Form 10-Q
Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

 


FORM 10-Q

 


 

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2006

or

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                  to                 

Commission file number 001-09718

 


The PNC Financial Services Group, Inc.

(Exact name of registrant as specified in its charter)

 


 

Pennsylvania   25-1435979

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

One PNC Plaza, 249 Fifth Avenue, Pittsburgh, Pennsylvania 15222-2707

(Address of principal executive offices)

(Zip Code)

(412) 762-2000

(Registrant’s telephone number, including area code)

 


(Former name, former address and former fiscal year, if changed since last report)

 


Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes   x         No   ¨         

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. Check one:

Large accelerated filer  x         Accelerated filer  ¨         Non-accelerated filer  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes  ¨         No   x

As of July 31, 2006, there were 294,455,070 shares of the registrant’s common stock ($5 par value) outstanding.

 



Table of Contents

The PNC Financial Services Group, Inc.

Cross-Reference Index to 2006 Second Quarter Form 10-Q

 

      Pages

PART I – FINANCIAL INFORMATION

  

Item 1. Financial Statements (Unaudited).

   37-62

Consolidated Income Statement

   37

Consolidated Balance Sheet

   38

Consolidated Statement Of Cash Flows

   39

Notes To Consolidated Financial Statements (Unaudited)

  

Note 1 Accounting Policies

   40

Note 2 Acquisitions

   47

Note 3 Securities

   48

Note 4 Asset Quality

   49

Note 5 Goodwill And Other Intangible Assets

   49

Note 6 Variable Interest Entities

   50

Note 7 Capital Securities Of Subsidiary Trusts

   51

Note 8 Certain Employee Benefit And Stock-Based Compensation Plans

   51

Note 9 Financial Derivatives

   53

Note 10 Earnings Per Share

   55

Note 11 Shareholders’ Equity And Other Comprehensive Income

   56

Note 12 Legal Proceedings

   57

Note 13 Segment Reporting

   58

Note 14 Commitments And Guarantees

   61

Statistical Information (Unaudited)

  

Average Consolidated Balance Sheet And Net Interest Analysis

   63-64

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

   1-36, 63-64

Consolidated Financial Highlights

   1-2

Financial Review

  

Executive Summary

   3

Consolidated Income Statement Review

   7

Consolidated Balance Sheet Review

   10

Off-Balance Sheet Arrangements And Variable Interest Entities

   14

Business Segments Review

   15

Critical Accounting Policies And Judgments

   24

2002 BlackRock Long-Term Retention And Incentive Plan

   24

Status Of Defined Benefit Pension Plan

   24

Risk Management

   25

Internal Controls And Disclosure Controls And Procedures

   33

Glossary Of Terms

   33

Cautionary Statement Regarding Forward-Looking Information

   35

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

   25-32

Item 4. Controls and Procedures.

   33

PART II – OTHER INFORMATION

  

Item 1. Legal Proceedings.

   65

Item 1A. Risk Factors.

   65

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.

   65

Item 6. Exhibits.

   65

Signature

   65

Corporate Information

   66


Table of Contents

CONSOLIDATED FINANCIAL HIGHLIGHTS

THE PNC FINANCIAL SERVICES GROUP, INC.

 

Dollars in millions, except per share data    Three months ended June 30     Six months ended June 30  
Unaudited    2006     2005     2006     2005  

FINANCIAL PERFORMANCE

        

Revenue

        

Net interest income, taxable-equivalent basis (a)

   $562     $541     $1,125     $1,053  

Noninterest income

   1,230     929     2,415     1,903  

Total revenue

   $1,792     $1,470     $3,540     $2,956  

Net income

   $381     $282     $735     $636  

Per common share

        

Diluted earnings

   $1.28     $.98     $2.47     $2.22  

Cash dividends declared

   $.55     $.50     $1.05     $1.00  

SELECTED RATIOS

        

Net interest margin

   2.90 %   3.00 %   2.93 %   3.01 %

Noninterest income to total revenue

   69     63     68     65  

Efficiency

   64     71     66     69  

Return on

        

Average common shareholders’ equity

   17.49 %   14.34 %   17.08 %   16.68 %

Average assets

   1.64     1.29     1.60     1.50  

See page 33 for a glossary of certain terms used in this Report.

Certain prior period amounts included in these Consolidated Financial Highlights have been reclassified to conform with the current period presentation.

 

(a) The interest income earned on certain earning assets is completely or partially exempt from federal income tax. As such, these tax-exempt instruments typically yield lower returns than a taxable investment. To provide more meaningful comparisons of yields and margins for all earning assets, we also provide revenue on a taxable-equivalent basis by increasing the interest income earned on tax-exempt assets to make it fully equivalent to interest income on other taxable investments. This adjustment is not permitted under generally accepted accounting principles (GAAP) in the Consolidated Income Statement.

The following is a reconciliation of net interest income as reported in the Consolidated Income Statement to net interest income on a taxable-equivalent basis (in millions):

 

     Three months ended June 30    Six months ended June 30
     2006    2005    2006    2005

Net interest income, GAAP basis

   $556    $534    $1,112    $1,040

Taxable-equivalent adjustment

   6    7    13    13
                   

Net interest income, taxable-equivalent basis

   $562    $541    $1,125    $1,053
                   

 

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     June 30     December 31     June 30  
Unaudited    2006     2005     2005  

BALANCE SHEET DATA (dollars in millions, except per share data)

      

Assets

   $94,914     $91,954     $90,794  

Loans, net of unearned income

   50,548     49,101     49,317  

Allowance for loan and lease losses

   611     596     628  

Securities

   21,724     20,710     20,437  

Loans held for sale

   2,165     2,449     2,275  

Deposits

   63,493     60,275     58,673  

Borrowed funds

   15,651     16,897     18,206  

Shareholders’ equity

   8,827     8,563     8,243  

Common shareholders’ equity

   8,820     8,555     8,235  

Book value per common share

   29.92     29.21     28.35  

Common shares outstanding (millions)

   295     293     290  

Loans to deposits

   80 %   81 %   84 %

ASSETS UNDER MANAGEMENT (billions)

   $506     $494     $456  

FUND ASSETS SERVICED (billions)

      

Accounting/administration net assets

   $743     $835     $766  

Custody assets

   389     476     462  

CAPITAL RATIOS

      

Tier 1 risk-based (a)

   8.8 %   8.3 %   8.3 %

Total risk-based (a)

   12.4     12.1     11.9  

Leverage (a)

   7.7     7.2     7.2  

Tangible common equity

   5.2     5.0     5.0  

Common shareholders’ equity to assets

   9.3     9.3     9.1  

ASSET QUALITY RATIOS

      

Nonperforming assets to loans, loans held for sale and foreclosed assets

   .44 %   .42 %   .32 %

Nonperforming loans to loans

   .41     .39     .27  

Net charge-offs (recoveries) to average loans (for the three months ended) (b)

   .24     .33     (.32 )

Allowance for loan and lease losses to loans

   1.21     1.21     1.27  

Allowance for loan and lease losses to nonperforming loans

   294     314     476  
(a) The regulatory minimums are 4.0% for Tier 1, 8.0% for Total, and 3.0% for Leverage ratios. The well-capitalized levels are 6.0% for Tier 1, 10.0% for Total, and 5.0% for Leverage ratios.
(b) This ratio for the three months ended June 30, 2005 (net recoveries of $38 million annualized and divided by average loans of $47.1 billion) reflects the impact of a $53 million loan recovery during that quarter. Excluding the impact of this recovery, the ratio of net charge-offs to average loans for the second quarter of 2005 would have been .13%.

 

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FINANCIAL REVIEW

THE PNC FINANCIAL SERVICES GROUP, INC.

This Financial Review should be read together with our unaudited Consolidated Financial Statements and unaudited Statistical Information included elsewhere in this Report and with Items 6, 7, 8 and 9A of our 2005 Annual Report on Form 10-K (“2005 Form 10-K”). We have reclassified certain prior period amounts to conform with the current period presentation. For information regarding certain business and regulatory risks, see the Risk Factors and Risk Management sections in this Financial Review and Items 1A and 7 of our 2005 Form 10-K. Also, see the Cautionary Statement Regarding Forward-Looking Information and Critical Accounting Policies And Judgments sections in this Financial Review for certain other factors that could cause actual results or future events to differ, perhaps materially, from those anticipated in the forward-looking statements included in this Report or from historical performance. See Note 13 Segment Reporting in the Notes To Consolidated Financial Statements included in Part I, Item 1 of this Report for a reconciliation of total business segment earnings to total PNC consolidated net income as reported on a generally accepted accounting principles (“GAAP”) basis.

 

EXECUTIVE SUMMARY

THE PNC FINANCIAL SERVICES GROUP, INC.

PNC is one of the largest diversified financial services companies in the United States, operating businesses engaged in retail banking, corporate and institutional banking, asset management and global fund processing services. We operate directly and through numerous subsidiaries, providing many of our products and services nationally and others in our primary geographic markets in Pennsylvania; New Jersey; the greater Washington, DC area, including Virginia and Maryland; Ohio; Kentucky and Delaware. We also provide certain asset management and global fund processing services internationally.

KEY STRATEGIC GOALS

Our strategy to enhance shareholder value centers on achieving revenue growth in our various businesses underpinned by prudent management of risk, capital and expenses. In each of our business segments, the primary drivers of growth are the acquisition, expansion and retention of customer relationships. We strive to achieve such growth in our customer base by providing convenient banking options, leading technological systems and a broad range of asset management products and services. We also intend to grow through appropriate and targeted acquisitions and, in certain businesses, by expanding into new geographical markets.

In recent years, we have managed our interest rate risk to achieve a moderate risk profile with limited exposure to earnings volatility resulting from interest rate fluctuations. Our actions have created a balance sheet characterized by strong asset quality and significant flexibility to take advantage, where appropriate, of changing interest rates and to adjust to changing market conditions.

On February 15, 2006, we announced that BlackRock and Merrill Lynch had entered into a definitive agreement pursuant to which Merrill Lynch will contribute its investment management business to BlackRock in exchange for newly issued BlackRock common and preferred stock. Upon the closing of this transaction, which we expect to occur around September 30, 2006, BlackRock’s assets under management would increase to approximately $1 trillion and Merrill Lynch would own 65 million equity shares, or approximately 49%, of the combined company. At the closing of the transaction, we expect to continue to own approximately 44 million shares of BlackRock common stock, representing an ownership interest of approximately 34%. In addition, upon closing, the carrying value of our investment in BlackRock would

increase, based on the price of BlackRock stock at the time of announcement of this transaction and other factors, resulting in our recognizing an after-tax gain we currently estimate to be approximately $1.6 billion. This gain would significantly enhance our capital position and our tangible common equity ratio.

This transaction must be approved by BlackRock shareholders and is subject to obtaining appropriate regulatory and other approvals. We currently control more than 80% of the voting interest in BlackRock and will vote our interest in support of the transaction.

Additional information on this transaction is included in Note 2 Acquisitions in the Notes To Consolidated Financial Statements in this Report. To the extent that statements we make in this Report about our expectations for future results include results from BlackRock, those expectations do not give any effect to the impact to PNC from the change to the equity method of accounting for PNC’s interest in BlackRock that would take place when BlackRock and Merrill Lynch close this transaction.

THE ONE PNC INITIATIVE

As further described in our 2005 Form 10-K, the One PNC initiative began in January 2005 and is an ongoing, company-wide initiative with goals of moving closer to the customer, improving our overall efficiency and targeting resources to more value-added activities. PNC expects to realize $400 million of total annual pretax earnings benefit by mid-2007 from this initiative.

PNC plans to achieve approximately $300 million of cost savings through a combination of workforce reduction and other efficiencies. Of the approximately 3,000 positions to be eliminated, approximately 2,400 had been eliminated as of June 30, 2006. We estimate that these changes will result in employee severance and other implementation costs of approximately $74 million, including $54 million recognized during the second half of 2005 and $9 million recognized during the first six months of 2006. We expect that the remaining charges of approximately $11 million will be incurred later in 2006 and early 2007. In addition, PNC intends to achieve at least $100 million in net revenue growth through the implementation of various pricing and business growth enhancements driven by the One PNC initiative. Initiatives are progressing according to plan.


 

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We realized a net pretax financial benefit from the One PNC program of approximately $120 million in the first six months of 2006, including $60 million in the second quarter. We expect to capture approximately $265 million in cumulative value by the end of 2006 as originally planned.

KEY FACTORS AFFECTING FINANCIAL PERFORMANCE

Our financial performance is substantially affected by several external factors outside of our control, including:

  ·   General economic conditions,
  ·   Loan demand and utilization of credit commitments,
  ·   The level of interest rates, and the shape of the interest rate yield curve,
  ·   The performance of the capital markets, and
  ·   Customer demand for other products and services.

In addition to changes in general economic conditions, including the direction, timing and magnitude of movement in interest rates and the performance of the capital markets, our success in the remainder of 2006 will depend, among other things, upon:

  ·   Further success in the acquisition, growth and retention of customers,
  ·   Successful execution of the One PNC initiative,
  ·   Revenue growth,
  ·   A sustained focus on expense management and improved efficiency,
  ·   Maintaining strong overall asset quality, and
  ·   Prudent risk and capital management.

 

SUMMARY FINANCIAL RESULTS

 

    Three months ended     Six months
ended
 
In millions, except per share data   June 30
2006
    June 30
2005
    June 30
2006
    June 30
2005
 

Net income

  $381     $282     $735     $636  

Diluted earnings per share

  $1.28     $.98     $2.47     $2.22  

Return on

       

Average common

shareholders’ equity

  17.49 %   14.34 %   17.08 %   16.68 %

Average assets

  1.64 %   1.29 %   1.60 %   1.50 %

Results for the first six months of 2005 reflected the impact of the reversal of deferred tax liabilities that benefited earnings by $45 million, or $.16 per diluted share, in the first quarter of 2005 related to our transfer of ownership in BlackRock from PNC Bank, National Association (“PNC Bank, N.A.”) to PNC Bancorp, Inc. that occurred in January 2005.

Our second quarter 2006 performance included the following accomplishments:

  ·   Net income for the second quarter increased 35% compared with the second quarter of 2005, substantially due to a 32% increase in total noninterest income.
  ·   Solid growth in revenue and well-managed expenses propelled strong improvement in operating leverage compared with the prior year second quarter.
  ·   Average loans for the second quarter of 2006 increased $2.8 billion, or 6%, compared with the second quarter of 2005, primarily as a result of increased residential mortgage, commercial and commercial real estate loans, in part due to our expansion into the greater Washington, DC area. In addition, average loans for the second quarter of 2005 included $2.0 billion related to the Market Street Funding commercial paper conduit that was deconsolidated in October 2005.
  ·   Average deposits for the second quarter increased $6.0 billion, or 11%, compared with the same quarter in the prior year, primarily as the result of an increase in Eurodollar deposits, retail certificates of deposit, money market deposits, and demand and other noninterest-bearing deposits, in part due to our expansion into the greater Washington, DC area.
  ·   Asset quality remained very strong, with the ratio of nonperforming assets to loans, loans held for sale and foreclosed assets at .44%. The ratio of net charge-offs to average loans was .24% for the quarter.
  ·   We increased the common stock dividend 10%, to 55 cents per share, and repurchased approximately 1.8 million of our common shares during the second quarter of 2006.

 

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BALANCE SHEET HIGHLIGHTS

Total assets were $94.9 billion at June 30, 2006. Total average assets were $92.8 billion for the first six months of 2006 compared with $85.5 billion for the first six months of 2005. This increase was primarily attributable to a $6.8 billion increase in interest-earning assets. An increase of $3.9 billion in average loans was the primary factor for the increase in average interest-earning assets. In addition, average total securities increased $3.3 billion in the first half of 2006 compared with the prior year period.

Average total loans were $49.5 billion for the first six months of 2006 and $45.6 billion in the first six months of 2005. This increase was driven by continued improvements in market loan demand and targeted sales efforts across our banking businesses, as well as our expansion into the greater Washington, DC area that began in May 2005. The increase in average total loans reflected growth in residential mortgages of approximately $2.0 billion, commercial loans of approximately $1.4 billion, and commercial real estate loans of approximately $.8 billion. In addition, average loans for the first half of 2005 included $2.1 billion related to Market Street Funding (“Market Street”) which was deconsolidated in October 2005. Loans represented 64% of average interest-earning assets for the first six months of 2006 and 65% for the first six months of 2005.

Average securities totaled $21.2 billion for the first six months of 2006 and $17.9 billion for the first six months of 2005. Of this increase, $3.0 billion was attributable to increases in mortgage-backed, asset-backed, and other debt securities. The higher average securities balances reflected our desire to continue investing through the interest rate cycle and the Riggs acquisition. Securities comprised 28% of average interest-earning assets for the first half of 2006 and 26% for the first half of 2005.

 

Average total deposits were $61.8 billion for the first six months of 2006, an increase of $6.8 billion over the first six months of 2005. The increase in average total deposits was primarily driven by the impact of higher certificates of deposit, money market account and noninterest-bearing deposit balances, and by higher Eurodollar deposits. Similar to its impact on average loans and securities described above, our expansion into the greater Washington, DC area also contributed to the increase in average total deposits. Average total deposits represented 67% of average total assets for the first half of 2006 and 64% for the first half of 2005. Average transaction deposits were $41.0 billion for the first six months of 2006 compared with $37.8 billion for the first six months of 2005.

Average borrowed funds were $15.4 billion for the first six months of 2006 and $15.7 billion for the first six months of 2005. This decrease was primarily due to a significant decline in commercial paper due to the deconsolidation of Market Street in October 2005, partially offset by net increases in bank notes and senior debt, subordinated debt and federal funds purchased.

Shareholders’ equity totaled $8.8 billion at June 30, 2006, compared with $8.6 billion at December 31, 2005. See the Consolidated Balance Sheet Review section of this Financial Review for additional information.


 

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BUSINESS SEGMENT HIGHLIGHTS

 

    Three months ended   Six months ended
In millions  

June 30

2006

 

June 30

2005

 

June 30

2006

 

June 30

2005

Total segment earnings

  $390   $383   $783   $712

Total business segment earnings for the second quarter and first half of 2005 included the benefit of a $53 million loan recovery included in the Corporate & Institutional Banking business segment. A summary of results for both the first half and second quarter of 2006 comparisons with the prior year periods follows. Further analysis of business segment results for the six-month periods is found on pages 15 through 23.

We provide a reconciliation of total business segment earnings to total PNC consolidated net income as reported on a GAAP basis in Note 13 Segment Reporting in the Notes To Consolidated Financial Statements in this Report and in the Results of Businesses - Summary table on page 15.

