UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

 

(Mark One)

ý

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended June 30, 2004

 

OR

 

o

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from            to            

 

Commission file number 0-5127

 

MERCANTILE BANKSHARES CORPORATION

(Exact name of registrant as specified in its charter)

 

Maryland

 

52-0898572

(State or other jurisdiction of
incorporation or organization)

 

(I.R.S. Employer
Identification No.)

 

2 Hopkins Plaza
Baltimore, Maryland 21201

(Address of principal executive offices) (Zip Code)

 

(410) 237-5900

(Registrant’s telephone number, including area code)

 

NONE

(Former name, former address and former fiscal year, if changed since last report)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes ý  No o

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes ý  No o

 

As of July 31, 2004, 79,092,605 shares of registrant’s Common Stock, $2 par value per share, were outstanding.

 

 



 

PART I – FINANCIAL INFORMATION

Item 1. Financial Statements (Unaudited)

 

MERCANTILE BANKSHARES CORPORATION

CONSOLIDATED BALANCE SHEETS

 

(Dollars in thousands, except per share data)

 

June 30,
2004

 

December 31,
2003

 

June 30,
2003

 

ASSETS

 

 

 

 

 

 

 

Cash and due from banks

 

$

296,046

 

$

321,882

 

$

350,833

 

Interest-bearing deposits in other banks

 

158

 

14,583

 

258

 

Federal funds sold

 

125,000

 

26,236

 

324,274

 

Securities purchased under resale agreements

 

 

 

100,000

 

Total cash and cash equivalents

 

421,204

 

362,701

 

775,365

 

Investment securities available-for-sale (Note 4)

 

3,014,862

 

3,123,514

 

2,692,101

 

Investment securities held-to-maturity (Note 4)

 

50,699

 

49,417

 

51,189

 

Total investment securities

 

3,065,561

 

3,172,931

 

2,743,290

 

Loans held-for-sale

 

747

 

14,925

 

85,740

 

Loans:

 

 

 

 

 

 

 

Commercial

 

2,723,066

 

2,577,021

 

2,314,680

 

Commercial real estate

 

2,910,749

 

2,738,832

 

2,145,959

 

Construction

 

1,129,208

 

1,064,021

 

887,237

 

Residential real estate

 

1,468,804

 

1,335,375

 

1,092,785

 

Consumer

 

1,472,300

 

1,482,860

 

1,031,760

 

Lease financing

 

57,983

 

74,051

 

88,510

 

Total loans

 

9,762,110

 

9,272,160

 

7,560,931

 

Less: allowance for loan losses

 

(158,431

)

(155,337

)

(142,261

)

Loans, net

 

9,603,679

 

9,116,823

 

7,418,670

 

Bank premises and equipment, less accumulated depreciation of $156,722 (June 2004), $152,771 (December 2003) and $124,171 (June 2003)

 

141,523

 

140,922

 

104,099

 

Other real estate owned, net

 

402

 

191

 

376

 

Goodwill, net (Note 7)

 

517,615

 

522,173

 

119,730

 

Other intangible assets, net (Note 7)

 

52,478

 

56,223

 

16,107

 

Other assets

 

326,936

 

308,583

 

232,924

 

Total assets

 

$

14,130,145

 

$

13,695,472

 

$

11,496,301

 

 

 

 

 

 

 

 

 

LIABILITIES

 

 

 

 

 

 

 

Deposits:

 

 

 

 

 

 

 

Noninterest-bearing deposits

 

$

3,043,242

 

$

2,750,721

 

$

2,276,408

 

Interest-bearing deposits

 

7,600,452

 

7,511,832

 

6,359,166

 

Total deposits

 

10,643,694

 

10,262,553

 

8,635,574

 

Short-term borrowings

 

891,879

 

809,021

 

816,309

 

Accrued expenses and other liabilities

 

115,705

 

134,735

 

90,291

 

Long-term debt

 

637,570

 

647,722

 

578,533

 

Total liabilities

 

12,288,848

 

11,854,031

 

10,120,707

 

 

 

 

 

 

 

 

 

SHAREHOLDERS’ EQUITY

 

 

 

 

 

 

 

Preferred stock, no par value; authorized 2,000,000 shares; issued and outstanding - None

 

 

 

 

 

 

 

Common stock, $2 par value; authorized 130,000,000 shares; issued shares - 79,088,986 (June 2004), 79,772,705 (December 2003) and 69,093,254 (June 2003); restricted shares - 137,278 (June 2004), 121,369 (December 2003) and 171,369 (June 2003)

 

158,178

 

159,545

 

138,187

 

Capital surplus

 

522,758

 

548,664

 

128,714

 

Retained earnings

 

1,168,462

 

1,110,748

 

1,063,381

 

Accumulated other comprehensive income (loss)

 

(8,101

)

22,484

 

45,312

 

Total shareholders’ equity

 

1,841,297

 

1,841,441

 

1,375,594

 

Total liabilities and shareholders’ equity

 

$

14,130,145

 

$

13,695,472

 

$

11,496,301

 

 

See notes to consolidated financial statements

 

2



 

MERCANTILE BANKSHARES CORPORATION

STATEMENTS OF CONSOLIDATED INCOME

 

 

 

For the 6 Months
Ended  June 30,

 

For the 3 Months
Ended  June 30,

 

(Dollars in thousands, except per share data)

 

2004

 

2003

 

2004

 

2003

 

INTEREST INCOME

 

 

 

 

 

 

 

 

 

Interest and fees on loans

 

$

261,176

 

$

222,954

 

$

132,116

 

$

111,962

 

Interest and dividends on investment securities:

 

 

 

 

 

 

 

 

 

Taxable interest income

 

53,566

 

53,822

 

26,165

 

26,638

 

Tax-exempt interest income

 

1,697

 

964

 

820

 

497

 

Dividends

 

561

 

428

 

300

 

199

 

Other investment income (losses)

 

2,969

 

2,882

 

(372

)

2,318

 

Total interest and dividends on investment securities

 

58,793

 

58,096

 

26,913

 

29,652

 

Other interest income

 

764

 

2,040

 

589

 

1,314

 

Total interest income

 

320,733

 

283,090

 

159,618

 

142,928

 

INTEREST EXPENSE

 

 

 

 

 

 

 

 

 

Interest on deposits

 

40,640

 

48,579

 

19,873

 

23,450

 

Interest on short-term borrowings

 

2,899

 

3,014

 

1,480

 

1,469

 

Interest on long-term debt

 

10,460

 

7,648

 

5,205

 

5,286

 

Total interest expense

 

53,999

 

59,241

 

26,558

 

30,205

 

NET INTEREST INCOME

 

266,734

 

223,849

 

133,060

 

112,723

 

Provision for loan losses

 

4,779

 

6,067

 

2,353

 

3,051

 

NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES

 

261,955

 

217,782

 

130,707

 

109,672

 

NONINTEREST INCOME

 

 

 

 

 

 

 

 

 

Investment and wealth management

 

44,919

 

36,873

 

22,936

 

19,508

 

Service charges on deposit accounts

 

20,470

 

16,371

 

10,351

 

8,311

 

Mortgage banking related fees

 

5,233

 

4,895

 

2,293

 

2,507

 

Investment securities gains

 

535

 

7,351

 

590

 

6,536

 

Other income

 

30,278

 

17,800

 

15,380

 

8,575

 

Total noninterest income

 

101,435

 

83,290

 

51,550

 

45,437

 

NONINTEREST EXPENSES

 

 

 

 

 

 

 

 

 

Salaries

 

89,477

 

70,732

 

44,689

 

36,317

 

Employee benefits

 

23,441

 

18,747

 

10,928

 

9,319

 

Net occupancy expense of bank premises

 

11,879

 

8,315

 

5,819

 

4,219

 

Furniture and equipment expenses

 

14,937

 

13,542

 

7,573

 

6,743

 

Communications and supplies

 

8,499

 

6,617

 

4,195

 

