National City (NCC)

National City Corporation (NCC) is one of the top 15 banks in the country, with more than 29,000 employees, approximately 1,434 branches, and more than 2,100 ATMs throughout the Midwest and Florida (as of September 30, 2008). Its retail and commercial banking franchise operates primarily in Ohio, Illinois, Indiana, Kentucky, Michigan, Missouri, Pennsylvania, and Florida, while its mortgage business (including conforming mortgages and home equity loans) is more national in scope. NCC acquired three banks in 2004 (Allegiant Bancorp, Provident Financial Group, and Wayne Bancorp), but then was relatively quiet on the acquisitions front until July 2006. In July 2006, NCC announced two bank deals (technically, thrifts), both in Florida, with combined assets of roughly $7 billion and a combined purchase price of roughly $2.1 billion. On the divestiture side, NCC sold National Processing (its 83%-owned payment processing subsidiary) to Bank of America in October 2004, and in December 2006 sold off its national non-conforming mortgage business, First Franklin, to Merrill Lynch.

NCC classifies its operations into the following five reportable segments: Retail Banking, Commercial Banking Regional, Commercial Banking National, Mortgage Banking, and Asset Management. Retail Banking specializes in providing retail and small business banking facilities, while Commercial Banking offers term loans, structured finance, syndicated loans, treasury management, and other similar services to large and middle-market businesses in the company's footprint (regional division) and outside (national division). Mortgage Banking, comprising NCM (National City Mortgage) and NHE (National Home Equity), originates home equity loans and residential mortgages both regionally and nationally. Asset Management provides investment management, custody, retirement planning, tax planning, brokerage, and other related financial advisory services to institutions and affluent clientele.

Real estate loans in all (consumer and commercial, including held-for-sale) accounted for 60.7% of total loans as of September 30, 2008, followed by commercial (32.8%), and consumer (6.5%). The securities portfolio was a conservative 7.0% of average earning assets in 3Q08. Non-interest-bearing and other low-cost deposits funded 38.6% of average earning assets in the quarter, with time deposits and borrowings funding 25.7% and 22.6%, respectively. As of September 30, 2008, NCC had $145.0 billion in total assets, $113.7 billion in loans, and $95.6 billion in deposits.

NCC has a respectable mix of fee-income businesses, including trust and investment management, investment banking and brokerage, and a significant credit card portfolio. This diversifies NCC's revenue stream and enhances its ability to cross-sell products and services. Non-interest income constituted a significant 37.3% of net revenue in 2007, though slightly down from 40.1% of net revenue in 2006. In 3Q08, non-interest income constituted 27.4% of net revenue, significantly lower from 36.2% in 3Q07.

Net security losses arising from impairment of available for sale securities of $91 million coupled with large amounts of provisional losses on mortgage loan purchases, led to the decline in the loan sale and servicing revenues

NCC continues to support its internal growth initiatives with strategic acquisitions (including Forbes First Financial, the two Florida thrifts, and more recently, MAF Bancorp) and prudent capital management. NCC repurchased 20.1 million shares in 2006, following 43.5 million shares repurchased in 2005. In 2007, NCC repurchased about 43.5 million shares during the first three quarters of 2007. However, the company stopped repurchasing shares since 4Q07, so as to allow capital ratios to migrate toward the top of NCC's target range. During 2Q08, the company completed the raising of $7.0 billion of additional equity capital, which enhanced the pro forma Tier I capital ratio to 11.08% (well above its peer group) from 6.67% as on March 31, 2008, but has resulted in substantial dilution to the existing shareholders. The company has also reduced the size of its balance sheet, which it intends to manage very tightly throughout 2008 and beyond. Additionally, during 1Q08, NCC reduced its dividend by 95%, to further strengthen its capital position.

