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 Quarterly Period Ended March 31, 2004
Commission File Number 0-8076
FIFTH THIRD BANCORP
(Exact name of Registrant as specified in its charter)
Fifth Third Center
Cincinnati, 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
Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).
There were 562,853,868 shares of the Registrant’s Common Stock, without par value, outstanding as of April 30, 2004.
INDEX
Part I. Financial Information
Item 1.
Item 2.
Item 3.
Item 4.
Part II. Other Information
Item 6.
2
Fifth Third Bancorp and Subsidiaries
Condensed Consolidated Balance Sheets (unaudited)
Assets
Cash and Due from Banks
Securities Available-for-Sale (a)
Securities Held-to-Maturity (b)
Trading Securities
Other Short-Term Investments
Loans Held for Sale
Loans and Leases:
Commercial Loans
Construction Loans
Commercial Mortgage Loans
Commercial Lease Financing
Residential Mortgage Loans
Consumer Loans
Consumer Lease Financing
Unearned Income
Total Loans and Leases
Reserve for Credit Losses
Total Loans and Leases, Net
Bank Premises and Equipment
Operating Lease Equipment
Accrued Interest Receivable
Goodwill
Intangible Assets
Servicing Rights
Other Assets
Total Assets
Liabilities
Deposits:
Demand
Interest Checking
Savings
Money Market
Other Time
Certificates - $100,000 and Over
Foreign Office
Total Deposits
Federal Funds Purchased
Short-Term Bank Notes
Other Short-Term Borrowings
Accrued Taxes, Interest and Expenses
Other Liabilities
Long-Term Debt
Total Liabilities
Minority Interest
Shareholders’ Equity
Common Stock (c)
Preferred Stock (d)
Capital Surplus
Retained Earnings
Accumulated Nonowner Changes in Equity
Treasury Stock
Total Shareholders’ Equity
Total Liabilities and Shareholders’ Equity
See Notes to Condensed Consolidated Financial Statements
3
Condensed Consolidated Statements of Income (unaudited)
Interest Income
Interest and Fees on Loans and Leases
Interest on Securities:
Taxable
Exempt from Income Taxes
Total Interest on Securities
Interest on Other Short-Term Investments
Total Interest Income
Interest Expense
Interest on Deposits:
Total Interest on Deposits
Interest on Federal Funds Purchased
Interest on Short-Term Bank Notes
Interest on Other Short-Term Borrowings
Interest on Long-Term Debt
Total Interest Expense
Net Interest Income
Provision for Credit Losses
Net Interest Income After Provision for Credit Losses
Other Operating Income
Electronic Payment Processing Revenue
Service Charges on Deposits
Mortgage Banking Net Revenue
Investment Advisory Revenue
Other Service Charges and Fees
Operating Lease Revenue
Securities Gains, Net
Securities Gains, Net - Non-Qualifying Hedges on Mortgage Servicing
Total Other Operating Income
Operating Expenses
Salaries, Wages and Incentives
Employee Benefits
Equipment Expenses
Net Occupancy Expenses
Operating Lease Expenses
Other Operating Expenses
Total Operating Expenses
Income from Continuing Operations Before Income Taxes and Minority Interest
Applicable Income Taxes
Income from Continuing Operations Before Minority Interest
Minority Interest, Net of Tax
Income from Continuing Operations
Income from Discontinued Operations, Net of Tax
Net Income
Dividends on Preferred Stock
Net Income Available to Common Shareholders
Basic Earnings Per Share:
Income from Discontinued Operations
Diluted Earnings Per Share:
4
Condensed Consolidated Statements of Cash Flows (unaudited)
Operating Activities
Adjustments to Reconcile Net Income to Net Cash Provided by Operating Activities:
Minority Interest in Net Income
Depreciation, Amortization and Accretion
Stock-Based Compensation Expense
Provision for Deferred Income Taxes
Realized Securities Gains
Realized Securities Gains - Non Qualifying Hedges on Mortgage Servicing
Realized Securities Losses
Realized Securities Losses - Non-Qualifying Hedges on Mortgage Servicing
Proceeds from Sales/Transfers of Residential Mortgage and Other Loans Held for Sale
Net Gain on Sales of Loans
Increase in Residential Mortgage and Other Loans Held for Sale
Increase in Trading Securities
(Increase) Decrease in Accrued Interest Receivable
Decrease (Increase) in Other Assets
(Decrease) Increase in Accrued Taxes, Interest and Expenses
(Decrease) Increase in Other Liabilities
Net Cash Provided by Operating Activities
Investing Activities
Proceeds from Sales of Securities Available-for-Sale
Proceeds from Calls, Paydowns and Maturities of Securities Available-for-Sale
Purchases of Securities Available-for-Sale
Proceeds from Calls, Paydowns and Maturities of Securities Held-to-Maturity
Purchases of Securities Held-to-Maturity
Decrease (Increase) in Other Short-Term Investments
Increase in Loans and Leases
Decrease in Operating Lease Equipment
Purchases of Bank Premises and Equipment
Proceeds from Disposal of Bank Premises and Equipment
Net Cash Used In Investing Activities
Financing Activities
(Decrease) Increase in Core Deposits
(Decrease) Increase in Certificates - $100,000 and Over, including Foreign Office
Increase in Federal Funds Purchased
Increase in Other Short-Term Borrowings
Proceeds from Issuance of Long-Term Debt
Repayment of Long-Term Debt
Payment of Cash Dividends
Exercise of Stock Options, Net
Purchases of Treasury Stock
Other
Net Cash Provided by Financing Activities
Decrease in Cash and Due from Banks
Cash and Due from Banks at Beginning of Period
Cash and Due from Banks at End of Period
Cash Payments
Interest
Federal Income Taxes
5
Condensed Consolidated Statements of Changes in Shareholders’ Equity (unaudited)
Total Shareholders’ Equity, Beginning
Nonowner Changes in Equity, Net of Tax:
Change in Unrealized Gains and (Losses) on Securities Available-for-Saleand Qualifying Cash Flow Hedges
Net Income and Nonowner Changes in Equity
Cash Dividends Declared:
Common Stock (2004 - $.32 per share and 2003 - $.26 per share)
Preferred Stock
Stock Options Exercised including Treasury Shares Issued
Loans Issued Related to the Exercise of Stock Options, Net
Excess Corporate Tax Benefit Related to Stock-Based Compensation
Shares Purchased
Total Shareholders’ Equity, Ending
6
Notes to Condensed Consolidated Financial Statements
In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure—an Amendment of FASB Statement No. 123.” This Statement amends SFAS No. 123, “Accounting for Stock-Based Compensation,” to provide alternative methods of transition for a voluntary change to the fair value method of accounting for stock-based employee compensation. In addition, this Statement amends the disclosure requirements of SFAS No. 123 to require more prominent disclosures about the method of accounting for stock-based employee compensation and the effect of the method used on reported results in both annual and interim financial statements. This Statement was
7
Notes to Condensed Consolidated Financial Statements (continued)
effective for financial statements for fiscal years ending after December 15, 2002. Effective January 1, 2004, the Registrant adopted the fair value recognition provisions of SFAS No. 123 using the retroactive restatement method described in SFAS No. 148. As a result, financial information for all prior periods has been restated to reflect the compensation expense that would have been recognized had the fair value method of accounting been applied to all awards granted to employees after January 1, 1995. See Note 12 for further discussion.
In November 2002, the FASB issued Interpretation No. 45, (FIN 45) “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others,” which elaborates on the disclosures to be made by a guarantor about its obligations under certain guarantees issued. It also clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. The Interpretation expands on the accounting guidance of SFAS No. 5, “Accounting for Contingencies,” SFAS No. 57, “Related Party Disclosures” and SFAS No. 107, “Disclosures about Fair Value of Financial Instruments.” It also incorporates without change the provisions of FASB Interpretation No. 34, “Disclosure of Indirect Guarantees of Indebtedness of Others,” which is superseded. The initial recognition and measurement provisions of this Interpretation apply on a prospective basis to guarantees issued or modified after December 31, 2002. The disclosure requirements in this Interpretation were effective for periods ending
8
after December 15, 2002. Significant guarantees that have been entered into by the Registrant are disclosed in Note 6. Adoption of this Standard did not have a material effect on the Registrant’s Condensed Consolidated Financial Statements.
