UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
FORM 10-Q
For the quarterly period ended March 31, 2011
or
For the transition period from to
Commission file number 001-09718
The PNC Financial Services Group, Inc.
(Exact name of registrant as specified in its charter)
(State or other jurisdiction of
incorporation or organization)
One PNC Plaza, 249 Fifth Avenue, Pittsburgh, Pennsylvania 15222-2707
(Address of principal executive offices, including zip code)
(412) 762-2000
(Registrant’s telephone number, including area code)
(Former name, former address and former fiscal year, if changed since last report)
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes x No ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer x Accelerated filer ¨ Non-accelerated filer ¨ Smaller reporting company ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes ¨ No x
As of April 29, 2011, there were 526,282,991 shares of the registrant’s common stock ($5 par value) outstanding.
Cross-Reference Index to First Quarter 2011 Form 10-Q
PART I – FINANCIAL INFORMATION
Item 1. Financial Statements (Unaudited).
Consolidated Income Statement
Consolidated Balance Sheet
Consolidated Statement Of Cash Flows
Notes To Consolidated Financial Statements (Unaudited)
Note 1 Accounting Policies
Note 2 Divestiture
Note 3 Loan Sale and Servicing Activities and Variable Interest Entities
Note 4 Loans and Commitments to Extend Credit
Note 5 Asset Quality and Allowances for Loan and Lease Losses and Unfunded Loan
Commitments and Letters of Credit
Note 6 Purchased Impaired Loans
Note 7 Investment Securities
Note 8 Fair Value
Note 9 Goodwill and Other Intangible Assets
Note 10 Capital Securities of Subsidiary Trusts and Perpetual Trust Securities
Note 11 Certain Employee Benefit And Stock-Based Compensation Plans
Note 12 Financial Derivatives
Note 13 Earnings Per Share
Note 14 Total Equity And Other Comprehensive Income
Note 15 Income Taxes
Note 16 Legal Proceedings
Note 17 Commitments and Guarantees
Note 18 Segment Reporting
Statistical Information (Unaudited)
Average Consolidated Balance Sheet And Net Interest Analysis
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Financial Review
Consolidated Financial Highlights
Executive Summary
Consolidated Income Statement Review
Consolidated Balance Sheet Review
Off-Balance Sheet Arrangements And Variable Interest Entities
Fair Value Measurements
Business Segments Review
Critical Accounting Estimates And Judgments
Status Of Qualified Defined Benefit Pension Plan
Recourse And Repurchase Obligations
Risk Management
Internal Controls And Disclosure Controls And Procedures
Glossary Of Terms
Cautionary Statement Regarding Forward-Looking Information
Item 3. Quantitative and Qualitative Disclosures About Market Risk.
Item 4. Controls and Procedures.
PART II – OTHER INFORMATION
Item 1. Legal Proceedings.
Item 1A. Risk Factors.
Item 2. Unregistered Sales Of Equity Securities And Use Of Proceeds.
Item 6. Exhibits.
Exhibit Index.
Signature
Corporate Information
FINANCIAL REVIEW
CONSOLIDATED FINANCIAL HIGHLIGHTS
THE PNC FINANCIAL SERVICES GROUP, INC.
FINANCIAL RESULTS (a)
Revenue
Net interest income
Noninterest income
Total revenue
Noninterest expense
Pretax, pre-provision earnings from continuing operations (b)
Provision for credit losses
Income from continuing operations before income taxes and noncontrolling interests (pretax earnings)
Income from continuing operations before noncontrolling interests
Income from discontinued operations, net of income taxes (c)
Net income
Less:
Net income (loss) attributable to noncontrolling interests
Preferred stock dividends, including TARP (d)
Redemption of TARP preferred stock discount accretion (d)
Net income attributable to common shareholders (d)
Diluted earnings per common share
Continuing operations
Discontinued operations (c)
Cash dividends declared per common share (e)
PERFORMANCE RATIOS
Net interest margin (f)
Noninterest income to total revenue
Efficiency
Return on:
Average common shareholders’ equity
Average assets
See page 53 for a glossary of certain terms used in this Report.
Certain prior period amounts have been reclassified to conform with the current period presentation, which we believe is more meaningful to readers of our consolidated financial statements.
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CONSOLIDATED FINANCIAL HIGHLIGHTS(CONTINUED) (a)
BALANCE SHEET DATA (dollars in millions, except per share data)
Assets
Loans (b) (c)
Allowance for loan and lease losses (b)
Interest-earning deposits with banks (b)
Investment securities (b)
Loans held for sale (c)
Goodwill and other intangible assets
Equity investments (b)
Noninterest-bearing deposits
Interest-bearing deposits
Total deposits
Transaction deposits
Borrowed funds (b)
Shareholders’ equity
Common shareholders’ equity
Accumulated other comprehensive income (loss)
Book value per common share
Common shares outstanding (millions)
Loans to deposits
ASSETS UNDER ADMINISTRATION (billions)
Discretionary assets under management
Nondiscretionary assets under administration
Total assets under administration
CAPITAL RATIOS
Tier 1 common
Tier 1 risk-based (d)
Total risk-based (d)
Leverage (d)
Common shareholders’ equity to assets
ASSET QUALITY RATIOS
Nonperforming loans to total loans
Nonperforming assets to total loans, OREO and foreclosed assets
Nonperforming assets to total assets
Net charge-offs to average loans (for the three months ended) (annualized)
Allowance for loan and lease losses to total loans
Allowance for loan and lease losses to nonperforming loans (e)
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This Financial Review, including the Consolidated Financial Highlights, should be read together with our unaudited Consolidated Financial Statements and unaudited Statistical Information included elsewhere in this Report and with Items 6, 7, 8 and 9A of our 2010 Annual Report on Form 10-K (2010 Form 10-K). We have reclassified certain prior period amounts to conform with the current period presentation, which we believe is more meaningful to readers of our consolidated financial statements. For information regarding certain business and regulatory risks, see the Risk Management section in this Financial Review, Item 1A and the Risk Management section of Item 7 of our 2010 Form 10-K, and Note 16 Legal Proceedings and Note 17 Commitments and Guarantees in the Notes to Consolidated Financial Statements included in Part I, Item 1 of this Report. Also, see the Cautionary Statement Regarding Forward-Looking Information and Critical Accounting Estimates And Judgments sections in this Financial Review for certain other factors that could cause actual results or future events to differ, perhaps materially, from historical performance and those anticipated in the forward-looking statements included in this Report. See Note 18 Segment Reporting in the Notes To Consolidated Financial Statements included in Part I, Item 1 of this Report for a reconciliation of total business segment earnings to total PNC consolidated net income from continuing operations before noncontrolling interests as reported on a generally accepted accounting principles (GAAP) basis.
EXECUTIVE SUMMARY
PNC is one of the largest diversified financial services companies in the United States and is headquartered in Pittsburgh, Pennsylvania.
PNC has businesses engaged in retail banking, corporate and institutional banking, asset management, and residential mortgage banking, providing many of its products and services nationally and others in PNC’s primary geographic markets located in Pennsylvania, Ohio, New Jersey, Michigan, Maryland, Illinois, Indiana, Kentucky, Florida, Virginia, Missouri, Delaware, Washington, D.C., and Wisconsin. PNC also provides certain products and services internationally.
KEY STRATEGICGOALS
We manage our company for the long term and are focused on managing toward a moderate risk profile while maintaining strong capital and liquidity positions, investing in our markets and products, and embracing our corporate responsibility to the communities where we do business.
Our strategy to enhance shareholder value centers on driving growth in pre-tax, pre-provision earnings by achieving growth in revenue from our balance sheet and diverse business mix that exceeds growth in expenses controlled through disciplined cost management.
The primary drivers of revenue growth are the acquisition, expansion and retention of customer relationships. We strive to expand our customer base by offering convenient banking options and leading technology solutions, providing a broad range of fee-based and credit products and services, focusing on customer service, and through a significantly enhanced branding initiative. This strategy is designed to give our consumer customers choices based on their needs. Rather than striving to optimize fee revenue in the short term, our approach is focused on effectively growing targeted market share and “share of wallet.” We may also grow revenue
through appropriate and targeted acquisitions and, in certain businesses, by expanding into new geographical markets.
We are focused on our strategies for quality growth. We are committed to a moderate risk philosophy characterized by disciplined credit management and limited exposure to earnings volatility resulting from interest rate fluctuations and the shape of the interest rate yield curve. We made substantial progress in transitioning our balance sheet over the past two years, working to return to our moderate risk profile throughout our expanded franchise. Our actions have created a well-positioned balance sheet, strong bank level liquidity and investment flexibility to adjust, where appropriate and permissible, to changing interest rates and market conditions.
2011 CAPITAL ACTIONS
On April 7, 2011, our Board of Directors approved an increase to PNC’s quarterly common stock dividend from $.10 per common share to $.35 per common share, which was paid on May 5, 2011. Our Board of Directors also confirmed that PNC may begin to purchase common stock under its existing 25 million share repurchase program in open market or privately negotiated transactions. PNC plans to repurchase up to $500 million of common stock during the remainder of 2011. The discussion of capital within the Consolidated Balance Sheet Review section of this Financial Review includes additional information regarding our common stock repurchase program.
Our ability to take these actions had been subject to the results of the supervisory assessment of capital adequacy undertaken by the Board of Governors of the Federal Reserve System (Federal Reserve) and our primary bank regulators as part of the capital adequacy assessment of the 19 bank holding companies that participate in the Supervisory Capital Assessment Program. As we announced on March 18, 2011, the Federal Reserve accepted the capital plan that we submitted for their review and did not object to our capital actions.
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RECENT MARKET AND INDUSTRYDEVELOPMENTS
In addition to numerous legislative and regulatory developments, there have been dramatic changes in the competitive landscape of our industry over the last several years.
Beginning in late 2008, efforts by the Federal government, including the US Congress, the US Department of the Treasury, the Federal Reserve, the FDIC, and the Securities and Exchange Commission, to stabilize and restore confidence in the financial services industry have impacted and will likely continue to impact PNC and our stakeholders. These efforts, which will continue to evolve, include the Emergency Economic Stabilization Act of 2008, the American Recovery and Reinvestment Act of 2009, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), in particular, and other legislative, administrative and regulatory initiatives, including the new rules set forth in Regulation E related to overdraft charges.
Dodd-Frank is extensive, complicated and comprehensive legislation that impacts practically all aspects of a banking organization. Dodd-Frank will negatively impact revenue and increase both the direct and indirect costs of doing business for PNC. It includes provisions that could increase regulatory fees and deposit insurance assessments and impose heightened capital and prudential standards, while at the same time impacting the nature and costs of PNC’s businesses, including consumer lending, private equity investment, derivatives transactions, interchange fees on debit card transactions, and asset securitizations.
Until such time as the regulatory agencies issue final regulations implementing all of the numerous provisions of Dodd-Frank, a process that will extend at least over the next year and might last several years, PNC will not be able to fully assess the impact the legislation will have on its businesses. However, we believe that the expected changes will be manageable for PNC and will have a smaller impact on us than on our larger peers.
Included in these recent legislative and regulatory developments are evolving regulatory capital standards for financial institutions. Dodd-Frank requires the Federal Reserve Board to establish capital requirements that would, among other things, eliminate the Tier 1 treatment of trust preferred securities following a phase-in period expected to begin in 2013. Evolving standards also include the so-called “Basel III” initiatives that are part of the Basel II effort by international banking supervisors to update the original international bank capital accord (Basel I), which has been in effect since 1988. The recent Basel III capital initiative, which has the support of US banking regulators, includes heightened capital requirements for major banking institutions in terms of both higher quality capital and higher regulatory capital ratios. Basel III capital standards will require implementing regulations by the banking regulators. These regulations will
become effective under a phase-in period beginning January 1, 2013, and will become fully effective January 1, 2019.
Dodd-Frank also establishes, as an independent agency organized as a bureau within the Federal Reserve, the Bureau of Consumer Financial Protection (CFPB). Starting July 21, 2011, the CFPB will have the authority to prescribe rules governing the provision of consumer financial products and services, and it is expected that the CFPB will issue new regulations, and amend existing regulations, regarding consumer protection practices. Also on that date, the authority of the Office of the Comptroller of the Currency (OCC) to examine PNC Bank, N.A. for compliance with consumer protection laws, and to enforce such laws, will transfer to CFPB.
Additionally, new provisions concerning the applicability of state consumer protection laws will become effective on July 21, 2011. Questions may arise as to whether certain state consumer financial laws that may have previously been preempted are no longer preempted after this date. Depending on how such questions are resolved, we may experience an increase in state-level regulation of our retail banking business and additional compliance obligations, revenue impacts, and costs.
Dodd-Frank and its implementation, as well as other statutory and regulatory initiatives that will be ongoing, will introduce numerous regulatory changes over the next several years. While we believe that we are well positioned to navigate through this process, we cannot predict the ultimate impact of these actions on PNC’s business plans and strategies.
RESIDENTIAL MORTGAGEFORECLOSURE MATTERS
Beginning in the third quarter of 2010, mortgage foreclosure documentation practices among US financial institutions received heightened attention by regulators and the media. PNC’s US market share for residential servicing is approximately 1.5%. The vast majority of our servicing business is on behalf of other investors, principally the Federal Home Loan Mortgage Corporation (FHLMC) and the Federal National Mortgage Association (FNMA). Following the initial reports regarding these practices, we conducted an internal review of our foreclosure procedures. Based upon our review, we believe that PNC has systems designed to ensure that no foreclosure proceeds unless the loan is genuinely in default.
Similar to other banks, however, we identified issues regarding some of our foreclosure practices. Accordingly, after implementing a delay in pursuing individual foreclosures, we have been moving forward or are in the process of moving forward in most jurisdictions on such matters under procedures designed to address as appropriate any documentation issues. We are also proceeding with new foreclosures under enhanced procedures designed as part of this review to minimize the risk of errors related to the processing of documentation in foreclosure cases.
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The Federal Reserve and the OCC, together with the FDIC and others, conducted a publicly-disclosed interagency horizontal review of residential mortgage servicing operations at PNC and thirteen other federally regulated mortgage servicers. As a result of that review, in April 2011 PNC entered into a consent order with the Federal Reserve and PNC Bank N.A. entered into a consent order with the OCC. Collectively, these consent orders describe certain foreclosure-related practices and controls that the regulators found to be deficient and require PNC and PNC Bank to, among other things, develop and implement plans and programs to enhance PNC’s residential mortgage servicing and foreclosure processes, retain an independent consultant to review certain residential mortgage foreclosure actions, take certain remedial actions, and oversee compliance with the orders and the new plans and programs. The two orders do not resolve any other federal or state governmental, legislative or regulatory authority investigations, which may result in significant additional actions, penalties or other remedies, and they do not foreclose the potential for civil money penalties from the bank regulators.
For additional information, please see Note 16 Legal Proceedings and Note 17 Commitments and Guarantees in the Notes To Consolidated Financial Statements in this Report and our Current Report on Form 8-K dated April 14, 2011.
PNC’S PARTICIPATION IN SELECT GOVERNMENT PROGRAMS
Information on these programs is provided in Item 7 of our 2010 Form 10-K.
KEY FACTORS AFFECTING FINANCIAL PERFORMANCE
Our financial performance is substantially affected by several external factors outside of our control including the following:
General economic conditions, including the speed and stamina of the moderate economic recovery in general and on our customers in particular,
The level of, and direction, timing and magnitude of movement in, interest rates and the shape of the interest rate yield curve,
The functioning and other performance of, and availability of liquidity in, the capital and other financial markets,
Loan demand, utilization of credit commitments and standby letters of credit, and asset quality,
Customer demand for other products and services,
Changes in the competitive and regulatory landscape and in counterparty creditworthiness and performance as the financial services industry restructures in the current environment,
The impact of the extensive reforms enacted in the Dodd-Frank legislation and other legislative, regulatory and administrative initiatives, including those outlined above, and
The impact of market credit spreads on asset valuations.
In addition, our success will depend, among other things, upon:
Further success in the acquisition, growth and retention of customers,
Continued development of the geographic markets related to our recent acquisitions, including full deployment of our product offerings,
Revenue growth,
A sustained focus on expense management,
Managing the distressed assets portfolio and other impaired assets,
Improving our overall asset quality and continuing to meet evolving regulatory capital standards,
Continuing to maintain and grow our deposit base as a low-cost funding source,
Prudent risk and capital management related to our efforts to return to our desired moderate risk profile,
Actions we take within the capital and other financial markets, and
The impact of legal and regulatory contingencies.
SALE OF PNC GLOBAL INVESTMENT SERVICING
On July 1, 2010, we sold PNC Global Investment Servicing Inc. (GIS), a leading provider of processing, technology and business intelligence services to asset managers, broker-dealers and financial advisors worldwide, for $2.3 billion in cash pursuant to a definitive agreement entered into on February 2, 2010. The pretax gain recorded in the third quarter of 2010 related to this sale was $639 million, or $328 million after taxes.
Results of operations of GIS through March 31, 2010 are presented as income from discontinued operations, net of income taxes, on our Consolidated Income Statement in this Report. Once we entered into the sales agreement, GIS was no longer a reportable business segment. See Note 2 Divestiture in our Notes To Consolidated Financial Statements in this Report.
INCOME STATEMENT HIGHLIGHTS
Strong results for the first quarter reflected pretax earnings from continuing operations of $1.1 billion, compared with $.9 billion for the first quarter of 2010.
Net interest income for the first three months of 2011 was $2.2 billion and the net interest margin was 3.94%, compared with $2.4 billion and 4.24% for the first three months of 2010. The decreases compared with the prior year quarter were attributable to lower purchase accounting accretion, soft loan demand and the low interest rate environment partially offset by lower funding costs.
Noninterest income of $1.5 billion for the first quarter of 2011 increased from $1.4 billion in the prior year first quarter.
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The provision for credit losses declined to $421 million for the first three months of 2011 from $751 million for the first three months of 2010 driven by overall credit quality improvement and continuation of actions to reduce exposure levels.
Noninterest expense totaled $2.1 billion for the first quarter of both 2011 and 2010.
CREDIT QUALITY HIGHLIGHTS
Improvement in overall credit quality continued in the first quarter of 2011. Nonperforming assets decreased $43 million to $5.3 billion at March 31, 2011 compared with December 31, 2010. Accruing loans past due of $1.9 billion were relatively unchanged from December 31, 2010. The allowance for loan and lease losses was $4.8 billion, or 3.19% of total loans and 108% of nonperforming loans, as of March 31, 2011.
BALANCE SHEET HIGHLIGHTS
Total loans were $149 billion at March 31, 2011 and $151 billion at December 31, 2010. Growth in commercial loans of $1.4 billion during the quarter was offset by declines in commercial real estate loans of $.8 billion and residential mortgage loans of $.7 billion. Loans and commitments originated and renewed totaled approximately $27 billion in the first quarter, including $.9 billion of small business loans.
Total deposits were $182 billion at March 31, 2011 and $183 billion at December 31, 2010. Transaction deposits of $135 billion were essentially stable compared with December 31, 2010. Higher cost retail certificates of deposit continued to decline with a reduction of $1.5 billion, or 4%, in the first quarter.
PNC’s high quality balance sheet was core funded with a loan to deposit ratio of 82% at March 31, 2011 and a strong bank liquidity position to support growth.
PNC’s strong capital levels were reflected in its Tier 1 common capital ratio which increased to 10.3% at March 31, 2011 from 9.8% at December 31, 2010.
PNC reached a definitive agreement in January 2011 to acquire 19 branches and approximately $390 million of deposits from BankAtlantic Bancorp, Inc. located in the Tampa, Florida area. The transaction has received regulatory approval and is expected to close in June 2011, subject to customary closing conditions.
Our Consolidated Income Statement and Consolidated Balance Sheet Review sections of this Financial Review describe in greater detail the various items that impacted our results for the first three months of 2011 and 2010.
AVERAGE CONSOLIDATED BALANCE SHEETHIGHLIGHTS
Various seasonal and other factors impact our period-end balances whereas average balances are generally more
indicative of underlying business trends apart from the impact of acquisitions, divestitures and consolidations of variable interest entities.
The Consolidated Balance Sheet Review section of this Financial Review provides information on changes in selected Consolidated Balance Sheet categories at March 31, 2011 compared with December 31, 2010.
Total average assets were $262.6 billion for the first three months of 2011 compared with $267.1 billion for the first three months of 2010. Average interest-earning assets were $224.1 billion for the first three months of 2011, compared with $227.0 billion in the first three months of 2010. In both comparisons, the declines were primarily driven by an $8.6 billion decrease in average total loans partially offset by a $5.5 billion increase in average total investment securities. The overall decline in average loans reflected soft customer loan demand, loan repayments, dispositions and net charge-offs. The increase in total investment securities reflected net investments of excess liquidity in short duration, high quality securities, primarily residential mortgage-backed securities.
The decrease in average total loans primarily reflected declines in commercial real estate of $4.9 billion and residential real estate of $3.9 billion, partially offset by a $.8 billion increase in commercial loans. Commercial real estate loans declined due to loan sales, paydowns, and charge-offs. The decrease in residential real estate was impacted by portfolio management activities, paydowns and net charge-offs. Commercial loans increased due to a combination of new volume, improved utilization and new Market Street commitments. Loans represented 67% of average interest-earning assets for the first three months of 2011 and 70% of average interest-earning assets for the first three months of 2010.
Average securities available for sale increased $4.8 billion, to $55.4 billion, in the first quarter of 2011 compared with the first quarter of 2010. Average residential mortgage-backed agency securities increased $7.2 billion and other debt securities increased $2.1 billion in the comparison while residential mortgage-backed non-agency securities declined $2.2 billion and commercial mortgage-backed securities decreased $2.1 billion. The impact of purchases of high quality agency residential mortgage-backed securities and diversifiable other debt was partially offset by the natural run-off from paydowns of other security types.
Average securities held to maturity increased $.8 billion, to $6.7 billion, in the first three months of 2011 compared with the first three months of 2010. An increase of $2.1 billion in commercial mortgage-backed securities more than offset a $1.2 billion decrease in asset-backed securities in the comparison. Purchases of commercial mortgage-backed securities during the first quarter of 2011 outpaced the effect of paydowns of other security types.
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Total investment securities comprised 28% of average interest-earning assets for the first three months of 2011 and 25% for the first three months of 2010.
Average noninterest-earning assets totaled $38.5 billion in the first three months of 2011 compared with $40.2 billion in the first three months of 2010. The decline reflected a decrease in average goodwill and other intangible assets.
Average total deposits were $180.8 billion for the first quarter of 2011 compared with $183.1 billion for the first quarter of 2010. Average deposits declined from the prior year period primarily as a result of decreases in retail certificates of deposit and other time deposits, which were partially offset by increases in money market balances, demand and other noninterest-bearing deposits. Growing core checking deposits as a lower-cost funding source and as the cornerstone product to build customer relationships is the primary objective of our deposit strategy. Furthermore, core checking accounts are critical to our strategy of expanding our payment business. Total deposits at March 31, 2011 were $182.0 billion compared with $183.4 billion at December 31, 2010 and are further discussed within the Consolidated Balance Sheet Review section of this Report.
Average total deposits represented 69% of average total assets for both the first three months of 2011 and 2010.
Average transaction deposits were $132.6 billion for the first three months of 2011 compared with $125.2 billion for the first three months of 2010. The ongoing planned reduction of high-cost and primarily nonrelationship certificates of deposit is part of our overall deposit strategy that is focused on growing demand and other transaction deposits as the cornerstone product of customer relationships and a lower-cost, stable funding source.
Average borrowed funds were $38.4 billion for the first quarter of 2011 compared with $42.3 billion for the first quarter of 2010. Maturities of Federal Home Loan Bank (FHLB) borrowings drove the decline compared with the first quarter of 2010. Total borrowed funds at March 31, 2011 were $35.0 billion compared with $39.5 billion at December 31, 2010 and are further discussed within the Consolidated Balance Sheet Review section of this Financial Review. In addition, the Liquidity Risk Management portion of the Risk Management section of this Financial Review includes additional information regarding our sources and uses of borrowed funds.
BUSINESS SEGMENT HIGHLIGHTS
Total business segment earnings were $639 million for the first three months of 2011 and $659 million for the first three months of 2010. Highlights of results for the first three months of 2011 and 2010 are included below. The Business Segments Review section of this Financial Review includes a Results of Business-Summary table and further analysis of our business
segment results over these periods including presentation differences from Note 18 Segment Reporting in our Notes To Consolidated Financial Statements of this Report.
We provide a reconciliation of total business segment earnings to PNC consolidated income from continuing operations before noncontrolling interests as reported on a GAAP basis in Note 18 Segment Reporting in our Notes To Consolidated Financial Statements of this Report
Retail Banking
Retail Banking incurred a loss of $18 million for the quarter compared with earnings of $24 million for the year ago quarter. Earnings declined from the prior year quarter as lower revenues resulting from the impact of Regulation E rules related to overdraft fees and a low interest rate environment were partially offset by a lower provision for credit losses. Retail Banking continued to maintain its focus on growing customers and deposits, improving customer and employee satisfaction, investing in the business for future growth, and disciplined expense management during this period of market and economic uncertainty.
Corporate & Institutional Banking
Corporate & Institutional Banking earned $432 million in the first quarter of 2011 compared with $368 million in the first quarter of 2010. The increase in earnings was due to a decrease in the provision for credit losses, somewhat offset by declines in net interest income and revenue from commercial mortgage banking activities. We continued to focus on adding new clients and increased our cross selling to serve our clients’ needs, particularly in the western markets, and remained committed to strong expense discipline.
Asset Management Group
Asset Management Group earned $43 million in the first quarter of 2011 compared with $39 million in the first quarter of 2010. Assets under administration were $219 billion as of March 31, 2011. Earnings for the first quarter of 2011 reflected a benefit from the provision for credit losses compared with the provision for the first quarter of 2010. The business maintained its focus on new client acquisition and client asset growth during the quarter.
Residential Mortgage Banking
Residential Mortgage Banking earned $71 million in the first quarter of 2011 compared with $78 million in the first quarter of 2010. Earnings declined from the prior year first quarter primarily as a result of a higher provision for credit losses, lower servicing fees, lower net interest income and higher noninterest expense offset partially by increased loans sales revenue and higher net economic hedging gains on mortgage servicing rights.
BlackRock
Our BlackRock business segment earned $86 million in the first three months of 2011 and $77 million in the first three
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months of 2010. Higher earnings at BlackRock for the first quarter of 2011 compared to the first quarter of 2010 were due to the effect of growth in base and performance fees as well asBlackRock Solutions ® and advisory fees.
Distressed Assets Portfolio
This business segment consists primarily of assets acquired with acquisitions and had earnings of $25 million for the first three months of 2011 compared with $73 million in the first three months of 2010. The decline was driven by a decrease in net interest income, partially offset by a lower provision for credit losses and an increase in noninterest income.
Other
“Other” reported earnings of $193 million for the three months of 2011 compared with a net loss of $11 million for the first three months of 2010. The increase in earnings over the first quarter of 2010 primarily reflected the impact of integration costs incurred in the 2010 period, the reversal of a portion of an indemnification liability for certain Visa litigation in the first quarter of 2011 and higher net gains on sales of securities net of other-than-temporary impairments (OTTI) in the first quarter of 2011.
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CONSOLIDATED INCOME STATEMENTREVIEW
Our Consolidated Income Statement is presented in Part I, Item 1 of this Report.
Net income for the first three months of 2011 was $832 million compared with $671 million for the first three months of 2010. Total revenue for the first three months of 2011 was $3.6 billion compared with $3.8 billion for the three months of 2010. The decline in total revenue in the comparison reflected lower net interest income in 2011.
NET INTEREST INCOME AND NET INTEREST MARGIN
Net interest margin
Changes in net interest income and margin result from the interaction of the volume and composition of interest-earning assets and related yields, interest-bearing liabilities and related rates paid, and noninterest-bearing sources of funding. See the Statistical Information (Unaudited) – Average Consolidated Balance Sheet And Net Interest Analysis section of this Report for additional information.
The decrease in net interest income and net interest margin compared with the first quarter of 2010 was attributable to lower purchase accounting accretion, soft loan demand and the low interest rate environment partially offset by lower funding costs.
The net interest margin was 3.94% for the first three months of 2011 and 4.24% for the first three months of 2010. The following factors impacted the comparison:
A 50 basis point decrease in the yield on interest-earning assets. The yield on loans, the largest portion of our earning assets, decreased 41 basis points.
These factors were partially offset by a 21 basis point decline in the rate accrued on interest-bearing liabilities. The rate accrued on interest-bearing deposits, the largest component, decreased 26 basis points.
We expect that our purchase accounting accretion will decrease by as much as $700 million for full year 2011 compared with 2010. Excluding the impact of this factor, we expect our net interest income to increase for full year 2011 by $100 million or more. Overall, we also expect that our net interest margin will decline for full year 2011 compared with 2010.
NONINTEREST INCOME
Summary
Noninterest income totaled $1.5 billion for the first three months of 2011, compared with $1.4 billion for the first three months of 2010.
Noninterest income in the first quarter of 2011 increased $71 million compared with the first quarter of 2010 due to higher residential mortgage fees, higher net gains on sales of securities net of OTTI and a decrease in repurchase reserves partially offset by lower corporate service fees and a decline in service charges on deposits primarily from the impact of Regulation E rules pertaining to overdraft fees.
Additional Analysis
Asset management revenue increased $4 million to $263 million in the first three months of 2011 compared with the first three months of 2010. The increase in the comparisons was driven by higher equity markets, successful client retention, growth in new clients and strong sales performance. Assets under management at March 31, 2011 totaled $110 billion compared with $105 billion at March 31, 2010. Higher equity earnings from our BlackRock investment also contributed to the improved first quarter results.
For the first quarter of 2011, consumer services fees totaled $311 million compared with $296 million in the first quarter of 2010. The increase in fees reflected higher volume-related transaction fees, such as debit cards and credit cards.
Corporate services revenue totaled $217 million in the first three months of 2011 and $268 million in the first three months of 2010. Commercial mortgage servicing revenue declined due to higher impairment charges and lower ancillary fee income. Corporate services fees include the noninterest component of treasury management fees, which continued to be a strong contributor to revenue.
Residential mortgage revenue totaled $195 million in the first quarter of 2011 and $147 million in the first quarter of 2010. Higher loan sales revenue and net economic hedging gains on mortgage servicing rights drove the increase over the first quarter of 2010.
Service charges on deposits totaled $123 million for the first three months of 2011 and $200 million for the first three months of 2010. The decline resulted primarily from the impact of Regulation E rules pertaining to overdraft fees.
Net gains on sales of securities totaled $37 million for the first quarter of 2011 and $90 million for the first quarter of 2010. The net credit component of OTTI of securities recognized in earnings was a loss of $34 million in the first quarter of 2011, compared with a loss of $116 million in the first quarter of 2010.
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Other noninterest income totaled $343 million for the first three months of 2011 compared with $240 million for the first three months of 2010. The increase was driven by several individually insignificant items.
Other noninterest income typically fluctuates from period to period depending on the nature and magnitude of transactions completed. Further details regarding our trading activities are included in the Market Risk Management – Trading Risk portion of the Risk Management section of this Financial Review, further details regarding equity and alternative investments are included in the Market Risk Management-Equity And Other Investment Risk section and further details regarding gains or losses related to our equity investment in BlackRock are included in the Business Segments Review section.
Looking to full year 2011, we see momentum in our fee-based revenues resulting from client growth and depth in our expanded franchise. At the same time, we will see the continued impact of ongoing regulatory reforms. Excluding the expected incremental negative impact of two aspects of anticipated regulatory changes on fees related to Regulation E and interchange rates of approximately $400 million for full year 2011 as further discussed in the Retail Banking portion of the Business Segments Review section of this Report, we expect noninterest income for full year 2011 to increase in the low-to-mid single digits (in terms of percentages) compared with 2010.
PRODUCTREVENUE
In addition to credit and deposit products for commercial customers, Corporate & Institutional Banking offers other services, including treasury management, commercial real estate, and capital markets-related products and services, that are marketed by several businesses primarily to commercial customers.
Treasury management revenue, which includes fees as well as net interest income from customer deposit balances, totaled $301 million for the first three months of 2011 and $296 million for the first three months of 2010.
Revenue from capital markets-related products and services totaled $139 million in the first quarter of 2011 compared with $161 million in the first quarter of 2010. The decrease was due to a number of large underwriting transactions and loan sale activity in the first quarter a year ago which did not recur, which were partially offset by increased derivatives client revenue and reduced impact of credit risk on customer derivative position values
Commercial mortgage banking activities include revenue derived from commercial mortgage servicing (including net interest income and noninterest income from loan servicing and ancillary services), and revenue derived from commercial mortgage loans intended for sale and related hedges (including loan origination fees, net interest income, valuation adjustments and gains or losses on sales).
Commercial mortgage banking activities resulted in revenue of $41 million in the first three months of 2011 compared with $115 million in the first three months of 2010. This decline was due to a reduction in the value of commercial mortgage servicing rights largely driven by higher loan prepayment rates and lower interest rates, and lower ancillary commercial mortgage servicing fees.
PROVISION FOR CREDITLOSSES
The provision for credit losses totaled $421 million for the first three months of 2011 compared with $751 million for the first three months of 2010. The significant decline from the first three months of 2010 was driven by overall credit quality improvement and continuation of actions to reduce exposure levels.
The Credit Risk Management portion of the Risk Management section of this Financial Review includes additional information regarding factors impacting the provision for credit losses.
We anticipate an overall improvement in credit migration for full year 2011 and a continued reduction in our nonperforming loans assuming modest GDP growth. As a result, we expect that our full year 2011 provision for credit losses will be at least $800 million less than our full year 2010 provision for credit losses assuming budgeted loan growth projections.
NONINTEREST EXPENSE
Noninterest expense was $2.1 billion for the first three months of both 2011 and 2010. Integration costs included in noninterest expense totaled $102 million in the first quarter of 2010.
Apart from the possible impact of the legal and regulatory contingencies disclosed in our 2010 Form 10-K and this Report, we expect that total noninterest expense for full year 2011 will be less than total noninterest expense for full year 2010. The magnitude of the decline will be dependent upon the pace of our investment in business growth opportunities.
EFFECTIVE TAX RATE
The effective tax rate was 27.0% in the first quarter of 2011 compared with 27.9% in the first quarter of 2010. We anticipate that the effective tax rate will remain approximately the same for the remainder of 2011.
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CONSOLIDATED BALANCE SHEETREVIEW
SUMMARIZED BALANCE SHEET DATA
Loans
Investment securities
Cash and short-term investments
Loans held for sale
Equity investments
Other, net
Total assets
Liabilities
Deposits
Borrowed funds
Total liabilities
Total shareholders’ equity
Noncontrolling interests
Total equity
Total liabilities and equity
The summarized balance sheet data above is based upon our Consolidated Balance Sheet in this Report.
The decline in total assets at March 31, 2011 compared with December 31, 2010 was primarily due to lower investment securities.
An analysis of changes in selected balance sheet categories follows.
LOANS
A summary of the major categories of loans outstanding follows. Outstanding loan balances reflect unearned income, unamortized discount and premium, and purchase discounts and premiums totaling $2.6 billion at March 31, 2011 and $2.7 billion at December 31, 2010. The balances do not include future accretable net interest (i.e., the difference between the undiscounted expected cash flows and the recorded investment in the loan) on the purchased impaired loans.
Loans decreased $1.2 billion, or 1%, as of March 31, 2011 compared with December 31, 2010. Growth in commercial loans of $1.4 billion was offset by declines of $.8 billion in commercial real estate loans, $.7 billion of residential real estate loans and $.6 billion of home equity loans compared with year end. Commercial loans increased due to a combination of new volume, improved utilization and new Market Street commitments. Commercial real estate loans declined due to loan sales, paydowns, and charge-offs. The decrease in residential real estate was impacted by portfolio management activities, paydowns and net charge-offs. Home
equity loans declined due to increased paydowns in the first quarter of 2011 as well as lower refinancing activity.
Loans represented 58% of total assets at March 31, 2011 and 57% at December 31, 2010. Commercial lending represented 54% of the loan portfolio at March 31, 2011 and 53% at December 31, 2010. Consumer lending represented 46% at March 31, 2011 and 47% at December 31, 2010.
Commercial real estate loans represented 7% of total assets at both March 31, 2011 and December 31, 2010.
Details Of Loans
Commercial
Retail/wholesale
Manufacturing
Service providers
Real estate related (a)
Financial services
Health care
Total commercial
Commercial real estate
Real estate projects
Commercial mortgage
Total commercial real estate
Equipment lease financing
TOTAL COMMERCIAL LENDING (b)
Consumer
Home equity
Lines of credit
Installment
Residential real estate
Residential mortgage
Residential construction
Credit card
Other consumer
Education
Automobile
TOTAL CONSUMER LENDING
Total loans
Total loans above include purchased impaired loans of $7.5 billion, or 5% of total loans, at March 31, 2011, and $7.8 billion, or 5% of total loans, at December 31, 2010.
We are committed to providing credit and liquidity to qualified borrowers. Total loan originations and new commitments and renewals totaled $27 billion for the first three months of 2011.
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Our loan portfolio continued to be diversified among numerous industries and types of businesses. The loans that we hold are also concentrated in, and diversified across, our principal geographic markets.
Commercial lending is the largest category and is the most sensitive to changes in assumptions and judgments underlying the determination of the allowance for loan and lease losses (ALLL). This estimate also considers other relevant factors such as:
Actual versus estimated losses,
Regional and national economic conditions,
Business segment and portfolio concentrations,
Industry conditions,
The impact of government regulations, and
Risk of potential estimation or judgmental errors, including the accuracy of risk ratings.
Higher Risk Loans
Our loan portfolio includes certain loans deemed to be higher risk and therefore more likely to result in credit losses. We established specific and pooled reserves on the total commercial
lending category of $2.5 billion at March 31, 2011. This commercial lending reserve included what we believe to be adequate and appropriate loss coverage on the higher risk commercial loans in the total commercial portfolio. The commercial lending reserve represented 52% of the total ALLL of $4.8 billion at that date. The remaining 48% of ALLL pertained to the total consumer lending category. This category of loans is more homogenous in nature and has certain characteristics that can be assessed at a total portfolio level in terms of loans representing higher risk. We do not consider government insured/government guaranteed loans to be higher risk as we do not believe these loans will result in a significant loss because of their structure. Additional information regarding our higher risk loans is included in Note 5 Asset Quality and Allowances for Loan and Lease Losses and Unfunded Loan Commitments and Letters of Credit in our Notes To Consolidated Financial Statements included in this Report.
Information related to purchased impaired loans, purchase accounting accretion and accretable net interest recognized during the first three months of 2011 and 2010 follows.
