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Fifth Third Bancorp
annual report 2005
focused.
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Fifth Third Bancorp is a diversified financial services company headquartered in Cincinnati, Ohio. The Company has $105.2 billion in assets and operates 19 affiliates with 1,119 full-service banking centers, including 119 BankMart® locations open seven days a week inside select grocery stores, and 2,024 Jeanie® ATMs in Ohio, Kentucky, Indiana, Michigan, Illinois, Florida, Tennessee, West Virginia, Pennsylvania and Missouri. The financial Rapids strength of Fifth Third’s Ohio and Michigan banks continues to be recognized by rating agencies with Detroit Cleveland deposit ratings of AA- and Aa1 from Standard & Poor’s and Moody’s, respectively. Additionally, Fifth Third Bancorp continues to maintain among the highest short-term ratings available at A-1+ and Prime-1 and is recognized by Moody’s with a senior debt rating of Aa2. Fifth Third operates four main businesses: Retail, Commercial, Investment Advisors and Fifth Third Processing Solutions. Fifth Third is among the largest money managers in the Midwest and, as of December 31, 2005, has $196 billion in assets under care – of which it manages $33 billion for individuals, corporations and not-for-profit organizations. Investor information and press releases can be viewed at www.53.com.Fifth Third’s common stock is traded through the NASDAQ® National Market Systemunder the Orlando symbol “FITB.”
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financial highlights
For the years ended December 31 2005 2004 Percent Change
$ in millions, except per share data
Earnings and Dividends
Net Income $1,549 $1,525 2
Common Dividends Declared 810 735 10
Per Share Earnings $2.79 $2.72 3
Diluted Earnings 2.77 2.68 3
Cash Dividends 1.46 1.31 11
Book Value 17.00 16.00 6
At Year-End
Assets $105,225 $94,456 11
Total Loans and Leases 71,229 60,367 18
Deposits 67,434 58,226 16
Shareholders’ Equity 9,446 8,924 6
Year-End Market Price 37.72 47.30 (20)
Market Capitalization 20,958 26,377 (21)
Key Ratios (percent)
Return on Average Assets (ROA) 1.50 1.61 (7)
Return on Average Equity (ROE) 16.6 17.2 (3)
Net Interest Margin 3.23 3.48 (7)
Efficiency Ratio 53.2 53.9 (1)
Average Shareholders’ Equity to Average Assets 9.06 9.34 (3)
Actuals
Common Shares Outstanding (in thousands) 555,623 557,649 —
Banking Centers 1,119 1,011 11
Full-Time Equivalent Employees 21,681 19,659 10
Deposit and Debt Ratings Moody’s Standard & Poor’s Fitch
Fifth Third Bancorp
Commercial Paper Prime -1 A-1 F1+
Senior Debt Aa2 A+ AA-
Fifth Third Bank and Fifth Third Bank (Michigan)
Short-Term Deposit Prime -1 A-1+ F1+
Long-Term Deposit Aa1 AA- AA
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letter from the President & Chief Executive Officer
focused on
value creation.
Dear Shareholders and Friends,
2005 proved to be a challenging year for Fifth Third, with both revenue and net income significantly below our initial expectations. Earnings per diluted share for the full-year were $2.77, an increase of three percent over last year’s earnings of $2.68. Total revenues were flat compared to the prior year and totaled $5.5 billion.
Return on average assets for the full-year 2005 was 1.50 percent and return on average equity was 16.6 percent, compared to 1.61 percent and 17.2 percent, respectively, in 2004. Despite these relatively modest results, your company still earned more than $1.5 billion in net income and added significantly to our customer base.
Throughout its history, the story of Fifth Third has been one of growth and value creation that was perhaps
unrivaled in the banking industry. In fact, Fifth Third is more than five times larger than it was when I sat down
to compose this letter just 10 years ago. During that time, deposits, loans, assets and, most importantly, net income have all increased more than five-fold. Unfortunately, we have learned that challenges can also increase with size and even the most highly regarded
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“We have learned that challenges can also increase with size and even the most highly regarded of companies and strongest of cultures are not immune to difficulties.”
companies and strongest cultures are not immune to difficulties. Our performance over the last two years has not matched our historical success. And while disappointing and below our potential, I believe these results are best understood within the context of the many things we accomplished this year to improve our competitive position and drive revenue and earnings growth in the years to come – progress that will ultimately be reflected in our performance. After reviewing both our business performance and key priorities as detailed in this letter and the pages that follow, I hope you will agree that Fifth Third is making significant progress and taking the right steps to regain
traction and enhance shareholder value over the long run.
2005 Business Performance
Loan growth remained strong in 2005, with period end total loans and leases increasing by $10.9 billion, or 18 percent, over 2004. Commercial customer additions and steadily improving loan demand throughout the year resulted in a 22 percent increase in commercial loan outstandings. Similar success was achieved through the hard work of our retail employees, with consumer loans increasing by 13 percent over the prior year.
Retail transaction account growth and commercial customer additions resulted in good deposit growth trends in 2005, despite a sluggish start to the year. On a full-year average basis, total transaction deposits increased by $4.8 billion, or 11 percent, and total core deposits increased by $7.0 billion, or 14 percent, over 2004.
Noninterest revenues experienced mixed results in 2005, with strong performance from Fifth Third Processing Solutions and our commercial line of
business mitigated by more modest results in other areas. In total, noninterest revenues increased by a healthy 10 percent over the prior year, excluding operating lease revenue, gains and losses on the sales of securities and a gain realized on the sales of certain third-party sourced merchant processing contracts in 2004.
Despite good loan and deposit trends, spread-based revenues proved to be our greatest challenge in 2005 and remained essentially unchanged from prior year levels. Increased funding costs resulting from the convergence of short- and long-term interest rates and sharp declines in returns realized from our securities portfolio resulted in 25 basis points of contraction in our net interest margin. This compression offset growth generated from core banking activities and resulted in flat overall revenue performance for the year.
Operating expenses decreased by two percent compared to 2004 but increased by 11 percent when debt termination charges in the prior year are excluded. This increase was largely due to sales force and banking center additions and investments in information technology. While the investments associated with this increase in spending resulted in negative operating leverage in 2005, we believe that these improvements in
distribution and infrastructure are essential to the future success of Fifth Third.
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Our Priorities
Investing For Growth
With the profit margins available in our business,
success has always been a function of the ability to
generate revenue growth. However, the temptation to
curtail investments and slash costs is extremely high
during difficult times. The benefits of these strategies
are generally short term in nature and the impact can
extend well into the future. Success in any business is
defined as consistently delivering above average returns
that compound over time. History has shown that a
company cannot shrink its way to meeting that standard.
During 2005, Fifth Third:
• Invested in distribution. We added 63 de-novo
banking centers and relocated other existing
facilities across the footprint to drive deposit and
loan growth in the years to come. These additions
complement the 76 new banking centers added in
2004 and together will be an integral growth driver
as we continue to attract customers and increase
productivity. We acquired and integrated First
National Bankshares of Florida, creating three
affiliates in some of the fastest growing deposit
markets in the country. Continuing de-novo
investments will result in powerful distribution
networks in the Orlando, Tampa and Southwest
Florida metropolitan markets.
• Invested in people. We increased our sales force by
nearly 1,400 positions in 2005. We still have work
to do in reaching productivity goals for many of
these additions, but I remain confident that a
strong culture of sales measurement, accountability
and performance-based rewards will drive future
revenue growth.
• Invested in customer service. The manner and
efficiency in which we support and interact with
our customers is critical to Fifth Third’s success.
In order to improve our service, we began
extensive customer polling efforts to identify
successes as well as opportunities for
improvement. Based on feedback from our
customers, we realigned employee incentives,
adjusted fee policies and expanded our product
set. More opportunities exist to enhance customer
service levels and improve retention, and
we are committed to delivering best-in-class
customer service.
• Invested in technology. With the expertise that
comes from the successful handling of more than
16.4 billion electronic transactions in 2005,
we are dedicated to providing a proven sales
culture with the absolute best tools available to
serve and grow our customer base. Initiatives
included new relationship management systems,
fully automated and integrated teller platforms,
new call center management systems and
improved processing capabilities with enhanced
capacity, reliability and scale.
“Success in any business is defined as consistently delivering above average returns that compound over time. History has shown that a company cannot shrink its way to meeting that standard.”
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“Our primary responsibility
is to invest shareholders’ capital
in a manner that enhances value while ensuring
that our businesses are being properly
compensated for the level of risk being assumed.”
Maintaining Financial Discipline
Financial discipline is the foundation of great companies, and great companies consistently deliver superior risk-adjusted returns relative to the competition. Fifth Third is determined to once again be one of those companies. Our primary responsibility is to invest shareholders’ capital in a manner that enhances value while ensuring that our businesses are being properly compensated for the level of risk being assumed. We will continue to improve our ability to measure and manage risk in all its various forms – credit, interest rate, operational liquidity and general business – in order to reduce volatility and react more quickly to changing business and economic climates.
In business, just as in personal finance, investment climates are not all created equal. Fifth Third will take a long-term view and will forego short-term profits if they are accompanied by the potential for excess risk and volatility. During 2005, Fifth Third:
• Responded to relatively low long-term interest rates and a poor climate for acquisitions by returning excess capital to shareholders. We increased the dividend by 11 percent to $1.46 per common share and repurchased 38 million shares, six percent of total outstanding, for $1.6 billion.
• Responded to the relatively inferior return inherent in continuing to invest in bond securities by foregoing current period earnings through a $5.6 billion, or 18 percent, reduction in average securities held on the balance sheet.
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Fostering a Team-Driven Culture
I have always believed, regardless of starting position, the bank with the best people will gain leading market share over time. Everything we do at Fifth Third is focused on identifying and rewarding top performers with the opportunity to drive results through our unique affiliate operating model. In recent years, as we have many times in the past, we experienced some change at both the affiliate and senior management levels. We thank these leaders for their efforts and honor their contributions by recommitting to the challenge of revenue growth and matching the work ethic for which this company has
long been known. In each of our affiliates, we have experienced leaders working as a team to serve all of the customers in their market. Whether, like me, these leaders have been with Fifth Third for a very long time or have brought to our company many years of banking experience gained elsewhere, we all share a team orientation, a sales focus and a desire to serve our customers and shareholders. We remain committed to the challenge of driving revenue growth and capitalizing on the opportunities that lie ahead.
Supporting Our Communities
Fifth Third has always operated under the premise that helping to build stronger communities will result in a
stronger and more dynamic bank. Lending to build and revitalize neighborhoods, philanthropic giving and active community involvement are long-standing traditions at Fifth Third. I invite you to read about our most recent
efforts on page 20 of this report.
“We remain committed to the challenge of driving revenue growth and capitalizing on the opportunities that lie ahead.”
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“We have asked a great deal of our employees in 2005, and they have delivered. However, many challenges remain, and we still have a lot of work remaining to complete our shared vision of what Fifth Third can become.”
In Closing
Fifth Third has truly been transformed in the last couple of years, but perhaps not in the manner you would expect. The growth trajectories of the key drivers in our business – deposits, fees and loans – remain intact, with annualized growth rates consistent with Fifth Third’s standards and historical performance. Change can be seen, however, in improvements in our commitment to customer service, use of technology, corporate governance and capital and risk management. Perhaps more so than at any time in our history, Fifth Third today has the infrastructure necessary to aggressively
compete in a consolidating financial services landscape while maintaining the local market differentiation provided by our affiliate bank model. In the years to come, you can expect to see Fifth Third continuing to increase our presence in high opportunity markets while remaining mindful of opportunities to establish affiliates in new metropolitan markets.
I would like to thank our customers, employees, board members and the communities in our 19 affiliates for their contributions and continued support. We have asked a great deal of our employees in 2005, and they have delivered. However, many challenges remain, and we still have a lot of work remaining to complete our shared vision of what Fifth Third can become. The focus for 2006 will be on continuing to generate quality deposit and loan growth, enhancing all of our businesses and gaining market share by meeting more of the financial services needs of our customers. Our
existing competitive and financial strengths, combined with superior talent and an enhanced infrastructure and focus, make me extremely optimistic about the years to come.
Sincerely,
George A. Schaefer, Jr.
President & Chief Executive Officer
January 2006
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sticking to a successful business model
focused on commitment.
Our affiliate operating structure differentiates us from the competition and ensures that our customers receive individualized service and comprehensive financial solutions. All aspects of customer relationships are managed locally by affiliate presidents responsible for each affiliate’s
operation and community development. Competitive pressures are different in every market, so we rely on experienced local officers empowered
with the authority and infrastructure to employ the best practices of our company to deliver a personalized level of service to our customers.
FITB Affiliate State Deposits (billions) Percent of FITB Assets (billions) Banking Centers Affiliate President Years in Banking Cincinnati OH $12.3 18% $17.4 106 R. Sullivan
30 Chicago IL 8.9 13 10.1 140 T. Zink 17 Western Michigan MI 7.3 11 9.6 135 M. Van Dyke 20 Detroit MI 4.4 7 7.1 83 G. Kosch 22 Columbus OH 3.7 5 5.1 65 R. Eversole 21 Cleveland OH 3.7 5 5.7 86 T. Clossin 22 South Florida FL 3.6 5 6.8 45 T. Quinn 13 Dayton OH 3.3 5 3.8 62 R. Webb 19 Indianapolis IN 3.3 5 5.4 81 M. Spagnoletti 31 Toledo OH 3.2 5 4.6 50 R. LaClair 23 Southern Indiana IN 2.4 4 3.4 52 J. Daniel 36 Louisville KY 1.8 3 2.2 46 P. McHugh 19 Northern Michigan MI 1.4 2 2.1 25 J. Pelizzari 27 Northern Kentucky KY 1.3 2 1.7 34 T. Rawe 31 Nashville TN 1.1 2 2.1 20 D. Hogan 21 Lexington KY 1.1 2 1.8 21 S. Barnes 34 Ohio Valley WV 0.9 1 1.6 27 D. Call 18 Tampa Bay FL 0.9 1 1.4 26 B. Keenan 19 Orlando FL 0.7 1 1.3 15 G. Howlett 30
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Fifth Third believes in the affiliate model. In a
relationship business, this model keeps motivated
decision makers close to the customer. It creates
the ability to respond with market-specific strategies and
flexible pricing to go after entrenched large
market share competitors and the less efficient smaller
institutions. It is based on the individual talent and
entrepreneurship of our employees. It inspires new
ideas from the bottom up because all of our affiliates,
business lines and banking centers are managed to
detailed financial statements. It fosters a culture of
business ownership. It rewards talented individuals for
making the right decisions for customers, communities
and shareholders. It encourages our employees to
work together across business lines to develop
complete financial solutions for our customers.
Our affiliate model is characterized by a local presence
with market knowledge, management accountability
and a team approach. We believe it is the key to our
past and future success, and we are committed to it.
Establishing a presence in new metropolitan markets is an important part of our continuing growth. In 2005, new affiliates were established in Tampa and Orlando, and our presence was greatly enhanced in
Fifth Third operates 19 affiliates with 1,119 banking centers and 2,024 Jeanie® ATMs in 10 states and now has three affiliates with $5.2 billion in deposits and $9.5 billion in assets in the state of Florida.
our existing South Florida affiliate with the January acquisition of First National Bankshares of Florida. Fifth Third now has three affiliates, $5.2 billion in deposits and $9.5 billion in assets in the state of Florida. Efforts are underway to continue to expand our presence in these markets with the planned addition of 22 new banking centers in 2006. In addition, the seeds for two new affiliates were planted in 2005, with the opening of two banking centers in St. Louis and three banking centers in Pittsburgh.
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long-term vision of people and technology
focused on expertise.
Fifth Third has been highly successful over the
years in gaining new customers. High-performing
employees, a
performance-based sales culture,
a strong balance sheet and nimble operating model
have afforded Fifth Third numerous advantages
in a highly competitive industry. Beginning in
2004 and continuing in earnest through 2005,
Fifth Third endeavored to add another advantage
over peers – a superior “Service First” mentality
enabled by increasingly streamlined processes
and technological innovation.
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Improving the way we support and grow our customer
base is critical to continuing Fifth Third’s growth.
In order to succeed, we must improve information
flow to create a better understanding of our customers,
the products they have, the products they should have
and the opportunities to serve them better. In 2005,
we made an investment in an improved customer
relationship management solution that creates a single
customer view across our key operating platforms.
This solution crosses business lines and affiliates with
a seamless integration of a common set of sales and
management information. The simplified and faster
information flow will increase reaction time for sales
opportunities and allow for management decisions that
consider all aspects of a customer relationship.
We are committed to improving the experience our
customers have when they enter a banking center.
Recent improvements in the automation and
standardization of account opening procedures,
with predetermined touch and follow-up points, will
greatly reduce new account attrition. Our new
teller automation platform is a significant step toward
improving customer service and supplying employees
with the tools they need to deliver a great customer
experience. By eliminating the manual processes and
paper forms that create inefficiency, we are reducing
the workload to execute a single transaction and
allowing our front line employees to focus more time
where it belongs – with the customer.
Our operations group is taking major steps to ensure a
“Service First” mentality within our central call center.
Customer service personnel currently handle
approximately 50 million calls annually. Fifth Third
strives to show our customers that we value every
single one of those experiences. Strategic changes are
being implemented in how we manage, recognize and
reward representatives, with emphasis migrating from
volume to resolution. We also are in the midst of
We are committed to improving the experience our customers have when they enter a banking center.
implementing a new system to track the effective
resolution of customer service issues, allowing for
faster identification and improvement of processes.
Fifth Third is implementing an improved customer
service model through a long-term investment in
technology and efficiency that will provide a
competitive advantage for years to come. These
efforts represent a tremendous challenge, but one
in which Fifth Third has laser-like focus. Recent
increases in equipment and depreciation expenses
illustrate these investments are not without cost.
However, Fifth Third expects information technology
expenses to begin to show trend improvement in 2006,
and benefits will be realized through improvement in
customer service and ongoing growth in both our
customer base and in products delivered.
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retail banking
focused on service.
Fifth Third’s 1,119 banking centers, including
119 Bank Mart® locations open seven days a
week inside select grocery stores, and 2,024
Jeanie® ATM’s serve as the primary point of
contact for our six million customers. Fifth
Third’s internet banking and bill payment
system provides an additional point of access
for customers to manage their money quickly
and conveniently – 24 hours a day, seven days
a week. Through these channels, Fifth Third
strives to provide industry leading products,
convenience and customer service to the
individual and small business customers within
our geographic footprint.
Bancorp Average Transaction Deposits
$ billions
2000 2001 2002 2003 2004 2005
$22.5 $26.4 $35.8 $40.4 $43.2 $47.9
10 15 20 25 30 35 40
Average Consumer Loans & Leases
$ billions
2000 2001 2002 2003 2004 2005
$21.4 $22.1 $22.4 $26.3 $27.6 $31.6
10 15 20 25 30 35 40 45
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With increased database marketing and new deposit and cash management products, small business deposits increased by 19 percent in 2005.
Fifth Third is focused on continuing to drive core
deposit growth within the retail franchise, with the
goal of core funding total earning asset growth. To
accomplish this goal, we introduced an “everyday great
rate” approach on transaction accounts and time
deposits, improved customer and account
segmentation and put new tools in the hands of our
retail sales force. Our banking center employees
responded in 2005. Average transaction account
balances increased by 11 percent in 2005, highlighted
by 33 percent growth in average savings and money
market balances and eight percent growth in average
consumer demand deposits. Average core deposits
overall increased by 14 percent over the prior year.
Consumer loan generation also remained strong in
2005 with period end balances increasing by
$3.8 billion, or 13 percent, over 2004.
In 2005, our long-standing dedication to sales
performance and tracking individual results was
complemented by increased emphasis on customer
service and retention. Today, we interview customers
about their experiences in our banking centers so we
can evaluate the service we deliver in every affiliate,
region and banking center. For the first time, incentive
compensation programs across the Bancorp
incorporate customer satisfaction results to ensure that
we are providing best-in-class customer service. Our
initial efforts are meeting with success, with total retail
account openings increasing by 13 percent and
attrition rates improving by 20 percent on a full-year
basis in 2005. Despite this success, we are continuing
to develop a number of additional initiatives to
improve the overall customer experience.
Small business banking received special focus in 2005.
Fifth Third believes that competition in the small
business segment is primarily service related.
We deploy individual relationship managers to work
with small business customers and learn about their
businesses. That knowledge allows us to deliver
customized solutions through integrated web-based
platforms that offer big company functionality at
small business prices. With increased database
marketing and new bundled deposit and cash
management products, small business deposits
increased by 19 percent in 2005 and now total
$5.1 billion. Investments in streamlined underwriting
capabilities drove similar performance in small
business lending with 19 percent growth over the
prior year.
We will continue recent de-novo banking center
expansion activities with the planned addition of
approximately 50 net new offices in 2006.
Investments in this area continue to be primarily
concentrated in the Chicago, Florida, Detroit and
Nashville markets, but expansion efforts also will
continue in Pittsburgh and St. Louis.
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commercial banking
focused
on relationships.
Fifth Third’s commercial relationship officers are respected for their commitment to understanding the challenges and opportunities facing each of our commercial customers. Our relationship officers provide creative and insightful perspectives that come from our almost 150 years of commercial banking experience. Decisions are made locally by people familiar with our business partners and the communities in which they operate. Fifth Third’s commercial team has the experience to advise our customers, the financial resources to support their growth and the willingness, infrastructure and ability to provide customized financial solutions.
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Fifth Third’s team of commercial bankers is committed to a single goal – building solid relationships with our business partners by quickly and efficiently matching products and services to their needs. Fifth Third offers a comprehensive product set from traditional commercial and industrial lending, to real estate and leasing, to corporate and international finance, trade facilitation and payment solutions. Our extensive cash management expertise spans across industries and international borders. Fifth Third offers dedicated teams and strategic partnerships ready to assist companies in improving cash flow and growing their business.
Sales force additions and increasing productivity drove significant market share gains across our footprint in 2005. The resulting customer growth and sales of corporate treasury management products resulted in 14 percent growth in average commercial demand deposits and 23 percent average commercial loan and lease growth. Related deposit service revenues were essentially unchanged from 2004 levels, fully overcoming the negative impact on deposit revenues from increasing earnings credit rates on compensating balances.
The depth and breadth of Fifth Third’s commercial relationships can be seen in commercial noninterest income performance in 2005. Commercial banking revenue increased 22 percent over 2004 with widespread strength across numerous subcategories. Foreign exchange revenues increased by 16 percent, and international letter of credit revenues increased by 15 percent, driving 15 percent growth in international related revenues overall. New customer additions and increasing loan demand throughout the year contributed to 49 percent growth in commercial loan- and lease-related fees. Separately, corporate finance also delivered very strong growth with a 142 percent increase in customer interest rate derivative sales revenue.
