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 March 31, 2005

 

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 April 29, 2005,  79,491,610 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)

 

March 31,
2005

 

December 31,
2004

 

March 31,
2004

 

ASSETS

 

 

 

 

 

 

 

Cash and due from banks

 

$

304,969

 

$

244,875

 

$

296,077

 

Interest-bearing deposits in other banks

 

158

 

158

 

158

 

Federal funds sold

 

26,901

 

101

 

353,893

 

Total cash and cash equivalents

 

332,028

 

245,134

 

650,128

 

Investment securities available-for-sale (Note 4)

 

2,807,721

 

2,908,694

 

3,006,218

 

Investment securities held-to-maturity (Note 4) fair value of $20,371 (2005), $21,094 (December 2004) and $28,436 (March 2004)

 

19,704

 

20,176

 

26,555

 

Total investment securities

 

2,827,425

 

2,928,870

 

3,032,773

 

Loans held-for-sale

 

24,341

 

11,000

 

38,741

 

Loans:

 

 

 

 

 

 

 

Commercial

 

2,797,435

 

2,813,325

 

2,566,692

 

Commercial real estate

 

3,180,853

 

3,122,701

 

2,836,846

 

Construction

 

1,347,365

 

1,268,350

 

1,105,346

 

Residential real estate

 

1,543,778

 

1,486,106

 

1,387,647

 

Consumer

 

1,487,040

 

1,484,583

 

1,473,491

 

Lease financing

 

56,751

 

53,368

 

64,398

 

Total loans

 

10,413,222

 

10,228,433

 

9,434,420

 

Less: allowance for loan losses

 

(149,017

)

(149,002

)

(156,635

)

Loans, net

 

10,264,205

 

10,079,431

 

9,277,785

 

Bank premises and equipment, less accumulated depreciation of $144,515 (2005), $142,384 (December 2004) and $154,468 (March 2004)

 

141,135

 

139,946

 

141,482

 

Other real estate owned, net

 

145

 

212

 

134

 

Goodwill

 

507,791

 

507,791

 

522,226

 

Other intangible assets, net (Note 7)

 

46,122

 

48,226

 

54,223

 

Other assets

 

484,641

 

465,080

 

424,890

 

Total assets

 

$

14,627,833

 

$

14,425,690

 

$

14,142,382

 

LIABILITIES

 

 

 

 

 

 

 

Deposits:

 

 

 

 

 

 

 

Noninterest-bearing deposits

 

$

3,098,666

 

$

3,049,031

 

$

2,769,189

 

Interest-bearing deposits

 

7,872,610

 

7,750,168

 

7,774,398

 

Total deposits

 

10,971,276

 

10,799,199

 

10,543,587

 

Short-term borrowings

 

856,963

 

887,857

 

904,327

 

Accrued expenses and other liabilities

 

179,747

 

129,996

 

149,052

 

Long-term debt

 

681,331

 

690,955

 

657,411

 

Total liabilities

 

12,689,317

 

12,508,007

 

12,254,377

 

COMMITMENTS and CONTINGENCIES (Note 6)

 

 

 

 

 

 

 

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 - 79,485,853 (2005), 79,300,506 (December 2004) and 79,974,797 (March 2004); restricted shares - 168,930 (2005), 143,528 (December 2004) and 140,167 (March 2004)

 

158,972

 

158,601

 

159,950

 

Capital surplus

 

538,075

 

530,705

 

553,955

 

Retained earnings

 

1,264,634

 

1,231,102

 

1,139,360

 

Accumulated other comprehensive income (loss)

 

(23,165

)

(2,725

)

34,740

 

Total shareholders’ equity

 

1,938,516

 

1,917,683

 

1,888,005

 

Total liabilities and shareholders’ equity

 

$

14,627,833

 

$

14,425,690

 

$

14,142,382

 

 

See notes to consolidated financial statements

 

2



 

MERCANTILE BANKSHARES CORPORATION

STATEMENTS OF CONSOLIDATED INCOME

 

 

 

For the 3 months ended
March 31,

 

(Dollars in thousands, except per share data)

 

2005

 

2004

 

INTEREST INCOME

 

 

 

 

 

Interest and fees on loans

 

$

152,544

 

$

129,129

 

Interest and dividends on investment securities:

 

 

 

 

 

Taxable interest income

 

24,992

 

27,401

 

Tax-exempt interest income

 

721

 

877

 

Other investment income

 

644

 

333

 

Total interest and dividends on investment securities

 

26,357

 

28,611

 

Other interest income

 

344

 

106

 

Total interest income

 

179,245

 

157,846

 

INTEREST EXPENSE

 

 

 

 

 

Interest on deposits

 

25,305

 

20,767

 

Interest on short-term borrowings

 

4,042

 

1,419

 

Interest on long-term debt

 

6,815

 

5,255

 

Total interest expense

 

36,162

 

27,441

 

NET INTEREST INCOME

 

143,083

 

130,405

 

Provision for loan losses

 

756

 

2,426

 

NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES

 

142,327

 

127,979

 

NONINTEREST INCOME

 

 

 

 

 

Investment and wealth management

 

24,057

 

21,983

 

Service charges on deposit accounts

 

10,426

 

10,692

 

Mortgage banking-related fees

 

2,283

 

2,940

 

Investment securities gains and (losses), net

 

414

 

(55

)

Nonmarketable investments

 

5,271

 

4,204

 

Other income

 

15,418

 

13,390

 

Total noninterest income

 

57,869

 

53,154

 

NONINTEREST EXPENSES

 

 

 

 

 

Salaries

 

46,554

 

44,788

 

Employee benefits

 

11,897

 

12,513

 

Net occupancy expense of bank premises

 

6,922

 

6,060

 

Furniture and equipment expenses

 

7,279

 

7,364

 

Communications and supplies

 

4,040

 

4,304

 

Other expenses

 

23,461

 

18,357

 

Total noninterest expenses

 

100,153

 

93,386

 

Income before income taxes

 

100,043

 

87,747

 

Applicable income taxes

 

37,416

 

32,050

 

NET INCOME

 

$

62,627

 

$

55,697

 

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

 

 

 

 

 

Basic

 

$

0.79

 

$

0.70

 

Diluted

 

$

0.78

 

$

0.69

 

DIVIDENDS PAID PER COMMON SHARE

 

$

0.35

 

$

0.33

 

 

See notes to consolidated financial statements

 

3



 

MERCANTILE BANKSHARES CORPORATION

STATEMENTS OF CHANGES IN CONSOLIDATED SHAREHOLDERS’ EQUITY

 

For the 3 months ended March 31, 2005 and 2004

 

(Dollars in thousands, except per share data)

 

Total

 

Common
Stock

 

Capital
Surplus

 

Retained
Earnings

 

Accumulated Other
Comprehensive
Income (Loss)

 

BALANCE, DECEMBER 31, 2003

 

$

1,841,441

 

$

159,545

 

