Fifth Third Bank 2005 Annual Report Download - page 69

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Fifth Third Bancorp 67
12. COMMITMENTS AND CONTINGENT LIABILITIES
The Bancorp, in the normal course of business, uses derivatives
and other financial instruments to manage its interest rate risks and
prepayment risks and to meet the financing needs of its customers.
These financial instruments primarily include commitments to
extend credit, standby and commercial letters of credit, foreign
exchange contracts, commitments to sell residential mortgage
loans, principal only swaps, interest rate swap agreements, written
options and interest rate lock commitments. These instruments
involve, to varying degrees, elements of credit risk, counterparty
risk and market risk in excess of the amounts recognized in the
Bancorp’s Consolidated Balance Sheets. As of December 31, 2005,
100% of the Bancorp’s risk management derivatives exposure was
to investment grade companies. The contract or notional amounts
of these instruments reflect the extent of involvement the Bancorp
has in particular classes of financial instruments.
Creditworthiness for all instruments is evaluated on a case-by-
case basis in accordance with the Bancorp’s credit policies. While
notional amounts are typically used to express the volume of these
transactions, it does not represent the much smaller amounts that
are potentially subject to credit risk. Entering into derivative
instruments involves the risk of dealing with counterparties and
their ability to meet the terms of the contract. The Bancorp
controls the credit risk of these transactions through adherence to
a derivatives products policy, credit approval policies and
monitoring procedures. Collateral, if deemed necessary, is based
on management’s credit evaluation of the counterparty and may
include business assets of commercial borrowers, as well as
personal property and real estate of individual borrowers and
guarantors.
A summary of significant commitments and contingent
liabilities at December 31:
Contract or
Notional
Amount
($ in millions) 2005 2004
Commitments to extend credit $35,724 31,312
Letters of credit (including standby letters of
credit) 7,300 5,923
Foreign exchange contracts for customers:
Spots 190 342
Forwards 5,703 4,624
Written options 765 349
Forward contracts to sell mortgage loans 1,285 739
Principal only swaps 71 130
Interest rate swap agreements 15,401 9,798
Written options 717 437
Interest rate lock commitments 480 328
Commitments to extend credit are agreements to lend,
typically having fixed expiration dates or other termination clauses
that may require payment of a fee. Since many of the
commitments to extend credit may expire without being drawn
upon, the total commitment amounts do not necessarily represent
future cash flow requirements. The Bancorp is exposed to credit
risk in the event of nonperformance for the amount of the
contract. Fixed-rate commitments are also subject to market risk
resulting from fluctuations in interest rates and the Bancorp’s
exposure is limited to the replacement value of those
commitments. As of December 31, 2005 and 2004, the Bancorp
had a reserve for probable credit losses totaling $69 million and
$53 million, respectively, included in other liabilities.
Standby and commercial letters of credit are conditional
commitments issued to guarantee the performance of a customer
to a third party. At December 31, 2005, approximately $2.3 billion
of standby letters of credit expire within one year, $4.7 billion
expire between one to five years and $.3 billion expire thereafter.
At December 31, 2005, letters of credit of approximately $26
million were issued to commercial customers for a duration of one
year or less to facilitate trade payments in domestic and foreign
currency transactions. As of December 31 2005, the Bancorp had a
reserve for probable credit losses totaling $1 million included in
other liabilities. Approximately 69% of the total standby letters of
credit are secured and in the event of nonperformance by the
customers, the Bancorp has rights to the underlying collateral
provided including commercial real estate, physical plant and
property, inventory, receivables, cash and marketable securities.
As discussed in Note 8, the Bancorp’s policy is to enter into
derivative contracts to accommodate customers, to offset customer
accommodations and to offset its own market risk incurred in the
ordinary course of its business. Contingent obligations arising from
market risk assumed in derivatives are offset with additional rights
contained in other derivatives or contracts, such as loans or
borrowings. Certain derivatives provide the Bancorp rights without
contingent obligations (purchased options). Other derivatives
represent contingent obligations without additional rights (written
options, including interest rate lock commitments). Still other
derivatives provide additional rights combined with contingent
obligations (forward exchange spots and forwards, forward
contracts to sell mortgage loans, principal only swaps and interest
rate swap agreements). All derivatives that possess a contingent
obligation are shown in the table.
There are claims pending against the Bancorp and its
subsidiaries that have arisen in the normal course of business. See
Note 13 for additional information regarding these proceedings.
13. LEGAL AND REGULATORY PROCEEDINGS
During 2003, eight putative class action complaints were filed in
the United States District Court for the Southern District of Ohio
against the Bancorp and certain of its officers alleging violations of
federal securities laws related to disclosures made by the Bancorp
regarding its integration of Old Kent Financial Corporation and its
effect on the Bancorp’s infrastructure, including internal controls,
prospects and related matters. The complaints, which had been
consolidated, sought unquantified damages on behalf of putative
classes of persons who purchased the Bancorp’s common stock,
attorneys’ fees and other expenses. On March 31, 2005, the
Bancorp announced that it had settled this suit. The settlement
agreement was approved by the court on November 14, 2005 and
has become non-appealable. The Bancorp, along with its insurer
and other parties, have paid a total of $17 million to a fund to settle
the claims with the class members. The impact of the disposition
of this lawsuit is not material to the Bancorp.
During May 2005, the Bancorp filed suit in the United States
District Court for the Southern District of Ohio related to a
dispute with the Internal Revenue Service concerning the timing of
deductions associated with certain leveraged lease transactions in
its 1997 tax return. The Internal Revenue Service has also
proposed adjustments to the tax effects of certain leveraged lease
transactions in subsequent tax return years. The proposed
adjustments relate to the Bancorp’s portfolio of lease-in lease-out
transactions, service contract leases and qualified technology
equipment leases with both domestic and foreign municipalities.
The Bancorp is challenging the Internal Revenue Service’s
proposed treatment of all of these leasing transactions. The
Bancorp’s original net investment in these leases totaled
approximately $900 million. The Bancorp continues to believe that
its treatment of these leveraged leases was appropriate and in
compliance with applicable tax law and regulations. While
management cannot predict with certainty the result of the suit,
given the tax treatment of these transactions has been challenged
by the Internal Revenue Service, the Bancorp believes a resolution
may involve a projected change in the timing of the leveraged lease