exv13 EX-13 3 z02267exv13.htm INCORPORATED SECTIONS OF REGISTRANT'S 2005 ANNUAL REPORT TO SHAREHOLDERS
 

FINANCIAL REVIEW AND REPORTS

Comerica Incorporated and Subsidiaries

           
Financial Results and Key Corporate Initiatives
    21  
Overview/ Earnings Performance
    22  
Strategic Lines of Business
    35  
Balance Sheet and Capital Funds Analysis
    38  
Risk Management
    43  
Critical Accounting Policies
    57  
Forward-Looking Statements
    61  
Consolidated Financial Statements:
       
 
Consolidated Balance Sheets
    63  
 
Consolidated Statements of Income
    64  
 
Consolidated Statements of Changes in Shareholders’ Equity
    65  
 
Consolidated Statements of Cash Flows
    66  
Notes to Consolidated Financial Statements
    67  
Report of Management
    118  
Reports of Independent Registered Public Accounting Firm
    119  
Historical Review
    121  

19


 

TABLE 1: SELECTED FINANCIAL DATA

                                         
Years Ended December 31

2005 2004 2003 2002 2001





(dollar amounts in millions, except per share data)
EARNINGS SUMMARY
                                       
Total interest income
  $ 2,726     $ 2,237     $ 2,412     $ 2,797     $ 3,393  
Net interest income
    1,956       1,810       1,926       2,132       2,102  
Provision for loan losses
    (47 )     64       377       635       241  
Net securities gains
                50       41       20  
Noninterest income (excluding net securities gains)
    942       857       837       859       817  
Noninterest expenses
    1,666       1,493       1,483       1,515       1,587  
Provision for income taxes
    418       353       292       281       401  
Net income
    861       757       661       601       710  
PER SHARE OF COMMON STOCK
                                       
Basic net income
  $ 5.17     $ 4.41     $ 3.78     $ 3.43     $ 3.93  
Diluted net income
    5.11       4.36       3.75       3.40       3.88  
Cash dividends declared
    2.20       2.08       2.00       1.92       1.76  
Common shareholders’ equity
    31.11       29.94       29.20       28.31       27.17  
Market value
    56.76       61.02       56.06       43.24       57.30  
YEAR-END BALANCES
                                       
Total assets
  $ 53,013     $ 51,766     $ 52,592     $ 53,301     $ 50,750  
Total earning assets
    48,646       48,016       48,804       47,780       46,566  
Total loans
    43,247       40,843       40,302       42,281       41,196  
Total deposits
    42,431       40,936       41,463       41,775       37,570  
Total borrowings
    4,263       4,479       5,063       5,756       7,489  
Total medium- and long-term debt
    3,961       4,286       4,801       5,216       5,503  
Total common shareholders’ equity
    5,068       5,105       5,110       4,947       4,807  
AVERAGE BALANCES
                                       
Total assets
  $ 52,506     $ 50,948     $ 52,980     $ 51,130     $ 49,688  
Total earning assets
    48,232       46,975       48,841       47,053       45,722  
Total loans
    43,816       40,733       42,370       42,091       41,371  
Total deposits
    40,640       40,145       41,519       37,712       35,312  
Total borrowings
    5,637       4,815       5,624       7,725       8,782  
Total medium- and long-term debt
    4,186       4,540       5,074       5,763       6,198  
Total common shareholders’ equity
    5,097       5,041       5,033       4,884       4,605  
CREDIT QUALITY
                                       
Allowance for loan losses
  $ 516     $ 673     $ 803     $ 791     $ 637  
Allowance for credit losses on lending-related commitments
    33       21       33       35       18  
Total allowance for credit losses
    549       694       836       826       655  
Total nonperforming assets
    162       339       538       579       627  
Net loans charged-off
    110       194       365       481       189  
Net loans charged-off as a percentage of average total loans
    0.25 %     0.48 %     0.86 %     1.14 %     0.46 %
Allowance for loan losses as a percentage of total period-end loans
    1.19       1.65       1.99       1.87       1.55  
Allowance for loan losses as a percentage of total nonperforming assets
    319       198       149       136       102  
RATIOS
                                       
Net interest margin
    4.06 %     3.86 %     3.95 %     4.55 %     4.61 %
Return on average assets
    1.64       1.49       1.25       1.18       1.43  
Return on average common shareholders’ equity
    16.90       15.03       13.12       12.31       15.16  
Efficiency ratio
    57.40       55.90       53.64       50.59       54.30  
Dividend payout ratio
    43.05       47.71       53.33       56.47       45.36  
Average common shareholders’ equity as a percentage of average assets
    9.71       9.90       9.50       9.55       9.27  
Tier 1 common capital as a percentage of risk-weighted assets
    7.86       8.13       8.04       7.39       7.30  

20


 

2005 FINANCIAL RESULTS AND KEY CORPORATE INITIATIVES

 
Financial Results

  •  Reported net income of $861 million, or $5.11 per diluted share, compared to $757 million, or $4.36 per diluted share, for 2004
 
  •  Returned 16.90 percent on average common shareholders’ equity and 1.64 percent on average assets
 
  •  Raised the quarterly cash dividend six percent, to $0.55 per share, an annual rate of $2.20 per share, for an annual dividend payout ratio of 43 percent
 
  •  Repurchased 9.0 million shares of outstanding common stock for $525 million, which combined with dividends, returned 104 percent of earnings to shareholders
 
  •  Generated growth from December 31, 2004 to December 31, 2005 of $2.4 billion in loans and $2.3 billion in unused commitments to extend credit
 
  •  Generated growth in average loans, excluding Financial Services Division loans, from 2004 to 2005, including growth in the Midwest & Other (3 percent), Western (7 percent) and Texas (11 percent) markets
 
  •  Improved credit quality, resulting in an $84 million decline in net loan charge-offs, a $174 million decline in total nonaccrual loans and a $328 million decline in watch list loans (generally consistent with regulatory special mention and substandard loans)
 
  •  Experienced growth in investment advisory revenue of 43 percent in 2005, resulting primarily from an increase in assets under management at Munder Capital Management to $41 billion at December 31, 2005, from $38 billion at December 31, 2004

 
Key Corporate Initiatives

  •  Continued organic growth focused in high growth markets, including the opening of 18 new banking centers in 2005; banking center expansion in 2006 is expected to be comparable to 2005
 
  •  Sold Framlington Group Limited (a London, England based investment manager), and actively pursuing the sale of our Mexican bank charter, businesses not central to our initiatives
 
  •  Continued to refine and develop the enterprise-wide risk management program, including improvement of analytics and systems used to enhance credit and operational risk management
 
  •  Experienced a slight decline in full-time equivalent staff, in spite of 102 additional FTE employees added to support new banking center openings

21


 

OVERVIEW/EARNINGS PERFORMANCE

      Comerica Incorporated (the Corporation) is a financial holding company headquartered in Detroit, Michigan. The Corporation’s major business segments are the Business Bank, Small Business & Personal Financial Services (renamed the Retail Bank in 2006), and Wealth & Institutional Management. The core businesses are tailored to each of the Corporation’s four primary geographic markets: Midwest & Other Markets, Western, Texas and Florida.

      The accounting and reporting policies of the Corporation and its subsidiaries conform to U.S. generally accepted accounting principles and prevailing practices within the banking industry. The Corporation’s consolidated financial statements are prepared based on the application of accounting policies, the most significant of which are described on page 67 in Note 1 to the consolidated financial statements. The most critical of these significant accounting policies are discussed in the “Critical Accounting Policies” section on page 57 of this financial review.

      As a financial institution, the Corporation’s principal activity is lending to and accepting deposits from businesses and individuals. The primary source of revenue is net interest income, which is derived principally from the difference between interest earned on loans and interest paid on deposits and other funding sources. The Corporation also provides other products and services that meet the financial needs of customers and which generate noninterest income, the Corporation’s secondary source of revenue. Growth in loans, deposits and noninterest income are affected by many factors, including the economic growth in the markets the Corporation serves, the financial requirements and health of customers, and successfully adding new customers and/or increasing the number of products used by current customers. Success in providing products and services depends on the financial needs of customers and the types of products desired.

      The Corporation generated growth of $2.4 billion in loans and $2.3 million in unused commitments to extend credit from December 31, 2004 to December 31, 2005. Average loans grew in the Corporation’s Specialty Businesses (42 percent), Private Banking (9 percent), and Middle Market (6 percent) loan portfolios in 2005, compared to 2004. The Specialty Businesses loan portfolio includes loans in the Corporation’s Financial Services Division (FSD), where customers deposit large balances (primarily noninterest-bearing) and the Corporation pays certain customer services expenses (included in noninterest expenses on the consolidated statements of income) and/or makes low-rate loans (included in net interest income on the consolidated statements of income) to such customers. Average deposits increased $495 million, or one percent, in 2005, compared to 2004. Average FSD deposits increased $1.1 billion in 2005 compared to 2004, primarily due to continued strong mortgage business activity. FSD deposit levels may change with the direction of mortgage activity changes, the desirability of such deposits, and competition for the deposits. Net interest income increased eight percent in 2005, compared to 2004, primarily due to loan growth. Net interest income in 2005 was also impacted by the warrant accounting change discussed in Note 1 to the consolidated financial statements on page 67. Noninterest income, excluding net securities gains and net gains on sale of businesses, increased four percent in 2005, compared to 2004.

      The Corporation’s credit staff closely monitors the financial health of our lending customers in order to assess ability to repay and to adequately provide for expected losses. Loan quality showed continued improvement during 2005, with improving credit quality trends resulting in a significant decline in both net loan charge-offs and total nonperforming assets in 2005, compared to 2004. The tools developed in 2004 and 2005 for evaluating the adequacy of the allowance for loan losses, and the resulting information gained from these processes, continue to help the Corporation monitor and manage credit risk.

      Noninterest expenses in 2005 increased 12 percent compared to 2004. Approximately half of the 12 percent increase in 2005 related to customer services expense in the Financial Services Division ($46 million), and credit-related costs ($39 million), including the provision for credit losses on lending-related commitments and other real estate expense. Customer services expense represents expenses paid on behalf of Financial Services Division customers, and is one method to attract and retain title and escrow deposits in that division. Other factors contributing to the increase in noninterest expenses in 2005 included profitability-based incentives ($41 million), pension and staff insurance ($20 million) and new banking centers ($12 million). Full-time equivalent employees declined by approximately 75 employees from year-end 2004 to year-end 2005, in spite of 102 additional FTE employees added to support new banking center openings.

22


 

      A majority of the Corporation’s revenues are generated by the Business Bank business segment, making the Corporation highly sensitive to changes in the business environment in its primary geographic markets. To facilitate better balance among business segments, the Corporation opened 18 banking centers in 2005 and plans to continue banking center expansion in markets with favorable demographics. This is expected to provide opportunity for growth in the Small Business & Personal Financial Services and the Wealth & Institutional Management business segments as the Corporation penetrates existing relationships through cross-selling and develops new relationships.

      For 2006, management expects the following, compared to 2005:

  •  Mid-to-high single digit average loan growth
  •  Mid-single digit average loan growth excluding Financial Services Division loans
  •  Average full year net interest margin of about 4.00%
  •  Provision for credit losses consistent with credit-related charge-offs of 25 to 30 basis points of average loans
  •  Low-single digit noninterest income growth, excluding net gain on sales of businesses
  •  Noninterest expenses relatively unchanged, excluding the provision for credit losses on lending-related commitments (included in the above outlook for the provision for credit losses) and excluding any future changes in the value of subsidiary share-based compensation awards and minority-owned shares classified as liabilities (see the “Other Market Risks” section of this financial review on page 54)
  •  Active capital management

23


 

TABLE 2: ANALYSIS OF NET INTEREST INCOME-Fully Taxable Equivalent (FTE)

                                                                             
Years Ended December 31

2005 2004 2003



Average Average Average Average Average Average
Balance Interest Rate Balance Interest Rate Balance Interest Rate









(dollar amounts in millions)
Commercial loans(1)(2)(3)
  $ 24,575     $ 1,381       5.62 %   $ 22,139     $ 933       4.22 %   $ 23,764     $ 978       4.11 %
Real estate construction loans
    3,194       231       7.23       3,264       177       5.43       3,540       178       5.04  
Commercial mortgage loans(1)
    8,566       534       6.23       7,991       415       5.19       7,521       403       5.35  
Residential mortgage loans
    1,388       80       5.74       1,237       70       5.68       1,192       73       6.12  
Consumer loans
    2,696       159       5.89       2,668       126       4.73       2,474       122       4.94  
Lease financing
    1,283       49       3.81       1,272       52       4.06       1,283       59       4.59  
International loans
    2,114       126       5.98       2,162       102       4.69       2,596       115       4.44  
Business loan swap income(4)
          (2 )                 182                   285        
   
   
   
   
   
   
   
   
   
 
 
Total loans(2)(3)(5)
    43,816       2,558       5.84       40,733       2,057       5.05       42,370       2,213       5.22  
Investment securities available-for-sale(6)
    3,861       148       3.76       4,321       147       3.36       4,529       166       3.65  
Short-term investments
    555       24       4.45       1,921       36       1.88       1,942       36       1.85  
   
   
   
   
   
   
   
   
   
 
 
Total earning assets
    48,232       2,730       5.65       46,975       2,240       4.76       48,841       2,415       4.94  
Cash and due from banks
    1,721                       1,685                       1,811                  
Allowance for loan losses
    (623 )                     (787 )                     (831 )                
Accrued income and other assets
    3,176                       3,075                       3,159                  
   
               
               
             
 
Total assets
  $ 52,506                     $ 50,948                     $ 52,980                  
   
               
               
             
Money market and NOW deposits(1)
  $ 17,282       337       1.95     $ 17,768       188       1.06     $ 17,359       204       1.18  
Savings deposits(1)
    1,545       7       0.49       1,629       6       0.39       1,571       8       0.50  
Certificates of deposit(1)(4)(7)
    5,929       167       2.81       5,962       104       1.74       8,061       139       1.72  
Foreign office time deposits(8)
    877       37       4.18       664       17       2.60       618       19       3.15  
   
   
   
   
   
   
   
   
   
 
 
Total interest-bearing deposits
    25,633       548       2.14       26,023       315       1.21       27,609       370       1.34  
Short-term borrowings
    1,451       52       3.59       275       4       1.25       550       7       1.20  
Medium- and long-term debt(4)(7)
    4,186       170       4.05       4,540       108       2.39       5,074       109       2.14  
   
   
   
   
   
   
   
   
   
 
 
Total interest-bearing sources
    31,270       770       2.46       30,838       427       1.38       33,233       486       1.46  
         
   
         
   
         
   
 
Noninterest-bearing deposits(1)
    15,007                       14,122                       13,910                  
Accrued expenses and other liabilities
    1,132                       947                       804                  
Shareholders’ equity
    5,097                       5,041                       5,033                  
   
               
               
             
 
Total liabilities and shareholders’ equity
  $ 52,506                     $ 50,948                     $ 52,980                  
   
               
               
             
Net interest income/rate spread (FTE)
          $ 1,960       3.19             $ 1,813       3.38             $ 1,929       3.48  
         
               
               
       
FTE adjustment(9)
          $ 4                     $ 3                     $ 3          
         
               
               
       
Impact of net noninterest-bearing sources of funds
                    0.87                       0.48                       0.47  
               
               
               
 
Net interest margin (as a percentage of average earning assets) (FTE)(2)(3)
                    4.06 %                     3.86 %                     3.95 %
               
               
               
 

                                                     
(1) FSD balances included above:
                                                                       
   
Loans (primarily low-rate)
  $ 1,893     $ 8       0.45 %   $ 885     $ 5       0.53 %   $ 1,048     $ 4       0.42 %
   
Interest-bearing deposits
    2,600       76       2.91       2,027       31       1.53       2,259       29       1.28  
   
Noninterest-bearing deposits
    5,851                       5,280                       5,891                  
(2) Impact of FSD loans (primarily low-rate) on the following:
                                                                       
   
Commercial loans
                    (0.43 )%                     (0.15 )%                     (0.17 )%
   
Total loans
                    (0.24 )                     (0.10 )                     (0.13 )
   
Net interest margin (FTE) (assuming loans were funded by noninterest bearing deposits)
                    (0.15 )                     (0.06 )                     (0.08 )
(3) Impact of third quarter 2005 warrant accounting change on the following:
                                                                       
   
Commercial loans
          $ 20       0.08 %                                                
   
Total loans
            20       0.05                                                  
   
Net interest margin (FTE)
            20       0.04                                                  
 
(4) The gain or loss attributable to the effective portion of cash flow hedges of loans is shown in “Business loan swap income”. The gain or loss attributable to the effective portion of fair value hedges of deposits and medium- and long-term debt, which totaled a net gain of $58 million in 2005, is included in the related interest expense line items.
(5) Nonaccrual loans are included in average balances reported and are used to calculate rates.
(6) Average rate based on average historical cost.
(7) Certificates of deposit and medium- and long-term debt average balances have been adjusted to reflect the gain or loss attributable to the risk hedged by risk management swaps that qualify as a fair value hedge.
(8) Includes substantially all deposits by foreign domiciled depositors; deposits are primarily in excess of $100,000.
(9) The FTE adjustment is computed using a federal income tax rate of 35%.