In March 2004, the Securities and Exchange Commission staff released Staff Accounting Bulletin (SAB) No. 105, “Application of Accounting Principles to Loan Commitments.” This SAB disallows the inclusion of expected future cash flows related to the servicing of a loan in the determination of the fair value of a loan commitment. Further, no other internally developed intangible asset should be recorded as part of the loan commitment derivative. Recognition of intangible assets would only be appropriate in a third-party transaction, such as a purchase of a loan commitment or in a business combination. The SAB is effective for
9
all loan commitments entered into after March 31, 2004, but does not require retroactive adoption for loan commitments entered into on or before March 31, 2004. Adoption of this SAB will not have a material effect on the Registrant’s Condensed Consolidated Financial Statements.
Mortgage servicing rights
Other consumer and commercial servicing rights
Core Deposits
Total
2004 (a)
2005
2006
2007
2008
(a) Includes three months actual and nine months estimated
Other Consumer andCommercial
Servicing Assets
Consumer
Residual
Fixed
Rate
Adjustable
Fair value of retained interests
Weighted-average life (in years)
Prepayment speed assumption (annual rate)
Residual servicing cash flows discount rate (annual)
Weighted average default rate
10
Balance at January 1
Amount capitalized
Amortization
Sales
Change in valuation reserve
Balance at March 31
Servicing valuation provision
Permanent impairment write-off
11
12
13
Foreign exchange contracts for customers
Interest rate lock commitments and forward contracts related to interest rate lock commitments
Derivative instruments related to MSR portfolio
Derivative instruments related to interest rate risk
March 31,
2003
Interest rate lock commitments
Forward contracts related to interest rate lock commitments
14
Average
Pay
Interest rate swaps related to debt:
Receive fixed/pay floating
Receive floating/pay fixed
Interest rate swaps related to LIBOR-based loans:
Mortgage lending commitments:
Forward contracts
Mortgage servicing rights portfolio:
Principal only swaps
Interest rate swaps - Receive fixed/pay floating
Purchased options
Sold options
Swaptions related to interest rate risk:
Written
Purchased
Through March 31, 2004, the Registrant had transferred, subject to credit recourse, certain primarily fixed-rate, short-term, investment grade commercial loans to an unconsolidated QSPE that is wholly owned by an independent third-party. The outstanding balance of such loans at March 31, 2004 was approximately $2.0 billion. These loans may be transferred back to the Registrant upon the occurrence of an event specified in the legal documents that established the QSPE. These events include borrower default on the loans transferred, bankruptcy preferences initiated against underlying borrowers and ineligible loans transferred by the Registrant to the QSPE. The maximum amount of credit risk in the event of nonperformance by the
15
underlying borrowers is approximately equivalent to the total outstanding balance of $2.0 billion at March 31, 2004. The outstanding balances are generally secured by the underlying collateral that include commercial real estate, physical plant and property, inventory, receivables, cash and marketable securities. Given the investment grade nature of the loans transferred as well as the underlying collateral security provided, the Registrant has not maintained any loss reserve related to these loans transferred.
On July 23, 2002, the Registrant entered into an agreement to acquire Franklin Financial Corporation and its subsidiary, Franklin National Bank, headquartered in Franklin, Tennessee. At March 31, 2004, Franklin Financial Corporation had approximately $948 million in total assets and $801 million in total deposits. The pending transaction is structured as a tax-free exchange of stock for a total transaction value expected to be approximately $305 million. The pending transaction was approved by Franklin Financial Corporation shareholders on May 3, 2004 and is subject to regulatory approval. Pursuant to the current terms of the
16
Affiliation Agreement with Franklin Financial Corporation, the transaction must be consummated by June 30, 2004.
On March 27, 2003, the Registrant announced that it and Fifth Third Bank had entered into a Written Agreement with the Federal Reserve Bank of Cleveland and the State of Ohio Department of Commerce, Division of Financial Institutions, which outlined a series of steps to address and strengthen the Registrant’s risk management processes and internal controls. These steps included independent third-party reviews and the submission of written plans in a number of areas. These areas included the Registrant’s management, corporate governance, internal audit, account reconciliation procedures and policies, information technology
17
and strategic planning. On April 7, 2004, the Registrant announced that the Federal Reserve Bank of Cleveland and the Ohio Department of Commerce, Division of Financial Institutions, have terminated the Written Agreement.
Three Months Ended
Service Cost
Interest Cost
Expected Return on Assets
Amortization & Deferral of Transition Amount
Amortization of Actuarial Loss
Amortization of Unrecognized Prior Service Cost
Net periodic pension cost
Effective January 1, 2004, the Registrant began recognizing expense for stock-based compensation under the fair value method of accounting described in SFAS No. 123. The Registrant also adopted the retroactive restatement method for recognizing stock-based compensation expense described in SFAS No. 148. Under SFAS No. 123, the Registrant recognizes compensation expense for the fair value of the stock-based grants over their vesting period. Stock-based compensation awards were eligible for issuance through March 23, 2004 under the 1998 Long Term Incentive Stock Plan and thereafter are eligible for issuance under the Incentive Compensation Plan, adopted on January 20, 2004 and approved by shareholders on March 23, 2004, to key employees, officers and directors of the Registrant and its subsidiaries. The Incentive Compensation Plan provides for nonqualified and incentive stock options, stock appreciation rights, restricted stock and restricted stock units, performance shares and performance units and stock awards. Option grants are at fair market value at the date of the grant, have up to ten year terms and vest and become fully exercisable at the end of three to four years of continued employment. There were no significant stock-based grants during the three months ended March 31, 2004. Stock-based grants during the three months ended March 31, 2003 represented approximately 1.0% of average outstanding shares. The weighted
18
average fair value of options granted was $14.44 and $18.38 for the three months ended March 31, 2004 and March 31, 2003, respectively. The fair value of the options is estimated on the date of grant using the Black-Scholes option pricing model with the following assumptions used for grants in 2004 and 2003:
Expected Dividend Yield
Expected Option Life (in years)
Expected Volatility
Risk-Free Interest Rate
Net income available to common shareholders, as previously reported
Stock-based compensation expense determined under the fair value method, net of tax
Net income available to common shareholders, as restated
Basic earnings per share:
As previously reported
As restated
Diluted earnings per share:
19
Reclassification adjustment, pretax:
Change in unrealized net gains (losses) arising during period
Reclassification adjustment for net gains included in net income
Change in unrealized net gains (losses) on securities available-for-sale
Related tax effects:
Reclassification adjustment, net of tax:
Accumulated nonowner changes in equity:
Beginning balance -
Unrealized net (losses) gains on securities available-for-sale, net of tax benefit of $28 million and tax of $236 million, respectively
Change in unrealized net gains (losses) on securities available-for-sale, net of tax
Ending balance -
Unrealized net gains on securities available-for-sale, net of tax of $80 million and $196 million, respectively
Unrealized net losses on qualifying cash flow hedges, net of tax benefit of $4 million and $9 million, respectively
Unrealized net gains (losses) on qualifying cash flow hedges, net of tax of $4 million and tax benefit of $7 million, respectively
