Fifth Third Bank 2004 Annual Report Download - page 32

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
30 Fifth Third Bancorp
The balance sheet repositioning in the fourth quarter of 2004
changed the interest rate sensitivity profi le of the Bancorp from
liability sensitive to asset sensitive (i.e., from a negative outlook to
a positive outlook in a rising rate environment). Management does
not expect any signifi cant adverse effect to net interest income in
2005 based on the current composition of the portfolio, antici-
pated trends in rates and earning asset and deposit growth.
Use of Derivatives to Manage Interest Rate Risk
An integral component of the Bancorp’s interest risk management
strategy is its use of derivative instruments to minimize signifi -
cant unplanned fl uctuations in earnings and cash fl ows caused
by market volatility. Examples of derivative instruments that the
Bancorp may use as part of its interest rate risk management strate-
gy include interest rate swaps, interest rate fl oors, interest rate caps,
forward contracts, principal only swaps, options and swaptions.
Interest rate swap contracts are exchanges of interest payments,
such as fi xed-rate payments for fl oating-rate payments, based on
a common notional amount and maturity date. Interest rate fl oors
protect against declining rates, while interest rate caps protect
against rising interest rates. Forwards are contracts in which the
buyer agrees to purchase, and the seller agrees to make delivery of,
a specifi c fi nancial instrument at a predetermined price or yield.
Swaptions provide the buyer the option to exchange streams of
payments with the seller over a specifi ed period of time.
As part of its overall risk management strategy relative to
its mortgage banking activity, the Bancorp enters into forward
contracts accounted for as free-standing derivatives to economically
hedge interest rate lock commitments, which are also considered
free-standing derivatives.
The Bancorp also establishes derivative contracts with repu-
table third parties to economically hedge signifi cant exposures
assumed in commercial customer accommodation derivative
contracts. Generally, these contracts have similar terms in order to
protect the Bancorp from the market volatility. Credit risks arise
from the possible inability of counterparties to meet the terms
of their contracts, which the Bancorp minimizes through credit
approvals, limits and monitoring procedures. The notional amount
and fair values of these derivatives as of December 31, 2004 are
included in Note 9 to the Consolidated Financial Statements.
Mortgage Servicing Rights and Interest Rate Risk
The net carrying amount of the MSR portfolio was $339 million
as of December 31, 2004. The Bancorp maintains a non-qualifying
hedging strategy relative to its mortgage banking activity, including
consultation with an 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 purchase of free-standing derivatives (princi-
pal only swaps, swaptions, fl oors, interest rate swaps, options and
forward contracts). The mark-to-market adjustments associated
with these derivatives are expected to economically hedge a portion
of the change in value of the MSR portfolio caused by fl uctuating
discount rates, earnings rates and prepayment speeds. The value
of servicing rights can fl uctuate sharply depending on changes in
interest rates and other factors. Generally, as interest rates decline
and loans are prepaid to take advantage of refi nancing, the total
value of existing servicing rights declines because no further servic-
ing fees are collected on repaid loans.
The increase in interest rates during 2004 and the resulting
impact of changing prepayment speeds led to the recovery of $60
million in temporary impairment in the MSR portfolio as compared
to the $3 million in temporary impairment recognized in 2003.
The servicing rights are deemed impaired when a borrower’s loan
rate is distinctly higher than prevailing market rates. See Note 8
to the Consolidated Financial Statements for further discussion on
servicing rights.
Foreign Currency Risk
The Bancorp enters into foreign exchange derivative contracts
for the benefi t of commercial customers involved in international
trade to hedge their exposure to foreign currency fl uctuations. The
Bancorp has in place several controls to ensure excessive risk is not
being taken in providing this service to customers. These include
Based upon expected repayments, the following is a summary of the remaining maturities of loans and leases held for investment as of Decem-
ber 31, 2004:
TABLE 25: LOAN AND LEASE MATURITIES
($ in millions) Less than 1 year 1-5 years Greater than 5 years Total
Commercial, fi nancial and agricultural . . . . . . . . . . . . . . . . . . . . . . . . $ 9,503 5,641 914 16,058
Real estate - commercial mortgage loans . . . . . . . . . . . . . . . . . . . . . . . 2,124 4,729 783 7,636
Real estate - construction loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,657 1,669 400 4,726
Residential mortgage loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,957 2,527 2,504 6,988
Consumer loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,583 9,465 3,875 18,923
Lease fi nancing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,524 3,163 790 5,477
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 23,348 27,194 9,266 59,808
Segregated by sensitivity to interest rate changes, the following is a summary of expected repayments exceeding one year as of December 31, 2004:
TABLE 26: LOAN AND LEASE INTEREST RATE SENSITIVITY
Interest Rate
($ in millions) Predetermined Floating or Adjustable
Commercial, fi nancial and agricultural . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,992 4,563
Real estate - commercial mortgage loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,228 3,284
Real estate - construction loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 478 1,591
Residential mortgage loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,647 3,384
Consumer loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,438 6,902
Lease fi nancing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,953 —
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $16,736 19,724
TABLE 27: MATURITY DISTRIBUTION OF CERTIFICATES – $100,000 AND OVER
As of December 31, 2004 ($ in millions)
Three months or less . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 908
Over three months through six months . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 292
Over six months through one year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 422
Over one year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 499
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,121