24


 

TABLE 3: RATE-VOLUME ANALYSIS-Fully Taxable Equivalent (FTE)

                                                     
2005/2004 2004/2003


Increase Increase Net Increase Increase Net
(Decrease) (Decrease) Increase (Decrease) (Decrease) Increase
Due to Rate Due to Volume* (Decrease) Due to Rate Due to Volume* (Decrease)






(in millions)
Interest income (FTE):
                                               
Loans:
                                               
 
Commercial loans
  $ 311     $ 137     $ 448     $ 24     $ (69 )   $ (45 )
 
Real estate construction loans
    59       (5 )     54       14       (15 )     (1 )
 
Commercial mortgage loans
    83       36       119       (12 )     24       12  
 
Residential mortgage loans
    1       9       10       (6 )     3       (3 )
 
Consumer loans
    31       2       33       (5 )     9       4  
 
Lease financing
    (3 )           (3 )     (7 )           (7 )
 
International loans
    27       (3 )     24       7       (20 )     (13 )
 
Business loan swap income (expense)
    (184 )           (184 )     (103 )           (103 )
   
   
   
   
   
   
 
   
Total loans
    325       176       501       (88 )     (68 )     (156 )
Investment securities available-for-sale
    19       (18 )     1       (12 )     (7 )     (19 )
Short-term investments
    35       (47 )     (12 )     5       (5 )      
   
   
   
   
   
   
 
   
Total interest income (FTE)
    379       111       490       (95 )     (80 )     (175 )
Interest expense:
                                               
Interest-bearing deposits:
                                               
 
Money market and NOW deposits
    159       (10 )     149       (21 )     5       (16 )
 
Savings deposits
    1             1       (2 )           (2 )
 
Certificates of deposit
    64       (1 )     63       2       (37 )     (35 )
 
Foreign office time deposits
    11       9       20       (3 )     1       (2 )
   
   
   
   
   
   
 
   
Total interest-bearing deposits
    235       (2 )     233       (24 )     (31 )     (55 )
Short-term borrowings
    6       42       48             (3 )     (3 )
Medium- and long-term debt
    76       (14 )     62       12       (13 )     (1 )
   
   
   
   
   
   
 
   
Total interest expense
    317       26       343       (12 )     (47 )     (59 )
   
   
   
   
   
   
 
   
Net interest income (FTE)
  $ 62     $ 85     $ 147     $ (83 )   $ (33 )   $ (116 )
   
   
   
   
   
   
 


Rate/volume variances are allocated to variances due to volume.

Net Interest Income

      Net interest income is the difference between interest and yield-related fees earned on assets, and interest paid on liabilities. Adjustments are made to the yields on tax-exempt assets in order to present tax-exempt income and fully taxable income on a comparable basis. Gains and losses related to the effective portion of risk management interest rate swaps that qualify as hedges are included with the interest income or expense of the hedged item when classified in net income. Net interest income on a fully taxable equivalent (FTE) basis comprised 68 percent of net revenues in 2005, compared to 68 percent in 2004 and 69 percent in 2003. Table 2 on page 24 of this financial review provides an analysis of net interest income for the years ended December 31, 2005, 2004 and 2003. The rate-volume analysis in Table 3 above details the components of the change in net interest income on a FTE basis for the years ended December 31, 2005, compared to 2004 and December 31, 2004, compared to 2003.

25


 

      Net interest income (FTE) was $2.0 billion in 2005, an increase of $147 million, or eight percent, from 2004. The net interest margin (FTE), which is net interest income (FTE) expressed as a percentage of average earning assets, increased to 4.06 percent in 2005, from 3.86 percent in 2004. The increases in net interest income and net interest margin resulted primarily from a greater contribution from noninterest-bearing deposits in a higher rate environment and loan growth. Net interest income in 2005 was also impacted by the warrant accounting change discussed in Note 1 to the consolidated financial statements on page 67, which resulted in a $20 million increase in net interest income and a four basis point increase in the net interest margin in 2005. Average earning assets increased $1.3 billion, or three percent, to $48.2 billion in 2005, compared to 2004, primarily as a result of a $3.1 billion increase in average loans, partially offset by a $1.4 billion decline in average short-term investments and a $460 million decline in average investment securities available-for-sale. The Corporation expects, on average, net interest margin in 2006 to be about 4.00 percent for the full year.

      Net interest income and net interest margin are impacted by the operations of the Corporation’s Financial Services Division (FSD). FSD customers deposit large balances (primarily noninterest-bearing) and the Corporation pays certain customer services expenses (included in “noninterest expenses” on the consolidated statements of income) and/or makes low-rate loans (included in “net interest income” on the consolidated statements of income) to such customers. Footnote (1) to Table 2 on page 24 of this financial review displays average FSD loans and deposits, with related interest income/expense and average rates. As shown in Footnote (2) to Table 2 on page 24 of this financial review, the impact of FSD loans (primarily low-rate) on net interest margin (assuming the loans were funded by FSD noninterest-bearing deposits) was a decrease of 15 basis points and six basis points in 2005 and 2004, respectively.

      The Corporation implements various asset and liability management tactics to manage exposure to net interest income risk. This risk represents the potential reduction in net interest income that may result from a fluctuating economic environment, including changes to interest rates and loan and deposit portfolio growth rates. Such actions include the management of earning assets, funding and capital and the utilization of interest rate swap contracts. Interest rate swap contracts are employed to effectively fix the yields on certain variable rate loans and to alter the interest rate characteristics of deposits and debt issued throughout the year. Refer to the “Interest Rate Risk” section on page 48 of this financial review for additional information regarding the Corporation’s asset and liability management policies.

      In 2004, net interest income (FTE) was $1.8 billion, a decrease of $116 million, or six percent, from 2003. The net interest margin (FTE) decreased to 3.86 percent in 2004, from 3.95 percent in 2003. The declines in net interest income and net interest margin were the result of the impact of high-spread interest rate swap maturities and a restructuring of the investment portfolio in late 2002 and 2003, designed to achieve more consistent cash flows. Average earning assets decreased $1.9 billion, or four percent, to $47.0 billion, primarily as the result of a $1.6 billion decrease in average loans.

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TABLE 4: ANALYSIS OF THE ALLOWANCE FOR LOAN LOSSES

                                                 
Years Ended December 31

2005 2004 2003 2002 2001





(dollar amounts in millions)
Balance at beginning of year
  $ 673     $ 803     $ 791     $ 637     $ 585  
Loans charged-off:
                                       
 
Domestic
                                       
   
Commercial
    91       201       302       423       198  
   
Real estate construction
                                       
     
Real estate construction business line
    2       2       1             1  
     
Other
                1       1       1  
   
   
   
   
   
 
       
Total real estate construction
    2       2       2       1       2  
   
Commercial mortgage
                                       
     
Commercial real estate business line
    4       4       4       6        
     
Other
    13       19       18       4       3  
   
   
   
   
   
 
       
Total commercial mortgage
    17       23       22       10       3  
   
Residential mortgage
    1       1                    
   
Consumer
    15       14       11       11       7  
   
Lease financing
    37       13       4       9       7  
 
International
    11       14       67       63       15  
   
   
   
   
   
 
   
Total loans charged-off
    174       268       408       517       232  
Recoveries:
                                       
 
Domestic
                                       
   
Commercial
    55       52       28       27       35  
   
Real estate construction
                             
   
Commercial mortgage
    3       3       1       2       1  
   
Residential mortgage
                            1  
   
Consumer
    5       2       3       3       5  
   
Lease financing
          1             3       1  
 
International
    1       16       11       1        
   
   
   
   
   
 
   
Total recoveries
    64       74       43       36       43  
   
   
   
   
   
 
Net loans charged-off
    110       194       365       481       189  
Provision for loan losses
    (47 )     64       377       635       241  
   
   
   
   
   
 
Balance at end of year
  $ 516     $ 673     $ 803     $ 791     $ 637  
   
   
   
   
   
 
Allowance for loan losses as a percentage of total loans at end of year
    1.19 %     1.65 %     1.99 %     1.87 %     1.55 %
Net loans charged-off during the year as a percentage of average loans outstanding during the year
    0.25       0.48       0.86       1.14       0.46  

 

           The following table provides an analysis of the changes in the allowance for credit losses on lending-related commitments.

                                         
Years Ended December 31

2005 2004 2003 2002 2001





(dollar amounts in millions)
Balance at beginning of year
  $ 21     $ 33     $ 35     $ 18     $ 23  
Charge-offs on lending-related commitments*
    6                          
Provision for credit losses on lending-related commitments
    18       (12 )     (2 )     17       (5 )
   
   
   
   
   
 
Balance at end of year
  $ 33     $ 21     $ 33     $ 35     $ 18  
   
   
   
   
   
 

 

           *  Charge-offs result from the sale of unfunded lending-related commitments.

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TABLE 5: ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES

                                                                                     
Years Ended December 31

2005 2004 2003 2002 2001





Amount % Amount % Amount % Amount % Amount %










(dollar amounts in millions)
Domestic
                                                                               
 
Commercial
  $ 302       55 %   $ 411       54 %   $ 487       54 %   $ 476       57 %   $ 410       58 %
 
Real estate construction
    16       8       23       8       31       8       26       8       17       8  
 
Commercial mortgage
    62       21       76       20       95       20       86       17       61       15  
 
Residential mortgage
    1       3       2       3       5       3       2       3       1       3  
 
Consumer
    24       6       25       7       27       6       25       6       14       6  
 
Lease financing
    28       3       44       3       26       3       8       3       9       3  
International
    27       4       40       5       91       6       130       6       88       7  
Unallocated
    56               52               41               38               37          
   
   
   
   
   
   
   
   
   
   
 
   
Total
  $ 516       100 %   $ 673       100 %   $ 803       100 %   $ 791       100 %   $ 637       100 %
   
   
   
   
   
   
   
   
   
   
 


Amount — allocated allowance

% — loans outstanding as a percentage of total loans


Provision and Allowance for Credit Losses

      The provision for loan losses reflects management’s evaluation of the adequacy of the allowance for loan losses. The allowance for loan losses represents management’s assessment of probable losses inherent in the Corporation’s loan portfolio. The allowance provides for probable losses that have been identified with specific customer relationships and for probable losses believed to be inherent in the loan portfolio, but that have not been specifically identified. Internal risk ratings are assigned to each business loan at the time of approval and are subject to subsequent periodic reviews by the Corporation’s senior management. The Corporation performs a detailed quarterly credit quality review on both large business and certain large personal purpose consumer and residential mortgage loans that have deteriorated below certain levels of credit risk, and may allocate a specific portion of the allowance to such loans based upon this review. The Corporation defines business loans as those belonging to the commercial, real estate construction, commercial mortgage, lease financing and international loan portfolios. A portion of the allowance is allocated to the remaining business loans by applying projected loss ratios, based on numerous factors identified below, to the loans within each risk rating. In addition, a portion of the allowance is allocated to these remaining loans based on industry specific and international risks inherent in certain portfolios, including portfolio exposures to automotive, retail, contractor, technology-related, entertainment, air transportation and healthcare industries, Small Business Administration loans and Mexican risks. The portion of the allowance allocated to all other consumer and residential mortgage loans is determined by applying projected loss ratios to various segments of the loan portfolio. Projected loss ratios for all portfolios incorporate factors, such as recent charge-off experience, current economic conditions and trends, and trends with respect to past due and nonaccrual amounts, and are supported by underlying analysis, including information on migration and loss given default studies from each of the three major domestic geographic markets, as well as mapping to bond tables. The total allowance for loan losses was $516 million at December 31, 2005, compared to $673 million at December 31, 2004. The allocated portion of the allowance was $460 million at December 31, 2005, a decrease of $161 million from year-end 2004. The decrease resulted primarily from the impact of favorable migration data on projected loss factors, a decrease in loan specific reserves and a decrease in the reserve associated with industry specific and international risks.

      Actual loss ratios experienced in the future may vary from those projected. The uncertainty occurs because factors may exist, which affect the determination of probable losses inherent in the loan portfolio and are not necessarily captured by the application of projected loss ratios or identified industry specific and international risks. An unallocated portion of the allowance is maintained to capture these probable losses. The unallocated allowance reflects management’s view that the allowance should recognize the margin for error inherent in the

28


 

process of estimating expected loan losses. Factors that were considered in the evaluation of the adequacy of the Corporation’s unallocated allowance include the inherent imprecision in the risk rating system and the risk associated with new customer relationships. The unallocated allowance associated with the margin for inherent imprecision covers probable loan losses as a result of an inaccuracy in assigning risk ratings or stale ratings which may not have been updated for recent negative trends in the particular credits. The unallocated allowance due to new business migration risk is based on an evaluation of the risk of rating downgrades associated with loans that do not have a full year of payment history. The unallocated allowance was $56 million at December 31, 2005, an increase of $4 million from year-end 2004. This increase was due, in part, to an increase in new customer relationships.

      The total allowance, including the unallocated amount, is available to absorb losses from any segment within the portfolio. Unanticipated economic events, including political, economic and regulatory instability in countries where the Corporation has loans, could cause changes in the credit characteristics of the portfolio and result in an unanticipated increase in the allocated allowance. Inclusion of other industry specific and international portfolio exposures in the allocated allowance, as well as significant increases in the current portfolio exposures, could also increase the amount of the allocated allowance. Any of these events, or some combination, may result in the need for additional provision for loan losses in order to maintain an adequate allowance.

      The provision for loan losses was a credit of $47 million in 2005, compared to a provision of $64 million and $377 million in 2004 and 2003, respectively. The $111 million decrease in the provision for loan losses in 2005, compared to 2004, was primarily the result of improving credit quality trends in net loan charge-offs, nonperforming loans and watch list loans. These trends reflect improving economic conditions in certain of the Corporation’s primary geographic markets. While the economic conditions in the Corporation’s Michigan market deteriorated slightly over the last year, the economic conditions in both the Western and Texas markets have continued to improve in line with, or slightly better than, growth in the national economy. The average 2005 Michigan Business Activity index compiled by the Corporation declined approximately three percent when compared to the average for 2004. The struggling automotive industry contributed, in part, to the decline. Forward-looking indicators suggest these economic conditions should continue in 2006. The decrease in the provision for loan losses in 2004, compared to 2003, was primarily the result of improving credit quality trends, which reflected improved economic conditions in all of the Corporation’s primary geographic markets in 2004.

      Net loan charge-offs in 2005 were $110 million, or 0.25 percent of average total loans, compared to $194 million, or 0.48 percent, in 2004 and $365 million, or 0.86 percent, in 2003. An analysis of the changes in the allowance for loan losses, including charge-offs and recoveries by loan category, is presented in Table 4 on page 27 of this financial review.

      Nonperforming assets at December 31, 2005 were $162 million, as compared to $339 million at December 31, 2004. During 2005, $222 million of loans with balances greater than $2 million were transferred to nonaccrual, compared to $332 million in 2004, and $154 million of nonaccrual business loans were charged-off, compared to $248 million in 2004. The carrying value of nonaccrual loans as a percentage of contractual value was 54 percent at both December 31, 2005 and 2004. For further information on changes in nonperforming assets, see the “Nonperforming Assets” section of this financial review on page 44.

      The allowance as a percentage of total loans, nonperforming assets and annual net loan charge-offs is provided in the following table.

                         
Years Ended
December 31

2005 2004 2003



Allowance for loan losses as a percentage of total loans at end of year
    1.19 %     1.65 %     1.99 %
Allowance for loan losses as a percentage of total nonperforming assets at end of year
    319       198       149  
Allowance for loan losses as a percentage of total net loan charge-offs for the year
    469       346       220  

      The allowance for loan losses as a percentage of total period-end loans decreased to 1.19 percent at December 31, 2005, from 1.65 percent at December 31, 2004. The allowance for loan losses as a percentage of nonperforming assets increased to 319 percent at December 31, 2005, from 198 percent at December 31, 2004.

29


 

The decrease in allowance coverage of total loans and increase in allowance coverage of nonperforming assets resulted primarily from improved credit quality trends in 2005. The increase in the allowance for loan losses as a percentage of net loan charge-offs for the year ended December 31, 2005, when compared to the prior year, resulted from lower levels of net loan charge-offs in 2005.

      The Corporation maintains an allowance to cover probable credit losses inherent in lending-related commitments, including letters of credit and financial guarantees, which is included in “accrued expenses and other liabilities” on the consolidated balance sheets. Lending-related commitments for which it is probable that the commitment will be drawn (or sold) are reserved with the same projected loss rates as loans, or with specific reserves. In general, the probability of draw is considered certain once the credit becomes a watch list credit. Non-watch list credits have a lower probability of draw, to which standard loan loss rates are applied. The allowance for credit losses on lending-related commitments was $33 million at December 31, 2005, compared to $21 million at December 31, 2004, an increase of $12 million, resulting primarily from an increase in specific reserves related to unused commitments to extend credit to customers in the automotive industry. An analysis of the changes in the allowance for credit losses on lending-related commitments is presented on page 27 of this financial review.