NCC has been more active than most in repositioning its businesses to enhance its growth story. Sharpening its focus on traditional retail and commercial banking in faster-growing states, NCC made a couple of acquisitions to gain a foothold in the Florida market, while cutting its exposure to subprime origination and servicing with the sale of First Franklin. More recently, the acquisition of MAF Bancorp gives NCC access to Wisconsin market, while increasing its presence significantly in the fast-growing Chicago market.

In 3Q08, the company announced that it expects its Performance Improvement Initiative to result in annual savings of $500-$600 million by 2011. The company expects to realize $240 million of this reduction in 2009, and estimates associated charges to be in the range of $80-$100 million. Further, the company expects a reduction of approximately 4,000 positions or 14% of its total workforce, over the next three years.

NCC initiated its retail-banking footprint in Florida, with the acquisitions of Fidelity Bankshares, Inc (FFFL) and Harbor Florida Bancshares, Inc. (HARB). NCC now has a 94-branch network along Florida's east coast, with total assets of more than $7 billion. Given the relative growth rates of the Florida markets versus NCC's traditional Midwest markets, a move there likely makes sense over the long term. Near term, however, we note that pricing appeared somewhat high to us (roughly a 20% premium for each, relative to what we see as already-full, public-market values for bank and thrift stocks). We also note that competition in Florida is fierce, that expansion by numerous competitors makes the success of each new branch less certain, and ongoing turmoil in the real estate markets is likely to have a significant impact on operations there.

We view NCC's oversized mortgage business as one key culprit behind its woes. We viewed the First Franklin sale positively in this regard, although we note that National City Mortgage has actually been more volatile than National Consumer Finance / First Franklin when viewed as a line of business. Recently NCC took some restructuring initiatives in its mortgage business which include suspending the originations of broker-sourced home equity loans, moving the non-saleable warehouse inventory into the loan portfolio and narrowing the product range to agency eligible first mortgages and high quality jumbo loans. The company expects a much lower level of mortgage originations in FY 2008 compared to 2007 as a result of the initiatives.

While hedging is an important aspect of such a business and it has added significantly to overall mortgage banking results in recent years, its impact is highly volatile under GAAP accounting, leading to wide swings in reported revenues and earnings. The year 2006 included $294 million of net hedging losses, compared to $285 million of gains in 2005. However, in 2007, net hedging gains were $36 million. In 3Q08, the company reported net hedging losses of $189 million as compared to loss of $146 million in 2Q08. These volatile components have translated into a high degree of difficulty in forecasting earnings.

Balance sheet growth has been another significant problem. Loan growth was positive in the fourth quarter, primarily driven by strong growth in commercial loans, transfers to portfolio of mortgage loans formerly held for sale and loans acquired in recent acquisitions. We think a slight increase in overall portfolio loan balances for the coming quarters is quite normal. While some of this stems from the implementation of the originate-and-sell strategy for certain indirect consumer loans, organic growth has also been weak and still represents a headwind on the revenue side. Also, as of 4Q07, total purchased funds increased to $35.0 billion from $33.3 billion in the prior-year period. The higher level of purchased funds corresponds to a larger loan portfolio and resulted from the inability to sell certain mortgage loans during the last half of 2007. Deposit growth had been soft in 2006, as it has been for many companies this year as well, with just a 0.9% increase year-over-year in 2006. Average deposits grew 16.3% year-over-year in 4Q07 and 10.8% in FY07, though the growth mostly came from expensive borrowing and time deposits. In 3Q08, average deposits grew 5.6% year-over-year. Increased competition for deposits is also translating into spread compression.

Credit metrics have significantly deteriorated in recent quarters. NPAs have ticked up in each of the last ten quarters, ending 3Q08 at 3.10% of related assets (up 41 bps sequentially and 212 bps year-over-year). NCC had been bleeding reserves into the earnings for about two years, with the allowance now sitting at 3.40% of total loans and 108% of non-performers in the current quarter. Provision for credit losses increased 221.0% year-over-year to $1.2 billion.

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