PNC

Business Context and Reporting Period

This Form 10-Q covers The PNC Financial Services Group, Inc. for the quarterly and nine-month periods ended September 30, 2006. PNC is a diversified financial services company operating in retail banking, corporate and institutional banking, asset management, and global fund processing. The reporting period is significantly impacted by the closing of the BlackRock/MLIM transaction on September 29, 2006, which resulted in the deconsolidation of BlackRock from PNC's balance sheet and a reduction in PNC's ownership interest to approximately 34%.

Key Financial Metrics

Note: Q3 2006 results include a $2.1 billion pre-tax gain on the BlackRock/MLIM transaction and $244 million in pre-tax charges from balance sheet repositioning.

Material Changes vs. Prior Period

• Revenue Surge: Total revenue for the nine months ended September 30, 2006, increased 52% compared to the prior year, driven primarily by a $2.1 billion pre-tax gain on the BlackRock/MLIM transaction. Excluding this gain, organic revenue growth was modest.
• Net Income Growth: Net income for the nine months ended September 30, 2006, rose 129% to $2.219 billion. The increase was largely attributable to the after-tax gain of approximately $1.3 billion from the BlackRock transaction.
• Balance Sheet Shift: Total assets increased to $98.4 billion. The deconsolidation of BlackRock reduced reported assets under management from $469 billion (Sep 2005) to $52 billion (Sep 2006), as BlackRock's assets are no longer consolidated.
• Margin Compression: Net interest margin declined slightly to 2.92% for the nine months ended September 30, 2006, compared to 2.99% in the prior year, due to higher rates paid on deposits and borrowed funds outpacing yield increases on earning assets.
• Asset Quality: Nonperforming assets to loans, loans held for sale, and foreclosed assets improved to 0.36% from 0.42% at year-end 2005. Net charge-offs to average loans were 0.37% for the quarter.

Guidance, Outlook, and Risks

• BlackRock/MLIM Transaction: Following the transaction, PNC accounts for its 34% interest in BlackRock using the equity method. Future earnings from BlackRock will be reported as a separate line item within noninterest income, reducing reported revenue and expense categories compared to the prior consolidated presentation.
• Mercantile Acquisition: On October 8, 2006, PNC agreed to acquire Mercantile Bankshares for approximately $6.0 billion. The transaction is expected to close in Q1 2007, subject to regulatory and shareholder approval.
• One PNC Initiative: PNC expects to realize $400 million in annual pretax earnings benefits by mid-2007 from this efficiency initiative. Approximately $300 million is expected from cost savings, with $100 million from revenue growth.
• Securities Repositioning: PNC executed a portfolio rebalancing in Q3 2006, selling $6.0 billion of securities at a pretax loss of $196 million to optimize the portfolio for a steeper yield curve and reduce interest rate volatility exposure.
• Accounting Changes: Adoption of FSP FAS 13-2 effective January 1, 2007, is expected to result in an after-tax charge to opening retained earnings of approximately $140 million to $160 million related to cross-border lease transactions.
• Risks: Key risks include interest rate volatility, credit quality deterioration (management notes current asset quality levels are not sustainable long-term), integration risks from the Mercantile acquisition, and regulatory changes.

Investor Verification Checklist

• BlackRock Gain Sustainability: Verify the one-time nature of the $1.3 billion after-tax gain and its impact on normalized earnings per share.
• Normalized Efficiency Ratio: Assess the efficiency ratio excluding the impact of the BlackRock transaction and balance sheet repositioning charges to gauge operational performance.
• Net Interest Margin Outlook: Monitor the impact of rising deposit costs on future net interest margins, particularly given the flat or inverted yield curve environment.
• Mercantile Integration: Review the timeline and potential costs associated with the pending Mercantile Bankshares acquisition.
• Securities Portfolio: Evaluate the remaining unrealized losses in the securities portfolio ($151 million net unrealized loss) and the strategy for managing interest rate risk.
• Future Accounting Charges: Confirm the timing and magnitude of the expected $140-$160 million charge related to cross-border lease accounting changes in 2007.