Retail Banking

Retail Banking’s earnings were $375 million for the first six months of 2006 compared with $311 million for the same period in 2005. Compared with the prior year, revenues increased 12% and noninterest expenses increased 5%, resulting in a 21% earnings improvement. The increase in earnings was driven by higher taxable-equivalent net interest income fueled by continued customer and balance sheet growth along with improved fee income from customers and a sustained focus on expense management.

Earnings from Retail Banking totaled $185 million in the second quarter of 2006 compared with $162 million in the second quarter of 2005. Revenue increased 10% compared with the second quarter of 2005, while noninterest expense increased only 4%, driving a 14% increase in earnings.

Corporate & Institutional Banking

Earnings from Corporate & Institutional Banking for the first six months of 2006 totaled $221 million compared with $254 million for the first six months of 2005. This decline was primarily attributable to a $53 million loan recovery recognized in the second quarter of 2005 compared with a $29 million provision for credit losses in the first half of 2006. In addition to the $81 million swing in the provision for credit losses, total revenue increased $91 million and noninterest expenses grew by $59 million for the first six months of 2006 compared with the comparable 2005 period.

Corporate & Institutional Banking earned $116 million in the second quarter of 2006 compared with $144 million in the second quarter of 2005. The earnings decrease compared with the prior year quarter was largely the result of an increase in the provision for credit losses, primarily due to a $53 million loan recovery referred to above that benefited the prior year quarter. Revenue increased $61 million in the second quarter of 2005, driven by an increase in noninterest income, while noninterest expense increased $37 million.

BlackRock

Earnings totaled $134 million for BlackRock for the first half of 2006 compared with $100 million for the prior year first half. Higher earnings in 2006 reflected higher investment

advisory and administration fees due to an increase in assets under management and increased performance fees which more than offset higher expenses primarily associated with business growth.

BlackRock earned $63 million in the second quarter of 2006, an increase of $10 million, or 19%, compared with the second quarter of 2005. The increase compared with the prior year quarter was largely the result of growth in investment advisory and administrative fees. BlackRock’s assets under management increased to $464 billion at June 30, 2006 compared with $414 billion at June 30, 2005.

PNC owns approximately 69% of BlackRock and we consolidate BlackRock into our financial statements. Accordingly, approximately 31% of BlackRock’s earnings are recognized as minority interest expense in the Consolidated Income Statement. BlackRock financial information included in the Financial Review section of this Report is presented on a stand-alone basis. The market value of our BlackRock shares was approximately $6.2 billion at June 30, 2006 while the book value at that date was approximately $767 million.

PFPC

PFPC’s earnings of $53 million in the first six months of 2006 increased $6 million, or 13%, compared with the first six months of 2005. Higher earnings in the first half of 2006 reflected servicing revenue contributions from several growth areas of the business and the successful implementation of expense control initiatives which improved the company’s operating margin.

PFPC earned $26 million in the second quarter of 2006 compared with $24 million in the second quarter of 2005. The earnings increase from the second quarter of 2005 was a result of continued emphasis on cost reductions and process efficiencies as competitive factors impacted revenue growth.

Other

“Other” for the first half of 2006 was a net loss of $7 million, while “Other” for the first half of 2005 was a net loss of $46 million. The first six months of 2005 included the impact of Riggs acquisition integration costs totaling $19 million after-tax. In addition, the first half of 2006 benefited in the comparison with higher equity management gains and lower net securities losses. Net securities losses for the first six months of 2005 reflected actions taken during the second quarter of that year regarding our securities portfolio that resulted in realized net securities and other losses of approximately $20 million after-tax. These factors were partially offset by the first quarter 2005 benefit recognized from a $45 million deferred tax liability reversal related to the internal transfer of our investment in BlackRock as described above under Summary Financial Results.

We recorded earnings of $10 million in “Other” for the second quarter of 2006 primarily as a result of $54 million of pretax equity management gains. “Other” for the second quarter of 2005 was a net loss of $85 million. The increase in earnings compared with the second quarter of 2005 reflected higher equity management gains and lower net securities losses in the 2006 period, along with the impact of the nonrecurring Riggs costs referred to above in second quarter 2005 results.


 

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CONSOLIDATED INCOME STATEMENT REVIEW

NET INTEREST INCOME AND NET INTEREST MARGIN

 

    Three months ended     Six months ended  
Dollars in millions  

June 30

2006

   

June 30

2005

   

June 30

2006

   

June 30

2005

 

Taxable-equivalent net interest income

  $562     $541     $1,125     $1,053  

Net interest margin

  2.90 %   3.00 %   2.93 %   3.01 %

We provide a reconciliation of net interest income as reported under GAAP to net interest income presented on a taxable-equivalent basis in the Consolidated Financial Highlights section on page 1 of this Report.

Changes in net interest income and margin result from the interaction of the volume and composition of interest-earning assets and related yields, interest-bearing liabilities and related rates paid, and noninterest-bearing sources. See Statistical Information-Average Consolidated Balance Sheet And Net Interest Analysis included on pages 63 and 64 of this Report for additional information.

The increase in taxable-equivalent net interest income for the first six months of 2006 compared with the first six months of 2005 reflected the impact of a $6.8 billion increase in average interest-earning assets in 2006, driven by organic growth and our expansion into the greater Washington, DC area. The $5.2 billion increase in average interest-earning assets for the second quarter of 2006 compared with the second quarter of 2005 drove the increase in taxable-equivalent net interest income in the second quarter of 2006.

The following factors contributed to the decline in net interest margin for the first half of 2006 compared with the first half of 2005:

  ·   An increase in the average rate paid on deposits of 103 basis points for the first six months of 2006 compared with the 2005 period. The average rate paid on money market accounts, the largest single component of interest-bearing deposits, increased 117 basis points.
  ·   An increase in the average rate paid on borrowed funds of 156 basis points for the first half of 2006 compared with the first half of 2005.
  ·   By comparison, the yield on interest-earning assets increased only 84 basis points. Loans, the single largest component, increased 87 basis points.
  ·   These factors were partially offset by the favorable impact on net interest margin in 2006 of an increase of 20 basis points related to noninterest-bearing sources of funding.

The decline in net interest margin for the second quarter of 2006 compared with the second quarter of 2005 reflected the following:

 

  ·   An increase in the average rate paid on deposits of 106 basis points for the second quarter of 2006 compared with the second quarter of 2005. The average rate paid on money market accounts, the largest single component of interest-bearing deposits, increased 115 basis points.
  ·   An increase in the average rate paid on borrowed funds of 158 basis points for the second quarter of 2006 compared with the prior year period.
  ·   By comparison, the yield on interest-earning assets increased only 81 basis points. Loans, the single largest component, increased 90 basis points.
  ·   These factors were partially offset by the favorable impact on net interest margin in 2006 of an increase of 21 basis points related to noninterest-bearing sources of funding.

We believe that net interest margins for our industry will continue to be challenged if the yield curve remains flat or inverted, as competition for loans and deposits remains intense and as customers continue to migrate from lower cost to higher cost deposits. Consequently, we believe that our taxable-equivalent net interest income will be relatively flat to up through the remainder of 2006 and that our net interest margin may continue to be under pressure in the latter half of 2006. This outlook includes the impact of financing costs associated with share repurchases.

PROVISION FOR CREDIT LOSSES

The provision for credit losses increased $85 million, to $66 million, in the first half of 2006 compared with the first half of 2005. For the second quarter of 2006, the provision for credit losses increased $71 million, to $44 million, compared with the prior year second quarter. The increases in both comparisons reflected the following:

  ·   A $53 million loan recovery in the second quarter of 2005 resulting from a litigation settlement,
  ·   The impact of overall loan growth, as total average loans grew $3.9 billion in the first half of 2006 and $2.8 billion in the second quarter of 2006 compared with the respective prior year periods, and
  ·   The effect of a single large overdraft situation during the second quarter of 2006.

We do not expect to sustain asset quality at its current level. However, based on the assets we currently hold and current business trends and activities, we believe that overall asset quality will remain strong by historical standards for at least the near term. See the Credit Risk Management portion of the Risk Management section of this Financial Review for additional information regarding factors that impact the provision for credit losses.

NONINTEREST INCOME

Summary

Noninterest income was $2.415 billion for the first six months of 2006, an increase of $512 million, or 27%, compared with the first six months of 2005. Noninterest income for the second quarter of 2006 totaled $1.230 billion and totaled $929 million in the prior year second quarter, an increase of $301 million, or 32%. Higher asset management fees was the largest factor in both comparisons. In addition, noninterest income in both 2006 periods reflected increases in most other major categories.


 

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Additional Analysis

Asset management fees totaled $890 million in the first half of 2006, an increase of $242 million compared with the first half of 2005. Asset management fees increased $95 million, to $429 million, for the second quarter of 2006 compared with the second quarter of 2005. The increase reflected the impact of higher performance fees, BlackRock’s first quarter 2005 acquisition of SSRM and other growth in assets managed. Assets under management at June 30, 2006 totaled $506 billion compared with $456 billion at June 30, 2005.

Fund servicing fees of $431 million for the first six months of 2006 represented an $8 million decline from the prior year period. For the second quarter of 2006, fund servicing fees totaled $210 million, a decline of $9 million from the second quarter of 2005. The decrease in fund servicing fees in both comparisons is primarily due to lower fund accounting and transfer agent fees during 2006 due to loss of clients and price concessions.

PFPC provided fund accounting/administration services for $743 billion of net fund investment assets and provided custody services for $389 billion of fund investment assets at June 30, 2006, compared with $766 billion and $462 billion, respectively, at June 30, 2005. The decreases in domestic accounting/administration net fund assets and custody fund assets at June 30, 2006 resulted primarily from the deconversion of a major client during the first quarter of 2006 which was partially offset by new business, asset inflows from existing customers and equity market appreciation.

Service charges on deposits grew $27 million, to $153 million, in the first half of 2006 compared with the prior year first half. Service charges on deposits increased $13 million in the second quarter of 2006 compared with the prior year second quarter. These increases can be attributed to customer growth, expansion of the branch network, including the expansion into the greater Washington, DC area that began in May 2005, and various pricing actions resulting from the One PNC initiative.

Brokerage fees totaled $122 million in the first six months of 2006 and $112 million in the first six months of 2005. Brokerage fees increased $6 million, to $63 million, for the second quarter of 2006 compared with the second quarter of 2005. These increases reflected higher annuity income, along with higher brokerage commissions and mutual fund-related revenues in 2006.

Consumer services fees grew $46 million, to $183 million, for the first half of 2006 compared with the prior year first half. Consumer services fees increased $21 million, to $94 million, in the second quarter of 2006 compared with the second quarter of 2005. Higher fees reflected the impact of consolidating our merchant services activities in the fourth quarter of 2005 as a result of our increased ownership interest in the merchant services business. The increases in fees were also due to higher debit card revenues resulting from higher transaction volumes, our expansion into the greater Washington, DC area and pricing actions related to the One PNC initiative. These factors were partially offset by lower ATM surcharge revenue in the 2006

periods compared with the respective prior year periods as a result of changing customer behavior and a strategic decision to reduce the out-of-footprint ATM network.

Corporate services revenue totaling $292 million in the first six months of 2006 represented a $71 million, or 32%, increase over the comparable prior year period. Corporate services revenue increased $44 million, or 39%, in the second quarter of 2006 compared with the second quarter of 2005. Both 2006 periods benefited from the impact of our October 2005 Harris Williams acquisition that resulted in higher revenues.

Equity management (private equity) net gains on portfolio investments totaled $61 million for the first half of 2006 compared with $44 million for the first half of 2005. For the second quarter of 2006, net gains on portfolio investments totaled $54 million compared with $12 million in the prior year quarter. Based on the nature of private equity activities, net gains or losses may be volatile from period to period.

Net securities losses amounted to $12 million for the first six months of 2006 compared with net securities losses of $35 million in the first six months of 2005. Net securities losses totaled $8 million in the second quarter of 2006 and $26 million in the second quarter of 2005. Amounts for both 2005 periods reflect actions taken during the second quarter of that year regarding our securities portfolio that resulted in realized net securities and other losses of approximately $31 million.

Noninterest revenue from trading activities, which is primarily customer-related, was $112 million for the first half of 2006 compared with $61 million for the first half of 2005. For the second quarter of 2006, noninterest revenue from trading activities was $55 million, compared with $11 million in the prior year second quarter. We provide additional information on our trading activities under Market Risk Management – Trading Risk in the Risk Management section of this Financial Review.

Other noninterest income of $183 million for the first six months of 2006 represented a $33 million increase compared with the prior year first half. Other noninterest income increased $27 million, to $96 million, in the second quarter of 2006 compared with the second quarter of 2005. Other noninterest income typically fluctuates from period to period depending on the nature and magnitude of transactions completed.

Other noninterest income for the first half of 2006 included gains totaling $26 million, including $13 million recognized in the second quarter, related to our contributions of BlackRock stock to the PNC Foundation. These transactions also impacted noninterest expense in each of those periods.

PRODUCT REVENUE

In addition to credit products to commercial customers, Corporate & Institutional Banking offers treasury management and capital markets-related products and services, commercial loan servicing and equipment leasing products that are marketed by several businesses across PNC.

Treasury management revenue, which includes fees as well as net interest income from customer deposit balances, totaled $208 million for first six months of 2006 and $200 million for first six months of 2005. For the second quarter of 2006,


 

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revenue totaled $106 million compared with $103 million for the second quarter of 2005. The higher revenue in both comparisons reflected continued expansion and client utilization of commercial payment card services, strong revenue growth in various electronic payment and information services, and a steady increase in business-to-business processing volumes.

Revenue from capital markets products and services was $140 million for the first half of 2006, compared with $71 million in the first half of 2005. Consolidated revenue from capital markets products and services, including mergers and acquisitions advisory activities, for the second quarter of 2006 totaled $76 million compared with $29 million for the second quarter of 2005. The acquisition of Harris Williams together with improved customer and proprietary trading activities drove the increase in capital markets revenue in both comparisons.

Midland Loan Services offers servicing, real estate advisory and technology solutions for the commercial real estate finance industry. Midland’s revenue, which includes fees and net interest income from servicing portfolio deposit balances, totaled $84 million for first six months of 2006 and $64 million for first six months of 2005. Second quarter 2006 revenue totaled $42 million compared with $32 million for the second quarter of 2005. Revenue growth in both comparisons was primarily driven by growth in the commercial mortgage servicing portfolio and related services.

Revenue from equipment leasing products was $38 million for the first half of 2006 and $36 million for the first half of 2005. Second quarter 2006 revenue from equipment leasing products totaled $20 million compared with $18 million for the second quarter of 2005. The impact of the interest cost of funding the potential tax exposure on the cross-border leasing portfolio had, and is expected to continue to have, a negative impact on leasing revenue in 2006. See Cross-Border Leases and Related Tax and Accounting Matters within the Consolidated Balance Sheet Review section of this Financial Review for further information.

As a component of our advisory services to clients, we provide a select set of insurance products to fulfill specific customer financial needs. Primary insurance offerings include:

  ·   Annuities,
  ·   Life,
  ·   Credit life,
  ·   Health,
  ·   Disability, and
  ·   Commercial lines coverage.

Client segments served by these insurance solutions include those in Retail Banking and Corporate & Institutional Banking. Insurance products are sold by licensed PNC insurance agents and through licensed third-party arrangements. Revenue from these products was $35 million in the first six months of 2006 and $31 million in first six months of 2005. Revenue for the second quarter of 2006 totaled $18 million compared with $17 million for the second quarter of 2005. The increases resulted from higher annuity fee revenue.

PNC, through subsidiary companies Alpine Indemnity Limited and PNC Insurance Corp., participates as a reinsurer for its general liability, automobile liability and workers’

compensation programs and as a direct writer for its property and terrorism programs.

In the normal course of business, Alpine Indemnity Limited and PNC Insurance Corp. maintain insurance reserves for reported claims and for claims incurred but not reported based on actuarial assessments. We believe these reserves were adequate at June 30, 2006.

NONINTEREST EXPENSE

Year-to-date June 30, 2006 and 2005

Total noninterest expense was $2.320 billion for the first six months of 2006 and $2.040 billion for the first six months of 2005. The efficiency ratio was 66% for the first six months of 2006 compared with 69% for the first six months of 2005.

Noninterest expense for the first half of 2006 included the following:

  ·   An increase of $185 million in BlackRock operating expenses, reflecting growth in that business and integration costs related to the pending Merrill Lynch transaction,
  ·   Expenses totaling $43 million related to Harris Williams, which we acquired in October 2005, and
  ·   An increase of $30 million related to the consolidation of our merchant services activities in the fourth quarter of 2005.

Apart from the impact of these items, noninterest expense for the first six months of 2006 increased $22 million over the prior year period primarily due to the impact of our expansion into the greater Washington, DC area and contributions of BlackRock stock to the PNC Foundation, partially offset by the benefit of the One PNC initiative.

Second quarter 2006 and 2005

Total noninterest expense was $1.149 billion for the second quarter of 2006 and $1.040 billion for the second quarter of 2005. The efficiency ratio was 64% for the second quarter of 2006 and 71% for the second quarter of 2005.

Noninterest expense for the second quarter of 2006 reflected a $74 million increase in operating expenses at BlackRock, $24 million of expenses related to Harris Williams, and an increase of $14 million related to the fourth quarter 2005 consolidation of our merchant services activities. Apart from the impact of these items, noninterest expense for the second quarter of 2006 decreased $3 million compared with the prior year second quarter.

We expect that the percentage increase in total noninterest expense for full year 2006 compared with 2005, excluding BlackRock, will be in the low single-digit range, with the increase primarily attributable to the acquisition of Harris Williams and the consolidation of merchant services in the fourth quarter of 2005. However, noninterest expense will continue to be impacted by ongoing investments in our businesses.


 

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Period-end employees totaled 26,032 at June 30, 2006 (comprised of 23,791 full-time and 2,241 part-time) compared with 25,348 at December 31, 2005 (comprised of 23,593 full-time and 1,755 part-time) and 25,874 at June 30, 2005 (comprised of 24,397 full-time and 1,477 part-time). The increase in part-time employees reflects Retail Banking initiatives to utilize more customer-facing employees during peak business hours versus full-time employees for the entire day.

EFFECTIVE TAX RATE

Our effective tax rate for the first six months of 2006 was 33.1% compared with 29.4% for the first six months of 2005. The lower effective rate for first half of 2005 was attributable to the impact of the reversal of deferred tax liabilities in connection with the transfer of our ownership in BlackRock to our intermediate bank holding company. This transaction reduced our first quarter 2005 tax provision by $45 million.

