INVESTMENT SUMMARY

We have arrived at PNC’s valuation using weighted average of sum-of-the-parts valuation, Price/Sales (P/S) multiple and Price/Earning (P/E) multiple approaches assigning weights of 0.80, 0.10 and 0.10, respectively. PNC’s valuation under sum-of-the-parts valuation, P/S multiple approach and P/E multiple approach is $54.90, $52.47 and $26.99, respectively, which translates into weighted average share price of $51.87 implying a downward risk of 27.7% from current market price of $71.74 as on May 1, 2008.

Sum-of-the-parts valuation

We believe that sum-of-the-parts valuation is the most appropriate method for valuation of PNC wherein we have valued PNC’s core banking operations (after excluding BlackRock’s investment and earnings from operations) and BlackRock separately. We have used Price/Book (P/B) for valuation of PNC’s core banking operations and a P/E multiple-based approach for valuation of BlackRock.

PNC’s standalone valuation (core banking operation valuation) after adjusting for investments in BlackRock is $35.65 per share using a P/B multiple of 1.48x on its adjusted 2009 book value. The P/B multiple is based on average 2009 P/B multiple for PNC’s peers plus a 20% premium for its diversified revenue mix and stronger expected growth in net interest income relative to most of its peers.

Using a P/E multiple of 19.79x, we suggest a valuation of $166.83 per share for BlackRock. (BlackRock has been historically trading at a one-year forward P/E of 19.79 while its peers have traded at an average one-year forward P/E of 14.9x). PNC has around 34% stake in BlackRock and per share impact of BlackRock’s investment on PNC is $19.25. We believe that PNC’s investment in BlackRock, which forms nearly 40% of PNC’s valuation, could be a major support to downside risk for the PNC stock. According to the WSJ: “Spotty performance and investor defections are making a lot of mutual-fund companies look cheap -- and very attractive for buyers. A shopping spree for fund firms is under way, as other asset managers and private-equity firms launch takeovers. Globally, asset-management transactions broke records last year, with buyers spending more than $50 billion to acquire partial or full ownership of 241 fund managers, according to investment bank Jefferies Putnam Lovell. More than 70 deals have been announced in 2008.

"The M&A market for asset management is going to be very strong" in coming months, said BlackRock Inc. Chief Executive Larry Fink in the latest earnings announcement at the money-management firm, which earned $242 million in the last quarter and took over Merrill Lynch's asset-management business in 2006.”

Based on sum-of-the-parts valuation, PNC’s per share valuation is approximately $54.90 per share.

PNC core banking operations – excluding BlackRock

BlackRock

P/E based valuation

We expect PNC’s 2009 EPS at 1.96 per share (Including loss on off balance sheet exposure). Based on a P/E of 13.75x for PNC, which is based on its peer group’s P/E for 2009 plus a 20% premium, PNC’s valuation is approximately $26.99 per share.

P/S based valuation

For 2009 we expect revenues for PNC of $6.7 bn with revenue per share of $19.81. Based on a P/S multiple of 2.65x (industry P/S for 2009 plus a 20% premium), PNC’s valuation comes to around $52.47 per share.

IV. Investment Highlights

Weaker capital ratios and significant exposure to riskier assets

PNC’s current capital ratios could prove to be inadequate to cushion against loan and mark-to-market losses. With one of the lowest tier 1 and tier II capital ratios in its peer group (out of over 330 banks that we have reviewed), PNC could be impacted by probable losses from loan delinquencies and mark-to-market losses.

As of March 31, 2008, PNC’s tier one capital ratio and total risk based capital stood at 7.7% and 11.4%, respectively, down noticeably from 8.6% and 12.2% as of March 31, 2007. PNC is striving to achieve a target tier 1 capital ratio of 8% by the end of 2008 as is evident from the initiatives taken in 1Q2008, including putting its share repurchase activity on hold and issuing trust preferred securities of $450 mn, which resulted in an improvement in the bank’s tier 1 capital ratio to 7.7% in 1Q2008 over 6.8% in 4Q2007. However, we believe that such initiatives may be difficult to sustain in the coming quarters amid rising delinquencies and continued tight credit and capital market conditions. The continuing pressure on the bank to uplift its capital ratios may result in PNC postponing its planned share repurchase activity, curtailing its dividends and being forced to raise capital on terms and costs not as favorable as earlier, in the forthcoming quarters.

PNC’s low capital ratios are a serious constraint on the bank’s ability to absorb expected rising charge-offs from increasing delinquencies on its loan portfolio, and may impact the bank’s lending business if the losses last further than currently anticipated. A weaker capital cushion to expected increasing charge-offs together with a high exposure to commercial and mainly real estate loans makes PNC highly vulnerable to regulatory concerns with regard to its capital levels.

