UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended June 30, 2004
Commission File Number 0-8076
FIFTH THIRD BANCORP
(Exact name of Registrant as specified in its charter)
(State or other jurisdiction
of incorporation or organization)
(I.R.S. Employer
Identification Number)
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 560,690,190 shares of the Registrant’s Common Stock, without par value, outstanding as of July 31, 2004.
INDEX
Part I. Financial Information
Management’s Discussion and Analysis of Financial Condition and Results of Operations (Item 2)
Overview
Statements of Income Analysis
Balance Sheet Analysis
Recent Accounting Standards
Critical Accounting Policies
Controls and Procedures (Item 4)
Quantitative and Qualitative Disclosure about Risk (Item 3)
Credit Risk Management
Market Risk Management
Liquidity Risk Management
Capital Management
Off-Balance Sheet Arrangements
Contractual Obligations and Commitments
Condensed Consolidated Financial Statements and Notes (Item 1)
Balance Sheets – June 30, 2004 and 2003 and December 31, 2003
Statements of Income – Three and Six Months Ended June 30, 2004 and 2003
Statements of Cash Flows – Six Months Ended June 30, 2004 and 2003
Statements of Changes in Shareholders’ Equity – Six Months Ended June 30, 2004 and 2003
Notes to Condensed Consolidated Financial Statements
Part II. Other Information
Legal Proceedings (Item 1)
Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities (Item 2)
Exhibits and Reports on Form 8-K (Item 6)
Signatures
Certifications
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.
TABLE 1: Selected Financial Data
Three Months Ended
June 30,
Six Months Ended
Percent
Change
Income Statement Data (in millions)
Net interest income (a)
Noninterest income
Total revenue (a)
Provision for credit losses
Noninterest expense
Net income available to common shareholders
Common Share Data
Earnings per share
Earnings per diluted share
Cash dividends per common share
Book value per share
Dividend payout ratio
Financial Ratios
Return on average assets (ROA)
Return on average shareholders’ equity (ROE)
Average equity as a percent of average assets
Net interest margin (a)
Efficiency ratio (a)
Credit Quality
Total net losses charged-off (in millions)
Net losses charged-off as a percent of average loans and leases
Reserve as a percent of loans and leases
Nonperforming assets as a percent of loans, leases and other assets, including other real estate owned
Underperforming assets as a percent of loans, leases and other assets, including other real estate owned
Average Balances (in millions)
Loans
Investment securities and other short-term investments
Total assets
Demand deposits
Interest-bearing deposits
Short-term borrowings
Long-term borrowings
Shareholders’ equity
Regulatory Capital Ratios
Tier-1 capital
Total risk-based capital
Leverage
3
Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)
The following is management’s discussion and analysis of certain significant factors that have affected Fifth Third Bancorp’s (the Registrant or Fifth Third) financial condition and results of operations during the periods included in the Condensed Consolidated Financial Statements, which are a part of this filing.
This overview of management’s discussion and analysis highlights selected information in the financial results of the Registrant and may not contain all of the information that is important to you. For a more complete understanding of trends, events, commitments, uncertainties, liquidity, capital resources and critical accounting estimates, you should carefully read this entire document. Each of these items could have an impact on the Registrant’s financial condition and results of operations.
The Registrant is a diversified financial services company headquartered in Cincinnati, Ohio. The Registrant has $96 billion in assets, operates 17 affiliates with 992 full-service Banking Centers including 130 Bank Mart® locations open seven days a week inside select grocery stores and 1,844 Jeanie® ATMs in Ohio, Indiana, Kentucky, Michigan, Illinois, Florida, West Virginia, and Tennessee. The financial strength of two of the Registrant’s affiliate banks, Fifth Third Bank and Fifth Third Bank (Michigan), continues to be recognized by rating agencies with deposit ratings of AA- and Aa1 from Standard & Poor’s and Moody’s, respectively. Additionally, the Registrant is recognized by Moody’s with one of the highest senior debt ratings for any U.S. bank holding company of Aa2. The Registrant operates four main businesses: Commercial Banking, Retail Banking, Investment Advisors and Fifth Third Processing Solutions.
The Registrant’s revenues are equally dependent on net interest income and noninterest income. For the six months ended June 30, 2004, net interest income, on a taxable equivalent basis, and noninterest income provided 53% and 47% of total revenue, respectively. Changes in interest rates, credit quality and the capital markets are therefore primary factors that drive the performance of the Registrant. As described on pages 62-64 of the Registrant’s 2003 Annual Report, risk identification, measurement, monitoring, control and reporting are important to the management of risk and to the continuation of the strong financial performance and capital strength of the Registrant.
Net interest income is derived from the interest collected from borrowers and on interest-earning investments less interest paid to depositors and on other interest-bearing liabilities. Generally, the rates of interest the Registrant earns on its assets and owes on its liabilities are established for a period of time. The change in market interest rates over time exposes the Registrant to interest-rate risk and potential adverse changes in net interest income. The Registrant manages this risk by continually analyzing and adjusting the composition of its assets and liabilities based on their payment streams and interest rates, the timing of their maturities and their sensitivity to changes in market interest rates.
The Registrant is also exposed to the risk of losses on its loan and lease portfolio as a result of changing expected cash flows caused by loan defaults, inadequate collateral or changes in prepayment rates, among other factors.
Noninterest income is derived primarily from electronic funds transfer (“EFT”) and merchant transaction processing fees, fiduciary and investment management fees, banking fees and service charges, mortgage banking revenue and operating lease revenue. The Registrant manages market risk and credit risk by monitoring and reacting to changes that may impact revenue.
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
4
securities. The Registrant believes this measure to be the preferred industry measurement of net interest income as it provides a relevant comparison between taxable and non-taxable amounts.
The Registrant’s net income available to common shareholders was $448 million for the second quarter of 2004, up eight percent compared to $415 million for the same period last year. Earnings per diluted share were $.79 for the second quarter, up 11 percent from $.71 for the same period last year. The Registrant increased its quarterly dividend to $.32 per common share from $.29, an increase of 10% on a year-over-year basis. The financial results reflect growth experienced across nearly all of the lines of business, including solid growth in both commercial and consumer loans. The Registrant also benefited from improvements in commercial credit quality and continued expense control. Noninterest income increased as the Registrant continues to benefit from its strong emphasis on cross-selling services to its customers.
The Registrant continues to invest in the geographic areas within its footprint that offer the best growth prospects. The Registrant opened 42 new banking centers during the first half of 2004 and plans for a similar number in the second half of 2004 in high population, low market share areas. The Registrant also completed its acquisition of Franklin Financial Corporation (‘Franklin”) during the second quarter of 2004, which expanded the Registrant’s presence in the Nashville market to 11 full-service banking centers with plans to open an additional six by mid-2005.
The Registrant’s capital ratios exceed the “well-capitalized” guidelines as defined by the Board of Governors of the Federal Reserve System (“FRB”). As of June 30, 2004, the Tier 1 capital ratio was 10.52 percent and the Total Risk Based capital ratio was 12.75 percent. The Registrant’s capital strength and financial stability have enabled the Registrant to maintain credit ratings that are equaled or surpassed by only three other U.S. bank holding companies.
Net Interest Income
Net interest income (FTE basis) for the second quarter of 2004 was $771 million, a three percent increase over $749 million for the same period last year. The increase in net interest income was due to the $6.2 billion or eight percent increase in average interest-earning assets, mitigated by the 15 basis point (bp) decrease in net interest margin. Tables 2 and 3 provide the relative impact of the growth in the balance sheet and changes in interest rates on net interest income. The net interest margin has contracted 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 implementation of Financial Accounting Standards Board’s (“FASB”) Statement of Financial Accounting Standards (‘SFAS”) No. 150 during the third quarter of 2003, and the resulting reclassification of $11 million of minority interest expense into interest expense caused the net interest margin to contract by 5 bp year over year. See Note 2 of the Notes to Condensed Consolidated Financial Statements for further discussion of the adoption of SFAS No. 150. The contribution of noninterest-bearing funding to the net interest margin declined from 36 bp in the second quarter of 2003 to 26 bp in the second quarter of 2004 due to both the lower level of interest rates and the Registrant’s share repurchase activity. The Registrant has repurchased 19.2 million shares of its common stock for approximately $1.1 billion since the beginning of the third quarter in 2003, including 8.5 million shares repurchased in the second quarter 2004. The Registrant views share repurchases as an effective means of delivering value to shareholders in a low interest rate environment.
Average loans and leases grew by $4.5 billion or nine percent for the second quarter of 2004 over the comparable period in 2003. The increase in average loans and leases in the second quarter of 2004 included growth in commercial loans and leases of $1.4 billion, growth in commercial construction and mortgage loans of $1.8 billion and growth in the total consumer loan and lease category of $1.3 billion, as compared to the second quarter of 2003. The Registrant benefited from increasing credit line usage in its existing commercial customer base as well as continued success in gaining new customers within its footprint.
5
Average investment securities and other short-term investments for the second quarter of 2004 grew $1.6 billion or six percent from the second quarter of 2003. Over the past several months, the Registrant has taken action to migrate the investment portfolio to be more heavily weighted towards adjustable-rate and shorter-term securities in connection with the asset/liability management activities.
Average demand deposits for the second quarter of 2004 increased $2.2 billion or 22 percent over the second quarter of 2003 reflecting the Registrant’s success in generating new account growth in its commercial line of business. Average interest-bearing deposits were lower by $1.5 billion or three percent in the second quarter of 2004 from the comparable period in 2003. The decline is largely attributable to certificates of deposits greater than $100,000, which declined $2.0 billion or 48 percent in the second quarter of 2004. The movement in this deposit type is a function of overall balance sheet funding requirements. A key focus of the Registrant for the remainder of the year is growing its interest-bearing products such as checking, savings and money market accounts in order to reduce its reliance on other sources to fund the expected growth in the balance sheet.
Average long-term debt increased $4.2 billion or 52 percent in the second quarter of 2004 over the comparable period in 2003. The Registrant has increased long-term debt to fund the growth in the balance sheet and to reduce its short-term wholesale funding position.
The Registrant expects that net interest margin and net interest income trends in coming periods will benefit from the steepness in the short end of the yield curve and moderation in the level of prepayment activity. The Registrant expects mid-single digit growth in net interest income in the third quarter on an annualized sequential basis over the second quarter, with 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.
