UNITED STATESSECURITIES AND EXCHANGE COMMISSION
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934QUARTERLY PERIOD ENDED September 30, 2004
Commission File Number 0-2525
Huntington Bancshares Incorporated
41 South High Street, Columbus, Ohio 43287
Registrant’s telephone number (614) 480-8300
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 and (2) has been subject to such filing requirements for the past 90 days.
Yes [X] No [ ]
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).
There were 231,105,691 shares of Registrant’s without par value common stock outstanding on October 31, 2004.
INDEX
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Part 1. Financial Information
Item 1. Financial Statements
See notes to unaudited condensed consolidated financial statements
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Condensed Consolidated Statements of Income(Unaudited)
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Condensed Consolidated Statements of Changes in Shareholders’ Equity
See notes to unaudited consolidated financial statements.
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Condensed Consolidated Statements of Cash Flows(Unaudited)
See notes to unaudited condensed consolidated financial statements.
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Notes to Unaudited Condensed Consolidated Financial Statements
Note 1 – Basis of Presentation
The accompanying unaudited condensed consolidated financial statements of Huntington Bancshares Incorporated (Huntington) reflect all adjustments consisting of normal recurring accruals, which are, in the opinion of Management, necessary for a fair presentation of the consolidated financial position, the results of operations, and cash flows for the periods presented. These unaudited condensed consolidated financial statements have been prepared according to the rules and regulations of the Securities and Exchange Commission (SEC) and, therefore, certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States (GAAP) have been omitted. The Notes to the Consolidated Financial Statements appearing in Huntington’s 2003 Annual Report on Form 10-K (2003 Form 10-K), which include descriptions of significant accounting policies, as updated by the information contained in this report, should be read in conjunction with these interim financial statements.
Certain amounts in the prior year’s financial statements have been reclassified to conform to the 2004 presentation.
For statement of cash flows purposes, cash and cash equivalents are defined as the sum of “Cash and due from banks” and “Federal funds sold and securities purchased under resale agreements.” The statement of cash flows for the nine-months ended September 30, 2003, has been corrected to properly reflect the sale of branch offices during the third quarter of 2003.
Note 2 – New Accounting Pronouncements
Emerging Issues Task Force Issue No. 03-1, The Meaning of Other-Than-Temporary Impairments and Its Application to Certain Investments (EITF 03-1): The Emerging Issues Task Force reached a consensus about the criteria that should be used to determine when an investment is considered impaired, whether that impairment is other than temporary, and the measurement of an impairment loss. EITF 03-1 also included accounting considerations subsequent to the recognition of an other-than-temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. On September 30, 2004, the FASB issued FSP 03-1-1 which delayed the effective date for the measurement and recognition guidance contained in paragraphs 10–20 of Issue 03-1 due to additional proposed guidance expected to be finalized in the fourth quarter of 2004.
At September 30, 2004, Huntington had $2.5 billion of debt securities with current market values less than their amortized cost. These debt securities had an aggregate unrealized loss of $32.7 million at September 30, 2004. None of these securities were equity securities or debt securities that can contractually be prepaid or otherwise settled in such a way that Huntington would not recover substantially all of its cost. At September 30, 2004, a total of $26.8 million of these debt securities had market values that were 5% or more below their amortized cost. The aggregate unrealized loss for these securities was $1.5 million. The declines in value are the result of interest rate fluctuations and Huntington believes the declines are temporary; therefore, no impairment loss has been recorded except as described in the paragraph below. Until the final FSP 03-1-1 is finalized, Huntington cannot determine the impact that the proposed guidance might have on the financial statements.
At September 30, 2004, Management made a decision, to sell $11 million of equity securities, with unrealized losses of $0.9 million. Consequently, Huntington recognized the unrealized losses in the third quarter of 2004.
Emerging Issues Task Force Issue No. 03-16, Accounting for Investment in Limited Liability Companies (EITF 03-16): The Task Force reached a consensus that an investment in a limited liability company (LLC) that maintains a “specific ownership account” for each investor should be viewed as similar to an investment in a limited partnership for purposes of determining whether a noncontrolling investment in a LLC should be accounted for using the cost method or the equity method. The current rules require a noncontrolling investment in a limited partnership to be accounted for under the equity method unless the interest is so minor that the limited partner may have virtually no influence over the partnership operating and financial policies. The guidance for evaluating an investment in a LLC should be applied for reporting periods beginning after June 15, 2004. The impact of EITF 03-16 was not material to Huntington’s financial condition, results of operations, or cash flows.
SEC Staff Accounting Bulletin No. 105, Application of Accounting Principles to Loan Commitments (SAB 105): On March 9, 2004, the SEC issued SAB 105, which summarizes the views of the SEC staff regarding the application of
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generally accepted accounting principles to loan commitments accounted for as derivative instruments. Specifically, SAB 105 indicated that the fair value of loan commitments that are required to follow derivative accounting under FAS 133, Accounting for Derivative Instruments and Hedging Activities, should not consider the expected future cash flows related to the associated servicing of the future loan. Prior to SAB 105, Huntington did not consider the expected future cash flows related to the associated servicing in determining the fair value of loan commitments. The adoption of SAB 105 did not have a material effect on Huntington’s financial results.
FASB Staff Position No. 106-2, Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003(FSP 106-2): In December 2003, a law was approved that expands Medicare benefits, primarily adding a prescription drug benefit for Medicare-eligible retirees beginning in 2006. The law also provides a federal subsidy to companies that sponsor postretirement benefit plans providing prescription drug coverage. FSP 106-2 was issued in May 2004 and supersedes FSP 106-1 issued in January 2004. FSP 106-2 specifies that any Medicare subsidy must be taken into account in measuring the employer’s postretirement health care benefit obligation and will also reduce the net periodic postretirement cost in future periods. The new guidance is effective for the reporting periods beginning on or after June 15, 2004. The impact of this new pronouncement was not material to Huntington’s financial condition, results of operations, or cash flows.
AICPA Statement of Position No. 03-3, Accounting for Certain Loans or Debt Securities Acquired in a Transfer (SOP 03-3): In December 2003, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants issued SOP 03-3 to address accounting for differences between the contractual cash flows of certain loans and debt securities and the cash flows expected to be collected when loans or debt securities are acquired in a transfer and those cash flow differences are attributable, at least in part, to credit quality. As such, SOP 03-3 applies to loans and debt securities purchased or acquired in purchase business combinations and does not apply to originated loans. The application of SOP 03-3 limits the interest income, including accretion of purchase price discounts, that may be recognized for certain loans and debt securities. Additionally, SOP 03-3 requires that the excess of contractual cash flows over cash flows expected to be collected (nonaccretable difference) not be recognized as an adjustment of yield or valuation allowance, such as the allowance for credit losses. Subsequent to the initial investment, increases in expected cash flows generally should be recognized prospectively through adjustment of the yield on the loan or debt security over its remaining life. Decreases in expected cash flows should be recognized as impairment. SOP 03-3 is effective for loans and debt securities acquired in fiscal years beginning after December 15, 2004, with early application encouraged. The impact of this new pronouncement is not expected to be material to Huntington’s financial condition, results of operations, or cash flows.
Note 3 – Securities and Exchange Commission Investigation
As previously disclosed, Huntington continues to have ongoing discussions with the staff of the Securities and Exchange Commission (SEC) regarding resolution of its formal investigation into certain financial accounting matters relating to fiscal years 2002 and earlier and certain related disclosure matters. It is anticipated that a settlement of this matter will involve the entry of an order by the SEC requiring Huntington to comply with various provisions of the Securities Exchange Act of 1934 and the Securities Act of 1933, along with the imposition of a civil money penalty. No assurances, however, can be provided as to the ultimate timing or outcome of this matter pending a final settlement.
Note 4 – Formal Supervisory Agreements and Impact on Pending Acquisition
On November 3, 2004, Huntington announced that it expects to enter into formal supervisory agreements with its banking regulators, the Federal Reserve and the Office of the Controller of the Currency, providing for a comprehensive action plan designed to address its financial reporting and accounting policies, procedures, and controls and its corporate governance practices. Huntington remains in active dialogue with banking regulators concerning these and related matters and is working diligently to resolve this in a full and comprehensive manner.
On January 27, 2004, Huntington announced the signing of a definitive agreement to acquire Unizan Financial Corp. (Unizan), a financial holding company based in Canton, Ohio, with $2.7 billion of assets at December 31, 2003. Under the terms of the agreement, Unizan shareholders would receive 1.1424 shares of Huntington common stock, on a tax-free basis, for each share of Unizan.
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As part of its November 3, 2004, announcement, Huntington indicated that it is negotiating a one-year extension of its merger agreement with Unizan. Huntington intends to withdraw its current application with the Federal Reserve to acquire Unizan and to resubmit the application for regulatory approval of the merger once it has successfully resolved the aforementioned regulatory concerns.
Huntington believes that it will be able to address all of the issues that have been raised by its banking regulators and the SEC (see Note 3) concerning these matters in a comprehensive manner and is working aggressively to do so. No assurances, however, can be provided as to the ultimate timing or outcome of these matters.
Note 5 – Stock Repurchase Plan
Effective April 27, 2004, the board of directors authorized a new share repurchase program (the 2004 Repurchase Program) which cancelled the 2003 Repurchase Program and authorized Management to repurchase not more than 7,500,000 shares of Huntington common stock. Purchases will be made from time-to-time in the open market or through privately negotiated transactions depending on market conditions. As of September 30, 2004, there have been no share repurchases made under the 2004 Repurchase Program.
Note 6 – Operating Lease Assets
Operating lease assets at September 30, 2004, December 31, 2003, and September 30, 2003, were as follows:
Depreciation related to operating lease assets was $54.6 million and $86.5 million for the three months ended September 30, 2004 and 2003, respectively. For the respective nine-month periods, depreciation was $187.0 million and $290.5 million.
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Note 7 – Investment Securities
Listed below are the contractual maturities (under 1 year, 1-5 years, 6-10 years and over 10 years) of investment securities at September 30, 2004, December 31, 2003, and September 30, 2003:
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The growth in the Asset Backed Securities from year-end and the year-ago quarter primarily consisted of over 10-year variable-rate securities.
Note 8 – Segment Reporting
Huntington has three distinct lines of business: Regional Banking, Dealer Sales, and the Private Financial Group (PFG). A fourth segment includes the company’s Treasury functions and capital markets activities and other unallocated assets, liabilities, revenue, and expense. Lines of business results are determined based upon the company’s management reporting system, which assigns balance sheet and income statement items to each of the business segments. The process is designed around Huntington’s organizational and management structure and, accordingly, the results below are not necessarily comparable with similar information published by other financial institutions. A description of each segment and discussion of financial results is provided below.
Regional Banking: This segment provides products and services to retail, business banking, and commercial customers. These products and services are offered in seven operating regions within the five states of Ohio, Michigan, West Virginia, Indiana, and Kentucky through the company’s traditional banking network. Each region is further divided into Retail and Commercial Banking units. Retail products and services include home equity loans and lines of credit, first mortgage loans, direct installment loans, business loans, personal and business deposit products, as well as sales of investment and insurance services. Retail products and services comprise 59% and 80% of total Regional Banking loans and deposits, respectively. These products and services are delivered to customers through banking offices, ATMs, Direct Bank—Huntington’s customer service center, and Web Bank at huntington.com. Commercial banking serves middle-market and commercial banking relationships, which use a variety of banking products and services including commercial loans, international trade, cash management, leasing, interest rate protection products, capital market alternatives, 401(k) plans, and mezzanine investment capabilities.
Dealer Sales: This segment serves over 3,500 automotive dealerships within Huntington’s primary banking markets as well as in Arizona, Florida, Georgia, Pennsylvania, and Tennessee. The segment finances the purchase of automobiles by consumers of the automotive dealerships, purchases automobiles from dealers and simultaneously leases the automobiles under long-term direct financing leases to consumers, finances dealership floor plan inventories, real estate, or working capital needs, and provides other banking services to the automotive dealerships and their owners.
Private Financial Group: This segment provides products and services designed to meet the needs of the company’s higher net worth customers. Revenue is derived through trust, asset management, investment advisory, brokerage, insurance, and private banking products and services.
Treasury/Other: This segment includes revenue and expense related to assets, liabilities, and equity that are not directly assigned or allocated to one of the other three business segments. Assets included in this segment include investment securities, bank owned life insurance, and mezzanine loans originated through Huntington Capital Markets. A match-funded transfer pricing system is used to attribute appropriate interest income and interest expense to other business segments. This segment includes the net impact of interest rate risk management, including derivative activities. Furthermore, this segment’s results include the earnings from the company’s investment securities portfolios and capital markets activities. Additionally, income or expense and provision for income taxes, not allocated to other business segments, are also included.
Use of Operating Earnings to Measure Segment Performance
Management uses earnings on an operating basis, rather than on a GAAP basis, to measure underlying performance trends for each business segment. Analyzing earnings on an operating basis is very helpful in assessing underlying performance trends, a critical factor used by Management to determine the success of strategies and future earnings capabilities. Operating earnings represent GAAP earnings adjusted to exclude the impact of the significant items listed in the reconciliation table below. See Note 12 for further discussions regarding Restructuring Reserves.
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Listed below is certain reported financial information reconciled to Huntington’s three and nine month 2004 and 2003 operating results by line of business.
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Note 9 – Comprehensive Income
The components of Huntington’s Other Comprehensive Income in the three and nine months ended September 30 were as follows:
Activity in Accumulated Other Comprehensive Income for the nine months ended September 30, 2004 and 2003 was as follows:
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Note 10 – Earnings per Share
Basic earnings per share is the amount of earnings for the period available to each share of common stock outstanding during the reporting period. Diluted earnings per share is the amount of earnings available to each share of common stock outstanding during the reporting period adjusted for the potential issuance of common shares upon the exercise of stock options. The calculation of basic and diluted earnings per share for each of the three and nine months ended September 30 is as follows:
The average market price of Huntington’s common stock for the period was used in determining the dilutive effect of outstanding stock options. Common stock equivalents are computed based on the number of shares subject to stock options that have an exercise price less than the average market price of Huntington’s common stock for the period.
