DBRS Comments on Fifth Third Bancorp’s 4Q10 Earnings – Senior at A (low) Remains Unchanged

DBRS Inc. (DBRS) has today commented on the 4Q10 results of Fifth Third Bancorp (Fifth Third or the Company). For the quarter, Fifth Third reported net income available to common shareholders of $270 million, up $95 million from $175 million in 3Q10 and marked its third consecutive profitable quarter. The Company continued to strengthen its risk profile as evidenced by declining chargeoffs, improved funding and higher levels of capitalization. Additionally, the Company has just completed a $1.7 billion common stock offering and $1 billion senior debt offering with which it intends to repay its $3.4 billion in TARP preferred shares. DBRS sees Fifth Third’s improving performance positively and in line with expectations while consistent with its current ratings and Stable trend. The Company is currently rated A (low) and R-1 (low) for senior and short-term obligations, respectively.

DBRS notes that the Company’s 4Q10 positive quarterly results are indicative of the Company’s recovery from a difficult economic environment and highlight the franchise strength that underpins Fifth Third’s ability to generate earnings. Adjusted income before provision and taxes (IBPT, excludes securities gains, BOLI litigation gains and FTE) of $576 million has remained resilient over recent quarters yet remains constrained. IBPT remained solid, but was down 8.4% from 3Q10 due to abnormally strong mortgage banking income in the prior quarter. Primarily driving the quarterly performance improvement was Fifth Third’s provision that declined 64% to $166 million from $457 million in 3Q10, its lowest level since 3Q07. Importantly for DBRS, the 29% provision to adjusted IBPT ratio is indicative of a healthy relationship between revenues and credit costs for the first time since 4Q07.

Continuing the trend seen in recent quarters, Fifth Third’s asset quality metrics generally improved further in the fourth quarter. Quarterly metrics were strongly influenced by the 3Q10 $228 million sale of residential mortgage loans and $961 million transfer of commercial loans to held-for-sale accelerating the disposition of these loans as the majority of the HFS loans were sold consistent with their marks. These loans represented about half of Fifth Third’s residential mortgage nonperforming loans (NPLs) and over one-third of its commercial NPLs at 3Q10.

Total 4Q10 NPAs (including held-for-sale - HFS) fell 11% to $2. 5 billion as non-accrual HFS loans fell 64% due to the sales. Non-performing loans alone increased $96 million from a $110 million increase in restructured non-accrual commercial loans. Commercial NPA inflows were up 6% while consumer NPAs inflows were nearly flat. The Company’s reserve protection levels continue to be strong with a $3.0 billion allowance that now covers NPAs 1.38 times (compared to 1.53 times at 3Q10) while NPAs fell to 3.08% of loans, leases and OREO, down from 3.51% last quarter. Fifth Third noted that Florida and Michigan properties represented approximately 42% of NPAs at 4Q10 and that nonperformers have been conservatively marked at 63% of the original face values. DBRS also notes that mortgage repurchase risk appears to be modest given its $101 million repurchase reserve against $161 million in claims with minimal (2%) private securitization exposure.

The Company’s outlook for 1Q11 indicates lower NPAs (excluding HFS loans) and reserves with stable net charge-offs. Early stage delinquencies (30 to 89 day) declined 4.6% sequentially in the quarter to $636 million with early stage commercial loan balances $45 million lower to $207 million or 18% while consumer loans were up 3% to $428 million largely due to seasonality. Moreover, ninety day past dues fell 13.6% to $274 million in the quarter. In line with credit trends, Fifth Third’s loan loss provision expense fell 64% to $166 million at 4Q10 impacted by the loan sales, transfers and improving credit quality. The allowance for loan loss reflected a $190 million sequential decline as the Company signaled confidence in the improving credit picture.

Fifth Third has also been working diligently to reduce the size of its troubled debt restructurings (TDRs) for the past several quarters, the bulk of which are consumer TDRs. In 4Q10, $1.6 billion or 88% of the $1.8 billion in consumer TDRs were accruing of which $1.3 billion were current. Negatively, nonaccrual consumer TDRs were $206 million at 4Q10, increasing nearly 18% sequentially. DBRS views the re-default rates on modified loans positively however, particularly for the 2009 vintages that comprise approximately 56% of the TDRs and exhibit re-default rates in the 20% to 25% range at 4Q10.