CONSOLIDATED BALANCE SHEET REVIEW

SUMMARIZED BALANCE SHEET DATA

 

In millions   June 30
2006
  December 31
2005

Assets

   

Loans, net of unearned income

  $50,548   $49,101

Securities available for sale and held to maturity

  21,724   20,710

Loans held for sale

  2,165   2,449

Other

  20,477   19,694

Total assets

  $94,914   $91,954

Liabilities

   

Funding sources

  $79,144   $77,172

Other

  6,311   5,629

Total liabilities

  85,455   82,801

Minority and noncontrolling interests in consolidated entities

  632   590

Total shareholders’ equity

  8,827   8,563

Total liabilities, minority and noncontrolling interests, and shareholders’ equity

  $94,914   $91,954

Our Consolidated Balance Sheet is presented in Part I, Item 1 on page 38 of this Report.

Various seasonal and other factors impact our period-end balances whereas average balances (discussed under the Balance Sheet Highlights section of this Financial Review above and included in the Statistical Information section of this Report on pages 63 and 64) are more indicative of underlying business trends.

An analysis of changes in certain balance sheet categories follows.

LOANS, NET OF UNEARNED INCOME

Loans increased $1.4 billion, to $50.5 billion, at June 30, 2006 compared with the balance at December 31, 2005, with the majority of the increase due to higher total commercial loans. Targeted sales efforts across our banking businesses drove the increase in total loans.

Details Of Loans

 

In millions  

June 30

2006

   

December 31

2005

 

Commercial

   

Retail/wholesale

  $5,393     $4,854  

Manufacturing

  4,164     4,045  

Other service providers

  2,179     1,986  

Real estate related

  2,903     2,577  

Financial services

  1,479     1,438  

Health care

  641     616  

Other

  3,805     3,809  

Total commercial

  20,564     19,325  

Commercial real estate

   

Real estate projects

  2,438     2,244  

Mortgage

  768     918  

Total commercial real estate

  3,206     3,162  

Equipment lease financing

  3,583     3,628  

Total commercial lending

  27,353     26,115  

Consumer

   

Home equity

  13,853     13,790  

Automobile

  1,008     938  

Other

  1,388     1,445  

Total consumer

  16,249     16,173  

Residential mortgage

  7,416     7,307  

Other

  358     341  

Unearned income

  (828 )   (835 )

Total, net of unearned income

  $50,548     $49,101  

As the table above indicates, our total loan portfolio continued to be diversified among types of loan products and numerous industries and businesses. The loans that we hold are also diversified across the geographic areas where we do business.

Commercial Lending Exposure (a)

 

    

June 30

2006

   

December 31

2005

 

Investment grade or equivalent

   48 %   46 %

Non-investment grade

    

$50 million or greater

   2     2  

All other non-investment grade

   50     52  

Total

   100 %   100 %
(a) Includes total commercial lending in the Retail Banking and Corporate & Institutional Banking business segments.

 

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Commercial loans are the largest category and are the most sensitive to changes in assumptions and judgments underlying the determination of the allowance for loan and lease losses. We have allocated approximately $502 million, or 82%, of the total allowance for loan and lease losses at June 30, 2006 to the commercial loan category. This allocation also considers other relevant factors such as:

  ·   Actual versus estimated losses,
  ·   Regional and national economic conditions,
  ·   Business segment and portfolio concentrations,
  ·   Industry competition and consolidation,
  ·   The impact of government regulations, and
  ·   Risk of potential estimation or judgmental errors, including the accuracy of risk ratings.

Net Unfunded Credit Commitments

 

In millions   

June 30

2006

  

December 31

2005

Commercial

   $28,175    $27,774

Consumer

   9,975    9,471

Commercial real estate

   2,419    2,337

Other

   335    596

Total

   $40,904    $40,178

Commitments to extend credit represent arrangements to lend funds or provide liquidity subject to specified contractual conditions. Commercial commitments are reported net of participations, assignments and syndications, primarily to financial institutions, totaling $7.1 billion at June 30, 2006 and $6.7 billion at December 31, 2005.

Unfunded liquidity commitments totaled $4.6 billion at June 30, 2006 and December 31, 2005 and are included in the preceding table primarily within the “Commercial” and “Consumer” categories.

In addition to credit commitments, our net outstanding standby letters of credit totaled $4.3 billion at June 30, 2006 and $4.2 billion at December 31, 2005. Standby letters of credit commit us to make payments on behalf of our customers if specified future events occur.

 

Cross-Border Leases and Related Tax and Accounting Matters

The equipment lease portfolio totaled $3.6 billion at June 30, 2006. Aggregate residual value at risk on the lease portfolio at June 30, 2006 was $1.1 billion. We have taken steps to mitigate $.6 billion of this residual risk, including residual value insurance coverage with third parties, third party guarantees, and other actions. The portfolio included approximately $1.7 billion of cross-border leases at June 30, 2006. Cross-border leases are leveraged leases of equipment located in foreign countries, primarily in western Europe and Australia. We have not entered into cross-border lease transactions since 2003.

Upon completing examination of our 1998-2000 consolidated federal income tax returns, the IRS provided us with an examination report which proposes increases in our tax liability, principally arising from adjustments to several of our cross-border lease transactions.

The IRS has begun an audit of our 2001-2003 consolidated federal income tax returns. We expect them to again make adjustments to the cross-border lease transactions referred to above as well as to new cross-border lease transactions entered into during those years. We believe our reserves for these exposures were adequate at June 30, 2006.

In July 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position No. FAS 13-2, Accounting for a Change or Projected Change in the Timing of Cash Flows Relating to Income Taxes Generated by a Leveraged Lease Transaction (“FSP 13-2”). FSP 13-2 is effective January 1, 2007 and will require a recalculation of the timing of income recognition and the reevaluation of lease classification for actual or projected changes in the timing of tax benefits for leveraged leases. Any cumulative adjustment will be recognized through retained earnings upon adoption of FSP 13-2. See Note 1 Accounting Policies in the Notes To Consolidated Financial Statements in this Report for additional information. We estimate that the cumulative adjustment that we will record effective January 1, 2007 from the recalculations required by FSP 13-2 will be in the range of approximately $140 million to $160 million, after-tax. Any immediate or future reductions in earnings from our adoption of FSP 13-2 would be recovered in subsequent years.

In addition to these transactions, three lease-to-service contract transactions that we were party to were structured as partnerships for tax purposes. These partnerships are under audit by the IRS. However, we do not believe that our exposure from these transactions is material to our consolidated results of operations or financial position.

Additional information on cross-border lease transactions is included under “Cross-Border Leases and Related Tax and Accounting Matters” in the Consolidated Balance Sheet Review section of Item 7 of our 2005 Form 10-K.


 

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SECURITIES

Details Of Securities (a)

 

In millions   Amortized
Cost
  Fair
Value

June 30, 2006

   
SECURITIES AVAILABLE FOR SALE  

Debt securities

   

Mortgage-backed

  $14,939   $14,492

US Treasury and government agencies

  3,297   3,169

Commercial mortgage-backed

  2,274   2,180

Asset-backed

  1,442   1,425

State and municipal

  150   147

Other debt

  90   88

Corporate stocks and other

  223   223

Total securities available for sale

  $22,415   $21,724

December 31, 2005

   
SECURITIES AVAILABLE FOR SALE  

Debt securities

   

Mortgage-backed

  $13,794   $13,544

US Treasury and government agencies

  3,816   3,744

Commercial mortgage-backed

  1,955   1,919

Asset-backed

  1,073   1,063

State and municipal

  159   158

Other debt

  87   86

Corporate stocks and other

  196   196

Total securities available for sale

  $21,080   $20,710
(a) Securities held to maturity at June 30, 2006 and December 31, 2005 were less than $.5 million.

Securities represented 23% of total assets at June 30, 2006 and December 31, 2005.

At June 30, 2006, securities available for sale included a net unrealized loss of $691 million, which represented the difference between fair value and amortized cost. The comparable amount at December 31, 2005 was a net unrealized loss of $370 million. The impact on bond prices of increases in interest rates and tightening asset spreads during the first six months of 2006 was reflected in the net unrealized loss position at June 30, 2006.

The fair value of securities available for sale decreases when interest rates increase and vice versa. Further increases in interest rates after June 30, 2006, if sustained, will adversely impact the fair value of securities available for sale compared with the balance at June 30, 2006. Net unrealized gains and losses in the securities available for sale portfolio are included in shareholders’ equity as accumulated other comprehensive income or loss, net of tax.

We evaluate our portfolio of securities available for sale in light of changing market conditions and other factors and, where appropriate, take steps intended to improve our overall positioning.

The expected weighted-average life of securities available for sale was 4 years and 5 months at June 30, 2006 and 4 years and 1 month at December 31, 2005.

 

We estimate that at June 30, 2006 the effective duration of securities available for sale is 3.2 years for an immediate 50 basis points parallel increase in interest rates and 3.0 years for an immediate 50 basis points parallel decrease in interest rates. Comparable amounts at December 31, 2005 were 2.7 years and 2.4 years, respectively.

LOANS HELD FOR SALE

Education loans held for sale totaled $1.5 billion at June 30, 2006 and $1.9 billion at December 31, 2005 and represented the majority of our loans held for sale at each date. We classify substantially all of our education loans as loans held for sale. Generally, we sell education loans when the loans are placed into repayment status. Gains on sales of education loans are reflected in the Other noninterest income line item in our Consolidated Income Statement and in the results for the Retail Banking business segment.

FUNDING AND CAPITAL SOURCES

Details Of Funding Sources

 

In millions    June 30
2006
   December 31
2005

Deposits

     

Money market

   $26,801    $24,462

Demand

   16,104    17,157

Retail certificates of deposit

   13,775    13,010

Savings

   2,114    2,295

Other time

   1,452    1,313

Time deposits in foreign offices

   3,247    2,038

Total deposits

   63,493    60,275

Borrowed funds

     

Federal funds purchased

   3,320    4,128

Repurchase agreements

   2,136    1,691

Bank notes and senior debt

   3,503    3,875

Subordinated debt

   4,329    4,469

Other

   2,363    2,734

Total borrowed funds

   15,651    16,897

Total

   $79,144    $77,172

The decline in total borrowed funds compared with the balance at December 31, 2005 reflects a decrease in federal funds purchased and maturities of $850 million of bank notes during the first half of 2006 partially offset by an issuance of $500 million of bank notes in June 2006 and an increase in repurchase agreements.

Capital

We manage our capital position by making adjustments to our balance sheet size and composition, issuing debt and equity instruments, making treasury stock transactions, maintaining dividend policies and retaining earnings.

The increase of $264 million in total shareholders’ equity at June 30, 2006 compared with December 31, 2005 reflected the impact of earnings and a reduction in shares held in treasury, partially offset by a higher accumulated other comprehensive loss.

Common shares outstanding at June 30, 2006 were 294.7 million compared with 292.9 million at December 31, 2005. The increase in shares outstanding during the first half of 2006


 

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reflected share issuances related to various employee stock-based compensation plans and the exercise of employee stock options.

We purchased 1.8 million common shares under our common stock repurchase program during the first six months of 2006, with all purchases occurring in the second quarter. Our current program, which permits us to purchase up to 20 million shares on the open market or in privately negotiated transactions, will remain in effect until fully utilized or until modified, superseded or terminated. As of June 30, 2006, remaining availability for purchases under this program was 17.8 million shares. The extent and timing of additional share repurchases under this program will depend on a number of factors including, among others, market and general economic conditions, economic and regulatory capital considerations, alternative uses of capital, and the potential impact on our credit rating. We expect to continue to be active in share repurchases under favorable market conditions.

 

Risk-Based Capital

 

Dollars in millions   June 30
2006
    December 31
2005
 

Capital components

   

Shareholders’ equity

   

Common

  $8,820     $8,555  

Preferred

  7     8  

Trust preferred capital securities

  1,418     1,417  

Minority interest

  345     291  

Goodwill and other intangibles

  (4,113 )   (4,122 )

Net unrealized securities losses, after-tax

  449     240  

Net unrealized losses on cash flow hedge derivatives, after-tax

  59     26  

Equity investments in nonfinancial companies

  (44 )   (40 )

Other, net

  (8 )   (11 )

Tier 1 risk-based capital

  6,933     6,364  

Subordinated debt

  2,125     2,216  

Eligible allowance for credit losses

  714     697  

Total risk-based capital

  $9,772     $9,277  

Assets

   

Risk-weighted assets, including off-balance sheet instruments and market risk equivalent assets

  $78,731     $76,673  

Adjusted average total assets

  89,908     88,329  

Capital ratios

   

Tier 1 risk-based

  8.8 %   8.3 %

Total risk-based

  12.4     12.1  

Leverage

  7.7     7.2  

Tangible common equity

  5.2     5.0  

The access to, and cost of, funding new business initiatives including acquisitions, the ability to engage in expanded business activities, the ability to pay dividends, the level of deposit insurance costs, and the level and nature of regulatory oversight depend, in part, on a financial institution’s capital strength. At June 30, 2006, each of our banking subsidiaries was considered “well-capitalized” based on regulatory capital ratio requirements. We believe our bank subsidiaries will continue to meet these requirements during the remainder of 2006.


 

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OFF-BALANCE SHEET ARRANGEMENTS AND VARIABLE INTEREST ENTITIES

We engage in a variety of activities in the normal course of business that involve unconsolidated entities or that are otherwise not reflected in our Consolidated Balance Sheet that are generally referred to as “off-balance sheet arrangements.” Further information on these types of activities is included in Note 14 Commitments And Guarantees included in the Notes To Consolidated Financial Statements in Part I, Item 1 of this Report.

Further information on the variable interest entities (“VIEs”) in the following tables is included in our 2005 Form 10-K under this same heading in Part I, Item 7 and in Note 3 Variable Interest Entities in the Notes To Consolidated Financial Statements included in Part II, Item 8 of that report.

We hold significant variable interests in VIEs that have not been consolidated because we are not considered the primary beneficiary. Information on these VIEs follows:

Non-Consolidated VIEs - Significant Variable Interests

 

In millions    Aggregate
Assets
   Aggregate
Liabilities
  

PNC Risk

of Loss

 

June 30, 2006

        

Collateralized debt obligations (a)

   $6,362    $5,888    $49 (b)

Private investment funds (a)

   5,740    1,180    13 (b)

Market Street

   3,458    3,458    5,095 (c)

Partnership interests in low income housing projects

   35    29    7  

Total

   $15,595    $10,555    $5,164  

December 31, 2005

        

Collateralized debt obligations (a)

   $6,290    $5,491    $51 (b)

Private investment funds (a)

   5,186    1,051    13 (b)

Market Street

   3,519    3,519    5,089 (c)

Partnership interests in low income housing projects

   35    29    2  

Total

   $15,030    $10,090    $5,155  
(a) Held by BlackRock.
(b) Includes both PNC’s risk of loss and BlackRock’s risk of loss, limited to PNC’s ownership interest in BlackRock.
(c) Includes off-balance sheet liquidity commitments to Market Street of $4.6 billion and other credit enhancements of $462 million at June 30, 2006. The comparable amounts at December 31, 2005 were $4.6 billion and $444 million, respectively.

 

The aggregate assets and liabilities of VIEs that we have consolidated in our financial statements are as follows:

Consolidated VIEs – PNC Is Primary Beneficiary

 

In millions   

Aggregate

Assets

   Aggregate
Liabilities

June 30, 2006

     

Partnership interests in low income housing projects

   $619    $619

Other

   33    30

Total

   $652    $649

December 31, 2005

     

Partnership interests in low income housing projects

   $680    $680

Other

   12    10

Total

   $692    $690

We also have subsidiaries that invest in and act as the investment manager for private equity funds organized as limited partnerships as part of our equity management activities. The funds invest in private equity investments to generate capital appreciation and profits. As permitted by FASB Interpretation No. 46 (Revised 2003), “Consolidation of Variable Interest Entities,” we have deferred applying the provisions of the interpretation for these entities pending further action by the FASB. Information on these entities follows:

Investment Company Accounting – Deferred Application

 

In millions    Aggregate
Assets
   Aggregate
Equity
  

PNC Risk

of Loss

Private Equity Funds

        

June 30, 2006

   $124    $124    $113

December 31, 2005

   $109    $109    $35

PNC’s risk of loss in the tables above includes equity investments and unfunded commitments.


 

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BUSINESS SEGMENTS REVIEW

We operate four major businesses engaged in providing banking, asset management and global fund processing services. Business segment results, including inter-segment revenues, and a description of each business are included in Note 13 Segment Reporting included in the Notes To Consolidated Financial Statements under Part I, Item 1 of this Report.

 

Results of individual businesses are presented based on our management accounting practices and our management structure. There is no comprehensive, authoritative body of guidance for management accounting equivalent to GAAP; therefore, the financial results of individual businesses are not necessarily comparable with similar information for any other company. We refine our methodologies from time to time as our management accounting practices are enhanced and our businesses and management structure change. Financial results are presented, to the extent practicable, as if each business operated on a stand-alone basis. As permitted under GAAP, we have aggregated the business results for certain operating segments for financial reporting purposes.

 

Our capital measurement methodology is based on the concept of economic capital for our banking businesses. However, we have increased the capital assigned to Retail Banking to 6% of funds to reflect the capital required for well-capitalized banks and to approximate market comparables for this business. The capital for BlackRock and PFPC currently reflects legal entity shareholders’ equity, which exceeds required economic capital.

  

We have allocated the allowance for loan and lease losses and unfunded loan commitments and letters of credit based on our assessment of risk inherent in the loan portfolios. Our allocation of the costs incurred by operations and other support areas not directly aligned with the businesses is primarily based on the use of services.

 

Total business segment financial results differ from total consolidated results. The impact of these differences is primarily reflected in minority interest in income of BlackRock and in the “Other” category in the Results of Businesses – Summary table that follows. “Other” includes residual activities that do not meet the criteria for disclosure as a separate reportable business, such as asset and liability management activities, related net securities gains or losses, certain trading activities, equity management activities, differences between business segment performance reporting and financial statement reporting (GAAP), most corporate overhead and intercompany eliminations.

 

The period-end employee statistics disclosed for each business segment in the tables that follow reflect staff directly employed by the respective business segment and may exclude operations, technology and staff services employees not directly managed by the respective business segment.

