DBRS Confirms PNC Financial at A (high), Trend Stable

DBRS, Inc. (DBRS) has today confirmed its ratings for PNC Financial Services Group, Inc. (PNC or the Company) and its subsidiaries, including the Company’s A (high) Issuer & Senior Debt rating and its R-1 (low) Short-Term Instruments rating. The trend on all ratings is Stable. The ratings action follows a detailed review of the Company’s operating results, financial fundamentals and future prospects.

PNC’s ratings are underpinned by a strong franchise with robust market shares and a diversified revenue stream from a corporate-driven business that is complemented by a growing retail franchise, a sizable mortgage bank and a well-developed asset management business in addition to a significant investment in Blackrock.

The ratings confirmation reflects DBRS’s view that despite pressures from a challenging operating environment, PNC has strengthened its franchise and balance sheet. Nonetheless, financial performance remains muted due to higher operating costs and a slow revenue growth environment. Exacerbating already elevated expense levels is the March 2, 2012 RBC Bank USA (RBCU) acquisition. Importantly, the Company continues to reduce its combined balance sheet risk, remains completely core funded and is rebuilding it capital position post-RBCU acquisition. DBRS notes that PNC has been able to enhance its franchise through the financial crisis by significantly extending its geographic footprint and customer base with the RBCU and National City Corporation acquisitions. DBRS also sees the Company as one of the best performers through the crisis enabling it to grow and prosper while others lost ground.

Indeed, the recent RBCU transaction added over 400 branches in the Southeast (primarily in North Carolina, Florida, Georgia and Alabama), $18 billion in deposits and $14.5 billion of loans to PNC. The Company’s footprint now covers nearly half the U.S. population across 17 states and Washington, D.C. DBRS sees the Company’s success in growing and deepening relationships across its enlarged franchise as its primary opportunity to achieve future revenue growth.

Overall trends for the Company are positive. However, PNC does face a number of challenges including exposures and costs related to residential mortgages and servicing, reducing operating expenses, and managing its interest rate position. While 2011 revenues were weaker due to pressure on spread income, 2012 figures have strengthened due to both acquired and organic growth. Meanwhile, PNC’s balance sheet asset sensitivity has increased, which should provide lift when interest rates eventually do rise. Nonetheless, rates are expected to remain low over the intermediate term, which will require careful interest rate risk management.

While the Company is and will be impacted by new regulations and restrictions, DBRS sees PNC as being in a generally advantageous position based on not being in the top asset-size tier, as well as not having an investment banking business. That being said, the Company will likely be under increased regulatory scrutiny especially due to its burgeoning presence in retail banking. DBRS anticipates that PNC is likely to continue to outperform through its conservative risk approach, focusing on incremental improvement and careful execution. Fully capturing the RBCU opportunity and executing on improving and expanding its customer relationships will be an important ratings driver going forward.

Asset quality continues to improve with charge-offs, non-accrual loans, 30-89 day and 90 day past dues all declining in 1H12. While criticized commercial loans have increased over the past six months, the growth was primarily driven by the acquired RBCU loans. While DBRS believes there are likely some asset quality challenges remaining within the RBCU loan portfolio, PNC’s purchase accounting marks (through a nearly 13% mark-to-market writedown at closing) have largely mitigated the embedded risks. Nonetheless, DBRS is mindful of the improving, but still elevated, losses and non-performers in its $35.8 billion (20% of loans) home equity portfolio. Moreover, PNC’s $2.3 billion restructured loans (TDRs) and $718 million other real estate owned (OREO) balances have grown over the past year. DBRS views any further significant decline in real estate prices as elevating losses in these asset classes, as well as in the investment portfolio, where PNC has a declining $5.9 billion position in non-agency residential mortgage-backed securities (MBS) and $5.9 billion in non-agency Commercial MBS.

Positively and partially mitigating these concerns are the general decline in riskier assets, 99.5% reserve coverage of NPLs (including OREO, but excluding TDRs), strong performance from its C&I loan book (38% of loans) and the purchase impaired loan portfolio being marked to 75% of the unpaid principal balance. Moreover, 60% of investment portfolio securities were high quality U.S. government agencies or agency RMBS and the AFS portfolio moved to a net unrealized gain position of $666 million at 2Q12 ($1,126 million including HTM investment securities).

2Q12 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. Moreover, the Company noted that it could incur additional losses of up to $350 million for securitized residential mortgages. Positively, however, the overall portfolio (subject to putback) credit performance appears to be good and PNC had $462 million in residential mortgage repurchase reserves at 2Q12. DBRS sees the Company’s rep and warranty exposure in its mortgage servicing business, which has a significant private investor component, and any potential fine from the recent consent order, as being absorbable through earnings. Nonetheless, DBRS would see future outsized putback charges exceeding quarterly earnings as potentially pressuring ratings.

Net revenue generation continues to be ample in DBRS’s opinion. Adjusted quarterly income before taxes and provisions (IBPT) is currently in the $1.7 billion range while provisions have been variable in the $190 million to $256 million range. This conservatively generates approximately $1.4 billion in pre-tax net revenue, providing an ample earnings cushion against future unforeseen credit events and losses. PNC’s 2Q11 provisions of $256 million were exceeded by $315 million in net charge-offs (NCOs), as PNC’s credit metrics improved. Even with the modest reserve release, loan loss reserves were a still solid 2.3% of total loans. DBRS expects PNC’s earnings to gradually strengthen in the near-to intermediate term; as income should get some lift from modest commercial loan growth and RBCU synergies and expense savings. Moreover, cost savings initiatives and merger expense saves are expected to eliminate $550 million in total annual expenses.

Capital remains sound despite the RCBU acquisition. Indeed, PNC’s Tier 1 Common capital decreased approximately 1.2 percentage points from the RCBU acquisition and was 9.29% at 2Q12 (compared to 10.50% at 2Q11), while TCE/TA declined 64 bps to 8.25% over the same period. The common dividend was increased in April from $0.35 to $0.40 per share bringing the dividend payout ratio to approximately 41%. DBRS expects PNC to rebuild capital following the acquisition and management expects to reach PNC’s Basel III Tier 1 common capital ratio goal of 8.0 to 8.5 percent by year-end 2013 without the benefit of phase−ins, based on Basel III proposed rules. Rounding out its financial profile, PNC has strong liquidity at the bank and holding company (where the parent company had approximately $3.2 billion in cash and investments) and is richly deposit funded with a 115% deposit/gross loan ratio.
DBRS believes that sustained organic earnings growth and core profitability in PNC’s principal businesses, successful leveraging of its recent acquisitions and continued improvements in operating efficiency could lead to positive rating implications. By contrast, declining core earnings growth and profitability, weakening capital ratios, RBCU franchise miscues or decline in customer relationships could lead to negative rating pressure.

Headquartered in Pittsburgh, Pennsylvania, the PNC Financial Services Group, Inc. reported total assets of $300 billion and total deposits of $207 billion as of June 30, 2012.

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

The principal applicable methodology is the Global Methodology for Rating Banks and Banking Organizations. Other methodologies used include the DBRS Criteria – Intrinsic and Support Assessments. Both can be found on the DBRS website under Methodologies.

The sources of information used for this rating include the company documents, company presentations, company call transcripts, 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.

This rating is endorsed by DBRS Ratings Limited for use in the European Union.

Lead Analyst: William Schwartz
Rating Committee Chair: Alan G. Reid
Initial Rating Date: 06 April 2006
Most Recent Rating Update: 21 June 2011

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