Form 10-Q
Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

 

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

For the quarterly period ended June 30, 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 July 31, 2008, there were 346,497,190 shares of the registrant’s common stock ($5 par value) outstanding.


Table of Contents

The PNC Financial Services Group, Inc.

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

 

PART I – FINANCIAL INFORMATION    Pages

Item 1.     Financial Statements (Unaudited).

   42-73

Consolidated Income Statement

   42

Consolidated Balance Sheet

   43

Consolidated Statement Of Cash Flows

   44

Notes To Consolidated Financial Statements (Unaudited)

  

Note 1     Accounting Policies

   45

Note 2     Acquisitions And Divestitures

   52

Note 3     Variable Interest Entities

   52

Note 4     Securities

   54

Note 5     Asset Quality

   56

Note 6     Fair Value

   56

Note 7     Goodwill And Other Intangible Assets

   60

Note 8     Capital Securities Of Subsidiary Trusts

   61

Note 9     Certain Employee Benefit And Stock-Based Compensation Plans

   62

Note 10   Financial Derivatives

   63

Note 11   Earnings Per Share

   66

Note 12   Shareholders’ Equity And Other Comprehensive Income

   67

Note 13   Summarized Financial Information Of BlackRock

   68

Note 14   Legal Proceedings

   68

Note 15   Commitments And Guarantees

   68

Note 16   Segment Reporting

   71
  

Statistical Information (Unaudited)

  

Average Consolidated Balance Sheet And Net Interest Analysis

   74-75

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

   1-41

Financial Review

  

Consolidated Financial Highlights

   1-2

Executive Summary

   3

Consolidated Income Statement Review

   6

Consolidated Balance Sheet Review

   10

Off-Balance Sheet Arrangements And Variable Interest Entities

   14

Fair Value Measurements And Fair Value Option

   17

Business Segments Review

   20

Critical Accounting Policies And Judgments

   28

Status Of Qualified Defined Benefit Pension Plan

   28

Risk Management

   29

Internal Controls And Disclosure Controls And Procedures

   38

Glossary Of Terms

   38

Cautionary Statement Regarding Forward-Looking Information

   40

Item 3.     Quantitative and Qualitative Disclosures About Market Risk.

   29-37

Item 4.     Controls and Procedures.

   38

PART II – OTHER INFORMATION

  

Item 1.     Legal Proceedings.

   76

Item 1A.  Risk Factors.

   76

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

   76

Item 6.     Exhibits.

   76

Exhibit Index.

   76

Signature

   76

Corporate Information

   77


Table of Contents

FINANCIAL REVIEW

CONSOLIDATED FINANCIAL HIGHLIGHTS

THE PNC FINANCIAL SERVICES GROUP, INC.

 

Dollars in millions, except per share data    Three months ended
June 30
     Six months ended
June 30
 
Unaudited        2008      2007              2008             2007      

FINANCIAL PERFORMANCE (a)

            

Revenue

            

Net interest income

   $ 977      $ 738      $ 1,831     $ 1,361  

Noninterest income

     1,062        975        2,029       1,966  

Total revenue

   $ 2,039      $ 1,713      $ 3,860     $ 3,327  

Noninterest expense

   $ 1,115      $ 1,040      $ 2,157     $ 1,984  

Net income

   $ 505      $ 423      $ 882     $ 882  

Per common share

            

Diluted earnings

   $ 1.45      $ 1.22      $ 2.54     $ 2.67  

Cash dividends declared

   $ .66      $ .63      $ 1.29     $ 1.18  

SELECTED RATIOS

            

Net interest margin (b)

     3.47 %      3.03 %      3.28 %     3.00 %

Noninterest income to total revenue

     52        57        53       59  

Efficiency (c)

     55        61        56       60  

Return on

            

Average common shareholders’ equity

     13.99 %      11.61 %      12.32 %     13.39 %

Average assets

     1.44        1.38        1.26       1.54  

See page 38 for a glossary of certain terms used in this Report.

Certain prior period amounts have been reclassified to conform with the current period presentation.

(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) Calculated as annualized taxable-equivalent net interest income divided by average earning assets. The interest income earned on certain earning assets is completely or partially exempt from federal income tax. As such, these tax-exempt instruments typically yield lower returns than taxable investments. To provide more meaningful comparisons of margins for all earning assets, we use net interest income on a taxable-equivalent basis in calculating net interest margin 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 taxable-equivalent adjustments to net interest income for the three months ended June 30, 2008 and June 30, 2007 were $10 million and $8 million, respectively. The taxable-equivalent adjustments to net interest income for the six months ended June 30, 2008 and June 30, 2007 were $19 million and $14 million, respectively.
(c) Calculated as noninterest expense divided by total revenue.

 

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Unaudited    June 30
2008
    December 31
2007
           June 30    
2007
 

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

           

Assets

   $ 142,771     $ 138,920        $ 125,651  

Loans, net of unearned income

     73,040       68,319          64,714  

Allowance for loan and lease losses

     988       830          703  

Securities available for sale

     31,032       30,225          25,903  

Loans held for sale

     2,288       3,927          2,562  

Goodwill and other intangibles

     9,928       9,551          8,658  

Equity investments

     6,376       6,045          5,584  

Deposits

     84,689       82,696          77,221  

Borrowed funds

     32,472       30,931          24,516  

Shareholders’ equity

     15,108       14,854          14,504  

Common shareholders’ equity

     14,602       14,847          14,497  

Book value per common share

     42.17       43.60          42.36  

Common shares outstanding (millions)

     346       341          342  

Loans to deposits

     86 %     83 %        84 %
 

ASSETS ADMINISTERED (billions)

           

Managed

   $ 66     $ 73        $ 77  

Nondiscretionary

     111       113          111  
 

FUND ASSETS SERVICED (billions)

           

Accounting/administration net assets

   $ 988     $ 990        $ 868  

Custody assets

     471       500          467  
 
CAPITAL RATIOS            

Tier 1 risk-based (a)

     8.2 %     6.8 %        8.3 %

Total risk-based (a)

     11.9       10.3          11.8  

Leverage (a)

     7.3       6.2          7.3  

Tangible common equity

     4.3       4.7          5.5  

Common shareholders’ equity to assets

     10.2       10.7          11.5  
 
ASSET QUALITY RATIOS            

Nonperforming loans to total loans

     .95 %     .66 %        .36 %

Nonperforming assets to total loans and foreclosed assets

     1.00       .72          .40  

Nonperforming assets to total assets

     .51       .36          .21  

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

     .62       .49          .20  

Allowance for loan and lease losses to loans

     1.35       1.21          1.09  

Allowance for loan and lease losses to nonperforming loans

     142       183          303  
(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 investment servicing. 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 investment servicing internationally.

KEY STRATEGIC GOALS

We manage our company for the long term by focusing on maintaining a moderate risk profile, investing in our markets and products, and embracing our corporate responsibility to the communities where we do business.

Our strategy to enhance shareholder value centers on driving positive operating leverage by achieving growth in revenue from our balance sheet and 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 solutions, 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.

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.

RECENT ACQUISITION AND DIVESTITURE ACTIVITY

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 was a banking and financial services company with approximately $3.2 billion in assets, $2.7 billion in deposits, and 65 branches in south-central Pennsylvania, northern Maryland and northern Delaware.

As previously reported, 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. Business segment information for the periods presented in this report reflects the reclassification of results for Hilliard Lyons, including the gain on the sale of this business, from the Retail Banking business segment to “Other.”

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.


 

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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 continue to 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,

   

The successful integration of our recent acquisitions,

   

Continued development of the markets related to our recent acquisitions, 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     Six months ended  
In millions, except per share data   June 30
2008
    June 30
2007
    June 30
2008
    June 30
2007
 

Net income

  $ 505     $ 423     $ 882     $ 882  

Diluted earnings per share

  $ 1.45     $ 1.22     $ 2.54     $ 2.67  

Return on

         

Average common shareholders’ equity

    13.99 %     11.61 %     12.32 %     13.39 %

Average assets

    1.44 %     1.38 %     1.26 %     1.54 %

Highlights of the second quarter of 2008 included the following:

   

Net interest income grew 32% in the second quarter of 2008 compared with the second quarter of 2007 reflecting a significant decline in funding costs. The net interest margin expanded to 3.47% compared with 3.03% in the second quarter of 2007.

   

Noninterest income increased 9% compared with the second quarter of 2007. Diversity of noninterest revenue continued to differentiate us.

   

Net income for the second quarter of 2008 included an after-tax gain of $52 million, or $.15 per diluted share, on the mark to market of our BlackRock long-term incentive plan (LTIP) shares obligation and $24 million, or $.07 per diluted share, of after-tax integration costs.

   

Average loans increased 15% and average deposits increased 7% in the second quarter of 2008 compared with the second quarter of 2007.

   

Certain market risk positions were lowered during the second quarter via a reduction of commercial mortgage loans held for sale intended for securitization by approximately 23% and trading assets by approximately 22%, resulting in increased hedge coverage in connection with these activities.

   

Overall asset quality continued to be manageable in a challenging credit environment. Coverage ratio of the

 

allowance for loan and lease losses to total loans improved to 1.35% at June 30, 2008 from 1.21% at December 31, 2007.

   

We continued to maintain a strong capital position. Our Tier 1 risk-based capital ratio increased to 8.2% at June 30, 2008 compared with 6.8% at December 31, 2007.

In addition, we created positive operating leverage by growing revenue while controlling noninterest expense. Revenue growth of 16% in the first half of 2008 compared with the same period in 2007 exceeded noninterest expense growth of 9% for the same periods.

Our Consolidated Income Statement Review section of this Financial Review describes in greater detail the various items that impacted our results for the second quarter and first half of 2008 and 2007.

BALANCE SHEET HIGHLIGHTS

Total assets were $142.8 billion at June 30, 2008 compared with $138.9 billion at December 31, 2007. Total average assets were $141.0 billion for the first six months of 2008 compared with $115.4 billion for the first six months of 2007. This increase reflected a $20.6 billion increase in average interest-earning assets and a $5.0 billion increase in average noninterest-earning assets. An increase of $12.2 billion in loans and a $5.8 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 half of 2008 reflected an increase in average goodwill of $2.3 billion primarily related to the acquisition of Sterling on April 4, 2008, Yardville National Bancorp (“Yardville”) on October 26, 2007 and Mercantile Bankshares Corporation (“Mercantile”) on March 2, 2007.

The impact of the Sterling, Yardville and Mercantile 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 $71.1 billion for the first six months of 2008 and $58.8 billion in the first six months of 2007. The increase in average total loans included growth in commercial loans of $6.7 billion, consumer loans of $2.3 billion, residential mortgage loans of $1.7 billion and commercial real estate loans of $1.6 billion. Loans represented 63% of average interest-earning assets for the first six months of 2008 and 64% for the first six months of 2007.

