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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the Quarter Ended June 30, 2002
Commission File Number 0-8076
FIFTH THIRD BANCORP
(Exact name of Registrant as specified in its charter)
Ohio 31-0854434
(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification Number)
Fifth Third Center
Cincinnati, Ohio 45263
(Address of principal executive offices)
Registrant's telephone number, including area code: (513) 534-5300
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
--- ---
There were 580,409,448 shares of the Registrant's Common Stock, without par
value, outstanding as of July 31, 2002.
FIFTH THIRD BANCORP
INDEX
Part I. Financial Information
Item 1. Financial Statements
Condensed Consolidated Balance Sheets -
June 30, 2002 and 2001 and December 31, 2001 3
Condensed Consolidated Statements of Income -
Three and Six Months Ended June 30, 2002 and 2001 4
Condensed Consolidated Statements of Cash Flows -
Six Months Ended June 30, 2002 and 2001 5
Condensed Consolidated Statements of Changes in Shareholders' Equity -
Six Months Ended June 30, 2002 and 2001 6
Notes to Condensed Consolidated Financial Statements 7 - 19
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations 20 - 26
Item 3. Quantitative and Qualitative Disclosures About Market Risk 27 - 28
Part II. Other Information
Item 6. Exhibits and Reports on Form 8-K 29
Signatures 30
Fifth Third Bancorp and Subsidiaries
Condensed Consolidated Balance Sheets (unaudited)
- -------------------------------------------------------------------------------------------------------
June 30, December 31, June 30,
($000's) 2002 2001 2001
- -------------------------------------------------------------------------------------------------------
Assets
Cash and Due from Banks $ 1,746,350 2,030,950 1,585,300
Securities Available-for-Sale (a) 23,418,350 20,506,594 18,719,861
Securities Held-to-Maturity (b) 21,602 16,472 19,395
Other Short-Term Investments 559,208 224,674 700,074
Loans Held for Sale 1,290,316 2,180,063 2,932,347
Loans and Leases
Commercial Loans 11,521,402 10,838,518 10,690,126
Construction Loans 3,253,524 3,356,172 3,495,358
Commercial Mortgage Loans 5,759,142 6,085,060 6,596,721
Commercial Lease Financing 3,275,267 3,150,863 2,934,245
Residential Mortgage Loans 4,202,772 4,505,067 4,439,013
Consumer Loans 13,991,688 12,564,893 11,886,770
Consumer Lease Financing 2,343,959 1,958,410 2,503,772
Unearned Income (959,815) (911,091) (970,914)
Reserve for Credit Losses (649,166) (624,080) (617,270)
- -------------------------------------------------------------------------------------------------------
Total Loans and Leases 42,738,773 40,923,812 40,957,821
Bank Premises and Equipment 837,438 832,738 819,061
Accrued Income Receivable 519,475 617,882 545,633
Goodwill 686,266 682,300 573,933
Mortgage Servicing Rights 414,491 426,376 549,826
Intangible Assets 249,324 267,464 222,607
Other Assets 2,441,744 2,317,015 2,207,782
- -------------------------------------------------------------------------------------------------------
Total Assets $ 74,923,337 71,026,340 69,833,640
- -------------------------------------------------------------------------------------------------------
Liabilities
Deposits
Demand $ 9,162,972 9,243,549 7,621,352
Interest Checking 16,558,345 13,474,278 11,567,613
Savings and Money Market 11,119,146 8,417,228 7,162,973
Time Deposits, including Foreign 13,248,801 14,719,035 18,751,747
- -------------------------------------------------------------------------------------------------------
Total Deposits 50,089,264 45,854,090 45,103,685
Federal Funds Borrowed 1,892,985 2,543,769 4,356,098
Short-Term Bank Notes - 33,938 -
Other Short-Term Borrowings 3,689,255 4,875,023 3,526,820
Accrued Taxes, Interest and Expenses 2,327,759 1,962,882 1,964,855
Other Liabilities 748,858 665,945 555,465
Long-Term Debt 7,544,529 7,029,926 7,085,993
Guaranteed Preferred Beneficial Interests in
Convertible Subordinated Debentures - - 172,500
- -------------------------------------------------------------------------------------------------------
Total Liabilities 66,292,650 62,965,573 62,765,416
- -------------------------------------------------------------------------------------------------------
Minority Interest 440,348 421,490 -
- -------------------------------------------------------------------------------------------------------
Shareholders' Equity
Common Stock (c) 1,295,208 1,293,715 1,280,024
Preferred Stock (d) 9,250 9,250 9,250
Capital Surplus 1,460,138 1,494,764 1,271,182
Retained Earnings 5,364,282 4,837,807 4,422,847
Accumulated Nonowner Changes in Equity 224,537 7,823 84,921
Treasury Stock (163,076) (4,082) -
- -------------------------------------------------------------------------------------------------------
Total Shareholders' Equity 8,190,339 7,639,277 7,068,224
- -------------------------------------------------------------------------------------------------------
Total Liabilities and Shareholders' Equity $ 74,923,337 71,026,340 69,833,640
=======================================================================================================
(a) Amortized cost: June 30, 2002 - $23,047,287, December 31, 2001 - $20,479,014
and June 30, 2001 - $18,587,032.
(b) Market values: June 30, 2002 - $21,602, December 31, 2001 - $16,472 and June
30, 2001 - $19,395.
(c) Common Shares: Stated value $2.22 per share; authorized at June 30, 2002,
December 31, 2001 and June 30, 2001 - 1,300,000,000; outstanding at June 30,
2002 - 580,985,828 (excludes 2,441,276 treasury shares), December 31, 2001 -
582,674,580 (excludes 80,000 treasury shares) and June 30, 2001 -
576,587,585.
(d) 490,750 shares of no par value preferred stock are authorized of which none
had been issued; 7,250 shares of 8.00% cumulative Series D convertible (at
$23.5399 per share) perpetual preferred stock with a stated value of $1,000
were authorized, issued and outstanding; 2,000 shares of 8.00% cumulative
Series E perpetual preferred stock with a stated value of $1,000 were
authorized, issued and outstanding.
See Notes to Condensed Consolidated Financial Statements 3
Fifth Third Bancorp and Subsidiaries
Condensed Consolidated Statements of Income (unaudited)
- ---------------------------------------------------------------------------------------------------------------------------
Three Months Ended Six Months Ended
June 30, June 30,
-----------------------------------------------------
($000's except per share) 2002 2001 2002 2001
- ---------------------------------------------------------------------------------------------------------------------------
Interest Income
Interest and Fees on Loans and Leases $ 702,484 919,792 $ 1,401,240 1,858,970
Interest on Securities
Taxable 329,652 287,161 632,320 587,271
Exempt from Income Taxes 13,884 17,666 28,136 34,763
- ---------------------------------------------------------------------------------------------------------------------------
Total Interest on Securities 343,536 304,827 660,456 622,034
Interest on Other Short-Term Investments 1,281 3,797 3,317 6,602
- ---------------------------------------------------------------------------------------------------------------------------
Total Interest Income 1,047,301 1,228,416 2,065,013 2,487,606
- ---------------------------------------------------------------------------------------------------------------------------
Interest Expense
Interest on Deposits
Interest Checking 79,661 84,128 147,048 170,919
Savings and Money Market 48,677 53,798 92,594 115,941
Time Deposits, Including Foreign 118,854 274,763 255,613 591,687
- ---------------------------------------------------------------------------------------------------------------------------
Total Interest on Deposits 247,192 412,689 495,255 878,547
Interest on Federal Funds Borrowed 10,527 61,503 22,797 110,031
Interest on Short-Term Bank Notes - - 54 -
Interest on Other Short-Term Borrowings 15,940 61,111 32,877 138,707
Interest on Long-Term Debt 95,626 85,396 189,846 164,200
- ---------------------------------------------------------------------------------------------------------------------------
Total Interest Expense 369,285 620,699 740,829 1,291,485
- ---------------------------------------------------------------------------------------------------------------------------
Net Interest Income 678,016 607,717 1,324,184 1,196,121
Provision for Credit Losses 64,040 25,618 119,002 91,557
Merger-Related Provision for Credit Losses - 35,437 - 35,437
- ---------------------------------------------------------------------------------------------------------------------------
Net Interest Income After Provision for Credit Losses 613,976 546,662 1,205,182 1,069,127
Other Operating Income
Electronic Payment Processing Income 121,787 78,371 229,845 147,936
Service Charges on Deposits 106,092 91,871 204,660 169,700
Mortgage Banking Revenue 10,156 53,157 111,829 113,622
Investment Advisory Income 91,959 80,409 176,407 157,524
Other Service Charges and Fees 141,023 118,226 271,946 242,113
Securities Gains, Net 201 2,788 9,501 7,107
Securities Gains (Losses), Net - Non-Qualifying Hedges on
Mortgage Servicing 35,654 - (1,041) -
- ---------------------------------------------------------------------------------------------------------------------------
Total Other Operating Income 506,872 424,822 1,003,147 838,002
- ---------------------------------------------------------------------------------------------------------------------------
Operating Expenses
Salaries, Wages and Incentives 224,771 216,225 442,742 419,429
Employee Benefits 44,726 38,933 94,327 76,817
Equipment Expenses 19,444 23,159 40,032 47,611
Net Occupancy Expenses 35,403 37,049 69,538 73,647
Other Operating Expenses 195,531 197,727 381,104 380,968
Merger-Related Charges - 219,229 - 219,229
- ---------------------------------------------------------------------------------------------------------------------------
Total Operating Expenses 519,875 732,322 1,027,743 1,217,701
- ---------------------------------------------------------------------------------------------------------------------------
Income Before Income Taxes, Minority Interest & Cumulative Effect 600,973 239,162 1,180,586 689,428
Applicable Income Taxes 187,282 110,274 367,311 254,140
- ---------------------------------------------------------------------------------------------------------------------------
Income Before Minority Interest & Cumulative Effect 413,691 128,888 813,275 435,288
Minority Interest, Net of Tax 9,429 - 18,858 -
- ---------------------------------------------------------------------------------------------------------------------------
Income Before Cumulative Effect 404,262 128,888 794,417 435,288
Cumulative Effect of Change in Accounting
Principle, Net of Tax - - - 6,781
- ---------------------------------------------------------------------------------------------------------------------------
Net Income 404,262 128,888 794,417 428,507
Dividends on Preferred Stock 185 185 370 370
- ---------------------------------------------------------------------------------------------------------------------------
Net Income Available to Common Shareholders $ 404,077 128,703 $ 794,047 428,137
===========================================================================================================================
Per Share:
Earnings $ 0.69 0.22 $ 1.36 0.75
Diluted Earnings $ 0.68 0.22 $ 1.34 0.73
Cash Dividends $ 0.23 0.20 $ 0.46 0.40
- ---------------------------------------------------------------------------------------------------------------------------
Average Shares (000's):
