 %      
    


 


       


 


     

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

                                            

At quarter end

     12.9       11.8     9 %                      

Average

     13.0       11.7     11 %     12.8       11.7     9 %
    


 


 

 


 


 


(1)

Includes incentives, discretionary bonus costs, long-term incentive plan compensation, and stock-based compensation.

 

(2)

Includes full-time, part-time and temporary employees, and persons employed on a contract basis, but excludes professional services related to outsourced service providers.

 

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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, and as Noted)

 

For the second quarter of 2007, net revenue growth of 10% remained on par with compensation and benefits expense growth. For the first half of 2007, net revenue growth outpaced compensation and benefits expense growth, resulting in a declining ratio of compensation and benefits expense as a percentage of total net revenues.

 

Expenses Excluding Compensation and Benefits

 

The increase in professional services expense from the second quarter and first half of 2006 was primarily due to increases in fees paid to outsourced service providers and consultants. The increase in advertising and marketing development expense from the first half of 2006 was primarily due to higher media spending related to the Company’s “Talk to Chuck™” national advertising campaign.

 

LIQUIDITY AND CAPITAL RESOURCES

 

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

 

CSC is a financial holding company, which is a type of bank holding company subject to supervision and regulation by the Board of Governors of the Federal Reserve System (Federal Reserve Board) under the Bank Holding Company Act of 1956, as amended. In July 2006, USTC (currently reflected as a discontinued operation for financial statement purposes) became a financial holding company. CSC and its depository institution subsidiaries, which include Schwab Bank and U.S. Trust, are subject to the Federal Reserve Board’s risk-based and leverage capital guidelines. These regulations require banks and bank holding companies to maintain minimum levels of capital. In addition, CSC’s depository institution subsidiaries are subject to limitations on the amount of dividends they can pay to CSC. Based on their respective regulatory capital ratios at June 30, 2007 and December 31, 2006, the Company’s depository institution subsidiaries are considered well capitalized.

 

Liquidity

 

CSC

 

CSC’s liquidity needs are generally met through cash generated by its subsidiaries, as well as cash provided by external financing. Charles Schwab & Co., Inc. (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), as well as from the funding of cash dividends, share repurchases, acquisitions, and other investments. The Medium-Term Notes, of which $262 million was issued and outstanding at June 30, 2007, have maturities ranging from 2007 to 2010 and fixed interest rates ranging from 6.52% to 8.05% with interest payable semiannually. The Medium-Term Notes are rated A2 by Moody’s Investors Service (Moody’s), A- by Standard & Poor’s Ratings Group (S&P), and A by Fitch Ratings, Ltd. (Fitch).

 

CSC has a prospectus supplement on file with the Securities and Exchange Commission (SEC) enabling CSC to issue up to $750 million in Senior or Senior Subordinated Medium-Term Notes, Series A. At June 30, 2007, all of these notes remained unissued.

 

CSC has a Registration Statement under the Securities Act of 1933 on Form S-3 on file with the SEC relating to a universal shelf registration for the issuance of up to $1.0 billion aggregate amount of various securities, including common stock, preferred stock, debt securities, and warrants. At June 30, 2007, all of these securities remained unissued.

 

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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, and as Noted)

 

CSC has authorization from its Board of Directors to issue commercial paper up to the amount of CSC’s committed, unsecured credit facility (see below), not to exceed $1.5 billion. At June 30, 2007, no commercial paper has been issued. CSC’s ratings for these short-term borrowings are P-1 by Moody’s, A-2 by S&P, and F1 by Fitch.

 

CSC maintains an $800 million committed, unsecured credit facility with a group of eighteen banks which is scheduled to expire in June 2008. This facility replaced a similar facility that expired in June 2007. These facilities were unused during the first half of 2007. Any issuances under CSC’s commercial paper program will reduce the amount available under this facility. The funds under this facility are available for general corporate purposes and CSC pays a commitment fee on the unused balance of this facility. The financial covenants in this facility require CSC to maintain a minimum level of stockholders’ equity, Schwab to maintain a minimum net capital ratio, as defined, and CSC’s depository institution subsidiaries to be well capitalized, as defined. Management believes that these restrictions will not have a material effect on its ability to meet foreseeable dividend or funding requirements.

