SunTrust Banks 10-K 2008
Documents found in this filing:
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
2007 FORM 10-K
x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2007
¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
Commission File Number 001-08918
SUNTRUST BANKS, INC.
(Exact name of registrant as specified in its charter)
303 Peachtree Street, N.E., Atlanta, Georgia 30308
(Address of principal executive offices) (Zip Code)
(Registrants telephone number, including area code)
Securities registered pursuant to section 12(b) of the Act:
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 Exchange 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 disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of the Form 10-K or any amendment to this Form 10-K. x
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of large accelerated filer, accelerated filer and small reporting company 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 Exchange Act). Yes ¨ No x
The aggregate market value of the voting Common Stock held by non-affiliates at June 30, 2007 was approximately $29.6 billion, based on the New York Stock Exchange closing price for such shares on that date. For purposes of this calculation, the Registrant has assumed that its directors and executive officers are affiliates.
At February 13, 2008, 348,742,997 shares of the Registrants Common Stock, $1.00 par value, were outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Part III information is incorporated herein by reference, pursuant to Instruction G of Form 10-K, to SunTrusts Definitive Proxy Statement for its 2008 Annual Shareholders Meeting, which will be filed with the Commission no later than April 30, 2008 (the Proxy Statement). Certain Part I and Part II information required by Form 10-K is incorporated by reference to the SunTrust Annual Report to Shareholders, but the Annual Report to Shareholders for the year ended December 31, 2007 shall not be deemed filed with the Securities and Exchange Commission.
Table of Contents
SunTrust Banks, Inc. (SunTrust or the Company) one of the nations largest commercial banking organizations is a diversified financial services holding company whose businesses provide a broad range of financial services to consumer and corporate customers. SunTrust was incorporated in 1984 under the laws of the State of Georgia. The principal executive offices of the Company are located in the SunTrust Plaza, Atlanta, Georgia 30308.
Additional information relating to our businesses and our subsidiaries is included in the information set forth in Item 7, Managements Discussion and Analysis of Financial Condition and Results of Operations (the MD&A), and Note 22, Business Segment Reporting, to the Consolidated Financial Statements in Item 8 of this report.
Primary Market Areas
Through its flagship subsidiary SunTrust Bank, the Company provides deposit, credit, and trust and investment services. Additional subsidiaries provide mortgage banking, asset management, securities brokerage, capital market services and credit-related insurance. SunTrust enjoys strong market positions in some of the highest-growth markets in the United States and operates primarily within Florida, Georgia, Maryland, North Carolina, South Carolina, Tennessee, Virginia, and the District of Columbia. Within the geographic footprint, SunTrust strategically operated under five business segments during 2007. These business segments were: Retail, Commercial, Corporate and Investment Banking (CIB), Mortgage, and Wealth and Investment Management. In addition, SunTrust provides clients with a selection of technology-based banking channels, including the Internet, automated teller machines, PC and twenty-four hour telebanking. SunTrusts client base encompasses a broad range of individuals and families, high net-worth clients, businesses, and institutions.
Acquisition and Disposition Activity
As part of its operations, the Company regularly evaluates the potential acquisition of, and holds discussions with, various financial institutions and other businesses of a type eligible for financial holding company ownership or control. In addition, the Company regularly analyzes the values of, and may submit bids for, the acquisition of customer-based funds and other liabilities and assets of such financial institutions and other businesses. The Company may also consider the potential disposition of certain of its assets, branches, subsidiaries or lines of businesses.
On March 31, 2005, SunTrust sold the Receivables Capital Management factoring division and, in December of 2005, sold Carswell of Carolina, Inc., a full service insurance agency. In 2006, SunTrust sold its Bond Trustee business and acquired 11 Florida Wal-Mart banking branches. In 2007, GenSpring Family Offices, LLC, a wholly owned subsidiary of SunTrust Banks, Inc., acquired Inlign Wealth Management Investments, Inc. and TBK Investments, Inc. We also completed the sale of our minority interest in Lighthouse Investment Partners, LLC on January 2, 2008 and expect to complete the acquisition of GB&T Bancshares, Inc. during the second quarter of 2008. Additional information on these and other acquisitions and dispositions is included in Note 2, Acquisitions/Dispositions, to the Consolidated Financial Statements in Item 8 which are incorporated herein by reference.
Government Supervision and Regulation
As a bank holding company and a financial holding company, the Company is subject to the regulation and supervision of the Board of Governors of the Federal Reserve System (the Federal Reserve). SunTrust Bank is a Georgia state bank which has branches in Georgia, Florida, Tennessee, Alabama, Virginia, West Virginia, Maryland, North Carolina, South Carolina, the District of Columbia, Mississippi and Arkansas. SunTrust Bank is a member of the Federal Reserve System, and is regulated by the Federal Reserve, the Federal Deposit Insurance Corporation (the FDIC) and the Georgia Department of Banking and Finance.
The Companys banking subsidiary is subject to various requirements and restrictions under federal and state law, including requirements to maintain reserves against deposits, restrictions on the types and amounts of loans that may be made and the interest that may be charged thereon, and limitations on the types of investments that may be made and the types of services that may be offered. Various consumer laws and regulations also affect the operations of the bank and its subsidiaries. In
addition to the impact of regulation, commercial banks are affected significantly by the actions of the Federal Reserve as it attempts to control the money supply and credit availability in order to influence the economy.
Pursuant to the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, bank holding companies from any state may acquire banks located in any other state, subject to certain conditions, including concentration limits. In addition, a bank may establish branches across state lines by merging with a bank in another state, subject to certain restrictions. A bank holding company may not directly or indirectly acquire ownership or control of more than 5% of the voting shares or substantially all of the assets of any bank or merge or consolidate with another bank holding company without the prior approval of the Federal Reserve.
There are a number of obligations and restrictions imposed on bank holding companies and their depository institution subsidiaries by federal law and regulatory policy that are designed to reduce potential loss exposure to the depositors of such depository institutions and to the FDIC insurance fund in the event the depository institution becomes in danger of default or is in default. For example, under a policy of the Federal Reserve with respect to bank holding company operations, a bank holding company is required to serve as a source of financial strength to its subsidiary depository institutions and commit resources to support such institutions in circumstances where it might not do so absent such policy. In addition, the cross-guarantee provisions of federal law require insured depository institutions under common control to reimburse the FDIC for any loss suffered or reasonably anticipated as a result of the default of a commonly controlled insured depository institution or for any assistance provided by the FDIC to a commonly controlled insured depository institution in danger of default. The federal banking agencies have broad powers under current federal law to take prompt corrective action to resolve problems of insured depository institutions. The extent of these powers depends upon whether the institutions in question are well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized or critically undercapitalized as such terms are defined under regulations issued by each of the federal banking agencies.
The Federal Reserve and the FDIC have issued substantially similar risk-based and leverage capital guidelines applicable to United States banking organizations. In addition, these regulatory agencies may from time to time require that a banking organization maintain capital above the minimum levels, whether because of its financial condition or actual or anticipated growth. The Federal Reserve risk-based guidelines define a tier-based capital framework. Tier 1 capital includes common shareholders equity, trust preferred securities, minority interests and qualifying preferred stock, less goodwill and other adjustments. Tier 2 capital consists of preferred stock not qualifying as Tier 1 capital, mandatory convertible debt, limited amounts of subordinated debt, other qualifying term debt, the allowance for credit losses up to a certain amount and a portion of the unrealized gain on equity securities. The sum of Tier 1 and Tier 2 capital represents the Companys qualifying total capital. Risk-based capital ratios are calculated by dividing Tier 1 and total capital by risk-weighted assets. Assets and off-balance sheet exposures are assigned to one of four categories of risk-weights, based primarily on relative credit risk. The leverage ratio is determined by dividing Tier 1 capital by adjusted average total assets.
The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA), among other things, identifies five capital categories for insured depository institutions (well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized) and requires the respective federal regulatory agencies to implement systems for prompt corrective action for insured depository institutions that do not meet minimum capital requirements within such categories. FDICIA imposes progressively more restrictive constraints on operations, management and capital distributions, depending on the category in which an institution is classified. Failure to meet the capital guidelines could also subject a banking institution to capital raising requirements. An undercapitalized bank must develop a capital restoration plan and its parent holding company must guarantee that banks compliance with the plan. The liability of the parent holding company under any such guarantee is limited to the lesser of five percent of the banks assets at the time it became undercapitalized or the amount needed to comply with the plan. Furthermore, in the event of the bankruptcy of the parent holding company, such guarantee would take priority over the parents general unsecured creditors. In addition, FDICIA requires the various regulatory agencies to prescribe certain non-capital standards for safety and soundness relating generally to operations and management, asset quality and executive compensation and permits regulatory action against a financial institution that does not meet such standards.
The various regulatory agencies have adopted substantially similar regulations that define the five capital categories identified by FDICIA, using the total risk-based capital, Tier 1 risk-based capital and leverage capital ratios as the relevant capital measures. Such regulations establish various degrees of corrective action to be taken when an institution is considered undercapitalized. Under the regulations, a well capitalized institution must have a Tier 1 risk-based capital ratio of at least
six percent, a total risk-based capital ratio of at least ten percent and a leverage ratio of at least five percent and not be subject to a capital directive order.
Regulators also must take into consideration: (a) concentrations of credit risk; (b) interest rate risk (when the interest rate sensitivity of an institutions assets does not match the sensitivity of its liabilities or its off-balance-sheet position); and (c) risks from non-traditional activities, as well as an institutions ability to manage those risks, when determining the adequacy of an institutions capital. This evaluation will be made as a part of the institutions regular safety and soundness examination. In addition, the Company, and any bank with significant trading activity, must incorporate a measure for market risk in their regulatory capital calculations.
There are various legal and regulatory limits on the extent to which the Companys subsidiary bank may pay dividends or otherwise supply funds to the Company. In addition, federal and state bank regulatory agencies also have the authority to prevent a bank or bank holding company from paying a dividend or engaging in any other activity that, in the opinion of the agency, would constitute an unsafe or unsound practice. The Federal Deposit Insurance Act (the FDI Act) provides that, in the event of the liquidation or other resolution of an insured depository institution, the claims of depositors of the institution (including the claims of the FDIC as subrogee of insured depositors) and certain claims for administrative expenses of the FDIC as a receiver will have priority over other general unsecured claims against the institution. If an insured depository institution fails, insured and uninsured depositors, along with the FDIC, will have priority in payment ahead of unsecured, nondeposit creditors, including the parent bank holding company, with respect to any extensions of credit they have made to such insured depository institution.
FDIC regulations require that management report annually on its responsibility for preparing its institutions financial statements, and establishing and maintaining an internal control structure, and procedures for financial reporting, and compliance with designated laws and regulations concerning safety and soundness.
On November 12, 1999, financial modernization legislation known as the Gramm-Leach-Bliley Act (the GLB Act) was signed into law. Under the GLB Act, a bank holding company which elects to become a financial holding company may engage in expanded securities activities, insurance sales, and underwriting activities, and other financial activities, and may also acquire securities firms and insurance companies, subject in each case to certain conditions. The Company has elected to become a financial holding company under the GLB Act. If any of our banking subsidiaries ceases to be well capitalized or well managed under applicable regulatory standards, the Federal Reserve may, among other things, place limitations on our ability to conduct these broader financial activities or, if the deficiencies persist, require us to divest the banking subsidiary. In order to become and maintain its status as a financial holding company, the Company and all of its affiliated depository institutions must be well-capitalized, well-managed, and have at least a satisfactory Community Reinvestment Act of 1977 (CRA) rating. Furthermore, if the Federal Reserve determines that a financial holding company has not maintained a satisfactory CRA rating, the Company will not be able to commence any new financial activities or acquire a company that engages in such activities, although the Company will still be allowed to engage in activities closely related to banking and make investments in the ordinary course of conducting merchant banking activities.