6
TABLE 2: Consolidated Average Balance Sheets and Analysis of Net Interest Income (FTE Basis)
Revenue/
Cost
Assets
Interest-Earning Assets:
Loans and Leases (a)
Securities:
Taxable
Exempt from Income Taxes (a)
Other Short-Term Investments
Total Interest-Earning Assets
Cash and Due from Banks
Other Assets
Reserve for Credit Losses
Total Assets
Liabilities and Shareholders’ Equity
Interest-Bearing Liabilities:
Interest Checking
Savings
Money Market
Other Time Deposits
Certificates - $100,000 and Over
Foreign Office Deposits
Federal Funds Purchased
Short-Term Bank Notes
Other Short-Term Borrowings
Long-Term Debt
Total Interest-Bearing Liabilities
Demand Deposits
Other Liabilities
Total Liabilities
Minority Interest
Shareholders’ Equity
Total Liabilities and Shareholders’ Equity
Net Interest Income Margin(FTE basis)
Net Interest Rate Spread(FTE basis)
Interest-Bearing Liabilities to Interest-Earning Assets
7
TABLE 3: Consolidated Average Balance Sheets and Analysis of Net Interest Income (FTE Basis)
Total Liabilities and Shareholders’Equity
8
Provision for Credit Losses
The provision for credit losses was $88 million in the second quarter of 2004 compared to $109 million in the same period last year and $83 million last quarter. The increase from the prior quarter is due to the overall growth in loans and leases. The reserve for credit losses as a percent of loans and leases declined to 1.43 percent from 1.45 percent at March 31, 2004 and 1.49 percent at June 20, 2003. Net charge-offs decreased to $59 million in the second quarter of 2004 as compared to $77 million in the same period of 2003. Credit quality metrics and trends have continued to improve for the Registrant as the economy has improved. Refer to the “Credit Risk Management” section for further information on the provision for credit losses, net charge-offs, nonperforming assets and other factors considered by the Registrant in assessing the credit quality of the loan portfolio and the reserve for credit losses.
Noninterest Income
For the three and six months ended June 30, 2004 noninterest income increased by 21 percent and 14 percent on a year-over- year basis, respectively.
TABLE 4: Noninterest Income
Electronic payment processing revenue
Service charges on deposits
Mortgage banking net revenue
Investment advisory revenue
Other noninterest income
Operating lease revenue
Securities gains, net
Securities gains, net – non-qualifyinghedges on mortgage servicing
Total noninterest income
NA – Not applicable given the prior period balance is zero
Electronic payment processing revenue increased in the second quarter of 2004 despite both the sale of certain out-of-footprint third-party merchant processing contracts, which represented approximately $22 million in quarterly revenue and the $7 million impact of the 2003 MasterCard®/VISA® settlement. The Registrant continues to realize strong sales momentum from the addition of new customer relationships in both its merchant services and EFT businesses. Merchant processing revenue declined two percent in the second quarter of 2004 from the comparable period last year due to the above-mentioned sale of certain out-of-footprint contracts, which resulted in a $148 million gain included in other noninterest income. Excluding the impact of the lost revenue from the sale, merchant processing revenue increased 25% 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 an improving retail sector of the economy; comparisons being provided to supplement an understanding of the fundamental revenue trends. Compared to the same period in 2003, EFT revenues increased by 14 percent in the second quarter of 2004 and 25 percent exclusive of the revenue impact of $7 million in the second quarter of 2004 associated with the 2003 MasterCard®/VISA® settlement; comparisons being provided to supplement an understanding of the fundamental revenue trends. 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 207,000 merchant locations and 1,350 financial institutions worldwide.
9
Service charges on deposits increased primarily due to continued sales success in corporate treasury management products and commercial deposit campaigns. Commercial deposit revenues increased 21 percent over last year’s second quarter on the strength of continued focus on cross-sell initiatives and new customer relationships. Retail deposit revenues were flat over last year’s second quarter. Growth in the number of retail checking account relationships and in deposits is a key focus for the Registrant for the remainder of the year.
Mortgage banking net revenue declined in comparison to the prior year as a result of the record high level of refinancing activity in 2003. The components of mortgage banking net revenue for the three and six months ended June 30, 2004 and June 30, 2003 are as follows:
TABLE 5: Components of Mortgage Banking Net Revenue
Total mortgage banking fees and loan sales
Net (losses) gains and mark-to-market adjustments on both settled and outstanding free-standing derivative financial instruments
Net valuation adjustments and amortization on mortgage servicing rights (MSR’s)
Securities gains, net – non-qualifying hedges on mortgage servicing
Total mortgage banking net revenue, including securitiesgains related to risk management strategy
Mortgage originations declined to $2.8 billion in the second quarter of 2004 as compared to $4.9 billion in the same period last year directly contributing to the decrease in core mortgage banking fees in the second quarter of 2004 compared to the second quarter of 2003. The increase in interest rates during the second quarter of 2004 and corresponding decrease in prepayment speeds led to a reversal of temporary impairment of $56 million in the valuation reserve for the MSR portfolio in the second quarter of 2004 as compared to the $27 million in temporary impairment recognized in the second quarter of 2003. Servicing rights are deemed impaired when a borrower’s loan rate is distinctly higher than prevailing market rates. As mortgage interest rates continue to increase from record lows, the Registrant expects mortgage banking revenues in the second half of 2004 to stabilize at levels similar to those seen in the first quarter of 2004.
The increase in investment advisory revenue in the current quarter compared to the second quarter of 2003 resulted primarily from strengthening sales in institutional asset management, retail brokerage and private client services. Institutional asset management increased 34 percent largely as a result of new customer additions in its retirement plan services and products. Retail brokerage grew 15 percent largely due to growth in mutual fund fees. Private client services increased 16 percent largely due to success in its personal trust products. 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 advantage of a diverse and expanding customer base. The Registrant is one of the largest money managers in the Midwest and as of June 30, 2004 had over $171 billion in assets under care and $35 billion in assets under management.
The increase in operating lease revenue is due to the consolidation beginning in the third quarter of 2003 of a special purpose entity (“SPE”) formed for the purpose of the sale and subsequent leaseback of leased autos in the third quarter of 2003. The consolidation was the result of the Registrant’s implementation of FASB’s
10
Interpretation No. 46R (“FIN” 46). See Note 2 of the Notes to Condensed Consolidated Financial Statements. The operating lease revenue declined $8 million from the first quarter of 2004 and will continue to decline as the leases mature.
The major components of other noninterest income for the three and six months ended June 30, 2004 and 2003 are as follows:
TABLE 6: Components of Other Noninterest Income
Three Months
Ended June 30,
Cardholder fees
Consumer loan and lease fees
Commercial banking revenue
Bank owned life insurance income
Insurance income
Gain on sale of certain merchant processing contracts
Other
Total other noninterest income
The second quarter of 2004 results include the pretax gain of approximately $148 million on the previously mentioned sale of certain out-of-footprint third-party sourced merchant processing contracts. Compared to the same period in 2003, the other component of other noninterest income decreased due to a loss of $8 million resulting from a decline in market value of a free-standing purchased option utilized to hedge against interest rate risk. The fair value of this purchased option at the end of the second quarter was $2 million. The remaining categories of the other component of other noninterest income were flat to slightly down on a year over year basis.
Noninterest Expense
Noninterest expense increased 20 percent in the second quarter of 2004 over the same period last year. Comparisons to the same period last year are impacted by (i) the implementation of FIN 46 in the third quarter of 2003, resulting in the recognition of $32 million of depreciation expense in the 2004 second quarter on operating lease assets; (ii) a charge of $20 million related to the early retirement of approximately $200 million of Federal Home Loan Bank (“FHLB”) advances in the second quarter of 2003 recorded in other noninterest expense; (iii) a $31 million pre-tax recovery in the second quarter of 2003 of previously charged-off treasury clearing and settlement account balances recorded in other noninterest expense; and (iv) a charge of $78 million related to the early retirement of approximately $1 billion of FHLB advances in the second quarter of 2004 recorded in other noninterest expense. Excluding the impact of these items, noninterest expenses were flat compared to the same period in 2003; comparison being provided to supplement an understanding of the fundamental trends in noninterest expense. The Registrant is continuing to focus on efficiency initiatives as part of its core emphasis on operating leverage. These initiatives include increasing levels of automation of processes, the rationalization and reduction of non-core businesses as they relate to the Registrant’s retail and middle market customer base, returns on invested capital and related opportunities for continued growth.
11
The efficiency ratio (noninterest expense divided by the sum of taxable equivalent net interest income and noninterest income) was 48.9 percent and 45.5 percent for the second quarter of 2004 and 2003, respectively.
TABLE 7: Noninterest Expense
Salaries, wages and incentives
Employee benefits
Equipment expenses
Net occupancy expense
Operating lease expense
Other noninterest expense
Total noninterest expense
Compared to the same period in 2003, the combination of salaries, wages, incentives and employee benefits decreased four percent in the second quarter of 2004. Full time equivalent employees totaled 18,937 as of June 30, 2004 as compared to 19,830 as of June 30, 2003.
Net occupancy expenses increased due to $4 million of higher depreciation expense related to the increase in branches and expansion of the Registrant’s main operations center and $3 million of higher repairs and maintenance expense.
The major components of other noninterest expense for the three and six months ended June 30, 2004 and 2003 are as follows:
TABLE 8: Components of Other Noninterest Expense
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 noninterest expense
The comparisons in the other component of other noninterest expense largely relate to the debt retirement charges and the treasury clearing and settlement account recovery, all as discussed above. Loan and lease expenses declined due to the mortgage origination volume decrease from the record highs seen in 2003. The Registrant has reduced the mortgage origination cost infrastructure consistent with the current volume of activity.
12
Applicable Income Taxes
The Registrant’s income from continuing operations before income taxes, applicable income tax expense and effective tax rate for each of the periods indicated were:
TABLE 9: Applicable Income Taxes
Income from continuing operations before income taxesand minority interest
Applicable income taxes
Effective tax rate
Applicable income tax expense for all periods include the benefit from tax-exempt income, tax-advantaged investments and general business tax credits, partially offset by the effect of nondeductible expenses. The increase in the tax rate in the second quarter of 2004 results from the previously mentioned sale of certain out-of-footprint third-party sourced merchant processing contracts, which included certain goodwill that was not tax deductible. The Registrant expects the effective tax rate in future periods to be similar with historical levels.
