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 September 30, 2007

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 October 31, 2007, there were 340,516,769 shares of the registrant’s common stock ($5 par value) outstanding.


Table of Contents

The PNC Financial Services Group, Inc.

Cross-Reference Index to Third Quarter 2007 Form 10-Q

 

PART I – FINANCIAL INFORMATION   Pages

Item 1.     Financial Statements (Unaudited).

  40-68

Consolidated Income Statement

  40

Consolidated Balance Sheet

  41

Consolidated Statement Of Cash Flows

  42

Notes To Consolidated Financial Statements (Unaudited)

 

Note 1     Accounting Policies

  43

Note 2     Acquisitions

  50

Note 3     Securities

  51

Note 4     Asset Quality

  52

Note 5     Goodwill And Other Intangible Assets

  53

Note 6     Variable Interest Entities

  54

Note 7     Capital Securities Of Subsidiary Trusts

  55

Note 8     Certain Employee Benefit And Stock-Based Compensation Plans

  56

Note 9     Financial Derivatives

  57

Note 10   Earnings Per Share

  59

Note 11   Income Taxes

  60

Note 12   Shareholders’ Equity And Other Comprehensive Income

  61

Note 13   Legal Proceedings

  62

Note 14   Segment Reporting

  63

Note 15   Commitments And Guarantees

  66
 

Statistical Information (Unaudited)

 

Average Consolidated Balance Sheet And Net Interest Analysis

  69-70

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

  1-39,69-70

Financial Review

 

Consolidated Financial Highlights

  1-2

Executive Summary

  3

Consolidated Income Statement Review

  7

Consolidated Balance Sheet Review

  11

Off-Balance Sheet Arrangements And Variable Interest Entities

  15

Business Segments Review

  17

Critical Accounting Policies And Judgments

  26

Status Of Qualified Defined Benefit Pension Plan

  26

Risk Management

  27

Internal Controls And Disclosure Controls And Procedures

  36

Glossary Of Terms

  36

Cautionary Statement Regarding Forward-Looking Information

  38

Item 3.     Quantitative and Qualitative Disclosures About Market Risk.

  27-35

Item 4.     Controls and Procedures.

  36

PART II – OTHER INFORMATION

 

Item 1.     Legal Proceedings.

  71

Item 1A.  Risk Factors.

  71

Item 2.     Unregistered Sales Of Equity Securities And Use Of Proceeds.

  71

Item 6.     Exhibits.

  72

Exhibit Index.

  72

Signature

  72

Corporate Information

  73


Table of Contents

CONSOLIDATED FINANCIAL HIGHLIGHTS

THE PNC FINANCIAL SERVICES GROUP, INC.

 

Dollars in millions, except per share data   Three months ended
September 30
       Nine months ended
September 30
 
Unaudited       2007              2006                2007              2006      

FINANCIAL PERFORMANCE (a)

              

Revenue

              

Net interest income, taxable-equivalent basis (b)

  $ 767      $ 574        $ 2,142      $ 1,699  

Noninterest income

    990        2,943          2,956        5,358  

Total revenue

  $ 1,757      $ 3,517        $ 5,098      $ 7,057  

Noninterest expense

  $ 1,099      $ 1,167        $ 3,083      $ 3,474  

Net income

  $ 407      $ 1,484        $ 1,289      $ 2,219  

Per common share

              

Diluted earnings

  $ 1.19      $ 5.01        $ 3.85      $ 7.46  

Cash dividends declared

  $ .63      $ .55        $ 1.81      $ 1.60  

SELECTED RATIOS

              

Net interest margin

    3.00 %      2.89 %        3.00 %      2.92 %

Noninterest income to total revenue (c)

    57        84          58        76  

Efficiency (d)

    63        33          61        49  

Return on

              

Average common shareholders’ equity

    11.25 %      65.94 %        12.62 %      33.87 %

Average assets

    1.27        6.17          1.44        3.17  

See page 36 for a glossary of certain terms used in this Report.

(a) The Executive Summary and Consolidated Income Statement Review (Noninterest Income-Summary and Noninterest Expense) portions of the Financial Review section of this Report provide information regarding items impacting the comparability of the periods presented.
(b) 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 taxable investments. 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 earned on taxable investments. This adjustment is not permitted under 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
September 30
     Nine months ended
September 30
         2007              2006          2007      2006

Net interest income, GAAP basis

  $ 761      $ 567      $ 2,122      $ 1,679

Taxable-equivalent adjustment

    6        7        20        20

Net interest income, taxable-equivalent basis

  $ 767      $ 574      $ 2,142      $ 1,699

 

(c) Calculated as noninterest income divided by the sum of net interest income (GAAP basis) and noninterest income. Noninterest income for the 2007 periods presented above reflected income from our equity investment in BlackRock, Inc. (“BlackRock”) included in the “Asset management” line item. Noninterest income for the 2006 periods presented included the impact of BlackRock on a consolidated basis, primarily consisting of asset management fees.
(d) Calculated as noninterest expense divided by the sum of net interest income (GAAP basis) and noninterest income. Noninterest expense for the 2006 periods included the impact of BlackRock on a consolidated basis.

 

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Unaudited   September 30
2007
    December 31
2006
       September 30
2006
 

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

          

Assets

  $ 131,366     $ 101,820        $ 98,436  

Loans, net of unearned income

    65,760       50,105          48,900  

Allowance for loan and lease losses

    717       560          566  

Securities available for sale

    28,430       23,191          19,512  

Loans held for sale

    3,004       2,366          4,317  

Goodwill and other intangibles

    8,935       4,043          4,008  

Equity investments

    5,975       5,330          5,130  

Deposits

    78,409       66,301          64,572  

Borrowed funds

    27,453       15,028          14,695  

Shareholders’ equity

    14,539       10,788          10,758  

Common shareholders’ equity

    14,532       10,781          10,751  

Book value per common share

    43.12       36.80          36.60  

Common shares outstanding (millions)

    337       293          294  

Loans to deposits

    84 %     76 %        76 %

ASSETS ADMINISTERED (billions) (a)

          

Managed

  $ 77     $ 54        $ 52  

Nondiscretionary

    112       86          89  

FUND ASSETS SERVICED (billions)

          

Accounting/administration net assets

  $ 922     $ 837        $ 774  

Custody assets

    497       427          399  

CAPITAL RATIOS

          

Tier 1 risk-based (b)

    7.5 %     10.4 %        10.4 %

Total risk-based (b)

    10.9       13.5          13.6  

Leverage (b)

    6.8       9.3          9.4  

Tangible common equity

    5.2       7.4          7.5  

Common shareholders’ equity to assets

    11.1       10.6          10.9  

ASSET QUALITY RATIOS

          

Nonperforming loans to total loans

    .38 %     .29 %        .34 %

Nonperforming assets to total loans and foreclosed assets

    .43       .34          .39  

Nonperforming assets to total assets

    .22       .17          .19  

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

    .30       .36          .37  

Allowance for loan and lease losses to loans

    1.09       1.12          1.16  

Allowance for loan and lease losses to nonperforming loans

    290       381          339  
(a) Amounts at September 30, 2007 reflect the impact of our March 2, 2007 acquisition of Mercantile Bankshares Corporation (“Mercantile”).
(b) The regulatory minimums are 4.0% for Tier 1, 8.0% for Total, and 4.0% for Leverage ratios. The well-capitalized levels are 6.0% for Tier 1, 10.0% for Total, and 5.0% for Leverage ratios.

 

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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 2006 Annual Report on Form 10-K (“2006 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 Management section in this Financial Review and Items 1A and 7 of our 2006 Form 10-K and Item 1A included in Part II of this Report. 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 14 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 based on assets, with 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, Washington, DC, Maryland, Virginia, Ohio, Kentucky and Delaware. We also provide certain global fund processing services internationally.

KEY STRATEGIC GOALS

Our strategy to enhance shareholder value centers on driving positive operating leverage by achieving growth in revenue from our diverse business mix that exceeds growth in expenses as a result of disciplined cost management. In each of our business segments, the primary drivers of revenue growth are the acquisition, expansion and retention of customer relationships. We strive to expand our customer base by providing convenient banking options and leading technology systems, providing a broad range of fee-based products and services, focusing on customer service, and through a significantly enhanced branding initiative. We also intend to grow revenue through appropriate and targeted acquisitions and, in certain businesses, by expanding into new geographical markets.

In recent years, we have maintained a moderate risk profile characterized by strong credit quality and limited exposure to earnings volatility resulting from interest rate fluctuations and the shape of the interest rate yield curve. Our actions have created a balance sheet reflecting a strong capital position and investment flexibility to adjust, where appropriate, to changing interest rates and market conditions. We continue to be disciplined in investing capital in our businesses while returning a portion to shareholders through dividends and share repurchases.

PENDING ACQUISITIONS

ALBRIDGE SOLUTIONS INC.

On November 1, 2007, we announced that we had signed a definitive agreement to acquire Lawrenceville, New Jersey-based Albridge Solutions Inc. (“Albridge”), a provider of portfolio accounting and enterprise wealth management services. Albridge provides financial advisors with consolidated client account information from hundreds of data sources, and its enterprise approach to providing a unified client view and performance reporting helps advisors build their client and asset base. Albridge

will extend PFPC’s capabilities into the delivery of knowledge-based information services through its relationships with 150 financial institutions and more than 100,000 financial advisors with assets under management that exceed $1 trillion. The financial terms of the agreement have not been disclosed.

The transaction is expected to close before the end of the first quarter of 2008 and is subject to customary closing conditions, including regulatory approvals.

STERLING FINANCIAL CORPORATION

On July 19, 2007, we entered into a definitive agreement with Sterling Financial Corporation (“Sterling”) for PNC to acquire Sterling for approximately 4.5 million shares of PNC common stock and $224 million in cash. Based upon PNC’s closing common stock price on July 17, 2007, the consideration represents $565 million in stock and cash or approximately $19.00 per Sterling share.

Sterling, based in Lancaster, Pennsylvania with approximately $3.3 billion in assets and $2.6 billion in deposits, provides banking and other financial services, including leasing, trust, investment and brokerage, to individuals and businesses through 67 branches in Pennsylvania, Maryland and Delaware. The transaction is expected to close in the first quarter of 2008 and is subject to customary closing conditions, including regulatory approvals and the approval of Sterling’s shareholders.

RECENTLY COMPLETED ACQUISITIONS

YARDVILLE NATIONAL BANCORP

On October 26, 2007, we acquired Hamilton, New Jersey-based Yardville National Bancorp (“Yardville”). Yardville shareholders received in the aggregate approximately 3.4 million shares of PNC common stock and $156 million in cash. Total consideration was approximately $399 million in stock and cash. Yardville added approximately $2.6 billion in assets, $1.9 billion in deposits and 35 branches in central New Jersey and eastern Pennsylvania at closing. The Yardville technology systems conversion is scheduled for the first quarter of 2008.

ARCS COMMERCIAL MORTGAGE CO., L.P.

On July 2, 2007, we acquired ARCS Commercial Mortgage Co., L.P. (“ARCS”), a Calabasas Hills, California-based lender with 10 origination offices in the United States. ARCS has been a leading originator and servicer of agency multifamily loans for the past decade. It originated more than $2.1 billion of loans in 2006 and services approximately $13 billion of commercial mortgage loans.


 

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MERCANTILE BANKSHARES CORPORATION

We acquired Mercantile effective March 2, 2007 for approximately 53 million shares of PNC common stock and $2.1 billion in cash. Total consideration paid was approximately $5.9 billion. We completed the Mercantile technology systems conversion in September 2007.

Mercantile has added banking and investment and wealth management services through 235 branches in Maryland, Virginia, the District of Columbia, Delaware and southeastern Pennsylvania. This transaction has significantly expanded our presence in the mid-Atlantic region, particularly within the attractive Baltimore and Washington, DC markets.

We refer you to our Form 8-K filed March 8, 2007 for additional information on this transaction.

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,

   

Customer demand for other products and services,

   

Movement of customer deposits from lower to higher rate accounts or to investment alternatives,

   

The level of, direction, timing and magnitude of movement in interest rates, and the shape of the interest rate yield curve, and

   

The performance of, and availability of liquidity in, the capital markets.

In addition, our success in the remainder of 2007 and into 2008 will depend, among other things, upon:

   

Further success in the acquisition, growth and retention of customers,

   

The successful integration of Yardville and progress toward closing and integrating the Sterling acquisition,

   

Revenue growth,

   

A sustained focus on expense management and creating positive operating leverage,

   

Maintaining strong overall asset quality, and

   

Prudent risk and capital management.

SUMMARY FINANCIAL RESULTS

 

     Three months ended     Nine months ended  
      Sept. 30
2007
    Sept. 30
2006
    Sept. 30
2007
    Sept. 30
2006
 

Net income (millions)

   $ 407     $ 1,484     $ 1,289     $ 2,219  

Diluted earnings per share

   $ 1.19     $ 5.01     $ 3.85     $ 7.46  

Return on

          

Average common shareholders’ equity

     11.25 %     65.94 %     12.62 %     33.87 %

Average assets

     1.27 %     6.17 %     1.44 %     3.17 %

 

Earnings for the first nine months of 2007 included the impact of after-tax integration costs related to acquisitions and the 2006 BlackRock/Merrill Lynch investment management business (“MLIM”) transaction totaling $49 million, or $.15 per diluted share. The net after-tax impact of our BlackRock LTIP shares obligation was not significant for the first nine months of 2007 as the gain recognized in connection with PNC’s transfer of BlackRock shares to satisfy a portion of our BlackRock LTIP shares obligation in the first quarter of 2007 offset the quarterly net mark-to-market adjustments on our remaining shares obligation for the nine month period.

Earnings for the third quarter of 2007 included an after-tax loss of $32 million, or $.09 per diluted share, from the net mark-to-market adjustments on our remaining BlackRock LTIP shares obligation, and after-tax integration costs related to acquisitions and the 2006 BlackRock/MLIM transaction totaling $30 million, or $.09 per diluted share.

Earnings for the third quarter and first nine months of 2006 included the impact of the following items:

   

The gain on the BlackRock/MLIM transaction totaling $1.3 billion after-tax, or $4.36 per diluted share;

   

Securities portfolio rebalancing charges totaling $127 million after-tax, or $.43 per diluted share;

   

The mortgage loan portfolio repositioning loss of $31 million after-tax, or $.10 per diluted share; and

   

Our share of the after-tax impact of BlackRock/MLIM integration costs, which totaled $31 million, or $.10 per diluted share, for the third quarter of 2006 and $39 million, or $.13 per diluted share, for the first nine months of 2006.

In addition to the impact of the items described above, the decline in diluted earnings per share in both comparisons reflected the shares PNC issued for the Mercantile acquisition in the first quarter of 2007.

Highlights of the third quarter of 2007 included the following:

   

During September 2007, we completed the integration of the 11 banks that comprised Mercantile – the largest technology systems conversion in our history. We can now offer the full breadth of our products and services throughout our expanded mid-Atlantic region, including the Baltimore metropolitan area.

   

A diverse revenue mix continued to differentiate PNC. Noninterest income accounted for 57% of total revenue in the third quarter of 2007 and 58% for the first nine months of 2007. Each of PNC’s primary businesses grew revenue in the third quarter of 2007 compared with the same quarter of 2006.

   

Asset quality remained strong, reflecting PNC’s commitment to maintaining a moderate risk profile. Nonperforming assets to total assets were .22% at September 30, 2007 compared with .19% at September 30, 2006.


 

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PNC had a strong liquidity position and favorable loan-to-deposit ratio of 84% at September 30, 2007. Average loans grew 29% and average deposits increased 21% compared with the third quarter of 2006, mostly due to the Mercantile acquisition.

   

PNC purchased 5.5 million of its common shares at a cost of $383 million during the third quarter of 2007 under its common stock repurchase program. During the first nine months of 2007, PNC purchased 10.9 million common shares under the program at a total cost of $778 million. On October 4, 2007, our Board of Directors authorized a new program to purchase up to 25 million shares of PNC common stock, which replaced and terminated the prior common stock repurchase program.

