10-K 1 d10k.htm FORM 10-K Form 10-K

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Management’s Discussion and Analysis of Financial Condition and Results of Operations

  

Selected Financial Data

   18

Overview

   19

Recent Accounting Standards

   20

Critical Accounting Policies

   20

Risk Factors

   22

Statements of Income Analysis

   25

Business Segment Review

   31

Fourth Quarter Review

   35

Balance Sheet Analysis

   36

Risk Management

   39

Management’s Assessment as to the Effectiveness of Internal Control over Financial Reporting

   50

Reports of Independent Registered Public Accounting Firm

   51

Financial Statements

  

Consolidated Statements of Income

   52

Consolidated Balance Sheets

   53

Consolidated Statements of Changes in Shareholders’ Equity

   54

Consolidated Statements of Cash Flows

   55

 

Notes to Consolidated Financial Statements

 

Summary of Significant Accounting and Reporting Policies

   56  

Legal and Regulatory Proceedings

   73

Business Combinations

   61  

Related Party Transactions

   74

Securities

   62  

Accumulated Other Comprehensive Income

   75

Loans and Leases and Allowance for Loan and Lease Losses

   63  

Common Stock and Treasury Stock

   76

Loans Acquired in a Transfer

   64  

Stock-Based Compensation

   76

Bank Premises and Equipment

   64  

Other Noninterest Income and Other Noninterest Expense

   79

Goodwill

   64  

Income Taxes

   79

Intangible Assets

   65  

Retirement and Benefit Plans

   81

Sales of Receivables and Servicing Rights

   65  

Earnings Per Share

   82

Derivatives

   67  

Fair Value of Financial Instruments

   83

Other Assets

   70  

Certain Regulatory Requirements and Capital Ratios

   84

Short-Term Borrowings

   70  

Parent Company Financial Statements

   85

Long-Term Debt

   71  

Segments

   86

Commitments, Contingent Liabilities and Guarantees

   72     

Annual Report on Form 10-K

        88

Consolidated Ten Year Comparison

        99

Directors and Officers

        100

Corporate Information

       

FORWARD-LOOKING STATEMENTS

This report may contain forward-looking statements about Fifth Third Bancorp and/or the company as combined acquired entities within the meaning of Sections 27A of the Securities Act of 1933, as amended, and Rule 175 promulgated thereunder, and 21E of the Securities Exchange Act of 1934, as amended, and Rule 3b-6 promulgated thereunder, that involve inherent risks and uncertainties. This report may contain certain forward-looking statements with respect to the financial condition, results of operations, plans, objectives, future performance and business of Fifth Third Bancorp and/or the combined company including statements preceded by, followed by or that include the words or phrases such as “believes,” “expects,” “anticipates,” “plans,” “trend,” “objective,” “continue,” “remain” or similar expressions or future or conditional verbs such as “will,” “would,” “should,” “could,” “might,” “can,” “may” or similar expressions. There are a number of important factors that could cause future results to differ materially from historical performance and these forward-looking statements. Factors that might cause such a difference include, but are not limited to: (1) general economic conditions and weakening in the economy, specifically the real estate market, either national or in the states in which Fifth Third, one or more acquired entities and/or the combined company do business, are less favorable than expected; (2) deteriorating credit quality; (3) political developments, wars or other hostilities may disrupt or increase volatility in securities markets or other economic conditions; (4) changes in the interest rate environment reduce interest margins; (5) prepayment speeds, loan origination and sale volumes, charge-offs and loan loss provisions; (6) Fifth Third’s ability to maintain required capital levels and adequate sources of funding and liquidity; (7) changes and trends in capital markets; (8) competitive pressures among depository institutions increase significantly; (9) effects of critical accounting policies and judgments; (10) changes in accounting policies or procedures as may be required by the Financial Accounting Standards Board or other regulatory agencies; (11) legislative or regulatory changes or actions, or significant litigation, adversely affect Fifth Third, one or more acquired entities and/or the combined company or the businesses in which Fifth Third, one or more acquired entities and/or the combined company are engaged; (12) ability to maintain favorable ratings from rating agencies; (13) fluctuation of Fifth Third’s stock price; (14) ability to attract and retain key personnel; (15) ability to receive dividends from its subsidiaries; (16) potentially dilutive effect of future acquisitions on current shareholders’ ownership of Fifth Third; (17) effects of accounting or financial results of one or more acquired entities; (18) difficulties in combining the operations of acquired entities; (19) ability to secure confidential information through the use of computer systems and telecommunications networks; and (20) the impact of reputational risk created by these developments on such matters as business generation and retention, funding and liquidity. Fifth Third undertakes no obligation to release revisions to these forward-looking statements or reflect events or circumstances after the date of this report.


MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

The following is management’s discussion and analysis of certain significant factors that have affected Fifth Third Bancorp’s (the “Bancorp” or “Fifth Third”) financial condition and results of operations during the periods included in the Consolidated Financial Statements, which are a part of this report. Reference to the Bancorp incorporates the parent holding company and all consolidated subsidiaries.

 

TABLE 1: SELECTED FINANCIAL DATA

             
 

For the years ended December 31 ($ in millions, except per share data)

   2007     2006    2005    2004    2003
 

Income Statement Data

             

Net interest income (a)

   $3,033     2,899    2,996    3,048    2,944

Noninterest income

   2,467     2,012    2,374    2,355    2,398

    Total revenue (a)

   5,500     4,911    5,370    5,403    5,342

Provision for loan and lease losses

   628     343    330    268    399

Noninterest expense

   3,311     2,915    2,801    2,863    2,466

Net income

   1,076     1,188    1,549    1,525    1,665

Common Share Data

             

Earnings per share, basic

   $2.00     2.14    2.79    2.72    2.91

Earnings per share, diluted

   1.99     2.13    2.77    2.68    2.87

Cash dividends per common share

   1.70     1.58    1.46    1.31    1.13

Book value per share

   17.20     18.02    17.00    16.00    15.29

Dividend payout ratio

   84.9 %   74.2    52.7    48.9    39.4

Financial Ratios

             

Return on average assets

   1.05 %   1.13    1.50    1.61    1.90

Return on average equity

   11.2     12.1    16.6    17.2    19.0

Average equity as a percent of average assets

   9.35     9.32    9.06    9.34    10.01

Tangible equity

   6.05     7.79    6.87    8.35    8.56

Net interest margin (a)

   3.36     3.06    3.23    3.48    3.62

Efficiency (a)

   60.2     59.4    52.1    53.0    46.2

Credit Quality

             

Net losses charged off

   $462     316    299    252    312

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

   .61 %   .44    .45    .45    .63

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

   1.17     1.04    1.06    1.19    1.33

Allowance for credit losses as a percent of loans and leases

   1.29     1.14    1.16    1.31    1.47

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

   1.32     .61    .52    .51    .61

Average Balances

             

Loans and leases, including held for sale

   $78,348     73,493    67,737    57,042    52,414

Total securities and other short-term investments

   11,994     21,288    24,999    30,597    28,947

Total assets

   102,477     105,238    102,876    94,896    87,481

Transaction deposits (b)

   50,987     49,678    48,177    43,260    40,372

Core deposits (c)

   61,765     60,178    56,668    49,468    46,798

Wholesale funding (d)

   27,254     31,691    33,615    33,629    28,812

Shareholders’ equity

   9,583     9,811    9,317    8,860    8,754

Regulatory Capital Ratios

             

Tier I capital

   7.72 %   8.39    8.35    10.31    10.97

Total risk-based capital

   10.16     11.07    10.42    12.31    13.42

Tier I leverage

   8.50     8.44    8.08    8.89    9.11

(a)

Amounts presented on a fully taxable equivalent basis (“FTE”). The taxable equivalent adjustments for years ending December 31, 2007, 2006, 2005, 2004 and 2003 were $24 million, $26 million, $31 million, $36 million and $39 million, respectively.

(b)

Includes demand, interest checking, savings, money market and foreign office deposits.

(c)

Includes transaction deposits plus other time deposits.

(d)

Includes certificates $100,000 and over, other foreign office deposits, federal funds purchased, short-term borrowings and long-term debt.

 

TABLE 2: QUARTERLY INFORMATION

                                       
     2007    2006

For the three months ended ($ in millions, except per share data)

   12/31    9/30    6/30    3/31    12/31    9/30    6/30    3/31

Net interest income (FTE)

   $785    760    745    742    744    719    716    718

Provision for loan and lease losses

   284    139    121    84    107    87    71    78

Noninterest income

   509    681    669    608    181    626    622    584

Noninterest expense

   940    853    765    753    760    731    726    698

Income before cumulative effect

   16    325    376    359    66    377    382    359

Cumulative effect of change in accounting principle, net of tax

   -    -    -    -    -    -    -    4

Net income

   16    325    376    359    66    377    382    363

Earnings per share, basic

   .03    .61    .69    .65    .12    .68    .69    .66

Earnings per share, diluted

   .03    .61    .69    .65    .12    .68    .69    .65

 

18    Fifth Third Bancorp


MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

OVERVIEW

 

This overview of management’s discussion and analysis highlights selected information in the financial results of the Bancorp and may not contain all of the information that is important to you. For a more complete understanding of trends, events, commitments, uncertainties, liquidity, capital resources and critical accounting policies and estimates, you should carefully read this entire document. Each of these items could have an impact on the Bancorp’s financial condition, results of operations and cash flows.

The Bancorp is a diversified financial services company headquartered in Cincinnati, Ohio. At December 31, 2007, the Bancorp had $111.0 billion in assets, operated 18 affiliates with 1,227 full-service Banking Centers including 102 Bank Mart® locations open seven days a week inside select grocery stores and 2,211 Jeanie® ATMs in Ohio, Kentucky, Indiana, Michigan, Illinois, Florida, Tennessee, West Virginia, Pennsylvania, Missouri and Georgia. The Bancorp reports on five business segments: Commercial Banking, Branch Banking, Consumer Lending, Investment Advisors and Fifth Third Processing Solutions (“FTPS”).

The Bancorp believes that banking is first and foremost a relationship business where the strength of the competition and challenges to growth can vary in every market. Its affiliate operating model provides a competitive advantage by keeping the decisions close to the customer and by emphasizing individual relationships. Through its affiliate operating model, individual managers from the banking center to the executive level are given the opportunity to tailor financial solutions for their customers.

The Bancorp’s revenues are fairly evenly dependent on net interest income and noninterest income. For the year ended December 31, 2007, net interest income, on a fully taxable equivalent (“FTE”) basis, and noninterest income provided 55% and 45% of total revenue, respectively. Therefore, changes in interest rates, credit quality, economic trends and the capital markets are primary factors that drive the performance of the Bancorp. As discussed in the Risk Management section, risk identification, measurement, monitoring, control and reporting are important to the management of risk and to the financial performance and capital strength of the Bancorp.

Net interest income is the difference between interest income earned on assets such as loans, leases and securities, and interest expense paid on liabilities such as deposits, short-term borrowings and long-term debt. Net interest income is affected by the general level of interest rates, the relative level of short-term and long-term interest rates, changes in interest rates and changes in the amount and composition of interest-earning assets and interest-bearing liabilities. Generally, the rates of interest the Bancorp earns on its assets and pays on its liabilities are established for a period of time. The change in market interest rates over time exposes the Bancorp to interest rate risk through potential adverse changes to net interest income and financial position. The Bancorp manages this risk by continually analyzing and adjusting the composition of its assets and liabilities based on their payment streams and interest rates, the timing of their maturities and their sensitivity to changes in market interest rates. Additionally, in the ordinary course of business, the Bancorp enters into certain derivative transactions as part of its overall strategy to manage its interest rate and prepayment risks. The Bancorp is also exposed to the risk of losses on its loan and lease portfolio as a result of changing expected cash flows caused by loan defaults and inadequate collateral due to a weakening economy within the Bancorp’s footprint.

Net interest income, net interest margin, net interest rate spread and the efficiency ratio are presented in Management’s Discussion and Analysis of Financial Condition and Results of Operations on an FTE basis. The FTE basis adjusts for the tax-favored status of income from certain loans and securities held by the Bancorp that are not taxable for federal income tax

purposes. The Bancorp believes this presentation to be the preferred industry measurement of net interest income as it provides a relevant comparison between taxable and non-taxable amounts.

Noninterest income is derived primarily from electronic funds transfer (“EFT”) and merchant transaction processing fees, card interchange, fiduciary and investment management fees, corporate banking revenue, service charges on deposits and mortgage banking revenue. Noninterest expense is primarily driven by personnel costs and occupancy expenses in addition to expenses incurred in the processing of credit and debit card transactions for its customers and merchant and financial institution clients.

On November 2, 2007, the Bancorp completed its acquisition of R-G Crown Bank (“Crown”), a subsidiary of R&G Financial Corporation, with $2.8 billion in assets and $1.7 billion in deposits located in Florida and Augusta, Georgia. As of December 31, 2007, the Bancorp’s Florida affiliates have 141 full-service locations, of which 28 were acquired as part of the Crown acquisition. Additionally, the 3 Crown banking centers in Augusta allowed the Bancorp to enter the state of Georgia.

On August 16, 2007, the Bancorp announced an agreement to acquire First Charter Corporation (“First Charter”), which operates 57 banking centers in North Carolina and 2 in suburban Atlanta. The acquisition is awaiting regulatory approval with a planned close in the second quarter of 2008.

Earnings Summary

The Bancorp’s net income was $1.1 billion or $1.99 per diluted share in 2007, a nine percent decrease compared to $1.2 billion and $2.13 per diluted share in 2006. Current year results were impacted by a $177 million charge to lower the current cash surrender value of one of the Bancorp’s bank-owned life insurance (“BOLI”) policies. The BOLI charge reflected a decrease in cash surrender value due to declines in value of the policies underlying investments due to significant disruptions in the financial markets and widening credit spreads. This charge reflected an additional $22 million recorded subsequent to the Bancorp’s issuance of fourth quarter of 2007 earnings. Current year results were also impacted by provision for loan and lease losses of $628 million, an increase of $285 million over 2006. The increased provision for loan and lease losses was a result of the deteriorating credit environment discussed further in the Risk Management section.

Net interest income (FTE) increased five percent compared to 2006. Net interest margin increased to 3.36% in 2007 from 3.06% in 2006 largely due to the balance sheet actions taken in the fourth quarter of 2006. See Comparison of 2006 with 2005 section for specific balance sheet actions taken.

Noninterest income increased 23% compared to 2006. Noninterest income in 2007 reflects the impact of the previously mentioned $177 million BOLI charge, while the 2006 results included $415 million in losses related to fourth quarter balance sheet actions. Excluding these items, noninterest income increased nine percent compared to 2006 with growth in electronic payment processing, service charges on deposits and corporate banking revenue offset by lower mortgage banking net revenue.

Noninterest expense increased 14% compared to 2006. Noninterest expense in 2007 included $172 million in charges related to the Bancorp’s indemnification of estimated current and future Visa Inc. (“Visa”) litigation settlements and $8 million of acquisition-related costs, while 2006 results included $49 million in charges related to the termination of debt and other financing agreements. Excluding these items, noninterest expense increased nine percent resulting from volume-based transaction growth in


 

Fifth Third Bancorp    19


MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

payment processing, higher technology related expenses reflecting infrastructure upgrades and higher occupancy expense from continued de novo growth.

The Bancorp maintains a conservative approach to both lending and investing activities as it does not originate or hold subprime loans, nor does it hold collateralized debt obligations (“CDOs”) or asset-backed securities backed by subprime loans in its securities portfolio. However, the Bancorp has exposure to the housing markets, which weakened considerably during 2007, particularly in the upper Midwest and Florida. Consequently, net charge-offs as a percent of average loans and leases were 61 basis points (“bp”) in 2007 compared to 44 bp in 2006. At December 31, 2007, nonperforming assets as a percent of loans and leases increased to 1.32% from .61% at December 31, 2006.

The Bancorp’s capital ratios exceed the “well-capitalized” guidelines as defined by the Board of Governors

of the Federal Reserve System (“FRB”). As of December 31, 2007, the Tier I capital ratio was 7.72% and the total risk-based capital ratio was 10.16%. The Bancorp had senior debt ratings of “Aa3” with Moody’s, “A+” with Standard & Poor’s, “AA-” with Fitch and “AAL” with DBRS at December 31, 2007, which indicate the Bancorp’s strong capacity to meet its financial commitments. The “well-capitalized” capital ratios, along with strong credit ratings, provide the Bancorp with access to the capital markets.

The Bancorp continues to invest in the geographic areas that offer the best growth prospects through acquisitions and de novo expansion, while at the same time meeting the banking needs of our existing communities through a well-distributed banking center network. During 2007, the Bancorp opened 77 additional banking centers. In 2008, banking center expansion will be focused in high growth markets, such as Florida, Chicago, Tennessee, Georgia and North Carolina.


 

RECENT ACCOUNTING STANDARDS

 

In July 2006, the Financial Accounting Standards Board (“FASB”) issued Staff Position (“FSP”) No. FAS 13-2, “Accounting for a Change or Projected Change in the Timing of Cash Flows Relating to Income Taxes Generated by a Leveraged Lease Transaction.” This FSP was effective for fiscal years beginning after December 15, 2006. Upon adoption of this FSP on January 1, 2007, the Bancorp recognized an after-tax adjustment to beginning retained earnings of $96 million representing the cumulative effect of applying the provisions of this FSP.

In July 2006, the FASB issued Interpretation (“FIN”) No. 48, “Accounting for Uncertainty in Income Taxes – An Interpretation of FASB Statement No. 109.” This Interpretation clarifies the accounting for uncertainty in income taxes recognized in accordance with FASB Statement

No. 109, “Accounting for Income Taxes.” This Interpretation also prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This Interpretation was effective for fiscal years beginning after December 15, 2006. Upon adoption of this Interpretation on January 1, 2007, the Bancorp recognized an after-tax adjustment to beginning retained earnings of $2 million representing the cumulative effect of applying the provisions of this Interpretation.

See Note 1 of the Notes to Consolidated Financial Statements for further discussion on these standards along with a description other recently issued accounting pronouncements


 

CRITICAL ACCOUNTING POLICIES

 

Allowance for Loan and Lease Losses

The Bancorp maintains an allowance to absorb probable loan and lease losses inherent in the portfolio. The allowance is maintained at a level the Bancorp considers to be adequate and is based on ongoing quarterly assessments and evaluations of the collectibility and historical loss experience of loans and leases. Credit losses are charged and recoveries are credited to the allowance. Provisions for loan and lease losses are based on the Bancorp’s review of the historical credit loss experience and such factors that, in management’s judgment, deserve consideration under existing economic conditions in estimating probable credit losses. In determining the appropriate level of the allowance, the Bancorp estimates losses using a range derived from “base” and “conservative” estimates. The Bancorp’s strategy for credit risk management includes a combination of conservative exposure limits significantly below legal lending limits and conservative underwriting, documentation and collections standards. The strategy also emphasizes diversification on a geographic, industry and customer level, regular credit examinations and quarterly management reviews of large credit exposures and loans experiencing deterioration of credit quality.

Larger commercial loans that exhibit probable or observed credit weakness are subject to individual review. When individual loans are impaired, allowances are allocated based on management’s estimate of the borrower’s ability to repay the loan given the availability of collateral and other sources of cash flow, as well as an evaluation of legal options available to the Bancorp. The review of individual loans includes those loans that are impaired as provided in Statement of Financial Accounting Standards (“SFAS”) No. 114, “Accounting by Creditors for Impairment of a Loan.” Any allowances for impaired loans are measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate or the fair value of the underlying collateral. The Bancorp evaluates the collectibility of both

principal and interest when assessing the need for a loss accrual. Historical loss rates are applied to commercial loans which are not impaired and thus not subject to specific allowance allocations. The loss rates are derived from a migration analysis, which tracks the historical net charge-off experience sustained on loans according to their internal risk grade. The risk grading system currently utilized for allowance analysis purposes encompasses ten categories.

Homogenous loans and leases, such as consumer installment and residential mortgage, are not individually risk graded. Rather, standard credit scoring systems and delinquency monitoring are used to assess credit risks. Allowances are established for each pool of loans based on the expected net charge-offs. Loss rates are based on the average net charge-off history by loan category.

Historical loss rates for commercial and consumer loans may be adjusted for significant factors that, in management’s judgment, are necessary to reflect losses inherent in the portfolio. Factors that management considers in the analysis include the effects of the national and local economies; trends in the nature and volume of delinquencies, charge-offs and nonaccrual loans; changes in mix; credit score migration comparisons; asset quality trends; risk management and loan administration; changes in the internal lending policies and credit standards; collection practices; and examination results from bank regulatory agencies and the Bancorp’s internal credit examiners.

The Bancorp’s current methodology for determining the allowance for loan and lease losses is based on historical loss rates, current credit grades, specific allocation on impaired commercial credits and other qualitative adjustments. Allowances on individual loans and historical loss rates are reviewed quarterly and adjusted as necessary based on changing borrower and/or collateral conditions and actual collection and charge-off experience. An unallocated allowance is maintained to recognize


 

20    Fifth Third Bancorp


MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

the imprecision in estimating and measuring loss when evaluating allowances for individual loans or pools of loans.

Loans acquired by the Bancorp through a purchase business combination are evaluated for credit impairment. Reductions to the carrying value of the acquired loans as a result of credit impairment are recorded as an adjustment to goodwill. The Bancorp does not carry over the acquired company’s allowance for loan and lease losses, nor does the Bancorp add to its existing allowance for the acquired loans as part of purchase accounting.

