N.M., not a meaningful value.

 

 12

TABLE OF CONTENTS

and Results of Operations

 

INTRODUCTION

 

Huntington Bancshares Incorporated (we or our) is a multi-state diversified financial holding company organized under Maryland law in 1966 and headquartered in Columbus, Ohio. Through our subsidiaries, including our bank subsidiary, The Huntington National Bank (the Bank), organized in 1866, we provide full-service commercial and consumer banking services, mortgage banking services, automobile financing, equipment leasing, investment management, trust services, brokerage services, customized insurance service programs, and other financial products and services. Our banking offices are located in Ohio, Michigan, Pennsylvania, Indiana, West Virginia, and Kentucky. Selected financial service activities are also conducted in other states including: Auto Finance and Dealer Services (AFDS) offices in Arizona, Florida, Tennessee, Texas, and Virginia; Private Financial, Capital Markets, and Insurance Group (PFCMIG) offices in Florida; and Mortgage Banking offices in Maryland and New Jersey. International banking services are available through the headquarters office in Columbus and a limited purpose office located in both the Cayman Islands and Hong Kong.

 

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) provides you with information we believe necessary for understanding our financial condition, changes in financial condition, results of operations, and cash flows and should be read in conjunction with the financial statements, notes, and other information contained in this report.

 

Our discussion is divided into key segments:

 

 

A reading of each section is important to understand fully the nature of our financial performance and prospects.

 

Forward-Looking Statements

 

This report, including MD&A, contains certain forward-looking statements, including certain plans, expectations, goals, projections, and statements, which are subject to numerous assumptions, risks, and uncertainties. Statements that do not describe historical or current facts, including statements about beliefs and expectations, are forward-looking statements. The forward-looking statements are intended to be subject to the safe harbor provided by Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934.

 

Actual results could differ materially from those contained or implied by such statements for a variety of factors including: (a) deterioration in the loan portfolio could be worse than expected due to a number of factors such as the underlying value of the collateral could prove less valuable than otherwise assumed and assumed cash flows may be worse than expected; (b) changes in economic conditions; (c) movements in interest rates and spreads; (d) competitive pressures on product pricing and services; (e) success and timing of other business strategies; (f) the nature, extent, and timing of governmental actions and reforms, including the rules of participation for the Trouble Asset Relief Program voluntary Capital Purchase Plan under the Emergency Economic Stabilization Act of 2008, which may be changed unilaterally and retroactively by legislative or regulatory actions; and (g) extended disruption of vital infrastructure. Additional factors that could cause results to differ materially from those described above can be found in Huntington’s 2008 Form 10-K.

 

All forward-looking statements speak only as of the date they are made and are based on information available at that time. We assume no obligation to update forward-looking statements to reflect circumstances or events that occur after the date the forward-looking statements were made or to reflect the occurrence of unanticipated events except as required by federal securities laws. As forward-looking statements involve significant risks and uncertainties, caution should be exercised against placing undue reliance on such statements.

 13

 

Risk Factors

 

We, like other financial companies, are subject to a number of risks that may adversely affect our financial condition or results of operation, many of which are outside of our direct control, though efforts are made to manage those risks while optimizing returns. Among the risks assumed are: (1) credit risk , which is the risk of loss due to loan and lease customers or other counterparties not being able to meet their financial obligations under agreed upon terms, (2) market risk , which is the risk of loss due to changes in the market value of assets and liabilities due to changes in market interest rates, foreign exchange rates, equity prices, and credit spreads, (3) liquidity risk , which is the risk of loss due to the possibility that funds may not be available to satisfy current or future obligations based on external macro market issues, investor and customer perception of financial strength, and events unrelated to the company such as war, terrorism, or financial institution market specific issues, and (4) operational risk , which is the risk of loss due to human error, inadequate or failed internal systems and controls, violations of, or noncompliance with, laws, rules, regulations, prescribed practices, or ethical standards, and external influences such as market conditions, fraudulent activities, disasters, and security risks.

 

Throughout 2008, we operated in what is now being labeled by many industry observers as the most difficult environment for financial institutions in many decades. What began as a subprime lending crises in 2007, turned into a widespread housing, banking, and capital markets crisis in 2008. As a result, 2008 represented a year of tremendous capital markets turmoil as capital markets ceased to function and credit markets were largely closed to businesses and consumers. The unavailability of credit to many borrowers and lack of credit flow, even between banks, contributed to the weakening of the economy, especially in the second half of 2008, and the 2008 fourth quarter in particular.

 

Concurrent with and reflecting this environment, the weakness that had been centered primarily in the housing and capital markets segments, spilled over into other segments of the economy. The most visible sector negatively impacted was manufacturing, and most notably, the automobile industry. As 2008 ended, it was estimated that the United States economy had lost 3.6 million jobs, with approximately 50% of those losses occurring in the fourth quarter. According to the United States Labor Department, nationwide unemployment at 2008 year-end was 7.6%.

 

While the United States government took several actions in 2008 and into 2009, such as the largest stimulus plan in United States’ history, and is considering even further actions, no assurances can be given regarding their effectiveness in strengthening the capital markets and improving the economy. Therefore, for the foreseeable future, we believe we will be operating in a heightened risk environment. Of the major risk factors, those most likely to affect us are credit risk, market risk, and liquidity risk.

