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 March 31, 2008

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, including 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, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer X Accelerated filer      Non-accelerated filer     Smaller reporting company     

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 April 30, 2008, there were 345,849,293 shares of the registrant’s common stock ($5 par value) outstanding.


Table of Contents

The PNC Financial Services Group, Inc.

Cross-Reference Index to First Quarter 2008 Form 10-Q

 

PART I – FINANCIAL INFORMATION    Pages

Item 1.     Financial Statements (Unaudited).

   41-71

Consolidated Income Statement

   41

Consolidated Balance Sheet

   42

Consolidated Statement Of Cash Flows

   43

Notes To Consolidated Financial Statements (Unaudited)

  

Note 1     Accounting Policies

   44

Note 2     Acquisitions And Divestitures

   51

Note 3     Variable Interest Entities

   51

Note 4     Securities

   54

Note 5     Asset Quality

   55

Note 6     Fair Value

   56

Note 7     Goodwill And Other Intangible Assets

   59

Note 8     Capital Securities Of Subsidiary Trusts

   60

Note 9     Certain Employee Benefit And Stock-Based Compensation Plans

   60

Note 10   Financial Derivatives

   62

Note 11   Earnings Per Share

   64

Note 12   Shareholders’ Equity And Other Comprehensive Income

   65

Note 13   Summarized Financial Information of BlackRock

   66

Note 14   Legal Proceedings

   66

Note 15   Commitments And Guarantees

   67

Note 16   Segment Reporting

   69
  

Statistical Information (Unaudited)

  

Average Consolidated Balance Sheet And Net Interest Analysis

   72-73

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

   1-40

Financial Review

  

Consolidated Financial Highlights

   1-2

Executive Summary

   3

Consolidated Income Statement Review

   6

Consolidated Balance Sheet Review

   9

Off-Balance Sheet Arrangements And Variable Interest Entities

   13

Fair Value Measurements And Fair Value Option

   16

Business Segments Review

   19

Critical Accounting Policies And Judgments

   27

Status Of Qualified Defined Benefit Pension Plan

   27

Risk Management

   28

Internal Controls And Disclosure Controls And Procedures

   37

Glossary Of Terms

   37

Cautionary Statement Regarding Forward-Looking Information

   39

Item 3.     Quantitative and Qualitative Disclosures About Market Risk.

   28-36

Item 4.     Controls and Procedures.

   37

PART II – OTHER INFORMATION

  

Item 1.     Legal Proceedings.

   74

Item 1A.  Risk Factors.

   74

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

   74

Item 4.     Submission Of Matters To A Vote Of Security Holders

   74

Item 6.     Exhibits.

   75

Exhibit Index.

   75

Signature

   75

Corporate Information

   76

 


Table of Contents

FINANCIAL REVIEW

CONSOLIDATED FINANCIAL HIGHLIGHTS

THE PNC FINANCIAL SERVICES GROUP, INC.

 

Dollars in millions, except per share data  

Three months ended

March 31

 
Unaudited       2008              2007      

FINANCIAL PERFORMANCE (a)

      

Revenue

      

Net interest income, taxable-equivalent basis (b)

  $ 863      $ 629  

Noninterest income

    967        991  

Total revenue

  $ 1,830      $ 1,620  

Noninterest expense

  $ 1,042      $ 944  

Net income

  $ 377      $ 459  

Per common share

      

Diluted earnings

  $ 1.09      $ 1.46  

Cash dividends declared

  $ .63      $ .55  

SELECTED RATIOS

      

Net interest margin

    3.09 %      2.95 %

Noninterest income to total revenue (c)

    53        61  

Efficiency (d)

    57        58  

Return on

      

Average tangible common shareholders’ equity

    25.98 %      26.63 %

Average common shareholders’ equity

    10.62        15.59  

Average assets

    1.08        1.73  

See page 37 for a glossary of certain terms used in this Report.

(a) The Executive Summary and Consolidated Income Statement Review 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
March 31
         2008              2007    

Net interest income, GAAP basis

  $ 854      $ 623

Taxable-equivalent adjustment

    9        6

Net interest income, taxable-equivalent basis

  $ 863      $ 629

 

(c) Calculated as noninterest income divided by the sum of net interest income (GAAP basis) and noninterest income.
(d) Calculated as noninterest expense divided by the sum of net interest income (GAAP basis) and noninterest income.

 

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Unaudited   March 31
2008
    December 31
2007
           March 31    
2007
 

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

          

Assets

  $ 139,991     $ 138,920        $ 122,563  

Loans, net of unearned income

    70,802       68,319          62,925  

Allowance for loan and lease losses

    865       830          690  

Securities available for sale

    28,581       30,225          26,475  

Loans held for sale

    2,516       3,927          2,382  

Goodwill and other intangibles

    9,349       9,551          8,668  

Equity investments

    6,187       6,045          5,408  

Deposits

    80,410       82,696          77,367  

Borrowed funds

    32,779       30,931          20,456  

Shareholders’ equity

    14,423       14,854          14,739  

Common shareholders’ equity

    14,416       14,847          14,732  

Book value per common share

    42.26       43.60          42.63  

Common shares outstanding (millions)

    341       341          346  

Loans to deposits

    88 %     83 %        81 %
 

ASSETS ADMINISTERED (billions)

          

Managed

  $ 65     $ 73        $ 76  

Nondiscretionary

    111       113          111  
 

FUND ASSETS SERVICED (billions)

          

Accounting/administration net assets

  $ 1,000     $ 990        $ 822  

Custody assets

    476       500          435  
 
CAPITAL RATIOS           

Tier 1 risk-based (a)

    7.7 %     6.8 %        8.6 %

Total risk-based (a)

    11.4       10.3          12.2  

Leverage (a)

    6.8       6.2          8.7  

Tangible common equity

    4.7       4.7          5.8  

Common shareholders’ equity to assets

    10.3       10.7          12.0  
 
ASSET QUALITY RATIOS           

Nonperforming loans to total loans

    .77 %     .64 %        .28 %

Nonperforming assets to total loans and foreclosed assets

    .83       .70          .32  

Nonperforming assets to total assets

    .42       .34          .17  

Net charge-offs to average loans

    .57       .49          .27  

Allowance for loan and lease losses to loans

    1.22       1.21          1.10  

Allowance for loan and lease losses to nonperforming loans

    159       190          388  
(a) 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 2007 Annual Report on Form 10-K (“2007 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 2007 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 historical performance and those anticipated in the forward-looking statements included in this Report. See Note 16 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 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 offering 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 may also grow revenue through appropriate and targeted acquisitions and, in certain businesses, by expanding into new geographical markets.

A volatile and significantly challenging financial market environment began in 2007 and has continued into 2008, and has been accompanied by uncertain prospects for the overall national economy. We are focused on our strategies for growth. We remain committed to maintaining a moderate risk profile characterized by disciplined credit management 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 well-positioned and strong balance sheet, ample liquidity 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 when appropriate.

 

ACQUISITION AND DIVESTITURE ACTIVITY

On March 31, 2008, we sold J.J.B. Hilliard, W.L. Lyons, LLC (“Hilliard Lyons”), a Louisville, Kentucky-based wholly-owned subsidiary of PNC and a full-service brokerage and financial services provider, to Houchens Industries, Inc. We recognized an after-tax gain of $23 million in the first quarter of 2008 in connection with this divestiture.

On April 4, 2008, we acquired Lancaster, Pennsylvania-based Sterling Financial Corporation (“Sterling”) for approximately 4.6 million shares of PNC common stock and $224 million in cash. Sterling is a banking and financial services company with approximately $3.2 billion in assets, $2.7 billion in deposits, and 67 branches in south-central Pennsylvania, northern Maryland and northern Delaware.

KEY FACTORS AFFECTING FINANCIAL PERFORMANCE

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

   

General economic conditions,

   

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

   

The functioning and other performance of, and availability of liquidity in, the capital and other financial markets,

   

Loan demand, utilization of credit commitments and standby letters of credit, and asset quality,

   

Customer demand for other products and services,

   

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

   

The impact of market credit spreads on asset valuations.

Starting in the middle of 2007, and continuing at present, there has been significant turmoil and volatility in worldwide financial markets, accompanied by uncertain prospects for the overall national economy. Our performance for the remainder of 2008 will be impacted by developments in these areas. In addition, our success in 2008 will depend, among other things, upon:

   

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


 

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The successful integration of our recent acquisitions,

   

Continued development of the Mercantile franchise, including full deployment of our product offerings,

   

Revenue growth,

   

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

   

Maintaining solid overall asset quality,

   

Prudent risk and capital management, and

   

Actions we take within the capital and other financial markets.

SUMMARY FINANCIAL RESULTS

 

     Three months ended  
      March 31,
2008
    March 31,
2007
 

Net income (millions)

   $ 377     $ 459  

Diluted earnings per share

   $ 1.09     $ 1.46  

Return on

      

Average tangible common shareholders’ equity

     25.98 %     26.63 %

Average common shareholders’ equity

     10.62 %     15.59 %

Average assets

     1.08 %     1.73 %

The decline in earnings for the first quarter of 2008 compared with the first quarter of 2007 reflected a higher provision for credit losses in 2008, partially offset by an increase in operating leverage as the increase in net interest income exceeded the decline in noninterest income and increase in noninterest expense. Our Consolidated Income Statement Review section of this Financial Review describes in greater detail the various items that impacted our results for the first quarter of 2008 and 2007.

Highlights of the first quarter of 2008 included the following:

   

We continued to grow revenue while controlling noninterest expense, creating positive operating leverage. Revenue growth of 13% exceeded noninterest expense growth of 10% in the year-over-year comparison.

   

Net interest income on a taxable-equivalent basis grew 37% in the first quarter of 2008 compared with the first quarter of 2007. The net interest margin improved to 3.09% compared with 2.95% in the first quarter of 2007. Noninterest income declined 2% compared with the first quarter of 2007 as several increases in fee income were more than offset by valuation and trading losses.

   

Average loans for the first quarter increased 28% over first quarter 2007, while average deposits increased 17% in the comparison.

   

Overall asset quality remained solid despite the impact of the challenging credit environment. The allowance for loan and lease losses was 1.22% of total loans at March 31, 2008 and 1.21% at December 31, 2007.

   

PNC maintained a strong liquidity position and continued to be well capitalized, building the Tier 1 risk-based capital ratio to 7.7% at March 31, 2008 compared with 6.8% at December 31, 2007. In April 2008, we announced a 5% increase of the cash dividend on common stock to 66 cents per share in recognition of the current market environment and reflecting confidence in our ability to grow earnings.

BALANCE SHEET HIGHLIGHTS

Total assets were $140.0 billion at March 31, 2008 compared with $138.9 billion at December 31, 2007. Total average assets were $140.6 billion for the first three months of 2008 compared with $107.4 billion for the first three months of 2007. This increase reflected a $26.1 billion increase in average interest-earning assets and a $7.1 billion increase in average noninterest-earning assets. An increase of $15.3 billion in loans and a $6.6 billion increase in securities available for sale were the primary factors for the increase in average interest-earning assets.

The increase in average noninterest-earning assets for the first quarter of 2008 reflected an increase in average goodwill of $3.6 billion primarily related to the acquisition of Mercantile on March 2, 2007 and Yardville on October 26, 2007.

The impact of the Mercantile and Yardville acquisitions is also reflected in our year-over-year increases in average total loans, average securities available for sale and average total deposits described further below.

Average total loans were $69.3 billion for the first three months of 2008 and $54.1 billion in the first three months of 2007. The increase in average total loans included growth in commercial loans of $7.7 billion and growth in commercial real estate loans of $3.5 billion. Loans represented 62% of average interest-earning assets for the first three months of 2008 and 63% for the first three months of 2007.

Average securities available for sale totaled $30.0 billion for the first quarter of 2008 and $23.4 billion for the first quarter of 2007. Average residential and commercial mortgage-backed securities increased $5.5 billion on a combined basis in the comparison. Securities available for sale comprised 27% of average interest-earning assets for both the first three months of 2008 and 2007.

Average total deposits were $81.6 billion for the first three months of 2008, an increase of $11.9 billion over the first three months of 2007. Average deposits grew from the prior year period primarily as a result of increases in money market accounts, time deposits in foreign offices, other time deposits, and demand and other noninterest-bearing deposits.

Average total deposits represented 58% of average total assets for the first three months of 2008 and 65% for the first three months of 2007. Average transaction deposits were $52.5 billion for the first quarter of 2008 compared with $47.0 billion for the first quarter of 2007.


 

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Average borrowed funds were $32.1 billion for the first three months of 2008 and $16.8 billion for the first three months of 2007. Increases of $8.2 billion in Federal Home Loan Bank borrowings, $2.6 billion in bank notes and senior debt and $2.4 billion in other borrowed funds drove the increase compared with the first quarter of 2007.

Shareholders’ equity totaled $14.4 billion at March 31, 2008 compared with $14.9 billion at December 31, 2007. See the Consolidated Balance Sheet Review section of this Financial Review for additional information.

BUSINESS SEGMENT HIGHLIGHTS

Total business segment earnings decreased $103 million for the first quarter of 2008, to $313 million, compared with the first quarter of 2007. Highlights of results for the first three months of 2008 and 2007 are included below. The Business Segments Review section of this Financial Review includes further analysis of our business segment results over these periods.

We provide a reconciliation of total business segment earnings to total PNC consolidated net income as reported on a GAAP basis in Note 16 Segment Reporting in the Notes To Consolidated Financial Statements in this Report.

Retail Banking

Retail Banking’s earnings were $221 million for the first quarter of 2008 compared with $201 million for the same period in 2007. The 10% increase in earnings over the first quarter in 2007 was driven by acquisitions and gains related to our ownership interest in Visa and the Hilliard Lyons sale, partially offset by an increase in the provision for credit losses.

 

Corporate & Institutional Banking

Corporate & Institutional Banking earned $2 million in the first quarter of 2008 compared with $132 million in the first quarter of 2007. First quarter 2008 earnings were impacted by pretax valuation losses of $177 million on commercial mortgage loans and commitments held for sale, net of hedges. The decrease compared with the first quarter of 2007 also resulted from higher provision for credit losses and noninterest expense somewhat offset by higher taxable-equivalent net interest income.

BlackRock

Our BlackRock business segment earned $60 million for the first quarter of 2008, a 15% increase compared with $52 million in the first quarter of 2007.

PFPC

PFPC earned $30 million for the first three months of 2008 compared with $31 million in the year-earlier period. While servicing revenue growth of 14% was realized through new business, organic growth, and the completion of two acquisitions in December 2007, increased costs related to this growth and the acquisitions offset the increase.

