UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
For the quarterly period ended September 30, 2015
or
For the transition period from to
Commission File Number 001-15185
First Horizon National Corporation
(Exact name of registrant as specified in its charter)
(State or other jurisdiction
incorporation of organization)
(IRS Employer
Identification No.)
165 MADISON AVENUE
MEMPHIS, TENNESSEE
(Registrant’s telephone number, including area code) (901) 523-4444
(Former name, former address and former fiscal year, if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. x Yes ¨ No
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). x Yes ¨ No
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). ¨ Yes x No
APPLICABLE ONLY TO CORPORATE ISSUERS:
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
Class
Outstanding on September 30, 2015
Common Stock, $.625 par value
Table of Contents
FIRST HORIZON NATIONAL CORPORATION
INDEX
Part I. Financial Information
Item 1. Financial Statements
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3. Quantitative and Qualitative Disclosures about Market Risk
Item 4. Controls and Procedures
Part II. Other Information
Item 1. Legal Proceedings
Item 1A. Risk Factors
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
Item 3. Defaults Upon Senior Securities
Item 4. Mine Safety Disclosures
Item 5. Other Information
Item 6. Exhibits
Signatures
Exhibit Index
Exhibit 10.1
Exhibit 31(a)
Exhibit 31(b)
Exhibit 32(a)
Exhibit 32(b)
PART I.
FINANCIAL INFORMATION
The Consolidated Condensed Statements of Condition (unaudited)
The Consolidated Condensed Statements of Income (unaudited)
The Consolidated Condensed Statements of Comprehensive Income (unaudited)
The Consolidated Condensed Statements of Equity (unaudited)
The Consolidated Condensed Statements of Cash Flows (unaudited)
The Notes to the Consolidated Condensed Financial Statements (unaudited)
Note 1 Financial Information
Note 2 Acquisitions and Divestitures
Note 3 Investment Securities
Note 4 Loans
Note 5 Allowance for Loan Losses
Note 6 Intangible Assets
Note 7 Other Income and Other Expense
Note 8 Changes in Accumulated Other Comprehensive Income Balances
Note 9 Earnings Per Share
Note 10 Contingencies and Other Disclosures
Note 11 Pensions, Savings, and Other Employee Benefits
Note 12 Business Segment Information
Note 13 Variable Interest Entities
Note 14 Derivatives
Note 15 Master Netting and Similar Agreements - Repurchase, Reverse Repurchase, and Securities Borrowing and Lending Transactions
Note 16 Fair Value of Assets & Liabilities
Note 17 Other Events
This financial information reflects all adjustments that are, in the opinion of management, necessary for a fair presentation of the financial condition and results of operations for the interim periods presented.
1
CONSOLIDATED CONDENSED STATEMENTS OF CONDITION
(Dollars in thousands, except per share amounts)(Unaudited)
Assets:
Cash and due from banks
Federal funds sold
Securities purchased under agreements to resell (Note 15)
Total cash and cash equivalents
Interest-bearing cash
Trading securities
Loans held-for-sale (a)
Securities available-for-sale (Note 3)
Securities held-to-maturity (Note 3)
Loans, net of unearned income (Note 4) (b)
Less: Allowance for loan losses (Note 5)
Total net loans
Goodwill (Note 6)
Other intangible assets, net (Note 6)
Fixed income receivables
Premises and equipment, net
Real estate acquired by foreclosure (c)
Derivative assets (Note 14)
Other assets
Total assets
Liabilities and equity:
Deposits:
Savings
Time deposits
Other interest-bearing deposits
Certificates of deposit $100,000 and more
Interest-bearing
Noninterest-bearing
Total deposits
Federal funds purchased
Securities sold under agreements to repurchase (Note 15)
Trading liabilities
Other short-term borrowings
Term borrowings
Fixed income payables
Derivative liabilities (Note 14)
Other liabilities
Total liabilities
Equity:
First Horizon National Corporation Shareholders’ Equity:
Preferred stock - Series A, non-cumulative perpetual, no par value, liquidation preference of $100,000 per share - (shares authorized - 1,000; shares issued - 1,000 on September 30, 2015, September 30, 2014 and December 31, 2014)
Common stock - $.625 par value (shares authorized - 400,000,000; shares issued - 234,237,439 on September 30, 2015; 235,248,564 on September 30, 2014; and 234,219,663 on December 31, 2014)
Capital surplus
Undivided profits
Accumulated other comprehensive loss, net (Note 8)
Total First Horizon National Corporation Shareholders’ Equity
Noncontrolling interest
Total equity
Total liabilities and equity
Certain previously reported amounts have been revised to reflect the retroactive effect of the adoption of ASU 2014-01,“Equity Method and Joint Venture: Accounting for Investments in Qualified Affordable Housing Projects.” See Note 1 - Financial Information for additional information.
See accompanying notes to consolidated condensed financial statements.
2
CONSOLIDATED CONDENSED STATEMENTS OF INCOME
(Dollars and shares in thousands except per share data, unless otherwise noted)(Unaudited)
Interest income:
Interest and fees on loans
Interest on investment securities available-for-sale
Interest on investment securities held-to-maturity
Interest on loans held-for-sale
Interest on trading securities
Interest on other earning assets
Total interest income
Interest expense:
Interest on deposits:
Interest on trading liabilities
Interest on short-term borrowings
Interest on term borrowings
Total interest expense
Net interest income
Provision for loan losses
Net interest income after provision for loan losses
Noninterest income:
Fixed income
Deposit transactions and cash management
Brokerage, management fees and commissions
Trust services and investment management
Bankcard income
Bank-owned life insurance
Other service charges
Mortgage banking
Insurance commissions
Equity securities gains/(losses), net
All other income and commissions (Note 7)
Total noninterest income
Adjusted gross income after provision for loan losses
Noninterest expense:
Employee compensation, incentives, and benefits (three and nine months ended September 30, 2015, include $6.3 million and $2.9 million, respectively, of benefit and three and nine months ended September 30, 2014, include $.9 million and $2.6 million, respectively, of expense associated with pension and post-retirement plans reclassified from accumulated other comprehensive income)
Occupancy
Computer software
Operations services
Equipment rentals, depreciation, and maintenance
Professional fees
Advertising and public relations
FDIC premium expense
Communications and courier
Legal fees
Contract employment and outsourcing
Amortization of intangible assets
Foreclosed real estate
Repurchase and foreclosure provision
All other expense (Note 7)
Total noninterest expense
Income/(loss)before income taxes
Provision/(benefit) for income taxes (three and nine months ended September 30, 2015, include $2.4 million and $1.1 million, respectively, of income tax expense and three and nine months ended September 30, 2014, include $.3 million and $1.0 million, respectively, of income tax benefit reclassified from accumulated other comprehensive income)
Net income/(loss)
Net income attributable to noncontrolling interest
Net income/(loss) attributable to controlling interest
Preferred stock dividends
Net income/(loss) available to common shareholders
Basic earnings/(loss) per share (Note 9)
Diluted earnings/(loss) per share (Note 9)
Weighted average common shares (Note 9)
Diluted average common shares (Note 9)
Cash dividends declared per common share
Certain previously reported amounts have been revised to reflect the retroactive effect of the adoption of ASU 2014-01, “Equity Method and Joint Venture: Accounting for Investments in Qualified Affordable Housing Projects.” See Note 1 - Financial Information for additional information.
3
CONSOLIDATED CONDENSED STATEMENTS OF COMPREHENSIVE INCOME
(Dollars in thousands) (Unaudited)
Other comprehensive income/(loss), net of tax:
Unrealized fair value adjustments:
Securities available-for-sale
Recognized pension and other employee benefit plans net periodic benefit costs
Other comprehensive income/(loss)
Comprehensive income/(loss)
Comprehensive income attributable to noncontrolling interest
Comprehensive income/(loss) attributable to controlling interest
Certain previously reported amounts have been revised to reflect the retroactive effect of the adoption of ASU 2014-01, “Equity Method and Joint Venture: Accounting for Investments in Qualified Affordable Housing Projects.” See Note 1-Financial Information for additional information.
4
CONSOLIDATED CONDENSED STATEMENTS OF EQUITY
(Dollars in thousands except per share data) (Unaudited)
Balance, January 1
Other comprehensive income/(loss) (a)
Cash dividends declared:
Preferred stock ($4,650 per share for the nine months ended September 30, 2015 and 2014)
Common stock ($.18 and $.15 per share for the nine months ended September 30, 2015 and 2014, respectively)
Common stock repurchased (b)
Common stock issued for:
Stock options and restricted stock - equity awards
Stock-based compensation expense
Dividends declared - noncontrolling interest of subsidiary preferred stock
Tax benefit/(benefit reversal) - stock based compensation expense
Balance, September 30
5
CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS
(Dollars in thousands)(Unaudited)
Operating Activities
Adjustments to reconcile net income/(loss) to net cash provided/(used) by operating activities:
Provision/(benefit) for deferred income taxes
Depreciation and amortization of premises and equipment
Net other amortization and accretion
Net (increase)/decrease in derivatives
Fair value adjustment to foreclosed real estate
Litigation and regulatory matters
Equity securities (gains)/losses, net
(Gains)/losses on extinguishment of debt
Loss on deconsolidation of securitization trusts
Net (gains)/losses on sale/disposal of fixed assets
Proceeds from sale of mortgage servicing rights
Loans held-for-sale:
Purchases
Gross proceeds from settlements and sales
Fair value adjustments and other
Net (increase)/decrease in:
Interest receivable
Net increase/(decrease) in:
Interest payable
Total adjustments
Net cash provided/(used) by operating activities
Investing Activities
Available-for-sale securities:
Sales
Maturities
Premises and equipment:
Loans
Interests retained from securitizations classified as trading securities
Net cash provided/(used) by investing activities
Financing Activities
Common stock:
Stock options exercised
Cash dividends paid
Repurchase of shares (a)
Cash dividends paid - preferred stock - noncontrolling interest
Cash dividends paid - Series A preferred stock
Term borrowings:
Payments/maturities
Increases in restricted and secured term borrowings
Net cash paid to deconsolidate/collapse securitization trusts
Deposits
Short-term borrowings
Net cash provided/(used) by financing activities
Net increase/(decrease) in cash and cash equivalents
Cash and cash equivalents at beginning of period
Cash and cash equivalents at end of period
Supplemental Disclosures
Total interest paid
Total taxes paid
Total taxes refunded
Transfer from loans to other real estate owned
Certain previously reported amounts have been revised to reflect the retroactive effect of the adoption of ASU 2014-01, “Equity Method and Joint Ventures: Accounting for Investments in Qualified Affordable Housing Projects.” See Note 1 – Financial Information for additional information.
6
Notes to the Consolidated Condensed Financial Statements (Unaudited)
Note 1 – Financial Information
Basis of Accounting. The unaudited interim consolidated condensed financial statements of First Horizon National Corporation (“FHN”), including its subsidiaries, have been prepared in conformity with accounting principles generally accepted in the United States of America and follow general practices within the industries in which it operates. This preparation requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. These estimates and assumptions are based on information available as of the date of the financial statements and could differ from actual results. In the opinion of management, all necessary adjustments have been made for a fair presentation of financial position and results of operations for the periods presented. These adjustments are of a normal recurring nature unless otherwise disclosed in this Quarterly Report on Form 10-Q. The operating results for the interim 2015 periods are not necessarily indicative of the results that may be expected going forward. For further information, refer to the audited consolidated financial statements which were included in the 2014 Annual Report to shareholders, and which were filed as part of Exhibit 99.1 to FHN’s Current Report on Form 8-K dated October 19, 2015.
Summary of Accounting Changes. In January 2014, the FASB issued ASU 2014-01, “Equity Method and Joint Ventures: Accounting for Investments in Qualified Affordable Housing Projects.” ASU 2014-01 permits reporting entities to make an accounting policy election to account for their investments in qualified affordable housing projects using a proportional amortization method if certain conditions are met. Under the proportional amortization method, an entity amortizes the initial cost of the investment in proportion to the tax credits and other tax benefits received and recognizes the net investment performance in the income statement as a component of income tax expense/(benefit). A reporting entity should evaluate whether the conditions have been met to apply the proportional amortization method to an investment in a qualified affordable housing project through a limited liability entity at the time of initial investment on the basis of facts and circumstances that exist at that time. A reporting entity should reevaluate the conditions upon the occurrence of certain specified events. An investment in a qualified affordable housing project through a limited liability entity should be tested for impairment when there are events or changes in circumstances indicating that it is more likely than not that the carrying amount of the investment will not be realized. For those investments in qualified affordable housing projects not accounted for using the proportional amortization method, the investment should be accounted for as an equity method investment or a cost method investment. The decision to apply the proportional amortization method of accounting is an accounting policy decision that should be applied consistently to all qualifying affordable housing project investments rather than a decision to be applied to individual investments. The provisions of ASU 2014-01 are effective for annual periods, and interim reporting periods within those annual periods, beginning after December 15, 2014.
Effective January 1, 2015, FHN retroactively adopted the requirements of ASU 2014-01 with an election to use the proportional amortization method for all qualifying investments. FHN believes the proportional amortization method better represents the economics of its qualified affordable housing investments and provides users with a better understanding of the returns from such investments when compared to the equity method. FHN will continue to use the equity method for non-qualifying affordable housing investments and its other tax credit investments. The cumulative effects of the retrospective application of the change in amortization method are summarized in the tables below.
(Dollars in thousands, except per share amounts)
Increase/(decrease) to previously reported Consolidated Statements of Condition amounts
Increase/(decrease) to previously reported Consolidated Statements of Income amounts
Other expense
Provision/(benefit) for income taxes
Income/(loss) available to common shareholders
Diluted earnings/(loss) per share
7
Note 1 – Financial Information (Continued)
Investment balances, including all legally binding commitments to fund future investments, are included in Other assets on the Consolidated Condensed Statements of Condition. A liability is recognized in Other liabilities on the Consolidated Condensed Statements of Condition for all legally binding unfunded commitments to fund qualifying LIHTC investments. Amortization and other write-downs of qualifying LIHTC investments are presented on a net basis as a component of the Provision/(benefit) for income taxes on the Consolidated Condensed Statements of Income, while amortization and write-downs of non-qualifying LIHTC and other tax credit investments are recorded in Other expense. The income tax credits and deductions are recorded as a reduction of income tax expense and a reduction of federal income taxes payable.
In January 2014, the FASB issued ASU 2014-04, “Receivables—Troubled Debt Restructurings by Creditors: Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure.” ASU 2014-04 clarifies that an in-substance repossession or foreclosure occurs, and a creditor is considered to have received physical possession of residential real estate collateralizing a consumer mortgage loan, upon either (1) the creditor obtaining legal title to the residential real estate property upon completion of a foreclosure or (2) the borrower conveying all interest in the residential real estate property to the creditor to satisfy that loan through completion of a deed in lieu of foreclosure or through a similar legal agreement. Additionally, the amendments require interim and annual disclosure of both (1) the amount of foreclosed residential real estate property held by the creditor and (2) the recorded investment in consumer mortgage loans collateralized by residential real estate property that are in the process of foreclosure according to local requirements of the applicable jurisdiction. ASU 2014-04 is effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2014. An entity is required to adopt ASU 2014-04 using either a modified retrospective transition method or a prospective transition method. Under the modified retrospective transition method, an entity should apply ASU 2014-04 by means of a cumulative-effect adjustment to residential consumer mortgage loans and foreclosed residential real estate properties existing as of the beginning of the annual period for which the amendments are effective. FHN adopted the requirements of ASU 2014-04 prospectively and this did not have a material effect on FHN’s statements of condition, results of operation or cash flows.
In August 2014, the FASB issued ASU 2014-14, “Classification of Certain Government-Guaranteed Mortgage Loans upon Foreclosure.” ASU 2014-14 requires that a mortgage loan be derecognized and that a separate other receivable be recognized upon foreclosure if 1) the loan has a government guarantee that is not separable from the loan before foreclosure, 2) at the time of foreclosure the creditor has the intent to convey the real estate to the guarantor and make a recoverable claim on the guarantee and 3) at the time of foreclosure any amount of the claim that is based on the fair value of the real estate is fixed. For qualifying foreclosures, the amount of the receivable recognized should be measured based on the amount of the loan balance expected to be recovered from the guarantor. ASU 2014-14 is effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2014 and may be adopted through either a prospective only approach or through a reclassification from other real estate owned to other receivable on the effective date. FHN adopted the requirements for ASU 2014-14 prospectively for transactions occurring after its effective date and this did not have a material effect on FHN’s statements of condition, results of operation or cash flows.
In June 2014, the FASB issued ASU 2014-11, “Repurchase-to-Maturity Transactions, Repurchase Financings, and Disclosures.” ASU 2014-11 makes two changes to accounting for repurchase agreements. First, it requires secured borrowing accounting for repurchase-to-maturity transactions. Second, it requires separate accounting for a transfer of a financial asset executed contemporaneously with a repurchase agreement with the same counterparty, which will result in secured borrowing accounting for the repurchase agreement. ASU 2014-11 also requires additional disclosures for repurchase transactions that are recognized as secured borrowings, including disaggregation by class of collateral, the remaining contractual tenor of the arrangements and the risks inherent in the agreements. Adoption of ASU 2014-11 will only affect FHN’s disclosures as it does not execute repurchase-to maturity or repurchase financing transactions. These disclosure revisions are effective for annual periods beginning after December 15, 2014, and for interim periods beginning after March 15, 2015. FHN revised its disclosures upon adoption of ASU 2014-11.
In September 2015, the FASB issued ASU 2015-16, “Simplifying the Accounting for Measurement-Period Adjustments.” ASU 2015-16 requires that measurement-period adjustments to provisional amounts recognized in a business combination be recorded in the period in which they are identified. The cumulative effect on the income statement should be recognized in the same period as if the accounting had been completed as of the acquisition date. Previously, measurement-period adjustments required revision of the initial balance sheet for an acquisition with corresponding revision of all affected prior period financial statements. ASU 2015-16 requires disclosure of the income statement effects by line item when measurement-period adjustments are recognized. ASU 2015-16 is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015. Early application is permitted for reporting periods for which financial statements have not yet been issued. FHN has elected to early adopt the provisions of ASU 2015-16 because it considers the revised guidance to be more effective in communicating the financial statement effects of measurement-period adjustments.
8
Accounting Changes Issued but Not Currently Effective
In May 2014, the FASB issued ASU 2014-09, “Revenue from Contracts with Customers.” ASU 2014-09 does not change revenue recognition for financial instruments. The core principle of ASU 2014-09 is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. This is accomplished through a five-step recognition framework involving 1) the identification of contracts with customers, 2) identification of performance obligations, 3) determination of the transaction price, 4) allocation of the transaction price to the performance obligations and 5) recognition of revenue as performance obligations are satisfied. Additionally, qualitative and quantitative information is required for disclosure regarding the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. The effective date of ASU 2014-09 has been deferred to annual reporting periods beginning after December 15, 2017, including interim periods within that reporting period. Early application is permitted for annual reporting periods beginning after December 15, 2016, and associated interim periods. Transition to the new requirements may be made by retroactively revising prior financial statements (with certain practical expedients permitted) or by a cumulative effect through retained earnings. If the latter option is selected, additional disclosures are required for comparability. FHN is evaluating the effects of ASU 2014-09 on its revenue recognition practices.
In June 2014, the FASB issued ASU 2014-12, “Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved after the Requisite Service Period.” ASU 2014-12 requires that a performance target that affects vesting, and that could be achieved after the requisite service period, be treated as a performance condition in determining expense recognition for the award. Thus, compensation cost is recognized over the requisite service period based on the probability of achievement of the performance condition. Expense is adjusted after the requisite service period for changes in the probability of achievement. ASU 2014-12 is effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2015. The adoption of ASU 2014-12 will have no effect on FHN.
In August 2014, the FASB issued ASU 2014-15, “Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern.” ASU 2014-15 requires an entity’s management to evaluate whether there are conditions or events, considered in the aggregate, that raise substantial doubt about the entity’s ability to continue as a going concern within one year after the date that the financial statements are issued. If such events or conditions exist, additional disclosures are required and management should evaluate whether its plans sufficiently alleviate the substantial doubt. ASU 2014-15 is effective for the annual period ending after December 15, 2016 and all interim and annual periods thereafter. The provisions of ASU 2014-15 are not anticipated to affect FHN.
In February 2015, the FASB issued ASU 2015-02, “Amendments to the Consolidation Analysis.” ASU 2015-02 revises current consolidation guidance to modify the evaluation of whether limited partnerships and similar legal entities are variable interest entities. ASU 2015-02 also eliminates the presumption that a general partner should consolidate a limited partnership, revises the consolidation analysis for reporting entities that have fee arrangements and related party relationships with variable interest entities, and provides a scope exception for entities with interests in registered money market funds. ASU 2015-02 is effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2015. FHN has evaluated the provisions of ASU 2015-02 on its consolidation assessments and there will not be a significant effect upon adoption.
In April 2015, the FASB issued ASU 2015-03, “Simplifying the Presentation of Debt Issuance Costs.” ASU 2015-03 requires that debt issuance costs related to a recognized debt liability be presented as a direct reduction from the carrying value of that debt liability, consistent with debt discounts. ASU 2015-03 requires application on a retrospective basis, with prior periods revised to reflect the effects of adoption. ASU 2015-03 is effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2015. Consistent with current requirements, FHN currently classifies debt issuance costs within Other assets in the Consolidated Condensed Statements of Condition. ASU 2015-03 will have no effect on FHN’s recognition of interest expense.
9
Note 2 – Acquisitions and Divestitures
On October 17, 2014, First Tennessee Bank National Association (“FTBNA”) purchased thirteen bank branches in Middle and East Tennessee. The fair value of the acquired assets totaled $437.6 million, including $413.4 million in cash, $7.5 million in fixed assets, and $15.7 million of goodwill and intangible assets. FTBNA also assumed $437.2 million of deposits associated with these branches. FTBNA paid a deposit premium of 3.32 percent and acquired an immaterial amount of loans as part of the transaction. In relation to the branch acquisition FHN recorded $4.0 million in goodwill, representing the excess of the estimated fair value of liabilities assumed over the estimated fair value of the assets acquired (refer to Note 6 – Intangible Assets for additional information), all of which is expected to be deductible for tax purposes. FHN’s operating results for 2015 and 2014 include the impact of branch activity subsequent to the October 17, 2014 closing date.
In fourth quarter 2014, FHN entered into a merger agreement with TrustAtlantic Financial Corporation (“TrustAtlantic Financial”). TrustAtlantic Financial owned all the capital stock of TrustAtlantic Bank. TrustAtlantic Financial and TrustAtlantic Bank were headquartered in Raleigh, North Carolina. TrustAtlantic Bank had five branches located in North Carolina in the communities of Raleigh, Cary and Greenville. The holding company transaction closed on October 2, 2015, and as a result FHN took control of TrustAtlantic Bank. TrustAtlantic Bank merged into FTBNA on October 16, 2015 and the TrustAtlantic Bank branches became First Tennessee branches upon closing that merger. The aggregate transaction value of the merger was approximately $95 million.
In addition to the transactions mentioned above, FHN acquires or divests assets from time to time in transactions that are considered business combinations or divestitures but are not material to FHN individually or in the aggregate.
10
Note 3 – Investment Securities
The following tables summarize FHN’s investment securities on September 30, 2015 and 2014:
(Dollars in thousands)
Securities available-for-sale (“AFS”):
U.S. treasuries
Government agency issued mortgage-backed securities (“MBS”)
Government agency issued collateralized mortgage obligations (“CMO”)
Other U.S. government agencies
States and municipalities
Equity and other (a)
Total securities available-for-sale (b)
Securities held-to-maturity (“HTM”):
Total securities held-to-maturity
Securities available-for-sale:
Government agency issued MBS
Government agency issued CMO
Securities held-to-maturity:
11
Note 3 – Investment Securities (Continued)
The amortized cost and fair value by contractual maturity for the available-for-sale and held-to-maturity securities portfolios on September 30, 2015, are provided below:
Within 1 year
After 1 year; within 5 years
After 5 years; within 10 years
After 10 years
Subtotal
Government agency issued MBS and CMO (a)
Equity and other
Total
The table below provides information on gross gains and gross losses from investment securities for the three and nine months ended September 30:
Gross gains on sales of securities
Gross losses on sales of securities
Net gain/(loss) on sales of securities (a)
Venture capital investments (b)
Net other than temporary impairment (“OTTI”) recorded (c)
Total securities gain/(loss), net
12
The following tables provide information on investments within the available-for-sale portfolio that had unrealized losses as of September 30, 2015 and 2014:
Total debt securities
Equity
Total temporarily impaired securities
FHN has reviewed investment securities that were in unrealized loss positions in accordance with its accounting policy for OTTI and does not consider them other-than-temporarily impaired. For debt securities with unrealized losses, FHN does not intend to sell them and it is more-likely-than-not that FHN will not be required to sell them prior to recovery. The decline in value is primarily attributable to changes in interest rates and not credit losses. For equity securities, FHN has both the ability and intent to hold these securities for the time necessary to recover the amortized cost.
13
Note 4 – Loans
The following table provides the balance of loans by portfolio segment as of September 30, 2015 and 2014, and December, 31 2014:
Commercial:
Commercial, financial, and industrial
Commercial real estate
Retail:
Consumer real estate (a)
Permanent mortgage
Credit card & other
Loans, net of unearned income
Allowance for loan losses
COMPONENTS OF THE LOAN PORTFOLIO
The loan portfolio is disaggregated into segments and then further disaggregated into classes for certain disclosures. GAAP defines a portfolio segment as the level at which an entity develops and documents a systematic method for determining its allowance for credit losses. A class is generally determined based on the initial measurement attribute (i.e., amortized cost or purchased credit-impaired), risk characteristics of the loan, and FHN’s method for monitoring and assessing credit risk. Commercial loan portfolio segments include commercial, financial and industrial (“C&I”) and commercial real estate (“CRE”). Commercial classes within C&I include general C&I, loans to mortgage companies, the trust preferred loans (“TRUPS”) (i.e. long-term unsecured loans to bank and insurance - related businesses) portfolio and purchased credit-impaired (“PCI”) loans. Loans to mortgage companies includes commercial lines of credit to qualified mortgage companies primarily for the temporary warehousing of eligible mortgage loans prior to the borrower’s sale of those mortgage loans to third party investors. Commercial classes within CRE include income CRE, residential CRE and PCI loans. Retail loan portfolio segments include consumer real estate, permanent mortgage, and the credit card and other portfolio. Retail classes include HELOC, real estate (“R/E”) installment and PCI loans within the consumer real estate segment, permanent mortgage (which is both a segment and a class), and credit card and other.
Concentrations
FHN has a concentration of residential real estate loans (32 percent of total loans), the majority of which is in the consumer real estate segment (29 percent of total loans). Loans to finance and insurance companies total $2.1 billion (22 percent of the C&I portfolio, or 13 percent of the total loans). FHN had loans to mortgage companies totaling $1.4 billion (14 percent of the C&I segment, or 8 percent of total loans) as of September 30, 2015. As a result, 36 percent of the C&I segment was sensitive to impacts on the financial services industry.
Purchased Credit-Impaired Loans
The following table presents a rollforward of the accretable yield for the three and nine months ended September 30, 2015 and 2014:
Balance, beginning of period
Additions
Accretion
Adjustment for payoffs
Adjustment for charge-offs
Increase in accretable yield (a)
Balance, end of period
14
Note 4 – Loans (Continued)
At September 30, 2015, the ALLL related to PCI loans was $2.9 million compared to $2.8 million at September 30, 2014. A loan loss provision expense of $.1 million was recognized during the three months ended September 30, 2015 as compared to a loan loss provision expense of $.4 million recognized during the three months ended September 30, 2014. A loan loss provision credit of $.4 million was recognized during the nine months ended September 30, 2015 as compared to a loan loss provision expense of $2.1 million recognized during the nine months ended September 30, 2014. The following table reflects the outstanding principal balance and carrying amounts of the acquired PCI loans as of September 30, 2015 and 2014, and December 31, 2014:
Commercial, financial and industrial
Consumer real estate
Credit card and other
15
Impaired Loans
The following tables provide information at September 30, 2015 and 2014, by class related to individually impaired loans and consumer TDRs. Recorded investment is defined as the amount of the investment in a loan, before valuation allowance but which does reflect any direct write-down of the investment. For purposes of this disclosure, PCI loans and net LOCOM have been excluded.
Impaired loans with no related allowance recorded:
General C&I
Income CRE
Residential CRE
HELOC (a)
R/E installment loans (a)
Permanent mortgage (a)
Impaired loans with related allowance recorded:
TRUPS
HELOC
R/E installment loans
Total commercial
Total retail
Total impaired loans
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Asset Quality Indicators
FHN employs a dual grade commercial risk grading methodology to assign an estimate for the probability of default (“PD”) and the loss given default (“LGD”) for each commercial loan using factors specific to various industry, portfolio, or product segments that result in a rank ordering of risk and the assignment of grades PD 1 to PD 16. Each PD grade corresponds to an estimated one-year default probability percentage; a PD 1 has the lowest expected default probability, and probabilities increase as grades progress down the scale. PD 1 through PD 12 are “pass” grades. PD grades 13-16 correspond to the regulatory-defined categories of special mention (13), substandard (14), doubtful (15), and loss (16). Pass loan grades are required to be reassessed annually or earlier whenever there has been a material change in the financial condition of the borrower or risk characteristics of the relationship. All commercial loans over $1 million and certain commercial loans over $500,000 that are graded 13 or worse are reassessed on a quarterly basis. LGD grades are assigned based on a scale of 1-12 and represent FHN’s expected recovery based on collateral type in the event a loan defaults. See Note 5 - Allowance for Loan Losses for further discussion on the credit grading system.
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The following tables provide the balances of commercial loan portfolio classes with associated allowance, disaggregated by PD grade as of September 30, 2015 and 2014:
PD Grade:
14,15,16
Collectively evaluated for impairment
Individually evaluated for impairment
Purchased credit-impaired loans
Total commercial loans
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The retail portfolio is comprised primarily of smaller-balance loans which are very similar in nature in that most are standard products and are backed by residential real estate. Because of the similarities of retail loan-types, FHN is able to utilize the Fair Isaac Corporation (“FICO”) score, among other attributes, to assess the credit quality of consumer borrowers. FICO scores are refreshed on a quarterly basis in an attempt to reflect the recent risk profile of the borrowers. Accruing delinquency amounts are indicators of asset quality within the credit card and other retail portfolio.
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The following tables reflect period end balances and average FICO scores by origination vintage for the HELOC, real estate installment, and permanent mortgage classes of loans as of September 30, 2015 and 2014:
Origination Vintage
pre-2003
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
R/E Installment Loans
Permanent Mortgage
pre-2004
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Nonaccrual and Past Due Loans
The following table reflects accruing and non-accruing loans by class on September 30, 2015:
Commercial (C&I):
Loans to mortgage companies
TRUPS (a)
Total commercial (C&I)
Commercial real estate:
Total commercial real estate
Consumer real estate:
Total consumer real estate
Credit card
Other
Total credit card & other
Total loans, net of unearned
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The following table reflects accruing and non-accruing loans by class on September 30, 2014:
Troubled Debt Restructurings
As part of FHN’s ongoing risk management practices, FHN attempts to work with borrowers when necessary to extend or modify loan terms to better align with their current ability to repay. Extensions and modifications to loans are made in accordance with internal policies and guidelines which conform to regulatory guidance. Each occurrence is unique to the borrower and is evaluated separately. FHN considers regulatory guidelines when restructuring loans to ensure that prudent lending practices are followed. As such, qualification criteria and payment terms consider the borrower’s current and prospective ability to comply with the modified terms of the loan.
A modification is classified as a TDR if the borrower is experiencing financial difficulty and it is determined that FHN has granted a concession to the borrower. FHN may determine that a borrower is experiencing financial difficulty if the borrower is currently in default on any of its debt, or if it is probable that a borrower may default in the foreseeable future. Many aspects of a borrower’s financial situation are assessed when determining whether they are experiencing financial difficulty, particularly as it relates to commercial borrowers due to the complex nature of loan structures, business/industry risk, and borrower/guarantor structures. Concessions could include extension of the maturity date, reductions of the interest rate (which may make the rate lower than current market for a new loan with similar risk), reduction or forgiveness of accrued interest, or principal forgiveness. When evaluating whether a concession has been granted, FHN also considers whether the borrower has provided additional collateral or guarantors, among other things, and whether such additions adequately compensate FHN for the restructured terms. The assessments of whether a borrower is experiencing (or is likely to experience) financial difficulty and whether a concession has been granted is subjective in nature and management’s judgment is required when determining whether a modification is classified as a TDR.
