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

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-K

Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the fiscal year ended December 31, 2007

Commission file number 001-09718

THE PNC FINANCIAL SERVICES GROUP, INC.

(Exact name of registrant as specified in its charter)

 

   

Pennsylvania

      

25-1435979

   
  (State or other jurisdiction of incorporation or organization)      (I.R.S. Employer Identification No.)  

One PNC Plaza

249 Fifth Avenue

Pittsburgh, Pennsylvania 15222-2707

(Address of principal executive offices, including zip code)

Registrant’s telephone number, including area code - (412) 762-2000

Securities registered pursuant to Section 12(b) of the Act:

 

Title of Each Class

      

  Name of Each Exchange

    on Which Registered

    

Common Stock, par value $5.00

     New York Stock Exchange

$1.60 Cumulative Convertible Preferred Stock-Series C, par value $1.00

     New York Stock Exchange

$1.80 Cumulative Convertible Preferred Stock-Series D, par value $1.00

     New York Stock Exchange

Securities registered pursuant to Section 12(g) of the Act:

$1.80 Cumulative Convertible Preferred Stock - Series A, par value $1.00

$1.80 Cumulative Convertible Preferred Stock - Series B, par value $1.00

8.25% Convertible Subordinated Debentures Due 2008

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes X No     

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes      No X

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

Indicate by check mark if the disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.     

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

 

Large accelerated filer X   Accelerated filer        Non-accelerated filer     

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

The aggregate market value of the registrant’s outstanding voting common stock held by nonaffiliates on June 29, 2007, determined using the per share closing price on that date on the New York Stock Exchange of $71.58, was approximately $24.4 billion. There is no non-voting common equity of the registrant outstanding.

Number of shares of registrant's common stock outstanding at February 15, 2008: 340,774,529

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the definitive Proxy Statement of The PNC Financial Services Group, Inc. to be filed pursuant to Regulation 14A for the annual meeting of shareholders to be held on April 22, 2008 ("Proxy Statement") are incorporated by reference into Part III of this Form 10-K.


TABLE OF CONTENTS

 

PART I         Page  

Item 1

  Business.   2

Item 1A

  Risk Factors.   9

Item 1B

  Unresolved Staff Comments.   12

Item 2

  Properties.   12

Item 3

  Legal Proceedings.   12

Item 4

 

Submission of Matters to a Vote of Security Holders.

  14
  Executive Officers of the Registrant   14
  Directors of the Registrant   15

PART II

   

Item 5

 

Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.

  15
  Common Stock Performance Graph   16

Item 6

  Selected Financial Data.   17

Item 7

 

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

  19

Item 7A

 

Quantitative and Qualitative Disclosures About Market Risk.

  64

Item 8

 

Financial Statements and Supplementary Data.

  65

Item 9

 

Changes in and Disagreements With Accountants on Accounting and Financial Disclosure.

  123

Item 9A

  Controls and Procedures.   123

Item 9B

  Other Information.   123

PART III

   

Item 10

 

Directors, Executive Officers and Corporate Governance.

  123

Item 11

  Executive Compensation.   124

Item 12

 

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.

  124

Item 13

 

Certain Relationships and Related Transactions, and Director Independence.

  126

Item 14

 

Principal Accounting Fees and Services.

  126

PART IV

   

Item 15

 

Exhibits, Financial Statement Schedules.

  126

SIGNATURES

  127

EXHIBIT INDEX

  E-1

PART I

Forward-Looking Statements: From time to time, The PNC Financial Services Group, Inc. (“PNC” or the “Corporation”) has made and may continue to make written or oral forward-looking statements regarding our outlook or expectations for earnings, revenues, expenses, capital levels, asset quality or other future financial or business performance, strategies or expectations, or the impact of legal, regulatory or supervisory matters on our business operations or performance. This Annual Report on Form 10-K (the“Report” or “Form 10-K”) also includes forward-looking statements. With respect to all such forward-looking statements, you should review our Risk Factors discussion in Item 1A and our Risk Management, Critical Accounting Policies and Judgments, and Cautionary Statement Regarding Forward-Looking Information sections included in Item 7 of this Report.

 

ITEM 1 – BUSINESS

BUSINESS OVERVIEW We are one of the largest diversified financial services companies in the United States based on assets, with businesses engaged in retail banking, corporate and institutional banking, asset management and global fund processing services. We provide many of our products and services nationally and others in our primary geographic markets located in Pennsylvania, New Jersey, Washington, DC, Maryland, Virginia, Ohio, Kentucky and Delaware. We also provide certain global fund processing services internationally. At December 31, 2007, our consolidated total assets, deposits and shareholders' equity were $138.9 billion, $82.7 billion and $14.9 billion, respectively.

We were incorporated under the laws of the Commonwealth of Pennsylvania in 1983 with the consolidation of Pittsburgh National Corporation and Provident National Corporation. Since 1983, we have diversified our geographical presence, business mix and product capabilities through internal growth, strategic bank and non-bank acquisitions and equity investments, and the formation of various non-banking subsidiaries.

ACQUISITION AND DIVESTITURE ACTIVITY On December 7, 2007, we acquired Albridge Solutions Inc. (“Albridge”), a Lawrenceville, New Jersey-based provider of portfolio accounting and enterprise wealth management services. Albridge provides financial advisors with consolidated client account information from hundreds of data sources, and its enterprise approach to providing a unified client view and performance reporting helps advisors build their client and asset base. Albridge will extend PFPC’s capabilities into the delivery of knowledge-based information services through its relationships with 150 financial institutions and more than 100,000 financial advisors with assets under management that exceed $1 trillion.

Also on December 7, 2007, we acquired Coates Analytics, LP (“Coates Analytics”), a Chadds Ford, Pennsylvania-based provider of web-based analytic tools that help asset managers identify wholesaler territories and financial advisor targets, promote products in the marketplace and strengthen competitive intelligence. Coates Analytics will complement PFPC’s business strategy as it currently serves six of the 10 largest broker/dealers and provides market data to more than 40 of the leading asset management and fund companies.

On November 16, 2007, we entered into a definitive agreement to sell J.J.B. Hilliard, W.L.Lyons, Inc. (“Hilliard Lyons”), a wholly-owned subsidiary of PNC and a full-service brokerage and financial services provider, to Houchens Industries, Inc. Hilliard Lyons is headquartered in Louisville, Kentucky and has 76 branch offices mainly in cities outside of PNC’s retail banking footprint with approximately $29 billion of brokerage account assets and $5 billion of assets under management. As a result of the sale, we expect to report an after-tax gain of approximately $20 million and increase

Tier 1 regulatory capital by approximately $135 million after elimination of goodwill recorded upon the purchase of


 

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Hilliard Lyons in 1998. We expect this transaction to close in the first half of 2008, subject to regulatory and certain other required approvals.

On October 26, 2007, we acquired Hamilton, New Jersey-based Yardville National Bancorp (“Yardville”). Total consideration paid was approximately $399 million in stock and cash. Yardville’s subsidiary bank, The Yardville National Bank (“Yardville National Bank”), is a commercial and consumer bank and at closing had approximately $2.6 billion in assets, $2.0 billion in deposits and 35 branches in central New Jersey and eastern Pennsylvania. We plan to merge Yardville National Bank into PNC Bank, National Association (“PNC Bank, N.A.”) in the first quarter of 2008.

On July 19, 2007, we entered into a definitive agreement with Sterling Financial Corporation (“Sterling”) for PNC to acquire Sterling for approximately 4.5 million shares of PNC common stock and $224 million in cash. Sterling, based in Lancaster, Pennsylvania with approximately $3.2 billion in assets and $2.7 billion in deposits, provides banking and other financial services, including leasing, trust, investment and brokerage, to individuals and businesses through 67 branches in Pennsylvania, Maryland and Delaware. We expect this transaction to close in the second quarter of 2008, subject to customary closing conditions and the approval of Sterling’s shareholders.

On July 2, 2007, we acquired ARCS Commercial Mortgage Co., L.P. (“ARCS”), a Calabasas Hills, California-based lender with 10 origination offices in the United States. ARCS has been a leading originator and servicer of agency multifamily loans for the past decade. It originated more than $2.1 billion of loans in 2006 and services approximately $13 billion of commercial mortgage loans.

On March 2, 2007, we acquired Mercantile Bankshares Corporation (“Mercantile”). Total consideration paid was approximately $5.9 billion in stock and cash. Mercantile has added banking and investment and wealth management services through 235 branches in Maryland, Virginia, the District of Columbia, Delaware and southeastern Pennsylvania. This transaction has significantly expanded our presence in the mid-Atlantic region, particularly within the attractive Maryland, Northern Virginia and Washington, DC markets.

Our acquisition of Mercantile added approximately $21 billion of assets and $12.5 billion of deposits to our Consolidated Balance Sheet. Our Consolidated Income Statement includes the impact of Mercantile subsequent to our March 2, 2007 acquisition.

We include information on significant recent and pending acquisitions and divestitures in Note 2 Acquisitions and Divestitures in the Notes To Consolidated Financial Statements in Item 8 of this Report and here by reference.

REVIEW OF LINES OF BUSINESS In addition to the following information relating to our lines of business, we incorporate information under the captions Line of Business Highlights,

Product Revenue, Leases and Related Tax Matters, and Business Segments Review in Item 7 of this Report here by reference. Also, we include financial and other information by business in Note 26 Segment Reporting in the Notes To Consolidated Financial Statements in Item 8 of this Report here by reference. We have four major businesses engaged in providing banking, asset management and global fund processing products and services: Retail Banking; Corporate & Institutional Banking; BlackRock; and PFPC. Assets, revenue and earnings attributable to foreign activities were not material in the periods presented.

RETAIL BANKING

Retail Banking provides deposit, lending, brokerage, trust, investment management, and cash management services to approximately 2.9 million consumer and small business customers within our primary geographic markets. Our customers are serviced through over 1,100 offices in our branch network, the call center located in Pittsburgh and the Internet – www.pncbank.com. The branch network is located primarily in Pennsylvania, New Jersey, Washington, DC, Maryland, Virginia, Ohio, Kentucky and Delaware. Brokerage services are provided through PNC Investments, LLC, and Hilliard Lyons. See the Business Overview section of this Item 1 regarding our planned divestiture of Hilliard Lyons in the first half of 2008. Retail Banking also serves as investment manager and trustee for employee benefit plans and charitable and endowment assets and provides nondiscretionary defined contribution plan services. These services are provided to individuals and corporations primarily within our primary geographic markets.

Our core strategy is to acquire and retain customers who maintain their primary checking and transaction relationships with PNC. We also seek revenue growth by deepening our share of our customers’ financial assets and needs, including savings and liquidity deposits, loans and investable assets. A key element of our strategy is to continue to optimize our physical distribution network by opening and upgrading stand-alone and in-store branches in attractive sites while consolidating or selling branches with less opportunity for growth.

CORPORATE & INSTITUTIONAL BANKING

Corporate & Institutional Banking provides lending, treasury management, and capital markets-related products and services to mid-sized corporations, government entities, and selectively to large corporations. Lending products include secured and unsecured loans, letters of credit and equipment leases. Treasury management services include cash and investment management, receivables management, disbursement services, funds transfer services, information reporting, and global trade services. Capital markets-related products and services include foreign exchange, derivatives, loan syndications, mergers and acquisitions advisory and related services to middle-market companies, securities underwriting, and securities sales and trading. We also provide commercial loan servicing, real estate advisory and technology solutions for the commercial real estate finance industry. We provide products and services generally within


 

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our primary geographic markets, with certain products and services provided nationally.

Corporate & Institutional Banking is focused on becoming a premier provider of financial services in each of the markets it serves. Its value proposition to its customers is driven by providing a broad range of competitive and high quality products and services by a team fully committed to delivering the comprehensive resources of PNC to help each client succeed. Corporate & Institutional Banking’s primary goals are to achieve market share growth and enhanced returns by means of expansion and retention of customer relationships and prudent risk and expense management.

BLACKROCK

BlackRock, Inc. (“BlackRock”) is one of the largest publicly traded investment management firms in the United States with $1.357 trillion of assets under management at December 31, 2007. BlackRock manages assets on behalf of institutional and individual investors worldwide through a variety of fixed income, cash management, equity and balanced and alternative investment separate accounts and funds. In addition, BlackRock provides risk management, investment system outsourcing and financial advisory services globally to institutional investors.

At December 31, 2007, our ownership interest in BlackRock was approximately 33.5%. Our investment in BlackRock is a strategic asset of PNC and a key component of our diversified earnings stream. The ability of BlackRock to grow assets under management is the key driver of increases in its revenue, earnings and, ultimately, shareholder value. BlackRock’s strategies for growth in assets under management include a focus on achieving client investment performance objectives in a manner consistent with their risk preferences and delivering excellent client service. The business dedicates significant resources to attracting and retaining talented professionals and to the ongoing enhancement of its investment technology and operating capabilities to deliver on its strategy.

PFPC

PFPC is a leading full service provider of processing, technology and business solutions for the global investment industry. Securities services include custody, securities lending, and accounting and administration for funds registered under the 1940 Act and alternative investments. Investor services include transfer agency, managed accounts, subaccounting, and distribution. We serviced $2.5 trillion in total fund assets and 72 million shareholder accounts as of December 31, 2007 both domestically and internationally.

PFPC’s international and domestic capabilities were expanded during 2007. We received approval for a banking license in Ireland and a branch in Luxembourg, which will allow PFPC to provide depositary services in Europe’s leading domicile for traditional investment funds and the second largest

worldwide domicile after the United States. The opening of a sales office in London supported this initiative. The acquisition of Albridge and Coates Analytics in December 2007 will enhance our business model and product offerings with the delivery of information services to asset managers, financial advisors, and the distribution channel to help them better service their respective target markets.

PFPC focuses technological resources on driving efficiency through streamlining operations and developing flexible systems architecture and client-focused servicing solutions.

SUBSIDIARIES Our corporate legal structure at December 31, 2007 consisted of three subsidiary banks, including their subsidiaries, and approximately 67 active non-bank subsidiaries. PNC Bank, N.A., headquartered in Pittsburgh, Pennsylvania, is our principal bank subsidiary. At December 31, 2007, PNC Bank, N.A. had total consolidated assets representing approximately 90% of our consolidated assets. Our other bank subsidiaries are PNC Bank, Delaware and Yardville National Bank. Our non-bank PFPC subsidiary has obtained a banking license in Ireland and a branch in Luxembourg, which allow PFPC to provide depositary services as part of its business. For additional information on our subsidiaries, you may review Exhibit 21 to this Report.

STATISTICAL DISCLOSURE BY BANK HOLDING COMPANIES The following statistical information is included on the indicated pages of this Report and is incorporated herein by reference:

 

Form 10-K page

Average Consolidated Balance Sheet And Net Interest Analysis

   119

Analysis Of Year-To-Year Changes In Net Interest Income

   118

Book Values Of Securities

   26 and 84-86

Maturities And Weighted-Average Yield Of Securities

   86

Loan Types

   25, 87 and 120

Selected Loan Maturities And Interest Sensitivity

   122

Nonaccrual, Past Due And Restructured Loans And Other Nonperforming Assets

   47-48, 74, 89 and 120

Potential Problem Loans And Loans Held For Sale

   27 and 47-48

Summary Of Loan Loss Experience

   48-49 and 121

Assignment Of Allowance For Loan And Lease Losses

   48-49 and 121

Average Amount And Average Rate Paid On Deposits

   119

Time Deposits Of $100,000 Or More

   91 and 122

Selected Consolidated Financial Data

   17-18

SUPERVISION AND REGULATION

OVERVIEW

PNC is a bank holding company registered under the Bank Holding Company Act of 1956 as amended (“BHC Act”) and a financial holding company under the Gramm-Leach-Bliley Act (“GLB Act”).

We are subject to numerous governmental regulations, some of which are highlighted below. You should also read Note 22 Regulatory Matters in the Notes To Consolidated Financial Statements in Item 8 of this Report, included here by reference,


 

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for additional information regarding our regulatory issues. Applicable laws and regulations restrict permissible activities and investments and require compliance with protections for loan, deposit, brokerage, fiduciary, mutual fund and other customers, among other things. They also restrict our ability to repurchase stock or to receive dividends from bank subsidiaries and impose capital adequacy requirements. The consequences of noncompliance can include substantial monetary and nonmonetary sanctions.

In addition, we are subject to comprehensive examination and supervision by, among other regulatory bodies, the Board of Governors of the Federal Reserve System (“Federal Reserve”) and the Office of the Comptroller of the Currency (“OCC”). We are subject to examination by these regulators, which results in examination reports and ratings (which are not publicly available) that can impact the conduct and growth of our businesses. These examinations consider not only compliance with applicable laws and regulations, but also capital levels, asset quality and risk, management ability and performance, earnings, liquidity, and various other factors. An examination downgrade by any of our federal bank regulators potentially can result in the imposition of significant limitations on our activities and growth. These regulatory agencies generally have broad discretion to impose restrictions and limitations on the operations of a regulated entity where the agencies determine, among other things, that such operations are unsafe or unsound, fail to comply with applicable law or are otherwise inconsistent with laws and regulations or with the supervisory policies of these agencies. This supervisory framework could materially impact the conduct, growth and profitability of our operations. We are also subject to regulation by the Securities and Exchange Commission (“SEC”) by virtue of our status as a public company and due to the nature of some of our businesses.

As a regulated financial services firm, our relationships and good standing with regulators are of fundamental importance to the continuation and growth of our businesses. The Federal Reserve, OCC, SEC, and other domestic and foreign regulators have broad enforcement powers, and powers to approve, deny, or refuse to act upon our applications or notices to conduct new activities, acquire or divest businesses or assets, or reconfigure existing operations.

Over the last several years, there has been an increasing regulatory focus on compliance with anti-money laundering laws and regulations, resulting in, among other things, several significant publicly announced enforcement actions. There has also been a heightened focus recently on the protection of confidential customer information.

There are numerous rules governing the regulation of financial services institutions and their holding companies. Accordingly, the following discussion is general in nature and does not purport to be complete or to describe all of the laws and regulations that apply to us.

 

BANK REGULATION

As a bank holding company and a financial holding company, we are subject to supervision and regular inspection by the Federal Reserve. Our subsidiary banks and their subsidiaries are subject to supervision and examination by applicable federal and state banking agencies, principally the OCC with respect to PNC Bank, N.A. and Yardville National Bank, and the Federal Reserve Bank of Cleveland and the Office of the State Bank Commissioner of Delaware with respect to PNC Bank, Delaware.

Notwithstanding PNC’s reduced ownership interest in BlackRock and the deconsolidation resulting from the BlackRock/MLIM transaction (described in Note 2 Acquisitions and Divestitures in the Notes To Consolidated Financial Statements in Item 8 of this Report), BlackRock continues to be subject to the supervision and regulation of the Federal Reserve to the same extent as it was prior to the transaction.

Parent Company Liquidity and Dividends.  The principal source of our liquidity at the parent company level is dividends from PNC Bank, N.A. Our subsidiary banks are subject to various federal and state restrictions on their ability to pay dividends to PNC Bancorp, Inc., the direct parent of the subsidiary banks, which in turn may affect the ability of PNC Bancorp, Inc. to pay dividends to PNC at the parent company level. As noted below, we expect to merge Yardville National Bank into PNC Bank, N.A., in the first quarter of 2008. Our subsidiary banks are also subject to federal laws limiting extensions of credit to their parent holding company and non-bank affiliates as discussed in Note 22 Regulatory Matters included in the Notes To Consolidated Financial Statements in Item 8 of this Report, which is incorporated herein by reference. Further information on bank level liquidity and parent company liquidity and on certain contractual restrictions is also available in the Liquidity Risk Management section and in the “Perpetual Trust Securities” and “Acquired Entity Trust Preferred Securities” sections of the Off-Balance Sheet Arrangements and VIEs section of Item 7 of this Report.

Under Federal Reserve policy, a bank holding company is expected to act as a source of financial strength to each of its subsidiary banks and to commit resources to support each such bank. Consistent with the “source of strength” policy for subsidiary banks, the Federal Reserve has stated that, as a matter of prudent banking, a bank holding company generally should not maintain a rate of cash dividends unless its net income available to common shareholders has been sufficient to fully fund the dividends and the prospective rate of earnings retention appears to be consistent with the corporation's capital needs, asset quality and overall financial condition. This policy does not currently have a negative impact on PNC’s ability to pay dividends at our current level.

Additional Powers Under the GLB Act.  The GLB Act permits a qualifying bank holding company to become a “financial holding company” and thereby to affiliate with financial


 

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companies engaging in a broader range of activities than would otherwise be permitted for a bank holding company. Permitted affiliates include securities underwriters and dealers, insurance companies and companies engaged in other activities that are determined by the Federal Reserve, in consultation with the Secretary of the Treasury, to be “financial in nature or incidental thereto” or are determined by the Federal Reserve unilaterally to be “complementary” to financial activities. We became a financial holding company as of March 13, 2000.

The Federal Reserve is the “umbrella” regulator of a financial holding company, with its operating entities, such as its subsidiary broker-dealers, investment managers, investment companies, insurance companies and banks, also subject to the jurisdiction of various federal and state “functional” regulators with normal regulatory responsibility for companies in their lines of business.

As subsidiaries of a financial holding company under the GLB Act, our non-bank subsidiaries are allowed to conduct new financial activities or acquire non-bank financial companies with after-the-fact notice to the Federal Reserve. In addition, our non-bank subsidiaries (and any financial subsidiaries of subsidiary banks) are now permitted to engage in certain activities that were not permitted for banks and bank holding companies prior to enactment of the GLB Act, and to engage on less restrictive terms in certain activities that were previously permitted. Among other activities, we currently rely on our status as a financial holding company to conduct mutual fund distribution activities, merchant banking activities, and underwriting and dealing activities.

To continue to qualify for financial holding company status, our domestic subsidiary banks must maintain “well capitalized” capital ratios, examination ratings of “1” or “2” (on a scale of 1 to 5), and certain other criteria that are incorporated into the definition of “well managed” under the BHC Act and Federal Reserve rules. If we were to no longer qualify for this status, we could not continue to enjoy the after-the-fact notice process for new non-banking activities and non-banking acquisitions, and would be required promptly to enter into an agreement with the Federal Reserve providing a plan for our subsidiary banks to meet the “well capitalized” and “well managed” criteria. The Federal Reserve would have broad authority to limit our activities. Failure to satisfy the criteria within a six-month period could result in a requirement that we conform existing non-banking activities to activities that were permissible prior to the enactment of the GLB Act. If a subsidiary bank failed to maintain a “satisfactory” or better rating under the Community Reinvestment Act of 1977, as amended (“CRA”), we could not commence new activities or make new investments in reliance on the GLB Act.

In addition, the GLB Act permits a national bank, such as PNC Bank, N.A., to engage in expanded activities through the formation of a “financial subsidiary.” In order to qualify to

establish or acquire a financial subsidiary, PNC Bank, N.A. and each of its depository institution affiliates must be “well capitalized” and “well managed” and may not have a less than “satisfactory” CRA rating. A national bank that is one of the largest 50 insured banks in the United States, such as PNC Bank, N.A., must also have issued debt (which, for this purpose, may include the uninsured portion of PNC Bank, N.A.’s long-term certificates of deposit) with certain minimum ratings. PNC Bank, N.A. has filed a financial subsidiary certification with the OCC and currently engages in insurance agency activities through a financial subsidiary. PNC Bank, N.A. may also generally engage through a financial subsidiary in any activity that is financial in nature or incidental to a financial activity. Certain activities, however, are impermissible for a financial subsidiary of a national bank, including insurance underwriting, insurance investments, real estate investment or development, and merchant banking.

If one of our domestic subsidiary banks were to fail to meet the “well capitalized” or “well managed” and related criteria, PNC Bank, N.A. would be required to enter into an agreement with the OCC to correct the condition. The OCC would have the authority to limit the activities of the bank. If the condition were not corrected within six months or within any additional time granted by the OCC, PNC Bank, N.A. could be required to conform the activities of any of its financial subsidiaries to activities in which a national bank could engage directly. In addition, if the bank or any insured depository institution affiliate receives a less than satisfactory CRA examination rating, PNC Bank, N.A. would not be permitted to engage in any new activities or to make new investments in reliance on the financial subsidiary authority.

Other Federal Reserve and OCC Regulation.  The federal banking agencies possess broad powers to take corrective action as deemed appropriate for an insured depository institution and its holding company. The extent of these powers depends upon whether the institution in question is considered “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” or “critically undercapitalized.” Generally, the smaller an institution’s capital base in relation to its risk-weighted assets, the greater the scope and severity of the agencies’ powers, ultimately permitting the agencies to appoint a receiver for the institution. Business activities may also be influenced by an institution’s capital classification. For instance, only a “well capitalized” depository institution may accept brokered deposits without prior regulatory approval and an “adequately capitalized” depository institution may accept brokered deposits only with prior regulatory approval. At December 31, 2007, each of our domestic subsidiary banks exceeded the required ratios for classification as “well capitalized.” For additional discussion of capital adequacy requirements, we refer you to “Funding and Capital Sources” in the Consolidated Balance Sheet Review section of Item 7 of this Report and to Note 22 Regulatory Matters included in the Notes To Consolidated Financial Statements in Item 8 of this Report.


 

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Laws and regulations limit the scope of our permitted activities and investments. In addition to the activities that would be permitted to be conducted by a financial subsidiary, national banks (such as PNC Bank, N.A.) and their operating subsidiaries may engage in any activities that are determined by the OCC to be part of or incidental to the business of banking.

Moreover, examination ratings of “3” or lower, lower capital ratios than peer group institutions, regulatory concerns regarding management, controls, assets, operations or other factors, can all potentially result in practical limitations on the ability of a bank or bank holding company to engage in new activities, grow, acquire new businesses, repurchase its stock or pay dividends, or to continue to conduct existing activities.

The Federal Reserve’s prior approval is required whenever we propose to acquire all or substantially all of the assets of any bank or thrift, to acquire direct or indirect ownership or control of more than 5% of the voting shares of any bank or thrift, or to merge or consolidate with any other bank holding company or thrift holding company. When reviewing bank acquisition applications for approval, the Federal Reserve considers, among other things, each subsidiary bank’s record in meeting the credit needs of the communities it serves in accordance with the CRA. Our ability to grow through acquisitions could be limited by these approval requirements.

At December 31, 2007, PNC Bank, N.A. and PNC Bank, Delaware, were rated “outstanding” and Yardville National Bank was rated “satisfactory” with respect to CRA.

FDIC Insurance.  All three of our domestic subsidiary banks are insured by the FDIC and subject to premium assessments. Regulatory matters could increase the cost of FDIC deposit insurance premiums to an insured bank. Since 1996, the FDIC had not assessed banks in the most favorable capital and assessment risk classification categories for insurance premiums for most deposits, due to the favorable ratio of the assets in the FDIC’s deposit insurance funds to the aggregate level of insured deposits outstanding. This resulted in significant cost savings to all insured banks. Deposit insurance premiums are assessed as a percentage of the deposits of the insured institution.

Beginning January 1, 2007, the FDIC reinstituted the assessment premiums for all deposits, which could impose a significant cost to all insured banks, including our subsidiary banks, reducing the net spread between deposit and other bank funding costs and the earnings from assets and services of the bank, and thus the net income of the bank. Because of a one-time assessment credit based on deposit premiums that the subsidiary banks of PNC had paid prior to 1996, the deposit insurance assessment for PNC’s subsidiary banks should be substantially offset through 2008.

