Exhibit 13.1

 

 

Table 1 — Selected Financial Data⁽¹⁾

 

N.M., not a meaningful value.

 

AND RESULTS OF OPERATIONS

 

INTRODUCTION

 

Huntington Bancshares Incorporated (we or our) is a multi-state diversified financial holding company organized under Maryland law in 1966 and headquartered in Columbus, Ohio. Through our subsidiaries, including our bank subsidiary, The Huntington National Bank (the Bank), organized in 1866, we provide full-service commercial and consumer banking services, mortgage banking services, automobile financing, equipment leasing, investment management, trust services, brokerage services, reinsurance of private mortgage insurance, reinsurance of credit life and disability insurance, retail and commercial insurance-agency services, and other financial products and services. Our banking offices are located in Ohio, Michigan, Pennsylvania, Indiana, West Virginia, and Kentucky. Selected financial service activities are also conducted in other states including: Dealer Sales offices in Arizona, Florida, Georgia, Nevada, New Jersey, New York, North Carolina, South Carolina, and Tennessee; Private Financial and Capital Markets Group offices in Florida; and Mortgage Banking offices in Maryland and New Jersey. Sky Insurance offers retail and commercial insurance agency services in Ohio, Pennsylvania, and Indiana. International banking services are available through the headquarters office in Columbus and a limited purpose office located in both the Cayman Islands and Hong Kong.

 

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) provides you with information we believe necessary for understanding our financial condition, changes in financial condition, results of operations, and cash flows and should be read in conjunction with the financial statements, notes, and other information contained in this report.

 

Our discussion is divided into key segments:

 

 

A reading of each section is important to understand fully the nature of our financial performance and prospects.

 

Forward-Looking Statements

 

This report, including MD&A, contains certain forward-looking statements, including certain plans, expectations, goals, and projections, and including statements about the benefits of our merger with Sky Financial, which are subject to numerous assumptions, risks, and uncertainties. Statements that do not describe historical or current facts, including statements about beliefs and expectations, are forward-looking statements. The forward-looking statements are intended to be subject to the safe harbor provided by Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934.

 

Actual results could differ materially from those contained or implied by such statements for a variety of factors including: (1) deterioration in the loan portfolio could be worse than expected due to a number of factors such as the underlying value of the collateral could prove less valuable than otherwise assumed and assumed cash flows may be worse than expected; (2) merger benefits including expense efficiencies and revenue synergies may not be fully realized and/or within the expected timeframes; (3) merger disruptions may make it more difficult to maintain relationships with clients, associates, or suppliers; (4) changes in economic conditions; (5) movements in interest rates; (6) competitive pressures on product pricing and services; (7) success and timing of other business strategies; (8) the nature, extent, and timing of governmental actions and reforms; and (9) extended disruption of vital infrastructure. Additional factors that could cause results to differ materially from those described above can be

 

found in Huntington’s 2007 Annual Report on Form 10-K, and documents subsequently filed by us with the Securities and Exchange Commission.

 

All forward-looking statements speak only as of the date they are made and are based on information available at that time. We assume no obligation to update forward-looking statements to reflect circumstances or events that occur after the date the forward-looking statements were made or to reflect the occurrence of unanticipated events except as required by federal securities laws. As forward-looking statements involve significant risks and uncertainties, readers of this document are cautioned against placing undue reliance on such statements.

 

Risk Factors

 

We, like other financial companies, are subject to a number of risks, many of which are outside of our direct control, though efforts are made to manage those risks while optimizing returns. Among the risks assumed are: (1) credit risk, which is the risk that loan and lease customers or other counterparties will be unable to perform their contractual obligations, (2) market risk, which is the risk that changes in market rates and prices will adversely affect our financial condition or results of operation, (3) liquidity risk, which is the risk that we, or the Bank, will have insufficient cash or access to cash to meet operating needs, and (4) operational risk, which is the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events. Please refer to the “Risk Management and Capital” section for additional information regarding risk factors. Additionally, more information on risk is set forth under the heading “Risk Factors” included in Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2007, and subsequent filings with the SEC.

