Fifth Third Bank 2003 Annual Report Download - page 24

Notes to Consolidated Financial Statements
FIFTH THIRD BANCORP AND SUBSIDIARIES
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The reserve is based on ongoing quarterly assessments of the
probable estimated losses inherent in the loan and lease portfolio. In
determining the appropriate level of reserves, the Bancorp estimates
losses using a range derived from “base” and “conservative” estimates.
The Bancorp’s methodology for assessing the appropriate reserve level
consists of several key elements, as discussed below. The Bancorp’s
strategy for credit risk management includes a combination of
conservative exposure limits significantly below legal lending limits,
and conservative underwriting, documentation and collection
standards. The strategy also emphasizes diversification on a geographic,
industry and customer level, regular credit examinations and quarterly
management reviews of large credit exposures and loans experiencing
deterioration of credit quality.
Larger commercial loans that exhibit probable or observed credit
weaknesses are subject to individual review. Where appropriate,
reserves are allocated to individual loans based on management’s
estimate of the borrower’s ability to repay the loan given the
availability of collateral, other sources of cash flow and legal options
available to the Bancorp.
Included in the review of individual loans are those that are
impaired as provided in Statement of Financial Accounting Standards
(SFAS) No. 114, “Accounting by Creditors for Impairment of a
Loan.” Any reserves for impaired loans are measured based on the
present value of expected future cash flows discounted at the loan’s
effective interest rate or fair value of the underlying collateral. The
Bancorp evaluates the collectibility of both principal and interest when
assessing the need for loss accrual.
Historical loss rates are applied to other commercial loans not
subject to specific reserve allocations. The loss rates are derived from a
migration analysis, which computes the net charge-off experience
sustained on loans according to their internal risk grade. These grades
encompass ten categories that define a borrower’s ability to repay their
loan obligations. The risk rating system is intended to identify and
measure the credit quality of all commercial lending relationships.
Homogenous loans, such as consumer installment, residential
mortgage loans and automobile leases, are not individually risk
graded. Rather, standard credit scoring systems and delinquency
monitoring are used to assess credit risk. Reserves are established
for each pool of loans based on the expected net charge-offs for one
year. Loss rates are based on the average net charge-off history by
loan category.
Historical loss rates for commercial and consumer loans may be
adjusted for significant factors that, in management’s judgment,
reflect the impact of any current conditions on loss recognition.
Factors that management considers in the analysis include the
effects of the national and local economies, trends in the nature
and volume of loans (delinquencies, charge-offs and nonaccrual
loans), changes in mix, credit score migration comparisons, asset
quality trends, risk management and loan administration, changes
in the internal lending policies and credit standards, collection
practices and examination results from bank regulatory agencies
and the Bancorp’s internal credit examiners.
An unallocated reserve is maintained to recognize the imprecision
in estimating and measuring loss when evaluating reserves for
individual loans or pools of loans. Reserves on individual loans and
historical loss rates are reviewed quarterly and adjusted as necessary
based on changing borrower and/or collateral conditions and actual
collection and charge-off experience.
The Bancorp’s primary market areas for lending are Ohio,
Kentucky, Indiana, Florida, Michigan, Illinois, West Virginia and
Tennessee. When evaluating the adequacy of reserves, consideration
is given to this regional geographic concentration and the closely
associated effect changing economic conditions has on the
Bancorp’s customers.
The Bancorp has not substantively changed any aspect of its overall
approach in the determination of the reserve for loan and lease losses.
There have been no material changes in assumptions or estimation
techniques as compared to prior years that impacted the determination
of the current year reserve for loan and lease losses.
Loan Sales and Securitizations
When the Bancorp sells loans through either securitizations or
individual loan sales in accordance with its investment policies, it
may retain one or more subordinated tranches, servicing rights,
interest-only strips, credit recourse, other residual interests and in
some cases, a cash reserve account, all of which are considered
retained interests in the securitized or sold loans. Gain or loss on
sale or securitization of the loans depends in part on the previous
carrying amount of the financial assets sold or securitized, allocated
between the assets sold and the retained interests based on their
relative fair value at the date of sale or securitization. To obtain fair
values, quoted market prices are used if available. If quotes are not
available for retained interests, the Bancorp calculates fair value
based on the present value of future expected cash flows using both
management’s best estimates and third-party data sources for the
key assumptions — credit losses, prepayment speeds, forward yield
curves and discount rates commensurate with the risks involved.
Gain or loss on sale or securitization of loans is reported as a
component of other operating income in the Consolidated
Statements of Income. Retained interests from securitized or sold
loans, excluding servicing rights, are carried at fair value.
Adjustments to fair value for retained interests classified as
available-for-sale securities are included in accumulated
nonowner changes in equity, or in other operating income in the
Consolidated Statements of Income if the fair value has declined
below the carrying amount and such decline has been determined
to be other-than-temporary. Adjustments to fair value for
retained interests classified as trading securities are recorded
within other operating income in the Consolidated Statements of
Income.
Servicing rights resulting from residential mortgage and home
equity line of credit loan sales are amortized in proportion to and
over the period of estimated net servicing revenues and are reported
as a component of mortgage banking net revenue and other service
charges and fees, respectively, in the Consolidated Statements of
Income. Servicing rights are assessed for impairment monthly,
based on fair value, with temporary impairment recognized
through a valuation allowance and permanent impairment
recognized through a write-off of the servicing asset and related
valuation reserve. Key economic assumptions used in measuring
any potential impairment of the servicing rights include the
prepayment speed of the underlying loans, the weighted-average
life of the loan, the discount rate and the weighted-average default
rate, as applicable. The primary risk of material changes to the
value of the servicing rights resides in the potential volatility in the
economic assumptions used, particularly the prepayment speed.
The Bancorp monitors this risk and adjusts its valuation allowance
as necessary to adequately reserve for any probable impairment in
the portfolio. For purposes of measuring impairment, the mortgage
servicing rights are stratified based on the financial asset type and