Minimum pension liability, net of tax benefit of $34 million and $28 million, respectively
Current period change
Unrealized net gains on securities available-for-sale
Unrealized net gains (losses) on qualifying cash flow hedges
Minimum pension liability
Accumulated nonowner changes in equity
20
EPS
Income from continuing operations
Dividends on preferred stock
Net income from continuing operations available to common shareholders
Income from discontinued operations, net of tax
Net income available to common shareholders
Diluted EPS
Effect of dilutive securities:
Stock options
Dividends on convertible preferred stock
Income from continuing operations plus assumed conversions
Net income available to common shareholders plus assumed conversions
21
Commercial
Banking
Retail
Investment
Advisory
Services
ElectronicPayment
Processing (a)
General
Corporate
and Other
Three months ended March 31, 2004:
Net interest income (b)
Provision for credit losses
Net interest income after provision for credit losses
Other operating income
Operating expenses
Income before income taxes and cumulative effect
Applicable income taxes (c)
Selected Financial Information
Goodwill as of January 1, 2004
Goodwill recognized
Goodwill as of March 31, 2004
Identifiable assets
Three months ended March 31, 2003:
Income from continuing operations before income taxes and minority interest
Minority interest, net
Income from discontinued operations
Goodwill as of January 1, 2003
Goodwill as of March 31, 2003
22
23
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 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 Sections 27A of the Securities Act of 1933, as amended, and Rule 175 promulgated thereunder, and 21E of the Securities Exchange Act of 1934, as amended, and Rule 3b-6 promulgated thereunder, that involve inherent risks and uncertainties. This report contains certain forward-looking statements with respect to the financial condition, results of operations, plans, objectives, future performance and business of the Registrant including statements preceded by, followed by or that include the words or phrases such as “believes,” “expects,” “anticipates,” “plans,” “trend,” “objective,” “continue,” “remain,” “pattern” or similar expressions or future or conditional verbs such as “will,” “would,” “should,” “could,” “might,” “can,” “may” or similar expressions. There are a number of important factors that could cause future results to differ materially from historical performance and these forward-looking statements. Factors that might cause such a difference include, but are not limited to: (1) competitive pressures among depository institutions increase significantly; (2) changes in the interest rate environment reduce interest margins; (3) prepayment speeds, loan origination and sale volumes, charge-offs and loan loss provisions; (4) general economic conditions, either national or in the states in which the Registrant does business, are less favorable than expected; (5) political developments, wars or other hostilities may disrupt or increase volatility in securities markets or other economic conditions; (6) changes and trends in the securities markets; (7) legislative or regulatory changes or actions, or significant litigation, adversely affect the Registrant or the businesses in which the Registrant is engaged; and (8) the impact of reputational risk created by the developments discussed above on such matters as business generation and retention, funding and liquidity. 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 net income was $430 million for the first quarter of 2004, up 10 percent compared to $390 million for the same period last year. Earnings per diluted share were $.75 for the first quarter, up 12 percent from $.67 for the same period last year. Financial results in the current and all prior periods are impacted by the Registrant’s adoption on a retroactive basis of the fair value provisions of SFAS No. 123 for expense recognition of employee stock-based compensation. The impact on salaries, wages, and incentives expense for the first quarter of 2004 was $23 million ($19 million after-tax), compared to $36 million ($29 million after-tax) in the first quarter of 2003.
Net interest income, net interest margin, net interest rate spread and the efficiency ratio are presented in Management’s Discussion and Analysis of Financial Condition and Results of Operations on a fully taxable equivalent (FTE) basis as the interest on certain loans and securities held by the Registrant is not taxable for federal income tax purposes. The FTE basis adjusts for the tax-favored status of income from certain loans and securities. The Registrant believes this measure to be the preferred industry measurement of net interest income and provides relevant comparison between taxable and non-taxable amounts.
24
Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)
Cash dividends per share paid to shareholders for the first quarter of 2004 increased 23 percent to $.32 per common share compared to the same period in 2003. The Registrant’s net interest income (FTE), net income, earnings per share, earnings per diluted share, cash dividends per share, dividend payout ratio, return on average assets (ROA), return on average equity (ROE), net interest margin (FTE) and efficiency ratio for the three months ended March 31, 2004 and 2003 are as follows:
TABLE 1: Operating Data
Net interest income (FTE)
Net income
Earnings per share
Earnings per diluted share
Cash dividends per common share
Dividend payout ratio
ROA
ROE
Net interest margin (FTE)
Efficiency ratio
25
TABLE 2: Consolidated Average Balance Sheets and Analysis of Net Interest Income (Taxable Equivalent Basis)
Revenue/
Cost
Interest-Earning Assets:
Loans and Leases (a)
Securities:
Exempt from Income Taxes (a)
Total Interest-Earning Assets
Liabilities and Shareholders’ Equity
Interest-Bearing Liabilities:
Other Time Deposits
Foreign Office Deposits
Total Interest-Bearing Liabilities
Demand Deposits
Net Interest Income Margin (FTE)
Net Interest Rate Spread (FTE)
Interest-Bearing Liabilities to Interest-Earning Assets
(a) Interest income and yield include the effects of taxable equivalent adjustments using a federal income tax rate of 35%, reduced by the nondeductible portion of interest expenses. The net taxable equivalent adjustment amounts included in the above table are $9 million and $10 million for the three months ended March 31, 2004 and March 31, 2003, respectively.
26
Net interest income (FTE) for the first quarter of 2004 was $759 million, a six percent increase over $716 million for the same period last year despite a 14 basis point (bp) decrease in net interest margin. The increase in net interest income was due to the $7.1 billion, or nine percent, increase in average interest-earning assets, mitigated by the decrease in net interest margin. The net interest margin has contracted as compared to the same period in 2003 due to the absolute level of interest rates and the impact of new origination volumes at lower market rates of interest. The contribution of noninterest-bearing funding to the net interest margin declined from 41 bp in the first quarter of 2003 to 27 bp in the first quarter of 2004, largely due to the Registrant’s share repurchase activity. The Registrant has repurchased 15.5 million shares of its common stock for a total of approximately $922 million since the beginning of the second quarter in 2003, including the 5.6 million shares repurchased in the first quarter 2004. The Registrant views share repurchases as an effective means of delivering value to shareholders in the current low interest rate environment. Additional contraction in the net interest margin is attributable to the implementation of SFAS No. 150 during the third quarter of 2003, and the resulting reclassification of $11 million of minority interest expense into interest expense in the first quarter of 2004 in comparison to 2003. See Note 2 of the Notes to Condensed Consolidated Financial Statements for further discussion of the adoption of SFAS No. 150. The Registrant expects that net interest margin and net interest income trends in coming periods will continue to benefit from the steepness in the short end of the yield curve and moderation in the level of prepayment activity with absolute results dependent on the magnitude of deposit growth in relation to balance sheet growth and the speed of interest rate changes in an improving economy.
