PNC FINANCIAL SERVICES GROUP INC 10-K 2007
Documents found in this filing:
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the fiscal year ended December 31, 2006
Commission file number 001-09718
THE PNC FINANCIAL SERVICES GROUP, INC.
(Exact name of registrant as specified in its charter)
One PNC Plaza
249 Fifth Avenue
Pittsburgh, Pennsylvania 15222-2707
(Address of principal executive offices, including zip code)
Registrants telephone number, including area code - (412) 762-2000
Securities registered pursuant to Section 12(b) of the Act:
Securities registered pursuant to Section 12(g) of the Act:
$1.80 Cumulative Convertible Preferred Stock - Series A, par value $1.00
$1.80 Cumulative Convertible Preferred Stock - Series B, par value $1.00
8.25% Convertible Subordinated Debentures Due 2008
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes X No
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes No X
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 if the disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.
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):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes No X
The aggregate market value of the registrants outstanding voting common stock held by nonaffiliates on June 30, 2006, determined using the per share closing price on that date on the New York Stock Exchange of $70.17, was approximately $20.6 billion. There is no non-voting common equity of the registrant outstanding.
Number of shares of registrants common stock outstanding at February 16, 2007: 293,164,316
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the definitive Proxy Statement of The PNC Financial Services Group, Inc. to be filed pursuant to Regulation 14A for the annual meeting of shareholders to be held on April 24, 2007 (Proxy Statement) are incorporated by reference into Part III of this Form 10-K.
Forward-Looking Statements: From time to time The PNC Financial Services Group, Inc. (PNC or the Corporation) has made and may continue to make written or oral forward-looking statements regarding our outlook or expectations for earnings, revenues, expenses, capital levels, asset quality or other future financial or business performance, strategies or expectations, or the impact of legal, regulatory or supervisory matters on our business operations or performance. This Annual Report on Form 10-K (the Report or Form 10-K) also includes forward-looking statements. With respect to all such forward-looking statements, you should review our Risk Factors discussion in Item 1A and our Cautionary Statement Regarding Forward-Looking Information included in Item 7 of this Report.
ITEM 1 BUSINESS
BUSINESS OVERVIEW We are one of the largest diversified financial services companies in the United States based on assets, with businesses engaged in retail banking, corporate and institutional banking, asset management and global fund processing services. We provide many of our products and services nationally and others in our primary geographic markets located in Pennsylvania; New Jersey; the greater Washington, DC area, including Maryland and Virginia; Ohio; Kentucky; and Delaware. We also provide certain global fund processing services internationally. At December 31, 2006, our consolidated total assets, deposits and shareholders equity were $101.8 billion, $66.3 billion and $10.8 billion, respectively.
We were incorporated under the laws of the Commonwealth of Pennsylvania in 1983 with the consolidation of Pittsburgh National Corporation and Provident National Corporation. Since 1983, we have diversified our geographical presence, business mix and product capabilities through internal growth, strategic bank and non-bank acquisitions and equity investments, and the formation of various non-banking subsidiaries.
On October 8, 2006, we entered into a definitive agreement with Mercantile Bankshares Corporation (Mercantile) for PNC to acquire Mercantile. Mercantile shareholders will be entitled to .4184 shares of PNC common stock and $16.45 in cash for each share of Mercantile, or in the aggregate approximately 53 million shares of PNC common stock and $2.1 billion in cash. Based on PNCs recent stock prices, this transaction is valued at approximately $6.0 billion in the aggregate.
Mercantile is a bank holding company with approximately $18 billion in assets that provides banking and investment and wealth management services through 240 offices in Maryland, Virginia, the District of Columbia, Delaware and southeastern Pennsylvania. The transaction is expected to close in March 2007 and is subject to customary closing conditions, including regulatory approvals.
We acquired Riggs National Corporation (Riggs), a Washington, DC based banking company, effective May 13, 2005. Under the terms of the agreement, Riggs merged into The PNC Financial Services Group, Inc. and PNC Bank, National Association (PNC Bank, N.A.), our principal bank subsidiary, acquired substantially all of the assets of Riggs Bank, N.A., the principal banking subsidiary of Riggs.
We include information on significant recent acquisitions in Note 2 Acquisitions in the Notes To Consolidated Financial Statements in Item 8 of this Report and here by reference.
REVIEW OF LINES OF BUSINESS In addition to the following information relating to our lines of business, we incorporate
information under the captions Line of Business Highlights, Product Revenue, Cross-Border Leases and Related Tax and Accounting Matters, and Business Segments Review in Item 7 of this Report here by reference. Also, we include financial and other information by business in Note 21 Segment Reporting in the Notes To Consolidated Financial Statements in Item 8 of this Report here by reference.
We have four major businesses engaged in providing banking, asset management and global fund processing products and services: Retail Banking; Corporate & Institutional Banking; BlackRock; and PFPC. Assets, revenue and earnings attributable to foreign activities were not material in the periods presented.
Retail Banking provides deposit, lending, brokerage, trust, investment management, and cash management services to approximately 2.5 million consumer and small business customers within our primary geographic area. Our customers are serviced through approximately 850 offices in our branch network, the call center located in Pittsburgh and the Internet www.pncbank.com. The branch network is located primarily in Pennsylvania; New Jersey; the greater Washington, DC area, including Maryland and Virginia; Ohio; Kentucky; and Delaware. Brokerage services are provided through PNC Investments, LLC, and J.J.B. Hilliard, W.L. Lyons, Inc. Retail Banking also serves as investment manager and trustee for employee benefit plans and charitable and endowment assets and provides nondiscretionary defined contribution plan services and investment options through its Vested Interest® product. These services are provided to individuals and corporations primarily within our primary geographic markets.
Our goal is to generate sustainable revenue growth by continuing to increase our customer base. We also seek revenue growth by attempting to sell additional products and services to these customers. In addition, we are focused on optimizing our network of branches by opening and upgrading stand-alone and in-store branches in attractive sites while consolidating or selling branches with less opportunity for growth.
CORPORATE & INSTITUTIONAL BANKING
Corporate & Institutional Banking provides lending, treasury management, and capital markets products and services to mid-sized corporations, government entities and selectively to large corporations. Lending products include secured and unsecured loans, letters of credit and equipment leases. Treasury management services include cash and investment management, receivables management, disbursement services, funds transfer services, information reporting and global trade services. Capital markets-related products and services include foreign exchange, derivatives, loan syndications, mergers and acquisitions advisory and related services to middle-market companies, securities underwriting, and securities sales and trading. Corporate & Institutional Banking also provides
commercial loan servicing, real estate advisory and technology solutions for the commercial real estate finance industry. Corporate & Institutional Banking provides products and services generally within our primary geographic markets, with certain products and services provided nationally.
Corporate & Institutional Banking is focused on becoming a premier provider of financial services in each of the markets it serves. Its value proposition to its customers is driven by providing a broad range of competitive and high quality products and services by a team fully committed to delivering the comprehensive resources of PNC to help each client succeed. Corporate & Institutional Bankings primary goals are to achieve market share growth and enhanced returns by means of expansion and retention of customer relationships and prudent risk and expense management.
BlackRock, Inc. (BlackRock) is one of the largest publicly traded investment management firms in the United States. As of December 31, 2006, BlackRocks assets under management were approximately $1.1 trillion. The firm manages assets on behalf of institutions and individuals worldwide through a variety of fixed income, cash management, equity, and alternative investment separate account and mutual fund products. In addition, BlackRock provides BlackRock Solutions®, risk management, investment system outsourcing, and financial advisory services to institutional investors. The firm has a major presence in key global markets, including the United States, Europe, Asia, Australia and the Middle East. For additional information, please see BlackRocks filings with the SEC, accessible on the SECs website or on the firms website at www.blackrock.com.
On September 29, 2006, Merrill Lynch contributed its investment management business (MLIM) to BlackRock in exchange for 65 million shares of newly issued BlackRock common and preferred stock. Immediately following the closing, PNC continued to own approximately 44 million shares of BlackRock common stock. Accordingly, at December 31, 2006, our ownership interest in BlackRock was approximately 34%. Prior to this transaction, BlackRock had been a majority-owned subsidiary of PNC. See Note 2 Acquisitions in the Notes To Consolidated Financial Statements in Item 8 of this Report for further details regarding the BlackRock/MLIM transaction.
Subsequent to the BlackRock/MLIM transaction, our BlackRock investment continues to be a strategic asset of PNC and a key component of our diversified earnings stream. The ability of BlackRock to grow assets under management is the key driver of increases in its revenue, earnings and, ultimately, shareholder value. BlackRocks strategies for growth in assets under management include a focus on achieving client investment performance objectives in a manner consistent with their risk preferences and delivering excellent client service. The business dedicates significant
resources to attracting and retaining talented professionals and to the ongoing enhancement of its investment technology and operating capabilities to deliver on its strategy.
PFPC is a leading full service provider of processing, technology and business solutions for the global investment industry. Securities services include custody, securities lending, and accounting and administration for funds registered under the 1940 Act and alternative investments. Investor services include transfer agency, managed accounts, subaccounting, and distribution. PFPC serviced $2.2 trillion in total assets and 68 million shareholder accounts as of December 31, 2006 both domestically and internationally through its Ireland and Luxembourg operations.
PFPC focuses technological resources on driving efficiency through streamlining operations and developing flexible systems architecture and client-focused servicing solutions.
SUBSIDIARIES Our corporate legal structure at December 31, 2006 consisted of two subsidiary banks, including their subsidiaries, and approximately 60 active non-bank subsidiaries. PNC Bank, N.A., headquartered in Pittsburgh, Pennsylvania, is our principal bank subsidiary. At December 31, 2006, PNC Bank, N.A. had total consolidated assets representing approximately 89% of our consolidated assets. Our other bank subsidiary is PNC Bank, Delaware. For additional information on our subsidiaries, you may review Exhibit 21 to this Report.
STATISTICAL DISCLOSURE BY BANK HOLDING COMPANIES The following statistical information is included on the indicated pages of this Report and is incorporated herein by reference:
SUPERVISION AND REGULATION
PNC is a bank holding company registered under the Bank Holding Company Act of 1956 as amended (BHC Act) and
a financial holding company under the Gramm-Leach-Bliley Act (GLB Act).
We are subject to numerous governmental regulations, some of which are highlighted below. You should also read Note 4 Regulatory Matters in the Notes To Consolidated Financial Statements in Item 8 of this Report, included here by reference, for additional information regarding our regulatory issues. Applicable laws and regulations restrict permissible activities and investments and require compliance with protections for loan, deposit, brokerage, fiduciary, mutual fund and other customers, among other things. They also restrict our ability to repurchase stock or to receive dividends from bank subsidiaries and impose capital adequacy requirements. The consequences of noncompliance can include substantial monetary and nonmonetary sanctions.
In addition, we are subject to comprehensive examination and supervision by, among other regulatory bodies, the Board of Governors of the Federal Reserve System (Federal Reserve) and the Office of the Comptroller of the Currency (OCC). We are subject to examination by these regulators, which results in examination reports and ratings (which are not publicly available) that can impact the conduct and growth of our businesses. These examinations consider not only compliance with applicable laws and regulations, but also capital levels, asset quality and risk, management ability and performance, earnings, liquidity, and various other factors. An examination downgrade by any of our federal bank regulators potentially can result in the imposition of significant limitations on our activities and growth. These regulatory agencies generally have broad discretion to impose restrictions and limitations on the operations of a regulated entity where the agencies determine, among other things, that such operations are unsafe or unsound, fail to comply with applicable law or are otherwise inconsistent with laws and regulations or with the supervisory policies of these agencies. This supervisory framework could materially impact the conduct, growth and profitability of our operations.
We are also subject to regulation by the Securities and Exchange Commission (SEC) by virtue of our status as a public company and due to the nature of some of our businesses.
As a regulated financial services firm, our relationships and good standing with regulators are of fundamental importance to the continuation and growth of our businesses. The Federal Reserve, OCC, SEC, and other domestic and foreign regulators have broad enforcement powers, and powers to approve, deny, or refuse to act upon our applications or notices to conduct new activities, acquire or divest businesses or assets, or reconfigure existing operations.
Over the last several years, there has been an increasing regulatory focus on compliance with anti-money laundering laws and regulations, resulting in, among other things, several
significant publicly announced enforcement actions. There has also been a heightened focus recently on the protection of confidential customer information.
There are numerous rules governing the regulation of financial services institutions and their holding companies. Accordingly, the following discussion is general in nature and does not purport to be complete or to describe all of the laws and regulations that apply to us.
As a bank holding company and a financial holding company, we are subject to supervision and regular inspection by the Federal Reserve. Our subsidiary banks and their subsidiaries are subject to supervision and examination by applicable federal and state banking agencies, principally the OCC with respect to PNC Bank, N.A. and the Federal Reserve Bank of Cleveland and the Office of the State Bank Commissioner of Delaware with respect to PNC Bank, Delaware.
Notwithstanding PNCs reduced ownership interest in BlackRock and the deconsolidation resulting from the BlackRock/MLIM transaction, BlackRock continues to be subject to the supervision and regulation of the Federal Reserve to the same extent as it was prior to the transaction.
Parent Company Liquidity and Dividends. The principal source of our liquidity at the parent company level is dividends from PNC Bank, N.A. Our subsidiary banks are subject to various federal and state restrictions on their ability to pay dividends to PNC Bancorp, Inc., the direct parent of the subsidiary banks, which in turn may affect the ability of PNC Bancorp, Inc. to pay dividends to PNC at the parent company level. Our subsidiary banks are also subject to federal laws limiting extensions of credit to their parent holding company and non-bank affiliates as discussed in Note 4 Regulatory Matters included in the Notes To Consolidated Financial Statements in Item 8 of this Report, which is incorporated herein by reference. Further information is also available in the Liquidity Risk Management section of Item 7 of this Report.
Under Federal Reserve policy, a bank holding company is expected to act as a source of financial strength to each of its subsidiary banks and to commit resources to support each such bank. Consistent with the source of strength policy for subsidiary banks, the Federal Reserve has stated that, as a matter of prudent banking, a bank holding company generally should not maintain a rate of cash dividends unless its net income available to common shareholders has been sufficient to fully fund the dividends and the prospective rate of earnings retention appears to be consistent with the corporations capital needs, asset quality and overall financial condition. This policy does not currently have a negative impact on PNCs ability to pay dividends at our current level.
Additional Powers Under the GLB Act. The GLB Act permits a qualifying bank holding company to become a financial
holding company and thereby to affiliate with financial companies engaging in a broader range of activities than would otherwise be permitted for a bank holding company. Permitted affiliates include securities underwriters and dealers, insurance companies and companies engaged in other activities that are determined by the Federal Reserve, in consultation with the Secretary of the Treasury, to be financial in nature or incidental thereto or are determined by the Federal Reserve unilaterally to be complementary to financial activities. We became a financial holding company as of March 13, 2000.