The table below summarizes the end of period commercial and consumer loans and leases, including loans held for sale, by major category:
TABLE 10: Components of Loan Portfolio (including held for sale)
Commercial:
Commercial
Mortgage
Construction
Leases
Subtotal
Consumer:
Installment
Mortgage and construction
Credit card
Total
Commercial loan and lease outstandings, including loans held for sale, increased eight percent compared to December 31, 2003 and 13 percent compared to June 30, 2003. The increase in commercial loans and leases was attributable to growth in middle-market and small business loan originations, the strength of new customer additions and strong sales results in several markets, including Cincinnati, Chicago, Indianapolis and Louisville, and the acquisition of $441 million of commercial loans in the Franklin transaction consummated on June 11, 2004. Total participation in commercial loan syndication lending represents approximately six percent of the total commercial loans and leases outstanding and has not changed significantly in the past twelve months.
13
Consumer loan and lease outstandings, including loans held for sale, increased three percent compared to December 31, 2003 and five percent compared to June 30, 2003. Consumer loan comparisons to the prior periods are impacted by the securitization and sale of $903 million in home equity lines of credit in the third quarter of 2003 and $750 million of automotive loans in the second quarter of 2004. The portfolio was also impacted by the acquisition of $140 million of consumer loans in the Franklin transaction. The Registrant is continuing to devote significant focus on producing retail-based loan originations given the strong credit performance and attractive yields available in these products. Residential mortgage and construction loans, including held for sale, increased 15 percent compared to December 31, 2003 and one percent compared to June 30, 2003. Comparisons to prior periods are dependent upon the volume and timing of originations as well as the timing of loan sales. Residential mortgage originations totaled $2.8 billion in the second quarter of 2004 compared to $2.0 billion in the first quarter of 2004 and $4.9 billion in the second quarter of 2003. Consumer lease balances decreased five percent during the second quarter compared to December 31, 2003 and eight percent compared to June 30, 2003.
Investment Securities
At June 30, 2004, total investment securities were $30.5 billion, compared to $29.2 billion at both December 31, 2003 and at June 30, 2003, representing an increase of four percent. The increased rate environment resulted in an unrealized loss on the available-for-sale securities portfolio at June 30, 2004 of $677 million, compared to an unrealized loss of $77 million at December 31, 2003 and an unrealized gain of $457 million at June 30, 2003. Responding to the change in interest rates, the Registrant has allocated a greater portion of current purchases to adjustable-rate and shorter-term securities. At June 30, 2004, 11 percent of the debt securities in the available-for-sale portfolio were adjustable-rate instruments, compared to seven percent at December 31, 2003. The estimated average life of the debt securities in the available-for-sale portfolio at June 30, 2004 was 5.1 years based on current prepayment expectations, compared to 5.2 years at December 31, 2003.
14
Information presented below is on a weighted average life basis, anticipating future prepayments. Yield information is presented on a fully taxable equivalent basis and is computed utilizing historical cost balances. Maturity and yield calculations for the total available-for-sale portfolio exclude equity securities that have no stated yield or maturity.
TABLE 11: Available-for-Sale Securities
Amortized
Fair
Value
Weighted Average
Life (in years)
Weighted
Average Yield
U.S. Treasuries:
Average life of one year or less
Average life 1 – 5 years
Average life 5 – 10 years
Average life greater than 10 years
U.S. Government agencies and corporations:
States and political subdivisions:
Agency mortgage-backed securities:
Other bonds, notes and debentures (a):
Other securities (b)
Total available-for-sale securities
15
TABLE 12: Components of Available-for-Sale Portfolio
of Total
U.S. Treasury
U.S. Government agencies and corporations
States and political subdivisions
Agency mortgage-backed securities
Other bonds, notes and debentures
Other securities
Deposits
Total deposits at June 30, 2004 increased four percent compared to June 30, 2003 due largely to the increase in demand and interest checking deposits. The majority of metropolitan areas within the Registrant’s footprint experienced double-digit growth rates in commercial demand deposits largely due to new customer additions. The deposit portfolio was also impacted by the acquisition of $767 million of deposits in the Franklin transaction. The increase in total transaction account balances was offset by the decrease in certificates greater than $100,000. The movement in these certificates of deposits is a function of overall balance sheet requirements. Compared to December 31, 2003, transaction deposits were flat, excluding the acquisition of $327 million of transaction deposits obtained in the Franklin transaction. 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. The Registrant is confident in its ability to competitively price and generate growth in customers and deposit balances in an increasing interest rate environment. The foreign office deposits represent U.S. dollar denominated deposits of the Registrant’s foreign branch located in the Cayman Islands. The Registrant utilizes these deposit balances as a method to fund earning asset growth.
TABLE 13: Deposits
2004
December 31,
2003
Year-over-Year
Percent Change
Demand
Interest checking
Money market
Other time
Certificates - $100,000 and over
Foreign office
Total deposits
Borrowings
The Registrant has been actively reducing its dependence on overnight wholesale funding given the rising interest rate environment. Federal funds purchased totaled $3.9 billion, compared to $6.9 billion at December 31, 2003 and $5.8 billion at June 30, 2003. Long-term debt was $14.8 billion at June 30, 2004, compared with $9.1 billion at December 31, 2003 and $8.3 billion at June 30, 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. This adoption resulted in the consolidation of a long-term debt obligation. The balance of this long-term debt obligation at June 30, 2004 is $523 million. See Note 2 of the Notes to Condensed Consolidated Financial Statements for further discussion of adoption of FIN 46. As previously discussed, the
16
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 second quarter of 2004, the Registrant issued $775 million of short-term bank notes, $2.3 billion of medium-term bank notes with maturities of up to two years, $2 billion of three to five year FHLB advances and $750 million of 36 to 39-month structured repurchase agreements. The Registrant continues to explore additional alternatives regarding the level and cost of various other sources of funds. Refer to the “Liquidity Risk Management” section for discussion of liquidity management of the Registrant.
TABLE 14: Borrowings
Federal funds purchased
Short-term bank notes
Other short-term borrowings
Long-term debt
Total borrowings
Note 2 of the Notes to Condensed Consolidated Financial Statements discusses new accounting policies adopted by the Registrant during 2004 and 2003 and the expected impact of accounting policies issued but not yet required to be adopted. Effective January 1, 2004, the Registrant adopted, on a retroactive basis, the provisions of SFAS No. 123, “Accounting for Stock-Based Compensation.” To the extent that the adoption of new accounting standards affects the Registrant’s financial condition, results of operations or liquidity, the impacts are discussed in the applicable sections of Management’s Discussion and Analysis and the Notes to the Condensed Consolidated Financial Statements.
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 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.
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
17
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 is in the process of being revised at the end of the second quarter of 2004 to provide for a dual risk rating system that provides for 13 probability of default grade categories and an additional six 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 will 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 $812 million was adequate, but not excessive, to absorb estimated credit losses associated with the loan and lease portfolio at June 30, 2004.
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 repricing characteristics of certain assets and liabilities so that changes in interest rates do not adversely affect net interest
18
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 (principal-only (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. This 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 intent and ability to hold the security to recovery or maturity. A decline in value that is considered to be other-than-temporary is recorded as a loss within noninterest 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 noninterest 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 noninterest 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 noninterest 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 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 the financial asset type and interest rates. In
19
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 noninterest 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 June 30, 2004, due to immediate 10 percent and 20 percent adverse changes in the current prepayment assumption would be approximately $17 million and $33 million, respectively and due to immediate 10 percent and 20 percent favorable changes in the current prepayment assumption would be approximately $19 million and $39 million, respectively. The change in the fair value of MSR’s at June 30, 2004, due to immediate 10 percent and 20 percent adverse changes in the discount rate assumption would be approximately $11 million and $21 million, respectively and due to immediate 10 percent and 20 percent favorable changes in the discount rate assumption would be approximately $11 million and $24 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.
20
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.
21
Risk Management
Managing risk is an essential component of successfully operating a financial services company. The Registrant’s ability to properly and effectively identify, measure, monitor, control and report risk in its business activities is critical to its financial soundness and profitability. Among the most prominent risk exposures are credit, market, liquidity and operational risk, including legal and reputational risk. Credit risk is the risk that a borrower or counterparty will fail to perform its obligation at the required time. Market risk arises from fluctuations in interest rates, foreign exchange rates and equity prices that may result in the potential reduction in net interest income and/or changes in the values of financial instruments, such as trading and available-for-sale securities that are accounted for on a mark-to-market basis. Liquidity risk is the risk of loss resulting from an institution’s inability to meet its obligations when they come due without incurring unacceptable losses. Operational risk, as defined by the Registrant, is the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events including legal and reputational risk.
The following discussion of the Registrant’s risk management process focuses primarily on developments since December 31, 2003. The Registrant’s risk management processes have not substantially changed from year-end and are described in the Registrant’s 2003 Annual Report, beginning on page 62.
The objective of the Registrant’s credit risk management strategy is to quantify and manage credit risk on an aggregate portfolio basis as well as to limit the risk of loss resulting from an individual customer default. Credit risk is managed through a combination of conservative exposure limits and underwriting, documentation and collection standards and overall counterparty limits. The Registrant’s credit risk management strategy also emphasizes diversification on a geographic, industry and customer level, regular credit examinations and monthly management reviews of large credit exposures and credits experiencing deterioration of credit quality. Lending officers with the authority to extend credit are delegated specific authority amounts, the utilization of which is closely monitored. Lending activities are largely decentralized, while the Enterprise Risk Management division manages the policy process centrally. The Credit Risk Review function, within the Enterprise Risk Management division, provides objective assessments of the quality of underwriting and documentation, the accuracy of risk grades and the charge-off and reserve analysis process.
The Registrant’s credit review process and overall assessment of required reserves is based on ongoing quarterly assessments of the probable estimated losses inherent in the loan and lease portfolio. In addition to the individual review of larger commercial loans that exhibit probable or observed credit weaknesses, the commercial credit review process includes the use of a risk grading system. The risk grading systems utilized in 2003 for commercial loans and leases encompassed ten categories. This risk grading system is in the process of being revised at the end of the second quarter of 2004 to provide for a dual risk rating system that provides for 13 probability of default grade categories and an additional six 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 grading system is consistent with Basel II expectations and should allow for more precision in the analysis of commercial credit risk. Scoring systems and delinquency monitoring are used to assess the credit risk in the Registrant’s homogenous consumer loan portfolios.
22
Quantitative and Qualitative Disclosure about Risk (continued)
The Registrant’s credit risk management strategy includes minimizing size risk and other concentrations of risk. Table 15 provides 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.
