Fifth Third Bank 2011 Annual Report Download - page 30

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
28 Fifth Third Bancorp
revenue from MSRs can increase through increases in fair value.
When rates fall, mortgage originations tend to increase and the value
of MSRs tends to decline, also with some offsetting revenue effect.
Even though the origination of mortgage loans can act as a “natural
hedge,” the hedge is not perfect, either in amount or timing. For
example, the negative effect on revenue from a decrease in the fair
value of residential MSRs is immediate, but any offsetting revenue
benefit from more originations and the MSRs relating to the new
loans would accrue over time. It is also possible that, because of the
recession and deteriorating housing market, even if interest rates
were to fall, mortgage originations may also fall or any increase in
mortgage originations may not be enough to offset the decrease in
the MSRs value caused by the lower rates.
Fifth Third typically uses derivatives and other instruments to
hedge its mortgage banking interest rate risk. Fifth Third generally
does not hedge all of its risks, and the fact that Fifth Third attempts
to hedge any of the risks does not mean Fifth Third will be
successful. Hedging is a complex process, requiring sophisticated
models and constant monitoring. Fifth Third may use hedging
instruments tied to U.S. Treasury rates, LIBOR or Eurodollars that
may not perfectly correlate with the value or income being hedged.
Fifth Third could incur significant losses from its hedging activities.
There may be periods where Fifth Third elects not to use derivatives
and other instruments to hedge mortgage banking interest rate risk.
Changes in interest rates could also reduce the value of MSRs.
Fifth Third acquires MSRs when it keeps the servicing rights after
the sale or securitization of the loans that have been originated or
when it purchases the servicing rights to mortgage loans originated
by other lenders. Fifth Third initially measures all residential MSRs
at fair value and subsequently amortizes the MSRs in proportion to,
and over the period of, estimated net servicing income. Fair value is
the present value of estimated future net servicing income,
calculated based on a number of variables, including assumptions
about the likelihood of prepayment by borrowers. 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.
Changes in interest rates can affect prepayment assumptions
and thus fair value. When interest rates fall, borrowers are usually
more likely to prepay their mortgage loans by refinancing them at a
lower rate. As the likelihood of prepayment increases, the fair value
of MSRs can decrease. Each quarter Fifth Third evaluates the fair
value of MSRs, and decreases in fair value below amortized cost
reduce earnings in the period in which the decrease occurs.
The preparation of Fifth Third’s financial statements requires
the use of estimates that may vary from actual results.
The preparation of consolidated financial statements in conformity
with U.S. GAAP requires management to make significant estimates
that affect the financial statements. Two of Fifth Third’s most
critical estimates are the level of the ALLL and the valuation of
MSRs. Due to the uncertainty of estimates involved, Fifth Third
may have to significantly increase the ALLL and/or sustain credit
losses that are significantly higher than the provided allowance and
could recognize a significant provision for impairment of its MSRs.
If Fifth Third’s ALLL is not adequate, Fifth Third’s business,
financial condition, including its liquidity and capital, and results of
operations could be materially adversely affected.
Fifth Third regularly reviews its litigation reserves for adequacy
considering its litigation risks and probability of incurring losses
related to litigation. However, Fifth Third cannot be certain that its
current litigation reserves will be adequate over time to cover its
losses in litigation due to higher than anticipated settlement costs,
prolonged litigation, adverse judgments, or other factors that are
largely outside of Fifth Third’s control. If Fifth Third’s litigation
reserves are not adequate, Fifth Third’s business, financial
condition, including its liquidity and capital, and results of
operations could be materially adversely affected. Additionally, in
the future, Fifth Third may increase its litigation reserves, which
could have a material adverse effect on its capital and results of
operations.
Changes in accounting standards could impact Fifth Third’s
reported earnings and financial condition.
The accounting standard setters, including the FASB, the SEC and
other regulatory bodies, periodically change the financial accounting
and reporting standards that govern the preparation of Fifth Third’s
consolidated financial statements. These changes can be hard to
predict and can materially impact how Fifth Third records and
reports its financial condition and results of operations. In some
cases, Fifth Third could be required to apply a new or revised
standard retroactively, which would result in the recasting of Fifth
Third’s prior period financial statements.
Future acquisitions may dilute current shareholders’
ownership of Fifth Third and may cause Fifth Third to
become more susceptible to adverse economic events.
Future business acquisitions could be material to Fifth Third and it
may issue additional shares of stock to pay for those acquisitions,
which would dilute current shareholders’ ownership interests.
Acquisitions also could require Fifth Third to use substantial cash or
other liquid assets or to incur debt. In those events, Fifth Third
could become more susceptible to economic downturns and
competitive pressures.
Difficulties in combining the operations of acquired entities
with Fifth Third’s own operations may prevent Fifth Third
from achieving the expected benefits from its acquisitions.
Inherent uncertainties exist when integrating the operations of an
acquired entity. Fifth Third may not be able to fully achieve its
strategic objectives and planned operating efficiencies in an
acquisition. In addition, the markets and industries in which Fifth
Third and its potential acquisition targets operate are highly
competitive. Fifth Third may lose customers or the customers of
acquired entities as a result of an acquisition. Future acquisition and
integration activities may require Fifth Third to devote substantial
time and resources and as a result Fifth Third may not be able to
pursue other business opportunities.
After completing an acquisition, Fifth Third may find certain
items are not accounted for properly in accordance with financial
accounting and reporting standards. Fifth Third may also not realize
the expected benefits of the acquisition due to lower financial
results pertaining to the acquired entity. For example, Fifth Third
could experience higher charge offs than originally anticipated
related to the acquired loan portfolio.
Fifth Third may sell or consider selling one or more of its
businesses. Should it determine to sell such a business, it may
not be able to generate gains on sale or related increase in
shareholders’ equity commensurate with desirable levels.
Moreover, if Fifth Third sold such businesses, the loss of
income could have an adverse effect on its earnings and future
growth.
Fifth Third owns several non-strategic businesses that are not
significantly synergistic with its core financial services businesses.
Fifth Third has, from time to time, considered the sale of such
businesses. If it were to determine to sell such businesses, Fifth
Third would be subject to market forces that may make completion
of a sale unsuccessful or may not be able to do so within a desirable
time frame. If Fifth Third were to complete the sale of non-core
businesses, it would suffer the loss of income from the sold