For all classes within the commercial portfolio segment, TDRs are typically modified through forbearance agreements (generally 6 to 12 months). Forbearance agreements could include reduced interest rates, reduced payments, release of guarantor, or entering into short sale agreements. FHN’s proprietary modification programs for consumer loans are generally structured using parameters of U.S. government-sponsored programs such as Home Affordable Modification Program (“HAMP”). Within the HELOC and R/E
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installment loans classes of the consumer portfolio segment, TDRs are typically modified by reducing the interest rate (in increments of 25 basis points to a minimum of 1 percent for up to 5 years) and a possible maturity date extension to reach an affordable housing debt ratio. Permanent mortgage TDRs are typically modified by reducing the interest rate (in increments of 25 basis points to a minimum of 2 percent for up to 5 years) and a possible maturity date extension to reach an affordable housing debt ratio. After 5 years the interest rate steps up 1 percent every year thereafter until it reaches the Federal Home Loan Mortgage Corporation Weekly Survey Rate cap. Contractual maturities may be extended to 40 years on permanent mortgages and to 30 years for consumer real estate loans. Within the credit card class of the consumer portfolio segment, TDRs are typically modified through either a short-term credit card hardship program or a longer-term credit card workout program. In the credit card hardship program, borrowers may be granted rate and payment reductions for 6 months to 1 year. In the credit card workout program, customers are granted a rate reduction to 0 percent and term extensions for up to 5 years to pay off the remaining balance.
Despite the absence of a loan modification, the discharge of personal liability through bankruptcy proceedings is considered a concession. As a result, FHN classifies all non-reaffirmed residential real estate loans discharged in Chapter 7 bankruptcy as nonaccruing TDRs.
On September 30, 2015 and 2014, FHN had $304.7 million and $346.0 million portfolio loans classified as TDRs, respectively. For TDRs in the loan portfolio, FHN had loan loss reserves of $51.2 million and $60.9 million, or 17 percent as of September 30, 2015, and 18 percent as of September 30, 2014. Additionally, $72.6 million and $83.1 million of loans held-for-sale as of September 30, 2015 and 2014, respectively were classified as TDRs.
The following tables reflect portfolio loans that were classified as TDRs during the three and nine months ended September 30, 2015 and 2014:
Total troubled debt restructurings
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The following tables present TDRs which re-defaulted during the three and nine months ended September 30, 2015 and 2014, and as to which the modification occurred 12 months or less prior to the re-default. Financing receivables that became classified as TDRs within the previous 12 months and for which there was a payment default during the period are calculated by first identifying TDRs that defaulted during the period and then determining whether they were modified within the 12 months prior to the default. For purposes of this disclosure, FHN generally defines payment default as 30 or more days past due.
The determination of whether a TDR is placed on nonaccrual status generally follows the same internal policies and procedures as other portfolio loans. However, FHN will typically place a consumer real estate loan on nonaccrual status if it is 30 or more days delinquent upon modification into a TDR. For commercial loans, a nonaccrual TDR that is reasonably assured of repayment according to its modified terms may be returned to accrual status by FHN upon a detailed credit evaluation of the borrower’s financial condition and prospects for repayment under the revised terms. For consumer loans, FHN’s evaluation supporting the decision to return a modified loan to accrual status includes consideration of the borrower’s sustained historical repayment performance for a reasonable period prior to the date on which the loan is returned to accrual status, which is generally a minimum of six months. FHN may also consider a borrower’s sustained historical repayment performance for a reasonable time prior to the restructuring in assessing whether the borrower can meet the restructured terms, as it may indicate that the borrower is capable of servicing the level of debt under the modified terms. Otherwise, FHN will continue to classify a restructured loan as nonaccrual. Consistent with regulatory guidance, upon sustained performance and classification as a TDR over FHN’s year-end, the loan will be removed from TDR status as long as the modified terms were market-based at the time of modification.
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Note 5 - Allowance for Loan Losses
The ALLL includes the following components: reserves for commercial loans evaluated based on pools of credit graded loans and reserves for pools of smaller-balance homogeneous retail loans, both determined in accordance with ASC 450-20-50. The reserve factors applied to these pools are an estimate of probable incurred losses based on management’s evaluation of historical net losses from loans with similar characteristics and are subject to qualitative adjustments by management to reflect current events, trends, and conditions (including economic considerations and trends). The pace of the economic recovery, performance of the housing market, unemployment levels, labor participation rate, regulatory environment, regulatory guidance, and both positive and negative portfolio segment-specific trends, are examples of additional factors considered by management in determining the ALLL. Additionally, management considers the inherent uncertainty of quantitative models that are driven by historical loss data. Management evaluates the periods of historical losses that are the basis for the loss rates used in the quantitative models and selects historical loss periods that are believed to be the most reflective of losses inherent in the loan portfolio as of the balance sheet date. Management also periodically reviews analysis of the loss emergence period which is the amount of time it takes for a loss to be confirmed (initial charge-off) after a loss event has occurred. FHN performs extensive studies as it relates to the historical loss periods used in the model and the loss emergence period and model assumptions are adjusted accordingly. The ALLL also includes reserves determined in accordance with ASC 310-10-35 for loans determined by management to be individually impaired and an allowance associated with PCI loans. See Note 1 – Summary of Significant Accounting Policies and Note – 5 Allowance for Loan Losses in the Notes to Consolidated Financial Statements which were filed as part of Exhibit 99.1 to FHN’s Current Report on Form 8-K dated October 19, 2015, for additional information about the policies and methodologies used in the aforementioned components of the ALLL.
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Note 5 - Allowance for Loan Losses (Continued)
The following table provides a rollforward of the allowance for loan losses by portfolio segment for the three and nine months ended September 30, 2015 and 2014:
Balance as of July 1, 2014
Charge-offs
Recoveries
Provision/(provision credit) for loan losses
Balance as of September 30, 2014
Balance as of January 1, 2014
Allowance - individually evaluated for impairment
Allowance - collectively evaluated for impairment
Allowance - purchase credit impaired loans
Loans, net of unearned as of September 30, 2014:
Balance as of July 1, 2015
Balance as of September 30, 2015
Balance as of January 1, 2015
Allowance - purchased credit-impaired loans
Loans, net of unearned as of September 30, 2015:
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Note 6 – Intangible Assets
The following is a summary of intangible assets, net of accumulated amortization, included in the Consolidated Condensed Statements of Condition:
December 31, 2013
Amortization expense
September 30, 2014
December 31, 2014
September 30, 2015
The gross carrying amount and accumulated amortization of other intangible assets subject to amortization is $70.3 million and $44.7 million, respectively on September 30, 2015. Estimated aggregate amortization expense is expected to be $1.3 million for the remainder of 2015, and $5.0 million, $4.7 million, $4.5 million, $4.2 million, and $1.5 million for the twelve-month periods of 2016, 2017, 2018, 2019, and 2020, respectively. No goodwill is carried in the Corporate and Non-strategic segments.
Gross goodwill, accumulated impairments, and accumulated divestiture related write-offs were determined beginning January 1, 2012, when a change in accounting requirements resulted in goodwill being assessed for impairment rather than being amortized. Gross goodwill of $200.0 million with accumulated impairments and accumulated divestiture related write-offs of $114.1 million and $85.9 million, respectively, were previously allocated to the non-strategic segment, resulting in $0 net goodwill allocated to the non-strategic segment as of September 30, 2014 and 2015. The regional bank and fixed income segments do not have any accumulated impairments or divestiture related write-offs. The following is a summary of goodwill by reportable segment included in the Consolidated Condensed Statements of Condition as of and for the nine months ended September 30, 2014 and 2015.
Impairments
Divestitures
Net change in goodwill during 2014
Net change in goodwill during 2015
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Note 7 – Other Income and Other Expense
Following is detail of All other income and commissions and All other expense as presented in the Consolidated Condensed Statements of Income:
All other income and commissions:
Gain/(loss) on extinguishment of debt
ATM interchange fees
Electronic banking fees
Letter of credit fees
Deferred compensation (a)
All other expense:
Other insurance and taxes
Travel and entertainment
Customer relations
Employee training and dues
Supplies
Miscellaneous loan costs
Tax credit investments
Certain previously reported amounts have been revised to reflect the retroactive effect of the adoption of ASU 2014-01, “Equity Method and Joint Venture: Accounting for Investments in Qualified Affordable Housing Projects.” See Note 1-Financial Information for addition information.
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Note 8 – Changes in Accumulated Other Comprehensive Income Balances
The following table provides the changes in accumulated other comprehensive income by component, net of tax, for the three and nine months ended September 30, 2015:
(Dollars in thousands, unless otherwise noted)
Other comprehensive income before reclassifications, Net of tax expense of $9.5 million for unrealized gain/(loss) on securities available-for-sale
Amounts reclassified from accumulated other comprehensive income, Net of tax benefit of $2.4 million for pension and post retirement plans
Net current period other comprehensive income, Net of tax expense of $9.5 million and tax benefit of $2.4 million for unrealized gain/(loss) on securities available-for-sale and pension and post retirement plans, respectively
Other comprehensive income before reclassifications, Net of tax expense of $8.2 million for unrealized gain/(loss) on securities available-for-sale
Amounts reclassified from accumulated other comprehensive income, Net of tax benefit of $1.1 million for pension and post retirement plans
Net current period other comprehensive income, Net of tax expense of $8.2 million and tax benefit of $1.1 million for unrealized gain/(loss) on securities available-for-sale and pension and post retirement plans, respectively
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Note 8 – Changes in Accumulated Other Comprehensive Income Balances (Continued)
The following table provides the changes in accumulated other comprehensive income by component, net of tax, for the three and nine months ended September 30, 2014:
Other comprehensive income before reclassifications, Net of tax benefit of $7.0 million for unrealized gain/(loss) on securities available-for-sale
Amounts reclassified from accumulated other comprehensive income, Net of tax expense of $.3 million for pension and post retirement plans
Net current period other comprehensive income, Net of tax benefit of $7.0 million and tax expense of $.3 million for unrealized gain/(loss) on securities available-for-sale and pension and post retirement plans, respectively
Other comprehensive income before reclassifications, Net of tax expense of $9.8 million for unrealized gain/(loss) on securities available-for-sale
Amounts reclassified from accumulated other comprehensive income, Net of tax expense of $1.0 million for pension and post retirement plans
Net current period other comprehensive income, Net of tax expense of $9.8 million and $1.0 million for unrealized gain/(loss) on securities available-for-sale and pension and post retirement plans, respectively
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Note 9 – Earnings Per Share
The following table provides reconciliations of net income to net income available to common shareholders and the difference between average basic common shares outstanding and average diluted common shares outstanding:
(Dollars and shares in thousands, except per share data)
Weighted average common shares outstanding - basic
Effect of dilutive securities
Weighted average common shares outstanding - diluted
Net income/(loss) per share available to common shareholders
Diluted income/(loss) per share available to common shareholders
The following table presents outstanding options and other equity awards that were anti-dilutive (the exercise price was higher than the weighted-average market price) excluded from the calculation of diluted earnings per share:
Anti-dilutive stock options
Weighted average exercise price of anti-dilutive stock options
Anti-dilutive other equity awards
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Note 10 – Contingencies and Other Disclosures
Contingencies
General
Contingent liabilities arise in the ordinary course of business. Often they are related to lawsuits, arbitration, mediation, and other forms of litigation. Various litigation matters are threatened or pending against FHN and its subsidiaries. Also, FHN at times receives requests for information, subpoenas, or other inquiries from federal, state, and local regulators, from other government authorities, and from other parties concerning various matters relating to FHN’s current or former lines of business. Certain matters of that sort are pending at this time, and FHN is cooperating in those matters. Pending and threatened litigation matters sometimes are resolved in court or before an arbitrator, and sometimes are settled by the parties. Regardless of the manner of resolution, frequently the most significant changes in status of a matter occur over a short time period, often following a lengthy period of little substantive activity. In view of the inherent difficulty of predicting the outcome of these matters, particularly where the claimants seek very large or indeterminate damages, or where the cases present novel legal theories or involve a large number of parties, or where claims or other actions may be possible but have not been brought, FHN cannot reasonably determine what the eventual outcome of the pending matters will be, what the timing of the ultimate resolution of these matters may be, or what the eventual loss or impact related to each matter may be. FHN establishes loss contingency liabilities for litigation matters when loss is both probable and reasonably estimable as prescribed by applicable financial accounting guidance. If loss for a matter is probable and a range of possible loss outcomes is the best estimate available, accounting guidance requires a liability to be established at the low end of the range.
Based on current knowledge, and after consultation with counsel, management is of the opinion that loss contingencies related to threatened or pending litigation matters should not have a material adverse effect on the consolidated financial condition of FHN, but may be material to FHN’s operating results for any particular reporting period depending, in part, on the results from that period.
Litigation – Loss Contingencies
As used in this Note, “material loss contingency matters” generally fall into at least one of the following categories: (i) FHN has determined material loss to be probable and has established a material loss liability in accordance with applicable financial accounting guidance, other than matters reported as having been substantially settled or otherwise substantially resolved; (ii) FHN has determined material loss to be probable but is not reasonably able to estimate an amount or range of material loss liability; or (iii) FHN has determined that material loss is not probable but is reasonably possible, and that the amount or range of that material loss is estimable. As defined in applicable accounting guidance, loss is reasonably possible if there is more than a remote chance of a material loss outcome for FHN. Set forth below are disclosures for certain pending or threatened litigation matters, including all matters mentioned in (i) or (ii) and certain matters mentioned in (iii). In addition, certain other matters are discussed relating to FHN’s former mortgage origination and servicing businesses. In all litigation matters discussed, unless settled or otherwise resolved, FHN believes it has meritorious defenses and intends to pursue those defenses vigorously.
FHN reassesses the liability for litigation matters each quarter as the matters progress. At September 30, 2015, the aggregate amount of liabilities established for all material loss contingency matters was $17.1 million. The liabilities discussed in this paragraph are separate from those discussed under the heading “Established Repurchase Liability” below.
In each material loss contingency matter, except as otherwise noted, there is a more than slight chance that each of the following outcomes will occur: the plaintiff will substantially prevail; the defense will substantially prevail; the plaintiff will prevail in part; or the matter will be settled by the parties. At September 30, 2015, FHN estimates that for all material loss contingency matters, estimable reasonably possible losses in future periods in excess of currently established liabilities could aggregate in a range from zero to approximately $70 million.
As a result of the general uncertainties discussed above and the specific uncertainties discussed for each matter mentioned below, it is possible that the ultimate future loss experienced by FHN for any particular matter may materially exceed the amount, if any, of currently established liability for that matter. That possibility exists both for matters included in the estimated reasonable possible loss (“RPL”) range mentioned above and for matters not included in that range.
On October 30, 2015, FHN learned that an arbitration panel had awarded certain claimants $11.6 million. This matter was brought by two former customers of FHN’s subsidiary FTN Financial Securities Corp. (“FTN”), led by First United Bank & Trust, related to purchases of PreTSL securities from FTN in 2006 and 2007. After considering the terms of the award, FHN has recognized a pre-tax expense of $11.6 million for the third quarter of 2015 related to this matter. The expense is recognized as other non-interest expense within the Fixed Income segment and is included in the aggregate liability for contingencies at September 30, 2015 reported above.
Certain Matters Included in Reasonably Possible Loss Range
Debit Transaction Sequencing Litigation Matter. FTBNA is a defendant in a putative class action lawsuit concerning overdraft fees charged in connection with debit card transactions. A key claim is that the method used to order or sequence the transactions posted each day was improper. The case is styled as Hawkins v. First Tennessee Bank National Association, before the Circuit Court for Shelby County, Tennessee, Case No. CT-004085-11. The plaintiff seeks actual damages of at least $5 million, unspecified restitution of fees charged, and unspecified punitive damages, among other things. FHN’s estimate of RPL for this matter is subject to significant
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Note 10 – Contingencies and Other Disclosures (Continued)
uncertainties regarding: whether a class will be certified and, if so, the definition of the class; claims as to which no dollar amount is specified; the potential remedies that might be available or awarded; the ultimate outcome of potentially significant motions such as motions to dismiss, or for summary judgment; and the incomplete status of the discovery process.
RPL-Included First Horizon Branded Mortgage Securitization Litigation Matters. Several pending litigation matters are discussed under the heading “First Horizon Branded Mortgage Securitization Litigation Matters” below. For certain of those FHN has been able to estimate RPL. Those estimable matters are the FDIC (NY) and FDIC (AL) cases. The estimates for those matters are included in the RPL range discussed above. The RPL estimates are subject to significant uncertainties regarding: the dollar amounts claimed; the potential remedies that might be available or awarded; the outcome of any settlement discussions; the outcome of potentially significant motions; the availability of significantly dispositive defenses; the incomplete status of the discovery process; and the lack of precedent claims.
Certain Matters Not Included in Reasonably Possible Loss Range
Several pending litigation matters are discussed under the heading “First Horizon Branded Mortgage Securitization Litigation Matters” below. For certain of those FHN has been able to estimate RPL as mentioned in the preceding paragraph, and for others FHN has not. Those matters for which RPL currently is not estimable are the FHLB of San Francisco, Metropolitan Life, Royal Park, Integra REC and Tennessee Consolidated Retirement System indemnity cases. FHN is unable to estimate an RPL range due to significant uncertainties regarding: claims as to which the claimant specifies no dollar amount; the potential remedies that might be available or awarded; the availability of significantly dispositive defenses such as statutes of limitations or repose; the outcome of potentially dispositive early-stage motions such as motions to dismiss; the identity and value of assets that FHN may be required to repurchase for those claims seeking asset repurchase; the incomplete status of the discovery process; the lack of a precise statement of damages; and lack of precedent claims.
Litigation – Gain Contingencies
In second quarter 2015 FHN reached an agreement with the U.S. Department of Justice (“DOJ”) and the Office of the Inspector General for the Department of Housing and Urban Development (“HUD”) to settle potential claims related to FHN’s underwriting and origination of loans insured by the Federal Housing Administration (“FHA”). Under that agreement FHN paid $212.5 million. FHN believes that certain insurance policies, having an aggregate policy limit of $75 million, provide coverage for FHN’s losses and related costs. The insurers have denied and/or reserved rights to deny coverage. FHN has brought suit against the insurers to enforce the policies under Tennessee law. In connection with this litigation the previously recognized expenses associated with the settled matter may be recouped in part. Under applicable financial accounting guidance FHN has determined that although material gain from this litigation is not probable there is more than a slight chance of a material gain outcome for FHN. FHN cannot determine a probable outcome that may result from this matter because of the uncertainty of the potential outcomes of the legal proceedings and also due to significant uncertainties regarding: legal interpretation of the relevant contracts; potential remedies that might be available or awarded; and lack of discovery.
First Horizon Branded Mortgage Securitization Litigation Matters
Prior to September 2008 FHN originated and sold home loan products through various channels and conducted its servicing business under the First Horizon Home Loans and First Tennessee Mortgage Servicing brands. Those sales channels included the securitization of loans into pools held by trustees and the sale of the resulting securities, sometimes called “certificates,” to investors. These activities are discussed in more detail below under the heading “Legacy Home Loan Sales and Servicing.”
At the time this report is filed, FHN, along with multiple co-defendants, is defending lawsuits brought by investors which claim that the offering documents under which certificates relating to First Horizon branded securitizations (“FH proprietary securitizations”) were sold to them were materially deficient. The plaintiffs and venues of these suits are: (1) Federal Deposit Insurance Corporation (“FDIC”) as receiver for Colonial Bank, in the U.S. District Court for the Middle District of Alabama (Case No. CV-12-791-WKW-WC); and (2) FDIC as receiver for Colonial Bank, in the U.S. District Court for the Southern District of New York (Case No. 12 Civ. 6166 (LLS)(MHD)). The plaintiffs in the pending suits claim to have purchased certificates in a number of separate FH proprietary securitizations and demand that FHN repurchase their investments, or answer in damages or rescission, among other remedies sought. A third suit of this sort, brought by Charles Schwab Corp. in the Superior Court of San Francisco, California, was settled by the parties in October 2015. Because the settlement occurred after quarter-end, liability for this suit is included in the liabilities established for material loss contingency matters mentioned above.
In some of the pending suits underwriters are co-defendants and have demanded, under provisions in the applicable underwriting agreements, that FHN indemnify them for their expenses and any losses they may incur. In addition, FHN has received indemnity demands from underwriters in certain other suits as to which investors claim to have purchased certificates in FH proprietary
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securitizations. FHN has not been named a defendant in these suits, which FHN is defending indirectly as indemnitor. The plaintiffs and venues of these other indemnity-only suits are: (3) FHLB of San Francisco, in the Superior Court of San Francisco County, California (Case No. CGC-10-497840); (4) Metropolitan Life Insurance Co., in the Supreme Court of New York County, New York (No. 651360-2012); (5) Royal Park Invs. SA/NV, in the Supreme Court of New York County, New York (No. 652607-2012); (6) Commonwealth of Virginia ex rel. Integra REC LLC, in the Circuit Court for the City of Richmond (No. CL14-399); and (7) Tennessee Consolidated Retirement System, in the Chancery Court for Davidson County, Tennessee (No. 13-1729-II).
Details concerning the original purchase amounts and ending balances of the investments at issue in most of these pending suits, as to which FHN is a named defendant or as to which FHN has an agreement to indemnify an underwriter defendant, are set forth below. Information about the performance of the FH proprietary securitizations related to these suits is available in monthly reports published by the trustee for the securitization trusts. FHN believes that certain plaintiffs did not purchase the entire certificate in the securitizations in which they invested. Reporting by the trustee is at a certificate level and, as a result, ending certificate balances in the following table were adjusted to reflect FHN’s estimate of the ending balance of each partial certificate purchased by these plaintiffs. Plaintiffs in the pending lawsuits claim to have purchased a total of $145.7 million of certificates and the purchase prices of the certificates subject to the indemnification requests total $613.9 million. Although the Charles Schwab suit was pending at September 30, 2015, it was settled shortly afterward and is excluded from this table.
Vintage
Original Purchase Price:
Ending Balance per the September 25, 2015 trust statements:
If FHN were to repurchase certificates, it would recognize as a loss the difference between the amount paid (adjusted for any related litigation liability previously established) and the fair value of the certificates at that time.
The total ending certificate balance of the investments which are the subject of the current pending lawsuits was $204.7 million as reported on the September 25, 2015, trust statements, with approximately 85 percent of the remaining balances performing. Cumulative losses on the investments which are the subject of the remaining lawsuits, as reported on the trust statements, represent approximately 7 percent of the original principal amount underlying the certificates purchased. Ending certificate balances reflect the remaining principal balance on the certificates, after the monthly principal and interest distributions and after reduction for applicable cumulative and current realized losses. Recognized cumulative losses may not take into account all outstanding principal and interest amounts advanced by the servicer due to nonpayment by the borrowers; reimbursement of those advances to the servicer may increase cumulative losses. Losses often are reported by the trustee based on each certificate within a pool or group, which limits FHN’s ability to ascertain losses at the individual investor level.
As discussed below under “Legacy Home Loan Sales and Servicing,” other investors may attempt to pursue similar claims, and securitization trustees or other parties may attempt to pursue loan repurchase, make-whole, or indemnity claims. At September 30, 2015, except for the Charles Schwab case, FHN had not recognized a liability for exposure for investment rescission, loan repurchase, damages, or other actual or potential claims arising from FHN’s previous securitization and related activities.
Legacy Home Loan Sales and Servicing
Overview
Prior to September 2008, as a means to provide liquidity for its legacy mortgage banking business, FHN originated loans through its legacy mortgage business, primarily first lien home loans, with the intention of selling them. Sales typically were effected either as non-recourse whole-loan sales or through non-recourse proprietary securitizations. Conventional conforming single-family residential mortgage loans were sold predominantly to two government-sponsored entities (“GSEs”): the Federal National Mortgage Association (“Fannie Mae,” “Fannie,” or “FNMA”), and the Federal Home Loan Mortgage Corporation (“Freddie Mac,” “Freddie,” or “FHLMC”).
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Federally insured or guaranteed whole-loans were pooled, and payments to investors were guaranteed through the Government National Mortgage Association (“Ginnie Mae,” “Ginnie,” or “GNMA”). Collectively, Fannie Mae, Freddie Mac, and Ginnie Mae are referred to as the “Agencies.” Many mortgage loan originations, especially those “nonconforming” mortgage loans that did not meet criteria for whole-loan sales to the GSEs or insurance through Ginnie Mae, were sold to investors, or certificate-holders, predominantly through First Horizon (“FH”) branded proprietary securitizations but also, to a lesser extent, through whole-loan sales to private non-Agency purchasers. In addition, FHN originated with the intent to sell and sold HELOCs and second lien mortgages through whole-loan sales to private purchasers and, to a lesser extent, through FH proprietary securitizations.
On August 31, 2008 FHN sold its national mortgage origination and servicing platforms along with a portion of its servicing assets and obligations. This is sometimes referred to as the “2008 sale,” the “2008 divestiture,” the “platform sale,” or other similar terms. FHN contracted to have its remaining servicing obligations sub-serviced. Since the 2008 platform sale FHN has sold substantially all remaining servicing assets and obligations.
FHN also sold certain Agency mortgage loans with full recourse under agreements to repurchase the loans upon default, and originated or underwrote mortgage loans under the FHA insurance program mentioned above or the Veteran’s Administration (“VA”) guaranty program. After the 2008 sale these lending activities continued but were substantially curtailed.
Agency Whole-Loan Sales
Even though Agency loans were sold without recourse for credit loss, FHN may be obligated to either repurchase a loan for the unpaid principal balance (“UPB”) or make the purchaser whole for the economic loss incurred if FHN breached representations or warranties made by FHN to the purchaser at the time of the sale. Such representations and warranties typically covered both substantive and process matters, such as the existence and sufficiency of file documentation and the absence of fraud by borrowers or other third parties such as appraisers. Since the mortgage platform sale in 2008, Agencies, primarily the two GSEs, have accounted for the vast majority of repurchase/make-whole claims received.
In the fourth quarter of 2013 FHN entered into a definitive resolution agreement (“DRA”) with Fannie Mae, and in the first quarter of 2014 FHN entered into a DRA with Freddie Mac, in each case resolving certain legacy selling representation and warranty repurchase obligations associated with loans originated from 2000 to 2008 excluding certain loans FHN no longer serviced at the time of the DRA. Under each DRA, FHN remains responsible for repurchase obligations related to certain excluded defects (such as title defects and violations of the GSE’s Charter Act) and FHN continues to have obligations related to mortgage insurance rescissions, cancellations, and denials. With respect to loans where there has been a prior bulk sale of servicing, FHN is not responsible for mortgage insurance cancellations and denials to the extent attributable to the acts of the current servicer.
As a result of the DRAs, the repurchase pipeline overall is smaller, and the proportion of GSE-related repurchase requests in the pipeline also is smaller, than in periods pre-dating the DRAs. FHN’s repurchase liability as of September 30, 2015 contemplates, among other things, estimates of FHN’s repurchase exposure related to loans excluded from the DRAs and estimates of FHN’s repurchase exposure related to certain other whole-loan sales. See “Other Whole-Loan Sales” and “Established Repurchase Liability” below for additional information.
Other Whole-Loan Sales
Prior to the 2008 divestiture FHN also sold first lien mortgage loans through whole-loan sales to non-Agency purchasers. FHN made contractual representations and warranties to the purchasers generally similar to those made to Agency purchasers. As of September 30, 2015, 47 percent of repurchase/make-whole claims in the repurchase pipeline relate to other whole-loan sales. These claims are included in FHN’s liability methodology and the assessment of the adequacy of the repurchase and foreclosure liability.
Many of these loans were included by the purchasers in their own securitizations, not using the First Horizon brand. FHN’s contractual representations and warranties to these loan purchasers generally included repurchase and indemnity covenants for losses and expenses applicable to the securitization caused by FHN’s breach. Currently the following categories of legal actions are pending which involve FHN and non-Agency whole-loan sales: (i) FHN has received indemnification requests from purchasers of loans or their assignees in cases where FHN is not a defendant; (ii) FHN has received subpoenas seeking loan reviews in cases where FHN is not a defendant; (iii) FHN has received repurchase or make-whole demands from purchasers or their assignees; and (iv) FHN is a defendant in certain legal actions involving FHN-originated loans. In some cases the loans to be reviewed, or which otherwise are at issue, have not been identified specifically. Assignees can include securitizers or securitization trustees, among others. A loan is included in the repurchase pipeline only when an identifiable demand for repurchase has been made outside of active litigation.
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First Horizon Branded Proprietary Mortgage Securitizations
From 2005 through 2007 FHN originated and sold certain non-agency, nonconforming mortgage loans, consisting of Jumbo and Alternative-A (“Alt A”) first lien mortgage loans, to private investors through 80 proprietary securitization trusts under the FH brand. Securitized loans generally were sold indirectly to investors as interests, commonly known as certificates, in the trusts. The certificates were sold to a variety of investors, including GSEs in some cases, through securities offerings under a prospectus or other offering documents. In most cases, the certificates were tiered into different risk classes, with junior classes exposed to trust losses first and senior classes exposed after junior classes were exhausted. Through third quarter 2013, FHN continued to service substantially all of the remaining loans sold through FH proprietary securitizations. In 2013 FHN contracted to sell substantially all such servicing rights and obligations, with transfers occurring largely in fourth quarter 2013 and first quarter 2014. As of September 30, 2015, the aggregate remaining UPB in active FH proprietary securitizations from 2005 through 2007 was $5.2 billion consisting of $3.7 billion Alt-A mortgage loans and $1.5 billion Jumbo mortgage loans. No FH proprietary securitizations were created after 2007.
Representations and warranties were made to the securitization trustee, as the nominal purchaser of the loans, for the benefit of investors. As of September 30, 2015, the repurchase request pipeline contained no loan repurchase request related to FH proprietary first lien securitizations based on breaches of representations and warranties to the trustee.
FHN’s trustee is a defendant in a lawsuit in which the plaintiffs have asserted that the trustee has duties under federal law to review loans and otherwise act against FHN outside of the duties specified in the applicable trust documents. At September 30, 2015, FHN’s trustee had made no claims against FHN and no litigation by the trustee was pending against FHN.
Interests in securitized loans were sold as securities under prospectuses or other offering documents subject to the disclosure requirements of applicable federal and state securities laws. An investor could pursue (and in certain cases mentioned above, has pursued and is pursuing) a claim alleging that the prospectus or other disclosure documents were deficient by containing materially false or misleading information or by omitting material information. FHN believes a new federal securities law claim cannot be brought at this time due to the running of applicable limitation periods, but other claims might still be possible. Claims of this sort are resolved in a litigation context, unlike FHN’s GSE repurchase experience. FHN’s analysis of loss content and establishment of appropriate liabilities in these cases follow principles and practices associated with litigation matters as discussed above; that process does not involve the repurchase pipeline and repurchase liability.
Other Government Entity Loan Reviews
Certain government entities acting on behalf of several purchasers of FH proprietary and other securitizations have subpoenaed information from FHN and others. These include the FDIC (on behalf of certain failed banks) and the FHLBs of San Francisco, Atlanta, and Seattle, among others. Collectively, the subpoenas seek information concerning: a number of FH proprietary securitizations and/or underlying loan originations; and originations of certain other whole loans sold which, in many cases, were included by the purchaser in its own securitizations. See “Other Whole-Loan Sales” above for additional information concerning loans originated and sold by FHN that were included in other securitizations. Some subpoenas fail to identify the specific investments made or loans at issue. Moreover, FHN has limited information regarding at least some of the loans under review. The FDIC subpoenas partially overlap with the ongoing litigation matters mentioned above under “Litigation- Loss Contingencies.” Unless and until a review becomes an identifiable repurchase claim, the associated loans are not considered part of the repurchase pipeline.
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Private Mortgage Insurance
Private mortgage insurance (“MI”) was required by GSE rules for certain of the loans sold to GSEs and was also provided for certain of the loans that were securitized. MI generally was provided for the first lien loans sold or securitized having a loan-to-value ratio at origination of greater than 80 percent. Although unresolved MI cancellation notices related to GSE-owned loans are not formal repurchase requests, FHN includes these in the active repurchase request pipeline to the extent they relate to securitized loans or are excluded from the DRA settlements with the GSEs mentioned above. FHN tracks and monitors MI cancellation notices received when assessing the overall adequacy of FHN’s repurchase liability.
Established Repurchase Liability
Based on currently available information and experience to date, FHN has evaluated its loan repurchase exposure and has accrued for losses of $115.5 million and $126.2 million as of September 30, 2015 and 2014, respectively, including a smaller amount related to equity-lending junior lien loan sales. FHN used all available information to estimate losses related to potential repurchase obligations not included in the DRAs including future MI rescissions, prior bulk servicing sales where FHN is no longer the directly responsible party but still has repurchase obligations, and obligations related to certain other loan sales, including repurchase obligations related to non-GSE loan sales. Additionally, FHN continues to monitor claims included in the active pipeline, historical repurchase rates, and loss severities. Accrued liabilities for FHN’s estimate of these obligations are reflected in Other liabilities on the Consolidated Condensed Statements of Condition. Charges to increase the liability are included within Repurchase and foreclosure provision on the Consolidated Condensed Statements of Income. The estimates are based upon currently available information and fact patterns that exist as of the balance sheet dates and could be subject to future changes. Changes to any one of these factors could significantly impact the estimate of FHN’s liability.
