U.S. Bancorp - 10-Q quarterly report FY

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

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     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, and (2) has been subject to such filing requirements for the past 90 days.

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     This Form 10-Q contains forward-looking statements. Statements that are not historical or current facts, including statements about beliefs and expectations, are forward-looking statements. These statements often include the words “may,” “could,” “would,” “should,” “believes,” “expects,” “anticipates,” “estimates,” “intends,” “plans,” “targets,” “potentially,” “probably,” “projects,” “outlook” or similar expressions. These forward-looking statements cover, among other things, anticipated future revenue and expenses and the future prospects of U.S. Bancorp. Forward-looking statements involve inherent risks and uncertainties, and important factors could cause actual results to differ materially from those anticipated, including the following, in addition to those contained in U.S. Bancorp’s reports on file with the SEC: (i) general economic or industry conditions could be less favorable than expected, resulting in a deterioration in credit quality, a change in the allowance for credit losses, or a reduced demand for credit or fee-based products and services; (ii) changes in the domestic interest rate environment could reduce net interest income and could increase credit losses; (iii) inflation, changes in securities market conditions and monetary fluctuations could adversely affect the value or credit quality of our assets, or the availability and terms of funding necessary to meet our liquidity needs; (iv) changes in the extensive laws, regulations and policies governing financial services companies could alter our business environment or affect operations; (v) the potential need to adapt to industry changes in information technology systems, on which we are highly dependent, could present operational issues or require significant capital spending; (vi) competitive pressures could intensify and affect our profitability, including as a result of continued industry consolidation, the increased availability of financial services from non-banks, technological developments or bank regulatory reform; (vii) changes in consumer spending and savings habits could adversely affect our results of operations; (viii) changes in the financial performance and condition of our borrowers could negatively affect repayment of such borrowers’ loans; (ix) acquisitions may not produce revenue enhancements or cost savings at levels or within time frames originally anticipated, or may result in unforeseen integration difficulties; (x) capital investments in our businesses may not produce expected growth in earnings anticipated at the time of the expenditure; and (xi) acts or threats of terrorism, and/or political and military actions taken by the U.S. or other governments in response to acts or threats of terrorism or otherwise could adversely affect general economic or industry conditions. Forward-looking statements speak only as of the date they are made, and U.S. Bancorp undertakes no obligation to update them in light of new information or future events.

     Total net revenue, on a taxable-equivalent basis, was $3,133 million for the first quarter of 2005, compared with $3,097 million for the first quarter of 2004, a year-over-year increase of $36 million (1.2 percent). The increase in net revenue was comprised of a 4.9 percent increase in noninterest income and a 1.6 percent decline in net interest income. The increase in noninterest income over the first quarter of 2004 was driven by favorable variances in the majority of fee income categories, partially offset by a $59 million increase in losses on the sale of securities. The expansion of the Company’s merchant acquiring business in Europe accounted for approximately $26 million of the favorable change in noninterest income year-over-year. The 1.6 percent decline in net interest income reflected modest growth in average earning assets, offset by lower net interest margins. Average earning assets for the first quarter of 2005 increased over the same period of 2004 by $6.9 billion (4.2 percent), primarily driven by increases in retail loans and commercial loans, partially offset by a decline in investment securities. The net interest margin in the first quarter of 2005 was 4.08 percent, compared with 4.29 percent in the first quarter of 2004. The decline in the net interest margin reflected the current lending environment, asset/liability management decisions and the impact of changes in the yield curve from a year ago.

     Total noninterest expense was $1,331 million for the first quarter of 2005, compared with $1,455 million for the first quarter of 2004. The year-over-year decrease in total noninterest expense of $124 million (8.5 percent), primarily reflected the $163 million favorable change in the valuation of mortgage servicing rights and the $35 million debt prepayment expense that was taken in the first quarter of 2004. The expansion of the Company’s merchant acquiring business in Europe added approximately $31 million of expense. In addition, expenses reflected incremental investments in in-store branches, marketing initiatives, technology and higher pension costs from a year ago. The efficiency ratio (the ratio of noninterest expense to taxable-equivalent net revenue excluding net securities gains or losses) was 41.7 percent for the first quarter of 2005, compared with 47.0 percent for the first quarter of 2004.

