Quarterly Report
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

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

THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended September 30, 2010

Commission File Number 001-33653

 

 

LOGO

(Exact name of Registrant as specified in its charter)

 

 

 

Ohio   31-0854434

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification Number)

Fifth Third Center

Cincinnati, Ohio 45263

(Address of principal executive offices)

Registrant’s telephone number, including area code: (800) 972-3030

 

 

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

Indicate by check mark whether the Registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨

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

 

Large accelerated filer   x    Accelerated filer   ¨
Non-accelerated filer   ¨  (Do not check if a smaller reporting company)    Smaller reporting company   ¨

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

There were 796,283,198 shares of the Registrant’s common stock, without par value, outstanding as of September 30, 2010.

 

 

 


Table of Contents

 

LOGO

FINANCIAL CONTENTS

 

Part I. Financial Information

  

Glossary of Terms

     3   

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

  

Selected Financial Data

     4   

Overview

     5   

Non-GAAP Financial Measures

     7   

Recent Accounting Standards

     8   

Critical Accounting Policies

     8   

Statements of Income Analysis

     9   

Balance Sheet Analysis

     18   

Business Segment Review

     24   

Quantitative and Qualitative Disclosures about Market Risk (Item 3)

  

Risk Management – Overview

     30   

Credit Risk Management

     31   

Market Risk Management

     41   

Liquidity Risk Management

     44   

Capital Management

     45   

Off-Balance Sheet Arrangements

     47   

Controls and Procedures (Item 4)

     49   

Condensed Consolidated Financial Statements and Notes (Item 1)

  

Balance Sheets (unaudited)

     50   

Statements of Income (unaudited)

     51   

Statements of Changes in Equity (unaudited)

     52   

Statements of Cash Flows (unaudited)

     53   

Notes to Condensed Consolidated Financial Statements (unaudited)

     54   

Part II. Other Information

  

Legal Proceedings (Item 1)

     93   

Risk Factors (Item 1A)

     93   

Unregistered Sales of Equity Securities and Use of Proceeds (Item 2)

     93   

Exhibits (Item 6)

     94   

Signatures

     95   

Certifications

  

This report may contain forward-looking statements about Fifth Third Bancorp and/or the company as combined acquired entities within the meaning of Section 27A of the Securities Act of 1933, as amended, and Rule 175 promulgated thereunder, and Section 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 “will likely result,” “may,” “are expected to,” “is anticipated,” “estimate,” “forecast,” “projected,” “intends to,” or may include other similar words or phrases such as “believes,” “plans,” “trend,” “objective,” “continue,” “remain,” or similar expressions, or future or conditional verbs such as “will,” “would,” “should,” “could,” “might,” “can,” or similar verbs. 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) general economic conditions and weakening in the economy, specifically the real estate market, either nationally 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; (2) deteriorating credit quality; (3) political developments, wars or other hostilities may disrupt or increase volatility in securities markets or other economic conditions; (4) changes in the interest rate environment reduce interest margins; (5) prepayment speeds, loan origination and sale volumes, charge-offs and loan loss provisions; (6) Fifth Third’s ability to maintain required capital levels and adequate sources of funding and liquidity; (7) maintaining capital requirements may limit Fifth Third’s operations and potential growth; (8) changes and trends in capital markets; (9) problems encountered by larger or similar financial institutions may adversely affect the banking industry and/or Fifth Third; (10) competitive pressures among depository institutions increase significantly; (11) effects of critical accounting policies and judgments; (12) changes in accounting policies or procedures as may be required by the Financial Accounting Standards Board (FASB) or other regulatory agencies; (13) 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, including the recently enacted Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act); (14) ability to maintain favorable ratings from rating agencies; (15) fluctuation of Fifth Third’s stock price; (16) ability to attract and retain key personnel; (17) ability to receive dividends from its subsidiaries; (18) potentially dilutive effect of future acquisitions on current shareholders’ ownership of Fifth Third; (19) effects of accounting or financial results of one or more acquired entities; (20) difficulties in separating Fifth Third Processing Solutions from Fifth Third; (21) loss of income from any sale or potential sale of businesses that could have an adverse effect on Fifth Third’s earnings and future growth; (22) ability to secure confidential information through the use of computer systems and telecommunications networks; and (23) the impact of reputational risk created by these developments on such matters as business generation and retention, funding and liquidity. Additional information concerning factors that could cause actual results to differ materially from those expressed or implied in the forward-looking statements is available in the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2009, filed with the United States Securities and Exchange Commission (SEC). Copies of this filing are available at no cost on the SEC’s Web site at www.sec.gov or on the Fifth Third Web site at www.53.com. Fifth Third undertakes no obligation to release revisions to these forward-looking statements or reflect events or circumstances after the date of this report.

 

2


Table of Contents

 

Glossary of Terms

 

Fifth Third Bancorp provides the following list of acronyms as a tool for the reader. The acronyms identified below are used in Management’s Discussion & Analysis of Financial Condition & Results of Operations and in the Notes to Condensed Consolidated Financial Statements.

 

ALCO: Asset Liability Management Committee

ALLL: Allowance for Loan and Lease Losses

ARM: Adjustable Rate Mortgage

ASC: Accounting Standards Codification

ASU: Accounting Standards Update

BOLI: Bank Owned Life Insurance

bp: Basis point(s)

CDC: Fifth Third Community Development Corporation

CPP: Capital Purchase Program

DCF: Discounted Cash Flow

EESA: Emergency Economic Stabilization Act of 2008

ERISA: Employee Retirement Income Security Act

ERM: Enterprise Risk Management

ERMC: Enterprise Risk Management Committee

FASB: Financial Accounting Standards Board

FDIC: Federal Deposit Insurance Corporation

FHLB: Federal Home Loan Bank

FHLMC: Federal Home Loan Mortgage Corporation

FICO: Fair Isaac Corporation (credit rating)

FNMA: Federal National Mortgage Association

FRB: Federal Reserve Bank

FTE: Fully Taxable Equivalent

FTP: Funds Transfer Pricing

FTS: Fifth Third Securities

 

GNMA: Government National Mortgage Association

IRS: Internal Revenue Service

LIBOR: London InterBank Offered Rate

LTV: Loan-to-Value

MD&A: Management’s Discussion & Analysis of Financial Condition and Results of Operations

MSR: Mortgage Servicing Right

MVE: Market Value of Equity

NII: Net Interest income

OCI: Other Comprehensive Income

OREO: Other Real Estate Owned

OTTI: Other-Than-Temporary Impairment

PMI: Private Mortgage Insurance

QSPE: Qualifying Special-Purpose Entity

SEC: United States Securities and Exchange Commission

SCAP: Supervisory Capital Assessment Program

TAG: Transaction Account Guarantee

TARP: Troubled Asset Relief Program

TDR: Troubled Debt Restructuring

TSA: Transition Service Agreement

U.S. GAAP: Accounting principles generally accepted in the United States of America

VIE: Variable Interest Entity

VRDN: Variable Rate Demand Note

 

3


Table of Contents

 

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

 

The following is MD&A 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 Condensed Consolidated Financial Statements, which are a part of this filing. Reference to the Bancorp incorporates the parent holding company and all consolidated subsidiaries.

TABLE 1: Selected Financial Data

 

 

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

($ in millions, except per share data)

   2010      2009     % Change     2010      2009      % Change  

Income Statement Data

               

Net interest income (a)

   $ 916         874        5      $ 2,703         2,491         9   

Noninterest income

     827         851        (3     2,074         4,130         (50

Total revenue (a)

     1,743         1,725        1        4,777         6,621         (28

Provision for loan and lease losses

     457         952        (52     1,372         2,766         (50

Noninterest expense

     979         876        12        2,869         2,859         —     

Net income (loss) attributable to Bancorp

     238         (97     NM        420         835         (50

Net income (loss) available to common shareholders

     175         (159     NM        233         670         (65

Common Share Data

               

Earnings per share, basic

   $ 0.22         (0.20     NM      $ 0.29         1.00         (71

Earnings per share, diluted

     0.22         (0.20     NM        0.29         0.91         (68

Cash dividends per common share

     0.01         0.01        —          0.03         0.03         —     

Market value per share

     12.03         10.13        19        12.03         10.13         19   

Book value per share

     12.86         12.69        2        12.86         12.69         2   

Financial Ratios (%)

               

Return on assets

     0.84         (0.34     NM        0.50         0.96         (48

Return on average common equity

     6.8         (6.1     NM        3.1         10.1         (69

Average equity as a percent of average assets

     12.38         12.24        1        12.12         11.06         10   

Tangible equity (b)

     10.04         10.08        —          10.04         10.08         —     

Tangible common equity (b)

     6.70         6.74        (1     6.70         6.74         (1

Net interest margin (a)

     3.70         3.43        8        3.63         3.25         12   

Efficiency (a)

     56.2         50.8        11        60.1         43.2         39   

Credit Quality

               

Net losses charged off

   $ 956       $ 756        26      $ 1,972         1,872         5   

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

     4.95         3.75        32        3.41         3.06         11   

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

     4.20         4.69        (10     4.20         4.69         (10

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

     4.51         5.06        (11     4.51         5.06         (11

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

     2.72         4.09        (33     2.72         4.09         (33

Average Balances

               

Loans and leases, including held for sale

   $ 78,854         82,889        (5   $ 79,262         84,559         (6

Total securities and other short-term investments

     19,309         18,064        7        20,248         17,889         13   

Total assets

     111,854         113,453        (1     112,628         115,985         (3

Transaction deposits (e)

     64,941         55,607        17        64,887         54,034         20   

Core deposits (f)

     75,202         69,871        8        76,099         68,492         11   

Wholesale funding (g)

     19,236         25,947        (26     19,473         30,707         (37

Bancorp shareholders’ equity

     13,872         13,885        —          13,652         12,826         6   

Regulatory Capital Ratios (%)

               

Tier I capital

     13.85         13.19        5        13.85         13.19         5   

Total risk-based capital

     18.28         17.43        5        18.28         17.43         5   

Tier I leverage

     12.54         12.34        2        12.54         12.34         2   

Tier I common equity (b)

     7.34         7.01        5        7.34         7.01         5   

 

(a) Amounts presented on an FTE basis. The FTE adjustments were $4 and $5 for the three months ended September 30, 2010 and 2009, respectively, and $13 and $15 for the nine months ended September 30, 2010 and 2009, respectively.
(b) The tangible equity, tangible common equity and Tier I common equity ratios are non-GAAP measures. For further information, see the Non-GAAP Financial Measures section of the MD&A.
(c) The allowance for credit losses is the sum of the allowance for loan and lease losses and the reserve for unfunded commitments.
(d) Excludes nonaccrual loans held for sale.
(e) Includes demand, interest checking, savings, money market and foreign office deposits of commercial customers.
(f) Includes transaction deposits plus other time deposits.
(g) Includes certificates $100 thousand and over, other deposits, federal funds purchased, short-term borrowings and long-term debt.
NM: Not meaningful

 

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Table of Contents

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

 

 

OVERVIEW

Fifth Third Bancorp is a diversified financial services company headquartered in Cincinnati, Ohio. At September 30, 2010, the Bancorp had $112 billion in assets, operated 16 affiliates with 1,309 full-service Banking Centers, including 101 Bank Mart® locations open seven days a week inside select grocery stores, and 2,390 Jeanie® ATMs in 12 states throughout the Midwestern and Southeastern regions of the United States. The Bancorp reports on four business segments: Commercial Banking, Branch Banking, Consumer Lending and Investment Advisors. The Bancorp also has a 49% interest in Fifth Third Processing Solutions, LLC.