 

As related to credit risk , we anticipate continued pressure on credit quality performance, including higher loan delinquencies, net charge-offs, and the level of nonaccrual loans. All loan portfolios are expected to be impacted, although we believe the impact will be more concentrated in our commercial loan portfolio. Until unemployment levels decline, and the economic outlook improves, we anticipate that we will continue to build our allowance for credit losses in both absolute and relative terms.

 

With regard to market risk , the continuation of volatile capital markets is likely to be reflected in wide fluctuations in the valuation of certain assets, most notably mortgage asset-backed investment securities. Such fluctuations may result in additional asset value write-downs and other-than-temporary impairment (OTTI) charges.

 

We believe that actions taken by regulatory agencies and government bodies in late 2008 have been effective in reducing systemic liquidity risk. Specific actions included the FDIC raising the deposit insurance limit to $250,000 and providing full guarantees on noninterest bearing deposits at all FDIC-insured financial institutions. Among other actions, the most significant was the passage in October 2008 of the $700 billion Emergency Economic Stabilization Act; the cornerstone of which was the Troubled Asset Relief Program (TARP). The TARP’s voluntary Capital Purchase Plan (CPP) made available $350 billion of funds to banks and other financial institutions. We participated in TARP, which increased capital by $1.4 billion, as well as other such programs.

 

More information on risk is set forth below, and under the heading “Risk Factors” included in Item 1A of our 2008 Form 10-K for the year ended December 31, 2008. Additional information regarding risk factors can also be found in the “Risk Management and Capital” discussion.

 

Critical Accounting Policies and Use of Significant Estimates

 

Our financial statements are prepared in accordance with accounting principles generally accepted in the United States (GAAP). The preparation of financial statements in conformity with GAAP requires us to establish critical accounting policies and make accounting estimates, assumptions, and judgments that affect amounts recorded and reported in our financial statements. Note 1 of the Notes to Consolidated Financial Statements lists significant accounting policies we use in the development and presentation of our financial statements. This discussion and analysis, the significant accounting policies, and other financial statement disclosures identify and address key variables and other qualitative and quantitative factors necessary for an understanding and evaluation of our company, financial position, results of operations, and cash flows.

 

An accounting estimate requires assumptions about uncertain matters that could have a material effect on the financial statements if a different amount within a range of estimates were used or if estimates changed from period to period. Estimates are made

 14

 

under facts and circumstances at a point in time, and changes in those facts and circumstances could produce results that differ from when those estimates were made. The most significant accounting estimates and their related application are discussed below. This analysis is included to emphasize that estimates are used in connection with the critical and other accounting policies and to illustrate the potential effect on the financial statements if the actual amount were different from the estimated amount.

 

 

At December 31, 2008, the ACL as a percent of total loans and leases was 2.30%. To illustrate the potential effect on the financial statements of our estimates of the ACL, a 10 basis point, or 4%, increase would have required $41.1 million in additional reserves (funded by additional provision for credit losses), which would have negatively impacted 2008 net income by approximately $26.7 million, or $0.07 per common share.

 

Additionally, in 2007, we established a specific reserve of $115.3 million associated with our loans to Franklin Credit Management Corporation (Franklin). At December 31, 2008, our specific ALLL for Franklin loans increased to $130.0 million, and represented approximately 20% of the remaining loans outstanding. Table 21 details our probability-of-default and recovery-after-default performance assumptions for estimating anticipated cash flows from the Franklin loans that were used to determine the appropriate amount of specific ALLL for the Franklin loans. The calculation of our specific ALLL for the Franklin portfolio is dependent, among other factors, on the assumptions provided in the table, as well as the current one-month LIBOR rate on the underlying loans to Franklin. As the one-month LIBOR rate increases, the specific ALLL for the Franklin portfolio could also increase. Our relationship with Franklin is discussed in greater detail in the “Commercial Credit” section of this report.

 

 

Many of our assets are carried at fair value, including securities, mortgage loans held-for-sale, derivatives, mortgage servicing rights (MSRs), and trading assets. At December 31, 2008, approximately $5.1 billion of our assets were recorded at fair value. In addition to the above mentioned ongoing fair value measurements, fair value is also the unit of measure for recording business combinations.

 

FASB Statement No. 157, Fair Value Measurements , establishes a framework for measuring the fair value of financial instruments that considers the attributes specific to particular assets or liabilities and establishes a three-level hierarchy for determining fair value based on the transparency of inputs to each valuation as of the fair value measurement date. The three levels are defined as follows:

 

 

At the end of each quarter, we assess the valuation hierarchy for each asset or liability measured. From time to time, assets or liabilities may be transferred within hierarchy levels due to changes in availability of observable market inputs to measure fair value at the measurement date. Transfers into or out of hierarchy levels are based upon the fair value at the beginning of the reporting period.

 15

 

The table below provides a description and the valuation methodologies used for financial instruments measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy. The fair values measured at each level of the fair value hierarchy can be found in Note 19 of the Notes to the Consolidated Financial Statements.