FDIC deposit insurance premiums are “risk based”; therefore, higher fee percentages would be charged to banks that have lower capital ratios or higher risk profiles. These risk profiles take into account weaknesses that are found by the primary banking regulator through its examination and supervision of

the bank. A negative evaluation by the FDIC or a bank’s primary federal banking regulator could increase the costs to a bank and result in an aggregate cost of deposit funds higher than that of competing banks in a lower risk category. Our subsidiary banks are subject to “cross-guarantee” provisions under federal law that provide that if one of these banks fails or requires FDIC assistance, the FDIC may assess a “commonly-controlled” bank for the estimated losses suffered by the FDIC. Such liability could have a material adverse effect on our financial condition or that of the assessed bank. While the FDIC's claim is junior to the claims of depositors, holders of secured liabilities, general creditors and subordinated creditors, it is superior to the claims of the bank’s shareholders and affiliates, including PNC and intermediate bank holding companies.

SECURITIES AND RELATED REGULATION

The SEC, together with either the OCC or the Federal Reserve, regulates our registered broker-dealer subsidiaries. These subsidiaries are also subject to rules and regulations promulgated by the Financial Industry Regulatory Authority (“FINRA”), among others. Hilliard Lyons is also a member of the New York Stock Exchange and various regional and national exchanges whose members are subject to regulation and supervision.

Several of our subsidiaries are registered with the SEC as investment advisers and, therefore, are subject to the requirements of the Investment Advisers Act of 1940, as amended, and the SEC's regulations thereunder. The principal purpose of the regulations applicable to investment advisers is the protection of clients and the securities markets, rather than the protection of creditors and shareholders of investment advisors. The regulations applicable to investment advisers cover all aspects of the investment advisory business, including limitations on the ability of investment advisers to charge performance-based or non-refundable fees to clients; record-keeping; operational, marketing and reporting requirements; disclosure requirements; limitations on principal transactions between an adviser or its affiliates and advisory clients; as well as general anti-fraud prohibitions. These investment advisory subsidiaries also may be subject to state securities laws and regulations. In addition, our investment advisory subsidiaries that are investment advisors to registered investment companies and other managed accounts are subject to the requirements of the Investment Company Act of 1940, as amended, and the SEC’s regulations thereunder. PFPC is subject to regulation by the SEC as a service provider to registered investment companies.

Additional legislation, changes in rules promulgated by the SEC, other federal and state regulatory authorities and self- regulatory organizations, or changes in the interpretation or enforcement of existing laws and rules may directly affect the method of operation and profitability of investment advisers. The profitability of investment advisers could also be affected by rules and regulations that impact the business and financial communities in general, including changes to the laws


 

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governing taxation, antitrust regulation and electronic commerce.

Over the past several years, the SEC and other governmental agencies have been investigating the mutual fund industry, including PFPC and other service providers. The SEC has adopted and proposed various rules, and legislation has been introduced in Congress, intended to reform the regulation of this industry. The effect of regulatory reform has, and is likely to continue to, increase the extent of regulation of the mutual fund industry and impose additional compliance obligations and costs on our subsidiaries involved with that industry.

Under provisions of the federal securities laws applicable to broker-dealers, investment advisers and registered investment companies and their service providers, a determination by a court or regulatory agency that certain violations have occurred at a company or its affiliates can result in fines, restitution, a limitation of permitted activities, disqualification to continue to conduct certain activities and an inability to rely on certain favorable exemptions. Certain types of infractions and violations can also affect a public company in its timing and ability to expeditiously issue new securities into the capital markets. In addition, expansion of activities of a broker-dealer generally requires approval of FINRA and regulators may take into account a variety of considerations in acting upon such applications, including internal controls, capital, management experience and quality, and supervisory concerns.

PFPC and BlackRock are also subject to regulation by appropriate authorities in the foreign jurisdictions in which they do business.

BlackRock has subsidiaries in securities and related businesses subject to SEC and FINRA regulation, as described above. For additional information about the regulation of BlackRock, we refer you to the discussion under the “Regulation” section of Item 1 Business in BlackRock’s most recent Annual Report on Form 10-K, which may be obtained electronically at the SEC’s website at www.sec.gov.

COMPETITION We are subject to intense competition from various financial institutions and from non-bank entities that engage in similar activities without being subject to bank regulatory supervision and restrictions.

In making loans, our subsidiary banks compete with traditional banking institutions as well as consumer finance companies, leasing companies and other non-bank lenders, and institutional investors including CLO managers, hedge funds, mutual fund complexes and private equity firms. Loan pricing, structure and credit standards are under competitive pressure as lenders seek to deploy capital and a broad range of borrowers have access to capital markets. Traditional deposit activities are subject to pricing pressures and customer migration as a result of intense competition for consumer investment dollars.

 

Our subsidiary banks compete for deposits with the following:

   

Other commercial banks,

   

Savings banks,

   

Savings and loan associations,

   

Credit unions,

   

Treasury management service companies,

   

Insurance companies, and

   

Issuers of commercial paper and other securities, including mutual funds.

Our various non-bank businesses engaged in investment banking and private equity activities compete with the following:

   

Commercial banks,

   

Investment banking firms,

   

Merchant banks,

   

Insurance companies,

   

Private equity firms, and

   

Other investment vehicles.

In providing asset management services, our businesses compete with the following:

   

Investment management firms,

   

Large banks and other financial institutions,

   

Brokerage firms,

   

Mutual fund complexes, and

   

Insurance companies.

The fund servicing business is also highly competitive, with a relatively small number of providers. Merger, acquisition and consolidation activity in the financial services industry has also impacted the number of existing or potential fund servicing clients and has intensified competition.

We include here by reference the additional information regarding competition included in the Item 1A Risk Factors section of this Report.

EMPLOYEES Period-end employees totaled 28,320 at December 31, 2007 (comprised of 25,480 full-time and 2,840 part-time employees).

SEC REPORTS AND CORPORATE GOVERNANCE INFORMATION

We are subject to the informational requirements of the Securities Exchange Act of 1934, as amended (“Exchange Act”), and, in accordance with the Exchange Act, we file annual, quarterly and current reports, proxy statements, and other information with the SEC. Our SEC File Number is 001-09718. You may read and copy this information at the SEC’s Public Reference Room located at 100 F Street NE, Room 1580, Washington, D.C. 20549. You can obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330.

You can also obtain copies of this information by mail from the Public Reference Section of the SEC, 100 F Street, NE, Washington, D.C. 20549, at prescribed rates.


 

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The SEC also maintains an internet World Wide Web site that contains reports, proxy and information statements, and other information about issuers, like us, who file electronically with the SEC. The address of that site is www.sec.gov. You can also inspect reports, proxy statements and other information about us at the offices of the New York Stock Exchange, 20 Broad Street, New York, New York 10005.

We also make our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to those reports filed or furnished to the SEC pursuant to Section 13(a) or 15(d) of the Exchange Act available free of charge on or through our internet website as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC. PNC’s corporate internet address is www.pnc.com and you can find this information at www.pnc.com/secfilings. Shareholders and bondholders may also obtain copies of these filings without charge by contacting Shareholder Services at 800-982-7652 or via e-mail at web.queries@computershare.com for copies without exhibits, or by contacting Shareholder Relations at (800) 843-2206 or via e-mail at investor.relations@pnc.com for copies of exhibits. We filed the certifications of our Chairman and Chief Executive Officer and our Chief Financial Officer required pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 with respect to our Annual Report on Form 10-K for 2006 and both amendments thereto with the SEC as exhibits to that report and have filed the CEO and CFO certifications required by Section 302 of that Act with respect to this Form 10-K as exhibits to this Report.

Information about our Board and its committees and corporate governance at PNC is available on PNC’s corporate website at www.pnc.com/corporategovernance. Shareholders who would like to request printed copies of the PNC Code of Business Conduct and Ethics or our Corporate Governance Guidelines or the charters of our Board’s Audit, Nominating and Governance, or Personnel and Compensation Committees (all of which are posted on the PNC corporate website) may do so by sending their requests to George P. Long, III, Corporate Secretary, at corporate headquarters at One PNC Plaza, 249 Fifth Avenue, Pittsburgh, Pennsylvania 15222-2707. Copies will be provided without charge to shareholders.

Our common stock is listed on the New York Stock Exchange (“NYSE”) under the symbol “PNC.” Our Chairman and Chief Executive Officer submitted the required annual CEO’s Certification regarding the NYSE’s corporate governance listing standards (a Section 12(a) CEO Certification) to the NYSE within 30 days after our 2007 annual shareholders meeting.

ITEM 1ARISK FACTORS

We are subject to a number of risks potentially impacting our business, financial condition, results of operations and cash flows. Indeed, as a financial services organization, certain elements of risk are inherent in every one of our transactions and are presented by every business decision we make. Thus, we encounter risk as part of the normal course of our business, and we design risk management processes to help manage these risks.

 

There are risks that are known to exist at the outset of a transaction. For example, every loan transaction presents credit risk (the risk that the borrower may not perform in accordance with contractual terms) and interest rate risk (a potential loss in earnings or economic value due to adverse movement in market interest rates or credit spreads), with the nature and extent of these risks principally depending on the identity of the borrower and overall economic conditions. These risks are inherent in every loan transaction; if we wish to make loans, we must manage these risks through the terms and structure of the loans and through management of our deposits and other funding sources. The success of our business is dependent on our ability to identify, understand and manage the risks presented by our business activities so that we can balance appropriately revenue generation and profitability with these inherent risks. We discuss our principal risk management processes and, in appropriate places, related historical performance in the Risk Management section included in Item 7 of this Report.

The following are the key risk factors that affect us. These risk factors and other risks are also discussed further in other parts of this Report.

A sustained weakness or weakening in business and economic conditions generally or specifically in the principal markets in which we do business could adversely affect our business and operating results.

PNC’s business could be adversely affected to the extent that weaknesses in business and economic conditions have direct or indirect impacts on us or on our customers and counterparties. These conditions could lead, for example, to one or more of the following:

 

   

A decrease in the demand for loans and other products and services offered by us;

   

A decrease in the value of our loans held for sale;

   

A decrease in the usage of unfunded commitments;

   

A decrease in customer savings generally and in the demand for savings and investment products offered by us; and

   

An increase in the number of customers and counterparties who become delinquent, file for protection under bankruptcy laws, or default on their loans or other obligations to us. An increase in the number of delinquencies, bankruptcies or defaults could result in a higher level of nonperforming assets, net charge-offs, provision for credit losses, and valuation adjustments on loans held for sale.

Although many of our businesses are national and some are international in scope, our retail banking business is concentrated within our retail branch network footprint (Delaware, Indiana, Kentucky, New Jersey, Ohio, Pennsylvania, Washington, D.C., Maryland and Virginia), and thus that business is particularly vulnerable to adverse changes in economic conditions in these regions.


 

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Changes in interest rates, in the shape of the yield curve, in valuations in the debt or equity markets, or disruptions in the liquidity or other functioning of financial markets could directly impact our assets and liabilities and our performance.

Given our business mix, our traditional banking activities of gathering deposits and extending loans, and the fact that most of our assets and liabilities are financial in nature, we tend to be particularly sensitive to market interest rate movement and the performance of the financial markets. Starting in the middle of 2007, there has been significant turmoil and volatility in worldwide financial markets which is, at present, ongoing. These conditions have resulted in increased liquidity risk. In addition to the impact on the economy generally, with some of the potential effects outlined above, changes in interest rates, in the shape of the yield curve, or in valuations in the debt or equity markets or disruptions in the liquidity or other functioning of financial markets, all of which have been seen recently, could directly impact us in one or more of the following ways:

 

   

Such situations could affect the difference between the interest that we earn on assets and the interest that we pay on liabilities, as well as the value of some or all of our on-balance sheet and off-balance sheet financial instruments or the value of equity investments that we hold or of our equity funding obligations;

   

Such situations could affect the ability of borrowers to repay their loans or other counterparties to meet their obligations, and thus could directly or indirectly increase the credit risk associated with some of our financial transactions;

   

Such situations could adversely affect the operation of our businesses, including by impacting the nature, profitability or risk profile of the financial transactions in which we engage;

   

To the extent to which we access capital markets to raise funds to support our business and overall liquidity position, such situations could affect the cost of such funds or our ability to raise such funds; and

   

Such situations could affect the value of the assets that we manage or otherwise administer for others or the assets for which we provide processing and information services. Although we are not directly impacted by changes in the value of assets that we manage or administer for others or for which we provide processing and information services, decreases in the value of those assets would affect our fee income relating to those assets and could result in decreased demand for our services.

Among the situations that could have one or more of the preceding impacts are (1) ongoing volatility in the markets for real estate and other assets commonly securing financial products, as well as in the markets for such financial products, and (2) changes in the availability of insurance providing

credit enhancement with respect to financial products or in the ratings of the companies providing such insurance.

As a result of the high percentage of our assets and liabilities that are in the form of interest-bearing instruments, the monetary, tax and other policies of the government and its agencies, including the Federal Reserve, which have a significant impact on interest rates and overall financial market performance, can affect the activities and results of operations of bank holding companies and their subsidiaries, such as PNC and our subsidiaries. An important function of the Federal Reserve is to regulate the national supply of bank credit and market interest rates. The actions of the Federal Reserve influence the rates of interest that we charge on loans and that we pay on borrowings and interest-bearing deposits and can also affect the value of our on-balance sheet and off-balance sheet financial instruments. Both due to the impact on rates and by controlling access to direct funding from the Federal Reserve Banks, the Federal Reserve’s policies also influence, to a significant extent, our cost of funding. We cannot predict the nature or timing of future changes in monetary, tax and other policies or the effect that they may have on our activities and results of operations.

We operate in a highly competitive environment, both in terms of the products and services we offer, the geographic markets in which we conduct business, as well as our labor markets and competition for talented employees. Competition could adversely impact our customer acquisition, growth and retention, as well as our credit spreads and product pricing, causing us to lose market share and deposits and revenues.

We are subject to intense competition from various financial institutions and from non-bank entities that engage in similar activities without being subject to bank regulatory supervision and restrictions. This competition is described in Item 1 under “Competition.”

In all, the principal bases for competition are pricing (including the interest rates charged on loans or paid on interest-bearing deposits), structure, the range of products and services offered, and the quality of customer service (including convenience and responsiveness to customer needs and concerns). The ability to access and use technology is an increasingly important competitive factor in the financial services industry. Technology is important not only with respect to delivery of financial services but also in processing information. Each of our businesses consistently must make significant technological investments to remain competitive.

A failure to address adequately the competitive pressures we face could make it harder for us to attract and retain customers across our businesses. On the other hand, meeting these competitive pressures could require us to incur significant additional expenses or to accept risk beyond what we would otherwise view as desirable under the circumstances. In addition, in our interest sensitive businesses, pressures to increase rates on deposits or decrease rates on loans could


 

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reduce our net interest margin with a resulting negative impact on our net interest income. Any of these results would likely have an adverse effect on our overall financial performance.

We grow our business in part by acquiring from time to time other financial services companies, and these acquisitions present us with a number of risks and uncertainties related both to the acquisition transactions themselves and to the integration of the acquired businesses into PNC after closing.

Acquisitions of other financial services companies in general present risks to PNC in addition to those presented by the nature of the business acquired. In particular, acquisitions may be substantially more expensive to complete (including as a result of costs incurred in connection with the integration of the acquired company) and the anticipated benefits (including anticipated cost savings and strategic gains) may be significantly harder or take longer to achieve than expected. In some cases, acquisitions involve our entry into new businesses or new geographic or other markets, and these situations also present risks resulting from our inexperience in these new areas. As a regulated financial institution, our pursuit of attractive acquisition opportunities could be negatively impacted due to regulatory delays or other regulatory issues. Regulatory and/or legal issues relating to the pre-acquisition operations of an acquired business may cause reputational harm to PNC following the acquisition and integration of the acquired business into ours and may result in additional future costs arising as a result of those issues.

Our pending acquisition of Sterling presents many of the risks and uncertainties related to acquisition transactions themselves and to the integration of the acquired businesses into PNC after closing described above. Sterling presents regulatory and litigation risk as a result of financial irregularities at Sterling’s commercial finance subsidiary.

The performance of our asset management businesses may be adversely affected by the relative performance of our products compared with alternative investments.

Asset management revenue is primarily based on a percentage of the value of assets under management and, in some cases, performance fees, in most cases expressed as a percentage of the returns realized on assets under management, and thus is impacted by general changes in capital markets valuations and customer preferences. In addition, investment performance is an important factor influencing the level of assets under management. Poor investment performance could impair revenue and growth as existing clients might withdraw funds in favor of better performing products. Also, performance fees could be lower or nonexistent. Additionally, the ability to attract funds from existing and new clients might diminish.

The performance of our fund servicing business may be adversely affected by changes in investor preferences, or changes in existing or potential fund servicing clients or alternative providers.

 

Fund servicing fees are primarily derived from the market value of the assets and the number of shareholder accounts that we administer for our clients. The performance of our fund processing business is thus partially dependent on the underlying performance of its fund clients and, in particular, their ability to attract and retain customers. Changes in interest rates or a sustained weakness, weakening or volatility in the debt and equity markets could (in addition to affecting directly the value of assets administered as discussed above) influence an investor’s decision to invest or maintain an investment in a particular mutual fund or other pooled investment product. Other factors beyond our control may impact the ability of our fund clients to attract or retain customers or customer funds, including changes in preferences as to certain investment styles. Further, to the extent that our fund clients’ businesses are adversely affected by ongoing governmental investigations into the practices of the mutual and hedge fund industries, our fund processing business’ results also could be adversely impacted. As a result of these types of factors, fluctuations may occur in the level or value of assets for which we provide processing services. In addition, this regulatory and business environment is likely to continue to result in operating margin pressure for our various services.

As a regulated financial services firm, we are subject to numerous governmental regulations and to comprehensive examination and supervision by regulators, which affects our business as well as our competitive position.

PNC is a bank and financial holding company and is subject to numerous governmental regulations involving both its business and organization. Our businesses are subject to regulation by multiple bank regulatory bodies as well as multiple securities industry regulators. Applicable laws and regulations restrict our ability to repurchase stock or to receive dividends from bank subsidiaries and impose capital adequacy requirements. They also restrict permissible activities and investments and require compliance with protections for loan, deposit, brokerage, fiduciary, mutual fund and other customers, and for the protection of customer information, among other things. The consequences of noncompliance can include substantial monetary and nonmonetary sanctions as well as damage to our reputation and business.

In addition, we are subject to comprehensive examination and supervision by banking and other regulatory bodies. Examination reports and ratings (which often are not publicly available) and other aspects of this supervisory framework can materially impact the conduct, growth, and profitability of our businesses.

We discuss these and other regulatory issues applicable to PNC in the Supervision and Regulation section included in Item 1 of this Report and in Note 22 Regulatory Matters in the Notes To Consolidated Financial Statements in Item 8 of this Report and here by reference.

Over the last several years, there has been an increasing regulatory focus on compliance with anti-money laundering


 

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laws and regulations, resulting in, among other things, several significant publicly-announced enforcement actions. There has also been a heightened focus recently, by customers and the media as well as by regulators, on the protection of confidential customer information. A failure to have adequate procedures to comply with anti-money laundering laws and regulations or to protect the confidentiality of customer information could expose us to damages, fines and regulatory penalties, which could be significant, and could also injure our reputation with customers and others with whom we do business.

We must comply with generally accepted accounting principles established by the Financial Accounting Standards Board, rules set forth by the SEC, income tax regulations established by the Department of the Treasury, and revenue rulings and other guidance issued by the Internal Revenue Service, which affect our financial condition and results of operations.

Changes in accounting standards, or interpretations of those standards, can impact our revenue recognition and expense policies and affect our estimation methods used to prepare the consolidated financial statements. Changes in income tax regulations, revenue rulings, revenue procedures, and other guidance can impact our tax liability and alter the timing of cash flows associated with tax deductions and payments. New guidance often dictates how changes to standards and regulations are to be presented in our consolidated financial statements, as either an adjustment to beginning retained earnings for the period or as income or expense in current period earnings. Certain changes may also be required to be applied retrospectively.

Our business and financial performance could be adversely affected, directly or indirectly, by natural disasters, by terrorist activities or by international hostilities.

The impact of natural disasters, terrorist activities and international hostilities cannot be predicted with respect to severity or duration. However, any of these could impact us directly (for example, by causing significant damage to our facilities or preventing us from conducting our business in the ordinary course), or could impact us indirectly through a direct impact on our borrowers, depositors, other customers, suppliers or other counterparties. We could also suffer adverse consequences to the extent that natural disasters, terrorist activities or international hostilities affect the economy and capital and other financial markets generally. These types of impacts could lead, for example, to an increase in delinquencies, bankruptcies or defaults that could result in our experiencing higher levels of nonperforming assets, net charge-offs and provisions for credit losses.

Our ability to mitigate the adverse consequences of such occurrences is in part dependent on the quality of our resiliency planning, including our ability to anticipate the nature of any such event that occurs. The adverse impact of natural disasters or terrorist activities or international hostilities also could be

increased to the extent that there is a lack of preparedness on the part of national or regional emergency responders or on the part of other organizations and businesses that we deal with, particularly those that we depend upon.

ITEM 1BUNRESOLVED STAFF COMMENTS

There are no SEC staff comments regarding PNC’s periodic or current reports under the Exchange Act that are pending resolution.

ITEM 2 – PROPERTIES

Our executive and administrative offices are located at One PNC Plaza, Pittsburgh, Pennsylvania. The thirty-story structure is owned by PNC Bank, N. A. We occupy the entire building. In addition, PNC Bank, N.A. owns a thirty-four story structure adjacent to One PNC Plaza, known as Two PNC Plaza, that houses additional office space.

We own or lease numerous other premises for use in conducting business activities. We consider the facilities owned or occupied under lease by our subsidiaries to be adequate. We include here by reference the additional information regarding our properties in Note 9 Premises, Equipment and Leasehold Improvements in the Notes To Consolidated Financial Statements in Item 8 of this Report.

ITEM 3 – LEGAL PROCEEDINGS

Adelphia

Some of our subsidiaries are defendants (or have potential contractual contribution obligations to other defendants) in several pending lawsuits brought during late 2002 and 2003 arising out of the bankruptcy of Adelphia Communications Corporation and its subsidiaries.

One of the lawsuits was brought on Adelphia’s behalf by the unsecured creditors’ committee and equity committee in Adelphia’s consolidated bankruptcy proceeding and was removed to the United States District Court for the Southern District of New York by order dated February 9, 2006. Pursuant to Adelphia’s plan of reorganization, this lawsuit will be prosecuted by a contingent value vehicle, known as the Adelphia Recovery Trust. In October 2007, the Adelphia Recovery Trust filed an amended complaint in this lawsuit, adding defendants and making additional allegations. The other lawsuits, one of which is a putative consolidated class action, were brought by holders of debt and equity securities of Adelphia and have been consolidated for pretrial purposes in the above district court. The bank defendants, including the PNC defendants, have entered into a settlement of the consolidated class action. This settlement was approved by the district court in November 2006. In December 2006, a group of class members appealed orders related to the settlement to the United States Court of Appeals for the Second Circuit. The amount for which we would be responsible under this settlement is insignificant.

The non-settled lawsuits arise out of lending and investment banking activities engaged in by PNC subsidiaries together with other financial services companies. In the aggregate, hundreds of other financial services companies and numerous


 

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other companies and individuals have been named as defendants in one or more of these lawsuits. Collectively, with respect to some or all of the defendants, the lawsuits allege federal law claims (including violations of federal securities and banking laws), violations of common law duties, aiding and abetting such violations, voidable preference payments, and fraudulent transfers, among other matters. The lawsuits seek monetary damages (including in some cases punitive or treble damages), interest, attorneys’ fees and other expenses, and a return of the alleged voidable preference and fraudulent transfer payments, among other remedies.

We believe that we have defenses to the claims against us in these lawsuits, as well as potential claims against third parties, and intend to defend the remaining lawsuits vigorously. These lawsuits involve complex issues of law and fact, presenting complicated relationships among the many financial and other participants in the events giving rise to these lawsuits, and have not progressed to the point where we can predict the outcome of the non-settled lawsuits. It is not possible to determine what the likely aggregate recoveries on the part of the plaintiffs in these remaining matters might be or the portion of any such recoveries for which we would ultimately be responsible, but the final consequences to PNC could be material.

Data Treasury

In March 2006, a first amended complaint was filed in the United States District Court for the Eastern District of Texas by Data Treasury Corporation against PNC and PNC Bank, N.A., as well as more than 50 other financial institutions, vendors, and other companies, claiming that the defendants are infringing, and inducing or contributing to the infringement of, the plaintiff’s patents, which allegedly involve check imaging, storage and transfer. The plaintiff seeks unspecified damages and interest and trebling of both, attorneys’ fees and other expenses, and injunctive relief against the alleged infringement. We believe that we have defenses to the claims against us in this lawsuit and intend to defend it vigorously. In January 2007, the district court entered an order staying the claims asserted against PNC under two of the four patents allegedly infringed by PNC, pending reexamination of these patents by the United States Patent and Trademark Office. The Patent Office has since indicated that all of the claims are allowable. In September 2007, the parties agreed to stay the other two patents-in-suit pending reexamination of those patents. The entire case is presently stayed. Data Treasury has moved to lift the stay.

CBNV Mortgage Litigation

Between 2001 and 2003, on behalf of either individual plaintiffs or a putative class of plaintiffs, several separate actions were filed in state and federal court against Community Bank of Northern Virginia (“CBNV”) and other defendants challenging the validity of second mortgage loans the defendants made to the plaintiffs. CBNV was merged into one of Mercantile’s banks. These cases were either filed in, or removed to, the United States District Court for the Western District of Pennsylvania.

 

In July 2003, the court conditionally certified a class for settlement purposes and preliminarily approved a settlement of the various actions. Thereafter, certain plaintiffs who had initially opted out of the proposed settlement and other objectors challenged the validity of the settlement in the district court. The district court approved the settlement, and these “opt out” plaintiffs and other objectors appealed to the United States Court of Appeals for the Third Circuit. In August 2005, the court of appeals reversed the district court’s approval of the settlement and remanded the case to the district court with instructions to consider and address certain specific issues when re-evaluating the settlement. In August 2006, the settling parties submitted a modified settlement agreement to the district court for its approval. In January 2008, the district court conditionally certified a class for settlement purposes, preliminarily approved the proposed modified settlement agreement, and directed that the settlement agreement be submitted to the class members for their consideration. This settlement remains subject to final court approval. Some of the objecting plaintiffs are seeking permission to appeal the district court’s decision certifying the class for settlement purposes and preliminarily approving the settlement. These same plaintiffs also filed a motion to stay the district court proceedings pending a decision on their appeal request. The district court denied the stay request, and there is a similar stay motion pending in the appeals court.

In January 2008, the district court also issued an order sending back to state court in North Carolina the claims of certain plaintiffs seeking to represent a class of North Carolina borrowers.

In addition to these lawsuits, several individuals have filed actions on behalf of themselves or a putative class of plaintiffs alleging claims involving CBNV’s second mortgage loans. These actions also were filed in, or transferred for coordinated or consolidated pre-trial proceedings to, the United States District Court for the Western District of Pennsylvania.

The plaintiffs in these lawsuits seek unquantified monetary damages, interest, attorneys’ fees and other expenses, and a refund of all origination fees and fees paid for title services.

BAE Derivative Litigation

In September 2007, a derivative lawsuit was filed on behalf of BAE Systems plc by a holder of its American Depositary Receipts against current and former directors and officers of BAE, Prince Bandar bin Sultan, PNC (as successor to Riggs National Corporation and Riggs Bank, N.A.), Joseph L. Allbritton, Robert L. Allbritton, and Barbara Allbritton. The complaint alleges that BAE directors and officers breached their fiduciary duties by making or permitting to be made improper or illegal bribes, kickbacks and other payments with respect to a military contract obtained in the mid-1980s from the Saudi Arabian Ministry of Defense, and that Prince Bandar was the primary recipient or beneficiary of these payments. The complaint also alleges that Riggs, together with the Allbrittons (as former directors, officers and controlling


 

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persons of Riggs), acted as the primary intermediaries through which the payments were laundered and actively concealed, and aided and abetted the BAE defendants’ breaches of fiduciary duties. As it relates to PNC, plaintiff is seeking unquantified monetary damages (including punitive damages), an accounting, interest, attorneys’ fees and other expenses. We believe that we have defenses to the claims against us in this lawsuit and intend to defend it vigorously. We have filed a motion seeking dismissal of the claims against us. As a result of our acquisition of Riggs, PNC may be responsible for indemnifying the Allbrittons in connection with this lawsuit.