Other

“Other” earnings for the first quarter of 2008 totaled $64 million compared with earnings of $43 million for the first quarter of 2007. The higher earnings in the first quarter of 2008 reflected growth in net interest income related to asset and liability management activity, net securities gains and the partial reversal of the Visa indemnification liability, partially offset by net trading losses.


 

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CONSOLIDATED INCOME STATEMENT REVIEW

Our Consolidated Income Statement is presented in Part I, Item 1 of this Report. Total revenue for the first quarter of 2008 increased 13% compared with the first quarter of 2007. We created positive operating leverage as total noninterest expense increased 10% in the comparison.

NET INTEREST INCOME AND NET INTEREST MARGIN

 

     Three months ended
March 31
 
Dollars in millions        2008             2007      

Taxable-equivalent net interest income

   $ 863     $ 629  

Net interest margin

     3.09 %     2.95 %

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 the Statistical Information-Average Consolidated Balance Sheet And Net Interest Analysis section of this Report for additional information.

The 37% increase in taxable-equivalent net interest income for the first three months of 2008 compared with the first three months of 2007 was consistent with the $26.1 billion, or 31%, increase in average interest-earning assets and wider net interest margin over this period. The reasons driving the higher interest-earning assets in the comparison are further discussed in the Balance Sheet Highlights portion of the Executive Summary section of this Financial Review.

We expect net interest income to be at least 20% higher for full year 2008 compared with 2007, assuming our current expectations for interest rates and economic conditions. Our forward-looking statements are based on our current expectations that interest rates will remain low through most of 2008 with continued wide market credit spreads and our view that national economic conditions currently point toward a mild recession.

The net interest margin was 3.09% for the first quarter of 2008 and 2.95% for the first quarter of 2007. The following factors impacted the comparison:

   

The Mercantile acquisition.

   

A decrease in the rate paid on interest-bearing liabilities of 78 basis points. The rate paid on interest-bearing deposits, the single largest component, decreased 70 basis points.

   

These factors were partially offset by a 40 basis point decrease in the yield on interest-earning assets. The

 

yield on loans, the single largest component, decreased 50 basis points.

   

In addition, the impact of noninterest-bearing sources of funding decreased 24 basis points due to lower interest rates and a lower proportion of noninterest-bearing sources of funding to interest-earning assets.

Comparing yields and rates paid to the broader market, during the first three months of 2008, the average federal funds rate was 3.17% compared with 5.26% for the first three months of 2007.

We believe that net interest margins for our industry will continue to be impacted by competition for high quality loans and deposits and customer migration from lower to higher rate deposit or other products. We expect our net interest margin to improve for full year 2008 compared with 2007, assuming our current expectations for interest rates and economic conditions.

PROVISION FOR CREDIT LOSSES

The provision for credit losses totaled $151 million for the first quarter of 2008 compared with $8 million for the first quarter of 2007. The higher provision in the comparison was driven by general credit quality migration, especially in our commercial real estate portfolio, including residential real estate development exposure, and growth in total credit exposure. Total residential real estate development outstandings were approximately $2.1 billion at March 31, 2008.

Given our projections for loan growth and continued credit deterioration, and our view that national economic conditions currently point toward a mild recession, we expect that the provision for credit losses will be approximately $600 million for full year 2008, including the impact of the Sterling acquisition.

The Credit Risk Management portion of the Risk Management section of this Financial Review includes additional information regarding factors impacting the provision for credit losses.

NONINTEREST INCOME

Summary

Noninterest income totaled $967 million for the first three months of 2008 compared with $991 million for the first three months of 2007.

Noninterest income for the first quarter of 2008 included the following items:

   

A gain of $114 million from the sale of Hilliard Lyons,

   

A gain of $95 million related to the redemption of a portion of our Visa Class B common shares related to Visa’s March 2008 initial public offering,


 

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Net securities gains of $41 million,

   

Gains of $40 million related to our equity investment in BlackRock, largely due to a net mark-to-market adjustment on our remaining BlackRock LTIP shares obligation,

   

Equity management gains of $23 million,

   

Valuation losses related to our commercial mortgage loans and commitments held for sale, net of hedges, of $177 million, and

   

Trading losses of $76 million.

Noninterest income for the first quarter of 2007 included the following:

   

A net gain related to our equity investment in BlackRock of $52 million, representing an $82 million gain recognized in connection with our transfer of BlackRock shares to satisfy a portion of our 2002 LTIP obligation, partially offset by a net mark-to-market adjustment totaling $30 million on our remaining BlackRock LTIP shares obligation,

   

Trading income of $52 million, and

   

Equity management gains of $32 million and net securities losses of $3 million.

Apart from the impact of these items, noninterest income increased $49 million, or 6%, for the first three months of 2008 compared with the first three months of 2007.

Additional Analysis

Fund servicing fees increased $25 million, to $228 million, in the first three months of 2008 compared with the first three months of 2007. This increase primarily resulted from the growth in PFPC’s offshore operations and its acquisitions of Albridge Solutions Inc. and Coates Analytics, LP in December 2007.

PFPC provided fund accounting/administration services for $1 trillion of net fund investment assets and provided custody services for $476 billion of fund investment assets at March 31, 2008, compared with $822 billion and $435 billion, respectively, at March 31, 2007. PFPC continued to see both organic growth and growth from new business in each of its product areas.

Asset management fees totaled $212 million in the first quarter of 2008, an increase of $47 million compared with the first quarter of 2007. Higher equity earnings from our BlackRock investment and the full quarter impact in 2008 of Mercantile, which we acquired in March 2007, drove the increase compared with the first quarter of 2007. Assets managed at March 31, 2008 totaled $65 billion compared with $76 billion at March 31, 2007. The decline in assets under management was primarily due to the effects of the Hilliard Lyons sale and comparatively lower equity markets in the first quarter of 2008.

Consumer services fees grew $13 million, to $170 million, for the first quarter of 2008 compared with the first quarter of

2007. This increase reflected the impact of Mercantile and higher debit card revenues resulting from higher transaction volumes.

Corporate services revenue totaled $164 million in the first three months of 2008 compared with $159 million in the first three months of 2007. Higher revenue from treasury management and third party consumer loan servicing activities, along with the full quarter impact of Mercantile, were the primary factors in the increase.

Service charges on deposits grew $5 million, to $82 million, in the first three months of 2008 compared with the first three months of 2007. The increase reflected the full quarter impact in 2008 of Mercantile.

Net securities gains totaled $41 million for the first quarter of 2008 compared with net securities losses of $3 million in the first quarter of 2007.

Other noninterest income totaled $70 million for the first three months of 2008 compared with $233 million for the first three months of 2007.

Other noninterest income for 2008 included the $114 million gain from the sale of Hilliard Lyons, the $95 million gain from the redemption of a portion of our investment in Visa related to their March 2008 initial public offering, and gains of $40 million related to our equity investment in BlackRock as described above. The impact of these items was more than offset by valuation losses related to our commercial mortgage loans and commitments held for sale, net of hedges, of $177 million, and trading losses of $76 million.

The net gain related to our equity investment in BlackRock of $52 million and trading income of $52 million were included in other noninterest income for the first quarter of 2007.

Additional information regarding our transactions related to Visa is included in Note 15 Commitments And Guarantees in the Notes To Consolidated Financial Statements included in this Report. Further details regarding our trading activities are included in the Market Risk Management – Trading Risk portion of the Risk Management section of this Financial Review.

Other noninterest income typically fluctuates from period to period depending on the nature and magnitude of transactions completed.

We expect that total revenue will increase by a low teens percentage for full year 2008 compared with full year 2007, assuming our current expectations for interest rates and economic conditions. We also expect PNC to create positive operating leverage for full year 2008 with a percentage growth in total revenue relative to 2007 that will exceed the percentage growth in noninterest expense from 2007.


 

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PRODUCT REVENUE

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

Revenue from capital markets-related products and services totaled $76 million in the first quarter of 2008 compared with $67 million in the first quarter of 2007. This increase was primarily driven by strong customer derivative activity partially offset by a decline in merger and acquisition advisory fees.

Treasury management revenue, which includes fees as well as net interest income from customer deposit balances, increased 21% to $133 million in the first quarter of 2008 compared with $110 million for the first quarter of 2007. The higher revenue reflected the impact of Mercantile and strong growth in the commercial payment card services business and in investment products.

Commercial mortgage banking activities include revenue derived from loan originations, commercial mortgage servicing, direct loan sales, and mark-to-market valuation adjustments and related hedging activities for held for sale commercial mortgage loans intended for securitization. Commercial mortgage banking activities resulted in a net loss of $96 million in the first quarter of 2008, including valuation losses of $177 million on commercial mortgage loans and commitments held for sale, net of hedges, due to the impact of an illiquid market. Excluding these losses, commercial mortgage banking activities revenue was $81 million in the first quarter of 2008 compared with $73 million in the first quarter of 2007. This increase was largely due to higher net interest income from a larger portfolio of commercial mortgage loans held for sale.

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, and disability. Revenue from these products totaled $18 million for the first three months of both 2008 and 2007.

PNC, through its subsidiary company Alpine Indemnity Limited, 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 maintains insurance reserves for reported claims and for claims incurred but not reported based on actuarial assessments. We believe these reserves were adequate at March 31, 2008.

 

NONINTEREST EXPENSE

Total noninterest expense was $1.042 billion for the first quarter of 2008 and $944 million for the first quarter of 2007. Noninterest expense for 2008 included the reversal of $43 million of the Visa indemnification liability that we established in the fourth quarter of 2007.

Apart from the impact of this item, noninterest expense increased $141 million, or 15%, in the first three months of 2008 compared with the first three months of 2007. The higher noninterest expense in 2008 resulted from Mercantile and Yardville operating and Yardville integration costs, and investments in growth initiatives while maintaining disciplined expense management. Additional information regarding our transactions related to Visa is included in Note 15 Commitments and Guarantees in the Notes To Consolidated Financial Statements included in this Report.

We expect noninterest expense to grow at a mid-single digit percentage for full year 2008 compared with 2007.

PERIOD-END EMPLOYEES

 

     March 31 2008    December 31 2007    March 31 2007

Full-time

   24,492    25,480    24,828

Part-time

   2,843    2,840    2,867
    

Total

   27,335    28,320    27,695

Statistics at March 31, 2008 exclude 994 Hilliard Lyons employees as we sold Hilliard Lyons on that date.

EFFECTIVE TAX RATE

Our effective tax rate was 40.0% for the first quarter of 2008 and 30.7% for the first quarter of 2007. The higher effective tax rate for the first quarter of 2008 was due to taxes associated with the gain on the sale of Hilliard Lyons. We expect our effective tax rate to be approximately 31% for the remainder of 2008.


 

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CONSOLIDATED BALANCE SHEET REVIEW

SUMMARIZED BALANCE SHEET DATA

 

In millions    March 31
2008
   December 31
2007

Assets

       

Loans, net of unearned income

   $ 70,802    $ 68,319

Securities available for sale

     28,581      30,225

Cash and short-term investments

     10,078      10,425

Loans held for sale

     2,516      3,927

Equity investments

     6,187      6,045

Goodwill and other intangible assets

     9,349      9,551

Other

     12,478      10,428
 

Total assets

   $ 139,991    $ 138,920

Liabilities

       

Funding sources

   $ 113,189    $ 113,627

Other

     10,371      8,785
 

Total liabilities

     123,560      122,412

Minority and noncontrolling interests in consolidated entities

     2,008      1,654

Total shareholders’ equity

     14,423      14,854
 

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

   $ 139,991    $ 138,920

The summarized balance sheet data above is based upon our Consolidated Balance Sheet that is presented in Part I, Item 1 of this Report.

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

An analysis of changes in certain balance sheet categories follows.

LOANS, NET OF UNEARNED INCOME

Loans increased $2.5 billion, to $70.8 billion, at March 31, 2008 compared with the balance at December 31, 2007. In February 2008, we transferred the education loans in our held for sale portfolio to the loan portfolio as further described in the Loans Held For Sale section of this Consolidated Balance Sheet Review.

 

Details Of Loans

 

In millions    March 31
2008
    December 31
2007
 

Commercial

      

Retail/wholesale

   $ 6,298     $ 5,973  

Manufacturing

     5,170       4,705  

Other service providers

     3,563       3,529  

Real estate related (a)

     5,701       5,425  

Financial services

     1,390       1,268  

Health care

     1,605       1,446  

Other

     5,912       6,261  

Total commercial

     29,639       28,607  

Commercial real estate

      

Real estate projects

     6,448       6,114  

Mortgage

     2,603       2,792  

Total commercial real estate

     9,051       8,906  

Lease financing

     3,464       3,500  

Total commercial lending

     42,154       41,013  

Consumer

      

Home equity

     14,315       14,447  

Education

     2,024       132  

Automobile

     1,533       1,513  

Other

     2,156       2,234  

Total consumer

     20,028       18,326  

Residential mortgage

     9,299       9,557  

Other

     272       413  

Unearned income

     (951 )     (990 )

Total, net of unearned income

   $ 70,802     $ 68,319  
(a) Includes loans related to customers in the real estate and construction industries.

Total loans represented 51% of total assets at March 31, 2008 and 49% of total assets at December 31, 2007.

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.

Approximately $2.1 billion of the $6.5 billion of real estate projects loans at March 31, 2008 were in residential real estate development. These represented approximately 3% of total loans and 2% of total assets at March 31, 2008.

Our home equity loan outstandings totaled $14.3 billion at March 31, 2008. In this portfolio, we consider the higher risk loans to be those with a recent FICO credit score of less than or equal to 660 and a loan-to-value ratio greater than or equal to 90%. We had $569 million or approximately 4% of the total portfolio in this grouping at March 31, 2008. Consistent with the entire home equity portfolio, approximately 93% of these higher-risk loans are located in our geographic footprint. In our $9.3 billion residential mortgage portfolio, loans with a recent FICO credit score of less than or equal to 660 and a loan-to-value ratio greater than or equal to 90% totaled $105 million and comprised approximately 1% of the total at March 31, 2008.


 

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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 $777 million, or 90%, of the total allowance for loan and lease losses at March 31, 2008 to these loans. We allocated $77 million, or 9%, of the remaining allowance at that date to consumer loans and $11 million, or 1%, to all other 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.

Net Unfunded Credit Commitments

 

In millions    March 31
2008
   December 31
2007

Commercial

   $ 38,402    $ 39,171

Consumer

     11,075      10,875

Commercial real estate

     2,652      2,734

Other

     297      567

Total

   $ 52,426    $ 53,347

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 $7.9 billion at March 31, 2008 and $8.9 billion at December 31, 2007.