 

 

 

Alt-A mortgage-backed / Private-label collateralized mortgage obligation (CMO) securities, included within our Level 3 investment securities portfolio, represent mortgage-backed securities collateralized by first-lien residential mortgage loans. As the lowest level input that is significant to the fair value measurement in its entirety is Level 3, we classify all securities within this portfolio as Level 3. The securities are priced with the assistance of an outside third-party consultant using a discounted cash flow approach

 16

 

using the third-party’s proprietary pricing model. The model uses inputs such as estimated prepayment speeds, losses, recoveries, default rates that are implied by the underlying performance of collateral in the structure or similar structures, discount rates that are implied by market prices for similar securities, and collateral structure types and house price depreciation and appreciation that are based upon macroeconomic forecasts.

 

We analyzed both our Alt-A mortgage-backed and private-label CMO securities portfolios to determine if the impairment in these portfolios was other-than-temporary. We performed this analysis, with the assistance of third-party consultants with knowledge of the structures of these securities and expertise in the analysis and pricing of mortgage-backed securities, and using the guidance in FSP EITF 99-20-1, to determine whether we believed it probable that we would have a loss of principal on a security within the portfolio in the future. All securities in these portfolios remained current with respect to interest and principal at December 31, 2008. (See Note 2 of the Notes to the Consolidated Financial Statements for additional information regarding FSP EITF 99-20-1.)

 

For each security with any indication of impairment, we analyzed nine reasonably possible scenarios, based around the scenario that we considered most likely. To develop these nine scenarios, we analyzed the amount of principal loss that we would expect to have if the expected default rate of the loans underlying the security were 10% higher and 10% lower than the most likely default scenario, a range we believe covers the reasonably possible scenarios for these securities. We also analyzed, for each of these default scenarios, the amount of principal loss that we would expect to have if the severity of the losses that we experienced at default were both 10% higher and 10% lower than the most likely severity-of-loss scenario, a range we believe covers the reasonably possible scenarios for these securities.

 

For each security subject to this additional review, we analyzed all nine of these scenarios to determine whether principal loss was probable. As a result of this analysis, we believe that we will experience a loss of principal on 19 Alt-A mortgage-backed securities and one private-label CMO security. The analysis indicated future expected losses of principal on these other-than-temporarily impaired securities ranged from 0.5% to 75.2% of the par value of the securities in our most-likely scenario. The average amount of expected principal loss was 9.6% of the par value of the securities. These losses were projected to occur beginning anywhere from 25 months to as many as 151 months in the future. We measured the amount of impairment on these securities using the fair value of the security in the scenario we considered to be most likely, using discount rates ranging from 14% to 23%, depending on both the potential variability of outcomes for each security and the expected duration of cash flows for each security. As a result, we recorded $176.9 million of OTTI for our Alt-A mortgage-backed securities and $5.7 million of OTTI for our private-label CMO security.

 

Recognition of additional OTTI could be required for our Alt-A mortgage-backed and private-label CMO securities. To estimate potential impairment losses, we perform stress testing under which we increase probability-of-default and loss-given-default performance assumptions related to the underlying collateral mortgages. Increasing probability-of-default and loss-given-default estimates to 150% and 125%, respectively, of our current most-likely case estimates would result in: (a) the recognition of additional OTTI of $74.3 million, or $0.13 per common share, and (b) a reduction to our equity position of $17.1 million, as most of the decline in fair value would already be reflected in our equity.

 

Pooled-trust-preferred securities , also included within our Level 3 investment securities portfolio, represent collateralized debt obligations (CDOs) backed by a pool of debt securities issued by financial institutions. As the lowest level input that is significant to the fair value measurement in its entirety is Level 3, we classify all securities within this portfolio as Level 3. The collateral is generally trust preferred securities and subordinated debt securities issued by banks, bank holding companies, and insurance companies. The first and second-tier bank trust preferred securities, which comprise 80% of the pooled-trust-preferred securities portfolio, are priced with the assistance of an outside third-party consultant using a discounted cash flow approach, and the independent third-party’s proprietary pricing models. The model uses inputs such as estimated default and deferral rates that are implied from the underlying performance of the issuers in the structure, and discount rates that are implied by market prices for similar securities and collateral structure types. Insurance company securities, which comprise 20% of the pooled-trust-preferred securities portfolio, are priced by utilizing a third-party pricing service that determines the fair value based upon trades of similar financial instruments.

 

Cash flow analyses of the first and second-tier bank trust preferred securities issued by banks and bank holding companies were conducted to test for any OTTI, and in accordance with FSP EITF 99-20-1, OTTI was recorded in certain securities within these portfolios as we concluded it was probable that all cash flows would not be collected. The discount rate used to calculate the cash flows ranged from 11%-15%, and was heavily impacted by an illiquidity premium due to the lack of an active market for these securities. We assumed that all issuers deferring interest payments would ultimately default, and we assumed a 10% recovery rate on such defaults. In addition, future defaults were estimated based upon an analysis of the financial strength of the issuers. As a result of this testing, we recognized OTTI of $14.5 million in the pooled-trust-preferred securities portfolio during 2008.

 

Recognition of additional OTTI could be required for our pooled-trust-preferred securities. Our estimates of potential OTTI are performed on a security-by-security basis. The significant variable in estimating OTTI on these securities is the probability of default by banks issuing underlying collateral securities. Tripling the default assumptions we used to evaluate these securities at December 31, 2008,

 17

 

would result in: (a) the recognition of additional OTTI of $64.3 million, or $0.11 per common share, and (b) a reduction to our equity position of only $5.1 million as most of the decline in fair value would already be reflected in our equity.