Valuation of Purchased Impaired Loans
Commercial and commercial real estate loans:
Unpaid principal balance
Purchased impaired mark
Recorded investment
Allowance for loan losses
Net investment
Consumer and residential mortgage loans:
Total purchased impaired loans:
The unpaid principal balance of purchased impaired loans declined from $9.7 billion at December 31, 2010 to $9.2 billion at March 31, 2011 due to amounts determined to be uncollectible, payoffs and disposals. The remaining purchased impaired mark at March 31, 2011 was $1.7 billion which was a decline from $1.9 billion at December 31, 2010. The net investment of $6.9 billion at December 31, 2010 declined 4% to $6.6 billion at March 31, 2011 primarily due to payoffs, disposals and further impairment partially offset by accretion during 2011. At March 31, 2011, our largest individual
purchased impaired loan had a recorded investment of $22 million.
We currently expect to collect total cash flows of $8.8 billion on purchased impaired loans, representing the $6.6 billion net investment at March 31, 2011 and the accretable net interest of $2.2 billion shown in the Accretable Net Interest-Purchased Impaired Loans table that follows. These represent the net future cash flows on purchased impaired loans, as contractual interest will be reversed.
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Purchase Accounting Accretion
Non-impaired loans
Impaired loans
Reversal of contractual interest on impaired loans
Net impaired loans
Securities
Borrowings
Total
In addition to the amounts in the table above, cash received in excess of recorded investment from sales or payoffs of impaired commercial loans (cash recoveries) totaled $81 million for the first quarter of 2011 and $75 million for the first quarter of 2010. We do not expect this level of cash recoveries to be sustainable.
Remaining Purchase Accounting Accretion
Total loans (gross)
Accretable Net Interest – Purchased Impaired Loans
January 1
Accretion (including cash recoveries)
Net reclassifications to accretable from non-accretable
Disposals
March 31
Net unfunded credit commitments are comprised of the following:
Net Unfunded Credit Commitments
Commercial / commercial real estate (a)
Home equity lines of credit
Consumer credit card and other unsecured lines
Commitments to extend credit represent arrangements to lend funds or provide liquidity subject to specified contractual conditions. Commercial commitments reported above exclude syndications, assignments and participations, primarily to financial institutions, totaling $16.3 billion at March 31, 2011 and $16.7 billion at December 31, 2010.
Unfunded liquidity facility commitments and standby bond purchase agreements totaled $229 million at March 31, 2011 and $458 million at December 31, 2010 and are included in the preceding table primarily within the “Commercial / commercial real estate” category.
In addition to credit commitments, our net outstanding standby letters of credit totaled $10.2 billion at March 31, 2011 and $10.1 billion at December 31, 2010. Standby letters of credit commit us to make payments on behalf of our customers if specified future events occur.
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INVESTMENT SECURITIES
Details of Investment Securities
March 31, 2011
SECURITIES AVAILABLE FOR SALE
Debt securities
US Treasury and government agencies
Residential mortgage-backed
Agency
Non-agency
Commercial mortgage-backed
Asset-backed
State and municipal
Other debt
Corporate stocks and other
Total securities available for sale
SECURITIES HELD TO MATURITY
Commercial mortgage-backed (non-agency)
Total securities held to maturity
December 31, 2010
The carrying amount of investment securities totaled $61.0 billion at March 31, 2011, a decrease of $3.3 billion, or 5%, from $64.3 billion at December 31, 2010. The decline resulted from principal payments and net sales of primarily agency mortgage-backed securities and government agency securities. Investment securities represented 24% of total assets at both March 31, 2011 and December 31, 2010.
We evaluate our portfolio of investment securities in light of changing market conditions and other factors and, where appropriate, take steps intended to improve our overall positioning. We consider the portfolio to be well-diversified and of high quality. US Treasury and government agencies, agency residential mortgage-backed securities and agency commercial mortgage-backed securities collectively represented 59% of the investment securities portfolio at March 31, 2011.
At March 31, 2011, the securities available for sale portfolio included a net unrealized loss of $637 million, which represented the difference between fair value and amortized cost. The comparable amount at December 31, 2010 was a net unrealized loss of $861 million. The fair value of investment securities is impacted by interest rates, credit spreads, market volatility and liquidity conditions. The fair value of investment securities generally decreases when interest rates increase and vice versa. In addition, the fair value generally decreases when credit spreads widen and vice versa.
The improvement in the net unrealized pretax loss compared with December 31, 2010 was primarily due to improved liquidity in non-agency residential mortgage-backed securities markets. Net unrealized gains and losses in the securities available for sale portfolio are included in shareholders’ equity as accumulated other comprehensive income or loss from continuing operations, net of tax.
Unrealized gains and losses on available for sale securities do not impact liquidity or risk-based capital. However, reductions in the credit ratings of these securities would have an impact on the determination of risk-weighted assets which could reduce our regulatory capital ratios. In addition, the amount representing the credit-related portion of OTTI on available for sale securities would reduce our earnings and regulatory capital ratios.
The expected weighted-average life of investment securities (excluding corporate stocks and other) was 4.8 years at March 31, 2011 and 4.7 years at December 31, 2010.
We estimate that, at March 31, 2011, the effective duration of investment securities was 3.4 years for an immediate 50 basis points parallel increase in interest rates and 3.3 years for an immediate 50 basis points parallel decrease in interest rates. Comparable amounts at December 31, 2010 were 3.1 years and 2.9 years, respectively.
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The following table provides detail regarding the vintage, current credit rating, and FICO score of the underlying collateral at origination, where available, for residential mortgage-backed, commercial mortgage-backed and other asset-backed securities held in the available for sale and held to maturity portfolios:
Fair Value – Available for Sale
Fair Value – Held to Maturity
Total Fair Value
% of Fair Value:
By Vintage
2011
2010
2009
2008
2007
2006
2005 and earlier
Not Available
By Credit Rating
AAA
AA
A
BBB
BB
B
Lower than B
No rating
By FICO Score
>720
<720 and >660
<660
No FICO score
We conduct a comprehensive security-level impairment assessment quarterly on all securities in an unrealized loss position to determine whether the loss represents OTTI. Our assessment considers the security structure, recent security collateral performance metrics, external credit ratings, failure of the issuer to make scheduled interest or principal payments, our judgment and expectations of future performance, and relevant independent industry research, analysis and forecasts.
We also consider the severity of the impairment and the length of time that the security has been impaired in our assessment. Results of the periodic assessment are reviewed by a cross-functional senior management team representing Asset & Liability Management, Finance, and Market Risk
Management. The senior management team considers the results of the assessments, as well as other factors, in determining whether the impairment is other-than-temporary.
We recognize the credit portion of OTTI charges in current earnings for those debt securities where we do not intend to sell and believe we will not be required to sell the securities prior to expected recovery. The noncredit portion of OTTI is included in accumulated other comprehensive loss.
We recognized OTTI for the first three months of 2011 and 2010 as follows:
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Other-Than-Temporary Impairments
Credit portion of OTTI losses (a)
Non-agency residential mortgage-backed
Total credit portion of OTTI losses
Noncredit portion of OTTI losses(recoveries) (b)
Total OTTI losses
The following table summarizes net unrealized gains and losses (including the credit and noncredit portions of OTTI) recorded on non-agency residential and commercial mortgage-backed and other asset-backed securities, which represent our most significant categories of securities not backed by the US government or its agencies. A summary of all OTTI credit losses recognized for the first three months of 2011 by investment type is included in Note 7 Investment Securities in the Notes To Consolidated Financial Statements in this Report.
Asset-Backed
Available for Sale Securities (Non-Agency)
Credit Rating Analysis
Other Investment Grade (AA, A, BBB)
Total Investment Grade
Total Sub-Investment Grade
Total No Rating
OTTI Analysis
Investment Grade:
OTTI has been recognized
No OTTI recognized to date
Sub-Investment Grade:
No Rating:
Securities Held to Maturity (Non-Agency)
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Residential Mortgage-Backed Securities
At March 31, 2011, our residential mortgage-backed securities portfolio was comprised of $29.5 billion fair value of US government agency-backed securities and $7.2 billion fair value of non-agency (private issuer) securities. The agency securities are generally collateralized by 1-4 family, conforming, fixed-rate residential mortgages. The non-agency securities are also generally collateralized by 1-4 family residential mortgages. The mortgage loans underlying the non-agency securities are generally non-conforming (i.e., original balances in excess of the amount qualifying for agency securities) and predominately have interest rates that are fixed for a period of time, after which the rate adjusts to a floating rate based upon a contractual spread that is indexed to a market rate (i.e., a “hybrid ARM”), or interest rates that are fixed for the term of the loan.
Substantially all of the non-agency securities are senior tranches in the securitization structure and at origination had credit protection in the form of credit enhancement, over-collateralization and/or excess spread accounts.
During the first quarter of 2011, we recorded OTTI credit losses of $28 million on non-agency residential mortgage-backed securities. As of March 31, 2011, $26 million of the credit losses related to securities rated below investment grade. As of March 31, 2011, the noncredit portion of OTTI losses recorded in accumulated other comprehensive loss for non-agency residential mortgage-backed securities totaled $650 million and the related securities had a fair value of $4 billion.
The fair value of sub-investment grade investment securities for which we have not recorded an OTTI credit loss as of March 31, 2011 totaled $2 billion, with unrealized net losses of $29 million. The results of our security-level assessments indicate that we will recover the entire cost basis of these securities. Note 7 Investment Securities in the Notes To Consolidated Financial Statements in this Report provides further detail regarding our process for assessing OTTI for these securities.
Commercial Mortgage-Backed Securities
The fair value of the non-agency commercial mortgage-backed securities portfolio was $6.4 billion at March 31, 2011 and consisted of fixed-rate, private-issuer securities collateralized by non-residential properties, primarily retail properties, office buildings, and multi-family housing. The agency commercial mortgage-backed securities portfolio was $1.3 billion fair value at March 31, 2011 consisting of multi-family housing. Substantially all of the securities are the most senior tranches in the subordination structure.
There were no OTTI credit losses on commercial mortgage-backed securities during the first quarter of 2011.
Asset-Backed Securities
The fair value of the asset-backed securities portfolio was $5.2 billion at March 31, 2011 and consisted of fixed-rate and floating-rate, private-issuer securities collateralized primarily by various consumer credit products, including residential mortgage loans, credit cards, automobile loans, and student loans. Substantially all of the securities are senior tranches in the securitization structure and have credit protection in the form of credit enhancement, over-collateralization and/or excess spread accounts.
We recorded OTTI credit losses of $5 million on asset-backed securities during first three months of 2011. All of the securities were collateralized by first and second lien residential mortgage loans and were rated below investment grade. As of March 31, 2011, the noncredit portion of OTTI losses recorded in accumulated other comprehensive loss for asset-backed securities totaled $142 million and the related securities had a fair value of $645 million.
For the sub-investment grade investment securities (available for sale and held to maturity) for which we have not recorded an OTTI loss through March 31, 2011, the remaining fair value was $203 million, with unrealized net losses of $1 million. The results of our security-level assessments indicate that we will recover the entire cost basis of these securities. Note 7 Investment Securities in the Notes To Consolidated Financial Statements in this Report provides further detail regarding our process for assessing OTTI for these securities.
If current housing and economic conditions were to worsen, if market volatility and illiquidity were to worsen, or if market interest rates were to increase appreciably, the valuation of our investment securities portfolio could continue to be adversely affected and we could incur additional OTTI credit losses that would impact our Consolidated Income Statement.
LOANS HELDFOR SALE
Commercial mortgages at fair value
Commercial mortgages at lower of cost or market
Total commercial mortgages
Residential mortgages at fair value
Residential mortgages at lower of cost or market
Total residential mortgages
We stopped originating certain commercial mortgage loans designated as held for sale in 2008 and continue pursuing opportunities to reduce these positions at appropriate prices. We sold $16 million of commercial mortgage loans held for
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sale carried at fair value in the first three months of 2011 and sold $24 million in the first three months of 2010.
We recognized net gains of $13 million in the first three months of 2011 on the valuation and sale of commercial mortgage loans held for sale, net of hedges, compared with net gains of $9 million recognized in the first three months of 2010.
Residential mortgage loan origination volume was $3.2 billion in the first three months of 2011. Substantially all such loans were originated under agency or Federal Housing Administration (FHA) standards. We sold $3.4 billion of loans and recognized related gains of $84 million during the first three months of 2011. The comparable amounts for the first three months of 2010 were $1.9 billion and $39 million, respectively.
Interest income on loans held for sale was $69 million in the first three months of 2011, and $66 million in the first three months of 2010 and is included in Other interest income on our Consolidated Income Statement.
GOODWILL AND OTHER INTANGIBLE ASSETS
Goodwill and other intangible assets totaled $10.8 billion at both March 31, 2011 and December 31, 2010. See Note 9 Goodwill and Other Intangible Assets included in the Notes To Consolidated Financial Statements in this Report.
FUNDING AND CAPITAL SOURCES
Details Of Funding Sources
Money market
Demand
Retail certificates of deposit
Savings
Other time
Time deposits in foreign offices
Federal funds purchased and repurchase agreements
Federal Home Loan Bank borrowings
Bank notes and senior debt
Subordinated debt
Total borrowed funds
Total funding sources decreased $5.9 billion at March 31, 2011 compared with December 31, 2010.
Total deposits decreased $1.4 billion, or 1%, at March 31, 2011 compared with December 31, 2010. Interest-bearing deposits represented 73% of total deposits at both March 31, 2011 and December 31, 2010. Total borrowed funds decreased $4.5 billion since December 31, 2010. The decline from December 31, 2010 was primarily due to maturities of bank notes and senior debt, FHLB borrowings and other borrowings.
Capital
See 2011 Capital Actions in the Executive Summary section of this Financial Review for additional information regarding our April 2011 increase to PNC’s quarterly common stock dividend and our plans to purchase shares under PNC’s existing common stock repurchase program (described below) during the remainder of 2011.
We manage our capital position by making adjustments to our balance sheet size and composition, issuing debt, equity or hybrid instruments, executing treasury stock transactions, managing dividend policies and retaining earnings.
Total shareholders’ equity increased $.9 billion, to $31.1 billion, at March 31, 2011 compared with December 31, 2010 as retained earnings increased $.8 billion. Common shares outstanding were 526 million at both March 31, 2011 and December 31, 2010.
Our current common stock repurchase program permits us to purchase up to 25 million shares of PNC common stock on the open market or in privately negotiated transactions. This program will remain in effect until fully utilized or until modified, superseded or terminated. The extent and timing of share repurchases under this program will depend on a number of factors including, among others, market and general economic conditions, economic and regulatory capital considerations, alternative uses of capital, regulatory and contractual limitations, and the potential impact on our credit ratings. We did not purchase any shares in the first three months of 2011 under this program.
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Risk-Based Capital
Capital components
Common
Preferred
Trust preferred capital securities
Eligible deferred income taxes on goodwill and other intangible assets
Pension, other postretirement benefit plan adjustments
Net unrealized securities losses, after-tax
Net unrealized losses (gains) on cash flow hedge derivatives, after-tax
Tier 1 risk-based capital
Eligible allowance for credit losses
Total risk-based capital
Tier 1 common capital
Preferred equity
Risk-weighted assets, including off-balance sheet instruments and market risk equivalent assets
Adjusted average total assets
Capital ratios
Tier 1 risk-based
Total risk-based
Leverage
Federal banking regulators have stated that they expect all bank holding companies to have a level and composition of Tier 1 capital well in excess of the 4% regulatory minimum, and they have required the largest US bank holding companies, including PNC, to have a capital buffer sufficient to withstand losses and allow them to meet credit needs of their customers through the economic downturn. They have also stated their view that common equity should be the dominant form of Tier 1 capital. As a result, regulators are now emphasizing the Tier 1 common capital ratio in their evaluation of bank holding company capital levels, although this metric is not provided for in the regulations. We seek to manage our capital consistent with these regulatory principles, and believe that our March 31, 2011 capital levels were aligned with them.
Dodd-Frank requires the Federal Reserve Board to establish capital requirements that would, among other things, eliminate the Tier 1 treatment of trust preferred securities following a phase-in period expected to begin in 2013. Accordingly, PNC will evaluate its alternatives, including the potential for early redemption of some or all of its trust preferred securities, based on such considerations it may consider relevant, including dividend rates, the specifics of the future capital requirements, capital market conditions and other factors. PNC is also subject to replacement capital covenants with respect to certain of its trust preferred securities as discussed in Note 13 Capital Securities of Subsidiary Trusts and Perpetual Trust Securities in Item 8 of our 2010 Form 10-K.
Our Tier 1 common capital ratio was 10.3% at March 31, 2011, compared with 9.8% at December 31, 2010. Our Tier 1 risk-based capital ratio increased 50 basis points to 12.6% at March 31, 2011 from 12.1% at December 31, 2010. Increases in both ratios were attributable to retention of earnings and a decline in risk-weighted assets in 2011.
At March 31, 2011, PNC Bank, N.A., our domestic bank subsidiary, was considered “well capitalized” based on US regulatory capital ratio requirements. To qualify as “well-capitalized”, regulators currently require banks to maintain capital ratios of at least 6% for Tier 1 risk-based, 10% for total risk-based, and 5% for leverage, which are indicated on page 2 of this Report. We believe PNC Bank, N.A. will continue to meet these requirements during the remainder of 2011.
The access to, and cost of, funding for new business initiatives including acquisitions, the ability to engage in expanded business activities, the ability to pay dividends, the level of deposit insurance costs, and the level and nature of regulatory oversight depend, in part, on a financial institution’s capital strength.
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OFF-BALANCE SHEETARRANGEMENTS AND VARIABLE INTEREST ENTITIES
We engage in a variety of activities that involve unconsolidated entities or that are otherwise not reflected in our Consolidated Balance Sheet that are generally referred to as “off-balance sheet arrangements.” Additional information on these types of activities is included in our 2010 Form 10-K and in the following sections of this Report:
Commitments, including contractual obligations and other commitments, included within the Risk Management section of this Financial Review,
Note 3 Loan Sale and Servicing Activities and Variable Interest Entities in the Notes To Consolidated Financial Statements,
Note 10 Capital Securities of Subsidiary Trusts and Perpetual Trust Securities in the Notes To Consolidated Financial Statements, and
Note 17 Commitments and Guarantees in the Notes To Consolidated Financial Statements.
PNC consolidates variable interest entities (VIEs) when we are deemed to be the primary beneficiary. The primary beneficiary of a VIE is determined to be the party that meets both of the following criteria: (1) has the power to make decisions that most significantly affect the economic performance of the VIE and (2) has the obligation to absorb losses or the right to receive benefits that in either case could potentially be significant to the VIE.
A summary of VIEs, including those that we have consolidated and those in which we hold variable interests but have not consolidated into our financial statements, as of March 31, 2011 and December 31, 2010 is included in Note 3 of this Report.
PNC Capital Trust E Trust Preferred Securities
In February 2008, PNC Capital Trust E issued $450 million of 7.75% Trust Preferred Securities due March 15, 2068 (the Trust E Securities). PNC Capital Trust E’s only assets are $450 million of 7.75% Junior Subordinated Notes due March 15, 2068 and issued by PNC (the JSNs). The Trust E Securities are fully and unconditionally guaranteed by PNC. We may, at our option, redeem the JSNs at 100% of their principal amount on or after March 15, 2013.
In connection with the closing of the Trust E Securities sale, we agreed that, if we have given notice of our election to defer interest payments on the JSNs or a related deferral period is continuing, then PNC would be subject during such period to restrictions on dividends and other provisions protecting the status of the JSN debenture holder similar to or in some ways more restrictive than those potentially imposed under the Exchange Agreements with Trust II and Trust III, as described in Note 13 Capital Securities of Subsidiary Trusts and Perpetual Trust Securities (Note 13) in our 2010 Form 10-K. PNC Capital Trusts C and D have similar protective provisions with respect to $500 million in principal amount of junior subordinated debentures. Also, in connection with the closing of the Trust E Securities sale, we entered into a replacement capital covenant, which is described in Note 13 in our 2010 Form 10-K.
Acquired Entity Trust Preferred Securities
As a result of the National City acquisition, we assumed obligations with respect to $2.4 billion in principal amount of junior subordinated debentures issued by the acquired entity. As a result of other prior acquisitions, we assumed obligations with respect to $158 million in principal amount of junior subordinated debentures issued by the acquired entities. As described in Note 13 in our 2010 Form 10-K, during 2010 we redeemed $81 million in principal amount related to the junior subordinated debentures issued by the acquired entities. Under the terms of the outstanding debentures, if there is an event of default under the debentures or PNC exercises its right to defer payments on the related trust preferred securities issued by the statutory trusts or there is a default under PNC’s guarantee of such payment obligations, PNC would be subject during the period of such default or deferral to restrictions on dividends and other provisions protecting the status of the debenture holders similar to or in some ways more restrictive than those potentially imposed under the Exchange Agreements with Trust II and Trust III, as described in Note 13 in our 2010 Form 10-K.
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FAIR VALUE MEASUREMENTS
In addition to the following, see Note 8 Fair Value in the Notes To Consolidated Financial Statements in this Report for further information regarding fair value.
Assets recorded at fair value represented 27% of total assets at both March 31, 2011 and December 31, 2010. Liabilities recorded at fair value represented 2% and 3% of total liabilities at March 31, 2011 and December 31, 2010, respectively.
The following table includes the assets and liabilities measured at fair value and the portion of such assets and liabilities that are classified within Level 3 of the valuation hierarchy.
Securities available for sale
Financial derivatives
Residential mortgage loans held for sale
Trading securities
Residential mortgage servicing rights
Commercial mortgage loans held for sale
Customer resale agreements
Other assets
Level 3 assets as a percentage of total assets at fair value
Level 3 assets as a percentage of consolidated assets
Trading securities sold short
Other liabilities
Level 3 liabilities as a percentage of total liabilities at fair value
Level 3 liabilities as a percentage of consolidated liabilities
The majority of Level 3 assets represent non-agency residential mortgage-backed and asset-backed securities in the available for sale securities portfolio for which there was a lack of observable market activity.
During the first three months of 2011, no significant transfers of assets or liabilities between the hierarchy levels occurred.
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BUSINESS SEGMENTS REVIEW
We have six reportable business segments:
Once we entered into an agreement to sell GIS, it was no longer a reportable business segment. We sold GIS on July 1, 2010.
Business segment results, including inter-segment revenues, and a description of each business are included in Note 18 Segment Reporting included in the Notes To Consolidated Financial Statements of this Report. Certain amounts included in this Financial Review differ from those amounts shown in Note 18 primarily due to the presentation in this Financial Review of business net interest revenue on a taxable-equivalent basis.
Results of individual businesses are presented based on our management accounting practices and management structure. There is no comprehensive, authoritative body of guidance for management accounting equivalent to GAAP; therefore, the financial results of our individual businesses are not necessarily comparable with similar information for any other company. We refine our methodologies from time to time as our management accounting practices are enhanced and our businesses and management structure change. Certain prior period amounts have been reclassified to reflect current methodologies and our current business and management structure. Financial results are presented, to the extent practicable, as if each business operated on a stand-alone basis. We have aggregated the business results for certain similar operating segments for financial reporting purposes.
Assets receive a funding charge and liabilities and capital receive a funding credit based on a transfer pricing
methodology that incorporates product maturities, duration and other factors.
Capital is intended to cover unexpected losses and is assigned to our business segments using our risk-based economic capital model, including consideration of the goodwill and other intangible assets at those business segments, as well as the diversification of risk among the business segments. We have revised certain capital allocations among our business segments, including amounts for prior periods. PNC’s total capital did not change as a result of these adjustments for any periods presented.
We have allocated the ALLL and unfunded loan commitments and letters of credit based on our assessment of risk inherent in the business segment loan portfolios. Our allocation of the costs incurred by operations and other shared support areas not directly aligned with the businesses is primarily based on the use of services.
Total business segment financial results differ from total consolidated results from continuing operations before noncontrolling interests, which itself excludes the earnings and revenue attributable to GIS through March 31, 2010 that is reflected in discontinued operations. The impact of these differences is reflected in the “Other” category. “Other” for purposes of this Business Segments Review and the Business Segment Highlights in the Executive Summary includes residual activities that do not meet the criteria for disclosure as a separate reportable business, such as gains or losses related to BlackRock transactions including LTIP share distributions and obligations, integration costs, asset and liability management activities including net securities gains or losses and certain trading activities, exited businesses, equity management activities, alternative investments, intercompany eliminations, most corporate overhead, and differences between business segment performance reporting and financial statement reporting (GAAP), including the presentation of net income attributable to noncontrolling interests.
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Results Of Businesses – Summary
(Unaudited)
Total business segments
Other (b) (c)
Income from continuing operations before noncontrolling interests (d)
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RETAIL BANKING
Three months ended March 31
Dollars in millions, except as noted
INCOME STATEMENT
Service charges on deposits
Brokerage
Consumer services
Total noninterest income
Pretax earnings (loss)
Income taxes (benefit)
Earnings (loss)
AVERAGE BALANCE SHEET
Indirect auto
Indirect other
Credit cards
Total consumer
Commercial and commercial real estate
Floor plan
Noninterest-bearing demand
Interest-bearing demand
Total transaction deposits
Certificates of deposit
Return on average capital
Return on average assets
OTHER INFORMATION (a)
Credit-related statistics:
Commercial nonperforming assets
Consumer nonperforming assets
Total nonperforming assets (b)
Impaired loans (c)
Commercial lending net charge-offs
Credit card lending net charge-offs
Consumer lending (excluding credit card) net charge-offs
Total net charge-offs
Commercial lending annualized net charge-off ratio
Credit card lending annualized net charge-off ratio
Consumer lending (excluding credit card) annualized net charge-off ratio
Total annualized net charge-off ratio
Other statistics:
ATMs
Branches (d)
At March 31
OTHER INFORMATION (CONTINUED)(a)
Home equity portfolio credit statistics:
% of first lien positions (e)
Weighted average loan-to-value ratios (e)
Weighted average FICO scores (f)
Annualized net charge-off ratio
Loans 30 – 59 days past due
Loans 60 – 89 days past due
Loans 90 days past due
Customer-related statistics:
Retail Banking checking relationships
Retail online banking active customers
Retail online bill payment active customers
Brokerage statistics:
Financial consultants (g)
Full service brokerage offices
Brokerage account assets (billions)
Highlights of Retail Banking’s performance for the first quarter of 2011 include the following:
In January, PNC reached a definitive agreement to acquire 19 branches and approximately $390 million of deposits from BankAtlantic Bancorp, Inc. All of the branches are located in the Tampa, Florida area. The transaction is expected to close in June 2011, subject to customary closing conditions. The transaction is expected to provide Retail Banking with the opportunity to establish a foothold in the Tampa area and to expand our branch presence in the Florida market.
Retail Banking launched a new checking account line-up and a new credit card suite during the first quarter. The new products are designed to provide more choices for customers.
Net new checking relationships grew 56,000 in the first quarter and 142,000 over the prior year, strong results reflecting gains in all of our markets. We are
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seeing strong retention and increasing acquisition in all of our markets.
Success in implementing Retail Banking’s deposit strategy resulted in growth in average demand deposits of $3.0 billion, or 8%, over the prior year.
Our investment in online banking capabilities continues to pay off. Active online bill payment and active online banking customers grew by 5% and 6%, respectively, during the first quarter of 2011. In a year-over-year comparison, active online bill payment grew 25% and active online banking customers grew 16%.
PNC’s branch footprint covers nearly one-third of the US population with a network of 2,446 branches and 6,660 ATM machines at March 31, 2011. We continue to invest in the branch network. In the first quarter of 2011, we opened 6 traditional branches, consolidated 30 branches, and had a net decrease of 13 ATMs.
Total revenue for the first quarter of 2011 was $1.2 billion compared with $1.4 billion for the first quarter of 2010. Net interest income of $818 million declined $51 million compared with the first quarter of 2010. Net interest income was negatively impacted by lower interest credits assigned to deposits, reflective of the rate environment, and benefited from higher demand deposits and increased education loans.
Noninterest income declined $61 million when compared with the first quarter of 2010. The decline was driven by lower overdraft fees resulting from Regulation E rules.
For 2011, Retail Banking revenue continues to be negatively impacted by the rules set forth in Regulation E related to overdraft fees and is expected to be negatively impacted by the potential limits related to interchange rates on debit card transactions (proposed in Dodd-Frank.) The incremental negative impact of these two aspects of regulatory reform on fees is estimated to be approximately $400 million in 2011 compared with 2010 if limits to interchange rates are implemented consistent with rules currently proposed by the Federal Reserve Board. Changes in the proposed interchange rules could impact this estimate. Further, this estimate does not include any additional impact to revenue of other or additional regulatory requirements. There could be other aspects of regulatory reform that further impact these or other areas of our business as regulatory agencies, including the new CFPB, issue proposed and final regulations pursuant to Dodd-Frank and other legislation. See additional information regarding legislative and regulatory developments in the Executive Summary section of this Financial Review.
The provision for credit losses was $276 million for the first quarter of 2011 compared with $339 million in the first quarter of 2010. Net charge-offs were $257 million for the first quarter of 2011 compared with $300 million in prior year first quarter. Improvements in credit quality are evident in the
credit card and small business portfolios. However, the home equity portfolio is challenged by trends reflecting an increase in bankruptcies, continued loan modifications, many of which resulted in troubled debt restructurings, and a longer foreclosure timeline.
Noninterest expense for the first three months of 2011 increased $26 million from the same period last year. The increase was driven by continued investment in the business.
Growing core checking deposits as a lower-cost funding source and as the cornerstone product to build customer relationships is the primary objective of our deposit strategy. Furthermore, core checking accounts are critical to our strategy of expanding our payments business. The deposit strategy of Retail Banking is to remain disciplined on pricing, target specific products and markets for growth, and focus on the retention and growth of balances for relationship customers.
In the first quarter of 2011, average total deposits decreased $5.5 billion, or 4%, compared with 2010.
Average demand deposits increased $3.0 billion, or 8%, over the same quarter in 2010. The increase was primarily driven by customer growth and customer preferences for liquidity.
Average money market deposits increased $683 million, or 2%, from the first three months of 2010. The increase was primarily due to core money market growth as customers generally prefer more liquid deposits in a low rate environment.
In the first three months of 2011, average certificates of deposit decreased $10.3 billion from the same period last year. This decline is expected to continue in 2011, although at a slower pace, due to the continued run-off of higher rate certificates of deposits.
Currently, we plan to maintain our focus on a relationship-based lending strategy that targets specific customer sectors (mass consumers, homeowners, students, small businesses and auto dealerships) and our moderate risk lending approach. In the first quarter of 2011, average total loans were $58.4 billion, a decrease of $902 million, or 2%, over the same quarter last year.
Average education loans grew $1.0 billion compared with the first three months of 2010, primarily due to portfolio purchases.
Average indirect auto loans increased $507 million over the first quarter of 2010. The increase was due to the expansion of our indirect sales force and product introduction to acquired markets, as well as overall increases in auto sales. The indirect other portfolio is primarily a run-off portfolio comprised of marine, RV, and other indirect loan products.
Average floor plan loans grew $276 million compared with the first quarter of 2010, primarily
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due to higher line utilization as dealers maintained higher inventory levels due to product availability and improved sales prospects.
Average credit card balances decreased $348 million over the first quarter of 2010. The decrease was primarily the result of weak consumer demand in response to the economic environment. This resulted in fewer active accounts generating balances coupled with increased paydowns on existing accounts.
Average home equity loans declined $757 million compared with the first three months of 2010. Consumer loan demand remained soft in the current
economic climate. The decline is driven by loan demand being outpaced by paydowns, refinancings, and charge-offs. Retail Banking’s home equity loan portfolio is relationship based, with 96% of the portfolio attributable to borrowers in our primary geographic footprint. The nonperforming assets and charge-offs that we have experienced are within our expectations given current market conditions.
Average commercial and commercial real estate loans declined $669 million compared with the first quarter of 2010. The decline was primarily due to loan demand being outpaced by refinancings, paydowns, and charge-offs.
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CORPORATE & INSTITUTIONAL BANKING
Corporate service fees
Provision for (recoveries of) credit losses
Pretax earnings
Income taxes
Earnings
Commercial – real estate related
Asset-based lending
COMMERCIAL MORTGAGE SERVICING PORTFOLIO (in billions)
Beginning of period
Acquisitions/additions
Repayments/transfers
End of period
OTHER INFORMATION
Consolidated revenue from: (a)
Treasury Management
Capital Markets
Commercial mortgage loans held for sale (b)
Commercial mortgage loan servicing (c)
Total commercial mortgage banking activities
Total loans (d)
Nonperforming assets (d) (e)
Impaired loans (d) (f)
Net charge-offs
Net carrying amount of commercial mortgage servicing rights (d)
Highlights of Corporate & Institutional Banking performance include:
Added new clients at a record pace in 2010 and continued this momentum during the first quarter of 2011.
Loan commitments, primarily in our Middle Market and Business Credit segments, grew from the first quarter of 2010. Average loans grew over $1 billion from the fourth quarter of 2010.
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Cross sales of treasury management and capital markets products to customers in PNC’s western markets continued to be successful following the systems conversions. Sales in the first quarter of 2011 were ahead of target and were up compared with the first quarter last year.
Midland Loan Services, one of the leading third-party providers of servicing for the commercial real estate industry, received the highest U.S. servicer and special servicer ratings from Fitch Ratings and Standard & Poor’s and is in its 11th consecutive year of achieving these ratings.
Midland was the number one servicer of FNMA and FHLMC loans and was the second leading servicer of commercial and multifamily loans by volume as of December 31, 2010 according to Mortgage Bankers Association.
Mergers and Acquisitions Journal named Harris William & Co. Advisor of the Year in its March 2011 issue.
Net interest income for the first quarter of 2011 was $799 million, a decrease of $91 million from the first quarter of 2010, reflecting lower purchase accounting accretion, lower interest credits assigned to deposits and a decrease in average loans, partially offset by improved loan spreads and an increase in average deposits.
Corporate service fees were $187 million for the first three months of 2011, a decrease of $55 million from the first three months of 2010, primarily due to a reduction in the value of commercial mortgage servicing rights largely driven by higher loan prepayment rates and lower interest rates, and lower ancillary commercial mortgage servicing fees. The major components of corporate service fees are treasury management, corporate finance fees and commercial mortgage servicing revenue.
Our Treasury Management business, which is one of the top providers in the country, continued to invest in markets, products and infrastructure as well as major initiatives such as healthcare. The healthcare initiative is designed to help provide our customers opportunities to reduce operating costs.
Other noninterest income was $112 million for the first three months of 2011 compared with $129 million in the first quarter of 2010 primarily due to a decline in underwriting revenues.
The provision for credit losses was a recovery of $30 million in the first quarter 2011 compared with a provision of $236 million in the first three months of 2010. The improvement reflected continued positive migration in portfolio credit quality along with lower loan levels. Net charge-offs for the first three months of 2011 of $153 million decreased $118 million or 44% compared with the 2010 period. The decline
was attributable primarily to the commercial real estate and equipment finance portfolios. Nonperforming assets declined across all portfolios for the fourth consecutive quarter.
Noninterest expense was $445 million in the first three months of 2011 and was flat compared to the same period a year ago. Lower compensation costs due to the sale of a duplicative agency servicing operation were offset by higher credit-related costs.
Average loans were $63.9 billion for the first quarter of 2011 compared with $66.4 billion in the first quarter of 2010. The decrease in average loans of $2.5 billion or 4% compared with 2010 was driven by exits of certain client relationships combined with lower utilization rates.
PNC Real Estate provides commercial real estate and real-estate related lending and is one of the industry’s top providers of both conventional and affordable multifamily financing. Commercial real estate loans declined in the first three months of 2011 compared with the first three months of 2010 due to loan sales, paydowns and charge-offs.
PNC Business Credit is one of the top asset-based lenders in the country. It expanded its operations with the acquisition of an asset-based lending group in the United Kingdom which was completed in November 2010. Total loans acquired were approximately $300 million. Loan commitments and loan utilization rates increased throughout 2010 and into the first quarter of 2011.
PNC Equipment Finance is the 6th largest bank-affiliated leasing company with $9 billion in equipment finance assets. Average loans and leases declined slightly in the first quarter 2011 compared with the first quarter of 2010 due to runoff and sales of non-strategic portfolios, which offset portfolio acquisitions and improved origination volumes within our middle market customer base.
Average deposits were $46.0 billion for the first quarter of 2011, an increase of $3.9 billion, or 9%, compared with the first three months of 2010. Our customers have continued to move balances to noninterest-bearing demand deposits to maintain liquidity.
The commercial mortgage servicing portfolio was $266 billion at March 31, 2011 compared with $282 billion at March 31, 2010. The decrease was primarily the result of the sale of a duplicative agency servicing operation, a non-core business, in the second quarter of 2010.
See the additional revenue discussion regarding treasury management, capital markets-related products and services, and commercial mortgage banking activities in the Product Revenue section of the Consolidated Income Statement Review.
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ASSET MANAGEMENT GROUP
Certificates of deposit and other
Total nonperforming assets (a) (b)
Impaired loans (a) (c)
Total net charge-offs (recoveries)
Assets Under Administration (in billions) (a) (d)
Personal
Institutional
Asset Type
Equity
Fixed Income
Liquidity/Other
Highlights of Asset Management Group’s performance during the first three months of 2011 include the following:
Substantially increased new client acquisition and year-over-year sales and also outperformed first quarter goals;
Focused hiring to drive growth across the footprint;
Piloted new financial reporting technology to clients in several markets, and
Continued signs of improvement in credit performance.
Assets under administration were $219 billion at March 31, 2011 compared with $209 billion at March 31, 2010. Discretionary assets under management were $110 billion at March 31, 2011 compared with $105 billion at March 31, 2010. The increase in the comparisons was driven by higher equity markets, successful client retention, growth in new clients and strong sales performance.
Total revenue for the first quarter of 2011 was $222 million compared with $227 million for the same period in 2010. Net interest income was $60 million for the first quarter of 2011 compared with $63 million in the first quarter of 2010. The decrease was attributable to lower loan yields and lower interest credits assigned to deposits reflective of the current low rate environment. Noninterest income of $162 million for the first three months of 2011 declined slightly from the prior year first quarter as the exit of acquisition-related noncore products mitigated solid growth in asset management fees from improved equity markets and strong sales performance.
Provision for credit losses was a benefit of $6 million in the first quarter of 2011 reflecting improved credit quality compared with provision of $9 million for the first quarter of 2010. A net recovery of $11 million was recognized for the first quarter compared with net charge-offs of $4 million in the first quarter of 2010.
Noninterest expense of $160 million in the first quarter of 2011 increased $4 million, or 3%, from the year ago first quarter. The increase was attributable to investments in the business to drive growth.
Average deposits for the quarter increased $765 million, or 11%, over the prior year first quarter. Average transaction deposits grew 15% compared with first quarter 2010 and were substantially offset by the strategic run off of higher rate certificates of deposit in the comparison. Average loan balances decreased $126 million, or 2%, from the prior year first quarter primarily due to the current economy.