      Management expects the full-year 2006 provision for credit losses, which encompasses both loan losses and credit losses on lending-related commitments, to be consistent with credit-related charge-offs, or between 25 to 30 basis points of full-year average loans.

Noninterest Income

                           
Years Ended December 31

2005 2004 2003



(in millions)
Service charges on deposit accounts
  $ 218     $ 231     $ 238  
Fiduciary income
    177       171       169  
Commercial lending fees
    63       55       63  
Letter of credit fees
    70       66       65  
Foreign exchange income
    37       37       36  
Brokerage fees
    36       36       34  
Investment advisory revenue, net
    51       35       30  
Card fees
    39       32       27  
Bank-owned life insurance
    38       34       42  
Equity in earnings of unconsolidated subsidiaries
    16       12       6  
Warrant income
    9       7       4  
Net securities gains
                50  
Net gain on sales of businesses
    56       7        
Other noninterest income
    132       134       123  
   
   
   
 
 
Total noninterest income
  $ 942     $ 857     $ 887  
   
   
   
 

      Noninterest income increased $85 million, or 10 percent, to $942 million in 2005, compared to $857 million in 2004, and decreased $30 million, or three percent, in 2004, compared to $887 million in 2003. Excluding net securities gains and net gain on sales of businesses ($56 million, $7 million and $50 million in 2005, 2004 and 2003, respectively), noninterest income increased four percent in 2005 and two percent in 2004. An analysis of increases and decreases by individual line item is presented below.

      Service charges on deposit accounts decreased $13 million, or six percent, in 2005, compared to a decrease of $7 million, or three percent, in 2004. The decreases in 2005 and 2004 were primarily due to higher earnings credit allowances, driven by a higher interest rate environment, provided to business customers, and the popularity of free checking accounts which were marketed beginning in mid-2004.

      Fiduciary income increased $6 million, or four percent, in 2005 and increased $2 million, or one percent, in 2004. Personal and institutional trust fees are the two major components of fiduciary income. These fees are

30


 

based on services provided and assets managed. Fluctuations in the market values of the underlying assets managed, which include both equity and fixed income securities, impact fiduciary income. The increases in 2005 and 2004 are primarily due to improvements in equity markets. There was also $3 million in fees recovered in 2005 that were previously reversed in 2004.

      Commercial lending fees increased $8 million, or 16 percent, in 2005, compared to a decrease of $8 million, or 13 percent, in 2004. The increase in 2005 was primarily due to an increase in fees resulting from increased opportunities in 2005 to lead or co-lead syndicated lending arrangements. The decline in 2004 was primarily due to a decline in all three of the major components of commercial lending fees: agent bank fees, commitment fees in arrears and service charges on commercial loans. The decline in agent bank fees in 2004 was primarily due to a decline in the volume of loan participations. The decrease in commitment fees in arrears and service charges on commercial loans in 2004 was primarily due to the impact that improvements in the credit quality of customers had on fees earned.

      Letter of credit fees increased $4 million, or six percent, in 2005, compared to an increase of $1 million, or less than one percent, in 2004. The increase in 2005 was primarily due to an adjustment of deferred fee amortization to more closely align the amortization periods with actual terms of the letters of credit. The increase in 2004 related to the demand for international trade services from new and existing Middle Market and National Dealer Services customers.

      Foreign exchange income remained flat at $37 million in 2005, compared to an increase of $1 million, or two percent, in 2004.

      Brokerage fees remained flat at $36 million in 2005, compared to an increase of $2 million, or eight percent, in 2004. Brokerage fees include commissions from retail broker transactions and mutual fund sales and are subject to changes in the level of market activity. The increase in 2004 was primarily due to increased transaction volumes as a result of improved market conditions.

      Investment advisory revenue, which mainly includes revenue generated by the Corporation’s asset management reporting unit (Munder Capital Management or Munder), increased $16 million, or 43 percent, in 2005, compared to an increase of $5 million, or 16 percent, in 2004. The increase in 2005 resulted primarily from growth in assets under management, due to new customer relationships. The increase in 2004 resulted from continued market growth. Assets under management at Munder totaled $41 billion, $38 billion and $34 billion at December 31, 2005, 2004 and 2003, respectively.

      Card fees, which consist primarily of interchange fees earned on debit and commercial cards, increased $7 million, or 22 percent, to $39 million, compared to $32 million in 2004, and increased $5 million, or 20 percent, compared to $27 million in 2003. Growth in both 2005 and 2004 was primarily due to an increase in transaction volume, due in part to new customer accounts.

      Bank-owned life insurance income increased $4 million, to $38 million in 2005, compared to a decrease of $8 million, to $34 million in 2004. The increase in 2005 was primarily due to an increase in earnings and death benefits received on policies held. The decrease in 2004 was primarily due to a decline in earnings and death benefits received on policies held.

      Equity in earnings of unconsolidated subsidiaries increased $4 million, to $16 million in 2005, compared to an increase of $6 million, to $12 million in 2004. The increases in both 2005 and 2004 were largely due to an increase in income from a United Kingdom subsidiary, Framlington Group Limited (Framlington) (a London, England based investment manager), of which Munder was a minority owner. Munder sold its interest in Framlington in the fourth quarter 2005. Framlington income included in equity of earnings of unconsolidated subsidiaries totaled $8 million in 2005, $4 million in 2004 and $1 million in 2003, and is exclusive of the net gain on sale of Framlington, which is included in “net gain on sales of businesses” on the consolidated statements of income and discussed below. For further information, see Note 25 to the consolidated financial statements on page 115.

      Warrant income was $9 million in 2005, compared to $7 million in 2004 and $4 million in 2003. In the third quarter 2005, the Corporation changed its accounting for warrants so as to recognize in warrant income the changes in the fair value of warrants held. For a further discussion of the warrant accounting change, see Note 1 to the consolidated financial statements on page 67.

31


 

      The Corporation’s net revenue from sales and write-downs related to its investment securities portfolio was nominal in both 2005 and 2004. A net gain of $50 million was recognized in 2003. The significant net gain in 2003 resulted primarily from a restructuring of the investment portfolio in late 2002 and 2003, designed to achieve more consistent cash flows.

      The net gain on sales of businesses in 2005 included a net gain of $55 million on the sale of Framlington, while the net gain in 2004 included a net gain of $7 million on the sale of a portion of the Corporation’s merchant card processing business. For further information on the sale of Framlington, see Note 25 to the consolidated financial statements on page 115.

      Other noninterest income decreased $2 million, or one percent, in 2005, compared to an increase of $11 million, or eight percent, in 2004. Other noninterest income in 2005 included $8 million of income (net of write-downs) from unconsolidated venture capital and private equity investments, $3 million of risk management hedge ineffectiveness gains and $25 million of amortization expense on low income housing investments (netted against noninterest income). Other noninterest income in 2004 included $13 million of income distributions (net of write-downs) from unconsolidated venture capital and private equity investments, $4 million of risk management hedge ineffectiveness losses and $20 million of amortization expense on low income housing investments (netted against noninterest income). Other noninterest income in 2003 included $9 million of write-downs (net of income distributions) of unconsolidated venture capital and private equity investments, $3 million of risk management hedge ineffectiveness losses and $13 million of amortization expense on low income housing investments (netted against noninterest income).

      Management expects a low-single digit growth in noninterest income in 2006 from 2005 levels, excluding net gains on sales of businesses.

Noninterest Expenses

                           
Years Ended December 31

2005 2004 2003



(in millions)
Salaries
  $ 820     $ 760     $ 736  
Employee benefits
    184       159       161  
   
   
   
 
 
Total salaries and employee benefits
    1,004       919       897  
Net occupancy expense
    121       125       128  
Equipment expense
    56       58       61  
Outside processing fee expense
    78       68       71  
Software expense
    49       43       37  
Customer services
    69       23       25  
Litigation and operational losses
    18       24       18  
Provision for credit losses on lending-related commitments
    18       (12 )     (2 )
Other noninterest expenses
    253       245       248  
   
   
   
 
 
Total noninterest expenses
  $ 1,666     $ 1,493     $ 1,483  
   
   
   
 

      Noninterest expenses increased $173 million, or 12 percent, to $1,666 million in 2005, compared to $1,493 million in 2004, and increased $10 million, or less than one percent, in 2004, compared to $1,483 million in 2003. Approximately half of the 12 percent increase in 2005 related to customer services expense in the Financial Services Division ($46 million), and credit-related costs ($39 million), including the provision for credit losses on lending-related commitments and other real estate expense. An analysis of increases and decreases by individual line item is presented below.

      Salaries expense increased $60 million, or eight percent, in 2005, compared to an increase of $24 million, or three percent, in 2004. The increase in 2005 was primarily due to a $42 million increase in business unit and executive incentives, including an accrual of $4 million related to the warrant accounting change discussed in Note 1 to the consolidated financial statements on page 67, annual merit increases of approximately $18 million and an increase of $11 million in stock-based compensation expense. These increases were

32


 

partially offset by a full-time equivalent employee reduction in staff size of approximately 75 employees from year-end 2004 to year-end 2005 and a $5 million decline in severance expense. The increase in 2004 was primarily due to merit increases of approximately $17 million and an increase of $9 million in severance expense, $9 million in executive incentives, and $6 million in stock-based compensation expense. These increases were partially offset by a full-time equivalent employee reduction in staff size of approximately 300 employees from year-end 2003 to year-end 2004. Severance expense was $6 million in 2005, compared to $11 million and $2 million in 2004 and 2003, respectively. For further information on stock-based compensation, refer to Notes 1 and 14 to the consolidated financial statements on pages 67 and 85, respectively.

      Employee benefits expense increased $25 million, or 15 percent, in 2005, compared to a decrease of $2 million, or one percent, in 2004. The increase in 2005 and decrease in 2004 resulted primarily from changes in pension expense. For a further discussion of pension expense, refer to Note 15 to the consolidated financial statements on page 88.

      Net occupancy and equipment expense, on a combined basis, decreased $6 million, or three percent, to $177 million in 2005, compared to a decrease of $6 million, or three percent, in 2004. Net occupancy expense declined in spite of new banking centers added in the last year, due to the purchase of a previously leased operations center in March 2005, which results in annual savings of $7 million, beginning in April 2005, and other lease re-negotiations. The decrease in 2004 resulted primarily from lease termination costs associated with the consolidation of Western region facilities in 2003.

      Outside processing fee expense increased $10 million, or 15 percent, to $78 million in 2005, from $68 million in 2004, and decreased $3 million, or five percent, in 2004, compared to $71 million in 2003. The 2005 increase in outside processing fees resulted, in part, from the outsourcing of certain retirement services processing in the second quarter 2005.

      Software expense increased $6 million, or 13 percent, in 2005, compared to an increase of $6 million, or 16 percent in 2004. The increases in both 2005 and 2004 were primarily due to increased investments in technology and the implementation of several systems, which had previously been in the development stages, increasing both amortization and maintenance costs.

      Customer services expense increased $46 million, or 203 percent, to $69 million in 2005, from $23 million in 2004, and decreased $2 million, or 10 percent, in 2004, compared to $25 million in 2003. Customer services expense represents compensation provided to customers, and is one method to attract and retain title and escrow deposits in the Corporation’s Financial Services Division. The amount of customer services expense varies from period to period as a result of changes in the level of noninterest-bearing deposits in the Corporation’s Financial Services Division and the earnings credit allowances provided on these deposits, as well as a competitive environment.

      Litigation and operational losses decreased $6 million, or 23 percent, to $18 million in 2005, from $24 million in 2004, and increased $6 million, or 30 percent, in 2004, compared to $18 million in 2003. Litigation and operational losses include traditionally defined operating losses, such as fraud or processing problems, as well as uninsured losses and litigation losses. These expenses are subject to fluctuation due to timing of authorized and actual litigation settlements as well as insurance settlements.

      The provision for credit losses on lending-related commitments was $18 million in 2005, compared to a credit of $12 million in 2004 and a credit of $2 million in 2003. For additional information on the provision for credit losses on lending-related commitments, refer to Notes 1 and 19 to the consolidated financial statements on pages 67 and 96, respectively and the “Provision and Allowance for Credit Losses” section on page 28 of this financial review.

      Other noninterest expenses increased $8 million, or four percent, in 2005, compared to a $3 million decrease, or two percent, in 2004. The increase in other noninterest expenses in 2005 was primarily due to a $9 million increase in other real estate expenses, resulting from a large write-down and operating costs incurred on a single Michigan property in the Private Banking business. The decline in other noninterest expenses in 2004, compared to 2003, was primarily due to a decrease in state taxes of $7 million, a decline in consulting fees of $5 million and a decline in telecommunications expense of $5 million. These decreases were partially offset by an increase in interest expense recorded on tax liabilities of $14 million in 2004, compared to 2003.

33


 

      Management expects noninterest expenses in 2006 to be relatively unchanged from 2005 levels, excluding the provision for credit losses on lending-related commitments and excluding any future changes in the value of subsidiary share-based compensation awards and minority-owned shares classified as liabilities (see the “Other Market Risks” section of this financial review on page 54). Inherent in this outlook are incremental expenses, compared to 2005, of about $20 million for share-based compensation awards, $18 million for pensions and $20 million for new banking centers. For further discussion of subsidiary share-based compensation awards classified as liabilities, see Note 27 to the consolidated financial statements on page 117. Customer services expense and incentive compensation are expected to be lower in 2006, compared to 2005.

      The Corporation’s efficiency ratio is defined as total noninterest expenses divided by the sum of net interest income (FTE) and noninterest income, excluding net securities gains. The ratio increased to 57.40 percent in 2005, compared to 55.90 percent in 2004 and 53.64 percent in 2003. The efficiency ratio increased in 2005 primarily due to higher expense levels and increased in 2004 primarily due to changes in net revenues.

Income Taxes

      The provision for income taxes was $418 million in 2005, compared to $353 million in 2004 and $292 million in 2003. The effective tax rate, computed by dividing the provision for income taxes by income before income taxes, was 32.7 percent in 2005, 31.8 percent in 2004 and 30.7 percent in 2003. The effective tax rate increase in 2005, from 2004 levels was primarily due to an increase in state tax expense as a percentage of pre-tax income. The effective tax rate increase in 2004, from 2003 levels resulted, in part, from foreign tax credits recognized in 2003 and a decrease in non-taxable revenue on bank-owned life insurance policies. The Corporation’s net deferred income taxes was a liability of $160 million at December 31, 2005. Included in net deferred taxes were deferred tax assets of $445 million, which the Corporation’s management believes will be realized in future periods. In the event that the future taxable income does not occur in the manner anticipated, other initiatives could be undertaken to preclude the need to recognize a valuation allowance against the deferred tax asset.

34


 

STRATEGIC LINES OF BUSINESS

Business Segments

      The Corporation’s operations are strategically aligned into three major business segments: the Business Bank, Small Business & Personal Financial Services, and Wealth & Institutional Management. These business segments are differentiated based upon the products and services provided. In addition to the three major business segments, the Finance Division is also reported as a segment. The Other category includes items not directly associated with these business segments or the Finance Division. Note 23 to the consolidated financial statements on page 107 describes the business activities of each business segment and the methodologies which form the basis for these results, and presents financial results of these business segments for the years ended December 31, 2005, 2004 and 2003.

      The following table presents net income (loss) by business segment.

                                                   
Years Ended December 31

2005 2004 2003



(dollar amounts in millions)
Business Bank
  $ 649       71 %   $ 684       73 %   $ 614       72 %
Small Business & Personal Financial Services
    161       18       176       19       179       21  
Wealth & Institutional Management
    103       11       75       8       57       7  
   
   
   
   
   
   
 
      913       100 %     935       100 %     850       100 %
Finance
    (71 )             (158 )             (139 )        
Other
    19               (20 )             (50 )        
   
         
         
       
 
Total
  $ 861             $ 757             $ 661          
   
         
         
       

      The Business Bank’s net income decreased $35 million, or five percent, to $649 million in 2005, compared to an increase of $70 million, or 11 percent, to $684 million in 2004. Net interest income (FTE) increased $8 million in 2005, compared to 2004, primarily due to a $20 million adjustment related to the change in warrant accounting discussed in Note 1 to the consolidated financial statements on page 67. Net interest income was also impacted by an increase in average loan balances of eight percent (five percent, excluding Financial Services Division (FSD) loans), an increase in average deposit balances of four percent (a decrease of three percent, excluding FSD deposits), and an increase in deposit spreads, partially offset by a decline in loan spreads. The provision for loan losses decreased $26 million in 2005, primarily due to an improvement in credit quality trends, as discussed in the “Provision and Allowance for Credit Losses” section of this financial review on page 28, partially offset by higher loan growth. Noninterest income of $282 million in 2005 increased $4 million from 2004, reflecting a $9 million increase in commercial lending fees partially offset by a $6 million decrease in service charges on deposit accounts. In addition, 2004 noninterest income included a $7 million gain on the sale of a portion of the Corporation’s merchant card processing business. Noninterest expenses increased $121 million in 2005, primarily due to a $46 million increase in customer services expense in FSD, a $30 million increase in salaries and employee benefits expense, and a $23 million increase in the provision for credit losses on lending-related commitments. The salaries and employee benefits expense increase included a $4 million business unit incentive accrual related to the warrant accounting change discussed in Note 1 to the consolidated financial statements on page 67.