Fifth Third has always recognized the importance of maintaining conservative underwriting and a strong credit culture. Profitable growth is achieved by attracting new customers, not simply by increasing exposure to existing customers. The result is a diverse and granular commercial loan portfolio with industry concentrations and exposure limits closely monitored. At year end 2005, over 89 percent of commercial loan and lease obligations were less than $5 million and 88 percent of exposures were originated in footprint.
As we begin a new year, we see tremendous potential for further growth in a number of our markets. In 2005, Fifth Third opened its first commercial banking office in Toronto, Canada, which offers seamless, cross-border banking to Canadian- and U.S.-based companies. With a proven strategy, a dedication to forging strong local partnerships, an expanded sales force and conservative credit culture, Fifth Third will continue to provide our customers with solutions that create lasting business relationships.
New customer additions and increasing loan demand throughout the year contributed to 49 percent growth in commercial loan- and lease related fees.
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processing solutions
focused
on growth.
Fifth Third Processing Solutions (FTPS), our electronic payment processing division, initiates, captures, authorizes and settles electronic payment transactions as part of integrated cash management solutions for financial institutions, merchants and consumers all over the world. As a leading electronic payment processor, we help our customers eliminate paper and reduce cycle time and expense while providing instant online access to information through a platform integrated with traditional banking services. With robust systems architecture, including three world-class data centers, we provide a highly reliable processing environment for even the most demanding processing applications.
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FTPS had another outstanding year and delivered an 18 percent increase in annual revenues. Exclusive of the impact of the 2004 sales of certain third-party sourced merchant processing contracts, electronic payment processing revenue increased 23 percent. In 2005, FTPS processed more than 16.4 billion electronic transactions, an increase of 33 percent over 2004 and double the number processed just three years ago. FTPS operates three primary businesses – Merchant Services, Financial Institution and Card Services.
Our Merchant Services group provides over 127,000 merchant locations with debit, credit and stored-value payment processing. For more than three decades, Fifth Third has been trusted by the nation’s top retailers and businesses to provide superior card acceptance solutions. At Fifth Third, we understand that all merchants are not the same. We have developed flexible system architecture with a wealth of technology options and processing features capable of meeting the individual requirements of any business. Among the largest bankcard acquirers in the nation, FTPS currently processes annual credit and debit card volume of nearly $200 billion. In 2005, merchant revenues increased by 15 percent, or 27 percent on a core basis.
Our Financial Institution and Card Services groups together provide a complete global payments solution delivered with a consultative approach from one of the nation’s leading financial institutions. We act as a business advisor to our clients, forging strategic partnerships and creating solutions that enable revenue enhancements while simultaneously reducing costs. Customers are provided with a full array of capabilities including correspondent banking services, Check 21 processing and support, automated teller machine processing, credit and debit card management, network gateway access, fraud monitoring services and international banking.
FTPS currently drives approximately 12,500 automated teller machines and supports more than 33 million debit cards for approximately 1,500 financial institutions around the world. In 2005, financial institution and card revenues increased by 21 percent over the prior year.
As one of the few processors that can offer customers a complete array of financial services solutions, the outlook for FTPS remains as bright as ever. In Merchant Services, FTPS is building upon its core competencies in large merchant processing and increasing profit margins by continuing recent momentum in the penetration of the middle market channel. The Financial Institutions group continues to see significant growth potential through the expansion of relationships with existing customers and by increasing the card issuer base through upstream participation of large financial institutions. FTPS is also experiencing significant success in partnering with retail teammates in the expansion of Fifth Third’s credit card portfolio through increased focus and enhanced point-of-sale approval strategies.
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investment advisors
focused on wealth creation.
Fifth Third Investment Advisors is a full-service money management business with $33 billion in assets under management and $196 billion in assets under care. Fifth Third takes a careful, disciplined approach to investing client assets and delivers a full spectrum of investment strategies of varying scope and complexity for both long- and short-term investment horizons. Our broad array of equity and fixed income products are offered through separately managed portfolios, daily-valued collective funds, lifestyle funds and our nationally recognized mutual funds*.
*For important disclosures, see the bottom of page 31.
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Fifth Third’s institutional investment professionals help commercial clients manage their assets more efficiently and profitably, provide retirement planning for their employees and achieve their financial goals through a range of innovative services.
Fifth Third Asset Management (FTAM) professionals are committed to helping clients successfully manage investment funds by taking the time to learn their needs and carefully creating individualized plans tailored to their risk, reward and liquidity objectives. FTAM provides advisory services for a long list of institutional clients including states and municipalities, Taft-Hartley plans, pension and profit sharing plans and foundations and endowments.
Fifth Third’s retail brokerage business encompasses over 2,400 full-time licensed securities representatives deployed throughout the affiliate network. Our brokerage sales force is focused on working closely with banking center personnel to deepen customer relationships and meet all of the financial services needs of our retail customers. Fifth Third’s experienced team of financial advisors offers customers sound advice to achieve well-diversified portfolios that remain aligned with long-term financial goals.
Fifth Third’s private client group creates individualized, comprehensive solutions to assist our customers in achieving financial success including:
| • |
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Wealth Planning |
Expert advice concerning life event planning, cash flow and tax efficiency analysis, benefit and stock option optimization, wealth transfer, business succession and tax and estate planning strategies.
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Investment Services |
Investment strategies constructed around specific objectives offering choices between managed portfolios and self-directed brokerage services available through Fifth Third Securities.
| • |
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Trust Services |
Dedicated to servicing wealth across generations with trust strategies that help preserve wealth and provide for efficient transfer to heirs or charitable institutions.
| • |
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Private Banking Comprehensive services designed to meet |
traditional and specialized banking needs, including personal checking and cash management, mortgage loans, lines of credit and other customized solutions.
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Wealth Protection |
Specialized tools and techniques to safeguard wealth, including customized hedging and diversification strategies, as well as tailored insurance strategies for wealth creation, preservation and business planning.
Investment advisory revenues were essentially unchanged in 2005, but ended the year on a positive note with fourth quarter revenues increasing five percent over the prior year. Modest revenue performance in 2005 resulted primarily from declines in brokerage-related revenues.
Fifth Third continues to focus its efforts on improving execution in retail brokerage and growing the institutional money management business by improving penetration and cross-sell of money management products and 401(k) plans into out large middle market commercial customer base. Success in these efforts will help drive growth and diversification of revenues in 2006.
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committed to our neighbors & community
focused on community.
The Foundation Office administers grants on behalf of the Fifth Third Foundation and the eight charitable trusts for which the bank serves as trustee. \The primary areas of giving for the Fifth Third Foundation are arts & culture, community development, education and health & human services.
In 2005, the Fifth Third Foundation announced a matching gift of $500,000 to the American Veterans Disabled for Life Memorial, which is to be built near the National Mall in Washington, D.C. in 2010. The gift was the first corporate foundation gift for the Memorial, which will be the first to honor all of America’s disabled veterans.
Fifth Third Community Development Corporation invests in low-income housing, historic tax credit and economic development projects to support community revitalization in neighborhoods throughout the Fifth Third footprint.
Our Community Affairs department identifies lending and real estate opportunities in traditionally underserved markets, such as ethnically diverse, urban and low- to moderate-income census tracts. This group also champions financial literacy by providing homebuyer training, credit counseling and college savings match programs.
United Way Giving
Over the past five years, Fifth Third’s corporate and employee contributions to the United Way have reached $44.2 million. 2005 was a year marked by natural disasters – hurricanes Katrina and Rita changed the landscape of our country and caused an outpouring of generosity from individuals from all walks of life. Fifth Third employees were no different. Many volunteered at disaster collection stations, some held fundraisers, while still others made contributions to organizations such as the United Way and the American Red Cross. In honor of its nearly 22,000 employees, Fifth Third donated $500,000 to the 2005 disaster relief effort.
Table of Contents
2005 Annual Report
Financial Contents
| Management’s Discussion and Analysis of Financial Condition and Results of Operations |
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| Management’s Assessment as to the Effectiveness of Internal Control over Financial Reporting |
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| Financial Statements |
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| Notes to the Consolidated Financial Statements |
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| Corporate Information |
91 | |
FORWARD-LOOKING STATEMENTS
This report may contain forward-looking statements about Fifth Third Bancorp and/or the company as combined acquired entities within the meaning of Sections 27A of the Securities Act of 1933, as amended, and Rule 175 promulgated thereunder, and 21E of the Securities Exchange Act of 1934, as amended, and Rule 3b-6 promulgated thereunder, that involve inherent risks and uncertainties. This report may contain certain forward-looking statements with respect to the financial condition, results of operations, plans, objectives, future performance and business of Fifth Third Bancorp and/or the combined company including statements preceded by, followed by or that include the words or phrases such as “believes,” “expects,” “anticipates,” “plans,” “trend,” “objective,” “continue,” “remain” or similar expressions or future or conditional verbs such as “will,” “would,” “should,” “could,” “might,” “can,” “may” or similar expressions. There are a number of important factors that could cause future results to differ materially from historical performance and these forward-looking statements. Factors that might cause such a difference include, but are not limited to: (1) competitive pressures among depository institutions increase significantly; (2) changes in the interest rate environment reduce interest margins; (3) prepayment speeds, loan origination and sale volumes, charge-offs and loan loss provisions; (4) general economic conditions, either national or in the states in which Fifth Third, one or more acquired entities and/or the combined company do business, are less favorable than expected; (5) political developments, wars or other hostilities may disrupt or increase volatility in securities markets or other economic conditions; (6) changes and trends in the securities markets; (7) legislative or regulatory changes or actions, or significant litigation, adversely affect Fifth Third, one or more acquired entities and/or the combined company or the businesses in which Fifth Third, one or more acquired entities and/or the combined company are engaged; (8) difficulties in combining the operations of acquired entities and (9) the impact of reputational risk created by the developments discussed above on such matters as business generation and retention, funding and liquidity. Fifth Third undertakes no obligation to release revisions to these forward-looking statements or reflect events or circumstances after the date of this report.
Table of Contents
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following is management’s discussion and analysis of certain significant factors that have affected Fifth Third Bancorp’s (the “Bancorp” or “Fifth Third”) financial condition and results of operations during the periods included in the Consolidated Financial Statements, which are a part of this report. Reference to the Bancorp incorporates the parent holding company and all consolidated subsidiaries.
TABLE 1: SELECTED FINANCIAL DATA
| For the years ended December 31 ($ in millions, except per share data) |
2005 |
2004 |
2003 |
2002 |
2001 | |||||||
| Income Statement Data |
||||||||||||
| Net interest income (a) |
$ | 2,996 | 3,048 | 2,944 | 2,738 | 2,476 | ||||||
| Noninterest income |
2,500 | 2,465 | 2,483 | 2,183 | 1,788 | |||||||
| Total revenue (a) |
5,496 | 5,513 | 5,427 | 4,921 | 4,264 | |||||||
| Provision for loan and lease losses |
330 | 268 | 399 | 246 | 236 | |||||||
| Noninterest expense |
2,927 | 2,972 | 2,551 | 2,337 | 2,453 | |||||||
| Net income |
1,549 | 1,525 | 1,665 | 1,531 | 1,002 | |||||||
| Common Share Data |
||||||||||||
| Earnings per share, basic |
$ | 2.79 | 2.72 | 2.91 | 2.64 | 1.74 | ||||||
| Earnings per share, diluted |
2.77 | 2.68 | 2.87 | 2.59 | 1.70 | |||||||
| Cash dividends per common share |
1.46 | 1.31 | 1.13 | .98 | .83 | |||||||
| Book value per share |
17.00 | 16.00 | 15.29 | 14.98 | 13.31 | |||||||
| Dividend payout ratio, as originally reported |
52.7 | % | 48.9 | 39.4 | 37.8 | 48.8 | ||||||
| Financial Ratios |
||||||||||||
| Return on average assets |
1.50 | % | 1.61 | 1.90 | 2.04 | 1.42 | ||||||
| Return on average equity |
16.6 | 17.2 | 19.0 | 18.4 | 13.6 | |||||||
| Average equity as a percent of average assets |
9.06 | 9.34 | 10.01 | 11.08 | 10.40 | |||||||
| Net interest margin (a) |
3.23 | 3.48 | 3.62 | 3.96 | 3.82 | |||||||
| Efficiency (a) |
53.2 | 53.9 | 47.0 | 47.5 | 57.5 | |||||||
| Credit Quality |
||||||||||||
| Net losses charged off |
$ | 299 | 252 | 312 | 187 | 227 | ||||||
| Net losses charged off as a percent of average loans and leases |
.45 | % | .45 | .63 | .43 | .54 | ||||||
| Allowance for loan and lease losses as a percent of loans and leases (b) |
1.06 | 1.19 | 1.33 | 1.49 | 1.50 | |||||||
| Allowance for credit losses as a percent of loans and leases (b) |
1.16 | 1.31 | 1.47 | 1.49 | 1.50 | |||||||
| Nonperforming assets as a percent of loans, leases and other assets, including other real estate owned |
.52 | .51 | .61 | .59 | .57 | |||||||
| Underperforming assets as a percent of loans, leases and other assets, including other real estate owned |
.74 | .74 | .89 | .95 | .96 | |||||||
| Average Balances |
||||||||||||
| Loans and leases, including held for sale |
$ | 67,737 | 57,042 | 52,414 | 45,539 | 44,888 | ||||||
| Total securities and other short-term investments |
24,999 | 30,597 | 28,947 | 23,585 | 19,938 | |||||||
| Total assets |
102,876 | 94,896 | 87,481 | 75,037 | 70,683 | |||||||
| Transaction deposits |
47,929 | 43,175 | 40,370 | 35,819 | 26,363 | |||||||
| Core deposits |
56,420 | 49,383 | 46,796 | 44,674 | 39,836 | |||||||
| Interest-bearing deposits |
50,520 | 43,908 | 44,008 | 39,976 | 38,255 | |||||||
| Short-term borrowings |
9,511 | 13,539 | 12,373 | 7,191 | 8,799 | |||||||
| Long-term debt |
16,384 | 13,323 | 8,747 | 7,640 | 6,301 | |||||||
| Shareholders’ equity |
9,317 | 8,860 | 8,754 | 8,317 | 7,348 | |||||||
| Regulatory Capital Ratios |
||||||||||||
| Tier I capital |
8.38 | % | 10.31 | 11.11 | 11.84 | 12.49 | ||||||
| Total risk-based capital |
10.45 | 12.31 | 13.56 | 13.65 | 14.55 | |||||||
| Tier I leverage |
8.08 | 8.89 | 9.23 | 9.84 | 10.64 | |||||||
| (a) | Amounts presented on a fully taxable equivalent basis (“FTE”). |
| (b) | At December 31, 2004, the reserve for unfunded commitments was reclassified from the allowance for loan and lease losses to other liabilities. The 2003 year-end reserve for unfunded commitments has been reclassified to conform to the current year presentation. The allowance for credit losses is the sum of the allowance for loan and lease losses and the reserve for unfunded commitments. |
TABLE 2: QUARTERLY INFORMATION (unaudited)
| 2005 |
2004 | ||||||||||||||||
| For the three months ended ($ in millions, except per share data) |
12/31 |
9/30 |
6/30 |
3/31 |
12/31 |
9/30 |
6/30 |
3/31 | |||||||||
| Net interest income (FTE) |
$ | 735 | 745 | 758 | 759 | 752 | 766 | 771 | 759 | ||||||||
| Provision for loan and lease losses |
134 | 69 | 60 | 67 | 65 | 26 | 90 | 87 | |||||||||
| Noninterest income |
636 | 622 | 635 | 607 | 479 | 611 | 749 | 626 | |||||||||
| Noninterest expense |
763 | 732 | 728 | 705 | 935 | 648 | 742 | 648 | |||||||||
| Net income |
332 | 395 | 417 | 405 | 176 | 471 | 448 | 430 | |||||||||
| Earnings per share, basic |
.60 | .71 | .75 | .73 | .31 | .84 | .80 | .76 | |||||||||
| Earnings per share, diluted |
.60 | .71 | .75 | .72 | .31 | .83 | .79 | .75 | |||||||||
22 Fifth Third Bancorp
Table of Contents
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
This overview of management’s discussion and analysis highlights selected information in the financial results of the Bancorp and may not contain all of the information that is important to you. For a more complete understanding of trends, events, commitments, uncertainties, liquidity, capital resources, risk factors and critical accounting policies and estimates, you should carefully read this entire document. Each of these items could have an impact on the Bancorp’s financial condition and results of operations.
The Bancorp is a diversified financial services company headquartered in Cincinnati, Ohio. The Bancorp has $105.2 billion in assets and operates 19 affiliates with 1,119 full-service Banking Centers and 2,024 Jeanie® ATMs in Ohio, Kentucky, Indiana, Michigan, Illinois, Florida, Tennessee, West Virginia, Pennsylvania and Missouri. The financial strength of the Bancorp’s largest banks, Fifth Third Bank and Fifth Third Bank (Michigan), continues to be recognized by rating agencies with deposit ratings of AA- and Aa1 from Standard & Poor’s and Moody’s, respectively. Additionally, the Bancorp is recognized by Moody’s with a senior debt rating of Aa2. The Bancorp operates four main businesses: Commercial Banking, Retail Banking, Investment Advisors and Fifth Third Processing Solutions (“FTPS”).
Fifth Third believes that banking is first and foremost a relationship business where the strength of the competition and challenges for growth can vary in every market. Our affiliate operating model provides a competitive advantage by keeping the decisions close to the customer and by emphasizing individual relationships. Through our affiliate operating model, individual managers, from the banking center to the executive level, are given the opportunity to tailor financial solutions for their customers.
The Bancorp’s revenues are fairly evenly dependent on net interest income and noninterest income. During 2005, net interest income, on a fully taxable equivalent (“FTE”) basis, and noninterest income provided 54% and 46% of total revenue, respectively. Therefore, changes in interest rates, credit quality, economic trends and the capital markets are primary factors that drive the performance of the Bancorp. As discussed later in the Risk Management section, risk identification, measurement, monitoring, control and reporting are important to the management of risk and to the continuation of the strong financial performance and capital strength of the Bancorp.
Net interest income, which continues to be the Bancorp’s largest revenue source, is the difference between interest income earned on assets such as loans, leases and securities, and interest expense paid on liabilities such as deposits and borrowings. Net interest income is affected by the general level of interest rates, the relative level of short-term and long-term interest rates, changes in interest rates and changes in the amount and composition of interest-earning assets and interest-bearing liabilities. Generally, the rates of interest the Bancorp earns on its assets and owes on its liabilities are established for a period of time. The change in market interest rates over time exposes the Bancorp to interest rate risk through potential adverse changes in net interest income and financial position. The Bancorp manages this risk by continually analyzing and adjusting the composition of its assets and liabilities based on their payment streams and interest rates, the timing of their maturities and their sensitivity to changes in market interest rates. Additionally, in the ordinary course of business, the Bancorp enters into certain derivative transactions as part of its overall strategy to manage its interest rate and prepayment risks.
The Bancorp is also exposed to the risk of losses on its loan and lease portfolio as a result of changing expected cash flows caused by loan defaults and inadequate collateral, among other factors.
Noninterest income is derived primarily from electronic funds transfer (“EFT”) and merchant transaction processing fees, fiduciary and investment management fees, banking fees and service charges and mortgage banking revenue.
Net interest income, net interest margin, net interest rate spread and the efficiency ratio are presented in Management’s Discussion and Analysis of Financial Condition and Results of Operations on an FTE basis. The FTE basis adjusts for the tax-favored status of income from certain loans and securities held by the Bancorp that are not taxable for federal income tax purposes. The Bancorp believes this measure to be the preferred industry measurement of net interest income as it provides a relevant comparison between taxable and non-taxable amounts.
Fiscal 2005 was a challenging year. The continued flattening of the yield curve, reduction in contribution from the largely fixed-rate securities portfolio, increased operating costs largely related to sales force additions, technology and de-novo investments and elevated charge-off experience in the fourth quarter contributed to nominal earnings per share growth and flat revenue performance for the year. The Bancorp did, however, continue to experience strong loan growth as well as a rebound in deposit growth trends following the implementation of the new deposit pricing strategy in the second half of 2005. Although net interest income will continue to be negatively impacted in 2006 by the overall contribution from and continued reductions in the securities portfolio, the benefits from the recent investments in the banking center distribution network, sales force expansion and technology infrastructure should drive improved financial trends in 2006.
The Bancorp completed its acquisition of First National Bankshares of Florida, Inc. (“First National”), a bank holding company with $5.6 billion in assets located primarily in Orlando, Tampa, Sarasota, Naples and Fort Myers, on January 1, 2005. The Bancorp completed its conversion activity associated with the First National acquisition in the first quarter of 2005. As of December 31, 2005, the Bancorp’s Florida affiliates have 86 full-service locations, of which 74 were acquired as part of the First National acquisition.
The Bancorp’s net income was $1.55 billion in 2005, a two percent increase compared to $1.53 billion in 2004. Earnings per diluted share were $2.77 in 2005, a three percent increase from $2.68 in 2004. The Bancorp’s dividend in 2005 increased to $1.46 per common share from $1.31, an increase of 11%.
Net interest income (FTE) decreased two percent compared to 2004. The net interest margin decreased from 3.48% in 2004 to 3.23% in 2005 largely due to the rise in short-term interest rates, the impact of the primarily fixed-rate securities portfolio and mix shifts within the core deposit base. Noninterest income was flat, predominantly due to the $157 million pre-tax gain recognized in 2004 on the sales of certain third-party sourced merchant processing contracts. Excluding the impact of the pre-tax gain, noninterest income increased eight percent largely due to an 18% increase in electronic payment processing revenue. Excluding the impact of 2004 debt retirement charges, noninterest expense increased 11% compared to last year, primarily due to increases in marketing, information technology, volume-related bankcard costs and the significant investments in the sales force and retail distribution network. Compared to 2004, average sales personnel increased by approximately 1,400 and 63 new banking centers have opened, excluding relocations, as well as the 70 net new Florida banking centers as a result of the acquisition of First National.
Credit quality metrics deteriorated during the fourth quarter of 2005 with full-year net charge-offs increasing 19% over 2004 as a result of certain commercial airline bankruptcies and an increase in consumer bankruptcies declared prior to the recently enacted reform legislation. Despite a ratio of .67% in the fourth quarter of 2005, net charge-offs as a percent of average loans and leases remained at .45% in 2005. Nonperforming assets as a percent of loans and leases were .52% at December 31, 2005 compared to .51% at December 31, 2004.