 

CSC also has direct access to $801 million of the $851 million uncommitted, unsecured bank credit lines, provided by eight banks that are primarily utilized by Schwab to manage short-term liquidity. The amount available to CSC under these lines is lower than the amount available to Schwab because the credit line provided by one of these banks is only available to Schwab. These lines were not used by CSC during the first half of 2007.

 

In addition, Schwab provides CSC with a $1.0 billion credit facility maturing in 2009. No funds were drawn under this facility at June 30, 2007.

 

See note “14 – Subsequent Events” in the Notes to Condensed Consolidated Financial Statements for a discussion of the Company’s capital restructuring plan.

 

Schwab

 

Liquidity needs relating to client trading and margin borrowing activities are met primarily through cash balances in brokerage client accounts, which were $18.2 billion and $19.9 billion at June 30, 2007 and December 31, 2006, respectively. Management believes that brokerage client cash balances and operating earnings will continue to be the primary sources of liquidity for Schwab in the future.

 

The Company has a lease financing liability related to an office building and land under a 20-year lease. The remaining lease financing liability of $123 million at June 30, 2007 is being reduced by a portion of the lease payments over the remaining lease term.

 

To manage short-term liquidity, Schwab maintains uncommitted, unsecured bank credit lines with a group of eight banks totaling $851 million at June 30, 2007. The need for short-term borrowings arises primarily from timing differences between cash flow requirements, scheduled liquidation of interest-bearing investments, andmovements of cash to meet segregation requirements. Schwab used such borrowings for ten days during the first half of 2007, with daily amounts borrowed averaging $241 million. There were no borrowings outstanding under these lines at June 30, 2007.

 

To satisfy the margin requirement of client option transactions with the Options Clearing Corporation (OCC), Schwab has unsecured letter of credit agreements with twelve banks in favor of the OCC aggregating $1.1 billion at June 30, 2007. Schwab pays a fee to maintain these arrangements. In connection with its securities lending activities, Schwab is required to provide collateral to certain brokerage clients. Schwab satisfies the collateral requirements by arranging letters of credit (LOCs), in favor of these brokerage clients, which are issued by multiple banks. Schwab also pays a fee to maintain these arrangements. At June 30, 2007, the aggregate face amount of these outstanding LOCs totaled $201 million. No funds were drawn under these LOCs at June 30, 2007.

 

Schwab is subject to regulatory requirements that are intended to ensure the general financial soundness and liquidity of broker-dealers. These regulations prohibit Schwab from repaying subordinated borrowings to CSC, paying cash

 

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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, and as Noted)

 

dividends, or making unsecured advances or loans to its parent 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 of $250,000. At June 30, 2007, Schwab’s net capital was $1.1 billion (9.3% of aggregate debit balances), which was $886 million in excess of its minimum required net capital and $523 million in excess of 5% of aggregate debit balances. Schwab targets net capital to be approximately 10% of its aggregate debit balances, which primarily consist of client margin loans.

 

To manage Schwab’s regulatory capital requirement, CSC provides Schwab with a $1.4 billion subordinated revolving credit facility which is scheduled to expire in March 2008. The amount outstanding under this facility at June 30, 2007 was $220 million. Borrowings under this subordinated lending arrangement qualify as regulatory capital for Schwab.

 

In addition, CSC provides Schwab with a $1.0 billion credit facility maturing in 2009. Borrowings under this facility do not qualify as regulatory capital for Schwab. No funds were drawn under this facility at June 30, 2007.

 

Schwab Bank

 

Schwab Bank’s current liquidity needs are generally met through deposits from banking clients and equity capital.