The USA Patriot Act of 2001 (Patriot Act) substantially broadens existing anti-money laundering legislation and the extraterritorial jurisdiction of the United States; imposes new compliance and due diligence obligations; creates new crimes and penalties; compels the production of documents located both inside and outside the United States, including those of non-U.S. institutions that have a correspondent relationship in the United States; and clarifies the safe harbor from civil liability to customers. The United States Department of the Treasury has issued a number of regulations that further clarify the Patriot Acts requirements or provide more specific guidance on their application. The Patriot Act requires all financial institutions, as defined, to establish certain anti-money laundering compliance and due diligence programs. The Patriot Act requires financial institutions that maintain correspondent accounts for non-U.S. institutions, or persons that are involved in private banking for non-United States persons or their representatives, to establish, appropriate, specific and, where necessary, enhanced due diligence policies, procedures, and controls that are reasonably designed to detect and report instances of money laundering through those accounts. Bank regulators are focusing their examinations on anti-money laundering compliance, and the Company continues to enhance its anti-money laundering compliance programs.
Federal banking regulators, as required under the GLB Act, have adopted rules limiting the ability of banks and other financial institutions to disclose nonpublic information about consumers to nonaffiliated third parties. The rules require disclosure of privacy policies to consumers and, in some circumstances, allow consumers to prevent disclosure of certain personal information to nonaffiliated third parties. The privacy provisions of the GLB Act affect how consumer information is transmitted through diversified financial services companies and conveyed to outside vendors.
The FDIC merged the Bank Insurance Fund (BIF) and the Savings Association Insurance Fund (SAIF) to form the Deposit Insurance Fund (DIF) on March 31, 2006 in accordance with the Federal Deposit Insurance Reform Act of 2005. The FDIC maintains the DIF by assessing depository institutions an insurance premium. The amount each institution is assessed is based upon statutory factors that include the balance of insured deposits as well as the degree of risk the institution poses to the insurance fund. The FDIC uses a risk-based premium system that assesses higher rates on those institutions that pose greater risks to the DIF. The FDIC places each institution in one of four risk categories using a two-step process based first on capital ratios (the capital group assignment) and then on other relevant information (the supervisory group assignment).
The Companys non-banking subsidiaries are regulated and supervised by various regulatory bodies. For example, SunTrust Robinson Humphrey, Inc. is a broker-dealer and investment adviser registered with the Securities and Exchange Commission (SEC), and the Financial Industry Regulatory Authority, Inc. (FINRA). SunTrust Investment Services, Inc. is also a broker-dealer and investment adviser registered with the SEC and a member of the FINRA. Trusco Capital Management, Inc. (Trusco) is an investment adviser registered with the SEC.
In addition, there have been a number of legislative and regulatory proposals that would have an impact on the operation of bank/financial holding companies and their bank and non-bank subsidiaries. It is impossible to predict whether or in what form these proposals may be adopted in the future and, if adopted, what their effect will be on us.
SunTrust operates in a highly competitive industry that could become even more competitive as a result of legislative, regulatory and technological changes, and continued consolidation. The Company also faces aggressive competition from other domestic and foreign lending institutions and from numerous other providers of financial services. The ability of non-banking financial institutions to provide services previously limited to commercial banks has intensified competition. Because non-banking financial institutions are not subject to the same regulatory restrictions as banks and bank holding companies, they can often operate with greater flexibility and lower cost structures. Securities firms and insurance companies that elect to become financial holding companies may acquire banks and other financial institutions. This may significantly change the competitive environment in which the Company conducts business. Some of the Companys competitors have greater financial resources and/or face fewer regulatory constraints. As a result of these various sources of competition, the Company could lose business to competitors or be forced to price products and services on less advantageous terms to retain or attract clients, either of which would adversely affect the Companys profitability.
The Companys ability to expand into additional states remains subject to various federal and state laws. See Government Supervision and Regulation for a more detailed discussion of interstate banking and branching legislation and certain state legislation.
As of December 31, 2007, there were 32,323 full-time equivalent employees within SunTrust. None of the domestic employees within the Company is subject to a collective bargaining agreement. Management considers its employee relations to be good.
See also the following additional information which is incorporated herein by reference: Business Segments (under the caption Business Segments in Item 7, the MD&A and in Note 22 to the Consolidated Financial Statements in Item 8, Financial Statements and Supplementary Data (the Notes)); Net Interest Income (under the captions Net Interest Income/Margin in the MD&A and Selected Financial Data in Item 6); Securities (under the caption Securities Available for Sale in the MD&A and Note 5 of the Notes); Outstanding Loans and Leases (under the caption Loans in the MD&A and Note 6 of the Notes); Deposits (under the caption Deposits in the MD&A); Short-Term Borrowings (under the caption Liquidity Risk in the MD&A and Note 10 Other Short-Term Borrowings and Contractual Commitments of the Notes); Trading Activities in the MD&A and Trading Assets (under the caption Trading Assets in the MD&A and Notes 4 and 20 of the Notes); Market Risk Management (under the caption Market Risk Management in the MD&A); Liquidity Risk Management (under the caption Liquidity Risk in the MD&A); Operational Risk Management (under the caption Operational Risk Management in the MD&A).
SunTrusts 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 pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 (the Exchange Act) are available on the Companys website at www.suntrust.com under the Investor Relations Section as soon as reasonably practicable after the Company electronically files such material with, or furnishes it to the SEC. The public may read and copy any materials the Company files with the SEC at the SEC Public Reference Room at 100 F Street, NE, Washington, DC, 20549. The public also may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC also maintains an Internet site that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC. The SECs website address is www.sec.gov. In addition, SunTrust makes available on its website at www.suntrust.com under the heading Corporate Governance its: (i) Code of Ethics; (ii) Corporate Governance Guidelines; and (iii) the charters of SunTrust Board committees, and also intends to disclose any amendments to its Code of Ethics, or waivers of the Code of Ethics on behalf of its Chief Executive Officer, Chief Financial Officer and Chief Accounting Officer, on its website. These corporate governance materials are also available free of charge in print to shareholders who request them in writing to: SunTrust Banks, Inc., Attention: Investor Relations, P.O. Box 4418, Mail Code GA-ATL-634, Atlanta, Georgia 30302-4418.
The Companys Annual Report on Form 10-K is being distributed to shareholders in lieu of a separate annual report containing financial statements of the Company and its consolidated subsidiaries.
The risks contained in this report are not the only risks faced by us. Additional risks that are not presently known, or that we presently deem to be immaterial, also could have a material adverse effect on our financial condition, results of operations, business and prospects. This Report also contains forward-looking statements that may not be realized as a result of certain factors, including, but not limited to, the risks described herein and in our other public filings with the SEC. Please refer to the section in this Report entitled Cautionary Statement Regarding Forward-Looking Statements for additional information regarding forward-looking statements.
Weakness in the economy and in the real estate market, including specific weakness within our geographic footprint, has adversely affected us and may continue to adversely affect us.
If the strength of the U.S. economy in general and the strength of the local economies in which we conduct operations declines, or continues to decline, this could result in, among other things, a deterioration of credit quality or a reduced demand for credit, including a resultant effect on our loan portfolio and allowance for loan and lease losses. A significant portion of our residential mortgages and commercial real estate loan portfolios are composed of borrowers in the Southeastern and Mid-Atlantic regions of the United States, in which certain markets have been particularly adversely affected by declines in real estate value, declines in home sale volumes, and declines in new home building. These factors could result in higher delinquencies and greater charge-offs in future periods, which would materially adversely affect our financial condition and results of operations.
Weakness in the real estate market, including the secondary residential mortgage loan markets, has adversely affected us and may continue to adversely affect us.
Significant ongoing disruptions in the secondary market for residential mortgage loans have limited the market for and liquidity of many mortgage loans. The effects of ongoing mortgage market challenges, combined with the ongoing correction in residential real estate market prices and reduced levels of home sales, could result in further price reductions in single family home values, adversely affecting the value of collateral securing mortgage loans that we hold, mortgage loan originations and profits on sale of mortgage loans. Declining real estate prices and higher interest rates have caused higher delinquencies and losses on certain mortgage loans, particularly Alt-A mortgages and home equity lines of credit and mortgage loans sourced from brokers that are outside our branch bank network. These trends could continue. These conditions have resulted in losses, write downs and impairment charges in our mortgage and other lines of business, especially in the third and fourth quarters of 2007. Continued declines in real estate values, home sales volumes and financial stress on borrowers as a result of job losses, interest rate resets on adjustable rate mortgage loans or other factors could have further adverse effects on borrowers that result in higher delinquencies and greater charge-offs in future periods, which adversely affect our financial condition or results of operations. Additionally, decreases in real estate values might adversely affect the creditworthiness of state and local governments, and this might result in decreased profitability or credit losses from loans made to such governments.
As a financial services company, adverse changes in general business or economic conditions could have a material adverse effect on our financial condition and results of operations.
A sustained weakness or weakening in business and economic conditions generally or specifically in the principal markets in which we do business could have one or more of the following adverse impacts on our business:
Changes in market interest rates or capital markets could adversely affect our revenue and expense, the value of assets and obligations, costs of capital or liquidity.
Given our business mix, and the fact that most of the assets and liabilities are financial in nature, we tend to be sensitive to market interest rate movement and the performance of the financial markets. In addition to the impact on the general economy, changes in interest rates or in valuations in the debt or equity markets could directly impact us in one or more of the following ways:
The fiscal and monetary policies of the federal government and its agencies could have a material adverse effect on our earnings.
The Board of Governors of the Federal Reserve System regulates the supply of money and credit in the United States. Its policies determine in large part the cost of funds for lending and investing and the return earned on those loans and investments, both of which affect the net interest margin. They also can materially decrease the value of financial assets we hold, such as debt securities and mortgage servicing rights (MSRs). Its policies also can adversely affect borrowers, potentially increasing the risk that they may fail to repay their loans. Changes in Federal Reserve Board policies are beyond our control and difficult to predict; consequently, the impact of these changes on our activities and results of operations is difficult to predict.
We may be required to repurchase mortgage loans or indemnify mortgage loan purchasers as a result of breaches of representations and warranties, borrower fraud, or certain borrower defaults, which could harm our liquidity, results of operations and financial condition.
When we sell mortgage loans, whether as whole loans or pursuant to a securitization, we are required to make customary representations and warranties to the purchaser about the mortgage loans and the manner in which they were originated. Our whole loan sale agreements require us to repurchase or substitute mortgage loans in the event we breach any of these representations or warranties. In addition, we may be required to repurchase mortgage loans as a result of borrower fraud or in the event of early payment default of the borrower on a mortgage loan. Likewise, we are required to repurchase or substitute mortgage loans if we breach a representation or warranty in connection with our securitizations. The remedies available to us against the originating broker or correspondent may not be as broad as the remedies available to a purchaser of mortgage loans against us, and we face the further risk that the originating broker or correspondent may not have the financial capacity to perform remedies that otherwise may be available to us. Therefore, if a purchaser enforces its remedies against us, we may not be able to recover our losses from the originating broker or correspondent. Recently, we have received an increased number of repurchase and indemnity demands from purchasers as a result of borrower fraud and early borrower payment defaults. While we have taken steps to enhance our underwriting policies and procedures, there can be no assurance that these steps will be effective nor impact risk associated with loans sold in the past. If repurchase and indemnity demands increase, our liquidity, results of operations and financial condition will be adversely affected.
Clients could pursue alternatives to bank deposits, causing us to lose a relatively inexpensive source of funding.
Checking and savings account balances and other forms of client deposits could decrease if clients perceive alternative investments, such as the stock market, as providing superior expected returns. When clients move money out of bank deposits in favor of alternative investments, we can lose a relatively inexpensive source of funds, increasing the Companys funding costs.
Consumers may decide not to use banks to complete their financial transactions, which could affect net income.
Technology and other changes now allow parties to complete financial transactions without banks. For example, consumers can pay bills and transfer funds directly without banks. This process could result in the loss of fee income, as well as the loss of client deposits and the income generated from those deposits.
We have businesses other than banking which subjects the Company to a variety of risks.
We are a diversified financial services company. This diversity subjects earnings to a broader variety of risks and uncertainties.
Hurricanes and other natural disasters may adversely affect loan portfolios and operations and increase the cost of doing business.