$

548,664

 

$

1,110,748

 

$

22,484

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

55,697

 

 

 

 

 

55,697

 

 

 

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

 

12,256

 

 

 

 

 

 

 

12,256

 

Comprehensive income

 

67,953

 

 

 

 

 

 

 

 

 

Cash dividends paid:

 

 

 

 

 

 

 

 

 

 

 

Common stock ($.33 per share)

 

(26,335

)

 

 

 

 

(26,335

)

 

 

Issuance of 31,674 shares for dividend reinvestment and stock purchase plan

 

1,298

 

63

 

1,235

 

 

 

 

 

Issuance of 5,873 shares for employee stock purchase dividend reinvestment plan

 

257

 

12

 

245

 

 

 

 

 

Issuance of 138,251 shares for employee stock option plan

 

2,431

 

277

 

2,154

 

 

 

 

 

Restricted stock awards

 

 

 

 

 

 

 

 

 

 

 

Issuance of 26,294 shares

 

1,199

 

53

 

1,146

 

 

 

 

 

Deferred compensation

 

(1,263

)

 

 

 

 

(1,263

)

 

 

Amortization

 

513

 

 

 

 

 

513

 

 

 

Vested stock options

 

511

 

 

511

 

 

 

BALANCE, MARCH 31, 2004

 

$

1,888,005

 

$

159,950

 

$

553,955

 

$

1,139,360

 

$

34,740

 

 

 

 

 

 

 

 

 

 

 

 

 

BALANCE, DECEMBER 31, 2004

 

$

1,917,683

 

$

158,601

 

$

530,705

 

$

1,231,102

 

$

(2,725

)

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

62,627

 

 

 

 

 

62,627

 

 

 

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

 

(20,440

)

 

 

 

 

 

 

(20,440

)

Comprehensive income

 

42,187

 

 

 

 

 

 

 

 

 

Cash dividends paid:

 

 

 

 

 

 

 

 

 

 

 

Common stock ($.35 per share)

 

(27,750

)

 

 

 

 

(27,750

)

 

 

Issuance of 26,355 shares for dividend reinvestment and stock purchase plan

 

1,278

 

53

 

1,225

 

 

 

 

 

Issuance of 5,441 shares for employee stock purchase dividend reinvestment plan

 

273

 

11

 

262

 

 

 

 

 

Issuance of 115,703 shares for employee stock option plan

 

1,519

 

231

 

1,288

 

 

 

 

 

Directors’ deferred compensation plan:

 

 

 

 

 

 

 

 

 

 

 

Issuance of 884 shares

 

 

2

 

(2

)

 

 

 

 

Contribution

 

202

 

 

 

202

 

 

 

 

 

Dividend

 

 

 

 

60

 

(60

)

 

 

Restricted stock awards

 

 

 

 

 

 

 

 

 

 

 

Issuance of 36,964 shares

 

1,890

 

74

 

1,816

 

 

 

 

 

Deferred compensation

 

(1,938

)

 

 

 

 

(1,938

)

 

 

Amortization

 

653

 

 

 

 

 

653

 

 

 

Vested stock options

 

2,519

 

 

2,519

 

 

 

BALANCE, MARCH 31, 2005

 

$

1,938,516

 

$

158,972

 

$

538,075

 

$

1,264,634

 

$

(23,165

)

 

See notes to consolidated financial statements

 

4



 

MERCANTILE BANKSHARES CORPORATION

STATEMENTS OF CONSOLIDATED CASH FLOWS

 

Increase (decrease) in cash and cash equivalents

 

For the 3 months ended March 31,

 

(Dollars in thousands)

 

2005

 

2004

 

CASH FLOWS FROM OPERATING ACTIVITIES:

 

 

 

 

 

Net income

 

$

62,627

 

$

55,697

 

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

 

 

 

 

 

Provision for loan losses

 

756

 

2,426

 

Depreciation

 

3,714

 

3,900

 

Amortization of other intangible assets

 

2,072

 

2,032

 

Investment securities (gains) / losses

 

(414

)

55

 

Income of investments in private equity funds

 

(2,181

)

(141

)

Write-downs of other real estate owned

 

1

 

 

Gains on sales of other real estate owned

 

(125

)

(13

)

Gains on sales of premises

 

(1,147

)

(564

)

Net (increase) decrease in assets:

 

 

 

 

 

Interest receivable

 

(5,796

)

(1,939

)

Other receivables

 

363

 

2,991

 

Bank-owned life insurance

 

(951

)

(794

)

Other assets

 

(6,615

)

(11,126

)

Loans held-for-sale

 

(13,341

)

(23,816

)

Net increase (decrease) in liabilities:

 

 

 

 

 

Interest payable

 

8,268

 

6,052

 

Accrued expenses

 

19,969

 

(25,110

)

Taxes payable

 

24,441

 

37,273

 

Net cash provided by operating activities

 

91,641

 

46,923

 

CASH FLOWS FROM INVESTING ACTIVITIES:

 

 

 

 

 

Proceeds from maturities of investment securities held-to-maturity

 

472

 

1,658

 

Proceeds from maturities of investment securities available-for-sale

 

219,959

 

297,156

 

Proceeds from sales of investment securities available-for-sale

 

15,997

 

8

 

Purchases of investment securities held-to-maturity

 

 

(4,765

)

Purchases of investment securities available-for-sale

 

(167,201

)

(244,497

)

Net increase in customer loans

 

(185,665

)

(163,394

)

Proceeds from sales of other real estate owned

 

191

 

75

 

Capital expenditures

 

(5,619

)

(702

)

Proceeds from sales of premises

 

2,075

 

1,169

 

Purchases of private equity funds

 

(1,458

)

(183

)

Net cash used in investing activities

 

(121,249

)

(113,475

)

CASH FLOWS FROM FINANCING ACTIVITIES:

 

 

 

 

 

Net increase in noninterest-bearing deposits

 

49,635

 

18,468

 

Net increase in checking plus interest and savings accounts

 

38,811

 

268,332

 

Net increase (decrease) in certificates of deposit

 

83,631

 

(5,766

)

Net (decrease) increase in short-term borrowings

 

(30,894

)

95,306

 

Repayment of long-term debt

 

(1

)

(12

)

Proceeds from issuance of shares

 

3,070

 

3,986

 

Dividends paid

 

(27,750

)

(26,335

)

Net cash provided by financing activities

 

116,502

 

353,979

 

Net increase in cash and cash equivalents

 

86,894

 

287,427

 

Cash and cash equivalents at beginning of period

 

245,134

 

362,701

 

Cash and cash equivalents at end of period

 

$

332,028

 

$

650,128

 

SUPPLEMENTAL INFORMATION

 

 

 

 

 

Cash payments for interest

 

$

27,894

 

$

21,389

 

Cash payments for income taxes

 

13,226

 

2,579

 

 

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 / Restructuring

 

The following provides information concerning acquisitions and restructurings. Acquisitions are accounted for as purchases with the results of their operations subsequent to the acquisition date to be included in Bankshares’ Statements of Consolidated Income.

