UNITED STATESSECURITIES AND EXCHANGE COMMISSION
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934QUARTERLY PERIOD ENDED March 31, 2005
Commission File Number 0-2525
Huntington Bancshares Incorporated
41 South High Street, Columbus, Ohio 43287
Registrant’s telephone number (614) 480-8300
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 and (2) has been subject to such filing requirements for the past 90 days.
Yes þ No o
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).
There were 232,294,999 shares of Registrant’s without par value common stock outstanding on April 30, 2005.
INDEX
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Part 1. Financial Information
Item 1. Financial Statements
Condensed Consolidated Balance Sheets
See notes to unaudited condensed consolidated financial statements
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Condensed Consolidated Statements of Income(Unaudited)
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Condensed Consolidated Statements of Changes in Shareholders’ Equity
See notes to unaudited condensed consolidated financial statements.
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Condensed Consolidated Statements of Cash Flows(Unaudited)
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Notes to Unaudited Condensed Consolidated Financial Statements
Note 1 – Basis of Presentation
The accompanying unaudited condensed consolidated financial statements of Huntington Bancshares Incorporated (Huntington or the Company) reflect all adjustments consisting of normal recurring accruals, which are, in the opinion of Management, necessary for a fair presentation of the consolidated financial position, the results of operations, and cash flows for the periods presented. These unaudited condensed consolidated financial statements have been prepared according to the rules and regulations of the Securities and Exchange Commission (SEC or Commission) and, therefore, certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States (GAAP) have been omitted. The Notes to the Consolidated Financial Statements appearing in Huntington’s 2004 Annual Report on Form 10-K (2004 Form 10-K), which include descriptions of significant accounting policies, as updated by the information contained in this report, should be read in conjunction with these interim financial statements.
Certain amounts in the prior-year’s financial statements have been reclassified to conform to the 2005 presentation.
For statement of cash flows purposes, cash and cash equivalents are defined as the sum of “Cash and due from banks” and “Federal funds sold and securities purchased under resale agreements.”
Note 2 – New Accounting Pronouncements
Financial Accounting Standards Board (FASB) Statement No. 123 (revised 2004), Share-Based Payment(Statement 123R) – Statement 123R was issued in December 2004, requiring that the compensation cost relating to share-based payment transactions be recognized in the financial statements. That cost will be measured based on the fair value of the equity or liability instruments issued. Statement 123R covers a wide range of share-based compensation arrangements including share options, restricted share plans, performance-based awards, share appreciation rights, and employee share purchase plans. Statement 123R replaces FASB Statement No. 123, Accounting for Stock-Based Compensation (Statement 123), and supersedes Accounting Principles Board (APB) Opinion No. 25,Accounting for Stock Issued to Employees (APB 25). Statement 123, as originally issued in 1995, established as preferable a fair-value-based method of accounting for share-based payment transactions with employees. However, that Statement permitted entities the option of continuing to apply the guidance in APB 25, as long as the footnotes to financial statements disclosed pro forma net income under the preferable fair-value-based method. In its 2004 Form 10-K, Huntington disclosed adopting Statement 123R effective January 1, 2005. Subsequently however, new guidance was issued by the SEC that provides the option to postpone adoption of Statement 123R until the first annual reporting period that begins after June 15, 2005. As such, Huntington has postponed the adoption of Statement 123R until January 1, 2006. (The impact of adopting Statement 123R is described in Note 9.)
Staff Accounting Bulletin No. 107, Share Based Payments (SAB 107) – On March 29, 2005, the SEC issued SAB 107 to provide public companies additional guidance in applying the provisions of Statement 123R. Among other things, SAB 107 describes the SEC staff’s expectations in determining the assumptions that underlie the fair value estimates and discusses the interaction of Statement 123R with certain existing SEC guidance. Huntington will adopt the provisions of SAB 107 in conjunction with the adoption of FAS 123R beginning January 1, 2006. (see Note 9.)
FASB Interpretation No. 47, Accounting for Conditional Asset Retirement Obligations (FIN 47) – In March 2005, the FASB issued FIN 47, which clarifies that the term “conditional asset retirement obligation” as used in FASB Statement No. 143, Accounting for Asset Retirement Obligations, refers to a legal obligation to perform an asset retirement activity in which the timing and (or) method of settlement are conditional on a future event that may or may not be within the control of the entity. An entity is required to recognize a liability for the fair value of a conditional asset retirement obligation if the fair value of the liability can be reasonably estimated. FIN 47 becomes effective for fiscal years ending after December 15, 2005. Huntington is currently evaluating the impact of adopting FIN 47.
Note 3 – Securities and Exchange Commission Formal Investigation
On June 26, 2003, Huntington announced that the Securities and Exchange Commission staff was conducting a formal investigation into certain financial accounting matters relating to fiscal years 2002 and earlier and certain related disclosure matters. On August 9, 2004, Huntington announced the Company was in negotiations with the staff of the SEC regarding a settlement of the formal investigation and disclosed that it expected that a settlement of this matter, which is
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subject to approval by the SEC, would involve the entry of an order requiring, among other possible matters, Huntington to comply with various provisions of the Securities Exchange Act of 1934 and the Securities Act of 1933, along with the imposition of a civil money penalty.
On April 25, 2005, Huntington announced that it has proposed a settlement to the staff of the Securities and Exchange Commission regarding the resolution of its previously announced formal investigation into certain financial accounting matters relating to fiscal years 2002 and earlier and certain related disclosure matters, and that the staff has agreed to recommend the proposed settlement offer to the Commission. The proposed settlement, which is subject to approval by the Commission, is expected to involve the entry of an order requiring Huntington; its chief executive officer, Thomas E. Hoaglin; its former vice chairman and chief financial officer, Michael J. McMennamin; and its former controller, John Van Fleet, to comply with various provisions of the Securities Exchange Act of 1934 and the Securities Act of 1933. The proposed settlement would call for the payment of a $7.5 million civil money penalty by the company, which, if approved, would be distributed pursuant to the Fair Fund provisions of Section 308(a) of the Sarbanes-Oxley Act of 2002. This civil money penalty would have no current period financial impact on Huntington’s results, as reserves for this amount were established and expensed prior to December 31, 2004. The proposed settlement would also require the disgorgement of $360,000 by Hoaglin in respect of his previously paid 2002 annual bonus, and disgorgement of previously paid bonuses and prejudgment interest for McMennamin and Van Fleet of $265,215 and $26,660, respectively. In addition, Hoaglin, McMennamin, and Van Fleet would pay civil money penalties of $50,000; $75,000; and $25,000; respectively. The proposed settlement would also impose certain other relief with respect to McMennamin and Van Fleet.
No assurances can be made as to final timing or outcome.
Note 4 – Formal Regulatory Supervisory Agreements
On March 1, 2005, Huntington announced that it had entered into formal written agreements with its banking regulators, the Federal Reserve Bank of Cleveland (FRBC) and the Office of the Comptroller of the Currency (OCC), providing for a comprehensive action plan designed to enhance its corporate governance, internal audit, risk management, accounting policies and procedures, and financial and regulatory reporting. The agreements call for independent third-party reviews, as well as the submission of written plans and progress reports by Management and remain in effect until terminated by the banking regulators.
Management has been working with its banking regulators over the past several months and has been taking actions and devoting significant resources to address all of the issues raised. Management believes that the changes it has already made, and is in the process of making, will address these issues fully and comprehensively. No assurances, however, can be provided as to the ultimate timing or outcome of these matters.
Note 5 – Pending Acquisition
On January 27, 2004, Huntington announced the signing of a definitive agreement to acquire Unizan Financial Corp. (Unizan), a financial holding company based in Canton, Ohio. On November 3, 2004, Huntington announced that it was negotiating a one-year extension of its pending merger agreement with Unizan. It was also announced that Huntington was withdrawing its current application with the FRBC to acquire Unizan and intends to resubmit the application for regulatory approval of the merger once Huntington has successfully resolved the pending SEC and banking regulatory concerns. On November 11, 2004, Huntington and Unizan jointly announced they had entered into an amendment to their January 26, 2004 merger agreement. The amendment extends the term of the agreement for one year from January 27, 2005 to January 27, 2006.
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Note 6 — Investment Securities
Listed below are the contractual maturities (under 1 year, 1-5 years, 6-10 years, and over 10 years) of investment securities at March 31, 2005, December 31, 2004, and March 31, 2004:
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Based upon its assessment, Management does not believe any individual unrealized loss at March 31, 2005, represents an other-than-temporary impairment. In addition, Huntington has both the intent and ability to hold these securities for a time necessary to recover the amortized cost. There were no temporary impairments of any securities recognized in either of the three-month periods ended March 31, 2005 and 2004.
Note 7 – Other Comprehensive Income
The components of Huntington’s Other Comprehensive Income in the three months ended March 31 were as follows:
Activity in Accumulated Other Comprehensive Income for the three months ended March 31, 2005 and 2004 was as follows:
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Note 8 – Earnings per Share
Basic earnings per share is the amount of earnings for the period available to each share of common stock outstanding during the reporting period. Diluted earnings per share is the amount of earnings available to each share of common stock outstanding during the reporting period adjusted for the potential issuance of common shares upon the exercise of stock options. The calculation of basic and diluted earnings per share for each of the three months ended March 31 is as follows:
The average market price of Huntington’s common stock for the period was used in determining the dilutive effect of outstanding stock options. Common stock equivalents are computed based on the number of shares subject to stock options that have an exercise price less than the average market price of Huntington’s common stock for the period.
Options on approximately 2.6 million and 2.8 million shares were outstanding at March 31, 2005 and 2004, respectively, but were not included in the computation of diluted earnings per share because the effect would be antidilutive. The weighted average exercise price for these options was $26.96 per share and $26.74 per share at the end of the same respective periods.
On January 7, 2005, Huntington released from escrow 86,118 shares of Huntington common stock to former shareholders of LeaseNet, Inc., which were previously issued in September 2002. A total of 373,896 common shares, previously held in escrow, was returned to Huntington. All shares in escrow had been accounted for as treasury stock.
Note 9 – Stock-Based Compensation
Huntington’s stock-based compensation plans are accounted for based on the intrinsic value method promulgated by APB Opinion 25, Accounting for Stock Issued to Employees, and related interpretations. Compensation expense for employee stock options is generally not recognized if the exercise price of the option equals or exceeds the fair value of the stock on the date of grant.