RESULTS OF BUSINESSES - SUMMARY

(Unaudited)

 

     Earnings     Revenue (b)    

Return on

Average Capital (c)

    Average Assets (d)
Six months ended June 30 – dollars in millions    2006     2005     2006    2005     2006     2005     2006    2005

Retail Banking

   $375     $311     $1,535    $1,373     26 %   23 %   $29,326    $26,423

Corporate & Institutional Banking

   221     254     722    631     22     30     25,896    24,601

BlackRock

   134     100     775    534     29     25     1,924    1,563

PFPC

   53     47     426    426     29     35     2,416    2,083

Total business segments

   783     712     3,458    2,964     25     26     59,562    54,670

Minority interest in income of BlackRock

   (41 )   (30 )              

Other

   (7 )   (46 )   82    (8 )       33,230    30,802

Total consolidated (a)

   $735     $636     $3,540    $2,956     17 %   17 %   $92,792    $85,472
(a) Business segment revenue is presented on a taxable-equivalent basis. A reconciliation of total consolidated revenue on a book (GAAP) basis to total consolidated revenue on a taxable-equivalent basis follows:

 

Six months ended June 30 – (in millions)    2006    2005

Total consolidated revenue, book (GAAP) basis

   $3,527    $2,943

Taxable-equivalent adjustment

   13    13

Total consolidated revenue, taxable-equivalent basis

   $3,540    $2,956
(b) Amounts for BlackRock represent the sum of total operating revenue and nonoperating income. Amounts for PFPC represent the sum of servicing revenue and net nonoperating income (expense) less debt financing costs.
(c) Percentages for BlackRock and PFPC reflect return on average equity.
(d) Period-end balances for BlackRock and PFPC.

 

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Retail Banking (Unaudited)

 

Six months ended June 30

Taxable-equivalent basis

Dollars in millions

  2006     2005  

INCOME STATEMENT

   

Net interest income

  $832     $769  

Noninterest income

   

Asset management

  174     164  

Service charges on deposits

  148     122  

Brokerage

  117     109  

Consumer services

  174     128  

Other

  90     81  

Total noninterest income

  703     604  

Total revenue

  1,535     1,373  

Provision for credit losses

  37     29  

Noninterest expense

  891     848  

Pretax earnings

  607     496  

Minority interest

  9    

Income taxes

  223     185  

Earnings

  $375     $311  

AVERAGE BALANCE SHEET

   

Loans

   

Consumer

   

Home equity

  $13,797     $13,037  

Indirect

  1,003     904  

Other consumer

  1,225     1,156  

Total consumer

  16,025     15,097  

Commercial

  5,574     4,927  

Floor plan

  967     1,031  

Residential mortgage

  1,612     1,053  

Other

  243     275  

Total loans

  24,421     22,383  

Goodwill

  1,477     1,197  

Loans held for sale

  1,706     1,400  

Other assets

  1,722     1,443  

Total assets

  $29,326     $26,423  

Deposits

   

Noninterest-bearing demand

  $7,842     $7,366  

Interest-bearing demand

  7,987     7,820  

Money market

  14,671     13,039  

Total transaction deposits

  30,500     28,225  

Savings

  2,146     2,738  

Certificates of deposit

  13,339     10,642  

Total deposits

  45,985     41,605  

Other liabilities

  549     402  

Capital

  2,961     2,761  

Total funds

  $49,495     $44,768  

PERFORMANCE RATIOS

   

Return on average capital

  26 %   23 %

Noninterest income to total revenue

  46     44  

Efficiency

  58     62  

 

At June 30

Dollars in millions except

as noted

  2006     2005  

OTHER INFORMATION (a)

           

Credit-related statistics:

   

Total nonperforming assets (b)

  $104     $84  

Net charge-offs

  $33     $30  

Annualized net charge-off ratio

  .27 %   .27 %

Home equity portfolio credit statistics:

   

% of first lien positions

  45 %   48 %

Weighted average loan-to-value ratios

  69 %   70 %

Weighted average FICO scores

  728     720  

Loans 90 days past due

  .21 %   .18 %

Checking-related statistics:

   

Retail Banking checking relationships

  1,956,000     1,882,000  

Consumer DDA households using online banking

  897,000     793,000  

% of consumer DDA households using online banking

  51 %   47 %

Consumer DDA households using online bill payment

  305,000     167,000  

% of consumer DDA households using online bill payment

  17 %   10 %

Small business deposits:

   

Noninterest-bearing

  $4,338     $4,177  

Interest-bearing

  $1,423     $1,517  

Money market

  $2,661     $2,702  

Certificates of deposit

  $564     $353  

Brokerage statistics:

   

Margin loans

  $194     $218  

Financial consultants (c)

  775     789  

Full service brokerage offices

  100     98  

Brokerage account assets (billions)

  $43     $41  

Other statistics:

   

Gains on sales of education loans (d)

  $11     $4  

Full-time employees

  9,674     10,079  

Part-time employees

  1,526     832  

ATMs

  3,553     3,788  

Branches (e)

  846     827  

ASSETS UNDER ADMINISTRATION (billions) (f)

   

Assets under management:

   

Personal

  $40     $41  

Institutional

  10     9  

Total

  $50     $50  

Asset Type

   

Equity

  $31     $31  

Fixed income

  12     13  

Liquidity/Other

  7     6  

Total

  $50     $50  

Nondiscretionary assets under administration:

   

Personal

  $25     $26  

Institutional

  60     59  

Total

  $85     $85  

Asset Type

   

Equity

  $31     $31  

Fixed income

  26     26  

Liquidity/Other

  28     28  

Total

  $85     $85  
(a) Presented as of June 30 except for net charge-offs, annualized net charge-off ratio, gains on sales of education loans, and small business deposits, which are for the six months ended June 30.
(b) Includes nonperforming loans of $95 million at June 30, 2006 and $74 million at June 30, 2005.
(c) Financial consultants provide services in full service brokerage offices and PNC traditional branches.
(d) Included in “Noninterest income-Other”.
(e) Excludes certain satellite branches that provide limited products and service hours.
(f) Excludes brokerage account assets.

 

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Retail Banking’s earnings were $375 million for the first six months of 2006 compared with $311 million for the same period in 2005. Compared with the prior year, revenues increased 12% and noninterest expenses increased 5%, resulting in a 21% earnings improvement. The increase in earnings was driven by improved fee income from customers, higher taxable-equivalent net interest income fueled by continued customer and balance sheet growth, and a sustained focus on expense management.

Highlights of Retail Banking’s performance during the first six months of 2006 include:

 

·   Consumer and small business checking relationships increased by 74,000, or 4%, compared with June 30, 2005.
·   Consumer-related new checking relationships increased 4%, average consumer demand deposits increased 6% and home equity loans increased 6% compared with the prior year amounts.
·   Since June 30, 2005, consumer-related checking households using on-line banking increased 13% and checking households using on-line bill payment increased 83%.
·   The small business area continued its positive momentum. Average small business loans increased 14% over the first six months of 2005 on the strength of increased demand from both existing customers and new relationships. Small business checking relationships increased 5%.
·   Customer assets in brokerage accounts totaled $43 billion at June 30, 2006 compared with $41 billion at June 30, 2005. Brokerage fees increased $8 million or 7% over the first six months of 2005 as a result of increased distribution of investment products.
·   Retail Banking’s efficiency ratio improved to 58% compared with 62% a year earlier.
·   The branch network increased a net 19 branches to a total of 846 branches at June 30, 2006 compared with June 30, 2005. This increase was comprised of 26 new branches with 7 branch consolidations. Our strategy is to continue to optimize our network by opening new branches in high growth areas and consolidating branches in areas of declining market opportunity and/or growth.
·   Asset quality remains very strong.

Total revenue for the first six months of 2006 was $1.535 billion compared with $1.373 billion for the same period last year. Taxable-equivalent net interest income of $832 million increased $63 million, or 8%, compared with 2005 due to an 11% increase in average deposits and a 9% increase in average loan balances. The net interest income growth has been somewhat mitigated by declining spreads on the loan portfolio.

 

Noninterest income increased $99 million, or 16%, compared with the first six months of 2005 primarily driven by increased consumer services fees and service charges on deposits. This growth can be attributed primarily to the following:

 

·   Customer growth,
·   Expansion of the branch network, including a new market,
·   Consolidation of our merchant services activities,
·   Increased brokerage account assets and activities,
·   Increased asset management fees,
·   Increased third party loan servicing activities, and
·   Various pricing actions resulting from the One PNC initiative.

The provision for credit losses increased $8 million in the first six months of 2006 compared with 2005. Overall asset quality remained strong despite the increase in nonperforming loans, net charge-offs, and provision, which was primarily driven by a single large overdraft situation.

Noninterest expense in the first six months of 2006 totaled $891 million, an increase of $43 million, or 5%, compared with the first six months of 2005. Operating costs increased $42 million compared with the prior year period as a result of our expansion into the greater Washington, DC area. Other expense increases were primarily attributable to continued growth of the company’s branch network, the consolidation of the company’s merchant services activities and an increase in volume related expenses tied to revenue, offset by lower staff-related expense as a result of One PNC initiatives.

Full-time employees at June 30, 2006 totaled 9,674, a decline of 405 from June 30, 2005. Part-time employees have increased by 694 since June 30, 2005. The decline in full-time employees and increase in part-time employees is a direct result of various cost-saving initiatives. These initiatives include utilizing more part-time customer-facing employees during peak business hours versus full-time employees for the entire day.


 

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We have adopted a relationship-based lending strategy to target specific customer sectors (homeowners, small businesses and auto dealerships) while seeking to maintain a moderate risk profile in the loan portfolio.

 

·   Average commercial loans grew $647 million, or 13%, on the strength of increased loan demand from existing small business customers and the acquisition of new relationships through our sales efforts.
·   Average home equity loans grew by $760 million, or 6%, compared with the first six months of 2005. Consumer loan demand is starting to slow as a result of the rising rate environment.
·   Average indirect loans grew $99 million, or 11%, compared with the first six months of 2005. The indirect auto business benefited from increased sales and marketing efforts.
·   Average residential mortgage loans increased $559 million, or 53%, primarily due to the addition of loans from the greater Washington, DC area acquisition. Payoffs in our existing portfolio, which will continue throughout 2006, reduced the impact of the additional loans acquired.

Growing core checking deposits as a lower cost-funding source and as the cornerstone product to build customer relationships is the primary objective of our deposit strategy. Average total deposits increased $4.4 billion, or 11%, compared with the first six months of 2005. The deposit growth was driven by increases in the number of checking relationships and the recapture of consumer certificate of deposit balances as interest rates have risen.

During this rising rate environment, we expect the rate of growth in demand deposit balances to be less than the rate of growth for customer checking relationships. Additionally, we expect to see customers shift their funds from lower yielding interest-bearing deposits to higher yielding deposits or investment products, and to

pay off loans. The shift has been evident during the last three to four quarters and has impacted the level of average demand deposits in that period.

 

·   Certificates of deposits increased $2.7 billion and money market deposits increased $1.6 billion. These increases were attributable to the rising interest rate environment attracting customers back into these products.
·   Average demand deposit growth of $.6 billion, or 4%, was driven by a $.8 billion increase from the expansion into the greater Washington, DC area and a decline of $.2 billion in the core business due to customers shifting funds into higher yielding deposits, business sweep products, and investment products.
·   Small business and consumer-related checking relationships retention remains strong and stable. Consumer-related checking relationship retention has benefited from improved penetration rates of debit cards, online banking and online bill payment.

Assets under management of $50 billion at June 30, 2006 remained unchanged compared with the balance at June 30, 2005. The effect of comparatively higher equity markets was offset by client net asset outflows. Client net asset outflows are the result of ordinary course distributions from trust and investment management accounts and account closures exceeding investment additions from new and existing clients.

Nondiscretionary assets under administration of $85 billion at June 30, 2006 also remained unchanged compared with the balance at June 30, 2005. The effect of comparatively higher equity markets was offset by the loss of a sizeable master custody agreement in the first quarter of 2006.


 

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CORPORATE & INSTITUTIONAL BANKING

(Unaudited)

 

Six months ended June 30

Taxable-equivalent basis

Dollars in millions except as noted

  2006   2005  

INCOME STATEMENT

   

Net interest income

  $348   $361  

Noninterest income
Corporate service fees

  246   181  

Other

  128   89  

Noninterest income

  374   270  

Total revenue

  722   631  

Provision for (recoveries of) credit losses

  29   (52 )

Noninterest expense

  368   309  

Pretax earnings

  325   374  

Income taxes

  104   120  

Earnings

  $221   $254  

AVERAGE BALANCE SHEET

   

Loans

   

Corporate (a)

  $9,834   $10,680  

Commercial real estate

  2,702   1,974  

Commercial – real estate related

  2,469   1,952  

Asset-based lending

  4,353   4,177  

Total loans (a)

  19,358   18,783  

Loans held for sale

  871   646  

Other assets

  5,667   5,172  

Total assets

  $25,896   $24,601  

Deposits

  $9,519   $8,925  

Commercial paper (b)

    2,148  

Other liabilities

  3,581   3,355  

Capital

  1,986   1,681  

Total funds

  $15,086   $16,109  

Earnings from Corporate & Institutional Banking for the first six months of 2006 totaled $221 million compared with $254 million for the first six months of 2005. This decline was primarily attributable to a $53 million loan recovery recognized in the second quarter of 2005 compared with a $29 million provision for credit losses in the first half of 2006. In addition to the $81 million swing in the provision for credit losses, total revenue increased $91 million and noninterest expenses grew by $59 million for the first six months of 2006 compared with the comparable 2005 period.

 

Six months ended June 30

Taxable-equivalent basis

Dollars in millions except as noted

  2006     2005  

PERFORMANCE RATIOS

   

Return on average capital

  22 %   30 %

Noninterest income to total revenue

  52     43  

Efficiency

  51     49  
COMMERCIAL MORTGAGE SERVICING PORTFOLIO (in billions)    

Beginning of period

  $136     $98  

Acquisitions/additions

  32     35  

Repayments/transfers

  (17)     (14)  

End of period

  $151     $119  

OTHER INFORMATION

   

Consolidated revenue from: (c)

   

Treasury Management

  $208     $200  

Capital Markets

  $140     $71  

Midland Loan Services

  $84     $64  

Equipment Leasing

  $38     $36  

Total loans (a) (d)

  $20,057     $20,726  

Nonperforming assets (d) (e)

  $125     $77  

Net charge-offs (recoveries)

  $16     $(56)  

Full-time employees (d)

  1,899     1,791  

Net gains on commercial mortgage loan sales

  $25     $27  

Net carrying amount of commercial mortgage servicing rights (d)

  $385     $276  
(a) Includes lease financing and Market Street. Effective October 17, 2005, Market Street was deconsolidated from our Consolidated Balance Sheet.
(b) Amount for 2005 includes Market Street.
(c) Represents consolidated PNC amounts.
(d) At June 30.
(e) Includes nonperforming loans of $112 million at June 30, 2006 and $57 million at June 30, 2005.

Highlights of the first six months of 2006 for Corporate & Institutional Banking included:

 

·   Average loan balances increased $575 million, or 3%, over 2005. The prior year average included $2.1 billion in loans from the Market Street Funding commercial paper conduit that was deconsolidated in October 2005. Excluding the impact of deconsolidating the conduit, average loan balances increased 16%. The growth in loans was driven by continuing customer demand, increasing utilization and our expansion into the greater Washington, DC area in May 2005. Based upon the impact of increasing competitive pressures and shrinking loan spreads on PNC’s risk/reward criteria, we expect slower growth in loans during the remainder of 2006.
·   Average deposits increased $594 million, or 7%, over the prior year first half driven by growth in our commercial mortgage servicing portfolio and related deposits and the sale of treasury management products. As more clients improve the management of their overall liquidity given the higher rate environment, we anticipate slower growth in deposits for the remainder of 2006.
·   Total revenue increased 14% compared with 2005 as strong growth in fee income offset a modest decline in taxable-equivalent net interest income. This growth was driven by increases in capital markets activities, including mergers and acquisitions advisory activities, Midland Loan Services and treasury management products and services.

 

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·   Commercial mortgage servicing revenue, which includes fees and net interest income, totaled $84 million for the first six months of 2006. The 31% revenue growth was primarily driven by growth in the commercial mortgage servicing portfolio, which increased to $151 billion, or 27%, and in other commercial real estate related services.
·   Noninterest expense increased 19% compared with the first half of 2005. The increases in noninterest expenses and full-time employees were primarily due to acquisition activity and customer growth.

Taxable-equivalent net interest income declined $13 million, to $348 million, for the first six months of 2006 compared with the first six months of 2005. This decline was attributable to narrowing loan spreads partially offset by an increase in average loans outstanding.

Noninterest income totaled $374 million in the first half of 2006, an increase of $104 million, or 39%, compared with the prior year first half. The increase in corporate service fees reflected fee income attributable to the Harris Williams acquisition completed in October 2005 and growth in commercial mortgage servicing and treasury management revenues, partially offset by lower loan syndications income. Improved trading results partially offset by a decline in net gains on commercial mortgage loan sales drove the increase in other noninterest income.

 

The provision for credit losses was $29 million for the first six month months of 2006 compared with a credit of $52 million for the first six months of 2005. The prior year provision credit reflected the impact of the $53 million loan recovery referred to above. The higher provision for credit losses in the first half of 2006 reflected loan growth compared with the prior year first half and $16 million of net charge-offs during this period. Due to increases in nonperforming loans, nonperforming assets at June 30, 2006 increased $48 million compared with June 30, 2005, and were flat compared with the level at December 31, 2005. Based on the assets we currently hold and current business trends and activities, we believe that overall asset quality will remain strong at least for the near term. However, we anticipate that credit loss provisioning will continue with the growth of the loan portfolio and nonperforming loans will increase in future quarters.

See the additional revenue discussion regarding treasury management and capital markets-related products and services, commercial loan servicing, and equipment leasing products on page 8.


