Financial Review
Earnings Summary
National City Corporation ("National City" or "the Corporation") reported net income of $1,070.7 million, or $3.22 per diluted share, in 1998, compared to $1,122.2 million, or $3.42 per diluted share, in 1997, and $993.5 million, or $2.95 per diluted share, in 1996. Included in reported net income were after-tax merger and restructuring expenses of $261.9 million, or $.78 per diluted share, in 1998, $34.9 million, or $.11 per diluted share, in 1997, and $49.1 million, or $.15 per diluted share, in 1996.
Excluding merger and restructuring expenses, net income in 1998 of $1,332.6 million, or $4.00 per diluted share, increased 15.2% over 1997's net income of $1,157.1 million, or $3.53 per diluted share, and 27.8% over 1996's net income of $1,042.6 million, or $3.10 per diluted share. Results for 1998 and 1997 reflect strong loan and noninterest income growth and lower credit costs.
Excluding merger and restructuring expenses, return on average common equity was 19.18% in 1998, up from 18.77% in 1997 and 17.53% in 1996 (Chart 2). On this same basis, return on average assets was 1.66% in 1998, compared to 1.61% in 1997 and 1.47% in 1996 (Chart 3).
Merger and restructuring expenses in 1998 related to the merger with First of America Bank Corporation ("First of America") and the acquisition of Fort Wayne National Corporation ("Fort Wayne") and are further discussed in Note 3 to the Consolidated Financial Statements. Merger and restructuring expenses in 1997 consisted of costs associated with reorganizing National City's six Ohio banking subsidiaries under a single statewide charter, costs incurred in connection with the First of America merger, and reorganization costs at the Corporation's item-processing subsidiary. Merger expenses in 1996 were incurred as a result of the Integra Financial Corporation merger.
Financial data for all prior periods have been restated to reflect the merger with First of America, which was completed March 31, 1998 and accounted for as a pooling of interests. The financial results of Fort Wayne, accounted for as a purchase, are included in the results of operations subsequent to the date of acquisition, March 30, 1998. The Fort Wayne acquisition added $3.4 billion to total assets, $2.1 billion to loans and $2.3 billion to deposits.
Excluding merger and restructuring expenses, tangible or cash earnings per share were $4.20 in 1998, $3.68 in 1997 and $3.29 in 1996. This calculation adjusts net income for the non-cash impact of intangible amortization expense. Return on tangible equity, which excludes the non-cash impact of intangible amortization from net income and intangibles from average common equity, was 23.33% in 1998 versus 21.53% in 1997 and 20.39% in 1996.
Line of Business Results
National City's operations are managed along three major lines of business: corporate banking, retail banking, and fee-based businesses. A description of each business and the methodologies used to measure financial performance are described in Note 21 to the Consolidated Financial Statements on page 41. The following table summarizes net income by line of business for each of the last three years:
---------------------------------------------------------------
Net Income
------------------------------
(Dollars in Millions) 1998 1997 1996
---------------------------------------------------------------
Corporate banking $ 324.0 $ 257.0 $ 226.5
Retail banking 723.6 683.6 645.9
Fee-based businesses 210.8 133.9 121.8
Parent and other (187.7) 47.7 (.7)
---------------------------------------------------------------
Consolidated total $1,070.7 $1,122.2 $ 993.5
---------------------------------------------------------------
Total excluding merger and
restructuring expenses $1,332.6 $1,157.1 $1,042.6
---------------------------------------------------------------
The increase in corporate banking net income in both 1997 and 1998 was due primarily to loan and fee income growth coupled with lower credit costs.
The increase in retail banking net income in both years was due mainly to higher fee income. Declining spreads on deposits tended to offset the effect of higher lending volumes.
The increases in net income in the fee-based businesses reflect improved mortgage banking results, particularly in 1998. In addition, the personal wealth management and institutional trust businesses also contributed to the improving trend, aided by strong equity markets and new business. Partially offsetting these improvements were declines at the item-processing unit, National Processing, Inc. (National Processing), driven by higher expenses.
The decline in the parent and other category in 1998 reflects merger and restructuring expense partially offset by securities gains. In 1997, the increase was due to a higher contribution from the investment/funding unit.
Net Interest Income
Net interest income increased in 1998 as a result of the Fort Wayne acquisition, which added approximately $87 million, and strong loan growth, partially offset by a lower net interest margin. The decline in the net interest margin over the past two years was due primarily to the combination of a lower yield on earning assets, the reliance on higher cost borrowed funds to fund loan growth, and a lower contribution from free funds.
The following table reconciles net interest income shown in the financial statements to tax-equivalent net interest income used to compute the net interest margin. To compare the non-taxable asset yields to taxable yields, amounts are adjusted to pre-tax equivalents based on the marginal corporate tax rate of 35%.
----------------------------------------------------------------- (Dollars in Millions) 1998 1997 1996 ----------------------------------------------------------------- Net interest income $2,911.6 $2,810.3 $2,845.1 Tax equivalent adjustment 40.3 43.0 38.4 ----------------------------------------------------------------- Net interest income - tax equivalent $2,951.9 $2,853.3 $2,883.5 ----------------------------------------------------------------- Average earning assets $ 71,747 $ 65,259 $64,535 ----------------------------------------------------------------- Net interest margin 4.11% 4.37% 4.47% -----------------------------------------------------------------
National City's net interest income is affected by the use of off-balance sheet financial instruments (derivatives). The following table summarizes the contribution of derivatives to net interest income. Amounts in brackets represent a reduction of the related interest income or expense line.