The provision for credit losses was $83 million in the first quarter of 2004 compared to $85 million in the same period last year and $94 million last quarter. Net charge-offs for the quarter were $71 million compared to $65 million in the first quarter of 2003 and $95 million last quarter. However, net charge-offs as a percent of average loans and leases outstanding decreased 2 bp to .54 percent for the first quarter of 2004 from .56 percent for the first quarter of 2003 and decreased 18 bp from last quarter. The increase in net charge-offs in the current quarter compared to the first quarter of 2003 was primarily due to higher net charge-offs in commercial loans. Total commercial loan net charge-offs increased $4.7 million to $27.4 million in the current quarter compared to $22.7 million in the first quarter of 2003. The ratio of commercial loan net charge-offs to average loans outstanding in the first quarter of 2004 was .77 percent, compared with .70 percent in the first quarter of 2003. The increase in commercial loan net charge-offs compared to the first quarter of 2003 was concentrated in certain markets, including Cincinnati and Indianapolis, with individual credits ranging in size from less than $1 million to approximately $7 million. The Registrant experienced significant improvement in commercial loan net charge-off activity in the first quarter of 2004 as compared to the fourth quarter of 2003 as a result of overall improving credit trends and economic outlook. Commercial mortgage net charge-offs increased by $1.8 million in the current quarter compared with the first quarter of 2003. The increase was primarily due to weakness experienced in the Western Michigan commercial real estate sector during the current quarter. Total lease net charge-offs in the first quarter of 2004 were $6.7 million, compared with $9.7 million in the first quarter of 2003. The ratio of lease net charge-offs to average leases outstanding in the first quarter of 2004 was .48 percent, compared with .73 percent in the first quarter of 2003. Improvements in the level of lease net charge-off activity as compared to the first quarter of 2003 are attributable in large part to the Indianapolis market and are consistent with levels seen in more recent quarterly periods. Total consumer loan net charge-offs in the first quarter of 2004 were $29.6 million compared with $23.1 million in the first quarter of 2003, with increases in largely all markets. The ratio of consumer loan net charge-offs to average loans outstanding in the first quarter of 2004 was ..68 percent, compared with .61 percent in the first quarter of 2003. The weaker credit experience in consumer loans was partially offset by improvement in net charge-offs experienced in residential mortgages, which improved from $8.8 million in the first quarter of 2003 to $4.4 million in the first quarter of 2004. The ratio of residential mortgage charge-offs improved from .90 percent to .38 percent. The tables below provide the summary of credit loss experience and net charge-offs as a percentage of average loans and leases outstanding by loan category:
27
TABLE 3: Summary of Credit Loss Experience
Losses Charged Off:
Commercial, financial and agricultural loans
Real estate – commercial mortgage loans
Real estate – construction loans
Real estate – residential mortgage loans
Consumer loans
Lease financing
Total Losses
Recoveries of Losses Previously Charged Off:
Net Losses Charged Off:
Total Net Losses Charged Off
Reserve for Credit Losses, beginning
Provision Charged to Operations
Reserve for Credit Losses, ending
TABLE 4: Net Charge-Offs as a Percentage of Average Loans and Leases By Category
Weighted Average Ratio
28
The Registrant’s strategy for credit risk management includes a combination of conservative exposure limits significantly below legal lending limits and conservative underwriting, documentation and collection standards. In addition, the Registrant also emphasizes diversification on a geographic, industry and customer level and performs regular credit examinations and quarterly management reviews of large credit exposures as well as loans experiencing deterioration of credit quality.
The Registrant has not substantively changed in the current year any aspect to its overall approach in the determination of the reserve for loan and lease losses, and there have been no material changes in assumptions or estimation techniques as compared to prior periods that impacted the determination of the current period reserve. The increase in the provision for credit losses in the current quarter compared to the same period last year is primarily due to the increase in the total loan and lease portfolio as well as the overall assessed probable estimated loan and lease losses inherent in the portfolio. The reserve for credit losses at March 31, 2004 was at 1.45 percent of the total loan and lease portfolio compared to 1.47 at December 31, 2003 as the Registrant’s consideration of historical and anticipated loss rates in the portfolio has remained relatively consistent. The reserve for credit losses at March 31, 2003 was 1.49 percent of the total loan and lease portfolio. Additionally, the Registrant’s long history of low exposure limits, avoidance of national or sub-prime lending businesses, centralized risk management and diversified portfolio provide an effective position to weather an economic downturn and reduces the likelihood of significant unexpected credit losses.
Compared to the same periods in 2003, total other operating income increased seven percent to $626 million in the first quarter of 2004. Electronic payment processing revenue was $148 million in the first quarter of 2004, an increase of 14 percent compared to the same period in 2003. The Registrant continues to realize strong sales momentum from the addition of new customer relationships in both its merchant services and EFT businesses. Compared to the same period in 2003, merchant processing revenues increased 23 percent during the first quarter of 2004. The increase in merchant processing revenue in the current quarter was due to the addition of new customers and resulting increases in merchant transaction volumes, as well as an increase in transaction volume growth on the existing customer base reflective of the improvements in the retail sector of the economy. Compared to the same period in 2003, EFT revenues increased by four percent in the first quarter of 2004. Comparison to the prior period is impacted by the $7 million first quarter 2004 revenue impact associated with the 2003 MasterCard®/VISA® settlement. During 2003, VISA® and MasterCard® reached separate agreements to settle merchant litigation regarding debit card interchange reimbursement fees. These agreements, implemented in August 2003, included provisions to lower fee structures that resulted in a reduction in revenues for debit card issuers. The Registrant now handles electronic processing for over 201,000 merchant locations and 1,650 financial institutions worldwide.
Service charges on deposits increased eight percent over last year’s first quarter, primarily due to continued sales success in corporate treasury management products and commercial deposit campaigns. Commercial deposit revenues increased 14 percent over last year’s first quarter on the strength of continued focus on cross-sell initiatives and new customer relationships. Retail deposit revenues increased two percent over last year’s first quarter reflecting moderate success in new account generation.
29
Mortgage banking net revenue decreased $33 million to $44 million in the first quarter of 2004 compared to the same period in 2003. The components of mortgage banking net revenue for the three months ended March 31, 2004 and March 31, 2003 are as follows:
TABLE 5: Components of Mortgage Banking Net Revenue
Total mortgage banking fees and loan sales
Net gains and mark-to-market adjustments on both settled and outstanding free-standing derivative financial instruments
Net valuation adjustments and amortization on MSR’s
Mortgage banking net revenue
Securities gains, net – non-qualifying hedges on mortgage servicing
Total mortgage banking net revenue, including securities gains related to risk management strategy
Mortgage originations declined to $2.0 billion in the first quarter of 2004 as compared to $4.3 billion in the same period last year directly contributing to the decrease in core mortgage banking fees in the first quarter of 2004 compared to the first quarter of 2003. The Registrant currently expects mortgage banking originations and revenues to stabilize at levels similar to those seen this quarter as compared to the record level of refinance activity and applications seen during 2003.
The Registrant maintains a comprehensive management strategy relative to its mortgage banking activity, including consultation with an outside independent third-party specialist, in order to manage a portion of the risk associated with changes in impairment on its MSR portfolio as a result of changing interest rates. This strategy includes the utilization of available-for-sale securities and free-standing derivatives as well as engaging in loan securitization and sale transactions. The Registrant’s non-qualifying hedging strategy includes the purchase of various securities (primarily FHLMC and FNMA agency bonds, US treasury bonds and PO strips) and the purchase of free-standing derivatives (PO swaps, swaptions, floors, interest rate swaps, options and forward contracts). The interest income, mark-to-market adjustments and gain or loss from sale activities in these portfolios are expected to economically hedge a portion of the change in value of the MSR portfolio caused by fluctuating discount rates, earnings rates and prepayment speeds. The value of MSRs can fluctuate sharply depending on changes in interest rates and other factors. Generally, as interest rates decline, the value of MSRs declines because, as loans are prepaid to take advantage of an interest rate decline, no further servicing fees are collected in respect to those loans. The decrease in interest rates during the first quarter of 2004 and corresponding increase in prepayment speeds led to a net unfavorable change of $11 million in the valuation reserve for the MSR portfolio in the first quarter of 2004 as compared to the $15 million in temporary impairment recognized in the first quarter of 2003. The servicing rights are typically deemed impaired when a borrower’s loan rate is distinctly higher than prevailing market rates. Additionally, the Registrant realized net gains from settled free-standing derivative instruments as well as mark-to-market adjustments on outstanding free-standing derivatives during the first quarter of 2004 and 2003 as illustrated in Table 5.
Compared to the same period in 2003, investment advisory revenue increased 17 percent to $93 million in the first quarter of 2004. The increase in revenue in the current quarter compared to the first quarter of 2003 resulted primarily from strengthening sales in retirement plan services and both proprietary and third party mutual funds and improved institutional asset management revenues. The Registrant continues to focus its sales efforts on integrating services across business lines and working closely with retail and commercial team members to take
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advantage of a diverse and expanding customer base. The Registrant is one of the largest money managers in the Midwest and as of March 31, 2004 had over $179 billion in assets under care and $34 billion in assets under management.