Average securities available for sale totaled $30.7 billion for the first half of 2008 and $24.9 billion for the first half of 2007. Average residential and commercial mortgage-backed securities increased $4.6 billion on a combined basis in the comparison. In addition, asset-backed securities increased $.9 billion in the first six months of 2008 compared with the prior


 

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year six-month period. Securities available for sale comprised 27% of average interest-earning assets for the first six months of both 2008 and 2007.

Average total deposits were $82.8 billion for the first six months of 2008, an increase of $8.8 billion over the first six months of 2007. Average deposits grew from the prior year period primarily as a result of increases in money market balances, other time deposits, time deposits in foreign offices, and demand and other noninterest-bearing deposits.

Average total deposits represented 59% of average total assets for the first half of 2008 and 64% for the first half of 2007. Average transaction deposits were $54.1 billion for the first six months of 2008 compared with $49.2 billion for the first six months of 2007.

Average borrowed funds were $31.6 billion for the first six months of 2008 and $19.1 billion for the first six months of 2007. Increases of $8.8 billion in Federal Home Loan Bank borrowings, $1.8 billion in bank notes and senior debt and $1.4 billion in other borrowed funds drove the increase compared with the first half of 2007.

Shareholders’ equity totaled $15.1 billion at June 30, 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 were $663 million for the first six months of 2008 and $846 million for the first six months of 2007. Second quarter 2008 business segment earnings of $376 million decreased $58 million compared with the second quarter of 2007. Results for 2008 were impacted by a lower assigned revenue value for deposits in the current interest rate environment as well as the impact of net valuation adjustments on certain illiquid assets. Notwithstanding these factors, our business segments made significant progress in growing loans and deposits, adding customers and investing in products and services.

Highlights of results for the second quarter and first half 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 $335 million for the first half of 2008 compared with $419 million for the first half of 2007. The 20% decline in earnings over the prior year was driven by increases in expenses and the provision for credit losses, partially offset by benefits from the first quarter 2008 gain related to the Visa initial public offering and the net benefits from acquisitions.

 

Retail Banking’s earnings were $140 million for the second quarter of 2008 compared with $222 million for the same period in 2007. The decline from the prior year second quarter was driven by an increase in the provision for credit losses and lower net interest income.

Corporate & Institutional Banking

Corporate & Institutional Banking earned $136 million in the first six months of 2008 compared with $254 million in the first six months of 2007. Earnings in 2008 were impacted by pretax valuation losses of $156 million on commercial mortgage loans and commitments held for sale, net of hedges, and increases in the provision for credit losses and noninterest expenses, partially offset by higher net interest income.

For the second quarter of 2008, earnings from Corporate & Institutional Banking totaled $134 million compared with $122 million for the second quarter of 2007. Higher earnings in the second quarter of 2008 reflected higher revenue partially offset by increases in the provision for credit losses and noninterest expense.

BlackRock

Our BlackRock business segment earned $129 million for the first six months of 2008, a 17% increase compared with $110 million for the first six months of 2007. Earnings from our BlackRock business segment totaled $69 million for the second quarter of 2008 compared with $58 million for the second quarter of 2007.

Global Investment Servicing

Our Global Investment Servicing business segment, formerly PFPC, earned $63 million for the first six months of both 2008 and 2007. Earnings from Global Investment Servicing totaled $33 million in the second quarter of 2008 compared with $32 million in the second quarter of 2007. In the quarter comparison, increases in servicing revenue resulting from the impact of acquisitions and growth in offshore operations were offset by higher operating expenses resulting from investments in technology, a larger employee base to support business growth and costs related to acquisitions.

Other

“Other” earnings for the first half of 2008 totaled $219 million compared with earnings of $36 million for the first half of 2007. The first quarter 2008 gain on the sale of Hilliard Lyons, higher gains from PNC’s LTIP obligation in 2008, the first quarter 2008 partial reversal of the Visa indemnification liability and growth in net interest income related to asset and liability management activities, partially offset by lower trading results, drove the higher earnings in the comparison.

For the second quarter of 2008, “Other” earnings totaled $129 million compared with a net loss of $11 million in the second quarter of 2007. Higher earnings in the second quarter of 2008 were mainly due to higher net interest income and a net gain related to PNC’s LTIP obligation compared with a net loss in the prior year quarter.


 

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CONSOLIDATED INCOME STATEMENT REVIEW

Our Consolidated Income Statement is presented in Part I, Item 1 of this Report. Net income for the first six months of both 2008 and 2007 was $882 million. Net income for the second quarter of 2008 was $505 million compared with net income of $423 million for the second quarter of 2007. Total revenue for the first six months of 2008 increased 16% compared with the first six months of 2007. We created positive operating leverage as total noninterest expense increased 9% in the comparison.

NET INTEREST INCOME AND NET INTEREST MARGIN

 

    Three months ended     Six months ended  
Dollars in millions   June 30
2008
    June 30
2007
    June 30
2008
    June 30
2007
 

Net interest income

  $ 977     $ 738     $ 1,831     $ 1,361  

Net interest margin

    3.47 %     3.03 %     3.28 %     3.00 %

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 35% increase in net interest income for the first six months of 2008 compared with the first six months of 2007 was favorably impacted by the $20.6 billion, or 22%, increase in average interest-earning assets. Similarly, the 32% increase in net interest income for the second quarter of 2008 compared with the second quarter of 2007 reflected the $15.2 billion, or 15%, increase in average interest-earning assets over this period and a decrease in funding costs. Wider net interest margins also benefited the 2008 periods in both the second quarter and first half comparisons. The reasons driving the higher interest-earning assets in these comparisons are further discussed in the Balance Sheet Highlights portion of the Executive Summary section of this Financial Review.

We expect net interest income growth will exceed 28% for full year 2008 compared with 2007, assuming our current expectations for interest rates and economic conditions. We include our current economic assumptions underlying our forward-looking statements in the Cautionary Statement Regarding Forward-Looking Information section of this Financial Review.

The net interest margin was 3.28% for the first half of 2008 and 3.00% for the first half of 2007. The following factors impacted the comparison:

   

A decrease in the rate paid on interest-bearing liabilities of 114 basis points. The rate paid on interest-bearing deposits, the single largest component, decreased 102 basis points.

   

These factors were partially offset by a 58 basis point decrease in the yield on interest-earning assets. The yield on loans, the single largest component, decreased 79 basis points.

   

In addition, the impact of noninterest-bearing sources of funding decreased 28 basis points due to lower interest rates and a lower proportion of noninterest-bearing sources of funding to interest-earning assets.

The net interest margin was 3.47% for the second quarter of 2008 and 3.03% for the second quarter of 2007. The following factors impacted the comparison:

   

A decrease in the rate paid on interest-bearing liabilities of 151 basis points. The rate paid on interest-bearing deposits, the single largest component, decreased 132 basis points.

   

These factors were partially offset by a 76 basis point decrease in the yield on interest-earning assets. The yield on loans, the single largest component, decreased 105 basis points.

   

In addition, the impact of noninterest-bearing sources of funding decreased 31 basis points due to lower interest rates and a lower proportion of noninterest-bearing sources of funding to interest-earning assets.

For comparing to the broader market, during the first six months of 2008 the average federal funds rate was 2.62% compared with 5.25% for the first six months of 2007. The average federal funds rate was 2.09% for the second quarter of 2008 compared with 5.25% for the second quarter 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.

NONINTEREST INCOME

Summary

Noninterest income totaled $2.029 billion for the first six months of 2008 compared with $1.966 billion for the first six months of 2007.

Noninterest income for the first half of 2008 included the following:

   

Income from Hilliard Lyons totaling $164 million, including the first quarter gain of $114 million from the sale of this business,

   

Gains of $120 million related to our BlackRock LTIP shares adjustment,

   

A first quarter 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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Equity management gains and net securities gains totaling $56 million,

   

Valuation losses related to our commercial mortgage loans and commitments held for sale, net of hedges, of $156 million, and

   

Trading losses of $23 million.

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

   

Income from Hilliard Lyons totaling $113 million,

   

Trading income of $81 million,

   

A net gain related to our equity investment in BlackRock of $51 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 loss totaling $31 million on our remaining BlackRock LTIP shares obligation, and

   

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

Apart from the impact of these items, noninterest income increased $84 million, or 5%, for the first six months of 2008 compared with the first six months of 2007.

Noninterest income totaled $1.062 billion for the second quarter of 2008 compared with $975 million for the second quarter of 2007. The second quarter of 2008 included a gain of $80 million related to our BlackRock LTIP shares adjustment. In addition, the second quarter of 2007 included income from Hilliard Lyons of $58 million. Apart from the impact of these items, noninterest income increased $65 million, or 7%, in this comparison.

Additional Analysis

Fund servicing fees increased $50 million, to $462 million, in the first six months of 2008 compared with the first six months of 2007. Fund servicing fees totaled $234 million in the second quarter of 2008 compared with $209 million in the second quarter of 2007. The increases in both comparisons primarily resulted from the December 2007 acquisition of Albridge Solutions Inc. and growth in Global Investment Servicing’s offshore operations.

Global Investment Servicing provided fund accounting/administration services for $988 billion of net fund investment assets and provided custody services for $471 billion of fund investment assets at June 30, 2008, compared with $868 billion and $467 billion, respectively, at June 30, 2007. Global Investment Servicing experienced both organic growth and growth from new business in each of its product areas.

Asset management fees totaled $409 million in the first half of 2008, an increase of $54 million compared with the first half of 2007. For the second quarter of 2008, asset management fees totaled $197 million compared with $190 million in the

second quarter of 2007. Higher equity earnings from our BlackRock investment was reflected in both 2008 increases and our March 2007 acquisition of Mercantile impacted the six-month comparison. These factors more than offset the effect on fees of an $11 billion decrease in assets managed related to wealth management. Assets managed at June 30, 2008 totaled $66 billion compared with $77 billion at June 30, 2007. The decrease reflected the Hilliard Lyons sale and the impact of comparatively lower equity markets in the first six months of 2008.

Consumer services fees declined $17 million, to $319 million, for the first six months of 2008 compared with the first six months of 2007. For the second quarter of 2008, consumer services fees totaled $149 million compared with $179 million in the second quarter of 2007. In both comparisons, the sale of Hilliard Lyons more than offset the benefits of higher debit card and credit card revenues. The impact of expansion into new markets contributed to higher debit card revenue in the six-month comparison.

Corporate services revenue totaled $349 million in the first half of 2008 compared with $335 million in the first half of 2007. Corporate services revenue increased $9 million, to $185 million, in the second quarter of 2008 compared with the prior year quarter. Higher revenue from treasury management and third party consumer loan servicing activities, partially offset by lower revenue related to merger and acquisition advisory fees, were the primary factors in both increases.

Service charges on deposits grew $5 million, to $174 million, in the first six months of 2008 compared with the first six months of 2007, and reflected the impact of our expansion into new markets. Service charges on deposits totaled $92 million for the second quarter of both 2008 and 2007.

Net securities gains totaled $40 million for the first half of 2008 compared with net securities losses of $2 million in the first half of 2007.

