Fifth Third Bank 2003 Annual Report Download - page 52

FIFTH THIRD BANCORP AND SUBSIDIARIES
50
Management’s Discussion and Analysis of
Financial Condition and Results of Operations
of FIN 46 on July 1, 2003, required the Bancorp to consolidate a
special purpose entity involved in the sale-leaseback of certain auto
leases. The consolidation of these operating lease assets has resulted
in the Bancorp recognizing $124 million in operating lease revenue
during 2003, representing lease payments received, reflected as a
component of other operating income.
Electronic payment processing service revenue increased 12% in
2003 and 47% in 2002. Comparisons to the 2002 growth rate are
impacted by a slowdown in transaction volume growth rates on the
existing customer base reflective of overall economic conditions in
2003 and sluggish growth in the retail sector of the economy, the
MasterCard ®/Visa ® settlement implemented in August 2003, and
the fourth quarter 2001 purchase acquisition of Universal
Companies (USB). The Bancorp continues to realize positive sales
momentum from the addition of new customer relationships in
both its Merchant Services and Electronic Funds Transfer (EFT)
businesses.
Merchant processing revenues increased 16% in 2003, compared
to an 81% increase in 2002. The increase in 2003 is due to
transaction volume growth attributable to the addition of new
customers, offset by a slowdown in transaction volume growth on
the existing customer base reflective of sluggish growth in the retail
sector. The increase in 2002 was due to the addition of new
customers and resulting increase in transaction volumes, as well as
the incremental contributions from the fourth quarter 2001 USB
acquisition. Excluding the incremental revenue contribution from
USB, merchant processing revenues increased 35% in 2002
compared to 2001.
EFT revenues increased 7% in 2003, compared to a 22%
increase in 2002. Comparisons to 2002 are impacted by a slowdown
in transaction volume growth rates on the existing customer base
and a $13 million revenue impact associated with the MasterCard®/-
Visa®settlement. During 2003, VISA®and MasterCard®reached
separate agreements to settle merchant litigation regarding debit card
interchange reimbursement fees. These agreements, implemented in
August 2003, included provisions to lower fee structures which
resulted in a reduction in revenues for debit card issuers. The impact of
this settlement on the Bancorp's electronic payment processing
revenues for 2004 is expected to be approximately $30 million to $35
million. The Bancorp handled 9.0 billion ATM, point-of-sale and
e-commerce transactions in 2003, a 10% increase compared to 8.2
billion in 2002, and the Bancorp’s world-class capabilities as a
transaction processor position the Bancorp well to continue to take
advantage of the opportunities of e-commerce.
Service charges on deposits were $485 million in 2003, an
increase of 13% over 2002’s $431 million. Service charges on
deposits increased 17% in 2002 compared to 2001. The growth in
2003 was fueled by the expansion of the Bancorp’s retail and
commercial network, continued sales success in corporate treasury
management products, successful sales campaigns promoting retail
and commercial deposit accounts and the benefit of a lower interest
rate environment during the year. Commercial deposit based
revenues increased 15% over last year on the strength of continued
focus on cross-sell initiatives, new customer relationships and the
benefit of a lower interest rate environment with notable growth in
Chicago, Columbus, Cleveland, Cincinnati, Detroit and Grand
Rapids. Retail based deposit revenue increased 11% in 2003
compared to 2002, driven by the success of sales campaigns and
direct marketing programs in generating new account relationships.
Mortgage banking net revenue increased 61% to $302 million in
2003 from $188 million in 2002. In 2003 and 2002, mortgage
banking net revenue was comprised of $466 million and $386
million, respectively, of total mortgage banking fees and loan sales,
$14 million and $98 million, respectively, in gains and mark-to-
market adjustments on both settled and outstanding free-standing
derivative instruments and a reduction of $178 million and $296
million, respectively, in net valuation adjustments and amortization
on mortgage servicing rights (MSR) portfolio.
The Bancorp maintains a comprehensive management strategy
relative to its mortgage banking activity, including consultation with
an outside independent third-party specialist, in order to manage a
portion of the risk associated with changes in impairment on its MSR
portfolio as a result of changing interest rates. This strategy includes
the utilization of securities available-for-sale and free-standing
derivatives as well as engaging in loan securitization and sale
transactions. The Bancorp’s non-qualifying hedging strategy includes
the purchase of various securities (primarily FHLMC and FNMA
agency bonds, US treasury bonds, and PO strips) and the purchase of
free-standing derivatives (PO swaps, swaptions, floors, forward
contracts, options and interest rate swaps). The interest income,
mark-to-market adjustments and gain or loss from sale activities in
these portfolios are expected to economically hedge a portion of the
change in value of the MSR portfolio caused by fluctuating discount
rates, earnings rates and prepayment speeds. The combined
magnitude of decreasing interest rates in the first half of 2003 and
subsequent increase in interest rates in the second half of 2003 led to
the recognition of a net $3 million in temporary impairment for 2003.
The significant decline in interest rates in 2002 led to an increase in
prepayment speeds and the recognition of $140 million in temporary
impairment. Servicing rights are typically deemed impaired when a
borrower’s loan rate is distinctly higher than prevailing market rates. As
temporary impairment was recognized on the MSR portfolio in 2003
and 2002 due to falling primary and secondary mortgage rates and
earnings rates and corresponding increases in prepayment speeds, the
Bancorp sold certain of these securities resulting in net realized gains of
$3 million and $33 million in 2003 and 2002, respectively, that were
captured as a component of other operating income in the
Consolidated Statements of Income. In addition, the Bancorp
recognized net gains 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 of gains in mark-to-market adjustments and
settlement of free-standing derivative financial instruments in 2003
compared to 2002 resulted from movements of interest rates and
the resulting impact of changing prepayment speeds on 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,
2003 there were no available-for-sale securities held as a part of the
Bancorp’s overall hedging strategy and at December 31, 2002 the
Bancorp held $147 million of U.S. treasury bonds as part of the
non-qualifying hedging strategy. On an overall basis and inclusive
of the net security gain component of the Bancorp’s mortgage
banking risk management strategy, mortgage banking net revenue
increased 38% to $305 million in 2003 from $221 million in
2002.
In 2003, the Bancorp primarily used PO strips/swaps and
purchased options to hedge the economic risk of the MSR portfolio
as they are deemed to be the best available instrument for several
reasons. POs hedge the mortgage-LIBOR spread because they