 

Critical Accounting Policies and Use of Significant Estimates

 

Our financial statements are prepared in accordance with accounting principles generally accepted in the United States (GAAP). The preparation of financial statements in conformity with GAAP requires us to establish critical accounting policies and make accounting estimates, assumptions, and judgments that affect amounts recorded and reported in our financial statements. Note 1 of the Notes to Consolidated Financial Statements included in this report lists significant accounting policies we use in the development and presentation of our financial statements. This discussion and analysis, the significant accounting policies, and other financial statement disclosures identify and address key variables and other qualitative and quantitative factors necessary for an understanding and evaluation of our company, financial position, results of operations, and cash flows.

 

An accounting estimate requires assumptions about uncertain matters that could have a material effect on the financial statements if a different amount within a range of estimates were used or if estimates changed from period-to-period. Readers of this report should understand that estimates are made under facts and circumstances at a point in time, and changes in those facts and circumstances could produce actual results that differ from when those estimates were made. The most significant accounting estimates and their related application are discussed below. This analysis is included to emphasize that estimates are used in connection with the critical and other accounting policies and to illustrate the potential effect on the financial statements if the actual amount were different from the estimated amount.

 

 

Additionally, we established a specific reserve of $115.3 million associated with our loans to Franklin. To estimate the specific allowance associated with our loans to Franklin, we used estimates of probability-of-default and the loss-given-default for each of Franklin’s three portfolios of loans: acquired first-priority lien residential mortgage loans, acquired second-priority lien residential mortgage loans and originated first-priority lien loans. We used estimates of probability-of-default and the loss-given-default that resulted in an estimated loss of approximately 25% of the $2.1 billion unpaid principal balances of loans that support our loans to Franklin. We estimate that if the probability-of-default from this scenario were increased by 10% for each

 

portfolio and, additionally, the loss-given-default increased for each portfolio, that the provision for credit losses would have increased by approximately $102 million. Our relationship with Franklin is discussed in greater detail in the “Significant Items” section of this report.

 

 

Many of our assets are carried at fair value, including securities, derivatives, mortgage servicing rights (MSRs), and trading assets. Additionally, a smaller portion is carried at the lower of fair value or cost, including loans held-for-sale, while another portion is evaluated for impairment using fair value measurements. At December 31, 2007, approximately $6.2 billion of our assets were recorded at either fair value or at the lower of fair value or cost. In addition to the above mentioned ongoing fair value measurements, fair value is also the unit of measure for recording business combinations. On the date of the Sky Financial acquisition, July 1, 2007, all of Sky Financial’s assets and liabilities, including identifiable intangible assets, were recorded at their estimated fair value. The excess of purchase price over the fair value of net assets acquired was recorded as goodwill. Please refer to Note 3 of the Notes to Consolidated Financial Statements for additional information regarding the purchase, and related goodwill, of Sky Financial.

 

We estimate the fair value of a financial instrument using a variety of valuation methods. Where financial instruments are actively traded and have quoted market prices, quoted market prices are used for fair value. When observable market prices do not exist, we estimate fair value. Our valuation methods consider factors such as liquidity and concentration concerns and, for the derivatives portfolio, counterparty credit risk. Other factors such as model assumptions, market dislocations, and unexpected correlations can affect estimates of fair value. Imprecision in estimating these factors can impact the amount of revenue or loss.

 

Goodwill

Goodwill represents the excess of the cost of an acquisition over the fair value of the net assets acquired. We test the goodwill of each reporting unit for impairment annually, as of October 1, or more frequently if events or circumstances indicate possible impairment. We estimate the fair value of each reporting unit using a combination of a discounted cash flow analysis based on internal forecasts and market-based valuation multiples for comparable businesses. We identified no impairment during the three years ended December 31, 2007. For additional information regarding goodwill and the carrying values by lines of business, please refer to Note 8 of the Notes to the Consolidated Financial Statements.

