Note 7 - Earnings Per Share
The following table shows a reconciliation of earnings per common share to diluted earnings per common share:
| | | Three Months Ended | | | Six Months Ended | |
| | | June 30 | | | June 30 | |
| (In thousands, except per share data) | | 2008 | | | 2007 | | | 2008 | | | 2007 | |
| Net (loss)/income from continuing operations | | $ | (19,081 | ) | | $ | 21,944 | | | $ | (12,044 | ) | | $ | 92,251 | |
| Income from discontinued operations, net of tax | | | - | | | | 179 | | | | 883 | | | | 419 | |
| Net (loss)/income | | $ | (19,081 | ) | | $ | 22,123 | | | $ | (11,161 | ) | | $ | 92,670 | |
| | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | |
| Weighted average common shares | | | 171,680 | | | | 125,873 | | | | 148,898 | | | | 125,609 | |
| Effect of dilutive securities | | | - | | | | 2,864 | | | | - | | | | 3,111 | |
| Diluted average common shares | | | 171,680 | | | | 128,737 | | | | 148,898 | | | | 128,720 | |
| | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | |
| Earnings/(loss) per common share | | | | | | | | | | | | | | | | |
| Net (loss)/income from continuing operations | | $ | (.11 | ) | | $ | .18 | | | $ | (.08 | ) | | $ | .74 | |
| Income from discontinued operations, net of tax | | | - | | | | - | | | | .01 | | | | - | |
| Earnings/(loss) per common share | | $ | (.11 | ) | | $ | .18 | | | $ | (.07 | ) | | $ | .74 | |
| | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | |
| Diluted earnings/(loss) per common share | | | | | | | | | | | | | | | | |
| Net (loss)/income from continuing operations | | $ | (.11 | ) | | $ | .17 | | | $ | (.08 | ) | | $ | .72 | |
| Income from discontinued operations, net of tax | | | - | | | | - | | | | .01 | | | | - | |
| Diluted earnings/(loss) per common share | | $ | (.11 | ) | | $ | .17 | | | $ | (.07 | ) | | $ | .72 | |
Equity awards of 16,797 and 7,850 with weighted average exercise prices of $33.67 and $42.62 per share for the three months ended June 30, 2008 and 2007, respectively, and of 8,175 and 5,843 with weighted average exercise prices of $34.67 and $42.46 per share for the six months ended June 30, 2008 and 2007, respectively, were not included in the computation of diluted earnings per common share because such shares would have had an antidilutive effect on earnings per common share.
Note 8 - Contingencies and Other Disclosures
Contingencies. Contingent liabilities arise in the ordinary course of business, including those related to litigation. Various claims and lawsuits are pending against FHN and its subsidiaries. Although FHN cannot predict the outcome of these lawsuits, after consulting with counsel, management is of the opinion that when resolved, these lawsuits will not have a material adverse effect on the consolidated financial statements of FHN.
In November 2000, a complaint was filed in state court in Jackson County, Missouri against FHN’s subsidiary, First Horizon Home Loans. The case generally concerned the charging of certain loan origination fees, including fees permitted by Kansas and federal law but allegedly restricted or not permitted by Missouri law, when First Horizon Home Loans or its predecessor, McGuire Mortgage Company, made certain second-lien mortgage loans. Among other relief, plaintiffs sought a refund of fees, a repayment and forgiveness of loan interest, prejudgment interest, punitive damages, loan rescission, and attorneys’ fees. As a result of mediation, FHN entered into a final settlement agreement related to the McGuire lawsuit. The settlement has received final approval by the court, the court has entered its order making the settlement final, there have been no appeals, and the time for any appeals has expired. In connection with this settlement, FHN agreed to pay, under agreed circumstances using an agreed methodology, an aggregate of up to approximately $36 million. The period during which claims under the settlement can be made ended in 2007. Claims have been evaluated and objections made pursuant to the agreed upon challenge process. The challenge process has not yet concluded. Unchallenged claims have been paid, and as claims are paid, the reserve is reduced. At June 30, 2008, claims paid have totaled approximately $27 million and the total reserve remaining for this matter, based on the claims received and FHN’s evaluation of them to date, is approximately $3.7 million.
The loss reserve for this matter reflects an estimate of the amount that ultimately would be paid under the settlement. The amount reserved reflects the amount and value of claims actually received by the claims deadline plus fees and expenses that the settlement requires FHN to pay, all of which together are less than the maximum amount possible under the settlement. The ultimate amount paid under the settlement agreement is not expected to be higher than the amount reserved at present, and may be lower in the event some of the claims are reduced or rejected for reasons set forth in the settlement, and in any event cannot exceed the settlement amount.
Other disclosures – Indemnification agreements and guarantees. In the ordinary course of business, FHN enters into indemnification agreements for legal proceedings against its directors and officers and standard representations and warranties for underwriting agreements, merger and acquisition agreements, loan sales, contractual commitments, and various other business transactions or arrangements. The extent of FHN’s obligations under these agreements depends upon the occurrence of future events; therefore, it is not possible to estimate a maximum potential amount of payouts that could be required with such agreements.
FHN is a member of the Visa USA network. On October 3, 2007, the Visa organization of affiliated entities completed a series of global restructuring transactions to combine its affiliated operating companies, including Visa USA, under a single holding company, Visa Inc. (“Visa”). Upon completion of the reorganization, the members of the Visa USA network remained contingently liable for certain Visa litigation matters. Based on its proportionate membership share of Visa USA, FHN recognized a contingent liability of $55.7 million within noninterest expense in fourth quarter 2007 related to this contingent obligation.
In March 2008, Visa completed its initial public offering (IPO). Visa funded an escrow account from IPO proceeds that will be used to make payments related to the Visa litigation matters. Upon funding of the escrow, FHN reversed $30.0 million of the contingent liability previously recognized with a corresponding credit to noninterest expense for its proportionate share of the escrow account. A portion of FHN’s Class B shares of Visa were redeemed as part of the IPO resulting in $65.9 million of equity securities gains in first quarter 2008.
After the partial share redemption in conjunction with the IPO, FHN holds approximately 2.4 million Class B shares of Visa, which are included in the Consolidated Condensed Statement of Condition at their historical cost of $0. Transfer of these shares is restricted for a minimum of three years with the shares ultimately being converted into Class A shares of Visa. The final conversion ratio, which is presently estimated to approximate 70 percent, will fluctuate based on the ultimate settlement of the Visa litigation matters for which FHN has a proportionate contingent obligation.
First Horizon Home Loans, a division of First Tennessee Bank National Association, services a mortgage loan portfolio of $102.7 billion on June 30, 2008, a significant portion of which is held by GNMA, FNMA, FHLMC or private security holders. In connection with its servicing activities, First Horizon Home Loans guarantees the receipt of the scheduled principal and interest payments on the underlying loans. In the event of customer non-performance on the loan, First Horizon Home Loans is obligated to make the payment to the security holder. Under the terms of the servicing agreements, First Horizon Home Loans can utilize payments received from other prepaid loans in order to make the security holder whole.
Note 8 - Contingencies and Other Disclosures (continued)
In the event payments are ultimately made by First Horizon Home Loans to satisfy this obligation, for loans sold with no recourse, all funds are recoverable from the government agency at foreclosure sale.
First Horizon Home Loans is also subject to losses in its loan servicing portfolio due to loan foreclosures and other recourse obligations. Certain agencies have the authority to limit their repayment guarantees on foreclosed loans resulting in certain foreclosure costs being borne by servicers. In addition, First Horizon Home Loans has exposure on all loans sold with recourse. First Horizon Home Loans has various claims for reimbursement, repurchase obligations, and/or indemnification requests outstanding with government agencies or private investors. First Horizon Home Loans has evaluated all of its exposure under recourse obligations based on factors, which include loan delinquency status, foreclosure expectancy rates and claims outstanding. Accordingly, First Horizon Home Loans had an allowance for losses on the mortgage servicing portfolio of $38.5 million and $14.6 million on June 30, 2008 and 2007, respectively. First Horizon Home Loans has sold certain mortgage loans with an agreement to repurchase the loans upon default. For the single-family residential loans, in the event of borrower nonperformance, First Horizon Home Loans would assume losses to the extent they exceed the value of the collateral and private mortgage insurance, FHA insurance or VA guarantees. On June 30, 2008 and 2007, First Horizon Home Loans had single-family residential loans with outstanding balances of $92.4 million and $110.5 million, respectively, that were serviced on a full recourse basis. On June 30, 2008 and 2007, the outstanding principal balance of loans sold with limited recourse arrangements where some portion of the principal is at risk and serviced by First Horizon Home Loans was $3.6 billion and $3.2 billion, respectively. Additionally, on June 30, 2008 and 2007, $1.8 billion and $4.8 billion, respectively, of mortgage loans were outstanding which were sold under limited recourse arrangements where the risk is limited to interest and servicing advances.
FHN has securitized and sold HELOC and second-lien mortgages which are held by private security holders, and on June 30, 2008, the outstanding principal balance of these loans was $231.3 million and $61.4 million, respectively. On June 30, 2007, the outstanding principal balance of securitized and sold HELOC and second-lien mortgages was $303.1 million and $82.5 million, respectively. In connection with its servicing activities, FTBNA does not guarantee the receipt of the scheduled principal and interest payments on the underlying loans but does have residual interests of $7.8 million and $33.7 million on June 30, 2008 and 2007, respectively, which are available to make the security holder whole in the event of credit losses. FHN has projected expected credit losses in the valuation of the residual interest.
Note 9 – Pension and Other Employee Benefits
Pension plan. FHN provides pension benefits to employees retiring under the provisions of a noncontributory, defined benefit pension plan. Employees of FHN’s mortgage division and certain insurance subsidiaries are not covered by the pension plan. Pension benefits are based on years of service, average compensation near retirement and estimated social security benefits at age 65. The annual funding is based on an actuarially determined amount using the entry age cost method. The Pension Plan was closed to new participants on September 1, 2007.
FHN also maintains nonqualified pension plans for certain employees. These plans are intended to provide supplemental retirement income to the participants including situations where benefits under the pension plan have been limited under the tax code. All benefits provided under these plans are unfunded and payments to plan participants are made by FHN.
Other employee benefits. FHN provides postretirement medical insurance to full-time employees retiring under the provisions of the FHN Pension Plan. The postretirement medical plan is contributory with retiree contributions adjusted annually. The plan is based on criteria that are a combination of the employee’s age and years of service and utilizes a two-step approach. For any employee retiring on or after January 1, 1995, FHN contributes a fixed amount based on years of service and age at time of retirement. FHN’s postretirement benefits include prescription drug benefits. The Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the Act) introduced a prescription drug benefit under Medicare Part D as well as a federal subsidy to sponsors of retiree health care benefit plans that provide a benefit that is at least actuarially equivalent to Medicare Part D. FHN anticipates the plan to be actuarially equivalent through 2012.
Effective January 1, 2007, FHN adopted the final provisions of SFAS No. 158, which required that the annual measurement date of a plan’s assets and liabilities be as of the date of the financial statements. As a result of adopting the measurement provisions of SFAS No. 158, undivided profits were reduced by $2.1 million, net of tax, and accumulated other comprehensive income was credited by $8.3 million, net of tax.
The components of net periodic benefit cost for the three months ended June 30 are as follows:
| | | Pension Benefits | | | Postretirement Benefits | |
| (Dollars in thousands) | | 2008 | | | 2007 | | | 2008 | | | 2007 | |
| Components of net periodic benefit cost/(benefit) | | | | | | | | | | | | |
| Service cost | | $ | 4,206 | | | $ | 4,327 | | | $ | 71 | | | $ | 75 | |
| Interest cost | | | 7,345 | | | | 6,154 | | | | 610 | | | | 278 | |
| Expected return on plan assets | | | (11,792 | ) | | | (10,637 | ) | | | (439 | ) | | | (441 | ) |
| Amortization of prior service cost/(benefit) | | | 216 | | | | 220 | | | | (44 | ) | | | (44 | ) |
| Recognized losses/(gains) | | | 494 | | | | 1,810 | | | | (58 | ) | | | (178 | ) |
| Amortization of transition obligation | | | - | | | | - | | | | 247 | | | | 247 | |
| Net periodic cost/(benefit) | | $ | 469 | | | $ | 1,874 | | | $ | 387 | | | $ | (63 | ) |
| FAS 88 Settlement Expense | | $ | 715 | | | $ | - | | | $ | - | | | $ | - | |
| Total FAS 87 and FAS 88 Expense (Income) | | $ | 1,184 | | | $ | 1,874 | | | $ | 387 | | | $ | (63 | ) |
The components of net periodic benefit cost for the six months ended June 30 are as follows:
| | | Pension Benefits | | | Postretirement Benefits | |
| (Dollars in thousands) | | 2008 | | | 2007 | | | 2008 | | | 2007 | |
| Components of net periodic benefit cost/(benefit) | | | | | | | | | | | | |
| Service cost | | $ | 8,414 | | | $ | 8,654 | | | $ | 143 | | | $ | 150 | |
| Interest cost | | | 14,685 | | | | 12,308 | | | | 1,220 | | | | 556 | |
| Expected return on plan assets | | | (23,583 | ) | | | (21,274 | ) | | | (878 | ) | | | (882 | ) |
| Amortization of prior service cost/(benefit) | | | 433 | | | | 440 | | | | (88 | ) | | | (88 | ) |
| Recognized losses/(gains) | | | 987 | | | | 3,620 | | | | (116 | ) | | | (356 | ) |
| Amortization of transition obligation | | | - | | | | - | | | | 494 | | | | 494 | |
| Net periodic cost/(benefit) | | $ | 936 | | | $ | 3,748 | | | $ | 775 | | | $ | (126 | ) |
| FAS 88 Settlement Expense | | $ | 715 | | | $ | - | | | $ | - | | | $ | - | |
| Total FAS 87 and FAS 88 Expense (Income) | | $ | 1,651 | | | $ | 3,748 | | | $ | 775 | | | $ | (126 | ) |
In second quarter 2008, distributions from a non-qualified postretirement plan in conjunction with an early retirement triggered settlement accounting. In accordance with its practice, FHN performed a remeasurement of the plan in conjunction with the settlement and recognized $.7 million of settlement expense.
FHN expects to make no contributions to the pension plan or to the other employee benefit plans in 2008.
Note 10 – Business Segment Information
FHN has five business segments, Regional Banking, Capital Markets, National Specialty Lending, Mortgage Banking and Corporate. The Regional Banking segment offers financial products and services, including traditional lending and deposit taking, to retail and commercial customers in Tennessee and surrounding markets. Additionally, Regional Banking provides investments, insurance, financial planning, trust services and asset management, credit card, cash management, and check clearing services. The Capital Markets segment consists of traditional capital markets securities activities, structured finance, equity research, investment banking, loan sales, portfolio advisory, and correspondent banking. The National Specialty Lending segment consists of traditional consumer and construction lending activities in other national markets. The Mortgage Banking segment consists of core mortgage banking elements including originations and servicing and the associated ancillary revenues related to these businesses. The Corporate segment consists of restructuring, repositioning and efficiency initiatives, gains and losses on repurchases of debt, unallocated corporate expenses, expense on subordinated debt issuances and preferred stock, bank- owned life insurance, unallocated interest income associated with excess equity, net impact of raising incremental capital, revenue and expense associated with deferred compensation plans, funds management, and venture capital. Periodically, FHN adapts its segments to reflect changes in expense allocations among segments. Previously reported amounts have been reclassified to agree with current presentation.
In first quarter 2008, FHN revised its business line segments to better align with its strategic direction, representing a focus on its regional banking franchise and capital markets business. To implement this change, the prior Retail/Commercial Banking segment was split into its major components with the national portions of consumer lending and construction lending assigned to a new National Specialty Lending segment that more appropriately reflects the ongoing wind down of these businesses. Additionally, correspondent banking was shifted from Retail/Commercial Banking to the Capital Markets segment to better represent the complementary nature of these businesses. To reflect its geographic focus, the remaining portions of the Retail/Commercial Banking segment now represent the new Regional Banking segment. All prior period information has been revised to conform to the current segment structure.
Total revenue, expense and asset levels reflect those which are specifically identifiable or which are allocated based on an internal allocation method. Because the allocations are based on internally developed assignments and allocations, they are to an extent subjective. This assignment and allocation has been consistently applied for all periods presented. The following table reflects the amounts of consolidated revenue, expense, tax, and assets for each segment for the three and six months ended June 30:
| | | Three Months Ended | | | Six Months Ended | |
| | | June 30 | | | June 30 | |
| (Dollars in thousands) | | 2008 | | | 2007 | | | 2008 | | | 2007 | |
| Total Consolidated | | | | | | | | | | | | |
| Net interest income | | $ | 238,895 | | | $ | 239,432 | | | $ | 466,987 | | | $ | 476,851 | |
| Provision for loan losses | | | 220,000 | | | | 44,408 | | | | 460,000 | | | | 72,894 | |
| Noninterest income | | | 399,046 | | | | 280,299 | | | | 848,122 | | | | 563,487 | |
| Noninterest expense | | | 465,843 | | | | 457,240 | | | | 904,120 | | | | 860,252 | |
| Pre-tax (loss)/income | | | (47,902 | ) | | | 18,083 | | | | (49,011 | ) | | | 107,192 | |
| (Benefit)/provision for income taxes | | | (28,821 | ) | | | (3,861 | ) | | | (36,967 | ) | | | 14,941 | |
| (Loss)/income from continuing operations | | | (19,081 | ) | | | 21,944 | | | | (12,044 | ) | | | 92,251 | |
| Income from discontinued operations, net of tax | | | - | | | | 179 | | | | 883 | | | | 419 | |
| Net (loss)/income | | $ | (19,081 | ) | | $ | 22,123 | | | $ | (11,161 | ) | | $ | 92,670 | |
| Average assets | | $ | 36,146,101 | | | $ | 39,070,144 | | | $ | 36,654,243 | | | $ | 38,859,763 | |
| | | | | | | | | | | | | | | | | |
| Regional Banking | | | | | | | | | | | | | | | | |
| Net interest income | | $ | 120,384 | | | $ | 137,672 | | | $ | 240,949 | | | $ | 276,599 | |
| Provision for loan losses | | | 89,371 | | | | 14,071 | | | | 164,549 | | | | 28,275 | |
| Noninterest income | | | 92,536 | | | | 91,629 | | | | 179,607 | | | | 180,258 | |
| Noninterest expense | | | 150,294 | | | | 161,336 | | | | 300,817 | | | | 317,655 | |
| Pre-tax (loss)/income | | | (26,745 | ) | | | 53,894 | | | | (44,810 | ) | | | 110,927 | |
| (Benefit)/provision for income taxes | | | (19,799 | ) | | | 11,826 | | | | (33,307 | ) | | | 26,446 | |
| (Loss)/income from continuing operations | | | (6,946 | ) | | | 42,068 | | | | (11,503 | ) | | | 84,481 | |
| Income from discontinued operations, net of tax | | | - | | | | 179 | | | | 883 | | | | 419 | |
| Net (loss)/income | | $ | (6,946 | ) | | $ | 42,247 | | | $ | (10,620 | ) | | $ | 84,900 | |
| Average assets | | $ | 12,092,608 | | | $ | 12,345,139 | | | $ | 12,161,732 | | | $ | 12,307,934 | |
Certain previously reported amounts have been reclassified to agree with current presentation.