 

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BLACKROCK (Unaudited)

 

Six months ended June 30

Taxable-equivalent basis

Dollars in millions except as noted

  2006     2005  
INCOME STATEMENT    

Investment advisory and administrative fees

  $663     $443  

Other income

  93     78  

Total operating revenue

  756     521  

Operating expense

  539     354  

Fund administration and servicing costs

  21     19  

Total expense

  560     373  

Operating income

  196     148  

Nonoperating income

  19     13  

Pretax earnings

  215     161  

Minority interest

  1     1  

Income taxes

  80     60  

Earnings

  $134     $100  
PERIOD-END BALANCE SHEET    

Goodwill and other intangible assets

  $490     $500  

Other assets

  1,434     1,063  

Total assets

  $1,924     $1,563  

Liabilities and minority interest

  $883     $709  

Stockholders’ equity

  1,041     854  

Total liabilities and stockholders’ equity

  $1,924     $1,563  
PERFORMANCE DATA    

Return on average equity

  29 %   25 %

Operating margin (a)

  26     28  

Diluted earnings per share

  $2.02     $1.49  
ASSETS UNDER MANAGEMENT (in billions) (b)    

Separate accounts

   

Fixed income

  $283     $258  

Cash management

  10     8  

Cash management – securities lending

  11     7  

Equity

  23     19  

Alternative investment products

  27     23  

Total separate accounts

  354     315  

Mutual funds (c)

   

Fixed income

  25     26  

Cash management

  67     60  

Equity

  18     13  

Total mutual funds

  110     99  

Total assets under management

  $464     $414  
OTHER INFORMATION    

Full-time employees (b)

  2,317     2,141  

 

(a) While BlackRock reports its financial results on a GAAP basis, management believes that in evaluating its results, it is also useful to review additional non-GAAP measures, including operating margin, as adjusted, which is calculated as operating income excluding, net of tax, the State Street Research and Management (SSRM) fee-sharing payment, the LTIP expense, SSRM acquisition costs, Merrill Lynch Investment Managers (MLIM) transaction costs, and appreciation on Rabbi trust assets related to BlackRock’s deferred compensation plans divided by total revenue less, net of tax, reimbursable property management compensation and fund administration and servicing costs. We do not advocate that investors consider such non-GAAP financial measures in isolation from, or as a substitute for, financial information prepared in accordance with GAAP. The following is a reconciliation of this presentation to operating margin calculated on a GAAP basis (operating income divided by total revenue) in millions.

 

Six months ended June 30   2006     2005  

Operating income, GAAP basis

  $196     $148  

Add back: SSRM fee-sharing payment

  34    

Add back: LTIP expense

  29     30  

Less: portion of LTIP to be funded by BlackRock

  (5 )   (6 )

Add back: SSRM acquisition costs

    9  

Add back: MLIM transaction costs

  19    

Add back: appreciation on assets related to deferred compensation plans

  6     2  

Operating income, as adjusted

  $279     $183  

Total revenue, GAAP basis

  $756     $521  

Less: reimbursable property management compensation

  11     10  

Less: fund administration and servicing costs

  21     19  

Revenue used for operating margin calculation, as reported

  $724     $492  

Operating margin, GAAP basis

  26%     28%  

Operating margin, as adjusted

  39%     37%  

 

   We believe that operating margin, as adjusted, is an effective indicator of management’s ability to, and useful to management in deciding how to, effectively employ BlackRock’s resources. As such, we believe operating margin, as adjusted, provides useful disclosure to investors. The 2006 SSRM fee-sharing payment was excluded because it represents a non-recurring payment (based on a performance fee) pursuant to the SSRM acquisition agreement. The portion of the LTIP expense associated with awards to be met by the distribution to the LTIP participants of shares of BlackRock stock currently held by PNC has been excluded from operating income, as adjusted, because, exclusive of the potential impact related to LTIP participants’ put options, these charges will not impact BlackRock’s book value. SSRM acquisition costs consist of certain compensation costs and professional fees incurred in 2005. Compensation expense reflected in this amount represents direct incentives related to alternative product performance fees generated in 2004 by SSRM employees, assumed in conjunction with the acquisition and settled by BlackRock with no future service requirement. Compensation expense associated with appreciation on Rabbi trust assets related to BlackRock’s deferred compensation plans has been excluded because investment returns on these assets reported in nonoperating income, net of the related impact on compensation expense, result in a nominal impact on net income. MLIM transaction costs consist of compensation costs and certain professional fees incurred in 2006 related to the pending MLIM transaction. We have excluded fund administration and servicing costs from the operating margin, as adjusted, calculation because BlackRock receives offsetting revenue and expense for these services. Reimbursable property management compensation represents compensation and benefits paid to certain BlackRock Realty Advisors, Inc. (“Realty”) personnel. These employees are retained on Realty’s payroll when properties are acquired for Realty’s clients. The related compensation and benefits are fully reimbursed by Realty’s clients and have been excluded from revenue used for operating margin measurement, as adjusted, because they bear no economic cost to BlackRock.
(b) At June 30.
(c) Includes BlackRock Funds, BlackRock Liquidity Funds, BlackRock Closed-End Funds, PNC Investment Contract Fund and BlackRock Global Series plc.

 

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BlackRock reported earnings of $134 million for the first six months of 2006 compared with $100 million for the first six months of 2005. Higher earnings in 2006 reflected higher investment advisory and administration fees due to an increase in assets under management and increased performance fees. These factors more than offset the increase in expense due to increased compensation and benefits, general and administration expense, and a one-time expense of $34 million incurred in the first quarter of 2006 related to the January 2005 acquisition of SSRM. Earnings for the first half of 2005 included nonrecurring pretax expenses of $9 million associated with the SSRM acquisition.

Total operating revenue increased $235 million, or 45%, in the first six months of 2006 compared with the prior year period. The impact of higher assets under management and increased investment advisory and administration fees in 2006 was reflected in the significantly higher revenue. The increase in investment advisory and administration fees was the result of increases in fees earned across all asset classes as well as increased performance fees principally related to a large institutional real estate equity client account and an energy equity hedge fund acquired in the 2005 SSRM transaction.

Total expense for the first half of 2006 increased $187 million, or 50%, compared with the first half of 2005, primarily due to an increase in compensation and benefits. This increase reflected higher incentive compensation associated with higher performance fees and increased operating income growth, and higher salaries and benefits primarily attributable to higher staffing levels associated with business growth. Higher general and administration expense and the SSRM one-time expense of $34 million recognized in 2006 were also evident in the increase over the first half of 2005.

 

Assets under management at June 30, 2006 increased $50 billion, or 12%, compared with June 30, 2005. The increase was primarily attributable to net new business. The increase in assets under management reflected net subscriptions of $42 billion and market appreciation of $8 billion in the 12-month period.

The Executive Summary section of this Financial Review has further information related to BlackRock’s first quarter 2006 announcement of the pending transaction pursuant to which Merrill Lynch would contribute its investment management business to BlackRock in exchange for newly issued BlackRock common and preferred stock. Additional information on this transaction is also included in Note 2 Acquisitions in the Notes To Consolidated Financial Statements included in this Report.

BlackRock is listed on the New York Stock Exchange under the symbol BLK. Additional information about BlackRock is available in its SEC filings, which can be found at www.sec.gov and on BlackRock’s website, www.blackrock.com.


 

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PFPC (Unaudited)

 

Six months ended June 30

Dollars in millions except as noted

  2006     2005  

INCOME STATEMENT

   

Servicing revenue

  $445     $441  

Other revenue

        10  

Total operating revenue

  445     451  

Operating expense

  333     342  

Amortization of other intangibles, net

  7     7  

Total expense

  340     349  

Operating income

  105     102  

Debt financing

  21     18  

Nonoperating income (expense) (a)

  2     (7 )

Pretax earnings

  86     77  

Income taxes

  33     30  

Earnings

  $53     $47  

PERIOD-END BALANCE SHEET

   

Goodwill and other intangible assets

  $1,018     $1,009  

Other assets

  1,398     1,074  

Total assets

  $2,416     $2,083  

Debt financing

  $852     $987  

Other liabilities

  1,137     778  

Shareholder’s equity

  427     318  

Total funds

  $2,416     $2,083  

PERFORMANCE RATIOS

   

Return on average equity

  29 %   35 %

Operating margin (b)

  24     23  

SERVICING STATISTICS (at June 30)

   

Accounting/administration net fund assets (in billions) (c)

   

Domestic

  $671     $699  

Offshore

  72     67  

Total

  $743     $766  

Asset type (in billions)

   

Money market

  $247     $333  

Equity

  317     262  

Fixed income

  110     111  

Other

  69     60  

Total

  $743     $766  

Custody fund assets (in billions)

  $389     $462  

Shareholder accounts (in millions)

   

Transfer agency

  18     20  

Subaccounting

  47     38  

Total

  65     58  

OTHER INFORMATION

   

Full-time employees (at June 30)

  4,314     4,599  
(a)  Net of nonoperating expense.
(b)  Operating income divided by total operating revenue.
(c)  Includes alternative investment net assets serviced.

PFPC’s earnings of $53 million in the first six months of 2006 increased $6 million, or 13%, compared with the first six months of 2005. Higher earnings in the first half of 2006 reflected servicing revenue contributions from several growth areas of the business and the successful implementation of expense control initiatives which improved the company’s operating margin.

Highlights of PFPC’s performance in the first six months of 2006 included:

 

  ·   Offshore revenues increased 40% compared with the first half of 2005 fueled by new business in the alternative arena.

 

  ·   Managed account service revenue increased 31% due to a 72% increase in assets serviced.

 

  ·   Subaccounting revenues were up 12% as shareholder accounts grew by 24%.

Servicing revenue for the first six months of 2006 increased $4 million over the prior year first half, to $445 million. Excluding the $5 million comparative decline in revenue related to out-of-pocket and pass-through items that had no impact on earnings, servicing revenue increased $9 million compared with the first six months of 2005. Revenue increases related to offshore activities, custody, securities lending, subaccounting, and managed account services drove the higher servicing revenue in 2006, partially offset by a decline in fund accounting and transfer agency revenue due to loss of clients and price concessions.

In January 2005 PFPC accepted approximately $10 million to resolve a client contract dispute, which is reflected as other revenue in the table on this page.

Operating expense declined $9 million, to $333 million, in the first six months of 2006 compared with the first six months of 2005. Out-of-pocket and pass-through items declined by $5 million. The remainder of the decline is attributable to expense control and efficiencies implemented during the past year which resulted in a lower head count and the associated lower compensation costs.

Effective January 2005, PFPC restructured its remaining intercompany term debt obligations given the comparatively favorable interest rate environment at that time. PFPC recorded intercompany debt prepayment penalties, which are reflected as nonoperating expense in the preceding table, totaling $8 million on a pretax basis in the first quarter of 2005 to effect the restructuring. The current rising rate environment has caused debt expense to increase on a year to year comparison despite a reduction in outstandings.

The decreases in domestic accounting/administration net fund assets and custody fund assets at June 30, 2006 compared with June 30, 2005 resulted primarily from the deconversion of a major client during the first quarter of 2006, which was partially offset by new business, asset inflows from existing customers and equity market appreciation. Subaccounting shareholder accounts serviced by PFPC increased over the year-earlier period due to net new business and growth in existing client accounts. Total assets serviced by PFPC amounted to $1.9 trillion at both June 30, 2006 and June 30, 2005.

PFPC’s performance is partially dependent on the underlying performance of its fund clients and, in particular, their ability to attract and retain customers. As a result, to the extent that PFPC clients’ businesses are adversely affected by ongoing governmental investigations into the practices of the mutual and hedge fund industries, PFPC’s results also could be adversely impacted. In addition, this regulatory and business environment is likely to continue to result in operating margin pressure for our various services.


 

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CRITICAL ACCOUNTING POLICIES AND JUDGMENTS

Note 1 Accounting Policies in the Notes To Consolidated Financial Statements included in Part I, Item 1 of this Report and in Part II, Item 8 of our 2005 Form 10-K describe the most significant accounting policies that we use. Certain of these policies require us to make estimates and strategic or economic assumptions that may prove inaccurate or be subject to variations that may significantly affect our reported results and financial position for the period or in future periods.

We must use estimates, assumptions, and judgments when financial assets and liabilities are required to be recorded at, or adjusted to reflect, fair value. Assets and liabilities carried at fair value inherently result in a higher degree of financial statement volatility. Fair values and the information used to record valuation adjustments for certain assets and liabilities are based on either quoted market prices or are provided by other independent third-party sources, when available. When such third-party information is not available, we estimate fair value primarily by using cash flow and other financial modeling techniques. Changes in underlying factors, assumptions, or estimates in any of these areas could materially impact our future financial condition and results of operations.

We discuss the following critical accounting policies and judgments under this same heading in Item 7 of our 2005 Form 10-K:

  ·   Allowances for loan and lease losses and unfunded loan commitments and letters of credit
  ·   Private equity asset valuation
  ·   Lease residuals
  ·   Goodwill
  ·   Revenue recognition
  ·   Income taxes
  ·   Legal contingencies

Additional discussion and information on the application of these policies is found in other portions of this Financial Review and in the Notes To Consolidated Financial Statements in Part I, Item 1 of this Report.

2002 BLACKROCK LONG-TERM

RETENTION AND INCENTIVE PLAN

We describe BlackRock’s long-term retention and incentive plan (“LTIP”) in Note 18 Stock-Based Compensation Plans in the Notes To Consolidated Financial Statements included in Part II, Item 8 of our 2005 Form 10-K. We reported pretax expense of $26 million in the first six months of 2006 and $32 million in the first six months of 2005 related to LTIP awards.

 

STATUS OF DEFINED BENEFIT PENSION PLAN

We have a noncontributory, qualified defined benefit pension plan (“plan” or “pension plan”) covering eligible employees. Retirement benefits are derived from a cash balance formula based on compensation levels, age and length of service. Pension contributions are based on an actuarially determined amount necessary to fund total benefits payable to plan participants. Plan assets are currently approximately 60% invested in equity investments with most of the remainder invested in fixed income instruments. Plan fiduciaries determine and review the plan’s investment policy.

We calculate the expense associated with the pension plan in accordance with Statement of Financial Accounting Standards No. (“SFAS”) 87, “Employers’ Accounting for Pensions,” and we use assumptions and methods that are compatible with the requirements of SFAS 87, including a policy of reflecting trust assets at their fair market value. On an annual basis, we review the actuarial assumptions related to the pension plan, including the discount rate, rate of compensation increase and the expected return on plan assets. Neither the discount rate nor the compensation increase assumptions significantly affect pension expense.

The expected long-term return on assets assumption does significantly affect pension expense. We decreased the expected long-term return on plan assets assumption from the 8.5% used for 2005 to 8.25% for determining net periodic cost for 2006. This change will increase estimated pension expense in 2006 by approximately $4 million. Also, under current accounting rules, the differences between expected long-term returns and actual returns are accumulated and amortized to pension expense over future periods. Each one percentage point difference between our actual return and the expected return causes our expense in the following year to change by up to $3 million.

The table below reflects the estimated effects on current year pension expense of certain changes in assumptions, using 2006 estimated expense as a baseline.

 

Change in Assumption  

    
Estimated

Increase to 2006

Pension Expense

(in millions)

.5% decrease in discount rate

  $2

.5% decrease in expected long-term return on assets

  8

.5% increase in compensation rate

  1

We currently estimate a pretax pension benefit of $12 million in 2006 compared with a pretax benefit of $8 million in 2005. Actual pension benefit recognized for the first six months of 2006 totaled $6 million.


 

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In accordance with SFAS 87 and SFAS 132 (Revised 2003), “Employers’ Disclosures about Pensions and Other Postretirement Benefits,” we may have to eliminate any prepaid pension asset and recognize a minimum pension liability if the accumulated benefit obligation exceeds the fair value of plan assets at year-end. We would recognize the corresponding charge as a component of other comprehensive income and it would reduce total shareholders’ equity, but it would not affect net income. At December 31, 2005, the fair value of plan assets was $1.627 billion, which exceeded the accumulated benefit obligation of $1.232 billion. The status at year-end 2006 will depend primarily upon 2006 investment returns and the level of contributions, if any, we make to the plan during 2006.

Plan asset investment performance has the most impact on contribution requirements. However, contribution requirements are not particularly sensitive to actuarial assumptions. Investment performance will drive the amount of permitted contributions in future years. Also, current law sets limits as to both minimum and maximum contributions to the plan. In any event, any large near-term contributions to the plan will be at our discretion, as we currently expect that the minimum required contributions under the law will be minimal or zero for several years.

We maintain other defined benefit plans that have a less significant effect on financial results, including various nonqualified supplemental retirement plans for certain employees.

In March 2006, the FASB issued an Exposure Draft on a Proposed Statement of Financial Accounting Standards, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans - an amendment of FASB Statements No. 87, 88, 106, and 132(R)” proposing changes that would affect the accounting and reporting for our qualified pension plan, our nonqualified retirement plans, and our postretirement welfare benefit plans. The FASB expects to issue a final standard during the third quarter of 2006 with the changes applied prospectively at December 31, 2006. For additional information on the Exposure Draft, see the “Recent Accounting Pronouncements” section of Note 1 Accounting Policies in the Notes To Consolidated Financial Statements in this Report.

 

RISK MANAGEMENT

We encounter risk as part of the normal course of our business and we design risk management processes to help manage these risks. The Risk Management section included in Item 7 of our 2005 Form 10-K provides a general overview of the risk measurement, control strategies and monitoring aspects of our corporate-level risk management processes. Additionally, our 2005 Form 10-K provides an analysis of the risk management processes for what we view as our primary areas of risk: credit, operational, market and liquidity, as well as a discussion of our use of financial derivatives as part of our overall asset and liability risk management process. In appropriate places within that section, historical performance is also addressed. The following information in this Risk Management section updates our 2005 Form 10-K disclosures in these areas.

CREDIT RISK MANAGEMENT

Credit risk represents the possibility that a customer, counterparty or issuer may not perform in accordance with contractual terms. Credit risk is inherent in the financial services business and results from extending credit to customers, purchasing securities, and entering into financial derivative transactions. Credit risk is one of the most common risks in banking and is one of our most significant risks.

Nonperforming, Past Due And Potential Problem Assets

See Note 4 Asset Quality in the Notes To Consolidated Financial Statements of this Report and included here by reference for details of the types of nonperforming assets that we held at June 30, 2006 and December 31, 2005. In addition, certain performing assets have interest payments that are past due or have the potential for future repayment problems.

Total nonperforming assets at June 30, 2006 increased $15 million, to $231 million, compared with December 31, 2005 driven by an $18 million increase in nonperforming loans.

Foreclosed lease assets of $12 million at June 30, 2006 and $13 million at December 31, 2005 primarily represent our repossession of collateral related to a single airline industry credit. This repossessed collateral is currently being leased.

The amount of nonperforming loans that was current as to principal and interest was $121 million at June 30, 2006 and $115 million at December 31, 2005. While we believe that overall asset quality will remain strong for the near term, we anticipate an increase in nonperforming loans going forward. The current level of asset quality is not sustainable.