Outstanding 581,814 574,545 582,196 572,873
Diluted 594,257 590,234 594,631 588,416
===========================================================================================================================
See Notes to Condensed Consolidated Financial Statements
4
Fifth Third Bancorp and Subsidiaries
Condensed Consolidated Statements of Cash Flows (unaudited)
- ------------------------------------------------------------------------------------------------------------------------
Six Months Ended
June 30,
----------------------------------
($000's) 2002 2001
- ------------------------------------------------------------------------------------------------------------------------
Operating Activities
Net Income $ 794,417 428,507
Adjustments to Reconcile Net Income to Net Cash Provided by (Used In)
Operating Activities:
Provision for Credit Losses 119,002 91,557
Minority Interest in Net Income 18,858 -
Depreciation, Amortization and Accretion 145,809 97,344
Provision for Deferred Income Taxes 314,183 37,551
Realized Securities Gains (11,423) (10,160)
Realized Securities Gains - Non-Qualifying Hedges on Mortgage Servicing (46,487) -
Realized Securities Losses 1,922 3,053
Realized Securities Losses - Non-Qualifying Hedges on Mortgage Servicing 47,528 -
Proceeds from Sales of Residential Mortgage Loans Held for Sale 3,766,330 4,217,714
Net Gain on Sales of Loans (94,852) (109,110)
Increase in Residential Mortgage Loans Held for Sale (2,779,774) (5,404,905)
Decrease in Accrued Income Receivable 98,407 18,758
Increase in Other Assets (164,736) (235,669)
(Decrease) Increase in Accrued Taxes, Interest and Expenses (67,575) 191,757
Increase in Other Liabilities 83,121 164,129
- ------------------------------------------------------------------------------------------------------------------------
Net Cash Provided by (Used In) Operating Activities 2,224,730 (509,474)
- ------------------------------------------------------------------------------------------------------------------------
Investing Activities
Proceeds from Sales of Securities Available-for-Sale 7,276,471 5,390,413
Proceeds from Calls, Paydowns and Maturities of Securities Available-for-Sale 3,548,888 4,097,814
Purchases of Securities Available-for-Sale (12,776,260) (7,239,510)
Proceeds from Calls, Paydowns and Maturities of Securities Held-to-Maturity 4,603 14,294
Purchases of Securities Held-to-Maturity (9,733) -
Decrease in Other Short-Term Investments (334,534) (467,550)
(Increase) Decrease in Loans and Leases (2,548,566) 577,100
Purchases of Bank Premises and Equipment (67,093) (71,155)
Proceeds from Disposal of Bank Premises and Equipment 14,591 11,388
Net Cash Paid In Acquisitions - (146,807)
- ------------------------------------------------------------------------------------------------------------------------
Net Cash Provided by (Used in) Investing Activities (4,891,633) 2,165,987
- ------------------------------------------------------------------------------------------------------------------------
Financing Activities
Increase in Transaction Account Deposits 5,705,408 1,628,309
Decrease in Consumer Time Deposits (1,910,004) (581,660)
Increase (Decrease) in CDs - $100,000 and Over, including Foreign 439,770 (5,131,436)
(Decrease) Increase in Federal Funds Borrowed (650,784) 2,126,580
Decrease in Short-Term Bank Notes (33,938) (777,398)
(Decrease) Increase in Other Short-Term Borrowings (691,394) 2,373,328
Proceeds from Issuance of Long-Term Debt 6,612 -
Repayment of Long-Term Debt (22,845) (1,248,752)
Payment of Cash Dividends (268,397) (228,979)
Exercise of Stock Options 64,947 62,908
Purchases of Stock (256,036) -
Other (1,036) (651)
- ------------------------------------------------------------------------------------------------------------------------
Net Cash Provided by (Used In) Financing Activities 2,382,303 (1,777,751)
- ------------------------------------------------------------------------------------------------------------------------
Decrease in Cash and Due from Banks (284,600) (121,238)
Cash and Due from Banks at Beginning of Period 2,030,950 1,706,538
- ------------------------------------------------------------------------------------------------------------------------
Cash and Due from Banks at End of Period $ 1,746,350 1,585,300
- ------------------------------------------------------------------------------------------------------------------------
See Notes to Condensed Consolidated Financial Statements 5
Fifth Third Bancorp and Subsidiaries
Condensed Consolidated Statements of Changes in Shareholders' Equity (unaudited)
==============================================================================================================================
Six Months Ended
June 30,
--------------------------------------
($000's except per share) 2002 2001
==============================================================================================================================
Balance at December 31 $ 7,639,277 6,662,412
Net Income 794,417 428,507
Nonowner Changes in Equity, Net of Tax:
Change in Unrealized Gains on Securities Available-for-Sale
and Qualifying Cash Flow Hedges 216,714 56,909
- ------------------------------------------------------------------------------------------------------------------------------
Net Income and Nonowner Changes in Equity 1,011,131 485,416
Cash Dividends Declared:
Fifth Third Bancorp:
Common Stock (2002 - $.46 per share and 2001 - $.40 per share) (267,574) (209,691)
Preferred Stock (370) (185)
Pooled Companies Prior to Acquisition:
Common Stock - (50,872)
Preferred Stock - (185)
Stock Options Exercised including Treasury Shares Issued 64,947 62,908
Shares Purchased (256,036) -
Stock Issued in Acquisitions and Other (1,036) 118,421
- ------------------------------------------------------------------------------------------------------------------------------
Balance at June 30 $ 8,190,339 7,068,224
==============================================================================================================================
See Notes to Condensed Consolidated Financial Statements 6
FINANCIAL INFORMATION
Item 1. Notes to Condensed Consolidated Financial Statements
1. Basis of Presentation:
In the opinion of management, the unaudited Condensed Consolidated
Financial Statements include all adjustments (which consist of normal
recurring accruals) necessary to present fairly the condensed
consolidated financial position as of June 30, 2002 and 2001, the
results of operations for the three and six months ended June 30, 2002
and 2001, the statements of cash flows for the six months ended June
30, 2002 and 2001 and the statements of changes in shareholders' equity
for the six months ended June 30, 2002 and 2001. In accordance with
accounting principles generally accepted in the United States of
America for interim financial information, these statements do not
include certain information and footnote disclosures required for
complete annual financial statements. Financial information as of
December 31, 2001 has been derived from the audited Consolidated
Financial Statements of Fifth Third Bancorp (the "Registrant" or "Fifth
Third"). The results of operations for the three and six months ended
June 30, 2002 and 2001 and the statements of cash flows for the six
months ended June 30, 2002 and 2001 are not necessarily indicative of
the results to be expected for the full year. For further information,
refer to the Consolidated Financial Statements and footnotes thereto
for the year ended December 31, 2001, included in the Registrant's
Annual Report on Form 10-K/A.
Recent corporate accounting scandals and related developments have led
to a re-examination by accountants, the Securities and Exchange
Commission ("SEC") and bank regulatory authorities of long standing and
widely followed accounting policies. In addition, the SEC has announced
that it is in the process of examining the annual filings on Form 10-K
by the country's largest 500 publicly traded companies. Although the
Registrant is not presently aware of any accounting policies that it
will change as a result of this re-examination, changes may occur in
future filings. The Registrant cannot, however, quantify the likelihood
or effect of any such change.
Certain reclassifications have been made to prior periods' consolidated
financial statements and related notes to conform with the current
period presentation.
2. Business Combinations:
On January 2, 2001, the Registrant completed the acquisition of
Resource Management, Inc., d.b.a. Maxus Investment Group ("Maxus"), an
Ohio corporation. Maxus was a privately-held diversified financial
services company that provides investment management and brokerage
services, headquartered in Cleveland, Ohio. In connection with this
acquisition, the Registrant issued 470,162 shares of Fifth Third common
stock and paid $18.1 million in cash for the outstanding capital stock
of Maxus. This transaction was accounted for as a purchase transaction.
The results of operations of Maxus were included in the Condenced
Consolidated Financial Statements of the Registrant beginning January
2, 2001.
On March 9, 2001, the Registrant completed the acquisition of Capital
Holdings, Inc. ("Capital Holdings") and its subsidiary, Capital Bank
N.A., headquartered in Sylvania, Ohio. At December 31, 2000, Capital
Holdings had total assets of $1.1 billion and total deposits of $874
million. In connection with this acquisition, the Registrant issued
4,505,385 shares of Fifth Third common stock for the outstanding common
shares of Capital Holdings. This transaction was tax-free and was
accounted for as a pooling of interest. The accompanying prior period
Condensed Consolidated Financial Statements of the Registrant have not
been restated for Capital Holdings due to immateriality.
7
Item 1. Notes to Condensed Consolidated Financial Statements (continued)
On April 2, 2001, the Registrant completed the acquisition of Old Kent
Financial Corporation ("Old Kent"), a publicly-traded financial holding
company headquartered in Grand Rapids, Michigan. At December 31, 2000,
Old Kent had total assets of $23.8 billion and total deposits of $17.4
billion. In connection with this acquisition, the Registrant issued
103,716,638 shares of Fifth Third common stock, 7,250 shares of Fifth
Third Series D convertible perpetual preferred stock and 2,000 shares
of Fifth Third Series E perpetual preferred stock to the shareholders
of Old Kent. This transaction was tax-free and was accounted for as a
pooling of interest. The accompanying prior period Condensed
Consolidated Financial Statements of the Registrant have been restated
to include the financial results of Old Kent. Certain reclassifications
were made to Old Kent's financial statements to conform presentation.
During 2001, the Registrant incurred merger-related charges totaling
$384.0 million ($293.6 million after tax, or $.50 per diluted share) in
connection with the Old Kent merger transaction. The significant
components of the merger charge include employee-related charges of
$77.4 million, professional fees of $45.8 million, credit quality
charges of $35.4 million, duplicate facilities and equipment of $95.1
million, conversion costs of $70.8 million, $28.7 million loss incurred
on the sale of Old Kent's subprime mortgage lending portfolio in order
to align Old Kent with the Registrant's asset/liability management
policies, $15.2 million in net losses resulting from the sale of
subsidiaries, out-of-market mortgage operations and six branches
required to be divested as a condition for regulatory approval of the
merger and other merger-related charges of $15.6 million.