TABLE 15: Commercial Loan and Lease Portfolio Exposure
Real estate
Manufacturing
Retail trade
Business services
Wholesale trade
Individuals
Healthcare
Financial services and insurance
Transportation and warehousing
Accommodation and food
Other services
Public administration
Communication and information
Agribusiness
Entertainment and recreation
Utilities
Mining
By Loan Size
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.
23
The commercial portfolio is further characterized by 89 percent of outstanding balances and 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 96 percent of outstanding balances and 94 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.
TABLE 16: Commercial Loan Portfolio Exposure by State
Ohio
Michigan
Indiana
Illinois
Kentucky
Tennessee
Florida
Out-of-footprint
Analysis of Nonperforming Assets
Nonperforming assets include nonaccrual loans and leases on which ultimate collectibility of the full amount of the interest is uncertain, loans and leases which have been renegotiated to provide for a reduction or deferral of interest or principal because of deterioration in the financial position of the borrower and other assets, including other real estate owned and repossessed equipment. Underperforming assets include nonperforming assets and loans and leases past due 90 days or more as to principal or interest, which are not already accounted for as nonperforming assets.
Total nonperforming assets were $283 million at June 30, 2004, down $35 million compared to $318 million at December 31, 2003, and $24 million compared to $307 million at June 30, 2003. Total nonperforming assets as a percent of total loans, leases and other assets, including other real estate owned declined to .50 percent as of June 30, 2004 from .61 percent and .62 percent as of December 31, 2003 and June 30, 2003, respectively. During the same periods there has also been a decrease in loans and leases ninety days past due. The improvement in credit quality has been most evident in commercial loans with other categories remaining consistent with prior periods. The Registrant expects to see continued favorable trends in asset quality as economic conditions continue to improve.
24
The table below provides a summary of nonperforming and underperforming assets:
TABLE 17: Summary of Nonperforming and Underperforming Assets
Commercial loans
Lease financing
Total commercial
Commercial real estate:
Commercial mortgages
Total commercial real estate
Residential mortgages
Consumer loans
Total nonperforming loans
Renegotiated loans and leases
Other assets, including other real estate owned
Total nonperforming assets
Ninety days past due loans and leases
Total underperforming
Nonperforming assets as a percent of total loans, leases and other assets, including other real estate owned
Underperforming assets as a percent of total loans, leases and other assets, including other real estate owned
The table 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.
TABLE 18: Summary of Commercial Nonaccrual Loans and Leases by Loan Size
Less than $200,000
$200,000 to $1 million
$1 million to $5 million
$5 million to $10 million
$10 million to $15 million
25
Analysis of Net Loan Charge-offs
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:
TABLE 19: 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
Total losses
Recoveries of losses previously charged off:
Total recoveries
Net losses charged off:
Reserve for credit losses, beginning
Total net losses charged off
Provision charged to operations
Reserve for credit losses, ending
26
TABLE 20: Net Charge-Offs as a Percent of Average Loans and Leases
Weighted-average ratio
Net charge-offs as a percent of average loans and leases outstanding decreased 21 bp to .43 percent for the second quarter of 2004 from .64 percent for the second quarter of 2003 and decreased 11 bp from last quarter. The decrease in net charge-offs in the current quarter compared to the second quarter of 2003 was primarily due to lower net charge-offs in commercial loans and total lease financing. Total commercial loan net charge-offs decreased $9 million to $18 million in the current quarter compared to $27 million in the second quarter of 2003. The ratio of commercial loan net charge-offs to average commercial loans outstanding in the second quarter of 2004 was .50 percent, compared with .79 percent in the second quarter of 2003. The decrease in commercial loan net charge-offs compared to the second quarter of 2003 was concentrated in certain markets, including Columbus and Dayton, with individual credits ranging in size from less than $1 million to $3 million. The Registrant experienced significant improvement in commercial loan net charge-off activity in the second quarter of 2004 as compared to 2003 as a result of overall improving credit trends and economic outlook. Commercial mortgage net charge-offs were comparable to the low level seen in the second quarter of 2003. Total lease net charge-offs in the second quarter of 2004 were $7 million, compared with $23 million in the second quarter of 2003. The ratio of lease net charge-offs to average leases outstanding in the second quarter of 2004 was .51 percent, compared with 1.67 percent in the second quarter of 2003. The improvement in leasing net charge-offs is largely due to a $10.5 million charge-off related to a commercial airline lease credit occurring in the second quarter of 2003. The lease net charge-off ratio of .51 percent is comparable to the .48 percent in the first quarter of 2004. Total consumer loan net charge-offs in the second quarter of 2004 increased to $26.5 million compared with $23.4 million in the second quarter of 2003, with increases not concentrated in any specific market. The ratio of consumer loan net charge-offs to average loans outstanding was unchanged from the second quarter of 2003, and the ratio for residential mortgage loan net charge-offs improved from .32 percent to .24 percent due to improvements in most of the Registrant’s markets.
Provision and Reserve for Credit Losses
The reserve for credit losses provides coverage for probable and estimable losses in the loan and lease portfolio. The Registrant evaluates the reserve each quarter to determine that it is adequate to cover inherent losses. 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 reserve 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 June 30, 2004 was at 1.43 percent of the total loan and lease portfolio compared to 1.47 percent 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 June 30, 2003 was 1.49 percent of the total loan and lease portfolio. Additionally, the Registrant’s long history of low exposure limits, minimal exposure to national or sub-prime lending businesses, centralized risk management and a diversified portfolio reduces the likelihood of significant unexpected credit losses.
27
Market risk arises from fluctuations in interest rates, foreign exchange rates and equity prices that may result in the potential reduction in net interest income. Interest rate risk, a component of market 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: (i) assets and liabilities may mature or reprice at different times; (ii) short-term and long-term market interest rates may change by different amounts; or (iii) 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.
Net Interest Income Simulation Model
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 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 and incorporates the loss of free funding resulting from the Registrant’s share repurchase activity. 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 Asset/Liability Management Committee (“ALCO”), which includes senior management representatives and is accountable to the Risk and Compliance Committee of 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 June 30, 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 50 bp and 100 bp linear increase or decrease in all interest rates.
TABLE 21: 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 1.6 percent in the first year and .9 percent in the second year. A 200 bp linear increase in interest rates would decrease net interest income by 3.4 percent in the first year and 2.7
28
percent in the second year. A 100 bp linear decrease in interest rates would increase net interest income by .8 percent in the first year and decrease net interest income by an estimated 3.2 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. The Registrant is continuing to position itself to be less sensitive to a rising interest rate environment by increasing the proportion of variable interest yielding assets and increasing core deposits. 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.
Use of Derivatives to Manage Interest Rate Risk
The Registrant enters into derivative transactions to manage its interest rate and prepayment risk and to accommodate the business requirements of its customers. To manage its interest rate risk, the Registrant may enter into interest rate swaps, interest rate floors and caps, forward contracts, options and swaptions. Interest rate swaps involve the exchange of fixed-rate and variable-rate payments without exchange of the underlying notional amount on which the interest payments are calculated. Interest rate floors protect against declining rates while interest rate caps protect against rising interest rates. Forward contracts are contracts in which a buyer agrees to purchase and a seller agrees to make delivery of, a specific financial instrument at a predetermined price or yield. Swaptions have characteristics of both a swap and an option. Swaptions allow, but do not require, counterparties to exchange streams of payments over a specified period of time. As part of its risk management strategy for its mortgage banking operations, the Registrant may enter into free-standing derivatives (PO swaps, swaptions, floors, forward contracts, options and interest rate swaps) to economically hedge interest rate lock commitments and changes in the fair value of its largely fixed rate MSR portfolio. The Registrant also acts as a buyer and seller of interest rate derivative contracts on behalf of customers. The Registrant minimizes its market and liquidity risks by taking similar offsetting positions with approved, reputable counterparties. The notional amount and estimated net fair values of these derivatives as of June 30, 2004 are presented in Note 5 to the Condensed Consolidated Financial Statements.
Servicing Rights and Interest Rate Risk
The net carrying amount of the servicing rights portfolio was $358 million at June 30, 2004. The Registrant maintains a comprehensive management strategy relative to its mortgage banking activity, including consultation with an 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. The Registrant’s non-qualifying hedging strategy includes 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 servicing rights can fluctuate sharply depending on changes in interest rates and other factors. Generally, as interest rates decline, the value of servicing rights declines because, as loans are prepaid to take advantage of an interest rate decline, no further servicing fees are collected on those loans. The increase in interest rates during the second quarter of 2004 and corresponding decrease in prepayment speeds led to a reversal of temporary impairment of $56 million in the MSR portfolio in the second quarter of 2004 as compared to the $27 million in temporary impairment recognized in the second quarter of 2003. The servicing rights are deemed impaired when a borrower’s loan rate is distinctly higher than prevailing market rates. See Note 4 to the Condensed Consolidated Financial statements for further discussion.
Foreign Currency Risk
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 derivative contracts with approved, reputable counterparties with matching terms and currencies.
29
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 5.1 years at June 30, 2004, based on current prepayment expectations. Of the $30.2 billion (fair value basis) of securities in the portfolio at June 30, 2004, $3.3 billion in principal and accrued interest is expected to be received in the next twelve months, and an additional $2.7 billion in principal and accrued interest is expected to be received 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 FHLMC 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, certain floating rate home equity loans, certain auto loans and other consumer loans are also securitized, sold or transferred off-balance sheet. For the six months ended June 30, 2004 and 2003, a total of $4.3 billion and $8.5 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 June 30, 2004, $1.5 billion of debt or other securities were available for issuance under this shelf registration. Additionally, the Registrant also has $13.8 billion of funding available for issuance in connection with its bank note program. These sources, in addition to the Registrant’s 9.09 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 22: 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 61 percent of its average total assets during the first six months of 2004. In 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 various regional Federal Home Loan Banks as a funding source. Management does not rely on any one source of liquidity and manages availability in response to changing balance sheet needs.
30
The Registrant maintains a relatively high level of capital as a margin of safety for its depositors and shareholders. At June 30, 2004, shareholders’ equity was $8.4 billion compared to $8.7 billion at both December 31, 2003 and June 30, 2003, a decrease of three percent. Average shareholders’ equity as a percentage of average assets for the three months ended June 30, 2004 was 9.09 percent. The FRB adopted quantitative measures that 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 June 30, 2004 and 2003. The Registrant expects to maintain these ratios above the well-capitalized levels throughout 2004.
TABLE 23: Capital Ratios
Risk-based capital:
Tier 1
Total capital
Dividend Policy
The Registrant’s common stock dividend policy reflects its earnings outlook, desired payout ratios, the need to maintain adequate capital levels and alternative investment opportunities. The Registrant increased its quarterly dividend to $.32 from $.29 during the first quarter of 2004.
