Fifth Third Bancorp Annual Report 2004

Plain-text annual report

2 0 0 4 A N N U A L R E P O R T we are FOCUSED. we are COMMITTED. we are INVESTORS. we are Fifth Third. C O R P O R A T E P R O F I L E Grand Rapids Detroit Toledo Chicago South Bend Cleveland Indianapolis Columbus Dayton Cincinnati Evansville Louisville Lexington Nashville Orlando Tampa Sarasota Naples Fifth Third Bancorp Assets: $94 billion Rank in assets among U.S. peers: 11th we are Fifth Third. We are committed to acting with the highest level of integrity in everything we do and in every relationship – with our customers, shareholders and communities. We are focused on taking every opportunity to exceed our customers’ expectations – in products, price and service. We are committed to working as a team to meet customer needs – across business lines, geography and functions. We will continue to invest to achieve best-in-class performance – in convenience, sales and growth. We are focused on creating value – growing revenue, controlling expenses and effectively balancing risk and reward. We are committed, focused and will invest in the communities where we live and Market value of stock: $26 billion work – through charitable donations, volunteerism and Rank by market value among U.S. peers: 8th Total Employed: 21,027 Banking Centers: 1,011 civic leadership. We will maintain the flexibility and financial strength to adapt to changing business and economic conditions. We are Fifth Third. Fifth Third Bancorp is a diversified financial services company headquartered in Cincinnati, Ohio. The Company has $94.5 billion in assets as of December 31, 2004. The Company operates 17 affiliates with 1,011 full-service Banking Centers, including 128 Bank Mart® locations open seven days a week inside select grocery stores and 1,898 Jeanie® ATMs in Ohio, Kentucky, Indiana, Michigan, Illinois, Florida, Tennessee, West Virginia and Pennsylvania. The financial strength of Fifth Third’s largest banks continues to be recognized by rating agencies with deposit ratings of AA- and Aa1 from Standard & Poor’s and Moody’s, respectively. Additionally, Fifth Third Bancorp continues to maintain among the highest short-term ratings available at A-1 and Prime-1 and is recognized by Moody’s with one of the highest senior debt ratings for any U.S. bank holding company of Aa2. Fifth Third operates four main businesses: Retail, Commercial, Investment Advisors and Fifth Third Processing Solutions. Investor information and press releases can be viewed at www.53.com. Fifth Third’s common stock is traded through the NASDAQ® National Market System under the symbol “FITB.” F I N A N C I A L H I G H L I G H T S For the years ended December 31 $ in millions, except share data 2004 2003 Percent Change Earnings and Dividends Net Income Cash Dividends Declared Per Share Earnings Diluted Earnings Cash Dividends Declared Year-End Book Value Year-End Market Price At Year-End Assets Loans and Leases Deposits Shareholders’ Equity Market Capitalization Key Ratios (Percent) Return on Average Assets (ROA) Return on Average Equity (ROE) Net Interest Margin Efficiency Ratio Average Shareholders’ Equity to Average Assets Actuals Number of Shares Number of Banking Locations Number of Full-Time Equivalent Employees $ 1,525 735 $ 1,665 645 $ 2.72 2.68 1.31 16.00 47.30 $94,456 59,808 58,226 8,924 26,377 1.61 17.2 3.48 53.9 9.34 $ 2.91 2.87 1.13 15.29 59.10 $91,254 52,308 57,095 8,667 33,491 1.90 19.0 3.62 47.0 10.01 557,648,989 1,011 19,659 566,685,301 952 18,899 (8) 14 (7) (7) 16 5 (20) 4 14 2 3 (21) (15) (9) (4) 15 (7) (2) 6 4 Deposit and Debt Ratings Moody’s Standard & Poor’s Fitch Fifth Third Bancorp Commercial Paper Senior Debt Fifth Third Bank and Fifth Third Bank (Michigan) Short-Term Deposit Long-Term Deposit Prime -1 Aa2 Prime -1 Aa1 A-1 A+ A-1+ AA- F1+ AA- F1+ AA 1 L E T T E R F R O M T H E P R E S I D E N T & C H I E F E X E C U T I V E we know who we are Dear Shareholders and Friends, We improved our competitive positioning on many fronts in 2004 in order to drive revenue and earnings growth in the years to come. Business line revenue growth, success in attracting new deposit and loan customers and improved credit quality, however, were offset by the difficulties in managing through the transition from the lowest level in interest rates in over 40 years. Earnings per diluted share for the full year 2004 were $2.68, a decrease of seven percent over last year’s earnings of $2.87. Return on average assets was 1.61 percent and return on average equity was 17.2 percent, compared to 1.90 percent and 19.0 percent, respectively, in 2003. Earnings in 2004 were impacted by initiatives undertaken in the fourth quarter to better position the balance sheet for current and expected market conditions, including debt termination charges and securities losses totaling $326 million pre-tax ($208 million after-tax) or $.37 per diluted share. The prolonged low interest rate environment led to declines in asset yields, net interest margin and returns on capital in 2004 that ultimately led us to the decision to reposition the balance sheet. Although this action impacted fourth quarter and full-year results, we believe it was in the best long-term interests of our shareholders. The balance sheet is now better positioned as the economy trends toward what we believe will be a more normalized and favorable interest rate environment. George A. Schaefer, Jr. President & CEO 2 “We improved our competitive positioning on many fronts to drive revenue and earnings growth in the years to come.” 2004 highlights include: • The 2004 dividend of $1.31 per share was a 16 • The acquisition and integration of Franklin Financial, percent increase over last year and a 34 percent combined with continuing de-novo expansion, increase over the 2002 annual dividend. provided entry into the attractive Nashville market. • Credit quality improved in 2004 with nonperforming assets and net charge-offs, as a percent of loans and leases, declining from .61 percent in 2003 to .51 With $1.9 billion in assets and 14 locations, our Nashville affiliate provides a strong springboard for continued growth in the Southeast. percent in 2004 and from .63 percent in 2003 to .45 • The acquisition of First National Bankshares of Florida, percent in 2004, respectively. • Average loans and leases increased by nine percent and average transaction deposits increased by seven percent over 2003. • We added 1,155 net new sales positions throughout our markets. a $5.6 billion asset bank holding company located primarily in the rapidly expanding markets of Orlando, Tampa, Sarasota, Naples and Fort Myers, was announced in 2004 and subsequently completed early in 2005. First National was the largest bank holding company headquartered in the state of Florida and provides Fifth Third with a tremendous platform in some of the fastest growing deposit markets in the • We added 76 new banking center locations in 2004, United States. excluding relocations of existing facilities. We believe this is the most cost-effective method of expansion in our largest affiliate markets. • We also invested significantly in information technology including the launch of an improved internet banking platform. We completed numerous automation and infrastructure improvements that will all serve to ensure the scalability and strength of your company. 3 “our vision has not changed, and the very same core principles responsible for our success remain intact...” Outstanding financial performance has long been a locations in attractive metropolitan markets, nearly hallmark of Fifth Third. Revenue and earnings per $100 billion in assets, and, with a market capitalization diluted share have both increased at annual compound in excess of $25 billion, we rank among the 10 largest rates of 11 percent over the last 10 years. Over the last banks in the country. We are very enthusiastic about five years, these same measures have increased at the future and, with only an eight percent market share annual compound rates of nine percent and 12 percent, in our markets and a best-in-class operating model and respectively. Owners of our company have realized just distribution network, we have a tremendous opportunity a one percent annualized total return on this earnings in front of us. Our vision has not changed and the very growth over the same five-year time period. While same core principles responsible for our past success outperforming many broader market indices, this level remain intact, including an unwavering commitment to of investment performance has been the source of be the premier financial services provider and employer frustration for our management team and investors alike. of choice in all of our markets. We continue to strive to However, our focus as a management team remains on making the necessary investments and sound decisions exceed the expectations of our customers, shareholders and neighbors, and I invite you to read about our to strengthen our competitive advantage within our core approach and what we feel is the strength of our middle market commercial and retail customer base. franchise in the pages that follow. Ultimately, top line revenue growth and disciplined expense control will continue to drive the earnings and capital growth that we believe provides for stock price appreciation over the long-term. Today, Fifth Third is comprised of 17 affiliates headquartered in metropolitan markets throughout the Midwest and Florida. While every market is unique, two things remain constant at Fifth Third: a deeply held Fifth Third has grown over the years to become one of the largest and strongest financial services companies in belief in the talent and entrepreneurship of our employees combined with the knowledge that a the United States. With more than 1,000 banking decentralized operating model allows them the 4 flexibility to better serve our customers. We empower deposit growth by adding new customers, increasing local managers to find the best ways to produce growth. market share and striving to meet all the financial In the years to come, you can expect to see us continue services needs of our customers. Fifth Third continues to increase our presence in our existing markets and to maintain a cost advantage over competitors, establish affiliates in new metropolitan markets as an possesses one of the strongest balance sheets in the important part of our continuing growth. On average, industry, has a best-in-class distribution network, and, our expectation is to add 70 to 100 banking centers and with significant growth potential, we look with great to increase our sales force by 15 to 20 percent every optimism to the challenges that lie ahead in 2005. year. Our existing competitive and financial strength combined with enhanced infrastructure and technology, Sincerely, make me extremely optimistic about the future. Last year marked the passing of a good friend: James D. Kiggen served on our Board for 20 years and his insight was instrumental in the success of Fifth Third. He will be missed. I would also like to extend our appreciation George A. Schaefer, Jr. President & Chief Executive Officer for the guidance and leadership of Richard T. Farmer and January 2005 Joseph H. Head, Jr., both of whom retired from our Board of Directors in 2004 after 22 and 17 years of service, respectively. I would also like to thank our customers, employees, board members and our communities for their continued support and confidence. The focus in all of our markets in 2005 will be driving revenue and quality loan and We recently began hosting a series of employee meetings throughout our markets. Our credo, You Make the Difference, helps keep all clearly focused on our mission of exceeding the expectations of our customers, co-workers and shareholders, of being our customers’ first choice and of being a great place to work. 5 we are focused ...on customer’s NEEDS AND EXPECTATIONS Our sales culture is renowned throughout the industry, and our sales force has always worked extremely hard to generate new relationships to offer competitively-priced financial products and services. More recently, we have enhanced these efforts through the implementation of detailed relationship management databases, account retention strategies, increased automation and process improvement programs designed to reduce error rates. In early 2005, we began interviewing customers monthly about their experiences in our banking centers so we can evaluate the service we are delivering in every affiliate, region and banking center. For the first time in our history, incentive compensation programs across the Bancorp will incorporate customer satisfaction results. There are many factors affecting a customer’s decision about where to bank. Fifth Third offers not only convenience and competitively priced products, but also integrity, financial stability and a relentless drive to deliver the best service in every single one of our markets. Ultimately, customers trust us to ensure the safety of their money. This is a trust that we are intensely focused on maintaining every day. ...on REPUTATION The past couple of years have brought about a number of changes in our economy as corporate America continues to respond to the challenges of an evolving regulatory landscape. Fifth Third believes that great companies have a very real opportunity to differentiate themselves in this environment and we are committed to being among them. Fifth Third has long been known for its commitment to accountability at every level of the organization and this holds true for our commitment to best-in-class compliance, governance and risk management functions. A reputation for excellence takes a lifetime to build and only a moment to destroy, and Fifth Third views the integrity of its actions as one of its greatest assets. (L to R) Malcolm D. Griggs, Executive Vice President & Chief Risk Officer Daniel T. Poston, Executive Vice President, Internal Audit Paul L. Reynolds, Executive Vice President, Secretary & General Counsel 6 ...on our CORE BUSINESS In all of our markets, we focus on four business lines – retail and commercial banking, investment advisors and Fifth Third Processing Solutions (“FTPS”). Nearly half of our revenues are derived from retail banking and a third from the commercial business. Our investment advisors division makes up about 10 percent of our revenues and is one of the largest money managers in the Midwest with $34 billion in directly managed assets and over $182 billion in assets under care. FTPS handles ATM processing and merchant credit and debit card processing. FTPS, which accounts for about 11 percent of our revenues, processed 12 billion electronic transactions in 2004. Fifth Third believes that these businesses provide us with a diversified and profitable mix, as well as the necessary expertise to meet all of the financial service needs of our core retail and middle-market commercial customer base. RETAIL BANKING Fifth Third’s 1,011 banking centers, including 128 Bank Mart® locations, serve as the primary point of contact for our six million customers. Through these locations, Fifth Third strives to provide best-in-class products, convenience and customer service to the individual and small business customers within our geographic footprint. COMMERCIAL BANKING Fifth Third’s 1,200 commercial relationship officers and support staff offer companies within our geographic footprint a business partner of unparalleled capital strength and stability, sound expertise and experience and comprehensive and customized financial solutions for all their cash management, international and borrowing needs. (L to R) Robert A. Sullivan, Executive Vice President, Commercial Banking; Kevin T. Kabat, Executive Vice President, Retail Banking and Affiliate Administration; Neal E. Arnold, Executive Vice President, Investment Advisors and Fifth Third Processing Solutions. FIFTH THIRD PROCESSING SOLUTIONS FTPS authorizes, initiates, captures and settles electronic payment transactions as part of an integrated cash management solution for financial institutions and merchants all over the world. As a leading electronic processor, Fifth Third helps our commercial customers eliminate paper and reduce cycle time and expense while providing instant on-line access to information through a platform integrated with traditional banking services. INVESTMENT ADVISORS Fifth Third is a full-service money management firm featuring a broad array of equity and fixed income products catering to retail and commercial clients across our footprint. From retirement planning, wealth management, public finance to private client services, Fifth Third delivers a full spectrum of investment strategies of varying scope and complexity for both long and short-term investment horizons. 7 we are investors ...in DISTRIBUTION Over the last couple of years, our level of investment in our core businesses has accelerated rapidly. Most notably, we began a significant de-novo branching effort in 2002 to enhance distribution in our larger markets. This marks the first time in our history that we have undertaken a de-novo effort on this scale. For most of the last two decades, many in our industry believed that deregulation and the emergence of the internet would signal the demise of traditional bricks and mortar as a sales channel for the financial services industry. Fifth Third believes banking centers will continue to be a very important sales channel because we listen to our customers. The overwhelming majority of our customers visit one of our 1,011 banking centers several times a month. For this reason, Fifth Third built 76 new banking centers in 2004, excluding relocations, that attracted over $657 million in new deposits and $178 million in new loans. ...in PEOPLE Fifth Third has the business model, technology, incentives, awareness and ambition to become the employer of choice in all of our markets. More so than at any time in our history, the promise of being recognized and rewarded for individual performance is attracting people to work for Fifth Third. In 2004, Fifth Third added 1,155 net new sales positions throughout our 17 affiliate markets. Leadership, teamwork and integrity are just a few of the attributes of a Fifth Third employee – and why we think we have the best employees in the industry. 8 Fifth Third asks employees to be leaders in sales and service and matches that action with generous performance incentives and a commitment to career development. ...in TECHNOLOGY Fifth Third is investing in technology in order to improve efficiency, provide greater convenience for our customers and drive financial performance. We have invested significantly over the past couple of years and spent a great deal of time and effort upgrading our sales and support systems. Many of our customer information systems have been enhanced to provide for increased availability of information, reliability and timeliness. Significant upgrades were completed this year to our online banking platform, online customer interfaces, banking center workstations, network capacity and numerous sales information systems. We are now able to access more timely and detailed financial information regarding sales and profitability results. This information can be viewed on several levels, including line of business, affiliate, officer and banking center. ...in ACQUISITIONS In addition to core growth in our established markets, Fifth Third periodically utilizes acquisitions as a means of expanding its presence and gaining entry into new metropolitan markets. Our approach to acquisitions has remained unchanged over the years. Our primary hurdle when evaluating any transaction is determining whether we can grow revenue from the resulting platform. Cost cutting in the first year is not a path to long-term success and does not meet our return requirements. We are interested in adding platforms in large, deposit-rich metropolitan markets adjacent to our footprint that when combined with expansion efforts will enable us to achieve #1 market share over time. This holds true for our most recent acquisition of First National. This acquisition provides Fifth Third with a tremendous platform and opportunity in the most attractive and fastest growing markets in Western and Central Florida. We believe the foundation we have acquired will easily assimilate into our affiliate bank operating model and become an integral part of Fifth Third’s continuing growth. 9 we are committed ...to our BUSINESS MODEL Our affiliate operating structure differentiates us from our competitors and ensures that our customers receive individualized service and comprehensive financial solutions. All aspects of customer relationships are managed strength to support their growth and the willingness, resources and ability to provide them with customized financial solutions. All of our officers run their own business, manage to detailed financial statements and are compensated based on performance. In short, we strive to create a culture of business ownership, and we reward each of our officers for making the right decisions. A local presence with market knowledge, management accountability and a team approach characterize our affiliate banking model. We are committed to it. locally by local affiliate Presidents responsible for the bank’s operation and community development; and by local officers with the authority and incentives to make the right decisions for the Bank and our customers. Competitive pressures are different in every market and on every street corner, so we rely on experienced local officers empowered with the authority and infrastructure to employ the best practices of our company to deliver a personalized level of service to our customers. This approach is central to our strategy of ensuring decisions are made by the people most familiar with our customer’s needs. Fifth Third’s team has the experience to advise our customers, the financial 10 ...to our EMPLOYEES Banking is first and foremost a relationship built upon the foundation of daily interaction between customers and our most vital asset – our employees. The quality of our customer experience begins and ends with our team members. Motivated, talented and knowledge- able employees will earn the trust of their communities and gain market share over time. Our employees are the driver of our success. Each of our team members knows that they own their business, can impact the bottom line, are accountable for their results and are rewarded for their accomplishments. Our employees make the difference in terms of realizing our vision of continuing to be a growth company. Our employees make the difference in the lives of our customers, co-workers and neighbors by delivering superior performance. There is no stronger correlation than between daily individual employee contributions and growth in customers, revenue and bottom line earnings. We are committed to it. (L to R) R. Mark Graf, Senior Vice President & Chief Financial Officer; Pete Pesce, Executive Vice President, Human Resources; Greg D. Carmichael, Executive Vice President & Chief Information Officer; Diane L. Dewbrey, Senior Vice President, Operations ...to our COMMUNITIES Fifth Third provides banking, investments and processing solutions to six million customers everyday, and we leverage our success to strengthen the communities we serve. We reaffirmed our commitment through over $30 million in grants and support to deserving organizations, including $22 million from the Fifth Third Foundation and charitable trusts for which the Bank serves as Trustee. We were again honored to be included in BusinessWeek magazine’s “America’s Most Philanthropic Companies” listing for our giving as a percentage of revenues. Our commitment to diversity is equally unwavering. Employee diversity councils and minority mentoring programs are just two of the ways we work to build and nurture diverse employment and leadership throughout the Bancorp. The Fifth Third Foundation Office, Community Development Corporation and Community Affairs department are three key extensions of the Bank’s community investment activities. The Foundation Office helps direct grants for Arts & Culture, Community Development, Education and Health & Human Services, while the Fifth Third Community Development Corporation invests in low-income housing, historic tax credit and economic development projects to support community revitalization. Our Community Affairs department identifies lending and real estate opportunities in traditionally underserved 11 markets, such as ethnically diverse, urban and low- to moderate-income census tracts. This group also champions financial literacy – the keystone for stable communities – by providing homebuyer training, credit counseling and college savings match programs. As a leader in residential mortgage lending, Fifth Third partnered with Freddie Mac to launch the Homeownership Mobile, or eBus, a 38-foot mobile classroom. Fifth Third and Freddie Mac eBus staffers provide multi-lingual assistance, and the initiative helps combat many misconceptions about homeownership and the homebuyer process, such as the perceived need for near perfect credit or downpayments as large as 20 percent of the home price. Fifth Third also launched a new mortgage product, Immigrant Homeownership Program, to better serve the 4.2 million U.S. tax-paying, foreign-born individuals living in the Midwest. The program helps encourage many first-time homebuyers, as well as those with limited traditional credit histories, to begin a banking relationship. We are proud of our legacy of philanthropy. These initiatives and many others reflect our long-held belief that if you help build a stronger community, you will build a stronger bank. We are committed to it. United Way GIVING Over the past five years, Fifth Third’s corporate and employee contributions to the United Way have reached $38.8 million. 2000 $5.5 million 2001 $6.5 million 2002 $7.4 million 2003 $9.0 million 2004 $10.4 million 12 FIFTH THIRD BANCORP 2004 ANNUAL REPORT FINANCIAL CONTENTS Management’s Discussion and Analysis of Financial Condition and Results of Operations Selected Financial Data Overview Recent Accounting Standards Critical Accounting Policies Statements of Income Analysis Balance Sheet Analysis Risk Management Controls and Procedures Management’s Assessment as to the Effectiveness of Internal Control over Financial Reporting Reports of Independent Registered Public Accounting Firm Financial Statements Consolidated Statements of Income Consolidated Balance Sheets Consolidated Statements of Changes in Shareholders’ Equity Consolidated Statements of Cash Flows Notes to Consolidated Financial Statements Summary of Signiﬁ cant Accounting and Reporting Policies Securities Loans and Leases and Reserve for Loan and Lease Losses Bank Premises and Equipment Operating Lease Equipment Goodwill Intangible Assets Servicing Rights and Retained Interests Derivatives Short-Term Borrowings Long-Term Debt Commitments and Contingent Liabilities Legal and Regulatory Proceedings Guarantees Related Party Transactions Consolidated Ten Year Comparison Directors and Ofﬁ cers Corporate Information 40 45 46 47 47 47 47 48 48 50 51 52 52 53 53 Other Comprehensive Income Common Stock and Treasury Stock Stock-Based Compensation Other Noninterest Income and Other Noninterest Expense Sales and Transfers of Loans Discontinued Operations Income Taxes Retirement and Beneﬁ t Plans Earnings Per Share Fair Value of Financial Instruments Business Combinations Certain Regulatory Requirements and Capital Ratios Parent Company Financial Statements Segments 14 15 16 16 18 23 25 33 34 34 36 37 38 39 54 54 55 56 57 59 59 60 61 61 62 62 63 63 65 66 67 FORWARD-LOOKING STATEMENTS This report may contain forward-looking statements about Fifth Third Bancorp and/or the company as combined with acquired entities within the meaning of Sections 27A of the Securities Act of 1933, as amended, and Rule 175 promulgated thereunder, and 21E of the Securities Exchange Act of 1934, as amended, and Rule 3b-6 promulgated thereunder, that involve inherent risks and uncertainties. This report may contain certain forward-looking statements with respect to the ﬁ nancial condition, results of opera- tions, plans, objectives, future performance and business of Fifth Third Bancorp and/or the combined company including statements preceded by, followed by or that include the words or phrases such as “believes,” “expects,” “anticipates,” “plans,” “trend,” “objective,” “continue,” “remain” or similar expressions or future or conditional verbs such as “will,” “would,” “should,” “could,” “might,” “can,” “may” or similar expressions. There are a number of important factors that could cause future results to differ materi- ally from historical performance and these forward-looking statements. Factors that might cause such a difference include, but are not limited to: (1) competitive pressures among depository institutions increase signiﬁ cantly; (2) changes in the interest rate environment reduce interest margins; (3) prepayment speeds, loan origination and sale volumes, charge-offs and loan loss provisions; (4) general economic conditions, either national or in the states in which Fifth Third, one or more acquired entities and/or the combined company do business, are less favorable than expected; (5) political developments, wars or other hostilities may disrupt or increase volatility in securities markets or other economic conditions; (6) changes and trends in the securities markets; (7) legislative or regulatory changes or actions, or signiﬁ cant litigation, adversely affect Fifth Third, one or more acquired entities and/or the combined company or the businesses in which Fifth Third, one or more acquired entities and/or the combined company are engaged; (8) difﬁ culties in combining the operations of acquired entities and (9) the impact of reputational risk created by the developments discussed above on such matters as business generation and retention, funding and liquidity. Fifth Third undertakes no obligation to release revisions to these forward-looking statements or reﬂ ect events or circumstances after the date of this report. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following is management’s discussion and analysis of certain signiﬁ cant factors that have affected Fifth Third Bancorp’s (the “Bancorp” or “Fifth Third”) ﬁ nancial condition and results of operations during the periods included in the Consolidated Financial Statements, which are a part of this report. TABLE 1: SELECTED FINANCIAL DATA For the Years Ended December 31 ($ in millions, except per share data) Income Statement Data Net interest income (a) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Noninterest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total revenue (a) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Provision for loan and lease losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Noninterest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Common Share Data Earnings per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Earnings per diluted share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash dividends per common share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Book value per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dividend payout ratio, as originally reported . . . . . . . . . . . . . . . . . . . . . . . . . . . . Financial Ratios Return on average assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Return on average shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Average equity as a percent of average assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net interest margin (a) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Efﬁ ciency ratio (a) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Credit Quality Net losses charged off . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net losses charged off as a percent of average loans and leases . . . . . . . . . . . . . . . . Reserve for loan and lease losses as a percent of loans and leases (b) . . . . . . . . . . . Reserve for credit losses as a percent of loans and leases (b) . . . . . . . . . . . . . . . . . . Nonperforming assets as a percent of loans, leases and other assets, including other real estate owned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Underperforming assets as a percent of loans, leases and other assets, including other real estate owned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2004 $ 3,048 2,465 5,513 268 2,972 1,525 $ 2.72 2.68 1.31 16.00 48.9% 1.61% 17.2 9.34 3.48 53.9 $ 252 .45% 1.19 1.31 .51 .74 2003 2,944 2,483 5,427 399 2,551 1,665 2.91 2.87 1.13 15.29 39.4 1.90 19.0 10.01 3.62 47.0 312 .63 1.33 1.47 .61 .89 2002 2,738 2,183 4,921 246 2,337 1,531 2.64 2.59 .98 14.98 37.8 2.04 18.4 11.08 3.96 47.5 187 .43 1.49 1.49 .59 .95 2001 2,476 1,788 4,264 236 2,453 1,002 1.74 1.70 .83 13.31 48.8 1.42 13.6 10.40 3.82 57.5 227 .54 1.50 1.50 .57 .96 2000 2,297 1,476 3,773 138 2,027 1,055 1.86 1.83 .70 11.83 41.7 1.58 17.5 9.06 3.73 53.7 109 .26 1.43 1.43 .47 .77 Average Balances Loans and leases, including held for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Investment securities and other short-term investments . . . . . . . . . . . . . . . . . . . . Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Demand deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest-bearing deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Short-term borrowings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Regulatory Capital Ratios Tier 1 capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total risk-based capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Tier 1 leverage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (a) Amounts presented on a fully taxable equivalent basis (“FTE”). (b) As of December 31, 2004, the reserve for unfunded commitments has been reclassiﬁ ed from the reserve for loan and lease losses to other liabilities. The 2003 year-end reserve for unfunded commitments has been reclassiﬁ ed to conform to the current period presentation. The reserve for credit losses is the sum of the reserve for loan and lease losses and the reserve for unfunded commitments. $57,042 30,597 94,896 12,327 43,908 13,539 13,323 8,860 52,414 28,947 87,481 10,482 44,008 12,373 8,747 8,754 44,888 19,938 70,683 7,394 38,255 8,799 6,301 7,348 45,539 23,585 75,037 8,953 39,976 7,191 7,640 8,317 42,690 18,830 66,611 6,257 38,164 9,725 4,707 6,033 10.31% 12.31 8.89 12.49 14.55 10.64 11.84 13.65 9.84 11.40 13.50 9.49 11.11 13.56 9.23 TABLE 2: QUARTERLY INFORMATION For the Three Months Ended ($ in millions, except per share data) Net interest income (FTE) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Provision for loan and lease losses . . . . . . . . . . . . . . . . . . . . . . . . . . Noninterest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Noninterest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income from continuing operations before income taxes, minority interest and cumulative effect . . . . . . . . . . . . . . . . . . . Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Earnings per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Earnings per diluted share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12/31 $752 65 479 935 222 176 .31 .31 2004 2003 9/30 6/30 3/31 12/31 9/30 6/30 3/31 766 26 611 648 694 471 .84 .83 771 90 749 742 679 448 .80 .79 759 87 626 648 641 430 .76 .75 745 94 599 657 583 442 .78 .77 735 112 680 657 636 418 .73 .72 749 109 618 621 627 415 .72 .71 716 85 586 614 593 390 .68 .67 14 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW This overview of management’s discussion and analysis highlights selected information in the ﬁ nancial results of the Bancorp and may not contain all of the information that is important to you. For a more complete understanding of trends, events, commitments, uncertainties, liquidity, capital resources and critical accounting policies and estimates, you should carefully read this entire docu- ment. Each of these items could have an impact on the Bancorp’s ﬁ nancial condition and results of operations. The Bancorp is a diversiﬁ ed ﬁ nancial services company head- quartered in Cincinnati, Ohio. The Bancorp has $94.5 billion in assets, operates 17 afﬁ liates with 1,011 full-service banking centers and 1,898 Jeanie® ATMs in Ohio, Kentucky, Indiana, Michigan, Illinois, Florida, Tennessee, West Virginia and Pennsylvania. The ﬁ nancial strength of the Bancorp’s largest banks, Fifth Third Bank and Fifth Third Bank (Michigan), continues to be recognized by rating agencies with deposit ratings of AA- and Aa1 from Standard & Poor’s and Moody’s, respectively. Additionally, the Bancorp is recognized by Moody’s with one of the highest senior debt ratings for any U.S. bank holding company of Aa2. The Bancorp oper- ates four main businesses: Commercial Banking, Retail Banking, Investment Advisors and Fifth Third Processing Solutions. Fifth Third believes that banking is ﬁ rst and foremost a rela- tionship business where the strength of the competition and chal- lenges for growth can vary in every market. Our afﬁ liate operating model provides a competitive advantage by keeping the decisions close to the customer and by emphasizing individual relationships. Through our afﬁ liate operating model, individual managers, from the banking center to the executive level, are given the opportunity to tailor ﬁ nancial solutions for their customers. The Bancorp’s revenues are fairly evenly dependent on net interest income and noninterest income. During 2004, net interest income, on a fully taxable equivalent (“FTE”) basis, and noninter- est income provided 55% and 45% of total revenue, respectively. Changes in interest rates, credit quality, economic trends and the capital markets are primary factors that drive the performance of the Bancorp. As discussed later in the Risk Management section, risk identiﬁ cation, measurement, monitoring, control and report- ing are important to the management of risk and to the continua- tion of the strong ﬁ nancial performance and capital strength of the Bancorp. Net interest income is the difference between interest income on earning assets such as loans, leases and securities, and interest expense paid on liabilities such as deposits and borrowings, and continues to be the Bancorp’s largest revenue source. Net interest income is affected by the general level of interest rates, changes in interest rates and by changes in the amount and composition of interest-earning assets and interest-bearing liabilities. Generally, the rates of interest the Bancorp earns on its assets and owes on its liabilities are established for a period of time. The change in market interest rates over time exposes the Bancorp to interest- rate risk and potential adverse changes in net interest income. The Bancorp manages this risk by continually analyzing and adjusting the composition of its assets and liabilities based on their payment streams and interest rates, the timing of their maturities and their sensitivity to changes in market interest rates. Additionally, in the ordinary course of business, the Bancorp enters into certain deriva- tive transactions as part of its overall strategy to manage its interest rate risks and prepayment risks. The Bancorp is also exposed to the risk of losses on its loan and lease portfolio as a result of changing expected cash ﬂ ows caused by loan defaults and inadequate collateral, among other factors. Noninterest income is derived primarily from electronic funds transfer (“EFT”) and merchant transaction processing fees, ﬁ du- ciary and investment management fees, banking fees and service charges, mortgage banking revenue and operating lease revenue. Net interest income, net interest margin, net interest rate spread and the efﬁ ciency ratio are presented in Management’s Discussion and Analysis of Financial Condition and Results of Operations on an FTE basis. The FTE basis adjusts for the tax-favored status of income from certain loans and securities held by the Bancorp that are not taxable for federal income tax purposes. The Bancorp believes this measure to be the preferred industry measurement of net interest income as it provides a relevant comparison between taxable and non-taxable amounts. The Bancorp’s net income was $1.5 billion in 2004, down eight percent compared to $1.7 billion in 2003. Earnings per dilut- ed share were $2.68 in 2004, down seven percent from $2.87 in 2003. The Bancorp’s dividend in 2004 increased 16% to $1.31 per common share from $1.13 in 2003. The results of operations reﬂ ect the impact of the balance sheet repositioning initiatives announced and completed during the fourth quarter of 2004, including debt retirement charges and losses from security sales, which reduced net income and earnings per diluted share by $208 million and $.37, respectively. The prolonged low interest rate environment led to declines in asset yields, net interest margin and returns on capital in 2004, which ultimately led to the decision to reposition the balance sheet. Further discussion of the repositioning is included in relevant sections throughout this report. The results of operations also reﬂ ect the impact of the after-tax gain of $91 million, or $.16 per diluted share, from the sales of certain small merchant processing contracts in 2004 and an additional after-tax charge of $50 million, or $.09 per diluted share, from the early retirement of debt in the second quarter of 2004. The Bancorp experienced growth across nearly all of the lines of business, including solid growth in both commercial and consumer loans. The Bancorp also beneﬁ ted from improvements in commercial credit and continued control of operational expenses. Noninterest income was ﬂ at compared to 2003 as beneﬁ ts from the emphasis on cross-selling services and the gain from the sales of certain small merchant processing contracts were offset by losses on securities sold as a result of the balance sheet repositioning and a decrease in mortgage banking revenues. The Bancorp continues to invest in the geographic areas within its footprint that offer the best growth prospects. The Bancorp opened 76 new banking centers during 2004, excluding relocations, with a net increase of 50, excluding acquisitions. The Bancorp plans to add a similar number of new banking centers in 2005, as it believes additional banking centers are a cost effective method of expansion in its largest afﬁ liate markets. The Bancorp also completed its acquisition of Franklin Financial Corpora- tion (“Franklin Financial”) in June of 2004, which expanded the Bancorp’s presence in the Nashville market to 14 locations. In August 2004, the Bancorp announced an agreement to acquire First National Bankshares of Florida, Inc., a bank holding company with $5.6 billion in assets located primarily in Orlando, Tampa, Sarasota, Naples and Fort Myers. The acquisition was completed on January 1, 2005 and as a result of this transaction, the Florida afﬁ liate now has nearly 100 full-service locations and approximately $5 billion in deposits. The Bancorp’s capital ratios exceed the “well-capitalized” guide- lines as deﬁ ned by the Board of Governors of the Federal Reserve System (“FRB”). As of December 31, 2004, the Tier 1 capital ratio was 10.31% and the total risk-based capital ratio was 12.31%. The Bancorp’s capital strength and ﬁ nancial stability have enabled it to maintain a Moody’s credit rating that is equaled or surpassed by only three other U.S. bank holding companies. Fifth Third Bancorp 15 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RECENT ACCOUNTING STANDARDS In December 2002, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standard (“SFAS”) No. 148, “Accounting for Stock-Based Compensation- Transition and Disclosure—an Amendment of FASB Statement No. 123.” This Statement amends SFAS No. 123, “Accounting for Stock-Based Compensation,” to provide