Stock options for approximately 2.5 million and 6.4 million shares were vested and outstanding at September 30, 2004 and 2003, respectively, but were not included in the computation of diluted earnings per share because the options’ exercise price was greater than the average market price of the common shares for the period and, therefore, the effect would be antidilutive. The weighted average exercise price for these options was $27.04 per share and $23.19 per share at the end of the same respective periods.
On July 30, 2004, Huntington entered into an agreement with the former shareholders of LeaseNet, Inc. to issue in early 2005 up to 86,118 shares of Huntington common stock previously held in escrow subject to LeaseNet meeting certain contractual performance criteria. A total of 366,576 common shares, previously held in escrow, will be returned to Huntington. All shares in escrow had been accounted for as treasury stock.
On September 4, 2001, options totaling 3.2 million shares of common stock were granted to, with certain specified exceptions, full- and part-time employees under the Huntington Bancshares Incorporated Employee Stock Incentive Plan (the “Incentive Plan”). Under the terms of the Incentive Plan, these options were to vest on the earlier of September 4, 2006, or at such time as the closing price for Huntington’s common stock for five consecutive trading days reached or exceeded $25.00. Huntington’s common stock closing price exceeded $25.00 for each of the five consecutive trading days beginning October 1, 2004, and ending October 7, 2004. As a result, options for 2.0 million shares of common stock granted under the Incentive Plan, net of options for 1.2 million shares cancelled due to employee attrition, became fully vested and exercisable after the close of trading on October 7, 2004.
Note 11 – Stock-Based Compensation
Huntington’s stock-based compensation plans are accounted for based on the intrinsic value method promulgated by APB Opinion 25, Accounting for Stock Issued to Employees, and related interpretations. Compensation expense for employee stock options is generally not recognized if the exercise price of the option equals or exceeds the fair value of the stock on the date of grant.
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The following pro forma disclosures for net income and earnings per diluted common share is presented as if Huntington had applied the fair value method of accounting of Statement No. 123 in measuring compensation costs for stock options. The fair values of the stock options granted were estimated using the Black-Scholes option-pricing model. This model assumes that the estimated fair value of the options is amortized over the options’ vesting periods and the compensation costs would be included in personnel expense on the income statement. The following table also includes the weighted-average assumptions that were used in the option-pricing model for options granted in each of the quarters presented:
Note 12 – Restructuring Reserves
On a quarterly basis, Huntington assesses its remaining restructuring reserves, primarily related to lease obligations, and makes adjustments to those reserves as necessary. Based on these assessments, Huntington released $1.2 million in the third quarter of 2004. Huntington had remaining reserves for restructuring of $5.1 million, $9.7 million, and $8.7 million, as of September 30, 2004, December 31, 2003, and September 30, 2003, respectively. Huntington expects that the reserves will be adequate to fund the estimated future cash outlays.
Note 13 – Benefit Plans
Huntington sponsors the Huntington Bancshares Retirement Plan (the Plan), a non-contributory defined benefit pension plan covering substantially all employees. The Plan provides benefits based upon length of service and compensation levels. The funding policy of Huntington is to contribute an annual amount that is at least equal to the minimum funding requirements but not more than that deductible under the Internal Revenue Code. Although not required, Huntington made a discretionary contribution of $44.6 million to the Plan during the third quarter of 2004. In addition, Huntington has an unfunded, defined benefit post-retirement plan that provides certain healthcare and life insurance benefits to retired employees who have attained the age of 55 and have at least 10 years of vesting service under this plan. For any employee retiring on or after January 1, 1993, post-retirement healthcare benefits are based upon the employee’s number of months of service and are limited to the actual cost of coverage. Life insurance benefits are a percentage of the employee’s base salary at the time of retirement, with a maximum of $50,000 of coverage.
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The following table shows the components of net periodic benefit expense:
Huntington also sponsors other retirement plans. One of those plans is an unfunded Supplemental Executive Retirement Plan. This plan is a nonqualified plan that provides certain former officers of Huntington and its subsidiaries with defined pension benefits in excess of limits imposed by federal tax law. Other plans, including plans assumed in various past acquisitions, are unfunded, nonqualified plans that provide certain active and former officers of Huntington and its subsidiaries nominated by Huntington’s compensation committee with deferred compensation, post-employment, and/or defined pension benefits in excess of the qualified plan limits imposed by federal tax law.
Huntington has a 401(k) plan, which is a defined contribution plan that is available to eligible employees. Matching contributions by Huntington equal 100% on the first 3%, then 50% on the next 2%, of participant elective deferrals. The cost of providing this plan was $2.3 million and $2.1 million for the three months ended September 30, 2004 and 2003, respectively. For the respective nine-month periods, the cost was $7.0 million and $6.5 million.
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Note 14 – Commitments and Contingent Liabilities
Commitments:
In the ordinary course of business, Huntington makes various commitments to extend credit that are not reflected in the financial statements. The contract amount of these financial agreements at September 30, 2004, December 31, 2003, and September 30, 2003, were as follows:
Commitments to extend credit generally have fixed expiration dates, are variable-rate, and contain clauses that permit Huntington to terminate or otherwise renegotiate the contracts in the event of a significant deterioration in the customer’s credit quality. These arrangements normally require the payment of a fee by the customer, the pricing of which is based on prevailing market conditions, credit quality, probability of funding, and other relevant factors. Since many of these commitments are expected to expire without being drawn upon, the contract amounts are not necessarily indicative of future cash requirements. The interest rate risk arising from these financial instruments is insignificant as a result of their predominantly short-term, variable-rate nature.
Standby letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party. These guarantees are primarily issued to support public and private borrowing arrangements, including commercial paper, bond financing, and similar transactions. Most of these arrangements mature within two years. The carrying amount of deferred revenue associated with these guarantees was $3.9 million, $3.8 million, and $3.9 million at September 30, 2004, December 31, 2003, and September 30, 2003, respectively.
Commercial letters of credit represent short-term, self-liquidating instruments that facilitate customer trade transactions and generally have maturities of no longer than 90 days. The merchandise or cargo being traded normally secures these instruments.
Litigation:
In the ordinary course of business, there are various legal proceedings pending against Huntington and its subsidiaries. In the opinion of management, the aggregate liabilities, if any, arising from such proceedings are not expected to have a material adverse effect on Huntington’s consolidated financial position. (See also Note 3.)
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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
INTRODUCTION
Huntington Bancshares Incorporated (Huntington or the company) is a multi-state diversified financial holding company organized under Maryland law in 1966 and headquartered in Columbus, Ohio. Through its subsidiaries, Huntington is engaged in providing full-service commercial and consumer banking services, mortgage banking services, automobile financing, equipment leasing, investment management, trust services, and discount brokerage services, as well as reinsuring credit life and disability insurance, and selling other insurance and financial products and services. Huntington’s banking offices are located in Ohio, Michigan, West Virginia, Indiana, and Kentucky. Selected financial services are also conducted in other states including Arizona, Florida, Georgia, Maryland, New Jersey, Pennsylvania, and Tennessee. Huntington has a foreign office in the Cayman Islands and a foreign office in Hong Kong. The Huntington National Bank (the Bank), organized in 1866, is Huntington’s only bank subsidiary.
The following discussion and analysis provides investors and others with information that Management believes to be necessary for an understanding of Huntington’s financial condition, changes in financial condition, results of operations, and cash flows, and should be read in conjunction with the financial statements, notes, and other information contained in this report.
Forward-Looking Statements
This report, including Management’s Discussion and Analysis of Financial Condition and Results of Operations, contains forward-looking statements about Huntington. These include descriptions of products or services, plans or objectives of Management for future operations, including pending acquisitions, and forecasts of revenues, earnings, cash flows, or other measures of economic performance. Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts.
By their nature, forward-looking statements are subject to numerous assumptions, risks, and uncertainties. A number of factors could cause actual conditions, events, or results to differ significantly from those described in the forward-looking statements. These factors include, but are not limited to, those set forth below and under the heading “Business Risks” included in Item 1 of Huntington’s Annual Report on Form 10-K for the year ended December 31, 2003 (2003 Form 10-K), and other factors described in this report and from time-to-time in other filings with the Securities and Exchange Commission.
Management encourages readers of this report to understand forward-looking statements to be strategic objectives rather than absolute forecasts of future performance. Forward-looking statements speak only as of the date they are made. Huntington assumes no obligation to update forward-looking statements to reflect circumstances or events that occur after the date the forward-looking statements were made or to reflect the occurrence of unanticipated events.
Risk Factors
Huntington, like other financial companies, is subject to a number of risks, many of which are outside of Management’s control, though Management strives to manage those risks while optimizing returns. Among the risks assumed are: (1) credit risk, which is the risk that loan and lease customers or other counter parties will be unable to perform their contractual obligations, (2) market risk, which is the risk that changes in market rates and prices will adversely affect Huntington’s financial condition or results of operations, (3) liquidity risk, which is the risk that Huntington and / or the Bank will have insufficient cash or access to cash to meet operating needs, and (4) operational risk, which is the risk of loss resulting from inadequate or failed internal processes, people, or systems, or external events. The description of Huntington’s business contained in Item 1 of its 2003 Form 10-K, while not all inclusive, discusses a number of business risks that, in addition to the other information in this report, readers should carefully consider.
Formal Supervisory Agreements and Securities and Exchange Commission Investigation
On November 3, 2004, Huntington announced that it expects to enter into formal supervisory agreements with its banking regulators, the Federal Reserve and the Office of the Controller of the Currency, providing for a comprehensive action plan designed to address its financial reporting and accounting policies, procedures, and controls and its corporate governance practices. Huntington remains in active dialogue with its banking regulators concerning these and related matters.
As part of its November 3, 2004, announcement, Huntington indicated that it is negotiating a one-year extension of its merger agreement with Unizan. Huntington intends to withdraw its current application with the Federal Reserve to
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acquire Unizan and to resubmit the application for regulatory approval of the merger once it has successfully resolved the aforementioned regulatory concerns.
As previously disclosed, Huntington continues to have ongoing discussions with the staff of the Securities and Exchange Commission (SEC) regarding resolution of its formal investigation into certain financial accounting matters relating to fiscal years 2002 and earlier and certain related disclosure matters. It is anticipated that a settlement of this matter will involve the entry of an order by the SEC requiring Huntington to comply with various provisions of the Securities Exchange Act of 1934 and the Securities Act of 1933, along with the imposition of a civil money penalty.
Huntington’s Board of Directors has been overseeing a review of the Company’s financial accounting and reporting practices as they relate to the Company’s previous accounting restatements and other related matters during the course of the pending SEC formal investigation. It has recently engaged the Promontory Financial Group to provide assistance with respect to these and related regulatory matters.
Huntington believes that it will be able to address all of the issues that have been raised by the SEC and its banking regulators concerning these matters in a comprehensive manner and is working aggressively to do so. No assurances, however, can be provided as to the ultimate timing or outcome of these matters pending a final settlement.
Critical Accounting Policies and Use of Significant Estimates
Huntington’s 2003 Form 10-K lists Critical Accounting Policies and Use of Significant Estimates used in the development and presentation of its financial statements. These significant accounting policies, as well as the following discussion and analysis and other financial statement disclosures, identify and address key variables and other qualitative and quantitative factors that are necessary for an understanding and evaluation of Huntington, its financial position, results of operations, and cash flows.
The preparation of financial statements in conformity with accounting principles generally accepted in the United States (GAAP) requires Huntington’s Management to establish critical accounting policies and make accounting estimates, assumptions, and judgments that affect amounts recorded and reported in its financial statements. An accounting estimate requires assumptions about uncertain matters that could have a material effect on the financial statements of Huntington if a different amount within a range of estimates were used or if estimates changed from period to period. Readers of this interim report should understand that estimates are made under facts and circumstances at a point in time and changes in those facts and circumstances could produce actual results that differ from when those estimates were made. Huntington’s Management has identified the most significant accounting estimates and their related application in Huntington’s 2003 Form 10-K.
SUMMARY DISCUSSION OF RESULTS
Earnings comparisons from the first nine-months of 2003 through the first nine-months of 2004, including comparisons of third quarter of 2003 with the third quarter of 2004 performance, were impacted by a number of factors, some related to changes in the economic and competitive environment, while others reflected specific Management strategies or changes in accounting practices. Understanding the nature and implications of these factors on financial results is important in understanding the company’s income statement, balance sheet, and credit quality trends and the comparison of the current quarter and year-to-date performance with comparable prior-year periods. The key factors impacting the current reporting period comparisons are more fully described in the Significant Factors Influencing Financial Performance Comparisons section, which follows the summary of results below.
2004 Third Quarter versus 2003 Third Quarter
Huntington’s 2004 third quarter earnings were $93.5 million, or $0.40 per common share, both up 3% from $90.9 million and $0.39 per common share in the year-ago quarter. This $2.6 million increase in earnings primarily reflected:
Partially offset by:
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The return on average assets (ROA) and return on average equity (ROE), were 1.18% and 15.4%, respectively, down from 1.38% and 18.5%, respectively, in the year-ago quarter (see Table 1).
2004 Third Quarter versus 2004 Second Quarter
Compared with 2004 second quarter net income of $110.1 million and $0.47 per common share, 2004 third quarter earnings and earnings per share were both down 15%. This $16.6 million decrease in earnings primarily reflected:
The ROA and ROE were 1.18% and 15.4%, respectively, in the current quarter, down from 1.41% and 19.1%, respectively, in the prior quarter (see Table 1).
2004 First Nine Months versus 2003 First Nine Months
Earnings for the first nine months of 2004 were $307.8 million, or $1.32 per common share, up 10% and 9%, respectively, from the comparable year-ago period earnings of $279.1 million or $1.21 per common share. This $28.7 million increase in earnings primarily reflected:
The ROA and ROE were 1.32% and 17.6%, respectively, in the current nine-month period, down slightly from 1.37% and 17.9%, respectively, in the comparable year-ago period (see Table 2).