 

Certain other assets and liabilities which are not financial instruments also involve fair value measurements. A description of these assets and liabilities, and the methodologies utilized to determine fair value are discussed below:

 

Goodwill

Goodwill is tested for impairment annually, as of October 1, based upon reporting units, to determine whether any impairment exists. Goodwill is also tested for impairment on an interim basis if an event occurs or circumstances change between annual tests that would more likely than not reduce the fair value of the reporting unit below its carrying amount. Impairment losses, if any, would be reflected in noninterest expense. For 2008, we performed interim evaluations of our goodwill balances at June 30, 2008 and December 31, 2008 as well as our annual goodwill impairment assessment as of October 1, 2008. Based on our analyses, we concluded that the fair value of our reporting units exceeded the fair value of our assets and liabilities and therefore goodwill was not considered impaired at any of those dates.

 

Huntington identified four reporting units: Regional Banking, Private Financial & Capital Markets Group, Insurance, and AFDS. The reporting units were identified after establishing Huntington’s operating segments. Components of the regional banking segment have been aggregated as one reporting unit based upon the similar economic and operating characteristics of the components. Although Insurance is included within the Private Financial & Capital Markets Group segment for 2008, it is evaluated as a separate reporting unit since the nature of the products and services differ from the rest of the Private Financial & Capital Markets Group segment. The AFDS unit does not have goodwill, and therefore, is not subject to goodwill impairment testing.

 

The first step of impairment testing required a comparison of each reporting unit’s fair value to carrying value to identify potential impairment. An independent third party was engaged to assist with the impairment assessment.

 

To determine the fair value of the Private Financial & Capital Markets Group and Insurance reporting units, a market approach was utilized. Revenue, earnings and market capitalization multiples of comparable public companies were selected and applied to the reporting units’ results to calculate fair value. Using this approach, the Private Financial & Capital Markets Group and Insurance reporting units passed the first step, and as a result, no further impairment testing was required and goodwill was determined to not be impaired for these reporting units.

 

At December 31, 2008, our goodwill totaled $3.1 billion. Of this $3.1 billion, $2.9 billion, or 95%, was allocated to Regional Banking. To determine the fair value of the Regional Banking reporting unit, both an income (discounted cash flows) and market approach were utilized. The income approach is based on discounted cash flows derived from assumptions of balance sheet and income statement activity. It also factors in costs of equity and weighted-average costs of capital to determine an appropriate discount rate. The market approach is similar to the method for the Private Financial & Capital Markets Group and Insurance units as described above. The results of the income and market approach were weighted to arrive at the final calculation of fair value. As market capitalization has declined across the banking industry, we believed that a heavier weighting on the income approach was more representative of a market participant’s view. The Regional Banking unit did not pass the first step of the impairment test, and therefore, we conducted the second step of the impairment testing. The second step required a comparison of the implied fair value of goodwill to the carrying amount of goodwill.

 

The aggregate fair values were compared to market capitalization as an assessment of the appropriateness of the fair value measurements. As our stock price fluctuated greatly during 2008, we used our average stock price for the 30 days preceding the valuation date to determine market capitalization. The comparison between the aggregate fair values and market capitalization indicates an implied premium. A control premium analysis indicated that the implied premium was within range of the overall premiums observed in the market place.

 

To determine the implied fair value of goodwill, the fair value of Regional Banking (as determined in step one) is allocated to all assets and liabilities of the reporting unit including any recognized or unrecognized intangible assets. The allocation is done as if the reporting unit had been acquired in a business combination, and the fair value of the reporting unit was the price paid to acquire the reporting unit. Key valuations were the assessment of core deposit intangibles, the mark-to-fair value of outstanding debt, and discount on the loan portfolio. The mark adjustment on our outstanding debt is based upon observable trades or modeled prices using current yield curves and market spreads. The valuation of the loan portfolio indicated discounts that we believe were consistent with transactions occurring in the marketplace.

 

The results of this allocation indicated the implied fair value of Regional Banking’s goodwill exceeded the carrying amount of goodwill for Regional Banking, and therefore, goodwill was not impaired.

 

It is possible that our assumptions and conclusions regarding the valuation of our reporting units could change adversely and could result in impairment of our goodwill. Such impairment could have a material effect on our financial position and results of operations.

 18

 

Pension

Pension plan assets consist of mutual funds and Huntington common stock. Investments are accounted for at cost on the trade date and are reported at fair value. Mutual funds are valued at quoted redemption value. Huntington common stock is traded on a national securities exchange and is valued at the last reported sales price.

 

The discount rate and expected return on plan assets used to determine the benefit obligation and pension expense for December 31, 2008 are both assumptions. Any deviation from these assumptions could cause actual results to change.

 

Other Real Estate Owned (OREO)

OREO obtained in satisfaction of a loan is recorded at its estimated fair value less anticipated selling costs based upon the property’s appraised value at the date of transfer, with any difference between the fair value of the property and the carrying value of the loan charged to the ALLL. Subsequent declines in value are reported as adjustments to the carrying amount, and are charged to noninterest expense. Gains or losses not previously recognized resulting from the sale of OREO are recognized in noninterest expense on the date of sale.