Employee-related costs include the severance packages negotiated with
approximately 1,400 people (including all levels of the previous Old
Kent organization from the executive management level to back office
support staff) and the change-in-control payments made pursuant to
pre-existing employment agreements. Employee-related payments made
through June 30, 2002 totaled approximately $73.3 million, including
payments to the approximate 1,400 people that have been terminated as
of June 30, 2002. All terminations have been completed related to this
transaction.
Credit quality charges relate to conforming Old Kent commercial and
consumer loans to the Registrant's credit policies. Specifically, these
loans were conformed to the Registrant's credit rating and review
systems as documented in the Registrant's credit policies. Commercial
credit quality charges largely relate to Old Kent concentrations in
real estate investment property lending and sub prime lending and their
related collateral quality valuations as well as Old Kent's overall
higher commercial lending authorities, as compared to the Registrant's
standards. Consumer credit quality charges largely relate to the
application of the Registrant's more conservative grading of high
loan-to-value ("LTV") loans and purchased home equity loan portfolios.
Based on the conforming ratings, reserves were established based on the
present value of expected future cash flows discounted at the loan's
effective interest rate or fair value of the underlying collateral. The
Registrant evaluated the collectibility of both principal and interest
in assessing the need for a loss accrual. During the second quarter of
2001 the Registrant recognized a provision for credit losses and
charged-off $35.4 million in loans related to these factors.
Duplicate facilities and equipment charges of $95.1 million largely
include write-downs of duplicative equipment and software, negotiated
terminations of several office leases and other facility exit costs.
The Registrant has approximately $13.3 million of remaining negotiated
termination and lease payments of exited facilities as of June 30,
2002.
Conversion costs of $70.8 million include vendor contract termination
costs related to certain application systems of $19.9 million and the
conversion of new affiliates and banking centers (including signage and
all customer relationships).
8
Item 1. Notes to Condensed Consolidated Financial Statements (continued)
Summary of merger-related accrual activity at June 30:
($ in 000's) 2002
-------------------------------------------------------------
Balance, January 1 $ 54,541
Cash payments (37,115)
-------------------------------------------------------------
Balance, June 30 $ 17,426
-------------------------------------------------------------
On October 31, 2001, the Registrant completed the acquisition of USB,
Inc. (USB) and its subsidiaries. USB was a privately held company that
provides payment processing services for agent banks and small and
medium-sized merchants. This transaction was accounted for as a
purchase transaction. Earlier in fiscal 2001, the Registrant had
purchased 49% of USB's outstanding common and preferred stock. The
consolidated results of USB were included in the financial statements
of the Registrant beginning on October 31, 2001. The pro forma prior
period results are not material.
3. Supplemental Disclosure of Cash Flow Information:
For the first six months of 2002, the Registrant paid $781,295,000 in
interest and $35,554,000 in Federal income taxes. For the same period
in 2001, the Registrant paid $1,328,890,000 in interest and paid
$7,500,000 in Federal income taxes. During the first six months of 2002
and 2001, the Registrant had noncash investing activities consisting of
the securitization of $614,603,000 and $1,782,911,000 of residential
mortgage and consumer loans, respectively.
4. Derivative Financial Instruments:
The Registrant accounts for its derivatives under Statement of
Financial Accounting Standards ("SFAS") No. 133, "Accounting for
Derivative Instruments and Hedging Activities," as amended. The
standard requires recognition of all derivatives as either assets or
liabilities in the balance sheet and requires measurement of those
instruments at fair value through adjustments to either accumulated
nonowner changes in equity or current earnings or both, as appropriate.
Prior to entering a hedge transaction, the Registrant formally
documents the relationship between hedging instruments and hedged
items, as well as the risk management objective and strategy for
undertaking various hedge transactions. This process includes linking
all derivative instruments that are designated as fair value or cash
flow hedges to specific assets and liabilities on the balance sheet or
to specific forecasted transactions along with a formal assessment at
both inception of the hedge and on an ongoing basis as to the
effectiveness of the derivative instrument in offsetting changes in
fair values or cash flows of the hedged item. If it is determined that
the derivative instrument is not highly effective as a hedge, hedge
accounting is discontinued and the adjustment to fair value of the
derivative instrument is recorded in net income.
The Registrant maintains an overall interest rate risk management
strategy that incorporates the use of derivative instruments to
minimize significant unplanned fluctuations in earnings and cash flows
caused by interest rate volatility. The Registrant's interest rate risk
management strategy involves modifying the repricing characteristics of
certain assets and liabilities so that changes in interest rates do not
adversely affect the net interest margin and cash flows. Derivative
instruments that the Registrant may use as part of its interest rate
risk management strategy include interest rate and principal only
swaps, interest rate floors, forward contracts and both futures
contracts and options on futures contracts. Interest rate swap
contracts are exchanges of interest payments, such as fixed-rate
payments for floating-rate payments, based on a common notional amount
and maturity date. Forward contracts are contracts in which the buyer
agrees to purchase and the seller agrees to make
9
Item 1. Notes to Condensed Consolidated Financial Statements (continued)
delivery of a specific financial instrument at a predetermined price or
yield. Principal only ("PO") swaps are total return swaps based on
changes in value of the underlying PO trust. Futures contracts
represent the obligation to buy or sell a predetermined amount of debt
subject to the contract's specific delivery requirements at a
predetermined date and a predetermined price. Options on futures
contracts represent the right but not the obligation to buy or sell.
The Registrant also enters into foreign exchange contracts for the
benefit of customers. Generally, the Registrant hedges the exposure of
these free-standing derivatives, by entering into offsetting
third-party forward contracts with approved reputable counterparties
with matching terms and currencies that are generally settled daily.
Risks arise from the possible inability of counterparties to meet the
terms of their contracts and from any resultant exposure to movement in
foreign currency exchange rates, limiting the Registrant's exposure to
the replacement value of the contracts rather than the notional
principal or contract amounts. Free-standing derivatives also include
derivative transactions entered into for risk management purposes that
do not otherwise qualify for hedge accounting. The Registrant will
hedge its interest rate exposure on customer transactions by executing
offsetting swap agreements with primary dealers.
Upon adoption of this statement on January 1, 2001, the Registrant
recorded a cumulative effect of change in accounting principle of
approximately $6.8 million, net of tax.
FAIR VALUE HEDGES - The Registrant enters into interest rate swaps to
convert its nonprepayable, fixed-rate long-term debt to floating-rate
debt. The Registrant's practice is to convert fixed-rate debt to
floating-rate debt. Decisions to convert fixed-rate debt to floating
are primarily made through consideration of the asset/liability mix of
the Registrant, the desired asset/liability sensitivity and by interest
rate levels. For the quarter ended June 30, 2002, the Registrant met
certain criteria required to qualify for shortcut method accounting on
its fair value hedges of this type. Based on this shortcut method
accounting treatment, no ineffectiveness is assumed and fair value
changes in the interest rate swaps are recorded as changes in the value
of both swap and long-term debt. The Registrant has approximately $41.2
million, $13.7 million and $13.6 million of fair value hedges included
in other assets in the June 30, 2002 and 2001 and December 31, 2001
Condensed Consolidated Balance Sheets, respectively. Additionally, the
Registrant enters into forward contracts to hedge the forecasted sale
of its mortgage loans. For the quarter ended June 30, 2002, the
Registrant met certain criteria to qualify for matched terms accounting
on the hedged loans for sale. Based on this treatment, fair value
changes in the forward contracts are recorded as changes in the value
of both the forward contract and loans held for sale in the Condensed
Consolidated Balance Sheet. The Registrant had approximately $8.1
million, $6.5 million and $9.8 million of fair value hedges included in
loans held for sale in the June 30, 2002 and 2001 and December 31, 2001
Condensed Consolidated Balance Sheets, respectively.
As of June 30, 2002, there were no instances of designated hedges no
longer qualifying as fair value hedges.
CASH FLOW HEDGES - The Registrant enters into interest rate swaps to
convert floating-rate liabilities to fixed rates and to hedge certain
forecasted transactions. The liabilities are typically grouped and
share the same risk exposure for which they are being hedged. As of
June 30, 2002 and 2001 and December 31, 2001, $15.7 million, $1.0
million and $10.1 million, respectively, in deferred losses, net of
tax, related to existing hedges were recorded in accumulated nonowner
changes in equity. Gains and losses on derivative contracts that are
reclassified from accumulated nonowner changes in equity to current
period earnings are included in the line item in which the hedged
item's effect in earnings is recorded. As of June 30, 2002, $15.7
million in deferred losses on derivative instruments included in
accumulated nonowner changes in equity are expected to be reclassified
into earnings during the next twelve months. All components of each
derivative instrument's gain or loss are included in the assessment of
hedge effectiveness.
10
Item 1. Notes to Condensed Consolidated Financial Statements (continued)
For the quarter ended June 30, 2002, there were no cash flow hedges
that were discontinued related to forecasted transactions deemed not
probable of occurring. The maximum term over which the Registrant is
hedging its exposure to the variability of future cash flows for all
forecasted transactions, excluding those forecasted transactions
related to the payments of variable interest in existing financial
instruments, is five years for hedges converting floating-rate loans to
fixed. The Registrant had approximately $24.1 million, $1.6 million,
and $15.6 million of cash flow hedges related to the floating-rate
liabilities included in other short-term borrowings in the June 30,
2002 and 2001 and December 31, 2001 Condensed Consolidated Balance
Sheets, respectively.
FREE-STANDING DERIVATIVE INSTRUMENTS - The Registrant enters into
various derivative contracts that primarily focus on providing
derivative products to customers. These derivative contracts are not
linked to specific assets and liabilities on the balance sheet or to
forecasted transactions and, therefore, do not qualify for hedge
accounting.