The Bancorp’s determination of the allowance for commercial loans is sensitive to the risk grade it assigns to these loans. In the event that 10% of commercial loans in each risk category would experience a downgrade of one risk category, the allowance for commercial loans would increase by approximately $66 million at December 31, 2007. The Bancorp’s determination of the allowance for residential and retail loans is sensitive to changes in estimated loss rates. In the event that estimated loss rates would increase by 10%, the allowance for residential and consumer loans would increase by approximately $35 million at December 31, 2007. As several quantitative and qualitative factors are considered in determining the allowance for loan and lease losses, these sensitivity analyses do not necessarily reflect the nature and extent of future changes in the allowance for loan and lease losses. They are intended to provide insights into the impact of adverse changes in risk grades and estimated loss rates and do not imply any expectation of future deterioration in the risk ratings or loss rates. Given current processes employed by the Bancorp, management believes the risk grades and estimated loss rates currently assigned are appropriate.

The Bancorp’s primary market areas for lending are the Midwestern and Southeastern regions of the United States. When evaluating the adequacy of allowances, consideration is given to these regional geographic concentrations and the closely associated effect changing economic conditions have on the Bancorp’s customers.

In the current year, the Bancorp has not substantively changed any material aspect of its overall approach to determining its allowance for loan and lease losses. There have been no material changes in criteria or estimation techniques as compared to prior periods that impacted the determination of the current period allowance for loan and lease losses.

Valuation of Securities

Securities are classified as held-to-maturity, available-for-sale or trading on the date of purchase. Only those securities classified as held-to-maturity are reported at amortized cost. Available-for-sale and trading securities are reported at fair value with unrealized gains and losses included in accumulated other comprehensive income, net of related deferred income taxes, on the Consolidated Balance Sheets and noninterest income in the Consolidated Statements of Income, respectively. The fair value of a security is determined based on quoted market prices. If quoted market prices are not available, fair value is determined based on quoted prices of similar instruments. Realized securities gains or losses are reported within noninterest income in the Consolidated Statements of Income. The cost of securities sold is based on the specific identification method. Available-for-sale and held-to-maturity securities are reviewed quarterly for possible other-than-temporary impairment. The review includes an analysis of the facts and circumstances of each individual investment such as the severity of loss, the length of time the fair value has been below cost, the expectation for that security’s performance, the creditworthiness of the issuer and the Bancorp’s intent and ability to hold the security to recovery. A decline in value that is considered to be other-than-temporary is recorded as a loss within noninterest income in the Consolidated Statements of Income. At December 31, 2007, 85% of the unrealized losses in the available-for-sale securities portfolio were comprised of

securities issued by U.S. Government sponsored agencies and agency mortgage-backed securities. The Bancorp believes the price movements in these securities are dependent upon the movement in market interest rates. The Bancorp’s management also maintains the intent and ability to hold securities in an unrealized loss position to the earlier of the recovery of losses or maturity.

Reserve for Unfunded Commitments

The reserve for unfunded commitments is maintained at a level believed by management to be sufficient to absorb estimated probable losses related to unfunded credit facilities. The determination of the adequacy of the reserve is based upon an evaluation of the unfunded credit facilities, including an assessment of historical commitment utilization experience, credit risk grading and credit grade migration. Net adjustments to the reserve for unfunded commitments are included in other noninterest expense.

Income Taxes

The Bancorp estimates income tax expense based on amounts expected to be owed to the various tax jurisdictions in which the Bancorp conducts business. On a quarterly basis, management assesses the reasonableness of its effective tax rate based upon its current estimate of the amount and components of net income, tax credits and the applicable statutory tax rates expected for the full year. The estimated income tax expense is recorded in the Consolidated Statements of Income.

Deferred income tax assets and liabilities are determined using the balance sheet method and are reported in accrued taxes, interest and expenses in the Consolidated Balance Sheets. Under this method, the net deferred tax asset or liability is based on the tax effects of the differences between the book and tax basis of assets and liabilities and recognizes enacted changes in tax rates and laws. Deferred tax assets are recognized to the extent they exist and are subject to a valuation allowance based on management’s judgment that realization is more-likely-than-not.

Accrued taxes represent the net estimated amount due to taxing jurisdictions and are reported in accrued taxes, interest and expenses in the Consolidated Balance Sheets. The Bancorp evaluates and assesses the relative risks and appropriate tax treatment of transactions and filing positions after considering statutes, regulations, judicial precedent and other information and maintains tax accruals consistent with its evaluation of these relative risks and merits. Changes to the estimate of accrued taxes occur periodically due to changes in tax rates, interpretations of tax laws, the status of examinations being conducted by taxing authorities and changes to statutory, judicial and regulatory guidance that impact the relative risks of tax positions. These changes, when they occur, can affect deferred taxes and accrued taxes as well as the current period’s income tax expense and can be significant to the operating results of the Bancorp. As of January 1, 2007, the Bancorp adopted FIN 48, “Accounting for Uncertainty in Income Taxes.” Refer to Note 1 of the Notes to Consolidated Financial Statements for the impact of adopting this Interpretation. As described in greater detail in Note 15 of the Notes to Consolidated Financial Statements, the Internal Revenue Service is currently challenging the Bancorp’s tax treatment of certain leasing transactions. For additional information on income taxes, see Note 21 of the Notes to Consolidated Financial Statements.

Valuation of Servicing Rights

When the Bancorp sells loans through either securitizations or individual loan sales in accordance with its investment policies, it often obtains servicing rights. Servicing rights resulting from loan sales are initially recorded at fair value and subsequently amortized in proportion to, and over the period of, estimated net servicing income. Servicing rights are assessed for impairment monthly, based on fair value, with temporary impairment recognized


 

Fifth Third Bancorp    21


MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

through a valuation allowance and permanent impairment recognized through a write-off of the servicing asset and related valuation allowance. Key economic assumptions used in measuring any potential impairment of the servicing rights include the prepayment speeds of the underlying loans, the weighted-average life, the discount rate, the weighted-average coupon and the weighted-average default rate, as applicable. The primary risk of material changes to the value of the servicing rights resides in the potential volatility in the economic assumptions used, particularly the prepayment speeds.

The Bancorp monitors risk and adjusts its valuation allowance as necessary to adequately reserve for any probable impairment in the servicing portfolio. For purposes of measuring impairment, the servicing rights are stratified into classes based on the financial asset type and interest rates. Fees received for servicing loans owned by investors are based on a percentage of the outstanding monthly principal balance of such loans and are included in noninterest income as loan payments are received. Costs of servicing loans are charged to expense as incurred.

The change in the fair value of mortgage servicing rights (“MSRs”) at December 31, 2007, due to immediate 10% and 20% adverse changes in the current prepayment assumption would be approximately $29 million and $56 million,

respectively, and due to immediate 10% and 20% favorable changes in the current prepayment assumption would be approximately $32 million and $66 million, respectively. The change in the fair value of the MSR portfolio at December 31, 2007, due to immediate 10% and 20% adverse changes in the discount rate assumption would be approximately $22 million and $42 million, respectively, and due to immediate 10% and 20% favorable changes in the discount rate assumption would be approximately $24 million and $48 million, respectively. Sensitivity analysis related to other consumer and commercial servicing rights is not material to the Bancorp’s Consolidated Financial Statements. These sensitivities are hypothetical and should be used with caution. As the figures indicate, changes in fair value based on a 10% and 20% variation in assumptions typically cannot be extrapolated because the relationship of the change in assumptions to the change in fair value may not be linear. Also, the effect of variation in a particular assumption on the fair value of the interests that continue to be held by the transferor is calculated without changing any other assumption; in reality, changes in one factor may result in changes in another, which might magnify or counteract the sensitivities. Additionally, the effect of the Bancorp’s non-qualifying hedging strategy, which is maintained to lessen the impact of changes in value of the MSR portfolio, is excluded from the above analysis.


 

RISK FACTORS

 

Weakness in the economy and in the real estate market, including specific weakness within Fifth Third’s geographic footprint, has adversely affected Fifth Third and may continue to adversely affect Fifth Third.

If the strength of the U.S. economy in general and the strength of the local economies in which Fifth Third conducts operations declines, or continues to decline, this could result in, among other things, a deterioration in credit quality or a reduced demand for credit, including a resultant effect on Fifth Third’s loan portfolio and allowance for loan and lease losses. A significant portion of Fifth Third’s residential mortgage and commercial real estate loan portfolios are comprised of borrowers in Michigan, Northern Ohio and Florida, which markets have been particularly adversely affected by job losses, declines in real estate value, declines in home sale volumes, and declines in new home building. These factors could result in higher delinquencies and greater charge-offs in future periods, which would materially adversely affect Fifth Third’s financial condition and results of operations.

Deteriorating credit quality, particularly in real estate loans, has adversely impacted Fifth Third and may continue to adversely impact Fifth Third.

Fifth Third has experienced a downturn in credit performance, particularly in the fourth quarter of 2007, and Fifth Third expects credit conditions and the performance of its loan portfolio to continue to deteriorate in the near term. This caused Fifth Third to increase its allowance for loan and lease losses in the fourth quarter of 2007, driven primarily by higher allocations related to home equity loans and commercial real estate loans. Additional increases in the allowance for loan and lease losses may be necessary in the future. Accordingly, a decrease in the quality of Fifth Third’s credit portfolio could have a material adverse effect on earnings and results of operations.

Fifth Third’s results depend on general economic conditions within its operating markets.

The revenues of FTPS are dependent on the transaction volume generated by its merchant and financial institution customers. This transaction volume is largely dependent on consumer and corporate spending. If consumer confidence suffers and retail sales decline, FTPS will be negatively impacted. Similarly, if an economic downturn results in a

decrease in the overall volume of corporate transactions, FTPS will be negatively impacted. FTPS is also impacted by the financial stability of its merchant customers. FTPS assumes certain contingent liabilities related to the processing of Visa® and MasterCard® merchant card transactions. These liabilities typically arise from billing disputes between the merchant and the cardholder that are ultimately resolved in favor of the cardholder. These transactions are charged back to the merchant and disputed amounts are returned to the cardholder. If FTPS is unable to collect these amounts from the merchant, FTPS will bear the loss.

The fee revenue of Investment Advisors is largely dependent on the fair market value of assets under care and trading volumes in the brokerage business. General economic conditions and their effect on the securities markets tend to act in correlation. When general economic conditions deteriorate, consumer and corporate confidence in securities markets erodes, and Investment Advisors’ revenues are negatively impacted as asset values and trading volumes decrease. Neutral economic conditions can also negatively impact revenue when stagnant securities markets fail to attract investors.

Changes in interest rates could affect Fifth Third’s income and cash flows.

Fifth Third’s income and cash flows depend to a great extent on the difference between the interest rates earned on interest-earning assets such as loans and investment securities, and the interest rates paid on interest-bearing liabilities such as deposits and borrowings. These rates are highly sensitive to many factors that are beyond Fifth Third’s control, including general economic conditions and the policies of various governmental and regulatory agencies (in particular, the FRB). Changes in monetary policy, including changes in interest rates, will influence the origination of loans, the prepayment speed of loans, the purchase of investments, the generation of deposits and the rates received on loans and investment securities and paid on deposits or other sources of funding. The impact of these changes may be magnified if Fifth Third does not effectively manage the relative sensitivity of its assets and liabilities to changes in market interest rates. Fluctuations in these areas may adversely affect Fifth Third and its shareholders.


 

22    Fifth Third Bancorp


MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Fifth Third’s ability to maintain required capital levels and adequate sources of funding and liquidity.

Fifth Third is required to maintain certain capital levels in accordance with banking regulations. Fifth Third must also maintain adequate funding sources in the normal course of business to support its operations and fund outstanding liabilities. Fifth Third’s ability to maintain capital levels, sources of funding and liquidity could be impacted by changes in the capital markets in which it operates.

Each of Fifth Third’s subsidiary banks must remain well-capitalized for Fifth Third to retain its status as a financial holding company. In addition, failure by Fifth Third’s bank subsidiaries to meet applicable capital guidelines could subject the bank to a variety of enforcement remedies available to the federal regulatory authorities. These include limitations on the ability to pay dividends, the issuance by the regulatory authority of a capital directive to increase capital, and the termination of deposit insurance by the FDIC.

Changes and trends in the capital markets may affect Fifth Third’s income and cash flows.

Fifth Third enters into and maintains trading and investment positions in the capital markets on its own behalf and on behalf of its customers. These investment positions also include derivative financial instruments. The revenues and profits Fifth Third derives from its trading and investment positions are dependent on market prices. If it does not correctly anticipate market changes and trends, Fifth Third may experience investment or trading losses that may materially affect Fifth Third and its shareholders. Losses on behalf of its customers could expose Fifth Third to litigation, credit risks or loss of revenue from those customers. Additionally, substantial losses in Fifth Third’s trading and investment positions could lead to a loss with respect to those investments and may adversely affect cash flows and funding costs.

If Fifth Third does not adjust to rapid changes in the financial services industry, its financial performance may suffer.

Fifth Third’s ability to deliver strong financial performance and returns on investment to shareholders will depend in part on its ability to expand the scope of available financial services to meet the needs and demands of its customers. In addition to the challenge of competing against other banks in attracting and retaining customers for traditional banking services, Fifth Third’s competitors also include securities dealers, brokers, mortgage bankers, investment advisors, specialty finance and insurance companies who seek to offer one-stop financial services that may include services that banks have not been able or allowed to offer to their customers in the past or may not be currently able or allowed to offer. This increasingly competitive environment is primarily a result of changes in regulation, changes in technology and product delivery systems, as well as the accelerating pace of consolidation among financial service providers.

The preparation of Fifth Third’s financial statements requires the use of estimates that may vary from actual results.

The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make significant estimates that affect the financial statements. Two of Fifth Third’s most critical estimates are the level of the allowance for loan and lease losses and the valuation of mortgage servicing rights. Due to the inherent nature of these estimates, Fifth Third cannot provide absolute assurance that it will not significantly increase the allowance for loan and lease losses and/or sustain credit losses that are significantly higher than the provided allowance, nor that it will not recognize a

significant provision for impairment of its mortgage servicing rights. If Fifth Third’s allowance for loan and lease losses is not adequate, Fifth Third’s business, financial condition, including its liquidity and capital, and results of operations could be materially adversely affected. Additionally, in the future, Fifth Third may increase its allowance for loan and lease losses, which could have a material adverse effect on its capital and results of operations. For more information on the sensitivity of these estimates, please refer to the Critical Accounting Policies section.

Fifth Third regularly reviews its litigation reserves for adequacy considering its litigation risks and probability of incurring losses related to litigation. However, Fifth Third cannot be certain that its current litigation reserves will be adequate over time to cover its losses in litigation due to higher than anticipated settlement costs, prolonged litigation, adverse judgments, or other factors that are largely outside of Fifth Third’s control. If Fifth Third’s litigation reserves are not adequate, Fifth Third’s business, financial condition, including its liquidity and capital, and results of operations could be materially adversely affected. Additionally, in the future, Fifth Third may increase its litigation reserves, which could have a material adverse effect on its capital and results of operations.

Changes in accounting standards could impact Fifth Third’s reported earnings and financial condition.

The accounting standard setters, including FASB, U.S. Securities and Exchange Commission (“SEC”) and other regulatory bodies, periodically change the financial accounting and reporting standards that govern the preparation of Fifth Third’s consolidated financial statements. These changes can be hard to predict and can materially impact how Fifth Third records and reports its financial condition and results of operations. In some cases, Fifth Third could be required to apply a new or revised standard retroactively, which would result in the restatement of Fifth Third’s prior period financial statements.

Legislative or regulatory compliance, changes or actions or significant litigation, could adversely impact Fifth Third or the businesses in which Fifth Third is engaged.

Fifth Third is subject to extensive state and federal regulation, supervision and legislation that govern almost all aspects of its operations and limit the businesses in which Fifth Third may engage. These laws and regulations may change from time to time and are primarily intended for the protection of consumers, depositors and the deposit insurance funds. The impact of any changes to laws and regulations or other actions by regulatory agencies may negatively impact Fifth Third or its ability to increase the value of its business. Additionally, actions by regulatory agencies or significant litigation against Fifth Third could cause it to devote significant time and resources to defending itself and may lead to penalties that materially affect Fifth Third and its shareholders. Future changes in the laws, including tax laws, or regulations or their interpretations or enforcement may also be materially adverse to Fifth Third and its shareholders or may require Fifth Third to expend significant time and resources to comply with such requirements.

Fifth Third and/or the holders of its securities could be adversely affected by unfavorable ratings from rating agencies.

Fifth Third’s ability to access the capital markets is important to its overall funding profile. This access is affected by the ratings assigned by rating agencies to Fifth Third, certain of its affiliates and particular classes of securities they issue. The interest rates that Fifth Third pays on its securities are also influenced by, among other things, the credit ratings that it, its affiliates and/or its securities receive from recognized rating agencies. A


 

Fifth Third Bancorp    23


MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

downgrade to Fifth Third’s, or its affiliates’, credit rating could affect its ability to access the capital markets, increase its borrowing costs and negatively impact its profitability. A ratings downgrade to Fifth Third, its affiliates or their securities could also create obligations or liabilities to Fifth Third under the terms of its outstanding securities that could increase Fifth Third’s costs or otherwise have a negative effect on Fifth Third’s results of operations or financial condition. Additionally, a downgrade of the credit rating of any particular security issued by Fifth Third or its affiliates could negatively affect the ability of the holders of that security to sell the securities and the prices at which any such securities may be sold.

Fifth Third’s stock price is volatile.

Fifth Third’s stock price has been volatile in the past and several factors could cause the price to fluctuate substantially in the future. These factors include:

 

 

Actual or anticipated variations in earnings;

 

 

Changes in analysts’ recommendations or projections;

 

 

Fifth Third’s announcements of developments related to its businesses;

 

 

Operating and stock performance of other companies deemed to be peers;

 

 

Actions by government regulators;

 

 

New technology used or services offered by traditional and non-traditional competitors; and

 

 

News reports of trends, concerns and other issues related to the financial services industry.

Fifth Third’s stock price may fluctuate significantly in the future, and these fluctuations may be unrelated to Fifth Third’s performance. General market price declines or market volatility in the future could adversely affect the price of its common stock, and the current market price of such stock may not be indicative of future market prices.

Fifth Third could suffer if it fails to attract and retain skilled personnel.

As Fifth Third continues to grow, its success depends, in large part, on its ability to attract and retain key individuals. Competition for qualified candidates in the activities and markets that Fifth Third serves is great and Fifth Third may not be able to hire these candidates and retain them. If Fifth Third is not able to hire or retain these key individuals, Fifth Third may be unable to execute its business strategies and may suffer adverse consequences to its business, operations and financial condition.

If Fifth Third is unable to grow its deposits, it may be subject to paying higher funding costs.

The total amount that Fifth Third pays for funding costs is dependent, in part, on Fifth Third’s ability to grow its deposits. If Fifth Third is unable to sufficiently grow its deposits, it may be subject to paying higher funding costs. This could materially adversely affect Fifth Third’s earnings and results of operations.

Fifth Third’s ability to receive dividends from its subsidiaries accounts for most of its revenue and could affect its liquidity and ability to pay dividends.

Fifth Third Bancorp is a separate and distinct legal entity from its subsidiaries. Fifth Third Bancorp receives substantially all of its revenue from dividends from its subsidiaries. These dividends are the principal source of funds to pay dividends on Fifth Third Bancorp’s stock and interest and principal on its debt. Various federal and/or state laws and regulations limit the amount of dividends that Fifth Third’s bank and certain nonbank subsidiaries may pay. Also, Fifth Third Bancorp’s right to participate in a distribution of assets upon a subsidiary’s liquidation or reorganization is subject to the

prior claims of that subsidiary’s creditors. Limitations on Fifth Third Bancorp’s ability to receive dividends from its subsidiaries could have a material adverse effect on Fifth Third Bancorp’s liquidity and ability to pay dividends on stock or interest and principal on its debt.

Future acquisitions may dilute current shareholders’ ownership of Fifth Third and may cause Fifth Third to become more susceptible to adverse economic events.

Future business acquisitions could be material to Fifth Third and it may issue additional shares of common stock to pay for those acquisitions, which would dilute current shareholders’ ownership interests. Acquisitions also could require Fifth Third to use substantial cash or other liquid assets or to incur debt. In those events, Fifth Third could become more susceptible to economic downturns and competitive pressures.

Difficulties in combining the operations of acquired entities with Fifth Third’s own operations may prevent Fifth Third from achieving the expected benefits from its acquisitions.

Inherent uncertainties exist when integrating the operations of an acquired entity. Fifth Third may not be able to fully achieve its strategic objectives and planned operating efficiencies in an acquisition. In addition, the markets and industries in which Fifth Third and its potential acquisition targets operate are highly competitive. Fifth Third may lose customers or the customers of acquired entities as a result of an acquisition. Future acquisition and integration activities may require Fifth Third to devote substantial time and resources and as a result Fifth Third may not be able to pursue other business opportunities.

After completing an acquisition, Fifth Third may find certain items are not accounted for properly in accordance with financial accounting and reporting standards. Fifth Third may also not realize the expected benefits of the acquisition due to lower financial results pertaining to the acquired entity. For example, Fifth Third could experience higher charge offs than originally anticipated related to the acquired loan portfolio.

