Huntington Bancshares - 10-Q quarterly report FY2011 Q3

 

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There were 864,074,883 shares of Registrant’s common stock ($0.01 par value) outstanding on September 30, 2011.

The following listing provides a comprehensive reference of common acronyms and terms used throughout the document:

When we refer to “we,” “our,” and “us” in this report, we mean Huntington Bancshares Incorporated and our consolidated subsidiaries, unless the context indicates that we refer only to the parent company, Huntington Bancshares Incorporated. When we refer to the “Bank” in this report, we mean our only bank subsidiary, The Huntington National Bank, and its subsidiaries.

We are a multi-state diversified regional bank holding company organized under Maryland law in 1966 and headquartered in Columbus, Ohio. Through the Bank, we have 145 years of servicing the financial needs of our customers. Through our subsidiaries, we provide full-service commercial and consumer banking services, mortgage banking services, automobile financing, equipment leasing, investment management, trust services, brokerage services, customized insurance service programs, and other financial products and services. Our over 600 banking offices are located in Indiana, Kentucky, Michigan, Ohio, Pennsylvania, and West Virginia. Selected financial services and other activities are also conducted in various other states. International banking services are available through the headquarters office in Columbus, Ohio and a limited purpose office located in the Cayman Islands and another limited purpose office located in Hong Kong. Our foreign banking activities, in total or with any individual country, are not significant.

This MD&A provides information we believe necessary for understanding our financial condition, changes in financial condition, results of operations, and cash flows. The MD&A included in our 2010 Form 10-K should be read in conjunction with this MD&A as this discussion provides only material updates to the 2010 Form 10-K. This MD&A should also be read in conjunction with the financial statements, notes and other information contained in this report.

Our discussion is divided into key segments:

A reading of each section is important to understand fully the nature of our financial performance and prospects.

For the quarter, we reported net income of $143.4 million, or $0.16 per common share, compared with $145.9 million, or $0.16 per common share, in the prior quarter (see Table 1).

Fully-taxable equivalent net interest income was $410.1 million for the quarter, up $3.0 million, or 1%, from the prior quarter. The increase reflected the benefit of a 2% (6% annualized) increase in average earning assets, partially offset by a 6 basis point decline in the fully-taxable equivalent net interest margin to 3.34% from 3.40%.

The provision for credit losses in the 2011 third quarter was $43.6 million, up $7.8 million, or 22%, from the prior quarter. This reflected the combination of strong loan growth and the expectation of a weaker and prolonged economic recovery. These were partially offset by the benefits of an end-of-period decline of 8% in nonaccrual loans and a 4% decline in total Criticized commercial loans.

Total noninterest income increased $2.8 million, or 1%, from the prior quarter. This included an increase in other income of $15.1 million, or 33%, reflecting a $15.5 million gain on sale from the automobile securitization and a $2.8 million increase in market-related gains and capital markets income, which was partially offset by a $5.8 million decline in SBA servicing income. Service charges on deposit accounts and electronic banking income increased $4.5 million, or 7%, and $1.0 million, or 3%, respectively, primarily driven by new account growth. These benefits were partially offset by an $11.0 million decline in mortgage banking income, primarily driven by a negative $13.9 million linked quarter change in the net MSR valuation, the majority of which occurred over the last two weeks of the quarter.

Noninterest expense increased $10.7 million, or 2%. Personnel costs increased $8.3 million, or 4%, due to higher salary, severance, and healthcare costs. Outside data processing and other services increased $5.7 million, or 13%, primarily due to costs associated with a conversion to a new debit card processor.

The period end ACL as a percentage of total loans and leases decreased to 2.71% from 2.84%. However, the ACL as a percentage of period end NALs increased to 187% from 181%. Net charge-offs were $90.6 million, or an annualized 0.92% of average total loans and leases, down 7% from $97.5 million, or 1.01%, in the prior quarter. Credit quality continued its expected improvement. Even so, many of these performance metrics remain elevated compared with historical performance. We expect to see continued declines in nonaccrual loans and net charge-offs going forward.

Our general business objectives are: (1) grow revenue and profitability, (2) improve cross-sell and share-of-wallet across all business segments, (3) grow key fee businesses (existing and new), (4) improve credit quality, including lower NCOs and NALs, (5) reduce noncore CRE exposure, and (6) continue to improve our overall management of risk.

Throughout last year, and continuing into this year, we are taking advantage of what we view as an opportunity to make significant investments in strategic initiatives to position us for more profitable and sustainable long-term growth. This includes implementing our “Fair Play” banking philosophy, value proposition for our consumer customers, increasing share-of-wallet, investing in expanding existing business, and launching new businesses.