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RESIDENTIAL MORTGAGE BANKING
Loan servicing revenue
Servicing fees
Net MSR hedging gains
Loan sales revenue
Portfolio loans
Mortgage servicing rights (MSR)
Borrowings and other liabilities
RESIDENTIAL MORTGAGE SERVICING PORTFOLIO
(in billions)
Acquisitions
Additions
Servicing portfolio statistics: (a)
Fixed rate
Adjustable rate/balloon
Weighted average interest rate
MSR capitalized value (in billions)
MSR capitalization value (in basis points)
Weighted average servicing fee (in basis points)
Loan origination volume (in billions)
Percentage of originations represented by:
Agency and government programs
Refinance volume
Residential Mortgage Banking overview:
Total loan originations were $3.2 billion for the first quarter of 2011 compared with $2.0 billion in the first quarter of 2010. Refinance application volume was up compared to first quarter 2010. Loans continue to be originated primarily through direct channels under FNMA, FHLMC and FHA/VA agency guidelines.
Investors may request PNC to indemnify them against losses on certain loans or to repurchase loans that they believe do not comply with applicable contractual loan origination covenants and representations and warranties we have made. At March 31, 2011, the liability for estimated losses on repurchase and indemnification claims for the Residential Mortgage Banking business segment was $124 million compared with $188 million at March 31, 2010. See Note 17 Commitments and Guarantees in the Notes To Consolidated Financial Statements of this Report for additional information.
Residential mortgage loans serviced for others totaled $127 billion at March 31, 2011 compared with $141 billion at March 31, 2010 as payoffs continued to outpace new direct loan origination volume.
Noninterest income was $202 million in the first quarter of 2011 compared with $154 million in the first quarter of 2010. The increase resulted from higher loan sales revenue driven by higher loan origination volume and higher net economic hedging gains on mortgage servicing rights.
Net interest income was $56 million in the first quarter of 2011 compared with $74 million in the first quarter of 2010. The decrease in the comparisons was primarily due to lower interest earned on escrow deposits.
Noninterest expense was $137 million in the first quarter of 2011 compared with $120 million in the first quarter of 2010. The increase from the prior year first quarter was driven by higher loan origination volume and higher foreclosure-related expenses.
The fair value of mortgage servicing rights was $1.1 billion at March 31, 2011 compared with $1.3 billion at March 31, 2010. The decline was due to lower mortgage rates at March 31, 2011 and a smaller mortgage servicing portfolio.
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BLACKROCK
Information related to our equity investment in BlackRock follows:
Dollars in millions
Business segment earnings (a)
PNC’s economic interest in BlackRock (b)
Carrying value of PNC’s investment in BlackRock (c)
Market value of PNC’s investment in BlackRock (d)
PNC accounts for its BlackRock Series C Preferred Stock at fair value, which offsets the impact of marking-to-market the obligation to deliver these shares to BlackRock to help fund BlackRock LTIP programs. The fair value amount of the BlackRock Series C Preferred Stock is included on our Consolidated Balance Sheet in the caption Other assets. Additional information regarding the valuation of the BlackRock Series C Preferred Stock is included in Note 8 Fair Value in the Notes To Consolidated Financial Statements of this Report.
PNC accounts for its remaining investment in BlackRock under the equity method of accounting. Our percentage ownership of BlackRock common stock (approximately 25% at March 31, 2011) is higher than our overall share of BlackRock’s equity and earnings.
Our 2010 Form 10-K includes additional information about our investment in BlackRock, including BlackRock’s November 2010 secondary common stock offering and our sale of a portion of our shares of BlackRock common stock in that offering.
DISTRESSED ASSETS PORTFOLIO
Commercial Lending:
Commercial/Commercial real estate
Lease financing
Total commercial lending
Consumer Lending:
Total consumer lending
Total portfolio loans
Nonperforming assets (a) (b)
Net charge-offs (d)
Annualized net charge-off ratio (d)
LOANS (a)
Commercial Lending
Consumer Lending
This business segment consists primarily of assets acquired with acquisitions and had earnings of $25 million for the first three months of 2011 compared with $73 million in the first three months of 2010. The decline was driven by a decrease in
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net interest income, partially offset by a lower provision for credit losses and an increase in noninterest income.
Distressed Assets Portfolio overview:
Average loans declined to $14.2 billion in the first quarter of 2011 compared with $18.2 billion in the first quarter of 2010. The decline was impacted by portfolio management activities including loan sales, paydowns and net charge-offs.
Net interest income was $236 million in the first three months of 2011 compared with $342 million for the first three months of 2010. The decline was driven by lower purchase accounting accretion on impaired loans and a decline in average loan balances.
Noninterest income was $9 million for the first quarter of 2011 compared with a loss of $12 million for the first quarter of 2010. An increase in reserves for brokered home equity loan indemnification and repurchase obligations was recorded in the first quarter a year ago.
The provision for credit losses was $152 million in the first quarter of 2011 compared with $165 million in the first quarter of 2010. The decline was driven by improved credit performance within the mortgage and construction loan portfolios.
Noninterest expense for the first three months of 2011 was $53 million compared with $48 million in the first three months of 2010. The increase was driven by other real estate owned-related losses and expenses.
Nonperforming loans decreased $.5 billion, to $.9 billion, at March 31, 2011 compared with March 31, 2010. The consumer lending portfolio comprised 53% of the nonperforming loans at March 31, 2011. Nonperforming consumer loans decreased $.3 billion.
Net charge-offs were $123 million for the first quarter of 2011 and $111 million for the first quarter of 2010. The increase was driven by increased net charge-offs in the consumer lending portfolio.
Certain loans in this business segment may require special servicing given current loan performance and market conditions. Consequently, the business activities of this segment are focused on maximizing the value of the portfolio assigned to it while mitigating risk. Business intent drives the inclusion of assets in this business segment. Not all impaired loans are included in this business segment, nor are all of the loans included in this business segment considered impaired.
The $13.9 billion of loans held in this portfolio at March 31, 2011 are stated inclusive of a fair value adjustment on purchased impaired loans at acquisition. Taking the adjustment and the ALLL into account, the net carrying basis of this loan portfolio is 77% of customer outstandings.
Commercial Lending within the Distressed Assets Portfolio business segment is comprised of $1.5
billion in residential development assets (i.e. condominiums, townhomes, developed and undeveloped land) primarily acquired from National City and $.7 billion of performing cross-border leases. This commercial lending portfolio has declined 37% since March 31, 2010. For the residential development portfolio, a team of asset managers actively deploy workout strategies on this portfolio through reducing unfunded loan exposure, refinancing, customer payoffs, foreclosures and loan sales. The overall credit quality of this portfolio is considered to be moderately better at March 31, 2011 compared with the beginning of 2010 based upon continuing dispositions of credits, improved economic conditions and increased activity in several markets. The cross-border lease portfolio continues to demonstrate good credit quality.
The performance of the Consumer Lending portfolio is dependent upon economic growth, unemployment rates, the housing market recovery and the interest rate environment. The portfolio’s credit quality performance has stabilized through actions taken by management over the last two years. Approximately 76% of customers have been current with principal and interest payments for the past 12 months. Currently, the portfolio yields over 7%. Consumer Lending consists of residential real estate mortgages and consumer or brokered home equity loans.
Residential real estate mortgages are primarily legacy National City, originate for sale programs (now discontinued) and acquired portfolios. The residential real estate mortgage portfolio is composed of jumbo and ALT-A first lien mortgages, non-prime first and second lien mortgages and to a lesser extent, residential construction loans. We have implemented internal and external programs to proactively explore refinancing opportunities that would allow the borrower to qualify for a conforming mortgage loan which would be originated and sold by PNC or originated by a third-party originator. Also, loss mitigation programs have been developed to help manage risk and assist borrowers to maintain homeownership, when possible.
Home equity loans include second liens and brokered home equity lines of credit. We have implemented several modification programs to assist the loss mitigation teams that manage this risk. Additionally, we have initiated several voluntary and involuntary programs to reduce and/or block line availability on home equity lines of credit.
When loans are sold, investors may request PNC to indemnify them against losses or to repurchase loans that they believe do not comply with applicable contractual loan origination covenants and representations and warranties we have made. From 2005 to 2007, home equity loans were sold with such contractual provisions. At March 31, 2011, the
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liability for estimated losses on repurchase and indemnification claims for the Distressed Assets Portfolio business segment was $128 million. No additional reserves were recorded in the first quarter of 2011. See the Recourse and Repurchase Obligations section of this Financial Review and Note 17 Commitments and Guarantees in the Notes To Consolidated Financial Statements included in this Report for additional information.
CRITICAL ACCOUNTING ESTIMATESAND JUDGMENTS
Note 1 Accounting Policies in Part II, Item 8 of our 2010 Form 10-K and in the Notes To Consolidated Financial Statements included in Part I, Item 1 of this Report describe the most significant accounting policies that we use. Certain of these policies require us to make estimates or economic assumptions that may prove inaccurate or be subject to variations that may significantly affect our reported results and financial position for the period or in future periods.
We must use estimates, assumptions, and judgments when assets and liabilities are required to be recorded at, or adjusted to reflect, fair value.
Assets and liabilities carried at fair value inherently result in a higher degree of financial statement volatility. Fair values and the information used to record valuation adjustments for certain assets and liabilities are based on either quoted market prices or are provided by independent third-party sources, including appraisers and valuation specialists, when available. When such third-party information is not available, we estimate fair value primarily by using cash flow and other financial modeling techniques. Changes in underlying factors, assumptions, or estimates could materially impact our future financial condition and results of operations.
We discuss the following critical accounting policies and judgments under this same heading in Part II, Item 7 of our 2010 Form 10-K:
Allowances For Loan And Lease Losses And Unfunded Loan Commitments And Letters of Credit
Estimated Cash Flows on Purchased Impaired Loans
Goodwill
Lease Residuals
Revenue Recognition
Residential Mortgage Servicing Rights
Income Taxes
In conjunction with the acquisition of National City, PNC acquired servicing rights for residential real estate loans. We have elected to measure these mortgage servicing rights (MSRs) at fair value. MSRs are established and valued using
discounted cash flow modeling techniques which require management to make estimates regarding future net servicing cash flows, taking into consideration actual and expected mortgage loan prepayment rates, discount rates, servicing costs, and other factors.
PNC employs a risk management strategy designed to protect the value of MSRs from changes in interest rates and related market factors. MSR values are economically hedged with securities and derivatives, including interest-rate swaps, options, and forward mortgage-backed and futures contracts. As interest rates change, these financial instruments are expected to have changes in fair value negatively correlated to the change in fair value of the hedged MSR portfolio. The hedge relationships are actively managed in response to changing market conditions over the life of the MSR assets. Selecting appropriate financial instruments to hedge MSR valuation risk requires significant management judgment to assess how mortgage rates and prepayment speeds could affect the future values of MSRs. Hedging results can frequently be less predictable in the short term, but over longer periods of time are expected to protect the economic value of the MSR portfolio.
The fair value of residential MSRs and significant inputs to the valuation model as of March 31, 2011 are shown in the table below. The expected and actual rates of mortgage loan prepayments are the most significant factors driving the fair value. Management uses a third party model to estimate future loan prepayments. This model has been refined based on historical performance of PNC’s managed portfolio, as adjusted for current market conditions. Future interest rates are another important factor in the valuation of MSRs. Management utilizes market implied forward interest rates to estimate the future direction of mortgage and discount rates. The forward rates utilized are derived from the current yield curve for U.S. dollar interest rate swaps and are consistent with pricing of capital markets instruments. Changes in the shape and slope of the forward curve in future periods may result in volatility in the fair value estimate.
Fair value
Weighted-average life (in years) (a)
Weighted-average constant prepayment rate (a)
Spread over forward interest rate swap rates
A sensitivity analysis of the hypothetical effect on the fair value of MSRs for adverse changes in key assumptions is presented below. These sensitivities do not include the impact of the related hedging activities. Changes in fair value generally cannot be extrapolated because the relationship of the change in the assumption to the change in fair value may
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not be linear. Also, the effect of a variation in a particular assumption on the fair value of the MSRs is calculated independently without changing any other assumption. In reality, changes in one factor may result in changes in another (for example, changes in mortgage interest rates, which drive changes in prepayment rate estimates, could result in changes in the interest rate spread), which could either magnify or counteract the sensitivities.
Prepayment rate:
Decline in fair value from 10% adverse change
Decline in fair value from 20% adverse change
Spread over forward interest rate swap rates:
Recent Accounting Pronouncements
See Note 1 Accounting Policies in the Notes to the Consolidated Financial Statements of this Report regarding the impact of the adoption of new accounting guidance issued by the Financial Accounting Standards Board.
STATUS OFQUALIFIED DEFINED BENEFIT PENSION PLAN
We have a noncontributory, qualified defined benefit pension plan (plan or pension plan) covering eligible employees. Benefits are determined using a cash balance formula where earnings credits are a percentage of eligible compensation. Pension contributions are based on an actuarially determined amount necessary to fund total benefits payable to plan participants. Consistent with our investment strategy, plan assets are primarily invested in equity investments and fixed income instruments. Plan fiduciaries determine and review the plan’s investment policy, which is described more fully in Note 14 Employee Benefit Plans in our 2010 Form 10-K.
We calculate the expense associated with the pension plan and the assumptions and methods that we use include a policy of reflecting trust assets at their fair market value. On an annual basis, we review the actuarial assumptions related to the pension plan. The primary assumptions used to measure pension obligations and costs are the discount rate, compensation increase and expected long-term return on assets. Among these, the compensation increase assumption does not significantly affect pension expense.
The discount rate used to measure pension obligations is determined by comparing the expected future benefits that will be paid under the plan with yields available on high quality corporate bonds of similar duration. In lower interest rate environments, the sensitivity of pension expense to the assumed discount rate increases. The impact on pension expense of a 0.5% decrease in discount rate in the current environment is $19 million. In contrast, the sensitivity to the same change in discount rate in a higher interest rate environment is less significant.
The expected long-term return on assets assumption also has a significant effect on pension expense. The expected return on plan assets is a long-term assumption established by considering historical and anticipated returns of the asset classes invested in by the pension plan and the asset allocation policy currently in place. For purposes of setting and reviewing this assumption, “long term” refers to the period over which the plan’s projected benefit obligations will be disbursed. We review this assumption at each measurement date and adjust it if warranted. Our selection process references certain historical data and the current environment, but primarily utilizes qualitative judgment regarding future return expectations. Accordingly, we generally do not change the assumption unless we modify our investment strategy or identify events that would alter our expectations of future returns.
To evaluate the continued reasonableness of our assumption, we examine a variety of viewpoints and data. Various studies have shown that portfolios comprised primarily of US equity securities have returned approximately 10% annually over long periods of time, while US debt securities have returned approximately 6% annually over long periods. Application of these historical returns to the plan’s allocation ranges for equities and bonds produces a result between 7.25% and 8.75% and is one point of reference, among many other factors, that is taken into consideration. We also examine the plan’s actual historical returns over various periods. Recent experience is considered in our evaluation with appropriate consideration that, especially for short time periods, recent returns are not reliable indicators of future returns. While annual returns can vary significantly (rates of return for 2010, 2009, and 2008 were +14.87%, +20.61%, and -32.91%, respectively), the selected assumption represents our estimated long-term average prospective returns.
Acknowledging the potentially wide range for this assumption, we also annually examine the assumption used by other companies with similar pension investment strategies, so that we can ascertain whether our determinations markedly differ from others. In all cases, however, this data simply informs our process, which places the greatest emphasis on our qualitative judgment of future investment returns, given the conditions existing at each annual measurement date.
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As more fully described in our 2010 Form 10-K, the expected long-term return on plan assets for determining net periodic pension cost for 2011 is 7.75%, down from 8.00% in 2010.
Under current accounting rules, the difference between expected long-term returns and actual returns is accumulated and amortized to pension expense over future periods. Each one percentage point difference in actual return compared with our expected return causes expense in subsequent years to change by up to $9 million as the impact is amortized into results of operations.
The table below reflects the estimated effects on pension expense of certain changes in annual assumptions, using 2011 estimated expense as a baseline.
.5% decrease in discount rate
.5% decrease in expected long-term return on assets
.5% increase in compensation rate
We currently estimate a pretax pension expense of $11 million in 2011 compared with pretax expense of $46 million in 2010. This year-over-year expected reduction is primarily due to the amortization impact of the favorable 2010 investment returns as compared with the expected long-term return assumption, which has been established by considering the time over which the Plan’s obligations are expected to be paid.
Our pension plan contribution requirements are not particularly sensitive to actuarial assumptions. Investment performance has the most impact on contribution requirements and will drive the amount of permitted contributions in future years. Also, current law, including the provisions of the Pension Protection Act of 2006, sets limits as to both minimum and maximum contributions to the plan. We do not expect to be required by law to make any contributions to the plan during 2011.
We maintain other defined benefit plans that have a less significant effect on financial results, including various nonqualified supplemental retirement plans for certain employees.
RECOURSE AND REPURCHASEOBLIGATIONS
As discussed in Note 3 Loan Sale and Servicing Activities and Variable Interest Entities in our 2010 Form 10-K, PNC has sold commercial mortgage and residential mortgage loans directly or indirectly in securitizations and whole-loan sale transactions with continuing involvement. One form of continuing involvement includes certain recourse and loan repurchase obligations associated with the transferred assets in these transactions.
COMMERCIAL MORTGAGERECOURSE OBLIGATIONS
We originate, close, and service certain commercial mortgage loans which are sold to FNMA under FNMA’s Delegated Underwriting and Servicing (DUS) program. We have similar arrangements with FHLMC.
Under these programs, we generally assume up to a one-third pari passu risk of loss on unpaid principal balances through a loss share arrangement. The unpaid principal balance outstanding of loans sold as a participant in these programs was $13.2 billion at both March 31, 2011 and December 31, 2010, and the potential maximum exposure under the loss share arrangements was $4.0 billion at both March 31, 2011 and December 31, 2010. We maintain a reserve based upon these potential losses. The reserve for losses under these programs totaled $56 million and $54 million as of March 31, 2011 and December 31, 2010, respectively, and is included in Other liabilities on our Consolidated Balance Sheet. If payment is required under these programs, we would not have a contractual interest in the collateral underlying the mortgage loans on which losses occurred, although the value of the collateral is taken into account in determining our share of such losses. Our exposure and activity associated with these recourse obligations are reported in the Corporate & Institutional Banking segment.
RESIDENTIAL MORTGAGE LOAN REPURCHASE OBLIGATIONS
While residential mortgage loans are sold on a non-recourse basis, we assume certain loan repurchase obligations associated with mortgage loans we have sold to investors. These loan repurchase obligations primarily relate to situations where PNC is alleged to have breached certain origination covenants and representations and warranties made to purchasers of the loans in the respective purchase and sale agreements. Residential mortgage loans covered by these loan repurchase obligations include first and second-lien mortgage loans we have sold through Agency securitizations, Non-Agency securitizations, and whole-loan sale transactions. As discussed in Note 3 in our 2010 Form 10-K, Agency securitizations consist of mortgage loans sale transactions with FNMA, FHLMC, and the Government National Mortgage Association (GNMA) program, while Non-Agency securitizations and whole-loan sale transactions consist of mortgage loans sale transactions with private investors. Our
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exposure and activity associated with these loan repurchase obligations is reported in the Residential Mortgage Banking segment. In addition, PNC’s residential mortgage loan repurchase obligations include certain brokered home equity loans/lines that were sold to private investors by National City prior to our acquisition. PNC is no longer engaged in the brokered home equity lending business, and our exposure under these loan repurchase obligations is reported in the Distressed Assets Portfolio segment.
Loan covenants and representations and warranties are established through loan sale agreements with various investors to provide assurance that PNC has sold loans to investors of sufficient investment quality. Key aspects of such covenants and representations and warranties include the loan’s compliance with any applicable loan criteria established by the investor, including underwriting standards, delivery of all required loan documents to the investor or its designated party, sufficient collateral valuation, and the validity of the lien securing the loan. As a result of alleged breaches of these contractual obligations, investors may request PNC to indemnify them against losses on certain loans or to repurchase loans.
Indemnifications for loss or loan repurchases typically occur when, after review of the claim, we agree insufficient evidence exists to dispute the investor’s claim that a breach of a loan covenant and representation and warranty has occurred, such breach has not been cured, and the effect of such breach is deemed to have had a material and adverse effect on the value of the transferred loan. Depending on the sale agreement and upon proper notice from the investor, we typically respond to such indemnification and repurchase requests within 60 days, although final resolution of the claim may take a longer period of time. With the exception of the sales agreements associated with the Agency securitizations, most sale agreements do not provide for penalties or other remedies if we do not respond timely to investor indemnification or repurchase requests.
Investor indemnification or repurchase claims are typically settled on an individual loan basis through make-whole payments or loan repurchases; however, on occasion we may negotiate pooled settlements with investors. The following table details the unpaid principal balance of our unresolved indemnification and repurchase claims at March 31, 2011 and December 31, 2010.
Analysis of Unresolved Asserted Indemnification and Repurchase Claims
Residential mortgages:
Agency securitizations
Private investors (a)
Home equity loans/lines:
Private investors (b)
Total unresolved claims
To mitigate losses associated with indemnification and repurchase claims, we have established quality assurance programs designed to ensure loans sold meet specific underwriting and origination criteria provided for in the investor sale agreements. In addition, we investigate every investor claim on a loan by loan basis to determine the existence of a legitimate claim, and that all other conditions for indemnification or repurchase have been met prior to the settlement with an investor.
The table below details our indemnification and repurchase claim settlement activity during the first three months of 2011 and 2010. Any repurchased loan is appropriately considered in our nonperforming loan disclosures and statistics.
Analysis of Indemnification and Repurchase Claim Settlement Activity
Residential mortgages (d):
Private investors (e)
Private investors - Repurchases (f)
Total indemnification and repurchase settlements
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During 2010 and the first three months of 2011, unresolved and settled investor indemnification and repurchase claims were primarily related to one of the following alleged breaches in representations and warranties: 1) misrepresentation of income, assets or employment; 2) property evaluation or status issues (e.g., appraisal, title, etc.); or 3) underwriting guideline violations. During 2010, the frequency and timing of unresolved and settled investor indemnification and repurchase claims increased as a result of higher loan delinquencies which have been impacted by the deterioration in the overall economy and the prolonged weak residential housing sector. The increased volume of claims was also reflective of an industry trend where investors implemented certain strategies to aggressively reduce their exposure to losses on purchased loans. These same factors also contributed to the first quarter 2011 increase in the balance of unresolved indemnification and repurchase claims for residential mortgages. The year-over-year first quarter 2011 decline in indemnification and repurchase settlements for residential mortgages resulted primarily from higher claim rescission rates. Higher claim rescission rates also drove the first quarter 2011 decline in the balance of home equity loans/lines unresolved indemnification and repurchase claims. The year-over-year first quarter increase in home equity indemnification and repurchase settlements was attributed solely to the timing of when repurchases were executed.
For the first and second-lien mortgage balances of unresolved and settled claims contained in the tables above, a significant amount of these claims were associated with sold loans originated through correspondent lender and broker origination channels. For the home equity loans/lines sold portfolio, all unresolved and settled claims relate to loans originated through the broker origination channel. In certain instances when indemnification or repurchase claims are settled for these types of sold loans, we have recourse back to the correspondent lenders, brokers and other third-parties (e.g., contract underwriting companies, closing agents, appraisers, etc.). Depending on the underlying reason for the investor claim, we determine our ability to pursue recourse with these parties and file claims with them accordingly. Our historical recourse recovery rate has been insignificant as our efforts have been impacted by the inability of such parties to reimburse us for their recourse obligations (e.g., their capital availability or whether they remain in business) or contractual limitations that limit our ability to pursue recourse with these parties (e.g., loss caps, statutes of limitations, etc.). All of these factors are considered in the determination of our estimated indemnification and repurchase liability detailed below.
Origination and sale of residential mortgages is an ongoing business activity and, accordingly, management continually assesses the need for indemnification and repurchase liabilities pursuant to the associated investor sale agreements. We establish indemnification and repurchase liabilities for estimated losses on sold first and second-lien mortgages and
home equity loans/lines for which indemnification is expected to be provided or for loans that are expected to be repurchased. For the first and second-lien mortgage sold portfolio, we have established an indemnification and repurchase liability pursuant to investor sale agreements based on claims made and our estimate of future claims on a loan by loan basis. These relate primarily to loans originated during 2006-2008. For the home equity loans/lines sold portfolio, we have established indemnification and repurchase liabilities based upon this same methodology for loans sold during 2005-2007.
Indemnification and repurchase liabilities are initially recognized when loans are sold to investors and are subsequently evaluated for adequacy by management. Initial recognition and subsequent adjustments to the indemnification and repurchase liability for the first and second-lien mortgage sold portfolio are recognized in Residential mortgage revenue on the Consolidated Income Statement. Since PNC is no longer engaged in the brokered home equity lending business, only subsequent adjustments are recognized to the home equity loans/lines indemnification and repurchase liability. These adjustments are recognized in Other noninterest income on the Consolidated Income Statement.
Management’s subsequent evaluation of these indemnification and repurchase liabilities is based upon trends in indemnification and repurchase requests, actual loss experience, known and inherent risks in the underlying serviced loan portfolios, and current economic conditions. As part of its evaluation, management considers estimated loss projections over the life of the subject loan portfolio. At March 31, 2011 and December 31, 2010, the liability for estimated losses on indemnification and repurchase claims for residential mortgages totaled $124 million and $144 million, respectively. The indemnification and repurchase liability for home equity loans/lines was $128 million and $150 million at March 31, 2011 and December 31, 2010, respectively. These liabilities are included in Other liabilities on the Consolidated Balance Sheet.
The residential mortgages indemnification and repurchase liability declined during the first three months of 2011, reflecting lower actual repurchase and indemnification losses primarily driven by higher claim rescission rates. This decrease resulted despite higher levels of investor indemnification and repurchase claim activity as described above. The first quarter 2011 reduction in the home equity loans/lines indemnification and repurchase liability primarily resulted from loan repurchases.
We believe our indemnification and repurchase liabilities adequately reflect the estimated losses on anticipated investor indemnification and repurchase claims at March 31, 2011 and December 31, 2010. However, actual losses could be more or less than our established indemnification and repurchase liability. Factors that could affect our estimate include the
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timing and frequency of investor claims driven by investor strategies and behavior, our ability to successfully negotiate claims with investors, the housing markets which drive the estimates made for loan indemnification and repurchase losses, and other economic conditions. Accordingly, if we assumed an adverse change of 10% for the indemnification and repurchase claims, claim rescission rates, and indemnification and repurchase loss assumptions in our indemnification and repurchase liability model, this liability would increase to $296 million at March 31, 2011.
RISK MANAGEMENT
We encounter risk as part of the normal course of our business and we design risk management processes to help manage these risks.
The Risk Management section included in Part II, Item 7 of our 2010 Form 10-K describes our risk management philosophy, principles, governance and various aspects of our corporate-level risk management program. Additionally, our 2010 Form 10-K provides an analysis of our primary areas of risk: credit, operational, liquidity, and market, as well as a discussion of our use of financial derivatives as part of our overall asset and liability risk management process, and addresses historical performance in appropriate places within the Risk Management section of that report.
The following information updates our 2010 Form 10-K risk management disclosures.
CREDIT RISK MANAGEMENT
Credit risk represents the possibility that a customer, counterparty or issuer may not perform in accordance with contractual terms. Credit risk is inherent in the financial services business and results from extending credit to customers, purchasing securities, and entering into financial derivative transactions and certain guarantee contracts. Credit risk is one of our most significant risks.
ASSETQUALITY OVERVIEW
Asset quality trends for the first quarter of 2011 were mostly positive and included the following:
First quarter 2011 net charge-offs declined significantly to $533 million, down 23% from first quarter 2010 net charge-offs of $691 million and 33% from fourth quarter 2010 net charge-offs of $791 million. First quarter 2011 net charge-offs represented the lowest quarterly level of net charge-offs since first quarter 2009.
Reflecting ongoing reductions in credit exposure and improvements in asset quality, the provision for credit losses declined for the third consecutive quarter. The ALLL has also been decreasing.
Due to the improvement in the economy, nonperforming loans declined $73 million to $4.4 billion as of March 31, 2011.
Overall loan delinquency levels have mostly stabilized or improved modestly due to the improving economy, especially in late stage delinquencies with accruing loans 90 days or more past due declining 10% from year-end 2010.
Commercial credit quality trends improved noticeably with levels of criticized commercial loan outstandings declining by approximately $1 billion or over 7% to $12.7 billion at March 31, 2011. See Note 5 Asset Quality and Allowances for Loan and Lease Losses and Unfunded Loan Commitments and Letters of Credit in the Notes To Consolidated Financial Statements in this Report for additional information.
These positive trends were partially offset by the following:
Our ongoing loan modification efforts to assist homeowners and other borrowers continued to increase total trouble debt restructurings (TDRs). In particular, nonperforming TDRs increased to over 20% of total nonperforming loans. However, as the economy continues to improve, our loan modification efforts have begun to show signs of slowing.
Levels of other real estate owned (OREO) and foreclosed assets continued to increase modestly and now represent over 16% of total nonperforming assets. The majority of these assets are comprised of single family residential properties.
NONPERFORMINGASSETS AND LOAN DELINQUENCIES
Nonperforming Assets, including OREO and Foreclosed Assets
Nonperforming assets decreased $43 million from December 31, 2010, to March 31, 2011, remaining stable at approximately $5.3 billion. Nonperforming loans decreased $73 million to $4.4 billion while OREO and foreclosed assets increased $30 million to $865 million. The ratio of nonperforming assets to total loans and OREO and foreclosed assets was 3.50% for both March 31, 2011, and December 31, 2010. The ratio of nonperforming loans to total loans declined slightly, to 2.94%. The modest decrease in nonperforming loans from December 31, 2010, occurred across almost all loan classes, except for an increase in nonperforming commercial real estate loans and a small increase in nonperforming home equity loans. The increase in home equity loans was driven by increased levels of modifications that were determined to be TDRs.
At March 31, 2011, TDRs included in nonperforming loans increased to $882 million or 20% of total nonperforming loans compared to $784 million or 18% of nonperforming loans as of December 31, 2010. Within consumer nonperforming
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loans, residential real estate TDRs comprise approximately 37% of total residential real estate nonperforming loans at March 31, 2011, up modestly from 30% at December 31, 2010. Similarly, home equity TDRs comprise approximately 77% of home equity nonperforming loans at March 31, 2011, up slightly from 75% at December 31, 2010. The level of modifications that were determined to be TDRs in these portfolios is expected to result in elevated nonperforming loan levels for longer periods because TDRs remain in nonperforming status until a borrower has made at least six consecutive months of payments under the modified terms or ultimate resolution occurs. At March 31, 2011, our largest nonperforming asset was $33 million in the Accommodation and Food Services Industry and our average nonperforming loan associated with commercial lending was approximately $1 million. Our top ten nonperforming assets are all commercial loans and represent approximately 7% and 4% of total commercial nonperforming loans and total nonperforming assets, respectively, as of March 31, 2011.
Nonperforming Assets By Type
Nonperforming loans
Other industries
TOTAL COMMERCIAL LENDING
Consumer (b)
Total nonperforming loans
OREO and foreclosed assets
Other real estate owned (OREO)
Foreclosed and other assets
Total nonperforming assets
Amount of nonperforming loans current as to remaining principal and interest
Percentage of total nonperforming loans
Amount of TDRs included in nonperforming loans
Allowance for loan and lease losses to total nonperforming loans
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OREO and Foreclosed Assets
Other real estate owned (OREO):
Residential properties
Residential development properties
Commercial properties
Total OREO
Total OREO and foreclosed assets increased $30 million during the first quarter of 2011 from $835 million at December 31, 2010, to $865 million at March 31, 2011, which represents approximately 16% of total nonperforming assets. As of March 31, 2011, and December 31, 2010, approximately 60% and 58%, respectively, of our OREO and foreclosed assets are comprised of single family residential properties. The increase in the first quarter of 2011 was largely due to the resumption of foreclosures under enhanced procedures following the completion of a review of some of our foreclosure practices.
Change in Nonperforming Assets
Transferred in
Charge-offs and valuation adjustments
Principal activity including payoffs
Asset sales and transfers to held for sale
Returned to performing-TDRs
Returned to performing-Other
Loans held for sale and purchased impaired loans are excluded from nonperforming loans. Additionally, most consumer loans and lines of credit, not secured by residential real estate, are charged off after 120 to 180 days past due and as such are excluded from nonperforming status.
Purchased impaired loans are considered performing, even if contractually past due (or if we do not expect to receive payment in full based on the original contractual terms), as we are currently accreting interest income over the expected life of the loans. The accretable yield represents the excess of the expected cash flows on the loans at the measurement date over the recorded investment. Any decrease, other than for prepayments or interest rate decreases for variable rate notes, in the net present value of expected cash flows of individual commercial or pooled consumer purchased impaired loans would result in an impairment charge to the provision for loan losses in the period in which the change is deemed probable. Any increase in the net present value of expected cash flows of purchased impaired loans would first result in a recovery of previously recorded allowance for loan losses, to the extent applicable, and then an increase to accretable yield for the remaining life of the purchased impaired loans. Total
nonperforming loans and assets in the tables above are significantly lower than they would have been due to this accounting treatment for purchased impaired loans. This treatment also results in a lower ratio of nonperforming loans to total loans and a higher ratio of ALLL to nonperforming loans. We recorded purchased impaired loans at estimated fair value, including life of loan credit losses, of $12.7 billion at December 31, 2008. See Note 6 Purchased Impaired Loans in the Notes To Consolidated Financial Statements in this Report for additional information on these loans.
Loan Delinquencies
We regularly monitor the level of loan delinquencies and believe these levels to be a key indicator of loan portfolio asset quality. Measurement of delinquency and past due status are based on the contractual terms of each loan. Loans that are 30 days or more past due in terms of payment are considered delinquent. Loan delinquencies exclude loans held for sale, purchased impaired loans and loans that are government insured or guaranteed.
Total early stage loan delinquencies (accruing loans past due 30 to 89 days) increased by $50 million from December 31, 2010, to March 31, 2011, remaining relatively stable at approximately $1.4 billion. Commercial early stage delinquencies rose by $149 million from the prior quarter, mostly due to increases in commercial real estate, while consumer delinquencies fell by $99 million. The increase in commercial real estate early stage delinquencies was largely due to maturing loans in the first quarter of 2011 that were not repaid.
The improvement in consumer delinquencies was experienced across all loan classes.
Accruing loans past due 90 days or more are referred to as late stage delinquencies and are not included in nonperforming loans because they are well secured by collateral and in the process of collection. These loans declined approximately 10% from $542 million at December 31, 2010, to $486 million at March 31, 2011, reflecting improvement in commercial delinquency levels. The following tables display the delinquency status of our loans at March 31, 2011 and December 31, 2010. Additional information regarding accruing loans past due is included in Note 5 Asset Quality and Allowances for Loan and Lease Losses and Unfunded Loan Commitments and Letters of Credit in the Notes To Consolidated Financial Statements in this Report.
Accruing Loans Past Due 30 To 59 Days
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Accruing Loans Past Due 60 To 89 Days
Accruing Loans Past Due 90 Days Or More
Our Special Asset Committee closely monitors loans that are not included in the nonperforming or accruing past due categories and for which we are uncertain about the borrower’s ability to comply with existing repayment terms over the next six months. These loans totaled $523 million at March 31, 2011 and $574 million at December 31, 2010.
LOAN MODIFICATIONS AND TROUBLED DEBT RESTRUCTURINGS
Consumer Loan Modifications
We modify loans under government and PNC-developed programs based upon our commitment to help eligible homeowners and borrowers avoid foreclosure, where appropriate. Initially, a borrower is evaluated for a modification under a government program. If a borrower does not qualify under a government program, the borrower is then evaluated under a PNC program. Our programs utilize both temporary and permanent modifications and typically reduce the interest rate, extend the term and/or defer or forgive principal. Temporary and permanent modifications under programs involving a contractual change to loan terms are substantially all classified as TDRs, regardless of the period of time for which the modified terms apply, as discussed in more detail below.
A temporary modification, with a term between three and 60 months, involves a change in original loan terms for a period
of time and reverts to the original loan terms as of a specific date or the occurrence of an event, such as a failure to pay in accordance with the terms of the modification. Typically, these modifications are for a period of up to 24 months after which the interest rate reverts to the original loan rate. A permanent modification, with a term greater than 60 months, is a modification in which the terms of the original loan are changed, but could revert back to the original loan terms. Permanent modifications primarily include the government-created Home Affordable Modification Program (HAMP) or PNC-developed HAMP-like modification programs.
For consumer loan programs (e.g., residential mortgages, home equity loans and lines), we will enter into a temporary modification when the borrower has indicated a temporary hardship and a willingness to bring current the delinquent loan balance. Examples of this situation often include delinquency due to illness or death in the family, or a loss of employment. Permanent modifications are entered into when it is confirmed that the borrower does not possess the income necessary to continue making loan payments at the current amount, but our expectation is that payments at lower amounts can be made.
Residential mortgage and home equity loans and lines have been modified with changes in contractual terms for up to 60 months, although the majority involve periods of three to 24 months. The change in terms may include a reduced interest rate and/or an extension of the amortization period.
We also monitor the success rates and delinquency status of our loan modification programs to assess their effectiveness in serving our customers’ needs while mitigating credit losses. The following tables provide the number of accounts and unpaid principal balance of modified consumer real estate related loans as well as the number of accounts and unpaid principal balance of modified loans that were 60 days or more past due as of six months, nine months and twelve months after the modification date.
Bank-Owned Consumer Real Estate Related Loan Modifications
Conforming Mortgages
Permanent Modifications
Non-Prime Mortgages
Residential Construction
Home Equity
Temporary Modifications
Total Home Equity
Total Bank-Owned Consumer Real Estate Related Loan Modifications
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Bank-Owned Consumer Real Estate Related Loan Modifications Re-Default by Vintage
% of
VintageRe-defaulted
Third Quarter 2010
Second Quarter 2010
First Quarter 2010
Fourth Quarter 2009
Residential Construction (a)
Home Equity (b)
In addition to temporary loan modifications, we may make available to a borrower a payment plan or a HAMP trial payment period. Under a payment plan or a HAMP trial payment period, there is no change to the loan’s contractual terms so the borrower remains legally responsible for payment of the loan under its original terms. A payment plan involves the borrower making payments that differ from the contractual payment amount for a short period of time, generally three months, during which time a borrower is brought current. Our motivation is to allow for repayment of an outstanding past due amount through payment of additional amounts over the short period of time. Due to the short term nature of the payment plan and the expectation that all contractual principal and interest will be collected, there is a minimal impact to the ALLL.
Under a HAMP trial payment period, we allow a borrower to demonstrate successful payment performance before contractually establishing an alternative payment amount. Subsequent to successful borrower performance under the trial payment period, we will change a loan’s contractual terms and the loan would be classified as a TDR and a nonperforming
loan. However, the borrower is often already delinquent at the time of participation in the HAMP trial payment period. As such, upon successful completion, there is not a significant increase in the ALLL. If the trial payment period is unsuccessful, the loan will be charged-off at the end of the trial payment period to its estimated fair value of the underlying collateral less costs to sell.