BLACKROCK/MLIM TRANSACTION

As further described in our 2006 Form 10-K, on September 29, 2006 Merrill Lynch contributed its investment management business to BlackRock in exchange for 65 million shares of newly issued BlackRock common and preferred stock.

For the nine months ended September 30, 2006, our Consolidated Income Statement included our former 69% ownership interest in BlackRock. However, our Consolidated Balance Sheet as of September 30, 2007 and December 31, 2006 reflected the September 29, 2006 deconsolidation of BlackRock’s balance sheet amounts and recognized our approximate 34% ownership interest in BlackRock as an investment accounted for under the equity method. This accounting has resulted in a reduction in certain revenue and noninterest expense categories on our Consolidated Income Statement as our share of BlackRock’s net income is now reported in asset management noninterest income. In addition, beginning with fourth quarter 2006, we recognize gain or loss each quarter-end on our remaining liability to provide shares of BlackRock common stock to help fund certain BlackRock LTIP programs as that liability is marked to market based on changes in BlackRock’s common stock price. We will also continue to recognize gains or losses on the future transfer of shares for payouts under such LTIP programs.

BALANCE SHEET HIGHLIGHTS

Total assets were $131.4 billion at September 30, 2007 compared with $101.8 billion at December 31, 2006. The increase compared with December 31, 2006 was primarily due to the addition of approximately $21 billion of assets related to the Mercantile acquisition, growth in loans and higher securities available for sale.

Total average assets were $119.5 billion for the first nine months of 2007 compared with $93.7 billion for the first nine months of 2006. This increase reflected a $17.5 billion increase in average interest-earning assets and an $8.6 billion increase in average other noninterest-earning assets. An increase of $11.1 billion in loans and a $4.3 billion increase in

securities available for sale were the primary factors for the increase in average interest-earning assets.

The increase in average other noninterest-earning assets for the first nine months of 2007 reflected our equity investment

in BlackRock, which averaged $3.8 billion for the first nine months of 2007 and which had been consolidated for the same period of 2006, and an increase in average goodwill of $3.4 billion primarily related to the Mercantile acquisition.

Average total loans were $60.9 billion for the first nine months of 2007 and $49.8 billion in the first nine months of 2006. The increase in average total loans included the effect of the Mercantile acquisition for seven months of 2007, and higher commercial loans. The increase in average total loans included growth in commercial loans of $4.7 billion and growth in commercial real estate loans of $4.1 billion. Loans represented 64% of average interest-earning assets for the first nine months of both 2007 and 2006.

Average securities available for sale totaled $25.6 billion for the first nine months of 2007 and $21.3 billion for the first nine months of 2006. The seven-month impact of Mercantile contributed to the increase in average securities for the 2007 period. By primary classification, the increase in average securities reflected a $6.8 billion increase in mortgage-backed and asset-backed securities, which was partially offset by a $2.6 billion decline in US Treasury and government agencies securities. Securities available for sale comprised 27% of average interest-earning assets for the first nine months of 2007 and 28% for the comparable 2006 period.

Average total deposits were $75.5 billion for the first nine months of 2007, an increase of $12.7 billion over the first nine months of 2006. Average deposits grew from the prior year period primarily as a result of an increase in money market, noninterest-bearing demand deposits and retail certificates of deposit. These increases reflected the seven-month impact of the Mercantile acquisition.

Average total deposits represented 63% of average total assets for the first nine months of 2007 and 67% for the first nine months of 2006. Average transaction deposits were $50.0 billion for the first nine months of 2007 compared with $41.7 billion for the comparable 2006 period.

Average borrowed funds were $21.1 billion for the first nine months of 2007 and $15.2 billion for the first nine months of 2006. Increases of $2.6 billion in federal funds purchased and $2.6 billion in bank notes and senior debt drove the increase in average borrowed funds compared with the first nine months of 2006.

Shareholders’ equity totaled $14.5 billion at September 30, 2007, compared with $10.8 billion at December 31, 2006. The increase resulted primarily from the Mercantile acquisition. See the Consolidated Balance Sheet Review section of this Financial Review for additional information.


 

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BUSINESS SEGMENT HIGHLIGHTS

 

    Three months ended    Nine months ended
In millions   Sept. 30
2007
   Sept. 30
2006
   Sept. 30
2007
   Sept. 30
2006

Total segment earnings

  $ 436    $ 399    $ 1,291    $ 1,139

Total business segment earnings increased $152 million, or 13%, for the first nine months of 2007 compared with the first nine months of 2006. We refer you to page 18 of this Report for a Results of Businesses – Summary table, with further analysis of business segment results for the first nine months of 2007 and 2006 provided on pages 19 through 25.

Third quarter 2007 business segment earnings of $436 million increased $37 million, or 9%, compared with the third quarter of 2006. Highlights of results for the first nine months and third quarter periods are included below.

We provide a reconciliation of total business segment earnings to total PNC consolidated net income as reported on a GAAP basis in Note 14 Segment Reporting in the Notes To Consolidated Financial Statements in this Report. The presentation of BlackRock segment and total business segment earnings in this Financial Review differs from Note 14 in that these earnings exclude BlackRock/MLIM integration costs and prior year results reflect BlackRock as if it had been accounted for under the equity method.

Retail Banking

Retail Banking’s earnings were $678 million for the first nine months of 2007 compared with $581 million for the same period in 2006. The 17% increase over the prior year was driven by the Mercantile acquisition, strong market-related fees and continued customer growth, partially offset by an increase in the provision for credit losses and in noninterest expense.

Retail Banking earned $250 million for the third quarter of 2007, an increase of $44 million, or 21%, compared with the third quarter of 2006. The increase over the third quarter of 2006 was primarily due to the Mercantile acquisition, increased fee income and continued customer growth.

Corporate & Institutional Banking

Corporate & Institutional Banking earned $341 million in the first nine months of 2007 compared with $328 million in the first nine months of 2006. The increase compared with the 2006 period was largely the result of higher taxable-equivalent net interest income and corporate service fees, partly offset by an increase in noninterest expense, lower other noninterest income, and an increase in the provision for credit losses.

For the third quarter of 2007, earnings from Corporate & Institutional Banking totaled $87 million compared with $111

million for the third quarter of 2006. The decrease in the comparison was due to a higher provision for credit losses and higher noninterest expense, partially offset by increased revenues.

BlackRock

Our BlackRock business segment earned $176 million for the first nine months of 2007 compared with $137 million in the first nine months of 2006. Third quarter earnings totaled $66 million in 2007 and $42 million in 2006. The higher earnings in both comparisons reflected our approximate 34% ownership interest in a larger BlackRock entity during 2007 compared with the approximately 70% ownership interest in the corresponding 2006 periods in which we had consolidated BlackRock. The presentation of the 2006 period results has been modified to conform with our current business segment reporting presentation in this Financial Review.

PFPC

PFPC earned $96 million for the first nine months of 2007 compared with $93 million in the year-earlier period. Earnings for the 2006 period benefited from the impact of a $14 million reversal of deferred taxes related to earnings from foreign subsidiaries following management’s determination that the earnings would be indefinitely reinvested outside of the United States. Higher earnings in the first nine months of 2007 reflected the successful conversion of net new business, organic growth and market appreciation.

Earnings from PFPC totaled $33 million in the third quarter of 2007 compared with $40 million in the prior year third quarter. The prior year quarter results included the impact of the tax benefit described above. A $20 million, or 10%, increase in servicing revenue compared with the third quarter of 2006 was fueled by strong fee income growth in transfer agency, offshore operations, managed accounts, advanced output solutions and alternative investments.

Other

“Other” for the first nine months of 2007 was a net loss of $2 million, while “Other” earnings for the first nine months of 2006 totaled $1.1 billion. For the third quarter of 2007, “Other” resulted in a net loss of $29 million compared with earnings of $1.1 billion in the third quarter of 2006.

“Other” earnings for both 2006 periods was driven by the $1.3 billion after-tax gain on the BlackRock/MLIM transaction recorded in the third quarter of 2006. The impact of the gain was partially offset by the impact of charges related to the third quarter 2006 balance sheet repositioning activities and by BlackRock/MLIM integration costs.


 

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CONSOLIDATED INCOME STATEMENT REVIEW

NET INTEREST INCOME AND NET INTEREST MARGIN

 

     Three months ended     Nine months ended  
Dollars in millions    Sept. 30
2007
    Sept. 30
2006
    Sept. 30
2007
    Sept. 30
2006
 

Taxable-equivalent net interest income

   $ 767     $ 574     $ 2,142     $ 1,699  

Net interest margin

     3.00 %     2.89 %     3.00 %     2.92 %

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 of funding. See Statistical Information-Average Consolidated Balance Sheet And Net Interest Analysis included on pages 69 and 70 of this Report for additional information.

The 26% increase in taxable-equivalent net interest income for the first nine months of 2007 compared with the first nine months of 2006 was consistent with the $17.5 billion, or 23%, increase in average interest-earning assets over these periods. Similarly, the 34% increase in taxable-equivalent net interest income for the third quarter of 2007 compared with the prior year quarter reflected the $22.7 billion, or 29%, increase in average interest-earning assets over these quarters. The reasons driving the higher interest-earning assets in these comparisons are further discussed in the Balance Sheet Highlights portion of the Executive Summary section of this Financial Review.

The net interest margin was 3.00% for the first nine months of 2007 and 2.92% for the first nine months of 2006. The following factors impacted the comparison:

   

The Mercantile acquisition.

   

The yield on interest-earning assets increased 46 basis points. The yield on loans, the single largest component, increased 42 basis points.

   

These factors were partially offset by an increase in the rate paid on interest-bearing liabilities of 41 basis points. The rate paid on interest-bearing deposits, the single largest component, increased 38 basis points.

   

The impact of noninterest-bearing sources of funding increased 3 basis points for the nine months of 2007 due to higher rates.

The net interest margin was 3.00% for the third quarter of 2007 and 2.89% for the third quarter of 2006. The following factors impacted the comparison:

   

The Mercantile acquisition.

   

The yield on interest-earning assets increased 28 basis points. The yield on loans, the single largest component, increased 30 basis points.

   

These factors were partially offset by an increase in the rate paid on interest-bearing liabilities of 11 basis points. The rate paid on interest-bearing deposits, the single largest component, increased 6 basis points.

   

In addition, the impact of noninterest-bearing sources of funding decreased 6 basis points for the third quarter of 2007 as the proportion of average noninterest-bearing sources of funding to average interest-bearing assets declined in the comparison.

Comparing yields and rates paid to the broader market, during the first nine months of 2007, the average federal funds rate was 5.20% compared with 4.87% for the first nine months of 2006. The average federal funds rate was 5.09% during the third quarter of 2007 compared with 5.25% for the third quarter of 2006.

We believe that net interest margins for our industry will continue to be challenged given the current yield curve, as competition for loans and deposits remains intense, as customers continue to migrate from lower rate to higher rate deposits or other products, and as the benefit of adding or repricing investment securities is diminished.

PROVISION FOR CREDIT LOSSES

The provision for credit losses totaled $127 million for the first nine months of 2007 compared with $82 million for the first nine months of 2006. The provision for credit losses for the third quarter of 2007 was $65 million compared with $16 million for the third quarter of 2006. The higher provision in the third quarter and first nine months of 2007 was primarily due to growth in total credit exposure and modest credit quality migration.

Given current market conditions, we do not expect to maintain asset quality at its current level. To the extent actual outcomes differ from our estimates, changes to the provision for credit losses may be required that may reduce future earnings. 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 totaled $2.956 billion for the first nine months of 2007 compared with $5.358 billion for the first nine months of 2006.

Noninterest income for the first nine months of 2006 included the following items:

   

The $2.078 billion gain on the BlackRock/MLIM transaction,

   

The impact of BlackRock on a consolidated basis totaling $1.087 billion. Had our BlackRock investment been on the equity method during that time, BlackRock’s noninterest income reported by us would have been $144 million for that period, or lower by $943 million, and

   

The $196 million securities portfolio rebalancing loss and the $48 million mortgage loan portfolio repositioning loss.


 

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Apart from the impact of these items, noninterest income increased $375 million, or 15%, for the first nine months of 2007 compared with the first nine months of 2006 largely as a result of the acquisition of Mercantile and organic growth.

Noninterest income was $990 million for the third quarter of 2007 compared with $2.943 billion for the third quarter of 2006. Noninterest income for the third quarter of 2007 included the impact of a net loss of $50 million related to our mark-to-market adjustment on our remaining BlackRock LTIP shares obligation.

Noninterest income for the third quarter of 2006 included the following items:

   

The $2.078 billion gain on the BlackRock/MLIM transaction, partially offset by the balance sheet repositioning items totaling $244 million described above, and

   

The impact of BlackRock on a consolidated basis totaling $320 million. Had our BlackRock investment been on the equity method during that time, BlackRock’s noninterest income reported by us would have been $43 million for that quarter, or lower by $277 million.

Apart from the impact of these items, PNC’s noninterest income increased $208 million, or 25%, during the third quarter of 2007. The impact of the Mercantile acquisition, higher equity management (private equity) gains and growth in several other areas further described below were the primary drivers in the increase.

Additional Analysis

Asset management fees totaled $559 million for the first nine months of 2007 and $1.271 billion for the first nine months of 2006. Asset management fees totaled $204 million in the third quarter of 2007, a decrease of $177 million compared with the third quarter of 2006. Our equity income from BlackRock was included in asset management fees for the first nine months and third quarter of 2007, while asset management fees in the corresponding prior year periods was higher due to the impact of BlackRock’s revenue on a consolidated basis.

Assets managed at September 30, 2007 totaled $77 billion compared with $52 billion at September 30, 2006 and increased largely due to the Mercantile acquisition. We refer you to the Retail Banking section of the Business Segments Review section of this Financial Review for further discussion of our assets under management.

Fund servicing fees declined $24 million, to $620 million, in the first nine months of 2007 compared with the prior year first nine months. Amounts for 2006 included $66 million of distribution fee revenue at PFPC. Effective January 1, 2007, we refined our accounting and reporting of PFPC’s distribution fee revenue and related expense amounts and present these amounts net on a prospective basis. Prior to 2007, the distribution amounts were shown on a gross basis within fund servicing fees and within other noninterest expense. These amounts offset each other entirely and have no impact on earnings.

Fund servicing fees total $208 million for the third quarter of 2007, a $5 million decrease from the prior year period.

Included in these amounts for the third quarter of 2006 was distribution fee revenue of $22 million at PFPC. Apart from the impact of the distribution fee revenue included in the prior year amounts, fund servicing fees increased $42 million for the first nine months of 2007 and $17 million for the third quarter compared with the corresponding 2006 periods. Both increases were largely due to higher transfer agency and offshore revenues reflecting net new business and growth from existing clients.

PFPC provided fund accounting/administration services for $922 billion of net fund investment assets and provided custody services for $497 billion of fund investment assets at September 30, 2007, compared with $774 billion and $399 billion, respectively, at September 30, 2006. These increases were the result of new business obtained, organic growth from current customers and market appreciation.

Service charges on deposits of $258 million for the first nine months of 2007 represented a $24 million increase compared with the first nine months of 2006. Service charges on deposits grew $8 million, to $89 million, in the third quarter of 2007 compared with the third quarter of 2006. The increases in both comparisons can be attributed primarily to the impact of Mercantile.

Brokerage fees increased $26 million, to $209 million, for the first nine months of 2007 compared with the first nine months of 2006. For the third quarter of 2007, brokerage fees totaled $71 million compared with $61 million in the third quarter of 2006. In both comparisons, the increases were primarily due to higher mutual fund-related revenues, including a favorable impact from products related to the fee-based fund advisory business and higher annuity income.

Consumer services fees grew $32 million, to $304 million, for the first nine months of 2007 compared with the first nine months of 2006. Of that increase, $17 million occurred in the third quarter of 2007, as consumer service fees totaled $106 million in that period. This increase reflected the impact of Mercantile, higher debit card revenues resulting from higher transaction volumes, and revenue from the credit card business that began in the latter part of 2006. These factors were partially offset by lower ATM surcharge revenue in 2007 compared with the prior year period as a result of changing customer behavior and a strategic decision to reduce the out-of-footprint ATM network.