Our emphasis on cross-sell, coupled with customers increasingly being attracted by the benefits offered through our “Fair Play” banking philosophy is having a positive effect. The number of consumer checking account households grew at a 10.8% annualized rate for the first three quarters of 2011. These new households are not just focused around single service. We have been able to continue to grow our share of wallet with new and existing customers. Almost 73% of our consumer customers now have four or more products or services. On the commercial side, we also saw an increase with commercial relationships growing for the first nine months at an 8.6% annualized rate.

Wavering business and consumer confidence, U.S. debt and fiscal uncertainties, and slow economic growth remain challenges to the operating environment. Consumer sentiment has dropped to the lowest level since the recessionary period in 2008. Elevated housing inventories continue to present a near-term drag; however housing affordability is near record highs on historically low mortgage rates and lower home prices.

Regulatory reforms continue to be adopted which impose additional restrictions on current business practices. Recent actions affecting us included the Federal Reserve’s maturity extension program, and the rules and regulations that have been issued pursuant to the Dodd-Frank Act.

Federal Reserve Maturity Extension Program — Under the maturity extension program announced on September 21, 2011, the Federal Reserve intends to sell $400 billion of shorter-term Treasury securities by the end of 2012 and use the proceeds to buy longer-term securities. This will extend the average maturity of the securities in the Federal Reserve’s portfolio. By reducing the supply of longer-term securities in the market, it is the FOMC’s intention to put downward pressure on longer-term interest rates, including rates on financial assets that investors consider to be close substitutes for longer-term Treasury securities. Further, it is their objective that the reduction in longer-term interest rates, in turn, will contribute to a broad easing in financial market conditions that will provide additional stimulus to support the economic recovery. We do not anticipate that this recent announcement will have a material impact on our current securities portfolio or future investment strategy. However, it could cause our net interest margin to drop modestly.

Resolution Plan — The FRB and FDIC issued final regulations as required by section 165 of the Dodd-Frank Act regarding resolution plans, also referred to as “living wills.” Insured depository institutions with $50 billion or more in total assets must submit to the FDIC a plan whereby the institution can be resolved by the FDIC, in the event of failure, in a manner that ensures depositors will receive access to insured funds within the required timeframes and generally ensures an orderly liquidation of the institution. Additionally, bank holding companies with assets of $50 billion or more are required to submit to the FRB and the FDIC a plan that, in the event of material financial distress or failure, establishes the rapid and orderly liquidation of the company under the bankruptcy code and in a way that would not pose systemic risk to the financial system of the United States. The regulations allow for a tier approach for complying with the requirements based on materiality of the institution. Currently, we are required to submit resolution plans as prescribed by December 31, 2013.

Durbin Amendment — The Durbin Amendment to the Dodd-Frank Act instructed the Federal Reserve to establish the rate merchants pay banks for electronic clearing of debit card transactions (i.e., the interchange rate). The Federal Reserve recently issued its final rule establishing standards for debit card interchange fees and prohibiting network exclusivity arrangements and routing restrictions. The final rule establishes standards for assessing whether debit card interchange fees received by debit card issuers are reasonable and proportional to the costs incurred by issuers for electronic debit transactions. Under the final rule, the maximum permissible interchange fee that an issuer may receive for an electronic debit transaction will be the sum of 21 cents per transaction, 1 cent fraud prevention adjustment, and 5 basis points multiplied by the value of the transaction. This provision regarding debit card interchange fees became effective on October 1, 2011. Based on the final rule, we expect our 2011 fourth quarter electronic banking income to decline from the 2011 third quarter level by approximately 50%, or $16 million.

Recent industry events and related supervisory guidance brought about by the continued weak housing market have caused us to evaluate certain aspects of our mortgage operations. This included a review of our foreclosure documentation, MSR valuation, and representation and warranty reserve level. Additionally, we are evaluating potential impacts from recent announcements of the enhanced Home Affordable Refinance Program (HARP) and by PMI Mortgage Insurance Co. (PMI).

Foreclosure Documentation — On June 30, 2011, the OCC issued OCC Bulletin 2011-29 clarifying their expectations for the oversight and management of mortgage foreclosure activities by national banks and directing national banks to perform a self-assessment no later than September 30, 2011. We believe that, with the self-assessments we have performed and will continue to perform, we are in compliance with the OCC expectation for self-assessment.

Mortgage Servicing Rights — MSR fair values are estimated based on residential mortgage servicing revenue in excess of estimated market costs to service the underlying loans. Historically, the estimated market cost to service has been stable. Due to changes in the regulatory environment related to loan servicing and foreclosure activities, costs to service may potentially increase, however the potential impact on the market costs to service remains uncertain. Certain large residential mortgage loan servicers entered into consent orders with banking regulators in April 2011, which require the servicers to remedy deficiencies and unsafe or unsound practices and to enhance residential mortgage servicing and foreclosure processes. It is unclear what impact this may ultimately have on market costs to service.

