PNC FINANCIAL SERVICES GROUP, INC. quarterly report, Q3 FY2010

PNC Financial Services Group, Inc. — Third Quarter 2010 Form 10-Q

Reporting period: Three and nine months ended September 30, 2010. PNC is a diversified U.S. financial services company with retail and corporate banking, asset management, residential mortgage, and related businesses.

Financial results and position

Metric	Q3 2010	Q3 2009	First nine months 2010	First nine months 2009
Total revenue	$3.598 billion	$3.853 billion	$11.273 billion	$11.342 billion
Net interest income	$2.215 billion	$2.224 billion	$7.029 billion	$6.737 billion
Noninterest income	$1.383 billion	$1.629 billion	$4.244 billion	$4.605 billion
Provision for credit losses	$486 million	$914 million	$2.060 billion	$2.881 billion
Noninterest expense	$2.158 billion	$2.214 billion	$6.273 billion	$6.864 billion
Net income	$1.103 billion	$559 million	$2.577 billion	$1.296 billion
Diluted EPS	$2.07	$1.00	$4.24	$2.17

Q3 income from continuing operations before noncontrolling interests was $775 million; diluted EPS from continuing operations was $1.45. Discontinued operations contributed $328 million after tax, principally the GIS sale gain.
Pretax, pre-provision earnings, a non-GAAP measure, were $1.44 billion in Q3 and $5.00 billion year to date. The Q3 provision was below this measure.
Net interest margin was 3.96% in Q3 versus 3.76% a year earlier, but fell 39 basis points from Q2 2010. The nine-month margin was 4.18%, versus 3.72% in 2009.
Cash flows for the first nine months: operating activities provided $4.437 billion; investing activities provided $10.444 billion; financing activities used $15.445 billion. Cash and due from banks declined $564 million to $3.724 billion.
At September 30, total assets were $260.1 billion, loans $150.1 billion, deposits $179.2 billion, borrowed funds $39.8 billion, and shareholders’ equity $30.0 billion. Loans to deposits were 84%.
Regulatory capital ratios: Tier 1 risk-based 11.9%, Tier 1 common 9.6%, total risk-based 15.6%, and leverage 9.9%. PNC reported its bank subsidiary was well capitalized.
Asset quality improved in several measures: nonperforming assets were $5.7 billion, down $647 million from year-end 2009; nonperforming loans were 3.22% of loans; and Q3 annualized net charge-offs were 1.61%. The allowance was $5.2 billion, or 3.48% of loans and 108% of nonperforming loans.
PNC reported $59.5 billion of liquid assets, including $56.0 billion of available-for-sale securities; $28.7 billion of liquid assets were pledged as collateral. It also cited $8.4 billion of unused FHLB borrowing capacity and $23.7 billion of unused Federal Reserve secured borrowing capacity.

Material changes and key drivers

Q3 net income more than doubled year over year, primarily reflecting a lower credit-loss provision and a $328 million after-tax gain from selling PNC Global Investment Servicing (GIS). PNC sold GIS on July 1 for $2.3 billion in cash; its results through June 30 and the sale gain are reported in discontinued operations.
Q3 revenue declined 7% year over year, mainly from lower deposit service charges, lower commercial mortgage servicing values, and the prior-year gain on commercial loan sales. Nine-month revenue was broadly flat as lower interest expense partly offset weaker fee income.
The nine-month credit provision fell by $821 million year over year, reflecting reduced exposures and improving credit migration. Noninterest expense fell 9% year over year, helped by National City integration savings and prior-year FDIC assessment costs.
Loans declined $7.4 billion from December 31, 2009, despite the effect of consolidating Market Street and a credit-card securitization trust. Soft demand, repayments, portfolio dispositions, and charge-offs more than offset the consolidation impact. Investment securities rose $7.4 billion as excess liquidity was invested in short-duration, higher-quality securities.
Deposits declined $7.7 billion from year-end, chiefly due to lower retail certificates of deposit and money-market balances; transaction deposits increased. Common equity and capital ratios benefited from retained earnings, a $3.4 billion common-stock offering, the GIS sale, and lower risk-weighted assets. PNC redeemed $7.6 billion of TARP preferred stock in February.
PNC consolidated Market Street, a credit-card securitization trust, and certain tax-credit investments under new VIE accounting guidance effective January 1, 2010. Adoption added $4.2 billion of assets and liabilities and produced a $92 million after-tax reduction to retained earnings.

Outlook, risks, contingencies, and unusual items

Management expected Q4 net interest income and margin to decline from Q3, but more slowly than the Q2-to-Q3 decline, citing lower purchase-accounting accretion, soft loan demand, and low interest rates.
Management was optimistic about a stable-to-lower Q4 provision compared with Q3, conditional on credit trends and economic recovery. It expected Q4 expenses to be lower, partly due to lower integration costs and an anticipated reduction in the Visa indemnification liability. Full-year 2010 effective tax rate was expected to be about 26%.
National City acquisition savings reached $1.7 billion annualized in Q3; PNC said it was on track for its revised $1.8 billion goal by year-end. Q3 and year-to-date integration costs were $96 million and $309 million, respectively.
Expected regulatory impacts included about $100 million of Q4 revenue pressure from Regulation E overdraft rules (about $55 million more than Q3 impact) and approximately $75 million of full-year 2010 pressure from the Credit CARD Act. Legislation also ended the federally guaranteed student-loan program for private lenders effective July 1.
PNC said Dodd-Frank and Basel III implementation could raise costs, alter business activities, and affect capital requirements; the ultimate impacts and timing were uncertain. Management described the economic recovery as slow and uncertain.
PNC began reviewing foreclosure documentation practices after industry-wide scrutiny. It identified documentation issues, delayed some foreclosures while resolving them, and implemented enhanced procedures. The filing warned of potential higher servicing and legal costs, delays, repurchase claims, litigation, regulatory action, and reputational harm.
Mortgage-related contingencies included a $290 million liability for estimated repurchase and indemnification claims, including $155 million for Residential Mortgage Banking and $103 million for the Distressed Assets Portfolio. Management noted actual claims could exceed reserves. A new Federal Home Loan Bank of Chicago suit alleged misrepresentations involving mortgage-backed securities; the claimed transactions included approximately $345 million involving National City entities. The ultimate outcome and loss were uncertain.
Unusual items included an $89 million tax benefit from a favorable IRS ruling and a $250 million noncash reduction to common earnings from accelerated TARP preferred-stock discount accretion. A $105 million Q2 adjustment related mainly to purchased-loan interest income and borrowing accretion corrected items that should have been recorded in 2009; management judged it immaterial to prior, current, and estimated full-year statements.

Important facts for investors to verify

How much reported earnings depended on the GIS disposal gain and other nonrecurring items, and how continuing-operations earnings are trending.
Whether credit quality continues to improve, particularly in commercial real estate, residential mortgages, consumer portfolios, and purchased-impaired National City loans; review the allowance and charge-off trends alongside exclusions in the filing.
Whether loan demand, deposit mix, purchase-accounting accretion, and low interest rates develop as management expected, and the resulting effects on net interest income and margin.
Whether integration savings reach the $1.8 billion target and whether integration costs and other expenses decline as anticipated.
The actual financial and operational impact of foreclosure-documentation reviews, mortgage repurchase claims, legal proceedings, and evolving Dodd-Frank/Basel III rules.
Capital, liquidity, pledged collateral, and contingent obligations, including $97.1 billion of net unfunded credit commitments and $9.9 billion of net outstanding standby letters of credit.