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, 2006

 

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

 

(I.R.S. Employer

incorporation or organization)

 

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 a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated file” in Rule 12b-2 of the Exchange Act. (Check one).

 

Large accelerated filer ý

Accelerated filer o

Non-accelerated filer o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o    No ý

 

As of April 28, 2006, 123,214,689 shares of registrant’s Common Stock, $2 par value per share, were outstanding.

 

 



 

MERCANTILE BANKSHARES CORPORATION

Quarterly Report on Form 10-Q

March 31, 2006

 

Table of Contents

 

Part I

 

 Financial Information

 

 Item 1. Financial Statements (Unaudited)

 

 

Consolidated Balance Sheets

 

 

Consolidated Statements of Income

 

 

Consolidated Statements of Changes in Shareholders’ Equity

 

 

Consolidated Statements of Cash Flows

 

 

Notes to Consolidated Financial Statements

 

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

 

 Item 3. Quantitative and Qualitative Disclosures about Market Risk

 

 Item 4. Controls and Procedures

 

 

 

Part II - Other Information

 

 Item 1. Legal Proceedings

 

 Item 1A. Risk Factors

 

 Item 6. Exhibits

 

 

 

 Signatures

 

 

2



 

PART I – FINANCIAL INFORMATION

 

Item 1. Financial Statements (Unaudited)

 

MERCANTILE BANKSHARES CORPORATION

CONSOLIDATED BALANCE SHEETS

 

 

 

March 31,

 

December 31,

 

March 31,

 

(Dollars in thousands, except per share data)

 

2006

 

2005

 

2005

 

ASSETS

 

 

 

 

 

 

 

Cash and due from banks

 

$

317,376

 

$

369,536

 

$

304,969

 

Interest-bearing deposits in other banks

 

200

 

200

 

158

 

Federal funds sold

 

292,905

 

25,104

 

26,901

 

Total cash and cash equivalents

 

610,481

 

394,840

 

332,028

 

Trading account securities at fair value

 

8,000

 

 

 

Investment securities available-for-sale (Note 4)

 

3,119,562

 

3,089,628

 

2,807,721

 

Investment securities held-to-maturity (Note 4) - fair value of $16,858 (March 2006), $17,181 (December 2005) and $20,371 (March 2005)

 

16,448

 

16,659

 

19,704

 

Total investment securities

 

3,136,010

 

3,106,287

 

2,827,425

 

Loans held-for-sale

 

850

 

26,263

 

24,341

 

Loans:

 

 

 

 

 

 

 

Commercial

 

2,899,242

 

2,957,301

 

2,854,186

 

Commercial real estate

 

3,675,692

 

3,703,297

 

3,180,853

 

Construction

 

1,740,413

 

1,607,095

 

1,347,365

 

Residential real estate

 

1,856,250

 

1,802,373

 

1,735,492

 

Home equity lines

 

487,586

 

505,508

 

493,074

 

Consumer

 

1,036,985

 

1,032,271

 

802,252

 

Total loans

 

11,696,168

 

11,607,845

 

10,413,222

 

Less: allowance for loan losses

 

(141,874

)

(156,673

)

(149,017

)

Loans, net

 

11,554,294

 

11,451,172

 

10,264,205

 

Bank premises and equipment, less accumulated depreciation of $145,098 (March 2006), $146,585 (December 2005) and $144,515 (March 2005)

 

137,713

 

137,419

 

141,135

 

Other real estate owned, net

 

713

 

667

 

145

 

Goodwill, net

 

678,918

 

670,028

 

507,791

 

Other intangible assets, net (Note 8)

 

44,461

 

46,653

 

46,122

 

Other assets

 

611,787

 

588,400

 

484,641

 

Total assets

 

$

16,783,227

 

$

16,421,729

 

$

14,627,833

 

COMMITMENTS and CONTINGENCIES (Note 7)

 

 

 

 

 

 

 

LIABILITIES

 

 

 

 

 

 

 

Deposits:

 

 

 

 

 

 

 

Noninterest-bearing deposits

 

$

3,385,892

 

$

3,324,650

 

$

3,098,666

 

Interest-bearing deposits

 

9,187,664

 

8,752,700

 

7,872,610

 

Total deposits

 

12,573,556

 

12,077,350

 

10,971,276

 

Short-term borrowings

 

1,057,015

 

1,237,714

 

856,963

 

Accrued expenses and other liabilities

 

222,031

 

169,780

 

179,747

 

Long-term debt

 

701,706

 

742,163

 

681,331

 

Total liabilities

 

14,554,308

 

14,227,007

 

12,689,317

 

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 - 123,474,125 (March 2006), 123,248,121 (December 2005) and 119,228,780 (March 2005); restricted shares – 330,148 (March 2006), 249,090 (December 2005) and 253,395 (March 2005)

 

246,947

 

164,331

 

158,972

 

Capital surplus

 

595,813

 

676,830

 

538,075

 

Retained earnings

 

1,428,288

 

1,386,405

 

1,264,634

 

Accumulated other comprehensive income (loss)

 

(42,129

)

(32,844

)

(23,165

)

Total shareholders’ equity

 

2,228,919

 

2,194,722

 

1,938,516

 

Total liabilities and shareholders’ equity

 

$

16,783,227

 

$

16,421,729

 

$

14,627,833

 

 

See notes to consolidated financial statements

 

3



 

MERCANTILE BANKSHARES CORPORATION

STATEMENTS OF CONSOLIDATED INCOME

 

