UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
For the Quarterly Period Ended September 30, 2004
OR
For the transition period from to
Commission File No. 0-5965
NORTHERN TRUST CORPORATION
(Exact name of registrant as specified in its charter)
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)
50 South LaSalle Street
Chicago, Illinois
Registrant’s telephone number, including area code: (312) 630-6000
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes x No ¨
219,209,338 Shares - $1.66 2/3 Par Value
(Shares of Common Stock Outstanding on September 30, 2004)
PART I - FINANCIAL INFORMATION
($ In Millions Except Share Information)
Assets
Cash and Due from Banks
Federal Funds Sold and Securities Purchased under Agreements to Resell
Time Deposits with Banks
Other Interest-Bearing
Securities
Available for Sale
Held to Maturity (Fair value - $1,164.4 at September 2004, $1,081.6 at December 2003, $1,049.6 at September 2003)
Trading Account
Total Securities
Loans and Leases
Commercial and Other
Residential Mortgages
Total Loans and Leases (Net of unearned income - $482.9 at September 2004, $435.7 at December 2003, $400.1 at September 2003)
Reserve for Credit Losses Assigned to Loans and Leases
Buildings and Equipment, net
Customers’ Acceptance Liability
Trust Security Settlement Receivables
Other Assets
Total Assets
Liabilities
Deposits
Demand and Other Noninterest-Bearing
Savings and Money Market
Savings Certificates
Other Time
Foreign Offices - Demand
- Time
Total Deposits
Federal Funds Purchased
Securities Sold Under Agreements to Repurchase
Commercial Paper
Other Borrowings
Senior Notes
Long-Term Debt
Floating Rate Capital Debt
Liability on Acceptances
Other Liabilities
Total Liabilities
Stockholders’ Equity
Common Stock, $1.66 2/3 Par Value; Authorized 560,000,000 shares at September 2004, December 2003, and September 2003; Outstanding 219,209,338 shares at
September 2004, 220,118,476 shares at December 2003 and 220,354,163 shares at September 2003
Retained Earnings
Accumulated Other Comprehensive Income
Common Stock Issuable - Stock Incentive Plans
Deferred Compensation
Treasury Stock - (at cost, 8,712,186 shares at September 2004, 7,803,048 shares at December 2003, and 7,567,361 shares at September 2003)
Total Stockholders’ Equity
Total Liabilities and Stockholders’ Equity
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Three Months
Ended September 30
Nine Months
($ In Millions Except Per Share Information)
Noninterest Income
Trust Fees
Foreign Exchange Trading Profits
Treasury Management Fees
Security Commissions and Trading Income
Other Operating Income
Investment Security Gains
Total Noninterest Income
Net Interest Income
Interest Income
Interest Expense
Provision for Credit Losses
Net Interest Income after Provision for Credit Losses
Noninterest Expenses
Compensation
Employee Benefits
Occupancy Expense
Equipment Expense
Other Operating Expenses
Total Noninterest Expenses
Income from Continuing Operations before Income Taxes
Provision for Income Taxes
Income from Continuing Operations
Discontinued Operations
Income (Loss) from Discontinued Operations of NTRC
Loss on Disposal of NTRC
Income Tax Benefit (Expense)
Income (Loss) from Discontinued Operations
Net Income
Net Income Applicable to Common Stock
Per Common Share
- Basic
- Diluted
Cash Dividends Declared
Average Number of Common Shares Outstanding - Basic
Nine MonthsEnded
September 30
(In Millions)
Other Comprehensive Income (net of tax)
Net Unrealized Gains (Losses) on Securities Available for Sale
Net Unrealized Gains (Losses) on Cash Flow Hedge Designations
Foreign Currency Translation Adjustments
Other Comprehensive Income
Comprehensive Income
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CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY - NORTHERN TRUST CORPORATION
($ In Millions)
Preferred Stock
Balance at January 1
Series C Redeemed
Series D Redeemed
Balance at September 30
Common Stock
Balance at January 1 and September 30
Dividends Declared - Common Stock
Dividends Declared - Preferred Stock
Stock Issued - Incentive Plan and Awards
Other Comprehensive Income (Loss)
Stock Issuable, net of Stock Issued
Compensation Deferred
Compensation Amortized
Treasury Stock
Stock Options and Awards
Stock Purchased
Total Stockholders’ Equity at September 30
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Cash Flows from Operating Activities:
Adjustments to Reconcile Net Income to Net Cash Provided by Operating Activities:
Depreciation on Buildings and Equipment
(Increase) Decrease in Receivables
Decrease in Interest Payable
Amortization and Accretion of Securities and Unearned Income
Severance Costs Relating to Staff Reductions, net
Reduction in Office Space Leased and Owned, net
Loss on Sale of NTRC Assets
Gain on Sale of Higgins Road Branch Assets
Amortization and Retirement of Computer Software
Amortization of Other Intangibles
Net Decrease in Trading Account Securities
Other Operating Activities, net
Net Cash Provided by Operating Activities
Cash Flows from Investing Activities:
Net Decrease in Federal Funds Sold and Securities Purchased under Agreements to Resell
Net (Increase) Decrease in Time Deposits with Banks
Net (Increase) Decrease in Other Interest-Bearing Assets
Purchases of Securities-Held to Maturity
Proceeds from Maturity and Redemption of Securities-Held to Maturity
Purchases of Securities-Available for Sale
Proceeds from Sale, Maturity and Redemption of Securities-Available for Sale
Net Decrease in Loans and Leases
Purchases of Buildings and Equipment
Purchases and Development of Computer Software
Net (Increase) Decrease in Trust Security Settlement Receivables
Decrease in Cash Due to Acquisitions
Proceeds from Sale of Subsidiary and Branch Assets
Other Investing Activities, net
Net Cash Provided by (Used in) Investing Activities
Cash Flows from Financing Activities:
Net Increase (Decrease) in Deposits
Net Increase (Decrease) in Federal Funds Purchased
Net Increase (Decrease) in Securities Sold under Agreements to Repurchase
Net Increase in Commercial Paper
Net Decrease in Short-Term Other Borrowings
Proceeds from Term Federal Funds Purchased
Repayments of Term Federal Funds Purchased
Proceeds from Senior Notes & Long-Term Debt
Repayments of Senior Notes & Long-Term Debt
Treasury Stock Purchased
Net Proceeds from Stock Options
Cash Dividends Paid on Common Stock
Cash Dividends Paid on Preferred Stock
Redemption of Preferred Stock
Other Financing Activities, net
Net Cash Provided by (Used in) Financing Activities
Increase (Decrease) in Cash and Due from Banks
Cash and Due from Banks at Beginning of Year
Cash and Due from Banks at End of Period
Supplemental Disclosures of Cash Flow Information:
Interest Paid
Income Taxes Paid
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Notes to Consolidated Financial Statements
1. Basis of Presentation - The consolidated financial statements include the accounts of Northern Trust Corporation (Corporation) and its subsidiaries (collectively, Northern Trust), all of which are wholly-owned. Significant intercompany balances and transactions have been eliminated. The consolidated financial statements, as of September 30, 2004 and 2003, have not been audited by the Corporation’s independent public accountants. In the opinion of management, all accounting entries and adjustments, including normal recurring accruals, necessary for a fair presentation of the financial position and the results of operations for the interim periods have been made. As discussed in Note 3 of this Report, as a result of its disposition on June 15, 2003, the operating results of Northern Trust Retirement Consulting, L.L.C. (NTRC) for all periods presented have been shown as discontinued operations in the consolidated statement of income. Certain other reclassifications have been made to prior periods’ consolidated financial statements to place them on a basis comparable with the current period’s consolidated financial statements. For a description of Northern Trust’s significant accounting policies, refer to Note 1 of the Notes to Consolidated Financial Statements in the 2003 Annual Report to Shareholders.