3,181

 

Other expenses

 

38,520

 

28,877

 

20,163

 

17,270

 

Total noninterest expenses

 

186,753

 

146,830

 

93,367

 

77,049

 

Income before income taxes

 

176,637

 

154,242

 

88,890

 

78,060

 

Applicable income taxes

 

64,627

 

55,246

 

32,577

 

28,050

 

NET INCOME

 

$

112,010

 

$

98,996

 

$

56,313

 

$

50,010

 

NET INCOME PER SHARE OF COMMON STOCK (Note 3):

 

 

 

 

 

 

 

 

 

Basic

 

$

1.41

 

$

1.44

 

$

0.71

 

$

0.73

 

Diluted

 

$

1.40

 

$

1.43

 

$

0.71

 

$

0.72

 

DIVIDENDS PAID PER COMMON SHARE

 

$

0.68

 

$

0.63

 

$

0.35

 

$

0.33

 

 

See notes to consolidated financial statements

 

3



 

MERCANTILE BANKSHARES CORPORATION

STATEMENTS OF CHANGES IN CONSOLIDATED SHAREHOLDERS’ EQUITY

 

For The Six Months Ended June 30, 2004 and 2003

 

(Dollars in thousands, except per share data)

 

Total

 

Common
Stock

 

Capital
Surplus

 

Retained
Earnings

 

Accumulated
Other
Comprehensive
Income (Loss)

 

BALANCE, DECEMBER 31, 2002

 

$

1,324,358

 

$

137,672

 

$

120,577

 

$

1,010,248

 

$

55,861

 

Net income

 

98,996

 

 

 

 

 

98,996

 

 

 

Unrealized gains (losses) on securities available-for-sale, net of reclassification adjustment, net of taxes

 

(10,549

)

 

 

 

 

 

 

(10,549

)

Comprehensive income

 

88,447

 

 

 

 

 

 

 

 

 

Cash dividends paid:

 

 

 

 

 

 

 

 

 

 

 

Common stock ($.63 per share)

 

(43,365

)

 

 

 

 

(43,365

)

 

 

Issuance of 60,823 shares for dividend reinvestment and stock purchase plan

 

2,119

 

122

 

1,997

 

 

 

 

 

Issuance of 12,249 shares for employee stock purchase dividend reinvestment plan

 

455

 

25

 

430

 

 

 

 

 

Issuance of 89,053 shares for employee stock option plan

 

1,540

 

177

 

1,363

 

 

 

 

 

Issuance of 100,537 shares for restricted stock awards

 

3,561

 

202

 

3,359

 

 

 

 

 

Deferred compensation – restricted stock awards

 

(2,498

)

 

 

 

 

(2,498

)

 

 

Purchase of 5,500 shares under stock repurchase plan

 

(212

)

(11

)

(201

)

 

 

 

 

Vested stock options

 

1,189

 

 

1,189

 

 

 

BALANCE, JUNE 30, 2003

 

$

1,375,594

 

$

138,187

 

$

128,714

 

$

1,063,381

 

$

45,312

 

BALANCE, DECEMBER 31, 2003

 

$

1,841,441

 

$

159,545

 

$

548,664

 

$

1,110,748

 

$

22,484

 

Net income

 

112,010

 

 

 

 

 

112,010

 

 

 

Unrealized gains (losses) on securities available-for-sale, net of reclassification adjustment, net of taxes

 

(30,585

)

 

 

 

 

 

 

(30,585

)

Comprehensive income

 

81,425

 

 

 

 

 

 

 

 

 

Cash dividends paid:

 

 

 

 

 

 

 

 

 

 

 

Common stock ($.68 per share)

 

(53,957

)

 

 

 

 

(53,957

)

 

 

Issuance of 61,696 shares for dividend reinvestment and stock purchase plan

 

2,639

 

123

 

2,516

 

 

 

 

 

Issuance of 12,660 shares for employee stock purchase dividend reinvestment plan

 

557

 

25

 

532

 

 

 

 

 

Issuance of 215,631 shares for employee stock option plan

 

3,894

 

432

 

3,462

 

 

 

 

 

Issuance of 26,294 shares for restricted stock awards

 

1,199

 

53

 

1,146

 

 

 

 

 

Deferred compensation, net – restricted stock awards

 

(285

)

 

 

 

 

(285

)

 

 

Transfer opening balance related to directors’ deferred compensation plan

 

6,406

 

 

 

6,406

 

 

 

 

 

Directors’ deferred compensation plan contribution

 

196

 

 

 

196

 

 

 

 

 

Directors’ deferred compensation plan – dividend

 

 

 

 

54

 

(54

)

 

 

Purchase of 1,000,000 shares under stock repurchase plan

 

(44,110

)

(2,000

)

(42,110

)

 

 

 

 

Vested stock options

 

1,892

 

 

1,892

 

 

 

BALANCE, JUNE 30, 2004

 

$

1,841,297

 

$

158,178

 

$

522,758

 

$

1,168,462

 

$

(8,101

)

 

See notes to consolidated financial statements

 

4



 

MERCANTILE BANKSHARES CORPORATION

STATEMENTS OF CONSOLIDATED CASH FLOW

 

Increase (decrease) in cash and cash equivalents

 

For the 6 Months Ended

June 30,

 

(Dollars in thousands)

 

2004

 

2003

 

CASH FLOWS FROM OPERATING ACTIVITIES:

 

 

 

 

 

Net income

 

$

112,010

 

$

98,996

 

Adjustments to reconcile net income to net cash provided by operating activities:

 

 

 

 

 

Provision for loan losses

 

4,779

 

6,067

 

Depreciation and amortization

 

7,787

 

6,331

 

Amortization of other intangible assets

 

4,088

 

1,409

 

Investment securities gains

 

(535

)

(7,351

)

Write-downs (income) of investments in private equity funds

 

(229

)

188

 

Gains on sales of other real estate owned

 

(13

)

(268

)

Gains on sales of buildings

 

(963

)

(228

)

Net (increase) decrease in assets:

 

 

 

 

 

Interest receivable

 

3,954

 

5,036

 

Other receivables

 

3,751

 

(7,564

)

Bank-owned life insurance

 

(1,579

)

(868

)

Other assets

 

(4,864

)

1,104

 

Loans held-for-sale

 

14,178

 

(85,740

)

Net increase (decrease) in liabilities:

 

 

 

 

 

Interest payable

 

(1,125

)

921

 

Accrued expenses

 

(9,788

)

(2,182

)

Taxes payable

 

(5,278

)

(4,094

)

Net cash provided by operating activities

 

126,173

 

11,757

 

CASH FLOWS FROM INVESTING ACTIVITIES:

 

 

 

 

 

Proceeds from maturities of investment securities held-to-maturity

 

3,913

 

4,603

 

Proceeds from maturities of investment securities available-for-sale

 

532,465

 

439,129

 

Proceeds from sales of investment securities  available-for-sale

 

42,055

 

399,958

 

Purchases of investment securities held-to-maturity

 

(5,195

)

(2,401

)

Purchases of investment securities available-for-sale

 

(514,304

)

(954,481

)

Net increase in customer loans

 

(493,705

)

(251,555

)

Proceeds from sales of other real estate owned

 

75

 

268

 

Capital expenditures

 

(5,403

)

(8,376

)

Proceeds from sales of buildings

 

2,594

 

602

 

Business acquisitions (net of cash received)

 

 

(28,530

)

Other investing activity

 

(2,956

)

(1,085

)

Net cash used in investing activities

 

(440,461

)

(401,868

)

CASH FLOWS FROM FINANCING ACTIVITIES:

 

 

 

 

 

Net increase in noninterest-bearing deposits

 

292,521

 

189,663

 

Net increase in checking plus interest and savings accounts

 

178,657

 

150,951

 

Net (decrease) increase in certificates of deposit

 

(90,037

)

34,020

 

Net increase (decrease) in short-term borrowings

 

82,858

 

(7,076

)