Regulatory and Governmental Inquiries

In connection with an audit of the services provided by Mercantile Safe Deposit & Trust Company (now PNC Bank) as trustee of the AFL-CIO Building Investment Trust, a collective trust fund that invests pension plan assets in commercial real estate assets, the United States Department of Labor has identified the possibility that Mercantile collected unauthorized fees in violation of ERISA. If it is ultimately determined that these fees were collected in violation of the law, we could be subject to requirements to return the fees to the Building Investment Trust, with interest, and could also be subject to penalties and taxes.

As a result of the regulated nature of our business and that of a number of our subsidiaries, particularly in the banking and securities areas, we and our subsidiaries are the subject of investigations and other forms of regulatory inquiry, often as part of industry-wide regulatory reviews of specified activities. One of these situations is in connection with investigations of practices in the mutual fund industry, where several of our subsidiaries have received requests for information and other inquiries from governmental and regulatory authorities.

Our practice is to cooperate fully with regulatory and governmental investigations, audits and other inquiries, including those described above. Such investigations, audits and other inquiries may lead to remedies such as fines, restitution or alterations in our business practices.

Other

In addition to the proceedings or other matters described above, PNC and persons to whom we may have indemnification obligations, in the normal course of business, are subject to various other pending and threatened legal proceedings in which claims for monetary damages and other relief are asserted. See Note 24 Commitments and Guarantees in the Notes To Consolidated Financial Statements in Item 8 of this Report for additional information regarding the Visa indemnification and our obligation to provide indemnification to current and former officers, directors, employees and agents of PNC and companies we have acquired. We do not anticipate, at the present time, that the ultimate aggregate liability, if any, arising out of such other legal proceedings will have a material adverse effect on our financial position. However, we cannot now determine whether or not any claims asserted against us or others to whom we may have

indemnification obligations, whether in the proceedings or other matters specifically described above or otherwise, will have a material adverse effect on our results of operations in any future reporting period.

ITEM 4 – SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None during the fourth quarter of 2007.

EXECUTIVE OFFICERS OF THE REGISTRANT Information regarding each of our executive officers as of February 15, 2008 is set forth below. Executive officers do not have a stated term of office. Each executive officer has held the position or positions indicated or another executive position with the same entity or one of its affiliates for the past five years unless otherwise indicated below.

 

Name    Age    Position with PNC   

Year

Employed (1)

James E. Rohr

   59   

Chairman and Chief Executive Officer (2)

   1972

Joseph C. Guyaux

   57    President    1972

William S. Demchak

   45    Vice Chairman    2002

William C. Mutterperl

   61    Vice Chairman    2002

Timothy G. Shack

   57   

Executive Vice President and Chief Information Officer

   1976

Thomas K. Whitford

   51   

Executive Vice President and Chief Administrative Officer

   1983

Michael J. Hannon

   51   

Senior Vice President and Chief Credit Officer

   1982

Richard J. Johnson

   51   

Senior Vice President and Chief Financial Officer

   2002

Samuel R. Patterson

   49   

Senior Vice President and Controller

   1986

Helen P. Pudlin

   58   

Senior Vice President and General Counsel

   1989

John J. Wixted, Jr.

   56   

Senior Vice President and Chief Risk Officer

   2002
(1) Where applicable, refers to year employed by predecessor company.
(2) Also serves as a director of PNC.

William S. Demchak joined PNC as Vice Chairman and Chief Financial Officer in September 2002. In August 2005, he took on additional oversight responsibilities for the Corporation’s Corporate & Institutional Banking business and continued to oversee PNC’s asset and liability management and equity management activities while transitioning the responsibilities of Chief Financial Officer to Richard J. Johnson.

Thomas K. Whitford was appointed Chief Administrative Officer in May 2007. From April 2002 through May 2007, he served as Chief Risk Officer.

Richard J. Johnson joined PNC in December 2002 and served as Senior Vice President and Director of Finance until his appointment as Chief Financial Officer of the Corporation effective in August 2005.

John J. Wixted, Jr. joined PNC as Senior Vice President and Chief Regulatory Officer in August 2002. He served in this role until May 2007, when he was appointed Chief Risk Officer.


 

14


DIRECTORS OF THE REGISTRANT The name, age and principal occupation of each of our directors as of February 15, 2008, and the year he or she first became a director is set forth below:

 

   

Richard O. Berndt, 65, Managing Partner of Gallagher, Evelius & Jones LLP (law firm), (2007),

 

   

Charles E. Bunch, 58, Chairman and Chief Executive Officer of PPG Industries, Inc. (coatings, sealants and glass products), (2007),

 

   

Paul W. Chellgren, 65, Operating Partner, SPG Partners, LLC, (private equity), (1995),

 

   

Robert N. Clay, 61, President and Chief Executive Officer of Clay Holding Company (investments), (1987),

 

   

George A. Davidson, Jr., 69, Retired Chairman of Dominion Resources, Inc. (public utility holding company), (1988),

 

   

Kay Coles James, 58, President and Founder of The Gloucester Institute (non-profit), (2006),

 

   

Richard B. Kelson, 61, Operating Advisor, Pegasus Capital Advisors, L.P., (private equity), (2002),

 

   

Bruce C. Lindsay, 66, Chairman and Managing Member of 2117 Associates, LLC (advisory company), (1995),

 

   

Anthony A. Massaro, 63, Retired Chairman and Chief Executive Officer of Lincoln Electric Holdings, Inc. (full-line manufacturer of welding and cutting products), (2002),

 

   

Jane G. Pepper, 62, President of Pennsylvania Horticultural Society (non-profit membership organization), (1997),

 

   

James E. Rohr, 59, Chairman and Chief Executive Officer of PNC, (1990),

 

   

Donald J. Shepard, 61, Chairman of the Executive Board and Chief Executive Officer, AEGON N.V. (insurance), (2007),

 

   

Lorene K. Steffes, 62, Independent Business Advisor, (2000),

 

   

Dennis F. Strigl, 61, President and Chief Operating Officer of Verizon Communications Inc. (telecommunications), (2001),

 

   

Stephen G. Thieke, 61, Retired Chairman, Risk Management Committee of JP Morgan Incorporated (financial and investment banking services), (2002),

 

   

Thomas J. Usher, 65, Retired Chairman of United States Steel Corporation (integrated steelmaker) and Chairman of Marathon Oil Corporation (oil and gas industry), (1992),

 

   

George H. Walls, Jr., 65, former Chief Deputy Auditor of the State of North Carolina, (2006),

 

   

Helge H. Wehmeier, 65, Retired President and Chief Executive Officer of Bayer Corporation (healthcare, crop protection, and chemicals), (1992).

PART II

ITEM 5 – MARKET FOR REGISTRANTS COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

(a) Our common stock is listed on the New York Stock Exchange and is traded under the symbol “PNC.” At the close of business on February 15, 2008, there were 49,566 common shareholders of record.

Holders of PNC common stock are entitled to receive dividends when declared by the Board of Directors out of funds legally available for this purpose. Our Board of Directors may not pay or set apart dividends on the common stock until dividends for all past dividend periods on any series of outstanding preferred stock have been paid or declared and set apart for payment. The Board presently intends to continue the policy of paying quarterly cash dividends. However, the amount of any future dividends will depend on earnings, our financial condition and other factors, including contractual restrictions and applicable government regulations and policies (such as those relating to the ability of bank and non-bank subsidiaries to pay dividends to the parent company).

The Federal Reserve has the power to prohibit us from paying dividends without its approval. For further information concerning dividend restrictions and restrictions on loans, dividends or advances from bank subsidiaries to the parent company, you may review “Supervision and Regulation” in Item 1 of this Report, “Liquidity Risk Management” in the Risk Management section and “Perpetual Trust Securities”, “PNC Capital Trust E Trust Preferred Securities” and “Acquired Entity Trust Preferred Securities” in the Off-Balance Sheet Arrangements and VIEs section of Item 7 of this Report, and Note 22 Regulatory Matters in the Notes To Consolidated Financial Statements in Item 8 of this Report, which we include here by reference.

We include here by reference additional information relating to PNC common stock under the caption “Common Stock Prices/Dividends Declared” in the Statistical Information (Unaudited) section of Item 8 of this Report.

We include here by reference the information regarding our compensation plans under which PNC equity securities are authorized for issuance as of December 31, 2007 in the table (with introductory paragraph and notes) that appears under Item 12 of this Report.


 

15


Our registrar, stock transfer agent, and dividend disbursing agent is:

Computershare Investor Services, LLC

250 Royall Street

Canton, MA 02021

800-982-7652

We include here by reference the information that appears under the caption “Common Stock Performance Graph” at the end of this Item 5.

 

(b) Not applicable.

(c) Details of our repurchases of PNC common stock during the fourth quarter of 2007 are included in the following table:

In thousands, except per share data

 

2007 period   Total shares
purchased (a)
  Average
price
paid per
share
  Total shares
purchased as
part of
publicly
announced
programs (b)
  Maximum
number of
shares that
may yet be
purchased
under the
programs (b)

October 1 –

October 31

  318   $ 70.86   145   24,855

November 1 –

November 30

  433   $ 70.48   145   24,710

December 1 –

December 31

  169   $ 69.39       24,710

Total

  920   $ 70.41   290    
(a) Includes PNC common stock purchased under the program referred to in note (b) to this table and PNC common stock purchased in connection with our various employee benefit plans.
(b) Our current stock repurchase program, allows us to purchase up to 25 million shares on the open market or in privately negotiated transactions. This program was authorized on October 4, 2007 and replaced the prior program, which was authorized in February 2005. This program will remain in effect until fully utilized or until modified, superseded or terminated.

Common Stock Performance Graph

This graph shows the cumulative total shareholder return (i.e., price change plus reinvestment of dividends) on our common stock during the five-year period ended December 31, 2007, as compared with: (1) a selected peer group of our competitors, called the “Peer Group;” (2) an overall stock market index, the S&P 500 Index; and (3) a published industry index, the S&P 500 Banks. The yearly points marked on the horizontal axis of the graph correspond to December 31 of that year. The stock performance graph assumes that $100 was invested on January 1, 2003 for the five-year period and that any dividends were reinvested. The table below the graph shows the resultant compound annual growth rate for the performance period.

 

LOGO

 

    

Base

Period

 

Assumes $100 investment at Close of
Market on December 31, 2002

Total Return = Price change plus
reinvestment of dividends

  5-Year
Com-pound
Growth
Rate
 
    Dec02   Dec03   Dec04   Dec05   Dec06   Dec07      

PNC

  $100   136.06   148.25   165.41   204.29   187.41   13.39 %

S&P 500 Index

  $100   128.67   142.65   149.65   173.26   182.78   12.82 %

S&P 500 Banks

  $100   126.65   144.92   142.86   165.89   116.49   3.10 %

Peer Group

  $100   129.36   146.85   147.23   167.31   123.96   4.39 %

The Peer Group for the preceding chart and table consists of the following companies: BB&T Corporation; Comerica Inc.; Fifth Third Bancorp; KeyCorp; National City Corporation; The PNC Financial Services Group, Inc.; SunTrust Banks, Inc.; U.S. Bancorp.; Wachovia Corporation; Regions Financial Corporation; and Wells Fargo & Co. The Peer Group shown is the Peer Group approved by the Board’s Personnel and Compensation Committee for 2007.

Each yearly point for the Peer Group is determined by calculating the cumulative total shareholder return for each company in the Peer Group from December 31, 2002 to December 31 of that year (End of Month Dividend Reinvestment Assumed) and then using the median of these returns as the yearly plot point.

In accordance with the rules of the SEC, this section, captioned “Common Stock Performance Graph,” shall not be incorporated by reference into any of our future filings made under the Securities Exchange Act of 1934 or the Securities Act of 1933. The Common Stock Performance Graph, including its accompanying table and footnotes, is not deemed to be soliciting material or to be filed under the Exchange Act or the Securities Act.


 

16


ITEM 6 - SELECTED FINANCIAL DATA

 

     Year ended December 31  

Dollars in millions, except per share data

   2007           2006 (a)      2005    2004    2003  
   

SUMMARY OF OPERATIONS

                       

Interest income

   $6,166           $4,612    $3,734    $2,752    $2,712  

Interest expense

   3,251           2,367    1,580    783    716  

Net interest income

   2,915           2,245    2,154    1,969    1,996  

Provision for credit losses

   315           124    21    52    177  

Noninterest income

   3,790           6,327    4,173    3,572    3,263  

Noninterest expense

   4,296           4,443    4,306    3,712    3,467  

Income before minority interests and income taxes

   2,094           4,005    2,000    1,777    1,615  

Minority interest in income of BlackRock

             47    71    42    47  

Income taxes

   627           1,363    604    538    539  

Income before cumulative effect of accounting change

   1,467           2,595    1,325    1,197    1,029  

Cumulative effect of accounting change, net of tax

                              (28 )

Net income

   $1,467           $2,595    $1,325    $1,197    $1,001  
   

PER COMMON SHARE

                       

Basic earnings (loss)

                       

Before cumulative effect of accounting change

   $4.43           $8.89    $4.63    $4.25    $3.68  

Cumulative effect of accounting change

                              (.10 )

Net income

   $4.43           $8.89    $4.63    $4.25    $3.58  

Diluted earnings (loss)

                       

Before cumulative effect of accounting change

   $4.35           $8.73    $4.55    $4.21    $3.65  

Cumulative effect of accounting change

                              (.10 )

Net income

   $4.35           $8.73    $4.55    $4.21    $3.55  

Book value (At December 31)

   $43.60           $36.80    $29.21    $26.41    $23.97  

Cash dividends declared

   $2.44           $2.15    $2.00    $2.00    $1.94  
(a) See Note (a) on page 18.

Certain prior-period amounts have been reclassified to conform with the current period presentation, which we believe is more meaningful to readers of our consolidated financial statements. See Note 2 Acquisitions and Divestitures in the Notes To Consolidated Financial Statements in Item 8 of this Report for information on significant recent and planned business acquisitions and divestitures.

For information regarding certain business risks, see Item 1A Risk Factors and the Risk Management section of Item 7 of this Report. Also, see our Cautionary Statement Regarding Forward-Looking Information included in Item 7 of this Report for certain risks and uncertainties that could cause actual results to differ materially from those anticipated in forward-looking statements or from historical performance.

 

17


     At or for the year ended December 31  

Dollars in millions, except as noted

   2007            2006 (a)       2005     2004     2003  
   

BALANCE SHEET HIGHLIGHTS

                   

Assets

   $138,920            $101,820     $91,954     $79,723     $68,168  

Loans, net of unearned income

   68,319            50,105     49,101     43,495     36,303  

Allowance for loan and lease losses

   830            560     596     607     632  

Securities

   30,225            23,191     20,710     16,761     15,690  

Loans held for sale

   3,927            2,366     2,449     1,670     1,400  

Equity investments (b)

   6,045            5,330     1,323     1,058     997  

Deposits

   82,696            66,301     60,275     53,269     45,241  

Borrowed funds (c)

   30,931            15,028     16,897     11,964     11,453  

Shareholders’ equity

   14,854            10,788     8,563     7,473     6,645  

Common shareholders’ equity

   14,847            10,781     8,555     7,465     6,636  
   

ASSETS ADMINISTERED (in billions)

                   

Managed (d)

   $73            $54     $494     $383     $354  

Nondiscretionary

   113            86     84     93     87  
   

FUND ASSETS SERVICED (in billions)

                   

Accounting/administration net assets

   $990            $837     $835     $721     $654  

Custody assets

   500            427     476     451     401  
                                       

SELECTED RATIOS

                   

Net interest margin

   3.00 %          2.92 %   3.00 %   3.22 %   3.64 %

Noninterest income to total revenue

   57            74     66     64     62  

Efficiency

   64            52     68     67     66  

Return on

                   

Average common shareholders’ equity

   10.53            27.97     16.58     16.82     15.06  

Average assets

   1.19            2.73     1.50     1.59     1.49  
   

Loans to deposits

   83            76     81     82     80  

Dividend payout

   55.0            24.4     43.4     47.2     54.5  

Tier 1 risk-based capital

   6.8            10.4     8.3     9.0     9.5  

Common shareholders’ equity to total assets

   10.7            10.6     9.3     9.4     9.7  

Average common shareholders’ equity to average assets

   11.3            9.8     9.0     9.4     9.9  
(a) Noninterest income for 2006 included the pretax impact of the following: gain on the BlackRock/Merrill Lynch Investment Managers (“MLIM”) transaction of $2.1 billion; securities portfolio rebalancing loss of $196 million; and mortgage loan portfolio repositioning loss of $48 million. Noninterest expense for 2006 included the pretax impact of BlackRock/MLIM transaction integration costs of $91 million. An additional $10 million of integration costs, recognized in the fourth quarter of 2006, were included in noninterest income as a negative component of the asset management line. The after-tax impact of these items was as follows: BlackRock/MLIM transaction gain - $1.3 billion; securities portfolio rebalancing loss - $127 million; mortgage loan portfolio repositioning loss - $31 million; and BlackRock/MLIM transaction integration costs - $47 million.
(b) The balances at December 31, 2007 and December 31, 2006 include our investment in BlackRock.
(c) Includes long-term borrowings of $12.6 billion, $6.6 billion, $6.8 billion, $5.7 billion and $5.8 billion for 2007, 2006, 2005, 2004 and 2003, respectively. Borrowings which mature more than one year after December 31, 2007 are considered to be long-term.
(d) Assets under management at December 31, 2007 and December 31, 2006 do not include BlackRock’s assets under management as we deconsolidated BlackRock effective September 29, 2006.

 

18


ITEM 7 - MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

EXECUTIVE SUMMARY

THE PNC FINANCIAL SERVICES GROUP, INC.

PNC is one of the largest diversified financial services companies in the United States based on assets, with businesses engaged in retail banking, corporate and institutional banking, asset management, and global fund processing services. We provide many of our products and services nationally and others in our primary geographic markets located in Pennsylvania, New Jersey, Washington, DC, Maryland, Virginia, Ohio, Kentucky and Delaware. We also provide certain global fund processing services internationally.

KEY STRATEGIC GOALS

Our strategy to enhance shareholder value centers on driving positive operating leverage by achieving growth in revenue from our diverse business mix that exceeds growth in expenses as a result of disciplined cost management. In each of our business segments, the primary drivers of revenue growth are the acquisition, expansion and retention of customer relationships. We strive to expand our customer base by providing convenient banking options and leading technology systems, providing a broad range of fee-based products and services, focusing on customer service, and through a significantly enhanced branding initiative. We may also grow revenue through appropriate and targeted acquisitions and, in certain businesses, by expanding into new geographical markets.

We have maintained a moderate risk profile characterized by strong credit quality and limited exposure to earnings volatility resulting from interest rate fluctuations and the shape of the interest rate yield curve. Our actions have created a strong balance sheet, ample liquidity and investment flexibility to adjust, where appropriate, to changing interest rates and market conditions. We continue to be disciplined in investing capital in our businesses while returning a portion to shareholders through dividends and share repurchases when appropriate.

ACQUISITION AND DIVESTITURE ACTIVITY

A summary of pending and recently completed acquisitions and divestitures is included under Item 1 and in Note 2 Acquisitions and Divestitures in the Notes To Consolidated Financial Statements in Item 8 of this Report.

KEY FACTORS AFFECTING FINANCIAL PERFORMANCE

Our financial performance is substantially affected by several external factors outside of our control, including:

   

General economic conditions,

   

Loan demand, utilization of credit commitments and standby letters of credit, and asset quality

   

Customer demand for other products and services,

   

Movement of customer deposits from lower to higher rate accounts or to investment alternatives,

   

The level of, direction, timing and magnitude of movement in interest rates, and the shape of the interest rate yield curve, and

   

The functioning and other performance of, and availability of liquidity in, the capital and other financial markets.

   

The impact of credit spreads on valuations of commercial mortgage loans held for sale and the market for securitization and sale of these assets.

Starting in the middle of 2007, and continuing at present, there has been significant turmoil and volatility in worldwide financial markets, accompanied by uncertain prospects for the overall economy. Our performance in 2008 will be impacted by developments in these areas. In addition, our success in 2008 will depend, among other things, upon:

   

Further success in the acquisition, growth and retention of customers,

   

The successful integration of Yardville and progress toward closing and integrating the Sterling acquisition,

   

Completing the divestiture of Hilliard Lyons,

   

Continued development of the Mercantile franchise, including full deployment of our product offerings,

   

Revenue growth,

   

A sustained focus on expense management and creating positive operating leverage,

   

Maintaining strong overall asset quality,

   

Prudent risk and capital management, and

   

Actions we take within the capital and other financial markets.

SUMMARY FINANCIAL RESULTS

 

     Year ended December 31  

In billions, except for

per share data

   2007     2006  

Net income

   $1.467     $2.595  

Diluted earnings per share

   $4.35     $8.73  

Return on

      

Average common
shareholders’ equity

   10.53 %   27.97 %

Average assets

   1.19 %   2.73 %

We refer you to the Consolidated Income Statement Review portion of the 2006 Versus 2005 section of this Item 7 for significant items which collectively increased net income for 2006 by $1.1 billion, or $3.67 per diluted share.

Our performance in 2007 included the following accomplishments:

   

Our total assets at December 31, 2007 reached a record level of $139 billion, as further detailed in the Consolidated Balance Sheet Review section of this Item 7. We achieved growth by expanding our footprint, growing and deepening customer relationships, and enhancing product capabilities.

   

We differentiated ourselves with a diverse revenue mix of both interest and noninterest

 


19


 

income. Noninterest income represented 57% of total revenue for 2007.

   

Overall asset quality remained strong, reflecting our commitment to maintain a moderate risk profile. While nonperforming assets increased in 2007 compared with 2006, the coverage ratio of the allowance for loan and lease losses to nonperforming loans was 190% and the allowance for loan and lease losses to total loans increased to 1.21% at December 31, 2007.

   

PNC continued to be well capitalized and maintained a strong liquidity position.

   

At December 31, 2007, our investment in BlackRock was $4.1 billion and, based upon the closing price of BlackRock’s common stock on that date, we had an additional $5.3 billion of pretax value that was not recognized.

BALANCE SHEET HIGHLIGHTS

Total assets were $138.9 billion at December 31, 2007 compared with $101.8 billion at December 31, 2006. The increase compared with December 31, 2006 was primarily due to the addition of approximately $21 billion of assets related to the Mercantile acquisition, growth in loans and higher securities available for sale.

Total average assets were $123.4 billion for 2007 compared with $95.0 billion for 2006. This increase reflected a $20.3 billion increase in average interest-earning assets and an increase in average other noninterest-earning assets. An increase of $12.9 billion in loans and a $5.2 billion increase in securities available for sale were the primary factors for the increase in average interest-earning assets.

The increase in average other noninterest-earning assets for 2007 reflected our equity investment in BlackRock, which averaged $3.8 billion for 2007 and which had been consolidated for the first nine months of 2006, and an increase in average goodwill of $3.6 billion primarily related to the Mercantile and Yardville acquisitions.

Average total loans were $62.5 billion for 2007 and $49.6 billion for 2006. The increase in average total loans included the effect of the Mercantile acquisition for 10 months of 2007 and higher commercial loans. The increase in average total loans included growth in commercial loans of $5.3 billion and growth in commercial real estate loans of $4.5 billion. Loans represented 64% of average interest-earning assets for both 2007 and 2006.

Average securities available for sale totaled $26.5 billion for 2007 and $21.3 billion for 2006. The 10-month impact of Mercantile contributed to the increase in average securities for the 2007 period, along with overall balance sheet growth. Securities available for sale comprised 27% of average interest-earning assets for both 2007 and 2006.

Average total deposits were $76.8 billion for 2007, an increase of $13.5 billion over 2006. Average deposits grew from the

prior year primarily as a result of an increase in money market, noninterest-bearing demand deposits and retail certificates of deposit. These increases reflected the 10-month impact of the Mercantile acquisition and growth in deposits in Corporate & Institutional Banking.

Average total deposits represented 62% of average total assets for 2007 and 67% for 2006. Average transaction deposits were $50.7 billion for 2007 compared with $42.3 billion for 2006.

Average borrowed funds were $23.0 billion for 2007 and $15.0 billion for 2006. Increases of $3.2 billion in bank notes and senior debt, $2.5 billion in federal funds purchased and $1.5 billion in Federal Home Loan bank borrowings drove the increase in average borrowed funds compared with 2006.

Shareholders’ equity totaled $14.9 billion at December 31, 2007, compared with $10.8 billion at December 31, 2006. The increase resulted primarily from the Mercantile and Yardville acquisitions. See the Consolidated Balance Sheet Review section of this Item 7 for additional information.

LINE OF BUSINESS HIGHLIGHTS

We refer you to Item 1 of this Report under the captions Business Overview and Review of Lines of Business for an overview of our business segments and to the Business Segments Review section of this Item 7 for a Results Of Businesses – Summary table and further analysis of business segment results for 2007 and 2006, including presentation differences from Note 26. Total business segment earnings were $1.7 billion for 2007 and $1.5 billion for 2006.

We provide a reconciliation of total business segment earnings to total PNC consolidated net income as reported on a GAAP basis in Note 26 Segment Reporting in the Notes To Consolidated Financial Statements in Item 8 of this Report.

Retail Banking

Retail Banking’s 2007 earnings increased $128 million, to $893 million, up 17% compared with 2006. The increase in earnings over the prior year was driven by acquisitions and strong fee income and customer growth, partially offset by increases in the provision for credit losses and continued investments in the business.

Corporate & Institutional Banking

Corporate & Institutional Banking earned $432 million in 2007 compared with $454 million in 2006. While total revenue increased more than noninterest expense, earnings declined due to an increase in the provision for credit losses. Market-related declines in commercial mortgage- backed securities (“CMBS”) securitization activities and non-customer-related trading revenue resulted in a year-over-year reduction in noninterest income.


 

20


BlackRock

Our BlackRock business segment earned $253 million in 2007 and $187 million in 2006. Subsequent to the September 29, 2006 deconsolidation of BlackRock, these business segment earnings are determined primarily by taking our proportionate share of BlackRock’s earnings. Also, for this business segment presentation, after-tax BlackRock/MLIM transaction integration costs totaling $3 million and $65 million in 2007 and 2006, respectively, have been reclassified from BlackRock to “Other.”

PFPC

PFPC earned $128 million for 2007 compared with $124 million in 2006. Results for 2006 benefited from the impact of a $14 million reversal of deferred taxes related to earnings from foreign subsidiaries following management’s determination that the earnings would be indefinitely reinvested outside of the United States. Apart from the impact of this item, the earnings increase of $18 million in 2007 reflected the successful conversion of net new business, organic growth and market appreciation.

 

Other

“Other” incurred a loss of $239 million in 2007 compared with earnings for 2006 of $1.1 billion. “Other” for 2007 included the after-tax impact of the following:

   

Integration costs totaling $99 million after taxes,

   

A net after-tax charge of $83 million representing the net mark-to-market adjustment on our remaining BlackRock LTIP shares obligation partially offset by the gain recognized in connection with PNC’s first quarter transfer of BlackRock shares to satisfy a portion of our BlackRock LTIP shares obligation, and

   

A $53 million after-tax charge for an indemnification obligation related to certain Visa litigation.