2. Recent Accounting Pronouncements - In December 2003, the Financial Accounting Standards Board (FASB) issued revised Interpretation No. 46 (FIN 46(R)), “Consolidation of Variable Interest Entities,” which replaced the original Interpretation No. 46 that had been issued in January 2003. FIN 46(R) clarifies the application of Accounting Research Bulletin No. 51, “Consolidated Financial Statements,” to certain entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. Such entities are termed variable interest entities. Application of FIN 46(R) by public entities for all variable interest entities is required in financial statements for periods ending after March 15, 2004. Northern Trust re-evaluated the revised requirements of variable interest accounting with the issuance of FIN 46(R) and determined that there was no change required in Northern Trust’s accounting treatment currently in place for its existing variable interest entities. Northern Trust will continue to monitor, evaluate, and apply authoritative guidance and interpretations relating to variable interest accounting as it is issued.
In May 2004, the FASB issued Staff Position 106-2 (FSP 106-2), “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003” (the Act). FSP 106-2 provides guidance on the accounting for the effects of the Act for employers that sponsor post-retirement health care plans that provide prescription drug benefits. FSP 106-2 also requires employers to provide certain disclosures regarding the effect of the Federal subsidy provided by the Act. The disclosures required by this statement are included in Note 11.
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Notes to Consolidated Financial Statements (continued)
3. Discontinued Operations - On June 15, 2003, Northern Trust completed the sale of substantially all of the assets of NTRC. NTRC provided defined benefit, defined contribution and retiree health and welfare administrative services, including recordkeeping and customer service, and also provided retirement consulting and actuarial services, including plan design and communication. The operating results of the NTRC business for the current and all prior periods presented, including the loss on its disposition, are reflected as discontinued operations in the Corporation’s consolidated statement of income and in the results of operations in the C&IS business unit.
The sale of NTRC assets resulted in a pre-tax net loss of $20.2 million in the second quarter of 2003, principally reflecting the write-off of unamortized technology investments, lease exit costs, and severance benefits.
In the nine months ended September 30, 2004, pre-tax income from discontinued operations of $.6 million was recorded primarily as a result of a change in the original estimates used to calculate the loss on the disposal of certain assets that were not transferred in the sale.
4. Securities - The following table summarizes the book and fair values of securities.
Held to Maturity
Obligations of States and Political Subdivisions
Federal Agency
Other
Subtotal
U.S. Government
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Reconciliation of Book Values to Fair Values of Securities Held to Maturity
BookValue
FairValue
Total
Reconciliation of Amortized Cost to Fair Values of Securities Available for Sale
Amortized
Cost
Fair
Value
5. Loans and Leases - Amounts outstanding in selected loan categories are shown below.
Domestic
Residential Real Estate
Commercial
Broker
Commercial Real Estate
Personal
Lease Financing
Total Domestic
International
Total Loans and Leases
Net Loans and Leases
At September 30, 2004, other domestic and international loans included $682.5 million of overnight trust-related advances, compared with $672.2 million at December 31, 2003 and $810.2 million at September 30, 2003.
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5. Loans and Leases (continued)
At September 30, 2004, nonperforming loans and leases totaled $64.2 million. Included in this amount were loans with a recorded investment of $62.7 million (net of $12.0 million in charge-offs) that were also classified as impaired. A loan is impaired when, based on available information, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. Impaired loans totaling $2.9 million (net of $4.8 million in charge-offs) had no portion of the reserve for credit losses allocated to them while impaired loans totaling $59.8 million (net of $7.2 million in charge-offs) had an allocated reserve of $30.9 million. For the third quarter of 2004, the total recorded investment in impaired loans averaged $63.6 million. There was approximately $12 thousand of interest income recorded on impaired loans for the three months ended September 30, 2004.
At September 30, 2003, nonperforming loans and leases totaled $99.8 million and included $97.3 million (net of $19.8 million in charge-offs) of impaired loans. Of these impaired loans, $12.6 million (net of $9.8 million in charge-offs) had no portion of the reserve for credit losses allocated to them while $84.7 million (net of $10.0 million in charge-offs) had an allocated reserve of $44.6 million. Total recorded investment in impaired loans for the third quarter of 2003 averaged $96.4 million. There was $99 thousand of interest income recognized on such loans for the three months ended September 30, 2003.
At September 30, 2004, residential real estate loans totaling $2.4 million were held for sale and carried at the lower of cost or market. Loan commitments for residential real estate loans that will be held for sale when funded are carried at fair value and had a total notional amount of $9.0 million at September 30, 2004. All other loan commitments are carried at the amount of unamortized fees with a reserve for credit loss liability recognized for any probable losses. At September 30, 2004, legally binding commitments to extend credit totaled $16.0 billion, compared with $16.5 billion at December 31, 2003 and September 30, 2003.
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6. Reserve for Credit Losses - Changes in the reserve for credit losses were as follows:
Three Months Ended
Nine Months Ended
Balance at Beginning of Period
Charge-Offs
Recoveries
Net Charge-Offs
Balance at End of Period
Reserve for Credit Losses Assigned to:
Unfunded Commitments, Standby Letters of Credit and Derivatives
Total Reserve for Credit Losses
The reserve for credit losses represents management’s estimate of probable inherent losses that have occurred as of the date of the financial statements. The loan and lease portfolio and other credit exposures are regularly reviewed to evaluate the adequacy of the reserve for credit losses. In determining the level of the reserve, Northern Trust evaluates the reserve necessary for specific nonperforming loans and also estimates losses inherent in other credit exposures.
The result is a reserve with the following components:
Specific Reserve. The amount of specific reserve is determined through a loan-by-loan analysis of nonperforming loans that considers expected future cash flows, the value of collateral and other factors that may impact the borrower’s ability to pay.
Allocated Inherent Reserve. The amount of the allocated portion of the inherent loss reserve is based on loss factors assigned to Northern Trust’s credit exposures, which depend upon internal credit ratings. These loss factors primarily include management’s judgment concerning the effect of the current business cycle on the creditworthiness of Northern Trust’s borrowers as well as historical charge-off experience.
Unallocated Inherent Reserve. Management determines the unallocated portion of the inherent reserve based on factors that cannot be associated with a specific credit or loan category. These factors include management’s subjective evaluation of local and national economic and business conditions, portfolio concentration and changes in the character and size of the loan portfolio. The unallocated portion of the inherent reserve reflects management’s attempt to ensure that the overall reserve appropriately reflects a margin for the imprecision inherent in the process of estimating probable credit losses.
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7. Goodwill and Other Intangibles - Goodwill and other intangible assets are included in other assets in the consolidated balance sheet. The following table shows the changes in the carrying amount of goodwill by business unit for the three months ended September 30, 2004.
Balance at June 30, 2004
Goodwill Acquired – Legacy South
Balance at September 30, 2004
The gross carrying amount and accumulated amortization of other intangible assets at September 30, 2004 and September 30, 2003, was as follows:
Other Intangible Assets- Subject to Amortization
Other intangible assets consist primarily of the value of acquired client relationships. Amortization expense related to other intangible assets totaled $2.4 million and $2.9 million for the three months ended September 30, 2004 and 2003, respectively. Amortization for the remainder of 2004 and for the years 2005, 2006, 2007 and 2008 is estimated to be $2.5 million, $8.8 million, $8.5 million, $6.2 million and $4.3 million, respectively.