 

Mortgage Servicing Rights (MSRs)

MSRs and certain other servicing rights do not trade in an active, open market with readily observable prices. While sales of MSRs occur, the precise terms and conditions are typically not readily available. Therefore, we estimate the fair value of the MSRs on a monthly basis using a third-party valuation model. Fair value is estimated based upon discounted net cash flows calculated from a combination of loan level data and market assumptions. The valuation model combines loans based on common characteristics that impact servicing cash flows (e.g., investor, remittance cycle, interest rate, product type, etc.) in order to project net cash flows. Market valuation assumptions include prepayment speeds, discount rate, and servicing costs. Valuation assumptions are periodically reviewed against available market data (e.g., broker surveys) for reasonableness and adjusted if deemed appropriate.

 

The recorded MSR asset balance is adjusted to estimated fair value based upon the final month-end valuation, which utilizes the month-end rate curve and prepayment assumptions. Note 6 of the Notes to Consolidated Financial Statements contains an analysis of the impact to the fair value of MSRs resulting from changes in the estimates used by management.

 

Trading Securities and Securities Available-for-sale

Substantially all of our securities are valued based on quoted market prices. However, certain securities are less actively traded and do not always have quoted market prices. The determination of their fair value, therefore, requires judgment, as this determination may require benchmarking to similar instruments or analyzing default and recovery rates. Examples include certain collateralized mortgage and debt obligations and high-yield debt securities.

 

Derivatives

Our derivative positions are valued using internally and externally developed models based on observable market parameters (parameters that are actively quoted and can be validated to external sources) or model values where quoted market prices do not exist, including industry-pricing services.

 

Loans Held-for-sale

Loans held-for-sale are carried at the lower of (a) historical amortized cost or (b) fair value. The fair value of loans held-for-sale is generally based on observable market prices of similar instruments. If market prices are not available, fair value is determined using internally developed models based on the estimated cash flows, adjusted for credit risk. The adjusted cash flows are discounted using a rate that is appropriate for each maturity and incorporates the effects of interest rate changes. At December 31, 2007, loans held-for-sale included $73 million acquired from Sky Financial. The value of the Sky Financial impaired commercial loans held-for-sale is primarily determined by analyzing the underlying collateral of the loan and the external market prices of similar assets.

 

Other Investments - Equity Investments

We make certain equity investments through investments in equity funds (holding both private and publicly traded equity securities), directly in companies as a minority interest investor, and directly in companies in conjunction with our mezzanine lending activities. We measure these equity investments at fair value, with adjustments to the fair value recognized as a component of other non-interest income. For additional information regarding equity investments, please refer to “Price Risk” in the “Risk Management and Capital” section of this report.

 

 

In the ordinary course of business, we operate in various taxing jurisdictions and are subject to income and non-income taxes. The effective tax rate is based in part on our interpretation of the relevant current tax laws. We believe the aggregate liabilities related to taxes are appropriately reflected in the consolidated financial statements. We review the appropriate tax treatment of all transactions taking into consideration statutory, judicial, and regulatory guidance in the context of our tax positions. In addition, we rely on various tax opinions, recent tax audits, and historical experience.

 

From time to time, we engage in business transactions that may have an effect on our tax liabilities. Where appropriate, we have obtained opinions of outside experts and have assessed the relative merits and risks of the appropriate tax treatment of business transactions taking into account statutory, judicial, and regulatory guidance in the context of the tax position. However, changes to our estimates of accrued taxes can occur due to changes in tax rates, implementation of new business strategies, resolution of issues with taxing authorities regarding previously taken tax positions and newly enacted statutory, judicial, and regulatory guidance. Such changes can affect the amount of our accrued taxes and can be material to our financial position and/or results of operations. The potential impact of our operating results for any of these changes cannot be reasonably estimated. For additional information regarding income taxes, please refer to Note 17 of the Notes to the Consolidated Financial Statements.

