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Fifth Third Bancorp 10-Q 2006
Quarterly Report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


FORM 10-Q

 


QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF

THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended September 30, 2006

Commission File Number 0-8076

 


LOGO FIFTH THIRD BANCORP

(Exact name of Registrant as specified in its charter)

 


 

Ohio   31-0854434

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification Number)

Fifth Third Center

Cincinnati, Ohio 45263

(Address of principal executive offices)

Registrant’s telephone number, including area code: (513) 534-5300

 


Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer   x                    Accelerated filer  ¨                    Non-accelerated filer  ¨

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

There were 558,066,338 shares of the Registrant’s Common Stock, without par value, outstanding as of September 30, 2006.

 



FIFTH THIRD BANCORP

INDEX

 

Part I. Financial Information   
Management’s Discussion and Analysis of Financial Condition and Results of Operations (Item 2)   

Selected Financial Data

   3

Overview

   4

Recent Accounting Standards

   5

Critical Accounting Policies

   5

Statements of Income Analysis

   7

Business Segment Review

   14

Balance Sheet Analysis

   20
Quantitative and Qualitative Disclosure about Market Risk (Item 3)   

Risk Management – Overview

   25

Credit Risk Management

   25

Market Risk Management

   30

Liquidity Risk Management

   32

Capital Management

   33

Off-Balance Sheet Arrangements

   34

Contractual Obligations and Commitments

   35

Controls and Procedures (Item 4)

   36

Condensed Consolidated Financial Statements and Notes (Item 1)

  

Balance Sheets (unaudited)

   37

Statements of Income (unaudited)

   38

Statements of Changes in Shareholders’ Equity (unaudited)

   39

Statements of Cash Flows (unaudited)

   40

Notes to Condensed Consolidated Financial Statements (unaudited)

   41
Part II. Other Information   
Legal Proceedings (Item 1)    57
Risk Factors (Item 1A)    57
Unregistered Sales of Equity Securities and Use of Proceeds (Item 2)    57
Signatures    58
Exhibits (Item 6)    59

This report may contain forward-looking statements about the Registrant and/or the company as combined with acquired entities within the meaning of Sections 27A of the Securities Act of 1933, as amended, and Rule 175 promulgated thereunder, and 21E of the Securities Exchange Act of 1934, as amended, and Rule 3b-6 promulgated thereunder, that involve inherent risks and uncertainties. This report may contain certain forward-looking statements with respect to the financial condition, results of operations, plans, objectives, future performance and business of the Registrant and/or the combined company including statements preceded by, followed by or that include the words or phrases such as “believes,” “expects,” “anticipates,” “plans,” “trend,” “objective,” “continue,” “remain” or similar expressions or future or conditional verbs such as “will,” “would,” “should,” “could,” “might,” “can,” “may” or similar expressions. There are a number of important factors that could cause future results to differ materially from historical performance and these forward-looking statements. Factors that might cause such a difference include, but are not limited to: (1) competitive pressures among depository institutions increase significantly; (2) changes in the interest rate environment reduce interest margins; (3) prepayment speeds, loan origination and sale volumes, charge-offs and loan loss provisions; (4) general economic conditions, either national or in the states in which the Registrant, one or more acquired entities and/or the combined company do business, are less favorable than expected; (5) political developments, wars or other hostilities may disrupt or increase volatility in securities markets or other economic conditions; (6) changes and trends in the securities markets; (7) legislative or regulatory changes or actions, or significant litigation, adversely affect the Registrant, one or more acquired entities and/or the combined company or the businesses in which the Registrant, one or more acquired entities and/or the combined company are engaged; (8) difficulties in combining the operations of acquired entities and (9) the impact of reputational risk created by the developments discussed above on such matters as business generation and retention, funding and liquidity. Additional information concerning factors that could cause actual results to differ materially from those expressed or implied in the forward-looking statements is available in the Registrant’s Annual Report on Form 10-K for the year ended December 31, 2005, filed with the United States Securities and Exchange Commission (SEC). Copies of this filing are available at no cost on the SEC’s Web site at www.sec.gov or on the Registrant’s Web site at www.53.com. The Registrant undertakes no obligation to release revisions to these forward-looking statements or reflect events or circumstances after the date of this report.

 

2


Management’s Discussion and Analysis of Financial Condition and Results of Operations (Item 2)

The following is management’s discussion and analysis of certain significant factors that have affected Fifth Third Bancorp’s (“the Registrant” or “Fifth Third”) financial condition and results of operations during the periods included in the Condensed Consolidated Financial Statements, which are a part of this filing. Reference to the Registrant incorporates the parent holding company and all consolidated subsidiaries.

TABLE 1: Selected Financial Data

 

     For the three months
ended September 30,
   Percent
Change
    For the nine months
ended September 30,
   Percent
Change
 

($ in millions, except per share data)

   2006     2005      2006     2005   

Income Statement Data

              

Net interest income (a)

   $ 719     745    (3 )%   $ 2,154       2,262    (5 )%

Noninterest income

     662     622    6       1,934       1,864    4  

Total revenue (a)

     1,381     1,367    1       4,088       4,126    (1 )

Provision for loan and lease losses

     87     69    26       236       197    20  

Noninterest expense

     767     732    5       2,257       2,164    4  

Net income

     377     395    (5 )     1,123       1,217    (8 )

Common Share Data

              

Earnings per share, basic

   $ .68     .71    (4 )%   $ 2.02       2.19    (8 )%

Earnings per share, diluted

     .68     .71    (4 )     2.01       2.18    (8 )

Cash dividends per common share

     .40     .38    5       1.18       1.08    9  

Book value per share

     17.96     16.93    6         

Dividend payout ratio

     58.8 %   53.5    10       58.7 %     49.5    19  

Financial Ratios

              

Return on average assets

     1.41 %   1.51    (7 )%     1.42 %     1.59    (11 )%

Return on average equity

     15.1     16.6    (9 )     15.5       17.6    (12 )

Average equity as a percent of average assets

     9.33     9.11    2       9.19       9.04    2  

Tangible equity

     7.40     6.84    8         

Net interest margin (a)

     2.99     3.16    (5 )     3.03       3.27    (7 )

Efficiency (a)

     55.5     53.5    4       55.2       52.4    5  

Credit Quality

              

Net losses charged off

   $ 79     64    23 %   $ 219       183    20 %

Net losses charged off as a percent of average loans and leases

     .43 %   .38    13       .41 %     .37    11  

Allowance for loan and lease losses as a percent of loans and leases

     1.04     1.06    (2 )       

Allowance for credit losses as a percent of loans and leases (b)

     1.14     1.16    (2 )       

Nonperforming assets as a percent of loans, leases and other assets, including other real estate owned

     .56     .51    10         

Average Balances

              

Loans and leases, including held for sale

   $ 73,938     68,556    8 %   $ 72,896     $ 66,812    9 %

Total securities and other short-term investments

     21,582     24,915    (13 )     22,309       25,578    (13 )

Total assets

     105,868     103,699    2       105,452       102,501    3  

Transaction deposits

     48,543     47,568    2       48,923       47,591    3  

Core deposits

     59,337     56,298    5       59,257       55,862    6  

Wholesale funding

     33,040     34,615    (5 )     33,022       34,089    (3 )

Shareholders’ equity

     9,878     9,451    5       9,696       9,262    5  

Regulatory Capital Ratios

              

Tier I capital

     8.60 %   8.42    2 %       

Total risk-based capital

     10.56     10.54    —           

Tier I leverage

     8.52     7.93    7         

(a) Amounts presented on a fully taxable equivalent basis.
(b) The allowance for credit losses is the sum of the allowance for loan and lease losses and the reserve for unfunded commitments.

 

3


Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

OVERVIEW

This overview of management’s discussion and analysis highlights selected information in the financial results of the Registrant and may not contain all of the information that is important to you. For a more complete understanding of trends, events, commitments, uncertainties, liquidity, capital resources and critical accounting policies and estimates, you should carefully read this entire document. Each of these items could have an impact on the Registrant’s financial condition and results of operations.

The Registrant is a diversified financial services company headquartered in Cincinnati, Ohio. At September 30, 2006, the Registrant had $105.8 billion in assets, operated 19 affiliates with 1,145 full-service Banking Centers including 115 Bank Mart® locations open seven days a week inside select grocery stores and 2,114 Jeanie® ATMs in Ohio, Kentucky, Indiana, Michigan, Illinois, Florida, Tennessee, West Virginia, Pennsylvania and Missouri. The Registrant reports on five business segments: Commercial Banking, Branch Banking, Consumer Lending, Investment Advisors and Fifth Third Processing Solutions (“FTPS”). During the first quarter of 2006, the Registrant began separating its Retail line of business into the Branch Banking and Consumer Lending business segments. All prior year information has been updated to reflect this presentation.

The Registrant believes that banking is first and foremost a relationship business where the strength of the competition and challenges for growth can vary in every market. Its affiliate operating model provides a competitive advantage by keeping the decisions close to the customer and by emphasizing individual relationships. Through its affiliate operating model, individual managers, from the banking center to the executive level, are given the opportunity to tailor financial solutions for their customers.

The Registrant’s revenues are fairly evenly dependent on net interest income and noninterest income. For the three months ended September 30, 2006, net interest income, on a fully taxable equivalent (“FTE”) basis, and noninterest income provided 52% and 48% of total revenue, respectively. Therefore, changes in interest rates, credit quality, economic trends and the capital markets are primary factors that drive the performance of the Registrant. As discussed later in the Risk Management section, risk identification, measurement, monitoring, control and reporting are important to the management of risk and to the financial performance and capital strength of the Registrant.

Net interest income, which continues to be the Registrant’s largest revenue source, is the difference between interest income earned on assets such as loans, leases and securities, and interest expense paid on liabilities such as deposits and borrowings. Net interest income is affected by the general level of interest rates, the relative level of short- and long-term interest rates, changes in interest rates and changes in the amount and composition of interest-earning assets and interest-bearing liabilities. Generally, the rates of interest the Registrant earns on its assets and owes on its liabilities are established for a period of time. The change in market interest rates over time exposes the Registrant to interest rate risk through potential adverse changes to net interest income and financial position. The Registrant manages this risk by continually analyzing and adjusting the composition of its assets and liabilities based on their payment streams and interest rates, the timing of their maturities and their sensitivity to changes in market interest rates. Additionally, in the ordinary course of business, the Registrant enters into certain derivative transactions as part of its overall strategy to manage its interest rate and prepayment risks.

The Registrant is also exposed to the risk of losses on its loan and lease portfolio as a result of changing expected cash flows caused by loan defaults and inadequate collateral, among other factors.

Noninterest income is derived primarily from electronic funds transfer (“EFT”) and merchant transaction processing fees, card interchange, fiduciary and investment management fees, banking fees and service charges and mortgage banking revenue.