Note 10 – Business Segment Information (continued)
| | | Three Months Ended | | | Six Months Ended | |
| | | June 30 | | | June 30 | |
| (Dollars in thousands) | | 2008 | | | 2007 | | | 2008 | | | 2007 | |
| Capital Markets | | | | | | | | | | | | |
| Net interest income | | $ | 18,493 | | | $ | 13,693 | | | $ | 38,142 | | | $ | 24,422 | |
| Provision for loan losses | | | 18,522 | | | | 3,673 | | | | 33,553 | | | | 4,835 | |
| Noninterest income | | | 124,657 | | | | 92,997 | | | | 258,587 | | | | 184,305 | |
| Noninterest expense | | | 100,559 | | | | 80,480 | | | | 216,287 | | | | 167,099 | |
| Pre-tax income | | | 24,069 | | | | 22,537 | | | | 46,889 | | | | 36,793 | |
| Provision for income taxes | | | 8,960 | | | | 8,411 | | | | 17,397 | | | | 13,698 | |
| Net income | | $ | 15,109 | | | $ | 14,126 | | | $ | 29,492 | | | $ | 23,095 | |
| Average assets | | $ | 5,379,946 | | | $ | 6,182,294 | | | $ | 5,602,709 | | | $ | 6,127,691 | |
| | | | | | | | | | | | | | | | | |
| National Specialty Lending | | | | | | | | | | | | | | | | |
| Net interest income | | $ | 53,555 | | | $ | 59,438 | | | $ | 107,944 | | | $ | 123,994 | |
| Provision for loan losses | | | 108,106 | | | | 19,104 | | | | 257,675 | | | | 32,231 | |
| Noninterest income | | $ | (14,503 | ) | | | 12,448 | | | $ | (13,852 | ) | | | 24,447 | |
| Noninterest expense | | | 26,675 | | | | 38,212 | | | | 51,821 | | | | 73,391 | |
| Pre-tax (loss)/income | | | (95,729 | ) | | | 14,570 | | | | (215,404 | ) | | | 42,819 | |
| (Benefit)/provision for income taxes | | | (33,567 | ) | | | 5,987 | | | | (79,959 | ) | | | 15,869 | |
| Net (loss)/income | | $ | (62,162 | ) | | $ | 8,583 | | | $ | (135,445 | ) | | $ | 26,950 | |
| Average assets | | $ | 8,823,976 | | | $ | 9,730,084 | | | $ | 9,075,058 | | | $ | 9,703,643 | |
| | | | | | | | | | | | | | | | | |
| Mortgage Banking | | | | | | | | | | | | | | | | |
| Net interest income | | $ | 31,835 | | | $ | 28,382 | | | $ | 61,887 | | | $ | 48,978 | |
| Provision for loan losses | | | 4,001 | | | | (112 | ) | | | 4,223 | | | | (119 | ) |
| Noninterest income | | | 190,462 | | | | 74,945 | | | | 358,476 | | | | 151,654 | |
| Noninterest expense | | | 149,062 | | | | 115,461 | | | | 296,605 | | | | 220,701 | |
| Pre-tax income/(loss) | | | 69,234 | | | | (12,022 | ) | | | 119,535 | | | | (19,950 | ) |
| (Benefit)/provision for income taxes | | | 22,960 | | | | (6,854 | ) | | | 41,089 | | | | (17,287 | ) |
| Net (loss)/income | | $ | 46,274 | | | $ | (5,168 | ) | | $ | 78,446 | | | $ | (2,663 | ) |
| Average assets | | $ | 6,233,993 | | | $ | 6,784,982 | | | $ | 6,176,396 | | | $ | 6,501,498 | |
| | | | | | | | | | | | | | | | | |
| Corporate | | | | | | | | | | | | | | | | |
| Net interest income | | $ | 14,628 | | | $ | 247 | | | $ | 18,065 | | | $ | 2,858 | |
| Provision for loan losses | | | - | | | | 7,672 | | | | - | | | | 7,672 | |
| Noninterest income | | | 5,894 | | | | 8,280 | | | | 65,304 | | | | 22,823 | |
| Noninterest expense | | | 39,253 | | | | 61,751 | | | | 38,590 | | | | 81,406 | |
| Pre-tax (loss)/income | | | (18,731 | ) | | | (60,896 | ) | | | 44,779 | | | | (63,397 | ) |
| (Benefit)/provision for income taxes | | | (7,375 | ) | | | (23,231 | ) | | | 17,813 | | | | (23,785 | ) |
| Net (loss)/income | | $ | (11,356 | ) | | $ | (37,665 | ) | | $ | 26,966 | | | $ | (39,612 | ) |
| Average assets | | $ | 3,615,578 | | | $ | 4,027,645 | | | $ | 3,638,348 | | | $ | 4,218,997 | |
Certain previously reported amounts have been reclassified to agree with current presentation.
Note 11 – Derivatives
In the normal course of business, FHN utilizes various financial instruments, through its mortgage banking, capital markets and risk management operations, which include derivative contracts and credit-related arrangements, as part of its risk management strategy and as a means to meet customers’ needs. These instruments are subject to credit and market risks in excess of the amount recorded on the balance sheet in accordance with generally accepted accounting principles. The contractual or notional amounts of these financial instruments do not necessarily represent credit or market risk. However, they can be used to measure the extent of involvement in various types of financial instruments. Controls and monitoring procedures for these instruments have been established and are routinely reevaluated. The Asset/Liability Committee (ALCO) monitors the usage and effectiveness of these financial instruments.
Credit risk represents the potential loss that may occur because a party to a transaction fails to perform according to the terms of the contract. The measure of credit exposure is the replacement cost of contracts with a positive fair value. FHN manages credit risk by entering into financial instrument transactions through national exchanges, primary dealers or approved counterparties, and using mutual margining agreements whenever possible to limit potential exposure. With exchange-traded contracts, the credit risk is limited to the clearinghouse used. For non-exchange traded instruments, credit risk may occur when there is a gain in the fair value of the financial instrument and the counterparty fails to perform according to the terms of the contract and/or when the collateral proves to be of insufficient value. Market risk represents the potential loss due to the decrease in the value of a financial instrument caused primarily by changes in interest rates, mortgage loan prepayment speeds or the prices of debt instruments. FHN manages market risk by establishing and monitoring limits on the types and degree of risk that may be undertaken. FHN continually measures this risk through the use of models that measure value-at-risk and earnings-at-risk.
Derivative Instruments. FHN enters into various derivative contracts both in a dealer capacity, to facilitate customer transactions, and also as a risk management tool. Where contracts have been created for customers, FHN enters into transactions with dealers to offset its risk exposure. Derivatives are also used as a risk management tool to hedge FHN’s exposure to changes in interest rates or other defined market risks.
Derivative instruments are recorded on the Consolidated Condensed Statements of Condition as other assets or other liabilities measured at fair value. Fair value is defined as the price that would be received to sell a derivative asset or paid to transfer a derivative liability in an orderly transaction between market participants on the transaction date. Fair value is determined using available market information and appropriate valuation methodologies. For a fair value hedge, changes in the fair value of the derivative instrument and changes in the fair value of the hedged asset or liability are recognized currently in earnings. For a cash flow hedge, changes in the fair value of the derivative instrument, to the extent that it is effective, are recorded in accumulated other comprehensive income and subsequently reclassified to earnings as the hedged transaction impacts net income. Any ineffective portion of a cash flow hedge is recognized currently in earnings. For freestanding derivative instruments, changes in fair value are recognized currently in earnings. Cash flows from derivative contracts are reported as operating activities on the Consolidated Condensed Statements of Cash Flows.
Interest rate forward contracts are over-the-counter contracts where two parties agree to purchase and sell a specific quantity of a financial instrument at a specified price, with delivery or settlement at a specified date. Futures contracts are exchange-traded contracts where two parties agree to purchase and sell a specific quantity of a financial instrument at a specific price, with delivery or settlement at a specified date. Interest rate option contracts give the purchaser the right, but not the obligation, to buy or sell a specified quantity of a financial instrument, at a specified price, during a specified period of time. Caps and floors are options that are linked to a notional principal amount and an underlying indexed interest rate. Interest rate swaps involve the exchange of interest payments at specified intervals between two parties without the exchange of any underlying principal. Swaptions are options on interest rate swaps that give the purchaser the right, but not the obligation, to enter into an interest rate swap agreement during a specified period of time.
On June 30, 2008, FHN had approximately $25.2 million of cash receivables and $30.3 million of cash payables related to collateral posting under master netting arrangements with derivative counterparties.
Mortgage Banking
Mortgage banking interest rate lock commitments are short-term commitments to fund mortgage loan applications in process (the pipeline) for a fixed term at a fixed price. During the term of an interest rate lock commitment, First Horizon Home Loans has the risk that interest rates will change from the rate quoted to the borrower. First Horizon Home Loans enters into forward sales and futures contracts as economic hedges designed to protect the value of the interest rate lock commitments from changes in value due to changes in interest rates. Under SFAS No. 133, interest rate lock commitments qualify as derivative financial instruments and as such do not qualify for hedge accounting treatment. As a result,
Note 11 – Derivatives (continued)
the interest rate lock commitments are recorded at fair value with changes in fair value recorded in current earnings as gain or loss on the sale of loans in mortgage banking noninterest income. Prior to adoption of SAB No.109 fair value excluded the value of associated servicing rights. Additionally, on January 1, 2008, FHN adopted SFAS No. 157 which affected the valuation of interest rate lock commitments previously measured under the guidance of the EITF 02-03 by requiring recognition of concessions upon entry into the lock. Changes in the fair value of the derivatives that serve as economic hedges of interest rate lock commitments are also included in current earnings as a component of gain or loss on the sale of loans in mortgage banking noninterest income.
First Horizon Home Loans’ warehouse (mortgage loans held for sale) is subject to changes in fair value, due to fluctuations in interest rates from the loan closing date through the date of sale of the loan into the secondary market. Typically, the fair value of the warehouse declines in value when interest rates increase and rises in value when interest rates decrease. To mitigate this risk, First Horizon Home Loans enters into forward sales contracts and futures contracts to provide an economic hedge against those changes in fair value on a significant portion of the warehouse. These derivatives are recorded at fair value with changes in fair value recorded in current earnings as a component of the gain or loss on the sale of loans in mortgage banking noninterest income.
FHN adopted SFAS No. 159 on January 1, 2008. As discussed below, prior to adoption of SFAS No. 159, all warehouse loans were carried at the lower of cost or market, where carrying value was adjusted for successful hedging under SFAS No. 133 and the comparison of carrying value to market was performed for aggregate loan pools. To the extent that these interest rate derivatives were designated to hedge specific similar assets in the warehouse and prospective analyses indicate that high correlation was expected, the hedged loans were considered for hedge accounting under SFAS No. 133. Anticipated correlation was determined by projecting a dollar offset relationship for each tranche based on anticipated changes in the fair value of the hedged mortgage loans and the related derivatives, in response to various interest rate shock scenarios. Hedges were reset daily and the statistical correlation was calculated using these daily data points. Retrospective hedge effectiveness was measured using the regression correlation results. First Horizon Home Loans generally maintained a coverage ratio (the ratio of expected change in the fair value of derivatives to expected change in the fair value of hedged assets) of approximately 100 percent on warehouse loans hedged under SFAS No. 133. Effective SFAS No. 133 hedging resulted in adjustments to the recorded value of the hedged loans. These basis adjustments, as well as the change in fair value of derivatives attributable to effective hedging, were included as a component of the gain or loss on the sale of loans in mortgage banking noninterest income. Warehouse loans qualifying for SFAS No. 133 hedge accounting treatment totaled $2.6 billion on June 30, 2007. There were no warehouse loans qualifying for SFAS No. 133 hedge accounting treatment at June 30, 2008. The balance sheet impact of the related derivatives was net assets of $20.0 million on June 30, 2007. Net losses of $1.6 million representing the ineffective portion of these fair value hedges were recognized as a component of gain or loss on sale of loans for the six months ended June 30, 2007.
Upon adoption of SFAS No. 159, FHN elected to prospectively account for substantially all of its mortgage loan warehouse products at fair value upon origination and correspondingly discontinued the application of SFAS No. 133 hedging relationships for all new originations. First Horizon Home Loans enters into forward sales and futures contracts to provide an economic hedge against changes in fair value on a significant portion of the warehouse.
In accordance with SFAS No. 156, First Horizon revalues MSR to current fair value each month. Changes in fair value are included in servicing income in mortgage banking noninterest income. First Horizon Home Loans also enters into economic hedges of the MSR to minimize the effects of loss in value of MSR associated with increased prepayment activity that generally results from declining interest rates. In a rising interest rate environment, the value of the MSR generally will increase while the value of the hedge instruments will decline. First Horizon Home Loans enters into interest rate contracts (including swaps, swaptions, and mortgage forward sales contracts) to hedge against the effects of changes in fair value of its MSR. Substantially all capitalized MSR are hedged for economic purposes.
First Horizon Home Loans utilizes derivatives (including swaps, swaptions, and mortgage forward sales contracts) that change in value inversely to the movement of interest rates to protect the value of its interest-only securities as an economic hedge. Changes in the fair value of these derivatives are recognized currently in earnings in mortgage banking noninterest income as a component of servicing income.
Interest-only securities are included in trading securities with changes in fair value recognized currently in earnings in mortgage banking noninterest income as a component of servicing income.
Capital Markets
Capital Markets trades U.S. Treasury, U.S. Agency, mortgage-backed, corporate and municipal fixed income securities, and other securities for distribution to customers. When these securities settle on a delayed basis, they are considered forward contracts. Capital Markets also
Note 11 – Derivatives (continued)
enters into interest rate contracts, including options, caps, swaps, and floors for its customers. In addition, Capital Markets enters into futures contracts to economically hedge interest rate risk associated with a portion of its securities inventory. These transactions are measured at fair value, with changes in fair value recognized currently in capital markets noninterest income. Related assets and liabilities are recorded on the balance sheet as other assets and other liabilities. Credit risk related to these transactions is controlled through credit approvals, risk control limits and ongoing monitoring procedures through the Credit Risk Management Committee.
As of June 30, 2008, Capital Markets hedged $244.6 million of held-to-maturity trust preferred securities, which have an initial fixed rate term of five years before conversion to a floating rate. Capital Markets has entered into pay fixed, receive floating interest rate swaps to hedge the interest rate risk associated with this initial five year term. The balance sheet impact of those swaps was $6.8 million in other liabilities on June 30, 2008. Interest paid or received for these swaps was recognized as an adjustment of the interest income of the assets whose risk is being hedged.
Interest Rate Risk Management
FHN’s ALCO focuses on managing market risk by controlling and limiting earnings volatility attributable to changes in interest rates. Interest rate risk exists to the extent that interest-earning assets and liabilities have different maturity or repricing characteristics. FHN uses derivatives, including swaps, caps, options, and collars, that are designed to moderate the impact on earnings as interest rates change. FHN’s interest rate risk management policy is to use derivatives not to speculate but to hedge interest rate risk or market value of assets or liabilities. In addition, FHN has entered into certain interest rate swaps and caps as a part of a product offering to commercial customers with customer derivatives paired with offsetting market instruments that, when completed, are designed to eliminate market risk. These contracts do not qualify for hedge accounting and are measured at fair value with gains or losses included in current earnings in noninterest income.
FHN had entered into pay floating, receive fixed interest rate swaps to hedge the interest rate risk of certain large institutional certificates of deposit, totaling $61.9 million on June 30, 2007. These swaps matured in first quarter 2008 and had been accounted for as fair value hedges under the shortcut method. The balance sheet impact of these swaps was $.6 million in other liabilities on June 30, 2007. Interest paid or received for these swaps was recognized as an adjustment of the interest expense of the liabilities whose risk was being managed.
FHN has entered into pay floating, receive fixed interest rate swaps to hedge the interest rate risk of certain long-term debt obligations, totaling $1.2 billion and $1.1 billion on June 30, 2008 and 2007, respectively. These swaps have been accounted for as fair value hedges under the shortcut method. The balance sheet impact of these swaps was $29.1 million in other assets on June 30, 2008, and $41.5 million in other liabilities on June 30, 2007. Interest paid or received for these swaps was recognized as an adjustment of the interest expense of the liabilities whose risk was being managed.
FHN designates derivative transactions in hedging strategies to manage interest rate risk on subordinated debt related to its trust preferred securities. These qualify for hedge accounting under SFAS No. 133 using the long haul method. FHN has entered into pay floating, receive fixed interest rate swaps to hedge the interest rate risk of certain subordinated debt totaling $.3 billion on June 30, 2008 and 2007. The balance sheet impact of these swaps was $14.3 million and $29.7 million in other liabilities on June 30, 2008 and 2007, respectively. There was no ineffectiveness related to these hedges. Interest paid or received for these swaps was recognized as an adjustment of the interest expense of the liabilities whose risk is being managed.
FHN had utilized an interest rate swap as a cash flow hedge of the interest payment on floating-rate bank notes with a fair value of $100.5 million on June 30, 2007, and a maturity in first quarter 2009, which in first quarter 2008 was called early. The balance sheet impact of this swap was $.5 million in other assets and $.3 million, net of tax, in other comprehensive income on June 30, 2007. There was no ineffectiveness related to this hedge.
Note 12 - Restructuring, Repositioning, and Efficiency Charges
Throughout 2007, FHN conducted a company-wide review of business practices with the goal of improving its overall profitability and productivity. In addition, during 2007 management announced its intention to sell 34 full-service First Horizon Bank branches in its national banking markets. These sales were completed in second quarter 2008. In the second half of 2007, FHN also took actions to right size First Horizon Home Loans’ mortgage banking operations and to downsize FHN’s national lending operations, in order to redeploy capital to higher-return businesses. As part of its strategy to reduce its national real estate portfolio, FHN announced in January 2008 that it was discontinuing national homebuilder and commercial real estate lending through its First Horizon Construction Lending offices. Additionally, FHN initiated the repositioning of First Horizon Home Loans’ mortgage banking operations, which included sales of MSR in fourth quarter 2007 and the first and second quarters of 2008.
In June 2008, FHN announced that it had reached a definitive agreement with MetLife for the sale of more than 230 retail and wholesale mortgage origination offices nationwide as well as its loan origination and servicing platform. FHN also agreed with MetLife for the sale of servicing assets, and related hedges, on approximately $20 billion of first lien mortgage loans and related custodial deposits. The transaction is expected to close in third quarter 2008. MetLife will pay book value for the assets and liabilities it is acquiring, subject to an adjustment of up to $10.0 million.
Net costs recognized by FHN in the six months ended June 30, 2008 related to restructuring, repositioning, and efficiency activities were $47.2 million. Of this amount, $25.5 million represents exit costs that have been accounted for in accordance with Statement of Financial Accounting Standards No. 146, “Accounting for Costs Associated with Exit or Disposal Activities” (SFAS No. 146).
Significant expenses year to date for 2008 resulted from the following actions:
| · | Expense of $25.5 million associated with organizational and compensation changes due to right sizing operating segments, the divestiture of certain First Horizon Bank branches, the pending divestiture of certain mortgage banking operations and consolidating functional areas. |
| · | Losses of approximately $1.4 million from the sales of certain First Horizon Bank branches. |
| · | Transaction costs of $12.0 million from the contracted sales of mortgage servicing rights. |
| · | Expense of $8.3 million for the writedown of certain intangibles and other assets resulting from FHN’s divestiture of certain mortgage operations and from the change in FHN’s national banking strategy |
Losses from the disposition of certain First Horizon Bank branches in 2008 are included in losses/gains on divestitures in the noninterest income section of the Consolidated Statements of Income. Transaction costs recognized in 2008 from selling mortgage servicing rights are recorded as a reduction of mortgage banking income in the noninterest income section of the Consolidated Statements of Income. All other costs associated with the restructuring, repositioning, and efficiency initiatives implemented by management are included in the noninterest expense section of the Consolidated Statements of Income, including severance and other employee-related costs recognized in relation to such initiatives which are recorded in employee compensation, incentives, and benefits, facilities consolidation costs and related asset impairment costs which are included in occupancy, costs associated with the impairment of premises and equipment which are included in equipment rentals, depreciation and maintenance and other costs associated with such initiatives, including professional fees, intangible asset impairment costs, and the accrual of amounts due after June 30, 2008, in relation to the divestiture of mortage banking operations, which are included in all other expense. Additional amounts will be recognized in 2008 in relation to the conclusion of the mortage banking divestiture as well as discontinuation of national construction lending. At this time the amount of these additional charges is expected to be between $35 and $50 million.
Activity in the restructuring and repositioning liability for the three and six months ended June 30, 2008 and 2007 is presented in the following table, along with other restructuring and repositioning expenses recognized. All costs associated with FHN’s restructuring, repositioning, and efficiency initiatives are recorded as unallocated corporate charges within the Corporate segment.
Note 12 - Restructuring, Repositioning, and Efficiency Charges (continued)
| | | Three Months Ended | | | Six Months Ended | | | Three & Six Months Ended | |
| (Dollars in thousands) | | June 30, 2008 | | | June 30, 2008 | | | June 30, 2007 | |
| | | | | | | | | | | | | | | | | | | |
| | | Charged to | | | | | | Charged to | | | | | | Charged to | | | | |
| | | Expense | | | Liability | | | Expense | | | Liability | | | Expense | | | Liability | |
| Beginning Balance | | $ | - | | | $ | 22,690 | | | | - | | | | 19,675 | | | $ | - | | | $ | - | |
| Severance and other employee related costs | | | 5,732 | | | | 5,732 | | | | 13,122 | | | | 13,122 | | | | 7,997 | | | | 7,997 | |
| Facility consolidation costs | | | 2,963 | | | | 2,963 | | | | 3,854 | | | | 3,854 | | | | 3,788 | | | | 3,788 | |
| Other exit costs, professional fees and other | | | 1,652 | | | | 1,652 | | | | 8,484 | | | | 8,484 | | | | 2,969 | | | | 2,969 | |
| Total Accrued | | | 10,347 | | | | 33,037 | | | | 25,460 | | | | 45,135 | | | | 14,754 | | | | 14,754 | |
| Payments* | | | - | | | | 12,529 | | | | - | | | | 24,004 | | | | - | | | | 3,905 | |
| Accrual Reversals | | | - | | | | 2,563 | | | | - | | | | 3,186 | | | | - | | | | - | |
| Restructuring & Repositioning Reserve Balance | | $ | 10,347 | | | $ | 17,945 | | | $ | 25,460 | | | $ | 17,945 | | | $ | 14,754 | | | $ | 10,849 | |
| Other Restructuring & Repositioning Expenses: | | | | | | | | | | | | | | | | | | | | | | | | |
| Provision for loan portfolio divestiture | | | - | | | | | | | | - | | | | | | | $ | 7,672 | | | | | |
| Mortgage banking expense on servicing sales | | | 9,344 | | | | | | | | 12,011 | | | | | | | | - | | | | | |
| Loss on First Horizon Bank branch divestitures | | | 429 | | | | | | | | 1,424 | | | | | | | | - | | | | | |
| Impairment of premises and equipment | | | 4,104 | | | | | | | | 4,186 | | | | | | | | 5,159 | | | | | |
| Impairment of intangible assets | | | 1,732 | | | | | | | | 4,161 | | | | | | | | 11,733 | | | | | |
| Total Other Restructuring & Repositioning Expense | | | 15,609 | | | | | | | | 21,782 | | | | | | | | 24,564 | | | | | |
| Total Restructuring & Repositioning Charges | | $ | 25,956 | | | | | | | $ | 47,242 | | | | | | | $ | 39,318 | | | �� | | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| * Includes payments related to: | | Three Months Ended | | | Six Months Ended | | | Three & Six Months Ended | |
| | | June 30, 2008 | | | June 30, 2008 | | | June 30, 2007 | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Severance and other employee related costs | | $ | 4,238 | | | | | | | $ | 10,893 | | | | | | | $ | 2,329 | | | | | |
| Facility consolidation costs | | | 2,667 | | | | | | | | 3,901 | | | | | | | | 50 | | | | | |
| Other exit costs, professional fees and other | | | 5,624 | | | | | | | | 9,210 | | | | | | | | 1,526 | | | | | |
| | | $ | 12,529 | | | | | | | $ | 24,004 | | | | | | | $ | 3,905 | | | | | |
Cumulative amounts incurred beginning second quarter 2007, for costs associated with FHN’s restructuring, repositioning, and efficiency initiatives are presented in the following table:
| | | Charged to | |
| (Dollars in thousands) | | Expense | |
| Severance and other employee related costs* | | $ | 38,654 | |
| Facility consolidation costs | | | 16,985 | |
| Other exit costs, professional fees and other | | | 17,739 | |
| Other Restructuring & Repositioning (Income) and Expense: | | | | |
| Loan portfolio divestiture | | | 7,672 | |
| Mortgage banking expense on servicing sales | | | 18,439 | |
| Net gain on First Horizon Bank branch divestitures | | | (14,271 | ) |
| Impairment of premises and equipment | | | 13,474 | |
| Impairment of intangible assets | | | 18,160 | |
| Impairment of other assets | | | 29,108 | |
| Total Restructuring & Repositioning Charges Incurred as of June 30, 2008 | | $ | 145,960 | |
*Includes $1.2 million of deferred severance-related payments that will be paid after 2008.