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Table 1 — Selected Quarterly Income Statement Data
N.M. - - Not Meaningful.
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Table 2 - Selected YTD Income Statement Data
N.M. - Not Meaningful.
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Significant Factors Influencing Financial Performance Comparisons
Earnings comparisons from the first nine months of 2003 through the first nine months of 2004 were impacted by a number of factors, some related to changes in the economic and competitive environment, while others reflected specific Management strategies or changes in accounting practices. Those key factors are summarized below.
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The following table quantifies the earnings impact of changes in SEC related expenses / accruals, Unizan system conversion expenses, MSR and investment securities and trading account valuations, gains on sales of automobile loans, restructuring reserve releases, sale of the West Virginia banking offices, and a single, large commercial credit recovery on the specified periods.
Table 3 - Significant Items Influencing Earnings Performance Comparisons
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RESULTS OF OPERATIONS
Net Interest Income
Fully taxable equivalent net interest income increased $6.9 million, or 3%, from the year-ago quarter, reflecting the favorable impact of an 8% increase in average earning assets, partially offset by a 16 basis point, or an effective 5%, decline in the net interest margin. The fully taxable equivalent net interest margin decreased to 3.30% from 3.46%, reflecting the impact of lower rates and the strategic repositioning of portfolios to reduce automobile loans and to increase the relative proportion of lower-rate, and lower-risk, residential real estate-related loans and investment securities.
Average total loans and leases increased $1.7 billion, or 8%, from the 2003 third quarter due primarily to a $1.3 billion, or 11%, increase in average consumer loans. Contributing to the consumer loan growth was a $1.8 billion, or 84%, increase in average residential mortgages and a $0.5 billion, or 15%, increase in average home equity loans. Demand for residential mortgages and home equity loans remained strong during this twelve month period as interest rates remained near historically low levels. Average total automobile loans and leases decreased $1.1 billion, or 21%. This decline from the year-ago quarter reflected the sale of $2.6 billion of automobile loans over this 12-month period, partially offset by the rapid growth in direct financing leases due to the migration from operating lease assets, which have not been originated since April 2002.
During the third quarter, $153 million of automobile loans were sold, including $102 million of automobile loans transferred to loans held for sale during the 2004 second quarter. Combined, these transactions resulted in third quarter net pre-tax gains on the sale of automobile loans of $0.3 million. On a combined basis, these transactions increased the total automobile loans sold since the beginning of 2003 to $3.7 billion. These sales represented a continuation of a strategy to reduce exposure to automobile financing to approximately 20% of total credit exposure (see Table 10). At September 30, 2004, this exposure was $4.9 billion, down from $6.2 billion at year end and represented 21% of total credit exposure, down from 28% at year end 2003, and 30% at September 30, 2003.
Average total commercial and industrial (C&I) and commercial real estate (CRE) loan balances were $9.8 billion, up $0.4 billion, or 5%, from the year-ago quarter. This $9.8 billion consisted of middle-market C&I ($4.3 billion, down from $4.5 billion), middle market CRE ($3.5 billion, up from $3.1 billion), and small business C&I and CRE ($1.9 billion) loans. Small business C&I and CRE loans increased $188 million, or 11%. Middle-market C&I and CRE balances were impacted by a June 30, 2004 reclassification of $282 million of C&I loans to CRE loans. Adjusting for this reclassification, average middle-market C&I loans increased $93 million, or 2%, from the year-ago quarter and middle-market CRE loans increased $143 million, or 4%.
Average investment securities increased $0.7 billion, or 18%, from the year-ago quarter. This increase reflected the use of some of the proceeds from the previous sales of automobile loans to purchase 10-year variable rate securities.
Average total core deposits in the third quarter were $16.5 billion, up $0.7 billion, or 4%, from the year-ago quarter, reflecting a $0.8 billion, or 13%, increase in average interest bearing demand deposit accounts, partially offset by a $0.1 billion, or 6%, decline in retail CDs.
Tables 4 and 5 reflect quarterly average balance sheets and rates earned and paid on interest-earning assets and interest-bearing liabilities:
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Table 4 — Condensed Consolidated Quarterly Average Balance Sheets
N.M. - Not Meaningful
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Table 5 - Consolidated Quarterly Net Interest Margin Analysis
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Compared with the 2004 second quarter, fully taxable equivalent net interest income increased $4.4 million, or 2%, reflecting the favorable impact of a 1% increase in average earning assets and a one basis point increase in the net interest margin to 3.30% from 3.29%.
Compared with the second quarter, average total loans and leases increased $0.4 billion, or 2%, with the growth rate mitigated by a $0.5 billion, or 21%, decline in average automobile loans due to the second quarter ($512 million) and third quarter ($153 million) sales of automobile loans. Growth in mortgage-related consumer loans remained strong with average residential mortgages up $0.6 billion, or 17%, and average home equity loans up $0.1 billion, or 4%. Total average C&I and CRE loans increased slightly, primarily reflecting a $63 million, or 3%, increase in small business C&I and CRE loans. As discussed above, middle-market C&I and CRE loan balances were impacted by the $282 million loan reclassification on June 30, 2004. Adjusting for this reclassification, third quarter average middle-market C&I and CRE loans were essentially flat.
Compared with the second quarter, average investment securities declined $0.5 billion, or 10%.
Compared with the 2004 second quarter, average total core deposits increased $0.3 billion, or 2%, reflecting growth in interest bearing demand deposits, up $0.2 billion, or 3%, as well as non-interest bearing deposits, up $0.1 billion, or 2%.
Fully taxable equivalent net interest income for the first nine months of 2004 increased $49.7 million, or 8%, from the comparable year-ago period, reflecting the favorable impact of a 14% increase in average earning assets, partially offset by a 21 basis point, or an effective 6%, decline in the net interest margin. The fully taxable equivalent net interest margin decreased to 3.31% from 3.52%, reflecting the impact of lower rates and the strategic repositioning of portfolios to reduce automobile loans and increase the relative proportion of lower-rate, and lower-risk, residential real estate-related loans and investment securities.
Average total loans and leases increased $2.3 billion, or 12%, from the first nine months of 2003 due primarily to a $2.0 billion, or 19%, increase in average consumer loans. Contributing to the consumer loan growth was a $1.4 billion, or 72%, increase in average residential mortgages and a $0.5 billion, or 15%, increase in average home equity loans. Average total automobile loans and leases increased $0.1 billion, or 1%. This growth from the year-ago, nine-month period reflected the positive impact of underlying new automobile loan originations, the 2003 third quarter consolidation of a $1.0 billion automobile loan securitization trust, and the rapid growth in direct financing leases due to the migration from operating lease assets, which are no longer being originated. Partially offsetting these positive impacts was the sale of automobile loans over this period.
Average total C&I and CRE loans in the first nine months of 2004 increased $0.3 billion, or 3%, from the comparable year-ago period reflecting an 11% increase in small business C&I and CRE loans, and a 11% increase in middle-market CRE loans. Average middle-market C&I loans were down 5% from the year-ago period and reflected both weak demand and the impact from continued strategies to specifically lower exposure to large individual commercial credits, including shared national credits.
Average investment securities increased $1.4 billion, or 38%, from the year-ago nine-month period primarily reflecting the investment of a portion of the proceeds from the automobile loan sales.
Average total core deposits in the first nine months of 2004 were $16.1 billion, up $0.7 billion, or 4%, from the comparable year-ago period. This growth primarily reflected a $1.0 billion, or 16%, increase in interest bearing demand deposits, primarily money market accounts, partially offset by a $0.4 billion, or 13%, decline in retail CDs.
Table 6 reflects average balance sheets and rates earned and paid on interest-earning assets and interest-bearing liabilities, respectively, for the first nine-month periods of 2004 and 2003:
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Table 6 - Condensed Consolidated YTD Average Balance Sheets and Net Interest Margin Analysis
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Provision for Credit Losses
The provision for credit losses is the expense necessary to maintain the ALLL and the allowance for unfunded loan commitments (AULC) at levels adequate to absorb Management’s estimate of inherent losses in the total loan and direct financing lease portfolio, unfunded loan commitments, and letters of credit. Taken into consideration are such factors as current period net charge-offs that are charged against these allowances, current period loan and lease growth and any related estimate of likely losses associated with that growth based on historical experience, the current economic outlook, and the anticipated impact on credit quality of existing loans and leases, unfunded commitments and letters of credit (see Allowances for Credit Losses for additional discussion and Table 14).
The provision for credit losses in the 2004 third quarter was $11.8 million, a $39.8 million reduction from the year-ago quarter and a $6.8 million increase from the 2004 second quarter. The reduction from the year-ago quarter reflected overall improved portfolio quality performance, as well as an improved economic outlook, only partially offset by provision expense related to loan growth. The increase in provision for credit losses from the 2004 second quarter reflected the fact that the 2004 second quarter provision benefited from a $9.7 million recovery on a single C&I credit that had been charged-off in the 2002 fourth quarter. Underlying credit quality trends between the 2004 second and third quarter continued to improve. As previously disclosed, effective January 1, 2004, the company adopted a more quantitative approach to calculating the economic reserve component of the ALLL, making this component more responsive to changes in economic conditions. This change, combined with the existing quantitative approach for determining the transaction reserve component, as well as changes to the specific reserve component, will result in more volatility in the total ALLL and corresponding provision for credit losses (see Credit Risk for additional discussion).
The provision for credit losses in the first nine months of 2004 was $42.4 million, a $95.2 million, or 69%, decline from the comparable year-ago period. This reduction reflected the same factors impacting third quarter year-over-year performance.
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Non-Interest Income
Table 7 reflects non-interest income detail for each of the past five quarters, and the first nine-months of 2004 and 2003:
Table 7 — Non-Interest Income
N.M. — Not Meaningful.
Non-interest income decreased $82.9 million, or 30%, from the year-ago quarter. Comparisons with prior-period results are heavily influenced by the decline in operating leases and related operating lease income. These trends are expected to continue as all automobile leases originated since April 2002 are direct financing leases with income reflected in net interest income, not non-interest income. Reflecting the run-off of the operating lease portfolio, operating lease income declined $53.2 million, or 45%, from the 2003 third quarter. Excluding operating lease income, non-interest income decreased $29.7 million, or 19%, from the year-ago quarter with the primary drivers being:
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and options. As none of these instruments qualify for hedge accounting, the change in value of the trading account assets are reported as a component of other income, whereas the gains (losses) from the sale of securities that are available for sale are reported as investment securities gains (losses).
Compared with the 2004 second quarter, non-interest income declined $28.2 million, or 13%. This comparison is also heavily influenced by the decline in operating lease income for the reasons noted above. Reflecting the run-off of the operating lease portfolio, operating lease income declined $14.3 million, or 18%, from the 2004 second quarter. Excluding operating lease income, non-interest income decreased $13.9 million, or 10%, from the 2004 second quarter with the primary drivers being:
Non-interest income for the first nine months of 2004 declined $187.0 million, or 23%, from the comparable year-ago period. Comparisons with prior-period results are heavily influenced by the decline in operating leases and related operating lease income (see above discussion). Reflecting the run-off of the operating lease portfolio, operating lease income for the first nine months of 2004 declined $152.4 million, or 40%, from the comparable year-ago period. Excluding operating lease income, non-interest income for the first nine months of 2004 decreased $34.6 million, or 8%, from the comparable year-ago period with the primary drivers being:
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Non-Interest Expense
Table 8 reflects non-interest expense detail for each of the last five quarters and the first nine-month period for 2004 and 2003:
Table 8 - Non-Interest Expense
Non-interest expense decreased $26.8 million, or 9%, from the year-ago quarter. Comparisons with prior-period results are influenced by the decline in operating lease expense as the operating lease portfolio continues to run-off (see above operating lease income discussion). Excluding operating lease expense, non-interest expense increased $11.5 million, or 6%, from the year-ago quarter with the primary drivers being:
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The current quarter included $1.8 million of current quarter expenses related to Unizan integration planning and systems conversion. These expenses were spread across various non-interest expense categories with no meaningful impact on any single line item.
Compared with the 2004 second quarter, non-interest expense declined $8.7 million, or 3%. Comparisons with prior-period results are also heavily influenced by the decline in operating lease expense. Operating lease expense declined $7.7 million, or 12%, from the 2004 second quarter. Excluding operating lease expense, non-interest expense decreased $1.1 million from the second quarter with the primary drivers being:
Non-interest expense for the first nine months of 2004 declined $71.5 million, or 8%, from the comparable year-ago period. Comparisons with prior-period results are influenced by the decline in operating lease expense as the operating lease portfolio continues to run-off (see above operating lease income discussion). Operating lease expense declined $119.5 million, or 39%, from the 2003 nine-month period.
Excluding operating lease expense, non-interest expense for the first nine months of 2004 increased $48.0 million, or 8%, from the year-ago period with the primary drivers being:
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Operating Lease Assets
Table 9 reflects operating lease assets performance detail for each of the last five quarters, and the first nine-months of 2004 and 2003:
Table 9 - Operating Lease Performance
(1) As a percent of average operating lease assets, quarterly amounts annualized.
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Operating lease assets represent automobile leases originated before May 2002. This operating lease portfolio will run-off over time since all automobile lease originations after April 2002 have been recorded as direct financing leases and are reported in the automobile loan and lease category in earning assets. As a result, the non-interest income and non-interest expenses associated with the operating lease portfolio will also decline over time.
2004 Third Quarter versus 2003 Third Quarter and 2004 Second Quarter
Average operating lease assets in the 2004 third quarter were $0.8 billion, down $0.8 billion, or 49%, from the year-ago quarter and 18% from the 2004 second quarter.