The following pro forma disclosures for net income and earnings per diluted common share is presented as if Huntington had applied the fair value method of accounting of Statement No. 123 in measuring compensation costs for stock options. The fair values of the stock options granted were estimated using the Black-Scholes option-pricing model. This model assumes that the estimated fair value of the options is amortized over the options’ vesting periods and the compensation costs would be included in personnel expense on the income statement. The following table also includes the weighted-average assumptions that were used in the option-pricing model for options granted in each of the quarters presented:
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Note 10 – Benefit Plans
Huntington sponsors the Huntington Bancshares Retirement Plan (the Plan), a non-contributory defined benefit pension plan covering substantially all employees. The Plan provides benefits based upon length of service and compensation levels. The funding policy of Huntington is to contribute an annual amount that is at least equal to the minimum funding requirements but not more than that deductible under the Internal Revenue Code. In addition, Huntington has an unfunded, defined benefit post-retirement plan (Post-Retirement Benefit Plan) that provides certain healthcare and life insurance benefits to retired employees who have attained the age of 55 and have at least 10 years of vesting service under this plan. For any employee retiring on or after January 1, 1993, post-retirement healthcare benefits are based upon the employee’s number of months of service and are limited to the actual cost of coverage. Life insurance benefits are a percentage of the employee’s base salary at the time of retirement, with a maximum of $50,000 of coverage.
The following table shows the components of net periodic benefit expense:
There is no expected minimum contribution for 2005 to the Plan. Although not required, Huntington made a contribution to the Plan of $63.7 million in April 2005. Expected contributions for 2005 for the Post-Retirement Benefit Plan are $4.0 million.
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Huntington also sponsors other retirement plans, the most significant being the Supplemental Executive Retirement Plan and the Supplemental Retirement Income Plan. These plans are nonqualified plans that provide certain former officers and directors of Huntington and its subsidiaries with defined pension benefits in excess of limits imposed by federal tax law.
Huntington has a defined contribution plan that is available to eligible employees. Matching contributions by Huntington equal 100% on the first 3%, then 50% on the next 2%, of participant elective deferrals. The cost of providing this plan was $2.5 million and $2.4 million for the three months ended March 31, 2005 and 2004, respectively.
Note 11 – Commitments and Contingent Liabilities
Commitments to extend credit:
In the ordinary course of business, Huntington makes various commitments to extend credit that are not reflected in the financial statements. The contract amount of these financial agreements at March 31, 2005, December 31, 2004, and March 31, 2004, were as follows:
Commitments to extend credit generally have fixed expiration dates, are variable-rate, and contain clauses that permit Huntington to terminate or otherwise renegotiate the contracts in the event of a significant deterioration in the customer’s credit quality. These arrangements normally require the payment of a fee by the customer, the pricing of which is based on prevailing market conditions, credit quality, probability of funding, and other relevant factors. Since many of these commitments are expected to expire without being drawn upon, the contract amounts are not necessarily indicative of future cash requirements. The interest rate risk arising from these financial instruments is insignificant as a result of their predominantly short-term, variable-rate nature.
Standby letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party. These guarantees are primarily issued to support public and private borrowing arrangements, including commercial paper, bond financing, and similar transactions. Most of these arrangements mature within two years. The carrying amount of deferred revenue associated with these guarantees was $3.6 million, $4.1 million, and $3.4 million at March 31, 2005, December 31, 2004, and March 31, 2004, respectively.
Commercial letters of credit represent short-term, self-liquidating instruments that facilitate customer trade transactions and generally have maturities of no longer than 90 days. The merchandise or cargo being traded normally secures these instruments.
Commitments to sell loans:
Huntington entered into forward contracts, relating to its mortgage banking business. At March 31, 2005, December 31, 2004, and March 31, 2004, Huntington had commitments to sell residential real estate loans of $388.5 million, $311.3 million, and $414.5 million, respectively. These contracts mature in less than one year.
Litigation:
In the ordinary course of business, there are various legal proceedings pending against Huntington and its subsidiaries. In the opinion of Management, the aggregate liabilities, if any, arising from such proceedings are not expected to have a material adverse effect on Huntington’s consolidated financial position. (see Note 3.)
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Note 12 – Stock Repurchase Plan
Effective April 27, 2004, the board of directors authorized a new share repurchase program (the 2004 Repurchase Program) which cancelled the 2003 Repurchase Program and authorized Management to repurchase not more than 7,500,000 shares of Huntington common stock. As of March 31, 2005, there have been no share repurchases made under the 2004 Repurchase Program. On April 25, 2005, Huntington announced that it intends to reactivate its share repurchase program upon approval by the Commission of the proposed settlement offer to resolve the SEC formal investigation. It expects to repurchase these shares from time-to-time in the open market or through privately negotiated transactions depending on market conditions.
Note 13 – Segment Reporting
Huntington has three distinct lines of business: Regional Banking, Dealer Sales, and the Private Financial Group (PFG). A fourth segment includes the Company’s Treasury function and other unallocated assets, liabilities, revenue, and expense. Lines of business results are determined based upon the Company’s management reporting system, which assigns balance sheet and income statement items to each of the business segments. The process is designed around Huntington’s organizational and management structure and, accordingly, the results below are not necessarily comparable with similar information published by other financial institutions. An overview of this system is provided below, along with a description of each segment and discussion of financial results.
The following provides a brief description of the four operating segments of Huntington:
Regional Banking: This segment provides products and services to consumer, small business, and commercial customers. These products and services are offered in seven operating regions within the five states of Ohio, Michigan, West Virginia, Indiana, and Kentucky through the Company’s banking network of 335 branches, over 700 ATMs, plus Internet and telephone banking channels. Each region is further divided into Retail and Commercial Banking units. Retail products and services include home equity loans and lines of credit, first mortgage loans, direct installment loans, small business loans, personal and business deposit products, as well as sales of investment and insurance services. Retail products and services comprise 61% and 78%, of total regional banking loans and deposits, respectively. Commercial Banking serves middle market and large commercial banking relationships, which use a variety of banking products and services including, but not limited to, commercial loans, international trade, cash management, leasing, interest rate protection products, capital market alternatives, 401(k) plans, and mezzanine investment capabilities.
Dealer Sales: This segment serves more than 3,500 automotive dealerships within Huntington’s primary banking markets, as well as in Arizona, Florida, Georgia, Pennsylvania, and Tennessee. The segment finances the purchase of automobiles by customers of the automotive dealerships, purchases automobiles from dealers and simultaneously leases the automobiles to consumers under long-term operating or direct finance leases, finances the dealership’s floor plan inventories, real estate, or working capital needs, and provides other banking services to the automotive dealerships and their owners.
Private Financial Group: This segment provides products and services designed to meet the needs of the Company’s higher net worth customers. Revenue is derived through trust, asset management, investment advisory, brokerage, insurance, and private banking products and services.
Treasury / Other: This segment includes revenue and expense related to assets, liabilities, and equity that are not directly assigned or allocated to one of the other three business segments. Assets included in this segment include investment securities, bank owned life insurance, and mezzanine loans originated through Huntington Capital Markets.
Use of Operating Earnings to Measure Segment Performance
Management uses earnings on an operating basis, rather than on a GAAP basis, to measure underlying performance trends for each business segment and to determine the success of strategies and future earnings capabilities. Operating earnings represent GAAP earnings adjusted to exclude the impact of the significant items listed in the reconciliation table below. For the three months ending March 31, 2005, operating earnings were the same as reported GAAP earnings.
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Listed below is certain operating basis financial information reconciled to Huntington’s first quarter 2005 and 2004 reported results by line of business.
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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
INTRODUCTION
Huntington Bancshares Incorporated (Huntington or the Company) is a multi-state diversified financial holding company organized under Maryland law in 1966 and headquartered in Columbus, Ohio. Through its subsidiaries, Huntington is engaged in providing full-service commercial and consumer banking services, mortgage banking services, automobile financing, equipment leasing, investment management, trust services, and discount brokerage services, as well as reinsuring credit life and disability insurance, and selling other insurance and financial products and services. Huntington’s banking offices are located in Ohio, Michigan, West Virginia, Indiana, and Kentucky. Selected financial services are also conducted in other states including Arizona, Florida, Georgia, Maryland, Nevada, New Jersey, Pennsylvania, and Tennessee. Huntington has a foreign office in the Cayman Islands and a foreign office in Hong Kong. The Huntington National Bank (the Bank), organized in 1866, is Huntington’s only bank subsidiary.
The following discussion and analysis provides investors and others with information that Management believes to be necessary for an understanding of Huntington’s financial condition, changes in financial condition, results of operations, and cash flows, and should be read in conjunction with the financial statements, notes, and other information contained in this report.
Forward-Looking Statements
This report, including Management’s Discussion and Analysis of Financial Condition and Results of Operations, contains forward-looking statements about Huntington. These include descriptions of products or services, plans or objectives of Management for future operations, including pending acquisitions, and forecasts of revenues, earnings, cash flows, or other measures of economic performance. Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts.
By their nature, forward-looking statements are subject to numerous assumptions, risks, and uncertainties. A number of factors could cause actual conditions, events, or results to differ significantly from those described in the forward-looking statements. These factors include, but are not limited to, those set forth below and under the heading “Business Risks” included in Item 1 of Huntington’s Annual Report on Form 10-K for the year ended December 31, 2004 (2004 Form 10-K), and other factors described in this report and from time-to-time in other filings with the Securities and Exchange Commission.
Management encourages readers of this report to understand forward-looking statements to be strategic objectives rather than absolute forecasts of future performance. Forward-looking statements speak only as of the date they are made. Huntington assumes no obligation to update forward-looking statements to reflect circumstances or events that occur after the date the forward-looking statements were made or to reflect the occurrence of unanticipated events.
Risk Factors
Huntington, like other financial companies, is subject to a number of risks, many of which are outside of Management’s control. Management strives to mitigate those risks while optimizing returns. Among the risks assumed are: (1) credit risk, which is the risk that loan and lease customers or other counter parties will be unable to perform their contractual obligations, (2) market risk, which is the risk that changes in market rates and prices will adversely affect Huntington’s financial condition or results of operations, (3) liquidity risk, which is the risk that Huntington and / or the Bank will have insufficient cash or access to cash to meet operating needs, and (4) operational risk, which is the risk of loss resulting from inadequate or failed internal processes, people, or systems, or external events. The description of Huntington’s business contained in Item 1 of its 2004 Form 10-K, while not all inclusive, discusses a number of business risks that, in addition to the other information in this report, readers should carefully consider.
SEC Formal Investigation
On June 26, 2003, Huntington announced that the Securities and Exchange Commission (SEC or Commission) staff was conducting a formal investigation into certain financial accounting matters relating to fiscal years 2002 and earlier and certain related disclosure matters. On August 9, 2004, Huntington announced the Company was in negotiations with the staff of the SEC regarding a settlement of the formal investigation and disclosed that it expected that a settlement of this matter, which is subject to approval by the SEC, would involve the entry of an order requiring, among other possible
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matters, Huntington to comply with various provisions of the Securities Exchange Act of 1934 and the Securities Act of 1933, along with the imposition of a civil money penalty.