Other noninterest income totaled $276 million for the first six months of 2008 compared with $361 million for the first six months of 2007.

Other noninterest income for the first six months of 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 $120 million related to our BlackRock LTIP shares adjustment. The impact of these items was partially offset by valuation losses related to our commercial mortgage loans and commitments held for sale, net of hedges, of $156 million, impairments relating to our equity investments of $26 million and trading losses of $23 million.


 

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Trading income of $81 million and a net gain related to our BlackRock LTIP shares adjustment of $51 million were included in other noninterest income for the first six months of 2007.

For the second quarter of 2008, other noninterest income totaled $206 million compared with $128 million for the second quarter of 2007. The second quarter of 2008 included the $80 million gain related to our BlackRock LTIP shares adjustment.

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 mid-teens percentage for full year 2008 compared with full year 2007, assuming our current expectations for interest rates and economic conditions. We also expect 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.

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 mortgage loan servicing, that are marketed by several businesses to commercial and retail customers across PNC.

Revenue from capital markets-related products and services totaled $180 million in the first half of 2008 compared with $143 million in the first half of 2007. Revenue totaled $104 million for the second quarter of 2008 compared with $76 million for the second quarter of 2007. These increases were primarily driven by strong customer interest rate derivative and foreign exchange 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 19% to $266 million in the first six months of 2008 compared with $224 million for the first six months of 2007. The higher revenue reflected the impact of our expansion into new markets and strong growth in the commercial payment card

services and in cash and liquidity management products. For the second quarter of 2008, treasury management revenue totaled $133 million compared with $114 million in the second quarter of 2007.

Commercial mortgage banking activities include revenue derived from loan originations, commercial mortgage servicing (including net interest income and noninterest income from loan servicing and ancillary services), gains on sales of loans held for sale, net interest income on loans held for sale, and mark-to-market valuation adjustments on held for sale commercial mortgage loans intended for securitization and related commitments and derivative valuations. Commercial mortgage banking activities resulted in revenue of $9 million in the first six months of 2008 compared with $140 million in the first six months of 2007. The first half of 2008 included valuation losses of $156 million on commercial mortgage loans and commitments held for sale, net of hedges, due to the impact of an illiquid market in most of the first half of 2008.

For the second quarter of 2008, revenue from commercial mortgage banking activities totaled $105 million compared with $67 million in the second quarter of 2007. The increase reflected a $21 million positive valuation adjustment, net of hedges, and higher net interest income in the second quarter of 2008.

PROVISION FOR CREDIT LOSSES

The provision for credit losses totaled $337 million for the first six months of 2008 compared with $62 million for the first six months of 2007. The provision for credit losses for the second quarter of 2008 totaled $186 million compared with $54 million for the second quarter of 2007. The higher provision in both comparisons was driven by general credit quality migration, especially in the residential real estate development sector of our commercial real estate portfolio. Total residential real estate development outstandings were approximately $2.1 billion at June 30, 2008. Growth in our total credit exposure also contributed to the higher provision amounts in both comparisons.

Given our projections for loan growth and continued credit deterioration, and our current assumptions for the national economy, we expect that the provision for credit losses will be approximately $750 million for full year 2008, including the impact of the Sterling acquisition. However, we believe that increased operating leverage will be more than adequate to cover increased credit costs in 2008.

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.


 

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NONINTEREST EXPENSE

Total noninterest expense was $2.157 billion for the first six months of 2008 and $1.984 billion for the first six months of 2007. Noninterest expense totaled $1.115 billion for the second quarter of 2008 compared with $1.040 billion for the second quarter of 2007.

Noninterest expense for the first half of 2008 included the benefit of the first quarter 2008 reversal of $43 million of the $82 million Visa indemnification liability that we established in the fourth 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.

Higher noninterest expense in both the second quarter and first half comparisons with 2007 primarily resulted from investments in growth initiatives, including acquisitions, partially offset by the impact of the sale of Hilliard Lyons and disciplined expense management.

Integration costs included in noninterest expense totaled $27 million for the first half of 2008 and $26 million for the first

half of 2007. Integration costs in the second quarter of 2008 totaled $13 million compared with $15 million in the second quarter of 2007.

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

PERIOD-END EMPLOYEES

 

     June 30 2008    December 31 2007    June 30 2007

Full-time

   25,667    25,480    25,026

Part-time

   2,938    2,840    3,028
    

Total

   28,605    28,320    28,054

EFFECTIVE TAX RATE

Our effective tax rate was 35.4% for the first six months of 2008 and 31.1% for the first six months of 2007. The higher effective tax rate for the first six months 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 33% for full year 2008.


 

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CONSOLIDATED BALANCE SHEET REVIEW

SUMMARIZED BALANCE SHEET DATA

 

In millions    June 30
2008
   December 31
2007

Assets

       

Loans, net of unearned income

   $ 73,040    $ 68,319

Securities available for sale

     31,032      30,225

Cash and short-term investments

     9,245      10,425

Loans held for sale

     2,288      3,927

Equity investments

     6,376      6,045

Goodwill and other intangible assets

     9,928      9,551

Other

     10,862      10,428
 

Total assets

   $ 142,771    $ 138,920

Liabilities

       

Funding sources

   $ 117,161    $ 113,627

Other

     8,493      8,785
 

Total liabilities

     125,654      122,412

Minority and noncontrolling interests in consolidated entities

     2,009      1,654

Total shareholders’ equity

     15,108      14,854
 

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

   $ 142,771    $ 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 $4.7 billion, to $73.0 billion, at June 30, 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    June 30
2008
    December 31
2007
 

Commercial

      

Retail/wholesale

   $ 6,374     $ 5,973  

Manufacturing

     5,322       4,705  

Other service providers

     3,670       3,529  

Real estate related (a)

     6,101       5,425  

Financial services

     1,452       1,268  

Health care

     1,637       1,446  

Other

     6,419       6,261  

Total commercial

     30,975       28,607  

Commercial real estate

      

Real estate projects

     6,539       6,114  

Mortgage

     2,912       2,792  

Total commercial real estate

     9,451       8,906  

Lease financing

     3,522       3,500  

Total commercial lending

     43,948       41,013  

Consumer

      

Home equity

     14,735       14,447  

Education

     2,117       132  

Automobile

     1,590       1,513  

Other

     2,245       2,234  

Total consumer

     20,687       18,326  

Residential mortgage

     9,047       9,557  

Other

     292       413  

Unearned income

     (934 )     (990 )

Total, net of unearned income

   $ 73,040     $ 68,319  
(a) Includes loans to customers in the real estate and construction industries.

Total loans represented 51% of total assets at June 30, 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 June 30, 2008 were in residential real estate development. These represented approximately 3% of total loans and less than 2% of total assets at June 30, 2008.

Our home equity loan outstandings totaled $14.7 billion at June 30, 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 $544 million or approximately 4% of the total portfolio in this grouping at June 30, 2008. Consistent with the entire home equity portfolio, approximately 94% of these higher-risk loans are located in our geographic footprint. In our $9.0 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 $152 million and comprised approximately 2% of this portfolio at June 30, 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 $886 million, or 90%, of the total allowance for loan and lease losses at June 30, 2008 to these loans. We allocated $90 million, or 9%, of the remaining allowance at that date to consumer loans and $12 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    June 30
2008
   December 31
2007

Commercial

   $ 37,127    $ 39,171

Consumer

     11,394      10,875

Commercial real estate

     2,525      2,734

Other

     512      567

Total

   $ 51,558    $ 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 reported net of participations, assignments and syndications totaled $7.9 billion at June 30, 2008 and $8.9 billion at December 31, 2007. The decrease from December 31, 2007 was primarily due to Market Street.

Unfunded liquidity facility commitments and standby bond purchase agreements totaled $7.5 billion at June 30, 2008 and $9.4 billion at December 31, 2007 and are included in the preceding table primarily within the “Commercial” and “Consumer” categories. The decrease from December 31, 2007 was primarily due to Market Street.

In addition to credit commitments, our net outstanding standby letters of credit totaled $5.7 billion at June 30, 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

June 30, 2008

       

Debt securities

       

Residential mortgage-backed

   $ 22,175    $ 20,707

Commercial mortgage-backed

     5,884      5,754

Asset-backed

     3,568      3,162

US Treasury and government agencies

     32      33

State and municipal

     799      776

Other debt

     259      255

Corporate stocks and other

     349      345

Total securities available for sale

   $ 33,066    $ 31,032

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 22% of total assets at both June 30, 2008 and December 31, 2007.

At June 30, 2008, securities available for sale included a net pretax unrealized loss of $2.0 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. The fair value of securities available for sale is impacted by interest rates, credit spreads, volatility and illiquidity. We believe that substantially all of the decline in value of these securities is attributable to changes in credit spreads and not from deterioration in the credit quality of individual securities or underlying collateral, where applicable. However, if the current issues affecting the US housing market were to continue for the foreseeable future or worsen, or if market volatility and illiquidity were to continue or worsen, or if market interest rates were to increase appreciably, the valuation of our available for sale securities portfolio could be adversely affected. 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 Measurements and Fair Value Option section of this Financial Review includes information regarding other-than-temporary impairments totaling $9 million that we recognized during the second quarter of 2008.

The expected weighted-average life of securities available for sale (excluding corporate stocks and other) was 4 years and 3 months at June 30, 2008 and 3 years and 6 months at December 31, 2007.

We estimate that at June 30, 2008 the effective duration of securities available for sale was 3.4 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    June 30
2008
   December 31
2007

Commercial mortgage

   $ 1,864    $ 2,116

Residential mortgage

     102      117

Education

        1,525

Other

     322      169

Total

   $ 2,288    $ 3,927

During the second quarter of 2008, we reduced our inventory of commercial mortgage loans held for sale via securitizations by approximately $.5 billion, to $1.6 billion, and recognized a positive valuation adjustment for loans and commitments of $21 million, net of hedges. In early 2008, spreads widened and there was limited activity in the commercial real estate loan securitization market. During the first quarter of 2008, we recorded a negative valuation adjustment for loans and commitments of $177 million, net of hedges. These loans are recorded at fair value. The valuation adjustments were 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. If conditions similar to early 2008 recur, 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. We are not currently originating commercial mortgages for distribution through commercial real estate loan securitizations. We intend to pursue opportunities to further reduce our commercial mortgage loans held for sale position during the remainder of 2008 if we can receive prices we feel are appropriate.

 

We previously classified substantially all of our education loans as loans held for sale as we sold education loans to issuers of asset-backed paper when the loans were placed into repayment status. During 2008, 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 did not sell education loans during the second quarter of 2008 and do not anticipate sales of these loans in the foreseeable future.