 

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Nonperforming Assets By Business

 

In millions  

June 30

2006

 

December 31

2005

Retail Banking

  $104   $90

Corporate & Institutional Banking

  125   124

Other

  2   2

Total nonperforming assets

  $231   $216

Change In Nonperforming Assets

 

In millions   2006     2005  

January 1

  $216     $175  

Transferred from accrual

  127     79  

Returned to performing

  (10 )   (9 )

Principal activity including payoffs

  (46 )   (46 )

Asset sales

  (11 )   (7 )

Charge-offs and valuation adjustments

  (45 )   (28 )

June 30

  $231     $164  

Accruing Loans And Loans Held For Sale Past Due 90 Days Or More

 

    Amount  

Percent of Total

Outstandings

 
Dollars in millions  

June 30

2006

 

Dec. 31

2005

 

June 30

2006

   

Dec. 31

2005

 

Commercial

  $5   $12   .02 %   .06 %

Commercial real estate

  2   2   .06     .06  

Consumer

  19   22   .12     .14  

Residential mortgage

  7   10   .09     .14  

Other

  2        .56    

Total loans

  35   46   .07     .09  

Loans held for sale

  27   47   1.25     1.92  

Total loans and loans held for sale

  $62   $93   .12 %   .18 %

Loans and loans held for sale that are not included in nonperforming or past due categories but cause us to be uncertain about the borrower’s ability to comply with existing repayment terms over the next six months totaled $30 million and zero, respectively, at June 30, 2006 compared with $67 million and zero, respectively, at December 31, 2005. Approximately 63% of these loans are in the Corporate & Institutional Banking portfolio.

Allowances For Loan And Lease Losses And Unfunded Loan Commitments And Letters Of Credit

We maintain an allowance for loan and lease losses to absorb losses from the loan portfolio. We determine the allowance based on quarterly assessments of the probable estimated losses inherent in the loan portfolio. While we make allocations to specific loans and pools of loans, the total reserve is available for all loan and lease losses.

We refer you to Note 4 Asset Quality in the Notes To Consolidated Financial Statements in this Report regarding changes in the allowance for loan and lease losses and the allowance for unfunded loan commitments and letters of credit for additional information which is included herein by reference.

 

Allocation Of Allowance For Loan And Lease Losses

 

    June 30, 2006     December 31, 2005  
Dollars in millions   Allowance  

Loans to

Total

Loans

    Allowance  

Loans to

Total

Loans

 

Commercial

  $502   40.5 %   $489   39.2 %

Commercial real estate

  29   6.3     32   6.4  

Consumer

  25   32.3     24   33.1  

Residential mortgage

  7   14.7     7   14.9  

Lease financing

  45   5.5     41   5.7  

Other

  3   .7     3   .7  

Total

  $611   100.0 %   $596   100.0 %

In addition to the allowance for loan and lease losses, we maintain an allowance for unfunded loan commitments and letters of credit. We report this allowance as a liability on our Consolidated Balance Sheet. We determine this amount using estimates of the probability of the ultimate funding and losses related to those credit exposures. This methodology is similar to the one we use for determining the adequacy of our allowance for loan and lease losses.

The provision for credit losses for the first six months of 2006 and the evaluation of the allowances for loan and lease losses and unfunded loan commitments and letters of credit as of June 30, 2006 reflected loan growth, changes in loan portfolio composition, the impact of refinements to our reserve methodology, and changes in asset quality. The provision includes amounts for probable losses on loans and credit exposure related to unfunded loan commitments and letters of credit.

We do not expect to sustain asset quality at its current level. However, based on the assets we currently hold and current business trends and activities, we believe that overall asset quality will remain strong by historical standards for at least the near term. This outlook, combined with expected loan growth, may result in an increase in the allowance for loan and lease losses in future periods.

The allowance as a percent of nonperforming loans was 294% and as a percent of total loans was 1.21% at June 30, 2006. The comparable percentages at December 31, 2005 were 314% and 1.21%.

Charge-Offs And Recoveries

 

Six months ended
June 30 Dollars in
millions
  Charge-offs   Recoveries  

Net

Charge-offs

   

Percent of

Average

Loans

 

2006

       

Commercial

  $46   $10   $36     .36 %

Consumer

  24   8   16     .20  

Lease financing

       4   (4 )   (.29 )

Total

  $70   $22   $48     .20  

2005

       

Commercial (a)

  $28   $68   $ (40)   (.43 )%

Consumer

  21   7   14     .18  

Residential mortgage

  1     1     .04  

Lease financing

       1   (1 )   (.07 )

Total

  $50   $76   $ (26)   (.12 )
(a) Includes a $53 million loan recovery.

 

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We establish reserves to provide coverage for probable losses not considered in the specific, pool and consumer reserve methodologies, such as, but not limited to, industry concentrations and conditions; credit quality trends; recent loss experience in particular sectors of the portfolio; ability and depth of lending management; changes in risk selection and underwriting standards; and the timing of available information. The amount of reserves for these qualitative factors is assigned to loan categories and to business segments based on the relative specific and pool allocation amounts. The amount of reserve allocated for qualitative factors represented 8% of the total allowance and .1% of total loans at June 30, 2006.

CREDIT DEFAULT SWAPS

Credit default swaps provide, for a fee, an assumption by a third party of a portion of the credit risk related to the underlying financial instruments. We use the contracts to mitigate credit risk associated with commercial lending activities as well as proprietary derivative and convertible bond trading. Credit default swaps are included in the Free-Standing Derivatives table in the Financial Derivatives section of this Risk Management discussion. We realized a net loss of $4.5 million during the first six months of 2006 and minimal net gains during the same period of 2005 in connection with credit default swaps.

MARKET RISK MANAGEMENT OVERVIEW

Market risk is the risk of a loss in earnings or economic value due to adverse movements in market factors such as interest rates, credit spreads, foreign exchange rates, and equity prices.

MARKET RISK MANAGEMENT – INTEREST RATE RISK

Interest rate risk results primarily from our traditional banking activities of gathering deposits and extending loans. Many factors, including economic and financial conditions, movements in interest rates, and consumer preferences, affect the difference between the interest that we earn on assets and the interest that we pay on liabilities. Because of repricing term mismatches and embedded options inherent in certain of these products, changes in market interest rates not only affect expected near-term earnings, but the economic values of these assets and liabilities as well.

PNC’s Asset and Liability Management group centrally manages interest rate risk subject to interest rate risk limits and certain policies approved by the Asset and Liability Committee and the Risk Committee of the Board.

 

Sensitivity estimates and market interest rate benchmarks for the second quarter of 2006 and 2005 follow:

Interest Sensitivity Analysis

 

     

Second

Quarter

2006

   

Second

Quarter

2005

 

Net Interest Income Sensitivity Simulation

      

Effect on net interest income in first year from gradual interest rate change over following 12 months of:

      

100 basis point increase

   (1.3 )%   1.5 %

100 basis point decrease

   1.2 %   (2.0 )%

Effect on net interest income in second year from gradual interest rate change over the preceding 12 months of:

      

100 basis point increase

   (3.6 )%   3.1 %

100 basis point decrease

   2.8 %   (6.9 )%

Duration of Equity Model

      

Base case duration of equity (in years):

   1.0     (2.0 )

Key Period-End Interest Rates

      

One-month LIBOR

   5.33 %   3.34 %

Three-year swap

   5.62 %   4.03 %

In addition to measuring the effect on net interest income assuming parallel changes in current interest rates, we routinely simulate the effects of a number of nonparallel interest rate environments. The following Net Interest Income Sensitivity To Alternate Rate Scenarios table reflects the estimated percentage change in net interest income over the next two 12-month periods assuming (i) the PNC Economist’s most likely rate forecast, (ii) implied forward rates, which result in an essentially flat rate scenario, and (iii) a Two-Ten Inversion (200 basis points differential between two-year and ten-year rates) scenario. We are inherently sensitive to a flatter or inverted yield curve.

Net Interest Income Sensitivity To Alternate Rate Scenarios (for second quarter 2006)

 

     

PNC

Economist

   

Market

Forward

   

Two-Ten

Inversion

 

First year sensitivity

   .9 %   (.3 )%   (4.5 )%

Second year sensitivity

   5.7 %   .2 %   (4.3 )%

 

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When forecasting net interest income, we make assumptions about interest rates and the shape of the yield curve, the volume and characteristics of new business, and the behavior of existing positions. These assumptions determine the future level of simulated net interest income in the base interest rate scenario and the other interest rate scenarios presented in the table above. These simulations assume that as assets and liabilities mature, they are replaced or repriced at market rates.

All changes in forecasted net interest income are relative to results in a base rate scenario where current market rates are assumed to remain unchanged over the forecast horizon.

The graph below presents the yield curves for the base rate scenario and each of the alternative scenarios one year forward.

LOGO

Our risk position has become increasingly liability sensitive in part due to the increase in market interest rates and in part due to our balance sheet management strategy. We believe that we have the deposit funding base and balance sheet flexibility to take advantage, where appropriate, of changing interest rates and to adjust to changing market conditions.

MARKET RISK MANAGEMENT – TRADING RISK

Our trading activities primarily include customer-driven trading in fixed income securities, equities, derivatives, and foreign exchange contracts. They also include the underwriting of fixed income and equity securities and proprietary trading.

 

We use value-at-risk (“VaR”) as the primary means to measure and monitor market risk in trading activities. The Risk Committee of the Board establishes an enterprise-wide VaR limit on our trading activities.

The following table shows VaR usage for the second quarter of 2006 by product type:

VaR Usage by Product Type

 

In millions    Min    Max    Avg

Fixed Income

   $2.9    $5.0    $3.8

Equity

   .6    2.5    1.1

Foreign Exchange

   .1    .5    .2

Total

   3.8    6.8    5.1

To help ensure the integrity of the models used to calculate VaR for each portfolio and enterprise-wide, we use a process known as backtesting. The backtesting process consists of comparing actual observations of trading-related gains or losses against the VaR levels that were calculated at the close of the prior day. We would expect a maximum of two to three instances a year in which actual losses exceeded the prior day VaR measure. During the first six months of 2006, there were no such instances at the enterprise-wide level.

The following graph shows a comparison of enterprise-wide trading-related gains and losses against prior day VaR for the period.

LOGO


 

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Table of Contents

Total trading revenue for the first half and second quarter of 2006 and 2005 was as follows:

 

Six months ended June 30 – in millions    2006     2005

Net interest income

   ($3 )   $6

Noninterest income

   112     61

Total trading revenue

   $109     $67

Securities underwriting and trading (a)

   $6     $10

Foreign exchange

   31     17

Financial derivatives

   72     40

Total trading revenue

   $109     $67
Three months ended June 30 – in millions    2006     2005

Net interest income

   ($3 )   $4

Noninterest income

   55     11

Total trading revenue

   $52     $15

Securities underwriting and trading (a)

   $2     $5

Foreign exchange

   17     9

Financial derivatives

   33     1

Total trading revenue

   $52     $15
(a) Includes changes in fair value for certain loans accounted for at fair value.

Average trading assets and liabilities consisted of the following:

 

Six months ended June 30 - in millions    2006    2005

Assets

     

Securities (a)

   $1,636    $1,907

Resale agreements (b)

   350    828

Financial derivatives (c)

   1,080    772

Loans at fair value (c)

   86     

Total assets

   $3,152    $3,507

Liabilities

     

Securities sold short (d)

   $716    $1,104

Repurchase agreements and other borrowings (e)

   763    1,131

Financial derivatives (f)

   1,052    789

Borrowings at fair value (f)

   24     

Total liabilities

   $2,555    $3,024
Three months ended June 30 - in millions    2006    2005

Assets

     

Securities (a)

   $1,477    $1,932

Resale agreements (b)

   378    411

Financial derivatives (c)

   1,251    864

Loans at fair value (c)

   170     

Total assets

   $3,276    $3,207

Liabilities

     

Securities sold short (d)

   $769    $750

Repurchase agreements and other borrowings (e)

   641    1,078

Financial derivatives (f)

   1,200    909

Borrowings at fair value (f)

   48     

Total liabilities

   $2,658    $2,737
(a) Included in Interest-earning assets-Other on the Average Consolidated Balance Sheet and Net Interest Analysis.
(b) Included in Federal funds sold and resale agreements.
(c) Included in Noninterest-earning assets-Other.
(d) Included in Other borrowed funds.
(e) Included in Repurchase agreements and Other borrowed funds.
(f) Included in Accrued expenses and other liabilities.

 

MARKET RISK MANAGEMENT – EQUITY AND OTHER

INVESTMENT RISK

Equity investment risk is the risk of potential losses associated with investing in both private and public equity markets.

Private Equity

The private equity portfolio is comprised of investments that vary by industry, stage and type of investment.

At June 30, 2006, private equity investments carried at estimated fair value totaled $506 million compared with $449 million at December 31, 2005. As of June 30, 2006, approximately 44% of the amount was invested directly in a variety of companies and approximately 56% was invested in various limited partnerships. Private equity unfunded commitments totaled $140 million at June 30, 2006 compared with $78 million at December 31, 2005. The increase resulted from our $74 million commitment to a new equity fund, PNC Equity Partners II, LP, which had a first closing in June 2006. Our commitment is expected to be funded over a five-year period. This fund is not consolidated as we have less than a 50% ownership interest. See Note 14 Commitments And Guarantees in the Notes To Consolidated Financial Statements regarding our commitment to PNC Mezzanine Partners III, LP.

Other Investments

We also make investments in affiliated and non-affiliated funds with both traditional and alternative investment strategies. Such investments include investments in BlackRock’s mutual funds, hedge funds, and CDOs. The economic values could be driven by either the fixed-income market or the equity markets, or both.

LIQUIDITY RISK MANAGEMENT

Liquidity risk is the risk of potential loss if we were unable to meet our funding requirements at a reasonable cost. We manage liquidity risk to help ensure that we can obtain cost-effective funding to meet current and future obligations under both normal “business as usual” and stressful circumstances.

Our largest source of funding on a consolidated basis is the deposit base that comes from our retail and wholesale banking activities. Other borrowed funds come from a diverse mix of long and short-term funding sources. Liquid assets and unused borrowing capacity from a number of sources are also available to maintain our liquidity position.

Liquid assets consist of short-term investments (federal funds sold, resale agreements and other short-term investments) and securities available for sale. At June 30, 2006, our liquid assets totaled $24.4 billion, with $10.3 billion pledged as collateral for borrowings, trust, and other commitments.

PNC Bank, N.A. is a member of the Federal Home Loan Bank of Pittsburgh (“FHLB-Pittsburgh”) and as such has access to advances from FHLB-Pittsburgh secured generally by residential mortgages, other real estate related loans, and mortgage-backed securities. At June 30, 2006, our total unused borrowing capacity from FHLB-Pittsburgh under current collateral requirements was $24.8 billion.


 

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We can also obtain funding through alternative forms of borrowing, including federal funds purchased, repurchase agreements, and short-term and long-term debt issuances. In July 2004, PNC Bank, N.A. established a program to offer up to $20 billion in senior and subordinated unsecured debt obligations with maturities of more than nine months. Through June 30, 2006, PNC Bank, N.A. had issued $2.9 billion of debt under this program, including $500 million of 18-month floating rate notes, due January 2, 2008, issued during the second quarter of 2006 with interest payable monthly at the rate of 1-month LIBOR minus 5.5 basis points. These notes are not redeemable or subject to repayment at the option of the holder prior to maturity.

PNC Bank, N.A. established a program in December 2004 to offer up to $3.0 billion of its commercial paper. As of June 30, 2006, $10 million of commercial paper was outstanding under this program.

Our parent company’s routine funding needs consist primarily of dividends to PNC shareholders, share repurchases, debt service, the funding of non-bank affiliates, and acquisitions.

Parent company liquidity guidelines are designed to help ensure that sufficient liquidity is available to meet these requirements over the succeeding 12-month period. In managing parent company liquidity we consider funding sources, such as expected dividends to be received from PNC Bank, N.A. and potential debt issuance, and discretionary funding uses, the most significant of which is the external dividend to be paid on PNC’s stock.

The principal source of parent company cash flow is the dividends it receives from PNC Bank, N.A., which may be impacted by the following:

  ·   Capital needs,
  ·   Laws and regulations,
  ·   Corporate policies,
  ·   Contractual restrictions, and
  ·   Other factors.

Also, there are statutory and regulatory limitations on the ability of national banks to pay dividends or make other capital distributions or to extend credit to the parent company or its non-bank subsidiaries. The amount available for dividend payments to the parent company by PNC Bank, N.A. without prior regulatory approval was approximately $532 million at June 30, 2006.

In addition to dividends from PNC Bank, N.A., other sources of parent company liquidity include cash and short-term investments, as well as dividends and loan repayments from other subsidiaries. As of June 30, 2006, the parent company had approximately $1.6 billion in funds available from its cash and short-term investments.

We can also generate liquidity for the parent company and PNC’s non-bank subsidiaries through the issuance of securities in public or private markets. At June 30, 2006, we had unused capacity under effective shelf registration statements of approximately $1.6 billion of debt or equity securities. BlackRock, one of our majority-owned non-bank subsidiaries, also has access to public and private financing. In July 2006, PNC Funding Corp established a program to offer up to $3.0 billion of commercial paper to provide the parent company with additional liquidity.

 

As of June 30, 2006, there were $1.1 billion of parent company contractual obligations with maturities of less than one year, all of which mature in the third quarter of 2006.

Commitments

The following tables set forth contractual obligations and various other commitments representing required and potential cash outflows as of June 30, 2006.

Contractual Obligations

June 30, 2006 - in millions    Total

Remaining contractual maturities of time deposits

   $18,474

Borrowed funds

   15,651

Minimum annual rentals on noncancellable leases

   1,144

Nonqualified pension and postretirement benefits

   299

Purchase obligations (a)

   316

Total contractual cash obligations

   $35,884
(a) Includes purchase obligations for goods and services covered by noncancellable contracts and contracts including cancellation fees.

Other Commitments (a)

June 30, 2006 - in millions   

Total

Amounts
Committed

Loan commitments

   $40,904

Standby letters of credit

   4,292

Other commitments (b)

   5,265

Total commitments

   $50,461
(a) Other commitments are funding commitments that could potentially require performance in the event of demands by third parties or contingent events. Loan commitments are reported net of participations, assignments and syndications.
(b) Includes liquidity facilities commitments, standby bond repurchase agreements, equity funding commitments related to equity management and affordable housing, as well as BlackRock’s investment commitments and obligation under an acquired management contract.

FINANCIAL DERIVATIVES

We use a variety of financial derivatives as part of the overall asset and liability risk management process to help manage interest rate, market and credit risk inherent in our business activities. Substantially all such instruments are used to manage risk related to changes in interest rates. Interest rate and total return swaps, interest rate caps and floors and futures contracts are the primary instruments used by us for interest rate risk management.