“Other” earnings for 2006 included the $1.3 billion after-tax gain on the BlackRock/MLIM transaction recorded in the third quarter of 2006, partially offset by the after-tax impact of charges related to our third quarter 2006 balance sheet repositioning activities and BlackRock/MLIM integration costs. Further information regarding the BlackRock/MLIM transaction is included in Note 2 Acquisitions and Divestitures included in the Notes To Consolidated Financial Statements in Item 8 of this Report.


 

21


CONSOLIDATED INCOME STATEMENT REVIEW

NET INTEREST INCOME - OVERVIEW

Changes in net interest income and margin result from the interaction of the volume and composition of interest-earning assets and related yields, interest-bearing liabilities and related rates paid, and noninterest-bearing sources of funding.

See Statistical Information – Analysis of Year-To-Year Changes In Net Interest Income and Average Consolidated Balance Sheet and Net Interest Analysis in Item 8 of this Report for additional information.

NET INTEREST INCOME - GAAP RECONCILIATION

The interest income earned on certain assets is completely or partially exempt from federal income tax. As such, these tax-exempt instruments typically yield lower returns than a taxable investment. To provide more meaningful comparisons of yields and margins for all interest-earning assets, we also provide net interest income on a taxable-equivalent basis by increasing the interest income earned on tax-exempt assets to make it fully equivalent to interest income earned on other taxable investments. This adjustment is not permitted under GAAP in the Consolidated Income Statement.

A reconciliation of net interest income as reported in the Consolidated Income Statement (GAAP basis) to net interest income on a taxable-equivalent basis follows (in millions):

 

     For the year ended December 31,
       2007      2006      2005

Net interest income, GAAP basis

   $ 2,915    $ 2,245    $ 2,154

Taxable-equivalent adjustment

     27      25      33

Net interest income, taxable- equivalent basis

   $ 2,942    $ 2,270    $ 2,187

Taxable-equivalent net interest income increased $672 million, or 30%, in 2007 compared with 2006. This increase was consistent with the $20.3 billion, or 26%, increase in average interest-earning assets during 2007 compared with 2006. The reasons driving the higher interest-earning assets in 2007 are further discussed in the Balance Sheet Highlights portion of the Executive Summary section of this Item 7.

We expect net interest income to be higher in 2008 compared with 2007, assuming our current expectations for interest rates and economic conditions. Our forward-looking statements are based on our current expectations that interest rates will remain low through most of 2008 and that economic conditions, although showing slower growth than in recent years, will avoid a recession.

 

NET INTEREST MARGIN

The net interest margin was 3.00% for 2007 and 2.92% for 2006. The following factors impacted the comparison:

   

The Mercantile acquisition.

   

The yield on interest-earning assets increased 35 basis points. The yield on loans, the single largest component, increased 31 basis points.

   

These factors were partially offset by an increase in the rate paid on interest-bearing liabilities of 25 basis points. The rate paid on interest-bearing deposits, the single largest component, increased 22 basis points.

   

The impact of noninterest-bearing sources of funding decreased 2 basis points in 2007 compared with the prior year.

Comparing yields and rates paid to the broader market, the average federal funds rate was 5.03% during 2007 compared with 4.96% for 2006.

We believe that net interest margins for our industry will continue to be impacted by competition for high quality loans and deposits and customer migration from lower to higher rate deposit or other products. We expect our net interest margin to improve slightly in 2008 compared with 2007, assuming our current expectations for interest rates and economic conditions.

PROVISION FOR CREDIT LOSSES

The provision for credit losses totaled $315 million for 2007 and $124 million for 2006. Of the total 2007 provision, $188 million was recorded in the fourth quarter, including approximately $45 million related to our Yardville acquisition. The higher provision in 2007 was also impacted by an increase in our real estate portfolio, including residential real estate development exposure, and growth in total credit exposure. Total residential real estate development outstandings were approximately $2.1 billion at December 31, 2007.

We do not expect to sustain asset quality at its current level. Given our projections for loan growth and continued credit deterioration, we expect nonperforming assets and the provision for credit losses will be higher in 2008 compared with 2007. Also, we expect that the level of provision for credit losses in the first quarter of 2008 will be modestly lower than the amount reported for the fourth quarter of 2007.

The Credit Risk Management portion of the Risk Management section of this Item 7 includes additional information regarding factors impacting the provision for credit losses.

NONINTEREST INCOME

Summary

Noninterest income was $3.790 billion for 2007 and $6.327 billion for 2006. Noninterest income for 2007 included the impact of $83 million gain recognized in connection with our transfer of BlackRock shares to satisfy a portion of PNC’s LTIP obligation and a $210 million net loss representing the mark-to-market adjustment on our LTIP obligation.


 

22


Noninterest income for 2006 included the impact of the following items:

   

The gain on the BlackRock/MLIM transaction, which totaled $2.078 billion,

   

The effects of our third quarter 2006 balance sheet repositioning activities that resulted in charges totaling $244 million, and

   

PNC consolidated BlackRock in its results for the first nine months of 2006 but accounted for BlackRock on the equity method for the fourth quarter of 2006 and all of 2007. Had our BlackRock investment been on the equity method for all of 2006, BlackRock’s noninterest income reported by us would have been lower by $943 million for that year.

Apart from the impact of these items, noninterest income increased $367 million, or 10%, in 2007 compared with 2006 largely as a result of the Mercantile acquisition and growth in several fee income categories.

We expect that net interest income and noninterest income will increase in 2008 compared with 2007. We also believe that PNC will create positive operating leverage in 2008 with a percentage growth in total revenue relative to 2007 that will exceed the percentage growth in noninterest expense from 2007.

Additional analysis

Asset management fees totaled $784 million for 2007 and $1.420 billion for 2006. Our equity income from BlackRock has been included in asset management fees beginning with the fourth quarter of 2006. Asset management fees were higher in 2006 as the first nine months of 2006 reflected the impact of BlackRock’s revenue on a consolidated basis.

Assets managed at December 31, 2007 totaled $73 billion compared with $54 billion at December 31, 2006. This increase resulted primarily from the Mercantile acquisition. We refer you to the Retail Banking section of the Business Segments Review section of this Item 7 for further discussion of assets under management.

Fund servicing fees declined $58 million in 2007, to $835 million, compared with $893 million in the prior year. Amounts for 2006 included $117 million of distribution fee revenue at PFPC. Effective January 1, 2007, we refined our accounting and reporting of PFPC’s distribution fee revenue and related expense amounts and present these amounts net on a prospective basis. Prior to 2007, the distribution amounts were shown on a gross basis within fund servicing fees and within other noninterest expense and offset each other entirely with no impact on earnings.

Apart from the impact of the distribution fee revenue included in the 2006 amounts, fund servicing fees increased $59 million in 2007 compared with the prior year. Higher revenue from offshore operations, transfer agency, managed accounts and alternative investments contributed to the increase in

2007, reflecting net new business and growth from existing clients. The PFPC section of the Business Segments Review section of this Item 7 includes information on net fund assets and custody fund assets serviced.

Service charges on deposits increased $35 million, or 11%, to $348 million for 2007 compared with 2006. The increase was primarily due to the impact of Mercantile.

Brokerage fees increased $32 million, or 13%, to $278 million for 2007 compared with the prior year. The increase was primarily due to higher mutual fund-related revenues, continued growth in our fee-based fund advisory business and higher annuity income.

Consumer services fees increased $49 million, or 13%, to $414 million in 2007 compared with 2006. The increase reflected the impact of Mercantile, higher debit card revenues resulting from higher transaction volumes, and fees from the credit card business that began in the latter part of 2006.

Corporate services revenue was $713 million for 2007, an increase of $87 million, or 14%, over 2006. Higher revenue from commercial mortgage servicing including the impact of the ARCS acquisition, treasury management, third party consumer loan servicing activities and the Mercantile acquisition contributed to the increase in 2007 over the prior year.

Equity management (private equity) net gains on portfolio investments totaled $102 million in 2007 and $107 million in 2006. Based on the nature of private equity activities, net gains or losses may fluctuate from period to period.

Net securities losses totaled $5 million in 2007 and $207 million in 2006. We took actions during the third quarter of 2006 that resulted in the sale of approximately $6 billion of securities available for sale at an aggregate pretax loss of $196 million during that quarter.

Noninterest revenue from trading activities totaled $104 million in 2007 compared with $183 million in 2006. While customer trading income increased in comparison, total trading revenue declined in 2007 largely due to the lower economic hedging gains associated with commercial mortgage loan activity and economic hedging losses associated with structured resale agreements. We provide additional information on our trading activities under Market Risk Management – Trading Risk in the Risk Management section of this Item 7.

Net losses related to our BlackRock investment amounted to $127 million in 2007, representing the net of the mark-to-market adjustment on our LTIP obligation and gain recognized in connection with our transfer of shares to satisfy a portion of our LTIP obligation, compared with a net gain of $2.066 billion in 2006. The 2006 amount included the $2.078 billion gain on the BlackRock/MLIM transaction. See the BlackRock portion of the Business Segments Review section of Item 7 of this Report for further information.


 

23


Other noninterest income increased $29 million, to $344 million, in 2007 compared with 2006. Other noninterest income for 2007 included the negative impact in the fourth quarter of a $26 million valuation adjustment for commercial mortgage loans held for sale. In early 2008, spreads have been widening and there has been limited activity in the CMBS securitization market. We value our commercial mortgage loans held for sale based on securitization prices. Therefore, if these conditions continue, additional losses will be incurred that will be significantly higher than the losses incurred during the fourth quarter of 2007. However, we do not expect the impact to be significant to our capital position. Currently, these valuation losses are unrealized (non-cash) and all of the loans in this portfolio are performing.

Other noninterest income for 2006 included a $48 million loss incurred in the third quarter in connection with the rebalancing of our residential mortgage portfolio.

Other noninterest income typically fluctuates from period to period depending on the nature and magnitude of transactions completed and market price fluctuations.

PRODUCT REVENUE

In addition to credit products to commercial customers, Corporate & Institutional Banking offers other services, including treasury management and capital markets-related products and services, commercial loan servicing and insurance products that are marketed by several businesses across PNC.

Treasury management revenue, which includes fees as well as net interest income from customer deposit balances, increased 14% to $476 million for 2007 compared with $418 million for 2006. The higher revenue reflected continued expansion and client utilization of commercial payment card services, strong revenue growth in investment products and in various electronic payment and information services.

Revenue from capital markets-related products and services totaled $290 million for 2007 compared with $283 million in 2006. This increase was driven primarily by merger and acquisition advisory and related services.

Midland Loan Services offers servicing, real estate advisory and technology solutions for the commercial real estate finance industry. Midland’s revenue, which includes servicing fees and net interest income from servicing portfolio deposit balances, totaled $220 million for 2007 and $184 million for 2006, an increase of 20%. The revenue growth was primarily driven by growth in the commercial mortgage servicing portfolio and related services.

As a component of our advisory services to clients, we provide a select set of insurance products to fulfill specific customer financial needs. Primary insurance offerings include annuities, life, credit life, health, and disability. Revenue from these products increased 4% to $74 million for 2007 compared with $71 million for 2006.

 

PNC, through subsidiary company Alpine Indemnity Limited, participates as a direct writer for its general liability, automobile liability, workers’ compensation, property and terrorism insurance programs. In the normal course of business, Alpine Indemnity Limited maintains insurance reserves for reported claims and for claims incurred but not reported based on actuarial assessments. We believe these reserves were adequate at December 31, 2007.

NONINTEREST EXPENSE

Total noninterest expense was $4.296 billion for 2007, a decrease of $147 million compared with $4.443 billion for 2006.

Item 6 of this Report includes our efficiency ratios for 2007 and 2006, along with information regarding certain significant items impacting noninterest income and expense in 2006.

Noninterest expense for 2007 included the following:

   

Acquisition integration costs of $102 million, and

   

A charge of $82 million for an indemnification obligation related to certain Visa litigation.

Noninterest expense for 2006 included the following:

   

The first nine months of 2006 included $765 million of expenses related to BlackRock, which was still consolidated during that time, and

   

BlackRock/MLIM transaction integration costs totaling $91 million.

Apart from the impact of these items, noninterest expense increased $525 million, or 15%, in 2007 compared with 2006. These increases were largely a result of the acquisition of Mercantile. Investments in growth initiatives were mitigated by disciplined expense management.

We expect to incur pretax integration costs of approximately $70 million in 2008 primarily related to our planned acquisition of Sterling and additional costs related to the Yardville and Albridge acquisitions.

EFFECTIVE TAX RATE

Our effective tax rate was 29.9% for 2007 and 34% for 2006. The lower effective tax rate in 2007 compared with the prior year reflected the impact of the following matters:

   

An increase in income taxes related to the gain from, and a $57 million cumulative adjustment to increase deferred income taxes in connection with, the BlackRock/MLIM transaction in 2006, and

   

Lower pretax income for the fourth quarter of 2007 had the impact of reducing the effective tax rate for the full year.

Our effective tax rate is sensitive to levels of pretax income as certain income tax credits and items not subject to income tax remain relatively constant. Based upon current projections, we believe that the effective tax rate will be approximately 31% in 2008, before considering the impact of the pending sale of Hilliard Lyons.


 

24


CONSOLIDATED BALANCE SHEET REVIEW

SUMMARIZED BALANCE SHEET DATA

 

December 31 - in millions    2007    2006

Assets

       

Loans, net of unearned income

   $68,319    $50,105

Securities available for sale

   30,225    23,191

Loans held for sale

   3,927    2,366

Equity investments

   6,045    5,330

Goodwill and other intangible assets

   9,551    4,043

Other

   20,853    16,785

Total assets

   $138,920    $101,820

Liabilities

       

Funding sources

   $113,627    $81,329

Other

   8,785    8,818

Total liabilities

   122,412    90,147

Minority and noncontrolling interests in consolidated entities

   1,654    885

Total shareholders' equity

   14,854    10,788

Total liabilities, minority and noncontrolling interests, and shareholders' equity

   $138,920    $101,820

The summarized balance sheet data above is based upon our Consolidated Balance Sheet in Item 8 of this Report.

Our Consolidated Balance Sheet at December 31, 2007 reflects the addition of approximately $21 billion of assets resulting from our Mercantile acquisition and approximately $3 billion of assets related to our Yardville acquisition.

Various seasonal and other factors impact our period-end balances whereas average balances (discussed under the Balance Sheet Highlights section of this Item 7 and included in the Statistical Information section of Item 8 of this Report) are more indicative of underlying business trends.

An analysis of changes in selected balance sheet categories follows.

LOANS, NET OF UNEARNED INCOME

Loans increased $18.2 billion, or 36%, as of December 31, 2007 compared with December 31, 2006. Our Mercantile acquisition added $12.4 billion of loans including $4.9 billion of commercial, $4.8 billion of commercial real estate, $1.6 billion of consumer and $1.1 billion of residential mortgage loans. Our Yardville acquisition added $1.9 billion of loans.

 

Details Of Loans

 

December 31 - in millions    2007     2006  

Commercial

      

Retail/wholesale

   $6,653     $5,301  

Manufacturing

   4,563     4,189  

Other service providers

   3,014     2,186  

Real estate related (a)

   5,730     2,825  

Financial services

   1,226     1,324  

Health care

   1,260     707  

Other

   6,161     4,052  

Total commercial

   28,607     20,584  

Commercial real estate

      

Real estate projects

   6,114     2,716  

Mortgage

   2,792     816  

Total commercial real estate

   8,906     3,532  

Lease financing

   3,500     3,556  

Total commercial lending

   41,013     27,672  

Consumer

      

Home equity

   14,447     13,749  

Automobile

   1,513     1,135  

Other

   2,366     1,631  

Total consumer

   18,326     16,515  

Residential mortgage

   9,557     6,337  

Other

   413     376  

Unearned income

   (990 )   (795 )

Total, net of unearned income

   $68,319     $50,105  
(a) Includes loans related to customers in the real estate, rental, leasing and construction industries.

Our loan portfolio continued to be diversified among numerous industries and types of businesses. The loans that we hold are also concentrated in, and diversified across, our principal geographic markets. See Note 5 Loans, Commitments To Extend Credit and Concentrations of Credit Risk in the Notes To Consolidated Financial Statements in Item 8 of this Report for additional information.

Commercial lending outstandings in the table above are the largest category and are the most sensitive to changes in assumptions and judgments underlying the determination of the allowance for loan and lease losses. We have allocated $713 million, or 86%, of the total allowance for loan and lease losses at December 31, 2007 to these loans. We allocated $68 million, or 8%, of the remaining allowance at that date to consumer loans and $49 million, or 6%, to all other loans. This allocation also considers other relevant factors such as:

   

Actual versus estimated losses,

   

Regional and national economic conditions,

   

Business segment and portfolio concentrations,

   

Industry conditions,

   

The impact of government regulations, and

   

Risk of potential estimation or judgmental errors, including the accuracy of risk ratings.


 

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Net Unfunded Credit Commitments

 

December 31 - in millions    2007    2006

Commercial

   $ 39,171    $ 32,265

Consumer

     10,875      9,239

Commercial real estate

     2,734      2,752

Other

     567      579

Total

   $ 53,347    $ 44,835

Unfunded commitments are concentrated in our primary geographic markets. Commitments to extend credit represent arrangements to lend funds or provide liquidity subject to specified contractual conditions. Commercial commitments are reported net of participations, assignments and syndications, primarily to financial institutions, totaling $8.9 billion at December 31, 2007 and $8.3 billion at December 31, 2006. Consumer home equity lines of credit accounted for 80% of consumer unfunded credit commitments.

Unfunded liquidity facility commitments and standby bond purchase agreements totaled $9.4 billion at December 31, 2007 and $6.0 billion at December 31, 2006 and are included in the preceding table primarily within the “Commercial” and “Consumer” categories.

In addition to credit commitments, our net outstanding standby letters of credit totaled $4.8 billion at December 31, 2007 and $4.4 billion at December 31, 2006. Standby letters of credit commit us to make payments on behalf of our customers if specified future events occur. At December 31, 2007, the largest industry concentration was for general medical and surgical hospitals, which accounted for approximately 5% of the total letters of credit and bankers’ acceptances.

Leases and Related Tax Matters

The lease portfolio totaled $3.5 billion at December 31, 2007. Aggregate residual value at risk on the lease portfolio at December 31, 2007 was $1.1 billion. We have taken steps to mitigate $.6 billion of this residual risk, including residual value insurance coverage with third parties, third party guarantees, and other actions. The portfolio included approximately $1.7 billion of cross-border leases at December 31, 2007. Cross-border leases are leveraged leases of equipment located in foreign countries, primarily in western Europe and Australia. We have not entered into cross-border lease transactions since 2003.

We have reached a settlement with the Internal Revenue Service (IRS) regarding our tax liability related to cross- border lease transactions, principally arising from adjustments to the timing of income tax deductions in connection with IRS examinations of our 1998-2003 consolidated Federal income tax returns. The impact of the final settlement was included in results of operations for 2007 and was not material. See Note 1 Accounting Policies in the Notes To Consolidated Financial Statements in Item 8 of this Report regarding our adoption of FSP 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.”

 

SECURITIES

Details of Securities

 

In millions    Amortized
Cost
  

Fair

Value

December 31, 2007

       

SECURITIES AVAILABLE FOR SALE

       

Debt securities

       

Residential mortgage-backed

   $ 21,147    $ 20,952

Commercial mortgage-backed

     5,227      5,264

Asset-backed

     2,878      2,770

U.S. Treasury and government agencies

     151      155

State and municipal

     340      336

Other debt

     85      84

Corporate stocks and other

     662      664

Total securities available for sale

   $ 30,490    $ 30,225

December 31, 2006

       

SECURITIES AVAILABLE FOR SALE

       

Debt securities

       

Residential mortgage-backed

   $ 17,325    $ 17,208

Commercial mortgage-backed

     3,231      3,219

Asset-backed

     1,615      1,609

U.S. Treasury and government agencies

     611      608

State and municipal

     140      139

Other debt

     90      87

Corporate stocks and other

     321      321

Total securities available for sale

   $ 23,333    $ 23,191

Securities represented 22% of total assets at December 31, 2007 and 23% of total assets at December 31, 2006. Our acquisition of Mercantile included approximately $2 billion of securities classified as available for sale. The increase in total securities compared with December 31, 2006 was primarily due to higher balances in residential mortgage-backed, commercial mortgage-backed and asset-backed securities.

We evaluate our portfolio of securities available for sale in light of changing market conditions and other factors and, where appropriate, take steps intended to improve our overall positioning.

At December 31, 2007, the securities available for sale balance included a net unrealized loss of $265 million, which represented the difference between fair value and amortized cost. The comparable amount at December 31, 2006 was a net unrealized loss of $142 million. Net unrealized gains and losses in the securities available for sale portfolio are included in shareholders’ equity as accumulated other comprehensive income or loss, net of tax. The fair value of securities available for sale generally decreases when interest rates increase and vice versa.

The expected weighted-average life of securities available for sale (excluding corporate stocks and other) was 3 years and 6 months at December 31, 2007 and 3 years and 8 months at December 31, 2006.


 

26


We estimate that at December 31, 2007 the effective duration of securities available for sale was 2.8 years for an immediate 50 basis points parallel increase in interest rates and 2.5 years for an immediate 50 basis points parallel decrease in interest rates. Comparable amounts at December 31, 2006 were 2.6 years and 2.2 years, respectively.

LOANS HELD FOR SALE

Loans held for sale totaled $3.9 billion at December 31, 2007 compared with $2.4 billion a year ago.

Loans held for sale included commercial mortgage loans intended for securitization totaling $2.1 billion at December 31, 2007 and $.9 billion at December 31, 2006. The balance at December 31, 2007 increased as market conditions were not conducive to completing securitization transactions during the fourth quarter of 2007. We also reduced our origination activity in early 2008. During the fourth quarter of 2007, a lower of cost or fair value adjustment was recorded of $26 million. This loss was reflected in the other noninterest income line item in our Consolidated Income Statement and in the results of the Corporate & Institutional Banking business segment. In early 2008, spreads have been widening and there has been limited activity in the CMBS securitization market. We value our commercial mortgage loans held for sale based on securitization prices. Therefore, if these conditions continue, additional losses will be incurred that will be significantly higher than the losses incurred during the fourth quarter of 2007. However, we do not expect the impact to be significant to our capital position. Currently, these valuation losses are unrealized (non-cash) and all of the loans in this portfolio are performing.

Loans held for sale also included education loans held for sale of $1.5 billion at December 31, 2007 and $1.3 billion at December 31, 2006. Historically, we classified substantially all of our education loans as loans held for sale. Gains on sales of education loans totaled $24 million in 2007, $33 million for 2006 and $19 million for 2005. These gains are reflected in the other noninterest income line item in our Consolidated Income Statement and in the results of the Retail Banking business segment.

In the past, we have sold education loans to issuers of asset-backed paper when the loans are placed into repayment status. Recently, the secondary markets for education loans have been impacted by liquidity issues similar to other asset classes. As a result, we believe the ability to sell education loans and generate related gains will be limited in 2008. Given this outlook and the economic and customer relationship value inherent in this product, in February 2008, we transferred the loans at lower of cost or market value from held for sale to the loan portfolio.

 

GOODWILL AND OTHER INTANGIBLE ASSETS

The sum of goodwill and other intangible assets increased $5.5 billion at December 31, 2007 compared with the prior year end, to $9.6 billion. We added $4.7 billion of goodwill and other intangible assets in connection with the Mercantile acquisition. In addition, our acquisitions of ARCS, Yardville and Albridge collectively added $.9 billion of goodwill and other intangible assets during 2007. Additional information is included in Note 7 Goodwill And Other Intangible Assets in the Notes To Consolidated Financial Statements under Item 8 of this Report.

OTHER ASSETS

The increase of $4.1 billion in “Assets-Other” in the preceding “Summarized Balance Sheet Data” table included the impact of a $1.0 billion increase in Federal funds sold and resale agreements and a $1.0 billion increase in other short-term investments, including trading securities.


 

27


FUNDING AND CAPITAL SOURCES

Details Of Funding Sources

 

December 31 - in millions    2007    2006

Deposits

       

Money market

   $32,785    $28,580

Demand

   20,861    16,833

Retail certificates of deposit

   16,939    14,725

Savings

   2,648    1,864

Other time

   2,088    1,326

Time deposits in foreign offices

   7,375    2,973

Total deposits

   82,696    66,301

Borrowed funds

       

Federal funds purchased

   7,037    2,711

Repurchase agreements

   2,737    2,051

Federal Home Loan Bank borrowing

   7,065    42

Bank notes and senior debt

   6,821    3,633

Subordinated debt

   4,506    3,962

Other

   2,765    2,629

Total borrowed funds

   30,931    15,028

Total

   $113,627    $81,329

Total funding sources increased $32.3 billion at December 31, 2007 compared with the balance at December 31, 2006, as total deposits increased $16.4 billion and total borrowed funds increased $15.9 billion. Our acquisition of Mercantile added $12.5 billion of deposits and $2.1 billion of borrowed funds. The Yardville acquisition resulted in $2.0 billion of deposits.

During the first quarter of 2007 we issued borrowings to fund the $2.1 billion cash portion of the Mercantile acquisition. The remaining increase in borrowed funds was the result of growth in loans and securities and the need to fund other net changes in our balance sheet. During the second half of 2007 we substantially increased Federal Home Loan Bank borrowings, which provided us with additional liquidity at relatively attractive rates. The Liquidity Risk Management section of this Item 7 contains further details regarding actions we have taken which impacted our borrowed funds balances during 2007 and early 2008.

 

Capital

We manage our capital position by making adjustments to our balance sheet size and composition, issuing debt, equity or hybrid instruments, executing treasury stock transactions, managing dividend policies and retaining earnings.

Total shareholders’ equity increased $4.1 billion, to $14.9 billion, at December 31, 2007 compared with December 31, 2006. In addition to the net impact of earnings and dividends in 2007, this increase reflected a $2.5 billion reduction in treasury stock and a $1.0 billion increase in capital surplus, largely due to the issuance of PNC common shares for the Mercantile and Yardville acquisitions.

Common shares outstanding were 341 million at December 31, 2007 and 293 million at December 31, 2006. The increase in shares during 2007 reflected the issuance of approximately 53 million shares in connection with the Mercantile acquisition and approximately 3 million shares in connection with the Yardville acquisition.

In October 2007, our Board of Directors terminated the prior program and approved a new stock repurchase program to purchase up to 25 million shares of PNC common stock on the open market or in privately negotiated transactions. This new program will remain in effect until fully utilized or until modified, superseded or terminated. During 2007, we purchased 11 million common shares under our new and prior common stock repurchase programs at a total cost of approximately $800 million.

The extent and timing of additional share repurchases under the new program will depend on a number of factors including, among others, market and general economic conditions, economic and regulatory capital considerations, alternative uses of capital, regulatory limitations resulting from merger activity, and the potential impact on our credit rating. We do not expect to actively engage in share repurchase activity for the foreseeable future.


 

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Risk-Based Capital

 

December 31 - dollars in millions

   2007     2006  

Capital components

      

Shareholders’ equity

      

Common

   $14,847     $10,781  

Preferred

   7     7  

Trust preferred capital securities

   572     965  

Minority interest

   985     494  

Goodwill and other intangibles

   (8,853 )   (3,566 )

Eligible deferred income taxes on intangible assets

   119     26  

Pension, other postretirement and postemployment benefit plan adjustments

   177     148  

Net unrealized securities losses, after tax

   167     91  

Net unrealized losses (gains) on cash flow hedge derivatives, after tax

   (175 )   13  

Equity investments in nonfinancial companies

   (31 )   (30 )

Other, net

         (5 )

Tier 1 risk-based capital

   7,815     8,924  

Subordinated debt

   3,024     1,954  

Eligible allowance for credit losses

   964     681  

Total risk-based capital

   $11,803     $11,559  

Assets

      

Risk-weighted assets, including off-balance sheet instruments and market risk equivalent assets

   $115,132     $85,539  

Adjusted average total assets

   126,139     95,590  

Capital ratios

      

Tier 1 risk-based

   6.8 %   10.4 %

Total risk-based

   10.3     13.5  

Leverage

   6.2     9.3  

Tangible capital

      

Common shareholders’ equity

   $14,847     $10,781  

Goodwill and other intangibles

   (8,853 )   (3,566 )

Eligible deferred income taxes on intangible assets

   119     26  

Tangible capital

   $6,113     $7,241  

Total assets excluding goodwill and other intangible assets, net of eligible deferred income taxes

   $130,185     $98,280  

Tangible common equity

   4.7 %   7.4 %

The declines in capital ratios from December 31, 2006 were primarily due to the impact of acquisitions, which increased risk-weighted assets and goodwill, common share repurchases and organic balance sheet growth.

