Huntington National Bank 2005 Annual Report Download - page 35

MANAGEMENT’S DISCUSSION AND ANALYSIS HUNTINGTON BANCSHARES INCORPORATED
connection with the critical and other accounting policies and to illustrate the potential effect on the financial statements if the
actual amount were different from the estimated amount.
–T OTAL ALLOWANCES FOR CREDIT LOSSES — At December 31, 2005, the total allowances for credit losses (ACL) was
$305.3 million and represented the sum of the allowance for loan and lease losses (ALLL) and the allowance for unfunded loan
commitments and letters of credit (AULC). The amount of the ACL was determined by our judgments regarding the quality of
the loan portfolio, including loan commitments. All known relevant internal and external factors that affected loan collectibility
were considered. The ACL represents the estimate of the level of reserves appropriate to absorb inherent credit losses. We
believe the process for determining the ACL considers all of the significant 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 our estimates, additional provision for credit losses could be required, which could adversely affect
earnings or financial performance in future periods. At December 31, 2005, the ACL as a percent of total loans and leases was
1.25%. Based on the December 31, 2005 balance sheet, a 10 basis point increase in this ratio to 1.35% would require
$25.1 million in additional reserves funded by additional provision for credit losses, which would have negatively impacted
2005 net income by approximately $16.3 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.
–F AIR VALUE OF FINANCIAL INSTRUMENTS — A significant portion of our assets is carried at fair value, including securities,
derivatives, and trading assets. Additionally, a smaller portion is carried at the lower of fair value or cost, including held-for-
sale loans and mortgage servicing rights (MSRs). At December 31, 2005, approximately $4.9 billion of our assets were recorded
at either fair value or at the lower of fair value or cost.
The fair value of a financial instrument is defined as the amount at which the instrument could be exchanged in a current
transaction between willing parties, other than in a forced or liquidation sale. The majority of assets reported at fair value are
based on quoted market prices or on internally developed models that utilize independently sourced market parameters,
including interest rate yield curves, option volatilities, and currency rates.
We estimate the fair value of a financial instrument using a variety of valuation methods. Where financial instruments are
actively traded and have quoted market prices, quoted market prices are used for fair value. When observable market prices do
not exist, we estimate fair value. Our valuation methods consider factors such as liquidity and concentration concerns and, for
the derivatives portfolio, counterparty credit risk. Other factors such as model assumptions, market dislocations, and
unexpected correlations can affect estimates of fair value. Imprecision in estimating these factors can impact the amount of
revenue or loss recorded for a particular position.
Trading securities and securities available-for-sale
Substantially all of our securities are valued based on quoted market prices. However, certain securities are less actively
traded. These securities do not always have quoted market prices. The determination of their fair value, therefore, requires
judgment, as this determination may require benchmarking to similar instruments or analyzing default and recovery rates.
Examples include certain collateralized mortgage and debt obligations and high-yield debt securities.
Our securities available-for-sale are valued using quoted market prices. Our derivative positions are valued using internally
developed models based on observable market parameters — that is, parameters that are actively quoted and can be validated
to external sources, including industry-pricing services.
Loans held-for-sale
The fair value of loans in the held-for-sale portfolio is generally based on observable market prices of similar instruments. If
market prices are not available, fair value is based on the estimated cash flows, adjusted for credit risk. The credit risk
adjustment is discounted using a rate that is appropriate for each maturity and incorporates the effects of interest rate
changes.
MSRs and other servicing rights
MSRs and certain other servicing rights do not trade in an active, open market with readily observable prices. While sales of
MSRs occur, the precise terms and conditions are typically not readily available. Therefore, we estimate the fair value of
MSRs and certain other servicing rights using a discounted future cash flow model. For MSRs and certain other servicing
rights, the model considers portfolio characteristics, contractually specified servicing fees and assumptions related to
prepayments, delinquency rates, late charges, other ancillary revenues, costs to service, and other economic factors. Changes
in the assumptions used may have a significant impact on the valuation of these financial instruments. We believe that the
fair values and related assumptions used in the models are comparable to those used by other market participants. Note 5 of
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