Net interest income, net interest margin, net interest rate spread and the efficiency ratio are presented in Management’s Discussion and Analysis of Financial Condition and Results of Operations on an FTE basis. The FTE basis adjusts for the tax-favored status of income from certain loans and securities held by the Registrant that are not taxable for federal income tax purposes. The Registrant believes this presentation to be the preferred industry measurement of net interest income as it provides a relevant comparison between taxable and non-taxable amounts.

The Registrant’s net income was $377 million in the third quarter of 2006, a five percent decrease compared to $395 million for the same period last year. Earnings per diluted share were $.68 for the third quarter, a four percent decrease from $.71 for the same period last year. The Registrant’s quarterly dividend was $.40 per common share in the third quarter of 2006, a five percent increase over the $.38 dividend in the third quarter of 2005.

Net interest income (FTE) decreased three percent compared to the same period last year. Net interest margin decreased to 2.99% in the third quarter of 2006 from 3.16% in the same period last year and from 3.01% in the second quarter of 2006 largely due to the rise in short-term interest rates, the impact of the primarily fixed-rate securities portfolio and mix shifts within the core deposit base. Noninterest income increased six percent over the same period last year due to continued strong growth in electronic payment processing and corporate banking revenue and an $11 million increase in net securities gain partially offset by a $9 million decline in mortgage banking revenue. Noninterest expense increased five percent over the same quarter last year primarily due to increases in volume-related bankcard expenditures, equipment expenditures and occupancy expense related to the addition of de-novo banking centers and investments in technology, as well as an $11 million debt termination charge.

 

4


Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

 

Credit quality metrics deteriorated slightly in the third quarter of 2006. Net charge-offs as a percent of average loans and leases were .43% in the third quarter of 2006 compared to .37% in the second quarter of 2006 and .38% in the third quarter of 2005. At September 30, 2006, nonperforming assets as a percent of loans and leases increased to .56% from .49% at June 30, 2006 and .51% at September 30, 2005.

The Registrant’s capital ratios exceed the “well-capitalized” guidelines as defined by the Board of Governors of the Federal Reserve System (“FRB”). As of September 30, 2006, the Tier I capital ratio was 8.60% and the total risk-based capital ratio was 10.56%.

The Registrant continues to invest in the geographic areas that offer the best growth prospects, as it believes this investment is the most cost efficient method of expansion within its largest affiliate markets. During the first nine months of 2006, the Registrant opened 40 net new banking centers (excluding relocations and consolidations of existing facilities) with plans to add 10 to 12 new banking centers in high-growth markets during the fourth quarter of 2006.

RECENT ACCOUNTING STANDARDS

Note 2 of the Notes to Condensed Consolidated Financial Statements provides a complete discussion of the new accounting standards adopted by the Registrant during 2006 and 2005 and the expected impact of accounting standards issued but not yet required to be adopted.

CRITICAL ACCOUNTING POLICIES

Allowance for Loan and Lease Losses

The Registrant maintains an allowance to absorb probable loan and lease losses inherent in the portfolio. The allowance is maintained at a level the Registrant considers to be adequate and is based on ongoing quarterly assessments and evaluations of the collectibility and historical loss experience of loans and leases. Credit losses are charged and recoveries are credited to the allowance. Provisions for loan and lease losses are based on the Registrant’s review of the historical credit loss experience and such factors that, in management’s judgment, deserve consideration under existing economic conditions in estimating probable credit losses. In determining the appropriate level of the allowance, the Registrant estimates losses using a range derived from “base” and “conservative” estimates. The Registrant’s strategy for credit risk management includes a combination of conservative exposure limits significantly below legal lending limits and conservative underwriting, documentation and collections standards. The strategy also emphasizes diversification on a geographic, industry and customer level, regular credit examinations and quarterly management reviews of large credit exposures and loans experiencing deterioration of credit quality.

Larger commercial loans that exhibit probable or observed credit weakness are subject to individual review. Where appropriate, allowances are allocated to individual loans based on management’s estimate of the borrower’s ability to repay the loan given the availability of collateral, other sources of cash flow and legal options available to the Registrant. The review of individual loans includes those loans that are impaired as provided in SFAS No. 114, “Accounting by Creditors for Impairment of a Loan.” Any allowances for impaired loans are measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate or the fair value of the underlying collateral. The Registrant evaluates the collectibility of both principal and interest when assessing the need for loss accrual. Historical loss rates are applied to other commercial loans not subject to specific allowance allocations. The loss rates are derived from a migration analysis, which tracks the net charge-off experience sustained on loans according to their internal risk grade. The risk grading system currently utilized for allowance analysis purposes encompasses ten categories. The Registrant also maintains a dual risk rating system that provides for thirteen probability of default grade categories and an additional six grade categories for estimating actual losses given an event of default. The probability of default and estimated loss given default evaluations are not separated in the ten-grade risk rating system. The Registrant is in the process of completing significant validation and testing of the dual risk rating system prior to implementation for allowance analysis purposes. The dual risk rating system is expected to be consistent with Basel II requirements and will allow for more precision in the analysis of commercial credit risk.

Homogenous loans and leases, such as consumer installment, residential mortgage and automobile leases are not individually risk graded. Rather, standard credit scoring systems and delinquency monitoring are used to assess credit risks. Allowances are established for each pool of loans based on the expected net charge-offs for one year. Loss rates are based on the average net charge-off history by loan category.

Historical loss rates for commercial and consumer loans may be adjusted for significant factors that, in management’s judgment, reflect the impact of any current conditions on loss recognition. Factors that management considers in the analysis include the effects of the national and local economies, trends in the nature and volume of loans (delinquencies, charge-offs and nonaccrual loans), changes in mix, credit score migration comparisons, asset quality trends, risk management and loan administration, changes in the internal lending policies and credit standards, collection practices and examination results from bank regulatory agencies and the Registrant’s internal credit examiners.

 

5


Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

 

Regardless of the extent of the evaluation of the previously discussed factors, certain inherent but undetected losses are probable within the loan and lease portfolios. An unallocated component to the allowance is maintained to recognize the imprecision in estimating and measuring loss when evaluating allowances for individual loans or pools of loans. Allowances on individual loans and historical loss rates are reviewed quarterly and adjusted as necessary based on changing borrower and/or collateral conditions and actual collection and charge-off experience.

Loans acquired by the Registrant through a purchase business combination are evaluated for possible credit impairment. Reduction to the carrying value of the acquired loans as a result of credit impairment is recorded as an adjustment to goodwill. The Registrant does not carry over the acquired company’s allowance for loan and lease losses nor does the Registrant add to its existing allowance for the acquired loans as part of purchase accounting.

The Registrant’s determination of the allowance for commercial loans is sensitive to the risk grade it assigns to these loans. In the event that 10% of commercial loans in each risk category would experience a downgrade of one risk category, the allowance for commercial loans would increase by approximately $72 million at September 30, 2006. The Registrant’s determination of the allowance for residential and retail loans is sensitive to changes in estimated loss rates. In the event that estimated loss rates would increase by 10%, the allowance for residential and retail loans would increase by approximately $24 million at September 30, 2006. As several quantitative and qualitative factors are considered in determining the allowance for loan and lease losses, these sensitivity analyses do not necessarily reflect the nature and extent of future changes in the allowance for loan and lease losses. They are intended to provide insights into the impact of adverse changes in risk grades and inherent losses and do not imply any expectation of future deterioration in the risk rating or loss rates. Given current processes employed by the Registrant, management believes the risk grades and inherent loss rates currently assigned are appropriate.

The Registrant’s primary market areas for lending are Ohio, Kentucky, Indiana, Michigan, Illinois, Florida, Tennessee, West Virginia, Pennsylvania and Missouri. When evaluating the adequacy of allowances, consideration is given to this regional geographic concentration and the closely associated effect changing economic conditions have on the Registrant’s customers.

In the current year, the Registrant has not substantively changed any material aspect of its overall approach to determine its allowance for loan and lease losses. There have been no material changes in assumptions or estimation techniques as compared to prior periods that impacted the determination of the current period allowance for loan and lease losses. Based on the procedures discussed above, the Registrant is of the opinion that the allowance of $761 million was adequate, but not excessive, to absorb estimated credit losses associated with the loan and lease portfolio at September 30, 2006.

Valuation of Securities

Securities are classified as held-to-maturity, available-for-sale or trading on the date of purchase. Only those securities classified as held-to-maturity, and which management has both the intent and ability to hold to maturity, are reported at amortized cost. Available-for-sale and trading securities are reported at fair value with unrealized gains and losses, net of related deferred income taxes, included in accumulated other comprehensive income on the Condensed Consolidated Balance Sheets and noninterest income in the Condensed Consolidated Statements of Income, respectively. The fair value of a security is determined based on quoted market prices. If quoted market prices are not available, fair value is determined based on quoted prices of similar instruments. Realized securities gains or losses are reported within noninterest income in the Condensed Consolidated Statements of Income. The cost of securities sold is based on the specific identification method. Available-for-sale and held-to-maturity securities are reviewed quarterly for possible other-than-temporary impairment. The review includes an analysis of the facts and circumstances of each individual investment such as the severity of loss, the length of time the fair value has been below cost, the expectation for that security’s performance, the creditworthiness of the issuer and the Registrant’s intent and ability to hold the security. A decline in value that is considered to be other-than-temporary is recorded as a loss within noninterest income in the Condensed Consolidated Statements of Income. At September 30, 2006, 93% of the unrealized losses in the available-for-sale security portfolio were comprised of securities issued by U.S. Treasury and Government agencies, U.S. Government sponsored agencies and states and political subdivisions as well as agency mortgage-backed securities. The Registrant believes the price movements in these securities are dependent upon the movement in market interest rates. The Registrant also maintains its intent and ability to hold these securities.

Reserve for Unfunded Commitments

The reserve for unfunded commitments is maintained at a level believed by management to be sufficient to absorb estimated probable losses related to unfunded credit facilities. The determination of the adequacy of the reserve is based upon an evaluation of the unfunded credit facilities, including an assessment of historical commitment utilization experience, credit risk grading and credit grade migration. Net adjustments to the reserve for unfunded commitments are included in other noninterest expense.

 

6


Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

 

Taxes

The Registrant estimates income tax expense based on amounts expected to be owed to the various tax jurisdictions in which the Registrant conducts business. On a quarterly basis, management assesses the reasonableness of its effective tax rate based upon its current estimate of the amount and components of net income, tax credits and the applicable statutory tax rates expected for the full year. The estimated income tax expense is recorded in the Condensed Consolidated Statements of Income.

Deferred income tax assets and liabilities are determined using the balance sheet method and are reported in accrued taxes, interest and expenses in the Condensed Consolidated Balance Sheets. Under this method, the net deferred tax asset or liability is based on the tax effects of the differences between the book and tax basis of assets and liabilities and recognizes enacted changes in tax rates and laws. Deferred tax assets are recognized subject to management judgment that realization is more likely than not.