 

Recent Accounting Pronouncements and Developments

 

Note 2 to the Consolidated Financial Statements discusses new accounting policies adopted during 2007 and the expected impact of accounting policies recently issued but not yet required to be adopted. To the extent the adoption of new accounting standards materially affect financial condition, results of operations, or liquidity, the impacts are discussed in the applicable section of this MD&A and the Notes to the Consolidated Financial Statements.

 

Acquisitions

 

Sky Financial Group, Inc. (Sky Financial)

 

The merger with Sky Financial was completed on July 1, 2007. At the time of acquisition, Sky Financial had assets of $16.8 billion, including $13.3 billion of loans, and total deposits of $12.9 billion. The impact of this acquisition was included in our consolidated results for the last six months of 2007. Additionally, in September of 2007, Sky Bank and Sky Trust, National Association (Sky Trust), merged into the Bank and systems integration was completed. As a result, performance comparisons between 2007 and 2006 are affected.

 

As a result of this acquisition, we have a significant loan relationship with Franklin. This relationship is discussed in greater detail in the “Significant Items” section of this report.

 

Unizan Financial Corp.

 

The merger with Unizan Financial Corp. (Unizan) was completed on March 1, 2006. At the time of acquisition, Unizan had assets of $2.5 billion, including $1.6 billion of loans and core deposits of $1.5 billion. The impact of this acquisition was included in our consolidated results for the last ten months of 2006. As a result, performance comparisons between 2006 and 2005 are affected.

 

Impact Methodology

 

For both the Sky Financial and Unizan acquisitions, comparisons of the reported results are impacted as follows:

 

 

Given the significant impact of the mergers on reported results, we believe that an understanding of the impacts of each merger is necessary to understand better underlying performance trends. When comparing post-merger period results to premerger periods, we use the following terms when discussing financial performance:

 

 

After completion of our mergers, we combine the acquired companies’ operations with ours, and do not monitor the subsequent individual results of the acquired companies. As a result, the following methodologies were implemented to estimate the approximate effect of the mergers used to determine “merger-related” impacts.

 

Balance Sheet Items

 

Sky Financial

 

For average loans and leases, as well as total average deposits, Sky Financial’s balances as of June 30, 2007, adjusted for purchase accounting adjustments, and transfers of loans to loans held-for-sale, were used in the comparison. To estimate the impact on 2007 average balances, it was assumed that the June 30, 2007 balances, as adjusted, remained constant over time.

 

Unizan

 

For average loans and leases, as well as core average deposits, balances as of the acquisition date were pro-rated to the post-merger period being used in the comparison. For example, to estimate the impact on 2006 first quarter average balances, one-third of the closing date balance was used as those balances were in reported results for only one month of the quarter. Quarterly estimated impacts for the 2006 second, third, and fourth quarter results were developed using this same pro-rata methodology. Full-year 2006 estimated results represent the annual average of each quarter’s estimate. This methodology assumes acquired balances will remain constant over time.

 

Income Statement Items

 

Sky Financial

 

Sky Financial’s actual results for the first six months of 2007, adjusted for the impact of unusual items and purchase accounting adjustments, were determined. This six-month adjusted amount was multiplied by two to estimate an annual impact. This methodology does not adjust for any market related changes, or seasonal factors in Sky Financial’s 2007 six-month results. Nor does it consider any revenue or expense synergies realized since the merger date. The one exception to this methodology of holding the estimated annual impact constant relates to the amortization of intangibles expense where the amount is known and is therefore used.

 

Unizan

 

Unizan’s actual full year 2005 results were used for pro-rating the impact on post-merger periods. For example, to estimate the 2006 first quarter impact of the merger on personnel costs, one-twelfth of Unizan’s full-year 2005 personnel costs was used. Full quarter and year-to-date estimated impacts for subsequent periods were developed using this same pro-rata methodology. This results in an approximate impact since the methodology does not adjust for any unusual items or seasonal factors in Unizan’s 2005 reported results, or synergies realized since the merger date. The one exception to this methodology relates to the amortization of intangibles expense where the amount is known and is therefore used.