Compared to the same period in 2003, total other service charges and fees decreased 11 percent to $141 million in the first quarter of 2004. The major components of other service charges and fees for the three months ended March 31, 2004 and 2003 are as follows:
TABLE 6: Components of Other Service Charges and Fees
Cardholder fees
Consumer loan and lease fees
Commercial banking revenue
Bank owned life insurance income
Insurance income
Total Other Service Charges and Fees
Compared to the same period in 2003, other service charges and fees were flat to down across most of the categories. The other component of other service charges and fees declined due to a $3 million decline in gains on sale of fixed assets and a $3 million decline in customer interest rate derivative product fee revenue in the first quarter of 2004. The Registrant expects other service charges and fees revenue to remain at levels consistent with the first quarter 2004.
The efficiency ratio (operating expenses divided by the sum of taxable equivalent net interest income and other operating income) was 47.1 percent and 47.2 percent for the first quarter of 2004 and 2003, respectively. Total operating expenses increased $38 million, or six percent, to $652 million compared to the first quarter of 2003. Compared to the same period in 2003, salaries, wages, incentives and benefits decreased three percent in the first quarter of 2004. The Registrant continues to focus on efficiency initiatives, including increasing the level of automation of processes to improve operating leverage. The other component of other operating expenses was down slightly to $63 million in the first quarter of 2004 as compared to $69 million in the same period of 2003. The major components of other operating expenses for the three months ended March 31, 2004 and 2003 are shown in Table 7.
Operating expenses for the first quarter of 2004 include $38 million of expense, primarily depreciation expense, on operating lease assets consolidated as a result of the early adoption of FIN 46. See Note 2 of the Notes to Condensed Consolidated Financial Statements for discussion of adoption of FIN 46. Excluding the impact of FIN 46, total operating expenses were flat in comparison to the same period in 2003; comparisons being provided to supplement an understanding of the fundamental trends in operating expenses.
Comparisons of total operating expenses to prior periods are impacted by implications of growth in all of the Registrant’s markets and increases in spending related to the expansion and improvement of the sales force, increases in employee benefit expenses, growth of the retail banking platform, continuing investment in support personnel including risk management and internal audit functions, among others, process improvement, technology and infrastructure to support recent and future growth, volume related increases in expenses such as bankcard and increased FDIC insurance expense mitigated by the cost benefits being realized from certain outsourcing arrangements and a reduction in overall stock-based compensation expenses. Additionally, in areas
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that have experienced volume decreases like mortgage originations, which are down from the historic highs seen in 2003, the Registrant has been actively reducing the cost infrastructure.
TABLE 7: Components of Other Operating Expenses
Marketing and communications
Postal and courier
Bankcard
Intangible amortization
Franchise and other taxes
Loan and lease
Printing and supplies
Travel
Data processing and operations
Total Other Operating Expenses
Financial Condition and Capital Resources
The Registrant’s balance sheet remains strong with high-quality assets and solid capital levels. Total assets were $93.7 billion at March 31, 2004 compared to $91.2 billion at December 31, 2003 and $84.3 billion at March 31, 2003, an increase of three percent and 11 percent, respectively. Return on average equity was 19.7 percent for the first quarter of 2004 up from 18.0 percent from the comparable period in 2003. Return on average assets was 1.88 percent for the first quarter of 2004 and 1.90 percent for the same period last year.
The Registrant’s total loan portfolio excluding held for sale was $53.9 billion at March 31, 2004 compared to $52.3 billion at December 31, 2003 and $47.3 billion at March 31, 2003, an increase of three percent and 14 percent, respectively. The Registrant’s held-for-sale portfolio was $1.7 billion at March 31, 2004 compared to $1.9 billion at December 31, 2003 and $3.0 billion at March 31, 2003. The table below summarizes the end of period commercial and consumer loans and leases, including loans held for sale, by major category:
TABLE 8: Components of Loan Portfolio (including held for sale)
Commercial:
Mortgage
Construction
Leases
Subtotal
Consumer:
Installment
Mortgage & Construction
Credit Card
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Commercial loan and lease outstandings, including loans held for sale, totaled $28.6 billion at March 31, 2004 compared to $27.7 billion at December 31, 2003 and $25.4 billion at March 31, 2003, an increase of three percent and 12 percent, respectively. The increase in commercial loans and leases was attributable to growth in middle-market and small business commercial loan originations and on the strength of new customer additions and strong sales results in Columbus, Chicago, Indianapolis and Lexington. The following tables provide a breakout of the commercial loan and lease portfolio, including held for sale, by major industry classification and by size of credit illustrating the diversity and granularity of the Registrant’s portfolio. The commercial portfolio is further characterized by 88 percent of outstanding balances and 89 percent of exposures concentrated within the Registrant’s primary market areas of Ohio, Kentucky, Indiana, Florida, Michigan, Illinois, West Virginia and Tennessee. Exclusive of a national large-ticket leasing business, the commercial portfolio is characterized by 95 percent of outstanding balances and 93 percent of exposures concentrated within these eight states. The mortgage and construction segments of the commercial portfolio are characterized by 98 percent of outstanding balances and exposures concentrated within these eight states. As part of its overall credit risk management strategy, the Registrant emphasizes small participations in individual credits, strict monitoring of industry concentrations within the portfolio and a relationship-based lending approach that determines the level of participation in individual credits based on multiple factors, including the existence of and potential to provide additional products and services.
TABLE 9: Commercial Loan and Lease Portfolio Exposure by Industry
Manufacturing
Real Estate
Retail Trade
Business Services
Wholesale Trade
Individuals
Financial Services & Insurance
Healthcare
Transportation & Warehousing
Accommodation & Food
Public Administration
Other Services
Communication & Information
Agribusiness
Entertainment & Recreation
Utilities
Mining
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TABLE 10: Commercial Loan Portfolio Exposure by Loan Size by Obligor
Less than $5 million
$5 million to $15 million
$15 million to $25 million
Greater than $25 million
(a) Outstanding reflects total commercial customer loan and lease balances, net of unearned income, and exposure reflects total commercial customer lending commitments.
Consumer installment loan balances, including held for sale, increased two percent compared to December 31, 2003 and increased 16 percent compared to March 31, 2003. This increase was attributable to continued strong direct origination volume of $1.5 billion during the first quarter of 2004. The Registrant is continuing to devote significant focus on producing banking center based loan originations given the strong credit performance and attractive yields available in these products. Residential mortgage and construction loans, including held for sale, totaled $6.1 billion at March 31, 2004 compared to $5.9 billion at December 31, 2003 and $6.6 billion at March 31, 2003, an increase of five percent and a decrease of seven percent, respectively. Comparisons to prior periods are directly dependent upon the volume and timing of originations as well as the timing on loan sales. Residential mortgage originations totaled $2.0 billion in the first quarter of 2004 compared to $1.9 billion in the fourth quarter of 2003 and $4.3 billion in the first quarter of 2003. Consumer lease balances decreased three percent during the first quarter compared to both December 31, 2003 and March 31, 2003.
At March 31, 2004, total investment securities were $30.9 billion, compared to $29.2 billion at December 31, 2003 and $27.3 billion at March 31, 2003, an increase of six percent and 13 percent, respectively, and proportionately remained relatively consistent with the growth in the overall balance sheet. The estimated average life of the available-for-sale portfolio at March 31, 2004 was 4.2 years based on current prepayment expectations as compared to 3.2 years at March 31, 2003. The weighted average yield of the available-for-sale securities portfolio at March 31, 2004 was 4.5 percent compared to 5.0 percent at March 31, 2003.
Total deposits at March 31, 2004 increased $692 million, or one percent, compared to March 31, 2003 due to a $2.0 billion increase in transaction deposits and a $2.6 billion increase in foreign office deposits, offset by a $3.9 billion decrease in time deposits. The transaction account deposit growth during the current period is primarily attributable to commercial customer additions, net new retail checking account growth resulting from the Registrant’s competitive deposit products and a continued focus on expanding the customer base through successful deposit campaigns. Total deposits decreased $1.8 billion, or three percent, over December 31, 2003, due largely to a $2.0 billion decrease in foreign office deposits. The movement in these deposits is a function of overall balance sheet requirements. Transaction deposits were down one percent and time deposits were up six percent compared to December 31, 2003. The deposit balances represent an important source of funding and revenue growth opportunity and the Registrant is continuing to focus on net checking account growth in its retail and commercial franchises.