Servicing and Foreclosure Practices
After the 2008 platform sale a substantial portion of FHN’s first lien portfolio was serviced through subservicing arrangements. FHN’s servicing activities, including foreclosure and loss mitigation practices, initially were outsourced through a subservicing arrangement (the “2008 subservicing agreement”) with the platform buyer (the “2008 subservicer”). FHN entered into a replacement agreement in 2011 with a new subservicer (the “2011 subservicer”). Through third quarter 2013, FHN serviced a mortgage loan portfolio with an unpaid principal balance of approximately $15 billion as of September 30, 2013. In fourth quarter 2013 and first quarter 2014, FHN sold substantially all remaining servicing to the 2011 subservicer. As a result, the loan portfolio serviced by FHN at September 30, 2015 had an unpaid principal balance of $214.8 million. Servicing still retained by FHN continues to be subserviced by the 2011 subservicer.
FHN is subject to losses in its current and former loan servicing portfolio due to loan foreclosures. Foreclosure exposure arises from certain government agency agreements, as well as agreements with MI insurers, which limit the agency’s repayment guarantees on foreclosed loans and allow compensatory fees and penalties and curtailments of claims for violations of agreements or insurance policies, resulting in losses to the servicer. Foreclosure exposure also includes real estate costs, marketing costs, and costs to maintain properties.
In 2011 regulators entered into consent decrees with several institutions, including FHN’s 2008 subservicer, requiring comprehensive revision of loan modification and foreclosure processes, including the remediation of borrowers that have experienced financial harm. In 2012 the 2008 subservicer, along with certain others, entered into a settlement agreement with the OCC which replaced the consent decree.
Under FHN’s 2008 subservicing agreement, the 2008 subservicer had the contractual right to follow FHN’s prior servicing practices as they existed 180 days prior to August 2008 until the 2008 subservicer became aware that such practices did not comply with applicable servicing requirements, subject to the subservicer’s obligation to follow accepted servicing practices, applicable law, and new requirements, including evolving interpretations of such practices, law and requirements. In the event of a dispute such as that described below between FHN and the 2008 subservicer over any liabilities for the subservicer’s servicing and management of foreclosure or loss mitigation processes, FHN cannot predict the loss that may be incurred.
FHN’s 2008 subservicer has presented invoices and made demands under the 2008 subservicing agreement that FHN pay certain costs related to tax service contracts, miscellaneous transfer costs, servicing timeline penalties, compensatory damages, and curtailments charged by GSEs and a government agency prior to FHN’s transfer of subservicing to its 2011 subservicer in the amount of $8.6 million. The 2008 subservicer also is seeking reimbursement from FHN for expenditures the 2008 subservicer has incurred or anticipates it will incur under the consent decree and supervisory guidance relating to foreclosure review (collectively, “foreclosure review expenditures”). The foreclosure review expenditures for which the 2008 subservicer has sought reimbursement total $34.9 million. Although the most recent request was made in 2012, additional reimbursement requests might be made. FHN disagrees with
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the 2008 subservicer’s position and has made no reimbursements. In the event that the 2008 subservicer pursues its position through litigation, FHN believes it has meritorious defenses and intends to defend itself vigorously. FHN also believes that certain amounts billed to FHN by agencies for penalties and curtailments on claims by MI insurers for actions by the 2008 subservicer prior to the 2011 subservicing transfer but billed after that date are owed by the 2008 subservicer. This disagreement has the potential to result in litigation and, in any such future litigation, the claim against FHN may be substantial.
Other Disclosures - Visa Matters
FHN is a member of the Visa USA network. In October 2007, the Visa organization of affiliated entities completed a series of global restructuring transactions to combine its affiliated operating companies, including Visa USA, under a single holding company, Visa Inc. (“Visa”). Upon completion of the reorganization, the members of the Visa USA network remained contingently liable for certain Visa litigation matters (the “Covered Litigation”). Based on its proportionate membership share of Visa USA, FHN recognized a contingent liability in fourth quarter 2007 related to this contingent obligation. In March 2008, Visa completed its initial public offering (“IPO”) and funded an escrow account from its IPO proceeds to be used to make payments related to the Visa litigation matters. FHN received approximately 2.4 million Class B shares in conjunction with Visa’s IPO.
Conversion of these shares into Class A shares of Visa and, with limited exceptions, transfer of these shares is restricted until the final resolution of the covered litigation. In conjunction with the prior sales of Visa Class B shares in December 2010 and September 2011, FHN and the purchasers entered into derivative transactions whereby FHN will make, or receive, cash payments whenever the conversion ratio of the Visa Class B shares into Visa Class A shares is adjusted. The conversion ratio is adjusted when Visa deposits funds into the escrow account to cover certain litigation.
In July 2012, Visa and MasterCard announced a joint settlement (the “Settlement”) related to the Payment Card Interchange matter, one of the Covered Litigation matters. Based on the amount of the Settlement attributable to Visa and an assessment of FHN’s contingent liability accrued for Visa litigation matters, the Settlement did not have a material impact on FHN. In September 2014, Visa funded $450 million into the escrow account, and as a result FHN made a payment to the derivative counterparty of $2.4 million in October 2014. As of September 30, 2015, the conversion ratio is 165 percent reflecting the Visa stock split in March 2015, and the contingent liability is $.8 million. Future funding of the escrow would dilute this exchange rate by an amount that is not determinable at present.
As of September 30, 2015 and 2014, the derivative liabilities were $4.8 million and $7.6 million, respectively.
FHN now holds approximately 1.1 million Visa Class B shares. FHN’s Visa shares are not considered to be marketable and therefore are included in the Consolidated Condensed Statements of Condition at their historical cost of $0. The Settlement has been approved by the court but that approval has been appealed by certain of the plaintiffs and a hearing was conducted in September 2015 but the court has not issued its decision. Accordingly, the outcome of this matter remains uncertain. Additionally, other Covered Litigation matters are also pending judicial resolution, including new matters filed by class members who opted-out of the Settlement. So long as any Covered Litigation matter remains pending, FHN’s ability to transfer its Visa holdings continues to be restricted.
Other Disclosures – Indemnification Agreements and Guarantees
In the ordinary course of business, FHN enters into indemnification agreements for legal proceedings against its directors and officers and standard representations and warranties for underwriting agreements, merger and acquisition agreements, loan sales, contractual commitments, and various other business transactions or arrangements. The extent of FHN’s obligations under these agreements depends upon the occurrence of future events; therefore, it is not possible to estimate a maximum potential amount of payouts that could be required with such agreements.
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Note 11 – Pension, Savings, and Other Employee Benefits
Pension plan. FHN sponsors a noncontributory, qualified defined benefit pension plan to employees hired or re-hired on or before September 1, 2007. Pension benefits are based on years of service, average compensation near retirement or other termination, and estimated social security benefits at age 65. Benefits under the plan are “frozen” so that years of service and compensation changes after 2012 do not affect the benefit owed. The contributions are based upon actuarially determined amounts necessary to fund the total benefit obligation. FHN did not make any contributions to the qualified pension plan in 2014. Future decisions to contribute to the plan will be based upon pension funding requirements under the Pension Protection Act, the maximum amount deductible under the Internal Revenue Code, and the actual performance of plan assets. Management has assessed the need for future contributions, and does not currently anticipate that FHN will make a contribution to the qualified pension plan in 2015.
FHN also maintains non-qualified plans including a supplemental retirement plan that covers certain employees whose benefits under the qualified pension plan have been limited by tax rules. These other non-qualified plans are unfunded, and contributions to these plans cover all benefits paid under the non-qualified plans. Payments made under the non-qualified plans were $5.0 million for 2014. FHN anticipates making benefit payments under the non-qualified plans of $5.0 million in 2015.
Savings plan. FHN provides all qualifying full-time employees with the opportunity to participate in the FHN tax qualified 401(k) savings plan. The qualified plan allows employees to defer receipt of earned salary, up to tax law limits, on a tax-advantaged basis. Accounts, which are held in trust, may be invested in a wide range of mutual funds and in FHN common stock. Up to tax law limits, FHN provides a 100 percent match for the first 6 percent of salary deferred, with company match contributions invested according to a participant’s current investment elections. Through a non-qualified savings restoration plan, FHN provides a restorative benefit to certain highly-compensated employees who participate in the savings plan and whose contribution elections are capped by tax limitations.
Other employee benefits. FHN provides postretirement life insurance benefits to certain employees and also provides postretirement medical insurance benefits to retirement-eligible employees. The postretirement medical plan is contributory with FHN contributing a fixed amount for certain participants. FHN’s postretirement benefits include certain prescription drug benefits. In third quarter 2015, FHN notified participants of revisions to the retiree medical plan effective January 1, 2016. In conjunction with this action, FHN recognized an $8.3 million curtailment gain in third quarter 2015. FHN also recognized a $1.0 million reduction in the plans’ projected benefit obligation and a $5.3 million tax affected adjustment to accumulated other comprehensive income.
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Note 11 – Pension, Savings, and Other Employee Benefits (Continued)
The components of net periodic benefit cost for the three months ended September 30 are as follows:
Components of net periodic benefit cost
Service cost
Interest cost
Expected return on plan assets
Amortization of unrecognized:
Prior service cost/(credit)
Actuarial (gain)/loss
Net periodic benefit cost
ACS 715 curtailment gain
ACS 715 special termination benefits (a)
Total periodic benefit costs
The components of net periodic benefit cost for the nine months ended September 30 are as follows:
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Note 12 – Business Segment Information
FHN has four business segments: regional banking, fixed income, corporate, and non-strategic. The regional banking segment offers financial products and services, including traditional lending and deposit taking, to retail and commercial customers in Tennessee and other selected markets. Regional banking provides investments, financial planning, trust services and asset management, credit card, and cash management. Additionally, the regional banking segment includes correspondent banking which provides credit, depository, and other banking related services to other financial institutions nationally. The fixed income segment consists of fixed income sales, trading, and strategies for institutional clients in the U.S. and abroad, as well as loan sales, portfolio advisory, and derivative sales. The corporate segment consists of unallocated corporate expenses, expense on subordinated debt issuances, bank-owned life insurance, unallocated interest income associated with excess equity, net impact of raising incremental capital, revenue and expense associated with deferred compensation plans, funds management, tax credit investment activities, acquisition-related costs, and various charges related to restructuring, repositioning, and efficiency initiatives. The non-strategic segment consists of the wind-down national consumer lending activities, legacy mortgage banking elements including servicing fees (in periods subsequent to first quarter 2014 these amounts are significantly lower), and the associated ancillary revenues and expenses related to these businesses. Non-strategic also includes the wind-down trust preferred loan portfolio and exited businesses along with the associated restructuring, repositioning, and efficiency charges.
Periodically, FHN adapts its segments to reflect managerial or strategic changes. FHN may also modify its methodology of allocating expenses and equity among segments which could change historical segment results. Total revenue, expense, and asset levels reflect those which are specifically identifiable or which are allocated based on an internal allocation method. Because the allocations are based on internally developed assignments and allocations, they are to an extent subjective. Generally, all assignments and allocations have been consistently applied for all periods presented. The following table reflects the amounts of consolidated revenue, expense, tax, and assets for each segment for the three and nine months ended September 30:
Three Months Ended
September 30
Nine Months Ended
Consolidated
Noninterest income
Noninterest expense
Income/(loss) before income taxes
Average assets
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Note 12 – Business Segment Information (Continued)
Regional Banking
Fixed Income
Corporate
Net interest income/(expense)
Non-Strategic
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Note 13 – Variable Interest Entities
ASC 810 defines a VIE as an entity where the equity investors, as a group, lack either (1) the power through voting rights, or similar rights, to direct the activities of an entity that most significantly impact the entity’s economic performance, (2) the obligation to absorb the expected losses of the entity, (3) the right to receive the expected residual returns of the entity, or (4) sufficient equity at risk for the entity to finance its activities by itself. A variable interest is a contractual ownership, or other interest, that fluctuates with changes in the fair value of the VIE’s net assets exclusive of variable interests. Under ASC 810, as amended, a primary beneficiary is required to consolidate a VIE when it has a variable interest in a VIE that provides it with a controlling financial interest. For such purposes, the determination of whether a controlling financial interest exists is based on whether a single party has both the power to direct the activities of the VIE that most significantly impact the VIE’s economic performance and the obligation to absorb losses of the VIE or the right to receive benefits from the VIE that could potentially be significant.
Consolidated Variable Interest Entities
FHN holds variable interests in a proprietary residential mortgage securitization trust it established prior to 2008 as a source of liquidity for consumer lending operations. Based on its restrictive nature, the trust is considered a VIE as the holders of equity at risk do not have the power through voting rights or similar rights to direct the activities that most significantly impact the trusts’ economic performance. In situations where the retention of MSR and other retained interests, including residual interests, results in FHN potentially absorbing losses or receiving benefits that are significant to the trust, FHN is considered the primary beneficiary, as it is also assumed to have the power as servicer to most significantly impact the activities of the VIE. Consolidation of the trust results in the recognition of the trust proceeds as restricted borrowings since the cash flows on the securitized loans can only be used to settle the obligations due to the holders of the trust securities. Except for recourse due to breaches of representations and warranties made by FHN in connection with the sale of the loans to the trust, the creditors of the trust hold no recourse to the assets of FHN. The only trust included in the September 30, 2015 and September 30, 2014 balance of consolidated proprietary residential mortgage securitizations is a HELOC securitization trust that has entered a rapid amortization period and for which FHN is obligated to provide subordinated funding. During this period, cash payments from borrowers are accumulated to repay outstanding debt securities while FHN continues to make advances to borrowers when they draw on their lines of credit. FHN then transfers the newly generated receivables into the securitization trust and is reimbursed only after other parties in the securitization have received all of the cash flows to which they are entitled. If loan losses requiring draws on the related monoline insurers’ policies, which protect bondholders in the securitization, exceed a certain level, FHN may not receive reimbursement for all of the funds advanced to borrowers, as the senior bondholders and the monoline insurers typically have priority for repayment. This securitization trust is currently consolidated by FHN due to FHN’s status as the Master Servicer for the securitization and the retention of a significant residual interest. Because the trust is consolidated, amounts funded from monoline insurance policies are considered as additional restricted term borrowings in FHN’s Consolidated Condensed Statements of Condition.
FHN has established certain rabbi trusts related to deferred compensation plans offered to its employees. FHN contributes employee cash compensation deferrals to the trusts and directs the underlying investments made by the trusts. The assets of these trusts are available to FHN’s creditors only in the event that FHN becomes insolvent. These trusts are considered VIEs as there is no equity at risk in the trusts since FHN provided the equity interest to its employees in exchange for services rendered. FHN is considered the primary beneficiary of the rabbi trusts as it has the power to direct the activities that most significantly impact the economic performance of the rabbi trusts through its ability to direct the underlying investments made by the trusts. Additionally, FHN could potentially receive benefits or absorb losses that are significant to the trusts due to its right to receive any asset values in excess of liability payoffs and its obligation to fund any liabilities to employees that are in excess of a rabbi trust’s assets.
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Note 13 – Variable Interest Entities (Continued)
The following table summarizes VIEs consolidated by FHN as of September 30, 2015 and 2014:
Less: Allowance for loan losses
Liabilities:
Nonconsolidated Variable Interest Entities
Low Income Housing Partnerships. First Tennessee Housing Corporation (“FTHC”), a wholly-owned subsidiary of FTBNA, makes equity investments as a limited partner in various partnerships that sponsor affordable housing projects utilizing the Low Income Housing Tax Credit (“LIHTC”) pursuant to Section 42 of the Internal Revenue Code. The purpose of these investments is to achieve a satisfactory return on capital and to support FHN’s community reinvestment initiatives. The activities of the limited partnerships include the identification, development, and operation of multi-family housing that is leased to qualifying residential tenants generally within FHN’s primary geographic region. LIHTC partnerships are considered VIEs as FTHC, the holder of the equity investment at risk, does not have the ability to direct the activities that most significantly affect the performance of the entity through voting rights or similar rights. FTHC could absorb losses that are significant to the LIHTC partnerships as it has a risk of loss for its capital contributions and funding commitments to each partnership. The general partners are considered the primary beneficiaries as managerial functions give them the power to direct the activities that most significantly impact the entities’ economic performance and the managing members are exposed to all losses beyond FTHC’s initial capital contributions and funding commitments.
LIHTC investments that do not qualify for the proportional amortization method as defined in ASU 2014-01 and discussed in Note 1 are accounted for using the equity method. Expenses associated with these investments were not material for the three and nine months ended September 30, 2015 and 2014. The following table summarizes the impact to the Provision/(benefit) for income taxes on the Consolidated Condensed Statements of Income for the three and nine month periods ending September 30, 2015 and 2014 for LIHTC investments accounted for under the proportional amortization method.
Provision/(benefit) for income taxes:
Amortization of qualifying LIHTC investments
Low income housing tax credits
Other tax benefits related to qualifying LIHTC investments
Other Tax Credit Investments. First Tennessee New Markets Corporation (“FTNMC”), a wholly-owned subsidiary of FTBNA, makes equity investments through wholly-owned subsidiaries as a non-managing member in various limited liability companies (“LLCs”) that sponsor community development projects utilizing the New Market Tax Credit (“NMTC”) pursuant to Section 45 of the Internal Revenue Code. The purpose of these investments is to achieve a satisfactory return on capital and to support FHN’s community reinvestment initiatives. The activities of the LLCs include providing investment capital for low-income communities within FHN’s primary geographic region. A portion of the funding of FTNMC’s investment in a NMTC LLC is obtained via a loan from an unrelated third-party that is typically a community development enterprise. The NMTC LLCs are considered VIEs as FTNMC, the holder of the equity investment at risk, does not have the ability to direct the activities that most significantly affect the performance of the entity through voting rights or similar rights. While FTNMC could absorb losses that are significant to the NMTC LLCs as it has a risk of loss for its initial capital contributions, the managing members are considered the primary beneficiaries as managerial functions give them the power to direct the activities that most significantly impact the NMTC LLCs’ economic performance and the managing members are exposed to all losses beyond FTNMC’s initial capital contributions.
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FTHC also makes equity investments as a limited partner or non-managing member in entities that receive Historic Tax Credits pursuant to Section 47 of the Internal Revenue Code. The purpose of these entities is the rehabilitation of historic buildings with the tax credits provided to incent private investment in the historic cores of cities and towns. These entities are considered VIEs as FTHC, the holder of the equity investment at risk, does not have the ability to direct the activities that most significantly affect the performance of the entity through voting rights or similar rights. FTHC could absorb losses that are significant to the entities as it has a risk of loss for its capital contributions and funding commitments to each partnership. The managing members are considered the primary beneficiaries as managerial functions give them the power to direct the activities that most significantly impact the entities’ economic performance and the managing members are exposed to all losses beyond FTHC’s initial capital contributions and funding commitments.
Small Issuer Trust Preferred Holdings. FTBNA holds variable interests in trusts which have issued mandatorily redeemable preferred capital securities (“trust preferreds”) for smaller banking and insurance enterprises. FTBNA has no voting rights for the trusts’ activities. The trusts’ only assets are junior subordinated debentures of the issuing enterprises. The creditors of the trusts hold no recourse to the assets of FTBNA. These trusts meet the definition of a VIE as the holders of the equity investment at risk do not have the power through voting rights, or similar rights, to direct the activities that most significantly impact the trusts’ economic performance. Based on the nature of the trusts’ activities and the size of FTBNA’s holdings, FTBNA could potentially receive benefits or absorb losses that are significant to the trusts regardless of whether a majority of a trust’s securities are held by FTBNA. However, since FTBNA is solely a holder of the trusts’ securities, it has no rights which would give it the power to direct the activities that most significantly impact the trusts’ economic performance and thus it is not considered the primary beneficiary of the trusts. FTBNA has no contractual requirements to provide financial support to the trusts.
On-Balance Sheet Trust Preferred Securitization. In 2007, FTBNA executed a securitization of certain small issuer trust preferreds for which the underlying trust meets the definition of a VIE as the holders of the equity investment at risk do not have the power through voting rights, or similar rights, to direct the activities that most significantly impact the entity’s economic performance. FTBNA could potentially receive benefits or absorb losses that are significant to the trust based on the size and priority of the interests it retained in the securities issued by the trust. However, since FTBNA did not retain servicing or other decision making rights, FTBNA is not the primary beneficiary as it does not have the power to direct the activities that most significantly impact the trust’s economic performance. Accordingly, FTBNA has accounted for the funds received through the securitization as a term borrowing in its Consolidated Condensed Statements of Condition. FTBNA has no contractual requirements to provide financial support to the trust.
Proprietary Trust Preferred Issuances. FHN previously issued junior subordinated debt to First Tennessee Capital II (“Capital II”). Capital II was considered a VIE as FHN’s capital contributions to this trust were not considered “at risk” in evaluating whether the holders of the equity investments at risk in the trust had the power through voting rights, or similar rights, to direct the activities that most significantly impacted the entity’s economic performance. FHN was not the trust’s primary beneficiary as FHN’s capital contributions to the trust were not considered variable interests as they were not “at risk”. Consequently, Capital II was not consolidated by FHN. In third quarter 2015 FHN redeemed its junior subordinated debt, and as a result Capital II redeemed its 6.30 percent Capital Securities, Series B, and the trust was collapsed.
Proprietary Residential Mortgage Securitizations. FHN holds variable interests in proprietary residential mortgage securitization trusts it established prior to 2008 as a source of liquidity for its mortgage banking operations. Except for recourse due to breaches of representations and warranties made by FHN in connection with the sale of the loans to the trusts, the creditors of the trusts hold no recourse to the assets of FHN. Additionally, FHN has no contractual requirements to provide financial support to the trusts. Based on their restrictive nature, the trusts are considered VIEs as the holders of equity at risk do not have the power through voting rights, or similar rights, to direct the activities that most significantly impact the trusts’ economic performance. While FHN is assumed to have the power as servicer to most significantly impact the activities of such VIEs, in situations where FHN does not have the ability to participate in significant portions of a securitization trust’s cash flows FHN is not considered the primary beneficiary of the trust. Therefore, these trusts are not consolidated by FHN.
Agency Residential Mortgage Securitizations. Prior to third quarter 2008, FHN transferred first lien mortgages that were included in Agency-sponsored securitizations and retained MSR and in certain situations various other interests. Except for recourse due to breaches of representations and warranties made by FHN in connection with the sale of the loans to the trusts, the creditors of the trusts held no recourse to the assets of FHN. Additionally, FHN had no contractual requirements to provide financial support to the trusts. The Agencies’ or designated third parties’ status as Master Servicer and the rights they hold consistent with their guarantees on the securities issued provide them with the power to direct the activities that most significantly impact the trusts’ economic performance. Thus, such trusts were not consolidated by FHN as it was not considered the primary beneficiary even in situations where it could potentially receive benefits or absorb losses that were significant to the trusts.
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Holdings & Short Positions in Agency Mortgage-Backed Securities.FHN holds securities issued by various Agency securitization trusts. Based on their restrictive nature, the trusts meet the definition of a VIE since the holders of the equity investments at risk do not have the power through voting rights, or similar rights, to direct the activities that most significantly impact the entities’ economic performance. FHN could potentially receive benefits or absorb losses that are significant to the trusts based on the nature of the trusts’ activities and the size of FHN’s holdings. However, FHN is solely a holder of the trusts’ securities and does not have the power to direct the activities that most significantly impact the trusts’ economic performance, and is not considered the primary beneficiary of the trusts. FHN has no contractual requirements to provide financial support to the trusts.
Commercial Loan Troubled Debt Restructurings. For certain troubled commercial loans, FTBNA restructures the terms of the borrower’s debt in an effort to increase the probability of receipt of amounts contractually due. Following a troubled debt restructuring, the borrower entity typically meets the definition of a VIE as the initial determination of whether an entity is a VIE must be reconsidered as events have proven that the entity’s equity is not sufficient to permit it to finance its activities without additional subordinated financial support or a restructuring of the terms of its financing. As FTBNA does not have the power to direct the activities that most significantly impact such troubled commercial borrowers’ operations, it is not considered the primary beneficiary even in situations where, based on the size of the financing provided, FTBNA is exposed to potentially significant benefits and losses of the borrowing entity. FTBNA has no contractual requirements to provide financial support to the borrowing entities beyond certain funding commitments established upon restructuring of the terms of the debt that allows for preparation of the underlying collateral for sale.
Managed Discretionary Trusts. FHN serves as manager over certain discretionary trusts for which it makes investment decisions on behalf of the trusts’ beneficiaries in return for a reasonable management fee. The trusts meet the definition of a VIE since the holders of the equity investments at risk do not have the power, through voting rights or similar rights, to direct the activities that most significantly impact the entities’ economic performance. The management fees FHN receives are not considered variable interests in the trusts as all of the requirements related to permitted levels of decision maker fees are met. Therefore, the VIEs are not consolidated by FHN as it is not the trusts’ primary beneficiary. FHN has no contractual requirements to provide financial support to the trusts.
The following table summarizes FHN’s nonconsolidated VIEs as of September 30, 2015:
Classification
Type
Low income housing partnerships
Other Tax Credit Investments (b) (c)
Small issuer trust preferred holdings (d)
On-balance sheet trust preferred securitization
Proprietary and agency residential mortgage securitizations
Holdings of agency mortgage-backed securities (d)
Short positions in agency mortgage-backed securities (f)
Commercial loan troubled debt restructurings (i) (j)
Managed discretionary trusts (f)
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The following table summarizes FHN’s nonconsolidated VIEs as of September 30, 2014:
Proprietary trust preferred issuances (f)
Certain previously reported amounts have been revised to reflect the retroactive effect of the adoption of ASU 2014-01, “Equity Method and Joint Ventures: Accounting for Investments in Qualified Affordable Housing Projects.” See Note 1—Financial Information for additional information.
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Note 14 – Derivatives
In the normal course of business, FHN utilizes various financial instruments (including derivative contracts and credit-related agreements) through its fixed income and risk management operations, as part of its risk management strategy and as a means to meet customers’ needs. Derivative instruments are subject to credit and market risks in excess of the amount recorded on the balance sheet as required by GAAP. The contractual or notional amounts of these financial instruments do not necessarily represent credit or market risk. However, they can be used to measure the extent of involvement in various types of financial instruments. Controls and monitoring procedures for these instruments have been established and are routinely reevaluated. The Asset/Liability Committee (“ALCO”) controls, coordinates, and monitors the usage and effectiveness of these financial instruments.
Credit risk represents the potential loss that may occur if a party to a transaction fails to perform according to the terms of the contract. The measure of credit exposure is the replacement cost of contracts with a positive fair value. FHN manages credit risk by entering into financial instrument transactions through national exchanges, primary dealers or approved counterparties, and by using mutual margining and master netting agreements whenever possible to limit potential exposure. FHN also maintains collateral posting requirements with certain counterparties to limit credit risk. On September 30, 2015 and 2014, respectively, FHN had $88.6 million and $89.8 million of cash receivables and $47.4 million and $68.1 million of cash payables related to collateral posting under master netting arrangements, inclusive of collateral posted related to contracts with adjustable collateral posting thresholds and over collateralized positions, with derivative counterparties. With exchange-traded contracts, the credit risk is limited to the clearinghouse used. For non-exchange traded instruments, credit risk may occur when there is a gain in the fair value of the financial instrument and the counterparty fails to perform according to the terms of the contract and/or when the collateral proves to be of insufficient value. See additional discussion regarding master netting agreements and collateral posting requirements later in this note under the heading “Master Netting and Similar Agreements.” Market risk represents the potential loss due to the decrease in the value of a financial instrument caused primarily by changes in interest rates or the prices of debt instruments. FHN manages market risk by establishing and monitoring limits on the types and degree of risk that may be undertaken. FHN continually measures this risk through the use of models that measure value-at-risk and earnings-at-risk.
Derivative Instruments. FHN enters into various derivative contracts both in a dealer capacity, to facilitate customer transactions, and as a risk management tool. Where contracts have been created for customers, FHN enters into transactions with dealers to offset its risk exposure. Contracts with dealers that require central clearing are novated to a clearing agent who becomes FHN’s counterparty. Derivatives are also used as a risk management tool to hedge FHN’s exposure to changes in interest rates or other defined market risks.
Forward contracts are over-the-counter contracts where two parties agree to purchase and sell a specific quantity of a financial instrument at a specified price, with delivery or settlement at a specified date. Futures contracts are exchange-traded contracts where two parties agree to purchase and sell a specific quantity of a financial instrument at a specified price, with delivery or settlement at a specified date. Interest rate option contracts give the purchaser the right, but not the obligation, to buy or sell a specified quantity of a financial instrument, at a specified price, during a specified period of time. Caps and floors are options that are linked to a notional principal amount and an underlying indexed interest rate. Interest rate swaps involve the exchange of interest payments at specified intervals between two parties without the exchange of any underlying principal. Swaptions are options on interest rate swaps that give the purchaser the right, but not the obligation, to enter into an interest rate swap agreement during a specified period of time.
Trading Activities
FHN’s fixed income segment trades U.S. Treasury, U.S. Agency, mortgage-backed, corporate and municipal fixed income securities, and other securities for distribution to customers. When these securities settle on a delayed basis, they are considered forward contracts. Fixed income also enters into interest rate contracts, including caps, swaps, and floors, for its customers. In addition, fixed income enters into futures and option contracts to economically hedge interest rate risk associated with a portion of its securities inventory. These transactions are measured at fair value, with changes in fair value recognized currently in fixed income noninterest income. Related assets and liabilities are recorded on the Consolidated Condensed Statements of Condition as Derivative assets and Derivative liabilities. The FTN Financial Risk Committee and the Credit Risk Management Committee collaborate to mitigate credit risk related to these transactions. Credit risk is controlled through credit approvals, risk control limits, and ongoing monitoring procedures. Total trading revenues were $43.0 million and $41.2 million for the three months ended September 30, 2015 and 2014, respectively, and $143.2 million and $131.3 million for the nine months ended September 30, 2015 and 2014, respectively. Total revenues are inclusive of both derivative and non-derivative financial instruments, and are included in fixed income noninterest income.
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Note 14 – Derivatives (Continued)
The following tables summarize FHN’s derivatives associated with fixed income trading activities as of September 30, 2015 and 2014:
Customer Interest Rate Contracts
Offsetting Upstream Interest Rate Contracts
Option Contracts Purchased
Forwards and Futures Purchased
Forwards and Futures Sold
Option Contracts Written
Interest Rate Risk Management
FHN’s ALCO focuses on managing market risk by controlling and limiting earnings volatility attributable to changes in interest rates. Interest rate risk exists to the extent that interest-earning assets and interest-bearing liabilities have different maturity or repricing characteristics. FHN uses derivatives, including swaps, caps, options, and collars, that are designed to moderate the impact on earnings as interest rates change. Interest paid or received for swaps utilized by FHN to hedge the fair value of long term debt is recognized as an adjustment of the interest expense of the liabilities whose risk is being managed. FHN’s interest rate risk management policy is to use derivatives to hedge interest rate risk or market value of assets or liabilities, not to speculate. In addition, FHN has entered into certain interest rate swaps and caps as a part of a product offering to commercial customers that includes customer derivatives paired with upstream offsetting market instruments that, when completed, are designed to mitigate interest rate risk. These contracts do not qualify for hedge accounting and are measured at fair value with gains or losses included in current earnings in Noninterest expense on the Consolidated Condensed Statements of Income.
FHN has entered into pay floating, receive fixed interest rate swaps to hedge the interest rate risk of certain term borrowings totaling $250.0 million and $554.0 million on September 30, 2015 and 2014, respectively. These swaps have been accounted for as fair value hedges under the shortcut method. The balance sheet amount of these swaps was $6.1 million and $21.4 million in Derivative assets on September 30, 2015 and 2014, respectively. $304.0 million of these borrowings matured in January 2015.
FHN has designated a derivative transaction in a hedging strategy to manage interest rate risk on its $500 million noncallable senior debt maturing in December 2015. This derivative qualifies for hedge accounting under ASC 815-20 using the long-haul method. FHN entered into a pay floating, receive fixed interest rate swap to hedge the interest rate risk on this debt. The balance sheet amount of this swap was $2.1 million and $11.3 million in Derivative assets as of September 30, 2015 and 2014, respectively. There was no ineffectiveness related to this hedge.
