UNITED STATESSECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
FORM 10-Q
QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OFTHE SECURITIES EXCHANGE ACT OF 1934
For the Quarter Ended September 30, 2002
Commission File Number 0-8076
FIFTH THIRD BANCORP (Exact name of Registrant as specified in its charter)
Fifth Third CenterCincinnati, Ohio 45263(Address of principal executive offices)
Registrant’s telephone number, including area code: (513) 534-5300
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 o
There were 577,787,646 shares of the Registrant’s Common Stock, without par value, outstanding as of October 31, 2002.
FIFTH THIRD BANCORP
INDEX
Fifth Third Bancorp and SubsidiariesCondensed Consolidated Balance Sheets (unaudited)
See Notes to Condensed Consolidated Financial Statements.
Fifth Third Bancorp and SubsidiariesCondensed Consolidated Statements of Income (unaudited)
Fifth Third Bancorp and Subsidiaries Condensed Consolidated Statements of Cash Flows (unaudited)
See Notes to Condensed Consolidated Financial Statements
Fifth Third Bancorp and SubsidiariesCondensed Consolidated Statements of Changes in Shareholders’ Equity (unaudited)
FINANCIAL INFORMATION
1. Basis of Presentation:
2. Business Combinations:
8
3. Pending Acquisition:
4. Supplemental Disclosure of Cash Flow Information:
5. Derivative Financial Instruments:
6. New Accounting Pronouncements:
7. Business Segment Information:
Three Months Ended Sept. 30,($000’s)
8. Nonowner Changes in Equity:
9. Earnings Per Share:
The reconciliation of earnings per share to earnings per diluted share follows:
10. Stock Options and Employee Stock Grant:
11. Related Party Transactions:
The following is management’s discussion and analysis of certain significant factors that 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 earnings were $416.6 million for the third quarter of 2002 and $1.2 billion for the first nine months of 2002, up 49.1 percent and 71.1 percent, respectively, compared to $279.4 million and $707.6 million for the same periods last year. Earnings per diluted share were $.70 for the third quarter, up 48.9 percent from $.47 for the same period last year and $2.04 for the first nine months of 2002, up 68.6 percent from $1.21 for the same period last year. The Registrant’s operating earnings were $416.6 million for the third quarter of 2002 and $1.2 billion for the first nine months of 2002, up 14.6 percent and 20.1 percent, respectively, compared to $363.5 million and $1 billion for the same periods last year. Operating earnings per diluted share were $.70 for the third quarter, up 12.9 percent from $.62 for the same period last year, and $2.04 for the first nine months of 2002, up 18.6 percent from $1.72 for the same period last year. Third quarter and year-to-date 2002 operating earnings are equivalent to net income available to common shareholders. Operating earnings for the third quarter of 2001 exclude $84.1 million of after-tax merger charges, or $.14 per diluted share, associated with the merger and integration of Old Kent. Operating earnings for the first nine months of 2001 exclude $293.6 million of after-tax merger charges, or $.50 per diluted share and an after-tax nonrecurring charge for an accounting principle change related to the adoption of SFAS No.133 of $6.8 million, or $.01 per diluted share.
Consolidated Average Balance Sheets and Analysis of Net Interest Income (taxable equivalent basis)
Net interest income on a fully taxable equivalent basis for the third quarter of 2002 was $688.3 million, an 11.2 percent increase over $618.9 million for the same period last year, resulting principally from a $5.2 billion (eight percent) increase in average interest-earning assets and an 11 basis point (“bp”) increase in net interest margin, from 3.80 percent during the third quarter of 2001 to 3.91 percent in the third quarter of 2002. For the nine-month period, net interest income on a fully taxable equivalent basis increased to $2.0 billion, or 10.4 percent, from the $1.8 billion reported in the same period last year, resulting principally from a $2.5 billion (3.9 percent) increase in average interest-earning assets and a 23 bp increase in net interest margin, from 3.79 percent in 2001 to 4.02 percent in 2002. The negative effect of a decline in the yield on average interest-earning assets of 120 bp for the third quarter of 2002 and 137 bp for the first nine months of 2002 was offset by a decrease in funding costs of 150 bp for the third quarter of 2002 and 182 bp for the first nine months of 2002 as compared to the same periods last year. The decline in funding costs was primarily due to the repricing of borrowed funds and lower year-over-year deposit rates on existing accounts as well as the continued improvement in the overall mix of interest bearing liabilities. The decline in the yield on average interest-earning assets is primarily due to continued asset repricing in a lower rate environment and the sale and subsequent reinvestment of high coupon mortgage-backed
securities in the third quarter. The sale of these securities, and $89.3 million in related gains, were executed in order to minimize risk related to the anticipated elevated level of prepayment speeds on high coupon mortgage-backed securities. Although the effects of this strategy contributed to a decrease in the net interest margin from 4.07 percent in the second quarter to 3.91 percent in the third quarter, near and intermediate term net interest income performance trends will be stabilized given the resulting reduction in prepayment risk. The Registrant expects margin and net interest income trends in coming periods will be dependent upon the magnitude of loan demand, the overall level of business activity in the Registrant’s Midwestern footprint and the path of interest rates in the economy.