FUNDING AND CAPITAL SOURCES

Details Of Funding Sources

 

In millions    June 30
2008
   December 31
2007

Deposits

       

Money market

   $ 38,772    $ 32,785

Demand

     18,171      20,861

Retail certificates of deposit

     16,618      16,939

Savings

     2,801      2,648

Other time

     5,239      2,088

Time deposits in foreign offices

     3,088      7,375

Total deposits

     84,689      82,696

Borrowed funds

       

Federal funds purchased

     7,343      7,037

Repurchase agreements

     1,887      2,737

Federal Home Loan Bank borrowings

     9,572      7,065

Bank notes and senior debt

     5,804      6,821

Subordinated debt

     5,169      4,506

Other

     2,697      2,765

Total borrowed funds

     32,472      30,931

Total

   $ 117,161    $ 113,627

Total funding sources increased $3.5 billion, or 3%, at June 30, 2008 compared with December 31, 2007.

Total deposits increased $2.0 billion, or 2%, as higher money market balances and other time deposits more than offset declines in demand and time deposits in foreign offices. Total borrowed funds increased $1.5 billion, or 5%, at June 30, 2008 compared with the prior year end primarily due to the increase of $2.5 billion in Federal Home Loan Bank (“FHLB”) borrowings, partially offset by reductions in bank notes and senior debt and repurchase agreements. The Liquidity Risk Management portion of the Risk Management section of this Financial Review includes additional information regarding our 2008 borrowed funds activities.


 

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Capital

We manage our capital position by making adjustments to our balance sheet size and composition, issuing subordinated debt, equity or hybrid instruments, executing treasury stock transactions, maintaining dividend policies and retaining earnings. In April 2008, we announced a 5% increase of the cash dividend on our common stock, to 66 cents per share. Also, the Liquidity Risk Management section of this Report describes our May 2008 Series K preferred stock issuance.

Total shareholders’ equity increased $.3 billion, to $15.1 billion, at June 30, 2008 compared with December 31, 2007. In addition to net income, the Series K preferred stock issuance and new common shares issued in connection with the Sterling acquisition more than offset the impact of dividends and an increase in accumulated other comprehensive loss in the first six months of 2008. The increase in accumulated other comprehensive loss was primarily due to higher net unrealized losses on available for sale securities that reflected market illiquidity.

Common shares outstanding totaled 346 million at June 30, 2008 and 341 million at December 31, 2007. PNC issued approximately 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 half 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 And Tangible Capital

 

Dollars in millions    June 30
2008
    December 31
2007
 

Capital components

      

Shareholders’ equity

      

Common

   $ 14,602     $ 14,847  

Preferred

     506       7  

Trust preferred capital securities

     1,106       572  

Minority interest

     1,352       985  

Goodwill and other intangible assets

     (9,238 )     (8,853 )

Eligible deferred income taxes on intangible assets

     111       119  

Pension, other postretirement benefit
plan adjustments

     122       177  

Net unrealized securities losses,
after-tax

     1,283       167  

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

     (162 )     (175 )

Equity investments in
nonfinancial companies

     (42 )     (31 )

Tier 1 risk-based capital

     9,640       7,815  

Subordinated debt

     3,225       3,024  

Eligible allowance for credit losses

     1,112       964  

Total risk-based capital

   $ 13,977     $ 11,803  

Assets

      

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

   $ 117,549     $ 115,132  

Adjusted average total assets

     132,935       126,139  

Capital ratios

      

Tier 1 risk-based

     8.2 %     6.8 %

Total risk-based

     11.9       10.3  

Leverage

     7.3       6.2  

Tangible common equity

      

Common shareholders’ equity

   $ 14,602     $ 14,847  

Goodwill and other intangible assets

     (9,238 )     (8,853 )

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

     401       119  

Tangible common equity

   $ 5,765     $ 6,113  

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

   $ 133,934     $ 130,185  

Tangible common equity ratio

     4.3 %     4.7 %
(a) As of June 30, 2008, deferred taxes on taxable combinations were added to eligible deferred income taxes for non-taxable combinations that are used in the calculation of the tangible common equity ratio.

The tangible common equity information provided in the table above does not reflect the full value of our equity investment in BlackRock. As of June 30, 2008, the market value of our investment exceeded the book value by $3.3 billion. This unrecognized gain would have resulted in a $2.1 billion after-tax increase to our tangible common equity, to $7.9 billion. See additional information regarding our investment in BlackRock on page 26.

The access to, and cost of, funding new business initiatives including acquisitions, the ability to engage in expanded business activities, the ability to pay dividends, the level of deposit insurance costs, and the level and nature of regulatory oversight depend, in part, on a financial institution’s capital strength. At June 30, 2008, each of our domestic banking subsidiaries was considered “well-capitalized” based on US regulatory capital ratio requirements, which are indicated 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.”

Commitments, including contractual obligations and other commitments, are included within the Risk Management section of this Financial Review and in 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 that we have consolidated and those in which we hold a significant variable interest but have not consolidated into our financial statements as of June 30, 2008 and December 31, 2007.

Consolidated VIEs – PNC Is Primary Beneficiary

 

In millions   

Aggregate

Assets

   Aggregate
Liabilities

Partnership interests in low income housing projects

       

June 30, 2008

   $ 1,062    $ 1,062

December 31, 2007

   $ 1,110    $ 1,110

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
 

June 30, 2008

          

Market Street

   $ 4,582    $ 4,628    $ 7,230 (a)

Collateralized debt obligations

     47      1      5  

Partnership interests in low income housing projects

     50      34      8  

Total

   $ 4,679    $ 4,663    $ 7,243  

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 $7.0 billion and other credit enhancements of $.2 billion at June 30, 2008. The comparable amounts were $8.8 billion and $.2 billion at 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 six months of 2008, Market Street met all of its funding needs through the issuance of commercial paper.

Market Street commercial paper outstanding was $4.4 billion at June 30, 2008 and $5.1 billion at December 31, 2007. The weighted average maturity of the commercial paper was 31 days at June 30, 2008 compared with 32 days at December 31, 2007.

In the ordinary course of business during the first six months 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 $19 million and a June 30, 2008 position of zero. 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 Market Street commercial paper at December 31, 2007. PNC made no other purchases of Market Street commercial paper during 2007 or 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 commitment fees related to PNC’s portion of the liquidity facilities of $8 million and $2 million, respectively, for the six months ended June 30, 2008. The comparable amounts were $6 million and $2 million for the six months ended June 30, 2007.

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 June 30, 2008 and December 31, 2007 were effectively collateralized by Market Street’s assets. While PNC may be obligated to fund under the $7.0 billion of 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


 

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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. In addition, PNC would be required to fund $1.2 billion of the liquidity facilities if the underlying assets are in default. See Note 15 Commitments And Guarantees included in the Notes To Consolidated Financial Statements of this Report for additional information.

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. 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 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 $7.0 million as of June 30, 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

June 30, 2008 (a)

          

Trade receivables

   $ 1,522    $ 3,150    2.60

Automobile financing

     1,088      1,202    3.98

Collateralized loan obligations

     269      607    2.86

Credit cards

     400      400    .69

Residential mortgage

     14      14    27.50

Other

     1,141      1,307    1.68

Cash and miscellaneous
receivables

     148            

Total

   $ 4,582    $ 6,680    2.63

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 six months of 2008.

 

Market Street Commitments by Credit Rating (a)

 

      June 30,
2008
    December 31,
2007
 

AAA/Aaa

   14 %   19 %

AA/Aa

   5     6  

A/A

   78     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 the assets and liabilities of Market Street are not reflected in our Consolidated Balance Sheet.

We 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) related to Market Street as reconsideration events. We review 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 AA and Aa3 by Standard and Poor’s and Moody’s, respectively. This rating change has not impacted the Market Street commercial paper ratings of A1/P1. Various alternatives to the program-level enhancement are available if future rating changes impact either the ratings of Market Street commercial paper or its financial results.

Based on current accounting guidance, 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 commercial paper conduit at that time. Based on current accounting guidance, 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 June 30, 2008, the consolidation of Market Street would not have had a material impact on our risk-based capital ratios, credit ratings or debt covenants.

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%


 

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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.

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. PNC Capital Trusts C and D have similar protective provisions with respect to $500 million in principal amount of junior subordinated debentures.

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. 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.


 

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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 June 30, 2008, approximately 27% of our total assets were measured at fair value, consisting primarily of securities and other financial assets. Approximately 3% of our total liabilities were measured at fair value at that date. The corresponding amounts at March 31, 2008 were 28% and 4%, respectively.

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

 

     June 30, 2008
In millions    Level 1    Level 2    Level 3    Total Fair
Value

Assets

             

Securities available for sale

   $ 5,129    $ 24,749    $ 1,154    $ 31,032

Financial derivatives (a)

     25      2,283      85      2,393

Trading securities (b)

     624      1,509      30      2,163

Commercial mortgage loans held for sale (c)

           1,604      1,604

Customer resale agreements (d)

        1,001         1,001

Equity investments

           572      572

Other assets

            224      8      232

Total assets

   $ 5,778    $ 29,766    $ 3,453    $ 38,997

Liabilities

             

Financial derivatives (e)

   $ 30    $ 1,703    $ 154    $ 1,887

Trading securities sold short (f)

     1,278      93         1,371

Other liabilities

            234             234

Total liabilities

   $ 1,308    $ 2,030    $ 154    $ 3,492

 

(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.

 

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 our 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. The majority 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 June 30, 2008, our residential mortgage-backed securities portfolio was comprised of $9.8 billion fair value of US government agency-backed securities (substantially all classified as available for sale) and $11.0 billion fair value of private-issuer securities (substantially all 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


 

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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 higher risk (i.e., FICO scores of equal to or less than 660) 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 55% are vintage 2005 and earlier, approximately 24% are vintage 2006 and approximately 21% are vintage 2007 and 2008. At June 30, 2008, $10.9 billion, or 99%, of the private-issuer securities were rated “AAA” equivalents by at least two nationally recognized rating agencies. There were 11 private-issuer securities totaling $69 million fair value where at least one national rating agency rated the security either “AA” or “A” equivalent.

For one security, we recorded an other-than-temporary impairment charge of $7 million in the second quarter of 2008. Since June 30, 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 $6.4 billion fair value at June 30, 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 49% are vintage 2005 and earlier, approximately 35% are vintage 2006 and approximately 16% are vintage 2007 and 2008. At June 30, 2008, $6.3 billion, or 99%, 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 $52 million fair value where at least one national rating agency rated the security “AA” equivalent and three commercial mortgage-backed securities totaling $4 million where at least one national rating agency rated the security “BBB” equivalent.

Since June 30, 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 $3.2 billion fair value at June 30, 2008 (substantially all 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 $1.3 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 higher risk credit quality. Of the total asset-backed securities collateralized by fixed- and floating-rate home equity loans, approximately 39% are vintage 2005 and earlier, approximately 25% are vintage 2006 and approximately 36% are vintage 2007. At June 30, 2008, $3.0 billion, or 94%, of the other asset-backed securities were rated “AAA” equivalents by at least two nationally recognized rating agencies. There were five asset-backed securities totaling $63 million fair value where at least one national rating agency rated the security “AA” equivalent, 11 asset-backed securities totaling $130 million fair value where the rating was between “AA” equivalent and “BBB” equivalent, and two asset-backed securities totaling $6 million fair value where the rating was lower than “BBB” equivalent.