Fifth Third Bancorp 23
Table of Contents
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The Bancorp’s capital ratios exceed the “well-capitalized” guidelines as defined by the Board of Governors of the Federal Reserve System (“FRB”). As of December 31, 2005, the Tier I capital ratio was 8.38% and the Total risk-based capital ratio was 10.45%. The Bancorp’s capital strength and financial stability have enabled the Bancorp to maintain a Moody’s credit rating that is equaled or surpassed by only four other U.S. bank holding companies.
The Bancorp continues to invest in the geographic areas that offer the best growth prospects, as it believes this is the most cost efficient method of expansion within its largest affiliate markets. The Bancorp opened 63 new banking centers during 2005, excluding relocations, with a net increase of 34, excluding acquisitions. The Bancorp plans to continue adding banking centers in key markets during 2006 with a planned addition of approximately 50 net new locations during the year.
In December 2002, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standard (“SFAS”) No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure—an Amendment of FASB Statement No. 123.” This Statement provides alternative methods of transition for a voluntary change to the fair value method of accounting for stock-based employee compensation. Effective January 1, 2004, the Bancorp adopted the fair value recognition provisions of SFAS No. 123 using the retroactive restatement method described in SFAS No. 148. As a result, financial information for all periods prior to 2004 has been restated to reflect the compensation expense that would have been recognized had the fair value method of accounting been applied to all awards granted to employees after January 1, 1995. Stock-based
compensation expense is included in salaries, wages and incentives expense in the Consolidated Statements of Income.
In December 2004, the FASB issued SFAS No. 123 (Revised 2004), “Share-Based Payment.” This Statement requires measurement of the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award with the cost to be recognized over the service period. As the Bancorp has previously adopted the fair value recognition provisions of SFAS No. 123 and the retroactive restatement method described in SFAS No. 148, the adoption of this Statement will not have a material impact on the Bancorp’s Consolidated Financial Statements.
See Note 1 of the Notes to the Consolidated Financial Statements for discussion of certain proposal stage accounting literature developments.
Allowance for Loan and Lease Losses
The Bancorp maintains an allowance to absorb probable loan and lease losses inherent in the portfolio. The allowance is maintained at a level the Bancorp considers to be adequate and is based on ongoing quarterly assessments and evaluations of the collectibility and historical loss experience of loans and leases. Credit losses are charged and recoveries are credited to the allowance. Provisions for loan and lease losses are based on the Bancorp’s review of the historical credit loss experience and such factors that, in management’s judgment, deserve consideration under existing economic conditions in estimating probable credit losses. In determining the appropriate level of the allowance, the Bancorp estimates losses using a range derived from “base” and “conservative” estimates. The Bancorp’s strategy for credit risk management includes a combination of conservative exposure limits significantly below legal lending limits and conservative underwriting, documentation and collections standards. The strategy also emphasizes diversification on a geographic, industry and customer level, regular credit examinations and quarterly management reviews of large credit exposures and loans experiencing deterioration of credit quality.
Larger commercial loans that exhibit probable or observed credit weaknesses are subject to individual review. Where appropriate, allowances are allocated to individual loans based on management’s estimate of the borrower’s ability to repay the loan given the availability of collateral, other sources of cash flow and legal options available to the Bancorp. The review of individual loans includes those loans that are impaired as provided in SFAS No. 114, “Accounting by Creditors for Impairment of a Loan.” Any allowances for impaired loans are measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate or fair value of the underlying collateral. The Bancorp evaluates the collectibility of both principal and interest when assessing the need for loss accrual. Historical loss rates are applied to other commercial loans not subject to specific allowance allocations. The loss rates are derived from a migration analysis, which computes the net charge-off experience sustained on loans according to their internal risk grade. The risk grading system utilized for allowance analysis purposes encompasses ten categories. The Bancorp also maintains a dual risk rating system that provides for 13 probability of default grade categories and an
additional six grade categories measuring loss factors given an event of default. The probability of default and loss given default analyses are not separated in the ten grade risk rating system. The Bancorp is in the process of completing significant validation and testing of the dual risk rating system prior to implementation for allowance analysis purposes. The dual risk rating system is consistent with Basel II expectations and allows for more precision in the analysis of commercial credit risk.
Homogenous loans and leases, such as consumer installment, residential mortgage and automobile leases are not individually risk graded. Rather, standard credit scoring systems and delinquency monitoring are used to assess credit risks. Allowances are established for each pool of loans based on the expected net charge-offs for one year. Loss rates are based on the average net charge-off history by loan category.
Historical loss rates for commercial and consumer loans may be adjusted for significant factors that, in management’s judgment, reflect the impact of any current conditions on loss recognition. Factors that management considers in the analysis include the effects of the national and local economies, trends in the nature and volume of loans (delinquencies, charge-offs and nonaccrual loans), changes in mix, credit score migration comparisons, asset quality trends, risk management and loan administration, changes in the internal lending policies and credit standards, collection practices and examination results from bank regulatory agencies and the Bancorp’s internal credit examiners.
An unallocated allowance is maintained to recognize the imprecision in estimating and measuring loss when evaluating allowances for individual loans or pools of loans. Allowances on individual loans and historical loss rates are reviewed quarterly and adjusted as necessary based on changing borrower and/or collateral conditions and actual collection and charge-off experience.
Loans acquired by the Bancorp through a purchase business combination are evaluated for possible credit impairment. Reduction to the carrying value of the acquired loans as a result of credit impairment is recorded as an adjustment to goodwill. The Bancorp does not carry over the acquired company’s allowance for loan and lease losses nor does the Bancorp add to its existing allowance for the acquired loans as part of purchase accounting.
24 Fifth Third Bancorp
Table of Contents
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The Bancorp’s determination of the allowance for commercial loans is sensitive to the credit risk ratings it assigns to these loans. In the event that 10% of commercial loans in each risk category experienced downgrades of one risk category, the allowance for commercial loans would have increased by approximately $69 million at December 31, 2005. The Bancorp’s determination of the allowance for residential and retail loans is sensitive to changes in estimated loss rates. In the event that estimated loss rates increased by 10%, the allowance for residential and retail loans would have increased by approximately $23 million at December 31, 2005. Because several quantitative and qualitative factors are considered in determining the allowance for loan and lease losses, these sensitivity analyses do not necessarily reflect the nature and extent of future changes in the allowance for loan and lease losses. They are intended to provide insights into the impact of adverse changes in risk rating and inherent losses and do not imply any expectation of future deterioration in the risk rating or loss rates. Given current processes employed by the Bancorp, management believes the risk ratings and inherent loss rates currently assigned are appropriate.
The Bancorp’s primary market areas for lending are Ohio, Kentucky, Indiana, Michigan, Illinois, Florida, Tennessee, West Virginia and Pennsylvania. When evaluating the adequacy of allowances, consideration is given to this regional geographic concentration and the closely associated effect changing economic conditions have on the Bancorp’s customers.
In the current year, the Bancorp has not substantively changed any aspect to its overall approach in the determination of allowance for loan and lease losses. There have been no material changes in assumptions or estimation techniques as compared to prior periods that impacted the determination of the current period allowance for loan and lease losses. Based on the procedures discussed above, the Bancorp is of the opinion that the allowance of $744 million was adequate, but not excessive, to absorb estimated credit losses associated with the loan and lease portfolio at December 31, 2005.
Reserve for Unfunded Commitments
The reserve for unfunded commitments is maintained at a level believed by management to be sufficient to absorb estimated probable losses related to unfunded credit facilities. The determination of the adequacy of the reserve is based upon an evaluation of the unfunded credit facilities, including an assessment of historical commitment utilization experience, credit risk grading and credit grade migration. Net adjustments to the reserve for unfunded commitments are included in other noninterest expense.
Taxes
The Bancorp estimates income tax expense based on amounts expected to be owed to the various tax jurisdictions in which the Bancorp conducts business. On a quarterly basis, management assesses the reasonableness of its effective tax rate based upon its current estimate of the amount and components of net income, tax credits and the applicable statutory tax rates expected for the full year. The estimated income tax expense is recorded in the Consolidated Statements of Income.
Deferred income tax assets and liabilities are determined using the balance sheet method and are reported in accrued taxes, interest and expenses in the Consolidated Balance Sheet. Under this method, the net deferred tax asset or liability is based on the tax effects of the differences between the book and tax basis of assets and liabilities, and recognizes enacted changes in tax rates and laws. Deferred tax assets are recognized subject to management judgment that realization is more likely than not.
Accrued taxes represent the net estimated amount due or to be received from taxing jurisdictions and are reported in accrued taxes, interest and expenses in the Consolidated Balance Sheets. The Bancorp evaluates and assesses the relative risks and appropriate tax treatment of transactions and filing positions after considering statutes, regulations, judicial precedent and other information and maintains tax accruals consistent with its evaluation of these relative risks and merits. Changes to the
estimate of accrued taxes occur periodically due to changes in tax rates, interpretations of tax laws, the status of examinations being conducted by taxing authorities and changes to statutory, judicial and regulatory guidance that impact the relative risks of tax positions. These changes, when they occur, can affect deferred taxes and accrued taxes as well as the current period’s income tax expense and can be significant to the operating results of the Bancorp. As described in greater detail in Note 13 of the Notes to the Consolidated Financial Statements, the Internal Revenue Service is currently challenging the Bancorp’s tax treatment of certain leasing transactions. For additional information, see Note 22 of the Notes to the Consolidated Financial Statements.
Valuation of Servicing Rights
When the Bancorp sells loans through either securitizations or individual loan sales in accordance with its investment policies, it often retains servicing rights. Servicing rights resulting from loan sales are amortized in proportion to and over the period of estimated net servicing revenues. Servicing rights are assessed for impairment monthly, based on fair value, with temporary impairment recognized through a valuation allowance and permanent impairment recognized through a write-off of the servicing asset and related valuation allowance. Key economic assumptions used in measuring any potential impairment of the servicing rights include the prepayment speeds of the underlying loans, the weighted-average life of the loan, the discount rate, the weighted-average coupon and the weighted-average default rate, as applicable. The primary risk of material changes to the value of the servicing rights resides in the potential volatility in the economic assumptions used, particularly the prepayment speeds.
The Bancorp monitors risk and adjusts its valuation allowance as necessary to adequately reserve for any probable impairment in the portfolio. For purposes of measuring impairment, the servicing rights are stratified based on the financial asset type and interest rates. In addition, the Bancorp obtains an independent third-party valuation of mortgage servicing rights (“MSR”) on a quarterly basis. Fees received for servicing loans owned by investors are based on a percentage of the outstanding monthly principal balance of such loans and are included in noninterest income as loan payments are received. Costs of servicing loans are charged to expense as incurred.
The change in the fair value of MSRs at December 31, 2005, due to immediate 10% and 20% adverse changes in the current prepayment assumption would be approximately $19 million and $38 million, respectively, and due to immediate 10% and 20% favorable changes in the current prepayment assumption would be approximately $21 million and $43 million, respectively. The change in the fair value of the MSR portfolio at December 31, 2005, due to immediate 10% and 20% adverse changes in the discount rate assumption would be approximately $16 million and $31 million, respectively, and due to immediate 10% and 20% favorable changes in the discount rate assumption would be approximately $17 million and $36 million, respectively. Sensitivity analysis related to other consumer and commercial servicing rights is not material to the Bancorp’s Consolidated Financial Statements. These sensitivities are hypothetical and should be used with caution. As the figures indicate, change in fair value based on a 10% and 20% variation in assumptions typically cannot be extrapolated because the relationship of the change in assumptions to change in fair value may not be linear. Also, the effect of variation in a particular assumption on the fair value of the retained interests is calculated without changing any other assumption; in reality, changes in one factor may result in changes in another, which might magnify or counteract the sensitivities. Additionally, the effect of the Bancorp’s non-qualifying hedging strategy, which is maintained to lessen the impact of changes in value of the MSR portfolio, is excluded from the above analysis.
Fifth Third Bancorp 25
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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
General economic conditions, either national or in the states within Fifth Third’s footprint, are less favorable than expected.
The Bancorp is affected by general economic conditions in the United States and, in particular, the states within its footprint, which covers much of the Midwest and Florida. An economic downturn within the Bancorp’s footprint or the nation as a whole could negatively impact household and corporate incomes. This impact may lead to decreased demand for both loan and deposit products and increase the number of customers who fail to pay interest or principal on their loans.
The revenues of FTPS are dependent on the transaction volume generated by its merchant and financial institution customers, which is largely dependent on consumer and corporate spending. If consumer confidence suffers and retail sales decline, FTPS will be negatively impacted. Similarly, if an economic downturn results in a decrease in the overall volume of corporate transactions, FTPS will be negatively impacted. FTPS is also impacted by the financial stability of its merchant customers. FTPS assumes certain contingent liabilities related to the processing of Visa® and MasterCard® merchant card transactions. These liabilities typically arise from billing disputes between the merchant and the cardholder that are ultimately resolved in favor of the cardholder. These transactions are charged back to the merchant and disputed amounts are returned to the cardholder. If FTPS is unable to collect these amounts from the merchant, it will bear the loss.
The fee revenue of Investment Advisors is largely dependent on the fair market value of assets under care and trading volumes in the brokerage business. General economic conditions and their subsequent effect on the securities markets tend to act in a correlation. When general economic conditions deteriorate, consumer and corporate confidence in securities markets erodes, and Investment Advisors’ revenues are negatively impacted as asset values and trading volumes decrease. Neutral economic conditions can also negatively impact revenue when stagnant securities markets fail to attract investors.
If Fifth Third does not adjust to rapid changes in the financial services industry, its financial performance may suffer.
The Bancorp’s ability to deliver strong financial performance and returns on investment to shareholders will depend in part on its ability to expand the scope of available financial services offerings to meet the needs and demands of its customers. In addition to the challenge of competing against other banks in attracting and retaining customers for traditional banking services, the Bancorp’s competitors also include securities dealers, brokers, mortgage bankers, investment advisors, specialty finance and insurance companies who seek to offer one-stop financial services that may include services that banks have not been able or allowed to offer to their customers in the past. The increasingly competitive environment is primarily a result of changes in regulation, changes in technology and product delivery systems and the accelerating pace of consolidation among financial service providers.
Legislative or regulatory changes or actions, or significant litigation, could adversely impact Fifth Third or the businesses in which Fifth Third is engaged.
The Bancorp is subject to extensive state and federal regulation, supervision and legislation that govern almost all aspects of its operations. Laws and regulations may change from time to time and are primarily intended for the protection of consumers, depositors and the deposit insurance funds. The impact of any changes to laws and regulations or other actions by regulatory agencies may negatively impact the Bancorp or its ability to increase the value of its business. Additionally, actions by
regulatory agencies or significant litigation against the Bancorp could cause it to devote significant time and resources to defending itself and may lead to penalties that materially affect the Bancorp and its shareholders. Future changes in the laws or regulations or their interpretations or enforcement could be materially adverse to the Bancorp and its shareholders.
Fifth Third is exposed to operational risk.
Similar to any large corporation, the Bancorp is exposed to many types of operational risk, including reputational risk, legal and compliance risk, the risk of fraud or theft by employees or outsiders, unauthorized transactions by employees or operational errors, including clerical or record-keeping errors or those resulting from faulty or disabled computer or telecommunications systems.
Negative public opinion can result from the Bancorp’s actual or alleged conduct in any number of activities, including lending practices, corporate governance and acquisitions and from actions taken by government regulators and community organizations in response to those activities. Negative public opinion can adversely affect the Bancorp’s ability to attract and keep customers and can expose it to litigation and regulatory action.
Given the volume of transactions at the Bancorp, certain errors may be repeated or compounded before they are discovered and successfully rectified. The Bancorp’s necessary dependence upon automated systems to record and process its transaction volume may further increase the risk that technical system flaws or employee tampering or manipulation of those systems will result in losses that are difficult to detect. The Bancorp may also be subject to disruptions of its operating systems arising from events that are wholly or partially beyond its control (for example, computer viruses or electrical or telecommunications outages), which may give rise to disruption of service to customers and to financial loss or liability. The Bancorp is further exposed to the risk that its external vendors may be unable to fulfill their contractual obligations (or will be subject to the same risk of fraud or operational errors by their respective employees as is the Bancorp) and to the risk that the Bancorp’s (or its vendors’) business continuity and data security systems prove to be inadequate.
Changes in interest rates could affect Fifth Third’s income and cash flows.
The Bancorp’s income and cash flows depend to a great extent on the difference between the interest rates earned on interest-earning assets such as loans and investment securities, and the interest rates paid on interest-bearing liabilities such as deposits and borrowings. These rates are highly sensitive to many factors that are beyond the Bancorp’s control, including general economic conditions and the policies of various governmental and regulatory agencies (in particular, the FRB). Changes in monetary policy, including changes in interest rates, will influence the origination of loans, the prepayment speed of loans, the purchase of investments, the generation of deposits and the rates received on loans and investment securities and paid on deposits or other sources of funding. The impact of these changes may be magnified if the Bancorp does not effectively manage the relative sensitivity of its assets and liabilities to changes in market interest rates. Fluctuations in these areas may adversely affect the Bancorp and its shareholders.
Changes and trends in the capital markets may affect Fifth Third’s income and cash flows.
The Bancorp enters into and maintains trading and investment positions in capital markets on its own behalf and on behalf of its customers. These positions also include derivative financial instruments. The revenues and profits the Bancorp derives from its trading and investment positions are dependent on market prices. If it does not correctly anticipate market changes and trends, the Bancorp may experience investment or trading losses
26 Fifth Third Bancorp
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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
that may materially affect the Bancorp and its shareholders. Losses on behalf of its customers could expose the Bancorp to credit risks or could lead to the loss of revenue from those customers. Additionally, substantial losses in the Bancorp’s trading and investment positions could lead to a loss of relative liquidity with respect to those positions and may adversely affect cash flows and funding costs.
Changes in accounting standards could impact reported earnings.
The accounting standard setters, including the FASB, SEC and other regulatory bodies, periodically change the financial accounting and reporting standards that govern the preparation of the Bancorp’s consolidated financial statements. These changes can be hard to predict and can materially impact how it records and reports its financial condition and results of operations. In some cases, the Bancorp could be required to apply a new or revised standard retroactively, resulting in the restatement of prior period financial statements.
The preparation of Fifth Third’s financial statements requires the use of estimates that may vary from actual results.
The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make significant estimates that affect the financial statements. Two of the Bancorp’s most critical estimates are the level of the allowance for credit losses and the valuation of mortgage servicing rights. Due to the inherent nature of these estimates, the Bancorp cannot provide absolute assurance that it will not significantly increase the allowance for credit losses and/or sustain credit losses that are significantly higher than the provided allowance, nor that it will not recognize a significant provision for impairment of its mortgage servicing rights. For more information on the sensitivity of these estimates, refer to the Critical Accounting Policies section.
Fifth Third’s stock price is volatile.
The Bancorp’s stock price has been volatile in the past, and several factors could cause the price to fluctuate substantially in the future. These factors include:
| • | Actual or anticipated variations in earnings |
| • | Changes in analysts’ recommendations or projections |
| • | The Bancorp’s announcements of developments related to its businesses |
| • | Operating and stock performance of other companies deemed to be peers |
| • | New technology used or services offered by traditional and non-traditional competitors |
| • | News reports of trends, concerns and other issues related to the financial services industry |
The Bancorp’s stock price may fluctuate significantly in the future, and these fluctuations may be unrelated to the Bancorp’s performance. General market price declines or market volatility in the future could adversely affect the price of its common stock, and the current market price may not be indicative of future market prices.
Any future acquisitions will dilute current shareholders’ ownership of Fifth Third and may cause Fifth Third to become more susceptible to adverse economic events.
Future business acquisitions could be material to the Bancorp and it may issue additional shares of common stock to pay for those acquisitions, which would dilute current shareholders’ ownership interest. Acquisitions also could require the Bancorp to use substantial cash or other liquid assets or to incur debt. In those events, it could become more susceptible to economic downturns and competitive pressures.
Difficulties in combining the operations of acquired entities with Fifth Third’s own operations may prevent Fifth Third from achieving the expected benefits from its acquisitions.
The Bancorp may not be able to achieve fully the strategic objectives and operating efficiencies in an acquisition. Inherent uncertainties exist in integrating the operations of an acquired entity. In addition, the markets and industries in which the Bancorp and its potential acquisition targets operate are highly competitive. The Bancorp may lose customers or the customers of acquired entities as a result of an acquisition. Fifth Third also may lose key personnel, either from the acquired entity or from itself, as a result of an acquisition. These factors could contribute to Fifth Third not achieving the expected benefits from its acquisitions within desired time frames, if at all.
Fifth Third Bancorp 27
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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Net Interest Income
The relative performance of lending and deposit-raising functions is frequently measured by two statistics – net interest margin and net interest rate spread. Net interest margin is determined by dividing net interest income (FTE) by average interest-earning assets. Net interest rate spread is the difference between the average rate (FTE) earned on interest-earning assets and the average rate paid on interest-bearing liabilities. Net interest margin is greater than the net interest rate spread due to the interest income earned on those assets funded by noninterest-bearing liabilities, or free funding, such as demand deposits and shareholders’ equity.
Table 4 presents the components of net interest income in addition to net interest margin and net interest spread for the three years ended December 31, 2005, 2004 and 2003. Nonaccrual loans and leases and loans held for sale have been included in the average loans and leases balances. Average outstanding securities balances are based on amortized cost with any unrealized gains or losses on available-for-sale securities included in other assets. Table 5 provides the relative impact of changes in the balance sheet and changes in interest rates on net interest income.
The continued flattening of the yield curve resulted in a challenging environment for financial institutions in 2005. The average interest rate spread between the 3-month Treasury bill and the 10-year Treasury note compressed from 287 basis points (“bp”) in 2004 to 107 bp in 2005. At December 31, 2005, this interest rate spread declined to 31 bp. This significant decline illustrates the relative pressure between shorter-term and longer-term funding costs and general security portfolio reinvestment opportunities.
Net interest income (FTE) decreased two percent compared to 2004 as a result of net interest margin contracting 25 bp. The decline in net interest margin occurred despite a six percent increase in average interest-earning assets and a 13% increase in average demand deposits. In terms of mix between volume and yield, net interest income (FTE) decreased seven percent due to the impact of changes in interest rates. The decline in net interest margin largely resulted from the decrease in net interest rate spread attributable to the increased cost of deposits and wholesale funding, the impact of the primarily fixed-rate securities portfolio, the change in mix within the core deposit base and the additional non-core deposit funding resulting from common stock repurchase activity. Net interest rate spread declined 41 bp from 3.17% in 2004 to 2.76% in 2005.