Material breaches in security of Fifth Third’s systems may have a significant effect on Fifth Third’s business.

Fifth Third collects, processes and stores sensitive consumer data by utilizing computer systems and telecommunications networks operated by both Fifth Third and third party service providers. Fifth Third has security, backup and recovery systems in place, as well as a business continuity plan to ensure the system will not be inoperable. Fifth Third also has security to prevent unauthorized access to the system. In addition, Fifth Third requires its third party service providers to maintain similar controls. However, Fifth Third cannot be certain that the measures will be successful. A security breach in the system and loss of confidential information such as credit card numbers and related information could result in losing the customers’ confidence and thus the loss of their business.

Fifth Third is exposed to operational and reputational risk.

Fifth Third is exposed to many types of operational risk, including reputational risk, legal and compliance risk, the risk of fraud or theft by employees, customers or outsiders, unauthorized transactions by employees or operational errors.

Negative public opinion can result from Fifth Third’s actual or alleged conduct in activities, such as lending practices, data security, corporate governance and acquisitions, and may damage Fifth Third’s reputation. Additionally, actions taken by government regulators and community organizations may also damage Fifth Third’s reputation. This negative public opinion can adversely affect Fifth Third’s ability to attract and keep customers and can expose it to litigation and regulatory action.


 

24    Fifth Third Bancorp


MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Fifth Third’s necessary dependence upon automated systems to record and process its transaction volume poses the risk that technical system flaws or employee errors, tampering or manipulation of those systems will result in losses and may be difficult to detect. Fifth Third may also be subject to disruptions of its operating systems arising from events that are beyond its control (for example, computer viruses or electrical or telecommunications outages). Fifth Third is further exposed to the risk that its third party service providers may be unable to fulfill their contractual obligations (or will be subject to the same risk of fraud or operational errors as Fifth Third). These disruptions may interfere with service to Fifth Third’s customers and result in a financial loss or liability.

If Visa is unable to consummate its initial public offering on the terms currently contemplated, Fifth Third will not receive expected proceeds from such offering.

In the third and fourth quarters of 2007, Fifth Third incurred non-cash charges of $78 million and $94 million pretax, respectively, and created a $172 million litigation reserve,

related to Fifth Third’s potential share of estimated current and future litigation settlements that may be incurred due to Fifth Third being a member of Visa. Visa has announced plans for an initial public offering and to fund litigation settlements from an escrow account to be funded by such initial public offering. If that occurs, Fifth Third expects that it will be able to reverse the litigation reserve and record any gains that Fifth Third might receive as a selling stockholder in Visa’s proposed initial public offering. Visa filed a registration statement with the SEC on November 9, 2007 to sell its common stock in an initial public offering. However, there are no assurances that Visa will be able to complete an initial public offering on the terms currently contemplated by its registration statement or at all. If the number of shares or the price per share of Visa’s offering is less than Visa currently anticipates selling or if the Visa offering is not completed, Fifth Third could be materially adversely affected and may not realize proceeds sufficient to cover the indemnity liabilities Fifth Third accrued relating to Visa in 2007 in respect of third-party litigation.


 

STATEMENTS OF INCOME ANALYSIS

 

Net Interest Income

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

Net interest income (FTE) increased five percent, or $134 million, to $3.0 billion as a result of an increase in the net interest margin of 30 bp to 3.36%. The net interest margin improved as a result of the fourth quarter 2006 balance sheet actions which reduced the size of the Bancorp’s available-for-sale securities portfolio to a size that was more consistent with its liquidity, collateral and interest rate risk management requirements; improved the composition of the balance sheet with a lower concentration of fixed-rate assets;

lowered wholesale borrowings to reduce leverage; and better positioned the Bancorp for an uncertain economic and interest rate environment. Specifically, these actions included (i) the sale of $11.3 billion in available-for-sale securities with a weighted-average yield of 4.30%; (ii) reinvestment of approximately $2.8 billion in available-for-sale securities that were more efficient when used as collateral; (iii) repayment of $8.5 billion in wholesale borrowings at an average rate paid of 5.30%; and (iv) the termination of approximately $1.1 billion of repurchase and reverse repurchase agreements. The sale of investment securities and the corresponding repayment of wholesale funding added approximately 35 bp to the 2007 net interest margin.

The benefits of these balance sheet actions were partially offset by the 12% decline in the Bancorp’s free funding position in 2007. The decline primarily resulted from the increase in the average balance of other assets as well as the use of $1.1 billion to repurchase approximately 27 million shares during 2007. The average balance of other assets increased due to a $386 million deposit made with the Internal Revenue Service relating to leveraged lease litigation and increases in partnership investments. Refer to Note 15 of the Notes to Consolidated Financial Statements for further discussion about the Bancorp’s leveraged lease litigation.


 

TABLE 3: CONDENSED CONSOLIDATED STATEMENTS OF INCOME

        

For the years ended December 31 ($ in millions, except per share data)

   2007    2006    2005    2004    2003

Interest income (FTE)

   $6,051    5,981    5,026    4,150    4,030

Interest expense

   3,018    3,082    2,030    1,102    1,086

Net interest income (FTE)

   3,033    2,899    2,996    3,048    2,944

Provision for loan and lease losses

   628    343    330    268    399

Net interest income after provision for loan and lease losses (FTE)

   2,405    2,556    2,666    2,780    2,545

Noninterest income

   2,467    2,012    2,374    2,355    2,398

Noninterest expense

   3,311    2,915    2,801    2,863    2,466

Income from continuing operations before income taxes, minority interest and cumulative effect (FTE)

   1,561    1,653    2,239    2,273    2,477

Fully taxable equivalent adjustment

   24    26    31    36    39

Applicable income taxes

   461    443    659    712    786

Income from continuing operations before minority interest and cumulative effect

   1,076    1,184    1,549    1,525    1,652

Minority interest, net of tax

   -    -    -    -    (20)

Income from continuing operations before cumulative effect

   1,076    1,184    1,549    1,525    1,632

Income from discontinued operations, net of tax

   -    -    -    -    44

Income before cumulative effect

   1,076    1,184    1,549    1,525    1,676

Cumulative effect of change in accounting principle, net of tax

   -    4    -    -    (11)

Net income

   $1,076    1,188    1,549    1,525    1,665

Earnings per share, basic

   $2.00    2.14    2.79    2.72    2.91

Earnings per share, diluted

   1.99    2.13    2.77    2.68    2.87

Cash dividends declared per common share

   1.70    1.58    1.46    1.31    1.13

 

 

Fifth Third Bancorp    25


MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

 

TABLE 4: CONSOLIDATED AVERAGE BALANCE SHEETS AND ANALYSIS OF NET INTEREST INCOME (FTE)

 

 

For the years ended December 31

   2007    

2006

   

2005

 

($ in millions)

   Average
Balance
  

Revenue/

Cost

   Average
Yield/Rate
    Average
Balance
   Revenue/
Cost
   Average
Yield/Rate
   

Average

Balance

  

Revenue/

Cost

   Average
Yield/Rate
 

Assets

                        

Interest-earning assets:

                        

Loans and leases (a):

                        

Commercial loans

   $22,351    $1,639    7.33 %   $20,504    $1,479    7.21 %   $18,310    $1,063    5.81 %

Commercial mortgage

   11,078    801    7.23     9,797    700    7.15     8,923    551    6.17  

Commercial construction

   5,661    421    7.44     6,015    460    7.64     5,525    342    6.19  

Commercial leases

   3,683    158    4.29     3,730    185    4.97     3,495    179    5.11  

Subtotal - commercial

   42,773    3,019    7.06     40,046    2,824    7.05     36,253    2,135    5.89  

Residential mortgage

   10,489    642    6.13     9,574    568    5.94     8,982    495    5.51  

Home equity

   11,887    897    7.54     12,070    900    7.45     11,228    683    6.08  

Automobile loans

   10,704    675    6.30     9,570    552    5.77     8,649    455    5.26  

Credit card

   1,276    132    10.39     838    99    11.84     728    81    11.13  

Other consumer loans and leases

   1,219    65    5.29     1,395    68    4.87     1,897    81    4.27  

Subtotal - consumer

   35,575    2,411    6.78     33,447    2,187    6.54     31,484    1,795    5.70  

Total loans and leases

   78,348    5,430    6.93     73,493    5,011    6.82     67,737    3,930    5.80  

Securities:

                        

Taxable

   11,131    566    5.08     20,306    904    4.45     24,017    1,032    4.30  

Exempt from income taxes (a)

   499    36    7.29     604    45    7.38     789    58    7.39  

Other short-term investments

   364    19    5.33     378    21    5.52     193    6    2.89  

Total interest-earning assets

   90,342    6,051    6.70     94,781    5,981    6.31     92,736    5,026    5.42  

Cash and due from banks

   2,315         2,495         2,758      

Other assets

   10,613         8,713         8,102      

Allowance for loan and lease losses

   (793)               (751)               (720)            

Total assets

   $102,477               $105,238               $102,876            

Liabilities and Shareholders’ Equity

                        

Interest-bearing liabilities:

                        

Interest-bearing core deposits:

                        

Interest checking

   $14,820    $318    2.14 %   $16,650    $398    2.39 %   $18,884    $314    1.66 %

Savings

   14,836    456    3.07     12,189    363    2.98     10,007    176    1.76  

Money market

   6,308    269    4.26     6,366    261    4.10     5,170    140    2.71  

Foreign office deposits

   1,762    73    4.15     732    29    3.93     248    6    2.59  

Other time deposits

   10,778    495    4.59     10,500    433    4.12     8,491    263    3.09  

Total interest-bearing core deposits

   48,504    1,611    3.32     46,437    1,484    3.20     42,800    899    2.10  

Certificates - $100,000 and over

   6,466    328    5.07     5,795    278    4.80     4,001    129    3.22  

Other foreign office deposits

   1,393    68    4.91     2,979    148    4.97     3,719    120    3.21  

Federal funds purchased

   3,646    184    5.04     4,148    208    5.02     4,225    138    3.26  

Short-term bank notes

   -    -    -     -    -    -     248    6    2.60  

Other short-term borrowings

   3,244    140    4.32     4,522    194    4.28     5,038    138    2.74  

Long-term debt

   12,505    687    5.50     14,247    770    5.40     16,384    600    3.66  

Total interest-bearing liabilities

   75,758    3,018    3.98     78,128    3,082    3.94     76,415    2,030    2.66  

Demand deposits

   13,261         13,741         13,868      

Other liabilities

   3,875               3,558               3,276            

Total liabilities

   92,894         95,427         93,559      

Shareholders’ equity

   9,583               9,811               9,317            

Total liabilities and shareholders’ equity

   $102,477               $105,238               $102,876            

Net interest income

      $3,033         $2,899         $2,996   

Net interest margin

         3.36 %         3.06 %         3.23 %

Net interest rate spread

         2.72           2.37           2.76  

Interest-bearing liabilities to interest-earning assets

             83.86               82.43               82.40  

(a)

The fully taxable-equivalent adjustments included in the above table are $24 million, $26 million and $31 million for the years ended December 31, 2007, 2006 and 2005, respectively.

Average loans and leases increased seven percent, or $4.9 billion. The growth in average loans and leases in 2007 outpaced core deposit growth by $3.3 billion. This funding shortfall was more than offset by a $9.3 billion reduction in the average securities portfolio.

Average consumer loan and lease yields increased 24 bp, with growth driven by automobile loan and other consumer loan and lease yields. The interest rate on automobile loans increased 53 bp from 5.77% in 2006 to 6.30% in 2007. The increase in yield was due to increased pricing across the industry and a shift in the automobile portfolio to a higher percentage of used automobiles. The increase of 42 bp in the other consumer loan and lease yields was caused by the continued run-off of the consumer lease portfolio.

Interest expense on wholesale funding decreased 12%, or $191 million, to $1.4 billion due to a 14% decline in average balances. This decrease was the result of reductions in average balances of other foreign office deposits and long-term debt.

The cost of interest-bearing core deposits increased 12 bp to 3.32%, up from 3.20% in 2006. During 2007, the Bancorp continued to adjust its consumer deposit rates. The Bancorp’s strategy in adjusting rates is to move away from promotional rates towards highly competitive daily rates. This strategy resulted in an increased cost of interest-bearing core deposits as account balances migrate from interest checking to higher yielding accounts, such as savings and time deposits. During 2007, interest checking accounts comprised 31% of interest-bearing core deposits compared to 36% during 2006. During the third quarter of 2007, the Bancorp reclassified certain foreign office deposits as transaction deposits. The interest rates paid on these accounts are comparable to other commercial deposit accounts. Refer to the Deposits section for more information on this reclassification.


 

26    Fifth Third Bancorp


MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

 

TABLE 5: CHANGES IN NET INTEREST INCOME (FTE) ATTRIBUTED TO VOLUME AND YIELD/RATE (a)

For the years ended December 31

     2007 Compared to 2006      2006 Compared to 2005

($ in millions)

     Volume      Yield/Rate      Total      Volume      Yield/Rate      Total

Assets

                             

Increase (decrease) in interest income:

                             

Loans and leases:

                             

Commercial loans

     $135      25      160      136      280      416

Commercial mortgage

     93      8      101      57      92      149

Commercial construction

     (27)      (12)      (39)      32      86      118

Commercial leases

     (2)      (25)      (27)      11      (5)      6

Subtotal - commercial

     199      (4)      195      236      453      689

Residential mortgage

     56      18      74      34      39      73

Home equity

     (14)      11      (3)      54      163      217

Automobile loans

     69      54      123      51      46      97

Credit card

     46      (13)      33      13      5      18

Other consumer loans and leases

     (9)      6      (3)      (23)      10      (13)

Subtotal - consumer

     148      76      224      129      263      392

Total loans and leases

     347      72      419      365      716      1,081

Securities:

                             

Taxable

     (452)      114      (338)      (164)      36      (128)

Exempt from income taxes

     (8)      (1)      (9)      (13)      -      (13)

Other short-term investments

     (1)      (1)      (2)      8      7      15

Total interest-earning assets

     (114)      184      70      196      759      955

Cash and due from banks

                             

Other assets

                             

Allowance for loan and lease losses

                             

Total change in interest income

     (114)      184      70      196      759      955

Liabilities and Shareholders’ Equity

                             

Increase (decrease) in interest expense:

                             

Interest-bearing core deposits:

                             

Interest checking

     (41)      (39)      (80)      (41)      125      84

Savings

     81      12      93      45      142      187

Money market

     (2)      10      8      38      83      121

Foreign office deposits

     43      1      44      18      5      23

Other time deposits

     12      50      62      71      99      170

Total interest-bearing core deposits

     93      34      127      131      454      585

Certificates - $100,000 and over

     34      16      50      71      78      149

Other foreign office deposits

     (78)      (2)      (80)      (27)      55      28

Federal funds purchased

     (25)      1      (24)      (3)      73      70

Short-term bank notes

     -      -      -      (6)      -      (6)

Other short-term borrowings

     (55)      1      (54)      (15)      71      56

Long-term debt

     (97)      14      (83)      (86)      256      170

Total interest-bearing liabilities

     (128)      64      (64)      65      987      1,052

Demand deposits

                             

Other liabilities

                                         

Total change in interest expense

     (128)      64      (64)      65      987      1,052

Shareholders’ equity

                                         

Total liabilities and shareholders’ equity

                             

Total change in net interest income

     $14      120      134      131      (228)      (97)

 

(a)

Changes in interest not solely due to volume or yield/rate are allocated in proportion to the absolute amount of change in volume or yield/rate.

 

Interest income (FTE) from investment securities and short-term investments decreased $349 million to $621 million in 2007 compared to 2006 while the average yield on taxable securities increased 63 bp to 5.08% primarily due to the balance sheet actions in the fourth quarter of 2006.

Table 4 presents the components of net interest income, net interest margin and net interest spread for 2007, 2006 and 2005. Nonaccrual loans and leases and loans held for sale have been included in the average loan and lease balances. Average outstanding securities balances are based on amortized cost with any unrealized gains or losses on available-for-sale securities included in other assets. Table 5 provides the relative impact of changes in the balance sheet and changes in interest rates on net interest income.

Provision for Loan and Lease Losses

The Bancorp provides as an expense an amount for probable loan and lease losses within the loan portfolio that is based on factors previously discussed in the Critical Accounting Policies section. The provision is recorded to bring the allowance for loan and lease losses to a level deemed appropriate by the Bancorp. Actual credit losses on loans and leases are charged against the allowance for loan and lease losses. The amount of

loans actually removed from the Consolidated Balance Sheets is referred to as charge-offs. Net charge-offs include current period charge-offs less recoveries on previously charged-off loans and leases.

The provision for loan and lease losses increased to $628 million in 2007 compared to $343 million in 2006. The $285 million increase from the prior year is related to an increase in delinquencies, increases in the severity of loss due to real estate price deterioration in some the Bancorp’s key lending markets, the increase in automobile loans and credit card balances and a modest decline in economic conditions. As of December 31, 2007, the allowance for loan and lease losses as a percent of loans and leases increased to 1.17% from 1.04% at December 31, 2006.

Refer to the Credit Risk Management section for more detailed information on the provision for loan and lease losses including an analysis of loan portfolio composition, non-performing assets, net charge-offs, and other factors considered by the Bancorp in assessing the credit quality of the loan portfolio and the allowance for loan and lease losses.


 

    Fifth Third Bancorp    27


MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

 

TABLE 6: NONINTEREST INCOME

                        

For the years ended December 31 ($ in millions)

   2007    2006    2005    2004    2003

Electronic payment processing revenue

   $826    717    622    521    509

Service charges on deposits

   579    517    522    515    485

Investment advisory revenue

   382    367    358    363    335

Corporate banking revenue

   367    318    299    228    241

Mortgage banking net revenue

   133    155    174    178    302

Other noninterest income

   153    299    360    587    442

Securities gains (losses), net

   21    (364)    39    (37)    81

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

   6    3    -    -    3

Total noninterest income

   $2,467    2,012    2,374    2,355    2,398

 

Noninterest Income

Total noninterest income increased 23% compared to 2006 primarily due to the $415 million impact of the balance sheet actions in the fourth quarter of 2006 partially offset by a $177 million charge, taken in the fourth quarter of 2007, to reflect the decline in the cash surrender value of one of the BOLI policies. See Note 11 of the Notes to Consolidated Financial Statements for further information on the Bancorp’s BOLI

policies. Excluding the impact of these charges, noninterest income increased nine percent over 2006. The components of noninterest income are shown in Table 6.

Electronic payment processing revenue increased $109 million, or 15%, in 2007 as FTPS realized growth in each of its three product lines. The components of electronic payment processing revenue are shown in Table 7.


 

 

TABLE 7: COMPONENTS OF ELECTRONIC PAYMENT PROCESSING REVENUE

        

For the years ended December 31 ($ in millions)

   2007    2006    2005

Merchant processing revenue

   $308    255    224

Financial institutions revenue

   305    279    242

Card issuer interchange

   213    183    156

Electronic payment processing revenue

   $826    717    622

 

Merchant processing revenue increased $53 million, or 21%, due to the continued addition of new national merchant customers and resulting increases in merchant sales volumes. During 2007, the Bancorp signed large national merchant contracts with Walgreen Co., which converted during the year, and the U.S. Department of Treasury, a majority of which has been converted. These contracts contributed 37% of the revenue growth in merchant processing revenue during 2007. Financial institutions revenue increased $26 million, or 10%, as a result of continued success in attracting financial institution customers and increased debit card volumes associated with these customers. Card issuer interchange increased $30 million, or 16%, due to continued growth in debit and credit card volumes, of 11% and 29%, respectively, stemming from success in the Bancorp’s initiative in expanding its card customer base. Growth in card issuer interchange revenue was slightly mitigated by the cost of bankcard cash rewards. The Bancorp continues to see significant opportunities in attracting new financial institution customers and retailers. During 2007, the Bancorp processed over 26.7 billion transactions and handled electronic processing for over 2,500 financial institutions and over 155,000 merchant locations worldwide.

Service charges on deposits increased 12% compared to 2006. The increase was primarily driven by consumer deposit service charges, which increased 18% in 2007. The number of net new consumer checking accounts increased 49% during 2007 compared to 2006. Growth in the number of customer deposit account relationships and deposit generation continues to be a primary focus of the Bancorp.

Commercial deposit revenues increased five percent compared to the prior year. Commercial deposit revenues are offset by earnings credits on compensating balances. Net earnings credits were $64 million and $63 million for the years ended December 31, 2007 and 2006, respectively. Commercial customers receive earnings credits to offset the fees charged for banking services on their deposit accounts such as account maintenance, lockbox, ACH transactions, wire transfers and other ancillary corporate treasury management services. Earnings credits are based on the customer’s average

balance in qualifying deposits multiplied by the crediting rate. Qualifying deposits include demand deposits and interest-bearing checking accounts. The Bancorp has a standard crediting rate that is adjusted as necessary based on competitive market conditions and changes in short-term interest rates. Earnings credits cannot be given in excess of the fees charged for banking services provided, and the excess earnings credits may not be carried forward to future periods. Earnings credits are netted against gross service charges to arrive at commercial deposit revenue.

