Fifth Third Bank 2003 Annual Report Download - page 31

Notes to Consolidated Financial Statements
FIFTH THIRD BANCORP AND SUBSIDIARIES
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recognized a net gain of $15 million and $100 million in 2003 and
2002, respectively, related to changes in fair value and settlement of
free-standing derivatives purchased to economically hedge the MSR
portfolio. The decline in net security gains from securities
purchased and designated under the non-qualifying hedging strategy
in 2003 compared to 2002 is due to increased reliance on free-
standing derivatives rather than available-for-sale securities as part of
the Bancorp’s overall hedging strategy. As of December 31, 2002,
the Bancorp’s available-for-sale security portfolio included $147
million of securities related to the non-qualifying hedging strategy.
As of December 31, 2003, the Bancorp no longer held any
available-for-sale securities related to its non-qualifying hedging
strategy. As of December 31, 2003 and 2002, other assets included
free-standing derivative instruments with a fair value of $8 million
and $37 million, respectively, on outstanding notional amounts
totaling $.9 billion and $1.8 billion, respectively.
The continued decline in primary and secondary mortgage rates
during 2002 and the first six months of 2003 led to historically high
refinance rates and corresponding increases in prepayment speeds.
Therefore, during 2003 and 2002, the Bancorp determined a portion
of the MSR portfolio was permanently impaired, resulting in write-
offs of $129 million and $71 million, respectively, in MSR’s against
the related valuation reserve. Impairment charges are captured as a
component of mortgage banking net revenue in the Consolidated
Statements of Income.
The fair value of capitalized servicing rights was $307 million
and $264 million at December 31, 2003 and 2002, respectively.
The Bancorp serviced $24.5 billion and $26.5 billion of residential
mortgage loans for other investors at December 31, 2003 and 2002,
respectively.
9. Derivatives
The Bancorp maintains an overall interest rate risk management
strategy that incorporates the use of derivative instruments to minimize
significant unplanned fluctuations in earnings and cash flows caused by
interest rate volatility. The Bancorp’s interest rate risk management
strategy involves modifying the re-pricing characteristics of certain assets
and liabilities so that changes in interest rates do not adversely affect the
net interest margin and cash flows. Derivative instruments that the
Bancorp may use as part of its interest rate risk management strategy
include interest rate swaps, interest rate floors, interest rate caps, forward
contracts, options and swaptions. Interest rate swap contracts are
exchanges of interest payments, such as fixed-rate payments for floating-
rate payments, based on a common notional amount and maturity
date. Forward contracts are contracts in which the buyer agrees to
purchase, and the seller agrees to make delivery of, a specific financial
instrument at a predetermined price or yield. Swaptions, which have
the features of a swap and an option, allow, but do not require,
counterparties to exchange streams of payments over a specified period
of time. As part of its overall risk management strategy relative to its
mortgage banking activities, the Bancorp may enter into various free-
standing derivatives (PO swaps, swaptions, floors, forward contracts,
options and interest rate swaps) to economically hedge interest rate lock
commitments and changes in fair value of its largely fixed rate MSR
portfolio. PO swaps are total return swaps based on changes in the
value of the underlying PO trust. The Bancorp also enters into foreign
exchange contracts, interest rate swaps, floors and caps for the benefit of
customers. The Bancorp economically hedges the significant exposures
related to these free-standing derivatives, entered into for the benefit of
customers, by entering into offsetting third-party contracts with
approved reputable counterparties with matching terms and
currencies that are generally settled daily. Credit risks arise from the
possible inability of counterparties to meet the terms of their
contracts and from any resultant exposure to movement in foreign
currency exchange rates, limiting the Bancorp’s exposure to the
replacement value of the contracts rather than the notional principal
of contract amounts. The Bancorp minimizes the credit risk
through credit approvals, limits and monitoring procedures. The
Bancorp will hedge its interest rate exposure on customer transactions
by executing offsetting swap agreements with primary dealers.
Fair Value Hedges
The Bancorp enters into interest rate swaps to convert its non-
prepayable, fixed-rate long-term debt to floating-rate debt. The
Bancorp’s practice is to convert fixed-rate debt to floating-rate debt.
Decisions to convert fixed-rate debt to floating are made primarily
by consideration of the asset/liability mix of the Bancorp, the
desired asset/liability sensitivity and by interest rate levels. For the
years ended December 31, 2003 and 2002, certain interest rate
swaps met the criteria required to qualify for the shortcut method of
accounting. Based on this shortcut method accounting treatment,
no ineffectiveness is assumed and fair value changes in the interest
rate swaps are recorded as changes in the value of both the swap and
the long-term debt. If any of the interest rate swaps do not qualify
for the shortcut method of accounting, the ineffectiveness due to
differences in the changes in the fair value of the interest rate swap
and the long-term debt are reported within interest expense in the
Consolidated Statements of Income. For the years ended December
31, 2003 and 2002, changes in the fair value of any interest rate
swaps attributed to hedge ineffectiveness were insignificant to the
Bancorp’s Consolidated Statements of Income.
During 2003, the Bancorp terminated interest rate swaps
designated as fair value hedges and in accordance with SFAS No.
133, the fair value of the swaps at the date of termination was
recognized as a premium on the previously hedged long-term debt
and is being amortized over the remaining life of the long-term debt
as an adjustment to yield. The Bancorp had $54 million and $146
million of fair value hedges included in other assets in the
December 31, 2003 and 2002 Consolidated Balance Sheets,
respectively.
The Bancorp also enters into forward contracts to hedge the
forecasted sale of its residential mortgage loans. For the years ended
December 31, 2003 and 2002, the Bancorp met certain criteria to
qualify for matched terms accounting on the hedged loans for sale.
Based on this treatment, fair value changes in the forward contracts
are recorded as changes in the value of both the forward contract
and loans held for sale in the Consolidated Balance Sheets. The
Bancorp had $3 million and $25 million of fair value hedges
included in other liabilities in the December 31, 2003 and 2002
Consolidated Balance Sheets, respectively.
As of December 31, 2003, there were no instances of designated
hedges no longer qualifying as fair value hedges.
Cash Flow Hedges
The Bancorp enters into interest rate swaps to convert floating-rate
liabilities to fixed rates and to hedge certain forecasted transactions.
The liabilities are typically grouped and share the same risk exposure
for which they are being hedged. The Bancorp may also enter into
forward contracts to hedge certain forecasted transactions. As of
December 31, 2003 and 2002, $8 million and $17 million,