     The provision for credit losses for the first quarter of 2005 was $172 million, a decrease of $63 million (26.8 percent) from the first quarter of 2004. The decrease in the provision for credit losses year-over-year reflected a decrease in total net charge-offs. Net charge-offs in the first quarter of 2005 were $172 million, compared with $234 million in the first quarter of 2004. The decline in losses from a year ago was primarily the result of declining levels of stressed and nonperforming loans, continuing collection efforts and improving economic conditions. Refer to “Corporate Risk Profile” for further information on the provision for credit losses, net charge-offs, nonperforming assets and factors considered by the Company in assessing the credit quality of the loan portfolio and establishing the allowance for credit losses.

lower net interest margins. Average earning assets in the first quarter of 2005 increased over the first quarter of 2004 by $6.9 billion (4.2 percent), primarily driven by increases in retail loans and commercial loans, partially offset by a decline in investment securities. The net interest margin in the first quarter of 2005 was 4.08 percent, compared with 4.29 percent in the first quarter of 2004. The decline in the net interest margin reflected the current lending environment, asset/liability management decisions and the impact of changes in the yield curve from a year ago. Since the first quarter of 2004, credit spreads have tightened by approximately 14 basis points across most lending products due to competitive pricing and a higher proportion of lower spread credit products. The net interest margin also declined due to higher short-term rates and asset/liability decisions designed to maintain a neutral rate risk position, including a 40 percent reduction in the net receive fixed swap position between March 31, 2004, and March 31, 2005. Lower prepayment fees also contributed to the year-over-year decline. Increases in the value of deposits and net free funds helped to partially offset these factors.

accounts as an enhancement to its Silver Elite Checking product. Average branch-based noninterest-bearing deposits in the first quarter of 2005, excluding the migration of certain high-value customers to Silver Elite Checking, were higher by approximately $599 million (5.4 percent) over the same quarter of 2004. Average noninterest-bearing deposits in other areas, including commercial banking, private client, corporate trust, and mortgage, also increased year-over-year. These favorable variances were offset, however, by expected declines in average noninterest-bearing deposits in corporate banking as business customers utilized their excess liquidity.

     Average total savings products declined year-over-year by $1.9 billion (3.0 percent), principally due to a reduction in average money market account balances, partially offset by higher interest checking and savings accounts balances. Average branch-based interest checking deposits increased by $2.6 billion (18.0 percent) over the same quarter of 2004, in part, due to the change in the Silver Elite Checking product, as well as new account growth. Average branch-based interest checking deposits, excluding Silver Elite Checking, were higher by approximately $1.3 billion (9.2 percent) year-over-year. This positive variance in branch-based interest checking account deposits was partially offset by reductions in other areas, including broker dealer and institutional trust. Average money market account balances declined by $4.1 billion (12.0 percent) year-over-year, with the largest declines in government banking, national corporate banking, and the branches. These reductions were partially offset by strong growth in corporate trust deposits. The overall decrease in average money market account balances year-over-year was the result of the Company’s deposit pricing decisions in selected markets, given modest loan growth and excess liquidity throughout 2004. A portion of the money market balances migrated to time deposits greater than $100,000 as rates increased on the time deposit products.

     Average time certificates less than $100,000 were lower in the first quarter of 2005 than the first quarter of 2004 by $640 million (4.7 percent), as older, higher rate certificates continued to mature. This reduction was more than offset by an increase year-over-year of average time deposits greater than $100,000, most notably in corporate banking.