Stock Repurchase Program
On March 27, 2003, the Registrant announced that its Board of Directors had authorized management to repurchase up to 20 million shares of the Registrant’s common stock through the open market or in any private transaction. As of June 30, 2004, the Registrant had purchased all of the shares available under this authorization. On June 15, 2004, the Registrant announced that its Board of Directors had authorized management to purchase an additional 40 million shares of the Registrant’s common stock through the open market or in any private transaction. The timing of the purchases and the exact number of shares to be purchased depends upon market conditions. The authorization does not include specific price targets or an expiration date. The Registrant’s repurchase of equity securities were as follows:
TABLE 24: Share Repurchases
April 1, 2004 –
April 30, 2004
May 1, 2004 –
May 31, 2004
June 1, 2004 –
June 30, 2004
(a) The Registrant purchased 3,672 and 13,887 shares of its common stock during May and June 2004, respectively, in connection with various employee compensation and incentive plans of the Registrant. These purchases are not included against the maximum number of shares that may yet be purchased under the Board of Directors authorization.
31
The Registrant’s stock repurchase program is an important element of its capital planning activities. Given the level of excess capital, the Registrant views share repurchases as an effective means of delivering value to shareholders.
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 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, the Risk Compliance Committee and the Board of Directors.
As part of the Registrant’s asset/liability management, the Registrant may transfer, subject to credit recourse, certain types of individual financial assets to a non-consolidated qualified special purpose entity (“QSPE”) that is wholly owned by an independent third-party. 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. During the three months ended June 30, 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 June 30, 2004, the outstanding balance of loans transferred was $1.9 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.
The Registrant utilizes securitization trusts formed by independent third parties to facilitate the securitization process of residential mortgage loans, certain floating rate home equity lines of credit, certain auto loans and other consumer 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 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 June 30, 2004, the Registrant had retained servicing assets totaling $358 million, an interest-only strip totaling $1 million, subordinated tranche security interests totaling $68 million and residual interests totaling $50 million.
32
The Registrant had the following cash flows with these unconsolidated QSPE’s during the six months ended June 30, 2004 and 2003:
TABLE 25: 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 June 30, 2004, the Registrant had provided credit recourse on approximately $570 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 $570 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 $15 million relating to these residential mortgage loans sold.
The Registrant has certain obligations and commitments to make future payments under contracts. At June 30, 2004, the aggregate contractual obligations and commitments were:
TABLE 26: Aggregate Contractual Obligations and Other Commitments
Less than
One Year
1-3
Years
3-5
Annual rental/purchase commitments under noncancelable leases/contracts
Letters of credit
Commitments to extend credit
33
Fifth Third Bancorp and Subsidiaries
Condensed Consolidated Balance Sheets (unaudited)
Available-for-Sale Securities (a)
Held-to-Maturity Securities (b)
Trading Securities
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
Total Loans and Leases, Net
Bank Premises and Equipment
Operating Lease Equipment
Accrued Interest Receivable
Goodwill
Intangible Assets
Servicing Rights
Liabilities
Deposits:
Other Time
Foreign Office
Total Deposits
Accrued Taxes, Interest and Expenses
Common Stock (c)
Preferred Stock (d)
Capital Surplus
Retained Earnings
Accumulated Nonowner Changes in Equity
Treasury Stock
Total Shareholders’ Equity
See Notes to Condensed Consolidated Financial Statements
34
Condensed Consolidated Statements of Income (unaudited)
Interest Income
Interest and Fees on Loans and Leases
Interest on Securities:
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 After Provision for Credit Losses
Electronic Payment Processing Revenue
Service Charges on Deposits
Mortgage Banking Net Revenue
Investment Advisory Revenue
Other Noninterest Income
Operating Lease Revenue
Securities Gains, Net
Securities Gains, Net - Non-Qualifying Hedges on Mortgage Servicing
Total Noninterest Income
Noninterest Expenses
Salaries, Wages and Incentives
Employee Benefits
Equipment Expense
Net Occupancy Expense
Operating Lease Expense
Other Noninterest Expense
Total Noninterest Expense
Income from Continuing Operations Before Income Taxes and Minority Interest
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:
35
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
Decrease in Trading Securities
Net Gain on Divestitures
Decrease in Accrued Interest Receivable
Increase in Other Assets
Increase in Accrued Taxes, Interest and Expenses
(Decrease) Increase in Other Liabilities
Net Cash Provided by Operating Activities
Investing Activities
Proceeds from Sales of Available-for-Sale Securities
Proceeds from Calls, Paydowns and Maturities of Available-for-Sale Securities
Purchases of Available-for-Sale Securities
Proceeds from Calls, Paydowns and Maturities of Securities Held-to-Maturity
Purchases of Held-to-Maturity Securities
Decrease 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
Cash Received on Divestitures
Cash Acquired in Business Acquisitions
Net Cash Used In Investing Activities
Financing Activities
Increase in Core Deposits
Increase in Certificates - $100,000 and Over, Including Foreign Office
(Decrease) Increase in Federal Funds Purchased
Increase in Short-Term Bank Notes
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
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
Supplemental Cash Flow Information
Business Acquisitions:
Fair Value of Tangible Assets Acquired (Noncash)
Goodwill and Identifiable Intangible Assets Acquired
Liabilities Assumed
Stock Options
Common Stock Issued
Securitization of Automotive Loans:
Capitalized Servicing Rights
Residual Interest
Available-for-Sale Securities Retained
36
Condensed Consolidated Statements of Changes in Shareholders’ Equity (unaudited)
Total Shareholders’ Equity, Beginning
Nonowner Changes in Equity, Net of Tax:
Change in Unrealized Gains (Losses) on Available-for-Sale Securities and Qualifying Cash Flow Hedges
Net Income and Nonowner Changes in Equity
Cash Dividends Declared:
Common Stock (2004 - $.64 per share and 2003 - $.55 per share)
Preferred Stock
Stock Options Exercised including Treasury Shares Issued
Loans Issued Related to the Exercise of Stock Options, Net
Change in Corporate Tax Benefit Related to Stock-Based Compensation
Shares Purchased
Acquisition
Total Shareholders’ Equity, Ending
37
1. Basis of Presentation
In the opinion of management, the unaudited Condensed Consolidated Financial Statements include all adjustments (which consist of normal recurring accruals) necessary to present fairly the financial position as of June 30, 2004 and 2003, the results of operations for the three and six months ended June 30, 2004 and 2003, the cash flows for the six months ended June 30, 2004 and 2003 and the changes in shareholders’ equity for the six months ended June 30, 2004 and 2003. In accordance with accounting principles generally accepted in the United States of America for interim financial information, these statements do not include certain information and footnote disclosures required for complete annual financial statements. The results of operations for the three and six months ended June 30, 2004 and 2003 and the cash flows for the six months ended June 30, 2004 and 2003 are not necessarily indicative of the results to be expected for the full year. Financial information as of December 31, 2003 has been derived from the audited Consolidated Financial Statements of Fifth Third Bancorp (the “Registrant” or “Fifth Third”). These Consolidated Financial Statements have been retroactively restated due to the adoption of the fair value method of accounting for stock-based compensation as described in Note 12. For further information on this retroactive adoption, refer to the Registrant’s 8-K filed on April 14, 2004, which presents the Registrant’s Consolidated Financial Statements and Notes thereto for the year ended December 31, 2003.
Certain reclassifications have been made to prior periods’ Condensed Consolidated Financial Statements and related notes to conform with the current period presentation.
2. New Accounting Pronouncements
In December 2002, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“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 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 May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity.” This Statement establishes standards for how an entity classifies and measures certain financial instruments with characteristics of both liabilities and equity. This Statement requires that an issuer classify a financial instrument that is within its scope as a liability. Many of those instruments were previously classified as equity or in some cases presented between the liabilities section and the equity section of the statement of financial position. This Statement was effective for financial instruments entered into or modified after May 31, 2003 and otherwise was effective at the beginning of the first interim period beginning after June 15, 2003. Adoption of this Standard on July 1, 2003 required a reclassification of a minority interest to long-term debt and its corresponding minority interest expense to interest expense, relating to preferred stock issued during 2001 by a subsidiary of the Registrant. The existence of the mandatory redemption feature of this issue upon its mandatory conversion to trust preferred securities necessitated these reclassifications and did not result in any change in bottom line income statement trends.
In December 2003, the FASB issued SFAS No. 132 (Revised 2003), “Employers’ Disclosures about Pensions and Other Postretirement Benefits.” This Statement expands upon the existing disclosure requirements as
38
Notes to Condensed Consolidated Financial Statements (continued)
prescribed under the original SFAS No. 132 by requiring more details about pension plan assets, benefit obligations, cash flows, benefit costs and related information. SFAS No. 132(R) also requires companies to disclose various elements of pension and postretirement benefit costs in interim-period financial statements beginning after December 15, 2003. This Statement was effective for financial statements with fiscal years ending after December 15, 2003. The Registrant adopted this Standard, and its required disclosures for interim-period financial statements are included in Note 11.