This overview of MD&A 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 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, results of operations and cash flows. In addition, see the glossary section on page 3 of MD&A for a list of acronyms included as a tool for the reader of this quarterly report on Form 10-Q. The acronyms identified therein are used throughout this MD&A as well as the Notes to Condensed Consolidated Financial Statements.

The Bancorp 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. The Bancorp believes its affiliate operating model provides a competitive advantage by emphasizing individual relationships. Through its affiliate operating model, individual managers at all levels within the affiliates are given the opportunity to tailor financial solutions for their customers.

The Bancorp’s revenues are dependent on both net interest income and noninterest income. For the three months ended September 30, 2010, net interest income, on an FTE basis, and noninterest income provided 53% and 47% of total revenue, respectively. 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 financial performance and capital strength of the Bancorp.

Net interest income is the difference between interest income earned on assets such as loans, leases and securities, and interest expense incurred on liabilities such as deposits, short-term borrowings and long-term debt. 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 pays 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 to 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 due to a weakened economy within the Bancorp’s footprint.

Net interest income, net interest margin and the efficiency ratio are presented in MD&A 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 presentation to be the preferred industry measurement of net interest income as it provides a relevant comparison between taxable and non-taxable amounts.

Noninterest income is derived primarily from service charges on deposits, corporate banking revenue, mortgage banking net revenue, fiduciary and investment management fees and card and processing revenue. Noninterest expense is primarily driven by personnel costs and occupancy expenses, costs incurred in the origination of loans and leases, and insurance premiums paid to the FDIC.

Recent Legislative Developments

On July 21, 2010, the Dodd-Frank Act was signed into law. This act significantly changes the financial services industry and affects the lending, deposit, investment, trading and operating activities of financial institutions and their holding companies. The legislation establishes a Bureau of Consumer Financial Protection, changes the base for deposit insurance assessments, gives the Federal Reserve the ability to regulate and limit interchange rates charged to merchants for the use of debit cards, and excludes certain instruments currently included in determining Tier I regulatory capital. This act calls for federal regulatory agencies to adopt hundreds of new rules and conduct multiple studies over the next several years in order to implement its provisions. While the total impact of this legislation on Fifth Third is not currently known, the impact is expected to be substantial and may have an adverse impact on Fifth Third’s financial performance and growth opportunities.

Earnings Summary

The Bancorp’s net income available to common shareholders for the quarter ended September 30, 2010 was $175 million, or $0.22 per diluted share, which included $63 million in preferred stock dividends. For the quarter ended September 30, 2009, the Bancorp’s net loss available to common shareholders was $159 million, or $0.20 per diluted share, which included $62 million in preferred stock dividends.

 

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Table of Contents

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

 

 

The Bancorp’s net income available to common shareholders for the nine months ended September 30, 2010 was $233 million, or $0.29 per diluted share, which included $187 million in preferred stock dividends. For the nine months ended September 30, 2009, the Bancorp’s net income available to common shareholders was $670 million, or $0.91 per diluted share, which included $165 million in preferred stock dividends.

Net interest income (FTE) increased five percent in the third quarter of 2010 to $916 million, compared to $874 million in the same period last year, and increased nine percent to $2.7 billion during the nine months ended September 30, 2010, compared to $2.5 billion in the same period last year. The primary reason for the increase in net interest income was an increase in the interest rate spread, which increased 34 bp from the third quarter of 2009 and increased 42 bp compared to the nine months ended September 30, 2009. This was the result of a mix shift from higher cost term deposits to lower cost deposit products, as well as a decrease in average interest-bearing liabilities, partially offset by reduced loan demand. Third quarter 2010 and 2009 results included $14 million and $29 million, respectively, of net interest income due to the accretion of premiums and discounts on loans and deposits from acquisitions during 2008, while the nine months ended September 30, 2010 and 2009 included $52 million and $109 million, respectively. Excluding these adjustments, net interest income increased $57 million, or seven percent, from the third quarter of 2009 and increased $269 million, or 11%, from the nine months ended September 30, 2009. Net interest margin was 3.70% in the third quarter of 2010 and 3.63% for the nine months ended September 30, 2010, an increase of 27 bp from the third quarter of 2009 and 38 bp from the nine months ended September 30, 2009.

Noninterest income decreased three percent to $827 million in the third quarter of 2010 compared to the same period last year and decreased 50% to $2.1 billion in the nine months ended September 30, 2010 compared to the same period in 2009. Third quarter 2010 results include $152 million from the settlement of litigation associated with one of the Bancorp’s BOLI policies. Third quarter 2009 results include a $244 million gain from the sale of the Bancorp’s Visa, Inc. Class B common shares. Excluding these items, noninterest income increased $68 million, or 11%, driven by strong growth in mortgage banking net revenue. Results for the nine months ended September 30, 2010 included the $152 million BOLI settlement discussed above, while results for the nine months ended September 30, 2009 included a $1.8 billion gain generated by the sale of a majority interest in its merchant acquiring and financial institutions processing business (Processing Business Sale) and the $244 million gain from the sale of Visa, Inc. Class B common shares. Excluding these items, noninterest income decreased $206 million, or 10%, driven primarily by lower card and processing revenue due to the Processing Business Sale, as well as decreases in service charges on deposits and corporate banking revenue, partially offset by strong growth in mortgage banking net revenue.

Noninterest expense increased $103 million, or 12%, compared to the third quarter of 2009 and remained relatively flat compared to the nine months ended September 30, 2009. Results for the third quarter of 2010 included $25 million in legal expenses associated with the BOLI settlement discussed above while the third quarter of 2009 included the reversal of a $73 million Visa litigation reserve. Excluding these items, noninterest expense remained relatively flat compared to the third quarter of 2009 as decreases in the provision for unfunded commitments and letters of credit were offset by higher FDIC insurance premiums and an increase in expenses related to representations and warranties on residential mortgage loans sold to third-parties.

The Bancorp does not originate subprime mortgage loans, does not hold credit default swaps and does not hold asset-backed securities backed by subprime mortgage loans in its securities portfolio. However, the Bancorp has exposure to disruptions in the capital markets and weakened economic conditions. Throughout 2009 and into 2010, the Bancorp continued to be affected by high unemployment rates, weakened housing markets, particularly in the upper Midwest and Florida, and a challenging credit environment. Credit trends, however, continued to show signs of moderation in 2010 and, as a result, the provision for loan and lease losses decreased 52% to $457 million for the three months ended September 30, 2010, compared to $952 million during the three months ended September 30, 2009, and decreased 50% to $1.4 billion for the nine months ended September 30, 2010, compared to $2.8 billion during the same period in 2009.

Net charge-offs as a percent of average loans and leases increased to 4.95% during the third quarter of 2010 compared to 3.75% during the third quarter of 2009 and increased to 3.41% for the nine months ended September 30, 2010, compared to 3.06% in the same period in 2009. The increase for both periods was due to the effect of actions taken by the Bancorp to reduce credit risk. During the third quarter of 2010, residential mortgage loans in the Bancorp’s portfolio with a carrying value of $228 million were sold for $105 million, generating $123 million in net charge-offs. Additionally, commercial loans with a carrying value prior to transfer of $961 million were transferred to held for sale, generating $387 million in net charge-offs. As a result of these actions, nonperforming assets as a percent of loans, leases and other assets, including OREO (excluding nonaccrual loans held for sale) decreased to 2.72% at September 30, 2010, compared to 4.22% at December 31, 2009 and 4.09% at September 30, 2009. Nonperforming assets as a percent of loans, leases and other assets, including OREO and nonaccrual loans held for sale was 3.51% at September 30, 2010, compared to 4.38% at December 31, 2009 and 4.34% at September 30, 2009. For further discussion on credit quality, see the Credit Risk Management section.

The Bancorp’s capital ratios exceed the “well-capitalized” guidelines as defined by the Board of Governors of the Federal Reserve System. As of September 30, 2010, the Tier I capital ratio was 13.85%, the Tier I leverage ratio was 12.54% and the total risk-based capital ratio was 18.28%.

 

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Table of Contents

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

 

 

NON-GAAP FINANCIAL MEASURES

The Bancorp considers various measures when evaluating capital utilization and adequacy, including the tangible equity ratio, tangible common equity ratio and tier I common equity ratio, in addition to capital ratios defined by banking regulators. These calculations are intended to complement the capital ratios defined by banking regulators for both absolute and comparative purposes. Because U.S. GAAP does not include capital ratio measures, the Bancorp believes there are no comparable U.S. GAAP financial measures to these ratios. Tier I common equity is not formally defined by U.S. GAAP or codified in the federal banking regulations and, therefore, is considered to be a non-GAAP financial measure. Since analysts and banking regulators may assess the Bancorp’s capital adequacy using these ratios, the Bancorp believes they are useful to provide investors the ability to assess its capital adequacy on this same basis.

The Bancorp believes these non-GAAP measures are important because they reflect the level of capital available to withstand unexpected market conditions. Additionally, presentation of these measures allows readers to compare certain aspects of the Bancorp’s capitalization to other organizations. However, because there are no standardized definitions for these ratios, the Bancorp’s calculations may not be comparable with other organizations, and the usefulness of these measures to investors may be limited. As a result, the Bancorp encourages readers to consider its Condensed Consolidated Financial Statements in their entirety and not to rely on any single financial measure.

The following table reconciles U.S. GAAP to non-GAAP financial measures as of:

TABLE 2: Non-GAAP Financial Measures

 

 

As of ($ in millions)

   September 30,
2010
    December 31,
2009
    September 30,
2009
 

Total Bancorp shareholders’ equity (U.S. GAAP)

   $ 13,884        13,497        13,688   

Less: Goodwill

     (2,417     (2,417     (2,417

Intangible assets

     (72     (106     (119

Accumulated other comprehensive income

     (432     (241     (285
                        

Tangible equity (1)

     10,963        10,733        10,867   

Less: Preferred stock

     (3,642     (3,609     (3,599
                        

Tangible common equity (2)

   $ 7,321        7,124        7,268   
                        

Total assets (U.S. GAAP)

   $ 112,322        113,380        110,740   

Less: Goodwill

     (2,417     (2,417     (2,417

Intangible assets

     (72     (106     (119

Accumulated other comprehensive income, before tax

     (665     (370     (438
                        

Tangible assets, excluding unrealized gains / losses (3)

   $ 109,168        110,487        107,766   
                        

Total Bancorp shareholders’ equity (U.S. GAAP)

   $ 13,884        13,497        13,688   

Goodwill and certain other intangibles

     (2,525     (2,565     (2,559

Unrealized gains

     (432     (241     (285

Qualifying trust preferred securities

     2,763        2,763        2,763   

Other

     8        (26     (33
                        

Tier I capital

     13,698        13,428        13,574   

Less: Preferred stock

     (3,642     (3,609     (3,599

Qualifying trust preferred securities

     (2,763     (2,763     (2,763

Qualified noncontrolling (minority) interest in consolidated subsidiaries

     (30     —          —     
                        

Tier I common equity (4)

   $ 7,263        7,056        7,212   
                        

Risk-weighted assets (5) (a)

   $ 98,904        100,933        102,875   

Ratios:

      

Tangible equity (1) / (3)

     10.04     9.71        10.08   

Tangible common equity (2) / (3)

     6.70     6.45        6.74   

Tier I common equity (4) / (5)

     7.34     6.99        7.01   

 

(a) Under the banking agencies’ risk-based capital guidelines, assets and credit equivalent amounts of derivatives and off-balance sheet exposures are assigned to broad risk categories. The aggregate dollar amount in each risk category is multiplied by the associated risk weight of the category. The resulting weighted values are added together, resulting in the Bancorp’s total risk-weighted assets.