Interest rate lock commitments issued on residential mortgage loans
intended to be held for resale are also considered free-standing
derivative instruments. The interest rate exposure on these commitments
is economically hedged primarily with forward contracts. Additionally,
the Registrant enters into a combination of free-standing derivative
instruments (PO swaps, floors, forward contracts and interest rate
swaps) to hedge changes in fair value of its fixed rate mortgage
servicing rights portfolio. The commitments and free-standing
derivative instruments are marked to market and recorded as a component
of mortgage banking revenue in the Condensed Consolidated Statements of
Income. For the three and six months ended June 30, 2002 and 2001, the
Registrant recorded net gains of $6.4 million and $13.1 in 2002 and
$4.9 million and $11.0 million in 2001, respectively, on foreign
exchange contracts for customers, net losses of $1.7 million and $3.2
million in 2002 and a net gains of $2.9 million and $2.7 million in
2001, respectively, on the net change in interest rate locks and
forward contracts and net losses of $7.9 million and $11.0 million in
2002 and a net gain of $2.3 million and a net loss of $5.5 million in
2001, respectively, on free-standing derivatives related to mortgage
servicing rights. The Registrant has approximately $3.8 million, $2.6
million, and $3.7 million respectively, of free-standing derivatives
related to customer transactions included in accrued income receivable,
a net $.4 million, $3.8 million, and $2.1 million, respectively, of
free-standing derivatives related to interest rate locks and forward
commitments to sell included in other assets and $38.6 million, $2.2
million and $18.3 million, respectively, related to mortgage servicing
rights included in other assets in the June 30, 2002 and 2001 and
December 31, 2001 Condensed Consolidated Balance Sheets.
5. New Accounting Pronouncements:
In September 2000, the Financial Accounting Standards Board ("FASB")
issued SFAS No. 140, "Accounting for Transfers and Servicing of
Financial Assets and Extinguishments of Liabilities." The statement is
effective for transfers and servicing of financial assets occurring
after March 31, 2001, with certain disclosure and reclassification
requirements effective for financial statements for fiscal years ending
after December 15, 2000. Included in SFAS No. 140, which replaced SFAS
No. 125 of the same name, are the accounting and reporting standards
related to securitizations and Qualifying Special Purpose Entities
("QSPE"). The adoption of SFAS No. 140 did not have a material effect
on the Registrant.
In June 2001, the FASB issued SFAS No. 141, "Business Combinations,"
and SFAS No. 142, "Goodwill and Other Intangible Assets." These
Statements make significant changes to the accounting for business
combinations, goodwill, and intangible assets. SFAS No. 141 eliminates
the pooling of interests method of accounting for business combinations
with limited exceptions for combinations initiated prior to July 1,
2001. In addition, it further clarifies the criteria for recognition of
intangible assets separately from goodwill. The adoption of SFAS No.
141 did not
11
Item 1. Notes to Condensed Consolidated Financial Statements (continued)
have a material effect on the Registrant. SFAS No. 142 discontinues the
practice of amortizing goodwill and indefinite lived intangible assets
and initiates an annual review for impairment. Impairment would be
examined more frequently if certain indicators are encountered.
Intangible assets with a determinable useful life will continue to be
amortized over that period. The amortization provisions apply to
goodwill and intangible assets acquired after June 30, 2001. In
accordance with SFAS No. 142, the Registrant adopted the amortization
provisions effective January 1, 2002. The Registrant has also completed
the initial goodwill impairment test required by this standard and has
determined that no impairment existed as of January 1, 2002. The
following tables illustrate financial results on a pro forma basis as
if SFAS No. 142 was effective beginning January 1, 2001.
Results of Operations (000's except per share):
Three Months Ended June 30,
2002 2001
----------------------------------------------------------------------------------------------------------
Income Before Minority Interest and Cumulative Effect $413,691 137,388
Net Income Available to Common Shareholders $404,077 137,203
Earnings per Diluted Share $ .68 .24
----------------------------------------------------------------------------------------------------------
Six Months Ended June 30,
2002 2001
----------------------------------------------------------------------------------------------------------
Income Before Minority Interest and Cumulative Effect $813,275 452,288
Net Income Available to Common Shareholders $794,047 445,137
Earnings per Diluted Share $ 1.34 .76
----------------------------------------------------------------------------------------------------------
The following table presents a reconciliation between originally
reported Net Income Available to Common Shareholders for the three and
six months ending June 30, 2001 and Net Income Available to Common
Shareholders restated for the effects of SFAS No. 142 ($000's):
Three Months Ended Six Months Ended
June 30, 2001 June 30, 2001
-----------------------------------------------------------------------------------------------------------
Net Income Available to Common Shareholders (as
originally reported) $128,703 428,137
Effect of Goodwill Amortization Expense, Net $ 8,500 17,000
Earnings per Diluted Share $137,203 445,137
-----------------------------------------------------------------------------------------------------------
Detail of Intangible Assets as of June 30, 2002 ($000's):
Gross Carrying Accumulated
Amount Amortization (a)
--------------------------------------------------------------------------------------
Amortized Intangible Assets
Mortgage Servicing Rights $ 797,164 382,673
Core Deposits 341,617 144,489
Charter Agreements 860 619
Merchant Processing Agreements 59,945 7,990
--------------------------------------------------------------------------------------
Total $1,199,586 535,771
--------------------------------------------------------------------------------------
(a) Accumulated amortization for Mortgage Servicing Rights includes
$200.0 million of valuation allowance at June 30, 2002.
12
Item 1. Notes to Condensed Consolidated Financial Statements (continued)
As of June 30, 2002, the Registrant does not have any intangible assets
that are not currently being amortized. Amortization expense of $42.3
million and $92.0 million, respectively, was recognized on intangible
assets (including mortgage servicing rights) for the three and six
months ended June 30, 2002. Estimated future amortization expense is as
follows:
For the Years Ended December 31 ($000's)
--------------------------------------------------
2002 $209,191
--------------------------------------------------
2003 163,644
--------------------------------------------------
2004 118,711
--------------------------------------------------
2005 73,119
--------------------------------------------------
2006 43,492
--------------------------------------------------
In July 2001, the SEC issued Staff Accounting Bulletin (SAB) No. 102
"Selected Loan Loss Allowance Methodology and Documentation Issues."
This bulletin further clarifies the staff's view on the development,
documentation and application of a systematic methodology for
determining the allowance for loan and lease losses in accordance with
generally accepted accounting principles. The Registrant did not
experience any material changes to its existing methodology as a result
of adoption of this bulletin.
In June 2001, the FASB issued SFAS No. 143, "Accounting for Asset
Retirement Obligations." This Statement addresses financial accounting
and reporting for obligations associated with the retirement of
tangible long-lived assets and the associated asset retirement costs.
This Statement amends SFAS Statement No. 19, "Financial Accounting and
Reporting by Oil and Gas Producing Companies" and is effective for
financial statements issued for fiscal years beginning after June 15,
2002. Adoption of this standard is not expected to have a material
effect on the Registrant's Condensed Consolidated Financial Statements.
In August 2001, the FASB issued SFAS No. 144, "Accounting for the
Impairment and Disposal of Long-Term Assets." This Statement eliminates
the allocation of goodwill to long-lived assets to be tested for
impairment and details both a probability-weighted and "primary-asset"
approach to estimate cash flows in testing for impairment of a
long-lived asset. This Statement supersedes SFAS Statement No. 121,
"Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to Be Disposed Of," and the accounting and reporting provisions
of the Accounting Principles Board (APB) Opinion No. 30, "Reporting the
Results of Operations-Reporting the Effects of Disposal of a Segment of
a Business, and Extraordinary, Unusual and Infrequently Occurring
Events and Transactions." This Statement also amends Accounting
Research Bulletin (ARB) No. 51, "Consolidated Financial Statements."
SFAS No. 144 was effective for financial statements issued for fiscal
years beginning after December 15, 2001. Adoption of SFAS No. 144 did
not have a material effect on the Registrant.
In April 2002, the FASB issued SFAS No. 145, "Rescission of SFAS
Statements No. 4, 44, and 64, Amendment of SFAS Statement No. 13, and
Technical Corrections." This Statement rescinds SFAS Statement No. 4,
"Reporting Gains and Losses from Extinguishment of Debt," and an
amendment of that Statement, SFAS Statement No. 64, "Extinguishments of
Debt Made to Satisfy Sinking-Fund Requirements." This Statement also
rescinds SFAS Statement No. 44, "Accounting for Intangible Assets of
Motor Carriers." This Statement amends SFAS Statement No. 13,
"Accounting for Leases," to eliminate an inconsistency between the
required accounting for sale-leaseback transactions and the required
accounting for certain lease modifications that have economic effects
that are similar to sale-leaseback transactions. This Statement also
amends other existing authoritative pronouncements to make various
technical corrections, clarify meanings, or describe their
applicability under changed conditions. SFAS No. 145 is effective for
transactions
13
Item 1. Notes to Condensed Consolidated Financial Statements (continued)
occurring after May 15, 2002. Adoption of SFAS No. 145 did not have a
material effect on the Registrant.
In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities." This Statement addresses
financial accounting and reporting for costs associated with exit or
disposal activities and nullifies EITF Issue No. 94-3, "Liability
Recognition for Certain Employee Termination Benefits and Other Costs
to Exit an Activity (including Certain Costs Incurred in a
Restructuring)." This Statement requires recognition of a liability for
a cost associated with an exit or disposal activity when the liability
is incurred, as opposed to being recognized at the date an entity
commits to an exit plan under EITF No. 94-3.This Statement also
establishes that fair value is the objective for initial measurement of
the liability. This statement is effective for exit or disposal
activities that are initiated after December 31, 2002, with earlier
application encouraged.
6. Business Segment Information:
In accordance with SFAS No. 131, "Disclosures about Segments of an
Enterprise and Related Information," the Registrant has determined its
principal segments to be Retail Banking, Commercial Banking, Investment
Advisory Services and Electronic Payment Processing. Retail Banking
provides a full range of deposit products and consumer loans and
leases. Commercial Banking offers banking, cash management and
financial services to business, government and professional customers.
Investment Advisory Services provides a full range of investment
alternatives for individuals, companies and not-for-profit
organizations. Electronic Payment Processing, through Midwest Payment
Systems ("MPS"), provides electronic funds transfer ("EFT") services,
merchant transaction processing, operates the Registrant's Jeanie ATM
network and provides other data processing services to affiliated and
unaffiliated customers. General Corporate and Other includes the
investment portfolio, certain non-deposit funding, unassigned equity,
the net effect of funds transfer pricing and other items not allocated
to operating segments.
The financial information for each operating segment is reported on the
basis used internally by the Registrant's management to evaluate
performance and allocate resources.
The allocation has been consistently applied for all periods presented.
Revenues from affiliated transactions, principally EFT services from
MPS to the banking segments, are generally charged at rates available
to, and transactions with, unaffiliated customers.
The performance measurement of the operating segments is based on the
management structure of the Registrant and is not necessarily
comparable with similar information for any other financial
institution. The information is also not necessarily indicative of the
segment's financial condition and results of operations if they were
independent entities.