Investment advisory revenues increased four percent in 2007 compared to 2006 primarily due to success in cross-sell initiatives within the private banking group and improved retail brokerage performance. Private banking revenues increased $9 million, or seven percent, while institutional revenue and securities and brokerage revenue increased four percent and three percent, respectively, compared to 2006. These increases were partially offset by a slight decline in mutual fund fees. The Bancorp continues to focus its sales efforts on improving execution in retail brokerage and retail mutual funds and on growing the institutional money management business by improving penetration and cross-sell in its large middle-market commercial customer base. The Bancorp is one of the largest money managers in the Midwest and, as of December 31, 2007, had approximately $223.2 billion in assets under care, $33.4 billion in assets under management and $13.4 billion in its proprietary Fifth Third Funds.*

Corporate banking revenue increased $49 million, or 15%, in 2007 compared to 2006. The Bancorp has placed an increased focus on broadening its suite of commercial products and has seen a positive return on its investment. The growth in corporate banking revenue was largely attributable to increased institutional sales revenue, derivative product revenues, asset securitization and syndication fees, as well as increased letter of credit fees. The Bancorp is committed to providing a comprehensive range of financial services to large and middle-market businesses and continues to further seek opportunities to expand its product offerings.

Mortgage banking net revenue decreased to $133 million in


*FIFTH THIRD FUNDS® PERFORMANCE DISCLOSURE

Fifth Third Funds investments are: NOT INSURED BY THE FDIC or any other government agency, are not deposits or obligations of, or guaranteed by, any bank, the distributor or of the Funds any of their respective affiliates, and involve investment risks, including the possible loss of the principal amount invested. An investor should consider the fund’s investment objectives, risks and charges and expenses carefully before investing or sending money. The Funds’ prospectus contains this and other important information about the Funds. To obtain a prospectus or any other information about Fifth Third Funds, please call 1-800-282-5706 or visit www.53.com. Please read the prospectus carefully before investing. Fifth Third Funds are distributed by ALPS Distributors, Inc., member NASD, d/b/a FTAM Funds Distributor, Inc. ALPS Distributors, Inc. and FTAM Funds Distributor, Inc. are affiliated firms through direct ownership, although ALPS Distributors, Inc. and FTAM Funds Distributor, Inc. are not affiliates of Fifth Third Bank. Fifth Third Asset Management, Inc. serves as Investment Adviser to Fifth Third Funds and receives a fee for its services.

 

28    Fifth Third Bancorp


MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

2007 from $155 million in 2006. The components of mortgage banking net revenue are shown in Table 8. Residential mortgage originations in 2007 were $11.9 billion compared to $9.4 billion in 2006. Despite the increase in originations, gains on loan sales decreased $13 million as a result of lower margins on sales of mortgages affected by widening credit spreads in the residential mortgage market during 2007.

 

 

TABLE 8: COMPONENTS OF MORTGAGE BANKING NET REVENUE

For the years ended December 31

($ in millions)

   2007    2006    2005

Origination fees and gains on loan sales

   $79    92    128

Servicing revenue:

        

Servicing fees

   145    121    109

Servicing rights amortization

   (92)    (68)    (73)

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

   1    10    10

Net servicing revenue

   54    63    46

Mortgage banking net revenue

   $133    155    174

Mortgage net servicing revenue decreased $9 million compared to 2006. Net servicing revenue is comprised of gross servicing fees and related amortization as well as valuation adjustments on mortgage servicing rights and mark-to-market adjustments on both settled and outstanding free-standing derivative financial instruments. Servicing fees increased compared to 2006 as a result of growth in the Bancorp’s portfolio of residential mortgage loans serviced. The Bancorp’s total residential mortgage loans serviced at December 31, 2007 and 2006 were $45.9 billion and $38.6 billion, respectively, with $34.5 billion and $28.7 billion, respectively, of residential mortgage loans serviced for others. Servicing rights amortization increased over the prior year due to an increase in MSRs and decreased weighted-average life assumptions.

Temporary impairment on the MSR portfolio was $22 million in 2007 compared to a recovery in temporary impairment of $19 million in 2006. Servicing rights are deemed temporarily impaired when a borrower’s loan rate is distinctly higher than prevailing rates. Temporary impairment on servicing rights is reversed when the prevailing rates return to a level commensurate with the borrower’s loan rate. Further detail on the valuation of mortgage servicing rights can be found in Note 9 of the Notes to Consolidated Financial Statements. The Bancorp maintains a non-qualifying hedging strategy to manage a portion of the risk associated with the impact of changes in interest rates on the MSR portfolio. The Bancorp recognized a net gain of $23 million and a net loss of $9 million in 2007 and 2006, respectively, related to changes in fair value and settlement of free-standing derivatives purchased to economically hedge the MSR portfolio. See Note 10 of the Notes to Consolidated Financial Statements for more information on the free-standing derivatives used to hedge the MSR portfolio. In addition to the derivative positions used to economically hedge the MSR portfolio, the Bancorp acquires various securities (primarily principal-only strips) as a component of its non-qualifying hedging strategy. A gain of $6 million and $3 million was recognized in 2007 and 2006, respectively, related to the sale of securities used to economically hedge the MSR portfolio.

Other noninterest income declined 48% compared to the prior year. The major components of other noninterest income for each of the last three years are shown in Table 9. The decrease was primarily attributable to the previously mentioned $177 million charge taken in the fourth quarter of 2007 to lower the cash surrender value of one of the Bancorp’s BOLI policies. Exclusive of this charge, BOLI income totaled $71 million, a decrease of 16% compared to 2006 due to a lower crediting rate. Other noninterest income for the year ended 2007 included $23 million in gains on the sale of $144

million non-strategic credit card accounts recorded in the gain on loan sales caption. Additionally, during 2007 the Bancorp recognized a $15 million gain from the sale of FDIC deposit insurance credits, which were one-time assessment credits that the Bancorp was allocated in the FDIC Reform Act of 2005, offset by a $22 million loss due to the termination of cash flow hedges originally hedging $1.0 billion of auto loans classified as held for sale, both of which were recorded in the ‘Other’ line item in Table 9. Other noninterest income for the year ended 2006 included a $17 million loss in mark-to-market on free-standing derivatives related to the balance sheet actions taken in the fourth quarter, captured in the ‘Other’ line item in Table 9.

 

TABLE 9: COMPONENTS OF OTHER NONINTEREST INCOME

For the years ended December 31

($ in millions)

   2007    2006    2005

Bank owned life insurance

   $(106)    86    91

Cardholder fees

   56    49    46

Consumer loan and lease fees

   46    47    50

Insurance income

   32    28    27

Operating lease income

   32    26    55

Banking center fees

   29    22    21

Gain on loan sales

   25    17    24

Other

   39    24    46

Total other noninterest income

   $153    299    360

The Bancorp recognized net securities gains of $21 million in 2007 compared to net securities losses of $364 million in 2006. Securities losses in 2006 primarily consisted of losses resulting from balance sheet actions taken during the fourth quarter of 2006, partially offset by a $78 million gain from the sale of MasterCard, Inc. shares.

Noninterest Expense

The Bancorp continued to focus on expense control during 2007. The Bancorp expects that cost savings initiatives will continue to be somewhat mitigated by investments in certain high opportunity markets as well as continued volume-based expense growth in payments processing and an expected increase in FDIC insurance in 2008 due to the full utilization of FDIC insurance credits expected to occur in the first half of 2008.

During 2007, the Bancorp continued its investment in the expansion of its retail distribution network and information technology infrastructure. The efficiency ratio (noninterest expense divided by the sum of net interest income (FTE) and noninterest income) was 60.2% and 59.4% for 2007 and 2006, respectively. Noninterest expense for the year ended 2007 was impacted by a $78 million charge to record a liability for the Bancorp’s indemnification of Visa for the Visa/American Express litigation settlement that occurred in the third quarter of 2007 along with a fourth quarter accrual of $94 million for additional outstanding Visa litigation settlements. See Note 15 of the Notes to Consolidated Financial Statements for additional discussion on this litigation. Additionally, the efficiency ratio was impacted by the previously mentioned $177 million charge to noninterest income to lower the cash surrender value of one of the Bancorp’s BOLI policies. Excluding these charges, the efficiency ratio for 2007 was 55.3% (comparison being provided to supplement an understanding of fundamental trends).

Total noninterest expense increased 14% in 2007 compared to 2006. This comparison is impacted by the previously mentioned Visa litigation accrual in 2007 and a $49 million charge related to the termination of debt and other financing agreements in 2006. Exclusive of these charges, total noninterest expense increased $267 million, or 10%, over 2006 primarily due to increases in volume-related payment processing expenses, investments in information technology infrastructure and higher de novo related expenses.


 

Fifth Third Bancorp    29


MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

TABLE 10: NONINTEREST EXPENSE

             

For the years ended December 31 ($ in millions)

   2007     2006    2005    2004    2003

Salaries, wages and incentives

   $1,239     1,174    1,133    1,018    1,031

Employee benefits

   278     292    283    261    240

Net occupancy expense

   269     245    221    185    159

Payment processing expense

   244     184    145    114    116

Technology and communications

   169     141    142    120    106

Equipment expense

   123     116    105    84    82

Other noninterest expense

   989     763    772    1,081    733

Total noninterest expense

   $3,311     2,915    2,801    2,863    2,467

Efficiency ratio

   60.2 %   59.4    52.1    53.0    46.2

Total personnel cost (salaries, wages and incentives plus employee benefits) increased three percent in 2007 compared to 2006, due to higher revenue-based incentives and an increase in the number of employees. As of December 31, 2007, the Bancorp employed 22,678 employees, of which 6,349 were officers and 2,755 were part-time employees. Full time equivalent employees totaled 21,683 as of December 31, 2007 compared to 21,362 as of December 31, 2006.

Net occupancy expense increased 10% in 2007 over 2006 due to the addition of 46 banking centers, excluding 31 new banking centers added as a result of the Crown acquisition. The Bancorp remains focused on expanding its retail franchise through de novo growth with plans to open approximately 50 new banking centers in 2008, in addition to 57 new banking centers as a result of the pending acquisition with First Charter.

Payment processing expense includes third-party processing expenses, card management fees and other bankcard processing expenses. Payment processing expense increased 32% compared to last year due to increased processing volumes of 27% and 10% in the merchant and financial institutions businesses, respectively. Additionally, the increase in this caption reflects the conversion of national merchant contracts during the year.

The major components of other noninterest expense for each of the last three years are shown in Table 11. Other noninterest expense increased 30% in 2007 compared to 2006 primarily due to the previously mentioned Visa litigation settlement charges of $172 million, higher loan processing costs associated with collections activities, and volume-related increases in affordable housing investments expense. Other noninterest expense also included $13 million in provision for unfunded commitments, recorded in the ‘Other’ line item in

Table 11, an $11 million increase over the prior year. Marketing expense increased compared to the prior year as a result of the Bancorp’s new branding, expansion into newer markets and increased advertising as a result of the Crown acquisition.

 

TABLE 11: COMPONENTS OF OTHER NONINTEREST EXPENSE

For the years ended December 31

($ in millions)

   2007    2006    2005

Loan processing

   $119    93    89

Marketing

   84    78    76

Affordable housing investments

   57    42    35

Travel

   54    52    54

Postal and courier

   52    49    50

Intangible asset amortization

   42    45    46

Professional services fees

   35    28    26

Supplies

   31    28    35

Franchise and other taxes

   23    30    37

Operating lease

   22    18    40

Visa litigation accrual

   172    -    -

Debt termination

   -    49    -

Other

   298    251    284

Total other noninterest expense

   $989    763    772

Applicable Income Taxes

The Bancorp’s income from continuing operations before income taxes, applicable income tax expense and effective tax rate for each of the periods indicated are shown in Table 12. Applicable income tax expense for all periods includes the benefit from tax-exempt income, tax-advantaged investments and general business tax credits, partially offset by the effect of nondeductible expenses. The increase in the effective tax rate in 2007 was a result of an after-tax BOLI charge of $177 million on a lower pretax income base. See Note 11 and Note 21 of the Notes to Consolidated Financial Statements for further information.


 

TABLE 12: APPLICABLE INCOME TAXES

             

For the years ended December 31 ($ in millions)

   2007     2006    2005    2004    2003

Income from continuing operations before income taxes, minority interest and cumulative effect

   $1,537     1,627    2,208    2,237    2,438

Applicable income taxes

   461     443    659    712    786

Effective tax rate

   30.0 %   27.2    29.9    31.8    32.3

Comparison of 2006 with 2005

Net income for the year ended 2006 was $1.2 billion or $2.13 per diluted share, a 23% decrease compared to $1.5 billion and $2.77 per diluted share in 2005. The decrease in net income was primarily a result of the impact of the balance sheet actions announced and completed during the fourth quarter of 2006, which resulted in a pretax loss of $454 million. Specifically, these balance sheet actions included:

 

 

Sale of $11.3 billion in available-for-sale securities with a weighted-average yield of 4.30%;

 

 

Reinvestment of approximately $2.8 billion in available-for-sale securities that are more efficient when used as collateral for pledging purposes;

 

 

Repayment of $8.5 billion in wholesale borrowings at a weighted-average rate paid of 5.30%; and

 

 

Termination of approximately $1.1 billion of repurchase and reverse repurchase agreements.

 

These actions were taken to improve the asset/liability profile of the Bancorp and reduce the size of the Bancorp’s available-for-sale securities portfolio to a size that was more consistent with its liquidity, collateral and interest rate risk management requirements; improve the composition of the balance sheet with a lower concentration in fixed-rate assets; lower wholesale borrowings to reduce leverage; and better position the Bancorp for an uncertain economic and interest rate environment. The pretax losses consisted of:

 

 

$398 million in losses on the sale of securities;

 

 

$17 million in losses on derivatives to hedge the price of the securities sold, recorded in other noninterest income; and

 

 

$39 million in charges related to the termination of certain repurchase and reverse repurchase financing agreements, recorded in other noninterest expense.


 

30    Fifth Third Bancorp


MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Net interest income (FTE) decreased three percent compared to 2005. Net interest margin decreased to 3.06% in 2006 from 3.23% in 2005 largely due to rising short-term interest rates, the impact of the primarily fixed-rate securities portfolio and mix shifts within the core deposit base from demand deposit and interest checking categories to savings, money market and other time deposit categories paying higher rates of interest.

Noninterest income decreased 15% in 2006 compared to 2005 primarily due to the losses on the sale of securities and related derivative losses from the balance sheet actions taken in the fourth quarter of 2006 totaling $415 million. Excluding these losses, noninterest income increased $54 million, or two percent, in 2006 compared to 2005 due to continued strong growth in electronic payment processing and corporate

banking revenue offset by a $19 million decline in mortgage banking revenue.

Noninterest expense increased four percent in 2006 compared to 2005 primarily due to increases in employee incentives, volume-related payment processing expenditures, equipment expenditures and occupancy expense related to the addition of de novo banking centers, and $39 million in charges related to the termination of certain repurchase and reverse repurchase agreements. Excluding the $39 million in charges, noninterest expense increased by three percent.

In 2006, net charge-offs as a percent of average loans and leases were 44 bp compared to 45 bp in 2005. At December 31, 2006, nonperforming assets as a percent of loans and leases increased to .61% from .52% at December 31, 2005.


 

BUSINESS SEGMENT REVIEW

 

The Bancorp reports on five business segments: Commercial Banking, Branch Banking, Consumer Lending, Investment Advisors and Processing Solutions. Further detailed financial information on each business segment is included in Note 27 of the Notes to Consolidated Financial Statements.

Results of the Bancorp’s business segments are presented based on its management structure and management accounting practices. The structure and accounting practices are specific to the Bancorp; therefore, the financial results of the Bancorp’s business segments are not necessarily comparable with similar information for other financial institutions. The Bancorp refines its methodologies from time to time as management accounting practices are improved and businesses change. During 2007, the Bancorp changed the reporting of Processing Solutions to include certain revenues and expenses related to credit card processing that were previously listed under the Commercial and Branch Banking segments. Revisions to the Bancorp’s methodologies are applied on a retroactive basis.

 

TABLE 13: BUSINESS SEGMENT NET INCOME

For the years ended December 31 ($ in millions)

   2007    2006    2005

Income Statement Data

        

Commercial Banking

   $702    693    600

Branch Banking

   621    562    515

Consumer Lending

   130    179    203

Investment Advisors

   100    91    72

Processing Solutions

   153    138    123

General Corporate and Other

   (630)    (475)    36

Net income

   $1,076    1,188    1,549

The Bancorp manages interest rate risk centrally at the corporate level by employing a funds transfer pricing (“FTP”) methodology. This methodology insulates the business segments from interest rate volatility, enabling them to focus on serving customers through loan originations and deposit taking. The FTP system assigns charge rates and credit rates to classes of assets and liabilities, respectively, based on expected duration and the Treasury swap curve. Matching duration, or the expected average term until an instrument can be repriced, allocates interest income and interest expense to each segment so its resulting net interest income is insulated from interest rate risk. In a rising rate environment, the Bancorp benefits from the widening spread between deposit costs and wholesale funding costs. However, the Bancorp’s FTP system credits this benefit to deposit-providing businesses, such as Branch Banking and Investment Advisors, on a duration-adjusted basis. The net impact of the FTP methodology is captured in General Corporate and Other.

Management made several changes to the FTP methodology in 2007 to more appropriately calculate FTP charges and credits to each of the Bancorp’s business segments. Changes to the FTP methodology were applied retroactively and included adding a liquidity premium to loans, deposits and certificates of deposit to properly reflect

the Bancorp’s marginal cost of longer term funding. In addition, an FTP charge on fixed assets based on the average 5 year Treasury curve was added to the new FTP methodology.

The business segments are charged provision expense based on the actual net charge-offs experienced by the loans owned by each segment. Provision expense attributable to loan growth and change in factors in the allowance for loan and lease losses are captured in General Corporate and Other. The financial results of the business segments include allocations for shared services and headquarters expenses. Even with these allocations, the financial results are not necessarily indicative of the business segments’ financial condition and results of operations as if they were to exist as independent entities. Additionally, the business segments form synergies by taking advantage of cross-sell opportunities and when funding operations by accessing the capital markets as a collective unit. Net income by business segment is summarized in Table 13.

Commercial Banking

Commercial Banking offers banking, cash management and financial services to large and middle-market businesses, government and professional customers. In addition to the traditional lending and depository offerings, Commercial Banking products and services include, among others, foreign exchange and international trade finance, derivatives and capital markets services, asset-based lending, real estate finance, public finance, commercial leasing and syndicated finance. Table 14 contains selected financial data for the Commercial Banking segment.

Comparison of 2007 with 2006

Net income increased $9 million, or one percent, compared to 2006 as a result of continued success in the sale of corporate banking services, offset by a higher provision for loan and lease losses and growth in noninterest expense.

Net interest income was modestly lower in comparison to 2006 due to a 32 bp decline in the spread between loan yields and the related FTP charge. Average loans and leases increased nine percent over 2006, to $35.7 billion, with growth concentrated in C&I loans and commercial mortgage loans. The increase in commercial mortgage loans can be attributed to loans acquired from Crown in November 2007 and to the conversion of construction loans to permanent financing throughout 2007. Average core deposits increased modestly to $15.9 billion in 2007 compared to 2006 as the decrease in savings and money market balances were more than offset by the growth in foreign office deposits. Foreign office deposits represent commercial customers Eurodollar sweeps that pay rates comparable to money market deposits. Net charge-offs as a percent of average loans increased from 31 bp in 2006 to 36 bp in 2007 as the segment experienced a $15 million fraud related charge-off in its Chicago affiliate and an increase in charge-offs of commercial mortgage loans in parts of


 

Fifth Third Bancorp    31


MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

its footprint, specifically eastern Michigan and northeastern Ohio.

Noninterest income increased $82 million, or 17%, compared to 2006 largely due to an increase in corporate banking revenue of $49 million, or 17%. Increases in corporate banking revenue occurred in all subcaptions as a result of a build-out of its commercial product offerings by the Commercial Banking segment. During 2007, the segment introduced new treasury management products and remains focused on further penetration of middle-market customers and the healthcare industry throughout its affiliates. Other noninterest income grew by 62% compared to the prior year, as operating lease income grew from $18 million to $31 million on higher volumes.

Noninterest expense increased $66 million, or nine percent, in 2007 compared to 2006 primarily due to higher sales related incentives expense and a volume-related increase in affordable housing investments expense.

Comparison of 2006 with 2005

Net income increased $93 million, or 16%, compared to 2005 largely as a result of loan and deposit growth and success in the sale of corporate banking services. Average loans and leases increased 12% over 2005, to $32.7 billion, with growth occurring across all loan categories. Average core deposits increased to $15.8 billion in 2006 from $14.4 billion in 2005. The moderate decrease in average demand deposits from the prior year was primarily due to lower relative compensating balance requirements that was more than offset by increases in interest checking and savings and money market deposits. The increase in average loans and leases and core deposits led to a $140 million increase in net interest income compared to the prior year.

Noninterest income increased $18 million, or four percent, compared to 2005 largely due to an increase in corporate banking revenue of $16 million, or six percent. Noninterest expense increased $30 million, or four percent, in 2006 compared to 2005 primarily due to volume-related increases in loan, payment processing, operating lease and data processing expenses.

Branch Banking

Branch Banking provides a full range of deposit and loan and lease products to individuals and small businesses through 1,227 full-service banking centers. Branch Banking offers

depository and loan products, such as checking and savings accounts, home equity loans and lines of credit, credit cards and loans for automobile and other personal financing needs, as well as products designed to meet the specific needs of small businesses, including cash management services. Table 15 contains selected financial data for the Branch Banking segment.