Unfunded liquidity facility commitments and standby bond purchase agreements totaled $9.4 billion at both March 31, 2008 and December 31, 2007 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 $5.2 billion at March 31, 2008 and $4.8 billion at December 31, 2007. Standby letters of credit commit us to make payments on behalf of our customers if specified future events occur.

 

SECURITIES AVAILABLE FOR SALE

 

In millions    Amortized
Cost
   Fair Value

March 31, 2008

       

Debt securities

       

Residential mortgage-backed

   $ 20,510    $ 19,333

Commercial mortgage-backed

     5,837      5,762

Asset-backed

     2,858      2,538

US Treasury and government agencies

     40      41

State and municipal

     581      561

Other debt

     108      108

Corporate stocks and other

     240      238

Total securities available for sale

   $ 30,174    $ 28,581

December 31, 2007

       

Debt securities

       

Residential mortgage-backed

   $ 21,147    $ 20,952

Commercial mortgage-backed

     5,227      5,264

Asset-backed

     2,878      2,770

US Treasury and government agencies

     151      155

State and municipal

     340      336

Other debt

     85      84

Corporate stocks and other

     662      664

Total securities available for sale

   $ 30,490    $ 30,225

Securities available for sale represented 20% of total assets at March 31, 2008 and 22% of total assets at December 31, 2007.

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 March 31, 2008, securities available for sale included a net pretax unrealized loss of $1.6 billion, which represented the difference between fair value and amortized cost. The comparable amount at December 31, 2007 was a net unrealized loss of $265 million. We believe that the majority of the decline in value of these securities is attributable to changes in market spreads and not from deterioration in the credit quality of individual securities or underlying collateral where applicable. See Note 4 Securities in the Notes To Consolidated Financial Statements included in this Report for further information.


 

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Net unrealized gains and losses in the securities available for sale portfolio are included in shareholders’ equity as accumulated other comprehensive income or loss, net of tax. The fair value of debt securities available for sale generally increases when market interest rates decrease and vice versa. Market values are also impacted by volatility and illiquidity.

The expected weighted-average life of securities available for sale (excluding corporate stocks and other) was 3 years and 6 months at both March 31, 2008 and December 31, 2007.

We estimate that at March 31, 2008 the effective duration of securities available for sale was 3.5 years for an immediate 50 basis points parallel increase in interest rates and 3.3 years for an immediate 50 basis points parallel decrease in interest rates. Comparable amounts at December 31, 2007 were 2.8 years and 2.5 years, respectively.

LOANS HELD FOR SALE

 

In millions    March 31
2008
   December 31
2007

Commercial mortgage

   $ 2,268    $ 2,116

Residential mortgage

     112      117

Education

        1,525

Other

     136      169

Total

   $ 2,516    $ 3,927

Commercial mortgage loans held for sale included loans intended for securitization of $2.1 billion at March 31, 2008 and $2.0 billion at December 31, 2007 that were recorded at fair value. During the first quarter of 2008, we recorded a negative valuation adjustment for loans and commitments of $177 million, net of hedges. This loss was reflected in the other noninterest income line item in our Consolidated Income Statement and in the results of the Corporate & Institutional Banking business segment. We value our commercial mortgage loans held for sale based on securitization prices. In early 2008, spreads widened and there was limited activity in the commercial real estate loan securitization market. Therefore, if these conditions continue, additional valuation losses may be incurred. If spreads narrow, we may realize valuation gains. However, we do not expect the impact to be significant to our capital position. Currently, these valuation losses are unrealized. We are not currently originating commercial mortgages for distribution through commercial real estate loan securitizations. We intend to pursue opportunities to reduce our loans held for sale position when we can receive prices we feel are appropriate.

Historically, we classified substantially all of our education loans as loans held for sale. In the past, we have sold education loans to issuers of asset-backed paper when the loans are placed into repayment status. Recently, the secondary markets for education loans have been impacted by liquidity issues similar to those for other asset classes. In February 2008, given this outlook and the economic and

customer relationship value inherent in this product, we transferred these loans at lower of cost or market value from held for sale to the loan portfolio. We do not anticipate sales of education loans in the foreseeable future.

FUNDING AND CAPITAL SOURCES

Details Of Funding Sources

 

In millions    March 31
2008
   December 31
2007

Deposits

       

Money market

   $ 35,792    $ 32,785

Demand

     19,168      20,861

Retail certificates of deposit

     16,050      16,939

Savings

     2,608      2,648

Other time

     4,716      2,088

Time deposits in foreign offices

     2,076      7,375

Total deposits

     80,410      82,696

Borrowed funds

       

Federal funds purchased

     5,154      7,037

Repurchase agreements

     2,510      2,737

Federal Home Loan Bank borrowings

     9,663      7,065

Bank notes and senior debt

     6,842      6,821

Subordinated debt

     5,402      4,506

Other

     3,208      2,765

Total borrowed funds

     32,779      30,931

Total

   $ 113,189    $ 113,627

Total funding sources were relatively unchanged at March 31, 2008 compared with the balance at December 31, 2007. Total deposits declined $2.3 billion, or 3%, as increases in money market and other time deposits were more than offset with declines in other categories, primarily time deposits in foreign offices. Total borrowed funds increased $1.8 billion, or 6%, primarily due to the increase of $2.6 billion in Federal Home Loan Bank borrowings at March 31, 2008 compared with December 31, 2007. The increase in this category reduced our overnight borrowings. The Liquidity Risk Management portion of the Risk Management section of this Financial Review includes additional information regarding our first quarter 2008 borrowed funds activities.

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 decreased $.4 billion, to $14.4 billion, at March 31, 2008 compared with December 31, 2007. This decline was primarily due to a $.6 billion decrease in accumulated other comprehensive income (loss) which more than offset the net impact of earnings and dividends in the first


 

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quarter of 2008. The decrease in accumulated other comprehensive income (loss) was primarily due to higher net unrealized securities losses.

Common shares outstanding totaled 341 million at both March 31, 2008 and December 31, 2007. PNC issued 4.6 million common shares in April 2008 in connection with the closing of the Sterling acquisition.

Our current common stock repurchase program permits us to purchase up to 25 million shares of PNC common stock on the open market or in privately negotiated transactions. This program will remain in effect until fully utilized or until modified, superseded or terminated. The extent and timing of share repurchases under this program will depend on a number of factors including, among others, market and general economic conditions, economic and regulatory capital considerations, alternative uses of capital, regulatory limitations resulting from merger activity, and the potential impact on our credit ratings.

We did not purchase any shares during the first quarter of 2008 under this program. We do not expect to actively engage in share repurchase activity for the foreseeable future as we look to enhance our capital position.

 

Risk-Based Capital

 

Dollars in millions    March 31
2008
    December 31
2007
 

Capital components

      

Shareholders’ equity

      

Common

   $ 14,416     $ 14,847  

Preferred

     7       7  

Trust preferred capital securities

     1,021       572  

Minority interest

     1,352       985  

Goodwill and other intangible assets

     (8,668 )     (8,853 )

Eligible deferred income taxes on intangible assets

     113       119  

Pension, other postretirement benefit plan adjustments

     149       177  

Net unrealized securities losses, after-tax

     1,005       167  

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

     (356 )     (175 )

Equity investments in
nonfinancial companies

     (32 )     (31 )

Tier 1 risk-based capital

     9,007       7,815  

Subordinated debt

     3,298       3,024  

Eligible allowance for credit losses

     1,017       964  

Total risk-based capital

   $ 13,322     $ 11,803  

Assets

      

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

   $ 117,041     $ 115,132  

Adjusted average total assets

     132,219       126,139  

Capital ratios

      

Tier 1 risk-based

     7.7 %     6.8 %

Total risk-based

     11.4       10.3  

Leverage

     6.8       6.2  

Tangible common equity

      

Common shareholders’ equity

   $ 14,416     $ 14,847  

Goodwill and other intangibles

     (8,668 )     (8,853 )

Total deferred income taxes on goodwill and other intangible assets (a)

     393       119  

Tangible common equity

   $ 6,141     $ 6,113  

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

   $ 131,716     $ 130,185  

Tangible common equity ratio

     4.7 %     4.7 %
(a) As of March 31, 2008, deferred taxes on taxable combinations were added to eligible deferred income taxes for non-taxable combinations that are used in the calculation of Regulatory Capital Ratios.

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 March 31, 2008, each of our domestic banking subsidiaries was considered “well-capitalized” based on US 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 2008.


 

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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 March 31, 2008 and December 31, 2007. Additional information on our partnership interests in low income housing projects is included in our 2007 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

 

March 31, 2008

          

Market Street

   $ 5,186    $ 5,252    $ 8,992 (a)

Collateralized debt obligations

     55      1      5  

Partnership interests in low income housing projects

     50      34      8  

Total

   $ 5,291    $ 5,287    $ 9,005  

December 31, 2007

          

Market Street

   $ 5,304    $ 5,330    $ 9,019 (a)

Collateralized debt obligations

     255      177      6  

Partnership interests in low income housing projects

     50      34      8  

Total

   $ 5,609    $ 5,541    $ 9,033  
(a) PNC’s risk of loss consists of off-balance sheet liquidity commitments to Market Street of $8.8 billion and other credit enhancements of $.2 billion at both March 31, 2008 and December 31, 2007. 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 primarily involve purchasing assets or making loans secured by interests in pools of receivables from US corporations that desire access to the commercial paper market. Market Street funds

the purchases of assets 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 enhancements, liquidity facilities and program-level credit enhancement. Generally, Market Street mitigates its potential interest rate risk by entering into agreements with its borrowers that reflect interest rates based upon its weighted average commercial paper cost of funds. During 2007 and the first three months of 2008, Market Street met all of its funding needs through the issuance of commercial paper.

Market Street commercial paper outstanding was $5.1 billion at both March 31, 2008 and December 31, 2007. The weighted average maturity of the commercial paper was 31 days at March 31, 2008 compared with 32 days at December 31, 2007.

In the ordinary course of business during the first quarter of 2008, PNC Capital Markets, acting as a placement agent for Market Street, held a maximum daily position in Market Street commercial paper of $75 million with an average of $35 million and a quarter-end position of $35 million. This compares with a maximum daily position of $113 million with an average of $27 million during the year ended December 31, 2007. PNC Capital Markets owned less than $1 million of any Market Street commercial paper at December 31, 2007. PNC made no other purchases of Market Street commercial paper during 2007 or the first three months of 2008.

PNC Bank, National Association (“PNC Bank, N.A.”) provides certain administrative services, a portion of the program-level credit enhancement and 99% of liquidity facilities to Market Street in exchange for fees negotiated based on market rates. PNC recognized program administrator fees and commitments fees related to PNC’s portion of the liquidity facilities of $4 million and $1 million, respectively, for the three months ended March 31, 2008.

PNC views its credit exposure for the Market Street transactions as limited. Neither creditors nor investors in Market Street have any recourse to our general credit. The commercial paper obligations at March 31, 2008 and December 31, 2007 were effectively collateralized by Market Street’s assets. While PNC may be obligated to fund under liquidity facilities for events such as commercial paper market disruptions, borrower bankruptcies, collateral deficiencies or covenant violations, our 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 expected losses for the pool of assets and is sized to generally meet rating agency standards for comparably structured transactions. Of the $8.8 billion of liquidity facilities provided by PNC at March 31, 2008, only $2.8 billion required PNC to fund if the assets are in default.


 

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Program-level credit enhancement in the amount of 10% of commitments, excluding explicitly rated AAA/Aaa facilities, is provided by PNC and Ambac, a monoline insurer. PNC provides 25% of the enhancement in the form of a cash collateral account funded by a loan facility. This facility expires in March 2013. See Note 15 Commitments And Guarantees included in the Notes To Consolidated Financial Statements of this Report for additional information. The monoline insurer provides the remaining 75% of the enhancement in the form of a surety bond. The cash collateral account is subordinate to the surety bond.

Market Street is a limited liability company that has 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 $8.7 million as of March 31, 2008. 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.

Assets of Market Street Funding LLC

 

In millions    Outstanding    Commitments    Weighted
Average
Remaining
Maturity
In Years

March 31, 2008 (a)

          

Trade receivables

   $ 1,195    $ 2,838    2.61

Automobile financing

     1,207      1,382    4.04

Collateralized loan obligations

     776      1,257    2.30

Credit cards

     767      775    .03

Residential mortgage

     16      715    1.26

Other

     1,084      1,455    1.61

Cash and miscellaneous receivables

     141            

Total

   $ 5,186    $ 8,422    2.27

December 31, 2007 (a)

          

Trade receivables

   $ 1,375    $ 2,865    2.63

Automobile financing

     1,387      1,565    4.06

Collateralized loan obligations

     519      1,257    2.54

Credit cards

     769      775    .26

Residential mortgage

     37      720    .90

Other

     1,031      1,224    1.89

Cash and miscellaneous receivables

     186            

Total

   $ 5,304    $ 8,406    2.41
(a) Market Street did not recognize an asset impairment charge or experience a rating downgrade on its assets during 2007 and the first three months of 2008.

 

Market Street Commitments by Credit Rating (a)

 

      March 31,
2008
    December 31,
2007
 

AAA/Aaa

   20 %   19 %

AA/Aa

   4     6  

A/A

   73     72  

BBB/Baa

   3     3  

Total

   100 %   100 %
(a) Not all facilities are explicitly rated by the rating agencies. Facilities are structured to meet rating agency standards for comparably structured transactions.

We evaluated the design of Market Street, its capital structure, the Note, 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 are not the primary beneficiary as defined by FIN 46R and therefore Market Street is not reflected in our Consolidated Balance Sheet.

PNC would consider changes to the variable interest holders (such as new expected loss note investors and changes to program-level credit enhancement providers), terms of expected loss notes, and new types of risks (such as foreign currency or interest rate) in Market Street as reconsideration events. PNC reviews the activities of Market Street on at least a quarterly basis to determine if a reconsideration event has occurred. As indicated earlier, 75% of the program-level credit enhancement is provided by Ambac in the form of a surety bond. PNC Bank, N.A., in the role of program administrator, is closely following market developments relative to the rating agency outlooks of monoline insurers. Ambac is rated AAA by two of the three major rating agencies and was lowered to AA by the other agency in January 2008. This rating change has not impacted the Market Street commercial paper ratings of A1/P1. Various alternatives to the program-level enhancement are under consideration if future rating changes impact either the ratings of Market Street commercial paper or its financial results.

Based on current accounting guidance and market conditions, we are not required to consolidate Market Street into our consolidated financial statements. However, if PNC would be determined to be the primary beneficiary under FIN 46R, we would consolidate the conduit at that time. To the extent that the par value of the assets in Market Street exceeded the fair value of the assets upon consolidation, the difference would be recognized by PNC as a loss in our Consolidated Income Statement in that period. Based on the fair value of the assets held by Market Street at March 31, 2008, this reduction in earnings would not have had a material impact on our risk-based capital ratios, credit ratings or debt covenants.