 

 

For the 3 months ended

 

 

 

March 31,

 

(Dollars in thousands, except per share data)

 

2006

 

2005

 

INTEREST INCOME

 

 

 

 

 

Interest and fees on loans

 

$

196,055

 

$

152,544

 

Interest and dividends on investment securities:

 

 

 

 

 

Taxable interest income

 

29,795

 

24,992

 

Tax-exempt interest income

 

778

 

721

 

Other investment income

 

627

 

644

 

Total interest and dividends on investment securities

 

31,200

 

26,357

 

Other interest income

 

658

 

344

 

Total interest income

 

227,913

 

179,245

 

INTEREST EXPENSE

 

 

 

 

 

Interest on deposits

 

49,243

 

25,305

 

Interest on short-term borrowings

 

11,023

 

4,042

 

Interest on long-term debt

 

9,334

 

6,815

 

Total interest expense

 

69,600

 

36,162

 

NET INTEREST INCOME

 

158,313

 

143,083

 

Provision for credit losses

 

 

756

 

NET INTEREST INCOME AFTER PROVISION FOR CREDIT LOSSES

 

158,313

 

142,327

 

NONINTEREST INCOME

 

 

 

 

 

Investment and wealth management

 

26,121

 

24,057

 

Service charges on deposit accounts

 

10,292

 

10,426

 

Mortgage banking related fees

 

2,210

 

2,283

 

Investment securities gains and (losses)

 

(13

)

414

 

Nonmarketable investments

 

6,269

 

5,271

 

Other income

 

15,727

 

15,418

 

Total noninterest income

 

60,606

 

57,869

 

NONINTEREST EXPENSES

 

 

 

 

 

Salaries

 

49,099

 

46,554

 

Employee benefits

 

14,735

 

11,897

 

Net occupancy expense of bank premises

 

7,771

 

6,922

 

Furniture and equipment expenses

 

8,305

 

7,279

 

Communications and supplies

 

3,818

 

4,040

 

Other expenses

 

22,987

 

23,461

 

Total noninterest expenses

 

106,715

 

100,153

 

Income before income taxes

 

112,204

 

100,043

 

Applicable income taxes

 

41,445

 

37,416

 

NET INCOME

 

$

70,759

 

$

62,627

 

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

 

 

 

 

 

Basic

 

$

0.58

 

$

0.53

 

Diluted

 

$

0.57

 

$

0.52

 

DIVIDENDS PAID PER COMMON SHARE

 

$

0.26

 

$

0.23

 

 

See notes to consolidated financial statements

 

4



 

MERCANTILE BANKSHARES CORPORATION

STATEMENTS OF CHANGES IN CONSOLIDATED SHAREHOLDERS’ EQUITY

 

For the 3 months ended March 31, 2006 and 2005

 

 

 

 

 

 

 

 

 

 

 

Accumulated
Other

 

 

 

 

 

Common

 

Capital

 

Retained

 

Comprehensive

 

(Dollars in thousands, except per share data)

 

Total

 

Stock

 

Surplus

 

Earnings

 

Income (Loss)

 

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 ($0.23 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

)

BALANCE, DECEMBER 31, 2005

 

$

2,194,722

 

$

164,331

 

$

676,830

 

$

1,386,405

 

$

(32,844

)

Net income

 

70,759

 

 

 

 

 

70,759

 

 

 

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

 

(9,285

)

 

 

 

 

 

 

(9,285

)

Comprehensive income

 

61,474

 

 

 

 

 

 

 

 

 

Cash dividends paid:

 

 

 

 

 

 

 

 

 

 

 

Common stock ($0.26 per share)

 

(32,006

)

 

 

 

 

(32,006

)

 

 

Issuance of 41,898 shares for dividend reinvestment and stock purchase plan

 

1,539

 

84

 

1,455

 

 

 

 

 

Issuance of 7,155 shares for employee stock purchase dividend reinvestment plan

 

293

 

14

 

279

 

 

 

 

 

Issuance of 44,319 shares for employee stock option plan

 

972

 

88

 

884

 

 

 

 

 

Directors’ deferred compensation plan:

 

 

 

 

 

 

 

 

 

 

 

Issuance of 3,924 shares

 

137

 

8

 

129

 

 

 

 

 

Contribution

 

201

 

 

 

201

 

 

 

 

 

Dividend

 

 

 

 

 

76

 

(76

)

 

 

Nonvested stock awards

 

 

 

 

 

 

 

 

 

 

 

Issuance of 129,959 shares

 

 

 

259

 

(259

)

 

 

 

 

Repurchase of 3,371 shares for tax settlement

 

(129

)

(7

)

(122

)

 

 

 

 

Expense

 

1,065

 

 

 

1,065

 

 

 

 

 

Vested stock options

 

817

 

 

 

817

 

 

 

 

 

Adjustment for adoption of SFAS No. 123(R)

 

 

 

 

 

(3,206

)

3,206

 

 

 

Issuance of 41,084,826 shares for a 3 for 2 stock split

 

(166

)

82,170

 

(82,336

)

 

 

BALANCE, MARCH 31, 2006

 

$

2,228,919

 

$

246,947

 

$

595,813

 

$

1,428,288

 

$

(42,129

)

 

5



 

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)

 

2006

 

2005

 

CASH FLOWS FROM OPERATING ACTIVITIES:

 

 

 

 

 

Net income

 

$

70,759

 

$

62,627

 

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

 

 

 

 

 

Provision for credit losses

 