      Small Business & Personal Financial Services net income decreased $15 million, or eight percent, to $161 million in 2005, compared to a decrease of $3 million, or two percent, to $176 million in 2004. Net interest income (FTE) increased $24 million, or four percent, in 2005, primarily due to an increase in deposit balances, deposit spreads, and loan balances, partially offset by declines in loan spreads. The provision for loan losses increased $2 million in 2005, primarily due to an increase in net loan charge-offs. Noninterest income decreased $5 million in 2005, primarily due to a decrease in service charges on deposits. Noninterest expenses increased $43 million in 2005, primarily due to a $13 million increase in salaries and employee benefits expense, due in part, from the opening of 18 new banking centers in 2005, and a $19 million increase in allocated net corporate overhead expenses.

35


 

      Wealth & Institutional Management’s net income increased $28 million, or 37 percent, to $103 million in 2005, compared to an increase of $18 million, or 32 percent, to $75 million in 2004. Net interest income (FTE) remained unchanged at $149 million in 2005, as increases in loan balances were offset by declines in both loan and deposit spreads and deposit balances. The provision for loan losses declined $4 million in 2005, primarily due to an improvement in credit quality trends. Noninterest income increased $77 million in 2005, primarily due to a $55 million net gain on the sale of Framlington, a $16 million increase in investment advisory fees and an $8 million increase in personal trust fees. Noninterest expenses increased $39 million in 2005, primarily due to an $11 million increase in other real estate expenses, a $10 million increase in allocated net corporate overhead expenses and a $9 million increase in salaries and employee benefits expense.

      The net loss in the Finance Division was $71 million in 2005, compared to a net loss of $158 million in 2004. Contributing to the 2005 decline in net loss was a $108 million increase in net interest income (FTE) in 2005, primarily due to the rising rate environment in which interest income received from the lending-related business units rises more quickly than the longer-term value attributed to deposits generated by the business units. In addition, noninterest income increased $8 million in 2005, mainly due to a $6 million increase in risk management hedge income.

      Net income for the Other category was $19 million in 2005, compared to a net loss of $20 million in 2004. The increase in net income in 2005 was primarily due to an $83 million decrease in the provision for loan losses not assigned to the other segments. The decrease in the provision for loan losses was due, in part, to a decline in the reserve associated with industry specific and international risks.

Geographic Market Segments

      The Corporation’s management accounting system also produces market segment results for the Corporation’s four primary geographic markets: Midwest & Other Markets, Western, Texas and Florida. Note 23 to the consolidated financial statements on page 107 presents financial results of these market segments for the years ended December 31, 2005, 2004 and 2003.

      The following table presents net income (loss) by market segment.

                                                   
Years Ended December 31

2005 2004 2003



(dollar amounts in millions)
Midwest & Other Markets
  $ 495       54 %   $ 531       57 %   $ 457       54 %
Western
    314       34       295       31       289       34  
Texas
    88       10       91       10       92       11  
Florida
    16       2       18       2       12       1  
   
   
   
   
   
   
 
      913       100 %     935       100 %     850       100 %
Finance & Other Businesses
    (52 )             (178 )             (189 )        
   
         
         
       
 
Total
  $ 861             $ 757             $ 661          
   
         
         
       

      Midwest & Other Markets’ net income decreased $36 million, or seven percent, to $495 million in 2005, compared to an increase of $74 million, or 16 percent, in 2004. Net interest income (FTE) increased $8 million in 2005, as increases in deposit spreads and average loan balances (three percent) were partially offset by decreases in loan spreads and average deposit balances (one percent). The provision for loan losses increased $45 million, primarily due to higher loan growth in 2005 and a smaller benefit from an improvement in credit quality trends in 2005, compared to 2004, as discussed in the “Provision and Allowance for Credit Losses” section of this financial review on page 28. Noninterest income increased $84 million in 2005, primarily due to a $55 million net gain on the sale of Framlington, a $15 million increase in investment advisory fees, a $7 million increase in personal trust fees and a $6 million increase in card fees, partially offset by a $5 million decline in service charges on deposits. Noninterest expenses increased $103 million in 2005, primarily due to a $29 million increase in allocated net corporate overhead expenses, a $27 million increase in salaries and employee benefits expense and a $26 million increase in the provision for credit losses on lending-related commitments. In addition, there was a $10 million increase in other real estate expenses, and a $9 million

36


 

increase in outside processing fees which resulted, in part, from the outsourcing of certain retirement services processing in the second quarter of 2005.

      The Western market’s net income increased $19 million, or six percent, to $314 million in 2005, compared to an increase of $6 million, or two percent, to $295 million in 2004. Net interest income (FTE) increased $18 million in 2005, primarily due to a $20 million adjustment related to the warrant accounting change discussed in Note 1 to the consolidated financial statements on page 67. Net interest income was also impacted by an increase in average loan balances of 15 percent (seven percent, excluding FSD loans) and an increase in average deposit balances of seven percent (excluding FSD deposits, average deposits remained flat). The provision for loan losses decreased $64 million in 2005, primarily due to an improvement in credit quality trends. Noninterest income declined $10 million in 2005, primarily due to a $7 million gain on the sale of a portion of the Corporation’s merchant card processing business in 2004 and a $5 million decline in service charges on deposits in 2005. Noninterest expenses increased $75 million in 2005, primarily due to a $46 million increase in customer services expenses in FSD, a $15 million increase in salaries and employee benefits expense, and a $12 million increase in allocated net corporate overhead expenses. The increase in salaries and employee benefits expense resulted, in part, from the opening of 10 new banking centers in 2005 and a $4 million business unit incentive accrual related to the warrant accounting change discussed above.

      The Texas market’s net income decreased $3 million, or four percent, to $88 million in 2005, compared to a decrease of $1 million, or one percent, to $91 million in 2004. Net interest income (FTE) increased $3 million due to an increase in average loan balances (11 percent) and deposit spreads, partially offset by a decrease in average deposit balances (four percent) and loan spreads. The provision for loan losses decreased $6 million, primarily due to an improvement in credit quality trends, partially offset by an increase in loan balances. Noninterest expenses increased $16 million in 2005, primarily due to an $8 million increase in salaries and employee benefits expense, due in part, from the opening of 7 new banking centers in 2005, and a $7 million increase in allocated net corporate overhead expenses.

      The Florida market’s net income decreased $2 million, or seven percent, to $16 million in 2005, compared to an increase of $6 million, or 46 percent, to $18 million in 2004. Net interest income (FTE) increased $3 million in 2005, primarily due to an increase in loan balances (nine percent). The provision for loan losses decreased $3 million in 2005, primarily due to an improvement in credit quality trends. Noninterest income increased $1 million in 2005, while noninterest expenses increased $9 million due, in part, to a $3 million increase in operational losses and a $2 million increase in salaries and employee benefits expense.

      The net loss for the Finance & Other Businesses segment was $52 million in 2005, compared to a net loss of $178 million in 2004. Contributing to the decline in net loss in 2005, was a $115 million decrease in net interest expense (FTE), primarily due to the rising rate environment in which interest income received from the lending-related business units rises more quickly than the longer-term value attributed to deposits generated by the business units. In addition, the provision for loan losses decreased $83 million in 2005, primarily due to a decrease in the loan loss provision not assigned to the other segments. The decrease in the provision for loan losses not assigned to the other segments was due, in part, to a decline in the reserve associated with industry specific and international risks. Noninterest income increased $9 million in 2005, primarily due to a $6 million increase in risk management hedge income.

      The following table lists the Corporation’s banking centers by geographic market segments.

                           
December 31

2005 2004 2003



Midwest & Other Markets
    255       268       261  
Western
    61       51       43  
Texas
    59       52       50  
Florida
    6       6       6  
   
   
   
 
 
Total
    381       377       360  
   
   
   
 

37


 

BALANCE SHEET AND CAPITAL FUNDS ANALYSIS

      Total assets were $53.0 billion at December 31, 2005, an increase of $1.2 billion from $51.8 billion at December 31, 2004. On an average basis, total assets increased to $52.5 billion in 2005, from $50.9 billion in 2004, an increase of $1.6 billion. The Corporation also experienced a $495 million increase in average deposits and a $354 million decline in average medium- and long-term debt in 2005, compared to 2004.

TABLE 6: ANALYSIS OF INVESTMENT SECURITIES AND LOANS

                                             
December 31

2005 2004 2003 2002 2001





(in millions)
Investment securities available-for-sale:
                                       
 
U.S. Treasury and other Government agency securities
  $ 124     $ 192     $ 188     $ 46     $ 209  
 
Government-sponsored enterprise securities
    3,954       3,564       4,121       2,702       3,711  
 
State and municipal securities
    4       7       11       23       32  
 
Other securities
    158       180       169       282       339  
   
   
   
   
   
 
   
Total investment securities available-for-sale
  $ 4,240     $ 3,943     $ 4,489     $ 3,053     $ 4,291  
   
   
   
   
   
 
Commercial loans
  $ 23,545     $ 22,039     $ 21,579     $ 23,961     $ 24,069  
Real estate construction loans:
                                       
 
Real estate construction business line
    2,831       2,461       2,754       2,900       2,824  
 
Other
    651       592       643       557       434  
   
   
   
   
   
 
   
Total real estate construction loans
    3,482       3,053       3,397       3,457       3,258  
Commercial mortgage loans:
                                       
 
Commercial real estate business line
    1,450       1,556       1,655       1,626       1,421  
 
Other
    7,417       6,680       6,223       5,568       4,846  
   
   
   
   
   
 
   
Total commercial mortgage loans
    8,867       8,236       7,878       7,194       6,267  
Residential mortgage loans
    1,485       1,294       1,228       1,143       1,110  
Consumer loans
    2,697       2,751       2,610       2,465       2,260  
Lease financing
    1,295       1,265       1,301       1,296       1,217  
International loans:
                                       
 
Government and official institutions
    3       4       12       9       9  
 
Banks and other financial institutions
    46       11       45       199       427  
 
Commercial and industrial
    1,827       2,190       2,252       2,557       2,579  
   
   
   
   
   
 
   
Total international loans
    1,876       2,205       2,309       2,765       3,015  
   
   
   
   
   
 
   
Total loans
  $ 43,247     $ 40,843     $ 40,302     $ 42,281     $ 41,196  
   
   
   
   
   
 

38


 

TABLE 7: LOAN MATURITIES AND INTEREST RATE SENSITIVITY

                                     
December 31, 2005

Loans Maturing

After One
Within But Within After Five
One Year* Five Years Years Total




(in millions)
Commercial loans
  $ 18,045     $ 4,530     $ 970     $ 23,545  
Real estate construction loans
    2,506       764       212       3,482  
Commercial mortgage loans
    3,056       4,239       1,572       8,867  
International loans
    1,711       159       6       1,876  
   
   
   
   
 
   
Total
  $ 25,318     $ 9,692     $ 2,760     $ 37,770  
   
   
   
   
 
Sensitivity of Loans to Changes in Interest Rates:
                               
 
Predetermined (fixed) interest rates
          $ 3,649     $ 2,294          
 
Floating interest rates
            6,043       466          
         
   
       
   
Total
          $ 9,692     $ 2,760          
         
   
       


Includes demand loans, loans having no stated repayment schedule or maturity and overdrafts


Earning Assets

      Total earning assets were $48.6 billion at December 31, 2005, an increase of $630 million from $48.0 billion at December 31, 2004. The Corporation’s average earning assets balances are reflected in Table 2 on page 24. On an average basis, total earning assets were $48.2 billion in 2005, compared to $47.0 billion in 2004. Total loans were $43.2 billion at December 31, 2005, an increase of $2.4 billion from $40.8 billion at December 31, 2004. Total loans, on an average basis, increased $3.1 billion ($2.1 billion, excluding FSD loans), or eight percent (five percent, excluding FSD loans), to $43.8 billion in 2005, from $40.7 billion in 2004. The Corporation generated growth, on an average basis, in the Specialty Businesses (42 percent), Private Banking (9 percent), and Middle Market (6 percent) loan portfolios, from 2004 to 2005. The increase in average loans in the Specialty Businesses loan portfolio was primarily due to increases in average Financial Services Division (114 percent), Energy (39 percent), and Technology and Life Sciences (35 percent) loans. The Corporation generated loan growth, on an average basis, in all its geographic markets, including Western (15 percent) and Texas (11 percent), from 2004 to 2005.

      Management currently expects average loan growth for 2006 to be in the mid-to-high single digit range, (excluding FSD, in the mid-single digit range), compared to 2005.

      Short-term investments include interest-bearing deposits with banks, federal funds sold, securities purchased under agreements to resell, trading securities and loans held-for-sale. These investments provide a range of maturities under one year to manage short-term investment requirements of the Corporation. Interest-bearing deposits with banks are investments with banks in developed countries or foreign banks’ international banking facilities located in the United States. Average short-term investments declined $1.4 billion to $555 million during 2005, compared to 2004. Federal funds sold offer supplemental earning opportunities and serve correspondent banks. Loans held-for-sale typically represent residential mortgage loans and Small Business Administration loans that have been originated and which management decided to sell. In addition, as a result of the Corporation’s decision to sell its Mexican bank charter, a portion of the Corporation’s Mexican loan portfolio was included in loans held-for-sale at December 31, 2005. For further information, refer to Note 25 to the consolidated financial statements on page 115.

39


 

TABLE 8: ANALYSIS OF INVESTMENT SECURITIES PORTFOLIO-(Fully Taxable Equivalent)

                                                                                             
December 31, 2005

Maturity*

Weighted
Within 1 Year 1 - 5 Years 5 - 10 Years After 10 Years Total Average





Maturity
Amount Yield Amount Yield Amount Yield Amount Yield Amount Yield Yrs./Mos.











(dollar amounts in millions)
Available-for-sale
                                                                                       
 
U.S. Treasury and other Government agency securities
  $ 76       3.86 %   $       %   $       %   $ 47       3.40 %   $ 123       3.69 %     8/7  
 
Government-sponsored enterprise securities
                510       3.99       1,005       4.21       2,439       4.07       3,954       4.10       10/6  
 
State and municipal securities
    1       7.52       3       8.88       1       9.82                   5       8.78       3/5  
 
Other securities
                                                                                       
   
Other bonds, notes and debentures
    51       3.58       6       7.11       1       5.10                   58       3.97       0/5  
   
Other investments**
                                        100             100              
   
   
   
   
   
   
   
   
   
   
   
 
Total investment securities available-for-sale
  $ 128       3.77 %   $ 519       4.05 %   $ 1,007       4.22 %   $ 2,586       4.06 %   $ 4,240       4.09 %     10/4  
   
   
   
   
   
   
   
   
   
   
   
 


* Based on final contractual maturity.

**  Balances are excluded from the calculation of total yield.


     Investment securities available-for-sale increased $297 million to $4.2 billion at December 31, 2005, from $3.9 billion at December 31, 2004. Average investment securities available-for-sale declined $460 million to $3.9 billion in 2005, compared to $4.3 billion in 2004, primarily due to a $438 million decrease in average U.S. Treasury, Government agency, and Government-sponsored enterprise securities. Changes in U.S. Treasury, Government agency, and Government-sponsored enterprise securities resulted from interest rate risk and balance sheet management decisions. Average other securities decreased $20 million to $184 million in 2005, and consisted largely of money market and other fund investments at December 31, 2005.

      Average commercial real estate loans, consisting of real estate construction and commercial mortgage loans, increased $505 million, or four percent, from $11.3 billion in 2004 to $11.8 billion in 2005. Commercial mortgage loans are loans where the primary collateral is a lien on any real property. Real property is generally considered primary collateral if the value of that collateral represents more than 50 percent of the facility at loan approval. Average loans to borrowers included in the Corporation’s Real Estate Construction or Commercial Real Estate business lines represented $4.1 billion, or 35 percent, of the 2005 $11.8 billion average commercial real estate loans, as compared to $4.3 billion, or 38 percent, of the 2004 $11.3 billion average commercial real estate loans.

      Average residential mortgage loans increased $151 million, or 12 percent, from 2004, due to management’s decision to retain mortgages originated for certain relationship customers.

40


 

TABLE 9: INTERNATIONAL CROSS-BORDER OUTSTANDINGS

(year-end outstandings exceeding 1% of total assets)

                                   
December 31

Banks and
Government Other Commercial
and Official Financial and
Institutions Institutions Industrial Total




(in millions)
Mexico
                               
  2005   $ 3     $     $ 905     $ 908  
  2004     4             937       941  
  2003     12       3       1,106       1,121  

      Active risk management practices minimize risk inherent in international lending arrangements. These practices include structuring bilateral agreements or participating in bank facilities, which secure repayment from sources external to the borrower’s country. Accordingly, such international outstandings are excluded from the cross-border risk of that country. Mexico had cross-border outstandings of $908 million, or 1.71 percent of total assets at December 31, 2005 and was the only country with outstandings exceeding 1.00 percent of total assets at December 31, 2005. There were no countries with cross-border outstandings between 0.75 and 1.00 percent of total assets at year-end 2005. Additional information on the Corporation’s international cross-border risk in countries where the Corporation’s outstandings exceeded 1.00 percent of total assets at the end of one or more of the three years in the period ended December 31, 2005 is provided in Table 9 above.