 

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

 

 

RECENT ACCOUNTING STANDARDS

Note 3 of the Notes to Condensed Consolidated Financial Statements provides a complete discussion of the significant new accounting standards recently adopted by the Bancorp and the expected impact of significant accounting standards issued, but not yet required to be adopted.

CRITICAL ACCOUNTING POLICIES

The Bancorp’s Condensed Consolidated Financial Statements are prepared in accordance with U.S. GAAP. Certain accounting policies require management to exercise judgment in determining methodologies, economic assumptions and estimates that may materially affect the value of the Bancorp’s assets or liabilities and results of operations and cash flows. The Bancorp’s critical accounting policies include the accounting for allowance for loan and lease losses, reserve for unfunded commitments, income taxes, valuation of servicing rights, fair value measurements and goodwill. These accounting policies are discussed in detail in Management's Discussion and Analysis - Critical Accounting Policies in the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2009. No material changes have been made to the valuation techniques or models during the nine months ended September 30, 2010.

 

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

 

 

STATEMENTS OF INCOME ANALYSIS

Net Interest Income

Net interest income is the interest earned on securities, loans and leases (including yield-related fees) and other interest-earning assets less the interest paid for core deposits (includes transaction deposits and other time deposits) and wholesale funding (includes certificates $100,000 and over, other deposits, federal funds purchased, short-term borrowings and long-term debt). The net interest margin is calculated by dividing net interest income by average interest-earning assets. Net interest spread is the difference between the average rate earned on interest-earning assets and the average rate paid on interest-bearing liabilities. Net interest margin is typically greater than net interest rate spread due to the interest income earned on those assets that are funded by noninterest-bearing liabilities, or free funding, such as demand deposits or shareholders’ equity.

Tables 3 and 4 present the components of net interest income, net interest margin and net interest rate spread for the three and nine months ended September 30, 2010 and 2009. Nonaccrual loans and leases and loans held for sale have been included in the average loan and lease 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.

Net interest income was $916 million for the third quarter of 2010, an increase of $42 million from the third quarter of 2009. For the nine months ended September 30, 2010, net interest income was $2.7 billion, an increase of $212 million from the same period in 2009. Included within net interest income are adjustments related to the accretion of discounts on acquired loans and deposits, primarily as a result of the second quarter 2008 acquisition of First Charter, which increased net interest income $14 million and $52 million during the three and nine months ended September 30, 2010, respectively, compared to $29 million and $109 million during the three and nine months ended September 30, 2009, respectively. The purchase accounting accretion reflects the high discount rate in the market at the time of the acquisition; the total loan discounts are being accreted into net interest income over the remaining period to maturity of the loans acquired. Based upon the remaining period to maturity, and excluding the impact of prepayments, the Bancorp anticipates recognizing approximately $10 million in additional net interest income during the remainder of 2010 and $41 million in 2011 as a result of the amortization and accretion of premiums and discounts on acquired loans and deposits. Exclusive of the impact of these items, net interest income increased $57 million compared to the third quarter of 2009 and increased $269 million compared to the nine months ended September 30, 2009.

For the three and nine months ended September 30, 2010, net interest income was positively impacted by a decrease of $3.7 billion and $6.4 billion, respectively, in average interest-bearing liabilities coupled with a mix shift to lower cost core deposits from the same periods in 2009. This was primarily a result of runoff of higher priced term deposits as well as the benefit of lower rates offered on new term deposits. The nine months ended 2010 also benefited from an increase in the average equity position as a result of capital actions taken during the second quarter of 2009. This activity was partially offset by decreases of $2.8 billion and $2.9 billion for the three and nine months ended September 30, 2010, respectively, in average interest-earning assets. The shift in funding composition and improved pricing spreads on commercial loans resulted in an increase in the net interest rate spread to 3.44% and 3.35% for the three and nine months ended September 30, 2010, respectively, compared to 3.10% and 2.93% for the three and nine months ended September 30, 2009, respectively.

Net interest margin increased to 3.70% and 3.63% for the three and nine months ended September 30, 2010, respectively, compared to 3.43% and 3.25% in the same prior year periods. Net interest margin was affected by the amortization and accretion of premiums and discounts on acquired loans and deposits that increased net interest margin approximately 5 bp and 6 bp during the three and nine months ended September 30, 2010, respectively, compared to 10 bp and 13 bp increases in same prior year periods. Exclusive of these adjustments, net interest margin increased 32 bp in the third quarter of 2010 and increased 45 bp during the nine months ended September 30, 2010 compared to the same prior year periods driven by improved pricing on new commercial loan originations and a shift in funding composition to lower cost core deposits, an increase in free-funding balances and a decrease in average rates paid on interest bearing liabilities.

Total average interest-earning assets for the three and nine months ended September 30, 2010 decreased three percent from the same periods in the prior year. For the third quarter of 2010, average commercial loans and average consumer loans decreased eight percent and one percent, respectively, compared to the third quarter of 2009. For the nine months ended September 30, 2010, average commercial loans and average consumer loans decreased nine percent and two percent, respectively, compared to the nine months ended September 30, 2009. These decreases were partially offset by an increase in the average investment portfolio of seven percent in the three months ended September 30, 2010 compared to the third quarter of 2009 and an increase of 13% in the nine months ended September 30, 2010 compared to the same period in 2009. Further detail on the Bancorp’s investment securities portfolio and loan and lease portfolio can be found in the Investment Securities and Loan and Leases sections, respectively, of MD&A.

Interest income from loans and leases decreased $25 million, or two percent, compared to the third quarter of 2009. The decrease in interest income was a result of a five percent decrease in average loan and lease balances partially offset by a 12 bp increase in average yield. Exclusive of the amortization and accretion of premiums and discounts on acquired loans, interest income from loans and leases decreased $10 million compared to the prior year third quarter. For the nine months ended September 30, 2010, interest income from loans and leases decreased $106 million, or four percent, compared to the same period in 2009, due to a six percent decrease in average loan balances partially offset by a 14 bp increase in the average yield. Exclusive of the amortization and accretion of premiums and discounts on

 

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

 

 

acquired loans, interest income from loans and leases decreased $49 million in the nine months ended September 30, 2010 compared to the same prior year period.

Interest income from investment securities and short-term investments decreased $19 million, or 10%, compared to the third quarter of 2009 and $36 million, or seven percent, for the nine months ended September 30, 2010 compared to the same prior year period. The decrease in the third quarter of 2010 was primarily the result of a 66 bp decrease on the average yield of the portfolio. The decrease for the nine months ended September 30, 2010 compared to the same period in 2009 was the result of a 72 bp decrease in the average yield partially offset by a 13% increase in the average investment portfolio.

During the third quarter of 2010, average core deposits increased $5.3 billion, or eight percent, compared to the third quarter of 2009 and $7.6 billion, or 11%, for the nine months ended September 30, 2010 compared to the same period in 2009. The increases compared to both periods were primarily due to an increase in average demand deposits, average interest checking balances and average savings balances, partially offset by a decrease in average time deposits. The cost of average core deposits decreased 34 bp from the third quarter of 2009 to 0.59% and decreased 37 bp from the nine months ended September 30, 2009 to 0.65%, primarily as the result of a mix shift to lower cost core deposits and a decrease in rates on average time deposits of 67 bp and 77 bp during the three and nine months ended September 30, 2010, respectively, compared to the same periods in 2009.

During the third quarter of 2010, interest expense on wholesale funding decreased $34 million, or 25%, compared to the third quarter of 2009 and decreased $201 million, or 38%, for the nine months ended September 30, 2010 compared to the same period in 2009 primarily as a result of a 26% and 37% decline in average balances, respectively, and lower rates on certificates of deposit of $100,000 and over. During the three and nine months ended September 30, 2010, wholesale funding represented 26% and 25%, respectively, of interest-bearing liabilities compared to 33% and 37%, respectively, during the same prior year periods. The decline in wholesale funding balances is primarily a result of a decrease in other short term borrowings due to a repayment of Term Auction Facility funds which had an average balance for the three and nine months ended September 30, 2009 of $3.9 billion and $6.0 billion, respectively, in addition to decreases of $4.0 billion and $4.6 billion in certificates of deposit over $100,000 during the three and nine months ended September 30, 2010, respectively, compared to the same periods in the prior year as a result of maturities on certificates of deposit over $100,000. The decreased reliance on wholesale funding in the three and nine months ended September 30, 2010 compared to the prior year periods was a result of growth of core deposits and a decline in average interest earning assets. Refer to the Capital Management section for additional information on the Bancorp’s capital actions.

 

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

 

TABLE 3: Condensed Average Balance Sheets and Analysis of Net Interest Income

 

 

For the three months ended

   September 30, 2010     September 30, 2009     Attribution of Change in Net Interest
Income
(a)
 

($ in millions)

   Average
Balance
    Revenue/
Cost
     Average
Yield/

Rate
    Average
Balance
    Revenue/
Cost
     Average
Yield/

Rate
    Volume     Yield/Rate     Total  

Assets

                    

Interest-earning assets:

                    

Loans and leases (b):

                    

Commercial and industrial loans

   $ 26,348      $ 319         4.81   $ 27,416      $ 302         4.36     (12     29        17   

Commercial mortgage

     11,462        115         3.97        12,449        132         4.22        (9     (8     (17

Commercial construction

     2,955        23         3.06        4,475        31         2.74        (11     3        (8

Commercial leases

     3,257        35         4.34        3,522        41         4.59        (3     (3     (6
                                                                          

Subtotal – commercial

     44,022        492         4.44        47,862        506         4.19        (35     21        (14

Residential mortgage loans

     9,897        120         4.81        10,820        143         5.23        (12     (11     (23

Home equity

     11,897        120         3.99        12,452        129         4.10        (6     (3     (9

Automobile loans

     10,517        151         5.71        8,871        141         6.32        24        (14     10   

Credit card

     1,838        50         10.70        1,955        49         9.87        (3     4        1   

Other consumer loans/leases

     683        32         18.59        929        22         9.59        (7     17        10   
                                                                          

Subtotal – consumer

     34,832        473         5.38        35,027        484         5.48        (4     (7     (11
                                                                          

Total loans and leases

     78,854        965         4.85        82,889        990         4.73        (39     14        (25

Securities:

                    

Taxable

     15,580        159         4.06        15,652        180         4.55        (1     (20     (21

Exempt from income taxes (b)

     273        3         4.05        1,443        4         1.30        (6     5        (1

Other short-term investments

     3,456        3         0.36        969        —           0.10        2        1        3   
                                                                          

Total interest-earning assets

     98,163        1,130         4.57        100,953        1,174         4.61        (44     —          (44

Cash and due from banks

     2,283             2,257              

Other assets

     15,088             13,724              

Allowance for loan and lease losses

     (3,680          (3,481           
                                                                          

Total assets

   $ 111,854           $ 113,453              
                                                                          

Liabilities and Equity

                    

Interest-bearing liabilities:

                    

Interest checking

   $ 17,142      $ 12         0.29   $ 14,869      $ 9         0.24     1        2        3   

Savings

     19,905        24         0.48        16,967        29         0.67        4        (9     (5

Money market

     4,940        5         0.39        4,280        6         0.55        1        (2     (1

Foreign office deposits

     3,592        3         0.38        2,432        3         0.43        —          —          —     

Other time deposits

     10,261        67         2.57        14,264        116         3.24        (29     (20     (49

Certificates - $100,000 and over

     6,096        30         1.95        10,055        65         2.56        (22     (13     (35

Other deposits

     4        —           0.09        95        —           0.19        —          —          —     

Federal funds purchased

     302        —           0.17        404        —           0.15        —          —          —     

Other short-term borrowings

     1,880        1         0.21        5,285        4         0.32        (2     (1     (3

Long-term debt

     10,954        72         2.61        10,108        68         2.67        6        (2     4   
                                                                          

Total interest-bearing liabilities

     75,076        214         1.13        78,759        300         1.51        (41     (45     (86

Demand deposits

     19,362             17,059              

Other liabilities

     3,544             3,750              
                                                                          

Total liabilities

     97,982             99,568              

Total equity

     13,872             13,885              
                                                                          

Total liabilities and equity

   $ 111,854           $ 113,453              
                                                                          

Net interest income

     $ 916             874           (3     45        42   

Net interest margin

          3.70          3.43      

Net interest rate spread

          3.44             3.10         

Interest-bearing liabilities to interest-earning assets

          76.48             78.02         

 

(a) Changes in interest not solely due to volume or yield/rate are allocated in proportion to the absolute dollar amount of change in volume and yield/rate.
(b) The FTE adjustments included in the above table are $4 and $5 for the three months ended September 30, 2010 and 2009, respectively.