For both of the securities rated lower than “BBB” equivalent, we recorded other-than-temporary impairment charges totaling approximately $2 million in the second quarter of 2008. Since June 30, 2008, no significant deterioration in the credit ratings assigned to the other asset-backed securities has occurred.

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.


 

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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 both June 30, 2008 and March 31, 2008.

Assets and liabilities measured using Level 3 inputs represented $3.5 billion or 9% of total assets measured at fair value and $154 million or 4% of total liabilities measured at fair value at June 30, 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.

During the second quarter of 2008, securities transferred into Level 3 from Level 2 exceeded securities transferred out by $527 million. These primarily related to asset-backed securities, taxable auction rate securities, and residential mortgage-backed securities, and occurred due to reduced volume of recently executed transactions and the lack of corroborating market price quotations for these instruments.

As indicated in the table on page 17, our largest category of Level 3 assets consists of certain commercial mortgage loans held for sale.

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 were based on exit prices at June 30, 2008 reflecting an illiquid securitization market for these loans. However, it is our intention to continue to reduce the size of this portfolio.

Total securities measured at fair value at June 30, 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. In addition, other-than-temporary impairments on available for sale securities would 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 investment servicing 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 net interest revenue on a taxable-equivalent basis and income statement classification differences related to Global Investment Servicing.

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 our individual businesses are not necessarily comparable with similar information for any other company. We refine our methodologies from time to time as our management accounting practices are enhanced and our businesses and management structure change. Financial results are presented, to the extent practicable, as if each business operated on a stand-alone basis. As permitted under GAAP, we have aggregated the business results for certain similar 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 servicing 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 Global Investment Servicing reflects its legal entity shareholder’s 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 shared 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, earnings and gains or losses related to Hilliard Lyons, 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      Average Assets (a)
Six months ended June 30 – in millions    2008    2007    2008    2007    2008    2007

Retail Banking (b)

   $ 335    $ 419    $ 1,848    $ 1,707    $ 46,206    $ 39,171

Corporate & Institutional Banking

     136      254      724      751      35,575      27,471

BlackRock

     129      110      171      143      4,463      4,048

Global Investment Servicing (c) (d)

     63      63      465      408      2,606      2,400

Total business segments

     663      846      3,208      3,009      88,850      73,090

Other (b) (c) (e)

     219      36      652      318      52,123      42,325

Total consolidated

   $ 882    $ 882    $ 3,860    $ 3,327    $ 140,973    $ 115,415

 

(a) Period-end balances for BlackRock and Global Investment Servicing.
(b) Amounts for the periods presented reflect the reclassification of the results of Hilliard Lyons, which we sold on March 31, 2008, and the related gain on sale, from Retail Banking to “Other.”
(c) For our segment reporting presentation in this Financial Review, after-tax integration costs of $2 million related to Albridge Solutions and Coates Analytics have been reclassified from Global Investment Servicing to “Other” for the first six months of 2008. “Other” for the first six months of 2008 also includes $48 million of pretax other integration costs while “Other” for the first six months of 2007 includes $29 million of pretax integration costs primarily related to Mercantile.
(d) Global Investment Servicing 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 (a)

(Unaudited)

 

Six months ended June 30

Dollars in millions

  2008     2007  

INCOME STATEMENT

     

Net interest income

  $997     $985  

Noninterest income

     

Asset management

  222     213  

Service charges on deposits

  169     164  

Brokerage

  73     65  

Consumer services

  207     187  

Other

  180     93  

Total noninterest income

  851     722  

Total revenue

  1,848     1,707  

Provision for credit losses

  194     60  

Noninterest expense

  1,107     978  

Pretax earnings

  547     669  

Income taxes

  212     250  

Earnings

  $335     $419  

AVERAGE BALANCE SHEET

     

Loans

     

Consumer

     

Home equity

  $14,500     $14,060  

Indirect

  2,048     1,759  

Education

  1,466     110  

Other consumer

  1,688     1,434  

Total consumer

  19,702     17,363  

Commercial and commercial real estate

  14,798     11,150  

Floor plan

  1,032     995  

Residential mortgage

  2,442     1,715  

Other

  66     71  

Total loans

  38,040     31,294  

Goodwill and other intangible assets

  5,982     4,228  

Loans held for sale

  593     1,558  

Other assets

  1,591     2,091  

Total assets

  $46,206     $39,171  

Deposits

     

Noninterest-bearing demand

  $10,662     $9,974  

Interest-bearing demand

  9,443     8,728  

Money market

  18,534     16,385  

Total transaction deposits

  38,639     35,087  

Savings

  2,704     2,614  

Certificates of deposit

  16,383     16,684  

Total deposits

  57,726     54,385  

Other liabilities

  339     490  

Capital

  3,693     3,433  

Total funds

  $61,758     $58,308  

PERFORMANCE RATIOS

     

Return on average capital

  18 %   25 %

Noninterest income to total revenue

  46     42  

Efficiency

  60     57  
 

OTHER INFORMATION (b) (c)

     

Credit-related statistics:

     

Commercial nonperforming assets

  $304     $110  

Consumer nonperforming assets

  49     30  

Total nonperforming assets (d)

  $353     $140  

Commercial net charge-offs

  $106     $27  

Consumer net charge-offs

  54     25  

Total net charge-offs (e)

  $160     $52  

Commercial net charge-off ratio

  1.34 %   .45 %

Consumer net charge-off ratio

  .49 %   .26 %

Total net charge-off ratio (e)

  .85 %   .34 %

Other statistics:

     

Full-time employees

  11,671     10,786  

Part-time employees

  2,371     2,344  

ATMs

  4,015     3,917  

Branches (f)

  1,153     1,084  

 

At June 30

Dollars in millions, except where noted

  2008     2007  

OTHER INFORMATION (CONTINUED)

     

ASSETS UNDER ADMINISTRATION (in billions) (g)

 

   

Assets under management

     

Personal

  $46     $50  

Institutional

  20     22  

Total

  $66     $72  

Asset Type

     

Equity

  $36     $41  

Fixed income

  17     19  

Liquidity/other

  13     12  

Total

  $66     $72  

Nondiscretionary assets under administration

 

   

Personal

  $30     $30  

Institutional

  81     81  

Total

  $111     $111  

Asset Type

     

Equity

  $47     $47  

Fixed income

  27     28  

Liquidity/other

  37     36  

Total

  $111     $111  

Home equity portfolio credit statistics (j):

     

% of first lien positions

  39 %   42 %

Weighted average loan-to-value ratios (k)

  72 %   70 %

Weighted average FICO scores (l)

  726     727  

Annualized net charge-off ratio

  .44 %   .18 %

Loans 90 days past due

  .46 %   .26 %

Checking-related statistics (j):

     

Retail Banking checking relationships

  2,328,000     1,967,000  

Consumer DDA relationships using

online banking

  1,157,000     975,000  

% of consumer DDA relationships

using online banking

  56 %   55 %

Consumer DDA relationships using

online bill payment

  768,000     505,000  

% of consumer DDA relationships

using online bill payment

  37 %   29 %

Small business loans and managed deposits (j):

 

   

Small business loans

  $13,582     $5,410  

Managed deposits:

     

On-balance sheet

     

Noninterest-bearing demand

  $6,043     $4,250  

Interest-bearing demand

  1,851     1,505  

Money market

  3,349     2,595  

Certificates of deposit

  879     584  

Off-balance sheet (h)

     

Small business sweep checking

  2,958     1,933  

Total managed deposits

  $15,080     $10,867  

Brokerage statistics (j):

     

Financial consultants (i)

  394     350  

Full service brokerage offices

  24     23  

Brokerage account assets (billions)

  $18     $18  
(a) Information for all periods presented excludes the impact of Hilliard Lyons, which was sold on March 31, 2008, and whose results have been reclassified to “Other.”
(b) Presented as of June 30 except for net charge-offs and annualized net charge-off ratios.
(c) Amounts include the impact of Mercantile, which we acquired effective March 2, 2007. Amounts as of and for the six months ended June 30, 2008 include the impact of Yardville. Amounts subsequent to April 4, 2008 include the impact of Sterling.
(d) Includes nonperforming loans of $339 million at June 30, 2008 and $130 million at June 30, 2007.
(e) Increase related to the impact of more closely aligning small business and consumer loan charge-off policies.
(f) Excludes certain satellite branches that provide limited products and service hours.
(g) Excludes brokerage account assets.
(h) 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.
(i) Financial consultants provide services in full service brokerage offices and PNC traditional branches.
(j) Amounts at June 30, 2007 do not include the impact of Mercantile. Amounts at June 30, 2008 do not include the impact of Sterling, except for brokerage statistics. We generally do not report these statistics for acquired companies prior to systems conversion.
(k) Calculated as of origination date.
(l) Represents the most recent FICO scores we have on file.

 

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Retail Banking’s earnings were $335 million for the first six months of 2008 compared with $419 million for the same period in 2007. The 20% decline in earnings over the prior year was driven by increases in expenses and the provision for the credit losses, partially offset by benefits from the first quarter 2008 gain related to the Visa initial public offering and the net benefits from acquisitions.

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

 

 

The April 2008 acquisition of Sterling added 65 branches and 62 ATMs to our network. This acquisition has resulted in a leading deposit share in the central Pennsylvania footprint and enhanced our presence in surrounding markets.

 

Total reported checking relationships increased by a net 56,000 since December 31, 2007, reflecting both the conversion of Yardville accounts and strong organic growth. Without Yardville, we increased reported checking relationships by approximately 35,000 in the first half of the year, which compares favorably to the 13,000 reported relationships we added during the same period last year. This strong organic growth was driven by strength in both customer acquisition and retention with significant contributions coming from the former Mercantile franchise and our Workplace Banking Channel.

 

Our investment in online banking capabilities continues to pay off. Since June 30, 2007, the percentage of consumer checking households using online bill payment increased from 29% to 37%. We will continue to seek customer growth by expanding our use of technology. We recently launched our new “Virtual Wallet” product, which was specifically designed to provide a distinctive online money management experience for Generation Y customers in our footprint. This product features three accounts: a spend account to be used for purchases, a reserve account for short-term savings and a growth account for long-term savings. We expect to add long-term, loyal customers by attracting this customer segment now with a tech-driven solution and exceptional service.

 

In the first six months of 2008, we opened 8 new branches, consolidated 29 branches, and acquired 65 branches for a total of 1,153 branches at June 30, 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 six months of 2008 was $1.848 billion, an 8% increase compared with $1.707 billion for the same period in 2007. Net interest income of $997 million increased $12 million, or 1%, compared with the first six months of 2007. The growth was driven by acquisitions, partially offset by a lower value attributed to deposits in the lower interest rate environment in 2008 versus 2007.

 

Noninterest income increased $129 million, or 18%, compared with the first six months of 2007. This growth was 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,

   

Acquisitions,

   

Increased volume-related consumer fees, and

   

Customer growth.

