UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Quarter Ended September 30, 2001 Commission File Number 0-8076 FIFTH THIRD BANCORP (Exact name of Registrant as specified in its charter) Ohio 31-0854434 (State or other jurisdiction (I.R.S. Employer of incorporation or organization) Identification Number) Fifth Third Center Cincinnati, Ohio 45263 (Address of principal executive offices) Registrant's telephone number, including area code: (513) 579-5300 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____ --- There were 577,809,055 shares of the Registrant's Common Stock, without par value, outstanding as of October 31, 2001.
FIFTH THIRD BANCORP INDEX <TABLE> Part I. Financial Information <S> <C> Item 1. Financial Statement Condensed Consolidated Balance Sheets - September 30, 2001 and 2000 and December 31, 2000 3 Condensed Consolidated Statements of Income - Three and Nine Months Ended September 30, 2001 and 2000 4 Condensed Consolidated Statements of Cash Flows - Nine Months Ended September 30, 2001 and 2000 5 Condensed Consolidated Statements of Changes in Shareholders' Equity - Nine Months Ended September 30, 2001 and 2000 6 Notes to Condensed Consolidated Financial Statements 7 - 16 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 17 - 21 Item 3. Quantitative and Qualitative Disclosures About Market Risk 22 Part II. Other Information 23 </TABLE> 2
Fifth Third Bancorp and Subsidiaries Condensed Consolidated Balance Sheets (unaudited) <TABLE> <CAPTION> - -------------------------------------------------------------------------------------------------------------------------- September 30, December 31, September 30, ($000's) 2001 2000 2000 - -------------------------------------------------------------------------------------------------------------------------- Assets - -------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> Cash and Due from Banks $ 1,446,136 1,706,538 1,433,887 Securities Available for Sale (a) 20,952,183 19,028,803 18,239,166 Securities Held to Maturity (b) 16,738 552,563 606,872 Other Short-Term Investments 466,746 232,524 245,005 Loans Held for Sale 1,864,214 1,654,996 1,372,259 Loans and Leases Commercial Loans 10,682,686 10,674,980 10,465,746 Construction Loans 3,336,839 3,222,553 2,864,285 Commercial Mortgage Loans 6,248,635 6,226,839 6,067,467 Commercial Lease Financing 2,983,570 3,158,436 2,984,106 Residential Mortgage Loans 4,671,937 5,635,286 6,189,003 Consumer Loans 12,372,202 11,551,102 10,926,002 Consumer Lease Financing 1,813,334 3,006,942 3,030,265 Unearned Income (873,400) (945,748) (1,068,768) Reserve for Credit Losses (616,608) (609,340) (607,836) - -------------------------------------------------------------------------------------------------------------------------- Total Loans and Leases 40,619,195 41,921,050 40,850,270 Bank Premises and Equipment 826,173 803,793 809,478 Accrued Income Receivable 593,645 558,695 518,547 Other Assets 3,333,146 3,199,377 2,807,427 - -------------------------------------------------------------------------------------------------------------------------- Total Assets $ 70,118,176 69,658,339 66,882,911 - -------------------------------------------------------------------------------------------------------------------------- Liabilities - -------------------------------------------------------------------------------------------------------------------------- Deposits Demand $ 7,781,894 7,152,381 6,280,460 Interest Checking 11,436,884 10,319,753 9,469,969 Savings and Money Market 7,911,666 6,914,353 6,537,491 Time Deposits 18,442,284 23,972,954 19,944,789 - -------------------------------------------------------------------------------------------------------------------------- Total Deposits 45,572,728 48,359,441 42,232,709 Federal Funds Borrowed 2,246,652 2,178,703 4,381,259 Short-Term Bank Notes 14,100 - 2,900,536 Other Short-Term Borrowings 4,625,522 4,166,261 2,842,613 Accrued Taxes, Interest and Expenses 2,332,449 1,694,965 1,461,946 Other Liabilities 791,229 358,414 262,283 Long-Term Debt 6,957,334 6,065,643 6,591,390 Guaranteed Preferred Beneficial Interests in Convertible Subordinated Debentures 172,500 172,500 172,500 - -------------------------------------------------------------------------------------------------------------------------- Total Liabilities 62,712,514 62,995,927 60,845,236 - -------------------------------------------------------------------------------------------------------------------------- Shareholders' Equity - -------------------------------------------------------------------------------------------------------------------------- Common Stock (c) 1,282,980 1,263,538 1,258,300 Preferred Stock (d) 9,250 9,250 9,250 Capital Surplus 1,317,501 1,143,959 1,094,937 Retained Earnings 4,571,373 4,226,047 4,038,491 Unrealized Gains (Losses) on Securities Available for Sale 237,945 28,012 (198,531) Deferred Compensation - (2,727) - Treasury Stock (13,387) (5,667) (164,772) - -------------------------------------------------------------------------------------------------------------------------- Total Shareholders' Equity 7,405,662 6,662,412 6,037,675 - -------------------------------------------------------------------------------------------------------------------------- Total Liabilities and Shareholders' Equity $ 70,118,176 69,658,339 66,882,911 - -------------------------------------------------------------------------------------------------------------------------- </TABLE> (a) Amortized cost: September 30, 2001 - $20,542,514 December 31 ,2000 - $18,986,346 and September 30, 2000 - $18,531,779. (b) Market values: September 30, 2001 - $16,738, December 31, 2000 - $557,275 and September 30, 2000 - $599,363. (c) Common Shares: Stated value $2.22 per share; authorized at September 30, 2001 - 1,300,000,000, December 31, 2000 and September 30, 2000 - 650,000,000; outstanding at September 30, 2001 -577,668,069 (excludes 250,663 of treasury shares), December 31, 2000 -569,056,843 (excludes 104,455 treasury shares) and September 30, 2000 -563,201,628 (excludes 3,600,000 treasury shares). (d) 490,750 shares of no par value preferred stock are authorized of which none had been issued as of September 30, 2001; 7,250 shares of 8.00% Series D convertible perpetual preferred stock with a stated value of $1,000 were authorized, issued and outstanding at September 30, 2001; 2,000 shares of 8.00% Series E perpetual preferred stock with a stated value of $1,000 were authorized, issued and outstanding at September 30, 2001. See Notes to Condensed Consolidated Statements 3
Fifth Third Bancorp and Subsidiaries Condensed Consolidated Statements of Income (unaudited) <TABLE> <CAPTION> - ---------------------------------------------------------------------------------------------- ------------------------------ Three Months Ended Nine Months Ended September 30, September 30, ------------------------------ ------------------------------ ($000's except per share) 2001 2000 2001 2000 - ---------------------------------------------------------------------------------------------- ------------------------------ <S> <C> <C> <C> <C> Interest Income Interest and Fees on Loans and Leases $ 819,889 928,880 $ 2,678,859 2,641,494 Interest on Securities Taxable 317,249 325,677 904,520 948,490 Exempt from Income Taxes 16,167 18,448 50,930 55,779 - ---------------------------------------------------------------------------------------------- ------------------------------ Total Interest on Securities 333,416 344,125 955,450 1,004,269 Interest on Other Short-Term Investments 2,198 2,595 8,800 9,572 - ---------------------------------------------------------------------------------------------- ------------------------------ Total Interest Income 1,155,503 1,275,600 3,643,109 3,655,335 - ---------------------------------------------------------------------------------------------- ------------------------------ Interest Expense Interest on Deposits Interest Checking 75,568 81,741 246,487 229,117 Savings and Money Market 51,206 57,761 167,147 167,368 Time Deposits 244,639 334,315 836,326 929,991 - ---------------------------------------------------------------------------------------------- ------------------------------ Total Interest on Deposits 371,413 473,817 1,249,960 1,326,476 Interest on Federal Funds Borrowed 29,941 76,017 139,972 234,277 Interest on Short-Term Bank Notes 62 16,676 62 61,590 Interest on Other Short-Term Borrowings 37,856 51,667 176,563 146,457 Interest on Long-Term Debt 108,276 90,418 272,476 203,821 - ---------------------------------------------------------------------------------------------- ------------------------------ Total Interest Expense 547,548 708,595 1,839,033 1,972,621 - ---------------------------------------------------------------------------------------------- ------------------------------ Net Interest Income 607,955 567,005 1,804,076 1,682,714 Provision for Credit Losses 47,509 26,834 139,066 94,127 Merger-Related Provision for Credit Losses - - 35,437 12,000 - ---------------------------------------------------------------------------------------------- ------------------------------ Net Interest