Prior to third quarter 2015, FHN designated derivative transactions in hedging strategies to manage interest rate risk on subordinated debt related to its trust preferred securities. These qualified for hedge accounting under ASC 815-20 using the long-haul method. FHN hedged the interest rate risk of the subordinated debt totaling $200 million using a pay floating, receive fixed interest rate swap. The balance sheet amount of this swap was $9.8 million in Derivative liabilities as of September 30, 2014. There was no ineffectiveness related to this hedge. In third quarter 2015, FHN called its junior subordinated debt, which triggered a call of the trust preferred securities, and removed all associated hedges. The redemption resulted in a gain on extinguishment of debt of $5.8 million.
FHN has designated a derivative transaction in a hedging strategy to manage interest rate risk on $400.0 million of senior debt issued by FTBNA which matures in December 2019. This qualifies for hedge accounting under ASC 815-20 using the long-haul method. FHN entered into a pay floating, receive fixed interest rate swap to hedge the interest rate risk of the senior debt. The balance sheet impact of this swap was $8.8 million in Derivative assets as of September 30, 2015. There was an insignificant level of ineffectiveness related to this hedge.
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The following tables summarize FHN’s derivatives associated with interest rate risk management activities as of and for the three and nine months ended September 30, 2015 and 2014:
Customer Interest Rate Contracts Hedging
Hedging Instruments and Hedged Items:
Customer Interest Rate Contracts (a)
Offsetting Upstream Interest Rate Contracts (a)
Debt Hedging
Hedging Instruments:
Interest Rate Swaps (b)
Hedged Items:
Term Borrowings (b)
FHN hedges held-to-maturity trust preferred loans which have an initial fixed rate term before conversion to a floating rate. FHN has entered into pay fixed, receive floating interest rate swaps to hedge the interest rate risk associated with this initial term. Interest paid or received for these swaps is recognized as an adjustment of the interest income of the assets whose risk is being hedged. Basis adjustments remaining at the end of the hedge term are being amortized as an adjustment to interest income over the remaining life of the loans. Gains or losses are included in Other income and commissions on the Consolidated Condensed Statements of Income.
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The following tables summarize FHN’s derivative activities associated with held-to-maturity trust preferred loans as of and for the three and nine months ended September 30, 2015 and 2014:
Loan Portfolio Hedging
Interest Rate Swaps
Trust Preferred Loans (a)
Other Derivatives
In conjunction with the sales of a portion of its Visa Class B shares, FHN and the purchaser entered into derivative transactions whereby FHN will make or receive cash payments whenever the conversion ratio of the Visa Class B shares into Visa Class A shares is adjusted. As of September 30, 2015, the derivative liabilities associated with the sales of Visa Class B shares were $4.8 million compared to $7.6 million as of September 30, 2014. See the Visa Matters section of Note 10 – Contingencies and Other Disclosures for more information regarding FHN’s Visa shares.
FHN utilizes cross currency swaps and cross currency interest rate swaps to economically hedge its exposure to foreign currency risk and interest rate risk associated with non-U.S. dollar denominated loans. As of September 30, 2015, these loans were valued at $2.8 million. The balance sheet amount and the gains/losses associated with these derivatives were not significant. As of September 30, 2014, these loans were settled and so were the derivatives associated with them.
Master Netting and Similar Agreements
As previously discussed, FHN uses master netting agreements, mutual margining agreements and collateral posting requirements to minimize credit risk on derivative contracts. Master netting and similar agreements are used when counterparties have multiple derivatives contracts that allow for a “right of setoff,” meaning that a counterparty may net offsetting positions and collateral with the same counterparty under the contract to determine a net receivable or payable. The following discussion provides an overview of these arrangements which may vary due to the derivative type and market in which a derivative transaction is executed.
Interest rate derivatives are subject to agreements consistent with standard agreement forms of the International Swap and Derivatives Association (“ISDA”). Currently, all interest rate derivative contracts are entered into as over-the-counter transactions and collateral posting requirements are based on the net asset or liability position with each respective counterparty. For contracts that require central clearing, novation to a counterparty with access to a clearinghouse occurs and collateral is posted. Cash collateral received (posted) for interest rate derivatives is recognized as a liability (asset) on FHN’s balance sheet.
Interest rate derivatives with customers that are smaller financial institutions typically require posting of collateral by the counterparty to FHN. This collateral is subject to a threshold with daily adjustments based upon changes in the level or fair value of the derivative position. Positions and related collateral can be netted in the event of default. Collateral pledged by a counterparty is typically cash or securities. The securities pledged as collateral are not recognized within FHN’s Consolidated Condensed Statements of Condition. Interest rate derivatives associated with lending arrangements share the collateral with the related loan(s). The derivative and loan positions may be netted in the event of default. For disclosure purposes, the entire collateral amount is allocated to the loan.
Interest rate derivatives with larger financial institutions entered into prior to required central clearing typically contain provisions whereby the collateral posting thresholds under the agreements adjust based on the credit ratings of both counterparties. If the credit
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rating of FHN and/or FTBNA is lowered, FHN could be required to post additional collateral with the counterparties. Conversely, if the credit rating of FHN and/or FTBNA is increased, FHN could have collateral released and be required to post less collateral in the future. Also, if a counterparty’s credit ratings were to decrease, FHN and/or FTBNA could require the posting of additional collateral; whereas if a counterparty’s credit ratings were to increase, the counterparty could require the release of excess collateral. Collateral for these arrangements is adjusted daily based on changes in the net fair value position with each counterparty.
The net fair value, determined by individual counterparty, of all derivative instruments with adjustable collateral posting thresholds was $93.1 million of assets and $79.7 million of liabilities on September 30, 2015, and $104.7 million of assets and $77.6 million of liabilities on September 30, 2014. As of September 30, 2015 and 2014, FHN had received collateral of $156.9 million and $191.5 million and posted collateral of $79.9 million and $80.6 million, respectively, in the normal course of business related to these agreements.
Certain agreements entered into prior to required central clearing also contain accelerated termination provisions, inclusive of the right of offset, if a counterparty’s credit rating falls below a specified level. If a counterparty’s debt rating (including FHN’s and FTBNA’s) were to fall below these minimums, these provisions would be triggered, and the counterparties could terminate the agreements and require immediate settlement of all derivative contracts under the agreements. The net fair value, determined by individual counterparty, of all derivative instruments with credit-risk-related contingent accelerated termination provisions was $93.1 million of assets and $20.2 million of liabilities on September 30, 2015, and $104.7 million of assets and $19.1 million of liabilities on September 30, 2014. As of September 30, 2015 and 2014, FHN had received collateral of $156.9 million and $191.5 million and posted collateral of $24.6 million and $26.3 million, respectively, in the normal course of business related to these contracts.
FHN’s fixed income segment buys and sells various types of securities for its customers. When these securities settle on a delayed basis, they are considered forward contracts, and are generally not subject to master netting agreements. For futures and options, FHN transacts through a third party, and the transactions are subject to margin and collateral maintenance requirements. In the event of default, open positions can be offset along with the associated collateral.
For this disclosure, FHN considers the impact of master netting and other similar agreements which allow FHN to settle all contracts with a single counterparty on a net basis and to offset the net derivative asset or liability position with the related securities and cash collateral. The application of the collateral cannot reduce the net derivative asset or liability position below zero, and therefore any excess collateral is not reflected in the tables below.
The following table provides a detail of derivative assets and collateral received as presented on the Consolidated Condensed Statements of Condition as of September 30:
Derivative assets:
2015 (b)
2014 (b)
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The following table provides a detail of derivative liabilities and collateral pledged as presented on the Consolidated Condensed Statements of Condition as of September 30:
Derivative liabilities:
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Note 15 – Master Netting and Similar Agreements - Repurchase, Reverse Repurchase, and Securities Borrowing and Lending Transactions
For repurchase, reverse repurchase and securities borrowing and lending transactions, FHN and each counterparty have the ability to offset all open positions and related collateral in the event of default. Due to the nature of these transactions, the value of the collateral for each transaction approximates the value of the corresponding receivable or payable. For repurchase agreements within FHN’s fixed income business, transactions are collateralized by securities which are delivered on the settlement date and are maintained throughout the term of the transaction. For FHN’s repurchase agreements through banking activities, securities are typically pledged at the time of the transaction and not released until settlement. For asset positions, the collateral is not included on FHN’s Consolidated Condensed Statements of Condition. For liability positions, securities collateral pledged by FHN is generally represented within FHN’s trading or available-for-sale securities portfolios.
For this disclosure, FHN considers the impact of master netting and other similar agreements that allow FHN to settle all contracts with a single counterparty on a net basis and to offset the net asset or liability position with the related securities collateral. The application of the collateral cannot reduce the net asset or liability position below zero, and therefore any excess collateral is not reflected in the tables below.
The following table provides a detail of Securities purchased under agreements to resell as presented on the Consolidated Condensed Statements of Condition and collateral pledged by counterparties as of September 30:
Securities purchased under agreements to resell:
The following table provides a detail of Securities sold under agreements to repurchase as presented on the Consolidated Condensed Statements of Condition and collateral pledged by FHN as of September 30:
Securities sold under agreements to repurchase:
Due to the short duration of Securities sold under agreements to repurchase and the nature of collateral involved, the risks associated with these transactions are considered minimal. The following table provides a detail, by collateral type, of the remaining contractual maturity of Securities sold under agreements to repurchase as of September 30:
Total Securities sold under agreements to repurchase
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Note 16 – Fair Value of Assets & Liabilities
FHN groups its assets and liabilities measured at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. This hierarchy requires FHN to maximize the use of observable market data, when available, and to minimize the use of unobservable inputs when determining fair value. Each fair value measurement is placed into the proper level based on the lowest level of significant input. These levels are:
Transfers between fair value levels are recognized at the end of the fiscal quarter in which the associated change in inputs occurs.
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Note 16 – Fair Value of Assets & Liabilities (Continued)
Recurring Fair Value Measurements
The following table presents the balance of assets and liabilities measured at fair value on a recurring basis as of September 30, 2015:
Trading securities - fixed income:
Trading Loans
Corporate and other debt
Equity, mutual funds, and other
Total trading securities - fixed income
Trading securities - mortgage banking
Loans held-for-sale
Total securities available-for-sale
Other assets:
Mortgage servicing rights
Deferred compensation assets
Derivatives, forwards and futures
Derivatives, interest rate contracts
Derivatives, other
Total other assets
Trading liabilities - fixed income:
Total trading liabilities - fixed income
Other liabilities:
Total other liabilities
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The following table presents the balance of assets and liabilities measured at fair value on a recurring basis as of September 30, 2014:
Certain previously reported amounts have been reclassified to agree with current presentation.
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Changes in Recurring Level 3 Fair Value Measurements
The changes in Level 3 assets and liabilities measured at fair value for the three months ended September 30, 2015 and 2014, on a recurring basis are summarized as follows:
Balance on July 1, 2015
Total net gains/(losses) included in:
Net income
Other comprehensive income /(loss)
Issuances
Settlements
Net transfers into/(out of) Level 3
Balance on September 30, 2015
Net unrealized gains/(losses) included in net income
Balance on July 1, 2014
Balance on September 30, 2014
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The changes in Level 3 assets and liabilities measured at fair value for the nine months ended September 30, 2015 and 2014, on a recurring basis are summarized as follows:
Balance on January 1, 2015
Other comprehensive income / (loss)
Balance on January 1, 2014
In third quarter 2014, FHN completed sales of first lien mortgage loans from its loans held-for-sale portfolio. The sale populations primarily represented loans that had been originated with the intent to sell to FNMA or FHLMC and consisted of repurchased loans as well as loans that remained after FHN’s exit of mortgage origination activities in 2008. Smaller amounts of jumbo loans were also included in the sale, along with some loans insured under government programs. Almost all of these loans had been accounted for at elected fair value (a recurring measurement) with a small amount having been accounted for as LOCOM loans (a nonrecurring measurement). The contracted sale values for the loans reflected a substantial improvement in pricing for pre-2009 vintage first lien mortgages in comparison to FHN’s historical methodologies used to estimate fair value, which incorporate significant Level 3 inputs within a discounted cash flow model. Accordingly, the loans being sold were marked to the revised estimate of fair value during the quarter and the pricing evidence from the sale transactions was considered a Level 2 input within the valuation process for the remaining non-governmental guaranteed portion of first lien mortgage loans held-for-sale.
Nonrecurring Fair Value Measurements
From time to time, FHN may be required to measure certain other financial assets at fair value on a nonrecurring basis in accordance with GAAP. These adjustments to fair value usually result from the application of LOCOM accounting or write-downs of individual assets. For assets measured at fair value on a nonrecurring basis which were still held on the balance sheet at September 30, 2015 and 2014, respectively, the following tables provide the level of valuation assumptions used to determine each adjustment, the related carrying value, and the fair value adjustments recorded during the respective periods.
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Loans held-for-sale - first mortgages
Loans, net of unearned income (a)
Real estate acquired by foreclosure (b)
Other assets (c)
Loans held-for-sale - SBAs
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Level 3 Measurements
The following tables provide information regarding the unobservable inputs utilized in determining the fair value of level 3 recurring and non-recurring measurements as of September 30, 2015 and 2014:
Level 3 Class
Valuation Techniques
Unobservable Input
Values Utilized
Trading securities - mortgage
Loans held-for-sale - residential real estate
Derivative liabilities, other
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Trading securities-mortgage. Prepayment rates and credit spreads (part of the discount rate) are significant unobservable inputs used in the fair value measurement of FHN’s mortgage trading securities which include interest-only strips, principal-only strips, and subordinated bonds. Increases in prepayment rates and credit spreads in isolation would result in significantly lower fair value measurements for the associated assets. Conversely, decreases in prepayment rates and credit spreads in isolation would result in significantly higher fair value measurements for the associated assets. Generally, when market interest rates decline and other factors favorable to prepayments occur, there is a corresponding increase in prepayment rates as customers are expected to refinance existing mortgages under more favorable interest rate terms. Generally, changes in discount rates directionally mirror the changes in market interest rates. FHN’s Corporate Accounting Department monitors changes in the fair value of these securities monthly.
Loans held-for-sale. Foreclosure losses in 2015, credit spreads and delinquency adjustment factors in 2014, and prepayment rates in 2015 and 2014 are significant unobservable inputs used in the fair value measurement of FHN’s residential real estate loans held-for-sale. Loss severity trends are also assessed to evaluate the reasonableness of fair value estimates resulting from discounted cash flows methodologies as well as to estimate fair value for newly repurchased loans and loans that are near foreclosure. Significant increases (decreases) in any of these inputs in isolation would result in significantly lower (higher) fair value measurements. Draw rates are an additional significant unobservable input for HELOCs. Increases (decreases) in the draw rate estimates for HELOCs would increase (decrease) their fair value. All observable and unobservable inputs are re-assessed quarterly. Fair value measurements are reviewed at least quarterly by FHN’s Corporate Accounting Department.
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Derivative liabilities. In conjunction with the sales of portions of its Visa Class B shares, FHN and the purchasers entered into derivative transactions whereby FHN will make, or receive, cash payments whenever the conversion ratio of the Visa Class B shares into Visa Class A shares is adjusted. FHN uses a discounted cash flow methodology in order to estimate the fair value of FHN’s derivative liabilities associated with its prior sales of Visa Class B shares. The methodology includes estimation of both the resolution amount for Visa’s Covered Litigation matters as well as the length of time until the resolution occurs. Significant increases (decreases) in either of these inputs in isolation would result in significantly higher (lower) fair value measurements for the derivative liabilities. Additionally, FHN performs a probability weighted multiple resolution scenario to calculate the estimated fair value of these derivative liabilities. Assignment of higher (lower) probabilities to the larger potential resolution scenarios would result in an increase (decrease) in the estimated fair value of the derivative liabilities. Since this estimation process requires application of judgment in developing significant unobservable inputs used to determine the possible outcomes and the probability weighting assigned to each scenario, these derivatives have been classified within Level 3 in fair value measurements disclosures. The valuation inputs and process are discussed with senior and executive management when significant events affecting the estimate of fair value occur. Inputs are compared to information obtained from the public issuances and filings of Visa, Inc. as well as public information released by other participants in the applicable litigation matters.
Loans, net of unearned income and Real estate acquired by foreclosure. Collateral-dependent loans and Real estate acquired by foreclosure are primarily valued using appraisals based on sales of comparable properties in the same or similar markets. Multiple appraisal firms are utilized to ensure that estimated values are consistent between firms. This process occurs within FHN’s Credit Risk Management (commercial) and Default Servicing functions (primarily consumer) and the Credit Risk Management Committee reviews valuation methodologies and loss information for reasonableness. Back testing is performed during the year through comparison to ultimate disposition values and is reviewed quarterly within the Credit Risk Management function. Other collateral (receivables, inventory, equipment, etc.) is valued through borrowing base certificates, financial statements and/or auction valuations. These valuations are discounted based on the quality of reporting, knowledge of the marketability/collectability of the collateral and historical disposition rates.
Other assets – tax credit investments. The estimated fair value of tax credit investments accounted for under the equity method is generally determined in relation to the yield (i.e., future tax credits to be received) an acquirer of these investments would expect in relation to the yields experienced on current new issue and/or secondary market transactions. Thus, as tax credits are recognized, the future yield to a market participant is reduced, resulting in consistent impairment of the individual investments. Individual investments are reviewed for impairment quarterly, which may include the consideration of additional marketability discounts related to specific investments. Unusual valuation adjustments and the associated triggering events are discussed with senior and executive management when appropriate. A portfolio review is conducted annually, with the assistance of a third party, to assess the reasonableness of current valuations.
Fair Value Option
FHN elected the fair value option on a prospective basis for almost all types of mortgage loans originated for sale purposes under the Financial Instruments Topic (“ASC 825”). FHN determined that the election reduced certain timing differences and better matched changes in the value of such loans with changes in the value of derivatives used as economic hedges for these assets at the time of election.
Repurchased loans are recognized within loans held-for-sale at fair value at the time of repurchase, which includes consideration of the credit status of the loans and the estimated liquidation value. FHN has elected to continue recognition of these loans at fair value in periods subsequent to reacquisition. Due to the credit-distressed nature of the vast majority of repurchased loans and the related loss severities experienced upon repurchase, FHN believes that the fair value election provides a more timely recognition of changes in value for these loans that occur subsequent to repurchase. Absent the fair value election, these loans would be subject to valuation at the LOCOM value, which would prevent subsequent values from exceeding the initial fair value, determined at the time of repurchase, but would require recognition of subsequent declines in value. Thus, the fair value election provides for a more timely recognition of any potential future recoveries in asset values while not affecting the requirement to recognize subsequent declines in value.
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The following tables reflect the differences between the fair value carrying amount of residential real estate loans held-for-sale measured at fair value in accordance with management’s election and the aggregate unpaid principal amount FHN is contractually entitled to receive at maturity.
Residential real estate loans held-for-sale reported at fair value:
Total loans
Nonaccrual loans
Loans 90 days or more past due and still accruing
Assets and liabilities accounted for under the fair value election are initially measured at fair value with subsequent changes in fair value recognized in earnings. Such changes in the fair value of assets and liabilities for which FHN elected the fair value option are included in current period earnings with classification in the income statement line item reflected in the following table:
Changes in fair value included in net income:
Mortgage banking noninterest income
For the three months ended September 30, 2015, and 2014, the amounts for residential real estate loans held-for-sale include a loss of $.2 million and a gain of $.6 million, respectively, in pretax earnings that are attributable to changes in instrument-specific credit risk. For the nine months ended September 30, 2015, and 2014, the amounts for loans held-for-sale include gains of $.5 million and $3.2 million, respectively, in pretax earnings that are attributable to changes in instrument-specific credit risk. The portion of the fair value adjustments related to credit risk was determined based on estimated default rates and estimated loss severities. Interest income on residential real estate loans held-for-sale measured at fair value is calculated based on the note rate of the loan and is recorded in the interest income section of the Consolidated Condensed Statements of Income as interest on loans held-for-sale.
Determination of Fair Value
In accordance with ASC 820-10-35, fair values are based on 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. The following describes the assumptions and methodologies used to estimate the fair value of financial instruments recorded at fair value in the Consolidated Condensed Statements of Condition and for estimating the fair value of financial instruments for which fair value is disclosed under ASC 825-10-50.
Short-term financial assets. Federal funds sold, securities purchased under agreements to resell, and interest bearing deposits with other financial institutions and the Federal Reserve are carried at historical cost. The carrying amount is a reasonable estimate of fair value because of the relatively short time between the origination of the instrument and its expected realization.
Trading securities and trading liabilities. Trading securities and trading liabilities are recognized at fair value through current earnings. Trading inventory held for broker-dealer operations is included in trading securities and trading liabilities. Broker-dealer long positions are valued at bid price in the bid-ask spread. Short positions are valued at the ask price. Inventory positions are valued using observable inputs including current market transactions, LIBOR and U.S. treasury curves, credit spreads, and consensus prepayment speeds. Trading loans are valued using observable inputs including current market transactions, swap rates, mortgage rates, and consensus prepayment speeds.
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Trading securities also include retained interests in prior securitizations that qualify as financial assets, which primarily include interest-only strips, principal-only strips and subordinated bonds. FHN uses inputs including yield curves, credit spreads, and prepayment speeds to determine the fair value of principal-only strips. Subordinated bonds are bonds with junior priority and are valued using an internal model which includes contractual terms, frequency and severity of loss (credit spreads), prepayment speeds of the underlying collateral, and the yield that a market participant would require.
Securities available-for-sale. Securities available-for-sale includes the investment portfolio accounted for as available-for-sale under ASC 320-10-25, federal bank stock holdings, and short-term investments in mutual funds. Valuations of available-for-sale securities are performed using observable inputs obtained from market transactions in similar securities. Typical inputs include LIBOR and U.S. treasury curves, consensus prepayment estimates, and credit spreads. When available, broker quotes are used to support these valuations. Certain government agency debt obligations with limited trading activity are valued using a discounted cash flow model that incorporates a combination of observable and unobservable inputs. Primary observable inputs include contractual cash flows and the treasury curve. Significant unobservable inputs include estimated trading spreads and estimated prepayment speeds.
Investments in the stock of the Federal Reserve Bank and Federal Home Loan Banks are recognized at historical cost in the Consolidated Condensed Statements of Condition which is considered to approximate fair value. Short-term investments in mutual funds are measured at the funds’ reported closing net asset values. Investments in equity securities are valued using quoted market prices.
Securities held-to-maturity. Securities held-to-maturity reflects debt securities for which management has the positive intent and ability to hold to maturity. To the extent possible, valuations of held-to-maturity securities are performed using observable inputs obtained from market transactions in similar securities. Typical inputs include LIBOR and U.S. treasury curves and credit spreads. Debt securities with limited trading activity are valued using a discounted cash flow model that incorporates a combination of observable and unobservable inputs. Primary observable inputs include contractual cash flows, the treasury curve and credit spreads from similar instruments. Significant unobservable inputs include estimated credit spreads for individual issuers and instruments as well as prepayment speeds, as applicable.
Loans held-for-sale. Residential real estate loans held-for-sale are valued using current transaction prices and/or values on similar assets when available. Uncommitted bids may be adjusted based on other available market information. For all other loans FHN determines the fair value of residential real estate loans held-for-sale using a discounted cash flow model which incorporates both observable and unobservable inputs. Commencing in fourth quarter 2014, inputs include current mortgage rates for similar products, estimated prepayment rates, foreclosure losses, and various loan performance measures (delinquency, LTV, credit score). Prior to fourth quarter 2014, typical inputs included contractual cash flow requirements, current mortgage rates for similar products, estimated prepayment rates, credit spreads and delinquency penalty adjustments. Adjustments for delinquency and other differences in loan characteristics are typically reflected in the model’s discount rates. Loss severity trends and the value of underlying collateral are also considered in assessing the appropriate fair value for severely delinquent loans and loans in foreclosure. The valuation of HELOCs also incorporates estimates of loan draw rates as well as estimated cancellation rates for loans expected to become delinquent.
Loans held-for-sale also includes loans made by the Small Business Administration (“SBA”), which are accounted for at LOCOM. The fair value of SBA loans is determined using an expected cash flow model that utilizes observable inputs such as the spread between LIBOR and prime rates, consensus prepayment speeds, and the treasury curve. The fair value of other non-residential real estate loans held-for-sale is approximated by their carrying values based on current transaction values.
Loans, net of unearned income. Loans, net of unearned income are recognized at the amount of funds advanced, less charge-offs and an estimation of credit risk represented by the allowance for loan losses. The fair value estimates for disclosure purposes differentiate loans based on their financial characteristics, such as product classification, vintage, loan category, pricing features, and remaining maturity.
The fair value of floating rate loans is estimated through comparison to recent market activity in loans of similar product types, with adjustments made for differences in loan characteristics. In situations where market pricing inputs are not available, fair value is considered to approximate book value due to the monthly repricing for commercial and consumer loans, with the exception of floating rate 1-4 family residential mortgage loans which reprice annually and will lag movements in market rates. The fair value for floating rate 1-4 family mortgage loans is calculated by discounting future cash flows to their present value. Future cash flows are discounted to their present value by using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same time period.
Prepayment assumptions based on historical prepayment speeds and industry speeds for similar loans have been applied to the floating rate 1-4 family residential mortgage portfolio.
The fair value of fixed rate loans is estimated through comparison to recent market activity in loans of similar product types, with adjustments made for differences in loan characteristics. In situations where market pricing inputs are not available, fair value is
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estimated by discounting future cash flows to their present value. Future cash flows are discounted to their present value by using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same time period. Prepayment assumptions based on historical prepayment speeds and industry speeds for similar loans have been applied to the fixed rate mortgage and installment loan portfolios.
For all loan portfolio classes, adjustments are made to reflect liquidity or illiquidity of the market. Such adjustments reflect discounts that FHN believes are consistent with what a market participant would consider in determining fair value given current market conditions.
Individually impaired loans are measured using either a discounted cash flow methodology or the estimated fair value of the underlying collateral less costs to sell, if the loan is considered collateral-dependent. In accordance with accounting standards, the discounted cash flow analysis utilizes the loan’s effective interest rate for discounting expected cash flow amounts. Thus, this analysis is not considered a fair value measurement in accordance with ASC 820. However, the results of this methodology are considered to approximate fair value for the applicable loans. Expected cash flows are derived from internally-developed inputs primarily reflecting expected default rates on contractual cash flows. For loans measured using the estimated fair value of collateral less costs to sell, fair value is estimated using appraisals of the collateral. Collateral values are monitored and additional write-downs are recognized if it is determined that the estimated collateral values have declined further. Estimated costs to sell are based on current amounts of disposal costs for similar assets. Carrying value is considered to reflect fair value for these loans.
Mortgage servicing rights. FHN recognizes all classes of MSR at fair value. In third quarter 2013, FHN agreed to sell substantially all of its remaining legacy mortgage servicing. Since that time FHN has used the price in the definitive agreement, as adjusted for the portion of pricing that was not specific to the MSR, as a third-party pricing source in the valuation of the MSR.
Derivative assets and liabilities. The fair value for forwards and futures contracts is based on current transactions involving identical securities. Futures contracts are exchange-traded and thus have no credit risk factor assigned as the risk of non-performance is limited to the clearinghouse used.
Valuations of other derivatives (primarily interest rate related swaps, swaptions, caps, and collars) are based on inputs observed in active markets for similar instruments. Typical inputs include the LIBOR curve, Overnight Indexed Swap (“OIS”) curve, option volatility, and option skew. In measuring the fair value of these derivative assets and liabilities, FHN has elected to consider credit risk based on the net exposure to individual counterparties. Credit risk is mitigated for these instruments through the use of mutual margining and master netting agreements as well as collateral posting requirements. Any remaining credit risk related to interest rate derivatives is considered in determining fair value through evaluation of additional factors such as customer loan grades and debt ratings. Foreign currency related derivatives also utilize observable exchange rates in the determination of fair value. The determination of fair value for FHN’s derivative liabilities associated with its prior sales of Visa Class B shares are classified within Level 3 in the fair value measurements disclosure as previously discussed in the unobservable inputs discussion.
Real estate acquired by foreclosure. Real estate acquired by foreclosure primarily consists of properties that have been acquired in satisfaction of debt. These properties are carried at the lower of the outstanding loan amount or estimated fair value less estimated costs to sell the real estate. Estimated fair value is determined using appraised values with subsequent adjustments for deterioration in values that are not reflected in the most recent appraisal. Real estate acquired by foreclosure during periods prior to January 1, 2015 also includes properties acquired in compliance with HUD servicing guidelines which are carried at the estimated amount of the underlying government insurance or guarantee.
Nonearning assets. For disclosure purposes, nonearning assets include cash and due from banks, accrued interest receivable, and fixed income receivables. Due to the short-term nature of cash and due from banks, accrued interest receivable, and fixed income receivables, the fair value is approximated by the book value.
Other assets. For disclosure purposes, other assets consist of tax credit investments and deferred compensation assets that are considered financial assets. Tax credit investments accounted for under the equity method are written down to estimated fair value quarterly based on the estimated value of the associated tax credits which incorporates estimates of required yield for hypothetical investors. The fair value of all other tax credit investments is estimated using recent transaction information with adjustments for differences in individual investments. Deferred compensation assets are recognized at fair value, which is based on quoted prices in active markets. Beginning in first quarter 2015, Other assets also includes property acquired in connection with foreclosures of loans that have government insurance or guarantees. These receivables are valued at the expected amounts recoverable for the insurance or guarantees.
Defined maturity deposits. The fair value of these deposits is estimated by discounting future cash flows to their present value. Future cash flows are discounted by using the current market rates of similar instruments applicable to the remaining maturity. For disclosure purposes, defined maturity deposits include all certificates of deposit and other time deposits.
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Undefined maturity deposits. In accordance with ASC 825, the fair value of these deposits is approximated by the book value. For the purpose of this disclosure, undefined maturity deposits include demand deposits, checking interest accounts, savings accounts, and money market accounts.
Short-term financial liabilities. The fair value of federal funds purchased, securities sold under agreements to repurchase and other short-term borrowings are approximated by the book value. The carrying amount is a reasonable estimate of fair value because of the relatively short time between the origination of the instrument and its expected realization.
Term borrowings. The fair value of term borrowings is based on quoted market prices or dealer quotes for the identical liability when traded as an asset. When pricing information for the identical liability is not available, relevant prices for similar debt instruments are used with adjustments being made to the prices obtained for differences in characteristics of the debt instruments. If no relevant pricing information is available, the fair value is approximated by the present value of the contractual cash flows discounted by the investor’s yield which considers FHN’s and FTBNA’s debt ratings.
Other noninterest-bearing liabilities. For disclosure purposes, other noninterest-bearing liabilities include accrued interest payable and fixed income payables. Due to the short-term nature of these liabilities, the book value is considered to approximate fair value.
Loan commitments. Fair values of these commitments are based on fees charged to enter into similar agreements taking into account the remaining terms of the agreements and the counterparties’ credit standing.
Other commitments. Fair values of these commitments are based on fees charged to enter into similar agreements.
The following fair value estimates are determined as of a specific point in time utilizing various assumptions and estimates. The use of assumptions and various valuation techniques, as well as the absence of secondary markets for certain financial instruments, will likely reduce the comparability of fair value disclosures between financial institutions. Due to market illiquidity, the fair values for loans, net of unearned income, loans held-for-sale, and term borrowings as of September 30, 2015 and 2014, involve the use of significant internally-developed pricing assumptions for certain components of these line items. The assumptions and valuations utilized for this disclosure are considered to reflect inputs that market participants would use in transactions involving these instruments as of the measurement date. The valuations of legacy assets, particularly consumer loans within the non-strategic segment and TRUP loans, are influenced by the challenging economic conditions experienced during the past several years, including housing price declines and the effect on estimated collateral values, elevated unemployment or underemployment and risk perceptions of the financial sector. These considerations affect the estimate of a potential acquirer’s cost of capital assumption and cash flow volatility from these assets and the resulting fair value measurements may depart significantly from our internal estimates of the intrinsic value of these assets.
Assets and liabilities that are not financial instruments have not been included in the following table such as the value of long-term relationships with deposit and trust customers, premises and equipment, goodwill and other intangibles, deferred taxes, and certain other assets and other liabilities. Additionally, these measurements are solely for financial instruments as of the measurement date and do not consider the earnings potential of our various business lines. Accordingly, the total of the fair value amounts does not represent, and should not be construed to represent, the underlying value of the Company.
The following tables summarize the book value and estimated fair value of financial instruments recorded in the Consolidated Condensed Statements of Condition as well as unfunded loan commitments and stand by and other commitments as of September 30, 2015 and 2014.