The Federal Reserve is the umbrella regulator of a financial holding company, with its operating entities, such as its subsidiary broker-dealers, investment managers, investment companies, insurance companies and banks, also subject to the jurisdiction of various federal and state functional regulators with normal regulatory responsibility for companies in their lines of business.
As subsidiaries of a financial holding company under the GLB Act, our non-bank subsidiaries are allowed to conduct new financial activities or acquire non-bank financial companies with after-the-fact notice to the Federal Reserve. In addition, our non-bank subsidiaries (and any financial subsidiaries of subsidiary banks) are now permitted to engage in certain activities that were not permitted for banks and bank holding companies prior to enactment of the GLB Act, and to engage on less restrictive terms in certain activities that were previously permitted. Among other activities, we currently rely on our status as a financial holding company to conduct mutual fund distribution activities, merchant banking activities, and underwriting and dealing activities.
To continue to qualify for financial holding company status, our subsidiary banks must maintain well capitalized capital ratios, examination ratings of 1 or 2 (on a scale of 1 to 5), and certain other criteria that are incorporated into the definition of well managed under the BHC Act and Federal Reserve rules. If we were to no longer qualify for this status, we could not continue to enjoy the after-the-fact notice process for new non-banking activities and non-banking acquisitions, and would be required promptly to enter into an agreement with the Federal Reserve providing a plan for our subsidiary banks to meet the well capitalized and well managed criteria. The Federal Reserve would have broad authority to limit our activities. Failure to satisfy the criteria within a six-month period could result in a requirement that we conform existing non-banking activities to activities that were permissible prior to the enactment of the GLB Act. If a subsidiary bank failed to maintain a satisfactory or better rating under the Community Reinvestment Act of 1977, as amended (CRA), we could not commence new activities or make new investments in reliance on the GLB Act.
In addition, the GLB Act permits a national bank, such as PNC Bank, N.A., to engage in expanded activities through the
formation of a financial subsidiary. In order to qualify to establish or acquire a financial subsidiary, PNC Bank, N.A. and each of its depository institution affiliates must be well capitalized and well managed and may not have a less than satisfactory CRA rating. A national bank that is one of the largest 50 insured banks in the United States, such as PNC Bank, N.A., must also have issued debt (which, for this purpose, may include the uninsured portion of PNC Bank, N.A.s long-term certificates of deposit) with certain minimum ratings. PNC Bank, N.A. has filed a financial subsidiary certification with the OCC and currently engages in insurance agency activities through a financial subsidiary. PNC Bank, N.A. may also generally engage through a financial subsidiary in any activity that is financial in nature or incidental to a financial activity. Certain activities, however, are impermissible for a financial subsidiary of a national bank, including insurance underwriting, insurance investments, real estate investment or development, and merchant banking.
If one of our subsidiary banks were to fail to meet the well capitalized or well managed and related criteria, PNC Bank, N.A. would be required to enter into an agreement with the OCC to correct the condition. The OCC would have the authority to limit the activities of the bank. If the condition were not corrected within six months or within any additional time granted by the OCC, PNC Bank, N.A. could be required to conform the activities of any of its financial subsidiaries to activities in which a national bank could engage directly. In addition, if the bank or any insured depository institution affiliate receives a less than satisfactory CRA examination rating, PNC Bank, N.A. would not be permitted to engage in any new activities or to make new investments in reliance on the financial subsidiary authority.
Other Federal Reserve and OCC Regulation. The federal banking agencies possess broad powers to take corrective action as deemed appropriate for an insured depository institution and its holding company. The extent of these powers depends upon whether the institution in question is considered well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized or critically undercapitalized. Generally, the smaller an institutions capital base in relation to its total assets, the greater the scope and severity of the agencies powers, ultimately permitting the agencies to appoint a receiver for the institution. Business activities may also be influenced by an institutions capital classification. For instance, only a well capitalized depository institution may accept brokered deposits without prior regulatory approval and an adequately capitalized depository institution may accept brokered deposits only with prior regulatory approval. At December 31, 2006 and December 31, 2005, both of our subsidiary banks exceeded the required ratios for classification as well capitalized. For additional discussion of capital adequacy requirements, we refer you to Capital And Funding Sources in the Consolidated Balance Sheet Review section of Item 7 of this Report and to Note 4 Regulatory Matters included in the
Notes To Consolidated Financial Statements in Item 8 of this Report.
Laws and regulations limit the scope of our permitted activities and investments. In addition to the activities that would be permitted a financial subsidiary, national banks (such as PNC Bank, N.A.) and their operating subsidiaries may engage in any activities that are determined by the OCC to be part of or incidental to the business of banking.
Moreover, examination ratings of 3 or lower, lower capital ratios than peer group institutions, regulatory concerns regarding management, controls, assets, operations or other factors, can all potentially result in practical limitations on the ability of a bank or bank holding company to engage in new activities, grow, acquire new businesses, repurchase its stock or pay dividends, or to continue to conduct existing activities.
The Federal Reserves prior approval is required whenever we propose to acquire all or substantially all of the assets of any bank or thrift, to acquire direct or indirect ownership or control of more than 5% of the voting shares of any bank or thrift, or to merge or consolidate with any other bank holding company or thrift holding company. When reviewing bank acquisition applications for approval, the Federal Reserve considers, among other things, each subsidiary banks record in meeting the credit needs of the communities it serves in accordance with the CRA. Our ability to grow through acquisitions could be limited by these approval requirements.
At December 31, 2006, both of our bank subsidiaries, PNC Bank, N.A. and PNC Bank, Delaware, were rated outstanding with respect to CRA.
FDIC Insurance. Both of our subsidiary banks are insured by the FDIC and subject to premium assessments. Regulatory matters could increase the cost of FDIC deposit insurance premiums to an insured bank. Since 1996, the FDIC had not assessed banks in the most favorable capital and assessment risk classification categories for insurance premiums for most deposits, due to the favorable ratio of the assets in the FDICs deposit insurance funds to the aggregate level of insured deposits outstanding. This resulted in significant cost savings to all insured banks. Deposit insurance premiums are assessed as a percentage of the deposits of the insured institution.
Beginning January 1, 2007, the FDIC reinstituted the assessment premiums for all deposits, which could impose a significant cost to all insured banks, including our subsidiary banks, reducing the net spread between deposit and other bank funding costs and the earnings from assets and services of the bank, and thus the net income of the bank. Because of a one-time assessment credit based on deposit premiums that the subsidiary banks of PNC had paid prior to 1996, the deposit insurance assessment for PNCs subsidiary banks should be substantially offset for at least the next two years.
FDIC deposit insurance premiums are risk based; therefore, higher fee percentages would be charged to banks that have lower capital ratios or higher risk profiles. These risk profiles take into account weaknesses that are found by the primary banking regulator through its examination and supervision of the bank. A negative evaluation by the FDIC or a banks primary federal banking regulator could increase the costs to a bank and result in an aggregate cost of deposit funds higher than that of competing banks in a lower risk category.
Our subsidiary banks are subject to cross-guarantee provisions under federal law that provide that if one of these banks fails or requires FDIC assistance, the FDIC may assess a commonly-controlled bank for the estimated losses suffered by the FDIC. Such liability could have a material adverse effect on our financial condition or that of the assessed bank. While the FDICs claim is junior to the claims of depositors, holders of secured liabilities, general creditors and subordinated creditors, it is superior to the claims of the banks shareholders and affiliates, including PNC and intermediate bank holding companies.
SECURITIES AND RELATED REGULATION
The SEC, together with either the OCC or the Federal Reserve, regulates our registered broker-dealer subsidiaries. These subsidiaries are also subject to rules and regulations promulgated by the National Association of Securities Dealers, Inc. (NASD), among others. Hilliard Lyons is also a member of the New York Stock Exchange and subject to its regulations and supervision.
Several of our subsidiaries are registered with the SEC as investment advisers and, therefore, are subject to the requirements of the Investment Advisers Act of 1940 and the SECs regulations thereunder. The principal purpose of the regulations applicable to investment advisers is the protection of clients and the securities markets, rather than the protection of creditors and shareholders of investment advisors. The regulations applicable to investment advisers cover all aspects of the investment advisory business, including limitations on the ability of investment advisers to charge performance-based or non-refundable fees to clients; record-keeping; operational, marketing and reporting requirements; disclosure requirements; limitations on principal transactions between an adviser or its affiliates and advisory clients; as well as general anti-fraud prohibitions. These investment advisory subsidiaries also may be subject to state securities laws and regulations. In addition, our investment advisory subsidiaries that are investment advisors to registered investment companies and other managed accounts are subject to the requirements of the Investment Company Act of 1940, as amended, and the SECs regulations thereunder. PFPC is subject to regulation by the SEC as a service provider to registered investment companies.
Additional legislation, changes in rules promulgated by the SEC, other federal and state regulatory authorities and self-
regulatory organizations, or changes in the interpretation or enforcement of existing laws and rules may directly affect the method of operation and profitability of investment advisers. The profitability of investment advisers could also be affected by rules and regulations that impact the business and financial communities in general, including changes to the laws governing taxation, antitrust regulation and electronic commerce.
Recently, the SEC and other governmental agencies have been investigating the mutual fund industry, including its service providers. The SEC has adopted and proposed various rules, and legislation has been introduced in Congress, intended to reform the regulation of this industry. The effect of regulatory reform has, and is likely to continue to, increase the extent of regulation of the mutual fund industry and impose additional compliance obligations and costs on our subsidiaries involved with that industry.
Under various provisions of the federal securities laws (including in particular those applicable to broker-dealers, investment advisers and registered investment companies and their service providers), a determination by a court or regulatory agency that certain violations have occurred at a company or its affiliates can result in fines, a limitation of permitted activities, disqualification to continue to conduct certain activities and an inability to rely on certain favorable exemptions. Certain types of infractions and violations can also affect a public company in its timing and ability to expeditiously issue new securities into the capital markets. In addition, expansion of activities of a broker-dealer generally requires approval of the New York Stock Exchange and/or NASD, and regulators may take into account a variety of considerations in acting upon such applications, including internal controls, capital, management experience and quality, and supervisory concerns.
BlackRock has subsidiaries in securities and related businesses subject to SEC and NASD regulation, as described above. For additional information about the regulation of BlackRock, we refer you to the discussion under the Regulation section of Item 1 Business in BlackRocks most recent Annual Report on Form 10-K, which may be obtained electronically at the SECs website at www.sec.gov.
COMPETITION We are subject to intense competition from various financial institutions and from non-bank entities that engage in similar activities without being subject to bank regulatory supervision and restrictions.
In making loans, our subsidiary banks compete with traditional banking institutions as well as consumer finance companies, leasing companies and other non-bank lenders, and institutional investors including CLO managers, hedge funds, mutual fund complexes and private equity firms. Loan pricing, structure and credit standards are under competitive pressure as lenders seek to deploy capital and a broader range
of borrowers have access to capital markets. Traditional deposit activities are subject to pricing pressures and customer migration as a result of intense competition for consumer investment dollars.
Our subsidiary banks compete for deposits with the following:
Our various non-bank businesses engaged in investment banking and private equity activities compete with the following:
In providing asset management services, our businesses compete with the following:
The fund servicing business is also highly competitive, with a relatively small number of providers. Merger, acquisition and consolidation activity in the financial services industry has also impacted the number of existing or potential fund servicing clients and has intensified competition.
We include here by reference the additional information regarding competition included in the Item 1A Risk Factors section of this Report.
EMPLOYEES Period-end employees totaled 23,783 at December 31, 2006 (comprised of 21,455 full-time and 2,328 part-time employees).
SEC REPORTS AND CORPORATE GOVERNANCE INFORMATION
We are subject to the informational requirements of the Securities Exchange Act of 1934, as amended (Exchange Act), and, in accordance with the Exchange Act, we file annual, quarterly and current reports, proxy statements, and other information with the SEC. Our SEC File Number is 001-09718. You may read and copy this information at the SECs Public Reference Room located at 100 F Street NE, Room 1580, Washington, D.C. 20549. You can obtain
information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330.
You can also obtain copies of this information by mail from the Public Reference Section of the SEC, 100F Street, N.E., Washington, D.C. 20549, at prescribed rates.
The SEC also maintains an internet World Wide Web site that contains reports, proxy and information statements, and other information about issuers, like us, who file electronically with the SEC. The address of that site is www.sec.gov. You can also inspect reports, proxy statements and other information about us at the offices of The New York Stock Exchange, 20 Broad Street, New York, New York 10005.
We also make our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to those reports filed or furnished to the SEC pursuant to Section 13(a) or 15(d) of the Exchange Act available free of charge on or through our internet website as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC. PNCs corporate internet address is www.pnc.com and you can find this information under About PNC Investor Relations Financial Information SEC filings Form 10-K. Shareholders and bondholders may also obtain copies of these filings without charge by contacting Shareholder Services at 800-982-7652 or via e-mail at firstname.lastname@example.org for copies without exhibits, or by contacting Shareholder Relations at (800) 843-2206 or via e-mail at email@example.com for copies of exhibits. We filed the certifications of our Chairman and Chief Executive Officer and our Chief Financial Officer required pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 with respect to our Annual Report on Form 10-K for 2005 with the SEC as exhibits to that Report and have filed the CEO and CFO certifications required by Section 302 of that Act with respect to this Form 10-K as exhibits to this Report.
Information about our Board and its committees and corporate governance at PNC is available on PNCs corporate website at www.pnc.com under About PNC Investor Relations Corporate Governance. Shareholders who would like to request printed copies of the PNC Code of Business Conduct and Ethics or our Corporate Governance Guidelines or the charters of our Boards Audit, Nominating and Governance, or Personnel and Compensation Committees (all of which are posted on the PNC corporate website) may do so by sending their requests to George P. Long, III, Corporate Secretary, at corporate headquarters at One PNC Plaza, 249 Fifth Avenue, Pittsburgh, Pennsylvania 15222-2707. Copies will be provided without charge to shareholders.
Our common stock is listed on the New York Stock Exchange (NYSE) under the symbol PNC. Our Chairman and Chief Executive Officer submitted the required annual CEOs Certification regarding the NYSEs corporate governance
listing standards (a Section 12(a) CEO Certification) to the NYSE within 30 days after our 2006 annual shareholders meeting.
ITEM 1A RISK FACTORS
We are subject to a number of risks potentially impacting our business, financial condition, results of operations and cash flows. Indeed, as a financial services organization, certain elements of risk are inherent in every one of our transactions and are presented by every business decision we make. Thus, we encounter risk as part of the normal course of our business, and we design risk management processes to help manage these risks.
There are risks that are known to exist at the outset of a transaction. For example, every loan transaction presents credit risk (the risk that the borrower may not perform in accordance with contractual terms) and interest rate risk (a potential loss in earnings or economic value due to adverse movement in market interest rates or credit spreads), with the nature and extent of these risks principally depending on the identity of the borrower and overall economic conditions. These risks are inherent in every loan transaction; if we wish to make loans, we must manage these risks through the terms and structure of the loans and through management of our deposits and other funding sources. The success of our business is dependent on our ability to identify, understand and manage the risks presented by our business activities so that we can balance appropriately revenue generation and profitability with these inherent risks. We discuss our principal risk management processes and, in appropriate places, related historical performance in the Risk Management section included in Item 7 of this Report.