Deposits And Borrowed Funds

      Average deposits were $40.6 billion during 2005, an increase of $495 million, or one percent, from 2004. Average noninterest-bearing deposits grew $885 million, or six percent, from 2004. Noninterest-bearing deposits include title and escrow deposits in the Corporation’s Financial Services Division, which benefit from home mortgage financing and refinancing activity. Deposit levels may change with the direction of mortgage activity changes, the desirability of such deposits, and competition for the deposits. Average interest-bearing transaction, savings and money market deposits decreased $570 million, or three percent, during 2005, to $18.8 billion. Average certificates of deposit decreased $33 million in 2005, or one percent, from 2004. This decrease in average certificates of deposit was primarily due to certificates of deposit issued in denominations in excess of $100,000 including those issued through brokers or to institutional investors (“institutional CD’s”), which matured and were not replaced. An increase in average noninterest-bearing deposits contributed to the reduced level of average institutional CD’s.

      Average short-term borrowings increased $1.2 billion to $1.5 billion in 2005, compared to $275 million in 2004. Short-term borrowings include federal funds purchased, securities sold under agreements to repurchase, commercial paper and treasury tax and loan notes.

      The Corporation uses medium-term debt (both domestic and European) and long-term debt to provide funding to support earning assets while providing liquidity that mirrors the estimated duration of deposits. Long-term subordinated notes further help maintain the Corporation’s and subsidiary banks’ total capital ratios at a level that qualifies for the lowest FDIC risk-based insurance premium. Medium- and long-term debt decreased, on an average basis, by $354 million. Further information on medium- and long-term debt is provided in Note 10 to the consolidated financial statements on page 80.

41


 

Capital

      Common shareholders’ equity was $5.1 billion at both December 31, 2005 and 2004. The following table presents a summary of changes in common shareholders’ equity in 2005:

         
(in millions)

Balance at January 1, 2005
  $ 5,105  
Retention of retained earnings (net income less cash dividends declared)
    494  
Change in accumulated other comprehensive income (loss)*
    (101 )
Repurchase of approximately 9.0 million common shares
    (525 )
Net issuance of common stock under employee stock plans
    51  
Recognition of stock-based compensation expense
    44  
   
 
Balance at December 31, 2005
  $ 5,068  
   
 


Includes an increase in accumulated net losses on cash flow hedges ($75 million) and an increase in net unrealized losses on investment securities available-for-sale ($35 million), due to changes in the interest rate environment.


      Further information on the change in other comprehensive income (loss) is provided in Note 12 to the consolidated financial statements on page 83.

      The Corporation declared common dividends totaling $367 million, or $2.20 per share, on net income applicable to common stock of $861 million. The dividend payout ratio calculated on a per share basis, was 43 percent in 2005 versus 48 percent in 2004 and 53 percent in 2003.

      When capital exceeds necessary levels, the Corporation’s common stock can be repurchased as a way to return excess capital to shareholders. Repurchasing common stock offers a flexible way to control capital levels by adjusting the capital deployed in reaction to core balance sheet growth. In March 2004, and again in July 2005, the Board of Directors of the Corporation (the Board) authorized the purchase of up to 10 million shares of Comerica Incorporated outstanding common stock in the open market. In addition to limits that result from the Board authorization, the share repurchase program is constrained by holding company liquidity and capital levels relative to internal targets and regulatory minimums. The Corporation repurchased 9.0 million shares in the open market in 2005 for $525 million, compared to 6.5 million in 2004 for $370 million. Comerica Incorporated common stock available for repurchase under Board authority totaled 9.2 million shares at December 31, 2005. Refer to Note 11 to the consolidated financial statements on page 82 for additional information on the Corporation’s share repurchase program.

      At December 31, 2005, the Corporation and its U.S. banking subsidiaries exceeded the capital ratios required for an institution to be considered “well capitalized” by the standards developed under the Federal Deposit Insurance Corporation Improvement Act of 1991. Refer to Note 18 to the consolidated financial statements on page 95 for the capital ratios.

42


 

RISK MANAGEMENT

      The Corporation assumes various types of risk in the normal course of business. Management classifies the risk exposures into five areas: (1) credit, (2) market and liquidity, (3) operational, (4) compliance and (5) business risks; and employs, or is in the process of employing, various risk management processes to identify, measure, monitor and control these risks, as described below.

      The Corporation continues to enhance its risk management capabilities with additional processes, tools and systems designed to provide management with deeper insight into the Corporation’s various risks, enhance the Corporation’s ability to control those risks, and ensure that appropriate compensation is received for the risks taken.

      Specialized risk managers, along with the risk management committees in credit, market and liquidity, operational and compliance are responsible for the day-to-day management of those respective risks. The Corporation’s Enterprise-Wide Risk Management Committee is responsible for establishing the governance over the risk management process as well as providing oversight in managing the Corporation’s aggregate risk position. The Enterprise-Wide Risk Management Committee is principally made up of the various managers from the different risk areas and reports to the Enterprise Risk Committee of the Board.

Credit Risk

      Credit risk represents the risk of loss due to failure of a customer or counterparty to meet its financial obligations in accordance with contractual terms. The Corporation manages credit risk through underwriting, periodically reviewing, and approving its credit exposures using Board committee approved credit policies and guidelines. Additionally, the Corporation manages credit risk through loan sales and loan portfolio diversification, limiting exposure to any single industry, customer or guarantor, and selling participations and/or syndicating credit exposures above those levels it deems prudent to third parties.

      During 2005, the Corporation continued its focus on the credit components of the previously announced enterprise-wide risk management program. A two-factor risk rating system was implemented across all business segments in 2005. As of December 2005, substantially all of the loan portfolios were rated using the two-factor system which will be phased into the Corporation’s decision making process throughout 2006. The evaluation of the Corporation’s loan portfolios with the new tools is anticipated to provide improved measurement of the potential risks within the loan portfolios. Other enhancements in portfolio analytics were made in 2005, building a foundation upon which the trend analysis of the new ratings will be added.

43


 

TABLE 10: SUMMARY OF NONPERFORMING ASSETS AND PAST DUE LOANS

                                                 
December 31

2005 2004 2003 2002 2001





(dollar amounts in millions)
NONPERFORMING ASSETS
                                       
 
Nonaccrual loans:
                                       
   
Commercial
  $ 65     $ 161     $ 295     $ 368     $ 466  
   
Real estate construction:
                                       
     
Real estate construction business line
    3       31       21       17       8  
     
Other
          3       3       2       2  
   
   
   
   
   
 
       
Total real estate construction
    3       34       24       19       10  
   
Commercial mortgage:
                                       
     
Commercial real estate business line
    6       6       3       8       1  
     
Other
    29       58       84       45       17  
   
   
   
   
   
 
       
Total commercial mortgage
    35       64       87       53       18  
   
Residential mortgage
    2       1       2       1        
   
Consumer
    2       1       7       5       6  
   
Lease financing
    13       15       24       5       8  
   
International
    18       36       68       114       109  
   
   
   
   
   
 
     
Total nonaccrual loans
    138       312       507       565       617  
 
Reduced-rate loans
                             
   
   
   
   
   
 
     
Total nonperforming loans
    138       312       507       565       617  
 
Other real estate
    24       27       30       10       10  
 
Nonaccrual debt securities
                1       4        
   
   
   
   
   
 
     
Total nonperforming assets
  $ 162     $ 339     $ 538     $ 579     $ 627  
   
   
   
   
   
 
Nonperforming loans as a percentage of total loans
    0.32 %     0.76 %     1.26 %     1.34 %     1.50 %
Nonperforming assets as a percentage of total loans, other real estate and nonaccrual debt securities
    0.37       0.83       1.33       1.37       1.52  
Allowance for loan losses as a percentage of total nonperforming assets
    319       198       149       136       102  
Loans past due 90 days or more and still accruing
  $ 16     $ 15     $ 32     $ 43     $ 44  

     Nonperforming Assets

      Nonperforming assets include loans and loans held-for-sale on nonaccrual status, loans which have been renegotiated to less than market rates due to a serious weakening of the borrower’s financial condition, real estate which has been acquired primarily through foreclosure and is awaiting disposition (Other Real Estate or ORE) and debt securities on nonaccrual status.

      Consumer loans, except for certain large personal purpose consumer and residential mortgage loans, are charged-off no later than 180 days past due, and earlier, if deemed uncollectible. Loans, other than consumer loans, and debt securities are generally placed on nonaccrual status when management determines that principal or interest may not be fully collectible, but no later than 90 days past due on principal or interest, unless the loan or debt security is fully collateralized and in the process of collection. Loan amounts in excess of probable future cash collections are charged-off to an amount that management ultimately expects to collect. Interest previously accrued but not collected on nonaccrual loans is charged against current income at the time the loan is placed on nonaccrual. Income on such loans is then recognized only to the extent that cash

44


 

is received and where the future collection of principal is probable. Loans that have been restructured to yield a rate that was equal to or greater than the rate charged for new loans with comparable risk and have met the requirements for a return to accrual status are not included in nonperforming assets. However, such loans may be required to be evaluated for impairment. Refer to Note 3 of the consolidated financial statements on page 75 for a further discussion of impaired loans.

      Nonperforming assets decreased $177 million, or 52 percent, to $162 million at December 31, 2005, from $339 million at December 31, 2004. As shown in Table 10 above, nonaccrual loans decreased $174 million, or 56 percent, to $138 million at December 31, 2005, from $312 million at December 31, 2004. ORE decreased $3 million, to $24 million at December 31, 2005, from $27 million at December 31, 2004. There were no nonaccrual debt securities at December 31, 2005, and a nominal amount at December 31, 2004. The $174 million reduction in nonaccrual loans at December 31, 2005 from year-end 2004 levels resulted primarily from a $96 million decline in nonaccrual commercial loans, a $31 million decline in nonaccrual real estate construction loans, a $29 million decline in nonaccrual commercial mortgage loans and an $18 million decline in nonaccrual international loans. An analysis of nonaccrual loans at December 31, 2005, based on the Standard Industrial Classification (SIC) code, is presented on page 46. Loans past due 90 days or more and still on accrual status increased $1 million, to $16 million at December 31, 2005, from $15 million at December 31, 2004. Nonperforming assets as a percentage of total loans, other real estate and nonaccrual debt securities was 0.37 percent and 0.83 percent at December 31, 2005 and 2004, respectively.

      The following table presents a summary of changes in nonaccrual loans.

                 
2005 2004


(in millions)
Balance at January 1
  $ 312     $ 507  
Loans transferred to nonaccrual (1)
    222       332  
Nonaccrual business loan gross charge-offs (2)
    (154 )     (248 )
Loans transferred to accrual status (1)
    (15 )     (7 )
Nonaccrual business loans sold (3)
    (37 )     (96 )
Payments/ Other (4)
    (190 )     (176 )
   
   
 
Balance at December 31
  $ 138     $ 312  
   
   
 

 

  (1)  Based on an analysis of nonaccrual loans with book balances greater than $2 million  
 
  (2)  Analysis of gross loans charged-off:  

                   
Nonaccrual business loans
  $ 154     $ 248  
Performing watch list loans (as defined below)
    4       5  
Consumer and residential mortgage loans
    16       15  
   
   
 
 
Total gross loans charged-off
  $ 174     $ 268  
   
   
 

  (3)  Analysis of loans sold:  

                   
Nonaccrual business loans
  $ 37     $ 96  
Performing watch list loans (as defined below) sold
    60       69  
   
   
 
 
Total loans sold
  $ 97     $ 165  
   
   
 

  (4)  Net change related to nonaccrual loans with balances less than $2 million, other than business loan gross charge-offs and nonaccrual loans sold, are included in Payments/ Other.  

 

      Loans with balances greater than $2 million transferred to nonaccrual status decreased $110 million, or 33 percent, to $222 million in 2005, compared with $332 million in 2004. There were 4 loans greater than $10 million transferred to nonaccrual in 2005. These loans totaled $85 million and were to companies in the airline ($36 million), automotive ($30 million), and consumer nondurables ($19 million) industries.

45


 

      The Corporation sold $37 million of nonaccrual business loans in 2005. These loans were to customers in the wholesale trade ($11 million), manufacturing ($7 million), automotive ($6 million) and other ($13 million) industries. In addition, the Corporation sold $65 million of unfunded commitments with customers in the automotive sector. The losses associated with the sale of the unfunded commitments were charged to the “provision for credit losses on lending-related commitments” on the consolidated statements of income.

      The following table presents a summary of total internally classified nonaccrual and watch list loans (generally consistent with regulatory defined special mention, substandard and doubtful loans) at December 31, 2005. Consistent with the decrease in nonaccrual loans from December 31, 2004 to December 31, 2005, total combined nonaccrual and watch list loans declined both in dollars and as a percentage of the total loan portfolio.

                 
December 31

2005 2004


(dollar amounts
in millions)
Total nonaccrual and watch list loans
  $ 1,917     $ 2,245  
As a percentage of total loans
    4.4 %     5.5 %

      The following table presents a summary of nonaccrual loans at December 31, 2005 and loans transferred to nonaccrual and net loan charge-offs during the year ended December 31, 2005, based on the SIC code.

                                                   
December 31,
2005 Year Ended December 31, 2005


Loan
Nonaccrual Transferred to Net
SIC Category Loans Nonaccrual (1) Charge-Offs




(dollar amounts in millions)
Automotive
  $ 22       16 %   $ 50       23 %   $ 16       15 %
Manufacturing
    21       15       21       9       4       4  
Services
    20       15       18       8       12       10  
Real Estate
    15       11       24       11       8       8  
Entertainment
    14       10       13       6       4       3  
Air Transportation
    14       10       44       20       39       35  
Contractors
    7       5       11       5       9       9  
Consumer non-durables
    4       3       30       13       6       5  
Other
    21       15       11       5       12       11  
   
   
   
   
   
   
 
 
Total
  $ 138       100 %   $ 222       100 %   $ 110       100 %
   
   
   
   
   
   
 


(1)  Based on an analysis of nonaccrual loans with book balances greater than $2 million.


      Shared National Credit Program (SNC) loans comprised approximately 10 percent and 11 percent of total nonaccrual loans at December 31, 2005 and 2004, respectively. SNC loans are facilities greater than $20 million shared by three or more federally supervised financial institutions which are reviewed by regulatory authorities at the agent bank level. These loans comprised approximately 15 percent and 13 percent of total loans at December 31, 2005 and 2004, respectively. SNC loans comprised approximately 3 percent of 2005 total net loan charge-offs.

      The following nonaccrual loans table indicates the percentage of nonaccrual loan value to contractual value, which exhibits the degree to which loans reported as nonaccrual have been partially charged-off.

                 
December 31

2005 2004


(dollar amounts
in millions)
Carrying value of nonaccrual loans
  $ 138     $ 312  
Contractual value of nonaccrual loans
    258       578  
Carrying value as a percentage of contractual value
    54 %     54 %

46


 

      Key credit quality measures, including nonaccrual and watch list loans as a percentage of total loans, new loans transferred to nonaccrual and net loan charge-offs, improved in 2005. Management expects full-year 2006 credit-related charge-offs as a percentage of average loans to be approximately 25 to 30 basis points.

     Concentration of Credit

      Loans to borrowers in the automotive industry represented the largest significant industry concentration at December 31, 2005 and 2004. Loans to dealers and to borrowers involved with automotive production are reported as automotive, since management believes these loans react similarly to changes in economic conditions. This aggregation involves the exercise of judgment. Included in automotive production are: (a) original equipment manufacturers and Tier 1 and Tier 2 suppliers that produce components used in vehicles and whose primary revenue source is automotive-related (primary defined as greater than 50%) and (b) other manufacturers that produce components used in vehicles and whose primary revenue source is automotive-related. Loans less than $1 million and loans recorded in the Small Business division were excluded from the definition. Foreign ownership consists of North American affiliates of foreign automakers and suppliers.

      A summary of exposure and outstandings from loans, unused commitments and standby letters of credit and financial guarantees to companies related to the automotive industry follows:

                                       
December 31

2005 2004


Exposure Outstandings Exposure Outstandings




(in millions)
Production:
                               
 
Foreign
  $ 1,530     $ 672     $ 1,780     $ 730  
 
Domestic
    3,323       2,048       3,719       2,045  
   
   
   
   
 
     
Total production
    4,853       2,720       5,499       2,775  
Dealer:
                               
 
Floor plan
    3,898       2,800       3,537       2,531  
 
Other
    2,668       2,029       2,055       1,692  
   
   
   
   
 
     
Total dealer
    6,566       4,829       5,592       4,223  
   
   
   
   
 
   
Total automotive
  $ 11,419     $ 7,549     $ 11,091     $ 6,998  
   
   
   
   
 

      Nonaccrual loans to automotive borrowers comprised approximately 16 percent of total nonaccrual loans at December 31, 2005. The largest automotive loan on nonaccrual status at December 31, 2005, was $14 million. Total automotive net loan charge-offs were $16 million in 2005. The largest automotive loan charge-off during 2005 was $3 million. The following table presents a summary of automotive net loan charge-offs for the year ended December 31, 2005.