 

In 2004, Bankshares initiated a significant reorganization within its Community Banking network.  In a move designed to create banks of sufficient size and depth to compete more effectively today and in the future, Bankshares combined 11 affiliate banks to create four new organizations, all with a more prominent Mercantile identity. This reorganization has enabled Bankshares to operate more effectively and efficiently in the face of increased competitive and regulatory pressures.  Fewer, larger banks allow better leverage of our branch network, reduce administrative and operational redundancies and increase the breadth and depth of expertise within our Community Banks. All banks that were combined are geographically contiguous, share increasingly common market dynamics and offer the opportunity to create scale efficiencies. In 2004, Bankshares accrued approximately $2.3 million in restructuring charges due to this reorganization. The majority of these costs were in severance charges. At March 31, 2005, $1.4 million remains to be paid.

 

On January 25, 2005, Bankshares, Mercantile-Safe Deposit and Trust Company, a wholly owned subsidiary of Bankshares and a Maryland Bank (“MSD&T”), and Community Bank of Northern Virginia, a Virginia Bank (“CBNV”) entered into an Agreement and Plan of Merger. At December 31, 2004, CBNV had $880 million in assets, $654 million in gross loans and $649 million in deposits. The merger, which is subject to CBNV shareholder approval and certain bank regulatory approvals, among other conditions, is expected to be completed by the end of the second quarter of 2005. CBNV will hold a special meeting of shareholders of CBNV on May 16, 2005, to approve the merger. For the quarter ended March 31, 2005, Bankshares expensed merger-related costs totaling $0.3 million. These costs were included in noninterest expenses.

 

At the effective time and as a result of the Merger, each outstanding share of CBNV’s common stock (the “Bank Shares”) will be converted into the right to receive either (i) $20.375 in cash without interest (the “Cash Election Price”), or (ii) .4005 of Bankshares’ common stock (the “Exchange Ratio,” and together with the cash Election Price, the “Merger Consideration”). Each shareholder of CBNV will be entitled to elect the number of its Bank Shares to be exchanged for the Cash Election Price or to make no election, subject to a proration which will provide that the aggregate Merger Consideration exchanged for Bank Shares outstanding at the closing of the Merger will be allocated as 40% cash and 60% Bankshares’ common stock. The Merger is anticipated to be tax free to the shareholders of CBNV, as to the portion of the Merger Consideration received as Bankshares common stock. Outstanding CBNV stock options will be converted into stock options of Bankshares.

 

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 options, restricted stock awards and vested directors’ deferred compensation plan shares.  The following tables provide reconciliation between the computation of basic EPS and diluted EPS for the three months ended March 31, 2005 and 2004, respectively.

 

 

 

For the 3 months ended March 31,

 

2005 (In thousands, except per share data)

 

Net
Income

 

Weighted Average
Common Shares

 

EPS

 

Basic EPS

 

$

62,627

 

79,228

 

$

0.79

 

Dilutive effect of:

 

 

 

 

 

 

 

Stock options and restricted stock awards

 

 

 

479

 

 

 

Vested directors’ deferred compensation plan shares

 

 

 

168

 

 

 

Diluted EPS

 

$

62,627

 

79,875

 

$

0.78

 

 

 

 

 

 

 

 

 

 

 

For the 3 months ended March 31,

 

2004 (In thousands, except per share data)

 

Net
Income

 

Weighted Average
Common Shares

 

EPS

 

Basic EPS

 

$

55,697

 

79,725

 

$

0.70

 

Dilutive effect of:

 

 

 

 

 

 

 

Stock options and restricted stock awards

 

 

 

533

 

 

 

Diluted EPS

 

$

55,697

 

80,258

 

$

0.69

 

 

Antidilutive options and awards excluded from the computation of diluted earnings per share were 116,565 and 298,319 for the three months ended March 31, 2005 and 2004, respectively.

 

4. Investment Securities

 

At both periods presented, securities with an amortized cost of $1.1 billion were pledged as collateral for certain deposits as required.

 

The amortized cost and fair value of investment securities at March 31, 2005 and December 31, 2004 are shown below:

 

 

 

March 31, 2005

 

December 31, 2004

 

(Dollars in thousands)

 

Amortized
Cost

 

Gross
Unrealized
Gains

 

Gross
Unrealized
Losses

 

Fair
Value

 

Amortized
Cost

 

Gross
Unrealized
Gains

 

Gross
Unrealized
Losses

 

Fair
Value

 

Investment securities held-to-maturity

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

States and political subdivisions

 

$

19,704

 

$

683

 

$

16

 

$

20,371

 

$

20,176

 

$

921

 

$

3

 

$

21,094

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Investment securities available-for-sale

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

U.S. Treasury

 

$

521,307

 

$

1,511

 

$

2,487

 

$

520,331

 

$

605,505

 

$

4,534

 

$

980

 

$

609,059

 

U.S. Government agencies

 

875,677

 

1,329

 

11,246

 

865,760

 

853,930

 

3,742

 

4,699

 

852,973

 

Mortgage-backed securities

 

1,326,104

 

1,322

 

28,148

 

1,299,278

 

1,326,056

 

4,372

 

13,127

 

1,317,301

 

States and political subdivisions

 

60,405

 

433

 

88

 

60,750

 

61,984

 

917

 

31

 

62,870

 

Other investments

 

60,969

 

851

 

218

 

61,602

 

65,323

 

1,294

 

126

 

66,491

 

Total

 

$

2,844,462

 

$

5,446

 

$

42,187

 

$

2,807,721

 

$

2,912,798

 

$

14,859

 

$

18,963

 

$

2,908,694

 

 

At March 31, 2005, there were $328.3 million of individual securities that had unrealized losses for a period greater than 12 months. At March 31, 2005, these securities had an unrealized loss of $14.8 million of which 93.4% were mortgage-backed securities. Management has assessed the impairment of these securities and determined that the impairment is temporary. All principal and interest payments on available-for-sale debt securities in an unrealized loss position for greater than 12 months are expected to be collected given the high credit quality of the U.S. government agency debt securities and Bankshares ability and intent to hold the securities until such time as the value recovers or they mature.

 

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 on a timely basis.

 

Under Statements of Financial Accounting Standards (SFAS) Nos. 114 and 118, “Accounting by Creditors for Impairment of a Loan-an amendment of FASB Statements Nos. 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. 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 March 31, 2005, December 31, 2004 and March 31, 2004 is shown below.  See Annual Report on Form 10-K for more detail.