Financial derivatives involve, to varying degrees, interest rate, market and credit risk. For interest rate swaps and total return swaps, options and futures contracts, only periodic cash payments and, with respect to options, premiums, are exchanged. Therefore, cash requirements and exposure to credit risk are significantly less than the notional amount on these instruments. Further information on our financial derivatives, including the credit risk amounts of these derivatives as of June 30, 2006 and December 31, 2005, is presented in Note 1 Accounting Policies and Note 9 Financial Derivatives in the Notes To Consolidated Financial Statements in Part I, Item 1 of this Report.

Not all elements of interest rate, market and credit risk are addressed through the use of financial or other derivatives, and such instruments may be ineffective for their intended purposes due to unanticipated market characteristics, among other reasons.


 

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The following tables provide the notional amount and fair value of financial derivatives used for risk management and designated as accounting hedges as well as free-standing derivatives at June 30, 2006 and December 31, 2005. Weighted-average interest rates presented are based on contractual terms, if fixed, or the implied forward yield curve at each respective date, if floating.

Financial Derivatives - 2006

 

    

Notional/
Contract
Amount

  

Net
Fair Value

   

Weighted
Average

Maturity

   Weighted-Average
Interest Rates
 
June 30, 2006 - dollars in millions            Paid     Received  

Accounting Hedges

                            

Interest rate risk management

              

Asset rate conversion

              

Interest rate swaps (a)

              

Receive fixed

   $3,177    $ (42)   3 yrs. 3 mos.    5.48 %   4.84 %

Pay fixed

   10      1 yr. 5 mos.    3.31     5.53  

Interest rate floors (b)

   7      4 yrs. 9 mos.    NM     NM  

Forward purchase commitments

   100      2 mos.    NM     NM  

Futures contracts

   77            11 mos.    NM     NM  

Total asset rate conversion

   3,371    (42 )         

Liability rate conversion

              

Interest rate swaps (a)

              

Receive fixed

   5,345    (84 )   5 yrs. 11 mos.    5.61     5.37  

Total liability rate conversion

   5,345    (84 )         

Total interest rate risk management

   8,716    (126 )         

Commercial mortgage banking risk management

              

Pay fixed interest rate swaps (a)

   104    2     10 yrs. 2 mos.    5.46     5.62  

Pay total return swaps designated to loans held for sale (a)

   250    1     1 mo.    NM     5.25  

Total commercial mortgage banking risk management

   354    3           

Total accounting hedges (c)

   $9,070    $ (123)                      

Free-Standing Derivatives

              

Customer-related

              

Interest rate

              

Swaps

   $56,188    $51     3 yrs. 9 mos.    5.24 %   5.26 %

Caps/floors

              

Sold

   1,354    (4 )   6 yrs. 1 mo.    NM     NM  

Purchased

   686    2     7 yrs. 6 mos.    NM     NM  

Futures

   3,575    (3 )   8 mos.    NM     NM  

Foreign exchange

   4,684    1     7 mos.    NM     NM  

Equity

   3,345    (31 )   1 yr. 2 mos.    NM     NM  

Swaptions

   6,815    (15 )   6 yrs. 8 mos.    NM     NM  

Other

   20            11 yrs.    NM     NM  

Total customer-related

   76,667    1           

Other risk management and proprietary

              

Interest rate

              

Swaps

   11,442    16     8 yrs. 6 mos.    5.11 %   5.30 %

Caps/floors

              

Sold

   4,000    (18 )   3 yrs. 3 mos.    NM     NM  

Purchased

   4,510    23     3 yrs. 6 mos.    NM     NM  

Futures

   9,624    7     11 mos.    NM     NM  

Foreign exchange

   163      7 yrs. 3 mos.    NM     NM  

Credit derivatives

   2,448    (1 )   7 yrs.    NM     NM  

Risk participation agreements

   763      4 yrs.    NM     NM  

Commitments related to mortgage-related assets

   1,463    (14 )   3 mos.    NM     NM  

Options

              

Futures

   37,933    (6 )   8 mos.    NM     NM  

Swaptions

   15,387    45     10 yrs. 3 mos.    NM     NM  

Total other risk management and proprietary

   87,733    52           

Total free-standing derivatives

   $164,400    $53                        
(a)   The floating rate portion of interest rate contracts is based on money-market indices. As a percent of notional amount, 71% were based on 1-month LIBOR, 29% on 3-month LIBOR.
(b)   Interest rate floors have a weighted-average strike of 3.21%.
(c)   Fair value amounts include accrued interest of $72 million.
NM Not meaningful

 

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Financial Derivatives - 2005

 

    

Notional/
Contract
Amount

  

Net
Fair Value

  

Weighted
Average
Maturity

  

Weighted-Average

Interest Rates

 
December 31, 2005 - dollars in millions            

Paid

   

Received

 

Accounting Hedges

               

Interest rate risk management

               

Asset rate conversion

               

Interest rate swaps (a)

               

Receive fixed

   $2,926    $(9)    2 yrs. 10 mos.    4.75 %   4.42 %

Pay fixed

   12       2 yrs. 1 mo.    3.68     4.77  

Futures contracts

   42          1 yr. 1 mo.    NM     NM  

Total asset rate conversion

   2,980    (9)          

Liability rate conversion

               

Interest rate swaps (a)

               

Receive fixed

   5,345    84    6 yrs. 5 mos.    4.87     5.37  

Total liability rate conversion

   5,345    84          

Total interest rate risk management

   8,325    75          

Commercial mortgage banking risk management

               

Pay fixed interest rate swaps (a)

   251    (4)    10 yrs. 9 mos.    5.05     4.88  

Pay total return swaps designated to loans held for sale (a)

   250    (2)    1 mo.    NM     4.37  

Total commercial mortgage banking risk management

   501    (6)          

Total accounting hedges (b)

   $8,826    $69                  

Free-Standing Derivatives

               

Customer-related

               

Interest rate

               

Swaps

   $43,868    $34    4 yrs. 2 mos.    4.69 %   4.69 %

Caps/floors

               

Sold

   1,710    (4)    1 yr. 11 mos.    NM     NM  

Purchased

   1,446    3    11 mos.    NM     NM  

Futures

   2,570       10 mos.    NM     NM  

Foreign exchange

   4,687    4    5 mos.    NM     NM  

Equity

   2,744    (79)    1 yr. 6 mos.    NM     NM  

Swaptions

   2,559    (1)    8 yrs. 11 mos.    NM     NM  

Other

   230    1    10 yrs. 8 mos.    NM     NM  

Total customer-related

   59,814    (42)          

Other risk management and proprietary

               

Interest rate

               

Swaps

   2,369    1    4 yrs. 11 mos.    4.56 %   4.65 %

Basis swaps

   756    1    6 yrs. 10 mos.    4.14     4.85  

Pay fixed swaps

   2,474    (2)    7 yrs. 7 mos.    4.37     4.57  

Caps/floors

               

Sold

   2,000    (10)    2 yrs. 7 mos.    NM     NM  

Purchased

   2,310    14    2 yrs. 10 mos.    NM     NM  

Futures

   10,901    2    1 yr. 2 mos.    NM     NM  

Credit derivatives

   1,353       4 yrs. 7 mos.    NM     NM  

Risk participation agreements

   461       3 yrs. 11 mos.    NM     NM  

Commitments related to mortgage-related assets

   1,695    1    2 mos.    NM     NM  

Options

               

Futures

   33,384    3    5 mos.    NM     NM  

Swaptions

   15,440    30    7 yrs. 7 mos.    NM     NM  

Other

   24    4    4 mos.    NM     NM  

Total other risk management and proprietary

   73,167    44          

Total free-standing derivatives

   $132,981    $2                  
(a) The floating rate portion of interest rate contracts is based on money-market indices. As a percent of notional amount, 67% were based on 1-month LIBOR, 33% on 3-month LIBOR.
(b) Fair value amounts include accrued interest of $81 million.
NM Not meaningful

 

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INTERNAL CONTROLS AND DISCLOSURE CONTROLS AND PROCEDURES

As of June 30, 2006, we performed an evaluation under the supervision and with the participation of our management, including the Chairman and Chief Executive Officer and the Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures and of changes in our internal control over financial reporting.

Based on that evaluation, our management, including the Chairman and Chief Executive Officer and the Chief Financial Officer, concluded that our disclosure controls and procedures were effective as of June 30, 2006, and that there has been no change in internal control over financial reporting that occurred during the second quarter of 2006 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

GLOSSARY OF TERMS

Accounting/administration net fund assets - Net domestic and foreign fund investment assets for which we provide accounting and administration services. We do not include these assets on our Consolidated Balance Sheet.

Adjusted average total assets - Primarily comprised of total average quarterly (or annual) assets plus (less) unrealized losses (gains) on available-for-sale debt securities, less goodwill and certain other intangible assets.

Annualized - Adjusted to reflect a full year of activity.

Assets under management - Assets over which we have sole or shared investment authority for our customers/clients. We do not include these assets on our Consolidated Balance Sheet.

Basis point - One hundredth of a percentage point.

Charge-off - Process of removing a loan or portion of a loan from our balance sheet because it is considered uncollectible. We also record a charge-off when a loan is transferred to held for sale and the loan’s market value is less than its carrying amount.

Common shareholders’ equity to total assets - Common shareholders’ equity divided by total assets. Common shareholders’ equity equals total shareholders’ equity less the liquidation value of preferred stock.

Credit derivatives - Contractual agreements that provide protection against a credit event of one or more referenced credits. The nature of a credit event is established by the protection buyer and protection seller at the inception of a transaction, and such events include bankruptcy, insolvency and failure to meet payment obligations when due. The buyer of the credit derivative pays a periodic fee in return for a payment by the protection seller upon the occurrence, if any, of a credit event.

 

Custody assets - Investment assets held on behalf of clients under safekeeping arrangements. We do not include these assets on our Consolidated Balance Sheet. Investment assets held in custody at other institutions on our behalf are included in the appropriate asset categories on the Consolidated Balance Sheet as if physically held by us.

Derivatives - Financial contracts whose value is derived from publicly traded securities, interest rates, currency exchange rates or market indices. Derivatives cover a wide assortment of financial contracts, including forward contracts, futures, options and swaps.

Duration of equity - An estimate of the rate sensitivity of our economic value of equity. A negative duration of equity is associated with asset sensitivity (i.e., positioned for rising interest rates), while a positive value implies liability sensitivity (i.e., vulnerable to rising rates). For example, if the duration of equity is +1.5 years, the economic value of equity declines by 1.5% for each 100 basis point increase in interest rates.

Earning assets - Assets that generate income, which include: federal funds sold; resale agreements; other short-term investments, including trading securities; loans held for sale; loans, net of unearned income; securities; and certain other assets.

Economic capital - Represents the amount of resources that our business segments should hold to guard against potentially large losses that could cause insolvency. It is based on a measurement of economic risk, as opposed to risk as defined by regulatory bodies. The economic capital measurement process involves converting a risk distribution to the capital that is required to support the risk, consistent with our target credit rating. As such, economic risk serves as a “common currency” of risk that allows us to compare different risks on a similar basis.

Economic value of equity (“EVE”) - The present value of the expected cash flows of our existing assets less the present value of the expected cash flows of our existing liabilities, plus the present value of the net cash flows of our existing off-balance sheet positions.

Effective duration - A measurement, expressed in years, that, when multiplied by a change in interest rates, would approximate the percentage change in value of on- and off- balance sheet positions.

Efficiency - Noninterest expense divided by the sum of net interest income and noninterest income.

Foreign exchange contracts - Contracts that provide for the future receipt and delivery of foreign currency at previously agreed-upon terms.

Funds transfer pricing - A management accounting methodology designed to recognize the net interest income effects of sources and uses of funds provided by the assets and liabilities of our business segments. We assign these balances LIBOR-based funding rates at origination that represent the interest cost for us to raise/invest funds with similar maturity and repricing structures.


 

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Futures and forward contracts - Contracts in which the buyer agrees to purchase and the seller agrees to deliver a specific financial instrument at a predetermined price or yield. May be settled either in cash or by delivery of the underlying financial instrument.

GAAP - Accounting principles generally accepted in the United States of America.

Interest rate floors and caps - Interest rate protection instruments that involve payment from the seller to the buyer of an interest differential, which represents the difference between a short-term rate (e.g., three-month LIBOR) and an agreed-upon rate (the strike rate) applied to a notional principal amount.

Interest rate swap contracts - Contracts that are entered into primarily as an asset/liability management strategy to reduce interest rate risk. Interest rate swap contracts are exchanges of interest rate payments, such as fixed-rate payments for floating-rate payments, based on notional principal amounts.

Intrinsic value - The amount by which the fair value of an underlying stock exceeds the exercise price of an option on that stock.

Leverage ratio - Tier 1 risk-based capital divided by adjusted average total assets.

Net interest margin - Annualized taxable-equivalent net interest income divided by average earning assets.

Nondiscretionary assets under administration - Assets we hold for our customers/clients in a non-discretionary, custodial capacity. We do not include these assets on our Consolidated Balance Sheet.

Noninterest income to total revenue - Noninterest income divided by the sum of net interest income and noninterest income.

Nonperforming assets - Nonperforming assets include nonaccrual loans, troubled debt restructured loans, nonaccrual loans held for sale, foreclosed assets and other assets. We do not accrue interest income on assets classified as nonperforming.

Nonperforming loans - Nonperforming loans include loans to commercial, equipment lease financing, consumer, commercial real estate and residential mortgage customers as well as troubled debt restructured loans. Nonperforming loans do not include nonaccrual loans held for sale or foreclosed and other assets. We do not accrue interest income on loans classified as nonperforming.

Notional amount - A number of currency units, shares, or other units specified in a derivatives contract.

Operating leverage - The period to period percentage change in total revenue less the percentage change in noninterest expense. A positive percentage indicates that revenue growth exceeded expense growth (i.e., positive operating leverage) while a negative percentage implies expense growth exceeded revenue growth (i.e., negative operating leverage).

 

Options - Contracts that grant the purchaser, for a premium payment, the right, but not the obligation, to either purchase or sell the associated financial instrument at a set price during a period or at a specified date in the future.

Recovery - Cash proceeds received on a loan that we had previously charged off. We credit the amount received to the allowance for loan and lease losses.

Return on average capital - Annualized net income divided by average capital.

Return on average assets - Annualized net income divided by average assets.

Return on average common equity - Annualized net income divided by average common shareholders’ equity.

Risk-weighted assets - Primarily computed by the assignment of specific risk-weights (as defined by The Board of Governors of the Federal Reserve System) to assets and off-balance sheet instruments.

Securitization - The process of legally transforming financial assets into securities.

Swaptions - Contracts that grant the purchaser, for a premium payment, the right, but not the obligation, to enter into an interest rate swap agreement during a period or at a specified date in the future.

Tangible common equity ratio - Common shareholders’ equity less goodwill and other intangible assets (excluding mortgage servicing rights) divided by period-end assets less goodwill and other intangible assets (excluding mortgage servicing rights).

Taxable-equivalent interest - The interest income earned on certain assets is completely or partially exempt from federal income tax. As such, these tax-exempt instruments typically yield lower returns than a taxable investment. To provide more meaningful comparisons of yields and margins for all interest-earning assets, we also provide revenue on a taxable-equivalent basis by increasing the interest income earned on tax-exempt assets to make it fully equivalent to interest income on other taxable investments. This adjustment is not permitted under GAAP on the Consolidated Income Statement.

Tier 1 risk-based capital - Tier 1 risk-based capital equals: total shareholders’ equity, plus trust preferred capital securities, plus certain minority interests that are held by others; less goodwill and certain other intangible assets, less equity investments in nonfinancial companies and less net unrealized holding losses on available-for-sale equity securities. Net unrealized holding gains on available-for-sale equity securities, net unrealized holding gains (losses) on available-for-sale debt securities and net unrealized holding gains (losses) on cash flow hedge derivatives are excluded from total shareholders’ equity for tier 1 risk-based capital purposes.


 

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Tier 1 risk-based capital ratio - Tier 1 risk-based capital divided by period-end risk-weighted assets.

Total fund assets serviced - Total domestic and offshore fund investment assets for which we provide related processing services. We do not include these assets on our Consolidated Balance Sheet.

Total return swap - A non-traditional swap where one party agrees to pay the other the “total return” of a defined underlying asset (e.g., a loan), usually in return for receiving a stream of LIBOR-based cash flows. The total returns of the asset, including interest and any default shortfall, are passed through to the counterparty. The counterparty is therefore assuming the credit and economic risk of the underlying asset.

Total risk-based capital - Tier 1 risk-based capital plus qualifying senior and subordinated debt, other minority interest not qualified as tier 1, and the allowance for loan and lease losses, subject to certain limitations.

Total risk-based capital ratio - Total risk-based capital divided by period-end risk-weighted assets.

Transaction deposits - The sum of money market and interest-bearing demand deposits and demand and other noninterest-bearing deposits.

Value-at-risk (“VaR”) - A statistically-based measure of risk which describes the amount of potential loss which may be incurred due to severe and adverse market movements. The measure is of the maximum loss which should not be exceeded on 99 out of 100 days.

Yield curve - A graph showing the relationship between the yields on financial instruments or market indices of the same credit quality with different maturities. For example, a “normal” or “positive” yield curve exists when long-term bonds have higher yields than short-term bonds. A “flat” yield curve exists when yields are the same for short-term and long-term bonds. A “steep” yield curve exists when yields on long-term bonds are significantly higher than on short-term bonds. An “inverted” or “negative” yield curve exists when short-term bonds have higher yields than long-term bonds.

 

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING INFORMATION

We make statements in this Report, and we may from time to time make other statements, regarding our outlook or expectations for earnings, revenues, expenses and/or other matters regarding or affecting PNC that are forward-looking statements within the meaning of the Private Securities Litigation Reform Act. Forward-looking statements are typically identified by words such as “believe,” “expect,” “anticipate,” “intend,” “outlook,” “estimate,” “forecast,” “project” and other similar words and expressions.

Forward-looking statements are subject to numerous assumptions, risks and uncertainties, which change over time. Forward-looking statements speak only as of the date they are made. We do not assume any duty and do not undertake to update our forward-looking statements. Actual results or future events could differ, possibly materially, from those that we anticipated in our forward-looking statements, and future results could differ materially from our historical performance.

Our forward-looking statements are subject to the following principal risks and uncertainties. We provide greater detail regarding these factors in our 2005 Form 10-K, including in the Risk Factors and Risk Management sections. Our forward-looking statements may also be subject to other risks and uncertainties, including those discussed elsewhere in this Report or in our other filings with the SEC.

 

  ·   Our business and operating results are affected by business and economic conditions generally or specifically in the principal markets in which we do business. We are affected by changes in our customers’ financial performance, as well as changes in customer preferences and behavior, including as a result of changing economic conditions.