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Loans, net of unearned income and allowance for loan losses
Total loans, net of unearned income and allowance for loan losses
Short-term financial assets
Securities purchased under agreements to resell
Total short-term financial assets
Trading securities (a)
Securities available-for-sale (a) (b)
Securities held-to-maturity
Derivative assets (a)
Nonearning assets
Cash & due from banks
Accrued interest receivable
Total nonearning assets
Defined maturity
Undefined maturity
Trading liabilities (a)
Short-term financial liabilities
Securities sold under agreements to repurchase
Total short-term financial liabilities
Real estate investment trust-preferred
Term borrowings - new market tax credit investment
Borrowings secured by residential real estate
Other long term borrowings
Total term borrowings
Derivative liabilities (a)
Other noninterest-bearing liabilities
Accrued interest payable
Total other noninterest-bearing liabilities
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Certain previously reported amounts have been revised to reflect the retroactive effect of the adoption of ASU 2014-01, “Equity Method and Joint Venture: Accounting for Investments in Qualified Affordable Housing Projects.” See Note 1 – Financial Information for additional information.
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Unfunded Commitments:
Loan commitments
Standby and other commitments
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Note 17 – Other Events
In October 2015, FHN issued $500 million of 3.500% Senior Notes due December 15, 2020. Interest payments are due semi-annually on June 15 and December 15, commencing June 15, 2016. The sale of the Notes resulted in net proceeds to the Company of approximately $497 million. The Company expects to use the proceeds, along with other cash on hand, to retire its $500 million of 5.375% Senior Notes due December 15, 2015.
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General Information
Forward-Looking Statements
Financial Summary
Statement of Condition Review
Capital
Asset Quality - Trend Analysis of Third Quarter 2015 Compared to Third Quarter 2014
Risk Management
Repurchase Obligations, Off-Balance Sheet Arrangements, and Other Contractual Obligations
Market Uncertainties and Prospective Trends
Critical Accounting Policies
Non-GAAP Information
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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
GENERAL INFORMATION
First Horizon National Corporation (“FHN”) began as a community bank chartered in 1864 and as of September 30, 2015, was one of the 40 largest publicly traded banking organizations in the United States in terms of asset size.
The corporation’s two major brands – First Tennessee and FTN Financial - provide customers with a broad range of products and services. First Tennessee provides retail and commercial banking services throughout Tennessee and other selected markets and is the largest bank headquartered in the state of Tennessee. FTN Financial (“FTNF”) is an industry leader in fixed income sales, trading, and strategies for institutional clients in the U.S. and abroad.
FHN is composed of the following operating segments:
On October 17, 2014, First Tennessee Bank National Association (“FTBNA”), a subsidiary of FHN, purchased thirteen bank branches in Middle and East Tennessee. The fair value of the acquired assets totaled $437.6 million, including $413.4 million in cash, $7.5 million in fixed assets, and $15.7 million of goodwill and intangible assets. FTBNA also assumed $437.2 million of deposits associated with these branches. FTBNA paid a deposit premium of 3.32 percent and acquired an immaterial amount of loans as part of the transaction.
In fourth quarter 2014, FHN entered into a merger agreement with TrustAtlantic Financial Corporation (“TrustAtlantic Financial”). The transaction closed on October 2, 2015 and approximately 75 percent of the shares of TrustAtlantic Financial were converted into shares of FHN common stock at an exchange ratio of 1.3261 FHN shares for each TrustAtlantic Financial share, and approximately 25 percent of the shares of TrustAtlantic Financial were converted into cash. The aggregate transaction value was approximately $95 million. TrustAtlantic Financial reported, on a consolidated basis, approximately $405 million of total assets and approximately $350 million of total deposits at September 30, 2015.
For the purpose of this management’s discussion and analysis (“MD&A”), earning assets have been expressed as averages, unless otherwise noted, and loans have been disclosed net of unearned income. The following financial discussion should be read with the accompanying unaudited Consolidated Condensed Financial Statements and Notes in this report. Additional information including the 2014 financial statements, notes, and MD&A is provided in FHN’s 2014 Annual Report and in FHN’s Current Report on Form 8-K dated October 19, 2015.
ADOPTION OF ACCOUNTING UPDATES
Effective January 1, 2015, FHN retroactively adopted the requirements of ASU 2014-01, “Equity Method and Joint Ventures: Accounting for Investments in Qualified Affordable Housing Projects,” with an election to use the proportional amortization method for all qualifying investments. ASU 2014-01 permits reporting entities to make an accounting policy election to account for their investments in qualified affordable housing projects using a proportional amortization method if certain conditions are met. The
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retrospective application of ASU 2014-01 did not change Diluted earnings/(loss) per share for the three months ended September 30, 2014, but resulted in an increase in Diluted earnings/(loss) per share of $.01 for the nine months ended September 30, 2014, as well as for the year ended December 31, 2014 versus previously reported amounts. Additionally, Income/(loss) available to shareholders increased $.7 million and $2.2 million for the three and nine months ended September 30, 2014 and $3.0 million for the year ended December 31, 2014 versus previously reported amounts. FHN also recognized a decrease to Shareholders’ equity of $10.1 million at September 30, 2014 and $9.4 million at December 31, 2014 versus previously reported amounts. All prior periods, applicable tables and associated narrative in this report have been revised to reflect this change. For additional information see Note 1 – Financial Information in this report and also FHN’s Current Report on Form 8-K dated October 19, 2015.
Non-GAAP Measures
Certain measures are included in the narrative and tables in this MD&A that are “non-GAAP”, meaning (under U.S. financial reporting rules) they are not presented in accordance with generally accepted accounting principles (“GAAP”) in the U.S. and also are not codified in U.S. banking regulations currently applicable to FHN. Although other entities may use calculation methods that differ from those used by FHN for non-GAAP measures, FHN’s management believes such measures are relevant to understanding the capital position or financial results of FHN. Non-GAAP measures are reported to FHN’s management and Board of Directors through various internal reports.
Presentation of regulatory measures, even those which are not GAAP, provide a meaningful base for comparability to other financial institutions subject to the same regulations as FHN, as demonstrated by their use by banking regulators in reviewing capital adequacy of financial institutions. Although not GAAP terms, these regulatory measures are not considered “non-GAAP” under U.S. financial reporting rules as long as their presentation conforms to regulatory standards. Regulatory measures used in this MD&A include: tier 1 capital, generally defined as the sum of core capital (including common equity and instruments that cannot be redeemed at the option of the holder) adjusted for certain items under risk based capital regulations; common equity tier 1 capital (for periods subsequent to fourth quarter 2014), generally defined as common equity less goodwill, other intangibles, and certain other required regulatory deductions; and risk-weighted assets (“RWA”), which is a measure of total on- and off-balance sheet assets adjusted for credit and market risk, used to determine regulatory capital ratios. The regulatory common equity tier 1 used in 2015 and later periods is not the same as the non-regulatory, non-GAAP tier 1 common commonly used prior to 2015; comparisons between the two are not meaningful.
The non-GAAP measure presented in this filing is the tier 1 common capital ratio (for periods prior to first quarter 2015). Refer to Table 25 for a reconciliation of non-GAAP to GAAP measures and presentation of the most comparable GAAP items.
FORWARD-LOOKING STATEMENTS
This MD&A contains forward-looking statements with respect to FHN’s beliefs, plans, goals, expectations, and estimates. Forward-looking statements are statements that are not a representation of historical information but rather are related to future operations, strategies, financial results, or other developments. The words “believe,” “expect,” “anticipate,” “intend,” “estimate,” “should,” “is likely,” “will,” “going forward,” and other expressions that indicate future events and trends identify forward-looking statements. Forward-looking statements are necessarily based upon estimates and assumptions that are inherently subject to significant business, operational, economic and competitive uncertainties and contingencies, many of which are beyond FHN’s control, and many of which, with respect to future business decisions and actions (including acquisitions and divestitures), are subject to change. Examples of uncertainties and contingencies include, among other important factors, global, general and local economic and business conditions, including economic recession or depression; the pace, consistency, and extent of recovery of values and activity in the residential housing and commercial real estate markets; potential requirements for FHN to repurchase, or compensate for losses from, previously sold or securitized mortgages or securities based on such mortgages; potential claims relating to the foreclosure process; potential claims relating to participation in government programs, especially lending or other financial services programs; expectations of and actual timing and amount of interest rate movements, including the slope and shape of the yield curve, which can have a significant impact on a financial services institution; market and monetary fluctuations, including fluctuations in mortgage markets; inflation or deflation; customer, investor, regulatory, and legislative responses to any or all of these conditions; the financial condition of borrowers and other counterparties; competition within and outside the financial services industry; geopolitical developments including possible terrorist activity; natural disasters; effectiveness and cost-efficiency of FHN’s hedging practices; technological changes; fraud, theft, or other incursions through conventional, electronic, or other means affecting FHN directly or affecting its customers, business counterparties or competitors; demand for FHN’s product offerings; new products and services in the industries in which FHN operates; the increasing use of new technologies to interact with customers and others; and critical accounting estimates. Other factors are those inherent in originating, selling, servicing, and holding loans and loan-based assets, including prepayment risks, pricing concessions, fluctuation in U.S. housing and other real estate prices, fluctuation of collateral values, and changes in customer profiles. Additionally, the actions of the Securities and Exchange Commission (“SEC”), the Financial Accounting Standards Board (“FASB”), the Office of the Comptroller of the Currency (“OCC”), the Board of Governors of the Federal Reserve System (“Federal Reserve”), the Federal Deposit Insurance Corporation (“FDIC”), Financial Industry Regulatory Authority (“FINRA”), the Municipal
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Securities Rulemaking Board (“MSRB”), the Consumer Financial Protection Bureau (“CFPB”), the Financial Stability Oversight Council (“Council”), and other regulators and agencies; pending, threatened, or possible future regulatory, administrative, and judicial outcomes, actions, and proceedings; changes in laws and regulations applicable to FHN; and FHN’s success in executing its business plans and strategies and managing the risks involved in the foregoing, could cause actual results to differ, perhaps materially, from those contemplated by the forward-looking statements. FHN assumes no obligation to update or revise, whether as a result of new information, future events, or otherwise, any forward-looking statements that are made in this Quarterly Report or otherwise from time to time. Actual results could differ and expectations could change, possibly materially, because of one or more factors, including those presented in this Forward-Looking Statements section, in other sections of this MD&A, in other parts of and exhibits to this Quarterly Report on Form 10-Q for the period ended September 30, 2015, and in documents incorporated into this Quarterly Report.
FINANCIAL SUMMARY
For third quarter 2015, FHN reported net income available to common shareholders of $58.8 million or $.25 per diluted share compared to net income of $46.1 million or $.19 per diluted share in third quarter 2014. For the nine months ended September 30, 2015, FHN reported net income available to common shareholders of $32.6 million or $.14 per diluted share compared to net income of $169.2 million or $.71 per diluted share for the nine months ended September 30, 2014. The improvement in results for the third quarter compared to the prior year was driven by lower expenses, a reduction in the loan loss provision, and an increase in net interest income, partially offset by a decline in non interest income. The decline in results for the nine months ended September 30, 2015 compared to the prior year was the result of an increase in expenses and lower noninterest income, partially mitigated by an increase in net interest income and lower loan loss provisioning.
In third quarter 2015, FHN recognized an $11.6 million charge to litigation and regulatory matters related to a legal matter in which an arbitration panel found in favor of the claimants. In first quarter 2015, FHN recorded a charge to litigation and regulatory matters of $162.5 million related to a settlement with two federal agencies, the Department of Justice (“DOJ”) and the Department of Housing and Urban Development Office of Inspector General (“HUD”), to settle potential claims related to FHN’s underwriting and origination of FHA-insured mortgage loans.
Total revenue decreased $28.7 million and $27.0 million, respectively, for the three and nine months ended September 30, 2015 to $288.7 million and $872.2 million relative to the prior year. The decrease in revenue for both periods was primarily driven by a decline in mortgage banking income, partially offset by an increase in net interest income (“NII”) and higher fixed income product revenue in 2015 compared to 2014. For the three months ended September 30, 2015 compared to 2014, the decline in mortgage banking income was primarily the result of a $39.7 million gain on the sale of approximately $315 million in unpaid principal balance (“UPB”) of held-for-sale (“HFS”) mortgage loans recognized in third quarter 2014. For the nine months ended September 30, 2015 compared to 2014, the decrease in mortgage banking income was also affected by a larger positive mortgage warehouse valuation adjustment in 2014 associated with the non-performing portion of the HFS portfolio and the receipt of approximately $20.0 million of additional servicing fees in first quarter 2014 in conjunction with servicing sales.
Expenses for the three and nine months ended September 30, 2015 were $215.4 million and $810.1 million, respectively, compared to $244.0 million and $625.2 million, respectively, for the three and nine months ended September 30, 2014. For the quarter ended September 30, 2015 compared to 2014, the expense decrease was largely driven by a decline in losses from litigation and regulatory matters primarily related to expenses recognized in 2014, including $50.4 million in loss accruals related to legal matters, partially offset by $15.0 million of expense reversals associated with agreements with insurance companies for the recovery of expenses FHN incurred related to litigation losses in previous periods. In third quarter 2015, FHN recognized $10.9 million in net loss accruals related to legal matters. Lower personnel expense in third quarter 2015 relative to third quarter 2014 also contributed to the decline, but was somewhat offset by a $4.3 million reversal of repurchase and foreclosure provision related to the settlement of certain claims recognized in third quarter 2014. For the nine months ended September 30, 2015 compared to 2014, the increase in expenses was primarily the result of the $162.5 million charge to litigation and regulatory matters related to the settlement reached with DOJ/HUD previously mentioned and increased personnel expense relative to the same period of 2014, but was somewhat mitigated by lower occupancy expense which was primarily the result of a lease abandonment charge recognized in 2014 related to restructuring, repositioning, and efficiency initiatives.
On a consolidated basis, credit quality continued to improve in 2015 relative to a year ago, resulting in a $5.0 million decline in the loan loss provision to $1.0 million in third quarter 2015 and a $13.0 million decline in the loan loss provision to $8.0 million for the nine months ended September 30, 2015. Improvement from third quarter 2014 resulted in a 12 percent decline in the allowance for loan losses (“ALLL”) (on a period-end basis) and a 14 percent decline in non-performing loans from a year ago.
Return on average common equity and return on average assets for third quarter 2015 were 10.83 percent and .99 percent, respectively, compared to 8.16 percent and .84 percent, respectively, in third quarter 2014. During the nine months ended September 30, 2015 and 2014, the return on average common equity was 2.02 percent and 10.37 percent, respectively, and the return on average assets was .24 percent and 1.03 percent, respectively. The Tier 1 capital ratio was 12.11 percent as of September 30, 2015, compared to 14.47 percent on September 30, 2014. Total period-end assets increased to $25.4 billion on September 30, 2015, from $24.0 billion on September 30, 2014. Average loans increased 6 percent and 7 percent to $16.6 billion and $16.5 billion, respectively, in the three and nine months ended September 30, 2015 relative to the same periods in 2014. Average core deposits increased 20 percent and 16 percent
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to $18.5 billion and $18.2 billion, respectively, in the three and nine months ended September 30, 2015 relative to the prior year. Shareholders’ equity was $2.6 billion on September 30, 2015 and 2014. Average shareholders’ equity decreased to $2.5 billion in third quarter 2015 from $2.6 billion in third quarter 2014.
BUSINESS LINE REVIEW
Pre-tax income within the regional banking segment was $85.6 million during third quarter 2015 compared to $79.9 million in third quarter 2014. The increase in pre-tax income was driven by higher net interest income which more than offset an increase in loan loss provisioning and a decline in non-interest income. Non-interest expense was flat in third quarters 2015 and 2014. During the nine months ended September 30, 2015, the regional bank’s pre-tax income was $230.1 million compared to $209.9 million for the nine months ended September 30, 2014. The increase in pre-tax income for the first nine months of 2015 was primarily driven by an increase in net interest income which more than offset an increase in noninterest and loan loss provision expenses.
Total revenue increased 5 percent to $228.0 million in third quarter 2015 from $218.0 million in third quarter 2014, driven by an increase in net interest income (“NII”). The increase in NII was driven by several factors including higher average balances of loans to mortgage companies, additional commercial loan growth, the impact that higher deposit balances has on funds transfer pricing (“FTP”), improved deposit pricing, and an increase in cash basis income compared to third quarter 2014. These increases were somewhat offset by lower yielding commercial loans due to competitive pressure. Noninterest income decreased $1.4 million to $62.8 million in third quarter 2015. The decline in noninterest income was largely driven by lower brokerage, management fees, and commission income from the Bank’s wealth management group in 2015 relative to the prior year and a decline in income from trust services and investment management, partially offset by increases in fees from deposit transactions and bankcard income compared to a year ago. The decrease in brokerage, management fees and commissions was primarily driven by a reduction in annuity income as a result of lower volume in 2015 compared to the prior year, and also by a shift in product and fee structures which caused a temporary decline in revenues but should result in revenue streams over the long term.
Provision expense increased to $6.7 million in third quarter 2015 from $2.2 million in third quarter 2014. Both periods reflect continued strong performance with low levels of delinquencies and a decline in nonperforming loans. The increase in provision during third quarter 2015 was driven by a number of factors including loan growth within the commercial portfolios and a continued extension of the loss emergence period (“LEP”) for commercial loans in the current cycle. These factors were somewhat offset by the continued favorable impact of historically low net charge-offs which result in continued lower loss rates.
Noninterest expense was $135.8 million in third quarter 2015 down slightly from $135.9 million in third quarter 2014, as lower allocated personnel expenses, due in large part to gains recognized in third quarter 2015 related to an employee benefit plan amendment, were offset by increases in personnel expenses associated with strategic hires and retention efforts in growth markets, an increase in legal fees, and an increase in the provision for unfunded commitments in third quarter 2015 relative to the prior year.
Total revenue increased 6 percent to $674.5 million for the nine months ended September 30, 2015 from $634.9 million for the nine months ended September 30, 2014, driven by an increase in net interest income (“NII”). An increase in average balances of loans to mortgage companies, additional commercial loan growth, the impact that higher deposit balances has on FTP, and improved deposit pricing favorably impacted NII during the nine months ended September 30, 2015, but was somewhat mitigated by lower commercial loan yields. Noninterest income declined $1.4 million to $189.0 million for the nine months ended September 30, 2015, driven by a decrease in brokerage, management fees, and commission income and lower bankcard income relative to the same year-to-date period of 2014, but partially offset by an increase in deposit transactions. The decline in bankcard income was due in part to $2.8 million of Visa volume incentives recognized in second quarter 2014, but was somewhat mitigated by higher transaction volume in 2015 relative to the prior year.
Provision expense for the nine months ended September 30, 2015 increased to $28.7 million from $23.6 million for the nine months ended September 30, 2014. The factors affecting the 2015 quarterly provision expense also drove provision expense for the 2015 year-to-date period. Additionally, increased reserves associated with loss resulting from borrower fraud also led to higher loan loss provisioning in 2015 relative to the prior year. For the year-to-date period of 2014, provision expense was primarily affected by the consumer credit card portfolio as a result of trends in delinquencies, net charge-offs, and certain asset quality ratios for the smaller balance portion of the portfolio.
Noninterest expense was $415.8 million and $401.4 million for the nine months ended September 30, 2015 and 2014, respectively. The increase in expense was largely attributable to higher personnel expenses associated with loan growth, strategic hires, and retention efforts in growth markets in the nine months ended September 30, 2015 relative to the prior year. An increase in the provision for unfunded commitments and larger negative fair value marks associated with foreclosed real estate also contributed to the increase in expenses. These increases were partially offset by a decline in professional fees related to consulting projects in the year-to-date period of 2014 relative to the current year, as well as tighter project management and an incremental focus on cost reductions.
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Lower contract employment expenses primarily related to technology-related projects in 2014, and a decline in allocated expenses, also offset a portion of the expense increase. The decline in allocated expenses was due in large part to gains recognized in third quarter 2015 related to an employee benefit plan amendment, but partially offset by allocated FDIC premium expense which increased relative to the prior year, due in large part to $3.3 million of FDIC premium refunds recognized in second quarter 2014.
The fixed income segment had a pre-tax loss of $5.0 million during third quarter 2015 compared to pre-tax income of $4.9 million during third quarter 2014. The decline in results during third quarter 2015 compared to the prior year was primarily driven by an $11.6 million increase in loss accruals recognized in third quarter 2015 related to a legal matter in which an arbitration panel found in favor of the claimants. For the nine months ended September 30, 2015, fixed income’s pre-tax income was $15.3 million compared to $62.6 million for the nine months ended September 30, 2014. Pre-tax income for the nine months ended September 30, 2014 was higher when compared to the same period in 2015 due in large part to a $47.1 million expense recovery that was recognized in second quarter 2014 related to the Sentinel litigation matter which was settled in 2011 coupled with the arbitration matter previously mentioned which led to higher litigation expenses in 2015.
Fixed income product revenue was $43.0 million in third quarter 2015, up from $41.2 million in third quarter 2014, as fixed income product average daily revenue (“ADR”) increased slightly to $.7 million in 2015 from $.6 million in 2014. For the nine months ended September 30, 2015, fixed income product revenue was $143.2 million, up from $131.3 million in the prior year. The increase in fixed income revenue reflects more favorable market conditions due to increased rate volatility in 2015 relative to the prior year. Other product revenue was $8.8 million and $8.7 million in third quarter 2015 and 2014, respectively, and increased from $22.9 million for the nine months ended September 30, 2014 to $26.2 million for the same period in 2015. The increase in the year-to-date period was primarily driven by increases in fees from derivatives, loan sales, and portfolio advisory in 2015 relative to the prior year.
Noninterest expense was $59.8 million and $47.9 million in third quarter 2015 and 2014, respectively, and $165.7 million and $100.6 million for the nine months ended September 30, 2015 and 2014, respectively. The increase in expense for third quarter 2015 was primarily driven by the litigation charge related to the arbitration decision previously mentioned, but was also due to higher variable compensation expense as a result of higher fixed income product revenues in 2015 relative to the prior year. The expense increase for the year-to-date comparative period was primarily related to the 2014 Sentinel-related expense recoveries previously mentioned coupled with litigation expense in 2015, as well as higher variable compensation expenses in 2015.
The pre-tax loss for the corporate segment was $22.0 million and $26.6 million during the quarters ended September 30, 2015 and 2014, respectively, and was $74.1 million and $60.9 million during the nine months ended September 30, 2015 and 2014, respectively. The improvement in results in third quarter 2015 relative to third quarter 2014 was primarily driven by a decrease in expenses and higher noninterest income, partially offset by lower net interest income. For the nine months ended September 30, 2015, the decline in results was due in large part to a decrease in revenues which was partially mitigated by an expense decline.
Net interest expense increased $4.8 million in third quarter 2015 to $19.0 million due to the effect of the third quarter 2014 loan sales on FTP, the fourth quarter 2014 issuance of $400 million of senior notes, and a lower yielding available-for-sale (“AFS”) securities portfolio. Noninterest income (including securities gain/losses) was $8.6 million in third quarter 2015 up $4.4 million from $4.1 million in third quarter 2014. The increase in noninterest income was primarily driven by a $5.8 million gain on the extinguishment of junior subordinated notes underlying $200 million of trust preferred debt, partially offset by decreases in deferred compensation income. Deferred compensation income fluctuates with changes in the market value of the underlying investments and is mirrored by changes in deferred compensation expense which is included in personnel expense.
Noninterest expense was $11.5 million in third quarter 2015 compared to $16.5 million in third quarter 2014. The decrease in noninterest expense was due in large part to a $2.9 million decline in negative valuation adjustments associated with derivatives related to prior sales of Visa class B shares relative to the prior year and lower personnel-related expenses primarily related to a decrease in deferred compensation expense, which is directionally consistent with the decrease in deferred compensation income described above.
Net interest expense increased $16.4 million to $52.5 million for the year-to-date period ended September 30, 2015 driven by the same factors that impacted the quarterly increase described above. Noninterest income (including securities gain/losses) was $17.8 million for the nine months ended September 30, 2015, down from $22.6 million for the same period of 2014. The decrease in noninterest income was largely driven by a $5.6 million gain associated with the sale of a cost method investment recognized in first quarter 2014 and a decline in BOLI income as a result of lower policy benefits received in the year-to-date period of 2015 relative to the same period of 2014. Additionally, decreases in deferred compensation income for the nine months ended September 30, 2015 relative to the prior year also contributed to the decline in noninterest income, but were somewhat offset by the $5.8 million gain on the extinguishment of debt previously mentioned.
Noninterest expense decreased 17 percent, or $7.9 million, from $47.4 million for the nine months ended September 30, 2014 to $39.5 million for the nine months ended September 30, 2015. The decline in noninterest expense was largely the result of a $5.1 million decline in negative valuation adjustments associated with derivatives related to prior sales of Visa Class B shares compared to 2014
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and lower occupancy expense in the nine months ended September 30, 2015 primarily related to an efficiency-related lease abandonment expense of $4.7 million that was recognized in 2014. Additionally, personnel expense decreased in the nine months ended September 30, 2015. The decrease in personnel expense largely relates to a decline in deferred compensation income, but was offset somewhat by several favorable adjustments recognized in the year-to-date period of 2014, primarily associated with employee benefit plans and deferred compensation BOLI benefits.
The non-strategic segment had pre-tax income of $13.7 million in third quarter 2015 compared to pre-tax income of $9.1 million in third quarter 2014. For the nine months ended September 30, 2015, the non-strategic segment had a pre-tax loss of $117.1 million compared to pre-tax income of $41.3 million for the nine months ended September 30, 2014. The improvement for the quarterly period was driven by a decrease in expenses which more than offset lower revenues. For the year-to-date period the decline in pre-tax income was the result of an increase in litigation-related expenses and a decline in revenue, partially offset by a larger provision credit for loan losses.
Total revenue was $16.4 million and $56.6 million in third quarter 2015 and third quarter 2014, respectively. NII declined 16 percent to $14.3 million in third quarter 2015 from $17.0 million in third quarter 2014, consistent with the run-off of the non-strategic loan portfolios and the third quarter 2014 sales of mortgage loans HFS. Noninterest income (including securities gains/losses) decreased $37.6 million from $39.6 million in third quarter 2014 to $2.0 million in third quarter 2015 driven by a decline in mortgage banking income. In third quarter 2014, FHN sold approximately $315 million in UPB of mortgage loans HFS that resulted in $39.7 million of valuation gains that were recognized within mortgage banking income.
The provision for loan losses within the non-strategic segment was a provision credit of $5.7 million in third quarter 2015 compared to provision expense of $3.8 million in the prior year. The improvement was largely driven by a $30.1 million decrease in consumer real estate reserves primarily due to a 24 percent decline in loan balances from run-off, sustained levels of low net charge-offs, and continued stabilization/improvement of property values.
Noninterest expense decreased 81 percent, or $35.3 million, to $8.4 million in third quarter 2015 from $43.7 million in third quarter 2014. The decline in expense was largely due to a decline in net loss accruals related to litigation and regulatory matters from $35.2 million in third quarter 2014 to a net expense recovery of $.9 million in third quarter 2015. This decrease was offset somewhat by the reversal of $4.3 million of repurchase and foreclosure provision in third quarter 2014 related to the settlement of certain claims and an increase in occupancy expense associated with the reduction in sublease income in third quarter 2015 compared to the prior year as a result of the sale of a building in second quarter 2015.
Total revenue was $51.3 million and $114.5 million for the nine months ended September 30, 2015 and 2014, respectively, with NII declining 17 percent to $42.4 million for the 2015 year-to-date period from $51.2 million for the same period of 2014, consistent with the run-off of the non-strategic loan portfolios and the third quarter 2014 sales of mortgage loans HFS. Noninterest income (including securities gains/losses) decreased $54.3 million to $9.0 million for the nine months ended September 30, 2015 from $63.3 million. The decline in noninterest income was driven by a $66.7 million decline in mortgage banking income, which was the result of the third quarter 2014 gains previously mentioned, the receipt of approximately $20 million in previously unrecognized servicing fees in conjunction with servicing sales, and a larger positive mortgage warehouse valuation adjustment in 2014 due to positive fair value adjustments that reflected new information on market pricing for similar assets primarily related to the non-performing portion of the held-for-sale portfolio. A portion of this decline was somewhat offset by several transactions which negatively impacted noninterest income in the prior year, including a $4.4 million loss on the extinguishment of debt associated with the collapse of two HELOC securitization trusts, a $2.0 million loss on the deconsolidation of a securitization trust, and a $2.0 million negative fair value adjustment on an investment. Additionally, a $2.7 million gain on the sale of property recognized in second quarter 2015 also positively impacted other noninterest income during 2015.
The provision for loan losses within the non-strategic segment was a provision credit of $20.7 million for the nine months ended September 30, 2015 compared to a provision credit of $2.6 million for the nine months ended September 30, 2014. The increase in provision credit was largely driven by the consumer real estate portfolio due to lower portfolio balances, sustained low levels of net charge-offs, and continued stabilization/improvement of property values in the first nine months of 2015 relative to the prior year. This increase was somewhat offset by a reduction in the provision credit associated with the commercial portfolios, primarily driven by the disposition of three TRUP loans that had a favorable impact on prior year provision.
Noninterest expense increased to $189.2 million in the nine months ended September 30, 2015 from $75.8 million in the nine months ended September 30, 2014. The increase in noninterest expense was primarily due to a $126.2 million net increase in loss accruals related to litigation and regulatory matters including $162.5 million of loss accruals recognized in first quarter 2015 associated with the settlement reached with DOJ/HUD as previously mentioned, offset by $35.4 million of net litigation loss accruals recognized during the nine months ended September 30, 2014 related to legal matters. Additionally, the reversal of $4.3 million of repurchase and
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foreclosure provision recognized in 2014 related to the settlement of certain claims and an increase in occupancy expense associated with the reduction in sublease income previously mentioned contributed to the expense increase. Offsetting a portion of this increase, legal expense decreased $4.8 million for the nine months ended September 30, 2015 relative to the nine months ended September 30, 2014. Generally, most other expense categories declined given the continued wind-down of the legacy businesses.
INCOME STATEMENT REVIEW
Total consolidated revenue was $288.7 million in third quarter 2015 compared to $317.4 million in third quarter 2014. The decline in income was largely driven by a decrease in mortgage banking income, but was partially offset by increases in fixed income product revenue, net interest income and gains on the extinguishment of debt. Total expenses decreased $28.6 million from $244.0 million in third quarter 2014 to $215.4 million in third quarter 2015 primarily due to lower net losses from litigation and regulatory matters and a decline in personnel expenses relative to the prior year, somewhat offset by the recognition of a $4.3 million reversal of repurchase and foreclosure provision expense recognized in third quarter 2014 related to the settlement of certain repurchase claims. For the nine months ended September 30, 2015, total consolidated revenue declined 3 percent to $872.2 million from $899.1 million in the prior year primarily due to a decrease in mortgage banking, partially offset by increases in net interest income, fixed income product revenue and gains on the extinguishment of debt. Total expenses for the nine months ended September 30, 2015 increased $184.8 million to $810.1 million from $625.2 million for the nine months ended September 30, 2014 primarily driven by increases in litigation loss accruals and personnel expenses.
NET INTEREST INCOME
Net interest income increased 3 percent to $163.6 million in third quarter 2015 from $159.5 million in third quarter 2014. For the nine months ended September 30, 2015, NII increased 4 percent to $487.1 million from $468.7 million. For the three and nine months ended September 30, 2015, the increase in NII was primarily attributable to higher balances of loans to mortgage companies coupled with additional commercial and bank installment loan growth, partially offset by continued run-off of the non-strategic loan portfolios and lower yielding commercial loans due to competitive pressure. Average earning assets were $23.2 billion and $21.7 billion in third quarters 2015 and 2014, respectively, and $23.3 billion and $21.6 billion for the nine months ended September 30, 2015 and 2014, respectively. The increase in both periods relative to the prior year was primarily driven by loan growth within the regional bank, but was also impacted by higher average balances of excess cash held at the Federal Reserve (“Fed”), which more than offset continued run-off of the non-strategic loan portfolios and a decline in average balances of Loans HFS because of the third quarter 2014 loan sales.
For purposes of computing yields and the net interest margin, FHN adjusts net interest income to reflect tax exempt income on an equivalent pre-tax basis which provides comparability of net interest income arising from both taxable and tax-exempt sources. The consolidated net interest margin decreased to 2.85 percent in third quarter 2015 from 2.97 percent in third quarter 2014. The net interest spread was 2.72 percent in third quarter 2015 down 13 basis points from 2.85 percent in third quarter 2014 and the impact of free funding was 13 basis points in 2015 up from 12 basis points in 2014. For the nine months ended September 30, 2015, the net interest margin was 2.84 percent, down from 2.94 percent for the comparable period of 2014. The decline in NIM for the three and nine month period of 2015 was driven by several factors including an increase in excess cash held at the Fed, lower yielding commercial loans, run-off of the non-strategic loan portfolios, a lower yielding securities portfolio, and increased long-term funding costs. These negative effects were somewhat mitigated by higher average balances of loans to mortgage companies, improved deposit pricing, increased loan fees, and higher cash basis interest income.