 

(Dollars in thousands)

 

March 31,
2005

 

December 31,
2004

 

March 31,
2004

 

Impaired loans with a specific valuation allowance

 

$

17,188

 

$

18,365

 

$

25,971

 

All other impaired loans

 

11,592

 

9,113

 

16,508

 

Total impaired loans

 

$

28,780

 

$

27,478

 

$

42,479

 

 

 

 

 

 

 

 

 

Specific allowance for loan losses applicable to impaired loans

 

$

10,437

 

$

10,611

 

$

14,094

 

General allowance for loan losses applicable to other than impaired loans

 

138,580

 

138,391

 

142,541

 

Total allowance for loan losses

 

$

149,017

 

$

149,002

 

$

156,635

 

 

 

 

 

 

 

 

 

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

 

$

23

 

$

379

 

$

103

 

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

 

$

28,780

 

$

39,025

 

$

42,479

 

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

 

$

23

 

$

79

 

$

103

 

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

 

$

28,780

 

$

35,583

 

$

42,479

 

 

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 and Contingencies

 

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 $4.4 billion at March 31, 2005, $4.2 billion at December 31, 2004, and $3.6 billion at March 31, 2004.

 

Letters of credit are commitments issued to guarantee the performance of a customer to a third party. Outstanding letters of credit were $401.7 million at March 31, 2005, $379.8 million at December 31, 2004 and $303.3 million at March 31, 2004.  Fees received for issuing letters of credit are deferred and amortized over the life of the commitment.  The unamortized fees on letters of credit at March 31, 2005, December 31, 2004, and March 31, 2004 had a carrying value of $1.4 million, $1.3 million and $1.1 million, respectively.

 

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

 

8



 

totaled $220.9 million, $190.7 million and $148.6 million at March 31, 2005, December 31, 2004 and March 31, 2004, respectively.  No loss reserve has been established for potential 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 March 31, 2005.  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 $1.6 million at March 31, 2005, $1.7 million at December 31, 2004 and $2.2 million at March 31, 2004.  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 March 31, 2005, December 31, 2004 and March 31, 2004, $32.5 million, $28.9 million and $20.9 million, respectively, remained unfunded.

 

In the ordinary course of business, Bankshares and its subsidiaries are involved in a number of pending and threatened legal actions and proceedings. In certain of these actions and proceedings, claims for substantial monetary damages are asserted against Bankshares and its subsidiaries. In view of the inherent difficulty of predicting the outcome of such matters, Bankshares cannot state what the eventual outcome of pending matters will be. However, based on current knowledge, management does not believe that liabilities, if any, arising from pending litigation matters, will have a material adverse effect on the consolidated financial position or liquidity of Bankshares. If payment associated with a claim becomes probable and the cost can be reasonably estimated, a contingent liability would be established based on information currently available, advice of counsel and available insurance coverage.

 

As previously disclosed, on July 12, 2004, former employee John Pileggi filed a lawsuit against Mercantile Bankshares Corporation (“Bankshares”), Mercantile-Safe Deposit and Trust Company (“MSD&T”) and Edward J. Kelly, III, Chairman and CEO of Bankshares alleging that the public statements made by the defendants regarding the circumstances of Mr. Pileggi’s termination gave rise to claims of libel, invasion of privacy and false light. Mr. Pileggi also alleged breach of his employment contract and made a claim pursuant to a change-in-control agreement. The complaint sought actual and punitive damages amounting to in excess of $240 million.

 

On September 27, 2004, Bankshares filed a countersuit against Mr. Pileggi alleging that during his employment, Mr. Pileggi engaged in activities that constituted fraud, breach of contract, and breach of his fiduciary duty. The countersuit sought compensatory and punitive damages amounting to $8.2 million.

 

On March 30, 2005, Bankshares, MSD&T, Mr. Kelly and Mr. Pileggi agreed to dismiss all claims and provide full releases from any future claims. In addition, Mercantile has agreed to pay Mr. Pileggi $1.3 million in respect of Mr. Pileggi’s employment contract and certain related benefits. Mercantile also has agreed, subject to certain conditions, to pay a portion of the legal fees incurred by Mr. Pileggi.

 

7. Other Intangible Assets

 

The following table discloses the gross carrying amount and accumulated amortization of intangible assets subject to amortization at March 31, 2005 and December 31, 2004:

 

 

 

March 31, 2005

 

December 31, 2004

 

(Dollars in thousands)

 

Gross carrying
amount

 

Accumulated
amortization

 

Net
amount

 

Gross carrying
amount

 

Accumulated
amortization

 

Net
amount

 

Core deposits

 

$

49,881

 

$

(16,380

)

$

33,501

 

$

49,881

 

$

(15,014

)

$

34,867

 

Mortgage servicing

 

1,338

 

(1,072

)

266

 

1,370

 

(1,013

)

357

 

Customer lists and other

 

17,010

 

(4,655

)

12,355

 

17,010

 

(4,008

)

13,002

 

Total

 

$

68,229

 

$

(22,107

)

$

46,122

 

$

68,261

 

$

(20,035

)

$

48,226

 

 

Identifiable intangible assets are amortized based on estimated lives of up to 15 years. 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 flows is less than the carrying amount of the asset. Impairment is recognized by writing down the carrying value or adjusting the estimated life of the asset. Any impairment recognized in a valuation account is reflected in the income statement in the corresponding period.

 

The following table shows the current period and estimated future amortization expense for amortized intangible assets. The projections of amortization expense shown for mortgage servicing rights are based on asset balances and the interest rate environment as of March 31, 2005. Future amortization expense may be significantly different depending upon changes in the mortgage servicing portfolio, mortgage interest rates and market conditions.

 

9



 

(Dollars in thousands)

 

 

 

Core
deposits

 

Mortgage
servicing

 

Customer lists
and other

 

Total

 

Three months ended March 31, 2005 (actual)

 

 

 

$

1,367

 

$

54

 

$

651

 

$

2,072

 

Nine months ended December 31, 2005 (estimated)

 

 

 

4,100

 

74

 

1,939

 

6,113

 

Twelve months ended December 31, 2005 (estimated)

 

 

 

5,467

 

128

 

2,590

 

8,185

 

 

 

 

 

 

 

 

 

 

 

 

 

Estimate for year ended December 31,

 

2006

 

5,467

 

99

 

2,343

 

7,909

 

 

 

2007

 

5,209

 

39

 

2,149

 

7,397

 

 

 

2008

 

4,344

 

 

 

1,966

 

6,310

 

 

 

2009

 

4,020

 

 

 

1,028

 

5,048

 

 

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 quarters ended March 31, 2005 and 2004, respectively.  The total comprehensive income is included in the Statements of Changes in Consolidated Shareholders’ Equity.

 

 

 

For the 3 months ended March 31,

 

(Dollars in thousands)

 

2005

 

2004

 

Net income

 

$

62,627

 

$

55,697

 

Other comprehensive income, net of taxes:

 

 

 

 

 

Unrealized holding (losses) gains arising during the period

 

(20,190

)

12,223

 

Reclassification adjustment for (gains) losses included in net income

 

(250

)

33

 

Total

 

$

42,187

 

$

67,953

 

 

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 March 31, 2005, Bankshares and each 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 and Trust Company (MSD&T), the lead bank, as of March 31, 2005 and December 31, 2004.