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8. Accumulated Other Comprehensive Income - The following tables summarize the components of accumulated other comprehensive income at September 30, 2004 and 2003, and changes during the three and nine-month periods then ended, presented on an after-tax basis.
Beginning
Balance
(Net of Tax)
Ending
Pre-Tax
Amount
Unrealized Gains (Losses) on Securities Available for Sale
Less: Reclassification Adjustments
Unrealized Gains (Losses) on Cash Flow Hedge Designations
Minimum Pension Liability
Tax Effect
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9. Net Income Per Common Share Computations - The computation of net income per common share is presented in the following table.
Basic Net Income Per Common Share
Average Number of Common Shares Outstanding
Reported Income from Continuing Operations
Less: Dividends on Preferred Stock
Income from Continuing Operations Applicable to Common Stock
Reported Basic Income from Continuing Operations Per Common Share
Basic Income (Loss) from Discontinued Operations Per Common Share
Diluted Net Income Per Common Share
Plus Dilutive Potential Common Shares:
Stock Options
Stock Incentive Plans *
Average Common and Potential Common Shares
Reported Diluted Income from Continuing Operations Per Common Share
Diluted Income (Loss) from Discontinued Operations Per Common Share
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10. Other Charges - During the second quarter of 2003, Northern Trust implemented a number of strategic steps to reduce operating costs and strategically position itself for improved profitability, resulting in pre-tax charges included in noninterest expenses of $48.5 million. Of this charge, $22.9 million represents severance costs, $16.1 million reflects a reduction in the amount of required leased and owned office space, and $9.5 million relates to other charges consisting primarily of asset retirements.
Third quarter 2003 noninterest expenses included pre-tax charges totaling $6.2 million. Of this amount, $2.8 million reflected reductions in the amount of required leased office space and $3.4 million related to asset retirements resulting from the replacement of software applications.
Changes in the other liabilities line item on the consolidated balance sheet related to these actions were as follows:
Liabilities:
Established in 2003
Cash Payments in 2003
Balance at December 31, 2003
Adjustments to Original Reserve
Cash Payments in 2004
11. Pension and Other Postretirement Plans - The following tables set forth the net periodic pension cost of the domestic qualified and nonqualified pension benefit plans and the other postretirement plan for the three- and nine-month periods ended September 30, 2004 and 2003.
Net Periodic Pension Expense
Qualified Plan
Service Cost
Interest Cost
Expected Return on Plan Assets
Amortization:
Net Loss
Prior Service Cost (Benefit)
Nonqualified Plan
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11. Pension and Other Postretirement Plans (continued)
Net Periodic Benefit Expense
Other Postretirement Plan
Transition Obligation
For the nine months ended September 30, 2004, Northern Trust made $55.0 million in contributions to its qualified pension plan. The nonqualified plan made benefit payments totaling $1.2 million and $3.5 million, respectively, for the three- and nine-month periods ended September 30, 2004. These payments are estimated to be approximately $3.8 million for all of 2004. The postretirement health care plan made benefit payments totaling $1.1 million and $3.0 million, respectively, for the three- and nine-month periods ended September 30, 2004. These payments are estimated to be approximately $3.7 million for all of 2004.
“The Medicare Prescription Drug, Improvement and Modernization Act of 2003” (the Act) expands Medicare coverage, primarily by adding a voluntary prescription drug benefit for Medicare-eligibles starting in 2006. The Act provides employers currently sponsoring prescription drug programs for Medicare-eligibles with a range of options for coordinating with the new government-sponsored prescription drug program to potentially reduce program costs. These options include supplementing the government program on a secondary payer basis or accepting a direct subsidy from the government to support a portion of the cost of the employer’s program. Northern Trust anticipates that future benefit payments will be lower as a result of the new Medicare provision.
As permitted by FSP 106-2, Northern Trust made a one-time election in the third quarter to account for the prescription drug subsidy retrospectively. This action is expected to have a favorable impact on 2004 net periodic benefit expense for the medical post-retirement plan of $.2 million and the Accumulated Postretirement Benefit Obligation of $2.0 million. These amounts are based on preliminary estimates that depend on regulatory interpretations not yet available, and therefore, are subject to change.
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12. Stock-Based Compensation Plans - The Northern Trust Corporation 2002 Stock Plan (2002 Plan) provides for the grant of incentive stock options, nonqualified stock options, stock appreciation rights, stock awards, performance shares and stock units. As of September 30, 2004, shares available for future grant under the 2002 Plan totaled 11,238,562.
Statement of Financial Accounting Standards (SFAS) No. 123, “Accounting for Stock-Based Compensation,” establishes financial accounting and reporting standards for stock-based compensation plans. SFAS No. 123 allows two alternative accounting methods: (1) a fair-value-based method, or (2) an intrinsic-value-based method as prescribed by Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB No. 25) and related interpretations. Northern Trust has elected to account for its stock-based incentive plans and awards under APB No. 25, and has adopted the disclosure requirements of SFAS No. 123, as amended by SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure.”
Pro forma information regarding net income and earnings per share is presented below as if the Corporation had accounted for all stock-based compensation under the fair value method of SFAS No. 123. For purposes of estimating the fair value of the Corporation’s employee stock options at the grant date, a Black-Scholes option pricing model was used with the following weighted average assumptions for 2004 and 2003, respectively: risk-free interest rates of 3.13% and 3.94%; dividend yields of 2.54% and 2.08%; volatility factors of the expected market price of the Corporation’s common stock of 33.8% and 33.5%; and a weighted average expected life of the options of 5.5 years and 6.1 years.
The weighted average fair value of options granted in 2004 and 2003 was $13.65 per share and $10.40 per share, respectively. For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options’ six-month to four-year vesting periods.
The Corporation’s pro forma information follows.
(In Millions Except per Share Information)
Net Income as Reported
Add: Stock-Based Employee Compensation Expense Included in Reported Net Income, Net of Tax
Deduct: Total Stock-Based Employee Compensation Expense Determined Under the Fair Value Method, Net of Tax
Pro Forma Net Income
Earnings Per Share as Reported:
Basic
Diluted
Pro Forma Earnings Per Share:
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13. Contingent Liabilities - Standby letters of credit obligate Northern Trust to meet certain financial obligations of its clients, if, under the contractual terms of the agreement, the clients are unable to do so. These instruments are primarily issued to support public and private financial commitments, including commercial paper, bond financing, initial margin requirements on futures exchanges and similar transactions. Certain standby letters of credit have been secured with cash deposits or participated to others. Northern Trust is obligated to meet the entire financial obligation of these agreements and in certain cases is able to recover the amounts paid through recourse against cash deposits or other participants. Standby letters of credit outstanding were $2.7 billion on September 30, 2004, $2.5 billion on December 31, 2003 and $2.6 billion on September 30, 2003. Northern Trust’s liability on the consolidated balance sheet for standby letters of credit, measured as the amount of unamortized fees on these instruments was $4.5 million at September 30, 2004, $4.4 million at December 31, 2003 and $3.6 million at September 30, 2003.