Accrued taxes represent the net estimated amount due or to be received from taxing jurisdictions and are reported in accrued taxes, interest and expenses in the Condensed Consolidated Balance Sheets. The Registrant evaluates and assesses the relative risks and appropriate tax treatment of transactions and filing positions after considering statutes, regulations, judicial precedent and other information and maintains tax accruals consistent with its evaluation of these relative risks and merits. Changes to the estimate of accrued taxes occur periodically due to changes in tax rates, interpretations of tax laws, the status of examinations being conducted by taxing authorities and changes to statutory, judicial and regulatory guidance that impact the relative risks of tax positions. These changes, when they occur, can affect deferred taxes and accrued taxes as well as the current period’s income tax expense and can be significant to the operating results of the Registrant. See Note 2 of the Notes to the Condensed Consolidated Financial Statements for discussion of the recently issued accounting statement, which clarifies the accounting for uncertainty in income taxes. As described in greater detail in Note 9 of the Notes to the Condensed Consolidated Financial Statements, the Internal Revenue Service is currently challenging the Registrant’s tax treatment of certain leasing transactions.

Valuation of Servicing Rights

When the Registrant sells loans through either securitizations or individual loan sales in accordance with its investment policies, it often retains servicing rights. Servicing rights resulting from loan sales are amortized in proportion to and over the period of estimated net servicing revenues. Servicing rights are assessed for impairment monthly, based on fair value, with temporary impairment recognized through a valuation allowance and permanent impairment recognized through a write-off of the servicing asset and related valuation allowance. Key economic assumptions used in measuring any potential impairment of the servicing rights include the prepayment speeds of the underlying loans, the weighted-average life, the discount rate, the weighted-average coupon and the weighted-average default rate, as applicable. The primary risk of material changes to the value of the servicing rights resides in the potential volatility in the economic assumptions used, particularly the prepayment speeds.

The Registrant monitors risk and adjusts its valuation allowance as necessary to adequately reserve for any probable impairment in the portfolio. For purposes of measuring impairment, the servicing rights are stratified based on the financial asset type and interest rates. In addition, the Registrant obtains an independent third-party valuation of mortgage servicing rights (“MSR”) on a quarterly basis. Fees received for servicing loans owned by investors are based on a percentage of the outstanding monthly principal balance of such loans and are included in noninterest income as loan payments are received. Costs of servicing loans are charged to expense as incurred.

The change in the fair value of MSRs at September 30, 2006, due to immediate 10% and 20% adverse changes in the current prepayment assumption would be approximately $23 million and $43 million, respectively, and due to immediate 10% and 20% favorable changes in the current prepayment assumption would be approximately $25 million and $51 million, respectively. The change in the fair value of the MSR portfolio at September 30, 2006, due to immediate 10% and 20% adverse changes in the discount rate assumption would be approximately $18 million and $35 million, respectively, and due to immediate 10% and 20% favorable changes in the discount rate assumption would be approximately $19 million and $40 million, respectively. Sensitivity analysis related to other consumer and commercial servicing rights is not material to the Registrant’s Condensed Consolidated Financial Statements. These sensitivities are hypothetical and should be used with caution. As the figures indicate, change in fair value based on a 10% and 20% variation in assumptions typically cannot be extrapolated because the relationship of the change in assumptions to change in fair value may not be linear. Also, the effect of variation in a particular assumption on the fair value of the retained interests is calculated without changing any other assumption; in reality, changes in one factor may result in changes in another, which might magnify or counteract the sensitivities. Additionally, the effect of the Registrant’s non-qualifying hedging strategy, which is maintained to lessen the impact of changes in value of the MSR portfolio, is excluded from the above analysis.

STATEMENTS OF INCOME ANALYSIS

Net Interest Income

The increases in short-term rates during the second quarter of 2006 negatively impacted the Registrant’s net interest margin in the third quarter. The net interest margin declined to 2.99% from 3.01% in the second quarter and 3.16% in the third quarter of 2005. Net interest income (FTE) was $719 million for the third quarter of 2006, an increase of $3 million compared to the sequential quarter and a decline of $26 million compared to the prior year quarter. In terms of mix between volume and yield, the impact of

 

7


Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

 

changes in interest rates on net interest income (FTE) was a decrease of eight percent from the third quarter of 2005. Given the moderation of short-term rate increases during the third quarter, the Registrant currently expects a stable to slightly improved net interest margin in the fourth quarter with future trends dependent on the timing of any further short-term interest rate changes, the growth and composition of core deposits and loan growth.

Total average earning assets were relatively flat versus the second quarter and increased two percent over the third quarter of 2005. Margin compression was the result of a decrease in net interest spread of 7 basis points (“bp”) compared to the second quarter of 2006 and 40 bp compared to the third quarter 2005. The decrease in net interest spread was the result of higher short-term funding costs and the yield curve continuing to be flat, the impact of the primarily fixed rate security portfolio and a change in mix within core deposits. The average interest rate spread between the 3-month Treasury bill and the 10-year Treasury note compressed from 78 bp in the third quarter of 2005 to 24 bp in the second quarter of 2006 to negative 15 bp in the third quarter of 2006, illustrating the relative pressure between shorter-term and longer-term funding costs and general security portfolio reinvestment opportunities. The decrease in net interest rate spread was partially offset by an increased benefit from free funding of 73 bp in the third quarter of 2006, up 5 bp from the second quarter of 2006 and 23 bp over the third quarter of 2005. The relatively large increase in the benefit of free funding over the third quarter of 2005 was the result of higher funding costs and an improvement in the net free funding position of the Registrant, calculated as the total of noninterest-bearing liabilities and equity less noninterest-earning assets, which increased two percent to $16.8 billion.

The growth in average loans and leases since the third quarter of 2005 outpaced core deposit growth for the same period by $2.3 billion. The funding shortfall was more than offset by a $3.5 billion reduction in the average available-for-sale securities portfolio, as the Registrant continues to use cash flows from its securities portfolio to reduce its reliance on wholesale funding. In the third quarter of 2006, the Registrant sold approximately $726 million from its securities portfolio, which represented nearly all of its position in Federal Home Loan Mortgage Corporation (“FHLMC”) callable debt, in order to manage its credit exposure to certain government-sponsored entities. For the third quarter of 2006, wholesale funding represented 42% of interest-bearing liabilities, down from 45% for the same period in the prior year. In the current interest rate environment, the Registrant expects to continue to use cash flows from its securities portfolio during the remainder of 2006 to fund its loan and lease growth that is in excess of its core deposit growth.

During the third quarter of 2006, the Registrant continued its deposit pricing strategy of moving away from promotional rates and towards highly competitive daily rates. As part of this strategy, the Registrant maintains competitive deposit rates in all of its affiliate markets and across all of its deposit products. Additionally, interest checking balances have continued to migrate into money market, savings and time deposit accounts. During the third quarter of 2006, interest-checking balances were 36% of average interest-bearing core deposits and savings and money market combined to represent 41%, compared to 44% and 36%, respectively, in the third quarter of 2005.

The cost of interest-bearing core deposits was 3.32% in the third quarter of 2006, up from 3.12% in the second quarter of 2006 and 2.24% in the third quarter of 2005. Despite the increasing deposit rates, the relative cost advantage of interest-bearing core deposits compared to wholesale funding increased from 127 bp from the third quarter of 2005 and 188 bp in the second quarter of 2006 to 196 bp in the third quarter of 2006.

Interest income (FTE) from loans and leases increased $277 million, or 27%, compared to the third quarter of 2005. The increase resulted from the growth in average loans and leases of eight percent for the third quarter of 2006 over the comparable period in 2005 as well as a 106 bp increase in average rates. The increase in average loans and leases included growth in commercial loans and leases of 10% and growth in average consumer loans and leases of five percent compared to the third quarter of 2005.

Interest income (FTE) from investment securities and short-term investments decreased $28 million to $243 million for the third quarter of 2006 compared to the same period in 2005 due to the previously mentioned reduction of the investment securities portfolio. The average yield on taxable securities increased by only 17 bp as a result of 84% of the debt securities within the available-for-sale portfolio being fixed-rate securities and the relative stability in longer-term interest rates.

The interest on core deposits increased $143 million, or 60%, in the third quarter of 2006 over the comparable period in 2005 due to increases in short-term interest rates and increasing average balances. Average interest-bearing core deposits increased $3.4 billion, or eight percent, compared to the third quarter of 2005. The Registrant continues to focus on growing its core deposit balances in order to improve the funding mix and improve net interest margin trends. The growth in noninterest-bearing funds and other core deposits is a critical component in the growth of net interest income.

The interest on wholesale funding increased by $132 million, or 43%, in the third quarter over the comparable period in 2005 due to increasing short-term interest rates partially offset by a $1.6 billion decrease in average balances. The Registrant continues to reduce its reliance on wholesale funding by funding loan growth with core deposits and cash flows from its securities portfolio. Included within other short-term borrowings are the Registrant’s customer repo sweep balances, which were $2.5 billion on an average basis for both the three months ended September 30, 2006 and 2005.

 

8


Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

 

TABLE 2: Consolidated Average Balance Sheets and Analysis of Net Interest Income (FTE)

 

For the three months ended

   September 30, 2006     September 30, 2005     Attribution of Change
in Net Interest Income (a)
 

($ in millions)

   Average
Balance
    Revenue/
Cost
  

Average
Yield/

Rate

    Average
Balance
    Revenue/
Cost
  

Average
Yield/

Rate

    Volume    

Yield/

Rate

    Total  

Assets

                    

Interest-earning assets:

                    

Loans and leases (b):

                    

Commercial loans

   $ 20,769     $ 389    7.43 %   $ 18,203     $ 276    6.01 %   $ 42     71     113  

Commercial mortgage

     9,833       181    7.31       9,095       144    6.28       12     25     37  

Commercial construction

     5,913       118    7.90       5,700       91    6.37       4     23     27  

Commercial leases

     3,740       46    4.85       3,537       46    5.14       3     (3 )   —    
                                                              

Subtotal – commercial

     40,255       734    7.23       36,535       557    6.05       61     116     177  

Residential mortgage

     8,967       135    5.97       8,271       114    5.49       10     11     21  

Residential construction

     733       11    5.90       624       9    5.56       1     1     2  

Other consumer loans

     22,729       402    7.04       21,348       320    5.93       21     61     82  

Consumer leases

     1,254       15    4.63       1,778       20    4.54       (6 )   1     (5 )
                                                              

Subtotal – consumer

     33,683       563    6.64       32,021       463    5.73       26     74     100  
                                                              

Total loans and leases

     73,938       1,297    6.96       68,556       1,020    5.90       87     190     277  

Securities:

                    

Taxable

     20,836       231    4.39       24,013       255    4.22       (34 )   10     (24 )

Exempt from income taxes (b)

     587       10    7.29       787       15    7.42       (4 )   (1 )   (5 )

Other short-term investments

     159       2    5.69       115       1    3.49       —       1     1  
                                                              

Total interest-earning assets

     95,520       1,540    6.40       93,471       1,291    5.48       49     200     249  