Large scale natural disasters may significantly affect loan portfolios by damaging properties pledged as collateral and by impairing the ability of certain borrowers to repay their loans. The nature and level of natural disasters cannot be predicted and may be exacerbated by global climate change. The ultimate impact of a natural disaster on future financial results is difficult to predict and will be affected by a number of factors, including the extent of damage to the collateral, the extent to which damaged collateral is not covered by insurance, the extent to which unemployment and other economic conditions caused by the natural disaster adversely affect the ability of borrowers to repay their loans, and the cost of collection and foreclosure moratoriums, loan forbearances and other accommodations granted to borrowers and other clients.
Negative public opinion could damage our reputation and adversely impact business and revenues.
As a financial institution, our earnings and capital are subject to risks associated with negative public opinion. Negative public opinion could result from our actual or alleged conduct in any number of activities, including lending practices, the failure of any product or service sold by us to meet our customers expectations or applicable regulatory requirements, corporate governance and acquisitions, or from actions taken by government regulators and community organizations in response to those activities. Negative public opinion can adversely affect our ability to keep and attract and/or retain clients and can expose us to litigation and regulatory action. Actual or alleged conduct by one of our businesses can result in negative public opinion about our other businesses. Negative public opinion could also affect the Companys credit ratings, which are important to its access to unsecured wholesale borrowings; significant changes in these ratings could change the cost and availability of these sources of funding.
We rely on other companies to provide key components of our business infrastructure.
Third parties provide key components of our business infrastructure such as banking services, processing, and Internet connections and network access. Any disruption in such services provided by these third parties or any failure of these third parties to handle current or higher volumes of use could adversely affect our ability to deliver products and services to clients and otherwise to conduct business. Technological or financial difficulties of a third party service provider could adversely affect our business to the extent those difficulties result in the interruption or discontinuation of services provided by that party. We may not be insured against all types of losses as a result of third party failures and our insurance coverage may be inadequate to cover all losses resulting from system failures or other disruptions. Failures in our business infrastructure could interrupt the operations or increase the costs of doing business.
We rely on our systems, employees and certain counterparties, and certain failures could materially adversely affect our operations.
We are exposed to many types of operational risk, including the risk of fraud by employees and outsiders, clerical and record-keeping errors, and computer/telecommunications systems malfunctions. Our businesses are dependent on our ability to process a large number of increasingly complex transactions. If any of our financial, accounting, or other data processing systems fail or have other significant shortcomings, we could be materially adversely affected. We are similarly dependent on our employees. We could be materially adversely affected if one of our employees causes a significant operational break-down or failure, either as a result of human error or where an individual purposefully sabotages or fraudulently manipulates our operations or systems. Third parties with which we do business could also be sources of operational risk to us, including relating to break-downs or failures of such parties own systems or employees. Any of these occurrences could result in a
diminished ability of us to operate one or more of our businesses, potential liability to clients, reputational damage and regulatory intervention, which could materially adversely affect us.
We may also be subject to disruptions of our operating systems arising from events that are wholly or partially beyond our control, which may include, for example, computer viruses or electrical or telecommunications outages or natural disasters, or events arising from local or regional politics, including terrorist acts. Such disruptions may give rise to losses in service to customers and loss or liability to us. In addition there is the risk that our controls and procedures as well as business continuity and data security systems prove to be inadequate. Any such failure could affect our operations and could materially adversely affect our results of operations by requiring us to expend significant resources to correct the defect, as well as by exposing us to litigation or losses not covered by insurance.
We depend on the accuracy and completeness of information about clients and counterparties.
In deciding whether to extend credit or enter into other transactions with clients and counterparties, we may rely on information furnished by or on behalf of clients and counterparties, including financial statements and other financial information. We also may rely on representations of clients and counterparties as to the accuracy and completeness of that information and, with respect to financial statements, on reports of independent auditors.
Regulation by federal and state agencies could adversely affect the business, revenue and profit margins.
We are heavily regulated by federal and state agencies. This regulation is to protect depositors, the federal deposit insurance fund and the banking system as a whole. Congress and state legislatures and federal and state regulatory agencies continually review banking laws, regulations, and policies for possible changes. Changes to statutes, regulations, or regulatory policies, including interpretation or implementation of statutes, regulations, or policies, could affect us adversely, including limiting the types of financial services and products we may offer and/or increasing the ability of nonbanks to offer competing financial services and products. Also, if we do not comply with laws, regulations, or policies, we could receive regulatory sanctions and damage to our reputation. For more information, refer to Item 1,Business, of this Form 10-K.
Competition in the financial services industry is intense and could result in losing business or reducing margins.
We operate in a highly competitive industry that could become even more competitive as a result of legislative, regulatory and technological changes, and continued consolidation. We face aggressive competition from other domestic and foreign lending institutions and from numerous other providers of financial services. The ability of nonbanking financial institutions to provide services previously limited to commercial banks has intensified competition. Because nonbanking financial institutions are not subject to the same regulatory restrictions as banks and bank holding companies, they can often operate with greater flexibility and lower cost structures. Securities firms and insurance companies that elect to become financial holding companies may acquire banks and other financial institutions. This may significantly change the competitive environment in which we conduct business. Some of our competitors have greater financial resources and/or face fewer regulatory constraints. As a result of these various sources of competition, we could lose business to competitors or be forced to price products and services on less advantageous terms to retain or attract clients, either of which would adversely affect our profitability.
Future legislation could harm our competitive position.
Congress occasionally considers proposals to substantially change the financial institution regulatory system and to expand or contract the powers of banking institutions and bank holding companies. Such legislation may change banking statutes and the operating environment in substantial and unpredictable ways. If enacted, such legislation could increase or decrease the cost of doing business, limit or expand permissible activities, or affect the competitive balance among banks, savings associations, credit unions, and other financial institutions. We cannot predict whether new legislation will be enacted and, if enacted, the effect that it, or any regulations, would have on our activities, financial condition, or results of operations.
Maintaining or increasing market share depends on market acceptance and regulatory approval of new products and services.
Our success depends, in part, on the ability to adapt products and services to evolving industry standards. There is increasing pressure to provide products and services at lower prices. This can reduce net interest income and noninterest income from fee-based products and services. In addition, the widespread adoption of new technologies could require us to make substantial capital expenditures to modify or adapt existing products and services or develop new products and services. We may not be successful in introducing new products and services in response to industry trends or development in technology,
or those new products may not achieve market acceptance. As a result, we could lose business, be forced to price products and services on less advantageous terms to retain or attract clients, or be subject to cost increases.
The Parent Companys ability to receive dividends from its subsidiaries accounts for most of its revenue and could affect its liquidity and ability to pay dividends.
The Parent Company is a separate and distinct legal entity from its subsidiaries. It receives substantially all of its revenue from dividends from its subsidiaries. These dividends are the principal source of funds to pay dividends on the Parent Companys common stock and interest and principal on its debt. Various federal and/or state laws and regulations limit the amount of dividends that our bank and certain of its nonbank subsidiaries may pay to the Parent Company. Also, the Parent Companys right to participate in a distribution of assets upon a subsidiarys liquidation or reorganization is subject to the prior claims of the subsidiarys creditors. Limitations on the Parent Companys ability to receive dividends from its subsidiaries could have a material adverse effect on the Parent Companys liquidity and ability to pay dividends on common stock. For more information, refer to the Liquidity Risk section in the MD&A and Note 14, Capital, to the Consolidated Financial Statements.
Significant legal actions could subject us to substantial uninsured liabilities.
We are from time to time subject to claims related to our operations. These claims and legal actions, including supervisory actions by our regulators, could involve large monetary claims and significant defense costs. Substantial legal liability or significant regulatory action against us could have material adverse financial effects or cause significant reputational harm to us, which in turn could seriously harm our business prospects. We may be exposed to substantial uninsured liabilities, which could adversely affect our results of operations and financial condition.
Recently declining values of residential real estate may increase our credit losses, which would negatively affect our financial results.
We offer a variety of secured loans, including commercial lines of credit, commercial term loans, real estate, construction, home equity, consumer and other loans. Many of our loans are secured by real estate (both residential and commercial) in our market area. A major change in the real estate market, such as deterioration in the value of this collateral, or in the local or national economy, could adversely affect our customers ability to pay these loans, which in turn could impact us. Risk of loan defaults and foreclosures are unavoidable in the banking industry, and we try to limit our exposure to this risk by monitoring our extensions of credit carefully. We cannot fully eliminate credit risk, and as a result credit losses may occur in the future.
Deteriorating credit quality, particularly in real estate loans, has adversely impacted us and may continue to adversely impact us.
We have experienced a downturn in credit performance, particularly in the third and fourth quarters of 2007, and we expect credit conditions and the performance of our loan portfolio to continue to deteriorate in the near term. This deterioration has resulted in an increase in our loan loss reserves throughout 2007, which increases were driven primarily by residential real estate and home equity portfolios. Additional increases in loan loss reserves may be necessary in the future. Deterioration in the quality of our credit portfolio can have a material adverse effect on our capital, financial condition and results of operations.
Disruptions in our ability to access global capital markets may negatively affect our capital resources and liquidity.
In managing our consolidated balance sheet, we depend on access to global capital markets to provide us with sufficient capital resources and liquidity to meet our commitments and business needs, and to accommodate the transaction and cash management needs of our customers. Other sources of funding available to us, and upon which we rely as regular components of our liquidity risk management strategy, include inter-bank borrowings, repurchase agreements and borrowings from the Federal Reserve discount window. Any occurrence that may limit our access to the capital markets, such as a decline in the confidence of debt purchasers, our depositors or counterparties participating in the capital markets, or a downgrade of our debt rating, may adversely affect our capital costs and our ability to raise capital and, in turn, our liquidity.
We have in the past and may in the future pursue acquisitions, which could affect costs and from which we may not be able to realize anticipated benefits.
We have historically pursued an acquisition strategy, and intend to continue to seek additional acquisition opportunities. We may not be able to successfully identify suitable candidates, negotiate appropriate acquisition terms, complete proposed
acquisitions, successfully integrate acquired businesses into the existing operations, or expand into new markets. Once integrated, acquired operations may not achieve levels of revenues, profitability, or productivity comparable with those achieved by our existing operations, or otherwise perform as expected.
Acquisitions involve numerous risks, including difficulties in the integration of the operations, technologies, services and products of the acquired companies, and the diversion of managements attention from other business concerns. We may not properly ascertain all such risks prior to an acquisition or prior to such a risk impacting us while integrating an acquired company. As a result, difficulties encountered with acquisitions could have a material adverse effect on the business, financial condition, and results of operations.
Furthermore, we must generally receive federal regulatory approval before we can acquire a bank or bank holding company. In determining whether to approve a proposed bank acquisition, federal bank regulators will consider, among other factors, the effect of the acquisition on competition, financial condition, future prospects, including current and projected capital levels, the competence, experience, and integrity of management, compliance with laws and regulations, the convenience and needs of the communities to be served, including the acquiring institutions record of compliance under the Community Reinvestment Act, and the effectiveness of the acquiring institution in combating money laundering activities. In addition, we cannot be certain when or if, or on what terms and conditions, any required regulatory approvals will be granted. Consequently, we might be required to sell portions of the acquired institution as a condition to receiving regulatory approval or we may not obtain regulatory approval for a proposed acquisition on acceptable terms or at all, in which case we would not be able to complete the acquisition despite the time and expenses invested in pursuing it.
We depend on the expertise of key personnel. If these individuals leave or change their roles without effective replacements, operations may suffer.
The success of our business has been, and the continuing success will be, dependent to a large degree on the continued services of executive officers, especially our President and Chief Executive Officer, James M. Wells III, and other key personnel who have extensive experience in the industry. We do not carry key person life insurance on any of the executive officers or other key personnel. If we lose the services of any of these integral personnel and fail to manage a smooth transition to new personnel, the business could be impacted.
We may not be able to hire or retain additional qualified personnel and recruiting and compensation costs may increase as a result of turnover, both of which may increase costs and reduce profitability and may adversely impact our ability to implement the business strategy.
Our success depends upon the ability to attract and retain highly motivated, well-qualified personnel. We face significant competition in the recruitment of qualified employees. Our ability to execute the business strategy and provide high quality service may suffer if we are unable to recruit or retain a sufficient number of qualified employees or if the costs of employee compensation or benefits increase substantially.