The provision for credit losses was $55.5 million in the third quarter of 2002 compared to $47.5 million in the same period last year. Net charge-offs for the quarter were $43.6 million compared to $46.7 million in the third quarter of 2001 and $43.4 million last quarter. Net charge-offs as a percent of average loans and leases outstanding decreased 5 bp to .39 percent from .44 percent in the same period last year and declined 1 bp from last quarter. Nonperforming assets were $247.9 million at September 30, 2002, or .56 percent of total loans, leases and other real estate owned up 5 bp compared to $210.5 million, or .51 percent, at September 30, 2001 and increased 3 bp compared to the $231.1 million, or .53 percent last quarter. Underperforming assets were $439 million at September 30, 2002, or .99 percent of total loans, leases and other real estate owned, up 14 bp compared to the $350.9 million, or .85 percent, at September 30, 2001 and increased 4 bp compared to the $414 million, or .95 percent, last quarter. The Registrant’s strategy for credit risk management includes stringent, centralized credit policies, and uniform underwriting criteria for all loans as well as an overall $25 million credit limit for each customer, with limited exceptions. The strategy also emphasizes diversification on a geographic, industry and customer level, regular credit examinations and quarterly management reviews of large loans and loans experiencing deterioration of credit quality.
The Registrant has not substantively changed any aspect to its overall approach in the determination of the allowance for loan and lease 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 increase in the provision for credit losses in the current quarter compared to the same period last year is primarily due to the overall increase in the total loan and lease portfolio as well as the increase in the nonperforming and underperforming assets at September 30, 2002 as compared to September 30, 2001. The total reserve for credit losses as a percent of nonperforming assets was 266.65 percent at September 30, 2002, relatively consistent with 292.92 percent at September 30, 2001 and 265.45 percent at December 31, 2001. The total reserve for credit losses at September 30, 2002 remained steady at 1.50 percent of the total loan and lease portfolio compared to September 30, 2001 and December 31, 2001 as the Registrant’s consideration of historical and anticipated loss rates in the portfolio has remained relatively consistent. Additionally, the Registrant’s long history of low exposure limits, avoidance of national or sub-prime lending businesses, centralized risk management and diversified portfolio reduces the likelihood of significant unexpected losses.
Total other operating income, excluding non-mortgage related securities gains and losses, increased 12.2 percent to $518.3 million compared to $462.1 million in the third quarter of 2001, and increased to $1.5 billion for the first nine months of 2002, or 16.9 percent over the same period last year. Electronic payment processing income was $134.9 million in the third quarter of 2002, an increase of 56.8 percent compared to the same period in 2001 and increased to $364.7 million for the first nine months of 2002, a 55.9 percent increase over the same period last year. Electronic payment processing income for the third quarter of 2002 and for the first nine months of 2002 includes approximately $21 million and $64 million, respectively, of revenue from the fourth quarter 2001 purchase acquisition of USB. Excluding the revenue addition from USB, electronic payment processing income increased 32.3 percent in the third quarter and 28.5 percent for the first nine months period of 2002 compared to the same periods last year on the strength of increased transaction volumes of 25 percent and 24 percent, respectively. Increases in electronic funds transfers (“EFT”) and merchant processing continued in the third quarter on the strength of a broadly diversified and
largely non-cyclical customer base and product mix with several significant new customer relationships added during the quarter.
During the 2001 third quarter, the Registrant began an on-balance sheet non-qualifying hedging strategy to protect against volatility related to the value of the mortgage servicing rights portfolio. This strategy included the purchase of various securities classified as available-for-sale on the Condensed Consolidated Balance Sheet. Throughout the year certain of these securities were sold resulting in net realized gains of $33.8 million and $32.7 million, respectively, for the third quarter of 2002 and for the first nine months of 2002 compared to a net realized gain of $69.7 million for the three and nine months ended 2001.