The growth in average loans and leases of $10.7 billion over 2004 outpaced the $7.0 billion growth in core deposits in 2005. The $3.7 billion funding shortfall was more than offset through the $5.6 billion reduction in the average available-for-sale securities portfolio, as the Bancorp continues to reduce its reliance on wholesale funding. For the year, wholesale funding and long-term debt represented 44% of interest-bearing liabilities, down from 48% in 2004. The average securities portfolio represented 27% of interest-earning assets in 2005, down from 35% in the prior year. On an amortized cost basis, the average balance of the available-for-sale securities portfolio decreased 19% from 2004 to $24.4 billion as a result of the balance sheet initiative undertaken in the fourth quarter of 2004 and the 2005 run-off of the securities portfolio in order to fund loan growth in excess of core deposit growth. In 2006, the Bancorp will continue to use cash flows from its available-for-sale securities portfolio to fund its loan and lease growth, as it believes the loan portfolio provides the best reinvestment opportunity.
During 2005, the Bancorp began a strategic shift in its deposit pricing as it moved away from promotional rates towards highly competitive daily rates. As part of this strategy, the Bancorp aggressively increased deposit rates, including focusing on the relative pricing between the more and less liquid deposit products, and directed customers into the right products given their liquidity needs. In 2005, the average rate paid on interest-bearing core deposits increased 93 bp compared to a 186 bp increase in the average federal funds rate, whereas in 2004, the average rate paid on interest-bearing deposits decreased 15 bp compared to a 22 bp increase in the average federal funds rate. The combined results of these actions have been a 45% increase in net new account additions compared to 2004 and a migration of interest checking balances into money market and savings accounts.
In 2005, the cost of interest-bearing core deposits was 2.10%, up from 1.17% in 2004. Despite more aggressive increases in deposit rates during 2005 compared to 2004, the relative cost advantage of interest-bearing core deposits compared to non-core deposit funding increased by 45 bp to 126 bp in 2005. Within interest-bearing core deposits, the money market and other time deposit balances combined to represent 32% of the total in 2005 compared to 26% in 2004. Money market and other time deposit balances generally receive a higher rate of interest than interest checking and savings balances. In 2005, the combined rate paid on money market and other time deposit balances was 2.95% compared to the combined rate of 1.70% on interest checking and savings balances.
TABLE 3: CONDENSED CONSOLIDATED STATEMENTS OF INCOME
| For the years ended December 31 ($ in millions, except per share data) |
2005 |
2004 |
2003 |
2002 |
2001 |
|||||||||
| Interest income (FTE) |
$ | 5,026 | 4,150 | 4,030 | 4,168 | 4,754 | ||||||||
| Interest expense |
2,030 | 1,102 | 1,086 | 1,430 | 2,278 | |||||||||
| Net interest income (FTE) |
2,996 | 3,048 | 2,944 | 2,738 | 2,476 | |||||||||
| Provision for loan and lease losses |
330 | 268 | 399 | 246 | 236 | |||||||||
| Net interest income after provision for loan and lease losses (FTE) |
2,666 | 2,780 | 2,545 | 2,492 | 2,240 | |||||||||
| Noninterest income |
2,500 | 2,465 | 2,483 | 2,183 | 1,788 | |||||||||
| Noninterest expense |
2,927 | 2,972 | 2,551 | 2,337 | 2,453 | |||||||||
| Income from continuing operations before income taxes, minority interest and cumulative effect (FTE) |
2,239 | 2,273 | 2,477 | 2,338 | 1,575 | |||||||||
| Fully taxable equivalent adjustment |
31 | 36 | 39 | 39 | 45 | |||||||||
| Applicable income taxes |
659 | 712 | 786 | 734 | 523 | |||||||||
| Income from continuing operations before minority interest and cumulative effect |
1,549 | 1,525 | 1,652 | 1,565 | 1,007 | |||||||||
| Minority interest, net of tax |
— | — | (20 | ) | (38 | ) | (2 | ) | ||||||
| Income from continuing operations before cumulative effect |
1,549 | 1,525 | 1,632 | 1,527 | 1,005 | |||||||||
| Income from discontinued operations, net of tax |
— | — | 44 | 4 | 4 | |||||||||
| Income before cumulative effect |
1,549 | 1,525 | 1,676 | 1,531 | 1,009 | |||||||||
| Cumulative effect of change in accounting principle, net of tax |
— | — | (11 | ) | — | (7 | ) | |||||||
| Net income |
$ | 1,549 | 1,525 | 1,665 | 1,531 | 1,002 | ||||||||
| Earnings per share, basic |
$ | 2.79 | 2.72 | 2.91 | 2.64 | 1.74 | ||||||||
| Earnings per share, diluted |
2.77 | 2.68 | 2.87 | 2.59 | 1.70 | |||||||||
| Cash dividends declared per common share |
1.46 | 1.31 | 1.13 | .98 | .83 | |||||||||
28 Fifth Third Bancorp
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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
TABLE 4: CONSOLIDATED AVERAGE BALANCE SHEETS AND ANALYSIS OF NET INTEREST INCOME (FTE)
| For the years ended December 31 |
2005 |
2004 |
2003 |
|||||||||||||||||||||||||||
| ($ in millions) |
Average Balance |
Revenue/ Cost |
Average Yield/ Rate |
Average Balance |
Revenue/ Cost |
Average Yield/ Rate |
Average Balance |
Revenue/ Cost |
Average Yield/ Rate |
|||||||||||||||||||||
| Assets |
||||||||||||||||||||||||||||||
| Interest-earning assets: |
||||||||||||||||||||||||||||||
| Loans and leases |
$ | 67,737 | $ | 3,930 | 5.80 | % | $ | 57,042 | $ | 2,860 | 5.01 | % | $ | 52,414 | $ | 2,724 | 5.20 | % | ||||||||||||
| Securities: |
||||||||||||||||||||||||||||||
| Taxable |
24,017 | 1,032 | 4.30 | 29,365 | 1,217 | 4.15 | 27,584 | 1,226 | 4.45 | |||||||||||||||||||||
| Exempt from income taxes |
789 | 58 | 7.39 | 917 | 68 | 7.44 | 1,056 | 77 | 7.26 | |||||||||||||||||||||
| Other short-term investments |
193 | 6 | 2.89 | 315 | 5 | 1.48 | 307 | 3 | .97 | |||||||||||||||||||||
| Total interest-earning assets |
92,736 | 5,026 | 5.42 | 87,639 | 4,150 | 4.73 | 81,361 | 4,030 | 4.95 | |||||||||||||||||||||
| Cash and due from banks |
2,758 | 2,216 | 1,600 | |||||||||||||||||||||||||||
| Other assets |
8,102 | 5,763 | 5,250 | |||||||||||||||||||||||||||
| Allowance for loan and lease losses |
(720 | ) | (722 | ) | (730 | ) | ||||||||||||||||||||||||
| Total assets |
$ | 102,876 | $ | 94,896 | $ | 87,481 | ||||||||||||||||||||||||
| Liabilities and Shareholders’ Equity |
||||||||||||||||||||||||||||||
| Interest-bearing liabilities: |
||||||||||||||||||||||||||||||
| Interest checking |
$ | 18,884 | $ | 314 | 1.66 | % | $ | 19,434 | $ | 174 | .89 | % | $ | 18,679 | $ | 189 | 1.01 | % | ||||||||||||
| Savings |
10,007 | 176 | 1.76 | 7,941 | 58 | .72 | 8,020 | 64 | .79 | |||||||||||||||||||||
| Money market |
5,170 | 140 | 2.71 | 3,473 | 39 | 1.12 | 3,189 | 32 | 1.01 | |||||||||||||||||||||
| Other time deposits |
8,491 | 263 | 3.09 | 6,208 | 162 | 2.62 | 6,426 | 196 | 3.04 | |||||||||||||||||||||
| Certificates - $100,000 and over |
4,001 | 129 | 3.22 | 2,403 | 48 | 1.99 | 3,832 | 63 | 1.65 | |||||||||||||||||||||
| Foreign office deposits |
3,967 | 126 | 3.17 | 4,449 | 58 | 1.31 | 3,862 | 44 | 1.13 | |||||||||||||||||||||
| Federal funds purchased |
4,225 | 138 | 3.26 | 5,896 | 77 | 1.30 | 7,001 | 80 | 1.14 | |||||||||||||||||||||
| Short-term bank notes |
248 | 6 | 2.60 | 1,003 | 15 | 1.46 | 22 | — | 1.06 | |||||||||||||||||||||
| Other short-term borrowings |
5,038 | 138 | 2.74 | 6,640 | 78 | 1.14 | 5,350 | 55 | 1.03 | |||||||||||||||||||||
| Long-term debt |
16,384 | 600 | 3.66 | 13,323 | 393 | 2.95 | 8,747 | 363 | 4.15 | |||||||||||||||||||||
| Total interest-bearing liabilities |
76,415 | 2,030 | 2.66 | 70,770 | 1,102 | 1.56 | 65,128 | 1,086 | 1.67 | |||||||||||||||||||||
| Demand deposits |
13,868 | 12,327 | 10,482 | |||||||||||||||||||||||||||
| Other liabilities |
3,276 | 2,939 | 2,883 | |||||||||||||||||||||||||||
| Total liabilities |
93,559 | 86,036 | 78,493 | |||||||||||||||||||||||||||
| Minority interest |
— | — | 234 | |||||||||||||||||||||||||||
| Shareholders’ equity |
9,317 | 8,860 | 8,754 | |||||||||||||||||||||||||||
| Total liabilities and shareholders’ equity |
$ | 102,876 | $ | 94,896 | $ | 87,481 | ||||||||||||||||||||||||
| Net interest income margin |
$ | 2,996 | 3.23 | % | $ | 3,048 | 3.48 | % | $ | 2,944 | 3.62 | % | ||||||||||||||||||
| Net interest rate spread |
2.76 | 3.17 | 3.28 | |||||||||||||||||||||||||||
| Interest-bearing liabilities to interest-earning assets |
82.40 | 80.75 | 80.05 | |||||||||||||||||||||||||||
The benefit of noninterest-bearing funding increased to 47 bp in 2005 from 31 bp in the prior year due to a $1.5 billion increase in average demand deposits and higher short-term interest rates. The growth in noninterest-bearing funding is a critical component to the future growth in net interest income.
Interest income (FTE) from loans and leases increased $1.1 billion, or 37%, compared to 2004. The increase in average loans and leases in 2005 included growth in commercial loans of $6.8 billion, or 23%. The yield on commercial loans was 5.90% in 2005,
an increase of 103 bp from 2004. Average consumer loans increased by $3.9 billion, or 14%, compared to 2004. The yield on consumer loans was 5.69% in 2005, an increase of 52 bp from 2004.
The interest income (FTE) from investment securities and other short-term investments decreased $194 million, or 15%, in 2005 compared to 2004 due to the previously discussed reduction of the investment securities portfolio. The average yield on taxable securities increased by only 15 bp compared to 2004 largely due to
TABLE 5: CHANGES IN NET INTEREST INCOME (FTE) ATTRIBUTED TO VOLUME AND YIELD/RATE (a)
| For the years ended December 31 |
2005 Compared to 2004 |
2004 Compared to 2003 |
|||||||||||||||||
| ($ in millions) |
Volume |
Yield/Rate |
Total |
Volume |
Yield/Rate |
Total |
|||||||||||||
| Increase (decrease) in interest income: |
|||||||||||||||||||
| Loans and leases |
$ | 582 | 488 | 1,070 | 235 | (99 | ) | 136 | |||||||||||
| Securities: |
|||||||||||||||||||
| Taxable |
(228 | ) | 43 | (185 | ) | 76 | (85 | ) | (9 | ) | |||||||||
| Exempt from income taxes |
(10 | ) | — | (10 | ) | (10 | ) | 1 | (9 | ) | |||||||||
| Other short-term investments |
(2 | ) | 3 | 1 | — | 2 | 2 | ||||||||||||
| Total change in interest income |
342 | 534 | 876 | 301 | (181 | ) | 120 | ||||||||||||
| Increase (decrease) in interest expense: |
|||||||||||||||||||
| Interest checking |
(5 | ) | 145 | 140 | 8 | (23 | ) | (15 | ) | ||||||||||
| Savings |
18 | 100 | 118 | (1 | ) | (5 | ) | (6 | ) | ||||||||||
| Money market |
26 | 75 | 101 | 3 | 4 | 7 | |||||||||||||
| Other time deposits |
68 | 33 | 101 | (7 | ) | (27 | ) | (34 | ) | ||||||||||
| Certificates - $100,000 and over |
42 | 39 | 81 | (26 | ) | 11 | (15 | ) | |||||||||||
| Foreign office deposits |
(7 | ) | 75 | 68 | 7 | 7 | 14 | ||||||||||||
| Federal funds purchased |
(27 | ) | 88 | 61 | (13 | ) | 10 | (3 | ) | ||||||||||
| Short-term bank notes |
(9 | ) | — | (9 | ) | 15 | — | 15 | |||||||||||
| Other short-term borrowings |
(23 | ) | 83 | 60 | 15 | 8 | 23 | ||||||||||||
| Long-term debt |
103 | 104 | 207 | 154 | (124 | ) | 30 | ||||||||||||
| Total change in interest expense |
186 | 742 | 928 | 155 | (139 | ) | 16 | ||||||||||||
| Total change in net interest income |
$ | 156 | (208 | ) | (52 | ) | 146 | (42 | ) | 104 | |||||||||
| (a) | Changes in interest not solely due to volume or yield/rate are allocated in proportion to the absolute amount of change in volume or yield/rate. |
Fifth Third Bancorp 29
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the impact of the fixed-rate securities within the portfolio and the relative stability of longer-term interest rates throughout 2005 and as compared to 2004.
The interest paid on interest-bearing core deposits increased $460 million, or 106%, in 2005 compared to 2004 as a result of a 93 bp increase in cost and a $5.5 billion increase in average balance. The interest paid on long-term debt increased $204 million, or 52%, in 2005 due to a 69 bp increase in the cost of long-term debt and an increase in the average long-term debt outstanding. Average long-term debt increased $3.1 billion in 2005 to reduce the short-term wholesale funding position of the Bancorp. Average short-term wholesale funding declined $2.9 billion, or 14%, compared to 2004. The interest expense associated with wholesale funding increased $264 million, or 96%, due to rising short-term interest rates throughout 2005.
Provision for Loan and Lease Losses
The Bancorp provides as an expense an amount for probable loan and lease losses within the loan portfolio that is based on factors discussed in the Critical Accounting Policies section. The provision is recorded to bring the allowance for loan and lease losses to a level deemed appropriate by the Bancorp. Actual credit losses on loans and leases are charged against the allowance for loan and lease losses. The amount of loans actually removed from the Consolidated Balance Sheets is referred to as charge-offs. Net charge-offs include current charge-offs less recoveries in the current period on previously charged off assets.
The provision for loan and lease losses was $330 million in 2005 compared to $268 million in 2004. The $62 million increase from the prior year is due to the increase in net-charge-offs, which increased from $252 million in 2004 to $299 million in 2005, as well as 17% portfolio loan growth. The increase in net charge-offs was primarily due to $27 million in losses to bankrupt commercial airline carriers and a $15 million increase in consumer loan and lease losses associated with increased personal bankruptcies declared prior to the recently enacted reform legislation. Net charge-offs as a percent of average loans and leases was .45% for the years ended December 31, 2005 and 2004.
Refer to the Credit Risk Management section for further information on the provision for loan and lease losses, net
charge-offs and other factors considered by the Bancorp in assessing the credit quality of its loan and leases and the allowance for loan and lease losses.
Noninterest Income
Overall noninterest income was flat relative to 2004 due to the impact of the 2004 gain on the sales of certain third-party sourced merchant processing contracts and the decline in operating lease revenue. Excluding the impact of these items, noninterest income increased $375 million, or 18%, over 2004 (comparison being provided to supplement an understanding of the fundamental revenue trends). On this basis, nine of the Bancorp’s affiliate markets experienced high single digit or better percentage growth in noninterest revenue.
Electronic payment processing revenue increased $113 million, or 18%, in 2005 as FTPS realized growth across nearly all of its product lines. Revenue comparisons are impacted by the 2004 sales of certain third-party sourced merchant processing contracts. Exclusive of the impact of these transactions, electronic payment processing revenue increased 23% (comparison being provided to supplement an understanding of the fundamental revenue trends). The Bancorp continues to realize strong sales momentum from the addition of new customer relationships in both its merchant services and EFT businesses. Merchant processing revenue increased $46 million, or 15%, attributable to the addition of new customers and resulting increases in merchant transaction volumes, as well as an increase in transaction volume growth on the existing customer base. Excluding the impact of the revenue lost as a result of the 2004 sales of certain third-party sourced merchant processing contracts, merchant processing revenue increased 27% (comparison being provided to supplement an understanding of the fundamental revenue trends). Compared to 2004, EFT revenues, including debit and credit card interchange, increased $67 million, or 21%, in 2005. The Bancorp now handles electronic processing for over 127,000 merchant locations and 1,500 financial institutions.
Service charges on deposits increased $7 million over 2004 primarily due to sales success in corporate treasury management products and retail deposit accounts and modest retail pricing changes. Commercial deposit revenues were flat compared to last
TABLE 6: NONINTEREST INCOME
| For the years ended December 31 ($ in millions) |
2005 |
2004 |
2003 |
2002 |
2001 |
|||||||||||
| Electronic payment processing revenue |
$ | 735 | 622 | 575 | 512 | 347 | ||||||||||
| Service charges on deposits |
522 | 515 | 485 | 431 | 367 | |||||||||||
| Mortgage banking net revenue |
174 | 178 | 302 | 188 | 63 | |||||||||||
| Investment advisory revenue |
355 | 360 | 332 | 325 | 298 | |||||||||||
| Other noninterest income |
620 | 671 | 581 | 580 | 542 | |||||||||||
| Operating lease revenue |
55 | 156 | 124 | — | — | |||||||||||
| Securities gains (losses), net |
39 | (37 | ) | 81 | 114 | 28 | ||||||||||
| Securities gains, net – non-qualifying hedges on mortgage servicing rights |
— | — | 3 | 33 | 143 | |||||||||||
| Total noninterest income |
$ | 2,500 | 2,465 | 2,483 | 2,183 | 1,788 | ||||||||||
| TABLE 7: COMPONENTS OF MORTGAGE BANKING NET REVENUE
|
||||||||||||||||
| For the years ended December 31 ($ in millions) |
2005 |
2004 |
2003 |
2002 |
2001 |
|||||||||||
| Total mortgage banking fees and loan sales |
$ | 238 | 219 | 466 | 386 | 354 | ||||||||||
| Net (losses) gains and mark-to-market adjustments on both settled and outstanding free-standing derivative financial instruments |
(24 | ) | (9 | ) | 14 | 98 | 20 | |||||||||
| Net valuation adjustments and amortization on mortgage servicing rights |
(40 | ) | (32 | ) | (178 | ) | (296 | ) | (311 | ) | ||||||
| Mortgage banking net revenue |
$ | 174 | 178 | 302 | 188 | 63 | ||||||||||
| TABLE 8: COMPONENTS OF OTHER NONINTEREST INCOME
|
||||||||||||||||
| For the years ended December 31 ($ in millions) |
2005 |
2004 |
2003 |
2002 |
2001 |
|||||||||||
| Cardholder fees |
$ | 59 | 48 | 59 | 51 | 50 | ||||||||||
| Consumer loan and lease fees |
50 | 57 | 65 | 70 | 59 | |||||||||||
| Commercial banking revenue |
213 | 174 | 178 | 157 | 125 | |||||||||||
| Bank owned life insurance income |
91 | 61 | 62 | 62 | 52 | |||||||||||
| Insurance income |
31 | 31 | 28 | 55 | 49 | |||||||||||
| Gain on sale of branches |
— | — | — | 7 | 43 | |||||||||||
| Gain on sale of property and casualty insurance product lines |
— | — | — | 26 | — | |||||||||||
| Gain on sales of third-party sourced merchant processing contracts |
— | 157 | — | — | — | |||||||||||
| Other |
176 | 143 | 189 | 152 | 164 | |||||||||||
| Total other noninterest income |
$ | 620 | 671 | 581 | 580 | 542 | ||||||||||
30 Fifth Third Bancorp
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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
year due to a 77% increase in earnings credits on compensating balances as a result of higher short-term interest rates. The overall growth in commercial account relationships offset the negative impact to deposit service charges realized from the increased earnings credits provided to customers. Retail deposit revenues increased three percent due to growth in net new consumer deposit account production. Growth in the number of retail checking account relationships and in deposit balances remains a key focus for the Bancorp for the upcoming year.
Mortgage banking net revenue decreased to $174 million in 2005 from $178 million in 2004. The components of mortgage banking net revenue are shown in Table 7. Mortgage originations increased to $9.9 billion in 2005 compared to $8.4 billion in 2004, resulting in an increase in core mortgage banking fees of $19 million, or nine percent. The general decrease in prepayment speeds in 2005 led to the recovery of $33 million in temporary impairment on the MSR portfolio, following a recovery of $60 million in 2004. Servicing rights are deemed impaired when a borrower’s loan rate is distinctly higher than prevailing rates. Impairment on servicing rights is reversed when the prevailing rates return to a level commensurate with the borrower’s loan rate. Contributing to the decrease in mortgage revenue, the Bancorp recognized a net loss of $23 million in 2005 compared to a loss of $10 million in 2004 related to changes in fair value and settlement of free-standing derivatives purchased to economically hedge the MSR portfolio.
The Bancorp maintains a non-qualifying hedging strategy to manage a portion of the risk associated with changes in value of the MSR portfolio. During 2005, the Bancorp primarily used principal only swaps, interest rate swaps and swaptions to hedge the economic risk of the MSR portfolio as they were deemed to be the best available instruments for several reasons. Principal only swaps hedge the mortgage-LIBOR spread because they appreciate in value as a result of tightening spreads. They also provide prepayment protection by increasing in value when prepayment speeds increase, as opposed to MSRs that lose value in a faster prepayment environment. Receive fixed/pay floating interest rate swaps and swaptions increase in value when interest rates do not increase as quickly as expected. As of December 31, 2005 and 2004, the Bancorp held a combination of free-standing derivatives, including principal only swaps, swaptions and interest rate swaps with a net negative fair value of $6 million and a net positive fair value of $4 million, respectively, on outstanding notional amounts of $1.5 billion and $1.9 billion, respectively. In addition to the derivative positions used to economically hedge the MSR portfolio, the Bancorp began to acquire various securities (primarily principal only strips) during 2005 as an addition to its non-qualifying hedging strategy. Principal only strips increase in value as prepayments speeds increase, thus providing an economic hedge for the MSR portfolio. As of December 31, 2005, the Bancorp’s available-for-sale securities portfolio included $197 million of securities related to the non-qualifying hedging strategy.
The Bancorp believes the 2005 level of mortgage banking contribution to be sustainable with future growth in line with growth in originations.
The Bancorp’s total residential mortgage loans serviced at the end of 2005 and 2004 was $34.0 billion and $30.6 billion, respectively, with $25.7 billion and $23.0 billion, respectively, of residential mortgage loans serviced for others.
Investment advisory revenues were slightly down in 2005 compared to 2004 with increases in mutual fund revenues offset by decreases in retail brokerage, private client and retirement planning
services. The Bancorp continues to focus its sales efforts on integrating services across business lines and working closely with retail and commercial team members to take advantage of a diverse and expanding customer base. The Bancorp is one of the largest money managers in the Midwest and as of December 31, 2005 had over $196 billion in assets under care, $33 billion in assets under management and $12 billion in its proprietary Fifth Third Funds.*
Operating lease revenue declined $101 million from 2004 to $55 million. Operating lease revenues consist of commercial operating lease revenues that increased 49% and consumer operating lease revenues that decreased $103 million to $48 million. Consumer revenues are the result of the consolidation of an SPE in 2003 that was formed for the sole purpose of the sale and subsequent leaseback of leased autos. The consolidation was the result of the Bancorp’s early adoption of FASB Interpretation No. 46 (“FIN 46”). Declines in operating lease revenues will continue in 2006, however to a lesser extent than 2005, as automobile leases continue to mature and are offset by originations of commercial operating leases.
The major components of other noninterest income for each of the last five years are shown in Table 8. Other noninterest income declined eight percent compared to last year as the 2004 results included the pretax gain of approximately $157 million on the sale of certain third-party sourced merchant processing contracts. Excluding the impact of the gain, other noninterest income increased 20% (comparisons being provided to supplement an understanding of the fundamental revenue trends). The commercial banking revenue component of other noninterest income grew 22% to $213 million led by growth in international revenue, which includes foreign currency services and letter of credit fee revenue, and syndication fees. Compared to 2004, total international revenue increased 15% to $120 million and syndication fees increased 49% to $69 million. Bank owned life insurance (“BOLI”) income increased 48% to $91 million as a result of the increase in the Bancorp’s BOLI investment. The growth in the other component of other noninterest income was primarily due to a $24 million increase in customer interest rate derivative revenue.
Noninterest Expense
During 2005, the Bancorp has continued its investment in the expansion of the retail distribution network, growth in the sales force and in the information technology infrastructure. Operating expense levels are often measured using the efficiency ratio (noninterest expense divided by the sum of net interest income (FTE) and noninterest income), which was 53.2% and 53.9% for 2005 and 2004, respectively. The Bancorp has continued to focus on efficiency initiatives as part of its core emphasis on operating leverage and views its recent investments, including in the information technology infrastructure, as its platform for future growth and increasing expense efficiency.
Total noninterest expense decreased two percent in 2005 compared to 2004. Comparison to the prior year is impacted by a $247 million charge related to the early retirement of approximately $2.8 billion of long-term debt in the fourth quarter of 2004 and a $78 million charge related to the early retirement of approximately $1 billion of Federal Home Loan Bank (“FHLB”) advances in the second quarter of 2004. Exclusive of the impact of the debt termination charges, total noninterest expense increased by $280 million, or 11%, over 2004 due to increases in marketing, information technology, volume-related bankcard costs and the significant investments in the sales force and retail distribution network. Of the $280 million increase, 86% occurred in the
| * | FIFTH THIRD FUNDS® PERFORMANCE DISCLOSURE |
Fifth Third Funds investments are: NOT INSURED BY THE FDIC or any other government agency, are not deposits or obligations of, or guaranteed by, any bank, the distributor or of the Funds any of their respective affiliates, and involve investment risks, including the possible loss of the principal amount invested. An investor should consider the fund’s investment objectives, risks and charges and expenses carefully before investing or sending money. The Funds’ prospectus contains this and other important information about the Funds. To obtain a prospectus or any other information about Fifth Third Funds, please call 1-800-282-5706 or visit www.53.com. Please read the prospectus carefully before investing. Fifth Third Funds are distributed by Fifth Third Funds Distributor, Inc., 3435 Stelzer Road, Columbus, Ohio 43219.
Fifth Third Bancorp 31
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TABLE 9: NONINTEREST EXPENSE
| For the years ended December 31 ($ in millions) |
2005 |
2004 |
2003 |
2002 |
2001 | ||||||
| Salaries, wages and incentives |
$ | 1,133 | 1,018 | 1,031 | 1,029 | 959 | |||||
| Employee benefits |
283 | 261 | 240 | 201 | 148 | ||||||
| Equipment expense |
105 | 84 | 82 | 79 | 91 | ||||||
| Net occupancy expense |
221 | 185 | 159 | 142 | 146 | ||||||
| Operating lease expense |
40 | 114 | 94 | — | — | ||||||
| Merger-related charges |
— | — | — | — | 349 | ||||||
| Other noninterest expense |
1,145 | 1,310 | 945 | 886 | 760 | ||||||
| Total noninterest expense |
$ | 2,927 | 2,972 | 2,551 | 2,337 | 2,453 | |||||
|
TABLE 10: COMPONENTS OF OTHER NONINTEREST EXPENSE
|
|||||||||||
| For the years ended December 31 ($ in millions) |
2005 |
2004 |
2003 |
2002 |
2001 | ||||||
| Marketing and communications |
$ | 126 | 99 | 99 | 96 | 102 | |||||
| Postal and courier |
50 | 49 | 49 | 48 | 50 | ||||||
| Bankcard |
271 | 224 | 197 | 170 | 117 | ||||||
| Intangible and goodwill amortization |
46 | 29 | 40 | 37 | 71 | ||||||
| Franchise and other taxes |
37 | 32 | 33 | 30 | 18 | ||||||
| Loan and lease |
89 | 82 | 106 | 91 | 62 | ||||||
| Printing and supplies |
35 | 33 | 35 | 37 | 40 | ||||||
| Travel |
54 | 41 | 35 | 38 | 34 | ||||||
| Information technology and operations |
114 | 87 | 76 | 54 | 56 | ||||||
| Debt termination |
— | 325 | 20 | — | 1 | ||||||
| Other |
323 | 309 | 255 | 285 | 209 | ||||||
| Total other noninterest expense |
$ | 1,145 | 1,310 | 945 | 886 | 760 | |||||
Florida, Chicago, Detroit and Tennessee markets, as the Bancorp has focused investments in the markets with the greatest growth opportunities.
Salaries, wages and incentives increased 11% in 2005 compared to 2004 due to sales force expansion and the addition of First National employees. Compared to 2004, average sales personnel increased by 1,400. As of December 31, 2005, the Bancorp employed 22,901 employees, of which 5,741 were officers and 2,820 were part-time employees. Full time equivalent employees totaled 21,681 as of December 31, 2005 compared to 19,659 as of December 31, 2004.
Net periodic pension costs, included in employee benefits expense on the Bancorp’s Consolidated Statements of Income, declined to $14 million in 2005 compared to $16 million in 2004 primarily due to lower interest and settlement costs. The Bancorp’s pension expense is based upon specific actuarial assumptions, including the expected long-term rate of return on plan assets and the discount rate. At the beginning of 2005, the expected long-term rate of return was 8.00% and the discount rate was 5.85%. Lowering both the expected rate of return on plan assets and the discount rate by 0.25% would have increased the 2005 pension expense by approximately $1 million. See Note 23 of the Notes to the Consolidated Financial Statements for further discussion of the Bancorp’s pension plans.
Net occupancy expenses increased 19% in 2005 over 2004 due to the addition of 63 new banking centers that did not involve the relocation or consolidation of existing facilities, in addition to the 70 net additional banking centers added as a result of the First National acquisition. Operating lease expense declined 65% from 2004. Declines in operating lease expenses will continue in 2006,
however to a lesser extent than 2005, as automobile leases continue to mature and are offset by originations of commercial operating leases.
Total other noninterest expense decreased by 13% in 2005 compared to 2004. Excluding the impact of the debt termination charges, total other noninterest expense increased by $160 million, or 16%, from 2004 primarily due to increases in marketing and communications, volume-related bankcard costs and information technology expenses (comparison being provided to supplement an understanding of fundamental expense trends). Marketing and communications increased 27% compared to 2004 primarily due to increased spending on deposit campaign initiatives through direct mailings and media advertising. Bankcard expense increased 21% compared to last year due to an increase in the number of merchant and retail customers as well as continuing organic growth in debit and credit card usage causing a corresponding increase in debit transaction costs and membership fees. Information technology and operations costs increased 31% primarily due to continued investment focused on improving the Bancorp’s customer service capabilities and processes. Information technology investments included, among others, an improved customer relationship management solution that creates a single customer view across the Bancorp’s key operating systems, a new teller automation platform that provides employees with better access to information to improve customer service while eliminating certain manual processes and paper forms and customer service resolution tracking software.
Overall, the Bancorp expects low to mid-single digit percentage growth in expenses in 2006.
TABLE 11: APPLICABLE INCOME TAXES
| For the years ended December 31 ($ in millions) |
2005 |
2004 |
2003 |
2002 |
2001 | |||||||
| Income from continuing operations before income taxes, minority interest and cumulative effect |
$ | 2,208 | 2,237 | 2,438 | 2,299 | 1,530 | ||||||
| Applicable income taxes |
659 | 712 | 786 | 734 | 523 | |||||||
| Effective tax rate |
29.9 | % | 31.8 | 32.3 | 31.9 | 34.2 | ||||||
Applicable Income Taxes
The Bancorp’s income from continuing operations before income taxes, applicable income tax expense and effective tax rate for each of the periods indicated are shown in Table 11. Applicable income tax expense for all periods includes the benefit from tax-exempt income, tax-advantaged investments and general business tax credits, partially offset by the effect of nondeductible expenses. In 2005, several factors caused the decrease in the effective tax rate,
including the favorable resolution of certain income tax examinations and an increase in investments in a number of tax-favored assets, which resulted in increases in general business tax credits and tax-exempt income. In 2006, the Bancorp expects the effective tax rate to return to a more normalized historical level.
32 Fifth Third Bancorp
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Comparison of 2004 with 2003
Net income in 2004 decreased to $1.5 billion compared to $1.7 billion in 2003. Diluted earnings per common share were $2.68 compared to $2.87. In 2004, return on average assets was 1.61% and return on average shareholders’ equity was 17.2% versus 1.90% and 19.0%, respectively, in 2003. Earnings in 2004 were negatively impacted by initiatives undertaken to better position the balance sheet for market conditions, including debt termination charges and securities losses totaling $404 million pre-tax ($259 million after-tax). Earnings in 2004 were positively impacted by a $157 million pre-tax ($91 million after-tax) gain resulting from the sale of certain third-party sourced merchant processing contracts.
Net interest income (FTE) was $3.0 billion in 2004 compared to $2.9 billion in 2003. The net interest margin decline to 3.48% in 2004 from 3.62% in 2003 was primarily attributable to the prolonged low interest rate environment in the first half of 2004 and interest-bearing liabilities repricing more quickly than interest-earning assets in response to rising interest rates in the second half of 2004. The decline in net interest margin occurred despite an eight percent increase in average interest-earning assets from 2003 to 2004.
Noninterest income in 2004 was down slightly compared to 2003. Increases in service charges on deposits and electronic payment processing and investment advisory revenues were mitigated by a decrease in mortgage banking net revenue. The decrease in mortgage banking net revenue was a result of the record high level of refinancing activity seen in 2003.
Noninterest expense totaled $3.0 billion in 2004 compared to $2.6 billion in 2003. The increase primarily resulted from the previously discussed debt termination charges in 2004 totaling $325 million. Remaining increases primarily resulted from the expansion of the sales force and investment in additional banking centers.
The provision for loan and lease losses was $268 million in 2004 compared to $399 million in 2003. The decrease in the provision is due to the $60 million decrease in net charge-offs, from $312 million, or .63% of average loans and leases outstanding, in 2003 to $252 million, or .45% in 2004 as well as a decrease in the overall assessed allowance for loan and lease losses resulting from the consideration of historical and anticipated loss rates in the portfolio. The total allowance for loan and lease losses as a percent of total loans and leases was 1.19% at December 31, 2004 compared to 1.33% at December 31, 2003.
The Bancorp operates four main business segments: Commercial Banking, Retail Banking, Investment Advisors and Processing Solutions. Further detailed financial information on each business segment is included in Note 29 of the Notes to the Consolidated Financial Statements. For acquisitions accounted for under the purchase method, management “pools” historical results to improve comparability with the current period. For the prior periods presented, the income and average assets of First National have been included in the respective segments and are then eliminated in the Acquisitions caption to agree to the prior period’s reported results.
Results of the Bancorp’s business segments are presented based on its management structure and management accounting practices. The structure and practices are specific to the Bancorp; therefore, the financial results of the Bancorp’s business segments are not necessarily comparable with similar information for other financial institutions. The Bancorp refines its methodologies from time to time as management accounting practices are improved and businesses change. Revisions to the Bancorp’s methodologies are applied on a retroactive basis.
The Bancorp manages interest rate risk centrally at the corporate level by employing a funds transfer pricing (“FTP”) methodology. This methodology insulates the lines of business from interest rate risk, enabling them to focus on servicing customers through loan originations and deposit taking. The FTP system assigns charge rates and credit rates to classes of assets and liabilities, respectively, based on expected duration. The Bancorp has not changed the conceptual application of FTP during 2005 or 2004. The net impact of the FTP methodology is included in Other/Eliminations.
The financial results of the business segments include allocations for shared services and headquarters expenses. Even with these allocations, the financial results are not necessarily indicative of the business segments’ financial condition and results of operations as if they were to exist as independent entities. Additionally, the business segments form synergies by taking advantage of cross-sell opportunities and when funding operations
by accessing the capital markets as a collective unit. Net income by business segment is summarized in Table 12.
Commercial Banking
Commercial Banking provides a comprehensive range of financial services and products to large and middle-market businesses, governments and professional customers. In addition to the traditional lending and depository offerings, Commercial Banking products and services include, among others, cash management, foreign exchange and international trade finance, derivatives and capital markets services, asset-based lending, real estate finance, public finance, commercial leasing and syndicated finance.
Net income increased $79 million compared to 2004 largely as a result of loan and deposit growth and success in customer interest rate and foreign exchange derivative sales. Average loans and leases included in the commercial banking segment increased 12% over 2004, to $30.0 billion, due to growth in commercial and industrial loans, commercial mortgage loans and construction loans. Average core deposits increased to $14.4 billion in 2005 from $12.3 billion in 2004. The increase in average core deposits and loans and the related net FTP impact led to a $162 million increase in net interest income compared to the same period last year.
Noninterest income increased $85 million compared to 2004 largely due to an increase in customer interest rate derivative sales and international service revenue. Revenue from customer interest rate derivatives sales increased $24 million over 2004 and international service revenue, which includes letters of credit and foreign currency services, increased $16 million. Increases in these categories were partially offset by the impact of increased earnings credits, as a result of higher short-term interest rates, on service charges on deposits.
Noninterest expense increased $107 million in 2005 compared to 2004 as a result of sales force additions and higher information technology expenses. Investment in the sales force throughout 2004 and 2005 resulted in an 18% increase in total full-time equivalent sales employees from 1,184 to 1,401 at the end of 2005.
TABLE 12: BUSINESS SEGMENT NET INCOME
| For the years ended December 31 ($ in millions) |
2005 |
2004 |
|||||
| Commercial Banking |
$ | 784 | 705 | ||||
| Retail Banking |
1,091 | 1,063 | |||||
| Investment Advisors |
127 | 118 | |||||
| Processing Solutions |
120 | 207 | |||||
| Other/Eliminations |
(573 | ) | (556 | ) | |||
| Acquisitions |
— | (12 | ) | ||||
| Net income |
$ | 1,549 | 1,525 | ||||
Fifth Third Bancorp 33
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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The provision for loan and lease losses increased $23 million over 2004 primarily as a result of the previously discussed losses to bankrupt commercial airline carriers.
Retail Banking
Retail Banking provides a full range of deposit and loan and lease products to individuals and small businesses, and includes the branch network, consumer finance and mortgage banking. Through 1,119 banking centers, Retail Banking offers depository and loan products, such as checking and savings accounts, home equity lines of credit, credit cards and loans for automobile and other personal financing needs, as well as products designed to meet the specific needs of small businesses, including cash management services. Consumer finance services generally include the Bancorp’s indirect lending activities, which include loans to consumers through dealers and federal and private student education loans. Mortgage banking activities include the origination, retention and servicing of mortgage loans, sales and securitizations of mortgage loans or pools of mortgage loans and all associated hedging activities.
Net income increased $28 million compared to 2004. Average loans and leases increased 12% to $33.5 billion compared to 2004 as a result of increases in direct installment and residential mortgage, up 15% and 22%, respectively. Average core deposits increased three percent to $37.8 billion compared to 2004 with double-digit increases in savings, money market, demand deposits and consumer time deposits mitigated by a 15% decrease in interest checking. As a result of the growth in average loans and core deposits and the related net FTP impact, net interest income increased 11% compared to 2004.
Noninterest income declined seven percent from 2004. Increases in electronic payment processing revenue from bankcard interchange, up 35% over 2004, were offset by slight decreases in consumer and business fees and mortgage banking net revenue and a $103 million decrease in operating lease revenue from the continued maturity of consumer automobile leases.
Noninterest expense increased four percent compared to 2004 as lower operating lease expenses partially offset the increased employee related expenses, net occupancy costs resulting from the increase in banking centers and higher information technology expenses. Since 2004, acquisitions have accounted for 74 of the 108 net new banking centers that did not involve relocation or consolidation of existing facilities, complementing the ongoing de-novo growth. The Bancorp continues to position itself for sustained long-term growth through new banking center additions in key markets.
The retail business segment was also affected by increased personal bankruptcies declared prior to the recently enacted reform legislation, which resulted in an increase in net charge-offs of approximately $15 million above recent trends. Overall, the provision for loan and lease losses increased by $27 million over 2004.
Investment Advisors
Investment Advisors provides a full range of investment alternatives for individuals, companies and not-for-profit organizations. Investment Advisors primary services include trust, institutional, retirement, private client, asset management and
broker-dealer services. Fifth Third Securities, Inc., an indirect wholly-owned subsidiary of the Bancorp, offers full service retail brokerage services to individual clients. Fifth Third Asset Management, Inc., an indirect wholly-owned subsidiary of the Bancorp, provides asset management services and also advises the Bancorp’s proprietary family of mutual funds.
Net income increased eight percent to $127 million compared to 2004. The increase resulted from a 26% improvement in net interest income due to strong average loan and core deposit growth, up 23% and 13%, respectively. Total average loans were $2.6 billion and total average core deposits were $4.0 billion in 2005.
Noninterest income declined three percent from 2004 due to a decline in retail brokerage and retirement planning service revenues. Noninterest expense increased five percent largely as a result of increased sales force and information technology investments. In order to capitalize on an expanding customer base and additional growth opportunities, 91 full-time equivalent sales employees have been added since the end of 2004.
Processing Solutions
Fifth Third Processing Solutions provides electronic funds transfer, debit, credit and merchant transaction processing, operates the Jeanie® ATM network and provides other data processing services to affiliated and unaffiliated customers.
Net income decreased $87 million compared to 2004 largely due to the $157 million pretax gain resulting from the sale of certain third-party sourced merchant processing contracts in the prior year. Excluding the impact of the sale, net income increased by approximately 12% due to strong revenue growth across nearly all lines of business (comparison being provided to supplement an understanding of the fundamental trends). EFT revenue was up 19% over last year primarily due to new customer additions. Merchant revenue increased 15% due to increased volume at existing customers and new customer additions.
Noninterest expense was up largely due to sales force additions and information technology investments. Trends seen in 2005 are representative of strong continuing momentum in attracting new customer relationships and good results in the level of retail sales activity. The Bancorp continues to see significant opportunities to attract new financial institution customers and retailers within this segment.
Other/Eliminations
Other/Eliminations includes the unallocated portion of the investment portfolio, certain non-core deposit funding, unassigned equity and certain support activities and other items not attributed to the business segments.
The results of Other/Eliminations were negatively impacted by a decrease of $194 million in interest income from the investment securities portfolio from 2004 due primarily to the sale of approximately $6.4 billion in investment securities in the fourth quarter of 2004 as a result of the balance sheet repositioning. A $468 million increase in interest expense from wholesale funding and other borrowings in 2005 from 2004 also negatively impacted this category. The increase in interest expense resulted from the average interest rate on wholesale funding and other borrowings increasing from 1.98% in 2004 to 3.36% in 2005.
34 Fifth Third Bancorp
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The Bancorp’s 2005 fourth quarter earnings per diluted share were $.60 compared to $.31 per diluted share for the same period in 2004. Fourth quarter net income totaled $332 million compared to $176 million in the same quarter last year. Return on average assets and return on average equity were 1.27% and 13.9%, respectively, compared to 0.72% and 7.6% in 2004’s fourth quarter. Fourth quarter 2004 earnings were negatively impacted by $326 million in total pre-tax ($208 million after-tax) debt termination charges and securities losses, or $.37 per diluted share, related to the balance sheet initiatives undertaken. The Bancorp’s efficiency ratio was 55.6% in the fourth quarter compared to 76.0% last year and 53.5% in the previous quarter.
Compared to the fourth quarter of 2004, net interest income (FTE) decreased two percent, despite five percent growth in average earning assets, due to a 24 bp decline in the net interest margin (FTE). Compared to the third quarter of 2005, net interest income (FTE) decreased by $10 million due to five basis points of contraction in net interest margin (FTE). The decline in net interest margin in the fourth quarter was primarily the result of the higher cost of wholesale funding relative to previous periods.
Improved performance in certain business line revenue segments resulted in good noninterest income performance in the fourth quarter of 2005. Overall noninterest income, excluding operating lease revenues and securities gains and losses, increased by 18% over the same quarter last year and 16% on an annualized sequential basis.
Electronic payment processing revenues increased 16% over the same quarter last year as a result of continuing momentum in attracting new customer relationships and moderated by slower growth in the level of retail sales transaction volumes in the fourth quarter of 2005.
Sales of retail deposit accounts and corporate treasury management products led to an increase in deposit service revenues of six percent over the same quarter last year. Retail deposit revenues strengthened in the latter half of 2005 and increased by seven percent over the same quarter last year. Commercial deposit revenues increased by three percent over the same quarter last year with good growth in the number of relationships mitigated by the impacts of higher earnings credits on commercial deposit accounts. Compared to the third quarter of 2005, deposit service revenues declined modestly primarily due to a decrease in consumer overdraft related revenues.
Investment advisory revenues increased by five percent over the same quarter last year. The Bancorp continues to focus its efforts on improving execution in retail brokerage and growing the institutional money management business by improving penetration and cross-sell in our large middle market commercial customer base.
Mortgage banking net revenue totaled $42 million in the fourth quarter compared to $24 million in 2004’s fourth quarter. Mortgage originations remained strong and totaled $2.5 billion in the fourth quarter versus $2.9 billion last quarter and $2.0 billion in the fourth quarter of last year. Fourth quarter mortgage banking net service revenue was comprised of $65 million in total mortgage banking fees and loan sales, less $13 million in amortization and valuation adjustments on mortgage servicing rights and less $10 million of losses and mark-to-market adjustments on both settled and outstanding free-standing derivative financial instruments.
Other noninterest income totaled $165 million in the fourth quarter compared to $125 million in the same quarter last year. Other noninterest income increased by 32% primarily due to strong growth in commercial banking revenues, customer interest rate derivative sales, bank owned life insurance and cardholder fees. Compared to the third quarter of 2005, other noninterest income increased by $20 million due to very strong growth in commercial banking revenues and customer interest rate derivative sales.
Total noninterest expense decreased by 18% compared to the same quarter last year. Comparisons to the prior year quarter are impacted by the previously disclosed $247 million charge related to the early retirement of approximately $2.8 billion of long-term debt in the fourth quarter of 2004. Exclusive of the impact of this termination charge, total noninterest expense increased by 11% in the fourth quarter primarily due to increases in sales force headcount, information technology and occupancy expenditures related to the addition of 63 de-novo banking centers in 2005 that did not involve relocation. Compared to the third quarter of 2005, total noninterest expense increased by $31 million due to growth in volume-related bankcard costs, approximately $9 million in fraud related expenses and approximately $10 million in sales tax related expense.
Fourth quarter credit quality trends reflect an elevated level of net charge-offs associated with approximately $27 million in previously discussed losses to bankrupt commercial airline carriers and a $15 million increase in consumer loan and lease losses associated with increased personal bankruptcies declared prior to the recently enacted reform legislation. Net charge-offs as a percentage of average loans and leases were 67 bp in the fourth quarter, compared to 38 bp last quarter and 44 bp in the fourth quarter of 2004. Net charge-offs were $117 million in the fourth quarter, compared to $65 million in the same quarter last year and $64 million in the third quarter of 2005. The provision for loan and lease losses totaled $134 million in the fourth quarter compared to $65 million in the same quarter last year and $69 million in the third quarter of 2005.
Fifth Third Bancorp 35
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TABLE 13: COMPONENTS OF TOTAL LOANS AND LEASES (INCLUDING HELD FOR SALE)
| As of December 31 ($ in millions) |
2005 |
2004 |
2003 |
2002 |
2001 | ||||||
| Commercial loans and leases: |
|||||||||||
| Commercial |
$ | 19,299 | 16,058 | 14,226 | 12,786 | 10,909 | |||||
| Mortgage |
9,188 | 7,636 | 6,894 | 5,885 | 6,085 | ||||||
| Construction |
6,342 | 4,348 | 3,301 | 3,009 | 3,103 | ||||||
| Leases |
3,698 | 3,426 | 3,264 | 3,019 | 2,487 | ||||||
| Total commercial loans and leases |
38,527 | 31,468 | 27,685 | 24,699 | 22,584 | ||||||
| Consumer loans and leases: |
|||||||||||
| Installment |
21,250 | 18,093 | 17,429 | 14,584 | 12,138 | ||||||
| Mortgage and construction |
8,991 | 7,912 | 5,865 | 7,123 | 6,815 | ||||||
| Credit card |
866 | 843 | 762 | 537 | 448 | ||||||
| Leases |
1,595 | 2,051 | 2,448 | 2,343 | 1,743 | ||||||
| Total consumer loans and leases |
32,702 | 28,899 | 26,504 | 24,587 | 21,144 | ||||||
| Total loans and leases |
$ | 71,229 | 60,367 | 54,189 | 49,286 | 43,728 | |||||
Loans and Leases
Total loans and leases increased 18% compared to December 31, 2004. The Bancorp has experienced 10% or better average loan growth in both the consumer and commercial categories as well as at more than half of its affiliate markets.
Table 13 summarizes the total commercial and consumer loans and leases by major category as of the end of the last five fiscal years. Total commercial loans and leases increased 22% compared to December 31, 2004. Commercial loan comparisons to the prior year are impacted by $2.8 billion of commercial loans obtained in the First National acquisition in 2005. Excluding the impact of the acquisition, commercial loans and leases increased 14% compared to December 31, 2004 (comparison being provided to supplement an understanding of the fundamental lending trends). The growth in commercial loans was partially the result of an increase in overall line commitments, as line utilization remained at a level similar to 2004.
Total consumer loans increased 13% compared to December 31, 2004. Consumer loan comparisons to the prior year are impacted by the acquisition of $1.1 billion of consumer loans in the First National acquisition. Excluding the acquired loans, consumer loans and leases increased nine percent compared to December 31, 2004 (comparison being provided to supplement an understanding of the fundamental lending trends). The Bancorp is continuing to devote significant focus on producing retail-based loan originations given the attractive yields available in these products. Residential mortgage and construction loans, including held for sale, increased 14% compared to December 31, 2004. Excluding the impact of the acquisition, residential mortgage and construction loans increased four percent compared to December 31, 2004 (comparison being provided to supplement an understanding of the fundamental lending trends). Comparisons to prior years are dependent upon the volume and timing of originations as well as the timing of loan sales. Residential mortgage originations totaled $9.9 billion in 2005 compared to $8.4 billion in 2004.
Consumer lease balances decreased 22% in 2005 compared to 2004 largely resulting from continued competition from captive finance companies offering promotional lease rates and an overall increased emphasis on growth in other elements of the consumer lending business. The acquisition of First National did not have a material impact on consumer lease balances.
On an average basis, commercial loans and leases increased $6.8 billion, or 23%, compared to 2004 with the Bancorp experiencing double-digit growth in the majority of its markets, including 15% or greater growth in Chicago, Florida, Indianapolis, Lexington and Ohio Valley. The increase in average commercial loans and leases was primarily driven by strong growth in commercial construction loans, commercial and industrial loans and commercial mortgages. Commercial loan comparisons to the prior year are impacted by the First National acquisition in 2005 and the Franklin Financial acquisition in 2004. Excluding the impact of the acquisitions, average commercial loans and leases increased $3.8 billion, or 13%, compared to 2004 (comparison being provided to supplement an understanding of the fundamental lending trends).
On an average basis, consumer loans and leases increased $3.9 billion, or 14%, compared to 2004 with the Bancorp experiencing 15% or greater growth in its Florida, Nashville, Cleveland and Cincinnati markets. The growth in average consumer loans and leases was a result of double-digit growth in residential mortgage and construction loans and consumer installment loans mitigated by decreases in consumer leases. Consumer loan comparisons to the prior year are impacted by the First National acquisition in 2005, the Franklin Financial acquisition in 2004 and the securitization and sale of $750 million of automotive loans in 2004. Excluding the acquired loans and the automotive loan securitization, average consumer loans and leases increased $3.0 billion, or 11%, compared to 2004 (comparison being provided to supplement an understanding of the fundamental lending trends).
TABLE 14: COMPONENTS OF AVERAGE TOTAL LOANS AND LEASES
| For the years ended December 31 ($ in millions) |
2005 |
2004 |
2003 | ||||
| Commercial loans and leases: |
|||||||
| Commercial |
$ | 18,241 | 14,908 | 13,672 | |||
| Mortgage |
8,923 | 7,391 | 6,299 | ||||
| Construction |
5,525 | 3,807 | 3,097 | ||||
| Leases |
3,495 | 3,296 | 3,037 | ||||
| Total commercial loans and leases (including held for sale) |
36,184 | 29,402 | 26,105 | ||||
| Consumer loans and leases: |
|||||||
| Installment |
19,952 | 17,755 | 16,343 | ||||
| Mortgage and construction |
8,982 | 6,801 | 6,880 | ||||
| Credit card |
797 | 787 | 591 | ||||
| Leases |
1,822 | 2,297 | 2,495 | ||||
| Total consumer loans and leases (including held for sale) |
31,553 | 27,640 | 26,309 | ||||
| Total loans and leases (including held for sale) |
$ | 67,737 | 57,042 | 52,414 | |||
| Total portfolio loans and leases (excluding held for sale) |
$ | 66,685 | 55,951 | 49,700 | |||
36 Fifth Third Bancorp
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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Investment Securities
As of December 31, 2005, total investment securities decreased 10% to $22.4 billion from $25.0 billion at December 31, 2004, as the Bancorp continues its efforts to reduce the level of securities on the balance sheet. The increased rate environment resulted in net unrealized losses on the available-for-sale securities portfolio increasing to $609 million at December 31, 2005 from $114 million last year. The Bancorp continues to respond to the interest rate environment by using cash flows from the security portfolio to fund loan growth. At December 31, 2005, 17% of the debt securities in the available-for-sale portfolio were adjustable-rate instruments, compared to 14% at December 31, 2004. The estimated weighted-average life of
the debt securities in the available-for-sale portfolio at December 31, 2005 was 4.3 years compared to 4.4 years at December 31, 2004. At December 31, 2005, the fixed-rate securities within the available-for-sale securities portfolio had an estimated weighted-average life of 4.2 years and a weighted-average yield of 4.44%.
Information presented in Table 15 is on a weighted-average life basis, anticipating future prepayments. Yield information is presented on an FTE basis and is computed using historical cost balances. Maturity and yield calculations for the total available-for-sale and other securities portfolio exclude equity securities that have no stated yield or maturity.
TABLE 15: CHARACTERISTICS OF AVAILABLE-FOR-SALE AND OTHER SECURITIES
| As of December 31, 2005 ($ in millions) |
Amortized Cost |
Fair Value |
Weighted-Average Life (in years) |
Weighted-Average Yield |
|||||||
| U.S. Treasury and Government agencies: |
|||||||||||
| Average life of one year or less |
$ | 3 | $ | 3 | .2 | 2.16 | % | ||||
| Average life 1 – 5 years |
— | — | — | — | |||||||
| Average life 5 – 10 years |
498 | 477 | 7.4 | 3.71 | |||||||
| Average life greater than 10 years |
5 | 5 | 13.2 | 5.09 | |||||||
| Total |
506 | 485 | 7.4 | 3.71 | |||||||
| U.S. Government sponsored agencies: |
|||||||||||
| Average life of one year or less |
105 | 105 | .2 | 3.39 | |||||||
| Average life 1 – 5 years |
1,577 | 1,526 | 2.8 | 3.69 | |||||||
| Average life 5 – 10 years |
352 | 334 | 5.5 | 4.07 | |||||||
| Average life greater than 10 years |
— | — | — | — | |||||||
| Total |
2,034 | 1,965 | 3.2 | 3.74 | |||||||
| Obligations of states and political subdivisions (a): |
|||||||||||
| Average life of one year or less |
84 | 85 | .6 | 8.41 | |||||||
| Average life 1 – 5 years |
439 | 452 | 3.2 | 7.55 | |||||||
| Average life 5 – 10 years |
131 | 136 | 6.1 | 7.21 | |||||||
| Average life greater than 10 years |
3 | 3 | 11.7 | 7.59 | |||||||
| Total |
657 | 676 | 3.5 | 7.59 | |||||||
| Agency mortgage-backed securities: |
|||||||||||
| Average life of one year or less |
40 | 41 | .8 | 6.29 | |||||||
| Average life 1 – 5 years |
11,581 | 11,255 | 3.6 | 4.40 | |||||||
| Average life 5 – 10 years |
4,506 | 4,341 | 6.2 | 4.67 | |||||||
| Average life greater than 10 years |
— | — | — | — | |||||||
| Total |
16,127 | 15,637 | 4.4 | 4.48 | |||||||
| Other bonds, notes and debentures (b): |
|||||||||||
| Average life of one year or less |
83 | 84 | .2 | 8.37 | |||||||
| Average life 1 – 5 years |
1,081 | 1,060 | 3.0 | 4.52 | |||||||
| Average life 5 – 10 years |
938 | 916 | 6.8 | 5.02 | |||||||
| Average life greater than 10 years |
17 | 17 | 22.6 | 3.74 | |||||||
| Total |
2,119 | 2,077 | 4.8 | 4.89 | |||||||
| Other securities (c) |
1,090 | 1,084 | |||||||||
| Total available-for-sale and other securities |
$ | 22,533 | $ | 21,924 | 4.3 | 4.53 | % | ||||
| (a) | Taxable-equivalent yield adjustments included in above table are 2.83%, 2.54%, 2.43%, 2.56% and 2.55% for securities with an average life of one year or less, 1-5 years, 5-10 years, greater than 10 years and in total, respectively. |
| (b) | Other bonds, notes, and debentures consist of non-agency mortgage backed securities, certain other asset backed securities (primarily automobile and commercial loan backed securities) and corporate bond securities. |
| (c) | Other securities consist of FHLB and Federal Reserve Bank restricted stock holdings that are carried at cost, Federal Home Loan Mortgage Corporation (“FHLMC”) preferred stock holdings, certain mutual fund holdings and equity security holdings. |
TABLE 16: COMPONENTS OF INVESTMENT SECURITIES (AMORTIZED COST BASIS)
| As of December 31 ($ in millions) |
2005 |
2004 |
2003 |
2002 |
2001 | ||||||
| Available-for-sale: |
|||||||||||
| U.S. Treasury and Government agencies |
$ | 506 | 503 | 838 | 303 | 188 | |||||
| U.S. Government sponsored agencies |
2,034 | 2,036 | 3,877 | 2,308 | 1,142 | ||||||
| Obligations of states and political subdivisions |
657 | 823 | 922 | 1,033 | 1,198 | ||||||
| Agency mortgage-backed securities |
16,127 | 17,571 | 21,101 | 19,328 | 15,287 | ||||||
| Other bonds, notes and debentures |
2,119 | 2,862 | 1,401 | 1,084 | 1,872 | ||||||
| Other securities |
1,090 | 1,006 | 937 | 734 | 792 | ||||||
| Total available-for-sale and other securities |
$ | 22,533 | 24,801 | 29,076 | 24,790 | 20,479 | |||||
| Held-to-maturity: |
|||||||||||
| Obligations of states and political subdivisions |
$ | 378 | 245 | 126 | 52 | 16 | |||||
| Other bonds, notes and debentures |
11 | 10 | 9 | — | — | ||||||
| Total held-to-maturity |
$ | 389 | 255 | 135 | 52 | 16 | |||||
Fifth Third Bancorp 37
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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
TABLE 17: DEPOSITS
| As of December 31 ($ in millions) |
2005 |
2004 |
2003 |
2002 |
2001 | ||||||
| Demand |
$ | 14,609 | 13,486 | 12,142 | 10,095 | 9,243 | |||||
| Interest checking |
18,282 | 19,481 | 19,757 | 17,878 | 13,474 | ||||||
| Savings |
11,276 | 8,310 | 7,375 | 10,056 | 7,065 | ||||||
| Money market |
6,129 | 4,321 | 3,201 | 1,044 | 1,352 | ||||||
| Other time |
9,313 | 6,837 | 6,201 | 7,638 | 11,301 | ||||||
| Certificates - $100,000 and over |
4,343 | 2,121 | 1,856 | 1,723 | 2,197 | ||||||
| Foreign office |
3,482 | 3,670 | 6,563 | 3,774 | 1,222 | ||||||
| Total deposits |
$ | 67,434 | 58,226 | 57,095 | 52,208 | 45,854 | |||||
Deposits
Deposit balances represent an important source of funding and revenue growth opportunity. The Bancorp is continuing to focus on transaction account deposit growth in its retail and commercial franchises by enhancing its product offerings and providing competitive rates. The Bancorp’s goal is to improve the core deposit component of its funding profile.
Total deposits at December 31, 2005 increased 16% compared to December 31, 2004. The increase was attributable to strong growth in savings, money market, other time deposits and certificates - $100,000 and over as well as the addition of $3.8 billion in deposits from the First National acquisition in the first quarter of 2005, mitigated by decreases in interest checking and foreign office deposits. Transaction deposits at December 31, 2005 increased 10% compared to 2004. Excluding the impact of the $2.5 billion of transaction deposits obtained in the First National acquisition, transaction deposits increased five percent (comparison being provided to supplement an understanding of the fundamental deposit trends). Overall, the Bancorp averaged 17% transaction deposit growth across the Detroit,
Indianapolis, Lexington, Louisville, Florida and Cincinnati markets.
Foreign office deposits represent U.S. dollar denominated deposits of the Bancorp’s foreign branch located in the Cayman Islands. The Bancorp utilizes these deposit balances as a method to fund earning asset growth.
Borrowings
Given the expected continued rise in short-term interest rates, the Bancorp continued to reduce its dependence on overnight wholesale borrowings as short-term borrowings declined to 39% of total borrowings down from 42% at December 31, 2004. Long-term debt increased $1.2 billion compared to December 31, 2004. The Bancorp continues to explore additional alternatives regarding the level and cost of various other sources of funding. Refer to the Liquidity Risk Management section for discussion on the Bancorp’s liquidity management and Note 11 of the Notes to the Consolidated Financial Statements for a comprehensive listing of the components of long-term debt.
TABLE 18: BORROWINGS
| As of December 31 ($ in millions) |
2005 |
2004 |
2003 |
2002 |
2001 | ||||||
| Federal funds purchased |
$ | 5,323 | 4,714 | 6,928 | 4,748 | 2,544 | |||||
| Short-term bank notes |
— | 775 | 500 | — | 34 | ||||||
| Other short-term borrowings |
4,246 | 4,537 | 5,742 | 4,075 | 4,875 | ||||||
| Long-term debt |
15,227 | 13,983 | 9,063 | 8,179 | 7,030 | ||||||
| Total borrowings |
$ | 24,796 | 24,009 | 22,233 | 17,002 | 14,483 | |||||
Managing risk is an essential component of successfully operating a financial services company. The Bancorp’s risk management function is responsible for the identification, measurement, monitoring, control and reporting of risk and avoidance of those risks that are inconsistent with the Bancorp’s risk profile. The Enterprise Risk Management division, led by the Bancorp Chief Risk Officer, ensures consistency in the Bancorp’s approach to managing and monitoring risk including, but not limited to, credit, market, operational and regulatory compliance risk, within the structure of Fifth Third’s affiliate operating model. In addition, the Internal Audit division provides an independent assessment of the Bancorp’s internal control structure and related systems and processes. The Enterprise Risk Management division includes the following key functions: (i) a Risk Policy function that ensures consistency in the approach to risk management as the Bancorp’s clearinghouse for credit, market and operational risk policies, procedures and guidelines; (ii) an Operational Risk Management function that is responsible for the risk self-assessment process, the change control evaluation process, fraud prevention and detection, and root cause analysis and corrective action plans relating to identified operational losses; (iii) an Insurance Risk Management function that is responsible for all property, casualty and liability insurance policies including the claims administration process for the Bancorp; (iv) a Capital Markets Risk Management function that is responsible for establishing and monitoring proprietary trading limits, monitoring liquidity and interest rate risk and utilizing value at risk and earnings at risk models; (v) a Credit Risk Review function that is responsible for evaluating the sufficiency of underwriting, documentation and approval processes for consumer and commercial credits; (vi) a Compliance Risk Management
function that is responsible for oversight of compliance with all banking regulations and (vii) a Risk Strategies and Reporting function that is responsible for quantitative analytics and Board of Directors and senior management reporting on credit, market and operational risk metrics.
Designated risk managers have been assigned to all business lines reporting jointly to the senior executives within the division or affiliate and to the Enterprise Risk Management division. Affiliate risk management is handled by regional risk managers who are responsible for multiple affiliates and who report jointly to affiliate presidents and the Enterprise Risk Management division. In 2005, the business continuity planning and disaster recovery responsibilities were assumed by the risk manager for the information technology and operating divisions.
Risk management oversight and governance is provided by the Risk and Compliance Committee of the Board of Directors and through multiple management committees whose membership includes a broad cross-section of line of business, affiliate and support representatives. The Risk and Compliance Committee of the Board of Directors consists of three outside directors and has the responsibility for the oversight of credit, market, operational, regulatory compliance and strategic risk management activities for the Bancorp as well as for the Bancorp’s overall aggregate risk profile. The Risk and Compliance Committee has approved the formation of key management governance committees that are responsible for evaluating risks and controls. These committees include the Market Risk Committee, the Credit Risk Committee and the Operational Risk Committee. There are also new products and initiatives processes applicable to every line of business to ensure an appropriate standard readiness assessment is performed before launching a new product or initiative.