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Table 1- Net Interest Margin
Earning assets:
Loans, net of unearned income:
Commercial loans
Retail loans
Total loans, net of unearned income
Investment securities:
U.S. government agencies
Total investment securities
Other earning assets:
Securities purchased under agreements to resell (b)
Interest bearing cash
Total other earning assets
Interest income / total earning assets
Interest-bearing liabilities:
Interest-bearing deposits:
Time deposits (c)
Total interest-bearing core deposits
Certificates of deposit $100,000 and more (d)
Fixed income trading liabilities
Term borrowings (e)
Interest expense / total interest-bearing liabilities
Net interest spread
Effect of interest-free sources used to fund earning assets
Net interest margin (f)
NM – Not meaningful
FHN’s net interest margin is impacted by balance sheet factors such as interest-bearing cash levels, deposit balances, trading inventory, commercial loan volume, loan fees, cash basis income, and the potential rise in short term interest rates. For the remainder of 2015, NIM could be under pressure due to a meaningful buildup in cash balances, as well as a decline in loan yields from the competitive environment and ongoing low rates.
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PROVISION FOR LOAN LOSSES
The provision for loan losses is the charge to earnings that management determines to be necessary to maintain the ALLL at a sufficient level reflecting management’s estimate of probable incurred losses in the loan portfolio. The provision for loan losses was $1.0 million in third quarter 2015 compared to $6.0 million in third quarter 2014. For the nine months ended September 30, 2015 and 2014, the provision for loan losses was $8.0 million and $21.0 million, respectively. During third quarter 2015 and 2014 FHN experienced continued overall improvement in the loan portfolio. The allowance for loan losses declined 12 percent from September 30, 2014 to September 30, 2015. Overall, FHN’s asset quality trends remain historically strong. For additional information about the provision for loan losses refer to the Regional Banking and Non-Strategic sections of the Business Line Review section in this MD&A. Additionally, for additional information about general asset quality trends refer to Asset Quality - Trend Analysis of Third Quarter 2015 Compared to Third Quarter 2014 in this MD&A.
NONINTEREST INCOME
Noninterest income (including securities gains/(losses)) was $125.1 million in third quarter 2015 and represented 43 percent of total revenue compared to $157.8 million in third quarter 2014 and 50 percent of total revenue. For the nine months ended September 30, 2015 noninterest income was $385.1 million and represented 44 percent of total revenue compared to $430.4 million and 48 percent for the nine months ended September 30, 2014. The decline in noninterest income during both periods of 2015 relative to the prior year largely resulted from a decrease in mortgage banking income, but was partially mitigated by increases in fixed income sales revenue and all other income and commissions.
Fixed Income Noninterest Income
Fixed income noninterest income increased 9 percent in third quarter 2015 to $51.8 million from $47.6 million in third quarter 2014. For the nine months ended September 30, 2015 and 2014, fixed income noninterest income was $169.7 million and $152.1 million, respectively, representing a 12 percent increase. Revenue from fixed income product sales was up in both periods reflecting more favorable market conditions due to increased rate volatility in 2015 relative to the respective periods of the prior year. Revenue from other products increased to $8.8 million in third quarter 2015 from $6.4 million in third quarter 2014, primarily driven by increases in fees from loan and derivative sales. During the nine months ended September 30, 2015, revenue from other products increased to $26.5 million from $20.8 million for the nine months ended September 30, 2014, largely driven by increases in fees from loan sales, derivative sales, and portfolio advisory.
Table 2 - Fixed Income Noninterest Income
Fixed income product revenue
Other product revenue
Total fixed income noninterest income
Brokerage, Management Fees and Commissions
Income from brokerage, management fees and commissions was $11.6 million and $35.5 million for the three and nine months ended September 30, 2015 and 2014, respectively, compared to $12.3 million and $37.5 million for the three and nine months ended September 30, 2014, respectively. The decline in income was primarily driven by a reduction in annuity income as a result of lower volume in 2015 compared to the prior year, and also by a shift in product and fee structures which caused a temporary decline in revenues but should result in revenue streams over the long term.
Bankcard Income
Bankcard income was $5.6 million in third quarter 2015, up slightly from $5.5 million in third quarter 2014. For the nine months ended September 30, 2015 and 2014 bankcard income was $16.6 million and $18.0 million, respectively. The decline in bankcard income for the year-to-date period was primarily the result of $2.8 million of Visa volume incentives recognized in second quarter 2014, but was somewhat mitigated by higher transaction volume in 2015 relative to the prior year.
Bank Owned Life Insurance
BOLI income increased 17 percent to $4.1 million in third quarter 2015 from $3.5 million in third quarter 2014, driven by higher policy benefits received in the quarter relative to the prior year. For the nine months ended September 30, 2015, BOLI income was $11.0 million compared to $12.9 million for the nine months ended September 30, 2014. The decline in BOLI income for the nine months ended September 30, 2015 relative to the prior year was primarily due to the receipt of $2.8 million of policy benefits in first quarter 2014.
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Mortgage Banking Noninterest Income
Mortgage banking income was $.8 million in third quarter 2015 down from $41.6 million in third quarter 2014. The decline in mortgage banking income during third quarter 2015 relative to the prior year was primarily due to $39.7 million of gains on the sales of approximately $315 million in UPB of HFS mortgage loans recognized in third quarter 2014. During the nine months ended September 30, 2015 and 2014 mortgage banking income was $2.7 million and $69.4 million, respectively. The decline in mortgage banking income for the nine months ended September 30, 2015 relative to the prior year, was the result of several transactions recognized in 2014 that positively impacted mortgage banking income, including the third quarter 2014 gains previously mentioned, the receipt of approximately $20 million in previously unrecognized servicing fees in conjunction with servicing sales, and a larger positive mortgage warehouse valuation adjustment in 2014 due to positive fair value adjustments that reflected new information on market pricing for similar assets primarily related to the non-performing portion of the held-for-sale portfolio. Other mortgage banking income for the nine months ended September 30, 2014 also included a $2.0 million loss associated with the deconsolidation of a securitization trust.
Securities Gains/Losses
In third quarter 2014, FHN recognized net securities losses of $.9 million which was primarily the result of a loss on the sale of an investment. During the nine months ended September 30, 2014, FHN recognized net securities gains of $2.9 million, as a $5.6 million gain on the sale of a cost method investment in first quarter 2014 more than offset $2.0 million of negative fair value adjustments related to an investment and the $.9 million loss on the sale previously mentioned. Securities gains/(losses) for the three and nine months ended September 30, 2015 were not material.
Other Noninterest Income
All other income and commissions increased to $12.5 million in third quarter 2015 from $9.1 million in third quarter 2014 primarily due to a $5.8 million gain on the extinguishment of junior subordinated notes underlying $200 million of trust preferred debt, partially offset by a decline in deferred compensation income. For the nine months ended September 30, 2015 all other income and commissions increased $11.1 million to $34.4 million. The increase in all other income and commissions for the year-to-date period was largely driven by the $5.8 million gain previously mentioned and $2.5 million of net gains on the sales of properties, as well as a $4.4 million loss recognized in first quarter 2014 on the extinguishment of debt associated with the collapse of two HELOC securitization trusts, somewhat offset by a decline in deferred compensation income. The following table provides detail regarding FHN’s other income.
Table 3 - Other Income
Other income:
Gain/(loss) on repurchases of debt
NONINTEREST EXPENSE
Noninterest expense was $215.4 million in third quarter 2015 compared to $244.0 million in third quarter 2014. The decrease in noninterest expense during third quarter 2015 relative to the prior year was primarily the result of a decrease in net litigation and regulatory loss accruals and lower personnel expense, somewhat offset by the recognition of an expense recovery to repurchase and foreclosure provision expense in third quarter 2014.
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For the nine months ended September 30, 2015 noninterest expense was $810.1 million compared to $625.2 million for the nine months ended September 30, 2014. The increase in noninterest expense was primarily the result of increases in net litigation and regulatory loss accruals in the nine months ended September 30, 2015 coupled with an increase in personnel expenses relative to the prior year.
Employee Compensation, Incentives, and Benefits
Employee compensation, incentives, and benefits (personnel expense), which is generally the largest component of noninterest expense, was $116.2 million in third quarter 2015, a 4 percent decrease from $120.7 million in third quarter 2014. The decline in personnel expense was primarily due to an $8.3 million gain recognized during third quarter 2015 related to an amendment of certain employee benefit plans as well as lower deferred compensation expenses in the quarter relative to the prior year. These decreases were partially offset by increases in variable compensation associated with higher fixed income product sales revenue within FHN’s fixed income operating segment in third quarter 2015, as well as higher pension-related expenses driven by an increase in the pension liability as a result of a decline in the discount rate and a new mortality table at the most recent measurement date. Higher employee medical expenses in third quarter 2015 relative to the prior year also offset a portion of the decline in personnel expenses during the quarter. For the nine months ended September 30, 2015, personnel expense was $375.6 million, a 4 percent increase from $359.6 million for the nine months ended September 30, 2014. The increase in personnel expense during the year-to-date period was largely driven by increases in variable compensation associated with higher fixed income product sales revenue relative to the prior year and higher incentive expense associated with loan growth, strategic hires, and retention within the regional bank. Additionally, higher pension-related and employee medical costs contributed to the increase in personnel expenses during the nine months ended September 30, 2015, as well as several favorable adjustments recognized during 2014 related to employee performance equity awards, employee benefit plans, and deferred compensation BOLI benefits resulting in lower personnel expense in 2014. These increases were offset somewhat by the gain associated with the employee benefit plan amendment previously mentioned and lower deferred compensation expenses relative to the nine months ended September 30, 2014.
Occupancy expense was $13.3 million and $12.4 million in third quarter 2015 and 2014, respectively. The increase in occupancy expense was largely due to lower sublease income received in third quarter 2015 relative to the prior year as a result of the sale of a building in second quarter 2015. For the nine months ended September 30, 2015 and 2014 occupancy expense was $37.3 million and $41.9 million, respectively, primarily the result of $4.6 million of lease abandonment expense recognized in first quarter 2014 related to efficiency initiatives, somewhat offset by the reduction in sublease income, previously mentioned.
Professional Fees
Professional fees were $5.1 million and $14.1 million for the three and nine months ended September 2015, down from $6.2 million and $16.4 million for the same periods of 2014. The decrease in professional fees was related to various consulting projects in 2014.
FDIC Premium Expense
FDIC premium expense was $4.5 million and $3.5 million for the three months ended September 30, 2015 and 2014, respectively, and was $12.9 million and $8.6 million for the nine months ended September 30, 2015 and 2014, respectively. The increase in the year-to-date period includes the receipt of $3.3 million of FDIC premium refunds recognized in second quarter 2014.
Legal Fees
Legal fees were $3.6 million in third quarter 2015 compared to $4.3 million in third quarter 2014 and were $11.7 million and $15.3 million for the nine months ended September 30, 2015 and 2014, respectively. The decline in legal fees was driven by a reduction in costs related to litigation matters in 2015 relative to the prior year. Legal fees for the nine months ended September 30, 2014 included an $8.5 million expense recovery related to the Sentinel matter.
Contract Employment and Outsourcing
Expenses associated with contract employment and outsourcing decreased $1.8 million and $3.5 million, respectively, for the three and nine months ended September 30, 2015 to $3.4 million and $11.3 million. The decrease was primarily driven by elevated expenses in 2014 related to technology-related projects within the regional bank.
Repurchase and Foreclosure Provision
For the three and nine months ended September 30, 2014, FHN recorded a $4.3 million reversal of repurchase and foreclosure provision related to the settlement of certain claims. No repurchase provision expense was recorded in 2015.
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Other Noninterest Expense
All other expenses decreased $29.1 million to $30.4 million in third quarter 2015 from $59.5 million in third quarter 2014. The decrease in expense was primarily driven by a $24.5 million decline in net losses from litigation and regulatory matters primarily related to expenses recognized in 2014, including $50.4 million in loss accruals related to legal matters, partially offset by $15.0 million of expense reversals associated with agreements with insurance companies for the recovery of expenses FHN incurred related to litigation losses in previous periods. Litigation and regulatory matters in third quarter 2015 included an $11.6 million loss associated with a legal matter in which an arbitration panel found in favor of the claimants. Additionally, in third quarter 2015, FHN recognized $.3 million of negative valuation adjustments associated with derivatives related to prior sales of Visa class B shares, compared to $3.2 million of negative valuation adjustments in third quarter 2014.
For the nine months ended September 30, 2015 all other expenses were $230.9 million compared to $59.9 million for the nine months ended September 30, 2014. The increase in expense for the year-to-date period was the result of a $176.1 million increase in net loss accruals related to legal matters. Losses from litigation and regulatory matters were $173.4 million for the nine months ended September 30, 2015 and primarily relate to $162.5 million of loss accruals recognized in first quarter 2015 related to the settlement of potential claims related to FHN’s underwriting and origination of FHA-insured mortgage loans and $11.6 million of loss accruals recognized in third quarter 2015 associated with the arbitration decision previously mentioned. For the nine months ended September 30, 2014, FHN recognized $110.9 million of loss accruals related to legal matters, which were more than offset by $113.6 million of expense reversals associated with agreements with insurance companies for the recovery of expenses FHN incurred related to litigation losses in previous periods. Additionally, expenses were favorably impacted during the nine months ended September 30, 2015 by a $5.1 million decrease in negative valuation adjustments associated with the derivatives related to prior sales of Visa Class B shares. The following table provides detail regarding FHN’s other expense.
Table 4 - Other Expense
Other expense:
Litigation and regulatory matters (a)
INCOME TAXES
FHN recorded an income tax provision of $8.9 million in third quarter 2015, compared to an income tax provision of $16.8 million in third quarter 2014. For the nine months ended September 30, 2015, FHN recorded an income tax provision of $8.2 million compared to an income tax provision of $70.5 million for the nine months ended September 30, 2014. The effective tax rates for the three months ended September 30, 2015 and 2014 were approximately 12 percent and 25 percent, respectively. For the nine months ended September 30, 2015 and 2014 the effective tax rates were approximately 15 percent and 28 percent, respectively. Since pre-tax income is the most important component in determining the effective tax rate, the comparison of the tax rate from period to period, by itself, will not provide meaningful information unless pre-tax income is fairly consistent. The company’s effective tax rate is favorably affected by recurring items such as bank-owned life insurance, tax-exempt income, and credits and other tax benefits from affordable housing investments. The company’s effective tax rate also may be affected by items that may occur in any given period but are not consistent from period to period, such as changes in the deferred tax asset valuation allowance and changes in unrecognized tax benefits.
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A deferred tax asset (“DTA”) or deferred tax liability (“DTL”) is recognized for the tax consequences of temporary differences between the financial statement carrying amounts and the tax bases of existing assets and liabilities. The tax consequence is calculated by applying enacted statutory tax rates, applicable to future years, to these temporary differences. As of September 30, 2015, FHN’s gross DTA (net of a valuation allowance) and gross DTL were $345.8 million and $112.4 million, respectively, resulting in a net DTA of $233.4 million at September 30, 2015, compared with $231.5 million at September 30, 2014.
In order to support the recognition of the DTA, FHN’s management must conclude that the realization of the DTA is more likely than not. FHN evaluates the likelihood of realization of the DTA based on both positive and negative evidence available at the time, including (as appropriate) scheduled reversals of DTLs, projected future taxable income, tax planning strategies, and recent financial performance. Realization is dependent on generating sufficient taxable income prior to the expiration of the carryforwards attributable to the DTA. In projecting future taxable income, FHN incorporates assumptions including the amount of future state and federal pretax operating income, the reversal of temporary differences, and the implementation of feasible and prudent tax planning strategies. These assumptions require significant judgment about the forecasts of future taxable income and are consistent with the plans and estimates used to manage the underlying business.
As of September 30, 2015, FHN had federal tax credit carryforwards which will expire in varying amounts between 2031 and 2034, state income tax net operating loss (“NOL”) carryforwards which will expire in varying amounts between 2016 and 2032, and federal capital loss carryforwards, which will expire in 2017. As of September 30, 2015 and 2014, FHN established a valuation allowance of $.1 million and $4.1 million, respectively, against its state NOL carryforwards and $40.4 million and $45.0 million, respectively, against its capital loss carryforwards. FHN’s DTA after valuation allowance was $345.8 million and $312.1 million as of September 30, 2015 and 2014, respectively. Based on current analysis, FHN believes that its ability to realize the remaining DTA is more likely than not. FHN monitors its DTA and the need for a valuation allowance on a quarterly basis. A significant adverse change in FHN’s taxable earnings outlook could result in the need for further valuation allowances. In the event FHN is able to determine that the deferred tax assets are realizable in the future in excess of their net recorded amount, FHN would make an adjustment to the valuation allowance, which would reduce the provision for income taxes.
Changes in tax laws and rates could also affect recorded DTAs and DTLs in the future. Management is not aware of the enactment of any such changes that would have a material effect on the company’s results of operations, cash flows or financial position.
STATEMENT OF CONDITION REVIEW
Total period-end assets were $25.4 billion on September 30, 2015, compared to $24.0 billion on September 30, 2014 and $25.7 billion on December 31, 2014. Average assets increased to $25.3 billion in third quarter 2015 from $23.8 billion in third quarter 2014 and $24.6 billion in fourth quarter 2014. The increase in average assets compared to third quarter 2014 is primarily attributable to increases in loan balances and other earning assets, somewhat offset by a decline in loans HFS. The increase in period-end assets relative to September 30, 2014 was largely driven by increases in loan balances, interest bearing cash and securities purchased under agreements to resell. Period-end assets decreased relative to December 31, 2014 driven by a decline in interest-bearing cash, somewhat offset by increases in loans and other interest bearing assets.
EARNING ASSETS
Earning assets consist of loans, investment securities, other earning assets such as trading securities, interest-bearing cash, and loans HFS. Average earning assets increased to $23.2 billion in 2015 from $21.7 billion a year earlier and increased $.7 billion from fourth quarter 2014. A more detailed discussion of the major line items follows. Unless otherwise indicated, references below to balances for 2015 or 2014 refer to period-end balances at September 30, 2015 or September 30, 2014, respectively, or average balances for the third quarter of 2015 or 2014.
Period-end loans increased to $16.7 billion as of September 30, 2015 from $15.8 billion on September 30, 2014. Average loans for 2015 were $16.6 billion compared to $15.8 billion for 2014. The increase in average and period-end loan balances was primarily due to loan growth within the regional bank’s commercial portfolios, partially offset by balance declines within FHN’s run-off portfolios within the non-strategic segment.
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Table 5 - Average Loans
Credit card, OTC and other
C&I loans are the largest component of the commercial portfolio comprising 87 percent of average commercial loans in third quarter 2015 and 2014. C&I loans increased 14 percent, or $1.1 billion, from 2014 due to an increase in the average balance of loans to mortgage companies coupled with net loan growth within the regional bank’s general commercial portfolio and an increase in asset-based lending. Commercial real estate loans increased 13 percent or $164.8 million to $1.4 billion in 2015 because of growth in expansion markets and opportunities with new and existing customers within the regional bank.
Average retail loans declined 7 percent, or $439.3 million, from a year ago to $5.7 billion in 2015. The consumer real estate portfolio (home equity lines and installment loans) declined $334.1 million, to $4.8 billion as the continued wind-down of portfolios within the non-strategic segment outpaced a $181.3 million increase in real estate installment loans from new originations within the regional bank. The permanent mortgage portfolio declined $106.2 million to $475.7 million in 2015 largely driven by run-off of legacy assets. Credit Card and Other increased slightly to $353.1 million in 2015.
Investment Securities
FHN’s investment portfolio consists principally of debt securities including government agency issued mortgage-backed securities (“MBS”) and government agency issued collateralized mortgage obligations (“CMO”), substantially all of which are classified as available-for-sale (“AFS”). FHN utilizes the securities portfolio as a source of income, liquidity and collateral for repurchase agreements, for public funds, and as a tool for managing risk of interest rate movements. Period-end investment securities increased 4 percent from $3.5 billion on September 30, 2014 to $3.7 billion on September 30, 2015. Average investment securities were $3.7 billion in 2015 and $3.6 billion in 2014, representing 16 percent of earning assets in 2015 and 2014. The amount of securities purchased for the investment portfolio is largely driven by the desire to protect the value of non-rate sensitive liabilities and equity and maximize yield on FHN’s excess liquidity without negatively affecting future yields while operating in this historically low interest rate environment.
Loans Held-for-Sale
Loans HFS consists of the mortgage warehouse (primarily repurchased government-guaranteed loans), student, small business (prior to second quarter 2015), and home equity loans. The average balance of loans HFS decreased $192.7 million from 2014 and averaged $126.1 million in 2015. On September 30, 2015 and 2014, loans HFS were $124.3 million and $151.9 million, respectively. The lower balances of both average and period-end loans HFS reflect the third quarter 2014 sales of loans with approximately $315 million in unpaid principal balance.
Other Earning Assets
All other earning assets include trading securities, securities purchased under agreements to resell, federal funds sold (“FFS”), and interest-bearing deposits with the Federal Reserve Bank (“FRB”) and other financial institutions. All other earning assets averaged $2.7 billion in 2015, a $712.8 million increase from $2.0 billion in 2014. The increase was largely the result of a $518.5 million increase in interest-bearing cash driven primarily by inflow of core deposits, as well as increases of $118.7 million and $77.8 million in securities purchased under agreements to resell (“asset repos”) and trading securities, respectively. Fixed income’s trading inventory fluctuates daily based on customer demand. Asset repos are used in fixed income trading activity and generally correlate
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with the level of fixed income trading liabilities (short-positions) as securities collateral from repo transactions is used to fulfill trades. All other earning assets were $2.7 billion and $2.2 billion on September 30, 2015 and 2014, respectively, and $3.5 billion on December 31, 2014. The spike in other earning assets on December 31, 2014 was driven by an inflow of customer deposits and proceeds from the issuance of senior notes.
Non-earning assets
Period-end non-earning assets were $2.2 billion on September 30, 2015 and 2014, respectively.
Core Deposits
Average core deposits were $18.5 billion during third quarter 2015, up 20 percent from $15.4 billion during third quarter 2014. The increase in average core deposits was driven by several factors including an increase in commercial customer deposits, FHN’s decision to increase deposits in a third party network deposits sweep program, a new product offering within correspondent banking, the addition of approximately $440 million of deposits associated with the fourth quarter 2014 branch acquisition, and an increase in public funds. The third party deposits program is an FDIC-insured deposit sweep program where financial institutions can receive unsecured deposits for the long-term (several years) and in larger-dollar increments. The new product offering within correspondent banking previously mentioned resulted in a shift in funding from federal funds purchased (“FFP”). Period-end core deposits were $18.6 billion on September 30, 2015, up 18 percent from $15.7 billion on September 30, 2014, driven by the same factors that affected average balances.
Short-Term Funds
Average short-term funds (certificates of deposit greater than $100,000, FFP, securities sold under agreements to repurchase, trading liabilities, and other short-term borrowings) decreased 43 percent to $2.1 billion in third quarter 2015 from $3.6 billion in third quarter 2014. The decrease was primarily driven by declines in other short-term borrowings and FFP. The decline in other short-term borrowings was due to higher FHLB borrowings in third quarter 2014 as a result of loan growth and deposit fluctuations. Loan growth in 2015 was largely funded with deposits. Average FFP, which currently is composed primarily of funds from correspondent banks, was $.5 billion in third quarter 2015 compared to $1.0 billion in third quarter 2014. FFP fluctuates depending on the amount of excess funding of FHN’s correspondent bank customers, and the decrease between third quarter 2015 and 2014 was also affected by a new product offering introduced in late fourth quarter 2014 in correspondent banking that resulted in a shift of funds from FFP to deposits. On average, short-term purchased funds accounted for 9 percent of FHN’s funding (core deposits plus short-term purchased funds and term borrowings) in third quarter 2015 compared to 18 percent in third quarter 2014. Period-end short-term funds decreased $1.1 billion from $3.2 billion on September 30, 2014 to $2.0 billion on September 30, 2015. The decrease in period-end balances was largely driven by a reduction of FHLB borrowings and FFP which resulted from the shift in funding previously mentioned.
Term Borrowings
Term borrowings include senior and subordinated borrowings with original maturities greater than one year. Term borrowings averaged $1.5 billion in third quarter 2015, a $38.8 million and $203.8 million decrease from third quarter 2014 and fourth quarter 2014, respectively. The decrease in average term borrowings primarily relates to $304 million of subordinated notes that matured during first quarter 2015 and $206 million of junior subordinated notes underlying $200 million of trust preferred debt that were called in third quarter 2015, which more than offset proceeds from the issuance of $400 million of senior notes in fourth quarter 2014. Term borrowings were $1.3 billion and $1.5 billion on September 30, 2015 and 2014, respectively, and $1.9 billion on December 31, 2014.
Other Liabilities
Period-end other liabilities were $858.9 million on September 30, 2015 compared to $1.0 billion on September 30, 2014, as a $113.9 increase in net pension funding status was more than offset by a $234.6 million decrease in fixed income payables, which fluctuate based on the level of pending unsettled trades at the end of the quarter.
CAPITAL
Management’s objectives are to provide capital sufficient to cover the risks inherent in FHN’s businesses, to maintain excess capital to well-capitalized standards, and to assure ready access to the capital markets. Average equity was $2.5 billion in third quarter 2015 compared to $2.6 billion in third quarter 2014. The decrease in equity was primarily driven by an increase in the effects of net pension funding status within other comprehensive income largely due to a decline in the discount rate as of the most recent measurement date (December 31, 2014), as well as decreases in capital surplus and common stock because of shares that were purchased under the 2014 share repurchase program mentioned below. These decreases were somewhat offset by the impact of net income recognized since third quarter 2014 on retained earnings and an increase in unrealized gains associated with the AFS securities portfolio within accumulated other comprehensive income. Period-end equity was $2.6 billion on September 30, 2015 and 2014.
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In January 2014, FHN’s board of directors approved a share repurchase program which enables FHN to repurchase its common stock in the open market or in privately negotiated transactions, subject to certain conditions. In July 2015 the board increased and extended that program. The current program authorizes total purchases of up to $200 million and expires on January 31, 2017. During third quarter 2015, FHN did not repurchase any shares under this authorization due to restrictions related to the acquisition of TrustAtlantic Financial which closed on October 2, 2015. Total purchases under this program through September 30, 2015 were $54.3 million.
The following tables provide a reconciliation of Shareholders’ equity from the Consolidated Condensed Statements of Condition to Common Equity Tier 1, Tier 1 and Total Regulatory Capital as well as certain selected capital ratios:
Table 6 - Regulatory Capital and Ratios
Shareholders’ equity (a)
FHN Non-cumulative perpetual preferred
Common equity
Regulatory adjustments:
Goodwill and other intangibles
Net unrealized (gains)/losses on securities
Minimum pension liability
Disallowed servicing assets
Disallowed deferred tax assets
Common equity tier 1 (b)
Qualifying noncontrolling interest - FTBNA preferred stock (c)
Qualifying trust preferred (d)
Other deductions from tier 1 (e)
Tier 1 capital
Tier 2 capital (d)
Total regulatory capital
Common Equity Tier 1 (b)
First Tennessee Bank National Association (f)
Tier 1
Tier 1 Common (g)
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Banking regulators define minimum capital ratios for bank holding companies and their bank subsidiaries. Based on the capital rules and definitions prescribed by the banking regulators, should any depository institution’s capital ratios decline below predetermined levels, it would become subject to a series of increasingly restrictive regulatory actions. The system categorizes a depository institution’s capital position into one of five categories ranging from well-capitalized to critically under-capitalized. In third quarter 2015, for an institution the size of FHN to qualify as well-capitalized, Common Equity Tier 1, Tier 1 Capital, Total Capital, and Leverage capital ratios must be at least 6.5 percent, 8 percent, 10 percent, and 5 percent, respectively. As of September 30, 2015, FHN and FTBNA had sufficient capital to qualify as well-capitalized institutions. The Basel III risk-based capital regulations became effective January 1, 2015 for FHN and FTBNA. Capital ratios decreased in 2015 relative to 2014 due to the implementation of the Basel III regulations, the impact of net income/(loss) less dividends and share repurchases on retained earnings and increases in risk-weighted assets from growth in earning assets. Additionally, the September 30, 2015 Tier 1 and Total Capital ratios for FHN decreased relative to 2014 as a result of the redemption of the $200 million trust preferred securities. Throughout the next year, capital ratios are expected to remain significantly above well-capitalized standards.
Pursuant to board authority, FHN may repurchase shares of its common stock from time to time and will evaluate the level of capital and take action designed to generate or use capital, as appropriate, for the interests of the shareholders, subject to legal and regulatory restrictions. FHN’s board has not authorized a preferred stock purchase program. The following tables provide information related to securities repurchased by FHN during third quarter 2015:
Table 7 - Issuer Purchases of Common Stock
Compensation Plan-Related Repurchase Authority:
(Volume in thousands, except per share data)
July 1 to July 31
August 1 to August 31
September 1 to September 30
*- amount less than 1
N/A- Not applicable
Compensation Plan Programs:
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Other Repurchase Authority:
(Dollar values and volume in thousands, except per share data)
N/A- not applicable
Other Programs:
ASSET QUALITY - TREND ANALYSIS OF THIRD QUARTER 2015 COMPARED TO THIRD QUARTER 2014
Loan Portfolio Composition
FHN groups its loans into portfolio segments based on internal classifications reflecting the manner in which the ALLL is established and how credit risk is measured, monitored, and reported. From time to time, and if conditions are such that certain subsegments are uniquely affected by economic or market conditions or are experiencing greater deterioration than other components of the loan portfolio, management may determine the ALLL at a more granular level. Commercial loans are composed of commercial, financial, and industrial (“C&I”) and commercial real estate (“CRE”). Retail loans are composed of consumer real estate; permanent mortgage; and credit card and other. FHN has a concentration of residential real estate loans (32 percent of total loans), the majority of which is in the consumer real estate portfolio (29 percent of total loans). Industry concentrations are discussed under the heading C&I below. Consolidated key asset quality metrics for each of these portfolios can be found in Table 15 – Asset Quality by Portfolio.
As economic and real estate conditions develop, enhancements to underwriting and credit policies and guidelines may be necessary or desirable. Credit underwriting guidelines are outlined in Exhibit 13 to FHN’s 2014 Annual Report on Form 10-K in the Loan Portfolio Composition discussion in the Asset Quality Section beginning on page 26 and continuing to page 32. There have been no material changes to FHN’s credit underwriting guidelines or significant changes or additions to FHN’s loan product offerings in 2015.
The following is a description of each portfolio:
COMMERCIAL LOAN PORTFOLIOS
C&I
The C&I portfolio was $9.6 billion on September 30, 2015, and is comprised of loans used for general business purposes and primarily composed of relationship customers in Tennessee and other selected markets that are managed within the regional bank. Typical products include working capital lines of credit, term loan financing of owner-occupied real estate and fixed assets, and trade credit enhancement through letters of credit.
The following table provides the composition of the C&I portfolio by industry as of September 30, 2015 and 2014. For purposes of this disclosure, industries are determined based on the North American Industry Classification System (“NAICS”) industry codes used by Federal statistical agencies in classifying business establishments for the collection, analysis, and publication of statistical data related to the U.S. business economy.
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Table 8 - C&I Loan Portfolio by Industry
Industry:
Finance & insurance
Wholesale trade
Healthcare
Manufacturing
Real estate rental & leasing (a)
Public Administration
Retail trade
Other (transportation, education, arts, entertainment, etc) (b)
Total C&I loan portfolio
As of September 30, 2015, finance and insurance, the largest component, represents 22 percent of the C&I portfolio. The balances of loans to mortgage companies were 14 percent of the C&I portfolio as of September 30, 2015, as compared to 11 percent of the C&I portfolio in 2014, and include balances related to both home purchase and refinance activity. This portfolio class, which generally fluctuates with mortgage rates and seasonal factors, includes commercial lines of credit to qualified mortgage companies primarily for the temporary warehousing of eligible mortgage loans prior to the borrower’s sale of those mortgage loans to third party investors. Generally, lending to mortgage lenders increases when there is a decline in mortgage rates and decreases when rates rise. Significant loan concentrations are considered to exist for a financial institution when there are loans to numerous borrowers engaged in similar activities that would cause them to be similarly impacted by economic or other conditions. 36 percent of FHN’s C&I portfolio (Finance and Insurance plus Loans to Mortgage Companies) could be affected by items that uniquely impact the financial services industry. Except as discussed under “Finance and Insurance”, on September 30, 2015, FHN did not have any other concentrations of C&I loans in any single industry of 10 percent or more of total loans.
