Fifth Third Bank 2008 Annual Report Download - page 20

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
18 Fifth Third Bancorp
Income Taxes
The Bancorp estimates income tax expense based on amounts
expected to be owed to the various tax jurisdictions in which the
Bancorp conducts business. On a quarterly basis, management
assesses the reasonableness of its effective tax rate based upon its
current estimate of the amount and components of net income,
tax credits and the applicable statutory tax rates expected for the
full year. The estimated income tax expense is recorded in the
Consolidated Statements of Income.
Deferred income tax assets and liabilities are determined
using the balance sheet method and are reported in either other
assets or accrued taxes, interest and expenses in the Consolidated
Balance Sheets. Under this method, the net deferred tax asset or
liability is based on the tax effects of the differences between the
book and tax basis of assets and liabilities and recognizes enacted
changes in tax rates and laws. Deferred tax assets are recognized
to the extent they exist and are subject to a valuation allowance
based on management’s judgment that realization is more-likely-
than-not.
Accrued taxes represent the net estimated amount due to
taxing jurisdictions and are reported in accrued taxes, interest and
expenses in the Consolidated Balance Sheets. The Bancorp
evaluates and assesses the relative risks and appropriate tax
treatment of transactions and filing positions after considering
statutes, regulations, judicial precedent and other information and
maintains tax accruals consistent with its evaluation of these
relative risks and merits. Changes to the estimate of accrued taxes
occur periodically due to changes in tax rates, interpretations of
tax laws, the status of examinations being conducted by taxing
authorities and changes to statutory, judicial and regulatory
guidance that impact the relative risks of tax positions. These
changes, when they occur, can affect deferred taxes and accrued
taxes as well as the current period’s income tax expense and can
be significant to the operating results of the Bancorp. As
described in greater detail in Note 16 of the Notes to
Consolidated Financial Statements, the Internal Revenue Service
(IRS) has challenged the Bancorp’s tax treatment of certain leasing
transactions. For additional information on income taxes, see
Note 22 of the Notes to Consolidated Financial Statements.
Valuation of Servicing Rights
When the Bancorp sells loans through either securitizations or
individual loan sales in accordance with its investment policies, it
often obtains servicing rights. Servicing rights resulting from loan
sales are initially recorded at fair value and subsequently amortized
in proportion to, and over the period of, estimated net servicing
income. Servicing rights are assessed for impairment monthly,
based on fair value, with temporary impairment recognized
through a valuation allowance and permanent impairment
recognized through a write-off of the servicing asset and related
valuation allowance. Key economic assumptions used in
measuring any potential impairment of the servicing rights include
the prepayment speeds of the underlying loans, the weighted-
average life, the discount rate, the 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 risk and adjusts its valuation
allowance as necessary to adequately reserve for impairment in the
servicing portfolio. For purposes of measuring impairment, the
servicing rights are stratified into classes based on the financial
asset type and interest rates. Fees received for servicing loans
owned by investors are based on a percentage of the outstanding
monthly principal balance of such loans and are included in
noninterest income in the Consolidated Statements of Income as
loan payments are received. Costs of servicing loans are charged
to expense as incurred.
The change in the fair value of mortgage servicing rights
(MSRs) at December 31, 2008 due to immediate 10% and 20%
adverse changes in the current prepayment assumptions would be
approximately $33 million and $63 million, respectively, and due
to immediate 10% and 20% favorable changes in the current
prepayment assumptions would be approximately $37 million and
$78 million, respectively. The change in the fair value of the MSR
portfolio at December 31, 2008 due to immediate 10% and 20%
adverse changes in the discount rate assumption would be
approximately $15 million and $30 million, respectively, and due
to immediate 10% and 20% favorable changes in the discount rate
assumption would be approximately $16 million and $34 million,
respectively. The sensitivity analysis related to other consumer
and commercial servicing rights is not material to the Bancorp’s
Consolidated Financial Statements. These sensitivities are
hypothetical and should be used with caution. As the figures
indicate, changes in fair value based on a 10% and 20% variation
in assumptions typically cannot be extrapolated because the
relationship of the change in assumptions to the change in fair
value may not be linear. Also, the effect of a variation in a
particular assumption on the fair value of the servicing rights is
calculated without changing any other assumption; in reality,
changes in one factor may result in changes in another, which
might magnify or counteract the sensitivities. Additionally, the
effect of the Bancorp’s non-qualifying hedging strategy, which is
maintained to lessen the impact of changes in value of the MSR
portfolio, is excluded from the above analysis.
Fair Value Measurements
Effective January 1, 2008, the Bancorp adopted SFAS No. 157,
“Fair Value Measurements”, which provides a framework for
measuring fair value under accounting principles generally
accepted in the United States of America. SFAS No. 157 defines
fair value as the price that would be received to sell an asset or
paid to transfer a liability in an orderly transaction between market
participants at the measurement date. SFAS No. 157 addresses
the valuation techniques used to measure fair value. These
valuation techniques include the market approach, income
approach and cost approach. The market approach uses prices or
relevant information generated by market transactions involving
identical or comparable assets or liabilities. The income approach
involves discounting future amounts to a single present amount
and is based on current market expectations about those future
amounts. The cost approach is based on the amount that currently
would be required to replace the service capacity of the asset.
SFAS No. 157 establishes a fair value hierarchy, which
prioritizes the inputs to valuation techniques used to measure fair
value into three broad levels. The fair value hierarchy gives the
highest priority to quoted prices in active markets for identical
assets or liabilities (Level 1) and the lowest priority to
unobservable inputs (Level 3). A financial instrument’s
categorization within the fair value hierarchy is based upon the
lowest level of input that is significant to the instrument’s fair
value measurement. The three levels within the fair value
hierarchy are described as follows:
Level 1 - Quoted prices (unadjusted) in active markets
for identical assets or liabilities that the Bancorp has the
ability to access at the measurement date.
Level 2 - Inputs other than quoted prices included within
Level 1 that are observable for the asset or liability,
either directly or indirectly. Level 2 inputs include:
quoted prices for similar assets or liabilities in active
markets; quoted prices for identical or similar assets or
liabilities in markets that are not active; inputs other
than quoted prices that are observable for the asset or
liability; and inputs that are derived principally from or
corroborated by observable market data by correlation
or other means.