14
Item 1. Notes to Condensed Consolidated Financial Statements (continued)
Total revenues exclude non-mortgage related securities gains of $0.2
million and $9.5 million for the three and six months ended June 30,
2002 and $2.8 million and $7.1 million for the three and six months
ended June 30, 2001, respectively. Results of operations and selected
financial information by operating segment for the three and six months
ended June 30, 2002 and 2001 are as follows:
Three Months Investment Electronic General
Ended June 30, Commercial Retail Advisory Payment Corporate
($000's) Banking Banking Services Processing And Eliminations Total
(a) Other (a)
- --------------------------------------------------------------------------------------------------------------------------------
2002
Total Revenues $339,457 552,359 124,467 128,469 47,570 (7,635) 1,184,687
- --------------------------------------------------------------------------------------------------------------------------------
Net Income Available to
Common Shareholders $139,334 171,165 32,834 34,681 26,063 - 404,077
- --------------------------------------------------------------------------------------------------------------------------------
Goodwill at Mar. 31, 2002 $183,378 235,817 98,393 168,079 - - 685,667
Goodwill Recognized
During the Period - - - 599 - - 599
Impairment Losses - - - - - - -
- --------------------------------------------------------------------------------------------------------------------------------
Goodwill at June 30, 2002 $183,378 235,817 98,393 168,678 - - 686,266
- --------------------------------------------------------------------------------------------------------------------------------
2001
- --------------------------------------------------------------------------------------------------------------------------------
Total Revenues $280,074 466,051 103,137 86,535 99,787 (5,833) 1,029,751
- --------------------------------------------------------------------------------------------------------------------------------
Net Income Available to
Common Shareholders $ 94,656 114,386 24,357 23,859 (128,555) - 128,703
- --------------------------------------------------------------------------------------------------------------------------------
Six Months Investment Electronic General
Ended June 30, Commercial Retail Advisory Payment Corporate
($000's) Banking Banking Services Processing And Eliminations Total
(a) Other (a)
- --------------------------------------------------------------------------------------------------------------------------------
2002
Total Revenues $663,320 1,094,621 239,013 243,098 93,024 (15,246) 2,317,830
- --------------------------------------------------------------------------------------------------------------------------------
Net Income Available to
Common Shareholders $279,182 342,221 64,762 65,315 42,567 - 794,047
- --------------------------------------------------------------------------------------------------------------------------------
Goodwill at Jan. 1, 2002 $183,378 235,817 98,393 164,712 - - 682,300
Goodwill Recognized
During the Period - - - 3,966 - - 3,966
Impairment Losses - - - - - - -
- --------------------------------------------------------------------------------------------------------------------------------
Goodwill at June 30, 2002 $183,378 235,817 98,393 168,678 - - 686,266
- --------------------------------------------------------------------------------------------------------------------------------
Identifiable Assets
(in millions) $ 20,015 25,765 1,693 394 27,056 - 74,923
- --------------------------------------------------------------------------------------------------------------------------------
2001
- --------------------------------------------------------------------------------------------------------------------------------
Total Revenues $541,848 955,912 200,698 161,792 178,291 (11,525) 2,027,016
- --------------------------------------------------------------------------------------------------------------------------------
Net Income Available to
Common Shareholders $201,513 265,489 47,135 48,772 (134,772) - 428,137
- --------------------------------------------------------------------------------------------------------------------------------
Identifiable Assets
(in millions) $ 20,099 26,240 1,082 307 22,106 - 69,834
- --------------------------------------------------------------------------------------------------------------------------------
(a) Electronic Payment Processing service revenues provided to the banking
segments by MPS are eliminated in the Condensed Consolidated Statements of
Income.
15
Item 1. Notes to Condensed Consolidated Financial Statements (continued)
7. Nonowner Changes in Equity:
The Registrant has elected to present the disclosures required by SFAS
No. 130, "Reporting Comprehensive Income," in the Condensed
Consolidated Statement of Changes in Shareholders' Equity on page 6.
The caption "Net Income and Nonowner Changes in Equity" represents
total comprehensive income as defined in the statement. Disclosure of
the reclassification adjustments, related tax effects allocated to
nonowner changes in equity and accumulated nonowner changes in equity
for the six months ended June 30 are as follows:
Six Months Ended
June 30,
($000's) 2002 2001
- ------------------------------------------------------------------------------------------------------------------------
Reclassification Adjustment, Pretax
- ------------------------------------------------------------------------------------------------------------------------
Change in unrealized net gains arising during period $351,944 98,586
Reclassification adjustment for net gains included in net income (8,460) (7,107)
- ------------------------------------------------------------------------------------------------------------------------
Change in unrealized net gains on securities available-for-sale $343,484 91,479
- ------------------------------------------------------------------------------------------------------------------------
Related Tax Effects
- ------------------------------------------------------------------------------------------------------------------------
Change in unrealized net gains arising during period $122,546 35,698
Reclassification adjustment for net gains included in net income (1,317) (2,137)
- ------------------------------------------------------------------------------------------------------------------------
Change in unrealized net gains on securities available-for-sale $121,229 33,561
- ------------------------------------------------------------------------------------------------------------------------
Reclassification Adjustments, Net of Tax
- ------------------------------------------------------------------------------------------------------------------------
Change in unrealized net gains arising during period $229,398 62,888
Reclassification adjustment for net gains included in net income (7,143) (4,970)
- ------------------------------------------------------------------------------------------------------------------------
Change in unrealized net gains on securities available-for-sale $222,255 57,918
- ------------------------------------------------------------------------------------------------------------------------
Accumulated Nonowner Changes in Equity
- ------------------------------------------------------------------------------------------------------------------------
Beginning Balance
Unrealized net gains on securities available-for-sale $ 17,961 28,012
Current Period Change 222,255 57,918
- ------------------------------------------------------------------------------------------------------------------------
Ending Balance
Unrealized net gains on securities available-for-sale $240,216 85,930
- ------------------------------------------------------------------------------------------------------------------------
Beginning Balance
Unrealized net losses on qualifying cash flow hedges $(10,138) -
Current Period Change, net of tax of $3.0 million and $.5 million,
respectively (5,541) (1,009)
- ------------------------------------------------------------------------------------------------------------------------
Ending Balance
Unrealized net losses on qualifying cash flow hedges, net of tax of $8.4
million and $.5 million, respectively $(15,679) (1,009)
- ------------------------------------------------------------------------------------------------------------------------
Accumulated nonowner changes in equity $224,537 84,921
- ------------------------------------------------------------------------------------------------------------------------
16
Item 1. Notes to Condensed Consolidated Financial Statements (continued)
8. Earnings Per Share:
-------------------
The reconciliation of earnings per share to earnings per diluted share follows:
Three Months Ended June 30, 2002 2001
- ---------------------------------------------------------------------------------------------------------------------------------
Net Average Per-Share Net Average Per-Share
($000's except per share) Income Shares Amount Income Shares Amount
- ---------------------------------------------------------------------------------------------------------------------------------
EPS
Net Income $ 404,262 $ 128,888
Less: Dividends on Preferred Stock 185 185
- ---------------------------------------------------------------------------------------------------------------------------------
Income Available to Common Shareholders $ 404,077 581,814 $ 0.69 $ 128,703 574,545 $ 0.22
Effect of Dilutive Securities
Stock Options - 12,135 - 10,965
Convertible Preferred Stock 145 308 145 308
Interest on 6% Convertible
Subordinated Debentures due 2028,
Net of Applicable Income Taxes - - 1,640 4,416
- ---------------------------------------------------------------------------------------------------------------------------------
Earnings Per Diluted Share
Income Available to Common Shareholders
Plus Assumed Conversions $ 404,222 594,257 $ 0.68 $ 130,488 590,234 $ 0.22
=================================================================================================================================
Six Months Ended June 30, 2002 2001
- ---------------------------------------------------------------------------------------------------------------------------------
Net Average Per-Share Net Average Per-Share
($000's except per share) Income Shares Amount Income Shares Amount
- ---------------------------------------------------------------------------------------------------------------------------------
EPS
Net Income $ 794,417 $ 428,507
Less: Dividends on Preferred Stock 370 370
- ---------------------------------------------------------------------------------------------------------------------------------
Income Available to Common Shareholders $ 794,047 582,196 $ 1.36 $ 428,137 572,873 $ 0.75
Effect of Dilutive Securities
Stock Options - 12,127 - 10,819
Convertible Preferred Stock 290 308 290 308
Interest on 6% Convertible
Subordinated Debentures due 2028, 3,280 4,416
Net of Applicable Income Taxes - -
- ---------------------------------------------------------------------------------------------------------------------------------
Earnings Per Diluted Share
Income Available to Common Shareholders
Plus Assumed Conversions $ 794,337 594,631 $ 1.34 $ 431,707 588,416 $ 0.73
=================================================================================================================================
17
Item 1. Notes to Condensed Consolidated Financial Statements (continued)
9. Stock Options and Employee Stock Grant:
Options are eligible for issuance under the Registrant's 1998 Stock Option
Plan to key employees and directors of the Registrant and its subsidiaries.
Share grants represented approximately 1.1% and 1.2% of average outstanding
shares at June 30, 2002 and June 30, 2001, respectively. Option granted
generally have up to ten year terms and vest and become fully exercisable
at the end of three years of continued employment.
As permitted by SFAS 123, "Accounting for Stock-Based Compensation", the
Registrant has elected to disclose pro forma net income and earnings per
share amounts as if the fair-value based method had been applied in
measuring compensation costs.
Compared to the same period last year the Registrant's as reported and pro
forma information for the second quarter 2002 and first six months of 2002
are as follows:
Three Months Six Months
Ended June 30, Ended June 30,
2002 2001 2002 2001
-----------------------------------------------------------------------------------------------------------------------
As reported net income ($ in millions) $404.1 128.7 794.0 428.1
Pro forma net income ($ in millions) $375.8 104.8 746.0 379.6
-----------------------------------------------------------------------------------------------------------------------
As reported earnings per share $ 0.69 0.22 1.36 0.75
Pro forma earnings per share $ 0.65 0.18 1.28 0.66
As reported earnings per diluted share $ 0.68 0.22 1.34 0.73
Pro forma earnings per diluted share $ 0.63 0.18 1.25 0.65
=======================================================================================================================
Compensation expense in the pro forma disclosure is not indicative of
future amounts, as options vest over several years and additional grants
are generally made each year.
The weighted average fair value of options granted was $25.29 for the three
and six months ended June 30, 2002 and $18.58 and $18.61 for the three and
six months ended June 20, 2001. The fair value of each option is estimated
on the date of grant using the Black-Scholes option pricing model with the
following assumptions used for grants in 2002 and 2001: Expected dividend
yield of 1.38% and 1.83%, respectively; expected option lives of nine
years, expected volatility of 28% and risk-free interest rates of 5.1% for
both periods.