 

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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

       

March 31, 2008

   $ 1,085    $ 1,085

December 31, 2007

   $ 1,110    $ 1,110

Perpetual Trust Securities

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

In February 2008, PNC Preferred Funding LLC (the “LLC”), one of our indirect subsidiaries, sold $375 million of 8.700% Fixed-to-Floating Rate Non-Cumulative Exchangeable Perpetual Trust Securities of PNC Preferred Funding Trust III (“Trust III”) to third parties in a private placement. In connection with the private placement, Trust III acquired $375 million of Fixed-to-Floating Rate Non-Cumulative Perpetual Preferred Securities of the LLC (the “LLC Preferred Securities”). The sale was similar to the March 2007 private placement by the LLC of $500 million of 6.113% Fixed-to-Floating Rate Non-Cumulative Exchangeable Trust Securities (the “Trust II Securities”) of PNC Preferred Funding Trust II (“Trust II”) in which Trust II acquired $500 million of LLC Preferred Securities and to the December 2006 private placement by PNC REIT Corp. of $500 million of 6.517% Fixed-to-Floating Rate Non-Cumulative Exchangeable Perpetual Trust Securities (the “Trust I Securities”) of PNC Preferred Funding Trust I (“Trust I”) in which Trust I acquired $500 million of LLC Preferred Securities.

Each Trust III Security is automatically exchangeable into a share of Series J Non-Cumulative Perpetual Preferred Stock of PNC, each Trust II Security is automatically exchangeable into a share of Series I Non-Cumulative Perpetual Preferred Stock of PNC, and each Trust I Security is automatically exchangeable into a share of Series F Non-Cumulative Perpetual Preferred Stock of PNC Bank, N.A., in each case 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.

PNC has contractually committed to each of Trust II and Trust III that if full dividends are not paid in a dividend period on the Trust II Securities or the Trust III Securities, as applicable, or the LLC Preferred Securities held by Trust II or Trust III, as applicable, 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.

PNC Bank, N.A. has contractually committed to Trust I that if full dividends are not paid in a dividend period on the Trust Securities, LLC Preferred Securities or any other parity equity securities issued by the LLC, neither PNC Bank, N.A. nor its subsidiaries will declare or pay dividends or other distributions with respect to, or redeem, purchase or acquire or make a liquidation payment with respect to, any of its equity capital securities during the next succeeding period (other than to holders of the LLC Preferred Securities and any parity equity securities issued by the LLC) except: (i) in the case of dividends payable to subsidiaries of PNC Bank, N.A., to PNC Bank, N.A. or another wholly-owned subsidiary of PNC Bank, N.A. or (ii) in the case of dividends payable to persons that are not subsidiaries of PNC Bank, N.A., to such persons only if, (A) in the case of a cash dividend, PNC has first irrevocably committed to contribute amounts at least equal to such cash dividend or (B) in the case of in-kind dividends payable by PNC REIT Corp., PNC has committed to purchase such in-kind dividend from the applicable PNC REIT Corp. holders in exchange for a cash payment representing the market value of such in-kind dividend, and PNC has committed to contribute such in-kind dividend to PNC Bank, N.A.

PNC Capital Trust E Trust Preferred Securities

In February 2008, PNC Capital Trust E issued $450 million of 7.75% Trust Preferred Securities due March 15, 2068 (the “Trust E Securities”). PNC Capital Trust E’s only assets are $450 million of 7.75% Junior Subordinated Notes due March 15, 2068 and issued by PNC (the “JSNs”). The Trust E Securities are fully and unconditionally guaranteed by PNC.

We may, at our option, redeem the JSNs at 100% of their principal amount on or after March 15, 2013. We have agreed to redeem the JSNs on March 15, 2038, but only out of net proceeds from the sale of certain replacement capital securities described in the JSN indenture. The Trust E Securities will be redeemed at the time of the JSN redemption. If we defer interest on the JSNs and either pay current interest


 

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or the fifth anniversary of the deferral passes, we are obligated to issue certain qualifying securities defined in the JSN indenture to raise proceeds to fund the payment of accrued and unpaid interest.

In connection with the closing of the Trust E Securities sale, we agreed that, if we have given notice of our election to defer interest payments on the JSNs or a related deferral period is continuing, then PNC would be subject during such period to restrictions on dividends and other provisions protecting the status of the JSN debenture holder similar to or in some ways more restrictive than those potentially imposed under the Exchange Agreements with Trust II and Trust III, as described above.

Acquired Entity Trust Preferred Securities

As a result of the Mercantile, Yardville and Sterling acquisitions, we assumed obligations with respect to $158 million in principal amount of junior subordinated debentures issued by the acquired entities, $85 million of which related to the April 2008 Sterling acquisition. 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 Agreements with Trust II and Trust III, as described above.

FAIR VALUE MEASUREMENTS AND FAIR VALUE OPTION

We adopted SFAS 157, “Fair Value Measurements” (“SFAS 157”), and SFAS 159, “The Fair Value Option for Financial Assets and Financial Liabilities – Including an amendment of FASB Statement No. 115” (“SFAS 159”), on January 1, 2008. SFAS 157 defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. SFAS 159 permits entities to choose to measure many financial instruments and certain other items at fair value. Under SFAS 159, we elected to fair value certain commercial mortgage loans classified as held for sale and certain customer resale agreements and bank notes to align the accounting for the changes in the fair value of these financial instruments with the changes in the value of their related hedges. See Note 6 Fair Value in the Notes To Consolidated Financial Statements included in this Report for further information.

At March 31, 2008, approximately 28% of our total assets were measured at fair value, consisting primarily of securities and other financial assets. Approximately 4% of our total liabilities were measured at fair value at that date.

Assets and liabilities measured at fair value on a recurring basis, including instruments for which PNC has elected the fair value option, are summarized below:


 

Fair Value Measurements - Summary

 

     March 31, 2008
In millions    Level 1    Level 2    Level 3    Total Fair
Value

Assets

             

Securities available for sale

   $ 3,405    $ 24,943    $ 233    $ 28,581

Financial derivatives (a)

     63      3,983      90      4,136

Trading securities (b)

     796      2,297         3,093

Commercial mortgage loans held for sale (c)

           2,068      2,068

Customer resale agreements (d)

        1,032         1,032

Equity investments

           545      545

Other assets

            229      4      233

Total assets

   $ 4,264    $ 32,484    $ 2,940    $ 39,688

Liabilities

             

Financial derivatives (e)

   $ 72    $ 2,986    $ 239    $ 3,297

Trading securities sold short (f)

     938      29         967

Other liabilities

            226             226

Total liabilities

   $ 1,010    $ 3,241    $ 239    $ 4,490

 

(a) Included in Other assets on the Consolidated Balance Sheet.
(b) Included in Trading securities and other short-term investments on the Consolidated Balance Sheet.
(c) Included in Loans held for sale on the Consolidated Balance Sheet. PNC has elected the fair value option under SFAS 159 for certain commercial mortgage loans held for sale intended for CMBS securitization.
(d) Included in Federal funds sold and resale agreements on the Consolidated Balance Sheet. PNC has elected the fair value option under SFAS 159 for this item.
(e) Included in Other liabilities on the Consolidated Balance Sheet.
(f) Included in Other borrowed funds on the Consolidated Balance Sheet.

 

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Valuation Hierarchy

The following is an outline of the valuation methodologies used for measuring fair value under SFAS 157 for the major items above. The fair value hierarchy (i.e., Level 1, Level 2, and Level 3) is described in detail in Note 6 Fair Value in the Notes To Consolidated Financial Statements included in this Report. Any models used to determine fair values based on the descriptions below are subject to review and independent testing as part of PNC’s model validation and internal control testing processes. Significant models are tested by our Model Validation Committee on at least an annual basis. In addition, we have teams independent of the traders verify marks and assumptions used for valuations at each period end.

Securities

Securities include both the available for sale and trading portfolios. We use market prices, sourced from pricing services, dealer quotes or recent trades to determine the fair value of securities. Almost all of our securities are classified as Level 1 or Level 2 in the fair value hierarchy. In circumstances where market prices are limited or unavailable, valuations may require significant management judgments or adjustments to determine fair value. In these cases, the securities are classified as Level 3.

Residential Mortgage-Backed Securities

At March 31, 2008, our residential mortgage-backed securities portfolio was comprised of $8.3 billion fair value of US government agency securities (substantially all classified as available for sale) and $11.4 billion fair value of private-issuer securities ($11.0 billion fair value classified as available for sale). The agency securities are generally collateralized by 1-4 family, conforming, fixed-rate residential mortgages. The private-issuer securities are also generally collateralized by 1-4 family residential mortgages. The mortgage loans underlying the private-issuer securities are generally non-conforming (i.e., original balances in excess of the amount qualifying for agency securities) and predominately have interest rates that are fixed for a period of time, after which the rate adjusts to a floating rate based upon a contractual spread that is indexed to a market rate (i.e., a “hybrid ARM”). Of the total private-issuer securities, we consider that, based on the underlying credit score of the borrower, less than 1% were sub-prime credit quality. Substantially all of the securities are senior tranches in the subordination structure and have credit protection in the form of credit enhancement, over-collateralization and / or excess spread accounts. Of the total private-issuer securities, approximately 56% are vintage 2005 and earlier, approximately 25% are vintage 2006 and approximately 19% are vintage 2007 and 2008. At March 31, 2008, $11.3 billion of the private-issuer securities were rated “AAA” equivalents by at least two nationally recognized rating agencies. There were eleven private-issuer securities totaling $88 million fair value where at least one national rating agency rated the security “AA” equivalent. Since March 31, 2008, no significant deterioration in the credit ratings assigned to the private-issuer securities has occurred.

 

Commercial Mortgage-Backed Securities

The commercial mortgage-backed securities portfolio was $6.6 billion fair value at March 31, 2008 ($5.8 billion fair value classified as available for sale), and consisted of fixed-rate, private-issuer securities collateralized by non-residential properties, primarily retail properties, office buildings, and multi-family housing. Substantially all of the securities are the most senior tranches in the subordination structure. Of the total commercial mortgage-backed securities, approximately 47% are vintage 2005 and earlier, approximately 35% are vintage 2006 and approximately 18% are vintage 2007. At March 31, 2008, $6.5 billion of the commercial mortgage-backed securities were rated “AAA” equivalents by at least two nationally recognized rating agencies. There were four commercial mortgage-backed securities totaling $53 million fair value where at least one national rating agency rated the security “AA” equivalent. Since March 31, 2008, no significant deterioration in the credit ratings assigned to the commercial mortgage-backed securities has occurred.

Other Asset-Backed Securities

The asset-backed securities portfolio was $2.6 billion fair value at March 31, 2008 ($2.5 billion fair value classified as available for sale), and consisted of fixed-rate and floating-rate, private-issuer securities collateralized primarily by various consumer credit products, including home equity loans, credit cards, and automobile loans. Substantially all of the securities are senior tranches in the subordination structure and have credit protection in the form of credit enhancement, over-collateralization and / or excess spread accounts. Of the $1.4 billion fair value of asset-backed securities collateralized by fixed- and floating-rate home equity loans (all classified as available for sale), we consider that, based on the underlying credit score of the borrower, approximately 23% were sub-prime credit quality. Of the total asset-backed securities collateralized by fixed- and floating-rate home equity loans, approximately 37% are vintage 2005 and earlier, approximately 29% are vintage 2006 and approximately 34% are vintage 2007. At March 31, 2008, $2.4 billion of the other asset-backed securities were rated “AAA” equivalents by at least two nationally recognized rating agencies. There were two asset-backed securities totaling $23 million fair value where at least one national rating agency rated the security “AA” equivalent, six asset-backed securities totaling $118 million fair value where the rating was between “AA” equivalent and “BBB” equivalent, and two asset-backed securities totaling $8 million fair value where the rating was lower than “BBB” equivalent. For both of the securities rated lower than “BBB” equivalent, we had taken an other-than temporary impairment charge in the fourth quarter of 2007 totaling approximately $6 million. There were also three asset-backed securities (all classified as trading) totaling $18 million fair value that were not rated. Since March 31, 2008, no significant deterioration in the credit ratings assigned to the other asset-backed securities has occurred.


 

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Financial Derivatives

Exchange-traded derivatives are valued using quoted market prices and are classified as Level 1. However, the majority of derivatives that we enter into are executed over-the-counter and are valued using internal techniques. Readily observable market inputs to these models can be validated to external sources, including industry pricing services, or corroborated through recent trades, dealer quotes, yield curves, implied volatility or other market related data. Certain derivatives, such as total rate of return swaps, are corroborated to the CMBX index. These derivatives are classified as Level 2. Derivatives priced using significant management judgment or assumptions are classified as Level 3. The fair values of our derivatives are adjusted for nonperformance risk as appropriate.

Commercial Mortgage Loans and Commitments Held for Sale

This portfolio of loans is held for securitization. As such, a synthetic securitization methodology is used to value the loans and the related unfunded commitments on an aggregate basis based upon current commercial mortgage-backed securities (CMBS) market structures and conditions. Observable inputs include the pricing of CMBS with similar collateral and using tranche interest rates from end of period yield curves. Management assumptions include subordination levels, CMBS bond spreads, and the value of the mortgage servicing rights. Adjustments are made to the valuations to account for securitization uncertainties, including the composition of the portfolio, market conditions, and liquidity. Based on the significance of unobservable inputs, we classify this portfolio as Level 3.

Equity Investments

The valuation of direct and partnership private equity investments requires significant management judgment due to the absence of quoted market prices, inherent lack of liquidity and the long-term nature of such investments. The carrying values of direct investments and affiliated partnership interests reflect the expected exit price and are based on various techniques including multiples of adjusted earnings of the entity, independent appraisals, anticipated financing and sale transactions with third parties or the pricing used to value the entity in a recent financing transaction. The limited partnership investments are generally valued based on the financial statements received from the general partner with the underlying investments being valued utilizing techniques similar to those noted above. These investments are classified as Level 3.

 

Level 3 Assets and Liabilities

Under SFAS 157, financial instruments are considered Level 3 when their values are determined using pricing models, discounted cash flow methodologies or similar techniques and at least one significant model assumption or input is unobservable.

Our Level 3 assets and liabilities represented 2% of our total assets and less than 1% of our total liabilities at March 31, 2008.

Assets and liabilities measured using Level 3 inputs represented $2.9 billion or 7% of total assets measured at fair value and $239 million or 5% of total liabilities measured at fair value at March 31, 2008.

As we adopted SFAS 157 as of January 1, 2008, there were no material increases or decreases in Level 3 items for the first quarter of 2008 resulting from transfers in or out of Level 3 during this period.