Widening credit spreads likely to increase mark-to-market losses. As of March 31, 2008, PNC had an exposure of $2.1 bn and $28.5 bn in CMBS and securities held for sale portfolio. During 4Q2007 and 1Q2008, PNC recorded mark-to-market losses of $26 mn and $177 mn, respectively, on its CMBS portfolio intended for securitization. In addition to this, the bank also recorded net unrealized loss of $23 mn on its securities available for sale in 1Q2008. Further, during 1Q2008 PNC transferred $1.8 bn of educational loans previously included under securities held for sale to its loan portfolio as the bank was finding it difficult to sell these loans under the current market conditions. With credit market problems showing no signs of reversal and CMBS securitization activity expected to continue to decrease in 2008 (which would further weaken banks’ ability to prudently sell their available for sale portfolio), we expect PNC to record further write-downs on its CMBS and securities available for sale portfolios. We expect PNC to record $297 mn and $61 mn mark-to-market loss relating to CMBS portfolio intended for securitization, in 2008 and 2009, respectively. Additionally, we expect PNC to record $596 mn and $312 mn unrealized loss on its securities available for sale portfolio for the remainder of 2008 and 2009, respectively. It is to be noted that while the mark-to-market adjustment on CMBS exposure is passed through the bank’s income statement, the securities held for sale portfolio are directly adjusted in equity with no impact on the bank’s net income.

Significant off-balance sheet exposure. As of December 31, 2007, PNC had an off-balance sheet exposure of $5.6 bn of assets and $5.5 bn of liabilities through its unconsolidated variable interest entities (VIE). PNC’s risk of maximum loss on its unconsolidated VIEs as on that date stood at $9.0 bn including off-balance sheet liquidity commitments of $8.8 bn to Market Street, a multi-seller asset-backed commercial paper conduit, and other credit enhancements of $0.2 bn. Considering the deteriorating state of commercial paper market, the $8.8 liquidity commitments to Market Street could put a strain on company’s liquidity going forward.

Market Street’s activities involve purchasing assets or making loans secured by pools of trade receivables or other loans made by US corporations. Market Street funds its assets by issuing commercial paper. Of its liquidity commitments of $8.8 bn to Market Street, PNC could be required to fund $2.8 bn if Market Street assets go in default. Further, PNC’s exposure to asset defaults is cushioned by risk of first loss provided by the borrower and any deal-specific enhancement provided by a third party. We believe that under the current conditions marked by rising delinquencies and increasing prospects of corporate bankruptcies, PNC’s loss exposure on asset default may materialize to some extent. This is particularly relevant considering that Market Street’s assets are composed primarily of trade receivables, auto loans, credit card loans and CDOs, all of which are highly prone to defaults. A default on these assets may result in PNC suffering significant losses, which could impact its valuation. We have estimated a total probable loss of $764 mn on PNC’s off balance sheet exposure, which has been evenly distributed over 2008 and 2009.

Inadequate allowances for loan losses relative to real estate exposure

Significant real estate loan exposure could be a cause for concern. Earnings of US banks, including PNC, have been (and in many cases are continuing) to be maligned by rising delinquencies in the real estate loans which have been the root cause of the current problems in financial markets. At the sector level, US banks’ exposure to real estate loans has increased persistently over the past three decades. In 2006, real estate loans as a percentage of total loans more than doubled to 57.4% compared with 27.8% in 1976. Within real estate loans, construction and land development loans (by far, the most risky real estate loans that can be made) have witnessed a considerable increase. The total construction and development loans have increased to 8.3% of gross loans in 2006 compared with 3.2% in 1976.

Over the current decade, the tremendous increase in real estate loans driven mainly by many banks’ and mortgage lenders’ lax lending policies during the low interest scenario in 2001-2003 was the primary driver behind US housing bubble and securitization crisis (see our reports on this issue - Intro: The great housing bull run – creation of asset bubble, Declining lending standards, lax underwriting activities increased the bubble – A comparison with the same during the S&L crisis and Securitization – dissimilarity between the S&L and the Subprime Mortgage crises, The bursting of housing bubble – declining home prices and rising foreclosure) through increased demand for residential housing properties and consequential increase in property prices. With the bubble busting in 2007and with US housing prices continuing their drastic fall since then, most of the loans made at the peak of bubble are witnessing higher default rates leading to rising NPAs and higher charge-offs to banks.