--------------------------------------------------------------
(Dollars in Millions) 1998 1997 1996
--------------------------------------------------------------
Interest adjustment to:
Loans $ 1.2 $ 9.2 $ 21.9
Securities (1.0) (2.5) (1.0)
--------------------------------------------------------------
Earning assets .2 6.7 20.9
Interest-bearing liabilities (40.0) (35.6) (22.0)
--------------------------------------------------------------
Effect on net interest income $ 40.2 $ 42.3 $ 42.9
--------------------------------------------------------------
The effects of changing interest rates on corporate performance are more fully discussed in the Market Risk Management discussion beginning on page 14.
The following table shows changes in interest income, interest expense and net interest income due to volume and rate variances for major categories of assets and liabilities:
----------------------------------------------------------------------------------------
1998 vs. 1997 1997 vs. 1996
------------------------------- -----------------------------
Due to Due to
Change in Change in
(Dollars in ------------------- Net ------------------ Net
Millions) Volume Rate* Change Volume Rate* Change
----------------------------------------------------------------------------------------
Increase (decrease) in tax equivalent interest income --
Loans** $456.2 $(135.8) $320.4 $104.0 $(43.4) $ 60.6
Securities 54.8 (7.7) 47.1 (18.8) 10.3 (8.5)
Short-term
investments 27.8 (3.9) 23.9 (9.2) 5.3 (3.9)
----------------------------------------------------------------------------------------
Total $538.8 $(147.4) $391.4 $ 76.0 $(27.8) $ 48.2
----------------------------------------------------------------------------------------
(Increase) decrease in interest expense --
NOW and money market
accounts $(64.6) $ 20.2 $(44.4) $ 6.5 $(44.6) $(38.1)
Savings 17.9 1.8 19.7 3.7 17.5 21.2
Time deposits 63.1 8.7 71.8 78.1 3.5 81.6
Borrowed funds (377.5) 37.6 (339.9) (144.7) 1.6 (143.1)
----------------------------------------------------------------------------------------
Total $(361.1) $ 68.3 $(292.8) $(56.4) $(22.0) $(78.4)
----------------------------------------------------------------------------------------
Increase (decrease) in tax equivalent net
interest income $ 98.6 $(30.2)
----------------------------------------------------------------------------------------
* Changes in interest income and interest expense not arising solely from rate or volume variances are included in rate variances.
** Includes mortgage loans held for sale.
Noninterest Income
------------------------------------------------------------------- (Dollars in Thousands) 1998 1997 1996 ------------------------------------------------------------------- Item processing revenue $ 484,503 $ 393,115 $ 364,512 Service charges on deposits 384,938 359,268 323,636 Trust and investment management fees 311,050 278,793 255,598 Card-related fees 201,168 205,631 191,272 Mortgage banking revenue 327,247 158,544 109,670 Service fees - other 91,869 93,936 80,713 Brokerage revenue 90,477 75,374 65,053 Real estate owned income 5,012 9,647 8,768 Other 283,419 192,085 129,265 ------------------------------------------------------------------- Total fees and other income $2,179,683 $1,766,393 $1,528,487 ------------------------------------------------------------------- Securities gains 134,459 81,239 108,650 ------------------------------------------------------------------- Total noninterest income $2,314,142 $1,847,632 $1,637,137 -------------------------------------------------------------------
Total fees and other income increased 23.4% in 1998 and 15.6% in 1997. The Fort Wayne acquisition added approximately $23 million to fee income in 1998 primarily within trust and investment management fees and service charges on deposits. Lower service fees earned on securitized credit card receivables, which have begun to amortize, reduced card-related fees in 1998.
Item processing revenue generated by National Processing increased 23.2% in 1998 and 7.8% in 1997. The increase in 1998 was due to acquisitions and an increase in merchant card revenue, offset by a decline in National Processing's merchant check and remittance operations. The increase in 1997 was primarily due to acquisitions.
Deposit service charges increased 7.1% in 1998 and 11.0% in 1997. The increase in 1998 was primarily due to an increase in debit card and other transaction volume as well as an increase in cash management revenue. The increase in 1997 was primarily due to the implementation of a uniform fee structure across the National City franchise.
Trust and investment management fees, which include both institutional trust and personal wealth management, increased 11.6% in 1998 and 9.1% in 1997. Revenue growth occurred in both periods due to new business volume and an increase in the market value of assets under management. At December 31, 1998, total assets under administration were $141.5 billion, compared to $106.3 billion at year-end 1997. Of that number, managed assets were $68.3 billion at December 31, 1998, compared to $55.4 billion at year-end 1997.
Mortgage banking revenue increased 106.4% in 1998 and 44.6% in 1997. Revenue growth in 1998 was driven by a favorable rate environment which increased the volume of loan originations to $20.1 billion in 1998, up from $8.4 billion in 1997. Pre-tax gains on mortgage loans sold totaled $211.0 million, $79.1 million and $47.8 million in 1998, 1997 and 1996, respectively. The volume of loans originated in 1998 also increased the size of the servicing portfolio to $35.2 billion at December 31, 1998, compared to $24.9 billion at December 31, 1997, and related servicing revenue. The increase in mortgage banking revenue in 1997 was also due to a favorable rate environment and the February 1997 acquisition of a mortgage origination business.
Brokerage revenue increased 20.0% in 1998 and 15.9% in 1997. Fueled by a strong equity market and aggressive marketing, the increase in both years reflects both higher retail brokerage sales and investment banking revenue.
The growth in other income in 1998 was primarily attributable to an increase in the cash surrender value of company-owned life insurance, and higher income related to venture capital and trading activities. Other income included branch sale gains of $52.1 million, $31.9 million and $38.9 million, in 1998, 1997 and 1996, respectively. Also in 1997, a gain of $18.8 million was realized from the sale of First of America's Florida-based banking operations, along with $13.0 million in equity appreciation on a private partnership investment.