38 Fifth Third Bancorp
Table of Contents
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
TABLE 19: COMMERCIAL LOAN AND LEASE PORTFOLIO EXPOSURE (a)
| 2005 |
2004 | |||||||||||||
| As of December 31 ($ in millions) |
Outstanding |
Exposure |
Nonaccrual |
Outstanding |
Exposure |
Nonaccrual | ||||||||
| Exposure by industry: |
||||||||||||||
| Real estate |
$ | 9,503 | 11,689 | 32 | 7,287 | 8,620 | 28 | |||||||
| Construction |
4,911 | 8,094 | 49 | 3,654 | 5,823 | 26 | ||||||||
| Manufacturing |
4,457 | 9,975 | 47 | 3,970 | 9,034 | 22 | ||||||||
| Retail trade |
3,602 | 5,962 | 18 | 2,957 | 4,903 | 11 | ||||||||
| Business services |
1,886 | 3,351 | 13 | 1,751 | 3,124 | 27 | ||||||||
| Wholesale trade |
1,879 | 3,540 | 9 | 1,619 | 3,178 | 6 | ||||||||
| Individuals |
1,840 | 2,371 | 12 | 1,673 | 2,135 | 11 | ||||||||
| Transportation and warehousing |
1,701 | 1,993 | 6 | 1,382 | 1,678 | 6 | ||||||||
| Healthcare |
1,664 | 2,844 | 10 | 1,355 | 2,245 | 5 | ||||||||
| Financial services and insurance |
1,111 | 3,069 | 1 | 744 | 2,348 | 1 | ||||||||
| Other |
1,041 | 1,596 | 3 | 781 | 1,335 | 4 | ||||||||
| Accommodation and food |
997 | 1,396 | 9 | 850 | 1,237 | 14 | ||||||||
| Other services |
945 | 1,260 | 9 | 748 | 1,027 | 5 | ||||||||
| Public administration |
830 | 1,004 | — | 796 | 911 | — | ||||||||
| Agribusiness |
569 | 752 | 2 | 509 | 676 | 4 | ||||||||
| Communication and information |
544 | 1,119 | 4 | 478 | 971 | 1 | ||||||||
| Entertainment and recreation |
527 | 749 | 3 | 443 | 639 | 3 | ||||||||
| Utilities |
301 | 1,001 | — | 237 | 729 | — | ||||||||
| Mining |
219 | 419 | — | 234 | 413 | — | ||||||||
| Total |
$ | 38,527 | 62,184 | 227 | 31,468 | 51,026 | 174 | |||||||
| Exposure by loan size: |
||||||||||||||
| Less than $5 million |
58 | % | 47 | 81 | 62 | 49 | 86 | |||||||
| $5 million to $15 million |
26 | 25 | 8 | 25 | 26 | 14 | ||||||||
| $15 million to $25 million |
10 | 14 | — | 9 | 13 | — | ||||||||
| Greater than $25 million |
6 | 14 | 11 | 4 | 12 | — | ||||||||
| Total |
100 | % | 100 | 100 | 100 | 100 | 100 | |||||||
| Exposure by state: |
||||||||||||||
| Ohio |
26 | % | 29 | 30 | 30 | 33 | 36 | |||||||
| Michigan |
22 | 21 | 21 | 25 | 23 | 28 | ||||||||
| Indiana |
10 | 10 | 25 | 11 | 10 | 12 | ||||||||
| Illinois |
10 | 10 | 8 | 10 | 10 | 13 | ||||||||
| Florida |
10 | 9 | 4 | 2 | 2 | 2 | ||||||||
| Kentucky |
6 | 6 | 6 | 6 | 6 | 4 | ||||||||
| Tennessee |
3 | 2 | 3 | 3 | 2 | 3 | ||||||||
| Pennsylvania |
1 | 1 | — | 1 | 1 | — | ||||||||
| West Virginia |
— | — | 1 | — | 1 | — | ||||||||
| Out-of-footprint |
12 | 12 | 2 | 12 | 12 | 2 | ||||||||
| Total |
100 | % | 100 | 100 | 100 | 100 | 100 | |||||||
| (a) | Outstanding reflects total commercial customer loan and lease balances, including held for sale and net of unearned income, and exposure reflects total commercial customer lending commitments. |
Significant risk policies approved by the management governance committees are also reviewed and approved by the Board of Directors Risk and Compliance Committee.
CREDIT RISK MANAGEMENT
The objective of the Bancorp’s credit risk management strategy is to quantify and manage credit risk on an aggregate portfolio basis, as well as to limit the risk of loss resulting from an individual customer default. The Bancorp’s credit risk management strategy is based on three core principles: conservatism, diversification and monitoring. The Bancorp believes that effective credit risk management begins with conservative lending practices. These practices include conservative exposure and counterparty limits and conservative underwriting, documentation and collection standards. The Bancorp’s credit risk management strategy also emphasizes diversification on a geographic, industry and customer level, regular credit examinations and monthly management reviews of large credit exposures and credits experiencing deterioration of credit quality. Lending officers with the authority to extend credit are delegated specific authority amounts, the utilization of which is closely monitored. Lending activities are largely decentralized, while the Enterprise Risk Management division manages the policy process centrally. The Credit Risk Review function, within the Enterprise Risk Management division, provides objective assessments of the quality of underwriting and
documentation, the accuracy of risk grades and the charge-off and allowance analysis process.
The Bancorp’s credit review process and overall assessment of required allowances is based on ongoing quarterly assessments of the probable estimated losses inherent in the loan and lease portfolio. The Bancorp uses this ongoing assessment to promptly identify potential problem loans or leases within the portfolio, maintain an adequate allowance and take any necessary charge-offs. In addition to the individual review of larger commercial loans that exhibit probable or observed credit weaknesses, the commercial credit review process includes the use of two risk grading systems. The current risk grading system utilized for allowance analysis purposes encompasses ten categories. The Bancorp also maintains a dual risk rating system that provides for 13 probability of default grade categories and an additional six grade categories measuring loss factors given an event of default. The probability of default and loss given default components are not separated in the ten grade risk rating system. The Bancorp is in the process of completing significant validation and testing of the dual risk rating system prior to implementation for allowance analysis purposes. The dual risk rating system is consistent with Basel II expectations and allows for more precision in the analysis of commercial credit risk. Scoring systems and delinquency monitoring are used to assess the credit risk in the Bancorp’s homogenous consumer loan portfolios.
Fifth Third Bancorp 39
Table of Contents
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
TABLE 20: SUMMARY OF NONPERFORMING AND UNDERPERFORMING ASSETS
| As of December 31 ($ in millions) |
2005 |
2004 |
2003 |
2002 |
2001 | |||||||
| Commercial loans and leases |
$ | 145 | 110 | 129 | 159 | 122 | ||||||
| Commercial mortgages |
51 | 51 | 42 | 41 | 57 | |||||||
| Commercial construction |
31 | 13 | 19 | 14 | 26 | |||||||
| Residential mortgages and construction |
30 | 24 | 25 | 18 | 11 | |||||||
| Consumer loans and leases |
37 | 30 | 27 | 15 | — | |||||||
| Total nonaccrual loans and leases |
294 | 228 | 242 | 247 | 216 | |||||||
| Renegotiated loans and leases |
— | 1 | 8 | — | — | |||||||
| Other assets, including other real estate owned |
67 | 74 | 69 | 26 | 19 | |||||||
| Total nonperforming assets |
361 | 303 | 319 | 273 | 235 | |||||||
| Commercial loans and leases |
21 | 22 | 15 | 29 | 25 | |||||||
| Commercial mortgages and construction |
14 | 13 | 12 | 18 | 24 | |||||||
| Credit card receivables |
10 | 13 | 13 | 9 | 8 | |||||||
| Residential mortgages and construction (a) |
53 | 43 | 51 | 60 | 56 | |||||||
| Consumer loans and leases |
57 | 51 | 54 | 46 | 51 | |||||||
| Total 90 days past due loans and leases |
155 | 142 | 145 | 162 | 164 | |||||||
| Total underperforming assets |
$ | 516 | 445 | 464 | 435 | 399 | ||||||
| Nonperforming assets as a percent of total loans, leases and other assets, including other real estate owned |
.52 | % | .51 | .61 | .59 | .52 | ||||||
| Underperforming assets as a percent of total loans, leases and other assets, including other real estate owned |
.74 | .74 | .89 | .95 | .96 | |||||||
| Allowance for loan and lease losses as a percent of nonperforming assets (b) |
206 | 235 | 219 | 251 | 265 | |||||||
| Allowance for credit losses as a percent of nonperforming assets (b) |
225 | 259 | 242 | 251 | 265 | |||||||
| Allowance for loan and lease losses as a percent of underperforming assets (b) |
144 | 160 | 150 | 157 | 156 | |||||||
| Allowance for credit losses as a percent of underperforming assets (b) |
158 | 176 | 166 | 157 | 156 | |||||||
| (a) | Information for all periods presented excludes advances made pursuant to servicing agreements to Government National Mortgage Association (“GNMA”) mortgage pools whose repayments are insured by the Federal Housing Administration or guaranteed by the Department of Veterans Affairs. As of December 31, 2005 and 2004, these advances were $13 million and $23 million, respectively. Information prior to December 31, 2004 was not available. |
| (b) | At December 31, 2004, the reserve for unfunded commitments was reclassified from the allowance for loan and lease losses to other liabilities. The 2003 year-end reserve for unfunded commitments has been reclassified to conform to the current year presentation. |
Portfolio Diversity
The Bancorp’s credit risk management strategy includes minimizing concentrations of risk through diversification. Table 19 provides breakouts of the commercial loan and lease portfolio, including held for sale, by major industry classification, size of credit and state, illustrating the diversity and granularity of the Bancorp’s portfolio.
The commercial portfolio is further characterized by 88% of outstanding balances and exposures concentrated within the Bancorp’s primary market areas of Ohio, Kentucky, Indiana, Michigan, Illinois, Florida, Tennessee, West Virginia and Pennsylvania. Exclusive of a national large-ticket leasing business, the commercial portfolio is characterized by 95% of outstanding balances and 92% of exposures concentrated within these nine states. The mortgage and construction segments of the commercial portfolio are characterized by 97% of outstanding balances and exposures concentrated within these nine states.
Analysis of Nonperforming and Underperforming Assets
Nonperforming assets include: (i) nonaccrual loans and leases for which ultimate collectibility of the full amount of the interest is uncertain; (ii) loans and leases that have been renegotiated to provide for a reduction or deferral of interest or principal because of deterioration in the financial position of the borrower and (iii) other assets, including other real estate owned and repossessed equipment. Loans are placed on nonaccrual status when the principal or interest is past due 90 days or more (unless the loan is both well secured and in process of collection) and payment in full of principal or interest under the contractual terms of the loan are not expected or upon deterioration of the financial condition of the borrower. When a loan is placed on nonaccrual status, the accrual of interest, amortization of loan premium, accretion of loan discount and amortization or accretion of deferred net loan fees or costs are discontinued. Commercial loans on nonaccrual status are reviewed for impairment at least quarterly. If the principal or a portion of principal is deemed a loss, the loss amount is charged off to the allowance for loan and lease losses.
Total nonperforming assets were $361 million at December 31, 2005, an increase of $58 million compared to $303 million at December 31, 2004. Nonperforming assets remain a small percentage of total loans, leases and other assets, including other real estate owned at .52% as of December 31, 2005, compared to .51% as of December 31, 2004.
Commercial nonaccrual credits as a percent of commercial loans increased from .56% in 2004 to .59% in 2005, primarily attributable to increases in the Columbus, Cincinnati, Evansville and Naples markets. Consumer nonaccrual credits as a percent of consumer loans decreased slightly from .21% in 2004 to .20% in 2005. Overall, nonaccrual credits continue to represent a small portion of the portfolio at just .41% as of December 31, 2005, compared to .38% as of December 31, 2004.
Underperforming assets include nonperforming assets and loans and leases past due 90 days or more as to principal or interest, which are not already accounted for as nonperforming assets because they are well secured by collateral and in the process of collection. Total loans and leases 90 days past due and not accounted for as nonperforming assets have increased from $142 million as of December 31, 2004 to $155 million as of December 31, 2005.
At December 31, 2005, there were $58 million of loans and leases currently performing in accordance with contractual terms, but for which there were serious doubts as to the ability of the borrower to comply with such terms. For the years 2005 and 2004, interest income of $8 million and $6 million, respectively, was recorded on nonaccrual and renegotiated loans and leases. For the years ended 2005 and 2004, additional interest income of $53 million and $33 million, respectively, would have been recorded if the nonaccrual and renegotiated loans and leases had been current in accordance with the original terms. Table 19 provides an analysis of the commercial nonaccrual loans and leases by major industry classification, size of credit and state, further illustrating the granularity of the Bancorp’s commercial loans and leases.
40 Fifth Third Bancorp
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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
TABLE 21: SUMMARY OF CREDIT LOSS EXPERIENCE
| For the years ended December 31 ($ in millions) |
2005 |
2004 |
2003 |
2002 |
2001 |
|||||||||||
| Losses charged off: |
||||||||||||||||
| Commercial loans |
$ | (99 | ) | (95 | ) | (152 | ) | (81 | ) | (106 | ) | |||||
| Commercial mortgage loans |
(13 | ) | (14 | ) | (9 | ) | (18 | ) | (12 | ) | ||||||
| Construction loans |
(5 | ) | (7 | ) | (3 | ) | (6 | ) | (2 | ) | ||||||
| Residential mortgage loans |
(18 | ) | (15 | ) | (24 | ) | (10 | ) | (7 | ) | ||||||
| Consumer loans |
(181 | ) | (156 | ) | (136 | ) | (115 | ) | (117 | ) | ||||||
| Lease financing |
(57 | ) | (34 | ) | (56 | ) | (43 | ) | (65 | ) | ||||||
| Total losses |
(373 | ) | (321 | ) | (380 | ) | (273 | ) | (309 | ) | ||||||
| Recoveries of losses previously charged off: |
||||||||||||||||
| Commercial loans |
24 | 14 | 16 | 20 | 21 | |||||||||||
| Commercial mortgage loans |
4 | 5 | 2 | 5 | 10 | |||||||||||
| Construction loans |
1 | — | 1 | 3 | — | |||||||||||
| Residential mortgage loans |
— | — | — | — | — | |||||||||||
| Consumer loans |
39 | 41 | 40 | 46 | 39 | |||||||||||
| Lease financing |
6 | 9 | 9 | 12 | 12 | |||||||||||
| Total recoveries |
74 | 69 | 68 | 86 | 82 | |||||||||||
| Net losses charged off: |
||||||||||||||||
| Commercial loans |
(75 | ) | (81 | ) | (136 | ) | (61 | ) | (85 | ) | ||||||
| Commercial mortgage loans |
(9 | ) | (9 | ) | (7 | ) | (13 | ) | (2 | ) | ||||||
| Construction loans |
(4 | ) | (7 | ) | (2 | ) | (3 | ) | (2 | ) | ||||||
| Residential mortgage loans |
(18 | ) | (15 | ) | (24 | ) | (10 | ) | (7 | ) | ||||||
| Consumer loans |
(142 | ) | (115 | ) | (96 | ) | (69 | ) | (78 | ) | ||||||
| Lease financing |
(51 | ) | (25 | ) | (47 | ) | (31 | ) | (53 | ) | ||||||
| Total net losses charged off |
$ | (299 | ) | (252 | ) | (312 | ) | (187 | ) | (227 | ) | |||||
| Net charge-offs as a percent of average loans and leases (excluding held for sale): |
||||||||||||||||
| Commercial loans |
.41 | % | .54 | 1.00 | .52 | .79 | ||||||||||
| Commercial mortgage loans |
.10 | .12 | .10 | .23 | .04 | |||||||||||
| Construction loans |
.07 | .15 | .09 | .12 | .06 | |||||||||||
| Residential mortgage loans |
.25 | .27 | .57 | .23 | .14 | |||||||||||
| Consumer loans |
.68 | .63 | .58 | .49 | .65 | |||||||||||
| Lease financing |
.96 | .46 | .84 | .65 | 1.13 | |||||||||||
| Total net losses charged off |
.45 | .45 | .63 | .43 | .54 | |||||||||||
Analysis of Net Loan Charge-offs
Net charge-offs as a percent of average loans and leases outstanding remained at .45% for 2005 and 2004. The ratio of commercial loan net charge-offs to average commercial loans outstanding decreased to .41% in 2005 compared to .54% in 2004 due to decreases in net charge-offs primarily in the Cincinnati, Detroit and Louisville markets, partially offset by increases in the Columbus and Grand Rapids markets. Commercial leasing net charge-offs increased $30 million as a result of approximately $27 million in charge-offs related to bankrupt commercial airline carriers during 2005. The ratio of commercial leasing net charge-offs to average commercial leases outstanding increased 85 bp from .21% in 2004 to 1.06% in 2005. Total consumer loan net charge-offs in 2005 increased to $142 million compared to $115 million in 2004 primarily due to increased personal bankruptcies associated with the recently enacted reform legislation. Overall, the level of net charge-offs remains a small percentage of the total loan and lease portfolio. Table 21 provides a summary of credit loss experience and net charge-offs as a percentage of average loans and leases outstanding by loan category.
Allowance for Credit Losses
The allowance for loan and lease losses provides coverage for probable and estimable losses in the loan and lease portfolio. The Bancorp evaluates the allowance each quarter to determine its adequacy to cover inherent losses. In the current year, the Bancorp has not substantively changed any aspect to its overall approach in the determination of the allowance for loan and lease losses, and there have been no material changes in assumptions or estimation techniques as compared to prior periods that impacted the determination of the current period allowance. In addition to the allowance for loan and lease losses, the Bancorp maintains a reserve for unfunded commitments. The methodology used to determine the adequate reserve for unfunded commitments is similar to the Bancorp’s methodology for determining the allowance for loan and lease losses. Table 22 shows the changes in the allowance for credit losses during 2005.
The allowance for loan and lease losses at December 31, 2005 decreased to 1.06% of the total portfolio loans and leases compared to 1.19% at December 31, 2004. The decrease in the allowance as a percentage of total portfolio loans and leases is attributable to an overall improved assessment of inherent losses in the portfolio from the consideration of historical and anticipated
TABLE 22: CHANGES IN ALLOWANCE FOR CREDIT LOSSES
| For the years ended December 31 ($ in millions) |
2005 |
2004 |
2003 |
2002 |
2001 |
|||||||||||
| Balance, beginning of year |
$ | 785 | 770 | 683 | 624 | 609 | ||||||||||
| Net charge-offs |
(299 | ) | (252 | ) | (312 | ) | (187 | ) | (227 | ) | ||||||
| Allowance of acquired institutions and other |
— | — | — | — | 6 | |||||||||||
| Provision for loan and lease losses |
330 | 268 | 399 | 246 | 201 | |||||||||||
| Merger-related provision |
— | — | — | — | 35 | |||||||||||
| Net change in reserve for unfunded commitments |
(2 | ) | (1 | ) | — | — | — | |||||||||
| Balance, end of year |
$ | 814 | 785 | 770 | 683 | 624 | ||||||||||
| Components of allowance for credit losses (a): |
||||||||||||||||
| Allowance for loan and lease losses |
$ | 744 | 713 | 697 | ||||||||||||
| Reserve for unfunded commitments |
70 | 72 | 73 | |||||||||||||
| Total allowance for credit losses |
$ | 814 | 785 | 770 | ||||||||||||
| (a) | At December 31, 2004, the reserve for unfunded commitments was reclassified from the allowance for loan and lease losses to other liabilities. The 2003 year-end reserve for unfunded commitments has been reclassified to conform to the current year presentation. |
Fifth Third Bancorp 41
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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
TABLE 23: ATTRIBUTION OF ALLOWANCE FOR LOAN AND LEASE LOSSES TO PORTFOLIO LOANS AND LEASES
| As of December 31 ($ in millions) |
2005 |
2004 |
2003 |
2002(a) |
2001(a) | |||||||
| Allowance attributed to: |
||||||||||||
| Commercial loans |
$ | 201 | 210 | 234 | 159 | 118 | ||||||
| Commercial mortgage loans |
78 | 73 | 77 | 117 | 102 | |||||||
| Construction loans |
47 | 43 | 34 | 41 | 32 | |||||||
| Residential mortgage loans |
37 | 44 | 29 | 43 | 31 | |||||||
| Consumer loans |
183 | 160 | 146 | 141 | 132 | |||||||
| Lease financing |
56 | 47 | 64 | 132 | 101 | |||||||
| Unallocated |
142 | 136 | 113 | 50 | 108 | |||||||
| Total allowance for loan and lease losses |
$ | 744 | 713 | 697 | 683 | 624 | ||||||
| Portfolio loans and leases: |
||||||||||||
| Commercial loans |
$ | 19,174 | 16,058 | 14,209 | 12,743 | 10,807 | ||||||
| Commercial mortgage loans |
9,188 | 7,636 | 6,894 | 5,885 | 6,085 | |||||||
| Construction loans |
7,037 | 4,726 | 3,636 | 3,327 | 3,356 | |||||||
| Residential mortgage loans |
7,152 | 6,988 | 4,425 | 3,495 | 4,505 | |||||||
| Consumer loans |
22,084 | 18,923 | 17,432 | 15,116 | 12,565 | |||||||
| Lease financing |
5,290 | 5,477 | 5,712 | 5,362 | 4,230 | |||||||
| Total portfolio loans and leases |
$ | 69,925 | 59,808 | 52,308 | 45,928 | 41,548 | ||||||
| Attributed allowance as a percent of respective portfolio loans: |
||||||||||||
| Commercial loans |
1.05 | % | 1.31 | 1.65 | 1.24 | 1.09 | ||||||
| Commercial mortgage loans |
.85 | .96 | 1.12 | 1.98 | 1.69 | |||||||
| Construction loans |
.67 | .90 | .94 | 1.24 | .97 | |||||||
| Residential mortgage loans |
.51 | .63 | .66 | 1.24 | .69 | |||||||
| Consumer loans |
.83 | .85 | .84 | .93 | 1.05 | |||||||
| Lease financing |
1.06 | .86 | 1.12 | 2.46 | 2.38 | |||||||
| Unallocated (as a percent of total portfolio loans and leases) |
.20 | .23 | .22 | .11 | .26 | |||||||
| Total portfolio loans and leases |
1.06 | % | 1.19 | 1.33 | 1.49 | 1.50 | ||||||
| (a) | The allowance for loan and lease losses in 2002 and 2001 includes funded and unfunded commitments. At December 31, 2004, the reserve for unfunded commitments was reclassified from the allowance for loan and lease losses to other liabilities. The 2003 year-end reserve for unfunded commitments has been reclassified to conform to the current period presentation. |
loss rates as well as a less than five basis point impact from the loans and leases obtained in the First National acquisition. The loans and leases obtained in the First National acquisition were recorded at fair value, which resulted in its previously existing allowance not being carried over, as the credit default risk was included in the determination of fair value.
Overall, the Bancorp’s long history of low exposure limits, minimal exposure to national or sub-prime lending businesses, centralized risk management and its diversified portfolio reduces the likelihood of significant unexpected credit losses. Table 23 provides the amount of the allowance for loan and lease losses by category.
Residential Mortgage Portfolio
Certain mortgage products have contractual features that may increase credit exposure to the Bancorp in the event of a decline in housing prices. These types of mortgage products offered by the Bancorp include high loan-to-value (“LTV”) ratios, multiple loans on the same collateral that when combined result in a high LTV (“80/20”) and interest-only loans. Table 24 shows the Bancorp’s
originations of these products in 2005 and 2004. The Bancorp does not currently originate mortgage loans that permit principal payment deferral or payments that are less than the accruing interest.
Tables 25 provides the amount of these loans as a percent of the residential mortgage loans in the Bancorp’s portfolio and the delinquency and charge-off percentages of these loan products as of December 31, 2005 and 2004, respectively.
The Bancorp also sells certain of these mortgage products in the secondary market with recourse. The outstanding balances and delinquency rates for these loans sold with recourse as of December 31, 2005 and 2004 were $1.2 billion and 1.24% and $.4 billion and 0.84%, respectively.
The Bancorp manages credit risk in the mortgage portfolio through conservative underwriting and documentation standards and geographic and product diversification. The Bancorp may also package and sell loans in the portfolio without recourse or may purchase mortgage insurance for the loans sold in order to mitigate credit risk.