Short-term borrowings and federal funds purchased totaled $15.3 billion, compared to $13.2 billion at December 31, 2003 and $9.2 billion at March 31, 2003. The movement in these borrowings is a function of overall balance sheet funding requirements. Long-term debt was $11.0 billion at March 31, 2004, compared with $9.1 billion at December 31, 2003 and $8.0 billion at March 31, 2003. As previously discussed, the early adoption of FIN 46 on July 1, 2003 resulted in the consolidation of an SPE for which the Registrant is deemed to be the primary beneficiary. The early adoption of FIN 46 resulted in the consolidation of a long-term debt obligation totaling
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$1.1 billion on July 1, 2003. See Note 2 of the Notes to Condensed Consolidated Financial Statements for further discussion of adoption of FIN 46. As previously discussed, adoption of SFAS No. 150 on July 1, 2003 resulted in the reclassification of a $482 million minority interest to long-term debt, relating to preferred stock issued during 2001 by a subsidiary of the Registrant. See Note 2 for further discussion of adoption of SFAS No. 150. In addition to the above, during the third quarter of 2003, an indirect wholly owned subsidiary of the Registrant issued $500 million of senior notes with a fixed interest rate of 3.4 percent maturing on August 15, 2008, and during the first quarter of 2004, the Registrant issued $2.1 billion of medium-term and long-term bank notes with interest rates ranging from 2.7 percent to 5.2 percent and maturities ranging from 18 months to 15 years. The Registrant continues to explore additional alternatives regarding the level and cost of various other sources of funds.
Total nonperforming assets were $308 million at March 31, 2004, down $10 million compared to $318 million at December 31, 2003, and up $1 million compared to $307 million at March 31, 2003. Total nonperforming assets as a percent of total loans, leases and other assets, including other real estate owned declined to .57 percent as of March 31, 2004 from .61 percent and .65 percent as of December 31, 2003 and March 31, 2003, respectively. During the same periods there has also been a decrease in loans and leases ninety days past due. Table 12 below provides a breakout of the commercial nonaccrual loans and leases by loan size further illustrating the granularity of the Registrant’s commercial loan portfolio. Nonperforming consumer loans and other assets, including other real estate owned, reflect the estimated salvage value of underlying collateral associated with previously charged-off assets.
Total underperforming assets were $441 million at March 31, 2004, or .82 percent of total loans, leases and other assets, including other real estate owned, down 7 bps compared to $464 million, or .89 percent, at December 31, 2003, and down 11 bps compared to $441 million, or .93 percent, at March 31, 2003. The tables below provide a summary of nonperforming and underperforming assets and commercial nonaccrual loans and leases exposure by loan size by obligor:
TABLE 11: Summary of Nonperforming and Underperforming Assets
Nonaccrual loans and leases
Renegotiated loans and leases
Other assets, including other real estate owned
Total nonperforming assets
Ninety days past due loans and leases
Total underperforming assets
Nonperforming assets as a percent of total loans, leases and other real estate owned
Underperforming assets as a percent of total loans, leases and other real estate owned
TABLE 12: Summary of Commercial Nonaccrual Loans and Leases by Loan Size by Obligor
Less than $200,000
$200,000 to $1 million
$1 million to $5 million
$5 million to $10 million
$10 million to $15 million
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The Registrant maintains a relatively high level of capital as a margin of safety for its depositors and shareholders. At March 31, 2004, shareholders’ equity was $8.9 billion compared to $8.7 billion at December 31, 2003 and $8.8 billion at March 31, 2003, an increase of two percent and one percent, respectively. Average shareholders’ equity as a percentage of average assets for the three months ended March 31, 2004 was 9.56 percent. The Board of Governors of the Federal Reserve System (FRB) adopted quantitative measures which assign risk weightings to assets and off-balance sheet items and also define and set minimum regulatory capital requirements (risk-based capital ratios). The guidelines 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 March 31, 2004 and 2003. The Registrant expects to maintain these ratios above the well-capitalized levels throughout 2004. At March 31, 2004, the Registrant had a Tier 1 risk-based capital ratio of 10.90 percent, a total risk-based capital ratio of 13.15 percent and a leverage ratio of 9.24 percent. At March 31, 2003, the Registrant had a Tier 1 risk-based capital ratio of 12.04 percent, a total risk-based capital ratio of 13.84 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 March 2003, the Board of Directors authorized the repurchase in the open market, or in any private transaction, of up to an additional 20 million common shares. During the first quarter of 2004, the Registrant repurchased 5,615,000 shares of common stock for an aggregate of approximately $325 million. At March 31, 2004, the remaining number of shares that can be repurchased under the plan approved by the Board of Directors was approximately 8.5 million shares.
Foreign Currency Exposure
At March 31, 2004, December 31, 2003 and March 31, 2003, the Registrant maintained foreign office deposits of $4.6 billion, $6.6 billion and $2.0 billion, respectively. These foreign deposits represent U.S. dollar denominated deposits of our foreign branch located in the Cayman Islands. The Registrant utilized these deposit balances to aid in the funding of earning asset growth. 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. The Registrant minimizes its exposure to these derivative contracts by entering 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 ongoing quarterly assessments and 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 that, in management’s judgment, deserve consideration under existing economic conditions in estimating probable credit losses. 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 a combination of conservative exposure limits significantly below legal lending limits, and conservative underwriting, documentation and collections standards. The strategy also emphasizes diversification on a geographic, industry and customer level, regular credit examinations and quarterly management reviews of large credit exposures and loans experiencing deterioration of credit quality.
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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. The review of individual loans includes those loans 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 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. The risk grading system utilized in 2003 for commercial loans and leases encompassed ten categories. This risk grading system was in the process of being revised at the end of the first quarter of 2004 to provide for a dual risk rating system that provides for 13 probability of default grade categories and an additional 6 grade categories measuring loss factors given an event of default. Previously, the probability of default and loss given default analyses had not been separated. The refined risk grading system is consistent with Basel II expectations, and should allow for more precision in the analysis of commercial credit risk.
Homogenous loans, such as consumer installment, residential mortgage loans and automobile leases are not individually risk graded. Rather, standard credit scoring systems and delinquency monitoring 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 that 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 and nonaccrual loans), changes in mix, credit score migration comparisons, asset quality trends, risk management and loan administration, 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, West Virginia and Tennessee. When evaluating the adequacy of reserves, consideration is given to this regional geographic concentration and the closely associated effect changing economic conditions have on the Registrant’s customers.
The Registrant has not substantively changed in the current year any aspect to its overall approach in the determination of reserve 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 reserve for loan and lease losses.
Based on the procedures discussed above, management is of the opinion that the reserve of $783 million was adequate, but not excessive, to absorb estimated credit losses associated with the loan and lease portfolio at March 31, 2004.
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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. The Registrant’s interest rate risk management strategy involves modifying the re-pricing 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 may use as part of its interest rate risk management strategy include interest rate swaps, interest rate floors, interest rate caps, forward contracts, options and swaptions. As part of its overall risk management strategy relative to its mortgage banking activity, the Registrant may enter into various free-standing derivatives (PO swaps, swaptions, floors, forward contracts, options and interest rate swaps) to economically hedge interest rate lock commitments and changes in fair value of its largely fixed rate MSR portfolio. The primary risk of material changes to the value of the derivative instruments is 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 Securities: The Registrant’s available-for-sale security portfolio is reported at fair value. The fair value of a security is determined based on quoted market prices. If quoted market prices are not available, fair value is determined based on quoted prices of similar instruments. Available-for-sale and held-to-maturity securities are reviewed quarterly for possible other-than-temporary impairment. The review includes an analysis of the facts and circumstances of each individual investment such as the length of time the fair value has been below cost, the expectation for that security’s performance, the credit worthiness of the issuer and the Registrant’s ability to hold the security to maturity. A decline in value that is considered to be other-than-temporary is recorded as a loss within other operating income in the Condensed Consolidated Statements of Income.