Comparison of 2007 with 2006

Net income increased $59 million, or 10%, compared to 2006 as the segment benefited from increased interest rates through the majority of the year and increased service charges on deposits. Net interest income increased $165 million as increases in total deposits were partially offset by a deposit mix shift toward higher paying deposit account types. Average core deposits increased three percent, to $39.9 billion, compared to 2006. Interest checking accounts decreased $1.9 billion, or 18% while savings and money market deposits increased $2.9 billion, or 24%, compared to 2006. Average loans and leases increased two percent to $17.0 billion, led by growth in credit card balances of 56%.

The provision for loan and lease losses increased $54 million over 2006 due to the deteriorating credit environment involving home equity loans, particularly in Michigan and Florida. Net charge-offs as a percent of average loans and leases increased significantly from 64 bp to 95 bp, with much of the increase occurring in the fourth quarter of 2007. The Bancorp experienced growth in charge-offs on home equity lines and loans with high loan-to-value (“LTV”) ratios, reflecting borrower stress and lower home prices.

Noninterest income increased nine percent from 2006. Service charges on deposits grew 15% compared to the prior year due to growth in consumer deposit fees driven by new account openings and higher levels of customer activity. Electronic payment processing revenue increased nine percent as card issuer interchange on debit cards grew $14 million, or 10%.

Noninterest expense increased eight percent compared to 2006. Net occupancy and equipment expenses increased 13% compared to 2006 as a result of the continued opening of new banking centers. The Bancorp built 66 de novo locations during 2007 and increased total banking centers by 77. The Bancorp will continue to position itself for sustained long-term growth through new banking center additions in key growth markets within its footprint.


 

TABLE 14: COMMERCIAL BANKING

For the years ended December 31

($ in millions)

   2007    2006    2005

Income Statement Data

        

Net interest income (FTE) (a)

   $1,310    1,317    1,177

Provision for loan and lease losses

   127    99    90

Noninterest income:

        

Corporate banking revenue

   341    292    276

Service charges on deposits

   154    146    149

Other noninterest income

   63    38    33

Noninterest expense:

        

Salaries, incentives and benefits

   264    244    247

Other noninterest expenses

   529    483    450

Income before taxes

   948    967    848

Applicable income taxes (a)

   246    274    248

Net income

   $702    693    600

Average Balance Sheet Data

        

Commercial loans

   $35,662    32,707    29,184

Demand deposits

   5,927    6,296    6,347

Interest checking

   4,098    3,862    3,129

Savings and money market

   4,331    5,049    4,738

Certificates $100,000 and over & other time

   1,838    1,755    1,113

Foreign office deposits

   1,483    515    194

 

 

Includes taxable-equivalent adjustments of $14 million for 2007, $13 million for 2006 and 2005.

 

TABLE 15: BRANCH BANKING

For the years ended December 31

($ in millions)

   2007    2006    2005

Income Statement Data

        

Net interest income

   $1,465    1,300    1,210

Provision for loan and lease losses

   162    108    97

Noninterest income:

        

Service charges on deposits

   421    365    368

Electronic payment processing

   174    159    143

Investment advisory revenue

   90    87    86

Other noninterest income

   94    100    91

Noninterest expense:

        

Salaries, incentives and benefits

   483    457    466

Net occupancy and equipment expenses

   173    153    138

Other noninterest expenses

   467    425    401

Income before taxes

   959    868    796

Applicable income taxes

   338    306    281

Net income

   $621    562    515

Average Balance Sheet Data

        

Consumer loans

   $11,838    11,461    10,775

Commercial loans

   5,173    5,296    5,278

Demand deposits

   5,757    5,840    5,977

Interest checking

   8,692    10,578    13,489

Savings and money market

   14,748    11,886    9,265

Certificates $100,000 and over & other time

   13,729    13,031    10,189

 

32    Fifth Third Bancorp    


MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Comparison of 2006 with 2005

Net income increased $47 million, or nine percent, compared to 2005. Net interest income increased $90 million as increases in average loans and leases and total deposits were partially offset by a deposit mix shift toward higher paying deposit account types. Average loans and leases increased four percent to $16.8 billion, led by growth in credit card balances of 21%. Branch Banking realized a shift to higher-rate deposit products throughout 2006. Interest checking and demand deposits decreased $3.0 billion, or 22%, and savings, money market and other time deposits increased $3.8 billion, or 21%, compared to 2005.

Noninterest income increased three percent from 2005 as growth in electronic payment processing revenue of $12 million was offset by $3 million decreases in both service charges on deposits and mortgage banking net revenue. Noninterest expense increased by three percent compared to 2005 as costs were contained despite the effect from the Bancorp’s continued de novo banking center growth strategy, which led to a 11% increase in net occupancy and equipment expense.

Consumer Lending

Consumer Lending includes the Bancorp’s mortgage, home equity, automobile and other indirect lending activities. Mortgage and home equity lending activities include the origination, retention and servicing of mortgage and home equity loans or lines of credit, sales and securitizations of those loans or pools of loans or lines of credit and all associated hedging activities. Other indirect lending activities include loans to consumers through mortgage brokers, automobile dealers and federal and private student education loans. Table 16 contains selected financial data for the Consumer Lending segment.

Comparison of 2007 with 2006

Net income decreased $49 million, or 28%, compared to 2006 despite increased originations, due to an increase in provision for loan and lease losses and decreased gain on sale margins. Net interest income was relatively flat compared to the prior year. Average residential mortgage loans increased seven percent compared to 2006 due to increased mortgage originations and loans acquired from Crown. Net charge-offs increased to 73 bp in 2007, an increase from 47 bp in 2006, due to greater severity of loss on residential mortgages and automobile loans related to declining real estate prices and a market surplus of used automobiles, respectively. The segment is focusing on managing credit risk through the restructuring of certain residential mortgage loans and careful consideration of underwriting and collection standards.

Noninterest income decreased 14% compared to 2006 due to a decline in mortgage banking net revenue. The Bancorp’s mortgage originations were $11.4 billion and $9.4 in 2007 and

2006, respectively. Despite the increase in originations, gain on sale margins decreased due to widening credit spreads in the residential mortgage market, resulting in a decrease in mortgage banking net revenue of $26 million, or 18%.

Comparison of 2006 with 2005

Net income decreased $24 million, or 12%, compared to 2005. Net interest income decreased $15 million, or four percent, despite average loans and leases increasing six percent, due to an 81 bp decline in the spread between loan yields and the related FTP charge as a result of the increasingly competitive environment in which this segment competes.

The Bancorp’s mortgage originations were $9.4 billion and $9.9 billion in 2006 and 2005, respectively. As a result of the decrease in originations and the corresponding decrease in gains on sales of mortgages, mortgage banking net revenue decreased $17 million, or 10%. Decreases in other noninterest income and expense were largely a result of the planned run off of the consumer operating lease portfolios. Operating lease income and expense decreased from 2005 by $39 million and $29 million, respectively.

Investment Advisors

Investment Advisors provides a full range of investment alternatives for individuals, companies and not-for-profit organizations. The Bancorp’s primary services include investments, trust, asset management, retirement plans and custody. Fifth Third Securities, Inc., an indirect wholly-owned subsidiary of the Bancorp, offers full service retail brokerage services to individual clients and broker dealer services to the institutional marketplace. Fifth Third Asset Management, Inc., an indirect wholly-owned subsidiary of the Bancorp, provides asset management services and also advises the Bancorp’s proprietary family of mutual funds. Table 17 contains selected financial data for the Investment Advisors segment.

Comparison of 2007 with 2006

Net income increased $9 million, or 10%, compared to 2006 on increases in investment advisory revenue of 5%. Net interest income increased 11% to $154 million on a five percent increase in average loans and leases and a seven percent increase in core deposits. Overall, noninterest income increased six percent from 2006. Fifth Third Private Bank, the Bancorp’s wealth management group, increased revenues by six percent on execution of cross-sell initiatives. Brokerage income also increased seven percent compared to 2006 as the overall equity markets performed well for much of 2007 and the segment increased the number of registered representatives. The segment realized only modest gains in institutional services income. Noninterest expenses remain contained, increasing four percent compared to 2006.


 

TABLE 16: CONSUMER LENDING

For the years ended December 31

($ in millions)

   2007    2006    2005

Income Statement Data

        

Net interest income

   $404    409    424

Provision for loan and lease losses

   148    94    89

Noninterest income:

        

Mortgage banking net revenue

   122    148    165

Other noninterest income

   75    81    124

Noninterest expense:

        

Salaries, incentives and benefits

   84    98    89

Other noninterest expenses

   169    169    222

Income before taxes

   200    277    313

Applicable income taxes

   70    98    110

Net income

   $130    179    203

Average Balance Sheet Data

        

Residential mortgage loans

   $10,156    9,523    8,957

Home equity

   1,335    1,311    1,173

Automobile loans

   9,711    8,560    7,584

Consumer leases

   917    1,328    1,822

 

TABLE 17: INVESTMENT ADVISORS

For the years ended December 31

($ in millions)

   2007    2006    2005

Income Statement Data

        

Net interest income

   $154    139    122

Provision for loan and lease losses

   13    4    4

Noninterest income:

        

Investment advisory revenue

   386    367    360

Other noninterest income

   22    19    17

Noninterest expense:

        

Salaries, incentives and benefits

   167    172    169

Other noninterest expenses

   228    209    214

Income before taxes

   154    140    112

Applicable income taxes

   54    49    40

Net income

   $100    91    72

Average Balance Sheet Data

        

Loans and leases

   $3,207    3,068    2,684

Core deposits

   4,978    4,673    4,027

 

Fifth Third Bancorp    33


MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Comparison of 2006 with 2005

Net income increased $19 million, or 26%, compared to 2005 as a result of an increase in net interest income and modest growth in investment advisory revenue. Net interest income increased 14%, to $139 million as the segment benefited from the liquidity premium placed on deposit accounts as previously discussed.

Noninterest income increased three percent from 2005 as the $7 million increase in Private Bank revenues was mitigated by a decrease in mutual fund revenue of $3 million. The decrease in mutual fund revenue was primarily the result of the deployment of an open architecture on proprietary fund sales. Noninterest expenses decreased modestly compared to the prior year due to the focus on expense control.

Processing Solutions

Fifth Third Processing Solutions provides electronic funds transfer, debit, credit and merchant transaction processing, operates the Jeanie® ATM network and provides other data processing services to affiliated and unaffiliated customers. Table 18 contains selected financial data for the Processing Solutions segment.

Comparison of 2007 with 2006

Net income increased $15 million, or 11%, versus the prior year as electronic payment processing revenues (the sum of merchant processing, financial institutions processing and card issuer interchange revenues) continued to produce double-digit increases. Merchant processing increased $55 million, or 21%, due to the addition and conversion of large national clients throughout the year. Card issuer interchange revenues increased primarily due to new customer additions and the resulting higher card sales volumes from the success in the Bancorp’s initiative to increase credit card penetration of its customer base. The Bancorp continues to see significant opportunities to attract new financial institution customers and retailers within this business segment.

The strong increase in noninterest income was mitigated by a 19% increase in noninterest expense due to network charges resulting from increased transaction volume in addition to expenses related to the conversion of large national merchant contracts. Expenses are expected to moderate in future periods to be more consistent with revenue growth while reflecting spread pressure relating to the renewal of current customer contracts.

 

TABLE 18: PROCESSING SOLUTIONS

For the years ended December 31

($ in millions)

   2007    2006    2005

Income Statement Data

        

Net interest income

   $(6)    (3)    (9)

Provision for loan and lease losses

   11    9    18

Noninterest income:

        

Merchant processing

   314    259    224

Financial institutions processing

   319    290    250

Card issuer interchange

   66    52    43

Other noninterest income

   43    34    41

Noninterest expense:

        

Salaries, incentives and benefits

   75    70    53

Payment processing expense

   237    169    127

Other noninterest expenses

   176    171    162

Income before taxes

   237    213    189

Applicable income taxes

   84    75    66

Net income

   $153    138    123

 

Comparison of 2006 with 2005

Net income increased $15 million, or 12%, versus the prior year as a result of increases in electronic payment processing fees mitigated by increases in personnel costs and payment processing expenses. Compared to 2006, merchant processing revenues and financial institution revenue increased 16%, while card issuer interchange earned on credit cards transactions increased 20%.

Noninterest expense increased 20% primarily due to headcount additions, investment in information technology and transaction processing costs. Salaries, incentives and benefits increased 33% with the addition of over 300 employees.

General Corporate and Other

General Corporate and Other includes the unallocated portion of the investment securities portfolio, securities gains/losses, certain non-core deposit funding, unassigned equity, provision expense in excess of net charge-offs and certain support activities and other items not attributed to the business segments.

Comparison of 2007 with 2006

The results of General Corporate and Other were primarily impacted by the increase in provision expense compared to the prior year. Provision expense over charge-offs increased by approximately $139 million compared to 2006 as the allowance for loan and lease losses as a percentage of loan and leases increased from 1.04% as of December 31, 2006 to 1.17% as of December 31, 2007. The increase is attributable to a number of factors including an increase in delinquencies, increases in the severity of loss due to real estate price deterioration in some the Bancorp’s key lending markets, the increase in automobile loans and credit card balances and a modest decline in economic conditions.

Comparison of 2006 with 2005

The results of General Corporate and Other were primarily impacted by the balance sheet actions in the fourth quarter of 2006 and the related loss on the sale of securities. General Corporate and Other was also impacted by wholesale funding repricing at a faster rate than securities as a result of rising short-term rates in the first half of 2006. The Bancorp experienced an increase in the average interest rate on wholesale funding from 3.36% in 2005 to 5.02% in 2006 compared to an increase in the average interest rate on securities from 4.36% in 2005 to 4.56% in 2006.


 

34    Fifth Third Bancorp


MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

FOURTH QUARTER REVIEW

 

The Bancorp’s 2007 fourth quarter net income was $16 million, or $.03 per diluted share, compared to $325 million, or $.61 per diluted share, in the third quarter of 2007 and $66 million, or $.12 per diluted share, for the fourth quarter of 2006. Return on average assets and return on average equity for the fourth quarter of 2007 were .06% and .7%, respectively, compared to 1.26% and 13.8% in the third quarter of 2007 and .25% and 2.6% in 2006’s fourth quarter. Fourth quarter 2007 earnings and ratios were negatively impacted by a charge of $177 million to lower the current cash surrender value of one of the Bancorp’s BOLI policies, a charge of $94 million related to Visa members’ indemnification of future litigation settlements, as well as $8 million in acquisition-related costs. The BOLI charge reflected an additional $22 million recorded subsequent to the Bancorp’s issuance of fourth quarter of 2007 earnings. In the fourth quarter of 2006, earnings and ratios were negatively impacted by $454 million in total pretax losses and charges related to balance sheet actions taken to improve the asset/liability profile of the Bancorp.

Fourth quarter 2007 net interest income (FTE) of $785 million increased $25 million, or three percent, from the third quarter of 2007 and $41 million, or six percent, from the same period a year ago. Sequential growth in net interest income was primarily driven by a five percent increase in earning assets and lower funding costs, both in core deposits and wholesale borrowings, resulting from lower market interest rates. These positive effects were partially offset by lower loan yields related to lower market interest rates, the reversal of previously recognized interest on higher nonperforming assets, and the impact of the issuance of trust preferred securities during the third and fourth quarters. Increases in net interest income compared to the fourth quarter of 2006 were primarily a result of the balance sheet actions in the prior year, mitigated by the issuance of $2.2 billion in trust preferred securities throughout 2007. The net interest margin was 3.29%, a 5 bp decrease from the third quarter of 2007 and a 13 bp increase over the fourth quarter of 2006.

Noninterest income of $509 million decreased by $172 million compared to the third quarter of 2007 and increased $328 million compared to the fourth quarter of 2006. Fourth quarter 2007 results include a $177 million charge to reduce the cash surrender value of one of the Bancorp’s BOLI policies and $22 million related to the termination of cash flow hedges on automobile loans held for sale. Third quarter results included a gain of $15 million on the sale of FDIC deposit insurance credits. Fourth quarter of 2006 results include $415 million in losses on securities and derivatives related to the Bancorp’s fourth quarter of 2006 balance sheet actions. Excluding those charges, sequential noninterest income growth was $42 million, or six percent, and year-over-year noninterest income growth was $112 million, or 19%, with strong growth in service charges on deposits, corporate banking and electronic payment processing revenue.

Electronic payment processing revenue of $223 million increased five percent sequentially and 15% compared with last year. Compared with a year ago, growth was driven by continued strong merchant processing results and strong growth in card issuer interchange driven by higher card usage and an increase in credit card accounts stemming from success in the Bancorp’s initiative to increase customer credit card penetration.

Service charges on deposits of $160 million increased six percent from the third quarter of 2007 and 30% versus the same quarter last year. Retail service charges increased three percent from the third quarter, driven by higher levels of customer activity and modest growth in transaction accounts. Retail service charges grew 41% compared with the fourth quarter of 2006, driven by higher levels of customer activity and comparisons to the unusual weakness experienced in the same quarter last year. Commercial service charges increased

10% sequentially and 19% compared with last year, primarily due to lower earnings credits on commercial deposit accounts and fee growth associated with new product and service offerings.

Investment advisory revenue of $94 million decreased one percent sequentially and increased four percent over fourth quarter of 2006. Private banking revenue increased two percent sequentially, largely due to higher insurance revenue, and nine percent from the same quarter last year on continued strong results particularly in wealth planning and trust. Brokerage fee revenue declined seven percent sequentially, reflecting the volatility in equity markets in the fourth quarter of 2007, and was flat compared with a year ago as the effect of adverse market conditions offset growth in the number of licensed brokers.

Corporate banking revenue of $106 million increased 17% sequentially and 29% over the fourth of 2006, reflecting the build out of the Bancorp’s corporate banking capabilities. The Bancorp realized growth both sequentially and year-over-year in all sub captions of corporate banking revenue.

Mortgage banking net revenue totaled $26 million in the fourth and third quarter of 2007 and $30 million in the fourth quarter of 2006. Mortgage originations of $2.7 billion decreased from $3.0 billion in the third quarter of 2007 and increased from $2.3 billion in the fourth quarter of 2006. Gains on loan sales of $18 million increased from $9 million in the third quarter and decreased from $23 million in fourth quarter of 2006. Improvement in the liquidity of the residential mortgage market during the fourth quarter of 2007 drove the higher gains on loan sales compared with the third quarter. Net servicing revenue, before MSR valuation adjustments, of $14 million in the fourth quarter was consistent with the third quarter of 2007 and increased $2 million over the fourth quarter of 2006.

Noninterest expense of $940 million increased 10% from third quarter of 2007 and increased 24% from the fourth quarter of 2006. Comparisons reflect expenses accrued related to future Visa litigation settlements of $94 million in the fourth quarter of 2007 and $78 million related to the Visa/American Express settlement in the third quarter of 2007. Exclusive of the Visa accruals and a $39 million charge associated with the termination of financing agreements in the fourth quarter of 2006, noninterest expense increased nine percent compared to the third quarter of 2006 and 17% compared to the same quarter last year. Both sequential and year-over-year increases were driven by volume-based increases in payment processing expense, higher de novo related occupancy expense and increased provision expense for unfunded loan commitments.

Net charge-offs as a percentage of average loans and leases were 89 bp, or $174 million, in the fourth quarter, compared with 60 bp, or $115 million, last quarter and 52 bp, or $97 million, in the fourth quarter of 2006. The increase was the result of commercial and consumer real estate loans concentrated in Michigan, northern Ohio and Florida. Comparisons were also affected by a $15 million fraud-related commercial loan charge-off in the fourth quarter of 2007.

Average loan and lease balances grew five percent sequentially and nine percent from the fourth quarter last year. Crown contributed approximately one percent of the sequential and year-over-year growth, primarily in commercial and residential mortgage loans. The Bancorp continued to grow credit card balances, increasing seven percent over the sequential quarter and 60% over the fourth quarter of 2006. Average core deposits were up three percent compared to the third quarter of 2007 and the fourth quarter of 2006. Crown contributed approximately one percent of the sequential and year-over-year growth. The Bancorp continued to generate overall deposit growth while realizing a mix shift from interest checking to savings accounts.


 

Fifth Third Bancorp    35


MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

BALANCE SHEET ANALYSIS

Loans and Leases

Total loans and leases increased 12% compared to December 31, 2006. Table 19 presents the Bancorp’s total commercial and consumer loan and lease portfolio classified by the primary purpose of the loan.

Total commercial loans and leases increased $6.1 billion, or 15%, compared to the prior year. Excluding loans acquired from Crown, commercial loans and leases increased approximately $5.6 billion, or 14%, reflecting growth in commercial and industrial loans throughout the Bancorp’s footprint. Commercial mortgage growth was primarily a result of the Crown acquisition. Growth in commercial mortgage and the decrease in commercial construction is also attributed to the conversion of construction loans to permanent financing.