As part of securities custody activities and at the direction of trust clients, Northern Trust lends securities owned by clients to borrowers who are reviewed by the Credit Policy Credit Approval Committee. In connection with these activities, Northern Trust has issued certain indemnifications against loss resulting from the bankruptcy of the borrower of securities. The borrowing party is required to fully collateralize securities received with cash, marketable securities, or irrevocable standby letters of credit. As securities are loaned, collateral is maintained at a minimum of 100 percent of the fair value of the securities plus accrued interest. The collateral is revalued on a daily basis. The amount of securities loaned subject to indemnification was $97.9 billion at September 30, 2004, $74.0 billion at December 31, 2003 and $65.6 billion at September 30, 2003. Because of the requirement to fully collateralize securities borrowed, management believes that the exposure to credit loss from this activity is remote and there are no liabilities reflected on the consolidated balance sheet at September 30, 2004, December 31, 2003 or September 30, 2003 related to these indemnifications.
In the normal course of business, the Corporation and its subsidiaries are routinely defendants in or parties to a number of pending and threatened legal actions, including actions brought on behalf of various classes of claimants, and regulatory matters. In certain of these actions and proceedings, claims for substantial monetary damages are asserted. In view of the inherent difficulty of predicting the outcome of such matters, the Corporation cannot state what the eventual outcome of these matters will be; however, based on current knowledge and after consultation with legal counsel, management does not believe that judgments or settlements, if any, arising from pending or threatened legal actions or regulatory matters, either individually or in the aggregate, will have a material adverse effect on the consolidated financial position or liquidity of the Corporation, although they could have a material effect on operating results for a particular period.
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13. Contingent Liabilities (continued)
In 2003, a putative class action was filed against Northern Trust Bank of California N.A. (later adding the Corporation) seeking class-wide reimbursement, with interest and punitive damages, for approximately 300 trust accounts that were allegedly charged fees in excess of fee provisions in the underlying trust documents. Virtually all of the trust accounts in the putative class were purchased in 1992 by the California bank from Trust Services of America, Inc., then a subsidiary of CalFed. Prior to the filing of this class action, the California bank had begun to file petitions seeking review and approval from the California probate court of reimbursements to these accounts, and 79 such petitions have already been approved with reimbursements for those accounts totaling approximately $2.5 million. During the second quarter 2004, the court dismissed the Corporation from the suit on jurisdictional grounds, but allowed most of the claims to proceed against the California bank, including claims challenging the previously approved petitions. On August 10, 2004, the Corporation announced that the California bank had entered into a settlement in principle to resolve the putative class action. The settlement remains subject to negotiation of a final written agreement and court approval. Upon final approval of the settlement, the California bank will pay approximately $21 million. The settlement, including estimated associated costs, resulted in a third quarter 2004 pre-tax charge of $17.0 million.
One subsidiary of the Corporation has been named as a defendant in several Enron-related class action suits that have been consolidated under a single complaint in the Federal District Court for the Southern District of Texas (Houston). Individual participants in the employee pension benefit plans sponsored by Enron Corp. sued various corporate entities and individuals, including The Northern Trust Company (Bank) in its capacity as the former directed trustee of the Enron Corp. Savings Plan and former service-provider for the Enron Corp. Employee Stock Ownership Plan. The lawsuit makes claims, inter alia, for breach of fiduciary duty to the plan participants, and seeks equitable relief and monetary damages in an unspecified amount against the defendants. On September 30, 2003, the court denied the Bank’s motion to dismiss the complaint as a matter of law. In an Amended Consolidated Complaint filed on January 2, 2004, plaintiffs continue to assert claims against the Bank and other defendants under the Employee Retirement Income Security Act of 1974, seeking a finding that defendants are liable to restore to the benefit plans and the plaintiffs hundreds of millions of dollars of losses allegedly caused by defendants’ alleged breaches of fiduciary duty. The trial date currently is scheduled for fall 2006. The Corporation and the Bank will continue to defend this action vigorously. In June 2003, after conducting an extensive investigation, which included the Bank and NTRC, the U.S. Department of Labor (DOL) filed a civil action against numerous parties charging that they violated their obligations to the Enron plan participants. The DOL did not name any Northern Trust entity or employee as a defendant in its suit. In another matter, in November and December 2003, Enron as debtor-in-possession filed two lawsuits seeking to recover for its bankruptcy estate more than $1 billion it paid in the fall of 2001 to buy back its commercial paper. Enron claims that the money it paid to buy back its commercial paper approximately six weeks prior to its bankruptcy filing represented “preference” payments and “fraudulent transfers” that can be reversed with
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the money going back to Enron. Since the Bank sold approximately $197 million of this Enron commercial paper that it held for some of its clients, the Bank and those clients are among scores of defendants named in these complaints. The Corporation and the Bank will defend these actions vigorously.
14. Pledged Assets - Securities and loans pledged to secure public and trust deposits, repurchase agreements and for other purposes as required or permitted by law were $9.9 billion on September 30, 2004, $10.1 billion on December 31, 2003 and $9.7 billion on September 30, 2003. Included in the September 2004 pledged assets were securities available for sale of $1.0 billion, which were pledged as collateral for agreements to repurchase securities sold transactions. The secured parties to these transactions have the right to repledge or sell these securities.
Northern Trust is also permitted to repledge or sell collateral from agreements to resell securities purchased transactions. The total fair value of accepted collateral as of September 30, 2004, December 31, 2003 and September 30, 2003 was $406.7 million, $407.2 million and $380.5 million, respectively. The fair value of repledged collateral as of September 30, 2004, December 31, 2003 and September 30, 2003 was zero, $50.4 million and $35.8 million, respectively. Repledged collateral was used in other agreements to repurchase securities sold transactions.
15. Business Units - The table on page 26, reflecting the earnings contribution of Northern Trust’s business units for the three- and nine-month periods ended September 30, 2004, is incorporated by reference.
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THIRD QUARTER CONSOLIDATED RESULTS OF OPERATIONS
Overview
Net income per common share on a diluted basis was $.52 for the third quarter, an increase of 2% from $.51 per share earned in last year’s third quarter. Net income increased 1% to $114.7 million from $113.8 million earned in the third quarter of last year. These results were reduced by an after-tax charge of $10.6 million, or $.05 earnings per share, for a proposed litigation settlement relating to the Northern Trust Bank of California N.A. This performance produced an annualized return on average common equity (ROE) of 14.40% versus 15.40% reported for the comparable quarter last year and an annualized return on average assets (ROA) of 1.13% versus 1.15% in 2003.
As a result of its disposition in June 2003, the operating results of Northern Trust Retirement Consulting, L.L.C. (NTRC) for all periods presented are shown as discontinued operations in Northern Trust’s consolidated statement of income.
Revenues stated on a fully taxable equivalent basis of $560.0 million were up 4% from $538.8 million in last year’s third quarter, while expenses increased 9%. The current quarter operating expenses were negatively impacted by a pre-tax charge of approximately $17.0 million related to the proposed litigation settlement. The quarterly performance benefited from an increase in trust fees, higher net interest income, and continued strength in the quality of our loan portfolio, offset by lower foreign exchange trading results.
Noninterest income totaled $407.4 million for the quarter, up 4% from $391.4 million reported last year, and accounted for 73% of total taxable equivalent revenue. Trust fees were $327.5 million in the quarter, up 8% compared with $304.0 million in the third quarter of last year and represented 58% of total taxable equivalent revenue. The increase in trust fees resulted primarily from new business and improved equity markets. The components of noninterest income for the third quarters of 2004 and 2003 are listed in the following table:
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Noninterest Income (continued)
Assets under administration totaled a record $2.40 trillion at September 30, 2004. This represents an increase in assets under administration of 12% from December 31, 2003 and 25% from September 30, 2003. Assets under management also reached a new high and totaled $534.6 billion compared with $435.7 billion at September 30, 2003. As of current quarter-end, managed assets were invested 40% in equities, 19% in fixed-income securities and 41% in cash and other assets.