The access to, and cost of, funding new business initiatives including acquisitions, the ability to engage in expanded business activities, the ability to pay dividends, the level of deposit insurance costs, and the level and nature of regulatory oversight depend, in part, on a financial institution's capital strength.

At December 31, 2007 and December 31, 2006, each of our domestic bank subsidiaries was considered “well capitalized” based on US regulatory capital ratio requirements. See the Supervision And Regulation section of Item 1 of this Report and Note 22 Regulatory Matters in the Notes To Consolidated

Financial Statements in Item 8 of this Report for additional information. We believe our bank subsidiaries will continue to meet these requirements in 2008.

We refer you to the “Perpetual Trust Securities” and “PNC Capital Trust E Trust Preferred Securities” portions of the Off-Balance Sheet Arrangements And VIEs section of this Item 7 for a discussion of two February 2008 hybrid capital securities issuances totaling $825 million that qualify as Tier 1 regulatory capital.

OFF-BALANCE SHEET ARRANGEMENTS AND VIES

We engage in a variety of activities that involve unconsolidated entities or that are otherwise not reflected in our Consolidated Balance Sheet that are generally referred to as “off-balance sheet arrangements.” The following sections of this Report provide further information on these types of activities:

   

Commitments, including contractual obligations and other commitments, included within the Risk Management section of this Item 7, and

   

Note 24 Commitments and Guarantees in the Notes To Consolidated Financial Statements included in Item 8 of this Report.

The following provides a summary of variable interest entities (“VIEs”), including those in which we hold a significant variable interest but have not consolidated and those that we have consolidated into our financial statements as of December 31, 2007 and 2006.

Non-Consolidated VIEs – Significant Variable Interests

 

In millions

  Aggregate
Assets
   Aggregate
Liabilities
  PNC Risk

of Loss

 

 

December 31, 2007

        

Market Street

  $5,304    $5,330   $9,019 (a)

Collateralized debt obligations

  255    177   6  

Partnership interests in low income housing projects

  50    34   8  

Total

  $5,609    $5,541   $9,033  

December 31, 2006

        

Market Street

  $4,020    $4,020   $6,117 (a)

Collateralized debt obligations

  815    570   22  

Partnership interests in low income housing projects

  33    30   8  

Total

  $4,868    $4,620   $6,147  
(a) PNC’s risk of loss consists of off-balance sheet liquidity commitments to Market Street of $8.8 billion and other credit enhancements of $.2 billion at December 31, 2007. The comparable amounts at December 31, 2006 were $5.6 billion and $.6 billion, respectively. These liquidity commitments are included in the Net Unfunded Credit Commitments table in the Consolidated Balance Sheet Review section of this Report.

 

29


Market Street

Market Street Funding LLC (“Market Street”) is a multi-seller asset-backed commercial paper conduit that is owned by an independent third party. Market Street’s activities primarily involve purchasing assets or making loans secured by interests in pools of receivables from US corporations that desire access to the commercial paper market. Market Street funds the purchases of assets or loans by issuing commercial paper which has been rated A1/P1 by Standard & Poor’s and Moody’s, respectively, and is supported by pool-specific credit enhancements, liquidity facilities and program-level credit enhancement. Generally, Market Street mitigates its potential interest rate risk by entering into agreements with its borrowers that reflect interest rates based upon its weighted average commercial paper cost of funds. During 2007 and 2006, Market Street met all of its funding needs through the issuance of commercial paper.

At December 31, 2007 Market Street commercial paper outstanding was $5.1 billion compared with $3.9 billion for the prior year-end. The weighted average maturity of the commercial paper was 32 days at December 31, 2007 compared with 23 days at December 31, 2006.

In the ordinary course of business during 2007, PNC Capital Markets, acting as a placement agent for Market Street, held a maximum daily position in Market Street commercial paper of $113 million with an average of $27 million and a year-end position of less than $1 million. This compares with a maximum daily position of $105 million with an average of $12 million during 2006. PNC Capital Markets did not own any Market Street commercial paper at December 31, 2006. PNC made no other purchases of Market Street commercial paper during 2007 or 2006.

PNC Bank, N.A. provides certain administrative services, a portion of the program-level credit enhancement and 99% of liquidity facilities to Market Street in exchange for fees negotiated based on market rates. PNC recognized program administrator fees and commitments fees related to PNC’s portion of the liquidity facilities of $12.6 million and $4.1 million, respectively, for the year ended December 31, 2007.

PNC views its credit exposure for the Market Street transactions as limited. Neither creditors nor investors in Market Street have any recourse to our general credit. The commercial paper obligations at December 31, 2007 and 2006 were effectively collateralized by Market Street’s assets. While PNC may be obligated to fund under liquidity facilities for events such as commercial paper market disruptions, borrower bankruptcies, collateral deficiencies or covenant violations, our credit risk under the liquidity facilities is secondary to the risk of first loss provided by the borrower or another third party in the form of deal-specific credit enhancement – for example, by the over collateralization of the assets. Deal-specific credit enhancement that supports the commercial paper issued by Market Street is generally structured to cover a multiple of expected losses for the pool

of assets and is sized to generally meet rating agency standards for comparably structured transactions. Of the $8.8 billion of liquidity facilities provided by PNC at December 31, 2007, only $2.8 billion required PNC to fund if the assets are in default.

Program-level credit enhancement in the amount of 10% of commitments, excluding explicitly rated AAA/Aaa facilities, is provided by PNC and Ambac, a monoline insurer. PNC provides 25% of the enhancement in the form of a cash collateral account funded by a loan facility. This facility expires on March 23, 2012. See Note 5 Loans, Commitments To Extend Credit and Concentrations of Credit Risk and Note 24 Commitments and Guarantees included in Item 8 of this Report for additional information. The monoline insurer provides the remaining 75% of the enhancement in the form of a surety bond. The cash collateral account is subordinate to the surety bond.

Market Street was restructured as a limited liability company in October 2005 and entered into a Subordinated Note Purchase Agreement (“Note”) with an unrelated third party. The Note provides first loss coverage whereby the investor absorbs losses up to the amount of the Note, which was $8.6 million as of December 31, 2007. Proceeds from the issuance of the Note are held by Market Street in a first loss reserve account that will be used to reimburse any losses incurred by Market Street, PNC Bank, N.A. or other providers under the liquidity facilities and the credit enhancement arrangements.

Assets of Market Street Funding LLC

 

In millions   Outstanding    Commitments    Weighted
Average
Remaining
Maturity In
Years

December 31, 2007 (a)

         

Trade receivables

  $ 1,375    $ 2,865    2.63

Automobile financing

    1,387      1,565    4.06

Collateralized loan obligations

    519      1,257    2.54

Credit cards

    769      775    .26

Residential mortgage

    37      720    .90

Other

    1,031      1,224    1.89

Cash and miscellaneous receivables

    186            

Total

  $ 5,304    $ 8,406    2.41

December 31, 2006 (a)

         

Trade receivables

  $ 1,165    $ 2,429    2.14

Automobile financing

    335      560    2.64

Collateralized loan obligations

    129      146    5.92

Credit cards

    814      819    .29

Residential mortgage

    501      618    .38

Other

    914      1,084    2.21

Cash and miscellaneous receivables

    162            

Total

  $ 4,020    $ 5,656    1.84
(a) Market Street did not recognize an asset impairment charge or experience a rating downgrade on its assets during 2007 or 2006.

 

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Market Street Commitments by Credit Rating (a)

 

     December 31, 2007     December 31, 2006  

AAA/Aaa

   19 %   10 %

AA/Aa

   6     5  

A/A

   72     77  

BBB/Baa

   3     8  

Total

   100 %   100 %
a) Not all Facilities are explicitly rated by the rating agencies. Facilities are structured to meet rating agency standards for comparably structured transactions.

As a result of the Note issuance, we reevaluated the design of Market Street, its capital structure and relationships among the variable interest holders under the provisions of FASB Interpretation No. 46, (Revised 2003) “Consolidation of Variable Interest entities (“FIN 46R”). Based on this analysis, we determined that we were no longer the primary beneficiary as defined by FIN 46R and deconsolidated Market Street from our Consolidated Balance Sheet effective October 17, 2005.

PNC considers changes to the variable interest holders (such as new expected loss note investors and changes to program- level credit enhancement providers), terms of expected loss notes, and new types of risks (such as foreign currency or interest rate) in Market Street as reconsideration events. PNC reviews the activities of Market Street on at least a quarterly basis to determine if a reconsideration event has occurred. As indicated earlier, 75% of the program-level credit enhancement is provided by Ambac in the form of a surety bond. PNC Bank, N.A., in the role of program administrator, is closely following market developments relative to the rating agency outlooks of monoline insurers. Ambac is currently rated AAA by two of the three major rating agencies and AA by the other agency. This rating change has not impacted the Market Street commercial paper ratings of A1/P1. Various alternatives to the program-level enhancement are under consideration if future rating changes impact either the ratings of Market Street commercial paper or its financial results.

Based on current accounting guidance and market conditions, we do not have to consolidate Market Street into our consolidated financial statements. However, if PNC would be determined to be the primary beneficiary under FIN 46R, we would consolidate the conduit at that time. To the extent that the par value of the assets in Market Street exceeded the fair value of the assets upon consolidation, the difference would be recognized by PNC as a loss in our Consolidated Income Statement in that period. Based on the fair value of the assets held by Market Street at December 31, 2007, this reduction in earnings would not have had a material impact on our risk-based capital ratios, credit ratings or debt covenants.

 

Consolidated VIEs – PNC Is Primary Beneficiary

 

In millions   

Aggregate

Assets

   Aggregate
Liabilities

Partnership interests in low income housing projects

       

December 31, 2007

   $ 1,110    $ 1,110

December 31, 2006

   $ 834    $ 834

The table above reflects the aggregate assets and liabilities of VIEs that we have consolidated in our financial statements.

Low Income Housing Projects

We make certain equity investments in various limited partnerships that sponsor affordable housing projects utilizing the Low Income Housing Tax Credit (“LIHTC”) pursuant to Section 42 of the Internal Revenue Code. The purpose of these investments is to achieve a satisfactory return on capital, to facilitate the sale of additional affordable housing product offerings and to assist us in achieving goals associated with the Community Reinvestment Act. The primary activities of the limited partnerships include the identification, development and operation of multi-family housing that is leased to qualifying residential tenants. Generally, these types of investments are funded through a combination of debt and equity, with equity typically comprising 30% to 60% of the total project capital.

We consolidated those LIHTC investments in which we own a majority of the limited partnership interests and are deemed to be primary beneficiary. We also consolidated entities in which we, as a national syndicator of affordable housing equity, serve as the general partner, and no other entity owns a majority of the limited partnership interests (together with the investments described above, the “LIHTC investments”). In these syndication transactions, we create funds in which our subsidiary is the general partner and sells limited partnership interests to third parties, and in some cases may also purchase a limited partnership interest in the fund. The fund’s limited partners can generally remove the general partner without cause at any time. The purpose of this business is to generate income from the syndication of these funds and to generate servicing fees by managing the funds. General partner activities include selecting, evaluating, structuring, negotiating, and closing the fund investments in operating limited partnerships, as well as oversight of the ongoing operations of the fund portfolio. The assets are primarily included in Equity Investments on our Consolidated Balance Sheet. Neither creditors nor equity investors in the LIHTC investments have any recourse to our general credit. The consolidated aggregate assets and debt of these LIHTC investments are provided in the Consolidated VIEs – PNC Is Primary Beneficiary table and reflected in the “Other” business segment.

We have a significant variable interest in certain other limited partnerships that sponsor affordable housing projects. We do not own a majority of the limited partnership interests in these entities and are not the primary beneficiary. We use the equity method to account for our investment in these entities.


 

31


Information regarding these partnership interests is reflected in the Non-Consolidated VIEs – Significant Variable Interests table.

Perpetual Trust Securities

We issue certain hybrid capital vehicles that qualify as capital for regulatory and rating agency purposes.

In December 2006, one of our indirect subsidiaries, PNC REIT Corp., sold $500 million of 6.517% Fixed-to-Floating Rate Non-Cumulative Exchangeable Perpetual Trust Securities (the “Trust Securities”) of PNC Preferred Funding Trust I (“Trust I”) in a private placement. PNC REIT Corp. had previously acquired the Trust Securities from the trust in exchange for an equivalent amount of Fixed-to-Floating Rate Non-Cumulative Perpetual Preferred Securities (the “LLC Preferred Securities”), of PNC Preferred Funding LLC (the “LLC”), held by PNC REIT Corp. The LLC’s initial material assets consist of indirect interests in mortgages and mortgage-related assets previously owned by PNC REIT Corp.

In March 2007, PNC Preferred Funding LLC sold $500 million of 6.113% Fixed-to-Floating Rate Non-Cumulative Exchangeable Perpetual Trust Securities of PNC Preferred Funding Trust II (“Trust II”), in a private placement. In connection with the private placement, Trust II acquired $500 million of LLC Preferred Securities.

In February 2008, PNC Preferred Funding LLC sold $375 million of 8.700% Fixed-to-Floating Rate Non-Cumulative Exchangeable Perpetual Trust Securities of PNC Preferred Funding Trust III (“Trust III”) in a private placement. In connection with the private placement, Trust III acquired $375 million of LLC Preferred Securities.

PNC REIT Corp. owns 100% of the LLC’s common voting securities. As a result, the LLC is an indirect subsidiary of PNC and is consolidated on our Consolidated Balance Sheet. Trust I, Trust II and Trust III’s investment in the LLC Preferred Securities is characterized as a minority interest on our Consolidated Balance Sheet since we are not the primary beneficiary of Trust I, Trust II or Trust III. This minority interest totaled approximately $980 million at December 31, 2007 (excluding Trust III, which was not yet formed). Each Trust I Security is automatically exchangeable into a share of Series F Non-Cumulative Perpetual Preferred Stock of PNC Bank, N.A. (the “PNC Bank Preferred Stock”), each Trust II Security is automatically exchangeable into a share of Series I Non-Cumulative Perpetual Preferred Stock of PNC (the “Series I Preferred Stock”), and each Trust III Security is automatically exchangeable into a share of Series J Non-Cumulative Perpetual Preferred Stock of PNC, in each case under certain conditions relating to the capitalization or the financial condition of PNC Bank, N.A. and upon the direction of the Office of the Comptroller of the Currency.

We entered into a replacement capital covenant in connection with each of the closing of the Trust Securities sale (the “Trust

Covenant”) and the closing of the Trust II Securities sale (the “Trust II Covenant”), in each case for the benefit of holders of a specified series of our long-term indebtedness (the “Covered Debt”). As of December 31, 2007, Covered Debt consists of our $200 million Floating Rate Junior Subordinated Notes issued on June 9, 1998.

We agreed in the Trust Covenant that neither we nor our subsidiaries (other than PNC Bank, N.A. and its subsidiaries) would purchase the Trust Securities, the LLC Preferred Securities or the PNC Bank Preferred Stock (collectively, the “Trust Covered Securities”) unless: (i) we have received the prior approval of the Federal Reserve Board, if such approval is then required under the Federal Reserve Board’s capital guidelines applicable to bank holding companies and (ii) during the 180-day period prior to the date of purchase, we or our subsidiaries, as applicable, have received proceeds from the sale of Qualifying Securities in the amounts specified in the Trust Covenant (which amounts will vary based on the type of securities sold). The Trust Covenant does not apply to redemptions of the Trust Covered Securities by the issuers of those securities.

We agreed in the Trust II Covenant that until March 29, 2017, neither we nor our subsidiaries would purchase or redeem the Trust II Securities, the LLC Preferred Securities or the Series I Preferred Stock (collectively, the “Trust II Covered Securities”), unless: (i) we have received the prior approval of the Federal Reserve Board, if such approval is then required under the Federal Reserve Board’s capital guidelines applicable to bank holding companies and (ii) during the 180-day period prior to the date of purchase, PNC, PNC Bank, N.A. or PNC Bank N.A.’s subsidiaries, as applicable, have received proceeds from the sale of Qualifying Securities in the amounts specified in the Trust II Covenant (which amounts will vary based on the type of securities sold).

“Qualifying Securities” means debt and equity securities having terms and provisions that are specified in the Trust Covenant or the Trust II Covenant, as applicable and that, generally described, are intended to contribute to our capital base in a manner that is similar to the contribution to our capital base made by the Trust Covered Securities or the Trust II Covered Securities, as applicable. We filed a copy of each of the Trust Covenant and the Trust II Covenant with the SEC as Exhibit 99.1 to PNC’s Form 8-K filed on December 8, 2006 and as Exhibit 99.1 to PNC’s Form 8-K filed on March 30, 2007, respectively.

PNC Bank, N.A. has contractually committed to Trust I that if full dividends are not paid in a dividend period on the Trust Securities, LLC Preferred Securities or any other parity equity securities issued by the LLC, neither PNC Bank, N.A. nor its subsidiaries will declare or pay dividends or other distributions with respect to, or redeem, purchase or acquire or make a liquidation payment with respect to, any of its equity capital securities during the next succeeding period (other than to holders of the LLC Preferred Securities and any parity equity securities issued by the LLC) except: (i) in the case of


 

32


dividends payable to subsidiaries of PNC Bank, N.A., to PNC Bank, N.A. or another wholly-owned subsidiary of PNC Bank, N.A. or (ii) in the case of dividends payable to persons that are not subsidiaries of PNC Bank, N.A., to such persons only if, (A) in the case of a cash dividend, PNC has first irrevocably committed to contribute amounts at least equal to such cash dividend or (B) in the case of in-kind dividends payable by PNC REIT Corp., PNC has committed to purchase such in-kind dividend from the applicable PNC REIT Corp. holders in exchange for a cash payment representing the market value of such in-kind dividend, and PNC has committed to contribute such in-kind dividend to PNC Bank, N.A.

PNC has contractually committed to each of Trust II and Trust III that if full dividends are not paid in a dividend period on the Trust II Securities or the Trust III Securities, as applicable, or the LLC Preferred Securities held by Trust II or Trust III, as applicable, PNC will not declare or pay dividends with respect to, or redeem, purchase or acquire, any of its equity capital securities during the next succeeding dividend period, other than: (i) purchases, redemptions or other acquisitions of shares of capital stock of PNC in connection with any employment contract, benefit plan or other similar arrangement with or for the benefit of employees, officers, directors or consultants, (ii) purchases of shares of common stock of PNC pursuant to a contractually binding requirement to buy stock existing prior to the commencement of the extension period, including under a contractually binding stock repurchase plan, (iii) any dividend in connection with the implementation of a shareholders’ rights plan, or the redemption or repurchase of any rights under any such plan, (iv) as a result of an exchange or conversion of any class or series of PNC’s capital stock for any other class or series of PNC’s capital stock, (v) the purchase of fractional interests in shares of PNC capital stock pursuant to the conversion or exchange provisions of such stock or the security being converted or exchanged or (vi) any stock dividends paid by PNC where the dividend stock is the same stock as that on which the dividend is being paid. We filed a copy of the Exchange Agreements containing those dividend restrictions with the SEC as Exhibit 4.16 to PNC’s Form 8-K filed on March 30, 2007 and as Exhibit 99.1 to PNC’s Form 8-K filed on February 19, 2008, respectively.

PNC Capital Trust E Trust Preferred Securities

In February 2008, PNC Capital Trust E issued $450 million of 7 3/4% Trust Preferred Securities due March 15, 2068 (the “Trust E Securities”). PNC Capital Trust E’s only assets are $450 million of 7 3/4% Junior Subordinated Notes due March 15, 2068 and issued by PNC (the “JSNs”). The Trust E Securities are fully and unconditionally guaranteed by PNC.

We may, at our option, redeem the JSNs at 100% of their principal amount on or after March 15, 2013. We have agreed to redeem the JSNs on March 15, 2038, but only out of net proceeds from the sale of certain replacement capital securities described in the JSN indenture. The Trust E Securities will be redeemed at the time of the JSN redemption.

If we defer interest on the JSNs and either pay current interest or the fifth anniversary of the deferral passes, we are obligated to issue certain qualifying securities defined in the JSN indenture to raise proceeds to fund the payment of accrued and unpaid interest.

In addition, we have entered into a replacement capital covenant (the “Trust E Covenant”) for the benefit of holders of a specified series of our long-term indebtedness (the “Trust E Covered Debt”). As of February 13, 2008, the Trust E Covered Debt consists of our $300 million 6.125% Junior Subordinated Notes issued in December 2003. We agreed in the Trust E Covenant that neither PNC nor its subsidiaries will repay, redeem or purchase the JSNs or the Trust E Securities on or after March 15, 2038 unless: (i) we have obtained the prior approval of the Federal Reserve Board, if such approval is then required by the Federal Reserve Board; and (ii) subject to certain limitations, during the 180-day period prior to the date of repayment, redemption or purchase, we have received proceeds from the sale of Trust E Qualifying Securities in the amounts specified in the Trust E Covenant (which amounts will vary based on the redemption date and the type of securities sold). “Trust E Qualifying Securities” means debt and equity securities having terms and provisions that are specified in the Trust E Covenant and that, generally described, are intended to contribute to our capital base in a manner that is similar to the contribution to our capital base made by the Trust E Covered Securities.

The Trust E Covenant will terminate upon the earlier to occur of (i) March 15, 2048, (ii) the date on which the JSNs are otherwise redeemed in full, (iii) the date on which the holders of a majority of the principal amount of the Trust E Covered Debt agree to terminate the Trust E Covenant, (iv) the date on which we no longer have outstanding any indebtedness eligible to qualify as covered debt or (v) the occurrence of an event of default and acceleration of the JSNs under the related indenture. We filed a copy of the Trust E Covenant with the SEC as Exhibit 99.1 to PNC’s Form 8-K filed February 13, 2008.

In connection with the closing of the Trust E Securities sale, we agreed that, if we have given notice of our election to defer interest payments on the JSNs or a related deferral period is continuing, then PNC would be subject during such period to restrictions on dividends and other provisions protecting the status of the JSN debenture holder similar to or in some ways more restrictive than those potentially imposed under the Exchange Agreements with Trust II and Trust III, as described above.

Acquired Entity Trust Preferred Securities

As a result of the Mercantile and Yardville acquisitions, we assumed obligations with respect to $73 million in principal amount of junior subordinated debentures issued by the acquired entities. Under the terms of these debentures, if there is an event of default under the debentures or PNC exercises its right to defer payments on the related trust preferred securities issued by the statutory trusts or there is a default under PNC’s guarantee of such payment obligations, PNC


 

33


would be subject during the period of such default or deferral to restrictions on dividends and other provisions protecting the status of the debenture holders similar to or in some ways more restrictive than those potentially imposed under the Exchange Agreements with Trust II and Trust III, as described above.

BUSINESS SEGMENTS REVIEW

We have four major businesses engaged in providing banking, asset management and global fund processing products and services. Business segment results, including inter-segment revenues, and a description of each business are included in Note 26 Segment Reporting included in the Notes To Consolidated Financial Statements under Item 8 of this Report.

Certain revenue and expense amounts included in this Business Segments Review differ from the amounts shown in Note 26 due to the presentation in this Business Segments Review of business revenue on a taxable-equivalent basis, the inclusion of BlackRock/MLIM transaction integration costs in the “Other” category, and income statement classification differences related to PFPC. Also, the presentation of BlackRock results for the 2006 period have been modified in this Business Segments Review as described on page 41 to conform with our current period presentation.

Results of individual businesses are presented based on our management accounting practices and our management structure. There is no comprehensive, authoritative body of guidance for management accounting equivalent to GAAP; therefore, the financial results of individual businesses are not necessarily comparable with similar information for any other company. We refine our methodologies from time to time as our management accounting practices are enhanced and our businesses and management structure change. Financial results are presented, to the extent practicable, as if each business, with the exception of our BlackRock segment, operated on a stand-alone basis. As permitted under GAAP, we have aggregated the business results for certain operating segments for financial reporting purposes.

Assets receive a funding charge and liabilities and capital receive a funding credit based on a transfer pricing methodology that incorporates product maturities, duration and other factors. Capital is intended to cover unexpected losses and is assigned to the banking and processing

businesses using our risk-based economic capital model. We have assigned capital equal to 6% of funds to Retail Banking to reflect the capital required for well-capitalized domestic banks and to approximate market comparables for this business. The capital assigned for PFPC reflects its legal entity shareholders' equity.

BlackRock business segment results for the nine months ended September 30, 2006 reflected our majority ownership in BlackRock during that period. Subsequent to the September 29, 2006 BlackRock/MLIM transaction closing, our ownership interest was reduced to approximately 34%. Since that date, our investment in BlackRock has been accounted for under the equity method but continues to be a separate reportable business segment of PNC. We describe our presentation method for the BlackRock segment for this Business Segments Review and our Line of Business Highlights on page 41.

We have allocated the allowances for loan and lease losses and unfunded loan commitments and letters of credit based on our assessment of risk inherent in the loan portfolios. Our allocation of the costs incurred by operations and other support areas not directly aligned with the businesses is primarily based on the use of services.

Total business segment financial results differ from total consolidated results. The impact of these differences is reflected in the “Other” category. “Other” for purposes of this Item 7 Financial Review includes residual activities that do not meet the criteria for disclosure as a separate reportable business, such as gains or losses related to BlackRock transactions including LTIP share distributions and obligations, BlackRock/MLIM transaction and acquisition integration costs, asset and liability management activities, net securities gains or losses, certain trading activities and equity management activities, differences between business segment performance reporting and financial statement reporting (GAAP), intercompany eliminations, and most corporate overhead.

Employee data as reported by each business segment in the tables that follow reflect staff directly employed by the respective businesses and excludes corporate and shared services employees. Prior period employee statistics generally are not restated for organizational changes.


 

34


Results Of Businesses - Summary

 

   Earnings    Revenue (a)    Average Assets (b)

Year ended December 31 - dollars in millions

   2007     2006    2007    2006    2007    2006

Retail Banking

   $893     $765    $3,801    $3,125    $42,424    $29,248

Corporate & Institutional Banking

   432     454    1,538    1,455    29,052    24,822

BlackRock (c)(d)

   253     187    338    1,170    4,259    3,937

PFPC (e)

   128     124    831    762    2,476    2,204

Total business segments

   1,706     1,530    6,508    6,512    78,211    60,211

Other (c )(f) (g)

   (239 )   1,065    224    2,085    45,207    34,801

Total consolidated

   $1,467     $2,595    $6,732    $8,597    $123,418    $95,012

 

(a) Business segment revenue is presented on a taxable-equivalent basis. The interest income earned on certain assets is completely or partially exempt from federal income tax. As such, these tax-exempt instruments typically yield lower returns than a taxable investment. To provide more meaningful comparisons of yields and margins for all interest-earning assets, we also provide revenue on a taxable-equivalent basis by increasing the interest income earned on tax-exempt assets to make it fully equivalent to interest income earned on other taxable investments. This adjustment is not permitted under GAAP. The following is a reconciliation of total consolidated revenue on a book (GAAP) basis to total consolidated revenue on a taxable-equivalent basis:

 

Year ended December 31 - dollars in millions

     2007      2006

Total consolidated revenue, book (GAAP) basis

   $ 6,705    $ 8,572

Taxable-equivalent adjustment

     27      25

Total consolidated revenue, taxable-equivalent basis

   $ 6,732    $ 8,597
(b) Period-end balances for BlackRock and PFPC.
(c) For our segment reporting presentation in this Business Segments Review and our Line of Business Highlights, after-tax BlackRock/MLIM transaction integration costs totaling $3 million and $65 million for 2007 and 2006 have been reclassified from BlackRock to “Other.” “Other” for 2007 also includes $96 million of after-tax acquisition integration costs and $53 million of after-tax Visa indemnification costs.
(d) For full year 2007 and the fourth quarter of 2006, revenue represents our equity income from BlackRock. For the first nine months of 2006, revenue represents the sum of total operating revenue and nonoperating income.
(e) PFPC revenue represents the sum of servicing revenue and nonoperating income (expense) less debt financing costs. Servicing revenue amounts for 2006 have been reclassified to conform with the current period presentation.
(f) “Other” for 2006 included the $2.1 billion pretax, or $1.3 billion after-tax, gain on the BlackRock/MLIM transaction.
(g) “Other” average assets are comprised primarily of securities available for sale and residential mortgage loans associated with asset and liability management activities. The average total balance increased in 2007 compared with 2006 primarily due to acquisitions and purchases of securities.

