DBRS Comments on Q2 2009 Earnings of PNC – Senior at A (high) – Ratings Unchanged

DBRS has today commented on the Q2 2009 earnings of PNC Financial Services Group, Inc. (PNC or the Company). This is the second quarter in which PNC’s results fully incorporate the acquisition of National City Corporation (completed on December 31, 2008). In DBRS’s view, PNC’s second quarter results reflected a mixed operating performance in a still-challenging environment. Weak net interest income, strong fee income growth, elevated expenses and sharply higher credit costs were balanced by relatively stable core operating earnings. The National City merger appears to be on track with solid accretion to earnings, ahead of schedule expense savings and conversions scheduled to begin in November. To keep the quarterly results in perspective, the Company was profitable and produced adjusted core operating earnings that exceeded provisions by over $400 million, however, that gap is narrowing. These results were within DBRS’s expectations and thus its ratings including Issuer & Senior Debt at A (high) and Negative trend remain unchanged.

On December 31, 2008, DBRS placed a negative outlook on the Company’s ratings reflecting the increase in near- to medium-term risk to the Company at a time of substantial turmoil in the credit and capital markets. PNC’s ratings remain under pressure, however, as DBRS stated that declining financial performance, including deteriorating credit quality or profitability; the inability to reduce high risk assets; or a troubled integration could lead to negative rating actions, while risk asset reduction, continuing strong profitability and a successful integration could restore the trends to Stable.

PNC reported net income of $207 million for the quarter compared to $530 million in Q1 2009 and net income of $517 million in the prior year’s quarter. Second quarter revenues of $4.0 billion were split 55% and 45% between net interest income and non-interest income, respectively. Benefitting fee revenues in Q2 2009 were net gains of $182 million in net gains primarily on sales of agency residential MBS and another strong performance in mortgage banking ($245 million in revenue although down 43% from an extraordinary Q1; origination volume declined 7.25%), which included MSR hedging gains of $58 million. DBRS expects this business, acquired from National City, to moderate with the rise in interest rates. Other more market-sensitive items (notably fund servicing and asset management) appear to be stabilizing from improving asset values and PNC had an OTTI charge on debt securities of $155 million in the quarter, as compared to $149 million in Q1 2009. Expenses (even when adjusted for the $133 million FDIC assessment, $73 million increase in integration expenses when compared to Q1 2009 and deferred compensation hedges) were roughly $54 million (2%) higher than Q1 2009. The Company has already realized $500 million in annualized cost savings from the National City merger toward its two-year goal of $1.2 billion.

Weak loan demand, loan runoff and the purchase of lower-yielding securities pressured the Company’s net interest margin which declined 19 basis points (bps) to 3.60% while net interest income declined 5.3% to $2.2 billion. Average total deposit levels were stable over the quarter, with an improvement in the mix. Average non-interest bearing deposits grew 6.4% as CDs declined $6.5 billion (9%), improving the Company’s funding costs. Moreover, PNC’s end of period deposits were 119% of its loans (excluding loans held for sale). DBRS views these deposit trends positively.

Asset quality substantially worsened in the quarter with the exception of near-term delinquencies. Non-performing assets (excluding purchased impaired loans) were 2.74% of loans and foreclosed assets at the end of the quarter, up sharply from 2.05% at March 31, 2009. Commercial real estate projects were weaker with NPAs of $1.4 billion, up 41% from Q1 2009. Driving the increase was deterioration in residential developments and projects located in Florida, New Jersey and Maryland had the largest representation. Net charge-offs (NCOs) also rose sharply to 1.89% of average loans in the second quarter, up 88 bps from the first quarter with commercial charge-offs exceeding consumer 2.05% to 1.68%. PNC’s quarterly loan loss provision of $1,087 million increased $207 million from Q1 2009 including a reserve build of $292 million in excess of NCOs signalling the Company’s expectation of further loan deterioration. The Company’s $4.6 billion reserve for loan loss covered 101% of total non-performing assets (including OREO) at June 30, 2009. While the reserve coverage was ample, it reflected a material decrease from 122% in the prior quarter. DBRS believes that elevated credit costs are still being absorbed by PNC’s strong earnings generation capability, as evidenced by $1.3 billion ($1.5 billion adjusted for the FDIC assessment, higher integration costs and deferred compensation changes) of income before provisions and taxes in the second quarter. That being said, credit quality deterioration and declining core profitability are some of the risks that are incorporated in DBRS’s Negative Trend.

PNC’s Tier 1 Capital ratio improved 50 bps to 10.5% at the end of the first quarter while Tier 1 Common was up 40 bps to 5.3%. The primary driver for the capital increase was the Company’s $624 million equity offering in May 2009 that brings the Company full1y within the required Supervisory Capital Assessment Program buffer. Unrealized losses in the Company’s $50 billion (up 8% in the quarter) investment securities portfolio declined by about $600 million in the second quarter to $3.8 billion, helping PNC’s tangible ratios. While DBRS is concerned about potential pressure on tangible common equity, it is somewhat mitigated by the improving trend, the high quality of the portfolio, its relative short duration and the Company’s ability and intent to hold the securities to maturity given their solid liquidity position. Moreover, PNC has a sizable unrecognized gain in its ownership interest in Blackrock, Inc. and is likely to record a $400 to $500 million (after-tax) one-time gain upon Blackrock’s pending Q4 2009 acquisition of Barclays Global Investors.

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

The applicable methodologies are Rating Banks and Bank Holding Companies Operating in the United States, and Enhanced Methodology for Bank Ratings – Intrinsic and Support Assessments which can be found on our website under Methodologies.

This is a Corporate (Financial Institutions) rating.