Net realized securities gains and losses are summarized as follows:
-----------------------------------------------------------------
(Dollars in Thousands) 1998 1997 1996
-----------------------------------------------------------------
Net realized gains (losses) --
debt securities $ 24,553 $ (3,633) $ 6,342
Tax expense (benefit) 8,594 (1,271) 2,219
-----------------------------------------------------------------
After tax $ 15,959 $ (2,362) $ 4,123
-----------------------------------------------------------------
Net realized gains -- equity
securities $109,906 $ 84,872 $102,308
Tax expense 38,467 29,862 27,544
-----------------------------------------------------------------
After tax $ 71,439 $ 55,010 $ 74,764
-----------------------------------------------------------------
Effect on net income $ 87,398 $ 52,648 $ 78,887
-----------------------------------------------------------------
Effect on earnings per share $ .26 $ .16 $ .23
-----------------------------------------------------------------
Noninterest Expense
The following table provides details of noninterest expense for the last three years:
------------------------------------------------------------------
(Dollars in Thousands) 1998 1997 1996
------------------------------------------------------------------
Salaries $1,309,820 $1,165,604 $1,109,160
Benefits and other personnel 284,937 283,841 270,630
Equipment 212,871 204,862 193,601
Net occupancy 202,664 193,555 197,014
Third party services 226,262 176,084 196,928
Credit card fees 139,416 126,108 118,796
Postage and supplies 141,525 130,491 138,319
FDIC assessments 6,815 9,292 34,479
State and local taxes 45,687 47,977 48,474
Marketing and public
relations 63,608 69,083 104,538
Transportation 52,621 47,325 44,669
Telephone 74,963 63,420 59,675
Other real estate owned 9,016 9,773 10,658
Amortization of intangibles 65,186 49,140 62,992
Other 162,346 150,113 135,800
------------------------------------------------------------------
2,997,737 2,726,668 2,725,733
------------------------------------------------------------------
Merger and restructuring 379,376 65,902 74,745
------------------------------------------------------------------
Total $3,377,113 $2,792,570 $2,800,478
------------------------------------------------------------------
Full-time equivalent staff 41,218 40,630 38,434
------------------------------------------------------------------
In 1998, merger and restructuring expenses were incurred in connection with the First of America and Fort Wayne transactions. In 1997, merger and restructuring expenses included $33.3 million in costs associated with reorganizing National City's six Ohio banking subsidiaries under a single statewide charter, $19.3 million in connection with the First of America merger and $13.3 million in severance and reorganization costs at National Processing. In 1996, merger and restructuring expenses were incurred in connection with the Integra Financial Corporation Merger.
The purchase acquisition of Fort Wayne added approximately $80 million to operating expenses in 1998.
Salary and other personnel expenses increased in both years as a result of acquisitions and higher incentive-based compensation associated with increased business activity. In 1998, the increase was also driven by internal and contract labor costs associated with technology initiatives and the Year 2000 Project, offset by lower benefit costs.
Third party service fees have fluctuated over the past three years. In 1998, the increase was due to the outsourcing of credit card processing to a third party vendor, increased brokerage clearing fees and other consulting costs. In 1997, the decline was primarily due to savings arising from the Integra Financial Corporation merger.
FDIC assessments decreased in 1998 and 1997 as a result of the statutory reduction in the Federal Deposit Insurance Corporation's deposit insurance premiums. In 1996, a one-time assessment of $22.0 million was incurred in connection with the recapitalization of the Savings Association Insurance Fund (SAIF).
Marketing and public relations expense in 1996 included a $30.4 million contribution to National City's Charitable Contributions Foundation.
Overhead performance by line of business is summarized in the table below:
-------------------------------------------------------------------------------------------
1998 1997 1996
--------------------- --------------------- ---------------------
Overhead Efficiency Overhead Efficiency Overhead Efficiency
Ratio Ratio Ratio Ratio Ratio Ratio
-------------------------------------------------------------------------------------------
Corporate banking 22.3% 38.2% 27.3% 41.6% 32.1% 44.2%
Retail banking 39.3 53.0 41.4 54.3 46.2 57.1
Fee-based businesses -- 75.6 -- 78.7 -- 77.5
Parent and other -- -- -- -- -- --
-------------------------------------------------------------------------------------------
Total 40.6% 65.8% 36.0% 60.5% 44.1% 63.5%
-------------------------------------------------------------------------------------------
Excluding merger and
restructuring
expenses 27.7% 58.4% 33.7% 59.0% 41.5% 61.8%
-------------------------------------------------------------------------------------------
The overhead ratio calculates noninterest expense less fee and other income as a percentage of tax equivalent net interest income. The efficiency ratio calculates noninterest expense as a percentage of fee and other income plus tax-equivalent net interest income. The fee-based businesses generally have lower gross margins than the banking businesses. Consequently, growth in these businesses penalizes the efficiency ratio. Conversely, strong fee income benefits the overhead ratio.
Earning Assets
Average earning assets for 1998 were $71,747 million compared to $65,259 million in 1997 and $64,535 million in 1996. The 9.9% increase in 1998 over 1997 was primarily due to a 10.1% increase in average loans and a 9.3% increase in securities and other earning assets. The increase in 1997 was due to a 2.3% increase in average loans, offset by a 3.2% decline in securities and other earning assets.
Loans: Ending loan balances for the last five years are summarized in the following table:
------------------------------------------------------------------------ (Dollars in Millions) 1998 1997 1996 1995 1994 ------------------------------------------------------------------------ Commercial $22,243 $18,218 $15,739 $15,437 $13,887 Real estate -- commercial 6,252 6,411 6,817 6,626 6,185 Real estate -- residential 9,664 9,987 11,164 11,755 10,969 Consumer 14,823 12,357 12,009 11,662 11,438 Credit card 1,852 2,048 2,240 2,531 3,040 Home equity 3,177 2,973 2,473 2,116 1,877 ------------------------------------------------------------------------ Total loans $58,011 $51,994 $50,442 $50,127 $47,396 ------------------------------------------------------------------------
The various categories of loans are subject to varying levels of risk. Management mitigates these risks through portfolio diversification and through standardization of lending policies.