     Credit and debit card revenue and corporate payment products revenue were both higher in the first quarter of 2005 than the first quarter of 2004 by $12 million, or 8.5 percent and 12.6 percent, respectively. The growth in credit and debit card revenue was driven by higher transaction volumes and rate changes. The corporate payment products revenue growth reflected growth in sales, card usage, rate changes and the recent acquisition of a small aviation card business. ATM processing services revenue was higher by $5 million (11.9 percent) in the first quarter of 2005 than the same quarter of the prior year due to increases in transaction volumes and sales. Merchant processing services revenue was higher in the first quarter of 2005 than the same quarter of 2004 by $37 million (26.2 percent), reflecting an increase in same store sales volume, new business, higher equipment fees, and the recent expansion of the Company’s merchant acquiring business in Europe. The recent European acquisitions accounted for approximately $26 million of the total increase. Deposit service charges were higher year-over-year by $25 million (13.5 percent) due to account growth, revenue enhancement initiatives and higher transaction-related fees. The favorable variance year-over-year in mortgage banking revenue of $8 million (8.5 percent) was primarily due to higher loan servicing revenue. Other income was higher by $51 million (49.5 percent), primarily due to higher income from equity investments relative to the same quarter of 2004. Partially offsetting these positive variances year-over-year were commercial products revenue, treasury management fees and trust and investment management fees, which declined by

$14 million (12.7 percent), $11 million (9.3 percent), and $2 million (.8 percent), respectively. Commercial products revenue declined due to reductions in loan syndication fees and leasing revenues. The decrease in treasury management fees was primarily due to higher earnings credit on customers’ compensating balances. Trust and investment management fees declined as revenues generated by favorable equity market valuations and core balance growth were more than offset by a change in the mix of fund balances and customers’ migration from paying for services with fees to paying with compensating balances.

     Residential mortgages held in the loan portfolio were $16.6 billion at March 31, 2005, compared with $15.4 billion at December 31, 2004, an increase of $1.2 billion (7.8 percent) from December 31, 2004. The increase in residential mortgages was primarily the result of an increase in consumer finance originations and asset/liability risk management decisions to retain a greater portion of the Company’s adjustable-rate loan production.

     Total retail loans outstanding, which include credit card, retail leasing, home equity and second mortgages and other retail loans, were $43.4 billion at March 31, 2005, compared with $43.2 billion at December 31, 2004. The growth of $.2 billion was driven primarily by an increase in installment and student loans, partially offset by reduced credit card activity due to seasonality.

portfolio represented adjustable-rate financial instruments. Adjustable-rate financial instruments include variable-rate collateralized mortgage obligations, mortgage-backed securities, agency securities, adjustable-rate money market accounts and asset-backed securities.

certificates of deposit less than $100,000 and savings products.

     Noninterest-bearing deposits were $28.9 billion at March 31, 2005, compared with $30.8 billion at December 31, 2004, a decrease of $1.9 billion (6.1 percent), primarily due to seasonality of corporate trust deposits and declining corporate banking deposits.

     Interest-bearing deposits totaled $90.8 billion at March 31, 2005, compared with $90.0 billion at December 31, 2004, an increase of $.9 billion (.9 percent). The increase in interest-bearing deposits was primarily due to increases in time deposits greater than $100,000 of $1.0 billion (5.8 percent), along with increases in time certificates of deposit less than $100,000 of $.4 billion (2.9 percent) and savings accounts of $.2 billion (3.0 percent). The Company also experienced growth in interest checking deposits. These increases were partially offset by a decrease of $.8 billion (2.5 percent) in money market accounts. Time deposits greater than $100,000 are largely viewed as purchased funds and are managed to levels deemed appropriate given alternative funding sources. The decrease in money market savings account balances reflects the Company’s deposit pricing decisions in selected markets, given modest loan growth and excess liquidity and a migration of some customer balances to time deposits.