 

756

 

Depreciation

 

3,860

 

3,714

 

Amortization of other intangible assets

 

2,325

 

2,072

 

Tax benefit from the issuance of stock-based awards

 

91

 

 

Write-downs of other real estate owned

 

 

1

 

Gains on sales of other real estate owned

 

 

(125

)

(Gains) losses on sales of investments securities

 

13

 

(414

)

Gains on sales of premises

 

(79

)

(1,147

)

Loans held-for-sale

 

25,124

 

(13,341

)

Net (increase) decrease in assets:

 

 

 

 

 

Interest receivable

 

(5,368

)

(5,796

)

Nonmarketable investments

 

(5,654

)

(3,132

)

Other assets

 

3,790

 

(6,252

)

Net increase (decrease) in liabilities:

 

 

 

 

 

Interest payable

 

9,814

 

8,268

 

Other liabilities

 

13,781

 

44,410

 

Net cash provided by operating activities

 

118,456

 

91,641

 

CASH FLOWS FROM INVESTING ACTIVITIES:

 

 

 

 

 

Proceeds from maturities of investment securities held-to-maturity

 

211

 

472

 

Proceeds from maturities of investment securities available-for-sale

 

246,420

 

219,959

 

Proceeds from sales of investment securities available-for-sale

 

599

 

15,997

 

Purchases of investment securities available-for-sale

 

(291,786

)

(167,201

)

Purchases of investment securities held-for-trading

 

(8,000

)

 

Net increase in customer loans

 

(88,307

)

(185,665

)

Proceeds from sales of other real estate owned

 

 

191

 

Capital expenditures

 

(4,448

)

(5,619

)

Proceeds from sales of premises

 

321

 

2,075

 

Business acquisition contingent consideration payment

 

(8,806

)

 

Purchase of nonmarketable investments

 

(3,873

)

(1,458

)

Net cash used in investing activities

 

(157,669

)

(121,249

)

CASH FLOWS FROM FINANCING ACTIVITIES:

 

 

 

 

 

Net increase in noninterest-bearing deposits

 

61,242

 

49,635

 

Net increase in interest-bearing deposits

 

435,203

 

122,442

 

Net decrease in short-term borrowings

 

(180,699

)

(30,894

)

Repayment of long-term debt

 

(32,446

)

(1

)

Tax benefit from the issuance of stock-based awards

 

765

 

 

Excess tax benefit related to stock-based awards

 

120

 

 

Proceeds from issuance of shares

 

2,804

 

3,070

 

Repurchase of common shares

 

(129

)

 

Dividends paid

 

(32,006

)

(27,750

)

Net cash provided by financing activities

 

254,854

 

116,502

 

Net increase in cash and cash equivalents

 

215,641

 

86,894

 

Cash and cash equivalents at beginning of period

 

394,840

 

245,134

 

Cash and cash equivalents at end of period

 

$

610,481

 

$

332,028

 

SUPPLEMENTAL INFORMATION

 

 

 

 

 

Cash payments for interest

 

$

59,786

 

$

27,891

 

Cash payments for income taxes

 

200

 

13,226

 

 

See notes to consolidated financial statements

 

6



 

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 purposes of comparability, certain prior period amounts have been reclassified to conform to 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 were accounted for as purchases with the results of their operations subsequent to the acquisition date to be included in Bankshares’ Statements of Consolidated Income.

 

On March 27, 2006, Bankshares signed a definitive merger agreement with James Monroe Bancorp, Inc. (“James Monroe”). The acquisition of this Arlington, Virginia-based commercial bank is expected to be completed in the third quarter of 2006. Under the terms of the agreement, shareholders of James Monroe will be entitled to elect to receive either cash in the amount of $23.50 for each share, or .6033 shares of Bankshares common stock for each share of James Monroe common stock they hold, so long as at least 50% but not more than 66% of the total consideration is paid in Bankshares stock. Bankshares’ acquisition of James Monroe is estimated to add $530 million in total assets, $378 million in gross loans, $471 million in total deposits (based on December 31, 2005 financial information), and six full-service branches and a loan production office located in the affluent, fast-growing markets of Northern Virginia and suburban Washington, D.C. The merger is subject to the approval of James Monroe shareholders and Federal and State banking authorities. For additional information, see the Form 8-K filed in connection with the merger on March 27, 2006.

 

On May 18, 2005, Bankshares completed its acquisition of Community Bank of Northern Virginia (“CBNV”), a bank headquartered in Sterling, Virginia, which was merged into Mercantile-Safe Deposit & Trust Company. The total consideration paid to CBNV shareholders in connection with the acquisition was $82.9 million in cash and 3.7 million shares of Bankshares’ common stock.

The transaction resulted in total assets acquired as of May 18, 2005 of $888.2 million, including $671.0 million of loans and leases; liabilities assumed were $842.3 million, including $626.9 million of deposits. Additionally, Bankshares recorded $162.1 million of goodwill and $4.6 million of core deposit intangibles. Bankshares expensed no merger-related costs for the three-month period ended March 31, 2006 and has expensed $1.3 million since the inception of the merger.

 

7



 

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, restricted stock units 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, 2006 and 2005, respectively.