Consolidated Trust Assets Under Administration(In Billions)
Corporate & Institutional
Total Managed Trust Assets
Total Non-Managed Trust Assets
Consolidated Trust Assets Under Administration
Trust fees are generally based on the market value of assets managed and administered, the volume of transactions, securities lending volume and spreads, and fees for other services rendered. Certain investment management fee arrangements also may provide for performance fees, which are based on client portfolio returns exceeding predetermined levels. In addition, Corporate & Institutional Services (C&IS) trust relationships are generally priced to reflect earnings from activities such as foreign exchange trading and custody-related deposits that are not included in trust fees. Based on prior analysis and current trust asset and product mix, management estimates that a 10% rise or fall in overall equity markets would cause a corresponding increase or decrease in Northern Trust’s trust fees of approximately 4% and total revenues of approximately 2%.
Trust fees from Corporate & Institutional Services (C&IS) in the quarter were up 9% to $165.1 million, reflecting new business and improved equity markets. Custody fees increased 18% to $68.5 million for the quarter, driven by strong growth in global custody revenues. Fees from asset management grew 5% to $57.1 million. Securities lending fees increased 1% to $25.5 million, reflecting higher lending volumes, partially offset by lower spreads earned on the investment of collateral.
C&IS assets under administration totaled $2.20 trillion at September 30, 2004 compared with $1.74 trillion at September 30, 2003. Assets under administration include $867.8 billion of global custody assets, an increase of 31% compared with $660.7 billion one year ago. C&IS assets under management totaled $428.9 billion compared with $336.7 billion at September 30, 2003. As of current quarter-end, C&IS managed assets were invested 37% in equities, 15% in fixed-income securities and 48% in cash and other assets.
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Trust fees from Personal Financial Services (PFS) in the quarter increased 6% and totaled $162.4 million. The increase in PFS trust fees resulted primarily from new business and improved equity markets. Revenue growth was broad-based, with all regions and the Wealth Management Group reporting year-over-year increases in trust fees. Personal trust assets under administration totaled $205.4 billion at September 30, 2004 compared with $180.8 billion at September 30, 2003. Of the total trust assets under administration, $105.7 billion is managed by Northern Trust compared with $99.0 billion at September 30, 2003. As of current quarter-end, PFS managed assets were invested 50% in equities, 38% in fixed-income securities and 12% in cash and other assets.
Foreign exchange trading profits were $26.5 million in the quarter compared with $28.9 million in the third quarter of last year, reflecting reduced volatility in the major currencies. Treasury management fees in the quarter were $22.4 million compared with $24.1 million in the same quarter last year. Revenues from security commissions and trading income were $11.4 million compared with $13.7 million recorded in the prior year quarter. Other operating income, the components of which are listed below, was $19.6 million for the third quarter compared with $20.7 million in the same period last year.
Loan Service Fees
Banking Service Fees
Other Income
Total Other Operating Income
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Net interest income for the quarter totaled $139.0 million, 3% higher than the $134.3 million reported in the third quarter of 2003. Net interest income is defined as the total of interest income and amortized fees on earning assets, less interest expense on deposits and borrowed funds, adjusted for the impact of hedging activity. When net interest income is adjusted to a fully taxable equivalent (FTE) basis, yields on taxable, nontaxable and partially taxable assets are comparable, although the adjustment to a FTE basis has no impact on net income. Net interest income for the quarter stated on a FTE basis totaled $152.6 million, up 4% from $147.4 million from the prior year quarter. The improvement resulted primarily from a $1.4 billion increase in average earning assets, funded in large part by a 17% increase in net noninterest-related funds. The net interest margin decreased slightly to 1.66% from 1.67% in the prior year quarter. The change was due primarily to a decline in the average yield of the residential mortgage loan portfolio attributable to the prior year refinancing activity and the growth in lower margin short-term money market assets, offset in part by the higher level of noninterest-related funding. Total average earning assets of $36.5 billion were 4% higher than a year ago with the increase concentrated in money market assets. Average loans were virtually unchanged from a year ago at $17.5 billion.
Average domestic loans outstanding during the quarter, at $17.0 billion, were 1% below the $17.1 billion in the third quarter of last year, while average international loans increased $149 million from a year ago to $533 million. Residential mortgages averaged $8.0 billion in the quarter, up 3% from the prior year’s third quarter and represented 46% of the total average loan portfolio. Commercial and industrial loans averaged $3.2 billion, down 14% from $3.8 billion last year, while personal loans increased 7% to average $2.6 billion compared with last year’s third quarter.
Northern Trust utilizes a diverse mix of funding sources. Total interest-related deposits averaged $21.2 billion, up 9% from the third quarter of 2003. Foreign office time deposits increased $1.4 billion, up 14% as a result of global custody activity, while retail deposit levels increased $350 million due primarily to higher balances in money market deposit accounts, offset in part by a reduction in savings certificates. Other interest-related funds averaged $9.1 billion in the quarter compared with $10.5 billion in last year’s third quarter due primarily to lower levels of federal funds purchased and securities sold under agreements to repurchase. The balances within these classifications vary based on funding requirements and strategies, interest rate levels, changes in the volume of lower-cost deposit sources, and the availability of collateral to secure these borrowings. Noninterest-related funds utilized to fund earning assets increased 17% from the prior year, averaging $6.2 billion.
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The reserve for credit losses at September 30, 2004 was $150.1 million compared with $151.4 million at the previous quarter-end. There was no provision for credit losses and net charge-offs were $1.3 million in the quarter. The provision for the prior year third quarter was $5.0 million and net charge-offs totaled $5.0 million. For a discussion of the provision and reserve for credit losses, refer to the “Asset Quality” section beginning on page 32.
Noninterest expenses totaled $377.8 million for the quarter, up 9% from $347.4 million in the year-ago quarter. The current quarter includes a pre-tax charge of $17.0 million related to the proposed litigation settlement, including estimated associated costs. The components of noninterest expenses and a discussion of significant changes from the prior year quarter are provided below.
Compensation and employee benefit expenses totaled $195.2 million. This compares with $190.8 million last year. Current period compensation expense reflects annual salary increases offset in part by lower incentive compensation. Employee benefit expenses increased as a result of higher pension and health care costs. These increases were offset by a reduction in the accrual for the performance-based portion of the Employee Stock Ownership Plan. Compensation and employee benefit expense increases were partially offset by lower staffing levels. Staff on a full-time equivalent basis at September 30, 2004 totaled 7,980 compared with 8,094 a year ago.
Net occupancy expense totaled $30.5 million compared with $29.3 million in the third quarter of 2003. The increase in occupancy expense reflects higher net rental costs. The prior year quarter included a $2.8 million charge to rent expense associated with reduced leased office space needs essentially offset by real estate tax refunds.
Equipment expense, comprised of depreciation, rental and maintenance costs totaled $21.4 million, down 1% from $21.5 million reported in the third quarter of 2003. Lower levels of rental and maintenance of computer hardware and equipment were offset by increases in data line lease costs.
