PNC FINANCIAL SERVICES GROUP INC 10-K 2008
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, 2007
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 registrant's 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 29, 2007, determined using the per share closing price on that date on the New York Stock Exchange of $71.58, was approximately $24.4 billion. There is no non-voting common equity of the registrant outstanding.
Number of shares of registrant's common stock outstanding at February 15, 2008: 340,774,529
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 22, 2008 ("Proxy Statement") are incorporated by reference into Part III of this Form 10-K.
TABLE OF CONTENTS
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 (theReport 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 Risk Management, Critical Accounting Policies and Judgments, and Cautionary Statement Regarding Forward-Looking Information sections 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, Washington, DC, Maryland, Virginia, Ohio, Kentucky and Delaware. We also provide certain global fund processing services internationally. At December 31, 2007, our consolidated total assets, deposits and shareholders' equity were $138.9 billion, $82.7 billion and $14.9 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.
ACQUISITION AND DIVESTITURE ACTIVITY On December 7, 2007, we acquired Albridge Solutions Inc. (Albridge), a Lawrenceville, New Jersey-based provider of portfolio accounting and enterprise wealth management services. Albridge provides financial advisors with consolidated client account information from hundreds of data sources, and its enterprise approach to providing a unified client view and performance reporting helps advisors build their client and asset base. Albridge will extend PFPCs capabilities into the delivery of knowledge-based information services through its relationships with 150 financial institutions and more than 100,000 financial advisors with assets under management that exceed $1 trillion.
Also on December 7, 2007, we acquired Coates Analytics, LP (Coates Analytics), a Chadds Ford, Pennsylvania-based provider of web-based analytic tools that help asset managers identify wholesaler territories and financial advisor targets, promote products in the marketplace and strengthen competitive intelligence. Coates Analytics will complement PFPCs business strategy as it currently serves six of the 10 largest broker/dealers and provides market data to more than 40 of the leading asset management and fund companies.
On November 16, 2007, we entered into a definitive agreement to sell J.J.B. Hilliard, W.L.Lyons, Inc. (Hilliard Lyons), a wholly-owned subsidiary of PNC and a full-service brokerage and financial services provider, to Houchens Industries, Inc. Hilliard Lyons is headquartered in Louisville, Kentucky and has 76 branch offices mainly in cities outside of PNCs retail banking footprint with approximately $29 billion of brokerage account assets and $5 billion of assets under management. As a result of the sale, we expect to report an after-tax gain of approximately $20 million and increase
Tier 1 regulatory capital by approximately $135 million after elimination of goodwill recorded upon the purchase of
Hilliard Lyons in 1998. We expect this transaction to close in the first half of 2008, subject to regulatory and certain other required approvals.
On October 26, 2007, we acquired Hamilton, New Jersey-based Yardville National Bancorp (Yardville). Total consideration paid was approximately $399 million in stock and cash. Yardvilles subsidiary bank, The Yardville National Bank (Yardville National Bank), is a commercial and consumer bank and at closing had approximately $2.6 billion in assets, $2.0 billion in deposits and 35 branches in central New Jersey and eastern Pennsylvania. We plan to merge Yardville National Bank into PNC Bank, National Association (PNC Bank, N.A.) in the first quarter of 2008.
On July 19, 2007, we entered into a definitive agreement with Sterling Financial Corporation (Sterling) for PNC to acquire Sterling for approximately 4.5 million shares of PNC common stock and $224 million in cash. Sterling, based in Lancaster, Pennsylvania with approximately $3.2 billion in assets and $2.7 billion in deposits, provides banking and other financial services, including leasing, trust, investment and brokerage, to individuals and businesses through 67 branches in Pennsylvania, Maryland and Delaware. We expect this transaction to close in the second quarter of 2008, subject to customary closing conditions and the approval of Sterlings shareholders.
On July 2, 2007, we acquired ARCS Commercial Mortgage Co., L.P. (ARCS), a Calabasas Hills, California-based lender with 10 origination offices in the United States. ARCS has been a leading originator and servicer of agency multifamily loans for the past decade. It originated more than $2.1 billion of loans in 2006 and services approximately $13 billion of commercial mortgage loans.
On March 2, 2007, we acquired Mercantile Bankshares Corporation (Mercantile). Total consideration paid was approximately $5.9 billion in stock and cash. Mercantile has added banking and investment and wealth management services through 235 branches in Maryland, Virginia, the District of Columbia, Delaware and southeastern Pennsylvania. This transaction has significantly expanded our presence in the mid-Atlantic region, particularly within the attractive Maryland, Northern Virginia and Washington, DC markets.
Our acquisition of Mercantile added approximately $21 billion of assets and $12.5 billion of deposits to our Consolidated Balance Sheet. Our Consolidated Income Statement includes the impact of Mercantile subsequent to our March 2, 2007 acquisition.
We include information on significant recent and pending acquisitions and divestitures in Note 2 Acquisitions and Divestitures 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, Leases and Related Tax 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 26 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 2.9 million consumer and small business customers within our primary geographic markets. Our customers are serviced through over 1,100 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, Washington, DC, Maryland, Virginia, Ohio, Kentucky and Delaware. Brokerage services are provided through PNC Investments, LLC, and Hilliard Lyons. See the Business Overview section of this Item 1 regarding our planned divestiture of Hilliard Lyons in the first half of 2008. 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. These services are provided to individuals and corporations primarily within our primary geographic markets.
Our core strategy is to acquire and retain customers who maintain their primary checking and transaction relationships with PNC. We also seek revenue growth by deepening our share of our customers financial assets and needs, including savings and liquidity deposits, loans and investable assets. A key element of our strategy is to continue to optimize our physical distribution network 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-related 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. We also provide commercial loan servicing, real estate advisory and technology solutions for the commercial real estate finance industry. We provide 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 with $1.357 trillion of assets under management at December 31, 2007. BlackRock manages assets on behalf of institutional and individual investors worldwide through a variety of fixed income, cash management, equity and balanced and alternative investment separate accounts and funds. In addition, BlackRock provides risk management, investment system outsourcing and financial advisory services globally to institutional investors.
At December 31, 2007, our ownership interest in BlackRock was approximately 33.5%. Our investment in BlackRock is 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. We serviced $2.5 trillion in total fund assets and 72 million shareholder accounts as of December 31, 2007 both domestically and internationally.
PFPCs international and domestic capabilities were expanded during 2007. We received approval for a banking license in Ireland and a branch in Luxembourg, which will allow PFPC to provide depositary services in Europes leading domicile for traditional investment funds and the second largest
worldwide domicile after the United States. The opening of a sales office in London supported this initiative. The acquisition of Albridge and Coates Analytics in December 2007 will enhance our business model and product offerings with the delivery of information services to asset managers, financial advisors, and the distribution channel to help them better service their respective target markets.
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, 2007 consisted of three subsidiary banks, including their subsidiaries, and approximately 67 active non-bank subsidiaries. PNC Bank, N.A., headquartered in Pittsburgh, Pennsylvania, is our principal bank subsidiary. At December 31, 2007, PNC Bank, N.A. had total consolidated assets representing approximately 90% of our consolidated assets. Our other bank subsidiaries are PNC Bank, Delaware and Yardville National Bank. Our non-bank PFPC subsidiary has obtained a banking license in Ireland and a branch in Luxembourg, which allow PFPC to provide depositary services as part of its business. 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 22 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 Yardville National Bank, 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 (described in Note 2 Acquisitions and Divestitures in the Notes To Consolidated Financial Statements in Item 8 of this Report), 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. As noted below, we expect to merge Yardville National Bank into PNC Bank, N.A., in the first quarter of 2008. 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 22 Regulatory Matters included in the Notes To Consolidated Financial Statements in Item 8 of this Report, which is incorporated herein by reference. Further information on bank level liquidity and parent company liquidity and on certain contractual restrictions is also available in the Liquidity Risk Management section and in the Perpetual Trust Securities and Acquired Entity Trust Preferred Securities sections of the Off-Balance Sheet Arrangements and VIEs 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 corporation's 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 domestic 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 domestic 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 risk-weighted 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, 2007, each of our domestic subsidiary banks exceeded the required ratios for classification as well capitalized. For additional discussion of capital adequacy requirements, we refer you to Funding and Capital Sources in the Consolidated Balance Sheet Review section of Item 7 of this Report and to Note 22 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 to be conducted by 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, 2007, PNC Bank, N.A. and PNC Bank, Delaware, were rated outstanding and Yardville National Bank was rated satisfactory with respect to CRA.