 

 

 

For the 3 months ended March 31,

 

 

 

Net

 

Weighted Average

 

 

 

2006 (In thousands, except per share data)

 

Income

 

Common Shares

 

EPS

 

Basic EPS

 

$

70,759

 

123,043

 

$

0.58

 

Dilutive effect of:

 

 

 

 

 

 

 

Stock options and restricted stock awards

 

 

 

962

 

 

 

Vested directors’ deferred compensation plan shares

 

 

 

289

 

 

 

Diluted EPS

 

$

70,759

 

124,294

 

$

0.57

 

 

 

 

For the 3 months ended March 31,

 

 

 

Net

 

Weighted Average

 

 

 

2005(In thousands, except per share data)

 

Income

 

Common Shares

 

EPS

 

Basic EPS

 

$

62,627

 

118,842

 

$

0.53

 

Dilutive effect of:

 

 

 

 

 

 

 

Stock options and restricted stock awards

 

 

 

719

 

 

 

Vested directors’ deferred compensation plan shares

 

 

 

252

 

 

 

Diluted EPS

 

$

62,627

 

119,813

 

$

0.52

 

 

Antidilutive options and awards excluded from the computation of diluted earnings per share were 22,120 and 174,848 for the three months ended March 31, 2006 and 2005, respectively.

 

4. Investment Securities

 

At March 31, 2006 and December 31, 2005, securities with an amortized cost of $1.4 billion and $1.3 billion, respectively, were pledged as collateral for certain deposits as required by regulatory guidelines. The following table shows amortized cost and fair value of investment securities at March 31, 2006 and December 31, 2005.

 

 

 

March 31, 2006

 

December 31, 2005

 

 

 

 

 

Gross

 

Gross

 

 

 

 

 

Gross

 

Gross

 

 

 

 

 

Amortized

 

Unrealized

 

Unrealized

 

Fair

 

Amortized

 

Unrealized

 

Unrealized

 

Fair

 

(Dollars in thousands)

 

Cost

 

Gains

 

Losses

 

Value

 

Cost

 

Gains

 

Losses

 

Value

 

Investment securities held-to-maturity States and political subdivisions

 

$

16,448

 

$

432

 

$

22

 

$

16,858

 

$

16,659

 

$

541

 

$

19

 

$

17,181

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Investment securities available-for-sale

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

U.S. Treasury

 

$

440,906

 

$

 

$

4,181

 

$

436,725

 

$

434,893

 

$

223

 

$

3,080

 

$

432,036

 

U.S. Government agencies

 

1,007,940

 

 

13,736

 

994,204

 

992,040

 

29

 

12,761

 

979,308

 

States and political subdivisions

 

66,272

 

118

 

329

 

66,061

 

70,017

 

306

 

188

 

70,135

 

Mortgage-backed securities

 

1,607,610

 

409

 

49,327

 

1,558,692

 

1,581,845

 

685

 

38,269

 

1,544,261

 

Other bonds, notes and debentures

 

19,899

 

 

209

 

19,690

 

19,083

 

 

215

 

18,868

 

Total bonds

 

3,142,627

 

527

 

67,782

 

3,075,372

 

3,097,878

 

1,243

 

54,513

 

3,044,608

 

Other investments

 

43,983

 

1,132

 

925

 

44,190

 

43,980

 

1,236

 

196

 

45,020

 

Total

 

$

3,186,610

 

$

1,659

 

$

68,707

 

$

3,119,562

 

$

3,141,858

 

$

2,479

 

$

54,709

 

$

3,089,628

 

 

8



 

The following table shows the unrealized gross losses and fair value of securities in the securities available-for-sale portfolio at March 31, 2006, by length of time that individual securities in each category have been in a continuous loss position.

 

 

 

Less than 12 Months

 

12 months or more

 

Total

 

 

 

Gross

 

 

 

Gross

 

 

 

Gross

 

 

 

 

 

Unrealized

 

Fair

 

Unrealized

 

Fair

 

Unrealized

 

Fair

 

(Dollars in thousands)

 

Losses

 

Value

 

Losses

 

Value

 

Losses

 

Value

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

U.S. Treasury

 

$

2,046

 

$

321,680

 

$

2,135

 

$

115,045

 

$

4,181

 

$

436,725

 

U.S. Government agencies

 

4,153

 

458,127

 

9,583

 

536,077

 

13,736

 

994,204

 

States and political subdivisions

 

281

 

58,482

 

48

 

7,579

 

329

 

66,061

 

Mortgage-backed securities

 

23,781

 

643,646

 

25,546

 

915,046

 

49,327

 

1,558,692

 

Other bonds, notes and debentures

 

16

 

3,962

 

193

 

15,728

 

209

 

19,690

 

Total bonds

 

30,277

 

1,485,897

 

37,505

 

1,589,475

 

67,782

 

3,075,372

 

Other investments

 

925

 

44,190

 

 

 

925

 

44,190

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

31,202

 

$

1,530,087

 

$

37,505

 

$

1,589,475

 

$

68,707

 

$

3,119,562

 

 

At March 31, 2006, there were $1.6 billion of individual securities that had unrealized losses for a period greater than 12 months. At March 31, 2006, these securities had an unrealized loss of $37.5 million of which 68.1% 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 the value recovers or they mature.

 

5. Allowance for Loan Losses and Reserve for Unfunded Commitments

 

During the first quarter of 2006, Bankshares refined the model used for determining certain components of the allowance for loan losses. The model refinement did not have a material impact on Bankshares’ recorded allowance for loan losses. Additionally, Bankshares reclassified a portion of the allowance for loan losses to a reserve for unfunded lending commitments reflected in other liabilities in the consolidated balance sheet. As a result of the refinement of the modeling process for the allowance for loan losses, Bankshares was able specifically to identify risk inherent in unfunded commitments and make the reclassification noted above. As no model data existed for previous years, prior period data has not been reclassified for comparability.