Income After Provision for Credit Losses 560,446 540,171 1,629,573 1,576,587 Other Operating Income Data Processing Income 86,038 64,627 233,974 176,832 Service Charges on Deposits 94,629 78,384 264,329 221,750 Mortgage Banking Revenue (28,047) 62,731 85,575 191,648 Investment Advisory Income 75,902 68,889 233,426 210,658 Other Service Charges and Fees 163,927 97,901 406,040 292,952 Securities Gains 3,232 420 10,339 360 Securities Gains - Non-Qualifying Hedges on Mortgage Servicing 69,673 - 69,673 - - ---------------------------------------------------------------------------------------------- ------------------------------ Total Other Operating Income 465,354 372,952 1,303,356 1,094,200 - ---------------------------------------------------------------------------------------------- ------------------------------ Operating Expenses Salaries, Wages and Incentives 210,271 194,204 629,700 582,593 Employee Benefits 38,948 35,006 115,765 116,459 Equipment Expenses 20,557 24,990 64,188 74,842 Net Occupancy Expenses 35,872 34,158 109,519 101,548 Other Operating Expenses 184,157 168,399 569,105 493,910 Merger-Related Charges 129,366 - 348,595 86,973 - ---------------------------------------------------------------------------------------------- ------------------------------ Total Operating Expenses 619,171 456,757 1,836,872 1,456,325 - ---------------------------------------------------------------------------------------------- ------------------------------ Income Before Income Taxes 406,629 456,366 1,096,057 1,214,462 Applicable Income Taxes 127,027 146,686 381,167 392,538 - ------------------------------------------------------------------------------------------------------------------------------ Net Income 279,602 309,680 714,890 821,924 Cumulative Effect of Change in Accounting Principle, Net of Tax - - 6,781 - Dividend on Preferred Stock 185 185 555 555 - ---------------------------------------------------------------------------------------------- ------------------------------ Net Income Available to Common Shareholders $ 279,417 309,495 $ 707,554 821,369 - ---------------------------------------------------------------------------------------------- ------------------------------ Per Share: Earnings $ 0.48 0.55 $ 1.23 1.46 Diluted Earnings $ 0.47 0.54 $ 1.21 1.43 Cash Dividends $ 0.20 0.18 $ 0.60 0.52 - ---------------------------------------------------------------------------------------------- ------------------------------ Average Shares (000's): Outstanding 577,252 565,440 574,349 565,831 Diluted 593,762 578,444 590,190 578,183 - ---------------------------------------------------------------------------------------------- ------------------------------ </TABLE> See Notes to Condensed Consolidated Financial Statements. 4
Fifth Third Bancorp and Subsidiaries Condensed Consolidated Statements of Cash Flows (unaudited) <TABLE> <CAPTION> ========================================================================================================================== Nine Months Ended September 30, --------------------------------- ($000's) 2001 2000 ========================================================================================================================== <S> <C> Operating Activities Net Income $ 714,890 821,924 Adjustments to Reconcile Net Income to Net Cash Provided by Operating Activities: Provision for Credit Losses 139,066 94,127 Cumulative Effect of Change in Accounting Principle, Net of Tax (6,781) - Depreciation, Amortization and Accretion 163,555 132,375 Provision for Deferred Income Taxes 122,173 136,649 Realized Securities Gains (14,805) (2,862) Realized Securities Gains - Non-Qualifying Hedges on Mortgage Servicing (70,760) - Realized Securities Losses 4,466 2,502 Realized Securities Losses - Non-Qualifying Hedges on Mortgage Servicing 1,087 - Proceeds from Sales of Residential Mortgage Loans Held for Sale 6,332,424 9,046,483 Net Gain on Sales of Loans (154,204) (125,115) Increase in Residential Mortgage Loans Held for Sale (6,378,564) (9,213,534) Increase in Accrued Income Receivable (29,254) (51,002) Increase in Other Assets (61,064) (227,494) Increase in Accrued Taxes, Interest and Expenses 378,597 240,268 Increase (Decrease) in Other Liabilities 390,122 (70,149) - -------------------------------------------------------------------------------------------------------------------------- Net Cash Provided by Operating Activities 1,530,948 784,172 ========================================================================================================================== Investing Activities Proceeds from Sales of Securities Available for Sale 7,386,252 4,855,347 Proceeds from Calls, Paydowns and Maturities of Securities Available for Sale 9,987,577 1,530,996 Purchases of Securities Available for Sale (16,721,457) (7,649,604) Proceeds from Calls, Paydowns and Maturities of Securities Held to Maturity 16,951 57,871 Purchases of Securities Held to Maturity - (12,339) Decrease (Increase) in Other Short-Term Investments (234,222) 142,870 Decrease (Increase) in Loans and Leases 579,217 (3,527,270) Purchases of Bank Premises and Equipment (132,846) (85,103) Proceeds from Disposal of Bank Premises and Equipment 42,272 7,664 Net Cash Paid In Acquisitions (146,807) - - -------------------------------------------------------------------------------------------------------------------------- Net Cash Provided by (Used in) Investing Activities 776,937 (4,679,568) ========================================================================================================================== Financing Activities Increase (Decrease) in Transaction Account Deposits 2,406,815 (108,489) Increase (Decrease) in Consumer Time Deposits (1,089,200) 11,517 Increase (Decrease) in CDs - $100,000 and Over, including Foreign (4,933,359) 473,876 Increase in Federal Funds Borrowed 17,134 1,137,918 Increase in Short-Term Bank Notes 14,100 1,083,136 Increase (Decrease) in Other Short-Term Borrowings 412,643 (2,192,393) Proceeds from Issuance of Long-Term Debt 3,673,213 5,189,968 Proceeds from Issuance of Subordinated Bank Notes - 249,774 Repayment of Long-Term Debt (2,807,920) (1,955,125) Payment of Cash Dividends (344,849) (320,579) Exercise of Stock Options 96,225 35,549 Proceeds from Sale of Common Stock - 16,704 Purchases of Stock (14,696) (214,964) Other 1,607 30,147 - -------------------------------------------------------------------------------------------------------------------------- Net Cash Provided by (Used In) Financing Activities (2,568,287) 3,437,039 ========================================================================================================================== Decrease in Cash and Due from Banks (260,402) (458,357) Cash and Due from Banks at Beginning of Period 1,706,538 1,892,244 - -------------------------------------------------------------------------------------------------------------------------- Cash and Due from Banks at End of Period $ 1,446,136 1,433,887 ========================================================================================================================== </TABLE> See Notes to Condensed Consolidated Financial Statements 5
Fifth Third Bancorp and Subsidiaries Condensed Consolidated Statements of Changes in Shareholders' Equity (unaudited) <TABLE> <CAPTION> ========================================================================================================================== Nine Months Ended September 30, -------------------------------------- ($000's) 2001 2000 ========================================================================================================================== <S> <C> <C> Balance at December 31 $ 6,662,412 $ 5,562,795 Net Income 708,109 821,924 Nonowner Changes in Equity, Net of Tax: Change in Unrealized Gains on Securities Available for Sale 209,933 103,330 - ------------------------------------------------------------------------------------------------------------------------- Net Income and Nonowner Changes in Equity 918,042 925,254 Cash Dividends Declared: Fifth Third Bancorp: Common Stock (2001 - $.60 per share and 2000 - $.52 per share) (325,572) (241,135) Preferred Stock (370) - Pooled Companies Prior to Acquisition: Common Stock (50,872) (85,584) Preferred Stock (185) (555) Stock Options Exercised including Treasury Shares Issued 96,225 35,549 Shares Purchased (14,696) (214,964) Stock Issued in Acquisitions and Other 120,678 56,315 - ------------------------------------------------------------------------------------------------------------------------- Balance at September 30 $ 7,405,662 $ 6,037,675 ========================================================================================================================= </TABLE> See Notes to Condensed Consolidated Financial Statements 6