Formal Regulatory Supervisory Agreements
Management has been working with its banking regulators over the past several months and has been taking actions and devoting significant resources to address all of the issues raised. Management believes that the changes that it has already made, and is in the process of making, will address these issues fully and comprehensively.
As announced November 12, 2004, Huntington and Unizan Financial Corp. (Unizan) have entered into an amendment to their January 26, 2004 merger agreement extending the term of the agreement for one year from January 27, 2005 to January 27, 2006, and Huntington has withdrawn its application with the Federal Reserve to acquire Unizan. On March 1, 2005, Huntington announced that it intends to resubmit the application for regulatory approval of the merger once the regulatory written agreements have been terminated. No assurance, however, can be provided as to the ultimate timing or outcome of these matters.
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SUMMARY DISCUSSION OF RESULTS
Huntington’s 2005 first quarter earnings were $96.5 million, or $0.41 per common share, down 7% from $104.2 million, and down 9% from $0.45 per common share in the year-ago quarter. Compared with 2004 fourth quarter net income of $91.1 million and $0.39 per common share, 2005 first quarter earnings and earnings per share were up 6% and 5%, respectively.
The return on average assets (ROA) and return on average equity (ROE) were 1.20% and 15.5%, respectively, in the current quarter, down from 1.36% and 18.4%, respectively, in the year-ago quarter, but up from 1.13% and 14.6%, respectively, in the 2004 fourth quarter. (see Table 1.)
Management’s Summary Review of 2005 First Quarter Performance versus 2004 First and Fourth Quarters
First quarter earnings per share performance of $0.41 was slightly below Management’s expectations. Management was pleased with loan and deposit growth, and a stable net interest margin and expense levels, but was disappointed with the weakness in fee revenue and one significant commercial loan net charge-off.
Loan growth grew strongly across all regions and loan categories. Deposits increased and the Company added new customers. Average total loans and leases were 11% higher than in the year-ago quarter. Compared with the 2004 fourth quarter, average total loans grew at a 14% annualized rate, reflecting 15% and 14% annualized growth in average total consumer and total commercial loans, respectively.
Average core deposits were 10% higher than a year ago. Compared with the fourth quarter, average core deposits increased at a 3% annualized growth rate. A slow down in first quarter core deposit growth is typical due to seasonal factors. However, this year’s 3% linked quarter annualized increase compared very favorably to the 2% annualized decrease in the year-earlier quarter. Importantly, the number of the Company’s consumer demand deposit households and small business demand deposit relationships both continued their positive growth trends and were 3% and 9% higher than a year ago, respectively.
Management was pleased with the relative stability of the net interest margin, as it declined only one basis point to 3.31% from the fourth quarter’s 3.38% level after taking into account a 6 basis point one-time positive impact to the fourth quarter net interest margin from a funding adjustment. The Company expects the net interest margin to improve slightly over the rest of the year from the current quarter’s level. This margin improvement, along with anticipated loan growth, is expected to be key drivers of higher revenue in coming quarters.
Certain fee income categories declined from the prior period more than anticipated. In particular, other income declined, reflecting soft equity markets which resulted in lower equity investment gains in the current quarter compared with gains in the fourth quarter. In addition, both commercial and personal service charge income declined consistent with recent industry trends.
Management was also pleased with overall credit quality performance, although annualized net charge-offs at 0.47% was higher than the 0.36% level in the 2004 fourth quarter, reflecting the negative impact from a single middle market commercial credit charge-off. Non-performing assets (NPAs) declined, as expected, and were only $73.3 million, or 0.30% of total loans and leases and other real estate at quarter-end, down from 0.46% at year end, and were the lowest level in many years. Improvement in the economic outlook and a reduction in specific reserves due to charge-offs resulted in a decline in the loan loss reserve ratio to 1.09% from 1.15% at year-end. In spite of this decline in the loan loss reserve ratio, the allowance strengthened in relation to the level of non-performing loans (NPL) as the NPL coverage ratio increased to 441%, up from 424% at the end of the fourth quarter, and remains among the highest in the Company’s peer group.
The capital position continued to strengthen. At March 31, 2005, the tangible common equity to risk-weighted assets ratio was 7.83%, down from 7.86% at year-end.
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Table 1 — Selected Quarterly Income Statement Data
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Significant Factors Influencing Financial Performance Comparisons
Earnings comparisons from the beginning of 2004 through the first three months of 2005 were impacted by a number of factors, some related to changes in the economic and competitive environment, while others reflected specific Management strategies or changes in accounting practices. Those key factors are summarized below.
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Significant 2005 first quarter performance highlights included:
The following table quantifies the earnings impact of the significant factors noted in #3-11 above on the specified periods.
Table 2 — Significant Items Influencing Earnings Performance Comparisons
RESULTS OF OPERATIONS
Net Interest Income
(This section should be read in conjunction with Significant Factors 1-4 and 10.)
2005 First Quarter versus 2004 First Quarter
Fully taxable equivalent net interest income increased $12.4 million, or 5%, from the year-ago quarter, reflecting the favorable impact of an 8% increase in average earning assets, partially offset by a 5 basis point, or an effective 1%, decline in the net interest margin. The fully taxable equivalent net interest margin decreased to 3.31% from 3.36% in the year-ago quarter. The decline from the year-ago quarter reflected the impact of the strategic repositioning of portfolios to reduce automobile loans and increase the relative proportion of lower-rate, lower-risk, residential real estate-related loans.
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The net interest margin was also adversely impacted by higher-than-normal levels of short-term assets. These assets averaged $0.3 billion for the quarter and reduced net interest income by $0.4 million and reduced the net interest margin by 5 basis points. The excess short-term assets resulted from a decision made in the fourth quarter of 2004 to fund maturities of long-term debt in the first quarter of 2005, by issuing negotiable certificates of deposit and medium-term bank notes. Short-term assets at March 31, 2005, represents a level that Management expects for the remainder of 2005.
Average total loans and leases increased $2.4 billion, or 11%, from the 2004 first quarter due primarily to a $1.5 billion, or 13%, increase in average consumer loans. Contributing to the consumer loan growth were a $1.2 billion, or 47%, increase in average residential mortgages and a $0.8 billion, or 20%, increase in average home equity loans.
Average total automobile loans declined $1.0 billion, or 34%, from the year-ago quarter reflecting the sale of $1.5 billion of automobile loans over this 12-month period as part of a strategy of reducing automobile loan and lease exposure as a percent of total credit exposure. Partially offsetting the decline in automobile loans was growth in direct financing leases due to the migration from operating lease assets, which have not been originated since April 2002. Average direct financing leases increased $0.5 billion, or 24%, from the year-ago quarter.
Average total commercial loans were $10.4 billion, up $0.9 billion, or 9%, from the year-ago quarter. This increase reflected a $0.4 billion, or 12%, increase in middle market real estate loans and a $0.3 billion, or 6%, increase in middle market commercial and industrial loans. Average small business loans, which include both commercial and industrial and commercial real estate loans, increased $0.2 billion, or 11%, reflecting continued success in meeting the needs of this targeted segment.
Average total core deposits in the first quarter were $17.0 billion, up $1.6 billion, or 10%, from the year-ago quarter, reflecting a $1.3 billion, or 20%, increase in average interest bearing demand deposit accounts, and a $0.3 billion, or 10%, increase in non-interest bearing deposits.
Tables 3 and 4 reflect quarterly average balance sheets and rates earned and paid on interest-earning assets and interest-bearing liabilities:
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Table 3 — Condensed Consolidated Quarterly Average Balance Sheets
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Table 4 — Consolidated Quarterly Net Interest Margin Analysis
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2005 First Quarter versus 2004 Fourth Quarter
Compared with the 2004 fourth quarter, fully taxable equivalent net interest income decreased $3.9 million, or 2%, reflecting a 7 basis point decrease in the net interest margin to 3.31% from 3.38% in the 2004 fourth quarter, partially offset by the favorable impact of a 2% increase in average earning assets. As previously disclosed, the 2004 fourth quarter net interest margin reflected a favorable 6 basis point impact from a $3.7 million funding cost adjustment.
Compared with the 2004 fourth quarter, average total loans and leases in the 2005 first quarter increased $0.8 billion, or 4%. Average total consumer loans accounted for slightly more than half of this increase as they increased $0.5 billion, or 4%, reflecting a $0.2 billion, or 6%, increase in residential mortgages and a $0.1 billion, or 2%, increase in average home equity loans. These sequential quarterly growth rates for both residential mortgages and home equity loans have generally trended lower over the last four quarters due to interest rates trending upward. In addition, average automobile loans and leases increased $0.2 billion, or 4%, due to growth in automobile loans and, to a slightly lesser degree, growth in direct financing leases. Automobile loan production increased 20% from the 2004 fourth quarter, which had been the lowest production quarter in recent history, but was 25% below the year-ago quarter production. The lower overall automobile loan production reflected continued aggressive competition in this sector. Average total commercial loans increased $0.4 billion, or 3%, led by a $0.2 billion, or 5%, increase in middle market commercial and industrial loans, reflecting the continued growth in attracting targeted commercial clients, as well as higher utilization rates. Average middle market real estate loans increased 3%, while small business loans increased 2%.
Reflecting typical seasonal factors, average total core deposits increased $0.1 billion, or 1%, from the fourth quarter with interest bearing demand deposits increasing $0.3 billion, or 3%, and non-interest bearing deposits decreasing $0.1 billion, or 3%. This linked quarter performance was better than in the comparable 2004 first quarter period when average total core deposits declined slightly.
Provision for Credit Losses
(This section should be read in conjunction with Significant Factor 5 and the Credit Risk section.)
The provision for credit losses combines the provision for loan and lease losses with the provision for losses on unfunded loan commitments. The provision for loan and lease losses is the expense necessary to maintain the ALLL at a level adequate to absorb Management’s estimate of probable credit losses in the loan and lease portfolio. The provision for losses on unfunded loan commitments is the expense necessary to maintain the AULC at a level adequate to absorb Management’s estimate of probable credit losses in the portfolio of unfunded loan commitments.
The provision for credit losses for the 2005 first quarter totaled $19.9 million, down $5.7 million, or 22%, from the year-ago quarter, but up $7.2 million from the 2004 fourth quarter. The decline from the year-ago quarter primarily reflected improved overall credit quality as reflected in the reduction in the relative level of each component of the ALLL. The increase from the 2004 fourth quarter primarily reflected the impact of a middle market commercial and industrial charge-off in excess of allocated reserves.
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Non-Interest Income
(This section should be read in conjunction with Significant Factor 1, 3, and 4.)
Table 5 reflects non-interest income detail for each of the past five quarters.