Note 13 – Fair Values of Assets and Liabilities
Effective January 1, 2008, upon adoption of SFAS No. 159, FHN elected the fair value option on a prospective basis for almost all types of mortgage loans originated for sale purposes. FHN believes such election will reduce certain timing differences and better match changes in the value of such loans with changes in the value of derivatives used as economic hedges for these assets. No transition adjustment was required upon adoption of SFAS No. 159 as FHN continues to account for mortgage loans held for sale which were originated prior to 2008 at the lower of cost or market value. Mortgage loans originated for sale are included in loans held for sale on the Consolidated Condensed Statements of Condition. Other interests retained in relation to residential loan sales and securitizations are included in trading securities on the Consolidated Condensed Statements of Condition. Additionally, effective January 1, 2008, FHN adopted SFAS No. 157 for existing fair value measurement requirements related to financial assets and liabilities as well as to non-financial assets and liabilities which are re-measured at least annually. FSP FAS 157-2 delays the effective date of SFAS No. 157 until fiscal years beginning after November 15, 2008, for non-financial assets and liabilities which are recognized at fair value on a non-recurring basis. Therefore, in 2008, FHN has not applied the provisions of SFAS No. 157 for non-recurring fair value measurements related to its non-financial long-lived assets under SFAS No. 144 (including real estate acquired by foreclosure) or its non-financial liabilities for exit or disposal activities initially measured at fair value under SFAS No. 146, as well as to goodwill and indefinite-lived intangible assets which are measured at fair value on a recurring basis for impairment assessment purposes but are not recognized in the financial statements at fair value.
In accordance with SFAS No. 157, FHN groups its assets and liabilities measured at fair value in three levels, based on the markets in which such assets and liabilities are traded and the reliability of the assumptions used to determine fair value. This hierarchy requires FHN to maximize the use of observable market data, when available, and to minimize the use of unobservable inputs when determining fair value. Each fair value measurement is placed into the proper level based on the lowest level of significant input. These levels are:
| · | Level 1 – Valuation is based upon quoted prices for identical instruments traded in active markets. |
| · | Level 2 – Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market. |
| · | Level 3 – Valuation is generated from model-based techniques that use significant assumptions not observable in the market. These unobservable assumptions reflect our own estimates of assumptions that market participants would use in pricing the asset or liability. Valuation techniques include use of option pricing models, discounted cash flow models and similar techniques. |
All divestiture-related line items in the Consolidated Condensed Statements of Condition have been combined with the related non-divestiture line items in preparation of the disclosure tables in this footnote. The table below presents the balances of assets and liabilities measured at fair value on a recurring basis. Derivatives in an asset position are included within Other assets while derivatives in a liability position are included within Other liabilities. Derivative positions constitute the only Level 3 measurements within Other assets and Other liabilities.
Note 13 – Fair Values of Assets and Liabilities (continued)
| | | June 30, 2008 | |
| (Dollars in thousands) | | Total | | | Level 1 | | | Level 2 | | | Level 3 | |
| Trading securities | | $ | 1,563,055 | | | $ | 2,929 | | | $ | 1,131,109 | | | $ | 429,017 | |
| Loans held for sale | | | 2,163,705 | | | | - | | | | 2,159,993 | | | | 3,712 | |
| Securities available for sale | | | 2,756,820 | | | | 32,086 | | | | 2,577,863 | | | | 146,871 | |
| Mortgage servicing rights, net | | | 1,139,395 | | | | - | | | | - | | | | 1,139,395 | |
| Other assets * | | | 306,985 | | | | 108,787 | | | | 97,363 | | | | 100,835 | |
| Total | | $ | 7,929,960 | | | $ | 143,802 | | | $ | 5,966,328 | | | $ | 1,819,830 | |
| | | | | | | | | | | | | | | | | |
| Trading liabilities | | $ | 464,225 | | | $ | 31 | | | $ | 464,194 | | | $ | - | |
| Commercial paper and other short-term borrowings | | | 205,412 | | | | - | | | | - | | | | 205,412 | |
| Other liabilities * | | | 252,221 | | | | 156,131 | | | | 90,775 | | | | 5,315 | |
| Total | | $ | 921,858 | | | $ | 156,162 | | | $ | 554,969 | | | $ | 210,727 | |
| | | | | | | | | | | | | | | | | |
* Derivatives are included in this category.
Note 13 – Fair Values of Assets and Liabilities (continued)
The changes in Level 3 assets and liabilities measured at fair value on a recurring basis are summarized as follows:
| | | Three Months Ended June 30, 2008 | |
| | | | | | | | | Securities | | Mortgage | | | Net derivative | | Commercial paper | |
| | | Trading | | | Loans held | | | available | | | servicing | | | assets and | | and other short- | |
| (Dollars in thousands) | | securities | | | for sale | | | for sale | | | rights, net | | | liabilities | | term borrowings | |
| Balance, beginning of quarter | | $ | 392,196 | | | $ | 4,753 | | | $ | 153,376 | | | $ | 895,923 | | | $ | 465,067 | | | $ | - | |
| Total net gains/(losses) | | | | | | | | | | | | | | | | | | | | | | | | |
| for the quarter included in: | | | | | | | | | | | | | | | | | | | | | |
| Net income | | | 79,261 | | | | (171 | ) | | | (236 | ) | | | 254,066 | | | | (307,054 | ) | | | 16,685 | |
| Other comprehensive income | | | - | | | | - | | | | (3,336 | ) | | | - | | | | - | | | | - | |
| Purchases, sales, issuances | | | | | | | | | | | | | | | | | | | | | |
| and settlements, net | | | (42,440 | ) | | | (849 | ) | | | (2,933 | ) | | | (10,594 | ) | | | (70,069 | ) | | | 188,727 | |
| Net transfers into/out of Level 3 | | | - | | | | (21 | ) | | | - | | | | - | | | | 7,576 | | | | - | |
| Balance, end of quarter | | $ | 429,017 | | | $ | 3,712 | | | $ | 146,871 | | | $ | 1,139,395 | | | $ | 95,520 | | | $ | 205,412 | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Net unrealized gains/(losses) | | | | | | | | | | | | | | | | | | | | | |
| included in net income for | | | | | | | | | | | | | | | | | | | | | |
| the quarter relating to assets | | | | | | | | | | | | | | | | | | | | |
| and liabilities held at June 30, 2008 | | $ | 56,696 | * | | $ | (1,795 | ) ** | | $ | 69 | *** | | $ | 216,442 | **** | | $ | (232,560 | ) ** | | $ | (16,685 | ) |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| | | Six Months Ended June 30, 2008 | |
| | | | | | | | | | | Securities | | Mortgage | | | Net derivative | | Commercial paper | |
| | | Trading | | | Loans held | | | available | | | servicing | | | assets and | | and other short- | |
| (Dollars in thousands) | | securities | | | for sale | | | for sale | | | rights, net | | | liabilities | | term borrowings | |
| Balance, beginning of year | | $ | 476,404 | | | $ | - | | | $ | 159,301 | | | $ | 1,159,820 | | | $ | 81,517 | | | $ | - | |
| Total net gains/(losses) | | | | | | | | | | | | | | | | | | | | | | | | |
| for the period included in: | | | | | | | | | | | | | | | | | | | | | |
| Net income | | | 20,077 | | | | (171 | ) | | | 69 | | | | (8,099 | ) | | | 54,267 | | | | 16,685 | |
| Other comprehensive income | | | - | | | | - | | | | (7,178 | ) | | | - | | | | - | | | | - | |
| Purchases, sales, issuances | | | | | | | | | | | | | | | | | | | | | |
| and settlements, net | | | (89,403 | ) | | | (849 | ) | | | (5,321 | ) | | | (12,326 | ) | | | (47,840 | ) | | | 188,727 | |
| Net transfers into/out of Level 3 | | | 21,939 | | | | 4,732 | | | | - | | | | - | | | | 7,576 | | | | - | |
| Balance, end of period | | $ | 429,017 | | | $ | 3,712 | | | $ | 146,871 | | | $ | 1,139,395 | | | $ | 95,520 | | | $ | 205,412 | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Net unrealized gains/(losses) | | | | | | | | | | | | | | | | | | | | | |
included in net income for | | | | | | | | | | | | | | | | | | | | | |
| the period relating to assets | | | | | | | | | | | | | | | | | | | | |
| and liabilities held at June 30, 2008 | | $ | (23,184 | ) * | | $ | (2,641 | ) ** | | $ | 69 | *** | | $ | 26,567 | **** | | $ | 53,062 | ** | | $ | (16,685 | ) |
| | |
| * | Six months ended June 30, 2008 includes $2.6 million included in Capital markets noninterest income, $11.8 million included in Mortgage banking noninterest income, and $9.3 million included in Revenue from loan sales and securitizations; three months ended June 30, 2008 included $2.6 million included in Capital markets noninterest income, $68.1 million included in Mortgage banking noninterest income, and $9.3 million in Revenue from loan sales and securitizations. |
| ** | Included in Mortgage banking noninterest income. |
| *** | Represents recognized gains and losses attributable to venture capital investments classified within securities available for sale that are included in Securities gains/(losses) in noninterest income. |
| **** | Six months ended June 30, 2008 includes $28.5 million included in Mortgage banking noninterest income and $(1.9) million included in Revenue from loan sales and securitizations; three months ended June 30, 2008 includes $218.3 million in Mortgage banking noninterest income and $(1.9) million included in Revenue from loan sales and securitizations. |
Note 13 – Fair Values of Assets and Liabilities (continued)
Additionally, FHN may be required, from time to time, to measure certain other financial assets at fair value on a nonrecurring basis in accordance with GAAP. These adjustments to fair value usually result from the application of lower of cost or market accounting or write-downs of individual assets. For assets measured at fair value on a nonrecurring basis in the first half of 2008 which were still held in the balance sheet at June 30, 2008, the following table provides the level of valuation assumptions used to determine each adjustment and the carrying value of the related individual assets or portfolios at June 30, 2008.
| | | | | | | | | | | | | | | Six Months Ended | |
| | | Carrying value at June 30, 2008 | | | June 30, 2008 | |
| (Dollars in thousands) | | Total | | | Level 1 | | | Level 2 | | | Level 3 | | | Total losses | |
| Loans held for sale | | $ | 149,469 | | | $ | - | | | $ | 94,763 | | | $ | 54,706 | | | $ | 25,303 | |
| Securities available for sale | | | 1,535 | | | | - | | | | 1,535 | | | | - | | | | 1,395 | * |
| Loans, net of unearned income** | | | 333,956 | | | | - | | | | - | | | | 333,956 | | | | 75,283 | |
| Other assets | | | 120,934 | | | | - | | | | - | | | | 120,934 | | | | 4,240 | |
| | | | | | | | | | | | | | | | | | | $ | 106,221 | |
| | | | | | | | | | | | | | | | | | | | | |
| * | Represents recognition of other than temporary impairment for cost method investments classified within securities available for sale. |
| ** | Represents carrying value of loans for which adjustments are based on the appraised value of the collateral. Writedowns on these loans are recognized as part of provision. |
In first quarter 2008, FHN recognized a lower of cost or market reduction in value of $36.2 million for its warehouse of trust preferred securities, which was classified within level 3 for Loans held for sale at March 31, 2008. The determination of estimated market value for the warehouse was based on a hypothetical securitization transaction for the warehouse as a whole. FHN used observable data related to prior securitization transactions as well as changes in credit spreads in the CDO market since the most recent transaction. FHN also incorporated significant internally developed assumptions within its valuation of the warehouse, including estimated prepayments and estimated defaults. In accordance with SFAS No. 157, FHN excluded transaction costs related to the hypothetical securitization in determining fair value.
In second quarter 2008, FHN designated its trust preferred warehouse as held to maturity. Accordingly, these loans were excluded from loans held for sale in the nonrecurring measurements table above as of June 30, 2008. In conjunction with the transfer of these loans to held to maturity status, FHN performed a lower of cost or market analysis on the date of transfer. This analysis was based on the pricing of market transactions involving securities similar to those held in the trust preferred warehouse with consideration given, as applicable, to any differences in characteristics of the market transactions, including issuer credit quality, call features and term. As a result of the lower of cost or market analysis, FHN determined that its existing valuation of the trust preferred warehouse was appropriate.
In first quarter 2008, FHN recognized a lower of cost or market reduction in value of $17.0 million relating to mortgage warehouse loans. Approximately $10.5 million was attributable to increased delinquencies or aging of loans. The market values for these loans are estimated using historical sales prices for these type loans, adjusted for incremental price concessions that a third party investor is assumed to require due to tightening credit markets and deteriorating housing prices. These assumptions are based on published information about actual and projected deteriorations in the housing market as well as changes in credit spreads. The remaining reduction in value of $6.5 million was attributable to lower investor prices, due primarily to credit spread widening. This reduction was calculated by comparing the total fair value of loans (using the same methodology that is used for fair value option loans) to carrying value for the aggregate population of loans that were not delinquent or aged.
FHN also recognized a lower of cost or market reduction in value of $8.3 million relating to mortgage warehouse loans during second quarter of 2008. Approximately $7.1 million is attributable to increased repurchases and delinquencies or aging of warehouse loans; the remaining reduction in value is attributable to lower investor prices, due primarily to credit spread widening. The market values for these loans are estimated using historical sales prices for these type loans, adjusted for incremental price concessions that a third party investor is assumed to require due to tightening credit markets and deteriorating housing prices. These assumptions are based on published information about actual and projected deteriorations in the housing market as well as changes in credit spreads.
Note 13 – Fair Values of Assets and Liabilities (continued)
Fair Value Option
As described above, upon adoption of SFAS No. 159, management elected fair value accounting for substantially all forms of mortgage loans originated for sale. In second quarter 2008, agreements were reached for the transfer of certain servicing assets and delivery of the servicing assets occurred. However, due to certain recourse provisions, these transactions did not qualify for sale treatment and the associated proceeds have been recognized within Commercial paper and other short term borrowings in the Consolidated Condensed Statement of Position as of June 30, 2008. Since servicing assets are recognized at fair value and since changes in the fair value of related financing liabilities will exactly mirror the change in fair value of the associated servicing assets, management elected to account for the financing liabilities at fair value under SFAS No. 159. Additionally, as the servicing assets have already been delivered to the buyer, the fair value of the financing liabilities associated with the transaction does not reflect any instrument-specific credit risk.
The following table reflects the differences between the fair value carrying amount of mortgages held for sale measured at fair value under SFAS No. 159 and the aggregate unpaid principal amount FHN is contractually entitled to receive at maturity.
| | | June 30, 2008 | |
| | | | | | | | | Fair value |
| | | Fair value | | | Aggregate | | | carrying amount |
| | | carrying | | | unpaid | | | less aggregate |
| (Dollars in thousands) | | amount | | | principal | | | unpaid principal |
| Loans held for sale reported at fair value: | | | | | | | | | |
| Total loans | | $ | 2,163,705 | | | $ | 2,157,321 | | | $ | 6,384 | |
| Nonaccrual loans | | | 320 | | | | 567 | | | | (247 | ) |
| Loans 90 days or more past due and still accruing | | | 890 | | | | 1,525 | | | | (635 | ) |
Assets and liabilities accounted for under SFAS No. 159 are initially measured at fair value. Gains and losses from initial measurement and subsequent changes in fair value are recognized in earnings. The change in fair value related to initial measurement and subsequent changes in fair value for mortgage loans held for sale and other short term borrowings for which FHN elected the fair value option are included in current period earnings with classification in the income statement line item shown below.
The amounts for loans held for sale includes approximately $5.2 million and $14.7 million of losses included in earnings for the three and six month periods ended June 30, 2008, respectively, attributable to changes in instrument-specific credit risk, which was determined based on both a quality adjustment for delinquencies and the full credit and liquidity spread on the non-conforming loans.
| | | Three Months Ended | | | Six Months Ended |
| | | June 30, 2008 | | | June 30, 2008 |
| (Dollars in thousands) | | | | | | | |
| Changes in fair value included in net income: | | | | | | | |
| Mortgage banking noninterest income | | | | | | | |
| Loans held for sale | | $ | (25,159 | ) | | | $ | (5,471 | ) |
| Commercial paper and other short-term borrowings | | | (16,685 | ) | | | | (16,685 | ) |
| Estimated changes in fair value due to credit risk | | | (5,204 | ) | | | | (14,665 | ) |
Interest income on mortgage loans held for sale measured at fair value is calculated based on the note rate of the loan and is recorded in the interest income section of the Consolidated Condensed Statements of Income as interest on loans held for sale.
Note 14 – Other Events
In second quarter 2008, FHN completed a public offering of 69 million shares of its common stock, which generated net proceeds of $659.8 million after consideration of underwriters’ discounts and commissions and offering costs. FHN intends to use substantially all of the net proceeds from the sales of the securities for general corporate purposes. To that end, $610.0 million of the proceeds from the offering was contributed to First Tennessee Bank, N.A. in the form of equity capital.
In July 2008, the Board of Directors of FHN determined that the dividend payable on October 1, 2008, will be paid in shares of common stock at the rate of 3.0615 percent, which means that 30.615 new dividend shares will be distributed for every 1,000 shares held on the record date of September 12, 2008. The dividend rate was determined to provide shareholders with new shares having a value of $0.20 for each share held on the record date, based on FHN’s volume weighted average share price on July 11, 2008, of $6.5328 per share. FHN currently intends to pay dividends in shares of common stock for the foreseeable future.
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
GENERAL INFORMATION
First Horizon National Corp. (NYSE: FHN) is a national financial services institution. From a small community bank chartered in 1864, FHN has grown to be one of the 30 largest bank holding companies in the United States in terms of asset size.
The 9,000 employees of FHN provide financial services to individuals and business customers through hundreds of offices located in more than 40 states. The corporation’s three major brands – First Tennessee, FTN Financial, and First Horizon – provide customers with a broad range of products and services including:
● | Regional banking, with one of the largest market shares in Tennessee and one of the highest customer retention rates of any bank in the country |
| Capital markets, one of the nation’s top underwriters of U.S. government agency securities |
| Mortgage banking, one of the nation’s top mortgage originators and recipient of consecutive awards for servicing excellence from Fannie Mae and Freddie Mac. Upon closing of the sale of its retail and wholesale mortgage offices nationwide and its loan origination and servicing platform outside Tennessee, the company will continue to provide mortgage services to customers in its First Tennessee Bank markets in and around Tennessee. |
FHN companies have been recognized as some of the nation’s best employers by AARP and Working Mother magazines.
In first quarter 2008 FHN revised its business line segments to better align with its strategic direction, representing a focus on its regional banking franchise and capital markets business. To implement this change, the prior Retail/Commercial Banking segment was split into its major components with the national portions of consumer lending and construction lending assigned to a new National Specialty Lending segment that more appropriately reflects the ongoing wind down of these businesses. Additionally, correspondent banking was shifted from Retail/Commercial Banking to the Capital Markets segment to better represent the complementary nature of these businesses. To reflect its geographic focus, the remaining portions of the Retail/Commercial Banking segment now represent the new Regional Banking segment. All prior period information has been revised to conform to the current segment structure and the business line reviews below are based on the new segment presentation.