 

 

 

March 31, 2005

 

December 31, 2004

 

(Dollars in thousands)

 

Bankshares

 

MSD&T

 

Bankshares

 

MSD&T

 

 

 

 

 

 

 

 

 

 

 

Tier I capital

 

$

1,412,974

 

$

419,288

 

$

1,370,112

 

$

411,587

 

Total risk-based capital

 

1,844,629

 

467,357

 

1,802,520

 

459,812

 

Net risk-weighted assets

 

11,323,077

 

3,839,217

 

11,109,137

 

3,847,161

 

Adjusted average total assets

 

13,873,772

 

4,669,943

 

13,674,386

 

4,504,451

 

 

 

 

 

 

 

 

 

 

 

Tier I capital ratio

 

12.48

%

10.92

%

12.33

%

10.70

%

Total capital ratio

 

16.29

%

12.17

%

16.23

%

11.95

%

Leverage ratio

 

10.18

%

8.98

%

10.02

%

9.14

%

 

Bankshares has an ongoing share repurchase program.  Purchases may be made from time to time, subject to regulatory requirements, in open market or in privately negotiated transactions. Purchased shares are retired. At March 31, 2005, there were 476,327 shares remaining available for repurchase under the plan.

 

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 two reportable segments – Banking and Investment and Wealth Management  (“IWM”).

 

The following tables present selected segment information for the three months ended March 31, 2005 and 2004. The components in the “Other” column consist of amounts for the nonbank affiliates, unallocated corporate expenses including income taxes 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.

 

 

 

For the 3 months ended March 31, 2005

 

(Dollars in thousands)

 

Banking

 

IWM

 

Other

 

Total

 

Net interest income

 

$

143,094

 

$

 

$

(11

)

$

143,083

 

Provision for loan losses

 

(756

)

 

 

(756

)

Noninterest income

 

29,491

 

24,313

 

4,065

 

57,869

 

Noninterest expenses

 

(80,451

)

(16,846

)

(2,856

)

(100,153

)

Adjustments

 

3,929

 

(1,209

)

(2,720

)

 

Income (loss) before income taxes

 

95,307

 

6,258

 

(1,522

)

100,043

 

Income tax (expense) benefit

 

(33,047

)

(2,506

)

(1,863

)

(37,416

)

Net income (loss)

 

$

62,260

 

$

3,752

 

$

(3,385

)

$

62,627

 

Average loans

 

$

10,313,937

 

 

 

$

424

 

$

10,314,361

 

Average earning assets

 

13,199,433

 

 

 

21,734

 

13,221,167

 

Average assets

 

14,348,599

 

 

 

159,745

 

14,508,344

 

Average deposits

 

10,903,318

 

 

 

(184,584

)

10,718,734

 

Average equity

 

1,805,588

 

 

 

144,688

 

1,950,276

 

 

 

 

For the 3 months ended March 31, 2004

 

(Dollars in thousands)

 

Banking

 

IWM

 

Other

 

Total

 

Net interest income

 

$

130,345

 

$

 

$

60

 

$

130,405

 

Provision for loan losses

 

(2,426

)

 

 

(2,426

)

Noninterest income

 

27,095

 

22,382

 

3,677

 

53,154

 

Noninterest expenses

 

(75,527

)

(17,379

)

(480

)

(93,386

)

Adjustments

 

3,231

 

(796

)

(2,435

)

 

Income (loss) before income taxes

 

82,718

 

4,207

 

822

 

87,747

 

Income tax (expense) benefit

 

(29,046

)

(1,683

)

(1,321

)

(32,050

)

Net income (loss)

 

$

53,672

 

$

2,524

 

$

(499

)

$

55,697

 

Average loans

 

$

9,338,236

 

 

 

$

197

 

$

9,338,433

 

Average earning assets

 

12,348,307

 

 

 

23,886

 

12,372,193

 

Average assets

 

13,069,701

 

 

 

548,492

 

13,618,193

 

Average deposits

 

10,138,846

 

 

 

(72,201

)

10,066,645

 

Average equity

 

1,373,147

 

 

 

475,314

 

1,848,461

 

 

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.  Currently, 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 March 31, 2005, Bankshares has interest rate swaps to convert a portion of its nonprepayable fixed-rate debt to floating-rate debt.  Bankshares also arranges interest rate swaps, caps and swaptions for commercial loan customers through its capital markets group.  Derivative transactions done with loan customers are hedged by means of an off-setting derivative trade with a third party.  In this way, Bankshares manages the market risk arising from capital markets related derivative activity.

 

The fair value of derivative instruments relating to hedging activities recorded in other assets was $1.6 million (notional $261.2 million) and $7.1 million (notional $294.5 million) at March 31, 2005 and December 31, 2004, respectively.  The fair value of derivative instruments relating to hedging activities recorded in other liabilities was $10.0 million (notional $175.7 million) and $6.8 million (notional $136.0 million) at March 31, 2005 and December 31, 2004, respectively.

 

Changes in the fair value of a derivative that is designated and qualifies as a fair value hedge, along with the gain or loss on the hedged asset or liability that is attributable to the hedged risk, are recorded as other noninterest income in the results of operations. For all hedge relationships, ineffectiveness resulting from differences between the changes in fair values or cash flows of the hedged item and changes in fair value of the derivative are recognized as other noninterest income in the results of operations. The net interest settlement on derivatives designated as fair value or cash flow hedges is treated as an adjustment of the interest income or interest expense of the hedged assets or liabilities. The fair-value hedges of nonprepayable fixed-rate debt were effective for the reported periods. The impact of the hedges decreased interest expense $1.6 million in the first three months of 2005 and $2.8 million for the same period in 2004.

 

The following tables summarize the gross position of derivatives relating to hedging activities at March 31, 2005 and December 31, 2004:

 

 

 

March 31, 2005

 

December 31, 2004

 

 

 

Notional or

 

Credit

 

Estimated

 

Notional or

 

Credit

 

Estimated

 

 

 

Contractual

 

Risk

 

Net

 

Contractual

 

Risk

 

Net

 

(Dollars in thousands)

 

Amount

 

Amount (1)

 

Fair Value

 

Amount

 

Amount (1)

 

Fair Value

 

Asset/Liability Management Hedges

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest Rate Contracts:

 

 

 

 

 

 

 

 

 

 

 

 

 

Swaps

 

$

350,000

 

$

4,082

 

$

(9,021

)

$

350,000

 

$

6,297

 

$

(143

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Customer Accommodations

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest Rate Contracts:

 

 

 

 

 

 

 

 

 

 

 

 

 

Swaps

 

$

75,024

 

$

826

 

$

632

 

$

68,575

 

$

684

 

$

398

 

Swaptions/Caps Purchased

 

5,941

 

68

 

68

 

5,971

 

80

 

80

 

Swaptions/Caps Sold

 

5,941

 

 

(68

)

5,971

 

 

(80

)

 


(1)          Credit risk amounts reflect the replacement cost for those contracts in a gain position in the event of nonperformance by all counterparties.