 

35


RETAIL BANKING

 

Year ended December 31

Taxable-equivalent basis

Dollars in millions

   2007     2006  

INCOME STATEMENT

      

Net interest income

   $2,065     $1,678  

Noninterest income

      

Asset management

   466     352  

Service charges on deposits

   339     304  

Brokerage

   269     236  

Consumer services

   399     348  

Other

   263     207  

Total noninterest income

   1,736     1,447  

Total revenue

   3,801     3,125  

Provision for credit losses

   138     81  

Noninterest expense

   2,239     1,827  

Pretax earnings

   1,424     1,217  

Income taxes

   531     452  

Earnings

   $893     $765  

AVERAGE BALANCE SHEET

      

Loans

      

Consumer

      

Home equity

   $14,209     $13,813  

Indirect

   1,897     1,052  

Other consumer

   1,597     1,248  

Total consumer

   17,703     16,113  

Commercial and commercial real estate

   12,534     5,721  

Floor plan

   978     910  

Residential mortgage

   1,992     1,440  

Other

   230     242  

Total loans

   33,437     24,426  

Goodwill and other intangible assets

   5,061     1,581  

Loans held for sale

   1,564     1,607  

Other assets

   2,362     1,634  

Total assets

   $42,424     $29,248  

Deposits

      

Noninterest-bearing demand

   $10,513     $7,841  

Interest-bearing demand

   8,876     7,906  

Money market

   16,786     14,750  

Total transaction deposits

   36,175     30,497  

Savings

   2,678     2,035  

Certificates of deposit

   16,637     13,861  

Total deposits

   55,490     46,393  

Other liabilities

   621     553  

Capital

   3,558     2,986  

Total funds

   $59,669     $49,932  

PERFORMANCE RATIOS

      

Return on average capital

   25 %   26 %

Noninterest income to total revenue

   46     46  

Efficiency

   59     58  

OTHER INFORMATION (a)

      

Credit-related statistics:

      

Nonperforming assets (b)

   $225     $106  

Net charge-offs

   $131     $85  

Net charge-off ratio

   .39 %   .35 %

Home equity portfolio credit statistics: (c)

      

% of first lien positions

   39 %   43 %

Weighted average loan-to-value ratios

   73 %   70 %

Weighted average FICO scores

   727     728  

Loans 90 days past due

   .37 %   .24 %

Checking-related statistics: (c)

      

Retail Banking checking relationships

   2,272,000     1,954,000  

Consumer DDA households using
online banking

   1,091,000     938,000  

% of consumer DDA households
using online banking

   54 %   53 %

Year ended December 31

Taxable-equivalent basis

Dollars in millions

   2007     2006  

Checking-related statistics: (c) (continued)

      

Consumer DDA households using
online bill payment

   667,000     404,000  

% of consumer DDA households
using online bill payment

   33 %   23 %

Small business loans and managed deposits: (c)

 

   

Small business loans

   $13,049     $5,116  

Managed deposits:

      

On-balance sheet

      

Noninterest-bearing demand

   $5,994     $4,383  

Interest-bearing demand

   1,873     1,649  

Money market

   3,152     2,592  

Certificates of deposit

   1,068     802  

Off-balance sheet (d)

      

Small business sweep checking

   2,780     1,733  

Total managed deposits

   $14,867     $11,159  

Brokerage statistics:

      

Margin loans

   $151     $163  

Financial consultants (e)

   769     758  

Full service brokerage offices

   100     99  

Brokerage account assets (billions)

   $48     $46  

Other statistics:

      

Gains on sales of education loans (f)

   $24     $33  

Full-time employees

   12,036     9,549  

Part-time employees

   2,309     1,829  

ATMs

   3,900     3,581  

Branches (g)

   1,109     852  

ASSETS UNDER ADMINISTRATION
(in billions) (h)

      

Assets under management

      

Personal

   $53     $44  

Institutional

   20     10  

Total

   $73     $54  

Asset Type

      

Equity

   $42     $34  

Fixed income

   18     12  

Liquidity/other

   13     8  

Total

   $73     $54  

Nondiscretionary assets under administration

      

Personal

   $30     $25  

Institutional

   83     61  

Total

   $113     $86  

Asset Type

      

Equity

   $49     $33  

Fixed income

   28     24  

Liquidity/other

   36     29  

Total

   $113     $86  
(a) Presented as of December 31 except for net charge-offs, net charge-off ratio, and gains on sales of education loans.
(b) Includes nonperforming loans of $215 million at December 31, 2007 and $96 million at December 31, 2006.
(c) Home equity portfolio credit statistics, checking-related statistics, and small business loans and managed deposits information excludes the impact of Yardville, which we acquired effective October 26, 2007 and expect to convert onto PNC’s financial and operational systems during March 2008.
(d) Represents small business balances. These balances are swept into liquidity products managed by other PNC business segments, the majority of which are off-balance sheet.
(e) Financial consultants provide services in full service brokerage offices and PNC traditional branches.
(f) Included in “Noninterest income-Other.”
(g) Excludes certain satellite branches that provide limited products and service hours.
(h) Excludes brokerage account assets.

 

36


Retail Banking’s 2007 earnings increased $128 million, to $893 million, up 17% compared with 2006. The increase in earnings over the prior year was driven by acquisitions and strong fee income and customer growth, partially offset by increases in the provision for credit losses and continued investments in the business.

Retail Banking’s performance during 2007 included the following:

 

   

The Mercantile acquisition added approximately $10.3 billion of loans and $12.0 billion of deposits to Retail Banking. The acquisition also:

   

Added 235 branches and 256 ATMs,

   

Significantly increased our presence in Maryland,

   

Added to our presence in Delaware, Virginia and the Washington, DC area,

   

Significantly increased the size of our small business banking franchise by adding approximately $7.7 billion of commercial and commercial real estate loans,

   

Expanded our customer base with the addition of approximately 286,000 checking relationships, and

   

Expanded our wealth management business with the addition of $22 billion in assets under management.

   

The Yardville acquisition has resulted in a leading deposit share in several wealthy counties in central New Jersey and added 35 branches and 39 ATMs.

   

The pending acquisition of Sterling, which did not impact 2007, is expected to result in a leading deposit share in the Central Pennsylvania footprint and enhance our presence in surrounding markets.

   

Customer service and customer retention continues to be our focus. In 2007, we partnered with the Gallup organization to help evaluate and improve customer and employee satisfaction.

   

Consumer and small business checking relationships increased 318,000 during 2007, not including the impact of Yardville.

   

Our investment in online banking capabilities continues to pay off. Since December 31, 2006, the percentage of consumer checking households using online bill payment increased from 23% to 33%.

   

In September 2006, we launched our PNC-branded credit card product. As of December 31, 2007, more than 155,000 cards have been issued and we have $244 million in receivable balances. The results to date have exceeded our expectations.

   

In addition to the acquisitions, we opened 21 new branches and consolidated 34 branches in 2007 for a total of 1,109 branches at December 31, 2007. We continue to optimize our network by opening new branches in high growth areas, relocating branches to areas of higher market opportunity, and consolidating branches in areas of declining opportunity.

   

Our wealth management and brokerage businesses have benefited from acquisitions, market conditions and strong business development in 2007. Asset management and brokerage fees increased $147 million, or 25%, over 2006.

Total revenue for 2007 was $3.801 billion compared with $3.125 billion last year. Taxable-equivalent net interest income of $2.065 billion increased $387 million, or 23%, compared with 2006 due to a 20% increase in average deposits and a 37% increase in average loan balances. Net interest income growth was the result of acquisitions and core business growth, although this growth has stabilized in recent quarters. In the current interest rate environment, Retail Banking deposits will be less valuable, and are expected to result in lower net interest income for this business segment in 2008 compared with 2007.

Noninterest income increased $289 million, to $1.736 billion, up 20% compared with 2006. This growth can be attributed primarily to the following:

   

The acquisitions,

   

Comparatively favorable equity markets,

   

Increased brokerage revenue and volumes,

   

Increased volume-related consumer fees,

   

Increased third party loan servicing activities,

   

New PNC-branded credit card product, and

   

Customer growth.

In the past, we have sold education loans to issuers of asset-backed paper when the loans are placed into repayment status. Recently, the secondary markets for education loans have been impacted by liquidity issues similar to other asset classes. As a result, we believe the ability to sell education loans and generate related gains will be limited in 2008. Given this outlook and the economic and customer relationship value inherent in this product, in February 2008, we transferred the loans at lower of cost or market value from held for sale to the loan portfolio.

The provision for credit losses increased $57 million in 2007, to $138 million, compared with 2006. Net charge-offs were $131 million in 2007, an increase of $46 million compared with 2006. The increases in provision and net charge-offs were primarily a result of residential real estate development exposure, continued growth in our commercial loan portfolio and charge-offs returning to a more normal level given the current credit conditions. Charge-offs over the last few years have been low compared with historical averages. Given the current environment, we believe provision levels and nonperforming assets will continue to increase in 2008.

Noninterest expense in 2007 totaled $2.239 billion, an increase of $412 million, or 23%, compared with 2006. Increases were primarily attributable to acquisitions (77% of the increase), higher volume-related expenses tied to noninterest income growth, continued investment in new branches, and investments in various initiatives such as the new PNC-branded credit card.


 

37


Full-time employees at December 31, 2007 totaled 12,036, an increase of 2,487 over the prior year. The acquisitions added approximately 2,300 full-time Retail Banking employees. Part-time employees have increased by 480 since December 31, 2006. The increase in part-time employees is a result of acquisitions and various customer service enhancement and efficiency initiatives. These initiatives include utilizing more part-time customer-facing employees rather than full-time employees during peak business hours.

Growing core checking deposits as a lower-cost funding source and as the cornerstone product to build customer relationships is the primary objective of our deposit strategy. Furthermore, core checking accounts are critical to our strategy of expanding our payments business. Average total deposits increased $9.1 billion, or 20%, compared with 2006.

 

 

Certificates of deposits increased $2.8 billion and money market deposits increased $2.0 billion. These increases were primarily attributable to acquisitions. The deposit strategy of Retail Banking is to remain disciplined on pricing, target specific markets for growth, and focus on the retention and growth of balances for relationship customers.

 

Average demand deposit growth of $3.6 billion, or 23%, was almost solely due to acquisitions as the core growth was impacted by customers shifting funds into higher yielding deposits in the first part of 2007, small business sweep checking products, and investment products.

 

Small business and consumer-related checking relationships retention remained strong and stable. Consumer-related checking relationship retention has benefited from improved penetration rates of debit cards, online banking and online bill payment.

Currently, we are focused on a relationship-based lending strategy that targets specific customer sectors (homeowners, small businesses and auto dealerships) while seeking to maintain a moderate risk profile in the loan portfolio.

 

 

Average commercial and commercial real estate loans grew $6.8 billion, or 119%, compared with 2006. The increase is attributable to acquisitions and organic loan growth on the strength of increased small business loan demand from existing customers and the acquisition of new relationships through our sales efforts. At December 31, 2007, commercial and commercial real estate loans totaled $14.4 billion. This portfolio included $3.6 billion of commercial real estate loans, the majority of which were added with the Mercantile acquisition.

 

Average home equity loans grew $396 million, or 3%, compared with 2006 primarily due to acquisitions. Consumer loan demand has slowed as a result of the current rate and economic environment. Our home equity loan portfolio is relationship based, with 93% of the portfolio attributable to borrowers in our primary geographic footprint. We monitor this portfolio closely and the charge-offs and delinquencies that we have experienced are within our expectations given current market conditions.

 

Average indirect loans grew $845 million, or 80%, compared with 2006. The increase is attributable to acquisitions and growth in our core portfolio that has benefited from increased sales and marketing efforts.

 

Average residential mortgage loans increased $552 million, or 38%, primarily due to the addition of loans from the acquisitions. In general, the only meaningful growth in our mortgage portfolio is a result of acquisitions.

Assets under management of $73 billion at December 31, 2007 increased $19 billion compared with the balance at December 31, 2006. The increase was primarily attributable to the Mercantile acquisition and core organic business growth, partially offset by other declines such as the divestiture of a Mercantile asset management subsidiary during the fourth quarter. The remaining portfolio growth was a result of positive client net asset flows. Client net asset flows are the result of investment additions from new and existing clients offset by ordinary course distributions from trust and investment management accounts and account closures.

Nondiscretionary assets under administration of $113 billion at December 31, 2007 increased $27 billion compared with the balance at December 31, 2006, primarily due to the impact of Mercantile.

See Note 2 Acquisitions and Divestitures in the Notes To Consolidated Financial Statements in Item 8 of this Report regarding our planned sale of Hilliard Lyons during the first half of 2008.


 

38


CORPORATE & INSTITUTIONAL BANKING

 

Year ended December 31

Taxable-equivalent basis

Dollars in millions except as noted

   2007     2006  

INCOME STATEMENT

      

Net interest income

   $818     $703  

Noninterest income

      

Corporate service fees

   564     526  

Other

   156     226  

Noninterest income

   720     752  

Total revenue

   1,538     1,455  

Provision for credit losses

   125     42  

Noninterest expense

   818     746  

Pretax earnings

   595     667  

Income taxes

   163     213  

Earnings

   $432     $454  

AVERAGE BALANCE SHEET

      

Loans

      

Corporate (a)

   $9,519     $8,633  

Commercial real estate

   3,590     2,876  

Commercial – real estate related

   3,580     2,433  

Asset-based lending

   4,634     4,467  

Total loans

   21,323     18,409  

Goodwill and other intangible assets

   1,919     1,352  

Loans held for sale

   1,319     893  

Other assets

   4,491     4,168  

Total assets

   $29,052     $24,822  

Deposits

      

Noninterest-bearing demand

   $7,301     $6,771  

Money market

   4,784     2,654  

Other

   1,325     907  

Total deposits

   13,410     10,332  

Other liabilities

   3,347     2,863  

Capital

   2,152     1,838  

Total funds

   $18,909     $15,033  

PERFORMANCE RATIOS

      

Return on average capital

   20 %   25 %

Noninterest income to total revenue

   47     52  

Efficiency

   53     51  

COMMERCIAL MORTGAGE SERVICING PORTFOLIO (in billions)

      

Beginning of period

   $200     $136  

Acquisitions/additions

   88     102  

Repayments/transfers

   (45 )   (38 )

End of period

   $243     $200  

OTHER INFORMATION

      

Consolidated revenue from (b):

      

Treasury management

   $476     $418  

Capital markets

   $290     $283  

Midland Loan Services

   $220     $184  

Total loans (c)

   $23,861     $18,957  

Nonperforming assets (c) (d)

   $243     $63  

Net charge-offs

   $70     $54  

Full-time employees (c)

   2,290     1,936  

Net gains on commercial mortgage loan sales

   $39     $55  

Commercial mortgage loans held for sale (c)

   $2,100     $871  

Valuation adjustment on commercial mortgage loans held for sale

   $(26)      

Net carrying amount of commercial mortgage servicing rights (c)

   $694     $471  
(a) Includes lease financing.
(b) Represents consolidated PNC amounts.
(c) Presented as of period end.
(d) Includes nonperforming loans of $222 million at December 31, 2007 and $50 million at December 31, 2006.

 

Corporate & Institutional Banking earned $432 million in 2007 compared with $454 million in 2006. While total revenue increased more than noninterest expense, earnings declined due to an increase in the provision for credit losses. Market-related declines in CMBS securitization activities and non-customer-related trading revenue resulted in a year- over-year reduction in noninterest income. Treasury management, commercial mortgage servicing, and capital markets revenues led by merger and acquisition advisory services showed growth over 2006.

Highlights during 2007 for Corporate & Institutional Banking included:

 

 

Total revenue increased $83 million, or 6%, to $1.5 billion for 2007 compared with 2006. The increase was driven by higher taxable-equivalent net interest income related to increases in loans and noninterest-bearing deposits. Corporate service fees were higher due to increased sales of treasury management products and services, commercial mortgage servicing, and fees generated by Harris Williams. Partially offsetting these increases were declines in other noninterest income from commercial mortgage loan sale gains and related economic hedging activities and lower non-customer-related trading revenue resulting from recent volatility in the financial markets. Other noninterest income also reflected a $26 million negative valuation adjustment on our commercial mortgage loans held for sale in the fourth quarter of 2007.

 

 

In early 2008, spreads have been widening and there has been limited activity in the CMBS securitization market. We value our commercial mortgage loans held for sale based on securitization prices. Therefore, if these conditions continue, additional losses will be incurred that will be significantly higher than the losses incurred during the fourth quarter of 2007. Currently, these valuation losses are unrealized (non-cash) and all of the loans in this portfolio are performing.

 

 

On July 2, 2007, PNC acquired ARCS, a leading originator and servicer of agency multifamily permanent financing products, which added a commercial mortgage servicing portfolio of $13 billion.

 

 

Commercial mortgage servicing-related revenue, which includes fees and net interest income, totaled $233 million for 2007 compared with $184 million for 2006. The 27% increase was primarily driven by growth in the commercial mortgage servicing portfolio. The total servicing portfolio increased to $243 billion at December 31, 2007. The related increase in deposits drove the increase in the net interest income portion of this revenue.


 

39


 

Average total loan balances increased $2.9 billion or 16%, to $21.3 billion in 2007 compared with 2006. The Mercantile acquisition accounted for a large part of this increase and fueled growth in all loan categories. Continuing customer demand was also a factor in the increase in corporate loans.

 

 

Commercial mortgage loans held for sale totaled $2.1 billion at December 31, 2007, driven by origination volumes along with an increase in the holding period during the second half of 2007 due to adverse market conditions. Subject to market conditions, our plan is for held for sale loans to decline as a result of placing loans in CMBS securitizations and reducing origination activity in the first half of 2008.

 

 

Beginning in 2008, we elected to identify commercial mortgage loans held for sale that we intend to securitize as instruments to be accounted for at fair value under the provisions of SFAS 159, The Fair Value Option for Financial Assets and Financial Liabilities – Including an amendment of FASB Statement No. 115 (SFAS 159. This change will result in the difference between the cost and fair value of these instruments being recognized in other noninterest income, where we also report the change in fair value of related economic hedging activities. Prior to the adoption of SFAS 159, under lower-of-cost-or-market accounting, gains were recognized when loans were sold and securitized. Losses were recognized either upon sale and securitization or at quarter-end if cost was greater than fair value.

 

 

The provision for credit losses increased $83 million, to $125 million, in 2007 compared with 2006. This increase was due to growth in total credit exposure and credit quality migration primarily related to commercial real estate exposures.

 

 

Nonperforming assets increased $180 million at December 31, 2007 compared with December 31, 2006. Higher nonaccrual loans, the largest component of nonperforming assets, were driven by increases in commercial real estate and commercial real estate related loans. Of this increase, $102 million occurred during the fourth quarter of 2007. Included in the December 31, 2007 amount was $103 million of nonperforming assets associated with the Mercantile portfolio. Given the current environment, we believe provision levels and nonperforming assets will continue to rise in 2008.

 

 

Average deposit balances for 2007 increased $3.1 billion, or 30%, to $13.4 billion in 2007 compared with 2006. The increase in corporate money market deposits reflected PNC’s action to avail itself of the opportunity to obtain funding from alternative sources. Growth in noninterest-bearing deposits was attributable primarily to our commercial mortgage servicing portfolio. In the current interest rate environment, deposits in this business segment will be less valuable and we expect the percentage growth in net interest income in 2008 to be less than it was in 2007.

 

 

Noninterest expense increased by $72 million, or 10%, to $818 million in 2007 compared with 2006. This increase reflected the impact of acquisitions as well as expenses associated with other growth and fee-based initiatives and customer growth. In addition, the noninterest expense increases reflected our business of originating transactions whose returns are heavily dependent on tax credits, whereby losses are taken through noninterest expense and the associated benefits result in a lower provision for income taxes. These losses were $25 million higher in 2007 compared with 2006.

See the additional revenue discussion regarding treasury management and capital markets-related products and Midland Loan Services on page 24.


 

40


BLACKROCK

Our BlackRock business segment earned $253 million in 2007 and $187 million in 2006. Subsequent to the September 29, 2006 deconsolidation of BlackRock, these business segment earnings are determined by taking our proportionate share of BlackRock’s earnings and subtracting our additional income taxes recorded on our share of BlackRock’s earnings. Also, for this business segment presentation, after-tax BlackRock/MLIM transaction integration costs totaling $3 million and $65 million in 2007 and 2006, respectively, have been reclassified from BlackRock to “Other.” In addition, the 2006 business segment earnings have been reduced by minority interest in income of BlackRock, excluding MLIM transaction integration costs, totaling $65 million and additional income taxes recorded on our share of BlackRock’s earnings totaling $7 million.

PNC’s investment in BlackRock was $4.1 billion at December 31, 2007 and $3.9 billion at December 31, 2006. Based upon BlackRock’s closing market price of $216.80 per common share at December 31, 2007, the market value of our investment in BlackRock was $9.4 billion at that date. As such, an additional $5.3 billion of pretax value was not recognized in our equity investment account at that date.

On October 1, 2007, BlackRock acquired the fund of funds business of Quellos Group, LLC (“Quellos”). The combined fund of funds platform operates under the name BlackRock Alternative Advisors and is comprised one of the largest fund of funds platforms in the world, with over $25 billion in assets under management. In connection with the acquisition, BlackRock paid $562 million in cash to Quellos and placed 1.2 million shares of BlackRock common stock into an escrow account. The shares of BlackRock common stock will be held in the escrow account for up to three years and will be available to satisfy certain indemnification obligations of Quellos under the acquisition agreement.

Therefore, any gain to be recognized by PNC resulting from the issuance of these shares and corresponding increase in PNC’s investment in BlackRock will be deferred pending the release of shares from the escrow account. In addition, Quellos may receive up to an additional $969 million in cash and BlackRock common stock through December 31, 2010 contingent on certain measures.

BLACKROCK/MLIM TRANSACTION

On September 29, 2006 Merrill Lynch contributed its investment management business (“MLIM”) to BlackRock in exchange for 65 million shares of newly issued BlackRock common and preferred stock. BlackRock accounted for the MLIM transaction under the purchase method of accounting. Further information regarding this transaction is included in Note 2 Acquisitions and Divestitures included in the Notes To Consolidated Financial Statements in Item 8 of this Report.

 

BLACKROCK LTIP PROGRAMS

BlackRock adopted the 2002 LTIP program to help attract and retain qualified professionals. At that time, PNC agreed to transfer up to four million of the shares of BlackRock common stock then held by us to help fund the 2002 LTIP and future programs approved by BlackRock’s board of directors, subject to certain conditions and limitations. Prior to 2006, BlackRock granted awards of approximately $233 million under the 2002 LTIP program, of which approximately $208 million were paid on January 30, 2007. The award payments were funded by 17% in cash from BlackRock and one million shares of BlackRock common stock transferred by PNC and distributed to LTIP participants. We recognized a pretax gain of $82 million in the first quarter of 2007 from the transfer of BlackRock shares. The gain was included in noninterest income and reflected the excess of market value over book value of the one million shares transferred in January 2007.

PNC’s noninterest income in 2007 also included a $209 million pretax charge related to our commitment to fund additional BlackRock LTIP programs. This charge represents the mark-to-market adjustment related to our remaining BlackRock LTIP shares obligation as of December 31, 2007 and resulted from the increase in the market value of BlackRock common shares during 2007. We recognized a similar charge for $12 million in 2006.

BlackRock granted additional restricted stock unit awards in January 2007, all of which are subject to achieving earnings performance goals prior to the vesting date of September 29, 2011. Of the shares of BlackRock common stock that we have agreed to transfer to fund their LTIP programs, approximately 1.6 million shares have been committed to fund the restricted stock unit awards vesting in 2011 and the amount remaining would then be available for future awards.

We may continue to see volatility in earnings as we mark to market our LTIP shares obligation each quarter-end. However, additional gains based on the difference between the market value and the book value of the committed BlackRock common shares will generally not be recognized until the shares are distributed to LTIP participants.


 

41


PFPC

 

Year ended December 31

Dollars in millions except as noted

   2007     2006  

INCOME STATEMENT

      

Servicing revenue (a)

   $863     $800  

Operating expense (a)

   637     586  

Operating income

   226     214  

Debt financing

   38     42  

Nonoperating income (b)

   6     4  

Pretax earnings

   194     176  

Income taxes

   66     52  

Earnings

   $128     $124  

PERIOD-END BALANCE SHEET

      

Goodwill and other intangible assets

   $1,315     $1,012  

Other assets

   1,161     1,192  

Total assets

   $2,476     $2,204  

Debt financing

   $989     $792  

Other liabilities

   865     917  

Shareholder’s equity

   622     495  

Total funds

   $2,476     $2,204  

PERFORMANCE RATIOS

      

Return on average equity

   23 %   29 %

Operating margin (c)

   26     27  

SERVICING STATISTICS

(at December 31)

      

Accounting/administration net fund

assets (in billions) (d)

      

Domestic

   $869     $746  

Offshore

   121     91  

Total

   $990     $837  

Asset type (in billions)

      

Money market

   $373     $281  

Equity

   390     354  

Fixed income

   123     117  

Other

   104     85  

Total

   $990     $837  

Custody fund assets (in billions)

   $500     $427  

Shareholder accounts (in millions)

      

Transfer agency

   19     18  

Subaccounting

   53     50  

Total

   72     68  

OTHER INFORMATION

      

Full-time employees (at December 31)

   4,784     4,381  
(a) Certain out-of-pocket expense items which are then client billable are included in both servicing revenue and operating expense above, but offset each other entirely and therefore have no effect on operating income. Distribution revenue and expenses which related to 12b-1 fees that PFPC receives from certain fund clients for the payment of marketing, sales and service expenses also entirely offset each other, but are netted for presentation purposes above. Amounts for 2006 have been reclassified to conform with the 2007 presentation.
(b) Net of nonoperating expense.
(c) Total operating income divided by total servicing revenue.
(d) Includes alternative investment net assets serviced.

PFPC earned $128 million for 2007 compared with $124 million in 2006. Results for 2006 benefited from the impact of a $14 million reversal of deferred taxes related to earnings from foreign subsidiaries following management’s determination that the earnings would be indefinitely reinvested outside of the United States. Apart from the impact of this item, earnings increased $18 million in 2007 reflecting the successful conversion of net new business, organic growth and market appreciation.

 

Highlights of PFPC’s performance in 2007 included:

 

   

Acquisitions of Albridge and Coates Analytics in December 2007 which will allow PFPC to add analytical information tools to its current product offerings.

 

   

Expansion in Europe included the approval of a banking license in Ireland and a branch in Luxembourg, which will allow PFPC to provide depositary services in Europe’s leading domicile for traditional investment funds and the second largest worldwide domicile after the United States. The opening of a new sales office in London will enhance efforts to expand global business development efforts afforded by these approvals.