● | Regional Banking offers financial products and services, including traditional lending and deposit-taking, to retail and commercial customers in Tennessee and surrounding markets. Additionally, Regional Banking provides investments, insurance, financial planning, trust services and asset management, credit card, cash management, and check clearing. On March 1, 2006, FHN sold its national merchant processing business. The continuing effects of the divestiture, which is included in the Regional Banking segment, are being accounted for as a discontinued operation. |
| | |
● | Capital Markets provides a broad spectrum of financial services for the investment and banking communities through the integration of traditional capital markets securities activities, structured finance, equity research, investment banking, loan sales, portfolio advisory services, and correspondent banking services. |
| | |
● | National Specialty Lending consists of traditional consumer and construction lending activities outside the regional banking footprint. In January 2008, FHN announced the discontinuation of national home builder and commercial real estate lending through its First Horizon Construction Lending offices. |
| | |
● | Mortgage Banking helps provide home ownership through First Horizon Home Loans, a division of First Tennessee Bank National Association (FTBNA), which operates offices in approximately 40 states and is one of the top 20 mortgage servicers and top 20 originators of mortgage loans to consumers. This segment consists of core mortgage banking elements including originations and servicing and the associated ancillary revenues related to these businesses. |
| | |
● | Corporate consists of unallocated corporate expenses including restructuring, repositioning, and efficiency initiatives, gains and losses on repurchases of debt, expense on subordinated debt issuances and preferred stock, bank-owned life insurance, unallocated interest income associated with excess equity, net impact of raising incremental capital, revenue and expense associated with deferred compensation plans, funds management and venture capital. |
For the purpose of this management discussion and analysis (MD&A), earning assets have been expressed as averages, and loans have been disclosed net of unearned income. The following is a discussion and analysis of the financial condition and results of operations of FHN for the three-month and six-month periods ended June 30, 2008, compared to the three-month and six-month periods ended June 30, 2007. To assist the reader in obtaining a better understanding of FHN and its performance, this discussion should be read in conjunction with FHN’s unaudited consolidated condensed financial statements and accompanying notes appearing in this report. Additional information including the 2007 financial statements, notes, and MD&A is provided in the 2007 Annual Report.
FORWARD-LOOKING STATEMENTS
This MD&A contains forward-looking statements with respect to FHN’s beliefs, plans, goals, expectations, and estimates. Forward-looking statements are statements that are not a representation of historical information but rather are related to future operations, strategies, financial results or other developments. The words “believe,” “expect,” “anticipate,” “intend,” “estimate,” “should,” “is likely,” “will,” "going forward," and other expressions that indicate future events and trends identify forward-looking statements. Forward-looking statements are necessarily based upon estimates and assumptions that are inherently subject to significant business, operational, economic and competitive uncertainties and contingencies, many of which are beyond a company’s control, and many of which, with respect to future business decisions and actions (including acquisitions and divestitures), are subject to change. Examples of uncertainties and contingencies include, among other important factors, general and local economic and business conditions; recession or other economic downturns, expectations of and actual timing and amount of interest rate movements, including the slope of the yield curve (which can have a significant impact on a financial services institution); market and monetary fluctuations; inflation or deflation; customer and investor responses to these conditions; the financial condition of borrowers and other counterparties; competition within and outside the financial services industry; geopolitical developments including possible terrorist activity; natural disasters; effectiveness of FHN’s hedging practices; technology; demand for FHN’s product offerings; new products and services in the industries in which FHN operates; and critical accounting estimates. Other factors are those inherent in originating, selling and servicing loans including prepayment risks, pricing concessions, fluctuation in U.S. housing prices, fluctuation of collateral values, and changes in customer profiles. Additionally, the actions of the Securities and Exchange Commission (SEC), the Financial Accounting Standards Board (FASB), the Office of the Comptroller of the Currency (OCC), the Board of Governors of the Federal Reserve System (Federal Reserve), Financial Industry Regulatory Authority (FINRA), and other regulators; regulatory and judicial proceedings and changes in laws and regulations applicable to FHN; and FHN’s success in executing its business plans and strategies and managing the risks involved in the foregoing, could cause actual results to differ. FHN assumes no obligation to update any forward-looking statements that are made from time to time. Actual results could differ because of several factors, including those presented in this Forward-Looking Statements section, in other sections of this MD&A, and other parts of this Quarterly Report on Form 10-Q for the period ended June 30, 2008.
FINANCIAL SUMMARY (Comparison of Second Quarter 2008 to Second Quarter 2007)
FINANCIAL HIGHLIGHTS
For second quarter 2008, FHN reported a net loss of $19.1 million or $.11 per diluted share compared to earnings of $22.2 million or $.17 per diluted share for second quarter 2007. Second quarter 2008 was impacted by several items including increased provisioning for loan losses and increased costs for estimated repurchase activity for prior loan sales, costs associated with the company’s restructuring, repositioning, and efficiency initiatives and a $12.6 million gain on the repurchase of debt. Provisioning for loan losses increased by $175.6 million over second quarter 2007 to $220.0 million in the current quarter as loan loss reserves grew from 1.03 percent of total loans in the second quarter 2007 to 2.59 percent in the second quarter 2008. FHN incurred net charges of $26.0 million in the second quarter 2008 from restructuring, repositioning, and efficiency initiatives compared to $39.3 million for second quarter 2007. Other items affecting second quarter 2007 were a net reduction in pretax earnings of $5.4 million related to legal settlements and $9.2 million of securities gains.
National Specialty Lending, Regional Banking, Mortgage Banking and Capital Markets were all impacted by increased provisioning in second quarter 2008 as FHN continued to actively manage the credit risk within its loan portfolios. Capital Markets fixed income sales generated $105.0 million of revenues compared to $48.3 million in the second quarter of 2007 as the Federal Reserve’s aggressive rate cuts in 2008 produced a steeper yield curve. Mortgage Banking pre-tax income increased over second quarter 2007 as origination income was positively impacted by higher gain on sale margins while servicing income was favorably impacted by hedging activities compared to 2007.
FHN improved its capital position in second quarter 2008 as it completed a public offering of 69 million shares of common stock. Key ratios were 6.96 percent for tangible common equity to tangible assets, 10.51 percent for Tier I and 15.15 percent for total capital as of June 30, 2008. Corporate net nterest margin improved to 3.01 percent for second quarter 2008 compared to 2.79 percent for second quarter 2007.
Return on average shareholders’ equity and return on average assets were (3.02) percent and (.21) percent, respectively, for the second quarter 2008. Return on average shareholders’ equity and return on average assets were 3.57 percent and .23 percent respectively, for the second quarter 2007. Total assets were $35.5 billion and shareholders’ equity was $2.7 billion on June 30, 2008, as compared to $38.4 billion and $2.5 billion, respectively, on June 30, 2007.
BUSINESS LINE REVIEW
Regional Banking
The pre-tax loss for Regional Banking was $26.7 million for second quarter 2008 compared to pre-tax income of $53.9 million for second quarter 2007. Total revenues for Regional Banking were $212.9 million for second quarter 2008 compared to $229.3 million for second quarter 2007.
Net interest income was $120.3 million in second quarter 2008 compared to $137.7 million in second quarter 2007. Regional Banking net interest margin was 4.38 percent in second quarter 2008 compared to 4.94 percent in the second quarter 2007. This compression resulted from narrowing spreads on deposits as Federal Reserve rate reductions in the first half of 2008 were not fully passed on to deposit customers.
Noninterest income increased slightly to $92.5 million in second quarter 2008 compared to $91.6 million in second quarter 2007 as increased fees from deposit and cash management as well as a $2.3 million foreclosure gain more than offset declines in trust and insurance income. The increase in deposit fees was due to growth in deposit accounts while decreases in trust income were primarily due to market conditions and the decline in insurance commissions is due to a soft property and casualty market.
Provision for loan losses increased to $89.4 million in second quarter 2008 from $14.1 million for the second quarter 2007. This increase was primarily a result of deterioration in home equity and commercial loan portfolios.
Noninterest expense decreased to $150.2 million in second quarter 2008 from $161.3 million for the second quarter 2007. While most expenses decreased, the majority of the decline is attributable to reductions in personnel expenses related to efficiency initiatives.
Capital Markets
Capital Markets pre-tax income was $24.1 million in second quarter 2008 compared to $22.5 million in second quarter 2007. Total revenues for Capital Markets were $143.1 million in second quarter 2008 compared to $106.7 million in second quarter 2007.
Net interest income was $18.5 million in second quarter 2008 compared to $13.7 million in second quarter 2007. This increase is primarily attributable to trading portfolio management activities implemented in the second half of 2007, a steeper yield curve and the effect of increases in the average trust preferred warehouse.
Income from fixed income sales increased to $105.0 million in second quarter 2008 from $48.3 million in second quarter 2007, reflecting an increase in activity during the second quarter 2008 as the Federal Reserve aggressively lowered rates the first half of 2008 resulting in a steeper yield curve. Other product revenues were $19.7 million in second quarter 2008 compared to $44.7 million in second quarter 2007. This decrease is primarily attributable to the effect of credit market disruptions on the pooled trust preferred product for which no transaction revenues were recognized in second quarter 2008.
Provision increased to $18.5 million from $3.7 million to reflect deterioration of correspondent banking loans.
Noninterest expense was $100.6 million in second quarter 2008 compared to $80.5 million in second quarter 2007. This increase is a result of higher production levels during second quarter 2008.
National Specialty Lending
National Specialty Lending had a pre-tax loss of $95.7 million in second quarter 2008 compared to pre-tax income of $14.6 million in second quarter 2007. The pre-tax loss in 2008 is primarily a result of an increase in the provision for loan losses to $108.1 million in second quarter 2008 compared to $19.1 million in second quarter 2007 due to deterioration in the national construction and consumer lending portfolios.
Total revenues for National Specialty Lending were $39.1 million for second quarter 2008 compared to $71.9 million for second quarter 2007. Net interest income declined to $53.6 million in the second quarter 2008, compared to $59.4 million for the second quarter 2007, as a result of the increase in nonaccrual construction loans. Noninterest income was a loss of $14.5 million for the second quarter 2008, compared to a gain of $12.4 million for the second quarter 2007, as the value of residual interests in prior securitizations declined. Additionally, increased costs were recorded for estimated repurchase activity related to prior loan sales and there were no loan sales executed in the second quarter 2008.
Noninterest expense was $26.7 million in second quarter 2008, compared to $38.2 million for second quarter 2007. Noninterest expense declined mainly due to lower personnel costs related to the business wind-down initiated during first quarter 2008.
Mortgage Banking
Mortgage Banking had a pre-tax income of $69.2 million in second quarter 2008, compared to a pre-tax loss of $12.0 million in second quarter 2007. Total revenues for Mortgage Banking were $222.3 million for second quarter 2008 compared to $103.3 million for second quarter 2007.
Net interest income was $31.8 million in second quarter 2008 compared to $28.3 million in second quarter 2007. The increase is consistent with the increase in the warehouse spread to 3.14% in the current quarter compared to 1.14% in second quarter 2007. Provision for loan losses increased to $4.0 million in the second quarter 2008 from $(.1) million in the second quarter 2007 reflecting deterioration of permanent mortgages in the portfolio.
Noninterest income was $190.5 million in second quarter 2008 compared to $74.9 million in second quarter 2007. Noninterest income consists primarily of mortgage banking-related revenue from the origination and sale of mortgage loans, fees from mortgage servicing and changes in fair value of mortgage servicing rights (MSR) net of hedge gains or losses.
Net origination income increased to $134.1 million in second quarter 2008 from $67.3 million in second quarter 2007 primarily due to a $39.0 million positive impact from the adoption of accounting standards, including the prospective election of fair value accounting for substantially all types of mortgage warehouse loans in the first quarter 2008. Gain on sale margins increased to 125 bps compared to 76 bps in second quarter 2007 as government loans constituted a higher percentage of deliveries and from the effects of favorable rate moves at the end of the current quarter.
Net servicing income increased to $42.6 million in the second quarter 2008 from a loss of $3.5 million in 2007. Servicing hedging activities and changes other than runoff in the value of capitalized servicing assets positively impacted net revenues by $16.5 million this quarter as compared to a negative impact of $14.7 million in second quarter 2007, primarily resulting from Federal Reserve interest rate decreases creating a steeper yield curve in 2008. The decrease in MSR value due to runoff was $37.1 million in second quarter 2008 compared to $62.6 million in second quarter 2007 as the value of MSR that prepaid this quarter was less valuable than a year ago and loans prepaid at a slower rate.
Noninterest expense was $149.1 million in second quarter 2008 compared to $115.5 million in second quarter 2007. This increase in the second quarter of 2008 resulted primarily from a $46.2 million effect of no longer deferring origination costs on warehouse loans accounted for at elected fair value in first quarter 2008. This amount is offset by a corresponding increase in origination income. The effects of cost reductions initiated after first quarter 2007 as part of right sizing operations and a decline in legal settlements of $8.4 million from 2007 partially offset the increase in noninterest expense attributable to the fair value election for warehouse loans and increased foreclosure expenses.
Corporate
The Corporate segment’s results yielded a pre-tax loss of $18.7 million in second quarter 2008 compared to a pre-tax loss of $60.9 million in second quarter 2007. Net interest income increased to $14.7 million from $.5 million in the second quarter 2007 as proceeds from the common stock issuance reduced the need for short term funding. Results for second quarter 2008 include $26.0 million of net charges associated with implementation of restructuring, repositioning and efficiency initiatives compared to $39.3 million of net charges in second quarter 2007. Gains of $12.6 million related to the repurchase of debt were also recognized in second quarter 2008. See discussion of the restructuring, repositioning and efficiency initiatives below for further details.
RESTRUCTURING, REPOSITIONING, AND EFFICIENCY INITIATIVES
Beginning in 2007, FHN conducted a company-wide review of business practices with the goal of improving its overall profitability and productivity. In addition, during 2007 management announced its intention to sell 34 full-service First Horizon Bank branches in its national banking markets. These sales were completed in second quarter 2008. In the second half of 2007, FHN also took actions to right size First Horizon Home Loans’ mortgage banking operations and to downsize FHN’s national lending operations, in order to redeploy capital to higher-return businesses. As part of its strategy to reduce its national real estate portfolio, FHN announced in January 2008 that it was discontinuing national homebuilder and commercial real estate lending through its First Horizon Construction Lending offices. Additionally, FHN initiated the repositioning of First Horizon Home Loans’ mortgage banking operations, which included sales of MSR in fourth quarter 2007 and the first and second quarters of 2008.
In June 2008, FHN announced that it had reached a definitive agreement with MetLife for the sale of more than 230 retail and wholesale mortgage origination offices nationwide as well as its loan origination and servicing platform. FHN also agreed with MetLife for the sale of servicing assets, and related hedges, on approximately $20 billion of first lien mortgage loans and related custodial deposits. The transaction is expected to close in third quarter 2008. MetLife will pay book value for the assets and liabilities it is acquiring, subject to an adjustment of up to $10.0 million.
Net costs recognized by FHN in the six months ended June 30, 2008, related to restructuring, repositioning, and efficiency activities were $47.2 million compared to $39.3 million for the first half of 2007. Included in noninterest income are $12.0 million of transaction costs related to contracted loan servicing sales and $1.4 million of losses related to First Horizon Bank branch sales. All other costs incurred in relation to the restructuring, repositioning, and efficiency initiatives implemented by management are included in noninterest expense. All costs associated with FHN’s restructuring, repositioning, and efficiency initiatives are recorded as unallocated corporate charges within the Corporate segment. Significant expenses for year to date 2008 resulted from the following actions:
| · | Expense of $25.5 million associated with organizational and compensation changes due to right sizing operating segments, the divestiture of certain First Horizon Bank branches, the pending divestiture of certain mortgage banking operations and consolidating functional areas. |
| · | Losses of approximately $1.4 million from the sales of certain First Horizon Bank branches. |
| · | Transaction costs of $12.0 million from the contracted sales of mortgage servicing rights. |
| · | Expense of $8.3 million for the write-down of certain intangibles and other assets resulting from FHN’s divestiture of certain mortgage operations and from the change in FHN’s national banking strategy |
Settlement of the obligations arising from current initiatives will be funded from operating cash flows. The effect of suspending depreciation on assets held for sale was immaterial to FHN’s results of operations for all periods. As a result of the change in FHN’s national banking strategy, a write-down of other intangibles of $2.4 million was recognized in first quarter 2008 related to certain banking licenses. As part of the agreement to sell certain mortgage banking assets, an impairment of $1.7 million was recognized in second quarter 2008 related to noncompete agreements. The recognition of these impairment losses will have no effect on FHN’s debt covenants. The impairment loss related to such intangible assets has been recorded as an unallocated corporate charge within the Corporate segment and is included in all other expense on the Consolidated Condensed Statements of Income. As a result of the restructuring, repositioning, and efficiency initiatives implemented to date by management, the effects of $175 million in aggregate annual pre-tax improvements are being experienced by FHN beginning in its first quarter 2008 run-rate. An additional $70 million in annual profitability improvements is anticipated to be experienced by the end of 2008 in relation to the First Horizon Bank branch divestitures and the restructuring of mortgage operations and national lending operations. Due to the broad nature of the actions being taken, all components of income and expense will be affected. Additional amounts will be recognized in 2008 in relation to the conclusion of the mortgage banking divestiture as well as the discontinuance of national construction lending. At this time, the amount of these additional charges is expected to be between $35 and $50 million.
Charges related to restructuring, repositioning, and efficiency initiatives for the three and six month periods ended June 30, 2008, and 2007 are presented in the following table based on the income statement line item affected. See Note 12 – Restructuring, Repositioning, and Efficiency Charges and Note 2 – Acquisitions/Divestitures for additional information.
Table 1 - Charges for Restructuring, Repositioning, and Efficiency Initiatives
| | | Three Months Ended | | | Six Months Ended | | | Three and Six Months | |
| | | June 30 | | | June 30 | | | Ended June 30 | |
| (Dollars in thousands) | | 2008 | | | 2008 | | | 2007 | |
| Noninterest income: | | | | | | | | | |
| Mortgage banking | | $ | (9,344 | ) | | $ | (12,011 | ) | | $ | - | |
| Losses on divestitures | | | (429 | ) | | | (1,424 | ) | | | - | |
| Total noninterest income | | | (9,773 | ) | | | (13,435 | ) | | | - | |
| Provision for loan losses | | | - | | | | - | | | | 7,672 | |
| Noninterest expense: | | | | | | | | | | | | |
| Employee compensation, incentives and benefits | | | 5,729 | | | | 13,141 | | | | 7,997 | |
| Occupancy | | | 3,338 | | | | 4,319 | | | | 3,726 | |
| Equipment rentals, depreciation and maintenance | | | 4,181 | | | | 4,264 | | | | 5,221 | |
| Operations services | | | 2 | | | | 2 | | | | - | |
| Communications and courier | | | 36 | | | | 42 | | | | - | |
| All other expense | | | 2,897 | | | | 12,039 | | | | 14,702 | |
| Total noninterest expense | | | 16,183 | | | | 33,807 | | | | 31,646 | |
| Loss before income taxes | | $ | (25,956 | ) | | $ | (47,242 | ) | | $ | (39,318 | ) |
Activity in the restructuring and repositioning liability for the six months ended June 30, 2008 is presented in the following table:
| (Dollars in thousands) | | | | | Liability | |
| Beginning Balance | | | | | $ | 19,675 | |
| Severance and other employee related costs | | | | | | 13,122 | |
| Facility consolidation costs | | | | | | 3,854 | |
| Other exit costs, professional fees and other | | | | | | 8,484 | |
| Total Accrued | | | | | | 45,135 | |
| Payments* | | | | | | 24,004 | |
| Accrual Reversals | | | | | | 3,186 | |
| Restructuring and Repositioning Reserve Balance | | | | | $ | 17,945 | |
| | | | | | | | |
| * Includes payments related to: | | Six Months Ended | | | | | |
| | | June 30, 2008 | | | | | |
| Severance and other employee related costs | | $ | 10,893 | | | | | |
| Facility consolidation costs | | | 3,901 | | | | | |
| Other exit costs, professional fees and other | | | 9,210 | | | | | |
| | | $ | 24,004 | | | | | |
INCOME STATEMENT
Total revenues (net interest income and noninterest income) were $637.9 million in second quarter 2008 compared to $519.8 million in 2007. Net interest income was $238.9 million in second quarter 2008 compared to $239.4 million in 2007 and noninterest income was $399.0 million in 2008 compared to $280.3 million in 2007. A discussion of the major line items follows.
NET INTEREST INCOME
Net interest income remained flat at $238.9 million in second quarter 2008 compared to $239.4 million in second quarter 2007. Earning assets declined 7.3 percent to $31.8 billion and interest-bearing liabilities declined 8.1 percent to $32.1 billion in second quarter 2008.
The activity levels and related funding for FHN’s mortgage production and servicing and capital markets activities affect the net interest margin. These activities typically produce different margins than traditional banking activities. Mortgage production and servicing activities can affect the overall margin based on a number of factors, including the shape of the yield curve, the size of the mortgage warehouse, the time it takes to deliver loans into the secondary market, the amount of custodial balances, and the level of MSR. Capital markets activities tend to compress the margin because of its strategy to reduce market risk by economically hedging a portion of its inventory on the balance sheet. As a result of these impacts, FHN’s consolidated margin cannot be readily compared to that of other bank holding companies.
The consolidated net interest margin was 3.01 percent for second quarter 2008 compared to 2.79 percent for second quarter 2007. The increased margin occurred as the net interest spread widened to 2.66 percent from 2.13 percent in 2007 while the impact of free funding decreased from 66 basis points to 35 basis points. The improvement in net interest margin primarily resulted from the decline in earning assets.