           
December 31,
2005

(in millions)
Production
  $ 16  
Dealer
     
   
 
 
Total automotive net loan charge-offs
  $ 16  
   
 
Foreign ownership
  $ 5  
Domestic ownership
    11  
   
 
 
Total automotive net loan charge-offs
  $ 16  
   
 

      In addition, the Corporation recorded automotive charge-offs of $6 million in 2005 from the sale of unfunded commitments, primarily related to domestic owned production companies.

      All other industry concentrations, as defined by management, individually represented less than 10 percent of total loans at year-end 2005.

47


 

     Commercial Real Estate Lending

      The Corporation takes measures to limit risk inherent in its commercial real estate lending activities. These measures include limiting exposure to those borrowers directly involved in the commercial real estate markets and adherence to policies requiring conservative loan-to-value ratios for such loans. Commercial real estate loans, consisting of real estate construction and commercial mortgage loans, totaled $12.3 billion at December 31, 2005, of which $4.2 billion, or 35 percent, was to borrowers included in the Corporation’s Real Estate Construction or Commercial Real Estate business lines.

      The real estate construction loan portfolio contains loans primarily made to long-time customers with satisfactory completion experience. The portfolio totaled $3.5 billion and included approximately 1,750 loans, of which 56 percent had balances less than $1 million at December 31, 2005. The largest real estate construction loan had a balance of approximately $14 million at December 31, 2005. The commercial mortgage loan portfolio totaled $8.8 billion at December 31, 2005. The portfolio included approximately 8,750 loans, of which 75 percent had balances of less than $1 million, at December 31, 2005. The largest commercial mortgage loan had a balance of approximately $75 million at December 31, 2005.

      The geographic distribution of real estate construction and commercial mortgage loan borrowers is an important factor in diversifying credit risk. The following table indicates, by location of lending office, the diversification of the Corporation’s real estate construction and commercial mortgage loan portfolio.

                                   
December 31, 2005

Real Estate Commercial
Construction Mortgage


Amount % Amount %




(dollar amounts in millions)
Michigan
  $ 1,291       37 %   $ 5,184       59 %
California
    1,389       40       1,782       20  
Texas
    572       16       736       8  
Florida
    100       3       279       3  
Other
    130       4       886       10  
   
   
   
   
 
 
Total
  $ 3,482       100 %   $ 8,867       100 %
   
   
   
   
 

Market Risk

      Market risk represents the risk of loss due to adverse movements in market rates or prices, which include interest rates, foreign exchange rates, and equity prices; the failure to meet financial obligations coming due because of an inability to liquidate assets or obtain adequate funding; and the inability to easily unwind or offset specific exposures without significantly lowering prices because of inadequate market depth or market disruptions.

      The Asset and Liability Policy Committee (ALPC) establishes and monitors compliance with the policies and risk limits pertaining to market risk management activities. The ALPC meets regularly to discuss and review market risk management strategies and is comprised of executive and senior management from various areas of the Corporation, including finance, lending, deposit gathering and risk management.

     Interest Rate Risk

      Net interest income is the predominant source of revenue for the Corporation. Interest rate risk arises primarily through the Corporation’s core business activities of extending loans and accepting deposits. The Corporation actively manages its exposure to interest rate risk. The principal objective of interest rate risk management is to maximize net interest income while operating within acceptable limits established for interest rate risk and maintaining adequate levels of funding and liquidity. The Corporation utilizes various types of financial instruments to manage the extent to which net interest income may be affected by fluctuations in interest rates.

48


 

     Interest Rate Sensitivity

      Interest rate risk arises in the normal course of business due to differences in the repricing and maturity characteristics of assets and liabilities. Since no single measurement system satisfies all management objectives, a combination of techniques is used to manage interest rate risk, including simulation analysis, economic value of equity and asset and liability repricing schedules.

      The Corporation frequently evaluates net interest income under various balance sheet and interest rate scenarios, using simulation analysis as its principal risk management technique. The results of these analyses provide the information needed to assess the balance sheet structure. Changes in economic activity, different from those management included in its simulation analyses, whether domestically or internationally, could translate into a materially different interest rate environment than currently expected. Management evaluates “base” net interest income under what is believed to be the most likely balance sheet structure and interest rate environment. The most likely interest rate environment is derived from management’s forecast for the next 12 months. This “base” net interest income is then evaluated against non-parallel interest rate scenarios that increase and decrease 200 basis points (but no lower than zero percent) from the most likely rate environment. Since movement is from the most likely rate environment, actual movement from the current rates may be more or less than 200 basis points. For this analysis, the rise or decline in interest rates occurs equally over four months. In addition, adjustments to asset prepayment levels, yield curves, and overall balance sheet mix and growth assumptions are made to be consistent with each interest rate environment. These assumptions are inherently uncertain and, as a result, the model cannot precisely predict the impact of higher or lower interest rates on net interest income. Actual results may differ from simulated results due to timing, magnitude and frequency of interest rate changes and changes in market conditions and management strategies, among other factors. However, the model can indicate the likely direction of change. Derivative instruments entered into for risk management purposes are included in these analyses. The table below as of December 31, 2005 and December 31, 2004 displays the estimated impact on net interest income during the next 12 months as it relates to the most likely scenario results from the 200 basis point non-parallel shock as described above.

 
Sensitivity of Net Interest Income to Changes in Interest Rates
                                   
December 31

2005 2004


Amount % Amount %




(in millions)
Change in Interest Rates:
                               
 
+200 basis points
  $ 84       4 %   $ 99       5 %
 
-200 basis points
    (51 )     (2 )     (74 )     (4 )

      Corporate policy limits adverse change to no more than five percent of management’s most likely net interest income forecast and the Corporation is operating within this policy guideline. The change in interest rate sensitivity from December 31, 2004 to December 31, 2005 was primarily a result of loan growth, activities in the Financial Services Division and active hedging. In addition, a variety of alternative scenarios are performed to assist in the portrayal of the corporation’s interest rate risk position, including, but not limited to, flat balance sheet and rates, 200 basis point parallel rate shocks and yield curve twists. Changes in interest rates will continue to impact the Corporation’s net interest income in 2006. This interest rate risk will be actively managed through the use of on- and off-balance sheet financial instruments so that the desired risk profile is achieved.

      In addition to the simulation analysis, an economic value of equity analysis and a traditional interest sensitivity gap analysis are performed as alternative measures of interest rate risk exposure. The economic value of equity analysis begins with an estimate of the mark-to-market valuation of the Corporation’s balance sheet and then applies the estimated market value impact of rate movements upon the assets and liabilities. The economic value of equity is then calculated as the residual necessary to re-balance the resulting assets and liabilities. The market value change in the economic value of equity is then compared to the corporate policy guideline limiting such adverse change to 10 percent of book equity as a result of a non-parallel 200-basis point increase or decrease in interest rates. The Corporation is operating within this policy parameter.

49


 

      The traditional interest sensitivity gap analysis provides a rudimentary directional outlook on the impact of changes in interest rates. Management recognizes the limited ability of a traditional gap schedule to accurately portray interest rate risk and therefore uses the results as a directional and corroborative tool.

      The Corporation uses investment securities and derivative instruments, predominantly interest rate swaps, as asset and liability management tools with the overall objective of mitigating the adverse impact to net interest income from changes in interest rates. These swaps primarily modify the interest rate characteristics of certain assets and liabilities (e.g., from a floating rate to a fixed rate, from a fixed rate to a floating rate or from one floating rate index to another). This strategy assists management in achieving interest rate risk management objectives.

Risk Management Derivative Instruments

     Risk Management Notional Activity

                         
Interest Foreign
Rate Exchange
Contracts Contracts Totals



(in millions)
Balance at January 1, 2004
  $ 10,818     $ 439     $ 11,257  
Additions
    4,781       15,136       19,917  
Maturities/amortizations
    (3,512 )     (15,141 )     (18,653 )
   
   
   
 
Balance at December 31, 2004
  $ 12,087     $ 434     $ 12,521  
Additions
    3,450       17,162       20,612  
Maturities/amortizations
    (4,082 )     (17,156 )     (21,238 )
   
   
   
 
Balance at December 31, 2005
  $ 11,455     $ 440     $ 11,895  
   
   
   
 

      The notional amount of risk management interest rate swaps totaled $11.5 billion at December 31, 2005, and $12.1 billion at December 31, 2004. The decrease in notional amount of $632 million from December 31, 2004 to December 31, 2005 reflects diminished interest rate risk in the core balance sheet when compared to the same period in 2004, as indicated in the rate shock simulation results on page 49, due to growth in the securities portfolio and changes in balance sheet mix. The fair value of risk management interest rate swaps was a net unrealized loss of $41 million at December 31, 2005, compared to a net unrealized gain of $159 million at December 31, 2004.

      For the year ended December 31, 2005, risk management interest rate swaps generated $57 million of net interest income, compared to $279 million of net interest income for the year ended December 31, 2004. The lower swap income for 2005 over 2004 was primarily due to the higher short-term rate environment in 2005, reducing spreads on swaps that receive a fixed rate and pay a floating rate.

      In 2003, the Corporation terminated interest rate swaps with a notional amount of $900 million that were designated as cash flow hedges. Of the pretax gain that was realized on the terminated swaps, $52 million was included in other comprehensive income and is being recognized in interest income through January 2006, the period during which the related hedged loans affect earnings. At December 31, 2005, $2 million of the pretax gain realized remains in other comprehensive income (loss).

      Table 11 on page 51 summarizes the expected maturity distribution of the notional amount of risk management interest rate swaps and provides the weighted average interest rates associated with amounts to be received or paid as of December 31, 2005. Swaps have been grouped by the asset and liability designation.

      In addition to interest rate swaps, the Corporation employs various other types of derivative instruments to mitigate exposures to interest rate and foreign currency risks associated with specific assets and liabilities (e.g., loans or deposits denominated in foreign currencies). Such instruments include interest rate caps and floors, purchased put options, foreign exchange forward contracts and foreign exchange swap agreements. The aggregate notional amounts of these risk management derivative instruments at December 31, 2005 and 2004 were $440 million and $434 million, respectively.

50


 

      Further information regarding risk management derivative instruments is provided in Notes 1, 10, and 19 to the consolidated financial statements on pages 67, 80 and 96, respectively.

TABLE 11: REMAINING EXPECTED MATURITY OF RISK MANAGEMENT INTEREST RATE SWAPS

                                                                     
Dec. 31, Dec. 31,
2011- 2005 2004
2006 2007 2008 2009 2010 2026 Total Total








(dollar amounts in millions)
Variable rate asset designation:
                                                               
 
Generic receive fixed swaps
  $ 3,000     $ 3,000     $ 3,200     $     $     $     $ 9,200     $ 9,800  
 
Weighted average:(1)
                                                               
   
Receive rate
    4.01 %     4.97 %     7.02 %     %     %     %     5.37 %     5.12 %
   
Pay rate
    5.67       6.04       7.12                         6.30       4.37  
Fixed rate asset designation:
                                                               
 
Pay fixed swaps
                                                               
   
Amortizing
  $ 2     $ 2     $ 1     $     $     $     $ 5     $ 7  
 
Weighted average:(2)
                                                               
   
Receive rate
    3.28 %     3.27 %     3.26 %     %     %     %     3.27 %     2.55 %
   
Pay rate
    3.54       3.53       3.52                         3.53       3.53  
Fixed rate deposit designation:
                                                               
 
Generic receive fixed swaps
  $     $     $     $     $     $     $     $ 30  
 
Weighted average:(1)
                                                               
   
Receive rate
     — %     %     %     %     %     %     %     2.55 %
   
Pay rate
                                              2.44  
Medium- and long-term debt designation:
                                                               
 
Generic receive fixed swaps
  $ 100     $ 450     $ 350     $ 100     $     $ 1,250     $ 2,250     $ 2,250  
 
Weighted average:(1)
                                                               
   
Receive rate
    2.95 %     5.82 %     6.17 %     6.06 %     %     5.98 %     5.85 %     6.05 %
   
Pay rate
    4.41       4.34       4.18       4.05             4.41       4.34       2.30  
   
   
   
   
   
   
   
   
 
Total notional amount
  $ 3,102     $ 3,452     $ 3,551     $ 100     $     $ 1,250     $ 11,455     $ 12,087  
   
   
   
   
   
   
   
   
 


(1)  Variable rates paid on receive fixed swaps are based on prime and LIBOR (with various maturities) rates in effect at December 31, 2005.
 
(2)  Variable rates received are based on three-month and six-month LIBOR or one-month Canadian Dollar Offered Rates in effect at December 31, 2005.

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Customer-Initiated and Other Derivative Instruments

 
Customer-Initiated and Other Notional Activity
                                 
Interest Foreign Energy
Rate Exchange Derivative
Contracts Contracts Contracts Totals




(in millions)
Balance at January 1, 2004
  $ 2,302     $ 1,904     $     $ 4,206  
Additions
    828       94,286             95,114  
Maturities/amortizations
    (538 )     (92,869 )           (93,407 )
Terminations
    (216 )                 (216 )
   
   
   
   
 
Balance at December 31, 2004
  $ 2,376     $ 3,321     $     $ 5,697  
Additions
    2,300       114,783       979       118,062  
Maturities/amortizations
    (570 )     (112,484 )           (113,054 )
Terminations
    (302 )     (31 )           (333 )
   
   
   
   
 
Balance at December 31, 2005
  $ 3,804     $ 5,589     $ 979     $ 10,372  
   
   
   
   
 

      The Corporation writes and purchases interest rate caps and enters into foreign exchange contracts, interest rate swaps and energy derivative contracts to accommodate the needs of customers requesting such services. Customer-initiated and other notional activity represented 47 percent at December 31, 2005, and 31 percent at December 31, 2004, of total derivative instruments, including commitments to purchase and sell securities. Refer to Notes 1 and 19 of the consolidated financial statements on pages 67 and 96, respectively, for further information regarding customer-initiated and other derivative instruments.

     Liquidity Risk and Off-Balance Sheet Arrangements

      Liquidity is the ability to meet financial obligations through the maturity or sale of existing assets or the acquisition of additional funds. The Corporation has various financial obligations, including contractual obligations and commercial commitments, which may require future cash payments. The following contractual obligations table summarizes the Corporation’s noncancelable contractual obligations and future required minimum payments. Refer to Notes 6, 9 and 10 of the financial statements on pages 77, 79 and 80, respectively, for a further discussion of these contractual obligations.

 
Contractual Obligations
                                           
December 31, 2005

Minimum Payments Due by Period

Less than 1-3 3-5 More than
Total 1 Year Years Years 5 Years





(in millions)
Deposits without a stated maturity*
  $ 34,184     $ 34,184     $     $     $  
Certificates of deposit and other deposits with a stated maturity*
    8,247       5,445       2,442       279       81  
Short-term borrowings*
    302       302                    
Medium- and long-term debt*
    3,830       200       1,790       115       1,725  
Operating leases
    284       50       81       60       93  
Commitments to fund low income housing partnerships
    109       53       50       5       1  
Other long-term obligations
    223       31       23       12       157  
   
   
   
   
   
 
 
Total contractual obligations
  $ 47,179     $ 40,265     $ 4,386     $ 471     $ 2,057  
   
   
   
   
   
 


Deposits and borrowings exclude interest

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      The Corporation has other commercial commitments that impact liquidity. These commitments include commitments to purchase and sell earning assets, commitments to fund private equity and venture capital investments, unused commitments to extend credit, standby letters of credit and financial guarantees and commercial letters of credit. The following commercial commitments table summarizes the Corporation’s commercial commitments and expected expiration dates by period.

     Commercial Commitments

                                           
December 31, 2005

Expected Expiration Dates by Period

Less than 1-3 3-5 More than
Total 1 Year Years Years 5 Years





(in millions)
Commitments to purchase investment securities
  $ 6     $ 6     $     $     $  
Commitments to sell investment securities
    6       6                    
Commitments to fund private equity and venture capital investments
    40                   5       35  
Unused commitments to extend credit
    30,609       13,853       7,605       6,978       2,173  
Standby letters of credit and financial guarantees
    6,433       4,376       1,091       854       112  
Commercial letters of credit
    269       234       18       17        
   
   
   
   
   
 
 
Total commercial commitments
  $ 37,363     $ 18,475     $ 8,714     $ 7,854     $ 2,320  
   
   
   
   
   
 

      Since many of these commitments expire without being drawn upon, the total amount of these commercial commitments does not necessarily represent the future cash requirements of the Corporation. Refer to the “Other Market Risks” section below and Note 19 of the consolidated financial statements on page 96 for a further discussion of these commercial commitments.