FDIC Insurance. All three of our domestic 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 through 2008.
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 FDIC's 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 Financial Industry Regulatory Authority (FINRA), among others. Hilliard Lyons is also a member of the New York Stock Exchange and various regional and national exchanges whose members are subject to regulation 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, as amended, and the SEC's 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.
Over the past several years, the SEC and other governmental agencies have been investigating the mutual fund industry, including PFPC and other 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 provisions of the federal securities laws 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, restitution, 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 FINRA 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.
PFPC and BlackRock are also subject to regulation by appropriate authorities in the foreign jurisdictions in which they do business.
BlackRock has subsidiaries in securities and related businesses subject to SEC and FINRA 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 broad 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 28,320 at December 31, 2007 (comprised of 25,480 full-time and 2,840 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, 100 F Street, NE, 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 at www.pnc.com/secfilings. 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 2006 and both amendments thereto 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/corporategovernance. 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 2007 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 and other risks 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, Washington, D.C., Maryland and Virginia), and thus that business is particularly vulnerable to adverse changes in economic conditions in these regions.
Changes in interest rates, in the shape of the yield curve, in valuations in the debt or equity markets, or disruptions in the liquidity or other functioning of financial 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. Starting in the middle of 2007, there has been significant turmoil and volatility in worldwide financial markets which is, at present, ongoing. These conditions have resulted in increased liquidity risk. 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 or disruptions in the liquidity or other functioning of financial markets, all of which have been seen recently, could directly impact us in one or more of the following ways:
Among the situations that could have one or more of the preceding impacts are (1) ongoing volatility in the markets for real estate and other assets commonly securing financial products, as well as in the markets for such financial products, and (2) changes in the availability of insurance providing
credit enhancement with respect to financial products or in the ratings of the companies providing such insurance.
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 in general present risks to PNC in addition to those presented by the nature of the business acquired. In particular, acquisitions may be substantially more expensive to complete (including as a result of 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 arising as a result of those issues.
Our pending acquisition of Sterling 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. Sterling presents regulatory and litigation risk as a result of financial irregularities at Sterlings commercial finance subsidiary.
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 22 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 capital and other financial 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 9 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.
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. Pursuant to Adelphias plan of reorganization, this lawsuit will be prosecuted by a contingent value vehicle, known as the Adelphia Recovery Trust. In October 2007, the Adelphia Recovery Trust filed an amended complaint in this lawsuit, adding defendants and making additional allegations. 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 the above district court. The bank defendants, including the PNC defendants, have entered into a settlement of the consolidated class action. This settlement was approved by the district court in November 2006. In December 2006, a group of class members appealed orders related to the settlement to the United States Court of Appeals for the Second Circuit. The amount for which we would be responsible under this settlement is insignificant.
The non-settled lawsuits arise out of lending and investment banking activities engaged in by PNC subsidiaries together with other financial services companies. In the aggregate, hundreds of other financial services companies and numerous
other companies and individuals have been named as defendants in one or more of these lawsuits. Collectively, with respect to some or all of the defendants, the lawsuits allege federal law claims (including violations of federal securities and banking laws), violations of common law duties, aiding and abetting such violations, voidable preference payments, and fraudulent transfers, among other matters. The lawsuits seek monetary damages (including in some cases punitive or treble damages), interest, attorneys fees and other expenses, and a return of the alleged voidable preference and fraudulent transfer payments, among other remedies.
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 non-settled lawsuits. 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 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 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 Patent Office has since indicated that all of the claims are allowable. In September 2007, the parties agreed to stay the other two patents-in-suit pending reexamination of those patents. The entire case is presently stayed. Data Treasury has moved to lift the stay.
CBNV Mortgage Litigation
Between 2001 and 2003, on behalf of either individual plaintiffs or a putative class of plaintiffs, several separate actions were filed in state and federal court against Community Bank of Northern Virginia (CBNV) and other defendants challenging the validity of second mortgage loans the defendants made to the plaintiffs. CBNV was merged into one of Mercantiles banks. These cases were either filed in, or removed to, the United States District Court for the Western District of Pennsylvania.
In July 2003, the court conditionally certified a class for settlement purposes and preliminarily approved a settlement of the various actions. Thereafter, certain plaintiffs who had initially opted out of the proposed settlement and other objectors challenged the validity of the settlement in the district court. The district court approved the settlement, and these opt out plaintiffs and other objectors appealed to the United States Court of Appeals for the Third Circuit. In August 2005, the court of appeals reversed the district courts approval of the settlement and remanded the case to the district court with instructions to consider and address certain specific issues when re-evaluating the settlement. In August 2006, the settling parties submitted a modified settlement agreement to the district court for its approval. In January 2008, the district court conditionally certified a class for settlement purposes, preliminarily approved the proposed modified settlement agreement, and directed that the settlement agreement be submitted to the class members for their consideration. This settlement remains subject to final court approval. Some of the objecting plaintiffs are seeking permission to appeal the district courts decision certifying the class for settlement purposes and preliminarily approving the settlement. These same plaintiffs also filed a motion to stay the district court proceedings pending a decision on their appeal request. The district court denied the stay request, and there is a similar stay motion pending in the appeals court.
In January 2008, the district court also issued an order sending back to state court in North Carolina the claims of certain plaintiffs seeking to represent a class of North Carolina borrowers.
In addition to these lawsuits, several individuals have filed actions on behalf of themselves or a putative class of plaintiffs alleging claims involving CBNVs second mortgage loans. These actions also were filed in, or transferred for coordinated or consolidated pre-trial proceedings to, the United States District Court for the Western District of Pennsylvania.
The plaintiffs in these lawsuits seek unquantified monetary damages, interest, attorneys fees and other expenses, and a refund of all origination fees and fees paid for title services.
BAE Derivative Litigation
In September 2007, a derivative lawsuit was filed on behalf of BAE Systems plc by a holder of its American Depositary Receipts against current and former directors and officers of BAE, Prince Bandar bin Sultan, PNC (as successor to Riggs National Corporation and Riggs Bank, N.A.), Joseph L. Allbritton, Robert L. Allbritton, and Barbara Allbritton. The complaint alleges that BAE directors and officers breached their fiduciary duties by making or permitting to be made improper or illegal bribes, kickbacks and other payments with respect to a military contract obtained in the mid-1980s from the Saudi Arabian Ministry of Defense, and that Prince Bandar was the primary recipient or beneficiary of these payments. The complaint also alleges that Riggs, together with the Allbrittons (as former directors, officers and controlling
persons of Riggs), acted as the primary intermediaries through which the payments were laundered and actively concealed, and aided and abetted the BAE defendants breaches of fiduciary duties. As it relates to PNC, plaintiff is seeking unquantified monetary damages (including punitive damages), an accounting, interest, attorneys fees and other expenses. We believe that we have defenses to the claims against us in this lawsuit and intend to defend it vigorously. We have filed a motion seeking dismissal of the claims against us. As a result of our acquisition of Riggs, PNC may be responsible for indemnifying the Allbrittons in connection with this lawsuit.
Regulatory and Governmental Inquiries
In connection with an audit of the services provided by Mercantile Safe Deposit & Trust Company (now PNC Bank) as trustee of the AFL-CIO Building Investment Trust, a collective trust fund that invests pension plan assets in commercial real estate assets, the United States Department of Labor has identified the possibility that Mercantile collected unauthorized fees in violation of ERISA. If it is ultimately determined that these fees were collected in violation of the law, we could be subject to requirements to return the fees to the Building Investment Trust, with interest, and could also be subject to penalties and taxes.
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 of investigations and other forms of regulatory inquiry, often as part of industry-wide regulatory reviews of specified activities. One of these situations is in connection with investigations of practices in the mutual fund industry, where several of our subsidiaries have received requests for information and other inquiries from governmental and regulatory authorities.
Our practice is to cooperate fully with regulatory and governmental investigations, audits and other inquiries, including those described above. Such investigations, audits and other inquiries may lead to remedies such as fines, restitution or alterations in our business practices.
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. See Note 24 Commitments and Guarantees in the Notes To Consolidated Financial Statements in Item 8 of this Report for additional information regarding the Visa indemnification and our obligation to provide indemnification to current and former officers, directors, employees and agents of PNC and companies we have acquired. 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 2007.