Our accounting policies and methods are critical to how we report our financial condition and results of operations. They require management to make estimates about matters that are uncertain.
Accounting policies and methods are fundamental to how we record and report the financial condition and results of operations. Management must exercise judgment in selecting and applying many of these accounting policies and methods so they comply with Generally Accepted Accounting Principles in the United States (US GAAP).
Management has identified certain accounting policies as being critical because they require managements judgment to ascertain the valuations of assets, liabilities, commitments and contingencies. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset, or reducing a liability. We have established detailed policies and control procedures that are intended to ensure these critical accounting estimates and judgments are well controlled and applied consistently. In addition, the policies and procedures are intended to ensure that the process for changing methodologies occurs in an appropriate manner. Because of the uncertainty surrounding our judgments and the estimates pertaining to these matters, we cannot guarantee that we will not be required to adjust accounting policies or restate prior period financial statements. See the Critical Accounting Policies section in the MD&A and Note 1, Accounting Policies, to the Consolidated Financial Statements in this report for more information.
Changes in our accounting policies or in accounting standards could materially affect how we report our financial results and condition.
From time to time, the Financial Accounting Standards Board (FASB) and SEC change the financial accounting and reporting standards that govern the preparation of our financial statements. These changes can be hard to predict and can
materially impact how we record and report our financial condition and results of operations. In some cases, we could be required to apply a new or revised standard retroactively, resulting in us restating prior period financial statements.
Our stock price can be volatile.
Our stock price can fluctuate widely in response to a variety of factors including:
General market fluctuations, industry factors, and general economic and political conditions and events, such as terrorist attacks, economic slowdowns or recessions, interest rate changes, credit loss trends, or currency fluctuations, also could cause our stock price to decrease regardless of operating results.
Our disclosure controls and procedures may not prevent or detect all errors or acts of fraud.
Our disclosure controls and procedures are designed to reasonably assure that information required to be disclosed by SunTrust in reports we file or submit under the Exchange Act is accumulated and communicated to management, and recorded, processed, summarized, and reported within the time periods specified in the SECs rules and forms. We believe that any disclosure controls and procedures or internal controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met.
These inherent limitations include the realities that judgments in decision-making can be faulty, that alternative reasoned judgments can be drawn, or that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people or by an unauthorized override of the controls. Accordingly, because of the inherent limitations in our control system, misstatements due to error or fraud may occur and not be detected.
Our financial instruments carried at fair value expose the Company to certain market risks.
We maintain an available for sale securities portfolio and trading assets which include various types of instruments and maturities. Compared to December 31, 2006, in 2007, we increased the size of trading assets in conjunction with the Companys adoption of the Statement of Financial Accounting Standards (SFAS) No. 157 and SFAS No. 159. In addition, the Company elected to record selected fixed-rate debt, mortgage loans, securitization warehouses and other trading assets at fair value. The changes in fair value of the financial instruments elected to be carried at fair value pursuant to the provisions of SFAS No. 159 are recognized in earnings. The financial instruments carried at fair value are exposed to market risks related to changes in interest rates and the Companys market-based credit spreads, as well as to the risk of default by specific borrowers. The Company manages the market risks associated with these instruments through active hedging arrangements or broader asset/liability management strategies. Changes in the market values of these financial instruments could have a material adverse impact on our financial condition or results of operations. We may classify additional financial assets or financial liabilities at fair value in the future.
Our revenues derived from our investment securities may be volatile and subject to a variety of risks.
We generally maintain investment portfolios in the fixed income, currency, commodity and equity markets. Unrealized gains and losses associated with our investment portfolio and mark to market gains and losses associated with our trading portfolio are affected by many factors, including our credit position, interest rate volatility, volatility in capital markets and other economic factors. Our return on such investments and trading have in the past experienced, and will likely in the future experience, volatility and such volatility may materially adversely affect our financial condition and results of operations.
We may enter into transactions with off-balance sheet entities affiliated with SunTrust or its subsidiaries.
We engage in a variety of transactions with off-balance sheet entities with which we are affiliated. While we have no obligation, contractual or otherwise, to do so, under certain limited circumstances, these transactions may involve providing some form of financial support to these entities. Any such actions may cause us to recognize current or future gains or losses.
Depending on the nature and magnitude of any transactions we enter into with off-balance sheet entities, accounting rules may require us to consolidate the financial results of these entities with our financial results.
We are subject to market risk associated with our asset management and commercial paper conduit businesses.
During 2007, we recorded approximately $525 million in market valuation losses related to securities that we purchased from certain money market funds managed by our subsidiary Trusco Capital Management, Inc. as well as Three Pillars Funding, LLC (Three Pillars), a multi-seller commercial paper conduit sponsored by us. At the time of purchase, these securities were predominantly AAA or AA-rated, residential mortgage-backed securities, structured investment vehicle (SIVs) securities, and corporate and consumer collateralized debt obligations. We cannot assure you that we will not sustain additional losses in the future related to these securities or the purchase of similar securities. The value of such securities may be effected by, among other things, a lack of liquidity in the market for these securities, deterioration in the credit quality of the underlying collateral, risks associated with the financial guarantees insuring the securities, and/or the fact that the respective investment vehicle enters restructuring proceedings. Such occurrences may materially adversely affect our financial condition, capital adequacy and results of operations.
Item 2. PROPERTIES
The Companys headquarters is located in Atlanta, Georgia. As of December 31, 2007, SunTrust Bank owned 703 of its 1,682 full-service banking offices and leased the remaining banking offices. (See Note 8, Premises and Equipment, to the Consolidated Financial Statements).
Item 3. LEGAL PROCEEDINGS
The Company and its subsidiaries are parties to numerous claims and lawsuits arising in the course of their normal business activities, some of which involve claims for substantial amounts. Although the ultimate outcome of these suits cannot be ascertained at this time, it is the opinion of management that none of these matters, when resolved, will have a material effect on the Companys consolidated results of operations or financial position.
Please also refer to our discussion in Note 18, Reinsurance Arrangements and Guarantees, to the Consolidated Financial Statements of certain litigation related accruals which we made during the quarter ended December 31, 2007 related to our ownership interest in Visa, Inc.
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of shareholders during the quarter ended December 31, 2007.
The principal market in which the common stock of the Company is traded is the New York Stock Exchange (NYSE). See Item 6 and Table 17 in the MD&A for information on the high and the low closing sales prices of the SunTrust Banks, Inc. common stock (Common Stock) on the NYSE, which is incorporated herein by reference. During the twelve months ended December 31, 2007 and 2006, we paid a quarterly dividend of $0.73 and $0.61 per share of common stock, respectively. Our Common Stock is held by approximately 36,702 Registered Shareholders as of December 31, 2007. See Table 23 in the MD&A for information on the monthly share repurchases activity, including total common shares repurchased and announced programs, weighted average per share price and the remaining buy-back authority under the announced programs, which is incorporated herein by reference.
Set forth below is a line graph comparing the yearly percentage change in the cumulative total shareholder return on SunTrust Common Stock against the cumulative total return of the S&P Composite-500 Stock Index, and the S&P Commercial Bank Industry Index for the five years commencing December 31, 2002 and ending December 31, 2007.
COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN*
Among SunTrust Banks, Inc., The S&P 500 Index
And The S & P Commercial Bank Industry Index
Copyright © 2008, Standard & Poors, a division of The McGraw-Hill Companies, Inc. All rights reserved.
Cautionary Statement Regarding Forward-Looking Statements
The information included or incorporated by reference in this Form 10-K may contain forward-looking statements. Statements that do not describe historical or current facts, including statements about beliefs and expectations, are forward-looking statements. These statements often include the words believes, expects, anticipates, estimates, intends, plans, targets, initiatives, potentially, probably, projects, outlook or similar expressions or future conditional verbs such as may, will, should, would, and could.
Forward looking statements involve significant risks and uncertainties. Investors are cautioned against placing undue reliance on our forward-looking statements. Actual results may differ materially from those set forth in the forward-looking statements. Such statements are based upon the current beliefs and expectations of the management of SunTrust and on information currently available to management. Such statements speak as of the date hereof, and SunTrust does not assume any obligation to update the statements included or incorporated by reference or to update the reasons why actual results could differ from those contained in such statements in light of new information or future events. The forward looking statements are intended to be subject to the safe harbor provided by Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, as amended (the Exchange Act).
Factors that might cause our future financial performance to vary from that described in our forward-looking statements include risks discussed in this MD&A and in other periodic reports that we file with the SEC. In addition, the discussion contained in Item 1A. Risk Factors, sets forth certain risks and uncertainties that we believe could cause actual future results to differ materially from expected results. However, other factors besides those listed below or discussed in our reports to the SEC also could adversely affect our results, and the reader should not consider this list of factors to be a complete set of all potential risks or uncertainties.
This narrative will assist readers in their analysis of the accompanying consolidated financial statements and supplemental financial information of the Company. It should be read in conjunction with the Consolidated Financial Statements and Notes.
When we refer to SunTrust, the Company, we, our and us in this narrative, we mean SunTrust Banks, Inc. and Subsidiaries (consolidated). Effective October 1, 2004, National Commerce Financial Corporation (NCF) merged with SunTrust. The results of operations for NCF were included with our results beginning October 1, 2004. Periods prior to the acquisition date do not reflect the impact of the merger.
In Managements Discussion and Analysis of Financial Condition and Results of Operations (MD&A), net interest income, net interest margin and the efficiency ratio are presented on a fully taxable-equivalent (FTE) basis and the quarterly ratios are presented on an annualized basis. The FTE basis adjusts for the tax-favored status of income from certain loans and investments. We believe this measure to be the preferred industry measurement of net interest income and it enhances comparability of net interest income arising from taxable and tax-exempt sources. We also present diluted earnings per common share excluding merger expense and an efficiency ratio excluding merger expense that exclude merger charges related to the NCF acquisition. We believe the exclusion of the merger charges, which represent incremental costs to integrate NCFs operations, is more reflective of normalized operations. Additionally, we present a return on average realized common shareholders equity, as well as a return on average common shareholders equity (ROE). We also present a return on average assets less net unrealized securities gains/losses and a return on average total assets (ROA). The return on average realized common shareholders equity and return on average assets less net unrealized securities gains/losses exclude realized securities gains and losses and the Coca-Cola Company dividend, from the numerator, and net unrealized securities gains from the denominator. We present a tangible efficiency ratio and a tangible equity to tangible assets ratio, which excludes the cost of and the other effects of intangible assets resulting from merger and acquisition (M&A) activity. We believe these measures are useful to investors because, by removing the effect of intangible asset costs from merger and acquisition activity (the level of which may vary from company to company), it allows investors to more easily compare our efficiency and capital adequacy to other companies in the industry. The measures are utilized by management to assess our efficiency, and that of our lines of business, as well as our capital adequacy. We provide reconcilements in Tables 21 and 22 in the MD&A for all non-US GAAP measures. Certain reclassifications may be made to prior period financial statements and related information to conform them to the 2007 presentation.
Our headquarters are located in Atlanta, Georgia, and we operate primarily within Florida, Georgia, Maryland, North Carolina, South Carolina, Tennessee, Virginia, and the District of Columbia. Within the geographic footprint, we operated under five business segments during 2007. These business segments were: Retail, Commercial, Corporate and Investment Banking, Wealth and Investment Management, and Mortgage.
In 2007, the financial services industry was significantly affected by turmoil in the financial markets created by a downturn in the consumer credit cycle, and specifically the residential housing market. The deterioration in the credit markets created market volatility and illiquidity, resulting in significant declines in the market values of a broad range of investment products and loans. We were not immune to the impacts of these market dynamics as our results clearly indicate through the increased provision for loan losses and net market valuation declines of various financial instruments carried at market value. In the second half of 2007, we recorded approximately $700 million in net market valuation losses on financial instruments carried at fair value. The majority of the market valuation loss was related to securities that were purchased from certain money market funds, as well as a multi-seller commercial paper conduit that we sponsor.