10. Related Party Transactions:
At June 30, 2002 and 2001, certain directors, executive officers, principal
holders of the Registrant's common stock and associates of such persons
were indebted, including undrawn commitments to lend, to the Registrant's
banking subsidiaries in the aggregate amount, net of participations, of
$495.1 million and $442.2 million, respectively. Such indebtedness was
incurred in the ordinary course of business on substantially the same terms
as those prevailing at the time of comparable transactions with unrelated
parties.
18
Item 1. Notes to Condensed Consolidated Financial Statements (continued)
11. Subsequent Event:
----------------
On July 23, 2002, the Registrant entered into an agreement to acquire
Franklin Financial Corporation and its subsidiary, Franklin National Bank,
headquartered in Franklin, Tennessee. At March 31, 2002, Franklin Financial
had approximately $775 million in total assets and $645 million in total
deposits. The transaction is structured as a tax-free exchange of stock for
a total transaction value of approximately $240 million. The transaction is
expected to close in the fourth quarter of 2002 and is subject to normal
regulatory approvals in addition to the approval of Franklin Financial
Corporation shareholders.
19
Item 2. Management's Discussion & Analysis of Financial Condition & Results of
Operations
The following is management's discussion and analysis of certain significant
factors that have affected the Registrant's financial condition and results of
operations during the periods included in the Condensed Consolidated Financial
Statements which are a part of this filing.
This report includes forward-looking statements within the meaning of Section
27A of the Securities Act of 1933, as amended, that involve inherent risks and
uncertainties. A number of important factors could cause actual results to
differ materially from those in the forward-looking statements. Those factors
include the economic environment, competition, products and pricing in
geographic and business areas in which the Registrant operates, prevailing
interest rates, changes in government regulations and policies affecting
financial services companies, credit quality and credit risk management, changes
in the banking industry including the effects of consolidation resulting from
possible mergers of financial institutions, acquisitions and integration of
acquired businesses. The Registrant undertakes no obligation to release
revisions to these forward-looking statements or reflect events or circumstances
after the date of this report.
Results of Operations
The Registrant's operating earnings were $404.1 million for the second quarter
of 2002 and $794.0 million for the first six months of 2002, up 19.5 percent and
23.2 percent, respectively, compared to $338.2 million and $644.4 million for
the same periods last year. Operating earnings per diluted share were $.68 for
the second quarter, up 17.2 percent from $.58 for the same period last year, and
$1.34 for the first six months of 2002, up 21.8 percent from $1.10 for the same
period last year. Second quarter and year-to-date 2002 operating earnings are
equivalent to net income available to common shareholders. Operating earnings
for the second quarter of 2001 exclude $209.5 million of after-tax merger
charges, or $.36 per diluted share, associated with the merger and integration
of Old Kent. Operating earnings for the first six months of 2001 further exclude
an after-tax nonrecurring charge for an accounting principle change of $6.8
million, or $.01 per diluted share.
Net interest income on a fully taxable equivalent basis for the second quarter
of 2002 was $688.1 million, an 11.1 percent increase over $619.4 million for the
same period last year, resulting principally from a $1.6 billion (2.4 percent)
increase in average interest-earning assets and a 31 basis point ("bp") increase
in net interest margin, from 3.76 percent during the second quarter of 2001 to
4.07 percent in the second quarter 2002. For the six-month period, net interest
income on a fully taxable equivalent basis increased to $1.3 billion, or 10.0
percent, from the $1.2 billion reported in the same period last year, resulting
principally from a $1.2 billion (1.8 percent) increase in average
interest-earning assets and 31 bp increase in net interest margin, from 3.78
percent in 2001 to 4.09 percent in 2002. The negative effect of a decline in the
yield on average interest-earning assets of 126 bp over the second quarter of
2002 and 144 bp over the first six months of 2002 was offset by a decrease in
funding costs of 178 bp over the second quarter 2002 and 196 bp over the first
six months of 2002. The decline in funding costs was primarily due to the
repricing of borrowed funds and lower year-over-year deposit rates on existing
accounts as well as the continued improvement in the overall mix of interest
bearing liabilities.
The provision for credit losses was $64.0 million in the second quarter of 2002
compared to $25.6 million in the same period last year. Net charge-offs for the
quarter were $43.4 million compared to $42.1 million in the second quarter of
2001 and $50.4 million last quarter. Net charge-offs as a percent of average
loans and leases outstanding increased 1 bp to 0.40 percent from 0.39 percent in
the same period last year and declined 9 bp from last quarter. Nonperforming
assets as a percentage of total loans, leases and other real estate owned was
0.53 percent at June 30, 2002 compared to 0.44 percent at June 30, 2001 and 0.57
percent last quarter. Underperforming assets were $414.0 million at June 30,
2002, or 0.95 percent of total loans, leases and other real estate owned, up 19
bp compared to the $316.3 million, or 0.76 percent, at June 30, 2001 and
decreased 4 bp compared to the $417.1 million or 0.99 percent last quarter.
20
Item 2. Management's Discussion & Analysis of Financial Condition & Results of
Operations (cont.)
The Registrant has not substantively changed any aspect to its overall approach
in the determination of the allowance for loan losses. There have been no
material changes in assumptions or estimation techniques as compared to prior
periods that impacted the determination of the current period allowance. The
total reserve for credit losses at June 30, 2002 as compared to June 30, 2001
has increased from 1.48 percent to 1.50 percent, respectively, of the total loan
and lease portfolio largely as a result of the Registrant's consideration of
historical and anticipated loss rates in the portfolio. The increase in the
provision amount in the current quarter compared to the same period last year is
primarily due to the overall increase in the total loan and lease portfolio as
well as the increase in nonperforming and underperforming assets at June 30,
2002 as compared to June 30, 2001.
Total other operating income, excluding non-mortgage related securities gains
and losses, increased 20.1 percent to $506.7 million compared to $422.0 million
in the second quarter 2001, and increased to $993.6 million for the first six
months of 2002, or 19.6 percent over the same period last year. Electronic
payment processing income was $121.8 million in the second quarter of 2002, an
increase of 55.4 percent compared to the same period in 2001 and increased to
$229.8 million for the first six months of 2002, a 55.4 percent increase over
the same period last year. Electronic payment processing income for the second
quarter of 2002 and for the first six months of 2002 includes an approximate $22
million and $43 million, respectively, of revenue from the fourth quarter 2001
purchase acquisition of Universal Companies (USB). Increases in electronic funds
transfers ("EFT") and merchant processing continued in the second quarter on the
strength of a broadly diversified customer base and product mix with several
significant new customer relationships added during the quarter.
During the 2001 third quarter, the Registrant began an on-balance sheet
non-qualifying hedging strategy to protect against volatility related to the
value of the mortgage servicing rights portfolio. This strategy included the
purchase of various securities classified as available-for-sale on the Condensed
Consolidated Balance Sheet. Throughout the year certain of these securities were
sold resulting in net realized gains of $35.7 million for the second quarter of
2002 and net realized losses of $1.0 million for the first six months of 2002.
Mortgage banking revenue totaled $10.2 million in the second quarter of 2002 and
$111.8 million for the first six months of 2002, excluding the net realized
security gains/losses from the non-qualifying mortgage servicing rights hedging
strategy. This represents a decrease of 80.9 percent and 1.6 percent,
respectively, compared to $53.2 million and $113.6 million for the same periods
last year. The decrease in core contribution of mortgage banking to total
revenue is primarily due to a decrease in loan originations from recent record
levels coupled with an increase in prepayment speeds and loan refinancing that
resulted in an increase in impairment recognized on the mortgage servicing
rights portfolio. Residential mortgage loan originations totaled $2.0 billion in
the second quarter of 2002 as compared to a total of $6.1 billion in total
originations in the same period last year, with in-market loan originations
totaling $2.3 billion in 2001. The decline in total mortgage originations from
the prior year is primarily due to the divestiture in the third quarter of 2001
of out-of-market origination capacity. The Registrant expects the core
contribution of mortgage banking to total revenues to continue to decline as
originations slow from recent record levels. Second quarter mortgage banking
revenue was comprised of $80.5 million in total mortgage banking fees in 2002,
as compared to $82.1 million in 2001, offset by $93.2 million in net valuation
adjustments and amortization on mortgage servicing rights in 2002, as compared
to $28.9 million in 2001. In addition, mortgage banking revenue for the second
quarter of 2002 included $22.8 million resulting from a servicing asset and
corresponding gain recognized from a $615 million loan securitization and sale
transaction. Including the $35.7 million in net realized gains on security sales
for the second quarter of 2002 and the $1.0 million in net realized security
losses for the first six months of 2002, mortgage banking revenue was $45.8
million and $110.8 million, respectively, representing a 13.8 percent and 2.5
percent decrease, over the respective periods in 2001.
21
Item 2. Management's Discussion & Analysis of Financial Condition & Results of
Operations (cont.)
Compared to the same periods in 2001, investment advisory income increased 14.4
percent to $92.0 million in the second quarter of 2002 and 12.0 percent to
$176.4 million for the first six months. Private Client and Retail brokerage
revenues drove the double-digit growth in the quarter with new product
introductions and increased marketing providing a positive contribution. The
Registrant continues to be one of the largest money managers in the Midwest and
as of June 30, 2002 had over $191 billion in assets under care and $30 billion
in assets under management.
Service charges on deposits increased 15.5 percent over last year's second
quarter and 20.6 percent over the first six months of 2001, primarily due to the
expansion of delivery systems and continued sales success in treasury management
services and Retail and Commercial deposit campaigns. Second quarter Retail
deposit revenue increased 5.3 percent year-over-year, and 9.0 percent for the
six month period, driven by the success of sales campaigns and direct marketing
programs in generating new account relationships in all of the Registrant's
markets. Commercial deposit revenues increased 33.5 percent over last year's
second quarter and 41.0 percent for the six month period on the strength of
successful cross-selling efforts and the benefit of a lower interest rate
environment.
Other service charges and fees increased 19.3 percent over the second quarter of
2001 and 12.3 percent over the first six months of 2001, due to increases in
nearly all categories. Compared to the same periods in 2001, commercial banking
revenues increased 38.9 percent and 37.9 percent, respectively, primarily due to
foreign exchange services increasing by 39.7 percent and 17.9 percent,
respectively, and total international revenues increasing by 34.8 percent and
25.5 percent, respectively. Institutional fixed income trading increased 20.7
percent in the second quarter of 2002 and 26.4 percent over the first six
months.