Residential conforming and certain residential construction loans have been permanently modified under HAMP or, if they do not qualify for a HAMP modification, under PNC- developed programs, which in some cases may operate similar to HAMP. These programs first require a reduction of the interest rate followed by an extension of term and, if appropriate, deferral or forgiveness of principal payments. As of March 31, 2011 and December 31, 2010, 1,188 accounts with a balance of $295 million and 1,027 accounts with a balance of $262 million, respectively, of residential real estate loans have been modified under HAMP and were still outstanding on our balance sheet. In October 2010, we signed a Service Provider Agreement for the government-sponsored Second Lien Modification Program and have begun modifying
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loans under this program. As of March 31, 2011, we have modified 11 accounts with a total balance of less than $1 million.
We do not re-modify a defaulted modified loan except for subsequent significant life events, as defined by the OCC. A re-modified loan continues to be classified as a TDR for the remainder of its term regardless of subsequent payment performance.
Commercial Loan Modifications
Modifications of terms for commercial loans are based on individual facts and circumstances. Commercial loan modifications may involve reduction of the interest rate, extension of the term of the loan and/or forgiveness of principal. Modified large commercial loans are usually already nonperforming prior to modification.
Beginning in 2010, we established certain commercial loan modification programs for small business loans, Small Business Administration loans, and investment real estate loans. As of March 31, 2011 and December 31, 2010, approximately $100 million and $88 million, respectively, in loan balances had been modified under these small business modification programs. None of these small business loan modifications have been determined to be TDRs.
Troubled Debt Restructurings
Loan modifications are evaluated and subject to classification as a TDR if the borrower is experiencing financial difficulty and we grant a concession to the borrower. TDRs typically result from our loss mitigation activities and could include rate reductions and/or principal forgiveness intended to minimize the economic loss and to avoid foreclosure or repossession of collateral. Purchased impaired loans are excluded from consideration as TDRs.
Troubled Debt Restructurings By Type
Consumer lending:
Real estate-related
Credit card (a)
Total TDRs
Nonperforming status
Accrual status
Total TDRs increased $177 million or 11% during the first quarter 2011 to $1.8 billion as of March 31, 2011. Of this total, nonperforming TDRs totaled $882 million, which represents approximately 20% of total nonperforming loans. However, as the economy continues to improve, our consumer real estate related loan modification efforts have begun to show signs of slowing.
TDRs that have returned to performing (accrual) status are excluded from nonperforming loans. These loans have demonstrated a period of at least six months of consecutive performance under the modified terms. These TDRs increased $96 million or 18% during the first quarter 2011 to $639 million as of March 31, 2011. This increase reflects the further seasoning and performance of the loan modification portfolio. Cumulatively, of the TDRs that have returned to performing status, approximately $46 million have subsequently re-defaulted and are no longer current under their modified terms.
ALLOWANCES FOR LOAN AND LEASE LOSSESAND UNFUNDED LOAN COMMITMENTS AND LETTERS OF CREDIT
We recorded $533 million in net charge-offs for the first quarter of 2011, compared to $691 million in the first quarter of 2010. This significantly lower level of total net charge-offs represents our lowest level of quarterly net charge-offs in two years. Commercial net charge-offs fell from $437 million in the first quarter of 2010 to $248 million in the first quarter of 2011. Consumer net charge-offs increased slightly from $254 million in the first quarter of 2010 to $285 million in the first quarter of 2011. This consumer increase was primarily due to higher net charge-offs in our home equity portfolio.
Loan Charge-Offs And Recoveries
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Total net charge-offs are significantly lower than they would have been otherwise due to the accounting treatment for purchased impaired loans. This treatment also results in a lower ratio of net charge-offs to average loans. Customer balances related to these purchased impaired loans were reduced by the fair value adjustments of $9.2 billion as of December 31, 2008. See Note 6 Purchased Impaired Loans in the Notes To Consolidated Financial Statements in this Report for additional information on net charge-offs related to these loans.
We maintain an ALLL to absorb losses from the loan portfolio and determine this allowance based on quarterly assessments of the estimated probable credit losses incurred in the loan portfolio. While we make allocations to specific loans and pools of loans, the total reserve is available for all loan and lease losses. Although quantitative modeling factors as discussed below are constantly changing as the financial strength of the borrower and overall economic conditions change, there were no significant changes during the first quarter of 2011 to the methodology we follow to determine our ALLL.
We establish specific allowances for loans considered impaired using methods prescribed by GAAP. All impaired loans are subject to individual analysis, except leases and large groups of smaller-balance homogeneous loans which may include, but are not limited to, credit card, residential mortgage, and consumer installment loans. Specific allowances for individual loans are determined by our Special Asset Committee based on an analysis of the present value of expected future cash flows from the loans discounted at their effective interest rate, observable market price, or the fair value of the underlying collateral.
Allocations to commercial loan classes (pool reserve methodology) are assigned to pools of loans as defined by our business structure and are based on internal probability of default and loss given default credit risk ratings. Key elements of the pool reserve methodology include:
Probability of Default (PD), which is primarily based on historical default analyses and is derived from the borrower’s internal PD credit risk rating;
Exposure at Default (EAD), which is derived from historical default data; and
Loss Given Default (LGD), which is based on historical loss data, collateral value and other structural factors that may affect our ultimate ability to collect on the loan and is derived from the loan’s internal LGD credit risk rating.
As more fully described in Part II, Item 7 of our 2010 Form 10-K, our pool reserve methodology is sensitive to changes in key risk parameters such as PDs, LGDs and EADs. In general, a given change in any of the major risk parameters will have a corresponding change in the pool reserve allocations for
non-impaired commercial loans. Our commercial loans are the largest category of credits and are most sensitive to changes in the key risk parameters and pool reserve loss rates. Additionally, other factors such as the rate of migration in the severity of problem loans will contribute to the final pool reserve allocations.
The majority of the commercial portfolio is secured by collateral, including loans to asset-based lending customers that continue to show demonstrably lower loss given default. Further, the large investment grade or equivalent portion of the loan portfolio has performed well and has not been subject to significant deterioration. Additionally, guarantees on loans greater than $1 million and owner guarantees for small business loans do not significantly impact our ALLL.
Allocations to consumer loan classes are based upon a roll-rate model based on statistical relationships, calculated from historical data that estimate the movement of loan outstandings through the various stages of delinquency and ultimately charge-off. In general, the estimated rates at which loan outstandings roll from one stage of delinquency to another are dependent on various factors such as FICO credit scores, loan-to-value ratios, the current economic environment, and geography.
The ALLL is significantly lower than it would have been otherwise due to the accounting treatment for purchased impaired loans. This treatment also results in a lower ratio of ALLL to total loans. Loan loss reserves on the purchased impaired loans were not carried over on the date of acquisition. In addition, these loans were recorded net of $9.2 billion of fair value adjustments as of December 31, 2008. As of March 31, 2011, we have established reserves of $876 million for purchased impaired loans.
A portion of the ALLL related to qualitative and measurement factors has been assigned to loan categories based on the relative specific and pool allocation amounts to provide coverage for specific and pool reserve methodologies. These factors include, but are not limited to, the following:
industry concentrations and conditions;
credit quality trends;
recent loss experience in particular sectors of the portfolio;
changes in risk selection and underwriting standards; and
timing of available information.
In addition to the ALLL, we maintain an allowance for unfunded loan commitments and letters of credit. We report this allowance as a liability on our Consolidated Balance Sheet. We determine this amount using estimates of the probability of the ultimate funding and losses related to those credit exposures. This methodology is very similar to the one we use for determining the adequacy of our ALLL.
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We refer you to Note 5 Asset Quality and Allowances for Loan and Lease Losses and Unfunded Loan Commitments and Letters of Credit for further information on key asset quality indicators that we use to evaluate our portfolio and establish the allowances.
Allowance for Loan and Lease Losses and Unfunded Loan Commitments and Letters of Credit
Adoption of ASU 2009-17, Consolidations
Acquired allowance adjustments
Net change in allowance for unfunded loan commitments and letters of credit
Consumer lending net charge-offs
Net charge-offs to average loans
Commercial lending
Consumer lending
The provision for credit losses totaled $421 million for the first quarter of 2011 compared to $751 million for the first quarter of 2010. This decrease in provision reflected reductions in overall credit exposure, changes in loan portfolio composition as well as the improvement in asset quality over the past year. For the first quarter of 2011, the provision for commercial credit losses declined by $266 million or 68% from the first quarter of 2010. Similarly, the provision for consumer credit losses decreased $64 million or 18% from the first quarter of 2010. Correspondingly, the level of ALLL has also been decreasing.
The portion of the ALLL allocated to commercial nonperforming loans was 26% at March 31, 2011 and 28% at December 31, 2010. Approximately 77% of total nonperforming loans are secured by collateral which would be expected to reduce credit losses and require less reserves in the event of default.
The allowance allocated to purchased impaired loans and consumer loans and lines of credit not secured by residential real estate, which are both excluded from nonperforming loans, was $1.3 billion and $1.4 billion at March 31, 2011, and December 31, 2010, respectively. Excluding these balances, the allowance as a percent of nonperforming loans was 79% and 77% as of March 31, 2011 and December 31, 2010, respectively.
See Note 5 Asset Quality and Allowances for Loan and Lease Losses and Unfunded Loan Commitments and Letters of Credit and Note 6 Purchased Impaired Loans in the Notes To Consolidated Financial Statements of this Report regarding changes in the ALLL and in the allowance for unfunded loan commitments and letters of credit.
CREDIT DEFAULT SWAPS
From a credit risk management perspective, we buy and sell credit loss protection via the use of credit derivatives. When we buy loss protection by purchasing a credit default swap (CDS), we pay a fee to the seller, or CDS counterparty, in return for the right to receive a payment if a specified credit event occurs for a particular obligor or reference entity. We purchase CDSs to mitigate the risk of economic loss on a portion of our loan exposures.
We also sell loss protection to mitigate the net premium cost and the impact of fair value accounting on the CDS in cases where we buy protection to hedge the loan portfolio. These activities represent additional risk positions rather than hedges of risk.
We approve counterparty credit lines for all of our CDS activities. Counterparty credit lines are approved based on a review of credit quality in accordance with our traditional credit quality standards and credit policies. The credit risk of our counterparties is monitored in the normal course of business. In addition, all counterparty credit lines are subject to collateral thresholds and exposures above these thresholds are secured.
CDSs are included in the “Derivatives not designated as hedging instruments under GAAP” table in the Financial Derivatives section of this Risk Management discussion.
LIQUIDITY RISK MANAGEMENT
Liquidity risk has two fundamental components. The first is the potential loss if we were unable to meet our funding requirements at a reasonable cost. The second is the potential inability to operate our businesses because adequate contingent liquidity is not available in a stressed environment. We manage liquidity risk at the bank and parent company levels to help ensure that we can obtain cost-effective funding to meet current and future obligations under both normal “business as usual” and stressful circumstances and to help ensure that we maintain an appropriate level of contingent liquidity.
Spot and forward funding gap analyses are the primary metrics used to measure and monitor bank liquidity risk. Funding gaps represent the difference in projected sources of liquidity available to offset projected uses. We calculate funding gaps for the overnight, thirty-day, ninety-day, one hundred eighty-day and one-year time intervals. Risk limits are established within our Liquidity Risk Policy. Management’s Asset and Liability Committee regularly reviews compliance with the established limits.
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Parent company liquidity guidelines are designed to help ensure that sufficient liquidity is available to meet our parent company obligations over the succeeding 24-month period. Risk limits for parent company liquidity are established within our Enterprise Capital Management Policy. The Board of Directors’ Risk Committee regularly reviews compliance with the established limits.
Bank Level Liquidity – Uses
Obligations requiring the use of liquidity can generally be characterized as either contractual or discretionary. At the bank level, primary contractual obligations include funding loan commitments, satisfying deposit withdrawal requests and maturities and debt service related to bank borrowings. We also maintain adequate bank liquidity to meet future potential loan demand and provide for other business needs, as necessary.
As of March 31, 2011, there were approximately $3.9 billion of bank borrowings with maturities of less than one year.
Bank Level Liquidity – Sources
Our largest source of bank liquidity on a consolidated basis is the deposit base that comes from our retail and commercial businesses. Liquid assets and unused borrowing capacity from a number of sources are also available to maintain our liquidity position. Borrowed funds come from a diverse mix of short and long-term funding sources.
At March 31, 2011, our liquid assets consisted of short-term investments (Federal funds sold, resale agreements, trading securities, and interest-earning deposits with banks) totaling $5.9 billion and securities available for sale totaling $54.5 billion. Of our total liquid assets of $60.4 billion, we had $24.6 billion pledged as collateral for borrowings, trust, and other commitments. The level of liquid assets fluctuates over time based on many factors, including market conditions, loan and deposit growth and active balance sheet management.
In addition to the customer deposit base, which has historically provided the single largest source of relatively stable and low-cost funding and liquid assets, the bank also obtains liquidity through the issuance of traditional forms of funding including long-term debt (senior notes and subordinated debt and FHLB advances) and short-term borrowings (Federal funds purchased, securities sold under repurchase agreements, commercial paper issuances, and other short-term borrowings).
PNC Bank, N.A. has the ability to offer up to $20 billion in senior and subordinated unsecured debt obligations with maturities of more than nine months. Through March 31, 2011, PNC Bank, N.A. had issued $6.9 billion of debt under this program. Total senior and subordinated debt declined to $4.9 billion at March 31, 2011 from $5.5 billion at December 31, 2010 due to maturities.
PNC Bank, N.A. is a member of the FHLB-Pittsburgh and as such has access to advances from FHLB-Pittsburgh secured generally by residential mortgage and other mortgage-related loans. At March 31, 2011, our unused secured borrowing capacity was $15.2 billion with FHLB-Pittsburgh. Total FHLB borrowings declined to $5.0 billion at March 31, 2011 from $6.0 billion at December 31, 2010 due to maturities.
PNC Bank, N.A. has the ability to offer up to $3.0 billion of its commercial paper. As of March 31, 2011, there were no issuances outstanding under this program. Commercial paper included in Other borrowed funds on our Consolidated Balance Sheet is issued by Market Street as described in Off-Balance Sheet Arrangements and Variable Interest Entities in this Financial Review.
PNC Bank, N.A. can also borrow from the Federal Reserve Bank of Cleveland’s (Federal Reserve Bank) discount window to meet short-term liquidity requirements. The Federal Reserve Bank, however, is not viewed as the primary means of funding our routine business activities, but rather as a potential source of liquidity in a stressed environment or during a market disruption. These potential borrowings are secured by securities and commercial loans. At March 31, 2011, our unused secured borrowing capacity was $25.0 billion with the Federal Reserve Bank.
Parent Company Liquidity – Uses
Obligations requiring the use of liquidity can generally be characterized as either contractual or discretionary. The parent company’s contractual obligations consist primarily of debt service related to parent company borrowings and funding non-bank affiliates. Additionally, the parent company maintains adequate liquidity to fund discretionary activities such as paying dividends to PNC shareholders, share repurchases, and acquisitions.
See 2011 Capital Actions in the Executive Summary section of this Financial Review for additional information regarding our April 2011 increase to PNC’s quarterly common stock dividend and our plans to purchase shares under PNC’s existing common stock repurchase plan during the remainder of 2011.
As of March 31, 2011, there were approximately $1.7 billion of parent company borrowings with maturities of less than one year.
Parent Company Liquidity – Sources
The principal source of parent company liquidity is the dividends it receives from its subsidiary bank, which may be impacted by the following:
Bank-level capital needs,
Laws and regulations,
Corporate policies,
Contractual restrictions, and
Other factors.
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The amount available for dividend payments by PNC Bank, N.A. to the parent company without prior regulatory approval was approximately $1.9 billion at March 31, 2011. There are statutory and regulatory limitations on the ability of national banks to pay dividends or make other capital distributions or to extend credit to the parent company or its non-bank subsidiaries. See Note 21 Regulatory Matters in the Notes To Consolidated Financial Statements in Part II, Item 8 of our 2010 Form 10-K for a further discussion of these limitations. Dividends may also be impacted by the bank’s capital needs and by contractual restrictions. We provide additional information on certain contractual restrictions under the “PNC Capital Trust E Trust Preferred Securities” and “Acquired Entity Trust Preferred Securities” sections of the Off-Balance Sheet Arrangements And Variable Interest Entities section of this Financial Review and in Note 13 Capital Securities of Subsidiary Trusts and Perpetual Trust Securities in the Notes To Consolidated Financial Statements in Part II, Item 8 of our 2010 Form 10-K.
In addition to dividends from PNC Bank, N.A., other sources of parent company liquidity include cash and short-term investments, as well as dividends and loan repayments from other subsidiaries and dividends or distributions from equity investments. As of March 31, 2011, the parent company had approximately $5.4 billion in funds available from its cash and short-term investments.
We can also generate liquidity for the parent company and PNC’s non-bank subsidiaries through the issuance of debt securities and equity securities, including certain capital securities, in public or private markets and commercial paper.
We have effective shelf registration statements pursuant to which we can issue additional debt and equity securities, including certain hybrid capital instruments. Total senior and subordinated debt and hybrid capital instruments was $15.8 billion at March 31, 2011 compared with $17.3 billion at December 31, 2010.
The parent company, through its subsidiary PNC Funding Corp, has the ability to offer up to $3.0 billion of commercial paper to provide additional liquidity. As of March 31, 2011, there were no issuances outstanding under this program.
Note 18 Equity in Part II, Item 8 of our 2010 Form 10-K describes the December 31, 2008 issuance of 75,792 shares of our Fixed Rate Cumulative Perpetual Preferred Shares, Series N (Series N Preferred Stock), related issuance discount and the issuance of a related common stock warrant to the US Treasury under the TARP Capital Purchase Program. In
addition, Note 18 in our 2010 Form 10-K describes our February 2010 redemption of the Series N Preferred Stock, the acceleration of the accretion of the remaining issuance discount on the Series N Preferred Stock in the first quarter of 2010 (and a corresponding reduction in retained earnings of $250 million in the first quarter of 2010), and the exchange by the US Treasury of the TARP warrant into warrants sold by the US Treasury in a secondary public offering. These common stock warrants will expire December 31, 2018.
Status of Credit Ratings
The cost and availability of short- and long-term funding, as well as collateral requirements for certain derivative instruments, is influenced by debt ratings.
In general, rating agencies base their ratings on many quantitative and qualitative factors, including capital adequacy, liquidity, asset quality, business mix, level and quality of earnings, and the current legislative and regulatory environment, including implied government support. In addition, rating agencies themselves have been subject to scrutiny arising from the financial crisis and could make or be required to make substantial changes to their ratings policies and practices, particularly in response to legislative and regulatory changes, including as a result of provisions in Dodd-Frank. Potential changes in the legislative and regulatory environment and the timing of those changes could impact our ratings, which as noted above, could impact our liquidity and financial condition. A decrease, or potential decrease, in credit ratings could impact access to the capital markets and/or increase the cost of debt, and thereby adversely affect liquidity and financial condition.
Credit ratings as of March 31, 2011 for PNC and PNC Bank, N.A. follow:
Senior debt
Preferred stock
PNC Bank, N.A.
Long-term deposits
Short-term deposits
Commitments
The following tables set forth contractual obligations and various other commitments as of March 31, 2011 representing required and potential cash outflows.
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Contractual Obligations
Remaining contractual maturities of time deposits (a)
Borrowed funds (a)
Minimum annual rentals on noncancellable leases
Nonqualified pension and postretirement benefits
Purchase obligations (b)
Total contractual cash obligations
At March 31, 2011, the liability for uncertain tax positions, excluding associated interest and penalties, was $294 million. This liability represents an estimate of tax positions that we have taken in our tax returns which ultimately may not be sustained upon examination by taxing authorities. Since the ultimate amount and timing of any future cash settlements cannot be predicted with reasonable certainty, this estimated liability has been excluded from the contractual obligations table. See Note 15 Income Taxes in the Notes To Consolidated Financial Statements of this Report for additional information.
Our contractual obligations totaled $84.6 billion at December 31, 2010. The decline in the comparison is primarily attributable to the maturities of borrowed funds.
Other Commitments (a)
Net unfunded credit commitments
Standby letters of credit (b)
Reinsurance agreements (c)
Other commitments (d)
Total commitments
MARKET RISK MANAGEMENT OVERVIEW
Market risk is the risk of a loss in earnings or economic value due to adverse movements in market factors such as interest rates, credit spreads, foreign exchange rates, and equity prices. We are exposed to market risk primarily by our involvement in the following activities, among others:
Traditional banking activities of taking deposits and extending loans,
Equity and other investments and activities whose economic values are directly impacted by market factors, and
Trading in fixed income products, equities, derivatives, and foreign exchange, as a result of customer activities and underwriting.
We have established enterprise-wide policies and methodologies to identify, measure, monitor, and report market risk. Market Risk Management provides independent oversight by monitoring compliance with these limits and guidelines, and reporting significant risks in the business to the Risk Committee of the Board.
MARKET RISK MANAGEMENT – INTEREST RATE RISK
Interest rate risk results primarily from our traditional banking activities of gathering deposits and extending loans. Many factors, including economic and financial conditions, movements in interest rates, and consumer preferences, affect the difference between the interest that we earn on assets and the interest that we pay on liabilities and the level of our noninterest-bearing funding sources. Due to the repricing term mismatches and embedded options inherent in certain of these products, changes in market interest rates not only affect expected near-term earnings, but also the economic values of these assets and liabilities.
Asset and Liability Management centrally manages interest rate risk within limits and guidelines set forth in our risk management policies approved by management’s Asset and Liability Committee and the Risk Committee of the Board.
Sensitivity results and market interest rate benchmarks for the first quarters of 2011 and 2010 follow:
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Interest Sensitivity Analysis
Net Interest Income Sensitivity Simulation
Effect on net interest income in first year from gradual interest rate change over following 12 months of:
100 basis point increase
100 basis point decrease (a)
Effect on net interest income in second year from gradual interest rate change over the preceding 12 months of:
Duration of Equity Model (a)
Base case duration of equity (in years):
Key Period-End Interest Rates
One-month LIBOR
Three-year swap
In addition to measuring the effect on net interest income assuming parallel changes in current interest rates, we routinely simulate the effects of a number of nonparallel interest rate environments. The following Net Interest Income Sensitivity to Alternative Rate Scenarios table reflects the percentage change in net interest income over the next two 12-month periods assuming (i) the PNC Economist’s most likely rate forecast, (ii) implied market forward rates, and (iii) a Two-Ten Slope decrease (a 200 basis point decrease between two-year and ten-year rates superimposed on current base rates) scenario.
Net Interest Income Sensitivity to Alternative Rate Scenarios (First Quarter 2011)
First year sensitivity
Second year sensitivity
All changes in forecasted net interest income are relative to results in a base rate scenario where current market rates are assumed to remain unchanged over the forecast horizon.
When forecasting net interest income, we make assumptions about interest rates and the shape of the yield curve, the volume and characteristics of new business, and the behavior of existing on- and off-balance sheet positions. These assumptions determine the future level of simulated net interest income in the base interest rate scenario and the other interest rate scenarios presented in the above table. These simulations assume that as assets and liabilities mature, they are replaced or repriced at then current market rates. We also consider forward projections of purchase accounting accretion when forecasting net interest income.
The following graph presents the yield curves for the base rate scenario and each of the alternate scenarios one year forward.
The first quarter 2011 interest sensitivity analyses indicate that our Consolidated Balance Sheet is positioned to benefit from an increase in interest rates. We believe that we have the deposit funding base and balance sheet flexibility to adjust, where appropriate and permissible, to changing interest rates and market conditions.
MARKET RISK MANAGEMENT – TRADING RISK
Our trading activities are primarily customer-driven trading in fixed income securities, derivatives, and foreign exchange contracts. They also include the underwriting of fixed income and equity securities.
We use value-at-risk (VaR) as the primary means to measure and monitor market risk in trading activities. The Risk Committee of the Board establishes an enterprise-wide VaR limit on our trading activities.
During the first three months of 2011, our VaR ranged between $1.8 million and $3.8 million, averaging $3.1 million. During the first three months of 2010, our VaR ranged between $5.9 million and $8.8 million, averaging $7.1 million.
To help ensure the integrity of the models used to calculate VaR for each portfolio and enterprise-wide, we use a process known as backtesting. The backtesting process consists of comparing actual observations of trading-related gains or losses against the VaR levels that were calculated at the close of the prior day. Over a typical business cycle, we would expect an average of two to three instances a year in which actual losses exceeded the prior day VaR measure at the enterprise-wide level. There were no such instances during the first three months of 2011 or 2010, as the trading markets have moved into a period of relatively low pricing volatility.
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The following graph shows a comparison of enterprise-wide trading-related gains and losses against prior day VaR for the period.
Total trading revenue was as follows:
Trading Revenue
In millions
Total trading revenue
Securities underwriting and trading (a)
Foreign exchange
Financial derivatives and other
Total trading revenue (b)
Trading revenue excludes the impact of economic hedging activities, which relate primarily to residential mortgage servicing rights, and residential and held-for-sale commercial real estate loans.
Trading revenue for the first quarter of 2011 decreased $13 million compared with the first quarter of 2010 primarily due to lower underwriting revenues, which were partially offset by increased derivative client sales and reduced impact of credit risk on customer derivative position values.
MARKET RISK MANAGEMENT – EQUITY AND OTHER INVESTMENT RISK
Equity investment risk is the risk of potential losses associated with investing in both private and public equity markets. In addition to extending credit, taking deposits, and underwriting and trading financial instruments, we make and manage direct investments in a variety of transactions, including management buyouts, recapitalizations, and growth financings in a variety of industries. We also have investments in affiliated and non-affiliated funds that make similar investments in private equity and in debt and equity-oriented hedge funds. The economic and/or book value of these investments and other assets such as loan servicing rights are directly affected by changes in market factors.
The primary risk measurement for equity and other investments is economic capital. Economic capital is a common measure of risk for credit, market and operational risk. It is an estimate of the worst-case value depreciation over
a one year horizon to a level commensurate with a financial institution with an A rating by the credit rating agencies. Given the illiquid nature of many of these types of investments, it can be a challenge to determine their fair values. Market Risk Management and Finance provide independent oversight of the valuation process.
Various PNC business units manage our equity and other investment activities. Our businesses are responsible for making investment decisions within the approved policy limits and associated guidelines.
A summary of our equity investments follows:
Tax credit investments
Private equity
Visa
PNC owned approximately 36 million common stock equivalent shares of BlackRock equity at March 31, 2011, accounted for under the equity method. The primary risk measurement, similar to other equity investments, is economic capital. The Business Segments Review section of this Financial Review includes additional information about BlackRock.
Tax Credit Investments
Included in our equity investments are tax credit investments which are mostly accounted for under the equity method. These investments, as well as equity investments held by consolidated partnerships, totaled $2.3 billion at March 31, 2011 and $2.1 billion at December 31, 2010.
Private Equity
The private equity portfolio is an illiquid portfolio comprised of equity and mezzanine investments that vary by industry, stage and type of investment.
Private equity investments carried at estimated fair value totaled $1.4 billion at both March 31, 2011 and December 31, 2010. As of March 31, 2011, $794 million was invested directly in a variety of companies and $652 million was invested indirectly through various private equity funds. Included in direct investments are investment activities of two private equity funds that are consolidated for financial reporting purposes. The noncontrolling interests of these funds totaled $255 million as of March 31, 2011. The indirect private equity funds are not redeemable, but PNC receives distributions over the life of the partnership from liquidation of the underlying investments by the investee.
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Our unfunded commitments related to private equity totaled $300 million at March 31, 2011 compared with $319 million at December 31, 2010.
At March 31, 2011, our investment in Visa Class B common shares totaled approximately 23 million shares. In March 2011, Visa funded $400 million to their litigation escrow account and reduced the conversion ratio of Visa B to A shares. We consequently recognized our estimated $38 million share of the $400 million as a reduction of our previously established indemnification liability and a reduction of noninterest expense. Our indemnification liability included on our Consolidated Balance Sheet at March 31, 2011 totaled $32 million. Our ultimate exposure to the specified Visa litigation may be different than this amount.
As of March 31, 2011, we had recognized $456 million of our Visa ownership, which we acquired with National City, on our Consolidated Balance Sheet. Based on the March 31, 2011 closing price of $73.62 for the Visa Class A shares, the market value of our investment was $837 million. The Visa Class B common shares we own generally will not be transferable, except under limited circumstances, until they can be converted into shares of the publicly traded class of stock, which cannot happen until the settlement of all of the specified litigation. It is expected that Visa will continue to adjust the conversion ratio of Visa Class B to Class A shares in connection with any settlements in excess of any amounts then in escrow for that purpose and will also reduce the conversion ratio to the extent that it adds any funds to the escrow in the future.
Note 17 Commitments and Guarantees in our Notes To Consolidated Financial Statements of this Report has further information on our Visa indemnification obligation.
Other Investments
We also make investments in affiliated and non-affiliated funds with both traditional and alternative investment strategies. The economic values could be driven by either the fixed-income market or the equity markets, or both. At March 31, 2011, other investments totaled $321 million compared with $318 million at December 31, 2010. We recognized net gains related to these investments of $15 million during the first three months of 2011 compared with $17 million during the first three months of 2010.
Given the nature of these investments, if market conditions affecting their valuation were to worsen, we could incur future losses.
Our unfunded commitments related to other investments totaled $9 million at March 31, 2011 and $11 million at December 31, 2010.
Financial Derivatives
We use a variety of financial derivatives as part of the overall asset and liability risk management process to help manage interest rate, market and credit risk inherent in our business activities. Substantially all such instruments are used to manage risk related to changes in interest rates. Interest rate and total return swaps, interest rate caps and floors, swaptions, options, forwards and futures contracts are the primary instruments we use for interest rate risk management. We also enter into derivatives with customers to facilitate their risk management activities.
Financial derivatives involve, to varying degrees, interest rate, market and credit risk. For interest rate swaps and total return swaps, options and futures contracts, only periodic cash payments and, with respect to options, premiums are exchanged. Therefore, cash requirements and exposure to credit risk are significantly less than the notional amount on these instruments.
Further information on our financial derivatives is presented in Note 1 Accounting Policies in our Notes To Consolidated Financial Statements under Part II, Item 8 of our 2010 Form 10-K and in Note 12 Financial Derivatives in the Notes To Consolidated Financial Statements in this Report, which is incorporated here by reference.
Not all elements of interest rate, market and credit risk are addressed through the use of financial or other derivatives, and such instruments may be ineffective for their intended purposes due to unanticipated market changes, among other reasons.
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The following table provides the notional or contractual amounts and estimated net fair value of financial derivatives at March 31, 2011 and December 31, 2010.
Derivatives designated as hedging instrument under GAAP
Interest rate contracts (a)
Asset rate conversion
Receive fixed swaps
Pay fixed swaps
Liability rate conversion
Forward purchase commitments
Total interest rate risk management
Total derivatives designated as hedging instruments (b)
Derivatives not designated as hedging instruments under GAAP
Derivatives used for residential mortgage banking activities:
Interest rate contracts
Swaps
Futures
Future options
Swaptions
Commitments related to residential mortgage assets
Total residential mortgage banking activities
Derivatives used for commercial mortgage banking activities:
Commitments related to commercial mortgage assets
Credit contracts
Credit default swaps
Derivatives used for customer-related activities:
Caps/floors
Sold (c)
Purchased
Foreign exchange contracts (c)
Equity contracts (c)
Risk participation agreements
Other contracts
Total customer-related
Derivatives used for other risk management activities:
Foreign exchange contracts
Other contracts (c) (d)
Total other risk management
Total derivatives not designated as hedging instruments
Total Gross Derivatives
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INTERNAL CONTROLS ANDDISCLOSURE CONTROLS AND PROCEDURES
As of March 31, 2011, we performed an evaluation under the supervision and with the participation of our management, including the Chairman and Chief Executive Officer and the Executive Vice President and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures and of changes in our internal control over financial reporting.
Based on that evaluation, our Chairman and Chief Executive Officer and our Executive Vice President and Chief Financial Officer concluded that our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities and Exchange Act of 1934, as amended) were effective as of March 31, 2011, and that there has been no change in PNC’s internal control over financial reporting that occurred during the first quarter of 2011 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
GLOSSARYOF TERMS
Accretable net interest (Accretable yield) – The excess of cash flows expected to be collected on a purchased impaired loan over the carrying value of the loan. The accretable net interest is recognized into interest income over the remaining life of the loan using the constant effective yield method.
Adjusted average total assets – Primarily comprised of total average quarterly (or annual) assets plus (less) unrealized losses (gains) on investment securities, less goodwill and certain other intangible assets (net of eligible deferred taxes).
Annualized – Adjusted to reflect a full year of activity.
Assets under management – Assets over which we have sole or shared investment authority for our customers/clients. We do not include these assets on our Consolidated Balance Sheet.
Basis point – One hundredth of a percentage point.
Cash recoveries – Cash recoveries used in the context of purchased impaired loans represent cash payments from customers that exceeded the recorded investment of the designated impaired loan.
Charge-off – Process of removing a loan or portion of a loan from our balance sheet because it is considered uncollectible. We also record a charge-off when a loan is transferred from portfolio holdings to held for sale by reducing the loan carrying amount to the fair value of the loan, if fair value is less than carrying amount.
Common shareholders’ equity to total assets – Common shareholders’ equity divided by total assets. Common shareholders’ equity equals total shareholders’ equity less the liquidation value of preferred stock.
Credit derivatives – Contractual agreements, primarily credit default swaps, that provide protection against a credit event of one or more referenced credits. The nature of a credit event is established by the protection buyer and protection seller at the inception of a transaction, and such events include bankruptcy, insolvency and failure to meet payment obligations when due. The buyer of the credit derivative pays a periodic fee in return for a payment by the protection seller upon the occurrence, if any, of a credit event.
Credit spread – The difference in yield between debt issues of similar maturity. The excess of yield attributable to credit spread is often used as a measure of relative creditworthiness, with a reduction in the credit spread reflecting an improvement in the borrower’s perceived creditworthiness.
Derivatives – Financial contracts whose value is derived from changes in publicly traded securities, interest rates, currency exchange rates or market indices. Derivatives cover a wide assortment of financial contracts, including but not limited to forward contracts, futures, options and swaps.
Duration of equity – An estimate of the rate sensitivity of our economic value of equity. A negative duration of equity is associated with asset sensitivity (i.e., positioned for rising interest rates), while a positive value implies liability sensitivity (i.e., positioned for declining interest rates). For example, if the duration of equity is +1.5 years, the economic value of equity declines by 1.5% for each 100 basis point increase in interest rates.
Earning assets – Assets that generate income, which include: Federal funds sold; resale agreements; trading securities; interest-earning deposits with banks; loans held for sale; loans; investment securities; and certain other assets.
Economic capital – Represents the amount of resources that a business segment should hold to guard against potentially large losses that could cause insolvency. It is based on a measurement of economic risk, as opposed to risk as defined by regulatory bodies. The economic capital measurement process involves converting a risk distribution to the capital that is required to support the risk, consistent with our target credit rating. As such, economic risk serves as a “common currency” of risk that allows us to compare different risks on a similar basis.
Effective duration – A measurement, expressed in years, that, when multiplied by a change in interest rates, would approximate the percentage change in value of on- and off- balance sheet positions.
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Efficiency – Noninterest expense divided by total revenue.
Fair value – The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.
FICO score – A credit bureau-based industry standard score created by Fair Isaac Co. which predicts the likelihood of borrower default. We use FICO scores both in underwriting and assessing credit risk in our consumer lending portfolio. Lower FICO scores indicate likely higher risk of default, while higher FICO scores indicate likely lower risk of default. FICO scores are updated on a periodic basis.
Foreign exchange contracts – Contracts that provide for the future receipt and delivery of foreign currency at previously agreed-upon terms.
Funds transfer pricing – A management accounting methodology designed to recognize the net interest income effects of sources and uses of funds provided by the assets and liabilities of a business segment. We assign these balances LIBOR-based funding rates at origination that represent the interest cost for us to raise/invest funds with similar maturity and repricing structures.
Futures and forward contracts – Contracts in which the buyer agrees to purchase and the seller agrees to deliver a specific financial instrument at a predetermined price or yield. May be settled either in cash or by delivery of the underlying financial instrument.
GAAP – Accounting principles generally accepted in the United States of America.
Interest rate floors and caps – Interest rate protection instruments that involve payment from the protection seller to the protection buyer of an interest differential, which represents the difference between a short-term rate (e.g., three-month LIBOR) and an agreed-upon rate (the strike rate) applied to a notional principal amount.
Interest rate swap contracts – Contracts that are entered into primarily as an asset/liability management strategy to reduce interest rate risk. Interest rate swap contracts are exchanges of interest rate payments, such as fixed-rate payments for floating-rate payments, based on notional principal amounts.
Intrinsic value– The amount by which the fair value of an underlying stock exceeds the exercise price of an option on that stock.
Investment securities – Collectively, securities available for sale and securities held to maturity.
Leverage ratio – Tier 1 risk-based capital divided by adjusted average total assets.
LIBOR – Acronym for London InterBank Offered Rate. LIBOR is the average interest rate charged when banks in the London wholesale money market (or interbank market) borrow unsecured funds from each other. LIBOR rates are used as a benchmark for interest rates on a global basis.
Loan-to-value ratio (LTV) – A calculation of a loan’s collateral coverage that is used both in underwriting and assessing credit risk in our lending portfolio. LTV is the sum total of loan obligations secured by collateral divided by the market value of that same collateral. Market values of the collateral are based on an independent valuation of the collateral. For example, an LTV of less than 90% is better secured and has less credit risk than an LTV of greater than or equal to 90%. Our real estate market values are updated on an annual basis but may be updated more frequently for select loans.
Loss Given Default (LGD) – An estimate of recovery based on collateral type, collateral value, loan exposure, or the guarantor(s) quality and guaranty type (full or partial). Each loan has its own LGD. The LGD risk rating measures the percentage of exposure of a specific credit obligation that we expect to lose if default occurs. LGD is net of recovery, through either liquidation of collateral or deficiency judgments rendered from foreclosure or bankruptcy proceedings. The LGD rating is updated with the same frequency as the borrower’s PD rating, and should be done more frequently than the PD if the collateral values and amounts change often.
Net interest income from loans and deposits – A management accounting assessment, using funds transfer pricing methodology, of the net interest contribution from loans and deposits.
Net interest margin – Annualized taxable-equivalent net interest income divided by average earning assets.
Nonaccretable difference – Contractually required payments receivable on a purchased impaired loan in excess of the cash flows expected to be collected.
Nondiscretionary assets under administration – Assets we hold for our customers/clients in a non-discretionary, custodial capacity. We do not include these assets on our Consolidated Balance Sheet.
Nonperforming assets – Nonperforming assets include non-accrual loans, certain non-accrual troubled debt restructured loans, OREO, foreclosed and other assets. We do not accrue interest income on assets classified as nonperforming.
Nonperforming loans – Loans for which we do not accrue interest income. Nonperforming loans include loans to commercial, commercial real estate, equipment lease
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financing, consumer (including loans and lines of credit secured by residential real estate), and residential real estate (including mortgages and construction) customers as well as certain non-accrual troubled debt restructured loans. Nonperforming loans do not include loans held for sale or OREO and foreclosed assets. Nonperforming loans do not include purchased impaired loans as we are currently accreting interest income over the expected life of the loans.