Commercial: Commercial loans grew throughout 1998 due to strong demand in local markets, aggressive sales efforts and competitive product offerings.
The majority of the commercial loan portfolio consists of loans made to middle-market customers in National City's six-state market. The loan mix is diverse, covering a broad range and number of borrowers. There are no concentrations of loans in any one industry and as a matter of policy, emerging concentrations within a particular industry are continually monitored and controlled. International loans totaled approximately $40 million in both 1998 and 1997.
An analysis of the maturity and interest rate sensitivity of commercial loans at the end of 1998 follows:
---------------------------------------------------------------------
One Year One to Over
(Dollars in Millions) or Less Five Years Five Years Total
---------------------------------------------------------------------
Variable rate $8,653 $6,960 $1,961 $17,574
Fixed rate 1,260 2,570 839 4,669
---------------------------------------------------------------------
Total $9,913 $9,530 $2,800 $22,243
---------------------------------------------------------------------
Commercial Real Estate: At December 31, 1998, total commercial real estate loans comprised 10.8% of the total loan portfolio compared to 12.3% in 1997. The portfolio contains no concentrations of real estate loans in any deteriorating economic areas.
The following table presents a breakdown of commercial mortgage loans (excluding owner-occupied) at December 31, 1998 by state and project type:
------------------------------------------------------------
(Dollars in Millions)
------------------------------------------------------------
By State: By Project:
Ohio $1,691 Apartments $1,031
Michigan 1,014 Retail 960
Illinois 415 Office 888
Indiana 354 Industrial 223
Pennsylvania 306 Healthcare 167
Kentucky 263 Land 165
Florida 64 Condo/Single
Other 246 Family 154
Other 765
------------------------------------------------------------
Total $4,353 Total $4,353
------------------------------------------------------------
Activities in commercial real estate are based primarily on relationships with developers who are active in National City's local markets, with more than 90% of outstandings in National City's six-state market.
Consumer: 73% of the portfolio is comprised of installment loans of which a majority are automobile sales financing; 65% of these loans are indirect and 97% are at fixed rates. The auto lease portfolio grew 56.2% to $1,528.5 million at December 31, 1998 compared to $978.5 million at year-end 1997.
Credit Card: In 1998, credit card balances declined as a result of attrition. The decline in credit card outstandings in 1997 and 1996 was primarily due to the sale of credit card receivables. Off-balance sheet securitized credit cards totaled $770 million and $870 million at December 31, 1998 and 1997, respectively.
Securities: Summary information with respect to the securities portfolio at December 31 follows:
----------------------------------------------------------------
1998 1997 1996
(Dollars in Amortized 1998 Amortized Amortized
Millions) Cost Yield* Cost Cost
----------------------------------------------------------------
U.S. Treasury and Federal agency debentures:
Under 1 year $ 105 6.54% $ 404 $ 652
1 to 5 years 714 5.30 1,154 2,259
5 to 10 years 393 5.52 1,170 1,094
Over 10 years -- -- 2,346 1,709
----------------------------------------------------------------
Total 1,212 5.47 5,074 5,714
----------------------------------------------------------------
Mortgage-backed securities:
Under 1 year 1,211 6.25 387 122
1 to 5 years 4,918 6.60 3,277 2,619
5 to 10 years 3,388 6.11 1,211 1,635
Over 10 years 202 6.01 349 501
----------------------------------------------------------------
Total 9,719 6.37 5,224 4,877
----------------------------------------------------------------
Asset-backed and corporate debt securities:
Under 1 year 762 6.13 453 95
1 to 5 years 1,953 6.27 814 625
5 to 10 years 294 6.41 231 233
Over 10 years 35 7.28 70 112
----------------------------------------------------------------
Total 3,044 6.28 1,568 1,065
----------------------------------------------------------------
States and political subdivisions:
Under 1 year 52 10.28 101 58
1 to 5 years 120 9.82 98 136
5 to 10 years 324 8.37 494 135
Over 10 years 421 8.22 122 321
----------------------------------------------------------------
Total 917 8.60 815 650
----------------------------------------------------------------
Other securities:
Under 1 year -- -- -- 183
1 to 5 years -- -- -- 2
5 to 10 years -- -- -- 3
Over 10 years 809 -- 585 678
----------------------------------------------------------------
Total 809 -- 585 866
----------------------------------------------------------------
Total securities $15,701 6.40% $13,266 $13,172
----------------------------------------------------------------
* Yield on debt securities only; equity securities excluded.
------------------------------------------------------------
Yields on tax-exempt securities are calculated on a tax equivalent basis using the marginal Federal income tax rate of 35%. Mortgage-backed securities are assigned to maturity categories based on their estimated average lives. Equity securities are included in other securities over 10 years.
The portfolio yield at December 31, 1998 was 6.40% compared to 6.60% at December 31, 1997. The decrease in portfolio yield is attributable to lower reinvestment rates and a decline in higher yielding assets that matured, prepaid or were called.
Investments in collateralized mortgage obligations (CMOs) totaled $4.6 billion and $5.9 billion at December 31, 1998 and 1997, respectively. CMOs and all mortgage-backed securities are continually monitored and subjected to stress tests for price and average life sensitivity. The amount of mortgage-backed securities that are either variable or adjustable rate totaled $692 million at December 31, 1998, or 7% of total mortgage-backed securities.