alternative methods of transition for a voluntary change to the fair value method of accounting for stock-based employee compensation. Effective Janu- ary 1, 2004, the Bancorp adopted the fair value recognition provi- sions of SFAS No. 123 using the retroactive restatement method described in SFAS No. 148. As a result, ﬁ nancial information for all prior periods has been restated to reﬂ ect the compensation expense that would have been recognized had the fair value method of accounting been applied to all awards granted to employees after January 1, 1995. Stock-based compensation expense is included in salaries, wages and incentives expense in the Consolidated State- ments of Income. In December 2004, the FASB issued SFAS No. 123 (Revised 2004), “Share-Based Payment.” This Statement requires measure- ment of the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award with the cost to be recognized over the vesting period. As the Bancorp has previously adopted the fair value recognition provisions of SFAS No. 123 and the retroactive restatement method described in SFAS No. 148, the adoption of this Statement will not have a material impact on the Bancorp’s Consolidated Financial Statements. In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of Both Liabili- ties and Equity.” This Statement establishes standards for how an entity classiﬁ es and measures certain ﬁ nancial instruments with characteristics of both liabilities and equity. This Statement requires that an issuer classify a ﬁ nancial instrument that is within its scope as a liability. Many of those instruments were previously classiﬁ ed as equity, or in some cases, presented between the liabilities section and the equity section of the statement of ﬁ nancial position. This CRITICAL ACCOUNTING POLICIES Reserve for Loan and Lease Losses The Bancorp maintains a reserve to absorb probable loan and lease losses inherent in the portfolio. The reserve is maintained at a level the Bancorp considers to be adequate and is based on ongoing quar- terly assessments and evaluations of the collectibility and historical loss experience of loans and leases. Credit losses are charged and recoveries are credited to the reserve. Provisions for loan and lease losses are based on the Bancorp’s review of the historical credit loss experience and such factors that, in management’s judgment, deserve consideration under existing economic conditions in esti- mating probable credit losses. In determining the appropriate level of reserves, the Bancorp estimates losses using a range derived from “base” and “conservative” estimates. The Bancorp’s method- ology for assessing the appropriate reserve level consists of several key elements. The Bancorp’s strategy for credit risk management includes a combination of conservative exposure limits signiﬁ cantly below legal lending limits and conservative underwriting, docu- mentation and collections standards. The strategy also emphasizes diversiﬁ cation on a geographic, industry and customer level, regu- lar credit examinations and quarterly management reviews of large credit exposures and loans experiencing deterioration of credit qual- ity. Larger commercial loans that exhibit probable or observed credit weaknesses are subject to individual review. Where appropri- ate, reserves are allocated to individual loans based on management’s estimate of the borrower’s ability to repay the loan given the avail- ability of collateral, other sources of cash ﬂ ow and legal options avail- able to the Bancorp. The review of individual loans includes those 16 Fifth Third Bancorp Statement was effective for ﬁ nancial instruments entered into or modiﬁ ed after May 31, 2003 and otherwise was effective at the beginning of the ﬁ rst interim period beginning after June 15, 2003. Adoption of this Statement on July 1, 2003 required a reclassiﬁ ca- tion of a minority interest to long-term debt and the corresponding minority interest expense to interest expense, relating to preferred stock issued during 2001 by a subsidiary of the Bancorp. The existence of the mandatory redemption feature of this issue upon its mandatory conversion to trust preferred securities necessitated these reclassiﬁ cations and did not result in any change in bottom line income statement trends. In January 2003, the FASB issued Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities.” This interpreta- tion requires variable interest entities (“VIEs”) to be consolidated by the primary beneﬁ ciary, which is deﬁ ned as the enterprise that will absorb the majority of the VIE’s expected losses if they occur, receive a majority of the VIE’s residual returns if they occur, or both. In December 2003, FASB issued Interpretation No. 46R (“FIN 46R”), “Consolidation of Variable Interest Entities — an interpretation of ARB 51 (revised December 2003).” FIN 46R was primarily issued to clarify the required accounting for interests in VIEs. The Bancorp early adopted the provisions of FIN 46 on July 1, 2003 and consolidated a VIE for which the Bancorp was deemed to be the primary beneﬁ ciary and was created for the sole purpose of participating in the sale and subsequent leaseback of leased autos. The Bancorp consolidated the operating lease assets and corresponding liability of the VIE as well as recognized an after- tax cumulative effect charge of $11 million ($.02 per diluted share) representing the difference between the carrying value of the leased autos sold and the carrying value of the newly consolidated obliga- tion as of July 1, 2003. Consolidation of these operating lease assets and corresponding liability did not impact risk-based capital ratios or bottom line income statement trends; however lease payments on the operating lease assets are now reﬂ ected as a component of noninterest income and depreciation expense is now reﬂ ected as a component of noninterest expense. loans that are impaired as provided in SFAS No. 114, “Accounting by Creditors for Impairment of a Loan.” Any reserves for impaired loans are measured based on the present value of expected future cash ﬂ ows discounted at the loan’s effective interest rate or fair value of the underlying collateral. The Bancorp evaluates the collectibility of both principal and interest when assessing the need for a loss accrual. Historical loss rates are applied to other commercial loans not subject to speciﬁ c reserve allocations. The loss rates are derived from a migration analysis, which computes the net charge-off expe- rience sustained on loans according to their internal risk grade. The Bancorp utilizes two risk grading systems for commercial loans and leases. The current risk grading system utilized for reserve analysis purposes encompasses ten categories. The Bancorp also maintains a dual risk rating system that provides for 13 probability of default grade categories and an additional six grade categories measuring loss factors given an event of default. The probability of default and loss given default analyses are not separated in the ten grade risk rating system. The Bancorp is in the process of completing signiﬁ - cant validation and testing of the dual risk rating system prior to implementation for reserve analysis purposes. The dual risk rating system is consistent with Basel II expectations and allows for more precision in the analysis of commercial credit risk. Homogenous loans, such as consumer installment, residen- tial mortgage loans and automobile leases are not individually risk graded. Rather, standard credit scoring systems and delinquency monitoring are used to assess credit risks. Reserves are established for each pool of loans based on the expected net charge-offs for one year. Loss rates are based on the average net charge-off history by MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS loan category. Historical loss rates for commercial and consumer loans may be adjusted for signiﬁ cant factors that, in management’s judgment, reﬂ ect the impact of any current conditions on loss recognition. Factors that management considers in the analysis include the effects of the national and local economies, trends in the nature and volume of loans (delinquencies, charge-offs and nonaccrual loans), changes in mix, credit score migration comparisons, asset quality trends, risk management and loan administration, changes in the internal lending policies and credit standards, collection practices and examination results from bank regulatory agencies and the Bancorp’s internal credit examiners. An unallocated reserve is maintained to recognize the impreci- sion in estimating and measuring loss when evaluating reserves for individual loans or pools of loans. Reserves on individual loans and historical loss rates are reviewed quarterly and adjusted as necessary based on changing borrower and/or collateral conditions and actual collection and charge-off experience. The Bancorp’s primary market areas for lending are Ohio, Kentucky, Indiana, Michigan, Illinois, Florida, Tennessee, West Virginia and Pennsylvania. When evaluating the adequacy of reserves, consideration is given to this regional geographic concen- tration and the closely associated effect changing economic condi- tions have on the Bancorp’s customers. The Bancorp has not substantively changed any aspect to its overall approach in the determination of the reserve for loan and lease losses. There have been no material changes in assumptions or estimation techniques as compared to prior periods that impacted the determination of the current period reserve for loan and lease losses. As of December 31, 2004, the reserve for unfunded commit- ments has been reclassiﬁ ed from the reserve for loan and lease losses to other liabilities. The December 31, 2003 reserve for unfunded commitments and all subsequent activity has been reclassiﬁ ed to conform to current period presentation. Valuation of Servicing Rights When the Bancorp sells loans through either securitizations or indi- vidual loan sales in accordance with its investment policies, it may retain servicing rights. Servicing rights resulting from loan sales are amortized in proportion to and over the period of estimated net servicing revenues. Servicing rights are assessed for impairment monthly, based on fair value, with temporary impairment recog- nized through a valuation allowance and permanent impairment recognized through a write-off of the servicing asset and related valuation reserve. Key economic assumptions used in measuring any potential impairment of the servicing rights include the prepay- ment speeds of the underlying loans, the weighted-average life of the loan, the discount rate, the weighted-average coupon and the weighted-average default rate, as applicable. The primary risk of material changes to the value of the servicing rights resides in the potential volatility in the economic assumptions used, particularly the prepayment speeds. The Bancorp monitors risk and adjusts its valuation allowance as necessary to adequately reserve for any probable impairment in the portfolio. For purposes of measuring impairment, the servicing rights are stratiﬁ ed based on the ﬁ nancial asset type and interest rates. In addition, the Bancorp obtains an independent third-party valuation of the mortgage servicing rights (“MSR”) portfolio on a quarterly basis. Fees received for servicing loans owned by investors are based on a percentage of the outstand- ing monthly principal balance of such loans and are included in noninterest income as loan payments are received. Costs of servic- ing loans are charged to expense as incurred. The change in the fair value of MSRs at December 31, 2004, due to immediate 10% and 20% adverse changes in the current prepayment assumptions would be a decrease of approximately $18 million and $33 million, respectively and due to immediate 10% and 20% favorable changes in the current prepayment assumption would be approximately $19 million and $40 million, respectively. The change in the fair value of the MSR portfolio at December 31, 2004, due to immediate 10% and 20% adverse changes in the discount rate assumptions would be a decrease of approximately $10 million and $18 million, respectively and due to immediate 10% and 20% favorable changes in the discount rate assumption would be approximately $10 million and $20 million, respectively. Sensi- tivity analysis related to other consumer and commercial servicing rights is not material to the Bancorp’s Consolidated Financial State- ments. These sensitivities are hypothetical and should be used with caution. As the ﬁ gures indicate, change in fair value based on a 10% and 20% variation in assumptions typically cannot be extrapolated because the relationship of the change in assumptions to change in fair value may not be linear. Also, the effect of a variation in a particular assumption on the fair value of the retained interests is calculated without changing any other assumption; in reality, changes in one factor may result in changes in another, which might magnify or counteract the sensitivities. Securities Securities are classiﬁ ed as held-to-maturity, available-for-sale or trading on the date of purchase. Only those securities classiﬁ ed as held-to-maturity, and which management has both the intent and ability to hold to maturity, are reported at amortized cost. Available- for-sale and trading securities are reported at fair value with unreal- ized gains and losses, net of related deferred income taxes, included in accumulated other comprehensive income on the Consolidated Balance Sheets and noninterest income in the Consolidated State- ments of Income, respectively. The fair value of a security is deter- mined based on quoted market prices. If quoted market prices are not available, fair value is determined based on quoted prices of similar instruments. Realized securities gains or losses are report- ed within noninterest income in the Consolidated Statements of Income. The cost of securities sold is based on the speciﬁ c identi- ﬁ cation method. Available-for-sale and held-to-maturity securities are reviewed quarterly for possible other-than-temporary impair- ment. The review includes an analysis of the facts and circumstanc- es of each individual investment such as the severity of loss, the length of time the fair value has been below cost, the expectation for that security’s performance, the creditworthiness of the issuer and the Bancorp’s intent and ability to hold the security. A decline in value that is considered to be other-than-temporary is recorded as a loss within noninterest income in the Consolidated Statements of Income. At December 31, 2004, 94% of the unrealized losses in the available-for-sale security portfolio were comprised of securities issued by U.S. Treasury and Government agencies, U.S. Govern- ment sponsored agencies and states and political subdivisions as well as agency mortgage-backed securities. The Bancorp believes the price movements in these securities are dependent upon the movement in market interest rates particularly given the negligible inherent credit risk for these securities. The Bancorp also maintains its intent and ability to hold these securities. Fifth Third Bancorp 17 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS STATEMENTS OF INCOME ANALYSIS TABLE 3: CONDENSED CONSOLIDATED STATEMENTS OF INCOME For the Years Ended December 31 ($ in millions, except per share data) Interest income (FTE) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net interest income (FTE) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Provision for loan and lease losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net interest income after provision for loan and lease losses (FTE) . . . . Noninterest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Noninterest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income from continuing operations before income taxes, minority interest and cumulative effect (FTE) . . . . . . . . . . . . . . . . . . . . . . . . Taxable equivalent adjustment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Applicable income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income from continuing operations before minority interest and cumulative effect . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Minority interest, net of tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income from continuing operations before cumulative effect . . . . . . . . Income from discontinued operations, net of tax . . . . . . . . . . . . . . . . . Income before cumulative effect . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cumulative effect of change in accounting principle, net of tax . . . . . . Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Earnings per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Earnings per diluted share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash dividends declared per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2004 $4,150 1,102 3,048 268 2,780 2,465 2,972 2,273 36 712 1,525 — 1,525 — 1,525 — $1,525 $ 2.72 2.68 1.31 2003 4,030 1,086 2,944 399 2,545 2,483 2,551 2,477 39 786 1,652 (20) 1,632 44 1,676 (11) 1,665 2.91 2.87 1.13 2002 4,168 1,430 2,738 246 2,492 2,183 2,337 2,338 39 734 1,565 (38) 1,527 4 1,531 — 1,531 2.64 2.59 .98 2001 4,754 2,278 2,476 236 2,240 1,788 2,453 1,575 45 523 1,007 (2) 1,005 4 1,009 (7) 1,002 1.74 1.70 .83 2000 4,994 2,697 2,297 138 2,159 1,476 2,027 1,608 47 511 1,050 — 1,050 5 1,055 — 1,055 1.86 1.83 .70 Net Interest Income The relative performance of lending and deposit-raising functions is frequently measured by two statistics – net interest margin and net interest rate spread. Net interest margin is determined by divid- ing net interest income (FTE) by average interest-earning assets. Net interest rate spread is the difference between the average FTE yield on interest-earning assets and the average rate paid on inter- est-bearing liabilities. Net interest margin is generally greater than the net interest rate spread due to the additional income earned on those assets funded by noninterest-bearing liabilities, or free fund- ing, such as demand deposits and shareholders’ equity. Table 4 presents net interest income, net interest margin and net interest spread for the three years ended December 31, 2004, 2003 and 2002, comparing interest income, average interest-bear- ing liabilities and average free funding outstanding. Nonaccrual loans and leases and loans held for sale have been included in the average loans and leases balances. Average outstanding securities balances are based upon amortized cost with any unrealized gains or losses on available-for-sale securities included in other assets. Table 5 also provides the relative impact of growth in the balance sheet and changes in interest rates on net interest income. Net interest income (FTE) in 2004 was $3.0 billion, a four percent increase over $2.9 billion in 2003. The increase in net inter- est income was due to the $6.3 billion, or eight percent, increase in average interest-earning assets, mitigated by the 14 basis point (“bp”) decrease in net interest margin. The net interest margin contracted in 2004 as compared to 2003 due to the low absolute level of interest rates in the ﬁ rst half of 2004 and interest-bear- ing liabilities repricing more quickly than interest-earning assets in response to rising interest rates in the second half of 2004. Addi- tionally, the contribution of noninterest-bearing funding to the net interest margin decreased to 31 bp in 2004 from 34 bp in 2003. The Bancorp implemented several actions, largely in the fourth quarter, to improve its long-term proﬁ le and reduce the risks associ- ated with increasing interest rates. These actions included: (i) the sale of approximately $6.4 billion of available-for-sale securities with a weighted-average coupon of 3.2%; (ii) the early retirement of approximately $3.8 billion of long-term debt, $2.8 billion in the fourth quarter, with a weighted-average rate of 5.4% and a weight- ed-average remaining maturity of approximately ﬁ ve years and; (iii) 18 Fifth Third Bancorp the termination of approximately $4.9 billion in notional of receive- ﬁ xed/pay-variable interest rate swaps. In total, these actions resulted in pre-tax securities losses of $79 million recorded in noninterest income and pre-tax debt termination charges of $325 million, $247 million in the fourth quarter, recorded in other noninterest expense. The Bancorp also decreased certain wholesale borrowings in order to further decrease the speed at which liabilities reprice relative to earning assets in response to anticipated increases in interest rates. These actions stabilized and improved the net interest margin as the 2004 year ended and have resulted in improved balance sheet positioning. Margin trends in 2005 will depend upon the timing, frequency, magnitude and direction of further interest rate changes, the level and mix of earning asset and deposit growth and the impact of capital management activities. The Bancorp currently expects net interest income and earning asset growth on an annualized sequen- tial basis during 2005 in the low double digit range. Interest income (FTE) on loans and leases increased $136 million, or ﬁ ve percent, compared to 2003. The increase in aver- age loans and leases included growth in commercial loans of $3.3 billion, or 13% in 2004. Excluding the impact of the Franklin Financial acquisition, average commercial loans increased by 12%; comparisons being provided to supplement an understanding of the fundamental trends. The increase in average commercial loans was primarily due to strong growth in the Chicago, Indianapolis and Cincinnati markets. The Bancorp’s continued investment in additional commercial sales people has largely contributed to its commercial loan portfolio growth in a period of ﬂ at to declining commercial loan demand. The Bancorp continues to beneﬁ t from increased credit line usage from existing commercial customers as well as success in gaining new customers within its footprint. Average consumer loans increased by $1.3 billion, or ﬁ ve percent, compared to 2003. Comparisons in consumer loans are impacted by the sales and securitizations of $903 million of home equity lines in the third quarter of 2003 and $750 million of automotive loans in the second quarter of 2004. Excluding these transactions, average consumer loans increased nine percent in 2004 from 2003; compar- isons being provided to supplement an understanding of the funda- mental trends. Average consumer loans increased in nearly all of the Bancorp’s markets with strong growth in Cleveland, Columbus and Detroit. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS TABLE 4: CONSOLIDATED AVERAGE BALANCE SHEETS AND ANALYSIS OF NET INTEREST INCOME (FTE) For the Years Ended December 31 2004 Average ($ in millions) Balance Revenue/ Cost Average Yield/Rate Average Balance 2003 Revenue/ Cost Average Yield/Rate Average Balance 2002 Revenue/ Cost Average Yield/Rate $57,042 $2,860 5.01% $52,414 $2,724 5.20% $45,539 $2,824 6.20% Assets Interest-earning assets: Loans and leases . . . . . . . . . . . . . . Securities: Taxable . . . . . . . . . . . . . . . . . . . Exempt from income taxes . . . . . Other short-term investments . . . Total interest-earning assets . . . . . . Cash and due from banks . . . . . . . . Other assets . . . . . . . . . . . . . . . . . . Reserve for loan and lease losses . . . 1,217 68 5 4,150 4.15 7.44 1.48 4.73 29,365 917 315 87,639 2,216 5,763 (722) Total assets . . . . . . . . . . . . . . . . . . . $94,896 Liabilities and Shareholders’ Equity Interest-bearing liabilities: Interest checking . . . . . . . . . . . . . Savings . . . . . . . . . . . . . . . . . . . . Money market . . . . . . . . . . . . . . . Other time deposits . . . . . . . . . . . Certiﬁ cates - $100,000 and over . Foreign ofﬁ ce deposits . . . . . . . . . Federal funds purchased . . . . . . . . Short-term bank notes . . . . . . . . . Other short-term borrowings . . . . Long-term debt . . . . . . . . . . . . . . Total interest-bearing liabilities . . . . Demand deposits . . . . . . . . . . . . . . Other liabilities . . . . . . . . . . . . . . . Total liabilities . . . . . . . . . . . . . . . . Minority interest . . . . . . . . . . . . . . Shareholders’ equity . . . . . . . . . . . . Total liabilities and shareholders’ $19,434 7,941 3,473 6,208 2,403 4,449 5,896 1,003 6,640 13,323 70,770 12,327 2,939 86,036 — 8,860 $ 174 58 39 162 48 58 77 15 78 393 1,102 .89% .72 1.12 2.62 1.99 1.31 1.30 1.46 1.17 2.95 1.56 equity . . . . . . . . . . . . . . . . . . . . $94,896 Net interest income margin . . . . . . Net interest rate spread . . . . . . . . . . Interest-bearing liabilities to interest- earning assets . . . . . . . . . . . . . . . $3,048 3.48% 3.17 80.75 27,584 1,056 307 81,361 1,600 5,250 (730) $87,481 $18,679 8,020 3,189 6,426 3,832 3,862 7,001 22 5,350 8,747 65,128 10,482 2,883 78,493 234 8,754 $87,481 1,226 77 3 4,030 4.45 7.26 .97 4.95 $ 189 64 32 196 63 44 80 — 55 363 1,086 1.01% .79 1.01 3.04 1.65 1.13 1.14 1.06 1.03 4.15 1.67 1,257 81 6 4,168 5.68 7.40 1.72 6.03 $ 296 158 27 335 77 35 54 — 67 381 1,430 1.83% 1.67 2.36 3.78 3.44 1.71 1.66 3.40 1.71 4.99 2.61 22,145 1,101 339 69,124 1,551 5,007 (645) $75,037 16,239 9,465 1,162 8,855 2,237 2,018 3,262 2 3,927 7,640 54,807 8,953 2,520 66,280 440 8,317 $2,944 3.62% 3.28 80.05 $75,037 $2,738 3.96% 3.42 79.29 TABLE 5: CHANGES IN NET INTEREST INCOME (FTE) ATTRIBUTED TO VOLUME AND YIELD/RATE (a) For the Years Ended December 31 2004 Compared to 2003 2003 Compared to 2002 ($ in millions) Volume Yield/Rate Total Volume Yield/Rate Total Increase (decrease) in interest income: Loans and leases . . . . . . . . . . . . . . . . . . . . . . . Securities: Taxable . . . . . . . . . . . . . . . . . . . . . . . . . . . Exempt from income taxes . . . . . . . . . . . . Other short-term investments . . . . . . . . . . . . Total change in interest income . . . . . . . . . . . . . Increase (decrease) in interest expense: Interest checking . . . . . . . . . . . . . . . . . . . . . . Savings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Money market . . . . . . . . . . . . . . . . . . . . . . . . Other time deposits . . . . . . . . . . . . . . . . . . . . Certiﬁ cates - $100,000 and over . . . . . . . . . . Foreign ofﬁ ce deposits . . . . . . . . . . . . . . . . . . Federal funds purchased . . . . . . . . . . . . . . . . . Short-term bank notes . . . . . . . . . . . . . . . . . . Other short-term borrowings . . . . . . . . . . . . . Long-term debt . . . . . . . . . . . . . . . . . . . . . . . Total change in interest expense . . . . . . . . . . . . . $235 76 (10) — 301 8 (1) 3 (7) (26) 7 (13) 15 15 154 155 Total change in net interest income . . . . . . . . . . $146 (99) (85) 1 2 (181) (23) (5) 4 (27) 11 7 10 — 8 (124) (139) (42) 136 (9) (9) 2 120 (15) (6) 7 (34) (15) 14 (3) 15 23 30 16 104 393 273 (3) (1) 662 40 (21) 27 (81) 38 )24 47 — 20 51 145 517 (493) (304) (1) (2) (800) (147) (73) (22) (58) (52) (15) (21) — (32) (69) (489) (311) (100) (31) (4) (3) (138) (107) (94) 5) (139) (14) 9) 26) — (12) (18) (344) 206) (a) Changes in interest not solely due to volume or yield/rate are allocated in proportion to the absolute amount of change in volume or yield/rate. Fifth Third Bancorp 19 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS TABLE 6: COMPONENTS OF AVERAGE LOAN PORTFOLIO For the Years Ended December 31 ($ in millions) Commercial loans: Commercial . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Mortgage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Construction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total commercial loans, including held for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consumer loans: Installment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Mortgage and construction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Credit card . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total consumer loans, including held for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total loan portfolio, including held for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total loan portfolio, excluding held for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The interest income (FTE) from investment securities and short-term investments decreased by $16 million, or one percent, in 2004 compared to 2003. The decrease in interest income is due to lower asset yields. As previously mentioned, the Bancorp sold approx- imately $6.4 billion of securities in the fourth quarter of 2004 with a weighted-average coupon of approximately 3.2% in order to improve its long-term proﬁ le and reduce the risks associated with increasing interest rates. The interest paid on interest-bearing deposits decreased $49 million, or eight percent, in 2004 compared to 2003. Average interest-bearing deposits were lower by $100 million, or less than one percent, compared to 2003. The four percent increase in aver- age interest checking balances and nine percent increase in money market balances were mitigated by the 37% decline in certiﬁ cates of deposit greater than $100,000. The movement in the certiﬁ cates of deposit category is largely a function of overall balance sheet funding requirements. Average demand deposits in 2004 increased $1.8 billion, or 18%, over 2003 reﬂ ecting the Bancorp’s success in generating new account growth in its commercial line of business. The growth in noninterest-bearing funding is a critical component in the growth in net interest income. A key focus of the Bancorp in 2005 continues to be growing its transaction account products such as checking, savings and money market accounts in order to reduce its reliance on other sources to fund the expected growth in the balance sheet. The interest paid on long-term debt increased by $30 million, or eight percent, in 2004 compared to 2003 due to the increase in the average long-term debt outstanding. Average long-term debt increased $4.6 billion, or 52%, in 2004 over 2003. The Bancorp has increased long-term debt to fund the growth in the balance sheet and to reduce its short-term wholesale funding position. Average federal funds purchased declined $1.1 billion, or 16%, compared to 2003. The interest expense associated with federal funds declined by only $3 million, or four percent, due to the federal funds rate increases that occurred throughout 2004. Provision for Loan and Lease Losses The Bancorp provides as an expense an amount for probable credit losses within the loan portfolio that is based on factors discussed in the Critical Accounting Policies. The provision is recorded to bring the reserve for loan and lease losses to a level deemed appropriate by the Bancorp. Actual credit losses on loans and leases are charged against the reserve for loan and lease losses. The amount of loans actually removed from the Consolidated Balance Sheets is referred to as charge-offs and net charge-offs include current charge-offs less recoveries in the current period on previously charged off assets. The provision for loan and lease losses was $268 million in 2004 compared to $399 million in 2003. The $131 million decrease in the provision was due to the reduction in net charge- offs as a percentage of average loans and leases and the continued improvement and expected stability in credit quality trends. Net charge-offs decreased to $252 million in 2004 as compared to $312 20 Fifth Third Bancorp 2004 $14,908 7,391 3,807 3,296 29,402 17,755 6,801 787 2,297 27,640 $57,042 $55,951 2003 13,672 6,299 3,097 3,037 26,105 16,343 6,880 591 2,495 26,309 52,414 49,700 2002 11,665 5,834 3,023 2,640 23,162 13,461 6,377 478 2,061 22,377 45,539 43,529 million in 2003. The reserve for loan and lease losses as a percent of loans and leases declined to 1.19% at December 31, 2004 from 1.33% at December 31, 2003. In addition, nonperforming assets as a percentage of loans, leases and other assets, including other real estate owned, declined to .51% from .61% in 2003. Refer to the Credit Risk Management section for further information on the provision for loan and lease losses, net charge-offs, nonperforming assets and other factors considered by the Bancorp in assessing the credit quality of the loan portfolio and the reserve for loan and lease losses. Noninterest Income Electronic payment processing revenue increased $47 million, or eight percent, in 2004 despite the sales of certain small merchant processing contracts. Excluding the lost revenue associated with the sold contracts of approximately $70 million for all of 2004, revenue increased 23%; comparisons being provided to supplement an understanding of the fundamental revenue trends. The Bancorp continues to realize strong sales momentum from the addition of new customer relationships in both its merchant services and EFT businesses. Merchant processing revenue was essentially ﬂ at in 2004 compared to 2003 due to the above-mentioned sales of certain small merchant processing contracts. Excluding the lost revenue associated with the sold contracts, merchant processing revenue increased 29% due to the addition of new customers and the result- ing increases in merchant transaction volumes, as well as an increase in transaction volume growth on the existing customer base reﬂ ec- tive of an improving retail sector of the economy. Compared to 2003, EFT revenues, including debit and credit card interchange, increased by 18% in 2004. The Bancorp now handles electronic processing for more than 127,000 merchant locations and 1,300 ﬁ nancial institutions worldwide. Service charges on deposits increased $30 million, or six percent, over 2003 primarily due to continued sales success in corporate treasury management products and commercial deposit campaigns. Commercial deposit revenues increased 14% over 2003 on the strength of a continued focus on cross-sell initiatives, an increased sales force and new customer relationships. Retail deposit revenues were ﬂ at compared to last year. Growth in the number of retail checking account relationships and in deposits is a key focus for the Bancorp for the upcoming year. Mortgage banking net revenue declined to $178 million in 2004 from $302 million as a result of the record high level of reﬁ nancing activity seen in 2003 that has declined in 2004 due to rising interest rates. The components of mortgage banking net revenue are shown in Table 8. As a result of rising interest rates, mortgage originations declined to $8.4 billion in 2004 compared to $16.0 billion in 2003, directly contributing to the decrease in core mortgage banking fees in 2004. The increase in interest rates during 2004 and the resulting impact of changing prepayment speeds led to the recovery of $60 million in temporary impairment on the MSR portfolio in 2004 as compared to the $3 million in tempo- MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS TABLE 7: NONINTEREST INCOME For the Years Ended December 31 ($ in millions) Electronic payment processing revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Service charges on deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Mortgage banking net revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Investment advisory revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other noninterest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Operating lease revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Securities (losses) gains, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Securities gains, net – non-qualifying hedges on mortgage servicing rights . . Total noninterest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . TABLE 8: COMPONENTS OF MORTGAGE BANKING NET REVENUE For the Years Ended December 31 ($ in millions) Total mortgage banking fees and loan sales . . . . . . . . . . . . . . . . . . . . . . . . . . Net (losses) gains and mark-to-market adjustments on both settled and outstanding free-standing derivative ﬁ nancial instruments . . . . . . . . . . . . Net valuation adjustments and amortization on mortgage servicing rights . . 2004 $ 622 515 178 360 671 156 (37) — $2,465 2004 $ 219 (9) (32) Mortgage banking net revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 178 2004 $ 48 57 174 61 31 — — 157 143 $ 671 TABLE 9: COMPONENTS OF OTHER NONINTEREST INCOME For the Years Ended December 31 ($ in millions) Cardholder fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consumer loan and lease fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial banking revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Bank owned life insurance income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Insurance income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gain on sale of branches . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gain on sale of property and casualty insurance product lines . . . . . . . . . . . Gain on sale of small merchant processing contracts . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total other noninterest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . rary impairment recognized in 2003. Servicing rights are deemed impaired when a borrower’s loan rate is distinctly higher than prevailing market rates. As temporary impairment was recognized on the MSR portfolio in 2003 due to falling primary and second- ary mortgage rates and earnings rates and corresponding increases in prepayment speeds, the Bancorp sold certain securities that were held at the time as a component of an overall non-qualifying hedging strategy it maintained in order to manage a portion of the risk associated with changes in impairment on its MSR portfolio. As a result, the Bancorp realized net gains of $3 million in 2003 that were captured as a component of other noninterest income in the Consolidated Statements of Income. In addition, the Bancorp recognized a net loss of $10 million and a net gain of $15 million in 2004 and 2003, respectively, related to changes in fair value and settlement of free-standing derivatives purchased to economically hedge the MSR portfolio. As of December 31, 2003, the Bancorp no longer held any available-for-sale securities related to its non- qualifying hedging strategy. In 2004, the Bancorp primarily used principal only swaps and swaptions to hedge the economic risk of the MSR portfolio as they are deemed to be the best available instrument for several reasons. Principal only swaps hedge the mortgage-LIBOR spread because they appreciate in value as a result of tightening spreads. They also provide prepayment protection as they increase in value as prepay- ment speeds increase, as opposed to MSRs that lose value in a faster prepayment environment. Swaptions are positive convexity hedges primarily used to hedge the negative convexity of the MSR port- folio. Due to an increasing interest rate environment in 2004, the 2003 2002 2001 2000 575 485 302 332 581 124 81 3 512 431 188 325 580 — 114 33 347 367 63 298 542 — 28 143 252 298 256 275 389 — 6 — 2,483 2,183 1,788 1,476 2003 466 14 (178) 302 2002 386 98 (296) 188 2001 354 20 (311) 63 2000 315 — (59) 256 2003 2002 2001 2000 59 65 178 62 28 — — — 189 581 51 70 157 62 55 7 26 — 152 580 50 59 125 52 49 43 — — 164 542 42 49 86 43 48 — — — 121 389 Bancorp increased the level of purchased options/swaptions used to economically hedge the MSR portfolio as compared to 2003. As of December 31, 2004 and 2003, the Bancorp held a combination of free-standing derivatives, including principal only swaps, swap- tions and interest rate swaps with a fair value of $4 million and $8 million, respectively, on an outstanding notional amount of $1.9 billion and $.9 billion, respectively. The increase in the derivative outstanding notionals at December 31, 2004 as compared to 2003 was primarily due to the level of current interest rates. The Bancorp expects the core contribution of mortgage bank- ing to total revenues to remain relatively ﬂ at from 2004 levels as reﬁ nance activity and new applications continue to moderate. The Bancorp’s total residential mortgage loan servicing port- folio at the end of 2004 and 2003 was $30.6 billion and $30.0 billion, respectively, with $23.0 billion and $24.5 billion, respec- tively, of loans serviced for others. The increase of $28 million, or eight percent, in investment advisory service revenue in 2004 compared to 2003 resulted primar- ily from strengthening sales in retirement plan services, improved institutional asset management and mutual fund revenues. The Bancorp is one of the largest money managers in the Midwest and as of December 31, 2004 had over $182 billion in assets under care, $34 billion of assets under management and $13 billion in its proprietary Fifth Third Funds.* The increase in operating lease revenue is due to the consoli- dation beginning in the third quarter of 2003 of a special purpose entity (“SPE”) formed for the purpose of the sale and subsequent leaseback of leased autos. The consolidation was the result of the *FIFTH THIRD FUNDS® PERFORMANCE DISCLOSURE Investments in the Fifth Third Funds are: NOT INSURED BY THE FDIC or any other government agency, are not deposits or obli- gations of, or guaranteed by, any bank, the distributor or any of their afﬁ liates, and involve investment risks, including the possible loss of the principal amount invested. An investor should consider the fund’s investment objectives, risks, and charges and expenses carefully before investing or sending money. This and other important information about the investment company can be found in the fund’s prospectus. To obtain a prospectus, please call 1-800-282-5706 or visit www.53.com. Please read the prospectus carefully before investing. Fifth Third Bancorp 21 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS TABLE 10: NONINTEREST EXPENSE For the Years Ended December 31 ($ in millions) Salaries, wages and incentives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Employee beneﬁ ts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Equipment expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net occupancy expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Operating lease expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Merger-related charges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other noninterest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total noninterest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . TABLE 11: COMPONENTS OF OTHER NONINTEREST EXPENSE For the Years Ended December 31 ($ in millions) Marketing and communications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Postal and courier . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Bankcard . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Intangible and goodwill amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Franchise and other taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loan and lease . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Printing and supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Travel . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Data processing and operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Debt prepayment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total other noninterest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2004 $1,018 261 84 185 114 — 1,310 $2,972 2004 $ 99 49 197 29 32 82 33 41 114 325 309 $1,310 2003 1,031 240 82 159 94 — 945 2,551 2002 1,029 201 79 142 — — 886 2,337 2001 2000 959 148 91 146 — 349 760 893 144 100 138 — 87 665 2,453 2,027 2003 2002 2001 2000 99 49 176 40 33 106 35 35 97 20 255 945 96 48 142 37 30 91 37 38 82 — 285 886 102 50 103 71 18 62 40 34 70 1 209 760 97 45 72 60 28 39 41 34 86 1 162 665 Bancorp’s adoption of FIN 46. The Bancorp expects operating lease revenue to decline in 2005 as the leases mature. The major components of other noninterest income for each of the last ﬁ ve years are shown in Table 9. In the second and third quarters of 2004, the Bancorp sold certain small merchant process- ing contracts resulting in a total gain of $157 million. The other component was impacted by the $22 million gain on the securitiza- tion and sale of $903 million of home equity lines of credit in 2003. The remaining categories in 2004 are ﬂ at to down as compared to 2003. over year decrease in stock compensation expense was offset by an increase in proﬁ t sharing expense to $69 million in 2004 from $48 million in 2003. Signiﬁ cant investments in the sales force contrib- uted to a four percent increase in full time equivalent employees from 2003 to 2004. Full time equivalent employees totaled 19,659 as of December 31, 2004 compared to 18,899 as of December 31, 2003. Net occupancy expenses increased primarily due to $10 million of higher depreciation expense related to the increase in banking centers and expansion of the Bancorp’s main operations center and $10 million of higher repairs and maintenance expense. Noninterest Expense The Bancorp continues to focus on efﬁ ciency initiatives as part of its core emphasis on operating leverage. These initiatives include increasing levels of process automation, the rationalization and reduction of non-core businesses as they relate to the Bancorp’s retail and middle market customer base, an increased emphasis on required returns on invested capital and related opportunities for continued growth. Operating expense levels are often measured using an efﬁ - ciency ratio (noninterest expense divided by the sum of net interest income (FTE) and noninterest income). The efﬁ ciency ratio was 53.9% and 47.0% for 2004 and 2003, respectively. Noninterest expense increased 17% in 2004 compared to 2003. Comparisons to the prior year are impacted by (i) $247 million of charges related to the early retirement of approximately $2.8 billion of long-term debt in the fourth quarter of 2004; (ii) a charge of $78 million related to the early retirement of approximately $1 billion of Federal Home Loan Bank (“FHLB”) advances in the second quarter of 2004; (iii) a charge of $20 million related to the early retirement of approximately $200 million of FHLB advances in 2003 and; (iv) a $31 million pre-tax recovery in 2003 of previously charged off treasury clearing and settlement account balances. Each of these items was recorded in other noninterest expense. Exclud- ing the impact of these items, noninterest expense increased three percent compared to 2003; comparisons being provided to supple- ment an understanding of the fundamental trends in noninterest expense. Total personnel costs (salaries, wages and incentives plus employee beneﬁ ts) increased by less than one percent in 2004 compared to 2003, and included $87 million in total stock compensation expense compared to $110 million in 2003. The year 22 Fifth Third Bancorp Pension Plans Pension costs, included in employee beneﬁ ts, declined to $16 million in 2004 compared to $31 million in 2003. The decrease is primarily due to lower amortization of actuarial losses and lower settlement expense. The Bancorp’s net pension expense for 2004 is based upon speciﬁ c actuarial assumptions, including an expected long-term rate of return on plan assets of 8.75%. The expected long-term rate of return on plan assets assumption reﬂ ects the average return expected on the assets invested to provide for the plan’s liabilities. In determining the expected long-term rate of return on plan assets assumption, the Bancorp evaluated actuarial and economic inputs, including long-term inﬂ ation rate assumptions and broad equity and bond indices long-term return projections as well as actual long- term plan performance. The discount rate assumption reﬂ ects the yield of a portfolio of high quality ﬁ xed-income instruments that have a similar duration to the plan’s liabilities. The discount rate determined on this basis has decreased from 6.00% at December 31, 2003 to 5.85% at December 31, 2004. Lowering the expected rate of return on plan assets by .25% (8.75% to 8.50%) and by lowering the discount rate by .25% (6.00% to 5.75%) would have increased the 2004 pension expense by approximately $1 million. The Bancorp based the determination of pension expense on a market-related valuation of assets. This market-related valuation recognizes investment gains or losses over a three-year period from the year in which they occur. Investment gains or losses for this purpose are the difference between the expected return calculated using the market-related value of assets and the actual return based on the market-related value of assets. Since the market-related value of assets recognizes gains or losses over a three-year period, the future value of assets will be impacted as previously deferred gains or losses are recorded. As of December 31, 2004 the Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS TABLE 12: APPLICABLE INCOME TAXES For the Years Ended December 31 ($ in millions) Income from continuing operations before income taxes, minority interest and cumulative effect . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Applicable income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Effective tax rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . had cumulative losses of approximately $101 million, which remain to be recognized in the calculation of the market-related value of assets. These unrecognized net actuarial losses result in an increase in the Bancorp’s future pension expense depending on several factors, including whether such losses at each measurement date exceed the corridor in accordance with SFAS No. 87, “Employers’ Accounting for Pensions.” The value of the plan assets has decreased from $223 million at December 31, 2003 to $201 million at December 31, 2004 as settlements and beneﬁ ts paid exceeded the investment returns and contributions made during 2004. The Bancorp’s unfunded plan status, net of beneﬁ t obligations, increased from $41 million at December 31, 2003 to an unfunded status of $53 million at December 31, 2004. During 2004, the Bancorp made $3 million in cash contributions to the plan and believes that, based on the actu- arial assumptions, no cash contribution to the plan will be required in 2005. Applicable Income Taxes The Bancorp’s income from continuing operations before income taxes, applicable income tax expense and effective tax rate for each of the periods indicated are shown in Table 12. Applicable income tax expense for all periods include the beneﬁ t from tax-exempt income, tax-advantaged investments and general business tax cred- its, partially offset by the effect of nondeductible expenses. Comparison of 2003 with 2002 Net income in 2003 increased to $1.7 billion compared to $1.5 billion in 2002. Earnings per diluted share were $2.87 compared to $2.59. BALANCE SHEET ANALYSIS Loans Table 13 summarizes the end of period commercial and consumer loans and leases, including loans held for sale, by major category. Commercial loan and lease outstandings, including loans held for sale, increased 14% compared to December 31, 2003. The increase in commercial loans and leases was attributable to growth in middle- market and small business loan originations, the strength of new customer additions, the acquisition of $441 million of commercial loans obtained in the Franklin Financial acquisition in 2004 and strong results in several markets, including Cincinnati, Chicago and Indianapolis. Consumer loan and lease outstandings, including loans held for sale, increased nine percent compared to 2003. Consumer loan 2004 $2,237 712 31.8% 2003 2,438 786 32.3 2002 2,299 734 31.9 2001 1,530 523 34.2 2000 1,561 511 32.7 Return on average assets was 1.90% and return on average shareholders’ equity was 19.0% compared to 2.04% and 18.4%, respectively, in 2002. Net interest income (FTE) was $2.9 billion in 2003 compared to $2.7 billion in 2002. The net interest margin declined to 3.62% in 2003 from 3.96% in 2002, which is attributable to the low abso- lute levels of interest rates in 2003 and corresponding impact of accelerated prepayments across all asset classes and higher origina- tion volumes at the lower rates. The decline in net interest margin was offset by an 18% increase in average earning assets from 2002 to 2003. Noninterest income increased 14% to $2.5 billion in 2003 compared to $2.2 billion in 2002. The increase in 2003 was driven, in part, by mortgage banking as a result of the large volume of mortgage originations due to the interest rate declines in the ﬁ rst half of 2003. The increase was also due, in part, to the adoption of FIN 46 in the third quarter of 2003 and the resulting recognition of $124 million of operating lease revenue. Noninterest expense totaled $2.6 billion in 2003 compared to $2.3 billion in 2002. The increase, in part, resulted from the adoption of FIN 46 in the third quarter of 2003 and the resulting recognition of $94 million of operating lease expense. Remaining increases were largely related to the expansion of the sale force and investment in additional banking centers. The provision for loan and lease losses was $399 million in 2003 compared to $246 million in 2002. During 2003, net charge-offs were $312 million, or .63% of average loans and leases outstanding, compared to $187 million, or .43%, during 2002. The increase in charge-offs was largely reﬂ ective of the overall challenging economic landscape in 2003 and growth in the overall loan portfolio. comparisons to the prior periods are impacted by the securitization and sale of $750 million of automotive loans and $140 million of consumer loans obtained in the Franklin Financial acquisition in 2004. Consumer installment loan originations were $6.9 billion in 2004 compared to $7.4 billion in 2003. The Bancorp is continuing to devote signiﬁ cant focus on producing retail-based loan origi- nations given the strong credit performance and attractive yields available in these products. Residential mortgage and construction loans, including held for sale, increased 35% compared to 2003 as the overall proportion of retained originations increased. Compari- sons to prior periods are dependent upon the volume and timing of originations as well as the timing of loan sales. Residential mort- gage originations totaled $8.4 billion in 2004 compared to $16.0 TABLE 13: COMPONENTS OF LOAN PORTFOLIO (INCLUDING HELD FOR SALE) As of December 31 ($ in millions) Commercial loans: 2004 2003 2002 2001 2000 Commercial . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Mortgage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Construction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total commercial loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consumer loans: Installment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Mortgage and construction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Credit card . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total consumer loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $16,058 7,636 4,348 3,426 31,468 18,093 7,912 843 2,051 28,899 Total loan portfolio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $60,367 14,226 6,894 3,301 3,264 27,685 17,429 5,865 762 2,448 26,504 54,189 12,786 5,885 3,009 3,019 24,699 14,584 7,123 537 2,343 24,587 49,286 10,909 6,085 3,103 2,487 22,584 12,138 6,815 448 1,743 21,144 43,728 10,734 6,227 2,819 2,571 22,351 11,249 7,570 361 2,654 21,834 44,185 Fifth Third Bancorp 23 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS billion in 2003. Consumer lease balances decreased 16% in 2004 compared to 2003 largely resulting from continued competition from captive ﬁ nance companies offering promotional lease rates. Consumer loan and lease outstandings are affected considerably by sales and securitizations, which totaled approximately $6.0 billion in 2004 and $15.6 billion in 2003. Investment Securities As of December 31, 2004, total investment securities were $25.0 billion, compared to $29.2 billion at December 31, 2003 represent- ing a decrease of 14%. The increased rate environment resulted in a net unrealized loss on the available-for-sale securities portfolio at December 31, 2004 of $114 million, compared to a net unreal- ized loss of $77 million at December 31, 2003. Responding to the change in interest rates, the Bancorp has allocated a greater portion of current purchases to adjustable-rate and shorter-term securities. As a result of all purchase and sale activity during 2004, 14% of the debt securities in the available-for-sale portfolio at December 31, 2004 were adjustable-rate instruments, compared to seven percent at December 31, 2003. The estimated average life of the debt secu- rities in the available-for-sale portfolio at December 31, 2004 was 4.4 years based on current prepayment expectations, compared to 5.2 years at December 31, 2003. Information presented in Table 15 is on a weighted-average TABLE 14: COMPONENTS OF INVESTMENT SECURITIES (AMORTIZED COST BASIS) As of December 31 ($ in millions) Available-for-sale: U.S. Treasury and Government agencies . . . . . . . . . . . . . . . . . . . . . . . . . U.S. Government sponsored agencies . . . . . . . . . . . . . . . . . . . . . . . . . . . Obligations of states and political subdivisions . . . . . . . . . . . . . . . . . . . . Agency mortgage-backed securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other bonds, notes and debentures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total available-for-sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Held-to-maturity: Obligations of states and political subdivisions . . . . . . . . . . . . . . . . . . . . Other bonds, notes and debentures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total held-to-maturity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2004 2003 2002 2001 2000 $ 503 2,036 823 17,571 2,862 1,006 $24,801 $ 245 10 — $ 255 838 3,877 922 21,101 1,401 937 29,076 126 9 — 135 303 2,308 1,033 19,328 1,084 734 24,790 52 — — 52 188 1,142 1,198 15,287 1,872 792 20,479 16 — — 16 211 1,235 889 13,897 1,978 776 18,986 475 45 33 553 TABLE 15: CHARACTERISTICS OF AVAILABLE-FOR-SALE SECURITIES As of December 31, 2004 ($ in millions) U.S. Treasuries and Government agencies: Average life of one year or less . . . . . . . . . . . . . . . . . Average life 1 – 5 years . . . . . . . . . . . . . . . . . . . . . . . Average life 5 – 10 years . . . . . . . . . . . . . . . . . . . . . . Average life greater than 10 years . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . U.S. Government sponsored agencies: Average life of one year or less . . . . . . . . . . . . . . . . . Average life 1 – 5 years . . . . . . . . . . . . . . . . . . . . . . . Average life 5 – 10 years . . . . . . . . . . . . . . . . . . . . . . Average life greater than 10 years . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Obligations of states and political subdivisions (a): Average life of one year or less . . . . . . . . . . . . . . . . . Average life 1 – 5 years . . . . . . . . . . . . . . . . . . . . . . . Average life 5 – 10 years . . . . . . . . . . . . . . . . . . . . . . Average life greater than 10 years . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Agency mortgage-backed securities: Average life of one year or less . . . . . . . . . . . . . . . . . Average life 1 – 5 years . . . . . . . . . . . . . . . . . . . . . . . Average life 5 – 10 years . . . . . . . . . . . . . . . . . . . . . . Average life greater than 10 years . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other bonds, notes and debentures (b): Average life of one year or less . . . . . . . . . . . . . . . . . Average life 1 – 5 years . . . . . . . . . . . . . . . . . . . . . . . Average life 5 – 10 years . . . . . . . . . . . . . . . . . . . . . . Average life greater than 10 years . . . . . . . . . . . . . . . Amortized Cost Fair Value Weighted-Average Life (in years) Weighted-Average Yield $ — 1 502 — 503 5 1,677 354 — 2,036 86 374 348 15 823 190 13,855 3,410 116 17,571 29 2,187 644 2 — 1 490 — 491 5 1,662 346 — 2,013 88 392 367 16 863 190 13,796 3,348 111 17,445 29 2,201 644 2 — 2.0 8.4 — 8.4 .2 3.0 6.2 — 3.6 .5 3.1 6.5 11.4 4.4 .6 4.0 6.1 10.8 4.4 .5 3.4 6.9 16.9 —% 6.08 3.70 — 3.71 7.15 3.60 4.08 — 3.70 8.20 7.65 7.25 6.63 7.52 6.02 4.43 4.48 4.65 4.46 6.53 4.20 3.21 5.63 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other securities (c) . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total available-for-sale securities . . . . . . . . . . . . . . . . . . (a) Taxable-equivalent yield adjustments included in above table are 2.81%, 2.62%, 2.49%, 2.28% and 2.58% for securities with an average life of one year or less, 1-5 years, 2,862 1,006 2,876 999 4.00 — 4.43% $24,801 24,687 4.2 — 4.4 5-10 years, greater than 10 years and in total, respectively. (b) Other bonds, notes and debentures consist of non-agency mortgage-backed securities, certain other asset backed securities (primarily credit card, automobile and commercial loan backed securities) and corporate bond securities. (c) Other securities consists of FHLB, Federal Reserve Bank and Federal Home Loan Mortgage Corporation (“FHLMC”) stock holdings, certain mutual fund holdings and equity security holdings. 24 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS life basis, anticipating future prepayments. Yield information is presented on an FTE basis and is computed utilizing historical cost balances. Maturity and yield calculations for the total available-for- sale portfolio exclude equity securities that have no stated yield or maturity. Deposits Total deposits at December 31, 2004 increased two percent compared to December 31, 2003. The $767 million of deposits obtained in the Franklin Financial acquisition and the $2.8 billion, or seven percent, increase in transaction deposits excluding Frank- lin Financial were offset by the decrease in foreign ofﬁ ce depos- its in 2004. The Bancorp utilizes these deposits, which represent U.S. dollar denominated deposits of the Bancorp’s foreign branch located in the Cayman Islands, as a method to fund earning asset growth. Transaction deposit balances represent an important source of funding and revenue growth opportunity and the Bancorp is continuing to focus on net checking account growth in its retail and commercial franchises. The Bancorp is conﬁ dent in its ability to competitively price and generate growth in customers and deposit balances in an increasing interest rate environment. Overall, the Bancorp experienced deposit growth with signiﬁ - cant contributions from the Chicago, Cleveland, Columbus, Detroit and Florida markets, due to the popularity of existing products. The Bancorp expects to attract new customer relationships across its footprint to drive transaction account deposit growth. Borrowings The Bancorp reduced its dependence on overnight wholesale fund- ing during 2004, given the rising interest rate environment. As previously mentioned in the Statements of Income Analysis section, the Bancorp retired approximately $3.8 billion of long-term debt during 2004. These instruments had a weighted-average coupon of approximately 5.4% and a total weighted-average remaining matu- rity of approximately ﬁ ve years. The Bancorp continues to explore additional alternatives regarding the level and cost of various other sources of funds. Refer to the Liquidity Risk Management section for discussion of the Bancorp’s liquidity management and Note 11 to the Consolidated Financial Statements for a detail of long-term debt. TABLE 16: DEPOSITS As of December 31 ($ in millions) Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest checking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Savings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Money market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other time . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Certiﬁ cates - $100,000 and over . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Foreign ofﬁ ce . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . TABLE 17: BORROWINGS As of December 31 ($ in millions) Federal funds purchased . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Short-term bank notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other short-term borrowings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Long-term debt and convertible subordinated debentures . . . . . . . . . . . . . . Total borrowings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . RISK MANAGEMENT Managing risk is an essential component of successfully operating a ﬁ nancial services company. The Bancorp’s risk management func- tion is responsible for the identiﬁ cation, measurement, monitoring, control and reporting of risk and avoidance of those risks that are inconsistent with the Bancorp’s risk proﬁ le. The Enterprise Risk Management division, led by the Bancorp Chief Risk Ofﬁ cer, ensures consistency in the Bancorp’s approach to managing and monitor- ing risk including, but not limited to, credit, market, operational and regulatory compliance risk, within the structure of Fifth Third’s afﬁ liate operating model. In addition, the Internal Audit division provides an independent assessment of the Bancorp’s internal control structure and related systems and processes. The Enterprise Risk Management division includes the following key functions: (i) a Risk Policy function that ensures consistency in the approach to risk management as the Bancorp’s clearinghouse for credit, market and operational risk policies, procedures and guidelines; (ii) an Operational Risk Management function that is responsible for the risk self-assessment process, the change control evaluation process, business continuity planning and disaster recovery, fraud preven- tion and detection, and root cause analysis and corrective action plans relating to identiﬁ ed operational losses; (iii) an Insurance Risk Management function that is responsible for all property, casualty and liability insurance policies including the claims administration process for the Bancorp; (iv) a Capital Markets Risk Management function that is responsible for establishing and monitoring propri- etary trading limits, monitoring liquidity and interest rate risk and 2004 $13,486 19,481 8,310 4,321 6,837 2,121 3,670 $58,226 2004 $ 4,714 775 4,537 13,983 $24,009 2003 12,142 19,757 7,375 3,201 6,201 1,856 6,563 57,095 2003 6,928 500 5,742 9,063 22,233 2002 10,095 17,878 10,056 1,044 7,638 1,723 3,774 52,208 2002 4,748 — 4,075 8,179 17,002 2001 9,243 13,474 7,065 1,352 11,301 2,197 1,222 45,854 2001 2,544 34 4,875 7,030 14,483 2000 7,152 10,320 5,991 923 14,231 5,049 4,694 48,360 2000 2,178 — 4,166 6,239 12,583 utilizing value at risk and earnings at risk models; (v) an Afﬁ liate Risk Management function that is responsible for the coordination of risk management activities in each banking afﬁ liate and division; (vi) a Credit Risk Review function that is responsible for evaluat- ing the sufﬁ ciency of underwriting, documentation and approval processes for consumer and commercial credits; (vii) a Compli- ance Risk Management function that is responsible for oversight of compliance with all banking regulations and; (viii) a Risk Strategies and Reporting function that is responsible for quantitative analytics and Board of Director and senior management reporting on credit, market and operational risk metrics. All business lines and afﬁ liates have a designated risk manager reporting jointly to a senior executive within the division or afﬁ liate and to the Enterprise Risk Management division. Risk management oversight and governance is provided by the Risk and Compliance Committee of the Board of Directors and through multiple management committees whose member- ship includes a broad cross-section of line of business, afﬁ liate and support representatives. The Risk and Compliance Committee of the Board of Directors consists of three outside directors and has the responsibility for the oversight of credit, market, operational, regulatory compliance and strategic risk management activities for the Bancorp as well as for the Bancorp’s overall aggregate risk proﬁ le. The Risk and Compliance Committee has approved the formation of key management governance committees that are responsible for evaluating risks and controls. These committees include the Market Fifth Third Bancorp 25 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS TABLE 18: COMMERCIAL LOAN AND LEASE PORTFOLIO EXPOSURE (a) As of December 31 ($ in millions) Outstanding Exposure Outstanding Exposure 2004 2003 By industry Manufacturing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Real estate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Construction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Retail trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Business services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Wholesale trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Individuals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Financial services and insurance . . . . . . . . . . . . . . . . . . . . Healthcare . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Transportation and warehousing . . . . . . . . . . . . . . . . . . . Accommodation and food . . . . . . . . . . . . . . . . . . . . . . . . Public administration . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Communication and information . . . . . . . . . . . . . . . . . . Entertainment and recreation . . . . . . . . . . . . . . . . . . . . . . Agribusiness . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Utilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Mining . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . By loan size Less than $5 million . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5 million to $15 million . . . . . . . . . . . . . . . . . . . . . . . . . $15 million to $25 million . . . . . . . . . . . . . . . . . . . . . . . . Greater than $25 million . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . By state Ohio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Michigan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Indiana . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Illinois . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Kentucky . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Tennessee . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Florida . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Pennsylvania . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . West Virginia . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Out-of-footprint . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,970 7,287 3,654 2,957 1,751 1,619 1,673 744 1,355 1,382 850 796 748 781 478 443 509 237 234 $31,468 62% 25 9 4 100% 30% 25 11 10 6 3 2 1 — 12 100% 9,034 8,620 5,823 4,903 3,124 3,178 2,135 2,348 2,245 1,678 1,237 911 1,027 1,335 971 639 676 729 413 3,497 6,303 3,121 2,449 1,851 1,330 1,511 602 1,151 1,222 861 862 648 645 423 401 456 164 188 7,464 7,289 4,896 4,060 2,964 2,508 1,943 1,938 1,714 1,434 1,144 965 878 857 768 603 593 531 278 51,026 27,685 42,827 49 26 13 12 100 33 23 10 10 6 2 2 1 1 12 100 66 24 7 3 100 31 26 10 10 7 1 2 — — 13 100 55 26 12 7 100 35 23 10 10 7 1 2 1 — 11 100 (a) Outstanding reﬂ ects total commercial customer loan and lease balances, net of unearned income and exposure reﬂ ects total commercial customer lending commitments. Risk Committee, the Credit Risk Committee and the Operational Risk Committee. There are also new products and new initiatives processes applicable to every line of business to ensure an appropri- ate standard readiness assessment is performed before launching a new product or initiative. Signiﬁ cant risk policies approved by the management gover- nance committees are also reviewed and approved by the Board of Directors Risk and Compliance Committee. CREDIT RISK MANAGEMENT The objective of the Bancorp’s credit risk management strategy is to quantify and manage credit risk on an aggregate portfolio basis as well as to limit the risk of loss resulting from an individual customer default. Credit risk is managed through a combination of conservative exposure limits and underwriting, documentation and collection standards and overall counterparty limits. The Bancorp’s credit risk management strategy also emphasizes diversiﬁ cation on a geographic, industry and customer level, regular credit examina- tions and monthly management reviews of large credit exposures and credits experiencing deterioration of credit quality. Lending ofﬁ cers with the authority to extend credit are delegated speciﬁ c authority amounts, the utilization of which is closely monitored. Lending activities are largely decentralized, while the Enterprise Risk Management division manages the policy process centrally. The Credit Risk Review function, within the Enterprise Risk Management division, provides objective assessments of the qual- 26 Fifth Third Bancorp ity of underwriting and documentation, the accuracy of risk grades and the charge-off and reserve analysis process. The Bancorp’s credit review process and overall assessment of required reserves is based on ongoing quarterly assessments of the probable estimated losses inherent in the loan and lease portfolio. In addition to the individual review of larger commercial loans that exhibit probable or observed credit weaknesses, the commercial credit review process includes the use of a risk grading system. The Bancorp utilizes two risk grading systems for commercial loans and leases. The current risk grading system utilized for reserve analysis purposes encompasses ten categories. The Bancorp also maintains a dual risk rating system that provides for 13 probability of default grade categories and an additional six grade categories measuring loss factors given an event of default. The probability of default and loss given default analyses are not separated in the ten grade risk rating system. The Bancorp is in the process of completing signiﬁ - cant validation and testing of the dual risk rating system prior to implementation for reserve analysis purposes. The dual risk rating system is consistent with Basel II expectations and allows for more precision in the analysis of commercial credit risk. Scoring systems and delinquency monitoring are used to assess the credit risk in the Bancorp’s homogenous consumer loan portfolios. The Bancorp’s credit risk management strategy includes mini- mizing size risk and other concentrations of risk. Table 18 provides a breakout of the commercial loan and lease portfolio, including held for sale, by major industry classiﬁ cation, by size of credit and by state, MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The table below provides a breakout of the commercial nonaccrual loans and leases by loan size further illustrating the granularity of the Bancorp’s commercial loan portfolio. TABLE 19: SUMMARY OF COMMERCIAL NONACCRUAL LOANS AND LEASES BY LOAN SIZE As of December 31 Less than $200,000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $200,000 to $1 million . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1 million to $5 million . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5 million to $10 million . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10 million to $15 million . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . TABLE 20: SUMMARY OF NONPERFORMING AND UNDERPERFORMING ASSETS 2004 24% 39 24 13 — 100% 2003 23 34 28 15 — 100 2002 16 19 34 25 6 100 As of December 31 ($ in millions) Commercial loans and leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial mortgages . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial construction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Residential mortgages and construction . . . . . . . . . . . . . . . . . . . . . . . . . . Consumer loans and leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total nonaccrual loans and leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Renegotiated loans and leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other assets, including other real estate owned . . . . . . . . . . . . . . . . . . . . . Total nonperforming assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial loans and leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial mortgages and construction . . . . . . . . . . . . . . . . . . . . . . . . . Credit card receivables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Residential mortgages and construction . . . . . . . . . . . . . . . . . . . . . . . . . . Consumer loans and leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total ninety days past due loans and leases . . . . . . . . . . . . . . . . . . . . . . 2004 $110 51 13 24 30 228 1 74 303 22 13 13 43 51 142 Total underperforming assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $445 Nonperforming assets as a percent of total loans, leases and other assets, including other real estate owned . . . . . . . . . . . . . . . . . . . . . . . . .51% Underperforming assets as a percent of total loans, leases and other assets, including other real estate owned . . . . . . . . . . . . . . . . . . . . . . . . Reserve for loan and lease losses as a percent of total nonperforming assets (a) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Reserve for credit losses as a percent of total nonperforming assets . . . . . . Reserve for loan and lease losses as a percent of total .74 235 259 2003 2002 2001 2000 129 42 19 25 27 242 8 69 319 15 12 13 51 54 145 464 .61 .89 219 242 159 41 14 18 15 247 — 26 273 29 18 9 60 46 162 435 .59 .95 251 251 122 57 26 11 — 216 — 19 235 25 24 8 56 51 164 399 .57 .96 265 265 73 42 11 42 6 174 2 25 201 31 6 5 49 37 128 329 .47 .77 304 304 underperforming assets (a) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 185 Reserve for credit losses as a percent of total underperforming assets . . . . 185 (a) As of December 31, 2004, the reserve for unfunded commitments has been reclassiﬁ ed from the reserve for loan and lease losses to other liabilities. The 2003 year-end reserve for unfunded commitments has been reclassiﬁ ed to conform to the current year presentation. The reserve for unfunded commitments balance was $72 million and $73 million at December 31, 2004 and 2003, respectively. The reserve for credit losses is the sum of the reserve for loan and lease losses and the reserve for unfunded commitments. 160 176 156 156 157 157 150 166 illustrating the diversity and granularity of the Bancorp’s portfolio. The commercial portfolio is further characterized by 88% of outstanding balances and exposures concentrated within the Bancorp’s primary market areas of Ohio, Kentucky, Indiana, Michi- gan, Illinois, Florida, Tennessee, West Virginia and Pennsylvania. Exclusive of a national large-ticket leasing business, the commercial portfolio is characterized by 95% of outstanding balances and 93% of exposures concentrated within these nine states. The mortgage and construction segments of the commercial portfolio are charac- terized by 98% of outstanding balances and exposures concentrated within these nine states. Analysis of Nonperforming Assets Nonperforming assets include nonaccrual loans and leases on which ultimate collectibility of the full amount of the interest is uncer- tain, loans and leases which have been renegotiated to provide for a reduction or deferral of interest or principal because of deterioration TABLE 21: CHANGES IN RESERVE FOR LOAN AND LEASE LOSSES For the Years Ended December 31 ($ in millions) Balance at January 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net charge-offs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Reserve of acquired institutions and other . . . . . . . . . . . . . . . . . . . . . . . Provision for loan and lease losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Merger-related provision . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Reclassiﬁ cation of reserve related to unfunded commitments . . . . . . . . . Balance at December 31 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . in the ﬁ nancial position of the borrower and other assets, includ- ing other real estate owned and repossessed equipment. Underper- forming assets include nonperforming assets and loans and leases past due 90 days or more as to principal or interest, which are not already accounted for as nonperforming assets. Commercial nonaccrual credits as a percent of loans improved considerably in 2004 to .56% from .68% in 2003 and were primar- ily driven by the Cincinnati, Columbus, Toledo, Indianapolis and Evansville markets. Consumer nonaccrual credits as a percent of loans increased slightly from .19% in 2003 to .21% in 2004 and was not attributable to any particular market. Overall, nonaccrual credits continue to represent a small portion of the portfolio at just .38% as of December 31, 2004, compared to .46% as of December 31, 2003. Total nonperforming assets were $303 million at December 31, 2004, down $16 million compared to $319 million at Decem- ber 31, 2003. Total nonperforming assets as a percent of total loans, 2004 $697 (252) — 268 — — $713 2003 683 (312) — 399 — (73) 697 2002 624 (187) — 246 — — 683 2001 609 (227) 6 201 35 — 624 2000 573 (109) 7 126 12 — 609 Fifth Third Bancorp 27 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS TABLE 22: ATTRIBUTION OF RESERVE FOR LOAN AND LEASE LOSSES TO LOAN PORTFOLIOS As of December 31 ($ in millions) Reserve attributed to: Commercial, ﬁ nancial and agricultural loans . . . . . . . . . . . . . . . . . . Real estate - commercial mortgage loans . . . . . . . . . . . . . . . . . . . . . Real estate - construction loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . Real estate - residential mortgage loans . . . . . . . . . . . . . . . . . . . . . . Consumer loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Lease ﬁ nancing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Unallocated . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total reserve for loan and lease losses . . . . . . . . . . . . . . . . . . . . . . . . . . Credit portfolios (excluding held for sale): Commercial, ﬁ nancial and agricultural loans . . . . . . . . . . . . . . . . . . Real estate - commercial mortgage loans . . . . . . . . . . . . . . . . . . . . . Real estate - construction loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . Real estate - residential mortgage loans . . . . . . . . . . . . . . . . . . . . . . Consumer loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Lease ﬁ nancing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total loans and leases (excluding held for sale) . . . . . . . . . . . . . . . . . . . Reserve as a percent of loan and lease portfolios (excluding held for sale): Commercial, ﬁ nancial and agricultural loans . . . . . . . . . . . . . . . . . . Real estate - commercial mortgage loans . . . . . . . . . . . . . . . . . . . . . Real estate - construction loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . Real estate - residential mortgage loans . . . . . . . . . . . . . . . . . . . . . . Consumer loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Lease ﬁ nancing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Unallocated (as a percent of total loans and leases) . . . . . . . . . . . . . . 2004 2003 2002(a) 2001(a) 2000(a) $ 210 73 43 44 160 47 136 $ 713 $16,058 7,636 4,726 6,988 18,923 5,477 $59,808 1.31% .96 .90 .63 .85 .86 .23 234 77 34 29 146 64 113 697 14,209 6,894 3,636 4,425 17,432 5,712 52,308 1.65 1.12 .94 .66 .84 1.12 .22 159 117 41 43 141 132 50 683 12,743 5,885 3,327 3,495 15,116 5,362 45,928 1.24 1.98 1.24 1.24 .93 2.46 .11 118 102 32 31 132 101 108 624 10,807 6,085 3,356 4,505 12,565 4,230 41,548 1.09 1.69 .97 .69 1.05 2.38 .26 107 103 28 18 134 113 106 609 10,669 6,227 3,223 5,635 11,551 5,225 42,530 1.00 1.65 .87 .31 1.16 2.17 .25 Total loans and leases (excluding held for sale) . . . . . . . . . . . . . . . . . . . (a) The reserve for loan and lease losses in 2002, 2001 and 2000 includes funded and unfunded commitments. As of December 31, 2004, the reserve for unfunded commitments has been reclassiﬁ ed from the reserve for loan and lease losses to other liabilities. The 2003 year-end reserve for unfunded commitments has been reclassiﬁ ed to conform to the current period presentation. 1.19% 1.50 1.49 1.33 1.43 TABLE 23: SUMMARY OF CREDIT LOSS EXPERIENCE For the Years Ended December 31 ($ in millions) 2004 2003 2002 2001 2000 Losses charged off: Commercial, ﬁ nancial and agricultural loans . . . . . . . . . . . . . . . . . . . Real estate - commercial mortgage loans . . . . . . . . . . . . . . . . . . . . . . Real estate - construction loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Real estate - residential mortgage loans . . . . . . . . . . . . . . . . . . . . . . . Consumer loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Lease ﬁ nancing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Recoveries of losses previously charged off: Commercial, ﬁ nancial and agricultural loans . . . . . . . . . . . . . . . . . . . Real estate - commercial mortgage loans . . . . . . . . . . . . . . . . . . . . . . Real estate - construction loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Real estate - residential mortgage loans . . . . . . . . . . . . . . . . . . . . . . . Consumer loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Lease ﬁ nancing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total recoveries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net losses charged off: Commercial, ﬁ nancial and agricultural loans . . . . . . . . . . . . . . . . . . . Real estate - commercial mortgage loans . . . . . . . . . . . . . . . . . . . . . . Real estate - construction loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Real estate - residential mortgage loans . . . . . . . . . . . . . . . . . . . . . . . Consumer loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Lease ﬁ nancing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (95) (14) (7) (15) (156) (34) (321) 14 5 — — 41 9 69 (81) (9) (7) (15) (115) (25) Total net losses charged off . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (252) Net charge-offs as a percent of average loans and leases (excluding held for sale): Commercial, ﬁ nancial and agricultural loans . . . . . . . . . . . . . . . . . . . Real estate - commercial mortgage loans . . . . . . . . . . . . . . . . . . . . . . Real estate - construction loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Real estate - residential mortgage loans . . . . . . . . . . . . . . . . . . . . . . . Consumer loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Lease ﬁ nancing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total net charge-offs as a percent of average loans and leases (excluding held for sale) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .54% .12 .15 .27 .63 .46 .45% (152) (9) (3) (24) (136) (56) (380) 16 2 1 — 40 9 68 (136) (7) (2) (24) (96) (47) (312) 1.00 .10 .09 .57 .58 .84 .63 (81) (18) (6) (10) (115) (43) (273) 20 5 3 — 46 12 86 (61) (13) (3) (10) (69) (31) (187) .52 .23 .12 .23 .49 .65 .43 (106) (12) (2) (7) (117) (65) (309) 21 10 — — 39 12 82 (85) (2) (2) (7) (78) (53) (227) .79 .04 .06 .14 .65 1.13 .54 (37) (22) (1) (3) (73) (40) (176) 16 10 — 1 31 9 67 (21) (12) (1) (2) (42) (31) (109) .20 .21 .03 .04 .41 .58 .26 28 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS leases and other assets, including other real estate owned declined to .51% as of December 31, 2004 from .61% as of December 31, 2003. Loans and leases 90 days past due have also declined at December 31, 2004 compared to December 31, 2003. The Bancorp expects credit quality trends in 2005 to remain similar to 2004. At December 31, 2004, there were $40.9 million of loans and leases currently performing in accordance with contractual terms, but for which there were serious doubts as to the ability of the borrower to comply with such terms. For the years 2004 and 2003, interest income of $6 million and $5 million, respectively, was recorded on nonaccrual and renegotiated loans and leases. For the years 2004 and 2003, additional interest income of $33 million and $23 million, respectively, would have been recorded if the nonaccrual and renegotiated loans and leases had been current in accordance with the original terms. Analysis of Net Loan Charge-offs Net charge-offs as a percent of average loans and leases outstanding decreased 18 bp to .45% for 2004 from .63% for 2003. The decrease in net charge-offs in the current year compared to 2003 was primar- ily due to lower net charge-offs in commercial loans and commercial and consumer lease ﬁ nancing. Total commercial loan net charge-offs decreased $55 million to $81 million in 2004 compared to $136 million in 2003. Commercial loan net charge-offs as a percentage of average commercial loans outstanding were .54% in 2004, compared to 1.00% in 2003. The decrease in commercial loan net charge-offs compared to 2003 was concentrated in several markets, includ- ing Columbus and Chicago. The Bancorp experienced signiﬁ cant improvement in commercial loan net charge-off activity in 2004 as compared to 2003 as a result of overall improving credit trends and economic outlook. Commercial mortgage net charge-offs were comparable to the low level seen in 2003. Commercial leasing net charge-offs improved due to charge-offs related to two commercial airline leases totaling $20 million occurring in 2003. Total consumer loan net charge-offs in 2004 increased to $115 million compared with $96 million in 2003, with increases not concentrated in any speciﬁ c market. The ratio of consumer loan net charge-offs to aver- age loans outstanding increased slightly to .63% in 2004 from .58% in 2003, and the ratio for residential mortgage loan net charge-offs improved from .57% to .27% due to improvements in most of the Bancorp’s markets. Provision and Reserve for Loan and Lease Losses The reserve for loan and lease losses provides coverage for probable and estimable losses in the loan and lease portfolio. The Bancorp evaluates the reserve each quarter to determine that it is adequate to cover inherent losses. In the current year, the Bancorp has not substantively changed any aspect to its overall approach in the determination of the reserve for loan and lease losses, and there have been no material changes in assumptions or estimation techniques as compared to prior periods that impacted the determination of the current period reserve. Table 21 shows the changes in the reserve for loan and lease losses during 2004. As of December 31, 2004, the reserve for unfunded commitments has been reclassiﬁ ed from the reserve for loan and lease losses to other liabilities. The December 31, 2003 reserve for unfunded commitments and all subsequent activity has been reclassiﬁ ed to conform to current period presentation. The increase in the balance of the reserve for loan and lease losses in 2004 compared to 2003 is primarily due to the increase in the total loan and lease portfolio. The reserve for loan and lease losses at December 31, 2004 decreased to 1.19% of the total loan and lease portfolio compared to 1.33% at December 31, 2003 due to improvements in credit quality trends. Additionally, the Bancorp’s long history of low exposure limits, minimal exposure to national or sub-prime lending businesses, centralized risk manage- ment and its diversiﬁ ed portfolio reduces the likelihood of signiﬁ - cant unexpected credit losses. Table 22 provides the amount of the reserve for loan and lease losses by category. MARKET RISK MANAGEMENT Market risk arises from ﬂ uctuations in interest rates, foreign exchange rates and equity prices that may result in the potential reduction in net interest income. Interest rate risk, a component of market risk, is the exposure to adverse changes in net interest income due to changes in interest rates. Management considers interest rate risk a prominent market risk in terms of its poten- tial impact on earnings. Interest rate risk can occur for any one or more of the following reasons: (i) assets and liabilities may mature or reprice at different times; (ii) short-term and long-term market interest rates may change by different amounts or; (iii) the remain- ing maturity of various assets or liabilities may shorten or lengthen as interest rates change. In addition to the direct impact of interest rate changes on net interest income, interest rates can indirectly impact earnings through their effect on loan demand, credit losses, mortgage origination fees, the value of servicing rights and other sources of the Bancorp’s earnings. Consistency of the Bancorp’s net interest income is largely dependent upon the effective manage- ment of interest rate risk. Net Interest Income Simulation Model The Bancorp employs a variety of measurement techniques to iden- tify and manage its interest rate risk, including the use of an earn- ings simulation model to analyze net interest income sensitivity to changing interest rates. The model is based on actual cash ﬂ ows and repricing characteristics for all of the Bancorp’s ﬁ nancial instru- ments and incorporates market-based assumptions regarding the effect of changing interest rates on the prepayment rates of certain assets and liabilities. The model also includes senior management projections for activity levels in each of the product lines offered by the Bancorp and incorporates the loss of free funding result- ing from the Bancorp’s share repurchase activity. Actual results will differ from these simulated results due to timing, magnitude and frequency of interest rate changes as well as changes in market conditions and management strategies. The Bancorp’s Asset/Liability Risk Management Committee (“ALCO”), which includes senior management representatives and is accountable to the Risk and Compliance Committee of the Board of Directors, monitors and manages interest rate risk within Board approved policy limits. In addition to the risk management activi- ties of ALCO, the Bancorp created a Market Risk Management department as part of the Enterprise Risk Management Division, which provides independent oversight of market risk activities. The Bancorp’s current interest rate risk policy limits are determined by measuring the anticipated change in net interest income over a 12- month and 24-month horizon assuming a 200 bp linear increase or decrease in all interest rates. In accordance with the current policy, the rate movements are assumed to occur over one year and are sustained thereafter. Given the low level of interest rates, the Bancorp’s ALCO has measured the risk of a decrease in interest rates at 100 basis points. Additionally, in order to further illus- trate the estimated earnings sensitivity of interest rate changes, the Bancorp has included the anticipated change to net interest income over a 12-month and 24-month horizon assuming a 100 bp linear increase. The following table shows the Bancorp’s estimated earn- ings sensitivity proﬁ le on the asset and liability positions as of December 31, 2004: TABLE 24: ESTIMATED EARNINGS SENSITIVITY PROFILE Change in Interest Rates (bp) +200 +100 -100 Change in Net Interest Income 12 Months .34% .32 .04 24 Months 4.07 2.86 (4.05) Fifth Third Bancorp 29 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Based upon expected repayments, the following is a summary of the remaining maturities of loans and leases held for investment as of Decem- ber 31, 2004: TABLE 25: LOAN AND LEASE MATURITIES ($ in millions) Less than 1 year 1-5 years Greater than 5 years Commercial, ﬁ nancial and agricultural . . . . . . . . . . . . . . . . . . . . . . . . Real estate - commercial mortgage loans . . . . . . . . . . . . . . . . . . . . . . . Real estate - construction loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Residential mortgage loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consumer loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Lease ﬁ nancing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 9,503 2,124 2,657 1,957 5,583 1,524 $ 23,348 5,641 4,729 1,669 2,527 9,465 3,163 27,194 914 783 400 2,504 3,875 790 9,266 Total 16,058 7,636 4,726 6,988 18,923 5,477 59,808 Segregated by sensitivity to interest rate changes, the following is a summary of expected repayments exceeding one year as of December 31, 2004: TABLE 26: LOAN AND LEASE INTEREST RATE SENSITIVITY ($ in millions) Commercial, ﬁ nancial and agricultural . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Real estate - commercial mortgage loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Real estate - construction loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Residential mortgage loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consumer loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Lease ﬁ nancing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . TABLE 27: MATURITY DISTRIBUTION OF CERTIFICATES – $100,000 AND OVER As of December 31, 2004 ($ in millions) Interest Rate Predetermined Floating or Adjustable $ 1,992 2,228 478 1,647 6,438 3,953 $16,736 4,563 3,284 1,591 3,384 6,902 — 19,724 Three months or less . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Over three months through six months . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Over six months through one year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Over one year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 908 292 422 499 $2,121 The balance sheet repositioning in the fourth quarter of 2004 changed the interest rate sensitivity proﬁ le of the Bancorp from liability sensitive to asset sensitive (i.e., from a negative outlook to a positive outlook in a rising rate environment). Management does not expect any signiﬁ cant adverse effect to net interest income in 2005 based on the current composition of the portfolio, antici- pated trends in rates and earning asset and deposit growth. Use of Derivatives to Manage Interest Rate Risk An integral component of the Bancorp’s interest risk management strategy is its use of derivative instruments to minimize signiﬁ - cant unplanned ﬂ uctuations in earnings and cash ﬂ ows caused by market volatility. Examples of derivative instruments that the Bancorp may use as part of its interest rate risk management strate- gy include interest rate swaps, interest rate ﬂ oors, interest rate caps, forward contracts, principal only swaps, options and swaptions. Interest rate swap contracts are exchanges of interest payments, such as ﬁ xed-rate payments for ﬂ oating-rate payments, based on a common notional amount and maturity date. Interest rate ﬂ oors protect against declining rates, while interest rate caps protect against rising interest rates. Forwards are contracts in which the buyer agrees to purchase, and the seller agrees to make delivery of, a speciﬁ c ﬁ nancial instrument at a predetermined price or yield. Swaptions provide the buyer the option to exchange streams of payments with the seller over a speciﬁ ed period of time. As part of its overall risk management strategy relative to its mortgage banking activity, the Bancorp enters into forward contracts accounted for as free-standing derivatives to economically hedge interest rate lock commitments, which are also considered free-standing derivatives. The Bancorp also establishes derivative contracts with repu- table third parties to economically hedge signiﬁ cant exposures assumed in commercial customer accommodation derivative contracts. Generally, these contracts have similar terms in order to protect the Bancorp from the market volatility. Credit risks arise from the possible inability of counterparties to meet the terms of their contracts, which the Bancorp minimizes through credit 30 Fifth Third Bancorp approvals, limits and monitoring procedures. The notional amount and fair values of these derivatives as of December 31, 2004 are included in Note 9 to the Consolidated Financial Statements. Mortgage Servicing Rights and Interest Rate Risk The net carrying amount of the MSR portfolio was $339 million as of December 31, 2004. The Bancorp maintains a non-qualifying hedging strategy relative to its mortgage banking activity, including consultation with an independent third-party specialist, in order to manage a portion of the risk associated with changes in impairment on its MSR portfolio as a result of changing interest rates. This strategy includes the purchase of free-standing derivatives (princi- pal only swaps, swaptions, ﬂ oors, interest rate swaps, options and forward contracts). The mark-to-market adjustments associated with these derivatives are expected to economically hedge a portion of the change in value of the MSR portfolio caused by ﬂ uctuating discount rates, earnings rates and prepayment speeds. The value of servicing rights can ﬂ uctuate sharply depending on changes in interest rates and other factors. Generally, as interest rates decline and loans are prepaid to take advantage of reﬁ nancing, the total value of existing servicing rights declines because no further servic- ing fees are collected on repaid loans. The increase in interest rates during 2004 and the resulting impact of changing prepayment speeds led to the recovery of $60 million in temporary impairment in the MSR portfolio as compared to the $3 million in temporary impairment recognized in 2003. The servicing rights are deemed impaired when a borrower’s loan rate is distinctly higher than prevailing market rates. See Note 8 to the Consolidated Financial Statements for further discussion on servicing rights. Foreign Currency Risk The Bancorp enters into foreign exchange derivative contracts for the beneﬁ t of commercial customers involved in international trade to hedge their exposure to foreign currency ﬂ uctuations. The Bancorp has in place several controls to ensure excessive risk is not being taken in providing this service to customers. These include MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS TABLE 28: AGENCY RATINGS As of February 9, 2005 Fifth Third Bancorp: Moody’s Standard and Poor’s Commercial paper . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Senior debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fifth Third Bank and Fifth Third Bank (Michigan): Short-term deposit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Long-term deposit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Prime-1 Aa2 Prime-1 Aa1 A-1 A+ A-1+ AA- TABLE 29: CAPITAL RATIOS As of December 31 ($ in millions) Tier 1 capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Risk-weighted assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Risk-based capital ratios: Tier 1 capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Leverage ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2004 $ 8,522 10,176 82,633 10.31% 12.31 8.89 2003 8,272 10,096 74,477 11.11 13.56 9.23 2002 7,747 8,935 65,444 11.84 13.65 9.84 2001 7,433 8,656 59,491 12.49 14.55 10.64 Fitch F1+ AA- F1+ AA 2000 6,377 7,554 55,943 11.40 13.50 9.49 TABLE 30: SHARE REPURCHASES For the Years Ended December 31 2004 2003 2002 Shares authorized for repurchase at January 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Additional authorizations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Shares repurchases (a) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Shares authorized for repurchase at December 31 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Average price paid per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (a) Excludes 40,850 shares repurchased during 2004 in connection with various employee compensation plans. These repurchases are not included against the maximum number 14,137,512 40,000,000 (18,452,400) 5,600,681 20,000,000 (11,463,169) 17,338,791 — (11,738,110) 35,685,112 14,137,512 5,600,681 $53.48 57.13 61.30 of shares that may yet be repurchased under the Board of Directors’ authorization. an independent determination of currency volatility and credit equivalent exposure on these contracts, counterparty credit approv- als and country limits. LIQUIDITY RISK MANAGEMENT The goal of liquidity risk management is to provide adequate funds to satisfy changes in loan and lease demand or unexpected deposit withdrawals. This goal is accomplished by maintaining liquid assets in the form of investment securities, maintaining sufﬁ cient unused borrowing capacity in the national money markets and delivering consistent growth in core deposits. The primary source of asset driven liquidity is provided by debt securities in the available-for- sale securities portfolio. The estimated average life of the avail- able-for-sale portfolio is 4.4 years at December 31, 2004, based on current prepayment expectations. Of the $24.7 billion (fair value basis) of available-for-sale securities in the portfolio at December 31, 2004, $3.8 billion is expected to be received in the next 12 months, and an additional $2.8 billion is expected to be received in the next 13 to 24 months. In addition to the proceeds from avail- able-for-sale portfolio securities, asset-driven liquidity is provided by the Bancorp’s ability to sell or securitize loan and lease assets. In order to reduce the exposure to interest rate ﬂ uctuations as well as to manage liquidity, the Bancorp has developed securitization and sale procedures for several types of interest-sensitive assets. A majority of the long-term, ﬁ xed-rate single-family residential mort- gage loans underwritten according to FHLMC or Federal National Mortgage Association guidelines are sold for cash upon origination. Periodically, additional assets such as jumbo ﬁ xed-rate residen- tial mortgages, certain ﬂ oating rate short-term commercial loans, certain ﬂ oating rate home equity loans, certain auto loans and other consumer loans are also securitized, sold or transferred off-balance sheet. For the years ended December 31, 2004 and 2003, a total of $6.7 billion and $15.9 billion, respectively, were sold, securitized, or transferred off-balance sheet. The Bancorp also has in place a shelf registration with the Securities and Exchange Commission permitting ready access to the public debt markets. As of December 31, 2004, $1.5 billion of debt or other securities were available for issuance under this shelf regis- tration. Additionally, as determined in accordance with applicable regulatory requirements, the Bancorp as of December 31, 2004 has $14.3 billion of funding available for issuance through private offerings of debt securities pursuant to its bank note program. In January 2005, a subsidiary of the Bancorp issued $500 million of subordinated bank notes under this bank note program. Such bank notes may be sold to qualiﬁ ed institutional buyers, ﬁ nancial institu- tions, banks, insurance companies and similar entities in the ordi- nary course of business from time to time, which together with the Bancorp’s 9.34% average equity capital base and shelf registration availability, constitute some of the various sources of funds utilized to maintain a stable and diverse funding base. Since June 2002, Moody’s senior debt rating for the Bancorp has been Aa2, a rating equaled or surpassed by only three other U.S. bank holding companies. This rating by Moody’s reﬂ ects the Bancorp’s capital strength and ﬁ nancial stability. Table 28 provides Moody’s, Standard and Poor’s and Fitch’s deposit and debt ratings as of February 9, 2005 for the Bancorp, Fifth Third Bank and Fifth Third Bank (Michigan). These debt ratings, along with capital ratios signiﬁ cantly above regulatory guidelines, provide the Bancorp with additional access to liquidity. Core customer deposits have historically provided the Bancorp with a sizeable source of relatively stable and low-cost funds. The Bancorp’s average core deposits and stockholders’ equity funded 61% of its average total assets during 2004. In addition to core deposit funding, the Bancorp also accesses a variety of other short- term and long-term funding sources, which include the use of various regional Federal Home Loan Banks as a funding source. Certiﬁ cates carrying a balance of $100,000 or more and deposits in the Bancorp’s foreign branch located in the Cayman Islands are wholesale funding tools utilized to fund asset growth. The maturity distribution of domestic certiﬁ cates of deposit of $100,000 and over as of December 31, 2004 is shown in Table 27. Management does not rely on any one source of liquidity and manages availability in response to changing balance sheet needs. CAPITAL MANAGEMENT The Bancorp maintains a relatively high level of capital as a margin of safety for its depositors and shareholders. At December 31, 2004, shareholders’ equity was $8.9 billion compared to $8.7 billion at December 31, 2003, an increase of three percent. Average share- holders’ equity as a percentage of average assets for the year ended Fifth Third Bancorp 31 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS December 31, 2004 was 9.34%. The FRB adopted quantitative measures that assign risk weightings to assets and off-balance sheet items and also deﬁ ne and set minimum regulatory capital require- ments (risk-based capital ratios). The guidelines deﬁ ne “well-capi- talized” ratios of Tier 1, total capital and leverage as 6%, 10% and 5%, respectively. The Bancorp exceeded these “well-capitalized” ratios at December 31, 2004 and 2003. The Bancorp expects to maintain these ratios above the well-capitalized levels. Dividend Policy The Bancorp’s common stock dividend policy reﬂ ects its earnings outlook, desired payout ratios, the need to maintain adequate capi- tal levels and alternative investment opportunities. In 2004, the Bancorp’s annual dividend increased to $1.31 from $1.13 in 2003. On June 15, 2004, the Bancorp announced that its Board of Directors had authorized management to purchase 40 million shares of the Bancorp’s common stock through the open market or in any private transaction. The timing of the purchases and the exact number of shares to be purchased depends upon market conditions. The authorization does not include speciﬁ c price targets or an expiration date. The Bancorp’s repurchase of equity securities is shown in Table 30. On January 10, 2005, the Bancorp repurchased 35.5 million shares of its common stock, approximately six percent of total outstanding shares, for approximately $1.6 billion in an overnight accelerated share repurchase transaction. The transaction provides that the counterparty will purchase shares in the market over a period of time. Upon completion, the Bancorp will receive or pay a price adjustment in the form of cash or shares, at its election, that is largely based on the volume weighted-average price of the shares purchased by the counterparty. On January 18, 2005, the Bancorp announced that its Board of Directors had authorized manage- ment to purchase 20 million shares of the Bancorp’s common stock through the open market or in any private transaction. The timing of the purchases and the exact number of shares to be purchased depends upon market conditions and may commence upon the completion of the overnight accelerated share repurchase transac- tion. The authorization does not include speciﬁ c price targets or an expiration date. The Bancorp’s stock repurchase program is an important element of its capital planning activities. The Bancorp views share repurchases as an effective means of delivering value to shareholders. Off-Balance Sheet Arrangements The Bancorp consolidates all of its majority-owned subsidiaries. Other entities, including certain joint ventures, in which there is greater than 20% ownership, but upon which the Bancorp does not possess, nor can it exert, signiﬁ cant inﬂ uence or control, are accounted for by equity method accounting and not consolidated. Those entities in which there is less than 20% ownership are gener- ally carried at the lower of cost or fair value. The Bancorp does not participate in any trading activities involving commodity contracts that are accounted for at fair value. In addition, the Bancorp has no fair value contracts for which a lack of marketplace quotations necessitates the use of fair value estimation techniques. The Bancorp’s derivative product policy and investment policies provide a framework within which the Bancorp and its afﬁ liates may use certain authorized ﬁ nancial derivatives as a market risk management tool in meeting the Bancorp’s ALCO capital planning directives, to hedge changes in fair value of its largely ﬁ xed rate mortgage servicing rights portfolio or to provide qualifying customers access to the derivative products market. These policies are reviewed and approved annually by the Audit Committee and the Risk and Compliance Committee of the Board of Directors. 32 Fifth Third Bancorp As part of the Bancorp’s market risk management, the Bancorp may transfer, subject to credit recourse, certain types of individual ﬁ nancial assets to a non-consolidated qualiﬁ ed special purpose entity (“QSPE”) that is wholly owned by an independent third- party. The accounting for QSPEs is currently under review by the FASB, and the conditions for consolidation or non-consolidation of such entities could change. During the year ended December 31, 2004, certain commercial loans (primarily ﬁ xed-rate short-term investment grade) were transferred to the QSPE. Generally, the loans transferred provide a lower yield due to their investment grade nature and therefore transferring these loans to the QSPE allows the Bancorp to reduce its exposure to these lower yielding loan assets while maintaining these customer relationships. These individual loans are transferred at par with no gain or loss recognized and qual- ify as sales, as set forth in SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities – a Replacement of FASB Statement No. 125.” At December 31, 2004, the outstanding balance of loans transferred was $1.9 billion. Given the investment grade nature of the loans transferred, as well as the underlying collateral security provided, the Bancorp has not maintained any loss reserve related to these loans transferred. The Bancorp utilizes securitization trusts formed by inde- pendent third parties to facilitate the securitization process of residential mortgage loans, certain ﬂ oating rate home equity lines of credit, certain auto loans and other consumer loans. The cash ﬂ ows to and from the securitization trusts are principally limited to the initial proceeds from the securitization trust at the time of sale with subsequent cash ﬂ ows relating to retained interests. The Bancorp’s securitization policy permits the retention of subordinat- ed tranches, servicing rights, interest-only strips, residual interests, credit recourse, other residual interests and, in some cases, a cash reserve account. At December 31, 2004, the Bancorp had retained servicing assets totaling $352 million, subordinated tranche secu- rity interests totaling $34 million and residual interests totaling $52 million. The Bancorp had the following cash ﬂ ows with these uncon- solidated QSPEs during the year ended December 31, 2004 and 2003. TABLE 31: CASH FLOWS WITH UNCONSOLIDATED QSPEs For the Years Ended December 31 ($ in millions) Proceeds from transfers, including new 2004 2003 securitizations . . . . . . . . . . . . . . . . . . . . . . . . . . $1,379 1,345 Proceeds from collections reinvested in 162 164 32 revolving-period securitizations . . . . . . . . . . . . . Transfers received from QSPEs . . . . . . . . . . . . . . . . Fees received . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46 116 25 At December 31, 2004, the Bancorp had provided credit recourse on approximately $569 million of residential mortgage loans sold to unrelated third parties. In the event of any customer default, pursuant to the credit recourse provided, the Bancorp is required to reimburse the third party. The maximum amount of credit risk in the event of nonperformance by the underlying borrowers is equivalent to the total outstanding balance of $569 million. In the event of nonperformance, the Bancorp has rights to the underlying collateral value attached to the loan. Consistent with its overall approach in estimating credit losses for various categories of residential mortgage loans held in its loan portfolio, the Bancorp maintains an estimated credit loss reserve of $17 million relating to these residential mortgage loans sold. Contractual Obligations and Commitments The Bancorp has certain obligations and commitments to make future payments under contracts. At December 31, 2004, the aggregate contractual obligations and commitments were: MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS TABLE 32: CONTRACTUAL OBLIGATIONS AND OTHER COMMITMENTS As of December 31, 2004 ($ in millions) Contractually obligated payments due by period: Total deposits (a) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Long-term debt (b) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest on ﬁ xed-rate long-term debt (c) . . . . . . . . . . . . . . . . . . . . . . . . . . Short-term borrowings (d) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Noncancelable leases (e) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Purchase obligations (f ) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total contractually obligated payments due by period . . . . . . . . . . . . . . . . . Other commitments by expiration period: Letters of credit (g) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commitments to extend credit (g) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Less than 1 year $54,504 3,306 169 10,026 49 29 $68,083 $ 1,817 18,698 1-3 years 4-5 years Greater than 5 years 195 4,587 240 — 87 22 5,131 2,360 12,614 21 3,246 178 — 69 8 3,522 1,452 — 3,506 2,844 717 — 186 — 7,253 294 — Total 58,226 13,983 1,304 10,026 391 59 83,989 5,923 31,312 Total other commitments by expiration period . . . . . . . . . . . . . . . . . . . . . . 37,235 (a) Includes demand, interest checking, savings, money market, other time, certiﬁ cates-$100,000 and over and foreign ofﬁ ce deposits. For additional information see the Deposits $20,515 14,974 1,452 294 discussion in the Balance Sheet Analysis section of Management’s Discussion and Analysis. (b) See Note 11 of the Notes to the Consolidated Financial Statements for additional information on these debt instruments. (c) Represents expected interest expense to be incurred on ﬁ xed-rate long-term debt. See Note 11 of the Notes to the Consolidated Financial Statements for additional information. (d) Includes federal funds purchased, bank notes, securities sold under repurchase agreements and other debt instruments as discussed in Note 10 of the Notes to the Consolidated Financial Statements. (e) See Note 4 of the Notes to the Consolidated Financial Statements for additional information on these noncancelable leases. (f ) Represents agreements to purchase goods or services. (g) See Note 12 of the Notes to the Consolidated Financial Statements for additional information on these commitments. CONTROLS AND PROCEDURES The Bancorp maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in the Bancorp’s Securities Exchange Act of 1934 (“Exchange Act”) reports is recorded, processed, summarized and reported within the time periods speciﬁ ed in the Securities and Exchange Commis- sion’s rules and forms, and that such information is accumulated and communicated to the Bancorp’s management, including its Chief Executive Ofﬁ cer and Chief Financial Ofﬁ cer, as appropri- ate, to allow timely decisions regarding required disclosure based closely on the deﬁ nition of “disclosure controls and procedures” in Exchange Act Rules 13a-15(e) and 15d-15(e). In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessar- ily was required to apply its judgment in evaluating the cost-beneﬁ t relationship of possible controls and procedures. As of the end of the period covered by this report, the Bancorp carried out an evaluation, under the supervision and with the participation of the Bancorp’s management, including the Bancorp’s Chief Executive Ofﬁ cer and Chief Financial Ofﬁ cer, of the effec- tiveness of the design and operation of the Bancorp’s disclosure controls and procedures. Based on the foregoing, the Bancorp’s Chief Executive Ofﬁ cer and Chief Financial Ofﬁ cer concluded that the Bancorp’s disclosure controls and procedures were effec- tive, in all material respects, to ensure that information required to be disclosed in the reports the Bancorp ﬁ les and submits under the Exchange Act is recorded, processed, summarized and reported as and when required. The Bancorp’s management also conducted an evaluation of internal control over ﬁ nancial reporting to determine whether any changes occurred during the year covered by this report that have materially affected, or are reasonably likely to materially affect, the Bancorp’s internal control over ﬁ nancial reporting. Based on this evaluation, there has been no such change during the year covered by this report. Fifth Third Bancorp 33 MANAGEMENT’S ASSESSMENT AS TO THE EFFECTIVENESS OF INTERNAL CONTROL OVER FINANCIAL REPORTING The Management of Fifth Third Bancorp is responsible for establishing and maintaining adequate internal control, designed to provide reasonable assurance regarding the reliability of ﬁ nancial reporting and the preparation of ﬁ nancial statements for external purposes in accordance with gener- ally accepted accounting principles. Internal control over ﬁ nancial reporting of Fifth Third Bancorp and subsidiaries (“the Bancorp”) includes those policies and procedures that: (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reﬂ ect the transactions of the Bancorp; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of ﬁ nancial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the Bancorp are being made only in accordance with authorizations of management and directors of the Bancorp; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Bancorp’s assets that could have a material effect on the ﬁ nancial statements. All internal control systems, no matter how well designed, have inherent limitations, including the possibility of human error and the circum- vention of overriding controls. Accordingly, even effective internal control can provide only reasonable assurance with respect to ﬁ nancial statement preparation. Further, because of changes in conditions, the effectiveness of internal control may vary over time. The Bancorp’s Management assessed the effectiveness of the Bancorp’s internal control over ﬁ nancial reporting as of December 31, 2004 as required by Section 404 of the Sarbanes Oxley Act of 2002. Management’s assessment is based on the criteria established in the Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and was designed to provide reasonable assurance that the Bancorp maintained effective internal control over ﬁ nancial reporting as of December 31, 2004. Based on this assessment, Management believes that the Bancorp maintained effective internal control over ﬁ nancial reporting as of December 31, 2004. The Bancorp’s independent registered public accounting ﬁ rm, that audited the Bancorp’s consolidated ﬁ nancial statements included in this annual report, has issued an attestation report on our internal control over ﬁ nancial reporting as of December 31, 2004 and Bancorp Management’s assessment of the internal control over ﬁ nancial reporting. This report appears below. George A. Schaefer, Jr. President and Chief Executive Ofﬁ cer February 9, 2005 R. Mark Graf Senior Vice President and Chief Financial Ofﬁ cer February 9, 2005 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Shareholders and Board of Directors of Fifth Third Bancorp: We have audited management’s assessment, included in the accompanying Management’s Assessment as to the Effectiveness of Internal Control over Financial Reporting, that Fifth Third Bancorp and subsidiaries (the “Bancorp”) maintained effective internal control over ﬁ nancial reporting as of December 31, 2004, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Bancorp’s management is responsible for maintaining effective internal control over ﬁ nancial reporting and for its assessment of the effectiveness of internal control over ﬁ nancial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Bancorp’s internal control over ﬁ nancial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over ﬁ nancial reporting was main- tained in all material respects. Our audit included obtaining an understanding of internal control over ﬁ nancial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions. A company’s internal control over ﬁ nancial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal ﬁ nancial ofﬁ cers, or persons performing similar functions, and effected by the company’s board of directors, management, and other person- nel to provide reasonable assurance regarding the reliability of ﬁ nancial reporting and the preparation of ﬁ nancial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over ﬁ nancial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reﬂ ect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of ﬁ nancial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the ﬁ nancial statements. Because of the inherent limitations of internal control over ﬁ nancial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evalua- tion of the effectiveness of the internal control over ﬁ nancial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, management’s assessment that the Bancorp maintained effective internal control over ﬁ nancial reporting as of December 31, 2004, is fairly stated, in all material respects, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Also in our opinion, the Bancorp maintained, in all material respects, effective internal control over ﬁ nancial reporting as of December 31, 2004, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated ﬁ nancial statements as of and for the year ended December 31, 2004 of the Bancorp and our report dated February 9, 2005 (which includes an explanatory paragraph related to the adoption on January 1, 2004 of the fair value recognition provisions of Statement of Financial Accounting Stan- dards (SFAS) No. 123, “Accounting for Stock-Based Compensation,” and the adoption of Financial Accounting Standards Board Interpretation No. 46, “Consolidation of Variable Interest Entities”) expressed an unqualiﬁ ed opinion on those ﬁ nancial statements. Cincinnati, Ohio February 9, 2005 34 Fifth Third Bancorp REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Shareholders and Board of Directors of Fifth Third Bancorp: We have audited the accompanying consolidated balance sheets of Fifth Third Bancorp and subsidiaries (the “Bancorp”) as of December 31, 2004 and 2003, and the related consolidated statements of income, changes in shareholders’ equity, and cash ﬂ ows for each of the three years in the period ended December 31, 2004. These ﬁ nancial statements are the responsibility of the Bancorp’s management. Our responsibil- ity is to express an opinion on these ﬁ nancial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the ﬁ nancial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the ﬁ nancial statements. An audit also includes assessing the accounting principles used and signiﬁ cant estimates made by management, as well as evaluating the overall ﬁ nancial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated ﬁ nancial statements present fairly, in all material respects, the ﬁ nancial position of Fifth Third Bancorp and subsidiaries at December 31, 2004 and 2003, and the results of their operations and their cash ﬂ ows for each of the three years in the period ended December 31, 2004, in conformity with accounting principles generally accepted in the United States of America. As discussed in Note 1 – New Accounting Pronouncements, effective January 1, 2004, the Bancorp changed its method of accounting for stock-based compensation by adopting the fair value recognition provisions of Statement of Financial Accounting Standards (SFAS) No. 123, “Accounting for Stock-Based Compensation,” using the retroactive restatement method. As further discussed in Note 1 – New Account- ing Pronouncements, the Bancorp adopted the provisions of Financial Accounting Standards Board Interpretation No. 46, “Consolidation of Variable Interest Entities,” effective July 1, 2003. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effec- tiveness of the Bancorp’s internal control over ﬁ nancial reporting as of December 31, 2004, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 9, 2005 expressed an unqualiﬁ ed opinion on management’s assessment of the effectiveness of the Bancorp’s internal control over ﬁ nancial reporting and an unqualiﬁ ed opinion on the effectiveness of the Bancorp’s internal control over ﬁ nancial reporting. Cincinnati, Ohio February 9, 2005 Fifth Third Bancorp 35 CONSOLIDATED STATEMENTS OF INCOME For the Years Ended December 31 ($ in millions, except per share data) Interest Income Interest and fees on loans and leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest on securities: Taxable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Exempt from income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total interest on securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest on other short-term investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest Expense Interest on deposits: Interest checking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Savings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Money market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other time . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Certificates–$100,000 and over . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Foreign office . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total interest on deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest on federal funds purchased . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest on short-term bank notes) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest on other short-term borrowings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest on long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net Interest Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Provision for loan and lease losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net Interest Income After Provision for Loan and Lease Losses . . . . . . . . . . . . . . . . . . . . Noninterest Income Electronic payment processing revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Service charges on deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Mortgage banking net revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Investment advisory revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other noninterest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Operating lease revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Securities (losses) gains, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Securities gains, net – non-qualifying hedges on mortgage servicing rights . . . . . . . . . . . . . . Total noninterest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Noninterest Expense Salaries, wages and incentives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Employee benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Equipment expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net occupancy expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Operating lease expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other noninterest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total noninterest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income from Continuing Operations Before Income Taxes, Minority Interest and Cumulative Effect . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Applicable income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income from Continuing Operations Before Minority Interest and Cumulative Effect . . . . . Minority interest, net of tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income from Continuing Operations Before Cumulative Effect . . . . . . . . . . . . . . . . . . . . . . Income from discontinued operations, net of tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income Before Cumulative Effect . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cumulative effect of change in accounting principle, net of tax . . . . . . . . . . . . . . . . . . . . . . . Net Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net Income Available to Common Shareholders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Earnings per share from continuing operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Earnings per share from discontinued operations, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Earnings per share from cumulative effect of change in accounting principle, net . . . . . . . . . Earnings Per Share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Earnings per diluted share from continuing operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Earnings per diluted share from discontinued operations, net . . . . . . . . . . . . . . . . . . . . . . . . . Earnings per diluted share from cumulative effect of change in accounting principle, net . . . Earnings Per Diluted Share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . See Notes to Consolidated Financial Statements. 36 Fifth Third Bancorp 2004) $2,847) 1,217) 45) 1,262) 5) 4,114) 174) 58) 39) 162) 48) 58) 539) 77) 15) 78) 393) 1,102) 3,012) 268) 2,744) 622) 515) 178) 360) 671) 156) (37) —) 2,465) 1,018) 261) 84) 185) 114) 1,310) 2,972) 2,237) 712) 1,525) —) 1,525) —) 1,525) —) $1,525) $1,524) $ 2.72) —) —) $ 2.72) $ 2.68) —) —) $ 2.68) 2003) 2,711) 1,226) 51) 1,277) 3) 3,991) 189) 64) 32) 196) 63) 44) 588) 80) —) 55) 363) 1,086) 2,905) 399) 2,506) 575) 485) 302) 332) 581) 124) 81) 3) 2,483) 1,031) 240) 82) 159) 94) 945) 2,551) 2,438) 786) 1,652) (20) 1,632) 44) 1,676) (11) 1,665) 1,664) 2.85) (.08) (.02) 2.91) 2.81) (.08) (.02) 2.87) 2002) 2,810) 1,257) 56) 1,313) 6) 4,129) 296) 158) 27) 335) 77) 35) 928) 54) —) 67) 381) 1,430) 2,699) 246) 2,453) 512) 431) 188) 325) 580) —) 114) 33) 2,183) 1,029) 201) 79) 142) —) 886) 2,337) 2,299) 734) 1,565) (38) 1,527) 4) 1,531) —) 1,531) 1,530) 2.63) .01) —) 2.64) 2.58) .01) —) 2.59) CONSOLIDATED BALANCE SHEETS As of December 31 ($ in millions, except share data) Assets Cash and due from banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Available-for-sale securities (amortized cost 2004–$24,801 and 2003–$29,076) . . . . . . . . . . . . . . . . . . . . . . . . . . Held-to-maturity securities (fair value 2004–$255 and 2003–$135) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Trading securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other short-term investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loans held for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loans and leases: Commercial loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Con struc tion loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Com mer cial mortgage loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Com mer cial lease financing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Res i den tial mortgage loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Con sum er loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Con sum er lease financing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Unearned income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total loans and leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Re serve for loan and lease losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total loans and leases, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Bank premises and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Operating lease equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accrued interest receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Intangible assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Servicing rights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Liabilities Deposits: Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . In ter est checking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Savings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Money market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other time . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Certificates–$100,000 and over . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Foreign office . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Federal funds purchased . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Short-term bank notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other short-term borrowings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accrued taxes, interest and expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Shareholders’ Equity Common stock (a) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Preferred stock (b) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Capital surplus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accumulated other comprehensive income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Treasury stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total Shareholders’ Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total Liabilities and Shareholders’ Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2004 2003) $ 2,561) 24,687) 255) 77) 532) 559) 16,058) 4,726) 7,636) 4,634) 6,988) 18,923) 2,273) (1,430) 59,808) (713) 59,095) 1,315) 304) 397) 979) 150) 352) 3,193) $94,456) $13,486) 19,481) 8,310) 4,321) 6,837) 2,121) 3,670) 58,226) 4,714) 775) 4,537) 2,216) 1,081) 13,983) 85,532) 1,295) 9) 1,934) 7,269) (169) (1,414) 8,924) 2,359) 28,999) 135) 55) 268) 1,881) 14,209) 3,636) 6,894) 4,430) 4,425) 17,432) 2,709) (1,427) 52,308) (697) 51,611) 1,061) 767) 408) 738) 195) 299) 2,478) 91,254) 12,142) 19,757) 7,375) 3,201) 6,201) 1,856) 6,563) 57,095) 6,928) 500) 5,742) 2,200) 1,059) 9,063) 82,587) 1,295) 9) 1,964) 6,481) (120) (962) 8,667) $94,456) 91,254) (a) Stated value $2.22 per share; authorized 1,300,000,000; outstanding at 2004 — 557,648,989 (excludes 25,802,702 treasury shares) and 2003 — 566,685,301 (excludes 16,766,390 treasury shares). (b) 490,750 shares of undesignated no par value preferred stock are authorized of which none had been issued; 7,250 shares of 8.0% cumulative Series D convertible (at $23.5399 per share) perpetual preferred stock with a stated value of $1,000 per share were authorized, issued and outstanding; 2,000 shares of 8.0% cumulative Series E perpetual preferred stock with a stated value of $1,000 per share were authorized, issued and outstanding. See Notes to Consolidated Financial Statements. Fifth Third Bancorp 37 CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY Accumulated Other Comprehensive Treasury Income 8 361 369 (489) (120) (49) Retained Earnings 4,502 1,531 (567) (1) 5,465 1,665 (645) (1) (3) 6,481 1,525 (735) (1) (1) 7,269 (169) Stock (4) (720) 180 (544) (655) 233 4 (962) (987) 33 222 281 (1) (1,414) Total 7,752) 1,531 ) 361) 1,892 (567) (1) (720) 128) 104) 19) (3) 8,604) 1,665 (489) 1,176 (645) (1) (655) 110) 97) (34) 18) (3) 8,667 1,525 (49) 1,476 (735) (1) (987) 87) —) 89) 11) 317) —) 8,924) ($ in millions, except per share data) Balance at December 31, 2001 . . . . . . . . . . . . . Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other comprehensive income . . . . . . . . . . . . . . . . Comprehensive income . . . . . . . . . . . . . . . . . . . . Cash dividends declared: Common stock at $.98 per share . . . . . . . . . . Preferred stock . . . . . . . . . . . . . . . . . . . . . . . . Shares acquired for treasury . . . . . . . . . . . . . . . . . Stock-based compensation expense . . . . . . . . . . . Stock options exercised, including treasury shares issued . . . . . . . . . . . . Excess corporate tax benefit related to stock-based compensation . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Balance at December 31, 2002 . . . . . . . . . . . . . Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other comprehensive income . . . . . . . . . . . . . . . . Comprehensive income . . . . . . . . . . . . . . . . . . . . Cash dividends declared: Common stock at $1.13 per share . . . . . . . . . Preferred stock . . . . . . . . . . . . . . . . . . . . . . . . Shares acquired for treasury . . . . . . . . . . . . . . . . . Stock-based compensation expense . . . . . . . . . . . Stock options exercised, including treasury shares issued . . . . . . . . . . . . Loans issued related to the exercise of stock options, net . . . . . . . . . . . . . . . . . . . . Excess corporate tax benefit related to stock-based compensation . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Balance at December 31, 2003 . . . . . . . . . . . . . Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other comprehensive income . . . . . . . . . . . . . . . . Comprehensive income . . . . . . . . . . . . . . . . . . . . Cash dividends declared: Common stock at $1.31 per share . . . . . . . . . Preferred stock . . . . . . . . . . . . . . . . . . . . . . . . Shares acquired for treasury . . . . . . . . . . . . . . . . . Stock-based compensation expense . . . . . . . . . . . Restricted stock grants . . . . . . . . . . . . . . . . . . . . . Stock options exercised, including treasury shares issued . . . . . . . . . . . . Excess corporate tax benefit related to stock-based compensation . . . . . . . . . . . . . . . . Stock issued in business combinations . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Balance at December 31, 2004 . . . . . . . . . . . . . See Notes to Con sol i dat ed Financial Statements. Common Stock $1,294 Preferred Stock 9 Capital Surplus 1,943 1 1,295 9 1,295 9 $1,295 9 128 (77) 19 (3) 2,010 110 (136) (34) 18 (4) 1,964 87 (33) (133) 11 36 2 1,934 38 Fifth Third Bancorp CONSOLIDATED STATEMENTS OF CASH FLOWS For the Years Ended December 31 ($ in millions) Operating Activities Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Adjustments to reconcile net income to net cash provided by operating activities: Provision for loan and lease losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Minority interest in net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cumulative effect of change in accounting principle, net of tax . . . . . . . . . . . . . . . . . . . . Depreciation, amortization and accretion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Stock-based compensation expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (Benefit) provision for deferred income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Realized securities gains . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Realized securities gains – non-qualifying hedges on mortgage servicing rights . . . . . . . . . Realized securities losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Realized securities losses – non-qualifying hedges on mortgage servicing rights . . . . . . . . Proceeds from sales/transfers of residential mortgage and other loans held for sale . . . . . . Net gains on sales of loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net gains on divestitures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Increase in residential mortgage and other loans held for sale . . . . . . . . . . . . . . . . . . . . . . Decrease (increase) in trading securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Decrease in accrued interest receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (Increase) decrease in other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (Decrease) increase in accrued taxes, interest and expenses . . . . . . . . . . . . . . . . . . . . . . . . (Decrease) increase in other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net Cash Provided by Operating Activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Investing Activities Proceeds from sales of available-for-sale securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Proceeds from calls, paydowns and maturities of available-for-sale securities . . . . . . . . . . . . . Purchases of available-for-sale securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Proceeds from calls, paydowns and maturities of held-to-maturity securities . . . . . . . . . . . . . Purchases of held-to-maturity securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (Increase) decrease in other short-term investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Increase in loans and leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Decrease in operating lease equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Purchases of bank premises and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Proceeds from disposal of bank premises and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash received from divestitures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash acquired in business combination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net Cash Used in Investing Activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Financing Activities Increase in core deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (Decrease) increase in certificates – $100,000 and over, including foreign office . . . . . . . . . . (Decrease) increase in federal funds purchased . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Increase (decrease) in short-term bank notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (Decrease) increase in other short-term borrowings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Proceeds from issuance of long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Repayment of long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Payment of cash dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Exercise of stock options, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Purchases of treasury stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net Cash Provided by Financing Activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Increase (Decrease) in Cash and Due from Banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash and Due from Banks at Beginning of Year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash and Due from Banks at End of Year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash Payments Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Federal income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Significant Noncash Transactions Business acquisitions: Fair value of tangible assets acquired (noncash) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Goodwill and identifiable intangible assets acquired . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Liabilities assumed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Stock options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Common stock issued . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Securitizations: Capitalized servicing rights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Residual interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Securities retained . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Reclassification of minority interest to long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consolidation of special purpose entity: Operating leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other assets/liabilities, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . See Notes to Consolidated Financial Statements. 2004 2003 $ 1,525 268 — — 459 87 (13) (58) — 95 — 6,824 (112) (91) (4,788) 259 16 (867) (26) (73) 3,505 11,331 6,234 (13,425) 42 (148) (264) (7,749) 357 (391) 13 233 29 (3,738) 3,327 (2,962) (2,238) 275 (1,210) 11,128 (6,283) (704) 89 (987) — 435 202 2,359 $ 2,561 $ 1,096 693 921 282 (916) (36) (281) 9 21 21 — — — — 1,665 399 20 11 550 110 295 (150) (3) 69 — 16,280 (340) (40) (10,501) (37) 45 (646) 253 135 8,115 22,522 9,264 (36,123) 18 (92) 33 (10,651) 214 (284) 16 67 — (15,016) 1,908 2,978 2,180 500 2,093 1,095 (2,159) (631) 63 (655) (3) 7,369 468 1,891 2,359 1,112 432 — — — — — 9 28 — 482 1,068 1,109 25 2002) 1,531) 246) 38) —) 338) 128) 253) (125) (86) 11) 53) 9,924) (269) (34) (9,892) (18) 49) 453) (114) (276) 2,210) 20,605) 7,481) (32,278) 5) (35) (69) (5,608) —) (174) 14) 55) —) (10,004) 4,916) 1,536) 2,204) (34) (304) 1,143) (635) (553) 104) (720) (3) 7,654) (140) 2,031) 1,891) 1,497) 456) — — — — — 10 — 25 — — — — Fifth Third Bancorp 39 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING AND REPORTING POLICIES Nature of Operations Fifth Third Bancorp (“Bancorp”), an Ohio corporation, conducts its principal activities through its banking and non-banking subsidiaries from 1,011 banking centers located throughout Ohio, Kentucky, Indiana, Michigan, Illinois, Florida, Tennessee, West Virginia and Pennsylvania. Principal activities include Commer- cial Banking, Retail Banking, Investment Advisors and Fifth Third Processing Solutions. est payments that have become past due one hundred and eighty days are charged off to the reserve for loan and lease losses. When a loan is placed on nonaccrual status, all previously accrued and unpaid interest receivable is charged against income and the loan is accounted for on the cash method thereafter, until qualifying for return to accrual status. Generally, a loan is returned to accrual status when all delinquent interest and principal payments become current in accordance with the terms of the loan agreement or when the loan is both well secured and in the process of collection. Basis of Presentation The Consolidated Financial Statements include the accounts of the Bancorp and its majority-owned subsidiaries. Other entities, including certain joint ventures, in which there is greater than 20% ownership, but upon which the Bancorp does not possess, nor can it exert, signiﬁ cant inﬂ uence or control, are accounted for by the equity method and not consolidated; those in which there is less than 20% ownership are generally carried at the lower of cost or fair value. All material intercompany transactions and balances have been eliminated. Certain prior period data has been reclassi- ﬁ ed to conform to current period presentation. Use of Estimates The preparation of ﬁ nancial statements in conformity with accounting principles generally accepted in the United States of Amer ica requires management to make estimates and assumptions that affect the amounts reported in the ﬁ nancial statements and accompanying notes. Actual results could differ from those esti- mates. Securities Securities are classiﬁ ed as held-to-maturity, available-for-sale or trading on the date of purchase. Only those securities classiﬁ ed as held-to-maturity, and which management has both the intent and ability to hold to maturity, are reported at amortized cost. Available-for-sale and trading securities are reported at fair value with unrealized gains and losses, net of related deferred income taxes, included in accumulated other comprehensive income and other noninterest income, respectively. The fair value of a security is determined based on quoted market prices. If quoted market prices are not available, fair value is determined based on quoted prices of similar instruments. Realized securities gains or losses are reported within noninterest income in the Consolidated State- ments of Income. The cost of securities sold is based on the speciﬁ c identiﬁ cation method. Available-for-sale and held-to-maturity securities are reviewed quarterly for possible other-than-tempo- rary impairment. The review includes an analysis of the facts and circumstances of each individual investment such as the severity of loss, the length of time the fair value has been below cost, the expectation for that security’s performance, the creditworthiness of the issuer and the Bancorp’s intent and ability to hold the security. A decline in value that is considered to be other-than-temporary is recorded as a loss within noninterest income in the Consolidated Statements of Income. Loans and Leases Interest income on loans is based on the principal balance outstand- ing computed using the effective interest method. The accrual of interest income for commercial, construction and mortgage loans is discontinued when there is a clear indication the borrower’s cash ﬂ ow may not be sufﬁ cient to meet payments as they become due. Such loans are also placed on nonaccrual status when the prin- cipal or interest is past due ninety days or more, unless the loan is well secured and in the process of collection. Consumer loans and revolving lines of credit for equity lines that have principal and interest payments that have become past due one hundred and twenty days and credit cards that have principal and inter- 40 Fifth Third Bancorp Loan and lease origination and commitment fees and certain direct loan and lease origination costs are deferred and the net amount amortized over the estimated life of the related loans, leases or commitments as a yield adjustment. Direct ﬁ nancing leases are carried at the aggregate of lease payments plus estimated residual value of the leased property, less unearned income. Interest income on direct ﬁ nancing leases is recognized over the term of the lease to achieve a constant periodic rate of return on the outstanding investment. Interest income on leveraged leases is recognized over the term of the lease to achieve a constant rate of return on the outstanding investment in the lease, net of the related deferred income tax liability, in the years in which the net investment is positive. Residential mortgage loans held for sale are valued at the lower of aggregate cost or fair value. Loans held for sale that qualify for fair value hedge accounting are carried at fair value. Fair value is based on the contract price at which the mortgage loans will be sold. The Bancorp generally has commitments to sell residential mortgage loans held for sale in the secondary market. Gains or losses on sales are recognized in mortgage banking net revenue upon delivery. Impaired loans are measured based on the present value of expected future cash ﬂ ows discounted at the loan’s effective interest rate or the fair value of the underlying collateral. The Bancorp eval- uates the collectibility of both principal and interest when assessing the need for a loss accrual. Other Real Estate Owned Other real estate owned (“OREO”), which is included in other assets, represents property acquired through foreclosure or other proceedings. OREO is carried at the lower of cost or fair value, less costs to sell. All property is periodically evaluated and reductions in fair value are recognized in noninterest expense in the Consolidated Statements of Income. Reserve for Loan and Lease Losses The Bancorp maintains a reserve to absorb probable loan and lease losses inherent in the portfolio. The reserve is maintained at a level the Bancorp considers to be adequate and is based on ongoing quar- terly assessments and evaluations of the collectibility and historical loss experience of loans and leases. Credit losses are charged and recoveries are credited to the reserve. Provisions for loan and lease losses are based on the Bancorp’s review of the historical credit loss experience and such factors that, in management’s judgment, deserve consideration under existing economic conditions in esti- mating probable credit losses. In determining the appropriate level of reserves, the Bancorp estimates losses using a range derived from “base” and “conservative” estimates. The Bancorp’s methodology for assessing the appropriate reserve level consists of several key elements, as discussed below. The Bancorp’s strategy for credit risk management includes a combination of conservative exposure limits signiﬁ cantly below legal lending limits and conservative underwriting, documentation and collections standards. The strat- egy also emphasizes diversiﬁ cation on a geographic, industry and customer level, regular credit examinations and quarterly manage- ment reviews of large credit exposures and loans experiencing dete- rioration of credit quality. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Larger commercial loans that exhibit probable or observed credit weaknesses are subject to individual review. Where appro- priate, reserves are allocated to individual loans based on manage- ment’s estimate of the borrower’s ability to repay the loan given the availability of collateral, other sources of cash ﬂ ow and legal options available to the Bancorp. The review of individual loans includes those loans that are impaired as provided in SFAS No. 114, “Accounting by Creditors for Impairment of a Loan.” Any reserves for impaired loans are measured based on the present value of expected future cash ﬂ ows discounted at the loan’s effec- tive interest rate or fair value of the underlying collateral. The Bancorp evaluates the collectibility of both principal and interest when assessing the need for a loss accrual. Historical loss rates are applied to other commercial loans not subject to speciﬁ c reserve allocations. The loss rates are derived from a migration analysis, which computes the net charge-off experience sustained on loans according to their internal risk grade. The Bancorp utilizes two risk grading systems for commercial loans and leases. The current risk grading system utilized for reserve analysis purposes encompasses ten categories. The Bancorp also maintains a dual risk rating system that provides for 13 probability of default grade categories and an additional six grade categories measuring loss factors given an event of default. The probability of default and loss given default analyses are not separated in the ten grade risk rating system. The Bancorp is in the process of completing signiﬁ cant validation and testing of the dual risk rating system prior to implementation for reserve analysis purposes. The dual risk rating system is consistent with Basel II expectations and allows for more precision in the analysis of commercial credit risk. Homogenous loans, such as consumer installment, residen- tial mortgage loans and automobile leases are not individually risk graded. Rather, standard credit scoring systems and delinquency monitoring are used to assess credit risks. Reserves are established for each pool of loans based on the expected net charge-offs for one year. Loss rates are based on the average net charge-off history by loan category. Historical loss rates for commercial and consumer loans may be adjusted for signiﬁ cant factors that, in management’s judgment, reﬂ ect the impact of any current conditions on loss recognition. Factors that management considers in the analysis include the effects of the national and local economies, trends in the nature and volume of loans (delinquencies, charge-offs and nonaccrual loans), changes in mix, credit score migration comparisons, asset quality trends, risk management and loan administration, changes in the internal lending policies and credit standards, collection practices and examination results from bank regulatory agencies and the Bancorp’s internal credit examiners. An unallocated reserve is maintained to recognize the impreci- sion in estimating and measuring loss when evaluating reserves for individual loans or pools of loans. Reserves on individual loans and historical loss rates are reviewed quarterly and adjusted as neces- sary based on changing borrower and/or collateral conditions and actual collection and charge-off experience. The Bancorp’s primary market areas for lending are Ohio, Kentucky, Indiana, Michigan, Illinois, Florida, Tennessee, West Virginia and Pennsylvania. When evaluating the adequacy of reserves, consideration is given to this regional geographic concen- tration and the closely associated effect changing economic condi- tions have on the Bancorp’s customers. The Bancorp has not substantively changed any aspect to its overall approach in the determination of the reserve for loan and lease losses. There have been no material changes in assumptions or estimation techniques as compared to prior periods that impacted the determination of the current period reserve for loan and lease losses. As of December 31, 2004, the reserve for unfunded commit- ments has been reclassiﬁ ed from the reserve for loan and lease losses to other liabilities. The December 31, 2003 reserve for unfunded commitments and all subsequent activity has been reclassiﬁ ed to conform to current period presentation. Reserve for Unfunded Commitments The reserve for unfunded commitments is maintained at a level believed by management to be sufﬁ cient to absorb estimated prob- able losses related to unfunded credit facilities. The determination of the adequacy of the reserve is based upon an evaluation of the unfunded credit facilities, including an assessment of historical commitment utilization experience, credit risk grading and credit grade migration. Net adjustments to the reserve for unfunded commitments are included in other noninterest expense. Loan Sales and Securitizations When the Bancorp sells loans through either securitizations or individual loan sales in accordance with its investment policies, it may retain one or more subordinated tranches, servicing rights, interest-only strips, credit recourse, other residual interests and in some cases, a cash reserve account, all of which are considered retained interests in the securitized or sold loans. Gain or loss on sale or securitization of the loans depends in part on the previous carrying amount of the ﬁ nancial assets sold or securitized, allocated between the assets sold and the retained interests based on their relative fair value at the date of sale or securitization. To obtain fair values, quoted market prices are used if available. If quotes are not available for retained interests, the Bancorp calculates fair value based on the present value of future expected cash ﬂ ows using both management’s best estimates and third-party data sources for the key assumptions, including credit losses, prepayment speeds, forward yield curves and discount rates commensurate with the risks involved. Gain or loss on sale or securitization of loans is reported as a component of noninterest income in the Consolidated State- ments of Income. Retained interests from securitized or sold loans, excluding servicing rights, are carried at fair value. Adjustments to fair value for retained interests classiﬁ ed as available-for-sale securi- ties are included in accumulated other comprehensive income in equity, or in noninterest income in the Consolidated Statements of Income if the fair value has declined below the carrying amount and such decline has been determined to be other-than-temporary. Adjustments to fair value for retained interests classiﬁ ed as trading securities are recorded within noninterest income in the Consoli- dated Statements of Income. Servicing rights resulting from residential mortgage, home equity line of credit and automotive loan sales are amortized in proportion to and over the period of estimated net servicing reve- nues and are reported as a component of mortgage banking net revenue and other noninterest income, respectively, in the Consoli- dated Statements of Income. Servicing rights are assessed for impairment monthly, based on fair value, with temporary impair- ment recognized through a valuation allowance and permanent impairment recognized through a write-off of the servicing asset and related valuation reserve. Key economic assumptions used in measuring any potential impairment of the servicing rights include the prepayment speeds of the underlying loans, the weighted-aver- age life of the loan, the discount rate, weighted-average coupon and the weighted-average default rate, as applicable. The primary risk of material changes to the value of the servicing rights resides in the potential volatility in the economic assumptions used, particularly the prepayment speeds. The Bancorp monitors this risk and adjusts its valuation allowance as necessary to adequately reserve for any probable impairment in the portfolio. For purposes of measuring impairment, the mortgage servicing rights are stratiﬁ ed based on the ﬁ nancial asset type and interest rates. In addition, the Bancorp obtains an independent third-party valuation of the mortgage servicing portfolio on a quarterly basis. Fees received for servicing loans owned by investors are based on a percentage of the outstand- ing monthly principal balance of such loans and are included in noninterest income. Costs of servicing loans are charged to expense as incurred. Fifth Third Bancorp 41 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Bank Premises and Equipment Bank premises and equipment, including leasehold improvements, are stated at cost less accumulated depreciation and amortization. Depreciation is calculated using the straight-line method based on estimated useful lives of the assets for book purposes, while acceler- ated depreciation is used for income tax purposes. Amortization of leasehold improvements is computed using the straight-line method over the lives of the related leases or useful lives of the related assets, whichever is shorter. In accordance with the adop- tion of SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” the Bancorp tests its long-lived assets for impairment through both a “probability-weighted” and “primary- asset” approach whenever events or changes in circumstances dictate. Maintenance, repairs and minor improvements are charged to noninterest expense as incurred. Operating Lease Equipment Operating lease equipment is recorded at cost, net of accumulated depreciation. Income from operating leases is recognized ratably over the term of the leases and recorded within noninterest income in the Consolidated Statements of Income. Depreciation expense on operating lease equipment is recorded on a straight-line basis over the term of the lease from the original cost of the asset to the estimated residual value at the end of the lease term. Depre- ciation expense is recorded within operating lease expense in the Consolidated Statements of Income. The estimated residual value of operating lease assets is periodically reviewed and, in the event that the original estimated residual value is determined to be greater than the asset’s estimated market value at the end of the lease term, depreciation expense is adjusted prospectively. Derivative Financial Instruments The Bancorp accounts for its derivatives in accordance with SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended. The Statement requires recognition of all derivatives as either assets or liabilities in the balance sheet and requires measurement of those instruments at fair value through adjustments to either accumulated other comprehensive income within shareholders’ equity or current earnings or both, as appro- priate. On the date the Bancorp enters into a derivative contract, the Bancorp designates the derivative instrument as either a fair value hedge, cash ﬂ ow hedge or as a free-standing derivative instru- ment. For a fair value hedge, changes in the fair value of the deriva- tive instrument and changes in the fair value of the hedged asset or liability or of an unrecognized ﬁ rm commitment attributable to the hedged risk are recorded in current period net income. For a cash ﬂ ow hedge, changes in the fair value of the derivative instru- ment, to the extent that it is effective, are recorded in accumulated other comprehensive income and subsequently reclassiﬁ ed to net income in the same period(s) that the hedged transaction impacts net income. For free-standing derivative instruments, changes in fair values are reported in current period net income. Prior to entering a hedge transaction, the Bancorp formally documents the relationship between the hedging instruments and hedged items, as well as the risk management objective and strategy for undertaking various hedge transactions. This process includes linking all derivative instruments that are designated as fair value or cash ﬂ ow hedges to speciﬁ c assets and liabilities on the balance sheet or to speciﬁ c forecasted transactions along with a formal assessment at both inception of the hedge and on an ongoing basis as to the effectiveness of the derivative instrument in offsetting changes in fair values or cash ﬂ ows of the hedged item. If it is determined that the derivative instrument is not highly effective as a hedge, hedge accounting is discontinued and the adjustment to fair value of the derivative instrument is recorded in net income. 42 Fifth Third Bancorp Earnings Per Share In accordance with SFAS No. 128, “Earnings Per Share,” basic earnings per share are computed by dividing net income available to common shareholders by the weighted-average number of shares of common stock outstanding during the period. Earnings per diluted share are computed by dividing adjusted net income avail- able to common shareholders by the weighted-average number of shares of common stock and common stock equivalents outstand- ing during the period. Dilutive common stock equivalents repre- sent the assumed conversion of convertible preferred stock and the exercise of stock options. Other Securities and other property held by Fifth Third Investment Advi- sors, a division of the Bancorp’s banking subsidiaries, in a ﬁ duciary or agency capacity are not included in the Consolidated Balance Sheets because such items are not assets of the subsidiaries. Invest- ment advisory revenue in the Consolidated Statements of Income is recognized on the accrual basis. Investment advisory service reve- nues are recognized monthly based on a fee charged per transaction processed and a fee charged on the market value of ending account balances associated with individual contracts. The Bancorp recognizes revenue from its electronic payment processing services on an accrual basis as such services are performed, recording revenues net of certain costs (primarily inter- change fees charged by credit card associations) not controlled by the Bancorp. Acquisitions of treasury stock are carried at cost. Reissuance of shares in treasury for acquisitions, stock option exercises or other corporate purposes is recorded based on the speciﬁ c identiﬁ cation method. New Accounting Pronouncements In December 2002, the FASB issued SFAS No. 148, “Account- ing for Stock-Based Compensation-Transition and Disclosure—an Amendment of FASB Statement No. 123.” This Statement amends SFAS No. 123, “Accounting for Stock-Based Compensation,” to provide alternative methods of transition for a voluntary change to the fair value method of accounting for stock-based employee compensation. In addition, this Statement amends the disclosure requirements of SFAS No. 123 to require more prominent disclo- sures about the method of accounting for stock-based employee compensation and the effect of the method used on reported results in both annual and interim ﬁ nancial statements. This Statement was effective for ﬁ nancial statements for ﬁ scal years ending after December 15, 2002. Effective January 1, 2004, the Bancorp adopt- ed the fair value recognition provisions of SFAS No. 123 using the retroactive restatement method described in SFAS No. 148. As a result, ﬁ nancial information for all prior periods has been restated to reﬂ ect the compensation expense that would have been recog- nized had the fair value method of accounting been applied to all awards granted to employees after January 1, 1995. The adoption of the retroactive restatement method resulted in the restatement of previously reported balances of capital surplus, retained earnings and deferred taxes. As of December 31, 2003, previously reported capital surplus was increased by $633 million, retained earnings were decreased by $529 million and deferred tax assets were increased by $104 million. As of December 31, 2002, previously reported capital surplus was increased by $530 million, retained earnings were decreased by $439 million, and deferred tax assets were increased by $91 million. In addition, in adopting the fair value method of expense recognition, the Bancorp deter- mined that in 2000 and 2001 certain outstanding stock options exchanged in immaterial business combinations were omitted from the determination of total purchase price and resulting goodwill. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Adjustment for those items resulted in an additional increase in goodwill and capital surplus balances as of December 31, 2002 and 2003 of $38 million. Stock-based compensation expense is included in salaries, wages and incentives expense in the Consoli- dated Statements of Income. The impact of the adoption of the retroactive restatement method for employee stock-based compensation on previously reported net income, basic and earnings per diluted share for 2003 and 2002 is as follows: ($ in millions, except per share data) Net income available to common shareholders, as originally reported . . . . . . . . . . . . . . . . Stock-based compensation expense determined under the fair value method, net of tax . . Net income available to common shareholders, as restated . . . . . . . . . . . . . . . . . . . . . . . . Earnings per share: As originally reported . . . . . . . . . . . . . . . . As restated . . . . . . . . . . . . . . . . . . . . . . . . Earnings per diluted share: As originally reported . . . . . . . . . . . . . . . . As restated . . . . . . . . . . . . . . . . . . . . . . . . 2003 2002 $1,754 1,634 (90) (104) $1,664 1,530 $3.07 2.91 3.03 2.87 2.82 2.64 2.76 2.59 The weighted-average fair value of stock options and stock appreciation rights granted was $14.11, $18.27 and $26.14 in 2004, 2003 and 2002, respectively. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model with the following assumptions used for grants in 2004, 2003 and 2002: expected option lives ranging from six to nine years; expected dividend yield of 2.3% for 2004, 1.6% for 2003, and 1.4% for 2002; expected volatility of 28% for all three years and risk-free interest rates of 3.9%, 4.4% and 5.0%, respectively. In December 2004, the FASB issued SFAS No. 123 (Revised 2004), “Share-Based Payment.” This Statement requires measure- ment of the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award with the cost to be recognized over the vesting period. This Statement is effective for ﬁ nancial statements as of the begin- ning of the ﬁ rst interim or annual reporting period that begins after June 15, 2005. As the Bancorp has previously adopted the fair value recognition provisions of SFAS No. 123 and the retroactive restatement method described in SFAS No. 148, the adoption of this Statement will not have a material impact on the Bancorp’s Consolidated Financial Statements. In April 2003, the FASB issued SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activi- ties.” This Statement amends and clariﬁ es ﬁ nancial accounting and reporting for derivative instruments, including certain embedded derivatives, and for hedging activities under SFAS No. 133. This Statement amends SFAS No. 133 to reﬂ ect the decisions made as part of the Derivatives Implementation Group (“DIG”) and in other FASB projects or deliberations. SFAS No. 149 was effective for contracts entered into or modiﬁ ed after June 30, 2003, and for hedging relationships designated after June 30, 2003. Adoption of this Statement did not have a material effect on the Bancorp’s Consolidated Financial Statements. In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity.” This Statement establishes standards for how an entity classiﬁ es and measures certain ﬁ nancial instruments with characteristics of both liabilities and equity. This Statement requires that an issuer classify a ﬁ nancial instrument that is within its scope as a liability. Many of those instruments were previously classiﬁ ed as equity, or in some cases, presented between the liabili- ties section and the equity section of the statement of ﬁ nancial posi- tion. This Statement was effective for ﬁ nancial instruments entered into or modiﬁ ed after May 31, 2003, and otherwise was effective at the beginning of the ﬁ rst interim period beginning after June 15, 2003. Adoption of this Statement on July 1, 2003 required a reclassiﬁ cation of a minority interest to long-term debt and the corresponding minority interest expense to interest expense, relat- ing to preferred stock issued during 2001 by a subsidiary of the Bancorp. The existence of the mandatory redemption feature of this issue upon its mandatory conversion to trust preferred secu- rities necessitated these reclassiﬁ cations and did not result in any change in bottom line income statement trends. In December 2003, the FASB issued SFAS No. 132 (Revised 2003), “Employers’ Disclosures about Pensions and Other Post- retirement Beneﬁ ts.” This Statement expands upon the existing disclosure requirements as prescribed under the original SFAS No. 132 by requiring more details about pension plan assets, beneﬁ t obligations, cash ﬂ ows, beneﬁ t costs and related information. SFAS No. 132(R) also requires companies to disclose various elements of pension and postretirement beneﬁ t costs in interim-period ﬁ nan- cial statements beginning after December 15, 2003. This State- ment is effective for ﬁ nancial statements with ﬁ scal years ending after December 15, 2003. The Bancorp adopted this Statement and all of its required disclosures are included in Note 23. In November 2002, the FASB issued Interpretation No. 45, (“FIN 45”) “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others,” which elaborates on the disclosures to be made by a guar- antor about its obligations under certain guarantees issued. It also clariﬁ es that a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation under- taken in issuing the guarantee. The Interpretation expands on the accounting guidance of SFAS No. 5, “Accounting for Contingen- cies,” SFAS No. 57, “Related Party Disclosures,” and SFAS No. 107, “Disclosures about Fair Value of Financial Instruments.” It also incorporates without change the provisions of FASB Interpreta- tion No. 34, “Disclosure of Indirect Guarantees of Indebtedness of Others,” which is superseded. The initial recognition and measure- ment provisions of this Interpretation apply on a prospective basis to guarantees issued or modiﬁ ed after December 31, 2002. The disclosure requirements in this Interpretation were effective for periods ending after December 15, 2002. Signiﬁ cant guarantees that have been entered into by the Bancorp are disclosed in Note 14. Adoption of this Interpretation did not have a material effect on the Bancorp’s Consolidated Financial Statements. In January 2003, the FASB issued Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities.” This Interpretation clariﬁ es the application of ARB No. 51, “Consoli- dated Financial Statements,” for certain entities in which equity investors do not have the characteristics of a controlling ﬁ nancial interest or do not have sufﬁ cient equity at risk for the entity to ﬁ nance its activities without additional subordinated support from other parties. This Interpretation requires variable interest enti- ties (“VIEs”) to be consolidated by the primary beneﬁ ciary which represents the enterprise that will absorb the majority of the VIE’s expected losses if they occur, receive a majority of the VIEs residual returns if they occur, or both. Qualifying Special Purpose Entities (“QSPE”) are exempt from the consolidation requirements of FIN 46. This Interpretation was effective for VIEs created after January 31, 2003 and for VIEs in which an enterprise obtains an interest after that date. In December 2003, the FASB issued Interpretation No. 46R (“FIN 46R”), “Consolidation of Variable Interest Entities — an interpretation of ARB 51 (revised December 2003),” which replac- es FIN 46. FIN 46R was primarily issued to clarify the required accounting for interests in VIEs. Additionally, this Interpretation exempts certain entities from its requirements and provides for special effective dates for enterprises that have fully or partially applied FIN 46 as of December 24, 2003. Application of FIN 46R is required in ﬁ nancial statements of public enterprises that have interests in structures that are commonly referred to as special- Fifth Third Bancorp 43 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS purpose entities, or SPEs, for periods ending after December 15, 2003. Application by public enterprises, other than small business issuers, for all other types of VIEs (i.e., non-SPEs) is required in ﬁ nancial statements for periods ending after March 15, 2004, with earlier adoption permitted. The Bancorp early adopted the provi- sions of FIN 46 on July 1, 2003. Through December 31, 2004 the Bancorp has provided full credit recourse to an unrelated and unconsolidated asset-backed SPE in conjunction with the sale and subsequent leaseback of leased autos. The unrelated and unconsoli- dated asset-backed SPE was formed for the sole purpose of partici- pating in the sale and subsequent lease-back transactions with the Bancorp. Based on this credit recourse, the Bancorp is deemed to be the primary beneﬁ ciary as it maintains the majority of the variable interests in this SPE and was therefore required to consolidate the entity. Early adoption of this Interpretation required the Bancorp to consolidate these operating lease assets and a corresponding liability as well as recognize an after-tax cumulative effect charge of $11 million ($.02 per diluted share) representing the difference between the carrying value of the leased autos sold and the carrying value of the newly consolidated obligation as of July 1, 2003. As of December 31, 2004, the outstanding balance of leased autos sold was approximately $259 million. Consolidation of these operating lease assets did not impact risk-based capital ratios or bottom line income statement trends; however lease payments on the operat- ing lease assets are now reﬂ ected as a component of noninterest income and depreciation expense is now reﬂ ected as a component of noninterest expense. The Bancorp also early adopted the provi- sions of FIN 46 related to the consolidation of two wholly-owned ﬁ nance entities involved in the issuance of trust preferred securi- ties. Effective July 1, 2003, the Bancorp deconsolidated the wholly- owned issuing trust entities resulting in a recharacterization of the underlying consolidated debt obligation from the previous trust preferred securities obligations to the junior subordinated deben- ture obligations that exist between the Bancorp and the issuing trust entities. See Note 14 for discussion of certain guarantees that the Bancorp has provided for the beneﬁ t of the wholly-owned issu- ing trust entities related to their debt obligations. In March 2004, the Securities and Exchange Commission staff released Staff Accounting Bulletin (“SAB”) No. 105, “Applica- tion of Accounting Principles to Loan Commitments.” This SAB disallows the inclusion of expected future cash ﬂ ows related to the servicing of a loan in the determination of the fair value of a loan commitment. Further, no other internally developed intangible asset should be recorded as part of the loan commitment deriva- tive. Recognition of intangible assets would only be appropriate in a third-party transaction, such as a purchase of a loan commit- ment or in a business combination. The SAB is effective for all loan commitments entered into after March 31, 2004, but does not require retroactive adoption for loan commitments entered into on or before March 31, 2004. Adoption of this SAB did not have a material effect on the Bancorp’s Consolidated Financial Statements. In March 2004, the Emerging Issues Task Force (“EITF”) reached a consensus on Issue 03-1, “The Meaning of Other-Than- Temporary Impairment and Its Application to Certain Invest- ments.” The EITF reached a consensus on an other-than-temporary impairment model for debt and equity securities accounted for under SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” and cost method investments. The basic model developed to evaluate whether an investment within the scope of Issue 03-1 is other-than-temporarily impaired involves a three-step process including, determining whether an invest- ment is impaired (fair value less than cost), evaluating whether the impairment is other-than-temporary and, if other-than-temporary, requiring recognition of an impairment loss equal to the difference between the investment’s cost and its fair value. In September 2004, the FASB issued Staff Position (“FSP”) No. EITF 03-01-1, “Effec- tive Date of Paragraphs 10-20 of EITF 03-01.” This FSP delays the effective date of the measurement and recognition guidance contained in paragraphs 10-20 of Issue 03-01. The amount of any other-than-temporary impairment that needs to be recognized in the future will be dependent on market conditions, the occurrence of certain events or changes in circumstances relative to an investee, the Bancorp’s intent and ability to hold the impaired investments at the time of the valuation and the measurement and recognition guidance to be deﬁ ned in a future FSP issuance. In December 2003, the Accounting Standards Executive Committee of the American Institute of Certiﬁ ed Public Accoun- tants issued Statement of Position (“SOP”) 03-3, “Accounting for Certain Loans and Debt Securities Acquired in a Transfer.” SOP 03-3 addresses the accounting for certain acquired loans that show evidence of credit deterioration since their origination (i.e. impaired loans) and for which a loss is deemed probable of occur- ring. SOP 03-3 requires acquired loans to be recorded at their fair value, deﬁ ned as the present value of future cash ﬂ ows, including interest income, to be recognized over the life of the loan. SOP 03-3 prohibits the carryover of an allowance for loan loss on certain acquired loans within its scope. SOP 03-3 is effective for loans that are acquired in ﬁ scal years beginning after December 15, 2004. The Bancorp will evaluate the applicability of this SOP for all prospective loans acquired in ﬁ scal years beginning after December 15, 2004. The Bancorp does not anticipate this Statement to have a material effect on its Consolidated Financial Statements. 44 Fifth Third Bancorp 2. SECURITIES The following table provides a breakdown of the securities portfolio as of December 31: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 2004 2003 Amortized Cost Unrealized Gains Unrealized Losses Fair Value Amortized Cost Unrealized Gains Unrealized Losses Fair Value ($ in millions) Available-for-sale: U.S. Treasury and Government agencies . . . . U.S. Government sponsored agencies . . . . . . . . . . . . . . . Obligations of states and $ 503 2,036 political subdivisions . . . . . 823 Agency mortgage-backed securities . . . . . . . . . . . . . . 17,571 Other bonds, notes and debentures . . . . . . . . . . . . . Other securities . . . . . . . . . . . 2,862 1,006 — 3 41 89 23 1 Total . . . . . . . . . . . . . . . . . . . . . . $24,801 157 Held-to-maturity: Obligations of states and political subdivisions . . . . . $ 245 Other bonds, notes and debentures . . . . . . . . . . . . . 10 Total . . . . . . . . . . . . . . . . . . . . . . $ 255 — — — (12) (26) (1) (215) (9) (8) (271) — — — 491 2,013 863 17,445 2,876 999 24,687 245 10 255 838 3,877 922 21,101 1,401 937 29,076 126 9 135 2 13 55 163 12 35 280 — — — (19) (36) — (283) (10) (9) (357) — — — 821 3,854 977 20,981 1,403 963 28,999 126 9 135 The amortized cost and approximate fair value of securities as of December 31, 2004, by contractual maturity, are shown in the following table. Actual maturities may differ from contractual maturities when there exists a right to call or prepay obligations with or without call or prepayment penalties. ($ in millions) Debt securities: Under 1 year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1-5 years . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6-10 years . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Over 10 years . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Available-for-Sale Held-to-Maturity Amortized Cost $ 46 1,514 2,637 19,598 1,006 $24,801 Fair Value 46 1,531 2,640 19,471 999 24,687 Amortized Cost Fair Value 22 1 105 127 — 255 22 1 105 127 — 255 The following tables provide the gross unrealized loss and fair value, aggregated by investment category and length of time the individual securities have been in a continuous unrealized loss position, as of December 31, 2004 and 2003: ($ in millions) 2004 U.S. Treasury and Less than 12 months 12 months or more Total Fair Value Unrealized Losses Fair Value Unrealized Losses Fair Value Unrealized Losses Government agencies . . . . . . $ — U.S. Government sponsored agencies . . . . . . . . . . . . . . . . 1,092 Obligations of states and political subdivisions . . . . . . Agency mortgage-backed securities . . . . . . . . . . . . . . . Other bonds, notes and debentures . . . . . . . . . . . . . . Other securities . . . . . . . . . . . . 13 7,510 1,234 47 Total . . . . . . . . . . . . . . . . . . . . . $ 9,896 2003 U.S. Treasury and Government agencies . . . . . . $ 735 U.S. Government sponsored agencies . . . . . . . . . . . . . . . . 2,232 Agency mortgage-backed securities . . . . . . . . . . . . . . . 12,868 Other bonds, notes and debentures . . . . . . . . . . . . . . Other securities . . . . . . . . . . . . 657 36 Total . . . . . . . . . . . . . . . . . . . . . $16,528 — (8) (1) (84) (8) (5) (106) (19) (36) (283) (9) (3) (350) 485 634 — 5,706 76 28 6,929 — — — 23 36 59 (12) (18) — (131) (1) (3) (165) — — — (1) (6) (7) 485 1,726 13 13,216 1,310 75 16,825 735 2,232 12,868 680 72 16,587 (12) (26) (1) (215) (9) (8) (271) (19) (36) (283) (10) (9) (357) Fifth Third Bancorp 45 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS At December 31, 2004, 94% of the unrealized losses in the available-for-sale security portfolio were comprised of securities issued by U.S. Treasury and Government agencies, U.S. Government sponsored agencies and states and political subdivisions as well as agency mortgage-backed securities. The Bancorp believes the price movements in these securities are dependent upon the movement in market interest rates particularly given the negligible inherent credit risk for these securities. At December 31, 2004, the percentage of unrealized losses in the available-for-sale security portfolio repre- sented by non-rated securities was one percent. At December 31, 2004 and 2003, securities with a fair value of $17.8 billion and $17.9 billion, respectively, were pledged to secure borrowings, public deposits, trust funds and for other purposes as required or permitted by law. Unrealized gains (losses) on trading securities held at Decem- ber 31, 2004 and 2003 were not material to the Consolidated Financial Statements. 3. LOANS AND LEASES AND RESERVE FOR LOAN AND LEASE LOSSES A summary of the loan portfolio as of December 31: As of December 31 ($ in millions) Loans held for sale: Commercial . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Residential mortgage . . . . . . . . . . . . . . . . . . . . . . . . . Other consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total loans held for sale . . . . . . . . . . . . . . . . . . . . . . . . . Loans and leases held for investment: Commercial: Commercial . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Construction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial mortgage . . . . . . . . . . . . . . . . . . . . . . Commercial lease ﬁ nancing . . . . . . . . . . . . . . . . . . Total commercial . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consumer: Residential mortgage . . . . . . . . . . . . . . . . . . . . . . . Construction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Credit card . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Home equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other consumer . . . . . . . . . . . . . . . . . . . . . . . . . . Consumer lease ﬁ nancing . . . . . . . . . . . . . . . . . . . Total consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2004 Unearned Income — — — — — — — (1,208) (1,208) — — — — — (222) (222) Gross $ — 545 14 $ 559 $16,058 4,348 7,636 4,634 32,676 6,988 378 843 10,508 7,572 2,273 28,562 Total loans and leases held for investment . . . . . . . . . . . $61,238 (1,430) 2003 Unearned Income — — — — — — — (1,166) (1,166) — — — — — (261) (261) (1,427) Gross 17 1,105 759 1,881 14,209 3,301 6,894 4,430 28,834 4,425 335 762 8,993 7,677 2,709 24,901 53,735 Net — 545 14 559 16,058 4,348 7,636 3,426 31,468 6,988 378 843 10,508 7,572 2,051 28,340 59,808 A summary of the gross investment in lease ﬁ nancing as of December 31: ($ in millions) Direct ﬁ nancing leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Leveraged leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The components of the investment in lease ﬁ nancing as of December 31: ($ in millions) Rentals receivable, net of principal and interest on nonrecourse debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Estimated residual value of leased assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gross investment in lease ﬁ nancing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Unearned income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net investment in lease ﬁ nancing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2004 $ 4,474 2,433 $ 6,907 2004 $ 4,749 2,158 6,907 (1,430) $ 5,477 Net 17 1,105 759 1,881 14,209 3,301 6,894 3,264 27,668 4,425 335 762 8,993 7,677 2,448 24,640 52,308 2003 4,978 2,161 7,139 2003 4,917 2,222 7,139 (1,427) 5,712 At December 31, 2004, the minimum future lease payments receivable for each of the years 2005 through 2009 were $1,375 million, $1,251 million, $934 million, $575 million and $356 million, respectively. Transactions in the reserve for loan and lease losses for the years ended December 31: ($ in millions) Balance at January 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Losses charged off . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Recoveries of losses previously charged off . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net charge-offs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Provision for loan and lease losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Reclassiﬁ cation of reserve for unfunded commitments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Balance at December 31 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2004 $ 697 (321) 69 (252) 268 — $ 713 2003 683 (380) 68 (312) 399 (73) 697 2002 624 (273) 86 (187) 246 — 683 46 Fifth Third Bancorp NOTES TO CONSOLIDATED FINANCIAL STATEMENTS As of December 31, 2004, the reserve for unfunded commit- ments, totaling $72 million, is included in other liabilities. The December 31, 2003 reserve for unfunded commitments has been reclassiﬁ ed from the reserve for loan and lease losses to other liabili- ties and all subsequent activity has been reclassiﬁ ed to conform to the current period presentation. See Note 1 for a discussion of the reserve for unfunded commitments. As of December 31, 2004, impaired loans, under SFAS No. 114, with a valuation reserve totaled $108 million and impaired loans without a valuation reserve totaled $54 million. The total 4. BANK PREMISES AND EQUIPMENT A summary of bank premises and equipment as of December 31: ($ in millions) Land and improvements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Buildings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Leasehold improvements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Construction in progress . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accumulated depreciation and amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . valuation reserve on the impaired loans at December 31, 2004 was $28 million. As of December 31, 2003, impaired loans with a valu- ation reserve totaled $173 million and impaired loans without a valuation reserve totaled $32 million. The total valuation reserve on the impaired loans at December 31, 2003 was $40 million. Average impaired loans, net of valuation reserves, were $140 million in 2004, $166 million in 2003 and $163 million in 2002. Cash basis interest income recognized on those loans during each of the years was immaterial. Estimated Useful Life 5 to 50 yrs. 3 to 20 yrs. 3 to 30 yrs. 2004 $ 265 933 811 175 133 (1,002) $1,315 2003 210 858 723 118 63 (911) 1,061 Depreciation and amortization expense related to bank prem- ises and equipment was $130 million in 2004, $106 million in 2003 and $97 million in 2002. Occupancy expense has been reduced by rental income from leased premises of $12 million in 2004, $14 million in 2003 and $14 million in 2002. The Bancorp’s subsidiaries have entered into a number of noncancelable lease agreements with respect to bank premises and 5. OPERATING LEASE EQUIPMENT Operating lease equipment primarily consists of automobiles leased to customers, which are reported at cost, net of accumulated depre- ciation. Upon the early adoption of FIN 46 on July 1, 2003, the Bancorp was required to consolidate operating lease assets of an unrelated and previously unconsolidated asset-backed SPE that was formed for the sole purpose of participating in sale-leaseback transactions with the Bancorp. See Note 1 for further discussion of the adoption of FIN 46. Operating lease equipment at December 31, 2004 and 2003 equipment. The minimum annual rental commitments under noncancelable lease agreements for land and buildings at Decem- ber 31, 2004, exclusive of income taxes and other charges, are $49 million in 2005, $45 million in 2006, $42 million in 2007, $37 million in 2008, $32 million in 2009 and $186 million in 2010 and subsequent years. Rental expense for cancelable and noncancelable leases was $57 million for 2004, $56 million for 2003 and $48 million for 2002. was $304 million and $767 million, net of accumulated deprecia- tion of $244 million and $542 million, respectively. Depreciable lives for operating lease equipment generally range from three years to ten years. The minimum future lease rental payments due from customers on operating lease equipment at December 31, 2004, totaled $270 million, of which $190 million is due in 2005, $77 million in 2006 and $3 million in 2007. Depreciation expense related to operating lease equipment for the years ended December 31, 2004 and 2003 was $106 million and $87 million, respectively. 6. GOODWILL Changes in the net carrying amount of goodwill by operating segment for the years ended December 31, 2004 and 2003 were as follows: ($ in millions) Commercial Banking Retail Banking Investment Advisors Processing Solutions Balance as of December 31, 2002 . . . . . . . . . . . . . . Goodwill adjustment . . . . . . . . . . . . . . . . . . . . . . . Balance as of December 31, 2003 . . . . . . . . . . . . . . Acquisition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Divestiture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Balance as of December 31, 2004 . . . . . . . . . . . . . . $188 — 188 185 — $373 234 — 234 78 — 312 101 (2) 99 4 — 103 217 — 217 — (26) 191 Total 740 (2) 738 267 (26) 979 SFAS No. 142, “Goodwill and Other Intangible Assets,” issued in June 2001, discontinued the practice of amortizing goodwill and initiated an annual review for impairment. Impairment is to be examined more frequently if certain indicators are encountered. The Bancorp has completed its most recent annual goodwill impairment test required by this Statement as of September 30, 2004 and has determined that no impairment exists. 7. INTANGIBLE ASSETS Intangible assets consist of servicing rights, core deposits, acquired merchant processing portfolios, customer lists and non-compete agreements. Intangibles are amortized on either a straight-line or an accelerated basis over their estimated useful lives, generally over a period of up to 25 years. The Bancorp reviews intangible assets for possible impairment whenever events or changes in circumstances indicate that carrying amounts may not be recoverable. Detail of amortizable intangible assets as of December 31: Fifth Third Bancorp 47 ($ in millions) Mortgage servicing rights . . . . . . Other consumer and commercial servicing rights . . Core deposits . . . . . . . . . . . . . . . Merchant processing portfolios . . Other intangible assets . . . . . . . . NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 2004 Gross Carrying Amount Accumulated Amortization (a) Net Carrying Amount Gross Carrying Amount $ 940 22 347 — 9 (601) (9) (204) — (2) 339 13 143 — 7 870 11 341 60 — 2003 Accumulated Amortization (a) Net Carrying Amount (581) (1) (181) (25) — 289 10 160 35 — Total . . . . . . . . . . . . . . . . . . . . . . (a) Accumulated amortization for mortgage servicing rights includes a $79 million and $152 million valuation allowance at December 31, 2004 and 2003, respectively. $1,318 1,282 (816) (788) 502 494 As of December 31, 2004, all of the Bancorp’s intangible assets were being amortized. Amortization expense of $130 million, $216 million and $191 million, respectively, was recognized on intan- gible assets (including servicing rights) for the years ended Decem- ber 31, 2004, 2003 and 2002, respectively. Estimated amortization expense, including servicing rights, is $119 million in 2005, $102 million in 2006, $82 million in 2007, $69 million in 2008 and $55 million in 2009. 8. SERVICING RIGHTS AND RETAINED INTERESTS Changes in capitalized servicing rights for the years ended Decem- ber 31: ($ in millions) Balance at January 1 . . . . . . . . . . . . . . . . . . . . . . . . . Amount capitalized . . . . . . . . . . . . . . . . . . . . . . . . . Amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Change in valuation reserve . . . . . . . . . . . . . . . . . . . 2004 $299 94 (101) — 60 2003 263 217 (177) (1) (3) Balance at December 31 . . . . . . . . . . . . . . . . . . . . . . Changes in the servicing rights valuation reserve for the years ended December 31: $352 299 ($ in millions) Balance at January 1 . . . . . . . . . . . . . . . . . . . . . . . . . Servicing valuation recovery (provision) . . . . . . . . . . Permanent impairment write-off . . . . . . . . . . . . . . . 2004 $(152) 60 13 2003 (278) (3) 129 $ (79) Balance at December 31 . . . . . . . . . . . . . . . . . . . . . . (152) The Bancorp maintains a non-qualifying hedging strategy to manage a portion of the risk associated with changes in impairment on the mortgage servicing rights (“MSR”) portfolio. This strategy includes the purchase of various free-standing derivatives (principal only swaps, swaptions, ﬂ oors, forward contracts, options and inter- est rate swaps). The mark-to-market adjustments associated with these derivatives are expected to economically hedge a portion of the change in value of the MSR portfolio caused by ﬂ uctuating discount rates, earnings rates and prepayment speeds. The increase in interest rates during 2004 and the resulting impact of changing prepayment speeds led to the recovery of $60 million in temporary impairment on the MSR portfolio. The combined magnitude of decreasing interest rates during the ﬁ rst six months of 2003 and subsequent increasing interest rates in the last six months of 2003, led to the recognition of a net $3 million in temporary impairment on the MSR portfolio in 2003. As temporary impairment was recognized on the MSR portfolio in 2003 due to falling primary and secondary mortgage rates and earnings rates and corresponding 9. DERIVATIVES The Bancorp maintains an overall interest rate risk management strategy that incorporates the use of derivative instruments to minimize signiﬁ cant unplanned ﬂ uctuations in earnings and cash ﬂ ows caused by interest rate volatility. The Bancorp’s interest rate risk management strategy involves modifying the repricing charac- teristics of certain assets and liabilities so that changes in interest rates do not adversely affect the net interest margin and cash ﬂ ows. Examples of derivative instruments that the Bancorp may use as part of its interest rate risk management strategy include interest rate swaps, interest rate ﬂ oors, interest rate caps, forward contracts, options and swaptions. Interest rate swap contracts are exchanges 48 Fifth Third Bancorp increases in prepayment speeds, the Bancorp sold certain securities that were held at the time as a component of the overall non-quali- fying hedging strategy, resulting in net realized gains of $3 million in 2003 that were captured as a component of other noninterest income in the Consolidated Statements of Income. In addition, the Bancorp recognized a net loss of $10 million and a net gain of $15 million in 2004 and 2003, respectively, related to changes in fair value and settlement of free-standing derivatives purchased to economically hedge the MSR portfolio. As of December 31, 2003, the Bancorp no longer held any available-for-sale securities related to its non-qualifying hedging strategy. As of December 31, 2004 and 2003, other assets included free-standing derivative instruments with a fair value of $7 million and $8 million, respec- tively, and other liabilities included a fair value of $3 million as of December 31, 2004. The outstanding notional amounts on the free-standing derivative instruments related to the MSR portfolio totaled $1.9 billion and $.9 billion as of December 31, 2004 and 2003, respectively. The continued decline in primary and secondary mortgage rates during 2003 led to historically high reﬁ nance rates and corre- sponding increases in prepayment speeds. Therefore, the Bancorp determined a portion of the MSR portfolio was permanently impaired, resulting in a write-off of $129 million in MSRs against the related valuation reserve. In 2004, interest rate movement expectations and corresponding continued acceleration in prepay- ment speeds resulted in the Bancorp determining a portion of the MSR portfolio was permanently impaired, resulting in a write- off of $13 million in MSRs against the related valuation reserve. Temporary changes in the MSR valuation reserve are captured as a component of mortgage banking net revenue in the Consolidated Statements of Income. The fair value of capitalized servicing rights was $353 million and $307 million at December 31, 2004 and 2003, respectively. The Bancorp serviced $23.0 billion and $24.5 billion of residential mortgage loans and $1.3 billion and $.9 billion of consumer loans for other investors at December 31, 2004 and 2003, respectively. of interest payments, such as ﬁ xed-rate payments for ﬂ oating-rate payments, based on a common notional amount and maturity date. Forward contracts are contracts in which the buyer agrees to purchase, and the seller agrees to make delivery of, a speciﬁ c ﬁ nancial instrument at a predetermined price or yield. Swaptions, which have the features of a swap and an option, allow, but do not require, counterparties to exchange streams of payments over a speciﬁ ed period of time. As part of its overall risk management strategy relative to its mortgage banking activity, the Bancorp may enter into freestand- ing forward contracts to economically hedge interest rate lock NOTES TO CONSOLIDATED FINANCIAL STATEMENTS commitments. Additionally, the Bancorp may enter into various free-standing derivatives (principal only swaps, swaptions, ﬂ oors, options and interest rate swaps) to economically hedge changes in fair value of its largely ﬁ xed-rate MSR portfolio. The Bancorp also enters into foreign exchange contracts and interest rate swaps, ﬂ oors and caps for the beneﬁ t of customers. The Bancorp economically hedges signiﬁ cant exposures related to these free-standing derivatives, entered into for the beneﬁ t of custom- ers, by entering into offsetting third-party contracts with approved, reputable counterparties with matching terms and currencies that are generally settled daily. Credit risks arise from the possible inability of counterparties to meet the terms of their contracts. The Bancorp’s exposure is limited to the replacement value of the contracts rather than the notional, principal or contract amounts. The Bancorp minimizes the credit risk through credit approvals, limits and monitoring procedures. Fair Value Hedges The Bancorp enters into interest rate swaps to convert its ﬁ xed-rate, long-term debt to ﬂ oating-rate debt. Decisions to convert ﬁ xed-rate debt to ﬂ oating are made primarily by consideration of the asset/ liability mix of the Bancorp, the desired asset/liability sensitivity and interest rate levels. For the years ended December 31, 2004 and 2003, certain interest rate swaps met the criteria required to qualify for the shortcut method of hedge accounting as deﬁ ned in SFAS No. 133, as amended. Based on this shortcut method of account- ing treatment, no ineffectiveness is assumed and fair value changes in the interest rate swaps are recorded as changes in the value of both the swap and the long-term debt. If any of the interest rate swaps do not qualify for the shortcut method of accounting, the ineffectiveness due to differences in the changes in the fair value of the interest rate swap and the long-term debt are reported within interest expense in the Consolidated Statements of Income. For the years ended December 31, 2004 and 2003, changes in the fair value of any interest rate swaps attributed to hedge ineffectiveness were insigniﬁ cant to the Bancorp’s Consolidated Statements of Income. During 2004 and 2003, the Bancorp terminated interest rate swaps designated as fair value hedges. In accordance with SFAS No. 133, the fair value of the swaps at the date of termination was recog- nized as a premium on the previously hedged long-term debt and is being amortized over the remaining life of the long-term debt as an adjustment to yield. The Bancorp also enters into forward contracts to hedge the forecasted sale of its residential mortgage loans. For the years ended December 31, 2004 and 2003, the Bancorp met certain criteria to qualify for matched terms hedge accounting as deﬁ ned in SFAS No. 133, as amended, on the hedged loans for sale. Based on this treatment, fair value changes in the forward contracts are recorded as changes in the value of both the forward contract and loans held for sale in the Consolidated Balance Sheets. As of December 31, 2004, there were no instances of desig- nated hedges no longer qualifying as fair value hedges. The follow- ing table reﬂ ects all fair value hedges included in the Consolidated Balance Sheets as of December 31: ($ in millions) Included in other assets: Interest rate swaps related to debt . . . . . . . . . Included in other liabilities: Interest rate swaps related to debt . . . . . . . . . Forward contracts related to mortgage loans held for sale . . . . . . . . . . . . . . . . . . . . . . . . Total included in other liabilities . . . . . . . . . . . . 2004 2003 $49 44 1 $45 54 — 3 3 Cash Flow Hedges The Bancorp enters into interest rate swaps to convert ﬂ oating-rate assets and liabilities to ﬁ xed rates and to hedge certain forecasted transactions. The assets and liabilities are typically grouped and share the same risk exposure for which they are being hedged. The Bancorp may also enter into forward contracts to hedge certain forecasted transactions. As of December 31, 2004 and 2003, $33 million and $8 million, respectively, in net deferred losses, net of tax, related to cash ﬂ ow hedges were recorded in accumulated other comprehensive income. Gains and losses on derivative contracts that are reclassiﬁ ed from accumulated other comprehensive income to current period earnings are included in the line item in which the hedged item’s effect in earnings is recorded. As of December 31, 2004, $17 million in deferred losses, net of tax, on derivative instruments included in accumulated other comprehensive income are expected to be reclassiﬁ ed into earnings during the next 12 months. All components of each derivative instrument’s gain or loss are included in the assessment of hedge effectiveness. The maximum term over which the Bancorp is hedging its exposure to the variability of future cash ﬂ ows is eight months for hedges converting ﬂ oating-rate debt to ﬁ xed. During the years ended December 31, 2004 and 2003, the Bancorp terminated certain derivatives qualifying as cash ﬂ ow hedges. The fair value of these contracts, net of tax, is included in accumulated other comprehensive income and is being amortized over the designated hedging periods, which range from 17 months to 14 years. For the year ended December 31, 2004, there were no cash ﬂ ow hedges that were discontinued related to forecasted transac- tions deemed not probable of occurring. The Bancorp had less than $1 million and had $7 million of cash ﬂ ow hedges converting ﬂ oat- ing-rate debt to ﬁ xed included in other liabilities as of December 31, 2004 and 2003, respectively. Free-Standing Derivative Instruments The Bancorp enters into various derivative contracts that focus on providing derivative products to commercial customers. These derivative contracts are not designated against speciﬁ c assets or liabilities on the balance sheet or to forecasted transactions and, therefore, do not qualify for hedge accounting. These instruments include foreign exchange derivative contracts entered into for the beneﬁ t of commercial customers involved in international trade to hedge their exposure to foreign currency ﬂ uctuations and vari- ous interest rate derivative contracts for the beneﬁ t of commercial customers. The Bancorp economically hedges signiﬁ cant exposures related to these derivative contracts entered into for the beneﬁ t of customers by generally entering into offsetting third-party forward contracts with approved reputable counterparties with matching terms and currencies that are typically settled daily. Interest rate lock commitments issued on residential mortgage loan commitments that will be held for resale are also considered free-standing derivative instruments. The interest rate exposure on these commitments is economically hedged primarily with forward contracts. The Bancorp also enters into a combination of freestand- ing derivative instruments (principal only swaps, swaptions, ﬂ oors, forward contracts, options and interest rate swaps) to economically hedge changes in fair value of its largely ﬁ xed rate MSR portfolio. Additionally, the Bancorp occasionally enters into free-standing derivative instruments in order to minimize signiﬁ cant ﬂ uctua- tions in earnings and cash ﬂ ows caused by interest rate volatility. The interest rate lock commitments and free-standing derivative instruments related to the MSR portfolio are marked to market and recorded as a component of mortgage banking net revenue, and the foreign exchange derivative contracts, other customer deriva- tive contracts and interest rate risk derivative contracts are marked to market and recorded within other noninterest income in the Consolidated Statements of Income. The net gains (losses) recorded in the Consolidated Statements of Income relating to free-stand- ing derivative instruments for the years ended December 31 are summarized in the table that follows on the next page. Fifth Third Bancorp 49 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ($ in millions) Foreign exchange contracts for customers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest rate lock commitments and forward contracts related to interest rate lock commitments . . . . . . . . . . . . Derivative instruments related to MSR portfolio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Derivative instruments related to interest rate risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2004 $ 45 1 (10) 7 2003 35 (1) 15 6 The following table reﬂ ects all free-standing derivatives included in the Consolidated Balance Sheets as of December 31: ($ in millions) Included in other assets: Foreign exchange contracts for customers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest rate contracts for customers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest rate lock commitments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Forward contracts related to interest rate lock commitments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Derivative instruments related to MSR portfolio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Derivative instruments related to interest rate risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total included in other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Included in other liabilities: Foreign exchange contracts for customers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest rate contracts for customers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest rate lock commitments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Derivative instruments related to MSR portfolio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total included in other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2004 $168 46 1 — 7 — $222 $137 46 1 3 $187 2002 25 (2) 100 — 2003 167 67 — (1) 8 7 248 131 67 — — 198 The following table summarizes the Bancorp’s derivative position (excluding $13.6 billion in notional amount related to customer accom- modation activity) as of December 31, 2004: ($ in millions) Interest rate swaps related to debt: Receive ﬁ xed/pay ﬂ oating . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Receive ﬂ oating/pay ﬁ xed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Forward contracts related to mortgage loans held for sale . . . . . . . . . . . . . Mortgage servicing rights portfolio: Principal only swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Receive ﬁ xed/pay ﬂ oating interest rate swaps . . . . . . . . . . . . . . . . . . . . Receive ﬂ oating/pay ﬁ xed interest rate swaps . . . . . . . . . . . . . . . . . . . . Purchased swaptions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Notional Amount $2,832 72 386 130 475 101 1,195 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,191 Weighted-Average Remaining Maturity (in months) Average Receive Rate Average Pay Rate 82 4 1 19 93 77 2 4.99% 2.29 4.21 2.50 4.49 2.83% 3.99 2.57 2.32 4.08 10. SHORT-TERM BORROWINGS Borrowings with original maturities of one year or less are classiﬁ ed as short-term. Federal funds purchased are excess balances in reserve accounts held at Federal Reserve Banks that the Bancorp purchased from other member banks on an overnight basis. Bank notes are promissory notes issued by the Bancorp’s subsidiary banks. Other ($ in millions) As of December 31: short-term borrowings includes securities sold under repurchase agreements, Federal Home Loan Bank advances and other borrow- ings with original maturities of one year or less. A summary of short-term borrowings and weighted-average rates follows: 2004 2003 2002 Amount Rate Amount Rate Amount Rate Federal funds purchased . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Short-term bank notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other short-term borrowings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Average for the years ending December 31: Federal funds purchased . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Short-term bank notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other short-term borrowings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Maximum month-end balance: Federal funds purchased . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Short-term bank notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other short-term borrowings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,714 775 4,537 $5,896 1,003 6,640 $8,037 1,275 8,233 2.00% 2.30 1.71 1.30% 1.46 1.17 $6,928 500 5,742 $7,001 22 5,350 $7,768 500 6,907 .91% 1.05 .74 1.14% 1.06 1.03 $4,748 — 4,075 $3,262 2 3,927 $5,976 34 4,399 1.21% — 1.27 1.66% 3.40 1.71 As of December 31, 2004, the Bancorp had issued $28 million in commercial paper, with unused lines of credit of $72 million available to support commercial paper transactions and other corporate requirements. 