 

 

In the ordinary course of business, we operate in various taxing jurisdictions and are subject to income and nonincome taxes. The effective tax rate is based in part on our interpretation of the relevant current tax laws. We believe the aggregate liabilities related to taxes are appropriately reflected in the consolidated financial statements. We review the appropriate tax treatment of all transactions taking into consideration statutory, judicial, and regulatory guidance in the context of our tax positions. In addition, we rely on various tax opinions, recent tax audits, and historical experience.

 

From time to time, we engage in business transactions that may have an effect on our tax liabilities. Where appropriate, we have obtained opinions of outside experts and have assessed the relative merits and risks of the appropriate tax treatment of business transactions taking into account statutory, judicial, and regulatory guidance in the context of the tax position. However, changes to our estimates of accrued taxes can occur due to changes in tax rates, implementation of new business strategies, resolution of issues with taxing authorities regarding previously taken tax positions and newly enacted statutory, judicial, and regulatory guidance. Such changes could affect the amount of our accrued taxes and could be material to our financial position and/or results of operations. (See Note 17 of the Notes to the Consolidated Financial Statements.)

 

Recent Accounting Pronouncements and Developments

 

Note 2 to the Consolidated Financial Statements discusses new accounting pronouncements adopted during 2008 and the expected impact of accounting pronouncements recently issued but not yet required to be adopted. To the extent the adoption of new accounting standards materially affect financial condition, results of operations, or liquidity, the impacts are discussed in the applicable section of this MD&A and the Notes to the Consolidated Financial Statements.

 

Acquisitions

 

Sky Financial Group, Inc. (Sky Financial)

 

The merger with Sky Financial was completed on July 1, 2007. At the time of acquisition, Sky Financial had assets of $16.8 billion, including $13.3 billion of loans, and total deposits of $12.9 billion. The impact of this acquisition was included in our consolidated results for the last six months of 2007. Additionally, in September 2007, Sky Bank and Sky Trust, National Association (Sky Trust), merged into the Bank and systems integration was completed. As a result, performance comparisons between 2008 and 2007, and 2007 and 2006, are affected.

 

As a result of this acquisition, we have a significant loan relationship with Franklin. This relationship is discussed in greater detail in the “Commercial Credit” section of this report.

 

Unizan Financial Corp. (Unizan)

 

The merger with Unizan was completed on March 1, 2006. At the time of acquisition, Unizan had assets of $2.5 billion, including $1.6 billion of loans and core deposits of $1.5 billion. The impact of this acquisition was included in our consolidated results for the last ten months of 2006. As a result, performance comparisons between 2007 and 2006, and 2006 and 2005, are affected.

 19

 

Impact Methodology

 

For both the Sky Financial and Unizan acquisitions, comparisons of the reported results are impacted as follows:

 

 

Given the significant impact of the mergers on reported results, we believe that an understanding of the impacts of each merger is necessary to understand better underlying performance trends. When comparing post-merger period results to premerger periods, we use the following terms when discussing financial performance:

 

 

After completion of our mergers, we combine the acquired companies’ operations with ours, and do not monitor the subsequent individual results of the acquired companies. As a result, the following methodologies were implemented to estimate the approximate effect of the mergers used to determine “merger-related” impacts.

 

Balance Sheet Items

 

Sky Financial

 

For average loans and leases, as well as total average deposits, Sky Financial’s balances as of June 30, 2007, adjusted for purchase accounting adjustments, and transfers of loans to loans held-for-sale, were used in the comparison. To estimate the impact on 2007 average balances, it was assumed that the June 30, 2007 balances, as adjusted, remained constant over time.

 

Unizan

 

For average loans and leases, as well as core average deposits, balances as of the acquisition date were pro-rated to the post-merger period being used in the comparison. For example, to estimate the impact on 2006 first quarter average balances, one-third of the closing date balance was used as those balances were in reported results for only one month of the quarter. Quarterly estimated impacts for the 2006 second, third, and fourth quarter results were developed using this same pro-rata methodology. Full-year 2006 estimated results represent the annual average of each quarter’s estimate. This methodology assumed acquired balances remained constant over time.

 

Income Statement Items

 

Sky Financial

 

Sky Financial’s actual results for the first six months of 2007, adjusted for the impact of unusual items and purchase accounting adjustments, were determined. This six-month adjusted amount was multiplied by two to estimate an annual impact. This methodology does not adjust for any market-related changes, or seasonal factors in Sky Financial’s 2007 six-month results. Nor does it consider any revenue or expense synergies realized since the merger date. The one exception to this methodology of holding the estimated annual impact constant relates to the amortization of intangibles expense where the amount is known and is therefore used.

 

Unizan

 

Unizan’s actual full-year 2005 results were used for pro-rating the impact on post-merger periods. For example, to estimate the 2006 first quarter impact of the merger on personnel costs, one-twelfth of Unizan’s full-year 2005 personnel costs was used. Full quarter and year-to-date estimated impacts for subsequent periods were developed using this same pro-rata methodology. This results in an approximate impact since the methodology does not adjust for any unusual items or seasonal factors in Unizan’s 2005 reported results, or synergies realized since the merger date. The one exception to this methodology relates to the amortization of intangibles expense where the amount is known and is therefore used.