The Market Risk Management – Equity and Other Investment Risk section of this Financial Review includes further information regarding Visa.

The provision for credit losses for the first six months of 2008 was $194 million compared to $60 million for the same period last year. Net charge-offs were $160 million for the first six months of 2008 and $52 million in the first six months of 2007. The increases in provision and net charge-offs were primarily a result of the following:

 

   

Aligning small business and consumer loan charge-off policies,

   

Downward credit migration of commercial loan portfolios primarily in Maryland, Virginia and New Jersey related to residential real estate development and related sectors,

   

Continued growth in our commercial loan portfolio, and

   

Increased levels of charge-offs given the current credit environment.

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 six months of 2008 totaled $1.107 billion, an increase of $129 million, or 13%, compared with the same period in 2007. The increase was primarily attributable to acquisitions, with the remainder related to expenses directly associated with fee income-related businesses and continued investments in the business.

Full-time employees at June 30, 2008 totaled 11,671, an increase of 885 over the prior year. Part-time employees have increased by 27 since June 30, 2007. The increase in full-time and part-time employees was primarily the result of the Yardville and Sterling acquisitions.

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 $3.3 billion, or 6%, compared with the first half of 2007.

 

 

Average money market deposits increased $2.1 billion, and average certificates of deposits declined $.3 billion.


 

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Money market deposits experienced core growth and both deposit categories benefited from the acquisitions. The decline in certificates of deposits was a result of a focus on relationship customers rather than pursuing higher-rate single service customers. 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 $1.4 billion, or 8%, was almost solely due to acquisitions as organic growth was impacted by current economic conditions, such as lower average balances per account.

 

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

Currently, we are focused on a relationship-based lending strategy that targets specific customer sectors (homeowners, small businesses and auto dealerships) while seeking to maintain a moderate risk profile in the loan portfolio.

 

 

Average commercial and commercial real estate loans grew $3.6 billion, or 33%, compared with the first half of 2007. The increase was primarily attributable to acquisitions. Organic loan growth reflecting the strength of increased small business loan demand from existing customers and the acquisition of new relationships through our sales efforts was also a factor in the increase. At June 30, 2008, commercial and commercial real estate loans totaled $15.1 billion. This portfolio included $3.7 billion of commercial real estate loans, of which approximately $3.0 billion were related to our expansion from acquisitions into the greater Maryland and Washington, DC markets.

 

Average home equity loans grew $440 million, or 3%, compared with the first half of 2007 primarily due to acquisitions. Consumer loan growth has slowed as a result of lower demand from our customers as well as tightening of credit standards. 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 $289 million, or 16%, compared with the first half of 2007. The increase is primarily attributable to acquisitions.

 

Average education loans grew $1.4 billion compared with the first half of 2007. The increase was primarily the result of the transfer of approximately $1.8 billion of education loans previously held for sale to the loan portfolio during the first quarter of 2008. 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 $727 million primarily due to the addition of loans from acquisitions.

Assets under management of $66 billion at June 30, 2008 decreased $6 billion compared with the balance at June 30, 2007. The decline in assets under management was primarily due to comparatively lower equity markets and the effects of the divestiture of a Mercantile asset management subsidiary during the fourth quarter, partially offset by the Sterling acquisition and positive net inflows.

Nondiscretionary assets under administration of $111 billion at June 30, 2008 remained flat when compared with the balance at June 30, 2007. The effects of net positive client flows were offset by comparatively lower equity markets.


 

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CORPORATE & INSTITUTIONAL BANKING

(Unaudited)

 

Six months ended June 30

Dollars in millions except as noted

   2008     2007

INCOME STATEMENT

    

Net interest income

   $491     $377

Noninterest income

    

Corporate service fees

   268     266

Other

   (35 )   108

Noninterest income

   233     374

Total revenue

   724     751

Provision for credit losses

   121     1

Noninterest expense

   425     385

Pretax earnings

   178     365

Income taxes

   42     111

Earnings

   $136     $254

AVERAGE BALANCE SHEET

    

Loans

    

Corporate (a)

   $11,603     $9,419

Commercial real estate

   5,321     4,055

Commercial – real estate related

   2,919     2,285

Asset-based lending

   5,107     4,513

Total loans (a)

   24,950     20,272

Goodwill and other intangible assets

   2,215     1,669

Loans held for sale

   2,312     1,142

Other assets

   6,098     4,388

Total assets

   $35,575     $27,471

Deposits

    

Noninterest-bearing demand

   $7,417     $7,017

Money market

   5,168     4,592

Other

   2,109     1,020

Total deposits

   14,694     12,629

Other liabilities

   5,296     2,906

Capital

   2,449     2,057

Total funds

   $22,439     $17,592
(a) Includes lease financing.

Corporate & Institutional Banking earned $136 million in the first six months of 2008 compared with $254 million in the first six months of 2007. Earnings in 2008 were impacted by pretax valuation losses of $156 million on commercial mortgage loans and commitments held for sale, net of hedges, and increases in the provision for credit losses and noninterest expenses, partially offset by higher net interest income.

 

Six months ended June 30

Dollars in millions except as noted

   2008     2007  

PERFORMANCE RATIOS

      

Return on average capital

   11 %   25 %

Noninterest income to total revenue

   32     50  

Efficiency

   59     51  

COMMERCIAL MORTGAGE SERVICING PORTFOLIO (in billions)

      

Beginning of period

   $243     $200  

Acquisitions/additions

   16     44  

Repayments/transfers

   (11 )   (22 )

End of period

   $248     $222  

OTHER INFORMATION

      

Consolidated revenue from: (a)

      

Treasury Management

   $266     $224  

Capital Markets

   $180     $143  

Commercial mortgage securitizations and valuations (b)

   $(97 )   $30  

Commercial mortgage loan servicing (c)

   106     110  

Total commercial mortgage banking activities

   $9     $140  

Total loans (d)

   $26,075     $21,662  

Nonperforming assets (d) (e)

   $329     $100  

Net charge-offs

   $50     $16  

Full-time employees (d)

   2,310     2,084  

Net carrying amount of commercial
mortgage servicing rights (d)

   $681     $493  
(a) Represents consolidated PNC amounts.
(b) Includes valuations on commercial mortgage loans held for sale and related commitments, derivative valuations, origination fees, gains on sale of loans held for sale and net interest income on loans held for sale.
(c) Includes net interest income and noninterest income from loan servicing and ancillary services.
(d) At June 30.
(e) Includes nonperforming loans of $321 million at June 30, 2008 and $87 million at June 30, 2007.

 

 

Net interest income grew $114 million, or 30%, in the first six months of 2008 compared with the first six months of 2007. The increase over the prior year was primarily a result of acquisitions, organic loan growth and an increase in commercial mortgage loans held for sale.

 

Corporate service fees increased slightly in the first half of 2008 compared with the prior year first half, to $268 million. Increases in treasury management, syndication and structured finance fees more than offset decreases in merger and acquisition advisory fees and mortgage servicing fees, net of amortization.

 

Other noninterest income was negative $35 million for the first six months of 2008 compared with income of $108 million in the first six months of 2007. The first six months of 2008 included losses of $156 million related to valuations of commercial mortgage loans and commitments held for sale, net of hedges. These losses are net of the $21 million positive valuation adjustment described below. These valuation losses reflect the illiquid market conditions and are non-cash losses. During the second quarter of 2008, we sold approximately $.5 billion of commercial mortgage loans held for sale via securitizations and recognized a positive


 

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valuation adjustment for loans and commitments of $21 million, net of hedges. As previously reported, PNC adopted SFAS 159 beginning January 1, 2008 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 continue pursuing opportunities to reduce our loans held for sale position if we can receive prices we feel are appropriate. Excluding the impact of these valuation losses, other income increased approximately 12% due to higher interest rate derivative and foreign exchange trading revenue from customer activity.

 

Noninterest expense increased $40 million, or 10%, compared with the first half 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 $121 million in the first six months of 2008 compared with $1 million in the first six months of 2007. The increase in the provision compared with the year-ago period was primarily due to credit quality migration mainly related to residential real estate development and related sectors along with growth in total credit exposure. Nonperforming assets increased $229 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 $4.7 billion, or 23%, from the prior year first half. The increase in corporate and commercial real estate loans resulted from higher utilization of facilities, new business and the impact of the Mercantile and Yardville acquisitions.

 

Average deposit balances increased $2.1 billion, or 16%, compared with the first six months of 2007. The increase resulted primarily from higher client time deposits and the impact of acquisitions.

 

The commercial mortgage servicing portfolio was $248 billion at June 30, 2008, an increase of $26 billion, or 12%, from June 30, 2007. The increase resulted from strong growth in the third quarter 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.

 

Average other assets and other liabilities increased $1.7 billion and $2.4 billion, respectively. These increases were due to customer driven trading and related hedging transactions. In addition, an increase in customer driven money management activities contributed to the higher other liabilities balance.

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


 

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BLACKROCK

Our BlackRock business segment earned $129 million in the first six months of 2008 and $110 million in the first six months of 2007. These results reflect our approximately 33.3% share of BlackRock’s reported GAAP earnings and the additional income taxes on these earnings incurred by PNC.

Our investment in BlackRock was $4.3 billion at June 30, 2008 and $4.1 billion at December 31, 2007. Based upon BlackRock’s closing market price of $177.00 per common share at June 30, 2008, the market value of our investment in BlackRock was $7.6 billion at that date. As such, an additional $3.3 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 half of 2008 included a $117 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 June 30, 2008 and resulted from the decrease in the market value of BlackRock common shares during the first six months of 2008. In the first six months of 2007, we recognized a pretax charge of $31 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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GLOBAL INVESTMENT SERVICING

(Unaudited)

 

Six months ended June 30

Dollars in millions except as noted

   2008     2007  

INCOME STATEMENT

      

Servicing revenue (a)

   $482     $424  

Operating expense (a)

   367     311  

Operating income

   115     113  

Debt financing

   19     19  

Nonoperating income (b)

   2     3  

Pretax earnings

   98     97  

Income taxes

   35     34  

Earnings

   $63     $63  

PERIOD-END BALANCE SHEET

      

Goodwill and other intangible assets

   $1,305     $1,005  

Other assets

   1,301     1,395  

Total assets

   $2,606     $2,400  

Debt financing

   $935     $734  

Other liabilities

   1,005     1,109  

Shareholder’s equity

   666     557  

Total funds

   $2,606     $2,400  

PERFORMANCE RATIOS

      

Return on average equity

   20 %   24 %

Operating margin (c)

   24     27  

SERVICING STATISTICS (at June 30)

      

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

      

Domestic

   $862     $765  

Offshore

   126     103  

Total

   $988     $868  

Asset type (in billions)

      

Money market

   $400     $286  

Equity

   358     373  

Fixed income

   126     118  

Other

   104     91  

Total

   $988     $868  

Custody fund assets (in billions)

   $471     $467  

Shareholder accounts (in millions)

      

Transfer agency

   19     20  

Subaccounting

   55     50  

Total

   74     70  

OTHER INFORMATION

      

Full-time employees (at June 30)

   4,946     4,522  
(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 are received 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.