Despite this challenging operating environment, which also included intense deposit competition and a prolonged flat to inverted yield curve, we made considerable progress in our shareholder value-oriented initiatives. In the first and second quarters of 2007, we conducted additional balance sheet restructuring activities related primarily to our mortgage and corporate loans and investment securities. These actions were a continuation of the balance sheet management initiatives that began in 2006. These actions were designed to more efficiently utilize our balance sheet and resulted in an improvement in net interest margin, reduced credit exposure, and increased liquidity. These actions resulted in a significant reduction in the size of the balance sheet, change in the mix of available for sale securities, and an increase in the size and active management of trading assets.
We also implemented the Excellence in Execution Efficiency and Productivity Program (E2) aimed at lowering our cost structure to drive higher financial performance and enhancing long term efficiency. We have realized $215.2 million in savings as a result of our E2 program and are well positioned going into 2008 to continue to more efficiently utilize resources while enhancing the overall customer service experience for our clients. For the year ended December 31, 2007, we recognized approximately $45 million in severance expense related to this program, which was recorded in other staff expense. We anticipate the run-rate of total cost savings of approximately $530 million will be achieved during 2009 through initiatives identified in corporate real estate, supplier management, off-shoring, and process/organizational reviews. These estimated cost savings do not include the cost of incremental investments or the benefit of non-recurring gains associated with the E2 initiatives.
For the year ended December 31, 2007, we reported net income available to common shareholders of $1,603.7 million, or $4.55 per diluted common share. For the fourth quarter of 2007, we reported net income available to common shareholders of $3.3 million, or $0.01 per diluted common share.
The following is a summary of our 2007 financial performance:
Adoption of Fair Value Accounting Standards
During the first quarter of 2007, we evaluated the provisions of the recently issued fair value accounting standards, Statement of Financial Accounting Standards (SFAS) No. 157, Fair Value Measurement, and SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities. SFAS No. 157 clarifies how to measure fair value when such measurement is otherwise required by US GAAP, and SFAS No. 159 provides companies with the option to elect to carry specific financial assets and financial liabilities at fair value. The provisions of SFAS No. 157 establish clearer and more consistent criteria for measuring fair value. The primary objective of SFAS No. 159 is to expand the use of fair value in US GAAP, with the focus on eligible financial assets and financial liabilities. As a means to expand the use of fair value, SFAS No. 159 allows companies to avoid some of the complexities of SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended by SFAS No. 149, and more closely align the economics of their business with their results of operations without having to apply a mixed attribute accounting model for certain financial instruments under a hedging relationship. Based on our evaluation of these standards in relation to our balance sheet management strategies and objectives, we early adopted these fair value standards as of January 1, 2007. The following is a synopsis of our thought process regarding how to apply SFAS No. 159 to our business:
The following discussion elaborates on our rationale for electing to record certain financial assets and financial liabilities at fair value, as well as provides relevant balance sheet and earnings information for those assets and liabilities carried at fair value. See Note 20, Fair Value, to the Consolidated Financial Statements for more information.
The economic environment since early 2006 has created financial challenges for financial institutions, specifically constraining the ability to grow net interest income. The flat to inverted yield curve has persisted for an unprecedented length of time compressing the interest spread on earning assets. In addition, the general market environment has constrained customer deposit growth, as customers shifted deposits into alternative investments and/or higher rate deposit products, accentuating the pressure on net interest margin. Average earning assets increased 8.0% in 2006 compared to 2005 and the average yield increased 92 basis points, while average customer deposits increased 4.1% in 2006 and the average rate on interest bearing customer deposits increased 106 basis points. The increase in deposits was entirely in higher cost time deposits, increasing 34.4%, while all other deposit products decreased 4.1%. Of particular note, average demand deposits declined 4.1% compared to 2005. The incremental earning asset growth not supported by customer deposits resulted in a 55.4% increase in wholesale deposits, with an average rate in 2006 of approximately 5%, which was more than 150 basis points higher than the average rate in 2005. All of the above dynamics resulted in a 17 basis point decline in our net interest margin during 2006.
In order to respond to the reduction in net interest margin, we began employing specific asset/liability management strategies beginning in the second quarter of 2006 that focused on moderating balance sheet growth. These strategies involved moderately downsizing our loan and securities portfolios, focusing on lower yielding assets and reducing reliance on higher rate wholesale deposits. We executed several specific transactions in 2006 that included the sale or securitization of $1.8 billion of residential real estate loans and $2.1 billion of student loans. We elected to warehouse, and subsequently sell, residential real estate loans in the secondary market that in the past had been placed in portfolio. Additionally, we sold $4.4 billion of shorter-term securities, primarily mortgage-backed and agency securities, with a 3.6% average yield and reinvested approximately $2.4 billion in longer-term securities with a 5.6% average yield. This combination of transactions caused a $2.0 billion reduction in the securities portfolio in the third and fourth quarters of 2006. Finally, we executed $1.5 billion in notional amount of receive-fixed interest rate swaps, which were designated as cash flow hedges under SFAS No. 133 on commercial loans, to extend the duration of the balance sheet and improve the overall earning asset yield.
We also restructured aspects of our capital in the third and fourth quarters of 2006, reducing our cost of capital while strengthening our Tier 1 capital position. These capital restructuring initiatives contributed to our well capitalized status, as Tier 1 capital increased to 7.72%, as of December 31, 2006, up 71 basis points from the prior year end.
The persistent challenging economic environment, exacerbated by an uncertain outlook for meaningful improvement, intensified in 2007 resulting in additional pressure on net interest income. While the yield curve steepened some in December 2006 and January 2007, the yield curve was again strongly inverted by the end of February 2007. Consequently, we determined that it was appropriate to reduce the size of our balance sheet through a structured asset sale of approximately $2 billion of lower yielding, large corporate loans and also executed an additional $1.1 billion notional of receive-fixed interest rate swaps on floating rate commercial loans. More significantly, we conducted a comprehensive review of our securities and loan portfolios, whereby we analyzed a variety of the portfolios characteristics, including absolute size, overall liquidity, customer collateral needs, credit and interest rate exposure, security type, and Tier 1 capital consumption. As a result, we determined that it would be appropriate to significantly reduce the overall size of our securities and loan portfolios, as well as to modify our asset/liability strategies to (1) reduce balance sheet utilization and related wholesale funding, (2) reduce risk weighted assets for Tier 1 capital purposes, (3) reduce interest rate risk, (4) significantly reduce credit risk, (5) minimize redundancy between the securities portfolio and the mortgage loan portfolio, (6) increase the overall portfolio yield, (7) increase the use of derivatives to manage duration and (8) significantly reduce the size of the available for sale securities portfolio and significantly increase the size of the trading securities portfolio.
As discussed in Note 1, Accounting Policies, to the Consolidated Financial Statements, we early adopted the fair value accounting standards SFAS No. 157 and SFAS No. 159. Shortly after the issuance of SFAS No. 157 in September 2006, we began identifying positions that would be impacted by the provisions of SFAS No. 157. In connection with the evaluation of SFAS No. 157, we also evaluated the draft provisions of SFAS No. 159. Generally, we support the elective use of fair value of financial instruments, as evidenced by our early adoption in 2006 of SFAS No. 155. In certain circumstances, fair value enables a company to more accurately align its financial performance with the market value of actively traded or hedged assets or liabilities. Fair value enables a company to mitigate the non-economic earnings volatility caused from financial assets and financial liabilities being carried at different bases of accounting, as well as to more accurately portray the active and dynamic management of a companys balance sheet. The objectives of the new fair value standards align closely with our recent balance sheet management strategies.
Subsequent to the final issuance of SFAS No. 159 on February 15, 2007, we re-evaluated the provisions of SFAS No. 159 and the potential impacts of SFAS No. 157. In addition to the impact of SFAS No. 159 alleviating the burdens of fair value hedge accounting on certain elements of our debt and loans held for sale, we also evaluated other potential impacts of the final provisions of SFAS No. 159 related to our recently formulated asset/liability strategies that specifically related to the investment and loan portfolios. The ability to record at fair value certain financial assets and liabilities resulted in us accelerating the deployment of the various asset/liability strategies that we had been evaluating during the first quarter. After an analysis of the potential impacts of these standards and discussions with our Board of Directors (the Board), we decided in late March to early adopt both SFAS No. 157 and SFAS No. 159. The aggregate impact to the first quarter due to early adopting these standards, including the related economic hedges, was a $60.8 million benefit to pre-tax income. The annual financial impact from adopting these standards was considered by the Compensation Committee of the Board in connection with the ordinary annual year-end review of our performance.
The most significant financial impacts of adopting the provisions of SFAS No. 157 related to valuing mortgage loans held for sale and the recording of the valuation of mortgage loan commitments (related to loans intended to be held for sale) that are derivatives under the provisions of SFAS No. 133, as amended by SFAS No. 149. Under SFAS No. 157, the fair value of a closed loan includes the embedded cash flows that are ultimately realized as servicing value either through retention of the servicing asset or through the sale of a loan on a servicing released basis. The valuation of loan commitments includes assumptions related to the likelihood that a commitment will ultimately result in a closed loan. These pull-through rates are based on our historical data, which is a significant unobservable assumption. Prior accounting requirements under EITF 02-03, Accounting for Contracts involved in Energy Trading and Risk Managements Activities, precluded the recognition of any day one gains and losses if fair value was not based on market observable data. Rather, these deferred gains and losses were recognized when the rate lock expired or when the underlying loan was ultimately sold. The change in valuation methodology under SFAS No. 157 accelerates the recognition of these day one gains and losses. During the first quarter, we recognized a $38.0 million reduction to mortgage production related income due to the acceleration of these day one losses previously deferred. As a result of adopting SFAS No. 157, we recorded a $10.9 million reduction to opening retained earnings.
In conjunction with adopting SFAS No. 159, we elected to record specific financial assets and financial liabilities at fair value. These instruments include all, or a portion, of the following: debt, available for sale debt securities, adjustable rate residential mortgage portfolio loans, securitization warehouses and trading loans. As a result of recording these financial
assets and liabilities at fair value as of January 1, 2007, in accordance with SFAS No. 157 and SFAS No. 159, we recorded in earnings in the first quarter of 2007 changes in these instruments fair values, as well as changes in fair value of any associated derivatives which would have otherwise been carried at fair value through earnings. Due to the unique retroactive application of the transition provisions, we have provided the following table that reflects the impact to opening retained earnings and first quarter earnings as a result of electing to carry these financial assets and financial liabilities at fair value and adopting the new fair value measurement requirements:
Upon electing to carry these assets and liabilities at fair value, we began to economically hedge and/or trade these assets or liabilities in order to manage the instruments fair value volatility and economic value. The following is a description of each asset and liability class for which fair value has been elected, including the specific reasons for electing fair value and the strategies for managing the assets and liabilities on a fair value basis. In association with adoption of the fair value standards, we recorded a reduction of $399.5 million in retained earnings on January 1, 2007.
Fixed Rate Debt
The debt that we elected to carry at fair value was all of our fixed rate debt that had previously been designated in qualifying fair value hedges using receive fixed/pay floating interest rate swaps, pursuant to the provisions of SFAS No. 133. This population specifically included $3.5 billion of fixed-rate Federal Home Loan Bank (FHLB) advances and $3.3 billion of publicly-issued debt. We elected to record this debt at fair value in order to align the accounting for the debt with the accounting for the derivative without having to account for the debt under hedge accounting, thus avoiding the complex and time consuming fair value hedge accounting requirements of SFAS No. 133. The reduction to opening retained earnings from recording the debt at fair value was $197.2 million. This move to fair value introduced potential earnings volatility due to changes in our credit spread that were not required to be valued under the SFAS No. 133 hedge designation. We estimated credit spreads above LIBOR rates, based on trading levels of our debt in the market as of each reporting date. Based on this methodology, we recognized a gain of approximately $157.5 million during 2007 due to changes in our credit spread. All of the debt, along with the interest rate swaps previously designated as hedges under SFAS No. 133, continues to remain outstanding.
During the year ended December 31, 2007, we consummated two fixed rate debt issuances. On September 10, 2007, we issued $500 million of Senior Notes, which carried a fixed coupon rate of 6.00% and had a term of 10 years. We did not enter into any hedges on this debt at issuance and, therefore, did not elect to carry the debt at fair value. On November 5, 2007, we issued $500 million of Senior Notes, which carried a fixed coupon rate of 5.25% and had a term of 5 years. We did enter into hedges in connection with this debt issuance and as a result elected to carry this debt at fair value.