independent credit administration function have higher levels of lending grades and support the business units in their credit decision process. Loan decisions are documented as to the borrower’s business, purpose of the loan, evaluation of the repayment source and the associated risks, evaluation of collateral, covenants and monitoring requirements, and risk rating rationale. The Company utilizes a credit risk rating system to measure the credit quality of individual commercial loan transactions. The Company uses the risk rating system for regulatory reporting, determining the frequency of review of the credit exposures, and evaluation and determination of specific allowance for commercial credit losses. The Company regularly forecasts potential changes in risk ratings, nonperforming status and potential for loss and the estimated impact on the allowance for credit losses. In the Company’s retail banking operations, standard credit scoring systems are used to assess credit risks of consumer, small business and small-ticket leasing customers and to price consumer products accordingly. The Company conducts the underwriting and collections of its retail products in loan underwriting and servicing centers specializing in certain retail products. Forecasts of delinquency levels, bankruptcies and losses in conjunction with projection of estimated losses by delinquency categories and vintage information are regularly prepared and are used to evaluate underwriting and collection and determine the specific allowance for credit losses for these products. Because business processes and credit risks associated with unfunded credit commitments are essentially the same as for loans, the Company utilizes similar processes to estimate its liability for unfunded credit commitments. The Company also engages in non-lending activities that may give rise to credit risk, including interest rate swap and option contracts for balance sheet hedging purposes, foreign exchange transactions, deposit overdrafts and interest rate swap contracts for customers, and settlement risk, including Automated Clearing House transactions, and the processing of credit card transactions for merchants. These activities are also subject to credit review, analysis and approval processes.

     In evaluating its credit risk, the Company considers changes, if any, in underwriting activities, the loan portfolio composition (including product mix and geographic, industry or customer-specific concentrations), trends in loan performance, the level of allowance coverage relative to similar banking institutions and macroeconomic factors. Economic conditions during the first quarter of 2005 have improved from the first quarter of 2004, as reflected in improved unemployment rates and bankruptcy levels, favorable trends related to corporate profits and consumer spending for retail goods and services. Relative to December 31, 2004, economic conditions are relatively unchanged with somewhat higher energy costs and some increasing inflationary trends. The Federal Reserve Bank continued its measured approach to increasing short-term interest rates in an effort to prevent an acceleration of inflation and maintain the current rate of economic growth.

     The Company had restructured loans of $58 million at March 31, 2005, compared with $68 million at December 31, 2004. Commitments to lend additional funds under restructured loans were $2 million as of March 31, 2005, compared with $12 million as of December 31, 2004. Restructured loans performing under the restructured terms beyond a specific timeframe are reported as accruing. Of the Company’s total restructured loans at March 31, 2005, $7 million were reported as accruing.

     Accruing loans 90 days or more past due totaled $285 million at March 31, 2005, compared with $294 million at December 31, 2004. These loans were not included in nonperforming assets and continue to accrue interest because they are adequately secured by collateral, and/or are in the process of collection and are reasonably expected to result in repayment or restoration to current status. The ratio of delinquent loans to total loans was ..22 percent at March 31, 2005, compared with ..23 percent at December 31, 2004.

     To monitor credit risk associated with retail loans, the Company monitors delinquency ratios in the various stages of collection including nonperforming status.

     Commercial and commercial real estate loan net charge-offs for the first quarter of 2005 were $33 million (.20 percent of average loans outstanding), compared with $84 million (.51 percent of average loans outstanding) in the first quarter of 2004. The year-over-year improvement from the first quarter of 2004 was broad-based across most industries within the commercial loan portfolio.

     Retail loan net charge-offs for the first quarter of 2005 were $130 million (1.22 percent of average loans outstanding), compared with $143 million (1.45 percent of average loans outstanding) for the first quarter of 2004. Lower levels of retail loan net charge-offs principally reflected the Company’s ongoing improvement in collection efforts and risk management.