 

The excess cash held in certain Schwab brokerage client accounts is swept into a money market deposit account at Schwab Bank. At June 30, 2007, these balances totaled $11.1 billion.

 

Schwab Bank has access to traditional funding sources such as deposits, federal funds purchased, and repurchase agreements. Additionally, CSC provides Schwab Bank with a $100 million short-term credit facility maturing in December 2007. Borrowings under this facility do not qualify as regulatory capital for Schwab Bank. No funds were drawn under this facility at June 30, 2007.

 

Schwab Bank maintains a credit facility with the Federal Home Loan Bank System (FHLB). At June 30, 2007, $619 million was available, and no funds were drawn under this facility.

 

U.S. Trust (currently reflected as a discontinued operation for financial statement purposes)

 

The liquidity needs of U.S. Trust are generally met through deposits from banking clients, equity capital, and borrowings.

 

The excess cash held in certain Schwab brokerage client accounts was previously swept into a money market deposit account at U.S. Trust. In May 2007, Schwab terminated this intercompany arrangement and moved all of these balances to a similar existing arrangement with Schwab Bank.

 

In addition to traditional funding sources such as deposits, federal funds purchased, and repurchase agreements, USTC’s depository institution subsidiaries have established their own external funding sources. At December 31, 2006, U.S. Trust had $52 million in Trust Preferred Capital Securities outstanding with a fixed interest rate of 8.41%. On February 1, 2007, U.S. Trust redeemed all of the outstanding Trust Preferred Capital Securities.

 

Certain of USTC’s depository institution subsidiaries have established credit facilities with the FHLB totaling $2.4 billion. At June 30, 2007, there were no balances outstanding under these facilities. Additionally, at June 30, 2007, U.S. Trust had $673 million of federal funds purchased.

 

U.S. Trust uses interest rate swap agreements (Swaps) with third parties to hedge the interest rate risk primarily associated with its variable rate deposits from banking clients. These Swaps are structured for U.S. Trust to receive a variable rate of interest and pay a fixed rate of interest. At June 30, 2007, the Swaps had a notional value of $560 million and a fair value of $7 million.

 

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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, and as Noted)

 

Concentration Risk

 

The Company’s most significant concentration of risk is its exposure to securities issued or collateralized by the U.S. Government and its agencies (U.S. Government securities). The Company’s direct market risk exposure, primarily from investments in securities available for sale, amounted to $3.4 billion at June 30, 2007. The Company maintains indirect exposure to U.S. Government securities held as collateral to secure its resale agreements. The Company’s primary credit exposure on these resale transactions is with its counterparty. The Company would have exposure to the U.S. Government securities only in the event of the counterparty’s default on the resale agreements. U.S. Government securities held as collateral for resale agreements at June 30, 2007 totaled $3.7 billion.

 

Capital Resources

 

The Company monitors both the relative composition and absolute level of its capital structure. Management is focused on limiting the Company’s use of capital and currently targets a long-term debt to total financial capital ratio of less than 30%. The Company’s total financial capital (long-term debt plus stockholders’ equity) at June 30, 2007 was $5.5 billion, up $62 million, or 1%, from December 31, 2006. At June 30, 2007, the Company had long-term debt of $384 million, or 7% of total financial capital, that bears interest at a weighted-average rate of 7.03%. At December 31, 2006, the Company had long-term debt of $388 million, or 7% of total financial capital.

 

The Company’s cash position (reported as cash and cash equivalents on its condensed consolidated balance sheet) and cash flows are affected by changes in brokerage client cash balances and the associated amounts required to be segregated under federal or other regulatory guidelines. Timing differences between cash and investments actually segregated on a given date and the amount required to be segregated for that date may arise in the ordinary course of business and are addressed by the Company in accordance with applicable regulations. Other factors which affect the Company’s cash position and cash flows include investment activity in securities, levels of capital expenditures, acquisition and divestiture activity, banking client deposit activity, brokerage and banking client loan activity, financing activity in long-term debt, payments of dividends, and repurchases of CSC’s common stock. The combination of these factors can cause significant fluctuations in the levels of cash and cash equivalents during specific time periods.