Mortgage banking net revenue totaled $9.4 million in the third quarter of 2002 and $121.2 million for the first nine months of 2002, excluding the net realized security gains from the non-qualifying mortgage servicing rights hedging strategy. This represents an increase of 133.5 percent and 41.7 percent, respectively, compared to a net loss of $28 million and net revenue of $85.6 million for the same periods last year. The increase in mortgage banking net revenue between years largely relates to a net increase in core mortgage banking fees driven by the combined results of all origination and sale activities, including favorable experience between years from interest rate lock commitment forward contracts. The total increase in all core mortgage banking fees, including interest rate lock hedging activity, was offset by an overall decrease in origination volume as originations totaled $2.7 billion in the third quarter of 2002 and $7.2 billion for the first nine months of 2002 as compared to total originations of $4.2 billion ($2 billion in-market) and $15.3 billion ($6 billion in-market) in the same periods last year, respectively. Future quarter mortgage banking year-over-year revenue comparisons will no longer be impacted by the divested out-of-market operations acquired from Old Kent given the timing of these sales in the third quarter of 2001. The Registrant expects the core contribution of mortgage banking to total revenues to decline as originations slow from recent record levels. Third quarter mortgage banking net revenue was comprised of $89.8 million in total mortgage banking fees in 2002, as compared to $54.5 million in 2001, plus $95.6 million in gains and mark-to-market adjustments on both settled and outstanding free-standing derivative financial instruments in 2002, as compared to a loss of $2.3 million in 2001, offset by $186.2 million in net valuation adjustments and amortization on mortgage servicing rights in 2002, as compared to $80.3 million in 2001. In addition, mortgage banking revenue for the third quarter of 2002 included $10.2 million resulting from a servicing asset and corresponding gain recognized from a $341 million loan sale transaction. Including the $33.8 million and $32.7 million, respectively, of net realized gains on security sales for the third quarter of 2002 and for the first nine months of 2002, mortgage banking revenue was $43.2 million and $154 million, respectively, representing a 3.7 percent increase and a .8 percent decrease, over the respective periods in 2001.
Compared to the same periods in 2001, investment advisory income increased nine percent to $82.7 million in the third quarter of 2002 and 11 percent to $259.1 million for the first nine months. Private Client and Retail brokerage revenues drove the growth in the quarter with new product introductions and increased marketing providing a positive contribution. The Registrant continues to be one of the largest money managers in the Midwest and as of September 30, 2002 had over $179 billion in assets under care and $28 billion in assets under management.
Service charges on deposits increased 20.2 percent over last year’s third quarter and 20.5 percent over the first nine months of 2001, primarily due to continued sales success in treasury management services and continued growth in the absolute number of deposit accounts resulting from sales success in Retail and Commercial deposit campaigns. Third quarter retail deposit revenue increased 9.6 percent year-over-year, and 8.3 percent for the nine-month period, driven by the success of sales campaigns and direct marketing programs in generating new account relationships in all of the Registrant’s markets. Commercial deposit revenues increased 37.8 percent over last year’s third quarter and 38.2 percent for the nine-month period on the strength of successful cross-selling efforts and the benefit of a lower interest rate environment.
Other service charges and fees decreased 12.3 percent over the third quarter of 2001 and increased 2.4 percent over the first nine months of 2001. The 2002 and 2001 amounts include a gain in the third quarter of 2002 of $7 million from the sale of six branches in Southern Illinois and a gain in third quarter of 2001 of $43 million on the sale of 11 branches in Arizona. Excluding the impact of the above branch sale gains, other service charges increased 13.1 percent over the third quarter of 2001 and 12.6 percent over the first nine months of 2001, due to increases in nearly all categories. Compared to the same periods in 2001, commercial banking revenues increased 18.8 percent and 29 percent, respectively, primarily due to total international revenues increasing by 15 percent and 21.7 percent, respectively. Institutional fixed income trading increased 23.5 percent in the third quarter of 2002 and 25.4 percent for the first nine months.
The efficiency ratio (operating expenses excluding merger-related charges incurred in 2001 divided by the sum of taxable equivalent net interest income and other operating income, excluding non-mortgage related net security gains) was 51.3 percent for the third quarter of 2002 and 46.5 percent for the first nine months of 2002 as compared to 45.3 percent and 47.5 percent, respectively, for the same periods last year. The decline as compared to the same periods in 2001 relates to a pre-tax expense of approximately $82 million realized during the third quarter of 2002 for certain charged-off treasury related aged receivable and in-transit reconciliation items. In a Report on Form 8-K dated September 10, 2002, the Registrant reported that it had concluded that certain predominantly treasury-related aged receivable and in-transit reconciliation items were impaired. The Registrant also reported that it was devoting significant effort and resources to a review of the impairment. Although the review is ongoing, on the basis of information currently available, the Registrant does not believe that there will be material additional charge-offs.