Available for Sale and Trading Securities
The available for sale debt securities that were transferred to trading were substantially all of the debt securities within specific asset classes, whether the securities were valued at an unrealized loss or unrealized gain. We elected to reclassify approximately $15.4 billion of securities to trading at January 1, 2007, as well as an additional $600 million of purchases of similar assets that occurred during the first quarter of 2007. The reduction to opening retained earnings related to reclassifying the $15.4 billion of securities to trading was $147.4 million. This net unrealized loss was already reflected in accumulated other comprehensive income and, therefore, upon reclassification to retained earnings, there was no net impact to total shareholders equity. Our securities portfolio is generally of high credit quality, such that the opening retained earnings adjustment was not significantly impacted by the credit risk embedded in the assets, but rather due to interest rates.
We elected to move these available for sale securities to trading securities in order to initially seed the trading securities portfolio that we intended to actively manage in connection with the overall management of our balance sheet. The transfer of securities to trading enabled us to more actively trade a more significant portion of our investment portfolio and reduce the overall size of the available for sale portfolio. In determining the assets to be sold, we considered economic factors, such as yield, collateral, interest terms, capital efficiency, and duration, in relation to our balance sheet strategies. In evaluating our total available for sale portfolio of approximately $23 billion at January 1, 2007, we determined that approximately $3 billion of securities were not available or were not practicable to be fair valued and reclassified to trading under SFAS No. 159, as these securities had matured or been called during the quarter, were subject to business restrictions, were privately placed or had nominal principal amounts. Approximately $5 billion of securities aligned with our recent balance sheet strategy, due to the nature of the assets (such as 30-year fixed rate mortgage backed securities (MBS), 10/1 adjustable rate mortgages (ARMs), floating rate asset backed securities (ABS) and municipal bonds); therefore, the securities continued to be classified as available for sale. These securities yielded over 5.6%, had a duration over 4.0%, and were in a $6.7 million net unrealized gain position as of January 1, 2007. The remaining $15.4 billion of securities, which included hybrid ARMs, commercial MBS, collateralized mortgage obligations (CMO) and MBS (excluding those classes of MBS that remained classified as securities available for sale), yielded approximately 4.5% and had a duration under 3.0%. The approximate $600 million of securities that were purchased in the first quarter and originally classified as available for sale were similar to the securities reclassified to trading on January 1, 2007 upon adoption of SFAS No. 159; accordingly, we reclassified these securities to trading pursuant to the provisions of SFAS No. 159.
During the first quarter of 2007, in connection with our decision to early adopt SFAS No. 159, we purchased approximately $1.7 billion of treasury bills, which were classified as trading securities, and approximately $3.2 billion of 30-year fixed rate MBS, which were classified as securities available for sale. We entered into approximately $13.5 billion notional of interest rate derivatives to mitigate the fair value volatility of the available for sale securities that had been reclassified to trading. Finally, as part of our asset/liability strategies, we executed an additional $7.5 billion notional receive-fixed interest rate swaps that were designated as cash flow hedges under SFAS No. 133 on floating rate commercial loans.
During the second quarter of 2007, we sold substantially all of the $16.0 billion in securities transferred to trading at prices that, in the aggregate and including the hedging gains and losses, approximated the fair value of the securities at March 31, 2007, and terminated the interest rate derivatives we had entered into as hedges of the fair value. We replaced a portion of these securities with an additional $5.4 billion of treasury bills classified as trading and $1.8 billion of 30-year fixed rate MBS classified as available for sale. In addition, we reduced wholesale overnight funding by approximately $4 billion. The 30-year fixed-rate MBS were a similar asset type to the securities that remained classified as available for sale but were substantially different from the securities reclassified to trading as part of our adoption. These securities yielded over 5.5% and had a duration of approximately 5.7%.
Subsequent to the transactions executed at the end of the first quarter and early second quarter, we continued to maintain an active trading portfolio, as well as refine our trading securities strategies. As trading securities matured or sold, we purchased additional trading securities that included longer dated agency debentures, commercial paper, ABS, corporate bonds, etc. During the year ended December 31, 2007, we purchased approximately $23 billion of trading securities for balance sheet management purposes. In addition, during 2007, we entered into $4.6 billion of FHLB letters of credit that we elected to record at fair value and used these letters of credit to satisfy customer collateral and deposit requirements.
Mortgage Loans Held for Sale
In connection with the early adoption of SFAS No. 159, we evaluated the composition of the mortgage loan portfolio including certain business restrictions on loans that are held by real estate investment trusts (REITs). As part of our overall balance sheet management strategies during the second quarter of 2006, we decided to no longer retain in our portfolio new originations of prime quality, mid-term adjustable rate, highly commoditized, conforming agency and nonagency conforming residential mortgage portfolio loans in order to moderate the growth of earning assets, but had not undertaken plans to sell or securitize any of these loans held in the loan portfolio. In connection with our recently formulated asset/liability management strategies, we evaluated the composition of the mortgage loan portfolio, particularly in light of our plans to no longer hold the above mentioned mortgage loans in our portfolio, as well as our expectation to begin to record at fair value substantially all newly-originated mortgage loans held for sale in the second quarter of 2007. Based on this evaluation, we elected to carry $4.1 billion of these types of loans held in the loan portfolio at fair value as of January 1, 2007 and transferred these loans to held for sale at the end of the first quarter. The loans that we elected to move to fair value were not owned by a REIT and had a weighted average coupon rate of approximately 4.9%. These loans were all performing loans and virtually none had been past due 30 days or more over the prior 12 month period. The reduction to opening retained earnings related to these loans was $44.2 million, which was net of a $4.1 million reduction in the allowance for loan losses related to these loans. In connection with recording these loans at fair value, we initiated hedging activities to mitigate the earnings volatility from changes in the loans fair value. During the twelve months ended December 31, 2007, we sold or securitized $3.4 billion of the $4.1 billion of mortgage loans transferred to loans held for sale that, in the aggregate and including the hedging gains and losses, approximated the fair value of the mortgage loans at March 31, 2007, and terminated the interest rate derivatives we had entered into as hedges of the fair value. As of December 31, 2007, $0.5 billion of the $4.1 billion in initially fair valued mortgage loans remained outstanding.
In the second quarter of 2007, we began recording at fair value certain newly-originated mortgage loans held for sale based upon defined product criteria. We chose to fair value these mortgage loans held for sale in order to eliminate the complexities and inherent difficulties of achieving hedge accounting and to better align reported results with the underlying economic changes in value of the loans and related hedge instruments. During 2007, we elected to record at fair value $27.4 billion of mortgage loans and classified these loans as held for sale. As of December 31, 2007, there were $5.9 billion of newly-originated mortgage loans at fair value held for sale. This election impacts the timing and recognition of origination fees and costs, as well as servicing value. Specifically, origination fees and costs, which had been appropriately deferred under SFAS No. 91 and recognized as part of the gain/loss on sale of the loan, are now recognized in earnings at the time of origination. For the year ended December 31, 2007, approximately $79 million in loan origination fees were recognized in noninterest income and approximately $78 million in loan origination costs were recognized in noninterest expense due to this fair value election. The servicing value, which had been recorded at the time the loan was sold as a mortgage servicing right, is now included in the fair value of the loan and recognized at origination of the loan. We began using derivatives to economically hedge changes in servicing value as a result of including the servicing value in the fair value of the loan. The estimated impact from recognizing servicing value, net of related hedging costs, as part of the fair value of the loan is captured in mortgage production income.
Our mortgage loans held for sale are carried at either the lower of cost or market or fair value. Under either accounting basis, the value of these loans is susceptible to declines in market value. Recent market events have affected the value and liquidity of mortgage loans, but to varying degrees depending on the nature and credit quality of the mortgage loans. The carrying value of our residential mortgage loans held for sale was $7.4 billion as of December 31, 2007, including approximately $153.2 million of Alt-A mortgage loans and no subprime mortgages. During the second half of 2007, investors concerns regarding the credit performance of subprime mortgages spread to other mortgage products, severely impacting the liquidity and market value of non-agency mortgage loans in the secondary market. As a result, we recorded approximately $165.4 million in pre-tax charges related primarily to losses on loan sales and declines in the market value of loans held for sale, including related hedges during the year. The loans held for sale and related derivatives were valued based on observable market data of similar assets, where available, as well as current performance data of the underlying loans. In instances when significant valuation assumptions were not readily observable in the market, instruments were valued based on the best available data in order to approximate fair value. These market values are susceptible to volatility due to the effect of the credit related issues impacting the mortgage loan market, as well as the absence of market liquidity. The value of these assets could be adversely impacted by further declines in market prices. Management limits the size and our overall exposure to these assets, as well as actively monitors the estimated market and economic value of these assets and determines the most advantageous approach to managing these assets.
Securitization and Trading Loans
As part of our securitization and trading activities, we often warehouse assets prior to sale or securitization, retain interests in securitizations, and maintain a portfolio of loans that we trade in the secondary market. At January 1, 2007, we transferred to trading assets approximately $600 million of loans, substantially all of which were purchased from the market for the purpose of sales into securitizations, which were previously classified as loans held for sale. Pursuant to the provisions of SFAS No. 159, we elected to carry warehoused and trading loans at fair value in order to reflect the active management of these positions and, in certain cases, to align the economics of these instruments with the hedges that we typically execute on certain of these loans. We also elected to reclassify our residual interests to trading assets, consistent with other residual positions we own. As of December 31, 2007, approximately $107 million of the $600 million of trading loans transferred into trading assets as of January 1, 2007 remained outstanding, and additional loans were purchased and recorded at fair value as part of our normal loan securitization and trading activities.
The assets securing these residual interests are primarily residential loans, commercial loans, corporate loans, and government sponsored student loans. The total value of our securitization warehouses that we have elected to carry at fair value, excluding certain mortgage loan warehouses, was approximately $44.8 million as of December 31, 2007. The assets held in the warehouses at December 31, 2007 include commercial loans. These warehouses were mark to market as of December 31, 2007 and reflect our best estimate of fair value taking into consideration the markets into which these assets will be securitized and/or sold and the credit quality of the assets held in the warehouse. The size of our securitization warehouse has decreased significantly during 2007 as a result of valuation write-downs, as well as our decision in the fourth quarter to exit certain aspects of the securitization business.
Table 1 Analysis of Changes in Net Interest Income1
Table 2 Consolidated Daily Average Balances, Income/Expense And Average Yields Earned And Rates Paid
Net Interest Income/Margin
Fully-taxable equivalent net interest income for 2007 was $4,822.2 million, an increase of $73.8 million, or 1.6%, from 2006. The increase in net interest income was primarily the result of balance sheet management strategies implemented throughout 2007 and 2006. Lower yielding loans and investment securities were reclassified to loans held for sale and trading assets, respectively, and a portion of these assets was subsequently sold enabling a reduction in higher cost liabilities.
For 2007, average earning assets decreased $3.2 billion, or 2.0%, while average interest-bearing liabilities decreased $1.2 billion, or 0.9%, compared to 2006. This decline was a result of balance sheet management strategies, which resulted in the sale of nearly $10 billion in loans during 2007, primarily comprised of mortgage loans, student loans, and corporate loans. Average securities available for sale were $11.3 billion during 2007, a decrease of $13.1 billion, or 53.6%, compared to 2006. In the first quarter of 2007, approximately $16.0 billion of securities were reclassified into trading assets to enable more active trading of a significant portion of this portfolio and reduce the overall size of securities available for sale. The decrease in average securities available for sale more than offset the growth of $9.9 billion in interest earning trading assets and the $0.4 billion growth in loans, net of the aforementioned sales of loans.
Average consumer and commercial deposits increased $0.8 billion, or 0.9%, in 2007 compared to 2006. This included increases of $2.2 billion in higher cost certificates of deposit and $2.8 billion in NOW account balances. These were partially offset by decreases of $0.8 billion in savings, $1.8 billion in money market, and $1.6 billion in demand deposits. We continue to pursue deposit growth initiatives utilizing product promotions along with efforts to increase our presence in specific markets within our footprint.