 

Global Investment Servicing, formerly PFPC, earned $63 million for both the first six months of 2008 and 2007. 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 Global Investment Servicing’s performance for the first six months of 2008 included:

 

   

Total fund accounting assets serviced increased 14% over the prior year, despite declines in major stock market indices over the same time frame, due to a 13% increase in the number of funds serviced.

 

   

Initiatives in the offshore arena have resulted in a 34% increase in servicing revenue and a 22% increase in assets serviced, which now stand at $126 billion.

 

   

Subaccounting shareholder accounts rose by 5 million, or 10%, to 55 million, as existing clients continued to convert additional fund families to this platform. Global Investment Servicing remains a leading provider of subaccounting services.

Servicing revenue for the first half of 2008 reached $482 million, an increase of $58 million, or 14%, over the first half 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 $56 million, or 18%, to $367 million, in the first six months of 2008 compared with the first six 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.

Total assets serviced by Global Investment Servicing amounted to $2.6 trillion at June 30, 2008 compared with $2.4 trillion at June 30, 2007 as this business segment continued to see both organic growth and growth from new business in each of its product lines.


 

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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 adoption in the first quarter of 2008 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.

The discount rate and compensation increase assumptions do not significantly affect 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 $32 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 six months of 2008. We remained focused on maintaining a moderate risk profile.

 

Nonperforming Assets by Type

 

In millions   

June 30

2008

  

December 31

2007

Nonaccrual loans

       

Commercial

       

Retail/wholesale

   $ 58    $ 39

Manufacturing

     34      35

Other service providers

     66      48

Real estate related (a)

     70      45

Financial services

     10      15

Health care

     7      4

Other

     8      7

Total commercial

     253      193

Commercial real estate

       

Real estate projects

     330      184

Mortgage

     35      28

Total commercial real estate

     365      212

Consumer

     24      17

Residential mortgage (b)

     49      27

Lease financing

     4      3

Total nonaccrual loans (b)

     695      452

Restructured loans

            2

Total nonperforming loans (b)

     695      454

Foreclosed and other assets

       

Residential mortgage

     28      16

Lease financing

        11

Other

     10      14

Total foreclosed and other assets

     38      41

Total nonperforming
assets (b) (c) (d)

   $ 733    $ 495
(a) Includes loans related to customers in the real estate and construction industries.
(b) We have adjusted the December 31, 2007 amounts to be consistent with the current methodology for recognizing nonaccrual residential mortgage loans serviced under master servicing arrangements.
(c) Excludes equity management assets carried at estimated fair value of $44 million at June 30, 2008 and $4 million at December 31, 2007.
(d) Excludes loans held for sale carried at lower of cost or market value of $59 million at June 30, 2008 (amount includes troubled debt restructured assets of $20 million) and $25 million at December 31, 2007.

Total nonperforming assets at June 30, 2008 increased $238 million, to $733 million, from the balance at December 31, 2007. Our nonperforming assets represented .51% of total assets at June 30, 2008 compared with .36% at December 31, 2007. The increase in nonperforming assets reflected higher nonaccrual residential real estate development loans, commercial real estate related loans and residential mortgage 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 $209 million at June 30, 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 June 30, 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

   $ 495     $ 184  

Transferred from accrual

     602       195  

Acquisition (a)

     9       35  

Charge-offs and valuation adjustments

     (185 )     (51 )

Principal activity including payoffs

     (153 )     (90 )

Returned to performing

     (31 )     (9 )

Asset sales

     (4 )     (4 )

June 30

   $ 733     $ 260  
(a) Sterling in 2008 and Mercantile in 2007.

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 in that period.

Accruing Loans Past Due 90 Days Or More

 

    Amount   Percent of Total
Outstandings
 
Dollars in millions  

June 30

2008

 

Dec. 31

2007

 

June 30

2008

   

Dec. 31

2007

 

Commercial

  $ 22   $ 14   .07 %   .05 %

Commercial real estate

    10     18   .11     .20  

Consumer

    70     49   .34     .27  

Residential mortgage

    46     43   .51     .45  

Other

    12     12   4.12     2.91  

Total loans

  $ 160   $ 136   .22     .20  

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 $262 million at June 30, 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

 

    June 30, 2008     December 31, 2007  
Dollars in millions   Allowance   

Loans to

Total

Loans

    Allowance   

Loans to

Total

Loans

 

Commercial

  $ 664    42.3 %   $ 560    41.8 %

Commercial real estate

    187    12.9       153    13.0  

Consumer

    90    28.5       68    26.9  

Residential mortgage

    9    12.4       9    14.0  

Lease financing

    35    3.5       36    3.7  

Other

    3    .4       4    .6  

Total

  $ 988    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 $337 million for the first six months of 2008 and $62 million for the first six months of 2007. The higher provision in the first half of 2008 compared with the prior year period was driven by general credit quality migration, especially in the residential real estate development sector of our commercial real estate portfolio. See the Consolidated Balance Sheet Review section of this Financial Review for further information. In addition, the provision for credit losses for the first six months of 2008 and the evaluation of the allowances for loan and lease losses and unfunded loan commitments and letters of credit as of June 30, 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, we expect that the provision for credit losses will be approximately $750 million for full year 2008, including the impact of the Sterling acquisition. However, we believe that increased operating leverage will be more than adequate to cover increased credit costs in 2008.

The allowance as a percent of nonperforming loans was 142% and as a percent of total loans was 1.35% at June 30, 2008. The comparable percentages at December 31, 2007 were 183% and 1.21%. We expect to continue to increase our allowance as a percent of total loans as the market and our credit quality migration dictates.


 

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Charge-Offs And Recoveries

 

Six months ended June 30
Dollars in millions
  Charge-
offs
  Recoveries   Net
Charge-
offs
  Percent
of
Average
Loans
 

2008

         

Commercial

  $ 141   $ 19   $ 122   .82 %

Consumer

    61     7     54   .55  

Commercial real estate

    35     3     32   .70  

Lease financing

    3     1     2   .16  

Total

  $ 240   $ 30   $ 210   .59  

2007

         

Commercial

  $ 58   $ 15   $ 43   .37 %

Consumer

    32     7     25   .29  

Commercial real estate

    1     1          

Total

  $ 91   $ 23   $ 68   .23  

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 that period.

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 4.3% of the total allowance and .06% of total loans, net of unearned income, at June 30, 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 and take proprietary trading positions, reflected in other noninterest income in our Consolidated Income Statement, totaled $7 million for the first six months of 2008 compared with $8 million for the first six months of 2007.

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 June 30, 2008, our liquid assets totaled $36.8 billion, with $21.0 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 June 30, 2008, we maintained significant unused borrowing capacity from the Federal Reserve Bank discount window and FHLB-Pittsburgh under current collateral requirements.

At June 30, 2008, we pledged $4.1 billion of loans and $15.4 billion of securities to the Federal Reserve Bank with a combined collateral value of $18.1 billion. Also, we pledged $31.7 billion of loans and $5.0 billion of securities to FHLB-Pittsburgh under a blanket lien with a combined collateral value of $18.1 billion as of that date. We pledged this collateral with the Federal Reserve Bank and FHLB- Pittsburgh for the ability to borrow if necessary. At June 30, 2008 we had no outstanding borrowings with the Federal Reserve Bank and $9.3 billion outstanding with FHLB-Pittsburgh resulting in unused borrowing capacity of $18.1 billion and $8.8 billion, respectively, for a combined unused borrowing capacity under these arrangements of $26.9 billion, which is based on current collateral requirements.


 

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At 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. At December 31, 2007 we had no outstanding borrowings with the Federal Reserve Bank and $6.8 billion outstanding with FHLB-Pittsburgh resulting in unused borrowing capacity of $18.2 billion and $16.7 billion, respectively, for a combined unused borrowing capacity under these arrangements of $34.9 billion.

In the first half of 2008 we increased FHLB borrowings, which provided us with additional liquidity at relatively attractive rates. Total FHLB borrowings were $9.6 billion at June 30, 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 June 30, 2008, PNC Bank, N.A. had issued $6.9 billion of debt under this program.

PNC Bank, N.A. established a program in December 2004 to offer up to $3.0 billion of its commercial paper. As of June 30, 2008, there were no issuances outstanding under this program.

As of June 30, 2008, there were $1.5 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 Variable Interest Entities 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 $510 million at June 30, 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 June 30, 2008, the parent company had approximately $679 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 July 2006, PNC Funding Corp established a program to offer up to $3.0 billion of commercial paper to provide the parent company with additional liquidity. As of June 30, 2008, $384 million of commercial paper was outstanding under this program.

In May 2008, we issued $500 million of Depositary Shares, each representing a fractional interest in a share of PNC Fixed-to-Floating Rate Non-Cumulative Perpetual Preferred Stock, Series K. Dividends are payable if and when declared beginning November 21, 2008 and then each May 21 and November 21 until May 21, 2013. After that date, dividends will be payable each 21st of August, November, February and May. Dividends will be paid at a rate of 8.25% prior to May 21, 2013 and at a rate of three-month LIBOR plus 422 basis points beginning May 21, 2013.

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

As of June 30, 2008, there were $1.7 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 June 30, 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.


 

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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 second quarters of 2008 and 2007 follow:

Interest Sensitivity Analysis

 

      Second
Quarter
2008
   

Second

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 )%   (2.5 )%

100 basis point decrease

   2.4 %   2.5 %

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 )%   (5.7 )%

100 basis point decrease

   2.5 %   4.4 %

Duration of Equity Model

      

Base case duration of equity (in years):

   2.6     3.2  

Key Period-End Interest Rates

      

One-month LIBOR

   2.46 %   5.32 %

Three-year swap

   3.89 %   5.39 %

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 (Second Quarter 2008)

 

      PNC
Economist
    Market
Forward
    Two-Ten
Inversion
 

First year sensitivity

   .3 %   (4.3 )%   (7.4 )%

Second year sensitivity

   (7.1 )%   (11.3 )%   (7.1 )%

 

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.

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 six months of 2008, our VaR ranged between $9.1 million and $13.8 million, averaging $11.7 million. During the first six months of 2007, our VaR ranged between $6.1 million and $9.3 million, averaging $7.6 million. The increase in VaR compared with the first half 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


 

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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 six 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 half and second quarter of 2008 and 2007 was as follows:

 

Six months ended June 30 – in millions    2008     2007

Net interest income

   $ 39     $ 1

Noninterest income

     (23 )     81

Total trading revenue

   $ 16     $ 82

Securities underwriting and trading (a)

   $ 10     $ 17

Foreign exchange

     33       27

Financial derivatives

     (27 )     38

Total trading revenue

   $ 16     $ 82

 

Three months ended June 30 – in millions    2008    2007

Net interest income

   $ 23    $ 1

Noninterest income

     53      29

Total trading revenue

   $ 76    $ 30

Securities underwriting and trading (a)

   $ 19    $ 8

Foreign exchange

     17      13

Financial derivatives

     40      9

Total trading revenue

   $ 76    $ 30
(a) Includes changes in fair value for certain loans accounted for at fair value.