Operating lease income, which totaled $64.4 million in the 2004 third quarter, represented 34% of non-interest income in the quarter. Operating lease income was down $53.2 million, or 45%, from the year-ago quarter and $14.3 million, or 18%, from the 2004 second quarter, reflecting the declines in average operating leases. As no new operating leases have been originated after April 2002, the operating lease asset balances will continue to decline through both depreciation and lease terminations. Net rental income was down 45% and 17%, respectively, from the year-ago and 2004 second quarter. Fees declined 45% from the year-ago quarter and 39% from the second quarter reflecting the recognition of deferred fees resulting from higher than expected prepayments of operating lease assets in the second quarter of this year. Recoveries from early terminations declined 55% from the year-ago quarter and 20% from the second quarter.
Operating lease expense totaled $54.9 million, down $38.2 million, or 41%, from the year-ago quarter and down $7.7 million, or 12%, from the 2004 second quarter. These declines also reflected the fact that this portfolio is decreasing over time as no new operating leases are being originated. The decline in operating lease expense from the year-ago quarter was partially offset by a $3.5 million increase in additional depreciation expense for the estimated decline in residual values.
Losses on operating lease assets consist of residual losses at termination and losses on early terminations. Residual losses arise if the ultimate value or sales proceeds from the automobile are less than Black Book value, which represents the insured amount under the company’s residual value insurance policies. This situation may occur due to excess wear-and-tear or excess mileage not collected from the lessee. Losses on early terminations occur when a lessee, due to credit or other reasons, turns in the automobile before the end of the lease term. A loss is realized if the automobile is sold for a value less than the net book value at the date of turn-in. Such losses are not covered by the residual value insurance policies. To the extent the company is successful in collecting any deficiency from the lessee, amounts received are recorded as recoveries from early terminations.
Credit losses on operating lease assets are included in operating lease expense and were $5.0 million in the current quarter, down from $10.0 million in the year-ago quarter and $5.2 million in the second quarter. Recoveries on operating lease assets are included in operating lease income and totaled $1.2 million, $2.6 million, and $1.5 million, for the same periods, respectively. The ratio of operating lease asset credit losses to average operating lease assets, net of recoveries, was an annualized 1.89% in the current quarter, 1.90% in the year-ago quarter, and 1.51% in the 2004 second quarter. As noted in the non-interest income discussion above, the operating lease portfolio will decline over time as no new operating lease assets have been generated since April 2002.
On a quarterly basis, Management evaluates the amount of residual value losses that it anticipates will result from the estimated fair value of a leased vehicle being less than the residual value inherent in the lease. Fair value includes estimated net proceeds from the sale of the leased vehicle plus expected residual value insurance proceeds and amounts expected to be collected from the lessee for excess mileage and other items that are billable under terms of the lease contract. When estimating the amount of expected insurance proceeds, Management takes into consideration policy caps that exist in two of the three residual value insurance policies and whether it expects aggregate claims under such policies to exceed these caps. Residual value losses exceeding any insurance policy cap are reflected in higher depreciation expense over the remaining life of the affected automobile lease. Also as part of its quarterly analysis, Management evaluates automobile leases individually for impairment.
Residual value losses on automobile leases booked prior to October 1, 2000, were covered by an insurance policy with a $120 million cap. During the third quarter, residual value losses exceeded this cap a few months earlier than anticipated due to higher than anticipated volume of turned in automobiles and to a lesser degree, softness in the used car market. Total losses above the cap are expected to be $18-$30 million, including $10 million already recognized and reflected in additional accumulated depreciation. As a result, the company anticipates that 2004 fourth quarter operating lease depreciation will be $2-$3 million higher than the 2004 third quarter expense level, with lesser amounts in quarters thereafter.
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The residual value insurance policy covering automobile leases originated between October 1, 2000 and April 30, 2002 contains a $50 million cap. At this time, the company anticipates that total claims against this policy will be $10-$18 million, well below the cap. To date, approximately $3 million of claims have been filed on this policy. All automobile leases originated since April 30, 2002, are covered under a policy that does not place a cap on losses. This policy will cover leases originated through April 30, 2005.
Average operating lease assets in the first nine-months of 2004 were $1.0 billion, down $0.8 billion, or 46%, from the comparable year-ago period.
Operating lease income, which totaled $232.0 million in the first nine months of 2004, represented 36% of non-interest income, and was down $152.4 million, or 40%, from the comparable year-ago period. Net rental income was down $144.2 million, or 40%. Fees declined $5.1 million, or 31%, from the same year-ago period. Recoveries from early terminations declined $3.1 million, or 41% from the year-ago period. Operating lease expense totaled $188.2 million, down $119.5 million, or 39%, from the comparable year-ago period. The declines in operating lease income and operating lease expense reflected the fact that this portfolio is decreasing over time as no new operating leases are being originated, and the same factors discussed above.
The ratio of operating lease asset credit losses to average operating lease assets, net of recoveries, was an annualized 1.71% in the first nine months of 2004, down from 1.94% in the comparable year-ago period.
Provision for Income Taxes
The provision for income taxes in the third quarter of 2004 was $38.3 million and represented an effective tax rate on income before taxes of 29.0%. The provision for income taxes increased $1.0 million from the year-ago quarter, due to a higher effective tax rate. The effective tax rates in the second quarter of 2004 and the third quarter 2003 were 28.3% and 26.3%, respectively. The higher effective tax rate in the 2004 third quarter reflected a reduction in estimated 2004 tax benefits (credits) from a reduced level of investments in partnerships and the recording of non-deductible expenses.
For the first nine months of 2004, provision for income taxes was $116.5 million and represented an effective tax rate on income before taxes of 27.5%. This represented an increase of $12.0 million from the same period in 2003, in which the effective tax rate was 26.3%, reflecting higher pre-tax income.
Each quarter, taxes for the full year are estimated and year-to-date tax accrual adjustments are made. Revisions to the full year estimate of accrued taxes occur periodically due to changes in the tax rates, audit resolution with taxing authorities, and newly enacted statutory, judicial, and regulatory guidance. These changes, when they occur, affect accrued taxes and can result in fluctuations in the quarterly effective tax rate.
In accordance with FAS 109, Accounting for Income Taxes, no deferred income taxes are to be recorded when a company intends to permanently reinvest their earnings from a foreign activity. As of September 30, 2004, the company intended to permanently reinvest the earnings from its foreign asset securitization activities of approximately $83.7 million.
Management expects the 2004 effective tax rate to remain below 30% as the level of tax-exempt income, general business credits, and asset securitization activities remain consistent with prior years.
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CREDIT RISK
Credit risk is the risk of loss due to adverse changes in a borrower’s ability to meet its financial obligations under agreed upon terms. The company is subject to credit risk in lending, trading, and investment activities. The nature and degree of credit risk is a function of the types of transactions, the structure of those transactions, and the parties involved. The majority of the company’s credit risk is associated with lending activities, as the acceptance and management of credit risk is central to profitable lending. Credit risk represents a limited portion of the total risks associated with the investment portfolio and is incidental to trading activities. Credit risk is mitigated through a combination of credit policies and processes and portfolio diversification. These include origination/underwriting criteria, portfolio monitoring processes, and effective problem asset management. There are very specific and differing methodologies for managing credit risk for commercial credits compared with consumer credits (see Credit Risk Management section of the Company’s 2003 Form 10-K for a complete discussion).
Loan and Lease Composition
Table 10 reflects period-end loan and lease portfolio mix by type of loan or lease, as well as by business segment:
Table 10 - Loans and Lease Portfolio Composition
During 2004, the composition of the loan and lease portfolio changed such that lower credit risk home equity loans and residential mortgages each represented 17% of total credit exposure at September 30, 2004, up from 15% and 11%, respectively, a year earlier. Conversely, C&I loans have declined from 24% a year ago to 23% at September 30, 2004, reflecting, in part, strategies to exit large, individual commercial credits, including out-of-footprint shared national credits.
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At the beginning of the 2004 second quarter, the criteria for categorizing commercial loans as either C&I loans or CRE loans was clarified. The new criteria are based on the purpose of the loan. Previously, the categorization was based on the nature of the collateral securing, or partially securing, the loan. Under this new methodology, as new loans are originated or existing loans renewed, loans secured by owner-occupied real estate are categorized as C&I loans (previously CRE loans) and unsecured loans for the purpose of developing real estate are categorized as CRE loans (previously C&I loans). As a result of this change, $282 million in C&I loans were reclassified to CRE loans effective June 30, 2004. Prior periods were not reclassified. This change had no impact on the underlying credit quality of total commercial loans. However, it did increase average reported CRE loans in the 2004 third quarter by $282 million, with an equal decrease in average reported C&I loans.
The company also has a portfolio of automobile operating lease assets. Although these assets are reflected on the balance sheet, they are not part of total loans and leases or earning assets. In addition, prior to June 30, 2004, there was a small pool of securitized automobile loans, which represented off-balance sheet securitized automobile loan assets. Both of these asset classes represent automobile financing credit exposure, despite not being components of total loans and leases. As such, operating lease assets and securitized loans are added to the on-balance sheet automobile loans and leases to determine a total automobile financing exposure, which Management finds helpful in evaluating the overall credit risk for the company.
During the third quarter of 2004, $153 million of automobile loans were sold, resulting in a third quarter pre-tax gain on the sale of automobile loans of $0.3 million. This sale increased the total automobile loans sold since the beginning of 2003 to $3.7 billion. These sales represented a continuation of a strategy to reduce exposure to automobile financing to approximately 20% of total credit exposure (see Table 10). At September 30, 2004, this exposure was $4.9 billion, down from $6.2 billion at year-end, and represented 21% of total credit exposure, down from 22% at the end of the last quarter and from 30% a year earlier.
Net Loan and Lease Charge-offs
Table 11 reflects net loan and lease charge-off detail for each of the last five quarters, and the first nine-month period for 2003 and 2004:
Table 11 - Net Loan and Lease Charge-offs
Net Charge-offs by Loan and Lease Type
Net Charge-offs - Annualized Percentages
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Table 11 - Net Loan and Lease Charge-offs Continued
Total net charge-offs for the 2004 third quarter were $16.5 million, or an annualized 0.30% of average total loans and leases. This was a reduction from $32.8 million, or 0.64%, in the year-ago quarter. However, it was an increase from $12.5 million in the second quarter, or an annualized 0.23% of average total loans and leases, as net charge-offs in the second quarter were reduced by a $9.7 million one-time recovery of a previously charged-off commercial loan. This recovery lowered total commercial (C&I and CRE) net charge-offs by 39 basis points and total loan and lease net charge-offs by 18 basis points. Excluding the impact of this recovery, 2004 second quarter total net charge-offs would have been $22.2 million, or an annualized 0.41% of average total loans and leases. Gross charge-offs in the third quarter declined $4.5 million, or 15%, from the second quarter.
Total commercial net charge-offs in the third quarter were $2.6 million, or an annualized 0.10%, down from $15.8 million, or an annualized 0.68%, in the year-ago quarter and up from only $137 thousand in the previous quarter. Adjusting for the $9.7 million recovery noted above (39 basis point impact), second quarter total commercial net charge-offs would have been $9.8 million, or an annualized 0.40% of related loans.
Total consumer net charge-offs in the current quarter were $13.9 million, or an annualized 0.45% of related loans. This compared with $16.9 million, or 0.61%, in the year-ago quarter and $12.4 million, or an annualized 0.41% of related loans in the 2004 second quarter.
Total automobile loan and lease net charge-offs in the 2004 third quarter were $7.6 million, or an annualized 0.74% of average automobile loans and leases. This compared with $12.2 million of net charge-offs, or an annualized 0.94%, in the year-ago quarter and $7.8 million, or an annualized 0.69% in the second quarter.
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Total net charge-offs for the first nine months of 2004 were $57.6 million, or an annualized 0.35% of average total loans and leases. This was a 46% reduction from $106.7 million, or 0.73%, in the comparable year-ago period. Performance for the first nine months of 2004 was consistent with the company’s net charge-off target of 0.35%-0.45% for a stable economic environment.
Total commercial (C&I and CRE) net charge-offs in the first nine months of 2004 were only $10.3 million, or an annualized 0.14%, down from $58.4 million, or 0.83%, in the comparable year-ago period. The decline from the year-ago period reflected improved credit quality, including lower non-performing assets (NPAs), as well as the benefit of a $9.7 million C&I recovery in the 2004 first nine-month period.
Total consumer net charge-offs in the first nine months of 2004 were $47.3 million, or an annualized 0.52% of related loans. This compared with $48.2 million, or 0.63%, in the comparable year-ago period. Total automobile loan and lease net charge-offs in the first nine months of 2004 were $31.9 million, or an annualized 0.94% of average automobile loans and leases, down slightly from $32.7 million, or an annualized 0.97% of average automobile loans and leases in the year-ago nine-month period.
Non-performing Assets and Past Due Loans and Leases
Table 12 reflects period-end NPAs and past due loans and leases detail for each of the last five quarters:
Table 12 - Non-Performing Assets and Past Due Loans and Leases
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NPAs were $80.5 million at September 30, 2004, down $56.6 million, or 41%, from the prior year, and up $5.8 million, or 8%, from June 30, 2004. NPAs as a percent of total loans and leases and other real estate were 0.36% at September 30, 2004, down from 0.65% a year-ago, but up slightly from 0.34% at June 30, 2004. At September 30, 2004, the company adopted a new policy of placing home equity loans and lines on non-accrual status when they exceed 180 days past due. Such loans were previously classified as accruing loans and leases past due 90 days or more. This policy change conforms the home equity loans and lines classification to that of other consumer loans secured by residential real estate. As a result of this change in policy, the current quarter included $7.7 million of non-performing home equity loans and lines secured by real estate. NPAs at September 30, 2004, included $30.2 million of lower-risk residential real estate-related assets, which represented 38% of total NPAs. This compared with $19.1 million, or 14%, at the end of the year-ago quarter.
The over 90-day delinquent, but still accruing, ratio was 0.24% at September 30, 2004, down from 0.31% a year ago, and unchanged from 0.24% at June 30, 2004.
