Fifth Third Bank 2004 Annual Report Download - page 43

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Fifth Third Bancorp 41
Larger commercial loans that exhibit probable or observed
credit weaknesses are subject to individual review. Where appro-
priate, reserves are allocated to individual loans based on manage-
ment’s estimate of the borrower’s ability to repay the loan given
the availability of collateral, other sources of cash fl ow and legal
options available to the Bancorp. The review of individual loans
includes those loans that are impaired as provided in 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 fl ows discounted at the loan’s effec-
tive interest rate or fair value of the underlying collateral. The
Bancorp evaluates the collectibility of both principal and interest
when assessing the need for a loss accrual. Historical loss rates are
applied to other commercial loans not subject to specifi c 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. The Bancorp utilizes two risk
grading systems for commercial loans and leases. The current risk
grading system utilized for reserve analysis purposes encompasses
ten categories. The Bancorp also maintains a dual risk rating system
that provides for 13 probability of default grade categories and an
additional six grade categories measuring loss factors given an event
of default. The probability of default and loss given default analyses
are not separated in the ten grade risk rating system. The Bancorp
is in the process of completing signifi cant validation and testing
of the dual risk rating system prior to implementation for reserve
analysis purposes. The dual risk rating system is consistent with
Basel II expectations and allows for more precision in the analysis
of commercial credit risk.
Homogenous loans, such as consumer installment, residen-
tial mortgage loans and automobile leases are not individually risk
graded. Rather, standard credit scoring systems and delinquency
monitoring are used to assess credit risks. 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 signifi cant factors that, in management’s judgment,
refl ect 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 impreci-
sion 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 neces-
sary 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, Michigan, Illinois, Florida, Tennessee, West
Virginia and Pennsylvania. When evaluating the adequacy of
reserves, consideration is given to this regional geographic concen-
tration and the closely associated effect changing economic condi-
tions have on the Bancorp’s customers.
The Bancorp has not substantively changed any aspect to 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 period reserve for loan and lease
losses. As of December 31, 2004, the reserve for unfunded commit-
ments has been reclassifi ed from the reserve for loan and lease losses
to other liabilities. The December 31, 2003 reserve for unfunded
commitments and all subsequent activity has been reclassifi ed to
conform to current period presentation.
Reserve for Unfunded Commitments
The reserve for unfunded commitments is maintained at a level
believed by management to be suffi cient to absorb estimated prob-
able losses related to unfunded credit facilities. The determination
of the adequacy of the reserve is based upon an evaluation of the
unfunded credit facilities, including an assessment of historical
commitment utilization experience, credit risk grading and credit
grade migration. Net adjustments to the reserve for unfunded
commitments are included in other noninterest expense.
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 fi nancial 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 fl ows using
both management’s best estimates and third-party data sources for
the key assumptions, including 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 noninterest income in the Consolidated State-
ments of Income. Retained interests from securitized or sold loans,
excluding servicing rights, are carried at fair value. Adjustments to
fair value for retained interests classifi ed as available-for-sale securi-
ties are included in accumulated other comprehensive income in
equity, or in noninterest 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 classifi ed as trading
securities are recorded within noninterest income in the Consoli-
dated Statements of Income.
Servicing rights resulting from residential mortgage, home
equity line of credit and automotive loan sales are amortized in
proportion to and over the period of estimated net servicing reve-
nues and are reported as a component of mortgage banking net
revenue and other noninterest income, respectively, in the Consoli-
dated Statements of Income. Servicing rights are assessed for
impairment monthly, based on fair value, with temporary impair-
ment 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 speeds of the underlying loans, the weighted-aver-
age life of the loan, the discount rate, weighted-average coupon 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 speeds. 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 stratifi ed based on
the fi nancial 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 outstand-
ing monthly principal balance of such loans and are included in
noninterest income. Costs of servicing loans are charged to expense
as incurred.