 

Certain tables and comments contained within our discussion and analysis provide detail of changes to reported results to quantify the estimated impact of the Sky Financial merger using this methodology.

 

Table 3 — Selected Annual Income Statements⁽¹⁾

N.M., not a meaningful value.

 

 

DISCUSSION OF RESULTS OF OPERATIONS

 

This section provides a review of financial performance from a consolidated perspective. It also includes a Significant Items Influencing Financial Performance Comparisons section that summarizes key issues important for a complete understanding of performance trends. Key consolidated balance sheet and income statement trends are discussed in this section. All earnings per share data are reported on a diluted basis. For additional insight on financial performance, please read this section in conjunction with the Lines of Business Discussion.

 

Summary

 

2007 versus 2006

 

We reported 2007 net income of $75.2 million and earnings per common share of $0.25. These results compared unfavorably with net income of $461.2 million and earnings per common share of $1.92 in 2006. Comparisons with the prior year were significantly impacted by: (a) our acquisition of Sky Financial, which closed on July 1, 2007, as well as the credit deterioration of the Franklin relationship that was also acquired with Sky Financial, (b) a 2006 reduction in the provision for income taxes as a result of the favorable resolution to certain federal income tax audits and (c) balance sheet restructuring charges taken in 2006 (see “Significant Items”). The Sky Financial acquisition solidified our position in Ohio, greatly expanded our presence in the central Indiana market, and established western Pennsylvania as a new market.

 

While the acquisition of Sky Financial had a positive impact to 2007 in many areas, the credit deterioration of the Franklin relationship late in 2007, acquired as part of the Sky Financial merger, was the largest setback to 2007 performance. A negative impact of $423.6 million pretax ($275.4 million after-tax, or $0.91 per common share based upon the annual average outstanding diluted common shares) related to this relationship. Although disappointing, and while we can give no further assurances, this charge represents our best estimate of the inherent loss within this credit relationship.

 

Other factors negatively impacting our 2007 performance included: (a) the need to build non-Franklin-related allowance for loan losses due to the continued weakness in the residential real estate development markets and (b) the volatility of the financial markets resulting in net market-related losses.

 

Despite the factors discussed above, 2007 showed positive signs. Expense control was a major highlight for the year. Non-merger-related expenses declined $47.5 million, or 4%, and represented the realization of most of the merger efficiencies that were targeted from the acquisition. Also, commercial loans showed good non-merger-related growth, and there was also strong non-merger-related growth in several key non-interest income activities, including deposit service charges, trust services, and other service charges.

 

Net interest income for 2007 increased $282.3 million, or 28%, from 2006. The current year included six months of net interest income attributable to the acquisition of Sky Financial, which added $13.3 billion of loans and $12.9 billion of deposits at July 1, 2007. As stated earlier, we saw good non-merger-related growth in total average commercial loans. However, total average automobile loans and leases continued to decline, as expected, due to lower consumer demand and competitive pricing. Additionally, the non-merger-related declines in total average residential mortgages, as well as the lack of growth in non-merger-related total average home equity loans, reflected the continued softness in the real estate markets. Growth in non-merger-related average total deposits was good in 2007, driven by strong growth in interest-bearing demand deposits. Our net interest margin increased seven basis points to 3.36% from 3.29% in 2006.

 

In addition to the Franklin credit deterioration discussed previously, credit quality generally weakened in 2007 compared with 2006. The ALLL increased to 1.44% in 2007 from 1.04% in the prior year. The ALLL coverage of nonaccruing loans (NALs) decreased to 181% at December 31, 2007, from 189% at December 31, 2006. Nonperforming assets (NPAs) also increased from the prior year, including the NPAs acquired from Sky Financial. The deterioration of all of these measures reflected the continued economic weakness in our Midwest markets, most notably among our borrowers in eastern Michigan and northern Ohio, and within the residential real estate development portfolio.