As indicated in the table on page 16, our largest category of Level 3 assets consists of certain commercial mortgage loans and commitments held for sale.

Approximately $143 million of the first quarter 2008 pretax valuation losses of $177 million on commercial mortgage loans and commitments held for sale was included in our Level 3 rollforward schedule. The remaining net losses pertained to derivative positions classified as Level 2.

We originated the loans held in the commercial real estate portfolio that are classified as held for sale and accounted for at fair value. The values of these loans are based on exit prices that were unusually low at March 31, 2008 primarily due to an illiquid securitization market for these loans. The loans that we originated are of high quality and we believe that current market prices do not reflect the appropriate level of risk inherent in our portfolio.

Total securities measured at fair value at March 31, 2008 included securities available for sale and trading securities consisting primarily of residential and commercial mortgage-backed securities and other asset-backed securities. Unrealized gains and losses on available for sale securities do not impact liquidity or risk-based capital. However, reductions in the credit ratings of these securities would have an impact on the determination of risk-weighted assets which could reduce our regulatory capital ratios.


 

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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 16 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 16 primarily due to the presentation in this Financial Review of business revenue on a taxable-equivalent basis and income statement classification differences related to PFPC.

Results of individual businesses are presented based on our management accounting practices and 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 domestic banks and to approximate market comparables for this business. The capital assigned for PFPC reflects its legal entity shareholders’ equity.

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 business segment 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 Business Segments Review and the Business Segment Highlights in the Executive Summary 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, integration costs, asset and liability management activities including net securities gains or losses and certain trading activities, 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 reflect staff directly employed by the respective businesses and excludes corporate and shared services employees.


 

Results Of Businesses – Summary

(Unaudited)

 

     Earnings      Revenue (a)      Average Assets (b)
Three months ended March 31 - in millions    2008    2007    2008    2007    2008    2007

Retail Banking

   $ 221    $ 201    $ 1,121    $ 839    $ 45,856    $ 34,449

Corporate & Institutional Banking

     2      132      242      370      35,245      26,498

BlackRock (c)

     60      52      81      68      4,357      3,870

PFPC (c) (d)

     30      31      228      200      2,699      2,378

Total business segments

     313      416      1,672      1,477      88,157      67,195

Other (c) (e)

     64      43      158      143      52,398      40,227

Total consolidated

   $ 377    $ 459    $ 1,830    $ 1,620    $ 140,555    $ 107,422

 

(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

 

Three months ended March 31 – in millions

     2008      2007

Total consolidated revenue, book (GAAP) basis

   $ 1,821    $ 1,614

Taxable-equivalent adjustment

     9      6

Total consolidated revenue, taxable-equivalent basis

   $ 1,830    $ 1,620

 

(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 $2 million for the first quarter of 2007 have been reclassified from BlackRock to “Other” and first quarter 2008 after-tax integration costs related to Albridge Solutions and Coates Analytics have been reclassified from PFPC to “Other.” “Other” for the first three months of 2008 and 2007 also includes $14 million and $11 million, respectively, of pretax other integration costs.
(d) PFPC revenue represents the sum of servicing revenue and nonoperating income (expense) less debt financing costs.
(e) “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)

 

Three months ended March 31

Taxable-equivalent basis

Dollars in millions

  2008     2007  

INCOME STATEMENT

     

Net interest income

  $499     $452  

Noninterest income

     

Asset management

  116     100  

Service charges on deposits

  80     75  

Brokerage

  64     63  

Consumer services

  101     88  

Other

  261     61  

Total noninterest income

  622     387  

Total revenue

  1,121     839  

Provision for credit losses

  104     23  

Noninterest expense

  581     496  

Pretax earnings

  436     320  

Income taxes

  215     119  

Earnings

  $221     $201  

AVERAGE BALANCE SHEET

     

Loans

     

Consumer

     

Home equity

  $14,366     $13,881  

Indirect

  2,026     1,480  

Education

  844     115  

Other consumer

  1,636     1,375  

Total consumer

  18,872     16,851  

Commercial and commercial real estate

  14,393     8,201  

Floor plan

  1,020     952  

Residential mortgage

  2,440     1,781  

Other

  208     233  

Total loans

  36,933     28,018  

Goodwill and other intangible assets

  5,945     2,942  

Loans held for sale

  1,131     1,562  

Other assets

  1,847     1,927  

Total assets

  $45,856     $34,449  

Deposits

     

Noninterest-bearing demand

  $10,458     $8,871  

Interest-bearing demand

  9,237     8,354  

Money market

  17,732     15,669  

Total transaction deposits

  37,427     32,894  

Savings

  2,609     2,243  

Certificates of deposit

  16,321     15,738  

Total deposits

  56,357     50,875  

Other liabilities

  545     708  

Capital

  3,638     3,287  

Total funds

  $60,540     $54,870  

PERFORMANCE RATIOS

     

Return on average capital

  24 %   25 %

Noninterest income to total revenue

  55     46  

Efficiency

  52     59  

OTHER INFORMATION (a) (b)

     

Credit-related statistics:

     

Nonperforming assets (c)

  $259     $123  

Net charge-offs (d)

  $84     $27  

Annualized net charge-off ratio (d)

  .91 %   .39 %

Other statistics:

     

Full-time employees

  11,014     11,838  

Part-time employees

  2,322     2,224  

ATMs

  3,903     3,862  

Branches (e)

  1,096     1,077  

Gains on sales of education loans

        $3  
(a) Presented as of March 31 except for net charge-offs, net charge-off ratio, and gains on sales of education loans. Information as of March 31, 2008 excludes Hilliard Lyons, which was sold as of that date.

 

At March 31

Dollars in millions, except where noted

  2008     2007  

OTHER INFORMATION (CONTINUED)

     

ASSETS UNDER ADMINISTRATION (in billions) (f)

 

   

Assets under management

     

Personal

  $46     $54  

Institutional

  19     22  

Total

  $65     $76  

Asset Type

     

Equity

  $36     $41  

Fixed income

  17     20  

Liquidity/other

  12     15  

Total

  $65     $76  

Nondiscretionary assets under administration

 

   

Personal

  $30     $31  

Institutional

  81     80  

Total

  $111     $111  

Asset Type

     

Equity

  $46     $42  

Fixed income

  27     28  

Liquidity/other

  38     41  

Total

  $111     $111  

Home equity portfolio credit statistics (i):

     

% of first lien positions

  39 %   43 %

Weighted average loan-to-value ratios

  72 %   70 %

Weighted average FICO scores (j)

  725     726  

Annualized net charge-off ratio

  .35 %   .18 %

Loans 90 days past due

  .42 %   .25 %

Checking-related statistics (i):

     

Retail Banking checking relationships

  2,305,000     1,962,000  

Consumer DDA relationships using

online banking

  1,128,000     960,000  

% of consumer DDA relationships

using online banking

  55 %   54 %

Consumer DDA relationships using

online bill payment

  723,000     450,000  

% of consumer DDA relationships

using online bill payment

  35 %   25 %

Small business loans and managed deposits (i):

 

   

Small business loans

  $13,778     $5,284  

Managed deposits:

     

On-balance sheet

     

Noninterest-bearing demand

  $5,946     $4,284  

Interest-bearing demand

  1,911     1,517  

Money market

  3,398     2,635  

Certificates of deposit

  1,030     681  

Off-balance sheet (g)

     

Small business sweep checking

  2,976     1,827  

Total managed deposits

  $15,261     $10,944  

Brokerage statistics (i):

     

Margin loans

    $166  

Financial consultants (h)

  387     757  

Full service brokerage offices

  24     99  

Brokerage account assets (billions)

  $18     $46  
(b) Amounts include the impact of Mercantile, which we acquired effective March 2, 2007. Amounts as of and for the three months ended March 31, 2008 include the impact of Yardville.
(c) Includes nonperforming loans of $246 million at March 31, 2008 and $93 million at March 31, 2007.
(d) Increase related to the impact of more closely aligning small business and consumer loan charge-off policies.
(e) Excludes certain satellite branches that provide limited products and service hours.
(f) Excludes brokerage account assets.
(g) 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.
(h) Financial consultants provide services in full service brokerage offices and PNC traditional branches.
(i) Amounts at March 31, 2007 do not include the impact of Mercantile or Yardville.
(j) Represents the most recent FICO scores we have on file.

 

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Retail Banking’s earnings were $221 million for the first quarter of 2008 compared with $201 million for the same period in 2007. The 10% increase in earnings over the first quarter in 2007 was driven by acquisitions and gains related to our ownership in Visa and the Hilliard Lyons sale, partially offset by an increase in the provision for credit losses.

Highlights of Retail Banking’s performance during the first quarter of 2008 include the following:

 

 

The sale of Hilliard Lyons was completed on March 31, 2008. The acquisition of Sterling closed on April 4, 2008 and the Yardville National Bank systems integration and conversion to the PNC brand was completed on March 7.

 

Total reported checking relationships increased by a net 33,000 in the first quarter, reflecting the conversion of Yardville accounts and strong organic growth. Without Yardville, we increased checking relationships by approximately 12,000 in the first quarter, compared with the 8,000 we added during the same period last year without Mercantile.

 

We continued to see excellent results with our converted Mercantile branches. In the first quarter, consumer DDA new account production was up nearly 400% from the fourth quarter of 2007 and the average consumer money market account was twice the average balance of PNC’s legacy accounts.

 

Our investment in online banking capabilities continues to pay off. Since March 31, 2007, the percentage of consumer checking households using online bill payment increased from 25% to 35%. We will continue to seek growth by expanding our use of technology and expect to launch a new suite of products in the second quarter, including a small business portal and mobile banking, to better serve businesses and to attract new customer segments.

 

In the first quarter of 2008, we opened 5 new branches and consolidated 18 branches for a total of 1,096 branches at March 31, 2008. We continue to work to optimize our network by opening new branches in high growth areas, relocating branches to areas of higher market opportunity, and consolidating branches in areas of declining opportunity.

Total revenue for the first quarter of 2008 was $1.121 billion, a 34% increase compared with $839 million for the same quarter in 2007. Taxable-equivalent net interest income of $499 million increased $47 million, or 10%, compared with the first quarter of 2007. The growth was driven by acquisitions, partially offset by a lower value attributed to deposits in the declining interest rate environment.

Noninterest income increased $235 million, to $622 million, up 61% compared with the prior year first quarter. This growth can be attributed primarily to the following:

 

   

A gain of $95 million from the redemption of a portion of our Visa Class B common shares related to Visa’s March 2008 initial public offering,

   

The $114 million gain related to our sale of Hilliard Lyons,

   

Acquisitions,

   

Increased volume-related consumer fees, and

   

Customer growth.

The provision for credit losses was $104 million for the first quarter of 2008 compared with $23 million in the year ago quarter. Net charge-offs were $84 million in the first quarter of 2008 and $27 million in the first quarter of 2007. The increases in provision and net charge-offs were primarily a result of aligning small business and consumer loan charge-off policies, commercial loan credit migration of portfolios primarily in Maryland and Virginia related to residential real estate development, continued growth in our commercial loan portfolio and charge-offs returning to a more normal level given the current credit conditions. Based upon the current environment, we believe the provision and nonperforming assets will continue to increase in 2008 versus 2007 levels.

Noninterest expense for the first quarter of 2008 totaled $581 million, an increase of $85 million, or 17%, compared with 2007. Increases were primarily attributable to acquisitions, expenses directly associated with fee income-related businesses, and continued investment in the branch network.

Full-time employees at March 31, 2008 totaled 11,014, a decrease of 824 over the prior year. The decline in full-time employees was primarily the result of the Hilliard Lyons sale. Part-time employees have increased by 98 since March 31, 2007 as a result of acquisitions 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.

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. Furthermore, core checking accounts are critical to our strategy of expanding our payments business. Average total deposits increased $5.5 billion, or 11%, compared with the first quarter of 2007.

 

 

Money market deposits increased $2.1 billion, and certificates of deposits increased $.6 billion. These increases were primarily attributable to acquisitions. The deposit strategy of Retail Banking is to remain disciplined on pricing, target specific products and markets for growth, and focus on the retention and growth of balances for relationship customers.

 

Average demand deposit growth of $2.5 billion, or 14%, was almost solely due to acquisitions as organic growth was impacted by current economic conditions.

 

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.


 

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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 and commercial real estate loans grew $6.2 billion, or 76%, compared with the first quarter of 2007. The increase is attributable to acquisitions and organic loan growth on the strength of increased small business loan demand from existing customers and the acquisition of new relationships through our sales efforts. At March 31, 2008, commercial and commercial real estate loans totaled $14.4 billion. This portfolio included $3.5 billion of commercial real estate loans, the majority of which were added with the Mercantile acquisition. Approximately $.6 billion of the commercial real estate loans were in residential real estate development.

 

Average home equity loans grew $485 million, or 3%, compared with the first quarter of 2007 primarily due to acquisitions. Consumer loan demand has slowed as a result of the current economic 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 the nonperforming assets and charge-offs that we have experienced are within our expectations given current market conditions.

 

Average indirect loans increased $546 million, or 37%, compared with the first quarter of 2007. The increase is attributable to acquisitions and organic growth in our portfolio that has benefited from increased sales and marketing efforts.

 

Average education loans grew $729 million compared with the first quarter of 2007. The increase was primarily the result of the transfer to portfolio of approximately $1.8 billion, or $.7 billion on average, education loans previously held for sale. The Loans Held For Sale portion of the Consolidated Balance Sheet Review section of this Financial Review includes additional information related to this transfer.

 

Average residential mortgage loans increased $659 million, or 37%, primarily due to the addition of loans from the acquisitions.

 

Assets under management of $65 billion at March 31, 2008 decreased $11 billion compared with the balance at March 31, 2007. The decline in assets under management was primarily due to the effects of the Hilliard Lyons sale and comparatively lower equity markets in the first quarter of 2008.

Nondiscretionary assets under administration of $111 billion at March 31, 2008 remained flat when compared with the balance at March 31, 2007. The effects of comparatively lower equity markets were offset by net positive client flows.

Our remaining investment in Visa Class B common shares totals approximately 3.5 million and is recorded at zero book value. At the IPO conversion ratio, these shares would convert to approximately 2.5 million of the publicly traded Visa Class A common shares. Based on the March 31, 2008 closing price of $62.36 for the Visa shares, our remaining investment had an unrecognized value of approximately $158 million. The Visa Class B common shares we own generally will not be transferable until they can be converted into shares of the publicly traded class of stock, which cannot happen until the later of three years after the IPO or settlement of all of the specified litigation. Additionally, Visa is allowed to reduce the number of shares that we own to fund any litigation liabilities that are above and beyond the initial escrow amount set aside at the time of the IPO. Note 15 Commitments And Guarantees in our Notes To Consolidated Financial Statements included in this Report has further information on our Visa indemnification obligation.