Asset Quality
Nonperforming Assets: A summary of nonaccrual and restructured loans and other nonperforming assets at December 31 follows:
------------------------------------------------------------------------------ (Dollars in Millions) 1998 1997 1996 1995 1994 ------------------------------------------------------------------------------ Commercial: Nonaccrual $ 95.4 $ 108.9 $ 119.6 $ 150.1 $ 94.0 Restructured .4 1.1 3.5 10.6 2.8 ------------------------------------------------------------------------------ Total commercial 95.8 110.0 123.1 160.7 96.8 ------------------------------------------------------------------------------ Real estate mortgage: Nonaccrual 120.2 123.4 104.5 137.3 173.5 Restructured 2.6 4.4 6.1 5.9 8.9 ------------------------------------------------------------------------------ Total real estate mortgage 122.8 127.8 110.6 143.2 182.4 ------------------------------------------------------------------------------ Total nonperforming loans 218.6 237.8 233.7 303.9 279.2 Other real estate owned (OREO) 29.9 35.5 48.7 52.5 87.4 ------------------------------------------------------------------------------ Total nonperforming assets $ 248.5 $ 273.3 $ 282.4 $ 356.4 $ 366.6 ------------------------------------------------------------------------------ Loans 90 days past due accruing interest $ 209.5 $ 136.1 $ 133.8 $ 92.8 $ 69.5 ------------------------------------------------------------------------------ Nonperforming loans and OREO as a percent of: Loans and OREO .4% .5% .6% .7% .8% Assets .3 .4 .4 .5 .5 Equity 3.5 4.4 4.5 6.0 7.3 ------------------------------------------------------------------------------
All loans considered impaired under SFAS No. 114 are included in non-performing loans.
Commercial and residential real estate loans are designated as nonperforming when payments are 90 or more days past due, when credit terms are renegotiated below market levels, or when individual analysis of a borrower's creditworthiness indicates that a credit should be placed on nonaccrual status, unless the loan is adequately collateralized and is in the process of collection.
Consumer loans are reported as "90 days past due accruing interest" once the 90-day criterion has been met, and are charged off in the month in which the loan becomes 120 days past due. Generally, when loans are classified as nonperforming or impaired, unpaid accrued interest is written off and future income may be recorded only as cash payments are received.
Although loans may be classified as nonperforming, many continue to pay interest irregularly or at less than original contractual rates. A summary of actual income booked on nonperforming loans versus their full contractual yields for each of the past five years follows:
------------------------------------------------------------------------------ (Dollars in Millions) 1998 1997 1996 1995 1994 ------------------------------------------------------------------------------ Income potential based on original contract $44.7 $31.5 $35.3 $34.4 $34.9 Actual income 10.2 13.1 15.9 15.2 14.1 ------------------------------------------------------------------------------
Allowance for Loan Losses: The following table presents a reconciliation of the allowance for loan losses:
-------------------------------------------------------------------------------- (Dollars in Millions) 1998 1997 1996 1995 1994 -------------------------------------------------------------------------------- Balance at beginning of year $941.9 $958.7 $947.0 $934.6 $874.0 Provision 201.4 225.4 239.9 205.0 195.9 Allowance related to loans acquired (sold) 27.4 (19.5) .1 11.6 21.2 Charge-offs: Commercial 43.7 63.7 67.0 59.3 68.5 Real estate -- commercial 9.3 8.1 6.1 7.8 7.6 Real estate -- residential 9.0 7.2 11.1 27.8 28.6 Consumer 154.9 165.3 176.3 132.4 82.1 Credit card 95.7 111.8 115.3 108.0 88.4 Home equity 8.8 4.7 4.9 2.6 1.7 -------------------------------------------------------------------------------- Total charge-offs 321.4 360.8 380.7 337.9 276.9 -------------------------------------------------------------------------------- Recoveries: Commercial 25.4 28.1 40.0 31.5 43.3 Real estate -- commercial 7.3 7.2 4.0 3.8 2.1 Real estate -- residential .7 1.3 5.8 10.0 5.5 Consumer 64.3 78.6 80.8 67.0 48.4 Credit card 19.8 21.2 20.5 19.7 20.1 Home equity 3.4 1.7 1.3 1.7 1.0 -------------------------------------------------------------------------------- Total recoveries 120.9 138.1 152.4 133.7 120.4 -------------------------------------------------------------------------------- Net charge-offs 200.5 222.7 228.3 204.2 156.5 -------------------------------------------------------------------------------- Balance at end of year $970.2 $941.9 $958.7 $947.0 $934.6 -------------------------------------------------------------------------------- Ratio of ending allowance to ending loans 1.67% 1.81% 1.90% 1.89% 1.97% --------------------------------------------------------------------------------
Net charge-offs as a percentage of average loans by portfolio type are shown in the following table:
--------------------------------------------------------------------------------
1998 1997 1996 1995 1994
--------------------------------------------------------------------------------
Commercial .09% .21% .18% .20% .19%
Real estate -- commercial .03 .01 .03 .06 .09
Real estate -- residential .08 .06 .05 .15 .23
Consumer .67 .72 .79 .56 .31
Credit card 4.08 4.37 4.23 3.37 2.59
Home equity .17 .11 .16 .04 .05
Total net charge-offs to
average loans .37% .44% .46% .42% .36%
--------------------------------------------------------------------------------
Consumer and credit card loans are charged off within industry norms, while commercial loans are evaluated individually.
The allowance for loan losses is evaluated based on an assessment of the losses inherent in the loan portfolio. This assessment results in an allowance consisting of two components, allocated and unallocated.
The allocated component of the allowance for loan losses reflects expected losses resulting from the analysis of individual loans, developed through specific credit allocations for individual loans and historical loss experience for each loan category. The specific credit allocations are based on a regular analysis of all loans and commitments over a fixed dollar amount where the internal credit rating is at or below a predetermined classification. The historical loan loss element is determined statistically using a loss migration analysis that examines loss experience and the related internal gradings of loans charged off. The loss migration analysis is performed quarterly and loss factors are periodically updated based on actual experience.
The allocated component of the allowance for loan losses also includes management's determination of the amounts necessary for concentrations and changes in mix and volume of the portfolio.
