DBRS Comments on Q2 Earnings of Fifth Third Bancorp–Senior at “A”; Negative Trend Remains Unchanged

DBRS has today commented on the Q2 2009 earnings and operating performance of Fifth Third Bancorp (Fifth Third or the Company). Fifth Third’s Q2 2009 results reflected high credit costs but also resilience in core operating earnings that were within DBRS’s expectations; thus its ratings including Issuer & Senior Debt at “A”, and Negative trend remain unchanged.

On April 24, 2009, DBRS downgraded Fifth Third’s Senior Debt to “A” and left the trend on Negative. The negative trend on the Company’s ratings reflects DBRS’s perception that material amounts of potential losses remain embedded in the Company’s loan portfolios. Despite having already charged-off a substantial amount of loans in this credit cycle, DBRS believes that Fifth Third faces further economic challenges from falling real estate values and rising unemployment given the Company’s footprint (including sizable exposures in Ohio, Michigan and Florida). DBRS notes that Fifth Third’s ratings remain under pressure, as continued credit deterioration, losses exceeding income before provisions and taxes (IBPT), and/or a sustained decline in core earnings power would likely result in negative rating actions.

In 2Q 2009, the Company produced $882 million in net income (before preferred stock dividends) primarily benefitting from the $1.8 billion (pre-tax) gain on the sale of a 51% interest in its processing business to Advent International but also reflecting relatively resilient core revenue. Adjusted IBPT was a solid $684 million in the quarter but was overwhelmed by the $1,041 million provision that included a $415 million reserve build. DBRS noted that this is the sixth consecutive quarter where the loan loss provision exceeded adjusted IBPT. The quarter produced higher nonperforming assets and 90 day past due loans, but also reflected some early signs of improvement in mortgage loss and early stage home equity delinquencies. Net interest income was stable compared with 1Q 2009 as 20 basis points (bps) of net interest margin (NIM) expansion was only partially offset by the 2.4% lower level of average loans and higher level of nonperforming loans in the quarter. Fee income strengthened over the quarter (adjusted for the $1.8 billion gain on sale) as stronger payment processing, deposit service charges and still rising mortgage revenues (and MSR hedge gain) more than offset the decline in corporate banking fees. Expenses (excluding the $55 million FDIC special deposit assessment) were stable with the prior quarter but the expense ratio remains elevated relative to last year’s level primarily due to higher collection and credits costs.

The Company was the beneficiary of a dramatic change in depositor behavior, with quarterly average deposit growth of almost 2% and average noninterest bearing deposits rising nearly 7.5%. Saving and accumulating cash for contingencies has become a new priority for consumers and businesses, while low interest rates de-motivated depositors from seeking yield leaving balances in DDA accounts. On the other hand, loan demand was very weak in the quarter with average loans (excluding held for sale) contracting 2.4% while nonperforming assets grew 7.3%.

A net quarterly gain of $882 million (before $26 million in preferred share dividends) was an improvement compared to the $50 million gain in the prior quarter and the $202 million loss in Q2 2008. The improvement over the prior quarter primarily reflected the $1,764 million gain on sale while the improvement over the last year quarter also reflected improved spread income based on lower funding costs and stronger fee income particularly in the mortgage business.

Loan quality deterioration continued as nonperforming loans rose almost 7% (not including restructured loans) in the second quarter to 3.17% of total portfolio loans and OREO. However, 90 day past due loans increased at a more modest 4.0% pace in the quarter and there were some early signs of improvement in mortgage loss and early stage home equity delinquencies in the quarter. Restructured loans (accrual) increased 75% to $1.1 billion in the quarter. With a $415 million reserve build in the quarter, the loan loss reserve increased to cover 135% of nonperforming loans (109% including all OREO and nonaccrual loans held for sale but excluding accruing restructured loans less than 90 days past due). Additionally, the Company had one of the highest reserve levels in the quarter among large banks at 4.28% of total loans (especially when adjusted for its modest credit card portfolio).

Loan quality continued to deteriorate further in the quarter across all asset classes (except auto) and nonperformers are expected to remain elevated for at least the balance of the year into 2010. Net charge-offs in the second quarter grew 28% to 3.08% of average loans (annualized) from 2.38% in Q1 2009 primarily due to continued losses in commercial loans (including mortgage and construction), residential mortgages, home equity and credit cards. Nonperforming loan inflows came primarily from commercial construction and commercial real estate loans with most other categories stable and troubled commercial loans actually declining. DBRS noted that continued high credit costs exceeding IBPT and/or a sustained decline in core net revenues would likely result in negative ratings pressure.

Provisioning expense was $1,041 million in Q2 2009, a 35% decrease over $773 million in Q1 2009 and $322 million higher than in Q2 2008. The provision was $415 million above net charge-offs in the quarter signalling the Company’s expectation of further loan deterioration.

The Company’s capital actions in the quarter included a $1.0 billion common equity issuance, and an exchange of 63% of Fifth Third’s convertible preferred shares when combined with the $1.1 billion (after-tax) gain on the 51% sale of the processing business in a joint venture raised its tangible common equity by 230 bps. Subsequently in the current quarter, Fifth Third sold Visa shares for roughly a $206 million (after-tax) gain that when combined with the other capital actions helped the Company to exceed its SCAP target by $650 million and substantially increased its capital ratios. Tier 1 capital ratio rose to 12.90% from 10.93% in the first quarter and Tier 1 common was reported at 7.00%. Tangible common equity was 6.55% of Tangible assets while Total capital ratio was 16.96% clearly reflecting the higher capital cushion that the Company has built that is especially noteworthy for its asset size, however regulatory ratios include $3.4 billion of TARP preferreds. The Visa share sale is expected to increase the tangible common equity ratio by an additional 19 bps.

Notes:
All figures are in U.S. dollars unless otherwise noted.

The applicable methodologies are Rating Banks and Bank Holding Companies Operating in the United States, and Enhanced Methodology for Bank Ratings – Intrinsic and Support Assessments which can be found on our website under Methodologies.

This is a Corporate (Financial Institutions) rating.