At the end of 1Q2008, PNC’s loan portfolio had 54.2% of its loan portfolio in the residential and commercial real estate sector, up from 52.8% at the end of 2006 (the apex of both the residential and commercial real estate bubbles). Within the real estate loan portfolio home equity (2^nd lien, highly susceptible to substantial loss and minimum recovery in a declining market), residential mortgages and commercial real estate form a substantial 20.2%, 13.1% and 12.8% of the total loan portfolio. Amid continually falling housing prices and rising delinquencies on real estate loans, PNC’s real estate loan exposure has driven most of the increase in the bank’s NPAs. PNC’s NPAs excluding real estate loans increased 63% to $230 mn in 1Q2008 over 1Q2007. This is a significant increase which shows noticeable stress in commercial and consumer finance lending that is already manifesting itself through losses. Even more damaging its NPAs on real estate loans increased a much higher 467% to $357 mn over the period. The outlook on the US housing sector continues to be bleak with the housing prices expected to witness a decline of 8.3% and 4.9% in 2008 and 2009, respectively. This, together with weak prospects of a near-term economic recovery in the US, is likely to drive PNC’s non-performing assets higher than the current levels. We believe that PNC is yet to witness a major impact of its weak loan portfolio on its earnings since its NPAs relative to total loans have just started to increase (0.83% of gross loans in 1Q2008 versus 0.32% of gross loans in 1Q2007). As the bank continues to confront bad loans in its real estate loan portfolio it’s NPAs and consequently the provision for loan losses can be expected to rise.

Inadequate provisions for loan losses. The banking industry in general and PNC in particular do not seem to have adequate provisions to cover their expected loan losses. Though the last few years have witnessed a stupendous rise in real estate loans, allowances as a percent of gross loans have dipped over the years, having slumped to 1.16% of gross loans in 2006 from nearly 2.67% in 1991. We believe this could turn out to be a serious concern as an increasing proportion of real estate and other loans are falling into default category. The impressive profits recorded by the banking sector before the advent of subprime crisis could be due for reversal as the banks are forced to record significant charge-offs apart from the need to increase their provisions to cover expected future losses with no indication of losses having hit the bottom yet. We believe that this reversal will extend beyond the short term, as well. The business cycle for commercial and investment banking will be soft for than just a quarter or two.

PNC’s year-end loan loss allowance balance as a percentage of gross loans stood at 1.21% and 1.12%, respectively, at the end of 2007 and 2006, respectively. With nearly 55% of PNC’s loan portfolio exposed towards real estate sector, we believe that an allowance cover of 1.21% of the gross loans could prove to be minuscule for the bank to adequately cover the expected loan losses in the current troubled macro economic environment. Although PNC made a provision for credit loss of $188 mn (including $45 mn for the Yardville acquisition) or 1.10% of gross loans in 4Q2007 followed by $151 mn or 0.85% of gross loans in 1Q2008, significantly up from the previous quarters, we feel that expected higher charge-offs would warrant a higher allowance than what has been currently built by PNC. This is also evident from the fact the PNC’s NPAs are witnessing a faster rise than its allowance for loan loss, with no sign of abatement or leveling of trend. In 1Q2008 PNC’s NPA increased 188% over 1Q2007 to $587 mn while year-end allowance for loan losses increased a much lower 25% to $865 mn. As a result of inadequate provisioning, the bank’s NPAs-to-allowances have increased to 68% in 1Q2008 from 30% in 1Q2007. We believe that PNC will face the pressure of raising its provisions in the coming quarters as it continues to witness increasing delinquencies leading to higher NPAs and loan losses. While the bank expects to add $600 mn to its allowance in 2008, we believe that this will be insufficient to cover the bank’s expected loan losses, which would continue to surface in coming quarters. We expect PNC to make a provision for credit loss of $806 mn and $847 mn in 2008 and 2009, respectively, representing about 1.18% and 1.24% of gross loans in these years.

Expected increase in net charge-off and NPAs due to rising delinquency rates. Historically, charge-offs for the US banking sector during recession periods in 1991 and 2001 averaged around 1%-2% of total loans. Over the past year charge-offs has increased from 0.47% of total loans in 4Q2006 to 0.79% in 4Q2007 for the banking industry as a whole while for PNC these have increased from 0.43% to 0.62% over the comparable period primarily owing to increased losses in the residential and commercial real estate lending.