 

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 has forward commitments to sell and fund individual fixed-rate and variable-rate mortgage loans that are reported at fair value. The fair value of the forward contracts was $1.5 million at March 31, 2005 and $1.2 million at December 31, 2004.

 

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 measured under the fair value method and 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. This plan requires that substantially all deferred fees be settled in Bankshares’ stock. The compensation cost for the phantom stock is included in other expenses.  Employee stock-based compensation amounts, included in salaries expense, for the quarters ended March 31, 2005 and 2004, respectively, are summarized in the following table:

 

 

 

For the 3 months ended March 31

 

(Dollars in thousands)

 

2005

 

2004

 

Stock options expense

 

$

713

 

$

406

 

Restricted stock awards expense

 

642

 

487

 

Included in salaries expense

 

$

1,355

 

$

893

 

 

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 three months ended March 31, 2005 and 2004, respectively.

 

 

 

For the 3 months ended March 31, 2005

 

For the 3 months ended March 31, 2004

 

(Dollars in thousands)

 

Qualified

 

Nonqualified

 

Total

 

Qualified

 

Nonqualified

 

Total

 

Service cost

 

$

1,778

 

$

165

 

$

1,943

 

$

1,572

 

$

141

 

$

1,713

 

Interest cost

 

2,813

 

35

 

2,848

 

2,549

 

101

 

2,650

 

Expected return on plan assets

 

(4,138

)

 

(4,138

)

(3,845

)

 

(3,845

)

Amortization of prior service cost

 

300

 

 

300

 

195

 

6

 

201

 

Recognized net actuarial (gain) loss

 

350

 

 

350

 

153

 

29

 

182

 

Amortization of transition asset

 

 

 

 

 

24

 

24

 

Net periodic benefit cost

 

$

1,103

 

$

200

 

$

1,303

 

$

624

 

$

301

 

$

925

 

 

The following table summarizes the components of the net periodic benefit cost for the other postretirement benefit plans for the three months ended March 31, 2005 and 2004, respectively.

 

 

 

For the 3 months ended March 31,

 

(Dollars in thousands)

 

2005

 

2004

 

Service cost

 

$

133

 

$

65

 

Interest cost

 

249

 

214

 

Expected return on plan assets

 

 

 

Amortization of prior service cost

 

 

 

Recognized net actuarial (gain) loss

 

88

 

38

 

Amortization of transition asset

 

 

 

Net periodic benefit cost

 

$

470

 

$

317

 

 

As previously disclosed in its financial statements for the year ended December 31, 2004, Bankshares generally makes cash contributions to the pension plan in amounts up to that permitted by guidelines established under employee benefit and tax laws after taking into consideration the funded status. If it is determined that there will be cash contributions, they are normally made after valuations have been finalized for the plan year and prior to the tax return filing date.  Bankshares does not anticipate making a contribution in 2005.

 

13



 

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 past practice where the allowance for loan losses was carried over in purchase accounting. The SOP is effective for loans acquired after December 15, 2004. Bankshares will utilize this SOP in evaluating the impact it will have on operations and financial statements with respect to Community Bank of Northern Virginia and will apply this SOP to any new acquisitions.

 

In November 2004, the Emerging Issues Task Force (“EITF”) published Issue 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” The Task Force discussed the meaning of other-than-temporary impairment and its application to certain investments carried at cost. The Task Force requested that the FASB staff consider other impairment models within U.S. GAAP when developing its views. The Task Force also requested that the scope of the impairment issue be expanded to include equity investments and investments subject to FASB Statement No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” and that that issue be addressed by the Task Force as a separate EITF issue. At the EITF meeting, the Task Force reached a consensus on one issue that certain quantitative and qualitative disclosures should be required for securities accounted for under Statement 115 that are impaired at the balance sheet date but for which an other-than-temporary impairment has not been recognized. The Board ratified the consensus on that one issue at its November 25, 2004 meeting. In September 2004, the Financial Accounting Standards Board (“FASB”) directed the FASB staff to issue two proposed FASB Staff Positions (“FSP”): Proposed FSP EITF Issue 03-1-a, which provides guidance for the application of paragraph 16 of EITF Issue 03-1 to debt securities that are impaired because of interest rate and/or sector spread increases, and Proposed FSP EITF Issue 03-1-b, which delays the effective date of Issue 03-1 for debt securities that are impaired because of interest rate and/or sector spread increases. The outcome of the proposed guidance under certain interpretations could have an adverse impact on Bankshares’ capital and earnings as it relates to securities deemed impaired within the available-for-sale investment portfolio. Bankshares cannot determine the potential impact until the FASB finalizes the proposed statement.

 

In December 2004, the FASB issued Statement No. 123 (Revised 2004) SFAS No. 123R, “Share-Based Payment,” which requires that the compensation cost relating to share-based payment transactions be recognized in financial statements. Share-based compensation arrangements include share options, restricted share plans, performance-based awards, share appreciation rights and employee share purchase plans. That cost will be measured based on the fair value of the equity or liability instruments issued. SFAS No. 123R replaces SFAS No. 123, “Accounting for Stock-Based Compensation,” and supersedes Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees.” SFAS No. 123 permitted entities the option of continuing to apply the guidance in Opinion 25, as long as the Notes to the financial statements disclosed what net income would have been had the preferable fair-value-based method been used. Bankshares’ adopted the cost recognition provision of SFAS No. 123, “Accounting for Stock-Based Compensation,” in 1995 and has been expensing compensation cost related to stock options. Bankshares does not anticipate this revision will have a material effect on the financial statements. On April 14, 2005, the Securities and Exchange Commission (SEC) approved a new rule that delays for public companies the effective date of SFAS No. 123R. Under the SEC’s rule SFAS, No. 123R is now effective for annual periods that begin after June 15, 2005.

 

14



 

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

 

MERCANTILE BANKSHARES CORPORATION

 

HIGHLIGHTS

 

Consolidated Financial Results

 

Net income for the quarter ended March 31, 2005 was $62.6 million, a 12.4% increase from net income of $55.7 million for the same period in 2004 and a 3.3% increase over the $60.6 million reported for the fourth quarter of 2004.  For the quarter ended March 31, 2005, diluted net income per share was $.78, an increase of 13.0% from the $.69 reported for the same period of last year and an increase of 2.6% from the $.76 reported for the fourth quarter of last year.  Adjusted weighted average shares outstanding decreased from 80.3 million for the quarter ended March 31, 2004, to 79.9 million for the quarter ended March 31, 2005.

 

Net interest income for the quarter ended March 31, 2005 increased 9.7% to $143.1 million from $130.4 million for the first quarter of last year.  The growth in net interest income was attributable to a 10.5% growth in average loans and a 14 basis point improvement in the net interest margin. Loan growth was solid in all categories, except for consumer loans which were up only slightly. The strongest growth was in average construction loans, which increased 20.4%. Twelve basis points of the improvement in the net interest margin was attributable to the effect of noninterest-bearing funds, which consist primarily of demand deposits and shareholders’ equity.

 

At March 31, 2005, nonperforming assets amounted to $31.4 million or 0.30% of period-end loans and other real estate owned, a decline from $48.1 million at March 31, 2004. Nonperforming assets were $31.1 million at December 31, 2004. The comparable nonperforming asset ratios were 0.51% and 0.30% at March 31, 2004 and December 31, 2004, respectively.  The level of “monitored” loans, or loans with characteristics suggesting that they could be classified as nonperforming in the near future, amounted to $2.2 million at March 31, 2005.  Monitored loans were $26.6 million at March 31, 2004 and $6.4 million at December 31, 2004. Nonperforming loans as a percentage of total loans remain at historic low levels.

 

Noninterest income, which includes investment and wealth management fees, service charges on deposit accounts, mortgage banking-related fees, securities gains and losses, nonmarketable investments income and other income, increased 8.9% to $57.9 million for the first quarter of 2005 from $53.2 million for the first quarter of 2004.

 

Noninterest expenses, which include salaries, employee benefits, net occupancy expense of bank premises, furniture and equipment expenses, communications and supplies and other expenses, increased by 7.2% for the quarter ended March 31, 2005 to $100.2 million from $93.4 million for the first quarter of 2004.

 

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 $63.1 million for the first quarter of 2005, an increase of 11.1% over the $56.8 million for the same period for 2004 and a 1.4% increase over the $62.2 million for the fourth quarter of 2004.  Diluted cash operating earnings per share for the first quarter of 2005 and 2004 were $.79 and $.71, respectively, and $.78 per share for the fourth quarter of 2004.  A reconciliation of net income (GAAP basis) to cash operating earnings can be found on page 34 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 more closely approximates the basis for measuring the adequacy of capital for regulatory purposes.  For the three months ended March 31, 2005, return on average assets was 1.75%, return on average tangible equity was 18.57% and average tangible equity to average tangible assets was 10.00%.  Comparable ratios for the three months ended March 31, 2004 were 1.64%, 18.01% and 9.75%, respectively.  A reconciliation of these ratios from their respective GAAP basis ratios can be found on page 34 of this filing.

 

15



 

SEGMENT REPORTING

 

As noted in Note No. 10 “Segment Reporting”, Bankshares report two business segments - Banking and Investment and Wealth Management (“IWM”) 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. Certain expense amounts, such as operations overhead, have been reclassified from internal financial reporting in order to provide for proper allocation of costs in the reported data. A schedule disclosing the details of these operating segments can be found in Note No. 10 of the financial statements.

 

Banking

 

The Banking segment consists of 13 affiliate banks. Mortgage banking activities are not viewed as a separate business line due to the insignificant impact on the core business of Bankshares and, accordingly, are included in the Banking segment.

 

In the second quarter of 2005, Bankshares will consolidate Fidelity Bank into Farmers and Mechanics. The consolidation of these banks allows the surviving banks to serve their local customers with greater size, scale and expertise. Also in the second quarter of 2005, Mercantile Potomac Bank will merge into Mercantile-Safe Deposit and Trust Company. This combination allows Bankshares to provide the resources necessary for the expansion into the Washington D.C. and Northern Virginia markets. The acquisition of Community Bank of Northern Virginia is also expected to occur in the second quarter and become a part of the Mercantile Potomac Division of Mercantile-Safe Deposit and Trust Company. Mercantile Potomac Bank and Fidelity Bank will continue to serve their respective markets under their own names with local leadership and local decision-making. The consolidations of Fidelity Bank into Farmers and Mechanics and Mercantile Potomac Bank into Mercantile-Safe Deposit and Trust Company and are both subject to regulatory approvals.

 

For the first quarter of 2005 compared with the first quarter of 2004 net income for Banking increased 16.0% to $62.3 million, from $53.7 million.  Net interest income for Banking increased 9.8% to $143.1 million for the three months ended March 31, 2005. The growth in net interest income in 2005 reflected a 6.9% increase in average earning assets, and a 14 basis point improvement in the net interest margin from 4.30% at March 31, 2004 to 4.44% at March 31, 2005. The increase in average loan balances of 10.4% for the first quarter of 2005 reflected strong growth in loans related to the real estate market. Commercial real estate loan balances increased 12.8%, residential real estate loan balances increased 11.6% and construction loan balances increased 20.4%. Commercial loan balances also reflected the improved economic environment with a 9.6% growth rate, while consumer loans remained flat and lease financings declined by 29.7%.  Average deposits included growth in noninterest-bearing, interest checking, savings accounts and time deposits greater than $100,000, offset by a reduction in balances associated with money market accounts and other time deposits in the first quarter of 2005, compared with the first quarter of 2004. The improvement in the net interest margin was primarily attributable to an 11 basis point improvement in the benefit provided by noninterest- bearing sources of funds.

 

As a reflection of the overall improvement in the Banking credit quality trends, there was a decrease of $1.7 million in the provision for loan losses for 2005. Banking recorded a provision for loan losses of $0.8 million for the first quarter of 2005 compared with $2.4 million for the same period of 2004. The allowance as a percent of loans was 1.43% at March 31, 2005 compared with 1.46% at December 31, 2004 and 1.66% at March 31, 2004.

 

Noninterest income increased by $2.4 million, with a gain from the sale of a branch related to the consolidation of overlapping branches of $1.1 million, gains on securities sold of $0.4 million, insurance fees increasing by $0.7 million and electronic banking fees increasing by $0.8 million, accounting for the largest gains. These gains were partially offset by a decrease of $0.8 million in mortgage banking fees and $0.3 million in service charges on deposit accounts. The first quarter growth in fee-based revenue was attributable to increased insurance sales, pricing, increased customer usage of electronic banking products offset by reduced mortgage origination income and cash management analysis fees.

 

Noninterest expenses were $80.5 million in the first quarter of 2005, compared to $75.5 million for the same period of 2004, an increase of $4.9 million (6.5%). Noninterest expenses net of adjustments were $76.5 million for the first quarter of 2005, compared with $72.3 million for the same period of 2004, a $4.2 million increase (5.8%). The increase in noninterest expenses was primarily attributable to $1.1 million in electronic banking expenses and $0.4 million in insurance commission costs, which were partially offset by the revenues generated by these services. Other increases in noninterest expenses were attributable to personnel expenses of $0.6 million and occupancy costs of $0.5 million. With the outsourcing to Sungard, IWM is no longer reimbursing the Banking segment for previously shared mainframe computer and technology costs, which increased current period expenses.

 

16



 

Investment & Wealth Management

 

Net income in IWM increased to $3.8 million in 2005, from $2.5 million in 2004. Compared with the fourth quarter of 2004, net income increased 16.8% from $3.3 million.

