Fifth Third Bank 2006 Annual Report Download - page 70

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Fifth Third Bancorp
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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, interest rate floors, interest rate caps, commodities
contracts, 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, 2006, all 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) 2006 2005
Commitments to extend credit $42,085 35,724
Letters of credit (including standby letters of
credit) 8,163 7,300
Customer derivatives in a gain position 3,911 2,410
Forward contracts to sell mortgage loans 1,418 1,285
Noncancelable lease obligations 695 609
Purchase obligations 24 34
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, 2006 and 2005, the Bancorp
had a reserve for probable credit losses totaling $75 million and
$69 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, 2006, approximately $2.9
billion of standby letters of credit expire within one year, $4.8
billion expire between one to five years and $.5 billion expire
thereafter. At December 31, 2006, letters of credit of
approximately $32 million were issued to commercial customers
for a duration of one year or less to facilitate trade payments in
domestic and foreign currency transactions. At December 31,
2006 and 2005, the reserve related to these standby letters of
credit was less than $1 million. Approximately 69% of the total
standby letters of credit were secured as of December 31, 2006
and 2005. In the event of nonperformance by the customers, the
Bancorp has rights to the underlying collateral, which can include
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. A liability arises when a
customer does not perform according to the derivative contract
while the Bancorp must perform the offsetting agreement.
Customer derivatives in a gain position with a corresponding
offset are included in the table. The fair value of these contracts at
December 31, 2006 and 2005 were $45 million and $31 million,
respectively.
The Bancorp’s subsidiaries have entered into a number of
noncancelable lease agreements. The minimum rental
commitments under noncancelable lease agreements are shown in
the table. The Bancorp has also entered into a limited number of
agreements for work related to banking center construction and to
purchase goods or services.
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 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, including penalties, 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
cash flows. Recently issued FSP FAS 13-2, which is effective as of
January 1, 2007, mandates that a change or projected change in the
timing of lessor cash flows related to income taxes generated by
leveraged lease transactions, excluding interest and penalty
assessments, will require a lessor to recalculate the rate of return
and allocation of income to positive investment years from
inception of the lease. Upon adoption of FSP FAS 13-2 on
January 1, 2007, the Bancorp recorded a $96 million after-tax
charge to retained earnings related to its portfolio of leveraged
leases. The amount of this reduction will be recognized as income
over the remaining term of the affected leases. In January 2007, the
Bancorp made a $356 million deposit with the IRS to mitigate the
risk associated with tax years after 1997 and, in particular, the
leveraged lease transactions noted above. The deposit enables the