Representation and Warranty Reserve —We primarily conduct our loan sale and securitization activity with FNMA and FHLMC. In connection with these and other sale and securitization transactions, we make representations and warranties that the loans meet certain criteria, such as collateral type and underwriting standards. We may be required to repurchase individual loans and / or indemnify these organizations against losses due to material breaches of these representations and warranties. At September 30, 2011, we had a reserve for such losses of $23.9 million, which is included in accrued expenses and other liabilities.

Home Affordable Refinance Program — The FHFA has announced changes to the Home Affordable Refinance Program designed to attract more borrowers with FNMA and FHLMC backed mortgages that can benefit from refinancing their residential mortgage loans under current low interest rates. The new operational details are to be issued by November 15, 2011. We do not expect the impact to be material.

PMI Mortgage Insurance Co. (PMI) — On August 19, 2011, PMI informed its customers that it was required to stop writing new commitments and we stopped doing new business with PMI at that time. On October 24, 2011, PMI informed all policyholders, insured parties, and servicers of loans insured by PMI that the Director of the Arizona Department of Insurance (Director) obtained an “Order Directing Full and Exclusive Possession and Control of Insurer” (the Order) with respect to PMI. Effective October 24, 2011, and pursuant to the Order, instead of a moratorium on claims payments, the Director instituted a partial claims payment plan. Claim payments will be made at 50%, with the remaining amount deferred as a policyholder claim. PMI has not been a significant provider of mortgage insurance for loans in our portfolio. We utilize a number of insurance providers, limiting our risk associated with any one provider. We do not expect the exposure associated with our owned residential mortgage portfolio to have a material impact on our results of operations or financial position.

The lack of prospects for meaningful economic improvement, higher interest rates, and wider spreads between short-term and long-term interest rates for the foreseeable future is a challenge. For example, broad-based loan growth, as well as growth in certain fee income activities, is expected to be less than would otherwise be the case in an expanding economy, even though growth in certain portfolios and activities is anticipated. Further, a period of prolonged low interest rates is expected to put pressure on our net interest margin. This would reflect more compression in loan and investment securities yields relative to any declines in deposit and funding rates. In addition, deposit inflows over and above any reinvestment opportunities at appropriate risk adjusted spreads means we may elect to curtail deposit growth, typically an engine of revenue growth. These revenue headwinds are magnified by the continued fragility of business and consumer confidence that is expected to continue the postponement of borrowing and investment decisions. Nevertheless, our success in growing and deepening relationships presents us with an opportunity to selectively expand revenue, while maintaining disciplined loan and deposit pricing, as well as conservative credit underwriting.

Net interest income is expected to continue to show very modest improvement from the third quarter level. The momentum we are seeing in loan and low cost deposit growth is expected to continue, yet the benefits will be mostly offset by pressure on the net interest margin due to the expected continued mix shift to higher quality loans and lower securities reinvestment rates that reflect the low absolute level and shape of the yield curve. If the current interest rate environment, which has partially resulted from the Federal Reserve Maturity Extension Program “Operation Twist”, remains unchanged through 2012, it could cause our net interest margin to drop modestly below our long-term range of 3.30% to 3.75%. Our C&I portfolio is expected to continue to show meaningful growth with much of this reflecting the positive impact from strategic initiatives to expand our commercial lending expertise into areas like specialty banking, asset based lending, and equipment financing, in addition to our long-standing continued support of middle market and small business lending. For automobile loans, we expect to see strong growth from September 30, 2011 balances. Residential mortgages are expected to show modest growth, with CRE continuing to experience modest declines.

We again anticipate the increase in total core deposits to match that of loans, reflecting continued growth in consumer households and commercial relationships. Further, we expect the shift toward low and no cost demand deposits and money market accounts will continue.

Noninterest income is expected to show a modest decline in the 2011 fourth quarter, primarily due to an anticipated 50%, or $16 million, decline in electronic banking income from the third quarter, given the newly mandated lower interchange fee structure implemented October 1, 2011. We expect to see continued growth of service charge income commensurate with customer growth and increased product penetration. Mortgage banking income should increase as the third quarter’s sizable MSR impairment is not expected to repeat. We also anticipate continued growth in the contribution from other key fee income activities including capital markets, treasury management services, and brokerage, reflecting the impact of our cross-sell and product penetration initiatives throughout the company as well as the positive impact from strategic initiatives.

Expense levels are expected to modestly decline in coming quarters though strategic actions like the current debit card conversion may cause short-term fluctuations.