Proceeds from issuance of long-term debt

 

 

300,000

 

Repayment of long-term debt

 

(231

)

(8,400

)

Proceeds from issuance of shares

 

7,090

 

4,114

 

Repurchase of common shares

 

(44,110

)

(212

)

Dividends paid

 

(53,957

)

(43,365

)

Net cash provided by financing activities

 

372,791

 

619,695

 

Net increase in cash and cash equivalents

 

58,503

 

229,584

 

Cash and cash equivalents at beginning of period

 

362,701

 

545,781

 

Cash and cash equivalents at end of period

 

$

421,204

 

$

775,365

 

SUPPLEMENTAL INFORMATION

 

 

 

 

 

Cash payments for interest

 

$

55,125

 

$

58,321

 

Cash payments for income taxes

 

62,571

 

50,199

 

 

See notes to consolidated financial statements

 

5



 

MERCANTILE BANKSHARES CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

1. Basis of Presentation

 

The consolidated financial statements, which include the accounts of Mercantile Bankshares Corporation (“Bankshares”) (Nasdaq: MRBK) and all of its affiliates, are prepared in conformity with accounting principles generally accepted in the United States of America and follow general practice within the banking industry.  In the opinion of management, the consolidated financial statements include all adjustments necessary for a fair presentation of the interim period.  These adjustments are of a normal nature and include adjustments to eliminate all significant intercompany transactions.  In view of the changing conditions in the national economy, the effect of actions taken by regulatory authorities and normal seasonal factors, the results for the interim period are not necessarily indicative of annual performance.  For comparability, certain prior period amounts have been reclassified to conform with current period presentation.

 

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and contingent assets and liabilities in the financial statements, and the disclosure of revenue and expenses during the reporting period.  These assumptions are based on information available as of the date of the financial statements and could differ from actual results.  See Annual Report on Form 10-K for more detail.

 

2. Business Combinations

 

The following provides information concerning acquisitions. These acquisitions were accounted for as purchases. The results of operations of these acquisitions subsequent to the acquisition dates are included in Bankshares’ Statements of Consolidated Income. Individually, the results of operations of these acquisitions prior to the acquisition dates were not material to Bankshares’ results of operations.

 

In March and April 2003, Bankshares acquired in separate transactions, Boyd Watterson Asset Management LLC (“BW”), an investment management firm, and Peremel & Company, Inc. (“Peremel”), a directed and discount brokerage company.  In the aggregate, the companies were purchased for approximately $29 million in cash.  The BW acquisition has a potential additional contingent payment of up to $8.6 million which, if paid, will be recorded as goodwill.  The contingent payment will be recorded assuming certain metrics are met and becomes payable three years from the acquisition date.  Bankshares finalized and recorded approximately $10.1 million of identified intangibles, mostly client relationships, as a result of these acquisitions.  These intangibles are being amortized on a straight-line basis over a range of three to eight years.  Goodwill recorded on these transactions totaled approximately $18.0 million at June 30, 2004.

 

On August 12, 2003, Bankshares completed its acquisition of F&M Bancorp (“F&M”), a bank holding company headquartered in Frederick, Maryland.  The total consideration paid to F&M shareholders in connection with the acquisition was $124.1 million in cash and 10.4 million shares of Bankshares’ common stock.  F&M transactions have been included in Bankshares’ financial results since August 13, 2003.  Acquired assets on August 12, 2003 totaled $2.2 billion, including $1.4 billion of loans and leases; liabilities assumed were $2.0 billion, including $1.7 billion of deposits. As of June 30, 2004, Bankshares had recorded $395.8 million of goodwill, $36.0 million of core deposit intangible, $5.8 million of mostly client relationship intangibles (relating to the two insurance subsidiaries) and $1.1 million in a trademark intangible. The weighted average amortization period for the newly-acquired core deposit intangible is nine years, and the client-relationship identified intangible ranges from three to fifteen years. On October 24, 2003, certain assets and liabilities of F&M were transferred to other Bankshares affiliates in order to align customers’ accounts with the Bankshares’ affiliate serving the geographic area where those customers reside.

 

6



 

3. Earnings Per Share

 

Basic earnings per share (“EPS”) are computed by dividing income available to common shareholders by weighted average common shares outstanding.  Diluted EPS are computed using the same components as basic EPS with the denominator adjusted for the dilutive effect of stock awards.  The following tables provide reconciliation between the computation of basic EPS and diluted EPS for the six months and quarters ended June 30, 2004 and 2003, respectively.

 

 

 

For the 6 Months Ended June 30,

 

 

 

2004

 

2003

 

(In thousands, except per share data)

 

Net
Income

 

Weighted Average
Common Shares

 

EPS

 

Net
Income

 

Weighted Average
Common Shares

 

EPS

 

Basic EPS

 

$

112,010

 

79,422

 

$

1.41

 

$

98,996

 

68,815

 

$

1.44

 

Dilutive effect of stock options and restricted stock awards

 

 

 

510

 

 

 

 

 

438

 

 

 

Vested directors deferred compensation plan shares

 

 

 

75

 

 

 

 

 

 

 

 

Diluted EPS

 

$

112,010

 

80,007

 

$

1.40

 

$

98,996

 

69,253

 

$

1.43

 

 

 

 

For the 3 Months Ended June 30,

 

 

 

2004

 

2003

 

(In thousands, except per share data)

 

Net
Income

 

Weighted Average
Common Shares

 

EPS

 

Net
Income

 

Weighted Average
Common Shares

 

EPS

 

Basic EPS

 

$

56,313

 

79,119

 

$

0.71

 

$

50,010

 

68,860

 

$

0.73

 

Dilutive effect of stock options and restricted stock awards

 

 

 

483

 

 

 

 

 

458

 

 

 

Vested directors deferred compensation plan shares

 

 

 

149

 

 

 

 

 

 

 

 

Diluted EPS

 

$

56,313

 

79,751

 

$

0.71

 

$

50,010

 

69,318

 

$

0.72

 

 

Antidilutive options and awards excluded from the computation of diluted earnings per share were 445,909 and 238,838 for the six months ended June 30, 2004 and 2003, respectively, and 593,500 and 249,978 for the second quarter of 2004 and 2003, respectively.

 

4. Investment Securities

 

The amortized cost and fair value of investment securities at June 30, 2004, December 31, 2003 and June 30, 2003 are shown below:

 

 

 

June 30, 2004

 

December 31, 2003

 

June 30, 2003

 

(Dollars in thousands)

 

Amortized
Cost

 

Fair
Value

 

Amortized
Cost

 

Fair
Value

 

Amortized
Cost

 

Fair
Value

 

Securities available-for-sale

 

 

 

 

 

 

 

 

 

 

 

 

 

U.S. Treasury

 

$

761,492

 

$

770,566

 

$

823,356

 

$

845,754

 

$

950,507

 

$

988,831

 

U.S. Government agencies

 

805,462

 

806,149

 

778,916

 

793,611

 

657,177

 

685,061

 

Mortgage-backed securities

 

1,246,021

 

1,221,506

 

1,288,109

 

1,283,630

 

927,625

 

933,508

 

States and political subdivisions

 

69,019

 

69,284

 

77,897

 

79,870

 

449

 

477

 

Other investments

 

145,375

 

147,357

 

118,948

 

120,649

 

83,694

 

84,224

 

Total

 

$

3,027,369

 

$

3,014,862

 

$

3,087,226

 

$

3,123,514

 

$

2,619,452

 

$

2,692,101

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Securities held-to-maturity

 

 

 

 

 

 

 

 

 

 

 

 

 

States and political subdivisions

 

$

25,663

 

$

26,590

 

$

28,213

 

$

30,115

 

$

36,224

 

$

39,239

 

Other investments

 

25,036

 

25,036

 

21,204

 

21,204

 

14,965

 

14,965

 

Total

 

$

50,699

 

$

51,626

 

$

49,417

 

$

51,319

 

$

51,189

 

$

54,204

 

 

7



 

5. Impaired Loans

 

When scheduled principal or interest payments are past due 90 days or more at quarter-end on any loan, the accrual of interest income is discontinued and subsequent receipts on these loans are recorded as a reduction of principal, and interest income is recorded only once principal recovery is reasonably assured. Previously accrued but uncollected interest on these loans is charged against interest income. Generally a loan may be restored to accruing status when all past due principal, interest and late charges have been paid and the bank expects repayment of the remaining contractual principal and interest.