Corporate services revenue increased $84 million, to $533 million, in the first nine months of 2007 compared with the first nine months of 2006. Corporate services revenue totaled $198 million in the third quarter of 2007 compared with $157 million in the third quarter of 2006. Higher revenue from mergers and acquisitions advisory and related services, treasury management, commercial mortgage servicing, and third party consumer loan servicing activities contributed to the increases in both comparisons.

Equity management (private equity) net gains on portfolio investments totaled $81 million for the first nine months of 2007 compared with $82 million for the first nine months of 2006. For the third quarter of 2007, such gains totaled $47 million compared with $21 million in the prior year third quarter. Based


 

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on the nature of private equity activities, net gains or losses may fluctuate from period to period and the level of gains recognized during the third quarter of 2007 may not be sustainable in future quarters.

Net securities losses totaled $4 million for the first nine months of 2007 and $207 million for the first nine months of 2006. Third quarter 2007 net securities losses were $2 million while the prior year quarter net losses totaled $195 million. Note 3 Securities in the Notes To Consolidated Financial Statements of this Report has additional information regarding our third quarter 2006 securities portfolio rebalancing actions which resulted in a pretax loss of $196 million for that quarter.

Noninterest revenue from trading activities totaled $114 million in the first nine months of 2007 and $150 million in the first nine months of 2006. Noninterest revenue from trading activities was $33 million for the third quarter of 2007 compared with $38 million for the third quarter of 2006. Customer trading income increased in both comparisons. However, total trading revenue declined in 2007 largely due to the impact of derivatives related to commercial mortgage loan activity and lower non-customer trading activities. 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 $281 million for the first nine months of 2007 represented a $79 million increase compared with the first nine months of 2006. Other noninterest income totaled $86 million for the third quarter of 2007, an increase of $67 million from the third quarter of 2006. The impact of the third quarter 2006 mortgage loan repositioning loss of $48 million was reflected in the increase in other noninterest income in both comparisons. Other noninterest income typically fluctuates from period to period depending on the nature and magnitude of transactions completed.

Due to the BlackRock/MLIM transaction, which resulted in a $2.1 billion pretax gain in the third quarter of 2006, we expect that total noninterest income will decline significantly for full year 2007 compared with full year 2006. Changes in noninterest income compared with the prior year also will be impacted by the deconsolidation of BlackRock and balance sheet repositioning actions in 2006, and by our BlackRock LTIP shares obligation. Apart from the comparative impact on noninterest income of these 2006 items, we expect that total revenue will increase by a high teens percentage for full year 2007 compared with 2006.

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 financing 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, increased 11% to $345 million for the first nine months of 2007 compared with $311 million for the first nine months of 2006.

Treasury management revenue increased 14% to $121 million

for the third quarter of 2007 compared with $106 million for the third quarter of 2006. The higher revenue reflected continued expansion and client utilization of commercial payment card services, strong revenue growth in various electronic payment and information services, and steady growth in deposits and core businesses.

Revenue from capital markets-related products and services increased 6% to $216 million for the first nine months of 2007 compared with $204 million in the first nine months of 2006. Capital markets-related products and services revenues totaled $73 million for the third quarter of 2007 compared with $64 million for the third quarter of 2006, an increase of 14%. In both comparisons, the increases were driven by merger and acquisition advisory and related services.

Midland Loan Services offers servicing, real estate advisory and technology solutions for the commercial real estate finance industry. Midland’s revenue, which includes servicing fees and net interest income from servicing portfolio deposit balances, totaled $169 million for first nine months of 2007 and $131 million for first nine months of 2006, an increase of 29%. Revenue from Midland totaled $59 million for the third quarter of 2007 compared with $47 million for the third quarter of 2006, an increase of 26%. The revenue growth in both comparisons was primarily driven by growth in the commercial mortgage servicing portfolio and related services.

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 products 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 increased 17% to $62 million for the first nine months of 2007 compared with $53 million for the first nine months of 2006. Insurance products revenue increased 17% to $21 million in the third quarter of 2007 compared with $18 million in the third quarter of 2006.

PNC, through subsidiary companies Alpine Indemnity Limited and PNC Insurance Corp., participates as a direct writer for its general liability, automobile liability, workers’ compensation, property and terrorism insurance 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 September 30, 2007.


 

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NONINTEREST EXPENSE

Total noninterest expense was $3.083 billion for the first nine months of 2007 and $3.474 billion for the first nine months of 2006. Total noninterest expense was $1.099 billion for the third quarter of 2007 and $1.167 billion for the third quarter of 2006.

Noninterest expense for the 2007 and 2006 periods included the following:

   

The first nine months of 2007 included acquisition integration costs of $67 million, of which $41 million were recognized in the third quarter, primarily related to our acquisition of Mercantile.

   

Noninterest expense for the first nine months of 2006 included $765 million of expenses, including $223 million in the third quarter, related to BlackRock, which was still consolidated during that time.

   

Noninterest expense for the first nine months 2006 also included $91 million of BlackRock/MLIM transaction integration costs, including $72 million in the third quarter of that year.

Apart from the impact of these items, noninterest expense increased $398 million, or 15%, in the first nine months of 2007 compared with the first nine months of 2006. Similarly, noninterest expense increased $186 million, or 21%, in the third quarter of 2007 compared with the prior year quarter. These increases were largely a result of the acquisition of Mercantile. Investments in growth initiatives were mitigated by disciplined expense management.

We expect total noninterest expense to decline for full year 2007 compared with full year 2006 due to the impact of the deconsolidation of BlackRock. Apart from this impact and integration costs, we expect noninterest expense to grow by a

low teens percentage for full year 2007 compared with 2006 primarily as a result of acquisitions.

We expect to continue to incur integration costs related to Mercantile. Such costs are currently estimated to be $11 million after-tax for the fourth quarter of 2007 and will be recognized within the noninterest expense and income tax categories. We also expect to recognize an after-tax charge of approximately $30 million related to the Yardville acquisition in the fourth quarter of 2007. These costs will be primarily credit related in the form of a provision for credit losses, estimated to be approximately $45 million as of the transaction close date.

PERIOD-END EMPLOYEES

 

     Sept. 30, 2007    December 31, 2006    Sept. 30, 2006

Full-time

   24,811    21,455    21,374

Part-time

   2,823    2,328    2,165
    

Total

   27,634    23,783    23,539

The increase in employees as of September 30, 2007 was due to the Mercantile acquisition.

EFFECTIVE TAX RATE

Our effective tax rate for the first nine months of 2007 was 31.0% compared with 34.9% for the first nine months of 2006. The effective tax rate was 30.7% for the third quarter of 2007 and 36.0% for the third quarter of 2006. The higher effective rate in the 2006 period for both comparisons was primarily due to the third quarter 2006 gain on the BlackRock/MLIM transaction and a related $57 million cumulative adjustment to deferred taxes recorded in the same quarter. We expect our effective tax rate to be approximately 31% for full year 2007.


 

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CONSOLIDATED BALANCE SHEET REVIEW

SUMMARIZED BALANCE SHEET DATA

 

In millions    September 30
2007
   December 31
2006

Assets

       

Loans, net of unearned income

   $ 65,760    $ 50,105

Securities available for sale

     28,430      23,191

Loans held for sale

     3,004      2,366

Equity investments

     5,975      5,330

Goodwill and other intangible assets

     8,935      4,043

Other

     19,262      16,785
 

Total assets

   $ 131,366    $ 101,820

Liabilities

       

Funding sources

   $ 105,862    $ 81,329

Other

     9,299      8,818
 

Total liabilities

     115,161      90,147

Minority and noncontrolling interests in consolidated entities

     1,666      885

Total shareholders’ equity

     14,539      10,788
 

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

   $ 131,366    $ 101,820

Our Consolidated Balance Sheet is presented in Part I, Item 1 on page 41 of this Report.

Our Consolidated Balance Sheet at September 30, 2007 reflects the addition of approximately $21 billion of assets resulting from our Mercantile acquisition.

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 69 and 70) are more indicative of underlying business trends.

An analysis of changes in certain balance sheet categories follows.

LOANS, NET OF UNEARNED INCOME

Loans increased $15.7 billion, to $65.8 billion, at September 30, 2007 compared with the balance at December 31, 2006. Our acquisition of Mercantile added $12.4 billion of loans including $4.9 billion of commercial, $4.8 billion of commercial real estate, $1.6 billion of consumer and $1.1 billion of residential mortgage loans.

 

Details Of Loans

 

In millions    September 30
2007
    December 31
2006
 

Commercial

      

Retail/wholesale

   $ 6,181     $ 5,301  

Manufacturing

     4,472       4,189  

Other service providers

     3,292       2,186  

Real estate related (a)

     4,502       2,825  

Financial services

     1,861       1,324  

Health care

     1,075       707  

Other

     5,352       4,052  

Total commercial

     26,735       20,584  

Commercial real estate

      

Real estate projects

     5,807       2,716  

Mortgage

     2,507       816  

Total commercial real estate

     8,314       3,532  

Equipment lease financing

     3,539       3,556  

Total commercial lending

     38,588       27,672  

Consumer

      

Home equity

     14,366       13,749  

Automobile

     1,521       1,135  

Other

     2,270       1,631  

Total consumer

     18,157       16,515  

Residential mortgage

     9,605       6,337  

Other

     396       376  

Unearned income

     (986 )     (795 )

Total, net of unearned income

   $ 65,760     $ 50,105  
(a) Includes loans related to customers in the real estate, rental, leasing and construction industries.

Our total loan portfolio continued to be diversified among numerous industries and types of businesses. The loans that we hold are also concentrated in, and diversified across, our principal geographic markets.

Commercial lending outstandings in the table above 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 $497 million, or 69%, of the total allowance for loan and lease losses at September 30, 2007 to these loans. This allocation also considers other relevant factors such as:

   

Actual versus estimated losses,

   

Regional and national economic conditions,

   

Business segment and portfolio concentrations,

   

Industry conditions,

   

The impact of government regulations, and

   

Risk of potential estimation or judgmental errors, including the accuracy of risk ratings.


 

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Net Unfunded Credit Commitments

 

In millions    September 30
2007
   December 31
2006

Commercial

   $ 37,906    $ 32,265

Consumer

     10,595      9,239

Commercial real estate

     3,507      2,752

Other

     582      579

Total

   $ 52,590    $ 44,835

Unfunded commitments are concentrated in our primary geographic markets. 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 $8.5 billion at September 30, 2007 and $8.3 billion at December 31, 2006.

Unfunded liquidity facility commitments and standby bond purchase agreements totaled $8.3 billion at September 30, 2007 and $6.0 billion at December 31, 2006 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 $4.8 billion at September 30, 2007 and $4.4 billion at December 31, 2006. Standby letters of credit commit us to make payments on behalf of our customers if specified future events occur.

Leases and Related Tax and Accounting Matters

The equipment lease portfolio totaled $3.5 billion at September 30, 2007. Aggregate residual value at risk on the lease portfolio at September 30, 2007 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 September 30, 2007. 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 examinations of our 1998-2000 and 2001-2003 consolidated federal income tax returns, the IRS provided us with examination reports which propose increases in our tax liability, principally arising from adjustments to the

timing of tax deductions from our cross-border lease transactions.

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”), became effective January 1, 2007. FSP 13-2 requires a recalculation of the timing of income recognition for actual or projected changes in the timing of tax benefits for leveraged leases. Any cumulative adjustment was to be recognized through retained earnings upon adoption of FSP 13-2. See Note 1 Accounting Policies in the Notes To Consolidated Financial Statements in Part I, Item 1 of this Report and in Item 8 of our 2006 Form 10-K for additional information. Effective January 1, 2007, we recalculated our leases and recorded a cumulative adjustment to beginning retained earnings of $149 million, after-tax, as required by FSP 13-2. This adjustment was based on our best estimate as to the timing and amount of ultimate settlement of this exposure. Any immediate or future reductions in earnings from our adoption of FSP 13-2 would be recovered in subsequent years.

In the second quarter of 2007, we reduced after-tax earnings by $13 million based on the status of our discussions with the IRS Appeals Division in resolving this matter. Further adjustments may be required in future periods as our estimates of the timing and settlement of the dispute change.

While the situation with respect to these proposed adjustments remains unresolved, we believe our reserves for these exposures were appropriate at September 30, 2007.

The adjustment to shareholders’ equity at January 1, 2007 included amounts related to three lease-to-service contract transactions that we were party to that were structured as partnerships for tax purposes. The partnership tax returns, depending on the particular partnership, have either been examined or are under examination by the IRS. 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 “Leases and Related Tax and Accounting Matters” in the Consolidated Balance Sheet Review section of Item 7 of our 2006 Form 10-K.


 

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SECURITIES

Securities Available for Sale

 

In millions    Amortized
Cost
  

Fair

Value

September 30, 2007

       

Debt securities

       

Residential mortgage-backed

   $ 20,683    $ 20,516

Commercial mortgage-backed

     4,879      4,865

Asset-backed

     2,376      2,320

US Treasury and government agencies

     153      153

State and municipal

     233      229

Other debt

     24      24

Corporate stocks and other

     324      323

Total securities available for sale

   $ 28,672    $ 28,430

December 31, 2006

       

Debt securities

       

Residential mortgage-backed

   $ 17,325    $ 17,208

Commercial mortgage-backed

     3,231      3,219

Asset-backed

     1,615      1,609

US Treasury and government agencies

     611      608

State and municipal

     140      139

Other debt

     90      87

Corporate stocks and other

     321      321

Total securities available for sale

   $ 23,333    $ 23,191

Securities represented 22% of total assets at September 30, 2007 and 23% of total assets at December 31, 2006. Our acquisition of Mercantile included approximately $2 billion of securities classified as available for sale.

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.

At September 30, 2007, securities available for sale included a net unrealized loss of $242 million, which represented the difference between fair value and amortized cost. The comparable amount at December 31, 2006 was a net unrealized loss of $142 million. Net unrealized gains and losses in the securities available for sale portfolio are included in shareholders’ equity as accumulated other comprehensive income (loss), net of tax.

The fair value of securities available for sale generally decreases when market interest rates increase and vice versa.

The expected weighted-average life of securities available for sale (excluding corporate stocks and other) was 4 years and 5 months at September 30, 2007 and 3 years and 8 months at December 31, 2006.

We estimate that at September 30, 2007 the effective duration of securities available for sale was 2.8 years for an immediate 50 basis points parallel increase in interest rates and 2.5 years for an immediate 50 basis points parallel decrease in interest

rates. Comparable amounts at December 31, 2006 were 2.6 years and 2.2 years, respectively.

Note 3 Securities in the Notes To Consolidated Financial Statements of this Report has additional information regarding our third quarter 2006 securities portfolio rebalancing actions which resulted in a pretax loss of $196 million for the third quarter and first nine months of 2006.

LOANS HELD FOR SALE

Education loans held for sale totaled $1.5 billion at September 30, 2007 and $1.3 billion at December 31, 2006. 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.

Loans held for sale also included commercial mortgage loans intended for securitization totaling $1.0 billion at September 30, 2007 and $698 million at December 31, 2006. The amount outstanding fluctuates based on the timing of securitization transactions.

FUNDING AND CAPITAL SOURCES

Details Of Funding Sources

 

In millions    September 30
2007
   December 31
2006

Deposits

       

Money market

   $ 33,007    $ 28,580

Demand

     18,957      16,833

Retail certificates of deposit

     16,511      14,725

Savings

     2,640      1,864

Other time

     2,190      1,326

Time deposits in foreign offices

     5,104      2,973

Total deposits

     78,409      66,301

Borrowed funds

       

Federal funds purchased

     6,658      2,711

Repurchase agreements

     1,990      2,051

Bank notes and senior debt

     7,794      3,633

Subordinated debt

     3,976      3,962

Federal Home Loan Bank borrowings

     4,772      42

Other

     2,263      2,629

Total borrowed funds

     27,453      15,028

Total

   $ 105,862    $ 81,329

Total funding sources increased $24.5 billion at September 30, 2007 compared with the balance at December 31, 2006, as total deposits increased $12.1 billion and total borrowed funds increased $12.4 billion. Our acquisition of Mercantile added $12.5 billion of deposits and $2.1 billion of borrowed funds.