The net interest margin increased 11 basis points from 3.00% in 2006 to 3.11% in 2007. The sale of lower yielding assets enabled a reduction in higher cost funding, thus improving the margin. The earning asset yield improved 29 basis points from 6.24% to 6.53% for 2007, while the cost of interest-bearing liabilities over the same period increased 17 basis points from 3.88% to 4.05%.
After exhibiting an upward trend during the first three quarters of 2007, the net interest margin declined from 3.18% during the third quarter of 2007 to 3.13% during the fourth quarter of 2007. Deposit pricing pressures along with declines in earning asset yields drove the decline, offset somewhat by the benefit of lower wholesale funding costs. We expect to continue to experience slight compression in the first quarter of 2008 as a result of the impact of the trading securities purchased during the fourth quarter of 2007 and then expect net interest margin to stabilize and possibly even expand during the remainder of 2008. Stabilizing or expanding margin will require some of the following to occur:
The net interest margin trends occurred in a market environment characterized by a continued flat to inverted yield curve. The Fed Funds target rate averaged 5.05% for 2007, an increase of 9 basis points compared to 2006. The Prime rate averaged 8.05% for 2007, an increase of 9 basis points compared to 2006. One-month LIBOR increased 12 basis points to 5.25%, three-month LIBOR increased 10 basis points to 5.30%, five-year swaps decreased 22 basis points to 5.01% and ten-year swaps decreased 9 basis points to 5.24% compared to prior year. This yield curve inversion negatively impacts us because rates on deposits, our most significant funding source, tend to track movements in three-month LIBOR while our loan yields tend to track movements in the five-year swap rate. Certain floating rate loans, floating rate liabilities, and derivative contracts contractually reset to the Prime rate as well as LIBOR. To the extent that these rates reset on a different frequency or a different rate relative to each other net interest income is affected. During the third and fourth quarter of 2007, one month LIBOR, three month LIBOR, and the Prime rate varied significantly versus each other.
Interest income that we were unable to recognize on nonperforming loans had a negative impact of four basis points on net interest margin in 2007 compared to one basis point of negative impact in 2006, as average nonaccrual loans increased $416.9 million, or 97.0% over 2006. Table 2 contains more detailed information concerning average loans, yields and rates paid.
Table 3 Noninterest Income
Noninterest income decreased by $39.7 million, or 1.1%, in 2007, compared to 2006. This decrease was driven by the negative impact of the turmoil in the capital markets that caused net mark to market valuation losses related to the purchase of certain securities and market value declines in the mortgage loan warehouse and securitization and trading assets. Positively impacting noninterest income in 2007 were increases in service charges on deposits, mortgage servicing related income, retail investment services, card fees, and other charges and fees. In addition, results for 2007 were impacted by the $234.8 million gain recognized on the sale of shares of The Coca-Cola Company, the $32.3 million gain recognized upon the merger of Lighthouse Partners, the $118.8 million gain on sale/leaseback of premises, and a $21.0 million increase in other income, primarily related to gains from the sale of private equity investments. In 2006 there was a $112.8 million gain, net of related expenses, on the sale of the Bond Trustee business, which positively impacted total noninterest income in 2006.
Trading account profits/(losses) and commissions declined $474.7 million due primarily to $527.7 million in negative mark to market valuations on collateralized debt obligations, MBS, SIV securities, and collateralized loan obligations, that occurred during the latter half of 2007. Contributing to these losses were negative mark to market valuation losses on securitization warehouses and trading activities. These losses were partially offset by market valuation gains of $164.4 million on changes in fair value of our public debt, including related hedges, higher profits from customer transactions in derivatives, structured leasing, merchant banking and equipment lease financing. See Trading Assets section in MD&A for further discussion. During 2006, trading related losses were primarily due to negative interest rate related marks on securitization residuals and economic hedges. Investment Banking income declined $15.7 million, or 6.8%, compared to 2006 due to lower securitization and syndicated finance activities.
Combined mortgage related income decreased $52.7 million, or 15.5%, compared to 2006. Mortgage production related income for 2007 was down $126.4 million, or 58.1%, compared to 2006. This decrease was primarily due to $165.4 million of net valuation losses in the second half of 2007 caused by spread widening related to mortgage loans held for sale, partially offset by the recognition of approximately $79 million of loan origination fees resulting from our election to record certain mortgage loans at fair value beginning in May 2007. Mortgage servicing related income increased $73.7 million, or 60.5%, compared to 2006. Mortgage servicing included gains on the sale of MSRs of $51.2 million during 2007 compared to $66.3 million in 2006 related to $219.0 million and $155.3 million of MSRs sold, respectively. This decrease mitigated the overall increase in mortgage servicing related income, which was principally due to higher fee income derived from a growing servicing portfolio. At December 31, 2007, total loans serviced for others was $114.6 billion compared with $91.5 billion at
December 31, 2006. An analysis of the fair value of our MSRs under varying interest rate environments suggests that falling mortgage interest rates coupled with increases in loan prepayments could cause impairment of this asset in the future.
Retail investment services increased $44.0 million, or 18.8%, compared to 2006. The increase was driven by higher annuity sales and higher recurring managed accounts fees. Service charges on deposit accounts increased $58.3 million, or 7.6%, during 2007 compared to 2006, due primarily to higher non sufficient fund fees.
Trust and investment management income decreased $1.9 million, or 0.3%, compared to 2006. The slight decline was primarily due to lost revenue from the Lighthouse Partners merger and sale of the Bond Trustee business, offset by growth in core revenue.
Card fees, which include fees from business credit cards and debit cards from consumers and businesses, increased $33.1 million, or 13.4%, from 2006. This increase was primarily due to higher interchange fees driven by higher transaction volumes.
Other charges and fees increased $17.0 million, or 3.7%, from 2006. The increase was due to higher operating lease income and insurance income. These increases were partially offset by decreases in loan fees and letter of credit fees.
Table 4 Noninterest Expense
Noninterest expense increased by $353.9 million, or 7.3%, during 2007 compared to 2006. Primary factors contributing to this increase included an increase in fraud losses, the Visa litigation expense recorded in the fourth quarter of 2007, an increase in total personnel expense related to our election to record certain mortgage loans held for sale at fair value during 2007 under SFAS No. 159, and other staff expense due to severance costs associated with E2.
Operating losses over and short increased $89.4 million, primarily due to mortgage application fraud losses we incurred in 2007 from customer misstatements of income and/or assets primarily on Alt-A products originated in prior periods. We also recorded a $76.9 million accrual for our proportionate share of certain Visa litigation. Despite recognizing this litigation cost, we expect that gains from Visas initial public offering, which is anticipated to occur during the first half of 2008 subject to market conditions, will be substantially greater than the litigation charges that we have recognized during 2007.
Total personnel expense increased $44.8 million, or 1.6%, due to our fair value election for certain mortgage loans held for sale during 2007 under SFAS No. 159. As a result of recording these loans at fair value, we recognized compensation expense related to origination activities that previously would have been deferred and recognized as part of gain/loss on the sale of these loans as a part of mortgage production income. The impact of this adoption for the full year 2007 was approximately $78 million. Offsetting this increase was a $30.7 million, or 6.5%, decrease in employee benefits due to reduced headcount. The number of employees decreased from 33,599 full-time equivalent positions at December 31, 2006 to 32,323 at December 31, 2007.
Other staff expense increased $40.0 million, or 43.2%, compared to 2006 due to the implementation of E2. In the first quarter of 2007, we initiated E2 in an effort to reduce overall expense growth as well as enhance how we conduct business with our customers. For the year ended December 31, 2007, we recognized approximately $45 million in severance expense related to this program, which was recorded in other staff expense. We anticipate the run-rate of total cost savings of approximately $530 million will be achieved during 2009 through initiatives identified in corporate real estate, supplier management, offshoring, and process/organizational reviews. Through 2007, we have realized approximately $215 million in run-rate cost savings. These estimated cost savings do not include the cost of incremental investments or the benefit of non-recurring gains associated with the E2 initiatives.
Marketing and customer development expense increased $21.8 million, or 12.6%, driven by our marketing campaigns focused on various deposit growth initiatives, including the My Cause marketing initiative. Outside processing and software increased $17.3 million, or 4.4%, compared to 2006, due to higher processing costs associated with higher transaction volumes and higher software amortization costs.
Other real estate expense increased $15.6 million compared to 2006 due to greater losses on loan-related properties as a result of deteriorating conditions in the housing market. Other expense increased $29.8 million, or 8.6%, compared to 2006 primarily due to write-downs related to Affordable Housing properties in 2007, offset by a $33.6 million reduction of the accrued liability and corresponding non-deductible other expense associated with a capital instrument we redeemed in the fourth quarter of 2007.
Provision for Income Taxes
The provision for income taxes includes both federal and state income taxes. In 2007, the provision was $615.5 million, compared to $869.0 million in 2006. The provision represents an effective tax rate of 27.4% for 2007 compared to 29.1% for 2006. The decrease in the effective tax rate was primarily attributable to the lower level of earnings and a higher level of tax-exempt income for the year ended 2007.
We adopted FIN 48, Accounting for Uncertainty in Income Taxes, an interpretation of SFAS No. 109 Accounting for Income Taxes, effective January 1, 2007. The cumulative effect adjustment recorded upon adoption resulted in an increase to unrecognized tax benefits of $55.0 million ($46.0 million on an after-tax basis), with offsetting adjustments to equity and goodwill. We classify interest and penalties related to our tax positions as a component of income tax expense. As of December 31, 2007, our cumulative unrecognized tax benefits amounted to $405.4 million ($316.2 million on an after-tax basis). Of this amount, $351.5 million ($277.5 million on an after-tax basis) would affect our effective tax rate, if recognized. The remaining $53.9 million ($38.7 million on an after-tax basis) is expected to impact goodwill, if recognized. After-tax interest expense related to unrecognized tax benefits was $18.0 million for the year ended December 31, 2007. Cumulative unrecognized tax benefits included interest of $80.0 million ($52.0 million on an after-tax basis) as of December 31, 2007. We continually evaluate the unrecognized tax benefits associated with our uncertain tax positions. It is reasonably possible that unrecognized tax benefits as of December 31, 2007 could decrease by an estimated $40.0 million ($26.0 million on an after-tax basis) by December 31, 2008, as a result of the expiration of statutes of limitations and potential settlements with federal and state taxing authorities. It is also reasonably possible that this decrease could be substantially offset by new matters arising during the same period. We file consolidated and separate income tax returns in the United States Federal jurisdiction and in various state jurisdictions. Our Federal returns through 1998 have been examined by the Internal Revenue Services (IRS) and issues for tax years 1997 and 1998 are still in dispute. We have paid the amounts assessed by the IRS in full and have filed refund claims with the IRS related to the disputed issues. Our 1999 through 2004 Federal income tax returns are currently under examination by the IRS. Generally, the state jurisdictions in which we file income tax returns are subject to examination for a period from three to seven years after returns are filed. The Corporations current estimate of the resolution of these various examinations is reflected in accrued income taxes; however, final settlement of the examinations or changes in the Corporations estimate may result in future income tax expense or benefit. In the opinion of management,
any future adjustments which may result from these examinations should not have a material effect on the Companys Consolidated Financial Statements.
Table 5 Loan Portfolio by Types of Loans
Table 6 Funded Exposures by Selected Industries1
Our portfolio is well diversified by product, client and geography throughout our footprint. We have relatively low exposure to credit card and other unsecured consumer loan products.
The commercial portfolio grew $1.3 billion, or 3.8%, in 2007 to $35.9 billion, or 29% of total loans, at December 31, 2007. The commercial real estate portfolio was $12.6 billion, or 10% of total loans, and the construction portfolio was $13.8 billion, or 11% of total loans, at December 31, 2007. The construction portfolio consists of $3.6 billion of residential construction to perm loans, $2.7 billion of residential construction loans, $3.3 billion of commercial construction loans, $2.9 billion of acquisition & development loans, and $1.3 billion of raw land loans. Commercial related construction loans continue to perform well. Performance of residential construction related loans has deteriorated; however, we have been
proactive in our credit monitoring and management processes to provide early warning alerts for problem loans in the portfolio. For example, we use an expanded liquidity and contingency analysis to provide a thorough view of borrower capacity and their ability to service obligations in a steep market decline. We have strict limits and have exposure caps on specific projects and borrowers for risk diversification.
Residential mortgages were $32.8 billion, or 27%, of the total loan portfolio as of December 31, 2007. Residential mortgages are comprised of core mortgages (prime first liens), prime second lien mortgages, home equity loans, lot loans, and Alt-A first and second mortgages. The core mortgage portfolio was $21.8 billion, or 18%, of the total loan portfolio as of December 31, 2007. There are minimal option adjustable rate mortgages (ARMs) or negative amortizing loans and virtually no subprime loans in the core portfolio. The core mortgage loans are roughly half prime jumbo and half prime ARMs. Some of the ARMs in the core first mortgage portfolio are interest-only ARMs; however, the interest-only period is typically ten years, unlike many interest-only products in the market which have short interest-only periods with early reset dates. The weighted average combined loan to value (LTV) at origination of the core portfolio was 76% and they have a current weighted average FICO score of 733. Prime second mortgages were $3.9 billion, or 3%, of total loans as of December 31, 2007 and are comprised of insured purchase money second liens or combo loans with a current weighted average FICO of 721. Home equity loans comprise $3.6 billion, or 3%, of the total loan portfolio as of December 31, 2007 and have a current weighted average FICO score of 722 and a 73% weighted average combined LTV at origination. 40% of the home equity loans are in a first lien position. Lot loans were $1.7 billion, or approximately 1% of total loans, as of December 31, 2007 and have a current weighted average FICO score of 729. Alt-A loans were $1.7 billion, or approximately 1% of total loans, as of December 31, 2007. Of the Alt-A loans, $1.2 billion are first liens and well secured with a weighted average combined LTV of 77% at origination and a weighted average FICO score of 702. The remaining $0.5 billion of Alt-A loans are second lien loans with a weighted average combined LTV of 97% at origination and a current weighted average FICO score of 691.
The home equity line portfolio was $14.9 billion, or 12%, of the total loan portfolio as of December 31, 2007, and had a current weighted average FICO score of 723. Approximately 25% of the portfolio was in a first lien position, and 77% of the portfolio had a weighted average combined LTV of 90% or less at origination.
The indirect consumer portfolio was $7.5 billion, or 6% of total loans, at December 31, 2007. This portfolio primarily consists of automobile loans generated through dealerships, has a current weighted average FICO of 701 and continues to perform well.
Table 7 Allowance for Loan and Lease Losses
Allowance for Loan and Lease Losses
We continuously monitor the quality of our loan portfolio and maintain an allowance for loan and lease losses (ALLL) sufficient to absorb probable losses inherent in our loan portfolio. We are committed to the timely recognition of problem loans and maintaining an appropriate and adequate ALLL. At year-end 2007, the ALLL was $1,282.5 million, which
represented 1.05% of period-end loans. This compares with an ALLL of $1,044.5 million, or 0.86% of loans as of December 31, 2006.
In addition to the review of credit quality through ongoing credit review processes, we employ a variety of modeling and estimation tools for measuring credit risk that are used to construct an appropriate ALLL. Our ALLL framework has three basic elements: specific allowances for loans individually evaluated for impairment, a formula-based component for pools of homogeneous loans not individually evaluated, and an unallocated component that is based on other inherent risk factors and imprecision associated with the modeling and estimation processes. This framework enables us to align loss estimation practices with the different types of credit risk inherent in the loan portfolio.
The first element of the ALLL analysis involves the estimation of allowances specific to individual impaired loans. In this process, specific allowances are established for nonaccruing loans greater than $2 million based on analysis of the most probable sources of repayment, including discounted future cash flows, liquidation of collateral, or the market value of the loan itself. As of December 31, 2007 and 2006, the specific allowance related to impaired loans totaled $17.5 million and $17.4 million, respectively.
The second element of the ALLL, the general allowance for homogeneous loan pools not individually evaluated, is determined by applying allowance factors to pools of loans within the portfolio that have similar risk characteristics. The general allowance factors are determined using a baseline factor that is developed from an analysis of historical charge-off experience and expected losses. Expected losses are based on estimated probabilities of default and loss given default derived from an internal risk rating process. These baseline factors are developed and applied to the various loan pools. Adjustments may be made to baseline reserves for some of the loan pools based on an assessment of internal and external influences on credit quality not fully reflected in the historical loss or risk-rating data. These influences may include elements such as changes in credit underwriting, concentration risk and/or recent observable asset quality trends. We continually evaluate our ALLL methodology seeking to refine and enhance this process as appropriate, and it is likely that the methodology will continue to evolve over time. As of December 31, 2007 and 2006, the general allowance calculations totaled $1,180.0 million and $937.1 million, respectively. The increase was primarily due to deterioration in credit quality of the residential mortgage and home equity portfolios. The increases to reserves associated with these were partially offset by lower ALLL factors associated with the commercial and commercial real estate portfolios.
The third element of the ALLL is the unallocated reserve that addresses inherent losses not included elsewhere in the ALLL. Qualitative factors of this third allowance element are subjective and require a high degree of management judgment. These factors include the inherent imprecision in models and lagging or incomplete data. As of December 31, 2007 and 2006, the ALLL estimated with respect to the third element totaled $85.0 million and $90.0 million, respectively.
Our charge-off policy meets or exceeds regulatory minimums. Losses on unsecured consumer loans are recognized at 90 days past-due compared to the regulatory loss criteria of 120 days. Secured consumer loans, including residential real estate, are typically charged-off between 120 and 180 days, depending on the collateral type, in compliance with FFIEC guidelines. Commercial loans and real estate loans are typically placed on non-accrual when principal or interest is past-due for 90 days or more unless the loan is both secured by collateral having realizable value sufficient to discharge the debt in-full and the loan is in the legal process of collection. Accordingly, secured loans may be charged-down to the estimated value of the collateral with previously accrued unpaid interest reversed. Subsequent charge-offs may be required as a result of changes in the market value of collateral or other repayment prospects.
The ratio of the ALLL to total nonperforming loans decreased to 87.8% as of December 31, 2007 from 196.4% as of December 31, 2006. The decline in this ratio was due to a $928.5 million increase in nonperforming loans driven primarily by a $697.6 million increase in residential mortgage nonperforming loans. The increase in residential mortgage nonperforming loans was driven primarily by deteriorating economic conditions including increased mortgage delinquency rates and declining home values in most markets that we serve along with maturation of the portfolio.
In addition to reserves held in the ALLL, we had $7.9 million and $2.5 million in other liabilities as of December 31, 2007 and 2006, respectively, that represents a reserve against certain unfunded commitments, including letters of credit.
Table 8 Summary of Loan and Lease Losses Experience
Provision for Loan Losses
The provision for loan losses is the result of a detailed analysis estimating an appropriate and adequate ALLL. The analysis includes the evaluation of impaired loans as prescribed under SFAS No. 114 Accounting by Creditors for Impairment of a Loan, and SFAS No. 118 Accounting by Creditors for Impairment of a Loan Income Recognition and Disclosures, and pooled loans and leases as prescribed under SFAS No. 5, Accounting for Contingencies. For the year ended December 31, 2007, the provision for loan losses was $664.9 million, an increase of $402.4 million, or 153%, from the year ended December 31, 2006.
The provision for loan losses was $242.1 million more than net charge-offs of $422.8 million during 2007, reflecting the downturn in the residential real estate markets and deteriorating credit conditions of the residential-mortgage and home equity portfolios.
Net charge-offs for the year ended December 31, 2007 increased $176.7 million from the $246.1 million of net charge-offs recorded in the prior year. The increase in net charge-offs was largely due to higher net charge-offs in the residential mortgage and home equity portfolios. A downturn in residential real estate prices has negatively affected the entire industry. Despite our avoidance of the subprime consumer real estate lending markets in our loan portfolio, the lower residential real estate valuations have affected even borrowers of higher credit quality.
Table 9 Nonperforming Assets and Accruing Loans Past Due 90 Days or More
Nonperforming assets, which consist of nonaccrual loans, restructured loans, other real estate owned (OREO) and other repossessed assets totaled $1,655.5 million as of December 31, 2007, an increase of $1,061.7 million, or 179%, compared to December 31, 2006.
Nonaccrual loans totaled $1,430.4 million as of December 31, 2007, an increase of $926.6 million, or 184%, compared to December 31, 2006. The increase was primarily driven by residential mortgage loans, which increased by $697.6 million.
Nonaccrual real estate construction loans increased $256.7 million from December 31, 2006 to $295.3 million as of December 31, 2007. The increase was largely driven by residential-related construction across the footprint.
Nonaccrual home equity lines of credit (HELOC) are classified in residential mortgages and were $135.8 million at December 31, 2007 compared with $36.6 million at December 31, 2006. The increase was driven by HELOCs originated through third-party channels, which accounted for 35% of nonperforming lines (excluding third party channels). There are no HELOCs in the portfolio that were originated as sub prime. The average combined original LTV of the total HELOC portfolio is approximately 74% and nearly 25% of the portfolio is in the first lien position. Approximately 23% of the portfolio has combined LTVs greater than 90%, and the remainder of the portfolio has combined LTVs primarily in the 60%-85% range.
When a loan is placed on nonaccrual, unpaid interest is reversed against interest income. If interest payments are being made by borrowers on nonaccrual loans, the interest is either recorded using the cash basis method of accounting or recognized at the end of the loan after the principal has been reduced to zero, depending on the type of loan. If and when a nonaccrual loan is returned to accruing status, the accrued interest at the date the loan is placed on nonaccrual status, and foregone interest
during the nonaccrual period, are recorded as interest income only after all principal has been collected for commercial loans. For consumer loans and residential mortgage loans, the accrued interest at the date the loan is placed on nonaccrual status, and foregone interest during the nonaccrual period, are recorded as interest income as of the date the loan no longer meets the 90 and 120 days past due criteria, respectively.
During 2007 and 2006 cash basis, interest income for nonaccrual loans amounted to $17.3 million and $16.6 million, respectively. For the years ended December 31, 2007 and 2006, estimated interest income of $85.0 million and $41.6 million, respectively, would have been recorded if all such loans had been accruing interest according to their original contractual terms.
Accruing loans past due ninety days or more increased $259.5 million from $351.5 million as of December 31, 2006 to $611.0 million as of December 31, 2007. The increase was primarily driven by deterioration in residential mortgages and home equity lines of credit.
Nonperforming residential real estate loans are collateralized by one-to-four family properties, and a portion of the loans risk may be mitigated by mortgage insurance. We apply rigorous loss mitigation processes to these nonperforming loans to ensure that the asset value is preserved to the greatest extent possible. Since early 2006, we have tightened the underwriting standards applicable to many of the residential loan products offered. The total Alt-A portfolio loans, which consist of loans with lower documentation standards, were approximately $1.7 billion as of December 31, 2007, representing less than 1.5% of our total loan portfolio and slightly more than 5% of our residential mortgage portfolio. Approximately $314 million of this portfolio was nonperforming at December 31, 2007. At December 31, 2007, the Alt-A portfolio was comprised of approximately 70% of loans secured by mortgages in first lien positions and 30% in second lien positions. The weighted average combined LTV of the first lien positions was 77% and the weighted average original FICO score was 702. For the second lien positions, the weighted average combined LTV was 97% and the weighted average original FICO score was 691.
We extensively utilized third-party insurance on the second lien Alt-A portfolio. It became apparent in the fourth quarter of 2007 that we would eventually reach the insurance stop loss at some point during 2008. As such, we reached a settlement agreement with our insurer to expedite the claim and review process. The ALLL estimation process in the fourth quarter took into consideration the insurance settlement when estimating the ALLL .
We discontinued originating first lien Alt-A portfolio loans in June 2006 and until mid-2007 originated a small amount of Alt-A loans for placement in the secondary market with more restrictive credit guidelines. We have now eliminated Alt-A production entirely.
OREO was $183.7 million, which represented an increase of $128.3 million, or 232%, compared to December 31, 2006. The increase was primarily due to nonperforming residential mortgage loans that have entered into the foreclosure process.
Table 10 Trading Assets