      The Corporation also holds a significant interest in certain variable interest entities (VIE’s), in which it is not the primary beneficiary, and in accordance with FASB Interpretation No. 46(R), “Consolidation of Variable Interest Entities” (FIN 46(R)), does not consolidate. The Corporation defines a significant interest in a VIE as a subordinated interest that exposes it to a significant portion of the VIE’s expected losses or residual returns. In general, a VIE is an entity that either (1) has an insufficient amount of equity to carry out its principal activities without additional subordinated financial support, (2) has a group of equity owners that are unable to make significant decisions about its activities, or (3) has a group of equity owners that do not have the obligation to absorb losses or the right to receive returns generated by its operations. If any of these characteristics is present, the entity is subject to a variable interests consolidation model, and consolidation is based on variable interests, not on ownership of the entity’s outstanding voting stock. Variable interests are defined as contractual, ownership, or other monetary interests in an entity that change with fluctuations in the entity’s net asset value. According to FIN 46(R), a company must consolidate an entity depending on whether the entity is a voting rights entity or a VIE. Refer to the “principles of consolidation” section in Note 1 of the consolidated financial statements on page 67 for a summarization of this interpretation. Also refer to Note 21 of the consolidated financial statements on page 103 for a discussion of the Corporation’s involvement in VIEs, including those in which it holds a significant interest but for which it is not the primary beneficiary.

      Liquidity requirements are satisfied with various funding sources. First, the Corporation accesses the purchased funds market regularly to meet funding needs. Purchased funds at December 31, 2005, comprised of certificates of deposit of $100,000 and over that mature in less than one year, foreign office time deposits and short-term borrowings, approximated $3.5 billion, compared to $2.9 billion and $4.0 billion at December 31, 2004 and December 31, 2003, respectively. Second, two medium-term note programs, a $15 billion senior note program and a $2 billion European note program, allow the principal banking subsidiary to issue debt with maturities between one month and 30 years. At year-end 2005, unissued debt relating to the two medium-term note programs totaled $16.7 billion. A third source, if needed, would be liquid assets, including cash and due from banks, short-term investments and investment securities available-for-sale, which totaled $7.0 billion at December 31, 2005. Additionally, the Corporation also had available $14.9 billion from a collateralized borrowing account with the Federal Reserve Bank at December 31, 2005.

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      The parent company held $11 million of cash and cash equivalents and $264 million of short-term investments with a subsidiary bank at December 31, 2005. In addition, the parent company had available $250 million of borrowing capacity under an unused commercial paper facility at December 31, 2005. Refer to Note 9 of the consolidated financial statements on page 79 for further information on the unused commercial paper facility. Another source of liquidity for the parent company is dividends from its subsidiaries. As discussed in Note 18 to the consolidated financial statements on page 95, banking subsidiaries are subject to regulation and may be limited in their ability to pay dividends or transfer funds to the holding company. During 2006, the banking subsidiaries can pay dividends up to $240 million plus 2006 net profits without prior regulatory approval. One measure of current parent company liquidity is investment in subsidiaries as a percentage of shareholders’ equity. An amount over 100 percent represents the reliance on subsidiary dividends to repay liabilities. As of December 31, 2005, the ratio was 110 percent.

      The Corporation regularly evaluates its ability to meet funding needs in unanticipated, stress environments. In conjunction with the quarterly 200 basis point interest rate shock analyses, discussed in the “Interest Rate Sensitivity” section on page 49 of this financial review, liquidity ratios and potential funding availability are examined. Each quarter, the Corporation also evaluates its ability to meet liquidity needs under a series of broad events, distinguished in terms of duration and severity. The evaluation projects that sufficient sources of liquidity are available in each series of events.

     Other Market Risks

      The Corporation’s market risk related to trading instruments is not significant, as trading activities are limited. Certain components of the Corporation’s noninterest income, primarily fiduciary income and investment advisory revenue, are at risk to fluctuations in the market values of underlying assets, particularly equity securities. Other components of noninterest income, primarily brokerage fees, are at risk to changes in the level of market activity.

      The fair value of share-based compensation as of the date of grant is recognized as compensation expense on a straight-line basis over the vesting period. In 2005, the Corporation recognized total share-based compensation expense of $45 million. The fair value of restricted stock is based on the market price of the Corporation’s stock at the grant date. Using the number of restricted stock awards issued in 2005, each $5.00 per share increase in stock price would result in an increase in pretax expense of approximately $1 million, from the assumed base, over the awards’ vesting period. The fair value of stock options is estimated on the date of grant using an option valuation model that requires several inputs. The option valuation model is sensitive to the market price of the Corporation’s stock at the grant date, which affects the fair value estimates and, therefore, the amount of expense recorded on future grants. Using the number of stock options granted in 2005 and the Corporation’s stock price at December 31, 2005, each $5.00 per share increase in stock price would result in an increase in pretax expense of approximately $3 million, from the assumed base, over the options’ vesting period. Refer to Notes 1 and 14 of the consolidated financial statements on pages 67 and 85, respectively, for further discussion of the adoption of SFAS No. 123. The expense associated with subsidiary share-based compensation plans and minority-owned shares accounted for as liabilities is affected by changes in the fair value of that subsidiary. At the current level of minority-owned options, unvested restricted shares and owned shares, a 10 percent increase in the subsidiary’s fair value would increase expense by approximately $4 million. For further discussion of subsidiary share-based compensation awards classified as liabilities, see Note 27 to the consolidated financial statements on page 117.

     Indirect Private Equity and Venture Capital Investments

      At December 31, 2005, the Corporation had a $96 million portfolio of indirect (through funds) private equity and venture capital investments, and had commitments of $40 million to fund additional investments in future periods. The value of these investments is at risk to changes in equity markets, general economic conditions and a variety of other factors. The majority of these investments are not readily marketable, and are reported in other assets. The investments are individually reviewed for impairment on a quarterly basis, by comparing the carrying value to the estimated fair value. The Corporation bases estimates of fair value for the majority of its indirect private equity and venture capital investments on the percentage ownership in the fair value of the entire fund, as reported by the fund management. In general, the Corporation does not have the benefit of the same information regarding the fund’s underlying investments as does fund management. Therefore, after indication that fund management adheres to accepted, sound and recognized valuation

54


 

techniques, the Corporation generally utilizes the fair values assigned to the underlying portfolio investments by fund management. For those funds where fair value is not reported by fund management, the Corporation derives the fair value of the fund by estimating the fair value of each underlying investment in the fund. In addition to using qualitative information about each underlying investment, as provided by fund management, the Corporation gives consideration to information pertinent to the specific nature of the debt or equity investment, such as relevant market conditions, offering prices, operating results, financial conditions, exit strategy, and other qualitative information, as available. The lack of an independent source to validate fair value estimates is an inherent limitation in the valuation process. The amount by which the carrying value exceeds the fair value, that is determined to be other than temporary impairment, is charged to current earnings and the carrying value of the investment is written down accordingly. At December 31, 2005, the Corporation had automotive exposure of about $20 million in indirect equity exposure (approximately 24 percent of the indirect equity portfolio) and $1 million in indirect debt exposure (approximately three percent of the indirect debt portfolio). With the exception of a single fund investment, the automotive-related positions do not represent a majority of any one fund’s investments, and therefore, the exposure related to these positions is mitigated by the performance of other investment interests within the fund’s portfolio of companies. Income from unconsolidated indirect private equity and venture capital investments in 2005 was $26 million, which was partially offset by $18 million of write-downs recognized on such investments in 2005. No generic assumption is applied to all investments when evaluating for impairment. The uncertainty in the economy and equity markets may affect the values of the fund investments. The following table provides information on the Corporation’s indirect private equity and venture capital investments portfolio.
         
December 31, 2005

(dollar amounts
in millions)
Number of investments
    109  
Balance of investments
  $ 96  
Largest single investment
    22  
Commitments to fund additional investments
    40  

      The Corporation holds a portfolio of approximately 800 warrants for generally non-marketable equity securities. These warrants are primarily from high technology, non-public companies obtained as part of the loan origination process. The warrant portfolio is recorded at fair value, as discussed in Note 1 to the consolidated financial statements. Fair value was determined using a Black-Scholes valuation model, which has four inputs: risk free rate, term, volatility, and stock price. Key assumptions used in the valuation were as follows. The risk free rate was estimated using the US treasury rate, as of the valuation date, corresponding with the expected term of the warrant. The Corporation used an expected term of one half of the remaining contractual term of each warrant, which averages approximately seven years. Volatility was estimated using an index of comparable publicly traded companies, based on the Standard Industrial Classification codes. For a substantial majority of the subject companies, an index method was utilized to estimate the current value of the underlying company. Under the index method, the subject companies’ values were “rolled-forward” from the inception date through the valuation date based on the change in value of an underlying index of guideline public companies. For the remaining companies, where sufficient financial data exists, a market approach method was utilized. The value of all warrants ($30 million at December 31, 2005) is at risk to changes in equity markets, general economic conditions and a variety of other factors.

Operational Risk

      Operational risk represents the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events. The definition includes legal risk, which is the risk of loss resulting from failure to comply with laws and regulations as well as prudent ethical standards and contractual obligations. It also includes the exposure to litigation from all aspects of an institution’s activities. The definition does not include strategic or reputational risks. Although operational losses are experienced by all companies and are routinely incurred in business operations, the Corporation recognizes the need to identify and control operational losses, and seeks to limit their impact to a level deemed appropriate by management after considering the nature of the Corporation’s business and the environment in which it operates. Operational risk is mitigated through a system of internal controls that are designed to keep operating risks at appropriate levels. The Corporation’s operational risk program was enhanced in 2005 to include an updated framework for

55


 

evaluating the risk associated with external service providers. The Corporation has established an Operational Risk Management Committee to ensure appropriate risk management techniques and systems are maintained. The Corporation has developed a framework that includes a centralized operational risk management function and business/support unit risk coordinators responsible for managing operational risk specific to the respective business lines.

      In addition, the Corporation’s internal audit and financial staff monitors and assesses the overall effectiveness of the system of internal controls on an ongoing basis. Internal Audit reports the results of reviews on the controls and systems to management and the Audit Committee of the Board. The internal audit staff independently supports the Audit Committee oversight process. The Audit Committee serves as an independent extension of the Board.

Compliance Risk

      Compliance risk represents the risk of regulatory sanctions or financial loss the Corporation may suffer as a result of its failure to comply with regulations and standards of good practice. Activities which may expose the Corporation to compliance risk include, but are not limited to, those dealing with the prevention of money laundering, privacy and data protection, community reinvestment initiatives, fair lending challenges resulting from the Corporation’s expansion of its banking center network, and employment and tax matters.

      The Enterprise-Wide Compliance Committee, comprised of senior business unit managers as well as managers responsible for compliance, audit and overall risk, oversees compliance risk throughout the Corporation. This enterprise-wide approach provides a consistent view of compliance across the organization. The Enterprise-Wide Compliance Committee also ensures that appropriate actions are implemented in business units to mitigate risk to an acceptable level.

Business Risk

      Business risk represents the risk of loss due to impairment of reputation, failure to fully develop and execute business plans, failure to assess current and new opportunities in business, markets and products, and any other event not identified in the defined risk categories of credit, market and liquidity, operational or compliance risks. Mitigation of the various risk elements that represent business risk is achieved through initiatives to help the Corporation better understand and report on the various risks. Wherever quantifiable, the Corporation intends to use situational analysis and other testing techniques to appreciate the scope and extent of these risks.

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CRITICAL ACCOUNTING POLICIES

      The Corporation’s consolidated financial statements are prepared based on the application of accounting policies, the most significant of which are described on page 67 in Note 1 to the consolidated financial statements. These policies require numerous estimates and strategic or economic assumptions, which may prove inaccurate or subject to variations. Changes in underlying factors, assumptions or estimates could have a material impact on the Corporation’s future financial condition and results of operations. The most critical of these significant accounting policies are the policies for allowance for credit losses, pension plan accounting and goodwill. These policies are reviewed with the Audit Committee of the Board and are discussed more fully below.

Allowance for Credit Losses

      The allowance for credit losses (combined allowance for loan losses and allowance for credit losses on lending-related commitments) is calculated with the objective of maintaining a reserve sufficient to absorb estimated probable losses. Management’s determination of the adequacy of the allowance is based on periodic evaluations of the loan portfolio, lending-related commitments, and other relevant factors. However, this evaluation is inherently subjective as it requires an estimate of the loss content for each risk rating and for each impaired loan, an estimate of the amounts and timing of expected future cash flows, an estimate of the value of collateral, including the market value of thinly traded or nonmarketable equity securities, and an estimate of the probability of drawing on unfunded commitments.

Allowance For Loan Losses

      Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. Consistent with this definition, all nonaccrual and reduced-rate loans (with the exception of residential mortgage and consumer loans) are impaired. The fair value of impaired loans is estimated using one of several methods, including collateral value, market value of similar debt, enterprise value, liquidation value and discounted cash flows. The valuation is reviewed and updated on a quarterly basis. While the determination of fair value may involve estimates, each estimate is unique to the individual loan, and none is individually significant.

      The portion of the allowance allocated to the remaining loans is determined by applying projected loss ratios to loans in each risk category. Projected loss ratios incorporate factors, such as recent charge-off experience, current economic conditions and trends, and trends with respect to past due and nonaccrual amounts, and are supported by underlying analysis, including information on migration and loss given default studies from each of the three major domestic geographic markets, as well as mapping to bond tables. Since a loss ratio is applied to a large portfolio of loans, any variation between actual and assumed results could be significant. In addition, a portion of the allowance is allocated to these remaining loans based on industry specific and international risks inherent in certain portfolios, including portfolio exposures to automotive, retailers, contractors, technology-related, entertainment, air transportation and healthcare industries, Small Business Administration loans and Mexican risks.

      An unallocated allowance is also maintained to cover factors affecting the determination of probable losses inherent in the loan portfolio that are not necessarily captured by the application of projected loss ratios or identified industry specific and international risks. The unallocated allowance considers the imprecision in the risk rating system and the risk associated with new customer relationships.

      The principal assumption used in deriving the allowance for loan losses is the estimate of loss content for each risk rating. To illustrate, if recent loss experience dictated that the projected loss ratios would be changed by five percent (of the estimate) across all risk ratings, the allocated allowance as of December 31, 2005 would change by approximately $14 million.

Allowance for Credit Losses on Lending-Related Commitments

      Lending-related commitments for which it is probable that the commitment will be drawn (or sold) are reserved with the same projected loss rates as loans, or with specific reserves. In general, the probability of draw

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is considered certain once the credit becomes a watch list credit. Non-watch list credits have a lower probability of draw, to which standard loan loss rates are applied.

Automotive Industry Concentration

      A concentration in loans to the automotive industry could result in significant changes to the allowance for credit losses if assumptions underlying the expected losses differed from actual results. For example, a bankruptcy by a domestic automotive manufacturer could adversely affect the risk ratings of its suppliers, causing actual losses to differ from those expected. The allowance for loan losses included a component for automotive suppliers, which assumed that suppliers whose largest customer was a domestic manufacturer would be downgraded by one risk rating in the event of bankruptcy. If that component were to cover all suppliers to that manufacturer (not just those suppliers whose largest customer was that manufacturer), the allowance for loan losses would increase by about $14 million at December 31, 2005. In addition, the allowance for credit losses on lending-related commitments included reserves for losses on certain unfunded commitments to that same manufacturer. Each five percentage point fluctuation in the market price (used to determine expected loss) of those unfunded commitments would change the allowance for credit losses on lending-related commitments by about $5 million at December 31, 2005.

      For further discussion of the methodology used in the determination of the allowance for credit losses, refer to the discussion of “Provision and Allowance for Credit Losses” section in this financial review on page 28, and Note 1 to the consolidated financial statements on page 67. To the extent actual outcomes differ from management estimates, additional provision for credit losses may be required that would adversely impact earnings in future periods. A substantial majority of the allocated allowance is assigned to business segments. Any earnings impact resulting from actual outcomes differing from management estimates would primarily affect the Business Bank segment. The industry specific and international allowance, and unallocated allowance for loan losses are not assigned to business segments, and any earnings impact resulting from actual outcomes differing from management estimates would primarily affect the “Other” category in segment reporting.

Pension Plan Accounting

      The Corporation has defined benefit plans in effect for substantially all full-time employees. Benefits under the plans are based on years of service, age and compensation. Assumptions are made concerning future events that will determine the amount and timing of required benefit payments, funding requirements and pension expense (income). The three major assumptions are the discount rate used in determining the current benefit obligation, the long-term rate of return expected on plan assets and the rate of compensation increase. The assumed discount rate is based on quoted rates for the Moody’s Investors Service Aa Corporate Bond Index in December, the last month prior to the year of recording the expense. The Corporation utilizes the Aa Corporate Bond Index from Moody’s Investors Service as this rate approximates the aggregation of rates on bonds matching the plans’ expected cash flows. The second assumption, long-term rate of return expected on plan assets, is set after considering both long-term returns in the general market and long-term returns experienced by the assets in the plan. The current asset allocation and target asset allocation model for the plans is detailed in Note 15 on page 88. The expected returns on these various asset categories are blended to derive one long-term return assumption. The assets are invested in certain collective investment funds and mutual investment funds administered by Munder Capital Management, equity securities, U.S. Treasury and other Government agency securities, Government-sponsored enterprise securities, corporate bonds and notes and a real estate investment trust. The third assumption, rate of compensation increase, is based on reviewing recent annual pension-eligible compensation increases as well as the expectation of future increases. The Corporation reviews its pension plan assumptions on an annual basis with its actuarial consultants to determine if the assumptions are reasonable and adjusts the assumptions to reflect changes in future expectations.