Table 13 reflects NPA activity. The $22.7 million of new NPAs in the 2004 third quarter included the addition of the $7.7 million of non-performing home equity loans and lines due to the policy change noted above. Excluding the $7.7 million, new NPAs in the third quarter were $15.1 million.
Non-performing Assets Activity
Table 13 — Non-Performing Asset Activity
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Allowances for Credit Losses (ACL) and Provision for Credit Losses
The company maintains two reserves, both of which are available to absorb possible credit losses: the allowance for loan and lease losses (ALLL) and the allowance for unfunded loan commitments (AULC). When summed together, these reserves constitute the total allowances for credit losses (ACL). Table 14 reflects activity in the ALLL and AULC for the past five quarters:
Table 14 — Allowances for Credit Losses
(1) The third quarter 2003 includes the allowance for loan losses associated with automobile loans from a securitizations trust that was consolidated as a result of the adoption of FASB Interpretation No. 46 on July 1, 2003.
The September 30, 2004, ALLL was $282.7 million, down from $336.4 million a year ago and from $286.9 million at June 30, 2004. These declines reflected continued credit quality improvement, the change in the mix of the loan portfolio to lower-risk residential mortgages and home equity loans, and improvement in the economic outlook. Expressed as a percent of period-end loans and leases, the ALLL at September 30, 2004, was 1.25%, down from 1.59% a year-ago and from 1.32% at June 30, 2004. The ALLL as a percent of NPAs was 351% at September 30, 2004, up from 245% a year ago, but down from 384% at June 30, 2004.
The September 30, 2004, AULC was $30.0 million, down slightly from $33.7 million at the end of the year-ago quarter, and from $31.2 million at June 30, 2004.
On a combined basis, the ACL as a percent of total loans and leases was 1.38% at September 30, 2004, compared with 1.75% a year ago and 1.46% at the end of last quarter. The ACL as a percent of NPAs was 389% at September 30, 2004, compared with 270% a year earlier and 426% at June 30, 2004.
The provision for credit losses in the 2004 third quarter was $11.8 million, a $39.8 million reduction from the year-ago quarter, but a $6.8 million increase from the 2004 second quarter. The reduction in provision expense from the year-ago quarter reflected overall improved portfolio quality performance and a stronger economic outlook, only partially offset by provision expense related to loan growth. The increase in provision expense from the second quarter primarily reflected lower recoveries, as the second quarter included a $9.7 million commercial loan recovery. As previously disclosed,
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effective January 1, 2004, the company adopted a more quantitative approach to calculating the economic reserve component of the ALLL making this component more responsive to changes in economic conditions (see discussion below). This change, combined with the quantitative approach for determining the transaction reserve component, as well as changes to the specific reserve component, may result in more volatility in the total ALLL, and corresponding provision for loan and lease losses.
The ALLL consists of three components, the transaction reserve, the economic reserve, and specific reserves (see the Credit Risk discussion in company’s 2003 Form 10-K for additional discussion).
Transaction reserve – This ALLL component is based on historical portfolio performance information. Specifically, the probability-of-default and the loss-in-event-of-default are assigned an expected risk factor based on the type and structure of each credit. Reserve factors are then calculated and applied at an individual loan level for all products.
Specific reserves – This ALLL component represents the sum of credit-by-credit reserve decisions for individual C&I and CRE loans when it is determined that the related expected risk factor is insufficient to cover the estimated losses embedded in the specified credit facility.
Economic reserve – This ALLL component reflects anticipated losses impacted by changes in the economic environment. As previously reported, effective January 1, 2004, the company adopted a significantly more quantitative approach to the calculation of the economic reserve component. In order to quantify the economic reserve, the company identified four statistically significant indicators of loss volatility over the seven-year period from 1996 through 2003. The four variables as identified by the regression model are: (1) the US Index of Leading Economic Indicators, (2) the US Corporate Profits Index, (3) the US Unemployment Index, and (4) the University of Michigan Current Consumer Confidence Index.
This methodology permits the decomposition of the total ALLL ratio into these three components and provides increased insight into the rationale for increases or decreases in the overall ALLL ratio. As shown in Table 14, the ALLL ratio at September 30, 2004 was 1.25%, of which 0.84% represented the transaction reserve, 0.33% the economic reserve, and 0.08% specific reserves. Of the 7 basis point decline in the ALLL ratio from 1.32% at June 30, 2004, the transaction and specific reserves each accounted for 2 basis points of the decline. This reflected the combination of the shift in the loan and lease portfolio mix toward higher credit quality loans, as well as the release of specific reserves due to the improvement in the credit quality and/or the resolution of individual C&I and CRE credit situations. The remaining 3 basis points of decline in the ALLL ratio represented lower relative economic reserves, reflecting an improved economic outlook. This more quantitative methodology for determining the ALLL will be more responsive to changes in the portfolio mix, the economic environment, and individual credit situations, with the result being an ALLL ratio that exhibits greater quarterly fluctuations.
MARKET RISK
Market risk is the potential for losses in the fair value of the company’s assets and liabilities due to changes in interest rates, exchange rates, and equity prices. The company incurs market risk in the normal course of business. Market risk arises when the company extends fixed-rate loans, purchases fixed-rate securities, originates fixed-rate certificates of deposit (CDs), obtains funding through fixed-rate borrowings, and leases automobiles and equipment based on expected lease residual values. Market risk arising from changes in interest rates, which affects the market values of fixed-rate assets and liabilities, is interest rate risk. Market risk arising from the possibility that the uninsured residual value of leased assets will be different at the end of the lease term than was estimated at the lease’s inception is residual value risk. From time to time, the company also has small exposures to trading risk and foreign exchange risk. At September 30, 2004, the company had $120.3 million of trading assets, primarily in its broker/dealer businesses.
Interest Rate Risk
Interest rate risk is the primary market risk incurred by the company. It results from timing differences in the repricing and maturity of assets and liabilities and changes in relationships between market interest rates and the yields on assets and rates on liabilities, including the impact of embedded options.
Management seeks to minimize the impact of changing interest rates on the company’s net interest income and the fair value of assets and liabilities. The board of directors establishes broad policies regarding interest rate and market risk
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and liquidity risk. The asset and liability committee (ALCO) establishes specific operating limits within the parameters of the board of directors’ policies. ALCO regularly monitors position concentrations and the level of interest rate sensitivity to ensure compliance with board of directors approved risk tolerances (see Interest Rate Risk discussion in the company’s 2003 Form 10-K for a complete discussion).
Interest rate risk modeling is performed monthly. Two broad approaches to modeling interest rate risk are employed: income simulation and economic value analysis. An income simulation analysis is used to measure the sensitivity of forecasted net interest income to changes in market rates over a one-year horizon. The economic value analysis (Economic Value of Equity or EVE) is calculated by subjecting the period-end balance sheet to changes in interest rates and measuring the impact of the changes in the value of the assets and liabilities.
The simulations for evaluating short-term interest rate risk exposure are scenarios that model gradual 100 and 200 basis point increasing and decreasing parallel shifts in interest rates over the next twelve-month period beyond the interest rate change implied by the current yield curve. The table below shows the results of the scenarios as of September 30, 2004, and June 30, 2004. All of the positions were well within the board of directors’ policy limits.
Net Interest Income at Risk (%)
The primary simulations for EVE risk assume an immediate and parallel increase in rates of +/- 100 and +/- 200 basis points beyond any interest rate change implied by the current yield curve. The table below outlines the results compared to the previous quarter and policy limits.
Economic Value of Equity at Risk (%)
LIQUIDITY RISK
The objective of effective liquidity management is to ensure that cash flow needs can be met on a timely basis at a reasonable cost under both normal operating conditions and unforeseen or unpredictable circumstances. The liquidity of the Bank is available to originate loans and leases and to repay deposit and other liabilities as they become due or are demanded by customers. Liquidity risk arises from the possibility that funds may not be available to satisfy current or future commitments based on external macro market issues, investor perception of financial strength, and events unrelated to the company such as war, terrorism, or financial institution market specific issues (see Liquidity discussion in the company’s 2003 Form 10-K for a complete discussion).
The primary source of funding is core deposits from retail and commercial customers (see Table 15). As of September 30, 2004, core deposits totaled $16.7 billion, and represented 83% of total deposits. This compared with $15.6 billion, or 83% of total deposits, a year earlier. Most of the growth in core deposits was attributable to growth in interest bearing and non-interest bearing demand deposits as retail CDs declined.
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Table 15 - Deposit Liabilities
Liquidity policies and limits are established by the board of directors, with operating limits set by ALCO. Two primary liquidity measures are the ratio of loans and operating lease assets to deposits and the percentage of assets funded with non-core, or wholesale, liabilities. The limits set by the board for these two liquidity measures are 135% and 40%, respectively. At September 30, 2004, the actual ratio of loans and operating leases to deposits was 116%, while the percentage of assets funded with non-core or wholesale liabilities was 35%. In addition, guidelines are established by ALCO to ensure diversification of wholesale funding by type, source, and maturity and provide sufficient balance sheet liquidity to cover 100% of wholesale funds maturing within a six-month time period. A contingency funding plan is in place, which includes forecasted sources and uses of funds under various scenarios in order to prepare for unexpected liquidity shortages, including the implications of any rating agency changes. ALCO meets monthly to identify and monitor liquidity issues, provide policy guidance, and oversee adherence to, and the maintenance of, an evolving contingency funding plan.
Credit ratings by the three major credit rating agencies are an important component of the company’s liquidity profile. Among other factors, the credit ratings are based on the financial strength, credit quality and concentrations in the loan portfolio, the level and volatility of earnings, capital adequacy, the quality of management, the liquidity of the balance sheet, the availability of a significant base of core retail and commercial deposits, and the company’s ability to access a broad array of wholesale funding sources. Adverse changes in these factors could result in a negative change in credit ratings and impact not only the ability to raise funds in the capital markets, but also the cost of these funds. In addition, certain financial on- and off-balance sheet arrangements contain credit rating triggers that could increase funding needs if a negative rating change occurs. Letter of credit commitments for marketable securities, interest rate swap collateral agreements, and certain asset securitization transactions contain credit rating provisions.
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As of September 30, 2004, credit ratings are as follows:
Management believes that sufficient liquidity exists to meet the funding needs of the Bank and the parent company.
OFF-BALANCE SHEET ARRANGEMENTS
Like other financial organizations, Huntington has various commitments in the ordinary course of business that, under GAAP, are not recorded in the financial statements. Specifically, Huntington makes various commitments to extend credit to customers, to sell loans, and to maintain obligations under operating-type non-cancelable leases for its facilities. Derivatives and other off-balance sheet arrangements are discussed under the “Market Risk” section of the company’s 2003 Form 10-K.
Standby letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party. These guarantees are primarily issued to support public and private borrowing arrangements, including commercial paper, bond financing, and similar transactions. There were $989 million of outstanding standby letters of credit at September 30, 2004. Non-interest income was recognized from the issuance of these standby letters of credit of $8.5 million for the nine-month period ended September 30, 2004. The carrying amount of deferred revenue related to standby letters of credit at September 30, 2004, was $3.9 million. Standby letters of credit are included in the determination of the amount of risk-based capital that the company and the Bank are required to hold.
CAPITAL
Capital is managed both at the parent and the Bank levels. Capital levels are maintained based on regulatory capital requirements and the economic capital required to support credit, market, and operation risks inherent in the company’s business and to provide the flexibility needed for future growth and new business opportunities. Management places significant emphasis on the maintenance of a strong capital position, which promotes investor confidence, provides access to the national markets under favorable terms, and enhances business growth and acquisition opportunities. The importance of managing capital is also recognized, and Management continually strives to maintain an appropriate balance between capital adequacy and providing attractive returns to shareholders.
Shareholders’ equity totaled $2.5 billion at September 30, 2004. This balance represented a $186 million increase from December 31, 2003. The growth in shareholders’ equity resulted from the retention of net income after dividends to shareholders of $181 million and stock option exercises of $18 million. This growth was offset by a decrease in accumulated other comprehensive income of $16 million. The decrease in accumulated other comprehensive income primarily resulted from a decline in the market value of securities available for sale, partially offset by an increase in the market value of cash flow hedges at September 30, 2004, compared with December 31, 2003.
On September 4, 2001, options totaling 3.2 million shares of common stock were granted to, with certain specified exceptions, full- and part-time employees under the Huntington Bancshares Incorporated Employee Stock Incentive Plan
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(the “Incentive Plan”). Under the terms of the Incentive Plan, these options were to vest on the earlier of September 4, 2006, or at such time as the closing price for Huntington’s common stock for five consecutive trading days reached or exceeded $25.00. Huntington’s common stock closing price exceeded $25.00 for each of the five consecutive trading days beginning October 1, 2004, and ending October 7, 2004. As a result, options for 2.0 million shares of common stock granted under the Incentive Plan, net of options for 1.2 million shares cancelled due to employee attrition, became fully vested and exercisable after the close of trading on October 7, 2004.
At September 30, 2004, the company had unused authority to repurchase up to 7.5 million shares, though no shares were repurchased during the 2004 third quarter. This authorization may be used to help mitigate the dilutive earnings impact resulting from the issuance of these Incentive Plan shares. All purchases under the current authorization will be made from time-to-time in the open market or through privately negotiated transactions depending on market conditions.
On October 13, 2004, the board of directors declared a quarterly cash dividend on its common stock of $0.20 per common share. The dividend is payable January 3, 2005, to shareholders of record on December 17, 2004.
Table 16 - Quarterly Common Stock Summary
Average equity to average assets in the 2004 third quarter was 7.66%, up from 7.49% a year earlier, and up from 7.42% for the second quarter of 2004 (see Table 17). At September 30, 2004, the tangible equity to assets ratio was 7.11%, up from 6.77% a year ago, and from 6.95% at June 30, 2004. The increase from June 30, 2004, primarily reflected growth in retained earnings.