The unallocated portion of the allowance is determined based on management's assessment of general economic conditions as well as specific economic factors in the individual markets in which National City operates. This determination inherently involves a higher degree of uncertainty and considers current risk factors that may not have yet manifested themselves in the Corporation's historical loss factors used to determine the allocated component of the allowance, and it recognizes that knowledge of the portfolio may be incomplete.
An allocation of the ending allowance for loan losses by major loan type follows:
------------------------------------------------------------------------------ (Dollars in Millions) 1998 1997 1996 1995 1994 ------------------------------------------------------------------------------ Commercial $217.8 $196.3 $197.0 $232.1 $201.6 Real estate mortgage 88.1 85.0 89.7 121.3 166.6 Consumer 135.6 154.3 153.9 152.5 131.2 Revolving credit 101.7 81.3 82.2 77.2 70.0 Unallocated 427.0 425.0 435.9 363.9 365.2 ------------------------------------------------------------------------------ Total $970.2 $941.9 $958.7 $947.0 $934.6 ------------------------------------------------------------------------------
The following table shows the percentage of loans in each category to total loans at year-end:
--------------------------------------------------------------------
1998 1997 1996 1995 1994
--------------------------------------------------------------------
Commercial 38.2% 35.1% 31.3% 30.8% 29.4%
Real
estate -- commercial 10.8 12.3 13.5 13.2 13.0
Real
estate -- residential 16.7 19.2 22.1 23.5 23.1
Consumer 25.6 23.8 23.8 23.3 24.1
Credit card 3.2 3.9 4.4 5.0 6.4
Home equity 5.5 5.7 4.9 4.2 4.0
--------------------------------------------------------------------
Total 100.0% 100.0% 100.0% 100.0% 100.0%
--------------------------------------------------------------------
Deposits and Borrowed Funds
Providing a stable source of low-cost funding, core deposits include noninterest bearing demand deposits, NOW and money market accounts, savings accounts and time deposits of individuals. Average core deposits were $49.8 billion in 1998 compared to $49.1 billion in 1997. The increase was due to the acquisition of Fort Wayne, with the balance mix shifting toward money market products from savings and certificate of deposit accounts.
Short- and long-term borrowed funds provided most of the funding to support loan growth. Average borrowed funds were $22.0 billion in 1998 compared to $15.4 billion in 1997.
A maturity distribution of certificates of deposit of $100,000 or more at year-end follows:
-------------------------------------------------------------
(Dollars in Millions) 1998 1997
-------------------------------------------------------------
Due in:
3 months or less $2,415 $1,714
3 to 6 months 572 616
6 to 12 months 557 636
Over 1 year 1,936 2,271
-------------------------------------------------------------
Total $5,480 $5,237
-------------------------------------------------------------
Details regarding federal funds borrowed and security repurchase agreements follow:
---------------------------------------------------------------
(Dollars in Millions) 1998 1997 1996
---------------------------------------------------------------
Balance at December 31 $9,427 $4,811 $5,157
Maximum outstanding at any month-end 9,738 5,945 5,267
Daily average amount outstanding 7,242 5,019 4,603
Weighted daily average interest rate 4.89% 4.70% 5.40%
Weighted daily interest rate for
amounts outstanding at December 31 4.30% 5.54% 5.82%
---------------------------------------------------------------
Capital
The Corporation has consistently maintained regulatory capital ratios at or above the "well capitalized" standards. For further detail on capital ratios, see Note 12 to the Consolidated Financial Statements.
On October 26, 1998, the Board of Directors authorized the repurchase of up to 30 million shares of National City common stock in the open market or through privately negotiated transactions subject to an aggregate purchase limit of $2.7 billion. Five million shares were repurchased during the fourth quarter of 1998.
The total market capitalization of the Corporation was approximately $23.7 billion at December 31, 1998, and there were 71,592 common stockholders of record.
Quarterly dividends paid per share and common stock prices follow:
-------------------------------------------------------------------
NYSE: NCC First Second Third Fourth Year
1998
Dividends paid $ .46 $ .46 $ .48 $ .48 $ 1.88
High 74.81 77.50 74.00 74.00 77.50
Low 56.94 65.38 57.00 58.75 56.94
Close 73.31 71.00 65.94 72.50 72.50
1997
Dividends paid $ .41 $ .41 $ .425 $ .425 $ 1.67
High 54.63 55.25 64.88 67.56 67.56
Low 42.50 44.63 52.25 54.13 42.50
Close 46.63 52.50 61.56 65.75 65.75
-------------------------------------------------------------------
Cash dividend payout is continually reviewed by management and the Board of Directors. For the past three- and five-year periods, the dividend payout ratio, excluding merger and restructuring expenses, has averaged 47.29% and 48.86%, respectively.
In December 1998, the Board of Directors declared a first quarter 1999 dividend of $.52 per common share, representing an 8.3% increase. The dividend is payable February 1 to stockholders of record on January 11, 1999, and continues the pattern of increasing the dividend twice per year.
Liquidity Management
Effective liquidity management ensures that the cash flow requirements of depositors and borrowers, as well as the operating cash needs of the Corporation, are met.
Funds are available from a number of sources, including the securities portfolio, the core deposit base, the ability to acquire large deposits and issue bank notes in the local and national markets, and the capability to securitize or package loans for sale.
The parent company has four major sources of funding to meet its liquidity requirements: dividends from its subsidiaries, the commercial paper market, a revolving credit agreement and access to the capital markets.
The main source for parent company cash requirements has been dividends from its subsidiaries. At January 1, 1999, $904.6 million was available within the bank subsidiaries to pay parent company dividends without prior regulatory approval, versus $501.2 million at January 1, 1998. During 1998, subsidiary banks declared $752.2 million in dividends to the parent company.