Valuation of 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, interest-only strips, credit recourse, other residual interests and, in some cases, a cash reserve account, all of which are considered retained interests in the securitized or sold loans. Gain or loss on sale or securitization of the loans depends in part on the previous carrying amount of the financial assets sold or securitized, allocated between the assets sold and the retained interests based on their relative fair value at the date of sale or securitization. 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. Gain or loss on sale or securitization of loans is reported as a component of other operating income in the Condensed Consolidated Statements of Income. Retained interests from securitized or sold loans, excluding servicing rights, are carried at fair value. Adjustments to fair value for retained interests classified as available-for-sale securities are included in accumulated nonowner changes in equity, or in other operating income in the Condensed Consolidated Statements of Income if the fair value has declined below the carrying amount and such decline has been determined to be other-than-temporary. Adjustments to fair value for retained interests classified as trading securities are recorded within other operating income in the Condensed Consolidated Statements of Income.
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 monthly, based on fair value, with temporary impairment recognized through a valuation allowance and permanent impairment recognized through a write-off of the servicing asset and related valuation reserve. Key economic assumptions used in measuring any potential impairment of the servicing rights include the prepayment speed of the underlying loans, the weighted-average life of the loan, the discount rate and the weighted-average default rate, as applicable. The primary risk of material changes to the value of the servicing rights resides in the potential volatility in the economic
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assumptions used, particularly the prepayment speed. The Registrant monitors risk and adjusts its valuation allowance as necessary to adequately reserve for any probable impairment in the portfolio. For purposes of measuring impairment, the servicing rights are stratified based on this financial asset type and interest rates. In addition, the Registrant obtains an independent third-party valuation of mortgaging servicing portfolio on a quarterly basis. Fees received for servicing loans owned by investors are based on a percentage of the outstanding monthly principal balance of such loans and are included in operating income as loan payments are received. Costs of servicing loans are charged to expense as incurred.
The change in the fair value of MSR’s at March 31, 2004, due to immediate 10 percent and 20 percent adverse changes in the current prepayment assumption would be approximately $15 million and $32 million, respectively and due to immediate 10 percent and 20 percent favorable changes in the current prepayment assumption would be approximately $19 million and $41 million, respectively. The change in the fair value of MSR’s at March 31, 2004, due to immediate 10 percent and 20 percent adverse changes in the discount rate assumption would be approximately $6 million and $12 million, respectively and due to immediate 10 percent and 20 percent favorable changes in the discount rate assumption would be approximately $6 million and $13 million, respectively. Sensitivity analysis related to other consumer and commercial servicing rights is not material to the Registrant’s Condensed Consolidated Financial Statements. These sensitivities are hypothetical and should be used with caution. As the figures indicate, change in fair value based on a 10 percent and 20 percent variation in assumptions generally cannot be extrapolated because the relationship of the change in assumptions to change in fair value may not be linear. Also, the effect of variation in a particular assumption on the fair value of the retained interests is calculated without changing any other assumption; in reality, changes in one factor may result in changes in another, which might magnify or counteract the sensitivities.
Off-Balance Sheet Arrangements and Certain Trading Activities
The Registrant consolidates all of its majority-owned subsidiaries. Other entities, including certain joint ventures, in which there is greater than 20% ownership, but upon which the Registrant does not possess, nor cannot exert, significant influence or control, are accounted for by equity method accounting and not consolidated. Those entities in which there is less than 20% ownership, but upon which the Registrant does not possess, nor cannot exert, significant influence or control are generally carried at the lower of cost or fair value.
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 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 largely 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 asset/liabitity 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 three months ended March 31, 2004, certain primarily fixed-rate short-term investment grade commercial loans were transferred to the QSPE. Generally, the loans transferred, due to their investment grade nature, provide a lower yield and therefore transferring these loans to the QSPE allows the Registrant to reduce its exposure to these lower yielding loan assets and at the same time maintain these customer relationships. 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 March 31, 2004, the outstanding balance of loans transferred was $2.0 billion. Given the investment grade nature of the loans transferred, as well as the underlying collateral security provided, the Registrant has not maintained any loss reserve related to these loans transferred.
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The Registrant utilizes securitization trusts formed by independent third parties to facilitate the securitization process of residential mortgage loans and certain floating rate home equity lines of credit. 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 with subsequent cash flows relating to retained interests. The Registrant’s securitization policy permits the retention of subordinated tranches, servicing rights, interest-only strips, residual interests, credit recourse, other residual interests and, in some cases, a cash reserve account. At March 31, 2004, the Registrant had retained servicing assets totaling $283 million, an interest-only strip totaling $1 million, subordinated tranche security interests totaling $51 million and residual interests totaling $31 million.
The accounting for QSPE’s is currently under review by the FASB and the conditions for consolidation or non-consolidation of such entities could change.
The Registrant had the following cash flows with these unconsolidated QSPE’s during the three months ended March 31:
TABLE 13: Cash Flows with Unconsolidated QSPE’s
Proceeds from transfers, including new securitizations
Proceeds from collections reinvested in revolving-
period securities
Transfers received from QSPE
Fees received
At March 31, 2004, the Registrant had provided credit recourse on approximately $568 million of residential mortgage loans sold to unrelated third parties. In the event of any customer default, pursuant to the credit recourse provided, the Registrant is required to reimburse the third-party. The maximum amount of credit risk in the event of nonperformance by the underlying borrowers is equivalent to the total outstanding balance of $568 million. In the event of nonperformance, the Registrant has rights to the underlying collateral value attached to the loan. Consistent with its overall approach in estimating credit losses for various categories of residential mortgage loans held in its loan portfolio, the Registrant maintains an estimated credit loss reserve of $14 million relating to these residential mortgage loans sold.
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Contractual Obligations and Commitments
The Registrant has certain obligations and commitments to make future payments under contracts. At March 31, 2004, the aggregate contractual obligations and commitments were:
TABLE 14: Aggregate Contractual Obligations and Other Commitments
Less than
One Year
1-3
Years
3-5
Long-Term Borrowings
Short-Term Borrowings
Annual Rental/PurchaseCommitments UnderNoncancelable Leases/Contracts
Letters of Credit
Commitments to Extend Credit
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Item 3. Quantitative and Qualitative Disclosures About Market Risk
Liquidity and Market 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 liquidity, composition 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 goal 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. The primary source of asset driven liquidity is provided by debt securities in the available-for-sale securities portfolio. The estimated average life of the available-for-sale portfolio is 4.2 years at March 31, 2004, based on current prepayment expectations. Of the $30.6 billion (fair value basis) of securities in the portfolio at March 31, 2004, $7.2 billion, or 23 percent, is expected to mature or be prepaid in the next twelve months, and an additional $3.0 billion, or 10 percent is expected to mature or be prepaid in the next 13 to 24 months. In addition to the sale of available-for-sale portfolio securities, asset-driven liquidity is provided by the Registrant’s ability to sell or securitize loan and lease assets. In order to reduce the exposure to interest rate fluctuations as well as to manage liquidity, the Registrant has developed securitization and sale procedures for several types of interest-sensitive assets. A majority of the 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 jumbo fixed-rate residential mortgages, certain floating rate short-term commercial loans and certain floating rate home equity loans are also securitized, sold or transferred off-balance sheet. For the three months ended March 31, 2004 and 2003, a total of $1.7 billion and $3.9 billion, respectively, were sold, securitized, or transferred off-balance sheet. The Registrant also has in place a shelf registration with the Securities and Exchange Commission permitting ready access to the public debt markets. As of March 31, 2004, $1.5 billion of debt or other securities were available for issuance under this shelf registration. Additionally, the Registrant also has $6.9 billion of funding available for issuance in connection with its bank note program. These sources, in addition to the Registrant’s 9.56 percent average equity capital base, provide a stable funding base.