During the first quarter of 2007 we issued borrowings to fund the $2.1 billion cash portion of the Mercantile acquisition. The


 

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remaining increase in borrowed funds was the result of growth in loans and securities and the need to fund other net changes in our balance sheet. During the third quarter of 2007 we substantially increased Federal Home Loan Bank borrowings, which provided us with additional liquidity at relatively attractive rates.

Capital

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

Total shareholders’ equity increased $3.8 billion, to $14.5 billion, at September 30, 2007 compared with December 31, 2006. In addition to the net impact of earnings and dividends in the first nine months of 2007, this increase reflected a $2.2 billion reduction in treasury stock and a $1.0 billion increase in capital surplus, largely due to the issuance of shares for the Mercantile acquisition.

Common shares outstanding at September 30, 2007 were 337 million compared with 293 million at December 31, 2006. The increase in shares outstanding during the first nine months of 2007 reflected the issuance of approximately 53 million shares in connection with the March 2007 Mercantile acquisition.

We purchased 10.9 million common shares under our prior common stock repurchase program during the first nine months of 2007 at a total cost of $778 million. This total included 5.5 million shares repurchased during the third quarter of 2007 at a total cost of $383 million. Effective October 4, 2007, our Board of Directors terminated the prior program and approved a new stock repurchase program to purchase up to 25 million shares of PNC common stock on the open market or in privately negotiated transactions. This new program will remain in effect until fully utilized or until modified, superseded or terminated.

The extent and timing of additional share repurchases under the new 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, regulatory limitations resulting from merger activity, and the potential impact on our credit rating.

 

Risk-Based Capital

 

Dollars in millions

    
 
September 30
2007
 
 
   
 
December 31
2006
 
 

Capital components

      

Shareholders’ equity

      

Common

   $ 14,532     $ 10,781  

Preferred

     7       7  

Trust preferred capital securities

     510       965  

Minority interest

     984       494  

Goodwill and other intangibles

     (8,221 )     (3,566 )

Eligible deferred income taxes on intangible assets

     115       26  

Pension, other postretirement benefit plan adjustments

     147       148  

Net unrealized securities losses, after-tax

     162       91  

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

     (39 )     13  

Equity investments in nonfinancial companies

     (29 )     (30 )

Other, net

     (4 )     (5 )

Tier 1 risk-based capital

     8,164       8,924  

Subordinated debt

     2,773       1,954  

Eligible allowance for credit losses

     844       681  

Total risk-based capital

   $ 11,781     $ 11,559  

Assets

      

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

   $ 108,451     $ 85,539  

Adjusted average total assets

     119,538       95,590  

Capital ratios

      

Tier 1 risk-based

     7.5 %     10.4 %

Total risk-based

     10.9       13.5  

Leverage

     6.8       9.3  

Tangible capital

      

Common shareholders’ equity

   $ 14,532     $ 10,781  

Goodwill and other intangibles

     (8,221 )     (3,566 )

Eligible deferred taxes

     115       26  

Tangible capital

   $ 6,426     $ 7,241  

Total assets excluding goodwill and other intangible assets, net of eligible deferred income taxes

   $ 123,260     $ 98,280  

Tangible common equity

     5.2 %     7.4 %

The declines in capital ratios from December 31, 2006 were due to an increase in risk-weighted assets and goodwill, primarily related to the Mercantile acquisition.

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 September 30, 2007, each of our banking subsidiaries was considered “well-capitalized” based on regulatory capital ratio requirements, as indicated in the Capital Ratios section of Consolidated Financial Highlights on page 2 of this Report. We believe our current bank subsidiaries will continue to meet these requirements during the remainder of 2007.


 

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OFF-BALANCE SHEET ARRANGEMENTS AND VARIABLE INTEREST ENTITIES

We engage in a variety of activities 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.” The following sections of this Report provide further information on these types of activities:

   

Commitments, including contractual obligations and other commitments, included within the Risk Management section of this Financial Review, and

   

Note 15 Commitments And Guarantees in the Notes To Consolidated Financial Statements included in Part I, Item 1 of this Report.

The following provides a summary of variable interest entities (“VIEs”), including those in which we hold a significant variable interest but have not consolidated and those that we have consolidated into our financial statements as of September 30, 2007 and December 31, 2006. Additional information on our partnership interests in low income housing projects is included in our 2006 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.

Non-Consolidated VIEs – Significant Variable Interests

 

In millions

    
 
Aggregate
Assets
    
 
Aggregate
Liabilities
    

 

PNC Risk

of Loss

 

 

September 30, 2007

          

Market Street

   $ 5,015    $ 5,023    $ 8,511 (a)

Collateralized debt obligations

     354      283      6  

Partnership interests in low income housing projects

     50      34      29  

Total

   $ 5,419    $ 5,340    $ 8,546  

December 31, 2006

          

Market Street

   $ 4,020    $ 4,020    $ 6,117 (a)

Collateralized debt obligations

     815      570      22  

Partnership interests in low income housing projects

     33      30      8  

Total

   $ 4,868    $ 4,620    $ 6,147  
(a) PNC’s risk of loss consists of off-balance sheet liquidity commitments to Market Street of $7.8 billion and other credit enhancements of $.7 billion at September 30, 2007. The comparable amounts at December 31, 2006 were $5.6 billion and $.6 billion, respectively. These liquidity commitments are included in the Net Unfunded Credit Commitments table in the Consolidated Balance Sheet Review section of this Report.

Market Street

Market Street Funding LLC (“Market Street”), is a multi-seller asset-backed commercial paper conduit that is owned by an independent third party. Market Street’s activities are limited to the purchasing of assets or making of loans secured by interests primarily in pools of receivables from US corporations that desire access to the commercial paper

market. The assets of Market Street consist primarily of automobile loans, purchased receivables, and credit card loans. Generally, Market Street mitigates potential interest rate risk by entering into agreements with customers that reflect an interest rate based upon its weighted average commercial paper cost of funds.

Market Street funds the purchases or loans by issuing commercial paper which has been rated A1/P1 by Standard & Poor’s and Moody’s, respectively, and is supported by pool-specific credit enhancement, liquidity facilities and program-level credit enhancement. During the third quarter of 2007, Market Street continued to meet its obligations in the commercial paper markets.

PNC Bank, National Association (“PNC Bank, N.A.”) provides certain administrative services, a portion of the program-level credit enhancement, and the majority of liquidity facilities to Market Street in exchange for fees negotiated based on market rates. All of Market Street’s assets at September 30, 2007 and December 31, 2006 collateralized the commercial paper obligations. PNC views its credit exposure for the Market Street transactions as limited. Facilities requiring PNC to fund for defaulted assets totaled $443 million at September 30, 2007. For 94% of the liquidity facilities at September 30, 2007, PNC is not required to fund if the assets are in default. PNC may be obligated to fund under liquidity facilities for events such as commercial paper market disruptions, borrower bankruptcies, collateral deficiencies or covenant violations. Additionally, PNC’s credit risk under the liquidity facilities is secondary to the risk of first loss provided by the borrower or another third party in the form of deal-specific credit enhancement – for example, by the over-collateralization of the assets. Deal-specific credit enhancement that supports the commercial paper issued by Market Street is generally structured to cover a multiple of the expected losses for the pool of assets and is sized to generally meet rating agency standards for comparably structured transactions. Credit enhancement is provided in part by PNC Bank, N.A. in the form of a cash collateral account that is funded by a loan facility that expires March 23, 2012. See Note 16 Commitments And Guarantees included in Part I, Item 1 of this Report for additional information. Neither creditors nor investors in Market Street have any recourse to PNC’s general credit. PNC recognized program administrator fees and commitment fees related to PNC’s portion of the liquidity facilities of $3.2 million and $1.0 million, respectively, for the quarter ended September 30, 2007. Comparable amounts were $9.1 million and $2.9 million for the nine months ended September 30, 2007.

Market Street was restructured as a limited liability company in October 2005 and entered into a subordinated Note Purchase Agreement (“Note”) with an unrelated third party. The Note provides first loss coverage whereby the investor absorbs losses up to the amount of the Note, which was $8.9 million as of September 30, 2007. Proceeds from the issuance of the Note are held by Market Street in a first loss reserve account that will be used to reimburse any losses incurred by Market Street, PNC Bank, N.A. or other providers under the liquidity facilities and the credit enhancement arrangements.


 

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As a result of the Note issuance, we reevaluated the design of Market Street, its capital structure and relationships among the variable interest holders under the provisions of FASB Interpretation No. 46, (Revised 2003) “Consolidation of Variable Interest Entities (“FIN 46R”). Based on this analysis, we determined that we were no longer the primary beneficiary as defined by FIN 46R and deconsolidated Market Street from our Consolidated Balance Sheet effective October 17, 2005. There have been no events or changes in the contractual terms of the Note since that date that would change this conclusion.

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

Partnership interests in low income housing projects

       

September 30, 2007

   $ 1,142    $ 1,142

December 31, 2006

   $ 834    $ 834

Investment Company Accounting – Deferred Application

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 FIN 46R, we have deferred applying the provisions of the interpretation for these entities pending adoption of FASB Staff Position No. (“FSP”) FIN 46(R)7, “Application of FASB Interpretation No. 46(R) to Investment Companies.” See Note 1 Accounting Policies in the Notes To Consolidated Financial Statements in Part I, Item 1 of the Report. These entities are not consolidated into our financial statements as of September 30, 2007 or December 31, 2006. Information on these entities follows:

 

In millions

    

 

Aggregate

Assets

    

 

Aggregate

Equity

    

 

PNC Risk

of Loss

Private Equity Funds

          

September 30, 2007

   $ 154    $ 154    $ 108

December 31, 2006

   $ 102    $ 102    $ 104

PNC’s risk of loss in the table above includes both the value of our equity investments and any unfunded commitments to the respective entities. These equity investments are included in our private equity portfolio discussed under Market Risk Management – Equity and Other Investment Risk in this Financial Review.

Perpetual Trust Securities

We issue certain hybrid capital vehicles that qualify as capital for regulatory and rating agency purposes.

In December 2006, one of our indirect subsidiaries, PNC REIT Corp., sold $500 million of 6.517% Fixed-to-Floating Rate Non-Cumulative Exchangeable Perpetual Trust Securities (the “Trust Securities”) of PNC Preferred Funding

Trust I (“Trust I”) in a private placement. PNC REIT Corp. had previously acquired the Trust Securities from the trust in exchange for an equivalent amount of Fixed-to-Floating Rate Non-Cumulative Perpetual Preferred Securities (the “LLC Preferred Securities”), of PNC Preferred Funding LLC (the “LLC”), held by PNC REIT Corp. The LLC’s initial material assets consist of indirect interests in mortgages and mortgage-related assets previously owned by PNC REIT Corp. Our 2006 Form 10-K includes additional information regarding the Perpetual Trust Securities, including descriptions of replacement capital and dividend restriction covenants.

In March 2007, PNC Preferred Funding LLC sold $500 million of 6.113% Fixed-to-Floating Rate Non-Cumulative Exchangeable Perpetual Trust Securities of PNC Preferred Funding Trust II (“Trust II”) in a private placement. In connection with the private placement, Trust II acquired $500 million of LLC Preferred Securities.

PNC REIT Corp. owns 100% of the LLC’s common voting securities. As a result, the LLC is an indirect subsidiary of PNC and is consolidated on our Consolidated Balance Sheet. Trust I and Trust II’s investment in the LLC Preferred Securities is characterized as a minority interest on our Consolidated Balance Sheet since we are not the primary beneficiary of Trust I and Trust II. This minority interest totaled approximately $980 million at September 30, 2007.

Each Trust II Security is automatically exchangeable into a share of Series I Non-Cumulative Perpetual Preferred Stock of PNC (the “Series I Preferred Stock”) under certain conditions relating to the capitalization or the financial condition of PNC Bank, N.A. and upon the direction of the Office of the Comptroller of the Currency.

Simultaneously with the closing of the Trust II Securities sale, we entered into a replacement capital covenant (the “Covenant”) for the benefit of holders of a specified series of our long-term indebtedness (the “Covered Debt”). As of September 30, 2007, Covered Debt consists of our $200 million Floating Rate Junior Subordinated Notes issued on June 9, 1998. We agreed in the Covenant that until March 29, 2017, neither we nor our subsidiaries would purchase or redeem the Trust Securities, the LLC Preferred Securities or the Series I Preferred Stock (collectively, the “Covenant Securities”) unless: (i) we have received the prior approval of the Federal Reserve Board, if such approval is then required by the Federal Reserve Board and (ii) during the 180-day period prior to the date of purchase, PNC, PNC Bank, N.A. or PNC Bank, N.A.’s subsidiaries, as applicable, have received proceeds from the sale of Qualifying Securities in the amounts specified in the Covenant (which amounts will vary based on the type of securities sold). “Qualifying Securities” means debt and equity securities having terms and provisions specified in the Covenant and that, generally described, are intended to contribute to our capital base in a manner that is similar to the contribution to our capital base made by the


 

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Covenant Securities. We filed a copy of the Covenant with the SEC as Exhibit 99.1 to PNC’s current report on Form 8-K filed on March 30, 2007.

We have also entered into an Exchange Agreement with Trust II in which we have agreed that if full dividends are not paid in a dividend period on the Trust II Securities and the LLC Preferred Securities held by Trust II, PNC will not declare or pay dividends with respect to, or redeem, purchase or acquire, any of its equity capital securities during the next succeeding dividend period, other than: (i) purchases, redemptions or other acquisitions of shares of capital stock of PNC in connection with any employment contract, benefit plan or other similar arrangement with or for the benefit of employees, officers, directors or consultants, (ii) purchases of shares of common stock of PNC pursuant to a contractually binding requirement to buy stock existing prior to the commencement of the extension period, including under a contractually binding stock repurchase plan, (iii) any dividend in connection with the implementation of a shareholders’ rights plan, or the redemption or repurchase of any rights under any such plan, (iv) as a result of an exchange or conversion of any class or series of PNC’s capital stock for any other class or series of PNC’s capital stock, (v) the purchase of fractional interests in shares of PNC capital stock pursuant to the conversion or exchange provisions of such stock or the security being converted or exchanged or (vi) any stock dividends paid by PNC where the dividend stock is the same stock as that on which the dividend is being paid. We filed a copy of the Exchange Agreement with the SEC as Exhibit 4.16 to PNC’s Form 8-K filed on March 30, 2007.

Acquired Entity Trust Preferred Securities

As a result of the Mercantile and Yardville acquisitions, we assumed obligations with respect to $73 million in principal amount of junior subordinated debentures issued by the acquired entities. Under the terms of these debentures, if there is an event of default under the debentures or PNC exercises its right to defer payments on the related trust preferred securities issued by the statutory trusts or there is a default under PNC’s guarantee of such payment obligations, PNC would be subject during the period of such default or deferral to restrictions on dividends and other provisions protecting the status of the debenture holders similar to or in some ways more restrictive than those potentially imposed under the Exchange Agreement with Trust II, as described above.

 

BUSINESS SEGMENTS REVIEW

We have four major businesses engaged in providing banking, asset management and global fund processing products and services. Business segment results, including inter-segment revenues, and a description of each business are included in Note 14 Segment Reporting included in the Notes To Consolidated Financial Statements under Part I, Item 1 of this Report. Certain revenue and expense amounts included in this Financial Review differ from the amounts shown in Note 14 due to the presentation in this Financial Review of business revenue on a taxable-equivalent basis, the inclusion of BlackRock/MLIM transaction integration costs in the “Other” category in this Financial Review, and income statement classification differences related to PFPC. Also, the presentation of BlackRock results for the 2006 period have been modified in this Financial Review as described on page 24 to conform with our current period presentation.

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, with the exception of our BlackRock segment, operated on a stand-alone basis. As permitted under GAAP, we have aggregated the business results for certain operating segments for financial reporting purposes.

Assets receive a funding charge and liabilities and capital receive a funding credit based on a transfer pricing methodology that incorporates product maturities, duration and other factors. Capital is intended to cover unexpected losses and is assigned to the banking and processing businesses using our risk-based economic capital model. We have assigned capital equal to 6% of funds to Retail Banking to reflect the capital required for well-capitalized banks and to approximate market comparables for this business. The capital assigned for PFPC reflects its legal entity shareholders’ equity.