 

   

Increases in total fund assets serviced from $2.2 trillion to $2.5 trillion, or 14%, and in total shareholder accounts serviced from 68 million to 72 million, or 6%, during the past year reflected the successful conversion of new business as well as organic growth from existing customers.

 

   

Combined revenue growth of 21% from managed accounts, offshore operations, and alternative investments, all targeted growth businesses, over the past year resulted from increased assets. Offshore and managed account assets serviced each exceeded $100 billion.

Servicing revenue for 2007 increased by $63 million, or 8%, over 2006, to $863 million. Increases in offshore operations, transfer agency, managed accounts, and alternative investments drove the higher servicing revenue.

Operating expense increased $51 million, or 9%, to $637 million in 2007 compared with 2006. The majority of this increase is attributable to increased headcount and technology costs to support new business achieved over the past year, as well as costs related to the 2007 acquisitions.

The discussions of PFPC under Item 1 and the Executive Summary portion of Item 7 of this Report include additional information regarding the Albridge and Coates Analytics acquisitions.


 

42


CRITICAL ACCOUNTING POLICIES AND JUDGMENTS

Our consolidated financial statements are prepared by applying certain accounting policies. Note 1 Accounting Policies in the Notes To Consolidated Financial Statements in Item 8 of this Report describes the most significant accounting policies that we use. Certain of these policies require us to make estimates and strategic or economic assumptions that may prove inaccurate or be subject to variations that may significantly affect our reported results and financial position for the period or in future periods.

We must use estimates, assumptions, and judgments when financial assets and liabilities are required to be recorded at, or adjusted to reflect, fair value. Assets and liabilities carried at fair value inherently result in a higher degree of financial statement volatility. Fair values and the information used to record valuation adjustments for certain assets and liabilities are based on either quoted market prices or are provided by other independent third-party sources, when available. When such third-party information is not available, we estimate fair value primarily by using cash flow and other financial modeling techniques. Changes in underlying factors, assumptions, or estimates in any of these areas could materially impact our future financial condition and results of operations.

Allowances For Loan And Lease Losses And Unfunded Loan Commitments And Letters Of Credit

We maintain allowances for loan and lease losses and unfunded loan commitments and letters of credit at levels that we believe to be adequate to absorb estimated probable credit losses inherent in the loan portfolio. We determine the adequacy of the allowances based on periodic evaluations of the loan and lease portfolios and other relevant factors. However, this evaluation is inherently subjective as it requires material estimates, all of which may be susceptible to significant change, including, among others:

   

Probability of default,

   

Loss given default,

   

Exposure at date of default,

   

Amounts and timing of expected future cash flows on impaired loans,

   

Value of collateral,

   

Historical loss exposure on consumer loans, residential mortgages and commercial lending, and

   

Amounts for changes in economic conditions and potential estimation or judgmental imprecision.

In determining the adequacy of the allowance for loan and lease losses, we make specific allocations to impaired loans, allocations to pools of watchlist and non-watchlist loans, and allocations to consumer and residential mortgage loans. We also allocate reserves to provide coverage for probable losses not covered in specific, pool and consumer reserve methodologies related to qualitative factors. While allocations are made to specific loans and pools of loans, the total reserve is available for all credit losses.

 

Commercial loans are the largest category of credits and are the most sensitive to changes in assumptions and judgments underlying the determination of the allowance for loan and lease losses. We have allocated approximately $560 million, or 67%, of the allowance for loan and lease losses at December 31, 2007 to the commercial loan category. Consumer and residential mortgage loan allocations are made at a total portfolio level based on historical loss experience adjusted for portfolio activity. Approximately $77 million, or 9.3%, of the allowance for loan and lease losses at December 31, 2007 have been allocated to these loans. The remainder of the allowance is allocated primarily to commercial real estate and lease financing loans.

To the extent actual outcomes differ from our estimates, additional provision for credit losses may be required that would reduce future earnings. See the following for additional information:

   

Allowances For Loan And Lease Losses And Unfunded Loan Commitments And Letters Of Credit in the Credit Risk Management section of this Item 7 (which includes an illustration of the estimated impact on the aggregate of the allowance for loan and lease losses and allowance for unfunded loan commitments and letters of credit assuming we increased pool reserve loss rates for certain loan categories), and

   

In Item 8 of this Report, Note 6 Asset Quality in the Notes To Consolidated Financial Statements, and Allocation Of Allowance For Loan And Lease Losses in the Statistical Information (Unaudited) section.

Private Equity Asset Valuation

At December 31, 2007, private equity investments carried at estimated fair value totaled $561 million compared with $463 million at December 31, 2006. We value private equity assets at each balance sheet date based primarily on either, in the case of limited partnership investments, the financial statements received from the general partner which reflect fair value or, for direct investments, the estimated fair value of the investments. There is a time lag in our receipt of the financial information that is the primary basis for the valuation of our limited partnership interests. As a result, we recognized in the fourth quarter of 2007 valuation changes related to limited partnership investments that reflected the impact of third quarter 2007 market conditions and performance of the underlying companies.

Due to the nature of the direct investments, we must make assumptions as to future performance, financial condition, liquidity, availability of capital, and market conditions, among others, to determine the estimated fair value of the investments. The valuation procedures that we apply to direct investments include techniques such as multiples of adjusted earnings for the entity, independent appraisals of the entity or the pricing used to value the entity in a recent financing transaction.

We value affiliated partnership interests based on the underlying investments of the partnership utilizing procedures consistent with those applied to direct investments.


 

43


We reflect changes in the value of private equity investments in our results of operations. Market conditions and actual performance of the companies could differ from these assumptions, resulting in lower valuations that could reduce earnings in future periods. Accordingly, the valuations may not represent amounts that will ultimately be realized from these investments.

Lease Residuals

We provide financing for various types of equipment, aircraft, energy and power systems, and rolling stock through a variety of lease arrangements. Direct financing leases are carried at the sum of lease payments and the estimated residual value of the leased property, less unearned income. Residual value insurance or guarantees by governmental entities provide support for a significant portion of the residual value. Residual values are subject to judgments as to the value of the underlying equipment that can be affected by changes in economic and market conditions and the financial viability of the residual guarantors and insurers. To the extent not guaranteed or assumed by a third party, or otherwise insured against, we bear the risk of ownership of the leased assets. This includes the risk that the actual value of the leased assets at the end of the lease term will be less than the residual value, which could result in an impairment charge and reduce earnings in the future. Residual values are reviewed for impairment on a quarterly basis.

Goodwill

Goodwill arising from business acquisitions represents the value attributable to unidentifiable intangible elements in the business acquired. Most of our goodwill relates to value inherent in the fund servicing, Retail Banking and Corporate & Institutional Banking businesses. The value of this goodwill is dependent upon our ability to provide quality, cost effective services in the face of competition from other market participants on a national and international basis. We also rely upon continuing investments in processing systems, the development of value-added service features, and the ease of access by customers to our services.

As such, the value of goodwill is ultimately supported by earnings, which is driven by transaction volume and, for certain businesses, the market value of assets under administration or for which processing services are provided. Lower earnings resulting from a lack of growth or our inability to deliver cost-effective services over sustained periods can lead to impairment of goodwill, which could result in a current period charge to earnings. At least annually, management reviews the current operating environment and strategic direction of each reporting unit taking into consideration any events or changes in circumstances that may have an effect on the unit. A reporting unit is defined as an operating segment or one level below an operating segment. This input is then used to calculate the fair value of the reporting unit, including goodwill, which is compared to its carrying value. If the fair value of the reporting unit exceeds its carrying amount, then the goodwill of that reporting unit is

not considered impaired. Based on the results of our analysis, there have been no impairment charges related to goodwill for the years 2007, 2006, and 2005. See Note 7 Goodwill and Other Intangible Assets in the Notes To Consolidated Financial Statements in Item 8 of this Report for additional information.

Revenue Recognition

We derive net interest and noninterest income from various sources, including:

   

Lending,

   

Securities portfolio,

   

Asset management and fund servicing,

   

Customer deposits,

   

Loan servicing,

   

Brokerage services,

   

Merger and acquisition advisory services,

   

Sale of loans and securities,

   

Certain private equity activities, and

   

Securities and derivatives trading activities including foreign exchange.

We also earn fees and commissions from issuing loan commitments, standby letters of credit and financial guarantees, selling various insurance products, providing treasury management services and participating in certain capital markets transactions.

The timing and amount of revenue that we recognize in any period is dependent on estimates, judgments, assumptions, and interpretation of contractual terms. Changes in these factors can have a significant impact on revenue recognized in any period due to changes in products, market conditions or industry norms.

Income Taxes

In the normal course of business, we and our subsidiaries enter into transactions for which the tax treatment is unclear or subject to varying interpretations. In addition, filing requirements, methods of filing and the calculation of taxable income in various state and local jurisdictions are subject to differing interpretations.

We evaluate and assess the relative risks and merits of the appropriate tax treatment of transactions, filing positions, filing methods and taxable income calculations after considering statutes, regulations, judicial precedent, and other information, and maintain tax accruals consistent with our evaluation of these relative risks and merits. The result of our evaluation and assessment is by its nature an estimate. We and our subsidiaries are routinely subject to audit and challenges from taxing authorities. In the event we resolve a challenge for an amount different than amounts previously accrued, we will account for the difference in the period in which we resolve the matter.

We resolved disputed issues for our 1998-2000 and 2001-2003 consolidated federal income tax returns with the IRS appeals division, as described in the Leases and Related Tax and Accounting Matters in the Consolidated Balance Sheet Review section of this Item 7.


 

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RECENT ACCOUNTING PRONOUNCEMENTS

See Note 1 Accounting Policies in the Notes To Consolidated Financial Statements in Item 8 of this Report for additional information on the following recent accounting pronouncements that are relevant to our business, including a description of each new pronouncement, the required date of adoption, our planned date of adoption, and the expected impact on our consolidated financial statements. All of the following pronouncements were issued by the FASB unless otherwise noted.

The following were issued in 2007:

   

SFAS 141(R), “Business Combinations”

   

SFAS 160, “Accounting and Reporting of Noncontrolling Interests in Consolidated Financial Statements, an Amendment of ARB No. 51”

   

In November 2007, the SEC issued Staff Accounting Bulletin No. 109,

   

In June 2007, the AICPA issued Statement of Position 07-1, “Clarification of the Scope of the Audit and Accounting Guide “Investment Companies” and Accounting by Parent Companies and Equity Method Investors for Investments in Investment Companies.” The FASB issued a final FSP in February 2008 which indefinitely delays the effective date of AICPA SOP 07-1.

   

FASB Staff Position No. (“FSP”) FIN 46(R) 7, “Application of FASB Interpretation No. 46(R) to Investment Companies”

   

FSP FIN 48-1, “Definition of Settlement in FASB Interpretation (“FIN”) No. 48”

   

SFAS 159, “The Fair Value Option for Financial Assets and Financial Liabilities – Including an amendment of FASB Statement No. 115”

The following were issued during 2006:

   

SFAS 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Benefit Plans – an amendment of FASB Statements No. 87, 88, 106 and 132(R)”(“SFAS 158”)

   

SFAS 157, “Fair Value Measurements”

   

FIN 48, “Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109”

   

FSP 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”

   

SFAS 156, “Accounting for Servicing of Financial Assets – an amendment of FASB Statement No. 140”

   

SFAS 155, “Accounting for Certain Hybrid Financial Instruments – an amendment of FASB Statements No. 133 and 140”

   

The Emerging Issues Task Force (“EITF”) of the FASB issued EITF Issue 06-4, “Accounting for

 

Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements”

STATUS OF DEFINED BENEFIT PENSION PLAN

We have a noncontributory, qualified defined benefit pension plan (“plan” or “pension plan”) covering eligible employees. Benefits are derived from a cash balance formula based on compensation levels, age and length of service. Pension contributions are based on an actuarially determined amount necessary to fund total benefits payable to plan participants. Consistent with our investment strategy, plan assets are currently approximately 60% invested in equity investments with most of the remainder invested in fixed income instruments. Plan fiduciaries determine and review the plan’s investment policy.

We calculate the expense associated with the pension plan in accordance with SFAS 87, “Employers’ Accounting for Pensions,” and we use assumptions and methods that are compatible with the requirements of SFAS 87, including a policy of reflecting trust assets at their fair market value. On an annual basis, we review the actuarial assumptions related to the pension plan, including the discount rate, the rate of compensation increase and the expected return on plan assets. Neither the discount rate nor the compensation increase assumptions significantly affects pension expense.

The expected long-term return on assets assumption does significantly affect pension expense. The expected long-term return on plan assets for determining net periodic pension cost for 2007 was 8.25%, unchanged from 2006. Under current accounting rules, the difference between expected long-term returns and actual returns is accumulated and amortized to pension expense over future periods. Each one percentage point difference in actual return compared with our expected return causes expense in subsequent years to change by up to $4 million as the impact is amortized into results of operations.

The table below reflects the estimated effects on pension expense of certain changes in assumptions, using 2008 estimated expense as a baseline.

 

Change in Assumption   

Estimated
Increase to 2008
Pension
Expense

(In millions)

.5% decrease in discount rate

   $1

.5% decrease in expected long-term return on assets

   $10

.5% increase in compensation rate

   $2

We currently estimate a pretax pension benefit of $26 million in 2008 compared with a pretax benefit of $30 million in


 

45


2007. The 2008 values and sensitivities shown above include the qualified defined benefit plan maintained by Mercantile that we integrated into the PNC plan as of December 31, 2007.

SFAS 158 was effective for PNC as of December 31, 2006. This statement affects the accounting and reporting for our qualified pension plan, our nonqualified retirement plans, our postretirement welfare benefit plans, and our postemployment benefit plans. See Note 1 Accounting Policies for further information regarding our adoption of SFAS 158.

Our pension plan contribution requirements are not particularly sensitive to actuarial assumptions. Investment performance has the most impact on contribution requirements and will drive the amount of permitted contributions in future years. Also, current law, including the provisions of the Pension Protection Act of 2006, sets limits as to both minimum and maximum contributions to the plan. In any event, any contributions to the plan in the near term will be at our discretion, as we expect that the minimum required contributions under the law will be minimal or zero for several years.

We maintain other defined benefit plans that have a less significant effect on financial results, including various nonqualified supplemental retirement plans for certain employees. See Note 17 Employee Benefit Plans in the Notes To Consolidated Financial Statements in Item 8 of this Report for additional information.

RISK MANAGEMENT

We encounter risk as part of the normal course of our business and we design risk management processes to help manage these risks. This Risk Management section first provides an overview of the risk measurement, control strategies, and monitoring aspects of our corporate-level risk management processes. Following that discussion is an analysis of the risk management process for what we view as our primary areas of risk: credit, operational, liquidity, and market. The discussion of market risk is further subdivided into interest rate, trading, and equity and other investment risk areas. Our use of financial derivatives as part of our overall asset and liability risk management process is also addressed within the Risk Management section of this Item 7. In appropriate places within this section, historical performance is also addressed.

OVERVIEW

As a financial services organization, we take a certain amount of risk in every business decision. For example, every time we open an account or approve a loan for a customer, process a payment, hire a new employee, or implement a new computer system, we incur a certain amount of risk. As an organization, we must balance revenue generation and profitability with the risks associated with our business activities. Risk management is not about eliminating risks, but about identifying and

accepting risks and then effectively managing them so as to optimize shareholder value.

The key to effective risk management is to be proactive in identifying, measuring, evaluating, and monitoring risk on an ongoing basis. Risk management practices support decision-making, improve the success rate for new initiatives, and strengthen the market’s confidence in an organization.

Corporate-Level Risk Management Overview

We support risk management through a governance structure involving the Board, senior management and a corporate risk management organization.

Although our Board as a whole is responsible generally for oversight of risk management, committees of the Board provide oversight to specific areas of risk with respect to the level of risk and risk management structure.

We use management level risk committees to help ensure that business decisions are executed within our desired risk profile. The Executive Risk Management Committee (“ERMC”), consisting of senior management executives, provides oversight for the establishment and implementation of new comprehensive risk management initiatives, reviews enterprise level risk profiles and discusses key risk issues.

The corporate risk management organization has the following key roles:

   

Facilitate the identification, assessment and monitoring of risk across PNC,

   

Provide support and oversight to the businesses, and

   

Identify and implement risk management best practices, as appropriate.

Risk Measurement

We conduct risk measurement activities specific to each area of risk. The primary vehicle for aggregation of enterprise-wide risk is a comprehensive risk management methodology that is based on economic capital. This primary risk aggregation measure is supplemented with secondary measures of risk to arrive at an estimate of enterprise-wide risk. The economic capital framework is a measure of potential losses above and beyond expected losses. Potential one year losses are capitalized to a level commensurate with a financial institution with an A rating by the credit rating agencies. Economic capital incorporates risk associated with potential credit losses (Credit Risk), fluctuations of the estimated market value of financial instruments (Market Risk), failure of people, processes or systems (Operational Risk), and income losses associated with declining volumes, margins and/or fees, and the fixed cost structure of the business (Business Risk). We estimate credit and market risks at an exposure level while we estimate the remaining risk types at an institution or business segment level. We routinely compare the output of our economic capital model with industry benchmarks.


 

46


Risk Control Strategies

We centrally manage policy development and exception oversight through corporate-level risk management. Corporate risk management is authorized to take action to either prevent or mitigate exceptions to policies and is responsible for monitoring compliance with risk management policies. The Corporate Audit function performs an independent assessment of the internal control environment. Corporate Audit plays a critical role in risk management, testing the operation of the internal control system and reporting findings to management and to the Audit Committee of the Board.

Risk Monitoring

Corporate risk management reports on a regular basis to our Board regarding the enterprise risk profile of the Corporation. These reports aggregate and present the level of risk by type of risk and communicate significant risk issues, including performance relative to risk tolerance limits. Both the Board and the ERMC provide guidance on actions to address key risk issues as identified in these reports.

CREDIT RISK MANAGEMENT

Credit risk represents the possibility that a customer, counterparty or issuer may not perform in accordance with contractual terms. Credit risk is inherent in the financial services business and results from extending credit to customers, purchasing securities, and entering into financial derivative transactions. Credit risk is one of our most significant risks.

Approved risk tolerances, in addition to credit policies and procedures, set portfolio objectives for the level of credit risk. We have established guidelines for problem loans, acceptable levels of total borrower exposure, and other credit measures. We seek to achieve our credit portfolio objectives by maintaining a customer base that is diverse in borrower exposure and industry types. We use loan participations with third parties, loan sales and syndications, and the purchase of credit derivatives to reduce risk concentrations.

The credit granting businesses maintain direct responsibility for monitoring credit risk within PNC. The Corporate Credit Policy area provides independent oversight to the measurement, monitoring and reporting of our credit risk and reports to the Chief Administrative Officer. Corporate Audit also provides an independent assessment of the effectiveness of the credit risk management process.

Nonperforming, Past Due And Potential Problem Assets

See the Nonperforming Assets And Related Information table in the Statistical Information (Unaudited) section of Item 8 of this Report and included here by reference for details of the types of nonperforming assets that we held at December 31 of each of the past five years. In addition, certain performing assets have interest payments that are past due or have the potential for future repayment problems.

 

Total nonperforming assets at December 31, 2007 increased $307 million, to $478 million, compared with the prior year- end. Nonperforming loans, the largest component of nonperforming assets, increased $290 million, to $437 million, at December 31, 2007 compared with December 31, 2006. Of this increase in nonperforming loans, $190 million occurred during the fourth quarter of 2007. The increase was primarily due to higher nonaccrual commercial real estate loans primarily related to residential real estate development exposure. At December 31, 2007, our largest nonperforming asset was approximately $20 million and our average nonperforming loan associated with commercial lending was approximately $0.5 million. We expect nonperforming assets to increase in 2008, although at a slower pace than we experienced in the fourth quarter of 2007.

The ratio of nonperforming assets to total assets rose to .34% at December 31, 2007 compared with .17% at December 31, 2006.

The amount of nonperforming loans that was current as to principal and interest was $178 million at December 31, 2007 and $59 million at December 31, 2006.

Nonperforming Assets By Business

 

In millions   

December 31

2007

   December 31
2006

Retail Banking

   $225    $106

Corporate & Institutional Banking

   243    63

Other

   10    2

Total nonperforming assets

   $478    $171

Change In Nonperforming Assets

 

In millions    2007     2006  

January 1

   $171     $216  

Transferred from accrual

   649     225  

Acquired- Mercantile and Yardville

   37      

Principal reductions and payoffs

   (179 )   (116 )

Asset sales

   (10 )   (17 )

Returned to performing

   (23 )   (17 )

Charge-offs and valuation adjustments

   (167 )   (120 )

December 31

   $478     $171  

Accruing Loans Past Due 90 Days Or More

 

     Amount    Percent of Total
Outstandings
 
Dollars in millions   

Dec. 31

2007

  

Dec. 31

2006

   Dec. 31
2007
   

Dec. 31

2006

 

Commercial

   $14    $9    .05 %   .04 %

Commercial real estate

   18    5    .20     .14  

Consumer

   49    28    .27     .17  

Residential mortgage

   13    7    .14     .11  

Other

   12    1    2.91     .27  

Total loans

   $106    $50    .16 %   .10 %

 

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Loans that are not included in nonperforming or past due categories but cause us to be uncertain about the borrower’s ability to comply with existing repayment terms over the next six months totaled $134 million at December 31, 2007, compared with $41 million at December 31, 2006.

Allowances For Loan And Lease Losses And Unfunded Loan Commitments And Letters Of Credit

We maintain an allowance for loan and lease losses to absorb losses from the loan portfolio. We determine the allowance based on quarterly assessments of the probable estimated losses inherent in the loan portfolio. While we make allocations to specific loans and pools of loans, the total reserve is available for all loan and lease losses.

In addition to the allowance for loan and lease losses, we maintain an allowance for unfunded loan commitments and letters of credit. We report this allowance as a liability on our Consolidated Balance Sheet. We determine this amount using estimates of the probability of the ultimate funding and losses related to those credit exposures. This methodology is similar to the one we use for determining the adequacy of our allowance for loan and lease losses.

We refer you to Note 6 Asset Quality in the Notes To Consolidated Financial Statements in Item 8 of this Report regarding changes in the allowance for loan and lease losses and in the allowance for unfunded loan commitments and letters of credit. Also see the Allocation Of Allowance For Loan And Lease Losses table in the Statistical Information (Unaudited) section of Item 8 of this Report for additional information included herein by reference.

We establish specific allowances for loans considered impaired using a method prescribed by SFAS 114, “Accounting by Creditors for Impairment of a Loan.” All impaired loans except leases and large groups of smaller-balance homogeneous loans which may include but are not limited to credit card, residential mortgage, and consumer installment loans are subject to SFAS 114 analysis. Specific allowances for individual loans over a set dollar threshold are determined by our Special Asset Committee based on an analysis of the present value of expected future cash flows from the loans discounted at their effective interest rate, observable market price, or the fair value of the underlying collateral. We establish specific allowance on all other impaired loans based on the loss given default credit risk rating.

Allocations to non-impaired commercial and commercial real estate loans (pool reserve allocations) are assigned to pools of loans as defined by our business structure and are based on internal probability of default and loss given default credit risk ratings.

Key elements of the pool reserve methodology include:

   

Probability of default (“PD”), which is primarily based on historical default analyses and is derived from the borrower’s internal PD credit risk rating;

   

Exposure at default (“EAD”), which is derived from historical default data; and

   

Loss given default (“LGD”), which is based on historical loss data, collateral value and other structural factors that may affect our ultimate ability to collect on the loan and is derived from the loan’s internal LGD credit risk rating.

Our pool reserve methodology is sensitive to changes in key risk parameters such as PDs, LGDs and EADs. In general, a given change in any of the major risk parameters will have a corresponding change in the pool reserve allocations for non-impaired commercial loans. Our commercial loans are the largest category of credits and are most sensitive to changes in the key risk parameters and pool reserve loss rates. To illustrate, if we increase the pool reserve loss rates by 5% for all categories of non-impaired commercial loans, then the aggregate of the allowance for loan and lease losses and allowance for unfunded loan commitments and letters of credit would increase by $39 million. Additionally, other factors such as the rate of migration in the severity of problem loans will contribute to the final pool reserve allocations.

We make consumer (including residential mortgage) loan allocations at a total portfolio level by consumer product line based on historical loss experience. We compute a four-quarter average loss rate from net charge-offs for the prior four quarters as a percentage of the average loans outstanding in those quarters. We apply this loss rate to loans outstanding at the end of the current period and make certain qualitative adjustments to determine the consumer loan allocation.

Charge-Offs And Recoveries

 

Year ended December 31

Dollars in millions

  Charge-offs   Recoveries   Net

Charge-offs

  Percent of
Average

Loans

 
 

 

2007

         

Commercial

  $156   $30   $126   .49 %

Commercial real estate

  16   1   15   .20  

Consumer

  73   14   59   .33  

Total

  $245   $45   $200   .32  

2006

         

Commercial

  $108   $19   $89   .44 %

Commercial real estate

  3   1   2   .06  

Consumer

  52   15   37   .23  

Residential mortgage

  3     3   .04  

Lease financing

  14   5   9   .32  

Total

  $180   $40   $140   .28  

We establish reserves to provide coverage for probable losses not considered in the specific, pool and consumer reserve methodologies, such as, but not limited to, industry concentrations and conditions, credit quality trends, recent loss experience in particular sectors of the portfolio, ability and depth of lending management, changes in risk selection and underwriting standards and the timing of available information. The amount of reserves for these qualitative factors is assigned to loan categories and to business segments


 

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primarily based on the relative specific and pool allocation amounts. The amount of reserve allocated for qualitative factors represented 4.6% of the total allowance and .1% of total loans at December 31, 2007.

The provision for credit losses totaled $315 million for 2007 and $124 million for 2006. Of the total 2007 provision, $188 million was recorded in the fourth quarter, including approximately $45 million related to our Yardville acquisition. The higher provision in 2007 was also impacted by our real estate portfolio, including residential real estate development exposure, and growth in total credit exposure. See the Consolidated Balance Sheet Review section of this Item 7 for further information. In addition, the provision for credit losses for 2007 and the evaluation of the allowances for loan and lease losses and unfunded loan commitments and letters of credit as of December 31, 2007 reflected loan and total credit exposure growth, changes in loan portfolio composition, and other changes in asset quality. The provision includes amounts for probable losses on loans and credit exposure related to unfunded loan commitments and letters of credit.

We do not expect to sustain asset quality at its current level. Given our projections for loan growth and continued credit deterioration, we expect nonperforming assets and the provision for credit losses will be higher in 2008 compared with 2007. Also, we expect that the level of provision for credit losses in the first quarter of 2008 will be modestly lower than the amount reported for the fourth quarter of 2007.

The allowance as a percent of nonperforming loans was 190% and as a percent of total loans was 1.21% at December 31, 2007. The comparable percentages at December 31, 2006 were 381% and 1.12%.

CREDIT DEFAULT SWAPS

From a credit risk management perspective, we buy and sell credit loss protection via the use of credit derivatives. When we buy loss protection by purchasing a credit default swap (“CDS”), we pay a fee to the seller, or CDS counterparty, in return for the right to receive a payment if a specified credit event occurs for a particular obligor or reference entity. We purchase CDSs to mitigate the risk of economic loss on a portion of our loan exposures. For credit protection, we use only traditional credit derivative instruments and do not purchase instruments such as “total return swaps.”

We also sell loss protection to mitigate the net premium cost and the impact of mark-to-market accounting on the CDS in cases where we buy protection to hedge the loan portfolio and to take proprietary trading positions. These activities represent additional risk positions rather than hedges of risk.

We approve counterparty credit lines for all of our trading activities, including CDSs. Counterparty credit lines are approved based on a review of credit quality in accordance with our traditional credit quality standards and credit policies.