Notional amount – A number of currency units, shares, or other units specified in a derivative contract.
Operating leverage – The period to period dollar or percentage change in total revenue (GAAP basis) less the dollar or percentage change in noninterest expense. A positive variance indicates that revenue growth exceeded expense growth (i.e., positive operating leverage) while a negative variance implies expense growth exceeded revenue growth (i.e.,negative operating leverage).
Options – Contracts that grant the purchaser, for a premium payment, the right, but not the obligation, to either purchase or sell the associated financial instrument at a set price during a specified period or at a specified date in the future.
Other real estate owned (OREO) – Foreclosed assets taken in settlement of troubled loans through surrender or foreclosure. Foreclosed assets include all assets received in full or partial satisfaction of a loan and include real and personal property, equity interests in corporations, partnerships, joint ventures, and beneficial interests in trusts. Premises that are no longer used in operations may also be included in real estate owned.
Other-than-temporary impairment (OTTI) – When the fair value of a security is less than its amortized cost basis, an assessment is performed to determine whether the impairment is other-than-temporary. If we intend to sell the security or more likely than not will be required to sell the security before recovery of its amortized cost basis less any current-period credit loss, an other-than-temporary impairment is considered to have occurred. In such cases, an other-than-temporary impairment is recognized in earnings equal to the entire difference between the investment’s amortized cost basis and its fair value at the balance sheet date. Further, if we do not expect to recover the entire amortized cost of the security, an other-than-temporary impairment is considered to have occurred. However for debt securities, if we do not intend to sell the security and it is not more likely than not that we will be required to sell the security before its recovery, the other-than-temporary loss is separated into (a) the amount representing the credit loss, and (b) the amount related to all other factors. The other-than-temporary impairment related to credit losses is recognized in earnings while the amount related to all other factors is recognized in other comprehensive income, net of tax.
Pretax, pre-provision earnings from continuing operations – Total revenue less noninterest expense, both from continuing operations.
Probability of Default (PD) – An internal risk rating that indicates the likelihood that a credit obligor will enter into default status.
Provision-adjusted net interest margin – Net interest margin less the ratio of the annualized provision for credit losses to average interest-earning assets.
Purchase accounting accretion – Accretion of the discounts and premiums on acquired assets and liabilities. The purchase accounting accretion is recognized in net interest income over the weighted average life of the financial instruments using the constant effective yield method.
Purchased impaired loans – Acquired loans determined to be credit impaired under FASB ASC 310-30 (AICPA SOP 03-3). Loans are determined to be impaired if there is evidence of credit deterioration since origination and for which it is probable that all contractually required payments will not be collected.
Recorded investment – The initial investment of a purchased impaired loan plus interest accretion and less any cash payments and writedowns to date. The recorded investment excludes any valuation allowance which is included in our allowance for loan and lease losses.
Recovery – Cash proceeds received on a loan that we had previously charged off. We credit the amount received to the allowance for loan and lease losses.
Residential development loans – Project-specific loans to commercial customers for the construction or development of residential real estate including land, single family homes, condominiums and other residential properties. This would exclude loans to commercial customers where proceeds are for general corporate purposes whether or not such facilities are secured.
Residential mortgage servicing rights hedge gains/(losses), net – We have elected to measure acquired or originated residential mortgage servicing rights (MSRs) at fair value under GAAP. We employ a risk management strategy designed to protect the economic value of MSRs from changes in interest rates. This strategy utilizes securities and a portfolio of derivative instruments to hedge changes in the fair value of MSRs arising from changes in interest rates. These financial instruments are expected to have changes in fair value which are negatively correlated to the change in fair value of the MSR portfolio. Net MSR hedge gains/(losses) represent the change in the fair value of MSRs, exclusive of changes due to time decay and payoffs, combined with the change in the fair value of the associated securities and derivative instruments.
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Return on average assets – Annualized net income divided by average assets.
Return on average capital – Annualized net income divided by average capital.
Return on average common shareholders’ equity – Annualized net income less preferred stock dividends, including preferred stock discount accretion and redemptions, divided by average common shareholders’ equity.
Risk-weighted assets – Computed by the assignment of specific risk-weights (as defined by the Board of Governors of the Federal Reserve System) to assets and off-balance sheet instruments.
Securitization – The process of legally transforming financial assets into securities.
Servicing rights – An intangible asset or liability created by an obligation to service assets for others. Typical servicing rights include the right to receive a fee for collecting and forwarding payments on loans and related taxes and insurance premiums held in escrow.
Swaptions – Contracts that grant the purchaser, for a premium payment, the right, but not the obligation, to enter into an interest rate swap agreement during a specified period or at a specified date in the future.
Taxable-equivalent interest – The interest income earned on certain assets is completely or partially exempt from Federal income tax. As such, these tax-exempt instruments typically yield lower returns than taxable investments. To provide more meaningful comparisons of yields and margins for all interest-earning assets, we use interest income on a taxable-equivalent basis in calculating average yields and net interest margins by increasing the interest income earned on tax-exempt assets to make it fully equivalent to interest income earned on other taxable investments. This adjustment is not permitted under GAAP on the Consolidated Income Statement.
Tier 1 common capital– Tier 1 risk-based capital, less preferred equity, less trust preferred capital securities, and less noncontrolling interests.
Tier 1 common capital ratio – Tier 1 common capital divided by period-end risk-weighted assets.
Tier 1 risk-based capital – Total shareholders’ equity, plus trust preferred capital securities, plus certain noncontrolling interests that are held by others; less goodwill and certain other intangible assets (net of eligible deferred taxes relating to taxable and nontaxable combinations), less equity investments in nonfinancial companies less ineligible servicing assets and less net unrealized holding losses on available for sale equity securities. Net unrealized holding gains on available for sale equity securities, net unrealized holding gains (losses) on available for sale debt securities and
net unrealized holding gains (losses) on cash flow hedge derivatives are excluded from total shareholders’ equity for Tier 1 risk-based capital purposes.
Tier 1 risk-based capital ratio – Tier 1 risk-based capital divided by period-end risk-weighted assets.
Total equity – Total shareholders’ equity plus noncontrolling interests.
Total return swap – A non-traditional swap where one party agrees to pay the other the “total return” of a defined underlying asset (e.g., a loan), usually in return for receiving a stream of LIBOR-based cash flows. The total returns of the asset, including interest and any default shortfall, are passed through to the counterparty. The counterparty is therefore assuming the credit and economic risk of the underlying asset.
Total risk-based capital – Tier 1 risk-based capital plus qualifying subordinated debt and trust preferred securities, other noncontrolling interest not qualified as Tier 1, eligible gains on available for sale equity securities and the allowance for loan and lease losses, subject to certain limitations.
Total risk-based capital ratio – Total risk-based capital divided by period-end risk-weighted assets.
Transaction deposits – The sum of interest-bearing money market deposits, interest-bearing demand deposits, and noninterest-bearing deposits.
Troubled debt restructuring – A restructuring of a loan whereby the lender for economic or legal reasons related to the borrower’s financial difficulties grants a concession to the borrower that the lender would not otherwise consider.
Value-at-risk (VaR) – A statistically-based measure of risk which describes the amount of potential loss which may be incurred due to severe and adverse market movements. The measure is of the maximum loss which should not be exceeded on 99 out of 100 days.
Watchlist – A list of criticized loans, credit exposure or other assets compiled for internal monitoring purposes. We define criticized exposure for this purpose as exposure with an internal risk rating of other assets especially mentioned, substandard, doubtful or loss.
Yield curve – A graph showing the relationship between the yields on financial instruments or market indices of the same credit quality with different maturities. For example, a “normal” or “positive” yield curve exists when long-term bonds have higher yields than short-term bonds. A “flat” yield curve exists when yields are the same for short-term and long-term bonds. A “steep” yield curve exists when yields on long-term bonds are significantly higher than on short-term bonds. An “inverted” or “negative” yield curve exists when short-term bonds have higher yields than long-term bonds.
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CAUTIONARY STATEMENTREGARDING FORWARD-LOOKING INFORMATION
We make statements in this Report, and we may from time to time make other statements, regarding our outlook or expectations for earnings, revenues, expenses, capital levels, liquidity levels, asset quality and/or other matters regarding or affecting PNC and its future business and operations that are forward-looking statements within the meaning of the Private Securities Litigation Reform Act. Forward-looking statements are typically identified by words such as “believe,” “plan,” “expect,” “anticipate,” “intend,” “outlook,” “estimate,” “forecast,” “will,” “should,” “project,” “goal,” “see” and other similar words and expressions.
Forward-looking statements are subject to numerous assumptions, risks and uncertainties, which change over time. Forward-looking statements speak only as of the date they are made. We do not assume any duty and do not undertake to update our forward-looking statements. Actual results or future events could differ, possibly materially, from those that we anticipated in our forward-looking statements, and future results could differ materially from our historical performance.
Our forward-looking statements are subject to the following principal risks and uncertainties. We provide greater detail regarding some of these factors in our 2010 Form 10-K and elsewhere in this Report, including in the Risk Factors and Risk Management sections of those reports. Our forward-looking statements may also be subject to other risks and uncertainties, including those discussed elsewhere in this Report or in our other filings with the SEC.
Our businesses and financial results are affected by business and economic conditions, both generally and specifically in the principal markets in which we operate. In particular, our businesses and financial results may be impacted by:
Changes in interest rates and valuations in the debt, equity and other financial markets.
Disruptions in the liquidity and other functioning of financial markets, including such disruptions in the markets for real estate and other assets commonly securing financial products.
Actions by the Federal Reserve and other government agencies, including those that impact money supply and market interest rates.
Changes in our customers’, suppliers’ and other counterparties’ performance in general and their creditworthiness in particular.
A slowing or failure of the moderate economic recovery that began in mid-2009 and continued throughout 2010 and into 2011.
Continued effects of the aftermath of recessionary conditions and the uneven spread of the positive impacts of the recovery on the economy in general
and our customers in particular, including adverse impact on loan utilization rates as well as delinquencies, defaults and customer ability to meet credit obligations.
Changes in levels of unemployment.
Changes in customer preferences and behavior, whether as a result of changing business and economic conditions, climate-related physical changes or legislative and regulatory initiatives, or other factors.
Turbulence in significant portions of the US and global financial markets could impact our performance, both directly by affecting our revenues and the value of our assets and liabilities and indirectly by affecting our counterparties and the economy generally.
We will be impacted by the extensive reforms provided for in the Dodd-Frank Act and ongoing reforms impacting the financial institutions industry generally. Further, as much of the Dodd-Frank Act will require the adoption of implementing regulations by a number of different regulatory bodies, the precise nature, extent and timing of many of these reforms and the impact on us is still uncertain.
Financial industry restructuring in the current environment could also impact our business and financial performance as a result of changes in the creditworthiness and performance of our counterparties and by changes in the competitive and regulatory landscape.
Our results depend on our ability to manage current elevated levels of impaired assets.
Given current economic and financial market conditions, our forward-looking financial statements are subject to the risk that these conditions will be substantially different than we are currently expecting. These statements are based on our current view that the moderate economic recovery that began in mid-2009 and continued throughout 2010 will transition into a self-sustaining economic expansion in 2011 pushing the unemployment rate lower amidst continued low interest rates.
Legal and regulatory developments could have an impact on our ability to operate our businesses or our financial condition or results of operations or our competitive position or reputation. Reputational impacts, in turn, could affect matters such as business generation and retention, our ability to attract and retain management, liquidity, and funding. These legal and regulatory developments could include:
Changes resulting from legislative and regulatory responses to the current economic and financial industry environment.
Other legislative and regulatory reforms, including broad-based restructuring of financial industry regulation (such as those under the Dodd-Frank Act)
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as well as changes to laws and regulations involving tax, pension, bankruptcy, consumer protection, and other aspects of the financial institution industry.
Unfavorable resolution of legal proceedings or other claims and regulatory and other governmental investigations or other inquiries. In addition to matters relating to PNC’s business and activities, such matters may also include proceedings, claims, investigations, or inquiries relating to pre-acquisition business and activities of acquired companies, such as National City. These matters may result in monetary judgments or settlements or other remedies, including fines, penalties, restitution or alterations in our business practices and in additional expenses and collateral costs.
The results of the regulatory examination and supervision process, including our failure to satisfy the requirements of agreements with governmental agencies.
Changes in accounting policies and principles.
Changes resulting from legislative and regulatory initiatives relating to climate change that have or may have a negative impact on our customers’ demand for or use of our products and services in general and their creditworthiness in particular.
Changes to regulations governing bank capital, including as a result of the Dodd-Frank Act and of the Basel III initiatives.
Our business and operating results are affected by our ability to identify and effectively manage risks inherent in our businesses, including, where appropriate, through the effective use of third-party insurance, derivatives, and capital management techniques, and by our ability to meet evolving regulatory capital standards.
The adequacy of our intellectual property protection, and the extent of any costs associated with obtaining rights in intellectual property claimed by others, can impact our business and operating results.
Our ability to anticipate and respond to technological changes can have an impact on our ability to respond to customer needs and to meet competitive demands.
Our ability to implement our business initiatives and strategies could affect our financial performance over the next several years.
Competition can have an impact on customer acquisition, growth and retention, as well as on our credit spreads and product pricing, which can affect market share, deposits and revenues.
Our business and operating results can also be affected by widespread disasters, terrorist activities or international hostilities, either as a result of the impact on the economy and capital and other financial markets generally or on us or on our customers, suppliers or other counterparties specifically.
Also, risks and uncertainties that could affect the results anticipated in forward-looking statements or from historical performance relating to our equity interest in BlackRock, Inc. are discussed in more detail in BlackRock’s filings with the SEC, including in the Risk Factors sections of BlackRock’s reports. BlackRock’s SEC filings are accessible on the SEC’s website and on or through BlackRock’s website at www.blackrock.com. This material is referenced for informational purposes only and should not be deemed to constitute a part of this Report.
We grow our business in part by acquiring from time to time other financial services companies, financial services assets and related deposits. Acquisitions present us with risks in addition to those presented by the nature of the business acquired. These include risks and uncertainties related both to the acquisition transactions themselves and to the integration of the acquired businesses into PNC after closing.
Acquisitions may be substantially more expensive to complete (including unanticipated costs incurred in connection with the integration of the acquired company) and the anticipated benefits (including anticipated cost savings and strategic gains) may be significantly harder or take longer to achieve than expected. Acquisitions may involve our entry into new businesses or new geographic or other markets, and these situations also present risks resulting from our inexperience in those new areas.
As a regulated financial institution, our pursuit of attractive acquisition opportunities could be negatively impacted due to regulatory delays or other regulatory issues. In addition, regulatory and/or legal issues relating to the pre-acquisition operations of an acquired business may cause reputational harm to PNC following the acquisition and integration of the acquired business into ours and may result in additional future costs or regulatory limitations arising as a result of those issues.
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Interest Income
Total interest income
Interest Expense
Total interest expense
Noninterest Income
Asset management
Corporate services
Net gains on sales of securities
Other-than-temporary impairments
Less: Noncredit portion of other-than-temporary impairments (a)
Net other-than-temporary impairments
Provision For Credit Losses
Noninterest Expense
Personnel
Occupancy
Equipment
Marketing
Total noninterest expense
Income from continuing operations before income taxes and noncontrolling interests
Income from discontinued operations (net of income taxes of zero and $14)
Less: Net income (loss) attributable to noncontrolling interests
Preferred stock dividends
Preferred stock discount accretion
Net income attributable to common shareholders
Basic Earnings Per Common Share
Discontinued operations
Diluted Earnings Per Common Share
Average Common Shares Outstanding
Basic
Diluted
See accompanying Notes To Consolidated Financial Statements.
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In millions, except par value
Unaudited
Cash and due from banks (includes $2 and $2 for VIEs) (a)
Federal funds sold and resale agreements (includes $823 and $866 measured at fair value) (b)
Interest-earning deposits with banks (includes $83 and $288 for VIEs) (a)
Loans held for sale (includes $2,684 and $2,755 measured at fair value) (b)
Investment securities (includes $110 and $192 for VIEs) (a)
Loans (includes $4,796 and $4,645 for VIEs) (includes $229 and $116 measured at fair value) (a) (b)
Allowance for loan and lease losses (includes $(128) and $(183) for VIEs) (a)
Net loans
Other intangible assets
Equity investments (includes $1,332 and $1,177 for VIEs) (a)
Other (includes $741 and $676 for VIEs) (includes $447 and $396 measured at fair value) (a) (b)
Noninterest-bearing
Interest-bearing
Other (includes $3,397 and $3,354 for VIEs) (a)
Allowance for unfunded loan commitments and letters of credit
Accrued expenses (includes $113 and $88 for VIEs) (a)
Other (includes $715 and $456 for VIEs) (a)
Preferred stock (c)
Common stock – $5 par value
Authorized 800 shares, issued 536 and 536 shares
Capital surplus – preferred stock
Capital surplus – common stock and other
Retained earnings
Common stock held in treasury at cost: 10 and 10 shares
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Operating Activities
Adjustments to reconcile net income to net cash provided (used) by operating activities
Depreciation and amortization
Deferred income taxes
Undistributed earnings of BlackRock
Net change in
Trading securities and other short-term investments
Accrued expenses and other liabilities
Net cash provided (used) by operating activities
Investing Activities
Sales
Repayments/maturities
Securities held to maturity
Purchases
Federal funds sold and resale agreements
Interest-earning deposits with banks
Net cash provided (used) by investing activities
(continued on following page)
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Consolidated Statement of Cash Flows
(continued from previous page)
Financing Activities
Federal Home Loan Bank short-term borrowings
Other short-term borrowed funds
Sales/issuances
Other long-term borrowed funds
Common and treasury stock
Federal Home Loan Bank long-term borrowings
Preferred stock – TARP
Acquisition of treasury stock
Preferred stock cash dividends paid
Common stock cash dividends paid
Net cash provided (used) by financing activities
Net Increase (Decrease) In Cash And Due From Banks
Cash and due from banks at beginning of period
Cash and due from banks at end of period
Supplemental Disclosures
Interest paid
Income taxes paid
Income taxes refunded
Non-cash Investing and Financing Items
Transfer from (to) loans to (from) loans held for sale, net
Transfer from loans to foreclosed assets
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NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS (UNAUDITED)
THE PNC FINANCIALSERVICES GROUP, INC.
Business
NOTE 1 ACCOUNTING POLICIES
BASIS OF FINANCIAL STATEMENT PRESENTATION
Our consolidated financial statements include the accounts of the parent company and its subsidiaries, most of which are wholly owned, and certain partnership interests and variable interest entities.
We prepared these consolidated financial statements in accordance with accounting principles generally accepted in the United States of America (GAAP). We have eliminated intercompany accounts and transactions. We have also reclassified certain prior year amounts to conform with the 2011 presentation. These reclassifications did not have a material impact on our consolidated financial condition or results of operations.
See Note 2 Divestiture regarding our July 1, 2010 sale of PNC Global Investment Servicing Inc. The Consolidated Income Statement for the first three months of 2010 and related disclosures in the Notes To Consolidated Financial Statements reflect the global investment servicing business as discontinued operations.
In our opinion, the unaudited interim consolidated financial statements reflect all normal, recurring adjustments needed to present fairly our results for the interim periods. The results of operations for interim periods are not necessarily indicative of the results that may be expected for the full year or any other interim period.
When preparing these unaudited interim consolidated financial statements, we have assumed that you have read the audited consolidated financial statements included in our 2010 Annual Report on Form 10-K (2010 Form 10-K). Reference is made to Note 1 Accounting Policies in the 2010 Form 10-K for a detailed description of significant accounting policies.
There have been no significant changes to these policies in the first three months of 2011 other than as disclosed herein. These interim consolidated financial statements serve to update the 2010 Form 10-K and may not include all information and notes necessary to constitute a complete set of financial statements.
We have considered the impact on these consolidated financial statements of subsequent events.
USE OFESTIMATES
We prepared these consolidated financial statements using financial information available at the time, which requires us to make estimates and assumptions that affect the amounts reported. Our most significant estimates pertain to our fair value measurements, allowances for loan and lease losses and unfunded loan commitments and letters of credit, purchased impaired loans, revenue recognition and valuation of residential mortgage servicing rights. Actual results may differ from the estimates and the differences may be material to the consolidated financial statements.
INVESTMENT IN BLACKROCK, INC.
We account for our investment in the common stock and Series B Preferred Stock of BlackRock (deemed to be in-substance common stock) under the equity method of accounting. The investment in BlackRock is reflected on our Consolidated Balance Sheet in Equity investments, while our equity in earnings of BlackRock is reported on our Consolidated Income Statement in Asset management revenue.
We also own 2.9 million shares of Series C Preferred Stock of BlackRock. Since these preferred shares are not deemed to be in substance common stock, we have elected to account for these preferred shares at fair value and the changes in fair value will offset the impact of marking-to-market the obligation to deliver these shares to BlackRock. Our investment in the BlackRock Series C Preferred Stock is included on our Consolidated Balance Sheet in Other assets.
As noted above, we mark-to-market our obligation to transfer BlackRock shares related to certain BlackRock long-term incentive plan (LTIP) programs. This obligation is classified as a derivative not designated as a hedging instrument under GAAP as disclosed in Note 12 Financial Derivatives.
NONPERFORMING ASSETS
Nonperforming assets include:
Nonaccrual loans,
Troubled debt restructurings, and
Foreclosed assets.
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Nonperforming loans are those loans that have deteriorated in credit quality to the extent that full collection of original contractual principal and interest is doubtful. When a loan is determined to be nonperforming (and as a result is impaired), the accrual of interest is ceased and the loan is classified as nonaccrual. The current year accrued and uncollected interest is reversed out of net interest income.
A loan acquired and accounted for under ASC Sub-Topic 310-30 – Loans and Debt Securities Acquired with Deteriorated Credit Quality is reported as an accruing loan and a performing asset.
We generally classify Commercial Lending (Commercial, Commercial Real Estate, and Equipment Lease Financing) loans as nonaccrual (and therefore nonperforming) when we determine that the collection of interest or principal is doubtful or when delinquency of interest or principal payments has existed for 90 days or more and the loans are not well-secured and in the process of collection. A loan is considered well-secured when the collateral in the form of liens on (or pledges of) real or personal property, including marketable securities, has a realizable value sufficient to discharge the debt in full, including accrued interest. Such factors that would lead to nonperforming status and subject to an impairment test would include, but are not limited to, the following:
Deterioration in the financial position of the borrower resulting in the loan moving from accrual to cash basis,
The collection of principal or interest is 90 days or more past due unless the asset is both well-secured and in the process of collection,
Reasonable doubt exists as to the certainty of the future debt service ability, whether 90 days have passed or not,
Customer has filed or will likely file for bankruptcy,
The bank advances additional funds to cover principal or interest,
We are in the process of liquidation of a commercial borrower, or
We are pursuing remedies under a guaranty.
We charge off commercial nonaccrual loans based on the facts and circumstances of the individual loans.
Additionally, in general, small business commercial term loans of less than $1 million and small business commercial revolving loans are placed on nonaccrual status at 90 days past due and charged off at 120 and 180 days past due, respectively.
Home equity installment loans and lines of credit, as well as residential real estate loans, that are well secured are classified as nonaccrual at 180 days past due. A consumer loan is considered well-secured when the collateral in the form of liens on (or pledges of) real or personal property, including marketable securities, have a realizable value sufficient to discharge the debt in full, including accrued interest.
Home equity installment loans and lines of credit and residential real estate loans that are not well secured and/or are in the process of collection are charged off at 180 days past due to the estimated fair value of the collateral less cost to sell. The remaining portion of the loan is placed on nonaccrual status.
Subprime mortgage loans for first liens with a loan-to-value (LTV) ratio of equal to or greater than 90% and second liens are classified as nonaccrual at 90 days past due. These loans are charged off as discussed above.
Most consumer loans and lines of credit, not secured by residential real estate, are charged off after 120 to 180 days past due. Generally, they are not placed on nonaccrual status as permitted by regulatory guidance.
If payment is received on a nonperforming loan, the payment is first applied to the past due principal; once this principal obligation has been fulfilled, payments are applied to recover any partial charge-off related to the impaired loan that might exist. Finally, if both past due principal and any partial charge-off have been recovered, then the payment will result in the recognition and recording of interest income. This process is followed for impaired loans with the exception of performing troubled debt restructurings (TDRs). Payments received on performing TDRs and other modified loans will be applied in accordance with the terms of the modified loan.
A loan is categorized as a TDR if a concession is granted due to deterioration in the financial condition of the borrower. TDRs may include certain modifications of terms of loans, receipts of assets from debtors in partial or full satisfaction of loans, or a combination thereof. Modified loans classified as TDRs are included in nonperforming loans until returned to performing status through the fulfilling of contractual terms for a reasonable period of time (generally 6 months).
See Note 5 Asset Quality and Allowances for Loan and Lease Losses and Unfunded Loan Commitments and Letters of Credit for additional TDR information.
Nonperforming loans are generally not returned to performing status until the obligation is brought current and the borrower has performed in accordance with the contractual terms for a reasonable period of time and collection of the contractual principal and interest is no longer in doubt.
Foreclosed assets are comprised of any asset seized or property acquired through a foreclosure proceeding or acceptance of a deed-in-lieu of foreclosure. Other real estate owned is comprised principally of commercial real estate and residential real estate properties obtained in partial or total satisfaction of loan obligations. Following the obtaining of a foreclosure judgment, or in some jurisdictions the initiation of proceedings under a power of sale in the loan instruments, the property will be sold. When we acquire the deed, we transfer the loan to other real estate owned included in Other assets on our Consolidated Balance Sheet. Property obtained in satisfaction of a loan is recorded at the lower of recorded investment or estimated fair value less cost to sell. We estimate fair values primarily based on appraisals, when
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available, or quoted market prices on liquid assets. Anticipated recoveries and government guarantees are also considered in evaluating the potential impairment of loans at the date of transfer. If the estimated fair value less cost to sell is less than the recorded investment, a charge-off is recognized against the Allowance for loan and lease losses (ALLL).
Subsequently, foreclosed assets are valued at the lower of the amount recorded at acquisition date or estimated fair value less cost to sell. Valuation adjustments on these assets and gains or losses realized from disposition of such property are reflected in Other noninterest expense.
See Note 5 Asset Quality and Allowances for Loan and Lease Losses and Unfunded Loan Commitments and Letters of Credit for additional information.
ALLOWANCEFOR LOAN AND LEASE LOSSES
We maintain the ALLL at a level that we believe to be adequate to absorb estimated probable credit losses incurred in the loan portfolio as of the balance sheet date. Our determination of the adequacy of the allowance is based on periodic evaluations of the loan and lease portfolios and other relevant factors. This evaluation is inherently subjective as it requires material estimates, all of which may be susceptible to significant change, including, among others:
Probability of default (PD),
Loss given default (LGD),
Exposure at date of default (EAD),
Amounts and timing of expected future cash flows,
Value of collateral, and
Qualitative factors such as changes in economic conditions that may not be reflected in historical results.
While our reserve methodologies strive to reflect all relevant risk factors, there continues to be uncertainty associated with, but not limited to, potential imprecision in the estimation process due to the inherent time lag of obtaining information and normal variations between estimates and actual outcomes. We provide additional reserves that are designed to provide coverage for losses attributable to such risks. The ALLL also includes factors which may not be directly measured in the determination of specific or pooled reserves. Such qualitative factors include:
Recent Credit quality trends,
Recent Loss experience in particular portfolios,
Recent Macro economic factors, and
Changes in risk selection and underwriting standards.
In determining the adequacy of the ALLL, we make specific allocations to impaired loans and allocations to portfolios of commercial and consumer loans. We also allocate reserves to provide coverage for probable losses incurred in the portfolio at the balance sheet date based upon current market conditions, which may not be reflected in historical loss data. While allocations are made to specific loans and pools of loans, the total reserve is available for all credit losses.
Nonperforming loans are considered impaired under ASC 310-Receivables and are allocated a specific reserve.
Specific reserve allocations are determined as follows:
For nonperforming loans greater than or equal to a defined dollar threshold and TDRs, specific reserves are based on an analysis of the present value of the loan’s expected future cash flows, the loan’s observable market price or the fair value of the collateral.
For nonperforming loans below the defined dollar threshold, the loans are aggregated for purposes of measuring specific reserve impairment using the applicable loan’s LGD percentage multiplied by the balance of the loans.
When applicable, this process is applied across all the loan classes in a similar manner. However, as previously discussed, certain consumer loans and lines of credit, not secured by residential real estate, are charged off instead of being classified as nonperforming.
Our credit risk management policies, procedures and practices are designed to promote sound and fair lending standards while achieving prudent credit risk management. We have policies, procedures and practices that address financial statement requirements, collateral review and appraisal requirements, advance rates based upon collateral types, appropriate levels of exposure, cross-border risk, lending to specialized industries or borrower type, guarantor requirements, and regulatory compliance.
ALLOWANCE FOR UNFUNDED LOAN COMMITMENTS ANDLETTERS OF CREDIT
We maintain the allowance for unfunded loan commitments and letters of credit at a level we believe is adequate to absorb estimated probable losses related to these unfunded credit facilities. We determine the adequacy of the allowance based on periodic evaluations of the unfunded credit facilities, including an assessment of the probability of commitment usage, credit risk factors, and the terms and expiration dates of the unfunded credit facilities. The allowance for unfunded loan commitments and letters of credit is recorded as a liability on the Consolidated Balance Sheet. Net adjustments to the allowance for unfunded loan commitments and letters of credit are included in the provision for credit losses.
The reserve for unfunded loan commitments is estimated in a manner similar to the methodology used for determining reserves for similar funded exposures. However, there is one important distinction. This distinction lies in the estimation of the amount of these unfunded commitments that will become funded. This is determined using a cash conversion factor or
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loan equivalency factor, which is a statistical estimate of the amount of an unfunded commitment that will fund over a given period of time. Once the future funded amount is estimated, the calculation of the allowance follows similar methodologies to those employed for on-balance sheet exposure.
EARNINGS PER COMMON SHARE
Basic earnings per common share is calculated using the two-class method to determine income attributable to common shareholders. Unvested share-based payment awards that contain nonforfeitable rights to dividends or dividend equivalents are considered participating securities under the two-class method. Income attributable to common shareholders is then divided by the weighted-average common shares outstanding for the period.
Diluted earnings per common share is calculated under the more dilutive of either the treasury method or the two-class method. For the diluted calculation, we increase the weighted-average number of shares of common stock outstanding by the assumed conversion of outstanding convertible preferred stock and debentures from the beginning of the year or date of issuance, if later, and the number of shares of common stock that would be issued assuming the exercise of stock options and warrants and the issuance of incentive shares using the treasury stock method. These adjustments to the weighted-average number of shares of common stock outstanding are made only when such adjustments will dilute earnings per common share. See Note 13 Earnings Per Share for additional information.
RECENT ACCOUNTING PRONOUNCEMENTS
In April 2011, the FASB issued ASU 2011- 03 – Transfers and Servicing (Topic 860): Reconsideration of Effective Control for Repurchase Agreements. This ASU removes from the assessment of effective control (1) the criterion requiring the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms, even in the event of default by the transferee, and (2) the collateral maintenance implementation guidance related to that criterion. Other criteria applicable to the assessment of effective control have not been changed by this ASU. ASU 2011-03 is effective for the first interim or annual period beginning on or after December 15, 2011 and should be applied prospectively to transactions or modifications of existing transactions that occur on or after the effective date. Early adoption is not permitted. The adoption of this new guidance is not expected to have a material effect on our results of operations or financial position.
In April 2011, the FASB issued ASU 2011-02, Receivables (Topic 310): A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring. The ASU clarifies when a loan modification constitutes a troubled debt
restructuring (TDR). This ASU (1) eliminates the sole use of the borrowers’ effective interest rate test to determine if a concession has occurred on the part of the creditor, (2) requires a modification with below market terms to be considered in determining classification as a TDR, (3) specifies that a borrower not currently in default may still be experiencing financial difficulty when payment default is “probable in the foreseeable future,” and (4) specifies that a delay in payment should be considered along with all other factors in determining classification as a TDR. The ASU guidance is effective for interim and annual periods beginning after June 15, 2011 and is to be applied retrospectively to the beginning of the annual period of adoption. We are currently evaluating the impact of this ASU.
In January 2010, the FASB issued ASU 2010-06, Fair Value Measurements and Disclosures (Topic 820), Improving Disclosures About Fair Value Measurements. This ASU requires purchases, sales, issuances and settlements to be reported separately in the Level 3 fair value measurement rollforward beginning with the first quarter 2011 reporting. See Note 8 Fair Value for additional information.
In July 2010, the FASB issued ASU 2010-20 – Receivables (Topic 310) – Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses. While the majority of the disclosures within this ASU were already required to be adopted and included in the 2010 Form 10-K, required disclosures about activity that occurs during a reporting period are effective for interim and annual reporting periods beginning on or after December 15, 2010. Comparative disclosures for earlier reporting periods that ended before initial adoption is encouraged. Comparative disclosures for those reporting periods ending after initial adoption are required. See Note 5 Asset Quality and Allowances for Loan and Lease Losses and Unfunded Loan Commitments and Letters of Credit for additional information. The effective date for disclosures related to troubled debt restructurings required by ASU 2010-20 was deferred by ASU 2011-01 – Receivables (Topic 310): Deferral of the Effective Date of Disclosures about Troubled Debt Restructurings in Update No. 2010-20, which was issued in January 2011. The disclosures were deferred until the FASB had completed ASU 2011-02. The effective date of the TDR disclosures is now consistent with the effective date of ASU 2011-02.
NOTE 2 DIVESTITURE
On July 1, 2010, we sold PNC Global Investment Servicing Inc. (GIS), a leading provider of processing, technology and business intelligence services to asset managers, broker-dealers and financial advisors worldwide, for $2.3 billion in cash pursuant to a definitive agreement entered into on February 2, 2010. This transaction resulted in a pretax gain of $639 million, net of transaction costs, in the third quarter of 2010. Results of operations of GIS through March 31, 2010
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are presented as Income from discontinued operations, net of income taxes, on our Consolidated Income Statement. As part of the sale agreement, PNC has agreed to provide certain transitional services on behalf of GIS until completion of related systems conversion activities. There were no assets or liabilities of GIS remaining at December 31, 2010.
NOTE 3 LOAN SALE ANDSERVICING ACTIVITIES AND VARIABLE INTEREST ENTITIES
LOAN SALE AND SERVICING ACTIVITIES
We have transferred residential and commercial mortgage loans in securitization or sales transactions in which we have continuing involvement. These transfers have occurred through Agency securitization, Non-Agency securitization, and whole-loan sale transactions. Agency securitizations consist of securitization transactions with Federal National Mortgage Association (FNMA), Federal Home Loan Mortgage Corporation (FHLMC), and Government National Mortgage Association (GNMA) (collectively the Agencies). FNMA and FHLMC generally securitize our transferred loans into mortgage-backed securities for sale into the secondary market through special purpose entities (SPEs) they sponsor. We, as an authorized GNMA issuer/servicer, pool loans into mortgage-backed securities for sale into the secondary market. In Non-Agency securitizations, we have transferred loans into securitization SPEs. In other instances third-party investors
have purchased (in whole-loan sale transactions) and subsequently sold our loans into securitization SPEs. Third-party investors have also purchased our loans in whole-loan sale transactions. Securitization SPEs, which are legal entities that are utilized in the Agency and Non-Agency securitization transactions, are VIEs.
Our continuing involvement in the Agency securitizations, Non-Agency securitizations, and whole-loan sale transactions generally consists of servicing, repurchases of previously transferred loans and loss share arrangements, and, in limited circumstances, holding of mortgage-backed securities issued by the securitization SPEs. Refer to Note 3 Loan Sale and Servicing Activities and Variable Interest Entities in our 2010 Form 10-K for additional information regarding our continuing involvement in these transactions. In addition, further details of our repurchase and loss share obligations are contained in Note 17 Commitments and Guarantees.
Certain loans transferred to the Agencies contain removal of account provisions (ROAPs). Under these ROAPs, we hold an option to repurchase at par individual delinquent loans that meet certain criteria. When we have the unilateral ability to repurchase a delinquent loan, effective control over the loan has been regained and we recognize the loan and a corresponding liability on the balance sheet regardless of our intent to repurchase the loan. At March 31, 2011 and December 31, 2010, the balance of our ROAP asset and liability totaled $256 million and $336 million, respectively.
Certain Financial Information and Cash Flows Associated with Loan Sale and Servicing Activities
FINANCIAL INFORMATION – March 31, 2011
Servicing portfolio (c)
Carrying value of servicing assets (d)
Servicing advances
Servicing deposits
Repurchase and recourse obligations (e)
Carrying value of mortgage-backed securities held (f)
FINANCIAL INFORMATION – December 31, 2010
CASH FLOWS – Three months ended March 31, 2011
Sales of loans (g)
Repurchases of previously transferred loans (h)
Contractual servicing fees received
Servicing advances recovered/(funded), net
Cash flows on mortgage-backed securities held (f)
CASH FLOWS – Three months ended March 31, 2010
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VARIABLE INTEREST ENTITIES (VIES)
As discussed in our 2010 Form 10-K, we are involved with various entities in the normal course of business that are deemed to be VIEs. The following provides a summary of VIEs, including those that we have consolidated and those in which we hold variable interests but have not consolidated into our financial statements as of March 31, 2011 and December 31, 2010.
Consolidated VIEs – Carrying Value (a)
Cash and due from banks
Allowance for loan and lease losses
Other borrowed funds
Accrued expenses
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Assets and Liabilities of Consolidated VIEs (a)
Market Street
Credit Card Securitization Trust
Tax Credit Investments (b)
Non-Consolidated VIEs
Tax Credit Investments (a)
Commercial Mortgage-Backed Securitizations (b)
Residential Mortgage-Backed Securitizations (b)
Collateralized Debt Obligations
MARKET STREET
Market Street is a multi-seller asset-backed commercial paper conduit that is owned by an independent third party. Market Street’s activities primarily involve purchasing assets or making loans secured by interests in pools of receivables from US corporations that desire access to the commercial paper market. Market Street funds the purchases of assets or loans by issuing commercial paper and is supported by pool-specific credit enhancements, liquidity facilities and program-level credit enhancement. Generally, Market Street mitigates its potential interest rate risk by entering into agreements with its borrowers that reflect interest rates based upon its weighted average commercial paper cost of funds. During 2010 and the first three months of 2011, Market Street met all of its funding needs through the issuance of commercial paper.
PNC Bank, N.A. provides certain administrative services, the program-level credit enhancement and all of the liquidity facilities to Market Street in exchange for fees negotiated based on market rates. Through these arrangements, PNC has the power to direct the activities of the SPE that most significantly affect its economic performance and these arrangements expose PNC to expected losses or residual returns that are significant to Market Street.