Fourth quarter revenues (non-FTE basis) of $1.57 billion were down 9.7% from the third quarter, which benefitted from a $152 million BOLI litigation gain as well as unusually strong mortgage banking income. Net interest income was slightly up and NIM expanded 5 basis points over the quarter to 3.75% as higher yielding CDs repriced, deposit mix shifted away from CDs and average loans grew slightly (0.4%). Noninterest income declined $171 million from last quarter to $656 million in 4Q10 due to the aforesaid BOLI gain and lower mortgage banking revenue that was partially offset by stronger corporate banking revenue and some securities gains. Both investment advisory and card and processing revenue produced good results over the quarter.

DBRS sees the resilient fee revenue performance in 4Q10, despite Reg E related pressures ($17 million estimated quarterly impact) and a tougher mortgage banking quarter, as highlighting the revenue generating ability of the Company’s business lines. Nevertheless, regulatory reform will continue to pressure noninterest income. In addition to Reg E related fee reductions which are already reflected in 4Q10 run rates, DBRS estimates that, in its current form, the Durbin amendment could reduce debit interchange revenues by 75% beginning in 2H11. DBRS notes that this estimate does not consider any mitigating actions the Company could take to recoup lost revenues. In 2010, debit interchange revenues were $204 million and the Company expects substantial mitigation of that amount to recoup the lost revenues. Noninterest expense grew 1.7% sequentially to $970 million (adjusted for $17 million in 4Q10 FHLB prepayment and $25 million 3Q10 BOLI legal expense) in the fourth quarter primarily due to higher incentive compensation, investment in sales force personnel that was only partially offset by lower credit-related expenses ($53 million in 4Q10 vs. $67 million in 3Q10).

In DBRS’s view, Fifth Third's liquidity and capital profile remain sound. Average core deposits increased 2% in the quarter compared to 3Q10, as all transaction deposit account types grew. Core deposits now fund 100% of the average loans (excluding HFS). With its new found profitability, the Company is now demonstrating its ability to generate capital internally and capitalization levels remains robust while providing significant loss absorption capacity. In 4Q10, the Tier 1 common ratio grew 16 bps to 7.50% while the tangible common equity to tangible assets (TCE, excluding unrealized gains and losses) ratio increased 34 bps, posting a stronger 7.04% at December 31, 2010. Fifth Third has also estimated the Tier 1 common ratio at 9.0% pro forma post the equity offering and TARP redemption and a 9.4% Tier 1 capital ratio including the above and Trust Preferred Securities phase-out. Moreover, given its modicum of counterparty risk and investment banking, its Tier 1 ratio is expected to improve upon (proposed) Basel III implementation.

Currently, Fifth Third is one of the 19 banks subject to a second round of Federal Reserve stress tests to ensure capital adequacy. The stress tests will test a bank’s ability to absorb losses over the next two years under at least two scenarios (baseline and adverse) and will take the proposed Basel III capital requirements into account as well as TARP repayment. Test results will also determine whether an institution may resume capital distributions (stock dividends and/or repurchases). The stress test results are expected to be communicated to BHCs (not publicly) no later than March 21, 2011.

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

The applicable methodologies are Global Methodology for Rating Banks and Banking Organizations, Enhanced Methodology for Bank Ratings – Intrinsic and Support Assessments, Rating Bank Subordinated Debt and Hybrid Instruments with Discretionary Payments, and Rating Bank Preferred Shares and Equivalent Hybrids which can be found on the DBRS website under Methodologies.

The sources of information used for this rating include the company documents, the Federal Deposit
Insurance Corporation and SNL Financial. DBRS considers the information available to it for the
purposes of providing this rating was of satisfactory quality.

Lead Analyst: William Schwartz
Initial Rating Date: 27 July 2005
Most Recent Rating Update: 26 March 2010

For additional information on this rating, please refer to the linking document below.