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Table 17 - Capital Adequacy
At September 30, 2004, the tangible equity to risk-weighted assets ratio was 7.80%, up significantly from 7.24% in the year-ago quarter, and up from 7.64% at June 30, 2004. The increase in the tangible equity to risk-weighted assets ratio reflected primarily the positive impact resulting from reducing the overall risk profile of earning assets throughout this period, most notably a less risky loan portfolio mix, as well as growth in low risk investment securities.
The Federal Reserve Board, which supervises and regulates the company, sets minimum capital requirements for each of these regulatory capital ratios. In the calculation of these risk-based capital ratios, risk weightings are assigned to certain asset and off-balance sheet items such as interest rate swaps, loan commitments, and securitizations. Huntington’s Tier 1 Risk-based Capital, Total Risk-based Capital, Tier 1 Leverage ratios, and risk-adjusted assets for the recent five quarters are well in excess of minimum levels established for “well capitalized” institutions of 6.00%, 10.00%, and 5.00%, respectively. At September 30, 2004, the company had regulatory capital ratios in excess of “well capitalized” regulatory minimums.
The Bank is primarily supervised and regulated by the Office of the Comptroller of the Currency, which establishes regulatory capital guidelines for banks similar to those established for bank holding companies by the Federal Reserve Board. At September 30, 2004, the Bank had regulatory capital ratios in excess of “well capitalized” regulatory minimums.
LINES OF BUSINESS DISCUSSION
Management uses earnings on an operating basis, rather than on a GAAP basis, to measure underlying performance trends for each business segment. Analyzing earnings on an operating basis is very helpful in assessing underlying performance trends, a critical factor used by Management to determine the success of strategies and future earnings capabilities. Operating earnings represent GAAP earnings adjusted to exclude the impact of the significant items discussed in Note 8 to the Condensed Consolidated Financial Statements.
Regional Banking
Regional Banking provides products and services to retail, business banking, and commercial customers. These products and services are offered in seven operating regions within the five states of Ohio, Michigan, West Virginia, Indiana, and Kentucky through the company’s traditional banking network. Each region is further divided into Retail and Commercial Banking units. Retail products and services include home equity loans and lines of credit, first mortgage loans, direct installment loans, business loans, personal and business deposit products, as well as sales of investment and insurance services. Retail products and services comprise 59% and 80% of total Regional Banking loans and deposits, respectively. These products and services are delivered to customers through banking offices, ATMs, Direct Bank— Huntington’s customer service center, and Web Bank at huntington.com. Commercial banking serves middle-market and commercial banking relationships, which use a variety of banking products and services including commercial loans, international trade,
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cash management, leasing, interest rate protection products, capital market alternatives, 401(k) plans, and mezzanine investment capabilities.
Regional banking contributed $59.1 million of the company’s net operating earnings in the third quarter of 2004, up $4.0 million, or 7%, from the third quarter of 2003. This increase was due primarily to a $27.5 million reduction in provision for credit losses, which was partially offset by $21.3 million decline in mortgage banking income. Total fully taxable equivalent revenues declined $18.4 million, or 7%, from the third quarter of 2003 due to lower mortgage banking income. Total expenses increased $3.0 million, or 2%, from the year-ago quarter. The ROA was 1.39% in the current quarter, down from 1.45% in the year-ago quarter, though the ROE of 22.4% in the current quarter increased from 21.2% in the year-ago quarter.
Compared with the year-ago quarter, 2004 third quarter net interest income increased $2.2 million, or 1%, reflecting an 18% increase in average total loans and 5% increase in average total deposits, partially offset by a 43 basis point decline in net interest margin to 4.10% from 4.53%.
Average total loans increased $2.4 billion, or 18%, primarily reflecting a $1.7 billion increase in average residential mortgages, a $0.5 billion, or 15%, increase in home equity loans and lines of credit, as well as a $0.5 billion, or 12%, increase in average CRE loans. The growth in home equity, residential mortgages, and CRE loans reflected the continued favorable impact of low interest rates on demand for real estate-related financing. Total average C&I loans declined $0.2 billion, or 6%, from the year-ago quarter, due in part to weak demand, as well as the impact from continued strategies to lower exposure to large individual commercial credits, and to a lesser degree, a decline in shared national credits. Small Business C&I and CRE loans (included in total average C&I and CRE loans) increased $0.2 billion, or 11%, due to specific strategies that focus on this business segment.
Average total deposits increased $0.8 billion, or 5%. This reflected strong growth in average interest bearing demand deposits, up $0.9 billion, or 15%, which was partially offset by a $0.1 billion, or 4%, decline in domestic time deposits. Of the $0.8 billion increase in average total deposits, Commercial Banking accounted for $0.6 billion and Small Business $0.3 billion, which was partially offset by a $0.1 billion decline in average total deposits in Mortgage Banking.
The company continued its focus on customer service and delivery channel optimization. From the year-ago quarter, six banking offices were opened while three were closed. The number of Retail Banking demand deposit account (DDA) households increased 2% from the end of the year-ago quarter. Progress was made in improving the Retail Banking 90-day cross sell ratio, from 2.0 products or services to 2.3, a 15% improvement. Further, the online banking penetration of retail households with on-line banking increased to 36% from 29% a year earlier, with a 31% increase in the number of online customers.
The 43 basis points, or an effective 9%, decline in the net interest margin to 4.10% from 4.53% reflected a combination of factors. This included a shift in the loan portfolio mix to lower-margin, but higher credit quality, consumer residential real estate-related loans. In addition, interest rates offered on deposits have been near historical lows throughout this period, and despite rising recently, they remain below levels of a year ago such that it remained difficult to make commensurate reductions in deposit rates compared with reductions in loan yields compared with a year earlier.
The provision for credit losses for the third quarter of 2004 was $5.1 million or $27.5 million less than in the year-ago quarter. This decline reflected the overall improvement in credit quality including lower NPAs, as well as the shift to lower-rate, lower-risk residential mortgages and home equity loans and lines. Net charge-offs were $7.2 million, or an annualized 0.18% of average loans and leases, down from $19.8 million, or an annualized 0.59%, in the year-ago quarter (see Credit Risk for additional discussion regarding charge-offs and allowance for loan loss reserve methodologies).
Non-interest income decreased $20.5 million, or 21%, from the year-ago quarter, primarily due to the $21.3 million lower mortgage banking income, partially offset by higher deposit service charges and equipment operating lease income. Mortgage banking income decreased $21.3 million, or 71%, from the year-ago quarter largely reflecting a change in reporting methodology. In 2004, MSR impairment and recovery is reflected in the Treasury/Other segment, whereas in the year-ago quarter a $17.8 million recovery of previously recorded MSR temporary impairment was recognized in Regional Banking. The remainder of the decline in mortgage banking income is attributable to lower production and lower gain on loan sales. The increase in equipment operating lease income reflected growth in operating leases, a relatively new business line. Deposit service charges increased $1.8 million, or 4%, reflecting an increase in demand deposit accounts and
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higher personal NSF and overdraft fees. The $1.4 million, or 11%, decline in other income reflected lower fee sharing revenue from internal partners.
Non-interest expense increased $3.0 million, or 2%, from the year-ago quarter, reflecting a $5.9 million, or 10%, increase in personnel costs due to higher salaries and benefit expenses, and to a lesser degree an increase in the number of employees. The $3.4 million, or 4%, decrease in other expenses reflected lower marketing, telecommunications, outside services, and transportation expenses, partially offset by higher occupancy.
Regional Banking earnings in the 2004 third quarter decreased $1.7 million, or 3%, from the 2004 second quarter. This reflected a $9.0 million increase in the provision or credit losses, an $8.1 million increase in net-interest income, and a $3.6 million decline in non-interest expense, partially offset by a $5.2 million decline in non-interest income. The ROA and ROE in the 2004 third quarter were 1.39% and 22.4%, respectively, down from 1.52% and 23.9% in the 2004 second quarter.
Net interest income increased $8.1 million, or 5%, from the prior quarter, reflecting 6% growth in average total loans and 2% in average total deposits, partially offset by a decline in the net interest margin to 4.10% from 4.15%.
Average total loans increased $0.8 billion, or 6%. Consumer loans increased $0.7 billion, or 11%, reflecting strong growth in residential mortgages and home equity loans and lines of credit. Excluding the impact of the $282 million of C&I loans reclassified as CRE loans on June 30, 2004, average C&I loans increased at a 15% annualized rate during the quarter, with average CRE loans decreasing at a 5% annualized rate. Total average deposits increased $0.4 billion, or 2%, reflecting growth in interest bearing and non-interest bearing demand deposits, up 3% and 2%, respectively, and a 3% increase in domestic time deposits.
From the end of the 2004 second quarter, the number of DDA households increased an annualized 6%, and the 90-day cross sell ratio increased to 2.34 products from 2.17 products. On-line banking penetration of retail households increased to 36%, and the number of active online users increased 7%.
The $9.0 million increase in provision for credit losses from the second quarter was primarily due to a $9.7 million recovery on a single C&I credit in the second quarter. Net charge offs were $7.2 million, or an annualized 0.18% of average loans and leases in the current quarter. This was up from $1.8 million, or 0.05%, in the second quarter, as the second quarter net charge-offs were reduced by the $9.7 million C&I recovery.
Non-interest expense declined $3.6 million, or 2%, from the second quarter of 2004. This reflected a $7.9 million decline in other expense as the second quarter included $5.8 million of costs related to investments in partnerships generating tax benefits for the first half of 2004. Personnel costs increased $4.1 million impacted by severance costs related to the 2% decline in full-time equivalent employees and lower deferred salary costs associated with lower loan production.
Regional banking contributed $167.9 million of the company’s net operating earnings in the first nine months of 2004, up $52.7 million from the comparable year-ago period. This increase reflected the benefits of a $93.4 million reduction in provision for credit losses, and an $11.5 million increase in net interest income, partially offset by a $14.5 million increase in non-interest expense and a $9.4 million decline in non-interest income. The ROA and ROE for first nine months of 2004 were 1.40% and 21.9%, respectively, up from 1.06% and 15.2%, respectively, in the year-ago period.
Net interest income in the first nine months of 2004 increased $11.5 million, or 3%, reflecting a 14% increase in average total loans and leases and a 5% increase in average total deposits, partially offset by a 32 basis point decline in net interest margin to 4.16% from 4.48%.
Average total loans increased $1.8 billion, or 14%, primarily reflecting a $1.3 billion, or 83%, increase in average residential mortgages, a $0.5 billion, or 15%, increase in home equity loans and lines of credit, as well as a $0.4 billion, or 12%, increase in average CRE loans. Total average C&I loans declined $0.3 million, or 7%, from the year-ago nine-month period. The growth in home equity, residential mortgages, and CRE loans, as well as the decline in C&I loans reflected the same factors noted above in the year-ago quarter comparison. Small Business C&I and CRE loans (included in total average C&I and CRE loans) increased $0.2 billion, or 11%, due to specific strategies that focus on this business segment.
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Average total deposits increased $0.7 billion, or 5%. This reflected strong growth in average interest bearing demand deposits, up $0.9 billion, or 17%, partially offset by a $0.4 billion, or 10%, decline in domestic time deposits. Of the $0.7 billion increase in average total deposits, Corporate Banking accounted for $0.6 billion and Small Business $0.3 billion, with this benefit partially offset by a $0.2 billion decline in average total Retail Banking deposits.
The 32 basis points, or an effective 7%, decline in the net interest margin to 4.16% from 4.48% reflected the same factors discussed above in the 2004 third quarter versus 2003 third quarter performance.
Provision for credit losses for the first nine months of 2004 was $3.2 million, down $93.4 million from the year-ago period reflecting the overall improvement in credit quality, as well as the shift to lower risk residential mortgages and home equity loans and lines. Net charge-offs for the first nine months were $20.6 million, or an annualized 0.19% of average loans and leases, down from $71.7 million, or 0.73%, in the comparable year-ago period. The first nine months of 2004 net charge-offs were reduced by a $9.7 million C&I recovery in the second quarter on a single credit that had been charged-off in the fourth quarter of 2002 (see Credit Risk for additional discussion regarding charge-offs and allowance for loan loss reserve methodologies).
Non-interest income for the first nine months of 2004 decreased $9.4 million, or 4%, from the comparable year-ago period, reflecting a combination of factors including declines in mortgage banking revenue and other income, partially offset by increases in service charges on deposit accounts, and higher other income.
Non-interest expense for the first nine months of 2004 increased $14.5 million, or 3%, from the year-ago period. This reflected an $11.6 million, or 6%, increase in personnel expenses for the same reasons noted above in the prior year quarter comparison. The $2.0 million, or 1%, increase in other expenses reflected higher occupancy, depreciation, and charge card processing expenses.
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Table 18 - Regional Banking
Table 18 Regional Banking (1)
(1) Operating basis, see page 52 for definition.N.M. — Not Meaningful.eop — End of Period.
(1) Operating basis, see page 52 for definition.N.M. — Not Meaningful.N/A — Not Available.eop — End of Period.
Dealer Sales
Dealer Sales serves over 3,500 automotive dealerships within Huntington’s primary banking markets as well as in Arizona, Florida, Georgia, Pennsylvania, and Tennessee. The segment finances the purchase of automobiles by consumers of the automotive dealerships, purchases automobiles from dealers and simultaneously leases the automobiles under long-term direct financing leases to consumers, finances dealership floor plan inventories, real estate, or working capital needs, and provides other banking services to the automotive dealerships and their owners.
The accounting for automobile leases significantly impacts the presentation of Dealer Sales’ financial results. Residual values on leased automobiles, including the accounting for residual value losses, is also an important factor in the overall profitability of automobile leases (see Operating Lease Performance for additional discussion). Automobile leases originated prior to May 2002 are accounted for as operating leases, with leases originated since April 2002 accounted for as direct financing leases. For automobile leases originated prior to May 2002, the related financial results are reported as operating lease income and operating lease expense, components of non-interest income and non-interest expense, respectively, whereas the cost of funding these leases is included in interest expense. Credit losses associated with these leases are also reflected in operating lease expense. With no new operating leases being originated, this portfolio, and related operating lease income and operating lease expense, will decrease over time and eventually become immaterial. In contrast, all new leases since April 2002 are originated as direct financing leases, where the income and funding are included in net interest income. As a result of the treatment of operating leases, the net interest margin increased during the three and nine-month periods ended September 30, 2004 compared with the same periods in 2003 as the declining operating lease portfolio resulted in less assessed interest expense. Direct financing lease credit losses are charged against an allowance for credit losses with provision for credit losses recorded to maintain an appropriate allowance level.