 

The allowance for loan losses and reserve for unfunded commitments is presented below.

 

 

 

For the 3 months ended March 31,

 

(Dollars in thousands)

 

2006

 

2005

 

Allowance for Loan Losses

 

 

 

 

 

Balance, beginning of period

 

$

156,673

 

$

149,002

 

Provision for credit losses

 

(990

)

756

 

Transfer to reserve for unfunded commitments

 

(13,968

)

 

Total

 

141,715

 

149,758

 

Charge-offs

 

(1,378

)

(1,942

)

Recoveries

 

1,537

 

1,201

 

Net recoveries (charge-offs)

 

159

 

(741

)

Balance, end of period

 

$

141,874

 

$

149,017

 

 

 

 

 

 

 

Reserve for Unfunded Commitments

 

 

 

 

 

Balance, beginning of period

 

$

 

$

 

Provision for credit losses

 

990

 

 

Transfer from allowance for loan losses

 

13,968

 

 

Balance, end of period

 

$

14,958

 

$

 

 

9



 

6. 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, 2006, December 31, 2005 and March 31, 2005 is shown below. See Annual Report on Form 10-K for more detail.

 

 

 

March 31,

 

December 31,

 

March 31,

 

(Dollars in thousands)

 

2006

 

2005

 

2005

 

Impaired loans with a specific valuation allowance

 

$

3,680

 

$

11,512

 

$

17,188

 

All other impaired loans

 

17,082

 

9,086

 

11,592

 

Total impaired loans

 

$

20,762

 

$

20,598

 

$

28,780

 

 

 

 

 

 

 

 

 

Specific allowance for loan losses applicable to impaired loans

 

$

2,108

 

$

4,150

 

$

10,437

 

General allowance for loan losses applicable to other than impaired loans

 

139,766

 

152,523

 

138,580

 

Total allowance for loan losses

 

$

141,874

 

$

156,673

 

$

149,017

 

 

 

 

 

 

 

 

 

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

 

$

35

 

$

128

 

$

23

 

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

 

$

20,762

 

$

26,703

 

$

28,780

 

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

 

$

35

 

$

14

 

$

23

 

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

 

$

20,762

 

$

20,598

 

$

28,780

 

 

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.

 

On May 18, 2005, Bankshares acquired, as part of the CBNV acquisition, two commercial real estate loans totaling $4.9 million that were within the scope of American Institute of Certified Public Accountants issued Statement of Position (“SOP”) 03-3, “Accounting for Certain Loans or Debt Securities Acquired in a Transfer.”  One of the loans was subsequently paid in full and the remaining loan is deemed to be immaterial for purposes of the required disclosures.

 

7. 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 $4.9 billion at March 31, 2006, $4.8 billion at December 31, 2005, and $4.4 billion at March 31, 2005.

 

10



 

Letters of credit are commitments issued to guarantee the performance of a customer to a third party. Outstanding letters of credit were $530.8 million at March 31, 2006, $540.6 million at December 31, 2005 and $401.7 million at March 31, 2005. 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, 2006, December 31, 2005, and March 31, 2005 had a carrying value of $1.7 million, $1.9 million and $1.4 million, respectively.

 

One of Bankshares’ mortgage banking subsidiaries 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 $253.4 million, $249.8 million and $220.9 million at March 31, 2006, December 31, 2005 and March 31, 2005, respectively. The loss reserve for potential losses on loans originated and sold in the secondary market was $67.9 thousand at March 31, 2006 and $60.7 thousand at December 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 $1.1 million at March 31, 2006, $1.3 million at December 31, 2005 and $1.6 million at March 31, 2005. These mortgages are generally in good standing and are well collateralized; 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, 2006, December 31, 2005 and March 31, 2005, $27.0 million, $26.6 million and $32.5 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, earnings 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.

 

8. Goodwill and Other Intangible Assets

 

Goodwill totaled $678.9 million at March 31, 2006 and $670.0 million at December 31, 2005. In 2005, Bankshares recorded $162.1 million in goodwill in connection with the CBNV acquisition that increased the Banking segment’s goodwill to $630.2 million. The IWM segment’s goodwill was $48.6 million at March 31, 2006 and $39.8 at December 31, 2005. The increase in goodwill, during the quarter, is related to the payment of $8.8 million in contingent consideration to the management of Boyd Watterson Asset Management as they met the performance conditions outlined in the merger agreement.

 

The following table discloses the gross carrying amount and accumulated amortization of intangible assets subject to amortization at March 31, 2006 and December 31, 2005.

 

 

 

March 31, 2006

 

December 31, 2005

 

(Dollars in thousands)

 

Gross
carrying
amount

 

Accumulated
amortization

 

Net
amount

 

Gross
carrying
amount

 

Accumulated
amortization

 

Net
amount

 

Core deposits

 

$

54,509

 

$

(22,277

)

$

32,232

 

$

54,509

 

$

(20,790

)

$

33,719

 

Mortgage servicing

 

2,967

 

(1,166

)

1,801

 

2,902

 

(1,145

)

1,757

 

Customer lists and other

 

17,845

 

(7,417

)

10,428

 

17,845

 

(6,668

)

11,177

 

Total

 

$

75,321

 

$

(30,860

)

$

44,461

 

$

75,256

 

$

(28,603

)

$

46,653

 

 

In connection with the CBNV acquisition, Bankshares recorded $4.6 million in core deposit intangibles. The core deposit intangible from CBNV is amortized over a weighted average remaining useful life of nine years on a straight-line basis.