The efficiency ratio (operating expenses divided by the sum of taxable
equivalent net interest income and other operating income, excluding
non-mortgage related net security gains) was 43.5 percent for the second quarter
of 2002 and 44.0 percent for the 2002 six-month period. This represents an
improvement from the 49.3 percent achieved in the second quarter of 2001 and
48.7 percent for the first six month period of 2001. The improvement in the 2002
second quarter and six month period efficiency ratio was due to revenue growth
of 14.7 percent and 13.9 percent, respectively, outpacing expense increases of
1.3 percent and 2.9 percent, respectively. Total operating expenses (excluding
merger related charges incurred in 2001 relating to the Old Kent acquisition)
increased to $519.9 million, or 1.3 percent compared to second quarter of 2001,
and increased 2.9 percent to 1.0 billion for the six-month period. Salaries,
wages, incentives and benefits increased 5.6 percent in the second quarter of
2002 and 8.2 percent for the six month period. The increase in compensation
expense related to the addition of sales officers and back-office personnel
along with an increase in profit sharing expense due to the inclusion of the
former Old Kent employees in the Fifth Third Profit Sharing Plan beginning in
January 2002 and was partially offset by expense from headcount reductions
related to the integration of Old Kent. Incremental expenses associated with the
fourth quarter purchase acquisition of USB also impact year-over-year operating
expense comparisons. Net occupancy expense decreased 4.4 percent during the
second quarter and 5.6 percent during the six month period primarily due to a
decrease in rent expense from the closure of duplicate facilities from the Old
Kent integration. Total other operating expenses remained relatively constant
for the current quarter and six month period of 2002 compared to the same
periods last year.
Financial Condition and Capital Resources
The Registrant's balance sheet remains strong with high-quality assets and solid
capital levels. Total assets were $74.9 billion at June 30, 2002 compared to
$70.6 billion at March 31, 2002 and $69.8 billion at June 30, 2001, an increase
of 6.2 percent and 7.3 percent, respectively. On an operating basis, return on
average equity was 20.2 percent and return on average assets was 2.20 percent
for the second quarter of 2002 compared to 18.9 percent and 1.89 percent,
respectively, for the same period last year.
22
Item 2. Management's Discussion & Analysis of Financial Condition & Results of
Operations (cont.)
Average interest-earning assets increased to $67.7 billion for the second
quarter of 2002, an increase of $1.6 billion, or 2.4 percent, over the same
period last year and increased $3.0 billion, or 4.7 percent, over the 2002 first
quarter. Average interest-earning assets increased primarily due to growth in
average taxable securities offset by a decrease in average loans and leases over
the same period last year. Average interest-earning assets increased over 2002
first quarter due to a $1.1 billion increase in average loans and leases and a
$1.9 billion increase in average taxable securities.
Transaction account deposits grew 39.8 percent, or $10.5 billion, over the same
period last year and $5.7 billion, or 18.3 percent, over 2001 year-end.
Transaction account deposit growth during the period is primarily attributable
to the success of campaigns emphasizing customer deposit accounts. Total
deposits increased 11.1 percent over the same period last year and 9.2 percent
over 2001 year-end, as transaction account deposit growth was offset by a
decrease in time deposits. This shift from time deposits to transaction deposits
provides the Registrant a more favorable funding mix.
The Registrant maintains a relatively high level of capital as a margin of
safety for its depositors and shareholders. At June 30, 2002, shareholders'
equity was $8.2 billion compared to $7.1 billion at June 30, 2001, an increase
of $1.1 billion, or 15.9 percent. Shareholders' equity as a percentage of total
assets as of June 30, 2002 was 10.9 percent. The Federal Reserve Board has
adopted risk-based capital guidelines that assign risk weightings to assets and
off-balance sheet items and also define and set minimum capital requirements
(risk-based capital ratios). The guidelines also define "well-capitalized"
ratios of Tier 1, total capital and leverage as 6 percent, 10 percent and 5
percent, respectively. The Registrant exceeded these "well-capitalized" ratios
at June 30, 2002 and 2001. The Registrant expects to maintain these ratios above
the well-capitalized levels throughout 2002. At June 30, 2002, the Registrant
had a Tier 1 risk-based capital ratio of 12.27 percent, a total risk-based
capital ratio of 14.65 percent and a leverage ratio of 10.35 percent. At June
30, 2001, the Registrant had a Tier 1 risk-based capital ratio of 11.50 percent,
a total risk-based capital ratio of 13.78 percent and a leverage ratio of 9.36
percent.
Critical Accounting Policies
Reserve for Credit Losses: The Registrant maintains a reserve to absorb probable
loan and lease losses inherent in the portfolio. The reserve for credit losses
is maintained at a level the Registrant considers to be adequate to absorb
probable loan and lease losses inherent in the portfolio and is based on
evaluations of the collectibility and historical loss experience of loans and
leases. Credit losses are charged and recoveries are credited to the reserve.
Provisions for credit losses are based on the Registrant's review of the
historical credit loss experience and such factors which, in management's
judgment, deserve consideration under existing economic conditions in estimating
probable credit losses. The reserve is based on ongoing quarterly assessments of
the probable estimated losses inherent in the loan and lease portfolio. In
determining the appropriate level of reserves, the Registrant estimates losses
using a range derived from "base" and "conservative" estimates. The Registrant's
methodology for assessing the appropriate reserve level consists of several key
elements, as discussed below.
Larger commercial loans that exhibit probable or observed credit weaknesses are
subject to individual review. Where appropriate, reserves are allocated to
individual loans based on management's estimate of the borrower's ability to
repay the loan given the availability of collateral, other sources of cash flow
and legal options available to the Registrant. Included in the review of
individual loans are those that are impaired as provided in SFAS No. 114,
"Accounting by Creditors for Impairment of a Loan." Any reserves for impaired
loans are measured based on the present value of expected future cash flows
discounted at the loan's effective interest rate or fair value of the underlying
collateral. The Registrant evaluates the collectibility of both principal and
interest when assessing the need for a loss accrual. Historical loss rates are
applied to other commercial loans not subject to specific reserve allocations.
The loss rates are derived from a migration analysis, which computes the net
charge-off experience sustained on loans according to
23
Item 2. Management's Discussion & Analysis of Financial Condition & Results of
Operations (cont.)
their internal risk grade. These grades encompass ten categories that define a
borrower's ability to repay their loan obligations.
Homogenous loans, such as consumer installment, residential mortgage loans, and
automobile leases are not individually risk graded. Reserves are established for
each pool of loans based on the expected net charge-offs for one year. Loss
rates are based on the average net charge-off history by loan category.
Historical loss rates for commercial and consumer loans may be adjusted for
significant factors that, in management's judgement, reflect the impact of any
current conditions on loss recognition. Factors which management considers in
the analysis include the effects of the national and local economies, trends in
the nature and volume of loans (delinquencies, charge-offs, nonaccrual and
problem loans), changes in the internal lending policies and credit standards,
collection practices, and examination results from bank regulatory agencies and
the Registrant's internal credit examiners.
An unallocated reserve is maintained to recognize the imprecision in estimating
and measuring loss when evaluating reserves for individual loans or pools of
loans. Reserves on individual loans and historical loss rates are reviewed
quarterly and adjusted as necessary based on changing borrower and/or collateral
conditions and actual collection and charge-off experience.
The Registrant's primary market areas for lending are Ohio, Kentucky, Indiana,
Florida, Michigan, Illinois and West Virginia. When evaluating the adequacy of
reserves, consideration is given to this regional geographic concentration and
the closely-associated effect changing economic conditions has on the
Registrant's customers.
The Registrant has not substantively changed any aspect to its overall approach
in the determination of the allowance for loan losses. There have been no
material changes in assumptions or estimation techniques as compared to prior
periods that impacted the determination of the current period allowance.
Based on the procedures discussed above, management is of the opinion the
reserve of $649,166,000 was adequate, but not excessive, to absorb estimated
credit losses associated with the loan and lease portfolio at June 30, 2002.
Valuation of Derivatives: The Registrant maintains an overall interest rate risk
management strategy that incorporates the use of derivative instruments to
minimize significant unplanned fluctuations in earnings and cash flows caused by
interest rate volatility. Derivative instruments that the Registrant may use as
part of its interest rate risk management strategy include interest rate and
principal only swaps, interest rate floors, forward contracts and both futures
contracts and options on futures contracts. The primary risk of material changes
to the value of the derivative instruments is the fluctuation in interest rates,
however, as the Registrant principally utilizes these derivative instruments as
part of a designated hedging program, the change in the derivative value is
generally offset by a corresponding change in the value of the hedged item or a
forecasted transaction.
Valuation of Mortgage Servicing Rights: When the Registrant sells loans through
either securitizations or individual loan sales in accordance with its
investment policies, it may retain one or more subordinated tranches, servicing
rights and in some cases a cash reserve account, all of which are retained
interests in the securitized or sold loans. Gain or loss on sale of the loans
depends in part on the previous carrying amount of the financial assets involved
in the sale, allocated between the assets sold and the retained interests based
on their relative fair value at the date of the sale. To obtain fair values,
quoted market prices are used if available. If quotes are not available for
retained interests, the Registrant calculates fair value based on the present
value of future expected cash flows using management's best estimates of the key
assumptions - credit losses, prepayment speeds, forward yield curves and
discount rates commensurate with the risks involved.
24
Item 2. Management's Discussion & Analysis of Financial Condition & Results of
Operations (cont.)
Servicing rights resulting from loan sales are amortized in proportion to, and
over the period of estimated net servicing revenues. Servicing rights are
assessed for impairment periodically, based on fair value, with any impairment
recognized through a valuation allowance. For purposes of measuring impairment,
the rights are stratified based on interest rate and original maturity. Fees
received for servicing mortgage loans owned by investors are based on a
percentage of the outstanding monthly principal balance of such loans and are
included in income as loan payments are received. Costs of servicing loans are
charged to expense as incurred.
Key economic assumptions used in measuring any potential impairment of the
servicing rights include the prepayment speed of the underlying mortgage loans,
the weighted-average life of the loan and the discount rate. The primary risk of
material changes to the value of the mortgage servicing rights resides in the
potential volatility in the economic assumptions used, particularly the
prepayment speed. The Registrant monitors this risk and adjusts its valuation
allowance as necessary to adequately reserve for any probable impairment in the
portfolio. By adjusting the allowance as necessary each quarter, the Registrant
mitigates its risk to material adverse changes in the value of the portfolio.