Analysis and Determination of the Allowance for Credit Losses The allowance for loan losses provides coverage for probable and estimable losses inherent in the Company’s loan and lease portfolio. Management evaluates the allowance each quarter to determine that it is adequate to cover these inherent losses. The evaluation of each element and the overall allowance is based on a continuing assessment of problem loans, recent loss experience and other factors, including regulatory guidance and economic conditions. Because business processes and credit risks associated with unfunded credit commitments are essentially the same as for loans, the Company utilizes similar processes to estimate its liability for unfunded credit commitments, which is included in other liabilities in the Consolidated Balance Sheet. Both the allowance for loan losses and the liability for unfunded credit commitments are included in the Company’s analysis of credit losses.

     At March 31, 2005, the allowance for credit losses was $2,269 million (1.76 percent of loans), compared with an allowance of $2,269 million (1.80 percent of loans) at December 31, 2004. The ratio of the allowance for credit losses to nonperforming loans was 404 percent at March 31, 2005, compared with 355 percent at December 31, 2004. The ratio of the allowance for credit losses to annualized loan net charge-offs was 325 percent at March 31, 2005, compared with 296 percent at December 31, 2004.

     Several factors were taken into consideration in evaluating the allowance for credit losses at March 31, 2005, including the risk profile of the portfolios and loan net charge-offs during the period, the level of nonperforming assets, the accruing loans 90 days or more past due, and delinquency ratios in most loan categories compared with December 31, 2004. Management also considered the uncertainty related to certain industry sectors, including the airline industry, and the extent of credit exposure to highly leveraged enterprise-value borrowers within the portfolio. In addition, concentration risks associated with commercial real estate and the mix of loans, including credit cards, loans originated through the consumer finance division and residential mortgages balances, and their relative credit risk were evaluated compared with other banks. Finally, the Company considers current economic conditions that might impact the portfolio.

     Included in the retail leasing portfolio was approximately $4.1 billion of retail leasing residuals at March 31, 2005, compared with $4.0 billion at December 31, 2004. At March 31, 2005, the commercial leasing portfolio had $739 million of residuals, compared with $769 million at December 31, 2004. No significant change in the concentration of the portfolios has occurred since December 31, 2004.

     The Company operates in many different businesses in diverse markets and relies on the ability of its employees and systems to process a high number of transactions. Operational risk is inherent in all business activities, and the management of this risk is important to the achievement of the Company’s objectives. In the event of a breakdown in the internal control system, improper operation of systems or improper employees’ actions, the Company could suffer financial loss, face regulatory action and suffer damage to its reputation.

     The Company manages operational risk through a risk management framework and its internal control processes. Within this framework, the Corporate Risk Committee (“Risk Committee”) provides oversight and assesses the most significant operational risks facing the Company within its business lines. Under the guidance of the Risk Committee, enterprise risk management personnel interact with business lines to monitor significant operating risks on a regular basis. Business lines have direct and primary responsibility and accountability for identifying, controlling, and monitoring operational risks embedded in their business activities. Business managers maintain a system of controls with the objective of providing proper transaction authorization and execution, proper system operations, safeguarding of assets from misuse or theft, and ensuring the reliability of financial and other data. Business managers ensure that the controls are appropriate and are implemented as designed.

     Each business line within the Company has designated risk managers. These risk managers are responsible for, among other things, coordinating the completion of ongoing risk assessments and ensuring that operational risk management is integrated into business decision-making activities. Business continuation and disaster recovery planning are also critical to effectively manage operational risks. Each business unit of the Company is required to develop, maintain and test these plans at least annually to ensure that recovery activities, if needed, can support mission critical functions including technology, networks and data centers supporting customer applications and business operations. The Company’s internal audit function validates the system of internal controls through risk-based, regular and ongoing audit procedures and reports on the effectiveness of internal controls to executive management and the Audit Committee of the Board of Directors.