EXECUTIVE OFFICERS OF THE REGISTRANT Information regarding each of our executive officers as of February 15, 2008 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.
Thomas K. Whitford was appointed Chief Administrative Officer in May 2007. From April 2002 through May 2007, he served as Chief Risk Officer.
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.
John J. Wixted, Jr. joined PNC as Senior Vice President and Chief Regulatory Officer in August 2002. He served in this role until May 2007, when he was appointed Chief Risk Officer.
(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 15, 2008, there were 49,566 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, dividends 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, PNC Capital Trust E Trust Preferred Securities and Acquired Entity Trust Preferred Securities in the Off-Balance Sheet Arrangements and VIEs section of Item 7 of this Report, and Note 22 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, 2007 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
We include here by reference the information that appears under the caption Common Stock Performance Graph at the end of this Item 5.
(c) Details of our repurchases of PNC common stock during the fourth quarter of 2007 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, 2007, 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, 2003 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: BB&T Corporation; Comerica Inc.; Fifth Third Bancorp; KeyCorp; National City Corporation; The PNC Financial Services Group, Inc.; SunTrust Banks, Inc.; U.S. Bancorp.; Wachovia Corporation; Regions Financial Corporation; and Wells Fargo & Co. The Peer Group shown is the Peer Group approved by the Boards Personnel and Compensation Committee for 2007.
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, 2002 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 and Divestitures in the Notes To Consolidated Financial Statements in Item 8 of this Report for information on significant recent and planned business acquisitions and divestitures.
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, Washington, DC, Maryland, 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 driving positive operating leverage by achieving growth in revenue from our diverse business mix that exceeds growth in expenses as a result of disciplined cost management. In each of our business segments, the primary drivers of revenue growth are the acquisition, expansion and retention of customer relationships. We strive to expand our customer base by providing convenient banking options and leading technology systems, providing a broad range of fee-based products and services, focusing on customer service, and through a significantly enhanced branding initiative. We may also grow revenue through appropriate and targeted acquisitions and, in certain businesses, by expanding into new geographical markets.
We have maintained a moderate risk profile characterized by strong credit quality and limited exposure to earnings volatility resulting from interest rate fluctuations and the shape of the interest rate yield curve. Our actions have created a strong balance sheet, ample liquidity and investment flexibility to adjust, where appropriate, to changing interest rates and market conditions. We continue to be disciplined in investing capital in our businesses while returning a portion to shareholders through dividends and share repurchases when appropriate.
ACQUISITION AND DIVESTITURE ACTIVITY
A summary of pending and recently completed acquisitions and divestitures is included under Item 1 and in Note 2 Acquisitions and Divestitures in the Notes To Consolidated Financial Statements in Item 8 of this Report.
KEY FACTORS AFFECTING FINANCIAL PERFORMANCE
Our financial performance is substantially affected by several external factors outside of our control, including:
Starting in the middle of 2007, and continuing at present, there has been significant turmoil and volatility in worldwide financial markets, accompanied by uncertain prospects for the overall economy. Our performance in 2008 will be impacted by developments in these areas. In addition, our success in 2008 will depend, among other things, upon:
SUMMARY FINANCIAL RESULTS
We refer you to the Consolidated Income Statement Review portion of the 2006 Versus 2005 section of this Item 7 for significant items which collectively increased net income for 2006 by $1.1 billion, or $3.67 per diluted share.
Our performance in 2007 included the following accomplishments:
BALANCE SHEET HIGHLIGHTS
Total assets were $138.9 billion at December 31, 2007 compared with $101.8 billion at December 31, 2006. The increase compared with December 31, 2006 was primarily due to the addition of approximately $21 billion of assets related to the Mercantile acquisition, growth in loans and higher securities available for sale.
Total average assets were $123.4 billion for 2007 compared with $95.0 billion for 2006. This increase reflected a $20.3 billion increase in average interest-earning assets and an increase in average other noninterest-earning assets. An increase of $12.9 billion in loans and a $5.2 billion increase in securities available for sale were the primary factors for the increase in average interest-earning assets.
The increase in average other noninterest-earning assets for 2007 reflected our equity investment in BlackRock, which averaged $3.8 billion for 2007 and which had been consolidated for the first nine months of 2006, and an increase in average goodwill of $3.6 billion primarily related to the Mercantile and Yardville acquisitions.
Average total loans were $62.5 billion for 2007 and $49.6 billion for 2006. The increase in average total loans included the effect of the Mercantile acquisition for 10 months of 2007 and higher commercial loans. The increase in average total loans included growth in commercial loans of $5.3 billion and growth in commercial real estate loans of $4.5 billion. Loans represented 64% of average interest-earning assets for both 2007 and 2006.
Average securities available for sale totaled $26.5 billion for 2007 and $21.3 billion for 2006. The 10-month impact of Mercantile contributed to the increase in average securities for the 2007 period, along with overall balance sheet growth. Securities available for sale comprised 27% of average interest-earning assets for both 2007 and 2006.
Average total deposits were $76.8 billion for 2007, an increase of $13.5 billion over 2006. Average deposits grew from the
prior year primarily as a result of an increase in money market, noninterest-bearing demand deposits and retail certificates of deposit. These increases reflected the 10-month impact of the Mercantile acquisition and growth in deposits in Corporate & Institutional Banking.
Average total deposits represented 62% of average total assets for 2007 and 67% for 2006. Average transaction deposits were $50.7 billion for 2007 compared with $42.3 billion for 2006.
Average borrowed funds were $23.0 billion for 2007 and $15.0 billion for 2006. Increases of $3.2 billion in bank notes and senior debt, $2.5 billion in federal funds purchased and $1.5 billion in Federal Home Loan bank borrowings drove the increase in average borrowed funds compared with 2006.
Shareholders equity totaled $14.9 billion at December 31, 2007, compared with $10.8 billion at December 31, 2006. The increase resulted primarily from the Mercantile and Yardville acquisitions. See the Consolidated Balance Sheet Review section of this Item 7 for additional information.
LINE OF BUSINESS HIGHLIGHTS
We refer you to Item 1 of this Report under the captions Business Overview and Review of Lines of Business for an overview of our business segments and to the Business Segments Review section of this Item 7 for a Results Of Businesses Summary table and further analysis of business segment results for 2007 and 2006, including presentation differences from Note 26. Total business segment earnings were $1.7 billion for 2007 and $1.5 billion for 2006.
We provide a reconciliation of total business segment earnings to total PNC consolidated net income as reported on a GAAP basis in Note 26 Segment Reporting in the Notes To Consolidated Financial Statements in Item 8 of this Report.
Retail Bankings 2007 earnings increased $128 million, to $893 million, up 17% compared with 2006. The increase in earnings over the prior year was driven by acquisitions and strong fee income and customer growth, partially offset by increases in the provision for credit losses and continued investments in the business.
Corporate & Institutional Banking
Corporate & Institutional Banking earned $432 million in 2007 compared with $454 million in 2006. While total revenue increased more than noninterest expense, earnings declined due to an increase in the provision for credit losses. Market-related declines in commercial mortgage- backed securities (CMBS) securitization activities and non-customer-related trading revenue resulted in a year-over-year reduction in noninterest income.
Our BlackRock business segment earned $253 million in 2007 and $187 million in 2006. Subsequent to the September 29, 2006 deconsolidation of BlackRock, these business segment earnings are determined primarily by taking our proportionate share of BlackRocks earnings. Also, for this business segment presentation, after-tax BlackRock/MLIM transaction integration costs totaling $3 million and $65 million in 2007 and 2006, respectively, have been reclassified from BlackRock to Other.
PFPC earned $128 million for 2007 compared with $124 million in 2006. Results for 2006 benefited from the impact of a $14 million reversal of deferred taxes related to earnings from foreign subsidiaries following managements determination that the earnings would be indefinitely reinvested outside of the United States. Apart from the impact of this item, the earnings increase of $18 million in 2007 reflected the successful conversion of net new business, organic growth and market appreciation.
Other incurred a loss of $239 million in 2007 compared with earnings for 2006 of $1.1 billion. Other for 2007 included the after-tax impact of the following:
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 after-tax impact of charges related to our third quarter 2006 balance sheet repositioning activities and BlackRock/MLIM integration costs. Further information regarding the BlackRock/MLIM transaction is included in Note 2 Acquisitions and Divestitures included in the Notes To Consolidated Financial Statements in Item 8 of this Report.