 

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CORPORATE & INSTITUTIONAL BANKING

(Unaudited)

 

Three months ended March 31

Taxable-equivalent basis

Dollars in millions except as noted

   2008     2007  

INCOME STATEMENT

    

Net interest income

   $241     $183  

Noninterest income

    

Corporate service fees

   123     127  

Other

   (122 )   60  

Noninterest income

   1     187  

Total revenue

   242     370  

Provision for (recoveries of) credit losses

   49     (16 )

Noninterest expense

   215     193  

Pretax earnings (loss)

   (22 )   193  

Income taxes (benefit)

   (24 )   61  

Earnings

   $2     $132  

AVERAGE BALANCE SHEET

    

Loans

    

Corporate (a)

   $11,333     $9,068  

Commercial real estate

   5,146     3,569  

Commercial – real estate related

   2,902     2,270  

Asset-based lending

   4,974     4,501  

Total loans (a)

   24,355     19,408  

Goodwill and other intangible assets

   2,191     1,544  

Loans held for sale

   2,418     1,302  

Other assets

   6,281     4,244  

Total assets

   $35,245     $26,498  

Deposits

    

Noninterest-bearing demand

   $7,481     $7,083  

Money market

   5,026     4,530  

Other

   2,029     926  

Total deposits

   14,536     12,539  

Other liabilities

   5,679     2,850  

Capital

   2,462     2,064  

Total funds

   $22,677     $17,453  
(a) Includes lease financing.

Corporate & Institutional Banking earned $2 million in the first quarter of 2008 compared with $132 million in the first quarter of 2007. First quarter 2008 earnings were impacted by pretax valuation losses of $177 million on commercial mortgage loans and commitments held for sale, net of hedges. The decrease compared with the first quarter of 2007 also resulted from higher provision for credit losses and noninterest expense somewhat offset by higher taxable-equivalent net interest income.

 

Three months ended March 31

Taxable-equivalent basis

Dollars in millions except as noted

   2008     2007  

PERFORMANCE RATIOS

      

Return on average capital

   NM     26 %

Noninterest income to total revenue

   NM     51  

Efficiency

   89 %   52  

COMMERCIAL MORTGAGE SERVICING PORTFOLIO (in billions)

      

Beginning of period

   $243     $200  

Acquisitions/additions

   5     16  

Repayments/transfers

   (4 )   (10 )

End of period

   $244     $206  

OTHER INFORMATION

      

Consolidated revenue from: (a)

      

Treasury Management

   $133     $110  

Capital Markets

   $76     $67  

Commercial mortgage valuations (b) (c)

   $(177 )    

Other commercial mortgage activities

   $81     $73  

Total commercial mortgage banking activities

   $(96 )   $73  

Total loans (d)

   $24,981     $21,193  

Nonperforming assets (d) (e)

   $317     $77  

Net charge-offs

   $15     $9  

Full-time employees (d)

   2,218     2,038  

Net carrying amount of commercial mortgage servicing rights (d)

   $678     $487  
(a) Represents consolidated PNC amounts.
(b) Included in other noninterest income above.
(c) Includes both loans and commitments and the impact of related hedges.
(d) At March 31.
(e) Includes nonperforming loans of $298 million at March 31, 2008 and $51 million at March 31, 2007.
NM Not meaningful.

 

 

Taxable-equivalent net interest income grew $58 million, or 32%, in the first quarter of 2008 compared with the first quarter of 2007. The increase over the prior year first quarter was primarily a result of acquisitions, an increase in commercial loans held for sale and organic loan growth.

 

Corporate service fees were $123 million in the first quarter of 2008 compared with $127 million in the first quarter of 2007. A decrease in mortgage servicing fees, net of amortization, and merger and acquisition advisory fees more than offset an increase in treasury management fees.

 

Other noninterest income was negative $122 million for the first quarter of 2008 compared with income of $60 million in the prior year first quarter. First quarter 2008 reflected valuation losses of $177 million on commercial mortgage loans and commitments held for sale, net of hedges. These valuation losses reflect the current illiquid market conditions and are non-cash losses. Beginning January 1, 2008, PNC adopted SFAS 159 and elected to account for its loans held for sale and intended for securitization at fair value. Given the current market disruption, we have stopped originating these loans. We intend to pursue opportunities to reduce our loans held for sale position when we can receive prices we feel are appropriate.


 

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Noninterest expense increased $22 million, or 11%, compared with the first quarter of 2007. The increase was primarily due to the impact of the Mercantile and ARCS Commercial Mortgage acquisitions, and other growth initiatives.

 

The provision for credit losses was $49 million in the first quarter of 2008 compared with a net recovery of $16 million in the first quarter of 2007. The increase in the provision compared with the year-ago quarter was primarily due to credit quality migration mainly related to commercial real estate exposure and growth in total credit exposure. Nonperforming assets increased $240 million in the comparison, the majority of which was due to acquisitions. The largest component of the increase was in commercial real estate and commercial real estate related loans. Based upon the current environment, we believe the provision will continue to increase in 2008 versus 2007 levels.

 

Average loan balances increased $4.9 billion, or 25%, from the prior year first quarter. The increase resulted

 

from organic loan growth in corporate and commercial real estate loans and the impact of the Mercantile and Yardville acquisitions.

 

Average deposit balances for the quarter increased $2.0 billion, or 16%, compared with the first quarter of 2007. The increase resulted primarily from higher client time deposits and the impact of acquisitions.

 

The commercial mortgage servicing portfolio was $244 billion at March 31, 2008, an increase of $38 billion, or 18%, from March 31, 2007. The increase resulted from strong growth in the second and third quarters of 2007 including the ARCS acquisition, which added $13 billion of commercial mortgage servicing. Servicing portfolio additions have been modest since the third quarter of 2007 due to the declining volumes in the commercial mortgage securitization market.

See the additional revenue discussion regarding treasury management, capital markets-related products and commercial mortgage banking activities on page 8.


 

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BLACKROCK

Our BlackRock business segment earned $60 million in the first three months of 2008 and $52 million in the first three months of 2007. These results reflect our approximately 33.4% share of BlackRock’s reported GAAP earnings and the additional income taxes on these earnings incurred by PNC.

PNC’s investment in BlackRock was $4.2 billion at March 31, 2008 and $4.1 billion at December 31, 2007. Based upon BlackRock’s closing market price of $204.18 per common share at March 31, 2008, the market value of our investment in BlackRock was $8.8 billion at that date. As such, an additional $4.6 billion of pretax value was not recognized in our equity investment or shareholders’ equity account at that date.

BLACKROCK LTIP PROGRAMS

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 $233 million under the 2002 LTIP program, of which approximately $208 million were paid on January 30, 2007. The award payments were funded by 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. The gain was

included in other noninterest income and reflected the excess of market value over book value of the one million shares transferred in January 2007. Additional BlackRock shares were distributed to LTIP participants during the first quarter of 2008, resulting in a $3 million pretax gain in other noninterest income.

PNC’s noninterest income for the first quarter of 2008 included a $37 million pretax gain related to our commitment to fund additional BlackRock LTIP programs. This gain represented the mark-to-market adjustment related to our remaining BlackRock LTIP shares obligation as of March 31, 2008 and resulted from the decrease in the market value of BlackRock common shares during the first three months of 2008. In the first quarter of 2007, we recognized a charge of $30 million for an increase in the market value of BlackRock common shares during that period.

BlackRock granted awards in 2007 under an additional LTIP program, all of which are subject to achieving earnings performance goals prior to the vesting date of September 29, 2011. Of the shares of BlackRock common stock that we have agreed to transfer to fund their LTIP programs, approximately 1.6 million shares have been committed to fund the awards vesting in 2011 and the amount remaining would then be available for future awards.

We may continue to see volatility in earnings as we mark to market our LTIP shares obligation each quarter end. However, additional gains based on the difference between the market value and the book value of the committed BlackRock common shares will generally not be recognized until the shares are distributed to LTIP participants.


 

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PFPC

(Unaudited)

 

Three months ended March 31

Dollars in millions except as noted

   2008     2007  

INCOME STATEMENT

      

Servicing revenue (a)

   $238     $208  

Operating expense (a)

   181     153  

Operating income

   57     55  

Debt financing

   11     10  

Nonoperating income (b)

   1     2  

Pretax earnings

   47     47  

Income taxes

   17     16  

Earnings

   $30     $31  

PERIOD-END BALANCE SHEET

      

Goodwill and other intangible assets

   $1,311     $1,008  

Other assets

   1,388     1,370  

Total assets

   $2,699     $2,378  

Debt financing

   $986     $760  

Other liabilities

   1,070     1,091  

Shareholder’s equity

   643     527  

Total funds

   $2,699     $2,378  

PERFORMANCE RATIOS

      

Return on average equity

   19 %   25 %

Operating margin (c)

   24     26  

SERVICING STATISTICS (at March 31)

      

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

      

Domestic

   $875     $731  

Offshore

   125     91  

Total

   $1,000     $822  

Asset type (in billions)

      

Money market

   $413     $280  

Equity

   358     352  

Fixed income

   128     111  

Other

   101     79  

Total

   $1,000     $822  

Custody fund assets (in billions)

   $476     $435  

Shareholder accounts (in millions)

      

Transfer agency

   19     18  

Subaccounting

   57     50  

Total

   76     68  

OTHER INFORMATION

      

Full-time employees (at March 31)

   4,865     4,400  
(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.
(b) Net of nonoperating expense.
(c) Total operating income divided by servicing revenue.
(d) Includes alternative investment net assets serviced.

 

PFPC earned $30 million for the first three months of 2008 compared with $31 million in the year-earlier period. While servicing revenue growth of 14% was realized through new business, organic growth, and the completion of two acquisitions in December 2007, increased costs related to this growth and the acquisitions offset the increase.

Highlights of PFPC’s performance for the first three months of 2008 included:

 

   

Total fund accounting assets serviced reached $1 trillion, a 22% increase over the prior year, with increases in all asset types despite declines in major stock market indices over the same time frame.

 

   

Initiatives in the offshore arena have resulted in a 41% increase in servicing revenue and a 37% increase in assets serviced, which now stand at $125 billion.

 

   

Subaccounting ledgers rose by 7 million, or 14%, to 57 million, as clients continue to convert accounts to this platform.

Servicing revenue for the first quarter of 2008 reached $238 million, an increase of $30 million, or 14%, over the first quarter of 2007. This increase resulted primarily from the growth in offshore operations and the acquisitions of Albridge Solutions Inc. and Coates Analytics, LP in December 2007.

Operating expense increased $28 million, or 18%, to $181 million, in the first three months of 2008 compared with the first three months of 2007. Investments in technology, a larger employee base to support business growth, and costs related to the recent acquisitions drove the higher expense level.

Debt financing costs increased due to debt incurred related to the fourth quarter 2007 acquisitions and nonoperating income declined from the first quarter of 2007 when a grant was received in a foreign jurisdiction for employment expansion offshore.

Total assets serviced by PFPC amounted to $2.6 trillion at March 31, 2008 compared with $2.2 trillion at March 31, 2007 as PFPC continued to see both organic growth and growth from new business in each of its lines of business.


 

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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 2007 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 measured and reported at 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. See Fair Value Measurements And Fair Value Option in this Financial Review for a description of fair value measurement under SFAS 157.

We discuss the following critical accounting policies and judgments under this same heading in Item 7 of our 2007 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 information regarding these policies is found elsewhere in this Financial Review and in the Notes To Consolidated Financial Statements in Part I, Item 1 of this Report.

In addition, see Note 1 Accounting Policies in the Notes To Consolidated Financial Statements regarding our first quarter 2008 adoption of the following:

   

EITF Issue 06-4, “Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements”,

   

SFAS 157, “Fair Value Measurements”,

   

SFAS 159, “The Fair Value Option for Financial Assets and Financial Liabilities – including an amendment of FASB Statement No. 115”, and

   

SEC Staff Accounting Bulletin No. 109

 

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. Consistent with our investment strategy, plan assets are primarily invested in equity investments and fixed income instruments. Plan fiduciaries determine and review the plan’s investment policy, which is described more fully in Note 17 Employee Benefit Plans in the Notes To Consolidated Financial Statements included under Part II, Item 8 of our 2007 Form 10-K.

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 or compensation increase assumptions significantly affects pension expense. However,

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 2008 was 8.25%, unchanged from 2007. 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 annual assumptions, using 2008 estimated expense as a baseline.

 

Change in Assumption   

Estimated

Increase to 2008
Pension
Expense

(In millions)

.5% decrease in discount rate

   $1

.5% decrease in expected long-term return

on assets

   $10

.5% increase in compensation rate

   $2

 

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We currently estimate a pretax pension benefit of $26 million in 2008 compared with a pretax benefit of $30 million in 2007.

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 risks 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 2007 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 2007 Form 10-K provides an analysis of the risk management processes for what we view as our primary areas of risk: credit, operational, liquidity and market, as well as a discussion of our use of financial derivatives as part of our overall asset and liability risk management process. The following updates our 2007 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 our most significant risks.

Nonperforming, Past Due And Potential Problem Assets

We continued to experience credit deterioration at a manageable pace and overall asset quality performed as anticipated in the challenging environment during the first quarter of 2008. We remained focused on maintaining a moderate risk profile.

 

Nonperforming Assets by Type

 

In millions   

March 31

2008

  

December 31

2007

Nonaccrual loans

       

Commercial

       

Retail/wholesale

   $ 32    $ 39

Manufacturing

     47      35

Other service providers

     68      48

Real-estate related

     63      45

Financial services

     16      15

Health care

     4      4

Other

     8      7

Total commercial

     238      193

Commercial real estate

       

Real estate projects

     251      184

Mortgage

     22      28

Total commercial real estate

     273      212

Consumer

     19      17

Residential mortgage

     10      10

Lease financing

     3      3

Total nonaccrual loans

     543      435

Restructured loans

     2      2

Total nonperforming loans

     545      437

Foreclosed and other assets

       

Residential mortgage

     21      16

Lease financing

     11      11

Other

     10      14

Total foreclosed and other assets

     42      41

Total nonperforming assets (a) (b)

   $ 587    $ 478
(a) Excludes equity management assets carried at estimated fair value of $5 million at March 31, 2008 and $4 million at December 31, 2007.
(b) Excludes loans held for sale carried at lower of cost or market value of $35 million at March 31, 2008 and $25 million at December 31, 2007 (amounts include troubled debt restructured assets of $21 million at March 31, 2008).