The credit risk of our counterparties is monitored in the normal course of business. In addition, all counterparty credit lines are subject to collateral thresholds and exposures above these thresholds are secured.

Credit default swaps are included in the Free-Standing Derivatives table in the Financial Derivatives section of this Risk Management discussion. Net gains from credit default swaps, reflected in the Trading line item on our Consolidated Income Statement, totaled $38 million for 2007 compared to net losses of $17 million for 2006.

OPERATIONAL RISK MANAGEMENT

Operational risk is defined as the risk of financial loss or other damage to us resulting from inadequate or failed internal processes or systems, human factors, or from external events. Operational risk may occur in any of our business activities and manifests itself in various ways, including but not limited to the following:

   

Errors related to transaction processing and systems,

   

Breaches of the system of internal controls and compliance requirements, and

   

Business interruptions and execution of unauthorized transactions and fraud by employees or third parties.

Operational losses may arise from legal actions due to operating deficiencies or noncompliance with contracts, laws or regulations.

To monitor and control operational risk, we maintain a comprehensive framework including policies and a system of internal controls that is designed to manage risk and to provide management with timely and accurate information about the operations of PNC. Management at each business unit is primarily responsible for its operational risk management program, given that operational risk management is integral to direct business management and most easily effected at the business unit level. Corporate Operational Risk Management oversees day-to-day operational risk management activities.

Technology Risk

The technology risk management program is a significant component of the operational risk framework. We have an integrated security and technology risk management framework designed to help ensure a secure, sound, and compliant infrastructure for information management. The technology risk management process is aligned with the strategic direction of the businesses and is integrated into the technology management culture, structure and practices. The application of this framework across the enterprise helps to support comprehensive and reliable internal controls.

Our business resiliency program manages the organization’s capabilities to provide services in the case of an event that results in material disruption of business activities. Prioritization of investments in people, processes, technology and facilities are based on different types of events, business


 

49


risk and criticality. Comprehensive testing validates our resiliency capabilities on an ongoing basis, and an integrated governance model is designed to help assure transparent management reporting.

Insurance

As a component of our risk management practices, we purchase insurance designed to protect us against accidental loss or losses which, in the aggregate, may significantly affect personnel, property, financial objectives, or our ability to continue to meet our responsibilities to our various stakeholder groups.

PNC, through a subsidiary company, Alpine Indemnity Limited, participates as a direct writer for its general liability, automobile liability, workers’ compensation, property and terrorism programs. PNC’s risks associated with its participation as a direct writer for these programs are mitigated through policy limits and annual aggregate limits. Risks in excess of Alpine policy limits and annual aggregates are mitigated through the purchase of direct coverage provided by various insurers up to limits established by PNC’s Corporate Insurance Committee.

LIQUIDITY RISK MANAGEMENT

Liquidity risk is the risk of potential loss if we were unable to meet our funding requirements at a reasonable cost. We manage liquidity risk to help ensure that we can obtain cost-effective funding to meet current and future obligations under both normal “business as usual” and stressful circumstances.

Our largest source of liquidity on a consolidated basis is the deposit base that comes from our retail and corporate and institutional banking activities. Other borrowed funds come from a diverse mix of short and long-term funding sources. Liquid assets and unused borrowing capacity from a number of sources are also available to maintain our liquidity position.

Liquid assets consist of short-term investments (federal funds sold, resale agreements and other short-term investments, including trading securities) and securities available for sale. At December 31, 2007, our liquid assets totaled $37.1 billion, with $24.2 billion pledged as collateral for borrowings, trust, and other commitments.

Bank Level Liquidity

PNC Bank, N.A. can borrow from the Federal Reserve Bank of Cleveland’s discount window to meet short-term liquidity requirements. These borrowings are secured by securities and commercial loans. PNC Bank, N.A. is also a member of the Federal Home Loan Bank (“FHLB”)-Pittsburgh and as such has access to advances from FHLB-Pittsburgh secured generally by residential mortgage loans. At December 31, 2007, we maintained significant unused borrowing capacity from the Federal Reserve Bank of Cleveland’s discount window and FHLB-Pittsburgh under current collateral requirements.

During the second half of 2007 we substantially increased FHLB borrowings, which provided us with additional liquidity

at relatively attractive rates. Total FHLB borrowings were $7.1 billion at December 31, 2007 compared with $42 million at December 31, 2006.

We can also obtain funding through traditional forms of borrowing, including federal funds purchased, repurchase agreements, and short and long-term debt issuances. In July 2004, PNC Bank, N.A. established a program to offer up to $20 billion in senior and subordinated unsecured debt obligations with maturities of more than nine months. Through December 31, 2007, PNC Bank, N.A. had issued $5.8 billion of debt under this program, including the following 2007 issuances:

   

In April 2007, $500 million of senior bank notes were issued that mature on October 3, 2008. Interest will be reset monthly to 1-month LIBOR minus 6 basis points and will be paid monthly.

   

In May 2007, $1 billion of senior bank notes were issued that mature June 17, 2008. Interest will be reset monthly to 1-month LIBOR minus 5 basis points and will be paid monthly.

   

In June 2007, $1 billion of senior bank notes were issued that mature on December 29, 2008. Interest will be reset monthly to 1-month LIBOR minus 4 basis points and will be paid monthly.

   

In December 2007, $350 million of subordinated bank notes were issued that mature on December 7, 2017. These notes pay interest semiannually at a fixed rate of 6.0%.

In January 2008, $50 million of senior bank notes were issued that mature on January 25, 2011. Interest will be reset quarterly to 3-month LIBOR plus 55 basis points and will be paid quarterly.

In January 2008, $100 million of senior bank notes were issued that mature on January 25, 2010. Interest will be reset quarterly to 3-month LIBOR plus 45 basis points and will be paid quarterly.

In February 2008, $175 million of senior bank notes were issued that mature on February 1, 2010. Interest will be reset quarterly to 3-month LIBOR plus 45 basis points and will be paid quarterly.

In February 2008, $500 million of senior bank notes were issued that mature on August 5, 2009. Interest will be reset quarterly to 3-month LIBOR plus 40 basis points and will be paid quarterly.

None of the 2007 or 2008 issuances described above are redeemable by us or the holders prior to maturity.

We have the ability to issue additional trust preferred securities out of our PNC Preferred Funding structure, subject to certain contractual restrictions. In February 2008, PNC Preferred Funding Trust III issued $375 million of 8.700% Fixed-to-Floating Rate Non-Cumulative Exchangeable Perpetual Trust Securities. See “Perpetual Trust Securities” in the Off-Balance Sheet Arrangements And VIEs section of this Item 7.


 

50


PNC Bank, N.A. established a program in December 2004 to offer up to $3.0 billion of its commercial paper. As of December 31, 2007, there were no issuances outstanding under this program.

As of December 31, 2007, there were $5.0 billion of PNC Bank, N.A. short- and long-term debt issuances with maturities of less than one year.

Parent Company Liquidity

Our parent company’s routine funding needs consist primarily of dividends to PNC shareholders, share repurchases, debt service, the funding of non-bank affiliates, and acquisitions.

Parent company liquidity guidelines are designed to help ensure that sufficient liquidity is available to meet these requirements over the succeeding 12-month period. In managing parent company liquidity we consider funding sources, such as expected dividends to be received from PNC Bank, N.A. and potential debt issuance, and discretionary funding uses, the most significant of which is the external dividend to be paid on PNC’s stock.

The principal source of parent company cash flow is the dividends it receives from PNC Bank, N.A., which may be impacted by the following:

   

Capital needs,

   

Laws and regulations,

   

Corporate policies,

   

Contractual restrictions, and

   

Other factors.

Also, there are statutory and regulatory limitations on the ability of national banks to pay dividends or make other capital distributions or to extend credit to the parent company or its non-bank subsidiaries. We provide additional information on these limitations in Note 22 Regulatory Matters in the Notes To Consolidated Financial Statements included in Item 8 of this Report and include such information here by reference. Dividends may also be impacted by the bank’s capital needs and by contractual restrictions. We provide additional information on certain contractual restrictions under the “Perpetual Trust Securities.” “PNC Capital Trust E Trust Preferred Securities,” and “Acquired Entity Trust Preferred Securities” sections of the Off-Balance Sheet Arrangements and VIEs section of this Item 7. The amount available for dividend payments to the parent company by PNC Bank, N.A. without prior regulatory approval was approximately $655 million at December 31, 2007.

In addition to dividends from PNC Bank, N.A., other sources of parent company liquidity include cash and short-term investments, as well as dividends and loan repayments from other subsidiaries and dividends or distributions from equity investments. As of December 31, 2007, the parent company had approximately $118 million in funds available from its cash and short-term investments. During 2007, $1.0 billion of parent company senior debt was redeemed by the holders, all during the fourth quarter.

 

We can also generate liquidity for the parent company and PNC’s non-bank subsidiaries through the issuance of securities in public or private markets.

   

In February 2007, we issued $775 million of floating rate senior notes due January 2012. Interest will be reset quarterly to 3-month LIBOR plus 14 basis points and interest will be paid quarterly.

   

Also in February 2007, we issued $500 million of floating rate senior notes due January 2014. Interest will be reset quarterly to 3-month LIBOR plus 20 basis points and will be paid quarterly.

   

In February 2007, we issued $600 million of subordinated notes due February 2017. These notes pay interest semiannually at a fixed rate of 5.625%.

   

In June 2007, we issued $500 million of Senior Notes that mature on June 12, 2009. Interest will be reset monthly to 1-month LIBOR plus 2 basis points. These notes are not redeemable by us or the holders prior to maturity.

   

In September 2007, we issued $250 million of senior notes that mature on September 28, 2012. These notes pay interest semiannually at a fixed rate of 5.50%.

None of the 2007 issuances described above are redeemable by us or the holders prior to maturity.

In February 2008, PNC Capital Trust E was formed and issued $450 million of Capital Securities. Proceeds from the issuance were used to purchase $450 million of junior subordinated notes issued by PNC that mature on March 15, 2068 and are redeemable on or after March 15, 2013 at par. These notes pay interest quarterly at a fixed rate of 7.75%.

We used the February 2007 issuances described above to fund a substantial portion of the cash portion of our Mercantile acquisition.

In the first half of 2007, we elected to redeem all of the underlying Capital Securities related to the following trusts, totaling $516 million:

   

UNB Capital Trust I ($16 million),

   

Riggs Capital Trust II ($200 million), and

   

PNC Institutional Capital Trust B ($300 million).

In July 2006, PNC Funding Corp established a program to offer up to $3.0 billion of commercial paper to provide the parent company with additional liquidity. As of December 31, 2007, $458 million of commercial paper was outstanding under this program.

As of December 31, 2007, there were $1.4 billion of parent company contractual obligations, including commercial paper, with maturities of less than one year.

We have effective shelf registration statements which enable us to issue additional debt and equity securities, including certain hybrid capital instruments.


 

51


Commitments

The following tables set forth contractual obligations and various other commitments representing required and potential cash outflows as of December 31, 2007.

 

Contractual Obligations

        Payment Due By Period

December 31, 2007 - in millions

   Total    Less than
one year
   One to three
years
   Four to five
years
   After five
years

Remaining contractual maturities of time deposits

   $26,402    $22,500    $2,443    $349    $1,110

Borrowed funds

   30,931    18,309    6,967    1,282    4,373

Minimum annual rentals on noncancellable leases

   1,239    172    296    233    538

Nonqualified pension and post-retirement benefits

   314    32    67    66    149

Purchase obligations (a)

   441    103    179    90    69

Total contractual cash obligations (b)

   $59,327    $41,116    $9,952    $2,020    $6,239
(a) Includes purchase obligations for goods and services covered by noncancellable contracts and contracts including cancellation fees.
(b) Excludes amounts related to our adoption of FIN 48 due to the uncertainty in terms of timing and amount of future cash outflows. Note 19 Income Taxes in our Notes To Consolidated Financial Statements in Item 8 of this Report includes additional information regarding our adoption of FIN 48 in 2007.

 

Other Commitments (a)

   Total

Amounts
Committed

   Amount Of Commitment Expiration By Period

December 31, 2007 - in millions

      Less than
one year
   One to three
years
   Four to five
years
   After five
years

Loan commitments

   $53,347    $20,401    $21,886    $10,128    $932

Standby letters of credit (b)

   4,761    2,427    1,317    862    155

Other commitments (c)

   473    108    64    259    42

Total commitments

   $58,581    $22,936    $23,267    $11,249    $1,129
(a) Other commitments are funding commitments that could potentially require performance in the event of demands by third parties or contingent events. Loan commitments are reported net of participations, assignments and syndications.
(b) Includes $1.8 billion of standby letters of credit that support remarketing programs for customers’ variable rate demand notes.
(c) Includes private equity funding commitments related to equity management, low income housing projects and other investments.

 

MARKET RISK MANAGEMENT OVERVIEW

Market risk is the risk of a loss in earnings or economic value due to adverse movements in market factors such as interest rates, credit spreads, foreign exchange rates, and equity prices. We are exposed to market risk primarily by our involvement in the following activities, among others:

   

Traditional banking activities of taking deposits and extending loans,

   

Private equity and other investments and activities whose economic values are directly impacted by market factors, and

   

Trading in fixed income products, equities, derivatives, and foreign exchange, as a result of customer activities, underwriting, and proprietary trading.

We have established enterprise-wide policies and methodologies to identify, measure, monitor, and report market risk. Market Risk Management provides independent oversight by monitoring compliance with these limits and

guidelines, and reporting significant risks in the business to the Joint Risk Committee of the Board.

MARKET RISK MANAGEMENT – INTEREST RATE RISK

Interest rate risk results primarily from our traditional banking activities of gathering deposits and extending loans. Many factors, including economic and financial conditions, movements in interest rates, and consumer preferences, affect the difference between the interest that we earn on assets and the interest that we pay on liabilities and the level of our noninterest-bearing funding sources. Due to the repricing term mismatches and embedded options inherent in certain of these products, changes in market interest rates not only affect expected near-term earnings, but also the economic values of these assets and liabilities.

Asset and Liability Management centrally manages interest rate risk within limits and guidelines set forth in our risk management policies approved by the Asset and Liability Committee and the Risk Committee of the Board.


 

52


Sensitivity results and market interest rate benchmarks for the fourth quarters of 2007 and 2006 follow:

Interest Sensitivity Analysis

     Fourth
Quarter

2007

 
 

 

  Fourth
Quarter

2006

 
 

 

Net Interest Income Sensitivity Simulation

      

Effect on net interest income in first year from gradual interest rate change over following 12 months of:

      

100 basis point increase

   (2.8 )%   (2.6 )%

100 basis point decrease

   2.9 %   2.5 %

Effect on net interest income in second year from gradual interest rate change over the preceding 12 months of:

      

100 basis point increase

   (6.4 )%   (5.5 )%

100 basis point decrease

   4.4 %   3.7 %

Duration of Equity Model

      

Base case duration of equity (in years):

   2.1     1.5  

Key Period-End Interest Rates

      

One month LIBOR

   4.60 %   5.32 %

Three-year swap

   3.91 %   5.10 %

In addition to measuring the effect on net interest income assuming parallel changes in current interest rates, we routinely simulate the effects of a number of nonparallel interest rate environments. The following Net Interest Income Sensitivity To Alternative Rate Scenarios table reflects the percentage change in net interest income over the next two 12-month periods assuming (i) the PNC Economist’s most likely rate forecast, (ii) implied market forward rates, and (iii) a Two-Ten Inversion (a 200 basis point inversion between two-year and ten-year rates superimposed on current base rates) scenario. We are inherently sensitive to a flatter or inverted yield curve.

Net Interest Income Sensitivity To Alternative Rate Scenarios (Fourth Quarter 2007)

 

     PNC

Economist

 

 

  Market
Forward
 
 
  Two-Ten
Inversion
 
 

First year sensitivity

   6.4 %   6.1 %   (8.7 )%

Second year sensitivity

   9.5 %   11.0 %   (7.7 )%

All changes in forecasted net interest income are relative to results in a base rate scenario where current market rates are assumed to remain unchanged over the forecast horizon.

When forecasting net interest income, we make assumptions about interest rates and the shape of the yield curve, the volume and characteristics of new business, and the behavior of existing on- and off-balance sheet positions. These assumptions determine the future level of simulated net interest income in the base interest rate scenario and the other interest rate scenarios presented in the following table. These simulations assume that as assets and liabilities mature, they are replaced or repriced at market rates.

 

The graph below presents the yield curves for the base rate scenario and each of the alternate scenarios one year forward.

LOGO

Our risk position is currently liability sensitive which was the objective of our recent balance sheet management strategies. We believe that we have the deposit funding base and balance sheet flexibility to adjust, where appropriate, to changing interest rates and market conditions.

MARKET RISK MANAGEMENT – TRADING RISK

Our trading activities primarily include customer-driven trading in fixed income securities, equities, derivatives, and foreign exchange contracts. They also include the underwriting of fixed income and equity securities and proprietary trading.

We use value-at-risk (“VaR”) as the primary means to measure and monitor market risk in trading activities. The Risk Committee of the Board establishes an enterprise-wide VaR limit on our trading activities.

During 2007, our VaR ranged between $6.1 million and $12.8 million, averaging $8.5 million. This range reflected an increase in market volatility.

To help ensure the integrity of the models used to calculate VaR for each portfolio and enterprise-wide, we use a process known as backtesting. The backtesting process consists of comparing actual observations of trading-related gains or losses against the VaR levels that were calculated at the close of the prior day. We would expect a maximum of two to three instances a year in which actual losses exceeded the prior day VaR measure. During 2007, there were two such instances at the enterprise-wide level.


 

53


The following graph shows a comparison of enterprise-wide trading-related gains and losses against prior day VaR for the period.

LOGO

Total trading revenue for the past three years was as follows:

 

Year end December 31 - in millions    2007    2006    2005

Net interest income (expense)

   $7    $(6)    $9

Noninterest income

   104    183    157

Total trading revenue

   $111    $177    $166

Securities underwriting and

trading (a)

   $41    $38    $47

Foreign exchange

   58    55    39

Financial derivatives

   12    84    80

Total trading revenue

   $111    $177    $166
(a) Includes changes in fair value for certain loans accounted for at fair value.

Average trading assets and liabilities consisted of the following:

 

Year ended - in millions    December 31
2007
   December 31
2006
   December 31
2005

Assets

        

Securities (a)

   $2,708    $1,712    $1,850

Resale agreements (b)

   1,133    623    663

Financial derivatives (c)

   1,378    1,148    772

Loans at fair value (c)

   166    128     

Total assets

   $5,385    $3,611    $3,285

Liabilities

        

Securities sold short (d)

   $1,657    $965    $993

Repurchase agreements and other borrowings (e)

   520    833    1,044

Financial derivatives (f)

   1,384    1,103    825

Borrowings at fair value (f)

   39    31     

Total liabilities

   $3,600    $2,932    $2,862
(a) Included in Interest-earning assets-Other on the Average Consolidated Balance Sheet And Net Interest Analysis.
(b) Included in Federal funds sold and resale agreements.
(c) Included in Noninterest-earning assets-Other.
(d) Included in Other borrowed funds.
(e) Included in Repurchase agreements and Other borrowed funds.
(f) Included in Accrued expenses and other liabilities.

 

MARKET RISK MANAGEMENT – EQUITY AND OTHER

INVESTMENT RISK

Equity investment risk is the risk of potential losses associated with investing in both private and public equity markets. In addition to extending credit, taking deposits, and underwriting and trading financial instruments, we make and manage direct investments in a variety of transactions, including management buyouts, recapitalizations, and later-stage growth financings in a variety of industries. We also have investments in affiliated and non-affiliated funds that make similar investments in private equity and in debt and equity-oriented hedge funds. The economic and/or book value of these investments and other assets such as loan servicing rights are directly affected by changes in market factors.

The primary risk measurement for equity and other investments is economic capital. Economic capital is a common measure of risk for credit, market and operational risk. It is an estimate of the worst-case value depreciation over one year within a 99.9% confidence level. Given the illiquid nature of many of these types of investments, it can be a challenge to determine their fair values. Market Risk Management and Finance provide independent oversight of the valuation process.

Various PNC business units manage our private equity and other investment activities. Our businesses are responsible for making investment decisions within the approved policy limits and associated guidelines.

BlackRock

PNC owns approximately 43 million shares of BlackRock common stock, accounted for under the equity method. Our total investment in BlackRock was $4.1 billion at December 31, 2007 compared with $3.9 billion at December 31, 2006. The market value of our investment in BlackRock was $9.4 billion at December 31, 2007. The primary risk measurement, similar to other equity investments, is economic capital.

Low Income Housing Projects And Historic Tax Credits

Included in our equity investments are limited partnerships that sponsor affordable housing projects. At December 31, 2007 these investments, consisting of partnerships accounted for under the equity method as well as equity investments held by consolidated partnerships, totaled $1.0 billion. The comparable amount at December 31, 2006 was $708 million. PNC’s equity investment at risk was $188 million at December 31, 2007 compared with $134 million at year-end 2006. We also had commitments to make additional equity investments in affordable housing limited partnerships of $98 million at December 31, 2007 compared with $71 million at December 31, 2006. At December 31, 2007 historic tax credit investments totaled $13 million with unfunded commitments related to these investments of $26 million.


 

54


Private Equity

The private equity portfolio is comprised of equity and mezzanine investments that vary by industry, stage and type of investment. Private equity investments are reported at fair value. Changes in the values of private equity investments are reflected in our results of operations. Due to the nature of the investments, the valuations incorporate assumptions as to future performance, financial condition, liquidity, availability of capital, and market conditions, among other factors, to determine the estimated fair value of the investments. Market conditions and actual performance of the investments could differ from these assumptions. Accordingly, lower valuations may occur that could adversely impact earnings in future periods. Also, the valuations may not represent amounts that will ultimately be realized from these investments. See Private Equity Asset Valuation in the Critical Accounting Policies And Judgments section of this Item 7 for additional information.

At December 31, 2007, private equity investments carried at estimated fair value totaled $561 million compared with $463 million at December 31, 2006. As of December 31, 2007, approximately 47% of the amount was invested directly in a variety of companies and approximately 53% was invested in various limited partnerships. Our unfunded commitments related to private equity totaled $270 million at December 31, 2007 compared with $283 million at December 31, 2006.

Other Investments

We also make investments in affiliated and non-affiliated funds with both traditional and alternative investment strategies. The economic values could be driven by either the fixed-income market or the equity markets, or both. At December 31, 2007, other investments totaled $389 million compared with $269 million at December 31, 2006. Our unfunded commitments related to other investments totaled $79 million at December 31, 2007 compared with $16 million at December 31, 2006. The amounts of other investments and related unfunded commitments at December 31, 2007 included those related to Steel City Capital Funding LLC as further described in Note 24 Commitments and Guarantees in the Notes To Consolidated Financial Statements in Item 8 of this Report.

 

IMPACT OF INFLATION

Our assets and liabilities are primarily monetary in nature. Accordingly, future changes in prices do not affect the obligations to pay or receive fixed and determinable amounts of money. During periods of inflation, monetary assets lose value in terms of purchasing power and monetary liabilities have corresponding purchasing power gains. The concept of purchasing power, however, is not an adequate indicator of the effect of inflation on banks because it does not take into account changes in interest rates, which are an important determinant of our earnings.

FINANCIAL DERIVATIVES

We use a variety of financial derivatives as part of the overall asset and liability risk management process to help manage interest rate, market and credit risk inherent in our business activities. Substantially all such instruments are used to manage risk related to changes in interest rates. Interest rate and total return swaps, interest rate caps and floors and futures contracts are the primary instruments we use for interest rate risk management.

Financial derivatives involve, to varying degrees, interest rate, market and credit risk. For interest rate swaps and total return swaps, options and futures contracts, only periodic cash payments and, with respect to options, premiums are exchanged. Therefore, cash requirements and exposure to credit risk are significantly less than the notional amount on these instruments. Further information on our financial derivatives is presented in Note 1 Accounting Policies and Note 15 Financial Derivatives in the Notes To Consolidated Financial Statements in Item 8 of this Report.

Not all elements of interest rate, market and credit risk are addressed through the use of financial or other derivatives, and such instruments may be ineffective for their intended purposes due to unanticipated market characteristics, among other reasons.


 

55


The following tables provide the notional or contractual amounts and estimated net fair value of financial derivatives used for risk management and designated as accounting hedges as well as free-standing derivatives at December 31, 2007 and 2006. Weighted-average interest rates presented are based on contractual terms, if fixed, or the implied forward yield curve at each respective date, if floating.

Financial Derivatives - 2007

 

December 31, 2007 - dollars in millions

   Notional/

Contract

Amount

   Estimated
Net

Fair
Value

 
 

 
 

  Weighted

Average

Maturity

   Weighted-AverageInterest Rates   
           Paid     Received  

Accounting Hedges

              

Interest rate risk management

              

Asset rate conversion

              

Interest rate swaps (a)

              

Receive fixed

   $7,856    $325     4 yrs. 2 mos.    4.28 %   5.34 %

Total asset rate conversion

   7,856    325           

Liability rate conversion

              

Interest rate swaps (a)

              

Receive fixed

   9,440    269     4 yrs. 10 mos.    4.12     5.09  

Total liability rate conversion

   9,440    269           

Total interest rate risk management

   17,296    594           

Commercial mortgage banking risk management

Pay fixed interest rate swaps (a)

  

1,128

  

(79

)

 

8 yrs. 8 mos.

  

5.45

 

 

4.52

 

            

Total commercial mortgage banking risk management

   1,128    (79 )         

Total accounting hedges (b)

   $18,424    $515                   

Free-Standing Derivatives

              

Customer-related

              

Interest rate

              

Swaps (c)

   $61,768    $(39 )   5 yrs. 4 mos.    4.46 %   4.49 %

Caps/floors

              

Sold (c)

   2,837    (5 )   6 yrs. 5 mos.    NM     NM  

Purchased

   2,356    7     3 yrs. 7 mos.    NM     NM  

Futures (c)

   5,564    (6 )   8 mos.    NM     NM  

Foreign exchange

   7,028    8     7 mos.    NM     NM  

Equity (c)

   1,824    (69 )   1 yr. 5 mos.    NM     NM  

Swaptions

   3,490    40     13 yrs. 10 mos.    NM     NM  

Other

   200          10 yrs. 6 mos.    NM     NM  

Total customer-related

   85,067    (64 )         

Other risk management and proprietary

              

Interest rate

              

Swaps

   41,247    6     4 yrs. 5 mos.    4.44 %   4.47 %

Caps/floors

              

Sold (c)

   6,250    (82 )   2 yrs. 1 mo.    NM     NM  

Purchased

   7,760    117     1 yr. 11 mos.    NM     NM  

Futures (c)

   43,107    (15 )   1 yr. 7 mos.    NM     NM  

Foreign exchange

   8,713    5     6 yrs. 8 mos.    NM     NM  

Credit derivatives

   5,823    42     12 yrs. 1 mo.    NM     NM  

Risk participation agreements

   1,183      4 yrs. 6 mos.    NM     NM  

Commitments related to mortgage-related assets

   3,190    10     4 mos.    NM     NM  

Options

              

Futures

   39,158    (2 )   8 mos.    NM     NM  

Swaptions

   21,800    49     8 yrs. 1 mo.    NM     NM  

Other (d)

   442    (201 )   NM    NM     NM  

Total other risk management and proprietary

   178,673    (71 )         

Total free-standing derivatives

   $263,740    (135 )                 
(a) The floating rate portion of interest rate contracts is based on money-market indices. As a percent of notional amount, 52% were based on 1-month LIBOR, 43% on 3-month LIBOR and 5% on Prime Rate.
(b) Fair value amount includes net accrued interest receivable of $130 million.
(c) The increases in the negative fair values from December 31, 2006 to December 31, 2007 for equity and in