Cash and due from banks

     2,355            2,742             

Other assets

     8,745            8,207             

Allowance for loan and lease losses

     (752 )          (721 )           
                                

Total assets

   $ 105,868          $ 103,699             
                                

Liabilities

                    

Interest-bearing liabilities:

                    

Interest checking

   $ 16,251     $ 102    2.49 %   $ 18,498     $ 86    1.84 %   $ (11 )   27     16  

Savings

     12,279       95    3.08       9,939       48    1.90       13     34     47  

Money market

     6,371       69    4.30       5,154       37    2.82       10     22     32  

Other time deposits

     10,794       116    4.24       8,730       68    3.14       19     29     48  

Certificates - $100,000 and over

     6,415       81    5.03       4,156       34    3.28       24     23     47  

Foreign office deposits

     3,668       47    5.05       3,925       34    3.41       (2 )   15     13  

Federal funds purchased

     4,546       61    5.33       4,001       35    3.50       5     21     26  

Other short-term borrowings

     4,056       45    4.42       5,619       41    2.92       (13 )   17     4  

Long-term debt

     14,355       205    5.66       16,914       163    3.80       (28 )   70     42  
                                                              

Total interest-bearing liabilities

     78,735       821    4.14       76,936       546    2.82       17     258     275  

Demand deposits

     13,642            13,977             

Other liabilities

     3,613            3,335             
                                

Total liabilities

     95,990            94,248             

Shareholders’ equity

     9,878            9,451             
                                

Total liabilities and shareholders’ equity

   $ 105,868          $ 103,699             
                                

Net interest income margin

     $ 719    2.99 %     $ 745    3.16 %   $ 32     (58 )   (26 )

Net interest rate spread

        2.26          2.66        

Interest-bearing liabilities to interest-earning assets

        82.43          82.31        
                            

(a) Changes in interest not solely due to volume or yield/rate are allocated in proportion to the absolute dollar amount of change in volume and yield/rate.
(b) The net taxable equivalent adjustment amounts included in the above table are $6 million and $8 million for the three months ended September 30, 2006 and 2005, respectively.

 

9


Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

 

TABLE 3: Consolidated Average Balance Sheets and Analysis of Net Interest Income (FTE)

 

For the nine months ended

   September 30, 2006     September 30, 2005     Attribution of Change
in Net Interest Income (a)
 

($ in millions)

   Average
Balance
    Revenue/
Cost
  

Average
Yield/

Rate

    Average
Balance
    Revenue/
Cost
  

Average
Yield/

Rate

    Volume    

Yield/

Rate

    Total  

Assets

                    

Interest-earning assets:

                    

Loans and leases (b):

                    

Commercial loans

   $ 20,160     $ 1,079    7.16 %   $ 18,016     $ 757    5.62 %   $ 98     224     322  

Commercial mortgage

     9,753       516    7.08       8,843       398    6.01       43     75     118  

Commercial construction

     5,987       340    7.58       5,349       237    5.93       31     72     103  

Commercial leases

     3,719       139    5.00       3,456       134    5.17       10     (5 )   5  
                                                              

Subtotal – commercial

     39,619       2,074    7.00       35,664       1,526    5.72       182     366     548  

Residential mortgage

     8,694       384    5.90       8,380       344    5.49       13     27     40  

Residential construction

     725       32    5.93       557       22    5.40       8     2     10  

Other consumer loans

     22,466       1,137    6.77       20,342       872    5.73       97     168     265  

Consumer leases

     1,392       50    4.79       1,869       65    4.62       (17 )   2     (15 )
                                                              

Subtotal – consumer

     33,277       1,603    6.44       31,148       1,303    5.59       101     199     300  
                                                              

Total loans and leases

     72,896       3,677    6.74       66,812       2,829    5.66       283     565     848  

Securities:

                    

Taxable

     21,527       712    4.42       24,569       789    4.30       (100 )   23     (77 )

Exempt from income taxes (b)

     616       34    7.41       819       46    7.35       (12 )   —       (12 )

Other short-term investments

     166       7    5.44       190       3    2.35       —       4     4  
                                                              

Total interest-earning assets

     95,205       4,430    6.22       92,390       3,667    5.31       171     592     763  

Cash and due from banks

     2,528            2,728             

Other assets

     8,467            8,101             

Allowance for loan and lease losses

     (748 )          (718 )           
                                

Total assets

   $ 105,452          $ 102,501             
                                

Liabilities

                    

Interest-bearing liabilities:

                    

Interest checking

   $ 16,955     $ 303    2.39 %   $ 19,240     $ 220    1.53 %   $ (29 )   112     83  

Savings

     11,979       259    2.89       9,660       109    1.51       31     119     150  

Money market

     6,296       188    3.99       4,900       90    2.46       31     67     98  

Other time deposits

     10,334       308    4.00       8,271       182    2.94       51     75     126  

Certificates - $100,000 and over

     5,473       191    4.66       3,883       89    3.05       45     57     102  

Foreign office deposits

     4,032       143    4.73       4,056       89    2.94       (1 )   55     54  

Federal funds purchased

     4,328       160    4.93       4,040       89    2.96       7     64     71  

Short-term bank notes

     —         —      —         332       6    2.60       (3 )   (3 )   (6 )

Other short-term borrowings

     4,540       142    4.18       5,250       102    2.60       (15 )   55     40  

Long-term debt

     14,649       582    5.31       16,528       429    3.47       (53 )   206     153  
                                                              

Total interest-bearing liabilities

     78,586       2,276    3.87       76,160       1,405    2.47       64     807     871  

Demand deposits

     13,693            13,791             

Other liabilities

     3,477            3,288             
                                

Total liabilities

     95,756            93,239             

Shareholders’ equity

     9,696            9,262             
                                

Total liabilities and shareholders’ equity

   $ 105,452          $ 102,501             
                                

Net interest income margin

     $ 2,154    3.03 %     $ 2,262    3.27 %   $ 107     (215 )   (108 )

Net interest rate spread

        2.35          2.84        

Interest-bearing liabilities to interest-earning assets

        82.54          82.43        
                            

(a) Changes in interest not solely due to volume or yield/rate are allocated in proportion to the absolute dollar amount of change in volume and yield/rate.
(b) The net taxable equivalent adjustment amounts included in the above table are $20 million and $24 million for the nine months ended September 30, 2006 and 2005, respectively.

 

10


Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

 

Provision for Loan and Lease Losses

The Registrant provides as an expense an amount for probable loan and lease losses within the loan portfolio that is based on the factors discussed in the Critical Accounting Policies section. The provision is recorded to bring the allowance for loan and lease losses to a level deemed appropriate by the Registrant. Actual credit losses on loans and leases are charged against the allowance for loan and lease losses. The amount of loans actually removed from the Condensed Consolidated Balance Sheets is referred to as charge-offs. Net charge-offs include current period charge-offs less recoveries in the current period on previously charged off assets.

The provision for loan and lease losses increased to $87 million in the third quarter of 2006 compared to $69 million in the same quarter last year. The increase is due to both the increase in net charge-offs from $64 million in the third quarter of 2005 to $79 million and increased loan growth in the third quarter of 2006. The allowance for loan and lease losses as a percent of loans and leases was 1.04% at September 30, 2006 compared to 1.06% at September 30, 2005. Refer to the Credit Risk Management section for further information on the provision for loan and lease losses, net charge-offs and other factors considered by the Registrant in assessing the credit quality of the loan portfolio and the allowance for loan and lease losses.

Noninterest Income

For the three and nine months ended September 30, 2006, noninterest income increased by six percent and four percent, respectively. The components of noninterest income for these periods are as follows:

TABLE 4: Noninterest Income

 

     For the three months
ended September 30,
  

Percent

Change

    For the nine months
ended September 30,
  

Percent

Change

 

($ in millions)

   2006    2005      2006    2005   

Electronic payment processing revenue

   $ 218    190    15 %   $ 626    544    15 %

Service charges on deposits

     134    137    (2 )     395    390    1  

Mortgage banking net revenue

     36    45    (19 )     125    132    (6 )

Investment advisory revenue

     89    89    (1 )     276    271    2  

Corporate banking revenue

     79    71    11       236    207    14  

Other noninterest income

     87    82    6       242    282    (14 )

Securities gains, net

     19    8    128       34    38    (10 )
                                    

Total noninterest income

   $ 662    622    6 %   $ 1,934    1,864    4 %
                                    

During the first quarter of 2006, the Registrant refined its presentation of noninterest income in order to provide more granularity around its revenue streams. The primary result of this refinement was the consolidation of the Registrant’s interest rate derivative sales, international service fees, institutional sales and loan and lease syndication fees into a new income statement line item named corporate banking revenue. Corporate banking revenue increased to $79 million in the third quarter of 2006, up 11% over the comparable period in 2005. The growth in corporate banking revenue was largely attributable to increases in institutional fees and other commercial fees.

Electronic payment processing revenue increased $28 million in the third quarter of 2006 compared to the same period last year. EFT revenue increased $18 million, or 18%, to $118 million, as a result of continued success in attracting financial institution customers as well as an $8 million increase in issuer interchange. Merchant processing revenue increased 11%, to $100 million, compared to the same period in 2005. Growth in the merchant business is expected to increase as national merchant additions announced throughout 2006 are fully realized. The Registrant continues to see significant opportunities in attracting new financial institutional customers and retailers. The Registrant handles electronic processing for approximately 120,000 merchant locations and over 1,600 financial institutions worldwide, including The Kroger Co., Nordstrom, Inc., the Armed Forces Financial Network and, most recently, Federated Department Stores, Inc. and Gregg Appliances, Inc.

Service charges on deposits decreased two percent in the third quarter of 2006 compared to the same period last year. Commercial deposit revenue decreased four percent while consumer deposit revenue remained stable. Despite growth in the number of relationships and overall activity, commercial service charges were negatively impacted compared to the third quarter last year by a 28% increase in earnings credits on commercial customer demand deposit accounts due to the higher interest rate environment. Net new consumer deposit account production increased by over 52% through the third quarter of 2006 compared to the same period last year. Growth in the number of customer deposit account relationships and deposit generation continues to be a primary focus of the Registrant.

 

11


Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

 

Mortgage banking net revenue decreased to $36 million in the third quarter of 2006 from $45 million in the same period last year. Mortgage originations were $2.3 billion and $2.9 billion in the third quarter of 2006 and 2005, respectively. The components of mortgage banking net revenue for the three and nine months ended September 30, 2006 and 2005 are as follows:

TABLE 5: Components of Mortgage Banking Net Revenue

 

     For the three months
ended September 30,
    For the nine months
ended September 30,
 

($ in millions)

   2006     2005     2006     2005  

Origination fees and gains (losses) on loan sales

   $ 21     34     69     95  

Servicing revenue:

        

Servicing fees

     30     28     90     80  

Servicing rights amortization

     (18 )   (21 )   (49 )   (54 )

Net valuation adjustments on servicing rights and free-standing derivatives entered into to economically hedge MSR

     3     4     15     11  
                          

Net servicing revenue

     15     11     56     37  
                          

Mortgage banking net revenue

   $ 36     45     125     132  
                          

Mortgage net servicing revenue increased by $4 million as compared to the same period last year. Net servicing revenue is comprised of gross servicing fees and amortization as well as valuation adjustments on mortgage servicing rights and mark-to-market adjustments on both settled and outstanding free-standing derivative financial instruments. The Registrant’s total residential mortgage loans serviced at September 30, 2006 and 2005 were $36.7 billion and $33.1 billion, respectively, with $27.8 billion and $24.5 billion, respectively, of residential mortgage loans serviced for others.

Net valuation adjustments on servicing rights and free-standing derivatives for the three months ended September 30, 2006 and 2005, were $3 million and $4 million, respectively. Temporary impairment on the MSR portfolio was $3 million compared to a reversal of $27 million during the third quarter of 2005. Servicing rights are deemed impaired when a borrower’s loan rate is distinctly higher than prevailing rates. Impairment on servicing rights is reversed when the prevailing rates return to a level commensurate with the borrower’s loan rate. The Registrant recognized a net gain of $6 million and a net loss of $23 million in the third quarter of 2006 and 2005, respectively, related to changes in fair value and the settlement of free-standing derivatives purchased to economically hedge the MSR portfolio.

The Registrant maintains a non-qualifying hedging strategy to manage a portion of the risk associated with changes in impairment on the MSR portfolio. In the third quarter of 2006, the Registrant primarily used principal only swaps, interest rate swaps and swaptions to hedge the economic risk of the MSR portfolio as they were deemed to be the best available instruments for several reasons. Principal only swaps hedge the mortgage-LIBOR spread because they appreciate in value as a result of tightening spreads. They also provide prepayment protection by increasing in value when prepayment speeds increase, as opposed to MSRs that lose value in a faster prepayment environment. Receive fixed/pay floating interest rate swaps and swaptions increase in value when interest rates do not increase as quickly as expected. As of September 30, 2006 and 2005, the Registrant held a combination of free-standing derivatives, including principal only swaps, swaptions and interest rate swaps with a net positive fair value of $1 million and a net negative fair value of $10 million, respectively, on outstanding notional amounts of $1.9 billion and $3.6 billion, respectively. In addition to the derivative positions used to economically hedge the MSR portfolio, the Registrant began to acquire various securities (primarily principal only strips) during 2005 and 2006 as a component of its non-qualifying hedging strategy. Principal only strips increase in value as prepayment speeds increase, thus providing an economic hedge for the MSR portfolio. As of September 30, 2006, the Registrant’s available-for-sale securities portfolio included $251 million of securities related to the non-qualifying hedging strategy.

Investment advisory revenues were stable in the third quarter of 2006 compared to the same period last year and down eight percent from a seasonally strong second quarter that reflected annually assessed trust and tax related fees. During the third quarter of 2006, the Registrant experienced increased private client and trust fees offset by lower mutual fund revenue. Mutual fund fees were down as the Registrant has continued to evolve toward a more open architectural framework to meet the needs of its customers. The Registrant continues to focus its sales efforts on improving execution in retail brokerage and retail mutual funds and on growing the institutional money management business by improving penetration and cross-sell in its large middle-market commercial customer base. The Registrant is one of the largest money managers in the Midwest and as of September 30, 2006 had over $215 billion in assets under care and $32 billion in assets under management.

 

12


Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

 

The major components of other noninterest income are as follows:

TABLE 6: Components of Other Noninterest Income

 

     For the three months
ended September 30,
   For the nine months
ended September 30,

($ in millions)

   2006    2005    2006    2005

Cardholder fees

   $ 13    12    36    34

Consumer loan and lease fees

     13    9    37    37

Operating lease income

     6    11    20    46

Bank owned life insurance income

     21    23    65    68

Insurance income

     7    8    21    20

Other

     27    19    63    77
                     

Total other noninterest income

   $ 87    82    242    282
                     

Other noninterest income increased by six percent in the third quarter of 2006 compared to the same period last year. The increase reflects net gains totaling $10.5 million from the sale of three branches in rural Indiana and the sale of $23 million of out-of-footprint credit card receivables. The increase was mitigated by the $5 million decrease in operating lease income resulting from the continued runoff in the operating lease portfolio. Operating lease revenues will moderate as automobile leases continue to mature and are offset by originations of commercial operating leases.

Net securities gains totaled $19 million in the third quarter and consisted of a $53 million gain from the sale of the Registrant’s remaining MasterCard, Inc. shares and $34 million of losses on other investment securities.

Noninterest Expense

During the third quarter, the Registrant continued to invest in the expansion of the retail distribution network. The efficiency ratio (noninterest expense divided by the sum of net interest income (FTE) and noninterest income) was 55.5% and 53.5% for the third quarter of 2006 and 2005, respectively. The Registrant continues to focus on efficiency initiatives as part of its core emphasis on operating leverage and views its recent investments in information technology and branch expansion as its platform for future growth and increasing expense efficiency.

With the continued focus on expense control, the Registrant expects growth in noninterest expenses to be consistent with recent trends. Cost savings initiatives will continue to be somewhat mitigated by investments in certain high opportunity markets, as evidenced by the 40 net new banking centers added in the first three quarters and the 10 to 12 net new banking centers expected to be added in the fourth quarter of 2006.

The major components of noninterest expense are as follows:

TABLE 7: Noninterest Expense

 

     For the three months
ended September 30,
  

Percent

Change

   

For the nine months

ended September 30,

  

Percent

Change

 

($ in millions)

   2006    2005      2006    2005   

Salaries, wages and incentives

   $ 288    285    1 %   $ 875    846    3 %

Employee benefits

     74    70    6       230    218    6  

Equipment expense

     34    26    30       90    76    18  

Net occupancy expense

     63    54    16       180    162    11  

Other noninterest expense

     308    297    4       882    862    2  
                                    

Total noninterest expense

   $ 767    732    5 %   $ 2,257    2,164    4 %
                                    

Total noninterest expense increased five percent in the third quarter of 2006 compared to the same period last year and increased one percent compared to the second quarter of 2006. The current quarter expenses reflected an additional $8 million of pension settlement expense, similar to the level experienced in the third quarter of last year, while second quarter expenses included a $9 million charge related to the April 2006 issuance of stock-based awards to retirement-eligible employees. Increases in noninterest expense over the prior year quarter resulted primarily from bankcard volume-related costs, included in other noninterest expense, and the increase in occupancy and equipment expenses offset by a decrease in operating lease expense. Net occupancy expenses increased 16% in the third quarter of 2006 over the same period last year primarily due to the addition of 61 net new banking centers since September 30, 2005.

 

13


Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

 

The major components of other noninterest expense are as follows:

TABLE 8: Components of Other Noninterest Expense

 

     For the three months
ended September 30,
   For the nine months
ended September 30,

($ in millions)

   2006    2005    2006    2005

Marketing and communications

   $ 29    36    95    98

Postal and courier

     12    13    37    37

Bankcard

     82    69    231    195

Loan and lease

     27    25    67    63

Travel

     13    13    39    40

Information technology and operations

     29    30    79    82

Operating lease

     4    8    14    34

Other

     112    103    320    313
                     

Total other noninterest expense

   $ 308    297    882    862
                     

Total other noninterest expense increased by $11 million from the third quarter of 2005 primarily due to an $11 million charge in the third quarter associated with the early extinguishment of debt in the form of a $300 million structured repurchase agreement. Marketing and communications declined primarily due to expenses incurred in the third quarter 2005 associated with increased spending on deposit campaign initiatives. Bankcard expense increased 19% compared to last year due to an increase in the number of merchant and retail customers as well as continued organic growth in debit and credit card usage. The decrease in operating lease expense is attributable to the continued runoff in the operating lease portfolio. The remaining expense captions continue to be well-controlled.

Applicable Income Taxes

The Registrant’s income before income taxes, applicable income tax expense and effective tax rate for each of the periods are as follows:

TABLE 9: Applicable Income Taxes

 

     For the three months
ended September 30,
   For the nine months
ended September 30,

($ in millions)

   2006     2005    2006    2005

Income before income taxes and cumulative effect

   $ 521     558    1,575    1,741

Applicable income taxes

     144     163    456    524

Effective tax rate

     27.6 %   29.2    28.9    30.1

Applicable income tax expense for all periods include the benefit from tax-exempt income, tax-advantaged investments and general business tax credits, partially offset by the effect of nondeductible expenses. Income tax expense for the third quarter of 2006 includes the favorable resolution of certain tax examinations.

Cumulative Effect of Change in Accounting Principle

In the first quarter of 2006, the Registrant recognized a benefit of approximately $4 million, net of $2 million of tax, related to the adoption of SFAS No. 123 (Revised 2004). The benefit recognized relates to the Registrant’s estimate of forfeiture experience to be realized for all unvested stock-based awards outstanding.

BUSINESS SEGMENT REVIEW

The Registrant reports on five business segments: Commercial Banking, Branch Banking, Consumer Lending, Investment Advisors and Processing Solutions. During the first quarter of 2006, the Registrant began reporting its Retail line of business as two business segments, Branch Banking and Consumer Lending. All prior year information has been updated to reflect this presentation. Further detailed financial information on each business segment is included in Note 14 of the Notes to the Condensed Consolidated Financial Statements.

Results of the Registrant’s business segments are presented based on its management structure and management accounting practices. The structure and practices are specific to the Registrant; therefore, the financial results of the Registrant’s business segments are not necessarily comparable with similar information for other financial institutions. The Registrant refines its methodologies from time to time as management accounting practices are improved and businesses change. Revisions to the Registrant’s methodologies are applied on a retroactive basis.

The Registrant manages interest rate risk centrally at the corporate level by employing a funds transfer pricing (“FTP”) methodology. This methodology insulates the business segments from interest rate risk, enabling them to focus on servicing customers through loan originations and deposit taking. The FTP system assigns charge and credit rates to classes of assets and liabilities, respectively, based on expected duration. The Registrant has not changed the conceptual application of FTP during 2005 or 2006. The net impact of the FTP methodology is included in Other/Eliminations.

 

14


Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

 

The financial results of the business segments include allocations for shared services and headquarters expenses. Even with these allocations, the financial results are not necessarily indicative of the business segments’ financial condition and results of operations as if they were to exist as independent entities. Additionally, the business segments form synergies by taking advantage of cross-sell opportunities and when funding operations by accessing the capital markets as a collective unit. Net income by business segment is summarized as follows:

TABLE 10: Business Segment Results

 

     For the three months
ended September 30,
    For the nine months
ended September 30,
 

($ in millions)

   2006     2005     2006     2005  

Commercial Banking

   $ 215     190     611     562  

Branch Banking

     254     204     718     597  

Consumer Lending

     30     34     109     136  

Investment Advisors

     40     27     114     83  

Processing Solutions

     69     27     149     94  

Other/Eliminations

     (231 )   (87 )   (578 )   (255 )
                          

Net income

   $ 377     395     1,123     1,217  
                          

Commercial Banking

Commercial Banking provides a comprehensive range of financial services and products to large and middle-market businesses, governments and professional customers. In addition to the traditional lending and depository offerings, Commercial Banking products and services include, among others, cash management, foreign exchange and international trade finance, derivatives and capital markets services, asset-based lending, real estate finance, public finance, commercial leasing and syndicated finance. The table below contains selected financial data for the Commercial Banking segment.