 

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.

 

11



 

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, 2006. Future amortization expense may be significantly different depending upon changes in the mortgage-servicing portfolio, mortgage interest rates and market conditions.

 

 

 

 

 

 

 

 

 

Customer

 

 

 

 

 

 

 

Core

 

Mortgage

 

lists

 

 

 

(Dollars in thousands)

 

 

 

deposits

 

servicing

 

and other

 

Total

 

Three months ended March 31, 2006 (actual)

 

 

 

$

1,487

 

$

89

 

$

749

 

$

2,325

 

Nine months ended December 31, 2006 (estimated)

 

 

 

4,463

 

233

 

1,866

 

6,562

 

Twelve months ended December 31, 2006 (estimated)

 

 

 

$

5,950

 

$

322

 

$

2,615

 

$

8,887

 

 

 

 

 

 

 

 

 

 

 

 

 

Estimate for year ended December 31,

 

2007

 

$

5,747

 

$

278

 

$

2,533

 

$

8,558

 

 

 

2008

 

4,653

 

261

 

1,637

 

6,551

 

 

 

2009

 

4,502

 

261

 

641

 

5,404

 

 

 

2010

 

4,502

 

241

 

505

 

5,248

 

 

9. 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, 2006 and 2005, respectively. The total comprehensive income is included in the Statements of Changes in Consolidated Shareholders’ Equity.

 

 

 

For the 3 months ended March 31,

 

 

 

2006

 

2005

 

 

 

Pretax

 

Tax

 

Net

 

Pretax

 

Tax

 

Net

 

(Dollars in thousands)

 

Amount

 

Benefit

 

Amount

 

Amount

 

Benefit

 

Amount

 

Net Income

 

 

 

 

 

$

70,759

 

 

 

 

 

$

62,627

 

Other comprehensive income

 

 

 

 

 

 

 

 

 

 

 

 

 

Unrealized holding (losses) gains arising during the period

 

(14,806

)

5,529

 

(9,277

)

(32,221

)

12,031

 

(20,190

)

Reclassification adjustment for (gains) losses included in net income

 

(13

)

5

 

(8

)

(414

)

164

 

(250

)

Total other comprehensive income

 

(14,819

)

5,534

 

(9,285

)

(32,635

)

12,195

 

(20,440

)

Total comprehensive income

 

 

 

 

 

$

61,474

 

 

 

 

 

$

42,187

 

 

12



 

10. 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, 2006, Bankshares and each of its bank affiliates exceeded all capital adequacy requirements to be considered well capitalized.

 

Actual capital amounts and ratios are presented in the following table for Bankshares and its affiliates.

 

March 31, 2006 (Dollars in thousands)

 

Tier I
Capital

 

Total
Risk-Based
Capital

 

Net
Risk-
Weighted
Assets

 

Adjusted
Average
Total Assets

 

Tier I
Capital
Ratio

 

Total
Capital
Ratio

 

Leverage
Ratio

 

Bankshares

 

$

1,554,465

 

$

2,007,694

 

$

12,943,856

 

$

15,638,122

 

12.01

%

15.51

%

9.94

%

Annapolis Banking & Trust

 

43,750

 

50,986

 

333,636

 

480,975

 

13.11

 

15.28

 

9.10

 

Citizens National Bank

 

105,113

 

153,331

 

1,147,768

 

1,295,059

 

9.16

 

13.36

 

8.12

 

Farmers & Mechanics Bank

 

165,181

 

226,141

 

1,344,649

 

1,694,947

 

12.28

 

16.82

 

9.75

 

Marshall National Bank & Trust

 

13,066

 

19,643

 

135,944

 

171,398

 

9.61

 

14.45

 

7.62

 

Mercantile County Bank

 

78,840

 

117,345

 

727,945

 

938,636

 

10.83

 

16.12

 

8.40

 

Mercantile Eastern Shore Bank

 

52,596

 

83,692

 

453,498

 

587,731

 

11.60

 

18.45

 

8.95

 

Mercantile Peninsula Bank

 

144,076

 

217,188

 

1,391,524

 

1,708,838

 

10.35

 

15.61

 

8.43

 

Mercantile-Safe Deposit & Trust Company

 

523,168

 

637,882

 

5,788,861

 

6,922,042

 

9.04

 

11.02

 

7.56

 

Mercantile Southern Maryland Bank

 

94,802

 

131,567

 

652,702

 

949,650

 

14.52

 

20.16

 

9.98

 

National Bank of Fredericksburg

 

37,762

 

48,846

 

370,932

 

458,858

 

10.18

 

13.17

 

8.23

 

Westminster Union Bank

 

67,911

 

99,024

 

512,659

 

813,006

 

13.25

 

19.32

 

8.35

 

 

December 31, 2005 (Dollars in thousands)

 

Tier I
Capital

 

Total
Risk-Based
Capital

 

Net
Risk-
Weighted
Assets

 

Adjusted
Average
Total Assets

 

Tier I
Capital
Ratio

 

Total
Capital
Ratio

 

Leverage
Ratio

 

Bankshares

 

$

1,518,454

 

$

1,975,313

 

$

12,848,926

 

$

15,471,385

 

11.82

%

15.37

%

9.81

%

Annapolis Banking & Trust

 

43,148

 

50,382

 

331,167

 

484,567

 