BlackRock business segment results for the nine months ended September 30, 2006 reflected our majority ownership in BlackRock during that period. Subsequent to the September 29, 2006 BlackRock/MLIM transaction closing, which had the effect of reducing our ownership interest to approximately 34%, our investment in BlackRock has been accounted for under the equity method but continues to be a separate reportable business segment of PNC. We describe our presentation method for the BlackRock segment for this Financial Review on page 24.


 

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We have allocated the allowances 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 reflected in the “Other” category. “Other” for purposes of this Financial Review includes residual activities that do not meet the criteria for disclosure as a separate reportable business, such as gains or losses related to BlackRock transactions

including LTIP share distributions and obligations, BlackRock/MLIM transaction and acquisition integration costs, asset and liability management activities, net securities gains or losses, certain trading activities and equity management activities, differences between business segment performance reporting and financial statement reporting (GAAP), intercompany eliminations, and most corporate overhead.

Employee data as reported by each business segment in the tables that follow reflects staff directly employed by the respective business and excludes corporate and shared services employees.


 

Results Of Businesses – Summary

(Unaudited)

 

     Earnings      Revenue (a)      Average Assets (b)
Nine months ended September 30 - (in millions)    2007     2006    2007    2006    2007    2006

Retail Banking

   $ 678     $ 581    $ 2,802    $ 2,326    $ 41,484    $ 29,319

Corporate & Institutional Banking

     341       328      1,139      1,065      28,133      24,517

BlackRock (c) (d)

     176       137      232      1,103      4,152      3,865

PFPC (e)

     96       93      617      568      2,171      2,053

Total business segments

     1,291       1,139      4,790      5,062      75,940      59,754

Other (c) (f) (g)

     (2 )     1,080      308      1,995      43,592      33,898

Total consolidated

   $ 1,289     $ 2,219    $ 5,098    $ 7,057    $ 119,532    $ 93,652

 

(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

 

Nine months ended September 30 - (in millions)

     2007      2006

Total consolidated revenue, book (GAAP) basis

   $ 5,078    $ 7,037

Taxable-equivalent adjustment

     20      20

Total consolidated revenue, taxable-equivalent basis

   $ 5,098    $ 7,057

 

(b) Period-end balances for BlackRock and PFPC.
(c) For our segment reporting presentation in this Financial Review, after-tax BlackRock/MLIM transaction integration costs totaling $4 million and $56 million for the nine months ended September 30, 2007 and September 30, 2006 have been reclassified from BlackRock to “Other.” “Other” for the first nine months of 2007 also includes $45 million of after-tax acquisition integration costs.
(d) For the first nine months of 2007, revenue represents our equity income from BlackRock. For the first nine months of 2006, revenue represents the sum of total operating revenue and nonoperating income.
(e) PFPC revenue represents the sum of servicing revenue and nonoperating income (expense) less debt financing costs. Prior period servicing revenue amounts have been reclassified to conform with the current period presentation.
(f) “Other” for the first nine months of 2006 included the $2.1 billion pretax, or $1.3 billion after-tax, gain on the BlackRock/MLIM transaction recorded in the third quarter of 2006.
(g) “Other” average assets are comprised primarily of securities available for sale and residential mortgage loans associated with asset and liability management activities.

 

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RETAIL BANKING

(Unaudited)

 

Nine months ended September 30

Taxable-equivalent basis

Dollars in millions

  2007     2006  

INCOME STATEMENT

     

Net interest income

  $1,522     $1,259  

Noninterest income

     

Asset management

  344     261  

Service charges on deposits

  251     227  

Brokerage

  200     176  

Consumer services

  292     260  

Other

  193     143  

Total noninterest income

  1,280     1,067  

Total revenue

  2,802     2,326  

Provision for credit losses

  68     46  

Noninterest expense

  1,652     1,356  

Pretax earnings

  1,082     924  

Income taxes

  404     343  

Earnings

  $678     $581  

AVERAGE BALANCE SHEET

     

Loans

     

Consumer

     

Home equity

  $14,139     $13,814  

Indirect

  1,852     1,025  

Other consumer

  1,566     1,224  

Total consumer

  17,557     16,063  

Commercial

  12,067     5,658  

Floor plan

  976     929  

Residential mortgage

  1,821     1,578  

Other

  233     245  

Total loans

  32,654     24,473  

Goodwill and other intangible assets

  4,799     1,583  

Loans held for sale

  1,561     1,641  

Other assets

  2,470     1,622  

Total assets

  $41,484     $29,319  

Deposits

     

Noninterest-bearing demand

  $10,357     $7,844  

Interest-bearing demand

  8,776     7,920  

Money market

  16,599     14,725  

Total transaction deposits

  35,732     30,489  

Savings

  2,687     2,089  

Certificates of deposit

  16,593     13,580  

Total deposits

  55,012     46,158  

Other liabilities

  636     537  

Capital

  3,535     2,970  

Total funds

  $59,183     $49,665  

PERFORMANCE RATIOS

     

Return on average capital

  26 %   26 %

Noninterest income to total revenue

  46     46  

Efficiency

  59     58  

OTHER INFORMATION (a) (b)

     

Credit-related statistics:

     

Nonperforming assets (c)

  $137     $95  

Net charge-offs

  $86     $64  

Net charge-off ratio

  .35 %   .35 %

Other statistics:

     

Full-time employees

  11,753     9,531  

Part-time employees

  2,248     1,660  

ATMs

  3,870     3,594  

Branches (d)

  1,072     848  

 

At September 30

Dollars in millions, except where noted

  2007     2006  

OTHER INFORMATION (CONTINUED)

     

ASSETS UNDER ADMINISTRATION (in billions) (e)

 

   

Assets under management

     

Personal

  $57     $42  

Institutional

  20     10  

Total

  $77     $52  

Asset Type

     

Equity

  $44     $32  

Fixed income

  20     12  

Liquidity/other

  13     8  

Total

  $77     $52  

Nondiscretionary assets under administration

     

Personal

  $31     $27  

Institutional

  81     62  

Total

  $112     $89  

Asset Type

     

Equity

  $50     $32  

Fixed income

  27     27  

Liquidity/other

  35     30  

Total

  $112     $89  

Home equity portfolio credit statistics:

     

% of first lien positions

  39 %   44 %

Weighted average loan-to-value ratios

  72 %   69 %

Weighted average FICO scores

  726     728  

Loans 90 days past due

  .30 %   .22 %

Checking-related statistics:

     

Retail Banking checking relationships

  2,275,000     1,958,000  

Consumer DDA households using online banking

  1,050,000     920,000  

% of consumer DDA households using online banking

  52 %   52 %

Consumer DDA households using online bill payment

  604,000     361,000  

% of consumer DDA households using online bill payment

  30 %   20 %

Small business loans and managed deposits:

     

Small business loans

  $13,157     $5,080  

Managed deposits:

     

On-balance sheet

     

Noninterest-bearing demand

  $6,119     $4,402  

Interest-bearing demand

  2,027     1,752  

Money market

  3,389     2,689  

Certificates of deposit

  1,070     763  

Off-balance sheet (f)

     

Small business sweep checking

  3,203     1,651  

Total managed deposits

  $15,808     $11,257  

Brokerage statistics:

     

Margin loans

  $161     $170  

Financial consultants (g)

  765     752  

Full service brokerage offices

  100     99  

Brokerage account assets (billions)

  $49     $44  

Other statistics:

     

Gains on sales of education loans (h)

  $20     $22  
(a) Presented as of September 30 except for net charge-offs, net charge-off ratio, and gains on sales of education loans, which are for the nine months ended. Small business sweep checking amounts are averages for the three months ended September 30.
(b) Amounts include the impact of Mercantile, which we acquired effective March 2, 2007.
(c) Includes nonperforming loans of $127 million at September 30, 2007 and $85 million at September 30, 2006.
(d) Excludes certain satellite branches that provide limited products and service hours.
(e) Excludes brokerage account assets.
(f) Represents small business balances. These balances are swept into liquidity products managed by other PNC business segments, the majority of which are off-balance sheet.
(g) Financial consultants provide services in full service brokerage offices and PNC traditional branches.
(h) Included in “Noninterest income-Other.”

 

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Retail Banking’s earnings were $678 million for the first nine months of 2007 compared with $581 million for the same period in 2006. The 17% increase over the prior year was driven by the Mercantile acquisition, strong market-related fees and continued customer growth, partially offset by increases in the provision for credit losses and noninterest expense.

The overview of Retail Banking’s performance during the first nine months of 2007 includes the following:

 

 

The acquisition of Mercantile in the first quarter added approximately $10.3 billion of loans and $12.0 billion of deposits to Retail Banking. The acquisition also:

   

Added 235 branches and 256 ATMs,

   

Significantly increased our presence in Maryland,

   

Added to our presence in Delaware, Virginia and the Washington, DC area,

   

Significantly increased the size of our small business banking franchise by adding approximately $7.7 billion of loans,

   

Expanded our customer base with the addition of approximately 286,000 checking relationships, and

   

Expanded our wealth management business with the addition of $22 billion in assets under management.

 

PNC announced the pending acquisition of Sterling, which is expected to result in a leading deposit share in the Central Pennsylvania footprint and to enhance our presence in surrounding markets.

 

Customer service and customer retention continues to be our focus. Beginning in the first quarter of 2007, we partnered with the Gallup organization to help evaluate and improve customer and employee satisfaction at the branch level.

 

Consumer and small business checking relationships increased 22,000 during the third quarter of 2007, not including the impact of Mercantile.

 

Our investment in online banking capabilities continues to pay off. Since September 30, 2006, the percentage of consumer checking households using online bill payment increased from 20% to 30%.

 

In September 2006, we launched our PNC-branded credit card product. As of September 30, 2007, more than 125,000 cards have been issued and we have $238 million in receivable balances. The results to date have exceeded our expectations.

 

In addition to Mercantile, we opened 21 new branches and consolidated 32 branches since September 30, 2006 for a total of 1,072 branches at September 30, 2007. We continue to optimize our network by opening new branches in high growth areas, relocating branches to areas of higher opportunity, and consolidating branches in areas of declining market opportunity.

 

Our wealth management and brokerage businesses have benefited from market conditions and strong business development.

   

Asset management and brokerage fees increased $107 million, or 24%, over the first nine months of 2006,

   

Brokerage assets increased $5 billion, or 11%, from September 30, 2006, and

   

Excluding the $22 billion of assets under management related to our acquisition of Mercantile in the first quarter, assets under management increased $3 billion compared with September 30, 2006.

In addition, on October 26, 2007 PNC closed on the acquisition of Yardville, which has resulted in a leading deposit share in several wealthy counties in central New Jersey.

Total revenue for the first nine months of 2007 was $2.802 billion compared with $2.326 billion for the same period last year. Taxable-equivalent net interest income of $1.522 billion increased $263 million, or 21%, compared with 2006 due to a 19% increase in average deposits and a 33% increase in average loan balances. Net interest income growth was primarily the result of the Mercantile acquisition and this growth has stabilized in recent quarters. In the current economic environment, we believe that organic growth in the balance sheet and net interest income will be more challenged than in recent periods.

Noninterest income increased $213 million, or 20%, compared with the first nine months of 2006. This growth can be attributed primarily to the following:

   

The Mercantile acquisition,

   

Comparatively favorable equity markets,

   

Increased assets under management,

   

Increased brokerage account assets and activities,

   

Increased third party loan servicing activities,

   

New PNC-branded credit card product,

   

Higher gains on asset sales, and

   

Customer growth.

The provision for credit losses increased $22 million in the first nine months of 2007, to $68 million, compared with the 2006 period. Net charge-offs were $86 million for the first nine months of 2007, an increase of $22 million compared with the first nine months of 2006. The increases in provision and net charge-offs were primarily a result of continued growth in our commercial loan portfolio and charge-offs returning to a more normal level given the current credit conditions. Charge-offs over the last few years have been low compared to historical averages.

Noninterest expense in the first nine months of 2007 totaled $1.652 billion, an increase of $296 million, or 22%, compared with the first nine months of 2006. Increases were primarily attributable to the Mercantile acquisition, higher volume-related expenses tied to noninterest income growth, continued investment in new branches, and investments in various initiatives such as the new PNC-branded credit card.

Full-time employees at September 30, 2007 totaled 11,753, an increase of 2,222 from September 30, 2006. The Mercantile acquisition added approximately 2,100 full-time Retail Banking employees. Part-time employees have increased by 588 since September 30, 2006. The increase in part-time employees is a result of the Mercantile acquisition and various customer service enhancement and efficiency initiatives. These initiatives include utilizing more part-time customer-facing employees rather than full-time employees during peak business hours.


 

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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 $8.9 billion, or 19%, compared with the first nine months of 2006. The deposit growth was driven by the Mercantile acquisition.

 

 

Certificates of deposits increased $3.0 billion and money market deposits increased $1.9 billion. These increases were primarily attributable to the Mercantile acquisition. Recent declines in deposit balances were a result of PNC’s strategy to focus on relationship customers rather than pursuing higher-rate single service products.

 

Average demand deposit growth of $3.4 billion, or 21%, was almost solely due to the Mercantile acquisition as the core growth was impacted by customers shifting funds into higher yielding deposits, small business sweep checking products, and investment products.

 

Small business and consumer-related checking relationships retention remained strong and stable. Consumer-related checking relationship retention has benefited from improved penetration rates of debit cards, online banking and online bill payment.

Currently, we are focused on a relationship-based lending strategy that targets 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 $6.4 billion, or 113%, compared with the first nine months of 2006. The increase is attributable to the Mercantile acquisition and organic loan growth 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 $326 million, or 2%, compared with the first nine months of 2006 primarily

 

due to the Mercantile acquisition. Consumer loan demand has slowed as a result of the current rate environment. Our home equity loan portfolio is relationship based, with 93% of the portfolio attributable to borrowers in our primary geographic footprint. We monitor this portfolio closely and, to date, have seen no significant deterioration in credit quality.

 

Average indirect loans grew $827 million, or 81%, compared with the first nine months of 2006. The increase is attributable to the Mercantile acquisition and growth in our core portfolio that has benefited from increased sales and marketing efforts.

 

Average residential mortgage loans increased $243 million, or 15%, primarily due to the addition of loans from the Mercantile acquisition. Payoffs in our existing portfolio, which will continue throughout 2007, partially offset the impact of the additional loans acquired. Additionally, our transfer of residential mortgages to held for sale and subsequent sale of those loans at the end of September 2006 reduced the size of this loan portfolio when compared with the first nine months of 2006.

Assets under management of $77 billion at September 30, 2007 increased $25 billion compared with the balance at September 30, 2006. The Mercantile acquisition added $22 billion in assets under management in the first quarter and the remaining portfolio growth was a result of the effects of comparatively higher equity markets and a breakeven position in client net asset flows. Client net asset flows are the result of investment additions from new and existing clients offset by ordinary course distributions from trust and investment management accounts and account closures.

Nondiscretionary assets under administration of $112 billion at September 30, 2007 increased $23 billion compared with the balance at September 30, 2006, primarily due to the impact of Mercantile.


 

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CORPORATE & INSTITUTIONAL BANKING

(Unaudited)

 

Nine months ended September 30

Taxable-equivalent basis

Dollars in millions except as noted

   2007    2006

INCOME STATEMENT

       

Net interest income

   $581    $517

Noninterest income

       

Corporate service fees

   427    377

Other

   131    171

Noninterest income

   558    548

Total revenue

   1,139    1,065

Provision for credit losses

   56    36

Noninterest expense

   596    547

Pretax earnings

   487    482

Income taxes

   146    154

Earnings

   $341    $328

AVERAGE BALANCE SHEET

       

Loans

       

Corporate (a)

   $9,272    $8,548

Commercial real estate

   3,460    2,786

Commercial – real estate related

   3,390    2,515

Asset-based lending

   4,578    4,424

Total loans

   20,700    18,273

Goodwill and other intangible assets

   1,828    1,336

Loans held for sale

   1,164    869

Other assets

   4,441    4,039

Total assets

   $28,133    $24,517

Deposits

       

Noninterest-bearing demand

   $7,120    $6,623

Money market

   4,716    2,321

Other

   1,160    902

Total deposits

   12,996    9,846

Other liabilities

   2,974    2,784

Capital

   2,081    1,806

Total funds

   $18,051    $14,436
(a)    Includes lease financing.