 

 Under Statements of Financial Accounting Standards (SFAS) Nos. 114 and 118, “Accounting by Creditors for Impairment of a Loan-an amendment of FASB Statements No. 5 and 15,” a loan is considered impaired, based on current information and events, if it is probable that Bankshares will not collect all principal and interest payments according to the contractual terms of the loan agreement. The impairment of a loan is measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate, or the fair value of the collateral if the repayment is expected to be provided predominantly by the underlying collateral. A majority of Bankshares’ impaired loans are measured by reference to the fair value of the collateral. Information with respect to impaired loans and the related valuation allowance (if the measure of the impaired loan is less than the recorded investment) at June 30, 2004, December 31, 2003 and June 30, 2003 is shown below.  See Annual Report on Form 10-K for more detail.

 

(Dollars in thousands)

 

June 30,
2004

 

December 31,
2003

 

June 30,
2003

 

Impaired loans with a specific valuation allowance

 

$

24,864

 

$

26,715

 

$

18,523

 

All other impaired loans

 

12,160

 

18,692

 

15,066

 

Total impaired loans

 

$

37,024

 

$

45,407

 

$

33,589

 

 

 

 

 

 

 

 

 

Specific allowance for loan losses applicable to impaired loans

 

$

14,497

 

$

14,925

 

$

8,840

 

General allowance for loan losses applicable to other than impaired loans

 

143,934

 

140,412

 

133,421

 

Total allowance for loan losses

 

$

158,431

 

$

155,337

 

$

142,261

 

 

 

 

 

 

 

 

 

Year-to-date interest income on impaired loans recorded on the cash basis

 

$

212

 

$

443

 

$

155

 

Year-to-date average recorded investment in impaired loans during the period

 

$

41,116

 

$

31,241

 

$

26,438

 

Quarter-to-date interest income on impaired loans recorded on the cash basis

 

$

109

 

$

223

 

$

58

 

Quarter-to-date average recorded investment in impaired loans during the period

 

$

39,752

 

$

37,382

 

$

28,822

 

 

Note: Impaired loans do not include large groups of smaller balance homogeneous loans that are evaluated collectively for impairment (e.g., residential mortgages and consumer installment loans).  The allowance for loan losses related to these loans is included in the general allowance for loan losses applicable to other than impaired loans.

 

6. Commitments

 

Bankshares is a party to financial instruments that are not reflected in the balance sheet, which include commitments to extend credit and standby letters of credit. Various commitments to extend credit (lines of credit) are made in the normal course of banking business. Letters of credit are issued for the benefit of customers by affiliated banks. These commitments are subject to loan underwriting standards and geographic boundaries consistent with Bankshares’ loans outstanding. Bankshares’ lending activities are concentrated in Maryland, Delaware and Virginia.

 

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Total commitments to extend credit were $3.9 billion at June 30, 2004, $3.6 billion at December 31, 2003, and $2.8 billion at June 30, 2003.

 

Letters of credit are commitments issued to guarantee the performance of a customer to a third party. Outstanding letters of credit were $320.9 million at June 30, 2004, $281.4 million at December 31, 2003 and $245.2 million at June 30, 2003.  Fees received for issuing letters of credit are deferred and amortized over the life of the commitment.  The fees on letters of credit at June 30, 2004, December 31, 2003, and June 30, 2003 had a carrying value of $1.2 million, $1.0 million and $0.4 million, respectively, representing unamortized fees.

 

8



 

Bankshares’ mortgage banking subsidiary is a Fannie Mae Delegated Underwriting and Servicing lender, and has a loss sharing arrangement for loans originated on behalf of and sold to Fannie Mae.  The unamortized principal balance of the underlying loans totaled $183.9 million, $149.4 million and $123.6 million at June 30, 2004, December 31, 2003 and June 30, 2003, respectively.  No loss reserve has been established for possible losses on loans originated and sold in the secondary market since there have been no losses recognized during the history of this arrangement and no losses were incurred at June 30, 2004.  The mortgage subsidiary also has originated and sold loans with recourse in the event of foreclosure on the underlying real estate.  The unamortized amount of principal balance of loans sold with recourse totaled $2.0 million at June 30, 2004, $2.3 million at December 31, 2003 and $2.8 million at June 30, 2003.  These mortgages are generally in good standing, are well-collateralized and no loss has ensued and no future loss is expected.

 

Bankshares has committed to invest funds in third-party private equity investments. At June 30, 2004, December 31, 2003 and June 30, 2003, $18.7 million, $16.1 million and $18.0 million, respectively, remained unfunded.

 

7. Goodwill and Other Intangible Assets

 

Goodwill decreased by $4.6 million during the second quarter of 2004.  This decrease was related to finalizing F&M’s purchase accounting adjustments.

 

The following table discloses the gross carrying amount and accumulated amortization of intangible assets subject to amortization at June 30, 2004 and December 31, 2003:

 

 

 

June 30, 2004

 

December 31, 2003

 

(Dollars in thousands)

 

Gross carrying
amount

 

Accumulated
amortization

 

Net
amount

 

Gross carrying
amount

 

Accumulated
amortization

 

Net
amount

 

Deposit intangibles

 

$

49,881

 

$

(12,280

)

$

37,601

 

$

49,881

 

$

(9,546

)

$

40,335

 

Mortgage servicing rights

 

2,670

 

(1,957

)

713

 

2,351

 

(1,790

)

561

 

Customer lists and other

 

17,010

 

(2,846

)

14,164

 

17,010

 

(1,683

)

15,327

 

Total

 

$

69,561

 

$

(17,083

)

$

52,478

 

$

69,242

 

$

(13,019

)

$

56,223

 

 

The projections of amortization expense shown for mortgage servicing rights are based on asset balances and the interest rate environment as of June 30, 2004. Future amortization expense may be significantly different depending upon changes in the mortgage servicing portfolio, mortgage interest rates and market conditions.

 

The following table shows the current period and estimated future amortization expense for amortized intangible assets. Identifiable intangible assets are amortized based on estimated lives of up to 15 years. Bankshares recorded $36.0 million of core deposit intangibles and $6.9 million in customer list and other intangibles in conjunction with the F&M acquisition. Management reviews other intangible assets for impairment yearly, or whenever events or changes in circumstances indicate that their carrying amounts may not be recoverable. For those intangible assets subject to amortization, impairment is indicated if the sum of undiscounted estimated future net cash flow is less than the carrying amount of the asset. Impairment is recognized by writing down the carrying value of the asset. Any impairment recognized in a valuation account is reflected in the income statement in the corresponding period. Bankshares recorded a $124 thousand impairment in the second quarter of 2004 for mortgage servicing rights. The mortgage servicing impairment valuation increased to $293 thousand at June 30, 2004 compared to $169 thousand at December 31, 2003.

 

The following table shows the current period and estimated future amortization expense for amortized intangible assets.