13.03

 

15.21

 

8.90

 

Citizens National Bank

 

103,600

 

151,903

 

1,139,217

 

1,281,737

 

9.09

 

13.33

 

8.08

 

Farmers & Mechanics Bank

 

164,489

 

225,553

 

1,341,615

 

1,700,721

 

12.26

 

16.81

 

9.67

 

Marshall National Bank & Trust

 

12,661

 

19,235

 

132,110

 

164,212

 

9.58

 

14.56

 

7.71

 

Mercantile County Bank

 

77,489

 

116,005

 

728,884

 

916,864

 

10.63

 

15.92

 

8.45

 

Mercantile Eastern Shore Bank

 

52,538

 

83,614

 

451,831

 

575,426

 

11.63

 

18.51

 

9.13

 

Mercantile Peninsula Bank

 

141,149

 

214,251

 

1,336,315

 

1,677,958

 

10.56

 

16.03

 

8.41

 

Mercantile-Safe Deposit & Trust Company

 

509,252

 

624,036

 

5,795,437

 

6,721,535

 

8.79

 

10.77

 

7.58

 

Mercantile Southern Maryland Bank

 

94,717

 

131,461

 

620,898

 

954,636

 

15.25

 

21.17

 

9.92

 

National Bank of Fredericksburg

 

37,081

 

48,169

 

353,718

 

455,590

 

10.48

 

13.62

 

8.14

 

Westminster Union Bank

 

66,961

 

98,053

 

509,424

 

810,677

 

13.14

 

19.25

 

8.26

 

 

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. During the quarter ended March 31, 2006, Bankshares purchased 3,371 shares in the net settlement of the minimum tax liability for vested restricted stock. At March 31, 2006, there were 472,956 shares remaining available for repurchase under the program.

 

13



 

11. 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 the operating results of which management relies on for decision-making and performance assessment. Bankshares has two reportable segments – Banking and Investment and Wealth Management (“IWM”). The Banking segment is comprised of 11 affiliate banks. During 2005, the Private Bank Group of Mercantile-Safe Deposit and Trust was consolidated into the Private Banking Group of IWM. The segment results have been reclassified to conform to current presentation for comparability. Additionally, as loans and deposits are now being reflected in the IWM segment, a funds transfer-pricing model was utilized to match the duration of the funding and investment of the IWM segment assets and liabilities.

 

The tables below present selected segment information for the three months ended March 31, 2006 and 2005. 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 were 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, 2006

 

(Dollars in thousands)

 

Banking

 

IWM

 

Other

 

Total

 

Net interest income

 

$

155,894

 

$

2,572

 

$

(153

)

$

158,313

 

Provision for loan losses

 

 

 

 

 

Noninterest income

 

30,066

 

26,194

 

4,346

 

60,606

 

Noninterest expenses

 

(85,272

)

(21,519

)

76

 

(106,715

)

Adjustments

 

5,106

 

(257

)

(4,849

)

 

Income (loss) before income taxes

 

105,794

 

6,990

 

(580

)

112,204

 

Income tax (expense) benefit

 

(37,115

)

(2,796

)

(1,534

)

(41,445

)

Net income (loss)

 

$

68,679

 

$

4,194

 

$

(2,114

)

$

70,759

 

Average loans

 

$

11,470,757

 

$

175,772

 

$

375

 

$

11,646,904

 

Average earning assets

 

14,748,209

 

175,772

 

(43,206

)

14,880,775

 

Average assets

 

16,172,368

 

176,272

 

87,324

 

16,435,964

 

Average deposits

 

11,983,954

 

270,132

 

(313,130

)

11,940,956

 

Average equity

 

2,004,455

 

36,758

 

220,433

 

2,261,646

 

 

 

 

For the 3 months ended March 31, 2005

 

(Dollars in thousands)

 

Banking

 

IWM

 

Other

 

Total

 

Net interest income

 

$

141,108

 

$

1,986

 

$

(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

 

3,536

 

(1,669

)

(1,867

)

 

Income (loss) before income taxes

 

92,928

 

7,784

 

(669

)

100,043

 

Income tax (expense) benefit

 

(32,288

)

(3,113

)

(2,015

)

(37,416

)

Net income (loss)

 

$

60,640

 

$

4,671

 

$

(2,684

)

$

62,627

 

Average loans

 

$

10,172,592

 

$

141,345

 

$

424

 

$

10,314,361

 

Average earning assets

 

13,058,088

 

141,345

 

21,734

 

13,221,167

 

Average assets

 

14,206,965

 

141,634

 

159,745

 

14,508,344

 

Average deposits

 

10,711,996

 

191,322

 

(184,584

)

10,718,734

 

Average equity

 

1,772,458

 

33,130

 

144,688

 

1,950,276

 

 

14



 

12. Derivative Instruments and Hedging Activities

 

SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities”, SFAS No. 138, “Accounting for Certain Derivative Instruments and Certain Hedging Activities – an amendment to FASB Statement No. 133,” and SFAS No. 149, “Amendment of Statement No. 133 on Derivative Instruments and Hedging Activities” (collectively referred to as “derivatives”), establish 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. At March 31, 2006, Bankshares had 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 executed with loan customers are hedged by means of an offsetting 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 is based on position and option valuations. The position valuation is estimated by using pricing models that incorporate quoted market prices for swap rates and futures contracts, as well as market volatility, and assumes all counterparties have the same credit rating. The option valuation is estimated by using standard market models (such as the modified Black-Scholes model on interest rate options), incorporating quoted market prices and volatilities. The fair value of derivative instruments relating to hedging activities recorded in other assets was $7.4 million (notional $397.1 million) and $5.3 million (notional $345.5 million) at March 31, 2006 and December 31, 2005, respectively. The fair value of derivative instruments relating to hedging activities recorded in other liabilities was $21.5 million (notional $628.7 million) and $12.3 million (notional $609.1 million) at March 31, 2006 and December 31, 2005, 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 and qualified for short-cut hedge accounting treatment. The impact of the hedges increased interest expense $108 thousand in the first three months of 2006 as compared to a decrease of $1.6 million for the same period in 2005.