     Customer-related business conditions may also increase operational risk or the level of operational losses in certain transaction processing business units, including merchant processing activities. Ongoing risk monitoring of customer activities and their financial condition and operational processes serve to mitigate customer-related operational risk. Refer to Note 11 of the Notes to Consolidated Financial Statements for further discussion on merchant processing.

     While the Company believes that it has designed effective methods to minimize operational risks, there is no absolute assurance that business disruption or operational losses would not occur in the event of a disaster. On an ongoing basis, management makes process changes and investments to enhance its systems of internal controls and business continuity and disaster recovery plans.

Sensitivity of Net Interest Income and Rate Sensitive Income

     The table above summarizes the interest rate risk of net interest income and rate sensitive income based on forecasts over the succeeding 12 months. At March 31, 2005, the Company’s overall interest rate risk position was slightly liability sensitive to changes in interest rates. Rate sensitive income includes net interest income as well as other income items that are sensitive to interest rates, including asset management fees, mortgage banking and the impact from compensating deposit balances. The Company manages its interest rate risk position by holding assets on the balance sheet with desired interest rate risk characteristics, implementing certain pricing strategies for loans and deposits and through the selection of derivatives and various funding and investment portfolio strategies. The Company manages the overall interest rate risk profile within policy limits. At March 31, 2005, and December 31, 2004, the Company was within its policy guidelines.

     The valuation analysis is dependent upon certain key assumptions about the nature of assets and liabilities with non-contractual maturities. Management estimates the average life and rate characteristics of asset and liability accounts based upon historical analysis and management’s expectation of rate behavior. These assumptions are validated on a periodic basis. A sensitivity analysis of key variables of the valuation analysis is provided to ALPC monthly and is used to guide hedging strategies. The results of the valuation analysis as of March 31, 2005, were well within policy guidelines. The Company also uses duration of equity as a measure of interest rate risk. The duration of equity is a measure of the net market value sensitivity of the assets, liabilities and derivative positions of the Company. The duration of assets was 1.74 years at March 31, 2005, compared with 1.68 years at December 31, 2004. The duration of liabilities was 1.96 years at March 31, 2005, compared with 2.02 years at December 31, 2004. After giving effect to the Company’s derivative positions and mortgage servicing valuation, the estimated duration of equity was 1.39 years at March 31, 2005, compared with .12 years at December 31, 2004. The duration of equity measure shows that sensitivity of the market value of equity of the Company was slightly liability sensitive to changes in interest rates.

     All interest rate derivatives that qualify for hedge accounting are recorded at fair value as other assets or liabilities on the balance sheet and are designated as either “fair value” or “cash flow” hedges. The Company performs an assessment, both at inception and quarterly thereafter, when required, to determine whether these derivatives are highly effective in offsetting changes in the value of the hedged items. Hedge ineffectiveness for both cash flow and fair value hedges is recorded in noninterest income. Changes in the fair value of derivatives designated as fair value hedges, and changes in the fair value of the hedged items, are recorded in earnings. Changes in the fair value of derivatives designated as cash flow hedges are recorded in other comprehensive income until income from the cash flows of the hedged items is realized. Customer-related interest rate swaps, foreign exchange rate contracts, and all other derivative contracts that do not qualify for hedge accounting are recorded at fair value and resulting gains or losses are recorded in trading account gains or losses or mortgage banking revenue.

     By their nature, derivative instruments are subject to market risk. The Company does not utilize derivative instruments for speculative purposes. Of the Company’s $39 billion of total notional amount of asset and liability management derivative positions at March 31, 2005, $35 billion was designated as either fair value or cash flow hedges. The cash flow hedge positions are interest rate swaps that hedge the forecasted cash flows from the underlying variable-rate LIBOR loans and floating-rate debt. The fair value hedges are primarily interest rate contracts that hedge the change in fair value related to interest rate changes of underlying fixed-rate debt and subordinated obligations. In addition, the Company uses forward commitments to