Nonaccrual loans and net charge-offs are expected to continue to decline. Provision for credit losses should remain near current levels, yet there could be some volatility given the uncertain and uneven nature of the economic recovery.

We anticipate the effective tax rate for the foreseeable future to be in the range of 24% to 27%.

This section provides a review of financial performance from a consolidated perspective. It also includes a “Significant Items” section that summarizes key issues important for a complete understanding of performance trends. Key Unaudited Condensed Consolidated Balance Sheet and Statement of Income trends are discussed. All earnings per share data are reported on a diluted basis. For additional insight on financial performance, please read this section in conjunction with the “Business Segment Discussion.”

From time-to-time, revenue, expenses, or taxes, are impacted by items judged by us to be outside of ordinary banking activities and / or by items that, while they may be associated with ordinary banking activities, are so unusually large that their outsized impact is believed by us at that time to be infrequent or short-term in nature. We refer to such items as Significant Items. Most often, these Significant Items result from factors originating outside the company; e.g., regulatory actions / assessments, windfall gains, changes in accounting principles, one-time tax assessments / refunds, litigation actions, etc. In other cases, they may result from our decisions associated with significant corporate actions out of the ordinary course of business; e.g., merger / restructuring charges, recapitalization actions, goodwill impairment, etc.

Even though certain revenue and expense items are naturally subject to more volatility than others due to changes in market and economic environment conditions, as a general rule volatility alone does not define a Significant Item. For example, changes in the provision for credit losses, gains / losses from investment activities, asset valuation writedowns, etc., reflect ordinary banking activities and are, therefore, typically excluded from consideration as a Significant Item.

We believe the disclosure of Significant Items provides a better understanding of our performance and trends to ascertain which of such items, if any, to include or exclude from an analysis of our performance; i.e., within the context of determining how that performance differed from expectations, as well as how, if at all, to adjust estimates of future performance accordingly. To this end, we adopted a practice of listing Significant Items in our external disclosure documents (e.g., earnings press releases, investor presentations, Forms 10-Q and 10-K).

Significant Items for any particular period are not intended to be a complete list of items that may materially impact current or future period performance.

Earnings comparisons were impacted by the Significant Items summarized below.

The following table reflects the earnings impact of the above-mentioned significant items for periods affected by this Results of Operations discussion:

One non-GAAP performance measurement that we believe is useful in analyzing our underlying performance trends is pretax, pre-provision income. This is the level of pretax earnings adjusted to exclude the impact of: (a) provision expense, (b) investment securities gains/losses, which are excluded because securities market valuations may become particularly volatile in times of economic stress, (c) amortization of intangibles expense, which is excluded because the return on tangible common equity is a key measurement we use to gauge performance trends, and (d) certain other items identified by us (see Significant Items) that we believe may distort our underlying performance trends.

The following table reflects pretax, pre-provision income for each of the past five quarters:

Pretax, pre-provision income was $240.7 million in the 2011 third quarter, down $1.9 million, or 1%, from the prior quarter. As discussed in the sections that follow, the decrease primarily reflected the negative impact from a lower net interest margin percentage and higher noninterest expense as compared to the prior quarter.

The following table details the change in our average loans / leases and deposits:

Fully-taxable equivalent net interest income decreased $2.5 million, or 1%, from the year-ago quarter. This reflected the benefit of a $1.3 billion, or 3%, increase in average total earning assets partially offset by an 11 basis point decline in the net interest margin. The increase in average earning assets reflected:

Partially offset by:

The 11 basis point decline in the net interest margin reflected a reduction in derivatives income, lower loan and securities yields, partially offset by the positive impacts of increases in low cost deposits and improved deposit pricing.

The $2.1 billion, or 6%, increase in average total loans and leases primarily reflected:

Partially offset by:

The $1.6 billion, or 4%, increase in average total deposits from the year-ago quarter reflected:

Partially offset by:

FTE net interest income increased $3.0 million, or 1%, from the 2011 second quarter. This reflected a $0.8 billion, or 2%, increase in average earning assets partially offset by a 6 basis point decline in the FTE net interest margin. The increase in average earning assets reflected:

The 6 basis point decline in the net interest margin reflected a reduction in derivatives income and lower loan yields, partially offset by the positive impact of increases in low cost deposits and improved deposit pricing.

The $0.8 billion, or 2% (8% annualized), increase in average total loans and leases reflected:

Partially offset by:

The $1.0 billion, or 2% (10% annualized), increase in average total deposits from the 2011 second quarter reflected:

Partially offset by:

Tables 6 and 7 reflect quarterly average balance sheets and rates earned and paid on interest-earning assets and interest-bearing liabilities.