FINANCIAL INFORMATION --------------------- Item 1. Notes to Condensed Consolidated Financial Statements - ------------------------------------------------------------- 1. In the opinion of management, the unaudited Condensed Consolidated Financial Statements include all adjustments (which consist of normal recurring accruals) necessary, to present fairly the consolidated financial position as of September 30, 2001 and 2000, the results of operations for the three and nine months ended September 30, 2001 and 2000, the statements of cash flows for the nine months ended September 30, 2001 and 2000 and the statement of changes in shareholders' equity for the nine months ended September 30, 2001 and 2000. In accordance with accounting principles generally accepted in the United States of America for interim financial information, these statements do not include certain information and footnote disclosures required for complete annual financial statements. Financial information as of December 31, 2000 has been derived from the audited Consolidated Financial Statements of Fifth Third Bancorp (the "Registrant" or "Fifth Third"). The results of operations for the three and nine months ended September 30, 2001 and 2000 and the statements of cash flows for the nine months ended September 30, 2001 and 2000 are not necessarily indicative of the results to be expected for the full year. For further information, refer to the Consolidated Financial Statements and footnotes thereto for the year ended December 31, 2000, included in the Registrant's Annual Report on Form 10-K. Certain reclassifications have been made to prior periods' consolidated financial statements and related notes to conform with the current period presentation. As described in Note 2, the accompanying prior period Condensed Consolidated Financial Statements of the Registrant have been restated to include the financial results of Old Kent Financial Corporation ("Old Kent"). 2. Business Combinations: --------------------- On January 2, 2001, the Registrant completed the acquisition of Resource Management, Inc., d.b.a. Maxus Investment Group ("Maxus"), an Ohio corporation. Maxus was a privately-held diversified financial services company that provides investment management and brokerage services, headquartered in Cleveland, Ohio. In connection with this acquisition, the Registrant issued 470,162 shares of Fifth Third common stock and paid $18,090,000 in cash for the outstanding capital stock of Maxus. This transaction was accounted for as a purchase transaction. The results of operations of Maxus have been included in the Condensed Consolidated Financial Statements of the Registrant since January 2, 2001. The pro forma prior period results are not material. On March 9, 2001, the Registrant completed the acquisition of Capital Holdings, Inc. ("Capital Holdings") and its subsidiary, Capital Bank N.A., headquartered in Sylvania, Ohio. At December 31, 2000, Capital Holdings had total assets of $1.1 billion and total deposits of $874 million. In connection with this acquisition, the Registrant issued 4,505,385 shares of Fifth Third common stock for the outstanding common shares of Capital Holdings. This transaction was tax-free and was accounted for as a pooling of interest. The accompanying prior period Condensed Consolidated Financial Statements of the Registrant have not been restated for Capital Holdings due to immateriality. On April 2, 2001, the Registrant completed the acquisition of Old Kent, a publicly-traded financial holding company headquartered in Grand Rapids, Michigan. At December 31, 2000, Old Kent had total assets of $23.8 billion 7
Item 1. Notes to Condensed Consolidated Financial Statements (continued) - ------------------------------------------------------------------------- and total deposits of $17.4 billion. In connection with this acquisition, the Registrant issued 103,716,638 shares of Fifth Third common stock, 7,250 shares of Fifth Third Series D convertible perpetual preferred stock and 2,000 shares of Fifth Third Series E perpetual preferred stock to the Shareholders of Old Kent. This transaction was tax-free and was accounted for as a pooling of interest. The accompanying prior period Condensed Consolidated Financial Statements of the Registrant have been restated to include the financial results of Old Kent. Certain reclassifications were made to Old Kent's financial statements to conform presentation. The summarized operating results for the separate companies and the combined amounts presented in the Condensed Consolidated Financial Statements follow: <TABLE> <CAPTION> Three Months Ended March 31, 2001 - -------------------------------------------------------------------------------------------------- ($000's) Fifth Third Old Kent Combined - -------------------------------------------------------------------------------------------------- <S> <C> <C> <C> Net Interest Income $ 392,935 $195,469 $ 588,404 Other Operating Income 292,492 120,688 413,180 Net Income Available to Common Shareholders 244,304 55,130 299,434 </TABLE> <TABLE> <CAPTION> Three Months Ended September 30, 2000 - ------------------------------------------------------------------------------------------------- ($000's) Fifth Third Old Kent Combined - ------------------------------------------------------------------------------------------------- <S> <C> <C> <C> Net Interest Income $ 370,994 $196,011 $ 567,005 Other Operating Income 254,378 118,574 372,952 Net Income Available to Common Shareholders 228,026 81,469 309,495 </TABLE> <TABLE> <CAPTION> Nine Months Ended September 30, 2000 - ------------------------------------------------------------------------------------------------- ($000's) Fifth Third Old Kent Combined - ------------------------------------------------------------------------------------------------- <S> <C> <C> <C> Net Interest Income $1,099,158 $583,556 $1,682,714 Other Operating Income 742,602 351,598 1,094,200 Net Income Available to Common Shareholders 626,483 194,886 821,369 </TABLE> The combined results are not necessarily indicative of the results that would have occurred had the acquisition been consummated in the past or which might be attained in the future. During 2001, the Registrant incurred merger-related charges totaling $384,032,000 ($293,618,000 after tax, or $.50 per diluted share) in connection with the Old Kent merger transaction. The significant components of the merger charge include employee-related 8
Item 1. Notes to Condensed Consolidated Financial Statements (continued) - ------------------------------------------------------------------------- charges of $77.4 million, professional fees of $45.8 million, credit quality charges of $35.4 million, duplicate facilities and equipment of $63.7 million, conversion costs of $70.8 million, divestitures and shutdown charges of $78.9 million (including losses incurred on the sale of Old Kent's east and west coast mortgage business and losses incurred on the sale of Old Kent's subprime mortgage lending portfolio and small-ticket leasing portfolio in order to align Old Kent with the Registrant's asset liability management policies) and other merger-related charges of $12 million. Employee-related costs include the severance packages negotiated with approximately 1,400 people (including all levels of the previous Old Kent organization from the executive management level to back office support staff) and the change-in-control payments made pursuant to pre-existing employment agreements. Employee-related payments made through September 30, 2001 totaled approximately $48.8 million, including payment to the approximate 970 people that have been terminated through September 30, 2001. Credit quality charges relate to conforming Old Kent commercial and consumer loans to the Registrant's credit policies. Specifically, these loans were conformed to the Registrant's credit rating and review systems as documented in the Registrant's credit policies. Commercial credit quality charges largely relate to Old Kent concentrations in real estate investment property lending and sub prime lending and their related collateral quality valuations as well as Old Kent's overall higher commercial lending authorities, as compared to the Registrant's standards. Consumer credit quality charges largely relate to the application of the Registrant's more conservative grading of high LTV loans and purchased home equity loan portfolios. Based on the conforming ratings, reserves were established based on the present value of expected future cash flows discounted at the loan's effective interest rate or fair value of the underlying collateral. The Registrant evaluated the collectibility of both principal and interest in assessing the need for a loss accrual. During the second quarter of 2001 the Registrant charged-off $35.4 million in loans related to these factors. Duplicate facilities and equipment charges of $63.7 million largely include the sale of the six branches required to be divested as a condition for regulatory approval of the merger, negotiated terminations of several office leases and writedowns of duplicative equipment and software. Conversion costs of $70.8 million include vendor contract termination costs related to certain application systems and the conversion of new affiliates and banking centers (including signage and all customer relationships). On October 31, 2001, the Registrant completed the acquisition of USB, Inc. (USB) and its subsidiaries. USB was a privately-held company that provides payment processing services for agent banks and small and medium-sized merchants. This transaction will be accounted for as a purchase transaction. Earlier in fiscal 2001, the Registrant had purchased 49% of USB'S outstanding common and preferred stock. The consolidated results of USB will be included in the financial statements of the Registrant beginning on October 31, 2001. 3. For the first nine months of 2001, the Registrant paid $1,912,407,000 in interest and $74,194,000 in Federal income taxes. For the same period in 2000, the Registrant paid $1,957,869,000 in interest and paid $125,950,000 in Federal income taxes. During the first nine months of 2001 and 2000, the Registrant had noncash investing activities consisting of the securitization of $2,818,324,000 and $1,436,359,000 of residential mortgage and consumer loans, respectively. 9