Table 2 - Net Interest Margin
| | | Three Months Ended | |
| | | June 30 | |
| | | 2008 | | | 2007 | |
| Consolidated yields and rates: | | | | | | |
| Loans, net of unearned income | | | 5.29 | % | | | 7.43 | % |
| Loans held for sale | | | 5.70 | | | | 6.45 | |
| Investment securities | | | 5.27 | | | | 5.55 | |
| Capital markets securities inventory | | | 4.45 | | | | 5.35 | |
| Mortgage banking trading securities | | | 12.48 | | | | 12.13 | |
| Other earning assets | | | 1.98 | | | | 5.04 | |
| Yields on earning assets | | | 5.24 | | | | 6.94 | |
| Interest-bearing core deposits | | | 2.21 | | | | 3.39 | |
| Certificates of deposits $100,000 and more | | | 3.45 | | | | 5.36 | |
| Federal funds purchased and securities sold under agreements to repurchase | | | 1.88 | | | | 4.99 | |
| Capital markets trading liabilities | | | 4.92 | | | | 5.43 | |
| Commercial paper and other short-term borrowings | | | 2.30 | | | | 5.14 | |
| Long-term debt | | | 3.17 | | | | 5.68 | |
| Rates paid on interest-bearing liabilities | | | 2.58 | | | | 4.81 | |
| Net interest spread | | | 2.66 | | | | 2.13 | |
| Effect of interest-free sources | | | .35 | | | | .66 | |
| FHN - NIM | | | 3.01 | % | | | 2.79 | % |
Prospectively, net interest margin should be positively influenced by the reduction of lower margin business assets and the core bank’s asset-sensitivity position heading into a likely rising short-term rate environment.
NONINTEREST INCOME
Mortgage Banking Noninterest Income
First Horizon Home Loans, a division of FHN, offers residential mortgage banking products and services to customers, which consist primarily of the origination or purchase of single-family residential mortgage loans. First Horizon Home Loans originates mortgage loans through its retail and wholesale operations for sale to secondary market investors and subsequently provides servicing for the majority of those loans.
Prior to adoption of new accounting standards in the first quarter 2008, origination income included origination fees, net of costs, gains/(losses) recognized on loans sold including the capitalized fair value of MSR, and the value recognized on loans in process including results from hedging. Origination fees, net of costs (including incentives and other direct costs), were deferred and included in the basis of the loans in calculating gains and losses upon sale. Gain or loss was recognized due to changes in fair value of an interest rate lock commitment made to the customer. Gains or losses from the sale of loans were recognized at the time a mortgage loan was sold into the secondary market. See Critical Accounting Policies and Note 1 – Financial Information for more discussion of the effects of adopting the new accounting standards.
Upon adoption of the new accounting standards, origination income includes origination fees, gains/(losses) recognized on loans sold including the capitalized fair value of MSR, and the value recognized on loans in process including results from hedging. Upon election of fair value accounting for substantially all warehouse loans, the value recognized on these loans includes changes in investor prices, MSR and concessions. The related origination fees are no longer deferred but recognized in origination income upon closing of a loan.
Origination income increased to $134.1 million in second quarter 2008 compared to $67.2 million last year as loans delivered into the secondary market were consistent with that of second quarter of 2007 of $7.2 billion. Margin on deliveries increased from 76 basis points in second quarter 2007 to 125 basis points in 2008 largely due to government loans constituting a much higher portion of deliveries and the effects of favorable rate moves at the end of the second quarter. The adoption of accounting standards positively impacted second quarter 2008 by $39.0 million.
Servicing income includes servicing fees, changes in the fair value of the MSR asset and net gains or losses from hedging MSR. First Horizon Home Loans employs hedging strategies intended to counter changes in the value of MSR and other retained interests due to changing interest rate environments (refer to discussion of MSR under Critical Accounting Policies). Net servicing income increased to $42.6 million in the second quarter 2008 from a loss of $3.5 million in 2007.
Servicing hedging activities and changes other than runoff in the value of capitalized servicing assets positively impacted net revenues by $16.5 million this quarter as compared to a negative impact of $14.7 million in second quarter 2007, due to Federal Reserve rate decreases and a steeper yield curve in 2008. Additionally, the change in MSR value due to runoff was $37.1 million in second quarter 2008 compared to $62.7 million last year as the value of MSR that prepaid this quarter was less valuable than a year ago and loans prepaid at a slower rate.
Other income includes FHN’s share of earnings from nonconsolidated subsidiaries accounted for under the equity method, which provide ancillary activities to mortgage banking, and fees from retail construction lending.
Table 3 - Mortgage Banking Noninterest Income
| | Three Months Ended | Percent | Six Months Ended | Percent |
| | June 30 | Change | June 30 | Change |
| | 2008 | 2007 | (%) | 2008 | 2007 | (%) |
Noninterest income (thousands): | | | | | | |
| Origination income | $ 134,095 | $ 67,281 | 99.3 + | $ 218,151 | $ 130,922 | 66.6 + |
| Servicing income | 42,614 | (3,496) | NM | 111,957 | (488) | NM |
| Other | (4,291) | 7,515 | NM | 1,022 | 13,963 | 92.7 - |
| Total mortgage banking noninterest income | $ 172,418 | $ 71,300 | 141.8 + | $ 331,130 | $ 144,397 | 129.3 + |
Mortgage banking statistics (millions): | | | | | | |
| Refinance originations | $ 3,292.3 | $ 3,038.0 | 8.4 + | $ 8,068.8 | $ 5,842.7 | 38.1 + |
| Home-purchase originations | 3,533.5 | 5,054.4 | 30.1 - | 6,266.5 | 8,552.1 | 26.7 - |
| Mortgage loan originations | $ 6,825.8 | $ 8,092.4 | 15.7 - | $14,335.3 | $ 14,394.8 | .4 - |
| Servicing portfolio - owned | $98,384.2 | $105,652.0 | 6.9 - | $98,384.2 | $105,652.0 | 6.9 - |
Capital Markets Noninterest Income
Capital markets noninterest income, the major component of revenue in the Capital Markets segment, is generated from the purchase and sale of securities as both principal and agent, and from other fee sources including structured finance, equity research, investment banking, loans sales, correspondent banking and portfolio advisory activities. Inventory positions are limited to the procurement of securities solely for distribution to customers by the sales staff. A portion of the inventory is hedged to protect against movements in fair value due to changes in interest rates.
Revenues from fixed income sales increased $56.7 million compared to second quarter 2007 reflecting the effects of a steeper yield curve resulting from the Federal Reserve’s aggressive rate cuts during the first half of 2008 and the associated positive impact on the demand for fixed income products. Revenues from other products decreased $19.5 million in comparison to second quarter 2007. This decrease is primarily attributable
to the effect of credit market disruptions on the pooled trust preferred product for which no transaction revenues were recorded in the second quarter 2008.
Table 4 - Capital Markets Noninterest Income
| | Three Months Ended | | Six Months Ended | |
| | June 30 | Growth | June 30 | Growth |
| (Dollars in thousands) | 2008 | 2007 | Rate (%) | 2008 | 2007 | Rate (%) |
| Noninterest income: | | | | | | |
| Fixed income | $105,002 | $48,258 | 117.6 + | $257,210 | $ 94,571 | 172.0 + |
| Other product revenue | 17,336 | 36,796 | 52.9 - | (3,415) | 77,596 | NM |
| Total capital markets noninterest income | $122,338 | $85,054 | 43.8 + | $253,795 | $172,167 | 47.4 + |
Other Noninterest Income
Other noninterest income includes deposit transactions and cash management fees, revenue from loan sales and securitizations, insurance commissions, trust services and investment management fees, net securities gains and losses and other noninterest income. Deposit transactions and cash management fees increased $3.7 million or 8.6 percent, reflecting growth in demand deposits and pricing initiatives. Revenue from loan sales and securitizations decreased $16.6 million due to decreased value of residuals from prior securitizations and the effects of credit market disruptions as the market for consumer loans disappeared in the latter half of 2007. Trust services and investment management income dropped 16.4 percent or $1.7 million due to market conditions and a change in product mix. Insurance commissions decreased 11.1 percent or $.9 million from $7.7 million in 2007 primarily due to a soft property and casualty market. Other revenues related to deferred compensation plans decreased $6.3 million in comparison to second quarter 2007, which is offset by a related decrease in noninterest expense associated with these plans.
NONINTEREST EXPENSE
Total noninterest expense for second quarter 2008 increased 2 percent to $465.8 million from $457.2 million in 2007. This increase includes a $46.2 million effect of no longer deferring origination costs on warehouse loans accounted for at elected fair value in second quarter 2008. This amount is offset by a corresponding increase in mortgage banking noninterest income. Additionally, results for second quarter 2008 include $26.0 million of charges associated with implementation of restructuring, repositioning and efficiency initiatives compared to $39.3 million in 2007. See discussion of the restructuring, repositioning and efficiency initiatives below for further details.
Employee compensation, incentives and benefits (personnel expense), the largest component of noninterest expense, increased to $277.1 million from $258.2 million in 2007 reflecting the effects of no longer deferring compensation directly attributable to the origination of mortgage loans accounted for at elected fair value and increased production levels in capital markets. Partially offsetting these amounts is the effects of FHN’s efficiency initiatives as headcount and production was significantly reduced in comparison to second quarter 2007.
Also included in noninterest expense was a decrease of $7.5 million compared to second quarter 2007 related to deferred compensation plans for which, as discussed above, there was a related decrease in revenue. Other noninterest expense increased by 4.7 percent as increases related to FDIC premiums, the recognition of origination costs for loans recognized at fair value, and expenses related to foreclosed property, were partially offset by $8.4 million of costs incurred in 2007 to settle a legal matter and general declines in 2008 due to benefits from the implementation of efficiency initiatives.
INCOME TAXES
The effective tax rate for second quarter 2008 was predominantly due to the effect of permanent items and the level of pre-tax income for the quarter. The provision for income taxes includes $10.5 million of favorable permanent differences. The favorable permanent differences include $8.0 million of benefits from affordable housing credits and increases in life insurance cash surrender values. It also includes another $2.0 million of benefits from the favorable resolution of outstanding tax issues including interest with taxing authorities.
PROVISION FOR LOAN LOSSES / ASSET QUALITY
The provision for loan losses is the charge to earnings that management determines to be necessary to maintain the allowance for loan losses at an adequate level reflecting management’s estimate of probable incurred losses in the loan portfolio. Analytical models based on loss experience adjusted for current events, trends and economic conditions are used by management to determine the amount of provision to be recognized and to assess the adequacy of the loan loss allowance. In response to economic conditions, in 2008 and fourth quarter 2007, FHN conducted focused portfolio management activities to identify problem credits and to ensure appropriate provisioning and reserve levels. See Critical Accounting Policies for additional discussion of these procedures. The provision for loan losses was $220.0 million in second quarter 2008 compared to $44.4 million in second quarter 2007. The provision for loan losses increased $175.6 million, reflecting recognition of portfolio stress due to declining economic conditions, especially in home equity loans, OTC loans and commercial loans. The net charge-off ratio increased to 235 basis points in second quarter 2008 from 41 basis points in second quarter 2007 as net charge-offs grew to $127.7 million from $23.0 million, driven by problem loans primarily in the national construction portfolios and an increase in problem loans in the home equity portfolio.
Table 5 - Net Charge-off Ratios *
| | | Three Months Ended | |
| | | June 30 | |
| | | 2008 | | | 2007 | |
| Total commercial | | �� | 1.73 | % | | | .32 | % |
| Retail real estate | | | 2.94 | | | | .43 | |
| Other retail | | | 4.19 | | | | 2.76 | |
| Credit card receivables | | | 5.63 | | | | 3.16 | |
| Total net charge-offs | | | 2.35 | | | | .41 | |
*Net charge-off ratios are calculated based on average loans, net of unearned income.
Table 7 provides information on the relative size of each loan portfolio.
Nonperforming loans in the loan portfolio were $760.1 million on June 30, 2008, compared to $128.0 million on June 30, 2007. The ratio of nonperforming loans in the loan portfolio to total loans was 342 basis points on June 30, 2008, and 57 basis points on June 30, 2007. The increase in nonperforming loans is primarily attributable to deterioration in the one-time close and homebuilder/condominiums portfolios, due primarily to the slowdown in the housing market. Nonperforming one-time close loans (the Retail Real Estate Construction line on Table 7) increased to $268.1 million on June 30, 2008 from $56.1 million on June 30, 2007. Nonperforming homebuilder/condominiums loans increased to $297.7 million on June 30, 2008 from $42.1 million on June 30, 2007. These portfolios are included in the Commercial Real Estate Construction line of Table 7.
Nonperforming assets were $876.1 million on June 30, 2008, compared to $194.1 million on June 30, 2007. The nonperforming assets ratio was 388 basis points on June 30, 2008 and 81 basis points last year. In addition to the increase in nonperforming loans, foreclosed assets increased $52.5 million, which is primarily attributable to deterioration in the national construction portfolios. Foreclosed assets are recognized at net realizable value, including estimated costs of disposal, at foreclosure. The nonperforming asset ratio is expected to remain under pressure throughout the balance of the current economic downturn.
Table 6 - Asset Quality Information
| | | Second Quarter | |
| (Dollars in thousands) | | | 2008 | | | | 2007 | |
| Allowance for loan losses: | | | | | | |
| Beginning balance on March 31 | | $ | 483,203 | | | $ | 220,806 | |
| Provision for loan losses | | | 220,000 | | | | 44,408 | |
| Divestitures/acquisitions/transfers | | | (382 | ) | | | (12,326 | ) |
| Charge-offs | | | (131,385 | ) | | | (26,493 | ) |
| Recoveries | | | 3,713 | | | | 3,524 | |
| Ending balance on June 30 | | $ | 575,149 | | | $ | 229,919 | |
| Reserve for off-balance sheet commitments | | | 22,303 | | | | 10,494 | |
| Total allowance for loan losses and reserve for off-balance sheet commitments | | $ | 597,452 | | | $ | 240,413 | |
| | | | | | | | | |
| | | June 30 | |
| | | | 2008 | | | | 2007 | |
| Regional Banking: | | | | | | | | |
| Nonperforming loans | | $ | 115,264 | | | $ | 20,692 | |
| Foreclosed real estate | | | 37,594 | | | | 27,289 | |
| Total Regional Banking | | | 152,858 | | | | 47,981 | |
| Capital Markets: | | | | | | | | |
| Nonperforming loans | | | 41,527 | | | | 11,921 | |
| Foreclosed real estate | | | 600 | | | | 810 | |
| Total Capital Markets | | | 42,127 | | | | 12,731 | |
| National Specialty Lending: | | | | | | | | |
| Nonperforming loans | | | 582,523 | | | | 95,411 | |
| Foreclosed real estate | | | 45,384 | | | | 14,276 | |
| Total National Specialty Lending | | | 627,907 | | | | 109,687 | |
| Mortgage Banking: | | | | | | | | |
| Nonperforming loans - held for sale**** | | | 30,704 | | | | 12,484 | |
| Foreclosed real estate | | | 22,542 | | | | 11,214 | |
| Total Mortgage Banking | | | 53,246 | | | | 23,698 | |
| Total nonperforming assets | | $ | 876,138 | | | $ | 194,097 | |
| | | | | | | | | |
| Total loans, net of unearned income | | $ | 22,225,232 | | | $ | 22,382,303 | |
| Insured loans | | | (739,276 | ) | | | (986,893 | ) |
| Loans excluding insured loans | | $ | 21,485,956 | | | $ | 21,395,410 | |
| Foreclosed real estate from GNMA loans | | $ | 35,737 | | | $ | 13,910 | |
| Potential problem assets* | | | 655,610 | | | | 149,335 | |
| Loans 30 to 89 days past due | | | 346,556 | | | | 179,617 | |
| Loans 30 to 89 days past due - guaranteed portion** | | | 138 | | | | 50 | |
| Loans 90 days past due | | | 90,678 | | | | 34,462 | |
| Loans 90 days past due - guaranteed portion** | | | 188 | | | | 181 | |
| Loans held for sale 30 to 89 days past due | | | 53,666 | | | | 26,457 | |
| Loans held for sale 30 to 89 days past due - guaranteed portion** | | | 53,666 | | | | 19,755 | |
| Loans held for sale 90 days past due | | | 66,599 | | | | 136,565 | |
| Loans held for sale 90 days past due - guaranteed portion** | | | 64,508 | | | | 130,677 | |
| Off-balance sheet commitments*** | | $ | 6,444,427 | | | $ | 7,201,579 | |
| Allowance to total loans | | | 2.59 | % | | | 1.03 | % |
| Allowance to loans excluding insured loans | | | 2.68 | | | | 1.07 | |
| Nonperforming assets to loans and foreclosed real estate | | | 3.88 | | | | .81 | |
| Nonperforming assets to unpaid principal balance of servicing portfolio (Mortgage Banking) | | | .05 | | | | .02 | |
| Allowance to nonperforming loans in the loan portfolio | | | .76 | x | | | 1.80 | x |
| Allowance to annualized net charge-offs | | | 1.13 | x | | | 2.50 | x |
| * | Includes 90 days past due loans. |
| ** | Guaranteed loans include FHA, VA, student and GNMA loans repurchased through the GNMA repurchase program. |
| *** | Amount of off-balance sheet commitments for which a reserve has been provided. |
**** | 2Q 2008 includes $20,788 of loans held-to-maturity. |
Certain previously reported amounts have been reclassified to agree with current presentation.
Potential problem assets in the loan portfolio, which are not included in nonperforming assets, represent those assets where information about possible credit problems of borrowers has caused management to have serious doubts about the borrower’s ability to comply with present repayment terms. This definition is believed to be substantially consistent with the standards established by the Office of the Comptroller of the Currency for loans classified substandard. In total, potential problem assets were $655.6 million on June 30, 2008, up from $149.3 million on June 30, 2007. Also, loans 30 to 89 days past due increased to $346.6 million on June 30, 2008, up from $179.6 million on June 30, 2007. This significant increase was primarily driven by the slowdown in the housing market and its impact on national homebuilder and one-time close portfolios. The current expectation of losses from both potential problem assets and loans 30 to 89 days past due has been included in management’s analysis for assessing the adequacy of the allowance for loan losses.
Asset quality indicators could remain stressed in 2008 due to the expectation that the housing industry and broader economic conditions may continue to deteriorate. Actual results could differ because of several factors, including those presented in the Forward-Looking Statements section of this MD&A discussion.
STATEMENT OF CONDITION REVIEW
EARNING ASSETS
Earning assets consist of loans, loans held for sale, investment securities, trading securities and other earning assets. During second quarter 2008, earning assets decreased 7.3 percent and averaged $31.8 billion compared to $34.3 billion in second quarter 2007 as all earning asset groups showed declines.
LOANS
Average total loans decreased to $21.7 billion for second quarter 2008 compared to 22.3 billion in the second quarter 2007. This reflects the net effect of several events affecting the loan portfolio. Reductions in loans occurred from the sale of the First Horizon Bank branches and elevated charge off levels in the latter half of 2007 and in the first half of 2008. Further, originations in the national construction lending portfolios were discontinued in first quarter 2008 which resulted in additional declines as compared to second quarter 2007 as existing balances pay down or charge off. Offsetting these impacts were increases in the loan portfolio as certain consumer loans, certain permanent mortgages, and certain trust preferred loans were included in the portfolio in second quarter 2008 compared to these loans being considered as loans held for sale in second quarter 2007. Average loans represented 68 percent of average earning assets in second quarter 2008 and 65 percent in 2007. Commercial, financial and industrial loans remained relatively flat at $7.2 billion in comparison to $7.3 billion in the second quarter 2007. Commercial Real Estate increased by 11.2 percent from 2007 mainly due to growth in income property lending in the first half of 2008. Commercial construction loans decreased 15 percent or $437.8 million since second quarter 2007, primarily due to the effects of the wind-down for national homebuilder lending announced in first quarter 2008 as well as elevated charge offs recognized in fourth quarter 2007 and first half 2008 in this portfolio. On June 30, 2008, FHN did not have any concentrations of 10 percent or more of total loans in any single industry.
Total retail loans decreased 2.1 percent or $225.6 million reflecting a decline in one-time close loans that was primarily due to curtailment of National Construction lending and increased charge offs in late 2007 through second quarter 2008. Additional loan information is provided in Table 7 – Average Loans.
| | Three Months Ended |
| | | June 30 |
| | | | | | Percent | | | Growth | | | | | | Percent | |
| (Dollars in millions) | | 2008 | | | of Total | | | Rate | | | 2007 | | | of Total | |
| Commercial: | | | | | | | | | | | | | | | |
| Commercial, financial and industrial | | $ | 7,212.9 | | | | 33 | % | | | (1.1 | )% | | $ | 7,292.4 | | | | 33 | % |
| Real estate commercial (a) | | | 1,401.3 | | | | 7 | | | | 11.2 | | | | 1,260.2 | | | | 5 | |
| Real estate construction (b) | | | 2,481.7 | | | | 11 | | | | (15.0 | ) | | | 2,919.5 | | | | 13 | |
| Total commercial | | | 11,095.9 | | | | 51 | | | | (3.3 | ) | | | 11,472.1 | | | | 51 | |
| Retail: | | | | | | | | | | | | | | | | | | | | |
| Real estate residential (c) | | | 7,878.8 | | | | 36 | | | | .3 | | | | 7,854.8 | | | | 35 | |
| Real estate construction (d) | | | 1,666.0 | | | | 8 | | | | (20.5 | ) | | | 2,095.0 | | | | 9 | |
| Other retail | | | 138.2 | | | | 1 | | | | (7.9 | ) | | | 150.0 | | | | 1 | |
| Credit card receivables | | | 193.9 | | | | 1 | | | | (.4 | ) | | | 194.7 | | | | 1 | |
| Real estate loans pledged | | | | | | | | | | | | | | | | | | | | |
| against other collateralized borrowings (e) | | | 735.8 | | | | 3 | | | | 35.3 | | | | 543.8 | | | | 3 | |
| Total retail | | | 10,612.7 | | | | 49 | | | | (2.1 | ) | | | 10,838.3 | | | | 49 | |
| Total loans, net of unearned | | $ | 21,708.6 | | | | 100 | % | | | (2.7 | )% | | $ | 22,310.4 | | | | 100 | % |
| (a) Includes nonconstruction income property loans |
| (b) Includes homebuilder, condominium, and income property construction loans |
(c) Includes home equity loans and lines of credit (average for second quarter 2008 and 2007 - $3.7 billion and $4.1 billion, respectively) |
| (d) Includes one-time close product |
| (e) Includes on-balance sheet securitizations of home equity loans |
Total loans are expected to continue to decline throughout 2008 as held-to-maturity originations of the national home equity, one-time close and homebuilder lending products have been discontinued and overall loan demand is expected to be soft given the economic environment.