 

Certain tables and comments contained within our discussion and analysis provide detail of changes to reported results to quantify the estimated impact of the Sky Financial merger using this methodology.

 20

N.M., not a meaningful value.

 

 21

 

DISCUSSION OF RESULTS OF OPERATIONS

 

This section provides a review of financial performance from a consolidated perspective. It also includes a “Significant Items” section that summarizes key issues important for a complete understanding of performance trends. Key consolidated balance sheet and income statement trends are discussed. All earnings per share data are reported on a diluted basis. For additional insight on financial performance, please read this section in conjunction with the “Lines of Business” discussion.

 

Summary

 

2008 versus 2007

 

We reported a net loss of $113.8 million in 2008, representing a loss per common share of $0.44. These results compared unfavorably with net income of $75.2 million, or $0.25 per common share, in 2007. Comparisons with the prior year were significantly impacted by a number of factors that are discussed later in the “Significant Items” section.

 

During 2008, the primary focus within our industry continued to be credit quality. The economy deteriorated substantially throughout the year in our regions, and continued to put stress on our borrowers. Our expectation is that the economy will remain under stress, and that no improvement will be seen through at least the end of 2009.

 

The largest setback to 2008 performance was the credit quality deterioration of the Franklin relationship that occurred in the 2008 fourth quarter resulting in a negative impact of $454.3 million, or $0.81 per common share. The loan restructuring associated with our relationship with Franklin, completed during the 2007 fourth quarter, continued to perform consistent with the terms of the restructuring agreement through the 2008 third quarter. However, cash flows that we received deteriorated significantly during the 2008 fourth quarter, reflecting a more severe than expected deterioration in the overall economy. This, and other factors discussed in the “Franklin relationship” section, resulted in a significant partial charge-off of the loans to Franklin. Although disappointing, and while we can give no further assurances, this charge represents our best estimate of the inherent loss within this credit relationship.

 

Non-Franklin-related net charge-offs (NCOs) and provision levels increased substantially compared with 2007. During 2008, the non-Franklin-related allowance for credit losses (ACL) as a percentage of total loans and leases increased to 2.01% compared with 1.36% at the prior year-end. Non-Franklin-related nonaccrual loans (NALs) also significantly increased to $851.9 million, compared with $319.8 million at the prior year-end, reflecting increased NALs in our commercial real estate (CRE) loans, particularly the single family home builder and retail properties segments, and within our commercial and industrial (C&I) portfolio related to businesses that support residential development. We expect to see continued levels of elevated charge-offs and provision expense during 2009.

 

Our year-end regulatory capital levels were strong. Our tangible equity ratio improved 264 basis points to 7.72% compared with the prior year-end, reflecting the benefits of a $0.6 billion preferred stock issuance in the 2008 second quarter and a $1.4 billion preferred stock issuance in the 2008 fourth quarter as a result of our participation in the Troubled Assets Relief Program (TARP) voluntary Capital Purchase Plan (CPP) (see “Risk Factors” included in Item 1A of our 2008 Form 10-K for the year ended December 31, 2008) . However, our tangible common equity ratio declined 104 basis points compared with the prior year-end, and we believe that it is important that we begin rebuilding our common equity. To that end, we reduced our quarterly common stock dividend to $0.01 per common share, effective with the dividend declared on January 22, 2009. Our period-end liquidity position was sound, as we have conservatively managed our liquidity position at both the parent company and bank levels. At December 31, 2008, the parent company had sufficient cash for operations and does not have any debt maturities for several years. Further, the Bank has a manageable level of debt maturities during the next 12-month period. In the 2008 fourth quarter, the FDIC introduced the Temporary Liquidity Guarantee Program (TLGP). One component of this program guarantees certain newly issued senior unsecured debt. In the 2009 first quarter, the Bank issued $600 million of debt as part of the TLGP.

 

Fully taxable net interest income in 2008 increased $231.1 million, or 18%, compared with 2007. The prior year reflected only six months of net interest income attributable to the acquisition of Sky Financial compared with twelve months for 2008. The Sky Financial acquisition added $13.3 billion of loans and $12.9 billion of deposits at July 1, 2007. There was good non-merger-related growth in total average commercial loans, partially offset by a decline in total average residential mortgages reflecting the continued slowdown in the housing market, as well as loan sales. Fully taxable net interest income in 2008 was negatively impacted by an 11 basis point decline in the net interest margin compared with 2007, primarily due to the interest accrual reversals resulting from loans being placed on nonaccrual status, as well as deposit pricing. We anticipate the net interest margin will remain under modest pressure during 2009 resulting from the absolute low-level of current interest rates and expected continued aggressive deposit pricing in our markets.

 

Noninterest income in 2008 increased $30.5 million, or 5%, compared with 2007. Comparisons with the prior year were affected by: (a) $153.2 million of lower noninterest income resulting from Significant Items (see “Significant Items” discussion), and (b) $137.4 million increase resulting from the Sky Financial acquisition. Considering the impact of both of these items, the remaining components of noninterest income increased $45.0 million, or 6%. The increase primarily reflects automobile operating

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lease income, and a 9% increase in brokerage and insurance income reflecting growth in annuity sales. These increases were partially offset by a 7% decline in trust services income reflecting the impact of lower market values on asset management revenues.