Finance and Insurance
The finance and insurance component of the C&I portfolio includes TRUPS (i.e., long-term unsecured loans to bank and insurance-related businesses), loans to bank holding companies, and asset-based lending to consumer finance companies. The TRUPS portfolio has been stressed over the last few years but has seen the stronger borrowers stabilize as there have been upgrades within the TRUPS and bank stock portfolio and also favorable resolutions. Finance and Insurance also includes approximately $1.0 billion of asset-based lending to consumer financing companies which have accounted for the growth in the finance and insurance component in 2015.
TRUPS lending was originally extended as a form of “bridge” financing to participants in the pooled trust preferred securitization program offered primarily to smaller banking (generally less than $15 billion in total assets) and insurance institutions through FHN’s fixed income business. Origination of TRUPS lending ceased in early 2008. Individual TRUPS are re-graded at least quarterly as part of FHN’s commercial loan review process. Typically, the terms of these loans include a prepayment option after a 5 year initial term (with possible triggers of early activation), have a scheduled 30 year balloon payoff, and include an option to defer interest for up to 20 consecutive quarters. As of September 30, 2015, two TRUPS relationships were on interest deferral compared to one TRUPS relationship on interest deferral as of September 30, 2014.
As of September 30, 2015, the unpaid principal balance (“UPB”) of trust preferred loans totaled $344.3 million ($208.0 million of bank TRUPS and $136.3 million of insurance TRUPS) with the UPB of other bank-related loans totaling $82.0 million. Inclusive of a remaining lower of cost or market (“LOCOM”) valuation allowance on TRUPS of $26.2 million, total reserves (ALLL plus the LOCOM) for TRUPS and other bank-related loans were $31.7 million or 7 percent of outstanding UPB.
C&I Asset Quality Trends
During third quarter and throughout 2015 performance of the C&I portfolio remained strong. The C&I ALLL increased slightly to $71.5 million as of September 30, 2015. The slight increase in reserves is driven by loan growth and a continued extension of the loss emergence period in the regional banking segment that was offset by lower loss rates because of historically low levels of net charge-offs. The allowance as a percentage of period-end loans declined to .74 percent as of September 30, 2015 from .82 percent as of September 30, 2014. Net charge-offs were $6.4 million in third quarter 2015 compared to a net recovery of $1.5 million in third quarter 2014. Nonperforming C&I loans decreased $11.8 million from September 30, 2014 to $29.6 million on September 30, 2015 driven by a $13.1 million decrease in nonperforming loans within the regional bank. The nonperforming loan (“NPL”) ratio decreased 18 basis points from September 30, 2014 to .31 percent of C&I loans as of September 30, 2015.
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The following table shows C&I asset quality trends by segment.
Table 9 - C&I Asset Quality Trends by Segment
Period-end loans
Nonperforming loans
Allowance for loan losses as of July 1, 2015
Allowance for loan losses as of September 30, 2015
Troubled debt restructurings
30+ Delinq. % (a)
NPL %
Net charge-offs % (qtr. annualized)
Allowance / loans %
Allowance / charge-offs
Allowance for loan losses as of July 1, 2014
Allowance for loan losses as of September 30, 2014
NM - Not meaningful
Loans are expressed net of unearned income.
Commercial Real Estate
The CRE portfolio was $1.5 billion on September 30, 2015. The CRE portfolio includes both financings for commercial construction and nonconstruction loans. This portfolio is segregated between the income-producing CRE class which contains loans, lines, and letters of credit to commercial real estate developers for the construction and mini-permanent financing of income-producing real estate, and the residential CRE class. Subcategories of income CRE consist of multi-family (29 percent), retail (26 percent), hospitality (14 percent), office (12 percent), industrial (11 percent), land/land development (3 percent), and other (5 percent). Nearly all of the income CRE class was originated through and continues to be managed by the regional bank.
The residential CRE class includes loans to residential builders and developers for the purpose of constructing single-family homes, condominiums, and town homes. Active residential CRE lending within the regional banking footprint is minimal with nearly all new
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originations limited to tactical advances to facilitate workout strategies with existing clients and selected new transactions with “strategic” clients. FHN considers a “strategic” residential CRE borrower as a homebuilder within the regional banking footprint who remained profitable during the most recent down cycle.
CRE Asset Quality Trends
The CRE portfolio had continued strong performance in third quarter 2015 with nonperforming loans and net charge-offs both declining from a year ago. Total CRE loans increased $209.7 million or 16 percent from third quarter 2014 to third quarter 2015. The allowance increased $9.9 million from third quarter 2014 to $25.3 million in third quarter 2015. The increase in allowance is attributable to the regional bank and is primarily driven by loan growth and a continued extension of the loss emergence period as compared to a year ago. Allowance as a percentage of loans increased 49 basis points from third quarter 2014 to 1.70 percent as of September 30, 2015. Net recoveries were $.3 million in third quarter 2015 compared to a net charge-off of $1.5 million in third quarter 2014. Nonperforming loans as a percentage of total CRE loans improved 57 basis points from third quarter 2014 to .54 percent as of September 30, 2015. Accruing delinquencies as a percentage of period-end loans increased 10 basis points from September 30, 2014 to .43 percent as of September 30, 2015. The following table shows commercial real estate asset quality trends by segment.
Table 10 - Commercial Real Estate Asset Quality Trends by Segment
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RETAIL LOAN PORTFOLIOS
Consumer Real Estate
The consumer real estate portfolio was $4.8 billion on September 30, 2015, and is primarily composed of home equity lines and installment loans including restricted balances (loans consolidated under ASC 810). The largest geographical concentrations of balances as of September 30, 2015, are in Tennessee (63 percent) and California (7 percent) with no other state representing more than 3 percent of the portfolio. As of September 30, 2015, approximately 61 percent of the consumer real estate portfolio was in a first lien position. At origination, weighted average FICO score of this portfolio was 747 and refreshed FICO scores averaged 742 as of September 30, 2015, as compared to 743 and 736, respectively, as of September 30, 2014. Generally, performance of this portfolio is affected by life events that affect borrowers’ finances, the level of unemployment, and home prices.
HELOCs comprise $2.2 billion of the consumer real estate portfolio as of September 30, 2015. FHN’s HELOCs typically have a 5 or 10 year draw period followed by a 15 or 10 year repayment period, respectively. During the draw period, a borrower is able to draw on the line and is only required to make interest payments. The line is automatically frozen if a borrower becomes 45 days or more past due on payments. Once the draw period has concluded, the line is closed and the borrower is required to make both principal and interest payments monthly until the loan matures. The principal payment generally is fully amortizing, but payment amounts will adjust when variable rates reset to reflect changes in the prime rate.
As of September 30, 2015, approximately 68 percent of FHN’s HELOCs are in the draw period, compared to 75 percent as of September 30, 2014. Based on when draw periods are scheduled to end per the line agreement, it is expected that $916.2 million, or 63 percent of HELOCs currently in the draw period, will have entered the repayment period during the next 60 months. Delinquencies and charge-off rates for HELOCs that have entered the repayment period are initially higher than HELOCs still in the draw period because of the increased minimum payment requirement; however, after some seasoning, performance of these loans begins to stabilize. The home equity lines of the consumer real estate portfolio are being monitored closely for those nearing the end of the draw period and borrowers are being contacted proactively early in the process. The following table shows the HELOCs currently in the draw period and expected timing of conversion to the repayment period.
Table 11 - HELOC Draw To Repayment Schedule
Months remaining in draw period:
0-12
13-24
25-36
37-48
49-60
>60
Consumer Real Estate Asset Quality Trends
Overall, performance of the consumer real estate portfolio improved in third quarter 2015 when compared with third quarter 2014. The ALLL decreased $35.9 million from third quarter 2015 to $82.5 million as of September 30, 2015, with 84 percent of the decline attributable to the non-strategic segment. The allowance as a percentage of loans was 1.71 percent as of September 30, 2015 compared to 2.31 percent as of September 30, 2014. The 60 basis point decline in the allowance as a percentage of loans from third quarter 2014 to third quarter 2015 is the result of continued run-off of the balances within the non-strategic portfolios, sustained levels of low net charge offs, and continued improvement/stabilization of property values. The balance of nonperforming loans was $111.7 million and $123.5 million as of September 30, 2015 and 2014, respectively, and the decrease was largely related to both improvement and run-off in the non-strategic segment of the portfolio. Loans delinquent 30 or more days and still accruing declined from $53.1 million as of September 30, 2014 to $44.3 million as of September 30, 2015. Net charge-offs were $2.2 million in third quarter 2015 compared to $7.8 million in third quarter 2014. The improvement in net charge-offs is the result of enhanced recovery efforts, improved borrower performance and stronger underlying collateral values. The following table shows consumer real estate asset quality trends by segment.
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Table 12 - Consumer Real Estate Asset Quality Trends by Segment
The permanent mortgage portfolio was $.5 billion on September 30, 2015. This portfolio is primarily composed of jumbo mortgages and one-time-close (“OTC”) completed construction loans that were originated through legacy businesses. Approximately 25 percent of loan balances as of September 30, 2015 are in California, but the remainder of the portfolio is somewhat geographically diverse. Run-off contributed to a majority of the $108.9 million decrease in permanent mortgage period-end balances from third quarter 2014 to third quarter 2015.
The ALLL remained relatively flat at $20.1 million as of September 30, 2015 compared to September 30, 2014. TDR reserves comprise 78 percent of the ALLL for the permanent mortgage portfolio as of September 30, 2015. Accruing delinquencies as a percentage of total loans decreased from 2.73 percent in third quarter 2014 to 2.01 percent in third quarter 2015. Nonperforming loans were relatively flat at $33.8 million as of September 30, 2015, although NPLs as a percentage of loans increased from 5.93 percent as of September 30, 2014 to 7.30 percent as of September 30, 2015 because of a decline in total permanent mortgage loans. Annualized net charge-offs as a percentage of average loans increased from .25 percent in third quarter 2014 to .67 percent in third quarter 2015. The following table shows permanent mortgage asset quality trends by segment.
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Table 13 - Permanent Mortgage Asset Quality Trends by Segment
30+ Delinq. % (b)
Credit Card and Other
The credit card and other portfolios were $.3 billion as of September 30, 2015, and primarily include credit card receivables, other consumer-related credits, and automobile loans. The allowance decreased to $11.5 million as of September 30, 2015 from $14.7 million as of September 30, 2014. In third quarter 2015, FHN recognized $2.5 million of net charge-offs in the credit card and other portfolios, compared to $2.8 million in third quarter 2014. Annualized net charge-offs as a percentage of average loans decreased 40 basis points from third quarter 2014 to 2.79 percent in third quarter 2015. Loans 30 days or more delinquent and accruing decreased from $5.1 million as of September 30, 2014 to $4.1 million September 30, 2015. The following table shows credit card and other asset quality trends by segment.
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Table 14 - Credit Card and Other Asset Quality Trends by Segment
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The following table provides additional asset quality data by loan portfolio:
Table 15 - Asset Quality by Portfolio
Key Portfolio Details
Period-end loans ($ millions)
Charge-offs % (qtr. annualized)
30+ Delinq. % (a)(b)
Allowance for Loan Losses
Management’s policy is to maintain the ALLL at a level sufficient to absorb estimated probable incurred losses in the loan portfolio. The total allowance for loan losses decreased 12 percent from third quarter 2014 to $210.8 million on September 30, 2015, from $238.6 million on September 30, 2014. Continued aggregate improvement in borrowers’ financial conditions through third quarter 2015, run-off of the non-strategic portfolios, and proactive management of problem credits contributed to the decline in the ALLL from a year ago. The ratio of allowance for loan losses to total loans, net of unearned income, decreased to 1.26 percent on September 30, 2015, from 1.51 percent on September 30, 2014.
The provision for loan losses is the charge to earnings necessary to maintain the ALLL at a sufficient level reflecting management’s estimate of probable incurred losses in the loan portfolio. The provision for loan losses decreased to $1.0 million in third quarter 2015 from $6.0 million in third quarter 2014.
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FHN expects asset quality trends to remain relatively stable for the near term. That expectation depends upon a continued economic recovery, among other things, which may or may not occur. The C&I portfolio is expected to continue to show stable trends but short-term variability (both positive and negative) is possible. The CRE portfolio should be relatively stable as FHN has observed property values stabilizing/improving. The remaining non-strategic consumer real estate and permanent mortgage portfolios should continue to steadily wind down. Asset quality metrics within non-strategic may become skewed as the portfolio continues to shrink and the denominator of asset quality ratios becomes smaller. Continued stabilization in performance of the consumer real estate portfolio assumes an ongoing economic recovery as consumer delinquency and loss rates are correlated with unemployment trends and strength of the housing market.
Consolidated Net Charge-offs
Net charge-offs were $11.5 million in third quarter 2015 compared to $11.0 million in third quarter 2014. The ALLL was 4.61 times annualized net charge-offs for third quarter 2015 compared with 5.47 times annualized net charge-offs for third quarter 2014 and the annualized net charge-offs to average loans ratio remained flat at .28 percent.
Commercial net charge-offs were $6.0 million in third quarter 2015 compared to a net charge-off of $0 in third quarter 2014. The increase in third quarter 2015 was primarily driven by a charge-off resulting from borrower fraud associated with one large regional bank C&I credit. Consolidated net charge-offs in the retail portfolios declined 50 percent from third quarter 2014 to $5.5 million in third quarter 2015. The decline in retail net charge-offs was largely driven by the consumer real estate portfolio in both the non-strategic and regional banking segments. The improvement is due to enhanced recovery efforts, stabilization/improvement of property values, continued declines in balances within the non-strategic portfolio, and overall improvement in performance compared to a year ago.
Nonperforming Assets
Nonperforming loans are loans placed on nonaccrual status if it becomes probable that full collection of principal and interest will not be collected in accordance with contractual terms, impairment has been recognized as a partial charge-off of principal balance, or on a case-by-case basis, if FHN continues to receive payments but there are atypical loan structures or other borrower-specific issues. Included in nonaccruals are loans in which FHN continues to receive payments, including residential real estate loans where the borrower has been discharged of personal obligation through bankruptcy and second liens, regardless of delinquency status, behind first liens that are 90 or more days past due or are TDRs. These, along with foreclosed real estate, excluding foreclosed real estate from government insured mortgages, represent nonperforming assets (“NPAs”).
Total nonperforming assets (including NPLs HFS) decreased to $217.2 million on September 30, 2015 from $256.9 million on September 30, 2014. The nonperforming assets ratio (nonperforming assets excluding NPLs HFS to total period-end loans plus foreclosed real estate and other assets) decreased to 1.25 percent in third quarter 2015 from 1.57 percent in third quarter 2014 due to a 27 percent decrease in foreclosed real estate (excluding foreclosed real estate from government insured mortgages) and a 14 percent decline in portfolio nonperforming loans from third quarter 2014 to third quarter 2015. Portfolio nonperforming loans declined $29.8 million from third quarter 2014 to $184.0 million on September 30, 2015. The decline in nonperforming loans was primarily driven by decreases in regional bank commercial nonaccrual loans and declines of consumer real estate nonperforming loans within the non-strategic segment.
Nonperforming C&I loans decreased to $29.6 million in 2015 from $41.4 million in 2014. Commercial real estate NPLs decreased $6.1 million to $8.1 million in 2015. Consumer nonperforming loans decreased to $146.3 million from $158.2 million in 2014, primarily due to a $10.2 million decline in non-strategic consumer real estate NPLs.
The ratio of ALLL to NPLs in the loan portfolio improved to 1.15 times in 2015 compared to 1.12 times in 2014, driven by lower nonperforming loans which was partially offset by a decrease in ALLL. Certain nonperforming loans in both the commercial and consumer portfolios are deemed collateral-dependent and are charged down to an estimate of collateral value less costs to sell. Because loss content has been recognized through a partial charge-off, typically reserves are not recorded. Additionally, a majority of FHN’s loans in held-for-sale are accounted for under the fair value option. As a result, losses related to nonperforming HFS loans have been recognized by FHN directly through the income statement.
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The following table provides nonperforming loans both before and after partial charge-offs, LOCOM adjustments, nonaccrual interest adjustments and negative fair value adjustments previously taken as of September 30, 2015 and 2014:
Table 16 - Nonperforming Loans
Held-to-maturity:
Gross nonperforming loans (a)
Less: Partial charge-offs (b)
Less: LOCOM adjustments (c)
Less: Nonaccrual interest adjustments (d)
Net nonperforming loans (e)
Held-for-sale: (f)
Gross nonperforming loans
Less: Fair value mark
Less: LOCOM adjustments
Net nonperforming loans
Total net nonperforming loans including held-for-sale
Table 17 provides an activity rollforward of foreclosed real estate balances for September 30, 2015 and 2014. The balance of foreclosed real estate, exclusive of inventory from government insured mortgages, decreased to $25.9 million as of September 30, 2015, from $35.3 million as of September 30, 2014 as FHN has continued efforts to avoid foreclosures by restructuring loans and working with borrowers while also executing sales of existing foreclosed assets. Additionally property values have stabilized which also affect the balance of foreclosed real estate. See the discussion of Foreclosure Practices in the Market Uncertainties and Prospective Trends section of MD&A for information regarding the impact on FHN.
Table 17 - Rollforward of Foreclosed Real Estate
Beginning balance (a)
Valuation adjustments
New foreclosed property
Disposals:
Single transactions
Bulk sales
Ending balance, September 30 (a)
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The following table provides consolidated asset quality information for the three months ended September 30, 2015 and 2014:
Table 18 - Asset Quality Information
Allowance for loan losses:
Beginning balance on July 1
Ending balance on September 30
Reserve for remaining unfunded commitments
Total allowance for loan losses and reserve for unfunded commitments
Nonperforming Assets by Segment
Regional Banking:
Nonperforming loans (a)
Foreclosed real estate (b)
Total Regional Banking
Non-Strategic:
Nonperforming loans held-for-sale after fair value adjustment
Total Non-Strategic
Corporate:
Total Corporate
Total nonperforming assets (a)
Loans and commitments:
Total period-end loans, net of unearned income
Less: Insured retail residential and construction loans (c)
Loans excluding insured loans
Foreclosed real estate from government insured mortgages (foreclosures occuring prior to January 1, 2015)
Potential problem assets (d)
Loans 30 to 89 days past due
Loans 30 to 89 days past due - guaranteed portion (e)
Loans 90 days past due (f)
Loans 90 days past due - guaranteed portion (e) (f)
Loans held-for-sale 30 to 89 days past due
Loans held-for-sale 30 to 89 days past due - guaranteed portion (e)
Loans held-for-sale 90 days past due (f)
Loans held-for-sale 90 days past due - guaranteed portion (e) (f)
Remaining unfunded commitments
Average loans, net of unearned
Allowance and net charge-off ratios
Allowance to total loans
Allowance to nonperforming loans in the loan portfolio
Allowance to loans excluding insured loans
Allowance to annualized net charge-offs
Nonperforming assets to loans and foreclosed real estate (g)
Nonperforming loans in the loan portfolio to total loans, net of unearned income
Total annualized net charge-offs to average loans (h)
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Past Due Loans and Potential Problem Assets
Past due loans are loans contractually past due as to interest or principal payments, but which have not yet been put on nonaccrual status. Loans in the portfolio that are 90 days or more past due and still accruing decreased to $20.9 million on September 30, 2015, from $28.9 million on September 30, 2014. The decrease was driven primarily by permanent mortgage and the consumer real estate portfolios. Loans 30 to 89 days past due decreased $5.2 million to $52.2 million on September 30, 2015. The decline in loans past due 30-89 days is also largely attributable to the consumer real estate and permanent mortgage portfolios.
Potential problem assets represent those assets where information about possible credit problems of borrowers has caused management to have serious doubts about the borrower’s ability to comply with present repayment terms. This definition is believed to be substantially consistent with the standards established by the OCC for loans classified as substandard. Potential problem assets in the loan portfolio, which includes loans past due 90 days or more and still accruing, were $194.1 million on September 30, 2015, $189.6 million on June 30, 2015, and $286.3 million on September 30, 2014. The 2 percent increase in potential problem assets from second quarter 2015 to third quarter 2015 was due to an increase in unfunded balances partially offset by a decrease in classified loans and non-performing assets. The 32 percent decline from third quarter 2014 to third quarter 2015 is due to the resolution of several larger substandard credits. The current expectation of losses from potential problem assets has been included in management’s analysis for assessing the adequacy of the allowance for loan losses.
Troubled Debt Restructuring and Loan Modifications
As part of FHN’s ongoing risk management practices, FHN attempts to work with borrowers when appropriate to extend or modify loan terms to better align with their current ability to repay. Extensions and modifications to loans are made in accordance with internal policies and guidelines which conform to regulatory guidance. Each occurrence is unique to the borrower and is evaluated separately. In a situation where an economic concession has been granted to a borrower that is experiencing financial difficulty, FHN identifies and reports that loan as a Troubled Debt Restructuring (“TDR”). FHN considers regulatory guidelines when restructuring loans to ensure that prudent lending practices are followed. As such, qualification criteria and payment terms consider the borrower’s current and prospective ability to comply with the modified terms of the loan. Additionally, FHN structures loan modifications to amortize the debt within a reasonable period of time. See Note 4 – Loans for further discussion regarding TDRs.
Commercial Loan Modifications
As part of FHN’s credit risk management governance processes, the Loan Rehab and Recovery Department (“LRRD”) is responsible for managing most commercial relationships with borrowers whose financial condition has deteriorated to such an extent that the credits are being considered for impairment, classified as substandard or worse, placed on nonaccrual status, foreclosed or in process of foreclosure, or in active or contemplated litigation. LRRD has the authority and responsibility to enter into workout and/or rehabilitation agreements with troubled commercial borrowers in order to mitigate and/or minimize the amount of credit losses recognized from these problem assets. The range of commercial workout strategies utilized by LRRD to mitigate the likelihood of loan losses is commensurate with the degree of commercial credit quality deterioration. While every circumstance is different, LRRD will generally use forbearance agreements (generally 6-12 months) as an element of commercial loan workouts, which include reduced interest rates, reduced payments, release of guarantor, or entering into short sale agreements. Senior credit management tracks classified loans and performs periodic reviews of such assets to understand FHN’s interest in the borrower, the most recent financial results of the borrower, and the associated loss mitigation approaches and/or exit plans that have been developed for those relationships. After initial identification, relationship managers prepare regular updates for review and discussion by more senior business line and credit officers.
The individual impairment assessments completed on commercial loans in accordance with the Accounting Standards Codification Topic related to Troubled Debt Restructurings (“ASC 310-40”) include loans classified as TDRs as well as loans that may have been modified yet not classified as TDRs by management. For example, a modification of loan terms that management would generally not consider to be a TDR could be a temporary extension of maturity to allow a borrower to complete an asset sale whereby the proceeds of such transaction are to be paid to satisfy the outstanding debt. Additionally, a modification that extends the term of a loan but does not involve reduction of principal or accrued interest, in which the interest rate is adjusted to reflect current market rates for similarly situated borrowers, is not considered a TDR. Nevertheless, each assessment will take into account any modified terms and will be comprehensive to ensure appropriate impairment assessment. If individual impairment is identified, management will either hold specific reserves on the amount of impairment, or, if the loan is collateral dependent, write down the carrying amount of the asset to the net realizable value of the collateral.
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Consumer Loan Modifications
Although FHN does not currently participate in any of the loan modification programs sponsored by the U.S. government, FHN does modify consumer loans using the parameters of Home Affordable Modification Program (“HAMP”). Generally, a majority of loans modified under any such proprietary programs are classified as TDRs.
Within the HELOC and R/E installment loan classes of the consumer portfolio segment, TDRs are typically modified by reducing the interest rate (in increments of 25 basis points to a minimum of 1 percent for up to 5 years) and a possible maturity date extension to reach an affordable housing debt ratio. Permanent mortgage TDRs are typically modified by reducing the interest rate (in increments of 25 basis points to a minimum of 2 percent for up to 5 years) and a possible maturity date extension to reach an affordable housing debt ratio. After 5 years the interest rate steps up 1 percent every year thereafter until it reaches the Freddie Mac Weekly Survey Rate cap. Contractual maturities may be extended to 40 years on permanent mortgages and to 30 years for consumer real estate loans. Within the credit card class of the consumer portfolio segment, TDRs are typically modified through either a short-term credit card hardship program or a longer-term credit card workout program. In the credit card hardship program, borrowers may be granted rate and payment reductions for 6 months to 1 year. In the credit card workout program, customers are granted a rate reduction to 0 percent and term extensions for up to 5 years to pay off the remaining balance.
Following classification as a TDR, modified loans within the consumer portfolio, which were previously evaluated for impairment on a collective basis determined by their smaller balances and homogenous nature, become subject to the impairment guidance in ASC 310-10-35, which requires individual evaluation of the debt for impairment. However, as applicable accounting guidance allows, FHN may aggregate certain smaller-balance homogeneous TDRs and use historical statistics, such as aggregated charge-off amounts and average amounts recovered, along with a composite effective interest rate to measure impairment when such impaired loans have risk characteristics in common.
On September 30, 2015 and 2014, FHN had $304.7 million and $346.0 million portfolio loans classified as TDRs, respectively. For TDRs in the loan portfolio, FHN had loan loss reserves of $51.2 million and $60.9 million, or 17 percent and 18 percent of TDR balances, as of September 30, 2015 and 2014, respectively. Additionally, FHN had $72.6 million and $83.1 million of HFS loans classified as TDRs as of September 30, 2015 and 2014, respectively. Total held-to-maturity TDRs decreased by $41.4 million with $23.2 million of the decline attributable to commercial TDRs and $13.5 million associated with permanent mortgage TDRs.
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The following table provides a summary of TDRs for the periods ended September 30, 2015 and 2014:
Table 19 - Troubled Debt Restructurings
Permanent mortgage:
Current
Delinquent
Non-accrual (a)
Total permanent mortgage
Non-accrual (b)
Credit card and other:
Non-accrual
Total credit card and other
Commercial loans:
Total held-to-maturity
Held-for-sale: (c)
Total held-for-sale
RISK MANAGEMENT
Except as discussed below, there have been no significant changes to FHN’s risk management practices as described under “Risk Management” beginning on page 42 of Exhibit 13 to FHN’s Annual Report on Form 10-K for the year ended December 31, 2014, which section is incorporated into this report by this reference.
MARKET RISK MANAGEMENT
There have been no significant changes to FHN’s market risk management practices as described under “Market Risk Management” beginning on page 43 of Exhibit 13 to FHN’s Annual Report on Form 10-K for the year ended December 31, 2014, which section is incorporated into this report by this reference.
Value-at-Risk (“VaR”) and Stress Testing
VaR is a statistical risk measure to estimate the potential loss in value from adverse market movements over an assumed fixed holding period within a stated confidence level. FHN employs a model to compute daily VaR measures for its trading securities inventory. FHN computes VaR using historical simulation with a 1-year lookback period at a 99 percent confidence level and 1-day and 10-day time horizons. Additionally, FHN computes a Stressed VaR (“SVaR”) measure. The SVaR computation uses the same model but with model inputs reflecting historical data from a continuous 12-month period that reflects a period of significant financial stress appropriate for Fixed Income’s trading securities portfolio.
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A summary of FHN’s VaR and SVaR measures for 1-day and 10-day time horizons is as follows:
Table 20 - VaR and SVaR Measures
1-day
VaR
SVaR
10-day
FHN’s overall VaR measure includes both interest rate risk and credit spread risk. Separate measures of these component risks are as follows:
Table 21 - Schedule of Risks Included in VaR
(Dollars in Thousands)
Interest rate risk
Credit spread risk
CAPITAL MANAGEMENT AND ADEQUACY
There have been no significant changes to FHN’s capital management practices as described under “Capital Management and Adequacy” on page 45 of Exhibit 13 to FHN’s Annual Report on Form 10-K for the year ended December 31, 2014, which section is incorporated into this report by this reference.
OPERATIONAL RISK MANAGEMENT
There have been no significant changes to FHN’s operational risk management practices as described under “Operational Risk Management” on page 45 of Exhibit 13 to FHN’s Annual Report on Form 10-K for the year ended December 31, 2014, which section is incorporated into this report by this reference.
COMPLIANCE RISK MANAGEMENT
There have been no significant changes to FHN’s compliance risk management practices as described under “Compliance Risk Management” on page 45 of Exhibit 13 to FHN’s Annual Report on Form 10-K for the year ended December 31, 2014, which section is incorporated into this report by this reference.
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CREDIT RISK MANAGEMENT
There have been no significant changes to FHN’s credit risk management practices as described under “Credit Risk Management” beginning on page 45 of Exhibit 13 to FHN’s Annual Report on Form 10-K for the year ended December 31, 2014, which section is incorporated into this report by this reference.
INTEREST RATE RISK MANAGEMENT
Except as disclosed below, there have been no significant changes to FHN’s interest rate risk management practices as described under “Interest Rate Risk Management” beginning on page 46 of Exhibit 13 to FHN’s Annual Report on Form 10-K for the year ended December 31, 2014, which section is incorporated into this report by this reference.
Net Interest Income Simulation Analysis
The information provided in this section, including the discussion regarding the outcomes of simulation analysis and rate shock analysis, is forward-looking. Actual results, if the assumed scenarios were to occur, could differ because of interest rate movements, the ability of management to execute its business plans, and other factors, including those presented in the Forward-Looking Statements section of this MD&A.
Management uses interest rate exposure models to formulate strategies to improve balance sheet positioning, earnings, or both, within FHN’s interest rate risk, liquidity, and capital guidelines. FHN uses simulation analysis as its primary tool to evaluate interest rate risk exposure. This type of analysis computes net interest income at risk under a variety of market interest rate scenarios to dynamically identify interest rate risk exposures exclusive of the potential impact on fee income. This risk management simulation, which considers forecasted balance sheet changes, prepayment speeds, deposit mix, pricing impacts, and other changes in the net interest spread, provides an estimate of the annual net interest income at risk for given changes in interest rates. The results help FHN develop strategies for managing exposure to interest rate risk. Like any risk management technique creating simulated outcomes for a range of given scenarios, interest rate simulation modeling is based on a number of assumptions and judgments. In this case, the assumptions relate primarily to loan and deposit growth, asset and liability prepayments, interest rates, and on- and off-balance sheet hedging strategies. Management believes the assumptions used and scenarios selected in its simulations are reasonable. Nevertheless, simulation modeling provides only a sophisticated estimate, not a precise calculation, of exposure to any given changes in interest rates.
The simulation models used to analyze net interest income create various at-risk scenarios looking at assumed increases and/or decreases in interest rates from instantaneous and staggered movements over a certain time period. In addition, the risk of changes in the yield curve is estimated by flattening and steepening the yield curve to simulate net interest income exposure. Management reviews these different scenarios to determine alternative strategies and executes based on that evaluation. The models are regularly updated to incorporate management action. Any scenarios that indicate a change in net interest income of 3 percent or more from a base net interest income are presented to the Board quarterly. At September 30, 2015, the interest rate environment remained at a low level. Under these market conditions, traditional scenarios estimating the impact of declining rates are not meaningful. Accordingly, declining rate shock scenarios (including minus 25 basis points and minus 200 basis points) were not performed.
The remaining scenarios performed attempt to capture risk to net interest income from rising rates and changes in the shape of the yield curve assuming a static balance sheet. Based on the rate sensitivity position on September 30, 2015, net interest income exposure over the next 12 months to a rate shock of plus 25 basis points, 50 basis points, 100 basis points, and 200 basis points on a flat balance sheet is estimated to be a favorable variance of 2.4 percent, 3.7 percent, 6.3 percent and 11.5 percent, respectively of base net interest income. A flattening yield curve scenario where long-term rates decrease and short-term rates are static, results in an unfavorable variance in net interest income of 1.4 percent of base net interest income. These hypothetical scenarios are used to create one estimate of risk, and do not necessarily represent management’s current view of future interest rates or market developments.
While the continuing low interest rate environment is not expected to have a significant impact on the capital position of FHN, the ability to expand net interest margin in this environment, without assuming additional credit risk, continues to be a challenge for FHN. As long as the historically low interest rate environment persists, net interest margin will typically decline as yields on fixed rate loans and investment securities decrease due to the combination of asset prepayments and lower reinvestment rates. With core deposit rates at historically low levels, there is little opportunity to offset the yield declines in fixed rate assets with corresponding declines in deposit rates.
LIQUIDITY MANAGEMENT
ALCO also focuses on liquidity management: the funding of assets with liabilities of the appropriate duration, while mitigating the risk of unexpected cash needs. A key objective of liquidity management is to ensure the continuous availability of funds to meet the demands of depositors, other creditors and borrowers, and the requirements of ongoing operations. This objective is met by maintaining liquid assets in the form of trading securities and securities available-for-sale, growing core deposits, and the repayment of loans. ALCO is responsible for managing these needs by taking into account the marketability of assets, the sources, stability, and
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availability of funding, and the level of unfunded commitments. Subject to market conditions and compliance with applicable regulatory requirements from time to time, funds are available from a number of sources including core deposits, the available-for-sale securities portfolio, the Federal Reserve Banks, access to Federal Reserve Bank programs, the FHLB, access to the overnight and term Federal Funds markets, loan sales, syndications, and dealer and commercial customer repurchase agreements.
FHN also may use unsecured borrowings as a source of liquidity. Currently, a large portion of unsecured borrowings is federal funds purchased from correspondent bank customers. These funds are considered to be substantially more stable than funds purchased in the national broker markets for federal funds due to the long, historical, and reciprocal nature of banking services provided by FHN to these correspondent banks. The remainder of FHN’s wholesale short-term borrowings is repurchase agreement transactions accounted for as secured borrowings with the regional bank’s business customers or fixed income’s broker dealer counterparties.
ALCO manages FHN’s exposure to liquidity risk through a dynamic, real time forecasting methodology. Base liquidity forecasts are reviewed by ALCO and are updated as financial conditions dictate. In addition to the baseline liquidity reports, robust stress testing of assumptions and funds availability are periodically reviewed. FHN maintains a contingency funding plan that may be executed should unexpected difficulties arise in accessing funding that affects FHN, the industry as a whole, or both. As a general rule, FHN strives to maintain excess liquidity equivalent to 15 percent or more of total assets, excluding access to the Federal Reserve’s discount window.
Core deposits are a significant source of funding and have historically been a stable source of liquidity for banks. Generally, core deposits represent funding from a financial institutions’ customer base which provide inexpensive, predictable pricing. The Federal Deposit Insurance Corporation insures these deposits to the extent authorized by law. Generally, these limits are $250 thousand per account owner for interest bearing and non-interest bearing accounts. The ratio of total loans, excluding loans HFS and restricted real estate loans, to core deposits was 89 percent in 2015 compared to 102 percent in 2014.
Both FHN and FTBNA may access the debt markets in order to provide funding through the issuance of senior or subordinated unsecured debt subject to market conditions and compliance with applicable regulatory requirements. In 2010, FHN issued $500 million of non-callable fixed rate senior notes due in December 2015. In 2014, FTBNA issued $400 million of fixed rate senior notes due in December 2019. In October 2015, FHN issued $500 million of fixed rate senior notes due in December 2020 for repayment of the senior notes due in December 2015. In third quarter 2015, FHN redeemed its junior subordinated debt underlying $200 million of trust preferred debt. Prior to the redemption, a portion of the trust preferred securities was eligible for inclusion in Tier 1 Capital. FHN also maintains $48.5 million of borrowings which are secured by residential real estate loans in a consolidated securitization trust.
Both FHN and FTBNA have the ability to generate liquidity by issuing preferred or common equity subject to market conditions and compliance with applicable regulatory requirements. In January 2013, FHN issued $100 million of Series A Non-Cumulative Perpetual Preferred Stock. As of September 30, 2015, FTBNA and subsidiaries had outstanding preferred shares of $295.4 million, which are reflected as noncontrolling interest on the Consolidated Condensed Statements of Condition.
Parent company liquidity is primarily provided by cash flows stemming from dividends and interest payments collected from subsidiaries. These sources of cash represent the primary sources of funds to pay cash dividends to shareholders and principal and interest to debt holders. The amount paid to the parent company through FTBNA common dividends is managed as part of FHN’s overall cash management process, subject to applicable regulatory restrictions. Certain regulatory restrictions exist regarding the ability of FTBNA to transfer funds to FHN in the form of cash, common dividends, loans, or advances. At any given time, the pertinent portions of those regulatory restrictions allow FTBNA to declare preferred or common dividends without prior regulatory approval in an aggregate amount equal to FTBNA’s retained net income for the two most recent completed years plus the current year to date. For any period, FTBNA’s ‘retained net income’ generally is equal to FTBNA’s regulatory net income reduced by the preferred and common dividends declared by FTBNA. Excess dividends in either of the two most recent completed years may be offset with available retained net income in the two years immediately preceding it. Applying the applicable rules, FTBNA’s total amount available for dividends was negative $250.2 million as of September 30, 2015 compared to negative $31.4 million as of September 30, 2014. Consequently, FTBNA could not pay common dividends to its sole common stockholder, FHN, or to its preferred shareholders without prior regulatory approval. FTBNA applied for and received approval from the OCC to declare and pay common dividends to FHN in the amount of $325 million in third quarter 2015 and $180 million in 2014. FTBNA applied for and received approval from the OCC to declare and pay preferred dividends in each quarter of 2014. Additionally, during the first three quarters of 2015 FTBNA declared and paid preferred dividends and during fourth quarter 2015 declared preferred dividends, with OCC approval as necessary.
Payment of a dividend to shareholders of FHN is dependent on several factors which are considered by the Board. These factors include FHN’s current and prospective capital, liquidity, and other needs, applicable regulatory restrictions, and also availability of funds to FHN through a dividend from FTBNA. Additionally, the Federal Reserve and the OCC generally require insured banks and bank holding companies to pay cash dividends only out of current operating earnings. Consequently, the decision of whether FHN will pay future dividends and the amount of dividends will be affected by current operating results. FHN paid a cash dividend of $.06 per common share on October 1, 2015, and in October 2015 the Board approved a $.06 per common share cash dividend payable on
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January 4, 2016, to shareholders of record on December 11, 2015. FHN paid a cash dividend of $1,550.00 per preferred share on October 13, 2015, and in October 2015 the Board approved a $1,550.00 per preferred share cash dividend payable on January 11, 2015, to shareholders of record on December 23, 2015.
CASH FLOWS
The Consolidated Condensed Statements of Cash Flows provide information on cash flows from operating, investing, and financing activities for the nine months ended September 30, 2015 and 2014. The level of cash and cash equivalents increased $42.5 million during 2015 compared to an increase of $81.8 million in 2014. During the nine months ended September 30, 2015, cash provided by investing activities and operating activities outpaced cash used by financing activities, whereas during the nine months ended September 30, 2014 cash provided by operating activities more than offset cash used by investing and financing activities.
Net cash provided by operating activities was $212.6 million in 2015 compared to $590.6 million in 2014. Operating cash flows in 2015 were favorably driven by cash-related net income items and a $194.2 million net increase in cash related to fixed income activities, but were somewhat offset by cash outflows related to operating assets and liabilities of $125.8 million. Operating cash flows in 2014 were positively affected by cash-related net income items, cash proceeds from MSR sales of $70.1 million, and $189.7 million of changes in cash related to operating assets and liabilities. Additionally, the sale of mortgage loans HFS positively impacted cash during 2014, however these increases were partially offset by a $215.5 million net change in cash related to fixed income activities.
Net cash provided by investing activities was $421.8 million in 2015, compared to net cash used of $124.4 million in 2014. Cash inflows in 2015 were primarily attributed to a $1.0 billion decline in interest-bearing cash and $40.4 million of proceeds from the sale of properties, but were partially offset by loan growth in the regional bank and $102.7 million in net cash used in the available-for-sale securities portfolio. In 2014, an increase in loan balances and activity related to the available-for-sale securities portfolio which resulted in a $115.4 million net decrease in cash as securities purchased outpaced maturities and sales, negatively affected cash provided by investing activities. These cash outflows were somewhat offset by a decrease in interest-bearing cash which favorably affected cash provided by investing activities.
Net cash used by financing activities was $592.0 million in 2015 compared to $384.4 million in 2014. In 2015, cash was negatively affected by a $803.3 million decrease in short-term borrowings and $519.5 million in payments on long-term borrowings, which included the maturity of $304 million of subordinated notes and the redemption of $206 million of trust preferred securities. Additionally dividends and share repurchases negatively affected financing cash flows in 2015. These outflows were somewhat mitigated by a $796.8 million increase in deposits resulting in part from a new correspondent banking product which resulted in a shift in funding from short-term borrowings. In 2014, cash was negatively affected by a decline in deposits and payments of long-term borrowings related to the collapse/resolution of two securitization trusts, but was offset by cash inflows from increased FHLB borrowings as a result of loan growth and deposit fluctuations.
REPURCHASE OBLIGATIONS, OFF-BALANCE SHEET ARRANGEMENTS, AND OTHER CONTRACTUAL OBLIGATIONS
Repurchase and Related Obligations from Loans Originated for Sale
Prior to September 2008, as a means to provide liquidity for its legacy mortgage banking business, FHN originated loans through its legacy mortgage business, primarily first lien home loans, with the intention of selling them. Some government-insured and government-guaranteed loans were originated with credit recourse retained by FHN and some other mortgages were originated to be held, but predominantly mortgage loans were intended to be sold without recourse for credit default. Sales typically were effected either as non-recourse whole loan sales or through non-recourse proprietary securitizations. Conventional conforming single-family residential mortgage loans were sold predominately to two GSEs: Fannie Mae and Freddie Mac. Also federally insured or guaranteed whole loans were pooled, and payments to investors were guaranteed through the Government National Mortgage Association (“Ginnie Mae,” “Ginnie,” or “GNMA”). Many mortgage loan originations, especially those “nonconforming” mortgage loans that did not meet criteria for whole loan sales to the GSEs or insurance through Ginnie (collectively, the “Agencies”), were sold to investors, or certificate-holders, predominantly through First Horizon branded proprietary securitizations (“FH proprietary securitizations”) but also, to a lesser extent, through whole loan sales to private non-Agency purchasers. In addition, FHN originated with the intent to sell and sold HELOCs and second lien mortgages through whole loan sales to private purchasers and, to a lesser extent, through FH proprietary securitizations.
For non-recourse loan sales, FHN has exposure for repurchase of loans arising from claims that FHN breached its representations and warranties made at closing to the purchasers, including GSEs, other whole loan purchasers, and the trustee of FH proprietary securitizations. Additionally, FHN has exposure to investors for investment rescission or damages arising from claims that offering documents were materially deficient in the case of loans transferred through FH proprietary securitizations. See “Other FHN Mortgage Exposures and Trends” within this section of MD&A for additional information.
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From 2009 to 2014 FHN received a high number of claims to either repurchase loans from the purchaser or remit payment to the purchaser to “make them whole” for economic losses incurred, primarily driven by loan delinquencies. In repurchase or make-whole claims a loan purchaser typically alleges that certain loans that were sold violated representations and warranties made by FHN at closing. While FHN has received claims from private whole-loan purchasers, a significant majority of claims received overall have related to whole loan sales to GSEs. Starting in 2014 the number of such claims, though still elevated, diminished substantially primarily as a result of resolution agreements made with the GSEs (discussed below) which significantly reduced new GSE claims. FHN also has the potential for financial exposure from loans transferred through FH proprietary securitizations. See Note 10 – Contingencies and Other Disclosures for other actions taken by investors of FH proprietary securitizations.
Origination Data
From 2005 through 2008, FHN originated and sold $69.5 billion of mortgage loans to the Agencies without recourse which includes $57.6 billion of loans sold to GSEs and $11.9 billion of loans guaranteed by Ginnie Mae. GSE loans originated in 2005 through 2008 account for approximately 90 percent of all repurchase requests/make-whole claims received from the third quarter 2008 divestiture of certain mortgage banking operations through September 30, 2015.
In addition, for many years ending in 2007, FHN securitized mortgage loans without recourse in First Horizon branded proprietary transactions. From 2005 through 2007, FHN securitized $26.7 billion of mortgage loans under the First Horizon brand. Although initially servicing generally was retained at the time the loans were sold, substantially all remaining servicing for these loans was sold in first quarter 2014.
The following table summarizes the loan composition of the FH proprietary mortgage securitizations from 2005 through 2007:
Table 22 - Composition of Off-Balance Sheet First Horizon Proprietary Mortgage Securitizations
Loan type:
Jumbo
Alt-A
Total FH proprietary securitizations
At September 30, 2015, the repurchase request pipeline contained no loan repurchase requests related to FH proprietary first lien securitized mortgage loans based on claims related to breaches of representations and warranties. At September 30, 2015, FHN had not accrued a liability for exposure for repurchase of loans arising from claims that FHN breached its representations and warranties made in FH proprietary securitizations at closing. Due to the sales of MSR from 2008 through 2014, FHN has limited visibility into current loan information such as principal payoffs, refinance activity, delinquency trends, and loan modification activity.
Active Pipeline
The amount of repurchase requests and make-whole claims is accumulated into the “active pipeline.” The active pipeline includes the amount of claims for repurchase, make-whole payments, loans as to which private mortgage insurance (“MI”) has been canceled, and information requests from purchasers of loans originated and sold through FHN’s legacy mortgage banking business. MI was required for certain of the loans sold to GSEs or that were securitized. MI generally was provided on first lien loans that were sold to GSEs or securitized that had a loan-to-value (“LTV”) ratio at origination of greater than 80 percent. Although unresolved MI cancellation notices are not formal repurchase requests, FHN includes those loans in the active pipeline. Additionally, FHN is responsible for covering losses for purchasers to the extent there is a shortfall in MI insurance coverage (MI curtailment).
For purposes of quantifying the amount of loans underlying the repurchase/make-whole claim or MI cancellation notice or curtailment, FHN uses the current UPB in all cases if the amount is available. If current UPB is unavailable, the original loan amount is substituted for the current UPB. When neither is available, the claim amount is used as an estimate of current UPB. On September 30, 2015, the active pipeline was $173.2 million, with approximately half of unresolved repurchase and make-whole claims relating to loans sold to GSEs.
Generally, the amount of a loan subject to a repurchase/make-whole claim, or with open MI issues, remains in the active pipeline throughout the appeals process with a claimant until parties agree on the ultimate outcome. FHN reviews each claim and MI cancellation notice individually to determine the appropriate response by FHN (e.g. appeal, provide additional information, repurchase loan or remit make-whole payment, or reflect cancellation of MI).
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In fourth quarter 2013 and in first quarter 2014, FHN entered into definitive resolution agreements (“DRAs”), discussed below in “Repurchase Accrual Methodology,” to resolve certain selling representation and warranty repurchase obligations with the GSEs. The balances for these DRAs are disclosed in the settlement column of Table 23 - Rollforward of the Active Pipeline and reflect the UPB of loans settled under the DRAs. Additionally, in third quarter 2014, FHN settled certain repurchase claims with a non-GSE third party who purchased certain GSE MSRs in connection with the mortgage divestiture in 2008.
The following tables provide a rollforward of the number and unpaid principal amount of loans in the active pipeline, including related unresolved MI cancellation notices, MI curtailments, and other requests for the three and nine months ended September 30, 2015:
Table 23 - Rollforward of the Active Pipeline
Repurchase/make whole requests:
FNMA (a)
FHLMC (a)
GNMA
Non-Agency whole loan-related
MI Cancellations
MI Curtailments
Other requests (b)
The following tables provide a rollforward of the number and unpaid principal amount of loans in the active pipeline, including related unresolved MI cancellation notices, MI curtailments, and other requests for the three and nine months ended September 30, 2014:
FNMA(a)
FHLMC(a)
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As of September 30, 2015, Agencies accounted for approximately 50 percent of the repurchase/make-whole requests in the active pipeline and 84 percent of the total active pipeline, inclusive of MI cancellation notices, MI curtailments, and all other claims. MI curtailment requests are intended only to cover the shortfall in MI insurance proceeds, therefore FHN’s loss from MI curtailments as a percentage of UPB in the pipeline generally is significantly lower than that of a repurchase or make-whole claim.
For loans in the active pipeline for which FHN has received notification of MI cancellation, a majority relate to loans sold to GSEs. Consistent with originations, a majority of repurchase/make-whole claims have been from Fannie Mae and Freddie Mac and 2007 represents the vintage with the highest volume of claims. Total new repurchase and make-whole claims from GSEs decreased 53 percent or $5.1 million to $4.5 million in 2015 from 2014. Total MI cancellation notices received decreased $4.3 million to $2.5 million in 2015.
Resolutions disclosed in Table 23 – Rollforward of the Active Pipeline include both favorable and unfavorable resolutions. The UPB of actual repurchases, make-whole requests, and settlement resolutions, which was $3.6 million and $10.8 million during third quarter 2015 and 2014, respectively, represents the UPB of loans for which FHN has incurred a loss on the actual repurchase of a loan, or where FHN has reimbursed a claimant for economic losses incurred. When loans are repurchased or make-whole payments have been made, the associated loss content on the repurchase, make-whole, or settlement resolution is reflected as a net realized loss in Table 24 – Reserves for Repurchase and Foreclosure Losses.
Rescissions or denials, which were $2.3 million and $14.2 million in third quarter 2015 and 2014, respectively, represent the amount of repurchase requests and make-whole claims that FHN was able to resolve without incurring loss. Of the loans resolved in third quarter 2015 relating to actual repurchase or make-whole claims, FHN was successful in favorably resolving approximately 40 percent of the claims compared to 57 percent in 2014. Resolutions related to other, MI cancellations, MI curtailments, and information requests, which were $23.6 million and $39.5 million during third quarter 2015 and 2014, respectively, include providing information to the claimant, issues related to MI coverage, and other items. Resolutions in this category include both favorable and unfavorable outcomes with MI companies, including situations where MI was ultimately cancelled. FHN does not realize loss (a decrease of the repurchase and foreclosure liability) for loans with MI issues unless a request for repurchase, or for make-whole or loss reimbursement, is submitted and such request is unfavorably resolved.
Repurchase Accrual Methodology
Over the past several years FHN’s approach for determining the adequacy of the repurchase and foreclosure reserve has evolved based on information available including estimated loss content within the active pipeline, loss content associated with loans in which MI coverage was ultimately lost, information made available by Fannie Mae to FHN which provided significant insight into their file selection and review process for loans previously sold by FHN to Fannie Mae with repurchase risk, as well as information received in connection with DRAs that FHN entered into with Fannie Mae and Freddie Mac in fourth quarter 2013 and first quarter 2014, respectively. Cumulative average loss severities range between 50 and 60 percent of the UPB subject to repurchase/make-whole. Repurchase rates vary based on investor, vintage, and claim type.
Repurchase Accrual Approach
The DRAs mentioned above resolved certain legacy selling representation and warranty repurchase obligations associated with loans originated from 2000 to 2008 excluding certain loans FHN no longer serviced at the time of the DRA. Under each DRA FHN remains responsible for repurchase obligations related to certain excluded defects (such as title defects and violations of the GSE’s Charter Act) and FHN continues to have obligations related to mortgage insurance rescissions, cancellations, curtailments and denials. With respect to loans where there has been a prior bulk sale of servicing, FHN is not responsible for mortgage insurance cancellations and denials to the extent attributable to the acts of the current servicer.
Repurchase obligations and estimates for probable incurred losses associated with loan populations not included in the DRAs, including obligations related to future mortgage insurance cancellations, loans included in bulk servicing sales prior to the DRAs, and other loan sales, are included in FHN’s remaining repurchase liability as of September 30, 2015.
In determining the loss content of GSE loans subject to repurchase requests excluded from the DRA settlements mentioned above (primarily loans included in bulk sales), FHN applied a vintage level estimate of loss to all loans sold to the GSEs that were not included in the settlements and which have not had a prior repurchase resolution. First pre-payment, default, and claim rate estimates are applied by vintage to estimate the aggregate claims expected but not yet resolved. Historical loss factors for each sale vintage and repurchase rates are then applied to estimate total loss content. Loss content related to other whole loan sales is estimated by applying
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the historical average repurchase and loss severity rates to the current UPB in the active pipeline to calculate estimated losses attributable to the current pipeline. FHN then uses an internal model to calculate loss content on estimated future inflows by applying historical average loss repurchase and severity rates to historical average inflows. For purposes of estimating loss content, FHN also considers MI cancellations. When assessing loss content related to loans where MI has been cancelled, FHN applies historical loss factors (including probability and loss severity ratios) to the total unresolved MI cancellations in the active pipeline, as well as applying these factors to historical average inflows to estimate loss content. Additionally, FHN identifies estimated losses related to MI curtailment requests.
Management continually monitors the repurchase pipeline, including inflows, rescission and loss severity rates, and resolutions, as well as other factors in consideration of the overall adequacy of the repurchase liability.
Repurchase and Foreclosure Liability
FHN compares the estimated probable incurred losses determined under the applicable loss estimation approaches described above for the respective periods with current reserve levels. Changes in the estimated required liability levels are recorded as necessary through the repurchase and foreclosure provision. There are certain second liens and HELOCs subject to repurchase claims that are not included in the active pipeline as these loans were originated and sold through different channels. Liability estimation for potential repurchase obligations related to these second liens and HELOCs was determined outside of the methodology for loans originated and sold through the national legacy mortgage origination platform and were not material as of third quarter 2015 and 2014.
The following table provides a rollforward of the legacy mortgage repurchase liability during the three and nine months ended September 30, 2015 and 2014:
Table 24 - Reserves for Repurchase and Foreclosure Losses
Legacy Mortgage
Beginning balance
Provision for repurchase and foreclosure losses
Net realized gain/(losses)
Balance on September 30
The liability for legacy mortgage repurchase and foreclosure losses was $114.8 million and $125.5 million as of September 30, 2015 and 2014, respectively. In third quarter 2015, FHN had $1.8 million of net realized losses for the repurchase of first lien loans or make-whole payments compared with $11.1 million during third quarter 2014. In third quarter 2014 FHN recognized a reduction to the repurchase and foreclosure provision of $4.3 million related to the settlement of certain repurchase claims.
Generally, repurchased loans are included in loans HFS and recognized at fair value at the time of repurchase, which contemplates the loan’s performance status and estimated liquidation value. FHN has elected to continue recognition of these loans at fair value in periods subsequent to reacquisition. After the loan repurchase is completed, classification (performing versus nonperforming) of the repurchased loans is determined based on an additional assessment of the credit characteristics of the loan in accordance with FHN’s internal credit policies and guidelines consistent with other loans FHN retains on the balance sheet, except that if a loan is delinquent when repurchased it is immediately classified as nonperforming.
Government-Backed Mortgage Lending Programs
FHN originated mortgage loans eligible for Federal Housing Administration (“FHA”) insurance or Veterans Administration (“VA’) guaranty. Those lending activities were substantially larger prior to September 2008, when FHN sold its national mortgage business. In connection with those programs FHN made certain representations and warranties as to the compliance of the loans with program requirements. Over the past several years, most recently in first quarter 2015, FHN has recognized significant losses associated with settling claims and potential claims, by government agencies as well as by private parties asserting claims on behalf of agencies, related to these origination activities.
Other FHN Mortgage Exposures and Trends
FHN has received no loan repurchase or make-whole requests from the trustee of FH proprietary securitizations, as described in Note 10 – Contingencies and Other Disclosures. However, FHN is defending several lawsuits by investors in FH proprietary securitizations.
In addition, also as described in Note 10, many non-GSE purchasers of whole loans from FHN included those loans in their own securitizations. In such other whole loan sales FHN made representations and warranties concerning the loans sold and provided
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indemnity covenants to the purchaser/securitizer. Typically the purchaser/securitizer assigned key contractual rights against FHN to the securitization trustee. Currently the following categories of actions are pending which involve FHN and non-GSE whole-loan sales: (i) FHN has received indemnification requests from purchasers of loans or their assignees in cases where FHN is not a defendant; (ii) FHN has received subpoenas seeking loan reviews in cases where FHN is not a defendant; (iii) FHN has received repurchase demands from purchasers or their assignees; and (iv) FHN is a defendant in legal actions involving FHN-originated loans. Also, FHN’s trustee is a defendant in a lawsuit in which the plaintiffs have asserted that the trustee has duties under federal law to review loans and otherwise to act against FHN outside of the duties specified in the applicable trust documents.
MARKET UNCERTAINTIES AND PROSPECTIVE TRENDS
Uncertainties remain surrounding the national economy, the housing market, Fed monetary policy, the regulatory and political environment, U.S. government spending generally, and economic and political situations outside the U.S. Those uncertainties will continue to present challenges for FHN. Although during 2014 and the first three quarters of 2015 the national economy exhibited improvement, improvement has been uneven. Certain indicators have been mixed and economic conditions could regress. While management considers asset quality at FHN to be strong, external factors may result in increased credit costs and loan loss provisioning and could also suppress loan demand from borrowers and further increase competition among financial institutions resulting in continued pressure on net interest income. Additionally, despite resolving certain selling representation and warranties repurchase obligations to GSEs, a downturn in the economic environment or disruptions in the housing market could affect borrower defaults and actions by MI companies resulting in elevated repurchase requests from GSEs and third party whole loan purchasers relative to current projections or could impact losses recognized by investors in FH proprietary securitizations which could result in repurchase losses or litigation. See the Repurchase and Related Obligations from Loans Originated for Sale section and Critical Accounting Policies section within this MD&A, and Note 10 – Contingencies and Other Disclosures within this report for additional discussion regarding FHN’s repurchase obligations.
In recent years, in response to the recession in 2008 and the following uneven recovery, the Federal Reserve has implemented a series of domestic monetary initiatives. Several of these have emphasized so-called quantitative easing strategies, the most recent of which ended during 2014. Other significant monetary strategies could be implemented in the future including, in particular, so-called tightening strategies. Federal Reserve strategies can, and often are intended to, affect the domestic money supply, inflation, interest rates, and the shape of the yield curve. Among other things, easing strategies are intended to lower interest rates, flatten the yield curve, and stimulate economic activity, while tightening strategies are intended to increase interest rates, steepen the yield curve, tighten the money supply, and restrain economic activity. Other things being equal, a transition from easing to possible tightening should tend to diminish or reverse downward pressure on rates, and to diminish the stimulus effect that low rates tend to have on the economy. Many external factors may interfere with the effects of these plans or cause them to be changed unexpectedly. Such factors include significant economic trends or events (such as, for example, the substantial drop in oil prices experienced in late 2014 and early 2015) as well as significant international monetary policies and events (such as, for example, the rise during 2014 and 2015 in the value of the U.S. dollar relative to many other currencies). Such strategies also can affect the U.S. and world-wide financial systems in ways that may be difficult to predict.
Although FHN has little direct exposure to non-U.S.-dollar-denominated assets or to foreign sovereign debt, major adverse events outside the U.S. could have a substantial indirect impact on FHN. Because the U.S. economy and the businesses of many of our customers are linked significantly to global economic and market conditions, a major adverse event could negatively impact liquidity in the U.S. causing funding costs to rise, or could potentially limit availability of funding through conventional markets in a worst-case scenario. FHN also could be adversely affected by events outside of the U.S. impacting hedging or other counterparties, customers with non-U.S. businesses and/or assets denominated in foreign currencies, the U.S. economy, interest rates, inflation/deflation rates, and the regulatory environment should there be a political response to major financial disruptions, all of which could have a financial impact on FHN.
Regulatory Matters
The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Reform Act”) made a substantial number of significant changes to how financial services companies are regulated. Many of the changes in the Reform Act continue to be incomplete, or are dependent upon new regulations to be issued or interpreted in the future. Overall, the Reform Act and its regulations have increased FHN’s regulatory compliance and certain other costs, and have constrained operations and revenues in some respects. FHN believes that additional impacts of this sort are likely as additional parts of the Act are implemented.
U.S. regulators have adopted enhanced new stress test rules pursuant to the Reform Act. Under these requirements covered institutions must conduct an annual stress test to determine whether capital is likely to be adequate to absorb losses which could stem from certain adverse economic scenarios provided by the regulators and must privately report the results to their primary regulator as well as publicly disclose certain of those results. FHN may satisfy the public disclosure requirements through postings on its website. FHN’s initial stress test posting was made in June 2015.
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Foreclosure Practices
Since 2009 governmental officials and agencies have scrutinized industry foreclosure practices, particularly in judicial foreclosure states, and have since expanded to include non-judicial foreclosure and loss mitigation practices including the effective coordination by servicers of foreclosure and loss mitigation activities. All of the changes to servicing practices including the additional oversight required arising out of this activity including those described below could impact FHN through increased operational and legal costs. FHN continues to review, monitor and revise, as appropriate, its foreclosure processes and coordinated loss mitigation practices with the goal of conforming them to evolving servicing requirements.
FHN’s national mortgage and servicing platforms were sold in August 2008 and the related servicing activities, including foreclosure and loss mitigation practices that were not transferred in 2008, were outsourced through a three-year subservicing arrangement (the “2008 subservicing agreement”) with the platform buyer (the “2008 subservicer”). The 2008 subservicing agreement expired in 2011 when FHN entered into a replacement agreement with a new subservicer (the “2011 subservicer”). In fourth quarter 2013, FHN contracted to sell a substantial majority of its remaining servicing obligations and servicing assets (including advances) to the 2011 subservicer. The servicing was transferred to the buyer in stages, and was substantially completed in first quarter 2014. The servicing still retained by FHN continues to be subserviced by the 2011 subservicer.
As discussed in more detail in Note 10 – Contingencies and Other Disclosures, the 2008 subservicer has been subject to a consent decree, and entered into a settlement agreement, with regulators related to alleged deficiencies in servicing and foreclosure practices. The 2008 subservicer has made demands of FHN to pay certain resulting costs and damages; FHN disagrees with those demands and has made no payments. This disagreement has the potential to result in litigation and, in any such future litigation; the claim against FHN may be substantial.
FHN anticipates continued compliance challenges relating to foreclosure, loss mitigation and servicing practices in connection with its efforts to comply with regulations and standards issued by the OCC and the CFPB including those relating to vendor management and changes in applicable state law relating to foreclosure and loss mitigation.
CRITICAL ACCOUNTING POLICIES
There have been no significant changes to FHN’s critical accounting policies as described in “Critical Accounting Policies” beginning on page 61 of Exhibit 13 to FHN’s Annual Report on Form 10-K for the year ended December 31, 2014, which section is incorporated into this report by this reference.
ACCOUNTING STANDARDS UPDATES ISSUED BUT NOT CURRENTLY EFFECTIVE
In August 2014, the FASB issued ASU 2014-15, “Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern.” ASU 2014-15 requires an entity’s management to evaluate whether there are conditions or events, considered in the
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aggregate, that raise substantial doubt about the entity’s ability to continue as a going concern within one year after the date that the financial statements are issued. If such events or conditions exist, additional disclosures are required and management should evaluate whether its plans sufficiently alleviate the substantial doubt. ASU 2014-15 is effective for the annual period ending after December 15, 2016 and all interim and annual periods thereafter. The provisions of ASU 2014-15 are not anticipated to affect FHN.
NON-GAAP INFORMATION
The following table provides a reconciliation of non-GAAP items presented in this MD&A to the most comparable GAAP presentation:
Table 25 - Non-GAAP to GAAP Reconciliation
Tier 1 Common (Non-GAAP)
(A) Tier 1 capital (a)
Less: Noncontrolling interest - FTBNA preferred stock (b)
Less: Preferred stock
Less: Trust preferred (c)
(B) Tier 1 common (Non-GAAP)
Risk Weighted Assets
(C) Risk weighted assets (a)
Total Assets
(D) Total assets (GAAP)
Ratios
(B)/(C) Tier 1 common to risk weighted assets (Non-GAAP)
(A)/(D) Tier 1 capital to total assets (GAAP)
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The information called for by this item is contained in
all of which materials are incorporated herein by reference. FHN’s Management’s Discussion and Analysis of Financial Condition and Results of Operations, Consolidated Financial Statements, and related Notes appearing in FHN’s 2014 Annual Report to shareholders all were filed as part of Exhibit 13 to FHN’s annual report on Form 10-K for the year ended December 31, 2014. Note 23 to the Consolidated Financial Statements was filed as part of Exhibit 99.1 to FHN’s Current Report on Form 8-K dated October 19, 2015. Portions of the Annual Report on Form 10-K for the year ended December 31, 2014 and the Current Report on Form 8-K dated October 19, 2015 not incorporated herein by reference are deemed not to be “filed” with the Commission with this report.
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Part II.
OTHER INFORMATION
The “Contingencies” section of Note 10 to the Consolidated Condensed Financial Statements beginning on page 32 of this Report is incorporated into this Item by reference.
Not applicable
(a) & (b) Not Applicable
Items 3, 4, and 5
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(a) Exhibits
Exhibits marked * represent management contracts or compensatory plans or arrangements required to be identified as such and filed as exhibits.
Exhibits marked ** are “furnished” pursuant to 18 U.S.C. Section 1350 and are not “filed” as part of this Report or as a separate disclosure document.
Exhibits marked *** contain or consist of interactive data file information which is unaudited and unreviewed.
In many agreements filed as exhibits, each party makes representations and warranties to other parties. Those representations and warranties are made only to and for the benefit of those other parties in the context of a business contract. Such representations and warranties may be partially or fully waived by such parties, or not enforced by such parties, in their discretion. No such representation or warranty may be relied upon by any other person for any purpose.
Exhibit
No.
Description
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
/s/ William C. Losch III
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EXHIBIT INDEX