Fifth Third Bank 2004 Annual Report Download - page 50

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
48 Fifth Third Bancorp
The Bancorp maintains an overall interest rate risk management
strategy that incorporates the use of derivative instruments to
minimize signifi cant unplanned fl uctuations in earnings and cash
fl ows caused by interest rate volatility. The Bancorp’s interest rate
risk management strategy involves modifying the repricing charac-
teristics of certain assets and liabilities so that changes in interest
rates do not adversely affect the net interest margin and cash fl ows.
Examples of derivative instruments that the Bancorp may use as
part of its interest rate risk management strategy include interest
rate swaps, interest rate fl oors, interest rate caps, forward contracts,
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. Forward contracts 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,
which have the features of a swap and an option, allow, but do
not require, counterparties to exchange streams of payments over a
specifi ed period of time.
As part of its overall risk management strategy relative to its
mortgage banking activity, the Bancorp may enter into freestand-
ing forward contracts to economically hedge interest rate lock
9. DERIVATIVES
Changes in capitalized servicing rights for the years ended Decem-
ber 31:
($ in millions) 2004 2003
Balance at January 1 . . . . . . . . . . . . . . . . . . . . . . . . . $299 263
Amount capitalized . . . . . . . . . . . . . . . . . . . . . . . . . 94 217
Amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (101) (177)
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . —(1)
Change in valuation reserve . . . . . . . . . . . . . . . . . . . 60 (3)
Balance at December 31 . . . . . . . . . . . . . . . . . . . . . . $352 299
Changes in the servicing rights valuation reserve for the years ended
December 31:
($ in millions) 2004 2003
Balance at January 1 . . . . . . . . . . . . . . . . . . . . . . . . . $(152) (278)
Servicing valuation recovery (provision) . . . . . . . . . . 60 (3)
Permanent impairment write-off . . . . . . . . . . . . . . . 13 129
Balance at December 31 . . . . . . . . . . . . . . . . . . . . . . $ (79) (152)
The Bancorp maintains a non-qualifying hedging strategy to
manage a portion of the risk associated with changes in impairment
on the mortgage servicing rights (“MSR”) portfolio. This strategy
includes the purchase of various free-standing derivatives (principal
only swaps, swaptions, fl oors, forward contracts, options and inter-
est rate swaps). 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 increase
in interest rates during 2004 and the resulting impact of changing
prepayment speeds led to the recovery of $60 million in temporary
impairment on the MSR portfolio. The combined magnitude of
decreasing interest rates during the fi rst six months of 2003 and
subsequent increasing interest rates in the last six months of 2003,
led to the recognition of a net $3 million in temporary impairment
on the MSR portfolio in 2003. As temporary impairment was
recognized on the MSR portfolio in 2003 due to falling primary
and secondary mortgage rates and earnings rates and corresponding
increases in prepayment speeds, the Bancorp sold certain securities
that were held at the time as a component of the overall non-quali-
fying hedging strategy, resulting in net realized gains of $3 million
in 2003 that were captured as a component of other noninterest
income in the Consolidated Statements of Income. In addition,
the Bancorp recognized a net loss of $10 million and a net gain
of $15 million in 2004 and 2003, respectively, related to changes
in fair value and settlement of free-standing derivatives purchased
to economically hedge the MSR portfolio. 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, 2004 and 2003, other assets included free-standing derivative
instruments with a fair value of $7 million and $8 million, respec-
tively, and other liabilities included a fair value of $3 million as of
December 31, 2004. The outstanding notional amounts on the
free-standing derivative instruments related to the MSR portfolio
totaled $1.9 billion and $.9 billion as of December 31, 2004 and
2003, respectively.
The continued decline in primary and secondary mortgage
rates during 2003 led to historically high refi nance rates and corre-
sponding increases in prepayment speeds. Therefore, the Bancorp
determined a portion of the MSR portfolio was permanently
impaired, resulting in a write-off of $129 million in MSRs against
the related valuation reserve. In 2004, interest rate movement
expectations and corresponding continued acceleration in prepay-
ment speeds resulted in the Bancorp determining a portion of the
MSR portfolio was permanently impaired, resulting in a write-
off of $13 million in MSRs against the related valuation reserve.
Temporary changes in the MSR valuation reserve are captured as a
component of mortgage banking net revenue in the Consolidated
Statements of Income.
The fair value of capitalized servicing rights was $353 million
and $307 million at December 31, 2004 and 2003, respectively.
The Bancorp serviced $23.0 billion and $24.5 billion of residential
mortgage loans and $1.3 billion and $.9 billion of consumer loans
for other investors at December 31, 2004 and 2003, respectively.
8. SERVICING RIGHTS AND RETAINED INTERESTS
2004 2003
($ in millions)
Gross Carrying
Amount
Accumulated
Amortization (a)
Net Carrying
Amount
Gross Carrying
Amount
Accumulated
Amortization (a)
Net Carrying
Amount
Mortgage servicing rights . . . . . . $ 940 (601) 339 870 (581) 289
Other consumer and
commercial servicing rights . . 22 (9) 13 11 (1) 10
Core deposits . . . . . . . . . . . . . . . 347 (204) 143 341 (181) 160
Merchant processing portfolios . . ——— 60 (25) 35
Other intangible assets . . . . . . . . 9 (2) 7 ———
Total . . . . . . . . . . . . . . . . . . . . . . $1,318 (816) 502 1,282 (788) 494
(a) Accumulated amortization for mortgage servicing rights includes a $79 million and $152 million valuation allowance at December 31, 2004 and 2003, respectively.
As of December 31, 2004, all of the Bancorp’s intangible assets
were being amortized. Amortization expense of $130 million, $216
million and $191 million, respectively, was recognized on intan-
gible assets (including servicing rights) for the years ended Decem-
ber 31, 2004, 2003 and 2002, respectively. Estimated amortization
expense, including servicing rights, is $119 million in 2005, $102
million in 2006, $82 million in 2007, $69 million in 2008 and
$55 million in 2009.