In January 2003, the FASB issued Interpretation No. 46 (“FIN” 46), “Consolidation of Variable Interest Entities.” This Interpretation clarifies the application of ARB No. 51, “Consolidated Financial Statements,” for certain entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated support from other parties. This Interpretation requires variable interest entities (“VIE’s”) to be consolidated by the primary beneficiary which represents the enterprise that will absorb the majority of the VIE’s expected losses if they occur, receive a majority of the VIE’s residual returns if they occur, or both. Qualifying Special Purpose Entities (“QSPE’s”) are exempt from the consolidation requirements of FIN 46. This Interpretation was effective for VIE’s created after January 31, 2003 and for VIE’s in which an enterprise obtains an interest after that date. In December 2003, the FASB issued Staff Interpretation No. 46R (FIN 46R), “Consolidation of Variable Interest Entities — an interpretation of ARB 51 (revised December 2003),” which replaces FIN 46. FIN 46R was primarily issued to clarify the required accounting for interests in VIE’s. Additionally, this Interpretation exempts certain entities from its requirements and provides for special effective dates for enterprises that have fully or partially applied FIN 46 as of December 24, 2003. Application of FIN 46R is required in financial statements of public enterprises that have interests in structures that are commonly referred to as special-purpose entities (SPE’s) for periods ending after December 15, 2003. Application by public enterprises, other than small business issuers, for all other types of VIE’s (i.e., non-SPE’s) is required in financial statements for periods ending after March 15, 2004, with earlier adoption permitted. The Registrant early adopted the provisions of FIN 46 on July 1, 2003. Through June 30, 2004, the Registrant has provided full credit recourse to an unrelated and unconsolidated asset-backed SPE in conjunction with the sale and subsequent leaseback of leased autos. The unrelated and unconsolidated asset-backed SPE was formed for the sole purpose of participating in the sale and subsequent lease-back transactions with the Registrant. Based on this credit recourse, the Registrant is deemed to be the primary beneficiary as it maintains the majority of the variable interests in this SPE and was therefore required to consolidate the entity. Early adoption of this Interpretation required the Registrant to consolidate these operating lease assets and a corresponding liability as well as recognize an after-tax cumulative effect charge of $11 million, representing the difference between the carrying value of the leased autos sold and the carrying value of the newly consolidated obligation as of July 1, 2003. As of June 30, 2004, the outstanding balance of leased autos sold was $480 million. Consolidation of these operating lease assets did not impact risk-based capital ratios or bottom line income statement trends; however lease payments on the operating lease assets are now reflected as a component of noninterest income and depreciation expense is now reflected as a component of noninterest expense. The Registrant also early adopted the provisions of FIN 46 related to the consolidation of two wholly-owned finance entities involved in the issuance of trust preferred securities. Effective July 1, 2003, the Registrant deconsolidated the wholly-owned issuing trust entities resulting in a recharacterization of the underlying consolidated debt obligation from the previous trust preferred securities obligations to the junior subordinated debenture obligations that exist between the Registrant and the issuing trust entities. See Note 6 for discussion of certain guarantees that the Registrant has provided for the benefit of the wholly-owned issuing trust entities related to their debt obligations.
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 all loan
39
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 did not have a material effect on the Registrant’s Condensed Consolidated Financial Statements.
In March 2004, the Emerging Issues Task Force (“EITF”) reached a consensus on Issue 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” The EITF reached a consensus on an other-than-temporary impairment model for debt and equity securities accounted for under SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” and cost method investments. The basic model developed to evaluate whether an investment within the scope of Issue 03-1 is other-than-temporarily impaired involves a three-step process including, determining whether an investment is impaired (fair value less than cost), evaluating whether the impairment is other-than-temporary and, if other-than-temporary, requiring recognition of an impairment loss equal to the difference between the investment’s cost and its fair value. The three-step model used to determine other-than-temporary impairments shall be applied prospectively to all current and future investments in interim or annual reporting periods beginning after June 15, 2004. The amount of any other-than-temporary impairment that may need to be recognized in the future will be dependent on market conditions, the occurrence of certain events or changes in circumstances relative to an investee and the Registrant’s intent and ability to hold the impaired investments at the time of the valuation.
In May 2004, FASB issued Staff Position (“FSP”) No. 106-2, “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003.” This FSP provides guidance on accounting for the effects of the Medicare prescription drug legislation by employers whose prescription drug benefits are actuarially equivalent to the drug benefit under Medicare Part D, and the subsidy is expected to offset or reduce the Company’s costs for prescription drug coverage. The FSP is effective for the first interim period beginning after June 15, 2004. The FSP also provides guidance for disclosures concerning the effects of the subsidy for employers when the employer has not yet determined actuarial equivalency. The Registrant does not anticipate the adoption of this FSP will have a material impact on its financial condition or results of operations.
In December 2003, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants issued Statement of Position (“SOP”) 03-03 “Accounting for Certain Loans and Debt Securities Acquired in a Transfer.” SOP 03-03 addresses the accounting for acquired loans that show evidence of having deteriorated in terms of credit quality since their origination (i.e. impaired loans). SOP 03-3 requires acquired loans to be recorded at their fair value defined as the present value of future cash flows. SOP 03-03 prohibits the carryover of an allowance for loan loss on certain acquired loans as credit losses are considered in the future cash flows assessment. SOP 03-03 is effective for loans that are acquired in fiscal years beginning after December 15, 2004. The Registrant will evaluate the applicability of this SOP for all prospective loans acquired in fiscal years beginning after December 15, 2004. The Registrant does not anticipate this Statement to have a material effect on its Condensed Consolidated Financial Statements.
3. Intangible Assets
Intangible assets consist of core deposits, acquired merchant processing portfolios and servicing rights. Intangibles, excluding servicing rights, are amortized on a straight-line basis over their estimated useful lives, generally over a period of up to 25 years. The Registrant reviews intangible assets for possible impairment whenever events or changes in circumstances indicate that carrying amounts may not be recoverable.
40
Detail of amortizable intangible assets as of June 30, 2004:
Mortgage servicing rights
Other consumer and commercial servicing rights
Core deposits
Other intangible assets
As of June 30, 2004, all of the Registrant’s intangible assets were being amortized. Amortization expense recognized on intangible assets (including servicing rights) for the three and six months ended June 30, 2004 and 2003 are as follows:
Estimated amortization expense, including servicing rights, for fiscal years 2004 through 2008 is as follows:
For the Years Ended December 31 ($ in millions)
2004 (a)
2005
2006
2007
2008
4. Retained Interests
In the second quarter of 2004, the Registrant securitized and sold $750 million of automotive loans, maintaining servicing responsibilities and retaining a residual interest with first risk of loss valued at approximately $21 million and a subordinated tranche of securities totaling $21 million. The investors and the securitization trust have no other recourse to the Registrant’s assets for failure of debtors to pay as due.
41
At June 30, 2004, the key economic assumptions used in measuring the Registrant’s servicing rights and residual interests were as follows:
WeightedAverageLife
(in years)
Prepayment
SpeedAssumption(annual)
WeightedAverageDefault Rate
(annual)
ResidentialMortgage Loans:
Servicing assets
Home equity lineof credit:
Residual interest
Automotive loans:
Based on historical credit experience, expected credit losses for servicing rights have been deemed not to be material.
Changes in capitalized servicing rights for the six months ended June 30:
($ in millions)
Balance at January 1
Amount capitalized
Amortization
Sales
Servicing valuation recovery (provision)
Balance at June 30
Changes in the servicing rights valuation reserve for the six months ended June 30:
Permanent impairment write-off
The Registrant maintains a non-qualifying hedging strategy to manage a portion of the risk associated with changes in impairment on the mortgage servicing rights (MSR) portfolio. This strategy previously included the purchase of various available-for-sale securities (primarily FHLMC and FNMA agency bonds, U.S. treasury bonds and principal only (“PO”) strips) and currently includes the purchase of various free-standing derivatives (PO swaps, swaptions, floors, forward contracts, options and interest rate swaps). 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 increase in interest rates during the first six months of 2004 and the resulting impact of changing prepayment speeds led to the reversal of $45 million in temporary impairment on the MSR portfolio.
42
During the first six months of 2003, a temporary impairment of $42 million was recognized on the MSR portfolio due to falling interest rates and earnings rates and corresponding increases in prepayment speed, and the Registrant sold certain of these available-for-sale securities resulting in net realized gains of $3 million that were captured as a component of noninterest income in the Condensed Consolidated Statements of Income. In addition, the Registrant recognized a net loss of $24 million and net gain of $38 million in the six months ended June 30, 2004 and 2003, respectively, related to changes in fair value and settlement of free-standing derivatives purchased to economically hedge the MSR portfolio. As of June 30, 2003, the Registrant no longer held any available-for-sale securities related to its non-qualifying hedging strategy. As of June 30, 2004 and 2003 other assets included free-standing derivative instruments related to the MSR portfolio with a fair value of $4 million and $(7) million, respectively, and other liabilities included a fair value of $3 million as June 30, 2004. The outstanding notional amounts on the free-standing derivative instruments related to the MSR portfolio totaled $.7 billion and $1.4 billion as of June 30, 2004 and 2003, respectively.
At the beginning of the second quarter of 2004, expectations of interest rate movement resulted in the acceleration of prepayment speeds on loans serviced by the Registrant. Due to this increase in prepayment speed, the Registrant recorded a permanent impairment of $13 million on its MSR portfolio. The continued decline in primary and secondary mortgage rates during the second quarter of 2003 led to historically high refinance rates and corresponding increases in prepayment speeds. Therefore, during the second quarter of 2003, the Registrant determined a portion of the MSR portfolio was permanently impaired, resulting in a write-off of $129 million in MSR’s against the related valuation reserve.
Temporary changes in the MSR valuation reserve are captured as a component of mortgage banking net revenue in the Condensed Consolidated Statements of Income.
5. Derivative Financial Instruments
The Registrant maintains an overall interest rate risk management strategy that incorporates the use of derivative instruments to minimize significant unplanned fluctuations in earnings and cash flows caused by interest rate volatility. The Registrant’s interest rate risk management strategy involves modifying the repricing characteristics of certain assets and liabilities so that changes in interest rates do not adversely affect the net interest margin and cash flows. Derivative instruments that the Registrant 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. Interest rate swap contracts are exchanges of interest payments, such as fixed-rate payments for floating-rate payments, based on a common notional amount and maturity date. Forward contracts are contracts in which the buyer agrees to purchase, and the seller agrees to make delivery of, a specific financial instrument at a predetermined price or yield. Swaptions, which have the features of a swap and an option, allow, but do not require, counterparties to exchange streams of payments over a specified period of time.
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. PO swaps are total return swaps based on changes in the value of the underlying PO trust.
The Registrant also enters into foreign exchange contracts and interest rate swaps, floors and caps for the benefit of customers. The Registrant economically hedges significant exposures related to these free-standing derivatives, entered into for the benefit of customers, by entering into offsetting third-party contracts with approved, reputable counterparties with matching terms and currencies that are generally settled daily. Credit risks arise from the possible inability of counterparties to meet the terms of their contracts and from any resultant exposure to movement in foreign currency exchange rates, limiting the Registrant’s exposure to the replacement value of the contracts rather than the notional, principal or contract amounts. The Registrant minimizes the credit risk through credit approvals, limits and monitoring procedures. The Registrant hedges its interest rate exposure on customer transactions by executing offsetting swap agreements with primary dealers.