As discussed in Item 1 of Form 10-K (page 45), subsidiary banks are subject to regulation and, among other things, may be limited in their ability to pay dividends or transfer funds to the parent company. Accordingly, consolidated cash flows as presented in the Consolidated Statements of Cash Flows on page 24 may not represent cash immediately available to National City's stockholders.
Funds raised in the commercial paper market through the Corporation's subsidiary, National City Credit Corporation, support short-term cash needs.
National City has a $350 million revolving credit agreement with a group of unaffiliated banks which serves as a back-up liquidity facility. The agreement expires February 1, 2001, with a provision to extend the expiration date under certain circumstances. No borrowings have occurred under this facility.
The parent company also has in place a $250 million shelf registration with the Securities and Exchange Commission permitting ready access to the public debt and preferred stock markets.
Forward-Looking Statements
The sections that follow, MARKET RISK MANAGEMENT and OTHER, contain certain forward-looking statements (as defined in the Private Securities Litigation Reform Act of 1995). These forward-looking statements involve significant risks and uncertainties including changes in general economic and financial market conditions, the Corporation's ability to execute its business plans, including its plan to address the Year 2000 issue, and the ability of third parties to effectively address their Year 2000 issues. Although National City believes that the expectations reflected in such forward-looking statements are reasonable, actual results may differ materially.Market Risk Management
Market risk is the risk of loss arising from adverse changes in the fair value of financial instruments due to changes in interest rates, exchange rates and equity prices. National City's market risk is composed primarily of interest rate risk. The Asset/Liability Management Committee (ALCO) is responsible for reviewing the interest rate sensitivity position of the Corporation and establishing policies to monitor and limit exposure to interest rate risk. The guidelines established by ALCO are reviewed by the Investment Committee of the Corporation's Board of Directors.
Asset/Liability Management: The primary goals of asset/liability management are to maximize net interest income and the net value of the Corporation's future cash flows within the interest rate risk limits set by ALCO.
Interest Rate Risk Measurement: Interest rate risk is monitored through the use of three complementary measures: static gap analysis, earnings simulation modeling and net present value estimation. While each of the interest rate risk measurements has limitations, taken together they represent a reasonably comprehensive view of the magnitude of interest rate risk in the Corporation, the distribution of risk along the yield curve, the level of risk through time, and the amount of exposure to changes in certain interest rate relationships.
Static Gap: Gap analysis measures the amount of repricing risk embedded in the balance sheet at a point in time. It does so by comparing the differences in the repricing characteristics of assets and liabilities. A gap is defined as the difference between the principal amount of assets and liabilities, adjusted for off-balance sheet instruments, which reprice within a specified time period. The cumulative one-year gap, at year-end, was (8.8%) of total earning assets adjusted for off-balance sheet investment surrogates. The policy limit for the one-year gap is plus or minus 15% of adjusted total earning assets.
Core deposits and loans with noncontractual maturities are included in the gap repricing distributions based upon historical patterns of balance attrition and pricing behavior which are reviewed at least annually.
The gap repricing distributions include principal cash flows from residential mortgage loans and mortgage-backed securities in the timeframes in which they are expected to be received. Mortgage prepayments are estimated by applying industry median projections of prepayment speeds to portfolio segments based on coupon range and loan age.
Earnings Simulation: The earnings simulation model forecasts one- and two-year net income under a variety of scenarios that incorporate changes in the absolute level of interest rates, changes in the shape of the yield curve and changes in interest rate relationships. Management evaluates the effects on income of alternative interest rate scenarios against earnings in a stable interest rate environment. This type of analysis is also most useful in determining the short-run earnings exposures to changes in customer behavior involving loan payments and deposit additions and withdrawals.
The most recent earnings simulation model projects net income would increase by approximately 2.2% of stable-rate net income if rates fall gradually by two percentage points over the next year. It projects a decrease of approximately 2.8% if the rates rise gradually by two percentage points, well within the (5.0%) policy limit. Management believes this reflects a slight liability-sensitive rate risk position for the one-year horizon. Within a two-year horizon, and assuming an additional 200 basis point move in rates, the model forecasts that net income would fall below that earned in a stable rate environment by 2.5% in a falling rate scenario and fall by 7.9% in a rising rate scenario. Both of these forecasts are within the two-year policy guideline of (15.0%).
Net income is also subject to changes in the shape of the yield curve. In general, a flattening of the yield curve would result in a decline in earnings due to the compression of earning asset yields and funding rates. Conversely, a steepening would result in increased earnings as investment margins widen. The earnings impact of these twist scenarios is modeled on a monthly basis and results of this analysis indicate an acceptable level of risk. Earnings are also affected by changes in spread relationships between key rate indices, such as Prime and Fed Funds. Variability between these key rate indices is simulated on a monthly basis. Management believes the earnings exposure to this variability is modest.
This dynamic simulation model includes assumptions about how the balance sheet is likely to evolve through time in different interest rate environments. Loan and deposit growth rate assumptions are derived from historical analysis and management's outlook, as are the assumptions used to project yields and rates for new loans and deposits. All maturities, calls and prepayments in the securities portfolio are assumed to be reinvested in two-year assets, as are the portion of derivatives used as off-balance sheet investment alternatives. Mortgage loan prepayment assumptions are developed from industry median estimates of prepayment speeds for portfolios with similar coupon ranges and seasoning. Noncontractual deposit growth rates and pricing are assumed to follow historical patterns. The sensitivities of key assumptions are analyzed periodically and reviewed by ALCO.
Net Present Value: The Net Present Value (NPV) of the balance sheet, at a point in time, is defined as the discounted present value of asset cash flows and derivative cash flows minus the discounted value of liability cash flows. Interest rate risk analysis using NPV involves changing the interest rates used in determining the cash flows and in discounting the cash flows. The resulting percentage change in NPV is an indication of the longer term repricing risk and options risk embedded in the balance sheet.