 

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

 

 

TABLE 4: Condensed Average Balance Sheets and Analysis of Net Interest Income

 

 

For the nine months ended

   September 30, 2010     September 30, 2009     Attribution of Change in Net Interest
Income
(a)
 

($ in millions)

   Average
Balance
    Revenue/
Cost
     Average
Yield/
Rate
    Average
Balance
    Revenue/
Cost
     Average
Yield/
Rate
    Volume     Yield/Rate     Total  

Assets

                    

Interest-earning assets:

                    

Loans and leases (b):

                    

Commercial and industrial loans

   $ 26,276      $ 928         4.72   $ 28,135      $ 870         4.14     (60     118        58   

Commercial mortgage

     11,689        358         4.09        12,641        417         4.41        (30     (29     (59

Commercial construction

     3,328        76         3.04        4,808        107         2.97        (33     2        (31

Commercial leases

     3,353        112         4.46        3,532        109         4.13        (6     9        3   
                                                                          

Subtotal – commercial

     44,646        1,474         4.41        49,116        1,503         4.09        (129     100        (29

Residential mortgage loans

     9,590        352         4.92        11,137        470         5.64        (62     (56     (118

Home equity

     12,111        363         4.01        12,616        394         4.17        (16     (15     (31

Automobile loans

     10,292        460         5.98        8,751        416         6.36        69        (25     44   

Credit card

     1,879        152         10.79        1,882        144         10.26        —          8        8   

Other consumer loans/leases

     744        81         14.54        1,057        61         7.64        (22     42        20   
                                                                          

Subtotal – consumer

     34,616        1,408         5.44        35,443        1,485         5.60        (31     (46     (77
                                                                          

Total loans and leases

     79,262        2,882         4.86        84,559        2,988         4.72        (160     54        (106

Securities:

                    

Taxable

     16,285        500         4.10        15,526        537         4.62        25        (62     (37

Exempt from income taxes (b)

     333        10         3.82        1,364        14         1.38        (16     12        (4

Other short-term investments

     3,630        6         0.25        999        1         0.15        4        1        5   
                                                                          

Total interest-earning assets

     99,510        3,398         4.57        102,448        3,540         4.62        (147     5        (142

Cash and due from banks

     2,231             2,347              

Other assets

     14,636             14,327              

Allowance for loan and lease losses

     (3,749          (3,137           
                                                                          

Total assets

   $ 112,628           $ 115,985              
                                                                          

Liabilities and Equity

                    

Interest-bearing liabilities:

                    

Interest checking

   $ 18,433      $ 40         0.29   $ 14,647      $ 29         0.26     8        3        11   

Savings

     19,279        84         0.58        16,651        96         0.77        13        (25     (12

Money market

     4,748        15         0.42        4,334        21         0.63        1        (7     (6

Foreign office deposits

     3,228        9         0.36        1,970        7         0.49        4        (2     2   

Other time deposits

     11,212        225         2.68        14,458        373         3.45        (74     (74     (148

Certificates - $100,000 and over

     6,496        101         2.08        11,098        233         2.81        (81     (51     (132

Other deposits

     6        —           0.06        193        —           0.21        —          —          —     

Federal funds purchased

     262        —           0.16        548        1         0.22        (1     —          (1

Other short-term borrowings

     1,604        3         0.22        7,620        40         0.70        (20     (17     (37

Long-term debt

     11,105        218         2.63        11,248        249         2.96        (3     (28     (31
                                                                          

Total interest-bearing liabilities

     76,373        695         1.22        82,767        1,049         1.69        (153     (201     (354

Demand deposits

     19,199             16,432              

Other liabilities

     3,404             3,960              
                                                                          

Total liabilities

     98,976             103,159              

Total equity

     13,652             12,826              
                                                                          

Total liabilities and equity

   $ 112,628           $ 115,985              
                                                                          

Net interest income

     $ 2,703           $ 2,491           6        206        212   

Net interest margin

          3.63          3.25      

Net interest rate spread

          3.35             2.93         

Interest-bearing liabilities to interest-earning assets

          76.75             80.79         

 

(a) Changes in interest not solely due to volume or yield/rate are allocated in proportion to the absolute dollar amount of change in volume and yield/rate.
(b) The FTE adjustments included in the above table are $13 and $15 for the nine months ended September 30, 2010 and 2009, respectively.

 

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

 

 

Provision for Loan and Lease Losses

The Bancorp provides as an expense an amount for probable loan and lease losses inherent within the loan portfolio that is based on factors discussed in the Critical Accounting Policies section of the Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2009. 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 Condensed Consolidated Balance Sheets is referred to as charge-offs. Net charge-offs include current period charge-offs less recoveries on previously charged-off loans and leases.

Provision for loan and lease losses was $457 million and $1.4 billion for the three and nine months ended September 30, 2010, respectively, compared to $952 million and $2.8 billion during the same periods in 2009. The three and nine months ended September 30, 2009 were significantly impacted by growth in nonperforming assets, increases in commercial and consumer delinquencies, and loss estimates once loans became delinquent. During the three and nine months ended September 30, 2010 the Bancorp experienced decreases in nonperforming assets and delinquencies resulting in a decline in provision expense compared to the prior year periods. In addition to these trends, signs of moderation in general economic conditions during 2010 further contributed to the decline.

Refer to the Credit Risk Management section as well as Note 6 of the Notes to Condensed Consolidated Financial Statements for more detailed information on the provision for loan and lease losses including an analysis of loan portfolio composition, nonperforming assets, net charge-offs, and other factors considered by the Bancorp in assessing the credit quality of the loan and lease portfolio and the allowance for loan and lease losses.

Noninterest Income

Noninterest income decreased $24 million and $2.1 billion compared to the three and nine months ended September 30, 2009, respectively. Results for both periods reflect a number of significant items including a favorable $152 million settlement of litigation related to one of the Bancorp’s BOLI policies during the current quarter, a gain of $244 million recognized on the sale of the Bancorp’s Visa, Inc. Class B common shares during the prior year third quarter and a $1.8 billion gain on the Processing Business Sale in the second quarter of 2009. Excluding these items, noninterest income increased $68 million, or 11%, compared to the third quarter of 2009 and decreased $206 million, or 10%, compared to the nine months ended September 30, 2009. The components of noninterest income for the three and nine month periods ending September 30, 2010 and 2009 are as follows:

TABLE 5: Noninterest Income

 

 

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

($ in millions)

   2010      2009     Change     2010      2009     Change  

Mortgage banking net revenue

   $ 232       $ 140        66      $ 498       $ 421        18   

Service charges on deposits

     143         164        (13     435         472        (8

Investment advisory revenue

     90         82        10        267         240        11   

Corporate banking revenue

     86         77        11        260         283        (8

Card and processing revenue

     77         74        5        235         539        (56

Gain on sale of processing business

     —           (6     100        —           1,758        (100

Other noninterest income

     195         312        (38     354         372        (5

Securities gains (losses), net

     4         8        (50     25         (12     NM   

Securities gains, net, non-qualifying hedges on mortgage servicing rights

     —           —          —          —           57        (100
                                                  

Total noninterest income

   $ 827       $ 851        (3   $ 2,074       $ 4,130        (50
                                                  

NM: Not meaningful

Mortgage banking net revenue increased $92 million and $77 million compared to the three and nine months ended September 30, 2009, respectively. The components of mortgage banking net revenue are shown in Table 6.

 

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TABLE 6: Components of Mortgage Banking Net Revenue

 

 

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

($ in millions)

   2010     2009     2010     2009  

Origination fees and gains on loan sales

   $ 173      $ 96      $ 332      $ 387   

Servicing revenue:

        

Servicing fees

     56        50        163        145   

Servicing rights amortization

     (43     (29     (91     (120

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

     46        23        94        9   
                                

Net servicing revenue

     59        44        166        34   
                                

Mortgage banking net revenue

   $ 232      $ 140      $ 498      $ 421   
                                

Origination fees and gains on loan sales increased $77 million compared to the third quarter of 2009 as increased refinance originations due to historically low interest rates and higher margins on loans sold were partially offset by a decline in purchase originations due to the homebuyer tax credit expiring during the second quarter of 2010. Origination fees and gains on loan sales decreased $55 million compared to the nine months ended September 30, 2009, as a surge in refinancing activity during the first six months of 2009 has not been sustained in 2010, primarily due to tighter underwriting standards and declining home values. Mortgage originations increased 21% to $5.6 billion compared to the third quarter of 2009 and decreased 24% to $12.8 billion compared to the nine months ended September 30, 2009.

Mortgage net servicing revenue increased $15 million and $132 million, respectively, for the three and nine months ended September 30, 2010 compared to the same periods in the prior year. Net servicing revenue is comprised of gross servicing fees and related servicing rights amortization as well as valuation adjustments on mortgage servicing rights and mark-to-market adjustments on both settled and outstanding free-standing derivative financial instruments. The increases in net servicing revenue were primarily due to improvements in net valuation adjustments on MSRs and MSR derivatives as gains on the Bancorp’s free-standing MSR derivatives exceeded impairment losses recorded against the hedged MSRs. This was the result of a widening spread between swap rates and secondary market mortgage rates as swap rates declined more than secondary market mortgage rates during the current quarter, as well as a positive carrying value in the net MSR hedge position. The Bancorp’s total residential loans serviced as of September 30, 2010, December 31, 2009, and September 30, 2009 was $62.4 billion, $58.5 billion, and $56.7 billion, respectively, with $52.4 billion, $48.6 billion, and $46.8 billion, respectively, of residential mortgage loans serviced for others.

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. Further detail on the valuation of MSRs can be found in Note 11 of the Notes to Condensed Consolidated Financial Statements. The Bancorp maintains a non-qualifying hedging strategy to manage a portion of the risk associated with changes in the valuation on the MSR portfolio. See Note 12 of the Notes to Condensed Consolidated Financial Statements for more information on the free-standing derivatives used to hedge the MSR portfolio.