The rising charge-offs by banks are driven primarily by rising delinquencies. Delinquency rates for real estate loans for the US banking sector have increased to 2.88% in 4Q2007 compared with 1.36% in 1Q2006, while the delinquency rates for consumer loans have increased from 2.79% to 3.39% over the period (we believe this 21.5% jump will increase as the risk in consumer finance is definitely underestimated, see The consumer finance sector risk is woefully unrecognized). At the end of 4Q2007, credit card loans, family residential mortgages and construction and development loans had higher delinquency rates of 2.32%, 2.11% and 1.83%, respectively, against 1.58% delinquency rates on all loans.

We expect US banks’ charge-offs to continue their upward stride as the downturn in US housing and financial markets have not yet reached an inflection point. On the contrary, the recent housing and economic indicators have been pointing towards a continued deterioration of the US economy. As housing prices continue to fall, consumer spending remains on a low, GDP forecasts for the US economy have been revised downwards, and financial markets are nowhere near stability, delinquencies and consequent loan losses can only be expected to move upwards (to the contrary of what may be seen in the popular financial media). Accordingly, we expect PNC’s charge-offs to increase to 0.77% and 1.03% of gross loans during 2008 and 2009, respectively, up from 0.36% in 2007

Net interest income growth to soften off weakening macro economic conditions

Lower loan growth to impact net interest income. The distressed condition of the US economy is continually dampening the business and consumer spending levels across the nation. As commercial and consumer loans growth are expected to plunge, the US banking sector’s net interest income is slated to take a hit in 2008 and 2009. I would like to note, as expressed earlier, that we acknowledge the wider NIM available to banks through the Fed’s aggressive reduction of interest rates and while these rates remain low margins should remain relatively high. The issue is that the margins cannot be translated into income without actual lending occurring. It is at this inflection point that we see PNC (as well as several other institutions) faltering. We expect PNC’s interest income from its real estate loans accounting for nearly 53% of its total loan portfolio to fall significantly over the next couple of years as the US housing markets remain destabilized. In addition, other lending businesses including manufacturing and financial services are expected to be adversely impacted by deteriorating economic conditions. In 1Q2008, PNC’s interest bearing assets (including loans and securities available for sale) witnessed a decline of 1.18% over 4Q2007. We expect PNC’s interest bearing assets to continue to witness its downward trend for the remainder of 2008 and the first half of 2009 with an estimated year-on-year decline of 3.0% and 0.1% in 2008 and 2009, respectively. As a result of lower interest earning assets, we expect PNC’s net interest income to register a q-o-q decline of 3.7%, 1.1% and 1.0% in 2Q2008, 3Q2008 and 4Q2008. However, on annual basis PNC’s 2008 net interest income stands 13.0% above its 2007 level primarily owing to the acquisitions made in 2007 which were not fully reflected in full year 2007 financial statements. In 2009, we expect the bank’s net interest income to remain comparable to 2008 with net interest income of $3,295 mn compared with $3,292 mn in 2008, but on a strictly comparable basis and/or organic growth perspective, income should see a downward trend.

Stable net interest margin (NIM) as Fed signals no further rate cuts. In its efforts to infuse liquidity in the economy and boost consumer sentiments, US Federal Reserve has cut the federal funds rate by 3.25% since September 2007 in a series of announcements, the latest one coming just a few days back on April 30, 2008. This has benefited banks in the form of improved net interest margin off lowering cost of deposits clubbed with increasing lending charges under the continued tight credit market conditions. PNC’s net interest margin also improved to 3.14% in 1Q2008 compared with 2.76% in 1Q2007 as its cost on borrowings declined to 3.25% from 3.82% while the cost of lending increased to 5.96% from 5.84% over the period. In view of the US Federal Reserve indication of not changing the discount rate in its upcoming meet in June 2008, we expect PNC to maintain its net interest margin at the current levels in the near-to-medium term. For 2008, we expect PNC’s net interest margin at 3.07%, comparable to the 2007 level, while for 2009 we expect a slight improvement in NIM to 3.15% as we expect a continuing rise in lending rates clubbed with stable/slightly higher borrowing costs.

Fee based income likely to contract off declining capital and credit market activities

Deteriorating capital markets to put pressure on fee based income. Though PNC’s diversified revenue stream with more than 50% of its revenues driven from non-interest income underpins the bank’s earning-ability in this troubled economic environment, we believe that the current economic and financial market conditions have deteriorated to an extent where the continuing problems in capital and credit markets are adversely impacting the banking sector’s fee-based income stream as well. A widespread uncertainty in the global equity and capital markets is likely to impact PNC’s fee based income in the coming quarters as transaction volumes and assets under management (AUM) levels have started to decline. According to Thomson Financial, US mortgage-backed securities issuance declined 75% to $61.0 bn in 1Q2008 from $273.9 bn in 1Q2007. Issuance of US asset-backed securities plunged 83% to $54.7 bn over $323.3 bn in 1Q2007. In 1Q2008 US investment-grade corporate bond issuance declined 31% to $185 bn while junk bond issuance declined 85% to $5.9 bn. Owing to a decline in investors’ appetite for new issues, stock and equity-linked offerings and high-yield bonds issuance are expected to witness a softer trend over the next couple of quarters.

