Fifth Third Bank 2003 Annual Report Download - page 67

FIFTH THIRD BANCORP AND SUBSIDIARIES
65
Management’s Discussion and Analysis of
Financial Condition and Results of Operations
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 have 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 periods that impacted
the determination of the current year reserve for loan and lease
losses.
Based on the procedures discussed above, management is of the
opinion that the reserve of $770 million was adequate, but not
excessive, to absorb estimated credit losses associated with the loan
and lease portfolio at December 31, 2003.
Valuation of 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 and swaptions. 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. The primary risk
of material changes to the value of the derivative instruments is
fluctuation in interest rates; however, as the Bancorp principally
utilizes these derivative instruments as part of a designated hedging
program, the change in the derivative value is generally offset by a
corresponding change in the value of the hedged item or a
forecasted transaction. The fair values of derivative financial
instruments are based on current market quotes.
Valuation of Securities: The Bancorp’s available-for-sale security
portfolio is reported at fair value. The fair value of a security is
determined based on quoted market prices. If quoted market prices are
not available, fair value is determined based on quoted prices of similar
instruments. Available-for-sale and held-to-maturity securities are
reviewed quarterly for possible other-than-temporary impairment. The
review includes an analysis of the facts and circumstances of each
individual investment such as the length of time the fair value has been
below cost, the expectation for that security’s performance, the credit
worthiness of the issuer and the Bancorp’s intent and ability to hold
the security to maturity. A decline in value that is considered to be
other-than-temporary is recorded as a loss within other operating
income in the Consolidated Statements of Income.
Valuation of Servicing Rights: 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 loan sales are amortized in
proportion to and over the period of estimated net servicing revenues.
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
financial asset type and interest rates. In addition, the Bancorp obtains
an independent third-party valuation of the mortgage servicing
portfolio on a quarterly basis. Fees received for servicing loans owned
by investors are based on a percentage of the outstanding monthly
principal balance of such loans and are included in operating income
as loan payments are received. Costs of servicing loans are charged to
expense as incurred.
The change in the fair value of the MSR's at December 31,
2003, to immediate 10 percent and 20 percent adverse changes in
the current prepayment assumption would be approximately $16
million and $31 million, respectively, and to immediate 10 percent
and 20 percent favorable changes in the current prepayment