43
FAIR VALUE HEDGES - The Registrant enters into interest rate swaps to convert its nonprepayable, fixed-rate, long-term debt to floating-rate debt. The Registrant’s practice is to convert fixed-rate debt to floating-rate debt. Decisions to convert fixed-rate debt to floating are made primarily by consideration of the asset/liability mix of the Registrant, the desired asset/liability sensitivity and interest rate levels. For the quarter ended June 30, 2004, certain interest rate swaps met the criteria required to qualify for the shortcut method of accounting. Based on this shortcut method of accounting treatment, no ineffectiveness is assumed and fair value changes in the interest rate swaps are recorded as changes in the value of both the swap and the long-term debt. If any of the interest rate swaps do not qualify for the shortcut method of accounting, the ineffectiveness due to differences in the changes in the fair value of the interest rate swap and the long-term debt are reported within interest expense in the Condensed Consolidated Statements of Income. For the three and six months ended June 30, 2004, changes in the fair value of any interest rate swaps attributed to hedge ineffectiveness were insignificant to the Registrant’s Condensed Consolidated Statement of Income.
During 2003, the Registrant terminated interest rate swaps designated as fair value hedges and in accordance with SFAS No. 133, an amount equal to the fair value of the swaps at the date of the termination was recognized as a premium on the previously hedged long-term debt and is being amortized as an adjustment to yield.
The Registrant also enters into forward contracts to hedge the forecasted sale of its residential mortgage loans. For the three months ended June 30, 2004, the Registrant met certain criteria to qualify for matched terms accounting on the hedged loans held for sale. Based on this treatment, fair value changes in the forward contracts are recorded as changes in the value of both the forward contract and loans held for sale in the Condensed Consolidated Balance Sheets.
As of June 30, 2004, there were no instances of designated hedges no longer qualifying as fair value hedges. The following table reflects all fair value hedges included in the Condensed Consolidated Balance Sheets:
Included in other assets:
Interest rate swaps related to debt
Included in other liabilities:
Forward contracts related to mortgage loans held for sale
Total included in other liabilities
CASH FLOW HEDGES - The Registrant enters into interest rate swaps to convert floating-rate assets and liabilities to fixed rates and to hedge certain forecasted transactions. The assets and liabilities are typically grouped and share the same risk exposure for which they are being hedged. The Registrant may also enter into forward contracts to hedge certain forecasted transactions. As of June 30, 2004 and 2003 and December 31, 2003, $52 million, $9 million and $8 million, respectively, in net deferred losses, net of tax, related to cash flow hedges were recorded in accumulated nonowner changes in equity. Gains and losses on derivative contracts that are reclassified from accumulated nonowner changes in equity to current period earnings are included in the line item in which the hedged item’s effect in earnings is recorded. As of June 30, 2004, $3 million in net deferred gains, net of tax, on derivative instruments included in accumulated nonowner changes in equity are expected to be reclassified into earnings during the next twelve months. All components of each derivative instrument’s gain or loss are included in the assessment of hedge effectiveness.
During 2003, the Registrant terminated a hedge designated as a cash flow hedge related to the purchase price for certain available-for-sale securities. In accordance with SFAS No. 133, an amount equal to the fair value at date of determination is being amortized over a period of 15 years as an adjustment to yield.
The maximum term over which the Registrant is hedging its exposure to the variability of future cash flows is 33 months for hedges converting LIBOR-based loans to fixed and 14 months for hedges converting floating-rate debt to fixed.
44
As of June 30, 2004, there were no instances of designated hedges no longer qualifying as cash flow hedges. The following table reflects all cash flow hedges included in the Condensed Consolidated Balance Sheets:
Interest rate swaps related to LIBOR-based loans
FREE-STANDING DERIVATIVE INSTRUMENTS - The Registrant enters into various derivative contracts that focus on providing derivative products to commercial customers. These derivative contracts are not designated against specific assets or liabilities on the balance sheet or to forecasted transactions and, therefore, do not qualify for hedge accounting. These instruments include foreign exchange derivative contracts entered into for the benefit of commercial customers involved in international trade to hedge their exposure to foreign currency fluctuations and various other derivative contracts for the benefit of commercial customers. The Registrant economically hedges significant exposures related to these derivative contracts entered into for the benefit of customers by entering into offsetting third-party forward contracts with approved, reputable counterparties with matching terms and currencies that are generally settled daily.
Interest rate lock commitments issued on residential mortgage loan commitments that will be held for resale are also considered free-standing derivative instruments. The interest rate exposure on these commitments is economically hedged primarily with forward contracts. The Registrant also enters into a combination of free-standing derivative instruments (PO swaps, swaptions, floors, forward contracts, options and interest rate swaps) to economically hedge changes in fair value of its largely fixed-rate MSR portfolio. Additionally, the Registrant occasionally may enter into free-standing derivative instruments (options, swaptions and interest rate swaps) in order to minimize significant fluctuations in earnings and cash flows caused by interest rate volatility. Revaluation gains and losses on interest rate lock commitments and free-standing derivative instruments related to the MSR portfolio are recorded as a component of mortgage banking revenue, revaluation gains and losses on foreign exchange derivative contracts, other commercial customer derivative contracts and interest rate risk derivative contracts are recorded within other noninterest income in the Condensed Consolidated Statements of Income.
The net gains (losses) recorded in the Condensed Consolidated Statements of Income relating to free-standing derivative instruments are summarized below:
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
45
The following table reflects all free-standing derivatives included in the Condensed Consolidated Balance Sheets:
Interest rate contracts for customers
Interest rate lock commitments
Forward contracts related to interest rate lock commitments
Total included in other assets
The following table summarizes the Registrant’s derivative instrument activity (excluding customer derivatives) at June 30, 2004:
Remaining Maturity
(in months)
Average
Pay
Rate
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 on mortgage loans held for sale
Mortgage servicing rights portfolio:
Principal only swaps
Interest rate swaps—Receive fixed/pay floating
Purchased swaptions
Swaptions related to interest rate risk:
Written
Purchased
The notional amount related to commercial customer contracts outstanding at June 30, 2004 was $11.0 billion.
46
6. Guarantees
The Registrant has performance obligations upon the occurrence of certain events under financial guarantees provided in certain contractual arrangements. These various arrangements are summarized below.
At June 30, 2004, the Registrant had issued approximately $5.6 billion of financial and performance standby letters of credit to guarantee the performance of various customers to third parties. The maximum amount of credit risk in the event of nonperformance by these parties is equivalent to the contract amount and totals $5.6 billion. Upon issuance, the Registrant recognizes a liability equivalent to the amount of fees received from the customer for these standby letter of credit commitments. At June 30, 2004, the Registrant maintained a credit loss reserve of approximately $18 million related to these standby letters of credit. Approximately 77 percent of the total standby letters of credit are secured and in the event of nonperformance by the customers, the Registrant has rights to the underlying collateral provided including commercial real estate, physical plant and property, inventory, receivables, cash and marketable securities.
Through June 30, 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 June 30, 2004 was approximately $1.9 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 underlying borrowers is approximately equivalent to the total outstanding balance of $1.9 billion at June 30, 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.
At June 30, 2004, the Registrant had provided credit recourse on approximately $570 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 $570 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 $15 million relating to these residential mortgage loans sold.
As of June 30, 2004, the Registrant has also fully and unconditionally guaranteed $349 million of certain long-term borrowing obligations issued by three wholly-owned issuing trust entities that have been deconsolidated upon the early adoption of the provisions of FIN 46. See Note 2 for further discussion of adoption of FIN 46.
The Registrant, through its electronic payment processing division, processes VISA® and MasterCard® merchant card transactions. Pursuant to VISA® and MasterCard® rules, the Registrant assumes certain contingent liabilities relating to these transactions, which typically arise from billing disputes between the merchant and cardholder that are ultimately resolved in the cardholder’s favor. In such cases, these transactions are “charged back” to the merchant and disputed amounts are refunded to the cardholder. In the event that the Registrant is unable to collect these amounts from the merchant, it will bear the loss for refunded amounts. The likelihood of incurring a contingent liability arising from chargebacks is relatively low, as most products or services are delivered when purchased and credits are issued on returned items. For the six months ended June 30, 2004, the Registrant processed approximately $59 million of chargebacks presented by issuing banks, resulting in actual losses of $1 million to the Registrant. The Registrant accrues for probable losses based on historical experience and maintained an estimated credit loss reserve of approximately $1 million at June 30, 2004.
47
Fifth Third Securities, Inc (“FTS”), a subsidiary of the Registrant, guarantees the collection of all margin account balances held by its brokerage clearing agent for the benefit of FTS customers. FTS is responsible for payment to its brokerage clearing agent for any loss, liability, damage, cost or expense incurred as a result of customers failing to comply with margin or margin maintenance calls on all margin accounts. The margin account balance held by the brokerage clearing agent as of June 30, 2004 was $54 million. In the event of any customer default, FTS has rights to the underlying collateral provided. Given certain FTS margin account relationships were in place prior to January 1, 2003 and the existence of the underlying collateral provided as well as the negligible historical credit losses, FTS does not maintain any loss reserve.
7. Business Combinations
On June 11, 2004, the Registrant completed the acquisition of Franklin Financial Corporation (“Franklin”), a bank holding company, and its subsidiary, Franklin National Bank. Franklin operated nine full-service banking centers in the Nashville, Tennessee metropolitan market. The acquisition of Franklin allows the Registrant to expand its presence in the Nashville, Tennessee metropolitan market. The Registrant now operates 11 full-service banking centers in the greater Nashville area.
Under the terms of the transaction, each share of Franklin common stock was exchanged for .5933 shares of the Registrant’s common stock, resulting in the issuance of 5.1 million shares of common stock. The common stock issued to effect the transaction was valued at $55.52 per share for a total transaction value of $317 million. The total purchase price also includes the fair value of stock awards issued in exchange for stock awards held by Franklin employees, for which the aggregate fair value was $36 million.
The assets and liabilities of Franklin were recorded on the balance sheet at their respective fair values as of the closing date. The fair values are preliminary and are subject to refinement as information becomes available. The results of Franklin’s operations were included in the Registrant’s income statement from the date of acquisition. In addition, the Registrant realized charges against its earnings for acquisition related expenses of approximately $2 million for the three and six months ended June 30, 2004. The acquisition related expenses consisted primarily of marketing costs, travel and relocation costs, printing, supplies and other costs associated with conversion.
The transaction resulted in total intangible assets of $282 million based upon the purchase price, the fair values of the acquired assets and assumed liabilities and applicable purchase accounting adjustments. Of this total intangibles amount, $7 million was allocated to core deposit intangibles, $6 million was allocated to customer lists and $2 million was allocated to noncompete agreements. The core deposit intangible and the customer lists are being amortized using an accelerated method over seven and five years, respectively. The noncompete agreements are being amortized using the straight-line method over the duration of the agreements. The remaining $267 million of intangible assets was recorded as goodwill. Goodwill recognized in the Franklin acquisition is not deductible for income tax purposes.