The commercial paper obligations at March 31, 2011 and December 31, 2010 were supported by Market Street’s assets. While PNC may be obligated to fund under the $6.7 billion of liquidity facilities for events such as commercial paper market disruptions, borrower bankruptcies, collateral deficiencies or covenant violations, our credit risk under the liquidity facilities is secondary to the risk of first loss provided by the
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borrower such as by the over-collateralization of the assets or by another third party in the form of deal-specific credit enhancement. Deal-specific credit enhancement that supports the commercial paper issued by Market Street is generally structured to cover a multiple of expected losses for the pool of assets and is sized to generally meet rating agency standards for comparably structured transactions. In addition, PNC would be required to fund $1.4 billion of the liquidity facilities if the underlying assets are in default. Market Street creditors have no direct recourse to PNC.
PNC provides program-level credit enhancement to cover net losses in the amount of 10% of commitments, excluding explicitly rated AAA/Aaa facilities. PNC provides 100% of the enhancement in the form of a cash collateral account funded by a loan facility. This facility expires in June 2015. At March 31, 2011, $689 million was outstanding on this facility. This amount is eliminated in PNC’s Consolidated Balance Sheet as we consolidate Market Street. We are not required to nor have we provided additional financial support to the SPE.
CREDIT CARDSECURITIZATION TRUST
We are the sponsor of several credit card securitizations facilitated through a trust. This bankruptcy-remote SPE or VIE was established to purchase credit card receivables from the sponsor and to issue and sell asset-backed securities created by it to independent third-parties. The SPE was financed primarily through the sale of these asset-backed securities. These transactions were originally structured as a form of liquidity and to afford favorable capital treatment. At March 31, 2011, Series 2007-1 and 2008-3 issued by the SPE were outstanding. Series 2006-1 was paid off during the first quarter of 2011.
Our continuing involvement in these securitization transactions consists primarily of holding certain retained interests and acting as the primary servicer. For each securitization series, our retained interests held are in the form of a pro-rata undivided interest, or sellers’ interest, in the transferred receivables, subordinated tranches of asset-backed securities, interest-only strips, discount receivables, and subordinated interests in accrued interest and fees in securitized receivables. We have consolidated the SPE as we are deemed the primary beneficiary of the entity based upon our level of continuing involvement. Our role as primary servicer gives us the power to direct the activities of the SPE that most significantly affect its economic performance and our holding of retained interests gives us the obligation to absorb or receive expected losses or residual returns that are significant to the SPE. Accordingly, all retained interests held in the credit card SPE are eliminated in consolidation. The underlying assets of the consolidated SPE are restricted only for payment of the beneficial interest issued by the SPE. We are not required to nor have we provided additional financial support to the SPE. Additionally, creditors of the SPE have no direct recourse to PNC.
TAX CREDIT INVESTMENTS
We make certain equity investments in various limited partnerships or limited liability companies (LLCs) that sponsor affordable housing projects utilizing the LIHTC pursuant to Sections 42 and 47 of the Internal Revenue Code. The purpose of these investments is to achieve a satisfactory return on capital, to facilitate the sale of additional affordable housing product offerings and to assist us in achieving goals associated with the Community Reinvestment Act. The primary activities of the investments include the identification, development and operation of multi-family housing that is leased to qualifying residential tenants. Generally, these types of investments are funded through a combination of debt and equity. We typically invest in these partnerships as a limited partner or non-managing member. We make similar investments in other types of tax credit investments.
Also, we are a national syndicator of affordable housing equity (together with the investments described above, the LIHTC investments). In these syndication transactions, we create funds in which our subsidiaries are the general partner or managing member and sell limited partnership or non-managing member interests to third parties, and in some cases may also purchase a limited partnership or non-managing member interest in the fund and/or provide mezzanine financing to the fund. The purpose of this business is to generate income from the syndication of these funds, generate servicing fees by managing the funds, and earn tax credits to reduce our tax liability. General partner or managing member activities include selecting, evaluating, structuring, negotiating, and closing the fund investments in operating limited partnerships or LLCs, as well as oversight of the ongoing operations of the fund portfolio.
Typically, the general partner or managing member will be the party that has the right to make decisions that will most significantly impact the economic performance of the entity. However, certain partnership or LLC agreements provide the limited partner or non-managing member the ability to remove the general partner or managing member without cause. This results in the limited partner or non-managing member being the party that has the right to make decisions that will most significantly impact the economic performance of the entity. The primary sources of losses and benefits in LIHTC investments are the tax credits, tax benefits due to passive losses on the investments, and development and operating cash flows. We have consolidated LIHTC investments in which we are the general partner or managing member and have a limited partnership interest or non-managing member interest that could potentially absorb losses or receive benefits that are significant. The assets are primarily included in Equity investments and Other assets on our Consolidated Balance Sheet with the liabilities classified in Other liabilities and third party investors’ interests included in the Equity section as Noncontrolling interests. Neither creditors nor equity investors in the LIHTC investments have any recourse
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to our general credit. There are no terms or conditions that have required or could require us, as the primary beneficiary, to provide financial support. Also, we have not provided nor do we intend to provide financial or other support to the limited partnership or LLC that we are not contractually obligated to provide. The consolidated aggregate assets and liabilities of these LIHTC investments are provided in the Consolidated VIEs table and reflected in the “Other” business segment.
For tax credit investments in which we do not have the right to make decisions that will most significantly impact the economic performance of the entity, we are not the primary beneficiary and thus they are not consolidated. These investments are disclosed in the Non-Consolidated VIEs table. The table also reflects our maximum exposure to loss. Our maximum exposure to loss is equal to our legally binding equity commitments adjusted for recorded impairment and partnership results. We use the equity method to account for our investment in these entities with the investments reflected in Equity investments on our Consolidated Balance Sheet. In addition, we increase our recognized investments and recognize a liability for all legally binding unfunded equity commitments. These liabilities are reflected in Other liabilities on our Consolidated Balance Sheet.
RESIDENTIAL AND COMMERCIALMORTGAGE-BACKED SECURITIZATIONS
In connection with each Agency and Non-Agency securitization discussed above, we evaluate each SPE utilized in these transactions for consolidation. In performing these assessments, we evaluate our level of continuing involvement in these transactions as the magnitude of our involvement ultimately determines whether or not we hold a variable interest and/or are the primary beneficiary of the SPE. Factors we consider in our consolidation assessment include the significance of (1) our role as servicer, (2) our holdings of mortgage-backed securities issued by the securitization SPE, and (3) the rights of third-party variable interest holders.
Our first step in our assessment is to determine whether we hold a variable interest in the securitization SPE. We hold a variable interest in an Agency and Non-Agency securitization SPE through our holding of mortgage-backed securities issued by the SPE and/or our repurchase and recourse obligations. Each SPE in which we hold a variable interest is evaluated to determine whether we are the primary beneficiary of the entity. For Agency securitization transactions, our contractual role as servicer does not give us the power to direct the activities that most significantly affect the economic performance of the SPEs. Thus, we are not the primary beneficiary of these entities. For Non-Agency securitization transactions, we would be the primary beneficiary to the extent our servicing activities give us the power to direct the activities that most significantly affect the economic performance of the SPE and we hold a more than insignificant
variable interest in the entity. At March 31, 2011, our level of continuing involvement in Non-Agency securitization SPEs did not result in PNC being deemed the primary beneficiary of any of these entities. Details about the Agency and Non-Agency securitization SPEs where we hold a variable interest and are not the primary beneficiary are included in the table above. Our maximum exposure to loss as a result of our involvement with these SPEs is the carrying value of the mortgage-backed securities, servicing assets, servicing advances, and our liabilities associated with our repurchase and recourse obligations. Creditors of the securitization SPEs have no recourse to PNC’s assets or general credit.
NOTE 4 LOANS AND COMMITMENTSTO EXTEND CREDIT
Loans outstanding were as follows:
Loans Outstanding
Total loans (a) (b)
At March 31, 2011, we pledged $15.1 billion of loans to the Federal Reserve Bank and $32.9 billion of loans to the Federal Home Loan Bank as collateral for the contingent ability to borrow, if necessary. The comparable amounts at December 31, 2010 were $12.6 billion and $32.4 billion, respectively.
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Commitments to extend credit represent arrangements to lend funds or provide liquidity subject to specified contractual conditions. At March 31, 2011, commercial commitments reported above exclude $16.3 billion of syndications, assignments and participations, primarily to financial institutions. The comparable amount at December 31, 2010 was $16.7 billion.
Commitments generally have fixed expiration dates, may require payment of a fee, and contain termination clauses in the event the customer’s credit quality deteriorates. Based on our historical experience, most commitments expire unfunded, and therefore cash requirements are substantially less than the total commitment.
NOTE 5 ASSET QUALITY ANDALLOWANCES FOR LOAN AND LEASE LOSSES AND UNFUNDED LOAN COMMITMENTS ANDLETTERS OF CREDIT
Asset Quality
We closely monitor economic conditions and loan performance trends to manage and evaluate our exposure to credit risk. Trends in delinquency rates are a key indicator, among other considerations, of credit risk within the loan portfolios. The measurement of delinquency status is based on the contractual terms of each loan. Loans that are 30 days or more past due in terms of payment are considered delinquent.
The level of nonperforming assets represents another key indicator of the potential for future credit losses. Nonperforming assets include nonperforming loans, TDRs, and other real estate owned (OREO) and foreclosed assets, but exclude purchased impaired loans. See Note 6 Purchased Impaired Loans for further information.
See Note 1 Accounting Policies for additional delinquency, nonperforming, and charge-off information.
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The following tables display the delinquency status of our loans and our nonperforming assets at March 31, 2011 and December 31, 2010.
Age Analysis of Past Due Accruing Loans
Percentage of total loans
Nonperforming Assets
Consumer (a)
TOTAL FORECLOSED AND OTHER ASSETS
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Loans whose contractual terms have been restructured in a manner which grants a concession to a borrower experiencing financial difficulties are considered TDRs. See Note 1 Accounting Policies for additional information. TDRs typically result from our loss mitigation activities and could include rate reductions, principal forgiveness, forbearance and other actions intended to minimize the economic loss and to avoid foreclosure or repossession of collateral. Total nonperforming loans in the table above include TDRs of $882 million at March 31, 2011 and $784 million at December 31, 2010.
TDRs returned to performing (accrual) status totaled $639 million and $543 million at March 31, 2011 and December 31, 2010, respectively, and are excluded from nonperforming loans. These loans have demonstrated a period of at least six months of consecutive performance under the modified terms.
In addition, credit cards and certain small business and consumer credit agreements whose terms have been modified are TDRs and totalled $314 million and $331 million at March 31, 2011 and December 31, 2010, respectively. However, since our policy is to exempt these loans from being placed on nonperforming status as permitted by regulatory guidance, these loans are excluded from nonperforming loans. As such, generally under the modified terms, these loans are directly charged off in the period that they become 120 to 180 days past due. At March 31, 2011 and December 31, 2010, remaining commitments to lend additional funds to debtors whose terms have been modified in a commercial or consumer TDR were immaterial.
Additional Asset Quality Indicators
We have two overall portfolio segments – Commercial Lending and Consumer Lending. Each of these two segments is comprised of one or more loan classes. Classes are characterized by similarities in initial measurement, risk attributes and the manner in which we monitor and assess credit risk. The commercial segment is comprised of the commercial, commercial real estate, equipment lease financing, and commercial purchased impaired loan classes. The consumer segment is comprised of the residential real estate, home equity, credit card, other consumer, and consumer purchased impaired loan classes. Asset quality indicators for each of these loan classes are discussed in more detail below.
Commercial Loan Class
For commercial loans, we monitor the performance of the borrower in a disciplined and regular manner based upon the level of credit risk inherent in the loan. To evaluate the level of credit risk, we assign an internal risk rating reflecting the borrower’s PD and LGD. This two-dimensional credit risk- rating methodology provides risk granularity in the monitoring
process on an ongoing basis. We adjust our risk-rating process through updates based on actual experience. The combination of the PD and LGD ratings assigned to a commercial loan, capturing both the combination of expectations of default and loss severity, reflects the relative estimated likelihood of loss for that loan at the reporting date. Loans with low PD and LGD have the lowest likelihood of loss. Conversely, loans with high PD and LGD have the highest likelihood of loss.
Based upon the amount of the lending arrangement and of the credit risk described above, we follow a formal schedule of periodic review. Generally, for higher risk loans this occurs on a quarterly basis, although we have established practices to review such credit risk more frequently, if circumstances warrant.
Commercial Real Estate Loan Class
We manage credit risk associated with our commercial real estate projects and commercial mortgage activities similar to commercial loans by analyzing PD and LGD. However, due to the nature of the collateral, for commercial real estate projects and commercial mortgages, the LGDs tend to be significantly lower than those seen in the commercial class. Additionally, risks connected with commercial real estate projects and commercial mortgage activities tend to be correlated to the loan structure and collateral location, project progress and business environment. As a result, these attributes are also monitored and utilized in assessing credit risk.
As with the commercial class, a quarterly overview is performed to assess geographic, product and loan type concentrations, in addition to industry risk and market and economic concerns. Often as a result of these overviews, more in-depth reviews and increased scrutiny is placed on areas of higher risk, adverse changes in risk ratings, deteriorating operating trends, and/or areas that concern management. The goal of these reviews is to assess risk and take actions to mitigate our exposure to such risks.
Equipment Lease Financing Loan Class
Similar to the other classes of loans within Commercial Lending, loans within the equipment lease financing class undergo a rigorous underwriting process. During this process, a PD and LGD are assigned based on the credit risk.
Based upon the dollar amount of the lease and of the level of credit risk, we follow a formal schedule of periodic review. Generally, this occurs on a quarterly basis, although we have established practices to review such credit risk more frequently, if circumstances warrant. Our review process entails analysis of the following factors: equipment value/residual value, exposure levels, jurisdiction risk, industry risk, guarantor requirements, and regulatory compliance.
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Commercial Purchased Impaired Loans Class
The credit impacts of purchased impaired loans are primarily determined through the estimation of expected cash flows. Commercial cash flow estimates are influenced by a number of credit related items which include but are not limited to: changes in estimated collateral value, receipt of additional collateral, secondary trading prices, circumstances of possible and/or ongoing liquidation, capital availability, business operations and payment patterns.
We attempt to proactively manage these factors by using various procedures that are customized to the risk of a given loan. These procedures include a review by our Special Asset Committee (SAC), ongoing outreach, contact, and assessment of obligor financial conditions, collateral inspection and appraisal.
See Note 6 Purchased Impaired Loans for additional information.
Commercial Lending Asset Quality Indicators
Pass
Rated (a)
Purchased impaired loans
Total commercial lending (e)
Residential Real Estate and Home Equity Loan Classes
We use several credit quality indicators, including credit scores, LTV ratios, delinquency rates, loan types and geography to monitor and manage credit risk within the residential real estate and home equity classes. We evaluate mortgage loan performance by source originators and loan servicers. A summary of asset quality indicators follows:
Credit Scores: We use a national third-party provider to update FICO credit scores for residential real estate and home equity loans on at least an annual basis. The updated scores are incorporated into a series of credit monitoring reports and the statistical models that estimate the individual loan risk values.
LTV: We regularly update the property values of real estate collateral and calculate a LTV ratio. This ratio updates our statistical models that estimate individual and class/segment level risk. The LTV ratio tends to indicate potential loss on a given loan and the borrower’s likelihood to make payment according to the contractual obligations.
Delinquency Rates: We monitor levels of delinquency rates for residential real estate and home equity loans.
Geography: Geographic concentrations are monitored to evaluate and manage exposures. Loan purchase programs are sensitive to, and focused within, certain regions to manage geographic exposures and associated risks.
The combination of FICO scores, LTV ratios and geographic location assigned to residential real estate and home equity loans are used to estimate the likelihood of loss for that loan at the reporting date. Loans with high FICO scores and low LTVs tend to have the lower likelihood of loss. Conversely, loans with low FICO scores, high LTVs, and in certain geographic locations tend to have a higher likelihood of loss.
At least annually, we obtain an updated property valuations on the real estate secured loans. For open credit lines secured by real estate or facilities in regions experiencing significant declines in property values, more frequent valuations may occur. The property values are monitored to determine LTV migration and those LTV migrations are stratified within various markets. Trends are analyzed to establish appropriate lending criteria to fit within our desired moderate risk profile.
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Consumer Real Estate Secured Asset Quality Indicators
Home equity (b)
Residential real estate (c)
Total (d)
Credit Card and Other Consumer Loan Classes
We monitor a variety of asset quality information in the management of the credit card and other consumer loan classes. Other consumer loan classes include education, automobile, and other secured and unsecured lines and loans. Along with the trending of delinquencies and losses for each class, FICO credit score updates are obtained at least annually, as well as a variety of credit bureau attributes.
The combination of FICO scores and delinquency status are used to estimate the likelihood of loss for consumer exposure at the reporting date. Loans with high FICO scores tend to have a lower likelihood of loss. Conversely, loans with low FICO scores tend to have a higher likelihood of loss.
Consumer Purchased Impaired Loans Class
Estimates of the expected cash flows primarily determine the credit impacts of consumer purchased impaired loans. Consumer cash flow estimates are influenced by a number of credit related items which include, but are not limited to, estimated real estate values, payment patterns, FICO scores, economic environment, LTV ratios and the date of origination. These key drivers are monitored regularly to help ensure that concentrations of risk are mitigated and cash flows are maximized.
Credit Card and Other Consumer Loan Classes Asset Quality Indicators
FICO greater than 719
650 to 719
620 to 649
Less than 620
Unscored (c)
Total loan balance
Weighted average current FICO score (d)
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Allowances for Loan and Lease Losses and Unfunded Loan Commitments and Letters of Credit
We maintain the ALLL and the Allowance for Unfunded Loan Commitments and Letters of Credit at levels that we believe to be adequate to absorb estimated probable credit losses incurred in the portfolios as of the balance sheet date. We use the two main portfolio segments – Commercial Lending and Consumer Lending – and we develop and document the ALLL under separate methodologies for each of these segments as further discussed and presented below.
Allowance for Loan and Lease Losses Components
For purchased non-impaired loans, the ALLL is the sum of three components: asset specific/individual impaired reserves, quantitative (formulaic or pooled) reserves, and qualitative (judgmental) reserves. See Note 6 Purchased Impaired Loans for additional ALLL information. While we make allocations to specific loans and pools of loans, the total reserve is available for all loan and lease losses. Although quantitative modeling factors as discussed below are constantly changing as the financial strength of the borrower and overall economic conditions change, there were no significant changes to our ALLL methodology during the first three months of 2011.
Asset Specific/Individual Component
Nonperforming loans and TDRs are considered impaired and are allocated a specific reserve. See Note 1 Accounting Policies for additional information.
Commercial Lending Quantitative Component
The estimates of the quantitative component of ALLL for exposure within the commercial lending portfolio segment are determined through a statistical loss model utilizing PD, LGD, and EAD. Based upon loan risk ratings we assign PDs and LGDs. Each of these statistical parameters is determined based on historical data and observable factors including those pertaining to specific borrowers that have proven to be
statistically significant in the estimation of incurred losses. PD is influenced by such factors as liquidity, industry, obligor financial structure, access to capital, and cash flow. LGD is influenced by collateral type, LTV, and guarantees by related parties.
Consumer Lending Quantitative Component
Quantitative estimates within the consumer lending portfolio segment are calculated using a roll-rate model based on statistical relationships, calculated from historical data that estimate the movement of loan outstandings through the various stages of delinquency and ultimately charge-off. In general, the estimated rates at which loan outstandings roll from one stage of delinquency to another are dependent on various factors such as FICO, LTV ratios, the current economic environment, and geography. Within the consumer lending portfolio segment, our Asset & Liability Management Group manages $3.6 billion of purchased mortgage loans that are serviced by third parties. Asset & Liability Management uses a loan loss reserve methodology that uses delinquent balances and a loss severity assumption to calculate the level of pooled loan loss reserves to be held against the portfolio.
Qualitative Component
While our quantitative reserve methodologies strive to reflect all risk factors, there continues to be a certain element of uncertainty associated with, but not limited to, potential imprecision in the estimation process due to the inherent time lag of obtaining information and normal variations between estimates and actual outcomes. We adjust the ALLL in consideration of these factors. The ALLL also includes factors which may not be directly measured in the determination of asset specific or quantitative reserves. Such qualitative factors include:
Credit quality trends;
Loss experience in particular portfolios;
Macro economic factors; and
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Rollforward of Allowance for Loan and Lease Losses and Associated Loan Data
ALLOWANCE FOR LOAN AND LEASE LOSSES
Charge-offs
Recoveries
TDRs individually evaluated for impairment
Other loans individually evaluated for impairment
Loans collectively evaluated for impairment
LOAN PORTFOLIO
Ratio of the allowance for loan and lease losses to total loans
March 31, 2010
Originated Impaired Loans
Originated impaired loans exclude leases and smaller balance homogeneous type loans as well as purchased impaired loans, but include acquired loans that are impaired subsequent to acquisition. See Note 6 Purchased Impaired Loans for additional information. We did not recognize any interest income on originated impaired loans, including TDRs that have not returned to performing status,
while they were impaired during the three months ended March 31, 2011 and March 31, 2010. The following table provides further detail on originated impaired loans individually evaluated for reserves and the associated ALLL.
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Impaired loans with an associated allowance
Total impaired loans with an associated allowance
Impaired loans without an associated allowance
Total impaired loans without an associated allowance
Total impaired loans
Allowance for Unfunded Loan Commitments and Letters of Credit
We maintain the allowance for unfunded loan commitments and letters of credit at a level we believe is adequate to absorb estimated probable losses related to these unfunded credit facilities. See Note 1 Accounting Policies for additional information.
Rollforward of Allowance for Unfunded Loan Commitments and Letters of Credit
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NOTE 6 PURCHASED IMPAIRED LOANS
As further described in Note 6 of the 2010 Form 10-K, at December 31, 2008, we identified certain loans related to the National City acquisition, for which there was evidence of credit quality deterioration since origination and it was probable that we would be unable to collect all contractually required principal and interest payments. GAAP requires these loans to be recorded at fair value at acquisition date and prohibits the “carrying over” or the creation of valuation allowances in the initial accounting for such loans acquired in a transfer.
Purchased Impaired Loans
The excess of cash flows expected at acquisition over the estimated fair value is referred to as the accretable yield and is recognized in interest income over the remaining life of the loan using the constant effective yield method. The difference between contractually required payments at acquisition and the cash flows expected to be collected at acquisition is referred to as the nonaccretable difference. Changes in the expected cash flows of individual commercial or pooled consumer purchased impaired loans from the date of acquisition will either impact the accretable yield or result in an impairment charge to the provision for credit losses in the period in which the changes become probable. Subsequent decreases to the net present value of expected cash flows will generally result in an impairment charge to the provision for
credit losses, resulting in an increase to the allowance for loan and lease losses, and a reclassification from accretable yield to nonaccretable difference. Prepayments and interest rate decreases for variable rate notes are treated as a reduction of cash flows expected to be collected and a reduction of projections of contractual cash flows such that the nonaccretable difference is not affected. Thus, for decreases in cash flows expected to be collected resulting from prepayments and interest rate decreases for variable rate notes, the effect will be to reduce the yield prospectively.
During the first three months of 2011, $1 million of provision and $22 million of charge-offs were recorded on purchased impaired loans. As of March 31, 2011, decreases in the net present value of expected cash flows of purchased impaired loans resulted in an allowance for loan and lease losses of $876 million on $5.8 billion of the impaired loans while the remaining $1.7 billion of impaired loans required no allowance as net present value of expected cash flows improved or remained the same. Subsequent increases in the net present value of cash flows will result in a recovery of any previously recorded allowance for loan and lease losses, to the extent applicable, and a reclassification from nonaccretable difference to accretable yield, which is recognized prospectively. Disposals of loans, which may include sales of loans or foreclosures, result in removal of the loan from the purchased impaired loan portfolio at its carrying amount.
Activity for the accretable yield for the first three months of 2011 follows.
Accretable Yield
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NOTE 7 INVESTMENT SECURITIES
Investment Securities Summary
Securities Available for Sale
Total debt securities
Securities Held to Maturity
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The fair value of investment securities is impacted by interest rates, credit spreads, market volatility and liquidity conditions. Net unrealized gains and losses in the securities available for sale portfolio are included in shareholders’ equity as accumulated other comprehensive income or loss, net of tax, unless credit-related.
The following table presents gross unrealized loss and fair value of securities available for sale at March 31, 2011 and December 31, 2010. The securities are segregated between investments that have been in a continuous unrealized loss
position for less than twelve months and twelve months or more based on the point in time the fair value declined below the amortized cost basis. The table includes debt securities where a portion of other-than-temporary impairment (OTTI) has been recognized in accumulated other comprehensive loss.
The gross unrealized loss on debt securities held to maturity was $4 million at March 31, 2011 and $5 million at December 31, 2010 with $608 million and $675 million of positions in a continuous loss position for less than 12 months at March 31, 2011 and December 31, 2010, respectively.
Gross Unrealized Loss and Fair Value of Securities Available for Sale
Fair
Value
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Evaluating Investments for Other-than-Temporary Impairments
For the securities in the above table, as of March 31, 2011 we do not intend to sell and believe we will not be required to sell the securities prior to recovery of the amortized cost basis.
On at least a quarterly basis, we conduct a comprehensive security-level assessment on all securities in an unrealized loss position to determine if OTTI exists. An unrealized loss exists when the current fair value of an individual security is less than its amortized cost basis. An OTTI loss must be recognized for a debt security in an unrealized loss position if we intend to sell the security or it is more likely than not we will be required to sell the security prior to recovery of its amortized cost basis. In this situation, the amount of loss recognized in income is equal to the difference between the fair value and the amortized cost basis of the security. Even if we do not expect to sell the security, we must evaluate the expected cash flows to be received to determine if we believe a credit loss has occurred. In the event of a credit loss, only the amount of impairment associated with the credit loss is recognized in income. The portion of the unrealized loss relating to other factors, such as liquidity conditions in the market or changes in market interest rates, is recorded in accumulated other comprehensive loss.
Equity securities are also evaluated to determine whether the unrealized loss is expected to be recoverable based on whether evidence exists to support a realizable value equal to or greater than the cost basis. If it is probable that we will not recover the amortized cost basis, taking into consideration the estimated recovery period and our ability to hold the equity security until recovery, OTTI is recognized in earnings equal to the difference between the fair value and the amortized cost basis of the security.
The security-level assessment is performed on each security, regardless of the classification of the security as available for sale or held to maturity. Our assessment considers the security structure, recent security collateral performance metrics if applicable, external credit ratings, failure of the issuer to make scheduled interest or principal payments, our judgment and expectations of future performance, and relevant independent industry research, analysis and forecasts. We also consider the severity of the impairment and the length of time the security has been impaired in our assessment. Results of the periodic assessment are reviewed by a cross-functional senior management team representing Asset & Liability Management, Finance, and Market Risk Management.
The senior management team considers the results of the assessments, as well as other factors, in determining whether the impairment is other-than-temporary.
For debt securities, a critical component of the evaluation for OTTI is the identification of credit-impaired securities, where management does not expect to receive cash flows sufficient to recover the entire amortized cost basis of the security. The paragraphs below describe our process for identifying credit impairment for our most significant categories of securities not backed by the US government or its agencies.
Non-Agency Residential Mortgage-Backed Securities and Asset-Backed Securities Collateralized by First-Lien and Second-Lien Residential Mortgage Loans
Potential credit losses on these securities are evaluated on a security by security basis. Collateral performance assumptions are developed for each security after reviewing collateral composition and collateral performance statistics. This includes analyzing recent delinquency roll rates, loss severities, voluntary prepayments, and various other collateral and performance metrics. This information is then combined with general expectations on the housing market and other economic factors to develop estimates of future performance.
Security level assumptions for prepayments, loan defaults, and loss given default are applied to every security using a third-party cash flow model. The third-party cash flow model then generates projected cash flows according to the structure of each security. Based on the results of the cash flow analysis, we determine whether we will recover the amortized cost basis of our security.
Credit Impairment Assessment Assumptions – Non-Agency Residential Mortgage-Backed and Asset-Backed Securities (a)
Long-term prepayment rate (annual CPR)
Prime
Alt-A
Remaining collateral expected to default
Loss severity
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Non-Agency Commercial Mortgage-Backed Securities
Credit losses on these securities are measured using property-level cash flow projections and forward-looking property valuations. Cash flows are projected using a detailed analysis of net operating income (NOI) by property type which, in turn, is based on the analysis of NOI performance over the past several business cycles combined with PNC’s economic outlook for the current cycle. Loss severities are based on property price projections, which are calculated using capitalization rate projections. The capitalization rate projections are based on a combination of historical capitalization rates and expected capitalization rates implied by current market activity, our outlook and relevant independent industry research, analysis and forecast. Securities exhibiting weaker performance within the model are subject to further analysis. This analysis is performed at the loan level, and includes assessing local market conditions, reserves, occupancy, rent rolls and master/special servicer details.
During the first quarter of 2011 and 2010, the OTTI credit losses recognized in noninterest income related to estimated credit losses on securities that we do not expect to sell were as follows:
Summary of OTTI Credit Losses Recognized in Earnings
Available for sale securities:
Summary of OTTI Noncredit (Losses) Recoveries Included in Accumulated Other Comprehensive Loss
The following table presents a rollforward of the cumulative OTTI credit losses recognized in earnings for all debt securities for which a portion of an OTTI loss was recognized in accumulated other comprehensive loss:
Rollforward of Cumulative OTTI Credit Losses Recognized in Earnings
For the three months ended March 31, 2011
Loss where impairment was not previously recognized
Additional loss where credit impairment was previously recognized
Reduction due to credit impaired securities sold
For the three months ended March 31, 2010
December 31, 2009
Information relating to gross realized securities gains and losses from the sales of securities is set forth in the following table.
Gains (Losses) on Sales of Securities Available for Sale
For the three months ended March 31
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The following table presents, by remaining contractual maturity, the amortized cost, fair value and weighted-average yield of debt securities March 31, 2011.
Contractual Maturity of Debt Securities
Total debt securities available for sale
Weighted-average yield, GAAP basis
Total debt securities held to maturity
Based on current interest rates and expected prepayment speeds, the weighted-average expected maturity of mortgage and other asset-backed debt securities were as follows as of March 31, 2011:
Weighted-Average Expected Maturity of Mortgage and Other Asset-Backed Debt Securities
Agency mortgage-backed securities
Non-agency mortgage-backed securities
Agency commercial mortgage-backed securities
Non-agency commercial mortgage-backed securities
Asset-backed securities
Weighted-average yields are based on historical cost with effective yields weighted for the contractual maturity of each security.
The following table presents the fair value of securities that have been either pledged to or accepted from others to collateralize outstanding borrowings.
Fair Value of Securities Pledged and Accepted as Collateral
Pledged to others
Accepted from others:
Permitted by contract or custom to sell or repledge
Permitted amount repledged to others
The securities pledged to others include positions held in our portfolio of investment securities, trading securities, and securities accepted as collateral from others that we are permitted by contract or custom to sell or repledge, and were used to secure public and trust deposits, repurchase agreements, and for other purposes. The securities accepted from others that we are permitted by contract or custom to sell or repledge are a component of Federal funds sold and resale agreements on our Consolidated Balance Sheet.
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NOTE 8 FAIR VALUE
Fair Value Measurement
Fair value is defined in GAAP as the price that would be received to sell an asset or the price paid to transfer a liability on the measurement date. The standard focuses on the exit price in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants. GAAP establishes a fair value reporting hierarchy to maximize the use of observable inputs when measuring fair value and defines the three levels of inputs as noted below.
Level 1
Quoted prices in active markets for identical assets or liabilities. Level 1 assets and liabilities may include debt securities, equity securities and listed derivative contracts that are traded in an active exchange market and certain US government agency securities that are actively traded in over-the-counter markets.
Level 2
Observable inputs other than Level 1 such as: quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, or other inputs that are observable or can be corroborated to observable market data for substantially the full term of the asset or liability. Level 2 assets and liabilities may include debt securities, equity securities and listed derivative contracts with quoted prices that are traded in markets that are not active, and certain debt and equity securities and over-the-counter derivative contracts whose fair value is determined using a pricing model without significant unobservable inputs. This category generally includes agency residential and commercial mortgage-backed debt securities, asset-backed securities, corporate debt securities, residential mortgage loans held for sale, and derivative contracts.
Level 3
Unobservable inputs that are supported by minimal or no market activity and that are significant to the fair value of the assets or liabilities. Level 3 assets and liabilities may include financial instruments whose value is determined using pricing models with internally developed assumptions, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation. This category generally includes certain available for sale and trading securities, commercial mortgage loans held for sale, private equity investments, residential mortgage servicing rights, BlackRock Series C Preferred Stock and certain financial derivative contracts. The available for sale and trading securities within Level 3 include non-agency residential mortgage-backed securities, auction rate securities, certain private-issuer asset-backed securities and corporate debt
securities. Nonrecurring items, primarily certain nonaccrual and other loans held for sale, commercial mortgage servicing rights, equity investments and other assets are also included in this category.
We characterize active markets as those where transaction volumes are sufficient to provide objective pricing information, with reasonably narrow bid/ask spreads and where dealer quotes received do not vary widely and are based on current information. Inactive markets are typically characterized by low transaction volumes, price quotations which vary substantially among market participants or are not based on current information, wide bid/ask spreads, a significant increase in implied liquidity risk premiums, yields, or performance indicators for observed transactions or quoted prices compared to historical periods, a significant decline or absence of a market for new issuance, or any combination of the above factors. We also consider nonperformance risks including credit risk as part of our valuation methodology for all assets and liabilities measured at fair value.
Any models used to determine fair values or to validate dealer quotes based on the descriptions below are subject to review and independent testing as part of our model validation and internal control testing processes. Our Model Validation Committee tests significant models on at least an annual basis. In addition, we have teams, independent of the traders, verify marks and assumptions used for valuations at each period end.
Securities Available for Sale and Trading Securities
Securities accounted for at fair value include both the available for sale and trading portfolios. We use prices obtained from pricing services, dealer quotes or recent trades to determine the fair value of securities. For 53% of our positions, we use prices obtained from pricing services provided by third party vendors. For an additional 12% of our positions, we use prices obtained from the pricing services as the primary input into the valuation process. One of the vendors’ prices are set with reference to market activity for highly liquid assets such as agency mortgage-backed securities, and matrix pricing for other assets, such as CMBS and asset-backed securities. Another vendor primarily uses pricing models considering adjustments for ratings, spreads, matrix pricing and prepayments for the instruments we value using this service, such as non-agency residential mortgage-backed securities, agency adjustable rate mortgage securities, agency CMOs and municipal bonds. Management uses various methods and techniques to corroborate prices obtained from pricing services and dealers, including reference to other dealer or market quotes, by reviewing valuations of comparable instruments, or by comparison to internal valuations. Dealer quotes received are typically non-binding. In circumstances where relevant market prices are limited or unavailable, valuations may require significant management judgments or adjustments to determine fair value. In these cases, the securities are classified as Level 3.
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The valuation techniques used for securities classified as Level 3 include using a discounted cash flow approach or, in certain instances, identifying a proxy security, market transaction or index. For certain security types, primarily non-agency residential securities, the fair value methodology incorporates values obtained from a discounted cash flow model. The modeling process incorporates assumptions management believes market participants would use to value the security under current market conditions. The assumptions used include prepayment projections, credit loss assumptions, and discount rates, which include a risk premium due to liquidity and uncertainty that are based on both observable and unobservable inputs. We use the discounted cash flow analysis, in conjunction with other relevant pricing information obtained from either pricing services or broker quotes to establish the fair value that management believes is representative under current market conditions. For purposes of determining fair value at March 31, 2011 and December 31, 2010, the relevant pricing service information was the predominant input.
In the proxy approach, the proxy selected has similar credit, tenor, duration, pricing and structuring attributes to the PNC position. The price, market spread, or yield on the proxy is then used to calculate an indicative market price for the security. Depending on the nature of the PNC position and its attributes relative to the proxy, management may make additional adjustments to account for market conditions, liquidity, and nonperformance risk, based on various inputs including recent trades of similar securities, single dealer quotes, and/or other observable and unobservable inputs.
Exchange-traded derivatives are valued using quoted market prices and are classified as Level 1. However, the majority of derivatives that we enter into are executed over-the-counter and are valued using internal models. Readily observable market inputs to these models can be validated to external sources, including industry pricing services, or corroborated through recent trades, dealer quotes, yield curves, implied volatility or other market-related data. Certain derivatives, such as total rate of return swaps, are corroborated to the CMBX index. These derivatives are classified as Level 2. Derivatives priced using significant management judgment or assumptions are classified as Level 3.
The fair values of our derivatives are adjusted for nonperformance risk including credit risk as appropriate. Our nonperformance risk adjustment is computed using new loan pricing and considers externally available bond spreads, in conjunction with internal historical recovery observations. The credit risk adjustment is not currently material to the overall derivatives valuation.
Residential Mortgage Loans Held for Sale
We have elected to account for certain residential mortgage loans originated for sale on a recurring basis at fair value. Residential mortgage loans are valued based on quoted market prices, where available, prices for other traded mortgage loans with similar characteristics, and purchase commitments and bid information received from market participants. These loans are regularly traded in active markets and observable pricing information is available from market participants. The prices are adjusted as necessary to include the embedded servicing value in the loans and to take into consideration the specific characteristics of certain loans that are priced based on the pricing of similar loans. These adjustments represent unobservable inputs to the valuation but are not considered significant to the fair value of the loans. Accordingly, residential mortgage loans held for sale are classified as Level 2.
Residential mortgage servicing rights (MSRs) are carried at fair value on a recurring basis. Currently, these residential MSRs do not trade in an active open market with readily observable prices. Although sales of servicing assets do occur, the precise terms and conditions typically would not be available. Accordingly, management determines the fair value of its residential MSRs using a discounted cash flow model incorporating assumptions about loan prepayment rates, discount rates, servicing costs, and other economic factors. As part of the pricing process, management compares its fair value estimates to third-party valuations on a quarterly basis to assess the reasonableness of the fair values calculated by its internal valuation models. Due to the nature of the valuation inputs, residential MSRs are classified as Level 3.
Commercial Mortgage Loans Held for Sale
We account for certain commercial mortgage loans classified as held for sale at fair value. The election of the fair value option aligns the accounting for the commercial mortgages with the related hedges. At origination, these loans were intended for securitization.
We determine the fair value of commercial mortgage loans held for sale by using a whole loan methodology. Fair value is determined using sale valuation assumptions that management believes a market participant would use in pricing the loans. When available, valuation assumptions included observable inputs based on whole loan sales. Adjustments are made to these assumptions to account for situations when uncertainties exist, including market conditions and liquidity. Credit risk is included as part of our valuation process for these loans by considering expected rates of return for market participants for similar loans in the marketplace. Based on the significance of unobservable inputs, we classified this portfolio as Level 3.