The decline in total trading revenue for the first six months of 2008 primarily related to our first quarter 2008 proprietary trading activities and reflected the negative impact of a very illiquid market on the assets that we held. In response to first quarter 2008 market volatility, during the second quarter of 2008 we substantially reduced our trading positions and increased our hedges in connection with proprietary trading activities.

 

Average trading assets and liabilities consisted of the following:

 

Six months ended June 30 – in millions    2008    2007

Trading assets

       

Securities (a)

   $ 3,177    $ 1,858

Resale agreements (b)

     2,046      1,254

Financial derivatives (c)

     2,420      1,166

Loans at fair value (c)

     103      177

Total trading assets

   $ 7,746    $ 4,455

Trading liabilities

       

Securities sold short (d)

   $ 1,642    $ 1,348

Repurchase agreements and other borrowings (e)

     864      653

Financial derivatives (f)

     2,460      1,178

Borrowings at fair value (f)

     28      39

Total trading liabilities

   $ 4,994    $ 3,218

 

Three months ended June 30 – in millions    2008    2007

Trading assets

       

Securities (a)

   $ 2,471    $ 2,144

Resale agreements (b)

     1,731      1,247

Financial derivatives (c)

     2,028      1,221

Loans at fair value (c)

     92      161

Total trading assets

   $ 6,322    $ 4,773

Trading liabilities

       

Securities sold short (d)

   $ 1,157    $ 1,431

Repurchase agreements and other borrowings (e)

     691      669

Financial derivatives (f)

     2,051      1,230

Borrowings at fair value (f)

     25      40

Total trading liabilities

   $ 3,924    $ 3,370
(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 $4.3 billion at June 30, 2008 compared with $4.1 billion at December 31, 2007. The market value of our investment in BlackRock was $7.6 billion at June 30, 2008. The primary risk measurement, similar to other equity investments, is economic capital.

Low Income Housing Projects

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 June 30, 2008 and


 

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$1.0 billion at December 31, 2007. PNC’s equity investment at risk was $209 million at June 30, 2008 compared with $188 million at year-end 2007. We also had commitments to make additional equity investments in affordable housing limited partnerships of $97 million at June 30, 2008 compared with $98 million at December 31, 2007. These commitments are included in other liabilities on the Consolidated Balance Sheet.

Visa

Our remaining investment in Visa Class B common shares totals approximately 3.6 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 June 30, 2008 closing price of $81.31 for the Visa shares, our remaining investment had an unrecognized pretax value of approximately $207 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.

Private Equity

The private equity portfolio is comprised of equity and mezzanine investments that vary by industry, stage and type of investment. At June 30, 2008, private equity investments carried at estimated fair value totaled $584 million compared with $561 million at December 31, 2007. As of June 30, 2008, $306 million was invested directly in a variety of companies and $278 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 $111 million as of June 30, 2008. Our unfunded commitments related to private equity totaled $254 million at June 30, 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 June 30, 2008, other investments totaled $541 million compared with $389 million at December 31, 2007. During the second quarter of 2008, we recognized impairments relating to these investments of $26 million. Given the nature of these investments and if current market conditions affecting their valuation were to continue or worsen, we could incur future impairment charges.

Our unfunded commitments related to other investments totaled $74 million at June 30, 2008 compared with $79 million at December 31, 2007.

 

COMMITMENTS

The following tables set forth contractual obligations and various other commitments representing required and potential cash outflows as of June 30, 2008.

Contractual Obligations

 

June 30, 2008 – in millions    Total

Remaining contractual maturities of time deposits

   $ 24,945

Borrowed funds

     32,472

Minimum annual rentals on noncancellable leases

     1,309

Nonqualified pension and post-retirement benefits

     315

Purchase obligations (a)

     420

Total contractual cash obligations

   $ 59,461
(a) Includes purchase obligations for goods and services covered by noncancellable contracts and contracts including cancellation fees.

Other Commitments (a)

 

June 30, 2008 – in millions    Total

Loan commitments

   $ 51,558

Standby letters of credit (b)

     5,672

Other commitments (c)

     445

Total commitments

   $ 57,675
(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 $2.5 billion of standby letters of credit that support remarketing programs for customers’ variable rate demand notes.
(c) Includes unfunded commitments related to private equity investments of $254 million and other investments of $74 million which are not on our Consolidated Balance Sheet. Also includes commitments related to low income housing projects of $97 million and historic tax credits of $20 million which are included in other liabilities on the Consolidated Balance Sheet.

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 June 30, 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    

June 30, 2008 – dollars in millions

            Paid     Received  

Accounting Hedges

               

Interest rate risk management

               

Asset rate conversion

               

Interest rate swaps (a)

               

Receive fixed

   $9,813    $303      3 yrs. 2 mos.    4.36 %   5.16 %

Forward purchase commitments

   1,000    11      1 mo.    NM     NM  

Liability rate conversion

               

Interest rate swaps (a)

               

Receive fixed

   9,275    279      4 yrs. 10 mos.    3.98 %   5.07 %

Total interest rate risk management

   20,088    593            

Total accounting hedges (b)

   $20,088    $593            

Free-Standing Derivatives

               

Customer-related

               

Interest rate

               

Swaps (c)

   $73,496    $(48)      5 yrs. 2 mos.    4.15 %   4.16 %

Caps/floors

               

Sold (c)

   2,767    (9 )    5 yrs. 7 mos.    NM     NM  

Purchased

   2,157    12      2 yrs. 11 mos.    NM     NM  

Futures

   5,742       9 mos.    NM     NM  

Foreign exchange

   9,747    5      5 mos.    NM     NM  

Equity

   1,258    (34 )    1 yr. 4 mos.    NM     NM  

Swaptions

   3,304    39      13 yrs. 5 mos.    NM     NM  

Total customer-related

   98,471    (35 )          

Other risk management and proprietary

               

Interest rate

               

Swaps (c) (d)

   31,205    (66 )    5 yrs.    3.98 %   3.96 %

Caps/floors

               

Sold

   500       5 mos.    NM     NM  

Purchased

   700    9      1 yr. 7 mos.    NM     NM  

Futures

   19,581       1 yr. 5 mos.    NM     NM  

Foreign exchange (c)

   3,436    (8 )    7 yrs. 3 mos.    NM     NM  

Credit derivatives

   5,178    106      15 yrs. 2 mos.    NM     NM  

Risk participation agreements

   1,426       4 yrs. 2 mos.    NM     NM  

Commitments related to mortgage-related assets

   3,447    5      3 mos.    NM     NM  

Options

               

Futures

   13,200    1      5 mos.    NM     NM  

Swaptions (c)

   10,778    (17 )    7 yrs. 6 mos.    NM     NM  

Other (e)

   488    (82 )    NM    NM     NM  

Total other risk management and proprietary

   89,939    (52 )          

Total free-standing derivatives

   $188,410    $(87)                    
(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, 40% on 3-month LIBOR and 12% on Prime Rate.
(b) Fair value amount includes net accrued interest receivable of $219 million.
(c) The increases in the negative fair values from December 31, 2007 to June 30, 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

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

Caps/floors

                

Sold

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

Purchased

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

Futures

     5,564       8 mos.    NM      NM  

Foreign exchange

     7,028      8      7 mos.    NM      NM  

Equity

     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      (58 )           

Other risk management and proprietary

                

Interest rate

                

Swaps

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

Caps/floors

                

Sold

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

Purchased

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

Futures

     43,107       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 (c)

     442      (201 )    NM    NM      NM  

Total other risk management and proprietary

     178,673      (56 )           

Total free-standing derivatives

   $ 263,740    $ (114 )                   
(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) 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 June 30, 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 June 30, 2008, and that there has been no change in internal control over financial reporting that occurred during the second 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, by the amount of that difference.

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 that would be paid to transfer a liability on the measurement date using the principal or most advantageous market for the asset or liability in an orderly transaction between willing market participants.


 

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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 less preferred stock dividends divided by average common shareholders’ equity.

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

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


 

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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 use interest income on a taxable-equivalent basis in calculating average yields and net interest margins 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.

 

Watchlist - A list of criticized loans, credit exposure or other assets compiled for internal monitoring purposes. We define criticized exposure for this purpose as exposure with an internal risk rating of other assets especially mentioned, substandard, doubtful or loss.

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 followed by a subdued recovery.

   

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 Financial Corporation (“Sterling”) presents regulatory and litigation risk, as a result of financial irregularities at Sterling’s commercial finance subsidiary, that may adversely 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 June 30      Six months ended June 30  
Unaudited          2008                2007              2008              2007      

Interest Income

                   

Loans

     $ 1,050        $ 1,084      $ 2,121      $ 1,980  

Securities available for sale

       419          355        823        665  

Other

       108          115        252        224  

Total interest income

       1,577          1,554        3,196        2,869  

Interest Expense

                   

Deposits

       362          532        812        1,000  

Borrowed funds

       238          284        553        508  

Total interest expense

       600          816        1,365        1,508  

Net interest income

       977          738        1,831        1,361  

Noninterest Income

                   

Fund servicing

       234          209        462        412  

Asset management

       197          190        409        355  

Consumer services

       149          179        319        336  

Corporate services

       185          176        349        335  

Service charges on deposits

       92          92        174        169  

Net securities gains (losses)

       (1 )        1        40        (2 )

Other

       206          128        276        361  

Total noninterest income

       1,062          975        2,029        1,966  

Total revenue

       2,039          1,713        3,860        3,327  

Provision for credit losses

       186          54        337        62  

Noninterest Expense

                   

Personnel

       547          544        1,091        1,034  

Occupancy

       90          81        185        168  

Equipment

       94          79        176        150  

Marketing

       34          29        56        50  

Other

       350          307        649        582  

Total noninterest expense

       1,115          1,040        2,157        1,984  

Income before income taxes

       738          619        1,366        1,281  

Income taxes

       233          196        484        399  

Net income

     $ 505        $ 423      $ 882      $ 882  

Earnings Per Common Share

                   

Basic

     $ 1.47        $ 1.24      $ 2.58      $ 2.71  

Diluted

     $ 1.45        $ 1.22      $ 2.54      $ 2.67  

Average Common Shares Outstanding

                   

Basic

       344          342        342        325  

Diluted

       347          346        345        329  

See accompanying Notes To Consolidated Financial Statements.

 

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Table of Contents

CONSOLIDATED BALANCE SHEET

THE PNC FINANCIAL SERVICES GROUP, INC.

 

In millions, except par value

Unaudited

   June 30
2008
    December 31
2007
 

Assets

    

Cash and due from banks

   $ 3,525     $ 3,567  

Federal funds sold and resale agreements (includes $1,001 measured
at fair value at June 30, 2008) (a)

     3,015       2,729  

Trading securities and other short-term investments

     2,705<