LOANS HELD FOR SALE / LOANS HELD FOR SALE – DIVESTITURE
Loans held for sale consist of first-lien mortgage loans (warehouse), HELOC, second-lien mortgages, student loans and small issuer trust preferred loans. The mortgage warehouse accounts for the majority of loans held for sale. Average loans held for sale decreased by 7.0 percent to $3.8 billion in second quarter 2008 from $4.1 billion in 2007. This change is primarily due to decreases in the warehouse as certain product types were curtailed in response to reduced demand in the secondary market. The average decrease of warehouse loans was partially offset by increases in loans held for sale associated with First Horizon bank branches. FHN continues to fund loan originations and maintain a stable liquidity position through loan sales and securitizations principally of first lien mortgage loans. In June 2008, approximately $330 million of permanent mortgage loans and $380 million of small issuer trust preferreds were transferred from held for sale to the loan portfolio. During second quarter 2008 loans held for sale – divestiture averaged $195.1 million.
TRADING ASSETS
Average trading assets decreased by 34 percent or $1.1 billion from second quarter 2007. This decline was primarily attributable to inventory management initiatives at Capital Markets.
DEPOSITS / OTHER SOURCES OF FUNDS
Core deposits declined slightly to $13.3 billion in second quarter 2008 compared to $13.6 billion in 2007, primarily reflecting disposition of the First Horizon Bank branches. Short-term purchased funds averaged $12.1 billion for second quarter 2008, down 18 percent or $2.7 billion from $14.9 billion in second quarter 2007. During the latter half of 2007 and first half of 2008, FHN has shifted wholesale borrowings from short-term certificates of deposit (CD) to less credit sensitive sources, including Federal Home Loan Bank advances and the Federal Reserve’s Term Auction Facility. In the second quarter 2008, short-term purchased funds accounted for 38 percent of FHN’s total funding down from 43 percent in second quarter 2007. Total funding is comprised of core deposits, purchased funds (including federal funds purchased, securities sold under agreements to repurchase, trading liabilities, certificates of deposit greater than $100,000, and short-term borrowings) and long-term debt. Long-term debt includes senior and subordinated borrowings, advances with original maturities greater than one year and other collateralized borrowings. Long-term debt averaged $6.7 billion in second quarter 2008 compared to $6.4 billion in second quarter 2007.
Financial Summary (Comparison of first six months of 2008 to first six months of 2007)
FHN recorded a net loss of $11.2 million or $.07 per diluted share for the six months ended June 30, 2008. Earnings were $92.7 million or $.72 per diluted share for the six months ended June 30, 2007. For the six months ended June 30, 2008, return on average shareholder’s equity and return on average assets were (.95) percent and (.06) percent respectively. Return on average shareholder’s equity and return on average assets were 7.55 percent and .48 percent for the six months ended June 30, 2007.
For the first six months of 2008, total revenues were $1.3 billion; an increase of 26.4 percent compared to $1.0 billion for the six months ended 2007. Noninterest income for the first six months of 2008 increased to $848.1 million from $563.5 million in 2007.
Mortgage Banking income was $331.1 million for the six months ended June 30, 2008 compared to $144.4 million for six months ended June 30, 2007 as 2008 included $135.9 million of favorable impact related to the adoption of the new accounting standards, including the prospective election of fair value accounting for mortgage warehouse loans.
Origination income increased to $218.2 million for the six months ended June 30, 2008, an increase from $130.9 million as first quarter of 2008 was favorably impacted by $135.9 million related to the adoption of accounting standards. Gain on sale margins were down from the first half of 2007, but were offset by increased volume of loans delivered into the secondary market. Servicing income increased as positive impacts from hedging results and changes in MSR due to run-off more than offset declines in servicing fees due to servicing sales occurring in the first half of 2008.
Capital Markets noninterest income increased by 47.4 percent to $253.8 million for the first half of 2008 from $172.2 million a year ago due to increased demand for fixed income securities resulting from a steeper yield curve in the first half of 2008. This increased production more than offset a decline in other revenues due to a LOCOM adjustment of $36.2 million in the first quarter 2008 and $45.1 million of revenue in the first half of 2007 related to pooled trust preferred loan sales.
Loan sale and securitization income decreased from $19.3 million for the six months ended June 30, 2007 to a loss of $11.1 million in 2008. Gain on second-lien and HELOC loan sales for the six months ended 2007 were $17.0 million while no sales were executed in the first half of 2008. Declines in residual values on prior securitizations of $9.4 million also negatively impacted loan sale and securitization income in 2008.�� Noninterest income was also impacted in the first six months of 2008 by securities gains of $65.9 million related to Visa Inc.’s initial public offering compared to less significant gains of $9.3 million related to shrinkage of investment portfolio in the first half of 2007.
Provision expense for loan losses increased by $387.1 million for the six months ended June 30, 2008, up from $72.9 million for the first half of 2007 as portfolio deterioration in the national construction lending, home equity, and commercial portfolios was recognized.
Noninterest expense increased to $904.1 million for the six months ended June 30, 2008 from $860.3 million from 2007 primarily driven by personnel expense. For the six months ended June 30 2008, personnel expense was $564.5 million compared to $504.5 million for the first half of 2007 as increases in capital market’s production, severance and retention costs related to restructuring, repositioning and efficiency initiatives and accelerated recognition of origination costs related to the prospective fair value election on substantially all of the mortgage warehouse loans more than offset declines in expense due to head count reductions.
Noninterest expense charges for restructuring, repositioning and efficiency initiatives (other than personnel related) were $20.7 million for the six months ended June 30, 2008 compared to $23.6 million during the first half of 2007. Other expenses decreased by 4.51 percent or $8.6 million for the six months ended June 30, 2008 compared to June 30, 2007. Other expenses was negatively impacted the first half of 2008 by increased FDIC premiums, recognition of origination costs for loans recognized at fair value, and expenses related to foreclosed property which were partially offset by a reversal of $30.0 million of the contingent liability for certain Visa legal matters and general declines from realization of benefits from efficiency initiatives. The first six months of 2007 were negatively impacted by an $8.4 million legal settlement.
Income taxes for the six months ended June 30, 2008 were positively impacted by state tax settlements while 2007 was positively impacted by a $7.5 million tax benefit due to legal consolidation of the mortgage company into the bank.
BUSINESS LINE REVIEW
Regional Banking
Total revenues for the six-month period were $420.6 million a decrease of 7.9 percent from $456.9 million in 2007. Net interest income decreased 12.9 percent or $35.6 million. Noninterest income of $179.6 million remained flat compared to $180.3 million in 2007. Increases in deposit transactions and cash management fees and foreclosure gains were offset by revenue declines in trust services, insurance commissions and annuity income. Provision expense for loan losses increased to $164.5 million in 2008 compared to $28.3 million in 2007. The increase was primarily due to deterioration in the home equity and commercial lending portfolios. Noninterest expense decreased to $300.8 million in 2008 compared to $317.7 million in 2007. The decline was primarily in personnel expense as efficiency initiatives were realized.
Capital Markets
Total revenues for 2008 increased to $296.7 million compared to $208.7 million for the first half of 2007. Net interest income was $38.1 million in 2008, an increase of 56.2 percent from 2007. The increase in net interest income is largely due to trading portfolio management activities in the second half of 2007, a steeper yield curve in 2008 and increases in the average trust preferred warehouse.
Fixed income revenue increased $162.6 million from 2007 to $257.2 million in 2008 as production increased due to the Federal Reserve rate cuts in the first half of 2008 creating a steeper yield curve. Other revenue declined $88.4 million primarily related to disruptions in the pooled trust preferred product in which no transactions were conducted in 2008 and a LOCOM adjustment of $36.2 million was recognized in the first quarter of 2008. Provision for loan losses was $33.5 million in 2008 compared to $4.8 million in 2007 reflecting deterioration in correspondent banking loans. Noninterest expense was $216.3 million, an increase of $49.2 million from $167.1 million in 2007. The increase is primarily driven by increased production in the first half of 2008.
National Specialty Lending
Total revenues for the six months ended June 30, 2008 were $94.0 million compared to $148.4 million in 2007. Net interest income was $107.9 million in 2008 compared to $124.0 million in 2007. The decline in net interest income is primarily due to increases in nonaccrual loans. Provision for loan losses increased to $257.7 million in 2008 compared to $32.2 million in 2007 reflecting the deterioration in the national construction and consumer lending portfolios.
Noninterest income was $(13.9) million for 2008 compared to $24.4 million in 2007. The decrease in noninterest income was partially due to declines in residual values from prior securitizations and increased costs related to estimated repurchase activity in 2008. Additionally, gains of approximately $16.8 million were recognized in 2007 related to loan sales which were not present in 2008. Noninterest expense declined to $51.8 million in 2008 compared to $73.4 million in 2007. The decline is related to the wind-down of this business segment initiated in the first quarter 2008.
Mortgage Banking
Total revenues for the six months ended June 30, 2008 were $420.4 million compared to $200.7 million in 2007. Net interest income was $61.9 million, an increase of 26.4 percent from 2007. The increase is consistent with the increase in the warehouse spread over 2007. Noninterest income was $358.5 million in 2008 compared to $151.7 million in 2007. Provision for loan losses was $4.2 million in 2008 compared to $(.1) million in 2007 reflecting deterioration of permanent mortgages in the portfolio.
Origination income increased 66.6 percent to $218.2 million for the six months ended June 30, 2008, an increase from $130.9 million as first half of 2008 was favorably impacted by $135.9 million related to the adoption of accounting standards. Gain on sale margins were down from the first half of 2007, but were offset by increased volume of loans delivered into the secondary market. Servicing income increased by $111.5 million to $111.9 million from negative $.5 million in 2007 as hedging results and changes in MSR due to run-off more than offset declines in servicing fees from decreases in the servicing portfolio.
Noninterest expense for 2008 was $296.6 million compared to $220.7 million for the six months ended June 30, 2007. Noninterest expense was negatively impacted by the recognition of $100.7 million of origination costs previously deferred due to adoption of fair value accounting for substantially all of the mortgage warehouse loans. These increased costs were offset in noninterest income by a corresponding increase in gain on sale. Noninterest expense was also negatively impacted by increased foreclosure and contract employment/outsourcing costs while legal settlement costs negatively impacted 2007 noninterest expense in 2007 by $8.4 million.
Corporate
Total revenues for the six months ended June 30, 2008 were $83.4 million compared to $25.8 million in 2007. Net interest income for 2008 was $18.1 million, a $15.2 million increase over 2007. The increase in net interest income was impacted by reduced funding due to net proceeds from the common stock issuance in the second quarter of 2008.
Noninterest income was $65.3 million in 2008 compared to $22.8 million in 2007. Noninterest income increases were primarily driven by $65.9 million of securities gains related to Visa Inc.’s initial public offering in 2008 compared to $9.3 million of securities gains in 2007 related to repositioning of the investment portfolio. Net charges related to restructuring were $47.2 million in 2008 compared to $39.3 million in 2007. Noninterest expense declined to $38.6 million in 2008 compared to $81.4 million in 2007. Increases in FDIC premiums in 2008 were more than offset by the reversal of $30.0 million of the contingent liability previously established for certain Visa legal matters.
CAPITAL
Management’s objectives are to provide capital sufficient to cover the risks inherent in FHN’s businesses, to maintain excess capital to well-capitalized standards and to assure ready access to the capital markets.
In the second quarter 2008, FHN completed a public offering of 69 million shares of common stock, which generated net proceeds of $659.8 million after consideration of underwriters’ discounts, commissions and offering costs. FHN then contributed $610.0 million of the proceeds from the offering to First Tennessee Bank, N.A. in the form of equity capital. To conserve FHN’s capital, in the second quarter FHN announced that the quarterly cash dividend will be replaced with a stock dividend, commencing October 1, 2008, while maintaining the quarterly dividend rate of $.20 per share. FHN currently intends to pay dividends in shares of common stock for the foreseeable future.
Average shareholders’ equity increased slightly by 2 percent in second quarter 2008 to $2.54 billion from $2.48 billion in 2007. Period-end shareholders’ equity was $2.7 billion on June 30, 2008, up 10 percent from the prior year. The increase is due to the common stock issuance in the second quarter of 2008. FHN’s board has authorized share repurchases from time to time. FHN will evaluate the level of capital and take action designed to generate or use capital as appropriate, for the interests of the shareholders. At the present time, consistent with the board’s determination to pay the quarterly dividend in shares, FHN intends to repurchase shares only in connection with employee stock programs to accommodate tax withholding and other similar needs.
Table 8 - Issuer Purchases of Equity Securities
| | | | | | | Total Number of | | Maximum Number |
| | | Total Number | | | | Shares Purchased | | of Shares that May |
| | | of Shares | | Average Price | | as Part of Publicly | | Yet Be Purchased |
| (Volume in thousands) | | Purchased | | Paid per Share | | Announced Programs | | Under the Programs |
| 2008 | | | | | | | | | | | | |
| April 1 to April 30 | | | 11 | | | $ | 11.67 | | | | 11 | | | | 36,313 | |
| May 1 to May 31 | | | * | | | | 11.20 | | | | * | | | | 36,313 | |
| June 1 to June 30 | | | 2 | | | | 9.67 | | | | 2 | | | | 36,311 | |
| Total | | | 13 | | | $ | 11.32 | | | | 13 | | | | | |
| * Amount is less than 500 shares |
| Compensation Plan Programs: |
| - | A consolidated compensation plan share purchase program was announced on August 6, 2004. This plan consolidated into a single share purchase program all of the previously authorized compensation plan share programs as well as the renewal of the authorization to purchase shares for use in connection with two compensation plans for which the share purchase authority had expired. The total number originally authorized under this consolidated compensation plan share purchase program is 25.1 million shares. On April 24, 2006, an increase to the authority under this purchase program of 4.5 million shares was announced for a new total authorization of 29.6 million shares. The shares may be purchased over the option exercise period of the various compensation plans on or before December 31, 2023. Stock options granted after January 2, 2004, must be exercised no later than the tenth anniversary of the grant date. On June 30, 2008, the maximum number of shares that may be purchased under the program was 28.8 million shares.
|
| Other Programs: |
| - | On October 16, 2007, the board of directors approved a 7.5 million share purchase authority that will expire on December 31, 2010. Purchases will be made in the open market or through privately negotiated transactions and will be subject to market conditions, accumulation of excess equity and prudent capital management. The new authority is not tied to any compensation plan, and replaces an older non-plan share purchase authority which was terminated. On June 30, 2008, the maximum number of shares that may be purchased under the program was 7.5 million shares. |
Banking regulators define minimum capital ratios for bank holding companies and their bank subsidiaries. Based on the capital rules and definitions prescribed by the banking regulators, should any depository institution’s capital ratios decline below predetermined levels, it would become subject to a series of increasingly restrictive regulatory actions. The system categorizes a depository institution’s capital position into one of five categories ranging from well-capitalized to critically under-capitalized. For an institution to qualify as well-capitalized, Tier 1 Capital, Total Capital and Leverage capital ratios must be at least 6 percent, 10 percent and 5 percent, respectively. As of June 30, 2008 and 2007, FHN and FTBNA had sufficient capital to qualify as well-capitalized institutions as shown in Note 6 – Regulatory Capital.
RISK MANAGEMENT
FHN has an enterprise-wide approach to risk governance, measurement, management, and reporting including an economic capital allocation process that is tied to risk profiles used to measure risk-adjusted returns. The Enterprise-wide Risk/Return Management Committee oversees risk management governance. Committee membership includes the CEO and other executive officers of FHN. The Executive Vice President (EVP) of Risk Management oversees reporting for the committee. Risk management objectives include evaluating risks inherent in business strategies, monitoring proper balance of risks and returns, and managing risks to minimize the probability of future negative outcomes. The Enterprise-wide Risk/Return Management Committee oversees and receives regular reports from the Credit Risk Management Committee, Asset/Liability Committee (ALCO), Capital Management Committee, Compliance Risk Committee, Operational Risk Committee, and the Executive Program Governance Forum. The Chief Credit Officer, EVP Funds Management and Corporate Treasurer, Chief Financial Officer, SVP Corporate Compliance, EVP of Risk Management, and EVP of Corporate Services chair these committees respectively. Reports regarding Credit, Asset/Liability Management, Market Risk, Capital Management, Compliance, and Operational Risks are provided to the Credit Policy and Executive and/or Audit Committee of the Board and to the full Board.
Risk management practices include key elements such as independent checks and balances, formal authority limits, policies and procedures, and portfolio management all executed through experienced personnel. The Internal Audit Department, Credit Risk Assurance, Credit Policy and Regulations, and Portfolio Management also evaluate risk management activities. These evaluations are reviewed with management and the Audit Committee, as appropriate.
MARKET UNCERTAINTIES AND PROSPECTIVE TRENDS
Given the significant current uncertainties that exist within the housing and credit markets, it is anticipated that the second half of 2008 will continue to be challenging for FHN. While the pending reduction of mortgage banking operations is expected to significantly decrease sensitivity to market pricing uncertainty, FHN will continue to be affected by market factors as it disposes of the remaining loan warehouse and attempts to reduce the remaining servicing portfolio. In addition, current volatility and reduced liquidity in the capital markets may adversely impact market execution putting continued pressure on revenues. As difficulties in the credit markets persist, FHN will continue to adapt its liquidity management strategies. Further deterioration of general economic conditions, or the housing market alone, could result in increased credit costs depending on the length and depth of this market cycle.
INTEREST RATE RISK MANAGEMENT
Interest rate risk is the risk that changes in prevailing interest rates will adversely affect assets, liabilities, capital, income and/or expense at different times or in different amounts. ALCO, a committee consisting of senior management that meets regularly, is responsible for coordinating the financial management of interest rate risk. FHN primarily manages interest rate risk by structuring the balance sheet to attempt to maintain the desired level of associated earnings while operating within prudent risk limits and thereby preserving the value of FHN’s capital.
Net interest income and the financial condition of FHN are affected by changes in the level of market interest rates as the repricing characteristics of loans and other assets do not necessarily match those of deposits, other borrowings and capital. To the extent that earning assets reprice more quickly than liabilities, this position should benefit net interest income in a rising interest rate environment and could negatively impact net interest income in a declining interest rate environment. In the case of floating rate assets and liabilities with similar repricing frequencies, FHN may also be exposed to basis risk, which results from changing spreads between earning and borrowing rates. Generally, when interest rates decline, Mortgage Banking faces increased prepayment risk associated with MSR.
In certain cases, derivative financial instruments are used to aid in managing the exposure of the balance sheet and related net interest income and noninterest income to changes in interest rates. As discussed in Critical Accounting Policies, derivative financial instruments are used by mortgage banking for two purposes. First, forward sales contracts and futures contracts are used to protect against changes in fair value of the pipeline and mortgage warehouse (refer to discussion of Pipeline and Warehouse under Critical Accounting Policies) from the time an interest rate is committed to the customer until the mortgage is sold into the secondary market due to increases in interest rates. Second, interest rate contracts are utilized to protect against MSR prepayment risk that generally accompanies declining interest rates. As interest rates fall, the value of MSR should decrease and the value of the servicing hedge should increase. The converse is also true.
Derivative instruments are also used to protect against the risk of loss arising from adverse changes in the fair value of capital markets’ securities inventory due to changes in interest rates. FHN does not use derivative instruments to protect against changes in fair value of loans or loans held for sale other than the mortgage pipeline, warehouse and certain small issuer trust preferred securities.
In addition to the balance sheet impacts, fee income and noninterest expense may be affected by actual changes in interest rates or expectations of changes. Mortgage banking revenue, which is generated from originating, selling and servicing residential mortgage loans, is highly sensitive to changes in interest rates due to the direct effect changes in interest rates have on loan demand. In general, low or declining interest rates typically lead to increased origination fees and profit from the sale of loans but potentially lower servicing-related income due to the impact of higher loan prepayments on the value of mortgage servicing assets. Conversely, high or rising interest rates typically reduce mortgage loan demand and hence income from originations and sales of loans while servicing-related income may rise due to lower prepayments. The earnings impact from originations and sales of loans on total earnings is more significant than servicing-related income. Net interest income earned on warehouse loans held for sale and on swaps and similar derivative instruments used to protect the value of MSR increases when the yield curve steepens and decreases when the yield curve flattens or inverts. In addition, a flattening or inverted yield curve negatively impacts the demand for fixed income securities and, therefore, Capital Markets’ revenue.