 

The following tables summarize the gross position of derivatives relating to hedging activities at March 31, 2006 and December 31, 2005.

 

 

 

March 31, 2006

 

December 31, 2005

 

 

 

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

 

$

 

$

(13,502

)

$

350,000

 

$

 

$

(10,349

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Customer Accommodations

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest Rate Contracts:

 

 

 

 

 

 

 

 

 

 

 

 

 

Swaps

 

$

664,124

 

$

7,377

 

$

3,867

 

$

592,934

 

$

5,327

 

$

3,462

 

Swaptions/Caps Purchased

 

5,818

 

57

 

57

 

5,850

 

57

 

57

 

Swaptions/Caps Sold

 

5,818

 

 

(57

)

5,850

 

 

(57

)

 


(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 individual fixed-rate and variable-rate mortgage loans that are on its balance sheet at fair value or are approved, but not yet funded. The fair value of the forward contracts was $5.2 million at March 31, 2006 and $0.2 million at December 31, 2005.

 

15



 

13. Stock-based Compensation Expense

 

Bankshares adopted SFAS No. 123(R), “Share-Based Payment,” effective January 1, 2006 under the modified version of prospective application. The following disclosures are provided pursuant to the requirements of SFAS 123(R).

 

Under SFAS 123(R) awards granted to retirement eligible employees are expensed immediately. Under Bankshares’ Omnibus Stock Plan, retirement eligible is defined as employees reaching normal retirement at age 65. As a practice, Bankshares has not granted awards to retirement eligible employees. As of March 31, 2006, there were no retirement eligible employees with outstanding awards that had not been fully expensed. Prior to implementing SFAS 123(R), Bankshares accrued compensation cost for share-based compensation based on total awards granted, pursuant to SFAS 123. Any subsequent forfeitures were reversed from compensation expense when the grant was cancelled or expired. Upon implementation of SFAS 123(R), Bankshares is estimating forfeitures upon the grant of awards and reducing the amount to be charged to expense by this estimate. The estimated forfeiture rate used to calculate the current quarter’s compensation cost was 2%. Because of the historically low forfeiture rate, the impact to compensation expense was immaterial as compared to the first quarter of 2005.

 

We sponsor several share-based plans, which are described below. The compensation cost that was expensed for those plans was $1.7 million and $1.4 million for the quarters ended March 31, 2006 and 2005, respectively. The total income tax benefit recognized in the income statement for share-based compensation arrangements was immaterial for the quarters ended March 31, 2006 and 2005. At March 31, 2006, unrecognized compensation cost related to nonvested stock options, restricted stock awards and restricted stock units (“RSU”) totaled $25 million. The cost of these nonvested awards is expected to be recognized over a weighted average period of 2.52 years.

 

The 1999 Omnibus Stock Plan permitted the grant of stock options and other stock incentives, including restricted stock awards, to key employees of Bankshares and its affiliates. The 1999 Plan provided for the issuance of up to 4,500,000 shares (as adjusted for the stock split) of Bankshares authorized but unissued common stock. Options outstanding were granted at market value and included both performance-based and nonperformance-based options. Options became exercisable ratably over three or four years. If certain levels of earnings per share of Bankshares and net income of affiliates were not achieved, all or a portion of the performance-based options were forfeited and became available for future grants. All options terminate 10 years from date of grant if not exercised. Restricted stock awards outstanding were granted at market value and vested ratably over three years or in total at the end of a specified three-year period. The number of shares of common stock that remained available for future grants under the Plan at March 31, 2006 was 329,815 shares.

 

The number of restricted stock awards granted in the quarters ended March 31, 2006 and 2005 was 129,959 and 55,446, respectively. Compensation expense is recognized on a straight-line basis over the vesting period. Relative to awards granted in the quarter ended March 31, 2006, 85,309 shares are subject to a one-year vesting, and 44,650 vest over three years.

 

On March 29, 2006, the Compensation Committee authorized the issuance of up to 317,802 performance based restricted stock units (“Performance RSUs”) pursuant to the 2006 Performance Stock Program. The vesting of the Performance RSUs will be determined based upon the percentage improvement in Bankshares’ pre-tax operating income (“PTOI”) over a three-year performance period (the “Performance Period”) ending December 31, 2008 (with no adjustments for acquisitions or other extraordinary events). In addition to the performance period, the awards earned are subject to an additional one-year service requirement. Depending on actual performance, the Performance RSUs will vest at levels from 0% to 100%. On the same date, the Committee also awarded 104,630 RSUs to Bankshares’ chief executive officer. The award will vest ratably over four years. The RSUs converted into common stock will not be available for sale until the employment of the chief executive officer terminates.

 

The table below summarizes activity related to stock options during the quarter ended March 31, 2006.

 

 

 

Options issued

 

Weighted average

 

Options

 

Weighted avera