TABLE 24: RESIDENTIAL MORTGAGE ORIGINATIONS
| For the years ended December 31 ($ in millions) |
2005 |
% of total |
2004 |
% of total |
||||||||
| Greater than 80% LTV with no mortgage insurance |
$ | 1,245 | 13 | % | $ | 1,286 | 15 | % | ||||
| Interest-only |
1,240 | 13 | 196 | 2 | ||||||||
| Greater than 80% LTV and interest-only |
408 | 4 | 34 | — | ||||||||
| 80/20 loans |
445 | 5 | 83 | 1 | ||||||||
|
TABLE 25: RESIDENTIAL MORTGAGE OUTSTANDINGS
|
||||||||||||
| As of December 31 ($ in millions) |
2005 |
% of total |
Delinquency % |
Charge-off % |
||||||||
| Greater than 80% LTV with no mortgage insurance |
$ | 1,773 | 25 | % | 3.11 | .10 | ||||||
| Interest-only |
899 | 13 | .41 | — | ||||||||
| Greater than 80% LTV and interest-only |
361 | 5 | .07 | .01 | ||||||||
| 80/20 loans |
28 | — | — | — | ||||||||
| 2004 |
% of total |
Delinquency % |
Charge-off % |
|||||||||
| Greater than 80% LTV with no mortgage insurance |
$ | 2,143 | 31 | % | 2.09 | .04 | ||||||
| Interest-only |
214 | 3 | — | — | ||||||||
| Greater than 80% LTV and interest-only |
40 | 1 | — | — | ||||||||
| 80/20 loans |
22 | — | — | — | ||||||||
42 Fifth Third Bancorp
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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
TABLE 26: LOAN AND LEASE MATURITIES
| As of December 31, 2005 ($ in millions) |
Less than 1 year |
1-5 years |
Greater than 5 years |
Total | |||||
| Commercial loans |
$ | 11,151 | 6,668 | 1,355 | 19,174 | ||||
| Commercial mortgage loans |
2,515 | 5,249 | 1,424 | 9,188 | |||||
| Commercial construction loans |
4,030 | 1,976 | 336 | 6,342 | |||||
| Residential mortgage and construction loans |
2,205 | 3,580 | 2,062 | 7,847 | |||||
| Consumer loans |
5,852 | 11,676 | 4,556 | 22,084 | |||||
| Lease financing |
1,634 | 2,754 | 902 | 5,290 | |||||
| Total |
$ | 27,387 | 31,903 | 10,635 | 69,925 | ||||
TABLE 27: LOAN AND LEASE INTEREST RATE SENSITIVITY
| Interest Rate | |||||
| As of December 31, 2005 ($ in millions) |
Predetermined |
Floating or Adjustable | |||
| Commercial loans |
$ | 2,424 | 5,599 | ||
| Commercial mortgage loans |
2,332 | 4,341 | |||
| Commercial construction loans |
386 | 1,926 | |||
| Residential mortgage and construction loans |
2,514 | 3,128 | |||
| Consumer loans |
7,327 | 8,905 | |||
| Lease financing |
3,656 | — | |||
| Total |
$ | 18,639 | 23,899 | ||
MARKET RISK MANAGEMENT
Market risk arises from the potential for fluctuations in interest rates, foreign exchange rates and equity prices that may result in the potential reduction of net income. Interest rate risk, a component of market risk, is the exposure to adverse changes in net interest income due to changes in interest rates. Management considers interest rate risk a prominent market risk in terms of its potential impact on earnings. Interest rate risk can occur for any one or more of the following reasons: (i) assets and liabilities may mature or reprice at different times; (ii) short-term and long-term market interest rates may change by different amounts or (iii) the remaining maturity of various assets or liabilities may shorten or lengthen as interest rates change. In addition to the direct impact of interest rate changes on net interest income, interest rates can indirectly impact earnings through their effect on loan demand, credit losses, mortgage origination fees, the value of servicing rights and other sources of the Bancorp’s earnings. Consistency of the Bancorp’s net interest income is largely dependent upon the effective management of interest rate risk.
Net Interest Income Simulation Model
The Bancorp employs a variety of measurement techniques to identify and manage its interest rate risk, including the use of an earnings simulation model to analyze net interest income sensitivity to changing interest rates. The model is based on actual cash flows and repricing characteristics for all of the Bancorp’s financial instruments and incorporates market-based assumptions regarding the effect of changing interest rates on the prepayment rates of certain assets and liabilities. The model also includes senior management projections for activity levels in each of the product lines offered by the Bancorp and incorporates the loss of free funding resulting from the Bancorp’s share repurchase activity. Actual results will differ from these simulated results due to timing, magnitude and frequency of interest rate changes as well as changes in market conditions and management strategies.
The Bancorp’s Asset/Liability Risk Management Committee (“ALCO”), which includes senior management representatives and is accountable to the Risk and Compliance Committee of the Board of Directors, monitors and manages interest rate risk within Board approved policy limits. In addition to the risk management activities of ALCO, the Bancorp created a Market Risk Management function as part of the Enterprise Risk Management division, which provides independent oversight of market risk activities. The Bancorp’s current interest rate risk policy limits are determined by measuring the anticipated change in net interest income over a 12-month and 24-month horizon assuming a 200 bp linear increase or decrease in all interest rates. In accordance with the current policy, the rate movements are assumed to occur over one year and are sustained thereafter. To further illustrate the
estimated sensitivity of interest rate changes, Table 28 includes the percentage change in net interest income over the next 12 and 24 months given the implied market forward rates as well as 100 bp and 200 bp linear increases or decreases in all interest rates. The following table shows the Bancorp’s estimated earnings sensitivity profile on the asset and liability positions as of December 31, 2005:
TABLE 28: ESTIMATED EARNINGS SENSITIVITY PROFILE
| Change in Net Interest Income |
||||||
| Change in Interest Rates (bp) |
12 Months |
24 Months |
||||
| +200 |
(.72 | )% | .10 | |||
| +100 |
(.57 | ) | .41 | |||
| -100 |
1.10 | .23 | ||||
| -200 |
1.52 | (2.44 | ) | |||
| Implied Market Forward Rates |
(1.79 | ) | (2.62 | ) | ||
The Bancorp also utilizes the market value of equity (“MVE”) as a measurement tool in managing interest rate sensitivity. Whereas net interest income simulation highlights exposures over a relatively short time horizon, the MVE analysis incorporates all cash flows over the estimated remaining life of all balance sheet and derivative positions. The MVE of the balance sheet, at a point in time, is defined as the discounted present value of asset cash flows and derivative cash flows less the discounted value of liability cash flows. The sensitivity of MVE to changes in the level of interest rates is a measure of the longer-term repricing risk. In contrast to the net interest income simulation, which assumes interest rates will change over a period of time, MVE uses instantaneous changes in rates. MVE values only the current balance sheet and does not incorporate the growth assumptions that are used in the net interest income simulation model. As with the net interest income simulation model, assumptions about the timing and variability of balance sheet cash flows are critical in the MVE analysis. Particularly important are the assumptions driving prepayments and the expected changes in balances and pricing of the indeterminate deposit portfolios. The following table shows the Bancorp’s MVE sensitivity profile as of December 31:
TABLE 29: ESTIMATED MVE SENSITIVITY PROFILE
| Change in MVE |
||||||
| Change in Interest Rates (bp) |
2005 |
2004 |
||||
| +100 |
(4.08 | )% | (4.82 | ) | ||
| -100 |
3.17 | 3.81 | ||||
While an instantaneous shift in interest rates is used in this analysis to provide an estimate of exposure, the Bancorp believes that a gradual shift in interest rates would have a much more modest impact. Since MVE measures the discounted present value of cash flows over the estimated lives of instruments, the change in MVE does not directly correlate to the degree that earnings would be impacted over a shorter time horizon (i.e., the current fiscal
Fifth Third Bancorp 43
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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
TABLE 30: MATURITY DISTRIBUTION OF CERTIFICATES - $100,000 AND OVER
| As of December 31, 2005 ($ in millions) |
|||
| Three months or less |
$ | 1,288 | |
| Over three months through six months |
700 | ||
| Over six months through one year |
1,736 | ||
| Over one year |
619 | ||
| Total |
$ | 4,343 | |
TABLE 31: AGENCY RATINGS
| As of December 31, 2005 |
Moody’s |
Standard and Poor’s |
Fitch | |||
| Fifth Third Bancorp: |
||||||
| Commercial paper |
Prime-1 | A-1 | F1+ | |||
| Senior debt |
Aa2 | A+ | AA- | |||
| Fifth Third Bank and Fifth Third Bank (Michigan): |
||||||
| Short-term deposit |
Prime-1 | A-1+ | F1+ | |||
| Long-term deposit |
Aa1 | AA- | AA |
year). Further, MVE does not take into account factors such as future balance sheet growth, changes in product mix, changes in yield curve relationships and changing product spreads that could mitigate the adverse impact of changes in interest rates. The net interest income simulation and MVE analyses do not necessarily include certain actions that management may undertake to manage this risk in response to anticipated changes in interest rates.
Table 26 (on the previous page) shows a summary of the remaining maturities of loans and leases held for investment based upon expected repayments. Additionally, Table 27 (on the previous page) shows a summary of expected repayments exceeding one year segregated by sensitivity to interest rate changes.
Use of Derivatives to Manage Interest Rate Risk
An integral component of the Bancorp’s interest rate risk management strategy is its use of derivative instruments to minimize significant unplanned fluctuations in earnings and cash flows caused by market volatility. Examples of derivative instruments that the Bancorp may use as part of its interest rate risk management strategy include interest rate swaps, interest rate floors, interest rate caps, forward contracts, principal only swaps, options and swaptions.
The Bancorp also establishes derivative contracts with reputable third parties to economically hedge significant exposures assumed in commercial customer accommodation derivative contracts. Generally, these contracts have similar terms in order to protect the Bancorp from the market volatility. See Note 8 of the Notes to the Consolidated Financial Statements for further discussion on derivatives.
Mortgage Servicing Rights and Interest Rate Risk
The net carrying amount of the MSR portfolio was $433 million as of December 31, 2005. The Bancorp maintains a non-qualifying hedging strategy relative to its mortgage banking activity, including consultation with an independent third-party specialist, in order to manage a portion of the risk associated with changes in value of its MSR portfolio as a result of changing interest rates. The value of servicing rights can fluctuate sharply depending on changes in interest rates and other factors. Generally, as interest rates decline and loans are prepaid to take advantage of refinancing, the total value of existing servicing rights declines because no further servicing fees are collected on repaid loans.
The volatility in longer-term interest rates during 2005 and the resulting impact of changing prepayment speeds led to a recovery of $33 million and $60 million of temporary impairment in 2005 and 2004, respectively. The servicing rights are deemed impaired when a borrower’s loan rate is distinctly higher than prevailing market rates. See Note 7 of the Notes to the Consolidated Financial Statements for further discussion on servicing rights.
Foreign Currency Risk
The Bancorp enters into foreign exchange derivative contracts to economically hedge certain foreign denominated loans. The derivatives are classified as free-standing instruments with the revaluation gain or loss being recorded within other noninterest income on the Consolidated Statements of Income. The balance of the Bancorp’s foreign denominated loans at December 31, 2005 is approximately $130 million. The Bancorp also enters into foreign exchange derivative contracts for the benefit of commercial customers involved in international trade to hedge their exposure to foreign currency fluctuations. The Bancorp has several controls in place to ensure excessive risk is not being taken in providing this service to customers. These include an independent determination of currency volatility and credit equivalent exposure on these contracts, counterparty credit approvals and country limits.
LIQUIDITY RISK MANAGEMENT
The goal of liquidity management is to provide adequate funds to meet changes in loan and lease demand or unexpected deposit withdrawals. This goal is accomplished by maintaining liquid assets in the form of investment securities, maintaining sufficient unused borrowing capacity in the national money markets and delivering consistent growth in core deposits. The primary source of asset driven liquidity is provided by debt securities in the available-for-sale securities portfolio. The estimated average life of the available-for-sale portfolio was 4.3 years at December 31, 2005, based on current prepayment expectations. Of the $21.9 billion (fair value basis) of available-for-sale and other securities in the portfolio at December 31, 2005, $3.8 billion in principal and interest is expected to be received in the next 12 months, and an additional $3.6 billion is expected to be received in the following 12 months. In addition to the sale of securities in the available-for-sale portfolio, asset-driven liquidity is provided by the Bancorp’s ability to sell or securitize loan and lease assets. In order to reduce the exposure to interest rate fluctuations and to manage liquidity, the Bancorp has developed securitization and sale procedures for several types of interest-sensitive assets. A majority of the long-term, fixed-rate single-family residential mortgage loans underwritten according to FHLMC or Federal National Mortgage Association (“FNMA”) guidelines are sold for cash upon origination. Periodically, additional assets such as jumbo fixed-rate residential mortgages, certain floating-rate short-term commercial loans, certain floating-rate home equity loans, certain auto loans and other consumer loans are also securitized, sold or transferred off-balance sheet. For the years ended December 31, 2005 and 2004, a total of $9.5 billion and $6.7 billion, respectively, were sold, securitized or transferred off-balance sheet.
The Bancorp also has in place a shelf registration with the Securities and Exchange Commission permitting ready access to the public debt markets. As of December 31, 2005, $1.5 billion of debt or other securities were available for issuance under this shelf registration. Additionally, the Bancorp has $15.1 billion of funding available for issuance through private offerings of debt securities pursuant to its bank note program. Such bank notes may be sold
44 Fifth Third Bancorp
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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
TABLE 32: CAPITAL RATIOS
| As of December 31 ($ in millions) |
2005 |
2004 |
2003 |
2002 |
2001 | |||||||
| Tier I capital |
$ | 8,209 | 8,522 | 8,272 | 7,747 | 7,433 | ||||||
| Total risk-based capital |
10,240 | 10,176 | 10,096 | 8,935 | 8,656 | |||||||
| Risk-weighted assets |
97,994 | 82,633 | 74,477 | 65,444 | 59,491 | |||||||
| Regulatory capital ratios: |
||||||||||||
| Tier I capital |
8.38 | % | 10.31 | 11.11 | 11.84 | 12.49 | ||||||
| Total risk-based capital |
10.45 | 12.31 | 13.56 | 13.65 | 14.55 | |||||||
| Tier I leverage ratio |
8.08 | 8.89 | 9.23 | 9.84 | 10.64 | |||||||
TABLE 33: SHARE REPURCHASES
| For the years ended December 31 |
2005 |
2004 |
2003 |
|||||||
| Shares authorized for repurchase at January 1 |
35,685,112 | 14,137,512 | 5,600,681 | |||||||
| Additional authorizations |
20,000,000 | 40,000,000 | 20,000,000 | |||||||
| Shares repurchases (a) |
(37,838,159 | ) | (18,452,400 | ) | (11,463,169 | ) | ||||
| Shares authorized for repurchase at December 31 |
17,846,953 | 35,685,112 | 14,137,512 | |||||||
| Average price paid per share |
$ | 43.19 | 53.48 | 57.13 | ||||||
| (a) | Excludes 134,435 and 40,850 shares repurchased during 2005 and 2004, respectively, in connection with various employee compensation plans. These repurchases are not included against the maximum number of shares that may yet be repurchased under the Board of Directors’ authorization. |
to qualified institutional buyers, financial institutions, banks, insurance companies and similar entities in the ordinary course of business from time to time. These sources, in addition to the Bancorp’s equity capital base, provide a stable funding base.
Table 31 provides Moody’s, Standard and Poor’s and Fitch’s deposit and debt ratings for the Bancorp, Fifth Third Bank and Fifth Third Bank (Michigan). These debt ratings, along with capital ratios above regulatory guidelines, provide the Bancorp with additional access to liquidity.
Core customer deposits have historically provided the Bancorp with a sizeable source of relatively stable and low-cost funds. The Bancorp’s average core deposits and shareholders’ equity funded 64% of its average total assets during 2005. In addition to core deposit funding, the Bancorp also accesses a variety of other short-term and long-term funding sources, which include the use of various regional Federal Home Loan Banks as a funding source. Certificates carrying a balance of $100,000 or more and deposits in the Bancorp’s foreign branch located in the Cayman Islands are wholesale funding tools utilized to fund asset growth. The maturity distribution of domestic certificates of deposit of $100,000 and over as of December 31, 2005 is shown in Table 30. Management does not rely on any one source of liquidity and manages availability in response to changing balance sheet needs.
CAPITAL MANAGEMENT
The Bancorp maintains a relatively high level of capital as a margin of safety for its depositors and shareholders. At December 31, 2005, shareholders’ equity was $9.4 billion compared to $8.9 billion at December 31, 2004, an increase of six percent. Average shareholders’ equity as a percentage of average assets for the year ended December 31, 2005 was 9.06%. See Note 27 of the Notes to the Consolidated Financial Statements for additional information regarding capital ratios.
Dividend Policy
The Bancorp’s common stock dividend policy reflects its earnings outlook, desired payout ratios, the need to maintain adequate capital levels and alternative investment opportunities. In 2005, the Bancorp’s annual dividend increased to $1.46 from $1.31 in 2004.
Stock Repurchase Program
On January 10, 2005, the Bancorp repurchased 35.5 million shares of its common stock, approximately six percent of total outstanding shares, for $1.6 billion in an overnight share repurchase transaction, where the counterparty in the transaction purchased shares in the open market over a period of time. This program was completed by the counterparty during the third quarter of 2005 and the Bancorp received a price adjustment of $97 million in cash. The price adjustment represented the difference between the original per share purchase price of $45.95 and the volume weighted-average price of $43.55 for actual shares acquired by the counterparty during the purchase period, plus interest.
On January 18, 2005, the Bancorp announced that its Board of Directors had authorized management to purchase 20 million shares of the Bancorp’s common stock through the open market or in any private transaction. The timing of the purchases and the exact number of shares to be purchased depends upon market conditions. The authorization does not include specific price targets or an expiration date.
The Bancorp’s stock repurchase program is an important element of its capital planning activities and the Bancorp views share repurchases as an effective means of delivering value to shareholders. The Bancorp’s repurchase of equity securities is shown in Table 33.
Off-Balance Sheet Arrangements
The Bancorp consolidates all of its majority-owned subsidiaries. Other entities, including certain joint ventures, in which there is greater than 20% ownership, but upon which the Bancorp does not possess, nor can exert, significant influence or control, are accounted for by equity method accounting and not consolidated. Those entities in which there is less than 20% ownership and on which the Bancorp does not possess, nor can exert, significant influence or control, are generally carried at the lower of cost or fair value.
The Bancorp does not participate in any trading activities involving commodity contracts that are accounted for at fair value. In addition, the Bancorp has no fair value contracts for which a lack of marketplace quotations necessitates the use of fair value estimation techniques. The Bancorp’s derivative product and investment policies provide a framework within which the Bancorp and its affiliates may use certain authorized financial derivatives as an asset/liability management tool in meeting the Bancorp’s ALCO capital planning directives, to hedge changes in fair value of its largely fixed-rate mortgage servicing rights portfolio or to provide qualifying commercial customers access to the derivative products market. These policies are reviewed and approved annually by the Risk and Compliance Committee of the Board of Directors.
As part of the Bancorp’s asset/liability management, the Bancorp may transfer, subject to credit recourse, certain types of individual financial assets to a non-consolidated qualified special purpose entity (“QSPE”) that is wholly owned by an independent third-party. The accounting for QSPEs is currently under review by the FASB and the conditions for consolidation or non-consolidation of such entities could change. During the year ended December 31, 2005, certain commercial loans (primarily floating-rate short-term investment-grade commercial loans) were transferred to the QSPE. Generally, the loans transferred, due to their investment grade nature, provide a lower yield and therefore transferring these loans to the QSPE allows the Bancorp to reduce its exposure to these assets while maintaining customer
Fifth Third Bancorp 45
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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
relationships. These individual loans are transferred at par with no gain or loss recognized and qualify as sales, as set forth in SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities – a Replacement of FASB Statement No. 125.” At December 31, 2005, the outstanding balance of loans transferred was $2.8 billion with a related loss reserve of $10 million.
The Bancorp had the following cash flows with these unconsolidated QSPEs during the years ended December 31, 2005 and 2004:
TABLE 34: CASH FLOWS WITH UNCONSOLIDATED QSPEs
| For the years ended December 31 ($ in millions) |
2005 |
2004 | ||||
| Proceeds from transfers, including new securitizations |
$ | 1,680 | 1,379 | |||
| Proceeds from collections reinvested in revolving-period securitizations |
132 | 162 | ||||
| Transfers received from QSPEs |
(18 | ) | — | |||
| Fees received |
32 | 32 | ||||
The Bancorp utilizes securitization trusts formed by independent third parties to facilitate the securitization process of residential mortgage loans, certain floating rate home equity lines of credit, certain auto loans and other consumer loans. The cash flows to and from the securitization trusts are principally limited to the initial proceeds from the securitization trust at the time of sale with subsequent cash flows relating to retained interests. The Bancorp’s securitization policy permits the retention of subordinated tranches, servicing rights,
interest-only strips, residual interests, credit recourse, other residual interests and, in some cases, a cash reserve account. At December 31, 2005, the Bancorp had retained servicing assets totaling $441 million, subordinated tranche security interests totaling $30 million and residual interests totaling $35 million.
At December 31, 2005, the Bancorp had provided credit recourse on approximately $1.3 billion of residential mortgage loans sold to unrelated third parties. In the event of any customer default, pursuant to the credit recourse provided, the Bancorp is required to reimburse the third party. The maximum amount of credit risk in the event of nonperformance by the underlying borrowers is equivalent to the total outstanding balance of $1.3 billion. In the event of nonperformance, the Bancorp has rights to the underlying collateral value attached to the loan. Consistent with its overall approach in estimating credit losses for various categories of residential mortgage loans held in its loan portfolio, the Bancorp maintains an estimated credit loss reserve of $21 million relating to these residential mortgage loans sold.
Contractual Obligations and Commitments
The Bancorp has certain obligations and commitments to make future payments under contracts. At December 31, 2005, the aggregate contractual obligations and commitments were:
TABLE 35: CONTRACTUAL OBLIGATIONS AND OTHER COMMITMENTS
| As of December 31, 2005 ($ in millions) |
Less 1 year |
1-3 years |
4-5 years |
Greater 5 years |
Total | ||||||
| Contractually obligated payments due by period: |
|||||||||||
| Total deposits (a) |
$ | 63,519 | 410 | 22 | 3,483 | 67,434 | |||||
| Long-term debt (b) |
3,669 | 4,018 | 4,188 | 3,352 | 15,227 | ||||||
| Short-term borrowings (c) |
9,569 | — | — | — | 9,569 | ||||||
| Noncancelable leases (d) |
65 | 123 | 106 | 315 | 609 | ||||||
| Partnership investment commitments (e) |
170 | — | — | — | 170 | ||||||
| Purchase obligations (f) |
14 | 20 | — | — | 34 | ||||||
| Total contractually obligated payments due by period |
$ | 77,006 | 4,571 | 4,316 | 7,150 | 93,043 | |||||