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Noninterest Expenses (continued)
Other operating expenses in the quarter totaled $130.7 million compared with $105.8 million last year. The current quarter includes the $17.0 million proposed litigation settlement while the prior year quarter included $3.4 million related to asset retirements resulting from the replacement of software applications. The majority of the remaining increase resulted from higher subcustodian and sub-advisor fees related to higher volumes and new business, and increased business promotion and advertising efforts. The components of other operating expenses were as follows:
Outside Services Purchased
Software Amortization and Other Costs
Business Promotion
Other Intangibles Amortization
Software Asset Retirements
Litigation Settlement and Related Costs
Other Expenses
Total Other Operating Expenses
The provision for income taxes was $53.9 million for the third quarter compared with $58.5 million in the year-ago quarter. The lower tax provision in 2004 primarily reflects lower pre-tax earnings, as well as changes in where income was earned, which reduced overall state income tax requirements. The effective income tax rate for the quarter was 32.0% compared with 33.8% in the third quarter of 2003.
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BUSINESS UNIT REPORTING
The following tables reflect the earnings contribution and average assets of Northern Trust’s business units for the three- and nine-month periods ended September 30, 2004 and 2003.
Corporate and
Institutional
Services
Personal Financial
Treasury and
Consolidated
Results of Operations Three Months
Net Interest Income *
Income before Income Taxes*
Provision for Income Taxes*
Loss from Discontinued Operations
Percentage of Net Income Contribution
Average Assets
Note: Certain reclassifications have been made to 2003 financial information to conform to the current year presentation.
Results of Operations Nine Months
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Corporate and Institutional Services
C&IS net income for the third quarter totaled $57.7 million compared with $56.2 million reported in 2003. Included in the above are the operating results of NTRC that have been classified and shown as discontinued operations for all periods presented. NTRC reported a net loss from operations of $1.0 million in the third quarter of 2003. Noninterest income from continuing operations was $218.8 million, up 4% from $211.3 million in last year’s third quarter. Trust fees in the quarter were up 9% to $165.1 million, reflecting new business and improved equity markets. Custody fees increased 18% to $68.5 million for the quarter, driven by strong growth in global custody revenues. Fees from asset management grew 5% to $57.1 million. Securities lending fees increased 1% to $25.5 million, reflecting higher lending volumes, partially offset by lower spreads earned on the investment of collateral. Other noninterest income was $53.7 million compared with $59.8 million in last year’s third quarter. Lower levels of foreign exchange trading profits and treasury management fees were the primary cause for the decline.
Net interest income stated on a FTE basis was $44.5 million, up 19% from $37.5 million in last year’s third quarter. Net interest income was positively impacted by a $3.2 billion or 22% increase in average earning assets. The increase was concentrated in short-term money market assets, offset in part by a 3% reduction in average loans outstanding. The net interest margin fell to .98% for the current quarter from 1.00% in last year’s third quarter. The net interest spread and margin were both negatively impacted by the change in the mix of the balance sheet as lower-rate money market assets grew while higher yielding loans declined.
The $.4 million provision for credit losses in the current quarter compares with a negative $7.0 million provision in the third quarter of last year. The negative provision in 2003 resulted primarily from the net impact of principal repayments and credit quality improvements. Total noninterest expenses of C&IS, which include both the direct expenses of the business unit and indirect expense allocations from Northern Trust Global Investments (NTGI) and Worldwide Operations and Technology (WWOT) for product and operating support, increased 4% and totaled $168.6 million for the third quarter. Increases in compensation expense resulting from annual salary increases and higher performance-based pay, costs associated with business promotion and advertising efforts, and fees for other professional services contributed to the overall increase in operating expenses.
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Personal Financial Services
PFS net income for the quarter was $62.8 million, down slightly from $63.2 million reported a year ago. Trust fees increased 6% and totaled $162.4 million. The increase in PFS trust fees resulted primarily from new business and improved equity markets. Revenue growth was broad-based, with all regions and the Wealth Management Group reporting year-over-year increases in trust fees. Other operating income totaled $23.1 million compared with $26.4 million in the prior year quarter. The decrease from the prior year was due to lower revenues from security commissions and trading income and treasury management fees.
Net interest income stated on a FTE basis, was $112.3 million in the quarter compared with $108.8 million in the prior year’s third quarter. These results reflect a 2% increase in average earning assets that was split between loans and money market assets and an increase in the net interest margin from 2.85% last year to 2.88% in the current quarter.
The negative $.4 million provision for credit losses, down from $12.0 million last year, was due primarily to the improved credit quality of certain commercial loans. Total noninterest expenses of PFS, which include both the direct expenses of the business unit and indirect expense allocations from NTGI and WWOT for product and operating support, increased 13% to $195.7 million from $173.4 million in last year’s third quarter. The current quarter includes a charge of approximately $17.0 million related to the proposed litigation settlement, including estimated associated costs. Higher compensation expense resulting from annual salary increases, increased occupancy expense related to the remodeling and expansion of existing locations, and higher allocations for product and operating support contributed to the overall increase in operating expenses.
Treasury and Other
The Treasury Department is responsible for managing the Bank’s wholesale funding, capital position and interest rate risk, as well as the investment portfolio. The ‘Other’ category of corporate income and noninterest expenses represents items that are not allocated to the business units and generally represent certain nonrecurring items and certain executive level compensation. Net interest income for the third quarter was a negative $4.2 million compared with $1.1 million in the year-ago quarter. The decline in net interest income resulted from the decrease in the net interest margin, due in large part to the continued decline in the yield on the residential mortgage loan portfolio resulting from refinancing activity over the past year. Noninterest expenses totaled $13.5 million for the quarter compared with $11.7 million in the year-ago period, which included the charge associated with a reduction in office space. The increase after adjusting for the prior year office space charge, reflects costs associated with higher corporate-based executive level compensation plan expenses and fees for other professional services.
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NINE-MONTH CONSOLIDATED RESULTS OF OPERATIONS
Net income per common share of $1.67 was 36% higher than the $1.23 per share reported in 2003. Net income was $373.0 million compared with $275.1 million earned last year. The ROE was 16.00% for the nine months compared with 12.64% last year, while the ROA was 1.24% compared with .96% in the previous year. Total revenues were 8% higher than the prior year while total expenses increased 2%, resulting in a productivity ratio of 152% compared with 144% last year.
As a result of the 2003 second quarter sale of the assets of NTRC, its operating results for all periods presented have been shown as discontinued operations in Northern Trust’s consolidated statement of income. The net income from discontinued operations in the current year totaled $.3 million compared with a $17.7 million net loss in the prior year, which included the $20.2 million pre-tax loss on the sale and NTRC’s net loss from operations.
Revenues stated on a FTE basis of $1.72 billion were up 8% from $1.60 billion last year. Trust fees were $991.6 million for the period, up 13% compared with last year. Trust fees represented 58% of total revenues and total fee-related income represented 74% of total revenues.
Trust fees from Corporate & Institutional Services (C&IS) increased 17% to $507.6 million. Custody fees increased 23% to $202.8 million for the period, reflecting strong growth in global custody revenues, while fees from asset management grew 11% to $171.6 million. Securities lending fees totaled $89.7 million compared with $75.4 million last year reflecting higher volumes, partially offset by lower spreads earned on the investment of collateral.
Trust fees from Personal Financial Services (PFS) in the period increased 9% and totaled $484.0 million compared with last year. The increase in PFS trust fees resulted primarily from new business and improved equity markets. Revenue growth was broad-based, with all regions and the Wealth Management Group reporting a year-over-year increase in trust fees.
Foreign exchange trading profits were $115.4 million in the period compared with $82.4 million last year. Treasury management fees were $68.1 million, down 6% from the comparable period last year. Revenues from security commissions and trading income were $38.8 million compared with $41.5 million in the prior year. Other operating income was $58.5 million for the period compared with $73.3 million in the same period last year. The prior year included a $17.8 million gain from the sale of a retail branch.
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Net interest income for the nine months stated on a fully taxable equivalent basis, totaled $450.8 million, virtually unchanged from the $451.0 million reported in the prior year period. The net interest margin decreased to 1.66% from 1.76% in the prior year due in large part to a decline in the yield on the residential mortgage loan portfolio due to the impact of refinancing activity and the growth in lower margin short-term money market assets. Total average earning assets of $36.2 billion were 6% higher than a year ago with the increase concentrated in money market assets, which were up 26% and averaged $10.8 billion for the period. Average securities decreased 1% to $8.0 billion while average loans were down 1% to $17.4 billion.
The 2004 provision for credit losses was a negative $5.0 million compared with $17.5 million required in 2003. Improved credit quality led to the negative provision for the current year. Net charge-offs totaled $2.1 million and represented .02% of average loans compared with $13.3 million or .10% of average loans in 2003.
Noninterest expenses totaled $1.13 billion for the period, up 2% from a year ago. The prior year included charges for severance, office space and software write-downs, which totaled $54.7 million.
Compensation and employee benefits represented 54% of total operating expenses and totaled $608.7 million. This compared with $595.0 million last year that included $19.5 million in severance-related costs. The current period expenses reflect annual salary increases, higher incentive compensation and increased retirement and health care costs.
Net occupancy expense totaled $92.2 million, down 10% from $102.5 million in the prior year. The prior period included $18.9 million associated with the reduction in leased office space needs. The remainder of the change from the prior year was the result of higher net rental costs, real estate taxes and building maintenance.
Equipment expense, comprised of depreciation, rental and maintenance costs, totaled $61.9 million, down 7% from $66.6 million in 2003. The current nine-month period reflects lower levels of rental and maintenance of computer hardware and equipment, data line lease costs and reduced depreciation of computer hardware and personal computers.
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Other operating expenses totaled $369.7 million for the period, up 7% from $345.3 million in 2003. The prior year included the costs associated with the standardization, replacement and elimination of software ($12.9 million) and outplacement benefit charges ($3.4 million). The current period reflects the third quarter charge related to the proposed litigation settlement, in addition to higher insurance premiums, growth driven increases in fees for global custody and asset management sub-advisor services, and higher costs associated with operating risks related to servicing and managing financial assets. These increases were partially offset by lower expenses from strategic initiatives implemented in 2003 to reduce operating costs.
BALANCE SHEET
Total assets at September 30, 2004 were $41.1 billion and averaged $40.4 billion for the third quarter, compared with last year’s average of $39.3 billion. Loans and leases totaled $17.7 billion at September 30, 2004 and averaged $17.5 billion for the third quarter, compared with $17.9 billion at September 30, 2003 and $17.5 billion for the third quarter of last year. Securities totaled $6.7 billion at September 30, 2004 and averaged $7.5 billion for the quarter, compared with $9.1 billion at September 30, 2003 and $8.8 billion on average last year. Money market assets totaled $11.9 billion at September 30, 2004 and averaged $11.5 billion in the third quarter, up 31% from the year-ago quarter.
Common stockholders’ equity increased to $3.23 billion at September 30, 2004 and averaged $3.17 billion for the quarter, up 8% from last year’s third quarter average. The increase primarily reflects the retention of earnings offset in part by the repurchase of common stock pursuant to the Corporation’s share buyback program. During the quarter, the Corporation acquired 891,251 shares at a cost of $36.6 million. An additional 7.5 million shares are authorized for purchase after September 30, 2004 under the previously announced share buyback program.
Northern Trust’s risk-based capital ratios remained strong at 11.3% for tier 1 capital and 13.8% for total capital at September 30, 2004. These ratios are well above the minimum regulatory requirements of 4% for tier 1 and 8% for total risk-based capital ratios. The leverage ratio (tier 1 capital to third quarter average assets) of 8.1% at September 30, 2004, also exceeded the minimum regulatory requirement of 3%. The Bank’s risk-based capital ratios at September 30, 2004 were 9.4% for tier 1 capital, 12.3% for total capital and 6.6% for the leverage ratio. Each of Northern Trust’s other subsidiary banks had a ratio of 10.6% or higher for tier 1 capital, 11.2% or higher for total risk-based capital, and 8.2% or higher for the leverage ratio.
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ASSET QUALITY
Nonperforming assets consist of nonaccrual loans and other real estate owned (OREO). Nonperforming assets at September 30, 2004 totaled $64.7 million compared with $67.9 million at June 30, 2004, $80.3 million at December 31, 2003 and $100.2 million at September 30, 2003. Domestic nonaccrual loans and leases, consisting primarily of commercial loans, totaled $64.2 million, or .37% of total domestic loans and leases at September 30, 2004, of which $40.5 million relates to two commercial clients that have exposure to asbestos-related claims. At June 30, 2004, December 31, 2003 and September 30, 2003, domestic nonaccrual loans and leases totaled $67.1 million, $80.0 million and $99.8 million, respectively. The $2.9 million decrease in nonperforming loans during the quarter is primarily the result of the charge-off of a commercial loan and net loan repayments.
The following table presents the outstanding amounts of nonaccrual loans and OREO. Also shown are loans that have interest or principal payments that are delinquent 90 days or more and are still accruing interest. The balance of loans delinquent 90 days or more and still accruing interest can fluctuate widely based on the timing of cash collections, renegotiations and renewals.
Nonperforming Assets and 90 Day Past Due Loans
Nonaccrual Loans
Total Nonaccrual Loans
Other Real Estate Owned
Total Nonperforming Assets
Total 90 Day Past Due Loans (still accruing)
Provision and Reserve for Credit Losses
The provision for credit losses is the charge against current earnings, determined through a disciplined credit risk management process, needed to maintain a reserve that is sufficient to absorb credit losses inherent in Northern Trust’s loan and lease portfolios and other credit undertakings. The reserve provides for probable losses that have been identified with specific borrower relationships (specific reserve) and for probable losses that are believed to be inherent in the loan and lease portfolios and other credit undertakings but that have not yet been specifically identified (inherent reserve).
Note 6 to the Consolidated Financial Statements includes a table that details the changes in the reserve for credit losses during the three- and nine-month periods ended September 30, 2004 and September 30, 2003 due to charge-offs, recoveries and the provision for credit losses during the respective periods. The following table shows (i) the specific reserve, (ii) the allocated portion of the inherent reserve and its components by loan category, and (iii) the unallocated portion of the inherent reserve at September 30, 2004, June 30, 2004, December 31, 2003 and September 30, 2003.
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Provision and Reserve for Credit Losses (continued)
Allocation of the Reserve for Credit Losses
($ in Millions)
Reserve
Percent
Loansto
TotalLoans
Percentof
Specific Reserve
Allocated Inherent Reserve
Total Allocated Inherent Reserve
Unallocated Inherent Reserve
Total Reserve
Reserve Assigned to:
Unfunded Commitments and Standby Letters of Credit
Specific Reserve. At September 30, 2004, the specific component of the reserve stood at $32.2 million compared with $32.9 million at June 30, 2004. The $.7 million decrease in specific reserves from June 30, 2004 is due primarily to the charge-off of a commercial loan that had been reserved for in a prior period, offset in part by an increase in the reserve required on a commercial credit exposure.
Allocated Inherent Reserve. The allocated inherent portion of the reserve totaled $93.3 million at September 30, 2004 compared with $94.4 million at June 30, 2004. This component of the reserve decreased by $1.1 million due primarily to the net reduction in the outstanding balance of lower-rated loans reflecting the receipt of principal repayments during a period of limited growth in commercial loan volumes.
Unallocated Inherent Reserve. The unallocated portion of the inherent reserve is based on management’s review of overall factors affecting the determination of probable inherent losses, primarily in the commercial portfolio, which are not necessarily captured by the application of historical loss ratios. This portion of the reserve analysis involves the exercise of judgment and reflects considerations such as management’s view that the reserve should have a margin that recognizes the imprecision inherent in the process of estimating probable credit losses. Although credit quality and business conditions have shown signs of improvement, there continues to be uncertainty with regard to the breadth of the economic recovery, the impact of record high oil prices and increases in interest rates from current historically low levels. The unallocated inherent portion of the reserve was $24.6 million at September 30, 2004.
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Other Factors. At September 30, 2004, the total amount of the two highest risk loan groupings, those rated “7” and “8” (based on Northern Trust’s internal rating scale, which closely parallels that of the banking regulators) was $165 million (of which $62.7 million was classified as impaired), essentially unchanged from $166 million at June 30, 2004 when $65.0 million was classified as impaired, and down from $280 million at September 30, 2003 when $97.3 million was classified as impaired.
Total Reserve. Management’s evaluation of the factors above resulted in a reserve for credit losses of $150.1 million at September 30, 2004. The reserve of $140.4 million assigned to loans and leases, as a percentage of total loans and leases was .79% at September 30, 2004, compared with .81% at June 30, 2004.
Reserves assigned to unfunded loan commitments, standby letters of credit and derivative products, recorded as a liability on the consolidated balance sheet, totaled $9.7 million at September 30, 2004, an increase of $.2 million from June 30, 2004.
Provision. No provision for credit losses was recorded in the third quarter of 2004 compared with a $5.0 million provision in the prior year quarter. The $5.0 million decrease in the provision resulted from overall continued improvement in the credit quality of the loan portfolio.
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MARKET RISK MANAGEMENT
As described in the 2003 Annual Report to Shareholders, Northern Trust manages its interest rate risk through measurement techniques which include simulation of earnings, simulation of the economic value of equity, and gap analysis. Also, as part of its risk management activities, it regularly measures the risk of loss associated with foreign currency positions using a value at risk model.
Based on this continuing evaluation process, Northern Trust’s interest rate risk position and the value at risk associated with the foreign exchange trading portfolio have not changed significantly since December 31, 2003.
FACTORS AFFECTING FUTURE RESULTS
This report contains statements that may be considered forward-looking, such as the statements relating to Northern Trust’s financial goals, dividend policy, expansion and business development plans, anticipated expense levels and projected profit improvements, business prospects and positioning with respect to market and pricing trends, strategic initiatives, re-engineering and outsourcing activities, new business results and outlook, changes in securities market prices, credit quality including reserve levels, planned capital expenditures and technology spending, and the effects of any extraordinary events and various other matters (including developments in litigation and regulation involving Northern Trust and changes in accounting policies, standards and interpretations) on Northern Trust’s business and results. Forward-looking statements are typically identified by words or phrases, such as “believe,” “expect,” “anticipate,” “intend,” “estimate,” “may increase,” “may fluctuate,” “plan,” “goal,” “strategy,” and similar expressions or future or conditional verbs such as “will,” “should,” “would,” and “could.” Forward-looking statements are Northern Trust’s current estimates or expectations of future events or future results. Actual results could differ materially from the results indicated by these statements because the realization of those results is subject to many risks and uncertainties including:
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FACTORS AFFECTING FUTURE RESULTS (continued)
36
Some of these risks and uncertainties that may affect future results are discussed in more detail in the sections of “Management’s Discussion and Analysis of Financial Condition and Results of Operations” captioned “Risk Management,” “Market Risk Management” and “Operational and Fiduciary Risk Management” in the 2003 Annual Report to Stockholders (pages 46-56) and in the sections of “Item 1—Business” of the 2003 Annual Report on Form 10-K captioned “Government Policies,” “Competition” and “Regulation and Supervision” (pages 7-14). All forward-looking statements included in this report are based upon information presently available, and Northern Trust assumes no obligation to update any forward-looking statements.
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The following schedule should be read in conjunction with the Net Interest Income section of Management's Discussion and Analysis of Financial Condition and Results of Operations.
CONSOLIDATED AVERAGE STATEMENT OF CONDITION
WITH ANALYSIS OF NET INTEREST INCOME
(Interest and rate on a fully taxable equivalent basis)
Average Earning Assets
Money Market Assets
Federal Funds Sold and Resell Agreements
Total Money Market Assets
Trading and Other
Total Earning Assets
Reserve for Credit Losses Assigned to Loans
Average Source of Funds
Foreign Offices Time
Total Interest-Related Funds
Interest Rate Spread
Noninterest-Related Deposits
Net Interest Income/Margin (FTE Adjusted)
Net Interest Income/Margin (Unadjusted)
ANALYSIS OF NET INTEREST INCOME CHANGES DUE TO VOLUME AND RATE
Earning Assets (FTE)
Interest-Related Funds
Net Interest Income (FTE)
38
2004
2003
39
The information called for by this item is incorporated herein by reference to “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Market Risk Management” on page 35 of this document.
The Corporation’s management, with the participation of the Corporation’s Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of Northern Trust’s “disclosure controls and procedures” (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the Exchange Act)) as of the end of the period covered by this report. Based on such evaluation, such officers have concluded that, as of the end of the period covered by this report, Northern Trust’s disclosure controls and procedures are effective in bringing to their attention on a timely basis material information relating to the Corporation (including its consolidated subsidiaries) required to be included in the Corporation’s periodic filings under the Exchange Act. Further, there have been no changes in the Corporation’s internal controls over financial reporting during the last fiscal quarter that have materially affected or that are reasonably likely to affect materially the Corporation’s internal controls over financial reporting.
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PART II - OTHER INFORMATION
Period
Average Price
Paid per Share
Total Number of
Shares Purchased as
Part of a PubliclyAnnounced Plan (2)
July 1 – 31, 2004
August 1 – 31, 2004
September 1 – 30, 2004
Total (Third Quarter)
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(i) Northern Partners Incentive Plan adopted July 19, 2004.
(i) Certification of CEO Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
(ii) Certification of CFO Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
(i) Certifications of CEO and CFO Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
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SIGNATURES
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.
(Registrant)
Date:
November 1, 2004
/s/ Steven L. Fradkin
Steven L. Fradkin
Executive Vice President and Chief
Financial Officer
/s/ Harry W. Short
Harry W. Short
Executive Vice President and Controller
(Chief Accounting Officer)
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EXHIBIT INDEX
The following exhibits have been filed with the Securities and Exchange Commission with Northern Trust Corporation’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2004. You may obtain copies of these exhibits from the SEC’s Internet site at http://www.sec.gov. Stockholders may also obtain copies of such exhibits by writing Rose A. Ellis, Secretary, Northern Trust Corporation, 50 South LaSalle Street, Chicago, Illinois 60675.
Description
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