 

In the first half of 2007, cash and cash equivalents decreased $1.0 billion, or 23%, to $3.5 billion primarily due to a decrease in payables to brokerage clients and an increase in net securities available for sale. These changes were partially offset by an increase in deposits from banking clients.

 

Capital Expenditures

 

In the first halves of 2007 and 2006, the Company’s capital expenditures were $83 million and $50 million, respectively. In the first half of 2006, the Company sold a data center for $62 million. Capital expenditures in the first halves of 2007 and 2006 were primarily for software and equipment relating to the Company’s information technology systems. Capital expenditures include capitalized costs for developing internal-use software of $29 million in the first half of 2007 and $15 million in the first half of 2006.

 

Dividends

 

During the first halves of 2007 and 2006, CSC paid common stock cash dividends of $125 million and $71 million, respectively. See note “14 – Subsequent Events” in the Notes to Condensed Consolidated Financial Statements for a discussion of the Company’s capital restructuring plan.

 

Share Repurchases

 

On April 25, 2007, the Board of Directors authorized the repurchase of up to $500 million of CSC’s common stock in addition to the remaining authorization previously granted by the Board of Directors on January 24, 2007. During the first half of 2007, CSC repurchased 33 million shares of its common stock for $642 million. CSC repurchased

 

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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, and as Noted)

 

28 million shares of its common stock for $446 million in the first half of 2006. As of June 30, 2007, CSC had remaining authority to repurchase up to $446 million of its common stock. See note “14 – Subsequent Events” in the Notes to Condensed Consolidated Financial Statements for a discussion of the Company’s capital restructuring plan.

 

Acquisition and Divestiture

 

Upon completion of the sale of U.S. Trust on July 1, 2007, the Company received proceeds of $3.3 billion. See note “14 - Subsequent Events” in the Notes to Condensed Consolidated Financial Statements for a discussion of the Company’s capital restructuring plan.

 

On March 31, 2007, the Company completed its acquisition of The 401(k) Company for $115 million in cash.

 

Off-Balance-Sheet Arrangements

 

The Company enters into various off-balance-sheet arrangements in the ordinary course of business, primarily to meet the needs of its clients. These arrangements include firm commitments to extend credit. Additionally, the Company enters into guarantees and other similar arrangements as part of transactions in the ordinary course of business. For discussion on the Company’s off-balance-sheet arrangements, see “Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Capital Resources” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2006, and note “8 – Commitments and Contingent Liabilities” in the Notes to Condensed Consolidated Financial Statements.

 

RISK MANAGEMENT

 

For discussion on the Company’s principal risks and some of the policies and procedures for risk identification, assessment, and management, see “Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations – Risk Management” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2006. For a discussion on liquidity risk, see “Item 1A – Risk Factors” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2006. See “Item 3 – Quantitative and Qualitative Disclosures About Market Risk” for additional information relating to market risk.

 

Given the nature of the Company’s net revenues, expenses, and risk profile, the Company’s earnings and CSC’s common stock price have been and may continue to be subject to significant volatility from period to period. The Company’s results for any interim period are not necessarily indicative of results for a full year or any other interim period. Risk is inherent in the Company’s business. Consequently, despite the Company’s attempts to identify areas of risk, oversee operational areas involving risk, and implement policies and procedures designed to manage risk, there can be no assurance that the Company will not suffer unexpected losses due to operating or other risks.

 

CRITICAL ACCOUNTING ESTIMATES

 

Certain of the Company’s accounting policies that involve a higher degree of judgment and complexity are discussed in “Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations – Critical Accounting Estimates” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2006. There have been no material changes to these critical accounting estimates during the first half of 2007.