Off-Balance Sheet and Certain Trading Activities
The Registrant does not participate in any trading activities involving
commodity contracts that are accounted for at fair value. In addition, the
Registrant has no fair value contracts for which a lack of marketplace
quotations necessitates the use of fair value estimation techniques. The
Registrant's off-balance sheet derivative product policy and investment policies
provide a framework within which the Registrant and its affiliates may use
certain authorized financial derivatives as an asset/liability management tool
in meeting the Registrant's Asset/Liability Management Committee's (ALCO)
capital planning directives, to hedge changes in fair value of its fixed rate
mortgage servicing rights portfolio or to provide qualifying customers access to
the derivative products market. These policies are reviewed and approved
annually by the Audit Committee and the Board of Directors.
As part of the Registrant's ALCO management, the Registrant may transfer,
subject to credit recourse, certain types of individual financial assets to a
non-consolidated QSPE that is wholly owned by an independent third party. During
the six months ended June 30, 2002, certain primarily fixed-rate short-term
investment grade commercial loans were transferred to the QSPE. These individual
loans are transferred at par with no gain or loss recognized and qualify as
sales, as set forth in SFAS No. 140. At June 30, 2002, the outstanding balance
of loans transferred was $1.9 billion. Given the investment grade nature of the
loans transferred, the Registrant does not expect this recourse feature to
result in a significant use of funds in future periods.
The Registrant had the following cash flows with the unconsolidated QSPE during
the six months ended June 30:
($ in millions) 2002 2001
-------------------------------------------------------------
Proceeds from transfers $141.2 88.7
Transfers received from QSPE $108.9 82.1
Fees received $ 13.7 10.4
-------------------------------------------------------------
Through June 30, 2002, the Registrant has sold, subject to credit recourse and
with servicing retained, a total of approximately $2.3 billion in leased autos
to an unrelated asset-backed special purpose entity that have subsequently been
leased back to the Registrant. No significant gain or loss has been recognized
on these transactions and the Registrant has established, and evaluates
quarterly, a loss reserve for estimated future losses based on historical loss
experience. As of June 30, 2002, the outstanding balance of these leases was
$1.8 billion and pursuant to this sale-leaseback, the Registrant has future
operating lease
25
Item 2. Management's Discussion & Analysis of Financial Condition & Results of
Operations (cont.)
payments and corresponding scheduled annual lease receipts from the underlying
lessee totaling $1.8 billion.
Finally, the Registrant utilizes securitization trusts formed by independent
third parties to facilitate the securitization process of residential mortgage
loans. The cash flows to and from the securitization trusts are principally
limited to the initial proceeds from the securitization trust at the time of
sale. Although the Registrant's securitization policy permits the retention of
subordinated tranches, servicing rights, and in some cases a cash reserve, the
Registrant has historically only retained mortgage servicing rights interests in
these sales.
Foreign Currency Exposure
At June 30, 2002 and 2001 and December 31, 2001, the Registrant maintained
foreign office deposits of $2.1 billion, $1.5 billion and $1.2 billion,
respectively. These foreign deposits represent U.S. dollar denominated deposits
in our foreign branches located in the Cayman Islands. In addition, the
Registrant enters into foreign exchange derivative contracts for the benefit of
customers involved in international trade to hedge their exposure to foreign
currency fluctuations. Generally, the Registrant enters into offsetting
third-party forward contracts with approved reputable counterparties with
matching terms and currencies that are generally settled daily.
26
Item 3. Quantitative and Qualitive Disclosures about Market Risk
Liquidity and Market Risk
The objective of the Registrant's asset/liability management function is to
maintain consistent growth in net interest income within the Registrant's policy
limits. This objective is accomplished through management of the Registrant's
balance sheet composition, liquidity, and interest rate risk exposures arising
from changing economic conditions, interest rates and customer preferences.
The goal of liquidity management is to provide adequate funds to meet changes in
loan and lease demand or unexpected deposit withdrawals. This is accomplished by
maintaining liquid assets in the form of investment securities, maintaining
sufficient unused borrowing capacity in the national money markets and
delivering consistent growth in core deposits. As of June 30, 2002, the
Registrant, in addition to the short-term investments had approximately $345.5
million in securities maturing or re-pricing within one year. Additional
asset-driven liquidity is provided by the remainder of the securities portfolio
and securitizable loan and lease assets. These sources, in addition to the
Registrant's 10.92 percent average equity capital base, provide a stable funding
base.
In addition to core deposit funding, the Registrant also accesses a variety of
other short-term and long-term funding sources. The Registrant also uses the
Federal Home Loan Bank (FHLB) as a funding source, issuing notes payable through
its FHLB member subsidiaries. The Registrant also has significant unused funding
capacity in the national money markets. The Registrant's A-1+/Prime-1 ratings on
its commercial paper and AA-/Aa2 ratings for its senior debt, along with the
AA-/Aa1 long-term deposit ratings of Fifth Third Bank (Ohio); Fifth Third Bank
(Michigan); Fifth Third Bank, Indiana; Fifth Third Bank, Kentucky, Inc.; and
Fifth Third Bank, Northern Kentucky, Inc. continue to be among the best in the
industry. The continued confidence of the rating agencies was recently
demonstrated by the ratings upgrade received from Moody's in June 2002. These
ratings, along with capital ratios significantly above regulatory guidelines,
provide the Registrant with additional liquidity. Management does not rely on
any one source of liquidity and manages availability in response to changing
balance sheet needs. Given the continued strength of the balance sheet, stable
credit quality, risk management policies and revenue growth trends, management
does not expect any downgrade in the credit ratings in the upcoming year.
Management considers interest rate risk the Registrant's most significant market
risk. Interest rate risk is the exposure to adverse changes in net interest
income due to changes in interest rates. Consistency of the Registrant's net
interest revenue is largely dependent upon the effective management of interest
rate risk.
The Registrant employs a variety of measurement techniques to identify and
manage its interest rate risk including the use of an earnings simulation model
to analyze net interest income sensitivity to changing interest rates. The model
is based on actual cash flows and repricing characteristics for on and
off-balance sheet instruments and incorporates market-based assumptions
regarding the effect of changing interest rates on the prepayment rates of
certain assets and liabilities. The model also includes senior management
projections for activity levels in each of the product lines offered by the
Registrant. Assumptions based on the historical behavior of deposit rates and
balances in relation to changes in interest rates are also incorporated into the
model. Actual results will differ from these simulated results due to timing,
magnitude, and frequency of interest rate changes as well as changes in market
conditions and management strategies.
The Registrant's ALCO, which includes senior management representatives and
reports to the Board of Directors, monitors and manages interest rate risk
within Board-approved policy limits. The Registrant's current interest rate risk
policy limits are determined by measuring the anticipated change in net interest
income over a 12- and 24-month horizon assuming a 200 bp linear increase or
decrease in all interest rates. Current policy limits this exposure to plus or
minus 7 percent of net interest income for a 12-month and a 24-month horizon.
27
Item 3. Quantitative and Qualitative Disclosures about Market Risk (continued)
The following table shows the Registrant's estimated earnings sensitivity
profile as of June 30, 2002:
Change in Percentage Change in
Interest Rates Net Interest Income
(basis points) 12 Months 24 Months
------------------------------------------------------
+ 200 0.94% 4.70%
- 200 (2.86)% (11.56)%
------------------------------------------------------
Given a linear 200 bp increase in the yield curve used in the simulation model,
it is estimated net interest income for the Registrant would increase by .94
percent over one year and 4.7 percent over two years. A 200 bp linear decrease
in interest rates would decrease net interest income by 2.86 percent over one
year and an estimated 11.56 percent over two years. Given the current federal
funds rate of 1.75 percent at June 30, 2002, a linear 175 bp decrease for
federal funds was modeled in the estimated earnings sensitivity profile in place
of the linear 200 bp decrease utilized for the remainder of the portfolio in
accordance with the Registrant's interest rate risk policy. Assuming a 175 bp
decrease for federal funds and a 200 bp decrease for the remainder of the
portfolio, the Registrant is currently out of compliance with the interest rate
risk policy. The Registrant's ALCO, along with senior management, have deemed
the risk of a 200 bp decrease in rates to be low given the current interest rate
environment and, therefore, have decided it is prudent to add no additional
coverage at this point. All of the other estimated changes in net interest
income are within the policy guidelines established by the Board of Directors.
Management does not expect any significant adverse effect to net interest income
in 2002 based on the composition of the portfolio and anticipated trends in
rates.
In order to reduce the exposure to interest rate fluctuations and to manage
liquidity, the Registrant has developed securitization and sale procedures for
several types of interest-sensitive assets. All long-term, fixed-rate single
family residential mortgage loans underwritten according to Federal Home Loan
Mortgage Corporation or Federal National Mortgage Association guidelines are
sold for cash upon origination. Periodically, additional assets such as
adjustable-rate residential mortgages, certain consumer leases and certain
short-term commercial loans are also securitized, sold or transferred
off-balance sheet. During the six months ended June 30, 2002 and 2001, a total
of $4.4 billion and $6.8 billion, respectively, were sold, securitized, or
transferred off-balance sheet (excluding $.7 billion of divestiture related
sales in 2001).
Management focuses its efforts on consistent net interest revenue and net
interest margin growth through each of the retail and wholesale business lines.
28
PART II. OTHER INFORMATION
Item 6. Exhibits and Reports on Form 8-K
(a) List of Exhibits
(3)(i) Amended Articles of Incorporation, as amended,
incorporated by reference to the Registrant's
Quarterly Report on Form 10-Q for the quarter ended
March 31, 2001
(3)(ii) Code of Regulations, as amended, incorporated by
reference to the Registrant's Quarterly Report on
Form 10-Q for the quarter ended March 31, 2001
Exhibit 99.1 Certification Pursuant to 18 U.S.C. Section 1350, as
Adopted Pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002 by Chief Executive Officer
Exhibit 99.2 Certification Pursuant to 18 U.S.C. Section 1350, as
Adopted Pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002 by Chief Financial Officer
(b) Reports on Form 8-K during the quarter ended June 30,2002:
The Registrant filed a report on Form 8-K dated June 7,
2002 related to its Regulation FD Disclosure to assist
investors, financial analysts and other interested parties
in their analysis of the Registrant.
29
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Fifth Third Bancorp
-------------------
Registrant
Date: August 14, 2002 /s/ Neal E. Arnold
------------------
Neal E. Arnold
Executive Vice President and
Chief Financial Officer
30