Dealer Sales contributed $17.3 million of the company’s net operating earnings in the third quarter of 2004, up $1.9 million, or 12%, from the 2003 third quarter. This increase was primarily due to a lower provision for credit losses, partially offset by lower net income from loan and lease assets (net interest income plus operating lease income less operating lease expense). The ROA and ROE for the third quarter of 2004 were 1.14% and 17.8%, respectively, up from 0.79% and 14.0%, respectively, in the 2003 third quarter.
Net interest income was $37.1 million, up $7.9 million, or 27%, from the year-ago quarter. This increase reflected a 94 basis point increase in the net interest margin to 2.90% from 1.96% a year ago, offset in part by a $949 million, or 16%, decrease in average total loans and leases. The decrease in average total loans and leases, and the net interest margin was driven by rapid growth in direct financing leases as average automobile loans declined due to loan sales. The net interest margin was favorably impacted by $12.0 million, or 68 basis points, by the run-off of operating lease assets and the fact that all of the funding cost associated with these assets is reflected in interest expense, whereas the income is reflected in non-interest income. In contrast, the net interest margin was negatively impacted by growth in lower yielding direct financing lease balances.
Average automobile direct financing leases increased $660 million, or 42%, reflecting the fact that this is still a maturing portfolio with relatively fewer maturities and pay-offs than a fully matured portfolio. Direct financing lease originations totaled $268 million in the third quarter of 2004, down 13% from $309 million in the 2003 third quarter. The growth in average direct financing lease balances contrasts with the $774 million, or 50%, decline in average operating lease assets, which consists of leases originated prior to May 2002 with balances running off through maturities and pay-offs.
Average automobile loans declined $1.7 billion, or 48%, compared with the same year-ago period, reflecting sales of automobile loans over the last twelve months as the company executes its strategy to reduce exposure to automobile financing to 20% of total credit exposure. Automobile loan originations declined $378 million, or 51%, to $362 million in the 2004 third quarter compared with $739 million in the 2003 third quarter, reflecting a highly competitive marketplace led by manufacturer captive finance companies, and Management’s decision to maintain high quality originations.
Also contributing to the change in average total loans and leases was an 18% increase in C&I loans, primarily dealer floor plan loans.
The provision for credit losses decreased $9.9 million, or 62%, from the year-ago quarter, partially reflecting a $4.5 million, or 37%, decline in charge-offs. The annualized net charge-off ratio for automobile loans was 1.11% in the third quarter of 2004, down from 1.19% in the 2003 third quarter while the annualized net charge-off ratio for direct
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financing leases was 0.43%, up from 0.36% in the year-ago quarter. The charge-off ratio for direct finance leases is expected to trend higher as this portfolio fully matures. The provision for credit losses also benefited from lower origination levels, as well as the higher credit quality nature of the originations in the 2004 third quarter compared to the year-ago period.
Non-interest income decreased $52.7 million, or 42%, driven by a $53.8 million, or 46%, decline in operating lease income as that portfolio continued to run-off. Other non-interest income increased $1.2 million, or 18%, primarily due to an increase in loan servicing income. Non-interest expense declined $37.9 million, or 33%, primarily reflecting a $38.7 million, or 42%, decline in operating lease expense. Other non-interest expense increased $0.5 million primarily due to higher lease residual value losses while personnel costs increased $0.3 million, or 6%, primarily due to less benefit from deferring loan origination costs, reflecting the decline in loan and lease production. See Operating Lease Assets discussion for more details.
Dealer Sales operating earnings in the third quarter of 2004 were down $3.7 million, or 18%, from the second quarter of 2004. The primary contributor to this decrease was lower net income from loan and lease assets (net interest income plus operating lease income less operating lease expense). The ROA and ROE in the 2004 third quarter were 1.14% and 17.8%, respectively, down from 1.27% and 20.5%, respectively, in the 2004 second quarter.
Net interest income was $37.1 million for third quarter of 2004, down $0.7 million, or 2%, from the previous quarter. This decrease reflected an 8% decline in average total loans and leases, partially offset by a 13 basis point increase in the net interest margin to 2.90% from 2.77%.
Average automobile loans decreased $479 million, or 21%, primarily as a result of loan sales at the end of the second quarter and throughout the third quarter of 2004. Also contributing to the decline was a 16% decrease in automobile loan originations in the third quarter of 2004 compared with the second quarter.
Average automobile direct financing leases increased $111 million, or 5%, reflecting the fact that this continues to be a maturing portfolio. Direct financing lease originations increased 9% compared with the second quarter of 2004. The growth in average direct financing lease balances contrasts with the $182 million, or 19%, decline in average operating lease assets.
During the third quarter of 2004, C&I loans, including dealer floor plan loans, decreased $87 million, or 11%, from the prior quarter, consistent with seasonal patterns for usage of available credit lines.
The provision for credit losses decreased $2.1 million, or 26%, primarily reflecting lower growth in loans and direct financing leases, as well as improved credit quality. Charge-offs in the 2004 third quarter remained unchanged at $7.8 million compared to the second quarter of 2004, though as an annualized percent of average total loans and leases net charge-offs increased to 0.63% from 0.58% in the second quarter due to the 8% decline in average loans and leases.
Non-interest income declined $15.8 million, or 18%, primarily due to a $14.6 million, or 19%, decline in operating lease income as that portfolio continued to run-off. Non-interest expense declined $8.6 million, or 10%, primarily reflecting a $7.9 million, or 13%, decline in operating lease expense, as well as the fact that the second quarter included a loss accrual associated with pending litigation.
Dealer Sales contributed $50.3 million of the company’s net operating earnings for the first nine months of 2004, up from $48.9 million for the same period a year ago. The earnings increase reflected higher net income from loan and lease assets (net interest income plus operating lease income less operating lease expense). The ROA and ROE for the first nine months of 2004 were 1.01% and 16.2%, respectively, up from 0.89% and 14.9%, respectively, for the 2003 nine-month period.
Net interest income was $109.8 million, up $36.9 million, or 51%, from the year-ago period. This significant increase reflected a $211 million, or 4%, increase in average total loans and leases, as well as an 84 basis point increase in the net interest margin to 2.67% from 1.83% a year ago. The increase in average total loans and leases was driven by rapid growth in direct financing leases as average automobile loans declined due to loan sales.
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Average automobile direct financing leases increased $822 million, or 63%, reflecting the fact that this is still a maturing portfolio with fewer maturities and pay-offs than a fully matured portfolio. Direct financing lease originations totaled $790 million in the first nine months of 2004, down 22% from $1.0 billion in the first nine months of 2003. The growth in average direct financing lease balances contrasted with an $836 million, or 46%, decline in average operating lease asset, which consists of all leases originated prior to May 2002 with balances running off through maturities and pay-offs.
Average automobile loans declined $758 million compared with the same period a year ago, reflecting the impact of loan sales, as well as an $814 million, or 39%, decline in originations. The decline in originations reflectd the highly competitive marketplace lead by manufacturer captive finance companies, and a decision by Management to maintain high quality loan originations. The impact of the loan sales and lower production levels was offset in part by the consolidation in July 2003 of $1.0 billion of previously securitized loans related to the adoption of FIN 46.
Also contributing to the growth in average total loans and leases was a $118 million, or 18%, increase in C&I loans, primarily dealer floor plan loans.
The net interest margin continued to be favorably impacted by the run-off of the operating lease assets and the fact that all of the funding cost associated with these assets is reflected in interest expense, whereas the income is reflected in non-interest income. In contrast, the net interest margin was negatively impacted by growth in lower yielding direct financing lease balances, loan sales, and a lower net interest margin associated with securitized loans that were recorded on the balance sheet as a result of the adoption of FIN 46.
The provision for credit losses decreased slightly from a year-ago, primarily reflecting a $0.9 million, or 3%, decline in net charge-offs. Net charge-offs for the first nine months of 2004 included a $4.7 million one-time charge in the first quarter to correct for the classification of claims received under policies purchased to protect the company from loss in the event repossessed vehicles had physical damage. Net charge-offs as an annualized percent of average total loans and leases decreased to 0.80% for the first nine months of 2004, down from 0.85% for the comparable year-ago period.
Non-interest income decreased $155.7 million, or 38%, driven by a $153.4 million, or 40%, decline in operating lease income as that portfolio continued to run-off. Brokerage and insurance income declined $1.5 million, or 47%, reflecting lower auto-related insurance income, with other non-interest income down $1.3 million, or 5%, primarily due to declines in securitization income that resulted from the adoption of FIN 46 in the third quarter of 2003. Non-interest expense declined $120.4 million, or 32%, primarily reflecting a $120.3 million, or 39%, decline in operating lease expense. Other non-interest expense declined $1.8 million, or 4%, primarily due to lower residual value insurance costs. In contrast, personnel costs increased $1.8 million, or 12%, primarily due to higher benefit costs and less benefit from deferring loan origination costs, reflecting the decline in loan and lease production.
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Table 19 - Dealer Sales (1)
(1) Operating basis, see page 52 for definition.
(2) Calculated assuming a 35% tax rate.
eop - End of Period.
Private Financial Group
The Private Financial Group (PFG) provides products and services designed to meet the needs of the company’s higher net worth customers. Revenue is derived through trust, asset management, investment advisory, brokerage, insurance, and private banking products and services. As of September 30, 2004, the trust division provides fiduciary services to more than 11,000 accounts with assets totaling $41.2 billion, including $9.1 billion managed by PFG. In addition, PFG has over $560 million in assets managed by Haberer Registered Investment Advisor, which provides investment management services to nearly 400 customers.
PFG provides investment management and custodial services to the company’s 29 proprietary mutual funds, including ten variable annuity funds, which represented more than $3 billion in total assets under management at September 30, 2004. The Huntington Investment Company offers brokerage and investment advisory services to both Regional Banking and PFG customers through more than 100 licensed investment sales representatives and nearly 700 licensed personal bankers. This customer base has over $4 billion in mutual fund and annuity assets. PFG’s insurance entities provide a complete array of insurance products including individual life insurance products ranging from basic term life insurance to estate planning, group life and health insurance, property and casualty insurance, mortgage title insurance, and reinsurance for payment protection products. Income and related expenses from the sale of brokerage and insurance products is shared with the line of business that generated the sale or provided the customer referral, most notably Regional Banking.
The Private Financial Group (PFG) contributed $7.9 million of the company’s net operating earnings in the third quarter of 2004, up $2.4 million, or 45%, from the third quarter of 2003. The increase reflected the benefits of lower provision for credit losses, higher non-interest income, and higher net-interest income, partially offset by an increase in non-interest expense. The ROA and ROE for the 2004 third quarter were 2.01% and 26.8%, respectively, up from 1.59% and 19.9%, respectively, in the 2003 third quarter.
Net interest income increased $0.6 million, or 6%, from the year-ago quarter as average loan balances increased $1.4 billion, or 16%, while average deposit balances were unchanged. Average total loans increased $189 million, or 16%, from the year-ago quarter reflecting 17% growth in consumer loans, 13% in C&I loans and 15% growth in Commercial CRE loans. Consumer loan growth occurred in personal credit lines and residential real estate loans, largely due to the favorable mortgage rate environment. C&I and CRE loan growth reflected initiatives to add relationship managers in several markets targeted for growth opportunities, most notably East and West Michigan and Central and Southern Ohio. Deposit balances remained flat as new account growth was offset by some large account runoff in East Michigan and Northeast Ohio due to rate competition. The net interest margin declined 28 basis points from the year-ago quarter to 3.16%, reflecting growth in lower-margin loans combined with shrinking margins on personal credit lines as customer rate adjustments typically lag behind prime rate increases by 30 to 60 days.
The provision for credit losses decreased $2.4 million from the year-ago quarter, reflecting a reduction in non-performing assets and a $0.5 million recovery of a prior period charge-off. The annualized total net charge-off ratio decreased to 0.18% in the third quarter 2004 from 0.24% in the year-ago quarter. Credit quality remained strong with total non-performing assets representing only 0.36% of total loans outstanding for the current quarter, a decline from 0.48% in the year-ago quarter.
Non-interest income, net of fees shared with other business units, increased $1.8 million, or 7%, from the year-ago quarter mainly due to growth in trust services income. Trust services income increased $1.6 million, or 11%, mainly due to revenue growth in personal trust and investment management business. Total trust assets grew 17% to $41.2 billion at September 30, 2004, up from $35.2 billion at September 30, 2003. For the same periods, managed assets grew to $9.6 billion from $8.6 billion, or 12%. This growth resulted mainly from new business development, reflecting the success of the new business delivery model utilizing the brokerage sales force to sell asset management services. Brokerage and insurance revenue increased $0.2 million, or 2%, as increased annuity revenue was largely offset by a decrease in title insurance and life agency revenue. The increased annuity revenue was mainly due to a shift in product sales mix from lower rate fixed annuities to higher rate variable and indexed annuities. The decrease in title insurance reflects the slowdown in mortgage refinancing activity from the 2003 third quarter while the decrease in life agency revenue resulted from the fact that several unusually large premium cases were sold in the year ago quarter.
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Non-interest expense increased $1.0 million, or 4%, from the 2003 third quarter primarily due to higher personnel costs reflecting an increase in the brokerage sales force to support the new sales distribution model, an increase in private banking relationship managers to support the expansion of the private banking presence in selected markets, higher trust and investment management sales commissions from increased new business development, and higher benefit costs. Increased personnel costs were partially offset by a reduction in allocated corporate overhead and product support expenses and reduced mutual fund clearing costs as a result of decreased trading activity and contract pricing renegotiation with the outside clearing agent.