 

As disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2006, the Company’s annual goodwill impairment testing date is April 1. In testing for a potential impairment of goodwill on April 1, 2007, management estimated the fair value of each of the Company’s reporting units (generally defined as the Company’s businesses for which financial information is available and reviewed regularly by management) and compared this value to the carrying value of the reporting unit. The estimated fair value of each reporting unit was greater than its carrying value, and therefore management concluded that no amount of goodwill was impaired.

 

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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, and as Noted)

 

FORWARD-LOOKING STATEMENTS

 

In addition to historical information, this Quarterly Report on Form 10-Q contains “forward-looking statements” within the meaning of Section 27A of the Securities Act, and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements are identified by words such as “believe,” “anticipate,” “expect,” “intend,” “plan,” “will,” “may,” “estimate,” “aim,” “target,” and other similar expressions. In addition, any statements that refer to expectations, projections, or other characterizations of future events or circumstances are forward-looking statements.

 

These forward-looking statements, which reflect management’s beliefs, objectives, and expectations as of the date hereof, are necessarily estimates based on the best judgment of the Company’s senior management. These statements relate to, among other things:

 

   

the impact on the Company’s financial position and results of operations related to the sale of U.S. Trust (see notes “1 – Basis of Presentation” and “12 - Discontinued Operations” in the Notes to Condensed Consolidated Financial Statements, Overview – Discontinued Operations, Results of Operations – Net Interest Revenue, and Liquidity and Capital Resources);

 

   

the impact of changes in unrecognized tax benefits on the Company’s results of operations (see note “4 – Taxes on Income” in the Notes to Condensed Consolidated Financial Statements);

 

   

the impact of changes in the likelihood of indemnification payment obligations on the Company’s results of operations (see note “8 – Commitments and Contingent Liabilities” in the Notes to Condensed Consolidated Financial Statements);

 

   

the impact of legal proceedings and regulatory matters (see note “8 – Commitments and Contingent Liabilities” in the Notes to Condensed Consolidated Financial Statements and Part II – Other Information, Item 1 – Legal Proceedings);

 

   

the impact of changes in the income tax benefit related to the sale of U.S. Trust (see note “12 – Discontinued Operations in the Notes to Condensed Consolidated Financial Statements);

 

   

the impact of changes in estimated costs related to past restructuring initiatives on the Company’s results of operations (see note “13 – Restructuring Reserve” in the Notes to Condensed Consolidated Financial Statements);

 

   

CSC’s capital restructuring plan and its impact on the Company’s financial position (see note “14 – Subsequent Events” in the Notes to Condensed Consolidated Financial Statements and Overview – Subsequent Events);

 

   

sources of liquidity and capital (see Liquidity and Capital Resources); and

 

   

target capital ratios (see Liquidity and Capital Resources).

 

Achievement of the expressed beliefs, objectives, and expectations described in these statements is subject to certain risks and uncertainties that could cause actual results to differ materially from the expressed beliefs, objectives, and expectations. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this Quarterly Report on Form 10-Q or, in the case of documents incorporated by reference, as of the date of those documents.

 

Important factors that may cause such differences are noted in this interim report and include, but are not limited to:

 

   

market conditions, including the demand for new corporate debt issuances;

 

   

the amount, timing, and terms of debt issuances in connection with CSC’s capital restructuring plan;

 

   

unanticipated adverse developments in litigation or regulatory matters;

 

   

the Company’s ability to sublease certain properties;

 

   

the amount of loans to the Company’s banking and brokerage clients;

 

   

the level of the Company’s stock repurchase activity;

 

   

the timing and impact of the settlement of tax audits;

 

   

potential breaches of contractual terms for which the Company has indemnification obligations;

 

   

changes in the income tax benefit based on the results of a tax survey related to the sale of U.S. Trust; and

 

   

the impact of pending and completed strategic transactions.

 

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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, and as Noted)

 

Certain of these factors, as well as general risk factors affecting the Company, are discussed in greater detail in “Item 1A – Risk Factors” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2006.