      The key actuarial assumptions that will be used to calculate 2006 expense for the defined benefit pension plans are a discount rate of 5.50 percent, a long-term rate of return on assets of 8.25 percent, and a rate of compensation increase of 4.00 percent. Pension expense in 2006 is expected to be approximately $50 million, an increase of $19 million from the $31 million recorded in 2005, primarily due to changes in the discount rate, the normal retirement age, plan demographics and progression, and updated mortality tables.

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      Changing the 2006 key actuarial assumptions discussed above in 25 basis point increments would have the following impact on pension expense in 2006:

                 
25 Basis Point

Increase Decrease
Key Actuarial Assumption:

(in millions)
Discount rate
  $ (6.4 )   $ 6.4  
Long-term rate of return
    (2.7 )     2.7  
Rate of compensation
    2.8       (2.8 )

      If the assumed long-term return on assets differs from the actual return on assets, the asset gains and losses are incorporated in the market-related value, which is used to determine the expected return on assets, over a five-year period. The Employee Benefits Committee, which is comprised of executive and senior managers from various areas of the Corporation, provides broad asset allocation guidelines to the asset manager, who reports results and investment strategy quarterly to the Committee. Actual asset allocations are compared to target allocations by asset category and investment returns for each class of investment are compared to expected results based on broad market indices.

      Note 15 on page 88 to the consolidated financial statements contains a table showing the funded status of the qualified defined benefit plan at year-end which was $27 million at December 31, 2005. Due to the long-term nature of pension plan assumptions, actual results may differ significantly from the actuarial-based estimates. Differences between estimates and experience are required to be deferred and amortized to pension expense in future years. As the table illustrates, the actuarial loss in the qualified defined benefit plan at December 31, 2005 increased to $349 million, compared to an actuarial loss of $295 million at December 31, 2004. Unless recovered in the market or by future assumption changes, this loss will be amortized to pension expense in future years. For further information, refer to Note 1 to the consolidated financial statements on page 67. In 2005, the actual return on plan assets was $66 million, compared to a return on plan assets of $112 million in 2004. The Corporation contributed $58 million and $62 million, in 2005 and 2004, respectively, to the qualified defined benefit plan to mitigate the impact of these actuarial losses on future years. Additional contributions, to the extent allowable by law, may be made to further mitigate these losses. For the foreseeable future, the Corporation has sufficient liquidity to make such payments.

      Pension expense is recorded in “employee benefits” expense on the consolidated statements of income, and is allocated to segments based on the segment’s share of salaries expense. Given the salaries expense included in 2005 segment results, pension expense was allocated approximately 36 percent, 35 percent, 24 percent and 5 percent to the Small Business & Personal Financial Services, Business Bank, Wealth & Institutional Management and Finance segments, respectively, in 2005.

      A minimum pension liability is required to be recorded in shareholders’ equity as part of accumulated other comprehensive income (loss) for pension plans where the accrued benefit cost is less than the accumulated benefit obligation. An after-tax minimum pension liability of $3 million and $13 million, primarily for the non-qualified defined benefit pension plan, was included in shareholders’ equity as part of accumulated other comprehensive income (loss) at December 31, 2005 and 2004, respectively.

Goodwill

      Goodwill arising from business acquisitions represents the value attributable to unidentifiable intangible elements in the business acquired. The fair value of goodwill is dependent upon many factors, including the Corporation’s ability to provide quality, cost effective services in the face of competition from other market leaders on a national and global basis. A decline in earnings as a result of business or market conditions, a lack of growth or the Corporation’s inability to deliver cost effective services over sustained periods can lead to impairment of goodwill which could adversely impact earnings in future periods.

      The majority of the Corporation’s goodwill relates to the acquisition premiums recorded when purchasing asset management and banking businesses. Goodwill is reviewed periodically for impairment by comparing the fair value of the reporting unit containing the goodwill to the book value of the reporting unit, including goodwill. If the book value is in excess of the fair value, impairment is indicated and the goodwill must be written down to its fair value.

59


 

      The fair value of reporting units is derived through use of internal valuation models for all units except the asset management reporting unit, which is part of the Wealth & Institutional Management segment. Inherent in these internal valuation models are assumptions related to the cash flows expected to be generated by reporting units, which are based on historical and projected growth expectations for reporting units, and on comparable market multiples. Cash flows are discounted using a risk-free rate plus a spread that incorporates long-term equity risk. The valuation for the Corporation’s asset management reporting unit (Munder) is based on an independent valuation prepared by an investment banker not affiliated with the Corporation. The annual test of goodwill and identified intangible assets that have an indefinite useful life, performed as of July 1, 2005, in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets” (SFAS No. 142), did not indicate that an impairment charge was required. In the fourth quarter 2005, Munder sold its interest in Framlington Group Limited, an indirectly owned unconsolidated subsidiary. Goodwill of $34 million was allocated to the sale in accordance with SFAS No. 142. Following the sale, the goodwill that remained on Munder was tested for impairment. The test did not indicate that an impairment charge was required. For a further discussion of the Corporation’s goodwill, refer to Note 7 to the consolidated financial statements on page 78.

      The valuation model for Munder includes, among others, estimates of a discount rate, market growth and new business growth assumptions. The following describes the estimated sensitivities to these assumptions, based on the most recent independent valuation.

      The discount rate assumption used in the valuation model was 13 percent. Increasing the discount rate by 200 basis points would result in a decrease in the valuation of approximately $15 million at the midpoint of the valuation range. The market growth rate assumptions used were approximately 7 percent for equity, 3 percent for fixed and 4 percent for cash investments. Decreasing the market growth rates by 50 percent would result in a decrease in the valuation of approximately $21 million at the midpoint of the valuation range. The new business growth assumption used was approximately 5 percent (compound annual growth rate) and the redemption (business attrition) rate used was approximately 3 percent. Decreasing the new business growth assumption and increasing the redemption rate by 10 percent would result in a combined decrease in the valuation of approximately $13 million.

      In addition, the valuation model uses a market valuation for comparable companies (market multiples). While the market multiple is not an assumption, a presumption that it provides an indicator of the value of Munder is inherent in the valuation.

      The fair value estimate is updated whenever there are indicators of impairment. At December 31, 2005, management estimates that it would take a decline in the fair value of Munder of $206 million to trigger impairment.

60


 

FORWARD-LOOKING STATEMENTS

      This report includes forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. In addition, the Corporation may make other written and oral communication from time to time that contain such statements. All statements regarding the Corporation’s expected financial position, strategies and growth prospects and general economic conditions expected to exist in the future are forward-looking statements. The words, “anticipates,” “believes,” “feels,” “expects,” “estimates,” “seeks,” “strives,” “plans,” “intends,” “outlook,” “forecast,” “position,” “target,” “mission,” “assume,” “achievable,” “potential,” “strategy,” “goal,” “aspiration,” “outcome,” “continue,” “remain,” “maintain,” “trend,” “objective,” and variations of such words and similar expressions, or future or conditional verbs such as “will,” “would,” “should,” “could,” “might,” “can,” “may” or similar expressions as they relate to the Corporation or its management, are intended to identify forward-looking statements.

      The Corporation cautions that forward-looking statements are subject to numerous assumptions, risks and uncertainties, which change over time. Forward-looking statements speak only as of the date the statement is made, and the Corporation does not undertake to update forward-looking statements to reflect facts, circumstances, assumptions or events that occur after the date the forward-looking statements are made. Actual results could differ materially from those anticipated in forward-looking statements and future results could differ materially from historical performance.

      In addition to factors mentioned elsewhere in this report or previously disclosed in the Corporation’s SEC reports (accessible on the SEC’s website at www.sec.gov or on the Corporation’s website at www.comerica.com), the following factors, among others, could cause actual results to differ materially from forward-looking statements and future results could differ materially from historical performance. The Corporation cautions that these factors are not exclusive.

  •  general political, economic or industry conditions, either domestically or internationally, may be less favorable than expected;
 
  •  developments concerning credit quality in various industry sectors may result in an increase in the level of the Corporation’s provision for credit losses, nonperforming assets, net charge-offs and reserve for credit losses;
 
  •  industries in which the Corporation has lending concentrations, including, but not limited to, automotive production, could suffer a significant decline which could adversely affect the Corporation;
 
  •  demand for commercial loans and investment advisory products may not increase as expected;
 
  •  the mix of interest rates and maturities of the Corporation’s interest earning assets and interest-bearing liabilities (primarily loans and deposits) may be less favorable than expected;
 
  •  interest rate margin changes may be different than expected;
 
  •  there could be fluctuations in inflation or interest rates;
 
  •  there could be changes in trade, monetary and fiscal policies, including, but not limited to, the interest rate policies of the Board of Governors of the Federal Reserve System;
 
  •  customer borrowing, repayment, investment and deposit practices generally may be different than anticipated;
 
  •  management’s ability to maintain and expand customer relationships may differ from expectations;
 
  •  management’s ability to retain key officers and employees may change;
 
  •  the introductions, withdrawal, success and timing of business initiatives and strategies, including, but not limited to the opening of new banking centers, and plans to grow personal financial services and wealth management, may be less successful or may be different than anticipated;
 
  •  competitive product and pricing pressures among financial institutions within the Corporation’s markets may change;

61


 

  •  legal and regulatory proceedings and related matters with respect to the financial services industry, including those directly involving the Corporation and its subsidiaries, could adversely affect the Corporation or the financial services industry in general;
 
  •  instruments, systems and strategies used to hedge or otherwise manage exposure to various types of credit, market and liquidity, operational, compliance and business risks and enterprise-wide risk could be less effective than anticipated, and the Corporation may not be able to effectively mitigate its risk exposures in particular market environments or against particular types of risk;
 
  •  there could be terrorist activities or other hostilities, which may adversely affect the general economy, financial and capital markets, specific industries, and the Corporation;
 
  •  there could be natural disasters, including, but not limited to, hurricanes, tornadoes, earthquakes and floods, which may adversely affect the general economy, financial and capital markets, specific industries, and the Corporation;
 
  •  there could be changes in applicable laws and regulations, including, but not limited to, those concerning taxes, banking, securities, and insurance; and
 
  •  there could be adverse conditions in the stock market.

62


 

CONSOLIDATED BALANCE SHEETS

Comerica Incorporated and Subsidiaries

                     
December 31

2005 2004


(in millions, except
share data)
ASSETS
               
Cash and due from banks
  $ 1,609     $ 1,139  
Short-term investments
    1,159       3,230  
Investment securities available-for-sale
    4,240       3,943  
 
Commercial loans
    23,545       22,039  
Real estate construction loans
    3,482       3,053  
Commercial mortgage loans
    8,867       8,236  
Residential mortgage loans
    1,485       1,294  
Consumer loans
    2,697       2,751  
Lease financing
    1,295       1,265  
International loans
    1,876       2,205  
   
   
 
   
Total loans
    43,247       40,843  
Less allowance for loan losses
    (516 )     (673 )
   
   
 
   
Net loans
    42,731       40,170  
Premises and equipment
    510       415  
Customers’ liability on acceptances outstanding
    59       57  
Accrued income and other assets
    2,705       2,812  
   
   
 
   
Total assets
  $ 53,013     $ 51,766  
   
   
 
 
LIABILITIES AND SHAREHOLDERS’ EQUITY
               
Noninterest-bearing deposits
  $ 15,666     $ 15,164  
Interest-bearing deposits
    26,765       25,772  
   
   
 
   
Total deposits
    42,431       40,936  
Short-term borrowings
    302       193  
Acceptances outstanding
    59       57  
Accrued expenses and other liabilities
    1,192       1,189  
Medium- and long-term debt
    3,961       4,286  
   
   
 
   
Total liabilities
    47,945       46,661  
Common stock — $5 par value:
               
 
Authorized — 325,000,000 shares
               
 
Issued — 178,735,252 shares at 12/31/05 and 12/31/04
    894       894  
Capital surplus
    461       421  
Accumulated other comprehensive loss
    (170 )     (69 )
Retained earnings
    4,796       4,331  
Less cost of common stock in treasury — 15,834,985 shares at 12/31/05 and 8,259,328 shares at 12/31/04
    (913 )     (472 )
   
   
 
   
Total shareholders’ equity
    5,068       5,105  
   
   
 
   
Total liabilities and shareholders’ equity
  $ 53,013     $ 51,766  
   
   
 

See notes to consolidated financial statements.

63


 

CONSOLIDATED STATEMENTS OF INCOME

Comerica Incorporated and Subsidiaries

                           
Years Ended December 31

2005 2004 2003



(in millions, except per share data)
INTEREST INCOME
                       
Interest and fees on loans
  $ 2,554     $ 2,054     $ 2,211  
Interest on investment securities
    148       147       165  
Interest on short-term investments
    24       36       36  
   
   
   
 
 
Total interest income
    2,726       2,237       2,412  
INTEREST EXPENSE
                       
Interest on deposits
    548       315       370  
Interest on short-term borrowings
    52       4       7  
Interest on medium- and long-term debt
    170       108       109  
   
   
   
 
 
Total interest expense
    770       427       486  
   
   
   
 
 
Net interest income
    1,956       1,810       1,926  
Provision for loan losses
    (47 )     64       377  
   
   
   
 
 
Net interest income after provision for loan losses
    2,003       1,746       1,549  
NONINTEREST INCOME
                       
Service charges on deposit accounts
    218       231       238  
Fiduciary income
    177       171       169  
Commercial lending fees
    63       55       63  
Letter of credit fees
    70       66       65  
Foreign exchange income
    37       37       36  
Brokerage fees
    36       36       34  
Investment advisory revenue, net
    51       35       30  
Card fees
    39       32       27  
Bank-owned life insurance
    38       34       42  
Equity in earnings of unconsolidated subsidiaries
    16       12       6  
Warrant income
    9       7       4  
Net securities gains
                50  
Net gain on sales of businesses
    56       7        
Other noninterest income
    132       134       123  
   
   
   
 
 
Total noninterest income
    942       857       887  
NONINTEREST EXPENSES
                       
Salaries
    820       760       736  
Employee benefits
    184       159       161  
   
   
   
 
 
Total salaries and employee benefits
    1,004       919       897  
Net occupancy expense
    121       125       128  
Equipment expense
    56       58       61  
Outside processing fee expense
    78       68       71  
Software expense
    49       43       37  
Customer services
    69       23       25  
Litigation and operational losses
    18       24       18  
Provision for credit losses on lending-related commitments
    18       (12 )     (2 )
Other noninterest expenses
    253       245       248  
   
   
   
 
 
Total noninterest expenses
    1,666       1,493       1,483  
   
   
   
 
Income before income taxes
    1,279       1,110       953  
Provision for income taxes
    418       353       292  
   
   
   
 
NET INCOME
  $ 861     $ 757     $ 661  
   
   
   
 
Basic net income per common share
  $ 5.17     $ 4.41     $ 3.78  
Diluted net income per common share
    5.11       4.36       3.75  
Cash dividends declared on common stock
    367       356       350  
Cash dividends declared per common share
    2.20       2.08       2.00  

See notes to consolidated financial statements.

64


 

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

Comerica Incorporated and Subsidiaries

                                                         
Accumulated
Common Stock Other Total

Capital Comprehensive Retained Treasury Shareholders’
In Shares Amount Surplus Income (Loss) Earnings Stock Equity







(in millions, except per share data)
BALANCE AT JANUARY 1, 2003
    174.8     $ 894     $ 363     $ 237     $ 3,684     $ (231 )   $ 4,947  
Net income
                            661             661  
Other comprehensive loss, net of tax
                      (163 )                 (163 )
                                       
 
Total comprehensive income
                                                    498  
Cash dividends declared on common stock ($2.00 per share)
                            (350 )           (350 )
Purchase of common stock
    (0.5 )                             (27 )     (27 )
Net issuance of common stock under employee stock plans
    0.7             (5 )           (22 )     43       16  
Recognition of stock-based compensation expense
                26                         26  
   
   
   
   
   
   
   
 
BALANCE AT DECEMBER 31, 2003
    175.0     $ 894     $ 384     $ 74     $ 3,973     $ (215 )   $ 5,110  
Net income
                            757             757  
Other comprehensive loss, net of tax
                      (143 )                 (143 )
                                       
 
Total comprehensive income
                                                    614  
Cash dividends declared on common stock ($2.08 per share)
                            (356 )           (356 )
Purchase of common stock
    (6.5 )                             (370 )     (370 )
Net issuance of common stock under employee stock plans
    2.0             2             (43 )