PNC’s non-interest income displayed some instability in 1Q2008 when its fee-based income from asset management; fund servicing and corporate services declined over 4Q2007. An unfavorable outlook for the US and global financial markets and slowing US economic growth could continue to impact the bank’s fee based income in near-to-medium-term. Amid concerns over financial meltdown and looming fears of recession in the US, PNC’s decision to sell W.L. Lyons will affect its wealth management revenues causing pressure on its fee-based income in the near-to-medium term. However the bank’s recent acquisitions including Albridge Solutions, Coates Analytics, ARCS, Mercantile Bank and Sterling Financial Corporation could partially offset the decline in fee based income.

Overall, we expect PNC’s non-interest income to decline 15.5% to $3.2 bn in 2008 from $3.8 bn in 2007 (which included the impact of extraordinary gains of $244 mn including gain on sale of Hilliard Lyons and Visa redemption gains).

BlackRock’s asset management business may face strain from deteriorating financial markets. PNC’s holding in BlackRock, one of the largest listed asset management companies in the US, is a significant source of income for the bank. PNC’s share in BlackRock’s earnings amounted to $333 mn in 2007 and $81 mn in 1Q2008, which formed 22.7% and 21.5% of the bank’s net income in the two periods, respectively. Though BlackRock has managed to maintain its total assets under management in 1Q2008 at nearly the same level as in 4Q2007, the company has witnessed a movement away from its equity and debt AUMs in favor of cash management assets highlighting the negative investor sentiments surrounding equity and debt markets. With the growing expectation of a prolonged crisis in financial markets, BlackRock’s AUM levels and consequently asset management revenues may be impacted adversely as an increased trend in a shift from equity and fixed income portfolio to the lower profit margin cash management business is witnessed. We expect BlackRock’s AUMs to remain stable with a nominal 1.2% increase in 2008, expecting growth from cash management to more than offset decline in equity and fixed assets under management. However, due to an increase in proportion of cash management to total AUM we expect BlackRock’s yield to decline to 0.317% in 2008 from 0.313% in 2007. It is worth noticing that BlackRock is leveraging its risk management services to procure contracts for management of distressed financial assets, which are on the rise in the current financial markets state. The contract from Fed Reserve to manage $30 bn worth of Bear Sterns assets under the JPM-Bear Sterns deal is a case in point. As the credit market deteriorates further more investors will turn towards risk management services offered by BlackRock, which could partially offset the dampening effect of lower revenues from assets under management. In addition, there are indications that Blackrock may attempt growth through acquisistion. This may add to aggregate income, but whether it actually adds to shareholder value, if true, remains to be seen.

Growth via acquisitions to slowdown

PNC has historically diversified its revenue stream while expanding its banking operations through inorganic growth via acquisitions. The bank had concluded a number of acquisitions including those of Yardville National Bancorp, Albridge Solutions, Coates Analytics, ARCS, Sterling Financial Corporation, and Mercantile Bank since 2007. However, under the current business environment, PNC is not planning any more acquisitions in the near-to-medium term as the focus has shifted to maintaining profitability levels and having appropriate capital ratios amid current capital and financial market turbulence. This could slow the bank’s growth trajectory witnessed in the recent years. Moreover, the bank is yet to integrate some of its earlier acquisitions such as those of Sterling and Mercantile, which could put a pressure on its margins in the coming quarters.

PNC’s provisioning for loan losses and NPA levels have also been hit in the recent quarter by the impact of consolidating some of the acquisitions made in 2007, particularly those of Mercantile Bank and Yardville. Nearly 50% of PNC’s NPAs as of March 31, 2008, related to the loans of Mercantile Bank (a commercial loan specialist) indicating that PNC could face increased charge-offs in future due to poor quality in the loan portfolio of Mercantile Bank. In addition, of the $188 mn provision for loan losses made during 4Q2007, around $45 mn related to the Yardville integration, which again signals the incremental costs of integrating acquisitions. The Sterling Bank acquisition, which closed in April 2008, may result in more such costs and charges in 2Q2008, thereby further impacting PNC’s financial performance.