 

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THE CHARLES SCHWAB CORPORATION

 

Item 3. Quantitative and Qualitative Disclosures About Market Risk

 

Market risk is the potential for loss due to a change in the value of a financial instrument held by the Company as a result of fluctuations in interest rates or equity prices.

 

For the Company’s market risk related to its interest rate risk, it has disclosed below a sensitivity analysis, referred to as a net interest revenue simulation model. The Company is exposed to interest rate risk primarily from changes in the interest rates on its interest-earning assets (mainly margin loans to clients, investments, loans to banking clients, mortgage-backed securities, and other fixed-rate investments) and its funding sources (including brokerage client cash balances, banking deposits, proceeds from stock-lending activities, and long-term debt) which finance these assets. To mitigate the risk of loss, the Company has established policies and procedures which include setting guidelines on the amount of net interest revenue at risk, and by monitoring the net interest margin and average maturity of its interest-earning assets and funding sources. To remain within these guidelines, the Company manages the maturity, repricing, and cash flow characteristics of the investment portfolios. The Company also has the ability to adjust the rates paid on certain brokerage client cash balances and certain banking deposits and the rates charged on margin loans.

 

The Company has market risk as a result of fluctuations in equity prices. However, the Company’s exposure to equity prices is not material. Additionally, the Company’s market risk related to financial instruments held for trading, financial instruments held for purposes other than trading, interest rate swaps related to a portion of its fixed interest rate medium-term notes, and forward sale and interest rate lock commitments related to its loans held for sale portfolio is not material.

 

Net Interest Revenue Simulation

 

The Company uses net interest revenue simulation modeling techniques to evaluate and manage the effect of changing interest rates. The simulation model (the model) includes all interest-sensitive assets and liabilities, as well as Swaps utilized by the Company to hedge its interest rate risk. Key variables in the model include the repricing of financial instruments, prepayment and reinvestment assumptions, and product pricing assumptions. Historically, the Company included additional variables (e.g., changes in the balances of client loans, deposits, brokerage client cash, and changes in the level and term structure of interest rates) in the model assumptions. Effective in 2007 for all periods presented, the Company uses constant balances and market rates in the model assumptions in order to minimize the number of variables and to better isolate risks. The simulations involve assumptions that are inherently uncertain and, as a result, cannot precisely estimate net interest revenue or precisely predict the impact of changes in interest rates on net interest revenue. Actual results may differ from simulated results due to balance growth or decline, the timing, magnitude, and frequency of interest rate changes as well as changes in market conditions and management strategies, including changes in asset and liability mix.

 

As demonstrated by the simulations presented below, 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 are repricing more quickly than interest-bearing liabilities).

 

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THE CHARLES SCHWAB CORPORATION

 

The forward-looking simulations in the following table exclude all of U.S. Trust’s net interest revenue and reflect the closing of the sale on July 1, 2007. In addition, the simulations assume that the asset and liability structure of the consolidated balance sheet would not be changed as a result of the simulated changes in interest rates. As the Company actively manages its consolidated balance sheet and interest rate exposure, in all likelihood the Company would take steps to manage any additional interest rate exposure that could result from changes in the interest rate environment. The following table shows the results of a gradual 200 basis point increase or decrease in interest rates relative to current market rates forecast on simulated net interest revenue over the next twelve months at June 30, 2007 and December 31, 2006.

 

Percentage Increase (Decrease)


   June 30,
2007


    December 31,
2006


 

Increase of 200 basis points

   6.6 %   7.4 %

Decrease of 200 basis points

   (4.8 %)   (5.5 %)

 

The simulations show a decrease in exposure to rate changes at June 30, 2007 from December 31, 2006, and the Company remains positioned to experience increases in net interest revenue as rates rise and decreases as rates fall.

 

Item 4. Controls and Procedures

 

Evaluation of disclosure controls and procedures: The management of the Company with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company’s disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934) as of June 30, 2007. Based on this evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that the Company’s disclosure controls and procedures were effective as of June 30, 2007.