Excluding the impact of the treasury related charged-off items, the efficiency ratio improved slightly to 44.5 percent for the third quarter of 2002 and to 44.2 percent for the first nine months of 2002. This slight improvement in the 2002 third quarter and nine-month period efficiency ratios, excluding the impact of the treasury related charged-off items, was due to revenue growth of 11.6 percent and 13.1 percent, respectively, outpacing expense increases of 9.7 percent and 5.1 percent, respectively. Total operating expenses (excluding merger-related charges incurred in 2001 relating to the Old Kent acquisition) increased to $619.2 million, or 26.4 percent compared to the third quarter of 2001, and increased 10.7 percent to $1.6 billion for the nine-month period. Salaries, wages, incentives and benefits increased 7.2 percent in the third quarter of 2002 and 7.9 percent for the nine-month period. The increase in compensation expense related to the addition of sales officers and back-office personnel along with an increase in profit sharing expense due to the inclusion of the former Old Kent employees in the Fifth Third Profit Sharing Plan beginning in January 2002 and was partially offset by headcount reductions related to the integration of Old Kent. Incremental expenses associated with the fourth quarter 2001 purchase acquisition of USB also impact year-over-year operating expense comparisons. Net occupancy expense remained relatively consistent for the third quarter and first nine months of 2002 compared to the same periods last year. Total other operating expenses increased 61.1 percent (16.5 percent excluding the treasury related charged-off items) in the third quarter and 19.9 percent (5.4 percent excluding the treasury related charged-off items) for the first nine months of 2002.
Financial Condition and Capital Resources
The Registrant’s balance sheet remains strong with high-quality assets and solid capital levels. Total assets were $77.7 billion at September 30, 2002 compared to $71 billion at December 31, 2001 and $70.1 billion at September 30, 2001, an increase of 9.4 percent and 10.8 percent, respectively. On an operating basis, return on average equity was 19.6 percent and return on average assets was 2.18 percent for the third quarter of 2002 compared to 19.7 percent and 2.04 percent, respectively, for the same period last year.
The Registrant’s total loan portfolio was $44.2 billion at September 30, 2002 compared to $41.5 billion at December 31, 2001 and $41.2 billion at September 30, 2001, an increase of $2.7 billion or 6.4 percent and $3 billion or 7.2 percent, respectively. Commercial loans and leases totaled $23.9 billion at September 30, 2002 compared to $22.5 billion at December 31, 2001 and $22.4 billion at September 30, 2001, an increase of 6.5 percent and 7.1 percent, respectively. The Commercial loan and lease portfolio increased despite declines in mortgage and construction balances on the strength of new customer additions and modest improvement in the level of economic activity in the Registrant’s customer base. Installment loan and lease balances increased during the third quarter as a result of continued strong origination volume and totaled $16.5 billion at September 30, 2002 compared to $13.9 billion at December 31, 2001 and $13.6 billion at September 30, 2001, an increase of 18.9 percent and 21.2 percent, respectively. Residential mortgage loans
totaled $3.3 billion at September 30, 2002 compared to $4.8 billion at December 31, 2001 and $4.9 billion at September 30, 2001, a decrease of 30.3 percent and 32.2 percent, respectively. The end of the period residential mortgage loan balance comparisons are impacted by the sale of $341 million of loans in the third quarter and the securitization and sale of $614 million in the second quarter of 2002. Loans held for sale, consisting primarily of residential mortgages to be sold in secondary markets, were $2.7 billion at September 30, 2002 and $2.2 billion at December 31, 2001 and $1.9 billion at September 30, 2001, an increase of 22.2 percent and 42.9 percent, respectively. The increase over prior periods is reflective of an increase in the overall level of mortgage origination volume and the Registrant’s policy to sell all qualifying fixed rate and certain adjustable rate mortgage loans.
At September 30, 2002, total available-for-sale and held-to-maturity investment securities were $24.4 billion, compared to $20.5 billion at December 31, 2001 and $21 billion at September 30, 2001, an increase of 19 percent and 16.5 percent, respectively, and proportionately remained relatively consistent with the growth in the overall balance sheet. The estimated average life of the portfolio at September 30, 2002 was 4.2 years based on current prepayment expectations.