Total nonperforming assets at March 31, 2008 increased $109 million, to $587 million, compared with $478 million at December 31, 2007. Our nonperforming assets represented .42% of total assets at March 31, 2008 compared with .34% at December 31, 2007. The increase in nonperforming assets reflected higher nonaccrual commercial real estate related loans and higher nonaccrual residential real estate development loans partially offset by the impact of aligning small business and consumer loan charge-off policies.

The amount of nonperforming loans that was current as to principal and interest was $216 million at March 31, 2008 and $178 million at December 31, 2007.

See Note 5 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 March 31, 2008 and December 31, 2007. In addition, certain performing assets have interest payments that are past due or have the potential for future repayment problems.


 

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Changes In Nonperforming Assets

 

In millions    2008     2007  

January 1

   $ 478     $ 171  

Transferred from accrual

     274       76  

Acquisition – Mercantile

       35  

Principal activity including payoffs

     (46 )     (49 )

Charge-offs and valuation adjustments

     (87 )     (22 )

Returned to performing

     (30 )     (4 )

Asset sales

     (2 )     (3 )

March 31

   $ 587     $ 204  

In the first quarter of 2008, we more closely aligned our charge-off policies for consumer and small business loans, which had the effect of reducing nonperforming assets by $44 million during the first quarter of 2008.

Accruing Loans Past Due 90 Days Or More

 

    Amount   Percent of Total
Outstandings
 
Dollars in millions  

March 31

2008

 

Dec. 31

2007

 

March 31

2008

   

Dec. 31

2007

 

Commercial

  $ 23   $ 14   .08 %   .05 %

Commercial real estate

    4     18   .04     .20  

Consumer

    61     49   .30     .27  

Residential mortgage

    11     13   .12     .14  

Other

    7     12   2.57     2.91  

Total loans

  $ 106   $ 106   .15     .16  

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 $177 million at March 31, 2008 compared with $134 million at December 31, 2007.

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 5 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

 

    March 31, 2008     December 31, 2007  
Dollars in millions   Allowance   

Loans to

Total

Loans

    Allowance   

Loans to

Total

Loans

 

Commercial

  $ 588    41.8 %   $ 560    41.8 %

Commercial real estate

    156    12.8       153    13.0  

Consumer

    77    28.4       68    26.9  

Residential mortgage

    9    13.1       9    14.0  

Lease financing

    33    3.5       36    3.7  

Other

    2    .4       4    .6  

Total

  $ 865    100.0 %   $ 830    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 totaled $151 million for the first quarter of 2008 and $8 million for the first quarter of 2007. The higher provision in the first quarter of 2008 compared with the prior year quarter was impacted by our real estate portfolio, including residential real estate development exposure, and growth in total credit exposure. See the Consolidated Balance Sheet Review section of this Financial Review for further information. In addition, the provision for credit losses for the first three months of 2008 and the evaluation of the allowances for loan and lease losses and unfunded loan commitments and letters of credit as of March 31, 2008 reflected loan and total credit exposure growth, changes in loan portfolio composition, and other 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.

Given our projections for loan growth and continued credit deterioration, and our current assumptions for the national economy, (i.e., mild recession), we expect that the provision for credit losses will be approximately $600 million for full year 2008, including the impact of the Sterling acquisition.

The allowance as a percent of nonperforming loans was 159% and as a percent of total loans was 1.22% at March 31, 2008. The comparable percentages at December 31, 2007 were 190% and 1.21%.


 

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Charge-Offs And Recoveries

 

Three months ended March 31
Dollars in millions
  Charge-
offs
  Recoveries   Net
Charge-
offs
  Percent
of
Average
Loans
 

2008

         

Commercial

  $ 70   $ 8   $ 62   .86 %

Consumer

    28     4     24   .51  

Commercial real estate

    11       11   .49  

Lease financing

    1           1   .16  

Total

  $ 110   $ 12   $ 98   .57  

2007

         

Commercial

  $ 31   $ 7   $ 24   .45 %

Consumer

    17     5     12   .29  

Total

  $ 48   $ 12   $ 36   .27  

In the first quarter of 2008, we more closely aligned our charge-off policies for consumer and small business loans, which had the effect of increasing charge-offs by $44 million during the first quarter of 2008.

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, the following:

   

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

   

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 3.9% of the total allowance and .05% of total loans, net of unearned income, at March 31, 2008.

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.

We also sell loss protection to mitigate the net premium cost and the impact of fair value 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 used to hedge our loan portfolio, reflected in other noninterest income in our Consolidated Income Statement, totaled $27 million for the first quarter of 2008 compared with $7 million for the first quarter of 2007. The 2008 amount excluded the impact of credit hedges that were part of the net valuation of commercial mortgages and commitments held for sale.

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, trading securities and other short-term investments) and securities available for sale. At March 31, 2008, our liquid assets totaled $34.7 billion, with $22.1 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 (“Federal Reserve Bank”) 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 and other mortgage-related loans. At March 31, 2008, we maintained significant unused borrowing capacity from the Federal Reserve Bank discount window and FHLB-Pittsburgh under current collateral requirements.

At March 31, 2008, we pledged $3.1 billion of loans and $16.5 billion of securities to the Federal Reserve Bank with a combined collateral value of $18.2 billion. Also, we pledged $32.2 billion of loans and $4.3 billion of securities to FHLB- Pittsburgh under a blanket lien with a combined collateral value of $18.9 billion as of that date. We pledged this collateral with the Federal Reserve Bank and FHLB-Pittsburgh for the contingent ability to borrow if necessary. At


 

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December 31, 2007, we had $1.6 billion of loans and $18.8 billion of securities pledged to the Federal Reserve Bank with a combined collateral value of $18.2 billion. Also at December 31, 2007, we pledged $33.5 billion of loans and $4.3 billion of securities to FHLB-Pittsburgh with a combined collateral value of $23.5 billion.

We had no Federal Reserve Bank borrowings outstanding at either March 31, 2008 or December 31, 2007.

In the first quarter of 2008 we increased FHLB borrowings, which provided us with additional liquidity at relatively attractive rates. Total FHLB borrowings were $9.7 billion at March 31, 2008 compared with $7.1 billion at December 31, 2007.

We can also obtain funding through traditional forms of borrowing, including federal funds purchased, repurchase agreements, and short 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 March 31, 2008, PNC Bank, N.A. had issued $6.9 billion of debt under this program, including $325 million of subordinated debt issued in March 2008 that matures on April 1, 2018. These notes pay interest semiannually at a fixed rate of 6.875%.

Our 2007 Form 10-K has additional information regarding the following first quarter 2008 issuances:

   

$50 million of senior bank notes issued in January that mature on January 25, 2011.

   

$100 million of senior bank notes issued in January that mature on January 25, 2010.

   

$175 million of senior bank notes issued in February that mature on February 1, 2010.

   

$500 million of senior bank notes issued in February that mature on August 5, 2009.

None of the 2008 issuances are redeemable by us or the holders prior to maturity.

We have the ability to issue additional trust preferred securities out of our PNC Preferred Funding structure, subject to certain contractual restrictions. In February 2008, PNC Preferred Funding Trust III issued $375 million of 8.70% Fixed-to-Floating Rate Non-Cumulative Exchangeable Perpetual Trust Securities. See “Perpetual Trust Securities” in the Off-Balance Sheet Arrangements And VIEs section of this Financial Review.

PNC Bank, N.A. established a program in December 2004 to offer up to $3.0 billion of its commercial paper. As of March 31, 2008, there were no issuances outstanding under this program.

As of March 31, 2008, there were $2.5 billion of PNC Bank, N.A. short- and long-term debt issuances with maturities of less than one year.

 

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 issuance, and discretionary funding uses, the most significant of which is the external dividend to be paid on PNC’s stock.

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

   

Capital needs,

   

Laws and regulations,

   

Corporate policies,

   

Contractual restrictions, and

   

Other factors.

Also, there are statutory and regulatory limitations on the ability of national banks to pay dividends or make other capital distributions or to extend credit to the parent company or its non-bank subsidiaries. Dividends may also be impacted by the bank’s capital needs and by contractual restrictions. We provide additional information on certain contractual restrictions under the “Perpetual Trust Securities.” “PNC Capital Trust E Trust Preferred Securities,” and “Acquired Entity Trust Preferred Securities” sections of the Off-Balance Sheet Arrangements And VIEs section of this Financial Review. The amount available for dividend payments to the parent company by PNC Bank, N.A. without prior regulatory approval was approximately $306 million at March 31, 2008.

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 March 31, 2008, the parent company had approximately $840 million in funds available from its cash and short-term investments.

We can also generate liquidity for the parent company and PNC’s non-bank subsidiaries through the issuance of securities in public or private markets.

In February 2008, PNC Capital Trust E was formed and issued $450 million of Capital Securities. Proceeds from the issuance were used to purchase $450 million of junior subordinated notes issued by PNC that mature on March 15, 2068 and are redeemable on or after March 15, 2013 at par. These notes pay interest quarterly at a fixed rate of 7.75%.

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 March 31, 2008, $911 million of commercial paper was outstanding under this program.


 

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We have effective shelf registration statements which enable us to issue additional debt and equity securities, including certain hybrid capital instruments.

As of March 31, 2008, there were $1.8 billion of parent company contractual obligations, including commercial paper, with maturities of less than one year.

We also provide tables showing contractual obligations and various other commitments representing required and potential cash outflows as of March 31, 2008 under the heading “Commitments” below.

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.

Asset and Liability Management 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 first quarters of 2008 and 2007 follow:

Interest Sensitivity Analysis

 

      First
Quarter
2008
   

First

Quarter
2007

 

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

   (2.6 )%   (2.6 )%

100 basis point decrease

   2.5 %   2.2 %

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

      

100 basis point increase

   (5.2 )%   (5.8 )%

100 basis point decrease

   2.0 %   3.3 %

Duration of Equity Model

      

Base case duration of equity (in years):

   2.2     2.0  

Key Period-End Interest Rates

      

One-month LIBOR

   2.70 %   5.32 %

Three-year swap

   2.73 %   4.95 %

 

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.

Net Interest Income Sensitivity To Alternate Rate Scenarios (First Quarter 2008)

 

      PNC
Economist
    Market
Forward
    Two-Ten
Inversion
 

First year sensitivity

   4.3 %   4.0 %   (7.5 )%

Second year sensitivity

   2.0 %   4.2 %   (7.3 )%

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 is currently liability sensitive, which has been the objective of 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.


 

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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 quarter of 2008, our VaR ranged between $9.4 million and $13.8 million, averaging $11.7 million. During the first quarter of 2007, our VaR ranged between $6.1 million and $8.4 million, averaging $7.2 million. The increase in VaR compared with the first quarter of 2007 reflected ongoing market volatility.

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. Under typical market conditions, we would expect an average of two to three instances a year in which actual losses exceeded the prior day VaR measure at the enterprise-wide level. As a result of increased volatility in certain markets, there were five such instances during the first three months of 2008.

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 three months of 2008 and 2007 was as follows:

 

Three months ended March 31 – in millions    2008     2007

Net interest income

   $ 16      

Noninterest income

     (76 )   $ 52

Total trading revenue

   $ (60 )   $ 52

Securities and financial derivatives (a)

   $ (76 )   $ 38

Foreign exchange

     16       14

Total trading revenue

   $ (60 )   $ 52
(a) Includes changes in fair value for certain loans accounted for at fair value.

 

Trading losses for the first quarter of 2008 were primarily related to our proprietary trading activities and reflected the negative impact of a very illiquid market during the quarter on the assets that we held. In response to first quarter 2008 market volatility, in April 2008 we substantially reduced our trading positions and increased our hedges in connection with these activities.

Average trading assets and liabilities consisted of the following:

 

Three months ended March 31 - in millions    2008    2007

Trading assets

       

Securities (a)

   $ 3,872    $ 1,569

Resale agreements (b)

     2,129      820

Financial derivatives (c)

     2,808      1,115

Loans at fair value (c)

     114      193

Total trading assets

   $ 8,923    $ 3,697

Trading liabilities

       

Securities sold short (d)

   $ 2,127    $ 1,264

Repurchase agreements and other borrowings (e)

     661      363

Financial derivatives (f)

     2,856      1,126

Borrowings at fair value (f)

     30      39

Total trading liabilities

   $ 5,674    $ 2,792
(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 $4.2 billion at March 31, 2008 compared with $4.1 billion at December 31, 2007. The market value of our investment in BlackRock was $8.8 billion at March 31, 2008. 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. These investments, consisting of partnerships accounted for under the equity method as well as equity investments held by consolidated partnerships, totaled $1.0 billion at both March 31, 2008 and December 31, 2007. PNC’s equity investment at risk was $194 million at March 31, 2008 compared with $188 million at year-end 2007. We also had commitments to make additional equity investments in affordable housing limited


 

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partnerships of $90 million at March 31, 2008 compared with $98 million at December 31, 2007.

At March 31, 2008 historic tax credit investments totaled $11 million with unfunded commitments related to these investments of $23 million. The comparable amounts at December 31, 2007 were $13 million and $26 million.

Private Equity

The private equity portfolio is comprised of equity and mezzanine investments that vary by industry, stage and type of investment. At March 31, 2008, private equity investments carried at estimated fair value totaled $557 million compared with $561 million at December 31, 2007. As of March 31, 2008, $272 million was invested directly in a variety of companies and $285 million was invested in various limited partnerships. Included in direct investments are investment activities of two private equity funds that are consolidated for financial reporting purposes. The minority and noncontrolling interests of these funds totaled $92 million as of March 31, 2008. Our unfunded commitments related to private equity totaled $273 million at March 31, 2008 and $270 million at December 31, 2007.

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 March 31, 2008, other investments totaled $467 million compared with $389 million at December 31, 2007. Our unfunded commitments related to other investments totaled $62 million at March 31, 2008 compared with $79 million at December 31, 2007. Other investments and related unfunded commitments include those related to Steel City Capital Funding LLC as further described in Note 15 Commitments And Guarantees in the Notes To Consolidated Financial Statements included in this Report.

COMMITMENTS

The following tables set forth contractual obligations and various other commitments representing required and potential cash outflows as of March 31, 2008.

Contractual Obligations

 

March 31, 2008 – in millions    Total

Remaining contractual maturities of time deposits

   $ 22,842

Borrowed funds

     32,779

Minimum annual rentals on noncancellable leases

     1,262

Nonqualified pension and post-retirement benefits

     314

Purchase obligations (a)

     447

Total contractual cash obligations

   $ 57,644
(a) Includes purchase obligations for goods and services covered by noncancellable contracts and contracts including cancellation fees.