The pro forma effect and the financial results of Franklin included in the results of operations subsequent to the date of the acquisitions were not material to the Registrant’s financial condition and operating results for the periods presented.
8. Discontinued Operations
In December 2003, the Registrant completed the sale of its corporate trust business, a component of the Commercial Banking segment. The discontinued operation had revenue and expenses of $3 million and $1 million, respectively, for the three months ended June 30, 2003 and revenue and expenses of $6 million and $3 million, respectively, for the six months ended June 30, 2003.
9. Related Party Transactions
At June 30, 2004 and 2003, certain directors, executive officers, principal holders of the Registrant’s common stock and associates of such persons were indebted, including undrawn commitments to lend, to the Registrant’s
48
banking subsidiaries in the aggregate amount, net of participations, of $318 million and $536 million, respectively. As of June 30, 2004 and 2003, the outstanding balance on loans to related parties, net of participations and undrawn commitments, was $83 million and $148 million, respectively.
Commitments to lend to related parties as of June 30, 2004, net of participations, were comprised of $306 million in loans and guarantees for various business and personal interests made to Registrant and subsidiary directors and $12 million to certain executive officers. This indebtedness was incurred in the ordinary course of business on substantially the same terms as those prevailing at the time of comparable transactions with unrelated parties.
None of the Registrant’s affiliates, officers, directors or employees has an interest in or receives any remuneration from any special purpose entities or qualified special purpose entities with which the Registrant transacts business.
10. Legal and Regulatory 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, prospects and related matters. The complaints, which have been consolidated, 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 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 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.
49
11. Retirement and Benefit Plans
The measurement date for all of the Registrant’s defined benefit retirement plans is December 31. As discussed in Note 2, the Registrant has adopted the expanded disclosure requirements of SFAS No. 132(R). The following summarizes the components of net periodic pension cost:
($ in thousands)
Service cost
Interest cost
Expected return on assets
Amortization and deferral of transition amount
Amortization of actuarial loss
Amortization of unrecognized prior service cost
Settlement
Net periodic pension cost
As previously disclosed in its Consolidated Financial Statements for the year ended December 31, 2003, the Registrant does not expect to contribute to its pension plan in 2004. Based on the current year actuarial assumptions, the Registrant did not make any cash contributions in the six months ended June 30, 2004 and does not anticipate making any cash contributions to the plan in 2004.
12. Stock-Based Compensation
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 and stock appreciation rights 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.
For the six months ended June 30, 2004, approximately .5 million restricted stock awards and 3.7 million stock appreciation rights were granted. For the six months ended June 30, 2003, approximately 6.2 million stock options were granted. The weighted average fair value of stock options and stock appreciation rights granted were $14.11 and $18.30 for the six months ended June 30, 2004 and June 30, 2003, respectively. The fair value of the stock options and stock appreciation rights are estimated on the date of grant using the Black-Scholes option pricing model with the following assumptions used for grants during the six months ended June 30, 2004 and 2003:
Expected dividend yield
Expected option life (in years)
Expected volatility
Risk-free interest rate
50
The adoption of the retroactive restatement method resulted in the restatement of previously reported balances of capital surplus, retained earnings and deferred taxes. As of June 30, 2003, previously reported capital surplus was increased by $589 million, retained earnings were decreased by $491 million and deferred tax assets were increased by $98 million. As of December 31, 2003, previously reported capital surplus was increased by $633 million, retained earnings were decreased by $529 million and deferred tax assets were increased by $104 million. In addition, in adopting the fair value method of expense recognition, the Registrant determined that in 2000 and 2001 certain outstanding stock options exchanged in immaterial business combinations were omitted from the determination of total purchase price and resulting goodwill. Adjustment for those items resulted in an additional increase in goodwill and capital surplus as of June 30, 2003 and December 31, 2003 of $38 million.
Stock-based compensation expense is included in salaries, wages and incentives expense in the Condensed Consolidated Statements of Income. The impact of the adoption of the retroactive restatement method for employee stock-based compensation on previously reported net income, basic and diluted earnings per share for the three months and six months ended June 30, 2003 is as follows:
$ in millions, (except per share data)
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:
13. Nonowner Changes in Equity
The Registrant has elected to present the disclosures required by SFAS No. 130, “Reporting Comprehensive Income,” in the Condensed Consolidated Statement of Changes in Shareholders’ Equity on page 31. The caption “Net Income and Nonowner Changes in Equity” represents total comprehensive income as defined in the Statement. Disclosure of the reclassification adjustments, related tax effects allocated to nonowner changes in equity and accumulated nonowner changes in equity for the six months ended June 30 are as follows:
51
Reclassification adjustment, pretax:
Change in unrealized net losses arising during period
Reclassification adjustment for net gains included in net income
Change in unrealized net losses on available-for-sale securities
Related tax effects:
Reclassification adjustment, net of tax:
Change in unrealized net losses on available-for-sale securities, net of tax benefit
Accumulated nonowner changes in equity:
Beginning balance -
Unrealized net (losses) gains on available-for-sale securities, net of tax benefit of$28 million and tax of $236 million, respectively
Ending balance -
Unrealized net (losses) gains on available-for-sale securities, net of tax benefit of$238 million and tax of $160 million, respectively
Unrealized net losses on qualifying cash flow hedges, net of tax benefit of $4 millionand $9 million, respectively
Change in unrealized net losses on qualifying cash flow hedges, net of tax benefit of$24 million and tax of $4 million, respectively
Unrealized net losses on qualifying cash flow hedges, net of tax benefit of $23million and $5 million, respectively
Minimum pension liability, net of tax benefit of $34 million and $28 million,respectively
Current period change
Unrealized net (losses) gains on available-for-sale securities
Unrealized net losses on qualifying cash flow hedges
Minimum pension liability
Accumulated nonowner changes in equity
52
14. Earnings Per Share
The reconciliation of earnings per share and earnings per diluted share follows:
(in thousands, except per share data)
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
Diluted EPS
Net income from continuing operationsavailable to common shareholders
Effect of dilutive securities:
Stock based awards
Dividends on convertible preferred stock
Income from continuing operations plusassumed conversions
Net income available to common shareholders plus assumed conversions
53
Options to purchase 15.7 million and 7.4 million shares outstanding during the three months ended June 30, 2004 and 2003, respectively, were not included in the computation of net income per diluted share because the exercise prices of these options were greater than the average market price of the common shares, and therefore, the effect would be antidilutive.
15. Subsequent Event
On August 2, 2004, the Registrant and First National Bankshares of Florida, Inc. (“First National”) announced the signing of a definitive agreement in which the Registrant will acquire First National and its subsidiaries, headquartered in Naples, Florida. Including First National’s pending acquisitions of First Bradenton Bank and Southern Community Bancorp, First National has approximately $5.3 billion in total assets, $3.9 billion in total deposits and 77 full-service banking centers located primarily in Orlando, Tampa, Sarasota, Naples and Fort Myers. Under terms of the agreement, which has been approved by both boards of directors, First National’s shareholders will receive .5065 shares of the Registrant’s common stock for each share of First National. Based on the price of the Registrant’s shares at the close of business on July 30, 2004, the transaction is valued at $25.00 per share of First National, for a total transaction value of approximately $1.58 billion, inclusive of pending acquisitions. Including pending acquisitions, First National is expected to have approximately 63 million diluted shares outstanding. The acquisition is expected to close in the first quarter of 2005 and is subject to normal regulatory approvals in addition to the approval of First National’s shareholders.
16. Business Segment Information
The Registrant’s principal activities include Commercial Banking, Retail Banking, Investment Advisors and Fifth Third Processing Solutions. Commercial Banking offers banking, cash management and financial services to business, government and professional customers. Retail Banking provides a full range of deposit products and consumer loans and leases. Investment Advisors provides a full range of investment alternatives for individuals, companies and not-for-profit organizations. Fifth Third Processing Solutions provides EFT services, merchant transaction processing, operates the Jeanie® ATM network and provides other data processing services to affiliated and unaffiliated customers. Other/Eliminations includes the investment portfolio, certain non-deposit funding, unassigned equity, the net effect of funds transfer pricing and other items not allocated to operating segments.
During the second quarter of 2004, the Registrant refined its segment reporting as a result of a cost center review and point of cross-sell identification. Prior periods have been restated to conform to current period presentation. The financial information for each operating segment is reported on the basis used internally by the Registrant’s management to evaluate performance and allocate resources. Revenues from affiliated transactions are generally charged at rates available to and transacted with unaffiliated customers.
The performance measurement of the operating segments is based on the management structure of the Registrant and is not necessarily comparable with similar information for any other financial institution. The information is also not necessarily indicative of the segment’s financial condition and results of operations if they were independent entities.
54
Results of operations and selected financial information by operating segment for the three and six months ended June 30, 2004 and 2003 are as follows:
Banking
Retail
Investment
Advisors
Other/
Eliminations
Three months ended June 30, 2004:
Net interest income (b)
Net interest income afterprovision for credit losses
Income before income taxes and cumulative effect
Applicable income taxes (c)
Selected Financial Information
Goodwill as of April 1, 2004
Goodwill recognized
Divestiture
Goodwill as of June 30, 2004
Average assets
Three months ended June 30, 2003:
Income from continuing operations before income taxes and minority interest
Minority interest, net
Income from discontinued operations
Goodwill as of April 1, 2003
Goodwill adjustment
Goodwill as of June 30, 2003
55
Six months ended June 30, 2004:
Net interest income after provision for credit losses
Goodwill as of January 1, 2004
Six months ended June 30, 2003:
Net income available to common
shareholders
Goodwill as of January 1, 2003
56
PART II. OTHER INFORMATION
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, which have been consolidated, 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.
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.
Period
(b) On March 27, 2003, the Registrant announced that its Board of Directors had authorized management to repurchase up to 20 million shares of the Registrant’s common stock through the open market or in any private transaction. The authorization was completed at the end of June. On June 15, 2004, the Registrant announced that its Board of Directors had authorized management to purchase up to an additional 40 million shares of the
57
Registrant’s common stock through the open market or any private transaction. The timing of the purchases and the exact number of shares to be purchased depends upon market conditions. The authorization does not include specific price targets or an expiration date.
(3)(i)
58
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: August 6, 2004
/s/ R. Mark Graf
R. Mark Graf
Senior Vice President and
Chief Financial Officer
59