Transaction account deposits grew 43.6 percent, or $11.8 billion, over the same period last year and $7.8 billion, or 25.2 percent, over 2001 year-end. Transaction account deposit growth during the period is primarily attributable to the success of campaigns emphasizing customer deposit accounts as well as the overall dynamic in the current economy with regard to equity market outflows. Total deposits increased 12.9 percent over the same period last year and 12.2 percent over 2001 year-end, as transaction account deposit growth was offset by a decrease in time deposits. This shift from time deposits to transaction deposits provides the Registrant a more favorable funding mix.
Short-term borrowings and federal funds borrowed totaled $7.2 billion, compared to $7.5 billion at December 31, 2001 and $6.9 billion at September 30, 2001 a decrease of 3.9 percent and an increase of 4 percent, respectively. The movement in these borrowings is a function of overall balance sheet funding requirements. Long term debt was $7.5 billion at September 30, 2002, compared with $7 billion at December 31, 2001 and September 30, 2001.
The Registrant maintains a relatively high level of capital as a margin of safety for its depositors and shareholders. At September 30, 2002, shareholders’ equity was $8.4 billion compared to $7.4 billion at September 30, 2001, an increase of $970 million, or 13.1 percent. Average shareholders’ equity as a percentage of total assets as of September 30, 2002 was 11.11 percent. The Federal Reserve Board has adopted risk-based capital guidelines that 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, 2002 and 2001. The Registrant expects to maintain these ratios above the well-capitalized levels throughout 2002. At September 30, 2002, the Registrant had a Tier 1 risk-based capital ratio of 12.10 percent, a total risk-based capital ratio of 13.96 percent and a leverage ratio of 10.21 percent. At September 30, 2001, the Registrant had a Tier 1 risk-based capital ratio of 11.69 percent, a total risk-based capital ratio of 13.93 percent and a leverage ratio of 9.79 percent.
In December 2001, and as amended in May 2002, the Board of Directors authorized the repurchase in the open market, or in any private transaction, of up to three percent of common shares outstanding. In the third quarter of 2002, the Registrant purchased approximately 3.3 million shares of common stock for an aggregate of approximately $202 million. At September 30, 2002, the total remaining common stock repurchase authority was approximately 10.1 million shares.
In September 2002, the Board of Directors approved an increase in the Registrant’s quarterly common stock dividend to $0.26 cents per share representing a 30% increase over the same quarter last year.
Foreign Currency Exposure
At September 30, 2002, December 31, 2001 and September 30, 2001 the Registrant maintained foreign office deposits of $2.4 billion, $1.2 billion and $2.1 billion, respectively. These foreign deposits represent U.S. dollar denominated deposits in our foreign branches 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. Generally, the Registrant enters into offsetting third-party forward contracts with approved reputable counterparties with matching terms and currencies that are generally settled daily.
Critical Accounting Policies
Reserve for Credit Losses: 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 and is 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 judgment, 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, as discussed below. The Registrant’s strategy for credit risk management includes stringent, centralized credit policies, and uniform underwriting criteria for all loans as well as an overall $25 million credit limit for each customer, with limited exceptions. The strategy also emphasizes diversification on a geographic, industry and customer level, regular credit examinations and quarterly management reviews of large loans and loans experiencing deterioration of credit quality.
Larger commercial loans that exhibit probable 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 SFAS 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. The risk rating system is intended to identify and measure the credit quality of all commercial lending relationships.
Homogenous loans, such as consumer installment, residential mortgage loans, and automobile leases are not individually risk graded. Rather, standard credit scoring systems are used to assess credit risks. 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 judgment, 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.
The Registrant’s primary market areas for lending are Ohio, Kentucky, Indiana, Florida, Michigan, Illinois and West Virginia. When evaluating the adequacy of reserves, consideration is given to this regional geographic concentration and the closely associated effect changing economic conditions has on the Registrant’s customers.
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.
Based on the procedures discussed above, management is of the opinion the reserve of $660,934,000 was adequate, but not excessive, to absorb estimated credit losses associated with the loan and lease portfolio at September 30, 2002.
Valuation of Derivatives: 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. Derivative instruments that the Registrant may use 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. The primary risk of material changes to the value of the derivative instruments is the fluctuation in interest rates, however, as the Registrant principally utilizes these derivative instruments as part of a designated hedging program, the change in the derivative value is generally offset by a corresponding change in the value of the hedged item or a forecasted transaction. The fair values of derivative financial instruments are based on current market quotes.