 

(Dollars in thousands)

 

 

 

Core
deposit
intangibles

 

Mortgage
servicing
intangibles

 

Customer lists
and other
intangibles

 

Total

 

Six months ended June 30, 2004 (actual)

 

 

 

$

2,734

 

$

182

 

$

1,172

 

$

4,088

 

Six months ended December 31, 2004 (estimated)

 

 

 

2,734

 

152

 

1,163

 

4,049

 

Twelve months ended December 31, 2004 (estimated)

 

 

 

5,468

 

334

 

2,335

 

8,137

 

 

 

 

 

 

 

 

 

 

 

 

 

Estimate for year ended December 31,

 

2005

 

5,467

 

342

 

2,326

 

8,135

 

 

 

2006

 

5,467

 

219

 

2,083

 

7,769

 

 

 

2007

 

5,209

 

 

 

1,890

 

7,099

 

 

 

2008

 

4,344

 

 

 

1,708

 

6,052

 

 

 

2009

 

4,120

 

 

 

985

 

5,105

 

 

9



 

8. Comprehensive Income

 

The following table summarizes the market value change and related tax effect of unrealized gains (losses) on securities available-for-sale for the six months ended June 30, 2004 and 2003.  The net amount is included in accumulated other comprehensive income (loss) in the Statements of Changes in Consolidated Shareholders’ Equity.

 

 

 

For the 6 Months Ended June 30,

 

 

 

2004

 

2003

 

(Dollars in thousands)

 

Pretax
Amount

 

Tax
(Expense)
Benefit

 

Net
Amount

 

Pretax
Amount

 

Tax
(Expense)
Benefit

 

Net
Amount

 

Unrealized gains (losses) on securities available-for-sale:

 

 

 

 

 

 

 

 

 

 

 

 

 

Unrealized holding gains (losses) arising during the period

 

$

(48,260

)

$

17,998

 

$

(30,262

)

$

(9,484

)

$

3,379

 

$

(6,105

)

Reclassification adjustment for (gains) losses included in net income

 

(535

)

212

 

(323

)

(7,351

)

2,907

 

(4,444

)

Total

 

$

(48,795

)

$

18,210

 

$

(30,585

)

$

(16,835

)

$

6,286

 

$

(10,549

)

 

9. Capital Adequacy

 

Bankshares and its bank affiliates are subject to various regulatory capital adequacy requirements administered by federal and state banking agencies.  These requirements include maintaining certain capital ratios above minimum levels.  These capital ratios include tier I capital and total risk-based capital as percentages of net risk-weighted assets and tier I capital as a percentage of adjusted average total assets (leverage ratio).  The minimum ratios for capital adequacy purposes are 4.00%, 8.00% and 4.00%, for the tier I capital, total capital and leverage ratios, respectively.  To be categorized as well capitalized, a bank must maintain minimum ratios of 6.00%, 10.00% and 5.00%, for its tier I capital, total capital and leverage ratios, respectively.  As of June 30, 2004, Bankshares and all of its bank affiliates exceeded all capital adequacy requirements to be considered well capitalized.

 

Capital ratios and the amounts used to calculate them are presented in the following table for Bankshares and Mercantile-Safe Deposit & Trust Company (MSD&T), the lead bank, as of June 30, 2004 and December 31, 2003.

 

 

 

June 30, 2004

 

December 31, 2003

 

(Dollars in thousands)

 

Bankshares

 

MSD&T

 

Bankshares

 

MSD&T

 

 

 

 

 

 

 

 

 

 

 

Tier I capital

 

$

1,286,355

 

$

401,076

 

$

1,248,492

 

$

396,186

 

Total risk-based capital

 

1,707,056

 

446,391

 

1,666,064

 

440,479

 

Net risk-weighted assets

 

10,552,378

 

3,607,148

 

10,020,487

 

3,529,223

 

Adjusted average total assets

 

13,290,852

 

4,433,480

 

13,011,399

 

4,353,713

 

 

 

 

 

 

 

 

 

 

 

Tier I capital ratio

 

12.19

%

11.12

%

12.46

%

11.23

%

Total capital ratio

 

16.18

%

12.38

%

16.63

%

12.48

%

Leverage ratio

 

9.68

%

9.05

%

9.60

%

9.10

%

 

Bankshares has an ongoing share repurchase program.  At June 30, 2004 there were 476,327 shares remaining for repurchase of the 2,000,000 shares previously authorized by the Board of Directors on December 11, 2001.  For the six months ended June 30, 2004 and the twelve months ended December 31, 2003, 1,000,000 and 5,500 shares, respectively, were repurchased by Bankshares.  In April 2004, Bankshares entered into a privately negotiated agreement for the accelerated repurchase of the one million shares.  Shares repurchased in 2003 were acquired in open market transactions.

 

10



 

10. Segment Reporting

 

Operating segments as defined by SFAS No. 131 Disclosures about Segments of an Enterprise and Related Information are components of an enterprise with separate financial information.  The component engages in business activities from which it derives revenues and incurs expenses and whose operating results management relies on for decision-making and performance assessment. Bankshares has three reportable segments — its 19 Community Banks, MSD&T Banking and Investment and Wealth Management  (IWM).

 

The following tables present selected segment information for the six months ended June 30, 2004 and 2003.  The components in the “Other” column consist of amounts for the nonbanking affiliates and intercompany eliminations.   Certain expense amounts such as operations overhead have been reclassified from internal financial reporting in order to provide for full cost absorption.  These reclassifications are shown in the “Adjustments” line.  F&M is included in the column “Community Banking” whereas BW and Peremel are included in the column “IWM”.

 

 

 

For the 6 Months Ended June 30, 2004

 

 

 

Banking

 

 

 

 

 

 

 

(Dollars in thousands)

 

Community

 

MSD&T

 

Total (1)

 

IWM

 

Other

 

Total

 

Net interest income

 

$

193,063

 

$

71,218

 

$

264,281

 

$

 

$

2,453

 

$

266,734

 

Provision for loan losses

 

256

 

(5,035

)

(4,779

)

 

 

(4,779

)

Noninterest income

 

42,474

 

22,087

 

55,613

 

45,229

 

593

 

101,435

 

Noninterest expenses

 

(111,323

)

(50,389

)

(152,764

)

(33,809

)

(180

)

(186,753

)

Adjustments

 

(3,486

)

11,872

 

8,386

 

(1,926

)

(6,460

)

 

Income (loss) before income taxes

 

120,984

 

49,753

 

170,737

 

9,494

 

(3,594

)

176,637

 

Income tax (expense) benefit

 

(42,009

)

(17,973

)

(59,982

)

(3,797

)

(848

)

(64,627

)

Net income (loss)

 

$

78,975

 

$

31,780

 

$

110,755

 

$

5,697

 

$

(4,442

)

$

112,010

 

Average loans

 

$

6,459,844

 

$

3,021,123

 

$

9,480,967

 

 

$

192

 

$

9,481,159

 

Average earning assets

 

8,793,808

 

4,060,059

 

12,518,189

 

 

105,293

 

12,623,482

 

Average assets

 

9,269,341

 

4,412,700

 

13,227,398

 

 

550,019

 

13,777,417

 

Average deposits

 

7,344,946

 

3,089,790

 

10,299,390

 

 

(66,939

)

10,232,451

 

Average equity

 

939,744

 

444,236

 

1,383,980

 

 

464,858

 

1,848,838

 

 

 

 

For the 6 Months Ended June 30, 2003

 

 

 

Banking

 

 

 

 

 

 

 

(Dollars in thousands)

 

Community

 

MSD&T

 

Total (1)

 

IWM

 

Other

 

Total

 

Net interest income

 

$

153,503

 

$

71,489

 

$

224,992

 

$

 

$

(1,143

)

$

223,849

 

Provision for loan losses

 

(3,109

)

(2,958

)

(6,067

)

 

 

(6,067

)

Noninterest income

 

31,542

 

21,592

 

45,968

 

37,164

 

158

 

83,290

 

Noninterest expenses

 

(78,352

)

(43,929

)

(115,115

)

(30,426

)

(1,289

)

(146,830

)

Adjustments

 

(3,220

)

7,763

 

4,543

 

(1,559

)

(2,984

)

 

Income (loss) before income taxes

 

100,364

 

53,957

 

154,321

 

5,179

 

(5,258

)

154,242

 

Income tax (expense) benefit

 

(34,637

)

(19,443

)

(54,080

)

(2,072

)

906

 

(55,246

)

Net income (loss)

 

$

65,727

 

$

34,514

 

$

100,241

 

$

3,107

 

$

(4,352

)

$

98,996

 

Average loans

 

$

4,527,296

 

$

2,909,487

 

$

7,436,783

 

 

$

253

 

$

7,437,036

 

Average earning assets

 

6,304,570

 

4,032,098

 

10,146,223

 

 

84,427

 

10,230,650

 

Average assets

 

6,624,800

 

4,326,291

 

10,661,253

 

 

119,121

 

10,780,374

 

Average deposits

 

5,359,878

 

3,118,910

 

8,362,812

 

 

(170,611

)

8,192,201

 

Average equity

 

843,198

 

454,182

 

1,297,380

 

 

12,517

 

1,309,897

 

 


(1)  Amounts do not necessarily add due to eliminations.

