Huntington National Bank 2004 Annual Report Download - page 31

MANAGEMENT’S DISCUSSION AND ANALYSIS HUNTINGTON BANCSHARES INCORPORATED
letters of credit (AULC). The determination of the amount of the ACL is based on Management’s current judgments regarding the
quality of the loan portfolio, and considers all known relevant internal and external factors that affect loan collectibility. The ACL
represents Management’s estimate as to the level of reserves appropriate to absorb probable inherent credit losses in the loan and
lease portfolio, as well as unfunded loan commitments. Management believes the process for determining the ACL considers all of
the potential factors that could result in credit losses. However, the process includes judgmental and quantitative elements that may
be subject to significant change. To the extent actual outcomes differ from Management estimates, additional provision for credit
losses could be required, which could adversely affect earnings or financial performance in future periods. At December 31, 2004,
the ACL as a percent of total loans and leases was 1.29%. Based on the December 31, 2004 balance sheet, a 10 basis point increase in
this ratio to 1.39% would require $23.6 million in additional reserves (funded by additional provision for credit losses), which
would have negatively impacted 2004 net income by approximately $15.3 million or $0.07 per share. A discussion about the process
used to estimate the ACL is presented in the Credit Risk section of Management’s Discussion and Analysis in this report.
–M ORTGAGE LOAN SERVICING RIGHTS — At December 31, 2004, there were $77.1 million of mortgage servicing rights included in
other assets. No active market exists with observable market prices for these financial instruments. To estimate fair values,
Management estimates future prepayments on the loans serviced for others, future ancillary revenue, future costs to service these
assets, adequate compensation for servicing the loans, and the appropriate discount rate to use. Note 5 of the Notes to Consolidated
Financial Statements contains an analysis of the impact to the fair value of mortgage servicing rights resulting from changes in the
estimates used by Management. A discussion about the process used to estimate the fair value of mortgage servicing rights is presented in
the Non-Interest Income section of Management’s Discussion and Analysis in this report.
At December 31, 2004, the assumptions and the sensitivity of the current fair value of the Huntington’s mortgage servicing rights to
immediate 10% and 20% adverse changes in those assumptions were:
Pre-tax decline in
fair value due to
10%
adverse 20%
(in millions of dollars) Actual change adverse
Constant pre-payment rate 21.70% $(4.8) $(9.1)
Discount rate 8.85 (2.2) (4.2)
–L EASE RESIDUAL VALUES UNDERLYING OPERATING LEASES — At December 31, 2004, a total of $403.4 million of its investment in
vehicles under operating leases represented Management’s estimate of the aggregate of each vehicle’s residual value, which is the
predicted value of the vehicle at the end of the lease term. The Company depreciates the vehicles it leases under operating lease
accounting to this residual value. The depreciation is recognized on a straight-line basis over the life of the lease. On a quarterly
basis, Management reviews the expected future residual value losses for leased automobiles taking into consideration the
insurance policy caps on insured losses. As a result of that review, Management determines how much impairment, if any, needs
to be recognized on these operating leases and whether the residual value should be adjusted prospectively. When the estimate
of this residual value declines, the Company increases its rate of depreciation to depreciate the vehicle to the new estimated
residual value by the end of the lease term.
To manage this risk, the Company purchased residual value insurance. The Company currently has one insurance policy in effect,
covering operating leases originated between October 2000 and April 2002. This policy covers $298.0 million of residual values but
has a $50 million cap on losses that it will cover. Based on current vehicle values, Management estimates total claims against this
policy will be $11-$25 million, well below the cap. A total of $105.1 million of residual values relate to originations prior to
October 2000 and are no longer covered by insurance. The insurance policy covering the residual values of these leases had a
$120 million cap and claims under that policy have exceeded this cap. Management estimates that future losses from this portfolio
could be $17-$28 million, of which $10 million has already been recognized through additional depreciation. Further discussion
about the process used to estimate the risk of residual value losses on operating leases is presented in the Market Risk and Operating Lease
Assets sections of Management’s Discussion and Analysis in this report. Notes 1 and 7 of the Notes to Consolidated Financial Statements
included in this report explain the accounting for operating lease assets in more detail.
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