 

Expenses were well controlled, with our efficiency ratio improving to 57.0% in 2008 compared with 62.5% in 2007. Noninterest expense in 2008 increased $165.5 million, or 13%, compared with 2007. Comparisons with the prior year were affected by: (a) $62.4 million of net lower expenses resulting from Significant Items (see “Significant Items” discussion) , and (b) $208.1 million increase resulting from the Sky Financial acquisition, including the impact of restructuring and merger costs. Considering the impact of both of these items, the remaining components of noninterest expense increased $20.4 million, or 1%. The increase primarily reflected increased collection and OREO expenses as the economy continues to weaken, as well as increased insurance expense and automobile operating lease expense. These increases are partially offset by a decline in personnel expense, as well as other expense categories, due to merger/restructuring efficiencies.

 

2007 versus 2006

 

We reported 2007 net income of $75.2 million and earnings per common share of $0.25. These results compared unfavorably with net income of $461.2 million and earnings per common share of $1.92 in 2006. Comparisons with the prior year were significantly impacted by: (a) our acquisition of Sky Financial, which closed on July 1, 2007, as well as the credit deterioration of the Franklin relationship that was also acquired with Sky Financial, (b) a 2006 reduction in the provision for income taxes as a result of the favorable resolution to certain federal income tax audits, and (c) balance sheet restructuring charges taken in 2006.

 

The credit deterioration of the Franklin relationship late in 2007 was the largest setback to 2007 performance. A negative impact of $423.6 million pretax ($275.4 million after-tax, or $0.91 per common share based upon the annual average outstanding diluted common shares) related to this relationship. Other factors negatively impacting our 2007 performance included: (a) the building of the non-Franklin-related allowance for loan losses due to continued weakness in the residential real estate development markets and (b) the volatility of the financial markets resulting in net market-related losses.

 

The negative factors discussed above were partially offset by the $47.5 million, or 4%, decline in non-merger-related expenses, representing the realization of most of the merger efficiencies that were targeted from the acquisition. Also, commercial loans showed good non-merger-related growth, and there was also strong non-merger-related growth in several key noninterest income activities, including deposit service charges, trust services, and electronic banking income.

 

Fully taxable net interest income for 2007 increased $285.6 million, or 28%, from 2006. Six months of net interest income attributable to the acquisition of Sky Financial was included in 2007. There was good non-merger-related growth in total average commercial loans. However, total average automobile loans and leases declined, as expected, due to lower consumer demand and competitive pricing. Additionally, the non-merger-related declines in total average residential mortgages, as well as the lack of growth in non-merger-related total average home equity loans, reflected the continued softness in the real estate markets, as well as loan sales. Growth in non-merger-related average total deposits was good in 2007, driven by strong growth in interest-bearing demand deposits. Our net interest margin increased seven basis points to 3.36% from 3.29% in 2006.

 

In addition to the Franklin credit deterioration discussed previously, credit quality generally weakened in 2007 compared with 2006. The ALLL increased to 1.44% in 2007 from 1.04% in the prior year. The ALLL coverage of NALs decreased to 181% at December 31, 2007, from 189% at December 31, 2006. Nonperforming assets (NPAs) also increased from the prior year, including the NPAs acquired from Sky Financial. The deterioration of all of these measures reflected the continued economic weakness in our Midwest markets, most notably among our borrowers in eastern Michigan and northern Ohio, and within the residential real estate development portfolio.

 

Significant Items

 

Definition of Significant Items

 

Certain components of the income statement are naturally subject to more volatility than others. As a result, readers of this report may view such items differently in their assessment of “underlying” or “core” earnings performance compared with their expectations and/or any implications resulting from them on their assessment of future performance trends.

 

Therefore, we believe the disclosure of certain “Significant Items” affecting current and prior period results aids readers of this report in better understanding corporate performance so that they can ascertain for themselves what, if any, items they may wish to include or exclude from their analysis of performance, within the context of determining how that performance differed from their expectations, as well as how, if at all, to adjust their estimates of future performance accordingly.

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To this end, we have adopted a practice of listing as “Significant Items”, individual and/or particularly volatile items that impact the current period results by $0.01 per share or more. Such “Significant Items” generally fall within the categories discussed below:

 

Timing Differences

 

Parts of our regular business activities are naturally volatile, including capital markets income and sales of loans. While such items may generally be expected to occur within a full-year reporting period, they may vary significantly from period to period. Such items are also typically a component of an income statement line item and not, therefore, readily discernable. By specifically disclosing such items, analysts/investors can better assess how, if at all, to adjust their estimates of future performance.

 

Other Items

 

From time to time, an event or transaction might significantly impact revenues or expenses in a particular reporting period that is judged to be infrequent, short-term in nature, and/or materially outside typically expected performance. Examples would be (1) merger costs as they typically impact expenses for only a few quarters during the period of transition; including related restructuring charges and asset valuation adjustments; (2) changes in an accounting principle; (3) large and infrequent tax assessments/refunds; (4) a large gain/loss on the sale of an asset; and (5) outsized commercial loan net charge-offs related to fraud. In addition, for the periods covered by this report, the impact of the Franklin relationship is deemed to be a significant item due to its unusually large size and because it was acquired in the Sky Financial merger and thus it is not representative of our typical underwriting criteria. By disclosing such items, analysts/investors can better assess how, if at all, to adjust their estimates of future performance.