 

11



 

11. Derivative Instruments and Hedging Activities

 

FASB Statement No. 133 (SFAS No. 133), Accounting for Derivative Instruments and Hedging Activities, FASB Statement No. 138 (SFAS No. 138), Accounting for Certain Derivative Instruments and Certain Hedging Activities — an amendment to FASB Statement No. 133 and FASB Statement No. 149 (SFAS No. 149), Amendment of Statement No. 133 on Derivative Instruments and Hedging Activities  (collectively referred to as derivatives), establishes accounting and reporting standards for derivative instruments and for hedging activities. Bankshares maintains an overall interest rate risk management strategy that incorporates the use of derivative instruments to minimize significant unplanned fluctuations in earnings that are caused by interest rate volatility.  Derivative instruments that are used as part of the interest rate risk management strategy have been restricted to interest rate swaps.  Interest rate swaps generally involve the exchange of fixed-rate and variable-rate interest payments between two parties, based on a common notional principal amount and maturity date. As of June 30, 2004, Bankshares has interest rate swaps to convert its nonprepayable fixed-rate debt to floating-rate debt.  Bankshares also arranges interest rate swaps for commercial loan customers through its capital markets group.  The increase in the number of contracts since December 31, 2003 is related to their activities.

 

The fair value of derivative instruments recorded in other assets was $2.4 million (notional $210.5 million) and $6.6 million (notional $203.1 million) at June 30, 2004 and December 31, 2003, respectively.  The fair value of derivative instruments recorded in other liabilities was $13.3 million (notional $160.5 million) and $8.0 million (notional $150.0 million) at June 30, 2004 and December 31, 2003, respectively.  For the six months ended June 30, 2004, Bankshares recognized a net gain of $6 thousand, which represented the ineffective portion of the fair-value hedge of fixed-rate loans made to borrowers.  For the year ended December 31, 2003, Bankshares recognized a net gain of $70 thousand.  The impact of the hedge decreased interest income $61 thousand in the first six months of 2004 and $167 thousand in 2003.  The fair-value hedges of nonprepayable fixed-rate debt were effective for the reported periods.  The impact of the hedges decreased interest expense $5.7 million in the first six months of 2004 and $8.5 million in 2003.

 

The following tables summarize the gross position of derivatives at June 30, 2004 and December 31, 2003:

 

 

 

 

 

 

 

Weighted Average

 

June 30, 2004 (Dollars in thousands)

 

Number
of Contracts

 

Notional
Amount

 

Years to
Maturity

 

Fixed Rate

 

Variable Rate

 

Fair
Value

 

Gross Position Summary:

 

 

 

 

 

 

 

 

 

 

 

 

 

Pay Fixed/Receive Variable Interest Rate Swaps

 

4

 

$

10,512

 

6.64

 

4.68

%

1.25

%

$

8

 

Receive Fixed/Pay Variable Interest Rate Swaps

 

7

 

360,512

 

7.95

 

5.21

%

1.99

%

(10,862

)

Total

 

11

 

$

371,024

 

7.91

 

 

 

 

 

$

(10,854

)

 

 

 

 

 

 

 

Weighted Average

 

December 31, 2003 (Dollars in thousands)

 

Number
of Contracts

 

Notional
Amount

 

Years to
Maturity

 

Fixed Rate

 

Variable Rate

 

Fair
Value

 

Gross Position Summary:

 

 

 

 

 

 

 

 

 

 

 

 

 

Pay Fixed/Receive Variable Interest Rate Swaps

 

1

 

$

3,108

 

0.33

 

9.38

%

4.00

%

$

(64

)

Receive Fixed/Pay Variable Interest Rate Swaps

 

3

 

350,000

 

8.44

 

5.21

%

1.98

%

(1,366

)

Total

 

4

 

$

353,108

 

8.37

 

 

 

 

 

$

(1,430

)

 

Mortgage loans held-for-sale have inherent forward contract (agreements to sell or purchase loans at a specific rate or yield) characteristics. Risk may arise from the corresponding parties’ inability to meet the terms of their contracts and from movement in interest rates. Bankshares had forward commitments to sell and fund individual fixed-rate and variable-rate mortgage loans that are reported at fair value. The fair value adjustments were not material at June 30, 2004 and December 31, 2003.

 

12



 

12. Stock-based Compensation Expense

 

Bankshares has several stock-based compensation programs for its directors, management and employees. Compensation costs for stock options and restricted stock awards are included in salary expense.  Another form of stock-based compensation is phantom stock, which is used for a portion of the Bankshares’ Directors’ Deferred Compensation Plan.  A change in this plan was approved at the annual shareholders’ meeting, and was effective April 1, 2004.  This plan requires all deferred fees to be settled in Bankshares’ stock.  This reduces the expense fluctuations that occurred with phantom stock, which resulted in variances corresponding to the changes in Bankshares’ stock price.  The compensation cost for the phantom stock is included in other expenses.  Stock-based compensation amounts for the six months ended and quarter ended June 30, 2004 and 2003, respectively, are summarized in the following table:

 

 

 

For the 6 Months Ended
June 30,

 

For the 3 Months Ended
June 30,

 

(Dollars in thousands)

 

2004

 

2003

 

2004

 

2003

 

Stock options expense

 

$

1,200

 

$

865

 

$

794

 

$

406

 

Restricted stock awards expense

 

1,007

 

922

 

519

 

604

 

Subtotal included in salaries expense

 

2,207

 

1,787

 

1,313

 

1,010

 

Phantom stock expense

 

(198

)

314

 

180

 

989

 

Total stock-based compensation expense

 

$

2,009

 

$

2,101

 

$

1,493

 

$

1,999

 

 

13.         Pension & Other Postretirement Benefit Plans

 

Bankshares sponsors qualified and nonqualified pension plans and other postretirement benefit plans for its employees.  The following table summarizes the components of the net periodic benefit cost for the pension plans for the six months ended and the three months ended June 30, 2004 and 2003, respectively.

 

 

 

For the 6 Months Ended June 30, 2004

 

For the 6 Months Ended June 30, 2003

 

 

 

Qualified

 

Nonqualified

 

Total

 

Qualified

 

Nonqualified

 

Total

 

Service cost

 

$

3,144

 

$

282

 

$

3,426

 

$

2,560

 

$

230

 

$

2,790

 

Interest cost

 

5,098

 

202

 

5,300

 

4,996

 

156

 

5,152

 

Expected return on plan assets

 

(7,690

)

 

(7,690

)

(6,198

)

 

(6,198

)

Amortization of prior service cost

 

390

 

12

 

402

 

390

 

12

 

402

 

Recognized net actuarial (gain) loss

 

354

 

58

 

412

 

1,122

 

16

 

1,138

 

Amortization of transition asset

 

 

48

 

48

 

 

50

 

50

 

Net periodic benefit cost

 

$

1,296

 

$

602

 

$

1,898

 

$

2,870

 

$

464

 

$

3,334

 

 

 

 

 

For the 3 Months Ended June 30, 2004

 

For the 3 Months Ended June 30, 2003

 

 

 

Qualified

 

Nonqualified

 

Total

 

Qualified

 

Nonqualified

 

Total

 

Service cost

 

$

1,572

 

$

141

 

$

1,713

 

$

1,280

 

$

115

 

$

1,395

 

Interest cost

 

2,549

 

101

 

2,650

 

2,498

 

78

 

2,576

 

Expected return on plan assets

 

(3,845

)

 

(3,845

)

(3,099

)

 

(3,099

)

Amortization of prior service cost

 

195

 

6

 

201

 

195

 

6

 

201

 

Recognized net actuarial (gain) loss

 

201

 

29

 

230

 

517

 

8

 

525

 

Amortization of transition asset

 

 

24

 

24

 

 

25

 

25

 

Net periodic benefit cost

 

$

672

 

$

301

 

$

973

 

$

1,391

 

$

232

 

$

1,623

 

 

13



 

The following table summarizes the components of the net periodic benefit cost for the other postretirement benefit plans for the six months ended and the three months ended June 30, 2004 and 2003, respectively.