For the three months ended September 30, 2010, the Bancorp recognized gains from derivatives economically hedging MSRs of $129 million, offset by a temporary impairment of $83 million, resulting in a net gain of $46 million. For the nine months ended September 30, 2010, the Bancorp recognized gains from derivatives economically hedging MSRs of $283 million partially offset by a temporary impairment of $189 million resulting in a net gain of $94 million. For the three months ended September 30, 2009, the Bancorp recognized gains from derivatives economically hedging MSRs of $61 million offset by a temporary impairment of $38 million resulting in a net gain of $23 million. For the nine months ended September 30, 2009, the Bancorp recognized gains from derivatives economically hedging MSRs of $65 million partially offset by temporary impairment of $56 million resulting in a net gain of $9 million. See Note 12 of the Notes to Condensed Consolidated Financial Statements for more information on free-standing derivatives used to hedge the MSR portfolio.

In addition to the derivative positions used to economically hedge the MSR portfolio, the Bancorp acquires various securities as a component of its non-qualifying hedging strategy. Net gains on sales of these securities were immaterial for the three and nine months ended September 30, 2010. In addition, net gains on the sales of these securities were immaterial for the third quarter of 2009 and $57 million during the nine months ended September 30, 2009.

Service charges on deposits decreased $21 million and $37 million for the three and nine months ended September 30, 2010, respectively, compared to the same periods in the prior year. Consumer deposit revenue decreased $21 million and $34 million compared to the three and nine months ended September 30, 2009, respectively, as the impact of Regulation E and new overdraft policies resulted in a decrease in overdraft occurrences. Regulation E became effective on July 1, 2010 for new accounts and August 15, 2010 for existing accounts. Regulation E is a Federal Reserve Board rule that prohibits financial institutions from charging consumers fees for paying overdrafts on ATMs and one-time debit card transactions unless a consumer consents, or opts in, to the overdraft service for those types of transactions.

Commercial deposit revenue was flat compared to the third quarter of 2009 as a slight increase in service fees for treasury management services was largely offset by a modest increase in earnings credits paid on customer balances. Commercial deposit revenue decreased $4 million compared to the nine months ended September 30, 2009, as increased earnings credits paid on customer balances resulted in lower

 

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net service fees. Commercial customers receive earnings credits to offset the fees charged for banking services on their deposit accounts such as account maintenance, lockbox, ACH transactions, wire transfers and other ancillary corporate treasury management services. Earnings credits are based on the customer’s average balance in qualifying deposits multiplied by the crediting rate. Qualifying deposits include demand deposits and interest-bearing checking accounts. The Bancorp has a standard crediting rate that is adjusted as necessary based on competitive market conditions and changes in short-term interest rates.

Investment advisory revenue for the three and nine months ended September 30, 2010 increased $8 million and $27 million, respectively, compared to the same periods last year. This was the result of improved market performance and sales force expansion that resulted in increased brokerage activity and assets under management and care. As of September 30, 2010, the Bancorp had approximately $190.0 billion in assets under care and managed $25.6 billion in assets for individuals, corporations and not-for-profit organizations.

Corporate banking revenue increased $9 million compared to the third quarter of 2009 as growth in both syndication and business lending fees was partially offset by a decline in international income due to lower foreign exchange and letter of credit volume. Corporate banking revenue decreased $23 million compared to the nine months ended September 30, 2009 as decreases in lease remarketing fees, international income and servicing fees were partially offset by growth in syndication and business lending fees.

Card and processing revenue increased $3 million compared to the third quarter of 2009 due to growth in debit and credit card transaction volumes. Card and processing revenue decreased $304 million compared to the nine months ended September 30, 2009 due to the Processing Business Sale completed on June 30, 2009. The financial institutions and merchant processing portions of the business sold historically comprised approximately 70% of total card and processing revenue. Excluding the impact of the sold portions of the business, card and processing revenue increased 11% compared to the nine months ended September 30, 2009 due to higher debit and credit card transaction volumes.

The major components of other noninterest income are as follows:

TABLE 7: Components of Other Noninterest Income

 

 

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

($ in millions)

   2010     2009     2010     2009  

Bank owned life insurance income (loss)

   $ 165      $ 12      $ 188      ($ 14

Operating lease income

     15        15        46        44   

Transition Service Agreement revenue

     13        38        38        38   

Insurance income

     10        10        26        36   

Consumer loan and lease fees

     9        11        24        34   

Cardholder fees

     8        12        27        36   

Banking center income

     6        5        16        17   

Gain on sale/redemption of Visa, Inc. ownership interests

     —          244        —          244   

Gain (loss) on loan sales

     (1     8        30        29   

Loss on sale of other real estate owned

     (29     (22     (59     (49

Other

     (1     (21     18        (43
                                

Total other noninterest income

   $ 195      $ 312      $ 354      $ 372   
                                

Other noninterest income decreased $117 million compared to the third quarter of 2009 primarily as a result of the $244 million gain recognized on the sale of Visa, Inc. Class B common shares during the third quarter of 2009, and a decrease in revenue related to the TSA from the Processing Business Sale in June of 2009. As part of the Processing Business Sale, the Bancorp entered into the TSA that resulted in the Bancorp recognizing approximately $13 million and $38 million in revenue during the three and nine months ended September 30, 2010, respectively, that were offset with expense from the TSA recorded in card and processing expense. These decreases were partially offset by a $152 million litigation settlement related to one of the Bancorp’s BOLI policies in the third quarter of 2010. Other noninterest income decreased $18 million compared to the nine months ended September 30, 2009, due to the items previously discussed, partially offset by a BOLI charge of $54 million recognized in the first quarter of 2009.

Net securities gains were $4 million and $25 million for the three and nine months ended September 30, 2010, respectively, compared to $8 million of net securities gains for the three months ended September 30, 2009, and net securities losses of $12 million for the nine months ended September 30, 2009. Net securities losses for the nine months ended September 30, 2009 included $18 million in losses attributable to the reclassification of securities related to deferred compensation plans from available-for-sale to trading.

Noninterest Expense

Total noninterest expense increased $103 million for the three months ended September 30, 2010 compared to the same period last year due to higher wages and other noninterest expenses. Noninterest expense increased $10 million for the nine months ended September 30, 2010 compared to the same period last year due to the items mentioned previously, partially offset by a decrease in card and processing expense resulting from the Processing Business Sale in June of 2009. In addition, the Bancorp incurred approximately $13 million and $38

 

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million in operating expenses during the three and nine months ended September 30, 2010, respectively, that were offset with revenue from the TSA recorded in other noninterest income. The major components of noninterest expense are detailed in the following table.

TABLE 8: Noninterest Expense

 

 

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

($ in millions)

   2010      2009      Percent
Change
    2010      2009      Percent
Change
 

Salaries, wages and incentives

   $ 360       $ 335         8      $ 1,046       $ 1,008         4   

Employee benefits

     82         83         (1     241         241         —     

Net occupancy expense

     72         75         (3     222         233         (5

Technology and communications

     48         43         10        138         133         3   

Equipment expense

     30         30         1        91         92         (2

Card and processing expense

     26         25         1        82         167         (51

Other noninterest expense

     361         285         27        1,049         985         6   
                                                    

Total noninterest expense

   $ 979       $ 876         12      $ 2,869       $ 2,859         —     
                                                    

Total personnel costs (salaries, wages and incentives plus employee benefits) increased eight percent and four percent for the three and nine months ended September 30, 2010 compared to the same periods last year, driven by an increase in base and variable compensation, partially offset by a decrease in deferred compensation. Base and variable compensation increased due to investments in the sales force during 2010. Full time equivalent employees totaled 20,667 at September 30, 2010 compared to 20,559 at September 30, 2009. The increase in full time equivalent employees from September 30, 2009 is primarily due to increases in the sales force during 2010, partially offset by the transfer of employees on January 1, 2010 from the Processing Business Sale in June of 2009.

Card and processing expense includes third-party processing expenses, card management fees and other bankcard processing expenses. Card and processing expense was flat for the three months ended September 30, 2010 compared to the same period last year. Card and processing expense decreased 51% for the nine months ended September 30, 2010 compared to the same period last year due to the Processing Business Sale in the second quarter of 2009.

The Bancorp continues to focus on efficiency initiatives as part of its core emphasis on operating leverage and expense control. The efficiency ratio (noninterest expense divided by the sum of net interest income (FTE) and noninterest income) was 56.2% and 50.8% for the third quarter of 2010 and 2009, respectively. The efficiency ratio was 60.1% and 43.2% for the nine months ended September 30, 2010 and 2009, respectively. Excluding the $1.8 billion gain on the Processing Business Sale in the second quarter of 2009, the efficiency ratio for the nine months ended September 30, 2009 was 59.0% (comparison being provided to illustrate the fundamental trend).

The major components of other noninterest expense are as follows:

TABLE 9: Components of Other Noninterest Expense

 

 

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

($ in millions)

   2010     2009     2010     2009  

Losses and adjustments

   $ 66      $ 40      $ 160      $ 83   

Loan and lease

     57        53        152        174   

FDIC insurance and other taxes

     55        48        190        199   

Professional services fees

     38        16        60        47   

Marketing

     27        18        75        53   

Affordable housing investments impairment

     25        22        72        60   

Travel

     14        11        38        29   

Postal and courier

     12        13        36        41   

Intangible asset amortization

     10        13        33        44   

Operating lease

     9        10        31        29   

OREO

     9        6        23        15   

Recruitment and education

     8        7        23        22   

Insurance

     6        11        31        38   

Visa litigation reserve

     —          (73     —          (73

Provision for unfunded commitments and letters of credit

     (23     45        (20     89   

Other

     48        45        145        135   
                                

Total other noninterest expense

   $ 361      $ 285      $ 1,049      $ 985   
                                

 

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Total other noninterest expense for the three months ended September 30, 2010 increased $76 million compared to the third quarter of 2009 primarily due to increases in charges to representation and warranty reserves related to residential mortgage loans sold to third-parties and higher professional service fees, partially offset by a decrease in the provision for unfunded commitments and letters of credit compared to the prior year third quarter. Additionally, the Bancorp recorded a reversal of the Visa litigation reserve in the third quarter of 2009. The expense for representation and warranties, which is included in losses and adjustments, totaled $44 million and $7 million during the three months ended September 30, 2010 and 2009, respectively, with the increase resulting primarily from a higher volume of repurchase demands. The increase in professional service fees was primarily the result of legal expenses incurred from the litigation settlement related to one of the Bancorp’s BOLI policies. The decrease in the provision for unfunded commitments and letters of credit was due to lower estimates of inherent losses resulting from a decrease in delinquent loans as general economic conditions began to show signs of moderation in 2010.

Total other noninterest expense for the nine months ended September 30, 2010 increased $64 million primarily due to the items mentioned previously. The expense for representation and warranties totaled $93 million and $16 million during the nine months ended September 30, 2010 and 2009, respectively, with the increase resulting primarily from a higher volume of repurchase demands.