 

Changes in internal control over financial reporting: No change in the Company’s internal control over financial reporting (as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934) was identified during the quarter ended June 30, 2007 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

 

PART II - OTHER INFORMATION

 

Item 1. Legal Proceedings

 

The Company is subject to claims and lawsuits in the ordinary course of its 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 various 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 in the Company’s Annual Report on Form 10-K for the year ended December 31, 2006.

 

The Company believes it has strong defenses in all significant matters currently pending and is vigorously 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. Predicting the outcome of a matter is inherently difficult, particularly where claimants seek substantial or unspecified damages, or when investigations or legal proceedings are at an early stage. In many cases, it is not possible to determine whether a loss will be incurred or to estimate the range of that loss until the matter is close to resolution. However, based on current information and consultation with counsel, management believes that the resolution of matters currently pending will not have a material adverse impact on the financial

 

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THE CHARLES SCHWAB CORPORATION

 

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.

 

Item 1A. Risk Factors

 

During the first half of 2007, there have been no material changes to the risk factors in “Item 1A – Risk Factors” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2006.

 

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

 

(c) Issuer Purchases of Equity Securities

 

The following table summarizes purchases made by or on behalf of CSC of its common stock for each calendar month in the second quarter of 2007.

 

Month


  

Total Number
of Shares
Purchased

(in thousands)


   Average
Price Paid
per Share


  

Total Number
of Shares
Purchased as
Part of Publicly
Announced
Program (1)

(in thousands)


  

Approximate
Dollar Value of
Shares that

May Yet be
Purchased under
the Program

(in millions)


April:

                       

Share Repurchase Program (1)

   8,039       $   19.26    8,039       $   542

Employee Transactions (2)

   56       $   19.46    N/A      N/A

May:

                       

Share Repurchase Program (1)

   1,317       $   19.72    1,317       $   516

Employee Transactions (2)

   2       $   19.37    N/A      N/A

June:

                       

Share Repurchase Program (1)

   3,388       $   20.64    3,388       $   446

Employee Transactions (2)

   2       $   21.64    N/A      N/A
    
  

  
  

Total:

                       

Share Repurchase Program (1)

   12,744       $   19.67    12,744       $   446

Employee Transactions (2)

   60       $   19.53    N/A      N/A
    
  

  
  


N/A Not applicable.

 

(1)

All shares were repurchased under authorizations by CSC’s Board of Directors covering up to $500 million each of common stock publicly announced by the Company on January 24, 2007 and April 25, 2007, respectively. The authorization announced on January 24, 2007 has been exhausted. The remaining authorization does not have an expiration date.

 

(2)

Includes restricted shares withheld (under the terms of grants under employee stock incentive plans) to offset tax withholding obligations that occur upon vesting and release of restricted shares. The Company may receive shares to pay the exercise price and/or to satisfy tax withholding obligations by employees who exercise stock options (granted under employee stock incentive plans), which are commonly referred to as stock swap exercises.

 

Item 3. Defaults Upon Senior Securities

 

None.

 

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THE CHARLES SCHWAB CORPORATION

 

Item 4. Submission of Matters to a Vote of Security Holders

 

The Annual Meeting of Stockholders of CSC was held on May 17, 2007. There were a total of 1,251,892,010 shares entitled to vote at the Annual Meeting, and a total of 1,161,849,429 shares were present in person or by proxy at the Annual Meeting. The voting results are provided below:

 

              

Shares

For


   Shares
Withheld


1.      Election of Directors:

                   

William F. Aldinger III

             1,125,035,886    36,813,543

Donald G. Fisher

             1,115,796,729    46,052,700

Paula A. Sneed

             1,143,246,946    18,602,483
    

Shares

For


   Shares
Against


   Abstentions

  