Valuation of Mortgage Servicing Rights: When the Registrant sells loans through either securitizations or individual loan sales in accordance with its investment policies, it may retain one or more subordinated tranches, servicing rights and in some cases a cash reserve account, all of which are retained interests in the securitized or sold loans. Gain or loss on sale of the loans depends in part on the previous carrying amount of the financial assets involved in the sale, allocated between the assets sold and the retained interests based on their relative fair value at the date of the sale. To obtain fair values, quoted market prices are used if available. If quotes are not available for retained interests, the Registrant calculates fair value based on the present value of future expected cash flows using both management’s best estimates and third party data sources for the key assumptions – credit losses, prepayment speeds, forward yield curves and discount rates commensurate with the risks involved.
Servicing rights resulting from loan sales are amortized in proportion to, and over the period of estimated net servicing revenues. Servicing rights are assessed for impairment periodically, based on fair value, with any impairment recognized through a valuation allowance. For purposes of measuring impairment, the rights are stratified based on interest rate and original maturity. Fees received for servicing mortgage loans owned by investors are based on a percentage of the outstanding monthly principal balance of such loans and are included in income as loan payments are received. Costs of servicing loans are charged to expense as incurred.
Key economic assumptions used in measuring any potential impairment of the servicing rights include the prepayment speed of the underlying mortgage loans, the weighted-average life of the loan and the discount
rate. The primary risk of material changes to the value of the mortgage servicing rights resides in the potential volatility in the economic assumptions used, particularly the prepayment speed. The Registrant monitors this risk and adjusts its valuation allowance as necessary to adequately reserve for any probable impairment in the portfolio. By adjusting the allowance as necessary each quarter, the Registrant mitigates its risk to material adverse changes in the value of the portfolio.
Off-Balance Sheet and Certain Trading Activities
The Registrant consolidates majority-owned subsidiaries that it controls. Other entities, including certain joint ventures, in which there is greater than 20% ownership, are accounted for by equity method accounting and not consolidated; those in which there is less than 20% ownership are generally carried at cost.
The Registrant does not participate in any trading activities involving commodity contracts that are accounted for at fair value. In addition, the Registrant has no fair value contracts for which a lack of marketplace quotations necessitates the use of fair value estimation techniques. The Registrant’s off-balance sheet derivative product policy and investment policies provide a framework within which the Registrant and its affiliates may use certain authorized financial derivatives as an asset/liability management tool in meeting the Registrant’s Asset/Liability Management Committee’s (ALCO) capital planning directives, to hedge changes in fair value of its fixed rate mortgage servicing rights portfolio or to provide qualifying customers access to the derivative products market. These policies are reviewed and approved annually by the Audit Committee and the Board of Directors.
As part of the Registrant’s ALCO management, the Registrant may transfer, subject to credit recourse, certain types of individual financial assets to a non-consolidated QSPE that is wholly owned by an independent third party. During the nine months ended September 30, 2002, certain primarily fixed-rate short-term investment grade commercial loans were transferred to the QSPE. These individual loans are transferred at par with no gain or loss recognized and qualify as sales, as set forth in SFAS No. 140. At September 30, 2002, the outstanding balance of loans transferred was $1.9 billion. Given the investment grade nature of the loans transferred, the Registrant does not expect this recourse feature to result in a significant use of funds in future periods.
The Registrant had the following cash flows with the unconsolidated QSPE during the nine months ended September 30:
Through September 30, 2002, the Registrant has sold, subject to credit recourse and with servicing retained, a total of approximately $2.3 billion in leased autos to an unrelated asset-backed special purpose entity that have subsequently been leased back to the Registrant. No significant gain or loss has been recognized on these transactions and the Registrant has established, and evaluates quarterly, a loss reserve for estimated future losses based on historical loss experience. As of September 30, 2002, the outstanding balance of these leases was $1.6 billion and pursuant to this sale-leaseback, the Registrant has future operating lease payments and corresponding scheduled annual lease receipts from the underlying lessee totaling $1.6 billion.
Finally, the Registrant utilizes securitization trusts formed by independent third parties to facilitate the securitization process of residential mortgage loans. The cash flows to and from the securitization trusts are principally limited to the initial proceeds from the securitization trust at the time of sale. Although the Registrant’s securitization policy permits the retention of subordinated tranches, servicing rights, and in
some cases a cash reserve, the Registrant has historically only retained mortgage servicing rights interests in these sales.