 

Other Commitments (a)

 

March 31, 2008 – in millions    Total

Loan commitments

   $ 52,426

Standby letters of credit (b)

     5,172

Other commitments (c)

     448

Total commitments

   $ 58,046
(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 $2.0 billion of standby letters of credit that support remarketing programs for customers’ variable rate demand notes.
(c) 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 is presented in Note 1 Accounting Policies and Note 10 Financial Derivatives in the Notes To Consolidated Financial Statements included in this Report.

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


 

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The following tables provide the notional 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 March 31, 2008 and December 31, 2007. 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 - 2008

 

   Notional/

Contract
Amount

   Estimated
Net Fair
Value
 
 
 
   Weighted-

Average
Maturity

   Weighted-Average

Interest Rates

 

 

March 31, 2008 – dollars in millions

            Paid     Received  

Accounting Hedges

               

Interest rate risk management

             

Asset rate conversion

             

Interest rate swaps (a)

             

Receive fixed

   $10,056    $570      3 yrs. 10 mos.    3.53 %   5.15 %

Liability rate conversion

             

Interest rate swaps (a)

             

Receive fixed

   9,415    563      5 yrs.    3.11     5.08  

Total interest rate risk management

   19,471    1,133          

Total accounting hedges (b)

   $19,471    $1,133          

Free-Standing Derivatives

               

Customer-related

             

Interest rate

             

Swaps (c)

   $68,789    $(101 )    5 yrs. 3 mos.    3.76 %   3.77 %

Caps/floors

             

Sold (c)

   2,992    (12 )    6 yrs. 1 mo.    NM     NM  

Purchased

   2,399    15      3 yrs. 8 mos.    NM     NM  

Futures (c)

   4,530    (7 )    11 mos.    NM     NM  

Foreign exchange (c)

   8,759    (2 )    7 mos.    NM     NM  

Equity (c)

   1,345    (47 )    1 yr. 6 mos.    NM     NM  

Swaptions

   3,627    71      13 yrs. 6 mos.    NM     NM  

Total customer-related

   92,441    (83 )        

Other risk management and proprietary

             

Interest rate

             

Swaps (c) (d)

   37,928    (182 )    5 yrs. 7 mos.    3.60 %   3.55 %

Caps/floors

             

Sold (c)

   1,850    (18 )    1 yr. 3 mos.    NM     NM  

Purchased

   2,060    37      1 yr. 7 mos.    NM     NM  

Futures (c)

   23,647    (13 )    1 yr. 3 mos.    NM     NM  

Foreign exchange

   13,914    1      4 yrs. 1 mo.    NM     NM  

Credit derivatives

   5,607    139      14 yrs. 7 mos.    NM     NM  

Risk participation agreements

   1,233       4 yrs. 5 mos.    NM     NM  

Commitments related to mortgage-related assets

   2,930    2      5 mos.    NM     NM  

Options

             

Futures

   32,811    15      5 mos.    NM     NM  

Swaptions

   11,473    (30 )    8 yrs.    NM     NM  

Other (e)

   503    (162 )    NM    NM     NM  

Total other risk management and proprietary

   133,956    (211 )        

Total free-standing derivatives

   $226,397    $(294 )                  
(a) The floating rate portion of interest rate contracts is based on money-market indices. As a percent of notional amount, 48% were based on 1-month LIBOR, 41% on 3-month LIBOR and 11% on Prime Rate.
(b) Fair value amount includes net accrued interest receivable of $139 million.
(c) The increase in the negative fair values from December 31, 2007 to March 31, 2008 for equity, interest rate contracts and foreign exchange were due to the changes in fair values of the existing contracts along with new contracts entered into during 2008.
(d) Due to the adoption of SFAS 159 as of January 1, 2008, we discontinued hedge accounting with our commercial mortgage banking pay fixed interest rate swaps; therefore, the fair value of these are now reported in this category.
(e) Relates to PNC’s obligation to help fund certain BlackRock LTIP programs and to certain customer-related derivatives. Additional information regarding the BlackRock/MLIM transaction and our BlackRock LTIP shares obligation is included in Note 2 Acquisitions and Divestitures included in the Notes To Consolidated Financial Statements in Item 8 of our 2007 Form 10-K.

NM Not meaningful

 

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Financial Derivatives - 2007

 

    

Notional/

Contract
Amount

  

Estimated

Net

Fair
Value

   

Weighted-

Average
Maturity

  

Weighted-
Average

Interest Rates

 
December 31, 2007 – dollars in millions            Paid     Received  

Accounting Hedges

              

Interest rate risk management

              

Asset rate conversion

              

Interest rate swaps (a)

Receive fixed

   $ 7,856    $ 325     4 yrs. 2 mos.    4.28 %   5.34 %

Liability rate conversion

              

Interest rate swaps (a)

Receive fixed

     9,440      269     4 yrs. 10 mos.    4.12     5.09  

Total interest rate risk management

     17,296      594           

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

     1,128      (79 )   8 yrs. 8 mos.    5.45     4.52  

Total accounting hedges (b)

   $ 18,424    $ 515                   

Free-Standing Derivatives

              

Customer-related

              

Interest rate

              

Swaps (c)

   $ 61,768    $ (39 )   5 yrs. 4 mos.    4.46 %   4.49 %

Caps/floors

              

Sold (c)

     2,837      (5 )   6 yrs. 5 mos.    NM     NM  

Purchased

     2,356      7     3 yrs. 7 mos.    NM     NM  

Futures (c)

     5,564      (6 )   8 mos.    NM     NM  

Foreign exchange

     7,028      8     7 mos.    NM     NM  

Equity (c)

     1,824      (69 )   1 yr. 5 mos.    NM     NM  

Swaptions

     3,490      40     13 yrs. 10 mos.    NM     NM  

Other

     200            10 yrs. 6 mos.    NM     NM  

Total customer-related

     85,067      (64 )         

Other risk management and proprietary

              

Interest rate

              

Swaps

     41,247      6     4 yrs. 5 mos.    4.44 %   4.47 %

Caps/floors

              

Sold (c)

     6,250      (82 )   2 yrs. 1 mo.    NM     NM  

Purchased

     7,760      117     1 yr. 11 mos.    NM     NM  

Futures (c)

     43,107      (15 )   1 yr. 7 mos.    NM     NM  

Foreign exchange

     8,713      5     6 yrs. 8 mos.    NM     NM  

Credit derivatives

     5,823      42     12 yrs. 1 mo.    NM     NM  

Risk participation agreements

     1,183      4 yrs. 6 mos.    NM     NM  

Commitments related to mortgage-related assets

     3,190      10     4 mos.    NM     NM  

Options

              

Futures

     39,158      (2 )   8 mos.    NM     NM  

Swaptions

     21,800      49     8 yrs. 1 mo.    NM     NM  

Other (d)

     442      (201 )   NM    NM     NM  

Total other risk management and proprietary

     178,673      (71 )         

Total free-standing derivatives

   $ 263,740    $ (135 )                 
(a) The floating rate portion of interest rate contracts is based on money-market indices. As a percent of notional amount, 52% were based on 1-month LIBOR, 43% on 3-month LIBOR and 5% on Prime Rate.
(b) Fair value amount includes net accrued interest receivable of $130 million.
(c) The increases in the negative fair values from December 31, 2006 to December 31, 2007 for equity and interest rate contracts were 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 and Divestitures included in the Notes to Consolidated Financial Statements in Item 8 of our 2007 Form 10-K.

NM Not meaningful

 

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INTERNAL CONTROLS AND DISCLOSURE CONTROLS AND PROCEDURES

As of March 31, 2008, 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 March 31, 2008, and that there has been no change in internal control over financial reporting that occurred during the first quarter of 2008 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; trading securities and other short-term investments; 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.

Efficiency - Noninterest expense divided by the sum of net interest income (GAAP basis) and noninterest income.

Fair value - The price that would be received to sell an asset or the price paid to transfer a liability on the measurement date using the principal or most advantageous market for the asset


 

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or liability in an orderly transaction between willing market participants.

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, 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 assets - Annualized net income divided by average assets.

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

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

Return on average tangible common shareholders’ equity - Annualized net income divided by average common shareholders’ equity less goodwill and other intangible assets (net of deferred taxes for both taxable and nontaxable combinations), and excluding loan servicing rights.

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 deferred taxes), and excluding loan servicing rights, divided by period-end assets less goodwill and other intangible assets (net of 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 relating to nontaxable combinations), 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 2007 Form 10-K and elsewhere in this Report, 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.

   

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.


 

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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.

   

Given current economic and financial market conditions, our forward-looking financial statements are subject to the risk that these conditions will be substantially different than we are currently expecting. These statements are based on our current expectations that interest rates will remain low through 2008 with continued wide market credit spreads and our view that national economic conditions currently point toward a mild recession.

   

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.

   

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.

   

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 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.

   

Our ability to implement our business initiatives and strategies could affect our financial performance over the next several years.

   

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 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 filings with the SEC, including in the Risk Factors sections of BlackRock’s reports. BlackRock’s SEC filings are 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. Acquisitions in general present us with risks in addition to 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. Our recent acquisition of Sterling presents regulatory and litigation risk, as a result of financial irregularities at Sterling’s commercial finance subsidiary, that may impact our financial results.


 

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CONSOLIDATED INCOME STATEMENT

THE PNC FINANCIAL SERVICES GROUP, INC.

 

In millions, except per share data      Three months ended March 31  
Unaudited          2008              2007      

Interest Income

         

Loans

     $ 1,071      $ 896  

Securities available for sale

       404        310  

Other

       144        109  

Total interest income

       1,619        1,315  

Interest Expense

         

Deposits

       450        468  

Borrowed funds

       315        224  

Total interest expense

       765        692  

Net interest income

       854        623  

Noninterest Income

         

Fund servicing

       228        203  

Asset management

       212        165  

Consumer services

       170        157  

Corporate services

       164        159  

Service charges on deposits

       82        77  

Net securities gains (losses)

       41        (3 )

Other

       70        233  

Total noninterest income

       967        991  

Total revenue

       1,821        1,614  

Provision for credit losses

       151        8  

Noninterest Expense

         

Personnel

       544        490  

Occupancy

       95        87  

Equipment

       82        71  

Marketing

       22        21  

Other

       299        275  

Total noninterest expense

       1,042        944  

Income before income taxes

       628        662  

Income taxes

       251        203  

Net income

     $ 377      $ 459  

Earnings Per Common Share

         

Basic

     $ 1.11      $ 1.49  

Diluted

     $ 1.09      $ 1.46  

Average Common Shares Outstanding

         

Basic

       339        308  

Diluted

       342        312  

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

   March 31
2008
    December 31
2007
 

Assets

    

Cash and due from banks

   $ 3,934     $ 3,567  

Federal funds sold and resale agreements (includes $1,032 measured
at fair value at March 31, 2008) (a)

     2,157       2,729  

Trading securities and other short-term investments

     3,987       4,129  

Loans held for sale (includes $2,068 measured
at fair value at March 31, 2008) (a)

     2,516       3,927  

Securities available for sale

     28,581       30,225  

Loans, net of unearned income of $951 and $990

     70,802       68,319  

Allowance for loan and lease losses

     (865 )     (830 )

Net loans

     69,937       67,489  

Goodwill

     8,244       8,405  

Other intangible assets

     1,105       1,146  

Equity investments

     6,187       6,045  

Other

     13,343       11,258  

Total assets

   $ 139,991     $ 138,920  

Liabilities

    

Deposits

    

Noninterest-bearing

   $ 19,176     $ 19,440  

Interest-bearing

     61,234       63,256  

Total deposits

     80,410       82,696  

Borrowed funds

    

Federal funds purchased

     5,154       7,037  

Repurchase agreements

     2,510       2,737  

Federal Home Loan Bank borrowings

     9,663       7,065  

Bank notes and senior debt (includes $11 measured
at fair value at March 31, 2008) (a)

     6,842       6,821  

Subordinated debt

     5,402       4,506  

Other

     3,208       2,765  

Total borrowed funds

     32,779       30,931  

Allowance for unfunded loan commitments and letters of credit

     152       134  

Accrued expenses

     3,878       4,330  

Other

     6,341       4,321  

Total liabilities

     123,560       122,412  

Minority and noncontrolling interests in consolidated entities

     2,008       1,654  

Shareholders’ Equity

    

Preferred stock (b)

    

Common stock - $5 par value

    

Authorized 800 shares, issued 353 shares

     1,764       1,764  

Capital surplus

     2,603       2,618  

Retained earnings

     11,664       11,497  

Accumulated other comprehensive loss

     (779 )     (147 )

Common stock held in treasury at cost: 12 and 12 shares

     (829 )     (878 )

Total shareholders’ equity

     14,423       14,854  

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

   $ 139,991     $ 138,920  

(a) Amounts represent items for which the Corporation has elected the fair value option under SFAS 159.

(b) 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.

 

     Three months ended March 31  

In millions

Unaudited

   2008     2007  

Operating Activities

    

Net income

   $ 377     $ 459  

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

    

Provision for credit losses

     151       8  

Depreciation, amortization and accretion

     92       77  

Deferred income taxes (benefit)

     (7 )     45  

Net securities (gains) losses

     (41 )     3  

Valuation adjustments

     108    

Net gains related to BlackRock

     (40 )     (52 )

Undistributed earnings of BlackRock

     (63 )     (37 )

Visa redemption gain

     (95 )  

Excess tax benefits from share-based payment arrangements

     (3 )     (8 )

Loans held for sale

     (549 )     (27 )

Trading securities and other short-term investments

     204       703  

Other assets

     (1,461 )     435  

Accrued expenses and other liabilities

     2,088       (486 )

Other

     (55 )     (69 )

Net cash provided by operating activities

     706       1,051  

Investing Activities

    

Repayment of securities

     1,130       1,167  

Sales

    

Securities

     2,363       3,425  

Visa shares

     95    

Loans

     24       162  

Purchases

    

Securities

     (3,055 )     (6,218 )

Loans

     (104 )     (784 )

Net change in

    

Loans

     (823 )     (216 )

Federal funds sold and resale agreements

     601       (30 )

Net cash received from Hilliard Lyons divestiture

     377    

Net cash paid for Mercantile acquisition

       (1,890 )

Other

     (242 )     (129 )

Net cash provided (used) by investing activities

     366       (4,513 )

Financing Activities

    

Net change in

    

Noninterest-bearing deposits

     (264 )     (839 )

Interest-bearing deposits

     (2,024 )     (515 )

Federal funds purchased

     (1,883 )     2,720  

Repurchase agreements

     (229 )     (198 )

Federal Home Loan Bank short-term borrowings

     (2,000 )  

Other short-term borrowed funds

     284       697  

Sales/issuances

    

Bank notes and senior debt

     825       1,273  

Subordinated debt

     759       595  

Federal Home Loan Bank long-term borrowings

     4,500    

Other long-term bor