Item 1. Notes to Condensed Consolidated Financial Statements (continued) - ------------------------------------------------------------------------- 4. Effective January 1, 2001, the Registrant adopted Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for Derivative Instruments and Hedging Activities," as amended, which establishes accounting and reporting standards for derivative instruments and hedging activities and requires recognition of all derivatives as either assets or liabilities in the statement of financial condition and measurement of those instruments at fair value. On the date the Registrant enters into a derivative contract, the Registrant designates the derivative instrument as either a fair value hedge, cash flow hedge or as a free-standing derivative instrument. For a fair value hedge, changes in the fair value of the derivative instrument and changes in the fair value of the hedged asset or liability or of an unrecognized firm commitment attributable to the hedged risk are recorded in current period net income. For a cash flow hedge, changes in the fair value of the derivative instrument to the extent that it is effective are recorded in other comprehensive income within shareholders' equity and subsequently reclassified to net income in the same period(s) that the hedged transaction impacts net income. For free-standing derivative instruments, changes in the fair values are reported in current period net income. Prior to entering a hedge transaction, the Registrant formally documents the relationship between hedging instruments and hedged items, as well as the risk management objective and strategy for undertaking various hedge transactions. This process includes linking all derivative instruments that are designated as fair value or cash flow hedges to specific assets and liabilities on the balance sheet or to specific forecasted transactions along with a formal assessment at both inception of the hedge and on an ongoing basis as to the effectiveness of the derivative instrument in offsetting changes in fair values or cash flows of the hedged item. If it is determined that the derivative instrument is not highly effective as a hedge, hedge accounting is discontinued and the fair value of the derivative instrument is recorded in net income. The Registrant maintains an overall interest rate risk management strategy that incorporates the use of derivative instruments to minimize significant unplanned fluctuations in earnings and cash flows caused by interest rate volatility. The Registrant's interest rate risk management strategy involves modifying the repricing characteristics of certain assets and liabilities so that changes in interest rates do not adversely affect the net interest margin and cash flows. Derivative instruments that the Registrant uses as part of its interest rate risk management strategy include interest rate and principal only swaps, interest rate floors, forward contracts and both futures contracts and options on futures contracts. Interest rate swap contracts are exchanges of interest payments, such as fixed-rate payments for floating-rate payments, based on a common notional amount and maturity date. Forward contracts are contracts in which the buyer agrees to purchase and the seller agrees to make delivery of a specific financial instrument at a predetermined price or yield. Principal only ("PO") swaps are total return swaps based on changes in value of an underlying PO trust. Futures contracts are contracts that represent the obligation to buy or sell a predetermined amount of debt subject to the contracts specific delivery requirements at a predetermined date and a predetermined price. Options on futures contracts represent the right but not the obligation to buy or sell. The Registrant also enters into foreign exchange contracts for the benefit of customers. By policy, the Registrant hedges the exposure of these free-standing derivatives entered into for the benefit of customers by entering into offsetting third-party forward contracts with approved reputable counterparties with matching terms and currencies that 10
Item 1. Notes to Condensed Consolidated Financial Statements (continued) - ------------------------------------------------------------------------- are generally settled daily. Risks arise from the possible inability of counterparties to meet the terms of their contracts and from any resultant exposure to movement in foreign currency exchange rates, limiting the Registrant's exposure to the replacement value of the contracts rather than the notional principal or contract amounts. Free-standing derivatives also include derivative transactions entered into for risk management purposes that do not otherwise qualify for hedge accounting. The Registrant will enter into interest rate swap agreements with commercial clients and an unconsolidated qualifying special purpose entity. The Registrant will hedge its interest rate exposure on these transactions by executing offsetting swap agreements with primary dealers. FAIR VALUE HEDGES - The Registrant enters into interest rate swaps to convert its nonprepayable, fixed-rate long-term debt to floating-rate debt. The Registrant's practice is to convert fixed-rate debt to floating-rate debt. Decisions to convert fixed-rate debt to floating are made primarily by consideration of the asset/liability mix of the Registrant, the desired asset/liability sensitivity and by interest rate levels. For the quarter ended September 30, 2001, the Registrant met certain criteria required to qualify for shortcut method accounting on its fair value hedges of this type. Based on this shortcut method accounting treatment, no ineffectiveness is assumed and fair value changes in the interest rate swaps are recorded as changes in the value of both swap and long term debt. The Registrant has approximately $23.7 million of fair value hedges included in other assets in the September 30, 2001 Condensed Consolidated Balance Sheet. As of September 30, 2001, there were no instances of designated hedges no longer qualifying as fair value hedges. CASH FLOW HEDGES - The Registrant enters into interest rate swaps to convert floating-rate liabilities to fixed rates. The liabilities are typically grouped and share the same risk exposure for which they are being hedged. As of September 30, 2001, $27.6 million in deferred losses related to existing hedges were recorded in other comprehensive income. Gains and losses on derivative contracts that are reclassified from cumulative other comprehensive income to current period earnings are included in the line item in which the hedged item's effect in earnings is recorded. As of September 30, 2001, $27.6 million in deferred losses on derivative instruments included in other comprehensive income are expected to be reclassified into earnings during the next twelve months. All components of each derivative instrument's gain or loss are included in the assessment of hedge effectiveness. Additionally, the Registrant enters into forward contracts to hedge the forecasted sale of its mortgage loans. For the quarter ended September 30, 2001, the Registrant met certain criteria to qualify for matched terms accounting on the hedged loans for sale. Based on this treatment, fair value changes in the forward contracts are recorded as changes in the value of both the forward contract and loans held for sale in the Condensed Consolidated Balance Sheet. For the quarter ended September 30, 2001, there were no cash flow hedges that were discontinued related to forecasted transactions deemed not probable of occurring. The maximum term over which the Registrant is hedging its exposure to the variability of future cash flows for all forecasted transactions, excluding those forecasted transactions related to the payments of variable interest in existing financial instruments, is five years for hedges converting floating-rate loans to fixed and one year for hedges of forecasted sales of mortgage loans. The Registrant has 11
Item 1.Notes to Condensed Consolidated Financial Statements (continued) ----------------------------------------------------------------------- approximately $27.6 million of cash flow hedges related to the floating- rate liabilities included in other short-term borrowings and $8 million of cash flow hedges related to loans held for sale included in other assets in the September 30, 2001 Condensed Consolidated Balance Sheet. FREE-STANDING DERIVATIVE INSTRUMENTS - The Registrant enters into various derivative contracts which primarily focus on providing derivative products to customers. These derivative contracts are not linked to specific assets and liabilities on the balance sheet or to forecasted transactions and, therefore, do not qualify for hedge accounting. Interest rate lock commitments issued on residential mortgage loans intended to be held for resale are also considered free-standing derivative instruments. The interest rate exposure on these commitments is economically hedged primarily with forward contracts. Additionally, the Registrant enters into a combination of free-standing derivative instruments (PO swaps, floors, forward contracts and interest rate swaps) to hedge changes in fair value of its fixed rate mortgage servicing rights portfolio. The commitments and free-standing derivative instruments are marked to market and recorded as a component of mortgage banking noninterest income in the Condensed Consolidated Statement of Income. For the three and nine months ended September 30, 2001, the Registrant recorded gains of $6.1 million and $17.2 million, respectively, on foreign exchange contracts for customers, gains of $.5 million and $2.8 million, respectively, on the net change in interest rate locks and forward contracts and gains of $17.9 million and $12.4 million, respectively, on free-standing derivatives related to mortgage servicing rights. The Registrant has approximately $3 million of free-standing derivatives related to customer transactions included in accrued income receivable and $28.2 million of free-standing derivatives related to interest rate locks and mortgage servicing rights included in other assets in the September 30, 2001 Condensed Consolidated Balance Sheet. 5. In September 2000, the Financial Accounting Standards Board ("FASB") issued SFAS No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities." The statement is effective for transfers and servicing of financial assets occurring after March 31, 2001, with certain disclosure and reclassification requirements effective for financial statements for fiscal years ending after December 15, 2000. Included in SFAS No. 140, which replaced SFAS No. 125 of the same name, are the accounting and reporting standards related to securitizations and Qualifying Special Purpose Entities ("QSPE"). The adoption of SFAS No. 140 did not have a material effect on the Registrant. 6. In June 2001, the FASB issued SFAS No. 141, "Business Combinations," and SFAS No. 142, "Goodwill and Other Intangible Assets." These Statements make significant changes to the accounting for business combinations, goodwill, and intangible assets. SFAS No. 141 eliminates the pooling of interests method of accounting for business combinations with limited exceptions for combinations initiated prior to July 1, 2001. In addition, it further clarifies the criteria for recognition of intangible assets separately from goodwill. This statement is effective for business combinations completed after June 30, 2001. SFAS No. 142 discontinues the practice of amortizing goodwill and indefinite lived intangible assets and initiates an annual review for impairment. Impairment would be 12
Item 1. Notes to Condensed Consolidated Financial Statements (continued) - ------------------------------------------------------------------------- examined more frequently if certain indicators are encountered. Intangible assets with a determinable useful life will continue to be amortized over that period. The amortization provisions apply to goodwill and intangible assets acquired after June 30, 2001. Goodwill and intangible assets on the books at June 30, 2001 will be affected when the Registrant adopts the Statement. The Registrant is currently in the process of finalizing the impact of implementation of the new FASB pronouncements concerning goodwill and other intangible assets. Fifth Third currently has approximately $550 million of unamortized goodwill that generates approximately $13 million in quarterly pretax amortization expense. Pending final implementation guidance, other related interpretations, and the determination of any newly identified intangible assets, Fifth Third expects the quarterly diluted earnings per share impact to be minimal and in the range of approximately $.01 to $.02 per share. 7. In July 2001, the SEC issued Staff Accounting Bulletin ("SAB") No. 102 "Selected Loan Loss Allowance Methodology and Documentation Issues." This bulletin further clarifies the staff's view on the development, documentation and application of a systematic methodology for determining allowances for loans and lease losses in accordance with generally accepted accounting principles. The Registrant did not experience any material changes to its existing methodology as a result of adoption of this bulletin. 8. In June 2001, the FASB issued SFAS No. 143, "Accounting for Asset Retirement Obligations." This Statement addresses financial accounting and reporting for obligations associated with the retirement of tangible long- lived assets and the associated asset retirement costs. This Statement amends FASB Statement No. 19, "Financial Accounting and Reporting by Oil and Gas Producing Companies" and is effective for financial statements issued for fiscal years beginning after June 15, 2002. Adoption of this standard is not expected to have a material effect on the Registrant's Condensed Consolidated Financial Statements. 9. In August 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment and Disposal of Long-Term Assets." This Statement eliminates the allocation of goodwill to long-lived assets to be tested for impairment and details both a probability-weighted and "primary-asset" approach to estimate cash flows in testing for impairment of a long-lived asset. This Statement supersedes FASB Statement No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of," and the accounting and reporting provisions of APB Opinion No. 30, "Reporting the Results of Operations-Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions." This Statement also amends ARB No. 51, "Consolidated Financial Statements." SFAS No. 144 is effective for financial statements issued for fiscal years beginning after December 15, 2001. The Registrant has not yet determined the impact of adopting this standard. 10. In accordance with SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information," the Registrant has determined its principal segments to be retail banking, commercial banking, investment advisory services and data processing. Retail banking provides a full range of deposit products and consumer loans and leases. Commercial banking offers services to business, government and professional customers. Investment advisory services provides a full range of investment alternatives for individuals, companies and not-for-profit organizations. Data processing, through Midwest Payment Systems ("MPS"), provides electronic funds transfer ("EFT") services, merchant transaction processing, operates the Registrant's Jeanie ATM network and provides other data processing services to affiliated and unaffiliated customers. General corporate and 13
Item 1. Notes to Condensed Consolidated Financial Statements (continued) ------------------------------------------------------------------------- other includes the investment portfolio, certain non-deposit funding, unassigned equity, the net effect of funds transfer pricing and other items not allocated to operating segments. Total revenues exclude securities gains and losses. Results of operations and selected financial information by operating segment for the three and nine months ended September 30, 2001 and 2000 are as follows: <TABLE> <CAPTION> Three Months Ended Investment General September 30, Commercial Retail Advisory Data Corporate ($000's) Banking Banking Services Processing (a) And Other Eliminations (a) Total - --------------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> <C> <C> 2001 Total Revenues $ 302,561 $399,734 $ 98,193 $ 89,965 $ 116,205 $ (6,254) $1,000,404 - --------------------------------------------------------------------------------------------------------------------------------- Net Income (Loss) Available to Common Shareholders $ 123,467 $143,495 $ 27,011 $ 32,043 $ (46,599) $ - $ 279,417 - --------------------------------------------------------------------------------------------------------------------------------- 2000 Total Revenues $ 257,647 $385,588 $ 82,525 $ 69,632 $ 149,728 $ (5,583) $ 939,537 - --------------------------------------------------------------------------------------------------------------------------------- Net Income Available to Common Shareholders $ 107,187 $124,557 $ 21,526 $ 23,935 $ 32,290 $ - $ 309,495 - --------------------------------------------------------------------------------------------------------------------------------- </TABLE> <TABLE> <CAPTION> Nine Months Ended Investment General September 30, Commercial Retail Advisory Data Corporate ($000's) Banking Banking Services Processing (a) And Other Eliminations (a) Total - --------------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> <C> <C> 2001 Total Revenues $ 844,409 $1,355,646 $ 298,891 $ 251,757 $ 294,496 $ (17,779) $ 3,027,420 - --------------------------------------------------------------------------------------------------------------------------------- Net Income (Loss) Available to Common Shareholders $ 324,980 $ 408,984 $ 74,146 $ 80,815 $ (181,371) $ - $ 707,554 - --------------------------------------------------------------------------------------------------------------------------------- Identifiable Assets $ 19,453 $ 22,660 $ 1,194 $ 265 $ 26,546 $ - $ 70,118 (in millions) 2000 Total Revenues $ 736,938 $1,168,752 $ 253,021 $ 189,242 $ 443,038 $ (14,437) $ 2,776,554 - --------------------------------------------------------------------------------------------------------------------------------- Net Income Available to Common Shareholders $ 290,076 $ 374,576 $ 68,585 $ 64,339 $ 23,793 $ - $ 821,369 - --------------------------------------------------------------------------------------------------------------------------------- Identifiable Assets $ 18,338 $ 20,677 $ 907 $ 114 $ 26,847 $ - $ 66,883 (in millions) - --------------------------------------------------------------------------------------------------------------------------------- </TABLE> (a) Data Processing services revenues provided to the banking segments by MPS are eliminated in the Condensed Consolidated Statements of Income. 14
Item 1. Notes to Condensed Consolidated Financial Statements (continued) - ------------------------------------------------------------------------- 11. The Registrant has elected to present the disclosures required by SFAS No. 130, "Reporting Comprehensive Income," in the Condensed Consolidated Statement of Changes in Shareholders' Equity on page 6. The caption "Net Income and Nonowner Changes in Equity" represents total comprehensive income as defined in the statement. Disclosure of the reclassification adjustments, related tax effects allocated to nonowner changes in equity and accumulated nonowner changes in equity for the nine months are as follows: <TABLE> <CAPTION> Nine Months Ended September 30, ($000's) 2001 2000 - ------------------------------------------------------------------------------------------------------------------ <S> <C> <C> Reclassification Adjustments, Before Tax - ------------------------------------------------------------------------------------------------------------------ Change in Unrealized Gains Arising During Period $377,551 149,484 Reclassification Adjustment for Gains Included in Net Income (10,339) (360) - ------------------------------------------------------------------------------------------------------------------ Net Unrealized Gains on Securities Available for Sale $367,212 149,124 - ------------------------------------------------------------------------------------------------------------------ Related Tax Effects - ------------------------------------------------------------------------------------------------------------------ Change in Unrealized Gains Arising During Period $161,058 45,937 Reclassification Adjustment for Gains Included in Net Income (3,779) (143) - ------------------------------------------------------------------------------------------------------------------ Net Unrealized Gains on Securities Available for Sale $157,279 45,794 - ------------------------------------------------------------------------------------------------------------------ Reclassification Adjustments, Net of Tax - ------------------------------------------------------------------------------------------------------------------ Change in Unrealized Gains Arising During Period $216,493 103,547 Reclassification Adjustment for Gains Included in Net Income (6,560) (217) - ------------------------------------------------------------------------------------------------------------------ Net Unrealized Gains on Securities Available for Sale $209,933 103,330 - ------------------------------------------------------------------------------------------------------------------ Accumulated Nonowner Changes in Equity - ------------------------------------------------------------------------------------------------------------------ Beginning Balance-Unrealized Holding Gains (Losses) on Securities Available for Sale $ 28,012 (301,861) Current Period Change 209,933 103,330 - ------------------------------------------------------------------------------------------------------------------ Ending Balance-Unrealized Holding Gains (Losses) on Securities Available for Sale $237,945 (198,531) - ------------------------------------------------------------------------------------------------------------------ </TABLE> 15
Item 1. Notes to Condensed Consolidated Financial Statements (continued) ------------------------------------------------------------------------- 12. The reconciliation of earnings per share to earnings per diluted share follows: <TABLE> <CAPTION> Three Months Ended September 30, 2001 2000 - ------------------------------------------------------------------------------------------------------------------------------- Net Average Per-Share Net Average Per-Share ($000's except per share) Income Shares Amount Income Shares Amount - ------------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> <C> EPS Net Income $ 279,602 $ 309,680 Less: Dividends on Preferred Stock 185 185 - ------------------------------------------------------------------------------------------------------------------------------- Income Available to Common Shareholders $ 279,417 577,252 $ .48 $ 309,495 565,440 $ .55 Effect of Dilutive Securities Stock Options 11,786 8,280 Convertible Preferred Stock 145 308 145 308 Interest on 6% Convertible Subordinated Debentures due 2028, Net of Applicable Income Taxes 1,640 4,416 1,640 4,416 - -------------------------------------------------------------------------------------------------------------------------- Earnings Per Diluted Share Income Available to Common Shareholders Plus Assumed Conversions $ 281,202 593,762 $ .47 $ 311,280 578,444 $ .54 - -------------------------------------------------------------------------------------------------------------------------- </TABLE> <TABLE> <CAPTION> Nine Months Ended September 30, 2001 2000 - ------------------------------------------------------------------------------------------------------------------------------- Net Average Per-Share Net Average Per-Share ($000's EXCEPT PER SHARE) Income Shares Amount Income Shares Amount - ------------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> <C> EPS Net Income $ 708,109 $ 821,924 Less: Dividends on Preferred Stock 555 555 - ------------------------------------------------------------------------------------------------------------------------------- Income Available to Common Shareholders $ 707,554 574,349 $ 1.23 $ 821,369 565,831 $ 1.46 Effect of Dilutive Securities Stock Options 11,117 7,628 Convertible Preferred Stock 435 308 435 308 Interest on 6% Convertible Subordinated Debentures due 2028, Net of Applicable Income Taxes 4,920 4,416 4,920 4,416 - ------------------------------------------------------------------------------------------------------------------------------- Earnings Per Diluted Share Income Available to Common Shareholders $ 712,909 590,190 $ 1.21 $ 826,723 578,183 $ 1.43 Plus Assumed Conversions - ------------------------------------------------------------------------------------------------------------------------------- </TABLE> 16
Item 2. Management's Discussion and Analysis of Financial Condition and Results - ------------------------------------------------------------------------------- of Operations - ------------- The following is management's discussion and analysis of certain significant factors which have affected the Registrant's financial condition and results of operations during the periods included in the Condensed Consolidated Financial Statements which are a part of this filing. This report includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, that involve inherent risks and uncertainties. A number of important factors could cause actual results to differ materially from those in the forward-looking statements. Those factors include the economic environment, competition, products and pricing in geographic and business areas in which the Registrant operates, prevailing interest rates, changes in government regulations and policies affecting financial services companies, credit quality and credit risk management, changes in the banking industry including the effects of consolidation resulting from possible mergers of financial institutions, acquisitions and integration of acquired businesses. The Registrant undertakes no obligation to release revisions to these forward-looking statements or reflect events or circumstances after the date of this report. Results of Operations - --------------------- The Registrant's operating earnings were $363.5 million for the third quarter of 2001 and $1 billion for the nine months of 2001, up 17.5 percent and 13.5 percent, respectively, compared to $309.5 million and $888 million for the same periods last year. Operating earnings per diluted share were $.62 for the third quarter, up 14.8 percent over last year's $.54, and $1.72 for the nine months of 2001, up 11.0 percent from $1.55 for the same period last year. Net interest income on a fully taxable equivalent basis for the third quarter of 2001 was $618.9 million, a 6.7 percent increase over $579.9 million for the same period last year, resulting principally from a 4.0 percent growth in average interest-earning assets and a 9 basis point ("bp") increase in net interest margin, from 3.71 percent during the third quarter of 2000 to 3.80 percent in the third quarter 2001. For the nine-month period, net interest income on a fully taxable equivalent basis increased to $1.8 billion, or 7.1 percent, from the $1.7 billion reported in the same period last year, resulting principally from a 6.3 percent growth in average interest-earning assets and a 3bp improvement in the net interest margin, from 3.76 percent to 3.79 percent. The negative effect of a decline in the yield on average interest-earning assets of 109bp over third quarter 2000 and 61bp over the first nine months of 2000, was offset by a decrease in funding costs of 121bp and 47bp for the three and nine months ended September 30, 2001, respectively. The decline in funding costs was primarily due to the repricing of borrowed funds and lower year-over-year deposit rates on existing accounts. The provision for credit losses was $47.5 million in the 2001 third quarter compared to $26.8 million in the same period last year. Net charge-offs for the quarter were $46.7 million compared to $23 million in the 2000 third quarter and $42.1 million last quarter. Net charge-offs as a percent of average loans and leases outstanding increased 22bp to .44 percent from .22 percent in the same period last year. Nonperforming assets as a percentage of total loans, leases and other real estate owned was .51 percent at September 30, 2001 compared to .42 percent at September 30, 2000 and .44 percent last quarter. Underperforming assets were $350.9 million at September 30, 2001, or .85 percent of total loans, leases and other real estate owned, up 16bp compared to the 17
Item 2. Management's Discussion and Analysis of Financial Condition and Results - ------------------------------------------------------------------------------- of Operations (continued) - ------------------------- $285.8 million, or .69 percent, at September 30, 2000 and up 9bp compared to the $316.3 million or .76 percent last quarter. The Registrant maintains a reserve to absorb probable loan and lease losses inherent in the portfolio. The reserve for credit losses is maintained at a level the Registrant considers to be adequate to absorb probable loan and lease losses inherent in the portfolio, based on evaluations of the collectibility and historical loss experience of loans and leases. Credit losses are charged and recoveries are credited to the reserve. Provisions for credit losses are based on the Registrant's review of the historical credit loss experience and such factors which, in management's judgement, deserve consideration under existing economic conditions in estimating probable credit losses. The reserve is based on ongoing quarterly assessments of the probable estimated losses inherent in the loan and lease portfolio. In determining the appropriate level of reserves, the Registrant estimates losses using a range derived from "base" and "conservative" estimates. The Registrant's methodology for assessing the appropriate reserve level consists of several key elements. Larger commercial loans that exhibit potential or observed credit weaknesses are subject to individual review. Where appropriate, reserves are allocated to individual loans based on management's estimate of the borrower's ability to repay the loan given the availability of collateral, other sources of cash flow and legal options available to the Registrant. Included in the review of individual loans are those that are impaired as provided in Statement of Financial Accounting Standards No. 114, "Accounting by Creditors for Impairment of a Loan." Any reserves for impaired loans are measured based on the present value of expected future cash flows discounted at the loan's effective interest rate or fair value of the underlying collateral. The Registrant evaluates the collectibility of both principal and interest when assessing the need for a loss accrual. Historical loss rates are applied to other commercial loans not subject to specific reserve allocations. The loss rates are derived from a migration analysis, which computes the net charge-off experience sustained on loans according to their internal risk grade. These grades encompass ten categories that define a borrower's ability to repay their loan obligations. Homogenous loans, such as consumer installment, residential mortgage loans, and automobile leases are not individually risk graded. Reserves are established for each pool of loans based on the expected net charge-offs for one year. Loss rates are based on the average net charge-off history by loan category. Historical loss rates for commercial and consumer loans may be adjusted for significant factors that, in management's judgement, reflect the impact of any current conditions on loss recognition. Factors which management considers in the analysis include the effects of the national and local economies, trends in the nature and volume of loans (delinquencies, charge-offs, nonaccrual and problem loans), changes in the internal lending policies and credit standards, collection practices, and examination results from bank regulatory agencies and the Registrant's internal credit examiners. An unallocated reserve is maintained to recognize the imprecision in estimating and measuring loss when evaluating reserves for individual loans or pools of loans. Reserves on individual loans and historical loss rates are reviewed quarterly and adjusted as necessary based on changing borrower and/or collateral conditions and actual collection and charge-off experience. 18
Item 2. Management's Discussion and Analysis of Financial Condition and Results - ------------------------------------------------------------------------------- of Operations (continued) - ------------------------- The Registrant has not substantively changed any aspect to its overall approach in the determination of the allowance for loan losses. There have been no material changes in assumptions or estimation techniques as compared to prior periods that impacted the determination of the current period allowance. The overall increase between periods in total non-performing and under-performing assets was offset by the decrease in loan and lease balances outstanding as of September 30, 2001. Total other operating income, excluding securities gains, increased 5.3 percent to $392.4 million compared to $372.5 million in the third quarter 2000, and increased to $1.2 billion for the first nine months of 2001, or 11.8 percent, compared to $1.1 billion for the same period last year. Data processing income increased 33.1 percent compared to the same period in 2000 to $86 million in the 2001 third quarter and 32.3 percent, to $234 million, in the nine-month period. Increases in electronic funds transfers ("EFT") and higher transaction volume from increased debit and ATM card usage, coupled with expansion of business-to- business e-commerce, contributed to the increase in data processing income. During the 2001 third quarter, the Registrant began an on-balance sheet hedging strategy to protect against impairment losses expected to be incurred on the mortgage servicing rights portfolio. This strategy included the purchase of various securities classified as available for sale on the balance sheet. Throughout the quarter these securities were sold resulting in realized gains of $69.7 million for the quarter and nine months ended September 30, 2001. Compared to the same periods in 2000, investment advisory income increased 10.2 percent to $75.9 million in the third quarter and 10.8 percent to $233.4 million for the first nine months of 2001. Although trust and investment management revenue comparisons were affected by lower equity market performance this quarter, income from private client services, corporate trust, and Fifth Third Securities experienced double-digit growth rates. Service charges on deposits increased 20.7 percent over the same period last year and 19.2 percent for the nine-month period primarily due to continued sales success in treasury management services and Retail and Commercial deposit campaigns. Excluding a pre-tax $42.7 million gain realized from the sale of 11 branches in Arizona in the 2001 third quarter, other service charges and fees increased 23.8 percent over the same period last year, and 24 percent for the nine-month period, primarily due to increases in loan origination fees across nearly all categories from continued strong loan demand. For the third quarter and nine months ended September 2001, commercial banking fees increased 46.3 percent and 36.2 percent, credit card fees increased 23.0 percent and 19.6 percent, and loan and lease fees increased 9.9 percent and 17.9 percent, respectively. Mortgage banking revenue decreased $90.1 million from $62.7 million in the third quarter of 2000 to a loss of $28 million in the third quarter of 2001 and decreased $106.1 million from $191.6 million for the first nine months of 2000 to $85.6 million for the first nine months of 2001 primarily due to impairment incurred in the mortgage servicing rights portfolio. Operating earnings include a nonrecurring pretax charge of $129.4 million in the 2001 third quarter, and $384 million and $99 million for the nine months ended 2001 and 2000, respectively. These merger-related charges were incurred in connection with Fifth Third's integration of Old Kent in 2001 and Old Kent's integration of Grand Premier Financial, Inc. and Merchant Bancorp, 19