 

2006 versus 2005

 

2006 net income was $461.2 million, or $1.92 per common share, up 12% and 8%, respectively, compared with $412.1 million, or $1.77 per common share, in 2005. The $49.1 million increase in net income primarily reflected:

 

 

 

 

Partially offset by:

 

 

Compared with 2005, the ROA for 2006 was 1.31%, up from 1.26%, and the ROE was 15.7%, down slightly from 16.0%.

 

2006 net income was impacted by a number of significant items, the largest of which were (1) the acquisition of Unizan on March 1, 2006, (2) a reduction in the provision for income taxes, and (3) a balance sheet restructuring, undertaken to utilize the excess capital resulting from the reduction of the provision for income taxes (See “Significant Items”).

 

Basis of Presentation

 

Significant Items

 

Certain components of the income statement are naturally subject to more volatility than others. As a result, readers of this report may view such items differently in their assessment of “underlying” or “core” earnings performance compared with their expectations and/or any implications resulting from them on their assessment of future performance trends.

 

Therefore, we believe the disclosure of certain “Significant Items” affecting current and prior period results aids readers of this report in better understanding corporate performance so that they can ascertain for themselves what, if any, items they may wish to include or exclude from their analysis of performance, within the context of determining how that performance differed from their expectations, as well as how, if at all, to adjust their estimates of future performance accordingly.

 

To this end, we have adopted a practice of listing as “Significant Items” in our external disclosure documents, including earnings press releases, investor presentations, reports on Forms 10-Q and 10-K, individual and/or particularly volatile items that impact the current period results by $0.01 per share or more. Such “Significant Items” generally fall within the categories discussed below:

 

Timing Differences

 

Parts of our regular business activities are naturally volatile, including capital markets income and sales of loans. While such items may generally be expected to occur within a full year reporting period, they may vary significantly from period to period. Such items are also typically a component of an income statement line item and not, therefore, readily discernable. By specifically disclosing such items, analysts/investors can better assess how, if at all, to adjust their estimates of future performance.

 

Other Items

 

From time to time, an event or transaction might significantly impact revenues or expenses in a particular reporting period that are judged to be one-time, short-term in nature, and/or materially outside typically expected performance. Examples would be (1) merger costs as they typically impact expenses for only a few quarters during the period of transition; e.g., restructuring charges, asset valuation adjustments, etc.; (2) changes in an accounting principle; (3) one-time tax assessments/refunds; (4) a large gain/loss on the sale of an asset; (5) outsized commercial loan net charge-offs related to fraud; etc. In addition, for the periods covered by this report, the impact of the Franklin restructuring is deemed to be a significant item due to its unusually large size

 

and because it was acquired in the Sky Financial merger and thus it is not representative of our typical underwriting criteria. By disclosing such items, analysts/investors can better assess how, if at all, to adjust their estimates of future performance.

 

Provision for Credit Losses

 

While the provision for credit losses may vary significantly among periods, and often exceeds $0.01 per share, we typically exclude it from the list of “Significant Items” unless, in our view, there is a significant, specific credit (or multiple significant, specific credits) affecting comparability among periods. In determining whether any portion of the provision for credit losses should be included as a significant item, we consider, among other things, that the provision is a major income statement caption rather than a component of another caption and, therefore, the period-to-period variance can be readily determined. We also consider the additional historical volatility of the provision for credit losses.

 

Other Exclusions

 

“Significant Items” for any particular period are not intended to be a complete list of items that may significantly impact future periods. A number of factors, including those described in Huntington’s 2007 Annual Report on Form 10-K and other factors described from time to time in Huntington’s other filings with the SEC, could also significantly impact future periods.