Corporate & Institutional Banking earned $341 million in the first nine months of 2007 compared with $328 million in the first nine months of 2006. Treasury management, mergers and acquisitions advisory services, and commercial mortgage servicing have shown strong growth over the comparable 2006 period. Capital markets and real estate activities, specifically net gains on commercial mortgage loan sales, have been negatively impacted by recent market conditions. The Mercantile acquisition had a positive impact on the 2007 period primarily reflected in net interest income.

 

Nine months ended September 30

Taxable-equivalent basis

Dollars in millions except as noted

   2007     2006  

PERFORMANCE RATIOS

      

Return on average capital

   22 %   24 %

Noninterest income to total revenue

   49     51  

Efficiency

   52     51  

COMMERCIAL MORTGAGE SERVICING PORTFOLIO (in billions)

      

Beginning of period

   $200     $136  

Acquisitions/additions

   80     69  

Repayments/transfers

   (36 )   (25 )

End of period (a)

   $244     $180  

OTHER INFORMATION

      

Consolidated revenue from: (b)

      

Treasury Management

   $345     $311  

Capital Markets

   $216     $204  

Midland Loan Services

   $169     $131  

Total loans (c)

   $22,455     $19,265  

Nonperforming assets (c) (d)

   $141     $94  

Net charge-offs

   $31     $30  

Full-time employees (c)

   2,267     1,925  

Net gains on commercial mortgage loan sales (a)

   $29     $37  

Net carrying amount of commercial mortgage servicing rights (c)

   $708     $414  
(a) Amounts at September 30, 2007 include the impact of the July 2, 2007 acquisition of ARCS Commercial Mortgage.
(b) Represents consolidated PNC amounts.
(c) At September 30.
(d) Includes nonperforming loans of $119 million at September 30, 2007 and $81 million at September 30, 2006.

Highlights of the first nine months of 2007 for Corporate & Institutional Banking included:

 

 

On July 2, 2007, PNC acquired ARCS, a leading originator and servicer of agency multifamily permanent financing products. This acquisition added a commercial mortgage servicing portfolio of $13 billion during the third quarter of 2007.

 

Average total loan balances increased $2.4 billion, or 13%, from the first nine months of 2006. In addition to the March 2007 Mercantile acquisition, which fueled growth in all loan categories, continuing customer demand was also a factor in the increase in corporate loans.

 

Nonperforming assets increased $47 million at September 30, 2007 compared with September 30, 2006. Included in the September 30, 2007 amount is $42 million of nonperforming assets associated with the Mercantile portfolio. The provision for credit losses increased $20 million in the nine-month comparison primarily due to growth in total credit exposure and modest credit quality migration given the current credit conditions.


 

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Average deposit balances for the first nine months of 2007 increased $3.1 billion, or 32%, compared with the first nine months of 2006. The increase in corporate money market deposits reflected PNC’s action to avail itself of the opportunity to obtain funding from alternative sources. Noninterest-bearing deposit growth was attributable primarily to our commercial mortgage servicing portfolio.

 

 

Total revenue increased $74 million, or 7%, for the first nine months of 2007 compared with the first nine months of 2006. The increase was driven by higher taxable-equivalent net interest income related to growth of noninterest bearing deposits as well as the increase in loans resulting from the Mercantile acquisition. Corporate service fees increased due to increased sales of treasury management products and services, commercial mortgage servicing, and mergers and acquisitions advisory services. These increases in revenue were partially offset by a decline in other noninterest income. This decline primarily reflected lower gains on commercial mortgage loan sales and related hedging activities and lower non-customer-related trading revenue as a result of recent volatility in the financial markets.

 

Commercial mortgage servicing-related revenue, which includes fees and net interest income, totaled $175 million for the first nine months of 2007, compared with $131 million for the first nine months of 2006. The increase of 34% was primarily driven by growth in the commercial mortgage servicing portfolio, including $13 billion related to the ARCS acquisition. The total portfolio increased to $244 billion at September 30, 2007. The associated increase in deposits has increased the net interest income portion of this revenue.

 

 

Noninterest expense increased by $49 million, or 9%, compared with the first nine months of 2006. This increase reflects the acquisitions of Mercantile and ARCS as well as expenses associated with other growth and fee-based initiatives, and customer growth. In addition, noninterest expense increases reflect our business of originating transactions whose returns are heavily dependent on tax credits, whereby losses are taken through noninterest expense and the associated benefits result in a lower provision for income taxes.

See the additional revenue discussion regarding treasury management and capital markets-related products and Midland Loan Services on page 9.


 

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BLACKROCK

Our BlackRock business segment earned $176 million for the first nine months of 2007 and $137 million for the first nine months of 2006. Subsequent to the September 29, 2006 deconsolidation of BlackRock, these business segment earnings are determined by taking our proportionate share of BlackRock’s earnings and subtracting our additional income taxes recorded on our share of BlackRock’s earnings. Also, for this business segment presentation, after-tax BlackRock/MLIM transaction integration costs totaling $4 million and $56 million for the nine months ended September 30, 2007 and September 30, 2006 have been reclassified from BlackRock to “Other.” In addition, these business segment earnings for the first nine months of 2006 have been reduced by minority interest in income of BlackRock, excluding MLIM transaction integration costs, totaling $65 million and additional income taxes recorded on our share of BlackRock’s earnings totaling $7 million.

We have modified the presentation of historical BlackRock business segment results as described above to conform with the current business segment reporting presentation in this Financial Review.

PNC’s investment in BlackRock was $4.0 billion at September 30, 2007 and $3.9 billion at December 31, 2006. Based upon BlackRock’s closing market price of $173.41 per common share at September 30, 2007, the market value of our investment in BlackRock was approximately $7.5 billion at that date. As such, an additional $3.5 billion of pretax value was not recognized in our investment account at that date.

On October 1, 2007, BlackRock acquired the fund of funds business of Quellos Group, LLC (“Quellos”). The combined fund of funds platform will operate under the name BlackRock Alternative Advisors and will comprise one of the largest fund of funds platforms in the world, with over $25 billion in assets under management. Products, including hedge, private equity and real asset fund of funds, as well as specialty and hybrid offerings, are managed on behalf of institutional and individual investors worldwide.

In connection with the acquisition, BlackRock paid approximately $562 million in cash to Quellos and placed 1.2 million shares of BlackRock common stock into an escrow account. The shares of BlackRock common stock will be held in the escrow account for up to three years and will be available to satisfy certain indemnification obligations of Quellos under the acquisition agreement. Therefore, any gain to be recognized by PNC resulting from the issuance of these shares and corresponding increase in our investment in BlackRock will be deferred pending the release of shares from the escrow account. In addition, Quellos may receive up to an additional $970 million in cash and BlackRock common stock over 3.5 years contingent on certain measures.

BLACKROCK/MLIM TRANSACTION

As further described in our 2006 Form 10-K, on September 29, 2006 Merrill Lynch contributed its investment management business (“MLIM”) to BlackRock in exchange for 65 million shares of newly issued BlackRock common and preferred stock.

 

For the nine months ended September 30, 2006, our Consolidated Income Statement included our former 69% ownership interest in BlackRock. However, our Consolidated Balance Sheet as of September 30, 2007 and December 31, 2006 reflected the September 29, 2006 deconsolidation of BlackRock’s balance sheet amounts and recognized our approximate 34% ownership interest in BlackRock as an investment accounted for under the equity method. This accounting has resulted in a reduction in certain revenue and noninterest expense categories on our Consolidated Income Statement as our share of BlackRock’s net income is now reported within asset management noninterest income.

BLACKROCK LTIP PROGRAMS

As further described in our 2006 Form 10-K and our current report on Form 8-K filed June 14, 2007, BlackRock adopted the 2002 LTIP program to help attract and retain qualified professionals. At that time, PNC agreed to transfer up to four million of the shares of BlackRock common stock then held by us to help fund the 2002 LTIP and future programs approved by BlackRock’s board of directors, subject to certain conditions and limitations. Prior to 2006, BlackRock granted awards of approximately $230 million under the 2002 LTIP program, of which approximately $210 million were paid on January 30, 2007. The award payments were funded by approximately 17% in cash from BlackRock and approximately one million shares of BlackRock common stock transferred by PNC and distributed to LTIP participants.

We recognized a pretax gain of $82 million in the first quarter of 2007 from the transfer of BlackRock shares to satisfy the majority of our 2002 LTIP obligation. The gain was included in noninterest income and reflected the excess of market value over book value of the approximately one million shares transferred in January 2007.

PNC’s noninterest income in the first nine months of 2007 also included an $81 million pretax charge related to our commitment to fund additional BlackRock LTIP programs. This charge represents the mark-to-market adjustment related to our remaining BlackRock LTIP shares obligation as of September 30, 2007.

BlackRock granted awards of approximately $260 million in January 2007 under an additional LTIP program, which were converted into approximately 1.5 million restricted stock units. All of these awards are subject to achieving earnings performance goals prior to the vesting date of September 29, 2011. The maximum value of awards that may be funded by PNC during the award period ending in September 2011 is approximately $271 million, which includes the $260 million of awards granted in January 2007. Shares remaining after that award period ends would be available for future awards.

While we may continue to see volatility in earnings as we mark to market our LTIP shares obligation each quarter-end, generally we will not recognize additional gains, if applicable, for the difference between the market value and the book value of the committed BlackRock common shares until the shares are distributed to LTIP participants.


 

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PFPC

(Unaudited)

 

Nine months ended September 30

Dollars in millions except as noted

   2007     2006  

INCOME STATEMENT

      

Servicing revenue (a)

   $640     $597  

Operating expense (a)

   470     440  

Operating income

   170     157  

Debt financing

   28     32  

Nonoperating income (b)

   5     3  

Pretax earnings

   147     128  

Income taxes (c)

   51     35  

Earnings

   $96     $93  

PERIOD-END BALANCE SHEET

      

Goodwill and other intangible assets

   $1,002     $1,015  

Other assets

   1,169     1,038  

Total assets

   $2,171     $2,053  

Debt financing

   $702     $813  

Other liabilities

   878     772  

Shareholder’s equity

   591     468  

Total funds

   $2,171     $2,053  

PERFORMANCE RATIOS

      

Return on average equity

   24 %   31 %

Operating margin (d)

   27     26  

SERVICING STATISTICS (at September 30)

      

Accounting/administration net fund assets (in billions)

      

Domestic

   $806     $695  

Offshore

   116     79  

Total

   $922     $774  

Asset type (in billions)

      

Money market

   $328     $260  

Equity

   377     331  

Fixed income

   117     111  

Other (e)

   100     72  

Total

   $922     $774  

Custody fund assets (in billions)

   $497     $399  

Shareholder accounts (in millions)

      

Transfer agency

   19     18  

Subaccounting

   51     48  

Total

   70     66  

OTHER INFORMATION

      

Full-time employees (at September 30)

   4,504     4,317  
(a) Certain out-of-pocket expense items which are then client billable are included in both servicing revenue and operating expense above, but offset each other entirely and therefore have no net effect on operating income. Distribution revenue and expenses which relate to 12b-1 fees that PFPC receives from certain fund clients for the payment of marketing, sales and service expenses also entirely offset each other, but are netted for presentation purposes above. Prior period amounts have been reclassified to conform with the current period presentation.
(b) Net of nonoperating expense.
(c) Income taxes for the nine months ended September 30, 2006 included the benefit of a $14 million reversal of deferred taxes related to foreign subsidiary earnings.
(d) Total operating income divided by servicing revenue.
(e) Includes alternative investment net assets serviced.

 

PFPC earned $96 million for the first nine months of 2007 compared with $93 million in the year-earlier period. Earnings for the 2006 period benefited from the impact of a $14 million reversal of deferred taxes related to earnings from foreign subsidiaries following management’s determination that the earnings would be indefinitely reinvested outside of the United States. Higher earnings in the first nine months of 2007 reflected the successful conversion of net new business, organic growth and market appreciation.

Highlights of PFPC’s performance in the first nine months of 2007 included:

 

   

PFPC’s offshore affiliate, PFPC Bank Ltd, obtained approval in the third quarter to provide depositary services in Luxembourg, Europe’s leading domicile for traditional investment funds and the second largest worldwide domicile after the United States.

 

   

PFPC announced the opening of a new sales office in London to expand its global business development efforts afforded by the international operations continued expansion in the European marketplace.

 

   

Total fund assets serviced by PFPC increased 25% to $2.5 trillion during the past year.

 

   

Revenue from managed accounts, offshore operations, and alternative investments, all targeted growth businesses, grew 18% over the past year.

Servicing revenue for the first nine months of 2007 increased by $43 million, or 7%, over the first nine months of 2006, to $640 million. Increases in transfer agency, managed accounts, offshore operations and alternative investments drove the higher servicing revenue.

Operating expense increased $30 million, or 7%, to $470 million, in the first nine months of 2007 compared with the first nine months of 2006. The majority of this increase is attributable to increased headcount and technology costs to support new business achieved over the past year.

Total assets serviced by PFPC amounted to $2.5 trillion at September 30, 2007 compared with $2.0 trillion at September 30, 2006. This increase resulted from the new business, organic growth in existing business, and strong market appreciation experienced since last September.


 

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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 2006 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 to be inaccurate or 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 2006 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

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. In particular, see Note 1 Accounting Policies and Note 11 Income Taxes in the Notes To Consolidated Financial Statements regarding our first quarter 2007 adoption of FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109” and the discussion under the heading Leases and Related Tax and Accounting Matters on page 12.

 

STATUS OF QUALIFIED DEFINED BENEFIT PENSION PLAN

We have a noncontributory, qualified defined benefit pension plan (“plan” or “pension plan”) covering eligible employees. 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 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, the rate of compensation increase and the expected return on plan assets. Neither the discount rate nor the compensation increase assumptions significantly affects pension expense.

The expected long-term return on assets assumption does significantly affect pension expense. The expected long-term return on plan assets for determining net periodic pension cost for 2007 was 8.25%, unchanged from 2006. Under current accounting rules, the difference between expected long-term returns and actual returns is accumulated and amortized to pension expense over future periods. Each one percentage point difference in actual return compared with our expected return causes expense in subsequent years to change by up to $4 million as the impact is amortized into results of operations.

The table below reflects the estimated effects on pension expense of certain changes in assumptions, using 2007 estimated expense as a baseline.

 

Change in Assumption

  

Estimated
Increase to 2007
Pension
Expense

(In millions)

.5% decrease in discount rate

   $2

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

   $10

.5% increase in compensation rate

   $2

We currently estimate a pretax pension benefit of $30 million in 2007 compared with a pretax benefit of $12 million in 2006. The primary reason for this change is 2006 investment returns in excess of the expected long-term return assumption. Actual pension benefit recognized for the first nine months of 2007 was $22 million. The 2007 values and sensitivities


 

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shown above also include the qualified defined benefit plan maintained by Mercantile that we plan to integrate into the PNC plan as of December 31, 2007. See Note 8 Certain Employee Benefit And Stock-Based Compensation Plans in the Notes To Consolidated Financial Statements in Part I, Item 1 of this Report for more information regarding these plans.

In September 2006, the FASB issued SFAS 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans – an amendment of FASB Statements No. 87, 88, 106 and 132 (R).” This statement affects the accounting and reporting for our qualified pension plan, our nonqualified retirement plans, our postretirement welfare benefit plans, and our postemployment benefit plans. SFAS 158 required recognition on the balance sheet of the overfunded or underfunded position of these plans as the difference between the fair value of plan assets and the related benefit obligations. To the extent that a plan’s net funded status differed from the amounts currently recognized on the balance sheet, the difference, net of tax, was recorded as a part of accumulated other comprehensive income (loss) (“AOCI”) within the shareholders’ equity section of the balance sheet. This guidance also required the recognition of any unrecognized actuarial gains and losses and unrecognized prior service costs to AOCI, net of tax. Post-adoption changes in unrecognized actuarial gains and losses as well as unrecognized prior service costs will be recognized in other comprehensive income, net of tax. SFAS 158 was effective for PNC as of December 31, 2006, with no retrospective application permitted for prior year-end reporting periods, and resulted in an adjustment for all unamortized net actuarial losses and prior service costs of $132 million after tax. See Note 1 Accounting Policies of our 2006 Form 10-K for further information regarding our adoption of this pronouncement.