50 Fifth Third Bancorp NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 11. LONG-TERM DEBT A summary of long-term debt at December 31: ($ in millions) Parent Company Senior: Maturity Interest Rate 2004 2003 Extendable notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2006 – 2009 2.375% $ 1,749 Subordinated: Fixed-rate notes (a) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Junior subordinated: Fixed-rate debentures (a) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2018 2027 4.5% 8.136% Subsidiaries Senior: Fixed-rate bank notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Floating-rate bank notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Extendable bank notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2005 – 2019 2005 2006 – 2014 1.05% – 5.20% 2.21% – 2.37% 2.11% – 2.43% Subordinated: Fixed-rate notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . FixFloat notes (a) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2005 2010 6.625% – 6.75% 7.75% Junior subordinated: Floating-rate debentures (a) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Floating-rate debentures (a) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Mandatorily redeemable securities (a) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Federal Home Loan Bank advances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Securities sold under repurchase agreements . . . . . . . . . . . . . . . . . . . . . . . . . Commercial paper-backed obligations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (a) Qualify as total capital for regulatory capital purposes. The 8.136% junior subordinated debentures due in 2027 were issued by the Bancorp to Fifth Third Capital Trust I (“FTCT1”). The Bancorp has fully and unconditionally guaranteed all of FTCT1’s obligations under trust preferred securities issued by FTCT1. The trust preferred securities are redeemable beginning in 2007. The three-month LIBOR plus 80 bp junior subordinated debentures due in 2027 were issued to Old Kent Capital Trust 1 (“OKCT1”). The Bancorp has fully and unconditionally guaran- teed all of OKCT1’s obligations under trust preferred securities issued by OKCT1. The trust preferred securities are redeemable beginning in 2007. Upon the early adoption of FIN 46 effective July 1, 2003, the Bancorp deconsolidated both FTCT1 and OKCT1 resulting in a recharacterization of the underlying consolidated debt obligations from the previous trust preferred securities obligations to junior subordinated debenture obligations. The junior subordinated debentures due in 2030 were assumed by a subsidiary of the Bancorp in connection with the acquisition of Franklin Financial. The obligations were issued to Franklin Capi- tal Trust 1 (“FCT1”). The Bancorp has fully and unconditionally guaranteed all of FCT1’s obligations under trust preferred securities issued by FCT1. The interest rate on the unsecured subordinated ﬁ xﬂ oat notes due in 2010 is 7.75% and will convert to a ﬂ oating rate during 2005. The notes may be redeemed on a semi-annual basis. The mandatorily redeemable securities due 2031 relate to a preferred stock obligation of a subsidiary of the Bancorp. The preferred stock will be automatically exchanged for trust preferred securities in 2031. Beginning ﬁ ve years from the date of issuance, the Bancorp’s subsidiary has the option, subject to regulatory approval, to exchange the preferred stock for trust preferred securi- 469 229 2,565 1,100 1,199 354 151 103 17 548 3,888 1,300 286 25 $13,983 — 458 233 497 — — 365 159 103 — 505 5,094 825 792 32 9,063 2027 2030 2031 2005 – 2034 2007 – 2008 2005 – 2007 2005 – 2032 2.96% 5.57% Varies 1.09% – 8.34% 2.00% – 2.15% 2.34% – 2.41% Varies ties or cash upon a change in the Bancorp’s senior debt rating to or below BBB, a change in the investor’s tax elections or a change in applicable tax law. Upon the adoption of SFAS No. 150 on July 1, 2003, the Bancorp reclassiﬁ ed its previous minority interest obli- gation to long-term debt and its corresponding minority interest expense to interest expense due to the existence of the mandatory redemption feature. At December 31, 2004, Federal Home Loan Bank advances have rates ranging from 1.09% to 8.34%, with interest payable monthly. The advances are secured by certain residential mortgage loans and securities totaling $8.4 billion. The advances mature as follows: $400 million in 2005, $105 million in 2006, $1,827 million in 2007, $3 million in 2008 and $1,553 million thereafter. At December 31, 2004, securities sold under agreements to repurchase have variable rates ranging from 2.00% to 2.15% with interest payable monthly. The repurchase agreements mature as follows: $1,000 million in 2007 and $300 million in 2008. The ﬂ oating-rate, commercial paper-backed obligations are rolling in nature, mature through 2007 and were recognized as a result of the early adoption of FIN 46 and related consolidation of an unrelated SPE involved in the sale and subsequent leaseback of certain automobile operating lease assets with the Bancorp. See Note 1 for further discussion of adoption of FIN 46. Medium-term senior notes and subordinated bank notes with maturities ranging from one year to 30 years can be issued by two subsidiary banks, of which $4.9 billion was outstanding at Decem- ber 31, 2004 with $14.3 billion available for future issuance. There were no other medium-term senior notes outstanding on either of the two subsidiary banks as of December 31, 2004. In January 2005, a subsidiary of the Bancorp issued $500 million of subordi- nated bank notes with a rate of 4.75% due in 2015. Fifth Third Bancorp 51 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 12. COMMITMENTS AND CONTINGENT LIABILITIES The Bancorp, in the normal course of business, uses derivatives and other ﬁ nancial instruments to manage its interest rate risks and prepayment risks and to meet the ﬁ nancing needs of its custom- ers. These ﬁ nancial instruments primarily include commitments to extend credit, standby and commercial letters of credit, foreign exchange contracts, commitments to sell residential mortgage loans, principal only swaps, interest rate swap agreements, written options and interest rate lock commitments. These instruments involve, to varying degrees, elements of credit risk, counterparty risk and market risk in excess of the amounts recognized in the Bancorp’s Consolidated Balance Sheets. As of December 31, 2004, 100% of the Bancorp’s risk management derivatives exposure was to investment grade companies. The contract or notional amounts of these instruments reﬂ ect the extent of involvement the Bancorp has in particular classes of ﬁ nancial instruments. Creditworthiness for all instruments is evaluated on a case-by- case basis in accordance with the Bancorp’s credit policies. While notional amounts are typically used to express the volume of these transactions, it does not represent the much smaller amounts that are potentially subject to credit risk. Entering into derivative instru- ments involves the risk of dealing with counterparties and their ability to meet the terms of the contract. The Bancorp controls the credit risk of these transactions through adherence to a derivatives products policy, credit approval policies and monitoring proce- dures. Collateral, if deemed necessary, is based on management’s credit evaluation of the counterparty and may include business assets of commercial borrowers, as well as personal property and real estate of individual borrowers and guarantors. A summary of signiﬁ cant commitments and contingent liabil- ities at December 31: ($ in millions) Commitments to extend credit . . . . . . . . . . . Letters of credit (including standby letters of credit) . . . . . . . . . . . . . . . . . . . . Foreign exchange contracts for customers: Spots . . . . . . . . . . . . . . . . . . . . . . . . . . . . Forwards . . . . . . . . . . . . . . . . . . . . . . . . . Written options . . . . . . . . . . . . . . . . . . . . Forward contracts to sell mortgage loans . . . Principal only swaps . . . . . . . . . . . . . . . . . . . Interest rate swap agreements . . . . . . . . . . . . Written options . . . . . . . . . . . . . . . . . . . . . . Interest rate lock commitments . . . . . . . . . . Contract or Notional Amount 2004 $31,312 2003 25,406 5,923 342 4,624 349 739 130 9,798 437 328 4,908 141 3,950 240 796 181 7,280 600 377 Commitments to extend credit are agreements to lend, typi- cally having ﬁ xed expiration dates or other termination clauses that 13. LEGAL AND REGULATORY PROCEEDINGS During 2003, eight putative class action complaints were ﬁ led in the United States District Court for the Southern District of Ohio against the Bancorp and certain of its ofﬁ cers alleging violations of federal securities laws related to disclosures made by the Bancorp regarding its integration of Old Kent and its effect on the Bancorp’s infrastructure, including internal controls, and prospects and relat- ed matters. The complaints, which have been consolidated, seek unquantiﬁ ed damages on behalf of putative classes of persons who purchased the Bancorp’s common stock, attorneys’ fees and other expenses. Management believes there are substantial defenses to may require payment of a fee. Since many of the commitments to extend credit may expire without being drawn upon, the total commitment amounts do not necessarily represent future cash ﬂ ow requirements. The Bancorp is exposed to credit risk in the event of nonperformance for the amount of the contract. Fixed- rate commitments are also subject to market risk resulting from ﬂ uctuations in interest rates and the Bancorp’s exposure is limited to the replacement value of those commitments. As of December 31, 2004 and 2003, the Bancorp had a reserve for probable credit losses totaling $53 million and $55 million, respectively, included in other liabilities. Standby and commercial letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party. At December 31, 2004, approximately $1,782 million of standby letters of credit expire within one year, $3,812 million expire between one to ﬁ ve years and $294 million expire thereafter. At December 31, 2004, letters of credit of approximately $35 million were issued to commercial customers for a duration of one year or less to facilitate trade payments in domestic and foreign currency transactions. The amount of credit risk involved in issu- ing letters of credit in the event of nonperformance by the other party is the contract amount. As of December 31, 2004 and 2003, the Bancorp had a reserve for probable credit losses totaling $19 million and $18 million, respectively, included in other liabilities. As discussed in Note 9, the Bancorp’s policy is to enter into derivative contracts to accommodate customers, to offset customer accommodations and to offset its own market risk incurred in the ordinary course of its business. Contingent obligations arising from market risk assumed in derivatives are offset with additional rights contained in other derivatives or contracts, such as loans or borrowings. Certain derivatives provide the Bancorp rights with- out contingent obligations (purchased options). Other derivatives represent contingent obligations without providing additional rights (written options, including interest rate lock commit- ments). Still other derivatives provide additional rights combined with contingent obligations (foreign exchange spots and forwards, forward contracts to sell mortgage loans, principal only swaps and interest rate swap agreements). All derivatives that possess a contin- gent obligation are included in the table. There are claims pending against the Bancorp and its subsidiar- ies that have arisen in the normal course of business. Based on a review of such litigation with legal counsel, management believes any resulting liability would not have a material effect upon the Bancorp’s consolidated ﬁ nancial position or results of operations. See Note 13 for additional information regarding these proceedings. these lawsuits. Management believes the impact of the ﬁ nal dispo- sition of these lawsuits will not be material to the Bancorp. The Bancorp and its subsidiaries are not parties to any other material litigation other than those arising in the normal course of business. While it is impossible to ascertain the ultimate resolu- tion or range of ﬁ nancial liability with respect to these contingent matters, management believes any resulting liability from these other actions would not have a material effect upon the Bancorp’s consolidated ﬁ nancial position or results of operations. 52 Fifth Third Bancorp NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 14. GUARANTEES The Bancorp has performance obligations upon the occurrence of certain events under ﬁ nancial guarantees provided in certain contractual arrangements. These various arrangements are summa- rized below. At December 31, 2004, the Bancorp had issued approximately $5.9 billion of ﬁ nancial and performance standby letters of credit to guarantee the performance of various customers to third parties. The maximum amount of credit risk in the event of nonperfor- mance by these parties is equivalent to the contract amount and totals $5.9 billion. Upon issuance, the Bancorp recognizes a liability equivalent to the amount of fees received from the customer for these standby letter of credit commitments. At December 31, 2004, the Bancorp maintained a credit loss reserve of approximately $19 million related to these ﬁ nancial standby letters of credit. Approxi- mately 75% of the total standby letters of credit are secured and in the event of nonperformance by the customers, the Bancorp has rights to the underlying collateral provided including commercial real estate, physical plant and property, inventory, receivables, cash and marketable securities. Through December 31, 2004, the Bancorp had transferred, subject to credit recourse, certain primarily ﬂ oating-rate and short- term investment grade commercial loans to an unconsolidated QSPE that is wholly owned by an independent third-party. The outstanding balance of such loans at December 31, 2004 was approximately $1.9 billion. These loans may be transferred back to the Bancorp upon the occurrence of an event speciﬁ ed in the legal documents that established the QSPE. These events include borrower default on the loans transferred, bankruptcy preferences initiated against underlying borrowers and ineligible loans trans- ferred by the Bancorp to the QSPE. The maximum amount of credit risk in the event of nonperformance by the underlying borrowers is approximately equivalent to the total outstanding balance of $1.9 billion at December 31, 2004. The outstanding balances are typi- cally secured by the underlying collateral that include commercial real estate, physical plant and property, inventory, receivables, cash and marketable securities. Given the investment grade nature of the loans transferred as well as the underlying collateral security provided, the Bancorp has not maintained any loss reserve related to these loans transferred. At December 31, 2004, the Bancorp had provided credit recourse on approximately $569 million of residential mortgage loans sold to unrelated third parties. In the event of any customer default, pursuant to the credit recourse provided, the Bancorp is required to reimburse the third party. The maximum amount of credit risk in the event of nonperformance by the underlying 15. RELATED PARTY TRANSACTIONS At December 31, 2004 and 2003, certain directors, executive ofﬁ - cers, principal holders of Bancorp common stock and associates of such persons were indebted, including undrawn commitments to lend, to the Bancorp’s banking subsidiaries in the aggregate amount, net of participations, of $260 million and $385 million, respective- ly. As of December 31, 2004 and 2003, the outstanding balance on loans to related parties, net of participations and undrawn commit- ments, was $70 million and $118 million, respectively. Commitments to lend to related parties as of December 31, 2004 and 2003, net of participations, were comprised of $244 million and $364 million, respectively, in loans and guarantees for various business and personal interests made to the Bancorp and subsidiary directors and $16 million and $21 million, respectively, to certain executive ofﬁ cers. This indebtedness was incurred in the borrowers is equivalent to the total outstanding balance of $569 million. In the event of nonperformance, the Bancorp has rights to the underlying collateral value attached to the loan. Consistent with its overall approach in estimating credit losses for various categories of residential mortgage loans held in its loan portfolio, the Bancorp maintains an estimated credit loss reserve of approximately $17 million relating to these residential mortgage loans sold. As of December 31, 2004, the Bancorp has also fully and unconditionally guaranteed $349 million of certain long-term borrowing obligations issued by three wholly-owned issuing trust entities that have been deconsolidated upon the early adoption of the provisions of FIN 46. See Note 1 for further discussion of adop- tion of FIN 46. During 2004, the Bancorp, through its electronic payment processing division, processed VISA® and MasterCard® merchant card transactions. Pursuant to VISA® and MasterCard® rules, the Bancorp assumes certain contingent liabilities relating to these transactions which typically arise from billing disputes between the merchant and cardholder that are ultimately resolved in the card- holder’s favor. In such cases, these transactions are “charged back” to the merchant and disputed amounts are refunded to the cardholder. In the event that the Bancorp is unable to collect these amounts from the merchant, it will bear the loss for refunded amounts. The likeli- hood of incurring a contingent liability arising from chargebacks is relatively low, as most products or services are delivered when purchased, and credits are issued on returned items. For the year ended December 31, 2004, the Bancorp processed approximately $121 million of chargebacks presented by issuing banks resulting in actual losses to the Bancorp of approximately $3 million. The Bancorp accrues for probable losses based on historical experience. The credit loss reserve was not material at December 31, 2004. Fifth Third Securities, Inc (“FTS”), a subsidiary of the Bancorp, guarantees the collection of all margin account balances held by its brokerage clearing agent for the beneﬁ t of FTS customers. FTS is responsible for payment to its brokerage clearing agent for any loss, liability, damage, cost or expense incurred as a result of customers failing to comply with margin or margin maintenance calls on all margin accounts. The margin account balance held by the broker- age clearing agent as of December 31, 2004 was $48 million. In the event of any customer default, FTS has rights to the underlying collateral provided. Given certain FTS margin account relation- ships were in place prior to January 1, 2003 and the existence of the underlying collateral provided as well as the negligible historical credit losses, FTS does not maintain any loss reserve. ordinary course of business on substantially the same terms as those prevailing at the time of comparable transactions with unrelated parties. During 2004, the Bancorp entered into a daily line of credit and term loan agreement with First National Bankshares of Florida, Inc. (“First National”) and its subsidiaries. Outstanding balances on the line of credit and term loan at December 31, 2004 were $328 million and $30 million, respectively. The Bancorp completed the acquisition of First National on January 1, 2005. None of the Bancorp’s afﬁ liates, ofﬁ cers, directors or employ- ees has an interest in or receives any remuneration from any special purpose entities or qualiﬁ ed special purpose entities with which the Bancorp transacts business. Fifth Third Bancorp 53 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 16. OTHER COMPREHENSIVE INCOME The Bancorp has elected to present the disclosures required by SFAS No. 130, “Reporting Comprehensive Income,” in the Consolidated Statements of Changes in Shareholders’ Equity on page 38 and in the table below. Disclosure of the reclassiﬁ cation adjustments, related tax effects allocated to other comprehensive income and accumulated other comprehensive income as of and for the years ended December 31: ($ in millions) Current Period Activity Accumulated Balance Pre-Tax Tax Effect Net Pre-Tax Tax Effect Net 2004 Losses on available-for-sale securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Reclassiﬁ cation adjustment for losses recognized in net income . . . . . . . . . . . . . . . Losses on cash ﬂ ow hedge derivatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Reclassiﬁ cation adjustment for gains recognized in net income . . . . . . . . . . . . . . . . Change in minimum pension liability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (74) 37 (39) (1) (1) Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (78) 2003 Losses on available-for-sale securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Reclassiﬁ cation adjustment for gains recognized in net income . . . . . . . . . . . . . . . . Gains (losses) on cash ﬂ ow hedge derivatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Change in minimum pension liability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(667) (84) 14 (17) Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(754) 2002 Gains on available-for-sale securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Reclassiﬁ cation adjustment for gains recognized in net income . . . . . . . . . . . . . . . . Losses on cash ﬂ ow hedge derivatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Change in minimum pension liability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 793 (147) (10) (80) Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 556 27 (13) 15 — — 29 234 30 (5) 6 265 (277) 51 3 28 (195) 17. COMMON STOCK AND TREASURY STOCK (47) 24 (24) (1) (1) (49) (433) (54) 9 (11) (489) 516 (96) (7) (52) 361 (114) (52) (98) (264) (77) (12) (97) (186) 674 (26) (80) 568 42 19 34 95 28 4 34 66 (236) 9 28 (199) The following is a summary of the share activity within common stock issued and treasury stock for the years ended December 31: Common Stock Treasury Stock ($ and shares in millions) Shares at December 31, 2001 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Shares acquired for treasury . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Stock options exercised, including treasury shares issued . . . . . . . . . . . . . . . . . . . . . . . . . . . Shares at December 31, 2002 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Shares acquired for treasury . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Stock options exercised, including treasury shares issued . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Shares at December 31, 2003 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Shares acquired for treasury . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Stock options exercised, including treasury shares issued . . . . . . . . . . . . . . . . . . . . . . . . . . . Restricted stock issued . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Stock issued in business combination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Value $1,294 — 1 1,295 — — — 1,295 — — — — — Shares at December 31, 2004 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,295 Shares 583 — — 583 — — — 583 — — — — — 583 Value $ 4 720 (180) 544 655 (233) (4) 962 987 (222) (33) (281) 1 $1,414 (72) (33) (64) (169) (49) (8) (63) (120) 438 (17) (52) 369 Shares — 12 (3) 9 12 (4) — 17 19 (4) (1) (5) — 26 On January 10, 2005, the Bancorp repurchased 35.5 million shares of its common stock, approximately six percent of the total outstanding shares, for approximately $1.6 billion in an overnight accelerated share repurchase transaction. The transaction provides that the counterparty will purchase shares in the market over a period of time. Upon completion, the Bancorp will receive or pay a price adjustment in the form of cash or shares, at its election, that is largely based on the volume weighted-average price of the shares purchased by the counterparty. 54 Fifth Third Bancorp NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 18. STOCK-BASED COMPENSATION The Bancorp has historically emphasized employee stock owner- ship. Accordingly, the Bancorp encourages further ownership through granting stock-based compensation to approximately 24% of its employees, including approximately 5,000 ofﬁ cers. Based on total stock-based awards outstanding and shares remain- ing for future grants under the Incentive Compensation Plan, the Bancorp’s total overhang is approximately 11%. The following table provides detail of the number of shares to be issued upon exercise of outstanding stock-based awards and remaining shares available for future issuance under all of the Bancorp’s equity compensation plans, as of December 31, 2004: Plan Category (in thousands) Equity compensation plans approved by shareholders: Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Restricted stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Performance units . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Stock appreciation rights (“SARs”) . . . . . . . . . . . . . . . . . . . . . . . Equity compensation plans not approved by shareholders: Employee stock purchase plan . . . . . . . . . . . . . . . . . . . . . . . . . . Total (g) Number of Shares to Be Issued Upon Exercise Weighted-Average Exercise Price Shares Available for Future Issuance (a) 33,442 596 (d) (e) 34,038 $46.40 (c) (c) (e) $46.40 (b) (b) (b) (b) 764(f ) 20,413(h) (a) Excludes shares to be issued upon exercise of outstanding awards. (b) Under the Incentive Compensation Plan, 20.0 million shares of stock were authorized for issuance as nonqualiﬁ ed and incentive stock options, SARs, restricted stock and restricted stock units, performance shares and performance units and stock awards. As of December 31, 2004, 19.1 million shares remain available for future issuance. (c) Not applicable (d) The number of shares to be issued is dependent upon the Bancorp achieving certain predeﬁ ned performance targets and ranges from zero shares to approximately 98 thousand shares, dependent on relative performance. (e) During 2004, approximately 3.7 million SARs were granted at a weighted-average grant price of $54.37. The number of shares to be issued upon exercise will be determined at exercise based on the difference between the grant price and the market price at the date of exercise. (f ) Represents remaining shares of Fifth Third common stock under the Bancorp’s 1993 Stock Purchase Plan, as amended and restated. (g) Excludes 2.7 million outstanding options awarded under plans assumed by the Bancorp in connection with certain mergers and acquisitions. The Bancorp has not made any awards under these plans and will make no additional awards under these plans. The weighted-average exercise price of the outstanding options is $31.92 per share. (h) Includes .5 million shares issuable relating to deferred stock compensation plans. Stock-based awards are eligible for issuance under the Bancorp’s Incentive Compensation Plan to key employees and directors of the Bancorp and its subsidiaries. The Incentive Stock Compensa- tion Plan was approved by shareholders on March 23, 2004. The plan authorized the issuance of up to 20 million shares as equity compensation, in addition to those shares available for issuance under the predecessor plan, the 1998 Long Term Incentive Stock Plan. During 2004, the Bancorp utilized all shares remaining under the predecessor plan. Options and SARs are issued at fair market value at the date of grant, have up to ten-year terms and vest and become fully exercisable at the end of three or four years of contin- ued employment. Currently, all SARs outstanding are to be settled with stock. Restricted stock grants vest after four years of continued employment and include dividend and voting rights. The Bancorp applies the fair value provisions of SFAS No. 123 in accounting for stock-based compensation plans. Under SFAS No. 123, the Bancorp recognizes compensation expense for the fair value of stock-based awards issued over their vesting period. Stock-based compensation expense was $87 million, $110 million and $128 million for the years ended December 31, 2004, 2003 and 2002, respectively. The exercise price of the Bancorp’s stock option grants equals the market price of the underlying stock on the date of grant. A summary of stock-based award activity during the years ended December 31: Options (shares in thousands) Outstanding at January 1 . . . . . . . . . . . . . . . . . . . . . . . . . . Exercised . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Canceled . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Granted (a) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2004 2003 2002 Shares 40,727 (4,248) (1,422) 1,105 Average Option Price $44.40 25.41 58.07 19.81 Shares 39,030 (3,843) (958) 6,498 Average Option Price $41.85 27.25 58.61 51.88 Shares 36,735 (3,736) (533) 6,564 Average Option Price $36.27 30.73 53.97 67.68 Outstanding at December 31 . . . . . . . . . . . . . . . . . . . . . . . Exercisable at December 31 . . . . . . . . . . . . . . . . . . . . . . . . (a) 2004 options granted include 1,021 options assumed as part of the Franklin Financial acquisition completed on June 11, 2004. These options were granted under a Franklin 36,162 30,912 $45.31 $43.57 39,030 29,935 $44.40 $40.46 40,727 30,574 $41.85 $36.96 Financial plan assumed by the Bancorp. Stock Appreciation Rights (shares in thousands) Outstanding at January 1 . . . . . . . . . . . . . . . . . . . . . . . . . . Exercised . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Canceled . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Granted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Outstanding at December 31 . . . . . . . . . . . . . . . . . . . . . . . Exercisable at December 31 . . . . . . . . . . . . . . . . . . . . . . . . Shares — — (187) 3,716 3,529 1 2004 2003 2002 Average Grant Price Shares Average Grant Price Shares Average Grant Price $ — — 54.40 54.37 $54.37 $54.40 — — — — — — — — — — — — — — — — — — — — — — — — Fifth Third Bancorp 55 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Restricted Stock (shares in thousands) Outstanding unvested at January 1 . . . . . . . . . . . . . . . . . . . Vested . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Canceled . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Granted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Outstanding unvested at December 31 . . . . . . . . . . . . . . . . Shares 48 (18) (41) 607 596 2004 2003 2002 Average Market Price at Grant $58.11 59.16 54.26 53.86 $54.01 Average Market Price at Grant $62.54 62.81 — 56.90 $58.11 Average Market Price at Grant $54.73 54.23 — 62.78 $62.54 Shares 165 (155) — 8 18 Shares 18 (8) — 38 48 At December 31, 2004, there were 14.2 million incentive options, 22.0 million non-qualiﬁ ed options, 3.5 million SARs, .1 million shares reserved for performance unit awards and .6 million restrict- ed stock awards outstanding and 19.1 million shares available for grant. Options, SARs and restricted stock outstanding represent seven percent of the Bancorp’s issued shares at December 31, 2004. Exercise Price per Share Under $11 . . . . . $11-$25 . . . . . . . $25-$40 . . . . . . . $40-$55 . . . . . . . Over $55 . . . . . . All options . . . . . Lowest Price $ 5.06 11.06 25.22 40.17 55.01 $ 5.06 Highest Price $10.86 24.90 39.96 54.99 68.76 $68.76 Outstanding Stock Options Exercisable Stock Options Number of Options at Year-End (000’s) Weighted-Average Exercise Price Average Remaining Contractual Life (in years) Number of Options (000’s) Weighted-Average Exercise Price 358 4,990 5,100 19,365 6,349 36,162 $ 7.49 19.06 35.81 48.37 66.37 $45.31 1.24 2.11 3.55 6.02 7.27 5.30 358 4,990 5,086 15,680 4,798 30,912 $ 7.49 19.06 35.81 47.65 66.61 $43.57 In addition, approximately 98 thousand shares of perfor- mance-based awards were granted during 2004. These awards are payable in stock and cash contingent upon the Bancorp achieving certain predeﬁ ned performance targets over the three-year measure- ment period. These performance targets are based on the Bancorp’s performance relative to a deﬁ ned peer group. The performance- based awards were granted at an average fair value of $55.75 per share. The Bancorp sponsors a Stock Purchase Plan that allows qualifying employees to purchase shares of the Bancorp’s common stock at a 15% discount from market price. During the years ended December 31, 2004, 2003 and 2002, respectively, there were 236,115, 194,133 and 157,308 shares purchased by participants and the Bancorp recognized compensation expense of $2 million in 2004 and $1 million in both 2003 and 2002. 19. OTHER NONINTEREST INCOME AND OTHER NONINTEREST EXPENSE The major components of other noninterest income and other noninterest expense for the years ended December 31: ($ in millions) Other noninterest income: Cardholder fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consumer loan and lease fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial banking revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Bank owned life insurance income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Insurance income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gain on sale of branches . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gain on sale of property and casualty insurance product lines . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gain on sale of small merchant processing contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other noninterest expense: Marketing and communication . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Postal and courier . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Bankcard . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Intangible amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Franchise and other taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loan and lease . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Printing and supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Travel . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Data processing and operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Debt prepayment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2004 2003 2002 $ 48 57 174 61 31 — — 157 143 $ 671 $ 99 49 197 29 32 82 33 41 114 325 309 $1,310 59 65 178 62 28 — — — 189 581 99 49 176 40 33 106 35 35 97 20 255 945 51 70 157 62 55 7 26 — 152 580 96 48 142 37 30 91 37 38 82 — 285 886 56 Fifth Third Bancorp NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 20. SALES AND TRANSFERS OF LOANS The Bancorp sold ﬁ xed and adjustable rate residential mortgage loans in securitization transactions, during 2004 and 2003. The Bancorp also securitized and sold certain automotive loans in 2004 and securitized and sold certain home equity lines of credit in 2003. In all of those sales, the Bancorp retained servicing responsibilities. In addition, the Bancorp retained a residual interest and an inter- est only strip (“IO strip”) in the 2003 home equity lines of credit securitization and a residual interest and a subordinated tranche in the 2004 automotive loans securitization. The Bancorp receives annual servicing fees at a percentage of the outstanding balance and rights to future cash ﬂ ows arising after the investors in the securi- tization trusts have received the return for which they contracted. The investors and the securitization trusts have no recourse to the Bancorp’s other assets for failure of debtors to pay when due. The Bancorp’s retained interests are subordinate to investor’s interests. Their value is subject to credit, prepayment and interest rate risks on the sold ﬁ nancial assets. In 2004 and 2003, the Bancorp recog- nized pretax gains of $112 million and $340 million, respectively, on the sales of residential mortgage loans, home equity lines of credit and automotive loans. Total proceeds from residential mort- gage loan, home equity lines of credit and automotive loan sales in 2004 and 2003 were $6.1 billion and $16.0 billion, respectively. Initial carrying values of retained interests recognized during 2004 and 2003 were as follows: ($ in millions) 2004 2003 $83 11 26 21 Mortgage servicing assets . . . . . . . . . . . . . . . . . . . . . Other consumer and commercial servicing assets . . . Consumer residual interests . . . . . . . . . . . . . . . . . . . Subordinated interests . . . . . . . . . . . . . . . . . . . . . . . 206 11 29 — The subordinated interests recognized in 2004 are securities retained from the automotive loan securitization. These securities are investment grade and are carried at their market value. Key economic assumptions used in measuring other retained interests at the date of securitization resulting from securitizations complet- ed during 2004 and 2003 were as follows: 2004 2003 Weighted- Average Life (in years) Prepayment Speed Assumption Discount Rate Weighted- Average Default Rate Weighted- Average Life (in years) Prepayment Speed Assumption Discount Rate Weighted- Average Default Rate Rate Residential mortgage loans: Servicing assets . . . . . Servicing assets . . . . Adjustable Fixed Home equity lines of credit: Servicing assets . . . . . Adjustable Residual interest . . . . Adjustable Automotive loans: Servicing assets . . . . . Residual interest . . . . Fixed Fixed 7.0 4.4 2.0 2.0 2.9 2.9 16.1% 25.6 9.5% 10.7 38.8 38.8 1.55 1.55 11.7 11.7 12.0 12.0 N/A N/A N/A .35% N/A 1.25 6.2 3.3 2.1 2.1 — — 15.5% 31.9 9.8% 10.7 40 40 — — 12.0 11.7 — — N/A N/A N/A .35% — — Expected credit losses and the effect of an unfavorable change in credit losses for servicing rights have been deemed to be immaterial based on historical credit experience. At December 31, 2004, key economic assumptions and the sensitivity of the current fair value of residual cash ﬂ ows to immediate 10% and 20% adverse changes in those assumptions are as follows: Prepayment Speed Assumption Residual Servicing Cash Flows Weighted-Average Default ($ in millions) Rate Residential mortgage loans: Servicing assets . . . . . Servicing assets . . . . . Home equity lines of credit: Servicing assets . . . . . Residual interest . . . . Fixed Adjustable Adjustable Adjustable Automotive loans: Servicing assets . . . . . Residual interest . . . . Fixed Fixed Weighted- Average Life (in years) Rate Impact of Adverse Change on Fair Value Discount 20% 10% Rate Impact of Adverse Change on Fair Value Impact of Adverse Change on Fair Value 10% 20% Rate 10% 20% 6.1 3.5 2.4 2.1 1.3 1.2 15.2% $16 2 29.6 35.0 35.0 1.55 1.55 1 2 — — $30 3 1 4 1 — 9.5% 11.4 11.7 11.7 12.0 12.0 $9 1 — 1 — — $17 1 — 1 — 1 —% — $— — — .35 — 1.25 — — — 1 $— — — 1 — 1 Fair Value $313 26 7 29 7 23 These sensitivities are hypothetical and should be used with caution. As the ﬁ gures indicate, changes in fair value based on a 10% variation in assumptions typically cannot be extrapolated because the relationship of the change in assumption to the change in fair value may not be linear. Also, in the above table, the effect of a variation in a particular assumption on the fair value of the retained interest is calculated without changing any other assump- tion; in reality, changes in one factor may result in changes in another (for example, increases in market interest rates may result in lower prepayments and increased credit losses), which might magnify or counteract the sensitivities. In addition to the retained interests listed above, the Bancorp retains certain investment grade securities from securitizations. The fair value of these retained securities was $34 million and $56 million at December 31, 2004 and 2003, respectively. The securi- ties are valued using quoted market prices. The following table provides a summary of the total loans and leases managed by the Bancorp, including loans securitized: Fifth Third Bancorp 57 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS For the Years Ended December 31 ($ in millions) Commercial loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial mortgage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Construction loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Residential mortgage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other consumer loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consumer leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total loans and leases managed and securitized (a) . . . . . . . . Less: Loans securitized . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loans held for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2004 $16,058 7,636 3,426 4,726 7,629 20,222 2,051 61,748 1,381 559 Balance 2003 14,226 6,894 3,264 3,636 5,801 19,036 2,448 55,305 1,116 1,881 Balance of Loans 90 Days or More Past Due 2004 2003 $ 21 8 1 9 44 62 3 $148 14 9 1 9 50 61 6 150 Net Credit Losses 2004 $ 81 9 7 6 15 118 19 $255 2003 136 7 22 2 24 96 25 312 Total loans and leases held for investment . . . . . . . . . . . . . . (a) Excluding securitized assets that the Bancorp continues to service but with which it has no other continuing involvement. $59,808 52,308 Static pool credit losses are calculated by aggregating the actual and projected future credit losses for a securitization and dividing these losses by the original balance in each pool of assets. For the home equity lines of credit securitized in 2003, the static pool credit losses were .78% and .66% as of December 31, 2004 and 2003, respectively. For the automotive loans securitized in 2004, the static pool credit losses were 1.14% as of December 31, 2004. During 2004 and 2003, the Bancorp transferred, subject to credit recourse, certain commercial loans to an unconsolidated QSPE that is wholly owned by an independent third party. At December 31, 2004 and 2003, the outstanding balance of loans transferred was $1.9 billion and $1.8 billion, respectively. The commercial loans transferred to the QSPE are primarily ﬂ oating-rate and short-term investment grade in nature. Generally, the loans transferred provide a lower yield due to their investment grade nature, and therefore transferring these loans to the QSPE allows the Bancorp to reduce its exposure to these lower yielding loan assets while maintaining the customer relationships. These commercial loans are transferred at par with no gain or loss recognized. The Bancorp receives rights to future cash ﬂ ows arising after the investors in the securitization trust have received the return for which they contracted. Due to the relatively short-term nature of the loans transferred, no value has been assigned to this retained future stream of fees to be received. As of December 31, 2004, the $1.9 billion balance of outstanding loans had a weighted-average remaining maturity of 62 days. During 2004, the Bancorp securitized and sold $750 million in automotive loans to an unconsolidated QSPE that is wholly owned by an independent third party. The Bancorp retained servic- ing rights and receives a servicing fee based on a percentage of the outstanding balance. Additionally, the Bancorp retained a subor- dinated tranche of securities and rights to future cash ﬂ ows arising after investors in the securitization trust have received the return for which they contracted. The investors and the securitization trust have no recourse to the Bancorp’s other assets for failure of debtors to pay when due. The Bancorp’s retained interest is subordinate to investor’s interests and its value is subject to credit, prepayment and interest rate risks on the sold automotive loans. As of December 31, 2004, the remaining balance of sold automotive loans was $568 million. During 2003, the Bancorp securitized and sold $903 million in home equity lines of credit to an unconsolidated QSPE that is wholly owned by an independent third party. The Bancorp retained servicing rights and receives a servicing fee based on a percentage of the outstanding balance. Additionally, the Bancorp retained rights to future cash ﬂ ows arising after investors in the securitization trust have received the return for which they contracted. The investors and the securitization trust have no recourse to the Bancorp’s other assets for failure of debtors to pay when due. The Bancorp’s retained interest is subordinate to investor’s interests and its value is subject to credit, prepayment and interest rate risks on the sold home equity lines of credit. As of December 31, 2004, the remaining balance of sold home equity lines of credit was $717 million. The Bancorp had the following cash ﬂ ows with unconsolidated QSPE’s during 2004 and 2003: ($ in millions) Proceeds from transfers, including new securitizations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Proceeds from collections re-invested in revolving-period securitizations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Transfers received from QSPE’s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fees received . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2004 $1,379 162 164 32 2003 1,345 46 116 25 58 Fifth Third Bancorp 21. DISCONTINUED OPERATIONS NOTES TO CONSOLIDATED FINANCIAL STATEMENTS In November 2003, the Bancorp announced an agreement to sell its corporate trust business, a component of the Commercial Banking segment. The transaction closed in December 2003. The Bancorp recognized an after-tax gain of $40 million on the sale, which is captured as a component of net income from discontinued opera- tions in the Consolidated Statements of Income. Financial information for discontinued operations is summa- rized below: ($ in millions) Total revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gain on sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income before income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Applicable income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net income from discontinued operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2003 $12 62 6 68 24 $44 $ 2 2002 12 — 6 6 2 4 2 22. INCOME TAXES The Bancorp and its subsidiaries ﬁ le a consolidated Federal income tax return. A summary of applicable income taxes included in the Consoli- dated Statements of Income as of December 31: ($ in millions) Current income taxes: U.S. income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . State and local income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total current tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred income taxes: U.S. income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . State and local income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total deferred taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2004 $691 34 725 (12) (1) (13) Applicable income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $712 2003 2002 482 9 491 264 31 295 786 454 27 481 257 (4) 253 734 Deferred income taxes are included as a component of accrued taxes, interest and expenses in the Consolidated Balance Sheets and are comprised of the following temporary differences as of December 31: ($ in millions) Deferred tax assets: Reserves for credit losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other comprehensive income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . State net operating losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total deferred tax assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred tax liabilities: Lease ﬁ nancing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . State deferred taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Bank premises and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total deferred tax liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total net deferred tax liability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2004 $ 250 141 95 153 122 761 1,819 236 75 231 2,361 $1,600 A reconciliation between the statutory U.S. income tax rate and the Bancorp’s effective tax rate for the years ended December 31: Statutory tax rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Increase (decrease) resulting from: State taxes, net of federal beneﬁ t . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Tax-exempt income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Credits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2004 35.0% 1.0 (2.0) (1.7) (.5) Effective tax rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31.8% 2003 35.0 1.0 (1.8) (1.2) (.8) 32.2 2003 269 137 66 154 53 679 1,801 238 54 241 2,334 1,655 2002 35.0 .6 (2.1) (.9) (.7) 31.9 Retained earnings at December 31, 2004 includes $157 million in allocations of earnings for bad debt deductions of former thrift subsidiaries for which no income tax has been provided. Under current tax law, if certain of the Bancorp’s subsidiaries use these bad debt reserves for purposes other than to absorb bad debt losses, they will be subject to Federal income tax at the current corporate tax rate. Fifth Third Bancorp 59 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS rate of return assumption reﬂ ects the average return expected on the assets invested to provide for the Plan’s liabilities. In determin- ing the expected long-term rate of return assumption, the Bancorp evaluated actuarial and economic inputs, including long-term inﬂ ation rate assumptions and broad equity and bond indices long- term return projections, as well as actual long-term historical Plan performance. Weighted-average assumptions 2004 2003 2002 For disclosure: Discount rate . . . . . . . . . . . . . . . . . . . . . Rate of compensation increase . . . . . . . . Expected return on plan assets . . . . . . . . 5.85% 5.10 8.00 For measuring net periodic pension cost: Discount rate . . . . . . . . . . . . . . . . . . . . . Rate of compensation increase . . . . . . . . Expected return on plan assets . . . . . . . . 6.00 5.00 8.75 6.00 5.00 8.75 6.75 5.10 9.00 6.75 5.10 9.00 7.25 4.86 8.99 Plan assets consist primarily of common trust and mutual funds (equities and ﬁ xed income) managed by Fifth Third Bank, a subsidiary of the Bancorp, and Bancorp common stock securities. The following table provides the Bancorp’s weighted-average asset allocations by asset category for 2004 and 2003: Weighted-average asset allocation 2004 2003 Equity securities . . . . . . . . . . . . . . . . . . . . . . Bancorp common stock . . . . . . . . . . . . . . . . Total equity securities . . . . . . . . . . . . . . . . . . Fixed income securities . . . . . . . . . . . . . . . . . Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65% 10 75 25 — 54 18 72 26 2 100% Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 The Bancorp’s policy for the investment of Plan assets is to employ investment strategies that achieve a weighted-average target asset allocation of 70% to 80% in equity securities, 20% to 25% in ﬁ xed income securities and up to ﬁ ve percent in cash. The accumulated beneﬁ t obligation for all deﬁ ned beneﬁ t plans was $251 million and $262 million at December 31, 2004 and 2003, respectively. For the Bancorp’s deﬁ ned beneﬁ t plans, with an accumulated beneﬁ t obligation exceeding assets, the total projected beneﬁ t obligation, accumulated beneﬁ t obligation and fair value of plan assets were $254 million, $251 million and $201 million, respectively, as of December 31, 2004 and $260 million, $257 million and $218 million, respectively, as of Decem- ber 31, 2003. The increase in the additional minimum pension liability, recorded as a reduction to shareholders’ equity, was $1 million, net of a tax beneﬁ t of less than $1 million, in 2004 and $11 million, net of a tax beneﬁ t of $6 million, in 2003. Based on the actuarial assumptions, the Bancorp expects to make no cash contribution to the Plan in 2005. Estimated pension beneﬁ t payments, which reﬂ ect expected future service, are $22 million in 2005 and $18 million in each year from 2006 to 2009. The total estimated payments for the years 2010 to 2014 is $82 million. The Bancorp’s proﬁ t sharing plan expense was $69 million for 2004, $48 million for 2003 and $58 million for 2002. Expenses recognized during the years ended December 31, 2004, 2003 and 2002 for matching contributions to the Bancorp’s deﬁ ned contribution savings plans were $28 million, $12 million and $14 million, respectively. 23. RETIREMENT AND BENEFIT PLANS The measurement date for all of the Bancorp’s deﬁ ned beneﬁ t retirement plans is December 31. A combined summary of the deﬁ ned beneﬁ t retirement plans as of and for the years ended December 31: ($ in millions) Projected beneﬁ t obligation at January 1 . . . . . . . . Service cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Settlement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Actuarial loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Beneﬁ ts paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Projected beneﬁ t obligation at December 31 . . . . . Fair value of plan assets at January 1 . . . . . . . . . . . . Actual return on assets . . . . . . . . . . . . . . . . . . . . . . Contributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . Settlement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Beneﬁ ts paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fair value of plan assets at December 31 . . . . . . . . . Funded status . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Unrecognized transition amount . . . . . . . . . . . . . . Unrecognized prior service cost . . . . . . . . . . . . . . . Unrecognized actuarial loss . . . . . . . . . . . . . . . . . . . Net amount recognized Amounts recognized in the Consolidated Balance Sheets consist of: Prepaid beneﬁ t cost . . . . . . . . . . . . . . . . . . . . Accrued beneﬁ t liability . . . . . . . . . . . . . . . . . Intangible asset . . . . . . . . . . . . . . . . . . . . . . . Deferred tax asset . . . . . . . . . . . . . . . . . . . . . Accumulated other comprehensive income . . . . . . . . . . . . . . . . . . . . . . . . . . . Net amount recognized . . . . . . . . . . . . . . . . . . . . . 2004 $ 264 1 15 (17) 1 (10) $ 254 $ 223 7 3 (22) (10) $ 201 $ (53) — 3 101 $ 51 $ — (51) 4 34 64 $ 51 2003 243 1 16 (27) 40 (9) 264 177 28 62 (35) (9) 223 (41) (1) 4 103 65 3 (39) 4 34 63 65 ($ in millions) 2004 2003 2002 Components of net periodic pension cost: Service cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Curtailment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Expected return on assets . . . . . . . . . . . . . . . . . . . Amortization and deferral of transition amount . . Amortization of actuarial loss . . . . . . . . . . . . . . . . Amortization of unrecognized prior service cost . . Settlement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net periodic pension cost . . . . . . . . . . . . . . . . . . . . . $ 1 15 — (18) (2) 9 1 10 $16 1 16 — (15) (2) 15 1 15 31 1 16 2 (23) (2) — — 19 13 Net periodic pension cost is recorded as a component of employee beneﬁ ts in the Consolidated Statements of Income. Net periodic pension cost for 2004, 2003 and 2002 included settlement charges of $10 million, $15 million and $19 million, respectively, primarily related to an increased level of lump-sum distributions made during the respective years as a result of the headcount reductions that occurred in connection with the inte- gration of Old Kent. The Plan assumptions are evaluated annually and are updated as necessary. The discount rate assumption reﬂ ects the yield of a portfolio of high quality ﬁ xed-income instruments that have a similar duration to the Plan’s liabilities. The expected long-term 60 Fifth Third Bancorp 24. EARNINGS PER SHARE Reconciliation of earnings per share to diluted earnings per share for the years ended December 31: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ($ in millions, except per share data) Income EPS Income from continuing operations before 2004 Average Shares Per Share Amount Income 2003 Average Shares Per Share Amount Income 2002 Average Shares Per Share Amount cumulative effect . . . . . . . . . . . . . . . . . . . . . $1,525 $1,632 $1,527 Net income from continuing operations available to commons shareholders (a) . . . . . . . . . . . . Income from discontinued operations, net of tax . . . . . . . . . . . . . . . . . . . . . . . . . . . Cumulative effect of change in accounting principle, net of tax . . . . . . . . . . . . . . . . . . . 1,524 561 $2.72 1,631 572 $2.85 1,526 580 $2.63 — — — — 44 (11) .08 (.02) 4 — .01 — Net income available to common shareholders . $1,524 561 $2.72 $1,664 572 $2.91 $1,530 580 $2.64 Diluted EPS Net income from continuing operations available to common shareholders . . . . . . . . . . . . . . . Effect of dilutive securities . . . . . . . . . . . . . . . . $1,524 Income from continuing operations plus assumed conversions (b) . . . . . . . . . . . . . . . . . . . . . . . 1,525 561 7 568 Income from discontinued operations, net of tax . . . . . . . . . . . . . . . . . . . . . . . . . . . Cumulative effect of change in accounting principle, net of tax . . . . . . . . . . . . . . . . . . . Net income available to common shareholders plus assumed conversions . . . . . . . . . . . . . . . — — 572 8 580 $1,631 $2.68 1,632 — — 44 (11) $1,526 $2.81 1,527 .08 (.02) 4 — 580 12 592 $2.58 .01 — $1,525 568 $2.68 $1,665 580 $2.87 $1,531 592 $2.59 (a) Dividends on preferred stock are $.740 million for the years ended December 31, 2004, 2003 and 2002. (b) The effect of dividends on convertible preferred stock is $.580 million for the years ended December 31, 2004, 2003 and 2002. Options to purchase 16.2 million, 7.0 million and 6.2 million shares outstanding at December 31, 2004, 2003 and 2002, respec- tively, were not included in the computation of net income per diluted share because the effect would be antidilutive. 25. FAIR VALUE OF FINANCIAL INSTRUMENTS Carrying amounts and estimated fair values for ﬁ nancial instruments as of December 31: ($ in millions) Financial assets: Cash and due from banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Available-for-sale securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Held-to-maturity securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Trading securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other short-term investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loans held for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total loans and leases, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Derivative assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Bank owned life insurance assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Financial liabilities: Deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Federal funds purchased . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Short-term bank notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other short-term borrowings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Derivative liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Short positions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other ﬁ nancial instruments: Commitments to extend credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Letters of credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Carrying Amount $ 2,561 24,687 255 77 532 559 59,095 271 1,573 58,226 4,714 775 4,537 13,983 232 15 53 19 2004 2003 Fair Value Carrying Amount Fair Value 2,561 24,687 255 77 532 562 59,708 271 1,573 58,221 4,714 775 4,537 14,232 232 15 53 19 2,359 28,999 135 55 268 1,881 51,611 302 1,016 57,095 6,928 500 5,742 9,063 208 2 55 18 2,359 28,999 135 55 268 1,897 52,331 302 1,016 56,990 6,928 500 5,742 9,724 208 2 55 18 Fair values for ﬁ nancial instruments, which were based on various assumptions and estimates as of a speciﬁ c point in time, represent liquidation values and may vary signiﬁ cantly from amounts that will be realized in actual transactions. In addition, certain non-ﬁ nancial instruments were excluded from the fair value disclosure requirements. Therefore, the fair values presented in the table above should not be construed as the underlying value of the Bancorp. The following methods and assumptions were used in deter- mining the fair value of selected ﬁ nancial instruments: Short-term ﬁ nancial assets and liabilities—for ﬁ nancial instru- ments with a short-term or no stated maturity, prevailing market rates and limited credit risk, carrying amounts approximate fair value. Those ﬁ nancial instruments include cash and due from banks, other short-term investments, certain deposits (demand, interest checking, savings and money market), federal funds purchased, short-term bank notes and other short-term borrowings. Fifth Third Bancorp 61 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Available-for-sale, held-to-maturity and trading securities, including short positions—fair values were based on prices obtained from an independent nationally recognized pricing service. Loans—fair values were estimated by discounting the future cash ﬂ ows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. Loans held for sale—the fair value of loans held for sale was estimated based on outstanding commitments from investors or current investor yield requirements. Deposits—fair values for other time, certiﬁ cates of deposit – $100,000 and over and foreign ofﬁ ce were estimated using a discounted cash ﬂ ow calculation that applies interest rates currently being offered for deposits of similar remaining maturities. 26. BUSINESS COMBINATIONS On June 11, 2004, the Bancorp completed the acquisition of Franklin Financial, a bank holding company located in the Nash- ville, Tennessee metropolitan market. Under the terms of the transaction, each share of Franklin Financial common stock was exchanged for .5933 shares of the Bancorp’s common stock, resulting in the issuance of 5.1 million shares of common stock. The common stock issued to effect the transaction was valued at $55.52 per common share for a total transaction value of $317 million. The total purchase price also includes the fair value of stock awards issued in exchange for stock awards held by Franklin Financial employees, for which the aggre- gate fair value was $36 million. The assets and liabilities of Franklin Financial were recorded on the balance sheet at their respective fair values as of the closing date. The results of Franklin Financial’s operations were included in the Bancorp’s income statement from the date of acquisition. The transaction resulted in total goodwill and intangible assets of $282 million based upon the purchase price, the fair values of the acquired assets and assumed liabilities and applicable purchase accounting adjustments. Of this total intangibles amount, $7 million was allocated to core deposit intangibles, $6 million was allocated to customer lists and $2 million was allocated to noncom- pete agreements. The core deposit intangible and the customer lists are being amortized using an accelerated method over seven Long-term debt—fair value of long-term debt was based on quoted market prices, when available, and a discounted cash ﬂ ow calcula- tion using prevailing market rates for borrowings of similar terms. Commitments and letters of credit—fair values of loan commit- ments and letters of credit were based on estimated probable credit losses. Derivative assets and derivative liabilities—fair values were based on the estimated amount the Bancorp would receive or pay to terminate the derivative contracts, taking into account the current interest rates and the creditworthiness of the counterparties. The fair values represent an asset or liability at December 31, 2004. Bank owned life insurance assets—fair values of insurance poli- cies owned by the Bancorp were based on the insurance contract’s cash surrender value, net of any policy loans. and ﬁ ve years, respectively. The noncompete agreements are being amortized using the straight-line method over the duration of the agreements. The remaining $267 million of intangible assets was recorded as goodwill. Goodwill recognized in the Franklin Finan- cial acquisition is not deductible for income tax purposes. The pro forma effect and the ﬁ nancial results of Franklin Financial included in the results of operations subsequent to the date of acquisition were not material to the Bancorp’s ﬁ nancial condition or the oper- ating results for the periods presented. On August 2, 2004, the Bancorp and First National announced the signing of a deﬁ nitive agreement in which the Bancorp would acquire First National and its subsidiaries, headquartered in Naples, Florida. As of December 31, 2004, First National has approxi- mately $5.6 billion in total assets, $3.8 billion in total deposits and 77 full-service banking centers located primarily in Orlando, Tampa, Sarasota, Naples and Fort Myers. The acquisition, which closed on January 1, 2005, provided First National’s shareholders with .5065 shares of the Bancorp’s common stock for each share of First National common stock. Based on the price of the Bancorp’s common shares at the close of business on December 31, 2004, the transaction is valued at $23.96 per share of First National common stock. The total transaction value, including the fair value of employee stock awards, is approximately $1.5 billion. 27. CERTAIN REGULATORY REQUIREMENTS AND CAPITAL RATIOS The principal source of income and funds for the Bancorp (parent company) are dividends from its subsidiaries. During 2004, the amount of dividends the bank subsidiaries can pay to the Bancorp without prior approval of regulatory agencies was limited to their 2004 eligible net proﬁ ts, as deﬁ ned, and the adjusted retained 2003 and 2002 net income of those subsidiaries. The Bancorp’s subsidiary banks must maintain cash reserve balances when total reservable deposit liabilities are greater than the regulatory exemption. These reserve requirements may be satisﬁ ed with vault cash and noninterest-bearing cash balances on reserve with a Federal Reserve Bank. In 2004 and 2003, the banks were required to maintain average cash reserve balances of $192 million and $290 million, respectively. In December of 2003, the Bancorp completed the merger of its Fifth Third Bank, Kentucky, Inc., Fifth Third Bank, Northern Kentucky, Inc., Fifth Third Bank, Indiana and Fifth Third Bank, Florida subsidiary banks with and into Fifth Third Bank (Michi- gan). Although these mergers changed the legal structure of the subsidiary banks, there were no signiﬁ cant changes to the Bancorp’s afﬁ liate structure or operating model. The Board of Governors of the Federal Reserve System (“FRB”) adopted quantitative measures which assign risk weightings to assets and off-balance sheet items and also deﬁ ne and set minimum 62 Fifth Third Bancorp regulatory capital requirements (risk-based capital ratios). All banks are required to have core capital (Tier 1) of at least 4% of risk- weighted assets, total capital of at least 8% of risk-weighted assets and a minimum Tier 1 leverage ratio of 3% of adjusted quarterly average assets. Tier 1 capital consists principally of shareholders’ equity including Tier 1 qualifying subordinated debt but exclud- ing unrealized gains and losses on securities available-for-sale, less goodwill and certain other intangibles. Total capital consists of Tier 1 capital plus certain debt instruments and the reserves for credit losses, subject to limitation. Failure to meet the minimum capital requirements can initiate certain actions by regulators that could have a direct material effect on the Consolidated Financial State- ments of the Bancorp. The regulations also deﬁ ne well-capitalized levels of Tier 1, total capital and Tier 1 leverage as 6%, 10% and 5%, respectively. The Bancorp and each of its subsidiary banks had Tier 1, total capital and leverage ratios above the well-capitalized levels at December 31, 2004 and 2003. As of December 31, 2004, the most recent notiﬁ cation from the FRB categorized the Bancorp and each of its subsidiary banks as well-capitalized under the regu- latory framework for prompt corrective action. Capital and risk-based capital and leverage ratios for the Bancorp and its signiﬁ cant subsidiary banks as of December 31: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 2004 2003 Amount Ratio Amount Ratio $10,176 5,772 4,164 161 8,522 5,009 3,617 153 8,522 5,009 3,617 153 12.31% 12.85 10.72 13.57 10.31 11.15 9.31 12.89 8.89 8.48 9.39 14.44 $10,096 5,154 3,813 N/A 8,272 4,354 3,266 N/A 8,272 4,354 3,266 N/A Condensed Statements of Cash Flows (Parent Company Only) For the Years Ended December 31 2004 2003 13.56% 11.88 11.11 N/A 11.11 10.03 9.52 N/A 9.23 7.74 8.84 N/A 2002 Operating Activities Net income . . . . . . . . . . . . . . . . . . . . . . . . . . Adjustments to reconcile net income to net cash provided by operating activities: Stock-based compensation expense . . . . . . Beneﬁ t for deferred income taxes . . . . . . . . Increase in other assets . . . . . . . . . . . . . . . . (Decrease) increase in accrued expenses and other liabilities . . . . . . . . . . . . . . . . . . . . Increase in undistributed earnings of subsidiaries . . . . . . . . . . . . . . . . . . . . . . Net Cash Provided by Operating Activities . Investing Activities Proceeds from sales of available-for-sale $1,525 1,665 1,531 — (1) (24) (84) 1 (5) (39) 54 — (3) (29) 2 (835) 581 (391) 1,285 (257) 1,244 securities . . . . . . . . . . . . . . . . . . . . . . . . . . Increase in loans to subsidiaries . . . . . . . . . . . Net Cash Used in Investing Activities . . . . . — (759) (759) Financing Activities Increase (decrease) in other short-term borrowings . . . . . . . . . . . . . . . . . . . . . . . . . Proceeds from issuance of long-term debt . . . . Payment of cash dividends . . . . . . . . . . . . . . . Purchases of treasury stock . . . . . . . . . . . . . . . Exercise of stock options . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net Cash Provided by (Used in) Financing Activities . . . . . . . . . . . . . . . . . . . . . . . . . . 24 1,749 (704) (987) 89 — — (471) (471) (89) 497 (631) (655) 97 7 1 (159) (158) 72 — (553) (719) 104 10 (Decrease) increase in cash . . . . . . . . . . . . . . Cash at January 1 . . . . . . . . . . . . . . . . . . . . . (7) 40 Cash at December 31 . . . . . . . . . . . . . . . . . . $ 33 40 — 40 — — — 171 (774) (1,086) ($ in millions) Total Capital (to Risk-Weighted Assets): Fifth Third Bancorp . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fifth Third Bank (Ohio) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fifth Third Bank (Michigan) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fifth Third Bank, N.A. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Tier 1 Capital (to Risk-Weighted Assets): Fifth Third Bancorp . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fifth Third Bank (Ohio) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fifth Third Bank (Michigan) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fifth Third Bank, N.A. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Tier 1 Leverage (to Average Assets): Fifth Third Bancorp . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fifth Third Bank (Ohio) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fifth Third Bank (Michigan) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fifth Third Bank, N.A. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28. PARENT COMPANY FINANCIAL STATEMENTS ($ in millions) Condensed Statements of Income (Parent Company Only) 2004 For the Years Ended December 31 2003 2002 Income Dividends from subsidiaries . . . . . . . . . . . . . . Interest on loans to subsidiaries . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total income . . . . . . . . . . . . . . . . . . . . . . . . . Expenses Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total expenses . . . . . . . . . . . . . . . . . . . . . . . . Income before taxes and change in undistributed earnings of subsidiaries . . . Applicable income taxes . . . . . . . . . . . . . . . . Income before change in undistributed $ 682 32 1 715 15 9 24 1,262 27 24 1,313 31 3 34 1,258 32 — 1,290 5 3 8 691 1 1,279 5 1,282 8 earnings of subsidiaries . . . . . . . . . . . . . . 690 1,274 1,274 Increase in undistributed earnings of subsidiaries . . . . . . . . . . . . . . . . . . . . . . . . 835 391 257 Net Income . . . . . . . . . . . . . . . . . . . . . . . . . . $1,525 1,665 1,531 2004 2003 Condensed Balance Sheets (Parent Company Only) At December 31 Assets Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loans to subsidiaries . . . . . . . . . . . . . . . . . . . . . . . . . Investment in subsidiaries . . . . . . . . . . . . . . . . . . . . . Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 33 2,340 9,034 137 102 Total Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $11,646 Liabilities Commercial paper . . . . . . . . . . . . . . . . . . . . . . . . . . Accrued expenses and other liabilities . . . . . . . . . . . . Long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . Shareholders’ Equity . . . . . . . . . . . . . . . . . . . . . . . $ 28 247 2,447 2,722 8,924 Total Liabilities and Shareholders’ Equity . . . . . . . $11,646 29. SEGMENTS 40 1,581 7,743 137 46 9,547 4 185 691 880 8,667 9,547 The Bancorp’s principal activities include Commercial Banking, Retail Banking, Investment Advisors and Fifth Third Processing Solutions. Commercial Banking offers banking, cash management and ﬁ nancial services to business, government and professional customers. Retail Banking provides a full range of deposit prod- ucts and consumer loans and leases. Investment Advisors provides a full range of investment alternatives for individuals, companies and not-for-proﬁ t organizations. Fifth Third Processing Solutions provides electronic funds transfer, debit, credit and merchant transaction processing, operates the Jeanie® ATM network and provides other data processing services to afﬁ liated and unafﬁ liated customers. The Other/Eliminations column includes the unal- located portion of the investment portfolio, certain non-deposit funding, unassigned equity and other items not attributed to the other segments. The Bancorp manages interest rate risk centrally at the corpo- rate level by employing a funds transfer pricing (“FTP”) methodol- ogy. This methodology insulates the segments from interest rate Fifth Third Bancorp 63 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS risk, enabling them to focus on serving customers through loan originations and deposit taking. The FTP system assigns charge rates and credit rates to classes of assets and liabilities, respec- tively, based on expected duration. In addition to the previously mentioned items, the Other/Eliminations column includes the net effect of the FTP methodology. The performance measurement of the segments is based on the management structure of the Bancorp and is not necessarily compa- rable with similar information for any other ﬁ nancial institution. Additionally, the information presented is not necessarily indicative of the segments’ ﬁ nancial condition and results of operations if they were to exist as independent entities. Generally, the segments form synergies by taking advantage of cross-sell opportunities and when funding operations by accessing the capital markets as a collective unit. In 2004, the Bancorp reﬁ ned its segment reporting as a result of a cost center review and point of cross-sell identiﬁ cation. Prior periods have been conformed to the current period presentation. The ﬁ nancial information for each segment is reported on the basis used internally by the Bancorp’s management to evaluate perfor- mance and allocate resources. The allocation has been consistently applied for all periods presented. Revenues from afﬁ liated transac- tions are typically charged at rates available to and transacted with unafﬁ liated customers. Results of operations and average assets by segment for each of the three years ended December 31 are as follows: ($ in millions) 2004 Net interest income (b) . . . . . . . . . . Provision for loan and lease losses . . Net interest income after provision for loan and lease losses . . . . . . . Noninterest income . . . . . . . . . . . . Noninterest expense . . . . . . . . . . . . Income before income taxes . . . . . . Applicable income taxes (c) . . . . . . Net income . . . . . . . . . . . . . . . . . . Average assets . . . . . . . . . . . . . . . . . 2003 Net interest income (b) . . . . . . . . . . Provision for loan and lease losses . . Net interest income after provision for loan and lease losses . . . . . . . Noninterest income . . . . . . . . . . . . Noninterest expense . . . . . . . . . . . . Income from continuing operations before income taxes, minority interest and cumulative effect . . . Applicable income taxes (c) . . . . . . Minority interest, net . . . . . . . . . . . Discontinued operations, net . . . . . Cumulative effect, net . . . . . . . . . . Net income . . . . . . . . . . . . . . . . . . Average assets . . . . . . . . . . . . . . . . . 2002 Net interest income (b) . . . . . . . . . . Provision for loan and lease losses . . Net interest income after provision for loan and lease losses . . . . . . . Noninterest income . . . . . . . . . . . . Noninterest expense . . . . . . . . . . . . Income from continuing operations Commercial Banking Retail Banking Investment Advisors Processing Solutions Other/ Eliminations Acquisitions (a) $ 1,203 96 1,107 429 608 928 280 $ 648 $25,327 $ 1,055 182 873 419 548 744 225 — 44 — $ 563 $22,561 $ 889 101 788 343 505 1,929 175 1,754 1,053 1,266 1,541 524 1,017 54,769 1,784 202 1,582 1,187 1,262 1,507 512 — — (11) 984 54,562 1,554 133 1,421 889 1,114 168 8 160 379 359 180 61 119 2,309 128 10 118 349 346 121 41 — — — 80 1,899 101 6 95 333 316 15 10 5 697 408 294 100 194 665 14 9 5 512 377 140 47 — — — 93 602 11 7 4 450 314 (254) (21) (233) (90) 343 (666) (214) (452) 12,244 (6) (1) (5) 27 42 (20) 5 (20) — — (45) 8,738 216 2 214 179 111 (13) — (13) (3) (12) (4) (3) (1) (418) (31) (3) (28) (11) (24) (15) (5) — — — (10) (881) (33) (3) (30) (11) (23) Total 3,048 268 2,780 2,465 2,972 2,273 748 1,525 94,896 2,944 399 2,545 2,483 2,551 2,477 825 (20) 44 (11) 1,665 87,481 2,738 246 2,492 2,183 2,337 before income taxes and 112 minority interest . . . . . . . . . . . . Applicable income taxes (c) . . . . . . 37 — Minority interest, net . . . . . . . . . . . — Discontinued operations, net . . . . . 75 Net income . . . . . . . . . . . . . . . . . . Average assets . . . . . . . . . . . . . . . . . 1,559 (a) In acquisitions accounted for under the purchase method, management “pools” historical results to improve comparability with the current period. The results of Franklin 626 205 — 4 $ 425 $20,069 2,338 773 (38) 4 1,531 75,037 1,196 407 — — 789 54,046 282 84 (38) — 160 (458) (18) (7) — — (11) (795) 140 47 — — 93 616 Financial have been included in the segments and eliminated in the Acquisitions column. (b) Net interest income is fully taxable equivalent and is presented on an FTP basis. (c) Applicable income taxes includes income tax provision and taxable equivalent adjustment reversal of $36 million, $39 million and $39 million for the years ended December 31, 2004, 2003 and 2002, respectively. 64 Fifth Third Bancorp AVERAGE ASSETS ($ IN MILLIONS) Interest-Earning Assets CONSOLIDATED TEN YEAR COMPARISON Loans and Leases Federal Funds Sold (a) Interest-Bearing Deposits in Banks (a) $57,042 52,414 45,539 44,888 42,690 38,652 36,014 33,850 30,742 27,598 $120 92 155 69 118 224 241 327 325 494 $195 215 184 132 82 103 135 186 211 182 Year 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 Securities $30,282 28,640 23,246 19,737 18,630 16,901 16,090 15,425 14,959 12,715 Total $87,639 81,361 69,124 64,826 61,520 55,880 52,480 49,788 46,237 40,989 Cash and Due from Banks Other Assets Total Average Assets $2,216 1,600 1,551 1,482 1,456 1,628 1,566 1,367 1,401 1,365 $5,763 5,250 5,007 5,000 4,229 3,344 2,782 2,495 2,212 1,715 $94,896 87,481 75,037 70,683 66,611 60,292 56,306 53,161 49,367 43,608 AVERAGE DEPOSITS AND SHORT-TERM BORROWINGS ($ IN MILLIONS) Year 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 Demand $12,327 10,482 8,953 7,394 6,257 6,079 5,627 4,932 4,492 4,050 Interest Checking $19,434 18,679 16,239 11,489 9,531 8,553 7,030 6,209 5,559 5,017 Savings $7,941 8,020 9,465 4,928 5,799 6,206 6,332 4,548 4,237 3,374 Money Market $3,473 3,189 1,162 2,552 939 1,328 1,471 2,508 2,909 2,949 INCOME ($ IN MILLIONS, EXCEPT PER SHARE DATA) Deposits Certiﬁ cates — $100,000 and Over Other Time Foreign Ofﬁ ce Total Short-Term Borrowings $6,208 6,426 8,855 13,473 13,716 13,858 15,117 15,887 15,171 12,597 $2,403 3,832 2,237 3,821 4,283 4,197 3,856 4,173 4,186 3,944 $4,449 3,862 2,018 1,992 3,896 952 270 441 569 1,007 $56,235 54,490 48,929 45,649 44,421 41,173 39,703 38,698 37,123 32,938 $13,539 12,373 7,191 8,799 9,725 8,573 7,095 6,113 4,837 4,582 Year 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 Interest Income $4,114 3,991 4,129 4,709 4,947 4,199 4,052 3,933 3,621 3,239 Interest Expense $1,102 1,086 1,430 2,278 2,697 2,026 2,047 2,030 1,853 1,677 Noninterest Income $2,465 2,483 2,183 1,788 1,476 1,335 1,161 901 746 613 Noninterest Expense $2,972 2,551 2,337 2,453 2,027 1,987 1,826 1,486 1,423 1,225 Per Share (b) Originally Reported Net Income Avail. to Common Shareholders Earnings Diluted Earnings Dividends Declared Earnings Diluted Earnings $1,524 1,664 1,530 1,001 1,054 871 759 756 646 588 $2.72 2.91 2.64 1.74 1.86 1.55 1.36 1.35 1.15 1.08 $2.68 2.87 2.59 1.70 1.83 1.53 1.34 1.33 1.13 1.06 $1.312/03 1.132/03 .982/03 .832/03 .702/03 .582/30 .471/30 .379/10 .324/70 .284/90 $2.72 2.91 2.64 1.74 1.70 1.32 1.09 1.10 .93 .85 $2.68 2.87 2.59 1.70 1.68 1.29 1.06 1.08 .91 .83 Total $69,774 66,863 56,120 54,448 54,146 49,746 46,798 44,811 41,960 37,520 Dividend Payout Ratio 48.9% 39.4 37.8 48.8 41.7 45.5 44.6 35.2 35.8 34.3 MISCELLANEOUS AT DECEMBER 31 ($ IN MILLIONS, EXCEPT PER SHARE DATA) Shareholders’ Equity Number of Shares of Stock Outstanding (b) 557,648,989 566,685,301 574,355,247 582,674,580 569,056,843 565,425,468 557,438,774 556,356,059 564,561,419 548,266,213 Year 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 Common Stock Preferred Stock Capital Surplus Retained Earnings Accumulated Other Comprehensive Income Treasury Stock Total Per Share (b) Reserve for Loan and Lease Losses $1,295 1,295 1,295 1,294 1,263 1,255 1,238 1,235 1,253 1,217 $ 9 9 9 9 9 9 9 9 9 14 $1,934 1,964 2,010 1,943 1,454 1,090 887 812 755 528 $7,269 6,481 5,465 4,502 3,982 3,551 3,179 3,000 2,663 2,397 $(169) (120) 369 8 28 (302) 135 140 17 46 $(1,414) (962) (544) (4) (1) — (58) (184) — — $8,924 8,667 8,604 7,752 6,735 5,603 5,390 5,005 4,695 4,200 $16.00 15.29 14.98 13.31 11.83 9.91 9.67 9.00 8.32 7.66 $713 697 683 624 609 573 532 509 484 474 (a) Federal funds sold and interest-bearing deposits in banks are combined in other short-term investments in the Consolidated Financial Statements. (b) Number of shares outstanding and per share data have been adjusted for stock splits in 2000, 1998, 1997 and 1996. Fifth Third Bancorp 65 DIRECTORS AND OFFICERS FIFTH THIRD BANCORP DIRECTORS George A. Schaefer, Jr. President & CEO Fifth Third Bancorp and Fifth Third Bank Darryl F. Allen Retired Chairman President & CEO Aeroquip-Vickers, Inc. John F. Barrett Chairman, President & CEO The Western & Southern Life Insurance Company James P. Hackett President & CEO Steelcase, Inc. Joan R. Herschede President & CEO The Frank Herschede Company Allen M. Hill Retired President & CEO DPL, Inc. Robert L. Koch II President & CEO, Koch Enterprises, Inc. Mitchel D. Livingston, Ph.D. Vice President for Student Affairs and Services University of Cincinnati Kenneth W. Lowe President & CEO The E.W. Scripps Company Hendrik G. Meijer Co-Chairman Meijer, Inc. Robert B. Morgan Executive Counselor Cincinnati Financial Corporation & Cincinnati Insurance Company James E. Rogers Chairman, President & CEO Cinergy Corp. John J. Schiff, Jr. Chairman, President & CEO Cincinnati Financial Corporation Dudley S. Taft President Taft Broadcasting Company Thomas W. Traylor CEO Traylor Bros., Inc. DIRECTORS EMERITI Neil A. Armstrong Philip G. Barach Vincent H. Beckman J. Kenneth Blackwell Milton C. Boesel, Jr. Douglas G. Cowan Thomas L. Dahl Ronald A. Dauwe Gerald V. Dirvin Thomas B. Donnell Nicholas M. Evans Richard T. Farmer Louis R. Fiore John D. Geary Ivan W. Gorr Joseph H. Head, Jr. William G. Kagler William J. Keating Jerry L. Kirby Michael H. Norris David E. Reese Brian H. Rowe C. Wesley Rowles Donald B. Shackelford David B. Sharrock Stephen Stranahan Dennis J. Sullivan, Jr. N. Beverley Tucker, Jr. Alton C. Wendzel FIFTH THIRD BANCORP OFFICERS George A. Schaefer, Jr. President & CEO Neal E. Arnold Executive Vice President Greg D. Carmichael Executive Vice President and Chief Information Officer David J. DeBrunner Senior Vice President & Controller Diane L. Dewbrey Senior Vice President R. Mark Graf Senior Vice President and Chief Financial Officer Malcolm D. Griggs Executive Vice President and Chief Risk Officer Kevin T. Kabat Executive Vice President Ronald D. Marks Senior Vice President & Treasurer Pete Pesce Executive Vice President Daniel T. Poston Executive Vice President & Auditor Paul L. Reynolds Executive Vice President, Secretary & General Counsel Robert A. Sullivan Executive Vice President AFFILIATE PRESIDENTS & CEOs Samuel G. Barnes Lexington, Kentucky Todd F. Clossin Northeastern Ohio John N. Daniel Southern Indiana Robert M. Eversole Central Ohio Patrick J. Fehring, Jr. Eastern Michigan Kevin C. Hale Florida Dan W. Hogan Tennessee Bruce K. Lee Northwestern Ohio Philip R. McHugh Louisville, Kentucky John E. Pelizzari Northern Michigan Timothy P. Rawe Northern Kentucky R. Daniel Sadlier Western Ohio Maurice J. Spagnoletti Central Indiana Michelle L. VanDyke Western Michigan Raymond J. Webb Ohio Valley Terry E. Zink Chicago AFFILIATE CHAIRMEN H. Lee Cooper Southern Indiana James R. Gaunt Louisville Gordon E. Inman Tennessee Donald B. Shackelford Central Ohio William A. Stinnett III Ohio Valley John S. Szuch Northwestern Ohio Gary L. Tice Florida FIFTH THIRD BANCORP BOARD COMMITTEES Executive Committee George A. Schaefer, Jr., Chairman Allen M. Hill Robert L. Koch II John J. Schiff, Jr. Dudley S. Taft Compensation Committee Allen M. Hill, Chairman Kenneth W. Lowe James E. Rogers Audit Committee Robert B. Morgan, Chairman Darryl F. Allen, Vice Chairman John F. Barrett James P. Hackett Joan R. Herschede Nominating and Corporate Governance Committee Dudley S. Taft, Chairman Darryl F. Allen Robert L. Koch II James E. Rogers Risk and Compliance Committee John F. Barrett, Chairman Hendrik G. Meijer Thomas W. Traylor Trust Committee Mitchel D. Livingston, Ph.D., Chairman Joan R. Herschede Kenneth W. Lowe George A. Schaefer, Jr. 66 Fifth Third Bancorp C O R P O R A T E I N F O R M A T I O N Corporate Office Fifth Third Center Cincinnati, Ohio 45263 (513) 579-5300 Website www.53.com Investor Relations R. Mark Graf Senior Vice President & Chief Financial Officer (513) 534-6936 (513) 534-3945 (fax) Bradley S. Adams Vice President & Investor Relations Officer (513) 534-0983 (513) 534-0629 (fax) Independent Registered Public Accounting Firm Deloitte & Touche LLP 250 East Fifth Street Cincinnati, OH 45202 Transfer Agent Computershare Investor Services LLC PO Box 2388 Chicago, IL 60690-2388 (888) 294-8285 Investordirect.53.com Stock Trading The common stock of Fifth Third Bancorp is traded in the over-the-counter market and is listed under the symbol “FITB” on the NASDAQ® National Market. Press Releases For copies of current press releases, please visit our website at www.53.com. stock data Fourth Quarter Third Quarter Second Quarter First Quarter ©Fifth Third Bank 2005 Member F.D.I.C. – Federal Reserve System ®Reg. U.S. Pat. & T.M. Office 2004 Low $45.32 $46.59 $51.13 $53.27 Dividends Paid Per Share $.35 $.32 $.32 $.32 High $60.01 $59.44 $60.49 $62.15 2003 Low $55.47 $52.50 $47.24 $47.05 Dividends Paid Per Share $.29 $.29 $.29 $.26 High $52.34 $54.07 $57.00 $60.00 we are Fifth Third. visit www.53.com

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