Applicable Income Taxes

The Bancorp’s income (loss) before income taxes, applicable income tax expense (benefit) and effective tax rate are as follows:

TABLE 10: Applicable Income Taxes

 

 

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

($ in millions)

   2010     2009     2010     2009  

Income (loss) before income taxes

   $ 303        (108   $ 523      $ 981   

Applicable income tax expense (benefit)

     65        (11     103        146   

Effective tax rate

     21.5     10.2     19.7     14.9

Applicable income tax expense (benefit) for all periods includes the tax benefit from tax-exempt income, tax-advantaged investments and general business tax credits, partially offset by the effect of certain nondeductible expenses. The effective tax rate for the nine months ended September 30, 2010 includes $23 million of non-cash charges relating to previously recognized tax benefits associated with stock-based compensation that will not be realized and a $24 million tax benefit resulting from the settlement of certain uncertain tax positions with the IRS during the first quarter of 2010.

Significant items affecting the effective tax rate for the third quarter of 2009 included the third quarter pre-tax loss and changes in estimates used in projecting the estimated effective tax rate for the year. Significant items affecting the effective tax rate for the nine months ended September 30, 2009 included pre-tax losses in the first and third quarters of 2009 and a $106 million tax benefit due to the impact of the decision to surrender one of the Bancorp’s BOLI policies and the determination that the losses on the policy recorded in prior periods were expected to be tax deductible. Further, the effective tax rate for the nine months ended September 30, 2009 was impacted by a $55 million tax benefit resulting from an agreement with the IRS to settle all of the Bancorp’s disputed leverage leases for all open years. These benefits were partially offset by the $1.8 billion pre-tax gain on the sale of the Processing Business, which had an effective tax rate of approximately 40%.

Deductibility of Executive Compensation

Certain sections of the Internal Revenue Code limit the deductibility of compensation paid to or earned by certain executive officers of a public company. This has historically limited compensation to $1 million per executive officer, and the Bancorp’s compensation philosophy has been to position pay to ensure deductibility. However, both the limit and the allowable compensation vehicles have changed as a result of the Bancorp’s participation in TARP. In particular, the Bancorp is not permitted to deduct compensation earned by certain executive officers in excess of $500,000 per executive officer as a result of the Bancorp’s participation in TARP. Therefore, a portion of the compensation earned by certain executive officers is not deductible by the Bancorp. The impact on the Bancorp’s tax liability as a result of payments in excess of this $500,000 per executive officer limit is approximately $4 million. The limitation of the deductibility of compensation earned by certain executive officers will continue until the Bancorp ends its participation in TARP. However, once the Bancorp has paid back its TARP funds, certain limitations will continue to apply to some forms of compensation granted while under TARP. The Bancorp’s Compensation Committee determined that the underlying executive compensation programs are appropriate and necessary to attract, retain and motivate senior executives, and that failing to meet these objectives creates more risk for the Bancorp and its value than the financial impact of losing the tax deduction.

 

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BALANCE SHEET ANALYSIS

Loans and Leases

The Bancorp classifies its loans and leases based upon the primary purpose of the loan. Table 11 summarizes end of period loans and leases, including loans held for sale, and Table 12 summarizes average total loans and leases, including loans held for sale.

TABLE 11: Components of Total Loans and Leases (includes held for sale)

 

 

     September 30, 2010      December 31, 2009      September 30, 2009  

($ in millions)

   Balance      % of
Total
     Balance      % of
Total
     Balance      % of
Total
 

Commercial:

                 

Commercial and industrial loans

   $ 26,502         34       $ 25,687         34       $ 26,215         33   

Commercial mortgage loans

     11,333         14         11,936         15         12,252         15   

Commercial construction loans

     2,500         3         3,871         5         4,268         5   

Commercial leases

     3,304         4         3,535         4         3,584         5   
                                                     

Subtotal – commercial

     43,639         55         45,029         58         46,319         58   
                                                     

Consumer:

                 

Residential mortgage loans

     9,989         13         9,846         12         9,955         12   

Home equity

     11,774         15         12,174         15         12,377         15   

Automobile loans

     10,738         14         8,995         11         8,972         11   

Credit card

     1,832         2         1,990         3         1,973         3   

Other consumer loans and leases

     770         1         812         1         886         1   
                                                     

Subtotal – consumer

     35,103         45         33,817         42         34,163         42   
                                                     

Total loans and leases

   $ 78,742         100       $ 78,846         100       $ 80,482         100   
                                                     

Total portfolio loans and leases (excludes loans held for sale)

   $ 76,009          $ 76,779          $ 78,419      
                                                     

At September 30, 2010, total loans and leases including loans held for sale were relatively flat compared to December 31, 2009 and decreased $1.7 billion, or two percent, compared to September 30, 2009. Compared to December 31, 2009 the decrease in total commercial loans of $1.4 billion was offset by an increase in total consumer loans of $1.3 billion. The decrease in total loans and leases from September 30, 2009 was a result of a six percent decrease in total commercial loans partially offset by a three percent increase in total consumer loans. In accordance with a change in U.S. GAAP, on January 1, 2010 the Bancorp consolidated certain commercial and industrial, automobile, and home equity loans with remaining outstanding balances of $412 million, $771 million and $248 million, respectively, at September 30, 2010. Excluding the impact of this change in U.S. GAAP, total loans and leases decreased $1.5 billion, or two percent, compared to December 31, 2009 and decreased $3.2 billion, or four percent, compared to September 30, 2009. For further discussion on this change in U.S. GAAP, refer to Note 3 and Note 10 of the Notes to Condensed Consolidated Financial Statements.

Total commercial loans and leases decreased $1.4 billion, or three percent, from December 31, 2009, as a result of decreases in commercial construction loans, commercial mortgage loans and commercial leases partially offset by an increase in commercial and industrial loans. Commercial and industrial loan balances increased $815 million, or three percent compared to December 31, 2009 as a result of the previously mentioned change in U.S. GAAP and a slight increase in overall demand. Commercial mortgage loans decreased $603 million, or five percent, compared to December 31, 2009, as a result of tightened lending requirements in an overall effort to limit exposure to commercial real estate. Commercial construction loans decreased $1.4 billion, or 35%, from December 31, 2009, primarily due to management’s strategy to suspend new lending on commercial non-owner occupied real estate beginning in 2008 and the outflow of completed construction projects that were transitioned to commercial mortgage loans. Total commercial leases decreased seven percent compared to December 31, 2009 as a result of general declines in leasing activity attributable to weak economic conditions.

Total commercial loans and leases decreased $2.7 billion, or six percent, compared to September 30, 2009, due to decreases in commercial construction loans, commercial mortgage loans and commercial leases, partially offset by an increase in commercial and industrial loans. Commercial and industrial loan balances increased $287 million, or one percent, compared to September 30, 2009 as a result of the impact of the previously mentioned change in U.S. GAAP partially offset by a decrease in customer demand for new loans and a decrease in line utilization rates from 36% to 32%. Included in the commercial and industrial balance at September 30, 2010 and 2009 were loans of approximately $1.22 billion and $1.24 billion, respectively, issued in conjunction with the Processing Business Sale in the second quarter of 2009. Commercial mortgage loans, commercial construction loans and commercial leases decreased $919 million, $1.8 billion and $280 million, respectively, as a result of the previously mentioned changes.

Total consumer loans and leases increased $1.3 billion, or four percent, compared to December 31, 2009. This increase was primarily a result of increases in automobile loans and residential mortgage loans, partially offset by decreases in home equity loans, credit card loans and other consumer loans and leases. Residential mortgage loans increased $143 million, or one percent, from December 31, 2009, due to an increase in residential mortgage loan originations as many customers took advantage of low interest rates during the third quarter of 2010. This growth included the impact of the sale of $228 million of residential mortgage loans in the third quarter of 2010. Automobile loans increased $1.7 billion, or 19%, compared to December 31, 2009, primarily as a result of the previously mentioned impact on automobile loans due to the change in U.S. GAAP and a strategic focus to increase automobile lending during 2010 through consistent and competitive pricing, enhanced customer service with our dealership network and disciplined sales execution. Home equity loans decreased

 

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

 

 

$400 million, or three percent, from December 31, 2009, as tighter underwriting standards and a decrease in customer demand were partially offset by the previously mentioned impact on home equity loans due to the change in U.S. GAAP. Credit card loans decreased $158 million, or eight percent, from December 31, 2009, as a result of pay downs on existing balances due to seasonality and a decrease in new account originations in 2010. Other consumer loans and leases, primarily made up of automobile leases and student loans designated as held for sale, decreased $42 million, or five percent, from the prior year end due to a decline in new originations as a result of tighter underwriting standards across the other consumer loan and lease portfolio.

Total consumer loans and leases increased $940 million, or three percent, compared to September 30, 2009 primarily due to an increase in automobile loans partially offset by decreases in home equity loans, credit card loans and other consumer loans. Automobile loans increased $1.8 billion, or 20%, compared to September 30, 2009, as a result of the previously mentioned change in U.S. GAAP combined with continued growth in new automobile loan originations in 2010. Home equity loans decreased $603 million, or five percent, from September 30, 2009 as a result of the previously mentioned changes in underwriting partially offset by the change in U.S. GAAP. Credit card loans decreased $141 million, or seven percent, from September 30, 2009, primarily as a result of a decrease in average balance per credit card and a decrease in new account originations in 2010. Other consumer loans and leases decreased $116 million, or 13%, compared to the same quarter last year as a result of the previously mentioned changes.

TABLE 12: Components of Average Total Loans and Leases (includes held for sale)

 

 

     September 30, 2010      December 31, 2009      September 30, 2009  

($ in millions)

   Balance      % of
Total
     Balance      % of
Total
     Balance      % of
Total
 

Commercial:

                 

Commercial and industrial loans

   $ 26,348         33       $ 25,838         32       $ 27,416         33   

Commercial mortgage loans

     11,462         15         12,126         15         12,449         15   

Commercial construction loans

     2,955         4         4,134         5         4,475         6   

Commercial leases

     3,257         4         3,574         5         3,522         4   
                                                     

Subtotal – commercial

     44,022         56         45,672         57         47,862         58   
                                                     

Consumer:

                 

Residential mortgage loans

     9,897         13         10,142         13         10,820         13   

Home equity

     11,897         15         12,291         16         12,452         15   

Automobile loans

     10,517         13         8,973         11         8,871         11   

Credit card

     1,838         2         1,982         2         1,955         2   

Other consumer loans and leases

     683         1         860         1         929         1   
                                                     

Subtotal – consumer

     34,832         44         34,248         43         35,027         42   
                                                     

Total average loans and leases

   $ 78,854         100       $ 79,920         100       $ 82,889         100   
                                                     

Total portfolio loans and leases (excludes loans held for sale)

   $ 76,617          $ 77,601          $ 80,060      
                                                     

Average commercial loans and leases decreased $1.7 billion, or four percent, compared to the fourth quarter of 2009 and decreased $3.8 billion, or eight percent, compared to the third quarter of 2009. The decrease in average total commercial loans and leases from both periods was driven by lower customer line utilization rates, lower demand for new loans and tighter underwriting standards implemented in 2008, partially offset by the impact of the previously discussed change in U.S. GAAP.

Average consumer loans and leases increased $584 million, or two percent, compared to the fourth quarter of 2009 due to an increase in average automobile loans as a result of the previously mentioned change in U.S. GAAP and an increase in origination activity, partially offset by declines in all other average consumer loan products due to lower customer demand and tighter underwriting standards. Average consumer loans and leases decreased $195 million, or one percent, compared to the third quarter of 2009. The decrease in the average consumer loan balances from the third quarter of 2009 is primarily a result of a nine percent decrease in average residential mortgage loans and four percent decrease in average home equity loans, partially offset by a 19% increase in average automobile loans. The previously mentioned change in U.S. GAAP contributed approximately $841 million to average automobile loans and $250 million to average home equity loans in the third quarter of 2010.