LIQUIDITY MANAGEMENT
ALCO focuses on being able to fund assets with liabilities of the appropriate duration, as well as the risk of not being able to meet unexpected cash needs. The objective of liquidity management is to ensure the continuous availability of funds to meet the demands of depositors, other creditors and borrowers, and the requirements of ongoing operations. This objective is met by maintaining liquid assets in the form of trading securities and securities available for sale, maintaining sufficient unused borrowing capacity in the national money markets, growing core deposits, and the repayment of loans and the capability to sell or securitize loans. ALCO is responsible for managing these needs by taking into account the
marketability of assets; the sources, stability and availability of funding; and the level of unfunded commitments. Subject to market conditions and compliance with applicable regulatory requirements from time to time, funds are available from a number of sources, including core deposits, the securities available for sale portfolio, the Federal Home Loan Bank (FHLB), the Federal Reserve Banks, access to capital markets through issuance of senior or subordinated bank notes and institutional certificates of deposit, availability to the overnight and term Federal Funds markets, dealer and commercial customer repurchase agreements, and through the sale or securitization of loans.
Core deposits are a significant source of funding and have been a stable source of liquidity for banks. The Federal Deposit Insurance Corporation insures these deposits to the extent authorized by law. For second quarter 2008 and 2007, the total loans, excluding loans held for sale and real estate loans pledged against other collateralized borrowings, to core deposits ratio was 158 percent and 160 percent, respectively. The ratio is expected to continue to decline as the national construction loan portfolios decrease. FHN periodically evaluates its liquidity position in conjunction with determining its ability and intent to hold loans for the foreseeable future.
FTBNA has a bank note program providing additional liquidity of $5.0 billion. This bank note program provides FTBNA with a facility under which it may continuously issue and offer short and medium-term unsecured notes. On June 30, 2008, $1.6 billion was available through the bank note program as a funding source subject to market conditions from time to time.
FHN and FTBNA have the ability to generate liquidity by incurring other debt subject to market conditions and compliance with applicable regulatory requirements from time to time. FHN evaluates alternative sources of funding, including loan sales, securitizations, syndications, and FHLB borrowings in its management of liquidity.
The Consolidated Condensed Statements of Cash Flows provide information on cash flows from operating, investing and financing activities for the six-month periods ended June 30, 2008 and 2007. For the six months ended June 30, 2008, net cash used in financing and investing activities exceeded positive cash flows from operating activities primarily due to a decline in wholesale deposits as FHN reduced its use of this more volatile funding source in response to the credit market disruptions that started in third quarter 2007. This was offset by positive cash flows of $.7 billion provided by the common stock issuance in the second quarter 2008. Impacting positive financing cash flows the first half of 2007 was an increase in deposits and long-term borrowings of $1.5 billion and $1.1 billion, respectively. Negative investing cash flows resulted from the decrease in cash related to First Horizon Bank branch sales. Cash provided by operating activities was positively impacted by decreases in trading securities and declines in loans held for sale due to a contracting warehouse. Operating cash flows in 2007 were negatively impacted by increases in the capital markets receivable and loans held for sale.
Parent company liquidity is maintained by cash flows stemming from dividends and interest payments collected from subsidiaries along with net proceeds from stock sales through employee plans, which represent the primary source of funds to pay dividends to shareholders and interest to debt holders. The amount paid to the parent company through FTBNA common dividends is managed as part of FHN’s overall cash management process, subject to applicable regulatory restrictions. The parent company also has the ability to enhance its liquidity position by raising equity or incurring debt subject to market conditions and compliance with applicable regulatory requirements from time to time.
Certain regulatory restrictions exist regarding the ability of FTBNA to transfer funds to FHN in the form of cash, common dividends, loans or advances. At any given time, the pertinent portions of those regulatory restrictions allow FTBNA to declare preferred or common dividends without prior regulatory approval in an amount equal to FTBNA’s retained net income for the two most recent completed years plus the current year to date. For any period, FTBNA’s ‘retained net income’ generally is equal to FTBNA’s regulatory net income reduced by the preferred and common dividends declared by FTBNA. One effect of this regulatory calculation method is that the amount available for preferred or common dividends by FTBNA without prior regulatory approval can change substantially at the beginning of each new fiscal year compared with the last day of the year just completed. However, due to the net retained loss experienced in 2007, during 2008, FTBNA’s excess dividends in the year 2007 may be applied against retained net income for the year 2005. Also, during 2009, FTBNA’s excess dividends in the year 2007 may be applied against the net retained net income for the years 2005 and 2006. Applying the applicable rules, FTBNA’s total amount available for dividends was ($74.0) million at December 31, 2007 and at January 1, 2008. Earnings (or losses) and dividends declared during 2008 will change the amount available during 2008 until December 31. As long as the dividends declared in 2008 do not exceed FTBNA’s net income in that year, the amount available for dividends at January 1, 2009 will be the same as that available at December 31, 2008.
FTBNA obtained approval from the OCC to declare and pay dividends on its preferred stock outstanding payable in April and July 2008, and recently requested similar approval for dividends on that class of stock payable in October 2008. FTBNA has not requested approval to pay common dividends to its sole common stockholder, FHN. Although FHN has funds available for dividends even without FTBNA dividends, availability of funds is not the sole factor considered by FHN’s Board in deciding whether or not to declare a dividend of any particular size; the Board also must consider FHN’s current and prospective capital, liquidity and other needs.
On April 27, 2008, FHN’s Board of Directors determined to cease paying cash dividends following the cash dividend of 20 cents per share payable on July 1, 2008. Instead, the Board intends to pay a dividend in shares of common stock with a value equal to the previous 20 cents per share cash dividend rate. The Board currently intends to reinstate a cash dividend at an appropriate and prudent level once earnings and other
conditions improve sufficiently, consistent with regulatory and other constraints. The Board anticipates that this policy will remain in effect for the foreseeable future.
OFF-BALANCE SHEET ARRANGEMENTS AND OTHER CONTRACTUAL OBLIGATIONS
First Horizon Home Loans originates conventional conforming and federally insured single-family residential mortgage loans. Likewise, FTN Financial Capital Assets Corporation purchases the same types of loans from customers. Substantially all of these mortgage loans are exchanged for securities, which are issued through investors, including government-sponsored enterprises (GSE), such as Government National Mortgage Association (GNMA) for federally insured loans and Federal National Mortgage Association (FNMA) and Federal Home Loan Mortgage Corporation (FHLMC) for conventional loans, and then sold in the secondary markets. Each of the GSE has specific guidelines and criteria for sellers and servicers of loans backing their respective securities. Many private investors are also active in the secondary market as issuers and investors. The risk of credit loss with regard to the principal amount of the loans sold is generally transferred to investors upon sale to the secondary market. To the extent that transferred loans are subsequently determined not to meet the agreed upon qualifications or criteria, the purchaser has the right to return those loans to FHN. In addition, certain mortgage loans are sold to investors with limited or full recourse in the event of mortgage foreclosure (refer to discussion of foreclosure reserves under Critical Accounting Policies). After sale, these loans are not reflected on the Consolidated Condensed Statements of Condition.
FHN’s use of government agencies as an efficient outlet for mortgage loan production is an essential source of liquidity for FHN and other participants in the housing industry. During second quarter 2008, approximately $6.9 billion of conventional and federally insured mortgage loans were securitized and sold by First Horizon Home Loans through these investors.
Historically, certain of FHN's originated loans, including non-conforming first-lien mortgages, second-lien mortgages and HELOC originated primarily through FTBNA, have not conformed to the requirements for sale or securitization through government agencies. FHN pooled and securitized these non-conforming loans in proprietary transactions. After securitization and sale, these loans are not reflected on the Consolidated Condensed Statements of Condition. These transactions, which were conducted through single-purpose business trusts, are an efficient way for FHN and other participants in the housing industry to monetize these assets. On June 30, 2008 and 2007, the outstanding principal amount of loans in these off-balance sheet business trusts was $23.6 billion and $25.7 billion, respectively. FHN has substantially reduced its origination of these loans in response to disruptions in the credit markets and did not execute a securitization of these loans in the first half of 2008. Given the historical significance of FHN's origination of non-conforming loans, the use of single-purpose business trusts to securitize these loans was an important source of liquidity to FHN. Future availability of this market will be subject to market conditions.
FHN has various other financial obligations, which may require future cash payments. Purchase obligations represent obligations under agreements to purchase goods or services that are enforceable and legally binding on FHN and that specify all significant terms, including fixed or minimum quantities to be purchased, fixed, minimum or variable price provisions, and the approximate timing of the transaction. In addition, FHN enters into commitments to extend credit to borrowers, including loan commitments, standby letters of credit, and commercial letters of credit. These commitments do not necessarily represent future cash requirements, in that these commitments often expire without being drawn upon.
MARKET RISK MANAGEMENT
Capital markets buys and sells various types of securities for its customers. When these securities settle on a delayed basis, they are considered forward contracts. Inventory positions are limited to the procurement of securities solely for distribution to customers by the sales staff, and ALCO policies and guidelines have been established with the objective of limiting the risk in managing this inventory.
CAPITAL MANAGEMENT
The capital management objectives of FHN are to provide capital sufficient to cover the risks inherent in FHN’s businesses, to maintain excess capital to well-capitalized standards and to assure ready access to the capital markets. Management has a Capital Management committee that is responsible for capital management oversight and provides a forum for addressing management issues related to capital adequacy. The committee reviews sources and uses of capital, key capital ratios, segment economic capital allocation methodologies, and other factors in monitoring and managing current capital levels, as well as potential future sources and uses of capital. The committee also recommends capital management policies, which are submitted for approval to the Enterprise-wide Risk/Return Management Committee and the Board.
OPERATIONAL RISK MANAGEMENT
Operational risk is the risk of loss from inadequate or failed internal processes, people, and systems or from external events. This risk is inherent in all businesses. Management, measurement and reporting of operational risk are overseen by the Operational Risk Committee, which is chaired by the EVP of Risk Management. Key representatives from the business segments, legal, shared services, risk management, and insurance are represented on the committee. Subcommittees manage and report on business continuity planning, information technology, data security, insurance, compliance, records management, product and system development, customer complaint, and reputation risks. Summary reports
of the committee’s activities and decisions are provided to the Enterprise-wide Risk/Return Management Committee. Emphasis is dedicated to refinement of processes and tools to aid in measuring and managing material operational risks and providing for a culture of awareness and accountability.
COMPLIANCE RISK MANAGEMENT
Compliance risk is the risk of legal or regulatory sanctions, material financial loss, or loss to reputation as a result of failure to comply with laws, regulations, rules, related self-regulatory organization standards, and codes of conduct applicable to banking activities. Management, measurement, and reporting of compliance risk are overseen by the Compliance Risk Committee, which is chaired by the EVP Risk Management. Key executives from the business segments, legal, risk management, and shared services are represented on the committee. Summary reports of the committee’s activities and decisions are provided to the Enterprise-wide Risk/Return Management Committee, and to the Audit Committee of the Board, as applicable. Reports include the status of regulatory activities, internal compliance program initiatives, and evaluation of emerging compliance risk areas.
CREDIT RISK MANAGEMENT
Credit risk is the risk of loss due to adverse changes in a borrower’s ability to meet its financial obligations under agreed upon terms. FHN is subject to credit risk in lending, trading, investing, liquidity/funding and asset management activities. The nature and amount of credit risk depends on the types of transactions, the structure of those transactions and the parties involved. In general, credit risk is incidental to trading, liquidity/funding and asset management activities, while it is central to the profit strategy in lending. As a result, the majority of credit risk is associated with lending activities.
FHN has processes and management committees in place that are designed to assess and monitor credit risks. These are subject to independent review by FHN’s Credit Risk Assurance Group, which encompasses both Credit Review and Credit Quality Control functions. The EVP of Credit Risk Assurance is appointed by and reports to the Credit Policy & Executive Committee of the Board. This group is charged with providing the Board and executive management with independent, objective, and timely assessments of FHN’s portfolio quality and credit risk management processes. The Asset Quality Committee has the responsibility of evaluating Management’s assessment of current asset quality for each lending product. In addition, the Asset Quality Committee evaluates the projected changes in classified loans, non-performing assets and charge-offs. A primary objective of this committee is to provide information about changing trends in asset quality by region or loan product, and to provide to senior management a current assessment of credit quality as part of the estimation process for determining the allowance for loan losses. The Credit Watch Committee has the primary responsibility of enforcing proper loan risk grading, identifying credit problems and monitoring actions to rehabilitate certain credits. Management also has a Credit Risk Management Committee that is responsible for enterprise-wide credit risk oversight and provides a forum for addressing management issues. The committee also recommends credit policies, which are submitted for approval to the Credit Policy and Executive Committee of the Board, and underwriting guidelines to manage the level and composition of credit risk in its loan portfolio and review performance relative to these policies. In addition, the Financial Counterparty Credit Committee, composed of senior managers, assesses the credit risk of financial counterparties and sets limits for exposure based upon the credit quality of the counterparty. FHN’s goal is to manage risk and price loan products based on risk management decisions and strategies. Management strives to identify potential problem loans and nonperforming loans early enough to correct the deficiencies. It is management’s objective that both charge-offs and asset write-downs are recorded promptly, based on management’s assessments of current collateral values and the borrower’s ability to repay.
FHN has a significant concentration of loans secured by residential real estate (52 percent of total loans) primarily in three portfolios. The retail real estate residential portfolio (36 percent of total loans) is comprised of primarily home equity lines and loans. While this portfolio is showing increased stress related to loss severities experienced due to the downturn in the housing market and economic conditions in general, it contains loans extended to strong borrowers with high credit scores and is geographically diversified.
The OTC portfolio (8 percent of total loans) has been negatively impacted by the downturn in the housing industry, certain discontinued product types, and the decreased availability of permanent mortgage financing. Portfolio performance issues are more acute in certain volatile markets.
The Residential CRE portfolio (8 percent of total loans) has also been negatively impacted by the housing industry downturn as liquidity has been severely stressed. Similar to the OTC portfolio, Residential CRE portfolio performance was driven by conditions in markets that have been significantly impacted by the downturn.
CRITICAL ACCOUNTING POLICIES
APPLICATION OF CRITICAL ACCOUNTING POLICIES AND ESTIMATES
FHN’s accounting policies are fundamental to understanding management’s discussion and analysis of results of operations and financial condition. The consolidated condensed financial statements of FHN are prepared in conformity with accounting principles generally accepted in the United States of America and follow general practices within the industries in which it operates. The preparation of the financial statements
requires management to make certain judgments and assumptions in determining accounting estimates. Accounting estimates are considered critical if (a) the estimate requires management to make assumptions about matters that were highly uncertain at the time the accounting estimate was made, and (b) different estimates reasonably could have been used in the current period, or changes in the accounting estimate are reasonably likely to occur from period to period, that would have a material impact on the presentation of FHN’s financial condition, changes in financial condition or results of operations.
It is management's practice to discuss critical accounting policies with the Board of Directors’ Audit Committee including the development, selection and disclosure of the critical accounting estimates. Management believes the following critical accounting policies are both important to the portrayal of the company’s financial condition and results of operations and require subjective or complex judgments. These judgments about critical accounting estimates are based on information available as of the date of the financial statements.
MORTGAGE SERVICING RIGHTS AND OTHER RELATED RETAINED INTERESTS
When FHN sells mortgage loans in the secondary market to investors, it generally retains the right to service the loans sold in exchange for a servicing fee that is collected over the life of the loan as the payments are received from the borrower. An amount is capitalized as MSR on the Consolidated Condensed Statements of Condition at current fair value. The changes in fair value of MSR are included as a component of Mortgage Banking – Noninterest Income on the Consolidated Condensed Statements of Income.
MSR Estimated Fair Value
In accordance with Statement of Financial Accounting Standards No. 156, “Accounting for Servicing of Financial Assets – an Amendment of FASB Statement No. 140,” FHN has elected fair value accounting for all classes of mortgage servicing rights. The fair value of MSR typically rises as market interest rates increase and declines as market interest rates decrease; however, the extent to which this occurs depends in part on (1) the magnitude of changes in market interest rates, and (2) the differential between the then current market interest rates for mortgage loans and the mortgage interest rates included in the mortgage-servicing portfolio.
Since sales of MSR tend to occur in private transactions and the precise terms and conditions of the sales are typically not readily available, there is a limited market to refer to in determining the fair value of MSR. As such, like other participants in the mortgage banking business, FHN relies primarily on a discounted cash flow model to estimate the fair value of its MSR. This model calculates estimated fair value of the MSR using predominant risk characteristics of MSR, such as interest rates, type of product (fixed vs. variable), age (new, seasoned, and moderate), agency type and other factors. FHN uses assumptions in the model that it believes are comparable to those used by other participants in the mortgage banking business and reviews estimated fair values and assumptions with third-party brokers and other service providers on a quarterly basis. FHN also compares its estimates of fair value and assumptions to recent market activity and against its own experience.
Estimating the cash flow components of net servicing income from the loan and the resultant fair value of the MSR requires FHN to make several critical assumptions based upon current market and loan production data.
Prepayment Speeds: Generally, when market interest rates decline and other factors favorable to prepayments occur there is a corresponding increase in prepayments as customers refinance existing mortgages under more favorable interest rate terms. When a mortgage loan is prepaid the anticipated cash flows associated with servicing that loan are terminated, resulting in a reduction of the fair value of the capitalized MSR. To the extent that actual borrower prepayments do not react as anticipated by the prepayment model (i.e., the historical data observed in the model does not correspond to actual market activity), it is possible that the prepayment model could fail to accurately predict mortgage prepayments and could result in significant earnings volatility. To estimate prepayment speeds, First Horizon Home Loans utilizes a third-party prepayment model, which is based upon statistically derived data linked to certain key principal indicators involving historical borrower prepayment activity associated with mortgage loans in the secondary market, current market interest rates and other factors, including First Horizon Home Loans’ own historical prepayment experience. For purposes of model valuation, estimates are made for each product type within the MSR portfolio on a monthly basis.
Table 9 - Mortgage Banking Prepayment Assumptions
| | | Three Months Ended | |
| | | June 30 | |
| | | 2008 | | | 2007 | |
| Prepayment speeds | | | | | | |
| Actual | | | 14.4 | % | | | 18.1 | % |
| Estimated* | | | 31.5 | | | | 16.1 | |
| * | Estimated prepayment speeds represent monthly average prepayment speed estimates for each of the periods presented. |
Discount Rate: Represents the rate at which expected cash flows are discounted to arrive at the net present value of servicing income. Discount rates will change with market conditions (i.e., supply vs. demand) and be reflective of the yields expected to be earned by market participants investing in MSR.
Cost to Service: Expected costs to service are estimated based upon the incremental costs that a market participant would use in evaluating the potential acquisition of MSR.
Float Income: Estimated float income is driven by expected float balances (principal, interest and escrow payments that are held pending remittance to the investor or other third party) and current market interest rates, including the thirty-day London Inter-Bank Offered Rate (LIBOR) and five-year swap interest rates, which are updated on a monthly basis for purposes of estimating the fair value of MSR.
First Horizon Home Loans engages in a process referred to as “price discovery” on a quarterly basis to assess the reasonableness of the estimated fair value of MSR. Price discovery is conducted through a process of obtaining the following information: (a) quarterly informal (and an annual formal) valuation of the servicing portfolio by prominent independent mortgage-servicing brokers, and (b) a collection of surveys and benchmarking data made available by independent third parties that include peer participants in the mortgage banking business. Although there is no single source of market information that can be relied upon to assess the fair value of MSR, First Horizon Home Loans reviews all information obtained during price discovery to determine whether the estimated fair value of MSR is reasonable when compared to market information. On June 30, 2008 and 2007, First Horizon Home Loans determined that its MSR valuations and assumptions were reasonable based on the price discovery process.
In second quarter 2008, agreements were reached for the transfer of certain servicing assets and delivery of the servicing assets occurred. However, due to certain recourse provisions, these transactions did not qualify for sale treatment and the associated proceeds have been recognized within commercial paper and other short term borrowings in the Consolidated Condensed Statement of Position as of June 30, 2008. Since servicing assets are recognized at fair value and since changes in the fair value of related financing liabilities will exactly mirror the change in fair value of the associated servicing assets, management elected to account for the financing liabilities at fair value under SFAS No. 159. Accordingly, the servicing assets are not hedged through the use of derivatives. The aggregate fair value of servicing assets and associated financing liabilities was $205.4 million at June 30, 2008.
The First Horizon Risk Management Committee (FHRMC) reviews the overall assessment of the estimated fair value of MSR monthly. The FHRMC is responsible for approving the critical assumptions used by management to determine the estimated fair value of First Horizon Home Loans’ MSR. In addition, FHN’s MSR Committee reviews the initial capitalization rates for newly originated MSR, the assessment of the fair value of MSR and the source of significant changes to the MSR carrying value each quarter.
Hedging the Fair Value of MSR
First Horizon Home Loans enters into financial agreements to hedge MSR in order to minimize the effects of loss in value of MSR associated with increased prepayment activity that generally results from declining interest rates. In a rising interest rate environment, the value of the MSR generally will increase while the value of the hedge instruments will decline. Specifically, First Horizon Home Loans enters into interest rate contracts (including swaps, swaptions and mortgage forward sales contracts) to hedge against the effects of changes in fair value of its MSR. Substantially all capitalized MSR are hedged. The hedges are economic hedges only, and are terminated and reestablished as needed to respond to changes in market conditions. Changes in the value of the hedges are recognized as a component of net servicing income in mortgage banking noninterest income. Successful economic hedging will help minimize earnings volatility that may result from carrying MSR at fair value. Fair values of the derivatives used to hedge MSR (and excess interest as discussed below) are obtained through price quotes received from third party broker-dealers in the derivative markets.