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Equity Investments
The valuation of direct and indirect private equity investments requires significant management judgment due to the absence of quoted market prices, inherent lack of liquidity and the long-term nature of such investments. The carrying values of direct and affiliated partnership interests reflect the expected exit price and are based on various techniques including multiples of adjusted earnings of the entity, independent appraisals, anticipated financing and sale transactions with third parties, or the pricing used to value the entity in a recent financing transaction. We value indirect investments in private equity funds based on net asset value as provided in the financial statements that we receive from their managers. Due to the time lag in our receipt of the financial information and based on a review of investments and valuation techniques applied, adjustments to the manager-provided value are made when available recent portfolio company information or market information indicates a significant change in value from that provided by the manager of the fund. These investments are classified as Level 3.
Customer Resale Agreements
We have elected to account for structured resale agreements, which are economically hedged using free-standing financial
derivatives, at fair value. The fair value for structured resale agreements is determined using a model which includes observable market data such as interest rates as inputs. Readily observable market inputs to this model can be validated to external sources, including yield curves, implied volatility or other market-related data. These instruments are classified as Level 2.
BlackRock Series C Preferred Stock
We have elected to account for the 2.9 million shares of the BlackRock Series C Preferred Stock received in a stock exchange with BlackRock at fair value. The Series C Preferred Stock economically hedges the BlackRock LTIP liability that is accounted for as a derivative. The fair value of the Series C Preferred Stock is determined using a third-party modeling approach, which includes both observable and unobservable inputs. This approach considers expectations of a default/liquidation event and the use of liquidity discounts based on our inability to sell the security at a fair, open market price in a timely manner. Although dividends are equal to common shares and other preferred series, significant transfer restrictions exist on our Series C shares for any purpose other than to satisfy the LTIP obligation. Due to the significance of unobservable inputs, this security is classified as Level 3.
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Assets and liabilities measured at fair value on a recurring basis, including instruments for which PNC has elected the fair value option, follow.
Fair Value Measurements – Summary
Financial derivatives (a) (b)
Total financial derivatives
Residential mortgage loans held for sale (c)
Trading securities (d)
Debt (e)
Total trading securities
Residential mortgage servicing rights (f)
Commercial mortgage loans held for sale (c)
Direct investments
Indirect investments (g)
Total equity investments
Customer resale agreements (h)
Loans (i)
BlackRock Series C Preferred Stock (j)
Total other assets
Financial derivatives (b) (k)
BlackRock LTIP
Trading securities sold short (l)
Total trading securities sold short
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Reconciliations of assets and liabilities measured at fair value on a recurring basis using Level 3 inputs for the three months ended March 31, 2011 and 2010 follow.
Three Months Ended March 31, 2011
(*) Attributableto unrealizedgains orlosses relatedto assets andliabilitiesheld at
March 31,2011
Level 3 Instruments Only
Residential mortgage-backed non-agency
Trading securities – Debt
Indirect investments
Total liabilities (c)
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Three Months Ended March 31, 2010
Residential mortgage-backed agency
Commercial mortgage-backed non-agency
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Net gains (realized and unrealized) included in earnings relating to Level 3 assets and liabilities were $102 million for the first three months of 2011 compared with net losses of $80 million for the first three months of 2010. These amounts included net unrealized gains of $68 million and amortization and accretion of $24 million for the first three months of 2011 compared with net unrealized losses of $95 million and amortization and accretion of $32 million for the first three months of 2010. The amortization and accretion amounts were included in interest income, and all other amounts were included in noninterest income on the Consolidated Income Statement.
During the first three months of 2011 and 2010, no material transfers of assets or liabilities between the hierarchy levels occurred.
Nonrecurring Fair Value Changes
We may be required to measure certain other financial assets at fair value on a nonrecurring basis. These adjustments to fair value usually result from the application of lower-of-cost-or-fair value accounting or write-downs of individual assets due to impairment.
The amounts below for nonaccrual loans represent the carrying value of loans for which adjustments are primarily based on the appraised value of collateral or the net book
value of the collateral from the borrower’s most recent financial statements if no appraisal is available. If an appraisal is outdated due to changed project or market conditions, or if the net book value is utilized, management applies internal assumptions in determining fair value. The amounts below for loans held for sale represent the carrying value of loans for which adjustments are primarily based on observable market data, management’s internal assumptions or the appraised value of collateral. The fair value determination of the equity investment resulting in an impairment loss included below was based on observable market data for other comparable entities as adjusted for internal assumptions and unobservable inputs. The amounts below for commercial mortgage servicing rights reflect an impairment of three strata at March 31, 2011 and at December 31, 2010, respectively. The fair value of commercial mortgage servicing rights is estimated by using an internal valuation model. The model calculates the present value of estimated future net servicing cash flows considering estimates of servicing revenue and costs, discount rates and prepayment speeds. The amounts below for long-lived assets held for sale represent the carrying value of the asset for which adjustments are primarily based upon the most recent appraised value or, if the net book value is utilized, management applies internal assumptions in determining fair value.
Fair Value Measurements – Nonrecurring (a)
Gains (Losses)
Three months ended
Nonaccrual loans
Commercial mortgage servicing rights
Long-lived assets held for sale
Fair Value Option
Refer to the Fair Value Measurement section of this Note 8 regarding the fair value of commercial mortgage loans held for sale, residential mortgage loans held for sale, customer resale agreements, and BlackRock Series C Preferred Stock.
Interest income on these loans is recorded as earned and reported on the Consolidated Income Statement in other interest income. The impact on earnings of offsetting economic hedges is not reflected in these amounts. Changes in fair value due to instrument-specific credit risk for both the first three months of 2011 and 2010 were not material.
Interest income on these loans is recorded as earned and reported on the Consolidated Income Statement in other interest income. Throughout 2010 and the first three months of 2011, certain residential mortgage loans for which we elected the fair value option were subsequently reclassified to portfolio loans. Changes in fair value due to instrument-specific credit risk for the first three months of 2011 and 2010 were not material.
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Interest income on structured resale agreements is reported on the Consolidated Income Statement in other interest income. Changes in fair value due to instrument-specific credit risk for both the first three months of 2011 and 2010 were not material.
The changes in fair value included in noninterest income for items for which we elected the fair value option follow.
Fair Value Option – Changes in Fair Value (a)
Residential mortgage loans – portfolio
Fair values and aggregate unpaid principal balances of items for which we elected the fair value option follow.
Fair Value Option – Fair Value and Principal Balances
Performing loans
Loans 90 days or more past due
Commercial mortgage loans held for sale (a)
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ADDITIONAL FAIR VALUE INFORMATIONRELATED TO FINANCIAL INSTRUMENTS
Cash and short-term assets
Net loans (excludes leases)
Mortgage servicing rights
Designated as hedging instruments under GAAP
Not designated as hedging instruments under GAAP
Demand, savings and money market deposits
Time deposits
Unfunded loan commitments and letters of credit
The aggregate fair values in the table above do not represent the total market value of PNC’s assets and liabilities as the table excludes the following:
real and personal property,
lease financing,
loan customer relationships,
deposit customer intangibles,
retail branch networks,
fee-based businesses, such as asset management and brokerage, and
trademarks and brand names.
We used the following methods and assumptions to estimate fair value amounts for financial instruments.
General
For short-term financial instruments realizable in three months or less, the carrying amount reported on our Consolidated Balance Sheet approximates fair value. Unless otherwise stated, the rates used in discounted cash flow analyses are based on market yield curves.
Cash and Short-Term Assets
The carrying amounts reported on our Consolidated Balance Sheet for cash and short-term investments approximate fair values primarily due to their short-term nature. For purposes of this disclosure only, short-term assets include the following:
due from banks,
interest-earning deposits with banks,
federal funds sold and resale agreements,
cash collateral,
customers’ acceptances, and
accrued interest receivable.
Securities include both the investment securities (comprised of available for sale and held to maturity securities) and trading portfolios. We use prices obtained from pricing services, dealer quotes or recent trades to determine the fair value of securities. For 55% of our positions, we use prices obtained from pricing services provided by third party vendors. For an additional 11% of our positions, we use prices obtained from the pricing services as the primary input into the valuation process. One of the vendors’ prices are set with reference to market activity for highly liquid assets such as agency mortgage-backed securities, and matrix pricing for other assets, such as CMBS and asset-backed securities. Another vendor primarily uses pricing models considering adjustments for ratings, spreads, matrix pricing and prepayments for the instruments we value using this service, such as non-agency residential mortgage-backed securities, agency adjustable rate mortgage securities, agency CMOs and municipal bonds. Management uses various methods and techniques to corroborate prices obtained from pricing services and dealers, including reference to other dealers’ quotes, by reviewing valuations of comparable instruments, or by comparison to internal valuations. Dealer quotes received are typically non-binding.
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NET LOANS AND LOANS HELDFOR SALE
Fair values are estimated based on the discounted value of expected net cash flows incorporating assumptions about prepayment rates, net credit losses and servicing fees. For purchased impaired loans, fair value is assumed to equal PNC’s recorded investment, which represents the present value of expected future principal and interest cash flows, as adjusted for any ALLL recorded for these loans. See Note 6 Purchased Impaired Loans for additional information. For revolving home equity loans and commercial credit lines, this fair value does not include any amount for new loans or the related fees that will be generated from the existing customer relationships. Non-accrual loans are valued at their estimated recovery value. Also refer to the Fair Value Measurement and Fair Value Option sections of this Note 8 regarding the fair value of commercial and residential mortgage loans held for sale. Loans are presented net of the ALLL and do not include future accretable discounts related to purchased impaired loans.
OTHER ASSETS
Other assets as shown in the accompanying table include the following:
FHLB and FRB stock,
equity investments carried at cost and fair value, and
BlackRock Series C Preferred Stock.
Investments accounted for under the equity method, including our investment in BlackRock, are not included in the accompanying table.
The carrying amounts of private equity investments are recorded at fair value. The valuation procedures applied to direct investments and affiliated partnership interests include techniques such as multiples of adjusted earnings of the entity, independent appraisals, anticipated financing and sales transactions with third parties, or the pricing used to value the entity in a recent financing transaction. We value indirect investments in private equity funds based on net asset value as provided in the financial statements that we receive from their managers. Due to the time lag in our receipt of the financial information and based on a review of investments and valuation techniques applied, adjustments to the manager-provided value are made when available recent investment portfolio company or market information indicates a significant change in value from that provided by the general partner.
Fair value of the noncertificated interest-only strips is estimated based on the discounted value of expected net cash flows. The aggregate carrying value of our investments that
are carried at cost and FHLB and FRB stock was $2.2 billion at March 31, 2011 and $2.4 billion as of December 31, 2010, both of which approximate fair value at each date.
MORTGAGE SERVICING ASSETS
Fair value is based on the present value of the estimated future cash flows, incorporating assumptions as to prepayment speeds, discount rates, escrow balances, interest rates, cost to service and other factors.
The key valuation assumptions for commercial and residential mortgage loan servicing assets at March 31, 2011 and December 31, 2010 are included in Note 9 Goodwill and Other Intangible Assets.
CUSTOMER RESALEAGREEMENTS
Refer to the Fair Value Measurement section of this Note 8 regarding the fair value of customer resale agreements.
DEPOSITS
The carrying amounts of noninterest-bearing demand and interest-bearing money market and savings deposits approximate fair values. For time deposits, which include foreign deposits, fair values are estimated based on the discounted value of expected net cash flows assuming current interest rates.
BORROWEDFUNDS
The carrying amounts of Federal funds purchased, commercial paper, repurchase agreements, proprietary trading short positions, cash collateral, other short-term borrowings, acceptances outstanding and accrued interest payable are considered to be their fair value because of their short-term nature. For all other borrowed funds, fair values are estimated primarily based on dealer quotes or discounted cash flow analysis.
UNFUNDED LOANCOMMITMENTS AND LETTERS OF CREDIT
The fair value of unfunded loan commitments and letters of credit is determined from a market participant’s view including the impact of changes in interest rates, credit and other factors. Because the interest rate on substantially all unfunded loan commitments and letters of credit varies with changes in market rates, these instruments are subject to little fluctuation in fair value due to changes in interest rates. We establish a liability on these facilities related to their creditworthiness.
FINANCIAL DERIVATIVES
Refer to the Fair Value Measurement section of this Note 8 regarding the fair value of financial derivatives.
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NOTE 9 GOODWILL AND OTHERINTANGIBLE ASSETS
Changes in goodwill and other intangible assets during the first three months of 2011 follow:
Summary of Changes in Goodwill and Other Intangible Assets
Additions/adjustments:
Mortgage and other loan servicing rights
Impairment charge
Amortization
Assets and liabilities of acquired entities are recorded at estimated fair value as of the acquisition date and are subject to refinement as information relative to the fair values at the date of acquisition becomes available.
Our investment in BlackRock changes when BlackRock repurchases its shares in the open market or issues shares for an acquisition or pursuant to its employee compensation plans. We adjust goodwill when BlackRock repurchases its shares at an amount greater (or less) than book value per share which results in an increase (or decrease) in our percentage ownership interest.
The gross carrying amount, accumulated amortization and net carrying amount of other intangible assets by major category consisted of the following:
Other Intangible Assets
Customer-related and other intangibles
Gross carrying amount
Accumulated amortization
Net carrying amount
Valuation allowance
While certain of our other intangible assets have finite lives and are amortized primarily on a straight-line basis, certain core deposit intangibles are amortized on an accelerated basis.
For customer-related and other intangibles, the estimated remaining useful lives range from less than one year to 10 years, with a weighted-average remaining useful life of 9 years.
Amortization expense on existing intangible assets, net of impairment reversal (charge) follows:
Amortization Expense on Existing Intangible Assets, Net (a)
Three months ended March 31, 2011
Three months ended March 31, 2010
Remainder of 2011
2012
2013
2014
2015
2016
Changes in commercial mortgage servicing rights follow:
Commercial Mortgage Servicing Rights
Additions (a)
Impairment (charge) reversal
Amortization expense
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We recognize as an other intangible asset the right to service mortgage loans for others. Commercial mortgage servicing rights are purchased in the open market and originated when loans are sold with servicing retained. Commercial mortgage servicing rights are initially recorded at fair value. These rights are subsequently measured using the amortization method. Accordingly, the commercial mortgage servicing rights are substantially amortized in proportion to and over the period of estimated net servicing income over a period of 5 to 10 years.
Commercial mortgage servicing rights are periodically evaluated for impairment. For purposes of impairment, the commercial mortgage servicing rights are stratified based on asset type, which characterizes the predominant risk of the underlying financial asset. If the carrying amount of any individual stratum exceeds its fair value, a valuation reserve is established with a corresponding charge to Corporate Services on our Consolidated Income Statement.
The fair value of commercial mortgage servicing rights is estimated by using an internal valuation model. The model calculates the present value of estimated future net servicing cash flows considering estimates on servicing revenue and costs, discount rates and prepayment speeds.
Changes in the residential mortgage servicing rights follow:
Additions:
From loans sold with servicing retained
Changes in fair value due to:
Time and payoffs (a)
Other (b)
Unpaid principal balance of loans serviced for others at March 31
We recognize mortgage servicing right assets on residential real estate loans when we retain the obligation to service these loans upon sale and the servicing fee is more than adequate compensation. Mortgage servicing rights are subject to declines in value principally from actual or expected prepayment of the underlying loans and defaults. We manage this risk by economically hedging the fair value of mortgage servicing rights with securities and derivative instruments which are expected to increase in value when the value of mortgage servicing rights declines.
The fair value of residential mortgage servicing rights is estimated by using third party software with internal valuation assumptions. The software calculates the present value of estimated future net servicing cash flows considering estimates on servicing revenue and costs, discount rates, prepayment speeds and future mortgage rates.
The fair value of residential and commercial MSRs and significant inputs to the valuation model as of March 31, 2011 are shown in the tables below. The expected and actual rates of mortgage loan prepayments are significant factors driving the fair value. Management uses a third party model to estimate future residential mortgage loan prepayments and internal proprietary models to estimate future commercial mortgage loan prepayments. These models have been refined based on historical performance of PNC’s managed portfolio, as adjusted for current market conditions. Future interest rates are another important factor in the valuation of MSRs. Management utilizes market implied forward interest rates to estimate the future direction of mortgage and discount rates. Changes in the shape and slope of the forward curve in future periods may result in volatility in the fair value estimate.
A sensitivity analysis of the hypothetical effect on the fair value of MSRs to adverse changes in key assumptions is presented below. These sensitivities do not include the impact of the related hedging activities. Changes in fair value generally cannot be extrapolated because the relationship of the change in the assumption to the change in fair value may not be linear. Also, the effect of a variation in a particular assumption on the fair value of the MSRs is calculated independently without changing any other assumption. In reality, changes in one factor may result in changes in another (for example, changes in mortgage interest rates, which drive changes in prepayment rate estimates, could result in changes in the interest rate spread), which could either magnify or counteract the sensitivities.
The following tables set forth the fair value of commercial and residential MSRs and the sensitivity analysis of the hypothetical effect on the fair value of MSRs to immediate adverse changes of 10% and 20% in those assumptions:
Commercial Mortgage Loan Servicing Assets – Key Valuation Assumptions
Weighted-average life (years)
Weighted-average constant prepayment rate
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Residential Mortgage Loan Servicing Assets – Key Valuation Assumptions
Revenue from mortgage and other loan servicing comprised of contractually specified servicing fees, late fees, and ancillary fees follows:
Revenue from Mortgage and Other Loan Servicing
We also generate servicing revenue from fee-based activities provided to others.
Revenue from commercial mortgage servicing rights, residential mortgage servicing rights and other loan servicing are reported on our Consolidated Income Statement in the line items Corporate services, Residential mortgage, and Consumer services, respectively.
NOTE 10 CAPITAL SECURITIES OFSUBSIDIARY TRUSTS AND PERPETUAL TRUST SECURITIES
CAPITAL SECURITIES OF SUBSIDIARY TRUSTS
Our capital securities of subsidiary trusts are described in Note 13 Capital Securities of Subsidiary Trusts and Perpetual Trust Securities in our 2010 Form 10-K. All of these Trusts are wholly owned finance subsidiaries of PNC. In the event of certain changes or amendments to regulatory requirements or federal tax rules, the capital securities are redeemable. The financial statements of the Trusts are not included in PNC’s consolidated financial statements in accordance with GAAP.
The obligations of the respective parent of each Trust, when taken collectively, are the equivalent of a full and unconditional guarantee of the obligations of such Trust under the terms of the capital securities. Such guarantee is subordinate in right of payment in the same manner as other
junior subordinated debt. There are certain restrictions on PNC’s overall ability to obtain funds from its subsidiaries. For additional disclosure on these funding restrictions, including an explanation of dividend and intercompany loan limitations, see Note 21 Regulatory Matters in our 2010 Form 10-K.
PNC is also subject to restrictions on dividends and other provisions potentially imposed under the Exchange Agreements with Trust II and Trust III, as described in Note 13 in our 2010 Form 10-K in the Perpetual Trust Securities section, and to other provisions similar to or in some ways more restrictive than those potentially imposed under those agreements.
PERPETUAL TRUSTSECURITIES
We issue certain hybrid capital vehicles that qualify as capital for regulatory purposes.
In February 2008, PNC Preferred Funding LLC (the LLC), one of our indirect subsidiaries, sold $375 million of 8.700% Fixed-to-Floating Rate Non-Cumulative Exchangeable Perpetual Trust Securities of PNC Preferred Funding Trust III (Trust III) to third parties in a private placement. In connection with the private placement, Trust III acquired $375 million of Fixed-to-Floating Rate Non-Cumulative Perpetual Preferred Securities of the LLC (the LLC Preferred Securities). The sale was similar to the March 2007 private placement by the LLC of $500 million of 6.113% Fixed-to-Floating Rate Non-Cumulative Exchangeable Trust Securities (the Trust II Securities) of PNC Preferred Funding Trust II (Trust II) in which Trust II acquired $500 million of LLC Preferred Securities and to the December 2006 private placement by PNC REIT Corp. of $500 million of 6.517% Fixed-to-Floating Rate Non-Cumulative Exchangeable Perpetual Trust Securities (the Trust I Securities) of PNC Preferred Funding Trust I (Trust I) in which Trust I acquired $500 million of LLC Preferred Securities. PNC REIT Corp. owns 100% of LLC’s common voting securities. As a result, LLC is an indirect subsidiary of PNC and is consolidated on our Consolidated Balance Sheet. Trust I, II and III’s investment in LLC Preferred Securities is characterized as a noncontrolling interest on our Consolidated Balance Sheet since we are not the primary beneficiary of Trust I, Trust II and Trust III. This noncontrolling interest totaled $1.3 billion at March 31, 2011.
Our 2010 Form 10-K includes additional information regarding the Trust I and Trust II Securities, including descriptions of replacement capital and dividend restriction covenants. The Trust III Securities include dividend restriction covenants similar to those described for Trust II Securities.
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NOTE 11 CERTAIN EMPLOYEE BENEFITAND STOCK-BASED COMPENSATION PLANS
PENSION AND POSTRETIREMENT PLANS
As described in Note 14 Employee Benefit Plans in our 2010 Form 10-K, we have a noncontributory, qualified defined benefit pension plan covering eligible employees. Benefits are determined using a cash balance formula where earnings credits are a percentage of eligible compensation. Pension contributions are based on an actuarially determined amount necessary to fund total benefits payable to plan participants.
We also maintain nonqualified supplemental retirement plans for certain employees and provide certain health care and life insurance benefits for qualifying retired employees (postretirement benefits) through various plans. The nonqualified pension and postretirement benefit plans are unfunded. The Company reserves the right to terminate or make plan changes at any time.
The components of our net periodic pension and post-retirement benefit cost for the first three months of 2011 and 2010 were as follows:
Net Periodic Pension and Postretirement Benefits Costs
Net periodic cost consists of:
Service cost
Interest cost
Expected return on plan assets
Amortization of prior service cost
Amortization of actuarial losses
Net periodic cost (benefit)
STOCK-BASED COMPENSATION PLANS
As more fully described in Note 15 Stock-Based Compensation Plans in our 2010 Form 10-K, we have long-term incentive award plans (Incentive Plans) that provide for the granting of incentive stock options, nonqualified stock options, stock appreciation rights, incentive shares/performance units, restricted stock, restricted share units, other share-based awards and dollar-denominated awards to executives and, other than incentive stock options, to non-employee directors. Certain Incentive Plan awards may be paid in stock, cash or a combination of stock and cash. We typically grant a substantial portion of our stock-based compensation awards during the first quarter of the year. As of March 31, 2011, no stock appreciation rights were outstanding.
Total compensation expense recognized related to all share-based payment arrangements during the first three months of 2011 and 2010 was $30 million and $27 million, respectively.
NONQUALIFIED STOCK OPTIONS
Options are granted at exercise prices not less than the market value of common stock on the grant date. Generally, options become exercisable in installments after the grant date. No option may be exercisable after 10 years from its grant date. Payment of the option exercise price may be in cash or shares of common stock at market value on the exercise date. The exercise price may be paid in previously owned shares.
For purposes of computing stock option expense, we estimated the fair value of stock options primarily by using the Black-Scholes option-pricing model. Option pricing models require the use of numerous assumptions, many of which are very subjective.
Option Pricing Assumptions
Weighted-average for the three months ended
Risk-free interest rate
Dividend yield
Volatility
Expected life
Grant-date fair value
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Stock Option Rollforward
PNC OptionsConverted FromNational City
Options
Outstanding at December 31, 2010
Granted
Exercised
Cancelled
Outstanding at March 31, 2011
Exercisable at March 31, 2011
During the first three months of 2011 we issued 108,150 shares from treasury stock in connection with stock option exercise activity. As with past exercise activity, we currently intend to utilize treasury stock primarily for any future stock option exercises.
INCENTIVE/PERFORMANCE UNIT SHARE AWARDS AND RESTRICTEDSTOCK/UNIT AWARDS
The fair value of nonvested incentive/performance unit share awards and restricted stock/unit awards is initially determined based on prices not less than the market value of our common stock price on the date of grant. The value of certain incentive/performance unit share awards are subsequently remeasured based on the achievement of one or more financial and other performance goals over a three-year period. The Personnel and Compensation Committee of the Board of Directors approves the final award payout with respect to incentive/performance unit share awards. Restricted stock/unit awards have various vesting periods generally ranging from 36 months to 60 months.
Beginning in 2011, we incorporated two changes to certain awards under our existing long-term incentive compensation programs. For certain grants of incentive performance units, the future payout amount will be subject to a negative annual adjustment if PNC fails to meet certain risk-related performance metrics. This adjustment is in addition to the existing financial performance metrics relative to our peers. These grants have a three-year performance period and are payable in either stock or a combination of stock and cash.
Additionally, performance-based restricted share units (performance RSUs) were granted in 2011 to certain of our executives in lieu of stock options. These performance RSUs have a service condition, an internal risk-related performance condition, and an external market condition. Satisfaction of the performance condition is based on four independent one-year performance periods and are payable solely in stock.
Nonvested Incentive/Performance Unit Share Awards and Restricted Stock/Unit Awards — Rollforward
Vested/Released
Forfeited
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In the chart above, the unit shares and related weighted-average grant-date fair value of the incentive/performance awards exclude the effect of dividends on the underlying shares, as those dividends will be paid in cash.
At March 31, 2011, there was $88 million of unrecognized deferred compensation expense related to nonvested share-based compensation arrangements granted under the Incentive Plans. This cost is expected to be recognized as expense over a period of no longer than five years.
LIABILITY AWARDS
Beginning in 2008, we granted cash-payable restricted share units to certain executives. The grants were made primarily as part of an annual bonus incentive deferral plan. While there are time-based and service-related vesting criteria, there are no market or performance criteria associated with these awards. Compensation expense recognized related to these awards was recorded in prior periods as part of annual cash bonus criteria. As of March 31, 2011, there were 764,979 of these cash-payable restricted share units outstanding.
During the third quarter of 2009, we entered into an agreement with certain of our executives regarding a portion of their salary to be payable in stock units. These units, which are cash-payable, have no future service, market or performance criteria and as such are fully expensed at grant date. These units totaled 280,174 at December 31, 2010 and were settled in cash on March 31, 2011 for approximately $18 million.
Nonvested Cash-Payable Restricted Share Unit—Rollforward
Vested and Released
NOTE 12 FINANCIAL DERIVATIVES
We use derivative financial instruments (derivatives) primarily to help manage exposure to interest rate, market and credit risk and reduce the effects that changes in interest rates may have on net income, fair value of assets and liabilities, and cash flows. We also enter into derivatives with customers to facilitate their risk management activities.
Derivatives represent contracts between parties that usually require little or no initial net investment and result in one party delivering cash or another type of asset to the other party based on a notional amount and an underlying as specified in
the contract. Derivative transactions are often measured in terms of notional amount, but this amount is generally not exchanged and it is not recorded on the balance sheet. The notional amount is the basis to which the underlying is applied to determine required payments under the derivative contract. The underlying is a referenced interest rate, commonly LIBOR, security price, credit spread or other index. Certain contracts and commitments, such as residential and commercial real estate loan commitments associated with loans to be sold, also qualify as derivative instruments.
All derivatives are carried on our Consolidated Balance Sheet at fair value. Derivative balances are presented on a net basis taking into consideration the effects of legally enforceable master netting agreements. Cash collateral exchanged with counterparties is also netted against the applicable derivative fair values.
Further discussion on how derivatives are accounted for is included in Note 1 Accounting Policies in our 2010 Form 10-K.
Derivatives Designated in Hedge Relationships
Certain derivatives used to manage interest rate risk as part of our asset and liability risk management activities are designated as accounting hedges under GAAP. Derivatives hedging the risks associated with changes in the fair value of assets or liabilities are considered fair value hedges, while derivatives hedging the variability of expected future cash flows are considered cash flow hedges. Designating derivatives as accounting hedges allows for gains and losses
on those derivatives, to the extent effective, to be recognized in the income statement in the same period the hedged items affect earnings.
Cash Flow Hedges
We enter into receive-fixed, pay-variable interest rate swaps to modify the interest rate characteristics of designated commercial loans from variable to fixed in order to reduce the impact of changes in future cash flows due to market interest rate changes. For these cash flow hedges, any changes in the fair value of the derivatives that are effective in offsetting changes in the forecasted interest cash flows are recorded in accumulated other comprehensive income and are reclassified to interest income in conjunction with the recognition of interest receipts on the loans. In the 12 months that follow March 31, 2011, we expect to reclassify from the amount currently reported in accumulated other comprehensive income net derivative gains of $382 million pretax, or $248 million after-tax, in association with interest receipts on the hedged loans. This amount could differ from amounts actually recognized due to changes in interest rates, hedge dedesignations, and the addition of other hedges subsequent to March 31, 2011. The maximum length of time over which
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forecasted loan cash flows are hedged is 10 years. We use statistical regression analysis to assess the effectiveness of these hedge relationships at both the inception of the hedge relationship and on an ongoing basis.
We also periodically enter into forward purchase and sale contracts to hedge the variability of the consideration that will be paid or received related to the purchase or sale of debt securities classified as available for sale. The forecasted purchase or sale is consummated upon gross settlement of the forward contract itself. As a result, hedge ineffectiveness, if any, is typically minimal. Gains and losses on these forward contracts are recorded in accumulated other comprehensive income and are recognized in earnings when the hedged cash flows affect earnings. In the 12 months that follow March 31, 2011, we expect to reclassify from the amount currently reported in accumulated other comprehensive loss, net derivative gains of $29 million pretax, or $19 million after-tax, as adjustments of yield on securities available for sale. The maximum length of time we are hedging forecasted purchases is three months. There were no amounts in accumulated other comprehensive income related to the forecasted sale of securities at March 31, 2011.
There were no components of derivative gains or losses excluded from the assessment of hedge effectiveness related to either cash flow hedge strategy.
During the first three months of 2011 and 2010, there were no gains or losses from cash flow hedge derivatives reclassified to earnings because it became probable that the original forecasted transaction would not occur.
Fair Value Hedges
We enter into receive-fixed, pay-variable interest rate swaps to hedge changes in the fair value of outstanding fixed-rate debt and borrowings caused by fluctuations in market interest rates. The specific products hedged include bank notes, Federal Home Loan Bank borrowings, and senior and subordinated debt. We also enter into pay-fixed, receive- variable interest rate swaps to hedge changes in the fair value of fixed rate investment securities caused by fluctuations in market interest rates. The specific products hedged include US Treasury, government agency and other debt securities. For these hedge relationships, we use statistical regression analysis to assess hedge effectiveness at both the inception of the hedge relationship and on an ongoing basis. There were no components of derivative gains or losses excluded from the assessment of hedge effectiveness.
Further detail regarding the notional amounts, fair values and gains and losses recognized related to derivatives used in fair value and cash flow hedge strategies is presented in the tables that follow.
The ineffective portion of the change in value of our fair value and cash flow hedge derivatives resulted in net losses of $6
million for the first three months of 2011 compared with net losses of less than $1 million for the first three months of 2010.
Derivatives Not Designated in Hedge Relationships
We also enter into derivatives which are not designated as accounting hedges under GAAP.
The majority of these derivatives are used to manage risk related to residential and commercial mortgage banking activities and are considered economic hedges. Although these derivatives are used to hedge risk, they are not designated as accounting hedges because the contracts they are hedging are typically also carried at fair value on the balance sheet, resulting in symmetrical accounting treatment for both the hedging instrument and the hedged item.
Our residential mortgage banking activities consist of originating, selling and servicing mortgage loans. Residential mortgage loans that will be sold in the secondary market, and the related loan commitments, which are considered derivatives, are accounted for at fair value. Changes in the fair value of the loans and commitments due to interest rate risk are hedged with forward loan sale contracts and Treasury and Eurodollar futures and options. Gains and losses on the loans and commitments held for sale and the derivatives used to economically hedge them are included in residential mortgage noninterest income on the Consolidated Income Statement.
We typically retain the servicing rights related to residential mortgage loans that we sell. Residential mortgage servicing rights are accounted for at fair value with changes in fair value influenced primarily by changes in interest rates. Derivatives used to hedge the fair value of residential mortgage servicing rights include interest rate futures, swaps and options, including caps, floors, and swaptions, and forward contracts to purchase mortgage-backed securities. Gains and losses on residential mortgage servicing rights and the related derivatives used for hedging are included in residential mortgage noninterest income.
Certain commercial mortgage loans are also sold into the secondary market as part of our commercial mortgage banking activities and are accounted for at fair value. Derivatives used to economically hedge these loans and commitments from changes in fair value due to interest rate risk and credit risk include forward loan sale contracts, interest rate swaps, and credit default swaps. Gains and losses on the commitments, loans and derivatives are included in other noninterest income.
The residential and commercial loan commitments associated with loans to be sold which are accounted for as derivatives are valued based on the estimated fair value of the underlying loan and the probability that the loan will fund within the terms of the commitment. The fair value also takes into account the fair value of the embedded servicing right.
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We offer derivatives to our customers in connection with their risk management needs. These derivatives primarily consist of interest rate swaps, interest rate caps, floors, swaptions, and foreign exchange and equity contracts. We primarily manage our market risk exposure from customer transactions by entering into offsetting derivative transactions with third-party dealers. Gains and losses on customer-related derivatives are included in other noninterest income.
The derivatives portfolio also includes derivatives used for other risk management activities. These derivatives are entered into based on stated risk management objectives.
This segment of the portfolio includes credit default swaps (CDS) used to mitigate the risk of economic loss on a portion of our loan exposure. We also sell loss protection to mitigate the net premium cost and the impact of mark-to-market accounting on CDS purchases to hedge the loan portfolio. The fair values of these derivatives typically are based on related credit spreads. Gains and losses on the derivatives entered into for other risk management are included in other noninterest income.
Included in the customer, mortgage banking risk management, and other risk management portfolios are written interest-rate caps and floors entered into with customers and for risk management purposes. We receive an upfront premium from the counterparty and are obligated to make payments to the counterparty if the underlying market interest rate rises above or falls below a certain level designated in the contract. At March 31, 2011, the fair value of the written caps and floors liability on our Consolidated Balance Sheet was $16 million compared with $15 million at December 31, 2010. Our ultimate obligation under written options is based on future market conditions and is only quantifiable at settlement.
Further detail regarding the derivatives not designated in hedging relationships is presented in the tables that follow.
Derivative Counterparty Credit Risk
By entering into derivative contracts we are exposed to credit risk. We seek to minimize credit risk through internal credit approvals, limits, monitoring procedures, executing master netting agreements and collateral requirements. We generally enter into transactions with counterparties that carry high quality credit ratings. Nonperformance risk including credit risk is included in the determination of the estimated net fair value.
We generally have established agreements with our major derivative dealer counterparties that provide for exchanges of marketable securities or cash to collateralize either party’s positions. At March 31, 2011, we held cash, US government securities and mortgage-backed securities totaling $980 million under these agreements. We pledged cash of $642 million under these agreements. To the extent not netted against derivative fair values under a master netting agreement, cash pledged is included in Other assets and cash held is included in Other borrowed funds on our Consolidated Balance Sheet.
The credit risk associated with derivatives executed with customers is essentially the same as that involved in extending loans and is subject to normal credit policies. We may obtain collateral based on our assessment of the customer’s credit quality.
We periodically enter into risk participation agreements to share some of the credit exposure with other counterparties related to interest rate derivative contracts or to take on credit exposure to generate revenue. We will make/receive payments under these agreements if a customer defaults on its obligation to perform under certain derivative swap contracts. Risk participation agreements are included in the derivatives table that follows. Our exposure related to risk participations where we sold protection is discussed in the Credit Derivatives section below.
Contingent Features
Some of PNC’s derivative instruments contain provisions that require PNC’s debt to maintain an investment grade credit rating from each of the major credit rating agencies. If PNC’s debt ratings were to fall below investment grade, it would be in violation of these provisions, and the counterparties to the derivative instruments could request immediate payment or demand immediate and ongoing full overnight collateralization on derivative instruments in net liability positions.
The aggregate fair value of all derivative instruments with credit-risk-related contingent features that were in a net liability position on March 31, 2011 was $825 million for which PNC had posted collateral of $627 million in the normal course of business. The maximum amount of collateral PNC would have been required to post if the credit-risk-related contingent features underlying these agreements had been triggered on March 31, 2011, would be an additional $198 million.
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Derivatives Total Notional or Contractual Amounts and Estimated Net Fair Values
Derivatives designated as hedging instruments under GAAP
Interest rate contracts:
Cash flow hedges
Fair value hedges
Total derivatives designated as hedging instruments
Residential mortgage servicing
Loan sales
Subtotal
Credit contracts:
Equity contracts
Other contracts (c)
Less: Legally enforceable master netting agreements
Less: Cash collateral
Total Net Derivatives
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Gains (losses) on derivative instruments and related hedged items follow:
Derivatives Designated in GAAP Hedge Relationships – Fair Value Hedges
Derivatives Designated in GAAP Hedge Relationships – Cash Flow Hedges
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Derivatives Not Designated as Hedging Instruments under GAAP
Gains (losses) included in residential mortgage banking activities (a)
Gains (losses) from commercial mortgage banking activities (b)
Gains (losses) from customer-related activities (b)
Gains (losses) from other risk management activities (b)
Total gains (losses) from derivatives not designated as hedging instruments
CREDIT DERIVATIVES
The credit derivative underlying is based on the credit risk of a specific entity, entities, or an index. As discussed above, we enter into credit derivatives, specifically credit default swaps and risk participation agreements, as part of our commercial mortgage banking hedging activities and for customer and other risk management purposes. Detail regarding credit default swaps and risk participations sold follows:
Credit Default Swaps
Credit Default Swaps – Sold
Single name
Index traded
Credit Default Swaps – Purchased
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The notional amount of these credit default swaps by credit rating follows:
Credit Ratings of Credit Default Swaps
Investment grade (a)
Subinvestment grade (b)
The referenced/underlying assets for these credit default swaps follow:
Referenced/Underlying Assets of Credit Default Swaps
We enter into credit default swaps under which we buy loss protection from or sell loss protection to a counterparty for the occurrence of a credit event related to a referenced entity or index. The maximum amount we would be required to pay under the credit default swaps in which we sold protection, assuming all referenced underlyings experience a credit event at a total loss, without recoveries, was $263 million at March 31, 2011 and $234 million at December 31, 2010.
Risk Participation Agreements
We have sold risk participation agreements with terms ranging from less than one year to 26 years. We will be required to make payments under these agreements if a customer defaults on its obligation to perform under certain derivative swap contracts with third parties.
Risk Participation Agreements Sold
Based on our internal risk rating process of the underlying third parties to the swap contracts, the percentages of the exposure amount of risk participation agreements sold by internal credit rating follow:
Internal Credit Ratings of Risk Participation Agreements Sold
Pass (a)
Below pass (b)
Assuming all underlying swap counterparties defaulted at March 31, 2011, the exposure from these agreements would be $76 million based on the fair value of the underlying swaps, compared with $49 million at December 31, 2010.