Investment Securities

The Bancorp uses investment securities as a means of managing interest rate risk, providing liquidity support and providing collateral for pledging purposes. As of September 30, 2010, total investment securities were $16.6 billion, compared to $18.9 billion at December 31, 2009 and $17.1 billion at September 30, 2009.

Securities are classified as trading when bought and held principally for the purpose of selling them in the near term. Securities are classified as available-for-sale when, in management’s judgment, they may be sold in response to, or in anticipation of, changes in market conditions. Securities that management has the intent and ability to hold to maturity are classified as held-to-maturity and reported at amortized cost. The Bancorp’s management has evaluated the securities in an unrealized loss position in the available-for-sale and held-to-maturity portfolios for OTTI. During the nine months ended September 30, 2010, the Bancorp recognized $3 million of OTTI on its investment securities portfolio. See Note 5 of the Notes to Condensed Consolidated Financial Statements for further information on OTTI.

 

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

 

 

At September 30, 2010, December 31, 2009 and September 30, 2009, the Bancorp’s investment portfolio primarily consisted of AAA-rated agency mortgage-backed securities. The Bancorp did not hold asset-backed securities backed by subprime mortgage loans in its investment portfolio at September 30, 2010, December 31, 2009 or September 30, 2009. Additionally, there was approximately $140 million of securities classified as below investment grade as of September 30, 2010, compared to $178 million as of December 31, 2009 and $179 million as of September 30, 2009.

TABLE 13: Components of Investment Securities

 

 

($ in millions)

   September 30,
2010
     December 31,
2009
     September 30,
2009
 

Available-for-sale and other: (amortized cost basis)

        

U.S. Treasury and Government agencies

   $ 300         464         367   

U.S. Government sponsored agencies

     1,691         2,143         1,745   

Obligations of states and political subdivisions

     191         240         310   

Agency mortgage-backed securities

     10,878         11,074         9,115   

Other bonds, notes and debentures

     995         2,541         2,556   

Other securities

     1,253         1,417         1,167   
                          

Total available-for-sale and other securities

   $ 15,308         17,879         15,260   
                          

Held-to-maturity: (amortized cost basis)

        

Obligations of states and political subdivisions

   $ 349         350         351   

Other bonds, notes and debentures

     5         5         5   
                          

Total held-to-maturity

   $ 354         355         356   
                          

Trading: (fair value)

        

Variable rate demand notes

   $ 114         235         966   

Other securities

     206         120         113   
                          

Total trading

   $ 320         355         1,079   
                          

As of September 30, 2010, available-for-sale securities on an amortized cost basis decreased $2.6 billion from December 31, 2009 and increased $48 million from September 30, 2009. The decrease from December 31, 2009 included the impact of a change in U.S. GAAP that required the Bancorp to consolidate certain VIEs, resulting in the elimination of approximately $805 million in commercial paper and $236 million of residual interests classified as available-for-sale securities on January 1, 2010. Further impacting the available-for-sale securities were approximately $932 million in paydowns on agency mortgage-backed securities, primarily related to the FNMA and FHLMC delinquent loan buy-back programs in the second quarter of 2010, and management’s decision to not reinvest cash flows in securities due to the low market rate environment. In addition, the decrease from December 31, 2009 includes the sale of approximately $151 million of commercial mortgage-backed securities and commercial mortgage obligations, the sale of approximately $103 million in trust preferred securities and $150 million in paydowns on other asset-backed securities in the first quarter of 2010. The change from September 30, 2009 was due to the factors previously discussed, offset by the purchase of approximately $2.0 billion in agency mortgage-backed securities during the fourth quarter of 2009.

At September 30, 2010, available-for-sale securities were 16% of total interest-earning assets, compared to 18% at December 31, 2009 and 16% at September 30, 2009. The estimated weighted-average life of the debt securities in the available-for-sale portfolio was 3.4 years at September 30, 2010 compared to 4.4 years at December 31, 2009 and 4.0 years at September 30, 2009. In addition, at September 30, 2010, the fixed-rate securities within the available-for-sale securities portfolio had a weighted-average yield of 4.32% compared to 4.48% at December 31, 2009 and 4.71% at September 30, 2009.

Information presented in Table 14 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 portfolio exclude equity securities that have no stated yield or maturity. Market rates declined throughout 2009 and into 2010 which led to net unrealized gains on agency mortgage-backed securities of $469 million, $308 million, and $369 million as of September 30, 2010, December 31, 2009 and September 30, 2009, respectively. Total net unrealized gains on the available-for-sale securities portfolio was $667 million at September 30, 2010 compared to $334 million at December 31, 2009 and $422 million at September 30, 2009.

 

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

 

 

TABLE 14: Characteristics of Available-for-Sale and Other Securities

 

 

As of September 30, 2010 ($ 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

   $ 100         100         0.2         0.23

Average life 1 – 5 years

     100         102         1.7         1.20   

Average life 5 – 10 years

     100         109         9.1         3.57   

Average life greater than 10 years

     —           —           14.2         2.20   
                                   

Total

     300         311         3.7         1.66   

U.S. Government sponsored agencies:

           

Average life of one year or less

     81         82         0.5         3.35   

Average life 1 – 5 years

     99         108         3.4         3.15   

Average life 5 – 10 years

     1,511         1,661         6.2         3.79   
                                   

Total

     1,691         1,851         5.7         3.73   

Obligations of states and political subdivisions (a):

           

Average life of one year or less

     91         92         0.2         7.46   

Average life 1 – 5 years

     12         13         2.9         7.29   

Average life 5 – 10 years

     57         57         6.6         6.69   

Average life greater than 10 years

     31         33         11.2         5.62   
                                   

Total

     191         195         4.0         6.92   

Agency mortgage-backed securities:

           

Average life of one year or less

     444         454         0.7         5.00   

Average life 1 – 5 years

     10,108         10,557         3.1         4.39   

Average life 5 – 10 years

     326         336         7.3         4.25   
                                   

Total

     10,878         11,347         3.1         4.41   

Other bonds, notes and debentures (b):

           

Average life of one year or less

     184         185         0.5         1.44   

Average life 1 – 5 years

     741         761         2.0         5.21   

Average life 5 – 10 years

     1         1         7.7         0.10   

Average life greater than 10 years

     69         71         23.4         7.21   
                                   

Total

     995         1,018         3.2         4.65   

Other securities (c)

     1,253         1,253         
                                   

Total available-for-sale and other securities

   $ 15,308         15,975         3.4         4.32
                                   

 

(a) Taxable-equivalent yield adjustments included in the above table are 2.57%, 0.98%, 0.44%, 1.94% and 1.73% 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 backed securities) and corporate bond securities.
(c) Other securities consist of FHLB and FRB restricted stock holdings that are carried at par, FHLMC and FNMA preferred stock holdings and certain mutual fund holdings and equity security holdings.

Trading securities decreased $35 million, or 10%, compared to December 31, 2009 and $759 million compared to September 30, 2009. The decrease from September 30, 2009 was driven by the sale of VRDNs, which were held by the Bancorp in its trading securities portfolio. These securities were purchased from the market during 2008 and 2009 through FTS who was also the remarketing agent. During the fourth quarter of 2009, the rates on these securities began to decline substantially, and as a result the Bancorp sold a majority of its VRDNs and replaced them with higher-yielding agency mortgage-backed securities classified as available-for-sale. The Bancorp continued to sell the VRDNs during 2010, resulting in the decrease in trading securities from December 31, 2009. For more information on the VRDNs, see Note 13 of the Notes to Condensed Consolidated Financial Statements. Trading securities included $5 million and $13 million of auction rate securities as of September 30, 2010 and December 31, 2009, respectively. The unrealized loss on these securities was approximately $1 million as of September 30, 2010, and approximately $4 million at December 31, 2009. Auction rate securities held by the Bancorp were immaterial as of September 30, 2009.

Deposits

Deposit balances represent an important source of funding and revenue growth opportunity. The Bancorp is continuing to focus on core deposit growth in its retail and commercial franchises by improving customer satisfaction, building full relationships and offering competitive rates. Core deposits represented 68% of the Bancorp’s asset funding base at September 30, 2010 and December 31, 2009, and 64% at September 30, 2009.

 

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

 

 

TABLE 15: Deposits

 

 

($ in millions)

   September 30, 2010      December 31, 2009      September 30, 2009  
   Balance      % of
Total
     Balance      % of
Total
     Balance      % of
Total
 

Demand

   $ 20,109         25       $ 19,411         23       $ 17,666         22   

Interest checking

     17,225         21         19,935         24         15,168         19   

Savings

     20,260         25         17,898         21         17,098         22   

Money market

     5,064         6         4,431         5         4,378         5   

Foreign office

     3,807         5         2,454         3         2,356         3   
                                                     

Transaction deposits

     66,465         82         64,129         76         56,666         71   

Other time

     9,379         12         12,466         15         13,725         17   
                                                     

Core deposits

     75,844         94         76,595         91         70,391         88   

Certificates - $100,000 and over

     5,515         6         7,700         9         8,962         12   

Other foreign office

     3         —           10         —           5         —     
                                                     

Total deposits

   $ 81,362         100       $ 84,305         100       $ 79,358         100   
                                                     

Core deposits decreased $751 million, or one percent, compared to December 31, 2009, as run off of higher priced certificates included in other time deposits continued and rate management actions on single product public funds accounts resulted in a decline in interest checking. These decreases were partially offset by growth in all other types of transaction accounts due to excess customer liquidity. Core deposits increased $5.5 billion, or eight percent, compared to September 30, 2009, as continued strong growth in all types of transaction accounts was partially offset by run-off of other time deposits as previously discussed.

The Bancorp uses other foreign office deposits, as well as certificates of deposit $100,000 and over, as a method to fund earning asset growth. Certificates $100,000 and over at September 30, 2010 decreased $2.2 billion, or 28%, compared to December 31, 2009, and decreased $3.4 billion, or 38%, compared to September 30, 2009, as customers opted to maintain their balances in liquid accounts as interest rates remain near historical lows.

TABLE 16: Average Deposits

 

 

     September 30, 2010      December 31, 2009      September 30, 2009  

($ in millions)

   Balance      % of
Total
     Balance      % of
Total
     Balance      % of
Total
 

Demand

   $ 19,362         24         18,137         23       $ 17,059         21   

Interest checking

     17,142         21         16,324         20         14,869         19   

Savings

     19,905         25         17,540         22         16,967         21   

Money market

     4,940         6         4,279         5         4,280         5   

Foreign office

     3,592         4         2,516         3         2,432         3   
                                                     

Transaction deposits

     64,941         80         58,796         73         55,607         69   

Other time

     10,261         13         13,049         16         14,264         18   
                                                     

Core deposits

     75,202         93         71,845         89         69,871         87   

Certificates - $100,000 and over

     6,096         7         8,200         11         10,055         13   

Other foreign office

     4         —           51         —           95         —     
                                                     

Total average deposits

   $ 81,302         100         80,096         100       $ 80,021         100   
                                                     

On an average basis, core deposits increased $3.4 billion, or five percent, compared to the fourth quarter of 2009, and increased $5.3 billion, or eight percent, compared to the third quarter of 2009 as transaction accounts increased due to migration of higher priced certificates into transaction accounts, the impact of historically low rates and excess customer liquidity.