The following are the key risk factors that affect us. These risk factors are also discussed further in other parts of this Report.
A sustained weakness or weakening in business and economic conditions generally or specifically in the principal markets in which we do business could adversely affect our business and operating results.
PNCs business could be adversely affected to the extent that weaknesses in business and economic conditions have direct or indirect impacts on us or on our customers and counterparties. These conditions could lead, for example, to one or more of the following:
Although many of our businesses are national and some are international in scope, our retail banking business is concentrated within our retail branch network footprint (Delaware, Indiana, Kentucky, New Jersey, Ohio, Pennsylvania, and the greater Washington, D.C. area, including Maryland and Virginia), and thus that business is particularly vulnerable to adverse changes in economic conditions in these regions.
Changes in interest rates or in valuations in the debt or equity markets could directly impact our assets and liabilities and our performance.
Given our business mix, our traditional banking activities of gathering deposits and extending loans, and the fact that most of our assets and liabilities are financial in nature, we tend to be particularly sensitive to market interest rate movement and the performance of the financial markets. In addition to the impact on the economy generally, with some of the potential effects outlined above, changes in interest rates, in the shape of the yield curve, or in valuations in the debt or equity markets could directly impact us in one or more of the following ways:
As a result of the high percentage of our assets and liabilities that are in the form of interest-bearing instruments, the monetary, tax and other policies of the government and its agencies, including the Federal Reserve, which have a significant impact on interest rates and overall financial market performance, can affect the activities and results of
operations of bank holding companies and their subsidiaries, such as PNC and our subsidiaries. An important function of the Federal Reserve is to regulate the national supply of bank credit and market interest rates. The actions of the Federal Reserve influence the rates of interest that we charge on loans and that we pay on borrowings and interest-bearing deposits and can also affect the value of our on-balance sheet and off-balance sheet financial instruments. Both due to the impact on rates and by controlling access to direct funding from the Federal Reserve Banks, the Federal Reserves policies also influence, to a significant extent, our cost of funding. We cannot predict the nature or timing of future changes in monetary, tax and other policies or the effect that they may have on our activities and results of operations.
We operate in a highly competitive environment, both in terms of the products and services we offer, the geographic markets in which we conduct business, as well as our labor markets and competition for talented employees. Competition could adversely impact our customer acquisition, growth and retention, as well as our credit spreads and product pricing, causing us to lose market share and deposits and revenues.
We are subject to intense competition from various financial institutions and from non-bank entities that engage in similar activities without being subject to bank regulatory supervision and restrictions. This competition is described in Item 1 under Competition.
In all, the principal bases for competition are pricing (including the interest rates charged on loans or paid on interest-bearing deposits), structure, the range of products and services offered, and the quality of customer service (including convenience and responsiveness to customer needs and concerns). The ability to access and use technology is an increasingly important competitive factor in the financial services industry. Technology is important not only with respect to delivery of financial services but also in processing information. Each of our businesses consistently must make significant technological investments to remain competitive.
A failure to address adequately the competitive pressures we face could make it harder for us to attract and retain customers across our businesses. On the other hand, meeting these competitive pressures could require us to incur significant additional expenses or to accept risk beyond what we would otherwise view as desirable under the circumstances. In addition, in our interest sensitive businesses, pressures to increase rates on deposits or decrease rates on loans could reduce our net interest margin with a resulting negative impact on our net interest income. Any of these results would likely have an adverse effect on our overall financial performance.
We grow our business in part by acquiring from time to time other financial services companies, and these acquisitions present us with a number of risks and uncertainties related both to the acquisition transactions themselves and to the integration of the acquired businesses into PNC after closing.
Acquisitions of other financial services companies also present risks to PNC other than those presented by the nature of the business acquired. In particular, acquisitions may be substantially more expensive to complete (including costs incurred in connection with the integration of the acquired company) and the anticipated benefits (including anticipated cost savings and strategic gains) may be significantly harder or take longer to achieve than expected. In some cases, acquisitions involve our entry into new businesses or new geographic or other markets, and these situations also present risks resulting from our inexperience in these new areas. As a regulated financial institution, our pursuit of attractive acquisition opportunities could be negatively impacted due to regulatory delays or other regulatory issues. Regulatory and/or legal issues relating to the pre-acquisition operations of an acquired business may cause reputational harm to PNC following the acquisition and integration of the acquired business into ours and may result in additional future costs and expenses arising as a result of those issues.
Our pending acquisition of Mercantile presents many of the risks and uncertainties related to acquisition transactions themselves and to the integration of the acquired businesses into PNC after closing described above.
The performance of our asset management businesses may be adversely affected by the relative performance of our products compared with alternative investments.
Asset management revenue is primarily based on a percentage of the value of assets under management and, in some cases, performance fees, in most cases expressed as a percentage of the returns realized on assets under management, and thus is impacted by general changes in capital markets valuations and customer preferences. In addition, investment performance is an important factor influencing the level of assets under management. Poor investment performance could impair revenue and growth as existing clients might withdraw funds in favor of better performing products. Also, performance fees could be lower or nonexistent. Additionally, the ability to attract funds from existing and new clients might diminish.
The performance of our fund servicing business may be adversely affected by changes in investor preferences, or changes in existing or potential fund servicing clients or alternative providers.
Fund servicing fees are primarily derived from the market value of the assets and the number of shareholder accounts that we administer for our clients. The performance of our
fund processing business is thus partially dependent on the underlying performance of its fund clients and, in particular, their ability to attract and retain customers. Changes in interest rates or a sustained weakness, weakening or volatility in the debt and equity markets could (in addition to affecting directly the value of assets administered as discussed above) influence an investors decision to invest or maintain an investment in a particular mutual fund or other pooled investment product. Other factors beyond our control may impact the ability of our fund clients to attract or retain customers or customer funds, including changes in preferences as to certain investment styles. Further, to the extent that our fund clients businesses are adversely affected by ongoing governmental investigations into the practices of the mutual and hedge fund industries, our fund processing business results also could be adversely impacted. As a result of these types of factors, fluctuations may occur in the level or value of assets for which we provide processing services. In addition, this regulatory and business environment is likely to continue to result in operating margin pressure for our various services.
As a regulated financial services firm, we are subject to numerous governmental regulations and to comprehensive examination and supervision by regulators, which affects our business as well as our competitive position.
PNC is a bank and financial holding company and is subject to numerous governmental regulations involving both its business and organization. Our businesses are subject to regulation by multiple bank regulatory bodies as well as multiple securities industry regulators. Applicable laws and regulations restrict our ability to repurchase stock or to receive dividends from bank subsidiaries and impose capital adequacy requirements. They also restrict permissible activities and investments and require compliance with protections for loan, deposit, brokerage, fiduciary, mutual fund and other customers, and for the protection of customer information, among other things. The consequences of noncompliance can include substantial monetary and nonmonetary sanctions as well as damage to our reputation and business.
In addition, we are subject to comprehensive examination and supervision by banking and other regulatory bodies. Examination reports and ratings (which often are not publicly available) and other aspects of this supervisory framework can materially impact the conduct, growth, and profitability of our businesses.
We discuss these and other regulatory issues applicable to PNC in the Supervision and Regulation section included in Item 1 of this Report and in Note 4 Regulatory Matters in the Notes To Consolidated Financial Statements in Item 8 of this Report and here by reference.
Over the last several years, there has been an increasing regulatory focus on compliance with anti-money laundering laws and regulations, resulting in, among other things, several
significant publicly-announced enforcement actions. There has also been a heightened focus recently, by customers and the media as well as by regulators, on the protection of confidential customer information. A failure to have adequate procedures to comply with anti-money laundering laws and regulations or to protect the confidentiality of customer information could expose us to damages, fines and regulatory penalties, which could be significant, and could also injure our reputation with customers and others with whom we do business.
We must comply with generally accepted accounting principles established by the Financial Accounting Standards Board, rules set forth by the SEC, income tax regulations established by the Department of the Treasury, and revenue rulings and other guidance issued by the Internal Revenue Service, which affect our financial condition and results of operations.
Changes in accounting standards, or interpretations of those standards, can impact our revenue recognition and expense policies and affect our estimation methods used to prepare the consolidated financial statements. Changes in income tax regulations, revenue rulings, revenue procedures, and other guidance can impact our tax liability and alter the timing of cash flows associated with tax deductions and payments. New guidance often dictates how changes to standards and regulations are to be presented in our consolidated financial statements, as either an adjustment to beginning retained earnings for the period or as income or expense in current period earnings. Certain changes may also be required to be applied retrospectively.
Our business and financial performance could be adversely affected, directly or indirectly, by natural disasters, by terrorist activities or by international hostilities.
The impact of natural disasters, terrorist activities and international hostilities cannot be predicted with respect to severity or duration. However, any of these could impact us directly (for example, by causing significant damage to our facilities or preventing us from conducting our business in the ordinary course), or could impact us indirectly through a direct impact on our borrowers, depositors, other customers, suppliers or other counterparties. We could also suffer adverse consequences to the extent that natural disasters, terrorist activities or international hostilities affect the economy and financial and capital markets generally. These types of impacts could lead, for example, to an increase in delinquencies, bankruptcies or defaults that could result in our experiencing higher levels of nonperforming assets, net charge-offs and provisions for credit losses.
Our ability to mitigate the adverse consequences of such occurrences is in part dependent on the quality of our resiliency planning, including our ability to anticipate the
nature of any such event that occurs. The adverse impact of natural disasters or terrorist activities or international hostilities also could be increased to the extent that there is a lack of preparedness on the part of national or regional emergency responders or on the part of other organizations and businesses that we deal with, particularly those that we depend upon.
ITEM 1B UNRESOLVED STAFF COMMENTS
There are no SEC staff comments regarding PNCs periodic or current reports under the Exchange Act that are pending resolution.
ITEM 2 PROPERTIES
Our executive and administrative offices are located at One PNC Plaza, Pittsburgh, Pennsylvania. The thirty-story structure is owned by PNC Bank, N. A. We occupy the entire building. In addition, PNC Bank, N.A. owns a thirty-four story structure adjacent to One PNC Plaza, known as Two PNC Plaza, that houses additional office space.
We own or lease numerous other premises for use in conducting business activities. We consider the facilities owned or occupied under lease by our subsidiaries to be adequate. We include here by reference the additional information regarding our properties in Note 10 Premises, Equipment and Leasehold Improvements in the Notes To Consolidated Financial Statements in Item 8 of this Report.
ITEM 3 LEGAL PROCEEDINGS
Some of our subsidiaries are defendants (or have potential contractual contribution obligations to other defendants) in several pending lawsuits brought during late 2002 and 2003 arising out of the bankruptcy of Adelphia Communications Corporation and its subsidiaries. There also are threatened additional proceedings arising out of the same matters. One of the lawsuits was brought on Adelphias behalf by the unsecured creditors committee and equity committee in Adelphias consolidated bankruptcy proceeding and was removed to the United States District Court for the Southern District of New York by order dated February 9, 2006. The other lawsuits, one of which is a putative consolidated class action, were brought by holders of debt and equity securities of Adelphia and have been consolidated for pretrial purposes in that district court. These lawsuits arise out of lending and securities underwriting activities engaged in by these PNC subsidiaries together with other financial services companies. In the aggregate, more than 400 other financial services companies and numerous other companies and individuals have been named as defendants in one or more of the lawsuits. Collectively, with respect to some or all of the defendants, the lawsuits allege federal law claims, including violations of federal securities and other federal laws, violations of common law duties, aiding and abetting such violations, voidable preference payments, and fraudulent transfers, among other matters. The lawsuits seek unquantified
monetary damages, interest, attorneys fees and other expenses, and a return of the alleged voidable preference and fraudulent transfer payments, among other remedies. The bank defendants, including the PNC defendants, have entered into a settlement of the consolidated class action referred to above. This settlement was approved by the district court in November 2006. In December 2006, a group of class members appealed the order approving the settlement agreement to the United States Court of Appeals for the Second Circuit. The amount for which we would be responsible under this settlement is insignificant. We believe that we have defenses to the claims against us in these lawsuits, as well as potential claims against third parties, and intend to defend the remaining lawsuits vigorously. These lawsuits involve complex issues of law and fact, presenting complicated relationships among the many financial and other participants in the events giving rise to these lawsuits, and have not progressed to the point where we can predict the outcome of the remaining lawsuits other than the one for which a settlement is pending. It is not possible to determine what the likely aggregate recoveries on the part of the plaintiffs in these remaining matters might be or the portion of any such recoveries for which we would ultimately be responsible, but the final consequences to PNC could be material.
In April 2005, an amended complaint was filed in the putative class action against PNC, PNC Bank, N.A., our Pension Plan and its Pension Committee in the United States District Court for the Eastern District of Pennsylvania (originally filed in December 2004). The complaint claims violations of the Employee Retirement Income Security Act of 1974, as amended (ERISA), arising out of the January 1, 1999 conversion of our Pension Plan from a traditional defined benefit formula into a cash balance formula, the design and continued operation of the Plan, and other related matters. Plaintiffs seek to represent a class of all current and former employee-participants in and beneficiaries of the Plan as of December 31, 1998 and thereafter. Plaintiffs also seek to represent a subclass of all current and former employee participants in and beneficiaries of the Plan as of December 31, 1998 and thereafter who were or would have become eligible for an early retirement subsidy under the former Plan at some time prior to the date of the amended complaint. The plaintiffs are seeking unquantified damages and equitable relief available under ERISA, including interest, costs, and attorneys fees. In November 2005, the court granted our motion to dismiss the amended complaint. Plaintiffs appealed this ruling to the United States Court of Appeals for the Third Circuit, which affirmed the district court ruling in an opinion dated January 30, 2007. On February 13, 2007, plaintiffs filed in the court of appeals a petition for rehearing. Plaintiffs may seek further judicial review of the dismissal of their complaint.
In March 2006, a first amended complaint was filed in the United States District Court for the Eastern District of Texas by Data Treasury Corporation against PNC and PNC Bank,
N.A., as well as more than 50 other financial institutions, vendors, and other companies, claiming that the defendants are infringing, and inducing or contributing to the infringement of, the plaintiffs patents, which allegedly involve check imaging, storage and transfer. The plaintiff seeks unspecified damages and interest and trebling of both, attorneys fees and other expenses, and injunctive relief against the alleged infringement. We are not in a position to assess the likely outcome of this matter, including our exposure, if any. We believe that we have defenses to the claims against us in this lawsuit and intend to defend it vigorously. In January 2007, the district court entered an order staying the claims asserted against PNC under two of the four patents allegedly infringed by PNC, pending reexamination of these patents by the United States Patent and Trademark Office. The lawsuit will proceed with respect to the other two patents. Further, the stay may be lifted once the Patent and Trademark Office completes its reexamination.
In August 2006, a lawsuit was filed in the United States District Court for the Eastern District of Texas by Ronald A. Katz Technology Licensing L. P. (RAKTL) against PNC, PNC Bank, N.A., and other defendants. In September 2006, this lawsuit was divided into separate actions, and amended complaints were then filed, one of which was against PNC and PNC Bank, N.A. This lawsuit is one of many related RAKTL patent infringement actions pending in various federal district courts against a large number of defendants. Each of the actions involves a single family of related patents that RAKTL refers to as the interactive call processing patents. The amended complaint alleged that PNC and PNC Bank, N.A. are infringing, and inducing or contributing to the infringement of, certain of the plaintiffs patents. In January 2007, the court dismissed the lawsuit against PNC following a settlement under which PNC and its affiliates received a non-exclusive license covering patents held by RAKTL. As part of the settlement, we agreed to pay a licensing fee to RAKTL. The amount of the fee is not material to PNC.
In its Form 10-Q for the quarter ended March 31, 2005, Riggs disclosed a number of pending lawsuits. All material lawsuits have been finally resolved, except one where a settlement agreement has been reached, subject to final documentation. The pending settlement is not material to PNC.
As a result of the acquisition of Riggs, PNC is now responsible for Riggs obligations to provide indemnification to its directors, officers, and, in some cases, employees and agents against certain liabilities incurred as a result of their service on behalf of or at the request of Riggs. PNC is also now responsible for Riggs obligations to advance on behalf of covered individuals costs incurred in connection with certain claims or proceedings, subject to written undertakings to repay all amounts so advanced if it is ultimately determined that the individual is not entitled to indemnification. Since the acquisition, we have advanced such costs on behalf of covered individuals from Riggs and expect to continue to do so in the
future at least with respect to lawsuits and other legal matters identified in Riggs first quarter 2005 Form 10-Q.
There are several pending judicial or administrative proceedings or other matters arising out of the three 2001 PAGIC transactions. These pending proceedings or other matters are described below. Among the requirements of a June 2003 Deferred Prosecution Agreement that one of our subsidiaries entered into relating to the PAGIC transactions was the establishment of a Restitution Fund through our $90 million contribution. The Restitution Fund will be available to satisfy claims, including for the settlement of the pending securities litigation referred to below. Louis W. Fryman, chairman of Fox Rothschild LLP in Philadelphia, Pennsylvania, is administering the Restitution Fund.
In December 2004 and January and March 2005, we entered into settlement agreements relating to certain of the lawsuits and other claims arising out of the PAGIC transactions. These settlements are described below, following a description of each of these pending proceedings and other matters.
The several putative class action complaints filed during 2002 in the United States District Court for the Western District of Pennsylvania arising out of the PAGIC transactions were consolidated in a consolidated class action complaint brought on behalf of purchasers of our common stock between July 19, 2001 and July 18, 2002 (the Class Period). The consolidated class action complaint names PNC, our Chairman and Chief Executive Officer, our former Chief Financial Officer, our Controller, and our independent auditors for 2001 as defendants and seeks unquantified damages, interest, attorneys fees and other expenses. The consolidated class action complaint alleges violations of federal securities laws related to disclosures regarding the PAGIC transactions and related matters.
In August 2002, the United States Department of Labor began a formal investigation of the Administrative Committee of our Incentive Savings Plan (Plan) in connection with the Administrative Committees conduct relating to our common stock held by the Plan. Both the Administrative Committee and PNC have cooperated fully with the investigation. In June 2003, the Administrative Committee retained Independent Fiduciary Services, Inc. (IFS) to serve as an independent fiduciary charged with the exclusive authority and responsibility to act on behalf of the Plan in connection with the pending securities class action litigation referred to above and to evaluate any legal rights the Plan might have against any parties relating to the PAGIC transactions. This authority includes representing the Plans interests in connection with the Restitution Fund set up under the Deferred Prosecution Agreement. The Department of Labor has communicated with IFS in connection with the engagement.
We received a letter in June 2003 on behalf of an alleged shareholder demanding that we take appropriate legal action
against our Chairman and Chief Executive Officer, our former Chief Financial Officer, and our Controller, as well as any other individuals or entities allegedly responsible for causing damage to PNC as a result of the PAGIC transactions. The Board referred this matter to a special committee of the Board for evaluation. The special committee completed its evaluation and reported its findings to the Board of Directors and to counsel for the alleged shareholder. The special committee recommended against bringing any claims against our current or former executive officers but made certain recommendations with respect to resolution of potential claims we had with respect to certain other third parties.
In July 2003, the lead underwriter on our Executive Blended Risk insurance coverage filed a lawsuit for a declaratory judgment against PNC and PNC ICLC in the United States District Court for the Western District of Pennsylvania. The complaint seeks a determination that the defendants breached the terms and conditions of the policy and, as a result, the policy does not provide coverage for any loss relating to or arising out of the Department of Justice investigation or the PAGIC transactions. Alternatively, the complaint seeks a determination that the policy does not provide coverage for the payments made pursuant to the Deferred Prosecution Agreement. The complaint also seeks attorneys fees and costs. In July 2004, the court granted our motion to stay the action until resolution of the claims against PNC in the pending consolidated class action described above.
In December 2004, we entered into a tentative settlement of the consolidated class action. In March 2005, the parties filed a stipulation of settlement of this lawsuit with the United States District Court for the Western District of Pennsylvania. This settlement also covered claims by the plaintiffs against AIG Financial Products and others related to the PAGIC transactions.
In July 2006, the district court approved this settlement. The defendant in that class action not participating in this settlement, our former independent auditors for the years ended 2001 and before, had objected to it and, on August 10, 2006, appealed the decision of the district court approving the settlement to the United States Court of Appeals for the Third Circuit.
On December 20, 2006, our former independent auditors for the years ended 2001 and before filed with the district court a tentative settlement agreement with the plaintiffs regarding the plaintiffs claims against it. This tentative settlement remains subject to court approval. If this tentative settlement agreement is finally approved by the court and after it becomes effective, this defendant will dismiss its appeal of the courts approval of our settlement, which would then become final.
In December 2004, we also settled all claims between us, on the one hand, and AIG Financial Products and its affiliate, American International Surplus Lines Insurance Company (AISLIC), on the other hand, related to the PAGIC
transactions. AIG Financial Products was our counterparty in the PAGIC transactions, and AISLIC is one of the insurers under our Executive Blended Risk insurance coverage. Subsequently, we settled claims against two of the other insurers under our Executive Blended Risk insurance coverage, as described below. Each of the amounts in these settlements represents a portion of the insurers share of our overall claim against our insurers with respect to any amounts disbursed out of the Restitution Fund. We are preserving our claim against our insurers with which we have not settled.
The following are the key elements of these settlements that remain conditional at present, pending resolution of the appeal of the district courts approval of the settlement of the consolidated class action:
We will be responsible for the costs of administering the settlement and the Restitution Fund and may incur additional costs in the future in connection with the advancement of expenses and/or indemnification obligations related to the subject matter of this lawsuit. We do not expect such costs to be material.
In connection with industry-wide investigations of practices in the mutual fund industry including market timing, late day trading, employee trading in mutual funds and other matters, several of our subsidiaries have received requests for information and other inquiries from state and federal governmental and regulatory authorities. These subsidiaries are fully cooperating in all of these matters. In addition, as a result of the regulated nature of our business and that of a number of our subsidiaries, particularly in the banking and securities areas, we and our subsidiaries are the subject from time to time of investigations and other forms of regulatory inquiry, often as part of industry-wide regulatory reviews of specified activities. Our practice is to cooperate fully with these investigations and inquiries.
In addition to the proceedings or other matters described above, PNC and persons to whom we may have indemnification obligations, in the normal course of business, are subject to various other pending and threatened legal proceedings in which claims for monetary damages and other relief are asserted. We do not anticipate, at the present time, that the ultimate aggregate liability, if any, arising out of such other legal proceedings will have a material adverse effect on our financial position. However, we cannot now determine whether or not any claims asserted against us or others to whom we may have indemnification obligations, whether in
the proceedings or other matters specifically described above or otherwise, will have a material adverse effect on our results of operations in any future reporting period.
ITEM 4 SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None during the fourth quarter of 2006.
EXECUTIVE OFFICERS OF THE REGISTRANT Information regarding each of our executive officers as of February 16, 2007 is set forth below. Executive officers do not have a stated term of office. Each executive officer has held the position or positions indicated or another executive position with the same entity or one of its affiliates for the past five years unless otherwise indicated below.
William S. Demchak joined PNC as Vice Chairman and Chief Financial Officer in September 2002. In August 2005, he took on additional oversight responsibilities for the Corporations Corporate & Institutional Banking business and continued to oversee PNCs asset and liability management and equity management activities while transitioning the responsibilities of Chief Financial Officer to Richard J. Johnson. From 1997 to 2002, he served as Global Head of Structured Finance and Credit Portfolio for J.P. Morgan Chase & Co.
William C. Mutterperl joined PNC as Vice Chairman in October 2002. From August 2002 to October 2002, he was a partner in the business law division of the international law firm of Brown Rudnick Berlack Israels LLP. From February 2002 to May 2002, he served as Executive Director of the Independent Oversight Board for Arthur Andersen LLP, headed by former Federal Reserve Chairman Paul Volcker.
Richard J. Johnson joined PNC in December 2002 and served as Senior Vice President and Director of Finance until his appointment as Chief Financial Officer of the Corporation effective in August 2005. From 1999 to 2002 he served as President and Chief Executive Officer for J.P. Morgan Services.
John J. Wixted, Jr. joined PNC as Senior Vice President and Chief Regulatory Officer in August 2002. From 1996 to 2002 he served as Senior Vice President for Banking Supervision and Regulation for the Federal Reserve Bank of Chicago.
(a) Our common stock is listed on the New York Stock Exchange and is traded under the symbol PNC. At the close of business on February 16, 2007, there were 41,285 common shareholders of record.
Holders of PNC common stock are entitled to receive dividends when declared by the Board of Directors out of funds legally available for this purpose. Our Board of Directors may not pay or set apart dividends on the common stock until dividends for all past dividend periods on any series of outstanding preferred stock have been paid or declared and set apart for payment. The Board presently intends to continue the policy of paying quarterly cash dividends. However, the amount of any future dividends will depend on earnings, our financial condition and other factors, including contractual restrictions and applicable government regulations and policies (such as those relating to the ability of bank and non-bank subsidiaries to pay dividends to the parent company).
The Federal Reserve has the power to prohibit us from paying dividends without its approval. For further information concerning dividend restrictions and restrictions on loans or advances from bank subsidiaries to the parent company, you may review Supervision and Regulation in Item 1 of this Report, Liquidity Risk Management in the Risk
Management section and Perpetual Trust Securities in the Off-Balance Sheet Arrangements and VIEs section of Item 7 of this Report, and Note 4 Regulatory Matters in the Notes To Consolidated Financial Statements in Item 8 of this Report, which we include here by reference.
We include here by reference additional information relating to PNC common stock under the caption Common Stock Prices/Dividends Declared in the Statistical Information (Unaudited) section of Item 8 of this Report.
We include here by reference the information regarding our compensation plans under which PNC equity securities are authorized for issuance as of December 31, 2006 in the table (with introductory paragraph and notes) that appears under Item 12 of this Report.
Our registrar, stock transfer agent, and dividend disbursing agent is:
Computershare Investor Services, LLC
250 Royall Street
Canton, MA 02021
(b) Not applicable.
(c) Details of our repurchases of PNC common stock during the fourth quarter of 2006 are included in the following table:
In thousands, except per share data
Common Stock Performance Graph
This graph shows the cumulative total shareholder return (i.e., price change plus reinvestment of dividends) on our common stock during the five-year period ended December 31, 2006, as compared with: (1) a selected peer group of our competitors, called the Peer Group; (2) an overall stock
market index, the S&P 500 Index; and (3) a published industry index, the S&P 500 Banks. The yearly points marked on the horizontal axis of the graph correspond to December 31 of that year. The stock performance graph assumes that $100 was invested on January 1, 2002 for the five-year period and that any dividends were reinvested. The table below the graph shows the resultant compound annual growth rate for the performance period.
The Peer Group for the preceding chart and table consists of the following companies: The Bank of New York Company, Inc.; BB&T Corporation; Fifth Third Bancorp; KeyCorp; National City Corporation; The PNC Financial Services Group, Inc.; SunTrust Banks, Inc.; U.S. Bancorp.; Wachovia Corporation; Regions Financial; and Wells Fargo & Company. The Peer Group shown is the Peer Group approved by the Boards Personnel and Compensation Committee in 2006. For 2007, the Peer Group will be revised to include Comerica Incorporated and exclude The Bank of New York Company, Inc.
Each yearly point for the Peer Group is determined by calculating the cumulative total shareholder return for each company in the Peer Group from December 31, 2001 to December 31 of that year (End of Month Dividend Reinvestment Assumed) and then using the median of these returns as the yearly plot point.
In accordance with the rules of the SEC, this section, captioned Common Stock Performance Graph, shall not be incorporated by reference into any of our future filings made under the Securities Exchange Act of 1934 or the Securities Act of 1933. The Common Stock Performance Graph, including its accompanying table and footnotes, is not deemed to be soliciting material or to be filed under the Exchange Act or the Securities Act.
ITEM 6 - SELECTED FINANCIAL DATA
Certain prior-period amounts have been reclassified to conform with the current period presentation, which we believe is more meaningful to readers of our consolidated financial statements. See Note 2 Acquisitions in the Notes To Consolidated Financial Statements in Item 8 of this Report for information on significant recent and planned business acquisitions.
For information regarding certain business risks, see Item 1A Risk Factors and the Risk Management section of Item 7 of this Report. Also, see our Cautionary Statement Regarding Forward-Looking Information included in Item 7 of this Report for certain risks and uncertainties that could cause actual results to differ materially from those anticipated in forward-looking statements or from historical performance.
THE PNC FINANCIAL SERVICES GROUP, INC.
PNC is one of the largest diversified financial services companies in the United States based on assets, with businesses engaged in retail banking, corporate and institutional banking, asset management and global fund processing services. We provide many of our products and services nationally and others in our primary geographic markets located in Pennsylvania; New Jersey; the greater Washington, DC area, including Maryland and Virginia; Ohio; Kentucky; and Delaware. We also provide certain global fund processing services internationally.
KEY STRATEGIC GOALS
Our strategy to enhance shareholder value centers on achieving revenue growth in our various businesses underpinned by prudent management of risk, capital and expenses. In each of our business segments, the primary drivers of growth are the acquisition, expansion and retention of customer relationships. We strive to achieve such growth in our customer base by providing convenient banking options, leading technological systems and a broad range of fee-based products and services. We also intend to grow through appropriate and targeted acquisitions and, in certain businesses, by expanding into new geographical markets.
In recent years, we have managed our interest rate risk to achieve a moderate risk profile with limited exposure to earnings volatility resulting from interest rate fluctuations and shape of the yield curve. Our actions have created a balance sheet characterized by strong asset quality and flexibility to adjust, where appropriate, to changing interest rates and market conditions.
On September 29, 2006, Merrill Lynch contributed its investment management business to BlackRock in exchange for 65 million shares of newly issued BlackRock common and preferred stock. BlackRock accounted for the MLIM transaction under the purchase method of accounting.
Immediately following the closing, PNC continued to own approximately 44 million shares of BlackRock common stock, representing an ownership interest of approximately 34% of the combined company after the closing (as compared with 69% immediately prior to the closing). Although PNCs share ownership percentage declined, PNCs investment in BlackRock increased due to the increase in total equity recorded by BlackRock as a result of the MLIM transaction.
Further information regarding the BlackRock/MLIM transaction is included in the BlackRock discussion within the Business Segments Review section of this Item 7.
MERCANTILE BANKSHARES ACQUISITION
On October 8, 2006, we entered into a definitive agreement with Mercantile Bankshares Corporation (Mercantile) for PNC to acquire Mercantile. Mercantile shareholders will be entitled to .4184 shares of PNC common stock and $16.45 in cash for each share of Mercantile, or in the aggregate approximately 53 million shares of PNC common stock and $2.1 billion in cash. Based on PNCs recent stock prices, the transaction is valued at approximately $6.0 billion in the aggregate.
Mercantile is a bank holding company with approximately $18 billion in assets that provides banking and investment and wealth management services through 240 offices in Maryland, Virginia, the District of Columbia, Delaware and southeastern Pennsylvania. This transaction will enable us to significantly expand our presence in the mid-Atlantic region, particularly within the attractive Baltimore and Washington, DC markets.
Our Mercantile integration strategy development and planning is progressing on track and has achieved several important objectives, including identifying leadership personnel for certain key positions within the Mercantile service territory. Our priority for the integration is the retention of customers and customer-facing staff. The transaction is subject to customary closing conditions, including regulatory approvals, and is expected to close in March 2007.
THE ONE PNC INITIATIVE
The One PNC initiative began in January 2005 and is an ongoing, company-wide initiative with goals of moving closer to the customer, improving our overall efficiency and targeting resources to more value-added activities. PNC expects to realize $400 million of total annual pretax earnings benefit by mid-2007 from this initiative.
PNC plans to achieve approximately $300 million of cost savings through a combination of workforce reduction and other efficiencies. Approximately 3,000 positions had been eliminated through December 31, 2006. We recognized employee severance and other implementation costs of $11 million in 2006 and $54 million in 2005. Estimated remaining charges to be incurred in early 2007 are not significant. In addition, PNC intends to achieve at least $100 million in net revenue growth through the implementation of various pricing and business growth enhancements driven by the One PNC initiative. The initiative is progressing according to plan.
We realized a net pretax financial benefit from the One PNC program of approximately $265 million in 2006. We achieved an annualized run rate benefit of $320 million in the fourth quarter of 2006.
KEY FACTORS AFFECTING FINANCIAL PERFORMANCE
Our financial performance is substantially affected by several external factors outside of our control, including:
In addition to changes in general economic conditions, including the direction, timing and magnitude of movement in interest rates and the performance of the capital markets, our success in 2007 will depend, among other things, upon:
SUMMARY FINANCIAL RESULTS
Net income for 2006 included the after-tax impact of the following items:
The aggregate impact of these items increased 2006 net income by $1.1 billion, or $3.67 per diluted common share.
We refer you to the Consolidated Income Statement Review portion of the 2005 Versus 2004 section of this Item 7 for significant items impacting 2005 results.
Our performance in 2006 included the following accomplishments:
BALANCE SHEET HIGHLIGHTS
Total average assets were $95.0 billion for 2006 compared with $88.5 billion for 2005. Average interest-earning assets were $77.7 billion for 2006 compared with $73.0 billion in 2005, an increase of $4.7 billion or 6%. Increases of $2.2 billion in average loans and $2.0 billion in average securities were the primary factors for the increase in average interest-earning assets.
Average total loans were $49.6 billion in 2006 and $47.4 billion for 2005. This increase was driven by continued improvements in market loan demand and targeted sales efforts across our banking businesses, as well as the full year impact of our expansion into the greater Washington, D.C. area, which began in May 2005. The increase in average total loans reflected growth in commercial loans of $1.2 billion, residential mortgages of $.8 billion and commercial real estate loans of $.6 billion, partially offset by modest declines in consumer and lease financing loans. In addition, average total loans for 2005 included $1.7 billion related to Market Street for the period prior to our deconsolidation of that entity in October 2005. Loans represented 64% of average interest-earning assets for 2006 and 65% for 2005.
Average securities totaled $21.3 billion in 2006 and $19.3 billion for 2005. The overall higher average securities balances reflected our desire to continue investing through the interest rate cycle and the full year impact of our May 2005 Riggs acquisition. The $2.0 billion increase over 2005 reflected an increase of $4.0 billion in mortgage-backed, asset-backed and other debt securities, partially offset by a $2.0 billion decline in US Treasury and government agencies
securities. Our third quarter 2006 securities portfolio rebalancing actions are further described in the Consolidated Balance Sheet Review section of this Item 7. Securities comprised 27% of average interest-earning assets for 2006 and 26% for 2005.
Average total deposits were $63.3 billion for 2006 compared with $57.6 billion for 2005. The increase in average total deposits was driven primarily by the impact of higher certificates of deposit, money market account and noninterest-bearing deposit balances, and by higher Eurodollar deposits. Growth in deposits from commercial mortgage loan servicing activities also contributed to the increase compared with 2005. Similar to its impact on average loans and securities described above, our expansion into the greater Washington, DC area also contributed to the increase in average total deposits. Average total deposits represented 67% of total sources of funds for 2006 and 65% for 2005. Average transaction deposits were $42.3 billion for 2006 and $39.5 billion for 2005.
Average borrowed funds were $15.0 billion for 2006 and $16.2 billion for 2005. Commercial paper declined $2.1 billion in the comparison as 2005 included $1.8 billion of commercial paper related to Market Street, which was deconsolidated in October 2005. Apart from the decrease in commercial paper, average borrowed funds increased $.9 billion in 2006 compared with the prior year primarily due to net increases in fed funds purchased.
Shareholders equity totaled $10.8 billion at December 31, 2006, compared with $8.6 billion at December 31, 2005. The increase of $2.2 billion in total shareholders equity compared with December 31, 2005 reflected the impact of 2006 net income on retained earnings and an increase in capital surplus in connection with the BlackRock/MLIM transaction.
LINE OF BUSINESS HIGHLIGHTS
We refer you to Item 1 of this Report for an overview of our business segments in Review of Lines of Business and to the Results of Businesses Summary table in the Business Segments Review section of this Item 7. Total business segment earnings were $1.5 billion for 2006 and $1.4 billion for 2005.
See Note 21 Segment Reporting in the Notes To Consolidated Financial Statements in Item 8 of this Report for a reconciliation of total business segment earnings to total PNC consolidated earnings as reported on a GAAP basis.
Retail Bankings 2006 earnings increased $83 million, or 12%, to $765 million compared with 2005. Revenue increased 9% and noninterest expense increased 6% compared with the prior year, creating positive operating leverage. The increase in earnings was driven by improved fee income from customers, higher taxable-equivalent net interest income fueled by continued customer and balance sheet growth, and a sustained focus on expense management. Positive operating leverage allows for annual earnings growth as well as the ability to reinvest in the business for future growth.
Corporate & Institutional Banking
Earnings from Corporate & Institutional Banking for 2006 totaled $463 million compared with $480 million for 2005. This decline was primarily attributable to the year-over- year $72 million change in the provision for credit losses principally as a result of a $53 million loan recovery recognized in the second quarter of 2005. The provision for credit losses was $42 million in 2006. In addition, the comparison was impacted by a $137 million increase in total revenue while noninterest expenses grew by $91 million in 2006 compared with 2005.
Our BlackRock business segment earned $187 million for 2006 and $152 million for 2005. These amounts represent BlackRocks contribution to PNCs earnings, including the impact of minority interest expense, as applicable, and additional income taxes recognized by PNC related to BlackRocks earnings. For our BlackRock business segment reporting presentation in this Item 7, we have reflected our portion of the 2006 BlackRock/MLIM integration costs in Other rather than in earnings from our BlackRock investment. BlackRock business segment earnings for 2006 reflected higher investment advisory and administration fees due to an increase in assets under management and increased performance fees. These factors more than offset the increase in expense due to increased compensation and benefits and higher general and administration expense, and a one-time expense of $34 million incurred during the first quarter of 2006 related to the January 2005 acquisition of State Street Research and Management.
For 2004, 2005 and the nine months ended September 30, 2006, our Consolidated Income Statement included our former 69%-71% ownership interest in BlackRocks net income through the BlackRock/MLIM transaction closing date. However, beginning September 30, 2006, our Consolidated Balance Sheet no longer reflected the consolidation of BlackRocks balance sheet but recognized our 34% ownership interest in BlackRock as an investment accounted for under the equity method. Our share of BlackRocks net income is now reported within asset management noninterest income in our Consolidated Income Statement.
PFPCs earnings of $124 million in 2006 increased $20 million, or 19%, compared with $104 million in 2005. Earnings for 2006 included the impact of a $14 million reversal of deferred taxes related to earnings from a foreign subsidiary following managements determination that the earnings would be indefinitely reinvested outside of the United States. Earnings for 2005 included the after-tax impact of a one-time termination fee of $6 million and a prepayment penalty of $5 million, along with $4 million of various tax benefits. Higher earnings in 2006 reflected servicing revenue contributions from several growth areas of the business and the successful implementation of expense control initiatives.
Other earnings for 2006 totaled $1.1 billion, while Other 2005 was a net loss of $93 million. Other earnings for 2006 included the $1.3 billion after-tax gain on the BlackRock/MLIM transaction recorded in the third quarter of 2006, partially offset by the impact of charges related to the following, on an after-tax basis:
Other for 2005 included the impact of implementation costs related to the One PNC initiative totaling $35 million after-tax, net securities losses of $27 million after-tax, and Riggs acquisition integration costs totaling $20 million after-tax. These factors were partially offset by the first quarter 2005 benefit recognized from a $45 million deferred tax liability reversal related to the internal transfer of our investment in BlackRock as described above under Summary Financial Results.
NET INTEREST INCOME - OVERVIEW
Changes in net interest income and margin result from the interaction of the volume and composition of interest-earning assets and related yields, interest-bearing liabilities and related rates paid, and noninterest-bearing sources.
See Statistical Information Analysis of Year-To-Year Changes In Net Interest Income and Average Consolidated Balance Sheet and Net Interest Analysis in Item 8 of this Report for additional information.
NET INTEREST INCOME - GAAP RECONCILIATION
The interest income earned on certain assets is completely or partially exempt from federal income tax. As such, these tax-exempt instruments typically yield lower returns than a taxable investment. To provide more meaningful comparisons of yields and margins for all interest-earning assets, we also provide net interest income on a taxable-equivalent basis by increasing the interest income earned on tax-exempt assets to make it fully equivalent to interest income earned on other taxable investments. This adjustment is not permitted under GAAP.
A reconciliation of net interest income as reported in the Consolidated Income Statement (GAAP basis) to net interest income on a taxable-equivalent basis follows (in millions):
Taxable-equivalent net interest income increased $83 million, or 4%, in 2006 compared with 2005. The increase reflected the impact of the 6% increase in average interest-earning assets during 2006 partially offset by a decline in the net interest margin as further described below.
NET INTEREST MARGIN
The net interest margin was 2.92% in 2006 compared with 3.00% for 2005, an 8 basis point decline. The following factors contributed to the decline in net interest margin in 2006:
The average federal funds rate for 2006 was 4.97% compared with 3.21% for 2005.
We believe that net interest margins for our industry will continue to be challenged if the yield curve remains flat or inverted, as competition for loans and deposits remains intense, as customers continue to migrate from lower cost to higher cost deposits or other products and as the benefit of adding investment securities is diminished.
From PNCs perspective, we believe that net interest income will increase and net interest margin will remain relatively stable in 2007 compared with 2006. However, due to seasonal factors in the first quarter of the year, we expect that our net interest margin will be pressured and that our net interest income will be relatively flat for the first quarter of 2007. These projections are based on assumptions underlying our most likely net interest income scenario, which may change over time.
PROVISION FOR CREDIT LOSSES
The provision for credit losses was $124 million for 2006 compared with $21 million for 2005. The provision for credit losses for 2005 included the benefit of a $53 million loan recovery in the second quarter of that year resulting from a litigation settlement. In addition to this item, the increase in the provision for credit losses in 2006 reflected the following factors:
We do not expect to sustain asset quality at its current level. However, based on the assets we currently hold and current business trends and activities, we believe that overall asset quality will remain strong by historical standards for at least the near term. To the extent actual outcomes differ from our estimates, additional provision for credit losses may be required that would reduce future earnings.
See the Credit Risk Management portion of the Risk Management section of this Item 7 for additional information regarding factors impacting the provision for credit losses.
Noninterest income was $6.327 billion for 2006 and $4.173 billion for 2005. Noninterest income for 2006 included the impact of the gain on the BlackRock/MLIM transaction, which totaled $2.078 billion, partially offset by the effects of our third quarter 2006 balance sheet repositioning activities that resulted in charges totaling $244 million.
Asset management fees amounted to $1.420 billion for 2006 and $1.443 billion for 2005, a decline of $23 million. Our equity income from BlackRock was included in asset management fees beginning with the fourth quarter of 2006. Asset management fees for 2005 and the first nine months of 2006 reflected the impact of BlackRocks revenue on a consolidated basis.
Assets managed at December 31, 2006 totaled $54 billion compared with $494 billion at December 31, 2005 and reflected the deconsolidation of BlackRock effective September 29, 2006. We refer you to the Retail Banking section of the Business Segments Review section of this Item 7 for further discussion of Retail Bankings assets under management.
Fund servicing fees increased $23 million in 2006, to $893 million, compared with $870 million in the prior year. Included in these amounts were distribution/out-of-pocket revenue amounts at PFPC totaling $170 million in 2006 and $147 million in 2005, the impacts of which were offset by expenses in the same amounts in each year.
PFPC provided fund accounting/administration services for $837 billion of net fund assets and provided custody services for $427 billion of fund assets at December 31, 2006, compared with $835 billion and $476 billion, respectively, at December 31, 2005. The decrease in custody fund assets at December 31, 2006 compared with December 31, 2005 resulted primarily from the deconversion of a major client during the first quarter of 2006, which was partially offset by new business, asset inflows from existing customers, and equity market appreciation.
Service charges on deposits increased $40 million, to $313 million, for 2006 compared with 2005. Customer growth, expansion of the branch network, including our expansion into the greater Washington, DC area that began in May 2005, and various pricing actions resulting from the One PNC initiative all contributed to the increase in 2006.
Brokerage fees increased $21 million, to $246 million, for 2006 compared with the prior year. The increase was primarily due to higher annuity income and mutual fund-related revenues, including favorable production from the fee-based fund advisory business.
Consumer services fees increased $72 million, to $365 million, in 2006 compared with 2005. Higher fees reflected the impact of consolidating our merchant services activities in the fourth quarter of 2005 as a result of our increased ownership interest in the merchant services business. The increase was also due to higher debit card revenues resulting from higher transaction volumes, our expansion into the greater Washington, DC area, and pricing actions related to the One PNC initiative. These factors were partially offset by lower ATM surcharge revenue in 2006 resulting from changing customer behavior and a strategic decision to reduce the out-of-footprint ATM network.
Corporate services revenue was $626 million for 2006, compared with $485 million in 2005. The increase in corporate services revenue compared with the prior year was primarily due to the full year benefit in 2006 of our October 2005 acquisition of Harris Williams.
Equity management (private equity) net gains on portfolio investments totaled $107 million in 2006 and $96 million for 2005. Based on the nature of private equity activities, net gains or losses may be volatile from period to period.
Net securities losses totaled $207 million in 2006 and $41 million in 2005. Our discussion under the Consolidated Balance Sheet Review section of this Item 7 provides additional information regarding actions we took during the third quarter of 2006 that resulted in the sale of approximately $6 billion of securities available for sale at an aggregate pretax loss of $196 million during that quarter.
Noninterest revenue from trading activities, which is primarily customer-related, totaled $183 million in 2006 compared with $157 million for 2005. We provide additional information on our trading activities under Market Risk Management Trading Risk in the Risk Management section of this Item 7.
Net gains related to our BlackRock investment were $2.066 billion for 2006, comprised of the $2.078 billion gain on the BlackRock/MLIM transaction partially offset by a fourth quarter mark-to-market adjustment of $12 million on our BlackRock long-term incentive plan (LTIP) obligation. See the BlackRock portion of the Business Segments Review section of Item 7 of this Report for further information.
Other noninterest income decreased $57 million, to $315 million, in 2006 compared with 2005. Other noninterest income for 2006 included the impact of the following:
These factors were partially offset by higher gains on sales of education loans held for sale in 2006 compared with the prior year.
Other noninterest income typically fluctuates from period to period depending on the nature and magnitude of transactions completed.
In addition to credit products to commercial customers, Corporate & Institutional Banking offers treasury management and capital markets-related products and services, commercial loan servicing, and equipment leasing products that are marketed by several businesses across PNC.
Treasury management revenue, which includes fees as well as net interest income from customer deposit balances, totaled $424 million for 2006 and $410 million for 2005. The higher revenue in 2006 reflected continued expansion and client utilization of commercial payment card services, strong revenue growth in various electronic payment and information services, and a steady increase in business-to-business processing volumes, which more than offset the reduced net interest margin due to rising rates.
Revenue from capital markets-related products and services, including mergers and acquisitions advisory activities, was $283 million for 2006 compared with $175 million for 2005. The acquisition of Harris Williams in October 2005 together with improved customer and proprietary trading activities drove the increase in capital markets revenue in the comparison.
Midland Loan Services offers servicing, real estate advisory and technology solutions for the commercial real estate finance industry. Midlands revenue, which includes servicing fees and net interest income from servicing portfolio deposit balances, totaled $184 million for 2006 and $144 million for 2005. Revenue growth was primarily driven by growth in the commercial mortgage servicing portfolio and related services.
As a component of our advisory services to clients, we provide a select set of insurance products to fulfill specific customer financial needs. Primary insurance offerings include:
Client segments served by these insurance solutions include those in Retail Banking and Corporate & Institutional
Banking. Insurance products are sold by licensed PNC insurance agents and through licensed third-party arrangements. Revenue from these products was $71 million in 2006 and $61 million in 2005. The increase resulted from higher annuity fee revenue.
PNC, through subsidiary companies Alpine Indemnity Limited and PNC Insurance Corp., participates as a direct writer for its general liability, automobile liability, workers compensation, property and terrorism insurance programs.
In the normal course of business, Alpine Indemnity Limited and PNC Insurance Corp. maintain insurance reserves for reported claims and for claims incurred but not reported based on actuarial assessments. We believe these reserves were adequate at December 31, 2006.
Total noninterest expense was $4.443 billion for 2006, an increase of $137 million compared with $4.306 billion for 2005.
Item 6, Selected Financial Data, of this Report includes our efficiency ratios for 2006 and 2005 and notes regarding certain significant items impacting noninterest income and expense in 2006.
Noninterest expense for 2006 included the following:
Apart from the impact of these items, noninterest expense for 2006 decreased $21 million compared with 2005 as the benefit of the One PNC initiative more than offset the impact of our expansion into the greater Washington, DC area and other investments in the business.
We will have a continued emphasis on expense management in 2007 as we continue our focus on sustaining positive operating leverage.
EFFECTIVE TAX RATE
Our effective tax rate was 34% for 2006 and 30.2% for 2005. The higher effective tax rate in 2006 compared with 2005 reflected the impact of the following:
Going forward, we believe that a more normal effective tax rate for PNC would be approximately 32%.
CONSOLIDATED BALANCE SHEET REVIEW
SUMMARIZED BALANCE SHEET DATA
The summarized balance sheet data above is based upon our Consolidated Balance Sheet in Item 8 of this Report.
Various seasonal and other factors impact our period-end balances whereas average balances (discussed under the Balance Sheet Highlights section of this Item 7 and included in the Statistical Information section of Item 8 of this Report) are normally more indicative of underlying business trends.
The increase in Equity investments above reflects BlackRock as an equity investment at December 31, 2006. BlackRocks assets and liabilities were consolidated on our Consolidated Balance Sheet at December 31, 2005.
The impact of the deconsolidation of BlackRocks balance sheet amounts and recognition of our ownership interest in BlackRock as an equity investment upon the closing of the BlackRock/MLIM transaction is discussed in the BlackRock portion of the Business Segments Review section of this Item 7.
An analysis of changes in selected other balance sheet categories follows.
LOANS, NET OF UNEARNED INCOME
Loans increased $1.0 billion, or 2%, as of December 31, 2006 compared with December 31, 2005. Increases in total commercial lending and consumer loans, driven by targeted sales efforts across our banking businesses, more than offset the decline in residential mortgage loans that resulted primarily from our third quarter 2006 mortgage loan repositioning.
Details Of Loans
As the table above indicates, the loans that we hold continued to be diversified among numerous industries and types of businesses. The loans that we hold are also concentrated in, and diversified across, the geographic areas where we do business. See Note 7 Loans, Commitments To Extend Credit and Concentrations of Credit Risk in the Notes To
Consolidated Financial Statements in Item 8 of this Report for additional information.
Commercial loans are the largest category and are the most sensitive to changes in assumptions and judgments underlying the determination of the allowance for loan and lease losses. We have allocated approximately $443 million, or 79%, of the total allowance for loan and lease losses at December 31, 2006 to the commercial loan category. This allocation also considers other relevant factors such as:
Commercial Lending Exposure (a)
Net Unfunded Credit Commitments
Unfunded commitments are concentrated in our primary geographic markets. Commitments to extend credit represent arrangements to lend funds or provide liquidity subject to specified contractual conditions. Commercial commitments are reported net of participations, assignments and syndications, primarily to financial institutions, totaling $8.3 billion at December 31, 2006 and $6.7 billion at December 31, 2005. Consumer home equity lines of credit accounted for 74% of consumer unfunded credit commitments.
Unfunded liquidity facility commitments and standby bond purchase agreements totaled $6.0 billion at December 31, 2006 and $5.1 billion at December 31, 2005 and are included in the preceding table primarily within the Commercial and Consumer categories.
In addition to credit commitments, our net outstanding standby letters of credit totaled $4.4 billion at December 31, 2006 and $4.2 billion at December 31, 2005. Standby letters of credit commit us to make payments on behalf of our
customers if specified future events occur. At December 31, 2006, the largest industry concentration was for general medical and surgical hospitals, which accounted for approximately 5% of the total letters of credit and bankers acceptances.
Leases and Related Tax and Accounting Matters
The equipment lease portfolio totaled $3.6 billion at December 31, 2006. Aggregate residual value at risk on the lease portfolio at December 31, 2006 was $1.1 billion. We have taken steps to mitigate $.6 billion of this residual risk, including residual value insurance coverage with third parties, third party guarantees, and other actions. The portfolio included approximately $1.7 billion of cross-border leases at December 31, 2006. Cross-border leases are leveraged leases of equipment located in foreign countries, primarily in western Europe and Australia. We have not entered into cross-border lease transactions since 2003.
Upon completing an examination of our 1998-2000 and 2001-2003 consolidated federal income tax returns, the IRS provided us with examination reports which propose increases in our tax liability, principally arising from adjustments to the timing of tax deductions from several of our cross-border lease transactions.
While the situation with respect to these proposed adjustments remains unresolved, we believe our reserves for these exposures were appropriate at December 31, 2006.
In July 2006, the Financial Accounting Standards Board (FASB) issued FASB Staff Position No. FAS 13-2, Accounting for a Change or Projected Change in the Timing of Cash Flows Relating to Income Taxes Generated by a Leveraged Lease Transaction (FSP 13-2). FSP 13-2 became effective January 1, 2007 and requires a recalculation of the timing of income recognition and the reevaluation of lease classification for actual or projected changes in the timing of tax benefits for leveraged leases. Any cumulative adjustment must be recognized through retained earnings upon adoption of FSP 13-2. See Note 1 Accounting Policies in the Notes To Consolidated Financial Statements in Item 8 of this Report for additional information. Effective January 1, 2007, we recorded a cumulative adjustment to beginning retained earnings from the recalculations of $149 million, after-tax, as required by FSP 13-2. This adjustment was based on our best estimate as to the timing and amount of ultimate settlement of this exposure. Any immediate or future reductions in earnings from our adoption of FSP 13-2 would be recovered in subsequent years.
The US Senate has passed a bill that, if it became law, would have an adverse impact on the tax treatment for our cross-border lease transactions. The US House of Representatives has passed a different version of this legislation that does not contain any provisions relating to the taxation of cross-border lease transactions. The differences between the two versions of this legislation will be resolved in conference. We cannot predict whether or not any new law impacting the tax treatment for our cross-border lease transactions will be enacted.
In addition to these transactions, three lease-to-service contract transactions that we were party to were structured as partnerships for tax purposes. However, we do not believe that our exposure from these transactions is material to our consolidated results of operations or financial position.
Details Of Securities (a)
Securities represented 23% of total assets at both December 31, 2006 and December 31, 2005. The increase in total securities compared with December 31, 2005 was primarily due to higher balances of mortgage-backed and commercial mortgage-backed securities, which more than offset the decline in US Treasury and government agencies securities.
At December 31, 2006, the securities available for sale balance included a net unrealized loss of $142 million, which represented the difference between fair value and amortized cost. The comparable amount at December 31, 2005 was a net unrealized loss of $370 million. Net unrealized gains and losses in the securities available for sale portfolio are included in shareholders equity as accumulated other comprehensive income or loss, net of tax.
The fair value of securities available for sale generally decreases when interest rates increase and vice versa. Further increases in interest rates in 2007, if sustained, will adversely impact the fair value of securities available for sale going forward compared with the fair value at December 31, 2006.
The expected weighted-average life of securities available for sale was 3 years and 8 months at December 31, 2006 and 4 years and 1 month at December 31, 2005.
We estimate that at December 31, 2006 the effective duration of securities available for sale is 2.6 years for an immediate 50 basis points parallel increase in interest rates and 2.2 years for an immediate 50 basis points parallel decrease in interest rates. Comparable amounts at December 31, 2005 were 2.7 years and 2.4 years, respectively.
We evaluate our portfolio of securities available for sale in light of changing market conditions and other factors and, where appropriate, take steps intended to improve our overall positioning.
During mid-August through early September 2006, we performed a comprehensive review of our securities available for sale portfolio and, by the end of September 2006, completed the process of executing portfolio rebalancing actions in response to the changing economic landscape, recent statements and actions by the Federal Open Market Committee (in particular, the decision not to raise the Fed funds target rate), and our desire to position the securities portfolio to optimize total return performance over the long term.
As a result, we repositioned our securities portfolio according to our market views. This included reallocating exposure to certain sectors, selling securities holdings we believed would likely underperform on a relative value basis, and retaining certain existing securities and purchasing incremental securities all of which we believe will outperform the market going forward as further discussed below.
As part of the rebalancing, we assessed the entire securities available for sale portfolio of which, for the majority of positions, fair value was less than amortized cost. We executed a strategy to reduce our US government agency and mortgage-backed security sector allocations and increase our interest rate swap sector allocation. We sold substantially all of our US government agency securities to reduce our interest rate spread exposure to that asset class. The US government agency securities that we retained are characterized by relatively short terms to maturity and smaller individual security balances. We also sold specific securities in the mortgage-backed portfolio (i.e., all of our holdings of specific coupon US government agency pass-through securities and collateralized mortgage obligations having specific collateral characteristics), and in the commercial mortgage-backed portfolio (i.e., all of our holdings of specific vintage securities) that we believe, given the underlying collateral, will underperform on a relative value basis. We retained the remaining holdings in our mortgage-backed portfolio including all of our holdings of mortgage-backed securities collateralized by hybrid adjustable rate mortgage loans, our commercial mortgage-backed portfolio and our asset-backed portfolio. Our objective was to reduce the portfolio credit spread and interest rate volatility exposures, to position the portfolio for a steeper yield curve and to optimize the relative value performance of the portfolio. We assessed the securities retained relative to the same portfolio objectives, our market view and outlook, our desired sector allocations and our
expectation of performance relative to market benchmarks, and, given our assessment, we confirmed our intent to hold these remaining securities until either recovery of fair value or maturity.
The portfolio rebalancing resulted in the sale during the third quarter of 2006 of $6.0 billion of securities available for sale at an aggregate pretax loss of $196 million, or $127 million after-tax. In connection with this rebalancing, we purchased approximately $1.8 billion of securities and added approximately $4.0 billion of interest rate swaps to maintain our interest rate risk position. We also reduced wholesale funding as a result of the actions taken.
The resulting net realized losses on the sale of the securities during the third quarter of 2006 were previously reflected as net unrealized securities losses within accumulated other comprehensive loss in the shareholders equity section of PNCs Consolidated Balance Sheet. Accordingly, total shareholders equity did not change as a result of these actions.
See the Consolidated Income Statement Review portion of the 2005 Versus 2004 section of this Item 7 for details of steps taken in the second quarter of 2005 regarding the sale of securities available for sale and related actions.
LOANS HELD FOR SALE
During the third quarter of 2006, we announced our plan to sell or securitize approximately $2.1 billion of loans from our residential mortgage portfolio. These transactions were substantially consummated during the fourth quarter of 2006. In accordance with GAAP, these loans were transferred to loans held for sale as of September 30, 2006. We recognized a pretax loss in the third quarter of 2006 of $48 million as a reduction of noninterest income, representing the mark to market valuation of these loans upon transfer to held for sale status. This loss, which is reported in the Other business segment, represented the decline in value of the loans almost entirely from the impact of increases in interest rates over the holding period.
Education loans held for sale totaled $1.3 billion at December 31, 2006 and $1.9 billion at December 31, 2005 and represented the majority of our loans held for sale at each date. We classify substantially all of our education loans as loans held for sale. Generally, we sell education loans when the loans are placed into repayment status. Gains on sales of education loans totaled $33 million for 2006, $19 million for 2005 and $30 million for 2004. These gains are reflected in the other noninterest income line item in our Consolidated Income Statement and in the results of the Retail Banking business segment.
The increase of $2.5 billion in Assets-Other in the preceding Summarized Balance Sheet Data table includes the impact
of a $1.4 billion increase in Federal funds sold and resale agreements and a $.6 billion increase in other short-term investments.
CAPITAL AND FUNDING SOURCES
Details Of Funding Sources
Various seasonal and other factors impact our period-end deposit balances whereas average balances (discussed under the Balance Sheet Highlights section of this Item 7 above) are normally more indicative of underlying business trends.
The increase in deposits as of December 31, 2006 was driven primarily by the impact of higher money market and certificates of deposit balances. In addition to growth in retail deposit balances, growth in deposits from commercial mortgage loan servicing activities also contributed to the increase compared with the prior year-end.
The decline in borrowed funds compared with the balance at December 31, 2005 reflected a decrease in federal funds purchased, maturities of $2.0 billion of bank notes and senior debt during 2006, a decline in subordinated debt in connection with our December 2006 redemption of $453 million of Capital Securities, and the deconsolidation of BlackRocks $250 million of convertible debentures. These factors were partially offset by the issuance of $1.5 billion of senior debt during the fourth quarter of 2006 and the issuance of $500 million of bank notes in June 2006.
We manage our capital position by making adjustments to our balance sheet size and composition, issuing debt and equity instruments, making treasury stock transactions, maintaining dividend policies and retaining earnings.
The increase of $2.2 billion in total shareholders equity at December 31, 2006 compared with December 31, 2005 reflected the impact of 2006 net income on retained earnings and an increase in capital surplus in connection with the BlackRock/MLIM transaction.
Common shares outstanding were 293 million at December 31, 2006 and December 31, 2005.
During 2006, we purchased 5 million common shares at a total cost of $354 million under our current common stock repurchase program, which offset net share issuances related to various employee stock-based compensation plans and the exercise of employee stock options and other share issuances. Our current program, which was authorized as of February 16, 2005, permits us to purchase up to 20 million shares on the open market or in privately negotiated transactions and will remain in effect until fully utilized or until modified, superseded or terminated. As of December 31, 2006, remaining availability for purchases under this program was 14.5 million shares. The extent and timing of additional share repurchases under this program will depend on a number of factors including, among others, market and general economic conditions, economic and regulatory capital considerations, alternative uses of capital, regulatory limitations resulting from merger activity, and the potential impact on our credit rating. We expect to continue to be active in share repurchases.
See Mercantile Bankshares Acquisition in the Executive Summary section of this Item 7 regarding our plans to issue PNC common stock and cash in connection with this pending acquisition. Also, our Liquidity Risk Management discussion in this Item 7 has further details on first quarter 2007 debt issuances related to funding the cash portion of this transaction.
The access to, and cost of, funding new business initiatives including acquisitions, the ability to engage in expanded business activities, the ability to pay dividends, the level of deposit insurance costs, and the level and nature of regulatory oversight depend, in part, on a financial institutions capital strength. The increases in the capital ratios at December 31, 2006 compared with the ratios at December 31, 2005 were primarily caused by the $1.6 billion increase in capital recognized in the third quarter of 2006 related to the BlackRock/MLIM transaction, partially offset by asset growth.
At December 31, 2006 and December 31, 2005, each of our bank subsidiaries was considered well capitalized based on regulatory capital ratio requirements. See the Supervision And Regulation section of Item 1 of this Report and Note 4 Regulatory Matters in the Notes To Consolidated Financial Statements in Item 8 of this Report for additional information. We believe our bank subsidiaries will continue to meet these requirements in 2007.
ARRANGEMENTS AND VIES
We engage in a variety of activities that involve unconsolidated entities or that are otherwise not reflected in our Consolidated Balance Sheet that are generally referred to as off-balance sheet arrangements. The following sections of this Report provide further information on these types of activities:
The following provides a summary of variable interest entities (VIEs), including those in which we hold a significant variable interest but have not consolidated and those that we have consolidated into our financial statements as of December 31, 2006 and 2005.
Non-Consolidated VIEs Significant Variable Interests
The aggregate assets and liabilities of VIEs that we have consolidated in our financial statements are as follows:
Consolidated VIEs PNC Is Primary Beneficiary
Market Street Funding LLC (Market Street), formerly Market Street Funding Corporation, is a multi-seller asset-backed commercial paper conduit that is owned by an independent third party. Market Streets activities are limited to the purchasing of assets or making of loans secured by interests primarily in pools of receivables from US corporations that desire access to the commercial paper market. Market Street funds the purchases or loans by issuing commercial paper which has been rated A1/P1 by Standard & Poors and Moodys, respectively, and is supported by pool-specific credit enhancement, liquidity facilities and program-level credit enhancement.
PNC Bank, N.A. provides certain administrative services, a portion of the program-level credit enhancement and the majority of liquidity facilities to Market Street in exchange for fees negotiated based on market rates. All of Market Streets assets at December 31, 2006 and 2005 collateralize the commercial paper obligations. PNC views its credit exposure for the Market Street transactions as limited. Facilities requiring PNC to fund for defaulted assets totaled $850 million at December 31, 2006. For 85% of the liquidity facilities at December 31, 2006, PNC is not required to fund if the assets are in default. PNC may be liable for funding under liquidity facilities for events such as borrower bankruptcies, collateral deficiencies or covenant violations. Additionally, PNCs obligations under the liquidity facilities are secondary to the risk of first loss provided by the borrower or another third party in the form of deal-specific credit enhancement for example, by the over collateralization of the assets. Deal-specific credit enhancement that supports the commercial paper issued by Market Street is generally structured to cover a multiple of the expected historical losses for the pool of assets and is sized to generally meet rating agency standards for comparably structured transactions. Credit enhancement is provided in part by PNC Bank, N.A. in the form of a cash collateral account that is funded by a loan facility that expires March 25, 2011. See Note 7 Loans, Commitments To Extend Credit and Concentrations of Credit Risk and Note 24
Commitments and Guarantees included in Item 8 of this Report for additional information. Neither creditors nor equity investors in Market Street have any recourse to our general credit. PNC accrued program administrator fees and commitment fees related to PNCs portion of the liquidity facilities of $11.3 million and $3.7 million, respectively, for the year ended December 31, 2006.
Under the provisions of FASB Interpretation No. 46, Consolidation of Variable Interest Entities (FIN 46), we consolidated Market Street effective July 1, 2003 as we were deemed the primary beneficiary of Market Street. In October 2005, Market Street was restructured as a limited liability company and entered into a subordinated Note Purchase Agreement (Note) with an unrelated third party. Consistent with other market participants, PNC elected to restructure Market Street and Market Street issued the Note for the primary purpose of providing our customers access to the asset-backed commercial paper markets in a more capital-efficient manner.
The Note provides first loss coverage whereby the investor absorbs losses up to the amount of the Note, which is $5.7 million as of December 31, 2006. The Note has an original maturity of eight years and bears interest at 18% with any default-related interest/fees charged by Market Street on specific transactions accruing to the benefit of the Note holder. Proceeds from the issuance of the Note were placed in a first loss reserve account that may be used to reimburse any losses incurred by Market Street, PNC Bank, N.A. or other providers under the liquidity facilities and the credit enhancement arrangements.
As a result of the Note issuance, we reevaluated whether PNC continued to be the primary beneficiary of Market Street under the provisions of FIN 46R. PNC evaluated the design of Market Street, its capital structure and relationships among the variable interest holders. PNC also performed a quantitative analysis, which computes and allocates expected loss or residual returns to variable interest holders. PNC considered variability generated from the risks specific to Market Street such as expected credit losses, facility pricing (including default-related pricing), and fee volatility in determining that the Note investor absorbed the majority of the expected variability and therefore is the primary beneficiary and required to consolidate Market Street. Based on this analysis, we determined that we were no longer the primary beneficiary and deconsolidated Market Street from our Consolidated Balance Sheet effective October 17, 2005.
As required under FIN 46R, reconsideration events such as changes in the Note contractual terms, additional Note investors and or changes in the inherent Market Street risks would trigger PNC to determine if the primary beneficiary has changed.
Low Income Housing Projects
We make certain equity investments in various limited partnerships that sponsor affordable housing projects utilizing
the Low Income Housing Tax Credit (LIHTC) pursuant to Section 42 of the Internal Revenue Code. The purpose of these investments is to achieve a satisfactory return on capital, to facilitate the sale of additional affordable housing product offerings and to assist us in achieving goals associated with the Community Reinvestment Act. The primary activities of the limited partnerships include the identification, development and operation of multi-family housing that is leased to qualifying residential tenants. Generally, these types of investments are funded through a combination of debt and equity, with equity typically comprising 30% to 60% of the total project capital.
We consolidated those LIHTC investments in which we own a majority of the limited partnership interests. We also consolidated entities in which we, as a national syndicator of affordable housing equity, serve as the general partner (together with the aforementioned LIHTC investments), and no other entity owns a majority of the limited partnership interests. In these syndication transactions, we create funds in which our subsidiary is the general partner and sells limited partnership interests to third parties, and in some cases may also purchase a limited partnership interest in the fund. The funds limited partners can generally remove the general partner without cause at any time. The purpose of this business is to generate income from the syndication of these funds and to generate servicing fees by managing the funds. General partner activities include selecting, evaluating, structuring, negotiating, and closing the fund investments in operating limited partnerships, as well as oversight of the ongoing operations of the fund portfolio. The assets are primarily included in Equity Investments on our Consolidated Balance Sheet. Neither creditors nor equity investors in the LIHTC investments have any recourse to our general credit. The consolidated aggregate assets and debt of these LIHTC investments are provided in the Consolidated VIEs PNC Is Primary Beneficiary table and reflected in the Corporate & Institutional Banking business segment.
We have a significant variable interest in certain other limited partnerships that sponsor affordable housing projects. We do not own a majority of the limited partnership interests in these entities and are not the primary beneficiary. We use the equity method to account for our investment in these entities. Information regarding these partnership interests is reflected in the Non-Consolidated VIEs Significant Variable Interests table.
We also have subsidiaries that invest in and act as the investment manager for private equity funds organized as limited partnerships as part of our equity management activities. The funds invest in private equity investments to generate capital appreciation and profits. As permitted by FASB Interpretation No. 46 (Revised 2003), Consolidation of Variable Interest Entities, we have deferred applying the provisions of the interpretation for these entities pending further action by the FASB. Information on these entities follows:
Investment Company Accounting Deferred Application
PNCs risk of loss in the tables above includes both the value of our equity investments and any unfunded commitments to the respective entities.
Perpetual Trust Securities
In December 2006, one of our indirect subsidiaries, PNC REIT Corp., sold $500 million of 6.517% Fixed-to-Floating Rate Non-Cumulative Exchangeable Perpetual Trust Securities (the Trust Securities) of PNC Preferred Funding Trust I, in a private placement. PNC REIT Corp. had previously acquired the Trust Securities from the trust in exchange for an equivalent amount of Fixed-to-Floating Rate Non-Cumulative Perpetual Preferred Securities (the LLC Preferred Securities), of PNC Preferred Funding LLC (the LLC), held by PNC REIT Corp. The LLCs initial material assets consist of indirect interests in mortgages and mortgage-related assets previously owned by PNC REIT Corp.
PNC REIT Corp. also owns 100% of the LLCs common voting securities. As a result, the LLC is an indirect subsidiary of PNC Bank, N.A. and is consolidated in accordance with GAAP on our consolidated balance sheet. PNC Preferred Funding Trust Is investment in the LLC Preferred Securities is characterized as a minority interest on our balance sheet since we are not the primary beneficiary of PNC Preferred Funding Trust I. This minority interest totaled approximately $490 million at December 31, 2006.
Each Trust Security is automatically exchangeable into a share of Series F Non-Cumulative Perpetual Preferred Stock of PNC Bank, N.A. (the PNC Bank Preferred Stock) under certain conditions relating to the capitalization or the financial condition of PNC Bank, N.A. and upon the direction of the OCC.
Simultaneously with the closing of the Trust Securities sale, we entered into a replacement capital covenant (the Covenant) for the benefit of holders of a specified series of our long-term indebtedness (the Covered Debt). As of December 31, 2006, Covered Debt consists of our
$200 million Floating Rate Junior Subordinated Notes issued on June 9, 1998. We agreed in the Covenant that neither we nor our subsidiaries (other than PNC Bank, N.A. and its subsidiaries) would purchase the Trust Securities, the LLC Preferred Securities or the PNC Bank Preferred Stock (collectively, the Covenant Securities) unless: (i) we have received the prior approval of the Federal Reserve Board, if such approval is then required by the Federal Reserve Board and (ii) during the 180-day period prior to the date of purchase, we or our subsidiaries, as applicable, have received proceeds from the sale of Qualifying Securities in the amounts specified in the Covenant (which amounts will vary based on the type of securities sold). Qualifying Securities means debt and equity securities having terms and provisions specified in the Covenant and that, generally described, are intended to contribute to our capital base in a manner that is similar to the contribution to our capital base made by the Covenant Securities. The Covenant does not apply to redemptions of the Covered Securities by the issuers of those securities. We filed a copy of the Covenant with the SEC as Exhibit 99.1 to PNCs Form 8-K filed on December 8, 2006.
PNC Bank, N.A. has contractually committed to PNC Preferred Funding Trust I that if full dividends are not paid in a dividend period on the Trust Securities, LLC Preferred Securities or any other parity equity securities issued by the LLC, neither PNC Bank, N. A. nor its subsidiaries will declare or pay dividends or other distributions with respect to, or redeem, purchase or acquire or make a liquidation payment with respect to, any of its equity capital securities during the next succeeding dividend period (other than to holders of the LLC Preferred Securities and any parity equity securities issued by the LLC) except: (i) in the case of dividends payable to subsidiaries of PNC Bank, N.A., to PNC Bank, N.A. or another wholly-owned subsidiary of PNC Bank, N.A. or (ii) in the case of dividends payable to persons that are not subsidiaries of PNC Bank, N.A., to such persons only if, (A) in the case of a cash dividend, PNC has first irrevocably committed to contribute amounts at least equal to such cash dividend or (B) in the case of in-kind dividends payable by PNC REIT Corp., PNC has committed to purchase such in-kind dividend from the applicable PNC REIT Corp. holders in exchange for a cash payment representing the market value of such in-kind dividend, and PNC has committed to contribute such in-kind dividend to PNC Bank. N.A.
BUSINESS SEGMENTS REVIEW
We have four major businesses engaged in providing banking, asset management and global fund processing services: Retail Banking; Corporate & Institutional Banking; BlackRock; and PFPC.
Certain of our products and services are offered through Corporate & Institutional Banking and marketed by several businesses across PNC, such as our treasury management activities, which include cash and investment management, receivables management, disbursement services, funds
transfer services, information reporting, and global trade services; capital markets-related products and services, which include foreign exchange, derivatives, loan syndications, securities underwriting, securities sales and trading, and mergers and acquisitions advisory and related services to middle-market companies; commercial loan servicing, real estate advisory and technology solutions for the commercial real estate finance industry; and equipment leasing products.
Results of individual businesses are presented based on our management accounting practices and our operating structure. There is no comprehensive, authoritative body of guidance for management accounting equivalent to GAAP; therefore, the financial results of individual businesses are not necessarily comparable with similar information for any other company. We refine our methodologies from time to time as our management accounting practices are enhanced and our businesses and management structure change. Financial results are presented, to the extent practicable, as if each business operated on a stand-alone basis. As permitted under GAAP, we have aggregated the business results for certain operating segments for financial reporting purposes.
Our capital measurement methodology is based on the concept of economic capital for our banking businesses. However, we have increased the capital assigned to Retail Banking to 6% of funds to reflect the capital required for well-capitalized banks and to approximate market comparables for this business. The capital for PFPC has been increased to reflect its legal entity shareholders equity.
BlackRock business segment results for the nine months ended September 30, 2006 and full year 2005 reflected our majority ownership in BlackRock during those periods. Subsequent to the September 29, 2006 BlackRock/MLIM transaction closing, our investment in BlackRock and capital position increased significantly but our ownership interest was reduced to approximately 34%. BlackRock is now accounted for under the equity method and continues to be a separate reportable business segment. For our business segment reporting presentation, we have reclassified historical BlackRock segment results to conform to our current approach, as further described on page 41.
We have allocated the allowances for loan and lease losses and unfunded loan commitments and letters of credit based on our assessment of risk inherent in the loan portfolios. Our allocation of the costs incurred by operations and other support areas not directly aligned with the businesses is primarily based on the use of services.
Total business segment financial results differ from total consolidated results. The impact of these differences is reflected in the Intercompany Eliminations and Other categories. Intercompany Eliminations reflects activities conducted among our businesses that are eliminated in the consolidated results. Other includes residual activities that do not meet the criteria for disclosure as a separate reportable
business, such as gains or losses related to our BlackRock investment, 2006 BlackRock/MLIM integration costs, One PNC implementation costs, asset and liability management activities, related net securities gains or losses, certain trading activities, equity management activities and minority interest in income of BlackRock up to September 29, 2006, differences between business segment performance reporting and financial statement reporting (GAAP), and most corporate overhead.
Business segment results, including inter-segment revenues, are included in Note 21 Segment Reporting in the Notes To Consolidated Financial Statements in Item 8 of this Report.
Employee data as reported by each business segment in the tables that follow reflect staff directly employed by the respective businesses and excludes corporate and shared services employees. Prior period employee statistics generally are not restated for organizational changes.
Results Of Businesses - Summary
Retail Bankings 2006 earnings increased $83 million, or 12%, to $765 million compared with 2005. Revenue increased 9% and noninterest expense increased 6% compared with the prior year, creating positive operating leverage. The increase in earnings was driven by improved fee income from customers, higher taxable-equivalent net interest income fueled by continued customer and balance sheet growth, and a sustained focus on expense management. Retail Bankings sustained focus on expense management has allowed for additional investments in the business as described below.
Highlights of Retail Bankings performance during 2006 include the following:
Total revenue for 2006 was $3.125 billion compared with $2.868 billion for 2005. Taxable-equivalent net interest income of $1.678 billion increased $85 million, or 5%, compared with 2005 due to a 7% increase in average deposits and a 5% increase in average loan balances. Net interest income growth has been somewhat mitigated by declining spreads on the loan portfolio. In the current rate environment, we expect the spread we receive on both loans and deposits to be under pressure.
Noninterest income increased $172 million, or 13%, compared with the prior year primarily driven by increased asset management fees, brokerage fees, consumer services fees and service charges on deposits. This growth can be attributed primarily to the following:
The provision for credit losses increased $29 million in 2006 compared with 2005. The increased provision is primarily a result of a single large overdraft situation and growth within the commercial loan portfolio.
Noninterest expense for 2006 totaled $1.827 billion, an increase of $101 million, or 6%, compared with 2005. Expense increases were primarily attributable to continued growth of the companys branch network, including our new greater Washington, DC area market, the consolidation of PNCs merchant services activities, expansion of the private client group, investments in various initiatives such as the new simplified checking account product line and new PNC-branded credit card, and an increase in volume-related expenses tied to revenue, partially offset by lower staff-related expense as a result of One PNC initiatives.
The new simplified checking product line is expected to continue to increase checking account households and average
balances per account. Two features of the new product line, free access to ATMs worldwide and a first time overdraft fee waiver, will, however, negatively impact growth rates on service charges on deposits fee income and noninterest expenses.
Full-time employees at December 31, 2006 totaled 9,549, a decline of 130 from December 31, 2005. Part-time employees have increased by 712 since December 31, 2005. The decline in full-time employees and increase in part-time employees is a direct result of various customer service enhancement and efficiency initiatives. These initiatives include utilizing more part-time customer-facing employees during peak business hours versus full-time employees for the entire day.
We have adopted a relationship-based lending strategy to target specific customer sectors (homeowners, small businesses and auto dealerships) while seeking to maintain a moderate risk profile in the loan portfolio.
Growing core checking deposits as a lower cost-funding source and as the cornerstone product to build customer relationships is the primary objective of our deposit strategy. Average total deposits increased $3.1 billion, or 7%, compared with 2005. The deposit growth was driven by increases in the number of checking relationships and the recapture of consumer certificate of deposit balances as interest rates have risen.
During the current rate environment, we expect the rate of growth in demand deposit balances to be equal to or less than the rate of overall growth for customer checking relationships. Additionally, we expect to see customers shift their funds from lower yielding interest-bearing deposits to higher yielding deposits or investment products, and to pay off loans. The shift has been evident during the past year and has impacted the level of average demand deposits in that period.
Assets under management of $54 billion at December 31, 2006 increased $5 billion compared with the balance at December 31, 2005. Asset growth was driven by the effect of comparatively higher equity markets combined with a breakeven position in client net asset flows. Client net asset flows are the result of investment additions from new and existing clients net of ordinary course distributions from trust and investment management accounts and account closures.
Nondiscretionary assets under administration of $86 billion at December 31, 2006 increased $2 billion compared with the balance at December 31, 2005. The effect of comparatively higher equity markets was partially offset by the loss of one significant master custody account and a sizeable reduction of another client account with minimal earnings impact.
CORPORATE & INSTITUTIONAL BANKING
Earnings from Corporate & Institutional Banking for 2006 totaled $463 million compared with $480 million for 2005. This decline was primarily attributable to the year over year $72 million change in the provision for credit losses principally as a result of a $53 million loan recovery recognized in the second quarter of 2005. In addition, the comparison was impacted by a $137 million increase in total revenue, while noninterest expenses grew by $91 million in 2006 compared with 2005.
Highlights of 2006 for Corporate & Institutional Banking included:
Commercial mortgage servicing revenue, which includes fees and net interest income, totaled $184 million for 2006, an
increase of $40 million over 2005. The 28% revenue increase over 2005 was driven by growth in the commercial mortgage servicing portfolio, which increased to $200 billion. The associated increase in deposits with the business has increased the net interest income portion of Midland Loan Services total revenue.
Taxable-equivalent net interest income declined $19 million, or 3%, to $720 million, in 2006 compared with 2005.
Noninterest income totaled $752 million in 2006, an increase of $156 million, or 26%, compared with the prior year. Corporate service fees increased 32% primarily due to fee income attributable to Harris Williams (acquisition completed in October 2005) and growth of treasury management fees. Improved trading results drove the 14% increase in other noninterest income.
Noninterest expense increased 14% compared with 2005. The increases in noninterest expense and full-time employees were primarily due to acquisition activity, customer growth, continuing investments, and the increase in the commercial mortgage servicing portfolio.
See the additional revenue discussion regarding treasury management, capital markets and Midland Loan Services under the caption Product Revenue on page 25.
Our BlackRock business segment earned $187 million in 2006 and $152 million in 2005. For this PNC business segment presentation, our share of MLIM transaction integration costs for 2006 have been reclassified from BlackRock to Other. In addition, these business segment earnings have been reduced by minority interest in income of BlackRock, excluding MLIM transaction integration costs, totaling $65 million and $71 million in 2006 and 2005, respectively. Also, these business segment earnings are net of additional PNC income taxes recorded on PNCs share of BlackRocks earnings.
PNCs BlackRock business segment earnings increased $35 million, or 23%, compared with 2005. We have modified the presentation of historical BlackRock business segment results as described above to conform with the current business segment reporting presentation in this Item 7. Higher earnings in 2006 reflected higher investment advisory and administrative fees due to an increase in assets under management, including BlackRocks acquisition of MLIM at the end of the third quarter of 2006 as further discussed below.
PNCs investment in BlackRock was $3.9 billion at December 31, 2006. Based upon BlackRocks closing market price of $151.90 per common share at December 31, 2006, the market value of our investment in BlackRock was approximately $6.7 billion at that date. As such, an additional $2.8 billion of value was not recognized in our investment account at that date.
On September 29, 2006, Merrill Lynch contributed its investment management business to BlackRock in exchange for 65 million shares of newly issued BlackRock common and preferred stock. BlackRock accounted for the MLIM transaction under the purchase method of accounting.
Immediately following the closing, PNC continued to own approximately 44 million shares of BlackRock common stock, representing an ownership interest of approximately 34% of the combined company after the closing (as compared with 69% immediately prior to the closing). Although PNCs share ownership percentage declined, PNCs investment in BlackRock increased due to the increase in total equity recorded by BlackRock as a result of the MLIM transaction.
Upon the closing of the BlackRock/MLIM transaction, the carrying value of our investment in BlackRock increased by approximately $3.1 billion to $3.8 billion, primarily reflecting PNCs portion of the increase in BlackRocks equity resulting from the value of shares issued in that transaction.
We also recorded a liability at September 30, 2006 for deferred taxes of approximately $.9 billion, related to the excess of the book value over the tax basis of our investment in BlackRock, and a liability of approximately $.6 billion related to our obligation to provide shares of BlackRock
common stock to help fund BlackRock LTIP programs described below. The LTIP liability will be adjusted quarterly based on changes in BlackRocks common stock price and the number of remaining committed shares. Accordingly, at each quarter-end PNC will record a charge to earnings if the market price of BlackRocks common stock increases and will record a credit to earnings if BlackRocks stock price declines.
The overall balance sheet impact of the BlackRock/MLIM transaction was an increase to our shareholders equity of approximately $1.6 billion. The increase to equity was comprised of an after-tax gain of approximately $1.3 billion, net of the expense associated with the LTIP liability and the deferred taxes, and an after-tax increase to capital surplus of approximately $.3 billion. The recognition of the gain is consistent with our existing accounting policy for the sale or issuance by subsidiaries of their stock to third parties. The gain represents the difference between our basis in BlackRock stock prior to the BlackRock/MLIM transaction and the new book value per share and resulting increase in value of our investment realized from the transaction. The direct increase to capital surplus rather than inclusion in the gain resulted from the accounting treatment required due to existing BlackRock repurchase commitments or programs.
For 2005 and the nine months ended September 30, 2006, our Consolidated Income Statement included our former approximately 69% - 70% ownership interest in BlackRocks net income through the closing date. However, beginning September 30, 2006, our Consolidated Balance Sheet no longer reflected the consolidation of BlackRocks balance sheet but recognized our ownership interest in BlackRock as an investment accounted for under the equity method. This accounting has resulted in a reduction in certain revenue and noninterest expense categories on PNCs Consolidated Income Statement as our share of BlackRocks net income is now reported within asset management noninterest income.
BLACKROCK LTIP PROGRAMS
BlackRock adopted the 2002 LTIP program to help attract and retain qualified professionals. At that time, we agreed to transfer 4 million of the shares of BlackRock common stock then held by us to fund the 2002 and future programs approved by BlackRocks board of directors, subject to certain conditions and limitations. PNCs noninterest income in the fourth quarter of 2006 included a $12 million charge related to our commitment to fund BlackRock LTIP programs. This charge represents the mark-to-market of our BlackRock LTIP obligation as of December 31, 2006 and is a result of the fourth quarter increase in the market value of BlackRock common shares. This increase in price also increased the unrecognized value of our investment in BlackRock at December 31, 2006 by approximately $128 million.
Prior to 2006, BlackRock granted awards under the 2002 LTIP program of approximately $230 million, of which approximately $210 million was paid on January 30, 2007.
The awards were funded by approximately 17% in cash from BlackRock and the remainder in BlackRock common stock transferred by us and distributed to LTIP participants (approximately 1 million shares). As permitted under the award agreements, employees elected to put approximately 95% of the stock portion of the awards back to BlackRock. These shares were retained by BlackRock as treasury stock.
We recognized a pretax gain of approximately $82 million in the first quarter of 2007 from the transfer of BlackRock shares to satisfy the majority of our 2002 LTIP obligation. The gain reflected the excess of market value over book value of approximately 1 million shares transferred in January 2007. We also expect to recognize a loss in the first quarter of 2007 on the mark-to-market adjustment on our remaining 3 million LTIP shares obligation. Each of these items will be recorded in noninterest income.
BlackRock granted additional restricted stock unit awards in January 2007, all of which are subject to achieving earnings performance goals prior to the vesting date of September 29, 2011. Of the shares of BlackRock common stock that we have agreed to transfer to fund their LTIP programs, approximately 1.6 million shares have been committed to fund the restricted stock unit awards vesting in 2011 and the amount remaining would then be available for future awards.
While we may continue to see volatility in earnings as we mark to market our LTIP shares obligation each quarter-end, we will not be able to recognize additional gains, if applicable, for the difference between the market value and the book value of the committed BlackRock common shares until the shares are distributed to LTIP participants. As of January 31, 2007, when the BlackRock closing market price was $167.76 per share, the unrecognized value related to the remaining 3 million LTIP shares was approximately $225 million and the unrecognized value of our total BlackRock investment was approximately $3.4 billion.