Our pension plan contribution requirements are not particularly sensitive to actuarial assumptions. Investment performance has the most impact on contribution requirements and will drive the amount of permitted contributions in future years. Also, current law, including the provisions of the Pension Protection Act of 2006, sets limits as to both minimum and maximum contributions to the plan. In any event, any contributions to the plan in the near term will be at our discretion, as we 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.

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 2006 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 2006 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 2006 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 in Part I, Item 1 of this Report and included here by reference for details of the types of nonperforming assets that we held at September 30, 2007 and December 31, 2006. In addition, certain performing assets have interest payments that are past due or have the potential for future repayment problems.

Total nonperforming assets at September 30, 2007 increased $115 million, to $286 million, compared with December 31, 2006. Of this increase, $68 million was related to the Mercantile portfolio.

The amount of nonperforming loans that was current as to principal and interest was $115 million at September 30, 2007 and $59 million at December 31, 2006. We believe that overall asset quality is strong by historical standards. However, overall asset quality may not be sustainable at the current level for the foreseeable future, particularly in the event of deteriorating economic conditions. This outlook, combined with expected loan or total credit exposure growth, may result in an increase in the allowance for loan and lease losses in future periods.

Nonperforming Assets By Business

 

In millions    Sept. 30
2007
   Dec. 31
2006

Retail Banking

   $ 137    $ 106

Corporate & Institutional Banking

     141      63

Other

     8      2

Total nonperforming assets

   $ 286    $ 171

 

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Change In Nonperforming Assets

 

In millions    2007     2006  

January 1

   $ 171     $ 215  

Transferred in

     304       182  

Acquisition – Mercantile

     35      

Principal activity including payoffs

     (115 )     (93 )

Charge-offs and valuation adjustments

     (94 )     (88 )

Returned to performing

     (8 )     (15 )

Asset sales

     (7 )     (10 )

September 30

   $ 286     $ 191  

Accruing Loans Past Due 90 Days Or More

 

     Amount    Percent of Total
Outstandings
 
Dollars in millions   

Sept. 30

2007

  

Dec. 31

2006

  

Sept. 30

2007

   

Dec. 31

2006

 

Commercial

   $ 28    $ 9    .11 %   .04 %

Commercial real estate

     23      5    .28     .14  

Consumer

     39      28    .21     .17  

Residential mortgage

     9      7    .09     .11  

Other

     5      1    1.26     .27  

Total loans

   $ 104    $ 50    .16     .10  

Loans 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 $128 million at September 30, 2007 compared with $41 million at December 31, 2006. This increase reflected credit quality migration.

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 Part I, Item 1 of this Report regarding changes in the allowance for loan and lease losses and changes in 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

 

 

     September 30, 2007     December 31, 2006  
Dollars in millions    Allowance   

Loans to

Total

Loans

    Allowance   

Loans to

Total

Loans

 

Commercial

   $ 497    40.6 %   $ 443    40.9 %

Commercial real estate

     113    12.6       30    7.0  

Consumer

     52    27.7       28    33.1  

Residential mortgage

     14    14.6       7    12.7  

Lease financing

     37    3.9       48    5.6  

Other

     4    .6       4    .7  

Total

   $ 717    100.0 %   $ 560    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 nine months of 2007 and the evaluation of the allowances for loan and lease losses and unfunded loan commitments and letters of credit as of September 30, 2007 reflected loan and total credit exposure growth, changes in loan portfolio composition, refinements to model parameters, 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.

The allowance as a percent of nonperforming loans was 290% and as a percent of total loans was 1.09% at September 30, 2007. The comparable percentages at December 31, 2006 were 381% and 1.12%.

Charge-Offs And Recoveries

 

Nine months ended
September 30 Dollars in
millions
   Charge-
offs
   Recoveries    Net
Charge-
offs
    Percent
of
Average
Loans
 

2007

            

Commercial

   $ 96    $ 20    $ 76     .41 %

Consumer

     49      11      38     .29  

Commercial real estate

     4      1      3     .06  

Total

   $ 149    $ 32    $ 117     .26  

2006

            

Commercial

   $ 85    $ 16    $ 69     .46 %

Consumer

     37      11      26     .22  

Commercial real estate

     2         2     .09  

Residential mortgage

     2         2     .04  

Lease financing

            4      (4 )   (.19 )

Total

   $ 126    $ 31    $ 95     .26  

 

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Table of Contents

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 primarily based on the relative specific and pool allocation amounts. The amount of reserve allocated for qualitative factors represented 9.1% of the total allowance and .1% of total loans, net of unearned income, at September 30, 2007.

CREDIT DEFAULT SWAPS

From a credit risk management perspective, we buy and sell credit loss protection via the use of credit derivatives. When we buy loss protection by purchasing a credit default swap (“CDS”), we pay a fee to the seller, or CDS counterparty, in return for the right to receive a payment if a specified credit event occurs for a particular obligor or reference entity. We purchase CDSs to mitigate the risk of economic loss on a portion of our loan exposures. For credit protection, we use only traditional credit derivative instruments and do not purchase instruments such as “total return swaps.”

We also sell loss protection to mitigate the net premium cost and the impact of mark-to-market accounting on the CDS in cases where we buy protection to hedge the loan portfolio and to take proprietary trading positions. These activities represent additional risk positions rather than hedges of risk.

We approve counterparty credit lines for all of our trading activities, including CDSs. Counterparty credit lines are approved based on a review of credit quality in accordance with our traditional credit quality standards and credit policies. The credit risk of our counterparties is monitored in the normal course of business. In addition, all counterparty credit lines are subject to collateral thresholds and exposures above these thresholds are secured.

Credit default swaps are included in the Free-Standing Derivatives table in the Financial Derivatives section of this Risk Management discussion. Net gains from credit default swaps, reflected in the Trading line item on our Consolidated Income Statement, totaled $16 million in the first nine months of 2007. For the first nine months of 2006, net losses totaled $11 million.

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 and the level of our noninterest-bearing funding sources. Due to the 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 also the economic values of these assets and liabilities.

PNC’s Asset and Liability Management group centrally manages interest rate risk within limits and guidelines set forth in our risk management policies approved by the Asset and Liability Committee and the Risk Committee of the Board.

Sensitivity estimates and market interest rate benchmarks for the third quarters of 2007 and 2006 follow:

Interest Sensitivity Analysis

 

      Third
Quarter
2007
    Third
Quarter
2006
 

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

   (2.9 )%   (2.2 )%

100 basis point decrease

   2.9 %   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

   (7.1 )%   (5.1 )%

100 basis point decrease

   5.9 %   4.0 %

Duration of Equity Model

      

Base case duration of equity (in years):

   3.0     .8  

Key Period-End Interest Rates

      

One-month LIBOR

   5.12 %   5.32 %

Three-year swap

   4.69 %   5.05 %

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 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 market forward rates, and (iii) a Two-Ten Inversion (a 200 basis point inversion between two-year and ten-year rates superimposed on current base rates) scenario. We are inherently sensitive to a flatter or inverted yield curve.


 

29


Table of Contents

Net Interest Income Sensitivity To Alternate Rate Scenarios (Third Quarter 2007)

 

      PNC
Economist
    Market
Forward
    Two-Ten
Inversion
 

First year sensitivity

   6.1 %   7.2 %   (8.3 )%

Second year sensitivity

   14.0 %   12.2 %   (8.7 )%

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.

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 on- and off-balance sheet 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 following table. These simulations assume that as assets and liabilities mature, they are replaced or repriced at market rates.

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

LOGO

Our risk position has become increasingly liability sensitive in part due to the continued flat yield curve and in part due to our balance sheet management strategies. We believe that we have the deposit funding base and balance sheet flexibility to adjust, where appropriate, to changing interest rates and market conditions.

MARKET RISK MANAGEMENT – TRADING RISK

Our trading activities 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.

 

During the first nine months of 2007, our VaR ranged between $6.1 million and $10.4 million, averaging $7.8 million.

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 nine months of 2007, 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

Total trading revenue for the first nine months and third quarter of 2007 and 2006 was as follows:

 

Nine months ended September 30 – in millions    2007    2006  

Net interest income

      $ (4 )

Noninterest income

   $ 114      150  

Total trading revenue

   $ 114    $ 146  

Securities underwriting and trading (a)

   $ 31    $ 27  

Foreign exchange

     42      42  

Financial derivatives

     41      77  

Total trading revenue

   $ 114    $ 146  

 

Three months ended September 30 – in millions    2007     2006  

Net interest income

   $ (1 )   $ (1 )

Noninterest income

     33       38  

Total trading revenue

   $ 32     $ 37  

Securities underwriting and trading (a)

   $ 14     $ 7  

Foreign exchange

     15       11  

Financial derivatives

     3       19  

Total trading revenue

   $ 32     $ 37  
(a) Includes changes in fair value for certain loans accounted for at fair value.

 

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Table of Contents

Average trading assets and liabilities consisted of the following:

 

Nine months ended September 30 – in millions    2007    2006

Trading assets

       

Securities (a)

   $ 2,446    $ 1,577

Resale agreements (b)

     1,168      413

Financial derivatives (c)

     1,241      1,127

Loans at fair value (c)

     172      113

Total trading assets

   $ 5,027    $ 3,230

Trading liabilities

       

Securities sold short (d)

   $ 1,626    $ 767

Repurchase agreements and other borrowings (e)

     676      744

Financial derivatives (f)

     1,252      1,085

Borrowings at fair value (f)

     40      29

Total trading liabilities

   $ 3,594    $ 2,625

 

Three months ended September 30 – in millions    2007    2006

Trading assets

       

Securities (a)

   $ 3,293    $ 1,460

Resale agreements (b)

     1,267      537

Financial derivatives (c)

     1,389      1,220

Loans at fair value (c)

     164      168

Total trading assets

   $ 6,113    $ 3,385

Trading liabilities

       

Securities sold short (d)

   $ 1,960    $ 867

Repurchase agreements and other borrowings (e)

     637      708

Financial derivatives (f)

     1,400      1,151

Borrowings at fair value (f)

     41      40

Total trading liabilities

   $ 4,038    $ 2,766
(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 Borrowed funds – Other.
(e) Included in Borrowed funds – Repurchase agreements and Other.
(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.

BlackRock

PNC owns approximately 43 million shares of BlackRock common stock, accounted for under the equity method. Our total investment in BlackRock was $4.0 billion at September 30, 2007 compared with $3.9 billion at

December 31, 2006. The market value of our investment in BlackRock was $7.5 billion at September 30, 2007. The primary risk measurement, similar to other equity investments, is economic capital.

Low Income Housing Projects And Historic Tax Credits

Included in our equity investments are limited partnerships that sponsor affordable housing projects. At September 30, 2007 these investments, consisting of partnerships accounted for under the equity method as well as equity investments held by consolidated partnerships, totaled $1.0 billion. The comparable amount at December 31, 2006 was $708 million. PNC’s equity investment at risk was $195 million at September 30, 2007 compared with $134 million at year-end 2006. We also had commitments to make additional equity investments in affordable housing limited partnerships of $74 million at September 30, 2007 compared with $71 million at December 31, 2006. At September 30, 2007 historic tax credit investments totaled $13 million with unfunded commitments related to these investments of $18 million.

Private Equity

The private equity portfolio is comprised of equity and mezzanine investments that vary by industry, stage and type of investment. At September 30, 2007, private equity investments carried at estimated fair value totaled $559 million compared with $463 million at December 31, 2006. As of September 30, 2007, approximately 45% of the amount was invested directly in a variety of companies and approximately 55% was invested in various limited partnerships. Our unfunded commitments related to private equity totaled $255 million at September 30, 2007 compared with $283 million at December 31, 2006.

Other Investments

We also make investments in affiliated and non-affiliated funds with both traditional and alternative investment strategies. The economic values could be driven by either the fixed-income market or the equity markets, or both. At September 30, 2007, other investments totaled $394 million compared with $269 million at December 31, 2006. Our unfunded commitments related to other investments totaled $57 million at September 30, 2007 compared with $16 million at December 31, 2006. The amounts of other investments and related unfunded commitments at September 30, 2007 included those related to Steel City Capital Funding LLC as further described in Note 15 Commitments And Guarantees in the Notes To Consolidated Financial Statements of this Report.


 

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Table of Contents

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 liquidity on a consolidated basis is the deposit base that comes from our retail and corporate and institutional banking activities. Other borrowed funds come from a diverse mix of short and long-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, including trading securities) and securities available for sale. At September 30, 2007, our liquid assets totaled $34.7 billion, with $24.3 billion pledged as collateral for borrowings, trust, and other commitments.

Bank Level Liquidity

PNC Bank, N.A. can borrow from the Federal Reserve Bank of Cleveland’s discount window to meet short-term liquidity requirements. These borrowings are secured by securities and commercial loans. PNC Bank, N.A. is also a member of the Federal Home Loan Bank (“FHLB”)-Pittsburgh and as such has access to advances from FHLB-Pittsburgh secured generally by residential mortgage loans. At September 30, 2007, we maintained significant unused borrowing capacity from the Federal Reserve Bank of Cleveland’s discount window and FHLB-Pittsburgh under current collateral requirements.

During the third quarter of 2007 we substantially increased Federal Home Loan Bank borrowings, which provided us with additional liquidity at relatively attractive rates.

We can also obtain funding through traditional 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 September 30, 2007, PNC Bank, N.A. had issued $5.4 billion of debt under this program.

PNC Bank, N.A. established a program in December 2004 to offer up to $3.0 billion of its commercial paper. As of September 30, 2007, there were no issuances outstanding under this program.

Parent Company Liquidity

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 issuances, 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. Dividends may also be impacted by the bank’s capital needs and by contractual restrictions. The amount available for dividend payments to the parent company by PNC Bank, N.A. without prior regulatory approval was approximately $730 million at September 30, 2007.

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 and dividends or distributions from equity investments. As of September 30, 2007, the parent company had approximately $1.5 billion in funds available from its cash and short-term investments. As of September 30, 2007 there were $490 million of parent company contractual obligations with maturities of less than one year.

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.

On September 28, 2007, PNC Funding Corp issued $250 million of Senior Notes that mature on September 28, 2012. These notes pay interest semiannually at a fixed rate of 5.50%. These notes are not redeemable by us or the holders prior to maturity.

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 September 30, 2007, $55 million of commercial paper was outstanding under this program.


 

32


Table of Contents

Commitments

The following tables set forth contractual obligations and various other commitments representing required and potential cash outflows as of September 30, 2007.

Contractual Obligations

 

September 30, 2007 – in millions    Total

Remaining contractual maturities of time deposits

   $ 23,805

Borrowed funds

     27,453

Minimum annual rentals on noncancellable leases

     1,196

Nonqualified pension and postretirement benefits

     342

Purchase obligations (a)

     440

Total contractual cash obligations (b)

   $ 53,236
(a) Includes purchase obligations for goods and services covered by noncancellable contracts and contracts including cancellation fees.
(b) Excludes amounts related to our adoption of FIN 48 due to the uncertainty in terms of timing and amount of future cash outflows. Note 11 Income Taxes in our Notes To Consolidated Financial Statements includes additional information regarding our adoption of FIN 48 in the first quarter of 2007.

Other Commitments (a)

 

September 30, 2007 – in millions    Total

Credit commitments

   $ 52,590

Standby letters of credit

     4,790

Other commitments (b)

     404

Total commitments

   $ 57,784
(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 private equity funding commitments related to equity management, low income housing projects and other investments.

 

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 we use 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 September 30, 2007 and December 31, 2006, 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.


 

33


Table of Contents

The following tables provide the notional or contractual amounts and estimated net fair value of financial derivatives used for risk management and designated as accounting hedges or free-standing derivatives at September 30, 2007 and December 31, 2006. 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 - 2007

 

   Notional/
Contract
Amount
   Estimated
Net

Fair
Value

 
 

 
 

   Weighted
Average
Maturity
   Weighted-

Average


Interest Rates

 

 


 

September 30, 2007 – dollars in millions

            Paid     Received  

Accounting Hedges

               

Interest rate risk management

               

Asset rate conversion

               

Interest rate swaps (a)

               

Receive fixed

   $8,239    $125      4 yrs. 1 mo.    4.98 %   5.45 %

Forward purchase commitments

   370           1 mo.    NM     NM  

Total asset rate conversion

   8,609    125            

Liability rate conversion

               

Interest rate swaps (a)

               

Receive fixed

   7,090    29      5 yrs. 7 mos.    4.87     5.22  

Total liability rate conversion

   7,090    29            

Total interest rate risk management

   15,699    154            

Commercial mortgage banking risk management
Pay fixed interest rate swaps (a)

   943    (23 )    9 yrs. 3 mos.    5.47     5.10  

Total commercial mortgage banking risk management

   943    (23 )          

Total accounting hedges (b)

   $16,642    $131            

Free-Standing Derivatives

               

Customer-related

               

Interest rate

               

Swaps

   $60,996    $14      5 yrs. 1 mo.    4.90 %   4.92 %

Caps/floors

               

Sold

   2,840    (4 )    6 yrs. 7 mos.    NM     NM  

Purchased

   2,168    6      3 yrs. 11 mos.    NM     NM  

Futures

   3,265    (2 )    9 mos.    NM     NM  

Foreign exchange

   8,534    (1 )    5 mos.    NM     NM  

Equity (c)

   1,847    (88 )    1 yr. 7 mos.    NM     NM  

Swaptions

   3,896    7      12 yrs. 9 mos.    NM     NM  

Total customer-related

   83,546    (68 )          

Other risk management and proprietary

               

Interest rate

               

Swaps

   47,812    (9 )    5 yrs. 1 mo.    4.85 %   4.86 %

Caps/floors

               

Sold

   6,250    (48 )    2 yrs. 4 mos.    NM     NM  

Purchased

   7,760    66      2 yrs. 2 mos.    NM     NM  

Futures

   41,400    (5 )    1 yr. 4 mos.    NM     NM  

Foreign exchange

   3,147    4      7 yrs. 9 mos.    NM     NM  

Credit derivatives

   5,264    3      11 yrs.    NM     NM  

Risk participation agreements

   936       4 yrs. 11 mos.    NM     NM  

Commitments related to mortgage-related assets

   3,405    4      5 mos.    NM     NM  

Options

               

Futures

   24,730    (4 )    5 mos.    NM     NM  

Swaptions

   17,785    49      8 yrs. 2 mos.    NM     NM  

Other (d)

   442    (72 )    NM    NM     NM  

Total other risk management and proprietary

   158,931    (12 )          

Total free-standing derivatives

   $242,477    $(80 )                  
(a) The floating rate portion of interest rate contracts is based on money-market indices. As a percent of notional amount, 55% were based on 1-month LIBOR, 39% on 3-month LIBOR and 6% on Prime Rate.
(b) Fair value amounts include net accrued interest receivable of $64 million.
(c) The increase in the negative value from December 31, 2006 to September 30, 2007 of $25 million was due to the changes in fair values of the existing contracts along with new contracts entered into during 2007.
(d) Relates to PNC’s obligation to help fund certain BlackRock LTIP programs. Additional information regarding the BlackRock/MLIM transaction and our BlackRock LTIP shares obligation is included in Note 2 Acquisitions included in the Notes To Consolidated Financial Statements in Item 8 of our 2006 Form 10-K and our current report on Form 8-K filed June 14, 2007.

NM Not meaningful

 

34


Table of Contents

Financial Derivatives - 2006

 

     Notional/
Contract
Amount
  

Estimated
Net

Fair
Value

    Weighted
Average
Maturity
 

Weighted-
Average

Interest Rates

 

December 31, 2006 – dollars in millions

          Paid     Received  

Accounting Hedges

             

Interest rate risk management

             

Asset rate conversion

             

Interest rate swaps (a)

Receive fixed

   $7,815    $62     3 yrs. 9 mos.   5.30 %   5.43 %

Interest rate floors (b)

   6          4 yrs. 3 mos.   NM     NM  

Total asset rate conversion

   7,821    62          

Liability rate conversion

             

Interest rate swaps (a)
Receive fixed

   4,245    6     6 yrs. 11 mos.   5.15     5.43  

Total liability rate conversion

   4,245    6          

Total interest rate risk management

   12,066    68          

Commercial mortgage banking risk management
Pay fixed interest rate swaps (a)

   745    (7 )   9 yrs. 11 mos.   5.25     5.09  

Total commercial mortgage banking risk management

   745    (7 )        

Total accounting hedges (c)

   $12,811    $61                  

Free-Standing Derivatives

             

Customer-related

             

Interest rate

             

Swaps

   $48,816    $9     4 yrs. 11 mos.   5.00 %   5.01 %

Caps/floors

             

Sold

   1,967    (3 )   7 yrs. 4 mos.   NM     NM  

Purchased

   897    3     7 yrs. 2 mos.   NM     NM  

Futures

   2,973    2     9 mos.   NM     NM  

Foreign exchange

   5,245      6 mos.   NM     NM  

Equity (d)

   2,393    (63 )   1 yr. 6 mos.   NM     NM  

Swaptions

   8,685    16     6 yrs. 10 mos.   NM     NM  

Other

   20          10 yrs. 6 mos.   NM     NM  

Total customer-related

   70,996    (36 )                

Other risk management and proprietary

             

Interest rate

             

Swaps

   19,631    4     7 yrs. 8 mos.   4.81 %   4.97 %

Caps/floors

             

Sold

   6,500    (50 )   2 yrs. 11 mos.   NM     NM  

Purchased

   7,010    59     3 yrs.   NM     NM  

Futures

   13,955    (3 )   1 yr. 4 mos.   NM     NM  

Foreign exchange

   1,958      5 yrs. 2 mos.   NM     NM  

Credit derivatives

   3,626    (11 )   7 yrs.   NM     NM  

Risk participation agreements

   786      5 yrs. 5 mos.   NM     NM  

Commitments related to mortgage-related assets

   2,723    10     2 mos.   NM     NM  

Options

             

Futures

   63,033    (2 )   8 mos.   NM     NM  

Swaptions

   25,951    54     6 yrs. 10 mos.   NM     NM  

Other (e)

   596    (12 )   NM   NM     NM  

Total other risk management and proprietary

   145,769    49          

Total free-standing derivatives

   $216,765    $13                  
(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, 27% on 3-month LIBOR and 6% on Prime Rate.
(b) Interest rate floors have a weighted-average strike of 3.21%.
(c) Fair value amounts include net accrued interest receivable of $94 million.
(d) See (c) on page 34.
(e) See (d) on page 34.

NM Not meaningful

 

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INTERNAL CONTROLS AND DISCLOSURE CONTROLS AND PROCEDURES

As of September 30, 2007, 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 September 30, 2007, and that there has been no change in internal control over financial reporting that occurred during the third quarter of 2007 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 (net of eligible deferred taxes).

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 by reducing the carrying amount by the allowance for loan losses associated with such loan or if the 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, primarily credit default swaps, 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.

Credit spread - The difference in yield between debt issues of similar maturity. The excess of yield attributable to credit spread is often used as a measure of relative creditworthiness, with a reduction in the credit spread reflecting an improvement in the borrower’s perceived creditworthiness.

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., positioned for declining interest 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 a business segment 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.

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.


 

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Efficiency - Noninterest expense divided by the sum of net interest income (GAAP basis) 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 a business segment. 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.

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 protection seller to the protection 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 income from loans and deposits - A management accounting assessment, using funds transfer pricing methodology, of the net interest contribution from loans and deposits.

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 (GAAP basis) and noninterest income.

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

Nonperforming loans - Nonperforming loans include loans to commercial, commercial real estate, equipment lease financing, consumer, and residential mortgage customers as well as troubled debt restructured loans. Nonperforming loans do not include 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 (GAAP basis) 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.


 

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Tangible common equity ratio - Period-end common shareholders’ equity less goodwill and other intangible assets (net of eligible deferred taxes), and excluding loan servicing rights, divided by period-end assets less goodwill and other intangible assets (net of eligible deferred taxes), and excluding loan 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 taxable investments. 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 earned 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 (net of eligible deferred taxes), 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.

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 subordinated debt and trust preferred securities, 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,” “will,” “ 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 some of these factors in our 2006 Form 10-K and in this Form 10-Q, including in the Risk Factors and Risk Management sections of these reports. 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 businesses and financial results are affected by business and economic conditions, both generally and specifically in the principal markets in which we operate. In particular, our businesses and financial results may be impacted by:

   

Changes in interest rates and valuations in the debt, equity and other financial markets.


 

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Disruptions in the liquidity and other functioning of financial markets, including such disruptions in the markets for real estate and other assets commonly securing financial products.

   

Actions by the Federal Reserve and other government agencies, including those that impact money supply and market interest rates.

   

Changes in our customers’, suppliers’ and other counterparties’ performance in general and their creditworthiness in particular.

   

Changes in customer preferences and behavior, whether as a result of changing business and economic conditions or other factors.

 

   

A continuation of recent turbulence in significant portions of the global financial markets could impact our performance, both directly by affecting our revenues and the value of our assets and liabilities and indirectly by affecting the economy generally.

   

Our operating results are affected by our liability to provide shares of BlackRock common stock to help fund certain BlackRock long-term incentive plan (“LTIP”) programs, as our LTIP liability is adjusted quarterly (“marked-to-market”) based on changes in BlackRock’s common stock price and the number of remaining committed shares, and we recognize gain or loss on such shares at such times as shares are transferred for payouts under the LTIP programs.

   

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 business initiatives and strategies could affect our financial performance over the next several years.

   

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, education lending, 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, derivatives, 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 also be affected by widespread natural disasters, terrorist activities or international hostilities, either as a result of the impact on the economy and capital and other financial 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 equity interest in BlackRock, Inc. are discussed in more detail in BlackRock’s 2006 Form 10-K, including in the Risk Factors section, and in BlackRock’s other filings with the SEC, accessible on the SEC’s website and on or through BlackRock’s website at www.blackrock.com.

We grow our business from time to time by acquiring other financial services companies, including our pending Sterling acquisition. Acquisitions in general present us with risks other than those presented by the nature of the business acquired. In particular, acquisitions may be substantially more expensive to complete (including as a result of costs incurred in connection with the integration of the acquired company) and the anticipated benefits (including anticipated cost savings and strategic gains) may be significantly harder or take longer to achieve than expected. In some cases, acquisitions involve our entry into new businesses or new geographic or other markets, and these situations also present risks resulting from our inexperience in these new areas. As a regulated financial institution, our pursuit of attractive acquisition opportunities could be negatively impacted due to regulatory delays or other regulatory issues. Regulatory and/or legal issues related to the pre-acquisition operations of an acquired business may cause reputational harm to PNC following the acquisition and integration of the acquired business into ours and may result in additional future costs arising as a result of those issues.


 

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CONSOLIDATED INCOME STATEMENT

THE PNC FINANCIAL SERVICES GROUP, INC.

 

In millions, except per share data   Three months ended September 30          Nine months ended September 30  
Unaudited       2007             2006                   2007              2006      

Interest Income

             

Loans

  $1,129     $838        $3,109      $2,382  

Securities available for sale

  366     271        1,031      769  

Other

  132     94          356      244  

Total interest income

  1,627     1,203          4,496      3,395  

Interest Expense

             

Deposits

  531     434        1,531      1,140  

Borrowed funds

  335     202          843      576  

Total interest expense

  866     636          2,374      1,716  

Net interest income

  761     567        2,122      1,679  

Provision for credit losses

  65     16          127      82  

Net interest income less provision for credit losses

  696     551          1,995      1,597  

Noninterest Income

             

Asset management

  204     381        559      1,271  

Fund servicing

  208     213        620      644  

Service charges on deposits

  89     81        258      234  

Brokerage

  71     61        209      183  

Consumer services

  106     89        304      272  

Corporate services

  198     157        533      449  

Equity management gains

  47     21        81      82  

Net securities losses

  (2 )   (195 )      (4 )    (207 )

Trading

  33     38        114      150  

Net gains (losses) related to BlackRock

  (50 )   2,078        1      2,078  

Other

  86     19          281      202  

Total noninterest income

  990     2,943          2,956      5,358  

Noninterest Expense

             

Compensation

  480     573        1,368      1,686  

Employee benefits

  73     86        219      249  

Net occupancy

  87     79        255      241  

Equipment

  77     77        227      234  

Marketing

  36     39        86      81  

Other

  346     313          928      983  

Total noninterest expense

  1,099     1,167          3,083      3,474  

Income before minority interest and income taxes

  587     2,327        1,868      3,481  

Minority interest in income of BlackRock

    6           47  

Income taxes

  180     837          579      1,215  

Net income

  $407     $1,484          $1,289      $2,219  

Earnings Per Common Share

             

Basic

  $1.21     $5.09        $3.92      $7.60  

Diluted

  $1.19     $5.01          $3.85      $7.46  

Average Common Shares Outstanding

             

Basic

  337     291        329      292  

Diluted

  340     296          333      297  

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

   September 30
2007
    December 31
2006
 

Assets

    

Cash and due from banks

   $3,318     $3,523  

Federal funds sold and resale agreements

   2,360     1,763  

Other short-term investments, including trading securities

   3,944     3,130  

Loans held for sale

   3,004     2,366  

Securities available for sale

   28,430     23,191  

Loans, net of unearned income of $986 and $795

   65,760     50,105  

Allowance for loan and lease losses

   (717 )   (560 )

Net loans

   65,043     49,545  

Goodwill

   7,836     3,402  

Other intangible assets

   1,099     641  

Equity investments

   5,975     5,330  

Other

   10,357     8,929  

Total assets

   $131,366     $101,820  

Liabilities

    

Deposits

    

Noninterest-bearing

   $18,570     $16,070  

Interest-bearing

   59,839     50,231  

Total deposits

   78,409     66,301  

Borrowed funds

    

Federal funds purchased

   6,658     2,711  

Repurchase agreements

   1,990     2,051  

Bank notes and senior debt

   7,794     3,633  

Subordinated debt

   3,976     3,962  

Federal Home Loan Bank borrowings

   4,772     42  

Other

   2,263     2,629  

Total borrowed funds

   27,453     15,028  

Allowance for unfunded loan commitments and letters of credit

   127     120  

Accrued expenses

   4,077     3,970  

Other

   5,095     4,728  

Total liabilities

   115,161     90,147  

Minority and noncontrolling interests in consolidated entities

   1,666     885  

Shareholders’ Equity

    

Preferred stock (a)

    

Common stock - $5 par value

    

Authorized 800 shares, issued 353 shares

   1,764     1,764  

Capital surplus

   2,631     1,651  

Retained earnings

   11,531     10,985  

Accumulated other comprehensive loss

   (255 )   (235 )

Common stock held in treasury at cost: 16 and 60 shares

   (1,132 )   (3,377 )

Total shareholders’ equity

   14,539     10,788  

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

   $131,366     $101,820  

(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.

 

Nine months ended September 30 - in millions

Unaudited

   2007      2006  

Operating Activities

     

Net income

   $1,289      $2,219  

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

     

Provision for credit losses

   127      82  

Depreciation, amortization and accretion

   238      268  

Deferred income taxes

   81      855  

Net securities losses

   4      207  

Valuation adjustments

   2      45  

Net gains related to BlackRock

   (1 )    (2,078 )

Undistributed earnings of BlackRock

   (132 )   

Excess tax benefits from share-based payment arrangements

   (13 )    (21 )

Loans held for sale

   (559 )    244  

Other short-term investments, including trading securities

   (327 )    140  

Other assets

   (263 )    168  

Accrued expenses and other liabilities

   162      (70 )

Other

   179      (539 )

Net cash provided by operating activities

   787      1,520  

Investing Activities

     

Repayment of securities

   3,527      2,663  

Sales

     

Secu