Broker

Non-Votes


2.      Approval of the Employee Stock Purchase Plan

   1,017,664,664    11,887,815    6,818,559    125,478,391

3.      Amendments to the 2004 Stock Incentive Plan

   999,632,609    28,895,635    7,842,794    125,478,391

Stockholder Proposals:

                   

1.      Disclosure by the Company relating to political contributions

   262,632,046    648,322,823    125,416,169    125,478,391

2.      Amendment of the Company’s Bylaws to require majority voting for the election of the board of directors

   503,048,698    524,753,400    8,568,940    125,478,391

 

All nominees for the election to the Board of Directors were elected. The Employee Stock Purchase Plan and amendments to the 2004 Stock Incentive Plan received the requisite level of stockholder approval. The stockholders did not approve either of the stockholder proposals.

 

 

Item 5. Other Information

 

None.

 

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THE CHARLES SCHWAB CORPORATION

 

Item 6. Exhibits

 

The following exhibits are filed as part of this Quarterly Report on Form 10-Q.

 

Exhibit
Number


  

Exhibit


           
10.116    Second Amendment to the Trust Agreement for the Charles Schwab Profit Sharing and Employee Stock Ownership Plan effective July 1, 1992, dated June 30, 1992.    (2 )
10.169    Third Amendment to the Trust Agreement for the Charles Schwab Profit Sharing and Employee Stock Ownership Plan effective January 1, 1996, dated May 8, 1996.    (2 )
10.291    The Charles Schwab Corporation 2004 Stock Incentive Plan, restated to include amendments approved at the Annual Meeting of Stockholders on May 17, 2007 (supersedes Exhibit 10.278).    (2 )
10.292    Form of Notice and Restricted Stock Agreement for Non-Employee Directors under The Charles Schwab Corporation 2004 Stock Incentive Plan (supersedes Exhibit 10.266).    (2 )
10.293    Form of Notice and Stock Option Agreement for Non-Employee Directors under The Charles Schwab Corporation 2004 Stock Incentive Plan (supersedes Exhibit 10.268).    (2 )
10.294    Form of Notice and Restricted Stock Agreement for Joseph R. Martinetto under The Charles Schwab Corporation 2004 Stock Incentive Plan dated May 18, 2007.    (2 )
10.295    Form of Notice and Nonqualified Stock Option Agreement for Joseph R. Martinetto under The Charles Schwab Corporation 2004 Stock Incentive Plan dated May 18, 2007.    (2 )
10.296    Stock Purchase Agreement dated July 2, 2007 by and among Charles R. Schwab, Helen O. Schwab, The Charles & Helen Schwab Living Trust, HOS Family Partners, LLC, 188 Partners, LP, and the Charles & Helen Schwab Foundation, and The Charles Schwab Corporation.    (2 )
10.297    Credit Agreement (364-Day Commitment) dated as of June 15, 2007 between the Registrant and the financial institutions listed therein (supersedes Exhibit 10.286).       
12.1    Computation of Ratio of Earnings to Fixed Charges.       
31.1    Certification Pursuant to Rule 13a-14(a)/15d-14(a), As Adopted Pursuant to Section 302 of The Sarbanes-Oxley Act of 2002.       
31.2    Certification Pursuant to Rule 13a-14(a)/15d-14(a), As Adopted Pursuant to Section 302 of The Sarbanes-Oxley Act of 2002.       
32.1    Certification Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of The Sarbanes-Oxley Act of 2002.    (1 )
32.2    Certification Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of The Sarbanes-Oxley Act of 2002.    (1 )

 

 

(1) Furnished as an exhibit to this quarterly report on Form 10-Q.

 

(2) Management contract or compensatory plan.

 

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THE CHARLES SCHWAB CORPORATION

 

SIGNATURE

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

   

THE CHARLES SCHWAB CORPORATION

   

                                (Registrant)

Date: August 7, 2007

  /s/ Joseph R. Martinetto
    Joseph R. Martinetto
   

Executive Vice President and

Chief Financial Officer

 

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