Huntington National Bank 2004 Annual Report Download - page 34

MANAGEMENT’S DISCUSSION AND ANALYSIS HUNTINGTON BANCSHARES INCORPORATED
home equity loans. It also reflected an improved economic outlook that resulted in a reduction in the relative level of the ALLL.
Among other factors that impacted earnings negatively, were SEC-related expenses and accruals, as well as a property lease
impairment in the fourth quarter of the year.
Results of Operations
Significant Factors Influencing Financial Performance Comparisons
Earnings comparisons among the three years ended December 31, 2004, are impacted by a number of factors, some related to changes
in the economic and competitive environment, while others reflected specific Management strategies or changes in accounting
practices. Those key factors are summarized below.
1. A
UTOMOBILE LEASES ORIGINATED BEFORE M AY 2002 ARE ACCOUNTED FOR AS OPERATING LEASES — Automobile leases
originated before May 2002 are accounted for using the operating lease method of accounting because they do not qualify as
direct financing leases. Operating leases are carried in other assets with the related rental income, other revenue, and credit
recoveries reflected as operating lease income, a component of non-interest income. Under this accounting method,
depreciation expenses, as well as other costs and charge-offs, are reflected as operating lease expense, a component of non-
interest expense. With no new operating leases originated since April 2002, the operating lease assets have declined rapidly
and will eventually become immaterial, as will the related operating lease income and expense. However, since operating
lease income and expense represented a significant percentage of total non-interest income and expense, respectively,
throughout these reporting periods, their downward trend influenced total non-interest income and non-interest expense
trends.
In contrast, automobile leases originated since April 2002 are accounted for as direct financing leases, an interest-bearing
asset included in total loans and leases with the related income reflected as interest income and included in the calculation of
the net interest margin. Credit charge-offs and recoveries are reflected in the ALLL, with related changes in the ALLL
reflected in provision for credit losses. The relative newness and rapid growth of the direct financing lease portfolio has
resulted in higher reported automobile lease growth rates than in a more mature portfolio. To better understand overall
trends in automobile lease exposure, it is helpful to compare trends in the combined total of direct financing leases plus
operating leases. (See Table 6.)
2. T RANSITION FROM A WEAK ECONOMIC ENVIRONMENT IN 2002 AND 2003 TO A SLOWLY RECOVERING ECONOMIC ENVIRONMENT IN
2004 — While difficult to quantify, Management believes the weak economic environment resulted in continued weak
demand for C&I loans. This, when combined with strategies to lower the overall credit risk profile of the Company (see
Factor 4 below), contributed to generally declining C&I loans throughout this period until the second half of 2004.
3. D ECLINING INTEREST RATES IN 2002 AND 2003 WITH GENERALLY INCREASING , THOUGH FLUCTUATING , INTEREST RATES
IN 2004 — Interest rates impacted, among other factors, loan and deposit growth, the net interest margin, and the valuation
of mortgage servicing rights (MSRs) and investment securities.
– The historically low interest rate environment of the last three years, despite a general increase in short-term rates
during 2004, resulted in strong demand and growth in residential real estate, home equity, and CRE loans throughout
this period. Mortgage banking revenue was also favorably impacted by significant mortgage origination activity most
notably in 2003.
– As interest rates fell in 2003 to historically low levels, it became increasingly difficult to lower interest rates offered on
deposit accounts commensurate with the overall decline in yields on earning assets. This created an extremely
competitive environment in which to grow deposits and contributed to the decline in the net interest margin
throughout 2003. Though short-term interest rates increased generally throughout 2004, they nevertheless remained at
historically low levels, and the market for deposits remained very competitive. As a result, deposit rates in 2004
increased thus dampening the expansion in the net interest margin.
– Since the second quarter of 2002, the Company generally has retained the servicing on mortgage loans it originates and
sells in the secondary market. This servicing asset, referred to as an MSR, is an interest only strip. Huntington is
typically paid 0.25%-0.35% of the loan balance to service the loans. The MSR represents the present value of expected
future net servicing income for the loan. The MSR asset is valued quarterly at the lower of cost or market, with
impairment of the asset, or recovery of prior temporary impairment, recorded in mortgage banking income. Expected
future net servicing income depends on the projected outstanding principal balances of the underlying loans, which can
be greatly reduced by prepayments. Prepayments usually increase when mortgage interest rates decline and decrease
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