Total consumer loans and leases increased $3.0 billion, or nine percent, compared to December 31, 2006 as a result of the Crown acquisition, growth in the automobile loan portfolio and increased promotion of credit cards. Excluding Crown, total consumer loans and leases increased approximately $1.5 billion, or four percent. Residential mortgage loans increased $1.5 billion, or 15%, compared to 2006, primarily from the Crown acquisition. Excluding Crown, residential mortgage loans increased approximately $260 million, or three percent, compared to the prior year. Residential mortgage originations totaled $11.9 billion in 2007 compared to $9.4 billion in 2006. Automobile loans increased $1.2 billion, or 12%, compared to 2006. The growth in automobile loans was attributed to an increase in the number of dealers in the Bancorp’s indirect automobile lending network from 8,700 in 2006 to 9,300 in 2007. A key focus for the Bancorp in 2007 was increasing its penetration of credit cards within in its retail footprint through marketing campaigns targeted to specific borrowers. Credit card balances increased 58%, to $1.6 billion, with growth primarily a result of a 26% increase in the number of accounts. The Bancorp will continue to focus on growing credit card balances throughout 2008.

Average commercial loans and leases increased $2.7 billion, or seven percent, compared to December 31, 2006,

with growth in commercial loans and commercial mortgage loans. The Bancorp experienced double-digit growth in more than a third of its affiliates, including 11% in the Florida affiliates, 29% in Lexington and 26% in Tennessee.

Average consumer loans and leases increased $2.1 billion, or six percent, compared to 2006. The growth in average consumer loans and leases was a result of strong growth in residential mortgage, automobile and credit card balances mitigated by a decline in home equity loans and consumer automobile leases. The Bancorp experienced its largest growth in the Chicago affiliate, an increase of $254 million, or nine percent. Additionally, the Bancorp saw growth of 11% in the Florida affiliates and 30% in Tennessee offset by a decline of nine percent in the Western Ohio affiliate.

Investment Securities

The Bancorp uses investment securities as a means of managing interest rate risk, providing liquidity support and providing collateral for pledging purposes. As of December 31, 2007, total investment securities were $11.2 billion compared to $11.6 billion at December 31, 2006. Securities are classified as available-for-sale when, in management’s judgment, they may be sold in response to, or in anticipation of, changes in market conditions. The Bancorp’s management has evaluated the securities in an unrealized loss position in the available-for-sale portfolio and maintains the intent and ability to hold these securities to the earlier of the recovery of the losses or maturity.

Net unrealized losses on the available-for-sale securities portfolio were $144 million at December 31, 2007 compared to $183 million at December 31, 2006. At December 31, 2007, 85% of the unrealized losses in the available-for-sale securities portfolio were comprised of agency mortgage-backed securities and securities issued by U.S. Government sponsored agencies. The Bancorp’s management believes the price movements in these securities were primarily the result of movement in market interest rates.


 

TABLE 19: COMPONENTS OF TOTAL LOANS AND LEASES (INCLUDING HELD FOR SALE)

As of December 31 ($ in millions)

   2007    2006    2005    2004    2003

Commercial:

              

Commercial loans

   $ 26,079    20,831    19,377    16,107    14,261

Commercial mortgage

     11,967    10,405    9,188    7,636    6,894

Commercial construction

     5,561    6,168    6,342    4,348    3,301

Commercial leases

     3,737    3,841    3,698    3,426    3,264

Total commercial loans and leases

     47,344    41,245    38,605    31,517    27,720

Consumer:

              

Residential mortgage loans

     11,433    9,905    8,991    7,912    5,865

Home equity

     11,874    12,154    11,805    10,318    8,783

Automobile loans

     11,183    10,028    9,396    7,734    8,606

Credit card

     1,591    1,004    788    794    727

Other consumer loans and leases

     1,157    1,167    1,644    2,092    2,488

Total consumer loans and leases

     37,238    34,258    32,624    28,850    26,469

Total loans and leases

   $ 84,582    75,503    71,229    60,367    54,189

TABLE 20: COMPONENTS OF AVERAGE TOTAL LOANS AND LEASES

As of December 31 ($ in millions)

   2007    2006    2005    2004    2003

Commercial:

              

Commercial loans

   $ 22,351    20,504    18,310    14,955    13,705

Commercial mortgage

     11,078    9,797    8,923    7,391    3,097

Commercial construction

     5,661    6,015    5,525    3,807    6,299

Commercial leases

     3,683    3,730    3,495    3,296    3,037

Total commercial loans and leases (including held for sale)

     42,773    40,046    36,253    29,449    26,138

Consumer:

              

Residential mortgage loans

     10,489    9,574    8,982    6,801    6,880

Home equity

     11,887    12,070    11,228    9,584    8,796

Automobile loans

     10,704    9,570    8,649    8,128    7,403

Credit card

     1,276    838    728    740    559

Other consumer loans and leases

     1,219    1,395    1,897    2,340    2,638

Total consumer loans and leases (including held for sale)

     35,575    33,447    31,484    27,593    26,276

Total loans and leases (including held for sale)

   $ 78,348    73,493    67,737    57,042    52,414

Total portfolio loans and leases (excluding held for sale)

   $ 76,033    72,447    66,685    55,951    49,700

 

36    Fifth Third Bancorp


MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

TABLE 21: COMPONENTS OF INVESTMENT SECURITIES (AMORTIZED COST BASIS)

As of December 31 ($ in millions)

   2007    2006    2005    2004    2003

Available-for-sale and other:

              

U.S. Treasury and Government agencies

   $3    1,396    506    503    838

U.S. Government sponsored agencies

   160    100    2,034    2,036    3,877

Obligations of states and political subdivisions

   490    603    657    823    922

Agency mortgage-backed securities

   8,738    7,999    16,127    17,571    21,101

Other bonds, notes and debentures

   385    172    2,119    2,862    1,401

Other securities

   1,045    966    1,090    1,006    937

Total available-for-sale and other securities

   $10,821    11,236    22,533    24,801    29,076

Held-to-maturity:

              

Obligations of states and political subdivisions

   $351    345    378    245    126

Other bonds, notes and debentures

   4    11    11    10    9

Total held-to-maturity

   $355    356    389    255    135

At December 31, 2007, the Bancorp’s investment portfolio primarily consisted of AAA rated agency mortgage-backed securities and the Bancorp does not hold CDOs or asset-backed securities backed by subprime loans. The balance of securities below investment grade was immaterial as of December 31, 2007.

Available-for-sale securities, on an amortized cost basis, decreased $415 million since December 31, 2006. At December 31, 2007, available-for-sale securities decreased to 11% of interest-earning assets, compared to 13% at December 31, 2006. The estimated weighted-average life of the debt securities in the available-for-sale portfolio was 6.8 years at December 31, 2007 compared to 4.3 years at December 31, 2006. At December 31, 2007, the fixed-rate securities within the available-for-sale securities portfolio had

a weighted-average yield of 5.31% compared to 5.13% at December 31, 2006. The increased yield from the prior year was a result of the balance sheet actions taken in the fourth quarter of 2006, which included the sale of $11.3 billion in available-for-sale securities with a weighted-average yield of 4.30%.

Information presented in Table 22 is on a weighted-average life basis, anticipating future prepayments. Yield information is presented on an FTE basis and is computed using historical cost balances. Maturity and yield calculations for the total available-for-sale portfolio exclude equity securities that have no stated yield or maturity. Further information on securities held by the Bancorp can be found in Note 3 of the Notes to Consolidated Financial Statements.


 

TABLE 22: CHARACTERISTICS OF AVAILABLE-FOR-SALE AND OTHER SECURITIES

As of December 31, 2007 ($ in millions)

   Amortized Cost    Fair Value    Weighted-Average
Life (in years)
   Weighted-Average
Yield
 

U.S. Treasury and Government agencies:

           

Average life of one year or less

   $-    $-    -    - %

Average life 1 – 5 years

   -    -    -    -  

Average life 5 – 10 years

   -    -    -    -  

Average life greater than 10 years

   3    3    12.7    5.89  

Total

   3    3    12.0    6.04  

U.S. Government sponsored agencies:

           

Average life of one year or less

   -    -    -    -  

Average life 1 – 5 years

   160    160    2.2    4.44  

Average life 5 – 10 years

   -    -    -    -  

Average life greater than 10 years

   -    -    -    -  

Total

   160    160    2.2    4.44  

Obligations of states and political subdivisions (a):

           

Average life of one year or less

   246    248    .4    7.31  

Average life 1 – 5 years

   187    191    2.2    7.04 (b)

Average life 5 – 10 years

   21    21    6.9    7.98 (b)

Average life greater than 10 years

   36    36    10.7    3.92 (b)

Total

   490    496    2.1    7.20  

Agency mortgage-backed securities:

           

Average life of one year or less

   2    2    .6    7.04  

Average life 1 – 5 years

   1,879    1,868    3.6    4.97  

Average life 5 – 10 years

   6,577    6,462    7.7    5.23  

Average life greater than 10 years

   280    277    10.4    5.45  

Total

   8,738    8,609    6.9    5.18  

Other bonds, notes and debentures (c):

           

Average life of one year or less

   93    92    .1    5.88  

Average life 1 – 5 years

   110    108    3.7    5.54  

Average life 5 – 10 years

   29    29    5.2    5.59  

Average life greater than 10 years

   153    147    28.3    7.45  

Total

   385    376    12.7    6.38  

Other securities (d)

   1,045    1,033      

Total available-for-sale and other securities

   $10,821    $10,677    6.83    5.31 %

(a)

Taxable-equivalent yield adjustments included in the above table are 2.41%, 2.31%, 2.63%, 1.29% and 2.37% for securities with an average life of one year or less, 1-5 years, 5-10 years, greater than 10 years and in total, respectively.

(b)

Weighted-average yield excludes $3 million, $15 million and $35 million of securities with an average life of 1-5 years, 5-10 years and greater than 10 years, respectively, related to qualified zone academy bonds whose yields are realized through income tax credits. The weighted-average effective yield of these instruments is 6.81%.

(c)

Other bonds, notes, and debentures consist of commercial paper, non-agency mortgage backed securities, certain other asset backed securities (primarily automobile and commercial loan backed securities) and corporate bond securities.

(d)

Other securities consist of Federal Home Loan Bank (“FHLB”) and Federal Reserve Bank restricted stock holdings that are carried at cost, Federal Home Loan Mortgage Corporation (“FHLMC”) preferred stock holdings, certain mutual fund holdings and equity security holdings.

 

Fifth Third Bancorp    37


MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

TABLE 23: DEPOSITS

As of December 31 ($ in millions)

   2007    2006    2005    2004    2003

Demand

   $ 14,404    14,331    14,609    13,486    12,142

Interest checking

     15,254    15,993    18,282    19,481    19,757

Savings

     15,635    13,181    11,276    8,310    7,375

Money market

     6,521    6,584    6,129    4,321    3,201

Foreign office

     2,572    1,353    421    153    16

Transaction deposits

     54,386    51,442    50,717    45,751    42,491

Other time

     11,440    10,987    9,313    6,837    6,201

Core deposits

     65,826    62,429    60,030    52,588    48,692

Certificates - $100,000 and over

     6,738    6,628    4,343    2,121    1,856

Other foreign office

     2,881    323    3,061    3,517    6,547

Total deposits

   $ 75,445    69,380    67,434    58,226    57,095

TABLE 24: AVERAGE DEPOSITS

As of December 31 ($ in millions)

   2007    2006    2005    2004    2003

Demand

   $ 13,261    13,741    13,868    12,327    10,482

Interest checking

     14,820    16,650    18,884    19,434    18,679

Savings

     14,836    12,189    10,007    7,941    8,020

Money market

     6,308    6,366    5,170    3,473    3,189

Foreign office

     1,762    732    248    85    2

Transaction deposits

     50,987    49,678    48,177    43,260    40,372

Other time

     10,778    10,500    8,491    6,208    6,426

Core deposits

     61,765    60,178    56,668    49,468    46,798

Certificates - $100,000 and over

     6,466    5,795    4,001    2,403    3,832

Other foreign office

     1,393    2,979    3,719    4,364    3,860

Total deposits

   $ 69,624    68,952    64,388    56,235    54,490

 

Deposits

Deposit balances represent an important source of funding and revenue growth opportunity. The Bancorp is continuing to focus on core deposit growth in its retail and commercial franchises by expanding its retail franchise, enhancing its product offerings and providing competitive rates. At December 31, 2007, core deposits represented 59% of the Bancorp’s asset funding base, compared to 62% at December 31, 2006.

In 2007, the Bancorp expanded its deposit product line by offering an equity-linked certificate of deposit and a new savings account to help customers identify and reach savings goals. Additionally in 2007, the Bancorp reclassified certain foreign office deposits as transaction deposits. Included in foreign office deposits are Eurodollar sweep accounts for the Bancorp’s commercial customers. These accounts bear interest at rates slightly higher than money market accounts, but the Bancorp does not have to pay FDIC insurance or hold collateral. The remaining foreign office balances are brokered deposits and the Bancorp uses these, as well as certificates of deposit $100,000 and over, as a method to fund earning asset growth.

Core deposits grew five percent compared to December 31, 2006, however, the Bancorp continues to realize a mix shift as customers move from lower-yield transaction accounts to higher-yield time deposits. Core deposits acquired from Crown were approximately $990 million at December 31, 2007.

On an average basis, core deposits increased three percent compared to 2006, while customers continued to migrate from interest checking to higher yielding accounts. This migration

from interest checking to savings and time deposit accounts resulted in double-digit growth in savings balances and a decrease in interest checking deposits. The Bancorp experienced double-digit average core deposit increases in the Tennessee, Orlando, Tampa, Louisville and Ohio Valley markets.

Borrowings

As of December 31, 2007 and 2006, total borrowings as a percentage of interest-bearing liabilities were 27% and 22%, respectively. The increase in short-term funding in 2007 represents a return to more normalized levels as the balance sheet actions during the fourth quarter of 2006 temporarily reduced the need for short-term funding. Compared to 2006, average short-term funding decreased $1.8 billion.

The Bancorp continues to explore additional alternatives regarding the level and cost of various other sources of funding. In March, August and October of 2007, Fifth Third Capital Trust IV, V and VI, wholly-owned non-consolidated subsidiaries of the Bancorp, issued $750 million, $575 million and $863 million, respectively, of Tier I-qualifying trust preferred securities to third-party investors and invested the proceeds in junior subordinated notes issued by the Bancorp.

Information on the average rates paid on borrowings is located in the Statement of Income Analysis, while a comprehensive listing of the composition of long-term debt can be found in Note 13 of the Notes to Consolidated Financial Statements. In addition, refer to the Liquidity Risk Management section for a discussion on the role of borrowings in the Bancorp’s liquidity management.


 

TABLE 25: BORROWINGS

           

As of December 31 ($ in millions)

   2007    2006    2005    2004    2003
                        

Federal funds purchased

   $4,427    1,421    5,323    4,714    6,928

Short-term bank notes

   -    -    -    775    500

Other short-term borrowings

   4,747    2,796    4,246    4,537    5,742

Long-term debt

   12,857    12,558    15,227    13,983    9,063

Total borrowings

   $22,031    16,775    24,796    24,009    22,233

 

38    Fifth Third Bancorp


MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

RISK MANAGEMENT

 

Managing risk is an essential component of successfully operating a financial services company. The Bancorp’s risk management function is responsible for the identification, measurement, monitoring, control and reporting of risk and mitigation of those risks that are inconsistent with the Bancorp’s risk profile. The Enterprise Risk Management division (“ERM”), led by the Bancorp’s Chief Risk Officer, ensures consistency in the Bancorp’s approach to managing and monitoring risk within the structure of the Bancorp’s affiliate operating model. In addition, the Internal Audit division provides an independent assessment of the Bancorp’s internal control structure and related systems and processes. The risks faced by the Bancorp include, but are not limited to, credit, market, liquidity, operational and regulatory compliance. ERM includes the following key functions:

 

 

Risk Policy - ensures consistency in the approach to risk management as the Bancorp’s clearinghouse for credit, market and operational risk policies, procedures and guidelines;

 

 

Credit Risk Review - responsible for evaluating the sufficiency of underwriting, documentation and approval processes for consumer and commercial credits, counter-party credit risk, the accuracy of risk grades assigned to commercial credit exposure, and appropriate recognition accounting for charge-offs, non-accrual status and specific reserves and reports directly to the Risk and Compliance Committee of the Board of Directors;

 

 

Consumer Credit Risk Management - responsible for credit risk management in consumer lending, including oversight of underwriting and credit administration processes as well as analytics and reporting functions;

 

 

Capital Markets Risk Management - responsible for establishing and monitoring proprietary trading limits, monitoring liquidity and interest rate risk and utilizing value at risk and earnings at risk models;

 

 

Compliance Risk Management - responsible for oversight of compliance with all banking regulations;

 

 

Operational Risk Management - responsible for enterprise operational risk programs, such as risk self assessments, key risk indicators and new products review as well as root cause analysis and corrective action plans relating to identified operational losses;

 

 

Bank Protection - responsible for fraud prevention and detection, and investigations and recovery;

 

 

Insurance Risk Management - responsible for all property, casualty and liability insurance policies including the claims administration process for the Bancorp;

 

 

Investment Advisors Risk Management - responsible for trust compliance, fiduciary risk, trading risk and credit risk in the Investment Advisors line of business; and

 

 

Risk Strategies and Reporting - responsible for quantitative analytics and Board of Directors and senior management reporting on credit, market and operational risk metrics.

Designated risk managers have been assigned to all business lines. Affiliate risk management is handled by regional risk managers who are responsible for multiple affiliates and report directly to ERM.

Risk management oversight and governance is provided by the Risk and Compliance Committee of the Board of Directors and through multiple management committees whose membership includes a broad cross-section of line of business, affiliate and support representatives. The Risk and Compliance Committee of the Board of Directors consists of five outside directors and has the responsibility for the oversight of credit, market, operational, regulatory compliance and strategic risk management activities for the Bancorp, as well as for the Bancorp’s overall aggregate risk profile. The

Risk and Compliance Committee of the Board of Directors has approved the formation of key management governance committees that are responsible for evaluating risks and controls. These committees include the Market Risk Committee, the Corporate Credit Committee, the Credit Policy Committee, the Operational Risk Committee and the Executive Asset Liability Committee. There are also new products and initiatives processes applicable to every line of business to ensure an appropriate standard readiness assessment is performed before launching a new product or initiative. Significant risk policies approved by the management governance committees are also reviewed and approved by the Risk and Compliance Committee of the Board of Directors.

CREDIT RISK MANAGEMENT

The objective of the Bancorp’s credit risk management strategy is to quantify and manage credit risk on an aggregate portfolio basis, as well as to limit the risk of loss resulting from an individual customer default. The Bancorp’s credit risk management strategy is based on three core principles: conservatism, diversification and monitoring. The Bancorp believes that effective credit risk management begins with conservative lending practices. These practices include conservative exposure and counterparty limits and conservative underwriting, documentation and collection standards. The Bancorp’s credit risk management strategy also emphasizes diversification on a geographic, industry and customer level as well as regular credit examinations and monthly management reviews of large credit exposures and credits experiencing deterioration of credit quality. Lending officers with the authority to extend credit are delegated specific authority amounts, the utilization of which is closely monitored. Lending activities are largely centralized, while ERM manages the policy and authority delegation process directly. The Credit Risk Review function, within ERM, provides objective assessments of the quality of underwriting and documentation, the accuracy of risk grades and the charge-off and reserve analysis process.

The Bancorp’s credit review process and overall assessment of required allowances is based on quarterly assessments of the probable estimated losses inherent in the loan and lease portfolio. The Bancorp uses these assessments to promptly identify potential problem loans or leases within the portfolio, maintain an adequate reserve and take any necessary charge-offs. In addition to the individual review of larger commercial loans that exhibit probable or observed credit weaknesses, the commercial credit review process includes the use of two risk grading systems. The risk grading system currently utilized for reserve analysis purposes encompasses ten categories. The Bancorp also maintains a dual risk rating system that provides for thirteen probabilities of default grade categories and an additional six grade categories for estimating actual losses given an event of default. The probability of default and loss given default evaluations are not separated in the ten-grade risk rating system. The Bancorp is in the process of completing significant validation and testing of the dual risk rating system prior to implementation for reserve analysis purposes. The dual risk rating system is expected to be consistent with Basel II expectations and allows for more precision in the analysis of commercial credit risk. Scoring systems, various analytical tools and delinquency monitoring are used to assess the credit risk in the Bancorp’s homogenous consumer loan portfolios.