The accounting for special purpose entities, including QSPE’s, is currently under review by the FASB and the conditions for consolidation or non-consolidation of such entities could change.
Liquidity and Market Risk
Managing risks is an essential part of successfully operating a financial services company. Among the most prominent risk exposures are interest rate, market and liquidity risk.
The objective of the Registrant’s asset/liability management function is to maintain consistent growth in net interest income within the Registrant’s policy limits. This objective is accomplished through management of the Registrant’s balance sheet composition, liquidity, and interest rate risk exposures arising from changing economic conditions, interest rates and customer preferences.
The goal of liquidity management is to provide adequate funds to meet changes in loan and lease demand or unexpected deposit withdrawals. This is accomplished by maintaining liquid assets in the form of investment securities, maintaining sufficient unused borrowing capacity in the national money markets and delivering consistent growth in core deposits. Additional asset-driven liquidity is provided by the Registrant's ability to sell or securitize loan and lease assets. These sources, in addition to the Registrant’s 11.11 percent average equity capital base, provide a stable funding base.
In June 2002, Moody’s raised its senior debt rating for the Registrant to Aa2 from Aa3, a rating equaled or surpassed by only three other U.S. bank holding companies. This upgrade by Moody’s reflects our capital strength and financial stability and further demonstrates the continued confidence of the rating agencies. The Registrant’s A-1+/Prime-1 ratings on its commercial paper and AA-/Aa2 ratings for its senior debt, along with the AA-/Aa1 long-term deposit ratings of Fifth Third Bank (Ohio); Fifth Third Bank (Michigan); Fifth Third Bank, Indiana; Fifth Third Bank, Kentucky, Inc.; and Fifth Third Bank, Northern Kentucky, Inc. continue to be among the best in the industry. These ratings, along with capital ratios significantly above regulatory guidelines, provide the Registrant with additional liquidity. In addition to core deposit funding, the Registrant also accesses a variety of other short-term and long-term funding sources. The Registrant also uses the Federal Home Loan Bank (FHLB) as a funding source, issuing notes payable through its FHLB member subsidiaries. The Registrant also has significant unused funding capacity in the national money markets. Management does not rely on any one source of liquidity and manages availability in response to changing balance sheet needs. Given the continued strength of the balance sheet, stable credit quality, risk management policies and revenue growth trends, management does not expect any downgrade in the credit ratings based on financial performance in the upcoming year. Management considers interest rate risk the Registrant’s most significant market risk. Interest rate risk is the exposure to adverse changes in net interest income due to changes in interest rates. Consistency of the Registrant’s net interest revenue is largely dependent upon the effective management of interest rate risk.
The Registrant employs a variety of measurement techniques to identify and manage its interest rate risk including the use of an earnings simulation model to analyze net interest income sensitivity to changing interest rates. The model is based on actual cash flows and repricing characteristics for on and off-balance sheet instruments and incorporates market-based assumptions regarding the effect of changing interest rates on the prepayment rates of certain assets and liabilities. The model also includes senior management projections for activity levels in each of the product lines offered by the Registrant. Assumptions based on the historical behavior of deposit rates and balances in relation to changes in interest rates are also incorporated into the model. Actual results will differ from these simulated results due to timing, magnitude, and frequency of interest rate changes as well as changes in market conditions and management strategies.
The Registrant’s ALCO, which includes senior management representatives and reports to the Board of Directors, monitors and manages interest rate risk within Board approved policy limits. The Registrant’s current interest rate risk policy limits are determined by measuring the anticipated change in net interest income over a 12 and 24 month horizon assuming a 200 bp linear increase or decrease in all interest rates.
Current policy limits this exposure to plus or minus 7 percent of net interest income for the first year and plus or minus 7 percent for the second year.