Table 5 — Non-Interest Income
N.M., not a meaningful value.
Non-interest income decreased $59.6 million, or 26%, from the year-ago quarter. Reflecting the run-off of the operating lease portfolio, operating lease income declined $42.1 million, or 47%, from the 2004 first quarter. Excluding operating lease income, non-interest income decreased $17.5 million, or 13%, from the year-ago quarter with the primary drivers being:
Partially offset by:
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Compared with the 2004 fourth quarter, non-interest income declined $14.9 million, or 8%. Reflecting the run-off of the operating lease portfolio, operating lease income declined $8.4 million, or 15%, from the 2004 fourth quarter. Excluding operating lease income, non-interest income decreased $6.5 million, or 5%, from the 2004 fourth quarter with the primary drivers being:
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Non-Interest Expense
(This section should be read in conjunction with Significant Factor 1 and 6-9.)
Table 6 reflects non-interest expense detail for each of the last five quarters.
Table 6 — Non-Interest Expense
Non-interest expense decreased $27.4 million, or 10%, from the year-ago quarter. Reflecting the run-off of the operating lease portfolios, operating lease expense declined $32.8 million, or 46%, from the 2004 first quarter. Excluding operating lease expense, non-interest expense increased $5.4 million, or 3%, from the year-ago quarter reflecting:
Compared with the 2004 fourth quarter, non-interest expense decreased $22.7 million, or 8%. Reflecting the run-off of the operating lease portfolios, operating lease expense declined $10.4 million, or 21%, from the 2004 fourth quarter. Excluding operating lease expense, non-interest expense decreased $12.4 million, or 5%, from the prior quarter reflecting:
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Operating Lease Assets
(This section should be read in conjunction with Significant Factor 1 and Lease Residual Risk section.)
Table 7 reflects operating lease assets performance detail for each of the last five quarters.
Table 7 — Operating Lease Performance
Average operating lease assets in the 2005 first quarter were $0.5 billion, down $0.6 billion, or 55%, from the year-ago quarter and 18% from the 2004 fourth quarter. (For a discussion of operating lease accounting, residual value loss determination, and related residual value insurance, see the Operating Lease Assets section of the Company’s 2004 Form 10-K.)
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Provision for Income Taxes
The provision for income taxes in the first quarter of 2005 was $28.6 million and represented an effective tax rate on income before taxes of 22.8%. The provision for income taxes decreased $6.4 million from the year-ago quarter, primarily due to a reduction in pre-tax earnings, as well as, the recognition of the effect of federal tax refunds on income tax expense. These federal tax refunds resulted from the ability to carry back federal tax losses to prior-years. The effective tax rates in the year-ago quarter and fourth quarter of 2004 were 25.1% and 29.0%, respectively.
Pursuant to APB 28, taxes for the full year are estimated and year-to-date accrual adjustments are made. Revisions to the full-year estimate of accrued taxes occur periodically due to changes in the tax rates, audit resolution with taxing authorities, and newly enacted statutory, judicial, and regulatory guidance. These changes, when they occur, affect accrued taxes and can result in fluctuations in the quarterly effective tax rate. Management reviews the appropriate tax treatment of all transactions taking into consideration statutory, judicial, and regulatory guidance in the context of Huntington’s tax positions. In addition, Management relies on various tax opinions, recent tax audits, and historical experience.
In accordance with FAS 109, Accounting for Income Taxes, no deferred income taxes are to be recorded when a company intends to reinvest permanently the earnings from a foreign activity. As of March 31, 2005, the Company intended to reinvest permanently the earnings from its foreign asset securitization activities of approximately $98.0 million. In accordance with FASB Staff Position No. 109-2, Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Act of 2004, at March 31, 2005, the range of possible amounts that Huntington is considering for repatriation in 2005 is between zero and $98.0 million. The related potential range of income tax is between zero and $5.1 million.
During the first quarter of 2005, the Internal Revenue Service commenced the audit of Huntington’s consolidated federal income tax returns for tax years 2002 and 2003.
In the ordinary course of business, the Company operates in various taxing jurisdictions and is subject to income tax. The effective tax rate is based in part on Management’s interpretation of the relevant current laws. Management believes the aggregate liabilities related to taxes are appropriately reflected in the consolidated financial statements.
The 2005 first quarter effective tax rate included the after-tax positive impact on net income due to the federal tax loss carry back, tax-exempt income, bank owned life insurance, asset securitization activities, and general business credits from investment in low income housing and historic property partnerships. The lower effective tax rate is expected to impact each quarter in 2005. In 2006, the effective tax rate is anticipated to increase to a more typical rate, slightly below 30%.
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CREDIT RISK
Credit risk is the risk of loss due to adverse changes in a borrower’s ability to meet its financial obligations under agreed upon terms. The Company is subject to credit risk in lending, trading, and investment activities. The nature and degree of credit risk is a function of the types of transactions, the structure of those transactions, and the parties involved. The majority of the Company’s credit risk is associated with lending activities, as the acceptance and management of credit risk is central to profitable lending. Credit risk is incidental to trading activities and represents a limited portion of the total risks associated with the investment portfolio. Credit risk is mitigated through a combination of credit policies and processes and portfolio diversification. These include origination/underwriting criteria, portfolio monitoring processes, and effective problem asset management (see Credit Risk Management section of the Company’s 2004 Form 10-K for additional discussion).
Credit Exposure Composition
Compared with the year-ago period, the composition of the loan and lease portfolio at March 31, 2005, had changed such that lower credit risk home equity loans and residential mortgages represented 19% and 16%, respectively, of total credit exposure, up from 18% and 12%, respectively, a year earlier. Conversely, higher risk automobile exposure, which consists of automobile loans and leases, as well as operating lease assets, declined from 24% to 20% at March 31, 2005.
At the beginning of the 2004 second quarter, the criteria for categorizing commercial loans as either C&I loans or CRE loans were clarified. The new criteria are based on the purpose of the loan. Previously, the categorization was based on the nature of the collateral securing, or partially securing, the loan. Under this new methodology, as new loans are originated or existing loans renewed, loans secured by owner-occupied real estate are categorized as C&I loans (previously CRE loans) and unsecured loans for the purpose of developing real estate are categorized as CRE loans (previously C&I loans). As a result of this change, $282 million in C&I loans were reclassified to CRE loans effective June 30, 2004. Prior periods were not reclassified. In addition, this change had no impact on the underlying credit quality of total commercial loans. Other than this one-time impact, the on-going use of this new methodology has not had a material impact on reported C&I and/or CRE loan growth rates.
Table 8 reflects period-end loan and lease portfolio mix by type of loan or lease, as well as by business segment:
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Table 8 — Credit Exposure Composition
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Non-Performing Assets and Past Due Loans and Leases
(This section should be read in conjunction with Significant Factor 5.)
Table 9 reflects period-end NPAs and past due loans and leases detail for each of the last five quarters:
Table 9 — Non-Performing Assets and Past Due Loans and Leases
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NPAs were $73.3 million at March 31, 2005, and represented only 0.30% of related assets, down $18.4 million from $91.7 million, or 0.43%, at the end of the year-ago quarter and down $35.3 million from $108.6 million, or 0.46%, at December 31, 2004. The decrease from the prior quarter reflected the expected first quarter sale of $35.7 million of other real estate owned (OREO) properties related to the previously disclosed workout of a troubled mezzanine financing relationship. Residential real estate NPAs, which historically have demonstrated less potential for subsequent losses, comprised 41% of total NPAs.
Non-performing loans and leases (NPLs), which exclude OREO, were $59.9 million at March 31, 2005, down 22% from $77.1 million a year earlier and down 6% from the end of the fourth quarter including the impact of the sale of an $8.8 million pool of NPLs in the fourth quarter. Expressed as a percent of total loans and leases, NPLs were only 0.25% at March 31, 2005, down from 0.36% at March 31, 2004, and 0.27% at December 31, 2004.
The over 90-day delinquent, but still accruing, ratio was 0.21% at March 31, 2005, down from 0.28% a year ago, and little changed from 0.23% at December 31, 2004.
Non-Performing Assets Activity
Table 10 — Non-Performing Asset Activity
Allowances for Credit Losses (ACL) and Provision for Credit Losses
(This section should be read in conjunction with Significant Factor 1, 4-5, and the Credit Risk section.)
The Company maintains two reserves, both of which are available to absorb possible credit losses: the allowance for loan and lease losses (ALLL) and the allowance for unfunded loan commitments (AULC). When summed together, these reserves constitute the total allowances for credit losses (ACL). Table 11 reflects activity in the ALLL and AULC for the past five quarters:
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Table 11 — Allowances for Credit Losses
The March 31, 2005, ALLL was $264.4 million, down from $295.4 million a year earlier and $271.2 million at December 31, 2004. Expressed as a percent of period-end loans and leases, the ALLL ratio at March 31, 2005, was 1.09%, down from 1.39% a year ago and 1.15% at December 31, 2004. These declines reflected the improvement in the economic outlook, the change in the mix of the loan portfolio to lower-risk residential mortgages and home equity loans, and the reduction of specific reserves related to improved or resolved individual problem commercial credits. Table 11 shows the change in the ALLL ratio from the 2004 first quarter and 2004 fourth quarter.
The ALLL as a percent of NPAs was 361% at March 31, 2005, up from 322% a year ago, and 250% at December 31, 2004.
The March 31, 2005, AULC was $31.6 million, down slightly from $32.1 million at the end of the year-ago quarter, and down from $33.2 million at December 31, 2004.
On a combined basis, the ACL as a percent of total loans and leases was 1.22% at March 31, 2005, compared with 1.55% a year earlier and 1.29% at the end of last quarter. Similarly, the ACL as a percent of NPAs was 404% at March 31, 2005, up from 357% a year earlier and 280% at December 31, 2004.
The provision for credit losses in the 2005 first quarter was $19.9 million, a $5.7 million reduction from the year-ago quarter, but a $7.2 million increase from the 2004 fourth quarter. The reduction in provision expense from the year-ago quarter reflected overall improved portfolio quality performance and a stronger economic outlook, only partially offset by provision expense related to loan growth. The increase in provision expense from the fourth quarter primarily reflected an
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increase in the transaction reserve due to loan growth and higher net charge-offs. This increase was partially offset by improvement in the economic outlook.
Management has an established process to determine the adequacy of the ALLL that relies on a number of analytical tools and benchmarks. No single statistic or measurement, in itself, determines the adequacy of the allowance. For determination purposes, the allowance is comprised of three components: the transaction reserve, specific reserve, and the economic reserve (see the Credit Risk section in the Company’s 2004 Form 10-K for additional discussion.)
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This methodology allows for a more meaningful discussion of Management’s view of the current economic conditions and the potential impact on the Company’s credit losses. The continued use of quantitative methodologies for the transaction reserve and the economic reserve may result in period-to-period fluctuation in the absolute and relative level of the ACL.