 

Significant Items Influencing Financial Performance Comparisons

 

Earnings comparisons among the three years ended December 31, 2007 were impacted by a number of significant items summarized below.

 

 

 

 

At December 31, 2007, following the troubled debt restructuring of our loans to Franklin, we had $1.2 billion of loans to Franklin (net of amounts charged off). An additional $0.3 billion of loans were held by other banks. These other participating banks have no recourse to Huntington. Franklin is a specialty consumer finance company primarily engaged in the servicing and resolution of performing, reperforming, and nonperforming residential mortgage loans. Franklin’s portfolio consists of loans secured by 1-4 family residential real estate that generally fall outside the underwriting standards of Fannie Mae and Freddie Mac and involve elevated credit risk as a result of the nature or absence of income documentation, limited credit histories, higher levels of consumer debt or past credit difficulties. Franklin purchased these loan portfolios at a discount to the unpaid principal balance and originated loans with interest rates and fees calculated to provide a rate of return adjusted to reflect the elevated credit risk inherent in these types of loans. Franklin originated nonprime loans through its wholly-owned subsidiary, Tribeca Lending Corp., and has generally held for investment the loans acquired and a significant portion of the loans originated. Franklin does not have significant exposure to repurchase

 

loans sold to others as substantially all of its loans have been retained. The following table details our loan relationship with Franklin after the restructuring on December 28, 2007:

 

Table 2 — Commercial Loans to Franklin

 

 

(1) The line of credit facility was not included in the restructuring.

 

The restructuring resulted in a total debt forgiveness of $300 million, of which Huntington forgave $280 million, which was recorded as a charge-off in 2007. In addition, we charged off our portion of the fixed-rate term loan of $117 million in 2007. These two loan charge-offs were reduced by the unamortized discount associated with the loan and by other amounts received from Franklin.

 

 

 

(1) Includes $5.1 million related to the positive impact of adopting SFAS No 156.

 

 

 

 

 

2007

 

 

2006

 

 

2005

 

 

 

Table 4 reflects the earnings impact of the above-mentioned significant items for periods affected by this Discussion of Results of Operations:

 

Table 4 — Significant Items Influencing Earnings Performance Comparison⁽¹⁾

 

 

(1) See Significant Factors Influencing Financial Performance discussion.

 

(2) Pre-tax unless otherwise noted.

 

(3) Based upon the annual average outstanding diluted common shares.

 

(4) After-tax.

 

Net Interest Income / Average Balance Sheet

 

(This section should be read in conjunction with Significant Items 1, 2, 3, 4, and 5.)

 

Our primary source of revenue is net interest income, which is the difference between interest income from earning assets (primarily loans, direct financing leases, and securities), and interest expense of funding sources (primarily interest bearing deposits and borrowings). Earning asset balances and related funding, as well as changes in the levels of interest rates, impact net interest income. The difference between the average yield on earning assets and the average rate paid for interest-bearing liabilities is the net interest spread. Non-interest bearing sources of funds, such as demand deposits and shareholders’ equity, also support earning assets. The impact of the non-interest bearing sources of funds, often referred to as “free” funds, is captured in the net interest margin, which is calculated as net interest income divided by average earning assets. Given the “free” nature of non-interest bearing sources of funds, the net interest margin is generally higher than the net interest spread. Both the net interest spread and net interest margin are presented on a fully-taxable equivalent basis, which means that tax-free interest income has been adjusted to a pre-tax equivalent income, assuming a 35% tax rate.

 

Table 5 shows changes in fully-taxable equivalent interest income, interest expense, and net interest income due to volume and rate variances for major categories of earning assets and interest bearing liabilities.

 

Table 5 — Change in Net Interest Income Due to Changes in Average Volume and Interest Rates⁽¹⁾

 

 

 

2007 versus 2006

 

Fully-taxable equivalent net interest income for 2007 increased $285.6 million, or 28%, from 2006. This reflected the favorable impact of a $7.9 billion, or 25%, increase in average earning assets, of which $7.3 billion represented an increase in average loans and leases, as well as the benefit of an increase in the fully-taxable net interest margin of seven basis points to 3.36%. The increase to average earning assets, and to average loans and leases, was primarily merger-related.