CONSOLIDATED INCOME STATEMENT REVIEW
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 of funding.
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 in the Consolidated Income Statement.
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 $672 million, or 30%, in 2007 compared with 2006. This increase was consistent with the $20.3 billion, or 26%, increase in average interest-earning assets during 2007 compared with 2006. The reasons driving the higher interest-earning assets in 2007 are further discussed in the Balance Sheet Highlights portion of the Executive Summary section of this Item 7.
We expect net interest income to be higher in 2008 compared with 2007, assuming our current expectations for interest rates and economic conditions. Our forward-looking statements are based on our current expectations that interest rates will remain low through most of 2008 and that economic conditions, although showing slower growth than in recent years, will avoid a recession.
NET INTEREST MARGIN
The net interest margin was 3.00% for 2007 and 2.92% for 2006. The following factors impacted the comparison:
Comparing yields and rates paid to the broader market, the average federal funds rate was 5.03% during 2007 compared with 4.96% for 2006.
We believe that net interest margins for our industry will continue to be impacted by competition for high quality loans and deposits and customer migration from lower to higher rate deposit or other products. We expect our net interest margin to improve slightly in 2008 compared with 2007, assuming our current expectations for interest rates and economic conditions.
PROVISION FOR CREDIT LOSSES
The provision for credit losses totaled $315 million for 2007 and $124 million for 2006. Of the total 2007 provision, $188 million was recorded in the fourth quarter, including approximately $45 million related to our Yardville acquisition. The higher provision in 2007 was also impacted by an increase in our real estate portfolio, including residential real estate development exposure, and growth in total credit exposure. Total residential real estate development outstandings were approximately $2.1 billion at December 31, 2007.
We do not expect to sustain asset quality at its current level. Given our projections for loan growth and continued credit deterioration, we expect nonperforming assets and the provision for credit losses will be higher in 2008 compared with 2007. Also, we expect that the level of provision for credit losses in the first quarter of 2008 will be modestly lower than the amount reported for the fourth quarter of 2007.
The Credit Risk Management portion of the Risk Management section of this Item 7 includes additional information regarding factors impacting the provision for credit losses.
Noninterest income was $3.790 billion for 2007 and $6.327 billion for 2006. Noninterest income for 2007 included the impact of $83 million gain recognized in connection with our transfer of BlackRock shares to satisfy a portion of PNCs LTIP obligation and a $210 million net loss representing the mark-to-market adjustment on our LTIP obligation.
Noninterest income for 2006 included the impact of the following items:
Apart from the impact of these items, noninterest income increased $367 million, or 10%, in 2007 compared with 2006 largely as a result of the Mercantile acquisition and growth in several fee income categories.
We expect that net interest income and noninterest income will increase in 2008 compared with 2007. We also believe that PNC will create positive operating leverage in 2008 with a percentage growth in total revenue relative to 2007 that will exceed the percentage growth in noninterest expense from 2007.
Asset management fees totaled $784 million for 2007 and $1.420 billion for 2006. Our equity income from BlackRock has been included in asset management fees beginning with the fourth quarter of 2006. Asset management fees were higher in 2006 as the first nine months of 2006 reflected the impact of BlackRocks revenue on a consolidated basis.
Assets managed at December 31, 2007 totaled $73 billion compared with $54 billion at December 31, 2006. This increase resulted primarily from the Mercantile acquisition. We refer you to the Retail Banking section of the Business Segments Review section of this Item 7 for further discussion of assets under management.
Fund servicing fees declined $58 million in 2007, to $835 million, compared with $893 million in the prior year. Amounts for 2006 included $117 million of distribution fee revenue at PFPC. Effective January 1, 2007, we refined our accounting and reporting of PFPCs distribution fee revenue and related expense amounts and present these amounts net on a prospective basis. Prior to 2007, the distribution amounts were shown on a gross basis within fund servicing fees and within other noninterest expense and offset each other entirely with no impact on earnings.
Apart from the impact of the distribution fee revenue included in the 2006 amounts, fund servicing fees increased $59 million in 2007 compared with the prior year. Higher revenue from offshore operations, transfer agency, managed accounts and alternative investments contributed to the increase in
2007, reflecting net new business and growth from existing clients. The PFPC section of the Business Segments Review section of this Item 7 includes information on net fund assets and custody fund assets serviced.
Service charges on deposits increased $35 million, or 11%, to $348 million for 2007 compared with 2006. The increase was primarily due to the impact of Mercantile.
Brokerage fees increased $32 million, or 13%, to $278 million for 2007 compared with the prior year. The increase was primarily due to higher mutual fund-related revenues, continued growth in our fee-based fund advisory business and higher annuity income.
Consumer services fees increased $49 million, or 13%, to $414 million in 2007 compared with 2006. The increase reflected the impact of Mercantile, higher debit card revenues resulting from higher transaction volumes, and fees from the credit card business that began in the latter part of 2006.
Corporate services revenue was $713 million for 2007, an increase of $87 million, or 14%, over 2006. Higher revenue from commercial mortgage servicing including the impact of the ARCS acquisition, treasury management, third party consumer loan servicing activities and the Mercantile acquisition contributed to the increase in 2007 over the prior year.
Equity management (private equity) net gains on portfolio investments totaled $102 million in 2007 and $107 million in 2006. Based on the nature of private equity activities, net gains or losses may fluctuate from period to period.
Net securities losses totaled $5 million in 2007 and $207 million in 2006. We took actions 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 totaled $104 million in 2007 compared with $183 million in 2006. While customer trading income increased in comparison, total trading revenue declined in 2007 largely due to the lower economic hedging gains associated with commercial mortgage loan activity and economic hedging losses associated with structured resale agreements. We provide additional information on our trading activities under Market Risk Management Trading Risk in the Risk Management section of this Item 7.
Net losses related to our BlackRock investment amounted to $127 million in 2007, representing the net of the mark-to-market adjustment on our LTIP obligation and gain recognized in connection with our transfer of shares to satisfy a portion of our LTIP obligation, compared with a net gain of $2.066 billion in 2006. The 2006 amount included the $2.078 billion gain on the BlackRock/MLIM transaction. See the BlackRock portion of the Business Segments Review section of Item 7 of this Report for further information.
Other noninterest income increased $29 million, to $344 million, in 2007 compared with 2006. Other noninterest income for 2007 included the negative impact in the fourth quarter of a $26 million valuation adjustment for commercial mortgage loans held for sale. In early 2008, spreads have been widening and there has been limited activity in the CMBS securitization market. We value our commercial mortgage loans held for sale based on securitization prices. Therefore, if these conditions continue, additional losses will be incurred that will be significantly higher than the losses incurred during the fourth quarter of 2007. However, we do not expect the impact to be significant to our capital position. Currently, these valuation losses are unrealized (non-cash) and all of the loans in this portfolio are performing.
Other noninterest income for 2006 included a $48 million loss incurred in the third quarter in connection with the rebalancing of our residential mortgage portfolio.
Other noninterest income typically fluctuates from period to period depending on the nature and magnitude of transactions completed and market price fluctuations.
In addition to credit products to commercial customers, Corporate & Institutional Banking offers other services, including treasury management and capital markets-related products and services, commercial loan servicing and insurance 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, increased 14% to $476 million for 2007 compared with $418 million for 2006. The higher revenue reflected continued expansion and client utilization of commercial payment card services, strong revenue growth in investment products and in various electronic payment and information services.
Revenue from capital markets-related products and services totaled $290 million for 2007 compared with $283 million in 2006. This increase was driven primarily by merger and acquisition advisory and related services.
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 $220 million for 2007 and $184 million for 2006, an increase of 20%. The 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 annuities, life, credit life, health, and disability. Revenue from these products increased 4% to $74 million for 2007 compared with $71 million for 2006.
PNC, through subsidiary company Alpine Indemnity Limited, 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 maintains 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, 2007.
Total noninterest expense was $4.296 billion for 2007, a decrease of $147 million compared with $4.443 billion for 2006.
Item 6 of this Report includes our efficiency ratios for 2007 and 2006, along with information regarding certain significant items impacting noninterest income and expense in 2006.
Noninterest expense for 2007 included the following:
Noninterest expense for 2006 included the following:
Apart from the impact of these items, noninterest expense increased $525 million, or 15%, in 2007 compared with 2006. These increases were largely a result of the acquisition of Mercantile. Investments in growth initiatives were mitigated by disciplined expense management.
We expect to incur pretax integration costs of approximately $70 million in 2008 primarily related to our planned acquisition of Sterling and additional costs related to the Yardville and Albridge acquisitions.
EFFECTIVE TAX RATE
Our effective tax rate was 29.9% for 2007 and 34% for 2006. The lower effective tax rate in 2007 compared with the prior year reflected the impact of the following matters:
Our effective tax rate is sensitive to levels of pretax income as certain income tax credits and items not subject to income tax remain relatively constant. Based upon current projections, we believe that the effective tax rate will be approximately 31% in 2008, before considering the impact of the pending sale of Hilliard Lyons.
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.
Our Consolidated Balance Sheet at December 31, 2007 reflects the addition of approximately $21 billion of assets resulting from our Mercantile acquisition and approximately $3 billion of assets related to our Yardville acquisition.
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 more indicative of underlying business trends.
An analysis of changes in selected balance sheet categories follows.
LOANS, NET OF UNEARNED INCOME
Loans increased $18.2 billion, or 36%, as of December 31, 2007 compared with December 31, 2006. Our Mercantile acquisition added $12.4 billion of loans including $4.9 billion of commercial, $4.8 billion of commercial real estate, $1.6 billion of consumer and $1.1 billion of residential mortgage loans. Our Yardville acquisition added $1.9 billion of loans.
Details Of Loans
Our loan portfolio continued to be diversified among numerous industries and types of businesses. The loans that we hold are also concentrated in, and diversified across, our principal geographic markets. See Note 5 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 lending outstandings in the table above 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 $713 million, or 86%, of the total allowance for loan and lease losses at December 31, 2007 to these loans. We allocated $68 million, or 8%, of the remaining allowance at that date to consumer loans and $49 million, or 6%, to all other loans. This allocation also considers other relevant factors such as:
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 $8.9 billion at December 31, 2007 and $8.3 billion at December 31, 2006. Consumer home equity lines of credit accounted for 80% of consumer unfunded credit commitments.
Unfunded liquidity facility commitments and standby bond purchase agreements totaled $9.4 billion at December 31, 2007 and $6.0 billion at December 31, 2006 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 $4.8 billion at December 31, 2007 and $4.4 billion at December 31, 2006. Standby letters of credit commit us to make payments on behalf of our customers if specified future events occur. At December 31, 2007, 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 Matters
The lease portfolio totaled $3.5 billion at December 31, 2007. Aggregate residual value at risk on the lease portfolio at December 31, 2007 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, 2007. 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.
We have reached a settlement with the Internal Revenue Service (IRS) regarding our tax liability related to cross- border lease transactions, principally arising from adjustments to the timing of income tax deductions in connection with IRS examinations of our 1998-2003 consolidated Federal income tax returns. The impact of the final settlement was included in results of operations for 2007 and was not material. See Note 1 Accounting Policies in the Notes To Consolidated Financial Statements in Item 8 of this Report regarding our adoption of FSP 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.
Details of Securities
Securities represented 22% of total assets at December 31, 2007 and 23% of total assets at December 31, 2006. Our acquisition of Mercantile included approximately $2 billion of securities classified as available for sale. The increase in total securities compared with December 31, 2006 was primarily due to higher balances in residential mortgage-backed, commercial mortgage-backed and asset-backed securities.
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.
At December 31, 2007, the securities available for sale balance included a net unrealized loss of $265 million, which represented the difference between fair value and amortized cost. The comparable amount at December 31, 2006 was a net unrealized loss of $142 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.
The expected weighted-average life of securities available for sale (excluding corporate stocks and other) was 3 years and 6 months at December 31, 2007 and 3 years and 8 months at December 31, 2006.
We estimate that at December 31, 2007 the effective duration of securities available for sale was 2.8 years for an immediate 50 basis points parallel increase in interest rates and 2.5 years for an immediate 50 basis points parallel decrease in interest rates. Comparable amounts at December 31, 2006 were 2.6 years and 2.2 years, respectively.
LOANS HELD FOR SALE
Loans held for sale totaled $3.9 billion at December 31, 2007 compared with $2.4 billion a year ago.
Loans held for sale included commercial mortgage loans intended for securitization totaling $2.1 billion at December 31, 2007 and $.9 billion at December 31, 2006. The balance at December 31, 2007 increased as market conditions were not conducive to completing securitization transactions during the fourth quarter of 2007. We also reduced our origination activity in early 2008. During the fourth quarter of 2007, a lower of cost or fair value adjustment was recorded of $26 million. This loss was reflected in the other noninterest income line item in our Consolidated Income Statement and in the results of the Corporate & Institutional Banking business segment. In early 2008, spreads have been widening and there has been limited activity in the CMBS securitization market. We value our commercial mortgage loans held for sale based on securitization prices. Therefore, if these conditions continue, additional losses will be incurred that will be significantly higher than the losses incurred during the fourth quarter of 2007. However, we do not expect the impact to be significant to our capital position. Currently, these valuation losses are unrealized (non-cash) and all of the loans in this portfolio are performing.
Loans held for sale also included education loans held for sale of $1.5 billion at December 31, 2007 and $1.3 billion at December 31, 2006. Historically, we classified substantially all of our education loans as loans held for sale. Gains on sales of education loans totaled $24 million in 2007, $33 million for 2006 and $19 million for 2005. 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.
In the past, we have sold education loans to issuers of asset-backed paper when the loans are placed into repayment status. Recently, the secondary markets for education loans have been impacted by liquidity issues similar to other asset classes. As a result, we believe the ability to sell education loans and generate related gains will be limited in 2008. Given this outlook and the economic and customer relationship value inherent in this product, in February 2008, we transferred the loans at lower of cost or market value from held for sale to the loan portfolio.
GOODWILL AND OTHER INTANGIBLE ASSETS
The sum of goodwill and other intangible assets increased $5.5 billion at December 31, 2007 compared with the prior year end, to $9.6 billion. We added $4.7 billion of goodwill and other intangible assets in connection with the Mercantile acquisition. In addition, our acquisitions of ARCS, Yardville and Albridge collectively added $.9 billion of goodwill and other intangible assets during 2007. Additional information is included in Note 7 Goodwill And Other Intangible Assets in the Notes To Consolidated Financial Statements under Item 8 of this Report.
The increase of $4.1 billion in Assets-Other in the preceding Summarized Balance Sheet Data table included the impact of a $1.0 billion increase in Federal funds sold and resale agreements and a $1.0 billion increase in other short-term investments, including trading securities.
FUNDING AND CAPITAL SOURCES
Details Of Funding Sources
Total funding sources increased $32.3 billion at December 31, 2007 compared with the balance at December 31, 2006, as total deposits increased $16.4 billion and total borrowed funds increased $15.9 billion. Our acquisition of Mercantile added $12.5 billion of deposits and $2.1 billion of borrowed funds. The Yardville acquisition resulted in $2.0 billion of deposits.
During the first quarter of 2007 we issued borrowings to fund the $2.1 billion cash portion of the Mercantile acquisition. The remaining increase in borrowed funds was the result of growth in loans and securities and the need to fund other net changes in our balance sheet. During the second half of 2007 we substantially increased Federal Home Loan Bank borrowings, which provided us with additional liquidity at relatively attractive rates. The Liquidity Risk Management section of this Item 7 contains further details regarding actions we have taken which impacted our borrowed funds balances during 2007 and early 2008.
We manage our capital position by making adjustments to our balance sheet size and composition, issuing debt, equity or hybrid instruments, executing treasury stock transactions, managing dividend policies and retaining earnings.
Total shareholders equity increased $4.1 billion, to $14.9 billion, at December 31, 2007 compared with December 31, 2006. In addition to the net impact of earnings and dividends in 2007, this increase reflected a $2.5 billion reduction in treasury stock and a $1.0 billion increase in capital surplus, largely due to the issuance of PNC common shares for the Mercantile and Yardville acquisitions.
Common shares outstanding were 341 million at December 31, 2007 and 293 million at December 31, 2006. The increase in shares during 2007 reflected the issuance of approximately 53 million shares in connection with the Mercantile acquisition and approximately 3 million shares in connection with the Yardville acquisition.
In October 2007, our Board of Directors terminated the prior program and approved a new stock repurchase program to purchase up to 25 million shares of PNC common stock on the open market or in privately negotiated transactions. This new program will remain in effect until fully utilized or until modified, superseded or terminated. During 2007, we purchased 11 million common shares under our new and prior common stock repurchase programs at a total cost of approximately $800 million.
The extent and timing of additional share repurchases under the new 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 do not expect to actively engage in share repurchase activity for the foreseeable future.
The declines in capital ratios from December 31, 2006 were primarily due to the impact of acquisitions, which increased risk-weighted assets and goodwill, common share repurchases and organic balance sheet growth.
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 institution's capital strength.
At December 31, 2007 and December 31, 2006, each of our domestic bank subsidiaries was considered well capitalized based on US regulatory capital ratio requirements. See the Supervision And Regulation section of Item 1 of this Report and Note 22 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 2008.
We refer you to the Perpetual Trust Securities and PNC Capital Trust E Trust Preferred Securities portions of the Off-Balance Sheet Arrangements And VIEs section of this Item 7 for a discussion of two February 2008 hybrid capital securities issuances totaling $825 million that qualify as Tier 1 regulatory capital.
OFF-BALANCE SHEET 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, 2007 and 2006.
Non-Consolidated VIEs Significant Variable Interests
Market Street Funding LLC (Market Street) is a multi-seller asset-backed commercial paper conduit that is owned by an independent third party. Market Streets activities primarily involve purchasing assets or making loans secured by interests in pools of receivables from US corporations that desire access to the commercial paper market. Market Street funds the purchases of assets 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 enhancements, liquidity facilities and program-level credit enhancement. Generally, Market Street mitigates its potential interest rate risk by entering into agreements with its borrowers that reflect interest rates based upon its weighted average commercial paper cost of funds. During 2007 and 2006, Market Street met all of its funding needs through the issuance of commercial paper.
At December 31, 2007 Market Street commercial paper outstanding was $5.1 billion compared with $3.9 billion for the prior year-end. The weighted average maturity of the commercial paper was 32 days at December 31, 2007 compared with 23 days at December 31, 2006.
In the ordinary course of business during 2007, PNC Capital Markets, acting as a placement agent for Market Street, held a maximum daily position in Market Street commercial paper of $113 million with an average of $27 million and a year-end position of less than $1 million. This compares with a maximum daily position of $105 million with an average of $12 million during 2006. PNC Capital Markets did not own any Market Street commercial paper at December 31, 2006. PNC made no other purchases of Market Street commercial paper during 2007 or 2006.
PNC Bank, N.A. provides certain administrative services, a portion of the program-level credit enhancement and 99% of liquidity facilities to Market Street in exchange for fees negotiated based on market rates. PNC recognized program administrator fees and commitments fees related to PNCs portion of the liquidity facilities of $12.6 million and $4.1 million, respectively, for the year ended December 31, 2007.
PNC views its credit exposure for the Market Street transactions as limited. Neither creditors nor investors in Market Street have any recourse to our general credit. The commercial paper obligations at December 31, 2007 and 2006 were effectively collateralized by Market Streets assets. While PNC may be obligated to fund under liquidity facilities for events such as commercial paper market disruptions, borrower bankruptcies, collateral deficiencies or covenant violations, our credit risk under the liquidity facilities is 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 expected losses for the pool
of assets and is sized to generally meet rating agency standards for comparably structured transactions. Of the $8.8 billion of liquidity facilities provided by PNC at December 31, 2007, only $2.8 billion required PNC to fund if the assets are in default.
Program-level credit enhancement in the amount of 10% of commitments, excluding explicitly rated AAA/Aaa facilities, is provided by PNC and Ambac, a monoline insurer. PNC provides 25% of the enhancement in the form of a cash collateral account funded by a loan facility. This facility expires on March 23, 2012. See Note 5 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. The monoline insurer provides the remaining 75% of the enhancement in the form of a surety bond. The cash collateral account is subordinate to the surety bond.
Market Street was restructured as a limited liability company in October 2005 and entered into a Subordinated Note Purchase Agreement (Note) with an unrelated third party. The Note provides first loss coverage whereby the investor absorbs losses up to the amount of the Note, which was $8.6 million as of December 31, 2007. Proceeds from the issuance of the Note are held by Market Street in a first loss reserve account that will 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.
Assets of Market Street Funding LLC
Market Street Commitments by Credit Rating (a)
As a result of the Note issuance, we reevaluated the design of Market Street, its capital structure and relationships among the variable interest holders under the provisions of FASB Interpretation No. 46, (Revised 2003) Consolidation of Variable Interest entities (FIN 46R). Based on this analysis, we determined that we were no longer the primary beneficiary as defined by FIN 46R and deconsolidated Market Street from our Consolidated Balance Sheet effective October 17, 2005.
PNC considers changes to the variable interest holders (such as new expected loss note investors and changes to program- level credit enhancement providers), terms of expected loss notes, and new types of risks (such as foreign currency or interest rate) in Market Street as reconsideration events. PNC reviews the activities of Market Street on at least a quarterly basis to determine if a reconsideration event has occurred. As indicated earlier, 75% of the program-level credit enhancement is provided by Ambac in the form of a surety bond. PNC Bank, N.A., in the role of program administrator, is closely following market developments relative to the rating agency outlooks of monoline insurers. Ambac is currently rated AAA by two of the three major rating agencies and AA by the other agency. This rating change has not impacted the Market Street commercial paper ratings of A1/P1. Various alternatives to the program-level enhancement are under consideration if future rating changes impact either the ratings of Market Street commercial paper or its financial results.
Based on current accounting guidance and market conditions, we do not have to consolidate Market Street into our consolidated financial statements. However, if PNC would be determined to be the primary beneficiary under FIN 46R, we would consolidate the conduit at that time. To the extent that the par value of the assets in Market Street exceeded the fair value of the assets upon consolidation, the difference would be recognized by PNC as a loss in our Consolidated Income Statement in that period. Based on the fair value of the assets held by Market Street at December 31, 2007, this reduction in earnings would not have had a material impact on our risk-based capital ratios, credit ratings or debt covenants.
Consolidated VIEs PNC Is Primary Beneficiary
The table above reflects the aggregate assets and liabilities of VIEs that we have consolidated in our financial statements.
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 and are deemed to be primary beneficiary. We also consolidated entities in which we, as a national syndicator of affordable housing equity, serve as the general partner, and no other entity owns a majority of the limited partnership interests (together with the investments described above, the LIHTC investments). 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 Other 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.
Perpetual Trust Securities
We issue certain hybrid capital vehicles that qualify as capital for regulatory and rating agency purposes.
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 (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.
In March 2007, PNC Preferred Funding LLC sold $500 million of 6.113% Fixed-to-Floating Rate Non-Cumulative Exchangeable Perpetual Trust Securities of PNC Preferred Funding Trust II (Trust II), in a private placement. In connection with the private placement, Trust II acquired $500 million of LLC Preferred Securities.
In February 2008, PNC Preferred Funding LLC sold $375 million of 8.700% Fixed-to-Floating Rate Non-Cumulative Exchangeable Perpetual Trust Securities of PNC Preferred Funding Trust III (Trust III) in a private placement. In connection with the private placement, Trust III acquired $375 million of LLC Preferred Securities.
PNC REIT Corp. owns 100% of the LLCs common voting securities. As a result, the LLC is an indirect subsidiary of PNC and is consolidated on our Consolidated Balance Sheet. Trust I, Trust II and Trust IIIs investment in the LLC Preferred Securities is characterized as a minority interest on our Consolidated Balance Sheet since we are not the primary beneficiary of Trust I, Trust II or Trust III. This minority interest totaled approximately $980 million at December 31, 2007 (excluding Trust III, which was not yet formed). Each Trust I 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), each Trust II Security is automatically exchangeable into a share of Series I Non-Cumulative Perpetual Preferred Stock of PNC (the Series I Preferred Stock), and each Trust III Security is automatically exchangeable into a share of Series J Non-Cumulative Perpetual Preferred Stock of PNC, in each case under certain conditions relating to the capitalization or the financial condition of PNC Bank, N.A. and upon the direction of the Office of the Comptroller of the Currency.
We entered into a replacement capital covenant in connection with each of the closing of the Trust Securities sale (the Trust
Covenant) and the closing of the Trust II Securities sale (the Trust II Covenant), in each case for the benefit of holders of a specified series of our long-term indebtedness (the Covered Debt). As of December 31, 2007, Covered Debt consists of our $200 million Floating Rate Junior Subordinated Notes issued on June 9, 1998.
We agreed in the Trust 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 Trust Covered Securities) unless: (i) we have received the prior approval of the Federal Reserve Board, if such approval is then required under the Federal Reserve Boards capital guidelines applicable to bank holding companies 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 Trust Covenant (which amounts will vary based on the type of securities sold). The Trust Covenant does not apply to redemptions of the Trust Covered Securities by the issuers of those securities.
We agreed in the Trust II Covenant that until March 29, 2017, neither we nor our subsidiaries would purchase or redeem the Trust II Securities, the LLC Preferred Securities or the Series I Preferred Stock (collectively, the Trust II Covered Securities), unless: (i) we have received the prior approval of the Federal Reserve Board, if such approval is then required under the Federal Reserve Boards capital guidelines applicable to bank holding companies and (ii) during the 180-day period prior to the date of purchase, PNC, PNC Bank, N.A. or PNC Bank N.A.s subsidiaries, as applicable, have received proceeds from the sale of Qualifying Securities in the amounts specified in the Trust II Covenant (which amounts will vary based on the type of securities sold).
Qualifying Securities means debt and equity securities having terms and provisions that are specified in the Trust Covenant or the Trust II Covenant, as applicable 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 Trust Covered Securities or the Trust II Covered Securities, as applicable. We filed a copy of each of the Trust Covenant and the Trust II Covenant with the SEC as Exhibit 99.1 to PNCs Form 8-K filed on December 8, 2006 and as Exhibit 99.1 to PNCs Form 8-K filed on March 30, 2007, respectively.
PNC Bank, N.A. has contractually committed to 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 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.
PNC has contractually committed to each of Trust II and Trust III that if full dividends are not paid in a dividend period on the Trust II Securities or the Trust III Securities, as applicable, or the LLC Preferred Securities held by Trust II or Trust III, as applicable, PNC will not declare or pay dividends with respect to, or redeem, purchase or acquire, any of its equity capital securities during the next succeeding dividend period, other than: (i) purchases, redemptions or other acquisitions of shares of capital stock of PNC in connection with any employment contract, benefit plan or other similar arrangement with or for the benefit of employees, officers, directors or consultants, (ii) purchases of shares of common stock of PNC pursuant to a contractually binding requirement to buy stock existing prior to the commencement of the extension period, including under a contractually binding stock repurchase plan, (iii) any dividend in connection with the implementation of a shareholders rights plan, or the redemption or repurchase of any rights under any such plan, (iv) as a result of an exchange or conversion of any class or series of PNCs capital stock for any other class or series of PNCs capital stock, (v) the purchase of fractional interests in shares of PNC capital stock pursuant to the conversion or exchange provisions of such stock or the security being converted or exchanged or (vi) any stock dividends paid by PNC where the dividend stock is the same stock as that on which the dividend is being paid. We filed a copy of the Exchange Agreements containing those dividend restrictions with the SEC as Exhibit 4.16 to PNCs Form 8-K filed on March 30, 2007 and as Exhibit 99.1 to PNCs Form 8-K filed on February 19, 2008, respectively.
PNC Capital Trust E Trust Preferred Securities
In February 2008, PNC Capital Trust E issued $450 million of 7 3/4% Trust Preferred Securities due March 15, 2068 (the Trust E Securities). PNC Capital Trust Es only assets are $450 million of 7 3/4% Junior Subordinated Notes due March 15, 2068 and issued by PNC (the JSNs). The Trust E Securities are fully and unconditionally guaranteed by PNC.
We may, at our option, redeem the JSNs at 100% of their principal amount on or after March 15, 2013. We have agreed to redeem the JSNs on March 15, 2038, but only out of net proceeds from the sale of certain replacement capital securities described in the JSN indenture. The Trust E Securities will be redeemed at the time of the JSN redemption.
If we defer interest on the JSNs and either pay current interest or the fifth anniversary of the deferral passes, we are obligated to issue certain qualifying securities defined in the JSN indenture to raise proceeds to fund the payment of accrued and unpaid interest.
In addition, we have entered into a replacement capital covenant (the Trust E Covenant) for the benefit of holders of a specified series of our long-term indebtedness (the Trust E Covered Debt). As of February 13, 2008, the Trust E Covered Debt consists of our $300 million 6.125% Junior Subordinated Notes issued in December 2003. We agreed in the Trust E Covenant that neither PNC nor its subsidiaries will repay, redeem or purchase the JSNs or the Trust E Securities on or after March 15, 2038 unless: (i) we have obtained the prior approval of the Federal Reserve Board, if such approval is then required by the Federal Reserve Board; and (ii) subject to certain limitations, during the 180-day period prior to the date of repayment, redemption or purchase, we have received proceeds from the sale of Trust E Qualifying Securities in the amounts specified in the Trust E Covenant (which amounts will vary based on the redemption date and the type of securities sold). Trust E Qualifying Securities means debt and equity securities having terms and provisions that are specified in the Trust E 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 Trust E Covered Securities.
The Trust E Covenant will terminate upon the earlier to occur of (i) March 15, 2048, (ii) the date on which the JSNs are otherwise redeemed in full, (iii) the date on which the holders of a majority of the principal amount of the Trust E Covered Debt agree to terminate the Trust E Covenant, (iv) the date on which we no longer have outstanding any indebtedness eligible to qualify as covered debt or (v) the occurrence of an event of default and acceleration of the JSNs under the related indenture. We filed a copy of the Trust E Covenant with the SEC as Exhibit 99.1 to PNCs Form 8-K filed February 13, 2008.
In connection with the closing of the Trust E Securities sale, we agreed that, if we have given notice of our election to defer interest payments on the JSNs or a related deferral period is continuing, then PNC would be subject during such period to restrictions on dividends and other provisions protecting the status of the JSN debenture holder similar to or in some ways more restrictive than those potentially imposed under the Exchange Agreements with Trust II and Trust III, as described above.
Acquired Entity Trust Preferred Securities
As a result of the Mercantile and Yardville acquisitions, we assumed obligations with respect to $73 million in principal amount of junior subordinated debentures issued by the acquired entities. Under the terms of these debentures, if there is an event of default under the debentures or PNC exercises its right to defer payments on the related trust preferred securities issued by the statutory trusts or there is a default under PNCs guarantee of such payment obligations, PNC
would be subject during the period of such default or deferral to restrictions on dividends and other provisions protecting the status of the debenture holders similar to or in some ways more restrictive than those potentially imposed under the Exchange Agreements with Trust II and Trust III, as described above.
BUSINESS SEGMENTS REVIEW
We have four major businesses engaged in providing banking, asset management and global fund processing products and services. Business segment results, including inter-segment revenues, and a description of each business are included in Note 26 Segment Reporting included in the Notes To Consolidated Financial Statements under Item 8 of this Report.
Certain revenue and expense amounts included in this Business Segments Review differ from the amounts shown in Note 26 due to the presentation in this Business Segments Review of business revenue on a taxable-equivalent basis, the inclusion of BlackRock/MLIM transaction integration costs in the Other category, and income statement classification differences related to PFPC. Also, the presentation of BlackRock results for the 2006 period have been modified in this Business Segments Review as described on page 41 to conform with our current period presentation.
Results of individual businesses are presented based on our management accounting practices and our management 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, with the exception of our BlackRock segment, operated on a stand-alone basis. As permitted under GAAP, we have aggregated the business results for certain operating segments for financial reporting purposes.
Assets receive a funding charge and liabilities and capital receive a funding credit based on a transfer pricing methodology that incorporates product maturities, duration and other factors. Capital is intended to cover unexpected losses and is assigned to the banking and processing
businesses using our risk-based economic capital model. We have assigned capital equal to 6% of funds to Retail Banking to reflect the capital required for well-capitalized domestic banks and to approximate market comparables for this business. The capital assigned for PFPC reflects its legal entity shareholders' equity.
BlackRock business segment results for the nine months ended September 30, 2006 reflected our majority ownership in BlackRock during that period. Subsequent to the September 29, 2006 BlackRock/MLIM transaction closing, our ownership interest was reduced to approximately 34%. Since that date, our investment in BlackRock has been accounted for under the equity method but continues to be a separate reportable business segment of PNC. We describe our presentation method for the BlackRock segment for this Business Segments Review and our Line of Business Highlights 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 Other category. Other for purposes of this Item 7 Financial Review includes residual activities that do not meet the criteria for disclosure as a separate reportable business, such as gains or losses related to BlackRock transactions including LTIP share distributions and obligations, BlackRock/MLIM transaction and acquisition integration costs, asset and liability management activities, net securities gains or losses, certain trading activities and equity management activities, differences between business segment performance reporting and financial statement reporting (GAAP), intercompany eliminations, and most corporate overhead.
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 2007 earnings increased $128 million, to $893 million, up 17% compared with 2006. The increase in earnings over the prior year was driven by acquisitions and strong fee income and customer growth, partially offset by increases in the provision for credit losses and continued investments in the business.
Retail Bankings performance during 2007 included the following:
Total revenue for 2007 was $3.801 billion compared with $3.125 billion last year. Taxable-equivalent net interest income of $2.065 billion increased $387 million, or 23%, compared with 2006 due to a 20% increase in average deposits and a 37% increase in average loan balances. Net interest income growth was the result of acquisitions and core business growth, although this growth has stabilized in recent quarters. In the current interest rate environment, Retail Banking deposits will be less valuable, and are expected to result in lower net interest income for this business segment in 2008 compared with 2007.
Noninterest income increased $289 million, to $1.736 billion, up 20% compared with 2006. This growth can be attributed primarily to the following:
In the past, we have sold education loans to issuers of asset-backed paper when the loans are placed into repayment status. Recently, the secondary markets for education loans have been impacted by liquidity issues similar to other asset classes. As a result, we believe the ability to sell education loans and generate related gains will be limited in 2008. Given this outlook and the economic and customer relationship value inherent in this product, in February 2008, we transferred the loans at lower of cost or market value from held for sale to the loan portfolio.
The provision for credit losses increased $57 million in 2007, to $138 million, compared with 2006. Net charge-offs were $131 million in 2007, an increase of $46 million compared with 2006. The increases in provision and net charge-offs were primarily a result of residential real estate development exposure, continued growth in our commercial loan portfolio and charge-offs returning to a more normal level given the current credit conditions. Charge-offs over the last few years have been low compared with historical averages. Given the current environment, we believe provision levels and nonperforming assets will continue to increase in 2008.
Noninterest expense in 2007 totaled $2.239 billion, an increase of $412 million, or 23%, compared with 2006. Increases were primarily attributable to acquisitions (77% of the increase), higher volume-related expenses tied to noninterest income growth, continued investment in new branches, and investments in various initiatives such as the new PNC-branded credit card.
Full-time employees at December 31, 2007 totaled 12,036, an increase of 2,487 over the prior year. The acquisitions added approximately 2,300 full-time Retail Banking employees. Part-time employees have increased by 480 since December 31, 2006. The increase in part-time employees is a result of acquisitions and various customer service enhancement and efficiency initiatives. These initiatives include utilizing more part-time customer-facing employees rather than full-time employees during peak business hours.
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. Furthermore, core checking accounts are critical to our strategy of expanding our payments business. Average total deposits increased $9.1 billion, or 20%, compared with 2006.
Currently, we are focused on a relationship-based lending strategy that targets specific customer sectors (homeowners, small businesses and auto dealerships) while seeking to maintain a moderate risk profile in the loan portfolio.
Assets under management of $73 billion at December 31, 2007 increased $19 billion compared with the balance at December 31, 2006. The increase was primarily attributable to the Mercantile acquisition and core organic business growth, partially offset by other declines such as the divestiture of a Mercantile asset management subsidiary during the fourth quarter. The remaining portfolio growth was a result of positive client net asset flows. Client net asset flows are the result of investment additions from new and existing clients offset by ordinary course distributions from trust and investment management accounts and account closures.
Nondiscretionary assets under administration of $113 billion at December 31, 2007 increased $27 billion compared with the balance at December 31, 2006, primarily due to the impact of Mercantile.
See Note 2 Acquisitions and Divestitures in the Notes To Consolidated Financial Statements in Item 8 of this Report regarding our planned sale of Hilliard Lyons during the first half of 2008.
CORPORATE & INSTITUTIONAL BANKING
Corporate & Institutional Banking earned $432 million in 2007 compared with $454 million in 2006. While total revenue increased more than noninterest expense, earnings declined due to an increase in the provision for credit losses. Market-related declines in CMBS securitization activities and non-customer-related trading revenue resulted in a year- over-year reduction in noninterest income. Treasury management, commercial mortgage servicing, and capital markets revenues led by merger and acquisition advisory services showed growth over 2006.
Highlights during 2007 for Corporate & Institutional Banking included:
See the additional revenue discussion regarding treasury management and capital markets-related products and Midland Loan Services on page 24.
Our BlackRock business segment earned $253 million in 2007 and $187 million in 2006. Subsequent to the September 29, 2006 deconsolidation of BlackRock, these business segment earnings are determined by taking our proportionate share of BlackRocks earnings and subtracting our additional income taxes recorded on our share of BlackRocks earnings. Also, for this business segment presentation, after-tax BlackRock/MLIM transaction integration costs totaling $3 million and $65 million in 2007 and 2006, respectively, have been reclassified from BlackRock to Other. In addition, the 2006 business segment earnings have been reduced by minority interest in income of BlackRock, excluding MLIM transaction integration costs, totaling $65 million and additional income taxes recorded on our share of BlackRocks earnings totaling $7 million.
PNCs investment in BlackRock was $4.1 billion at December 31, 2007 and $3.9 billion at December 31, 2006. Based upon BlackRocks closing market price of $216.80 per common share at December 31, 2007, the market value of our investment in BlackRock was $9.4 billion at that date. As such, an additional $5.3 billion of pretax value was not recognized in our equity investment account at that date.
On October 1, 2007, BlackRock acquired the fund of funds business of Quellos Group, LLC (Quellos). The combined fund of funds platform operates under the name BlackRock Alternative Advisors and is comprised one of the largest fund of funds platforms in the world, with over $25 billion in assets under management. In connection with the acquisition, BlackRock paid $562 million in cash to Quellos and placed 1.2 million shares of BlackRock common stock into an escrow account. The shares of BlackRock common stock will be held in the escrow account for up to three years and will be available to satisfy certain indemnification obligations of Quellos under the acquisition agreement.
Therefore, any gain to be recognized by PNC resulting from the issuance of these shares and corresponding increase in PNCs investment in BlackRock will be deferred pending the release of shares from the escrow account. In addition, Quellos may receive up to an additional $969 million in cash and BlackRock common stock through December 31, 2010 contingent on certain measures.
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. BlackRock accounted for the MLIM transaction under the purchase method of accounting. Further information regarding this transaction is included in Note 2 Acquisitions and Divestitures included in the Notes To Consolidated Financial Statements in Item 8 of this Report.
BLACKROCK LTIP PROGRAMS
BlackRock adopted the 2002 LTIP program to help attract and retain qualified professionals. At that time, PNC agreed to transfer up to four million of the shares of BlackRock common stock then held by us to help fund the 2002 LTIP and future programs approved by BlackRocks board of directors, subject to certain conditions and limitations. Prior to 2006, BlackRock granted awards of approximately $233 million under the 2002 LTIP program, of which approximately $208 million were paid on January 30, 2007. The award payments were funded by 17% in cash from BlackRock and one million shares of BlackRock common stock transferred by PNC and distributed to LTIP participants. We recognized a pretax gain of $82 million in the first quarter of 2007 from the transfer of BlackRock shares. The gain was included in noninterest income and reflected the excess of market value over book value of the one million shares transferred in January 2007.
PNCs noninterest income in 2007 also included a $209 million pretax charge related to our commitment to fund additional BlackRock LTIP programs. This charge represents the mark-to-market adjustment related to our remaining BlackRock LTIP shares obligation as of December 31, 2007 and resulted from the increase in the market value of BlackRock common shares during 2007. We recognized a similar charge for $12 million in 2006.
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.
We may continue to see volatility in earnings as we mark to market our LTIP shares obligation each quarter-end. However, additional gains based on the difference between the market value and the book value of the committed BlackRock common shares will generally not be recognized until the shares are distributed to LTIP participants.