PFG’s net contribution to the company’s operating earnings in the third quarter of 2004 was up $1.6 million, or 26%, from the second quarter. The increase primarily reflected the benefit of a $1.5 million decline in non-interest expense, a $0.6 million decline in the provision for credit losses and a $0.5 million increase in net interest income, partially offset by a $0.1 million decline in non-interest income. The ROA and ROE in 2004 were 2.01% and 26.8%, respectively, up from 1.67% and 21.3%, respectively in the previous quarter.
Net interest income increased $0.5 million, or 5%, from the previous quarter. Average loan balances increased 4%, while average deposit balances decreased 1%. Average total loans and leases increased 4% from the 2004 second quarter, with consumer, C&I and CRE, all increasing. The decline in deposit balances reflected some large account balance runoff in East Michigan and Northeast Ohio due to rate competition. In addition, there appears to have been deposit disintermediation to other investment alternatives as customers begin to use temporary cash accumulation to slowly move back into the investment market. The net interest margin increased slightly to 3.16% from 3.14% in the second quarter mainly due to the fact that customer deposit rates have essentially remained unchanged, whereas rates on loans have begun to increase.
The provision for credit losses decreased $0.6 million from the prior quarter. The decrease was due to a reduction in non-performing assets combined with the fact that in the current quarter there was a large $0.5 million recovery of a prior period charge-off. The annualized total net charge-off ratio decreased to 0.18% from 0.27% in the previous quarter. Credit quality remained strong with total non-performing assets representing only 0.36% of period-end total loans outstanding for the current quarter, down from 0.43% at the end of the second quarter.
Non-interest income, net of fees shared with other business units, declined slightly from the second quarter as modest increases in trust services income and brokerage and insurance income were offset by a reduction in inter-company other income. Trust services income increased $0.3 million, or 2%, from the previous quarter due to an increase in revenue from the Huntington Funds, reflecting a combination of asset growth and a reduction in money market fund fee waivers as yields improved. Total trust assets increased $2 billion, or 5%, during the third quarter and managed assets increased $0.3 billion, or 3%, mainly in Huntington Funds. Much of the total asset growth resulted from a new $1.5 billion institutional custody account in September. Although gross brokerage and insurance revenue declined $0.7 million, or 6%, mainly due to historical seasonality and continuing market trepidation, net brokerage and insurance revenue after fee sharing increased $0.2 million, or 2%, as proportionately more revenue was generated through the PFG brokerage and insurance specialists compared with retail banking offices.
Non-interest expense decreased $1.5 million, or 5%, from the prior quarter reflecting a decline in personnel costs due to lower commission expense as a result of the reduction in gross brokerage and insurance revenue combined with a change in the brokerage sales commission plan. In addition, the lower other expenses reflected a reduction in allocated corporate overhead and product support expenses, reduced mutual fund clearing costs as a result of decreased trading activity and contract pricing renegotiation with the outside clearing agent, and reduced travel and business development expenses.
PFG contributed $21.2 million of the company’s net operating earnings for the first nine months of 2004, up $2.5 million, or 13%, from the first nine months of 2003. The increase reflected the benefit of a $3.7 million decline in the provision for credit losses, a $3.6 million increase in net interest income, and a $3.0 million increase in non-interest income, partially offset by a $6.5 million increase in non-interest expense. The ROA and ROE for the first nine months of 2004 were 1.87% and 24.2%, respectively, compared with 1.92% and 24.3%, respectively, in the comparable year-ago period.
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Net interest income for the first nine months of 2004 increased $3.6 million, or 12%, from the comparable 2003 period as a result of 18% growth in average loan balances and 8% growth in average deposits. Average consumer loans increased 24%, with average C&I and CRE loans increasing 7% and 11%, respectively. This loan growth reflected the favorable mortgage loan environment, and to a lesser degree, the benefit of initiatives to add relationship managers in 2004 in several markets targeted for growth opportunities, most notably East and West Michigan and Central and Southern Ohio. The deposit growth occurred mainly in consumer and commercial money market accounts aided by promotional rate offerings and a redirection of sweep account balances from money market mutual fund accounts. The net interest margin for the first nine months of 2004 was 3.18%, down from 3.33% for the comparable 2003 period due to the fact that much of the loan growth was attributable to growth in lower yielding consumer loans.
The provision for credit losses declined $3.7 million in the current nine-month period compared with the prior year period, due largely to the fact that most of the significant current period charge-offs resulted in an offsetting release of previously established reserves. Net charge-offs expressed as an annualized percent of average total loans and leases was 0.17% for the first nine months of 2004, down from 0.20% in the same year-ago period. Credit quality remained strong as total NPAs represented only 0.36% of total loans at September 30, 2004, down from 0.48% a year earlier.
Non-interest income, net of fees shared with other business units, increased $3.0 million, or 4%, from the first nine months of 2003 mostly due to higher trust services income. Trust services income increased $4.2 million, or 9%, mainly due to revenue growth in personal trust and investment management business for the reasons discussed in the prior-year quarterly discussion above. Brokerage and insurance revenue was essentially unchanged from the prior year nine-month period as increased brokerage revenue was offset by lower insurance income. Brokerage revenue increased $2.0 million, or 7%, due mainly to increased mutual fund revenue and equity trade commissions. The increased mutual fund revenue reflected increased trading activity in early 2004 as the market was continuing its resurgence and IRA investments were strong. The increased equity trade commissions resulted from the fact that trading activity on certain investment management accounts are now being processed through the brokerage sales force. Insurance income decreased $3.2 million, or 28%, as a result of correcting the accounting for certain insurance products sold with automobile loans and leases. Beginning in 2004, these fees are now deferred and recognized over the life of the related automobile loan or lease. In addition, credit life insurance revenue declined as policy refunds and cancellations have exceeded new premiums written. Mortgage banking income decreased by $1.1 million due to increased mortgage portfolio servicing costs resulting from the growth in residential real estate mortgage loans and due to a change in fee sharing methodology that resulted in reduced income shared by Huntington Mortgage Group.
Non-interest expense increased $6.5 million, or 8%, in the first nine months of 2004 from the comparable year-ago period primarily reflecting a $5.7 million, or 13%, increase in personnel costs reflecting an increase in the brokerage sales force and private banking relationship managers (see earlier discussion), and higher benefit costs. Allocated expense for corporate overhead and product support costs increased $0.7 million, or 2%.
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Table 20 - Private Financial Group (1)
Treasury / Other
The Treasury/Other segment includes revenue and expense related to assets, liabilities, and equity that are not directly assigned or allocated to one of the other three business segments. Assets included in this segment include investment securities, bank owned life insurance, and mezzanine loans originated through Huntington Capital Markets.
Net interest income includes the net impact of administering Huntington’s investment securities portfolios as part of overall liquidity management. A match-funded transfer pricing system is used to attribute appropriate funding interest income and interest expense to other business segments. As such, net interest income includes the net impact of any over or under allocations arising from centralized management of interest rate risk. Furthermore, net interest income includes the net impact of derivatives used to hedge interest rate sensitivity as well as net interest income related to Huntington Capital Markets loan activity.
Non-interest income includes fee income related to Huntington Capital Markets activities and miscellaneous non-interest income not allocated to other business segments, including bank owned life insurance income. Fee income also includes MSR temporary impairment valuation recoveries or impairments, as well as any investment securities and/or trading assets gains or losses, which are used to mitigate MSR valuation changes. Prior to 2004, changes in MSR temporary impairment valuations were reflected in the Regional Banking business segment, whereas investment securities and/or trading assets gains or loss were reflected in the Treasury/Other segment. Since investment securities and/or trading account gains or losses are used to mitigate MSR valuation changes, and since this risk is managed centrally, for 2004 reporting both MSR valuation changes, as well as investment securities and/or trading assets gains or losses, are reflected in Treasury/Other results.
Non-interest expense includes expenses associated with Huntington Capital Markets activities, as well as certain corporate administrative and other miscellaneous expenses not allocated to other business segments.
The provision for income taxes for each of the other business segments is calculated at a statutory 35% tax rate though the company’s overall effective tax rate is lower. As a result, the provision for income taxes in Treasury/Other includes the difference between the actual effective tax rate and the statutory tax rate used to allocate income taxes to the other segments.
Treasury/Other net income decreased $11.5 million, or 58%, from the year-ago quarter. This reflected a combination of higher non-interest expense and lower net interest income, partially offset by higher non-interest income.
Net interest income decreased $4.0 million, or 21%, from the year-ago quarter. Driving this variance were a $10.7 million increase in wholesale funding costs, offset by a $6.5 million increase in interest income on securities.
The provision for credit losses declined $0.1 million from the year-ago quarter, attributable to decreased Huntington Capital Markets lending activity.
Non-interest income was $1.4 million higher than in the year-ago quarter, reflecting the impact of using investment securities gains and trading losses, reflected in other income, to offset valuation changes in MSR. In 2004, MSR temporary impairment and recovery is reflected in the Treasury/Other segment, whereas in the year-ago quarter MSR temporary impairment recovery of $17.8 million was recognized in Regional Banking. Other non-interest income was also down $3.0 million from the year-ago quarter reflecting lower income from trading activities and bank owned life insurance.
Non-interest expense for operational, administrative, and support groups, which was not specifically allocated to the other business segments increased $8.3 million from a year ago reflecting costs associated with the SEC formal investigation, as well as higher personnel and benefits costs.
The provision for income taxes decreased $0.6 million, reflecting the benefit of the company’s lower overall effective tax rate versus the 35% effective tax rate used to allocate provision for income taxes to each line of business, partially offset by a higher overall effective tax rate in the 2004 third quarter, compared with the year-ago quarter.
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Treasury/Other’s net income in the 2004 third quarter was $10.7 million, or 57%, lower than the second quarter. This reflected a combination factors including higher non-interest expense, lower net interest income, and lower non-interest income, partially offset by lower provision for income taxes.
Net interest income declined $3.5 million, or 19%, reflecting a $6.5 million decline in earnings from Huntington’s transfer pricing system as these earnings were allocated to the other business segments. This negative impact was partially offset by a $2.6 million increase in earnings on investment securities, where average balances were 19% higher than in the comparable year-ago period.
Non-interest income declined $2.6 million from the 2004 second quarter primarily reflecting a $2.5 million decrease in investment banking activity revenues from Huntington Capital Markets.
Non-interest expense increased $6.1 million, or 31%, from the second quarter, reflecting SEC-related costs in the third quarter.
The provision for credit losses increased $0.5 million, reflecting an increase in the provision not allocated to the other business segments.
The provision for income taxes decreased $1.9 million, reflecting the benefit of the company’s lower overall effective tax rate versus the 35% effective tax rate used to allocate provision for income taxes to each line of business.
Treasury/Other net income for the first nine months of 2004 declined $23.2 million, or 28%, from the comparable year-ago period. This reflected a combination of factors consisting of higher non-interest expense, lower net interest income, higher provision for credit losses, and lower non-interest income, partially offset by lower provision for income taxes.
Net interest income for the first nine months of 2004 decreased $4.4 million, or 7%, from the comparable year-ago period. Driving this variance was a $18.0 million increase in wholesale funding costs and a $14.3 million decline in revenue from derivatives activities, and a $27.6 million increase in interest income on securities.
The provision for credit losses for the first nine months of 2004 was $2.4 million higher than a year earlier, attributable to increased Huntington Capital Markets lending activity.
Non-interest income was $2.3 million, or 5%, lower than in the year-ago nine-month period, reflecting the impact of MSR temporary valuations changes on mortgage banking income, trading losses, and a decline in bank owned life insurance income, partially offset by the impact of investment securities gains used in conjunction with the trading losses to offset MSR impairment valuation changes.
Non-interest expense for operational, administrative, and support groups, not specifically allocated to the other business segments was up $22.8 million from last year including higher non-allocated personnel and benefits costs, expenses related to the SEC investigation, partially offset by lower other expenses allocated to other business segments.
The provision for income taxes declined $8.7 million, reflecting the benefit of the company’s lower overall effective tax rate versus the 35% effective tax rate used to allocate provision for income taxes to each line of business, partially offset by the company’s higher total effective tax rate in the first nine months of 2004 versus the comparable year-ago period.
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Table 21 - Treasury/Other(1)
Table 21 - Treasury/Other (1)
Table 22 — Total Company (1)
Table 22 - Total Company (1)
Item 3. Quantitative and Qualitative Disclosures about Market Risk
Quantitative and qualitative disclosures for the current period are found beginning on page 47 of this report, which includes changes in market risk exposures from disclosures presented in Huntington’s Form 10-K.
Item 4. Controls and Procedures
Huntington’s management, with the participation of its Chief Executive Officer and the Chief Financial Officer, evaluated the effectiveness of Huntington’s disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this report. Based upon such evaluation, Huntington’s Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, Huntington’s disclosure controls and procedures are effective.
There have not been any changes in Huntington’s internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fiscal quarter to which this report relates that have materially affected, or are reasonably likely to materially affect, Huntington’s internal control over financial reporting.
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PART II. OTHER INFORMATION
In accordance with the instructions to Part II, the other specified items in this part have been omitted because they are not applicable or the information has been previously reported.
Item 2. Changes in Securities and Use of Proceeds
(e)
(1) Information is as of the end of the Period. On January 16, 2003, the Registrant announced that its board of directors had authorized the repurchase from time to time of 8,000,000 shares of the Registrant’s common stock (the “2003 Repurchase Program”). The 2003 Repurchase Program did not have an expiration date. A total of 4,100,000 shares had been repurchased under the 2003 Repurchase Program in 2003. No shares were repurchased in the 2004 first quarter under the 2003 Repurchase Program or otherwise. On April 27, 2004, the Registrant announced that its board of directors had terminated the 2003 Repurchase Program and had authorized a new program for the repurchase in the open market or through privately negotiated transactions of 7,500,000 share of the Registrant’s common stock (the “2004 Repurchase Program”). The 2004 Repurchase Program does not have an expiration date.
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
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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.
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