 

The following table details the estimated merger-related impacts on our reported loans and deposits:

 

Table 6 — Average Loans/Leases and Deposits — Estimated Merger-Related Impacts

 

 

(1) Calculated as non-merger related / (prior period + merger-related)

 

The $0.8 billion, or 3%, non-merger-related increase in total average loans compared with the prior year primarily reflected a $1.2 billion, or 7%, increase in average total commercial loans. This increase was the result of strong growth in both middle-market commercial and industrial (C&I) loans and small business loans across substantially all regions. This was partially offset by a $0.4 billion, or 2%, decrease in average total consumer loans reflecting declines in automobile loans and leases and residential mortgages. These declines reflect weaker demand, a softer economy, as well as the continued impact of competitive pricing.

 

Average other earning assets increased $0.6 billion, primarily reflecting the increase in average trading account securities. The increase in these assets reflected a change in our strategy to use trading account securities to hedge the change in fair value of our mortgage servicing rights.

 

The $0.5 billion, or 1%, increase in total non-merger related average deposits primarily reflected a $0.6 billion, or 2%, increase in average total core deposits as interest bearing demand deposits grew $0.3 billion, or 9%. While there was also strong growth in core certificates of deposit, this was partially offset by the decline in savings and other domestic deposits, as customers transferred funds from lower rate to higher rate accounts. In 2007, we reduced our dependence on non-core funds (total liabilities less core deposits and accrued expenses and other liabilities) to 30% of total assets, down from 33% in 2006.

 

2006 versus 2005

 

Fully-taxable equivalent net interest income increased $59.4 million, or 6% ($59.0 million Unizan merger-related), from 2005, reflecting the favorable impact of a $2.1 billion, or 7%, increase in average earning assets, as the fully-taxable equivalent net interest margin declined 4 basis points to 3.29%. Average total loans and leases increased $1.6 billion, or 7% ($1.4 billion Unizan merger-related).

 

Average total commercial loans increased $1.2 billion, or 12% ($0.7 billion Unizan merger-related) from 2005. This growth reflected a $0.7 billion, or 15%, increase in average middle-market C&I loans, a $0.4 billion, or 12%, increase in average middle-market commercial real estate loans (CRE), and a $0.1 billion, or 4%, increase in average small business loans.

 

Average residential mortgages increased $0.5 billion, or 12% ($0.3 billion Unizan merger-related). Average home equity loans increased $0.2 billion, or 5%, but would have increased less than 1% were it not for the Unizan merger.

 

Average total investment securities increased $0.6 million, or 15%, from 2005.

 

Average total core deposits in 2006 increased $1.8 billion, or 10% ($1.3 billion Unizan merger-related), from 2005. Most of the increase reflected higher average core certificates of deposit, which increased $1.7 billion ($0.5 billion Unizan merger-related) resulting from continued customer demand for higher, fixed rate deposit products. Average interest bearing demand deposits increased $0.2 billion, primarily all merger-related, and average non-interest bearing deposits increased $0.2 billion ($0.1 billion merger-related). Average savings and other domestic time deposits declined $0.2 billion, despite $0.4 billion of increase related to the Unizan merger.

 

Table 7 shows average annual balance sheets and fully-taxable equivalent net interest margin analysis for the last five years. It details average balances for total assets and liabilities, as well as shareholders’ equity, and their various components, most notably loans and leases, deposits, and borrowings. It also shows the corresponding interest income or interest expense associated with each earning asset and interest bearing liability category along with the average rate with the difference resulting in the net interest spread. The net interest spread plus the positive impact from the non-interest bearing funds represents the net interest margin.

 

Table 7 — Consolidated Average Balance Sheet and Net Interest Margin Analysis