Since June 2002, Moody’s senior debt rating for the Registrant has been Aa2, a rating equaled or surpassed by only three other U.S. bank holding companies. This rating by Moody’s reflects the Registrant’s capital strength and financial stability.
TABLE 15: Agency Ratings
Fifth Third Bancorp:
Commercial Paper
Senior Debt
Fifth Third Bank and
Fifth Third Bank (Michigan)
Short-Term Deposit
Long-Term Deposit
These debt ratings, along with capital ratios significantly above regulatory guidelines, provide the Registrant with additional access to liquidity. Based on the continued strength of the balance sheet, stable credit quality, risk management policies and revenue growth trends, management does not currently expect any downgrade in these credit ratings based on financial performance. Core customer deposits have historically provided the Registrant with a sizeable source of relatively stable and low-cost funds. The Registrant’s average core deposits and stockholders’ equity funded 62 percent of its average total assets during the first three months of 2004. In
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Quantitative and Qualitative Disclosures About Market Risk (continued)
addition to core deposit funding, the Registrant also accesses a variety of other short-term and long-term funding sources, which include the use of the Federal Home Loan Bank as a funding source. Management does not rely on any one source of liquidity and manages availability in response to changing balance sheet needs.
Interest rate risk is the exposure to adverse changes in net interest income due to changes in interest rates. Management considers interest rate risk a prominent market risk in terms of its potential impact on earnings. Interest rate risk can occur for any one or more of the following reasons: (a) assets and liabilities may mature or re-price at different times; (b) short-term and long-term market interest rates may change by different amounts; or (c) the remaining maturity of various assets or liabilities may shorten or lengthen as interest rates change. In addition to the direct impact of interest rate changes on net interest income, interest rates can indirectly impact earnings through their effect on loan demand, credit losses, mortgage origination fees, the value of mortgage servicing rights and other sources of the Registrant’s earnings. Consistency of the Registrant’s net interest income 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 re-pricing characteristics for all of the Registrant’s financial 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. 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. In addition to the risk management activities of ALCO, the Registrant created a Market Risk Management department as part of the Enterprise Risk Management Division, which provides independent oversight of market risk activities. The Registrant’s current interest rate risk policy limits are determined by measuring the anticipated change in net interest income over a 12 month and 24 month horizon assuming a 200 bp linear increase or decrease in all interest rates. In accordance with the current policy, the rate movements occur over one year and are sustained thereafter.
The following table shows the Registrant’s estimated earnings sensitivity profile on the asset and liability positions as of March 31, 2004. Additionally, in order to further illustrate the estimated earnings sensitivity of interest rate changes, the Registrant has included the anticipated change to net interest income over a 12 month to 24 month horizon assuming a 100 bp linear increase, as well as a 50 bp linear increase or decrease in all interest rates. The interest rate yield curve as of April 7, 2004 is presented as the base case due to the increasing steepness that existed in the yield curve in response to recently changing economic indicators subsequent to March 31, 2004:
TABLE 16: Estimated Earnings Sensitivity Profile
+200
+100
+50
-50
-100
Given a linear 100 bp increase in the yield curve used in the simulation model, it is estimated that net interest income for the Registrant would decrease by 1.7 percent in the first year and decrease by 1.3 percent in the second year. A 200 bp linear increase in interest rates would decrease net interest income by 3.8 percent in the first year and decrease net interest income by an estimated 4.0 percent in the second year. A 100 bp linear
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decrease in interest rates would increase net interest income by .9 percent in the first year and decrease net interest income by an estimated 2.9 percent in the second year. Given the low level of interest rates, the Registrant’s ALCO has measured the risk of a decrease in interest rates at 100 basis points. Management does not expect any significant adverse effect to net interest income for the remainder of 2004 based on the composition of the portfolio and anticipated trends in rates.
In the ordinary course of business, the Registrant enters into derivative transactions as a part of its overall strategy to manage its interest rate risks and prepayment risks and to accommodate the business requirements of its customers. Derivative instruments that the Registrant may use as part of its interest rate risk management strategy include interest rate swaps, interest rate floors, interest rate caps, forward contracts, options and swaptions. As part of its overall risk management strategy relative to its mortgage banking activities, the Registrant enters into PO swaps, swaptions, floors, forward contracts, options and interest rate swaps to economically hedge interest rate lock commitments and changes in fair value of its largely fixed rate MSR portfolio. The notional amounts and fair values of these derivative instruments as of March 31, 2004 are presented in Note 5 to the Condensed Consolidated Financial Statements.
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Item 4. 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-15(e) and 15d-15(e). 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.
As of the end of the period covered by 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.
The Registrant also conducted an evaluation of internal control over financial reporting to determine whether any changes occurred during the quarter covered by this report that have materially affected, or are reasonably likely to materially affect, the Registrant’s internal control over financial reporting. Based on this evaluation, there has been no such change during the quarter covered by this report.
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PART II. OTHER INFORMATION
Item 1. Legal Proceedings
During 2003, eight putative class action complaints were filed in the United States District Court for the Southern District of Ohio against the Registrant and certain of its officers alleging violations of federal securities laws related to disclosures made by the Registrant regarding its integration of Old Kent Financial Corporation and its effect on the Registrant’s infrastructure, including internal controls, and prospects and related matters. The complaints seek unquantified damages on behalf of putative classes of persons who purchased the Registrant’s common stock, attorneys’ fees and other expenses. Management believes there are substantial defenses to these lawsuits and intends to defend them vigorously. The impact of the final disposition of these lawsuits cannot be assessed at this time.
The Registrant and its subsidiaries are not parties to any other material litigation other than those arising in the normal course of business. While it is impossible to ascertain the ultimate resolution or range of financial liability with respect to these contingent matters, management believes any resulting liability from these other actions would not have a material effect upon the Registrant’s consolidated financial position or results of operations.
On March 27, 2003, the Registrant announced that it and Fifth Third Bank had entered into a Written Agreement with the Federal Reserve Bank of Cleveland and the State of Ohio Department of Commerce, Division of Financial Institutions which outlines a series of steps to address and strengthen the Registrant’s risk management processes and internal controls. These steps include independent third-party reviews and the submission of written plans in a number of areas. These areas include the Registrant’s management, corporate governance, internal audit, account reconciliation procedures and policies, information technology and strategic planning. On April 7, 2004, the Registrant announced that the Federal Reserve Bank of Cleveland and the Ohio Department of Commerce, Division of Financial Institutions, have terminated the Written Agreement.
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 existence or effects of weaknesses in financial controls in the Registrant’s Treasury and/or Trust operations. The Registrant has responded to all of the Commission’s requests.
Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities
January 1, 2004 –
January 31, 2004
February 1, 2004 –
February 29, 2004
March 1, 2004 –
March 31, 2004
(a) On March 27, 2003, the Registrant announced that its Board of Directors had authorized management to repurchase up to 20,000,000 shares of the Registrant’s common stock through the open market or in any private transaction. The authorization does not have an expiration date.
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Item 4. Submission of Matters to a Vote of Security Holders
On March 23, 2004, the Registrant held its Annual Meeting of Shareholders for which the Board of Directors solicited proxies. At the Annual Meeting, the shareholders voted on the following proposals stated in the Proxy Statement dated February 19, 2004, which are incorporated herein by reference.
Election of Class III Directors:
Darryl F. Allen
Allen M. Hill
Dr. Mitchel D. Livingston
Hendrik G. Meijer
James E. Rogers
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Item 6. Exhibits and Reports on Form 8-K
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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: May 6, 2004
/s/ R. Mark Graf
R. Mark Graf
Senior Vice President and
Chief Financial Officer
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