TABLE 11: Commercial Banking Selected Financial Data

 

     For the three months
ended September 30,
   For the nine months
ended September 30,

($ in millions)

   2006    2005    2006    2005

Income Statement Data

           

Net interest income (FTE)

   $ 391    367    1,146    1,063

Provision for loan and lease losses

     29    26    96    79

Noninterest income:

           

Corporate banking revenue

     75    67    225    200

Service charges on deposits

     35    39    112    115

Other noninterest income

     18    13    43    42

Noninterest expense:

           

Salaries, incentives and benefits

     58    62    180    177

Other noninterest expenses

     128    126    380    352
                     

Income before taxes

     304    272    870    812

Applicable income taxes (a)

     89    82    259    250
                     

Net income

   $ 215    190    611    562
                     

Average Balance Sheet Data

           

Commercial loans

   $ 33,878    30,602    33,245    29,989

Demand deposits

     6,146    6,345    6,107    6,240

Interest checking

     3,881    3,353    3,856    3,004

Savings and money market

     4,987    5,120    5,218    4,768

Certificates over $100,000

     1,964    1,117    1,638    1,042

(a) Includes taxable-equivalent adjustments of $3 million for the three months ended September 30, 2006 and 2005 and $10 million for the nine months ended September 30, 2006 and 2005, respectively.

Net income increased $25 million, or 14%, compared to the third quarter of 2005 as a result of six and eight percent increases in net interest income and noninterest income, respectively. Net interest income increased as a result of growth in loans and leases and total deposits. Average commercial loans and leases increased 11% to $33.9 billion over the third quarter of 2005, with growth occurring across all loan categories. Despite modest growth in average core deposits, average total deposits increased nine percent to $17.5 billion in the third quarter of 2006 from $16.1 billion in 2005. The increase in average total deposits and loans and the related net FTP impact led to a $24 million increase in net interest income compared to the same period last year.

Noninterest income increased eight percent compared to the same quarter last year as corporate banking revenue continued to display solid gains tempered by lower service charges on deposits. Overall, corporate banking revenue increased $8 million, or

 

15


Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

 

12% percent, largely due to growth in nearly all sub-captions. Service charges on deposits decreased $4 million, or eight percent, as a result of lower compensating balances due to increased rates from a year ago. Noninterest expense decreased modestly compared to the third quarter of 2005, as increases in loan and bankcard expense were more than offset by decreases in employee compensation.

Branch Banking

Branch Banking provides a full range of deposit and loan and lease products to individuals and small businesses through 1,145 banking centers. Branch Banking offers depository and loan products, such as checking and savings accounts, home equity lines of credit, credit cards and loans for automobile and other personal financing needs, as well as products designed to meet the specific needs of small businesses, including cash management services. The table below contains selected financial data for the Branch Banking segment.

TABLE 12: Branch Banking Selected Financial Data

 

     For the three months
ended September 30,
   For the nine months
ended September 30,

($ in millions)

   2006    2005    2006    2005

Income Statement Data

           

Net interest income

   $ 489    421    1,417    1,228

Provision for loan and lease losses

     30    27    77    70

Noninterest income:

           

Electronic payment processing

     51    43    144    119

Service charges on deposits

     95    96    273    267

Investment advisory income

     20    22    66    65

Other noninterest income

     36    25    91    83

Noninterest expense:

           

Salaries, incentives and benefits

     113    116    346    343

Net occupancy and equipment expenses

     38    36    114    102

Other noninterest expenses

     119    113    346    326
                     

Income before taxes

     391    315    1,108    921

Applicable income taxes

     137    111    390    324
                     

Net income

   $ 254    204    718    597
                     

Average Balance Sheet Data

           

Consumer loans

   $ 11,434    10,855    11,316    10,546

Commercial loans

     4,308    4,082    4,303    3,920

Demand deposits

     5,555    5,685    5,612    5,626

Interest checking

     10,169    13,001    10,840    13,933

Savings and money market

     11,956    8,827    11,501    8,635

Time deposits

     13,647    10,484    12,689    9,943

Net income increased $50 million, or 24%, compared to the third quarter of 2005 as growth in average deposits led to a 16% increase in net interest income. Total average deposits increased nine percent over the third quarter of 2005 with double-digit increases in average savings, money market and consumer time deposits mitigated by a 22% decrease in average interest checking. As a result of the growth and the related net FTP impact from an increased short-term rate environment, net interest income increased $68 million compared to the same period last year.

Noninterest income increased $16 million, or nine percent, from the third quarter of 2005 as electronic payment processing continued to produce strong increases and the segment realized a gain on the sale of three branches. Electronic payment processing revenue increased $8 million, or 19%, with double-digit increases in interchange fees related to ATMs, debit and credit cards.

Noninterest expense increased modestly compared to the third quarter of 2005 as increases in transaction and net occupancy expense were offset by decreases in employee compensation. The Registrant continues to position itself for sustained long-term growth through new banking center additions in key markets including Nashville, Chicago and Florida.

 

16


Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

 

Consumer Lending

Consumer Lending includes the Registrant’s mortgage and home equity lending activities and other indirect lending activities. Mortgage and home equity lending activities include the origination, retention and servicing of mortgage and home equity loans or lines of credit, sales and securitizations of those loans or pools of loans or lines of credit and all associated hedging activities. Other indirect lending activities include loans to consumers through auto dealers and federal and private student education loans. The table below contains selected financial data for the Consumer Lending segment.

TABLE 13: Consumer Lending Selected Financial Data

 

     For the three months
ended September 30,
   For the nine months
ended September 30,

($ in millions)

   2006    2005    2006    2005

Income Statement Data

           

Net interest income

   $ 98    103    296    313

Provision for loan and lease losses

     24    36    74    77

Noninterest income:

           

Mortgage banking net revenue

     35    43    120    124

Other noninterest income

     15    30    61    103

Noninterest expense:

           

Salaries, incentives and benefits

     25    25    80    72

Other noninterest expenses

     53    63    154    181
                     

Income before taxes

     46    52    169    210

Applicable income taxes

     16    18    60    74
                     

Net income

   $ 30    34    109    136
                     

Average Balance Sheet Data

           

Consumer loans

   $ 20,507    19,471    20,242    18,896
                     

Net income decreased $4 million, or 11%, compared to the third quarter of 2005. Despite average loans and leases increasing five percent, net interest income decreased $5 million versus the prior year largely due to a 18 bp decline in the spread between loan yields and the related FTP charge due to the effects of the flattening yield curve and the increasing competitive nature in this segment. The Registrant is focused on meeting its customers’ varying financial needs by offering new consumer products while maintaining its current credit quality.

The Registrant had mortgage originations of $2.3 billion and $2.9 billion for the three months ended September 30, 2006 and 2005, respectively. As a result of the decrease in originations and the corresponding decrease in gains on sales of mortgages, mortgage banking net revenue decreased $8 million, or 19%. Decreases in other noninterest income and expense were largely a result of the runoff of the consumer automobile lease portfolio as operating lease income and expense decreased from the third quarter of 2005 by $8 million and $6 million, respectively.

 

17


Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

 

Investment Advisors

Investment Advisors provides a full range of investment alternatives for individuals, companies and not-for-profit organizations. The Registrant’s primary services include trust, asset management, retirement plans and custody. Fifth Third Securities, Inc., an indirect wholly-owned subsidiary of the Registrant, offers full-service retail brokerage services to individual clients and broker dealer services to the institutional marketplace. Fifth Third Asset Management, Inc., an indirect wholly-owned subsidiary of the Registrant, provides asset management services and also advises the Registrant’s proprietary family of mutual funds, Fifth Third Funds.* The table below contains selected financial data for the Investment Advisors segment.

TABLE 14: Investment Advisors Selected Financial Data

 

     For the three months
ended September 30,
   For the nine months
ended September 30,

($ in millions)

   2006    2005    2006    2005

Income Statement Data

           

Net interest income

   $ 60    48    172    139

Provision for loan and lease losses

     1    4    4    6

Noninterest income:

           

Investment advisory income

     89    90    277    273

Other noninterest income

     5    4    14    11

Noninterest expense:

           

Salaries, incentives and benefits

     40    43    125    127

Other noninterest expenses

     51    54    158    163
                     

Income before taxes

     62    41    176    127

Applicable income taxes

     22    14    62    44
                     

Net income

   $ 40    27    114    83
                     

Average Balance Sheet Data

           

Loans and leases

   $ 3,071    2,743    3,062    2,609

Core deposits

     4,602    3,822    4,467    3,981

Net income increased $13 million, or 49%, in the third quarter of 2006 compared to the same period last year. This increase was the result of a 26% improvement in net interest income due to loan and deposit growth and the related FTP impact. Average loans and leases increased to $3.1 billion, a 12% increase from the third quarter last year, while average core deposits increased 20% to $4.6 billion. Noninterest income was relatively flat compared to the same quarter last year. Noninterest expense decreased six percent as compared to the same period last year primarily related to a decrease in employee compensation. Employee compensation is expected to increase as the Registrant looks to expand its sales force throughout its footprint, particularly in retail brokerage.

 


* FIFTH THIRD FUNDS® PERFORMANCE DISCLOSURE

Fifth Third Funds investments are: NOT INSURED BY THE FDIC or any other government agency, are not deposits or obligations of, or guaranteed by, any bank, the distributor or of the Funds any of their respective affiliates, and involve investment risks, including the possible loss of the principal amount invested. An investor should consider the fund’s investment objectives, risks and charges and expenses carefully before investing or sending money. The Funds’ prospectus contains this and other important information about the Funds. To obtain a prospectus or any other information about Fifth Third Funds, please call 1-800-282-5706 or visit www.53.com. Please read the prospectus carefully before investing. Fifth Third Funds are distributed by Fifth Third Funds Distributor, Inc., 3435 Stelzer Road, Columbus, Ohio 43219.

 

18


Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

 

Processing Solutions

Fifth Third Processing Solutions provides electronic funds transfer, debit, credit and merchant transaction processing, operates the Jeanie® ATM network and provides other data processing services to affiliated and unaffiliated customers. The table below contains selected financial data for the Processing Solutions segment.

TABLE 15: Processing Solutions Selected Financial Data

 

     For the three months
ended September 30,
   For the nine months
ended September 30,

($ in millions)

   2006    2005    2006    2005

Income Statement Data

           

Net interest income

   $ 10    8    27    25

Provision for loan and lease losses

     3    3    6    9

Noninterest income:

           

Merchant processing

     100    90    284    251

EFT processing

     76    65    221    195

Other noninterest income

     59    3    89    18

Noninterest expense:

           

Salaries, incentives and benefits

     18    14    54    40

Net occupancy and equipment expenses

     4    2    8    4

Transaction processing

     79    65    218    181

Other noninterest expenses

     35    40    105    110
                     

Income before taxes

     106    42    230    145

Applicable income taxes

     37    15    81    51
                     

Net income

   $ 69    27    149    94
                     

Net income increased $42 million and $55 million for the three and nine months ended 2006, respectively. Excluding the securities gains from the sale of the Registrant’s MasterCard, Inc. shares, net income increased 27% and five percent for the three and nine months ended 2006, respectively, as electronic payment processing revenues continued to produce double-digit increases. Merchant and EFT revenues increased by 12% and 16%, respectively, compared to the third quarter of 2005 primarily due to new customer additions and related increased volume.

The strong increase in noninterest income was mitigated by a 13% increase in noninterest expense, which increased due to headcount additions, investment in information technology and transaction processing costs. The 23% increase in transaction processing costs resulted primarily from volume-related costs as merchant transactions processed increased 15% over the third quarter of 2005. The Registrant continues to see significant opportunities to attract new financial institution customers and retailers within this business segment.

Other/Eliminations

Other/Eliminations includes the unallocated portion of the investment portfolio, certain wholesale funding, unassigned equity and certain support activities and other items not attributed to the business segments.

The results of Other/Eliminations were primarily impacted by the increase in wholesale funding rates and the fixed rate nature of the available-for-sale securities portfolio. Interest expense on wholesale funding increased $68 million from the third quarter of 2005. This increase in interest expense resulted from the increase in the average interest rate on wholesale funding, which rose from 3.58% in the third quarter of 2005 to 5.34% in the third quarter of 2006. Interest income from the securities portfolio decreased $32 million from the third quarter of 2005 due to the continued runoff of the securities portfolio in 2005 and 2006.

 

19


Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

 

BALANCE SHEET ANALYSIS

Loans

The table below summarizes the end of period total loans and leases, which includes loans held for sale, by major category:

TABLE 16: Components of Total Loans and Leases (including held for sale)

 

     September 30, 2006     December 31, 2005     September 30, 2005  

($ in millions)

   Balance    Percent
of Total
    Balance    Percent
of Total
    Balance    Percent
of Total
 

Commercial:

               

Commercial loans

   $ 21,150    29 %   $ 19,299    27 %   $ 18,596    27 %

Commercial mortgage

     9,879    13       9,188    13       9,138    13  

Commercial construction

     5,879    8       6,342    9       5,880    8  

Commercial leases

     3,752    5       3,698    5       3,619    5  
                                       

Total commercial loans and leases

     40,660    55       38,527    54       37,233    53  
                                       

Consumer:

               

Residential mortgage

     8,911    12       8,296    12       8,564    12  

Residential construction

     718    1       695    1       649    1  

Credit card

     986    1       866    1       805    1  

Home equity

     12,429    17       12,000    17       11,766    17  

Other consumer loans

     9,473    13       9,250    13       9,236    13  

Consumer leases

     1,175    1       1,595    2       1,738    3  
                                       

Total consumer loans and leases

     33,692    45       32,702    46       32,758    47  
                                       

Total loans and leases

   $ 74,352    100 %   $ 71,229    100 %   $ 69,991    100 %
                                       

Total loans and leases increased six percent over the third quarter of 2005. Total commercial loans and leases increased $3.4 billion, or nine percent, compared to September 30, 2005. The increase in commercial loans and leases was primarily driven by strong growth in commercial and industrial loans which increased 14% over the third quarter of 2005. The mix of commercial loans was consistent with prior periods.

Total consumer loans and leases increased three percent compared to September 30, 2005 as a result of growth in home equity and residential mortgage loans. The Registrant continues to devote significant focus on producing retail loan originations given the attractive yields available in these products. Consumer lease balances decreased 26% from December 31, 2005 and 32% compared to September 30, 2005 largely resulting from continued competition from captive finance companies offering promotional lease rates. Excluding consumer leases, consumer loans increased 11% over September 30, 2005.

The table below summarizes the average total loans and leases by major category:

TABLE 17: Components of Average Total Loans and Leases (including held for sale)

 

     September 30, 2006     December 31, 2005     September 30, 2005  

($ in millions)

   Balance    Percent
of Total
    Balance    Percent
of Total
    Balance    Percent
of Total
 

Commercial:

               

Commercial loans

   $ 20,769    28 %   $ 18,909    27 %   $ 18,203    27 %

Commercial mortgage

     9,833    13       9,159    13       9,095    13  

Commercial construction

     5,913    8       6,051    9       5,700    8  

Commercial leases

     3,740    5       3,611    5       3,537    5  
                                       

Total commercial loans and leases

     40,255    54       37,730    54       36,535    53  

Consumer:

               

Residential mortgage

     8,967    12       8,444    12       8,271    12  

Residential construction

     733    1       673    1       624    1  

Credit card

     979    1       825    1       778    1  

Home equity

     12,366    17       11,884    17       11,702    17  

Other consumer loans

     9,384    13       9,251    13       8,868    13  

Consumer leases

     1,254    2       1,682    2       1,778    3  
                                       

Total consumer loans and leases

     33,683    46       32,759    46       32,021    47  
                                       

Total loans and leases

   $ 73,938    100 %   $ 70,489    100 %   $ 68,556    100 %
                                       

Total portfolio loans and leases (excluding held for sale)

   $ 72,903      $ 69,218      $ 67,539   
                           

 

20


Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

 

Average commercial loans and leases increased $3.7 billion, or 10%, compared to the third quarter of 2005. The Registrant experienced double-digit growth in many of its affiliates, including 18% in the Florida affiliates, 20% in Nashville and 24% in Cleveland.

On an average basis, consumer loans and leases increased $1.7 billion, or five percent, compared to the third quarter of 2005, highlighted by 29% growth in the Florida affiliates and 31% growth in the Nashville affiliate. The growth in average consumer loans and leases was a result of strong growth in each category mitigated by decreases in consumer leases.

Investment Securities

Total investment securities were $20.0 billion, $22.4 billion and $23.0 billion at September 30, 2006, December 31, 2005 and September 30, 2005, respectively. During the third quarter of 2006, decreasing long-term interest rates resulted in a decrease in the net unrealized loss on the available-for-sale securities portfolio from $1.0 billion at June 30, 2006 to $589 million at September 30, 2006. Securities are classified as available-for-sale when, in management’s judgment, they may be sold in response to or in anticipation of changes in market conditions. The Registrant maintains its intent and ability to hold these securities to the earlier of the recovery of the losses or maturity. At September 30, 2006, 93% of the unrealized losses in the available-for-sale security portfolio were comprised of securities issued by U.S. Treasury and Government agencies, U.S. Government sponsored agencies and states and political subdivisions as well as agency mortgage-backed securities. The Registrant believes the price movements in these securities were the result of the movement in market interest rates.

In the third quarter of 2006, the Registrant continued its efforts to reduce the level of available-for-sale securities on the balance sheet by not reinvesting cash flows from the portfolio. Also, in the third quarter of 2006, the Registrant sold $726 million of government agency debentures in order to manage its liquidity and reduce its credit exposure to certain government-sponsored entities as a result of recent market events. On an amortized cost basis, period end available-for-sale securities decreased $2.4 billion since December 31, 2005 and $2.9 billion since September 30, 2005. At September 30, 2006, available-for-sale securities have decreased to 21% of interest-earning assets, compared to 24% and 25% at December 31, 2005 and September 30, 2005, respectively. At September 30, 2006 and 2005, 16% of the debt securities in the available-for-sale portfolio were adjustable-rate instruments, compared to 17% at December 31, 2005. The estimated weighted-average life of the debt securities in the available-for-sale portfolio was 4.1 years at September 30, 2006 compared to 4.3 years at December 31, 2005 and 4.4 years at September 30, 2005.

Information presented in the following table is on a weighted-average life basis anticipating future prepayments. Yield information is presented on an FTE basis and is computed utilizing historical cost balances. Maturity and yield calculations for the total available-for-sale portfolio exclude equity securities that have no stated yield or maturity.

 

21


Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

 

TABLE 18: Characteristics of Available-for-Sale and Other Securities

 

As of September 30, 2006 ($ in millions)

   Amortized Cost    Fair Value    Weighted-
Average Life
(in years)
   Weighted-
Average Yield
 

U.S. Treasury and Government agencies:

           

Average life of one year or less

   $ 2    $ 2    0.4    0.03 %

Average life 1 – 5 years

     4      4    2.5    6.35  

Average life 5 – 10 years

     497      472    6.6    3.71  

Average life greater than 10 years

     —        —      —      —    
                         

Total

     503      478    6.6    3.72  

U.S. Government sponsored agencies:

           

Average life of one year or less

     84      84    0.2    4.86  

Average life 1 – 5 years

     823      801    2.5    3.95  

Average life 5 – 10 years

     152      144    5.5    4.03  

Average life greater than 10 years

     —        —      —      —    
                         

Total

     1,059      1,029    2.7    4.04  

Obligations of states and political subdivisions (a):

           

Average life of one year or less

     78      79    0.5    7.99  

Average life 1 – 5 years

     393      402    3.2    7.29  

Average life 5 – 10 years

     123      127    6.5    7.10 (b)

Average life greater than 10 years

     37      37    11.8    7.84 (b)
                         

Total

     631      645    4.0    7.26  

Agency mortgage-backed securities:

           

Average life of one year or less

     37      37    0.5    6.48  

Average life 1 – 5 years

     11,144      10,783    3.5    4.45  

Average life 5 – 10 years

     3,597      3,449    6.0    4.98  

Average life greater than 10 years

     —        —      —      —    
                         

Total

     14,778      14,269    4.1    4.58  

Other bonds, notes and debentures (c):

           

Average life of one year or less

     21      22    0.5    12.10  

Average life 1 – 5 years

     1,894      1,863    3.1    4.90  

Average life 5 – 10 years

     159      154    7.8    5.48  

Average life greater than 10 years

     68      69    13.1    5.65  
                         

Total

     2,142      2,108    3.8    5.04  

Other securities (d)

     990      985      
                         

Total available-for-sale and other securities

   $ 20,103    $ 19,514    4.1    4.66 %
                         

(a) Taxable-equivalent yield adjustments included in above table are 2.64%, 2.42%, 2.36%, 2.26% and 2.34% for securities with an average life of one year or less, 1-5 years, 5-10 years, greater than 10 years and in total, respectively.
(b) Weighted-average yield excludes $18 million and $35 million of securities with an average life of 5-10 years and greater than 10 years, respectively, related to qualified zone academy bonds whose yields are realized through income tax credits. The weighted-average effective yield of these instruments is 6.77%.
(c) Other bonds, notes and debentures consist of non-agency mortgage backed securities, certain other asset backed securities (primarily automobile and commercial loan backed securities) and corporate bond securities.
(d) Other securities consist of FHLB and Federal Reserve Bank restricted stock holdings that are carried at cost, FHLMC preferred stock holdings, certain mutual fund holdings and equity security holdings.

TABLE 19: Components of Investment Securities (amortized cost basis)

 

($ in millions)

  

September 30,

2006

  

December 31,

2005

  

September 30,

2005

Available-for-sale and other:

        

U.S. Treasury and Government agencies

   $ 503    506    504

U.S. Government sponsored agencies

     1,059    2,034    2,067

Obligations of states and political subdivisions

     631    657    707

Agency mortgage-backed securities

     14,778    16,127    16,280

Other bonds, notes and debentures

     2,142    2,119    2,375

Other securities

     990    1,090    1,060
                

Total available-for-sale and other securities

   $ 20,103    22,533    22,993
                

Held-to-maturity:

        

Obligations of states and political subdivisions

   $ 348    378    320

Other bonds, notes and debentures

     11    11    12
                

Total held-to-maturity

   $ 359    389    332
                

 

22


Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

 

Deposits

The table below summarizes the end of period total deposits by major category:

TABLE 20: Deposits

 

     September 30, 2006     December 31, 2005     September 30, 2005  

($ in millions)

   Balance    Percent
of Total
    Balance    Percent
of Total
    Balance    Percent
of Total
 

Demand

   $ 13,883    20 %   $ 14,609    22 %   $ 14,294    22 %

Interest checking

     15,855    23       18,282    27       18,169    28  

Savings

     12,392    18       11,276    17       10,437    16  

Money market

     6,462    9       6,129    9       5,855    9  
                                       

Transaction deposits

     48,592    70       50,296    75       48,755    75  

Other time

     10,818    17       9,313    14       8,867    13  
                                       

Core deposits

     59,410    87       59,609    89       57,622    88  

Certificates - $100,000 and over

     6,871    10       4,343    6       4,195    6  

Foreign office

     2,362    3       3,482    5       3,678    6  
                                       

Total deposits

   $ 68,643    100 %   $ 67,434    100 %   $ 65,495    100 %
                                       

Deposit balances represent an important source of funding and revenue growth opportunity. The Registrant continues to focus on transaction account deposit growth in its retail and commercial franchises by enhancing its product offering and providing competitive rates. The Registrant’s goal is to continue to grow the core deposit component of its funding profile. At September 30, 2006, core deposits represented 56% of the Registrant’s earning asset funding base, compared to 55% at September 30, 2005.

Total deposits increased five percent compared to September 30, 2005 primarily attributable to double-digit growth in savings, money market and other time deposits. The Registrant continues to realize a mix shift as customers move from lower-yield transaction accounts to higher-yield time deposits. Overall, transaction deposit balances remained stable compared to the third quarter of 2005.

Foreign office deposits represent U.S. dollar denominated deposits of the Registrant’s foreign branch located in the Cayman Islands. The Registrant utilizes these deposits as well as certificates $100,000 and over as a method to fund earning asset growth.

The table below summarizes the average total deposits by major category:

TABLE 21: Average Deposits

 

     September 30, 2006     December 31, 2005     September 30, 2005  

($ in millions)

   Balance    Percent
of Total
    Balance    Percent
of Total
    Balance    Percent
of Total
 

Demand

   $ 13,642    20 %   $ 14,099    21 %   $ 13,977    22 %

Interest checking

     16,251    23       17,828    27       18,498    29  

Savings

     12,279    18       11,036    17       9,939    15  

Money market

     6,371    9       5,974    9       5,154    8  
                                       

Transaction deposits

     48,543    70       48,937    74       47,568    74  

Other time

     10,794    16       9,143    13       8,730    14  
                                       

Core deposits

     59,337    86       58,080    87       56,298    88  

Certificates - $100,000 and over

     6,415    9       4,354    7       4,156    6  

Foreign office

     3,668    5       3,703    6       3,925    6  
                                       

Total deposits

   $ 69,420    100 %   $ 66,137    100 %   $ 64,379    100 %
                                       

On an average basis, core deposits increased five percent compared to the third quarter of 2005 primarily attributed to strong double-digit growth in savings, money market and other time deposits while continuing to change in average core deposit mix. The Registrant experienced double-digit average transaction deposit increases in the Florida affiliates and in the Nashville affiliate largely due to the de-novo expansion in these markets.

 

23


Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

 

Borrowings

Total short-term borrowings were $9.3 billion at September 30, 2006 compared to $9.6 billion at December 31, 2005 and September 30, 2005. Long-term debt decreased seven percent and 14% compared to December 31, 2005 and September 30, 2005, respectively. The Registrant continues to explore additional alternatives regarding the level and cost of various other sources of funding. Refer to the Liquidity Risk Management section for discussion on the Registrant’s liquidity management.

TABLE 22: Borrowings

 

($ in millions)

   September 30,
2006
   December 31,
2005
   September 30,
2005

Federal funds purchased

   $ 5,434    5,323    3,548

Other short-term borrowings

     3,833    4,246    6,075

Long-term debt

     14,170    15,227    16,522
                

Total borrowings

   $ 23,437    24,796    26,145
                

 

24


Quantitative and Qualitative Disclosure about Market Risk (Item 3)

RISK MANAGEMENT – OVERVIEW

Managing risk is an essential component of successfully operating a financial services company. The Registrant’s risk management function is responsible for the identification, measurement, monitoring, control and reporting of risk and avoidance of those risks that are inconsistent with the Registrant’s risk profile. The Enterprise Risk Management division (“ERM”), led by the Registrant’s Chief Risk Officer, ensures consistency in the Registrant’s approach to managing and monitoring risk within the structure of the Registrant’s affiliate operating model. The risks faced by the Registrant include, but are not limited to, credit, market, liquidity, operational and regulatory compliance. In addition, the Internal Audit division provides an independent assessment of the Registrant’s internal control structure and related systems and processes. ERM includes the following key functions:

 

    Risk Policy - ensures consistency in the approach to risk management as the Registrant’s clearinghouse for credit, market and operational risk policies, procedures and guidelines;

 

    Operational Risk Management - responsible for the risk self-assessment process, the change control evaluation process, fraud prevention and detection, and root cause analysis and corrective action plans relating to identified operational losses;

 

    Insurance Risk Management - responsible for all property, casualty and liability insurance policies including the claims administration process for the Registrant;

 

    Capital Markets Risk Management - responsible for establishing and monitoring proprietary trading limits, monitoring liquidity and interest rate risk and utilizing value at risk and earnings at risk models;

 

    Credit Risk Review - responsible for evaluating the sufficiency of underwriting, documentation and approval processes for consumer and commercial credits, counter-party credit risk, the accuracy of risk grades assigned to commercial credit exposures, and appropriate accounting for charge-offs, non-accrual status and specific reserves;

 

    Compliance Risk Management - responsible for oversight of compliance with all banking regulations;

 

    Risk Strategies and Reporting - responsible for quantitative analytics and Board of Directors and senior management reporting on credit, market and operational risk metrics; and

 

    Investment Advisors Risk Management – responsible for trust compliance, fiduciary risk and trading risk in the Investment Advisors line of business.

Designated risk managers have been assigned to the business lines reporting directly to ERM and indirectly to the senior executives within the division or affiliate. Affiliate risk management is handled by regional risk managers who are responsible for multiple affiliates and who report jointly to affiliate presidents and ERM.

Risk management oversight and governance is provided by the Risk and Compliance Committee of the Board of Directors and through multiple management committees whose membership includes a broad cross-section of line of business, affiliate and support representatives. The Risk and Compliance Committee of the Board of Directors consists of three outside directors and has the responsibility for the oversight of credit, market, operational, regulatory compliance and strategic risk management activities for the Registrant, as well as for the Registrant’s overall aggregate risk profile. The Risk and Compliance Committee has approved the formation of key management governance committees that are responsible for evaluating risks and controls. These committees include the Market Risk Committee, the Credit Risk Committee, the Operational Risk Committee and the Executive Asset Liability Risk Committee. There are also new products and initiatives processes applicable to every line of business to ensure an appropriate standard readiness assessment is performed before launching a new product or initiative. Significant risk policies approved by the management governance committees are also reviewed and approved by the Board of Directors’ Risk and Compliance Committee.

CREDIT RISK MANAGEMENT

The objective of the Registrant’s credit risk management strategy is to quantify and manage credit risk exposure on an aggregate portfolio basis, as well as to limit the risk of loss resulting from an individual customer default. The Registrant’s credit risk management strategy is based on three core principles: conservatism, diversification and monitoring. The Registrant believes that effective credit risk management begins with conservative lending practices. These practices include conservative exposure and counterparty limits and conservative underwriting, documentation and collection standards. The Registrant’s credit risk management strategy also emphasizes diversification on a geographic, industry and customer level, regular credit examinations and monthly management reviews of large credit exposures and credits experiencing deterioration of credit quality. Lending officers with the authority to extend credit are delegated specific authority amounts, the utilization of which is closely monitored. Lending activities are largely decentralized, while ERM manages the policy and authority delegation process centrally. The Credit Risk Review function, within ERM, provides objective assessments of the quality of underwriting and documentation, the accuracy of risk grades and the charge-off and reserve analysis process.

The Registrant’s credit review process and overall assessment of required allowances is based on quarterly assessments of the probable estimated losses inherent in the loan and lease portfolio. The Registrant uses these assessments to promptly identify potential problem loans or leases within the portfolio, maintain an adequate allowance and take any necessary charge-offs. In addition to the individual review of larger commercial loans that exhibit probable or observed credit weakness, the commercial credit review process includes the use of two risk grading systems. The risk grading system currently utilized for allowance analysis purposes encompasses ten categories. The Registrant also maintains a dual risk grading system that provides for thirteen

 

25


Quantitative and Qualitative Disclosure about Market Risk (continued)

 

probability of default grade categories and an additional six grade categories for estimating actual losses given an event of default. The probability of default and estimated loss given default evaluations are not separated in the ten-grade risk rating system. The Registrant is in the process of completing significant validation and testing of the dual risk rating system prior to implementation for allowance analysis purposes. The dual risk rating system is expected to be consistent with Basel II expectations and allows for more precision in the analysis of commercial credit risk. Scoring systems and delinquency monitoring are used to assess the credit risk in the Registrant’s homogenous consumer loan portfolios.

Portfolio Diversity

The Registrant’s credit risk management strategy includes minimizing concentrations of risk through diversification. The following table provides breakouts of the commercial loan and lease portfolio, including held for sale, by major industry classification, by loan size and by state, illustrating the diversity and granularity of the Registrant’s portfolio.

TABLE 23: Commercial Loan and Lease Portfolio (a)

 

     2006    2005

As of September 30 ($ in millions)

   Outstanding     Exposure    Nonaccrual    Outstanding    Exposure    Nonaccrual

By industry:

                

Real estate

   $ 10,312