 

At March 31, 2005, assets under administration by IWM were $48.0 billion, an increase of $1.5 billion from the first quarter of 2004. Bankshares had investment management responsibility for $21.7 billion, up from $21.4 billion for the same period last year.

 

Revenues increased $1.9 million, or 8.6% to $24.3 million in 2005 from $22.4 million in the first quarter of 2004. On a linked-quarter basis IWM revenue increased $1.3 million or 5.9% from $23.0 million in the fourth quarter of 2004. Revenue increases were achieved in the three principal client segments: private wealth, institutional and brokerage. Growth in IWM revenues was due to net new business flows, particularly in our institutional business, and to better equity markets. Weaker fixed income markets modestly offset stronger equity markets.

 

Expenses decreased 3.1% to $16.8 million in 2005. The $1.2 million increase in outsourcing expenses related to the IWM SunGard service contract was offset by a reduction in operation personnel expenses and technology allocations from the Banking segment.

 

During the first quarter of 2004, Bankshares entered into a seven-year service contract with SunGard Wealth Management Services to provide a new core accounting system and back-office operations that began in January of 2005. Conversion costs of approximately $1.8 million that were incurred in 2004 are being amortized over the life of the contract.

 

Other

 

The components in the “Other” column consist of amounts for the nonbanking affiliates, unallocated corporate expenses and intercompany eliminations.

 

For the first quarter of 2005 compared to the same period of 2004, noninterest income increased $0.4 million related to income from private equity investments. Noninterest expense increased $2.4 million. This increase is due mostly to $2.1 million in accrued costs, including a $1.3 million settlement, related to the Pileggi litigation matter.

 

The “adjustments” line, which represents corporate allocations from the lead Bank (MSD&T), increased $0.3 million in 2005 over the first quarter of 2004.

 

17



 

BANKSHARES EARNINGS PERFORMANCE

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 three months ended March 31, 2005 and 2004.

 

 

 

2005

 

2004

 

 

 

Average

 

Income (1)

 

Yield (1)

 

Average

 

Income (1)

 

Yield (1)

 

(Dollars in thousands)

 

Balance (2)

 

/ Expense

 

/ Rate

 

Balance (2)

 

/ Expense

 

/ Rate

 

Earning assets

 

 

 

 

 

 

 

 

 

 

 

 

 

Loans:

 

 

 

 

 

 

 

 

 

 

 

 

 

Commercial

 

$

2,848,452

 

$

41,467

 

5.90

%

$

2,623,891

 

$

33,693

 

5.16

%

Commercial real estate

 

3,133,446

 

48,534

 

6.28

 

2,777,493

 

40,656

 

5.89

 

Construction

 

1,328,633

 

20,451

 

6.24

 

1,103,901

 

14,209

 

5.18

 

Residential real estate

 

1,517,291

 

21,797

 

5.83

 

1,358,975

 

20,488

 

6.06

 

Consumer

 

1,486,539

 

21,396

 

5.84

 

1,474,173

 

21,229

 

5.79

 

Total loans

 

10,314,361

 

153,645

 

6.04

 

9,338,433

 

130,275

 

5.61

 

Federal funds sold, et al

 

31,854

 

343

 

4.37

 

47,791

 

106

 

0.89

 

Securities:

 

 

 

 

 

 

 

 

 

 

 

 

 

Taxable securities

 

 

 

 

 

 

 

 

 

 

 

 

 

U.S. Treasury securities

 

565,914

 

5,175

 

3.71

 

798,980

 

7,786

 

3.92

 

U.S. Agency securities

 

860,316

 

6,894

 

3.25

 

761,720

 

7,308

 

3.86

 

Mortgage-backed securities

 

1,303,700

 

12,923

 

4.02

 

1,277,802

 

12,307

 

3.87

 

Other investments (3)

 

63,943

 

649

 

4.12

 

42,934

 

338

 

3.17

 

Tax-exempt securities

 

 

 

 

 

 

 

 

 

 

 

 

 

States and political subdivisions

 

80,921

 

1,192

 

5.97

 

104,375

 

1,451

 

5.59

 

Total securities

 

2,874,794

 

26,833

 

3.79

 

2,985,811

 

29,190

 

3.93

 

Interest-bearing deposits in other banks

 

158

 

1

 

1.47

 

158

 

 

1.09

 

Total earning assets

 

13,221,167

 

180,822

 

5.55

 

12,372,193

 

159,571

 

5.19

 

Cash and due from banks

 

290,911

 

 

 

 

 

285,524

 

 

 

 

 

Bank premises and equipment, net

 

141,426

 

 

 

 

 

141,632

 

 

 

 

 

Other assets

 

1,004,526

 

 

 

 

 

975,241

 

 

 

 

 

Less: allowance for loan losses

 

(149,686

)

 

 

 

 

(156,397

)

 

 

 

 

Total assets

 

$

14,508,344

 

 

 

 

 

$

13,618,193

 

 

 

 

 

Interest-bearing liabilities

 

 

 

 

 

 

 

 

 

 

 

 

 

Deposits:

 

 

 

 

 

 

 

 

 

 

 

 

 

Savings

 

$

1,459,580

 

1,151

 

0.32

 

$

1,364,181

 

984

 

0.29

 

Checking plus interest accounts

 

1,350,521

 

515

 

0.15

 

1,236,552

 

461

 

0.15

 

Money market

 

1,550,919

 

3,589

 

0.94

 

1,590,460

 

2,362

 

0.60

 

Time deposits $100,000 and over

 

1,427,571

 

9,347

 

2.66

 

1,287,695

 

6,379

 

1.99

 

Other time deposits

 

1,905,548

 

10,703

 

2.28

 

1,979,433

 

10,581

 

2.15

 

Total interest-bearing deposits

 

7,694,139

 

25,305

 

1.33

 

7,458,321

 

20,767

 

1.12

 

Short-term borrowings

 

1,000,929

 

4,042

 

1.64

 

919,388

 

1,419

 

0.62

 

Long-term debt

 

689,372

 

6,815

 

4.01

 

649,058

 

5,255

 

3.26

 

Total interest-bearing funds

 

9,384,440

 

36,162

 

1.56

 

9,026,767

 

27,441

 

1.22

 

Noninterest-bearing deposits

 

3,024,595

 

 

 

 

 

2,608,324

 

 

 

 

 

Other liabilities and accrued expenses

 

149,033

 

 

 

 

 

134,641

 

 

 

 

 

Total liabilities

 

12,558,068

 

 

 

 

 

11,769,732

 

 

 

 

 

Shareholders’ equity

 

1,950,276

 

 

 

 

 

1,848,461

 

 

 

 

 

Total liabilities & shareholders’ equity

 

$

14,508,344

 

 

 

 

 

$

13,618,193

 

 

 

 

 

Net interest rate spread

 

 

 

$