 

 

 

For the 6 Months Ended June 30,

 

For the 3 Months Ended June 30,

 

 

 

2004

 

2003

 

2004

 

2003

 

Service cost

 

$

130

 

$

88

 

$

65

 

$

59

 

Interest cost

 

428

 

367

 

214

 

246

 

Expected return on plan assets

 

 

 

 

 

Amortization of prior service cost

 

 

 

 

 

Recognized net actuarial (gain) loss

 

81

 

64

 

43

 

43

 

Amortization of transition asset

 

 

 

 

 

Net periodic benefit cost

 

$

639

 

$

519

 

$

322

 

$

348

 

 

As previously disclosed in its financial statements for the year ended December 31, 2003, Bankshares generally makes cash contributions to the pension plan in amounts permitted by guidelines established under employee benefit and tax laws.  Bankshares currently estimates it will be able to contribute up to approximately $10 million to the pension plan for 2004.  Cash contributions are normally made after valuations have been finalized for the plan year and prior to the tax return filing date.  As of June 30, 2004, no contributions had been made.

 

14.         Recent Accounting Standards

 

In December 2003, the American Institute of Certified Public Accountants issued Statement of Position (“SOP”) 03-3, “Accounting for Certain Loans or Debt Securities Acquired in a Transfer,” which addresses the accounting for differences between contractual cash flows and expected cash flows for loans acquired in a transfer when those differences are attributable at least in part to credit quality.  It includes such loans acquired in purchase business combinations where there is evidence of deterioration in credit quality since origination. This SOP requires the difference between expected cash flows and the purchase price to be accreted as an adjustment to yield over the life of the acquired loans; the difference between contractual cash flows and expected cash flows is not subject to accretion. This SOP would represent a change from current practice where the allowance for loan losses is carried over in purchase accounting. The SOP is effective for loans acquired beginning after December 15, 2004. Bankshares is currently evaluating the impact it will have on operations and financial statements.

 

On March 9, 2004, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin No. 105 (“SAB 105”), “Application of Accounting Principles to Loan Commitments,” which summarizes the views of the SEC staff regarding the application of Generally Accepted Accounting Principles to loan commitments accounted for as derivative instruments.  SAB 105 states that the value of the servicing asset should not be included in the estimate of fair value of interest rate lock commitments (“IRLCs”).    IRLCs associated with mortgages to be held for sale represent commitments to extend credit at specified interest rates.  SAB 105 is applicable for all IRLCs accounted for as derivatives and entered into on or after April 1, 2004.  This SAB does not have a material impact on Bankshares’ financial statements.

 

15.         Subsequent Event/Contingencies

 

On July 12, 2004, former employee John Pileggi filed suit against Mercantile Bankshares Corporation, Mercantile-Safe Deposit and Trust Company and Edward J. Kelly, III. For additional detail, see Part II Other Information Item 1 “Legal Proceedings” below.

 

During the second quarter of 2004, the Maryland Legislature passed two tax bills relating to certain payments among related entities.  The first bill requires taxpayers to add back otherwise deductible interest and intangible expenses paid to related entities for tax years beginning after December 31, 2003.  Some exceptions apply, including certain interest expenses deducted among related banks, so long as the transactions fall within the legislation’s “safe harbor” provision.  In applying the add back and safe harbor provisions, Maryland’s Comptroller has been granted discretionary authority to determine whether the transaction giving rise to the payment had as a principal purpose the avoidance of tax and whether it was at arm’s length.  Additionally, the Comptroller’s Office now has the power to reallocate or reapportion income among related entities if it determines that the entities’ income is not accurately reflected on their tax returns.  The second bill gives taxpayers the right to take advantage of an amnesty period.  Bankshares is currently in the process of determining what impact, if any, this legislation will have on its operations and financial results.

 

14



 

Item 2.   Management’s Discussion and Analysis of Financial Condition and Results of Operations

MERCANTILE BANKSHARES CORPORATION

 

HIGHLIGHTS

 

Consolidated Financial Results

 

In March, April and August of 2003, Bankshares acquired in separate transactions, Boyd Watterson Asset Management, LLC (“BW”), Peremel & Company (“Peremel”), and F&M Bancorp (“F&M”), respectively, which are collectively referred to herein as “the Acquisitions”.  The Acquisitions were accounted for under the purchase method of accounting and have been included in Bankshares’ financial results since their respective closings. On October 24, 2003, certain assets and liabilities of F&M were transferred to other Bankshares’ affiliates in order to align customers’ accounts with the Bankshares’ affiliate serving the geographic area where those customers reside. (See Footnote No. 2 to the Consolidated Financial Statements included in this report.)

 

Net income for the quarter ended June 30, 2004 was $56.3 million, a 13% increase from net income of $50.0 million for the same period in 2003 and a 1% increase over the $55.7 million reported for the first quarter of 2004.  For the quarter ended June 30, 2004, diluted net income per share was $.71, a decrease of 1% from the $.72 reported for the same period of last year and an increase of 3% over the $.69 reported for the first quarter of this year.  Adjusted weighted average shares outstanding increased from 69.3 million for the quarter ended June 30, 2003, to 79.8 million for the quarter ended June 30, 2004 as a result of the F&M acquisition.  The results of operations for the Acquisitions are included from their respective merger dates forward.

 

Factors positively affecting earnings for the second quarter included strong growth in average loans and deposits, up 3.1% and 3.3%, respectively, from the first quarter of 2004, improved noninterest income and expense control.  Partially offsetting these factors was a 13 basis point (“bp”) decline in the net interest margin to 4.24% from 4.37% in the first quarter of 2004.  A loss of $0.7 million from Bankshares’ investment in three hedge funds, as compared to a gain of $3.0 million in the first quarter of 2004, accounted for 12 bp of the margin contraction.  These investments are carried in the “other investments” category within investment securities available-for-sale.

 

Bankshares also reports cash operating earnings, defined as “GAAP” (Generally Accepted Accounting Principles) earnings excluding the amortization of intangible assets associated with purchase accounting for business combinations; securities gains and losses; and other significant gains, losses or expenses (such as those associated with integrating acquired entities’ operations into Bankshares) unrelated to Bankshares’ core operations.  Cash operating earnings totaled $57.3 million for the second quarter of 2004, an increase of 22% over the $47.0 million for the same period for 2003 and a slight increase over the $56.8 million for the first quarter of 2004.  Diluted cash operating earnings per share for the second quarter of 2004 and 2003 were $.72, and $.68, respectively, and $.71 per share for the first quarter of 2004.  A reconciliation of net income (GAAP basis) to cash operating earnings can be found on page 33 of this filing.

 

Management believes that reporting several key measures based on cash operating earnings and tangible equity (equity less intangible assets and their related amortization expense) is important, as this is the basis for measuring the adequacy of capital for regulatory purposes.  For the three months ended June 30, 2004, return on average tangible assets was 1.73%, return on average tangible equity was 18.14% and average tangible equity to average tangible assets was 9.55%.  Comparable ratios for the three months ended June 30, 2003 were 1.86%, 17.05% and 10.91%, respectively.  A reconciliation of these ratios from their respective GAAP basis ratios can be found on page 33 of this filing.

 

For the first six months of 2004, net income was $112.0 million, an increase of 13% over the $99.0 million reported for the comparable period in 2003. Diluted net income per share was $1.40, a decrease of 2% from the $1.43 reported for the same period of last year. For the six months ended June 30, 2004, compared to the same period of 2003, cash operating earnings were $114.1 million and $95.8 million, respectively.  Diluted cash operating earnings per share for these periods were $1.43 and $1.38, respectively.  The ratios of return on average tangible assets, return on average tangible equity and average tangible equity to average tangible assets for the year-to-date 2004 were 1.74%, 18.10% and 9.64%, respectively.  These ratios for the year-to-date 2003 were 1.89%, 17.02% and 11.10%, respectively.

 

15



 

SEGMENT REPORTING

 

As noted in Footnote No. 10 “Segment Reporting”, Bankshares has historically reported three distinct business segments for which financial information is segregated for use in assessing performance and allocating resources when reporting to the Board of Directors. Segment financial information is subjective and, unlike financial accounting, is not necessarily based on GAAP. As a result, the financial information of the reporting segments is not necessarily comparable with similar information reported by others and may not be comparable with Bankshares’ consolidated results.

 

Banking

 

On a combined basis, Community Banks and MSD&T continue to be the primary contributors to Bankshares’ earnings. Historically, Bankshares has distinguished between two operating units, Community and MSD&T, with the former focused on small business and retail banking and the latter on commercial and specialty lending. With the F&M acquisition and the announced plan to consolidate 11 affiliate banks into 4 banks, this distinction is becoming less apparent. Increased house lending authority at the Community Banks has resulted in additional loan growth within their footprint and less referral and overline business to MSD&T.

 

Community Banking

 

Net income for the six months ended June 30, 2004, was $79.0 million. This represented a $13.2 million, or 20% increase over the same period last year. Community Banking was the primary beneficiary of the F&M acquisition. For the first half of 2004 compared to the same period last year, net interest income increased by $39.6 million, or 26%, to $193.1 million. Growth in average earning assets of $2.5 billion, largely attributable to the F&M acquisition, more than offset the effect of a 51 bp reduction in the net interest margin. Contributing to the net interest margin compression was the capital restructuring of the Community Banks during the third quarter of last year. $300 million of subordinated debt issued by Bankshares in April 2003, used in part to fund the cash portion of the F&M acquisition, was invested in a like amount of subordinated debt issued by the Community Banks. Excess equity capital was paid to Bankshares in the form of a special cash dividend. The $6.2 million in interest expense incurred during the first half of 2004 related to this subordinated debt reduced the Community Banks’ net interest margin by 15 bp. The Community Banks had a reduction in the provision for loan losses compared to the same period of 2003 as credit quality remained stable.

 

The year-over-year increases in noninterest income and noninterest expenses for the first half of 2004 compared to the same period of 2003, are attributable to the F&M acquisition and branch / market expansion programs at several Community Banks. Noninterest income increased year-over-year by $10.9 million, with deposit service charges increasing $4.1 million, insurance fees increasing $6.8 million, and electronic banking fees increasing $2.7 million accounting for the largest gains. These gains were partially offset by a decrease of $5.7 million in net gains on investment securities. Noninterest expenses increased by $33.0 million in the first half of 2004 compared to the same period of 2003. Over 50% of this increase is related to salaries and benefits, which grew by $16.4 million. Staffing levels increased from 1,868 full time equivalent to 2,267 full time equivalent year-over-year mostly due to the acquisition of F&M.  Occupancy expense increased by $3.1 million, furniture and equipment expenses increased by $1.6 million and amortization of intangible assets increased $2.4 million.

 

MSD&T

 

The net income contribution from MSD&T Banking declined by $2.7 million for the six months ended June 30, 2004 to $31.8 million compared to the same period last year. Contributing to the decline were reduced net interest income, a higher provision for loan losses and increased noninterest expenses. Partially offsetting these items was an increase in noninterest income.

 

The decline in net interest income in the first half of 2004 compared to the same period in 2003 was attributable to a 6 bp decline in the net interest margin from 3.64% to 3.58%. This decline is consistent with the overall decline experienced by Bankshares. The provision for loan losses was $5.0 million in the first half of 2004 compared to $3.0 million in the first half of 2003. Nonperforming loans declined during the current quarter due to collections and the return of several loans to performing status. For additional information, see discussion of nonperforming assets under “Nonperforming Assets” below.

 

The increase in noninterest income was spread across numerous categories. Noninterest income increased $0.5 million in the first half of 2004 compared to the first half of 2003. The year-over-year increase was mitigated by decreases in gains on investment securities of $1.3 million in 2003 and -0- in 2004, and a 5% decrease in mortgage banking related fees as a result of a slow down in refinancing activities. Noninterest expense increased by $6.5 million from the first half of 2003 to $50.4 million. This represents a 15% increase over the prior year. Increased personnel costs of $7.0 million accounted for the increase. Staffing levels increased from 1,143 full time equivalents to 1,216 full time equivalents year-over-year principally due to compliance and other staff functions. Costs for shared services are charged to Investment and Wealth Management (“IWM”) and Community Banking and are reflected in the noninterest

 

16



 

expense line. Certain other costs not directly charged are allocated to IWM and Community Banking as reflected in the “adjustments” line.

 

Investment & Wealth Management

 

Net income increased $2.6 million or 83% to $5.7 million for the six months ended June 30, 2004 as compared to the $3.1 million reported in the same period last year

 

Revenues for the first half of 2004 increased $8.1 million, or 22%, over the same period last year, with $5.4 million of the increase related to the BW and Peremel acquisitions. The remaining increase was primarily due to strong equity markets and new sales. Total assets under administration increased to $46.2 billion at June 30, 2004 from $42.0 billion at June 30, 2003. At June 30, 2004 and June 30, 2003 assets under management were $21.4 billion and $19.4 billion, respectively.

 

Noninterest expenses increased by $3.4 million or 11% to $33.8 million for the first half of 2004 from $30.4 million for the same period last year. The increase in noninterest expense is mostly due to the acquisition of BW and Peremel. Full time equivalent staff levels have increased from 293 at June 30, 2003 to 310 at June 30, 2004. The Peremel acquisition and the assumption of F&M’s brokerage operation accounted for the full time equivalent increase. During the first quarter of 2004, Bankshares entered into a 7-year service contract with SunGard Wealth Management Services to provide a new core accounting system and assume management of IWM’s back-office operations. Post conversion, which is expected late in 2004, Bankshares expects to achieve net savings in excess of $1.0 million in 2005. Management expects to incur conversion costs of $2.5 million.  $1.7 million of the conversion costs will be amortized over the life of the contract.  Bankshares also expects to incur exit costs of approximately $1.2 million in the second half of 2004.

 

17



 

CONSOLIDATED RESULTS

Net Interest Income and Net Interest Margin

 

Analysis of Interest Rates and Interest Differentials

The following table presents the distribution of the average consolidated balance sheet, interest income/expense and annualized yields earned and rates paid through the six months ended June 30, 2004 and 2003.

 

 

 

For the 6 Months Ended
June 30, 2004

 

For the 6 Months Ended
June 30, 2003

 

(Dollars in thousands)

 

Average
Balance

 

Income*/
Expense

 

Yield*/
Rate

 

Average
Balance

 

Income*/
Expense

 

Yield*/
Rate

 

Earning assets

 

 

 

 

 

 

 

 

 

 

 

 

 

Loans:**

 

 

 

 

 

 

 

 

 

 

 

 

 

Commercial

 

$

2,679,828

 

$

68,399

 

5.13

%

$

2,401,370

 

$

67,224

 

5.65

%

Commercial real estate

 

2,820,197

 

82,304

 

5.87

 

2,087,406

 

65,616

 

6.34