DBRS Comments on Q2 Earnings of U.S. Bancorp – Senior at AA Unchanged

DBRS has today commented on the Q2 2009 earnings of U.S. Bancorp (USB or the Company). Before preferred dividends and excluding charges associated with the repayment of TARP, the Company reported net income of $471 million for the quarter, 11% below Q1 2009 and 50% below the year ago quarter. Credit costs, which included a $1.4 billion provision for credit losses, remained elevated and the Company added $466 to reserves in the second quarter above net charge-offs. Nevertheless, USB’s credit quality remains strong relative to peers. Second quarter income before provisions and taxes (IBPT), ex-TARP related charges and a $123 million pre-tax charge related to the FDIC special assessment, was a solid $2.15 billion, sufficient to cover the elevated provisioning 1.5 times. DBRS sees this core operating performance, which included record net revenues of $4.2 billion, as indicating that the Company’s franchise strengths remain intact and DBRS sees USB as relatively well-positioned to manage the very difficult credit environment as it continues to generate strong IBPT and maintain healthy financial fundamentals. Therefore, DBRS’s ratings for the Company, including its AA rating for senior obligations and Stable Trend, remain unchanged.

Net charge-offs (NCOs) and nonperforming assets (NPAs) continued to trend higher in Q2 2009, though the pace of deterioration slowed somewhat from the prior quarter. Total NCOs in the quarter were $929 million, $141 million or 18% higher than in the prior quarter. NCO rates in the Company’s $33.7 billion average CRE portfolio declined to 1.44% from 1.58% thanks to lower losses on the $9.9 billion Construction & Development book. Given the challenging economic conditions and declining house prices, loss rates in USB’s residential mortgage (up 40 bps to 1.94%) and retail loan (up 37 bps to 2.99%) categories were higher in the second quarter. Excluding covered assets related to the Downey and PFF acquisitions (where USB has entered a loss sharing agreement with the FDIC), total Q2 2009 NCOs were 215 bps of average loans compared to 182 bps in the prior quarter and 98 bps in the year ago quarter. USB’s $1.4 billion second quarter provision added $466 million to reserves increasing the reserves to loans ratio (excluding covered assets) 29 bps from March 31, 2009 to 2.66%.

NPAs increased 18% from Q1 2009 and were $4.0 billion at June 30, 2009. Included in the second quarter total were $682 million of covered assets. As a percent of loans plus OREO, NPAs increased to 2.20% from 1.85% in the prior quarter and 0.68% in Q2 2008. Residential construction loans accounted for the largest portion (44%) of the $606 million increase from Q1 2009 and residential mortgage loans also showed some deterioration amid the slumping economy and weak housing markets. Reserve coverage of NPLs (excluding covered assets) was a strong 152% at June 30, 2009.

The Company saw some stability in 90+ day delinquencies in C&I lending and in the retail loan portfolios and the pace of increase in delinquencies slowed for the loan portfolio as a whole. Given the trajectory of delinquencies, NPAs and NCOs, DBRS believes further erosion in loan quality and rising loan losses are likely to continue through the balance of 2009, though potentially at a more moderate pace. DBRS notes, however, that the Company has the ability absorb higher loss provisions, if needed, given the stability and strength of its IBPT which was over $2.1 billion in the current quarter and higher than both Q1 2009 and Q2 2008.

Net interest income accounted for $2.1 billion, just over 50% of USB’s total Q2 2009 revenues. Year over year net interest income increased 10% and compared to the first quarter, net interest income was up nominally. Relative to Q1 2009, the net interest margin (NIM) was stable, increasing 1 basis point to 3.60%, as were average earning assets (down 0.4%). The Company’s average deposits grew $2.7 billion or 1.7% (unannualized) from the first quarter to $163 billion. Average loans (excluding covered assets) declined 0.7% from Q1 2009 to $173 billion, with declines in commercial lending (down 3.7%) and retail leasing (down 1.6%) offsetting growth in other areas. Similar to peers, USB reported lower line utilization from existing corporate and commercial customers and decreasing loan demand in general given the fragile economic environment.

The Company reported a strong fee quarter. Second quarter noninterest income of $2.1 billion, increased 15% from Q1 2009 and was 8.6% higher than Q2 2008. Relative to Q1 2009, fees were up across most categories reflecting some seasonal effects as well as better pricing. Mortgage banking revenues were particularly strong, growing $75 million from the prior quarter and $227 million from Q2 2008 to $308 million. Mortgage production was a record $16.3 billion in the quarter and changes in the fair value of the MSR contributed positively in the second quarter although the mortgage performance is likely to moderate given rising interest rates. Net securities losses improved from a $198 million loss in Q1 2009 to a $19 million loss in Q2 2009 reflecting improving stability in capital markets.

Excluding the FDIC special assessment, USB reported an efficiency ratio of 48%. While this was up from 46% in Q1 2009, the Company did generate positive core operating leverage relative to Q2 2008 and the Company remains one of the most efficient operators among peers. Higher OREO expenses and higher marketing expenses drove the increase in operating expenses from Q1 2009.

Although mindful of likely further weakening in asset quality, DBRS considers USB’s financial fundamentals and capital position as sound. Reflecting its general strength, the Company redeemed $6.6 billion of TARP preferred shares in the quarter and raised $2.7 billion of common equity. DBRS views the addition of common equity positively as it adds to the layer of protection for bondholders. The Company’s Tier 1 ratio was 9.4% at June 30, 2009 and the Tier 1 Common ratio improved from 5.4% at the end of the first quarter to 6.7% at June 30, 2009. Second quarter results validate DBRS’s view of USB’s capital position and its view on the Company’s strong internal capital generation ability. Liquidity for both the operating bank and the holding company remain ample.

Note:
All figures are in U.S. dollars unless otherwise noted.

The applicable methodologies are Rating Banks and Bank Holding Companies Operating in the United States and Enhanced Methodology for Bank Ratings – Intrinsic and Support Assessments, which can be found on our website under Methodologies.

This is a Corporate (Financial Institutions) rating.