The following table shows the Registrant’s estimated earnings sensitivity profile as of September 30, 2002:
Given a linear 200 bp increase in the yield curve used in the simulation model, it is estimated that net interest income for the Registrant would increase by 2.27 percent in the first year and 7.99 percent in the second year. A 200 bp linear decrease in interest rates would decrease net interest income by 2.90 percent in the first year and an estimated 13.20 percent in the second year. Given the current federal funds rate of 1.75 percent at September 30, 2002, a linear 175 bp decrease for federal funds was modeled in the estimated earnings sensitivity profile in place of the linear 200 bp decrease utilized for the remainder of the portfolio in accordance with the Registrant’s interest rate risk policy. The Registrant is currently out of compliance with the interest rate risk policy in the second year. The Registrant’s ALCO, along with senior management, have deemed the risk of a 200 bp decrease in rates to be low given the current interest rate environment and, therefore, have decided it is prudent to add no additional coverage at this point. Additionally, the Registrant’s interest rate risk profile has been impacted by the origination of floating rate home equity lines and increases in core deposits, which do not always move in step with market rates. The Registrant’s ALCO, along with senior management, views the origination of home equity products and gathering of core deposits as beneficial to the strength and stability of the Registrant's balance sheet and earnings and have decided it is prudent to add no additional coverage at this point. All of the other estimated changes in net interest income are within the policy guidelines established by the Board of Directors. Management does not expect any significant adverse effect to net interest income in 2002 or 2003 based on the composition of the portfolio and anticipated trends in rates.
In order to reduce the exposure to interest rate fluctuations and to manage liquidity, the Registrant has developed securitization and sale procedures for several types of interest-sensitive assets. All long-term, fixed-rate single family residential mortgage loans underwritten according to Federal Home Loan Mortgage Corporation or Federal National Mortgage Association guidelines are sold for cash upon origination. Periodically, additional assets such as adjustable-rate residential mortgages, certain consumer leases and certain short-term commercial loans are also securitized, sold or transferred off-balance sheet. During the nine months ended September 30, 2002 and 2001, a total of $6.8 billion and $9.1 billion, respectively, were sold, securitized, or transferred off-balance sheet (excluding $1.2 billion of divestiture related sales in 2001).
Management focuses its efforts on consistent net interest revenue and net interest margin growth through each of the retail and wholesale business lines.
Controls and Procedures
The Registrant maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in the Registrant’s Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to the Registrant’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure based closely on the definition of “disclosure controls and procedures” in Exchange Act Rules 13a-14 and 15d-14. In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.
Within 90 days prior to the date of this report, the Registrant carried out an evaluation, under the supervision and with the participation of the Registrant’s management, including the Registrant’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Registrant’s disclosure controls and procedures. Based on the foregoing, the Registrant’s Chief Executive Officer and Chief Financial Officer concluded that the Registrant’s disclosure controls and procedures were effective, in all material respects, to ensure that information required to be disclosed in the reports the Registrant files and submits under the Exchange Act is recorded, processed, summarized and reported as and when required.
There have been no significant changes in the Registrant’s internal controls or in other factors that could significantly affect the internal controls subsequent to the date the Registrant completed its evaluation, except as provided in the supervisory letter described in Item 5. Prior to this evaluation, however, the Registrant reviewed internal controls in its Treasury area to determine if there were improvements in internal control that could have limited the after-tax charge-off of $53 million in the third quarter. The Registrant has implemented certain additional processes and controls as a result of this review.
33
PART II. OTHER INFORMATION
Item 5. Other Information
In a Report on Form 8-K dated September 10, 2002, the Registrant reported that it had concluded that certain predominantly treasury-related aged receivable and in-transit reconciliation items were impaired. The Registrant also reported that it was devoting significant effort and resources to a review of the impairment.
On November 7, 2002, the Registrant received a supervisory letter from the Federal Reserve Bank of Cleveland and the Ohio Department of Commerce, Division of Financial Institutions relating to matters including procedures for access to the general ledger and other books and records; segregation of duties among functional areas; procedures for reconciling transactions; the engagement of third party consultants; and efforts to complete the impairment review referred to above. In addition, the supervisory letter imposes a moratorium on future acquisitions, including Franklin Financial Corporation, until the supervisory letter has been withdrawn by both the Federal Reserve Bank of Cleveland and the Ohio Department of Commerce, Division of Financial Institutions. The Registrant is periodically subjected to regulatory oversight and examinations and has historically and will continue to comply with any findings and recommendations resulting from these reviews.
On November 12, 2002, the Registrant was informed by a letter from the Securities and Exchange Commission that the Commission was conducting an informal investigation regarding the after-tax charge of $54 million reported in the Registrant's Form 8-K dated September 10, 2002 and the existance or effects of weaknesses in financial controls in the Registrant's Treasury and/or Trust operations. The Registrant intends to fully comply and assist the Commission in this review.
Item 6. Exhibits and Reports on Form 8-K
(a). List of Exhibits
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.
CERTIFICATION PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002
I, George A. Schaefer, Jr., certify that:
CERTIFICATION PURSUANTTO SECTION 302 OF THESARBANES-OXLEY ACT OF 2002
I, Neal E. Arnold, certify that: