DBRS Comments on PNC’s 2Q12 Earnings – Senior at A (high) – Ratings Unchanged

DBRS, Inc. (DBRS) has today commented that its ratings for PNC Financial Services Group, Inc. (PNC or the Company), including its Issuer & Senior Debt rating of A (high), are unchanged following the release of the Company’s 2Q12 earnings. PNC reported net income attributable to common shareholders of $526 million for 2Q12, down 31% from $766 million in 1Q12.

PNC’s second quarter results were muted due to several non-core items. 2Q12 earnings included a $284 million (after-tax) provision for residential mortgage loan repurchase obligations, an $85 million (after-tax) non-cash charge related to redemption of trust preferred securities, and a $34 million (after-tax) expense related to the integration of RBC Bank (USA). Excluding these non-core items, operating performance improved with the Company’s adjusted income before provision and taxes (adjusted IBPT) up sequentially by 13%. Adjusted revenues increased nearly 9% q-o-q partially offset by 5% growth in adjusted expenses. DBRS notes that excluding the non-core items, PNC achieved positive operating leverage.

PNC’s balance sheet trends were positive. In 2Q12, the Company delivered both commercial and consumer loan growth that was achieved through its customer growth strategy and increased presence in new markets, particularly its Southeast expansion. Indeed, PNC achieved its fifth consecutive quarter of average loan growth, with a sequential increase of 8% in the quarter. Commercial lending continued to reflect improvement, up 3% or $3.5 billion q-o-q driven by corporate banking, real estate finance and asset-based lending. Consumer lending increased $0.7 million largely due to increased automobile loans.

Moreover, strong loan growth was funded by a favorable shift in the deposit mix. Importantly, transaction deposits grew by 1% or $1.5 billion sequentially while retail CDs declined by $3.1 billion. PNC completed the expected run-off and repricing of the higher cost CDs acquired from National City. As a result, deposit costs declined 7 bps sequentially to 24 bps for 2Q12.

Net interest income of $2.5 billion was up 10% over the prior quarter and benefitted from a full quarter impact of the RBC Bank (USA) acquisition, organic loan growth, and reduced funding costs. Despite the low rate environment, PNC’s 5%, or $12.4 billion, linked quarter growth in average earning assets, coupled with higher yielding assets (particularly from the Southeast markets) and lower funding costs, allowed the net interest margin (NIM) to expand 18 bps q-o-q to 4.08%. Also, the Company redeemed around $800 million of trust preferred securities, which further reduced funding costs. PNC plans to redeem nearly $1 billion of trust preferred securities in 3Q12.

Fee revenues of $1.1 billion included a $438 million provision for residential mortgage repurchase obligations, up $406 million from $32 million in the prior quarter. Of concern, DBRS notes that while the outsized quarterly provision is absorbable within PNC’s quarterly earnings, it was unexpected and was nearly $88 million greater than the $350 million in reserves that PNC previously disclosed during its June investor conference. PNC management noted that changes in GSE put-back behavior, which has been noted at large servicers for several quarters, precipitated the additional reserve coverage. The provision represented reserve coverage for a total remaining unpaid mortgage balance of $106 billion, of which $15 billion is in GSE-related mortgages with 2006 to 2008 vintages; however, claims data is not publicly available. Moreover, the Company noted that it may need to put an additional $350 million in reserves if the claimant request or apply different criteria for put-back requests. Positively, however, the overall portfolio (subject to putback) credit performance appears to be good and PNC had $462 million in residential mortgage repurchase reserve at 2Q12. Nonetheless, DBRS sees future putback charges exceeding quarterly earnings as potentially pressuring ratings.

Excluding this heightened provision driven by increased repurchase claims, fee income increased 4% q-o-q attributable to strong underlying revenue from consumer, corporate, and mortgage services. Higher transaction volume drove Consumer Services fees to increase 10% to $290 million. Meanwhile, Corporate Services fees of $290 million grew 25% q-o-q due primarily to higher M&A advisory fees and commercial mortgage banking revenue. Service charges on deposits grew 13% linked quarter to $144 million driven by seasonally higher customer activity. These items offset the decline in other fee revenue stemming from lower revenue from customer initiated hedging activity.

PNC’s expenses grew by 8% to $2.6 billion in the quarter due partly to several non-core items. Excluding the $130 million noncash charge associated with its trust preferred securities redemption, the $149 million in RBC Bank (USA) operating costs, and the $52 million in integration costs, noninterest expense would have been nearly 13% lower at $2.3 billion in 2Q12, which is relatively flat to the prior quarter and up 7% compared to 2Q11. Core operating expenses were higher due to increases by approximately $20 million to $30 million (each or higher) charges for legal, OREO, mortgage foreclosure-related expenses and pension costs. Positively, the Company completed 60% of its $550 million continuous improvement annualized cost savings goals in 2Q12. DBRS sees ongoing expense discipline as important for PNC given the difficult operating environment.

Credit trends were favorable in the quarter and continued to improve. Overall, credit metrics declined sequentially with nonperforming assets (NPAs), delinquencies, and net charge-offs (NCOs) trending positively. NPAs declined 4% q-o-q to $4.2 billion, or 2.31% of total loans plus OREOs, while NCOs of $315 million continued to decline and represented 71 bps of average loans. Delinquencies decreased by 8%, or $353 million, over 1Q12. Despite improvements in credit quality, the loan loss provision increased by 38%, or $71 million, in the quarter largely due to impaired residential loans that were further affected by declining home prices and nonperforming commercial loans post the RBC Bank (USA) acquisition. Nevertheless, DBRS continues to view PNC as well reserved with an allowance for loan and lease losses (ALLL) to loans ratio of 2.30% at the end of 2Q12 and an ALLL/NPL (excluding purchased impaired loans) ratio of 120%.

Capitalization remains sound with an estimated Tier 1 common capital ratio of 9.3% and Tier 1 risk-based capital ratio of 11.4% at 2Q12. PNC continues to target a Basel III Tier 1 Common ratio of between 8.0% and 8.5% by the end of 2013. Moreover, PNC plans to purchase up to $250 million of common stock under its existing 25 million share repurchase program in open market or privately negotiated transactions during 2012. Repurchases were initiated in the second quarter with approximately $50 million repurchased as of June 30, 2012.

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
Approver: Alan G. Reid
Initial Rating Date: 6 April 2006
Most Recent Rating Update: 21 July 2011

For additional information on this rating, please see the linking document under Related Research.