 

  ·   The value of our assets and liabilities as well as our overall financial performance are affected by changes in interest rates or in valuations in the debt and equity markets. Actions by the Federal Reserve and other government agencies, including those that impact money supply and market interest rates, can affect our activities and financial results.

 

  ·   Competition can have an impact on customer acquisition, growth and retention, as well as on our credit spreads and product pricing, which can affect market share, deposits and revenues.

 

  ·   Our ability to implement our One PNC initiative, as well as other business initiatives and strategies we may pursue, could affect our financial performance over the next several years.

 

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  ·   Our ability to grow successfully through acquisitions is impacted by a number of risks and uncertainties related both to the acquisition transactions themselves and to the integration of the acquired businesses into PNC after closing. These uncertainties are present in transactions such as the pending acquisition by BlackRock of Merrill Lynch’s investment management business.

 

  ·   Legal and regulatory developments could have an impact on our ability to operate our businesses or our financial condition or results of operations or our competitive position or reputation. Reputational impacts, in turn, could affect matters such as business generation and retention, our ability to attract and retain management, liquidity and funding. These legal and regulatory developments could include: (a) the unfavorable resolution of legal proceedings or regulatory and other governmental inquiries; (b) increased litigation risk from recent regulatory and other governmental developments; (c) the results of the regulatory examination process, our failure to satisfy the requirements of agreements with governmental agencies, and regulators’ future use of supervisory and enforcement tools; (d) legislative and regulatory reforms, including changes to laws and regulations involving tax, pension, and the protection of confidential customer information; and (e) changes in accounting policies and principles.
  ·   Our business and operating results are affected by our ability to identify and effectively manage risks inherent in our businesses, including, where appropriate, through the effective use of third-party insurance and capital management techniques.

 

  ·   Our ability to anticipate and respond to technological changes can have an impact on our ability to respond to customer needs and to meet competitive demands.

 

  ·   The adequacy of our intellectual property protection, and the extent of any costs associated with obtaining rights in intellectual property claimed by others, can impact our business and operating results.

 

  ·   Our business and operating results can be affected by widespread natural disasters, terrorist activities or international hostilities, either as a result of the impact on the economy and financial and capital markets generally or on us or on our customers, suppliers or other counterparties specifically.

Also, risks and uncertainties that could affect the results anticipated in forward-looking statements or from historical performance relating to our majority-owned subsidiary BlackRock, Inc. are discussed in more detail in BlackRock’s 2005 Annual Report on Form 10-K, including in the Risk Factors section, and in BlackRock’s other filings with the SEC, accessible on the SEC’s website at www.sec.gov and on or through BlackRock’s website at www.blackrock.com.


 

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CONSOLIDATED INCOME STATEMENT

THE PNC FINANCIAL SERVICES GROUP, INC.

 

In millions, except per share data

Unaudited

  

Three months ended

June 30

        

Six months ended

June 30

 
       2006         2005               2006         2005  

Interest Income

           

Loans

   $ 797     $ 646        $ 1,544     $ 1,224  

Securities available for sale and held to maturity

     255       198          498       370  

Other

     74       57            150       111  

Total interest income

     1,126       901            2,192       1,705  

Interest Expense

           

Deposits

     379       224          706       406  

Borrowed funds

     191       143            374       259  

Total interest expense

     570       367            1,080       665  

Net interest income

     556       534          1,112       1,040  

Provision for (recoveries of) credit losses

     44       (27 )          66       (19 )

Net interest income less provision for (recoveries of) credit losses

     512       561            1,046       1,059  

Noninterest Income

           

Asset management

     429       334          890       648  

Fund servicing

     210       219          431       439  

Service charges on deposits

     80       67          153       126  

Brokerage

     63       57          122       112  

Consumer services

     94       73          183       137  

Corporate services

     157       113          292       221  

Equity management gains

     54       12          61       44  

Net securities losses

     (8 )     (26 )        (12 )     (35 )

Trading

     55       11          112       61  

Other

     96       69            183       150  

Total noninterest income

     1,230       929            2,415       1,903  

Noninterest Expense

           

Compensation

     558       481          1,113       960  

Employee benefits

     76       86          163       169  

Net occupancy

     83       72          162       145  

Equipment

     80       74          157       148  

Marketing

     22       25          42       45  

Other

     330       302            683       573  

Total noninterest expense

     1,149       1,040            2,320       2,040  

Income before minority and noncontrolling interests and income taxes

     593       450          1,141       922  

Minority and noncontrolling interests in income of consolidated entities

     15       9          28       15  

Income taxes

     197       159            378       271  

Net income

   $ 381     $ 282          $ 735     $ 636  

Earnings Per Common Share

           

Basic

   $ 1.30     $ .99        $ 2.51     $ 2.25  

Diluted

   $ 1.28     $ .98          $ 2.47     $ 2.22  

Average Common Shares Outstanding

           

Basic

     293       285          292       283  

Diluted

     297       288            297       286  

See accompanying Notes To Consolidated Financial Statements.

 

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CONSOLIDATED BALANCE SHEET

THE PNC FINANCIAL SERVICES GROUP, INC.

 

In millions, except par value

Unaudited

   June 30
2006
    December 31
2005
 

Assets

    

Cash and due from banks

   $ 3,438     $ 3,518  

Federal funds sold and resale agreements

     675       350  

Other short-term investments, including trading securities

     2,005       2,543  

Loans held for sale

     2,165       2,449  

Securities available for sale and held to maturity

     21,724       20,710  

Loans, net of unearned income of $828 and $835

     50,548       49,101  

Allowance for loan and lease losses

     (611 )     (596 )

Net loans

     49,937       48,505  

Goodwill

     3,636       3,619  

Other intangible assets

     862       847  

Other

     10,472       9,413  

Total assets

   $ 94,914     $ 91,954  

Liabilities

    

Deposits

    

Noninterest-bearing

   $ 14,434     $ 14,988  

Interest-bearing

     49,059       45,287  

Total deposits

     63,493       60,275  

Borrowed funds

    

Federal funds purchased

     3,320       4,128  

Repurchase agreements

     2,136       1,691  

Bank notes and senior debt

     3,503       3,875  

Subordinated debt

     4,329       4,469  

Other

     2,363       2,734  

Total borrowed funds

     15,651       16,897  

Allowance for unfunded loan commitments and letters of credit

     103       100  

Accrued expenses

     2,635       2,770  

Other

     3,573       2,759  

Total liabilities

     85,455       82,801  

Minority and noncontrolling interests in consolidated entities

     632       590  

Shareholders’ Equity

    

Preferred stock (a)

    

Common stock - $5 par value

    

Authorized 800 shares, issued 353 shares

     1,764       1,764  

Capital surplus

     1,385       1,358  

Retained earnings

     9,449       9,023  

Deferred compensation expense

     (60 )     (59 )

Accumulated other comprehensive loss

     (510 )     (267 )

Common stock held in treasury at cost: 58 and 60 shares

     (3,201 )     (3,256 )

Total shareholders’ equity

     8,827       8,563  

Total liabilities, minority and noncontrolling interests, and shareholders’ equity

   $ 94,914     $ 91,954  

(a)  Less than $.5 million at each date.

See accompanying Notes To Consolidated Financial Statements.

 

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CONSOLIDATED STATEMENT OF CASH FLOWS

THE PNC FINANCIAL SERVICES GROUP, INC.

 

Six months ended June 30 - in millions

Unaudited

   2006     2005  

Operating Activities

    

Net income

   $ 735     $ 636  

Adjustments to reconcile net income to net cash provided by operating activities

    

Provision for (recoveries of) credit losses

     66       (19 )

Depreciation, amortization and accretion

     182       166  

Deferred income taxes

     71       (40 )

Securities transactions

     12       35  

Valuation adjustments

     (2 )     (4 )

Excess tax benefits from share-based payment arrangements

     (17 )  

Net change in

    

Loans held for sale

     342       (590 )

Other short-term investments

     659       (221 )

Other

     (494 )     (1,050 )

Net cash provided (used) by operating activities

     1,554       (1,087 )

Investing Activities

    

Repayment of securities

     1,692       1,653  

Sales

    

Securities

     3,433       9,993  

Loans

     18       23  

Foreclosed and other nonperforming assets

     7       9  

Purchases

    

Securities

     (6,460 )     (15,397 )

Loans

     (658 )     (1,200 )

Net change in

    

Loans

     (913 )     (1,824 )

Federal funds sold and resale agreements

     (325 )     2,036  

Net cash paid for acquisitions

     (55 )     (372 )

Other

     (128 )     (118 )

Net cash used by investing activities

     (3,389 )     (5,197 )

Financing Activities

    

Net change in

    

Noninterest-bearing deposits

     (554 )     (1,517 )

Interest-bearing deposits

     3,770       3,173  

Federal funds purchased

     (808 )     2,481  

Repurchase agreements

     444       356  

Commercial paper

       1,747  

Other short-term borrowed funds

     (534 )     358  

Sales/issuances

    

Bank notes and senior debt

     504       1,299  

Other long-term borrowed funds

     412       335  

Common stock

     223       80  

Repayments/maturities

    

Bank notes and senior debt

     (850 )     (750 )

Subordinated debt

       (351 )

Other long-term borrowed funds

     (328 )     (352 )

Excess tax benefits from share-based payment arrangements

     17    

Acquisition of treasury stock

     (232 )     (80 )

Cash dividends paid

     (309 )     (283 )

Net cash provided by financing activities

     1,755       6,496  

Net Increase (Decrease) In Cash And Due From Banks

     (80 )     212  

Cash and due from banks at beginning of period

     3,518       3,230  

Cash and due from banks at end of period

   $ 3,438     $ 3,442  

Cash Paid For

    

Interest

   $ 1,063     $ 603  

Income taxes

     290       313  

Non-cash Items

    

Transfer from loans to loans held for sale, net

     56       11  

Transfer from loans to other assets

     5       10  

See accompanying Notes To Consolidated Financial Statements.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

THE PNC FINANCIAL SERVICES GROUP, INC.

 

BUSINESS

We are one of the largest diversified financial services companies in the United States, operating businesses engaged in:

  ·   Retail banking,
  ·   Corporate and institutional banking,
  ·   Asset management, and
  ·   Global fund processing services.

We provide many of our products and services nationally and others in our primary geographic markets located in Pennsylvania; New Jersey; the greater Washington, DC area, including Maryland and Virginia; Ohio; Kentucky and Delaware. We also provide certain asset management and global fund processing services internationally. We are subject to intense competition from other financial services companies and are subject to regulation by various domestic and international authorities.

NOTE 1 ACCOUNTING POLICIES

BASIS OF FINANCIAL STATEMENT PRESENTATION

Our unaudited interim consolidated financial statements include the accounts of the parent company and its subsidiaries, most of which are wholly owned, and certain partnership interests and variable interest entities. We prepared these unaudited interim consolidated financial statements in accordance with accounting principles generally accepted in the United States of America (“generally accepted accounting principles” or “GAAP”). We have eliminated all significant intercompany accounts and transactions. We have also reclassified certain prior period amounts to conform with the 2006 presentation. These reclassifications did not have a material impact on our consolidated financial condition or results of operations.

In our opinion, the unaudited interim consolidated financial statements reflect all normal, recurring adjustments needed to present fairly our results for the interim periods.

When preparing these unaudited interim consolidated financial statements, we have assumed that you have read the audited consolidated financial statements included in our 2005 Annual Report on Form 10-K.

SPECIAL PURPOSE ENTITIES

Special purpose entities are broadly defined as legal entities structured for a particular purpose. We use special purpose entities in various legal forms to conduct normal business activities. Special purpose entities that meet the criteria for a Qualifying Special Purpose Entity (“QSPE”) as defined in Statement of Financial Accounting Standards No. (“SFAS”) 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities,” are not required to be consolidated. We review special purpose entities that are not QSPEs for consolidation in accordance with Financial Accounting Standards Board (“FASB”) Interpretation No. 46

(Revised 2003), “Consolidation of Variable Interest Entities” (“FIN 46R”).

In general, a variable interest entity (“VIE”) is a special purpose entity formed as a corporation, partnership, limited liability corporation, or any other legal structure used to conduct activities or hold assets that either:

  ·   Does not have equity investors with voting rights that can directly or indirectly make decisions about the entity’s activities through those voting rights or similar rights, or
  ·   Has equity investors that do not provide enough cash or other financial resources for the entity to support its activities.

A VIE often holds financial assets, including loans or receivables, real estate or other property.

We consolidate a VIE if we are considered to be its primary beneficiary. The primary beneficiary is subject to a majority of the risk of loss from the VIE’s activities, is entitled to receive a majority of the entity’s residual returns, or both. Upon consolidation of a VIE, we generally record all of the VIE’s assets, liabilities and noncontrolling interests at fair value, with future changes based upon consolidation accounting principles. See Note 6 Variable Interest Entities for more information about non-consolidated VIEs in which we hold a significant interest.

BUSINESS COMBINATIONS

We record the net assets of companies that we acquire at their estimated fair value at the date of acquisition and we include the results of operations of the acquired business in our consolidated income statement from the date of acquisition. We recognize as goodwill the excess of the purchase price over the estimated fair value of the net assets acquired.

USE OF ESTIMATES

We prepare the unaudited interim consolidated financial statements using financial information available at the time, which requires us to make estimates and assumptions that affect the amounts reported. Actual results will differ from these estimates and the differences may be material to the consolidated financial statements.

REVENUE RECOGNITION

We earn net interest and noninterest income from various sources, including:

  ·   Lending,
  ·   Securities portfolio,
  ·   Investment management and fund servicing,
  ·   Customer deposits,
  ·   Loan servicing,
  ·   Brokerage services, and
  ·   Securities and derivatives trading activities, including foreign exchange.

 

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We also earn revenue from selling loans and securities, and we recognize income or loss from certain private equity activities. We also earn fees and commissions from:

  ·   Issuing loan commitments, standby letters of credit and financial guarantees,
  ·   Selling various insurance products,
  ·   Providing treasury management services, and
  ·   Participating in certain capital markets transactions.

Revenue earned on interest-earning assets is recognized based on the effective yield of the financial instrument.

We recognize asset management and fund servicing fees primarily as the services are performed. Asset management fees are generally based on a percentage of the fair value of the assets under management and performance fees are generally based on a percentage of the returns on such assets. Certain performance fees are earned upon attaining specified investment return thresholds and are recorded as earned. Fund servicing fees are primarily based on a percentage of the fair value of the fund assets and the number of shareholder accounts we service.

Service charges on deposit accounts are recognized as charged. Brokerage fees and gains on the sale of securities and certain derivatives are recognized on a trade-date basis.

We record private equity income or loss based on changes in the valuation of the underlying investments or when we dispose of our interest. Dividend income from private equity investments is generally recognized when received.

We recognize revenue from loan servicing, securities and derivatives and foreign exchange trading, and securities underwriting activities as they are earned based on contractual terms, as transactions occur or as services are provided. We recognize revenue from the sale of loans upon closing of the transaction.

In certain circumstances, revenue is reported net of associated expenses in accordance with applicable accounting guidance and industry practice.

INVESTMENTS

We have interests in various types of investments. The accounting for these investments is dependent on a number of factors including, but not limited to, items such as:

  ·   Marketability of the investment,
  ·   Ownership interest,
  ·   Our plans for the investment, and
  ·   The nature of the investment.

Private Equity Investments

We report private equity investments, which include direct investments in companies, interests in limited partnerships, and affiliated partnership interests, at estimated fair values. These estimates are based on available information and may not necessarily represent amounts that we will ultimately realize through distribution, sale or liquidation of the investments. The valuation procedures applied to direct investments include techniques such as multiples of cash flow of the entity, independent appraisals of the entity or the pricing used to value the entity in a recent financing transaction. We value affiliated partnership interests based on the underlying investments of the partnership using procedures consistent with those applied to direct investments. We generally value limited partnership investments based on the financial

                                                                                                          41

statements we receive from the general partner. We include all private equity investments in the consolidated balance sheet in other assets. Changes in the fair value of these assets are recognized in noninterest income.

We consolidate private equity investments when we are the general partner in a limited partnership and have determined that we have control of the partnership.

Equity Securities and Partnership Interests

We account for equity investments other than private equity investments under one of the following methods:

  ·   Marketable equity securities are recorded on a trade-date basis and are accounted for at fair value based on the securities’ quoted market prices from a national securities exchange. Dividend income on these securities is recognized in net interest income. Those purchased with the intention of recognizing short-term profits are placed in the trading account, carried at market value and classified as short-term investments. Gains and losses on trading securities are included in noninterest income. Marketable equity securities not classified as trading are designated as securities available for sale and are carried at fair value with unrealized gains and losses, net of income taxes, reflected in accumulated other comprehensive income or loss. Any unrealized losses that we have determined to be other-than-temporary are recognized in the period that the determination is made.

 

  ·   Investments in nonmarketable equity securities are recorded using the cost or equity method of accounting. The cost method is used for those investments in which we do not have significant influence over the investee. Under this method, there is no change to the cost basis unless there is an other-than-temporary decline in value. If the decline is determined to be other than temporary, we write down the cost basis of the investment to a new cost basis that represents realizable value. The amount of the write-down is accounted for as a loss included in noninterest income in the period the determination is made. Distributions received from income on cost method investments are included in interest or noninterest income depending on the type of investment. We use the equity method for those investments in which we have significant influence over the operations of the investee. Under the equity method, we record our equity ownership share of the net income or loss of the investee in noninterest income. We include nonmarketable equity securities in other assets in the consolidated balance sheet.

For investments in limited partnerships that are not required to be consolidated, we use either the cost method or the equity method as described above for nonmarketable equity securities. We use the equity method if our limited partner ownership interest in the partnership is greater than 3%. We use the cost method for the remaining limited partnership investments. We account for general partnership interests under the equity method when we have determined that we do not have control over these entities and are not required to consolidate them. General and limited partnership investments are included in other assets on the consolidated balance sheet.


 


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Debt Securities

Debt securities are recorded on a trade-date basis. We classify debt securities as securities and carry them at amortized cost if we have the positive intent and ability to hold the securities to maturity. Debt securities that we purchase for short-term appreciation or other trading purposes are carried at market value and classified as short-term investments. Gains and losses on these securities are included in noninterest income. Debt securities not classified as held to maturity or trading are designated as securities available for sale and carried at fair value with unrealized gains and losses, net of income taxes, reflected in accumulated other comprehensive income or loss. Other-than-temporary declines in the fair value of available for sale debt securities are recognized as a securities