Item 2. Management's Discussion and Analysis of Financial Condition and Results - ------------------------------------------------------------------------------- of Operations (continued) - ------------------------- Inc. in 2000. The merger-related charges incurred in 2001 consist of employee- related charges of $77.4 million, professional fees of $45.8 million, credit quality charges of $35.4 million, duplicate facilities and equipment of $63.7 million, conversion costs of $70.8 million, divestitures and shutdown charges of $78.9 million and other merger-related charges of $12 million. Excluding these merger-related charges, the efficiency ratio (operating expenses divided by the sum of taxable equivalent net interest income and other operating income) was 48.4 percent for the 2001 third quarter and 48.6 percent for the 2001 nine-month period. These ratios represent a slight decline from the 48.0 percent achieved in third quarter 2000 and an improvement over the 48.9 percent for the nine months ended 2000. The slight decline in the third quarter efficiency ratio was primarily due to increased operating expenses partially offset by increased revenues, while the nine month improvement was due to revenue growth outpacing expense increases. Total operating expenses, excluding the merger-related charges, increased to $489.8 million or 7.2 percent in the third quarter and increased 8.7 percent to $1.5 billion for the nine-month period. Salaries, wages, incentives and benefits increased 8.7 percent in the third quarter of 2001 and 6.6 percent during the nine-month period. Net occupancy expense increased 5.0 percent during the third quarter and 7.8 percent during the nine- month period primarily due to an increase in rent expense incurred. Total other operating expenses increased 9.4 percent in the third quarter and 15.2 percent for the nine-month period primarily as a result of an increase in third party credit card marketing and management service related expenses. Financial Condition - ------------------- The Registrant's balance sheet remains strong with high-quality assets and solid capital levels. Total assets were $70.1 billion at September 30, 2001 compared to $69.7 billion at December 31, 2000 and $66.9 billion at September 30, 2000, an increase of .7 percent and 4.8 percent, respectively. On an operating basis, return on average equity was 19.7 percent and return on average assets was 2.04 percent for the third quarter of 2001 compared to 20.6 percent and 1.83 percent, respectively, for the same quarter of last year. Net interest income growth continues to be fueled by interest-earning asset mix and growth and an increase in net interest margin. Average interest-earning assets increased to $64.7 billion for the third quarter of 2001, an increase of $2.5 billion, or 4.0 percent, over the same period last year and $1.9 billion, or 3.0 percent, over 2000 year-end. Average interest-earning assets increased primarily due to growth in taxable securities of $1.8 billion or 10.6 percent compared to prior year third quarter and $1.9 billion or 10.7 percent over 2000 year end. Transaction account deposits grew 21.7 percent, or $4.8 billion, over the same period last year and $2.7 billion, or 11.3 percent, over 2000 year-end. Deposit growth during the period is primarily attributable to the success of campaigns emphasizing customer deposit accounts. Liquidity and Capital Resources - ------------------------------- The maintenance of an adequate level of liquidity is necessary to ensure sufficient funds are available to meet customer loan demand and deposit withdrawals. The banking subsidiaries' liquidity sources consist of short-term marketable securities, maturing loans and federal funds loaned and selected securitizable loan assets. Liquidity has also been obtained through liabilities 20
Item 2. Management's Discussion and Analysis of Financial Condition and Results - ------------------------------------------------------------------------------- of Operations (continued) - ------------------------- such as customer-related core deposits, funds borrowed, certificates of deposit and public funds deposits. At September 30, 2001, shareholders' equity was $7.4 billion compared to $6 billion at September 30, 2000, an increase of $1.4 billion, or 22.7 percent. Shareholders' equity as a percentage of total assets as of September 30, 2001 was 10.6 percent. The Federal Reserve Board has adopted risk-based capital guidelines which assign risk weightings to assets and off-balance sheet items and also define and set minimum capital requirements (risk-based capital ratios). The guidelines also define "well-capitalized" ratios of Tier 1, total capital and leverage as 6 percent, 10 percent and 5 percent, respectively. The Registrant exceeded these "well-capitalized" ratios at September 30, 2001 and 2000. Estimated at September 30, 2001, the Registrant had a Tier 1 risk-based capital ratio of 11.9 percent, a total risk-based capital ratio of 14.1 percent and a leverage ratio of 9.7 percent. At September 30, 2000, the Registrant had a Tier 1 risk-based capital ratio of 11.4 percent, a total risk-based capital ratio of 13.6 percent and a leverage ratio of 9.1 percent. Foreign Currency Exposure - ------------------------- At September 30, 2001 and 2000, the Registrant maintained foreign office deposits of $2.1 billion and $1.5 billion, respectively. These foreign deposits represent U.S. dollar denominated deposits in our foreign branch located in the Cayman Islands. In addition, the Registrant enters into foreign exchange derivative contracts for the benefit of customers involved in international trade to hedge their exposure to foreign currency fluctuations. By policy, the Registrant enters into offsetting third-party forward contracts with approved reputable counter-parties with matching terms and currencies that are generally settled daily. 21
Item 3. Quantitative and Qualitative Disclosures about Market Risk - ------------------------------------------------------------------ Interest rate risk management focuses on maintaining consistent growth in net interest income within Board-approved policy limits. The Registrant uses an earnings simulation model to analyze net interest income sensitivity to movements in interest rates. Given an immediate, sustained 200 basis point upward ramp to the yield curve used in the simulation model, it is estimated net interest income for the Registrant would decrease by 1.51 percent over one year and increase by 1.12 percent over two years. A 200 basis point immediate, sustained downward ramp in the yield curve would decrease net interest income by an estimated .52 percent over one year and decrease net interest income by an estimated 4.80 percent over two years. For further discussion of the Registrant's market risk see the Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Market Risk, included in the Annual Report on Form 10-K for the year ended December 31, 2000. 22
PART II. OTHER INFORMATION --------------------------- Item 6. Exhibits and Reports on Form 8-K - ----------------------------------------- (a) List of Exhibits (3)(i) Amended Articles of Incorporation, as amended, incorporated by reference to the Registrant's Quarterly Report on Form 10-Q for the quarter ended March 31, 2001 (3)(ii) Code of Regulations, as amended, incorporated by reference to the Registrant's Quarterly Report on Form 10-Q for the quarter ended March 31, 2001 (b) Reports on Form 8-K The Registrant filed a report on Form 8-K dated September 6, 2001 related to its Regulation FD Disclosure to assist investors, financial analysts and other interested parties in their analysis of the Registrant. The Registrant filed a report on Form 8-K dated September 17, 2001 to announce the authorization by the Registrant's Board of Directors to repurchase shares of its common stock in accordance with SEC Release No. 44971. SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Fifth Third Bancorp ------------------- Registrant Date: November 14, 2001 /s/ Neal E. Arnold ------------------ Neal E. Arnold Executive Vice President and Chief Financial Officer 23