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NOTE 13 EARNINGS PER SHARE
Basic and Diluted Earnings per Common Share
Net income from continuing operations
Dividends distributed to common shareholders
Dividends distributed to preferred shareholders
Undistributed net income from continuing operations
Undistributed net income from discontinued operations
Undistributed net income
Percentage of undistributed income allocated to common shares
Undistributed income from continuing operations allocated to common shares
Plus: common dividends
Net income from continuing operations attributable to basic common shares
Net income from discontinued operations attributable to common shares
Net income attributable to basic common shares
Basic weighted-average common shares outstanding
Basic earnings per common share from continuing operations
Basic earnings per common share from discontinued operations
Basic earnings per common share
Less: BlackRock common stock equivalents
Net income from continuing operations attributable to diluted common shares
Net income attributable to diluted common shares
Dilutive potential common shares (a) (b)
Diluted weighted-average common shares outstanding
Diluted earnings per common share from continuing operations
Diluted earnings per common share from discontinued operations
(a) Excludes stock options considered to be anti-dilutive
(b) Excludes warrants considered to be anti-dilutive
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NOTE 14 TOTAL EQUITY ANDOTHER COMPREHENSIVE INCOME
Activity in total equity for the first three months of 2011 follows. The par value of our preferred stock outstanding at March 31, 2011 totaled $.1 million and is excluded from the table.
Rollforward of Total Equity
Balance at January 1, 2011
Other comprehensive income (loss), net of tax
Net unrealized gains on other-than-temporary impairment debt securities
Net unrealized securities gains
Net unrealized losses on cash flow hedge derivatives
Pension, other postretirement and postemployment benefit plan adjustments
Comprehensive income (loss)
Cash dividends declared
Common ($.10 per share)
Common stock activity (a)
Treasury stock activity (a)
Balance at March 31, 2011
Comprehensive income for the first three months of 2010 was $1.4 billion.
Change in Accumulated Other Comprehensive Income (Loss)
Change in net unrealized securities losses:
Decrease in net unrealized OTTI losses on debt securities
Less: OTTI losses realized in net income
Change in net unrealized losses on OTTI securities
Increase in net unrealized gains for non-OTTI securities
Less: Net gains realized in net income
Change in net unrealized gains on non-OTTI securities
Change in net unrealized securities losses
Change in net unrealized gains on cash flow hedge derivatives:
Increase in net unrealized gains during the period on cash flow hedge derivatives
Change in net unrealized gains on cash flow hedge derivatives
Change in pension, other postretirement and postemployment benefit plan adjustments
Change in other, net
Change in other comprehensive income (loss)
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Accumulated Other Comprehensive Income (Loss) Components
Net unrealized securities gains (losses)
OTTI losses on debt securities
Net unrealized gains on cash flow hedge derivatives
NOTE 15 INCOME TAXES
The net operating loss carryforwards at March 31, 2011 and December 31, 2010 follow:
Net Operating Loss Carryforwards
Federal
State
Valuation allowance – State
The federal net operating loss carryforwards expire from 2027 to 2028. The state net operating loss carryforwards will expire from 2011 to 2031. We have established a valuation allowance of $21 million relating to the state net operating losses at March 31, 2011 and December 31, 2010.
PNC’s consolidated federal income tax returns through 2006 have been audited by the IRS and we have resolved all matters through the IRS Appeals Division. The IRS began its examination of PNC’s 2007 and 2008 consolidated federal income tax returns during the third quarter of 2010.
The consolidated federal income tax returns of National City through 2007 have been audited by the IRS. Certain adjustments remain under review by the IRS Appeals Division for years 2003-2007. The IRS began its examination of National City’s 2008 consolidated federal income tax return during the third quarter of 2010.
We had unrecognized tax benefits of $294 million at March 31, 2011 and $238 million at December 31, 2010. At March 31, 2011, the amount of unrecognized tax benefits that if recognized would impact the effective tax rate was $125 million.
NOTE 16 LEGAL PROCEEDINGS
We establish accruals for legal proceedings when information related to the loss contingencies represented by those matters indicates both that a loss is probable and that the amount of loss can be reasonably estimated. Any such accruals are adjusted thereafter as appropriate to reflect changed circumstances. We also determine estimates of possible losses or ranges of possible losses, whether in excess of any related accrued liability or where there is no accrued liability, for those matters disclosed in this Note 16 and in Note 22 Legal Proceedings in Part II, Item 8 of our 2010 Form 10-K (“Prior Disclosure”) when we are able to do so. For disclosed matters where we are able to estimate such possible losses or ranges of possible losses, as of March 31, 2011, we estimate that it is reasonably possible that we could incur losses in an aggregate amount up to approximately $375 million, with it also being reasonably possible that we could incur no such losses at all in these matters. The estimates included in this amount are based on our analysis of currently available information and are subject to significant judgment and a variety of assumptions and uncertainties. As new information is obtained we may change our estimates. Due to the inherent subjectivity of the assessments and unpredictability of outcomes of legal proceedings, any amounts accrued or included in this aggregate amount may not represent the ultimate loss to us from the legal proceedings in question. Thus, our exposure and ultimate losses may be higher or lower, and possibly significantly so, than the amounts accrued or this aggregate amount.
The aggregate estimated amount provided above does not include an estimate for every matter disclosed in this Note 16 or in Prior Disclosure, as we are unable, at this time, to estimate the losses that it is reasonably possible that we could incur or ranges of such losses with respect to some of the matters disclosed for one or more of the following reasons. In our experience, legal proceedings are inherently unpredictable. In many legal proceedings, various factors exacerbate this inherent unpredictability, including, among others, one or more of the following: the proceeding is in its early stages; the damages sought are unspecified, unsupported or uncertain; it is unclear whether a case brought as a class action will be allowed to proceed on that basis or, if permitted to proceed as a class action, how the class will be defined; the plaintiff is seeking relief other than compensatory damages; the matter presents meaningful legal uncertainties, including novel issues of law; we have not engaged in meaningful settlement discussions; discovery has not started or is not complete; there are significant facts in dispute; and there are a large number of parties named as defendants (including where it is uncertain how liability, if any, will be shared among multiple defendants). Generally, the less progress that has been made in the proceedings or the broader the range of potential results, the harder it is for us to estimate losses or ranges of losses that it is reasonably possible we could incur. Therefore, as the estimated aggregate amount disclosed above does not include all of the matters disclosed below, the
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amount disclosed above does not represent our maximum reasonably possible loss exposure for all of the matters disclosed in this Note 16 or in Prior Disclosure. The estimated aggregate amount also does not reflect any of our exposure to matters not so disclosed, as discussed below under “Other.”
We include in some of the descriptions of individual matters in Prior Disclosure certain quantitative information related to the plaintiff’s claim against us alleged in the plaintiff’s pleadings or otherwise publicly available. While information of this type may provide insight into the potential magnitude of a matter, it does not necessarily represent our estimate of reasonably possible loss or our judgment as to any currently appropriate accrual.
Some of our exposure in matters described below may be offset by applicable insurance coverage. We do not consider the possible availability of insurance coverage in determining the amounts of any accruals or any estimates of possible losses or ranges of possible losses.
The disclosure below updates the description of legal proceedings in Prior Disclosure.
Securities and State Law Fiduciary Cases against National City
In The Dispatch Printing Company, et al. v. National City Corporation, et al. (Case No. 08CVH-6506) pending in the Franklin County, Ohio, Court of Common Pleas , trial is currently scheduled to begin in 2012.
With respect to the series of antitrust lawsuits filed against Visa®, MasterCard®, and several major financial institutions, including cases naming National City (since merged into PNC) and its subsidiary, National City Bank of Kentucky (since merged into National City Bank which has since merged into PNC Bank, N.A.), which have been consolidated for pretrial proceedings in the United States District Court for the Eastern District of New York under the caption In re Payment Card Interchange Fee and Merchant-Discount Antitrust Litigation (Master File No. 1:05-md-1720-JG-JO): In March 2011, we entered into a MasterCard Settlement and Judgment Sharing Agreement with MasterCard and other financial institution defendants and an Omnibus Agreement Regarding Interchange Litigation Sharing and Settlement Sharing with Visa, MasterCard and other financial institution defendants. The Omnibus Agreement, in substance, apportions a resolution of all claims against all defendants in this litigation into a Visa portion and a MasterCard portion, with the Visa portion being two-thirds and the MasterCard portion being one-third. This apportionment only applies in the case of either a global settlement involving all defendants or an adverse judgment against the defendants, to the extent that damages either are related to the merchants’ inter-network conspiracy claims or are otherwise not attributed to specific MasterCard or Visa conduct or damages. The MasterCard portion (or any MasterCard-related liability not subject to the
Omnibus Agreement) will then be apportioned under the MasterCard Settlement and Judgment Sharing Agreement among MasterCard and PNC and the other financial institution defendants parties to this agreement. Under this agreement, PNC’s responsibility for MasterCard-related exposure is, in percentage terms, de minimis. The responsibility for the Visa portion (or any Visa-related liability not subject to the Omnibus Agreement) will be apportioned under the pre-existing indemnification responsibilities and judgment and loss sharing agreements.
Adelphia
In April 2011, the parties settled the remaining Adelphia-related lawsuit in which a PNC subsidiary was a defendant (W. R. Huff Asset Management Co., L.L.C. v. Deloitte & Touche, L.L.P., et al. (03 MD 1529 (LMM), 03-CV-5752 (LMM)). This lawsuit, brought by holders of debt securities of Adelphia, was pending for pretrial purposes in the United States District Court for the Southern District of New York. The plaintiffs in this lawsuit alleged violations of the federal securities laws and sought, among other things, unspecified damages, interest, and attorneys’ fees. The amount of the settlement was not material to PNC and had been accrued.
CBNV Mortgage Litigation
In February 2011, in In re: Community Bank of Northern Virginia and Guaranty Bank Second Mortgage Litigation (No. 03-0425 (W.D. Pa.), MDL No. 1674), currently pending in the United States District Court for the Western District of Pennsylvania, the counsel with whom the defendants negotiated the original settlement and who were appointed settlement class counsel notified the district court that they have determined that the settlement is no longer in the best interests of the class covered by the settlement (referred to as the Kessler class). Settlement class counsel have also asked to be appointed interim class counsel, along with certain of the lawyers for the objectors to the settlement, for future proceedings.
Overdraft Litigation
With respect to the lawsuits consolidated for pre-trial proceedings in the United States District Court for the Southern District of Florida (the “MDL Court”) under the caption In re Checking Account Overdraft Litigation (MDL No. 2036, Case No. 1:09-MD-02036-JLK ), our motion to dismiss the consolidated amended complaint was denied in March 2011. The MDL Court has scheduled trial for 2013 for the cases that will be tried in that court.
In Henry v. PNC Bank, National Association (No. GD-10-022974), pending in the Court of Common Pleas of Allegheny County, Pennsylvania, we filed our Preliminary Objections in March 2011.
In Trombley, et al. v. National City Bank (Civil Action No. 10-00232 (JDB)), pending against National City Bank in the United States District Court for the District of Columbia, the court has delayed the hearing on final approval of the settlement until July 2011.
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Other Mortgage-Related Litigation
In Federal Home Loan Bank of Chicago v. Bank of America Funding Corp., et al. (Case No. 10CH45033)), pending in the Circuit Court of Cook County, Illinois, the plaintiff amended its complaint in March 2011 and filed a corrected amended complaint in April 2011. The corrected amended complaint does not identify any additional transaction for which the plaintiff seeks recovery from PNC nor does it add any additional substantive allegations.
Regulatory and Governmental Inquiries
As a result of the regulated nature of our business and that of a number of our subsidiaries, particularly in the banking and securities areas, we and our subsidiaries are the subject of investigations, audits and other forms of regulatory inquiry, in some cases as part of regulatory reviews of specified activities at multiple industry participants, including those described below and in Prior Disclosure.
In April 2011, as a result of a publicly-disclosed interagency horizontal review of residential mortgage servicing operations at fourteen federally regulated mortgage servicers, PNC entered into a consent order with the Board of Governors of the Federal Reserve System and PNC Bank, N.A. (“PNC Bank”) entered into a consent order with the Office of the Comptroller of the Currency. Collectively, these consent orders describe certain foreclosure-related practices and controls that the regulators found to be deficient and require PNC and PNC Bank to, among other things, develop and implement plans and programs to enhance PNC’s residential mortgage servicing and foreclosure processes, retain an independent consultant to review certain residential mortgage foreclosure actions, take certain remedial actions, and oversee compliance with the orders and the new plans and programs. The two orders do not foreclose the potential for civil money penalties from either of these regulators. Other governmental, legislative and regulatory inquiries on this topic, referred to in Prior Disclosure, are on-going, and may result in significant additional actions, penalties or other remedies.
Our practice is to cooperate fully with regulatory and governmental investigations, audits and other inquiries, including those described above and in Prior Disclosure. Such investigations, audits and other inquiries may lead to remedies including fines, penalties, restitution or alterations in our business practices.
In addition to the proceedings or other matters described above, PNC and persons to whom we may have indemnification obligations, in the normal course of business, are subject to various other pending and threatened legal proceedings in which claims for monetary damages and other relief are asserted. We do not anticipate, at the present time, that the ultimate aggregate liability, if any, arising out of such other legal proceedings will have a material adverse effect on our financial position. However, we cannot now determine whether or not any claims asserted against us or others to
whom we may have indemnification obligations, whether in the proceedings or other matters specifically described above, Prior Disclosure or otherwise, will have a material adverse effect on our results of operations in any future reporting period, which will depend on, among other things, the amount of the loss resulting from the claim and the amount of income otherwise reported for the reporting period.
See Note 17 Commitments and Guarantees for additional information regarding the Visa indemnification and our other obligations to provide indemnification, including to current and former officers, directors, employees and agents of PNC and companies we have acquired.
NOTE 17 COMMITMENTS AND GUARANTEES
Equity Funding and Other Commitments
Our unfunded commitments at March 31, 2011 included private equity investments of $300 million and other investments of $9 million.
Standby Letters of Credit
We issue standby letters of credit and have risk participations in standby letters of credit and bankers’ acceptances issued by other financial institutions, in each case to support obligations of our customers to third parties, such as remarketing programs for customers’ variable rate demand notes. Net outstanding standby letters of credit and internal credit ratings were as follows:
Net Outstanding Standby Letters of Credit
Net outstanding standby letters of credit
Internal credit ratings (as a percentage of portfolio):
If the customer fails to meet its financial or performance obligation to the third party under the terms of the contract or there is a need to support a remarketing program, then upon the request of the guaranteed party, we would be obligated to make payment to them. The standby letters of credit and risk participations in standby letters of credit and bankers’ acceptances outstanding on March 31, 2011 had terms ranging from less than 1 year to 8 years. The aggregate maximum amount of future payments PNC could be required to make under outstanding standby letters of credit and risk participations in standby letters of credit and bankers’ acceptances was $13.6 billion at March 31, 2011, of which $7.1 billion support remarketing programs.
As of March 31, 2011, assets of $2.5 billion secured certain specifically identified standby letters of credit. Recourse provisions from third parties of $3.4 billion were also available for this purpose as of March 31, 2011. In addition, a
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portion of the remaining standby letters of credit and letter of credit risk participations issued on behalf of specific customers is also secured by collateral or guarantees that secure the customers’ other obligations to us. The carrying amount of the liability for our obligations related to standby letters of credit and risk participations in standby letters of credit and bankers’ acceptances was $243 million at March 31, 2011.
Standby Bond Purchase Agreements and Other Liquidity Facilities
We enter into standby bond purchase agreements to support municipal bond obligations. At March 31, 2011, the aggregate of our commitments under these facilities was $84 million. We also enter into certain other liquidity facilities to support individual pools of receivables acquired by commercial paper conduits. At March 31, 2011 our total commitments under these facilities were $145 million.
Indemnifications
As further described in our 2010 Form 10-K, we are a party to numerous acquisition or divestiture agreements under which we have purchased or sold, or agreed to purchase or sell, various types of assets. These agreements generally include indemnification provisions under which we indemnify the third parties to these agreements against a variety of risks to the indemnified parties as a result of the transaction in question. When PNC is the seller, the indemnification provisions will generally also provide the buyer with protection relating to the quality of the assets we are selling and the extent of any liabilities being assumed by the buyer. Due to the nature of these indemnification provisions, we cannot quantify the total potential exposure to us resulting from them.
We provide indemnification in connection with securities offering transactions in which we are involved. When we are the issuer of the securities, we provide indemnification to the underwriters or placement agents analogous to the indemnification provided to the purchasers of businesses from us, as described above. When we are an underwriter or placement agent, we provide a limited indemnification to the issuer related to our actions in connection with the offering and, if there are other underwriters, indemnification to the other underwriters intended to result in an appropriate sharing of the risk of participating in the offering. Due to the nature of these indemnification provisions, we cannot quantify the total potential exposure to us resulting from them.
In the ordinary course of business, we enter into certain types of agreements that include provisions for indemnifying third parties. We also enter into certain types of agreements, including leases, assignments of leases, and subleases, in which we agree to indemnify third parties for acts by our agents, assignees and/or sublessees, and employees. We also enter into contracts for the delivery of technology service in which we indemnify the other party against claims of patent
and copyright infringement by third parties. Due to the nature of these indemnification provisions, we cannot calculate our aggregate potential exposure under them.
We engage in certain insurance activities which require our employees to be bonded. We satisfy this bonding requirement by issuing letters of credit which were insignificant in amount at March 31, 2011.
In the ordinary course of business, we enter into contracts with third parties under which the third parties provide services on behalf of PNC. In many of these contracts, we agree to indemnify the third party service provider under certain circumstances. The terms of the indemnity vary from contract to contract and the amount of the indemnification liability, if any, cannot be determined.
We are a general or limited partner in certain asset management and investment limited partnerships, many of which contain indemnification provisions that would require us to make payments in excess of our remaining unfunded commitments. While in certain of these partnerships the maximum liability to us is limited to the sum of our unfunded commitments and partnership distributions received by us, in the others the indemnification liability is unlimited. As a result, we cannot determine our aggregate potential exposure for these indemnifications.
Pursuant to their bylaws, PNC and its subsidiaries provide indemnification to directors, officers and, in some cases, employees and agents against certain liabilities incurred as a result of their service on behalf of or at the request of PNC and its subsidiaries. PNC and its subsidiaries also advance on behalf of covered individuals costs incurred in connection with certain claims or proceedings, subject to written undertakings by each such individual to repay all amounts advanced if it is ultimately determined that the individual is not entitled to indemnification. We generally are responsible for similar indemnifications and advancement obligations that companies we acquire had to their officers, directors and sometimes employees and agents at the time of acquisition. We advanced such costs on behalf of several such individuals with respect to pending litigation or investigations during the first three months of 2011. It is not possible for us to determine the aggregate potential exposure resulting from the obligation to provide this indemnity or to advance such costs.
In connection with the sale of GIS, and in addition to indemnification provisions as part of the divestiture agreement, PNC agreed to continue to act for the benefit of GIS as securities lending agent for certain of GIS’s clients. In such role, we provide indemnification to those clients against the failure of the borrowers to return the securities. The market value of the securities lent is fully secured on a daily basis; therefore, the exposure to us is limited to temporary shortfalls in the collateral as a result of short-term fluctuations in trading prices of the loaned securities. At March 31, 2011,
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the total maximum potential exposure as a result of these indemnity obligations was $7.5 billion, although the collateral at the time exceeded that amount. In addition, the purchaser of GIS, The Bank of New York Mellon Corporation, has entered into an agreement to indemnify PNC with respect to such exposure on the terms set forth in such indemnification agreement. Also in connection with the GIS divestiture, PNC has agreed to indemnify the buyer generally as described above.
VISA Indemnification
Our payment services business issues and acquires credit and debit card transactions through Visa U.S.A. Inc. card association or its affiliates (Visa). Our 2010 Form 10-K has additional information regarding the October 2007 Visa restructuring, our involvement with judgment and loss sharing agreements with Visa and certain other banks, and other 2010 developments in this area.
In March 2011, Visa funded $400 million to their litigation escrow account and reduced the conversion ratio of Visa B to A shares. We consequently recognized our estimated $38 million share of the $400 million as a reduction of our previously established indemnification liability and a reduction of noninterest expense.
Our Visa indemnification liability included on our Consolidated Balance Sheet at March 31, 2011 totaled $32 million as a result of the indemnification provision in Section 2.05j of the Visa By-Laws and/or the indemnification provided through the judgment and loss sharing agreements. Any ultimate exposure to the specified Visa litigation may be different than this amount.
Recourse and Repurchase Obligations
As discussed in Note 3 Loans Sale and Servicing Activities and Variable Interest Entities, PNC has sold commercial mortgage and residential mortgage loans directly or indirectly in securitizations and whole-loan sale transactions with continuing involvement. One form of continuing involvement includes certain recourse and loan repurchase obligations associated with the transferred assets in these transactions.
Commercial Mortgage Recourse Obligations
We originate, close and service commercial mortgage loans which are sold to FNMA under FNMA’s DUS program. We have similar arrangements with FHLMC.
Under these programs, we generally assume up to a one-third pari passu risk of loss on unpaid principal balances through a loss share arrangement. The unpaid principal balance outstanding of loans sold as a participant in these programs was $13.2 billion at both March 31, 2011 and December 31, 2010, and the potential maximum exposure under the loss share arrangements was $4.0 billion at both March 31, 2011 and December 31, 2010. We maintain a reserve based upon these potential losses. The reserve for losses under these
programs totaled $56 million and $54 million as of March 31, 2011 and December 31, 2010, respectively, and is included in Other liabilities on our Consolidated Balance Sheet. The comparable reserve as of March 31, 2010 was $65 million. If payment is required under these programs, we would not have a contractual interest in the collateral underlying the mortgage loans on which losses occurred, although the value of the collateral is taken into account in determining our share of such losses. Our exposure and activity associated with these recourse obligations are reported in the Corporate & Institutional Banking segment.
Analysis of Commercial Mortgage Recourse Obligations
Reserve adjustments, net
Residential Mortgage Loan Repurchase Obligations
While residential mortgage loans are sold on a non-recourse basis, we assume certain loan repurchase obligations associated with mortgage loans we have sold to investors. These loan repurchase obligations primarily relate to situations where PNC is alleged to have breached certain origination covenants and representations and warranties made to purchasers of the loans in the respective purchase and sale agreements. Residential mortgage loans covered by these loan repurchase obligations include first and second-lien mortgage loans we have sold through Agency securitizations, Non-Agency securitizations, and whole-loan sale transactions. As discussed in Note 3 in our 2010 Form 10-K, Agency securitizations consist of mortgage loans sale transactions with FNMA, FHLMC, and GNMA, while Non-Agency securitizations and whole-loan sale transactions consist of mortgage loans sale transactions with private investors. Our exposure and activity associated with these loan repurchase obligations is reported in the Residential Mortgage Banking segment. In addition, PNC’s residential mortgage loan repurchase obligations include certain brokered home equity loans/lines that were sold to private investors by National City prior to our acquisition. PNC is no longer engaged in the brokered home equity lending business, and our exposure under these loan repurchase obligations is reported in the Distressed Assets Portfolio segment.
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These investor indemnification or repurchase claims are typically settled on an individual loan basis through make-whole payments or loan repurchases; however, on occasion we may negotiate pooled settlements with investors.
Origination and sale of residential mortgages is an ongoing business activity and, accordingly, management continually assesses the need for indemnification and repurchase liabilities pursuant to the associated investor sale agreements. We
establish indemnification and repurchase liabilities for estimated losses on sold first and second-lien mortgages and home equity loans/lines for which indemnification is expected to be provided or for loans that are expected to be repurchased. For the first and second-lien mortgage sold portfolio, we have established an indemnification and repurchase liability pursuant to investor sale agreements based on claims made and our estimate of future claims on a loan by loan basis. These relate primarily to loans originated during 2006-2008. For the home equity loans/lines sold portfolio, we have established indemnification and repurchase liabilities based upon this same methodology for loans sold during 2005-2007.
Management’s subsequent evaluation of these indemnification and repurchase liabilities is based upon trends in indemnification and repurchase requests, actual loss experience, known and inherent risks in the underlying serviced loan portfolios, and current economic conditions. As part of its evaluation, management considers estimated loss projections over the life of the subject loan portfolio. At March 31, 2011 and December 31, 2010, the total indemnification and repurchase liability for estimated losses on indemnification and repurchase claims totaled $252 million and $294 million, respectively, and was included in Other liabilities on the Consolidated Balance Sheet. The comparable reserve as of March 31, 2010 was $247 million. An analysis of the changes in this liability during the first three months of 2011 and 2010 follows:
Analysis of Indemnification and Repurchase Liability for Asserted Claims and Unasserted Claims
Losses - loan repurchases and settlements
REINSURANCE AGREEMENTS
We have two wholly-owned captive insurance subsidiaries which provide reinsurance to third-party insurers related to insurance sold to our customers. These subsidiaries enter into various types of reinsurance agreements with third-party insurers where the subsidiary assumes the risk of loss through
either an excess of loss or quota share agreement up to 100% reinsurance. In excess of loss agreements, these subsidiaries assume the risk of loss for an excess layer of coverage up to specified limits, once a defined first loss percentage is met. In quota share agreements, the subsidiaries and third-party insurers share the responsibility for payment of all claims.
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Reserves recognized for probable losses on these policies and the aggregate maximum exposure up to the specified limits for all reinsurance contracts were as follows:
Reserves for probable losses
Maximum exposure (billions)
The comparable amount of reserves for probable losses as of December 31, 2010 was $150 million.
Repurchase and Resale Agreements
We enter into repurchase and resale agreements where we transfer investment securities to/from a third party with the agreement to repurchase/resell those investment securities at a future date for a specified price. These transactions are accounted for as collateralized borrowings/financings.
NOTE 18 SEGMENT REPORTING
Results of individual businesses are presented based on our management accounting practices and management structure. There is no comprehensive, authoritative body of guidance for management accounting equivalent to GAAP; therefore, the financial results of our individual businesses are not necessarily comparable with similar information for any other company. We refine our methodologies from time to time as our management accounting practices are enhanced and our businesses and management structure change.
Financial results are presented, to the extent practicable, as if each business operated on a stand-alone basis. As permitted under GAAP, we have aggregated the business results for certain similar operating segments for financial reporting purposes.
Assets receive a funding charge and liabilities and capital receive a funding credit based on a transfer pricing methodology that incorporates product maturities, duration and other factors.
Capital is intended to cover unexpected losses and is assigned to our business segments using our risk-based economic capital model, including consideration of the goodwill and other intangible assets at those business segments, as well as the diversification of risk among the business segments. We have revised certain capital allocations among our business
segments, including amounts for prior periods. PNC’s total capital did not change as a result of these adjustments for any periods presented.
We have allocated the allowances for loan and lease losses and unfunded loan commitments and letters of credit based on our assessment of risk inherent in each business segment’s loan portfolio. Our allocation of the costs incurred by operations and other shared support areas not directly aligned with the businesses is primarily based on the use of services.
Total business segment financial results differ from consolidated income from continuing operations before noncontrolling interests, which itself excludes the earnings and revenue attributable to GIS through March 31, 2010 that is reflected in discontinued operations. The impact of these differences is reflected in the “Other” category in the business segment tables. “Other” includes residual activities that do not meet the criteria for disclosure as a separate reportable business, such as gains or losses related to BlackRock transactions including LTIP share distributions and obligations, integration costs, asset and liability management activities including net securities gains or losses and certain trading activities, exited businesses, equity management activities, alternative investments, intercompany eliminations, most corporate overhead, and differences between business segment performance reporting and financial statement reporting (GAAP), including the presentation of net income attributable to noncontrolling interests. Assets, revenue and earnings attributable to foreign activities were not material in the periods presented for comparative purposes.
BUSINESS SEGMENTPRODUCTS AND SERVICES
Retail Banking provides deposit, lending, brokerage, trust, investment management, and cash management services to consumer and small business customers within our primary geographic markets. Our customers are serviced through our branch network, call centers and the internet. The branch network is located primarily in Pennsylvania, Ohio, New Jersey, Michigan, Maryland, Illinois, Indiana, Kentucky, Florida, Virginia, Missouri, Delaware, Washington, D.C., and Wisconsin.
Corporate & Institutional Banking provides lending, treasury management, and capital markets-related products and services to mid-sized corporations, government and not-for-profit entities, and selectively to large corporations. Lending products include secured and unsecured loans, letters of credit and equipment leases. Treasury management services include cash and investment management, receivables management, disbursement services, funds transfer services, information reporting, and global trade services. Capital markets-related products and services include foreign exchange, derivatives, loan syndications, mergers and acquisitions advisory and related services to middle-market
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companies, our multi-seller conduit, securities underwriting, and securities sales and trading. Corporate & Institutional Banking also provides commercial loan servicing, and real estate advisory and technology solutions for the commercial real estate finance industry. Corporate & Institutional Banking provides products and services generally within our primary geographic markets, with certain products and services offered nationally and internationally.
Asset Management Group includes personal wealth management for high net worth and ultra high net worth clients and institutional asset management. Wealth management products and services include financial planning, customized investment management, private banking, tailored credit solutions and trust management and administration for individuals and their families. Institutional asset management provides investment management, custody, and retirement planning services. The institutional clients include corporations, unions, municipalities, non-profits, foundations and endowments located primarily in our geographic footprint.
Residential Mortgage Banking directly originates primarily first lien residential mortgage loans on a nationwide basis with a significant presence within the retail banking footprint, and also originates loans through majority or minority owned affiliates. Mortgage loans represent loans collateralized by one-to-four-family residential real estate. These loans are typically underwritten to government agency and/or third party standards, and sold, servicing retained, to secondary mortgage conduits FNMA, FHLMC, Federal Home Loan
Banks and third-party investors, or are securitized and issued under the GNMA program. The mortgage servicing operation performs all functions related to servicing mortgage loans—primarily those in first lien position—for various investors and for loans owned by PNC. Certain loans originated through majority or minority owned affiliates are sold to others.
BlackRock is the largest publicly traded investment management firm in the world. BlackRock manages assets on behalf of institutional and individual investors worldwide through a variety of equity, fixed income, multi-asset class, alternative and cash management separate accounts and funds, including iShares®, the global product leader in exchange-traded funds. In addition, BlackRock provides market risk management, financial markets advisory and enterprise investment system services globally to a broad base of clients. At March 31, 2011, our economic interest in BlackRock was 20%.
PNC received cash dividends from BlackRock of $53 million during the first three months of 2011 and $46 million during the first three months of 2010.
Distressed Assets Portfolio includes commercial residential development loans, cross-border leases, consumer brokered home equity loans, retail mortgages, non-prime mortgages, and residential construction loans. These loans require special servicing and management oversight given current market conditions. We obtained the majority of these loans through acquisitions of other companies.
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Results Of Businesses
Income Statement
Other noninterest expense
Income (loss) from continuing operations before income taxes and noncontrolling interests
Income (loss) from continuing operations before noncontrolling interests
Inter-segment revenue
Average Assets (a)
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Taxable-equivalent basis Dollars in millions
Interest-earning assets:
Total investment securities
Total interest-earning assets/interest income
Noninterest-earning assets:
Liabilities and Equity
Interest-bearing liabilities:
Total interest-bearing deposits
Total interest-bearing liabilities/interest expense
Noninterest-bearing liabilities and equity:
Interest rate spread
Impact of noninterest-bearing sources
Net interest income/margin
Nonaccrual loans are included in loans, net of unearned income. The impact of financial derivatives used in interest rate risk management is included in the interest income/expense and average yields/rates of the related assets and liabilities. Basis adjustments related to hedged items are included in noninterest-earning assets and noninterest-bearing liabilities. Average balances of securities are based on amortized historical cost (excluding adjustments to fair value, which are included in other assets). Average balances for certain loans and borrowed funds accounted for at fair value, with changes in fair value recorded in trading noninterest income, are included in noninterest-earning assets and noninterest-bearing liabilities. The interest-earning deposits with the Federal Reserve are included in the ‘Other’ interest-earning assets category.
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Average Consolidated Balance Sheet And Net Interest Analysis (Continued)
Average
Balances
$22,916
8,917
3,100
2,436
7,758
1,323
3,092
472
50,014
4,130
3,435
7,574
57,588
53,502
19,847
6,514
55,036
16,766
151,665
3,021
1,602
9,801
223,677
(5,290)
3,436
42,756
$264,579
$58,016
25,078
7,092
41,724
740
2,650
135,300
4,179
7,680
12,799
9,569
4,886
39,113
174,413
45,306
218
12,687
31,955
Loan fees for the three months ended March 31, 2011, December 31, 2010, September 30, 2010, June 30, 2010, and March 31, 2010 were $38 million, $37 million, $29 million, $43 million, and $45 million, respectively.
Interest income includes the effects of taxable-equivalent adjustments using a marginal federal income tax rate of 35% to increase tax-exempt interest income to a taxable-equivalent basis. The taxable-equivalent adjustments to interest income for the three months ended March 31, 2011, December 31, 2010, September 30, 2010, June 30, 2010, and March 31, 2010 were $24 million, $22 million, $22 million, $19 million, and $18 million, respectively.
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ITEM 1. LEGAL PROCEEDINGS
See the information set forth in Note 16 Legal Proceedings in the Notes To Consolidated Financial Statements under Part I, Item 1 of this Report, which is incorporated by reference in response to this item.
ITEM 1A. RISKFACTORS
There are no material changes from any of the risk factors previously disclosed in PNC’s 2010 Form 10-K in response to Part I, Item 1A.
ITEM 2. UNREGISTERED SALESOF EQUITY
SECURITIES AND USE OFPROCEEDS
(c) Details of our repurchases of PNC common stock during the first quarter of 2011 are included in the following table:
In thousands, except per share data
Total sharespurchased
(a)
January 1 – 31
February 1 – 28
March 1 – 31
Effective January 2011, employer matching contributions to the PNC Incentive Savings Plan were no longer made in PNC common stock, but rather in cash. Note 14 Employee Benefit Plans in the Notes To Consolidated Financial Statements in Item 8 of our 2010 Form 10-K includes additional information regarding our employee benefit plans that use PNC common stock.
ITEM 6. EXHIBITS
The following exhibit index lists Exhibits filed, or in the case of Exhibits 32.1 and 32.2 furnished, with this Quarterly Report on Form 10-Q:
EXHIBIT INDEX
You can obtain copies of these Exhibits electronically at the SEC’s website at www.sec.gov or by mail from the Public Reference Section of the SEC, at 100 F Street, N.E., Washington, DC 20549 at prescribed rates. The Exhibits are also available as part of this Form 10-Q on or through PNC’s corporate website at www.pnc.com/secfilings. Shareholders and bondholders may also obtain copies of Exhibits, without charge, by contacting Shareholder Relations at 800-843-2206 or via e-mail at investor.relations@pnc.com. The interactive data file (XBRL) exhibit is only available electronically.
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on May 9, 2011 on its behalf by the undersigned thereunto duly authorized.
/s/ Richard J. Johnson
Richard J. Johnson
Executive Vice President and Chief Financial Officer
(Principal Financial Officer)
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CORPORATE INFORMATION
Corporate Headquarters
One PNC Plaza, 249 Fifth Avenue
Pittsburgh, Pennsylvania 15222-2707
412-762-2000
Stock Listing The common stock of the PNC Financial Services Group, Inc. is listed on the New York Stock Exchange under the symbol PNC.
Internet Information The PNC Financial Services Group, Inc.’s financial reports and information about its products and services are available on the internet at www.pnc.com. We provide information for investors on our corporate website under “About PNC – Investor Relations,” such as Investor Events, Quarterly Earnings, SEC Filings, Financial Information, Financial Press Releases and Message from the Chairman. Under “Investor Relations,” we will from time to time post information that we believe may be important or useful to investors. We generally post the following shortly before or promptly following its first use or release: financially-related press releases (including earnings releases), various SEC filings, presentation materials associated with earnings and other investor conference calls or events, and access to live and taped audio from such calls or events. When warranted, we will also use our website to expedite public access to time-critical information regarding PNC in advance of distribution of a press release or a filing with the SEC disclosing the same information. You can also find the SEC reports and corporate governance information described in the sections below in the Investor Relations section of our website.
Where we have included web addresses in this Report, such as our web address and web addresses of the SEC and of BlackRock, we have included those web addresses as inactive textual references only. Except as specifically incorporated by reference into this Report, information on those websites is not part hereof.
Financial Information We are subject to the informational requirements of the Securities Exchange Act of 1934, as amended (Exchange Act), and, in accordance with the Exchange Act, we file annual, quarterly and current reports, proxy statements, and other information with the SEC. You can obtain copies of these and other filings, including exhibits, electronically at the SEC’s internet website at www.sec.gov or on or through PNC’s corporate internet website at www.pnc.com/secfilings. Shareholders and bond holders may also obtain copies of these filings without charge by contacting Shareholder Services at 800-982-7652 or via the online contact form at www.computershare.com/contactus for copies without exhibits, and by contacting Shareholder Relations at 800-843-2206 or via email at
investor.relations@pnc.com for copies of exhibits, including financial statement and schedule exhibits where applicable. The interactive data file (XBRL) exhibit is only available electronically.
Corporate Governance at PNC Information about our Board of Directors and its committees and corporate governance at PNC is available on PNC’s corporate website at www.pnc.com/corporategovernance. Shareholders who would like to request printed copies of PNC’s Code of Business Conduct and Ethics or our Corporate Governance Guidelines or the charters of our Board’s Audit, Nominating and Governance, Personnel and Compensation, or Risk Committees (all of which are posted on the PNC corporate website) may do so by sending their requests to George P. Long, III, Chief Governance Counsel and Corporate Secretary, at corporate headquarters at the above address. Copies will be provided without charge to shareholders.
Inquiries For financial services call 888-PNC-2265.
Individual shareholders should contact Shareholder Services at 800-982-7652.
Analysts and institutional investors should contact William H. Callihan, Senior Vice President, Director of Investor Relations, at 412-762-8257 or via email at investor.relations@pnc.com.
News media representatives and others seeking general information should contact Fred Solomon, Vice President, Corporate Communications, at 412-762-4550 or via email at corporate.communications@pnc.com.
Common Stock Prices/Dividends Declared The table below sets forth by quarter the range of high and low sale and quarter-end closing prices for The PNC Financial Services Group, Inc. common stock and the cash dividends declared per common share.
2011 Quarter
First
2010 Quarter
Second
Third
Fourth
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Dividend Policy Holders of PNC common stock are entitled to receive dividends when declared by the Board of Directors out of funds legally available for this purpose. Our Board of Directors may not pay or set apart dividends on the common stock until dividends for all past dividend periods on any series of outstanding preferred stock have been paid or declared and set apart for payment. The Board presently intends to continue the policy of paying quarterly cash dividends. The amount of any future dividends will depend on economic and market conditions, our financial condition and operating results, and other factors, including contractual restrictions and applicable government regulations and policies (such as those relating to the ability of bank and non-bank subsidiaries to pay dividends to the parent company and regulatory capital limitations).
Dividend Reinvestment And Stock Purchase Plan
The PNC Financial Services Group, Inc. Dividend Reinvestment and Stock Purchase Plan enables holders of our common and preferred stock to conveniently purchase additional shares of common stock. You can obtain a prospectus and enrollment form by contacting Shareholder Services at 800-982-7652.
Registrar And Stock Transfer Agent
Computershare Trust Company, N.A.
250 Royall Street
Canton, MA 02021
800-982-7652
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