Commercial Portfolio

The Bancorp’s credit risk management strategy includes minimizing concentrations of risk through diversification. The following table provides breakouts of the commercial loan and lease portfolio, including held for sale, by major industry classification (as defined by the North American Industry


 

Fifth Third Bancorp    39


MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

TABLE 26: COMMERCIAL LOAN AND LEASE PORTFOLIO EXPOSURE(a)

      2007    2006

As of December 31 ($ in millions)

   Outstanding     Exposure    Nonaccrual    Outstanding    Exposure    Nonaccrual

By industry:

                

Real estate

   $11,564     14,450    147    10,652    13,196    50

Manufacturing

   6,570     14,365    28    5,198    11,443    22

Construction

   5,226     8,534    258    5,490    8,963    69

Retail trade

   4,175     7,251    29    3,655    6,515    27

Transportation and warehousing

   2,565     3,076    21    2,097    2,432    4

Financial services and insurance

   2,484     6,916    6    1,509    4,855    8

Healthcare

   2,347     4,007    15    1,860    3,208    9

Business services

   2,266     4,251    25    1,862    3,640    16

Wholesale trade

   2,179     4,127    16    1,827    3,642    11

Individuals

   1,252     1,626    15    1,364    1,785    13

Other services

   1,049     1,455    17    959    1,373    14

Accommodation and food

   1,036     1,470    21    860    1,323    10

Other

   963     1,897    59    578    1,269    4

Communication and information

   741     1,439    1    567    1,073    1

Public administration

   737     957    -    792    930    -

Entertainment and recreation

   617     873    6    602    841    2

Agribusiness

   606     788    3    609    782    8

Mining

   578     1,090    3    288    637    3

Utilities

   389     1,210    2    370    1,187    -

Total

   $47,334     79,782    672    41,139    69,094    271

By loan size:

                

Less than $200,000

   3 %   3    9    4    3    13

$200,000 to $1 million

   13     10    24    16    12    34

$1 million to $5 million

   28     23    43    32    27    48

$5 million to $10 million

   26     23    19    17    16    5

$10 million to $25 million

   13     14    5    21    24    -

Greater than $25 million

   17     27    -    10    18    -

Total

   100 %   100    100    100    100    100

By state:

                

Ohio

   26 %   30    20    25    28    36

Michigan

   20     18    36    22    19    19

Florida

   11     9    23    10    9    9

Illinois

   9     9    6    10    10    8

Indiana

   8     8    9    9    9    15

Kentucky

   5     5    2    6    6    8

Tennessee

   3     3    1    3    3    1

Pennsylvania

   2     2    -    1    2    -

Missouri

   1     1    -    1    1    -

All other states

   15     15    3    13    13    4

Total

   100 %   100    100    100    100    100

(a)

Outstanding reflects total commercial customer loan and lease balances, including held for sale and net of unearned income, and exposure reflects total commercial customer lending commitments.

 

Classification System), by loan size and by state, illustrating the diversity and granularity of the Bancorp’s portfolio.

The commercial portfolio is characterized by 85% of outstanding balances and exposures concentrated within the Bancorp’s primary market areas of Ohio, Kentucky, Indiana, Michigan, Illinois, Florida, Tennessee, Pennsylvania, and Missouri. Exclusive of the national large-ticket leasing business, the commercial portfolio is characterized by 91% of outstanding balances and 89% of exposures concentrated within these nine states. The following table provides further information on the location of commercial real estate and construction industry loans and leases.

TABLE 27: OUTSTANDING COMMERCIAL REAL ESTATE AND CONSTRUCTION LOANS AND LEASES BY STATE

 

As of December 31 ($ in millions)

   2007    2006

Michigan

   $ 4,692    4,637

Ohio

     4,167    4,072

Florida

     2,790    2,543

Illinois

     1,425    1,337

Indiana

     1,298    1,294

Kentucky

     791    794

Tennessee

     496    399

All other states

     1,131    1,066
           

Total

   $ 16,790    16,142
           

 

As of December 31, 2007, the Bancorp had outstanding homebuilder exposure of $4.4 billion, outstanding loans of $2.9 billion with $176 million in nonaccrual loans.

Residential Mortgage Portfolio

The Bancorp manages credit risk in the mortgage portfolio through conservative underwriting and documentation standards and geographic and product diversification. The Bancorp may also package and sell loans in the portfolio without recourse or may purchase mortgage insurance for the loans sold in order to mitigate credit risk.

Certain mortgage products have contractual features that may increase credit exposure to the Bancorp in the event of a decline in housing prices. These types of mortgage products offered by the Bancorp include loans with high LTV ratios, multiple loans on the same collateral that when combined result in a high LTV (“80/20”) and interest-only loans. Table 28 shows the Bancorp’s originations of these products for the years ended December 31, 2007 and 2006. The Bancorp does not originate mortgage loans that permit customers to defer principal payments or make payments that are less than the accruing interest. Table 29 provides the amount of these loans as a percent of the residential mortgage loans in the Bancorp’s portfolio and the delinquency rates of these loan products as of December 31, 2007 and 2006. The Bancorp


 

40    Fifth Third Bancorp    


MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

 

TABLE 28: RESIDENTIAL MORTGAGE ORIGINATIONS

For the years ended December 31 ($ in millions)

   2007    Percent of total     2006    Percent of total  

Greater than 80% LTV with no mortgage insurance

   $265    2 %   $679    7 %

Interest-only

   1,720    15     1,283    14  

Greater than 80% LTV and interest-only

   265    2     180    2  

80/20 loans

   212    2     431    5  

80/20 loans and interest only

   62    1     17    -  

TABLE 29: RESIDENTIAL MORTGAGE OUTSTANDINGS

 

     2007     2006  

As of December 31 ($ in millions)

   Balance    Percent of total     Delinquency Ratio     Balance    Percent of total     Delinquency Ratio  

Greater than 80% LTV with no mortgage insurance

   $2,146    21 %   8.93 %   $1,893    23 %   3.79 %

Interest-only

   1,620    16     1.83     1,227    15     .14  

Greater than 80% LTV and interest-only

   493    5     5.36     560    7     1.15  

80/20 loans

   -    -     -     28    -     .72  

previously sold certain of these mortgage products in the secondary market with recourse. The outstanding balances and delinquency rates for these loans sold with recourse as of December 31, 2007 and 2006 were $1.5 billion and 3.03% and $1.3 billion and 1.74%, respectively. Charge-offs on recourse loans were not material for the years ended December 31, 2007 and 2006. The balance of the mortgage portfolio not included in Table 29 is characterized by in footprint mortgage loans with less than 80% loan-to-value, with approximately two-thirds representing fixed rate mortgages.

The Bancorp originates certain non-conforming residential mortgage loans known as “Alt-A” loans. Borrower qualifications are comparable to other conforming residential mortgage products and the Bancorp has sold, without recourse, the majority of these loans into the secondary market. For the years ended December 31, 2007 and 2006, the Bancorp originated $756 million and $341 million of Alt-A mortgage loans. During 2007, approximately $152 million of Alt-A mortgage loans were moved from held for sale to held for investment, and an impairment charge of approximately $3 million was recognized in mortgage banking net revenue. As of December 31, 2007, the Bancorp held $134 million of Alt-A mortgage loans for investment with approximately $2.5 million in nonaccrual. As market conditions for these loans changed throughout 2007, management responded by making adjustments to underwriting standards and Alt-A loans are being underwritten and sold under an agency flow sale agreement.

Home Equity Portfolio

The home equity portfolio is characterized by 86% of outstanding balances within the Bancorp’s Midwest footprint of Ohio, Michigan, Kentucky, Indiana and Illinois. The portfolio has an average FICO score of 734 as of December 31, 2007, comparable with 735 at December 31, 2006 and 738 at December 31, 2005. Further detail on location and origination LTV ratios is included in Table 30.

Analysis of Nonperforming Assets

A summary of nonperforming assets is included in Table 31. Nonperforming assets include: (i) nonaccrual loans and leases for which ultimate collectibility of the full amount of the principal and/or interest is uncertain; (ii) restructured consumer loans which have not yet met the requirements to be classified

as a performing asset; (iii) commercial loans and leases that have been renegotiated to provide for a reduction or deferral of interest or principal because of deterioration in the financial position of the borrower and (iv) other assets, including other real estate owned and repossessed equipment. Loans are placed on nonaccrual status when the principal or interest is past due 90 days or more (unless the loan is both well secured and in process of collection) and payment of the full principal and/or interest under the contractual terms of the loan are not expected. Additionally, loans are placed on nonaccrual status upon deterioration of the financial condition of the borrower or upon the restructuring of the loan. When a loan is placed on nonaccrual status, the accrual of interest, amortization of loan premium, accretion of loan discount and amortization or accretion of deferred net loan fees or costs are discontinued and previously accrued but unpaid interest is reversed. Commercial loans on nonaccrual status are reviewed for impairment at least quarterly. If the principal or a portion of principal is deemed a loss, the loss amount is charged off to the allowance for loan and lease losses.

As of December 31, 2007 and 2006, nonperforming assets as a percentage of total loans and leases and other assets, including other real estate owned were 1.32% and .61%, respectively. Total nonperforming assets were $1.1 billion at December 31, 2007, an increase of $609 million compared to $455 million at December 31, 2006. The composition of nonaccrual credits continues to shift as 84% of nonaccrual credits were secured by real estate as of December 31, 2007 compared to 69% as of December 31, 2006 and 48% as of December 31, 2005.

Commercial nonaccrual credits increased from $271 million as of December 31, 2006 to $672 million as of December 31, 2007. The majority of the increase was driven by the real estate and construction industries in the Southern Florida, Northeastern Ohio and Eastern Michigan affiliates. These affiliates combined to account for 42% of commercial nonaccrual credits as of December 31, 2007. As shown in Table 26, the real estate and construction industries contributed to more than two-thirds of the increase in nonaccrual credits. At year end, a total of $57 million in nonaccrual credits were the result of the Crown acquisition.

Consumer nonaccrual credits increased from $81 million as of December 31, 2006 to $221 million as of December 31, 2007. The


 

TABLE 30: HOME EQUITY OUTSTANDINGS

     2007     2006  

As of December 31 ($ in millions)

   LTV less
than 80%
   LTV greater
than 80%
   Delinquency
Ratio
    LTV less
than 80%
   LTV greater
than 80%
  

Delinquency

Ratio

 

Ohio

   $1,873    $2,039    1.50 %   $2,006    $2,124    1.30 %

Michigan

   1,393    1,295    2.06     1,529    1,354    1.69  

Indiana

   628    641    1.95     684    686    1.66  

Illinois

   637    545    1.66     617    582    1.19  

Kentucky

   508    594    1.52     533    631    1.11  

Florida

   536    291    2.93     418    229    .96  

All other states

   174    689    3.07     153    678    1.61  

Total

   $5,749    $6,094    1.90 %   $5,940    $6,284    1.41 %

 

Fifth Third Bancorp    41


MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

TABLE 31: SUMMARY OF NONPERFORMING ASSETS AND DELINQUENT LOANS

As of December 31 ($ in millions)

   2007     2006    2005    2004    2003

Commercial loans

   $175     127    140    105    110

Commercial mortgage loans

   243     84    51    51    42

Commercial construction loans

   249     54    31    13    19

Commercial leases

   5     6    5    5    19

Residential mortgages loans(a)

   121     38    30    24    25

Home equity(b)(d)

   91     40         

Automobile loans(d)

   3     3         

Credit card(c)

   5     -    -    -    -

Other consumer loans and leases(d)

   1     -    37    30    27

Total nonaccrual loans and leases

   893     352    294    228    242

Commercial renegotiated loans and leases

   -     -    -    1    8

Repossessed personal property and other real estate owned

   171     103    67    74    69

Total nonperforming assets

   $1,064     455    361    303    319

Commercial loans

   $44     38    20    21    14

Commercial mortgage loans

   73     17    7    8    8

Commercial construction loans

   67     6    7    5    4

Commercial leases

   4     2    1    1    1

Residential mortgages loans(e)

   186     68    53    43    51

Home equity(d)

   72     51         

Automobile loans(d)

   13     11         

Credit card

   31     16    10    13    13

Other consumer loans and leases(d)

   1     1    57    51    54

Total 90 days past due loans and leases

   $491     210    155    142    145

Nonperforming assets as a percent of total loans, leases and other assets, including other real estate owned

   1.32 %   .61    .52    .51    .61

Allowance for loan and lease losses as a percent of nonperforming assets

   88     170    206    235    219

(a)

Residential mortgage nonaccrual loans include debt restructurings of $29 million as of December 31, 2007.

(b)

Home equity nonaccrual loans include debt restructurings of $46 million as of December 31, 2007.

(c)

All nonaccrual credit card balances are the result of debt restructurings.

(d)

Prior to 2006, other consumer loans and leases include home equity, automobile and other consumer loans and leases.

(e)

Information for all periods presented excludes advances made pursuant to servicing agreements to Government National Mortgage Association (“GNMA”) mortgage pools whose repayments are insured by the Federal Housing Administration or guaranteed by the Department of Veterans Affairs. As of December 31, 2007, 2006 and 2005, these advances were $25 million, $14 million and $13 million, respectively. Information prior to 2004 was not available.

increase in consumer nonaccrual credits is primarily attributable to the housing markets in the Michigan and Florida affiliates and the restructuring of certain high risk loans. Michigan and Florida nonaccrual credits accounted for 63% of the increase in nonaccrual credits in the consumer loan portfolio and, as of December 31, 2007, represented approximately half of the consumer nonaccrual credits. The Bancorp has devoted significant attention to loss mitigation activities and, during the past year, decreased the timing between delinquency and repossession of automobiles and proactively restructured certain real estate loans. Consumer restructured loans are recorded as nonaccrual credits until there is a sustained period of payment by the borrower, generally a minimum of six months of payments in accordance with the loans’ modified terms. Consumer restructured loans contributed approximately $80 million to nonaccrual loans as of December 31, 2007.

Included in nonaccrual credits as of December 31, 2007 were $43 million of loans and leases currently performing in accordance with contractual terms, but for which there were serious doubts as to the ability of the borrower to comply with such terms. For the years 2007 and 2006, interest income of $22 million and $10 million, respectively, was recorded on nonaccrual and renegotiated loans and leases. For the years ended 2007 and 2006, additional interest income of $144 million and $85 million, respectively, would have been recorded if the nonaccrual and renegotiated loans and leases had been current in accordance with the original terms. Although this value helps demonstrate the costs of carrying nonaccrual credits, the Bancorp does not expect to recover the full amount of interest as nonaccrual loans and leases are generally carried below their principal balance.

Analysis of Net Loan Charge-offs

Net charge-offs as a percent of average loans and leases were 61 bp for 2007, compared to 44 bp for 2006. Table 32 provides a summary of credit loss experience and net charge-offs as a percentage of average loans and leases outstanding by loan category.

The ratio of commercial loan net charge-offs to average commercial loans outstanding increased to 43 bp in 2007 compared to 34 bp in 2006 due to increases in net charge-offs in the commercial mortgage and commercial construction captions as homebuilders and developers were affected by the downturn in the real estate markets. Commercial net charge-offs in the Michigan affiliates grew $30 million over 2006, with the most stress appearing in the Detroit metro area. Commercial net charge-offs in the Florida affiliates grew $13 million over 2006. The Chicago affiliate also displayed a $21 million increase in commercial charge-offs, primarily due to a $15 million fraud related loss during the fourth quarter of 2007.

The ratio of consumer loan net charge-offs to average consumer loans outstanding increased to 84 bp in 2007 compared to 55 bp in 2006. Residential mortgage charge-offs increased 21 bp compared to 2006, reflecting increased foreclosure rates in the Bancorp’s key lending markets and the related increase in severity of loss on mortgage loans. During 2007, Florida, Michigan and Ohio were ranked among the top states in total mortgage foreclosures. These foreclosures not only added to the volume of charge-offs, but also hampered the Bancorp’s ability to recover the value of the homes collateralizing the mortgages as they contributed to declining home prices. Florida affiliates experienced the most stress, with residential mortgage net charge-offs increasing $11 million over 2006. Home equity charge-offs increased $41 million to 82 bp of average loans, primarily due to increases in the Michigan and Florida affiliates and among those products originated through a broker channel. Brokered home equity loans represented 50% of home equity charge-offs during 2007 despite representing only 23% of home equity lines and loans as of December 31, 2007. Management responded to the performance of the brokered home equity portfolio by reducing originations in 2007 of this product by 64% compared to 2006 and, at the end of 2007, eliminating this channel of origination. The ratio of automobile loan net charge-offs to average automobile


 

42    Fifth Third Bancorp    


MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

TABLE 32: SUMMARY OF CREDIT LOSS EXPERIENCE

For the years ended December 31 ($ in millions)

   2007     2006     2005     2004     2003  

Losses charged off:

          

Commercial loans

   $ (121 )   (131 )   (99 )   (95 )   (153 )

Commercial mortgage loans

     (46 )   (27 )   (13 )   (14 )   (9 )

Commercial construction loans

     (29 )   (7 )   (5 )   (7 )   (4 )

Commercial leases

     (1 )   (4 )   (38 )   (8 )   (24 )

Residential mortgage loans

     (43 )   (23 )   (19 )   (15 )   (24 )

Home equity

     (106 )   (65 )   (60 )   (52 )   (52 )

Automobile loans

     (117 )   (87 )   (63 )   (56 )   (41 )

Credit card

     (54 )   (36 )   (46 )   (35 )   (31 )

Other consumer loans and leases

     (27 )   (28 )   (30 )   (39 )   (42 )

Total losses

     (544 )   (408 )   (373 )   (321 )   (380 )

Recoveries of losses previously charged off:

          

Commercial loans

     12     24     24     14     16  

Commercial mortgage loans

     2     3     3     5     2  

Commercial construction loans

     -     -     1     -     -  

Commercial leases

     1     5     1     1     2  

Residential mortgage loans

     -     -     -     -     -  

Home equity

     9     9     10     10     15  

Automobile loans

     32     30     18     18     12  

Credit card

     8     5     5     6     5  

Other consumer loans and leases

     18     16     12     15     16  

Total recoveries

     82     92     74     69     68  

Net losses charged off:

          

Commercial loans

     (109 )   (107 )   (75 )   (81 )   (137 )

Commercial mortgage loans

     (44 )   (24 )   (10 )   (9 )   (7 )

Commercial construction loans

     (29 )   (7 )   (4 )   (7 )   (4 )

Commercial leases

     -     1     (37 )   (7 )   (22 )

Residential mortgage loans

     (43 )   (23 )   (19 )   (15 )   (24 )

Home equity

     (97 )   (56 )   (50 )   (42 )   (37 )

Automobile loans

     (85 )   (57 )   (45 )   (38 )   (29 )

Credit card

     (46 )   (31 )   (41 )   (29 )   (26 )

Other consumer loans and leases

     (9 )   (12 )   (18 )   (24 )   (26 )

Total net losses charged off

   $ (462 )   (316 )   (299 )   (252 )   (312 )

Net charge-offs as a percent of average loans and leases (excluding held for sale):

          

Commercial loans

     .49 %   .53     .41     .54     1.00  

Commercial mortgage loans

     .40     .25     .10     .12     .10  

Commercial construction loans

     .51     .11     .08     .17     .10  

Commercial leases

     .01     (.03 )   1.06     .21     .72  

Total commercial loans and leases

     .43     .34     .35     .35     .64  

Residential mortgage loans

     .48     .27     .23     .25     .53  

Home equity

     .82     .46     .44     .44     .43  

Automobile loans

     .83     .60     .53     .48     .40  

Credit card

     3.55     3.65     5.65     3.92     4.70  

Other consumer loans and leases

     .83     .91     1.06     .98     1.06  

Total consumer loans and leases

     .84     .55     .57     .56     .61  

Total net losses charged off

     .61 %   .44     .45     .45     .63  

loans increased to 83 bp in 2007 compared to 60 bp in 2006 displaying an expected increase due to a shift in the portfolio to a higher percentage of used automobiles and an increase in loss of severity due to a market surplus of used automobiles. The net charge-off ratio on credit card balances modestly declined compared to the prior year primarily due to a large origination of card balances in 2007. Although the credit characteristics of the credit card portfolio have been maintained during the origination of new cards, including the weighted average FICO and average line outstanding, the Bancorp does expect the charge-off ratio to increase as the portfolio matures. The Bancorp employs a risk-adjusted pricing methodology to ensure adequate compensation is received for those products that have higher credit costs.

Allowance for Credit Losses

The allowance for credit losses is comprised of the allowance for loan and lease losses and the reserve for unfunded commitments. The allowance for loan and lease losses provides coverage for probable and estimable losses in the loan and lease portfolio. The Bancorp evaluates the allowance each quarter to determine its adequacy to cover inherent losses. Several factors are taken into consideration in the determination of the overall allowance for loan and lease losses, including the unallocated

component. These factors include, but are not limited to, the overall risk profile of the loan and lease portfolios, net charge-off experience, the extent of impaired loans and leases, the level of nonaccrual loans and leases, the level of 90 days past due loans and leases and the overall percentage level of the allowance for loan and lease losses. The Bancorp also considers overall asset quality trends, credit administration and portfolio management practices, risk identification practices, credit policy and underwriting practices, overall portfolio growth, portfolio concentrations and current national and local economic conditions that might impact the portfolio.

In 2007, the Bancorp has not substantively changed any material aspect to its overall approach in the determination of the allowance for loan and lease losses and there have been no material changes in criteria or estimation techniques as compared to prior periods that impacted the determination of the current period allowance. In addition to the allowance for loan and lease losses, the Bancorp maintains a reserve for unfunded commitments. The methodology used to determine the adequacy of this reserve is similar to the Bancorp’s methodology for determining the allowance for loan and lease losses. The provision for unfunded commitments is included in other noninterest expense on the Consolidated Statements of Income. Table 33 shows the changes in the allowance for credit losses during 2007.