Net Loan and Lease Charge-Offs
Table 12 reflects net loan and lease charge-off detail for each of the last five quarters.
Table 12 — Net Loan and Lease Charge-Offs
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2005 First Quarter versus 2004 First Quarter and 2004 Fourth Quarter
Total net charge-offs for the 2005 first quarter were $28.3 million, or an annualized 0.47% of average total loans and leases. This was comparable to $28.6 million, or 0.53%, in the year-ago quarter but represented an increase from $20.9 million, or an annualized 0.36% of average total loans and leases, in the 2004 fourth quarter. The current quarter included a single $14.2 million middle market commercial charge-off related to a commercial leasing company with significant exposure to a service provider that declared bankruptcy. The 0.47% net charge-off ratio for average total loans and leases in the first quarter included 24 basis points related to this single credit.
Total commercial net charge-offs in the first quarter were $16.2 million, or an annualized 0.62%, up from $7.6 million, or an annualized 0.32%, in the year-ago quarter. As noted above, the current quarter included a $14.2 million middle market commercial charge-off, which represented 54 basis points of the 0.62% total commercial net charge-off ratio. Total commercial net charge-offs in the 2004 fourth quarter were $5.2 million, or an annualized 0.21%.
Total consumer net charge-offs in the current quarter were $12.1 million, or an annualized 0.36% of related loans. This compared with $21.0 million, or 0.70%, in the year-ago quarter with the decline from the year-ago quarter heavily influenced by lower automobile loan and lease net charge-offs. Total automobile loan and lease net charge-offs in the 2005 first quarter were $6.2 million, or an annualized 0.56% of related loans and leases, down significantly from $16.6 million, or an annualized 1.32%, in the year-ago quarter. The year-ago quarter included 37 basis points from a one-time $4.7 million cumulative adjustment.
Compared with the 2004 fourth quarter, first quarter total consumer net charge-offs decreased $3.7 million, primarily reflecting a $1.4 million decrease in home equity loan net charge-offs and a $1.3 million decrease in automobile loan and lease net charge-offs. Current quarter home equity loan net charge-offs were an annualized 0.35% of related loans, down from 0.48% in the fourth quarter, and current quarter automobile loan and lease net charge-offs of 0.56% declining from 0.70% of related loans and leases in the 2004 fourth quarter.
MARKET RISK
Market risk represents the risk of loss due to changes in the market value of assets and liabilities. The Company incurs market risk in the normal course of business. Market risk arises when the Company extends fixed-rate loans, purchases fixed-rate securities, originates fixed-rate CDs, obtains funding through fixed-rate borrowings, and leases automobiles and equipment based on expected lease residual values. The Company has identified three primary sources of market risk: interest rate risk, lease residual risk, and price risk.
Interest Rate Risk
Interest rate risk is the most significant market risk incurred by the Company. It results from timing differences in the repricing and maturity of assets and liabilities and changes in relationships between market interest rates and the yields on assets and rates on liabilities, including the impact of embedded options.
Management seeks to minimize the impact of changing interest rates on net interest income and the fair value of assets and liabilities. The board of directors establishes broad policies regarding interest rate and market risk, liquidity risk, counter-party credit risk, and settlement risk. The Market Risk Committee (MRC) establishes specific operating limits within the parameters of the board of directors’ policies.
Interest rate risk management is a dynamic process that encompasses monitoring loan and deposit flows, investment and funding activities, and assessing the impact of the changing market and business environment. Effective management of interest rate risk begins with understanding the interest rate characteristics of assets and liabilities and determining the appropriate interest rate risk posture given market expectations and policy objectives and constraints. The MRC regularly monitors position concentrations and the level of interest rate sensitivity to ensure compliance with board of directors approved risk tolerances.
Interest rate risk modeling is performed monthly. Two broad approaches to modeling interest rate risk are employed: income simulation and economic value analysis. An income simulation analysis is used to measure the sensitivity of forecasted net interest income to changes in market rates over a one-year horizon. Although bank owned life insurance and automobile operating lease assets are classified as non-interest earning assets, and the income from these assets is in
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non-interest income, these portfolios are included in the interest sensitivity analysis because both have attributes similar to fixed-rate interest earning assets. The economic value analysis (Economic Value of Equity or EVE) is calculated by subjecting the period-end balance sheet to changes in interest rates and measuring the impact of the changes in the value of the assets and liabilities.
The models used for these measurements take into account prepayment speeds on mortgage loans, mortgage-backed securities, and consumer installment loans, as well as cash flows of other loans and deposits. Balance sheet growth assumptions are also considered in the income simulation model. The models include the effects of embedded options, such as interest rate caps, floors, and call options, and account for changes in relationships among interest rates.
The baseline scenario for the income simulation analysis, with which all other scenarios are compared, is based on market interest rates implied by the prevailing yield curve as of the period end. Alternative interest rate scenarios are then compared with the baseline scenario. These alternative market rate scenarios include parallel rate shifts on both a gradual and immediate basis, movements in rates that alter the shape of the yield curve (i.e., flatter or steeper yield curve), and spot rates remaining unchanged for the entire measurement period. Scenarios are also developed to measure basis risk, such as the impact of LIBOR-based rates rising or falling faster than the prime rate.
The simulations for evaluating short-term interest rate risk exposure are scenarios that model gradual 100 and 200 basis point increasing and decreasing parallel shifts in interest rates over the next 12-month period beyond the interest rate change implied by the current yield curve. The table below shows the results of the scenarios as of March 31, 2005, and December 31, 2004. All of the positions were well within the board of directors’ policy limits .
Table 13 — Net Interest Income at Risk
The primary simulations for EVE risk assume an immediate and parallel increase in rates of +/- 100 and +/- 200 basis points beyond any interest rate change implied by the current yield curve. The table below outlines the results compared to the previous quarter and policy limits.
Table 14 — Economic Value of Equity at Risk
Lease Residual Risk
(This section should be read in conjunction with Significant Factor 1 and the Operating Lease Assets section.)
Lease residual risk associated with retail automobile and commercial equipment leases is the potential for declines in the fair market value of the vehicle or equipment below the maturity value estimated at origination. Most of Huntington’s lease residual risk is in its automobile leases. Used car values are the primary factor in determining the magnitude of the risk exposure. Since used car values are subject to many factors, lease residual risk has been extremely volatile throughout the history of automobile leasing. Management mitigates lease residual risk by purchasing residual value insurance. Residual
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value insurance provides for the recovery of a decline in the vehicle residual value as specified by the Automotive Lease Guide (ALG), an authoritative industry source, at the inception of the lease. As a result, the risk associated with market driven declines in used car values is mitigated.
Currently, three distinct residual value insurance policies are in place to address the residual risk in the portfolio. Two residual value insurance policies cover all vehicles leased prior to May 2002, and have associated total payment caps of $120 million and $50 million, respectively. During the 2004 third quarter, the $120 million cap was exceeded on the first policy, and it is Management’s assessment that the $50 million cap remains sufficient to cover any expected losses. A third residual insurance policy covers all originations from May 2002 through April 2005, and does not have a cap. Huntington has negotiated a 30-day extension for this policy.
Price Risk
Price risk represents the risk of loss from adverse movements in the non-interest related price of financing instruments that are carried at fair value. Price risk is incurred in the trading securities held by broker-dealer subsidiaries, in the foreign exchange positions that the Bank holds to accommodate its customers, in investments in private equity limited partnerships accounted for at fair value, and in the marketable equity securities available for sale held by insurance subsidiaries. To manage price risk, Management establishes limits as to the amount of trading securities that can be purchased, the foreign exchange exposure that can be maintained, and the amount of marketable equity securities that can be held by the insurance subsidiary.
LIQUIDITY RISK
The objective of effective liquidity management is to ensure that cash flow needs can be met on a timely basis at a reasonable cost under both normal operating conditions and unforeseen circumstances. The liquidity of the Bank is used to originate loans and leases and to repay deposit and other liabilities as they become due or are demanded by customers. Liquidity risk arises from the possibility that funds may not be available to satisfy current or future commitments based on external macro market issues, asset and liability activities, investor perception of financial strength, and events unrelated to the Company such as war, terrorism, or financial institution market specific issues. (see Liquidity section in the Company’s 2004 Form 10-K for additional discussion.)
The primary source of funding is core deposits from retail and commercial customers. (see Table 15.) As of March 31, 2005, core deposits totaled $17.1 billion, and represented 78% of total deposits. This compared with $15.8 billion, or 83% of total deposits, a year earlier. Most of the growth in core deposits was attributable to growth in interest bearing and non-interest bearing demand deposits.
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Table 15 — Deposit Composition
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Liquidity policies and limits are established by the board of directors, with operating limits set by the MRC, based upon analyses of the ratio of loans to deposits and the percentage of assets funded with non-core or wholesale funding. In addition, guidelines are established to ensure diversification of wholesale funding by type, source, and maturity and provide sufficient balance sheet liquidity to cover 100% of wholesale funds maturing within a six-month time period. A contingency funding plan is in place, which includes forecasted sources and uses of funds under various scenarios in order to prepare for unexpected liquidity shortages, including the implications of any rating changes. The MRC meets monthly to identify and monitor liquidity issues, provide policy guidance, and oversee adherence to, and the maintenance of, an evolving contingency funding plan.
Credit ratings by the three major credit rating agencies are an important component of the Company’s liquidity profile. Among other factors, the credit ratings are based on financial strength, credit quality and concentrations in the loan portfolio, the level and volatility of earnings, capital adequacy, the quality of management, the liquidity of the balance sheet, the availability of a significant base of core retail and commercial deposits, and the Company’s ability to access a broad array of wholesale funding sources. Adverse changes in these factors could result in a negative change in credit ratings and impact not only the ability to raise funds in the capital markets, but also the cost of these funds. In addition, certain financial on- and off-balance sheet arrangements contain credit rating triggers that could increase funding needs if a negative rating change occurs. Letter of credit commitments for marketable securities, interest rate swap collateral agreements, and certain asset securitization transactions contain credit rating provisions.
As a result of the formal SEC investigation and the banking regulatory supervisory agreements announced on November 3, 2004, the following rating agency actions were taken: (1) Moody’s reaffirmed their Negative outlook and placed all the ratings on review for possible downgrade, (2) Standard and Poor’s lowered their outlook from Stable to Negative, and (3) Fitch lowered their outlook from Stable to Negative. The cost of short-term borrowings was not materially affected by these actions.
On February 8, 2005, Moody’s announced the following rating actions:
On April 6, 2005, Standard and Poor’s announced the following rating actions:
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To date, these rating agency actions have had no significant adverse impact on rating triggers inherent in financial contracts. Management believes that sufficient liquidity exists to meet the funding needs of the Bank and the parent company. Credit ratings as of April 6, 2005, for the parent company and the Bank were:
Table 16 — Credit Rating Agency Ratings
OFF-BALANCE SHEET ARRANGEMENTS
In the normal course of business, the Company enters into various off-balance sheet arrangements. These arrangements include financial guarantees contained in standby letters of credit issued by the Bank and commitments by the Bank to sell mortgage loans.
Standby letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party. These guarantees are primarily issued to support public and private borrowing arrangements, including commercial paper, bond financing, and similar transactions. Most of these arrangements mature within two years. Approximately 46% of standby letters of credit are collateralized and nearly 97% are expected to expire without being drawn upon. There were $956 million, $945 million, and $944 million of outstanding standby letters of credit at March 31, 2005, December 31, 2004, and March 31, 2004, respectively. Non-interest income was recognized from the issuance of these standby letters of credit of $2.8 million for both the first three months of 2005 and 2004. The carrying amount of deferred revenue related to standby letters of credit at March 31, 2005, was $3.6 million. Standby letters of credit are included in the determination of the amount of risk-based capital that the Company and the Bank are required to hold.
The Bank enters into forward contracts relating to its mortgage banking business. At March 31, 2005, commitments to sell residential real estate loans totaled $388.5 million. These contracts mature in less than one year. The parent company and/or the Bank may also have liabilities under certain contractual agreements contingent upon the occurrence of certain events. A discussion of significant contractual arrangements under which the parent company and/or the Bank may be held contingently liable, including guarantee arrangements, is included in Note 11 of the Notes to Unaudited Condensed Consolidated Financial Statements.
Through its credit process, Management monitors the credit risks of outstanding standby letters of credit. When it is probable that a standby letter of credit will be drawn and not repaid in full, losses are recognized in provision for credit losses. Management does not believe that its off-balance sheet arrangements will have a material impact on its liquidity or capital resources.
CAPITAL
Capital is managed both at the parent and the Bank levels. Capital levels are maintained based on regulatory capital requirements and the economic capital required to support credit, market, and operation risks inherent in the Company’s business and to provide the flexibility needed for future growth and new business opportunities. Management places significant emphasis on the maintenance of a strong capital position, which promotes investor confidence, provides access to the national markets under favorable terms, and enhances business growth and acquisition opportunities. The importance of managing capital is also recognized and Management continually strives to maintain an appropriate balance between capital adequacy and providing attractive returns to shareholders.
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Shareholders’ equity totaled $2.6 billion at March 31, 2005. This balance represented a $52 million increase from December 31, 2004. The growth in shareholders’ equity resulted from the retention of net income after dividends to shareholders of $50 million, and an increase of $8 million as a result of stock options exercised, offset slightly by a reduction in accumulated other comprehensive income of $8 million. The decline in accumulated other comprehensive income resulted from a decline in the market value of securities available for sale at March 31, 2005, compared with December 31, 2004.
As of March 31, 2005, the Company had unused authority to repurchase up to 7.5 million common shares under an April 27, 2004, share repurchase authorization. On April 25, 2005, Huntington announced that it intended to reactivate its share repurchase program upon approval by the Commission of the proposed settlement offer to resolve the SEC formal investigation. It expects to repurchase these shares from time-to-time in the open market or through privately negotiated transactions depending on market conditions.
On January 19, 2005, the board of directors declared a quarterly cash dividend on its common stock of $0.20 per common share. The dividend was payable April 1, 2005, to shareholders of record on March 17, 2005. On April 27, 2005, the board of directors declared a quarterly cash dividend on its common stock of $0.215 per common share, a 7.5% increase. The dividend is payable July 1, 2005, to shareholders of record on June 16, 2005.
Average equity to average assets in the 2005 first quarter was 7.76%, up from 7.39% in the year ago quarter, and up from 7.74% for the 2004 fourth quarter. (see Table 17.) At March 31, 2005, the tangible equity to assets ratio was 7.42%, up from 6.97% a year ago, and 7.18% at December 31, 2004. At March 31, 2005, the tangible equity to risk-weighted assets ratio was 7.83%, up from 7.60% at the end of the year-ago quarter, and down from 7.86% at December 31, 2004. The increase in the tangible equity to risk-weighted assets ratio reflected primarily the positive impact resulting from reducing the overall risk profile of earning assets throughout this period, most notably a less risky loan portfolio mix.
Table 17 — Capital Adequacy
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Table 18 — Quarterly Common Stock Summary
The Federal Reserve Board, which supervises and regulates the Company, sets minimum capital requirements for each of these regulatory capital ratios. In the calculation of these risk-based capital ratios, risk weightings are assigned to certain asset and off-balance sheet items such as interest rate swaps, loan commitments, and securitizations. Huntington’s Tier 1 Risk-based Capital, Total Risk-based Capital, Tier 1 Leverage ratios, and risk-adjusted assets for the recent five quarters are well in excess of minimum levels established for “well capitalized” institutions of 6.00%, 10.00%, and 5.00%, respectively. At March 31, 2005, the Company had regulatory capital ratios in excess of “well capitalized” regulatory minimums.
The Bank is primarily supervised and regulated by the Office of the Comptroller of the Currency, which establishes regulatory capital guidelines for banks similar to those established for bank holding companies by the Federal Reserve Board. At March 31, 2005, the Bank had regulatory capital ratios in excess of “well capitalized” regulatory minimums.
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LINES OF BUSINESS DISCUSSION
This section reviews financial performance from a line of business perspective and should be read in conjunction with the Discussion of Results and other sections for a full understanding of the Company’s consolidated financial performance.
Funds Transfer Pricing
The Company uses a centralized funds transfer pricing (FTP) methodology to attribute appropriate net interest income to the business segments. The Treasury/Other business segment charges (credits) an internal cost of funds for assets held in (or pays for funding provided by) each line of business. The FTP rate is based on prevailing market interest rates for comparable duration assets (or liabilities). Deposits of an indeterminate maturity receive an FTP credit based on vintage-based pool rate. Other assets, liabilities, and capital are charged (credited) with a four-year moving average FTP rate. The intent of the FTP methodology is to eliminate all interest rate risk from the lines of business by providing matched duration funding of assets and liabilities. The result is to centralize the financial impact of interest rate and liquidity risk for the Company in Treasury/Other.
The FTP methodology also provides for a charge (credit) to the line of business when a fixed-rate loan is sold and the internal funding associated with the loan is extinguished. The charge (credit) to the line of business represents the cost (or benefit) to Treasury/Other of the early extinguishment of the internal fixed-rate funding. This charge (credit) has no impact on consolidated financial results.
Use of Operating Earnings
Management uses earnings on an operating basis, rather than on a GAAP basis, to measure underlying performance trends for each business segment. Operating earnings represent GAAP earnings adjusted to exclude the impact of certain items discussed in the Significant Factors Influencing Financial Performance Comparisons section and Table 2. (In addition to this discussion and Table 2, see Note 13 of the Notes to Unaudited Condensed Consolidated Financial Statements.) Analyzing earnings on an operating basis is very helpful in assessing underlying performance trends, a critical factor used by Management to determine the success of strategies and future earnings capabilities.
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Regional Banking
Regional Banking provides products and services to consumer, small business, and commercial customers. These products and services are offered in seven operating regions within the five states of Ohio, Michigan, West Virginia, Indiana, and Kentucky through the Company’s banking network of 335 branches, over 700 ATMs, plus Internet and telephone banking channels. Each region is further divided into Retail and Commercial Banking units. Retail products and services include home equity loans and lines of credit, first mortgage loans, direct installment loans, small business loans, personal and business deposit products, as well as sales of investment and insurance services. Retail products and services comprise 61% and 78%, of total regional banking loans and deposits, respectively. Commercial Banking serves middle market and large commercial banking relationships, which use a variety of banking products and services including, but not limited to, commercial loans, international trade, cash management, leasing, interest rate protection products, capital market alternatives, 401(k) plans, and mezzanine investment capabilities.
Regional Banking contributed $61.5 million of the Company’s net operating earnings in first quarter 2005, up $9.3 million, or 18%, from 2004 first quarter. This increase primarily reflected a $27.9 million, or 18%, increase in net interest income resulting from strong loan and deposit growth, partially offset by a $10.1 million increase in provision for credit losses, a $2.7 million, or 2%, increase in non-interest expense, and a higher provision for income taxes.
Total fully taxable equivalent revenue grew $27.2 million, or 12%, from the year-ago quarter, primarily reflecting an 18% increase in net interest income driven by a 19% increase in average loans and a 13% increase in average deposits, partially offset by a 1% decline in non-interest income.
The $2.7 billion, or 19%, increase in average total loans and leases reflected a 56% increase in average residential mortgages, a 21% increase in average home equity loans and lines of credit, and a 29% increase in middle market construction CRE loans. Though interest rates increased during this period, the level of interest rates remained low on an absolute basis, which continued to impact demand favorably for real estate-related financing. Average small business loans increased 11% reflecting specific strategies to focus on this business segment.
The $2.0 billion, or 13% increase in average total deposits, reflected strong growth in average interest bearing deposits, up 23%, domestic time deposits, up 11%, and non-interest bearing deposits, up 10%. Of the growth in average total deposits, Commercial Banking accounted for $1.0 billion, Retail Banking $0.8 billion, and Small Business $0.2 billion.
Supporting the growth in deposits, and evidence of improved sales success, was a 14,260, or 3%, increase in period-end demand deposit (DDA) household relationships, as well as a 4,218, or 9%, increase in small business DDA relationships. The DDA is viewed as the primary banking relationship account as most additional services are cross-sold to customers within the first 90-days after establishing a DDA account. The consumer new 90-day cross-sell ratio increased 23% to 2.70 in the 2005 first quarter compared with the year-ago period, with the small business new 90-day cross-sell ratio up 12% to 2.29.
Loan and deposit growth also reflected continued focus on customer service and delivery channel optimization. Since the prior-year quarter, five banking offices were opened, while two were closed. The number of on-line banking customers ended the first quarter 2005 at over 224,000, a 25% increase, and represented a relatively high 42% penetration of retail banking households, up from 34% a year earlier.
Net interest margin in the 2005 first quarter was 4.43%, unchanged from the year-ago quarter. The deposit margin increased as interest rates rose, but this was offset by a decline in loan margin due to a shift in the loan portfolio mix to lower-margin but higher credit quality consumer residential mortgage and home equity loans.
Total net charge-offs for the 2005 first quarter were $21.0 million, or an annualized 0.51% of average total loans and leases, up from $11.6 million, or 0.33%, in the year-ago quarter. The current quarter included 34 basis points related to a single $14.2 million middle market commercial charge-off. Consumer net charge-offs have remained little changed over the last five quarters and represented an annualized 0.27% of average loans and leases in the 2005 first quarter, unchanged from the year-ago quarter. Total NPAs declined 13% from the year-ago period. Despite steady credit quality performance, the provision for credit losses increased $10.2 million to $12.3 million, primarily reflecting the impact of the 2005 first quarter single commercial credit charge-off, and the strong growth in loans and leases. (See Credit Risk for additional discussion regarding charge-offs and allowance for loan loss reserve methodologies.)
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Non-interest income decreased $0.7 million, or 1%, compared with the first quarter of 2004. The decline was driven by declines in deposit service charges and other income of $2.3 million and $2.0 million, respectively, partially offset by increases in mortgage banking of $2.5 million and other service charges and fees of $0.6 million. The increase in mortgage banking income resulted from improved net marketing and higher net servicing fees. Personal service charges decreased $1.1 million, or 5%, primarily due to lower NSF activity. Commercial service charges declined $1.2 million, or 7%, as a result of lower transaction volumes, but was offset by higher commercial deposit balances. The $2.0 million decrease in other income was related to a one-time commercial mezzanine fee in the year-ago quarter. Mortgage income increased $2.5 million as a result of the 16% increase in the servicing portfolio.
Non-interest expense increased $2.7 million, or 2%, compared with the year-ago quarter. Growth in non-personnel costs increased $2.3 million, or 3%, and reflected higher occupancy, outside services, and operating losses. Personnel costs declined slightly as full-time equivalent employees decreased 2% from a year ago. The efficiency ratio decreased to 58% compared to 64% in the first quarter 2004, reflecting revenue growth and continued focus on controlling expenses.
The return on average assets and return on average equity for Regional Banking, were 1.39% and 25.0%, respectively, up from 1.38% and 20.9% in the 2004 first quarter.
Regional Banking earnings in the first quarter 2005 decreased $7.1 million, or 10%, from the 2004 fourth quarter driven primarily by increased provision for credit losses. Total revenue decreased $3.2 million as a result of seasonally lower deposit service charge income while expenses were essentially unchanged.
Net interest income increased $0.7 million reflecting a 3% increase in average total loans and leases and 2% increase in average total deposits, partially offset by a 4 basis point decline in the net interest margin.
The growth in average loans reflected strong growth in residential mortgages and commercial loans. Residential mortgages increased 6% while middle market C&I loans increased 5% and CRE and small business loans increased 3% and 2%, respectively.
Average total deposits increased 2%, led by strong 4% growth in average interest bearing demand deposits and 6% growth in retail CD’s, partially offset by a 3% seasonal decline in non-interest bearing demand deposits. The 4 basis point decline in the net interest margin reflected pressure on commercial and consumer loan spreads partially offset by increased spread on deposits.
The $7.9 million increase in provision for credit losses from the fourth quarter primarily reflected the impact of the one middle market C&I charge-off mentioned above. Total net charge-offs increased $11.3 million due to the single $14.2 million middle market commercial charge-off noted above. Consumer net charge-offs decreased to 27 basis points from 38 basis points in the prior quarter. Total NPAs as a percent of total loans and leases remained flat at 0.41% compared to the prior quarter.
Non-interest income decreased $4.0 million, or 5%, primarily due to a $2.2 million decline in deposit service charges, primarily seasonal, and a $2.2 million decline in other income due to lower income from terminated equipment leases.
Non-interest expense decreased $0.3 million reflecting a $1.8 million decline in personnel costs due to lower performance-based compensation, partially offset by a $1.2 million increase in other expenses, primarily occupancy and marketing. The efficiency ratio was 58% in the current quarter, essentially unchanged from the 2004 fourth quarter.
The return on average assets and return on average equity for Regional Banking were down from 1.56% and 25.8% in the prior quarter.
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Table 19 — Regional Banking(1)
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Table 19 - Regional Banking(1)
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Dealer Sales
Dealer Sales serves more than 3,500 automotive dealerships within Huntington’s primary banking markets, as well as in Arizona, Florida, Georgia, Pennsylvania, and Tennessee. The segment finances the purchase of automobiles by customers of the automotive dealerships, purchases automobiles from dealers and simultaneously leases the automobiles to consumers under long-term operating or direct finance leases, finances the dealership’s floor plan inventories, real estate, or working capital needs, and provides other banking services to the automotive dealerships and their owners.
The accounting for automobile leases significantly impacts the presentation of Dealer Sales’ financial results. Residual values on leased automobiles, including the accounting for residual value losses, are also an important factor in the overall profitability of auto leases. Automobile leases originated prior to May 2002 are accounted for as operating leases, with leases originated since April 2002 accounted for as direct financing leases. This accounting treatment impacts a number of Dealer Sales’ financial performance results and trends including net interest income, non-interest income, and non-interest expense. (See the Operating Lease Assets section and Significant Factor 1.)
Dealer Sales contributed $18.0 million of the Company’s net operating earnings in the first quarter, up $5.9 million, or 49%, from the 2004 first quarter. This increase primarily reflected the benefit of a decline in the provision for credit losses reflecting a combination of factors, most notably lower automobile loans as a result of planned sales. Partially offsetting this benefit was lower net income from loan and lease assets (net interest income plus operating lease income less operating lease expense) reflecting the impact of sold loans, as well as a decline in loan production given intense competition in the market place along with a decline in automobile sales from the year-ago quarter.
Net interest income increased 8%, due to a higher net interest margin, as average total loans and leases declined 9% from the year-ago quarter. This decline reflected a $1.0 billion, or 34%, decline in average automobile loans as $1.5 billion of automobile loans were sold over this period as part of a planned strategy to lower the Company’s overall credit exposure to the automobile financing sector. Automobile loan and lease production in the current quarter was down 25% and 31%, respectively. The decline in average automobile loans was partially offset by a 24% increase in average automobile leases and a 3% increase in middle market floor plan C&I loans.
The provision for credit losses declined $14.8 million, or 69%, from the year-ago quarter due to several factors. These factors included the impact of lower loan balances due to the sale of loans, improved credit quality, and the fact that provision expense in the year-ago quarter included a $4.7 million cumulative increase to correct the prior recording of insurance claims received.
Non-interest income and non-interest expense declined $43.3 million, or 45%, and $34.8 million, or 38%, respectively, reflecting the 56% decline in average operating lease assets between periods, as the operating lease portfolio continued to run-off (see Significant Factor 1). Other income declined $0.3 million reflecting lower fees earned from leases terminated early. Personnel costs decreased $0.2 million, or 4%, due to focused expense control.
The return on average assets and return on average equity for Dealer Sales, were 1.20% and 19.5%, respectively, up from 0.66% and 10.8% in 2004.
Dealer Sales’ net operating earnings in the first quarter were up $2.7 million, or 18%, from the 2004 fourth quarter. A soft car market continued to have adverse impacts on the operating performance of this segment. However this negative impact was partially offset by the benefit of improved credit quality, as demonstrated by lower net charge-offs and related provision, along with lower levels of non-interest expenses. The net contribution from loan and lease assets (net interest income plus operating lease income less operating lease expense) increased slightly from the fourth quarter.
Net interest income declined $1.7 million, or 4%, from the fourth quarter. The 2004 fourth quarter reflected a $3.7 million interest adjustment on an auto loan securitization. The net interest margin was also favorably impacted by the run-off of the operating lease assets due to the fact that all of the funding cost associated with these assets is reflected in interest expense, whereas the income is reflected in non-interest income.
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Average automobile loans increased 5% from the fourth quarter, with automobile leases increasing 3%. Also contributing to the growth in total loans and leases was a 5% increase in average middle market C&I loans, primarily dealer floor plan loans.
The provision for credit losses decreased $1.9 million, or 21%, reflecting the impact of improved credit quality within the existing portfolio, as well as the continued focus on originating high credit quality loans and leases. Annualized total net charge-offs was 0.48%, down from 0.58% in the 2004 fourth quarter.
Non-interest income decreased $9.4 million, or 15%, primarily reflecting an $8.6 million decline in operating lease income as that portfolio continued to run-off. Similarly, non-interest expense decreased $13.4 million, or 19%, reflecting a $10.6 million decline in operating lease expense, also reflecting the run-off of the operating lease portfolio. Other non-interest expense declined $2.4 million, or 15%, primarily due to lower residual value insurance costs, and personnel costs decreased 6% primarily due to lower headcounts and production related salary costs.
The return on average assets and return on average equity for Dealer Sales, were 1.20% and 19.5%, respectively, up from 1.01% and 15.9% in the fourth quarter.
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Table 20 - Dealer Sales(1)
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Table 20 — Dealer Sales (1)
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Private Financial Group
The Private Financial Group (PFG) provides products and services designed to meet the needs of the Company’s higher net worth customers. Revenue is derived through trust, asset management, investment advisory, brokerage, insurance, and private banking products and services. As of March 31, 2005, the trust division provides fiduciary services to more than 12,000 accounts with assets totaling $43.5 billion, with $10.0 billion managed by PFG, including approximately $600 million in assets managed by Haberer Registered Investment Advisor, which provides investment management services to nearly 600 customers.
PFG also provides investment management and custodial services to the Company’s 29 proprietary mutual funds, including ten variable annuity funds, which represented more than $3 billion in total assets under management at March 31, 2005. The Huntington Investment Company offers brokerage and investment advisory services to both Regional Banking and PFG customers through more than 100 licensed investment sales representatives and 639 licensed personal bankers. This customer base has over $4.7 billion in mutual fund and annuity assets. PFG’s insurance entities provide a complete array of insurance products including individual life insurance products ranging from basic term life insurance, to estate planning, group life and health insurance, property and casualty insurance, mortgage title insurance, and reinsurance for payment protection products. Income and related expenses from the sale of brokerage and insurance products is shared with the line of business that generated the sale or provided the customer referral, most notably Regional Banking.
The PFG contributed $10.1 million of the Company’s net operating earnings in the first quarter of 2005, up $2.2 million, or 27%, from the first quarter of 2004 primarily as a result of 10% growth in total revenue, achieved with only a 1% increase in total non-interest expense.
Net interest income increased $1.5 million, or 12%, from the year-ago quarter as average total loans increased 13%, while average deposit balances remained essentially flat. Loan growth was largely reflective of PFG’s 2004 initiative to add relationship managers in several markets targeted for growth opportunities, most notably East and West Michigan and Central and Southern Ohio.
Credit quality remained strong as indicated by a negative provision for credit losses for the first quarter of 2005. The negative provision for credit losses reflected the combination of very low charge-offs and the partial release of prior reserves as a result of a large pay down on a partially secured loan. The total annualized net charge-off ratio was only 0.06% in the first quarter and total NPA ratio was only 0.27%.
Non-interest income, net of fees shared with other business units, increased $2.5 million, or 9%, from the year-ago quarter mainly due to growth in trust income. Trust income increased $2.0 million, or 12%, mainly due to revenue growth in personal trust and investment management business. Total trust assets grew 11% to $43.5 billion at March 31, 2005, from $39.1 billion a year earlier. For the same comparable periods, managed assets grew 9% from $9.2 billion to $10.0 billion. Revenue earned from services provided to the Huntington proprietary mutual funds increased as the total equity and fixed income fund assets increased by 11% and fee waivers were discontinued as a result of increased money market yields. Brokerage and insurance revenue decreased $1.9 million, or 18%, mainly due to decreased annuity sales. The decreased annuity sales reflected a lower demand for fixed annuity products resulting from the rising interest rate environment combined with less attractive rates. Insurance revenue decreased due to reduced sales of life insurance products through the branch banking offices, as well as fewer large premium policy sales of advanced market life insurance products. The $2.5 million increase in other non-interest income resulted mainly from the change in accounting methodology to recognize as gross revenue vendor marketing allowances that were previously offset with the related expenses.
Non-interest expense increased $0.4 million, or 1%, from the 2004 first quarter. Increased expenses resulting from the aforementioned accounting methodology change were largely offset by reduced sales commissions as a result of the decreased brokerage and insurance revenue.
The ROA and ROE for the 2005 first quarter were 2.48% and 35.8%, respectively, up from 2.15% and 27.1%, respectively, in the year-ago quarter.
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PFG’s $10.1 million net contribution to the Company’s operating earnings in the first quarter of 2005 was up $3.0 million, or 42%, from the fourth quarter. The increased earnings resulted primarily from an 8% growth in total revenue and $2.4 million decrease in the provision for credit losses.
Net interest income increased $0.1 million from the fourth quarter. Commercial and consumer loans both reflected double digit annualized growth during the quarter. The decline in deposit balances reflected both seasonality, as well as some redirection of sweep account balances to money market mutual funds. The net interest margin declined slightly from 3.64% in the prior quarter to 3.62% in the current quarter mainly as a result of a decline in spread rates on allocated capital. Spread rates on loans remained essentially unchanged, while spread rates on deposits continued to widen, as customer deposit rates have not increased as quickly as market rates.
Provision for credit losses decreased $2.4 million from the prior quarter. The decrease was mainly due to lower net charge-offs combined with the partial release of a $0.7 million reserve established in the fourth quarter 2004 as a result of a significant pay down in the first quarter of 2005. The total annualized net charge-off ratio decreased to 0.06% from 0.32% and total NPAs declined to 0.27% from 0.40% of total loans outstanding.
Non-interest income, net of fees shared with other business units and excluding securities gains, increased $3.4 million, or 12%, from the fourth quarter. Trust income increased $0.9 million, or 5% from the previous quarter, due in part to growth in managed assets from $9.8 billion to $10.0 billion in the first quarter. Revenue growth also reflected Huntington’s new role as Fund administrator and the impact of a $0.2 million reserve established in the fourth quarter 2004 for the potential rebate of certain administrative fees. Personal trust revenue also reflected $0.1 million in annual fees for tax services provided to certain trust accounts. Institutional trust revenue growth mainly resulted from a large $1.5 billion custody account acquired in fourth quarter and the expansion of a large institutional investment management account relationship. Corporate trust revenue declined reflecting normal seasonal timing of annual renewal fees. Brokerage and insurance revenue increased $0.2 million, or 2%, in the first quarter as a result of increased retail investment sales. Mutual fund and annuity sales volume increased 22%, which helped generate additional brokerage revenue of $1.0 million, or 11% in the current quarter. Insurance revenue declined $0.7 million, or 21%, as fourth quarter 2004 reflected the sale of several large advanced market policies and the annual renewals of several large policies. The $2.5 million increase in other non-interest income resulted mainly from the change in accounting methodology to recognize as gross revenue vendor marketing allowances that were previously offset with the related expenses.
Non-interest expense increased $1.3 million, or 5%, from the prior quarter mainly due to the aforementioned accounting methodology change. Personnel expenses increased 3% as a result of increased benefit costs, mainly FICA and unemployment taxes.
The ROA and ROE in the 2005 first quarter were 2.48% and 35.8%, respectively, up from 1.75% and 23.0%, respectively in the previous quarter.
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Table 21 — Private Financial Group(1)
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eop — End of Period.
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Treasury / Other
The Treasury / Other segment includes revenue and expense related to assets, liabilities, and equity that are not directly assigned or allocated to one of the other three business segments. Assets included in this segment include investment securities, bank owned life insurance, and mezzanine loans originated through Huntington Capital Markets.
Net interest income includes the net impact of administering Huntington’s investment securities portfolios as part of overall liquidity management. A match-funded transfer pricing system is used to attribute appropriate funding interest income and interest expense to other business segments. As such, net interest income includes net interest income related to Huntington Capital Markets loan activity, as well as the net impact of any over or under allocations arising from centralized management of interest rate risk. Furthermore, net interest income includes the net impact of derivatives used to hedge interest rate sensitivity.
Non-interest income includes fee income related to Huntington Capital Markets activities and miscellaneous non-interest income not allocated to other business segments, including bank owned life insurance income. Fee income also includes MSR temporary impairment valuation recoveries or impairments, as well as any investment securities and/or trading assets gains or losses, which are used to mitigate MSR valuation changes.
Non-interest expense includes expenses associated with Huntington Capital Markets activities, as well as certain corporate administrative and other miscellaneous expenses not allocated to other business segments.
The provision for income taxes for each of the other business segments is calculated at a statutory 35% tax rate, though the Company’s overall effective tax rate is lower. As a result, the provision for income taxes in Treasury / Other includes the difference between the actual effective tax rate and the statutory tax rate used to allocate income taxes to the other segments.
Treasury / Other net income declined $19.0 million, or 73%, from the year-ago quarter primarily due to the negative impacts of lower net interest income, lower securities sale gains, lower provision for credit losses and higher non-interest expense, partially offset by the benefits of lower provision for taxes and lower non-interest income.
Net interest income declined $19.7 million primarily due to the impact of rising interest rates on the credits recognized by this unit to offset funds transfer pricing charges and credits to business segments (up $1.7 million), increased wholesale borrowing cost ($18.9 million including brokered and negotiable CDs), $9.3 million lower interest on securities due in part to a 14% reduction in balances, partially offset by higher derivative income of $2.7 million and higher net interest income from trading account assets.
The provision for credit losses decreased $1.3 million from the year-ago quarter, attributable to improved overall credit quality as reflected in the relative level of each component of the ALLL.
Non-interest income was $9.1 million lower than in the year-ago quarter. Mortgage banking income increased $14.0 million due to MSR impairment/recovery ($3.8 million recovery in the 2005 first quarter versus an impairment of $10.2 million in year-ago quarter). MSR impairment/recovery is hedged through a combination of trading activity and securities gains/(losses). The decreases in these gains more than offset the favorable variance in MSR (being down versus same quarter prior-year by $3.7 million and $14.1 million, respectively). Investment banking income from Capital Markets declined $2.4 million and equity investment gains are lower by $1.0 million.
Non-interest expense increased $4.3 million from the prior-year first quarter. The primary drivers for this variance included $3.6 million higher personnel cost from annual merit increases and bonuses, $1.3 million higher SEC and regulatory-related expenses incurred in the first quarter 2005, and $1.6 million higher net occupancy expense reflecting a prepayment penalty due to debt refinancing on the Company’s headquarters building as well as lower rental income. Offsetting this was a $3.8 million decline in miscellaneous expenses from operational, administrative, and support groups unallocated to business segments.
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Credit for income taxes increased $12.5 million from the prior-year. This reflected a $6.4 million positive impact related to the recognition of the effect of federal income tax refunds resulting from the ability to carry back federal tax losses to prior-years (as described in a previous section of this report), a $1.6 million decline in taxes attributed to Capital Markets due to lower income versus first quarter 2004, and the difference between Huntington’s effective and statutory tax rates.
Net income was $6.7 million higher than in the 2004 fourth quarter. Non-interest expenses and provision for income taxes are both lower than fourth quarter 2004 levels, though this benefit was partially offset by lower revenues (net interest income, non-interest income, and securities gains / (losses)) and increased provision for credit losses.
Net interest income declined $3.0 million due primarily to increased wholesale borrowing costs ($11.7 million including brokered deposits and negotiable CDs) offset by increased credits recognized by this unit to offset funds transfer pricing charges and credits to business segments of $7.4 million and an increase in derivative income of $0.6 million.
Non-interest income declined $4.9 million reflecting a number of factors. These included equity investment losses in the current quarter compared with gains in the prior quarter, non-recurring gains on Capital Markets Investment Banking deals in the fourth quarter of 2004, and $1.1 million lower securities gains in the first quarter partially offset by higher MSR recoveries in the current quarter.
Non-interest expense was down $10.2 million from the fourth quarter as the 2004 fourth quarter included a $7.8 million property impairment, SEC-related expenses and accruals, and an adjustment to pension expense that did not recur in the current quarter. These reductions were partially offset by higher seasonal costs for salaries and bonuses paid in the 2005 first quarter.
Provision for credit losses for the first quarter 2005 was $3.6 million higher than in the prior quarter, as the 2004 fourth quarter included a net $2.5 million provision reduction reflecting a transfer of non-performing loans to other real estate owned.
Provision for income taxes was $7.9 million lower than last quarter. The provision for income taxes decreased primarily due to the recognition of the effect of federal tax refunds on income tax expense, as well as a reduction in pre-tax earnings.
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Table 22 — Treasury / Other (1)
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Table 23 — Total Company (1)
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Item 3. Quantitative and Qualitative Disclosures about Market Risk
Quantitative and qualitative disclosures for the current period can be found in the Market Risk section of this report, which includes changes in market risk exposures from disclosures presented in Huntington’s Form 10-K.
Item 4. Controls and Procedures
Huntington’s Management, with the participation of its Chief Executive Officer and the Chief Financial Officer, evaluated the effectiveness of Huntington’s disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this report. Based upon such evaluation, Huntington’s Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, Huntington’s disclosure controls and procedures are effective.
There have not been any changes in Huntington’s internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fiscal quarter to which this report relates that have materially affected, or are reasonably likely to materially affect, Huntington’s internal control over financial reporting.
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PART II. OTHER INFORMATION
In accordance with the instructions to Part II, the other specified items in this part have been omitted because they are not applicable or the information has been previously reported.
Item 2. Changes in Securities and Use of Proceeds
(c)
Item 6. Exhibits
(a) Exhibits
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
Huntington Bancshares Incorporated(Registrant)
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