Borrowings

Total borrowings at September 30, 2010 increased $992 million, or eight percent, compared to December 31, 2009 and declined $1.2 billion, or eight percent, from September 30, 2009. The increase in the Bancorp’s funding position compared to December 31, 2009 was driven by a $2.9 billion decrease in total deposits partially offset by decreases of $2.3 billion and $104 million in investment securities and total loans and leases, respectively. The decrease from September 30, 2009 was primarily due to a $2.0 billion increase in total deposits that reduced the need in the Bancorp’s funding position. As of September 30, 2010, December 31, 2009 and September 30, 2009, total borrowings as a percentage of interest-bearing liabilities were 18%, 16% and 19%, respectively.

TABLE 17: Borrowings

 

 

($ in millions)

   September 30,
2010
     December 31,
2009
     September 30,
2009
 

Federal funds purchased

   $ 368       $ 182       $ 433   

Other short-term borrowings

     1,775         1,415         3,674   

Long-term debt

     10,953         10,507         10,162   
                          

Total borrowings

   $ 13,096         12,104       $ 14,269   
                          

 

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

 

 

 

Total short-term borrowings were $2.1 billion at September 30, 2010, compared to $1.6 billion at December 31, 2009 and $4.1 billion at September 30, 2009. The decrease in short-term borrowings from September 30, 2009 is primarily due to the repayment of $2.2 billion of term auction facility funds which were held by the Bancorp as of September 30, 2009. The Bancorp’s overall reduced reliance on short-term funding compared to September 30, 2009 can be attributed to declining asset balances and deposit growth. Short-term borrowings include securities sold under repurchase agreements which are accounted for as collateralized financing transactions and recorded at the amounts at which the securities were sold plus accrued interest.

Long-term debt at September 30, 2010 increased $446 million, or four percent, compared to December 31, 2009 and increased $791 million, or eight percent, compared September 30, 2009. Impacting the increase from both periods was the result of a change in U.S. GAAP that required the Bancorp to consolidate long-term debt on January 1, 2010 that had an outstanding balance of $834 million as of September 30, 2010. This was partially offset by the maturity of $800 million of long-term debt in the first quarter of 2010. In addition, FHLB advances increased approximately $498 million compared to September 30, 2009. For further discussion on the change in U.S. GAAP, refer to Notes 3 and 10 of the Notes to Condensed Consolidated Financial Statements.

TABLE 18: Average Borrowings

 

 

($ in millions)

   September 30,
2010
     December 31,
2009
     September 30,
2009
 

Federal funds purchased

   $ 302       $ 423       $ 404   

Other short-term borrowings

     1,880         3,029         5,285   

Long-term debt

     10,954         10,404         10,108   
                          

Total borrowings

   $ 13,136         13,856       $ 15,797   
                          

Average borrowings decreased $720 million and $2.7 billion from December 31, 2009 and September 30, 2009, respectively. This decrease was primarily a result of repayment of term auction facility funds made during 2009 which contributed $1.2 billion to average balances in the fourth quarter of 2009 and $3.5 billion in the third quarter of 2009. This activity was partially offset by an increase in FHLB advances of $260 million compared to the fourth quarter of 2009 and $499 million compared to the third quarter of 2009.

Information on the average rates paid on borrowings is discussed in the Statements of Income Analysis in MD&A. In addition, refer to the Liquidity Risk Management section for a discussion on the role of borrowings in the Bancorp’s liquidity management.

 

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

 

 

BUSINESS SEGMENT REVIEW

At September 30, 2010, the Bancorp reports on four business segments: Commercial Banking, Branch Banking, Consumer Lending and Investment Advisors. Additional detailed financial information on each business segment is included in Note 20 of the Notes to Condensed Consolidated Financial Statements.

Results of the Bancorp’s business segments are presented based on its management structure and management accounting practices. The structure and accounting 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.

On June 30, 2009, the Bancorp completed the Processing Business Sale, which represented the sale of a majority interest in the Bancorp’s merchant acquiring and financial institutions processing businesses. Financial data for the merchant acquiring and financial institutions processing businesses was originally reported in the former Processing Solutions segment through June 30, 2009. As a result of the sale, the Bancorp no longer presents Processing Solutions as a segment and therefore, historical financial information for the merchant acquiring and financial institutions processing businesses has been reclassified under General Corporate and Other for all periods presented.

The Bancorp manages interest rate risk centrally at the corporate level by employing a FTP methodology. This methodology insulates the business segments from interest rate volatility, enabling them to focus on serving 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 and the LIBOR swap curve. Matching duration allocates interest income and interest expense to each segment so its resulting net interest income is insulated from interest rate risk. In a rising rate environment, the Bancorp benefits from the widening spread between deposit costs and wholesale funding costs. However, the Bancorp’s FTP system credits this benefit to deposit-providing businesses, such as Branch Banking and Investment Advisors, on a duration-adjusted basis. The net impact of the FTP methodology is captured in General Corporate and Other.

The business segments are charged provision expense based on the actual net charge-offs experienced by the loans owned by each segment. Provision expense attributable to loan growth and changes in factors in the allowance for loan and lease losses are captured in General Corporate and Other. 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 existed 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 (loss) by business segment is summarized in the following table.

TABLE 19: Business Segment Results

 

 

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

($ in millions)

   2010     2009     2010     2009  

Commercial Banking

   $ (145     (124   $ 22        (57

Branch Banking

     46        90        153        249   

Consumer Lending

     (33     2        (50     34   

Investment Advisors

     6        12        29        41   

General Corporate and Other

     364        (77     266        568   
                                

Net income (loss)

     238        (97     420        835   

Less: Net income attributable to noncontrolling interest

     —          —          —          —     
                                

Net income (loss) attributable to Bancorp

     238        (97     420        835   

Dividends on preferred stock

     63        62        187        165   
                                

Net income (loss) available to common shareholders

   $ 175        (159   $ 233        670   
                                

 

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

 

 

Commercial Banking

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

TABLE 20: Commercial Banking

 

 

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

($ in millions)

   2010     2009     2010     2009  

Income Statement Data

        

Net interest income (FTE) (a)

   $ 389        352      $ 1,155        1,026   

Provision for loan and lease losses

     559        448        1,024        955   

Noninterest income:

        

Corporate banking revenue

     82        73        248        269   

Service charges on deposits

     50        49        146        146   

Other noninterest income

     7        (7     71        50   

Noninterest expense:

        

Salaries, incentives and benefits

     59        55        185        169   

Other noninterest expenses

     187        190        540        578   
                                

Loss before taxes

     (277     (226     (129     (211

Applicable income tax (benefit) expense (a)

     (132     (102     (151     (154
                                

Net (loss) income

   ($ 145     (124   $ 22        (57
                                

Average Balance Sheet Data

        

Commercial loans and leases

   $ 38,057        41,053      $ 38,565        42,080   

Demand deposits

     10,550        8,829        10,628        8,196   

Interest checking

     7,458        5,910        8,700        5,619   

Savings and money market

     2,967        2,400        2,812        2,504   

Certificates over $100,000

     3,094        4,668        3,107        4,528   

Foreign office deposits

     2,252        1,375        1,929        1,214   

 

(a) Includes FTE adjustments of $4 and $3 for the three months ended September 30, 2010 and 2009, respectively, and $10 for the nine months ended September 30, 2010 and 2009.

Commercial Banking net loss increased to $145 million in the third quarter of 2010, compared to $124 million in the same period in 2009. For the nine months ended September 30, 2010, Commercial Banking net income was $22 million, compared to a net loss of $57 million in the same period in the prior year. The change from the third quarter of 2009 was primarily due to an increase in the provision for loan and lease losses, partially offset by increases in net interest income and corporate banking revenue. The change from the nine months ended September 30, 2009 was due primarily to increases in net interest income and other noninterest income and a decrease in other noninterest expenses, partially offset by an increase in the provision for loan and lease losses and a decrease in corporate banking revenue. The increase in net interest income for both periods was primarily the result of a mix shift from higher cost term deposits to lower cost deposit products, partially offset by reduced loan demand and decreases of $10 million and $31 million for the three and nine months ended September 30, 2010, respectively, in the accretion of discounts on loans associated with the acquisition of First Charter in 2008.

Average commercial loans and leases decreased $3.0 billion, or seven percent, due to decreases across all commercial loan categories, including a $1.5 billion, or 35%, decrease in commercial construction loans. The overall decrease in commercial loans and leases is due to lower customer demand for new originations, lower utilization rates on corporate lines and tighter underwriting standards applied to both new commercial loan originations and renewals. These impacts were partially offset by the consolidation of approximately $724 million of certain commercial and industrial loans on January 1, 2010, which had a remaining balance of approximately $412 million at September 30, 2010. For further information on the consolidation of these loans, see Note 3 of the Notes to Condensed Consolidated Financial Statements.

Provision for loan and lease losses increased $111 million, or 25%, compared to the third quarter of 2009 and increased $69 million, or seven percent, compared to the nine months ended September 30, 2009 due to an increase in net charge-offs. Net charge-offs as a percent of average loans and leases increased to 584 bp for the third quarter of 2010 from 435 bp for the third quarter of 2009, largely due to net charge-offs on commercial loans moved to held for sale during the third quarter of 2010. For the nine months ended September 30, 2010, net charge-offs as a percent of average loans and leases increased to 371 bp, compared to 306 bp in the same period in 2009.

Average core deposits increased $4.7 billion, or 25%, compared to the third quarter of 2009 as the Commercial Banking segment realized significant growth in both demand deposits and interest checking accounts reflecting excess customer liquidity.

 

25


Table of Contents

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

 

 

 

Noninterest income increased $24 million, or 21%, compared to the third quarter of 2009 and remained flat compared to the nine months ended September 30, 2009. Corporate banking revenue increased $9 million, or 12%, in the third quarter of 2010 driven by increases in syndication and business lending fees. In addition, higher losses on loan sales were more than offset by an increase in other fee income. Noninterest expense remained flat compared to the third quarter of 2009 and decreased $22 million, or three percent, compared to the nine months ended September 30, 2009. For the nine months ended September 30, 2010, increases in compensation expense and impairment on low income housing investments were more than offset by declines in loan and lease expense from collections activities, FDIC insurance premiums and other losses.

Branch Banking

Branch Banking provides a full range of deposit and lending products to individuals and small businesses in 12 states in the Midwestern and Southeastern regions of the United States. Branch Banking offers depository and loan products, such as checking and savings accounts, home equity loans and lines of credit, credit cards and loans for automobile and other personal financing needs, as well as products designed to meet the specific needs of small businesses, including cash management services. The table below contains selected financial data for the Branch Banking segment.

TABLE 21: Branch Banking

 

 

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

($ in millions)

   2010      2009      2010      2009  

Income Statement Data

           

Net interest income

   $ 381         397       $ 1,144         1,171   

Provision for loan and lease losses

     150         150         425         426   

Noninterest income:

           

Service charges on deposits

     91         113         284         321   

Card and processing revenue

     77         68         221         194   

Investment advisory income

     27         22         78         60   

Other noninterest income

     32         27         85         87   

Noninterest expense:

           

Salaries, incentives and benefits

     134         123         410         370   

Net occupancy and equipment expense

     55         54         167         162   

Other noninterest expense

     198         161         574         490   
                                   

Income before taxes

     71         139         236         385   

Applicable income tax expense

     25         49         83         136   
                                   

Net income

   $ 46         90       $ 153         249