 

    Fifth Third Bancorp    43


MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

 

TABLE 33: CHANGES IN ALLOWANCE FOR CREDIT LOSSES

For the years ended December 31 ($ in millions)

   2007    2006    2005    2004    2003

Balance, beginning of year

   $847    814    785    770    683

Net losses charged off

   (462)    (316)    (299)    (252)    (312)

Provision for loan and lease losses

   628    343    330    268    399

Net change in reserve for unfunded commitments

   19    6    (2)    (1)    -

Balance, end of year

   $1,032    847    814    785    770

Components of allowance for credit losses:

              

Allowance for loan and lease losses

   $937    771    744    713    697

Reserve for unfunded commitments

   95    76    70    72    73

Total allowance for credit losses

   $1,032    847    814    785    770

 

Certain inherent but undetected losses are probable within the loan and lease portfolio. An unallocated component to the allowance for loan and lease losses is maintained to recognize the imprecision in estimating and measuring loss. The Bancorp’s current methodology for determining this measure is based on historical loss rates, current credit grades, specific allocation on impaired commercial credits and other qualitative adjustments. Approximately 90% of the required reserves come from the baseline historical loss rates, specific reserve estimates and current credit grades; while 10% comes from qualitative adjustments. As a result, the required reserves tend to slightly lag the deterioration in the portfolio due to the heavy reliance on realized historical losses and the credit grade rating process. Consequently, a larger unallocated allowance is required towards the end of the stronger part of the credit cycle. As the credit cycle deteriorates and the actual loss rates and downgrades increase, the Bancorp’s methodology will result in a lower unallocated allowance as the incurred losses are reflected into the main components of the methodology that drive the majority of the required reserve calculations. Unallocated allowance as a percent of total portfolio loans and leases for the year ended December 31, 2007 and 2006 were .06%.

The allowance for loan and lease losses at December 31, 2007 increased to 1.17% of the total portfolio loans and leases compared to 1.04% at December 31, 2006. This increase is reflective of a number of factors including: the increase in delinquencies, the real estate price deterioration in some the Bancorp’s key lending markets, the increase in automobile loans and credit card balances and the modest decline in

economic conditions. These factors were the primary drivers of the increased reserve factors for most of the Bancorp’s loan categories. Table 34 provides the amount of the allowance for loan and lease losses by category.

Real estate price deterioration, as determined by the Home Price Index, was most prevalent in Michigan, due in part to cutbacks by automobile manufacturers, and Florida, due to past real estate price appreciation and related overdevelopment. The Bancorp has sizable exposure in both of these markets. The deterioration in real estate values increased the expected loss once a loan becomes delinquent, particularly for home equity loans with high loan-to-value ratios.

During 2007, the Bancorp grew credit card balances as part of an initiative to more fully develop relationships with its current customers. In addition, the composition of the automobile loan portfolio changed to include a larger percentage of used automobiles. Although these products naturally produce higher charge-offs, which creates the need for a larger allowance for credit losses, the Bancorp employs a risk-adjusted pricing methodology to ensure adequate compensation is received for those products that have higher credit costs.

If trends in charge-offs, delinquent loans and economic conditions continue to deteriorate in 2008, the Bancorp would expect to record a larger allowance for credit losses in accordance with its allowance methodology. Overall, the Bancorp’s long history of low exposure limits, lack of exposure to subprime lending businesses, centralized risk management and its diversified portfolio reduces the likelihood of significant unexpected credit losses.


 

TABLE 34: ATTRIBUTION OF ALLOWANCE FOR LOAN AND LEASE LOSSES TO PORTFOLIO LOANS AND LEASES

 

As of December 31 ($ in millions)

   2007    2006    2005    2004    2003

Allowance attributed to:

              

Commercial loans

   $271    252    201    210    234

Commercial mortgage loans

   135    95    78    73    77

Commercial construction loans

   98    49    46    42    34

Residential mortgage loans

   67    51    38    45    29

Consumer loans

   287    247    183    160    146

Lease financing

   32    29    56    47    64

Unallocated

   47    48    142    136    113

Total allowance for loan and lease losses

   $937    771    744    713    697

Portfolio loans and leases:

              

Commercial loans

   $24,813    20,831    19,253    16,107    14,244

Commercial mortgage loans

   11,862    10,405    9,188    7,636    6,894

Commercial construction loans

   5,561    6,168    6,342    4,347    3,301

Residential mortgage loans

   10,540    8,830    7,847    7,366    4,760

Consumer loans

   22,943    23,204    22,006    18,875    17,398

Lease financing

   4,534    4,915    5,289    5,477    5,711

Total portfolio loans and leases

   $80,253    74,353    69,925    59,808    52,308

Attributed allowance as a percent of respective portfolio loans:

              

Commercial loans

   1.09%    1.21    1.05    1.31    1.65

Commercial mortgage loans

   1.14    .91    .85    .96    1.12

Commercial construction loans

   1.77    .80    .72    .96    1.03

Residential mortgage loans

   .63    .58    .49    .61    .61

Consumer loans

   1.25    1.06    .83    .85    .84

Lease financing

   .69    .59    1.06    .86    1.12

Unallocated (as a percent of total portfolio loans and leases)

   .06    .06    .20    .23    .22

Total portfolio loans and leases

   1.17%    1.04    1.06    1.19    1.33

 

44    Fifth Third Bancorp    


MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

MARKET RISK MANAGEMENT

Market risk arises from the potential for market fluctuations in interest rates, foreign exchange rates and equity prices that may result in potential reductions in net income. Interest rate risk, a component of market risk, is the exposure to adverse changes in net interest income or financial position due to changes in interest rates. Management considers interest rate risk a prominent market risk in terms of its potential impact on earnings. Interest rate risk can occur for any one or more of the following reasons:

 

 

Assets and liabilities may mature or reprice at different times;

 

 

Short-term and long-term market interest rates may change by different amounts; or

 

 

The expected maturity of various assets or liabilities may shorten or lengthen as interest rates change.

In addition to the direct impact of interest rate changes on net interest income, interest rates can indirectly impact earnings through their effect on loan demand, credit losses, mortgage originations, the value of servicing rights and other sources of the Bancorp’s earnings. Stability of the Bancorp’s net interest income is largely dependent upon the effective management of interest rate risk. Management continually reviews the Bancorp’s balance sheet composition and models the interest rate risk, and possible actions to reduce this risk, given numerous possible future interest rate scenarios.

Net Interest Income Simulation Model

The Bancorp employs a variety of measurement techniques to identify and manage its interest rate risk, including the use of an earnings simulation model to analyze net interest income sensitivity to changing interest rates. The model is based on contractual and assumed cash flows and repricing characteristics for all of the Bancorp’s financial instruments, and incorporates market-based assumptions regarding the effect of changing interest rates on the prepayment rates of certain assets and liabilities. The model also includes senior management projections of the future volume and pricing of each of the product lines offered by the Bancorp as well as other pertinent assumptions. Actual results will differ from these simulated results due to timing, magnitude and frequency of interest rate changes as well as changes in market conditions and management strategies.

The Bancorp’s Executive Asset Liability Committee (“ALCO”), which includes senior management representatives and is accountable to the Risk and Compliance Committee of the Board of Directors, monitors and manages interest rate risk within Board approved policy limits. In addition to the risk management activities of ALCO, the Bancorp has a Market Risk Management function as part of ERM that provides independent oversight of market risk activities. The Bancorp’s current interest rate risk exposure is evaluated by measuring the anticipated change in net interest income over 12-month and 24-month horizons assuming a 200 bp parallel ramped increase or decrease in market interest rates. In accordance with the current policy, the rate movements are assumed to occur over one year and are sustained thereafter.

Table 35 shows the Bancorp’s estimated earnings sensitivity profile and the ALCO policy limits on the asset and liability positions as of December 31, 2007:

TABLE 35: ESTIMATED EARNINGS SENSITIVITY PROFILE

    

Change in Net Interest
Income (FTE)

 

ALCO Policy Limits

Change in
Interest
Rates (bp)
 

12

Months

 

13 to 24

Months

 

12

Months

 

13 to 24

Months

+200

  (.31)%   3.19   (5.00)   (7.00)

+100

  (.30)   1.53   -   -

-100

  1.11   .60   -   -

-200

  1.44   (2.70)   (5.00)   (7.00)

Economic Value of Equity

The Bancorp also employs economic value of equity (“EVE”) as a measurement tool in managing interest rate sensitivity. Whereas net interest income simulation highlights exposures

over a relatively short time horizon, the EVE analysis incorporates all cash flows over the estimated remaining life of all balance sheet and derivative positions. The EVE of the balance sheet, at a point in time, is defined as the discounted present value of asset and derivative cash flows less the discounted value of liability cash flows. The sensitivity of EVE to changes in the level of interest rates is a measure of the longer-term interest rate risk. In contrast to the net interest income simulation, which assumes interest rates will change over a period of time, EVE uses instantaneous changes in rates. EVE values only the current balance sheet and does not incorporate the growth assumptions used in the net interest income simulation model. As with the net interest income simulation model, assumptions about the timing and variability of balance sheet cash flows are critical in the EVE analysis. Particularly important are the assumptions driving prepayments and the expected changes in balances and pricing of the transaction deposit portfolios. The following table shows the Bancorp’s EVE sensitivity profile as of December 31, 2007:

TABLE 36: ESTIMATED EVE SENSITIVITY PROFILE

 

Change in

Interest Rates (bp)

   Change in EVE   ALCO Policy Limits

+200

   (8.18)%   (20.0)

-200

   2.06   (20.0)

While an instantaneous shift in interest rates is used in this analysis to provide an estimate of exposure, the Bancorp believes that a gradual shift in interest rates would have a much more modest impact. Since EVE measures the discounted present value of cash flows over the estimated lives of instruments, the change in EVE does not directly correlate to the degree that earnings would be impacted over a shorter time horizon (i.e., the current fiscal year). Further, EVE does not take into account factors such as future balance sheet growth, changes in product mix, changes in yield curve relationships and changing product spreads that could mitigate the adverse impact of changes in interest rates. The net interest income simulation and EVE analyses do not necessarily include certain actions that management may undertake to manage this risk in response to anticipated changes in interest rates.

Use of Derivatives to Manage Interest Rate Risk

An integral component of the Bancorp’s interest rate risk management strategy is its use of derivative instruments to minimize significant fluctuations in earnings and cash flows caused by changes in market interest rates. Examples of derivative instruments that the Bancorp may use as part of its interest rate risk management strategy include interest rate swaps, interest rate floors, interest rate caps, forward contracts, principal only swaps, options and swaptions.

As part of its overall risk management strategy relative to its mortgage banking activity, the Bancorp enters into forward contracts accounted for as free-standing derivatives to economically hedge interest rate lock commitments that are also considered free-standing derivatives. In addition, the Bancorp hedges its exposure to mortgage loans held for sale.

The Bancorp also establishes derivative contracts with reputable third parties to economically hedge significant exposures assumed in commercial customer accommodation derivative contracts. Generally, these contracts have similar terms in order to protect the Bancorp from market volatility. Credit risks arise from the possible inability of counterparties to meet the terms of their contracts, which the Bancorp minimizes through approvals, limits and monitoring procedures. The notional amount and fair values of these derivatives as of December 31, 2007 are included in Note 10 of the Notes to Consolidated Financial Statements.


 

    Fifth Third Bancorp    45


MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

TABLE 37: PORTFOLIO LOAN AND LEASE PRINCIPAL CASH FLOWS

As of December 31, 2007 ($ in millions)

   Less than 1 year    1-5 years    Greater than 5
years
   Total

Commercial loans

   $13,266    10,035    1,512    24,813

Commercial mortgage loans

   5,154    4,946    1,762    11,862

Commercial construction loans

   3,860    1,302    399    5,561

Commercial leases

   615    1,523    1,599    3,737

Residential mortgage loans

   2,795    4,066    3,679    10,540

Home equity

   2,300    4,878    4,696    11,874

Automobile loans

   3,305    5,377    519    9,201

Credit card

   191    1,400    -    1,591

Other consumer loans and leases

   486    536    52    1,074

Total

   $31,972    34,063    14,218    80,253

TABLE 38: PORTFOLIO LOAN AND LEASE PRINCIPAL CASH FLOWS OCCURRING AFTER ONE YEAR

      Interest Rate

As of December 31, 2007 ($ in millions)

   Fixed    Floating or Adjustable

Commercial loans

   $2,546    9,001

Commercial mortgage loans

   2,339    4,369

Commercial construction loans

   432    1,269

Commercial leases

   3,122    -

Residential mortgage loans

   4,217    3,528

Home equity

   1,673    7,901

Automobile loans

   5,896    -

Credit card

   470    930

Other consumer loans and leases

   579    9

Total

   $21,274    27,007

 

Portfolio Loans and Leases and Interest Rate Risk

Although the Bancorp’s portfolio loans and leases contain both fixed and floating/adjustable rate products, the rates of interest earned by the Bancorp on the outstanding balances are generally established for a period of time. The interest rate sensitivity of loans and leases is directly related to the length of time the rate earned is established. Table 37 shows a summary of the expected principal cash flows of the Bancorp’s portfolio loans and leases as of December 31, 2007. Additionally, Table 38 shows a summary of expected principal cash flows occurring after one year as of December 31, 2007.

Mortgage Servicing Rights and Interest Rate Risk

The net carrying amount of the MSR portfolio was $610 million as of December 31, 2007 compared to $519 million as of December 31, 2006. The Bancorp maintains a non-qualifying hedging strategy relative to its mortgage banking activity in order to manage a portion of the risk associated with changes in the value of its MSR portfolio as a result of changing interest rates. The value of servicing rights can fluctuate sharply depending on changes in interest rates and other factors. Generally, as interest rates decline and loans are prepaid to take advantage of refinancing opportunities, the total value of existing servicing rights declines because no further servicing fees are collected on repaid loans.

The decrease in interest rates, particularly during the fourth quarter of 2007, led to the recognition of $22 million in temporary impairment of servicing rights during 2007, compared to a recovery of temporary impairment of $19 million in 2006. Servicing rights are deemed temporarily impaired when a borrower’s loan rate is distinctly higher than prevailing market rates. Impairment on servicing rights is reversed when the prevailing rates return to a level commensurate with the borrower’s loan rate. The Bancorp recognized a gain of $29 million in 2007 and a loss of $6 million in 2006 on free-standing derivatives and the sale of securities used to economically hedge the MSR portfolio. See Note 9 of the Notes to Consolidated Financial Statements for further discussion on servicing rights.

Foreign Currency Risk

The Bancorp enters into foreign exchange derivative contracts to economically hedge certain foreign denominated loans. The derivatives are classified as free-standing instruments with the revaluation gain or loss being recorded within other noninterest

income on the Consolidated Statements of Income. The balance of the Bancorp’s foreign denominated loans at December 31, 2007 was approximately $329 million compared to approximately $219 million at December 31, 2006. The Bancorp also enters into foreign exchange contracts for the benefit of commercial customers involved in international trade to hedge their exposure to foreign currency fluctuations. The Bancorp has several internal controls in place to ensure excessive risk is not being taken in providing this service to customers. These include an independent determination of currency volatility and credit equivalent exposure on these contracts, counterparty credit approvals and country limits.

LIQUIDITY RISK MANAGEMENT

The goal of liquidity management is to provide adequate funds to meet changes in loan and lease demand, unexpected deposit withdrawals and other contractual obligations. A summary of certain obligations and commitments to make future payments under contracts is included in Table 42. Mitigating liquidity risk is accomplished by maintaining liquid assets in the form of investment securities, maintaining sufficient unused borrowing capacity in the national money markets and delivering consistent growth in core deposits. The estimated weighted-average life of the available-for-sale portfolio was 6.8 years at December 31, 2007, based on current prepayment expectations. Of the $10.7 billion (fair value basis) of securities in the available-for-sale portfolio at December 31, 2007, $2.0 billion in principal and interest is expected to be received in the next 12 months, and an additional $1.5 billion is expected to be received in the next 13 to 24 months. In addition to available-for-sale securities, asset-driven liquidity is provided by the Bancorp’s ability to sell or securitize loan and lease assets. In order to reduce the exposure to interest rate fluctuations and to manage liquidity, the Bancorp has developed securitization and sale procedures for several types of interest-sensitive assets. A majority of the long-term, fixed-rate single-family residential mortgage loans underwritten according to FHLMC or Federal National Mortgage Association (“FNMA”) guidelines are sold for cash upon origination. Additional assets such as jumbo fixed-rate residential mortgages, certain floating rate short-term commercial loans, certain floating-rate home equity loans, certain automobile loans and other consumer loans are also capable of being securitized, sold or transferred off-balance sheet. For the year ended December 31, 2007 and 2006,


 

46    Fifth Third Bancorp    


MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

TABLE 39: AGENCY RATINGS

As of December 31, 2007

   Moody’s    Standard and Poor’s    Fitch    DBRS

Fifth Third Bancorp:

           

Commercial paper

   Prime-1    A-1    F1+    R-1M

Senior debt

   Aa3    A+    AA-    AAL

Subordinated debt

   A1    A    A+    A

Fifth Third Bank and Fifth Third Bank (Michigan):

           

Short-term deposit

   Prime-1    A-1+    F1+    R-1H

Long-term deposit

   Aa2    AA-    AA    AA

Senior debt

   Aa2    AA-    AA-   

Subordinated debt

   Aa3    A+    A+     

loans totaling $12.2 billion and $9.2 billion, respectively, were sold, securitized or transferred off-balance sheet.

In 2007, an indirect, wholly-owned special purpose subsidiary of the Bancorp established an effective shelf registration with the SEC to issue securities backed by automobile loans originated by the Bancorp’s Ohio and Michigan subsidiary banks. As of December 31, 2007, the Bancorp held $2.0 billion in held for sale automobile loans. The effect of the forecasted sale and securitization of these loans on the Bancorp’s financial results will depend on future market developments and related management decisions.

Additionally, the Bancorp has a shelf registration in place with the SEC permitting ready access to the public debt markets and qualifies as a “well-known seasoned issuer” under SEC rules. As of December 31, 2007, $5.8 billion of debt or other securities were available for issuance from this shelf registration under the current Bancorp’s Board of Directors’ authorizations. The Bancorp also has $16.2 billion of funding available for issuance through private offerings of debt securities pursuant to its bank note program. These sources, in addition to a 9.35% average equity capital base, provide the Bancorp with a stable funding base.

Core deposits have historically provided the Bancorp with a sizeable source of relatively stable and low cost funds. The Bancorp’s average core deposits and shareholders’ equity funded 70% of its average total assets during 2007. In addition to core deposit funding, the Bancorp also accesses a variety of other short-term and long-term funding sources, which include the use of various regional Federal Home Loan Banks as a funding source. Certificates carrying a balance of $100,000 or more and deposits in the Bancorp’s foreign branch located in the Cayman Islands are wholesale funding tools utilized to fund asset growth. Management does not rely on any one source of liquidity and manages availability in response to changing balance sheet needs.

Table 39 provides Moody’s, Standard and Poor’s, Fitch’s and DBRS deposit and debt ratings for the Bancorp, Fifth Third Bank and Fifth Third Bank (Michigan). These debt ratings, along with capital ratios above regulatory guidelines, provide the Bancorp with additional access to liquidity.

CAPITAL MANAGEMENT

The Bancorp maintains a relatively high level of capital as a margin of safety for its depositors and shareholders. At December 31, 2007, shareholders’ equity was $9.2 billion,

compared to $10.0 billion at December 31, 2006. Tangible equity as a percent of tangible assets was 6.05% at December 31, 2007 and 7.79% at December 31, 2006. The declines in shareholders’ equity and the tangible equity ratios are primarily a result of $1.1 billion in share repurchases during 2007. In March, August, and October of 2007, Fifth Third Capital Trust IV, V and VI, wholly-owned non-consolidated subsidiaries of the Bancorp, issued $750 million, $575 million and $863 million of Tier I-qualifying trust preferred securities to third party investors and invested the proceeds in junior subordinated notes issued by the Bancorp. See Note 13 of the Notes to Consolidated Financial Statements for further discussion of these issuances.

Regulatory capital ratios were lower compared with the prior year and were negatively affected by $1.1 billion in common stock share repurchases throughout 2007, the approximately $690 million repurchase of Tier I-qualifying outstanding shares of its Fifth Third REIT Series B Preferred Stock on December 27, 2007 and 12% growth in risk-weighted assets. The negative impacts of these factors were partially offset by the previously mentioned issuance of Tier I-qualifying trust preferred securities.

The Federal Reserve Board established quantitative measures that assign risk weightings to assets and off-balance sheet items and also define and set minimum regulatory capital requirements (risk-based capital ratios). Additionally, the guidelines define “well-capitalized” ratios for Tier I, total risk-based capital and leverage as 6%, 10% and 5%, respectively. The Bancorp exceeded these “well-capitalized” ratios for all periods presented. See Note 25 of the Notes to Consolidated Financial Statements for additional information regarding regulatory capital ratios.

Dividend Policy and Stock Repurchase Program

The Bancorp views dividends and share repurchases as an effective means of delivering value to shareholders. The Bancorp’s common stock dividend policy reflects its earnings outlook, desired payout ratios, the need to maintain adequate capital levels and alternative investment opportunities. In 2007, the Bancorp paid dividends per common share of $1.70, an increase of eight percent over the $1.58 paid in 2006 and an increase of 16% over the $1.46 paid in 2005.

The Bancorp’s stock repurchase program is an important element of its capital planning activities. The Bancorp’s repurchase of equity securities is shown in Table 41 and details on


 

TABLE 40: CAPITAL RATIOS

As of December 31 ($ in millions)

   2007     2006    2005    2004    2003

Average equity as a percent of average assets

   9.35 %   9.32    9.06    9.34    10.01

Tangible equity as a percent of tangible assets

   6.05     7.79    6.87    8.35    8.56

Tier I capital

   $8,924     8,625    8,209    8,522    8,168

Total risk-based capital

   11,733     11,385    10,240    10,176    9,992

Risk-weighted assets

   115,529     102,823    98,293    82,633    74,477

Regulatory capital ratios: