Fifth Third Bank 2013 Annual Report Download - page 32

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
30 Fifth Third Bancorp
require reporting of incentive compensation and to prohibit certain
compensation arrangements. The federal banking agencies and the
SEC proposed such rules in April 2011. In addition, in June 2012,
the SEC issued final rules to implement Dodd-Frank’s requirement
that the SEC direct the national securities exchanges to adopt
certain listing standards related to the compensation committee of a
company's board of directors as well as its compensation advisers. If
Fifth Third is unable to attract and retain qualified employees, or do
so at rates necessary to maintain its competitive position, or if
compensation costs required to attract and retain employees
become more expensive, Fifth Third’s performance, including its
competitive position, could be materially adversely affected.
Fifth Third’s mortgage banking revenue can be volatile from
quarter to quarter.
Fifth Third earns revenue from the fees it receives for originating
mortgage loans and for servicing mortgage loans. When rates rise,
the demand for mortgage loans tends to fall, reducing the revenue
Fifth Third receives from loan originations. At the same time,
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.
Fifth Third uses financial models for business planning
purposes that may not adequately predict future results.
Fifth Third uses financial models to aid in its planning for various
purposes including its capital and liquidity needs, potential charge-
offs, reserves, and other purposes. The models used may not
accurately account for all variables that could affect future results,
may fail to predict outcomes accurately and/or may overstate or
understate certain effects. As a result of these potential failures,
Fifth Third may not adequately prepare for future events and may
suffer losses or other setbacks due to these failures.
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. See the “Critical Accounting
Policies” section of the MD&A for more information regarding
management’s significant estimates. Additionally, Fifth Third’s
litigation reserve is a management estimate which is regularly
reviewed for accuracy.
Fifth Third regularly reviews its litigation reserve for adequacy
considering its litigation and regulatory investigation risks and
probability of incurring losses related to litigation and regulatory
investigations. However, Fifth Third cannot be certain that its
current litigation reserves will be adequate over time to cover its
losses in litigation or regulatory proceedings 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. In addition, if a material change to
a reserve amount is made to reflect new information, such a change
could result in a change to previously announced financial results.
Changes in accounting standards or interpretations could
impact Fifth Third’s reported earnings and financial
condition.
The accounting standard setters, including the FASB, the SEC and
other regulatory agencies, 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.