At year-end, a 150 basis point immediate increase in rates is estimated to reduce NPV by 3.8%. Additionally, NPV is projected to decrease by 3.7% if rates fall by 150 basis points. Policy limits restrict this amount to (10.0%) of NPV. Analysis of the average quarterly change in the Treasury yield curve over the past ten years indicates that a parallel curve shift of 150 basis points or more is an event that has less than a .1% chance of occurrence.
As with gap analysis and earnings simulation modeling, assumptions about the timing and variability of balance sheet cash flows are critical in NPV analysis. Particularly important are the assumptions driving mortgage prepayments and the assumptions about expected attrition of the core deposit portfolios. These assumptions are applied consistently across the different rate risk measures.
Summary information about each of the three interest-rate risk measures is presented below:
----------------------------------------------------------------------------------------------------------------------------
Year-end Average Maximum Minimum Year-end ALCO
1998 1998 1998 1998 1997 Guidelines
----------------------------------------------------------------------------------------------------------------------------
Static 1-Year Cumulative Gap -8.8% -8.1% -6.0% -10.6% -8.8% -15.0%
1-Year Net Income Simulation Projection
-200 bp Ramp vs. Stable Rate 2.2% 2.2% 2.9% 1.5% 1.7% - 5.0%
+200 bp Ramp vs. Stable Rate -2.8% -2.9% -2.3% - 3.6% -1.8% - 5.0%
2-Year Net Income Simulation Projection
-200 bp Ramp vs. Stable Rate -2.5% -1.2% 1.5% - 4.1% -2.7% -15.0%
+200 bp Ramp vs. Stable Rate -7.9% -7.4% -4.9% - 9.5% -7.2% -15.0%
Static Net Present Value Change
-150 bp Shock vs. Stable Rate -3.7% -4.2% -2.3% - 5.9% -3.5% -10.0%
+150 bp Shock vs. Stable Rate -3.8% -2.9% -1.4% - 4.0% -3.9% -10.0%
----------------------------------------------------------------------------------------------------------------------------
Interest Rate Risk Management: A variety of financial instruments are used to manage interest rate sensitivity. These include the securities in the investment portfolio, interest rate swaps, interest rate caps and floors, and, to a lesser extent, exchange-traded futures and options contracts. Frequently called interest rate derivatives, interest rate swaps, caps and floors have characteristics similar to securities but possess the advantages of customization of the risk-reward profile of the instrument, minimization of balance sheet leverage and improvement of the liquidity position. See Notes 1 and 19 to the Consolidated Financial Statements for further discussion on derivative financial instruments.
Due to borrowers' preferences for floating-rate loans and depositors' preferences for fixed-rate deposits, National City's balance sheet tends to move toward less liability sensitivity with the passage of time. The earnings simulation model indicates that if all prepayments, calls and maturities of the securities and derivatives portfolios expected over the next year were to remain uninvested, then the current liability sensitivity position would be lessened. The simulation model projects that in a 200 basis point rising interest rate environment, with no reinvestment, the resulting net income would be .9% less than that earned in a stable rate environment. Purchases of fixed-rate securities or interest rate derivative instruments have been made to offset the natural tendency toward a less liability sensitive interest rate risk position.
Management expects interest rates to be stable to slightly lower during 1999 and believes that the current modest level of liability sensitivity is appropriate.
Trading Risk Management: The Corporation maintains a trading account primarily to provide investment products and risk management services to its customers as well as to take proprietary risk positions. Trading risk is monitored on a regular basis through the use of the value-at-risk methodology (VAR). VAR is defined as the potential overnight dollar loss from adverse market movements, with 97.5% confidence, based on historical prices and market rates. During 1998, the maximum month-end measured VAR was $1.0 million, well within the limit established by ALCO of $2.3 million. Month-end VAR estimates are reported monthly to ALCO. Trading income for 1998 totaled $22.5 million.
Other
Year 2000: Management initiated the process of preparing its computer systems and applications for the Year 2000 in January 1995. The process involves identifying and remediating date recognition problems in computer systems and software and other operating equipment that could be caused by the date change from December 31, 1999 to January 1, 2000.
Management has completed its assessment of all business processes that could be affected by the Year 2000 issue. Each business process assessment included a review of the information systems used in that process, including related hardware and software, the involvement of any third parties, and any affected operating equipment. To date, the affected systems within 85% of those business processes determined to be critical for supporting the core services offered by National City have been remediated, unit tested, and returned to production. As part of the testing process, National City established a separate isolated testing environment that further tests the functioning of modified systems when linked together. Management expects to complete the remediation and testing of all affected systems within the critical business processes by the end of the second quarter of 1999.
Management is also working with significant customers, vendors, and business counterparties to monitor the progress of their Year 2000 efforts.
Management believes it has an effective plan in place to resolve the Year 2000 issue in a timely manner and, thus far, activities have tracked in accordance with the original plan. Management is in the process of modifying its existing business continuity plans and is also developing contingency plans to address potential risks in the event of Year 2000 failures, including non- compliance by third parties. Despite National City's efforts to date to remediate affected systems and develop contingency plans for potential risks, management has not yet completed all activities associated with resolving its Year 2000 issues. Under the unlikely scenario that the additional phases are not completed, National City could be materially adversely affected as a result of not being able to process transactions related to its core business activities. In addition, non-compliance by third parties (including loan customers) and disruptions to the economy in general resulting from Year 2000 issues could also have a negative impact of undeterminable magnitude on National City.
The total cost of the Year 2000 project is estimated at $65 million. Approximately one-half of this estimate represents costs related to internal personnel working on the project and certain capitalizable costs related to replacing non-compliant hardware and software. To date, $37 million of the total project costs have been incurred. During 1998, incremental noninterest expense associated with the project totaled approximately $21 million.