First Horizon Home Loans generally experiences increased loan origination and production in periods of low interest rates which result in the capitalization of new MSR associated with new production. This provides for a “natural hedge” in the mortgage-banking business cycle. New production and origination does not prevent First Horizon Home Loans from recognizing losses due to reduction in carrying value of existing servicing rights as a result of prepayments; rather, the new production volume results in loan origination fees and the capitalization of MSR as a component of realized gains related to the sale of such loans in the secondary market, thus the natural hedge, which tends to offset a portion of the reduction in MSR carrying value during a period of low interest rates. In a period of increased borrower prepayments, these losses can be significantly offset by a strong replenishment rate and strong net margins on new loan originations. To the extent that First Horizon Home Loans is unable to maintain a strong replenishment rate, or in the event that the net margin on new loan originations declines from historical experience, the value of the natural hedge may diminish, thereby significantly impacting the results of operations in a period of increased borrower prepayments.
First Horizon Home Loans does not specifically hedge the change in fair value of MSR attributed to other risks, including unanticipated prepayments (representing the difference between actual prepayment experience and estimated prepayments derived from the model, as described above), basis risk (meaning, the risk that changes in the benchmark interest rate may not correlate to changes in the mortgage market interest rate), discount rates, cost to service and other factors. To the extent that these other factors result in changes to the fair value of MSR, First Horizon Home Loans experiences volatility in current earnings due to the fact that these risks are not currently hedged.
Excess Interest (Interest-Only Strips) Fair Value – Residential Mortgage Loans
In certain cases, when First Horizon Home Loans sells mortgage loans in the secondary market, it retains an interest in the mortgage loans sold primarily through excess interest. These financial assets represent rights to receive earnings from serviced assets that exceed contractually specified servicing fees and are legally separable from the base servicing rights. Consistent with MSR, the fair value of excess
interest typically rises as market interest rates increase and declines as market interest rates decrease. Additionally, similar to MSR, the market for excess interest is limited, and the precise terms of transactions involving excess interest are not typically readily available. Accordingly, First Horizon Home Loans relies primarily on a discounted cash flow model to estimate the fair value of its excess interest.
Estimating the cash flow components and the resultant fair value of the excess interest requires First Horizon Home Loans to make certain critical assumptions based upon current market and loan production data. The primary critical assumptions used by First Horizon Home Loans to estimate the fair value of excess interest include prepayment speeds and discount rates, as discussed above. First Horizon Home Loans' excess interest is included as a component of trading securities on the Consolidated Condensed Statements of Condition, with realized and unrealized gains and losses included in current earnings as a component of mortgage banking income on the Consolidated Condensed Statements of Income.
Hedging the Fair Value of Excess Interest
First Horizon Home Loans utilizes derivatives (including swaps, swaptions and mortgage forward sales contracts) that change in value inversely to the movement of interest rates to protect the value of its excess interest as an economic hedge. Realized and unrealized gains and losses associated with the change in fair value of derivatives used in the economic hedge of excess interest are included in current earnings in mortgage banking noninterest income as a component of servicing income. Excess interest is included in trading securities with changes in fair value recognized currently in earnings in mortgage banking noninterest income as a component of servicing income.
The extent to which the change in fair value of excess interest is offset by the change in fair value of the derivatives used to hedge this asset depends primarily on the hedge coverage ratio maintained by First Horizon Home Loans. Also, as noted above, to the extent that actual borrower prepayments do not react as anticipated by the prepayment model (i.e., the historical data observed in the model does not correspond to actual market activity), it is possible that the prepayment model could fail to accurately predict mortgage prepayments, which could significantly impact First Horizon Home Loans’ ability to effectively hedge certain components of the change in fair value of excess interest and could result in significant earnings volatility.
Principal Only and Subordinated Bond Certificates
In some instances, FHN retains interests in the loans it securitizes by retaining certificated principal only strips or subordinated bonds. To determine the fair value of principal only strips, FHN uses the market prices from comparable assets such as publicly traded FNMA trust principal only strips that are adjusted to reflect the relative risk difference between readily marketable securities and privately issued securities. The fair value of subordinated bonds is determined using the best available market information, which may include trades of comparable securities, independently provided spreads to other marketable securities, and published market research. Where no market information is available, the company utilizes an internal valuation model. As of June 30, 2008, no market information was available, and the subordinated bonds were valued using an internal model which includes assumptions about timing, frequency and severity of loss, prepayment speeds of the underlying collateral, and the yield that a market participant would require. The assumptions were consistent with those embedded in the December 31, 2007 values, when there was more market information available, except that loss frequency and loss severity assumptions were worsened consistent with published industry cumulative historical loss information and published market projections of future deteriorations in real estate values. As of June 30, 2007, the subordinated bonds were valued using trades of comparable market securities and independently provided spreads. Both the principal only strips and the subordinated bonds are collateralized by prime or Alt-A jumbo loans which FHN originated and sold into private label securitizations, primarily in 2006 and 2007. FHN does not utilize derivatives to hedge against changes in the fair value of these certificates.
Residual-Interest Certificates Fair Value – HELOC and Second-lien Mortgages
In certain cases, when FHN sells HELOC or second-lien mortgages in the secondary market, it retains an interest in the loans sold primarily through a residual-interest certificate. Residual-interest certificates are financial assets which represent rights to receive earnings to the extent of excess income generated by the underlying loan collateral of certain mortgage-backed securities, which is not needed to meet contractual obligations of senior security holders. The fair value of a residual-interest certificate typically changes based on the differences between modeled prepayment speeds and credit losses and actual experience. Additionally, similar to MSR and interest-only certificates, the market for residual-interest certificates is limited, and the precise terms of transactions involving residual-interest certificates are not typically readily available. Accordingly, FHN relies primarily on a discounted cash flow model, which is prepared monthly, to estimate the fair value of its residual-interest certificates.
Estimating the cash flow components and the resultant fair value of the residual-interest certificates requires FHN to make certain critical assumptions based upon current market and loan production data. The primary critical assumptions used by FHN to estimate the fair value of residual-interest certificates include prepayment speeds, credit losses and discount rates, as discussed above. FHN’s residual-interest certificates are included as a component of trading securities on the Consolidated Condensed Statements of Condition, with realized and unrealized gains and losses included in current earnings as a component of other income on the Consolidated Condensed Statements of Income. FHN does not utilize derivatives to hedge against changes in the fair value of residual-interest certificates.
Sensitivity of MSR and Other Retained Interests
The sensitivity of the current fair value of all retained or purchased interests for MSR, net of offsetting fair value liabilities, to immediate 10 percent and 20 percent adverse changes in assumptions on June 30, 2008, are as follows:
Table 10 - Sensitivity of the Current Fair Value of All Retained or Purchased Interest for MSR
| (Dollars in thousands | | First | | | Second | | | | |
| except for annual cost to service) | | Liens | | | Liens | | | HELOC | |
| June 30, 2008 | | | | | | | | | |
| Fair value of retained interests | | $ | 1,111,204 | | | $ | 18,138 | | | $ | 10,053 | |
| Weighted average life (in years) | | | 5.7 | | | | 2.2 | | | | 2.1 | |
| | | | | | | | | | | | | |
| Annual prepayment rate | | | 14.7 | % | | | 34.7 | % | | | 37.0 | % |
| Impact on fair value of 10% adverse change | | $ | (41,670 | ) | | $ | (1,394 | ) | | $ | (736 | ) |
| Impact on fair value of 20% adverse change | | | (80,057 | ) | | | (2,649 | ) | | | (1,403 | ) |
| | | | | | | | | | | | | |
| Annual discount rate on servicing cash flows | | | 10.7 | % | | | 14.0 | % | | | 18.0 | % |
| Impact on fair value of 10% adverse change | | $ | (33,659 | ) | | $ | (451 | ) | | $ | (280 | ) |
| Impact on fair value of 20% adverse change | | | (64,948 | ) | | | (878 | ) | | | (544 | ) |
| | | | | | | | | | | | | |
| Annual cost to service (per loan)* | | $ | 52 | | | $ | 50 | | | $ | 50 | |
| Impact on fair value of 10% adverse change | | | (11,301 | ) | | | (373 | ) | | | (295 | ) |
| Impact on fair value of 20% adverse change | | | (22,603 | ) | | | (745 | ) | | | (590 | ) |
| | | | | | | | | | | | | |
| Annual earnings on escrow | | | 3.8 | % | | | 2.2 | % | | | 2.1 | % |
| Impact on fair value of 10% adverse change | | $ | (23,285 | ) | | $ | (326 | ) | | $ | (184 | ) |
| Impact on fair value of 20% adverse change | | | (46,570 | ) | | | (651 | ) | | | (367 | ) |
| * | The annual cost to service includes an incremental cost to service delinquent loans. Historically, this fair value sensitivity disclosure has not included this incremental cost. The annual cost to service first-lien mortgage loans without the incremental cost to service delinquent loans was $48 as of June 30, 2008. |
The sensitivity of the current fair value of retained interests for other residuals, net of offsetting fair value liabilities, to immediate 10 percent and 20 percent adverse changes in assumptions on June 30, 2008, are as follows:
Table 11 - Sensitivity of the Current Fair Value for Other Residuals
| | | | | | | | | | | Residual | | Residual |
| | | Excess | | | | | | | | Interest | | Interest |
| (Dollars in thousands | | Interest | | Certificated | | | | Subordinated | | Certificates | | Certificates |
| except for annual cost to service) | | IO | | PO | | IO | | Bonds | | 2nd Liens | | HELOC |
| June 30, 2008 | | | | | | | | | | | | | | | | | | |
| Fair value of retained interests | | $ | 375,999 | | | $ | 13,288 | | | $ | 296 | | | $ | 17,740 | | | $ | 3,937 | | | $ | 3,845 | |
| Weighted average life (in years) | | | 5.5 | | | | 4.3 | | | | 3.6 | | | | 8.7 | | | | 2.5 | | | | 2.2 | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Annual prepayment rate | | | 14.6 | % | | | 34.1 | % | | | 27.6 | % | | | 83.4 | % | | | 32.0 | % | | | 28.0 | % |
| Impact on fair value of 10% adverse change | | $ | (17,751 | ) | | $ | (612 | ) | | $ | (23 | ) | | $ | (548 | ) | | $ | (41 | ) | | $ | (385 | ) |
| Impact on fair value of 20% adverse change | | | (34,833 | ) | | | (1,282 | ) | | | (42 | ) | | | (1,067 | ) | | | (78 | ) | | | (711 | ) |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Annual discount rate on residual cash flows | | | 12.1 | % | | | 19.5 | % | | | 12.5 | % | | | 28.4 | % | | | 35.0 | % | | | 33.0 | % |
| Impact on fair value of 10% adverse change | | $ | (14,807 | ) | | $ | (510 | ) | | $ | (10 | ) | | $ | (1,055 | ) | | $ | (144 | ) | | $ | (401 | ) |
| Impact on fair value of 20% adverse change | | | (28,487 | ) | | | (979 | ) | | | (18 | ) | | | (1,945 | ) | | | (274 | ) | | | (742 | ) |
These sensitivities are hypothetical and should not be considered to be predictive of future performance. As the figures indicate, changes in fair value based on a 10 percent variation in assumptions generally cannot necessarily be extrapolated because the relationship of the change in assumption to the change in fair value may not be linear. Also, in this table, the effect of a variation in a particular assumption on the fair value of the retained interest is calculated independently from any change in another assumption. In reality, changes in one factor may result in changes in another, which might magnify or counteract the sensitivities. Furthermore, the estimated fair values as disclosed should not be considered indicative of future earnings on these assets.
PIPELINE AND WAREHOUSE
During the period of loan origination and prior to the sale of mortgage loans in the secondary market, First Horizon Home Loans has exposure to mortgage loans that are in the “mortgage pipeline” and the “mortgage warehouse”. The mortgage pipeline consists of loan applications that have been received, but have not yet closed as loans. Pipeline loans are either "floating" or "locked". A floating pipeline loan is one on which an interest
rate has not been locked by the borrower. A locked pipeline loan is one on which the potential borrower has set the interest rate for the loan by entering into an interest rate lock commitment. Once a mortgage loan is closed and funded, it is included within the mortgage warehouse, or the “inventory” of mortgage loans that are awaiting sale and delivery (at quarter end an average of approximately 37 days) into the secondary market.
Interest rate lock commitments are derivatives pursuant to SFAS 133 and are therefore recorded at estimates of fair value. Effective January 1, 2008, FHN applied the provisions of Staff Accounting Bulletin No. 109, “Written Loan Commitments Recorded at Fair Value Through Earnings” (SAB No. 109) prospectively for derivative loan commitments issued or modified after that date. SAB No. 109 requires inclusion of expected net future cash flows related to loan servicing activities in the fair value measurement of a written loan commitment. Also on January 1, 2008, FHN adopted Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (SFAS No. 157), which affected the valuation of interest rate lock commitments previously measured under the guidance of EITF 02-3, “Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management Activities”.
FHN adopted Statement of Financial Accounting Standards No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities - Including an Amendment of FASB Statement No. 115” (SFAS No. 159) on January 1, 2008. Prior to adoption of SFAS No. 159, all warehouse loans were carried at the lower of cost or market, where carrying value was adjusted for successful hedging under SFAS No. 133 and the comparison of carrying value to market was performed for aggregate loan pools. Upon adoption of SFAS No. 159, FHN elected to prospectively account for substantially all of its mortgage loan warehouse products at fair value upon origination and correspondingly discontinued the application of SFAS No. 133 hedging relationships for these new originations.
The fair value of interest rate lock commitments and the fair value of warehouse loans are impacted principally by changes in interest rates, but also by changes in borrower’s credit, and changes in profit margins required by investors for perceived risks (i.e., liquidity). First Horizon Home Loans does not hedge against credit and liquidity risk in the pipeline or warehouse. Third party models are used to manage the interest rate risk.
The fair value of loans whose principal market is the securitization market is based on recent security trade prices for similar product with a similar delivery date, with necessary pricing adjustments to convert the security price to a loan price. Loans whose principal market is the whole loan market are priced based on recent observable whole loan trade prices or published third party bid prices for similar product, with necessary pricing adjustments to reflect differences in loan characteristics. Typical adjustments to security prices for whole loan prices include adding the value of MSR to the security price or to the whole loan price if the price is servicing retained, adjusting for interest in excess of (or less than) the required coupon or note rate, adjustments to reflect differences in the characteristics of the loans being valued as compared to the collateral of the security or the loan characteristics in the benchmark whole loan trade, adding interest carry, reflecting the recourse obligation that will remain after sale, and adjusting for changes in market liquidity or interest rates if the benchmark security or loan price is not current. Additionally, loans that are delinquent or otherwise significantly aged are discounted to reflect the less marketable nature of these loans.
The fair value of First Horizon Home Loans’ warehouse (first-lien mortgage loans held for sale) changes with fluctuations in interest rates from the loan closing date through the date of sale of the loan into the secondary market. Typically, the fair value of the warehouse declines in value when interest rates increase and rises in value when interest rates decrease. To mitigate this risk, First Horizon Home Loans enters into forward sales contracts and futures contracts to provide an economic hedge against those changes in fair value on a significant portion of the warehouse. These derivatives are recorded at fair value with changes in fair value recorded in current earnings as a component of the gain or loss on the sale of loans in mortgage banking noninterest income.
Prior to the adoption of SFAS No. 159, to the extent that these interest rate derivatives were designated to hedge specific similar assets in the warehouse and prospective analyses indicate that high correlation is expected, the hedged loans were considered for hedge accounting under SFAS No. 133. Anticipated correlation was determined by projecting a dollar offset relationship for each tranche based on anticipated changes in the fair value of the hedged mortgage loans and the related derivatives, in response to various interest rate shock scenarios. Hedges were reset daily and the statistical correlation was calculated using these daily data points. Retrospective hedge effectiveness was measured using the regression results. First Horizon Home Loans generally maintained a coverage ratio (the ratio of expected change in the fair value of derivatives to expected change in the fair value of hedged assets) of approximately 100 percent on warehouse loans accounted for under SFAS No. 133.
Warehouse loans qualifying for SFAS No. 133 hedge accounting treatment totaled $2.6 billion on June 30, 2007. The balance sheet impacts of the related derivatives were net assets of $20.0 million on June 30, 2007. Net losses of $1.6 million representing the ineffective portion of these fair value hedges were recognized as a component of gain or loss on sale of loans for the six months ended June 30, 2007.
Interest rate lock commitments generally have a term of up to 60 days before the closing of the loan. During this period, the value of the lock changes with changes in interest rates. The interest rate lock commitment does not bind the potential borrower to entering into the loan, nor does it guarantee that First Horizon Home Loans will approve the potential borrower for the loan. Therefore, when determining fair value, First Horizon Home Loans makes estimates of expected "fallout” (locked pipeline loans not expected to close), using models, which consider cumulative historical fallout rates and other factors. Fallout can occur for a variety of reasons including falling rate environments when a borrower will abandon
an interest rate lock commitment at one lender and enter into a new lower interest rate lock commitment at another, when a borrower is not approved as an acceptable credit by the lender, or for a variety of other non-economic reasons. Changes in the fair value of interest rate lock commitments are recorded in current earnings as gain or loss on the sale of loans in mortgage banking noninterest income.
Because interest rate lock commitments are derivatives they do not qualify for hedge accounting treatment under SFAS 133. However, First Horizon Home Loans economically hedges the risk of changing interest rates by entering into forward sales and futures contracts. The extent to which First Horizon Home Loans is able to economically hedge changes in the mortgage pipeline depends largely on the hedge coverage ratio that is maintained relative to mortgage loans in the pipeline. The hedge coverage ratio can change significantly due to changes in market interest rates and the associated forward commitment prices for sales of mortgage loans in the secondary market. Increases or decreases in the hedge coverage ratio can result in significant earnings volatility to FHN.
For the period ended June 30, 2008, the valuation model utilized to estimate the fair value of loan applications locked prospectively from January 1, 2008, recognizes the full fair value of the ultimate loan adjusted for estimated fallout and estimated cost assumptions a market participant would use to convert the lock into a loan. The fair value of interest rate lock commitments was $12.5 million on June 30, 2008. For the period ended June 30, 2007, the valuation model utilized to estimate the fair value of interest rate lock commitments assumed a zero fair value on the date of the lock with the borrower. Subsequent to the lock date, the model calculated the change in value due solely to the change in interest rates and estimated fallout resulting in a net liability with an estimated fair value of $2.6 million on June 30, 2007.
FORECLOSURE RESERVES
As discussed above, First Horizon Home Loans typically originates mortgage loans with the intent to sell those loans to GSE and other private investors in the secondary market. Certain of the mortgage loans are sold with limited or full recourse in the event of foreclosure. On June 30, 2008 and 2007, the outstanding principal balance of mortgage loans sold with limited recourse arrangements where some portion of the principal is at risk and serviced by First Horizon Home Loans was $3.6 billion and $3.2 billion, respectively. Additionally, on June 30, 2008 and 2007, $1.8 billion and $4.8 billion, respectively, of mortgage loans were outstanding which were sold under limited recourse arrangements where the risk is limited to interest and servicing advances. On June 30, 2008 and 2007, $92.4 million and $110.5 million, respectively, of mortgage loans were outstanding which were serviced under full recourse arrangements.
Loans sold with limited recourse include loans sold under government guaranteed mortgage loan programs including the Federal Housing Administration (FHA) and Veterans Administration (VA). First Horizon Home Loans continues to absorb losses due to uncollected interest and foreclosure costs and/or limited risk of credit losses in the event of foreclosure of the mortgage loan sold. Generally, the amount of recourse liability in the event of foreclosure is determined based upon the respective government program and/or the sale or disposal of the foreclosed property collateralizing the mortgage loan. Another instance of limited recourse is the VA/No bid. In this case, the VA guarantee is limited and First Horizon Home Loans may be required to fund any deficiency in excess of the VA guarantee if the loan goes to foreclosure.
Loans sold with full recourse generally include mortgage loans sold to investors in the secondary market which are uninsurable under government guaranteed mortgage loan programs, due to issues associated with underwriting activities, documentation or other concerns.
Management closely monitors historical experience, borrower payment activity, current economic trends and other risk factors, and establishes a reserve for foreclosure losses for loans sold with limited recourse, loans serviced with full recourse, and loans sold with general representations and warranties, including early payment defaults. Management believes the foreclosure reserve is sufficient to cover incurred foreclosure losses relating to loans being serviced as well as loans sold where the servicing was not retained. The reserve for foreclosure losses is based upon a historical progression model using a rolling 12-month average, which predicts the probability or frequency of a mortgage loan entering foreclosure. In addition, other factors are considered, including qualitative and quantitative factors (e.g., current economic conditions, past collection experience, risk characteristics of the current portfolio and other factors), which are not defined by historical loss trends or severity of losses. On June 30, 2008 and 2007, the foreclosure reserve was $38.5 million and $14.6 million, respectively. Table 12 provides a summary of reserves for foreclosure losses for the periods ended June 30, 2008 and 2007. The servicing portfolio has decreased from $106.0 billion on June 30, 2007, to $102.7 billion on June 30, 2008 as FHN has reduced the portfolio through sales during the first half of 2008, while the foreclosure reserve has experienced increases primarily due to increases in both frequency and severity of projected losses.
Table 12 - Reserves for Foreclosure Losses