 

Provision for Credit Losses

 

While the provision for credit losses may vary significantly among periods, and often exceeds $0.01 per share, we typically exclude it from the list of “Significant Items” unless, in our view, there is a significant, specific credit (or multiple significant, specific credits) affecting comparability among periods. In determining whether any portion of the provision for credit losses should be included as a significant item, we consider, among other things, that the provision is a major income statement caption rather than a component of another caption and, therefore, the period-to-period variance can be readily determined. We also consider the additional historical volatility of the provision for credit losses.

 

Other Exclusions

 

“Significant Items” for any particular period are not intended to be a complete list of items that may significantly impact future periods. A number of factors, including those described in Huntington’s 2008 Annual Report on Form 10-K and other factors described from time to time in Huntington’s other filings with the SEC, could also significantly impact future periods.

 

Significant Items Influencing Financial Performance Comparisons

 

Earnings comparisons among the three years ended December 31, 2008, 2007, and 2006 were impacted by a number of significant items summarized below.

 

 

 

 

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(1) Includes $5.1 million related to the positive impact of adopting SFAS No 156.

 

 

 

(1) This amount included a $2.1 million gain reflected in mortgage banking income.

 

(2) $748 thousand of securities losses related to debt extinguishment, therefore, this amount is reflected as debt extinguishment in the above table.

 

(3) This amount is reflected entirely in mortgage banking income.

 

The 2008 securities losses total included OTTI adjustments of $176.9 million in our Alt-A mortgage-backed securities portfolio (see “Investment Portfolio” discussion within the “Credit Risk” section) .

 

 

2008

 

 

2007

 

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2006

 

 

Table 4 reflects the earnings impact of the above-mentioned significant items for periods affected by this Results of Operations discussion:

 

 

N.M., not a meaningful value.

 

Net Interest Income / Average Balance Sheet

 

(This section should be read in conjunction with Significant Items 1, 2, and 4.)

 

Our primary source of revenue is net interest income, which is the difference between interest income from earning assets (primarily loans, direct financing leases, and securities), and interest expense of funding sources (primarily interest bearing deposits and borrowings). Earning asset balances and related funding, as well as changes in the levels of interest rates, impact net interest income. The difference between the average yield on earning assets and the average rate paid for interest-bearing liabilities is the

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net interest spread. Noninterest bearing sources of funds, such as demand deposits and shareholders’ equity, also support earning assets. The impact of the noninterest bearing sources of funds, often referred to as “free” funds, is captured in the net interest margin, which is calculated as net interest income divided by average earning assets. Given the “free” nature of noninterest bearing sources of funds, the net interest margin is generally higher than the net interest spread. Both the net interest spread and net interest margin are presented on a fully taxable equivalent basis, which means that tax-free interest income has been adjusted to a pre-tax equivalent income, assuming a 35% tax rate.

 

The table below shows changes in fully taxable equivalent interest income, interest expense, and net interest income due to volume and rate variances for major categories of earning assets and interest bearing liabilities.

 

 

(1) The change in interest rates due to both rate and volume has been allocated between the factors in proportion to the relationship of the absolute dollar amounts of the change in each.

 

 

2008 versus 2007

 

Fully taxable equivalent net interest income for 2008 increased $231.1 million, or 18%, from 2007. This reflected the favorable impact of a $8.4 billion, or 21%, increase in average earning assets, of which $7.8 billion represented an increase in average loans and leases, partially offset by a decrease in the fully-taxable net interest margin of 11 basis points to 3.25%. The increase to average earning assets, and to average loans and leases, reflected the Sky Financial acquisition.

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The following table details the estimated merger-related impacts on our reported loans and deposits:

 

Table 6 — Average Loans/Leases and Deposits — Estimated Merger-Related Impacts — 2008 vs. 2007

 

 

(1) Calculated as non-merger related / (prior period + merger-related)

 

The $1.3 billion, or 3%, non-merger-related increase in average total loans and leases primarily reflected:

 

 

Partially offset by:

 

 

Average other earning assets increased $0.6 billion, primarily reflecting the increase in average trading account securities. The increase in these assets reflected a change in our strategy to use trading account securities to hedge the change in fair value of our MSRs, however, the practice of hedging the change in fair value of our MSRs using on-balance sheet trading assets ceased at the end of 2008.

 

The $0.3 billion, or 1%, increase in average total deposits reflected growth in other deposits. These deposits were primarily other domestic time deposits of $100,000 or more reflecting increases in commercial and public fund deposits. Changes from the prior year also reflected customers transferring funds from lower rate to higher rate accounts such as certificates of deposit as short-term rates had fallen.

 

2007 versus 2006

 

Fully taxable equivalent net interest income for 2007 increased $285.6 million, or 28%, from 2006. This reflected the favorable impact of a $7.9 billion, or 25%, increase in average earning assets, of which $7.3 billion represented an increase in average loans and leases, as well as the benefit of an increase in the fully-taxable net interest margin of seven basis points to 3.36%. The increase to average earning assets, and to average loans and leases, was primarily merger-related.

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The following table details the estimated merger-related impacts on our reported loans and deposits: